Germany's economy likely past its industrial peak – analysts

Germany's industrial sectors, a key element of the eurozone's largest economy, are on a likely path of decline as the country adapts to more expensive energy.

A combination of structurally higher energy prices, a drop in demand from China, competition from electric vehicles and subsidies in the US are weighing on production in Germany's industrial heartlands.

While trends toward decarbonization and electrification, as well as robotics and automation, are expected to benefit Germany's high-quality manufacturing in electrical engineering and mechanical engineering, economists believe more energy-intensive sectors, such as chemicals and steel, face long-term decline.

"German industrial production peaked in 2017 and is likely to decline over the medium term," said Andrew Kenningham, chief Europe economist at Capital Economics. "Gas prices are still around five times as high in Europe as in the US and we think they will converge with US levels only gradually."

Sick man of Europe

Germany's extensive industrial economy faced an existential crisis as Russian tanks rolled into Ukraine in February 2022. The political decision to phase out imports of Russian gas and oil severed a key supply of cheap energy that had helped Germany become a major producer and exporter of manufactured goods.

Energy prices ballooned from an average of €83/MWh in August 2021 to €467/MWh in August 2022. While that level is down significantly, it is still flirting with €100/MWh and vulnerable to further dislocations in energy prices.

The German economy is suffering as a result. It shrank 0.1% quarter over quarter in the third quarter, and while there were upward revisions of 0.1 percentage point in first- and second-quarter data, that still left consecutive quarters of growth of 0% and 0.1% respectively. Overall the economy is still just 0.3 percentage point higher than the pre-pandemic level, underperforming the other G7 countries. Economists at S&P Global Market Intelligence expect Germany's GDP to shrink 0.4% in 2023 before growing 0.5% in 2024.

Germany's manufacturing purchasing managers' index was just 40.7 in October, a 16th consecutive monthly contraction and well below the 50.0 level that marks stability, according to Market Intelligence data. Meanwhile, the ifo business climate survey — a monthly read on economic developments in the country — rose to 86.9 in October from 85.8 in September, but remained far below the 100 level of stability, suggesting worsening conditions.

Those indicators give "little reason for optimism in the short term," said Stefan Schilbe, chief German economist at HSBC.

Industry takes the brunt

The situation is particularly tough for energy-intensive sectors. Production in the chemicals industry is 23.6% below the peak at the end of 2017, with much of the production unlikely to return to the country according to Deutsche Bank. The building materials and paper industries have seen similarly sharp declines.

Steel production slumped 8.4% in 2022 to 36.4 million metric tons and as of August the 2023 total is down another 4% as the cost of energy bites, according to the German Steel Association.

"The deterioration of the cost situation has become a serious threat for the energy-intensive sectors, which could force companies to move production plants abroad," said Schilbe.

Concern over the long-term viability of these sectors has led to demands that the government intervene to cap power prices for energy-intensive sectors.

Experts say such an intervention is justified, particularly for electricity-intensive processes such as chlorine, polysilicon and aluminum production, until the renewables buildout in Germany has progressed far enough to bring down prices.

So far, political consensus on how to introduce a state-funded price cap has not been achieved. Critics say that it could reduce incentives for companies to modernize and improve efficiencies, while others warn that the subsidies are in breach of EU state aid rules.

Meanwhile, the automotive sector, home to global brands such as Mercedes and Volkswagen, has been under pressure since COVID-19. Some 5.3 million fewer cars were produced cumulatively in Germany from 2020 to 2022 than from 2017 to 2019, a decline of 34.6% as demand fell and acute tightness in supply chains limited the supply of semiconductors, according to Deutsche Bank.

"The transformation in the sector towards electromobility is likely to lead to net losses in value added in Germany," said Eric Heymann, senior economist at Deutsche Bank. "Production cutbacks are likely to be unavoidable, particularly for suppliers mainly producing parts and components for cars with internal combustion engines."

The bank believes higher costs will make it more difficult for German automakers to build cars at the same volumes they have traditionally.

"It is unlikely that production levels will return to previous highs," Heymann said.

The competition from China is also expected to grow if electric vehicles grab a bigger share of the global car market.

"There is a growing threat to German auto production from Chinese EVs, initially mostly overseas so affecting German production in its overseas plants but later in the decade in Europe too," Kennigham said.

Some industrial sectors will remain strong in Germany, particularly electrical engineering, where production has increased 18% since the beginning of 2015. Meanwhile, some large individual companies are expected to be able to ride the wave. Yet, Deutsche Bank anticipates manufacturing will decline further as a percentage of total gross value in the German economy, having fallen to 20.4% in 2022 from 22.9% in 2016.

"In the future, it will be more important to distinguish between Germany as an industrial location and German industrial companies," Heymann said.

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