DBRS Confirms Federal Republic of Germany at AAA, Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Federal Republic of Germany’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). All ratings have a Stable trend.

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS’s view that Germany will continue to steadily reduce its public-sector debt ratio and is well equipped to respond to potential challenges. Some indicators are pointing to a deceleration in economic growth to 1.7% in 2018 compared with 2.2% in 2017, which is largely explained by sluggish external demand and some transitory factors. Concurrently, downside risks on the external front are building up. Nevertheless, DBRS expects domestic demand to continue underpinning growth in coming years. German households, firms and the public sector’s ability to absorb shocks coupled with a buoyant labour market should support domestic demand even during more turbulent times. Germany’s dynamic economy will continue to benefit fiscal revenues and reinforce the ongoing reduction of the public debt-to-GDP ratio.

Germany’s AAA rating is underpinned by its large, competitive and diverse economy. Public finances are sound, harnessed by a strong and credible fiscal framework. Germany’s robust international position provides ample buffers to absorb external shocks. In spite of these strengths, the country faces challenges stemming from its underlying demographic trends and contingent liabilities. The projected decline in the working-age population over the medium- to long-term poses significant challenges to Germany’s growth potential and to the sustainability of its public finances. Contingent liabilities, stemming from the financial system or greater fiscal burden sharing within the currency union, could pressure public finances in the future.

RATING DRIVERS

Germany is strongly placed within the AAA category. DBRS could change the trend to Negative from Stable if the country’s growth and fiscal prospects deteriorate severely enough to place the public debt-to-GDP ratio on a persistent upward trajectory. Moreover, a material crystallisation of contingent liabilities could exert negative pressure on the ratings.

RATING RATIONALE

Steadily Strengthening and Healthy Public Finances

Germany’s general government fiscal position has steadily improved since 2010, accumulating budgetary surpluses at the three tiers of government since 2014. Last year, the general government recorded a headline surplus of 1.0% of GDP, compared with a deficit of 4.2% of GDP in 2014, and a structural surplus of 1.1%. The debt brake rule and the government’s commitment to avoid issuing new debt, act as anchors for fiscal performance and have contained public spending growth. The impetus of the economy, coupled with the tax bracket creep effect, have bolstered government revenues. According to the European Commission (EC), the fiscal surplus will peak at 1.6% of GDP in 2018, as strong domestic demand spurs tax revenues and the late adoption of the 2018 budget to some extent constrains expenditures.

The coalition agreement, coupled with other quantifiable measures included in the fiscal plan, envisages a cumulative fiscal stimulus of 4.0% of GDP between 2018 and 2022. Expenditure measures amount for the majority of the fiscal stimulus (2.6% of GDP), especially current spending, while measures aimed at reducing fiscal revenues will represent 1.4% of GDP. Even accounting for this more expansionary fiscal policy, DBRS expects Germany to continue to record fiscal surpluses and to avoid net borrowing between 2018 and 2022. In the medium term, the main challenge to fiscal sustainability stems from the demographic dynamics that the country faces because of a shrinking working-age population.

The general government debt-to-GDP ratio stood at 63.9% of GDP in 2017 and is on a clear downward trend. After peaking at 81% of GDP in 2010, the debt ratio has steadily fallen on the back of sizeable primary surpluses, lower interest costs, solid economic growth performance and ongoing winding down of the resolution entities. According to the EC’s latest projections, the public debt ratio will be close to the 60% threshold in 2018 and fall further to 53.7% by 2020. This will provide valuable room for future manoeuvres against less favourable monetary or capital market conditions, a cyclical slowdown, or demographic challenges. Moreover, Germany’s safe-haven status enhances the government’s capacity to obtain financing, particularly during turbulent times. The government benefits from extremely favourable financing conditions, with a significant share of its public debt paying negative yields.

Resilient Growth in the Face of External Obstacles; However, Demographic Challenges Lie Ahead

In 2018, the German economy is set to achieve its ninth consecutive year of uninterrupted real GDP growth. A temporary slump in industrial production resulting from new car emission standards and a less supportive external backdrop has largely explained the economic contraction of 0.2% in the third quarter of this year relative to the previous one. Domestic demand continues to be the primary growth driver. A buoyant labour market, growing disposable income, favourable financing conditions and anticipated fiscal relaxation will support aggregate demand. The unemployment rate, which was 3.4% in September, indicated evidence of labour shortages and increasing wage pressures.

Latest International Monetary Fund (IMF) projections point to annual average growth of 1.5% between 2018 and 2023, although downside risks have increased. Germany’s export-oriented industrial sector, well integrated into global value chains, could disproportionately suffer from a weaker external backdrop or new tariffs. In particular, tariffs on automobile exports to the US could have a substantial impact since the US is Germany’s main importer—especially for motor vehicles. In addition, a cliff-edge Brexit, collateral effects from tighter global financial conditions, a slowdown in emerging markets or an increase in geopolitical tensions pose negative risks. However, German households, firms and the public sector’s ability to absorb shocks, coupled with a buoyant labour market, should support domestic demand even during more turbulent times. Over the long-term, the key challenge will be to manage the impact of a shrinking population on potential growth.

