Germany is displaying something of a dual personality these days. Ask the average businessman how he feels about the state of the economy and he will smile; ask the average worker and he will stare at his shoes and shuffle his feet.
None of the macroeconomic ailments that ‘the sick man of Europe’ has been suffering from have disappeared, but even before the first Chancellorin, Angela Merkel, was voted into office last year, the economy was showing signs of a recovery. Exports have been booming, company profits are soaring and there are even signs that growth might pick up this year after nearly a decade of inertia.
However, the government’s deficit is still in breach of the EU’s 3% cap, unemployment is still hovering just under five million and economic growth has not yet begun. However, a quiet revolution has been under way and the country seems to have bottomed out. In February, the Ifo Index, a highly respected business confidence index, unexpectedly hit a 14-year high of 103.3 (see chart download file).
“Doubts regarding the durability of the upswing, which has been observable since last summer, should be further dispelled by these results. The upswing has gained both in breadth and momentum,” Ifo president Hans-Werner Sinn said when the results were released. “Particularly, the producers of investment and intermediary goods reported a better situation and outlook. In construction and in retailing especially, business expectations improved.”
The corporate sense of wellbeing is being driven by exports – Germany was again a leading world figure in exports last year; this year they are expected to rise by another 8%.
The government may have been reluctant in forcing painful reform through the Bundestag, but bosses have bypassed the unions to appease their employees, doing deals to cut pay and increase work hours.
“Corporates are doing well. They have restructured by signing agreements with their labour forces without dealing with the unions and now Germany is more productive than the surrounding countries,” says Ian Centis, a bank analyst at Commerzbank.
Economic peak
The economy is looking better than it has done for years. The consensus is for 1.7% growth in 2006, up from about 1% last year. Ifo’s chief economist Gebhard Flaig says growth could even hit 2% and Germany could be on its way to a “new economic peak” if the Merkel government sticks to its structural reform agenda.
“The economy is bottoming out, which signals improvement, but don’t expect any strong growth in the short term,” says HVB board member in charge of small and medium-sized enterprises (SMEs) and corporates, Johann Berger. “The economic driver in Germany is now export, but it is not just BMW and Mercedes that are doing the driving.”
The first shoots of recovery are pushing through fastest on the stock market and in merger and acquisition (M&A) activity. Corporate restructuring is starting to pay dividends and both earnings and profits rose sharply last year, driving up the DAX index from 4000 at the start of 2005 to about 5800 by early March.
Rising valuations has brought the initial public offering (IPO) market out of its torpor. The difficult flotation of Post Bank broke the ice last year and was followed by the very successful float of Premier TV. The number of IPOs has been building steadily from none in 2003 to 14 last year worth €4bn. This year, bankers are expecting between 20 and 30 IPOs on the main market and another 100 small-cap floats, which will make Germany one of the most active issuance markets in Europe. Recently, Christopher Pleister, head of the BVR co-operative banks association, said his members may list, so potentially adding to the count.
Profits up
The return to health of corporate Germany and the domestic capital markets is clearly visible in banks’ bottom lines. The giant of the German banking sector, Deutsche Bank, announced that fourth-quarter profits in 2005 tripled while revenue rose 23% to €6.55bn from €5.31bn in the same period the year before.
“We have invested in growth businesses and regions during 2005 and will continue to do so,” Deutsche Bank CEO Josef Ackermann said at a press conference. “Our objective now is to sustain, over the cycle, this level of pre-tax return on equity and double-digit earnings-per-share growth.”
Commerzbank also put in exceptional results, suggesting the entire sector has turned the corner after writing down huge losses following a slump at the turn of the millennium. Regarding its prospects in 2006, chief executive Klaus-Peter Mueller said in February that the bank was on a solid footing to increase revenues and profit. Earnings were up to €1.17bn in 2005, from a mere €362m in 2004, and trading profits doubled to €217m over the same period.
But the banking system is not yet out of the woods. Deutsche Bank is smarting from several recent gaffes. The most embarrassing was the revelation that a rogue trader, Anshul Rustagi, was disciplined in January for overstating his trading profits by £30m (€44.5m). An investigation is in progress so neither side can comment, but the scandal alarmed regulators as it suggests Deutsche Bank’s risk management systems may be less robust than they should be.
