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ab
The return of the Teutonic Tiger
Export strength blessing and curse
Germany faces long-term structural challenges
Investing in Germany
Germany in the fast lane
UBS research focusWealth Management Research
October 2010
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Germany in the fast lane2
Contents
UBS research focus
This report has been prepared by
UBS AG. Please see important disclaimer
at the end of the document. Past per-
formance is not an indication of future
returns. The market prices provided are
closing prices on the respective principal
stock exchange.
Publisher
UBS AG, Wealth Management Research,P.O. Box, CH-8098 Zurich
Editor in Chief
Dirk Faltin, Economist, UBS AG
Editors
Roy Greenspan
Anna Foca
Authors
Lena Lee Andresen, Strategist, UBS AG
Dirk Eenberger, Strategist, UBS AG
Dirk Faltin, Economist, UBS AG
Gerit Heinz, Analyst, UBS Deutschland AG
Andreas Hfert, Chief Economist, UBS AG
Markus Irngartinger, Strategist, UBS AG
Daniel Kalt, Economist, UBS AGGeorg Klein-Siebenbrgen, Analyst,
UBS Deutschland AG
Caesar Lack, Economist, UBS AG
Philipp Schttler, Strategist, UBS AG
Andr Schtz, Analyst, UBS Deutschland AG
Thomas Wacker, Analyst, UBS AG
Editorial deadline
1 October 2010
Project Management
Valrie Iserland
Desktop
WMR Desktop
Translation
24 Translate, St. Gallen, Switzerland;CLS Communication, Basel, Switzerland
Pictures
www.dreamstime.com
Printer
Fotorotar, Egg, Switzerland
Languages
Published in English, German and Spanish
Contact
UBS homepage: www.ubs.com
SAP-No. 82092E-1007
Editorial ..................................................................................................... 3
Highlights .................................................................................................. 4
Chapter 1
The return of the Teutonic Tiger ................................................................. 6
Chapter 2
Export strength blessing and curse ........................................................ 12
Chapter 3
Germany faces long-term structural challenges ........................................ 18
Chapter 4
Investing in Germany ............................................................................... 26
Bibliography ............................................................................................ 32
Selected UBS WMR publications .............................................................. 33
Order or subscribe
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UBS research focus October 2010 3
Dear reader,
Like a phoenix rising from the ashes, the German economy has staged a remarkable re-
covery so far this year. During the dark days of 2009, the economy contracted at its fast-
est pace in post-war history; this year, Germany is surging ahead of its peers. Even unem-
ployment, which has been Germanys Achilles heel for so long, is falling at an astonish-
ing pace recently reaching levels last seen nearly 20 years ago. Indeed, among the
major economies, Germany stands out in that its unemployment rate is now lower than
before the global economic recession.
How durable Germanys economic comeback is remains an open but important question,given its status as Europes largest economy, with 82 million people and a gross domestic
product of EUR 2.4 trillion (USD 3.23 trillion). Are we witnessing a new economic mira-
cle like the so-called Wirtschafswunderthat followed World War II? Or has the German
economy simply launched a short-lived breakaway, destined to rejoin the rest of the de-
veloped economies grinding along at a snails pace?
Continued success for Germany could be seen as vindication for the European economic
and social model. Indeed, in countries where the usefulness of more scal spending is
hotly debated, many experts are studying the German example, where early and decisive
scal consolidation has not stood in the way of a strong economic recovery.
Some policy makers in Germany are even using their newfound position of strength to
demand that weaker economies especially in peripheral Europe try to emulate the
German growth models focus on exports and competitiveness. But can the export-led
German economy maintain its dazzling performance if the export eld becomes over-
crowded with would-be competitors? And what if Germanys outperformance ultimately
depends on its trading partners spending beyond their means?
Investors looking to benet from the German economic powerhouse must confront
these questions in order to determine the best investment strategy. In this issue of
UBS research focus, we provide investors with extensive background on Germanys cur-
rent growth, its near-term outlook and long-run structural prospects. By tracing key
trends arising from the composition and cyclical character of the German economy, we
are able to identify some likely winners and losers from the current high-growth, low-
interest environment. We hope you will nd our advice useful.
Editorial
Andreas Hfert
Dirk Faltin
Andreas Hfert
Global Head
Wealth Management Research
Dirk Faltin
Head Thematic Research
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Germany in the fast lane44
Germany in the fast lane
The return of the Teutonic Tiger
Germanys brisk recovery in 2010, likely ahead of
all major economies this year, will probably fade
somewhat in the second half and into 2011. Nev-
ertheless, Germanys exceptionally strong export
position is bolstered by the still relatively weak
euro, which should remain a support for growth
in the near term. As long as global demand is
buoyant, Germany stands to benet. These fac-
tors also support the domestic economy in this
cycle. Importantly, Germany is unburdened by thedirect eect of a burst housing bubble, and pri-
vate sector nancial balance sheets are generally
strong. The performance of the labor market has
also been impressive. Interest rates are an issue to
watch: The current Eurozone rates are too low for
Germany and the risk of a housing bubble cannot
be ignored. But in the near term, we think
growth in Germany is likely to surprise positively,
in absolute terms and compared with other econ-
omies. The biggest risk to this favorable cyclical
outlook stems from any potential renewed slump
in global demand. For Europe as a whole, Germa-
nys return to strong growth this year is a double-
edged sword: It raises economic activity across
the continent, while at the same time fueling
long-standing imbalances.
Export strength blessing and curse
Germany undoubtedly has one of the most suc-
cessful export economies in the world. The coun-
trys export strength is based on its ability to pen-
etrate high growth markets, especially in the
Central and Eastern Europe (CEE) region and in
Asia, and on its superior competitiveness gained
through corporate restructuring and wage mod-eration. Thus, Germanys advantages in foreign
trade are of a lasting nature and they allow Ger-
many to benet more during global cyclical up-
swings than most of its peers. However, this trade
dependency has its downsides as well. During
economic downturns Germany tends to suer
more than comparable countries that are less
dependent on global trade. Also, Germanys
growth model may be vulnerable to protection-
ism, to structural shis in its main trading part-
ners and to lower-cost competition. Importantly,
Germanys export success does not seem to ben-et the German people at large. In our view, it
will be important to achieve a more balanced
growth model in future.
Germany faces long-term structural
challenges
Germanys strong cyclical growth before and aer
the global recession has diverted attention from
its weak average growth performance this dec-
ade. Germanys rapidly aging society, which com-
pares unfavorably to most of its peers, is a key
challenge to its growth potential. The results of
Germanys very low birth rate are practically irre-
versible now, especially since immigration will
probably not be able to stabilize the population.
Highlights
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UBS research focus October 2010 5
Labor market participation is already quite high,
meaning that the potential to oset the decline in
population by expanding the potential labor force
is limited. However, annual working hours are
very low in Germany and could be raised to partly
oset the negative eects of a shrinking labor
force. Capital accumulation, which in theory
could substitute labor, will not be raised signi-
cantly, in our view. However, there would seem
to be scope for improving total productivity, by
countering adverse trends in Germanys innova-tion potential and by continuing reforms of the
education system, including the implementation
of an immigration policy that attracts highly edu-
cated immigrants.
Investing in Germany
The outlook for German equities is positive: they
should benet from the global recovery even if it
continues at a more moderate pace going for-
ward. If Germany manages to tilt its economic
structure more towards consumption, the cyclical
swings of the stock market might also be less
pronounced in the future. In any case, it seems
prudent to add some consumer-related stocks to
German portfolios, as we think the biggest
bounce of the global economy lies behind us andthe German consumer seems to be in good mood
not least thanks to the favorable labor market
conditions. A slide back into recession though
not our base case could have severe negative
eects on German equities due to their cyclical
bias. German government bonds rank among the
safest bonds issued by Western countries. How-
ever, current yield levels lead us to conclude that
longer-dated maturities should be avoided and
that investors should seek alternatives beyond
government bonds.
Germany in the fast lane
Industrial recovery is much stronger in Germanythan in the Eurozone as a whole
Industrial production, index levels
Source: Reuters EcoWin, UBS WMR
90
80
85
95
100
105
110
120
115
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Germany Eurozone
Export market shares of the biggest exporters
Source: WTO database, UBS WMR
% of total world exports
2
0
4
6
8
10
12
14
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
USGermany JapanChina
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Germany in the fast lane6
Chapter 1
The return of the Teutonic Tiger
Germany is back. During the global economic
crisis German output contracted more than
in most comparable countries. Now the
countrys economy has regained its pre-crisis
strength. The cyclical outlook remains favo-
rable.
