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Apr 18, 2003 | 15:55 GMT

5 mins read

Germany: Ratings Threats and New Challenges

Credit ratings agencies have put Berlin on notice that Germany's AAA rating might be endangered if the country's economic house isn't put into order. Germany's debt problems are about to worsen, even without a credit downgrade, as the euro matures and the European Union expands.
Standard & Poor's and Fitch Ratings, two of the world's largest credit risk ratings firms, have served notice to Germany that it could lose its premium AAA debt rating if it cannot get deficit spending under control. A lower credit rating would make it more expensive for Germany to finance its debt. Though the country's debt problems have hardly reached the Godzilla proportions of Japan's, the situation has deteriorated sharply in the past two years. Part of the criteria for joining the eurozone was that no euro country could run a deficit in excess of 3 percent of GDP. The 2000 energy shock, 2001 global recession, post-Sept. 11 fallout and Iraq-related war jitters combined to drive German growth through the floor and debt through the roof. Germany's budget deficit is now 3.4 percent of GDP, unemployment stands at 11 percent and GDP is stagnant, with no signs that the situation will rectify itself anytime soon. STRATFOR doesn't actually expect a credit downgrade this year — Germany is simply too big to fall quickly, and its current rating outlook is neutral, not negative. But Berlin is doing very little to avoid a drop in overall economic performance. Chancellor Gerhard Schroeder has proposed some modest reforms that are indeed a step — if a timid one — in the right direction, but the only real passion in the political system comes from the legislators and ministers who would like to see a German counterweight to the American credit ratings firms. Economics work differently in Europe, you see. But Berlin's problem is more complicated than simply a matter of bad domestic policies. The international climate in which the country is competing for investors' cash also has become more difficult. Though Germany has rarely had problems recruiting buyers for its debt, several European states that used to be in different risk baskets have seen their credit ratings rise in recent years, partly via their association with Germany and France via the euro. Though this is broadly beneficial to Europe as a whole — easier credit terms, better liquidity and more wealth and economic activity — it also has placed most of the debt issued by the other European governments in the same risk basket as German debt. The sheer size of the German economy, some $1.9 trillion, has allowed the country's debt to remain in fashion, but since the euro's adoption Germany has gone from one of five states with a premium debt rating to one of seven, with five others rapidly closing the gap. The result is pressure on German debt sales just as the country's economic performance — and the all-important credit rating — is being called into question.
That competition for a finite number of debt-financing euros is about to intensify. In June 2004, 10 new states will join the EU, and all will likely be rewarded with immediate credit ratings increases — based both on their own merits and their closer association with Europe. That means that Germany is about to become one in 22. As with the formation of the eurozone, this evolution was by design. One of the EU's primary tenets is to promote economic convergence of its members. But what was not anticipated was that by making things easier for the Union's poorer members, things would necessarily get more difficult for Germany. This will make the chancellor's job more difficult in the coming 18 months. The Iraq war has Berlin in the "extraordinary circumstances" it needs to temporarily get away with its deficit spending. The brevity of the war, however, means that this window is narrow and closing. The pressures of the Stability Pact (which was, incidentally, written by Germans) will return shortly. With them will come all the normal issues associated with high deficits. Chronically high deficit spending tends to drive up interest rates as the government competes with private businesses for available capital. It also tends to gobble up resources, spiking the inflation that has been the avoid-at-all-costs bugaboo of European policymakers for decades. Throw in a gaggle of new Central European EU members, whose presence in the club will make financing German debt more costly, and Germany could well become a state locked into a cycle of high debt and low growth. The bottom line is that even without another credit downgrade, the cost of financing Germany's debt is about to rise. That will make it more difficult for Schroeder — or in STRATFOR's view, whoever replaces him — to use government spending to jumpstart the nation's economy. Just as the rest of Europe has benefited from association with Germany, the state's continued inability to get its economy growing now acts as an anchor weighing down growth on the continent as a whole. So far, Europe has avoided the worst. France and Italy, while not exactly dynamic, have generated enough growth to keep the EU lurching forward, but this state of affairs cannot last. Unlike defunct Japan, which depends upon the rest of the world for about one-fifth of its economy, nearly three-fifths of German GDP — some $1 trillion — revolves around international trade. About half of that is with the current EU-15. Germany's situation might not yet be as intractable as Japan's, but a Japanese-style shriveling in Germany would hurt Europe far more than Japan's narcosis has harmed Asia.

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