Current Issues

Outlook 2011:

February 14, 2011 Germany

German growth remains robust

The German economy weathered the crisis commendably. The pace

and vigour of the V-shaped recovery surprised economic forecasters. With growth of 3.6% the best performance since its reunification Germany was the star performer on the growth stage in the euro area.
Super year 2010 saw the German economy benefit from four factors in particular: the inventory cycle, the catch-up effects from investment activity

postponed in 2009, the recovery of the global economy accompanied by a revival of world trade, and expansionary monetary and fiscal policies.
However, these factors are petering out (inventory cycle and catch-up effects for investments), losing momentum (global economy) or even acting as a constraint (fiscal policy). For this reason, German GDP growth

is expected to continue reverting to normal in 2011. Nevertheless, it remains robust and at a prospective expansion rate of 2% should again far outstrip its potential. This would more than offset the deep slump in 2009.
Developments in the labour market remain very encouraging. On

average, 2011 will probably see the number of unemployed fall below the 3 million mark, with the unemployment rate easing from 7.7% towards 7%.
Stable core inflation. At the end of 2010 the inflation rate was 1.7% mainly

Authors Bernhard Grf +49 69 910-31738 bernhard.graef@db.com Tobias Just +49 69 910-31876 tobias.just@db.com Jochen Mbert +49 69 910-31727 jochen.moebert@db.com Stefan Schneider +49 69 910-31790 stefan-b.schneider@db.com Editor Stefan Schneider Technical Assistant Manuela Peter Deutsche Bank Research Frankfurt am Main Germany Internet: www.dbresearch.com E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 Managing Director Thomas Mayer

because of higher prices for heating oil and fuels. A sustained acceleration of core inflation is not to be expected despite GDP growth that is still far outstripping its potential, since the economys capacities are still being under-utilised and wage growth remains moderate. Nor are inflationary effects visible to date from either monetary or fiscal policy. For this reason we expect average annual inflation to come to roughly 2% in 2011, after 1.1% in 2010.
On the issue of public finance, Maastricht is in sight. The burgeoning

recovery, the upswing in the labour market and the measures of the austerity package should provide relief for public budgets. This is why we think the general government deficit could realistically shrink to about 2 % of GDP in 2011, bringing Germany back into line with the budget criterion of the Stability and Growth Pact already in the course of this year.

Current Issues

Outlook 2011:

German growth remains robust

Super year 2010 GDP growth
% qoq (left), % yoy (right) 3 2 1 0 -1 -2 -3 -4 07 08 % qoq (left) 09 10 % yoy (right) 1 6 4 2 0 -2 -4 -6 -8

The growth momentum shown by the German economy in 2010 surprised economic forecasters. No-one had expected to see a V-shaped recovery materialise at such a fast pace or with such vigour. With growth of 3.6% the best performance since its reunification Germany was the star performer on the growth stage in the euro area, outstripping the US economy by roughly percentage points. The foundation of this performance was mainly laid in Q2 2010 when real gross domestic product increased by 2.3% on the previous quarter. Under US accounting rules, i.e. where quarterly growth is extrapolated for the full year, the economy expanded by a whopping 9.4% in the second quarter! Super growth year 2010 saw the German economy benefit from four factors in particular: 1. The inventory cycle, both international and national. During the 2009 recession production was cut back sharply and inventories were slashed. These were slowly rebuilt in the course of 2010. 2. The catch-up effects from investment activity postponed in 2009. In a sign of the deep uncertainty that paralysed the global economy after the bankruptcy of Lehman Brothers, investments were cancelled or temporarily shelved. In Germany, investment in machinery and equipment plunged nearly 23% in 2009. This investment backlog eased last year around the globe. The boom in Germany was additionally spurred by infrastructure investment in connection with government stimulus packages. 3. The recovery of the global economy accompanied by a revival of world trade, which particularly stimulated the German economy thanks to its heavy export bias. Over the past year the global economy grew by roughly 4 % on the heels of negative growth of close to 1% in 2009, the first decline in the postwar period. The IMF estimates that world trade expanded by 11 % in 2010 following a downturn of a similar magnitude in 2009. 4. The expansionary monetary and fiscal policies in Germany and worldwide. The programmes launched in the OECD countries to fight the recession had a volume of around 2 % of GDP in 2009 and 2010. These factors are reflected in the growth mix of the German economy. Last year, inventory-building and investment in equipment generated 22% and 28% of GDP growth of 3.6%, respectively, with a further 30% coming from net exports.