Perhaps more serious was the storm caused when Deutsche Bank barred 300,000 retail investors from withdrawing from its DB Real Estate Fund at the end of last year. The bank froze the fund – the fifth largest in Germany worth €6bn – after it received less than it expected from the sale of some offices.
Real estate fund trouble
Despite the growing hype about the prospects of the German property market, the real estate fund business is in trouble. Three more funds suspended operations in January for much the same reasons and the government is thinking about shaking up regulators on how real estate assets are evaluated to avert a crisis. Investors are becoming increasingly jumpy and of the €3.43bn pulled out of open-ended funds last year, €3bn was withdrawn in December alone, according to the BVI, the German association of investment and asset management.
The German recovery is fragile and a real estate fund crisis will not help. Confidence will also be damaged by a hike in VAT rates to 19% that Chancellor Merkel plans for later this year, but despite these setbacks it seems that the mood in Germany is improving.
The Ifo economic report was followed by another report that suggests consumer confidence is finally on the mend. A poll by market researchers GfK found that consumer confidence was up for the fifth month in a row in March and Germans are more willing to go shopping than at any time in the past four years.
Lack of consumer confidence has been hanging like an albatross around the neck of the German economy. Alarmed by this persistent pessimism, the government has run television advertisements telling Germans “Du bist Deutschland” (You are Germany) to boost morale and revive their sense of national pride.
“Consumers are not spending in Germany and consumption is fuelling the rest of Europe’s growth. The lack of confidence has widespread consequences and also shows up in the poor markets for debt and lending. In this environment, German companies are pulling themselves up by their bootstraps,” says Commerzbank’s Mr Centis.
Part of the pessimism is due to the enormity of the reforms needed if Germany is to become competitive. Citizens are worried about unemployment and whether the pension system will be able to provide for them in retirement. (In February the government put the retirement age up to 67 in an attempt to avoid a funding crisis.)
Mr Berger says a pall is also hanging over the Mittelstand, the thousands of family-owned small industrial and service companies that make up the backbone of the German economy. Confidence here is growing but borrowing is still lackadaisical.
On the one hand, Mittelstand companies, like the population, are not spending their money or investing in new production, as they are still uncertain about the strength of the recovery, says Mr Berger. On the other hand small companies are nimbler, enabling many to restructure.
Mr Berger adds: “The Mittelstand has consolidated in two ways. The negative way is that thanks to the economic problems lots of companies have disappeared. The positive is that our customers have been doing their homework – cutting costs, improving their finances, innovating and moving to new markets. These ones have become very successful.”
Sectoral recovery
Many sectors, such as construction, are still struggling but others such as metallurgy, chemical, IT and consumer electronics have all but recovered and are now growing. Those that are doing best have aped their larger cousins and joined the export boom. The DAX-30 largest corporations account for two-thirds of Germany’s exports, but the remainder comes from the Mittelstand.
A Deutsche Bank report in February found that one in five SMEs earns at least half its revenue from exports and even among the smallest companies (with 20-99 employees), between a quarter to a third of revenues are generated by exports. Normally small companies turn to export when their home market is small. There are only nine EU countries with more than 20% of SME exporters and Germany is the only large country among them.
“The Mittelstand have transferred a lot of their production to central Europe but it is only the first step as there are also markets there. They see the central and eastern European countries as their markets,” says Mr Berger.
This more sophisticated business model has brought with it a demand for more sophisticated products. The flourishing Mittelstand has provided a boost for the banks and they are more than happy to cooperate. Gone are the days where a local businessmen wanted plain vanilla credits and deposits from his house bank. Now banks are offering sophisticated derivatives to small companies, and HVB has targeted increasingly smaller groups with tailored products to deepen and broaden this customer base. “Our customers have a lot of liquidity and we would like to see more demand on the credit side, but they are reluctant to invest and are waiting for things to improve,” says Mr Berger. “But five years ago, no one was even thinking about sophisticated products like derivatives. Now everyone wants them.”
