Germany’s Coming Downgrade

by Sylvester Eijffinger and Edin Mujagic

Sylvester Eijffinger is Professor of Financial Economics at Tilburg University in the Netherlands. Edin Mujagic is a monetary economist at Tilburg University.

TILBURG – On December 5, the Dutch celebrate Sinterklaas, a traditional winter holiday that people celebrate by preparing surprises for each other. But this year’s celebration was marred by a surprise that no one wanted: just days before, the credit-rating agency Standard & Poor’s stripped the Netherlands of its coveted triple-A status.

The Dutch government reacted to the downgrade much as France did when it lost its triple-A rating almost two years ago. There is no need for alarm, French officials insisted, because the other two big rating agencies, Moody’s and Fitch, maintained their highest ratings on French sovereign debt. But, earlier this year, France lost its triple-A rating at both Moody’s and Fitch, and S&P downgraded its debt yet again.

Indeed, the Netherlands has plenty of reason to worry – especially given that it is ostensibly doing everything right. When France was downgraded, its public debt exceeded 90% of GDP, and the government had made clear that it would not risk short-term economic growth by addressing its budget deficit. The Netherlands, by contrast, has a relatively low public debt/GDP ratio of 74%, which it is committed to reducing further.

This should raise serious concerns for the currency union’s most important economy – Germany – which, along with Finland, is now one of the only eurozone countries that retains a triple-A rating with S&P. (Luxembourg also enjoys a top credit rating, but its large financial sector makes it a unique case.)

The economies of Germany and the Netherlands are closely linked, with the latter highly dependent on its larger neighbor. For decades, Dutch monetary policy was based on matching German interest rates and maintaining a stable exchange rate between the Dutch guilder and the Deutsche Mark.

Likewise, both countries emphasize low deficits and public debt, with the Netherlands having long been Germany’s most loyal ally in European fiscal, economic, and monetary matters. Indeed, Germany and the Netherlands were among the main proponents of the European Union’s Stability and Growth Pact.

Germany’s public debt is higher than the Netherlands’, especially considering that the Dutch have a natural-gas supply worth well over 20% of GDP and pension-fund savings of some €1 trillion ($1.37 trillion), or roughly 140% of GDP. And, while Germany’s fiscal position is currently much healthier than that of the Netherlands, owing to its exceptional economic performance since the crisis began, faltering output is now threatening to weaken it considerably.

S&P cites weakening growth prospects as the reason for its downgrade of the Netherlands. The Dutch economy contracted by 1.2% this year, and is expected to grow by a meager 0.5% next year. But the outlook is not much better for Germany. While the Bundesbank projects a 1.8% annual growth rate for next year, this figure is highly uncertain. And, in the medium term, Germany will face significantly greater challenges from population aging than the Netherlands.

Another potentially destabilizing factor is the cost of saving the euro, which could skyrocket if the crisis escalates further. Given that Germany and the Netherlands have provided large guarantees, they risk a substantial increase in public debt.

Moreover, German politics is entering a new phase, with a grand coalition of Christian Democrats and Social Democrats set to rule the country for the next four years. While most Germans support the new government, and other countries have called it a boon for Europe, there is a risk that the two parties’ divergent views on how to fix the eurozone could cause friction. For example, the Social Democrats support the implementation of Eurobonds, which the Christian Democrats vehemently oppose.

More broadly, the coalition’s main potential benefit – strong support for the government in parliament – could backfire, with the parties’ conflicting stances preventing any significant reforms. And the reforms that are undertaken, such as the planned introduction of a minimum wage, could undermine economic performance.

Given that its medium-term economic outlook is very similar to that of the Netherlands, Germany should take the Dutch downgrade as a warning that its triple-A rating is far from secure. In fact, with Germany’s political effectiveness, economic momentum, and fiscal position at risk, a downgrade may well be only a matter of time.


Copyright: Project Syndicate, 2013.
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