Focus on Economics
Around the world, government debt has grown dramatically in response to the coronavirus crisis. But how sustainable is the debt that has built up? This paper analyses the prospects for reducing government debt ratios using the examples of Germany and Italy. It focuses on longer-term developments from 2023, when both the recession and the immediate recovery phase will presumably have come to an end. On the basis of various scenarios, we demonstrate how crucial the relationship between interest rates and economic growth rates is for meeting the consolidation challenge. In the current environment of extremely low interest rates, Germany’s debt-to-GDP ratio could fall below the Maastricht threshold in the course of this decade already and even Italy could succeed in slowly reducing its debt ratio with only moderate budget surpluses. A structural increase in the interest-growth differential, on the other hand, would pose a great risk to Italy’s debt sustainability.
Continued high infection rates, the risk of more contagious virus mutations and the resulting extended restrictions will cause Germany’s economy to contract sharply in the first quarter of 2021. But with increasing progress in the rollout of vaccines and restrictions being eased first cautiously and then more broadly as the virus is successfully controlled and a third wave is avoided, a noticeable recovery will emerge in the spring and a growth spurt in the summer. Germany’s GDP is forecast to grow by 3.3% in 2021 and 3.4% in 2022. The pre-crisis level will be reached again in the fourth quarter of 2021. Driven by vigorous catch-up growth, GDP in the euro area is set to grow by 4.6% in 2021 and 4.0% in 2022. The euro area as a whole, however, will not return to the pre-crisis level yet in 2021.
In the summer months Germany and the euro area were able to offset a large part of the previous economic contraction. However, as a result of the renewed sharp rise in the number of new COVID-19 infections since the beginning of autumn and the restrictions that became necessary, the recovery will stop temporarily. A decline in economic output is to be expected for the winter half-year of 2020/2021. Based on the encouraging perspective that effective vaccines will soon be available, KfW Research forecasts that the return to public life and social activities will lead to a surge in growth from next spring. Germany is set to grow by 4.0% in 2021 and the euro area by as much as 5.1%, starting from a lower level.
The coronavirus pandemic has led to an economic slump of historic proportions in Germany and the euro area. The low point, however, was passed back in April. It was followed by a vigorous catch-up movement that translates into very high growth in the present quarter. However, headwinds are gathering strength.
KfW Research stands by its forecast that Germany’s gross domestic product will contract by around 6% this year, before growing again by 5% next year. Gross domestic product in the euro area is set to contract by around 8% overall in 2020. A severe second wave of infections remains the highest risk, although new restriction measures will likely end up being more targeted than in spring.
Focus von Economics
The European Central Bank (ECB) is currently reviewing its monetary policy strategy. The central element in this process is the inflation target - in an environment of significantly lower rates of inflation than at the time the current target of "below, but close to, 2%" was set. We consider it particularly sensible to make the target more flexible, which would also allow inflation rates below 2% to be tolerated. Such a more flexible target would be compatible with the fulfilment of the ECB's mandate, would take account of the current new reality of low inflation, would give the ECB greater room for manoeuvre and, in perspective, would also make it easier for it to exit from its unconventional measures.
The pandemic has hit Europe like a bolt of lightning. The recession is unprecedented in breadth and depth, with the German economy expected to contract by around 6% in 2020. However, in the absence of a second wave of infections, an initially strong and then faltering recovery should begin as early as the second half of the year, which will be reflected in a catch-up growth rate of 5% in 2021. Output will thus return to its pre-crisis level in autumn of 2021. Aggregate output loss will then be around EUR 300 billion.
In the euro area, the recession will likely be even deeper (2020: -7%; 2021: +6%), since the pandemic has hit the other large countries – France, Italy and Spain – particularly hard and the structural environment is unfavourable as well.
Economics in Brief
Trade conflicts, Brexit, sanctions, geopolitical confrontations and now the coronavirus outbreak: Difficult international conditions are putting constant pressure on global trade. This is not just afflicting Europe’s exporters but also causing a noticeable slowdown in economic activity in the euro area.
