The Social Democratic Party (SPD) won the largest share of votes in Germany’s elections, but without an outright majority, it is not yet certain they will lead a coalition government in the German parliament (Bundestag). This departure from a “Grand Coalition” of the two largest parties, the Christian Democratic Unionists (CDU) and the SPD, would happen as Angela Merkel steps down as German Chancellor after 16 years. The coming days and weeks will reveal the makeup of the government, with a coalition between the SPD, Green Party and Free Democratic Party (FDP) most likely, and if Merkel’s CDU Party loses power, we would see a new approach to public spending and Germany’s green transition.
“Greening” the German economy took on greater importance in May this year, when the Merkel government announced its intention to achieve a net-zero level of greenhouse gas emissions by 2045, following a ruling by the German constitutional court which challenged existing targets set out in the Federal Climate Change Act.1 This revised ambition demands a much faster reduction in emissions than we have seen during the last decade and requires the expansion of renewable power generation on a scale that will create many political, technological and economic hurdles.
The Funding Conundrum
The “Net-Zero Germany” report from consultancy firm McKinsey & Company forecasts that €6 trillion needs to be invested to replace and maintain existing infrastructure, whilst also achieving a timely carbon neutral climate transition in Germany.2
Such a significant investment will require higher taxes or higher debt and possibly a combination of both, as Germany’s current public net fixed capital formation (public expenditure less capital depreciation) is much lower than many other developed countries. Grants from the European Union’s (EU) Next Generation Recovery Fund could provide a boost, but it would still be well short of the required spend suggested by McKinsey.
Merkel’s fiscal conservatism leaves Germany with a healthy debt-to-gross domestic product (GDP) ratio and plenty of firepower to significantly increase public spending, but it remains to be seen whether the political will exists. The left-leaning parties are open to embracing change, whilst private investment is preferred by the FDP. In a three-way coalition, one of the junior partners will likely provide the next German finance minister and heavily influence the balance between public and private funding.
Embracing Fiscal Change
Germany’s “debt brake”3 is a constitutional provision that limits federal government budget deficits to 0.35% of GDP. This forces the federal and regional governments to balance their budgets and prevents substantial discretionary fiscal spending. The COVID-19 pandemic triggered a special provision allowing the brake to be relaxed, whereupon the deficit expanded sharply in 2020 and 2021 and will remain high into 2022. Consequently, the new government has limited fiscal headroom, creating a financial dilemma, particularly given commitments to carbon neutrality.
Permanent changes to the debt brake require a constitutional change, which needs a two-thirds majority in both chambers of parliament. The Green and SPD parties would support a change, whilst the FDP and CDU want to maintain the brake and reduce public debt.
The debt brake debate is being influenced by proposed reform of the EU Stability and Growth Pact, which could become more decentralized and allow EU members to set their own fiscal policy objectives. A left-leaning German government would encourage an easier policy posture and support reform. However, if agreement to reform the pact is not reached by next spring, it may restrict fiscal policy in the EU during 2023, damaging any plans for increased public sector investment.
Germany is a global economic powerhouse thanks to globalization, but investment is needed in digitalization, technology, and infrastructure to address the growing trade imbalance with China and boost growth. Germany is reliant on exports to China yet demand for those goods and services is waning as Chinese technology improves.
Analysis from the International Monetary Fund4 estimates that any increase in public investment would have a proportionately greater effect on real long-term GDP, allowing Germany’s debt-to-GDP ratio to trend down over time. In the absence of substantial fiscal and capital expenditure, Germany and the euro area may continue to be laggards in the post-COVID global economy, weakening the private sector further and putting even more financial burden on the German state.
How Will Markets React?
The election outcome should not have a material impact on equity markets, in our view, although policies favored by the SPD and the Green Party such as income tax increases and a higher minimum wage could create negative sentiment amongst investors. The green transition will also influence markets, potentially hurting companies with high CO2 emission levels, for example airline and transport stocks. In contrast, the possibility of closer fiscal ties within Europe should boost eurozone trade, aiding certain banking stocks.
Any shift to the political left will likely increase volatility in bond markets, given increased uncertainty around fiscal policy. It may mean that German fiscal policy becomes more accommodative than in the past, increasing the net issuance of Bunds, which form a significant part of the European Central Bank’s (ECB) purchase programs. Ongoing ECB purchases should prevent yields rising significantly, keeping Germany’s borrowing costs manageable, although this only works if trust in the Federal Republic of Germany as a debtor with the best credit rating is maintained.
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1. Source: Bundesverfassungsgericht Press Release No. 31/2021 of April 29, 2021, “Constitutional complaints against the Federal Climate Change Act partially successful.”
2. Source: McKinsey & Company, “Germany can achieve zero emissions target cost-neutrally by 2045,” September 10, 2021.
3. Source: Deutsche Bundesbank, “Germany’s debt brake: surveillance by the Stability Council,” April 2019.
4. Source: IMF Blog, “Public Investment for the Recovery,” October 5, 2020.