Sources: Federal Statistical Office, DB Research

Contributions to growth
pp 4 2 0 -2 -4 -6 2008 2009 2010 Net exports Inventories Investment Government consumption Private consumption Real GDP (% yoy)
Sources: Federal Statistical Office, DB Research

German exports
% yoy 80 60 40 20 0 -20 -40 07 08 09 10 China 3 Total exports

Germany is the worlds outfitter The rebound in the investment cycle, particularly in the emerging markets of Asia, benefited Germanys exporting industry given its role as the worlds outfitter. Germany has exactly the right country and product mix in its export portfolio. This is impressively documented by the scale of Germanys exports to China, nearly 70% of which constitute machinery and transport equipment, i.e. capital goods, and which expanded by 45% last year, while Germanys total exports increased by merely close to 20%. With capital goods accounting for over 45% of its total exports, Germany is the leading such exporter in Europe. Moreover, the importance of the dynamically growing emerging economies of Asia and of China
February 14, 2011

Source: Federal Statistical Office

Outlook 2011

German exports to Asia

% of total exports China Southeast Asian EMs Other Asian countries 12 10 8 6 4 2 0 91 93 95 97 99 01 03 05 07 09
Source: Federal Statistical Office

in particular has noticeably increased over the past few years. In 2010 alone, the export share to China rose by one percentage point to over 5 % of Germany's total exports, putting them nearly at a par with exports to the United States, which accounts for about 6 % of German exports. All in all, more than 11% of German exports are shipped to the emerging markets and developing countries of Asia. Special effects of super year 2010 petering out Three of the four factors discussed here that drove growth in the super year 2010 are petering out, these being the economic policy stimuli, the inventory cycle and the investment catch-up effects. The fiscal packages to stimulate the economy have been phased out and many countries have already initiated consolidation programmes, marking the turning point in their fiscal policy. In Germany, this was done by means of the austerity package adopted last year. In many quarters, inventories have been assessed of late as having returned to reasonable levels, so it is unlikely that companies will continue to build them up, at least on a larger scale. This suggests that there will not be any significant growth stimuli in the current year from changes in inventories. In addition, the momentum of world trade started to weaken in the second half of 2010, and purchasing managers assessments of export orders have already been trending down worldwide since roughly mid-2010. This might be an indication that the investment activity postponed in 2009 has now been completed and that demand from abroad may have returned to normal accordingly. Global growth losing momentum It could also indicate, though, that the underlying business cycle in key regions of the world may generally have weakened a tad. While we are relatively optimistic on the prospects for the US economy, this undoubtedly does apply to Japan. The Japanese economy is likely to show more or less flat growth in 2011. But in the emerging markets of Asia, too, where growth is already moderating in China in particular as politically desired weaker dynamics are on the cards. Following a 10% increase in 2010 we look for real GDP to grow by 8 % in China in 2011. Thus, the expansion of the global economy is set to slow in 2011 to 4%, after 4 % in 2010. But this would still match the average growth of the past ten years. Eurozone remains a laggard in the economic cycle Not only Asias emerging economies are expected to place fewer orders with German businesses, though. Considering the adjustments necessary in the European crisis countries, i.e. mainly Greece, Ireland, Portugal and Spain, these are also likely to be a weaker source of stimuli for German exports. The consolidation efforts in the public sector in particular, but also in the private sector, will noticeably curb these countries growth and thus their imports. We expect Greece to remain mired in recession in 2011, while Portugal relapses into recession and Spain at best stagnates. However, this will not necessarily cause German exports to slump, since bilateral trade relations between Germany and these countries are very limited. Combined, exports to Spain, Ireland, Portugal and Greece only account for a good 5% of total German exports. By contrast, in other eurozone countries that are more important for Germanys exporting industry, e.g. France (over 10% of exports in 2009), the Netherlands (6 %), Austria (6%) and Belgium (5 %),
3

Global growth
% yoy 2009 2010F 2011F US Japan Euro area UK Asia China India Latin America Brazil EMEA Russia G7 World -2.6 -5.2 -4.1 -4.9 5.7 8.7 5.8 -2.4 -0.2 -5.2 -7.9 -3.5 -0.8 2.9 4.2 1.7 1.4 9.4 10.0 9.8 6.0 7.7 4.5 4.0 2.8 4.8 3.8 0.8 1.2 1.8 7.6 8.7 8.2 4.3 4.5 4.5 5.0 2.5 4.0 5

Sources: IMF. DB Research

Euro area: GDP growth

Real GDP (% yoy) 2008 2009 2010F 2011F Euro area Germany France Italy Spain Netherlands Belgium Austria Finland Greece Portugal Ireland 0.3 0.7 0.1 -1.3 0.9 1.9 0.8 1.9 1.0 2.0 0.0 -3.7 -4.1 -4.7 -2.5 -5.1 -3.7 -3.9 -2.7 -3.7 -8.1 -2.0 -2.6 -7.6 1.7 3.6 1.5 1.1 -0.3 1.6 2.1 1.8 2.8 -4.2 1.6 -0.5 1.2 2.0 1.2 0.9 0.2 1.2 1.6 1.6 2.5 -3.5 -0.5 0.5 6

