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The return of the Teutonic Tiger Export strength – blessing and curseGermany faces long-term structural challengesInvesting in Germany

Germany in the fast lane

UBS research focusWealth Management ResearchOctober 2010

Germany in the fast lane2

Contents

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PublisherUBS AG, Wealth Management Research,

P.O. Box, CH-8098 Zurich

Editor in ChiefDirk Faltin, Economist, UBS AG

EditorsRoy Greenspan

Anna Foca

AuthorsLena Lee Andresen, Strategist, UBS AG

Dirk Effenberger, Strategist, UBS AG

Dirk Faltin, Economist, UBS AG

Gerit Heinz, Analyst, UBS Deutschland AG

Andreas Höfert, Chief Economist, UBS AG

Markus Irngartinger, Strategist, UBS AG

Daniel Kalt, Economist, UBS AG

Georg Klein-Siebenbürgen, Analyst,

UBS Deutschland AG

Caesar Lack, Economist, UBS AG

Philipp Schöttler, Strategist, UBS AG

André Schütz, Analyst, UBS Deutschland AG

Thomas Wacker, Analyst, UBS AG

Editorial deadline1 October 2010

Project ManagementValérie Iserland

DesktopWMR Desktop

Translation24 Translate, St. Gallen, Switzerland;

CLS Communication, Basel, Switzerland

Pictureswww.dreamstime.com

PrinterFotorotar, Egg, Switzerland

LanguagesPublished in English, German and Spanish

[email protected]

UBS homepage: www.ubs.com

SAP-No. 82092E–1007

Editorial ..................................................................................................... 3

Highlights .................................................................................................. 4

Chapter 1

The return of the Teutonic Tiger ................................................................. 6

Chapter 2

Export strength – blessing and curse ........................................................ 12

Chapter 3

Germany faces long-term structural challenges ........................................ 18

Chapter 4

Investing in Germany ............................................................................... 26

Bibliography ............................................................................................ 32

Selected UBS WMR publications .............................................................. 33

Order or subscribeAs a UBS client you can subscribe to the printed version of UBS research focus via your client advisor or via the Printed & Branded Products mailbox: [email protected]. Electronic subscription is also available via WMR portal accessible from the UBS e-banking platform.

UBS research focus October 2010 3

Dear reader,

Like a phoenix rising from the ashes, the German economy has staged a remarkable re-covery so far this year. During the dark days of 2009, the economy contracted at its fast-est pace in post-war history; this year, Germany is surging ahead of its peers. Even unem-ployment, which has been Germany’s Achilles heel for so long, is falling at an astonish-ing pace – recently reaching levels last seen nearly 20 years ago. Indeed, among the major economies, Germany stands out in that its unemployment rate is now lower than before the global economic recession.

How durable Germany’s economic comeback is remains an open but important question, given its status as Europe’s largest economy, with 82 million people and a gross domestic product of EUR 2.4 trillion (USD 3.23 trillion). Are we witnessing a new “economic mira-cle” like the so-called Wirtschaftswunder that followed World War II? Or has the German economy simply launched a short-lived breakaway, destined to rejoin the rest of the de-veloped economies grinding along at a snail’s pace?

Continued success for Germany could be seen as vindication for the European economic and social model. Indeed, in countries where the usefulness of more fiscal spending is hotly debated, many experts are studying the German example, where early and decisive fiscal consolidation has not stood in the way of a strong economic recovery.

Some policy makers in Germany are even using their newfound position of strength to demand that weaker economies – especially in peripheral Europe – try to emulate the German growth model’s focus on exports and competitiveness. But can the export-led German economy maintain its dazzling performance if the export field becomes over-crowded with would-be competitors? And what if Germany’s outperformance ultimately depends on its trading partners spending beyond their means?

Investors looking to benefit from the German economic powerhouse must confront these questions in order to determine the best investment strategy. In this issue of UBS research focus, we provide investors with extensive background on Germany’s cur-rent growth, its near-term outlook and long-run structural prospects. By tracing key trends arising from the composition and cyclical character of the German economy, we are able to identify some likely winners and losers from the current high-growth, low- interest environment. We hope you will find our advice useful.

Editorial

Andreas Höfert

Dirk Faltin

Andreas Höfert

Global HeadWealth Management Research

Dirk Faltin

Head Thematic Research



The return of the Teutonic Tiger Germany’s brisk recovery in 2010, likely ahead of all major economies this year, will probably fade somewhat in the second half and into 2011. Nev-ertheless, Germany’s exceptionally strong export position is bolstered by the still relatively weak euro, which should remain a support for growth in the near term. As long as global demand is buoyant, Germany stands to benefit. These fac-tors also support the domestic economy in this cycle. Importantly, Germany is unburdened by the direct effect of a burst housing bubble, and pri-vate sector financial balance sheets are generally strong. The performance of the labor market has also been impressive. Interest rates are an issue to watch: The current Eurozone rates are too low for Germany and the risk of a housing bubble cannot be ignored. But in the near term, we think growth in Germany is likely to surprise positively, in absolute terms and compared with other econ-omies. The biggest risk to this favorable cyclical outlook stems from any potential renewed slump in global demand. For Europe as a whole, Germa-ny’s return to strong growth this year is a double-edged sword: It raises economic activity across the continent, while at the same time fueling long-standing imbalances.

Export strength – blessing and curseGermany undoubtedly has one of the most suc-cessful export economies in the world. The coun-try’s export strength is based on its ability to pen-etrate high growth markets, especially in the Central and Eastern Europe (CEE) region and in Asia, and on its superior competitiveness gained through corporate restructuring and wage mod-eration. Thus, Germany’s advantages in foreign trade are of a lasting nature and they allow Ger-many to benefit more during global cyclical up-swings than most of its peers. However, this trade dependency has its downsides as well. During economic downturns Germany tends to suffer more than comparable countries that are less dependent on global trade. Also, Germany’s growth model may be vulnerable to protection-ism, to structural shifts in its main trading part-ners and to lower-cost competition. Importantly, Germany’s export success does not seem to ben-efit the German people at large. In our view, it will be important to achieve a more balanced growth model in future.

Germany faces long-term structural challengesGermany’s strong cyclical growth before and after the global recession has diverted attention from its weak average growth performance this dec-ade. Germany’s rapidly aging society, which com-pares unfavorably to most of its peers, is a key challenge to its growth potential. The results of Germany’s very low birth rate are practically irre-versible now, especially since immigration will probably not be able to stabilize the population.

Highlights


Labor market participation is already quite high, meaning that the potential to offset the decline in population by expanding the potential labor force is limited. However, annual working hours are very low in Germany and could be raised to partly offset the negative effects of a shrinking labor force. Capital accumulation, which in theory could substitute labor, will not be raised signifi-cantly, in our view. However, there would seem to be scope for improving total productivity, by countering adverse trends in Germany’s innova-tion potential and by continuing reforms of the education system, including the implementation of an immigration policy that attracts highly edu-cated immigrants.

Investing in GermanyThe outlook for German equities is positive: they should benefit from the global recovery even if it continues at a more moderate pace going for-ward. If Germany manages to tilt its economic structure more towards consumption, the cyclical swings of the stock market might also be less pronounced in the future. In any case, it seems prudent to add some consumer-related stocks to German portfolios, as we think the biggest bounce of the global economy lies behind us and the German consumer seems to be in good mood – not least thanks to the favorable labor market conditions. A slide back into recession – though not our base case – could have severe negative effects on German equities due to their cyclical bias. German government bonds rank among the safest bonds issued by Western countries. How-ever, current yield levels lead us to conclude that longer-dated maturities should be avoided and that investors should seek alternatives beyond government bonds.


Industrial recovery is much stronger in Germany than in the Eurozone as a whole

Source: Reuters EcoWin, UBS WMR

Industrial production, index levels

90

8085

95100105110

120115

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Germany Eurozone

Export market shares of the biggest exporters

Source: WTO database, UBS WMR

% of total world exports

2

0

4

6

8

10

12

14

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

USGermany JapanChina


Chapter 1

The return of the Teutonic Tiger

Germany is back. During the global economic crisis German output contracted more than in most comparable countries. Now the country’s economy has regained its pre-crisis strength. The cyclical outlook remains favo-rable.

Germany has been surprising people lately. The world’s fourth-biggest economy has long been admired for its efficiency, innovation and skilled and disciplined workforce. Yet critics have also scorned Germany’s inflexibility, costly social sys-tem and opaque web of banks and industry. Ger-many’s recent economic surge has led some to praise its superior competitiveness, while others complain that the country’s growth model beg-gars its European neighbors and other countries as well.

In this UBS research focus we take a close look at the German economy. We assess its near-term outlook and its longer-term structural prospects. The present chapter discusses the business cycle in Germany. In the second chapter we examine the implications of Germany’s reliance on export-driven economic growth. In the third chapter we round out the picture by looking at structural trends and challenges and the longer-term out-look for Germany. The final chapter interprets our findings from an investor’s point of view.

Germany regains its pre-crisis punchFour years ago, Germany was hailed as the “Teu-tonic Tiger,” an exporting powerhouse and the growth engine of Europe. In 2006, the future looked bright for what was then the third-largest economy in the world. Unlike most of its Euro-pean peers, Germany had seemingly found the recipe for participating in the rapid development of the emerging economies in Central and East-ern Europe (CEE) and Asia. Then came the global recession, starting in late 2007. During the down-turn, Germany suffered more than most other comparable economies – at least in terms of lost output. Now, with the global recession over, the German economy appears to have recovered its pre-crisis strength.

