Germany Evolving Markets

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ab

The return of the Teutonic Tiger

Export strength blessing and curse

Germany faces long-term structural challenges

Investing in Germany

Germany in the fast lane

UBS research focusWealth Management Research

October 2010


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Germany in the fast lane2

Contents

UBS research focus

This report has been prepared by

UBS AG. Please see important disclaimer

at the end of the document. Past per-

formance is not an indication of future

returns. The market prices provided are

closing prices on the respective principal

stock exchange.

Publisher

UBS AG, Wealth Management Research,P.O. Box, CH-8098 Zurich

Editor in Chief

Dirk Faltin, Economist, UBS AG

Editors

Roy Greenspan

Anna Foca

Authors

Lena Lee Andresen, Strategist, UBS AG

Dirk Eenberger, Strategist, UBS AG

Dirk Faltin, Economist, UBS AG

Gerit Heinz, Analyst, UBS Deutschland AG

Andreas Hfert, Chief Economist, UBS AG

Markus Irngartinger, Strategist, UBS AG

Daniel Kalt, Economist, UBS AGGeorg Klein-Siebenbrgen, Analyst,

UBS Deutschland AG

Caesar Lack, Economist, UBS AG

Philipp Schttler, Strategist, UBS AG

Andr Schtz, Analyst, UBS Deutschland AG

Thomas Wacker, Analyst, UBS AG

Editorial deadline

1 October 2010

Project Management

Valrie Iserland

Desktop

WMR Desktop

Translation

24 Translate, St. Gallen, Switzerland;CLS Communication, Basel, Switzerland

Pictures

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Printer

Fotorotar, Egg, Switzerland

Languages

Published in English, German and Spanish

Contact

[email protected]

UBS homepage: www.ubs.com

SAP-No. 82092E-1007

Editorial ..................................................................................................... 3

Highlights .................................................................................................. 4

Chapter 1

The return of the Teutonic Tiger ................................................................. 6

Chapter 2

Export strength blessing and curse ........................................................ 12

Chapter 3

Germany faces long-term structural challenges ........................................ 18

Chapter 4

Investing in Germany ............................................................................... 26

Bibliography ............................................................................................ 32

Selected UBS WMR publications .............................................................. 33

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UBS research focus October 2010 3

Dear reader,

Like a phoenix rising from the ashes, the German economy has staged a remarkable re-

covery so far this year. During the dark days of 2009, the economy contracted at its fast-

est pace in post-war history; this year, Germany is surging ahead of its peers. Even unem-

ployment, which has been Germanys Achilles heel for so long, is falling at an astonish-

ing pace recently reaching levels last seen nearly 20 years ago. Indeed, among the

major economies, Germany stands out in that its unemployment rate is now lower than

before the global economic recession.

How durable Germanys economic comeback is remains an open but important question,given its status as Europes largest economy, with 82 million people and a gross domestic

product of EUR 2.4 trillion (USD 3.23 trillion). Are we witnessing a new economic mira-

cle like the so-called Wirtschafswunderthat followed World War II? Or has the German

economy simply launched a short-lived breakaway, destined to rejoin the rest of the de-

veloped economies grinding along at a snails pace?

Continued success for Germany could be seen as vindication for the European economic

and social model. Indeed, in countries where the usefulness of more scal spending is

hotly debated, many experts are studying the German example, where early and decisive

scal consolidation has not stood in the way of a strong economic recovery.

Some policy makers in Germany are even using their newfound position of strength to

demand that weaker economies especially in peripheral Europe try to emulate the

German growth models focus on exports and competitiveness. But can the export-led

German economy maintain its dazzling performance if the export eld becomes over-

crowded with would-be competitors? And what if Germanys outperformance ultimately

depends on its trading partners spending beyond their means?

Investors looking to benet from the German economic powerhouse must confront

these questions in order to determine the best investment strategy. In this issue of

UBS research focus, we provide investors with extensive background on Germanys cur-

rent growth, its near-term outlook and long-run structural prospects. By tracing key

trends arising from the composition and cyclical character of the German economy, we

are able to identify some likely winners and losers from the current high-growth, low-

interest environment. We hope you will nd our advice useful.

Editorial

Andreas Hfert

Dirk Faltin

Andreas Hfert

Global Head

Wealth Management Research

Dirk Faltin

Head Thematic Research


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Germanys brisk recovery in 2010, likely ahead of

all major economies this year, will probably fade

somewhat in the second half and into 2011. Nev-

ertheless, Germanys exceptionally strong export

position is bolstered by the still relatively weak

euro, which should remain a support for growth

in the near term. As long as global demand is

buoyant, Germany stands to benet. These fac-

tors also support the domestic economy in this

cycle. Importantly, Germany is unburdened by thedirect eect of a burst housing bubble, and pri-

vate sector nancial balance sheets are generally

strong. The performance of the labor market has

also been impressive. Interest rates are an issue to

watch: The current Eurozone rates are too low for

Germany and the risk of a housing bubble cannot

be ignored. But in the near term, we think

growth in Germany is likely to surprise positively,

in absolute terms and compared with other econ-

omies. The biggest risk to this favorable cyclical

outlook stems from any potential renewed slump

in global demand. For Europe as a whole, Germa-

nys return to strong growth this year is a double-

edged sword: It raises economic activity across

the continent, while at the same time fueling

long-standing imbalances.


Germany undoubtedly has one of the most suc-

cessful export economies in the world. The coun-

trys export strength is based on its ability to pen-

etrate high growth markets, especially in the

Central and Eastern Europe (CEE) region and in

Asia, and on its superior competitiveness gained

through corporate restructuring and wage mod-eration. Thus, Germanys advantages in foreign

trade are of a lasting nature and they allow Ger-

many to benet more during global cyclical up-

swings than most of its peers. However, this trade

dependency has its downsides as well. During

economic downturns Germany tends to suer

more than comparable countries that are less

dependent on global trade. Also, Germanys

growth model may be vulnerable to protection-

ism, to structural shis in its main trading part-

ners and to lower-cost competition. Importantly,

Germanys export success does not seem to ben-et the German people at large. In our view, it

will be important to achieve a more balanced

growth model in future.

Germany faces long-term structural

challenges

Germanys strong cyclical growth before and aer

the global recession has diverted attention from

its weak average growth performance this dec-

ade. Germanys rapidly aging society, which com-

pares unfavorably to most of its peers, is a key

challenge to its growth potential. The results of

Germanys very low birth rate are practically irre-

versible now, especially since immigration will

probably not be able to stabilize the population.

Highlights


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Labor market participation is already quite high,

meaning that the potential to oset the decline in

population by expanding the potential labor force

is limited. However, annual working hours are

very low in Germany and could be raised to partly

oset the negative eects of a shrinking labor

force. Capital accumulation, which in theory

could substitute labor, will not be raised signi-

cantly, in our view. However, there would seem

to be scope for improving total productivity, by

countering adverse trends in Germanys innova-tion potential and by continuing reforms of the

education system, including the implementation

of an immigration policy that attracts highly edu-

cated immigrants.


The outlook for German equities is positive: they

should benet from the global recovery even if it

continues at a more moderate pace going for-

ward. If Germany manages to tilt its economic

structure more towards consumption, the cyclical

swings of the stock market might also be less

pronounced in the future. In any case, it seems

prudent to add some consumer-related stocks to

German portfolios, as we think the biggest

bounce of the global economy lies behind us andthe German consumer seems to be in good mood

not least thanks to the favorable labor market

conditions. A slide back into recession though

not our base case could have severe negative

eects on German equities due to their cyclical

bias. German government bonds rank among the

safest bonds issued by Western countries. How-

ever, current yield levels lead us to conclude that

longer-dated maturities should be avoided and

that investors should seek alternatives beyond

government bonds.


Industrial recovery is much stronger in Germanythan in the Eurozone as a whole

Industrial production, index levels

Source: Reuters EcoWin, UBS WMR

90

80

85

95

100

105

110

120

115

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Germany Eurozone

Export market shares of the biggest exporters

Source: WTO database, UBS WMR

% of total world exports

2

0

4

6

8

10

12

14

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

USGermany JapanChina


6/36


Chapter 1


Germany is back. During the global economic

crisis German output contracted more than

in most comparable countries. Now the

countrys economy has regained its pre-crisis

strength. The cyclical outlook remains favo-

rable.