Germany has been surprising people lately. The
worlds fourth-biggest economy has long been
admired for its efciency, innovation and skilled
and disciplined workforce. Yet critics have alsoscorned Germanys inexibility, costly social sys-
tem and opaque web of banks and industry. Ger-
manys recent economic surge has led some to
praise its superior competitiveness, while others
complain that the countrys growth model beg-
gars its European neighbors and other countries
as well.
In this UBS research focus we take a close look at
the German economy. We assess its near-term
outlook and its longer-term structural prospects.
The present chapter discusses the business cycle
in Germany. In the second chapter we examine
the implications of Germanys reliance on export-
driven economic growth. In the third chapter we
round out the picture by looking at structural
trends and challenges and the longer-term out-
look for Germany. The nal chapter interprets our
ndings from an investors point of view.
Germany regains its pre-crisis punch
Four years ago, Germany was hailed as the Teu-
tonic Tiger, an exporting powerhouse and the
growth engine of Europe. In 2006, the future
looked bright for what was then the third-largesteconomy in the world. Unlike most of its Euro-
pean peers, Germany had seemingly found the
recipe for participating in the rapid development
of the emerging economies in Central and East-
ern Europe (CEE) and Asia. Then came the global
recession, starting in late 2007. During the down-
turn, Germany suered more than most other
comparable economies at least in terms of lost
output. Now, with the global recession over, the
German economy appears to have recovered its
pre-crisis strength.
In the rst half of 2010, the German economy
boomed. In the second quarter alone, it grew at
the fastest pace since reunication, back in 1990.
Up 2.2% from the rst quarter (an annualized
rate of over 9%), Germanys growth challenged
even that of China. Full-year growth is now likely
to exceed 3% for 2010. Needless to say, this
surge puts Germany ahead of every other country
in the Eurozone, the 16 countries sharing the
euro common currency. Figure 1.1 makes it clear
that Eurozone industrial activity is practically en-
tirely Made in Germany.
However, before we get too excited, these num-
bers need to be put into perspective. The sharp
rebound this year comes aer a nearly 5% con-
traction of the German economy in 2009. Indeed,
the total output loss during the crisis amounts to
more than 6.5% (measured from the peak in
Fig. 1.1: Industrial recovery is much stronger in Germany
than in the Eurozone as a whole
Source: Reuters EcoWin, UBS WMR
Industrial production, index levels
90
80
85
95
100
105
110
120
115
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Germany Eurozone
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UBS research focus October 2010 7
The return of the Teutonic Tiger
early 2008). Hence, even if the current speed of
recovery could be maintained, it would take an-
other year to fully make up for the output lost
during the crisis.
Exports feed German growth
The recovery in the rst half of this year reected
a surge in foreign demand for German merchan-
dise. Exports jumped by more than 8% in the
second quarter of 2010 compared to the rst
quarter, the strongest expansion since 1990. Im-ports also grew by a robust 7%. Thus, net trade
exports minus imports directly accounted for
nearly half of the expansion in the second quar-
ter. Domestic demand was also strong, but much
of this strength, especially in corporate invest-
ment spending, was also ultimately due to the
surge in foreign demand (see Fig. 1.2).
Why Germany is an export champ
We will examine the structural reasons for Germa-
nys trade success in detail in the second chapter.
Here, it sufces to say that German exporters greatly
benet from some broad economic developments.
For one thing, Germany embraced globalization
early and earnestly. It also sharpened its price com-
petitiveness through corporate restructuring, pro-
duction outsourcing to lower-cost countries, and
wage moderation, to name a few key factors.
German exporters have also had a boost lately
from the euros weakness.1 The so-called real
eective euro exchange rate, which compares the
euro to a basket of trading partners currencies,
has depreciated by about 6.5% over the rst six
months of 2010, compared to the previous six
months. According to OECD estimates, a 10%
depreciation of the euro would add about 1% to
German GDP in each of the next two years.2
At rst glance, these numbers suggest that the
lower real eective euro exchange rate could
boost German GDP by 0.6 to 0.7% next year and
beyond. The government debt crisis in Greece
and the precarious scal situation in other coun-tries of the Eurozone are behind the weaker euro.
We think this dynamic makes it likely that the
euro exchange rate should remain favorable for
German exporters in 2011.
The relatively weaker euro also puts German ex-
porters at a relative advantage versus their Euro-
zone competitors. To get a sense of the magni-
tude of this advantage, we consider the so-called
purchasing power parity (PPP) for dierent Euro-
pean countries. The PPP exchange rates represent
long-run equilibrium exchange rates. As shown in
Figure 1.3, Germanys long-term PPP against the
US dollar is nearly 1.5, compared to only 1.25 for
the Eurozone as a whole. For the less competitive
southern European countries, the comparable PPP
exchange rates are even lower, just below 1.2.
The average euro-US dollar exchange rate this
Fig. 1.2: Net trade was the main driver of economic activity
Source: Reuters EcoWin, UBS WMR
Quarterly real GDP growth composition, in %, y/y
7
9
5
3
1
1
3
5
2007 2008 2009 2010
Domestic final consumption Investment Net trade
Fig. 1.3: Germany can live with a higher euro exchange rate
Source: Reuters EcoWin, UBS WMR
Euro/US dollar exchange rates in purchasing power parities (PPP)
Portugal
Greece
Italy
Spain
Netherlands
Austria
France
Germany
0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6
Eurozone total average
1 Note that despite the recent appreciation, the euro is stillrelatively weak when compared to a basket of currencies.2 OECD (2001)
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Germany in the fast lane8
Chapter 1
year has so far been around 1.3. From the PPP
rates, it is clear that Germany can successfully
compete at such an exchange rate, while most
other Eurozone exporters struggle to sell their
products abroad.
Germanys export-driven rebound in the rst half
of 2010 also simply reects the severity of the
decline in 2009. Germany is recovering faster in
2010 because it contracted faster in 2009 (see
Fig. 1.4). Thus, global trade fell about 20% frompeak to trough, partly sentiment-driven. When
condence revived, orders that had been on hold
were reactivated. German exports dropped about
25% in 2009 and are now beneting more from
the correction than most other countries. Since
the lows in May 2009, German exports have now
risen some 30%, nearly regaining pre-crisis levels.
Export demand likely to fade
Foreign demand for German goods may moder-
ate in coming months and in 2011 given that the
scal programs launched in many countries
worldwide in response to the crisis are set to ex-
pire. While the German government implemented
its own signicant measures to support the econ-
omy, the countrys export orientation meant that
it also beneted from the spending programs of
its main trading partners. For example, Chinese
demand for German-made goods accounted for
only 2% of the 25% drop in German exports last
year. Yet orders from China contributed some 9%
to the 30% recovery, due in no small part to the
large Chinese scal stimulus package, of some
EUR 400 billion.
More than just exports
While exports are clearly the mainstay, the big
surprise in Germanys economic data in the sec-
ond quarter was robust domestic demand. Private
households, government spending and corporate
investments all contributed. Indeed, total domes-
tic demand accounted for 1.4% of the 2.2%
expansion in the second quarter, the most since
2006. Aer three negative quarters, consumer
spending rose by a healthy 0.6% in the second
quarter.
Gross xed investments posted a solid improve-
ment in the rst half of 2010, with investment in
machinery and equipment soaring 4.4% per
quarter. Construction investment rose even faster
in the second quarter, also reecting the excep-
tionally long and cold winter, which put many
construction projects on hold until the second
quarter.
Fiscal policy and the labor market miracle
A number of other factors also supported Germa-
nys domestic demand. First, as noted, the Ger-
man government launched a big scal stimulus
package in 2009, topped only by the US, Canada
and Australia among the G7 economies. It may
have accounted for about 3% of 2008 GDP. The
impact of these measures should be visible in
2009 and 2010 in roughly equal shares.3
Fig. 1.4: German exports recovered rapidly
Source: Reuters EcoWin, UBS WMR
Exports as % of GDP
23
18
28
33
38
43
1995 1997 1999 2001 2003 2005 2007 2009 2011
Germany France Italy UK
3 OECD (2009)
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UBS research focus October 2010 9
The return of the Teutonic Tiger
The unexpectedly strong labor market also bu-
oyed domestic demand. Germany is the only
large economy where, aer the global crisis, un-
employment is lower than before it. Indeed, as
Figure 1.5 shows, Germanys unemployment rate
rose only 0.7% to a peak of 8.3%. It then edged
lower, averaging around 7.8% in the rst half of
2010. In contrast, the Eurozone unemployment
rate rose by almost 3% during the crisis, and now
hovers at a high 10%.