In the first half of 2010, the German economy boomed. In the second quarter alone, it grew at the fastest pace since reunification, back in 1990. Up 2.2% from the first quarter (an annualized

rate of over 9%), Germany’s growth challenged even that of China. Full-year growth is now likely to exceed 3% for 2010. Needless to say, this surge puts Germany ahead of every other country in the Eurozone, the 16 countries sharing the euro common currency. Figure 1.1 makes it clear that Eurozone industrial activity is practically en-tirely «Made in Germany».

However, before we get too excited, these num-bers need to be put into perspective. The sharp rebound this year comes after a nearly 5% con-traction of the German economy in 2009. Indeed, the total output loss during the crisis amounts to more than 6.5% (measured from the peak in

Fig. 1.1: Industrial recovery is much stronger in Germany than in the Eurozone as a whole


Industrial production, index levels

90

8085

95100105110

120115

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Germany Eurozone



early 2008). Hence, even if the current speed of recovery could be maintained, it would take an-other year to fully make up for the output lost during the crisis.

Exports feed German growthThe recovery in the first half of this year reflected a surge in foreign demand for German merchan-dise. Exports jumped by more than 8% in the second quarter of 2010 compared to the first quarter, the strongest expansion since 1990. Im-ports also grew by a robust 7%. Thus, net trade – exports minus imports – directly accounted for nearly half of the expansion in the second quar-ter. Domestic demand was also strong, but much of this strength, especially in corporate invest-ment spending, was also ultimately due to the surge in foreign demand (see Fig. 1.2).

Why Germany is an export champWe will examine the structural reasons for Germa-ny’s trade success in detail in the second chapter. Here, it suffices to say that German exporters greatly benefit from some broad economic developments. For one thing, Germany embraced globalization early and earnestly. It also sharpened its price com-petitiveness through corporate restructuring, pro-duction outsourcing to lower-cost countries, and wage moderation, to name a few key factors.

German exporters have also had a boost lately from the euro’s weakness.1 The so-called real effective euro exchange rate, which compares the euro to a basket of trading partners’ currencies,

has depreciated by about 6.5% over the first six months of 2010, compared to the previous six months. According to OECD estimates, a 10% depreciation of the euro would add about 1% to German GDP in each of the next two years.2

At first glance, these numbers suggest that the lower real effective euro exchange rate could boost German GDP by 0.6 to 0.7% next year and beyond. The government debt crisis in Greece and the precarious fiscal situation in other coun-tries of the Eurozone are behind the weaker euro. We think this dynamic makes it likely that the euro exchange rate should remain favorable for German exporters in 2011.

The relatively weaker euro also puts German ex-porters at a relative advantage versus their Euro-zone competitors. To get a sense of the magni-tude of this advantage, we consider the so-called purchasing power parity (PPP) for different Euro-pean countries. The PPP exchange rates represent long-run equilibrium exchange rates. As shown in Figure 1.3, Germany’s long-term PPP against the US dollar is nearly 1.5, compared to only 1.25 for the Eurozone as a whole. For the less competitive southern European countries, the comparable PPP exchange rates are even lower, just below 1.2. The average euro-US dollar exchange rate this

Fig. 1.2: Net trade was the main driver of economic activity


Quarterly real GDP growth composition, in %, y/y

–7

–9

–5

–3

–1

1

3

5

2007 2008 2009 2010

Domestic final consumption Investment Net trade

Fig. 1.3: Germany can live with a higher euro exchange rate


Euro/US dollar exchange rates in purchasing power parities (PPP)

Portugal

Greece

Italy

Spain

Netherlands

Austria

France

Germany

0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6

Eurozone total average

1 Note that despite the recent appreciation, the euro is still relatively weak when compared to a basket of currencies.2 OECD (2001)


Chapter 1

year has so far been around 1.3. From the PPP rates, it is clear that Germany can successfully compete at such an exchange rate, while most other Eurozone exporters struggle to sell their products abroad.

Germany’s export-driven rebound in the first half of 2010 also simply reflects the severity of the decline in 2009. Germany is recovering faster in 2010 because it contracted faster in 2009 (see Fig. 1.4). Thus, global trade fell about 20% from peak to trough, partly sentiment-driven. When confidence revived, orders that had been on hold were reactivated. German exports dropped about 25% in 2009 and are now benefiting more from the correction than most other countries. Since the lows in May 2009, German exports have now risen some 30%, nearly regaining pre-crisis levels.

Export demand likely to fadeForeign demand for German goods may moder-ate in coming months and in 2011 given that the fiscal programs launched in many countries worldwide in response to the crisis are set to ex-pire. While the German government implemented its own significant measures to support the econ-omy, the country’s export orientation meant that it also benefited from the spending programs of its main trading partners. For example, Chinese demand for German-made goods accounted for only 2% of the 25% drop in German exports last year. Yet orders from China contributed some 9% to the 30% recovery, due in no small part to the large Chinese fiscal stimulus package, of some EUR 400 billion.

More than just exportsWhile exports are clearly the mainstay, the big surprise in Germany’s economic data in the sec-ond quarter was robust domestic demand. Private households, government spending and corporate investments all contributed. Indeed, total domes-tic demand accounted for 1.4% of the 2.2% expansion in the second quarter, the most since 2006. After three negative quarters, consumer spending rose by a healthy 0.6% in the second quarter.

Gross fixed investments posted a solid improve-ment in the first half of 2010, with investment in machinery and equipment soaring 4.4% per quarter. Construction investment rose even faster in the second quarter, also reflecting the excep-tionally long and cold winter, which put many construction projects on hold until the second quarter.

Fiscal policy and the labor market “miracle” A number of other factors also supported Germa-ny’s domestic demand. First, as noted, the Ger-man government launched a big fiscal stimulus package in 2009, topped only by the US, Canada and Australia among the G7 economies. It may have accounted for about 3% of 2008 GDP. The impact of these measures should be visible in 2009 and 2010 in roughly equal shares.3

Fig. 1.4: German exports recovered rapidly


Exports as % of GDP

23

18

28

33

38

43

1995 1997 1999 2001 2003 2005 2007 2009 2011

Germany France Italy UK

3 OECD (2009)



The unexpectedly strong labor market also bu-oyed domestic demand. Germany is the only large economy where, after the global crisis, un-employment is lower than before it. Indeed, as Figure 1.5 shows, Germany’s unemployment rate rose only 0.7% to a peak of 8.3%. It then edged lower, averaging around 7.8% in the first half of 2010. In contrast, the Eurozone unemployment rate rose by almost 3% during the crisis, and now hovers at a high 10%.

This solid labor market performance, in our view, reflects Germany’s exceptional social cohesion. Companies asked employees to work part-time to avoid large-scale layoffs. The government helped with short-shift subsidies to as many as 1.5 mil-lion workers at one time. Payrolls have proven relatively robust, expanding at a monthly rate of around 30,000 workers (equivalent to an annual-ized rate of 1%) over the summer months. We think employment prospects are brightening as companies’ hiring intentions are up sharply and consumers’ unemployment worries are steeply down. As workers went full-time again and, in some cases, even to overtime, compensation per employee recovered meaningfully in the first half of 2010, which should support consumer spend-ing in the coming months.

Firms and households not overleveragedUnlike many of its peers, Germany did not have a housing bubble. As shown in Figure 1.6, German house prices have been stable throughout most of this decade, while house prices in Spain and Great Britain more than doubled. Of course, Ger-man private households and, in particular, the banking sector, were hurt by the bursting of housing bubbles in other countries, but at least there was no such bubble at home. In sum, Ger-man households and companies do not hold ex-cessive amounts of debt. German households and firms did not expand their debt level over the last decade, in contrast to many of its European neighbors (see Figs. 1.7, 1.8, 1.9).

Interest rates too low Does all this mean that the German economy has de-coupled in a sustainable way from the other developed economies? The answer is no. Germa-ny’s trade-dependence means that its growth performance is clearly linked to that of its trading partners. However, there is a final and, in our

Fig. 1.5: Germany’s unemployment rate is falling rapidly


In %

7

6

8

9

10

11

12

13

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Germany Eurozone

Fig. 1.6: German house prices have remained stable


House price index (1995 = 100)

100

80

120

140

160

180

200

1995 1997 1999 2001 2003 2005 2007 2009 2011

Germany Eurozone

Fig. 1.7: German households have improved their balance sheets


Net assets of private sector excluding financial sector (% of GDP)

50

0

100

150

200

250

300

1999 2000 2001 2002 2003 2004 2005 2006 2007 20092008

Germany Eurozone (ex Germany)


Chapter 1

view, especially important factor supporting both consumer spending and corporate investment is Germany’s historically low interest rates. The Eu-ropean Central Bank has cut its short-term policy rate to a record low of 1%, particularly to support those economies that are laboring from past ex-cesses in their housing markets. For Germany, however, current interest rates are clearly too low.

Figure 1.10 shows so-called Taylor interest rates, which combine data about economic activity and inflation to indicate the appropriate level of short-term interest rates. By this measure, current short-term interest rates are more than one percentage point too low for Germany.

