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

DBRS Ratings GmbH (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 sharp economic shock from the global Coronavirus Disease (COVID-19) pandemic and the impact on its fiscal position. The German economy contracted by 5.8% year-on-year in the first three quarters of 2020, less severely than the euro area average, in part reflecting a relatively moderate prevalence of the virus and generous policy support measures. In response to the economic crisis, the government has used its fiscal space and the flexibility provided within its fiscal framework. The substantial support package will turn its fiscal surplus into a large deficit in 2020 and increase its public debt ratio significantly. Nevertheless, DBRS Morningstar expects government finances to return to a balanced position and the government debt ratio to resume its downward trajectory over the medium term.

Germany’s AAA ratings are 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. However, the country faces 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 the financial sector, large state guarantees, and fiscal burden sharing within the currency union, could eventually weigh on public finances.

RATING DRIVERS

Germany is strongly placed within the AAA category. DBRS Morningstar could downgrade the ratings 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

The German Economy is Recovering From The Coronavirus Pandemic

The German economy is set to contract sharply in 2020, before posting a partial recovery in 2021. Disruptions in external trade and global supply chains, together with containment measures imposed from mid-March until end-April to limit the spread of the virus, as well as partial renewed restrictions to contain a resurgence of cases since November, have affected economic activity. Nevertheless, compared to many European countries, Germany has managed to keep the virus somewhat contained, the associated mortality rate has been limited, and the fiscal response has been supportive. After contracting in the first half of the year, real GDP rebounded in the third quarter, with both the manufacturing and services sectors growing strongly. In its latest projections, the federal government is forecasting the economy to contract by 5.8% in 2020, before growing by 4.4% in 2021 largely driven by private consumption.

The growth outlook depends on the containment of the virus and deployment of a successful vaccine, the further recovery of export markets and global supply chains, and the effectiveness of economic policies. The federal government together with the German states put in place a test and contact tracing system that has proved largely functional, although there has been a second wave of cases. Germany’s industrial sector, well integrated into global and European value chains, could suffer from a renewed weakening in external demand. The government has adopted measures to support the recovery and has extended its short-time work scheme (Kurzarbeit), aimed at limiting job losses. The government is forecasting the harmonised unemployment rate to rise to just 3.7% in 2020 from 3.0% in 2019. While DBRS Morningstar expects the support measures to be effective, the near-term outlook is clouded by uncertainty.

Nevertheless, Germany’s large, competitive and diverse economy supports its resilience. Households, firms, and the public sector started the year in healthy financial positions. This has enabled them to absorb the shock and to 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 is increasing investment in digital and transport infrastructure, education, and research. Another long-term challenge for the economy is structural change in the car manufacturing industry as it transitions to the production of electric cars.

Germany Adopted One of The Largest Expansionary Fiscal Positions Among Advanced Economies

Germany’s prudent fiscal policy and financial flexibility allowed the federal government and the states (Länder) to adopt a comprehensive and substantial package of measures to respond to the economic crisis and to support the recovery. In addition to the Kurzarbeit scheme, discretionary measures and automatic stabilizers included tax relief, unemployment benefits, and liquidity assistance for small firms and the self-employed, among other measures, amounting to 13% of GDP. The government also adopted in March extensive loan guarantees, equivalent to 25% of GDP, through the state-owned development bank KfW and an Economic Stabilisation Fund for large-scale support for companies. In June, the government adopted an economic stimulus plan that included reductions in consumption taxes, further support for households, additional liquidity, as well as measures to support economic growth over the medium to longer term.

The fiscal surplus has turned into a deficit. The government has estimated the fiscal impact of all measures on the general government accounts at 4.7% of GDP in 2020 and 2.1% in 2021. To finance the spending and cover a shortfall in tax revenues in 2020, the Bundestag approved two supplementary federal budgets. Through an exception clause, it allowed the government to exceed temporarily the structural deficit limit of 0.35% of GDP (the statutory debt brake rule). This also ended the government’s commitment to a balanced federal budget – the “black zero” approach – that precluded issuing new debt. Thus, after posting surpluses at the various levels of government since 2014, the government is forecasting a deficit of 6.3% of GDP in 2020, as presented in its 2021 draft budget, lower than the one presented in the Stability Programme earlier in the year.

DBRS Morningstar expects Germany to return to a healthy budget position over the medium term. The government forecasts the deficit to fall below 3% of GDP by 2022, as the economy recovers and fiscal policy becomes less expansionary, aiming to comply with the debt brake by 2023. Over the longer term, a key challenge to fiscal sustainability stems from the demographic dynamics reflecting the country’s declining working-age population.

