As we start 2007, value added tax rates in Germany have been increased by three percentage points to 19%. This compares with a single percentage point on the five previous occasions when the VAT rate was increased since the 1970s. The majority view, particularly in Germany, is that this could well hit the pace of the country’s economic growth, taking it down to below 1.5%.
I beg to differ. I reckon real GDP growth could accelerate to 3% this year. The key to my view lies in the corporate sector. For a start, German business executives are not as pessimistic as the economists. The official business sentiment index is at its highest level since German unification. And at no other time has it been higher immediately before a VAT increase.
German business leaders have good reason to be optimistic. External and domestic demand remains buoyant. Foreign manufacturing order volumes have sustained expansion at a double-digit pace and domestic orders are accelerating.
| Capital’s share gets bigger |
| % of Germany’s national income, going to capital and workers |
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| Source: Datastream |
Moreover, a slowing US economy this year will matter little to German exporters, as the US accounts for less than 10% of total exports. Trade with eastern Europe is much more important, and exports there are growing at nearly 30% year on year.
Sure, the euro is strengthening against the dollar, but even a 10% appreciation in the next year would still allow for strong overall export growth.
However, the real story of why German CEOs are optimistic is that they are winning the battle with workers over compensation. The share of national income going to capital has risen remorselessly to a high of 34%. Real wage growth is falling and there is little the German unions can do about it. Higher pay demands are simply met with relocation threats from head office. Workers have just not been able to demand more pay.
But there are other compensations. German employment growth is gathering steam. In 2006, 334,000 jobs were created, compared with a loss of 26,000 in 2005. The unemployment rate is down to 9.6%, with the number of unemployed below 4 million for the first time in years.
Last year, overseas trade and corporate investment accounted for two-thirds of Germany’s annual real GDP growth of 2.8%. And all this new investment is bearing dividends. The productivity growth gap that the US has enjoyed over Germany has now disappeared.
| Germans are getting more productive |
| US productivity growth differential over Germany |
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| Source: Datastream |
Many German products are of world-class quality and in high demand. Porsche and BMW are the benchmarks in the auto industry. Siemens is a top brand name and SAP excels in software. As productivity improves, these goods and services have become more competitive.
Thus corporate earnings are growing at 20%-plus year on year. There is plenty of money circulating around the economy to finance business expansion plans and to upgrade existing facilities.
The main weakness in the German economy remains the consumer. Yet, even with higher VAT, I reckon the consumer is primed to make a comeback in 2007. Despite minimal wage increases, German households are running down savings. Household savings fell 2% in real terms last year. But with the savings rate still at 10%, there is scope for it to fall further. And surveys suggest that consumers are in high spirits to spend money.
If I am right and the German economy proves more resilient than the consensus believes, the European Central Bank will look to normalize monetary policy. That means it is likely to increase interest rates by 75 to 100 basis points this year. Money supply growth is uncomfortably strong for the central bankers in Frankfurt.
Rising eurozone interest rates, improved productivity and robust growth are key ingredients set to drive up the euro against the greenback. I reckon the euro could reach $1.45 by the end of this year.
David Roche is president of Independent Strategy Ltd, a London-based research firm.www.instrategy.com