Once Europe’s dependable powerhouse, Germany faces economic stagnation

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For much of the past two decades, the German economy has been a juggernaut.

Rather than hollow out like in so many major economies, its manufacturing sector was bolstered by industrial heavyweights – such as Volkswagen Group, Siemens AG and auto-parts supplier Continental AG – along with hundreds of small, often family-run enterprises that specialized in complex goods honed over decades.

Germany shipped out billions of dollars of luxury vehicles, machinery and other products to the world every month, leading to hefty trade surpluses that were increasingly rare in advanced economies. Its financial position was further supported by a penny-pinching federal government that ran eight consecutive balanced budgets, from 2012 to 2019.

But over the past year, Germany has hit a rough patch. Its output has fallen or stagnated in each of the past three quarters, and the International Monetary Fund projects it will be the only Group of Seven economy to shrink in 2023.

A hiccup was, perhaps, unavoidable: Russia halted shipments of natural gas to Germany last summer, depriving its producers of a cheap energy source. Now China, a key export market for the country, is dealing with its own economic malaise.

Still, the troubles run deeper. Germany faces a series of challenges, including a greying work force, steep electricity costs and a high-stakes shift to greener industrial policies. Its automakers – synonymous with quality engineering in the gas-powered era – face a rush of competition from electric-vehicle startups in Asia.

Facing these headwinds, Germany finds itself in an unusual position: a drag on European growth. For so many years, the continent could rely on its largest economy as a steady source of expansion. But the coming years could be lean. And that would hurt Germany’s neighbours, which have benefited from its boom years.

“I always think of Germany as this harbour to the world,” said Oliver Rakau, chief German economist at the consultancy Oxford Economics. “A lot of the final goods that are exported from Germany are actually at the end of a long supply chain that runs throughout Europe.”

“So if there’s low demand for German export goods, then there will be low demand for the inputs that come from Eastern Europe and Italy,” he added.

Speaking to shareholders in April, the head of BASF AG – the world’s largest chemical producer, with headquarters on the river Rhine – delivered a pessimistic take on business conditions. Some of his complaints (red tape and regulations) were garden variety for executives. But he also spoke of the debilitating cost of higher energy prices.

“Our competitiveness in Europe is challenged,” chief executive Martin Brudermüller explained. “And this is why we’re trying to take corrective action as quickly as possible and as decisively as possible.”

Two months earlier, BASF said it was shuttering some plants in its hometown of Ludwigshafen as a cost-cutting measure. At the same time, the chemical maker is building a production site in southern China that, with a potential price tag of €10-billion ($14.7-billion), is the company’s largest investment to date.

“We want to continue to grow enormously in China with a lot of profitability. This is why we invest there,” Mr. Brudermüller said.

Other companies are hoping to make similar moves. In May, a survey of 128 auto suppliers and manufacturers in Germany found that 27 per cent of those companies were planning to shift investments abroad. Not a single company said it was increasing its investments in Germany.

The subsidy war that’s broken out between rich countries is factoring into those decisions. Canadian governments, trying to compete with the U.S.’s towering Inflation Reduction Act, have extended tens of billions of dollars to land a handful of battery plants, including one that Volkswagen will build in Southern Ontario.

Germany isn’t sitting idle. Intel Corp. will spend more than €30-billion ($44-billion) on a pair of chip facilities in the central city of Magdeburg, with the German government kicking in one-third of the cost – just one of the semiconductor projects it’s recently lured with generous subsidies.

Inside the offices of the federal Finance Ministry in Berlin earlier this week, Florian Toncar was mulling over the Intel investment. “It’s a massive subsidization,” said the member of parliament, whose Free Democratic Party is part of the coalition government. “Probably the overall effect will be positive for Germany,” he added, because of the strategic importance of computer-chip supplies.

But Mr. Toncar cautions against waging a subsidy fight with other countries, or setting a precedent that major investments in Germany will be met with billions in corporate welfare. If American taxpayers subsidize the production of goods that Germany can import, he says, that’s “not the worst trade-off for Europe.”

China is another source of opportunity – and risk. German companies made record investments there last year, and for its automakers, the Chinese market is a cash cow. Mercedes-Benz AG sold 37 per cent of its passenger vehicles in China last year, easily more than its U.S. and German sales combined.

Even so, it’s a fraught time in the auto sector. Volkswagen was recently overtaken by BYD Auto Co. Ltd. – short for Build Your Dreams – as the top-selling vehicle brand in China. The German auto giant has lowered its sales outlook for this year as it struggles to sell EVs in China, which is teeming with upstart domestic brands, such as BYD. Those companies are now trying to muscle their way into the European market.

With electric vehicles, “China is able to produce the same product, at a similar quality, at a cheaper price,” said Carsten Brzeski, global head of macro at the Dutch bank ING Group.

In recent weeks, some media reports have suggested that Germany could reclaim an unfortunate title – “the sick man of Europe” – that dogged it during the 1990s and early 2000s, when it was saddled by the weighty costs of reunification and high unemployment. But the Germany of 2023 is much different, and stronger.

For one, the labour market is exceptionally tight, with a national unemployment rate of 3 per cent, less than half of the broader euro zone. Living standards, as measured by gross domestic product per capita, are considerably higher than in France or Italy. And after massive costs incurred during the pandemic, and as a result of Russia’s invasion of Ukraine, Germany is getting back to its belt-tightening ways: The proposed budget for 2024 would adhere to the “debt brake” of slim deficits.

Mr. Toncar said this fiscal restraint is appropriate as the European Central Bank tries to tackle inflation via higher interest rates. Several analysts think the ECB will start to lower rates by the middle of next year, which would bring relief to Germany’s hard-hit construction sector.

Holger Schmieding, the chief economist at Berenberg Bank, has thrown cold water on much of the pessimism. In a recent report, he said that Germany’s export-focused economy is exposed to cyclical factors – bloated inventories, China’s weakness and the consumer shift to services – that will fade with time.

But he also pointed to a deeper source of resilience: the survival instincts of the Mittelstand, those mid-sized companies that have deftly innovated over generations.

These companies “constantly scour for new opportunities in almost every conceivable direction,” he wrote. “The more they do so, the more such opportunities they find. As a result, these ‘hidden champions’ often dominate tiny niches of the global market.”

Still, it would be hazardous to think these low-profile companies are a passport to future success.

Robert Habeck, the Economy Minister, has advocated capping electricity prices for a select group of energy-intensive producers, aimed at keeping them in Germany for the long haul. (Mr. Schmieding favours a more accessible subsidy that protects against future price shocks, but still encourages companies to become more energy efficient.)

With such low unemployment, employers have struggled to find labour, and more than one-fifth of the population is now in its senior years. The German government is shaking up its immigration system in a bid to recruit more skilled workers from abroad. However, the rise of the Alternative for Germany (AfD) – a far-right political party that’s openly hostile to immigrants, and which is now polling above 20 per cent – could dull Germany’s appeal.

Mr. Brzeski of ING said Germany desperately needs to digitize its government services, which would speed up the glacial pace of bureaucratic processing, and repair its decaying infrastructure. (Contrary to the German reputation for punctuality, Deutsche Bahn rail service is racked with delays.)

The pursuit of fiscal restraint, Mr. Brzeski added, was fitting as Europe struggled with a debt crisis in the early 2010s. But it may have also lulled Germany’s leaders into a sense of complacency.

“It became almost a fetish to continue with those budgets and slight fiscal surpluses,” he said. “The downside to fiscal austerity is clearly that there was too little investment.”