By Jacob L. Shapiro

Germany’s economy has internal strengths to buttress it from the global exporters’ crisis. But while these strengths – including low unemployment, a dynamic labor market, increased exports to the U.S. and the EU, and low interest rates – can protect Germany to a degree, they cannot solve Germany’s underlying export dependency. They also cannot prevent the political chaos in the European Union that would result from an Italian banking crisis. And as both of these issues become more prominent, they will undermine the very dynamism shielding Germany from the same depth of pain that other high-exporting countries are experiencing.

This does not mean that we are ready to dust off the overused “sick man of Europe” designation for Germany. Nor do we believe that the German economy has reached a point of crisis yet. In our annual forecast, we predicted that Italy was going to be the weak link in Europe, and that Italy’s banking problems will force Germany to make extremely painful and politically unpopular decisions. Germany itself may not provide the impetus for the serious political and economic challenge that is coming for Berlin, but it will come one way or another.

The root of Germany’s vulnerability stems from a simple fact: roughly 45 percent of Germany’s GDP comes from exports. And more than any other European country, Germany’s dependence on these exports leaves it vulnerable to the slowdown of China’s economy, which we believe is only going to get worse.

Germany’s Exposure to China

A superficial glance at Germany’s overall export figures is misleading. China is the only country of Germany’s top five export destinations that is not a eurozone member or the United States. However, in 2014, China only accounted for 6.6 percent of German exports. Furthermore, Germany’s exports to the U.S. and the U.K. increased markedly in 2015, by 18.7 percent and 12.8 percent respectively, according to the Federal Statistical Office (Destatis). The surge in exports across the Atlantic made the U.S. Germany’s top export destination – the first time since 1961 that France did not occupy that position. In terms of export volume, 2015 was a record year for Germany.

However, the situation is less rosy when broken down by sector. Roughly 40 percent of all German exports come from three key sectors: automotive (18.9 percent), mechanical engineering (12.1 percent) and electrical equipment (6 percent). In each of these sectors, China accounts for a great deal more than 6.6 percent of German exports. China imported 10.4 percent of all German cars in 2014 and 17.5 percent of all German manufactured parts.

Yet, demand for German goods has been slipping. In 2015, China’s automotive imports from Germany fell almost 16 percent. And China is not the only country where demand is falling. As more countries see reductions in their own export numbers, their ability to import products will also decline. Japan, South Korea and Russia all imported between 1 percent and 3 percent of Germany’s vehicle exports in 2014, and are also all suffering from the exporter malaise. Brazil’s cyclical woes also worsen the overall picture.

The situation is even worse in the mechanical engineering sector. China imports roughly 10 percent of German exports in this sector – but it imported 7 percent less in 2015 than in 2014. The mechanical engineering sector exports more to emerging markets than any other sector – totaling 38 percent of all exports to these markets, according to a report by Coface. The German Engineering Federation has already said that the prospects for this sector are bleak in 2016 as a result of declining demand from China and other emerging markets. Electrical equipment accounts for a much smaller share of Germany’s exports, but China imports more from this sector than any other country – and its imports went from growing 17 percent in 2014 to stagnating in 2015.

Despite China’s negative impact on the growth of German exports, overall Germany did quite well. However, there has been a fundamental reorientation of German exports since 2014. Official data from Destatis shows that from 2001 to 2014, Germany’s exports to China grew by an average of 16 percent every year. In 2015, Germany was able to compensate for the declines in exports to China, Brazil, Russia and other countries because of higher demand from the U.S., the U.K., the EU and other advanced economies.

Some of those advanced economies – like Japan and South Korea – are now feeling the sting of China themselves. And neither the U.S. nor the U.K. will be able to sustain the kind of preternatural Chinese growth rates that functioned as an engine for the global economy for decades and that highly benefited the German economy. The OECD has already revised projections for growth in the U.S. economy in 2016 from 2.2 percent to 2 percent. So even as Germany reports some positive export numbers – including the 1 percent growth in export orders in January announced on March 7 and the 7.5 percent growth in orders from the eurozone – that data has be understood within the current context. Compared to the heady 2000s and early 2010s, there is now a new and much lower ceiling for growth of German exports.

A Bevy of Advantages

Even so, the exporter crisis we have observed in other countries has not yet emerged in Germany. There are a few key reasons for this, and all of them have to do with strong domestic demand, which has picked up the slack thus far. In 2015, Germany’s economy grew by 1.7 percent, and according to data compiled by Reuters from Destatis, 1.5 percent of total growth was a result of domestic demand. That is a marked change for Germany, as nearly 50 percent of German GDP growth was attributed to exports until the financial crisis in 2008, and as recently as 2012, GDP growth was primarily a result of export growth. The German government has projected that the economy will grow 1.7 percent in 2016. Berlin projects domestic consumption will increase by 1.9 percent and employment levels will remain high, even as export growth is expected to slow from 5.4 percent to 3.2 percent.