Sources: National statistical offices, Central Banks, DB Research

February 14, 2011

Current Issues

the economic recovery is continuing with only slightly weakened momentum but budget consolidation is underway there too. As a whole, the eurozone is expected to see growth of close to 1 % in 2011, after 1 % in 2010, with performance still being driven primarily by the German economy. Excluding Germany, eurozone growth would be merely on the high side of % in 2011 as in 2010. This means that the growth picture in the eurozone has reversed. While the southern peripheral countries driven by excessively low real interest rates and booming real estate markets posted robust growth over the past decade and left Germany trailing in the dust, the reverse scenario is likely to materialise in the coming years if the necessary consolidation of public and privatesector budgets on the periphery leads to feeble expansion. Export engine losing power
60 55 50 45 40 35 30 03 04 05 06 07 08 09 10 11 German exports (left) Global export orders* (right)
*brought forward by 4 months Sources: J.P. Morgan, NTC Research, Federal Statistical Office

Global export orders and German exports

% yoy (left), % (right) 30 20 10 0 -10 -20 -30

Purchasing managers less enthusiastic assessment in H2 2010 of future global export orders (although slightly up recently) suggests that German export growth dynamic probably peaked last autumn and that exports will grow this year at only about half the pace of 2010, or roughly 7 % in real terms. Thus German shipments abroad will increase at roughly the same pace as global trade, and the nearly synchronous pattern of global trade and German exports on record for many years is set to continue, which considering the increasing world market shares of the emerging economies impressively underscores the competitiveness of German industry. External contribution to remain unchanged at around one percentage point Since demand for imports is also set to ease during the stage of slower economic growth following an increase of 13% in 2010 we expect to see real imports climb by only 6 % or so in 2011 net exports are likely to repeat their contribution of roughly one percentage point of economic growth in the current year. In nominal terms Germanys trade surplus will equal about 6% of GDP in 2010, with the current account surplus coming in at about 4 %. Cloud over investment activity Given the pronounced export bias in the German economy, weaker export growth is also going to cast a cloud over investment activity. Goods exports generate about 33% of GDP, and the inclusion of services ups the percentage to no less than 40%. However, Germany also imports goods and services worth around 36% of GDP. Investment in machinery and equipment recovered in 2010 from a dramatic slump in 2009 (-22.6%), increasing by close to 10%. This was probably partly driven by purchases being brought forward, as the option of using declining-balance depreciation on moveable assets expired at the end of 2010. Nevertheless, at end-2010 investment in machinery and equipment still fell more than 10% short of the pre-crisis level. With capacity utilisation rising slowly, the growth to date probably came largely on the back of replacement investment and not so much investment in expansion. Given weaker external stimuli and the disappearance of broughtforward purchases we look for more moderate investment growth this year. This is underpinned by the fact that in early 2011 capacity utilisation is still slightly below average. Besides, the reading is still 5 percentage points lower than the average in 2006 and 2007 when investment in machinery and equipment increased by over 10%
February 14, 2011

Exports & investments

% yoy 20 15 10 5 0 -5 -10 -15 -20 -25 00 01 02 03 04 05 06 07 08 09 10 11 Investment in machinery & equipment Real exports
Sources: Federal Statistical Office, DB Research

Investment
Q1 2007=100 110 105 100 95 90 85 80 75 07 08 09 10 Total Mach. & equipment Construction
Source: Federal Statistical Office

Outlook 2011

Confidence indicators
2000 = 100 (left), % (right) 115 110 105 100 95 90 85 80 00 02 04 06 08 10 Ifo Index (left) Purchasing Managers Index (right)
Sources: ifo, Reuters

65 60 55 50 45 40 35 30

each year. All in all, investment in machinery and equipment is only expected to pick up by about 5 % in 2011, after 9.4% last year. We think there is little probability of a pronounced weakening of investment activity considering the still favourable outlook for corporate earnings, the extremely low interest rates and the general confidence of German industry. In November 2010, the Ifo Business Climate Index for German industry and trade climbed above its last peak, which had been reached during the 2006/07 boom, and continued to rise in December. Companies were very optimistic in their assessments of both the current business situation and prospects for the next six months. And at close to 61 points the Purchasing Managers Index clearly outstripped the 50-point mark delineating the border between growth and recession. Construction impacted only minimally by the crisis Unlike manufacturing, Germanys construction industry had been affected only minimally by the economic crisis. One reason is that construction did not experience a veritable boom as in many other European countries. In fact, before the crisis hit, construction had been well on its way towards recovering from the ten-year structural adjustment that had eroded one-third of German construction activity since the mid-1990s. Another reason is that the public sector had invested extensively in civil engineering projects and in measures to enhance the energy efficiency of privately and publicly owned buildings in order to prop up the sector. This resulted in the order volumes (of the construction industry) remaining roughly at pre-year levels in both the civil engineering and the residential segments even in the depths of the 2009 recession. Only the heavily cyclical commercial building segment was rocked to its foundations by a double-digit percentage slump in incoming orders. The picture is set to change in the course of this year: while civil engineering is losing ground because of the expiry of public stimulus measures, commercial building is starting to gain territory from a very low basis thanks to the pick-up in economic activity; the volume of civil engineering is likely to contract by about 5% in 2011, while commercial building will probably expand by a roughly similar amount. However, because small firms are not included when the construction output statistics are gathered and because these firms benefit more than others from renovation projects, the figure reported in the national accounts is likely to show a smaller increase in commercial building investment. What is noticeable in any event is the strong jump in residential construction: the number of building permits was up by close to 7% on the year-earlier figure during the first ten months of 2010, while the number of permits for multi-family dwellings was up by close to 10% yoy no less. Also the number of new orders for residential construction outstripped the pre-year reading up to October 2010 by around 10%. For 2011 the recovery in residential building should more than compensate for the adjustment strains in the civil engineering segment. We expect the construction industry as a whole to see an increase in full-year output. Industry benefiting strongly from global recovery Manufacturing output slumped by over 17% in 2009, affecting the capital goods segments in particular: mechanical engineering and metals production both saw output drop by over 25%. In Q2 2009, capacity utilisation in the manufacturing sector declined by more than 15 percentage points to slightly over 70%, reaching the lowest level since at least 1960 earlier data is not available. Only the food
5

