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Morgan Stanley - Where Has the Wirtschaftswunder Gone

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					March 2013




                                                                                                                                                  MORGAN STANLEY RESEARCH
German Economics                                                                                                                                  Europe

                                                                                                                                                  Morgan Stanley & Co. International plc+
Where Has the Wirtschaftswunder Gone?
Germany is sometimes viewed as the land of                Main German Macro Forecasts                                                             Elga Bartsch
economic miracles or Wirtschaftswunder. While                                                                                                     Chief European Economist
                                                                                                     2010A    2011A    2012A    2013E    2014E    elga.bartsch@morganstanley.com
Germany should recover earlier and stronger than          Real GDP                                      4.2      3.0      0.7      0.5      1.6   +44 (0) 20 7425 5434
                                                          Private Consumption                           0.9      1.7      0.8      0.6      1.3
other parts of the euro area, we have several             Government Consumption                        1.7      1.0      1.0      1.8      1.4
                                                          Gross Fixed Investment                        6.1      6.2     -2.2     -0.4      2.9
concerns about long-run growth.                               Machinery and Equipment                  10.3      7.0     -4.4     -2.4      3.9
                                                          Exports                                     13.7       7.8      4.1     3.8      5.7
First, German consumers are unlikely to become big        Imports                                     11.1       7.4      2.3     3.8      5.5
spenders even though they are hit by less austerity       Contribution to GDP Growth (%)
than their peers.                                          Final Domestic Demand                        1.9      2.2      0.2      0.6      1.5
                                                           Net Exports                                  1.9      0.7      1.1      0.3      0.6
                                                           Inventories                                  0.3      0.1     -0.7     -0.5     -0.5
Second, after extended weakness in corporate              Unemployment Rate (% of Labour Force)        7.1      6.0       5.5     5.8      5.9
investment and public infrastructure, corporates are      Real Disposable Income
                                                          Personal Saving Rate (% of Disp. Income)
                                                                                                       0.7
                                                                                                      12.1
                                                                                                               -0.6
                                                                                                               10.2
                                                                                                                          0.5
                                                                                                                          9.9
                                                                                                                                  0.7
                                                                                                                                  9.9
                                                                                                                                           1.0
                                                                                                                                           9.6
again cutting costs.                                      Inflation (CPI)                               1.2      2.0      2.0     1.7      1.6
                                                          GDP Deflator                                  0.9      0.8      1.3     2.0      1.6
                                                          Unit Labour Costs                            -3.1      4.1      3.0     1.7      0.8
Third, the government’s energy policy burdens
                                                          Current Account (% of GDP)                    6.0      5.7      6.3     6.0      6.2
consumers with high costs and could undermine
energy security for corporates.                           General Government Balance (% of GDP)        -4.1     -0.8      0.2     0.2      0.5
                                                          Primary Government Balance (% of GDP)       -1.6      1.8      2.6      2.4      2.6
                                                          General Government Debt (% of GDP)          82.5     80.5     81.4     80.4     78.0
With the September 22 general election still wide         Net Government Debt (% of GDP)              49.8     51.3     N/A      N/A      N/A
open, politics will likely dominate the domestic policy   ECB Policy Rate (%, EOP)                    1.00     1.00     0.75     0.75     0.75
debate and could possibly even stall European
reforms.                                                   E = Morgan Stanley Research estimates
                                                           Source: Eurostat, ECB, EU Commission, Morgan Stanley Research



For important disclosures, refer to the Disclosures Section, located at the end of this report.
                                                                                                    MORGAN STANLEY RESEARCH
                                                                                                              Germany Economics
                                                                                                                      March 2013




Germany Continues to Outperform But at a Smaller Margin

    5                                                                                                  Our
                                                                  GDP Growth, yoy
                                                                                                       Forecasts
    4

    3

    2

    1

    0

   -1
         %
   -2
                                        Germany                         Euro Area
   -3

   -4

   -5
        1991               1994                 1997                   2000    2003   2006   2009     2012

        Source: National Accounts, Morgan Stanley Research estimates


                                                                                                                                   2
                                                                                                           MORGAN STANLEY RESEARCH
                                                                                                                     Germany Economics
                                                                                                                             March 2013




Ifo Business Climate Is Bouncing off the Lows
  125                                                          Ifo Business Expectations
                                                                                                                              1 . 0




                                                               Ifo Business Climate
  120                                                                                                                         0 . 9




                                                               Ifo Business Conditions
  115                                                                                                                         0 . 8




  110                                                                                                                         0 . 7




  105                                                                                                                         0 . 6




  100                                                                                                                         0 . 5




   95                                                                                                                         0 . 4




   90                                                                                                                         0 . 3




   85                                                                                                                         0 . 2




   80                                                                                                                         0 . 1




   75                                                                                                                         0 . 0




    1960              1965            1970            1975              1980   1985   1990   1995   2000   2005    2010
        Source: Ifo, Statistisches Bundesamt, Morgan Stanley Research
                                                                                                                                          3
                                                                                                                               MORGAN STANLEY RESEARCH
                                                                                                                                                 Germany Economics
                                                                                                                                                         March 2013




A Difficult Start to 2013 …
Germany will probably be able to avoid a recession. For the year as a                Germany’s ability to become an engine of growth is limited. Historically,
                                                                                     Germany has grown less than the European average, with only two notable
whole, we think a modest recovery starting in the spring will yield an average       exceptions – reunification and the most recent period. There was a pronounced
GDP growth rate of only 0.5% in 2013. There are several reasons to be                phase of underperformance since the mid-1990s, where German growth on
bearish on Europe’s largest economy and to question the perception of                average trailed the rest of Europe by 0.9pp between 1995 and 2005. Five years
Germany being Europe’s new economic powerhouse. Factors that caused                  into this underperformance, the current account moved into positive territory
Germany to slow markedly in H2 2012 include its above-average export                 again. The re-emergence of Germany since 2005 is a relative short period,
reliance and its strong specialisation in capital goods production. A high share     reversing part of the secular decline seen before. Re-emergence has been
of industry in the overall economy makes Germany a high-beta play on the             characterised by strong manufacturing performance (with a stable share of
global business cycle. Alas, the German consumers who slowed down their              manufacturing in value-added since the mid-1990s while falling in most DMs),
                                                                                     prolonged wage moderation in an environment of rapidly rising wages
spending in the course of 2012 have not been able to provide a strong enough
                                                                                     elsewhere in the euro area, strong global growth and rising global imbalances.
offset and corporates scaled back investment since early 2012.                       Yet, volatile external demand and larger cyclical swings seem to be dampening
                                                                                     consumer demand – and hence Germany’s ability to be the engine of Europe’s
                                                                                     growth.
Going forward, we remain cautious on consumer spending growth as we
forecast the labour market to soften, project consumer price inflation to remain     The main risk to an eventual recovery in domestic demand in Germany is
elevated on the back of marked energy price increases and expect non-                a renewed intensification of the euro crisis. Despite an export and profit
discretionary housing spending (notably for rents and house prices but also for      boom, investment spending stayed weak, causing savings to exceed
electricity and gas) to weigh on discretionary spending. Germany’s past              investment by a rising margin and the current account surplus to rise. As a
caused a structural shift in the savings behaviour such that consumers have a        major international creditor, Germany remains vulnerable to external financial
tendency to save more in bad times (usually they would save less and keep            shocks. The recent reversal in German private net capital outflows to the
consumption steady). Concerns about the sovereign debt crisis in the euro            periphery was partly offset by official government loans and the ECB’s
area could reinforce this trend, we think. As a result, we have seen no              TARGET2 system. In its latest Article IV consultations, the IMF notes that the
                                                                                     German banking system remains vulnerable – notably institutions with high
progress on rebalancing recently and don’t expect the current account surplus
                                                                                     leverage ratios, heavy wholesale funding and low risk-adjusted profitability and
to come down meaningfully over the forecast horizon.                                 capital quality (due to the use of hybrid capital) are a concern. Reforming the
GDP Indicator points to Q1 bounce after Q4 slump                                     financial sector is key to raising the long-term growth potential. Reforms should
  2.5                                                                                include strengthening arm’s length financing, private equity and venture capital,
  2.0
                 Real GDP        Estimated                                           as well as addressing legacy issues in part of the state-owned banks (see Tests
                                                                                     of German Resilience).
  1.5

  1.0

  0.5

  0.0

  -0.5

  -1.0

  -1.5

  -2.0

  -2.5
   Q1-1991   Q1-1994   Q1-1997     Q1-2000   Q1-2003   Q1-2006   Q1-2009   Q1-2012
                                                                                                                                                                         4
 Source: IMF, Morgan Stanley Research
                                                                                                                                            MORGAN STANLEY RESEARCH
                                                                                                                                                                   Germany Economics
                                                                                                                                                                           March 2013




Germany – Main Macro Forecasts
                                       2007 2008 2009 2010 2011 2012 2013e 2014e               2012                         2013e                          2014e
                                                                                                 Q1    Q2     Q3     Q4       Q1e    Q2e     Q3e    Q4e      Q1e    Q2e    Q3e    Q4e

  GDP and Demand Components (1)
  GDP (yoy)                      3.3           1.1 -5.1 4.2         3.0    0.7    0.5    1.6    1.7    0.5    0.4    0.1      -0.9    0.6     0.8    1.3     1.7     1.2    1.7    1.8
  GDP (qoq)                      3.3           1.1 -5.1 4.2         3.0    0.7    0.5    1.6    0.5    0.3    0.2   -0.6       0.4    0.3     0.3    0.4     0.4     0.4    0.4    0.4
  Private Consumption (qoq)     -0.2           0.8 0.1 0.9          1.7    0.8    0.6    1.3    0.2    0.2    0.0    0.1       0.3    0.3     0.3    0.3     0.4     0.4    0.4    0.4
  Government Consumption (qoq)   1.4           3.2 3.0 1.7          1.0    1.0    1.8    1.4    0.6   -0.3    0.7    0.4       0.3    0.4     0.4    0.4     0.3     0.3    0.3    0.3
  Gross Fixed Investment (qoq)   4.8           1.4 -12.1 6.1        6.2   -2.2   -0.4    2.9   -1.0   -1.9   -0.5   -0.8       0.5    0.6     0.6    0.7     0.7     0.8    0.8    0.8
    Machinery & Equipment       10.5           2.9 -22.5 10.3       7.0   -4.4   -2.4    3.9   -1.1   -3.0   -2.2   -2.0       0.5    0.8     0.8    1.0     1.0     1.0    1.0    1.0
    Construction                -0.3          -0.7 -3.2 3.2         5.8   -1.1    0.4    1.8   -0.8   -1.4    0.7   -0.1       0.3    0.4     0.4    0.4     0.4     0.5    0.5    0.5
    Other (Software, Patents)           7.3    6.2   -2.9    3.3    3.9    3.2    5.7    5.2   -1.1    1.0    1.5    1.5      1.5     1.5     1.3    1.3     1.3     1.3    1.3    1.3
  Inventories (cont. to GDP growth)     0.6   -0.2 -1.4 0.3        0.1    -0.7   -0.5   -0.5   -0.2   -0.1   -0.3     0.2     -0.3   -0.3     0.0   0.1     -0.2    -0.2   -0.2   -0.2
  Total Domestic Demand (qoq)           1.9    1.2 -2.4 2.6        2.6    -0.4    0.2    1.1   -0.2   -0.4   -0.3     0.2     -1.9    4.1    -2.8   3.7     -3.1     4.0   -3.0    4.0
  Final Domestic Demand (qoq)           1.1    1.4 -1.7 2.0        2.4     0.2    0.7    1.6    0.0   -0.3    0.1     0.0      0.3    0.4     0.4   0.4      0.4     0.4    0.4    0.4
  Exports (qoq)                         8.0    2.8 -12.8 13.7      7.8     4.1    3.8    5.7    0.7    3.3    1.5    -2.0      2.0    1.8     1.2   1.1      1.5     1.5    1.5    1.5
  Imports (qoq)                         5.4    3.4 -8.0 11.1       7.4     2.3    3.8    5.5   -0.7    2.3    0.6    -0.6      1.6    1.6     1.5   1.3      1.3     1.3    1.3    1.3
  Net Exports (contr. to GDP growth)    1.6   0.0 -2.5 1.9         0.7     1.1   0.3    0.6    0.7     0.7   0.5    -0.8      0.3    0.2     0.0    0.0     0.2     0.2    0.2    0.2
  Industrial Production                 5.3   -2.5 -17.6 15.5      6.4    -0.3   -0.5    2.0
  Labour Market and Productivity
  Employment (% qoq)                    1.7    1.2   0.1    0.6     1.4    1.1    0.0    0.4    0.4    0.2    0.2    0.1      -0.1   -0.1     0.0    0.1     0.1     0.2    0.2    0.2
  Unemployment Rate (2)                 9.0    7.8    8.1    7.7    7.0    6.8    7.3    7.4    6.8    6.8    6.8    6.9      7.1     7.3     7.4    7.5     7.5     7.5    7.4    7.3
  Labour Productivity (% qoq)           1.5   -0.1   -5.2   3.6     1.6   -0.4    0.4    1.2    0.1    0.1    0.1   -0.7      0.5     0.4     0.3    0.3     0.3     0.2    0.2    0.2