The rate of German unemployment is at its lowest in 35 years – Destatis reported in 2016 that the unemployment rate was 4.3 percent. The labor market in Germany is very strong, both in terms of demand and compensation for workers. Germany’s Federal Employment Agency reported extremely high demand for labor in 2015. Reforms implemented by German Chancellor Angela Merkel’s predecessor Gerhard Schroeder resulted in decreased labor costs and increasing competitiveness. Workers are enjoying the benefits – the Council of Economic Experts estimated that wages across Germany grew roughly 3 percent in 2015. A national minimum wage of 8.50 euros was instituted last year, and some 3.7 million low income German workers are benefiting from the increasing purchasing power that comes as a result.

In addition, the decision to let more than a million refugees into Germany in 2015 presents some economic opportunities, although it has also created political challenges for Merkel. The influx of a million refugees and government spending to support them has further increased domestic demand. The German government spent over $11 billion – almost 0.3 percent of GDP – on refugees in 2015, according to local government data compiled by Frankfurter Allgemeine Zeitung, an increase from $2.5 billion in 2014. The German budget passed in November 2015 set aside about $8.8 billion for refugees in 2016, and if more refugees come to Germany, state spending could easily exceed this total, which would increase growth in any German industry involved in accommodating or integrating these refugees.

Another advantage for the German economy are the policies of the European Central Bank (ECB). The ECB announced another decrease in interest rates for marginal lending on March 10, and record low interest rates were already boosting domestic German consumption. Meanwhile, the ECB also pushed interest rates on deposits even further into negative territory, now standing at -0.4 percent, which means eurozone countries have an incentive to buy German goods rather than keep their money in savings. The weakness of the euro has increased demand for German exports in the U.S. and U.K. and monetary easing by the ECB is increasing demand from eurozone countries, which make up the biggest destination for German exports. Low oil prices have also put more money in the pockets of German consumers. Therefore, as wages go up and costs go down, consumers have more money to spend.

The result is that, even as Destatis showed a drop in exports of 0.5 percent in January, marking a second consecutive month of decline, German industrial production is showing signs of life, rising 3.3 percent in January. German factory orders were down overall in January, however, so the picture is not a simple one. The question is whether domestic demand can cover for Germany’s ultimate weakness. Germany’s dependence on exports will eventually catch up with it – and the timeline for when this will happen is ultimately not in Berlin’s control.

Overall Outlook

When Germany’s underlying export dependency begins to manifest more deeply, the first place it will be evident will be in German industry. On March 9, Siemens announced that it was going to cut 2,000 German jobs from its industrial drives and process solutions units. The company’s statement indicated that competition has increased markedly for products due to plunging demand in raw materials markets.

The loss of 2,000 jobs at one German company by itself does not mean that the German economy is doing poorly. But it is a perfect example of how Germany’s export dependency puts pressure on German domestic demand, which is what Germany is depending on for the majority of its GDP growth in 2016. A decline in exports could undermine Germany’s current employment rates. As much as Schroeder’s 2004 reforms have helped the labor market, they were not the cause of German prosperity in the 2000s. The demand for skilled workers increased in Germany because of strong demand for German products – and over this same time period, emerging markets like China made up a growing percentage of German exports, reaching almost 29 percent in 2015. Domestic consumption depends on workers having money with which to consume. And many of Germany’s workers have money because of industries dependent on exports. If German companies have to begin downsizing because of slowed export growth, domestic consumption will decline and Germany will really be in trouble.

Increasing exports to eurozone countries may be a useful stopgap to stem decline in demand for German exports. But eurozone countries already make up a disproportionately high percentage of total German exports – almost a third in 2014. This is another weakness in the German economic model. Germany must be able to export its goods to the eurozone. The eurozone is Germany’s primary market – and adopting the euro means these countries cannot devalue their currencies to make German goods less competitive.

Germany’s economy may be doing well, but Europe’s is not. Greece, Spain and southern Italy all have employment rates at or above 20 percent. In the last two years, Germany has come into conflict with Greece over economic policy – now Germany and Italy find themselves on opposite sides. Germany wants Italy to gets its banking crisis in order and to rein in state spending – without any financial assistance from Germany. Italy knows that while it has the second largest debt burden in the EU, Germany cannot afford to let the Italian situation get out of hand. France, the second biggest export destination for German goods, is not in as dire a situation as Italy, but prospects for growth in its economy don’t look good, and France and Germany also find themselves with diverging interests. The U.K. is contemplating an exit from the EU – and even if it stays, it will do so on its own terms.

Exports to Britain and the U.S. can only grow so much. And increasing exports to eurozone countries is a temporary solution. It fixes a short-term problem for Germany by replacing Chinese and emerging market demand for its exports. However, it makes Germany even more dependent on the eurozone. And there are no bandages or healing salves Germany can offer to eurozone countries to make them as economically successful as Germany.

Conclusion

Germany is becoming increasingly dependent on domestic consumption. This seems to bode well for Germany, given its low unemployment rates. But its healthy employment numbers developed in part due to global demand for German goods. Demand from China and other emerging markets is not going to reappear, and there is only so much that exporting to the eurozone, the U.K. and the U.S. can do. So global demand will continue to decline, and this will put pressure on German companies – which will in turn put pressure on domestic German demand.

I have cited many statistics in this briefing. The most important to remember is this: roughly 45 percent of Germany’s GDP comes from exports. Domestic consumption can push the limits of the gravitational force of this truth – but ultimately this will continue to pull Germany back down to earth, where many of the rest of the world’s exporters are currently in crisis.