DBRS Confirms Federal Republic of Germany at AAA, Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the Federal Republic of Germany’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA and its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

The Stable trend reflects DBRS’s view that the German economy will maintain its robust pace of growth, supporting public finances and reinforcing the ongoing reduction in public sector debt. Domestic demand continues to be the key growth driver, though firmer external demand largely explains the stronger-than expected-growth this year. Although the political situation remains fluid, DBRS views the absence of immediate challenges to the sovereign as limiting the associated risks.

Germany’s AAA rating is underpinned by its large, competitive and diverse economy, enhancing its resiliency to shocks. The country’s sound public finances, harnessed by its strong and credible fiscal framework, buttress the sovereign’s creditworthiness. Germany’s robust international position provides ample buffers to absorb external shocks and a stream of positive income flow for the economy.

In spite of these strengths, the country faces challenges stemming from its underlying demographic trends and contingent liabilities. The projected decline in the working-age population over the medium- to long-term poses significant challenges to Germany’s growth potential and to the sustainability of its public finances. In addition, a potential government recapitalisation or worse-than-expected performance of the resolution entities set up during the global financial crisis could affect the sovereign. Furthermore, greater fiscal burden sharing within the currency union could pressure public finances. DBRS views, however, that Germany is well positioned, both institutionally and fiscally, to absorb the potential crystallisation of liabilities currently outside the government balance sheet.

Following September’s federal elections, political parties have not been able to form a new government so far, leaving the “grand coalition” - i.e., the Christian Democratic Union (CDU)/Christian Social Union in Bavaria (CSU) and Social Democratic Party of Germany (SPD) - as a caretaker government. The collapse of negotiations to form the so-called Jamaica coalition (CDU/CSU, Greens and Liberals) has narrowed the likely political outcomes to another grand coalition, a minority government, or early elections. Exploratory discussions between the CDU/CSU and the SPD are set to start soon. Some kind of agreement between these parties seems likely, clearing the way for the formation of a new government in Q1 2018. However, DBRS does not rule out the possibility of snap elections next year. While it is unclear whether new elections will produce materially different results from September, they could exert additional pressure on political parties to reach a compromise. On the other hand, a booming economy, sound public finances and shrinking public debt ratio limit the impact of political uncertainty on economic and fiscal variables. Likewise, Germany’s strong political institutions and rule of law support the ratings.

Fiscal outturns have benefited from the favourable macroeconomic environment in Germany. The impetus of the economy, coupled with the tax bracket creep effect, have bolstered government revenues. DBRS expects the general government budget surplus to reach 0.9% of gross domestic product (GDP) in 2017, the fourth-consecutive year of positive fiscal balances. The provisional Draft Budgetary Plan for 2018, which assumes a no-policy-change scenario, envisages surpluses between 0.5% and 0.8% of GDP between 2017 and 2021. The brighter economic outlook may render these projections as conservative, but DBRS believes the incoming government will most likely ease fiscal policy on the margins once in office. This could take the form of tax relief measures and greater spending in key areas including education, physical and digital infrastructure, security and social issues. However, DBRS does not expect a significant deviation from the baseline projections as a result of the main political parties’ commitment to prudent fiscal policy and the debt brake rule in place. From a medium-term perspective, the main challenge to fiscal sustainability stems from the demographic dynamics that the country is facing because of a shrinking and ageing population.

The general government debt-to-GDP ratio is on a clear downward trend. After peaking at 81% of GDP in 2010, the debt ratio has steadily fallen on the back of sound primary surpluses, lower interest bills, solid growth performance and ongoing winding down of the resolution entities. DBRS expects the debt ratio to drop to 64.8% of GDP in 2017 from 68.1% of GDP in 2016 as a result of budgetary surplus and strong nominal GDP growth. Going forward, the government projects that public debt will fall below the 60% of GDP mark by 2020, stemming from similar drivers. Germany’s safe-haven status enhances the government’s capacity to obtain financing, particularly during turbulent times. The government benefits from extremely beneficial financing conditions, with a significant part of its debt yielding on the negative territory. The interest expenditure to GDP ratio is projected to decline to 1.2% in 2017 from 2.5% in 2010.

Germany continues to show strong economic momentum. After seven years of healthy expansion, largely driven by domestic demand, the German economy virtually closed its output gap in 2016. In 2017, real GDP rose 2.3% (calendar adjusted: 2.8%) year-on-year in the third quarter and is on track to a full-year 2.2%. Moreover, GDP growth could average 2% between 2018 and 2019. A buoyant labour market, boosting disposable income, and moderate inflation support private consumption. The pick-up in world trade, and especially a firmer euro area recovery, bode well for the export sector. In turn, stronger external demand and higher capacity utilisation encourage investment in machinery and equipment. The favourable income and financing cost conditions and a buoyant real estate market support construction investment. However, capacity constraints and labour market bottlenecks, especially in the construction sector, could dampen the expansion and put additional pressure on wages. On the external front, a retreat from cross-border integration, a cliff-edge Brexit and potential emerging markets slowdown represent the biggest downside risks to the outlook along with geopolitical tensions.