10

Residential construction is recovering

Incoming orders, 2000=100, sa, smoothed 160 140 120 100 80 00 01 02 03 04 05 06 07 08 09 10
Civil engineering Other structural Residential construction
Source: Destatis

11

Industrial production
% yoy Sectors Food Drinks Textiles Clothing Chemicals Pharma Plastics Metal prod. Met. products Electrical engineering Mechanical engineering Auto Manufacturing 5.0 -26.0 -3.8 -21.7 1.0 -17.3 9 24 11.5 11 12.5 6.5 12 5.1 -20.4 12.5 6 2008 2009 2010F 2011F 0.2 -1.7 -0.5 -4.0 1.5 1.5 12 0 18.5 1.5 13 22 14.5 1.5 1.5 0 -5 3.5 1.5 5 3 5

-4.5 -19.6 -14.6 -14.0 -3.8 -14.3 3.3 -2.2 -1.9 -10.5 -1.1 -27.2 2.0 -21.8

Sources: Federal Statistical Office, DB Research

February 14, 2011

Current Issues

Utilisation higher again

Capacity utilisation in Germany (%) Auto Chemicals Electrical engineering Mechanical engineering Metals processing Manufacturing 50 60 70 80 90 100 2009 low Recovery since 2009 low up to now Remaining gap to 2008 peak
Sources: Federal Statistical Office, DB Research

and pharmaceuticals industries largely avoided falling into recession at least in terms of their production volume growth thanks to their low susceptibility to fluctuations. However, in the subsequent quarters government monetary and fiscal stimulus programmes helped to kick-start a huge global increase in demand. German industry was among the beneficiaries: in fact, up to December 2010 the manufacturing sector reported foreign orders up more than 50% versus their low, while domestic orders were up roughly 30%. This recovery benefited the capital goods industries in particular. The early-cycle sectors (chemicals and metals production) as well as the automotive industry, boosted by the scrappage bonus, regained their footing fastest. However, growth in these sectors already started to cool noticeably in the second half of 2010 at the latest reading, metals production and metals processing did not even register a further increase in their order volumes. The late-cycle sectors such as mechanical engineering and (with a few slight exceptions) the auto industry are not yet feeling the brakes on their momentum. They are not expected to see growth start weakening until later in 2011. All in all, manufacturing output grew by 11.5% in 2010; for 2011, however, we expect production growth to slow to only about 6.5% close to half of this will be attributable to a statistical overhang i.e. the expansion in 2010. So the crisis-induced demand slump could be nearly overcome by late 2011. While the upswing in electrical engineering and mechanical engineering is continuing virtually unbridled, we expect both metals production and the chemicals industry to see their growth rates ease considerably. Encouraging labour trend continues Unlike all the other industrial countries, Germanys labour market weathered the crisis extraordinarily well. Thanks to the extension of short-time work schemes, companies good financial situation and the flexible working hours negotiated in collective wage agreements (including working-time accounts), unemployment increased only slightly during the 2009 crisis. This demonstrates how targeted reforms have boosted the flexibility of the German labour market. Over the past year the number of unemployed fell by roughly 260,000 to slightly over 3 million people at last reading (seasonally adjusted). This was its lowest level since 1992. The unemployment rate fell accordingly from its last high of 8.3% in summer 2009 to 7.4% recently. Moreover, during the recovery the number of hours worked was boosted strongly, and the number of people on short shifts was reduced from around 1 million to about 200,000. The low number of new registrations suggests that the number of shorttime workers will trend down further in the coming months. Besides, the number of workers obliged to make social-security contributions increased by nearly 1% in 2010, after decreasing by 0.2% in 2009. Exports, investment activity and probably also employment trend all returning to normal While the uptrend in job vacancies and the currently large number of companies planning to hire new staff point to a still faster increase in employment, this strikes us as being overly optimistic given the heavy dependence of employment on exports. Our expectations of weakening export and investment growth suggest that total employment is likely to grow in the current year at roughly the same pace as in 2010.

