By Eiko Sievert, Director, Sovereign and Public Sector Ratings

We have revised down our growth forecast for Germany (AAA/stable) this year but are still expecting solid growth of 3.5%, compared with a previous estimate of 4.4%, amid the rapid escalation of political tensions and sanctions following Russia’s invasion of Ukraine. This compares with somewhat stronger growth expectations in other major European economies such as France (4.2%) and the UK (4.6%).

Continued economic recovery in 2022: GDP growth forecast

Source: IMF, Scope Ratings

Russia is Germany’s 13^th largest trading partner with a trade volume of around EUR 60bn, but this accounts for just 2.3% of Germany’s total trade. The direct impact on trade resulting from the severe economic sanctions imposed on Russia since the start of the war in Ukraine is therefore manageable at an aggregate level.

However, Germany’s export-orientated economy and the reliance of exporters on international suppliers implies that the war in Ukraine will lead to further disruption particularly for the automotive sector given its reliance on vehicle component manufacturers including from Ukraine and Russia.

Counter-sanctions from Russia, such as closing Russian airspace, will also increase transport costs to China, Germany’s largest trading partner. While such disruption is manageable, it is likely to erode profitability across a broader range of industry sectors. Data from the Bank for International Settlements shows that German banks’ aggregate exposures to Russia fell significantly in recent years and stood at USD 7.4bn at the end of 2021 (less than 0.5% of total claims).

Other downside risks to Germany’s growth prospects remain in the near term. Many of these risks are external such as new Covid-19 waves, a further escalation of geopolitical risks, or a significant slowdown of economic growth in China. Particularly any shocks that result in further global supply chain disruptions could derail Germany’s recovery and put our revised growth estimate for 2022 under further pressure.

The war in Ukraine and sanctions on Russia are also magnifying domestic pressures, notably inflation. German households already face the highest electricity prices in the EU and, in line with most other European economies, prices are continuing to rise. The risk of further escalation and more severe sanctions in the energy sector remain.

Energy inflation rises across EU: electricity prices incl./excl. taxes; energy inflation rate

Source: Eurostat, Scope Ratings

To help address rising energy costs, Germany released part of the national oil reserves in coordination with the International Energy Agency. Since more than half of the electricity price faced by German households is due to taxes, there is some scope to also cushion the impact of higher energy costs through broad-based tax relief. However, inflationary pressures are likely to remain high. Besides disruptions to energy exports, Russia and the Ukraine are among the five largest wheat exporters in the world, adding to price pressure in energy, food and other commodities over the medium term.

More encouragingly, at least some of German manufacturers’ supply-chain problems are likely to prove temporary. If so, with order books across manufacturing sectors full, the German economy’s recovery might be slower than expected this year but continue robustly next year when we expect growth of around 2.7%, above the pre-pandemic trend.

Sustaining such growth depends critically on the reform agenda and investment priorities identified by the new coalition government which need to be implemented. These priorities include targeted infrastructure spending, supporting the transition towards a low carbon economy and reducing bureaucracy.