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German economy – the calm before the storm

A German economy appears to be in brilliant condition. In the last year with an merchandise exports worth €1 205.5bn and merchandise imports worth €954.6bn Germany reached a banner €252.9bn foreign trade surplus. Thereby, it enhanced its – even then –excellent result from the 2015, when it ran tangible trade surplus of €244.3bn. German trade excess is, in terms of per capita, around 14 times bigger than the trade overhang of another great export power, that is the Chinese economy. Amid the leading global economies solely Switzerland achieves better results in trade excess per capita. As well, the Germany’s current account balance surplus attains levels unprecedented in its history. So far, we still do not have data for the 2016, nonetheless we know that in 2015 the German economy had an overhang in the current account balance at the level of 8.5-8.8% GDP, whereas as far back as  2000 the same indicator was merely -2%.

Such a large trade overhang is an object of jealousy from many states all over the world and, unquestionably, attests to a very high competitiveness of German enterprises – both these small, middle (i.e. so-called Mittelstand sector) and the largest global corporations. Yet, the German political, industrial and financial elites are extraordinarily disconsolate and upset, though they do not often give voice to it publically. There are three quintessential issues that makes German leaders not sleeping calmly. These questions, in the sequence of their significance, are as follows:

  1. a disastrous state of the two biggest and flagship German banks – Deutsche Bank and Commerzbank, which feeds through all the German banking sector;
  2. a threat of Eurozone and the European Union breakup;
  3. an increasing probability of radical turn in international trade towards protectionism on global scale.

Ad a) German banking industry found itself in a miserable condition indeed. As accurately George Friedman – the chief of the private intelligence firm Stratfor – underlines:

Their (that is German – P.F.) banking system has already tremendous problems. Look at Deutsche Bank! They won’t be able to sustain this. Their economy will begin to be shrinking drastically and they won’t be able to control it. (…) On the German side you have a country on the brink of collapse. And you have to take seriously German banking crisis. Deutsche Bank is teetering.

Deutsche Bank – the symbol of German economy, the biggest bank of the biggest eurozone economy and the sole German bank that acts on a truly global scale – nowadays is experiencing gigantic difficulties. Among all European banks it amassed in its balances the mountain of toxic financial derivatives, which right now threatens with insolvency. It is estimated that Deutsche Bank gathered derivatives worth of approximately €42tn. By comparison, the annual Germany’s GDP amounts to just €3.033bn and yearly GDP of the European Union totals €14.6bn. No other bank in Europe has so sky-high exposure on derivatives.

Amid the giants of the Western banking industry it is just the Deutsche Bank which has the highest relation of borrowed capital to equity capital. Deutsche Bank has €67bn  ($75bn) of equity and €1.6bn ($1.8bn) assets which means that it is leveraged at 25 to 1 ration compared with American JP Morgan having $224bn of equity and $2.4bn assets, which makes it leveraged at 9 to 1 ratio. This means that Deutsche Bank urgently needs a serious recapitalization in order to diminish its financial leverage. If it does not do it, it case of breaking out of new economic crisis it will become very vulnerable for going broke.

Strikingly, Deutsche Bank and Commerzbank have extremely low price-to-book value ratios. They are at circa 0.30-0.37 level. For comparison, the largest U.S. banks, which nowise are healthy, have analogous ratios at minimum 0.70. It is assumed that this ratio is low if it is lower than 1.5 (sic!).

Deutsche Bank’s and Commerzbank’s shares have been going really badly in recent years. Several months ago first news that some big Asian hedge funds started to pull their money out of Deutsche Bank emerged. German banks exceptionally badly sustain the current European Central Bank’s monetary policy of negative interest rates – their profitability has been very low for an extended period of time. Credit default swaps for Deutsche Bank, which are a sort of insurance against a risk of Deutsche Bank’s bankruptcy, have been keeping at very high levels for some time.

Moreover, Deutsche Bank grapples with over 7 800 lawsuits all over the world, which were filed against it by aggrieved customers, business partners and governments. In latest years the reputation of Deutsche Bank rapidly aggravated as the bank has been losing consecutive trials all over the globe on frauds, money laundering, help in tax evasion, manipulation of various assets prices, etc.