Risks from the Housing Market Are Contained and Banks are Resilient Despite Low Profitability

Despite the continued buoyance in the property market in Germany, DBRS views the associated macroeconomic or financial stability risks as contained. On a nationwide basis, housing prices increases since 2010 seem to largely reflect fundamental factors, such as increasing household income, immigration, supply bottlenecks and supportive credit conditions. Price pressures are more acute in certain metropolitan areas. According to the Bundesbank’s latest estimates, house prices in German cities are overvalued by between 15% and 30%. However, DBRS sees no evidence of a debt-fuelled property boom. Credit standards have eased only marginally, and lending growth remains moderate. Moreover, the resilience of the German private sector helps to cap potential credit risks. Private sector leverage remains low, and debt servicing for mortgages is generally insensitive to abrupt interest rate changes. Although German authorities have made some progress in broadening their macroprudential toolkit, the Bundesbank sees no need to activate any macroprudential instruments tailored to contain risks in the residential real estate market at the moment.

German banks’ regulatory capital ratio has increased and stood at 19.1% at Q2 2018. The European Banking Association (EBA) 2018 stress test results for the eight German banks included in the exercise confirm their resilience with a weighted average CET1 ratio at 10.2% under the adverse scenario in 2020 compared to the 15.5% CET1 ratio in 2017. On the other hand, DBRS notes that profitability remains a key challenge —in the face of a low interest rate environment and high cost-to-income ratios— as well as interest rate risks. Weak earnings power was the primary driver behind the significant capital depletion for German banks in the adverse scenario of the stress test, which could lead some banks to further strengthen their capital ratios. Furthermore, although politically challenging, restructuring efforts in the Landesbanken space could strengthen resiliency, efficiency and reduce risks in the system.

Given the high reliance of German banks on net interest income, especially small retail banks, net interest margin compression has increasingly put pressure on profitability. The overall German financial sector would benefit from a gradual increase in interest rates but both the banking and insurance sectors are vulnerable to an abrupt hike in interest rates due to a maturity mismatch. On the other hand, the favourable macroeconomic environment has translated into lower provisioning needs. Non-performing loans as a share of total loans have steadily declined to 1.5% in 2017 from 3.3% in 2009.

The External Sector Will Continue to be Extremely Strong due to Demographics and Competitiveness

The German external position and performance continues to be very strong. Large and persistent current account surpluses—averaging 5.9% of GDP between 2002 and 2017—have enabled Germany to build up a strong net external asset position. Germany’s net international investment position stood at 54.0% of GDP at YE2017. A very competitive industrial sector is to a large extent responsible for Germany’s sizeable goods trade surplus. Although some temporary and cyclical factors have helped in recent years, a range of structural long-term factors including the prospect of an ageing population is incentivising households’ savings and German firms’ competitiveness have driven the large surpluses. As consequence, households and non-financial corporation have been net lenders for several years.

Going forward, DBRS expects the current account surplus to gradually decline over time. A strengthening domestic demand, bolstered by increasing disposable income and fiscal stimulus, will likely spur the demand for imports. In contrast, export growth could prove weaker than previously expected in the wake of increasingly protectionist measures and higher cost pressures in Germany, narrowing the competitiveness gap with its European peers.

Another Grand Coalition Paves the Way for Policy Continuity

Germany benefits from strong political institutions and the rule of law. After months of negotiations after the federal elections, the Christian Democratic Union (CDU)/Christian Social Union in Bavaria (CSU) and Social Democratic Party of Germany (SPD) renewed the grand coalition government in March 2018. Following the latest federal elections, the political landscape appears more fragmented and a weaker performance of the incumbent parties in recent regional elections suggests a higher risk of snap elections or government reshuffle. These scenarios could be precipitated by the upcoming CDU leadership change following Merkel’s decision to step down as party leader. Despite the prospect of potentially heightened political uncertainty in the coming months, DBRS expects fiscal and economic policy continuity with room for moderate changes in any plausible scenario.

Exploiting some discontent associated to the massive inflow of asylum seekers in 2015/2016, the anti-immigration Alternative for Germany has gained representativeness both in the Bundestag and all regional parliaments in Germany. On the other hand, parties in the centre of the political spectrum, including CDU/CSU, SPD, Greens, and Liberal, continue to account for most of the votes.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA (high) range. The main points discussed during the Rating Committee include Germany’s economic performance and outlook, fiscal and debt metrics, financial system, and political environment.

KEY INDICATORS

Fiscal Balance (% GDP): 1.0 (2017); 1.6 (2018F); 1.2 (2019F)
Gross Debt (% GDP): 63.9 (2017); 60.1 (2018F); 56.7 (2019F)
Nominal GDP (EUR billions): 3,277.3 (2017); 3,392.2 (2018F); 3,524.1 (2019F)
GDP per Capita (EUR): 39,648.9 (2017); 40,927.3 (2018F); 42,420 (2019F)
Real GDP growth (%): 2.2 (2017); 1.7 (2018F); 1.8 (2019F)
Consumer Price Inflation (%): 1.7 (2017); 1.8 (2018F); 1.8 (2019F)
Domestic Credit (% GDP): 139.1 (2016); 139.4 (2017); 141.4 (Jun-2018)
Current Account (% GDP): 8.0 (2017); 8.1 (2018F); 7.9 (2019F)
International Investment Position (% GDP): 50.7 (2016); 54 (2017); 58.2 (Jun-2018)
Gross External Debt (% GDP): 150.9 (2016); 144.9 (2017; 146 (Jun-2018)
Governance Indicator (percentile rank): 94.2 (2017)
Human Development Index: 0.9 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in euros unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Ministry of Finance, German debt agency (Deutsche Finanzagentur), Deutsche Bundesbank, Federal Statistical Office, European Banking Association, European Commission, Statistical Office of the European Communities, European Central Bank, International Monetary Fund, Organisation for Economic Co-operation and Development, World Bank, United Nations Development Programme, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 16 June 2011
Last Rating Date: 8 June 2018

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