13

Slowing upswing
Production index, manufacturing, seasonally adjusted, smoothed, 2005=100 120 +1.0% +6.2% 115 +6.5% 110 +11.5% 105 100 95 -17.3% 07 08 09 10 11 14 90

Sources: Federal Statistical Office, DB Research

Unemployment
Seasonally adjusted, million (left), % (right) 6 13 12 Unemployment rate 5 11 (right) 10 4 9 8 3 Number of 7 unemployed 6 (left) 2 5 05 06 07 08 09 10 11
Sources: Federal Labour Agency, DB Research

15

Short-time worker
Million 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 07 08 Total 09 10 11 16 New registrations
Source: Federal Labour Agency

February 14, 2011

Outlook 2011

Exports & employment

% yoy 30 20 10 0 -10 -20 -30 00 4 3 2 1 0 -1 -2 -3 -4 02 04 06 08 10 Nominal exports, 3M mov. avg. (left) Workers obliged to make soc.-sec. contrib. (right)
Sources: Federal Statistical Office, DB Research

Unemployment is set to trend down further and the number of unemployed should sink to just under 3 million on an annual average, bringing the unemployment rate down towards 7% accordingly. This means that Germanys labour market performance will remain a good example for others not only in Europe. Private consumption gaining momentum Given the continuing recovery of the labour market and the improvement in consumer confidence, the hopes of private consumption registering a sustainable recovery have also risen of late. Even though retail sales had only picked up by a good 1% in real terms in 2010, retailers have become significantly more optimistic. But will private consumption evolve from a source of hope into a driver of growth? Probably only to a limited extent. Since it has proved a disappointment every year since 2000 with an average increase of just over % and in fact has more or less stagnated for the past four years we expect to see an increase of 1 % in real terms in 2011. However, private consumption cannot compensate for the weaker growth stimuli from net exports and investment. Despite the top-up debate shaping up over wages and salaries we expect to see an only moderate increase in 2011. While not quite one-third of all collective agreements are set to expire in 2011, oneoff payments and positive wage drift will support incomes. All in all, total gross payrolls are likely to increase by over 2 % this year, up from 2 % in 2010. The transfers received by households are likely to increase at a slightly slower pace in 2011, while corporate and investment income are poised to jump faster than labour remuneration. So, all in all we expect disposable income to increase by nearly 2 % in 2011. This is tantamount to a real increase of around 1 %, which provides scope for us to forecast an increase in private consumption on a nearly constant savings ratio. 2011: Robust, sustainable 2% growth The individual components add up to growth of 2% for the current year, while we believe expansion of roughly 1 % is conceivable for 2012. On a quarterly basis we expect the growth of the German economy to return to normal in the course of 2011 with rates of 0.3% to 0.4% per quarter. The increase in real GDP is thus expected to fall noticeably short of the performance in 2010, when the special factors discussed above stimulated growth and drove the rate up to 3.6%. However, total economic growth is again running noticeably higher than its potential, and Germanys is the highest among the larger eurozone economies. Besides, growth is becoming increasingly self-sustaining since fiscal policy is now turning more restrictive in the wake of the stimulus packages as foreseen with the austerity package, and no additional boost is to be expected from monetary policy. Is Germany not doing enough for the domestic economy? Roughly half of the expansion in GDP is being driven by net exports and half by domestic activity. Back in 2010 the growth mix was still about 30% to 70%, with the domestic side tipping the scales. Internationally, Germany is being accused of doing too little for its domestic market, concentrating overly strongly on the competitiveness of its exports and generating correspondingly high external surpluses which, like the large deficits in the problem countries of Europe, could be manifestations of sectoral distortions. Robust

17

Real private consumption

% yoy 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 00 02 04 06 08 10 18
Sources: Federal Statistical Office, DB Research

Germany: Forecasts at a glance

% yoy 2009 2010 2011 Real GDP -4.7 3.6 Private consumption -0.2 0.5 Gov't expenditure 2.9 2.2 Fixed investment -10.1 5.5 Investment in M&E -22.6 9.4 Construction -1.5 2.8 Exports -14.3 14.2 Imports -9.4 13.0 Consumer prices 0.2 Budget balance, % GDP -3.0 Unemployment rate, % 8.2 Balance current account, % GDP 5.0 1.1 -3.5 7.7 5.0 2.0 1.3 0.8 3.1 5.8 0.7 7.4 6.6 2.0 -2.8 7.1 4.7 19

