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OO RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV
DE RUEHFT #1001/01 0950907
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O 040907Z APR 08
FM AMCONSUL FRANKFURT
TO RUEHC/SECSTATE WASHDC IMMEDIATE 5488
INFO RUEATRS/DEPT OF TREASURY WASHDC IMMEDIATE
RUCNMEM/EU MEMBER STATES  IMMEDIATE
RUCNFRG/FRG COLLECTIVE IMMEDIATE

UNCLAS SECTION 01 OF 02 FRANKFURT 001001 
 
SIPDIS 
 
DEPARTMENT FOR EUR/AGS 
TREASURY FOR LUKAS KOHLER/OFFICE FOR EUROPE AND EURASIA 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: EFIN ECON EU GM
 
SUBJECT: German Economy Holds its Breath for Financial Crisis to 
Pass 
 
 
ENTIRE TEXT IS SENSITIVE BUT UNCLASSIFIED.  NOT FOR INTERNET 
DISTRIBUTION 
 
¶1.  SUMMARY. The international financial crisis has so far had a 
limited impact in Germany and many analysts contend the EU and 
emerging markets will pick up most of the slack from lower exports 
to the U.S.  The soaring euro and a continuing stream of write-downs 
by German banks have shaken confidence in some quarters, resulting 
in a sustained reluctance by banks to lend to one another.  Our 
interlocutors were reasonably confident Germany would weather the 
storm, but most acknowledged that continued uncertainty in the 
markets made it difficult to look beyond the next several months. 
END SUMMARY. 
 
¶2.  In a series of meetings in Frankfurt and Wiesbaden on March 
27-28, EMIN, Congen Econoff, and FSNs met with senior economists and 
officials at Deutsche Bank, Goldman Sachs, the European Central Bank 
(ECB), and the German Council of Economic Experts.  Discussions 
ranged from recent actions by central banks to the health of the 
German economy. 
 
DECOUPLING: NOT IF, BUT HOW MUCH 
-------------------------------- 
 
¶3.  The theory that Germany's investment in and trade with new 
markets has reduced its once great reliance on exports to the U.S. 
has gained prominence in Germany and is commonly referred to as 
"decoupling."  Nonetheless, a senior economist at Deutsche Bank 
argued that, with the U.S. economy representing one quarter of world 
GDP, a slowdown was certain to have an effect on Germany, the 
world's largest exporter.  Although the Bundesbank recently 
indicated that German exports remained strong and would continue to 
do so, he argued that exports both to the U.S. and dollar-linked 
economies in the developing world would naturally decline by the end 
of the year, with a knock-on impact on overall growth.  The 
favorable news on current exports would disappear once the impact of 
the strong euro and the global slowdown appeared. 
 
¶4.  On the other hand, Goldman Sachs's chief economist argued that 
decoupling was here to stay.  Germany's exports to the developing 
world, especially to Brazil, Russia, India and China (the so-called 
BRIC countries), are expanding rapidly, while those to the U.S. 
represent a diminishing share of total trade.  Trade figures 
published by the German statistical office seem to prove the point: 
From 2006 to 2007, German trade with the BRIC countries increased 
15% from 63.1 billion euros ($99 billion) to 72.3 billion euros 
($114 billion), now almost on a par with the 73.4 billion euros 
($116 billion) of goods exported to the U.S., down from 77.9 billion 
euros ($123 billion) in 2006. 
 
¶5.  Economists at the German Council of Economic Experts, a 
prominent advisory body to the German government, agreed that the 
economy looked strong for 2008.  High-quality German industrial 
products, from machine tools to electronics, continue to be in high 
demand worldwide.  Competing on quality and reliability, rather than 
price alone, German sales are only marginally affected by the strong 
euro which may even help German firms gain a competitive edge on 
price-sensitive European competitors.  They also expect the effect 
of the subprime crisis on Germany to be limited since German 
enterprises traditionally rely heavily on their own capital 
resources and are therefore not as dependent on external credit.  In 
addition, they said the slowdown in the U.S. economy was 
sector-based focusing on areas such as construction that do not rely 
heavily on imports. 
 