This solid labor market performance, in our view,
reects Germanys exceptional social cohesion.
Companies asked employees to work part-time to
avoid large-scale layos. The government helped
with short-shi subsidies to as many as 1.5 mil-
lion workers at one time. Payrolls have proven
relatively robust, expanding at a monthly rate of
around 30,000 workers (equivalent to an annual-
ized rate of 1%) over the summer months. We
think employment prospects are brightening as
companies hiring intentions are up sharply and
consumers unemployment worries are steeply
down. As workers went full-time again and, in
some cases, even to overtime, compensation per
employee recovered meaningfully in the rst half
of 2010, which should support consumer spend-
ing in the coming months.
Firms and households not overleveraged
Unlike many of its peers, Germany did not have a
housing bubble. As shown in Figure 1.6, German
house prices have been stable throughout most
of this decade, while house prices in Spain and
Great Britain more than doubled. Of course, Ger-
man private households and, in particular, thebanking sector, were hurt by the bursting of
housing bubbles in other countries, but at least
there was no such bubble at home. In sum, Ger-
man households and companies do not hold ex-
cessive amounts of debt. German households and
rms did not expand their debt level over the last
decade, in contrast to many of its European
neighbors (see Figs. 1.7, 1.8, 1.9).
Interest rates too low
Does all this mean that the German economy has
de-coupled in a sustainable way from the otherdeveloped economies? The answer is no. Germa-
nys trade-dependence means that its growth
performance is clearly linked to that of its trading
partners. However, there is a nal and, in our
Fig. 1.5: Germanys unemployment rate is falling rapidly
Source: Reuters EcoWin, UBS WMR
In %
7
6
8
9
10
11
12
13
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Germany Eurozone
Fig. 1.6: German house prices have remained stable
Source: Reuters EcoWin, UBS WMR
House price index (1995 = 100)
100
80
120
140
160
180
200
1995 1997 1999 2001 2003 2005 2007 2009 2011
Germany Eurozone
Fig. 1.7: German households have improved theirbalance sheets
Source: Reuters EcoWin, UBS WMR
Net assets of private sector excluding financial sector (% of GDP)
50
0
100
150
200
250
300
1999 2000 2001 2002 2003 2004 2005 2006 2007 20092008
Germany Eurozone (ex Germany)
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Germany in the fast lane10
Chapter 1
view, especially important factor supporting both
consumer spending and corporate investment is
Germanys historically low interest rates. The Eu-
ropean Central Bank has cut its short-term policy
rate to a record low of 1%, particularly to support
those economies that are laboring from past ex-
cesses in their housing markets. For Germany,
however, current interest rates are clearly too low.
Figure 1.10 shows so-called Taylor interest rates,
which combine data about economic activity andination to indicate the appropriate level of short-
term interest rates. By this measure, current short-
term interest rates are more than one percentage
point too low for Germany.
The upshot is that the German economy is over-
stimulated, a fact that should not be underesti-
mated. Unduly low interest rates contributed
greatly to the housing bubbles in Spain and Ireland,
and triggered a more traditional consumption
boom in Greece. Earlier in the decade, suering
from weak demand, Germany needed low rates. As
it accounts for roughly a third of the Eurozone
economy, the European Central Bank (ECB) set
rates to t Germanys needs. These were clearly too
low for many of the other countries. We see an
increasing risk of some form of over-investment or
real estate bubble forming in Germany if interest
rates remain so low for much longer.
The recovery is a double-edged sword
Germanys strong economic rebound this year has
been greeted with mixed feelings among its neigh-
bors. As the biggest economy in Europe, it pushes
up demand for the products of other Europeancountries. On the other hand, Germanys export-
led rebound fuels the current account imbalances
that are at the heart of the sovereign debt prob-
lems facing some Eurozone countries. Ironically,
over the last few months, many in Germany have
chastised other Eurozone countries, most notably
Greece, for their proigacy, not realizing that
these excesses create the trade and current ac-
count surpluses that allow the German govern-
ment to run smaller budget decits especially if, as
we believe, interest rates will remain too low for
Germany for a considerable period of time.4
Fig. 1.8: German households were net lenders prior tothe recession
Source: Eurostat, UBS WMR
Note: Eurostat statistics in focus, 29/2009.
Net lending/borrowing of households, as % of disposable income, 2007
30
20
10
10
0
20
UK
Spain
US
Netherlands
EU
Belgium
Italy
France
G
ermany
Austria
Ireland
Gross household savings rate, 19952007 Gross household investment rate,19952007Net lending (+) / borrowing (), 19952007
Fig. 1.10: Taylor rate shows that interest rates are toolow for Germany
Source: Reuters EcoWin, UBS WMR
0
1
1
2
3
4
5
6
In %
2002200120001999 2003 2004 2005 2006 2007 2008 2009 2010
3-month Libor Taylor rate for Germany
Source: Eurostat, UBS WMR
Fig. 1.9: German companies were net lenders prior tothe recession
Note: Eurostat statistics in focus, 28/2009.
Net lending/borrowing of companies, % of gross value added, 2007
4030
1020
302010
0
40
France
Italy
EU
Austria
US
Ireland
Belgium
Germany
UK
Netherlands
Spain
Gross fixed capital formation, 19952007 Gross savings, 19952007
Net lending (+) / borrowing (), 19952007
4 For a detailed discussion of these issues, please refer tothe August UBS research focus, entitled The future of theeuro.
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UBS research focus October 2010 11
The return of the Teutonic Tiger
Conclusions
Germanys brisk recovery in 2010, likely ahead of
all major economies this year, will probably fade
somewhat in the second half and into 2011. Nev-
ertheless, Germanys exceptionally strong export
position is bolstered by the weak euro, which
should remain a support for growth in the near
term. As long as global demand is buoyant, Ger-
many stands to benet. These factors also sup-
port the domestic economy in this cycle.
Importantly, Germany is unburdened by the direct
eect of a burst housing bubble, and private sec-
tor nancial balance sheets are generally strong.
The performance of the labor market has also
been impressive. Interest rates are an issue to
watch: They are too low for Germany and the risk
of a housing bubble cannot be ignored. But in
the near term, we think growth in Germany is
likely to surprise positively, in absolute terms and
compared with other economies.
The biggest risk to this favorable cyclical outlook
stems from any potential renewed slump in global
demand. For Europe as a whole, Germanys re-
turn to strong growth this year is both a blessing
and a curse, as it raises economic activity across
the continent, while at the same time fueling
long-standing imbalances.
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Germany in the fast lane12
Chapter 2
Export strength blessing and curse
Germany is the export champ of Europe. Its
brisk export-driven recovery underpins our
positive near-term outlook on the German
economy. In this chapter, we take a close
look at Germanys export strength and con-
sider its benets and its drawbacks.
Until this year, when it was surpassed by China,
Germany was the worlds biggest exporter of
goods. Between 1995 and 2007 exports in-
creased by 8% and imports by around 7% peryear, on average. The strong increase in both im-
ports and exports in recent years led to the emer-
gence of the so-called bazaar theory, according
to which Germany is increasingly becoming a
trading place for goods and services (see Box 1).
Surely, one major factor driving Germanys export
growth has been the rapid expansion of the glo-
bal economy, which by extension increased the
market for Germanys exports. Between 2000
and 2007, the size of the potential export market
(measured as the weighted sum of goods and
services imports by Germanys trading partners)
increased by more than 50%. Other countries
experienced similar increases in their potential
export markets, but what sets German exporters
apart is their ability to maintain and in some cases
increase market share in the face of growing
competition from low-cost emerging countries
(see Figs. 2.1 and 2.2).
Germanys export success is driven by
cost-competitiveness
Germanys exceptionally strong export perform-
ance has generated much speculation about its
sources. Most studies nd that the market-share
gains resulted primarily from improvements in the
price-competitiveness of German products.