Germany has been surprising people lately. The

worlds fourth-biggest economy has long been

admired for its efciency, innovation and skilled

and disciplined workforce. Yet critics have alsoscorned Germanys inexibility, costly social sys-

tem and opaque web of banks and industry. Ger-

manys recent economic surge has led some to

praise its superior competitiveness, while others

complain that the countrys growth model beg-

gars its European neighbors and other countries

as well.

In this UBS research focus we take a close look at

the German economy. We assess its near-term

outlook and its longer-term structural prospects.

The present chapter discusses the business cycle

in Germany. In the second chapter we examine

the implications of Germanys reliance on export-

driven economic growth. In the third chapter we

round out the picture by looking at structural

trends and challenges and the longer-term out-

look for Germany. The nal chapter interprets our

ndings from an investors point of view.

Germany regains its pre-crisis punch

Four years ago, Germany was hailed as the Teu-

tonic Tiger, an exporting powerhouse and the

growth engine of Europe. In 2006, the future

looked bright for what was then the third-largesteconomy in the world. Unlike most of its Euro-

pean peers, Germany had seemingly found the

recipe for participating in the rapid development

of the emerging economies in Central and East-

ern Europe (CEE) and Asia. Then came the global

recession, starting in late 2007. During the down-

turn, Germany suered more than most other

comparable economies at least in terms of lost

output. Now, with the global recession over, the

German economy appears to have recovered its

pre-crisis strength.

In the rst half of 2010, the German economy

boomed. In the second quarter alone, it grew at

the fastest pace since reunication, back in 1990.

Up 2.2% from the rst quarter (an annualized

rate of over 9%), Germanys growth challenged

even that of China. Full-year growth is now likely

to exceed 3% for 2010. Needless to say, this

surge puts Germany ahead of every other country

in the Eurozone, the 16 countries sharing the

euro common currency. Figure 1.1 makes it clear

that Eurozone industrial activity is practically en-

tirely Made in Germany.

However, before we get too excited, these num-

bers need to be put into perspective. The sharp

rebound this year comes aer a nearly 5% con-

traction of the German economy in 2009. Indeed,

the total output loss during the crisis amounts to

more than 6.5% (measured from the peak in

Fig. 1.1: Industrial recovery is much stronger in Germany

than in the Eurozone as a whole


Industrial production, index levels

90

80

85

95

100

105

110

120

115

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Germany Eurozone


7/36



early 2008). Hence, even if the current speed of

recovery could be maintained, it would take an-

other year to fully make up for the output lost

during the crisis.

Exports feed German growth

The recovery in the rst half of this year reected

a surge in foreign demand for German merchan-

dise. Exports jumped by more than 8% in the

second quarter of 2010 compared to the rst

quarter, the strongest expansion since 1990. Im-ports also grew by a robust 7%. Thus, net trade

exports minus imports directly accounted for

nearly half of the expansion in the second quar-

ter. Domestic demand was also strong, but much

of this strength, especially in corporate invest-

ment spending, was also ultimately due to the

surge in foreign demand (see Fig. 1.2).

Why Germany is an export champ

We will examine the structural reasons for Germa-

nys trade success in detail in the second chapter.

Here, it sufces to say that German exporters greatly

benet from some broad economic developments.

For one thing, Germany embraced globalization

early and earnestly. It also sharpened its price com-

petitiveness through corporate restructuring, pro-

duction outsourcing to lower-cost countries, and

wage moderation, to name a few key factors.

German exporters have also had a boost lately

from the euros weakness.1 The so-called real

eective euro exchange rate, which compares the

euro to a basket of trading partners currencies,

has depreciated by about 6.5% over the rst six

months of 2010, compared to the previous six

months. According to OECD estimates, a 10%

depreciation of the euro would add about 1% to

German GDP in each of the next two years.2

At rst glance, these numbers suggest that the

lower real eective euro exchange rate could

boost German GDP by 0.6 to 0.7% next year and

beyond. The government debt crisis in Greece

and the precarious scal situation in other coun-tries of the Eurozone are behind the weaker euro.

We think this dynamic makes it likely that the

euro exchange rate should remain favorable for

German exporters in 2011.

The relatively weaker euro also puts German ex-

porters at a relative advantage versus their Euro-

zone competitors. To get a sense of the magni-

tude of this advantage, we consider the so-called

purchasing power parity (PPP) for dierent Euro-

pean countries. The PPP exchange rates represent

long-run equilibrium exchange rates. As shown in

Figure 1.3, Germanys long-term PPP against the

US dollar is nearly 1.5, compared to only 1.25 for

the Eurozone as a whole. For the less competitive

southern European countries, the comparable PPP

exchange rates are even lower, just below 1.2.

The average euro-US dollar exchange rate this

Fig. 1.2: Net trade was the main driver of economic activity


Quarterly real GDP growth composition, in %, y/y

7

9

5

3

1

1

3

5

2007 2008 2009 2010

Domestic final consumption Investment Net trade

Fig. 1.3: Germany can live with a higher euro exchange rate


Euro/US dollar exchange rates in purchasing power parities (PPP)

Portugal

Greece

Italy

Spain

Netherlands

Austria

France

Germany

0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6

Eurozone total average

1 Note that despite the recent appreciation, the euro is stillrelatively weak when compared to a basket of currencies.2 OECD (2001)


8/36


Chapter 1

year has so far been around 1.3. From the PPP

rates, it is clear that Germany can successfully

compete at such an exchange rate, while most

other Eurozone exporters struggle to sell their

products abroad.

Germanys export-driven rebound in the rst half

of 2010 also simply reects the severity of the

decline in 2009. Germany is recovering faster in

2010 because it contracted faster in 2009 (see

Fig. 1.4). Thus, global trade fell about 20% frompeak to trough, partly sentiment-driven. When

condence revived, orders that had been on hold

were reactivated. German exports dropped about

25% in 2009 and are now beneting more from

the correction than most other countries. Since

the lows in May 2009, German exports have now

risen some 30%, nearly regaining pre-crisis levels.

Export demand likely to fade

Foreign demand for German goods may moder-

ate in coming months and in 2011 given that the

scal programs launched in many countries

worldwide in response to the crisis are set to ex-

pire. While the German government implemented

its own signicant measures to support the econ-

omy, the countrys export orientation meant that

it also beneted from the spending programs of

its main trading partners. For example, Chinese

demand for German-made goods accounted for

only 2% of the 25% drop in German exports last

year. Yet orders from China contributed some 9%

to the 30% recovery, due in no small part to the

large Chinese scal stimulus package, of some

EUR 400 billion.

More than just exports

While exports are clearly the mainstay, the big

surprise in Germanys economic data in the sec-

ond quarter was robust domestic demand. Private

households, government spending and corporate

investments all contributed. Indeed, total domes-

tic demand accounted for 1.4% of the 2.2%

expansion in the second quarter, the most since

2006. Aer three negative quarters, consumer

spending rose by a healthy 0.6% in the second

quarter.

Gross xed investments posted a solid improve-

ment in the rst half of 2010, with investment in

machinery and equipment soaring 4.4% per

quarter. Construction investment rose even faster

in the second quarter, also reecting the excep-

tionally long and cold winter, which put many

construction projects on hold until the second

quarter.

Fiscal policy and the labor market miracle

A number of other factors also supported Germa-

nys domestic demand. First, as noted, the Ger-

man government launched a big scal stimulus

package in 2009, topped only by the US, Canada

and Australia among the G7 economies. It may

have accounted for about 3% of 2008 GDP. The

impact of these measures should be visible in

2009 and 2010 in roughly equal shares.3

Fig. 1.4: German exports recovered rapidly


Exports as % of GDP

23

18

28

33

38

43

1995 1997 1999 2001 2003 2005 2007 2009 2011

Germany France Italy UK

3 OECD (2009)


9/36



The unexpectedly strong labor market also bu-

oyed domestic demand. Germany is the only

large economy where, aer the global crisis, un-

employment is lower than before it. Indeed, as

Figure 1.5 shows, Germanys unemployment rate

rose only 0.7% to a peak of 8.3%. It then edged

lower, averaging around 7.8% in the rst half of

2010. In contrast, the Eurozone unemployment

rate rose by almost 3% during the crisis, and now

hovers at a high 10%.

