Germany now vulnerable as euro woes deepen

Posted on May 31, 2012

It’s no longer about the peripheral nations. It’s about Germany. Yet German risk is not reflected in record low Bund interest rates.

Germany is now vulnerable, having left it too late to amputate the infected parts of the eurozone. Irrespective of the course of events, Germany faces crippling costs.

    To date, the Germans have had a good European debt crisis. Favourable conversion exchange rates upon introduction of the euro, a dramatic fall in interest rates and the elimination of the risk of devaluation allowed banks to lend generously to weaker European countries. Debt-fuelled consumption and investment drove growth. German exporters were major beneficiaries of this growth.

    German exporters also benefited from a cheap euro, receiving a significant subsidy with the inclusion of weaker economies such as Italy, Spain, Portugal and Greece in the common currency. But the good times are ending.

    Germany’s strengths, especially its export fetish, are weaknesses. Exports are over 40 per cent of its gross domestic product, compared to less than 20 per cent in Japan and about 13 per cent in the US. Germany is heavily reliant on a narrowly based industrial sector, focused on investment goods. Germany’s service sector is weak. Germany’s fragmented banking system is fragile.

    German debt levels are high at around 81 per cent of GDP. The Bundesbank has stated that public debt levels will remain above 60 per cent for many years. German public finances are vulnerable to a rapidly ageing and shrinking population.

    But Germany’s greatest vulnerability is the financial exposure resulting from the crisis. Germany stands behind official institutions such as the European Central Bank. German guarantees supporting the European Financial Stability Facility, the eurozone’s rescue fund, are over €200bn.

    The largest single direct German exposure is the Bundesbank’s exposure under Target2 balances, which track cross-border payments to other central banks in the eurozone. Since the crisis commenced, this has met the funding needs of peripheral countries unable to access money markets to finance trade deficits and the capital flight out of their countries. Germany is by far the largest creditor in Target2 with total exposure exceeding €800bn, 30 per cent of German GDP.

    Some believe that the solution to the crisis is greater monetary and fiscal integration and mutualisation of debt through the issue of eurozone bonds backed jointly or severally by all member states. German liability for eurozone bonds would increase its exposure substantially. Germany’s Target2 balance would also continue to increase, at a rate of €80bn-€160bn per annum just to finance expected trade deficits in the rest of Europe.

    Alternatively, Europe may continue its current policy of partial solutions – austerity and monetary accommodation by the ECB. As they are unlikely to regain access to commercial funding in the near future, the debt of peripheral nations will shift to official institutions via bailouts, funding arrangements and the Target2 system, increasing Germany’s liability. A guarantee system or further funding of banks to combat capital flight from peripheral countries would further increase Germany’s commitment.

    If these options fail, then some European countries will need to restructure their debt and potentially leave the common currency. A Greek default alone would result in direct losses to Germany of around €90bn. Germany’s potential losses increase rapidly as more countries default or leave the eurozone.

    There are also real economy effects. Austerity or default will force many European economies into recession for a prolonged period. German exports will also be affected as Europe is around 60 per cent of its market.

    In the case of integration or partial solutions, the effects on Germany may be cushioned by the weakness of the euro, which will maintain export competitiveness. Defaults and a euro break-up may increase the value of the single currency, undermining German exports. Germany’s problems are likely to be compounded by a slowdown in emerging markets.

    Germany’s attempt to balance the benefits of the single currency and the advantages of preserving the eurozone against its traditional preference for fiscal and monetary conservatism has failed, leaving the nation with severe financial problems.

    German citizens will have to pay twice for the euro. In the early 2000s, they paid through internal devaluation – reductions in real wages, unemployment and labour market reforms. Now, they will have to pay for the bailouts. Once voters realise they were betrayed by Germany’s pro-European political elite, there will be an electoral revolt and, as in the rest of Europe, a strong challenge from radical political forces with unpredictable consequences.

    As Friedrich Nietzsche knew: “… hope is the worst of all evils, because it prolongs man’s torments.” Germany may not, as widely assumed, offer a safe haven in the European debt crisis.

    Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk

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