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IfW Economic Forecast: German Economy Remains on Track

10.03.2016

Despite to economic headwinds, researchers at the Kiel Institute for the World Economy (IfW) have revised their forecasts only slightly downward for the period leading up to 2017. Individual factors include weakness in China, plunging oil prices, wrangling between EU partners over the refugee crisis, and concerns about the strength of the global economy. The researchers now expect Germany to achieve gross domestic product (GDP) growth of 2 percent in 2016 (previously 2.2 percent) and 2.2 percent in 2017 (2.3 percent). The significant decline in exports over the winter due to weakness in foreign markets is the main reason for this downgrade. Nonetheless, the German economy will continue to perform well. Stefan Kooths, head of the IfW Forecasting Center: “The economic picture is mixed at present. Industry recently suffered a decline on the back of weaker foreign sales, while service providers benefited from continued growth in consumer spending. In fact, the outlook for the consumer sector is now better than at any time since reunification. On the whole, the German economy remains robust in a difficult international climate and continues to be on track for further growth, especially as industrial production also rose sharply again in January.”

Private consumption strong, investment second pillar of recovery

The improved momentum is primarily due to domestic factors. Private consumption is set to grow more strongly during the forecast period than at any time in the past 15 years. This growth is attributable to rising incomes due to the sustained strength of the labor market, additional stimulus from a further decline in oil prices, and government spending, such as the substantial increase in pensions from the middle of this year. Investment is also likely to pick up and become the second pillar of the recovery. Construction investment in particular is projected to increase at a significantly faster pace than in the previous year, thanks to exceptionally favorable conditions. Economic activity is being further boosted by increased state spending on the care and integration of refugees. The global economy is also expected to recover from its weakness over the course of this year, which will in turn provide better opportunities for German exporters. The expansionary monetary policy of the European Central Bank (ECB) will continue to act as a stimulus.

Decline in oil prices: positive and negative effects cancel each other out

In contrast, the recent decline in oil prices has not made any noticeable contribution to the outlook for the German economy. “A sharp fall in the price of key commodities initially disrupts the global economy, necessitating adjustments to supply relationships and partly also to production structures. This has a dampening effect on economic activity. In addition, the slump in oil prices was largely due to low demand for crude oil in a weaker global economic environment. As such, the increased purchasing power generated by lower oil prices in oil-importing countries, such as Germany, is likely to be largely offset by poorer sales prospects in international markets. Our forecast for GDP growth this year is therefore by and large unaffected by declining oil prices,” comments Kooths.

Outlook for the individual member states varies widely

According to the IfW researchers, the economic outlook for the euro area has deteriorated slightly. Consequently, they have lowered their predictions for GDP growth in the euro area to 1.5 percent in 2016 (previously 1.7 percent) and 1.9 percent in 2017 (2 percent). Kooths: “The euro area’s prospects are being negatively impacted by increased political uncertainty, turbulence in European financial markets, and the ongoing weakness of emerging markets. Having said that, positive business sentiment suggests the economy will find a firmer footing again over the course of this year.” The outlook for the individual member states varies widely. Spain and Ireland are now both experiencing a strong recovery, although activity can be expected to slow somewhat in Spain as a result of an uncertain political situation. Economic growth in France and Italy will most likely remain below the euro area average as structural problems continue to hamper more robust expansion, while Greece has slipped back into recession.

The researchers also warn of the possibility that the euro area crisis may escalate again. TARGET imbalances between the periphery and core eurozone countries have been rising markedly for some time, indicating renewed outflows of liquidity and capital. Kooths: “Expansionary monetary policy cannot eliminate the imbalances within the currency union. On the contrary, it runs the risk of creating new distortions. The TARGET figures show that the peripheral economies have not yet regained the trust of international lenders because there are still serious and unresolved structural problems.”

Border controls without significant effect

The IfW researchers believe that border controls within the Schengen Area and along the Balkan route will have little or no impact on the European economy and the internal market. “Longer waiting times for daily commuters and tourists are, of course, annoying for the individual, but looking at the overall picture, the movement of goods in Europe will not be affected in a macroeconomically significant way,” says Kooths. “Freight transport by air, rail, or sea is virtually unaffected by border checks, so cross-border truck traffic is the only area where there could potentially be some disruption. Only very few border crossings along the Balkan route are affected, though, accounting for a negligible share of the overall movement of goods. A further consideration is that border controls only need to operate in one direction and can take place in a targeted manner using risk profiling.”

World economy has weakened, lower oil prices trigger uncertainty

According to the findings of the IfW researchers, global economic activity has also weakened. Based on purchasing power parity, the experts predict that global production will increase by just 2.9 percent in 2016 (previously 3.4 percent) and 3.5 percent in 2017 ( 3.7 percent). Alongside structural problems and the weaker financial backdrop in the emerging markets, the uncertainty triggered by much lower oil prices is a key factor in this deterioration. “The collapse in prices from USD 108 in 2013 to USD 30 implies a loss of USD 1,300 billion by the oil-exporting countries, whose revenue has been reduced, and a corresponding gain by oil importers, who are now paying less for their oil. In the short term, the dampening effect on demand and investment in the oil-exporting countries appears to be prevailing,” says Kooths.

Comments by Stefan Kooths on the latest forecast: “It is important to avoid economic policy overreactions in the current environment because procyclical fiscal policy is ultimately bad for everyone.”

The German economy is currently operating at an almost normal rate of capacity utilization overall. From an economic policy standpoint, this is an ideal situation that policymakers should be wary of upsetting. It would not be improved by expanding economic output ahead of production potential, which would actually be a negative development, with every move into boom territory inevitably leading to painful adjustments at a later date. National economic policy is not able to influence the ongoing expansionary monetary environment, which is why fiscal action is more important than ever as a means of promoting stability. This also means that additional expenditure incurred in dealing with the influx of refugees (costs related to care and integration) should not be met by increased borrowing, but be financed instead through reallocation of existing spending or tax increases. That is all the more important because integrating refugees is a longer term commitment that will initially require additional resources, with any significant benefits not being realized until a much later date. It is also not yet known how many of those who have fled to Germany will remain here permanently after peace has been restored in their own countries. Additional spending programs aimed at the resident population that are funded through additional borrowing are even less desirable in the current macroeconomic environment. German economic policy is already procyclical, given rising structural deficits during the forecast period. The chosen path is thus not compatible with stabilization policy objectives and a change of direction is needed. Tasks should be prioritized or taxation increased.

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