The upshot is that the German economy is over-stimulated, a fact that should not be underesti-mated. Unduly low interest rates contributed greatly to the housing bubbles in Spain and Ireland, and triggered a more traditional consumption boom in Greece. Earlier in the decade, suffering from weak demand, Germany needed low rates. As it accounts for roughly a third of the Eurozone economy, the European Central Bank (ECB) set rates to fit Germany’s needs. These were clearly too low for many of the other countries. We see an increasing risk of some form of over-investment or real estate bubble forming in Germany if interest rates remain so low for much longer.

The recovery is a double-edged swordGermany’s strong economic rebound this year has been greeted with mixed feelings among its neigh-bors. As the biggest economy in Europe, it pushes up demand for the products of other European countries. On the other hand, Germany’s export-led rebound fuels the current account imbalances that are at the heart of the sovereign debt prob-lems facing some Eurozone countries. Ironically, over the last few months, many in Germany have chastised other Eurozone countries, most notably Greece, for their “profligacy,” not realizing that these excesses create the trade and current ac-count surpluses that allow the German govern-ment to run smaller budget deficits especially if, as we believe, interest rates will remain too low for Germany for a considerable period of time.4

Fig. 1.8: German households were net lenders prior to the recession

Source: Eurostat, UBS WMR

Note: Eurostat statistics in focus, 29/2009.

Net lending/borrowing of households, as % of disposable income, 2007

–30

–20

–10

10

0

20

UK

Spai

nUS

Net

herla

nds

EU

Belg

ium

Italy

Fran

ce

Ger

man

y

Aust

ria

Irela

nd

Gross household savings rate, 1995–2007 Gross household investment rate, 1995–2007Net lending (+) / borrowing (–), 1995–2007

Fig. 1.10: Taylor rate shows that interest rates are too low for Germany


0

–1

1

2

3

4

5

6

In %

2002200120001999 2003 2004 2005 2006 2007 2008 2009 2010

3-month Libor Taylor rate for Germany


Fig. 1.9: German companies were net lenders prior to the recession

Note: Eurostat statistics in focus, 28/2009.

Net lending/borrowing of companies, % of gross value added, 2007

–40–30

–10–20

3020100

40

Fran

ce

ItalyEU

Aust

riaUS

Irela

nd

Belg

ium

Ger

man

y

UK

Net

herla

nds

Spai

n

Gross fixed capital formation, 1995–2007 Gross savings, 1995–2007Net lending (+) / borrowing (–), 1995–2007

4 For a detailed discussion of these issues, please refer to the August UBS research focus, entitled “The future of the euro.”



ConclusionsGermany’s brisk recovery in 2010, likely ahead of all major economies this year, will probably fade somewhat in the second half and into 2011. Nev-ertheless, Germany’s exceptionally strong export position is bolstered by the weak euro, which should remain a support for growth in the near term. As long as global demand is buoyant, Ger-many stands to benefit. These factors also sup-port the domestic economy in this cycle.

Importantly, Germany is unburdened by the direct effect of a burst housing bubble, and private sec-tor financial balance sheets are generally strong. The performance of the labor market has also been impressive. Interest rates are an issue to watch: They are too low for Germany and the risk of a housing bubble cannot be ignored. But in the near term, we think growth in Germany is likely to surprise positively, in absolute terms and compared with other economies.

The biggest risk to this favorable cyclical outlook stems from any potential renewed slump in global demand. For Europe as a whole, Germany’s re-turn to strong growth this year is both a blessing and a curse, as it raises economic activity across the continent, while at the same time fueling long-standing imbalances.


Chapter 2

Export strength – blessing and curse

Germany is the export champ of Europe. Its brisk export-driven recovery underpins our positive near-term outlook on the German economy. In this chapter, we take a close look at Germany’s export strength and con-sider its benefits and its drawbacks.

Until this year, when it was surpassed by China, Germany was the world’s biggest exporter of goods. Between 1995 and 2007 exports in-creased by 8% and imports by around 7% per year, on average. The strong increase in both im-ports and exports in recent years led to the emer-gence of the so-called “bazaar theory,” according to which Germany is increasingly becoming a trading place for goods and services (see Box 1).

Surely, one major factor driving Germany’s export growth has been the rapid expansion of the glo-bal economy, which by extension increased the market for Germany’s exports. Between 2000 and 2007, the size of the potential export market (measured as the weighted sum of goods and services imports by Germany’s trading partners) increased by more than 50%. Other countries experienced similar increases in their potential export markets, but what sets German exporters apart is their ability to maintain and in some cases increase market share in the face of growing competition from low-cost emerging countries (see Figs. 2.1 and 2.2).

Germany’s export success is driven by cost-competitiveness …Germany’s exceptionally strong export perform-ance has generated much speculation about its sources. Most studies find that the market-share gains resulted primarily from improvements in the price-competitiveness of German products.

Fig. 2.1: Destination of German exports

Source: Federal Statistical Office, UBS WMR

% of total exports, 2008

10

0

20

30

40

50

60

Japa

n

Afric

a

Russ

ia

Mid

dle

East

Chin

a

Oil

expo

rtersUSCEE

Asia

Non

-Eu

rozo

ne

Euro

zone

EU-2

7

Fig. 2.2: Export market shares of the biggest exporters

Source: WTO database, UBS WMR

% of total world exports

2

0

4

6

8

10

12

14

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

USGermany JapanChina

German goods fill Asian harbors


Having adopted the euro in 1999 at a somewhat overvalued exchange rate, German exporters sought to restore price competitiveness by push-ing for wage moderation. As a result, wages grew only very little in the first half of this decade. In 2008, the level of real wages, adjusted for infla-tion, was virtually the same as in 2001 (see Fig. 2.3)1. Secondly, German companies also sought to take advantage of lower production costs by off-shoring parts of their production chain, espe-cially to the Central and Eastern European (CEE) countries (see Fig. 2.4)2.

1 The prolonged effort to contain costs through wage mod-eration was diluted by the appreciation of the euro be-tween 2002 and 2008. That means that Germany’s cost-competitiveness improved primarily versus other Eurozone countries, which explains the significant rise of Germany’s export market share within the Eurozone.2 Outsourcing and off-shoring can also explain the surge in German exports to these countries as the foreign-based subsidiaries or contracting firms are likely to have been equipped at least in part with capital goods produced in Germany, and they are sourcing intermediate inputs from there (Bundesbank, 2006a). Similarly, the sharp increase in imports from Central and Eastern Europe might be ex-plained by subsidiaries or contracting firms supplying inter-mediate or finished products to German parent companies.


Box 1: Germany’s export “bazaar”

The bazaar theory was first proposed by the influ-ential German economist Hans-Werner Sinn (Sinn, 2006). He argued that Germany is turning into a trading place, or bazaar, as its share of production content, in terms of total value added, diminishes. According to Sinn, high and inflexible domestic wages force German companies to respond to low-cost competition by shifting parts of their pro-duction to lower-cost countries. This output is then re-imported and the finished product is “Made in Germany,” commanding a premium price.

While this is a normal consequence of globali-zation, Sinn argues that it has gone too far. He feels it prevents domestic wages from adjusting

sufficiently to the levels of wages in the lower-cost countries. As a result, Germany is gradually losing its production capabilities and degenerat-ing into a mere trading place, or bazaar.

Some economists dispute Sinn’s conclusions, arguing that offshoring has not reduced the depth of production in Germany, but simply im-proved price competitiveness. What is more, Marin et al. (2003) find that multinational firms in Germany are not outsourcing the low-skill parts of production, but rather the most skill-intensive activities, often to Eastern Europe. This has impor-tant implications for education levels in Germany, which we will discuss in the next chapter.

Fig. 2.3: Weak wage growth in Germany


Nominal and real wage growth, in %, y/y

–1

–2

0

1

2

3

4

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Germany, nominal wagesEurozone, nominal wagesGermany, real wages

Fig. 2.4: Germany has gained price competitiveness


Real effective exchange rates (at unit labor costs)

Falling price competitiveness

Rising price competitiveness8580

9095

100105110115

125120

1994 1996 1998 2000 2002 2004 2006 2008 2010

SpainFrance ItalyGermany


… and in the longer run by non-price factorsIn contrast to cost or price factors, non-price fac-tors, such as quality improvements or efficiency gains, seemed to have played only a minor role during the pre-crisis export boom. In the longer run, however, non-price factors are important. Thus, Danninger and Joutz (2007) show that ties to fast-growing trading partners were an impor-tant driver behind Germany’s export strength from 2000 to 2005. In general, we think that German companies benefit in particular from their long-standing experience in overseas trade, their high degree of international integration, and a product range geared towards investment goods, which are in high demand, especially in the fast-growing emerging economies (see Figs. 2.5, 2.6 and 2.7).

This is important, because if German exports were growing only because of a surge in global invest-ment activity, then its export success would come to an end as soon as either the global cycle ma-tured or lower-cost competitors entered these growth markets. However, with its reliance on cost-competitiveness and structural non-price factors, we think Germany’s edge in international markets should be of a longer-term nature.

Export dependency increase economic volatilityGermany’s export boom was halted by the global economic crisis of 2008. In 2009, German exports registered their sharpest decline in postwar his-tory. Indeed, with exports falling some 25% in early 2009 compared to the previous year, Ger-many suffered more than most comparable coun-tries. The reason for this lies in the composition of German exports, which are, as we have seen, strongly geared towards capital goods (machinery and transportation equipment) and durable con-sumer goods, such as automobiles. Demand for such products can be easily delayed during times of rising economic uncertainty, in contrast, for example, to staples such as food and energy.

