This week has seen another number of downward revisions of the growth outlook for the German economy and in consequence for EMU as well. The council of economic advisors (“Sachverständigenrat”) is now only forecasting a GDP growth for the German economy of 1.9 percent in 2008, the EU commission cut its forecast yesterday to 2.1 percent.
In fact, the short term outlook for the German economy over the coming months is even worse than these numbers suggest. While GDP growth in the third quarter of 2007 to be published next week will most likely have been strong, there will be a significant slowdown going into 2008. According to the Sachverständigenrat, the statistical overhang for 2008 amounts to 0.9 percent (meaning even if you had a stagnation of GDP quarter-on-quarter in each single quarter of 2008, you would still record an annual GDP growth of 0.9 percent), meaning that in turn the quarter-on-quarter growth in 2008 is already forecasted to be very low.
Moreover, the growth rate of roughly 2 percent in both the forecast from the council of economic advisors as well as the EU commission is only reached by assuming finally a robust pick-up in consumption demand. While there are some signs that German consumption indeed is improving (car sales seem to have picked up lately and retail sales have recovered from the VAT shock in January), so far, it is far from being a growth engine. Real consumption is forecast by the Sachverständigenrat to slightly shrink in 2007 compared to 2006, mainly as a result of the VAT hike earlier this year. For 2008, now the experts have penciled in an increase by 2.0 percent. Given the new record for energy prices, it is a risky bet to base the hope for a decent growth in 2008 almost entirely on a recovery of the German consumption demand, a component that has not grown by 2 percent or more since 2000 and that has continued to disappoint over the past years and has on average not grown between 2002 and 2006.
In contrast, both drivers of the German recovery in 2006 and 2007 are set to be almost disfunctional in 2008: Given the recent rise of the euro to a record high and the slowdown in the US and Japan, export growth is set to slow.
In addition, fixed asset investment will be hit by a tripple blow going into 2008. First, the more expensive euro will hit the manufacturing profits and hence their cash-flow available for internal financing of investment. Second, the market turmoils have led to more restrictive financing conditions with banks tightening their credit requirements, making credit financing of investment harder.
Third, the German corporate tax reform coming into effect on January 1, 2008 will significantly dampen investment growth. While the tax reform cuts corporate tax rates by about 10 percentage points (to an effective roughly 30 percent including local taxes), it also cuts depreciation allowances, thus making investment for domestic companies much less attractive. In addition, temporarily extremely attractive depreciation allowances for 2006 and 2007 have led firms to pull investment forward, an impulse which will be missing in 2008.
This effect is also present in the forecasts of the EU commission and the Sachverständigenrat. In the Sachverständigenrat expertise, investment in equipment is set to growth by 3.4 percent in 2008 as a whole, after an increase of almost 11 percent this year. However, the statistical overhang at the end of 2007 is already more than 4 percent. Hence, the experts expect an actual drop in fixed investment in equipment at the beginning of next year.
A first sign of the extend of the slowdown to be expected for investment in fixed capital is the drop in domestic orders for capital goods in September by 4.8 percent month-on-month, bringing the September value down below that from 12 months ago in calendar adjusted terms. While this drop might overstate the real slowdown, the direction is not implausible.
So, one sadly has to say that the forces weighting on the German recovery are clear and present, while the forces supposing to keep the upswing from collapsing are mostly based on the hope that German companies continue to hire even though their demand and profit situation is deteriorating and this increase in employment is finally persuading the Germans to open their wallets. While the German economy might be more robust than in the dismal years between 2002 and 2005, this is still a highly risky bet.