DBRS Confirms Federal Republic of Germany at AAA, Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Federal Republic of Germany’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). All ratings have a Stable trend.

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS’s view that Germany will continue to steadily reduce its public-sector debt ratio and is well equipped to respond to potential challenges. After ending last year strongly, gross domestic product (GDP) growth started 2018 weaker than expected, mostly because of temporary factors. Although marginally decelerating in 2018, Germany’s economic dynamism will continue to benefit fiscal revenues and reinforce the ongoing reduction of the public debt-to-GDP ratio. The renewal of the grand coalition government between the Christian Democratic Union (CDU)/Christian Social Union in Bavaria (CSU) and Social Democratic Party of Germany (SPD) in March 2018 paves the way for policy continuity overall. The new fiscal plan includes some easing of fiscal policy for 2019-2022 but is still compatible with the Federal government’s commitment to avoid new borrowing during this period.

RATING DRIVERS

Germany is strongly placed within the AAA category. DBRS could change the trend to Negative from Stable if the country’s growth and fiscal prospects deteriorate severely enough to place the public debt-to-GDP ratio on a persistent upward trajectory. Moreover, a material crystallisation of contingent liabilities could exert negative pressure on the ratings.

RATING RATIONALE

Public Finances Healthy and Steadily Strengthening

Germany’s general government fiscal position has steadily improved since 2010, accumulating budgetary surpluses at the three tiers of government over the last few years. The public sector has undergone a sizeable consolidation process. Between 2010 and 2017, government revenue as share of GDP increased by 2.2 percentage points whereas expenditures dropped by 3.2 percentage points. In 2017, the general government recorded a headline surplus of 1.1% of GDP and a structural surplus of 1.3%. The impetus of the economy, coupled with the tax bracket creep effect, have bolstered government revenues.

DBRS expects the new budget for 2018 and the fiscal plan for 2019-2022 to be approved in July, replacing the interim budget currently in place. The new fiscal plan envisages the use of the available financial leeway in the key areas identified by the coalition agreement, including: spending on social issues, tax relief, physical and digital infrastructure, defence, and security. The implementation of the coalition agreement, coupled with other quantifiable measures included in the fiscal plan, is expected to reduce the general government surplus by a cumulative 2.8% of GDP between 2019 and 2022. Even accounting for this more expansionary fiscal policy, DBRS expects Germany to continue to record fiscal surpluses and to avoid new borrowing between 2018 and 2022. In the medium term, the main challenge to fiscal sustainability stems from the demographic dynamics that the country faces 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 sizeable primary surpluses, lower interest costs, solid economic growth performance and ongoing winding down of the resolution entities. In 2017, the debt ratio dropped 4.2 percentage points to 64.1% of GDP benefitting from a dynamic economic backdrop. For the first time since 2002, the public debt as a share of GDP may fall below the 60% mark by 2019, and decline to 52% by 2022. This will provide valuable room for manoeuvre in the future against less favourable monetary or capital market conditions, a cyclical slowdown, or to face demographic challenges. Moreover, Germany’s safe-haven status enhances the government’s capacity to obtain financing, particularly during turbulent times. The government benefits from extremely favourable financing conditions, with a significant share of its debt with negative yields.

Germany Continues to Power Ahead and Enters Late Economic Cycle; Demographic Challenges Lie Ahead

After eight years of uninterrupted growth, GDP is expected to remain above potential in the next couple of years. DBRS projects domestic demand to continue to be the primary driver of growth, although gradually decelerating. This year, the German economy is expected to expand by 2.3%. A host of transitory factors, including a colder winter, flu outbreak and industrial strikes, have largely explained the deceleration in the first quarter, but underlying growth drivers remain in place. A buoyant labour market, growing disposable income, moderate inflation, favourable financing conditions, solid external demand, and anticipated fiscal relaxation will support aggregate demand. The unemployment rate was 3.4% in April, with some evidence of labour shortages, and with a high capacity utilisation. This has led to higher negotiated wages in 2018. Overall, inflationary pressures are slowly surfacing. Despite some weakening in business confidence indicators, considerable production backlogs in construction and manufacturing should support activity through the remainder of the year.

DBRS expects GDP annual average growth of 1.7% between 2018 and 2023, although external risks appear tilted to the downside. The export-oriented German economy could come under pressure under a less supportive external backdrop. An escalation of protectionist measures could severely dampen dynamism. US steel and aluminium tariffs have a limited impact on German exports, given the small exposure to these products, but this increases the risk of escalation of measures. The risk of the United States implementing tariffs on automobile imports could have a direct impact on German exporters. The US is Germany’s third-largest trading partner and the major export market, especially of German motor vehicles. A reassessment of sovereign risk in the euro area could raise uncertainty and have a severe impact on confidence and activity. In addition, a cliff-edge Brexit, sustained energy price increases, a slowdown in emerging markets or geopolitical tensions also represent downside risks to the positive outlook. Over the long-term, the key challenge will be to manage the impact of a shrinking population on potential growth.