Fig. 2.1: Destination of German exports
Source: Federal Statistical Office, UBS WMR
% of total exports, 2008
10
0
20
30
40
50
60
Japan
Africa
Russia
Mid
dleEast
China
Oilexporters
US
CEE
Asia
Non-
Eurozone
Eurozone
EU-2
7
Fig. 2.2: Export market shares of the biggest exporters
Source: WTO database, UBS WMR
% of total world exports
2
0
4
6
8
10
12
14
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
USGermany JapanChina
German goods ll
Asian harbors
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UBS research focus October 2010 13
Having adopted the euro in 1999 at a somewhat
overvalued exchange rate, German exporters
sought to restore price competitiveness by push-
ing for wage moderation. As a result, wages grew
only very little in the rst half of this decade. In
2008, the level of real wages, adjusted for ina-
tion, was virtually the same as in 2001 (see Fig.
2.3)1. Secondly, German companies also sought
to take advantage of lower production costs by
o-shoring parts of their production chain, espe-
cially to the Central and Eastern European (CEE)
countries (see Fig. 2.4)2.
1 The prolonged eort to contain costs through wage mod-eration was diluted by the appreciation of the euro be-tween 2002 and 2008. That means that Germanys cost-competitiveness improved primarily versus other Eurozonecountries, which explains the signicant rise of Germanysexport market share within the Eurozone.2 Outsourcing and o-shoring can also explain the surge inGerman exports to these countries as the foreign-basedsubsidiaries or contracting rms are likely to have been
equipped at least in part with capital goods produced inGermany, and they are sourcing intermediate inputs fromthere (Bundesbank, 2006a). Similarly, the sharp increase inimports from Central and Eastern Europe might be ex-plained by subsidiaries or contracting rms supplying inter-mediate or nished products to German parent companies.
Export strength blessing and curse
Box 1: Germanys export bazaar
The bazaar theory was rst proposed by the inu-
ential German economist Hans-Werner Sinn (Sinn,
2006). He argued that Germany is turning into a
trading place, or bazaar, as its share of production
content, in terms of total value added, diminishes.
According to Sinn, high and inexible domestic
wages force German companies to respond tolow-cost competition by shiing parts of their pro-
duction to lower-cost countries. This output is then
re-imported and the nished product is Made in
Germany, commanding a premium price.
While this is a normal consequence of globali-
zation, Sinn argues that it has gone too far. He
feels it prevents domestic wages from adjusting
sufciently to the levels of wages in the lower-
cost countries. As a result, Germany is gradually
losing its production capabilities and degenerat-
ing into a mere trading place, or bazaar.
Some economists dispute Sinns conclusions,
arguing that oshoring has not reduced thedepth of production in Germany, but simply im-
proved price competitiveness. What is more,
Marin et al. (2003) nd that multinational rms in
Germany are not outsourcing the low-skill parts
of production, but rather the most skill-intensive
activities, oen to Eastern Europe. This has impor-
tant implications for education levels in Germany,
which we will discuss in the next chapter.
Fig. 2.3: Weak wage growth in Germany
Source: Reuters EcoWin, UBS WMR
Nominal and real wage growth, in %, y/y
1
2
0
1
2
3
4
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Germany, nominal wages
Eurozone, nominal wages
Germany, real wages
Fig. 2.4: Germany has gained price competitiveness
Source: Reuters EcoWin, UBS WMR
Real effective exchange rates (at unit labor costs)
Falling price competitiveness
Rising price competitiveness8580
9095
100105110115
125120
1994 1996 1998 2000 2002 2004 2006 2008 2010
SpainFrance ItalyGermany
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Germany in the fast lane14
and in the longer run by non-price factors
In contrast to cost or price factors, non-price fac-
tors, such as quality improvements or efciency
gains, seemed to have played only a minor role
during the pre-crisis export boom. In the longer
run, however, non-price factors are important.
Thus, Danninger and Joutz (2007) show that ties
to fast-growing trading partners were an impor-
tant driver behind Germanys export strength
from 2000 to 2005. In general, we think that
German companies benet in particular fromtheir long-standing experience in overseas trade,
their high degree of international integration, and
a product range geared towards investment
goods, which are in high demand, especially in
the fast-growing emerging economies (see Figs.
2.5, 2.6 and 2.7).
This is important, because if German exports were
growing only because of a surge in global invest-
ment activity, then its export success would come
to an end as soon as either the global cycle ma-
tured or lower-cost competitors entered these
growth markets. However, with its reliance on
cost-competitiveness and structural non-price
factors, we think Germanys edge in international
markets should be of a longer-term nature.
Export dependency increase economic
volatility
Germanys export boom was halted by the global
economic crisis of 2008. In 2009, German exports
registered their sharpest decline in postwar his-
tory. Indeed, with exports falling some 25% in
early 2009 compared to the previous year, Ger-
many suered more than most comparable coun-tries. The reason for this lies in the composition of
German exports, which are, as we have seen,
strongly geared towards capital goods (machinery
and transportation equipment) and durable con-
sumer goods, such as automobiles. Demand for
such products can be easily delayed during times
of rising economic uncertainty, in contrast, for
example, to staples such as food and energy.
Companies usually freeze their investment
projects when the economic outlook darkens, so
demand for German-made investment goodsdrops sharply. But when economic prospects
Chapter 2
Fig. 2.5: German exports are focused on capital goods
Source: UN Comtrade, UBS WMR
% of total exports, 2009
20
0
40
60
80
100
Japan Germany EU-27 France Italy Spain US UK
Investment & intermediate goods(capital goods)
Consumer goods & commodities
Fig. 2.6: Composition of Germanys exports
Source: Federal Statistical Office, UBS WMR
% of total exports, 2008
17.5
14.8
13.9
6.35.2
42.3
Vehicles
MachineryChemical products
Iron and steel products
Electrical products
Others
Fig. 2.7: Destinations of exports in 2009
Source: UN Comtrade, UBS WMR
Note: *Eastern Europe, Brazil, India, Indonesia, Russia
% of total exports
20
0
40
60
80
100
Japan Germany EU-27 Italy US France UK Spain
Major emerging markets * (ex China) Rest of worldChina
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UBS research focus October 2010 15
improve again, capital goods orders also tend to
rebound more strongly. Hence, Germany suers
more in the downturn, but also benets more
than most of its peers in an economic recovery.
Indeed, as can be seen in Figure 2.8, German
economic production is more volatile than that of
most of its neighbors. This is not a trivial dynamic.
Since the introduction of the euro, in 1999, about
80% of Germanys real GDP growth adjusted
for ination was generated from net exports(see Fig. 2.9) and a quarter of Germanys work-
force is employed in the export sector. Sharp
swings in the economic cycle can, therefore, be a
real challenge, not least for scal and monetary
policy makers.
Exporters face protectionism and low-cost
competition in the long-run
Germanys exceptionally open trade posture
makes it susceptible to increased economic vola-
tility and the protectionist sentiment of its trading
partners. Given its export dependence, any trend
towards protectionism harms Germany more than
most of its peers. However, this is probably miti-
gated to some extent by its specialization in high
quality investment goods and durable consumer
goods. These kinds of products resist easy substi-
tution. This could change, however. As Germanys
Asian trading partners reach a more mature stage
of development, their demand for capital goods
will likely diminish in favor of consumer goods.
Also, Asian and in particular Chinese manufactur-
ers are moving up the value chain themselves,
thus starting to encroach on Germanys productrange (see Fig. 2.10). As a result, German manu-
facturers face increasing competition from their
prime export markets, especially from China and
India, with their large pools of low-cost labor.
Hence, we doubt that German exporters can rely
only on cost-cutting to remain competitive in the
long term. Instead, they will have to focus on
innovation and efciency to maintain their export
success, factors that we discuss in more detail in
the next chapter.
Export strength blessing and curse
Fig. 2.10: Chinese exports focusing on capital goods
Source: UN Comtrade, UBS WMR
% of total exports
10
0
20
30
40
50
60
1992 1994 1996 1998 2000 2002 2004 2006 2008
Consumer goods
Intermediate goods
Capital goods
Agricultural & commodities
Fig. 2.8: German output growth is more volatile than incomparable countries
Source: Reuters EcoWin, UBS WMR
Standard deviation of industrial output change over the past 10 years
1
2
3
0
4
5
6
7
8
Germany France US UK
Fig. 2.9: Net trade was the key source of growth between
2000 and 2007
Source: Reuters EcoWin, UBS WMR
Real GDP, in % y/y and annual growth contributions
4
6
2
0
2
4
1992 1994 1996 1998 2000 2002 2004 2006 2008
Total real GDP growth
Domestic demand
Net trade
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Germany in the fast lane16
Export orientation weakens domestic
consumption
There is another problem with Germanys export-
led growth model. It appears to weaken domestic
demand both private household consumption
and corporate investment spending. The ip-side
of Germanys price competiveness is low wage
growth and high unemployment. The evidence
regarding employment is less straightforward.