  Private Household Income
  Wages per Employee                    2.7    3.6   0.3    0.4     5.8    2.6    2.1    1.9    2.2    2.4    2.6    2.7      2.5     2.0     2.0    1.8     1.8     1.9    2.0    2.0
  Real Disposable Income                0.3    1.9   -0.8    0.7   -0.6    0.5    0.7    1.0    1.7    0.7   -0.4    0.3     -0.5     0.7     1.2    1.0     1.1     1.4    1.7    1.9
  Savings Ratio (3)                    12.2   13.2   12.4   12.1   10.2    9.9    9.9    9.6   10.4   10.5   10.3   10.1     10.3    10.3    10.1   10.1    10.1    10.4   10.5   10.5

  Prices and Costs (% yoy)
  Consumer Prices                       2.3    2.6   0.3     1.2    2.3    2.0    1.6    1.6    2.1    1.9    2.0    2.0      1.5     1.7     1.6    1.5     1.5     1.7    1.6    1.5
  GDP Deflator                          1.6    0.8   1.2     0.9    0.8    1.3    2.0    1.6    1.2    1.2    1.4    1.5      2.1     2.0     2.0    2.0     1.4     0.0    0.0    0.0
  Unit Labour Costs                     1.1    3.7   5.8    -3.1    4.1    3.0    1.7    0.8    2.4    2.6    2.7    3.1      2.6     1.8     1.5    0.3     0.5     0.6    0.9    1.1

  External Sector
  Trade Balance (€ bn)                 195    178    139    155    159    188    186    194
  Current Account (€ bn)               181    154    141    151    147    167    161    171
   % of GDP                            7.4    6.2    5.9    6.0    5.7    6.3    6.0    6.2

  Government Accounts (4)
  General Gov. Deficit (€ bn)            -6    2   73 104            20   -4.2   -4.2    -14
   % of GDP                            -0.2 0.1 3.1 4.1             0.8   -0.2   -0.2   -0.5
  General Gov. Debt (% of GDP)         65.2 66.8 74.5 82.5         80.5   81.4   80.4   78.0

Source: Morgan Stanley Research
                                                                                                                                                                                         5
                                                                                                                          MORGAN STANLEY RESEARCH
                                                                                                                                            Germany Economics
                                                                                                                                                    March 2013




 Ifo Business Climate by Sector


 Business expectations 6M Ahead                                                 Current business conditions now


3                           Business Expectations by Sector          3
                                                                          3                         Current Business Conditions by Sector                  3
            Manufacturing
            Construction                                                                    Manufacturing
2                                                                    2
            Wholesale Trade                                               2                 Construction                                                   2
            Retail Trade                                                                    Wholesale Trade
1                                                                    1                      Retail Trade
                                                                          1                                                                                1


0                                                                    0    0                                                                                0


-1                                                                   -1   -1                                                                               -1


-2                                                                   -2   -2                                                                               -2

      Unit Standard Deviation                                                    Unit Standard Deviation
-3                                                                   -3   -3                                                                               -3
  2000       2002          2004         2006   2008    2010   2012          2000         2002         2004        2006   2008     2010       2012


 Source: Ifo, Morgan Stanley Research                                          Source: Ifo, Morgan Stanley Research




                                                                                                                                                                 6
                                                                                                                              MORGAN STANLEY RESEARCH
                                                                                                                                            Germany Economics
                                                                                                                                                    March 2013




Investor Sentiment, Business Climate and GDP Growth
       Business expectations for the next 6M                                      ZEW and Ifo surveys like-for-like
                                                                            115                                                                       120
                                                                                                Composite ZEW Index, LH
 60                                                                               80
                                                                            110                 Ifo Business Climate, RH
                                                                                                                                                      115
                                                                                  60
 40                                                                         105                                                                       110
                                                                                  40
 20                                                                         100                                                                       105
                                                                                  20
  0                                                                         95                                                                        100
                                                                                   0
 -20                                                                        90
                                                                                  -20                                                                 95
 -40            ZEW Business Expectations, LH                               85
                                                                                  -40                                                                 90
 -60            Ifo Business Expectations, RH                               80                                                                        85
                                                                                  -60
 -80                                                                        75    -80                                                                 80
   2000         2002       2004      2006        2008    2010      2012              2000     2002       2004      2006       2008   2010   2012
       Source: ZEW, Ifo                                                           Source: ZEW, Ifo, Morgan Stanley Research


       Ifo survey and GDP growth                                                  ZEW composite and GDP growth
  7%                                                                       120
                    German GDP, ca          Ifo Business Climate, sa RHS           7                                                                    60
                                                                                                 % yoy
  5%                                                                       115
                                                                                   5                                                                    40
                                                                           110
  3%
                                                                                   3
                                                                           105                                                                          20
  1%
                                             `                                     1
                                                                           100
                                                                                                                                                        0
  -1%
                                                                           95      -1

  -3%                                                                                                                                                   -20
                                                                           90      -3

  -5%                                                                      85      -5                German GDP, ca                                     -40
                                                                                                     Composite ZEW RH
  -7%                                                                      80      -7                                                                   -60
     1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012                          1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

       Source: Ifo, Bundesbank                                                    Source: ZEW, Bundesbank
                                                                                                                                                                 7
                                                                                                                                      MORGAN STANLEY RESEARCH
                                                                                                                                                  Germany Economics
                                                                                                                                                          March 2013




    Industrial Orders, Output, and Exports


       Order growth and production bottomed out                                   Expectations have rebounded, exports not yet



35%                                                                                             Recession                Export Expectations      Exports, yoy, 3mma
                        Recession                  Orders         Production     40

25%                                                                              30


15%                                                                              20

                                                                                 10
 5%

                                                                                  0
 -5%
                                                                                 -10
-15%
                                                                                 -20

-25%                                                                             -30

       %, yoy, 3MMA
-35%                                                                            -40
   Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 Jan-12   Jan-60 Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10




       Grey-shaded areas mark German recessions                                   Source: Ifo, Statistisches Bundesamt, Morgan Stanley Research
       Source: Statistisches Bundesamt, Morgan Stanley Research




                                                                                                                                                                       8
                                                                                                                               MORGAN STANLEY RESEARCH
                                                                                                                                                 Germany Economics
                                                                                                                                                         March 2013




Manufacturing Watch – Order inflow, Order books, Output plans, and Inventories
Manufacturing order demand by origin                                                    Manufacturing orders, sales and output
140                                                             Total           140   130                                                                    115
          2010=100                                              Domestic                    2005=100
                                                                Non-EMU                                                                                      110
130                                                                             130   120
                                                                EMU
                                                                                                                                                             105
120                                                                             120   110
                                                                                                                                                             100
110                                                                             110   100
                                                                                                                                                             95
100                                                                             100   90
                                                                                                                                                             90
 90                                                                             90    80
                                                                                                                                                             85
                                                                                      70                                     Manufacturing Orders
 80                                                                             80                                                                           80
                                                                                                                             Industrial Sales
                                                                                      60                                     Manufacturing Output            75
 70                                                                             70
                                                                                                                             Book to Bill Ratio, RH
                                                                                      50                                                           70
 60                                                                             60
                                                                                       1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
  2005       2006     2007    2008      2009    2010   2011   2012   2013

Output plans and export expectations                                                    Assessment of orders and inventories
   30                                                                       30
                                                                                       -7                                                                    20
                                                                                                       Inventories (inverted), LH
   20                                                                       20                                                                               10
                                                                                       -2              Order Demand, RH
   10                                                                       10                                                                               0
                                                                                        3
                                                                                                                                                             -10
      0                                                                     0
                                                                                        8
                                                                                                                                                             -20
  -10                                                                       -10
                                                                                      13                                                                     -30
  -20                                                                       -20
                                                                                      18                                                                     -40
                             Output Expectations LH
  -30                                                                       -30                                                                              -50
                                                                                      23
                             Export Expectations RH
  -40                                                                       -40                                                                              -60
                                                                                      28
                                                                                                                                                             -70
  -50                                                                       -50
                                                                                        1992     1996          2000         2004        2008          2012
    1992             1996        2000          2004      2008        2012
                                                                                                                                                                      9
Source: Ifo, Bundesbank
                                                                                                                     MORGAN STANLEY RESEARCH
                                                                                                                                      Germany Economics
                                                                                                                                              March 2013




Ahead of the September 22 Election
Chancellor Merkel likely to stay in power: Current polls indicate that       For starters, the election outcome is subject to considerable
Chancellor Merkel will continue to govern, most likely with the FDP.         uncertainty thanks to a new election law and 5% hurdle for
However, a new election law and the 5% hurdle for parliamentary              parliamentary representation (see box on the following page for details).
representation introduce additional uncertainties and could force her        Our concerns echo our assessment that progress on institutional reform
back into another bi-partisan Grand Coalition with the opposition Social
Democrats. A Red-Green minority government tolerated by the Left             in Europe will likely be very limited this year (see European Economics:
Party poses a relatively low risk, we think.                                 Crisis Contained, Not Resolved, January 7, 2013). A combination of
                                                                             complacency on the back of calmer euro area bond markets, conflicting
Reform standstill feared ahead of the election: Another view                 political paradigms on how best to address the crisis, diverging cyclical
mulled across EU capitals and many trading floors is that reforms            and financial positions across countries and a series of elections across
could come to a standstill once the campaign gets under way. While           Europe are slowing the reform process down.
we are also concerned about the limited reform progress, we don’t
view the German election as the main cause for the lack of progress.         Based on current opinion polls and her high personal popularity, Angela
                                                                             Merkel appears very likely to win a third term as Chancellor. But, it
Little policy change on euro, more on taxes, banks: We think a               is by no means certain who she would team up with as a junior coalition
change in government would bring only very limited change in how the         partner. Much will depend on how her current coalition partner, the Free
euro crisis is handled. Gradual steps towards a banking union, deeper        Democrats, fares and whether they and other smaller parties will be
economic integration and closer fiscal coordination are likely to be
dictated to all parties by voter preferences and constitutional              able to make it across the 5% hurdle for parliamentary representation. If
constraints. Similarly, the budget policies are limited by the debt brake.   a poor election performance of the FDP and/or the CSU prevents
Meaningful differences exist on taxes and banks though.                      another term of the current centre-right coalition, a bi-partisan Grand
                                                                             Coalition with the Social Democrats would seem the most likely
Details                                                                      election outcome to us. Chancellor Merkel already presided over such a
                                                                             Grand Coalition during her first term as Chancellor between 2005 and
The general elections in Germany later this year are starting to             2009. Another possible, but less plausible, coalition headed by Dr
garner considerable investor interest. This seems to be for two              Merkel could consist of the CDU/CSU and the Greens, which has
reasons: First, the future course of policy in the largest European          become possible in principle after the CDU/CSU decided to push for an
economy on taxes, bank regulation and energy usually attracts some           accelerated phasing out of nuclear power in Germany in reaction to the
interest. Second, many investors seem to wonder about the impact of          Fukushima disaster in Japan. Should Angela Merkel be unexpectedly
the election on European reform progress. The current consensus              unseated by the SPD Chancellor candidate Peer Steinbrueck, this
among pollsters and political pundits in Germany seems to be that            would likely be because of an outright victory of the Red-Green
Chancellor Merkel will continue to govern, most likely with her current
coalition partner, and that there will be reform standstill at the           coalition. In our view, a so-called ‘traffic light’ coalition in which the
European level ahead of the general elections, especially once the           SPD teams up with the Greens and the Free Democrats is a stretch of
election campaign gets under way in the summer. We would disagree            the imagination at the current juncture. Once we have outlined the major
with both assessments. Here’s why:                                           policy areas, we will return to a discussion of the different coalitions that
                                                                             could potentially be formed below.