Companies usually freeze their investment projects when the economic outlook darkens, so demand for German-made investment goods drops sharply. But when economic prospects

Chapter 2

Fig. 2.5: German exports are focused on capital goods

Source: UN Comtrade, UBS WMR


20

0

40

60

80

100

Japan Germany EU-27 France Italy Spain US UK

Investment & intermediate goods(capital goods)

Consumer goods & commodities

Fig. 2.6: Composition of Germany’s exports



17.5

14.8

13.9

6.35.2

42.3

Vehicles

Machinery

Chemical products

Iron and steel products

Electrical products

Others

Fig. 2.7: Destinations of exports in 2009


Note: *Eastern Europe, Brazil, India, Indonesia, Russia

% of total exports

20

0

40

60

80

100

Japan Germany EU-27 Italy US France UK Spain

Major emerging markets * (ex China) Rest of worldChina


improve again, capital goods orders also tend to rebound more strongly. Hence, Germany suffers more in the downturn, but also benefits more than most of its peers in an economic recovery.

Indeed, as can be seen in Figure 2.8, German economic production is more volatile than that of most of its neighbors. This is not a trivial dynamic. Since the introduction of the euro, in 1999, about 80% of Germany’s real GDP growth – adjusted for inflation – was generated from net exports (see Fig. 2.9) and a quarter of Germany’s work-force is employed in the export sector. Sharp swings in the economic cycle can, therefore, be a real challenge, not least for fiscal and monetary policy makers.

Exporters face protectionism and low-cost competition in the long-runGermany’s exceptionally open trade posture makes it susceptible to increased economic vola-tility and the protectionist sentiment of its trading partners. Given its export dependence, any trend towards protectionism harms Germany more than most of its peers. However, this is probably miti-gated to some extent by its specialization in high quality investment goods and durable consumer goods. These kinds of products resist easy substi-tution. This could change, however. As Germany’s Asian trading partners reach a more mature stage of development, their demand for capital goods will likely diminish in favor of consumer goods.

Also, Asian and in particular Chinese manufactur-ers are moving up the value chain themselves, thus starting to encroach on Germany’s product range (see Fig. 2.10). As a result, German manu-facturers face increasing competition from their prime export markets, especially from China and India, with their large pools of low-cost labor. Hence, we doubt that German exporters can rely only on cost-cutting to remain competitive in the long term. Instead, they will have to focus on innovation and efficiency to maintain their export success, factors that we discuss in more detail in the next chapter.


Fig. 2.10: Chinese exports focusing on capital goods


% of total exports

10

0

20

30

40

50

60

1992 1994 1996 1998 2000 2002 2004 2006 2008

Consumer goods

Intermediate goods

Capital goods

Agricultural & commodities

Fig. 2.8: German output growth is more volatile than in comparable countries


Standard deviation of industrial output change over the past 10 years

1

2

3

0

4

5

6

7

8

Germany France US UK

Fig. 2.9: Net trade was the key source of growth between2000 and 2007


Real GDP, in % y/y and annual growth contributions

–4

–6

–2

0

2

4

1992 1994 1996 1998 2000 2002 2004 2006 2008

Total real GDP growthDomestic demandNet trade


Export orientation weakens domestic consumption …There is another problem with Germany’s export-led growth model. It appears to weaken domestic demand – both private household consumption and corporate investment spending. The flip-side of Germany’s price competiveness is low wage growth and high unemployment. The evidence regarding employment is less straightforward. While some (Sinn, 2006) argue that offshoring increases domestic unemployment, others have found no such effect in their research (Klodt, 2004). However, there can be no doubt that wage growth stagnated throughout most of this decade, leading to exceptionally weak household consumption growth (see Fig. 2.11). Thus, the perception remains that Germany is buying its export success with a reduction or at least slower expansion of its population’s overall living stand-ards.

… and appears to drag on corporate invest-ment Since the inception of the euro, German corpo-rate investment spending has been unusually weak (see Fig. 2.12). In part, this reflects the growth of offshoring activities, which diverted investments from domestic projects in favor of CEE countries. We can also see this in the current account, which reflects all savings and spending in the economy. Germany has been running sur-pluses throughout this decade, meaning that German households have saved more than they have spent (see Fig. 2.13).

In general, saving is a good thing, as it forms the basis for investment. Yet if savings are persistently higher than spending in an economy, it means that domestic savings go elsewhere and are una-vailable to finance investments at home. German savings were invested in building up facilities in Eastern Europe. They also helped to fuel the con-struction and consumption booms in Greece, Spain and Ireland. Some of these savings were in portfolios and found their way into low quality financial assets. As the bubbles in southern Europe burst, German savers – and the German banking sector, which had moved these savings into the low quality assets – incurred substantial losses.

Rebalancing the German economyWe think Germany needs a more balanced growth model. This has been widely acknowl-edged by experts and policy makers. Yet most pundits and politicians in Germany demand ad-justments from deficit countries while striving to further improve Germany’s export competitive-ness. This seemingly irrational behavior can be explained by considering Germany’s industrial and institutional structure as it has evolved over time.

The success of Germany’s export-oriented growth model could be Germany’s own worst enemy. It has created an almost invincible alliance of pow-erful employers and unions who share a vested interest in the model’s continuation. They have so far been able to thwart any attempt to restructure

Chapter 2

Fig. 2.11: Weak German consumer spending since 2002


Consumer spending and nominal wage growth, in %, y/y

0

–2

2

4

6

8

10

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

WagesConsumption

Fig. 2.12: Corporate investment in France and Germany


Index Q1 2000 = 100

90

80

100

110

120

130

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

France Germany


the German economy. Even though external fac-tors – in particular, the spending patterns of its trading partners – will change, for the moment, at least, Germany’s power brokers are insisting on continuity. Also, it must be said, policies that pro-mote a more balanced growth mix – for example, through taxes, subsides or wages – risk weaken-ing Germany’s competitiveness without suffi-ciently strengthening domestic demand. These are issues to watch closely in Germany’s political arena over the coming years.

ConclusionsGermany is undoubtedly one of the world’s most successful export economies. Its export strength is based on its ability to penetrate high-growth mar-kets, especially in the CEE region and in Asia. Its success also reflects its superior cost competitive-ness, which has been achieved through corporate restructurings and wage moderation. These ad-vantages in foreign trade appear to be durable. They should allow Germany to benefit more dur-ing global cyclical upswings than most of its peers.

However, export dependency has its drawbacks as well. During economic downturns, Germany tends to suffer more than countries that are less dependent on global trade. Also, Germany’s growth model may be vulnerable to protection-ism, structural shifts in its main trading partners, and growing cost competition. It is important to note that Germany’s export success does not seem to benefit the broad population. We think achieving a more balanced growth model is one of the country’s key challenges for the future.


Fig. 2.13: Increasing imbalances within the Eurozone


Current account balances, in % of GDP

–12

–8

–4

0

4

8

12

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

SpainFrance ItalyGermany


Germany’s recent robust economic perform-ance will not go unchallenged. In this chap-ter, we look at structural trends, domestic and foreign, that will influence Germany’s long-term growth outlook.

Germany’s strong cyclical performance before and especially after the global financial crisis has diverted attention from its weak underlying eco-nomic growth. Adverse developments in per-cap-ita GDP, which is a common measure of living standard, have also been papered over by the good export news lately. In fact, the gap between Germany’s per-capita GDP and the average of the upper half of OECD countries actually widened over the past decade (see Fig. 3.1) and total eco-nomic growth between 1998 and 2007 averaged just 1%, compared to over 2% in France and around 3% in the UK and US. Indeed, according to OECD estimates, Germany’s long-term growth potential averaged just 1.2% in the period from 1998 to 2007 compared to 2.4% for the OECD as a whole (see Fig. 3.2). The question is: How will Germany’s growth potential develop in fu-ture?

Demographic challengesDemographics are an important factor determining a country’s long-term growth potential. Like many other industrial countries, Germany faces pro-found, even unprecedented, demographic changes in the coming decades. A persistently low birth rate over the past four decades or so, combined with rising life expectancy, make demographics an inescapable economic issue.

The most recent projections assume that by 2060 Germany’s population will decline from 82 million today to somewhere between 65 and 70 million (see Fig. 3.3). From an economic point of view, the demographic issue does not so much reflect the decline in the overall population as it does the shift in the population’s age structure. In particular, the contraction of the potential labor force is the main

Chapter 3

Germany faces long-term structural challenges

Fig. 3.1: Germany’s living standard slipped behind

Source: OECD (2009), UBS WMR

Note: Percentage gap to the simple average of the upper half of OECD countries in terms of GDP per capita in constant 2005 PPP.

GDP per capita gap to upper half of OECD countries, in %, 2008

–30

–20

–10

0

10

20

30

US

Net

herla

nds

Cana

daUK

Ger

man

y

Finl

and

Fran

ce

Japa

n

Italy

Spai

n

Nor

way

Fig. 3.2: Germany’s growth potential lagged behind the OECD average

Source: OECD, UBS WMR

Potential GDP growth, in %

0.5

0.0

1.0

1.5

2.0

3.0

2.5

3.5

1992 1994 1996 1998 2000 2002 2004 2006 20102008

Germany OECD



problem, since this is the age bracket that contrib-utes to pension funds and tax revenues.

