Back in May, investors may have noticed a strange occurrence. The International Monetary Fund (IMF) upgraded the UK economic outlook. It said, buoyed by resilient demand, the UK economy is expected to avoid a recession and “maintain positive growth in 2023”.
This was on 23 May 2023, shortly after on 25 May 2023 news came from Germany that its economy had shrunk for the second consecutive quarter, the official definition of a recession. Germany, once the powerhouse of Europe, is now the only member of the G7 to see its economy contract.
Below we’ll explore what’s gone wrong for Germany, what it means for Europe and what the future holds.
There are three main areas where Germany’s economy has become unstuck in recent months: its energy policies, its industrial strategy, and its geopolitical standing.
Economic summary
The cracks started to appear after Russia invaded Ukraine in March 2022. Germany’s economy slowed sharply in the second quarter of 2022, when quarterly GDP growth dropped from a 1% increase in Q1 2022 to -0.1% in Q2. Growth for the rest of 2022 was meagre, GDP grew by 0.5% in Q3, but it dropped again in Q4 when it contracted by 0.5%.
Germany expanded by 1.9% in 2022, which is below the 2.6% rate of growth for France and the 3.7% growth rate for Italy. Even the UK’s economy, which was severely derailed by last September’s mini budget, had a growth rate more than double that of Germany’s in 2022 at 4.1%.
Germany’s Russian problem
While there are economic headwinds globally, there is no denying that Germany is starting to look like an economic outlier.
One explanation for this is that the war in Ukraine exposed Germany’s unique economic and defensive vulnerabilities. Before the war in Ukraine, Germany enjoyed an eastern policy or “Ostpolitik” with Russia, according to the Carnegie Institute. This relationship spanned trade, energy, and a range of economic and social contracts.
Russia accounted for 2.3% of total German foreign trade in 2021. Outside of the European Union, Russia was Germany’s fourth largest trading partner.
However, after Russia invaded Ukraine, sanctions imposed on Russia by the EU and other countries meant that Germany had to severely limit ties with Russia almost at once. This had major economic consequences for Germany and exports from Germany to Russia dropped more than 45% in 2022 compared with 2021, just one reason why Germany’s trade surplus is still below the highs from 2019.
The energy question
The German parliament’s decision in 2011 to phase out nuclear energy due to the risk of a nuclear accident has proved controversial.
The war in Ukraine triggered a fresh debate about nuclear power in Germany, but the last three German nuclear power stations were still shut down for good in April. This nuclear phase out meant that Germany was reliant on oil and gas imports, mostly from Russia, and was exposed to the volatility in oil and gas prices in 2022.
The impact of rising oil and gas prices had a knock-on effect on Germany’s legendary current account surplus. It fell from 7.2% of GDP at the end of 2021, to 4.2% of GDP by the end of 2022, as you can see in the chart below.
German current account as a % of GDP
Source: Bloomberg, as of 31/03/2023.
However, since then, Germany’s made a laudable effort to wean itself off hydrocarbons. For example, it ceased all Russian gas imports in September 2022. By January of this year Crude oil imports from Russia as of January 2023 were 3,500 tonnes, down from 2.8 million tonnes in January 2022.
In the past year, Germany has seen oil imports rise from Norway, Kazakhstan, and the UAE, but perhaps what is most remarkable, is Germany’s move towards renewable energy sources because of the war. A total of 6.2 million tonnes of crude oil was imported to Germany in January 2023, which is a 20.5% decline in volume terms compared to a year earlier.
China recovery stalls
While Germany’s move towards renewable energy sources could boost its trade balance, there are some concerns about Germany’s largest trading partner, China.
Trade between Germany and China was down 10.5% in the first quarter of this year, compared with 2022. One of Germany’s most valuable industries, motor vehicles, saw exports drop by 23.9% in Q1 2023, compared with Q1 2022.
Due to this sharp decline, the value of goods traded between Germany and China was only slightly higher than the value of goods traded between Germany and the US, its second largest trading partner. Part of the reason for this decline, is a sluggish Chinese economic recovery since the start of the pandemic. So, Germany may not be able to rely on China, or its car exports to get it out of its economic slump.
Tensions with France
Since Angela Merkel stepped down from power in 2021, the two largest economies in the Eurozone, Germany and France have been reported to have experienced a rocky relationship. Culminating in a cancellation of a bilateral summit between French President Macron and German Chancellor Scholz, last November.
The reason for the cancellation was apparently because the two leaders were unlikely to agree on key issues including defence, energy policy and public finances.
For example, France has been keen to point out what it sees as Germany’s foolish decision to phase out nuclear power, while Germany’s €100bn upgrade of its aged military fleet has seen most of their contracts go to US firms rather than France.
Does a tit-for-tat dispute matter for Germany and its economy? We believe yes. Back when Germany was declared an economic powerhouse, Angela Merkel was also considered Europe’s leader. Now France, under President Macron is showing signs that it wants to become Europe’s de-facto leader, which could reduce Germany’s standing in the world. When that happens, it can have an economic impact.
The ECB kicks Germany when it’s down
Last, but by no means least. Germany, with its history of fiscal prudence, is still affected by rising European interest rates.
The ECB hiked interest rates in June to 3.5%, and interest rates in the currency bloc are expected to rise to 3.8% by December this year, before falling back slightly in 2024. German debt as a % of GDP is 68.6%, which is low compared to the UK, the US, and most other European countries.
However, debt levels in Germany have risen since the pandemic, and rising interest rates are pushing up the cost of Berlin’s interest payments, which means that there is less money available to pay for public services.
At 3.12%, the German 2-year government bond yield is at its highest level since 2008, and tighter financial conditions are already weighing on growth.
Looking forward, the IMF predicts that before recovering in 2024, Germany’s economy will remain muted in 2023. However, the IMF is also calling for fiscal consolidation in Germany to help bring down inflation. Thus, if growth does not pick up soon, the prospect of fiscal tightening combined with monetary tightening from the ECB could limit any economic recovery for Germany in the coming years.