                                                                                                                                                             10
                                                                                                                                                 MORGAN STANLEY RESEARCH
                                                                                                                                                                Germany Economics
                                                                                                                                                                        March 2013




German Politics at a Glance


  Coalition lost the majority in the upper house already                                       Voter support for Merkel’s CDU remains on the rise
                                                                                       45                           Voter intentions since 2009 election
  Distribution of Power in the German Bundesrat
  (Upper House of Parliament)                                                          40
                                                                                                                       CDU/CSU
  State                                 No. of Seats    Government     Next Election
                                                                                       35
  Baden-Wuerttemberg                         6          Greens/SPD              2016
  Bav aria                                   6          CSU/FDP            Fall 2013
                                                                                       30
  Berlin                                     4          SPD/CDU                 2016
  Brandenburg                                4          SPD/Lef t          Fall 2014                         SPD
                                                                                       25
  Bremen                                     3          SPD/Greens              2015
  Hamburg                                    3          SPD             Spring 2015    20
  Hesse                                      5          CDU/FDP            Fall 2013
                                                                                                                                      Greens
  Lower Saxony                               6          SPD/Greens        20-Jan-13    15      FDP
  Mecklenburg-West Pomerania                 3          SPD/CDU                 2016
  North Rhine-Westphalia                     6          SPD/Greens              2017                                                           Left
                                                                                       10                                                                      Pirates
  Rhineland-Palatinate                       4          SPD/Greens              2016
  Saarland                                   3          CDU/SPD                 2017    5
  Saxony                                     4          CDU/FPD            Fall 2014                                Others
  Saxony -Anhalt                             4          CDU/SPD         Spring 2016     0
  Schleswig-Holstein                         4          SPD/Greens/SSW          2017
                                                                                        Oct-09           Apr-10       Oct-10   Apr-11      Oct-11     Apr-12     Oct-12
  Thuringia                                  4          CDU/SPD            Fall 2014
  Total Number of Seats                      69
  of which                                              %
  CDU/CSU/FDP                                15                22%                                        Allens-     Emnid    Forsa       FG   Infratest Median   Last
  SPD/Left/Green                             36                52%                                         bach                          Wahlen                  Election
  Neutral                                    18                26%                          CDU/CSU         39%        39%      40%       41%     40%      40%     34%
                                                                                            SPD             27%        28%      24%       28%     27%      25%     23%
                                                                                            Greens          15%        16%      16%       14%     15%      17%     11%
                                                                                            FDP              6%        4%        4%       4%       5%      5%      15%
  Source: Bundesrat, IfD Allensbach, TNS Emnid, Forsa, Infratest Dimap,
                                                                                            Left-Party       7%        8%        8%       7%       6%      7%      12%
  Morgan Stanley Research
                                                                                            Pirates          3%        3%        3%         -      3%      3%       0%
                                                                                            Others          4%          2%       5%       6%       4%      3%       2%




                                                                                                                                                                                 11
                                                                                                                              MORGAN STANLEY RESEARCH
                                                                                                                                                  Germany Economics
                                                                                                                                                          March 2013




Overhang Mandates, a New Election law and the 5% limit add to Uncertainty
The 2013 election is the first under the new election law, which             Another element causing potential surprises is the hurdle for
reforms the so-called overhang mandates, after these were ruled              parliamentary representation. Only parties that receive at least 5% of
unconstitutional because they unduly favour the larger parties. On           the (second) votes or gain at least three direct mandates on the first
balance, the reform will likely limit the number of extra seats the two      votes can be represented in parliament. Hence, votes for small parties
largest parties can win – the so-called overhang mandates.                   that don’t make the cut get lost in terms of parliamentary representation.

These overhang mandates arise because, in a system of                        Therefore, less than 50% of votes can suffice to command a
personalised proportional parliamentary representation, German               majority of the seats. With some votes falling out of parliamentary
citizens cast two votes. With the first vote, they choose a candidate in     representation due to the 5% hurdle and some extra seats being added
their election district; with the second, they vote for a party. It is the   due to overhang mandates, sometimes as little at 47% of the national
second vote that determines the parties’ relative strength in the lower      vote has been sufficient to capture the majority of parliamentary seats.
house of parliament, the Bundestag.
                                                                             At the current juncture, two smaller parties are in danger of missing
But if a party manages to win more direct seats than the share in the        the 5% mark – the incumbent governing party FDP and the newly
second vote would suggest, it retains the additional seats as so-called      established ‘Pirate Party’. Both the Greens as well as the Left Party
‘overhang mandates’. The overhang mandates make it possible that a           seem to have a more comfortable margin over the 5% hurdle for now.
party can have more seats in parliament than the share in the second
vote would suggest.                                                          The Pirate Party, having been embroiled in internal discussions about
                                                                             its election platform and leadership, has lost considerable voter support
In July 2012, the German Constitutional Court declared parts of a            compared to last year, when it still looked like the newcomers might be
previously passed reform of the electoral system as unconstitutional.        able to mix up the political landscape in Berlin (see Germany
The consensus reached between the CDU/CSU, SPD, FDP and Green                Economics: Of Pacts, Politics and Pirates, May 3 2012).
faction in the Bundestag now foresees, among other changes, the
creation of ‘levelling seats’ (Ausgleichsmandate) in order to no
longer disproportionately discriminate against smaller parties.
                                                                             Potential Coalitions – The Political Arithmetic
Candidates from smaller parties have traditionally struggled to                                                                                      Last
achieve overhang mandates, as the most first votes are usually cast                                         Min            Max          Median     Election
for a candidate from either the CDU/CSU or SPD. The cross-party                 CDU/FDP                        43%            47%           45%          48%
compromise, which has now been formally agreed upon but not yet                 SPD/Greens                     38%            44%           42%          34%
passed through parliament, could potentially significantly increase the
number of seats in parliament to up to 700 from the current 620 (see            CDU/SPD                         63%               69%      65%          57%
“Endgueltiger Durchbruch beim neuen Wahlrecht”, Die Welt, October               CDU/Greens                      53%               57%      57%          45%
24, 2012). After a public hearing on the matter on January 14, the new          SPD/Greens/FDP                  42%               50%      47%          48%
law is expected to be passed in early spring this year. In the longer           SPD/Left                        30%               36%      32%          35%
term, it remains to be seen whether the newly elected parliamentarians          SPD/Left/Greens                 44%               52%      49%          46%
are willing to renegotiate electoral reform after the September election        SPD/Greens/Pirates              41%               47%      45%          34%
after what seems to be more of a temporary fix to the electoral system
for now.                                                                      Source: Polling Agencies, Morgan Stanley Research



                                                                                                                                                                   12
                                                                                                                        MORGAN STANLEY RESEARCH
                                                                                                                                         Germany Economics
                                                                                                                                                 March 2013




Major Policy Platforms – At a Glance
As the CDU started to reposition towards the middle of the political          The Social Democrats might be ready to go a bit further than the
spectrum on key domestic policy debates such as the labour market             CDU/CSU on regulating banks. According to a recent policy paper by the
and social affairs, the SPD was forced to move towards the left and           current Chancellor candidate and former Finance Minister Peer
embrace a more radical stance on some of these issues than, say, the          Steinbrueck (see Vertrauen zurueckgewinnen: Ein neuer Anlauf zur
Schroeder administration did with the Agenda 2010. The CDU, for               Baendigung der Finanzmaerkte, September 25, 2012) there should be a
instance, pushed for extended minimum wages, state provision of               strict separation between retail banking and investment banking, with the
childcare facilities and broadening of short shift subsidies. The SPD (like   former also extending to commercial banking – along the lines of other
the Greens) favours an increase in the top income tax rate from 42% to        policy proposals that challenge universal banking more broadly made by,
49%, an increase in the flat tax on capital income from 25% to 32%, as        for instance, the Liikanen report. Contrary to the CDU/CSU, Mr
well as the re-introduction of a wealth tax and a marked increase in the      Steinbrueck also favours a common bank resolution fund, which he calls a
inheritance tax (see Deutschland 2020 for details). After the current         banking ESM and which he envisages to have a size of €150-200 billion.
government already signed up for the financial transaction tax in the
European context, this discrepancy in policies vanished.                      Finally, on energy policy, we would expect all major parties to
                                                                              continue with the phasing out of nuclear power generation by 2022.
Similarly, we would expect a CDU and SPD-led government to                    After Chancellor Merkel decided in response to the Japanese nuclear
continue the current long-term fiscal consolidation strategy, which is        accident to accelerate the phasing out of nuclear power, thereby reversing
required by the constitutional debt brake rather than subject to political    an earlier policy decision, the phasing out of nuclear power and the
choices. In fact, it seems that, due to a number of revenue shortfalls, a     increase in use of renewable energy now seems to be consensus between
budget hole of around €10 billion (0.4% of GDP) has emerged and might         all main political parties, at least for now. Parties differ somewhat
require some adjustments. Possible adjustments circulated by the              regarding their stance on the provision of subsidies for the generation and
government coalition and reported in the press include a reduction in the     distribution of renewable energy, a topic that has recently started to make
central government’s contribution to the healthcare fund as well as the       headlines, given the sizeable cost borne by German households under the
distribution of profits of the state-owned KfW bank (see “Schaeuble plant     renewable energy act, EEG. As we have highlighted in our 2013 outlook,
umfangreiches Sparprogramm”, Spiegel Online, December 21, 2012). On           we think that energy policy is one of the areas where we have concerns
the whole, we therefore would not see any major risks to our budget deficit   about potential bottlenecks emerging in the German economy (see “Where
and government debt projections on the back of a possible change in           has the Wirtschaftswunder Gone?” European Economics: Crisis
government this autumn. Instead, we would expect the budget to remain         Contained, Not Resolved, January 7, 2013, p. 12). Investment in the power
broadly balanced until 2014. Consequently, debt to GDP should be              grid will be key to guaranteeing a secure uninterrupted supply and to allow
peaking out at around 81.5% of GDP in 2012.                                   building out the share of renewables in Germany.

Regarding financial regulation and banking reform, there are no major         Watch the new kid on the block -- a wildcard coming from a new anti-
differences between the political camps either. Many of these                 euro party -- called Alternatives for Germany -- that was founded in mid
developments are driven by European Directives or wider G20                   March. The highly respected Allensbach Institute for Demoskopie, which
consultations anyway. Concrete cases of bank restructuring are also           historically advises the centre-right on public opinion trends, does not view
guided by competition concerns of the European Commission, at least           this new party as likely to make it above the 5% hurdle though. Other
where banks got public sector support. In many cases, the reform of state-    pollsters, however, found at one in four Germans could imagine voting
owned banks is in the hands of regional states, which together with the       for this new anti-euro party. But like so many before and like the Pirate-
local savings banks tend to own the Landesbanks. Finance Minister             Party more recently, this one issue party is unlikely to shape German
Schaeuble has continued to push for tighter financial regulations and         politics, we think.
alongside Angela Merkel resisted pressures towards common financial
backstops for European banks or a joint deposit guarantee scheme.