While some (Sinn, 2006) argue that oshoring
increases domestic unemployment, others havefound no such eect in their research (Klodt,
2004). However, there can be no doubt that
wage growth stagnated throughout most of this
decade, leading to exceptionally weak household
consumption growth (see Fig. 2.11). Thus, the
perception remains that Germany is buying its
export success with a reduction or at least slower
expansion of its populations overall living stand-
ards.
and appears to drag on corporate invest-
ment
Since the inception of the euro, German corpo-
rate investment spending has been unusually
weak (see Fig. 2.12). In part, this reects the
growth of oshoring activities, which diverted
investments from domestic projects in favor of
CEE countries. We can also see this in the current
account, which reects all savings and spending
in the economy. Germany has been running sur-
pluses throughout this decade, meaning that
German households have saved more than they
have spent (see Fig. 2.13).
In general, saving is a good thing, as it forms the
basis for investment. Yet if savings are persistently
higher than spending in an economy, it means
that domestic savings go elsewhere and are una-
vailable to nance investments at home. German
savings were invested in building up facilities in
Eastern Europe. They also helped to fuel the con-
struction and consumption booms in Greece,
Spain and Ireland. Some of these savings were in
portfolios and found their way into low quality
nancial assets. As the bubbles in southernEurope burst, German savers and the German
banking sector, which had moved these savings
into the low quality assets incurred substantial
losses.
Rebalancing the German economy
We think Germany needs a more balanced
growth model. This has been widely acknowl-
edged by experts and policy makers. Yet most
pundits and politicians in Germany demand ad-
justments from decit countries while striving to
further improve Germanys export competitive-
ness. This seemingly irrational behavior can be
explained by considering Germanys industrial
and institutional structure as it has evolved over
time.
The success of Germanys export-oriented growth
model could be Germanys own worst enemy. It
has created an almost invincible alliance of pow-
erful employers and unions who share a vested
interest in the models continuation. They have so
far been able to thwart any attempt to restructure
Chapter 2
Fig. 2.11: Weak German consumer spending since 2002
Source: Reuters EcoWin, UBS WMR
Consumer spending and nominal wage growth, in %, y/y
0
2
2
4
6
8
10
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
WagesConsumption
Fig. 2.12: Corporate investment in France and Germany
Source: Reuters EcoWin, UBS WMR
Index Q1 2000 = 100
90
80
100
110
120
130
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
France Germany
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UBS research focus October 2010 17
the German economy. Even though external fac-
tors in particular, the spending patterns of its
trading partners will change, for the moment,
at least, Germanys power brokers are insisting on
continuity. Also, it must be said, policies that pro-
mote a more balanced growth mix for example,
through taxes, subsides or wages risk weaken-
ing Germanys competitiveness without suf-
ciently strengthening domestic demand. These
are issues to watch closely in Germanys political
arena over the coming years.
Conclusions
Germany is undoubtedly one of the worlds most
successful export economies. Its export strength is
based on its ability to penetrate high-growth mar-
kets, especially in the CEE region and in Asia. Its
success also reects its superior cost competitive-
ness, which has been achieved through corporate
restructurings and wage moderation. These ad-
vantages in foreign trade appear to be durable.
They should allow Germany to benet more dur-
ing global cyclical upswings than most of its
peers.
However, export dependency has its drawbacks as
well. During economic downturns, Germany
tends to suer more than countries that are less
dependent on global trade. Also, Germanys
growth model may be vulnerable to protection-
ism, structural shis in its main trading partners,
and growing cost competition. It is important to
note that Germanys export success does not
seem to benet the broad population. We think
achieving a more balanced growth model is one
of the countrys key challenges for the future.
Export strength blessing and curse
Fig. 2.13: Increasing imbalances within the Eurozone
Source: Reuters EcoWin, UBS WMR
Current account balances, in % of GDP
12
8
4
0
4
8
12
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
SpainFrance ItalyGermany
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Germany in the fast lane18
Germanys recent robust economic perform-
ance will not go unchallenged. In this chap-
ter, we look at structural trends, domestic
and foreign, that will inuence Germanys
long-term growth outlook.
Germanys strong cyclical performance before
and especially aer the global nancial crisis has
diverted attention from its weak underlying eco-
nomic growth. Adverse developments in per-cap-
ita GDP, which is a common measure of livingstandard, have also been papered over by the
good export news lately. In fact, the gap between
Germanys per-capita GDP and the average of the
upper half of OECD countries actually widened
over the past decade (see Fig.3.1) and total eco-
nomic growth between 1998 and 2007 averaged
just 1%, compared to over 2% in France and
around 3% in the UK and US. Indeed, according
to OECD estimates, Germanys long-term growth
potential averaged just 1.2% in the period from
1998 to 2007 compared to 2.4% for the OECD
as a whole (see Fig.3.2). The question is: How
will Germanys growth potential develop in fu-
ture?
Demographic challenges
Demographics are an important factor determining
a countrys long-term growth potential. Like many
other industrial countries, Germany faces pro-
found, even unprecedented, demographic changes
in the coming decades. A persistently low birth
rate over the past four decades or so, combined
with rising life expectancy, make demographics an
inescapable economic issue.
The most recent projections assume that by 2060
Germanys population will decline from 82 million
today to somewhere between 65 and 70 million
(see Fig. 3.3). From an economic point of view, the
demographic issue does not so much reect the
decline in the overall population as it does the shi
in the populations age structure. In particular, the
contraction of the potential labor force is the main
Chapter 3
Germany faces long-term structural
challenges
Fig. 3.1: Germanys living standard slipped behind
Source: OECD (2009), UBS WMR
Note: Percentage gap to the simple average of the upper half of OECD countries in terms of GDP per capita in constant2005 PPP.
GDP per capita gap to upper half of OECD countries, in %, 2008
30
20
10
0
10
20
30
US
Netherla
nds
Can
ada
UK
Germ
any
Finland
Fra
nce
Ja
pan
Italy
Spain
Nor
way
Fig. 3.2: Germanys growth potential lagged behindthe OECD average
Source: OECD, UBS WMR
Potential GDP growth, in %
0.5
0.0
1.0
1.5
2.0
3.0
2.5
3.5
1992 1994 1996 1998 2000 2002 2004 2006 20102008
Germany OECD
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UBS research focus October 2010 19
Germany faces long-term structural challenges
problem, since this is the age bracket that contrib-
utes to pension funds and tax revenues.
To illustrate the magnitude of the problem, the
old-age dependency ratio, which compares the
non-working population (those 65 and above)
and the prime working age population (15 64)
is expected to rise from 42 in 2008 to 73 by
2060. This means that, while 42 pensioners de-
pended on 100 workers in 2008, some 73 retirees
will claim benets from the contributions of 100workers in 50 years (see Figs. 3.4 and 3.5).
The number of Germanys workers could fall by
around 28% between 2007 and 2060, which
would be an annual average drop of around 0.5%.
Assuming this decline has a full impact on labor as
a production factor, the trend rate of GDP would
be reduced by an average of about one-third of a
percentage point per year.1 Thus, Germanys trend
rate of growth would soon turn negative, which
normally implies a contracting economy.
However, there are osetting factors, such as the
growth in the capital stock and in total factor pro-
ductivity. In general, an economys potential
growth rate is determined by three factors:
the quantitative input of labor (labor force
potential) and capital (capital stock)
improvements in the quality of individual pro-
duction
the efcient combination of the two factors
(total factor productivity) (see Box 2).
Germanys long-term growth potential
We estimate that from 2011 to 2050 Germanys
average potential growth rate will be about 0.9%
per year, assuming net immigration of 200,000
and no changes to the birth rate, the capital accu-
mulation rate and total factor productivity. The
aging eect on potential growth would be worst
towards the end of the 2020s and in the 2030s,
when the bulk of the baby boomers retire from
the labor force (see Fig. 3.6). Germanys expected
potential growth rate compares unfavorably with
1 The so-called output elasticity of labor, i.e. the eect oflabor supply changes on output, is typically assumed to betwo-thirds versus one-third for capital.
Fig. 3.3: Population expected to decline
Source: Federal Statistical Office, UBS WMR
Note: From 2009 results of the 12th coordinated population projection.