Even the smallest €1m turnover companies are buying things such as interest rate swaps and the larger companies with a turnover of €25–€100m or more are making use of nearly everything the big corporations demand. Munich-based HVB even sells a weather derivative to local businesses looking to hedge against Oktoberfest being rained off.
The growing activity has brought the banks another boon in the form of a big up-tick in M&A as the Mittelstand re-adjusts to the new realities and the failed companies are swallowed by the larger or leaner competitors. More than €80bn of deals were done in 2005, the most since 2001 and twice as many in 2004, according to Thomas Financial.
Question of reform
Since taking power, Chancellor Merkel’s government has said nothing about bank reform. It will be one of the more emotive issues on the docket for Germany’s Grand Coalition between the Christian Democrats she leads and the Social Democrats that control most of the power ministries.
Last summer saw what may be the last major bank reform for some time when the regional Landesbanken lost their state-backed Anstaltslast and Gewährträgerhaftung guarantees that had been handing them cheap credits. Cut off from this cushy business, the Landesbanken are looking for a new business model and drifting towards tie-ups with the slew of savings banks (Sparkassen) that effectively own them. The Landesbanken and Sparkassen are natural allies, but the cheap credits have driven a cultural wedge between the two that will be hard to repair.
“The Landesbanken will have to find a new source of cheap credit if they are going to survive in the long term and the obvious solution is to tie up with the Sparkassen,” says Mr Centis. “There is a slow drift towards creating Finanzgruppe with vertical and horizontal tie-ups between the Landesbanken and the Sparkassen, but it is not going quickly. The Sparkassen have a stable customer base and value their independence. They are very focused on their local markets.”
The selective recovery in the economy, the sudden boost to revenues and the prospect of a much improved business climate has had a much more dramatic effect on the private banks. Like the Mittelstand, they have also caught the M&A bug, with themselves as the star deals.
Last June, Italy’s UniCredit agreed to pay $18.3bn to buy out HVB Group AGl, in the third biggest deal in Europe last year and the largest ever cross-border banking acquisition.
The combined bank – the deal is more of a merger than a takeover – is a top three player in three of Europe’s wealthiest countries and the undisputed leader in the fast-growing eastern Europe market. HVB dominates its home turf in Bavaria and southern Germany but the deal has carved out a new area that is not defined by national boundaries, but by wealth.
“The merger with UniCredit makes us more competitive,” says Mr Berger. “UniCredit is the market leader in northern Italy, Bank Austria [a member of the HVB group] is the market leader in Austria and HVB is the market leader in southern Germany. This combined region is one of the richest in Europe. And we have a second base of growth in the new countries of eastern Europe, where our customers are now operating.”
The deal should have been a testament to the ongoing integration of European business, as with branches in 19 countries it has a good claim to be the first true pan-regional bank. However, the deal immediately ran into trouble in Poland.
Polish opposition
Poland tried to block the merger of HVB’s Polish subsidiary Bank BPH with UniCredit local bank Pekao to become Poland’s largest bank, overtaking the state-owned leader PKO Bank Polski. Warsaw has accused the EU anti-trust regulator of misjudging the impact of the deal and claims it will stifle Polish competition. It also says that the acquisition breaches Pekao’s 1999 privatisation deal and has threatened to renationalise the bank unless UniCredit sells it before April.
Commerzbank also entered the fray in November. Long a favourite candidate for a cross-border takeover, Commerzbank was itself doing the taking over, agreeing to a €4.6bn buy-out of its partners in Eurohypo to create the second largest bank in Germany.
It is a remarkable turnaround for a bank that was struggling to keep its head above water two years ago. The marriage with Eurohypo will allow Commerzbank to expand and CEO Mr Mueller says it is looking at more acquisitions.
Commerzbank will certainly be one of the bidders for the failed Berliner Bank, which goes under the gavel later this year, if the price is right. But with 20 other banks intending to bid, the prices could be high. Mr Mueller will have to decide just how strong he thinks the current recovery really is – but at least Germans are starting to shop again.