                                                                                                                                                              13
                                                                                                                                                  MORGAN STANLEY RESEARCH
                                                                                                                                                                     Germany Economics
                                                                                                                                                                             March 2013




 Possible Coalitions – Political Colour Combinations
  Red-Black or Grand Coalition. This would seem to be the most likely outcome if the               Red-Green. This is a potential election outcome if the Free Democrats fail to make
  current downtrend in voter support for the FDP cannot be reversed by September. It is            it across the 5% hurdle and are expelled from the next parliament. Both opposition
  also the outcome most favoured by voters. The SPD dominates the upper house, the                 parties, which governed together for two terms between 1998 and 2005 under
  Bundesrat, already. Hence, even in the case of confirmation of the current government in         Gerhard Schroeder, are closely aligned on many policy issues. A return of Red-
  September, there will effectively be a Grand Coalition for all policy areas that require upper
  house approval. In addition, any major institutional reforms at the European level, such as      Green would probably mean higher income, wealth and inheritance taxes and
  a change in the European Treaty, would likely necessitate a change in the German                 higher social welfare spending. In addition, both parties seem more open to the
  Constitution and would require a broad bi-partisan campaign.                                     idea of pooling debt within the euro area. The Greens are in favour of a debt
                                                                                                   redemption fund and the SPD has initially pushed for euro bonds and later for the
                                                                                                   debt redemption fund idea. Both parties also favour more pro-growth infrastructure
                                                                                                   investment in Germany and in Europe more broadly. Finally, Germany and France
                                                                                                   would be more aligned politically through the centre-left European Socialists. A
                                                                                                   future Chancellor Steinbrueck would likely also push for stricter financial regulation
                                                                                                   (e.g., shadow banking) together with his shadow finance minister from the Greens,
 A Grand Coalition Is What the Voters Seem to Prefer                                               Juergen Trittin, a former minister of environmental affairs under Schroeder. This
                                                                                                   scenario could also come to pass if a Red-Green minority government is
                                                                                                   tolerated by the Left party.
              How do you view the following party coalitions?
                                                                              52%
                                                                                                   Black-Green. Given that nuclear power is no longer a bone of contention between
     CDU/CSU - SPD                                  28%                                            the centre-left, the Greens and the centre-right, some political pundits have started
                                                                                                   to speculate about a possible coalition between Chancellor Merkel’s CDU and the
                                                                    44%
                                                                                                   Greens. We would not dismiss the possibility completely. But we feel it might
        SPD - Greens                                        36%
                                                                                                   still be too early. At least part of the CDU/CSU still have very different values in
                                                                                      Good         terms of religious beliefs, sexual orientation and family life that sit awkwardly with
                                                                                      Bad          the Greens and their often unconventional urban followers. Hence, it would probably
                                                       32%
   CDU/CSU - Greens                                               41%
                                                                                                   take a further modernisation of the CDU/CSU – a process that has already started
                                                                                                   under Angela Merkel’s leadership and that is being pushed also by Labour Minister
                                                                                                   Ursula von der Leyen.
                                              23%
      CDU/CSU - FDP                                                            54%
                                                                                                   Traffic light. If the FDP makes it into the next parliament but does not deliver
                                          19%
                                                                                                   enough votes for a re-run of the current coalition, a traffic light coalition appears the
   SPD - Greens - Left                                                                    64%
                                                                                                   only alternative to a Grand Coalition. The SPD would trade its position as a junior
                                                                                                   coalition partner in a Grand Coalition for a lead position in a potentially unstable
                                                                                                   three-party coalition. The Greens would also benefit as they would again sit on the
                                       15%
  SPD - Greens - FDP                                                                58%
                                                                                                   government bench. However, for the Free Democrats, entering a traffic light
                                                                                                   coalition would mark an abrupt political u-turn. While the FDP has not shied away
                                                                                                   from such u-turns in the past (e.g., in 1983, when the party famously pulled out of
                         0%    10%      20%      30%         40%        50%         60%     70%    an SPD-FDP coalition led by Helmut Schmidt and rang in the era under Chancellor
 Source: Forschungsgruppe Wahlen, Morgan Stanley Research                                          Helmut Kohl), it is difficult to imagine it would attempt such a u-turn in the midst of
                                                                                                   its recent leadership crisis. Already having earned a reputation for political
Black-Yellow. Another term for the current coalition and a third term for Angela                   favouritism in the current administration by insisting on specific measures
Merkel is unlikely to lead to any major policy changes in Germany. What’s more, the                benefitting its voters (e.g., subsidising hotels though a cut in the VAT on
gradual approach to European politics would be set to continue. The constitutional                 accommodation or benefitting doctors by abolishing the medical fee for visiting a
debt brake requires a balanced budget at the federal level in 2016, while the fiscal               surgery), a sudden switch towards the left might be a step too far to not alienate its
compact demands a debt reduction of around 7pp over three years and doesn’t                        traditional supporters.
leave that much room for fiscal policy manoeuvres.


                                                                                                                                                                                            14
                                                                                                                                                         MORGAN STANLEY RESEARCH
                                                                                                                                                                             Germany Economics
                                                                                                                                                                                     March 2013




Consumers: Fundamental Factors
     Consumer spending rebounds                                                           Stronger job growth and rising wages growth boost
3                                                                              3          incomes                           Jan 1992=100
                                                                                                        Employment
                                                                                    165
                                                                                                        Gross wages & salaries
2                                                                              2                        Tax & social security contributions
                                                                                    155                 Net wages & salaries
1                                                                              1                        Nominal disposable income
                                                                                    145                 Nominal consumer spending
0                                                                              0
                                                                                    135
-1                                                                             -1
                                                                                    125

-2                           Real disposable income                            -2
                                                                                    115

-3                           Real consumer spending                            -3   105
          %QoQ
-4                                                                             -4    95
  1991       1994         1997     2000       2003     2006      2009   2012           1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

     Source: Deutsche Bundesbank                                                          Source: Deutsche Bundesbank

     Household savings rate now stable at lower level                                     Consumers deleveraged since 2000
                                                                                          % of household disposable income
14                                                                                        14                                                                                            80
                     % of disposable income                                                          Mortgage Liabilities, RHS          Non-Mortgage Liabilities
                                                                                                      Savings Rate, LHS                                                                 70
                                                                                          13
13
                                     Household savings rate                                                                                                                             60
                                                                                          12
                                                                                                                                                                                        50
12
                                                                                          11                                                                                            40

11                                                                                                                                                                                      30
                                                                                          10
                                                                                                                                                                                        20
10                                                                                         9
                                                                                                                                                                                        10

                                                                                           8                                                                                            0
 9
                                                                                               1991   1993    1995    1997       1999    2001     2003     2005    2007   2009   2011
  1991       1994     1997       2000     2003       2006     2009   2012
                                                                                                                                                                                              15
     Source: Bundesbank                                                                   Source: OECD, Morgan Stanley Research
                                                                                                                                                     MORGAN STANLEY RESEARCH
                                                                                                                                                                          Germany Economics
                                                                                                                                                                                  March 2013




Consumers: Labour Market
Unemployment in Germany vs EMU                                                                             Total pay-rolls and vacancies
                                                                                                            200                                                                              1000
  12    UE rate,%                    Unemployment, SA '000 mom                   200                                yoy K
  11                                                                                                        150                                                                              800
                                                                                 150
  10                                                                                                                                                                                         600
                                                                                                            100
                                                                                 100
   9                                                                                                                                                                                         400
                                                                                                             50
   8                                                                             50                                                                                                          200
                                                                                                              0
   7                                                                             0                                                                                                           0
   6                                                                                                        -50
                                                                                                                                                                                             -200
                                                                                 -50
   5                                                                                                       -100              Vacancies, LH                                                   -400
               Germany mom, RH                                                   -100
   4           Germany                                                                                     -150          Employment RH                                                       -600
               Euroland
   3                                                                             -150                          1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
   2000        2002        2004     2006      2008       2010     2012

 Mini-jobs distort total employment                                                                       Companies’ hiring intentions and employment trends
  3%                                                                                                        2.5                                                                              2.0
                                                                                                                                 Germany -- Employment and Hiring Plans           Forecast
                                                                                                                                                                                             1.5
  2%
                                                                                                            1.5
                                                                                                                                                                                             1.0

  1%
                                                                                                                                                                                             0.5
                                                                                                            0.5

  0%                                                                                                                                                                                         0.0

                                                                                                           -0.5
                                                                                                                                                                                             -0.5
 -1%
                                                                                                                                                                                             -1.0
                                                                                                           -1.5
 -2%
                               Total employment                                                                                                                                              -1.5
                               Employment subject to social security contributions
       % yoy                                                                                                             Employment (yoy %)           Employment Expectations, RH
 -3%                                                                                                       -2.5                                                                              -2.0
    2002   2003     2004    2005   2006    2007   2008   2009   2010   2011   2012                          Jan-2000 Sep-2001 May-2003 Jan-2005 Sep-2006 May-2008 Jan-2010 Sep-2011 May-13
               Source: Bundesbank, Eurostat, European Commission,Labour Office. Morgan Stanley Research
                                                                                                                                                                                                    16
                                                                                                                                                  MORGAN STANLEY RESEARCH
                                                                                                                                                                        Germany Economics
                                                                                                                                                                                March 2013




Consumer Confidence, Consumer Finances and Purchasing Intentions
        German consumers’ outlook                                                                  Own financial situation
                                                                                           2.0                                                                                 2.0
       3.0          Standard Deviation from                                         3.0               Standard Deviation from LTA
                             LTA
       2.0                                                                          2.0    1.0                                                                                 1.0

       1.0                                                                          1.0
                                                                                           0.0                                                                                 0.0
       0.0                                                                          0.0

   -1.0                                                                             -1.0   -1.0                                                                                -1.0

   -2.0                                                                             -2.0
                                 Recent economic situation                                 -2.0                                                                               -2.0
   -3.0                          Expected economic situation                        -3.0                                                              Expected financial situation
                                                                                                                                          Recent financial situation
   -4.0                                                                             -4.0   -3.0                                                                    -3.0
      1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012                             1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012


        German and EMU consumers                                                                   Willingness to spend
3.0
                                  Consumer confidence
                                                                                             2.5                              Purchasing intentions
2.0                     Germany          EMU
                                                                                             1.5                                                      Germany          EMU

1.0
                                                                                             0.5

0.0
                                                                                            -0.5

-1.0
                                                                                            -1.5


-2.0                                                                                        -2.5
                                        Standard deviation
                                                                                                      Standard deviation from LTA
                                        from LTA
-3.0                                                                                        -3.5
   1985      1988     1991    1994   1997     2000      2003   2006   2009   2012              1985    1988    1991    1994    1997    2000    2003    2006     2009    2012


        Source: EU Commission, Morgan Stanley Research                                                                                                                                   17
                                                                                                                                                       MORGAN STANLEY RESEARCH
                                                                                                                                                                              Germany Economics
                                                                                                                                                                                      March 2013




Consumers: Consumer Spending Indicator and Retail Indicators
   Our consumer spending indicator                                                                Retail sales and consumer confidence
   % qoq                    German Consumer Expenditure Growth            Forecast              106
               Constant                              Car registrations
                                                                                                         2005=100
   2.0         Retail sales                          Consumer confidence           2.0                                                                                            10
               Consumer Spending Indicator           Consumer spending fcast                    104
   1.5                                                                             1.5
                                                                                                102                                                                               0
   1.0                                                                             1.0

   0.5                                                                             0.5          100                                                                               -10

   0.0                                                                             0.0           98
                                                                                                                                                                                  -20
   -0.5                                                                            -0.5
                                                                                                 96
   -1.0                                                                            -1.0                                      Retail Sales, LH                                     -30
                                                                                                 94                          Cons Confidence, RH
   -1.5                                                                            -1.5

                                                                                                 92                                                                               -40
   -2.0                                                                            -2.0
     Q1 2001    Q1 2003      Q1 2005    Q1 2007     Q1 2009     Q1 2011      Q1 2013              1995    1997      1999    2001       2003    2005   2007    2009    2011


   Retail sales and current conditions                                                            Retail sales and retail expectations
    106                                                                      Std. from    50     106                                                                               20
            2005=100                                                                                     2005=100                                                    Std. from
                                                                                   LTA
                                                                                                                                                                     LTA
    104                                                                                   30     104                                                                               10