Number of persons
60,000,000
55,000,000
65,000,000
70,000,000
75,000,000
80,000,000
85,000,000
197019601950 1980 1990 2000 2010 2020 2030 2040 2050 2060
Historical Lower limit Upper limit
Fig. 3.4: Dependence ratio increases
Source: OECD, UBS WMR
Ratio of dependent people to working population, in %
Note: From 2009 results of the 12th coordinated population projection.
1950 1970 1990 2010 2030 20702050
20
0
40
60
80
100
120total dependency ratio
old-age dependency ratio
young-age dependency ratio
Fig. 3.5: Strong increase in the number of older people
Source: OECD, UBS WMR
Note: From 2009 results of the 12th coordinated population projection.
Population by age groups, in %
2008 2060
20
61
1934
50
16
Below 20 years 20 to 65 years 65 years and older
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Germany in the fast lane20
Chapter 3
Box 2: Determining potential growth
GDP readings can be regarded as a combina-
tion of long-term production potential and a
shorter-term cyclical component. The produc-
tion potential or potential growth of an
economy refers to the total economic output
that can be produced with the production fa-
cilities, labor and capital that are available atany given time. The calculation takes account
of technological progress and assumes that
capacity utilization is at long-term average
levels.
Output in period t (Yt) is derived from a combi-
nation of the input factors labor (Lt = potential
labor force) and capital (Ct = capital stock). TFPt
(total factor productivity) captures the level of
technology or technological progress.
The level of total economic output is given by:
Yt = TFPt* f(Lt, Ct)
And the growth rate of total economic output is
given by:
lnYt = lnTFPt + a*lnLt + (1 a)*lnCt
Thus, the growth of total economic output is
determined by the change in technological
progress (lnTFPt) and the weighted growth rates
of the inputs of labor (a*lnLt) and capital
((1a)*lnCt). The weights correspond to the
shares of income from labor (a) and from capital
(1a) in national income.
The following diagram summarizes the various
factors aecting the variables in the economic
output equation:
Quality
Yt= TFPt f (Lt, Ct)
Quantity
Development of capital stockTechnological progress= total factor productivity
Potential labourforce
Domesticpopulation
Birth rate NumberBirth rate
Immigrants
Participationrate
Retirementage
Working hoursper employed person
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UBS research focus October 2010 21
those of all other G7 countries, apart from Italy
(see Figs. 3.7 and 3.8). We expect Germanys
per-capita GDP to grow by about 50% until
2050, compared with 65% for the G7 as a
whole (see Fig. 3.9).
Germanys low birth rate
The diagram in Box 2 summarizes approaches to
counteract the demographically inducted de-
cline in the potential growth rate. The input
factor labor, which typically accounts for abouttwo-thirds of total output, oers most options
for policy makers.
Germanys fertility rate, only 1.34 children per
woman of child-bearing age in 2008, has been
notoriously low for decades (see Fig. 3.10 and
Map 1). Without any net immigration, the fertil-
ity rate would have to be 2.1 to maintain the
current population. Measures to increase the
fertility rate can only work very gradually and
their eects would not be felt for some 20
years, when the additional children enter the
labor market. Thus, most projections assume
only marginal changes in Germanys birth rate in
future, with little eect on the population pro-
jections for the next 50 years.
Immigration can boost the labor supply
The next option to boost the potential labor sup-
ply is immigration. This has been quite volatile in
the past, but Germany has usually had net immi-
gration ranging between 129,000 and 354,000
persons annually since the 1950s. In the past ve
years or so, net immigration has declined mark-
edly. Between 2000 and 2007, annual net immi-gration averaged 129,000. According to UN pro-
jections, Germany should attract net immigration
of around 200,000 people per year in future. Yet,
assuming an unchanged birth rate, the total pop-
ulation and the potential labor force can only be
maintained with an annual net immigration of
about 450,000. Thus, in order to oset the ef-
fects of Germanys low fertility rate, net migra-
tion would need to more than double in future,
which seems highly improbable. To get a sense of
the impact on potential growth, we estimate that
without immigration, Germanys potentialgrowth rate would fall to below 0.5% by 2050
compared to the 0.9% with net immigration of
around 200,000 people.
Germany faces long-term structural challenges
Fig. 3.6: Germanys growth potential
Source: UN, Penn World Table 6.1, Groningen University, UBS WMR
Estimated growth potential and contributions, in %
1
0
1
2
3
4
1990 2000 2010 2020 2030 2040 2050
Population
Participation (aging)
Hours
Capital
TFP
GDP
GDP per capita
Labor productivity (GDP/hours)
Fig. 3.7: Potential growth rates for G7 countries
Source: UN, Penn World Table 6.1, Groningen University, UBS WMR
Estimated growth potential, in %
0.5
0
1.0
1.52.0
3.0
2.5
3.5
4.0
1980 1990 2000 2010 2020 2030 2040 2050
Germany
US
Japan
UK
France Canada
Italy
Fig. 3.8: Projected potential growth rates for G7 countries
Source: UN, Penn World Table 6.1, Groningen University, UBS WMR
Average growth rates of total potential GDP, in %
0.5
0.0
1.0
1.5
2.0
2.5
Japan Italy Germany France UK US Canada
20112020 20212040 20412050
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Germany in the fast lane22
Raising the labor market participation rate
An eective and potentially quick way of counter-
acting the deteriorating demographics would be to
boost the labor market participation rate and to
extend the eective working hours of those who
are employed.2 The participation rate measures the
actual labor force (employed plus registered unem-
ployed persons) as a share of the potential labor
force (everyone between ages 16 and 64). How-
ever, Germany already has one of the highest labor
market participation rates in Europe, surpassedonly by the Netherlands, Denmark and Sweden.
The same is true for Germanys female labor mar-
ket participation rate, which at 70.2% in 2008
stood above the EU average of 63.4%, and the
young age participation rate (15 to 24), which at
51.5% in 2008 was lower, for example, than in
Austria (61.5%) and the Netherlands (72.7%), but
still higher than the EU average at 44.6%. In short,
there is some scope to raise labor market
participation rates in Germany, but it appears to be
more limited than in most other countries.
2 One way to increase labor input would be to reduce struc-tural unemployment. However, it is important to note thatthis would not increase the growth potential, which isbased on the potential labor force (including both the em-ployed and the unemployed), but can only exert an eecton actual economic growth. Raising the participation ratemeans integrating the part of the working age populationinto the labor force that has so far not been available to thelabor market.
Chapter 3
Fig. 3.9: Projected GDP per capita growth rates
Source: UN, Penn World Table 6.1, Groningen University, UBS WMR
Average GDP per capita growth rates, in %
0.2
0.0
0.4
0.6
0.8
1.6
1.4
1.2
1.0
Japan US Italy Germany UK France Canada
20112020 20212040 20412050
Fig. 3.10: Germany has a low fertility rate
Source: EU Commission (The 2009 Ageing Report), UBS WMR
Number of births per woman
0.0
0.5
0.5
1.0
1.5
2.0
2.5
Germany Italy Spain EU Netherlands UK France
2008 20082060
Note: 20082060 projection by the EU Commission.
Natural population change (live births minus deaths),by regions, average 200307
per 1,000 inhabitants
< = 6.0
6.0
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UBS research focus October 2010 23
Germany faces long-term structural challenges
One obvious approach to the aging problem
would be to raise the minimum age for claiming a
pension in line with the increase in life expect-
ancy3. However, in comparison to other major
European countries, Germans already appear to
retire rather late, as can be inferred from the rela-
tively high labor market participation rate of per-
sons aged 55 to 64, which stood at 60.3% in
2008 compared to only 48.9% for the average of
the 27 European Union countries (see also Table 1).
While this is in principle a favorable comparisonfor Germany, the potential for further improve-
ments here as well appears to be more limited
compared to the rest of the EU. We have simu-
lated two dierent scenarios in order to estimate
the eect of higher retirement ages on German
productivity. In our rst scenario, we estimate that
making the retirement age two years higher by
2020 would li the potential growth rate only
marginally, to 1% on average by 2050. In our
other scenario, making the pension age ve years
higher by 2050 would yield an average potential
growth rate of 1.1%. Thus the overall impact
would be quite small, with the eect being felt
more strongly until about 2035. Aer that, the
labor force would shrink more rapidly, as the baby
boomers nally leave the labor force.
Germans work short hours
The factor labor can also be increased by means of
longer working hours. Here, it would appear that
Germany has the most scope for adjustment. Ger-
many and the Netherlands have the shortest work-
ing hours in the developed world. Weighing in at
just over 1,300 hours, Germans annual working
time falls nearly 470 hours short of the US and 160hours below their French neighbors. Given that
weekly hours in Germany are in line with the Euro-
pean average (but some two to three hours below
the US and the UK), this annual discrepancy is
largely attributable to more paid holidays and more
part-time employment in Germany. Indeed, so-
called atypical employment, including part-time
employment and small scale self-employment, has
risen rapidly over the past decade.