However, the weakness was not spread equally across all sales markets of European exports last year. Rather, the loss of momentum since 2017 has been mainly due to China and the dynamic Asian economies that are closely intertwined with that country. So in addition to the trade conflict, other factors such as the transition of the Chinese growth model, the accelerated expansion of e-mobility and the downswing in the global electronics cycle have probably also played a role in the region’s slowing demand for European goods.
From July to September, the euro area economy maintained the sluggish pace of growth of the previous quarter. This is no disappointment considering the decreasing sentiment indicators and temporary escalation of political risks. France and Spain in particular exhibited robust economic performance, while Italy and Germany – which is heavily affected by the industrial recession – expanded only marginally.
Some of the political headwind has also subsided of late. In particular, the hard Brexit which was still looming in the summer did not occur on 31 October, which prompted us to upgrade our forecast for the winter half year. KfW Research now expects the low but nonetheless clearly positive growth to continue in the current and next quarter, along with a gradual return to trend growth from spring. Economic output in the euro area should grow by 1.2% in all of 2019 and by 1.0% in 2020.
Going Digital – The Challenges Facing European SMEs
More than one in two European SMEs consider the use of new digital technologies necessary to secure their competitiveness. Many small and medium-sized enterprises have not yet made much progress here due to a number of digitalisation hurdles, including insufficient digital infrastructures and a lack of digital competency, both in the business itself and on the external labour market. This is shown in a joint study from KfW Research and the European promotional institutions Bpifrance, BGK, ICO and the British Business Bank, in which more than 2,500 small and medium-sized enterprises in Germany, France, Poland, Spain and the United Kingdom were surveyed. Although some SMEs anticipate that some tasks in their company may become obsolete as a result of digitalisation, most of them believe that the number of employees in their company will remain stable – or even grow.
Economics in Brief
Bulgaria has positioned itself to entering the Exchange Rate Mechanism II and ultimately to joining the euro. The EU country has long fulfilled the Maastricht convergence criteria. It also passed a recent ECB stress test which put the country's most important banks through their paces. But in order for its accession to the euro area to be crowned with success, Sofia still needs to make improvements in some areas.
Amid a contraction in overall economic output in Germany, the euro area’s largest economy, the monetary union as a whole nevertheless managed to achieve meagre growth of 0.2% on the previous quarter.
We are now more sceptical about the further outlook than in the spring. The most recent business surveys show that there is no end in sight to the industrial recession. The escalating trade conflicts and the UK government’s confrontational Brexit strategy are both taking their toll.
We therefore expect the economic weakness to continue until mid-2020 and have downgraded our growth forecast slightly to 1.0% for the current year and sharply to 0.7% for the coming year.
In the first quarter of this year the euro area economy grew 0.4%, twice the rate of the preceding quarter. The joy over this is likely to be short-lived, however. Adverse international conditions are weighing on the industrial sectors and the renewed escalation of trade tensions is hampering the trend reversal.
We therefore expect the growth rate to level off again in the current quarter and maintain our GDP forecast unchanged at 1.1% for 2019 and 1.5% for 2020.
The downward risks to the business cycle are substantial and have risen again lately. The likelihood of a hard Brexit, new turmoil surrounding Italy’s public finances, rising protectionism and sanctions is growing. This is fuelling concerns that the weakness, which has so far been restricted to the manufacturing sector, will spill over into the labour market and the aggregate economy.
In the course of 2018, economic performance in the monetary union slowed down significantly and the rapid deterioration in European business confidence at the start of the year is not good news. Even though one-off effects – such as the WLTP conversion – are subsiding, there are no signs of a vigorous recovery. Manufacturing, in particular, continues to suffer from the downturn in global activity and trade tensions.
KfW Research has therefore lowered its GDP forecast for 2019 to just 1.1%. The year 2020 should then see slightly more lively growth of 1.5%. However, our forecast is based on the assumption that none of the major downward risks materialises. In that case, a recession would probably be inevitable.