    102                                                                                   10     102                                                                               0


    100                                                                                   -10    100                                                                               -10

                                                                                                  98                                                                               -20
     98                                                                                   -30

                                                                                                  96                                                                               -30
     96                                                                                   -50

                                                                                                  94                Retail Sales, LH                                               -40
     94                    Retail Sales, LH                                               -70
                                                                                                                    Retail Business Expectations, RH
                           Retail Current Conditions, RH                                          92                                                                               -50
     92                                                                                   -90      1995    1997      1999     2001      2003   2005    2007   2009     2011
       1995     1997      1999   2001     2003     2005     2007     2009     2011
                                                                                                                                                                                               18
  Source: Statisches Bundesamt, Ifo, Morgan Stanley Research
                                                                                                                                 MORGAN STANLEY RESEARCH
                                                                                                                                                   Germany Economics
                                                                                                                                                           March 2013




Longer-Term Growth Prospects Are Rather Muted
While Germany should recover from spring onwards, our long-                  Finally, energy policy could call into question the ability to get an
term growth expectations remain more muted. Our 2014 growth                  affordable and secure supply of energy, especially electricity.
forecast of 1.6% might already surpass the rate of growth that seems         Transitioning towards a cleaner energy mix, the government aims to
sustainable in the long run. Several indicators suggest to us that the       raise the share of renewables from 20% at the moment to 50% in 2030
German economy is already running above capacity, at least at the            and 80% in 2050. An accelerated phasing-out of nuclear power is part of
margin. With resources more than fully utilised, there is a risk that        the transition. So far, the reduction in domestic nuclear power
bottlenecks emerge and the economy overheats (e.g., housing). There          generation was compensated by renewables, coal and importantly
are several potential obstacles to a rapid expansion of economic             imports. A successful transition will require large-scale investment in
activity in Germany that we are keeping an eye on at the moment: i)          power generation and distribution (see SVR). Secure energy supply is
the labour market, notably for skilled labour; ii) the state of the public   the main factor for industrial companies in deciding location (see IW).
infrastructure; and iii) the government’s energy policy in the context of    Worryingly, the frequency of critical network incidents increased
an accelerated phasing-out of nuclear power.                                 markedly last winter. A rising share of renewables could drive costs
                                                                             considerably higher too, as German households who are paying
With the actual level below the structural unemployment rate of              sizeable renewable fees can testify, thanks also to the inefficiencies in
~7%, job creation could become more difficult. A looming lack of             the EEG. For the time being, energy-intensive corporates are exempt
skilled labour has been a concern, especially in the face of adverse         from various environmental levies.
demographics, which are only partly eased by rising labour market
participation of females and foreigners. Elsewhere, a boom in jobs for
unskilled labour seems to be coming to an end, with higher minimum
wages and tighter temp work regulations. Slower growth could mean            13%                               Real GDP (% Y/Y)
rising unemployment. Hence, the government decided in early
December to extend short-shift subsidies (Kurzarbeitergeld) that             11%
                                                                                                                1951-60 = 8.1%    1961-70 = 4.5%
proved successful in preserving jobs in the last recession from six to        9%                                1971-81 = 2.9%    1981-90 = 2.3%
12 months. While cushioning the labour market, this might delay job                                             1991-00 = 1.9%    2001-10 = 1.0%
reallocation.                                                                 7%

Another factor weighing on long-term economic performance is                  5%
the deteriorating public infrastructure. Germany has the lowest
infrastructure investment among large EU countries. The share of              3%
public infrastructure investment as a percentage of GDP has been              1%
falling for years and has in fact been negative since 2003 once the
regular depreciation of the infrastructure assets is taken into account       -1%
Anecdotal evidence suggests that this lack of investment is starting to
negatively affect road transport, railways and waterways, especially in       -3%
the West German rust belt. A survey conducted by KfW of local
municipalities shows pent-up investment of ~€100 billion, notably in          -5%
education and transport (see KfW Kommunalpanel).                                 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011


                                                                             Source: Statisches Bundesamt, Morgan Stanley Research



                                                                                                                                                                    19
                                                                                                                                                 MORGAN STANLEY RESEARCH
                                                                                                                                                                       Germany Economics
                                                                                                                                                                               March 2013




 Corporates: Capex Outlook and Bank Lending to Corporates

      Capacity utilisation now decreasing fast                                                    Not Near a Credit Crunch




                                                                                               15.0     %yoy
                                                                                                                                                                                      15.0
15                                                                                       20                                                               Mortgages

                                                                                         15    12.5                                                       Loans to corporates         12.5
10
                                                                                                                                                          Loans to individuals
                                                                                         10    10.0                                                                                   10.0
 5
                                                                                         5
                                                                                                7.5                                                                                   7.5
 0                                                                                       0
                                                                                                5.0                                                                                   5.0
 -5                                                                                      -5

                                                                                         -10    2.5                                                                                   2.5
                                                                                                                   Statistical break
-10
                                                                                         -15    0.0                                                                                   0.0
-15                  Capex, RH
                                                                                         -20
                     Change in capacity utilisation, LH                           %yoy         -2.5                                                                                   -2.5
-20                                                                                      -25
  1992   1994    1996    1998    2000    2002    2004     2006   2008   2010   2012            -5.0                                                                                   -5.0
                                                                                                 Q1 1992 Q1 1995 Q1 1998 Q1 2001 Q1 2004 Q1 2007 Q1 2010 Q1 2013




      Source: Deutsche Bundesbank, Morgan Stanley Research                                        Source: ECB, Eurostat, Morgan Stanley Research; e = Morgan Stanley
                                                                                                  Research estimates




                                                                                                                                                                                         20
                                                                                                                                                              MORGAN STANLEY RESEARCH
                                                                                                                                                                                    Germany Economics
                                                                                                                                                                                            March 2013




Low Investment Spending Likely to Weigh on Long-term Growth

 Prolonged weakness in investment spending                                                 Public Infrastructure Deteriorating for Many Years
                                                                                     35
                                                                                                  Government net fixed capital formation at current prices
 24
                        Gross Fixed Capital Formation (%GDP)                         30
 23
                                                                                     25              Germany                          Spain
 22                                                                                                  France                           Italy
                                                                                     20              Netherlands
 21
                                                                                     15
 20

 19                                                                                  10

 18                                                                                   5

 17                                                                                   0
 16            Germany             EMU ex. Germany
                                                                                      -5
 15
                                                                                     -10
   1995    1997      1999        2001        2003   2005   2007   2009   2011
                                                                                           1991          1995               1999              2003        2007           2011

 Investment and Industry                                                                   Public non-residential investment
 45                                                                             11         9
                      Germany: Investment and Industry (% GDP)                                                 Germany: Investment in construction (%GDP)
                                                                                           8
                                                                                10
 40                                                                                        7

                                                                                9          6
 35
                                                                                           5
                                                                                8
                                                                                           4
 30
                                                                                7          3

                                                                                           2
 25         GVA: Industry ex. Construction                                                               Public Non-residential
                                                                                6
            Investment in Machinery and Equipment                                          1             Private Residential
                                                                                                         Private Non-residentail

 20                                                           5                            0
  1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012                              1970   1974      1978     1982      1986    1990     1994   1998    2002   2006   2010

 Source: Destatis, Ameco, Bundesbank
                                                                                                                                                                                                     21
                                                                                                                                                                              MORGAN STANLEY RESEARCH
                                                                                                                                                                                                       Germany Economics
                                                                                                                                                                                                               March 2013




Corporates: Energy Costs Increasingly Coming into Focus
 Share of renewables rising steadily                                                                    Households bear some of the costs through EEG
                        Gross Electricity Production by Source (TWh)                                                                       Electricity Prices for Housholds
                                                                                                                       Production, Transport, distribution        Electricity Tax
  700            Brown Coal       Nuclear   Stonecoal     Natural Gas      Renewable Energy    Other   25              EEG                                        §19-Contribution
                                                                                                                       KWK-Law                                    Concession-Charge
  600                                                                                                                  VAT                                        Hypothetical Price
                                                                                                       20
  500

  400                                                                                                  15


  300
                                                                                                       10

  200
                                                                                                        5
  100

     0                                                                                                  0
         1990    1992      1994    1996     1998   2000     2002        2004   2006   2008     2010             1998          2000           2002            2004        2006           2008      2010        2012


 Network incidents on the rise again                                                                   But still lagging behind many EMU partners
    25                                                                                                                        Renewable Energy in Electricity Production (2011)
                       System Average Interruption Duration Index -SAIDI
                                                                                                       100

                                                                                                        90
    20
                                                                                                        80

                                                                                                        70
    15
                                                                                                        60

                                                                                                        50
    10
                                                                                                        40

                                                                                                        30
     5                                                                                                  20

                                                                                                        10
     0                                                                                                      0
                2006          2007            2008            2009             2010           2011               NOR AT         SE    CH     PT DKK          FI   ES    IT   DE    IR    GRE FR   NL     BE   UK
                                                                                                                                                                                                                        22
  Source: Council of Economic Advisors Annual Report, Bundeskartellamt
                                                                                                                                                                                                  MORGAN STANLEY RESEARCH
                                                                                                                                                                                                                         Germany Economics
                                                                                                                                                                                                                                 March 2013




Where Has the Wirtschaftswunder Gone?
Potential output growth remains rather subdued at 1.25% on the                                                                               Low German trend growth indicates what a post-crisis euro area in
Bundesbank’s estimate (see Monthly Bulletin 12/2012). Our concern is                                                                         deleveraging mode might look like. In Germany, the reunification
that, without decisive action, it could start to fall again thanks to                                                                        bubble popped in the mid-1990s, forcing construction into a ten-year
adverse demographics and depressed investment. Next to the                                                                                   slump. Overbanked and overleveraged, Germany saw no meaningful
underinvestment by the public sector, corporate Germany has gone                                                                             loan growth in real terms since 2000 as both households and
back into cost-cutting mode and has announced more than 60,000 job                                                                           companies reduced their indebtedness. Banks looked elsewhere for
cuts in the course of 2012. Furthermore, it has been scaling back                                                                            business opportunities, some in US subprime, or the periphery. The IMF
investment in machinery and equipment since the start of 2012. Only                                                                          argues that the banking sector is still not downsized. When Germany
residential construction investment is growing at present – driven by                                                                        was branded the sick man of Europe, this seems to have caused a shift
concerns about the euro crisis at home and abroad. But residential                                                                           in consumer behaviour – and many a false start in the consumer sector
housing is not part of the nation’s productive capital stock. The capex                                                                      followed. Years of fiscal consolidation left Germany underinvested in
weakness is a concern because the global competition is unlikely to                                                                          infrastructure. While corporate restructuring led the way, the financial
abate, especially when the euro area periphery is undergoing serious                                                                         sector remains an issue.
structural changes.
                                                                                                                                             Germany’s industrial strategy allowed German exporters to gain
German Companies Back in Cost-Cutting Mode                                                                                                   global market share against a declining DM trend (see Germany
                                                                                                                                             Economics: Excelling at Exports, February 19, 2007). In addition to
                                                                                                                                             macro factors (e.g., wage moderation), micro factors are key to this
                                                                                                                                             success (see also Focus on Germany: Macro Reforms Meet Micro
70,000                                                                                                                                       Restructuring, August 24, 2005), notably so-called hidden champions[1].
                     Planned Job Reduction and Creation Since 2012
                                                                                                                                       1.4   Academic research shows that companies with above-average R&D
60,000                                                                                                                                       outperform their peers and create more jobs. As a result, the share of
                                                                                                                                       1.2   R&D-intensive companies has increased in Germany, where
                                                 Planned job creation (LHS)
                                                 Planned job reductions (LHS)
                                                                                                                                             technologically more advanced sectors account for about half of the
50,000                                                                                                                                       value-added in industry and are still gaining market share. In France or
                                                 Planned job reductions % employment (RHS)                                             1.0
                                                 Planned job creation % employment (RHS)                                                     Italy, where these sectors did not have a big share to start with, they
40,000                                                                                                                                       have been losing market share in the last ten years. Export-
                                                                                                                                       0.8   specialisation in R&D-intensive goods increased meaningfully in
                                                            0.7
                                                                                                                                             Germany and marginally in France, but declined sharply in Italy (see
30,000                                                                  0.6                                                            0.6
                                                                                                                                             DIW).
                                                                                                      0.5
20,000                                                                                                      0.4                        0.4
                                                                                                0.3
10,000                  0.2
                                                0.2                                 0.2
                                                                                                                  0.1                  0.2   [1]Despite a poor macro performance since the mid-1990s, many German companies have been
               0.2   0.2            0.1                                                                              0.1                     highly successful. Hidden champions refer to SMEs that maintain a top three position globally or
                                                                                          0.1                                    0.1         number one in Europe but typically don’t represent broadly known brands. These hidden champions
         0.0                                                      0.0         0.0                                          0.0               tend to be family-owned, excel in operational efficiency and are highly international. Sometimes they
                              0.0         0.0         0.0
     0                                                                                                                                 0.0   grow into global champions, e.g., SAP. Next to above-average revenue growth and profitability, one of
                                                                                                                                             their key characteristics is their high R&D spending (at 5% of revenues, roughly twice the average
           DE         FR        IT         ES          GR           FI         NL          BE         IRE          PT        AT              (see The German Miracle Keeps Running – How Germany’s Hidden Champions Stay Ahead in the
                                                                                                                                             Global Economy).