This solid labor market performance, in our view,

reects Germanys exceptional social cohesion.

Companies asked employees to work part-time to

avoid large-scale layos. The government helped

with short-shi subsidies to as many as 1.5 mil-

lion workers at one time. Payrolls have proven

relatively robust, expanding at a monthly rate of

around 30,000 workers (equivalent to an annual-

ized rate of 1%) over the summer months. We

think employment prospects are brightening as

companies hiring intentions are up sharply and

consumers unemployment worries are steeply

down. As workers went full-time again and, in

some cases, even to overtime, compensation per

employee recovered meaningfully in the rst half

of 2010, which should support consumer spend-

ing in the coming months.

Firms and households not overleveraged

Unlike many of its peers, Germany did not have a

housing bubble. As shown in Figure 1.6, German

house prices have been stable throughout most

of this decade, while house prices in Spain and

Great Britain more than doubled. Of course, Ger-

man private households and, in particular, thebanking sector, were hurt by the bursting of

housing bubbles in other countries, but at least

there was no such bubble at home. In sum, Ger-

man households and companies do not hold ex-

cessive amounts of debt. German households and

rms did not expand their debt level over the last

decade, in contrast to many of its European

neighbors (see Figs. 1.7, 1.8, 1.9).

Interest rates too low

Does all this mean that the German economy has

de-coupled in a sustainable way from the otherdeveloped economies? The answer is no. Germa-

nys trade-dependence means that its growth

performance is clearly linked to that of its trading

partners. However, there is a nal and, in our

Fig. 1.5: Germanys unemployment rate is falling rapidly


In %

7

6

8

9

10

11

12

13

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Germany Eurozone

Fig. 1.6: German house prices have remained stable


House price index (1995 = 100)

100

80

120

140

160

180

200

1995 1997 1999 2001 2003 2005 2007 2009 2011

Germany Eurozone

Fig. 1.7: German households have improved theirbalance sheets


Net assets of private sector excluding financial sector (% of GDP)

50

0

100

150

200

250

300

1999 2000 2001 2002 2003 2004 2005 2006 2007 20092008

Germany Eurozone (ex Germany)


10/36


Chapter 1

view, especially important factor supporting both

consumer spending and corporate investment is

Germanys historically low interest rates. The Eu-

ropean Central Bank has cut its short-term policy

rate to a record low of 1%, particularly to support

those economies that are laboring from past ex-

cesses in their housing markets. For Germany,

however, current interest rates are clearly too low.

Figure 1.10 shows so-called Taylor interest rates,

which combine data about economic activity andination to indicate the appropriate level of short-

term interest rates. By this measure, current short-

term interest rates are more than one percentage

point too low for Germany.

The upshot is that the German economy is over-

stimulated, a fact that should not be underesti-

mated. Unduly low interest rates contributed

greatly to the housing bubbles in Spain and Ireland,

and triggered a more traditional consumption

boom in Greece. Earlier in the decade, suering

from weak demand, Germany needed low rates. As

it accounts for roughly a third of the Eurozone

economy, the European Central Bank (ECB) set

rates to t Germanys needs. These were clearly too

low for many of the other countries. We see an

increasing risk of some form of over-investment or

real estate bubble forming in Germany if interest

rates remain so low for much longer.

The recovery is a double-edged sword

Germanys strong economic rebound this year has

been greeted with mixed feelings among its neigh-

bors. As the biggest economy in Europe, it pushes

up demand for the products of other Europeancountries. On the other hand, Germanys export-

led rebound fuels the current account imbalances

that are at the heart of the sovereign debt prob-

lems facing some Eurozone countries. Ironically,

over the last few months, many in Germany have

chastised other Eurozone countries, most notably

Greece, for their proigacy, not realizing that

these excesses create the trade and current ac-

count surpluses that allow the German govern-

ment to run smaller budget decits especially if, as

we believe, interest rates will remain too low for

Germany for a considerable period of time.4

Fig. 1.8: German households were net lenders prior tothe recession

Source: Eurostat, UBS WMR

Note: Eurostat statistics in focus, 29/2009.

Net lending/borrowing of households, as % of disposable income, 2007

30

20

10

10

0

20

UK

Spain

US

Netherlands

EU

Belgium

Italy

France

G

ermany

Austria

Ireland

Gross household savings rate, 19952007 Gross household investment rate,19952007Net lending (+) / borrowing (), 19952007

Fig. 1.10: Taylor rate shows that interest rates are toolow for Germany


0

1

1

2

3

4

5

6

In %

2002200120001999 2003 2004 2005 2006 2007 2008 2009 2010

3-month Libor Taylor rate for Germany

Source: Eurostat, UBS WMR

Fig. 1.9: German companies were net lenders prior tothe recession

Note: Eurostat statistics in focus, 28/2009.

Net lending/borrowing of companies, % of gross value added, 2007

4030

1020

302010

0

40

France

Italy

EU

Austria

US

Ireland

Belgium

Germany

UK

Netherlands

Spain

Gross fixed capital formation, 19952007 Gross savings, 19952007

Net lending (+) / borrowing (), 19952007

4 For a detailed discussion of these issues, please refer tothe August UBS research focus, entitled The future of theeuro.


11/36



Conclusions

Germanys brisk recovery in 2010, likely ahead of

all major economies this year, will probably fade

somewhat in the second half and into 2011. Nev-

ertheless, Germanys exceptionally strong export

position is bolstered by the weak euro, which

should remain a support for growth in the near

term. As long as global demand is buoyant, Ger-

many stands to benet. These factors also sup-

port the domestic economy in this cycle.

Importantly, Germany is unburdened by the direct

eect of a burst housing bubble, and private sec-

tor nancial balance sheets are generally strong.

The performance of the labor market has also

been impressive. Interest rates are an issue to

watch: They are too low for Germany and the risk

of a housing bubble cannot be ignored. But in

the near term, we think growth in Germany is

likely to surprise positively, in absolute terms and

compared with other economies.

The biggest risk to this favorable cyclical outlook

stems from any potential renewed slump in global

demand. For Europe as a whole, Germanys re-

turn to strong growth this year is both a blessing

and a curse, as it raises economic activity across

the continent, while at the same time fueling

long-standing imbalances.


12/36


Chapter 2


Germany is the export champ of Europe. Its

brisk export-driven recovery underpins our

positive near-term outlook on the German

economy. In this chapter, we take a close

look at Germanys export strength and con-

sider its benets and its drawbacks.

Until this year, when it was surpassed by China,

Germany was the worlds biggest exporter of

goods. Between 1995 and 2007 exports in-

creased by 8% and imports by around 7% peryear, on average. The strong increase in both im-

ports and exports in recent years led to the emer-

gence of the so-called bazaar theory, according

to which Germany is increasingly becoming a

trading place for goods and services (see Box 1).

Surely, one major factor driving Germanys export

growth has been the rapid expansion of the glo-

bal economy, which by extension increased the

market for Germanys exports. Between 2000

and 2007, the size of the potential export market

(measured as the weighted sum of goods and

services imports by Germanys trading partners)

increased by more than 50%. Other countries

experienced similar increases in their potential

export markets, but what sets German exporters

apart is their ability to maintain and in some cases

increase market share in the face of growing

competition from low-cost emerging countries

(see Figs. 2.1 and 2.2).

Germanys export success is driven by

cost-competitiveness

Germanys exceptionally strong export perform-

ance has generated much speculation about its

sources. Most studies nd that the market-share

gains resulted primarily from improvements in the

price-competitiveness of German products.