If average annual hours in Germany could be in-
creased by around 200 placing them roughly in
line with the European Union average, this would
3 Germany is planning to raise the pension age gradually to67 years
Table 1: German pension age is close to OECD average
Average eective age of retirement versus the ofcial age, 20022007
Men Women
Effective Ofcial Effective Ofcial
Iceland 68.9 67 Portugal 65.5 65
Portugal 66.6 65 Iceland 65.3 67
New Zealand 66.5 65 Ireland 64.9 65
Sweden 65.7 65 Turkey 64.3 58
Ireland 65.6 65 Switzerland 64.1 64
Switzerland 65.2 65 United States 63.9 65.8
United States64.6 65.8
New Zealand63.9 65
Australia 64.4 65 Norway 63.2 67
Norway 64.2 67 Spain 63.1 65
Turkey 63.5 60 Sweden 62.9 65
Denmark 63.5 65 Australia 62.2 63
Canada 63.3 65 United Kingdom 61.9 60
Uni ted Kingdom 63.2 65 Canada 61.9 65
Greece 62.4 58 Netherlands 61.3 65
Czech Republic 62.2 62 Denmark 61.3 65
Germany 62.1 65 Finland 61.0 65
Netherlands 61.6 65 Germany 61.0 65
Poland 61.4 65 Greece 60.9 58
Spain 61.4 65 Italy 60.8 57
Italy 60.8 57 Luxembourg 60.365
Finland 60.2 65 France 59.5 60
Hungary 59.7 62 Czech Republic 58.5 59
Belgium 59.6 60 Belgium 58.3 60
Slovak Republic 59.3 62 Hungary 58.2 60
Luxembourg 59.2 65 Austria 57.9 60
Austria 58.9 65 Poland 57.7 60
France 58.7 60 Slovak Republic 54.5 62
OECD average 62.7 63.7 OECD average 61.4 62.8
Source: OECD, UBS WMR
li the potential growth rate to around 1.4% by 2050 com-
pared to 1.1% with unchanged hours. The average potentialgrowth rate would rise from 0.9% to 1.2%, still below our
expectations for the G7 countries as a whole. To match the
expected G7 average growth potential of 1.6% over the period
Germany would need to return to the 2000 annual working
hours seen in the late 1960s.
Capital stock and efciency
A decline in the supply of labor can, in principle, be compen-
sated by increased capital accumulation, that is, higher capital
input. Yet, as an input factor in total production, labor carries
much more weight than capital, meaning that a drop in the
input of labor has to be compensated by a much stronger risein the capital stock. To achieve this, measures may be taken to
attract capital investments from abroad, which would also con-
tribute to a reduction of the external imbalances, for example,
the persistent current account surplus discussed in Chapter 2.
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UBS research focus October 2010 25
Education is the key
In an increasingly knowledge-driven global econ-
omy, human capital is a major factor for a coun-
trys competitiveness, especially in terms of inno-
vation. The latest OECD report on education gives
cause for some concern. Thus, according to the
OECD the number of students taking up univer-
sity-level education in Germany is still well below
the OECD average and especially well below that
of Germanys main peers (see Map 2). Also, on
the funding side, the OECD gures show that Ger-many spends below OECD average on education
(see Fig. 3.13). Finally, regarding the quality of
education, the OECDs PISA study for 2006 shows
mostly only average results for Germany, despite
some improvement on earlier assessments.
Interestingly, the PISA report shows that students
that were born abroad (rst-generation immi-
grants) scored much worse than their German
peers. The dierence in academic attainment was
about twice as big as the OECD average. Impor-
tantly, the performance dierence remained the
same for second-generation immigrants, which
may reect difculties with the integration of
immigrants in Germany.
This relates to a further problem of education in
Germany: the unfavorable skill-mix between emi-
grants and immigrants and the emerging brain
drain. Thus, while Germany is an important
source of highly skilled migrants to countries such
as the United States and Switzerland, it does not
attract a sufciently high number of comparable
foreign workers. The proportion of highly edu-
cated migrants is lower in Germany than in many
other OECD countries.
This unfavorable skill mix is partly related to the
strong recruitment of low-skilled labor in the
postwar economic boom, which triggered addi-
tional low-skilled immigration in later decades
through family connections. These problems
would need to be addressed via a comprehen-
sive immigration policy that allows the country
to attract more highly skilled workers from
abroad.
ConclusionsGermanys strong cyclical growth before and aer
the global recession has diverted attention from
its weak average growth performance this dec-
Germany faces long-term structural challenges
Educational attainment level by regions, 2007
Percentage of the population aged 2564 having tertiary education
< = 12.5
12.5
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Germany in the fast lane26
Investing in Germany
As we have shown in the previous chapters,
the structure of the German economy brings
with it certain advantages and threats. These
structural characteristics also have implica-
tions for investments in German equities and
bonds.
The cyclical story in the stock market and
beyond
The German stock market rebounded sharply
alongside the global economic recovery, initially onimproving business sentiment (see Fig. 4.1) and
later, with muted momentum, based on real eco-
nomic data. As discussed in previous chapters,
exports are traditionally an important driver of the
German economy. In fact, there has been a good
correlation between exports and DAX and MDAX1
movements since 2003 with the exception of the
2008 nancial crisis.
Taking a regional share index and breaking it
down into its sector components gives a general
picture of how cyclical the index is, and hence
how it is likely to perform during dierent phases
of the economic cycle. The German equity market
exhibits a higher weighting in cyclical sectors than
the Eurozone does overall (see Fig. 4.2), making it
a beneciary of supportive macroeconomic data.
The Industrials, Consumer Discretionary (primarily
1 The DAX is a blue chip stock market index of 30 majorGerman companies. The MDAX (mid-cap DAX) included 50Prime Standard shares from sectors excluding technologythat rank below the companies included in the DAX.
Chapter 4
automobiles), and Materials sectors account for
roughly 45% of the German market, compared
with only 32% of the Eurozone market. The cycli-
cal nature can also be seen by the higher volatility
of the German stock market compared to the US
market on average.
Moreover, the relatively weaker euro should sup-
port foreign demand for German products. It also
boosts exports to the emerging markets, which
make up an increasing share of German exports
and bring the added benet of strong growth po-
tential. Even if the euro were to strengthen, we
think German companies should still be competi-
tive at higher exchange rate levels, as we have
seen in Chapter 1.
2009200820072006200520042003200220012000 2010
80
75
85
90
95
100
110
105
3,000
2,000
4,000
5,000
6,000
7,000
9,000
8,000
Fig. 4.1: German stocks are correlated with business climate
Source: Bloomberg, UBS WMR
Ifo Business Climate Index (lhs) vs. DAX (rhs)
Ifo Business Climate DAX IndexM
aterials
Hea
lth
care
Consumer
Dis
cre
tionary
Ind
us
trials
Info
rma
tion
Tec
hno
logy
Uti
lities
Te
lecomm.
Serv
ices
Consumer
Stap
les
Fin
anc
ials
Energy
4.0
6.0
8.0
2.0
0.0
2.0
4.0
8.0
6.0
Fig. 4.2: More cyclical than the Eurozone
Source: Factset, UBS WMR
Sector differential MSCI Germany vs. MSCI EMU, in %
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UBS research focus October 2010 27
In addition to these cyclical factors, Germany is
currently beneting from good consumer senti-
ment. This should fuel domestic consumption,
which could also be supportive for the stock mar-
ket even if export momentum fades.
An Ifo at peak levels must not translate into
weak equity markets
In order to nd out how the German stock mar-
ket is geared to the economic cycle, we investi-
gated the degree of correlation between theMSCI Germany2 and one of the most important
domestic economic indicators, the Ifo Business
Climate Index. This monthly survey of diverse
industry representatives gives a good overview of
the current state of the economy as well as busi-
ness prospects for the next six months.
According to the September data, both expecta-
tions and the assessment of the current situation
remain at multi-year highs, which means that the
German economy continues to be in the boom
territory according to the Ifo business cycle clock
(see Fig. 4.3). Given the high levels, a sideways
movement or even a regression becomes more
likely, as economic growth momentum seems to
be slowing already. Our base case scenario sees
the economy turning to a more moderate growth
path, hence we think the Ifo index is unlikely to
backslide severely.