Source: European Restructuring Monitor, Morgan Stanley Research
                                                                                                                                                                                                                                                     23
                                                                                                                                       MORGAN STANLEY RESEARCH
                                                                                                                                                          Germany Economics
                                                                                                                                                                  March 2013




 But the German Housing Market Seems to Be Turning At Last


 Price-to-income shows significant undervaluation…                                          house price-to-rent underscores attractiveness


                  House Price-to-Disposable Income Ratio                                                           House Price-to-Rent Ratio
180                     (Long-Term Average = 100)                                     225                          (Long-Term Average = 100)
               Germany                   France                                                     Germany                France
160                                                                                   200
               Italy                     Spain                                                      Italy                  Spain
               Netherlands               Ireland                                      175           Netherlands            Ireland
140
               UK                        US                                                         UK                     US
                                                                                      150
120
                                                                                      125
100
                                                                                      100

 80                                                                                    75

 60                                                                                    50
  1993     1995        1997   1999       2001      2003   2005   2007   2009   2011     1993    1995        1997   1999   2001       2003   2005   2007     2009   2011




 Source: OECD, Morgan Stanley Research                                                  Source: OECD, Morgan Stanley Research




                                                                                                                                                                           24
                                                                                                                                     MORGAN STANLEY RESEARCH
                                                                                                                                                        Germany Economics
                                                                                                                                                                March 2013




  Construction: Residential, Corporate and Infrastructure



      Construction order volumes                                                         Construction output and orders

300
                                                   Non residential Building orders      250
275                                                                                              2005=100                                          Construction Output
                                                   Civil engineering orders             230
250                                                                                                                                                Construction Orders
                                                   Residential Building orders          210
225
                                                                                        190
200
                                                                                        170
175
                                                                                        150
150
                                                                                        130

125                                                                                     110

100      2005 =100                                                                      90

75                                                                                      70
  1992    1994   1996 1998        2000    2002     2004      2006 2008   2010    2012    1992     1994    1996    1998    2000    2002    2004   2006   2008   2010   2012




      Source: Deutsche Bundesbank, Morgan Stanley Research                               Source: Deutsche Bundesbank, Morgan Stanley Research




                                                                                                                                                                             25
                                                                                                                    MORGAN STANLEY RESEARCH
                                                                                                                                      German Economics
                                                                                                                                             March 2013



What if the Euro Overshoots?
A material EUR overshoot could derail the tentative stabilisation
                                                                            From an economic point of view, the impact of a stronger EUR is
in economic activity and the recovery in market sentiment. A key
                                                                            determined by the pattern of international trade on the share of
policy implication of a material EUR overshoot would be that the
                                                                            domestic production that is exported and on the degree of import
debate about an ECB rate reduction would be reopened, up to and
                                                                            competition, as well as the extent to which imported inputs are used in
including a deposit rate cut. In addition, a much stronger EUR could
                                                                            domestic production. The higher the share of imported inputs contained
also challenge the positive market sentiment vis-a-vis the periphery
                                                                            in goods exported, the less the domestic value added is negatively
and the structural improvements in export performance there.
                                                                            affected. In addition, exporters’ pricing power, which tends to be higher
                                                                            for differentiated products, matters and so does the size of the export
Our FX strategy team cautioned about the possibility of the EUR
                                                                            market. Together with the rate of capacity utilisation it determines
overshooting Their valuation models, which would still put EURUSD
                                                                            exporters’ pricing strategy where exporters could decide to absorb a
below fair value, suggest there is still scope for EURUSD to extend
                                                                            stronger EUR in their profit margins and protect their market share,
gains. In addition, Japanese investors are leading the way with a
                                                                            notably in large markets such as the US.
reallocation into EUR as the BoJ’s easing measures create JPY
liquidity that will be seeking higher returns overseas. As traditional
higher yielders such as AUD no longer generate the required returns,        Next to direct exports, foreign affiliate sales of euro area companies
our FX experts believe that attention will be returning to the EUR, and     abroad are another transmission channel for currency moves. Foreign
peripheral EMU. In terms of currency moves, EURJPY has been                 affiliate sales (FAS) account for a significant multiple of the direct
leading the way. But as EURUSD closes the gap this could cause a            exports, especially in the US. The FX impact on export demand, import
EURUSD overshoot to 1.40.                                                   competition and corporate profits also affects the wider euro area
                                                                            economy. The fall in output is partially offset by a fall in inflation (as
Normally, a short-lived EUR rally would not make a big difference           imports get cheaper and unemployment starts to rise). Initially, consumer
for the euro area growth outlook. But at the current juncture, the          spending is sheltered via lower domestic inflation and higher affordability
impact might be more pronounced, given only a tentative stabilisation       of imported goods while investment spending takes a serious hit.
in economic indicators, the unresolved issues regarding the EUR’s           Overall, a 10% appreciation in the euro’s external value reduces GDP by
institutional underpinnings and the ongoing rebalancing of the euro         ~ 0.5% in the first year. Hence, a material EUR overshoot could tilt
area. While a mildly stronger EUR might not necessarily be an issue         the debate on the ECB Governing Council back towards rate cuts.
for the euro area as a whole, some countries already face strong
competitive pressure and don’t have a domestic demand cushion to
offset deteriorating export demand as austerity continues to bite. This
holds in particular for Greece and Italy and to lesser extent for France,
Portugal and Spain.




                                                                                                                                                          26
                                                                                                                                             MORGAN STANLEY RESEARCH
                                                                                                                                                                         German Economics
                                                                                                                                                                                March 2013




Recovery in the Periphery vs. Impact of a Stronger Euro
Exports to the periphery are relatively small…                                           …while the EUR is not overvalued for Germany yet
                     Germany Goods Exports (%GDP)                                         1.7                  EURUSD Fair Value for EMU Countries
28
                                                  China
                                                                                                1.53
                                                  Japan                                                                                                    Fair Value Level
24                                                                                        1.5                                                              Current
                                                  UK                                                    1.41
                                                                                                               1.35
                                                  SWI
                                                                                                                        1.28
20                                                                                        1.3                                  1.26
                                                                                                                                      1.24   1.23
                                                  USA                                                                                               1.22
                                                                                                                                                               1.19     1.19

16                                                                                                                                                                             1.07
                                                                                          1.1

12                                                Other
                                                                                          0.9
 8
                                                                                          0.7
 4           Spain
             Italy
 0                                                                                        0.5
         EMU Periphery                  Other Trade Extra EMU                                   GER     IRE    AUT      FIN    SPA    POR    FRA    NET       BEL       ITA    GRE



                                         Exports to periphery over time…
                                         12            Germany Goods Exports to Euro Area Periphery (EUR bn)

                                         11

                                         10

                                          9

                                          8

                                          7
                                                                       IT ES IRE PT GR

                                          6

                                          5
                                           2000           2002      2004          2006   2008          2010           2012

                                          Source: Destatis, Morgan Stanley Research
                                                                                                                                                                                         27
                                                                                                                                                                          MORGAN STANLEY RESEARCH
                                                                                                                                                                                          German Economics
                                                                                                                                                                                                 March 2013




     Trade Pattern and Integrated Global Supply Chains Matter

     Trade pattern shows USD matters more than JPY                                                                   Foreign value added contained in exports varies
                                                                                                                     depending on integration into global supply chains

     Weights for 20 main trading
90                                                                                                              45
     partners, excluding intra-EMU
     trade
                                            Trade Weights EMU                                                                  Foreign Value Added Share of Exports (2009)                              40.4
80                                                                                                              40
        UK
70      Japan                                                                                                                                                                                    33.9
        Hong Kong
                                                                                                                35                                                                 32.0   32.3
                                                                                                    28.7                                                                    31.6
        China                                                                              14.3
60
        USA                                                                18.4
                                                                                   17.6                         30
                                                                   15.9
                                              12.1   14.9                                                                                                          25.7
                                                            19.1                                                                                 24.4       25.4
50                                   12.7                                                   8.2
                            12.5                                                                    6.3         25                      22.6
                                              7.3                  7.3     7.2     8.7      2.2     1.7
         9.4      10.8
40                                   7.3             7.2
                            7.4               1.7           7.4    1.7     1.5     2.0                                          18.9
                                     1.8             1.6                                            12.2        20     17.9
         6.2      6.1       1.0                             1.8
30       1.8      1.5                                                                      24.8
                                                                   18.5            17.1
                                              21.5   18.8                  22.9                                 15
                                     18.3
                                                            17.9
        15.1      17.7      22.5
20
                                                                                                    30.5        10
10                                   16.5     16.3   16.9          19.1            20.6    18.1
        14.3                                                14.7           15.0
                  11.9      10.4                                                                                 5
0
        AT         FI       GR       DE       IT     EMU    PT     FR      SP      BE      NT       IE           0
                                                                                                                        IT      SP      GR       AT         DE     FR       PO     BL      FI    NT     IR




     Note that that trade weights represent the global trade structure excluding the intra EMU trade over the        Source: WTO, Morgan Stanley Research
     period 2007-09. Source: ECB, Morgan Stanley Research




                                                                                                                                                                                                               28
                                                                                                                                                                                                        MORGAN STANLEY RESEARCH
                                                                                                                                                                                                                                     German Economics
                                                                                                                                                                                                                                            March 2013




Pricing Power, Profit Margins and Revenue Impact
      Export profit margins vary a great deal                                                                                         Foreign affiliate sales outgrew trade esp in US & UK
                                                                                                                                   8.0
 90                                                                                                                                                        Foreign Affiliates Sales % Exports (2009)
      Export profit margin is defined here as the share of
      manufacturing gross operating surplus (GOS) in
                                                             Export Profit Margins
      manufacturing gross value added (GVA). GOS has
                                                                                                                                   7.0         United States                                           6.8
      been estimated by subtracting manufacturing
 80   employee compensation from manufacturing GVA.                                                                                            United Kingdom
                                                                                                                                               China (except Hong Kong)
                                                                                                                                   6.0
              Belgium                                                                                                                          Japan
 70           France
              Germany                                                                                                              5.0       4.8

              Italy
 60           Netherlands
                                                                                                                                   4.0                                      3.7
              Greece                                                                                                                                                                                         3.6         3.5
              Ireland                                                                                                                                                             3.1
 50           Spain                                                                                                                3.0               2.7                                                           2.6
                                                                                                                                                                    2.4


                                                                                                                                   2.0                                                                                         1.8
 40
                                                                                                                                                            1.2                                                                       1.2
                                                                                                                                                                                                                                            1.0
                                                                                                                                   1.0
 30                                                                                                                                                                                                                                               0.4
                                                                                                                                                                                           0.3   0.3