Fig. 2.1: Destination of German exports

Source: Federal Statistical Office, UBS WMR

% of total exports, 2008

10

0

20

30

40

50

60

Japan

Africa

Russia

Mid

dleEast

China

Oilexporters

US

CEE

Asia

Non-

Eurozone

Eurozone

EU-2

7

Fig. 2.2: Export market shares of the biggest exporters

Source: WTO database, UBS WMR

% of total world exports

2

0

4

6

8

10

12

14

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

USGermany JapanChina

German goods ll

Asian harbors


13/36


Having adopted the euro in 1999 at a somewhat

overvalued exchange rate, German exporters

sought to restore price competitiveness by push-

ing for wage moderation. As a result, wages grew

only very little in the rst half of this decade. In

2008, the level of real wages, adjusted for ina-

tion, was virtually the same as in 2001 (see Fig.

2.3)1. Secondly, German companies also sought

to take advantage of lower production costs by

o-shoring parts of their production chain, espe-

cially to the Central and Eastern European (CEE)

countries (see Fig. 2.4)2.

1 The prolonged eort to contain costs through wage mod-eration was diluted by the appreciation of the euro be-tween 2002 and 2008. That means that Germanys cost-competitiveness improved primarily versus other Eurozonecountries, which explains the signicant rise of Germanysexport market share within the Eurozone.2 Outsourcing and o-shoring can also explain the surge inGerman exports to these countries as the foreign-basedsubsidiaries or contracting rms are likely to have been

equipped at least in part with capital goods produced inGermany, and they are sourcing intermediate inputs fromthere (Bundesbank, 2006a). Similarly, the sharp increase inimports from Central and Eastern Europe might be ex-plained by subsidiaries or contracting rms supplying inter-mediate or nished products to German parent companies.


Box 1: Germanys export bazaar

The bazaar theory was rst proposed by the inu-

ential German economist Hans-Werner Sinn (Sinn,

2006). He argued that Germany is turning into a

trading place, or bazaar, as its share of production

content, in terms of total value added, diminishes.

According to Sinn, high and inexible domestic

wages force German companies to respond tolow-cost competition by shiing parts of their pro-

duction to lower-cost countries. This output is then

re-imported and the nished product is Made in

Germany, commanding a premium price.

While this is a normal consequence of globali-

zation, Sinn argues that it has gone too far. He

feels it prevents domestic wages from adjusting

sufciently to the levels of wages in the lower-

cost countries. As a result, Germany is gradually

losing its production capabilities and degenerat-

ing into a mere trading place, or bazaar.

Some economists dispute Sinns conclusions,

arguing that oshoring has not reduced thedepth of production in Germany, but simply im-

proved price competitiveness. What is more,

Marin et al. (2003) nd that multinational rms in

Germany are not outsourcing the low-skill parts

of production, but rather the most skill-intensive

activities, oen to Eastern Europe. This has impor-

tant implications for education levels in Germany,

which we will discuss in the next chapter.

Fig. 2.3: Weak wage growth in Germany


Nominal and real wage growth, in %, y/y

1

2

0

1

2

3

4

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Germany, nominal wages

Eurozone, nominal wages

Germany, real wages

Fig. 2.4: Germany has gained price competitiveness


Real effective exchange rates (at unit labor costs)

Falling price competitiveness

Rising price competitiveness8580

9095

100105110115

125120

1994 1996 1998 2000 2002 2004 2006 2008 2010

SpainFrance ItalyGermany


14/36


and in the longer run by non-price factors

In contrast to cost or price factors, non-price fac-

tors, such as quality improvements or efciency

gains, seemed to have played only a minor role

during the pre-crisis export boom. In the longer

run, however, non-price factors are important.

Thus, Danninger and Joutz (2007) show that ties

to fast-growing trading partners were an impor-

tant driver behind Germanys export strength

from 2000 to 2005. In general, we think that

German companies benet in particular fromtheir long-standing experience in overseas trade,

their high degree of international integration, and

a product range geared towards investment

goods, which are in high demand, especially in

the fast-growing emerging economies (see Figs.

2.5, 2.6 and 2.7).

This is important, because if German exports were

growing only because of a surge in global invest-

ment activity, then its export success would come

to an end as soon as either the global cycle ma-

tured or lower-cost competitors entered these

growth markets. However, with its reliance on

cost-competitiveness and structural non-price

factors, we think Germanys edge in international

markets should be of a longer-term nature.

Export dependency increase economic

volatility

Germanys export boom was halted by the global

economic crisis of 2008. In 2009, German exports

registered their sharpest decline in postwar his-

tory. Indeed, with exports falling some 25% in

early 2009 compared to the previous year, Ger-

many suered more than most comparable coun-tries. The reason for this lies in the composition of

German exports, which are, as we have seen,

strongly geared towards capital goods (machinery

and transportation equipment) and durable con-

sumer goods, such as automobiles. Demand for

such products can be easily delayed during times

of rising economic uncertainty, in contrast, for

example, to staples such as food and energy.

Companies usually freeze their investment

projects when the economic outlook darkens, so

demand for German-made investment goodsdrops sharply. But when economic prospects

Chapter 2

Fig. 2.5: German exports are focused on capital goods

Source: UN Comtrade, UBS WMR


20

0

40

60

80

100

Japan Germany EU-27 France Italy Spain US UK

Investment & intermediate goods(capital goods)

Consumer goods & commodities

Fig. 2.6: Composition of Germanys exports



17.5

14.8

13.9

6.35.2

42.3

Vehicles

MachineryChemical products

Iron and steel products

Electrical products

Others

Fig. 2.7: Destinations of exports in 2009


Note: *Eastern Europe, Brazil, India, Indonesia, Russia

% of total exports

20

0

40

60

80

100

Japan Germany EU-27 Italy US France UK Spain

Major emerging markets * (ex China) Rest of worldChina


15/36


improve again, capital goods orders also tend to

rebound more strongly. Hence, Germany suers

more in the downturn, but also benets more

than most of its peers in an economic recovery.

Indeed, as can be seen in Figure 2.8, German

economic production is more volatile than that of

most of its neighbors. This is not a trivial dynamic.

Since the introduction of the euro, in 1999, about

80% of Germanys real GDP growth adjusted

for ination was generated from net exports(see Fig. 2.9) and a quarter of Germanys work-

force is employed in the export sector. Sharp

swings in the economic cycle can, therefore, be a

real challenge, not least for scal and monetary

policy makers.

Exporters face protectionism and low-cost

competition in the long-run

Germanys exceptionally open trade posture

makes it susceptible to increased economic vola-

tility and the protectionist sentiment of its trading

partners. Given its export dependence, any trend

towards protectionism harms Germany more than

most of its peers. However, this is probably miti-

gated to some extent by its specialization in high

quality investment goods and durable consumer

goods. These kinds of products resist easy substi-

tution. This could change, however. As Germanys

Asian trading partners reach a more mature stage

of development, their demand for capital goods

will likely diminish in favor of consumer goods.

Also, Asian and in particular Chinese manufactur-

ers are moving up the value chain themselves,

thus starting to encroach on Germanys productrange (see Fig. 2.10). As a result, German manu-

facturers face increasing competition from their

prime export markets, especially from China and

India, with their large pools of low-cost labor.

Hence, we doubt that German exporters can rely

only on cost-cutting to remain competitive in the

long term. Instead, they will have to focus on

innovation and efciency to maintain their export

success, factors that we discuss in more detail in

the next chapter.


Fig. 2.10: Chinese exports focusing on capital goods


% of total exports

10

0

20

30

40

50

60

1992 1994 1996 1998 2000 2002 2004 2006 2008

Consumer goods

Intermediate goods

Capital goods

Agricultural & commodities

Fig. 2.8: German output growth is more volatile than incomparable countries


Standard deviation of industrial output change over the past 10 years

1

2

3

0

4

5

6

7

8

Germany France US UK

Fig. 2.9: Net trade was the key source of growth between

2000 and 2007


Real GDP, in % y/y and annual growth contributions

4

6

2

0

2

4

1992 1994 1996 1998 2000 2002 2004 2006 2008

Total real GDP growth

Domestic demand

Net trade


16/36


Export orientation weakens domestic

consumption

There is another problem with Germanys export-

led growth model. It appears to weaken domestic

demand both private household consumption

and corporate investment spending. The ip-side

of Germanys price competiveness is low wage

growth and high unemployment. The evidence

regarding employment is less straightforward.