Against this background of strong economic growth and extremely low interest rates, the housing market has experienced a sustained upward trend since 2010. Despite some signs of overheating in the residential housing markets of certain metropolitan areas, the nationwide increases broadly reflect fundamental factors, such as increasing household income, immigration, supply bottlenecks and supportive credit conditions. While credit to households and corporates has picked up, its growth remains moderate and credit standards remain high. Furthermore, private sector leverage remains relatively low, and debt servicing for mortgages is generally insensitive to abrupt changes in interest rates (relatively longer interest rate lock-in periods).

The German banking sector remains resilient. German credit institutions average Tier 1 capital-to-risk-weighted assets stood at 16.6% in Q2 2017. On the other hand, leverage ratios for certain large private banks are comparatively high. Profitability of the banking sector remains low, constrained by structural factors and the low interest rates environment. Given the high reliance of German banks on net interest income, especially small retail banks, net interest margin compression has increasingly pressured its profitability. Offsetting this, the favourable macroeconomic environment has translated into lower provisioning needs. Although the overall German financial sector would benefit from a gradual increase in interest rates, both the banking and insurance sectors are vulnerable to an abrupt hike in interest rates due to a maturity mismatch. Restructuring efforts in the banking and insurance sectors may be needed to restore profitability and improve resilience to shocks (interest rate risks and low level of risk provisioning).

The German external position and performance continues to be very strong. Large and persistent current account surpluses - averaging 5.7% of GDP between 2002 and 2016 - have enabled Germany to build up a strong net external asset position, enhancing its ability to weather negative external shocks. Germany’s net international investment position stood at 57.2% of GDP in Q2 2017. The ample current account surpluses largely respond to structural factors, such as demographics, firms’ participation in global value-chains and returns on foreign investments, and manufacturing sector specialisation (high tech industries). On top of this, temporary factors, such as a weaker euro and low oil prices, widened the surplus between 2014 and 2016. Over the longer term, DBRS expects the sizeable current account surplus to gradually decline as these temporary factors fade, strong domestic demand supports imports, tighter labour markets help reduce the price-competitiveness gap relative to its euro area peers through higher wages, and older cohorts spend more.

RATING DRIVERS
Germany is strongly placed within the AAA category. DBRS could change the trend to Negative from Stable in the event of a deterioration in growth and fiscal prospects severe enough to place the public debt-to-GDP ratio on a persistent upward trajectory. Moreover, a material crystallisation of contingent liabilities could exert pressure on the ratings.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA (high) range. The main points discussed during the rating committee include Germany’s economic performance, fiscal and debt metrics, demographics and migration, the banking sector, and the political environment.

KEY INDICATORS

Fiscal Balance (% GDP): 0.8 (2016); 0.9 (2017F); 1.0 (2018F)
Gross Debt (% GDP): 68.1 (2016); 64.8 (2017F); 61.2 (2018F)
Nominal GDP (EUR billions): 3,144.1 (2016); 3,258.6 (2017F); 3,390.1 (2018F)
GDP per capita (EUR): 38,114 (2016); 39,180 (2017F); 40,564 (2018F)
Real GDP growth (%): 1.9 (2016); 2.2 (2017F); 2.1 (2018F)
Harmonized Consumer Price Inflation (%): 0.4 (2016); 1.7 (2017F); 1.5 (2018F)
Domestic credit (% GDP): 105.9 (2016); 106.7 (Jun-2017)
Current Account (% GDP): 8.3 (2016); 8.0 (2017F); 7.6 (2018F)
International Investment Position (% GDP): 54.4 (2016); 57.2 (Jun-2017)
Gross External Debt (% GDP): 146.9 (2016); 146.3 (Jun-2017)
Governance Indicator (percentile rank): 93.4 (2016)
Human Development Index: 0.93 (2015)

Notes:

All figures are in Euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development. Key Indicators’ sources include: European Commission, European Central Bank, Federal Statistical Office, Deutsche Bundesbank, World Bank, Human Development Index (UNDP), and Haver.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.
The sources of information used for this rating include Ministry of Finance, German debt agency (Deutsche Finanzagentur), Deutsche Bundesbank, Federal Statistical Office, European Commission, Statistical Office of the European Communities, European Central Bank, International Monetary Fund, Organisation for Economic Co-operation and Development, World Bank, United Nations Development Programme, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Javier Rouillet, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer Global Financial Institutions Group and Sovereign Ratings
Initial Rating Date: 16 June 2011
Last Rating Date: 21 July 21 2017

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