German GDP Growth at 2.5% in 2007, Public-Sector Finances Return to Balance

According to the Federal Statistics Office (FSO), GDP growth in 2007 slipped modestly from 2.9% to 2.5% year-on-year (y/y), or from 3.1% to 2.6% in calendar-adjusted terms (there were 1.6 fewer working days in 2007 than in 2006). Net exports delivered an even greater growth contribution—of 1.4 percentage points—than in 2006, and fixed investment added another 0.9 percentage point. By contrast, private consumption subtracted 0.2 percentage point, and only an unusually high growth contribution from government (0.4 percentage point) saved the day for consumption as a whole. Nevertheless, the growth contribution from domestic demand minus inventories almost halved from 1.7 to 0.9 percentage point.

Dichotomy Between Buoyant Exports/Investment and Weak Private Consumption

Based on the data provided—not corrected for working-day effects—real exports of goods and services grew by 8.3% and imports by 5.7% y/y in 2007, weaker than in 2006 (12.5% and 11.2%, respectively) but with a greater relative out-performance by exports. This ensured an increase in the contribution of net exports to GDP growth, to 1.4 percentage points. Furthermore, given the decline in the pace of overall GDP growth from 2.9% to 2.5%, the relative importance of net exports to Germany’s economic performance increased quite markedly in 2007—from slightly more than a third to more than one-half. Accordingly, domestic demand minus inventories was responsible for little more than a third of 2007 growth.

Among the domestic demand components, real fixed investment was almost as strong as in 2006, when its growth returned to a pace last seen during the heyday of the immediate post-unification period. Fixed investment grew by 4.9% y/y, compared to 6.1% in 2006. Within real fixed investment, equipment spending was up 8.4% y/y, fully maintaining the pace of the previous year, and representing the fourth year of above-average increases. This similarly applies to “other investment” (mainly computer software and licensing rights), which grew by 6.5% compared to 6.7% y/y in 2006. By contrast, construction investment posted only modest growth of 2.0%, following 4.3% in 2006 after a 10-year structural slump unwinding the post-unification boom. This was despite an unusually mild winter in early 2007 and is related to building activity having been brought forward to 2005/06 due to fiscal changes (abolishing the subsidy for new home owners, a rise in VAT). There was a big distinction between stagnating residential construction (up 0.3%) and a solid performance in the non-residential sector (up 4.3%), given the health of the corporate sector and recovering public finances. Finally, as in 2006, stocks had a minimal dampening impact on 2007 GDP growth of 0.1 percentage point.

The big disappointment in 2007 was private consumption, which actually declined slightly in price-adjusted terms (by 0.3% y/y), seemingly rendering the relatively positive performance of 2006 (up 1.0%) a one-off occurrence in view of slight net declines in the 2002-05 period. Weakness in 2007 was clearly related to the hike in value-added tax (VAT) in January and sharp price increases for food and energy in the second half of the year, however. As a result, provided that there is no additional upward pressure on inflation in 2008—which seems quite likely given the slowdown in global demand—the odds are high that improved employment and wage growth will come to the fore this year as driving factors behind German consumer spending.

Government consumption growth accelerated from 0.9% to 2.0% y/y in 2007, which is related to improved public finances—not least due to the VAT hike—and thus a smaller urge to cut public-sector employment or to contain wage growth.

Indications of Q4 Growth Momentum Remain Vague

Due to the usual revisions to the data for the first three quarters of the year—which will only be made public with the upcoming releases of 14 February (“flash” estimate) and 26 February (detailed figure)—and the fact that only calendar-unadjusted data was published with the current release, it is not possible to calculate the fourth-quarter performance with any degree of certainty. Nevertheless, market consensus estimates assume a range of 0.3-0.4% quarter-on-quarter (q/q), matching Global Insight’s January interim forecast of 0.4%. This would follow growth of 0.7% q/q in the third quarter, and the implied slowdown is expected to have stemmed from net exports and particularly private consumption. Indeed, the full-year figure of -0.3% published today for private consumption suggests that there may have been a q/q decline in the fourth quarter. A deterioration of net exports is less certain, given still quite resilient export orders indications and in view of slowing export growth going hand in hand with slowing imports, as observed from monthly merchandise trade data. By contrast, robust monthly data for investment goods orders suggests a strong performance for investment in the final quarter of 2007.

Public-Sector Finances in Balance for First Time Since Unification

Separately, the FSO has also published a first estimate of the 2007 public-sector budget situation—including the social insurance system—according to the Maastricht criteria. According to preliminary calculations, it expects “a black zero”, in other words a balanced budget with a marginal leaning towards a surplus. This compares to a deficit of 1.6% of GDP in 2006 and even 3.4% of GDP in 2005. This improvement in 2007, which broadly concurs with Global Insight’s January interim forecast of a deficit of 0.1% of GDP, is quite significant; apart from 2000, when one-off revenues from UMTS licences enabled a surplus, this is the first time in almost 20 years that the public sector has not posted a deficit. Although moderating revenue growth in recent months and the corporate tax reform of January 2008 suggest that progress will stall this year, ongoing improvement in the labour market and higher wage growth should ensure that there will not be a return to large deficits in the foreseeable future.

Outlook and Implications

The year 2007 ended on a relatively weak note due to the ramifications of the U.S. sub-prime crisis. It is therefore very likely that softening exports and weaker investment (the latter also due to worsened depreciation rules for taxation purposes) will lead to slower economic activity in 2008. This is also suggested by the slippage seen among leading indicators such as the purchasing managers’ index (PMI) or the Ifo business confidence index in recent months. On the other hand, manufacturing orders rebounded once more in October/November, and consumers will face a much more encouraging background than at the start of 2007. This includes less additional upward pressure on inflation (rather, improved chances of subsiding inflation due to softening global growth and thus also lower oil prices), higher nominal wage growth, and still-rising employment.

We also expect the European Central Bank (ECB) to now hold interest rates steady until mid-2008 and then even ease them a notch in reaction to the further euro appreciation above US$1.50 that we expect in the coming months. A negative influence may emerge from current efforts by the Social Democratic Party (SPD), a partner in the “grand coalition” government, to widen minimum wage regulations. This will run counter to the encouraging tendency for more labour-market flexibility—and thus employment—introduced with the Hartz labour-market reforms of 2003-05.