CORPORATE GERMANY NEEDS HELP

Divergences are now rife within the German government over the appropriate policy response to the economic downturn. While Chancellor Merkel has refused so far to embark into a genuine, powerful fiscal stimulus package, economy minister Glos is now publicly calling for immediate tax cuts.

Today's dismal data for industrial output in October, which points to a deep decline in GDP in 4Q, will strengthen Glos' position. Merkel has scheduled a "German economy summit" for December 14, but also said that no new stimulus programs would be decided at this meeting. Still, timeliness is now of the essence. So far, the labour market has been remarkably resilient in Germany, which probably helped to keep pressure for fiscal action low in public opinion.

However, given the speed at which economic activity is turning down, this will not last much longer. Germany will not be in a position to escape an increase in unemployment. The ongoing monetary relaxation will not have any meaningful impact on the real economy before the very end of 2009, in our view. An immediate fiscal stimulus could help limit the slump in the next quarters. However, we feel that fiscal action should target the corporate sector, in order to support the labour market, rather than stimulating consumption, which may well be counterproductive if German households raise their savings ratio.

The 2.1% mom decline in German industrial output in October was slightly worse than expected  (the market consensus was at -1.9%). This was the second consecutive monthly decline after the -3.3% contraction in September (revised up from an initial reading at -3.6%). German industry is increasingly struggling in a context of falling global demand, reflected, for instance, by the sharp fall in factory orders revealed last week (-14.4% in cumulative terms in September and October). The fall in output was the sharpest in the capital goods industry (-3.1% mom both in September and October) and durable goods (-2.3% in October after -6.2% in September). The details of the factory orders for September and October revealed that dwindling foreign demand rather than weak domestic demand was the main drag on the German industry. Industrial Germany is hit both by the downturn in the global investment cycle and by the extreme reluctance of households everywhere to commit to big-ticket purchases in a context of heightened uncertainty over their employment prospects.

German industrial output in October stood 3.2% below the 3rd quarter average. This is a very bad start for the fourth quarter. Moreover, output in December will probably be very weak, judging by the number of prominent manufacturing companies announcing extended Christmas breaks in production. All this creates a very significant downward risk to our already comparatively low forecast of a 0.5% qoq decline in GDP in 4Q, after a previous 0.5% fall in 3Q.

To support the economy, minister Glos called for “a tax cut for average earners”. However, targeting directly the consumers could have some counterproductive effects. The decline in energy costs is anyway already boosting households’ purchasing power. What is at stake now is the utilization of this income. Stimulating consumption may prove ineffective if households react by raising their savings ratio on the back of deteriorated employment prospects. The households savings ratio stood at 11.4% in 3Q 2008 in Germany, against 10.7% a year before, the highest level since 1994.

We think it would be preferable to help the corporate sector. Given the persisting difficulties on the credit market, the monetary easing will only gradually make its way to businesses. Besides, the sharp increase in yields on corporate bonds (+300 bps in 6 months for average risk) contribute to funding difficulties. Businesses are less leveraged in Germany than in France or Italy, but the German corporate debt is now standing at 95% of GDP against 70% at the time of the previous recession, in 1992-1993.

Tweaking the headline corporate tax would not be very efficient, in our view, since this tax is usually paid only on the profitable companies. It would not help the already struggling businesses. A more efficient solution would consist in granting a corporate tax holiday on past profits. Some companies may be paying now taxes levied on large past profits while their current cash receipts are shrinking dramatically. Deferring these payments would bring some relief to the business sector. A large holiday on payroll taxes and some permanent cut in these social contributions would also be efficient. It would reduce costs and would help maintain labour demand. Reducing labour costs, by limiting the unavoidable correction in employment, would reduce the risks of a spectacular rise in precautionary savings.