Germany’s growth prospects have deteriorated significantly after the escalation of the Russia-Ukraine war six months ago. We now expect the economy to grow just 1.6% in 2022 and 1.7% in 2023, after originally expecting growth of more than 4% this year and 3% in 2023.
In Scope Ratings’ economic baseline scenario, sharp increases in energy prices combined with renewed disruptions in global supply chains lead to a technical recession – an economic contraction for two consecutive quarters – in the export-oriented German economy from the 4th quarter of 2022.
Nonetheless, Germany’s debt-to-GDP ratio remains on track to fall below 65% by 2027 due to low interest rates and a rapid recovery in tax revenues following the pandemic crisis (illustration 1).
However, major uncertainties remain over Russia’s approach to exporting gas to Germany and the rest of Europe to fund its war effort, while also seeking to use western neighbors to provide economic and military support to Ukraine and impose sanctions on Russia to punish.
Figure 1: Debt level forecast for Germany under alternative gas shock scenarios
% of GDP
Source: Scope Ratings
Should gas market tensions persist, a more severe gas market shock, in which prices would double from Q2-2022 (as modeled by IW Cologne), would result in a deeper economic recession than in our baseline economic scenario, implying slower growth would imply for 2022 of around 1.3% before an annual economic downturn of 0.7% in 2023. This would take the debt-to-GDP ratio to over 72% in 2022, before gradually declining thereafter.
Such a scenario is increasingly possible as upward price pressures are evident in energy futures markets, where prices have more than doubled since the second quarter of 2022. Today’s all-time highs in European energy futures contracts also reflect markets’ concerns about obstacles to Germany’s diversification process stemming from reliance on gas imports.
Acute gas shortages can cause long-term economic damage
In an even more pessimistic scenario, where Russian President Vladimir Putin decided to maximize economic pain for Germany through periodic or permanent disruptions in Russian gas exports, which would result in acute shortages for Europe, Germany’s debt-to-GDP ratio would drop to something to rise above 75% by 2024.
This assumes that GDP in 2024 will be 6.6% below our baseline economic scenario and that Germany’s medium-term growth potential will be permanently hampered to some extent. Here, growth would only be around 1% in 2022 before declining by 2.1% in 2023 and 0.7% in 2024, with inflation hovering around 7% between 2022 and 2024. While rising gas storage capacity and falling structural demand have made such a scenario less likely this winter, Germany’s limited gas storage capacity offers few opportunities to adjust its energy mix.
However, high fiscal buffers built up before the pandemic crisis, adequate financial reserves and a mature fiscal policy framework support Germany’s fiscal resilience and debt sustainability even under such circumstances.
While economic damage from Russia’s energy export “armament” would be inevitable, Germany has sufficient financial capacity for further temporary relief, such as announced VAT cuts on gas in its autumn budget, to support consumers should gas prices continue to rise. In a bearish scenario, government intervention in the energy sector would increase and potentially include further demand-side measures beyond just voluntary gas savings.
Even with fuller storage facilities, reductions in gas consumption are proving critical
Efforts by the federal government to secure the country’s gas supply before winter continue, reducing the risk of even higher gas prices and possible gas shortages. Storage facilities were 81% full by the end of August and on track to meet statutory targets of 85% by October 1st and 95% by November 1st, suggesting Germany is close to gas reserves needed to get through the coming winter.
Despite the rebound effect after the pandemic crisis, we assume that the structural decline in Germany’s energy demand will continue in the coming years. Low-volume consumers, including households, curbed demand by about 6% from March 2022 following the escalation of Russia’s war against Ukraine.
Industrial consumers began to reduce demand much earlier, namely as early as August 2021, when wholesale gas prices rose sharply. This has resulted in an average fall in industrial demand of around 11%.
However, natural gas remains an important energy source for Germany, as it accounts for about 40% of total household energy consumption, more than 30% of industrial consumption and about 13% of electricity generation.
The faster Germany can replenish its gas supplies, diversify sources of supply and reduce domestic and industrial demand for gas, the less emergency government aid would ultimately be needed. Such moves require coordination with other EU member states, which would reassure participants in the gas markets and allow Berlin to quickly return to a structurally balanced budget, thereby ensuring the sustainability of its public finances.
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Eiko Sievert is Director in the Sovereign and Public Sector Ratings department at Scope Ratings GmbH. Jakob Suwalski, Director at Scope Ratings contributed to the writing of this comment.
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