Germany: Europe's very own Japan?
Dark clouds are gathering over Germany, a country that was not so long ago Europe's brightest economic prospect. The Pfandbrief, once a symbol of strength, is weakened. The guarantee mechanisms of Anstaltslast and Gewährträgerhaftung, which made life so simple for the Landesbanks, survive only because of an artificial life support machine that will be turned off in 2005. The plug has already been pulled on the Neuer Markt.
Taxi drivers in Frankfurt mutter unhappily about the influence that "Ossies" are having on the social fabric of the city, a signal that German mitbestimmung (co-determination) is fraying at the edges. They also ask visitors if business is as bad in the US or the UK as it is in Germany, an equally sure signal that the Finanzplatz is not functioning quite as prosperously as its architects had anticipated.
With bankruptcies proliferating, unemployment at its highest level for decades, and the wealth that many German investors thought they had accumulated on the stock market airbrushed into history, many will be hoping that things can not possibly get worse for Europe's largest economy. That hope, possibly enlivened by October's US-induced rally in the German equity market, may be illusory. There is a growing disparity between the government's estimates for GDP growth in 2002 and 2003 and those of independent analysts.
Longer term, an unthinkable notion is rapidly gaining credibility in some quarters - that Germany's economy and its financial services sector may become increasingly reminiscent of Japan's in the 1990s. In a report on German banks published in September, Merrill Lynch was disturbingly explicit about this, beginning its analysis by warning that it had never been so worried about the German banking industry, adding that the parallels with Japan are worrying. "The more we think about it," noted the Merrill report, "the more we see disturbing parallels with Japan. In particular, the rapidly eroding gains on the banks' equity holdings, coupled with higher refinancing costs and relatively low tier one ratios, raise serious questions about the banks' ability to withstand a protracted difficult economic environment."
If the Merrill Lynch assessment of the German banking industry did little to enhance its popularity among Frankfurt financiers, nor - about a fortnight later - did its e-mail to Standard & Poor's (S&P) questioning Commerzbank's liquidity. The German bank itself responded with predictable fury, insisting that there was no question about it facing a liquidity crisis. And in fairness to Commerzbank, it won the support of a number of its Frankfurt-based competitors in its repudiation of the e-slur. "Quite frankly that e-mail didn't help Commerzbank and it didn't help any of us in the market," says a representative of a foreign bank in Frankfurt. "In fact Commerzbank is actually very well funded compared with a number of its European competitors."
"I think we can safely say that when Commerzbank does its next round of capital raising, Merrill Lynch won't be at the top of its list of lead manager candidates," says another.
Some two weeks after the publication of the Merrill Lynch analysis, Dresdner Kleinwort Wasserstein distributed a report that could be interpreted as a direct response, bearing the title "Challenged, but extreme worries unfounded". "We fundamentally believe" said the DrKW assessment, "that there are no underlying liquidity problems in the main German banks."
That view is one that is echoed by a number of bankers in Frankfurt, many of whom respond angrily to the Merrill Lynch analysis in general and its menacing cross-references to Japan in particular. That is understandable enough, and if the sole basis of the Merrill Lynch argument had been the current state of German banks' balance sheets, it could probably be dismissed as something written by an analyst who had listened to too much of "Turning Japanese" by one hit wonders The Vapours, rather than by somebody who really thinks so. But Merrill found not just one but six themes that were common to Japan between 1989 and 2002 and Germany in the last three years.
Alongside the weak banking system, these common characteristics are stock market and property bubbles, labyrinthine webs of corporate cross-holdings, reliance on banks as big lenders in the economy and social barriers to change coupled with ageing populations.
On the one hand, Frankfurt-based bankers respond with dismissive insouciance to the suggestion that Germany is in danger of evolving into the Japan of Europe. On the other, and perhaps almost unwittingly, they hint at developments and characteristics that strengthen the suggestion. For example, in one breath a banker dismisses the Merrill Lynch report as "rubbish", but in virtually the next expresses the concern that the German corporate sector is withdrawing from both the bond and the loan market and has established budget trimming as its "number one priority". That implies a reluctance to invest, and in turn foreshadows dangers of protracted deflation. Sounds familiar?
Another banker also hints at important and potentially alarming similarities between Germany and Japan when he comments that "this is a consensus-based society, which means that important decisions tend to take a long time to make." Sounds familiar? Dithering indecision at a political level has, after all, exacerbated Japan's economic woes over the last decade.
In terms of Germany's capacity to respond more decisively to its deep-rooted structural difficulties than Japan has done, the outcome of the recent election did not help much. As Barclays Capital advised in an analysis published shortly after Schröder's narrow victory at the polls, "the re-election of the SPD/Greens coalition means there are unlikely to be any significant policy changes, and Germany's economic problems will remain." The tiny majority, meanwhile, will "make it difficult to speed up and intensify the reform process."
Whether it is because of this gloomy outlook for the broader economy, or because dealflow from Germany has been a disappointment to many bankers, or simply because of structural changes within the global financial services sector, there is something of a merry-go-round now taking place within the Frankfurt banking community, which is at least keeping some of the local headhunters busy. A clear trend has been that many of the so-called "pure" investment banks have been cutting back their local operations, some more sharply than others, while the larger balance sheet players appear to be bolstering theirs.
The most notable reduction, say local bankers, has been seen at houses such as Merrill Lynch and Morgan Stanley; conversely, those such as ABN Amro, Bank of America, and Citgroup/SSSB have been aggressively hiring new staff members. Much of that recruitment drive has, not surprisingly, been on the fixed income side, but it has not been exclusively so, and Citi/SSSB gave an insight into its ambitions as a full-service house with the recent recruitment of Paul Lerbinger as co-head of investment banking. Lerbinger arrived from Deutsche Bank, where he was head of equity capital markets.
"The investment banks are contracting pretty substantially," says a representative of one of the commercial-cum-investment banks that is beefing up its Frankfurt presence. "Of course that is more on the equity and M&A side, but I've also seen some evidence that they are cutting back in fixed income. Maybe that's because the US houses are overly preoccupied with short term return on equity levels than the European commercial banks, which tend to have much less ambitious targets. Whatever the reason, it does seem to be creating new opportunities for houses like Crédit Agricole, Royal Bank of Scotland, ABN Amro, Bank of America and others."
Although some of the pure investment banks may be cutting back their operations, there are few indications that the absurdly over-banked German market is becoming noticeably less competitive. That explains why, with an increasingly focused eye on their weak return on equity levels, the German banks in particular report that their strategy in the domestic market is necessarily becoming more selective.
At Commerzbank Securities in Frankfurt, global head of debt capital markets Roman Schmidt explains that the maths within the German market simply no longer add up. "If you look at the top 30 corporate names in Germany they are all over-banked," he says. "Everybody wants to do business with them but in many areas the business just isn't there. If each bank were to calculate how much return on equity they were giving up for every corporate client by providing them with balance sheet and credit lines, they would probably come to the conclusion that those corporates would never be able to make up for the shortfall in fees.
"That means we have to focus our business very selectively, and we have done so successfully. For example, at Commerzbank Securities we took a big bet on the expansion of the German ABS market and that business has really taken off." *