                                                                                                                                   0.0
 20                                                                                                                                                 Germany                        Spain                     France                     Italy
       1995             1997              1999               2001    2003         2005          2007           2009    2011

  Source: Eurostat, Morgan Stanley Research                                                                                                Source: Eurostat, National Statistics, Morgan Stanley Research
                                                                    EUR appreciation and its impact on different
                                                                    Manufacturing sectors
                                                                                                                              Impact of a One Percent EUR Appreciation
                                                                                                                        Industrial Production      Producer Prices Impact on Revenues
                                                                                                                                          Size of Response in:
                                                                                                                           1Y           2Y          1Y         2Y     1Y        2Y
                                                                    Total industry (excluding construction)               -0.3         -0.4        -0.2       -0.3   -0.6      -0.7
                                                                    Manufacturing                                         -0.4         -0.5        -0.2       -0.2   -0.6      -0.6
                                                                     Manufacture of food products and beverages           0.0          0.0         -0.2       -0.2   -0.2      -0.2
                                                                     Chemicals and chemical products                      -0.3         -0.3        -0.3       -0.2   -0.6      -0.5
                                                                     Rubber and plastic products                          -0.4         -0.5         0.0       -0.1   -0.5      -0.6
                                                                     Other non-metallic mineral products                  -0.4         -0.4         0.0       -0.1   -0.4      -0.5
                                                                     Basic metals                                         -0.8         -0.7        -0.5       -0.4   -1.3      -1.2
                                                                     Fabricated metal products                            -0.3         -0.4        -0.1       -0.1   -0.4      -0.5
                                                                     Machinery and equipment n.e.c.                       -0.5         -0.8         0.0        0.0   -0.5      -0.8
                                                                     Office machinery and computers                       -0.7         -0.8        -0.3       -0.3   -1.0      -1.1
                                                                     Electrical machinery and apparatus                   -0.5         -0.6         0.0       -0.1   -0.5      -0.7
                                                                     Radio, television & communic. equip.                 -0.7         -0.8        -0.2       -0.2   -0.9      -0.9
                                                                     Motor vehicles and trailers                          -0.5         -0.5         0.0        0.0   -0.5      -0.5
                                                                     Electricity, gas and water supply                    0.0          0.0         -0.4       -0.7   -0.4      -0.7

                                                                    MIG intermediate goods industry                       -0.5      -0.5           -0.2      -0.2         -0.8      -0.7
                                                                    MIG capital goods industry                            -0.5      -0.6            0.0       0.0         -0.5      -0.7
                                                                    Consumer goods industry                               -0.2      -0.2           -0.1      -0.2         -0.3      -0.4
                                                                     MIG durable consumer goods industry                  -0.4      -0.3           -0.1      -0.1         -0.4      -0.5
                                                                     MIG non-durable consumer goods industry              -0.1      -0.2           -0.1      -0.2         -0.2      -0.3
                                                                    MIG energy                                            0.2       0.2            -0.6      -0.7         -0.4      -0.5


                                                                      Note: Yellow fields indicate that the estimate is not statistically significant. Simulated impact is                                                                              29
                                                                      the sum of the impacts for IP and PPI. Source: ECB estimates, Morgan Stanley Research
                                                                                                        MORGAN STANLEY RESEARCH
                                                                                                                      German Economics
                                                                                                                             March 2013




The Reality of Rebalancing
Investment conclusion
 •   The euro area is in the midst of rebalancing its landscape in the face of a massive rotation in the growth performance of
     individual countries. An effective intra-euro area adjustment process is key to the smooth functioning of the single currency
     and hence the longevity of the EUR. In our view, there are already encouraging signs that this adjustment process works.
     Alas, the strong but unsustainable growth rates seen before the crisis are unlikely to return anytime soon.

What's new:
 •   As such, diverging growth trajectories and current account balances do not constitute an economics problem. In fact, the
     observed patterns in Europe can mainly be explained by intra-EMU portfolio diversification, by the poorer periphery
     catching up with the richer core, by interest rate convergence towards the lower benchmark level, by different demographic
     developments and by divergent cyclical trends.

Where we differ:
 •   Higher current account balances are due to a desirable rise in capital mobility since the start of EMU. But distortions could
     have caused an inefficient allocation of capital if the risks of investing abroad have been underpriced systematically due to
     an oversupply of bank funding, weak risk management notably in banks owned by the public sector, and low funding costs
     in some current account surplus countries. In addition, investors overlooked that within EMU the volatility of asset prices
     will have to rise to compensate for the exchange rate channel no longer being able to adjust.

Current accounts should be watched closely.
 •   There are two reasons for this: to monitor changes in competitiveness, and to track the deleveraging process. The two
     aspects of the current account – the trade flows and the capital flows – underscore that the intra-euro area adjustment
     cannot be one-sided. It is as much a problem of countries allocating foreign capital inflows inefficiently as it is of other
     countries providing the funding for excessive domestic spending or housing booms.



                                                                                                                                      30
                                                                                                                                         MORGAN STANLEY RESEARCH
                                                                                                                                                            German Economics
                                                                                                                                                                   March 2013




The Reality of Rebalancing

       Current account surpluses not shrinking                                                Corresponding capital exports cause core to have
       -- rebalancing down rather than up                                                     sizeable net assets tied up in the periphery

 15               Current Account Balance (% of GDP)                     MS Forecasts                           Net Investment Position (% of GDP)
                                                                                                                                                                 Belgium
 10
                                                                                                                                                            Netherlands
  5                                                                                                                                                     Germany
                                                                                                                                                  Finland
  0                                                                                                                                 Austria
                                                                                                                                France
  -5                                                                                                                             Italy
                                                                                                                Greece
 -10                                                                                                            Cyprus
            GER                 FRA            ITA
                                                                                                           Spain
 -15        SPA                 NLD            BEL                                                      Ireland
            POR                 GRE            IRE                                                   Portugal
 -20
   1992    1994   1996   1998    2000   2002   2004   2006   2008   2010     2012         -150              -100          -50                 0             50             100




                                                         Source: Eurostat, Morgan Stanley Research




                                                                                                                                                                             31
                                                                                                                                                          MORGAN STANLEY RESEARCH
                                                                                                                                                                                    German Economics
                                                                                                                                                                                           March 2013




Export Growth, Export Orders, and Export Composition
         Merchandise exports and import growth                                                          Intra and Extra Euro Area Trade Balance
                                                                                               25                  Ex EMU Trade Balance, EUR bn                                                        25
                % YoY                                                                                              Euro Area Trade, EUR bn
   30%                                                                                         20                  EMU Imports, yoy, RHS                                                               20
                                                                                                                   EMU Exports, yoy, RHS
                                                                                               15                                                                                                      15
   20%
                                                                                               10                                                                                                      10
   10%
                                                                                                5                                                                                                      5

    0%                                                                                          0                                                                                                      0

                                                                                               -5                                                                                                      -5
  -10%
                                                                                              -10                                                                                                      -10
  -20%                      Exports                  Imports
                                                                                              -15                                                                                                      -15
                                                                                                 Jan-       Jan-     Jan-        Jan-     Jan-     Jan-   Jan-   Jan-        Jan-   Jan-    Jan-
  -30%                                                                                            92         94       96          98       00       02     04     06          08     10      12
         1996     1998     2000     2002      2004     2006     2008   2010   2012


         Export expectations and foreign orders                                                             Merchandise exports by destination
                                                                                                                                  Merchandise Exports 12M avg
   30%                                                                           25                    -5            5            15       25          35               45          55            65

   20%                                                                                       Russia                  3.4                    20.4
                                                                                 15
                                                                                       SE Asian NICs                 3.9 3.9
   10%                                                                                        Africa               1.9 1.8
                                                                                 5             China                    6.2        11.1
   0%                                                                                         Japan                1.5                  17.0
                                                                                 -5      Other Asian                               9.0 13.2                                  YoY Growth, %
  -10%                                                                                   Middle East                     2.8      7.4
                                                                                                Asia                                                                         Share in Exports
                                                                                 -15                                                 8.4 16.0
  -20%                                                                                          US                         7.3     13.6
                                                                                              EU-27                  3.4                                                                   58.3
  -30%                   Foreign Orders (yoy)                                    -25
                         Exports (yoy)                                                    Euro Area                1.9                                           38.8
                         Export Expectations, RHS
  -40%                                                                           -35                   -5            5            15             25        35           45          55            65
      1992       1995       1998      2001      2004     2007      2010   2013

         Source: Ifo, Bundesbank

                                                                                                                                                                                                             32
                                                                                                                                        MORGAN STANLEY RESEARCH
                                                                                                                                                            German Economics
                                                                                                                                                                   March 2013




 Germany Has Been Excelling at Exports


     Still showing a solid but declining export                                               After becoming much more open towards
     performance within G5                                                                    international trade


      % of Total                                          China             Germany      90
14                                                        India             US                                 Trade in goods and Services % of GDP
                                                          Japan             UK
                                                          France                         80                   Advanced Economies             Africa
12                                                                                                            Developing Asia                CEE
                                                                                                              CIS & Mongolia                 Middle East
                                                                                         70
                                                                                                              Latin America                  Germany
10                                                                                                            China
                                                                                         60

8
                                                                                         50

6
                                                                                         40

4
                                                                                         30

2                                                                                        20


0                                                                                        10
1990 1992          1994   1996 1998         2000   2002 2004   2006   2008 2010   2012        1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010




     Source: IMF, Morgan Stanley Research




                                                                                                                                                                                33
                                                                                                                                  MORGAN STANLEY RESEARCH
                                                                                                                                              German Economics
                                                                                                                                                     March 2013




 Strong Price Competitiveness But Muted Domestic Demand Dynamics



  Long-term gains on price competitiveness
                                                                               Very muted domestic demand dynamics

120                 Developments in HICP (core relative to eurozone)
           Germany                                                       150       Final domestic demand, indexed, Q1
           France                                                                            EMU
           Italy                                                         145
115                                                                                          EMU-x-Germ
           Spain
           Netherlands                                                   140                 Germany
           Belgium                                                                           France
110        Greece                                                        135
                                                                                             Italy
           Portugal                                                      130                 Spain
           Ireland
           Austria                                                                           Netherlands
105                                                                      125                 Greece
           Finland
                                                                         120                 Portugal
                                                                                             Ireland
100                                                                      115                 UK
                                                                         110
95                                                                       105
         Jan1999=100
                                                                         100
90                                                                        95
  1999           2001         2003         2005   2007   2009     2011      1999          2001        2003         2005        2007   2009   2011




      Source: Eurostat, Morgan Stanley Research                                Source: National Statistics, Morgan Stanley Research




                                                                                                                                                              34
                                                                                                                                                     MORGAN STANLEY RESEARCH
                                                                                                                                                                         German Economics
                                                                                                                                                                                March 2013




Country Discrepancies Still Deepening




       Most Countries Not Yet Back at Pre-Crisis Levels                                    European GDP growth forecasts at a glance

                                                                                                                                 2011              2012         2013e       2014e
                                   Real GDP (1Q 2008 = 100)                                EU-15                                   1.4              -0.4          -0.4         1.0
101                                                                                        EMU                                     1.5              -0.5          -0.7         0.9
                                                                                           Austria                                 2.7               0.8           0.9         1.5
 97                                                                                        Belgium                                 1.8              -0.2           0.2         1.2
                                                                                           Denmark                                 1.1              -0.6           0.5         1.7
 93                                                                                        Finland                                 2.8              -0.2           0.0         1.4
                                                                                           France                                  1.7               0.0          -0.3         0.6
 89                                                                                        Germany                                 3.0               0.7           0.5         1.6
                                                                                           Greece                                 -6.1              -6.6          -4.0         0.0
 85
                                                                                           Ireland                                 1.4               0.7           1.1         2.4
                 GER                FRA                ITA
                                                                                           Italy                                   0.6              -2.2          -1.7         0.4
 81
                 SPA                GRE                IRE                                 Netherlands                             1.1              -0.9          -0.8         0.5
 77                                                                                        Portugal                               -1.6              -3.2          -3.0         0.3
                 POR                                                                       Spain                                   0.4              -1.4          -1.5         0.8
 73                                                                                        Sweden                                  3.8               0.8           1.3         2.1
  2008               2009            2010            2011             2012   2013   2014   UK                                      0.9               0.2           0.7         1.3




