Germany – at full steam, but choppy waters ahead

Germany remains Europe’s growth engine and “anchor of stability” in a continent that has been dealt a series of heavy blows throughout the course of 2016 and first quarter of 2017. These range from Brexit, political instability and the rise of nationalistic and protective sentiments among partners; the imminent threat of a recurring banking or sovereign crisis; the social challenges brought about by the refugee crisis and growing tensions with neighbours such as the case of Turkey and Russia.

Chancellor Angela Merkel, the most senior political leader in the European Union (EU) and often described as the most powerful persona in the EU, has effectively become a counterbalance to the noise from rising populist, isolationist and nationalistic rhetoric around the world.

Merkel’s calm and deliberate policy style has become a trademark for Germany, although it in no way moderates the determination with which Europe’s biggest economy – and the world’s fourth-largest – has been pursuing its national interests. These span the country’s revised open door policy, the insistence on austerity as the panacea for the European crisis, and a strict “no” towards a collectivisation of the European debt.

These three policy principles have come under attack from partners and voters and, for the moment, tainted the perceived invincibility of her chancellorship. The refugee crisis has cost Merkel support within her own party, the Christian Democratic Union (CDU) and its sister party the Christian Social Union (CSU). Moreover, the helplessness and growing xenophobia among a growing part of the German population has given rise to the anti-anything programme of the Alternative for Germany (AfD), similarly to other Front National in France, Five Star Movement in Italy, or the Party for Freedom in the Netherlands.

Fortunately for Germany, the quick rise of social democrat Martin Schulz as a serious contender for the chancellorship should be a positive, as it permits a refocusing of the political debate towards the social agenda and away from xenophobic and anti-European sentiments.

Pressures for change

The German austerity doctrine has also come under attack; not only from its Southern and Western European neighbors, who have failed to replicate Germany’s success in generating growth and driving reforms in the face of continuous high unemployment, political instability and shrinking tax revenues. Stronger headwinds are also blowing across the Atlantic, where the German export-centric model and its proliferation across Europe is regarded with awe. While accusations that Germany is manipulating the euro exchange rate are unfounded, it is nonetheless a fact that the low euro will further widen the European account surplus with the US.

So far, the German government has been ignoring the issue, however the growing trade imbalances should be addressed eventually. Ultimately the response boils down to two options. One would see Germany leave the euro and appreciate a Deutsche Mark 2.0; the other would be a deeper harmonisation and integration of European social and economic policies, including the collectivisation of European debt to stimulate growth and re-balance accounts. In its current form, the single currency fails to strike a balance between the German surplus and the needs of its weaker partner economies.

Unfortunately, the latter path requires a political vision missing in Berlin, Brussels or any other EU capital. A great example is the undermining of the bail-in mechanism within the European banking union framework when Italy’s third largest bank, Monte dei Paschi di Sienna, went bankrupt last December. Instead the Italian government arranged for a bail-out, again placing the responsibility on the shoulders of the public instead of the bank’s investors, for fear of losing votes for then-prime minister Matteo Renzi’s referendum, and thereby risking contagion in the system.

To date, the German banking sector has remained remarkably resilient. However, continuously low interest rates have increased the pressure. Clearly low interest rates are a pan-eurozone problem, but German banks appear to be more vulnerable than most of their European peers, given their heavy reliance on net interest margin and low return on equity ratios.

It has been a difficult year for Germany’s large private banks, clearly reflected in the ongoing crisis at Deutsche Bank, which has been involved in almost every banking scandal of the past few years and has been subject to massive and even existential regulatory penalties, Commerzbank also was forced to embark on a comprehensive cost cutting and business restructuring exercise.

After the 2008 financial crisis, German industry benefited from the availability of credit provided by the country’s large share of public-sector banks, such as savings banks, cooperatives and Landesbanken. Their small size, fragmented structure and credit exposure – in the case of the Landesbanken – may come back to haunt them, as low rates affect their ability to finance themselves.

An immediate effect of this margin pressure boiled down to nothing less than the end of free consumer banking in 2016, as most German banks introduced new fees and/or raised existing fees. The public-sector banks also fell behind the private banks in their digital transformation journey. Needless to say, the introduction of fees has triggered a migration towards the few remaining free alternatives, usually found in digital-only banks and challenger banks.

How do treasurers react to this environment?

Prepare for the unknown: The UK vote for Brexit has sent uncertainty skyrocketing, particularly as a clear strategy remains missing on both sides. This makes it impossible to predict the outcome of the “leave” negotiations. We recommend that treasurers consider how Brexit will impact liquidity management practices across the Europe, the Middle East and Africa (EMEA) region, and manage potential risks accordingly. Given the uncertainty, treasuries should prepare scenarios to assess changes of complexity to existing treasury structures in the region and explore opportunities around government incentives to hold euros in accounts on the continent.

Moreover, with the UK likely exiting the single market, treasuries must prepare for a transition phase until a new trade agreement can be negotiated, which likely will take longer than the two-year period for Brexit negotiations. Regulatory changes also should be considered, such as bank passporting, which may force a re-evaluation of existing bank relationships.

Adapt to changing tax structures: Uncertainty also derives from what to expect from the Trump administration and in its sabre-rattling regarding border taxes and the end of free trade. The new US administration has made the tackling of the US trade deficit a key priority and is playing through multiple scenarios. Moreover, European tax legislation is changing quickly, and there is a move towards more transparency and pressure to harmonise corporate tax regimes within the EU.

Initiatives such as base erosion and profit shifting (BEPS) aim to reduce profit-shifting through different geographies and tax jurisdictions, foremost by means of transfer pricing. Lastly, cash pooling, which is used by about two thirds of German treasuries, is also affected by changing tax legislation, as well as the impact of negative interest rates, and causes some headaches for corporate treasurers.

Hedging FX risk: Both Brexit and relationships with the US will also increase challenges, as both the euro and the pound tanked against the dollar in recent months, with no end in sight given the anticipated higher interest rates in the US.

Generally, we see a shift towards more flexible hedging strategies to enable corporations to respond more effectively to the challenges of this volatile landscape; moving away from annual, static set-and-forget hedging programmes and toward a layering strategy that creates a continuous rolling hedge. This allows banks to adjust hedges as forecasts change and currency movements occur, while maintaining a base level of downside protection at their budget rates.

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