By Eiko Sievert, Director, Sovereign Ratings

Germany’s (AAA/Stable) economy will expand by around 1.7% in 2024, well above its medium-run potential of 0.9% and up from a likely 0.2% expansion in 2023.

The main growth drivers are higher government spending, notably on defence and the energy transition, and improved consumer spending as inflation eases. More robust growth and a favourable public debt profile will contain near-term adverse pressures from higher interest rates on Germany’s public sector credit metrics.

The economic contraction in Q1 2023 was driven by a steep fall in government consumption, its largest QoQ decline in several decades reflecting, among other factors, the drawdown from high spending during the pandemic.

Government spending fell by 5.4% in Q1 2023 compared with the same quarter last year, reducing quarterly growth by 1.1pps (Figure 1). Spending stood at just 2% above levels from Q1 2020 at the onset of the Covid-19 pandemic, well below that of other AAA-rated sovereigns such as Austria (+13.5%), the Netherlands (+9.5%) and other large EU states such as France (+8.4%).

Figure 1. Quarterly contribution to GDP growth, pps

Source: German Federal Statistical Office, Scope Ratings.

While government finances will remain constrained, this sharp decline in government consumption looks temporary. Spending to support the energy transition is rising as is military expenditure in response to Russia’s war in Ukraine, in addition to higher social and health-care spending partly related to Germany’s ageing population.

The coalition government has earmarked around EUR 200bn to shield households and companies against higher energy prices by increasing domestic energy supply as well as introducing gas and electricity price brakes. While final spending on these price brakes may be lower than originally anticipated, the funds will be used to help fund the energy transition over coming years.

In addition, most of the EUR 100bn, equivalent to 2.6% of GDP in 2022, in extra-budgetary funds for modernising the German army will be spent over the next three to four years, sustaining government consumption.

Conversely, continued high inflation will constrain the recovery in household consumption this year, after real earnings fell by 4% last year. Consumer confidence should recover next year due to a recovery in real earnings as price brakes on energy prices shield households until at least April 2024.

Attempts to de-risk reliance on China cloud the trade outlook

As Germany seeks to reduce its reliance on trade with China, the volatility of growth contributions from net exports is likely to persist (Figure 1).

Trade with China fell by more than 10% in Q1 2023, but the country was still Germany’s most important trading partner for the seventh consecutive year last year.  Imports increased rapidly over the past two years, pushing the goods trade balance to a record deficit for Germany of EUR 18bn in Q1 2023.

This deficit is unlikely to reverse quickly. Germany will continue to rely on China for vital intermediate goods, such as rare earth metals vital for the energy transition, which come mostly from China.

Return to fiscal discipline limits spending; moderately higher interest expenses over coming years

Expansionary fiscal policy still has its limits in Germany. A return to the debt brake this year and rising interest payments will restrict government expenditure flexibility. The clear differences in priorities between the three coalition partners is also slowing reform. Negotiations around next year’s draft budget are tense as a deficit of around EUR 20bn remains amid disagreements over energy policy.

Figure 2. Net interest burden as a percentage of general government revenues, %

Note: “AAA-rated economies” include Austria, Denmark, Luxembourg, the Netherlands, Norway, Sweden and Switzerland. Source: IMF, Scope Ratings.

The 2023 federal budget indicated a 10-fold rise in interest expenses, picking up from EUR 3.9bn (0.7% of central government expenditure) in 2021 to EUR 39bn (8.2% of expenditure) in 2023. However, this is mainly driven by the government’s cash-based accounting approach, which overstates interest expenditure when rates rise.

The IMF’s accrual-based approach to measuring governments’ interest burdens as a share of government revenue is a more accurate reflection of when interest expenditure is incurred. While the general government interest burden will rise, it is likely to remain at around 2% of revenue over the next five years – higher than that for other AAA-rated countries, but low compared with the past decade and well below that of other large European states (Figure 2).

Germany also has a favourable residual maturity of its federal debt securities of more than 7.5 years and a low share of inflation-linked securities, which make up just 3.6% of outstanding debt compared with France (11%) and the UK (25%) where there were spikes in interest costs last year due to high inflation.