Risks from the Housing Market Are Contained and Banks are Resilient Despite Low Profitability

Despite some signs of overheating in the residential housing markets of certain metropolitan areas, DBRS sees no financial stability risk to the overall system. According to the Bundesbank’s latest calculation, housing is overvalued on average by up to 30% in the seven largest German cities. However, nationwide increases in housing prices since 2010 seem to largely reflect fundamental factors, such as increasing household income, immigration, supply bottlenecks and supportive credit conditions. Furthermore, credit standards remain high and lending growth moderate. There is no evidence of a debt-fuelled property boom. Private sector leverage remains low, and debt servicing for mortgages is generally insensitive to abrupt interest rate changes. German authorities have made some progress in broadening their macroprudential toolkit. Starting from 2017, the Federal Financial Supervisory Authority (BaFin) can impose loan-to-value and amortisation requirements for residential mortgage loans. However, there is scope for more measures to reduce the risks emanating from the real estate market.

Banking sector profitability remains low, constrained by structural factors and the low interest rate environment. Given the high reliance of German banks, especially small retail banks, on net interest income, net interest margin compression has increasingly put pressure on profitability. Offsetting this, the favourable macroeconomic environment has translated into lower provisioning needs. Similarly, non-performing loans as a share of total loans have steadily declined to 1.7% in 2016 from 3.3% in 2009. German banks’ regulatory capital ratio has increased and stood at 19.4% at end-2017. On the other hand, leverage ratios for certain large private banks and the overall cost-to-income ratio remain high. The three-pillar model of the German banking system is not conducive for wider-reaching restructuring efforts in the banking and insurance sectors, which may be needed to restore profitability and improve resilience to shocks.

The External Sector Will Continue to be Extremely Strong due to Demographics and Competitiveness

The German external position and performance continues to be very strong. Large and persistent current account surpluses - averaging 5.9% of GDP between 2002 and 2017 - have enabled Germany to build up a strong net external asset position. The current account surplus stood at 8.1% of GDP in 2017, reflecting a very competitive economy as well as positive net savings by households, non-financial corporations, and the general government. Although temporary and cyclical factors have played a role, a range of structural long-term factors including the prospect of an ageing population incentivising households’ savings and German firms’ competitiveness have driven the large surpluses. Therefore, DBRS expects the sizeable current account surplus to decline only gradually over time, as households age and relatively higher inflationary pressures reduce the competitiveness gap with its European peers. Germany’s net international investment position stood at 59.1% of GDP at end-2017.

Another Grand Coalition Paves the Way for Policy Continuity

Germany benefits from strong political institutions and the rule of law. The federal elections in September 2017 resulted in a more fragmented political landscape and a weaker performance of CDU/CSU and SPD. In contrast, the anti-immigration Alternative for Germany (AfD) entered the Bundestag for the first time, becoming the biggest opposition party in parliament with 92 seats out of 709. After a period of political stalemate, the CDU/CSU and SPD reached an agreement to form another grand coalition government. This will guarantee policy continuity overall during this political term. DBRS expects this government to ease fiscal policy relative to the no-policy change scenario and support incremental changes to strengthen the eurozone framework. These changes could strengthen fiscal supervision and foster structural reforms potentially through the creation of the so-called “European Monetary Fund”. The government could also favour an “investment budget” for the eurozone.

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 the economic outlook and its associated risks, fiscal and public debt developments, the overall state of the German banking system, and political developments.

KEY INDICATORS

Fiscal Balance (% GDP): 1.1 (2017); 1.3 (2018F); 0.8 (2019F)
Gross Debt (% GDP): 64.1 (2017); 61.0 (2018F); 58.3 (2019F)
Nominal GDP (EUR billions): 3,263.4 (2017); 3,395.4 (2018F); 3,528.9 (2019F)
GDP per Capita (EUR): 39,453.9 (2017); 40,932.4 (2018F); 42,455.8 (2019F)
Real GDP growth (%): 2.5 (2017); 2.3 (2018F); 2.1 (2019F)
Consumer Price Inflation (%): 1.7 (2017); 1.6 (2018F); 1.7 (2019F)
Domestic Credit (% GDP): 139.7 (2016); 140.1 (2017)
Current Account (% GDP): 8.1 (2017); 8.2 (2018F); 8.2 (2019F)
International Investment Position (% GDP): 54.2 (2016); 59.1 (2017)
Gross External Debt (% GDP): 148 (2016); 140.5 (2017)
Governance Indicator (percentile rank): 94.2 (2016)
Human Development Index: 0.93 (2015)

Notes:
All figures are in euros 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.

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, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 16 June 2011
Last Rating Date: 15 December 2017

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