Sources: Federal Statistical Office, DB Research

February 14, 2011

Current Issues

Contributions to growth
pp 4 3 2 1 0 -1 -2 Domestic market External contribution Real GDP (% yoy) 92 94 96 98 00 02 04 06 08 10
Sources: Federal Statistical Office, DB Research

domestic activity would boost Germanys imports, reduce the trade surpluses and in turn give growth in the problem countries a fillip. But is there any substance to this accusation? We dont think so. True, net exports generated about three-quarters of Germanys average GDP growth of 1.2% from 2001 to 2008. However, the result of such a comparison hinges strongly on the period chosen, as shown by chart 20. From 1995 to 2008 GDP growth averaged 1.6% p.a., with the contribution from net exports coming to not quite 40%. Moreover, German imports expanded at nearly the same pace as global trade. This documents the strength of the stimulus provided by Germany for the global economy also partly because German exports display a large percentage of foreign input in terms of preliminary and intermediate products. Export-induced imports are found in considerably more than 40% of German exports. This means that other countries also benefit from robust increases in German deliveries. Moreover, the stronger growth of the domestic markets in other European economies over the past few years is largely attributable to an overabundance of credit-driven growth in their real estate markets thanks to extremely low real interest rates. By contrast, Germany where interest levels appropriately reflected the business cycle and where there was no property market boom was referred to as the sick man of Europe. Household debt has surged in relation to disposable income in many countries since the launch of the euro, nearly doubling in some cases (in Italy and Spain, for instance) or even trebling (Greece). The opposite is true in Germany where it has declined. This tends to apply equally in terms of corporate debt. It now emerges that events in Germany were much healthier for the economy than in other countries whose domestic demand was cited as an example for Germany, but whose performance did not prove sustainable and compelled the countries affected to adopt consolidation packages lasting several years. A more balanced economic performance with stronger domestic activity is certainly to be welcomed. The only question, though, is at what price. German growth potential: Lower after the financial crisis? Debate has intensified again lately on Germanys potential growth rate. While some believe potential growth will remain lower permanently, other forecasts project higher growth potential thanks to successful reforms, particularly in the labour market. GDP can be regarded as a combination of potential output and a cyclical component. The potential output of an economy refers to the total economic output that can be produced making use of the production factors labour and capital that are available at a given time. The calculation takes account of technological progress and assumes normal capacity utilisation. Hence, the cyclical component equals the fluctuations in the utilisation of the overall potential. For the purpose of economic analysis it is important to be aware of potential growth, as it defines the maximum pace at which an economy can grow over a longer term without leading to tensions in the labour market and an acceleration of inflation. Once potential growth has been determined, other important indicators used in the analysis of the business cycle and inflationary risks, such as the output gap (i.e. the gap between potential and actual GDP) and structural unemployment, can also be calculated.

-3 -4 -5 20

World trade & German imports

% yoy 20 15 10 5 0 German imports World trade 95 97 99 01 03 05 07 09 21 -5 -10 -15

Sources: IMF, Federal Statistical Office

Household debt
% of GDP 1999 2008 120 100 80 60 40 20 0 GR ES IT PT DE 22
Source: Eurostat

Potential output & business cycle

Schematic Cyclical component Potential output Value Potential output Actual GDP Time t 23

February 14, 2011

Outlook 2011

Germany: Potential output

Total Potenfactor tial Labour Capital producoutput volume stock tivity Growth contribution % yoy 1971-80 1981-90 1991-00 2001-06 2007 2008 2009 2010 2011 2012-16 2.7 2.3 2.1 1.3 1.2 1.2 1.2 1.3 1.3 1.0 -0.8 0.0 -0.1 -0.1 0.0 0.0 0.1 0.2 0.2 -0.2 pp 0.9 0.6 0.6 0.5 0.4 0.4 0.4 0.4 0.4 0.3 2.6 1.8 1.6 1.0 0.8 0.8 0.8 0.8 0.8 0.8 24

However, growth potential cannot be observed directly, like for instance the number of persons in gainful employment or prices for individual goods. Therefore, estimates must be made using statistical procedures. Various methods can be used to do this, such as average, trend and filter procedures as well as production technology procedures. The filter procedures, including the frequently used Hodrick-Prescott filter, are relatively simple in their application, but they have the disadvantage that they actually need a completed economic cycle for analytical purposes. Given this endpoint problem they are very unreliable for analyses of the latest data. Besides, they do not allow any conclusions to be drawn about the reasons for a change in potential output. Production technology procedures that explain potential output via the factors involved in the production process i.e. labour, capital and technological progress (total factor productivity) avoid this disadvantage (the adjacent table shows how Germanys Council of Economic Experts calculates potential output). Potential growth roughly 1 % in 2011, ... There is little disagreement among the major economic research institutes as regards potential growth for 2011. The Council of Economic Experts, like the IMF and the OECD, forecast 1 % potential growth for the German economy in the current year. Our own analysis also arrives at roughly this rate. Hence the current growth rate of potential output is roughly in line with the average of the last five years. ... scarcely affected by the crisis, ... To be sure, the basis for determining potential growth is highly uncertain at present. Nonetheless, analysis shows that growth potential has so far not been noticeably affected by the financial crisis. This may seem surprising at first glance as earlier financial crises did have an evidently negative impact on the rate of potential growth, which was a result of sectoral distortions and a related increase in structural unemployment. In Germany, though, there was no real estate boom like in many other countries. Accordingly, unlike in the United States, Britain, Spain or Ireland, for instance, there was no need for adjustments in the construction industry. We therefore do not expect an increase in structural unemployment in Germany, nor related consequences for Germanys growth potential. According to OECD estimates, structural unemployment in Germany is even lower at present than in mid-2000, while the countries which experienced serious bubbles in their property markets and considerable sectoral adjustments when these bubbles burst are expected to be confronted with substantially higher structural unemployment and as a result lower growth potential. ... but will be squeezed by the demographics over the long term Even though the financial crisis has not severely harmed Germany's growth potential, demographic shifts mean there are still enormous challenges ahead. Germany's population will shrink by 20% by 2060. At the same time, the labour force aged between 15 and 65 years will decline by no less than 35%, as the baby-boom generation will soon start to reach retirement age and be replaced only partially by the cohorts born in years with low birth rates. The shrinking of the working-age population will accelerate considerably and exceed more than 1% per annum between 2020 and 2035. All other things being equal, this would imply stagnation in potential output.
9