While some (Sinn, 2006) argue that oshoring

increases domestic unemployment, others havefound no such eect in their research (Klodt,

2004). However, there can be no doubt that

wage growth stagnated throughout most of this

decade, leading to exceptionally weak household

consumption growth (see Fig. 2.11). Thus, the

perception remains that Germany is buying its

export success with a reduction or at least slower

expansion of its populations overall living stand-

ards.

and appears to drag on corporate invest-

ment

Since the inception of the euro, German corpo-

rate investment spending has been unusually

weak (see Fig. 2.12). In part, this reects the

growth of oshoring activities, which diverted

investments from domestic projects in favor of

CEE countries. We can also see this in the current

account, which reects all savings and spending

in the economy. Germany has been running sur-

pluses throughout this decade, meaning that

German households have saved more than they

have spent (see Fig. 2.13).

In general, saving is a good thing, as it forms the

basis for investment. Yet if savings are persistently

higher than spending in an economy, it means

that domestic savings go elsewhere and are una-

vailable to nance investments at home. German

savings were invested in building up facilities in

Eastern Europe. They also helped to fuel the con-

struction and consumption booms in Greece,

Spain and Ireland. Some of these savings were in

portfolios and found their way into low quality

nancial assets. As the bubbles in southernEurope burst, German savers and the German

banking sector, which had moved these savings

into the low quality assets incurred substantial

losses.

Rebalancing the German economy

We think Germany needs a more balanced

growth model. This has been widely acknowl-

edged by experts and policy makers. Yet most

pundits and politicians in Germany demand ad-

justments from decit countries while striving to

further improve Germanys export competitive-

ness. This seemingly irrational behavior can be

explained by considering Germanys industrial

and institutional structure as it has evolved over

time.

The success of Germanys export-oriented growth

model could be Germanys own worst enemy. It

has created an almost invincible alliance of pow-

erful employers and unions who share a vested

interest in the models continuation. They have so

far been able to thwart any attempt to restructure

Chapter 2

Fig. 2.11: Weak German consumer spending since 2002


Consumer spending and nominal wage growth, in %, y/y

0

2

2

4

6

8

10

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

WagesConsumption

Fig. 2.12: Corporate investment in France and Germany


Index Q1 2000 = 100

90

80

100

110

120

130

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

France Germany


17/36


the German economy. Even though external fac-

tors in particular, the spending patterns of its

trading partners will change, for the moment,

at least, Germanys power brokers are insisting on

continuity. Also, it must be said, policies that pro-

mote a more balanced growth mix for example,

through taxes, subsides or wages risk weaken-

ing Germanys competitiveness without suf-

ciently strengthening domestic demand. These

are issues to watch closely in Germanys political

arena over the coming years.

Conclusions

Germany is undoubtedly one of the worlds most

successful export economies. Its export strength is

based on its ability to penetrate high-growth mar-

kets, especially in the CEE region and in Asia. Its

success also reects its superior cost competitive-

ness, which has been achieved through corporate

restructurings and wage moderation. These ad-

vantages in foreign trade appear to be durable.

They should allow Germany to benet more dur-

ing global cyclical upswings than most of its

peers.

However, export dependency has its drawbacks as

well. During economic downturns, Germany

tends to suer more than countries that are less

dependent on global trade. Also, Germanys

growth model may be vulnerable to protection-

ism, structural shis in its main trading partners,

and growing cost competition. It is important to

note that Germanys export success does not

seem to benet the broad population. We think

achieving a more balanced growth model is one

of the countrys key challenges for the future.


Fig. 2.13: Increasing imbalances within the Eurozone


Current account balances, in % of GDP

12

8

4

0

4

8

12

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

SpainFrance ItalyGermany


18/36


Germanys recent robust economic perform-

ance will not go unchallenged. In this chap-

ter, we look at structural trends, domestic

and foreign, that will inuence Germanys

long-term growth outlook.

Germanys strong cyclical performance before

and especially aer the global nancial crisis has

diverted attention from its weak underlying eco-

nomic growth. Adverse developments in per-cap-

ita GDP, which is a common measure of livingstandard, have also been papered over by the

good export news lately. In fact, the gap between

Germanys per-capita GDP and the average of the

upper half of OECD countries actually widened

over the past decade (see Fig.3.1) and total eco-

nomic growth between 1998 and 2007 averaged

just 1%, compared to over 2% in France and

around 3% in the UK and US. Indeed, according

to OECD estimates, Germanys long-term growth

potential averaged just 1.2% in the period from

1998 to 2007 compared to 2.4% for the OECD

as a whole (see Fig.3.2). The question is: How

will Germanys growth potential develop in fu-

ture?

Demographic challenges

Demographics are an important factor determining

a countrys long-term growth potential. Like many

other industrial countries, Germany faces pro-

found, even unprecedented, demographic changes

in the coming decades. A persistently low birth

rate over the past four decades or so, combined

with rising life expectancy, make demographics an

inescapable economic issue.

The most recent projections assume that by 2060

Germanys population will decline from 82 million

today to somewhere between 65 and 70 million

(see Fig. 3.3). From an economic point of view, the

demographic issue does not so much reect the

decline in the overall population as it does the shi

in the populations age structure. In particular, the

contraction of the potential labor force is the main

Chapter 3

Germany faces long-term structural

challenges

Fig. 3.1: Germanys living standard slipped behind

Source: OECD (2009), UBS WMR

Note: Percentage gap to the simple average of the upper half of OECD countries in terms of GDP per capita in constant2005 PPP.

GDP per capita gap to upper half of OECD countries, in %, 2008

30

20

10

0

10

20

30

US

Netherla

nds

Can

ada

UK

Germ

any

Finland

Fra

nce

Ja

pan

Italy

Spain

Nor

way

Fig. 3.2: Germanys growth potential lagged behindthe OECD average

Source: OECD, UBS WMR

Potential GDP growth, in %

0.5

0.0

1.0

1.5

2.0

3.0

2.5

3.5

1992 1994 1996 1998 2000 2002 2004 2006 20102008

Germany OECD


19/36



problem, since this is the age bracket that contrib-

utes to pension funds and tax revenues.

To illustrate the magnitude of the problem, the

old-age dependency ratio, which compares the

non-working population (those 65 and above)

and the prime working age population (15 64)

is expected to rise from 42 in 2008 to 73 by

2060. This means that, while 42 pensioners de-

pended on 100 workers in 2008, some 73 retirees

will claim benets from the contributions of 100workers in 50 years (see Figs. 3.4 and 3.5).

The number of Germanys workers could fall by

around 28% between 2007 and 2060, which

would be an annual average drop of around 0.5%.

Assuming this decline has a full impact on labor as

a production factor, the trend rate of GDP would

be reduced by an average of about one-third of a

percentage point per year.1 Thus, Germanys trend

rate of growth would soon turn negative, which

normally implies a contracting economy.

However, there are osetting factors, such as the

growth in the capital stock and in total factor pro-

ductivity. In general, an economys potential

growth rate is determined by three factors:

the quantitative input of labor (labor force

potential) and capital (capital stock)

improvements in the quality of individual pro-

duction

the efcient combination of the two factors

(total factor productivity) (see Box 2).

Germanys long-term growth potential

We estimate that from 2011 to 2050 Germanys

average potential growth rate will be about 0.9%

per year, assuming net immigration of 200,000

and no changes to the birth rate, the capital accu-

mulation rate and total factor productivity. The

aging eect on potential growth would be worst

towards the end of the 2020s and in the 2030s,

when the bulk of the baby boomers retire from

the labor force (see Fig. 3.6). Germanys expected

potential growth rate compares unfavorably with

1 The so-called output elasticity of labor, i.e. the eect oflabor supply changes on output, is typically assumed to betwo-thirds versus one-third for capital.

Fig. 3.3: Population expected to decline


Note: From 2009 results of the 12th coordinated population projection.