As a result of the new borrowing needs, the general government debt-to-GDP ratio is set to increase significantly in 2020. After falling below 60% in 2019, the government is forecasting the debt ratio to increase to 71%, still below the 2010 peak of 82.4% of GDP. Despite the sharp increase in debt, the government benefits from very favourable financing conditions. Germany continues to enjoy a safe-haven status. This supports DBRS Morningstar’s positive qualitative assessment of the “Debt and Liquidity” building block.

Financial Stability Risks Have Risen But Are Manageable

The Deutsche Bundesbank has recently identified as the main risks to financial stability, a potential sharp rise in corporate insolvencies resulting from the coronavirus crisis, the potential underestimation of credit risks and the overvaluation of assets, particularly real estate. While the crisis has been severe, the corporate sector is not expected to record substantial insolvencies, given their largely sound balance sheets and the government’s liquidity support measures. Nationwide, house price increases seem to largely reflect rising household income, immigration, supply bottlenecks and supportive credit conditions. There seems to be no evidence of a debt-driven property boom. Household debt remains low, debt servicing’s vulnerability to interest rate rises is limited as most mortgages are fixed rate, and homeownership is relatively low in Germany, mitigating macroeconomic and financial stability risks.

To address the build-up of risks, the German authorities have broadened their macroprudential toolkit to include borrower-based measures in recent years. The German Financial Supervisory Authority (BaFin) also activated the domestic countercyclical capital buffer in July 2019, lifting it to 0.25% of risk weighted assets, to enhance the resilience of the financial system. However, in March 2020, in response to the current economic crisis the ECB Supervisory Board provided temporary capital relief measures for euro area banks to increase their capacity to lend to the economy. Subsequently, BaFin reduced the countercyclical capital buffer to 0% effective from April 2020.

German banks entered the crisis with resilient capital positions and strong liquidity. Moreover, the majority of the Landesbanken have now been restructured, reducing risks in the banking system. However, profitability has been weak and the operating environment has deteriorated with the current crisis. Net interest margin compression has put pressure on profitability amid low interest rates, constraining the ability of German banks to absorb significant increases in credit costs. Moreover, a sharp rise in insolvencies could lead to high loans defaults and losses for banks. While asset quality is still good, the full impact from the pandemic has not yet materialised, and credit costs are likely to increase.

Solid Institutions and Stable Political Environment Reassure Policy Continuity

Germany benefits from strong political institutions, lessening the risks associated with its more fragmented political landscape. Although the Alternative for Germany gained seats in the Bundestag and regional parliaments for the first time in 2017, 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. The CDU/CSU and SPD renewed the grand coalition government in March 2018, with Chancellor Angela Merkel remaining in office, since 2005.

Changes in party leadership have added some degree of uncertainty to German politics. 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. But, after unrest within the party, Kramp-Karrenbauer stepped down as party leader in 2020. The CDU has yet to find a new successor to Ms Merkel. Ahead of the next national elections, currently planned for Autumn 2021, German politics could become less predictable than in the past. Despite some political uncertainty on the horizon, DBRS Morningstar expects broad economic policy continuity and continued support for European integration.

The German External Sector Remains 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 cyclical factors in recent years have contributed to higher external account savings, structural factors – including higher household and corporate savings rates – have driven large surpluses in the current account. The current account surplus is set to decline in 2020, as exports are expected to fall sharply reflecting weak external demand, while imports could be fall less steeply.

Persistent current account surpluses, averaging 6.0% of GDP between 2002 and 2019, have enabled Germany to build up a strong net external asset position. Germany’s net international investment position stood at 71.0% of GDP at the end of 2019. This supports DBRS Morningstar’s positive qualitative assessment of the “Balance of Payments” building block.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/370831.

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in 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 https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include Germany’s Federal Ministry of Finance (2021 Draft Budgetary Plan), Federal Ministry for Economic Affairs and Energy (Federal Government’s Interim Projection September 2020), the Federal Government (Measures by the Federal Government to contain the spread of the COVID-19 pandemic and address its impacts), German Finance Agency (Deutsche Finanzagentur), Deutsche Bundesbank (Monthly Report November 2020), Federal Statistical Office, Federal Financial Supervisory Authority (BaFin), ifo Institute, European Commission (2020 Autumn Forecasts), Statistical Office of the European Communities, European Central Bank (ECB), IMF (World Economic Outlook October 2020), IMF (International Financial Statistics),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.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

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 12-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.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/370829.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Jason Graffam, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Financial Institutions and Sovereign Ratings
Initial Rating Date: June 16, 2011
Last Rating Date: June 5, 2020

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