To illustrate the magnitude of the problem, the old-age dependency ratio, which compares the non-working population (those 65 and above) and the prime working age population (15 – 64) is expected to rise from 42 in 2008 to 73 by 2060. This means that, while 42 pensioners de-pended on 100 workers in 2008, some 73 retirees will claim benefits from the contributions of 100 workers in 50 years (see Figs. 3.4 and 3.5). The number of Germany’s workers could fall by around 28% between 2007 and 2060, which would be an annual average drop of around 0.5%. Assuming this decline has a full impact on labor as a production factor, the trend rate of GDP would be reduced by an average of about one-third of a percentage point per year.1 Thus, Germany’s trend rate of growth would soon turn negative, which normally implies a contracting economy.

However, there are offsetting factors, such as the growth in the capital stock and in total factor pro-ductivity. In general, an economy’s potential growth rate is determined by three factors:

n the quantitative input of labor (labor force potential) and capital (capital stock)

n improvements in the quality of individual pro-duction

n the efficient combination of the two factors (total factor productivity) (see Box 2).

Germany’s long-term growth potential We estimate that from 2011 to 2050 Germany’s average potential growth rate will be about 0.9% per year, assuming net immigration of 200,000 and no changes to the birth rate, the capital accu-mulation rate and total factor productivity. The aging effect on potential growth would be worst towards the end of the 2020s and in the 2030s, when the bulk of the baby boomers retire from the labor force (see Fig. 3.6). Germany’s expected potential growth rate compares unfavorably with

1 The so-called output elasticity of labor, i.e. the effect of labor supply changes on output, is typically assumed to be two-thirds versus one-third for capital.

Fig. 3.3: Population expected to decline


Note: From 2009 results of the 12th coordinated population projection.

Number of persons

60,000,000

55,000,000

65,000,000

70,000,000

75,000,000

80,000,000

85,000,000

197019601950 1980 1990 2000 2010 2020 2030 2040 2050 2060

Historical Lower limit Upper limit

Fig. 3.4: Dependence ratio increases


Ratio of dependent people to working population, in %


1950 1970 1990 2010 2030 20702050

20

0

40

60

80

100

120total dependency ratio

old-age dependency ratio

young-age dependency ratio

Fig. 3.5: Strong increase in the number of older people



Population by age groups, in %

2008 2060

20

61

1934

50

16

Below 20 years 20 to 65 years 65 years and older


Chapter 3

Box 2: Determining potential growth

GDP readings can be regarded as a combina-tion of long-term production potential and a shorter-term cyclical component. The produc-tion potential – or potential growth – of an economy refers to the total economic output that can be produced with the production fa-cilities, labor and capital that are available at any given time. The calculation takes account of technological progress and assumes that capacity utilization is at long-term average levels.

Output in period t (Yt) is derived from a combi-nation of the input factors labor (Lt = potential labor force) and capital (Ct = capital stock). TFPt (total factor productivity) captures the level of technology or technological progress.

The level of total economic output is given by:

Yt = TFPt* f(Lt, Ct)

And the growth rate of total economic output is given by:

ΔlnYt = ΔlnTFPt + a*ΔlnLt + (1 – a)*ΔlnCt

Thus, the growth of total economic output is determined by the change in technological progress (ΔlnTFPt) and the weighted growth rates of the inputs of labor (a*ΔlnLt) and capital ((1–a)*ΔlnCt). The weights correspond to the shares of income from labor (a) and from capital (1–a) in national income.

The following diagram summarizes the various factors affecting the variables in the economic output equation:

Quality

Yt = TFPt • f (L t , C t)

Quantity

Development of capital stockTechnological progress= total factor productivity

Potential labourforce

Domesticpopulation

Birth rate NumberBirth rate

Immigrants

Participationrate

Retirementage

Working hoursper employed person


those of all other G7 countries, apart from Italy (see Figs. 3.7 and 3.8). We expect Germany’s per-capita GDP to grow by about 50% until 2050, compared with 65% for the G7 as a whole (see Fig. 3.9).

Germany’s low birth rateThe diagram in Box 2 summarizes approaches to counteract the demographically inducted de-cline in the potential growth rate. The input factor labor, which typically accounts for about two-thirds of total output, offers most options for policy makers.

Germany’s fertility rate, only 1.34 children per woman of child-bearing age in 2008, has been notoriously low for decades (see Fig. 3.10 and Map 1). Without any net immigration, the fertil-ity rate would have to be 2.1 to maintain the current population. Measures to increase the fertility rate can only work very gradually and their effects would not be felt for some 20 years, when the additional children enter the labor market. Thus, most projections assume only marginal changes in Germany’s birth rate in future, with little effect on the population pro-jections for the next 50 years.

Immigration can boost the labor supplyThe next option to boost the potential labor sup-ply is immigration. This has been quite volatile in the past, but Germany has usually had net immi-gration ranging between 129,000 and 354,000 persons annually since the 1950s. In the past five years or so, net immigration has declined mark-edly. Between 2000 and 2007, annual net immi-gration averaged 129,000. According to UN pro-jections, Germany should attract net immigration of around 200,000 people per year in future. Yet, assuming an unchanged birth rate, the total pop-ulation and the potential labor force can only be maintained with an annual net immigration of about 450,000. Thus, in order to offset the ef-fects of Germany’s low fertility rate, net migra-tion would need to more than double in future, which seems highly improbable. To get a sense of the impact on potential growth, we estimate that without immigration, Germany’s potential growth rate would fall to below 0.5% by 2050 compared to the 0.9% with net immigration of around 200,000 people.


Fig. 3.6: Germany’s growth potential

Source: UN, Penn World Table 6.1, Groningen University, UBS WMR

Estimated growth potential and contributions, in %

–1

0

1

2

3

4

1990 2000 2010 2020 2030 2040 2050

PopulationParticipation (aging)

HoursCapital

TFPGDP

GDP per capitaLabor productivity (GDP/hours)

Fig. 3.7: Potential growth rates for G7 countries


Estimated growth potential, in %

0.50

1.01.52.0

3.02.5

3.54.0

1980 1990 2000 2010 2020 2030 2040 2050

GermanyUS

JapanUK

France CanadaItaly

Fig. 3.8: Projected potential growth rates for G7 countries


Average growth rates of total potential GDP, in %

0.5

0.0

1.0

1.5

2.0

2.5

Japan Italy Germany France UK US Canada

2011–2020 2021–2040 2041–2050


Raising the labor market participation rateAn effective and potentially quick way of counter-acting the deteriorating demographics would be to boost the labor market participation rate and to extend the effective working hours of those who are employed.2 The participation rate measures the actual labor force (employed plus registered unem-ployed persons) as a share of the potential labor force (everyone between ages 16 and 64). How-ever, Germany already has one of the highest labor market participation rates in Europe, surpassed only by the Netherlands, Denmark and Sweden. The same is true for Germany’s female labor mar-ket participation rate, which at 70.2% in 2008 stood above the EU average of 63.4%, and the young age participation rate (15 to 24), which at 51.5% in 2008 was lower, for example, than in Austria (61.5%) and the Netherlands (72.7%), but still higher than the EU average at 44.6%. In short, there is some scope to raise labor market participation rates in Germany, but it appears to be more limited than in most other countries.

2 One way to increase labor input would be to reduce struc-tural unemployment. However, it is important to note that this would not increase the growth potential, which is based on the potential labor force (including both the em-ployed and the unemployed), but can only exert an effect on actual economic growth. Raising the participation rate means integrating the part of the working age population into the labor force that has so far not been available to the labor market.

Chapter 3

Fig. 3.9: Projected GDP per capita growth rates


Average GDP per capita growth rates, in %

0.20.0

0.40.60.8

1.61.41.21.0

Japan US Italy Germany UK France Canada

2011–2020 2021–2040 2041–2050

Fig. 3.10: Germany has a low fertility rate

Source: EU Commission (The 2009 Ageing Report), UBS WMR

Number of births per woman

0.0

–0.5

0.5

1.0

1.5

2.0

2.5

Germany Italy Spain EU Netherlands UK France

2008 2008–2060

Note: 2008–2060 projection by the EU Commission.

Natural population change (live births minus deaths),by regions, average 2003–07

per 1,000 inhabitants

< = –6.0

–6.0 – <= –3.0

–3.0 – <= –1.0

–1.0 – <=0.0

0.0 – <= 2.5

2.5 – <= 5.0

5.0 – <= 10.0

> 100

DK: average 2006–07UK: average 2003–06


Map 1



One obvious approach to the aging problem would be to raise the minimum age for claiming a pension in line with the increase in life expect-ancy3. However, in comparison to other major European countries, Germans already appear to retire rather late, as can be inferred from the rela-tively high labor market participation rate of per-sons aged 55 to 64, which stood at 60.3% in 2008 compared to only 48.9% for the average of the 27 European Union countries (see also Table 1). While this is in principle a favorable comparison for Germany, the potential for further improve-ments here as well appears to be more limited compared to the rest of the EU. We have simu-lated two different scenarios in order to estimate the effect of higher retirement ages on German productivity. In our first scenario, we estimate that making the retirement age two years higher by 2020 would lift the potential growth rate only marginally, to 1% on average by 2050. In our other scenario, making the pension age five years higher by 2050 would yield an average potential growth rate of 1.1%. Thus the overall impact would be quite small, with the effect being felt more strongly until about 2035. After that, the labor force would shrink more rapidly, as the baby boomers finally leave the labor force.

