Germany: Special Funds Are Reducing Fiscal Transparency; Debt Ratio Trending Downward

Germany retains significant room for budgetary manoeuvre with a prospect of lower debt-to-GDP medium run. However, financial flexibility of the central government is constitutionally constrained by the so-called debt break. The debt brake limits structural deficits of the central government to 0.35% of GDP, or around EUR 15bn a year.

By increasingly making use of special funds, which are exempt from the state’s debt-brake provisions, for expenditure under core areas of central-government responsibility such as support for green transition and military expenditure, the government is curtailing visibility of public outlays just as the economy navigates an unexpectedly sluggish post-Covid recovery.

Germany’s economy finds itself in the slow lane

Germany is the only AAA-rated state with an economy still not at pre-pandemic levels of output (Figure 1) and, given a likely significant Q2 slowdown, it may not reach such a pre-pandemic threshold until the end of 2022.

Figure 1. Real GDP levels in AAA-rated sovereigns

2019Q4 = 100

In response to escalation of the Russia-Ukraine war, the government intends to significantly raise military spending. Parliament approved a special military fund on 3 June with support from the Christian Democratic Union/Christian Social Union opposition to enshrine the fund in the constitution.

Additional borrowing of EUR 100bn, equivalent to around 3% of GDP, for which repayments would begin in 2031, will be excluded from deficit-limiting calculations of the debt brake.

The move is only the latest of a series of measures that would side-step debt-brake limitations over the coming years, on aggregate totalling to circa EUR 212bn (6% of GDP) in value.

The goal of compliance with the debt brake from 2023 on looks ambitious

The government’s objective of complying with the debt brake from 2023 on appears ambitious. Berlin will likely be confronted with further expenditure requirements on top of additional investment needed for the energy transition, digitalisation as well as social security, including accommodation and integration of more than 800,000 Ukrainian refugees hosted by Germany. As consequence, we expect a general government deficit of 4.5% of GDP this year and 2.9% for next year, and general government deficits exceeding 1% of GDP until 2025.

Additional funds are also much needed to tackle Germany’s significant investment gap. We have previously estimated this gap at around EUR 410bn. As demographic pressures reduce Germany’s growth potential over this next decade, it is important that additional funding is spent on growth-enhancing investment where possible.

Near term, Germany’s recovery is held back by supply-chain disruptions and high inflation

In the near term, Germany’s recovery from the pandemic is being held back by supply-chain disruption and price hikes, with both factors exacerbated by an ongoing Russia-Ukraine war. Producer prices were up 34% YoY in April 2022, mostly driven up by high input prices of electricity, gas and crude oil, but also of basic metals and chemicals, while Germans are trimming consumption outlays due to appreciable loss of real disposable income this year.

We therefore expect real GDP to grow only 2.3% in 2022, half the rate we expected for this year as of December 2021. Significant downside risk remains, not least the risk of Russian countersanctions resulting in interruption of gas flow to Germany before a currently envisioned phase-out of Russian gas is complete. China’s zero-Covid policy and trade disruptions are also set to hold back export performance.

That said, Germany’s general government debt levels will gradually decline from an expected 72% of GDP in 2022 to around 65% by 2027 despite increased use of special funds and slower economic growth than that experienced in economies of Germany’s AAA-rated sovereign peers.

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Eiko Sievert is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Julian Zimmermann, Senior Analyst in Sovereign and Public Sector ratings at Scope Ratings, contributed to writing this commentary.