It all hinges on Germany

It's a sign of the times that in some instances investors in Europe appear keener on the return of their capital than the return on their capital. That was the case when Germany sold 3.9 billion euros worth of six-month bonds at a yield of minus 0.0122 per cent last week, highlighting the faith that investors still seem to have, that no matter what else happens in the Euro Zone, Germany will hold it together.

It is notable that of all the Euro Zone countries, Germany was the only nation to neither have its credit ratings downgraded nor placed on negative outlook by Standard & Poor's on Friday.

It reflected S&P's expectation that “its public finances will continue to withstand potential financial and economic shocks and that consensus in favour of prudent budgetary policies will remain, thereby containing the net general government debt ratio.”

2011 went off well

Germany's net general government debt ratio stands at 80 per cent of GDP. After emerging from the Lehman crisis earlier than most of the rest of the world, the German economy has held up in this second round of the crisis, growing 3 per cent in 2011, according to figures published last week by the German Federal Statistical Office.

While unemployment rates have risen elsewhere on the continent, Germany's fell in December, and the annual unemployment rate of 7.1 per cent for 2011 is the lowest since 1991. German annual exports crossed the 1-trillion-euros threshold for the first time ever by as early as December 6, 2011, and rose 12 per cent over the year as a whole — driven by the auto, machinery, chemical and electronic sectors, estimates the Federation of German Wholesale, Foreign Trade and Services, the BGA.

How Germany does in the year ahead is of great significance to the region's ability to solve the crisis, not least because of its huge contribution to the region's GDP (around a third) — not to mention the 440-billion-euro bailout fund, the European Financial Stability Facility (its contribution to this may well have to rise in view of the nine sovereign rating downgrades).

In recent quarters, the strength of the export sector has also provided a boost to neighbouring economies, including the Netherlands, France, Austria and Poland, home to companies that are integrated into the production processes in Germany.

“Germany is the anchor of Europe,” says Mr Christian Schulz, senior economist at Berenberg Bank. “If it wasn't there, any remaining confidence would disappear, the exchange rate would collapse.”

It does have a number of buffers: firstly German competitiveness remains high, thanks to the labour market reforms brought in by former Chancellor Gerhard Schroder, a painful period of adjustment at the time, but which has left the economy much more resilient through the crisis.

Another factor that helped in the first round of the crisis — and could act as a buffer should the situation worsen — was the Kurzarbeit programme brought in by the government, whereby it subsidised firms (particularly the Mittlestand, small and medium-sized businesses that make up much of the German economy) to keep workers on but for reduced hours.

Of the Western nations, Germany is also the most exposed to fast growing areas: exports to BRIC nations account for 4 per cent of GDP, against figures for the US and the UK in the region of 1 per cent.

Uncertain future

2012 won't be an easy year for Germany: as the German statistical office made clear, the first three quarters accounted for much of the growth in 2011, and estimated that the economy shrank around 0.25 per cent in the fourth quarter. Many expect that trend to continue into the current quarter, putting the country into a technical — if shallow — recession.

“We don't see how Germany will be able to escape the policy-induced recession in the remainder of the euro area — even assuming that the sovereign debt crisis does not escalate materially,” said analysts at Morgan Stanley in a research piece published earlier this week, forecasting that in 2012 as a whole, the economy will grow just 0.1 per cent.

After their strong growth in 2011, exports in Germany are likely to grow just 1.75 per cent in 2012, said Deutsche Bank in a recent note.

 How a somewhat weaker Germany will impact the handling of the Euro Zone crisis remains to be seen, though some believe it may help force the country's hand.

Options that would involve deepening the Euro Zone's dependence on Germany have proved a hard sell for Ms Merkel, particularly in a country that is yet to feel the full force of the crisis. (Consumer spending has been on the rise in recent quarters). A recent scandal involving the largely ceremonial President Christian Wulff is threatening to undermine the government, with some warning that his resignation could even cause the collapse of the coalition government.

 “From a distance Merkel appears to be the strongest leader but internally she is massively under pressure,” says Uli Brueckner, a professor of European Studies at Stanford University's Berlin campus.

 “What might be a positive is that if there is a slowdown in Germany that could change the narrative of the crisis,” says James Ashley, an economist at RBC Capital Markets in London.

“If Germany is in a recession, the relative costs of muddling through change somewhat,” he says.

Italy's position

Also impacting the narrative is the growing assertiveness of Mr Mario Monti, Italy's Prime Minister, cutting into the leadership that has so far been held by France and Germany.

This past week saw a series of bilateral meetings between the three heads of government. Mr Monti, while eager to embrace austerity — much of which he is already implementing at great speed — wants more, telling a Germany daily Die Welt that the austerity could cause a political backlash in Italy.

In recognition, Mr Monti and Ms Merkel issued a joint statement urging nations to adopt a strategy to promote growth — within available resources — rather than just an austerity drive.

At the same time, those positions — in particular that of the French President, Mr Nicolas Sarkozy, could be weakened by the S&P downgrades.

 January began with a brief period of calm — bond auctions by both Italy and Spain during the week saw yields fall below 5 and 4 per cent, respectively.

However, with the developments this week, Germany's status as a haven country for investors will only be strengthened, as will its say over what happens next. 

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