Germans work short hoursThe factor labor can also be increased by means of longer working hours. Here, it would appear that Germany has the most scope for adjustment. Ger-many and the Netherlands have the shortest work-ing hours in the developed world. Weighing in at just over 1,300 hours, Germans’ annual working time falls nearly 470 hours short of the US and 160 hours below their French neighbors. Given that weekly hours in Germany are in line with the Euro-pean average (but some two to three hours below the US and the UK), this annual discrepancy is largely attributable to more paid holidays and more part-time employment in Germany. Indeed, so-called atypical employment, including part-time employment and small scale self-employment, has risen rapidly over the past decade. If average annual hours in Germany could be in-creased by around 200 placing them roughly in line with the European Union average, this would

3 Germany is planning to raise the pension age gradually to 67 years

Table 1: German pension age is close to OECD averageAverage effective age of retirement versus the official age, 2002–2007

Men WomenEffective Official Effective Official

Iceland 68.9 67 Portugal 65.5 65

Portugal 66.6 65 Iceland 65.3 67

New Zealand 66.5 65 Ireland 64.9 65

Sweden 65.7 65 Turkey 64.3 58

Ireland 65.6 65 Switzerland 64.1 64

Switzerland 65.2 65 United States 63.9 65.8

United States 64.6 65.8 New Zealand 63.9 65

Australia 64.4 65 Norway 63.2 67

Norway 64.2 67 Spain 63.1 65

Turkey 63.5 60 Sweden 62.9 65

Denmark 63.5 65 Australia 62.2 63

Canada 63.3 65 United Kingdom 61.9 60

United Kingdom 63.2 65 Canada 61.9 65

Greece 62.4 58 Netherlands 61.3 65

Czech Republic 62.2 62 Denmark 61.3 65

Germany 62.1 65 Finland 61.0 65

Netherlands 61.6 65 Germany 61.0 65

Poland 61.4 65 Greece 60.9 58

Spain 61.4 65 Italy 60.8 57

Italy 60.8 57 Luxembourg 60.3 65

Finland 60.2 65 France 59.5 60

Hungary 59.7 62 Czech Republic 58.5 59

Belgium 59.6 60 Belgium 58.3 60

Slovak Republic 59.3 62 Hungary 58.2 60

Luxembourg 59.2 65 Austria 57.9 60

Austria 58.9 65 Poland 57.7 60

France 58.7 60 Slovak Republic 54.5 62

OECD average 62.7 63.7 OECD average 61.4 62.8


lift the potential growth rate to around 1.4% by 2050 com-pared to 1.1% with unchanged hours. The average potential growth rate would rise from 0.9% to 1.2%, still below our expectations for the G7 countries as a whole. To match the expected G7 average growth potential of 1.6% over the period Germany would need to return to the 2’000 annual working hours seen in the late 1960s.

Capital stock and efficiencyA decline in the supply of labor can, in principle, be compen-sated by increased capital accumulation, that is, higher capital input. Yet, as an input factor in total production, labor carries much more weight than capital, meaning that a drop in the input of labor has to be compensated by a much stronger rise in the capital stock. To achieve this, measures may be taken to attract capital investments from abroad, which would also con-tribute to a reduction of the external imbalances, for example, the persistent current account surplus discussed in Chapter 2.


There also appears to be some scope for improv-ing Germany’s attractiveness for international investments. Despite some progress in reducing anti-competitive product regulations, Germany remains more heavily regulated than many other countries, ranking 14th out of 28 countries on the OECD’s Product Market Regulation indicator, 16th on barriers to entrepreneurship and 20th on barriers to trade and investment. The picture is confirmed by the 2010 edition of the World Bank’s Doing Business survey, which ranks Ger-many only 102 out of 181 countries in the survey. Other factors hampering capital investments in-clude the relative lack of venture capital and pri-vate equity investment in Germany.

Strong on innovation, but there are risks Innovation is another important way to improve labor efficiency and potential growth. In most country rankings, Germany ranks in the upper range of innovation performance (see Figs. 3.11 and 3.12)4. In general, Germany tends to perform fairly well in terms of new patents. For example, OECD figures show that German companies file the third-highest number of patents in medium-high and medium-low technology sectors, after Switzerland and Sweden, while in high technol-ogy sectors they rank eighth. However, financing and government support for innovation projects are typically just about or even below average in Germany 5. These weaknesses are worrisome, as they could endanger Germany’s strong position in the long run. Indeed, some indications suggest that Germany’s innovation potential is already diminishing. Thus, in the 1990s, German compa-nies filed 4.8 patents per million workers each year. Yet, in the period from 2000 to 2006, this ratio has come down to only 0.25 patents per million workers per year.

4 The Innovation Indicator by Rae and Sollie (2007) ranks Germany 11th out of 27 OECD countries.5 OECD (2010a)

Fig. 3.11: Germany is among the most innovative countries in the EU

Source: PRO INNO Europe, UBS WMR

0.00.10.20.30.40.5

0.70.6

Gre

ece

Spai

n

Portu

gal

Net

herla

nds

Czec

h. R

ep.

EU-2

7

Fran

ce

Irela

nd

Aust

riaUK

Ger

man

y

Finl

and

Swed

en

Switz

erla

nd

Italy

Innobarometer, PRO INNO Europe, 2009

Innovation leaders Innovation followers

Fig. 3.12: German enterprises are most innovation-focusedin Europe


010203040

6050

70

Italy

Net

herla

nds

UK

Portu

gal

EU

Gre

ece

Swed

en

Irela

nd

Aust

ria

Finl

and

Belg

ium

Ger

man

y

Spai

n

Enterprises engaged in innovation as share of all enterprises, in %, 2006

Note: From Eurostat Statistics in Focus 33/2009.

Chapter 3

Fig. 3.13: Germany spends below average on education


Public spending on education as % of GDP

0

4

8

12

16

US UK Spain France Germany Italy

Total spending on education Spending on tertiary education OECD average (total) OECD average (tertiary education)

Note: From Education at a Glance, 2010.


Education is the key In an increasingly knowledge-driven global econ-omy, human capital is a major factor for a coun-try’s competitiveness, especially in terms of inno-vation. The latest OECD report on education gives cause for some concern. Thus, according to the OECD the number of students taking up univer-sity-level education in Germany is still well below the OECD average and especially well below that of Germany’s main peers (see Map 2). Also, on the funding side, the OECD figures show that Ger-many spends below OECD average on education (see Fig. 3.13). Finally, regarding the quality of education, the OECD’s PISA study for 2006 shows mostly only average results for Germany, despite some improvement on earlier assessments. Interestingly, the PISA report shows that students that were born abroad (first-generation immi-grants) scored much worse than their German peers. The difference in academic attainment was about twice as big as the OECD average. Impor-tantly, the performance difference remained the same for second-generation immigrants, which may reflect difficulties with the integration of immigrants in Germany.

This relates to a further problem of education in Germany: the unfavorable skill-mix between emi-grants and immigrants and the emerging brain drain. Thus, while Germany is an important source of highly skilled migrants to countries such as the United States and Switzerland, it does not attract a sufficiently high number of comparable foreign workers. The proportion of highly edu-cated migrants is lower in Germany than in many other OECD countries.

This unfavorable skill mix is partly related to the strong recruitment of low-skilled labor in the postwar economic boom, which triggered addi-tional low-skilled immigration in later decades through family connections. These problems would need to be addressed via a comprehen-sive immigration policy that allows the country to attract more highly skilled workers from abroad.

ConclusionsGermany’s strong cyclical growth before and after the global recession has diverted attention from its weak average growth performance this dec-


Educational attainment level by regions, 2007

Percentage of the population aged 25–64 having tertiary education

< = 12.5

12.5 – <= 20.0

20.0 – <= 27.5

27.5 – <= 35.0

> 35.0

Data not available


Map 2

ade. Germany’s rapidly aging society, which com-pares unfavorably to most of its peers, is a key challenge to its growth potential. The results of Germany’s very low birth rate are practically irre-versible now, especially since immigration will probably not be able to stabilize the population. Labor market participation is already quite high, meaning that the potential to offset the decline in population by expanding the potential labor force is limited. However, annual working hours are very low in Germany and could be raised to partly offset the negative effects of a shrinking labor force. Capital accumulation, which in theory could substitute labor, will, in our view, not be raised significantly. However, there would seem to be scope for improving total productivity, by countering adverse trends in Germany’s innova-tion potential and by continuing reforms of the education system, including the implementation of an immigration policy that attracts highly edu-cated immigrants.


Investing in Germany

As we have shown in the previous chapters, the structure of the German economy brings with it certain advantages and threats. These structural characteristics also have implica-tions for investments in German equities and bonds.

The cyclical story in the stock market and beyondThe German stock market rebounded sharply alongside the global economic recovery, initially on improving business sentiment (see Fig. 4.1) and later, with muted momentum, based on real eco-nomic data. As discussed in previous chapters, exports are traditionally an important driver of the German economy. In fact, there has been a good correlation between exports and DAX and MDAX1 movements since 2003 – with the exception of the 2008 financial crisis.