Number of persons

60,000,000

55,000,000

65,000,000

70,000,000

75,000,000

80,000,000

85,000,000

197019601950 1980 1990 2000 2010 2020 2030 2040 2050 2060

Historical Lower limit Upper limit

Fig. 3.4: Dependence ratio increases


Ratio of dependent people to working population, in %


1950 1970 1990 2010 2030 20702050

20

0

40

60

80

100

120total dependency ratio

old-age dependency ratio

young-age dependency ratio

Fig. 3.5: Strong increase in the number of older people



Population by age groups, in %

2008 2060

20

61

1934

50

16

Below 20 years 20 to 65 years 65 years and older


20/36


Chapter 3

Box 2: Determining potential growth

GDP readings can be regarded as a combina-

tion of long-term production potential and a

shorter-term cyclical component. The produc-

tion potential or potential growth of an

economy refers to the total economic output

that can be produced with the production fa-

cilities, labor and capital that are available atany given time. The calculation takes account

of technological progress and assumes that

capacity utilization is at long-term average

levels.

Output in period t (Yt) is derived from a combi-

nation of the input factors labor (Lt = potential

labor force) and capital (Ct = capital stock). TFPt

(total factor productivity) captures the level of

technology or technological progress.

The level of total economic output is given by:

Yt = TFPt* f(Lt, Ct)

And the growth rate of total economic output is

given by:

lnYt = lnTFPt + a*lnLt + (1 a)*lnCt

Thus, the growth of total economic output is

determined by the change in technological

progress (lnTFPt) and the weighted growth rates

of the inputs of labor (a*lnLt) and capital

((1a)*lnCt). The weights correspond to the

shares of income from labor (a) and from capital

(1a) in national income.

The following diagram summarizes the various

factors aecting the variables in the economic

output equation:

Quality

Yt= TFPt f (Lt, Ct)

Quantity

Development of capital stockTechnological progress= total factor productivity

Potential labourforce

Domesticpopulation

Birth rate NumberBirth rate

Immigrants

Participationrate

Retirementage

Working hoursper employed person


21/36


those of all other G7 countries, apart from Italy

(see Figs. 3.7 and 3.8). We expect Germanys

per-capita GDP to grow by about 50% until

2050, compared with 65% for the G7 as a

whole (see Fig. 3.9).

Germanys low birth rate

The diagram in Box 2 summarizes approaches to

counteract the demographically inducted de-

cline in the potential growth rate. The input

factor labor, which typically accounts for abouttwo-thirds of total output, oers most options

for policy makers.

Germanys fertility rate, only 1.34 children per

woman of child-bearing age in 2008, has been

notoriously low for decades (see Fig. 3.10 and

Map 1). Without any net immigration, the fertil-

ity rate would have to be 2.1 to maintain the

current population. Measures to increase the

fertility rate can only work very gradually and

their eects would not be felt for some 20

years, when the additional children enter the

labor market. Thus, most projections assume

only marginal changes in Germanys birth rate in

future, with little eect on the population pro-

jections for the next 50 years.

Immigration can boost the labor supply

The next option to boost the potential labor sup-

ply is immigration. This has been quite volatile in

the past, but Germany has usually had net immi-

gration ranging between 129,000 and 354,000

persons annually since the 1950s. In the past ve

years or so, net immigration has declined mark-

edly. Between 2000 and 2007, annual net immi-gration averaged 129,000. According to UN pro-

jections, Germany should attract net immigration

of around 200,000 people per year in future. Yet,

assuming an unchanged birth rate, the total pop-

ulation and the potential labor force can only be

maintained with an annual net immigration of

about 450,000. Thus, in order to oset the ef-

fects of Germanys low fertility rate, net migra-

tion would need to more than double in future,

which seems highly improbable. To get a sense of

the impact on potential growth, we estimate that

without immigration, Germanys potentialgrowth rate would fall to below 0.5% by 2050

compared to the 0.9% with net immigration of

around 200,000 people.


Fig. 3.6: Germanys growth potential

Source: UN, Penn World Table 6.1, Groningen University, UBS WMR

Estimated growth potential and contributions, in %

1

0

1

2

3

4

1990 2000 2010 2020 2030 2040 2050

Population

Participation (aging)

Hours

Capital

TFP

GDP

GDP per capita

Labor productivity (GDP/hours)

Fig. 3.7: Potential growth rates for G7 countries


Estimated growth potential, in %

0.5

0

1.0

1.52.0

3.0

2.5

3.5

4.0

1980 1990 2000 2010 2020 2030 2040 2050

Germany

US

Japan

UK

France Canada

Italy

Fig. 3.8: Projected potential growth rates for G7 countries


Average growth rates of total potential GDP, in %

0.5

0.0

1.0

1.5

2.0

2.5

Japan Italy Germany France UK US Canada

20112020 20212040 20412050


22/36


Raising the labor market participation rate

An eective and potentially quick way of counter-

acting the deteriorating demographics would be to

boost the labor market participation rate and to

extend the eective working hours of those who

are employed.2 The participation rate measures the

actual labor force (employed plus registered unem-

ployed persons) as a share of the potential labor

force (everyone between ages 16 and 64). How-

ever, Germany already has one of the highest labor

market participation rates in Europe, surpassedonly by the Netherlands, Denmark and Sweden.

The same is true for Germanys female labor mar-

ket participation rate, which at 70.2% in 2008

stood above the EU average of 63.4%, and the

young age participation rate (15 to 24), which at

51.5% in 2008 was lower, for example, than in

Austria (61.5%) and the Netherlands (72.7%), but

still higher than the EU average at 44.6%. In short,

there is some scope to raise labor market

participation rates in Germany, but it appears to be

more limited than in most other countries.

2 One way to increase labor input would be to reduce struc-tural unemployment. However, it is important to note thatthis would not increase the growth potential, which isbased on the potential labor force (including both the em-ployed and the unemployed), but can only exert an eecton actual economic growth. Raising the participation ratemeans integrating the part of the working age populationinto the labor force that has so far not been available to thelabor market.

Chapter 3

Fig. 3.9: Projected GDP per capita growth rates


Average GDP per capita growth rates, in %

0.2

0.0

0.4

0.6

0.8

1.6

1.4

1.2

1.0

Japan US Italy Germany UK France Canada

20112020 20212040 20412050

Fig. 3.10: Germany has a low fertility rate

Source: EU Commission (The 2009 Ageing Report), UBS WMR

Number of births per woman

0.0

0.5

0.5

1.0

1.5

2.0

2.5

Germany Italy Spain EU Netherlands UK France

2008 20082060

Note: 20082060 projection by the EU Commission.

Natural population change (live births minus deaths),by regions, average 200307

per 1,000 inhabitants

< = 6.0

6.0


23/36



One obvious approach to the aging problem

would be to raise the minimum age for claiming a

pension in line with the increase in life expect-

ancy3. However, in comparison to other major

European countries, Germans already appear to

retire rather late, as can be inferred from the rela-

tively high labor market participation rate of per-

sons aged 55 to 64, which stood at 60.3% in

2008 compared to only 48.9% for the average of

the 27 European Union countries (see also Table 1).

While this is in principle a favorable comparisonfor Germany, the potential for further improve-

ments here as well appears to be more limited

compared to the rest of the EU. We have simu-

lated two dierent scenarios in order to estimate

the eect of higher retirement ages on German

productivity. In our rst scenario, we estimate that

making the retirement age two years higher by

2020 would li the potential growth rate only

marginally, to 1% on average by 2050. In our

other scenario, making the pension age ve years

higher by 2050 would yield an average potential

growth rate of 1.1%. Thus the overall impact

would be quite small, with the eect being felt

more strongly until about 2035. Aer that, the

labor force would shrink more rapidly, as the baby

boomers nally leave the labor force.

Germans work short hours

The factor labor can also be increased by means of

longer working hours. Here, it would appear that

Germany has the most scope for adjustment. Ger-

many and the Netherlands have the shortest work-

ing hours in the developed world. Weighing in at

just over 1,300 hours, Germans annual working

time falls nearly 470 hours short of the US and 160hours below their French neighbors. Given that

weekly hours in Germany are in line with the Euro-

pean average (but some two to three hours below

the US and the UK), this annual discrepancy is

largely attributable to more paid holidays and more

part-time employment in Germany. Indeed, so-

called atypical employment, including part-time

employment and small scale self-employment, has

risen rapidly over the past decade.

