DBRS Morningstar Confirms Federal Republic of Germany at AAA, Stable Trend

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

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS Morningstar’s view that Germany’s credit fundamentals remain solid, despite the weak economic performance over the past year. After a lower-than-expected outturn in 2018, the German economy has slowed further in 2019, with forecasts pointing to growth of around 0.5% for the whole year. Growth, nevertheless, is expected to strengthen moderately in 2020. DBRS Morningstar also expects the German government to continue posting a healthy budget position and the government debt ratio to decline further, despite stimulative fiscal measures being implemented. In 2019, the government debt-to-GDP ratio is projected to fall below 60% for the first time since 2002.

Germany’s AAA rating is supported by its large, competitive and diverse economy, its sound public finances and strong and credible fiscal framework, and a robust external position, which provides ample buffers to absorb shocks. The country also faces some long-term challenges stemming from its underlying demographic trends and contingent liabilities. The projected decline in the working-age population poses challenges to Germany’s growth potential and the long-term sustainability of its public finances. Contingent liabilities, emanating from state-owned banks and higher fiscal burden sharing within the currency union, could weigh on public finances in the future.

RATING DRIVERS

Germany is strongly placed within the AAA category. DBRS Morningstar could change the trend to Negative 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 materialisation of substantial contingent liabilities could put negative pressure on the ratings.

RATING RATIONALE

Growth is Expected to Recover After A Slowdown but Demographic Challenges Lie Ahead

The performance of the German economy has weakened in 2019, but a gradual recovery is expected in 2020. In the first three quarters of the year, annual real GDP growth was 0.6%, compared with 1.5% in 2018. On the production side, the slowdown has been more pronounced in the industrial sector, with auto manufacturing posting the sharpest decline among main manufacturing sectors, in part reflecting the weakness in the global car market. The export-oriented German industry has been affected to a large extent by weak global trade and external uncertainties in 2019. German export growth has weakened significantly this year compared with 2018. Fixed investment has also slowed, while private consumption and government spending have strengthened moderately. Employment growth has slowed, but the unemployment rate remains very low, at 3.1% in September 2019, while labour shortages are pushing wages up. The outlook is for the German economy to grow by 1.0% to 1.2% in 2020, driven by domestic demand.

Downside risks to the economic outlook are mainly external. Germany’s industrial sector, well integrated into global value chains, could suffer from a further weakening in external demand or protectionist measures. In particular, potential US tariffs on imported cars and parts from the EU could have a substantial impact on German exports, as the US is Germany’s main export market. A no-deal Brexit and sharper slowdown in the Chinese economy are additional downside risks. Upside risks include the easing in global trade tensions and stronger growth elsewhere in Europe.

Germany’s large, competitive and diverse economy supports its resilience, while it also faces long-term challenges. The healthy position of households, firms and the public sector enable them to absorb shocks and support Germany’s long-term growth prospects. A key long-term challenge for the economy is the impact of a declining population on potential growth. The government estimates growth of potential output at 1.6%. One of the government’s objectives is to enhance the growth drivers of the German economy. To achieve its objective, the government will be increasing investment in digital and transport infrastructure, education and research over the next four years. Another long-term challenge for the economy could be the structural changes in the car industry as it shifts to the production of electric cars.

Public Finances Remain Sound and The Public Debt Ratio is Declining

Germany has a prudent fiscal policy. It has accumulated budgetary surpluses at the various levels of government (federation, states, local authorities, and social security funds) since 2014. In 2018, the general government recorded a higher-than-expected fiscal surplus of 1.9% of GDP. The structural surplus was 1.4%. Both the statutory debt brake rule, which sets a structural deficit limit of 0.35% of GDP, and the government’s commitment to a balanced federal budget (the “black zero” approach), which precludes issuing new debt, act as anchors for Germany’s strong fiscal performance.

Over the next four years, the government plans to use the fiscal space to continue increasing public investment and provide tax relief. In its coalition agreement, the government set a cumulative fiscal stimulus equivalent to 4% of 2018 GDP between 2019 and 2022. Expenditure measures account for most of the stimulus. As presented in the 2020 draft budget, discretionary measures will amount to 0.5% of GDP in 2020 after 0.6% in 2019, although capacity constraints in the construction and public works sector pose a challenge to the full execution of public investment projects. The budget includes the Climate Action Programme 2030, with an expansionary effect of around 0.1% of GDP per year.

While the fiscal surplus is set to decrease, DBRS Morningstar expects Germany will maintain a healthy budget position. Over the longer term, the main challenge to fiscal sustainability stems from the demographic dynamics reflecting the country’s declining working-age population. In response, the government has set up a ‘commission on intergenerational fairness’ to review the pension system, with the recommendations expected by March 2020.

The general government debt-to-GDP ratio fell to 61.9% of GDP in 2018 and remains on a downward trend. After peaking at 82.4% of GDP in 2010, the debt ratio has been steadily declining driven by primary surpluses, lower interest costs, economic growth and winding down of the resolution entities. According to the government’s 2020 draft budget, the public debt ratio will fall to 59.8% in 2019 and to 54.8% by 2022. Moreover, Germany enjoys a safe-haven status. For the past several years, the government has benefitted from very favourable financing conditions. This supports DBRS Morningstar’s assessment for the Debt and Liquidity building block.