Taking a regional share index and breaking it down into its sector components gives a general picture of how cyclical the index is, and hence how it is likely to perform during different phases of the economic cycle. The German equity market exhibits a higher weighting in cyclical sectors than the Eurozone does overall (see Fig. 4.2), making it a beneficiary of supportive macroeconomic data. The Industrials, Consumer Discretionary (primarily

1 The DAX is a blue chip stock market index of 30 major German companies. The MDAX (mid-cap DAX) included 50 Prime Standard shares from sectors excluding technology that rank below the companies included in the DAX.

Chapter 4

automobiles), and Materials sectors account for roughly 45% of the German market, compared with only 32% of the Eurozone market. The cycli-cal nature can also be seen by the higher volatility of the German stock market compared to the US market on average.

Moreover, the relatively weaker euro should sup-port foreign demand for German products. It also boosts exports to the emerging markets, which make up an increasing share of German exports and bring the added benefit of strong growth po-tential. Even if the euro were to strengthen, we think German companies should still be competi-tive at higher exchange rate levels, as we have seen in Chapter 1.

2009200820072006200520042003200220012000 2010

80

75

85

90

95

100

110

105

3,000

2,000

4,000

5,000

6,000

7,000

9,000

8,000

Fig. 4.1: German stocks are correlated with business climate

Source: Bloomberg, UBS WMR

Ifo Business Climate Index (lhs) vs. DAX (rhs)

Ifo Business Climate DAX Index

Mat

eria

ls

Heal

thca

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–4.0–6.0–8.0

–2.00.02.04.0

8.06.0

Fig. 4.2: More cyclical than the Eurozone

Source: Factset, UBS WMR

Sector differential MSCI Germany vs. MSCI EMU, in %


In addition to these cyclical factors, Germany is currently benefiting from good consumer senti-ment. This should fuel domestic consumption, which could also be supportive for the stock mar-ket even if export momentum fades.

An Ifo at peak levels must not translate into weak equity marketsIn order to find out how the German stock mar-ket is geared to the economic cycle, we investi-gated the degree of correlation between the MSCI Germany2 and one of the most important domestic economic indicators, the Ifo Business Climate Index. This monthly survey of diverse industry representatives gives a good overview of the current state of the economy as well as busi-ness prospects for the next six months.

According to the September data, both expecta-tions and the assessment of the current situation remain at multi-year highs, which means that the German economy continues to be in the boom territory according to the Ifo business cycle clock (see Fig. 4.3). Given the high levels, a sideways movement or even a regression becomes more likely, as economic growth momentum seems to be slowing already. Our base case scenario sees the economy turning to a more moderate growth path, hence we think the Ifo index is unlikely to backslide severely.

What would this scenario mean for the perform-ance of the German stock market? We looked to historical precedent for an indication. Although we do not expect the past to repeat itself, there are episodes that bear more than a passing re-semblance to the current situation. Looking at patterns since 1990, we found that when the Ifo index ranged between 100 and 110, the MSCI Germany was likely to follow one of two trajecto-ries:

n If the Ifo trended sideways, which it has started to do with its September release, in two-thirds of all observations the stock mar-ket showed a positive performance in the following three months (with an average of +3.2% over the period). Results were even

2 The MSCI Germany is a broad equity index including 50 companies.

slightly better in the following six months, with almost 80% of observations showing an average performance of 6.1%.

n But what if the Ifo Business Climate Index started to trend downwards from high levels? In the 31 cases since 1990 where the Ifo fell while in the range of 100 to 110, the three months stock market performance after the release turned out to be slightly positive. However, after six month the average per-formance was negative.

Put simply, a lowering Ifo index could indicate slowing growth, but this will not necessarily trans-late into poor performance for the MSCI Ger-many index. In fact, the German stock market has historically performed well as long as the indica-tor remained in boom territory.

Keep an eye on medium-sized companiesHaving shown that Germany is currently the growth engine of Europe, and why we believe that economic growth will remain robust over the com-ing years, we expect the large-cap DAX index to perform quite well. The mid-cap MDAX also pro-vides interesting opportunities. We would advise long-term investors with a higher risk tolerance to put some money in the mid cap segment of the equity market.


11010510095908580 115

upswing boom

recession downturn

80

70

75

85

90

95

100

110

105Sept. 2010

Fig. 4.3: The Ifo business cycle clock

Source: Ifo Konjunkturtest, UBS WMR

Ifo current assessment and Ifo expectations over the last 24 months

Ifo

expe

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sub

inde

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Ifo current assessment subindex


Medium-sized firms benefit from emerging markets demandThe MDAX index tracks the mid-cap segment and comprises 50 companies. On average, the compa-nies in this index generate about a third of their revenues in Germany (see Fig. 4.4). Our expecta-tions for a more robust domestic economy, as discussed in Chapter 1, should support the earn-ings growth of German companies, and their stock prices.

However, the future of global economic growth lies with emerging markets. These countries face less sovereign debt problems and therefore less fiscal tightening, and they have healthier banking systems and more favorable demographics. In terms of revenue, investors in medium-sized com-panies achieve a slightly higher exposure to de-mand from emerging markets – especially devel-oping Asia – than they would with an investment in the DAX. Investments in this market segment are thus more geared to strong economic mo-mentum than in the large caps.

Financials share is low among mid capsThis feature also reflect the sector composition of the equity market segments. The MDAX is heavily geared to Industrials and has a much lower weight in Financials than the DAX (see Fig. 4.5). We believe that there is still a lot of pent-up de-mand for capital goods after the financial crisis. Accordingly, we see especially smaller sized com-panies as the beneficiaries of a multi-year capital spending cycle. With all the regulation like Basel III imposed on the banking sector and sovereign debt issues still lingering, direct exposure to these factors can be reduced by choosing an invest-ment in the MDAX.

Cyclical mid caps even benefit from slow growthMedium-sized companies show a higher sensitiv-ity to the economic cycle. Accordingly, although they suffer more than large caps in downturns, they usually perform particularly well in an up-swing. When leading indicators lose momentum but growth remains robust, mid caps can still perform relatively well, as seen between 2003 and 2006. In our view, medium-sized companies offer attractive opportunities for long-term inves-tors who can bear temporary setbacks caused by volatile economic data. The difference between

Chapter 4

Fig. 4.4: Sales distribution of MDAX companies by region

Source: Commerzbank, Thomson Reuters, UBS WMR

In %

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EM Asia

RoW

Germany

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30.7

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Fig. 4.5: Higher industrial share in MDAX

Source: Factset, UBS WMR

DAX vs. MDAX, in %


mid and large cap performance is likely to be-come less pronounced when global economic momentum slows and risk aversion rises, however (see Fig. 4.6).

German interest rates at the most depressed levels since BismarckThe post-financial crisis period will be remem-bered for decades as a time of ultra-low interest rates. This holds true not only for the ECB’s policy rate, but also for Bund yields. Ever since rates were first recorded in 1871, when the German empire was founded and Bismarck was appointed its Imperial Chancellor, yields on 10-year govern-ment bonds have never been lower than they are today (see Fig. 4.7). Even more relevant for the economy, inflation-adjusted real interest rates are well below their 50-year average.

After the Lehman collapse in the midst of the financial crisis, 10-year interest rates fell to around 3%. But now that the global economy has found its way out of the woods and equity markets have recovered, interest rates are down another 100 bps, close to 2%. What is pushing bond yields lower and bond prices up?

Three main factors are contributing to the current low interest rate environment:

n Consumer price inflation remains at subdued levels and will likely stay low in the coming year. Hence, investors are demanding a low premium for future inflation. In addition, in-vestors have accounted for slower trend growth going forward. As discussed in Chap-ter 3, we agree with this growth outlook for the German economy.

n The ECB’s ultra-loose monetary policy is keep-ing a lid on interest rates.

n Some of the Eurozone’s member states face challenging times ahead. Investors started questioning the sustainability of the peripheral countries’ public debt late last year, and called for higher risk premia. As a consequence, investors sought the relative safety of German government bonds, which explains the recent decline in bond yields. While risk aversion on bond markets was certainly high and has even increased of late, it did not spill over to equity


2007200420011998199519921989 2010

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Fig. 4.6: Global economic expansion supports MDAX

Source: Thomson Reuters, UBS WMR`

US purchasing manager sentiment (ISM) index above 50 signals expansion;difference in yearly change of MDAX and DAX in percentage points

ISM Manufacturing MDAX relative to DAX

20001990198019701960195019401930192019101900189018801870 2010

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Fig. 4.7: 10-year government bond yields at lowest levelsince Bismarck


In %

end of month yearly average

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Shaded area: periods of strong negative correlation between equity markets return and bond yields(measured by 180day rolling correlation)Source: Reuters EcoWin, UBS WMR

10-year Bund yields DAX-30

Fig. 4.8: Positive correlation between equities andbond yields has broken down since mid-2009In % Index


markets. Bund yields and equities are currently negatively correlated, meaning that one rises as the other falls. This is a rather rare phe-nomenon. In the past, such a constellation has typically been resolved by a sudden in-crease in yields, rather than a drop in equity prices (see Fig. 4.8).

While there are some factors in place which speak for low interest rates, their current extreme levels seem hard to justify given the positive near-to me-dium term outlook for the German economy. With soft factors like high risk aversion calling the shots, the bond market is subject to changes in risk senti-ment, which usually happen faster than changes in fundamental factors. While we would not rule out that German Bund yields fall even further, we see a good chance for yields to finally pick up: not least because the European Central Bank (ECB) is in our view not likely to start raising the policy rate before mid-2011, and, as we set out in Chapter 1, the recovery in Germany is likely to continue. Long-term interest rates usually react quite a bit in ad-vance of the first rate hike in a tightening cycle. The implications for investors are manifold. Most importantly, we think bond investors will face much more challenging conditions in the future. The bond bull market that has been in place for at least the last 20 years seems close to an end. Given that the prices of long-dated bonds react more strongly to a given change in yields, we recommend avoid-ing longer-term government bonds.