If average annual hours in Germany could be in-

creased by around 200 placing them roughly in

line with the European Union average, this would

3 Germany is planning to raise the pension age gradually to67 years

Table 1: German pension age is close to OECD average

Average eective age of retirement versus the ofcial age, 20022007

Men Women

Effective Ofcial Effective Ofcial

Iceland 68.9 67 Portugal 65.5 65

Portugal 66.6 65 Iceland 65.3 67

New Zealand 66.5 65 Ireland 64.9 65

Sweden 65.7 65 Turkey 64.3 58

Ireland 65.6 65 Switzerland 64.1 64

Switzerland 65.2 65 United States 63.9 65.8

United States64.6 65.8

New Zealand63.9 65

Australia 64.4 65 Norway 63.2 67

Norway 64.2 67 Spain 63.1 65

Turkey 63.5 60 Sweden 62.9 65

Denmark 63.5 65 Australia 62.2 63

Canada 63.3 65 United Kingdom 61.9 60

Uni ted Kingdom 63.2 65 Canada 61.9 65

Greece 62.4 58 Netherlands 61.3 65

Czech Republic 62.2 62 Denmark 61.3 65

Germany 62.1 65 Finland 61.0 65

Netherlands 61.6 65 Germany 61.0 65

Poland 61.4 65 Greece 60.9 58

Spain 61.4 65 Italy 60.8 57

Italy 60.8 57 Luxembourg 60.365

Finland 60.2 65 France 59.5 60

Hungary 59.7 62 Czech Republic 58.5 59

Belgium 59.6 60 Belgium 58.3 60

Slovak Republic 59.3 62 Hungary 58.2 60

Luxembourg 59.2 65 Austria 57.9 60

Austria 58.9 65 Poland 57.7 60

France 58.7 60 Slovak Republic 54.5 62

OECD average 62.7 63.7 OECD average 61.4 62.8


li the potential growth rate to around 1.4% by 2050 com-

pared to 1.1% with unchanged hours. The average potentialgrowth rate would rise from 0.9% to 1.2%, still below our

expectations for the G7 countries as a whole. To match the

expected G7 average growth potential of 1.6% over the period

Germany would need to return to the 2000 annual working

hours seen in the late 1960s.

Capital stock and efciency

A decline in the supply of labor can, in principle, be compen-

sated by increased capital accumulation, that is, higher capital

input. Yet, as an input factor in total production, labor carries

much more weight than capital, meaning that a drop in the

input of labor has to be compensated by a much stronger risein the capital stock. To achieve this, measures may be taken to

attract capital investments from abroad, which would also con-

tribute to a reduction of the external imbalances, for example,

the persistent current account surplus discussed in Chapter 2.


24/36


25/36


Education is the key

In an increasingly knowledge-driven global econ-

omy, human capital is a major factor for a coun-

trys competitiveness, especially in terms of inno-

vation. The latest OECD report on education gives

cause for some concern. Thus, according to the

OECD the number of students taking up univer-

sity-level education in Germany is still well below

the OECD average and especially well below that

of Germanys main peers (see Map 2). Also, on

the funding side, the OECD gures show that Ger-many spends below OECD average on education

(see Fig. 3.13). Finally, regarding the quality of

education, the OECDs PISA study for 2006 shows

mostly only average results for Germany, despite

some improvement on earlier assessments.

Interestingly, the PISA report shows that students

that were born abroad (rst-generation immi-

grants) scored much worse than their German

peers. The dierence in academic attainment was

about twice as big as the OECD average. Impor-

tantly, the performance dierence remained the

same for second-generation immigrants, which

may reect difculties with the integration of

immigrants in Germany.

This relates to a further problem of education in

Germany: the unfavorable skill-mix between emi-

grants and immigrants and the emerging brain

drain. Thus, while Germany is an important

source of highly skilled migrants to countries such

as the United States and Switzerland, it does not

attract a sufciently high number of comparable

foreign workers. The proportion of highly edu-

cated migrants is lower in Germany than in many

other OECD countries.

This unfavorable skill mix is partly related to the

strong recruitment of low-skilled labor in the

postwar economic boom, which triggered addi-

tional low-skilled immigration in later decades

through family connections. These problems

would need to be addressed via a comprehen-

sive immigration policy that allows the country

to attract more highly skilled workers from

abroad.

ConclusionsGermanys strong cyclical growth before and aer

the global recession has diverted attention from

its weak average growth performance this dec-


Educational attainment level by regions, 2007

Percentage of the population aged 2564 having tertiary education

< = 12.5

12.5


26/36



As we have shown in the previous chapters,

the structure of the German economy brings

with it certain advantages and threats. These

structural characteristics also have implica-

tions for investments in German equities and

bonds.

The cyclical story in the stock market and

beyond

The German stock market rebounded sharply

alongside the global economic recovery, initially onimproving business sentiment (see Fig. 4.1) and

later, with muted momentum, based on real eco-

nomic data. As discussed in previous chapters,

exports are traditionally an important driver of the

German economy. In fact, there has been a good

correlation between exports and DAX and MDAX1

movements since 2003 with the exception of the

2008 nancial crisis.

Taking a regional share index and breaking it

down into its sector components gives a general

picture of how cyclical the index is, and hence

how it is likely to perform during dierent phases

of the economic cycle. The German equity market

exhibits a higher weighting in cyclical sectors than

the Eurozone does overall (see Fig. 4.2), making it

a beneciary of supportive macroeconomic data.

The Industrials, Consumer Discretionary (primarily

1 The DAX is a blue chip stock market index of 30 majorGerman companies. The MDAX (mid-cap DAX) included 50Prime Standard shares from sectors excluding technologythat rank below the companies included in the DAX.

Chapter 4

automobiles), and Materials sectors account for

roughly 45% of the German market, compared

with only 32% of the Eurozone market. The cycli-

cal nature can also be seen by the higher volatility

of the German stock market compared to the US

market on average.

Moreover, the relatively weaker euro should sup-

port foreign demand for German products. It also

boosts exports to the emerging markets, which

make up an increasing share of German exports

and bring the added benet of strong growth po-

tential. Even if the euro were to strengthen, we

think German companies should still be competi-

tive at higher exchange rate levels, as we have

seen in Chapter 1.

2009200820072006200520042003200220012000 2010

80

75

85

90

95

100

110

105

3,000

2,000

4,000

5,000

6,000

7,000

9,000

8,000

Fig. 4.1: German stocks are correlated with business climate

Source: Bloomberg, UBS WMR

Ifo Business Climate Index (lhs) vs. DAX (rhs)

Ifo Business Climate DAX IndexM

aterials

Hea

lth

care

Consumer

Dis

cre

tionary

Ind

us

trials

Info

rma

tion

Tec

hno

logy

Uti

lities

Te

lecomm.

Serv

ices

Consumer

Stap

les

Fin

anc

ials

Energy

4.0

6.0

8.0

2.0

0.0

2.0

4.0

8.0

6.0

Fig. 4.2: More cyclical than the Eurozone

Source: Factset, UBS WMR

Sector differential MSCI Germany vs. MSCI EMU, in %


27/36


In addition to these cyclical factors, Germany is

currently beneting from good consumer senti-

ment. This should fuel domestic consumption,

which could also be supportive for the stock mar-

ket even if export momentum fades.

An Ifo at peak levels must not translate into

weak equity markets

In order to nd out how the German stock mar-

ket is geared to the economic cycle, we investi-

gated the degree of correlation between theMSCI Germany2 and one of the most important

domestic economic indicators, the Ifo Business

Climate Index. This monthly survey of diverse

industry representatives gives a good overview of

the current state of the economy as well as busi-

ness prospects for the next six months.

According to the September data, both expecta-

tions and the assessment of the current situation

remain at multi-year highs, which means that the

German economy continues to be in the boom

territory according to the Ifo business cycle clock

(see Fig. 4.3). Given the high levels, a sideways

movement or even a regression becomes more

likely, as economic growth momentum seems to

be slowing already. Our base case scenario sees

the economy turning to a more moderate growth

path, hence we think the Ifo index is unlikely to

backslide severely.