As if all that were not enough, German banks are gravely exposed on countries of Southern Europe, which banking sectors have giant troubles on their own to recover from downturn and non-performing loans heavy burden. What is more, the German banking industry in general has a high exposure on certain branches of business that have been striving against dire difficulties in latest years. For one, Deutsche Bank gave many credits to American shale oil gas exploitation companies when the hydrocarbon prices on global market were still high. Almost three years ago these prices plummeted and to this very day remain low. This situation results in these firms instead of yielding high profits, have been bringing high losses for three years and frequently do not have funds to pay back the previously contracted debts. The similar situation concerns the container shipping industry. Approximately one fourth of non-performing loans lent to shipowners acting in this business is owed to one of German banks.

All the above-mentioned factors bode badly for the future of German financial sector. They, indeed, mean that at least two largest German banks are in equally bad condition as the leading Italian banks.

Ad b) Brexit and a real menace of the eurozone dissolution mean quite a serious troubles for the German economy. It is just because of the eurozone, that the German economy, to a significant measure, could prosper so much in recent years. If the Southern European states decide to leave the euro zone and return to their former currencies, their exchange rates against euro would depreciate substantially and – in consequence – German export to these countries would become much less competitive and viable in contrast to German imports inflowing from these states. In addition to that, German banks, what was mentioned above, have a giant exposure to Southern European states. Their withdrawal from the eurozone almost for sure would entail a wave of bankruptcies of indebted firms, banks, and even whole states. The debts incurred by them in latest years would be still denominated in euros, whereas the exchange rates of their newly implemented national currencies in case of resignation of the common European currency would quickly considerably devalue vis-à-vis euro. As a result the German banking industry, even without this struggling with huge difficulties, would – in the event of realization of such a scenario – suddenly be burdened with an enormous amount of non-performing loans which had been imprudently lent to Southern European enterprises and countries. Furthermore, Brexit acutely afflicted Deutsche Bank, for it is the largest bank from continental Europe functioning in London’s City which receives as much as 19% of its incomes from activity in the United Kingdom.

Ad c) German politicians received news of Trump’s victory in the U.S. presidential elections with great unease. It seems that the principal reason for that were his announcements of pulling the United States out of negotiations concerning a creation of immense trans-Atlantic free trade zone so-called TTIP  as well as urgent necessity to diminish gigantic trade deficits of the world superpower. Trump repeatedly implied that so high trade overhangs which China and Germany record with the U.S. are absolutely unacceptable and harmful for his motherland. Many German politicians during the last presidential campaign across the pond did not hide that they would most willingly see Hillary Clinton – not Donald Trump – in the White House. For certain, this did not escape the attention of the final winner of American presidential elections. De facto, TTIP has been buried yet. In the narrative of the incumbent White House occupant Germany is not as much and ally and a partner of the United States, but rather an economic power which egotistically takes advantage of other European Union member states foisting the unfavorable eurozone on them. Additionally, Trump argues that euro is underappreciated relative to the U.S. dollar, which is beneficial to German exporters. Berlin does not conceal that it fears plans of the Trump administration to enforce duties on imports of automotive industry products from abroad together with depreciation of the U.S. dollar in relation to the euro. Among German economic circles the apprehension that the Trump’s trade policy portends broader shift in world economy which may be summed up as a global return to protectionism is increasing. But even if only the U.S. would go this way, the sheer significance of American economy for Berlin is sufficiently great (the U.S. accounts for about 10% of aggregate German exports and circa 20% of German trade surplus) means that it would be a severe blow for the German export machine. Needless to say, it is not desired in Germany due to the simple cause that no other big economy in world is more reliant on free and uncustomed trade exchange of goods and services in global markets than the German one.

The factors described above make sanguine prospects of German economy quite dubious. It is not a good news for the Central European countries, since there are strongly dependent on an economic situation in Germany. If it is good, exports of these states flowing to Germany thrives together with investments flowing from Germany and in wake of that the dynamics of their GDP rises. On top of that, Germany remains the largest net contributor to the EU budget, which will soon be additionally reduced in result of Great Britain’s withdrawal from the European Union. Naturally, if Germany plunges into recession or economic depression, the proclivity of German politicians to pay money to the joint EU budget would measurably decline, especially if countries other than Germany, in particular those outside eurozone, would benefit from such transfers.       

2_pdfsam_3_pdfsam_German Economy - the Calm Before the Storm-1

One thought on “German economy – the calm before the storm”

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