Source: German Council of Economic Experts (2010/11)

House prices
House price in relation to income, long-term average = 100 US ES GB DE IE 200 180 160 140 120 100 80 60 40 2008 25

2000

2002

2004

2006

Source: OECD

Population development
% yoy 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2 -1.4 Population -1.6 2010 2020 2030 2040 2050 2060 Medium variant, lower limit Total 15-65 cohort
Source: Federal Statistical Office

26

February 14, 2011

Current Issues

Decline in growth potential probably inevitable in the long run A decline in the growth rate of Germany's potential output appears inevitable. The Council of Economic Experts already expects growth potential to fall to only 1% per year for the period 2012 through 2016. Just how sharply Germanys growth potential will fall over a longer-term horizon, when the damping effects of demographic change will be strongest, will depend on how society decides on issues such as the start of the working life, the retirement age, gainful employment, annual working hours as well as immigration. Monetary policy: ECB in a difficult situation ECB: Key rate & 3M rate
% 6 5 4 3 2 Refi rate 3M rate 99 01 03 05 07 09 11 27 1 0
Sources: ECB, DB Research

Given the diverging economic patterns in the core and peripheral EMU countries as well as persistent problems in the banking sectors of various countries, the ECB finds itself between a rock and a hard place. Since the situation varies very considerably from country to country and thus policy changes also have an asymmetrical impact, it is difficult to gear policy to the eurozone average. We believe that the ECBs willingness to stage an exit from its extremely relaxed monetary policy should not be underestimated, and we expect it to start tightening the monetary reins in the second half of 2011 at the latest. True, not too long ago it did decide to postpone the exit from its fixed rate tender procedure with full allotment. But by saying that up until March the interest rate on 3month refinancing operations will be set at the average of the onemonth refi rates within these periods the ECB has indicated that this rate may indeed head north. Moreover, it spoke of the separation principle, i.e. that it could always boost key interest rates before exiting from its full allotment policy for refinancing operations and reverting to normal auction procedures. The ECB probably made this reference to avoid undermining the credibility of its monetary stance. However, such steps will hardly be up for discussion until some way is found to defuse the sovereign debt crisis facing the peripheral countries. Nevertheless, the ECB is still likely to be the first central bank among the major industrial countries to reverse the thrust of its monetary policy. In doing so it will be confronted with far fewer problems than the Fed, which recently decided to extend its quantitative easing policy by purchasing long-term US Treasuries and which could expand its balance sheet by up to a further USD 900 bn, to over USD 3,200 bn, by the end of the second quarter. By contrast, the ECBs easing moves consisted largely of cutting interest rates, expanding tender volumes and lengthening the duration of its refinancing operations. For this reason it is relatively simple for the ECB to syphon liquidity out of the markets when these operations expire. Purchases of covered bonds (Pfandbriefe) and sovereign debt that served to stabilise these markets and that were sterilised accordingly (i.e. the resultant increases in liquidity were subsequently drained from the system via other measures) played an only minor role. The programme to buy Pfandbriefe worth EUR 60 bn has been wrapped up and the government bond purchases currently total only slightly less than EUR 85 bn. All in all, we expect the ECB to start raising key rates in the second half of the year. By year-end the ECBs refi rate could stand at 1.75% and rise further in 2012, provided that the euro does not persistently soar to new highs.

Central bank balances

EUR bn & USD bn, resp. 2,500 2,000 1,500 1,000 500 07 08 09 10 11 28
Sources: Fed, ECB