What would this scenario mean for the perform-

ance of the German stock market? We looked to

historical precedent for an indication. Although

we do not expect the past to repeat itself, there

are episodes that bear more than a passing re-semblance to the current situation. Looking at

patterns since 1990, we found that when the Ifo

index ranged between 100 and 110, the MSCI

Germany was likely to follow one of two trajecto-

ries:

If the Ifo trended sideways, which it has

started to do with its September release, in

two-thirds of all observations the stock market

showed a positive performance in the follow-

ing three months (with an average of +3.2%

over the period). Results were even slightly

2 The MSCI Germany is a broad equity index including50 companies.

better in the following six months, with almost

80% of observations showing an average per-

formance of 6.1%.

But what if the Ifo Business Climate Index

started to trend downwards from high levels?

In the 31 cases since 1990 where the Ifo fell

while in the range of 100 to 110, the three

months stock market performance aer the

release turned out to be slightly positive. How-

ever, aer six month the average performancewas negative.

Put simply, a lowering Ifo index could indicate

slowing growth, but this will not necessarily trans-

late into poor performance for the MSCI Ger-

many index. In fact, the German stock market has

historically performed well as long as the indica-

tor remained in boom territory.

Keep an eye on medium-sized companies

Having shown that Germany is currently the

growth engine of Europe, and why we believe that

economic growth will remain robust over the com-

ing years, we expect the large-cap DAX index to

perform quite well. The mid-cap MDAX also pro-

vides interesting opportunities. We would advise

long-term investors with a higher risk tolerance to

put some money in the mid cap segment of the

equity market.


11010510095908580 115

upswing boom

recession downturn

80

70

75

85

90

95

100

110

105Sept. 2010

Fig. 4.3: The Ifo business cycle clock

Source: Ifo Konjunkturtest, UBS WMR

Ifo current assessment and Ifo expectations over the last 24 months

Ifo

expectations

subindex

Ifo current assessment subindex


28/36


Medium-sized rms benet from emerging

markets demand

The MDAX index tracks the mid-cap segment and

comprises 50 companies. On average, the compa-

nies in this index generate about a third of their

revenues in Germany (see Fig. 4.4). Our expecta-

tions for a more robust domestic economy, as

discussed in Chapter 1, should support the earn-

ings growth of German companies, and their

stock prices.

However, the future of global economic growth

lies with emerging markets. These countries face

less sovereign debt problems and therefore less

scal tightening, and they have healthier banking

systems and more favorable demographics. In

terms of revenue, investors in medium-sized com-

panies achieve a slightly higher exposure to de-

mand from emerging markets especially devel-

oping Asia than they would with an investment

in the DAX. Investments in this market segment

are thus more geared to strong economic mo-

mentum than in the large caps.

Financials share is low among mid caps

This feature also reect the sector composition of

the equity market segments. The MDAX is heavily

geared to Industrials and has a much lower

weight in Financials than the DAX (see Fig. 4.5).

We believe that there is still a lot of pent-up de-

mand for capital goods aer the nancial crisis.

Accordingly, we see especial ly smaller sized com-

panies as the beneciaries of a multi-year capital

spending cycle. With all the regulation like Basel

III imposed on the banking sector and sovereign

debt issues still lingering, direct exposure to thesefactors can be reduced by choosing an invest-

ment in the MDAX.

Cyclical mid caps even benet from slow

growth

Medium-sized companies show a higher sensitiv-

ity to the economic cycle. Accordingly, although

they suer more than large caps in downturns,

they usually perform particularly well in an up-

swing. When leading indicators lose momentum

but growth remains robust, mid caps can still

perform relatively well, as seen between 2003and 2006. In our view, medium-sized companies

oer attractive opportunities for long-term inves-

tors who can bear temporary setbacks caused by

volatile economic data. The dierence between

Chapter 4

Fig. 4.4: Sales distribution of MDAX companies by region

Source: Commerzbank, Thomson Reuters, UBS WMR

In %

US

EM Asia

RoW

Germany

Europe ex Germany32.9

30.7

14.5

13.3

8.2

Industria

ls

Consumer

Discretionary

Materia

ls

Energy

Consumer

Stap

les

Hea

lthCare

Information

Tec

hno

logy

Te

lecomm

.

Services

Financia

ls

Uti

lities

6.0

12.0

0.0

6.0

12.0

18.0

30.0

24.0

Fig. 4.5: Higher industrial share in MDAX

Source: Factset, UBS WMR

DAX vs. MDAX, in %


29/36


mid and large cap performance is likely to be-

come less pronounced when global economic

momentum slows and risk aversion rises, however

(see Fig. 4.6).

German interest rates at the most

depressed levels since Bismarck

The post-nancial crisis period will be remem-

bered for decades as a time of ultra-low interest

rates. This holds true not only for the ECBs policy

rate, but also for Bund yields. Ever since rateswere rst recorded in 1871, when the German

empire was founded and Bismarck was appointed

its Imperial Chancellor, yields on 10-year govern-

ment bonds have never been lower than they are

today (see Fig. 4.7). Even more relevant for the

economy, ination-adjusted real interest rates are

well below their 50-year average.

Aer the Lehman collapse in the midst of the

nancial crisis, 10-year interest rates fell to

around 3%. But now that the global economy

has found its way out of the woods and equity

markets have recovered, interest rates are down

another 100 bps, close to 2%. What is pushing

bond yields lower and bond prices up?

Three main factors are contributing to the current

low interest rate environment:

Consumer price ination remains at subdued

levels and will likely stay low in the coming

year. Hence, investors are demanding a low

premium for future ination. In addition, inves-

tors have accounted for slower trend growth

going forward. As discussed in Chapter 3, weagree with this growth outlook for the Ger-

man economy.

The ECBs ultra-loose monetary policy is keep-

ing a lid on interest rates.

Some of the Eurozones member states face

challenging times ahead. Investors started

questioning the sustainability of the peripheral

countries public debt late last year, and called

for higher risk premia. As a consequence, in-

vestors sought the relative safety of Germangovernment bonds, which explains the recent

decline in bond yields. While risk aversion on

bond markets was certainly high and has even

increased of late, it did not spill over to equity


2007200420011998199519921989 2010

40

35

30

45

50

55

60

70

Index in %

65

30

40

20

10

0

10

30

40

20

Fig. 4.6: Global economic expansion supports MDAX

Source: Thomson Reuters, UBS WMR`

US purchasing manager sentiment (ISM) index above 50 signals expansion;difference in yearly change of MDAX and DAX in percentage points

ISM Manufacturing MDAX relative to DAX

20001990198019701960195019401930192019101900189018801870 2010

4

2

0

6

8

12

10

Fig. 4.7: 10-year government bond yields at lowest levelsince Bismarck


In %

end of month yearly average

20082006200420022000 2010

0

2

4

6

8

1,000

3,000

5,000

7,000

9,000

Shaded area: periods of strong negative correlation between equity markets return and bond yields(measured by 180day rolling correlation)Source: Reuters EcoWin, UBS WMR

10-year Bund yields DAX-30

Fig. 4.8: Positive correlation between equities andbond yields has broken down since mid-2009

In % Index


30/36


markets. Bund yields and equities are currently

negatively correlated, meaning that one rises

as the other falls. This is a rather rare phenom-

enon. In the past, such a constellation has

typically been resolved by a sudden increase in

yields, rather than a drop in equity prices (see

Fig. 4.8).

While there are some factors in place which speak

for low interest rates, their current extreme levels

seem hard to justify given the positive near-to me-dium term outlook for the German economy. With

so factors like high risk aversion calling the shots,

the bond market is subject to changes in risk senti-

ment, which usually happen faster than changes in

fundamental factors. While we would not rule out

that German Bund yields fall even further, we see a

good chance for yields to nally pick up: not least

because the European Central Bank (ECB) is in our

view not likely to start raising the policy rate before

mid-2011, and, as we set out in Chapter 1, the

recovery in Germany is likely to continue. Long-

term interest rates usually react quite a bit in ad-

vance of the rst rate hike in a tightening cycle.

The implications for investors are manifold. Most

importantly, we think bond investors will face much

more challenging conditions in the future. The

bond bull market that has been in place for at least

the last 20 years seems close to an end. Given that

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