GERMANY SNEEZES, EUROPE CATCHES A COLD / GEOPOLITICAL FUTURES

Germany Sneezes, Europe Catches a Cold

The risk for Berlin is whether to prioritize its economy or EU stability.

By Ekaterina Zolotova 

In the first three months of the year, Germany’s economy fell short of low expectations of zero growth. 

Instead, gross domestic product shrank for a second consecutive quarter, putting Europe’s largest economy in technical recession. 

Continuing to believe in the economy’s near-term prospects, the government points to huge investments in clean energy and the production of semiconductors and batteries. 

However, the bigger problem for Berlin than its minor recession is what its slowdown means for the eurozone and other EU economies. 

Member states’ economies are closely linked with Germany’s, so declines in Germany could spell trouble for them as well.

Technical Recession

The stars aligned for Germany in the first quarter of 2023. A warm winter reduced the damage from an energy crunch, industrial activity continued to recover, supply chains continued to stabilize, and China continued to reopen after COVID-19 restrictions. 

However, this was not enough to lift Germany out of danger, and its economy shrank by 0.3 percent compared with the previous three months. 

Surveys of business sentiment were weak. Inflation remains high, coming in at 6.3 percent for Germany in May. 

The European Central Bank has indicated that it will continue to raise interest rates to bring price growth closer to its 2 percent target, but higher borrowing costs translate into less borrowing and thus slower growth.

Amid rising prices, German households cut spending by 1.2 percent, especially on food and beverages, clothing and footwear, furniture and household goods. 

They also bought fewer cars, which may be due to the expiration of government support for purchases of hybrids and electric vehicles in early 2023.

Manufacturers aren’t feeling too comfortable either. 

German industrial companies cut production late last year due to record-high energy prices, as Europe snapped up pricier liquefied natural gas to replace Russian piped gas. 

Manufacturing in Germany was 1.3 percent lower in March than in February. 

At the same time, German industry has seen a drop in demand from its main consumers. 

On a quarterly basis, industrial orders decreased by 1 percent in the first quarter compared with the fourth quarter of 2022. 

This is a bigger problem in Germany, where exports account for about 40 percent of GDP, than it would be in most other countries. 

Especially critical is the automotive industry. 

Because of sanctions, German carmakers have cut deliveries and even sold factories in Russia, while in Asia a surge in popularity of Chinese-made electric vehicles has eaten into German profits. 

Volkswagen, for years the region’s dominant carmaker, reported a nearly 15 percent drop in sales in China in the first quarter. 

Adding insult to injury, German manufacturers expect a shortage of semiconductors to continue for the rest of the year.

Margin of Safety

The German economy is entering a transitional period, but it retains a significant margin of safety that will enable it to overcome a short recession and achieve more efficient growth. 

This transition will not change the basic structure of the German economy – mechanical engineering and exports – but Berlin, relying on investment and innovation, apparently seeks to gain a competitive advantage in the market for EVs and batteries.

Germany has a competitive edge in many important sectors, such as the automotive industry, aircraft manufacturing, electrical engineering, and chemicals and pharmaceutical production. 

Machinery and equipment are important drivers of German industry, employing more than a million people and encompassing nearly 6,600 companies, almost 90 percent of which are small or midsized. 

These sectors are performing well despite the recession and sales slump.

In addition, German carmakers expect growth to pick up in the second quarter thanks to improvements in supply chains and order backlogs. 

Volkswagen started fiscal year 2023 with strong revenue growth; sales revenue is already up 22 percent, driven by a recovery in sales in Europe and North America, and the company expects sales for the year to rise by 10-15 percent. 

Mercedes-Benz credited high prices and a backlog of orders during the supply chain crisis for its recent strong profits, while BMW closed fiscal year 2022 with record sales and profitability.

The challenge going forward for German carmakers is adapting to the transition to electric vehicles. 

For example, BMW expects half of its sales to come from EVs before 2030. 

Moreover, Germany is investing more in factories to make chips and batteries, including in foreign subsidiaries closer to its major markets. In North America, for example, Volkswagen is opening its first overseas battery plant in Canada.

Cause for Concern

Though Germany has its advantages, as well as enticing growth opportunities in rising industries, the picture isn’t as rosy for the rest of the European Union – and that’s a problem for Berlin. 

The health of the German economy directly affects EU states, and a drop-off in trade can disrupt continental production chains and government revenues. 

The fall in Germans’ purchasing power will reduce imports and production, which may affect the fulfillment of export orders and ripple through economies closely integrated with Germany. 

Austria, the Czech Republic, Denmark, Hungary, the Netherlands, Poland, Slovakia and Romania all get at least 20 percent of their imports from Germany. 

Roughly the same countries rely on exports to Germany. 

General uncertainty and falling output in the rest of Europe risk exacerbating tensions between EU partners at a time when they are already bickering over fiscal policy. 

Germany does not want its neighbors to lose purchasing power and buy fewer German goods, but it also is not interested in helping others to the detriment of its own economy.

Moreover, Germany is the largest contributor to the EU budget. 

As the investment needs of the German economy grow, Berlin will be less able to contribute simultaneously to European investment. 

Germany’s neighbors are already critical of its massive spending. 

Heavyweights like Italy and France have lashed out at Berlin over its 200 billion-euro ($215 billion) aid package to protect customers and businesses from the energy crisis. 

In addition to regional frictions, this could create new rifts in the German government over whether to prioritize EU stability or the German economy.

A technical recession is not Germany’s biggest worry. 

It has enough competitive advantages that, with the right approach and government support, it can return to growth in the near future. 

Germany’s key industry, machinery, is even optimistic. 

Instead, the most difficult task for Berlin is deciding how much to sacrifice its own financing needs for the rest of Europe. 

Uncertainty in the east and the lack of permanent and cheap sources of energy will remain issues for Europe going forward.