Fed ECB

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Outlook 2011

Consumer prices
% yoy 4 3 2 1 Total Excl. energy 07 08 09 10 11 29 0 -1

Inflation: Stable core rate Inflation ran moderately in 2010. Worries about a possible surge in the inflation rate proved to be just as unfounded as those about deflation. At year-end 2010, the rate was 1.7% and it increased to 1.9% in January being driven by higher prices for heating oil and fuels in particular. The annual average for 2010 was 1.1%. The adjusted core inflation rate, which strips out energy prices, was stable last year at close to 1%, thus falling slightly below the longterm average. Price drivers (possible exceptions being energy and food) are not on the horizon despite GDP growth that is still far outstripping its potential since, according to OECD calculations, the economys capacities are still being substantially under-utilised and wage growth remains moderate. For this reason we look for the inflation reading to hover at around 2% in 2011 and remain in check at about 1 % in 2012. In our forecast we assume that the oil price will increase only moderately, averaging USD 97 per barrel in 2011 and inching up to USD 98 per barrel in the following year. Whither financial markets? It is most difficult at present to forecast yield performance since the current readings are certainly not fundamental equilibrium levels on account of the central bank purchases of government bonds, in the US in particular, and the unbroken flight to quality. Thus the outlook hinges of course not only on the shape of growth and inflation going forward, but also to a considerable extent on the development of the special factors discussed earlier: whether the Fed will complete its announced quantitative easing programme and how the euro crisis will play out. In our baseline scenario we assume that no major eurozone economy will have to seek a bailout via the European rescue package (European Financial Stability Facility EFSF). It follows that the flight to quality is likely to slow, with the high yield premiums demanded for problem sovereigns declining as a result. However, this will probably take place only very slowly and yield spreads are likely to remain very high in comparison with the pre-crisis levels, since the spreads are mainly being shaped by how the markets assess the efforts and success of the problem countries in consolidating their finances. The financial aid for Greece and Ireland has only bought time for these economies. It is still absolutely essential that these countries consolidate their public finances in a sustainable and, above all, confidence-building manner. Since the boom in the German economy is set to continue and real returns of about 1% at present can really not be regarded as normal, we believe that German yields will increase in the course of 2011 also against a backdrop of tightening US interest rates. At end-2011 German paper could yield around 4%. Public finances: Maastricht in sight The burgeoning recovery and the upswing in the labour market should provide relief for public budgets in 2011 as already in 2010. Given the cyclical forces and a half percentage point reduction of the structural deficit we think that the general government deficit could realistically shrink to about 2 % of GDP. This means that Germany would fall back into line with the budget criterion of the Stability and Growth Pact already in the course of this year.

Source: Federal Statistical Office

10Y government bond yields

% 5.5 5.0 4.5 4.0 3.5 3.0 US DE 05 07 09 11 30 2.5 2.0 1.5
Source: DB Research

EMU: Yield spreads

Vs. German Bunds, basis points 1,100 1,000 900 800 700 600 500 400 300 200 100 0 10 11
Source: DB Research

PT IE ES GR IT

09

31

Real returns
% 8 Yield on 10Y government 7 bonds minus inflation 6 5 4 3 2 1 0 80 84 88 92 96 00 04 08 Sources: Federal Statistical Office, DB Research 32

February 14, 2011

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Current Issues

Public finances
% of GDP 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 -4.0 07 08 09 10 11 Budget balance (left) Debt (right) 33 76 74 72 70 68 66 64 62 60

Stepping on the debt brake Part of the budget improvement in 2011 will be driven by the austerity package, which calls for a consolidation volume of around EUR 80 bn from 2011 to 2014 and which was launched to comply with the debt brake anchored in Germanys Basic Law. The debt brake limits new structural debt from 2016 to no more than 0.35% of GDP. For the current year the austerity packages consolidation volume is set to hit over EUR 11 bn, or roughly 0.4% of GDP, thanks to higher revenues (e.g. cutbacks in energy tax breaks, fillips from the aviation tax and tax on nuclear fuel rods) and expenditure cutbacks (e.g. setting off the parenting benefit against unemployment benefit II, reducing the parenting benefit, abolishing the heating cost component in the housing benefit and saving on administrative costs). The government debt ratio, which came to about 66% of GDP before the outbreak of the crisis, is therefore likely to peak at around 74% of GDP in 2011 and decline noticeably to less than 70% by 2016. This performance differs positively from that in other eurozone countries, whose new debt will be far higher than in Germany and whose debt ratios will temporarily continue to climb. According to European Commission calculations, the public debt level is set to increase by a further almost 10 percentage points in Spain by 2012, to 73%, while the readings in France and Portugal increase from 83% to around 90% and in Ireland and Greece by 17 percentage points, to 114% and 156%, respectively. Bernhard Grf (+49 69 910-31738, bernhard.graef@db.com) Tobias Just (+49 69 910-31876, tobias.just@db.com) Jochen Mbert (+49 69 910-31727, jochen.moebert@db.com) Stefan Schneider (+49 69 910-31790, stefan-b.schneider@db.com)

Sources: Deutsche Bundesbank, DB Research

Public debt
% of GDP 160 2010 2011 2012 100 80 60 40 ES DE FR PT IE IT GR 34 140 120

Source: European Commission

Copyright 2011. Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite Deutsche Bank Research. The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made. In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt fr Finanzdienstleistungsaufsicht. In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated by the Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this information is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Printed by: HST Offsetdruck Schadt & Tetzlaff GbR, Dieburg ISSN Print: 1612-314X / ISSN Internet and e-mail: 1612-3158

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