What would this scenario mean for the perform-
ance of the German stock market? We looked to
historical precedent for an indication. Although
we do not expect the past to repeat itself, there
are episodes that bear more than a passing re-semblance to the current situation. Looking at
patterns since 1990, we found that when the Ifo
index ranged between 100 and 110, the MSCI
Germany was likely to follow one of two trajecto-
ries:
If the Ifo trended sideways, which it has
started to do with its September release, in
two-thirds of all observations the stock market
showed a positive performance in the follow-
ing three months (with an average of +3.2%
over the period). Results were even slightly
2 The MSCI Germany is a broad equity index including50 companies.
better in the following six months, with almost
80% of observations showing an average per-
formance of 6.1%.
But what if the Ifo Business Climate Index
started to trend downwards from high levels?
In the 31 cases since 1990 where the Ifo fell
while in the range of 100 to 110, the three
months stock market performance aer the
release turned out to be slightly positive. How-
ever, aer six month the average performancewas negative.
Put simply, a lowering Ifo index could indicate
slowing growth, but this will not necessarily trans-
late into poor performance for the MSCI Ger-
many index. In fact, the German stock market has
historically performed well as long as the indica-
tor remained in boom territory.
Keep an eye on medium-sized companies
Having shown that Germany is currently the
growth engine of Europe, and why we believe that
economic growth will remain robust over the com-
ing years, we expect the large-cap DAX index to
perform quite well. The mid-cap MDAX also pro-
vides interesting opportunities. We would advise
long-term investors with a higher risk tolerance to
put some money in the mid cap segment of the
equity market.
Investing in Germany
11010510095908580 115
upswing boom
recession downturn
80
70
75
85
90
95
100
110
105Sept. 2010
Fig. 4.3: The Ifo business cycle clock
Source: Ifo Konjunkturtest, UBS WMR
Ifo current assessment and Ifo expectations over the last 24 months
Ifo
expectations
subindex
Ifo current assessment subindex
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Germany in the fast lane28
Medium-sized rms benet from emerging
markets demand
The MDAX index tracks the mid-cap segment and
comprises 50 companies. On average, the compa-
nies in this index generate about a third of their
revenues in Germany (see Fig. 4.4). Our expecta-
tions for a more robust domestic economy, as
discussed in Chapter 1, should support the earn-
ings growth of German companies, and their
stock prices.
However, the future of global economic growth
lies with emerging markets. These countries face
less sovereign debt problems and therefore less
scal tightening, and they have healthier banking
systems and more favorable demographics. In
terms of revenue, investors in medium-sized com-
panies achieve a slightly higher exposure to de-
mand from emerging markets especially devel-
oping Asia than they would with an investment
in the DAX. Investments in this market segment
are thus more geared to strong economic mo-
mentum than in the large caps.
Financials share is low among mid caps
This feature also reect the sector composition of
the equity market segments. The MDAX is heavily
geared to Industrials and has a much lower
weight in Financials than the DAX (see Fig. 4.5).
We believe that there is still a lot of pent-up de-
mand for capital goods aer the nancial crisis.
Accordingly, we see especial ly smaller sized com-
panies as the beneciaries of a multi-year capital
spending cycle. With all the regulation like Basel
III imposed on the banking sector and sovereign
debt issues still lingering, direct exposure to thesefactors can be reduced by choosing an invest-
ment in the MDAX.
Cyclical mid caps even benet from slow
growth
Medium-sized companies show a higher sensitiv-
ity to the economic cycle. Accordingly, although
they suer more than large caps in downturns,
they usually perform particularly well in an up-
swing. When leading indicators lose momentum
but growth remains robust, mid caps can still
perform relatively well, as seen between 2003and 2006. In our view, medium-sized companies
oer attractive opportunities for long-term inves-
tors who can bear temporary setbacks caused by
volatile economic data. The dierence between
Chapter 4
Fig. 4.4: Sales distribution of MDAX companies by region
Source: Commerzbank, Thomson Reuters, UBS WMR
In %
US
EM Asia
RoW
Germany
Europe ex Germany32.9
30.7
14.5
13.3
8.2
Industria
ls
Consumer
Discretionary
Materia
ls
Energy
Consumer
Stap
les
Hea
lthCare
Information
Tec
hno
logy
Te
lecomm
.
Services
Financia
ls
Uti
lities
6.0
12.0
0.0
6.0
12.0
18.0
30.0
24.0
Fig. 4.5: Higher industrial share in MDAX
Source: Factset, UBS WMR
DAX vs. MDAX, in %
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UBS research focus October 2010 29
mid and large cap performance is likely to be-
come less pronounced when global economic
momentum slows and risk aversion rises, however
(see Fig. 4.6).
German interest rates at the most
depressed levels since Bismarck
The post-nancial crisis period will be remem-
bered for decades as a time of ultra-low interest
rates. This holds true not only for the ECBs policy
rate, but also for Bund yields. Ever since rateswere rst recorded in 1871, when the German
empire was founded and Bismarck was appointed
its Imperial Chancellor, yields on 10-year govern-
ment bonds have never been lower than they are
today (see Fig. 4.7). Even more relevant for the
economy, ination-adjusted real interest rates are
well below their 50-year average.
Aer the Lehman collapse in the midst of the
nancial crisis, 10-year interest rates fell to
around 3%. But now that the global economy
has found its way out of the woods and equity
markets have recovered, interest rates are down
another 100 bps, close to 2%. What is pushing
bond yields lower and bond prices up?
Three main factors are contributing to the current
low interest rate environment:
Consumer price ination remains at subdued
levels and will likely stay low in the coming
year. Hence, investors are demanding a low
premium for future ination. In addition, inves-
tors have accounted for slower trend growth
going forward. As discussed in Chapter 3, weagree with this growth outlook for the Ger-
man economy.
The ECBs ultra-loose monetary policy is keep-
ing a lid on interest rates.
Some of the Eurozones member states face
challenging times ahead. Investors started
questioning the sustainability of the peripheral
countries public debt late last year, and called
for higher risk premia. As a consequence, in-
vestors sought the relative safety of Germangovernment bonds, which explains the recent
decline in bond yields. While risk aversion on
bond markets was certainly high and has even
increased of late, it did not spill over to equity
Investing in Germany
2007200420011998199519921989 2010
40
35
30
45
50
55
60
70
Index in %
65
30
40
20
10
0
10
30
40
20
Fig. 4.6: Global economic expansion supports MDAX
Source: Thomson Reuters, UBS WMR`
US purchasing manager sentiment (ISM) index above 50 signals expansion;difference in yearly change of MDAX and DAX in percentage points
ISM Manufacturing MDAX relative to DAX
20001990198019701960195019401930192019101900189018801870 2010
4
2
0
6
8
12
10
Fig. 4.7: 10-year government bond yields at lowest levelsince Bismarck
Source: Reuters EcoWin, UBS WMR
In %
end of month yearly average
20082006200420022000 2010
0
2
4
6
8
1,000
3,000
5,000
7,000
9,000
Shaded area: periods of strong negative correlation between equity markets return and bond yields(measured by 180day rolling correlation)Source: Reuters EcoWin, UBS WMR
10-year Bund yields DAX-30
Fig. 4.8: Positive correlation between equities andbond yields has broken down since mid-2009
In % Index
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Germany in the fast lane30
markets. Bund yields and equities are currently
negatively correlated, meaning that one rises
as the other falls. This is a rather rare phenom-
enon. In the past, such a constellation has
typically been resolved by a sudden increase in
yields, rather than a drop in equity prices (see
Fig. 4.8).
While there are some factors in place which speak
for low interest rates, their current extreme levels
seem hard to justify given the positive near-to me-dium term outlook for the German economy. With
so factors like high risk aversion calling the shots,
the bond market is subject to changes in risk senti-
ment, which usually happen faster than changes in
fundamental factors. While we would not rule out
that German Bund yields fall even further, we see a
good chance for yields to nally pick up: not least
because the European Central Bank (ECB) is in our
view not likely to start raising the policy rate before
mid-2011, and, as we set out in Chapter 1, the
recovery in Germany is likely to continue. Long-
term interest rates usually react quite a bit in ad-
vance of the rst rate hike in a tightening cycle.
The implications for investors are manifold. Most
importantly, we think bond investors will face much
more challenging conditions in the future. The
bond bull market that has been in place for at least
the last 20 years seems close to an end. Given that