Conservative investors might find more value in government bond alternatives. Luckily, the Ger-man market offers a broad spectrum of risk sub-stitutes, most notably covered bonds (mostly Pfandbriefe) and bonds from agencies or the Ger-man Länder (see Fig. 4.9). We advise more per-formance-oriented investors to prefer corporate bonds, since their performance is not just driven by interest rate changes, but also the credit qual-ity of the issuer.

In the longer run, interest rate and bond market developments will also depend on the future course of the 16-country-Eurozone. We provide a brief discussion of some of the relevant aspects in Box 3 (see page 32). For more detailed infor-mation, please refer to the August 2010 UBS research focus, “The future of the euro.”

Chapter 4

Fig. 4.9: Government bonds and alternatives dominatethe German bond market

Source: Deutsche Bundesbank, Kapitalmarktstatistik August 2010

Banks

Corporates

Agencies, others*

Pfandbriefe*

Bunds

Local Governments*

Structure of German bond market in % of outstanding bonds

32

24

9

7

16

12

Note: *marks alternatives to Bunds (government bonds)

ConclusionsOur outlook for German equities is positive: they should benefit from the global recovery even if it continues at a more moderate pace going for-ward. If Germany manages to turn its economic structure more towards consumption, the cyclical swings of the stock market might also be less pronounced in the future. In any case, it seems prudent to add some consumer-related stocks to German portfolios, as the biggest bounce of the global economy lies behind us and the German consumer seems to be in a good mood – not least thanks to the favorable labor market condi-tions. A return to recession – though not our base case – could have severe negative effects on Ger-man equities due to their cyclical bias. German government bonds rank among the safest in the Western countries. However, current yield levels lead us to conclude that longer-dated maturities should be avoided and that investors should seek alternatives beyond government bonds.



Box 3: If Germany were to leave the Eurozone

The fiscal crisis in Greece and the precarious fiscal situation in other Eurozone countries is ultimately due to persistent current account imbalances. As we have argued in the August 2010 UBS research focus “The future of the euro“, one, surprising solution would be for Germany to quit the euro. Clearly, this is a risk scenario, but if Germany exited the Eurozone and had its own currency, its government bonds may actually become even more attrac-tive as euro investors would be tempted to benefit from a likely appreciation of this new currency. Germany’s short-term policy rates would also likely need to be higher to fight inflation than they would in the weaker re-mainder of the Eurozone. A German exit from the Eurozone would also have consequences for outstanding bonds of German issuers.

Most bond documentations do not contain a clause allowing an issuer to re-denominate into another currency, especially when the currency defined for payments continues to exist. We think voluntary exchange offers are the most likely way that issuers could re-de-nominate without facing legal difficulties.

However, numerous obstacles stand in the way of determining which bonds may be re-denomi-nated, as some companies use foreign issuance vehicles and some may want to keep their bonds in euro if part of their revenues remains in Euro. We think short-term bonds could be covered by a transition period, and long-term bonds of na-tional and local governments are most likely to be exchanged. Investors who want to speculate on Germany’s potential exit from the Eurozone should stick to public sector bonds and German stocks, excluding export-oriented companies and corporate bonds in general. We think a re-de-nomination of corporate bonds is highly ques-tionable.

It is important to note that export-oriented com-panies could suffer as a new German currency would potentially appreciate strongly and this would undo the present currency advantages for domestic exporters. Thus the short-term impact of Germany leaving the Eurozone would probably be negative, while longer-term performance would depend to a large extent on the global economy, structural developments and domestic consumers.


Bibliography

– Allard, C. et al. (2005), “Explaining differences in external sector performance among large Euro Area countries,” IMF Country Reports, No. 05/401.

– Bundesbank (2006a), “Determinants of the current accounts in central and east European EU member states and the role of German di-rect investment,” Monthly Report, January.

– Bundesbank (2006b), “Germany in the globali-zation process,” Monthly Report, December.

– Danninger, S. and F. Joutz (2007), “What ex-plains Germany’s rebounding export market share?” IMF Working Papers, No. 07/24.

– Egeln, J. et al. (2007), “Bericht zur technolo-gischen Leistungsfähigkeit Deutschlands 2007,” Federal Ministry of Education and Re-search, Berlin.

– EU Commission, “2009 Ageing Report: Eco-nomic and budgetary projections for the EU-27 member states (2008–2060),” Brussels.

– Federal Ministry of Education and Research (2009a), “Research and innovation for Ger-many,” Federal Ministry of Education and Re-search, Bonn.

– Federal Statistical Office (2009b), ”Germany’s Population by 2060 – Results of the 12th coordi-nated population projection,” Wiesbaden.

– Gottschalk, S. et al. (2007), “Start-ups zwischen Forschung und Finanzierung: Hightech-Gründ-ungen in Deutschland,” Zentrum für Eu-ropäische Wirtschaftsforschung, Mannheim.

– Hülskamp, N. and O. Koppel (2005), “Deutsch-lands Position im Innovationswettbewerb - Ergebnisse des IW-Innovationsbenchmarkings,” IW-Trends, Vol. 32, No. 3.

– Klodt, H. (2004) “Mehr Arbeitsplätze durch Auslandsinvestitionen,” Die Weltwirtschaft, Vol. 4/2004.

Bibliography

– Marin, D. et al. (2003), “Ownership, Capital and Outsourcing: What drives German invest-ment to Eastern Europe,” LMU, Munich, Dis-cussion paper No. 2002-3.

– Niefert, M. et al. (2006), “Hightech-Gründun-gen in Deutschland: Trends und Entwicklung-sperspektiven,” Zentrum für Europäische Wirt-schaftsforschung, Mannheim.

– OECD (2001), “Standard shocks in the OECD Interlink Model,” ECO/WKP (2001) 32.

– OECD (2009), “Fiscal packages across OECD countries: Overview and country details.”

– OECD (2010a), “Germany’s growth potential, structural reforms and global imbalances,” Eco-nomics Department working papers, No. 780.

– OECD (2010b), “Education at a glance 2010: OECD indicators.”

– OECD (2010c), “OECD Economic Surveys: Germany.”

– Rae, D. and M. Sollie (2007), “Globalisation and the European Union: which countries are best placed to cope?” OECD Economics De-partment Working Papers, No. 586.

– Sinn, H.-W. (2006), “The pathological export boom and the bazaar effect: how to solve the German puzzle,” The World Economy, Vol. 29, No. 9.

– Stahn, K. (2006), “Has the impact of key deter-minants of German exports changed?” De Brandt, O., H. Herrmann and G. Parigi (eds.), Convergence or divergence in Europe? Growth and business cycles in France, Germany and Italy, Springer, Berlin/Heidelberg.

– Von Hirschhausen, C. et al. (2009), “Innova-tionsindikator Deutschland 2009,” Deutsches Institut für Wirtschaftsforschung, Berlin.

Selected UBS WMR publications

UBS research focus:The rush for resources chal-lenges emerging marketsDespite the recent economic slow-down, resources are becoming scarcer again. Emerging markets are in the spotlight – their resource demand has risen sharply. Resource use and resulting scarcities can have adverse environmental and social consequences for emerging markets, and may act as a drag on economic growth. Finding solutions to mitigate the adverse effects and to make growth more sustainable will, in our view, offer interesting opportunities for companies and investors.

36 pages A4; English, German, French, Italian, Spanish, Portuguese; September 2010. SAP No. 82092E-1006

Global outlook4th Quarter 2010UBS global outlook is a flagship pub-lication from UBS Wealth Manage-ment Research that provides a com-prehensive assessment of the global macroeconomic outlook, key invest-ment opportunities and important financial market risks. The report is published quarterly.

20 pages A4; English, German, French, Italian, Spanish, Portuguese, Chinese traditional, Chinese simplified and Russian; September 2010. SAP no. 83351E-1003

UBS research focus: The future of the euroIn 2009, at the euro’s 10-year anni-versary its inception was hailed as a resounding success. Yet, the “Great Recession” has provided a severe jolt to the currency’s credibility. In many Eurozone countries, deficit and debt levels have surged to unprecedented heights and investors are concerned with the apparent cracks in the union. We believe that, in the long-term, the Eurozone may need to be reshaped, meaning that some coun-tries may have to leave the euro for it to survive.

32 pages A4; English, German, French, Italian, Russian; August 2010. SAP No. 82092E-1005

UBS investor’s guideThis research publication appears monthly and contains current infor-mation and forecasts which are important for the financial planning and investment decisions of active Wealth Management clients. UBS investor’s guide gives the back-ground to UBS’s current investment strategy and the latest global eco-nomic developments, together with market analyses and recommenda-tions for equities, bonds, currencies and the emerging markets. Please ask your client advisor.

56 pages A5; English, German, French, Italian, Chinese (traditional and simplified); September 2010.

Order or subscribeAs a client of UBS you can order or subscribe to the above publications. Please ask your client advisor or send an e-mail to the following address: [email protected] can find publicly available publications (with freely accessible content) at www.ubs.com/research.


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