      Source: Eurostat, Morgan Stanley Research estimates (2012-13)                        Source: National Statistics, Morgan Stanley Research estimates (e)
                                                                                                                                                                                         35
                                                                                                                                                         MORGAN STANLEY RESEARCH
                                                                                                                                                                             German Economics
                                                                                                                                                                                    March 2013




Main Morgan Stanley European Macro Forecasts, 2009-14E
                                                           EU-15                                      EMU                                      UK                                   Sweden
% Annual Change                         2009    2010    2011 2012e 2013e 2014e         2009 2010    2011 2012e 2013e 2014e    2009    2010    2011 2012e 2013e 2014e      2009 2010 2011 2012e 2013e
Real GDP                                 -4.3     2.0     1.4    -0.4 -0.2  1.0         -4.3  1.9     1.5  -0.5  -0.5   0.9    -4.0     1.8     0.9  -0.2   0.8   1.6      -5.0 6.3   3.8   0.8   1.4
Private Consumption                      -1.3     1.0     0.0    -0.6  0.1  0.7         -0.9  0.9     0.1  -0.9  -0.1   0.7    -3.1     1.3    -0.9   0.5   0.7   1.0      -0.2 3.9   2.2   1.4   1.7
Gross Fixed Investment                  -13.0     0.4     1.1    -2.4 -0.5  2.2        -12.8 -0.2     1.6  -3.2  -0.8   1.4   -13.7     3.5    -2.4   1.1   0.8   5.3    -15.5  6.7   6.7   3.6   1.7
Construction Investment                 -12.3     0.3     0.4    -1.2 -0.3  1.3         -9.1 -3.2     0.3  -2.5  -0.8   0.6   -26.9   13.8      0.3   4.3   1.6   4.5    -29.1 25.4   5.7   3.1   1.5
Exports                                 -11.8   10.3      6.0     1.8  2.6  2.3        -12.7 11.0     6.3   2.2   2.7   1.6    -8.2     6.4     4.5  -0.2   2.1   5.2    -12.5 10.0   7.4   0.7   2.7
Imports                                 -11.3     9.3     3.6    -0.1  1.8  1.8        -11.4  9.4     4.1  -0.6   2.0   1.2   -11.0     8.0     0.5   1.8   0.7   3.9    -14.1 11.5   6.3   0.2   3.2
Unemployment Rate (%)                     9.1     9.6     9.7   10.5  11.2 11.4          9.6 10.1   10.2 11.2    12.1 12.3      7.6     7.9     8.1   8.0   7.9   7.8       8.2 8.2   7.5   7.6   7.7
CPI Inflation (Annual Average)            0.6     1.9     3.0     2.5  1.7  1.9          0.3  1.6     2.7   2.5   1.5   1.8     2.2     3.3     4.5   2.8   2.6   2.4      -0.5 1.2   3.0   0.9   0.5
Current Account Balance (% of GDP)       -0.1    -0.1     0.1     0.8  1.2  1.3         -0.2  0.0     0.1   1.2   1.6   1.7    -1.3    -2.5    -1.9  -2.3 -2.4 -2.7         6.7 6.7   6.5   6.4   6.7
Govt. Budget Balance (% of GDP)          -7.0    -6.6    -4.6    -3.6 -3.4 -3.3         -6.3 -6.2    -4.1  -3.4  -2.9  -2.8   -11.3    -9.6    -8.0  -5.2 -6.5 -6.0        -1.0 0.3   0.4 -0.2 -0.7
Govt. Debt (% of GDP)                    74.4   80.0    83.0    88.3  90.9 91.1         80.0 85.6   88.1 93.0    95.7 95.4     53.1   60.4    66.2   74.5 77.5 80.3       42.6 39.5 38.4 37.8 37.4
Exchange Rate against US$ 1               NA      NA      NA      NA   NA   NA          1.43 1.34   1.30 1.29    1.25 0.00     0.89   0.86    0.83   0.83 0.76 0.00      10.24 9.02 8.92 8.80 8.70

                                                        Germany                                     France                                     Italy                                Spain
% Annual Change                         2009    2010    2011 2012e 2013e 2014e         2009 2010    2011 2012e 2013e 2014e     2009 2010       2011 2012e 2013e 2014e    2009 2010 2011 2012e 2013e
Real GDP                                 -5.1     4.2     3.0   0.8   0.3   1.3         -3.1  1.6     1.7   0.1  -0.1   0.8     -5.5  1.8        0.6  -2.1 -1.2    0.5    -3.7 -0.3  0.4 -1.5 -1.5
Private Consumption                      -0.1     0.6     1.5   1.2   0.6   1.3          0.2  1.4     0.2   0.0   0.1   0.8     -1.6  1.2        0.1  -4.1 -1.7    0.0    -3.8  0.7 -1.0 -1.8 -2.6
Gross Fixed Investment                  -11.9     5.8     6.6  -2.9   1.1   2.8        -10.5  1.1     3.6   0.4  -0.5   1.7   -11.7   2.0       -1.3  -8.9 -2.7    0.9   -18.6 -6.8 -6.0 -10.2 -7.2
Construction Investment                  -3.0     2.2     5.4   0.4   1.7   1.8        -12.1 -0.3     3.2   0.6  -0.5   2.3   -10.4  -3.6       -1.6  -8.3 -2.4    1.0   -16.6 -9.8 -9.0 -11.4 -7.1
Exports                                 -13.6   13.7      8.2   4.8   3.5   5.1        -11.8  9.2     5.5   2.3  -0.1   2.1   -17.7 11.2         6.7   1.9   3.0   5.0   -10.0 11.3  7.6   3.7   6.2
Imports                                  -9.2   11.7      7.2   3.3   3.7   4.7         -9.5  8.4     5.2   0.1   0.5   2.4   -13.6 12.3         1.2  -7.4   0.5   3.0   -17.2  9.2 -0.9 -3.7 -1.8
Unemployment Rate (%)                     7.7     7.1     5.9   5.5   6.0   6.0          9.2  9.3     9.2   9.8  10.2 10.4       7.8  8.4        8.4  11.0 12.7 12.8      18.0 20.1 21.7 25.1 26.8
CPI Inflation (Annual Average)            0.3     1.2     2.3   2.0   1.9   1.6          0.1  1.5     2.1   2.0   1.2   1.7      0.8  1.5        2.8   3.0   1.5   2.1    -0.3  1.8  3.2   2.4   1.8
Current Account Balance (% of GDP)        5.9     6.0     5.7   6.3   5.9   5.9         -1.5 -1.8    -2.1  -2.1  -1.8  -1.9     -2.2 -3.6       -3.1  -2.5 -0.7    0.3    -5.5 -5.5 -3.8 -2.1 -0.4
Govt. Budget Balance (% of GDP)          -3.1    -4.1    -0.8  -0.2   0.0   0.9         -7.5 -7.1    -5.2  -4.5  -3.4  -2.9     -5.4 -4.6       -3.9  -3.0 -2.5 -2.2     -11.2 -9.3 -8.9 -8.0 -6.1
Govt. Debt (% of GDP)                    74.4   82.4    80.6   81.4  80.8  78.3         79.0 82.6   86.1 90.0    92.5 93.3    116.1 118.6     120.1 126.6 128.0 126.7     53.9 61.2 68.5 86.5 95.8

                                                        Netherlands                                 Austria                                   Greece                                Finland
% Annual Change                         2009    2010     2011 2012e 2013e 2014e        2009 2010    2011 2012e 2013e 2014e     2009 2010       2011 2012e 2013e 2014e    2009 2010 2011 2012e 2013e
Real GDP                                 -3.7     1.6      1.1   -0.9 -0.6   1.0        -3.8  2.1     2.7    0.6  0.8   1.5     -2.3 -4.4       -7.1  -6.5 -4.5 -1.0      -8.5  3.3   2.7 -0.2   0.2
Private Consumption                      -2.1     0.3     -1.0   -1.3 -0.8   0.2         1.1  1.7     0.7    0.3  0.8   1.3     -1.8 -4.6       -5.5  -6.4 -4.9 -1.3      -2.9  3.3   2.4   2.0  1.0
Gross Fixed Investment                  -12.0    -7.2      5.7  -4.7  -3.1   2.4        -7.8  0.8     7.3    1.2  1.6   1.7   -11.2 -16.5     -13.8 -11.1 -11.0 -5.1     -13.2  1.9   6.8 -1.9 -1.1
Exports                                  -7.7   11.2       3.9    2.9  3.2   4.8       -15.6  8.7     7.2    2.0  2.9   4.8   -20.1   3.8        0.1   0.3   3.3   5.2   -21.3  7.5   2.6 -0.6   3.3
Imports                                  -7.1   10.2       3.6    2.6  2.4   4.7       -13.3  8.8     7.2    1.2  2.8   4.9   -18.6  -4.8     -12.8   -8.2 -7.7 -1.6     -17.2  6.9   5.7 -1.6   2.7
Unemployment Rate (%)                     3.7     4.5      4.4    5.2  5.8   6.2         4.8  4.4     4.1    4.5  4.8   4.6      9.5 12.6      17.7   23.6 24.9 24.9       8.2  8.4   7.8   7.7  8.0
CPI Inflation (Annual Average)            1.2     1.3      2.3    2.4  2.3   1.5         0.4  1.7     3.6    2.6  2.1   1.8      1.4  4.7        3.3   1.5 -0.6 -0.2       0.0  1.2   3.4   2.8  2.6
Current Account Balance (% of GDP)        5.2     7.7      9.7    7.8  8.7   9.0         2.7  3.4     0.6    1.4  1.2   1.3   -11.2 -10.1       -9.8  -7.6 -6.5 -5.5       1.8  1.5 -1.6 -1.3 -1.0
Govt. Budget Balance (% of GDP)          -5.6    -5.1     -4.4  -3.7  -3.1  -3.2        -4.1 -4.5    -2.5   -2.9 -2.6  -2.2   -15.6 -10.7       -9.6  -7.4 -6.7 -5.3      -2.7 -2.8 -0.9 -1.7 -1.5
Govt. Debt (% of GDP)                    60.8   63.1     65.5   69.4  70.5  71.6        69.2 72.0   72.4 74.3    75.8 75.7    129.7 148.3     170.6 188.8 192.0 195.1     43.5 48.6 49.0 53.5 55.4



   Notes: 1. End of period, against USD except UK and Sweden, whose exchange rates are against EUR, NA = not available
   e = Morgan Stanley Research estimates
   Source: National Statistics Offices, Morgan Stanley Research
                                                                                                                                                                                                 36
                                                                                                                 MORGAN STANLEY RESEARCH
                                                                                                                                  German Economics
                                                                                                                                         March 2013




Further Reading
Mar 4, 2013 Economics & Strategy: Framing Europe After the Italian Elections   May 3, 2012 Germany Economics: Of Pacts, Politics and Pirates


Feb 4, 2013 Strategy and Economics: What If the Euro Overshoots?               Sep 6, 2011   Germany Economics: Quo Vadis Politics?


Jan 16, 2013 Germany Economics: Politics Ahead of the Polls                    Jul 7, 2011   Germany: Industrial Production, May 2011 - Output
                                                                                             recovers beyond expectations

Jan 7, 2013   European Economics: Crisis Contained, Not Resolved
                                                                               Jul 4, 2011   Constitutional Court to Rule against Bailouts?


Aug 30, 2012 Euro Economics Strategy: Concerns about the German                May 4, 2011 Fast-Forward to Full Employment
             Constitutional Court

Jun 11, 2012 Economics and Strategy: A Road to Euro Redemption?




                                                                                                                                                  37
                                                                                                                                                                                                     MORGAN STANLEY RESEARCH
                                                                                                                                                                                                                                 German Economics
                                                                                                                                                                                                                                        March 2013




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Description: Where Has the Wirtschaftswunder Gone?