Financial Stability Risks Have Risen but Macroprudential Measures Have Been Adopted

DBRS Morningstar views risks to financial stability as manageable. The Deutsche Bundesbank has identified as main financial stability risks the potential underestimation of credit risks and the overvaluation of assets, particularly real estate. Nationwide, house price increases seem to largely reflect rising household income, immigration, supply bottlenecks and supportive credit conditions. Price increases have been stronger in certain metropolitan areas. The Bundesbank’s estimates suggest that house prices in German cities could be overvalued by between 15% and 30%. However, there seems to be no evidence of a debt-driven property boom. Household debt remains low, debt servicing’s vulnerability to abrupt interest rate rises is limited as most mortgages are fixed rate, and homeownership is relatively low in Germany, mitigating macroeconomic and financial stability risks.

Credit standards have eased only marginally, but lending growth has picked up. To address the build-up of risks, German authorities have broadened their macroprudential toolkit to include borrower-based measures (limits on the loan-to-value ratio and amortisation requirements) in recent years. Moreover, in June 2019, the German Financial Supervisory Authority activated the domestic countercyclical capital buffer, lifting it to 0.25% of risk weighted assets from July 2019, to enhance the resilience of the financial system (for more information, see DBRS Morningstar commentary “Germany: Activation of Countercyclical Capital Buffer Indicates Rising Financial Risks, but Adds Macroprudential Flexibility”).
https://www.dbrs.com/research/347579/

German banks’ capital positions look resilient, but profitability is weak. Stress test results in 2018 and 2019 for the eight large banks confirm their resilience. Asset quality is good and provisioning needs is low. Non-performing loans were just 1.3% of total loans in Q2 2019. Furthermore, although politically challenging, ongoing restructuring efforts in the Landesbanken (state-owned banks) sector could strengthen efficiency and reduce risks in the banking system. On the other hand, net interest margin compression has put pressure on profitability, amid low interest rates and high cost-to-income ratios. While the overall German financial sector could benefit from a gradual increase in interest rates, both the banking and insurance sectors are vulnerable to a sharp rise in interest rates given their maturity mismatch.

Solid Institutions and Stable Political Environment Reassure Policy Continuity

Germany benefits from solid political institutions, lessening the risks associated with the more fragmented political landscape after the federal elections in 2017. Benefitting from some discontent associated with the large inflow of asylum seekers in 2015/2016, the anti-immigration Alternative for Germany gained seats in the Bundestag and regional parliaments in Germany. Nevertheless, parties in the centre of the political spectrum, including the Christian Democratic Union (CDU)/Christian Social Union in Bavaria (CSU) and the Social Democratic Party of Germany (SPD), the Greens, and the Liberals, continue to account for most of the seats. After months of negotiation talks, the CDU/CSU and SPD renewed the grand coalition government in March 2018, with Chancellor Angela Merkel remaining in office, since 2005.

Changes in parties’ leadership have added some degree of uncertainty to German politics. At the European elections and the regional vote in Bremen in May 2019 the SPD suffered significant losses, and in December it elected a new leadership critical of some policies of the coalition, raising concerns about the durability of the grand coalition. At the same time, following Chancellor Angela Merkel’s decision to step down as party leader of the CDU, Ms Annegret Kramp-Karrenbauer was elected as the new leader in December 2018. Despite some political uncertainty in the medium term, DBRS Morningstar expects broad economic policy continuity and continued support for European integration.

The External Sector is Expected to Remain One of The Strongest in Europe

The German external position remains very strong. A competitive industrial sector is to a large extent accountable for Germany’s sizeable goods trade surplus. Although some cyclical factors have contributed in recent years, structural factors – including German firms’ savings and an ageing population incentivising households’ savings – have driven large surpluses in the current account. Large and persistent current account surpluses, averaging 6.0% of GDP between 2002 and 2018, have enabled Germany to build up a strong net external asset position. Germany’s net international investment position stood at 62.0% of GDP at the end of 2018. This supports DBRS Morningstar’s assessment for the Balance of Payments building block.

Over the coming years, the current account surplus is set to decline only gradually. The government is forecasting the surplus to decrease from 7.5% of GDP in 2018 to below 7.0% in 2020. Solid domestic demand, bolstered by fiscal stimulus and rising disposable incomes, is expected to boost demand for imports. In contrast, export growth could prove weaker than previously expected under intensifying protectionist measures and a worse-than-expected Chinese slowdown.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments:
https://www.dbrs.com/research/354067/

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euro (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal 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 Germany’s Federal Ministry of Finance, German Finance Agency (Deutsche Finanzagentur), Deutsche Bundesbank (Bbk), Federal Statistical Office, European Banking Association, European Commission (EC), Statistical Office of the European Communities, European Central Bank, IMF, World Bank, UNDP, BIS, Haver Analytics. DBRS Morningstar 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 Morningstar had no access to relevant internal documents for the rated entity or a related third party.

DBRS Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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: Adriana Alvarado, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: June 16, 2011
Last Rating Date: June 7, 2019

DBRS Ratings Limited
20 Fenchurch Street, 31st Floor,
London EC3M 3BY United Kingdom
Registered and incorporated under the laws of England and Wales: Company No. 7139960

For more information on this credit or on this industry, visit www.dbrs.com.