BANKING SECTOR: NERVOUS WAIT FOR NORMALITY TO RESUME 
--------------------------------------------- ------- 
 
¶6.  European Central Bank (ECB) officials confirmed that interbank 
lending remained abnormal in Germany and Europe, with three-month 
rates still far above the official ECB rate.  The ECB on March 25 
allotted an extra 50 billion euros ($77.1 billion) in short-term 
credit as part of its weekly refinancing operation.  The bank 
announced March 28 it would provide 150 billion euros ($237 billion) 
in additional liquidity, which would include its first ever 
six-month refinancing operations, with three transactions at 25 
billion euros ($40 billion dollars) starting April 3. 
 
¶7.  Officials at the ECB argued that recent operations were driven 
primarily by banks' need for liquidity at the end of the reporting 
cycle, and reflect somewhat normal circumstances.  Private bank 
economists said that Spanish banks were large demanders of ECB 
credit.  ECB officials said that their acceptance of a wide range of 
collateral and a large set of counterparts in monetary operations, 
two practices that the U.S. Federal Reserve is reportedly now moving 
closer toward, have been keys to the successful response to the lack 
 
FRANKFURT 00001001  002 OF 002 
 
 
of liquidity. 
 
¶8.  The officials emphasized the difference in conditions in the 
U.S. and European financial markets in the current crisis saying of 
the U.S. "Who knows what we would have done?" and drawing a clear 
line between the interest rate policies of the Federal Reserve and 
the ECB.  Apart from the obvious difference in mandate, with the ECB 
primarily committed to price stability, officialssaid that they saw 
a different economic environmnt in Europe, with euro-zone inflation 
at a recod high of 3.3% in February and oil prices and demad both 
strong.  For Germany, the ECB expects excetional wage growth in 
2008 despite increased dowward risks.  When coupled with rising 
inflation,the ECB has little choice but to keep interest rats up. 
The Deutsche Bank economist even worried aout possible 
"stagflation" -- stagnation in Europan economies and rampant 
inflation in the develoing world -- and said that the key was for 
the EB to hold firm on interest rates. 
 
¶9.  The healt of the German banking sector was again questioned 
this week as greater than expected write-downs emrged from state 
banks BayernLB and WestLB (4.3 bllion euros or $6.7 billion, and 
1.6 billion eurs or $2.5 billion respectively).  Moreover, Deutsce 
Bank stepped back this week from profit target of only a month ago 
and reported expected write-owns in its leverage loan portfolio of 
2.5 billin euros ($4.0 billion) in the first quarter of 200.  The 
Deutsche Bank economist said his bank hadadjusted too slowly to new 
circumstances and, lie others, had not generated a new business 
model nd now faced a deteriorating revenue stream.  On te 
accounting side, he said the "mark to market" system has not worked 
well in a dysfunctional market where current prices do not reflect 
the true value of assets, and write-downs have a multiplier effect 
as banks unravel holdings.  Several experts wondered when cash-rich 
sovereign wealth funds would step in to buy up undervalued assets, 
seeing such a development as only a matter of time.  The Goldman 
Sachs economist predicted that German banks would leave capital 
markets and return to their core business: private lending. 
¶10.  A number of interlocutors speculated on the need for new 
regulation.  ECB officials echoed ECB President Jean Claude 
Trichet's testimony before the European Parliament on March 26 in 
which he pointed to the need for new regulation to be anti-cyclical. 
Present rules, they claim, have exacerbated problems rather than 
prevent them.  Rules kicked in when it was too late and are partly 
to blame for the downward spiral experienced in financial markets. 
One economist proposed that asset values should be included in the 
calculation of interest rates by central banks to prevent bubbles 
resulting from artificially low rates.  Private bank economists 
agreed that new rules on liquidity requirements for the financial 
sector were necessary. 
¶11.  COMMENT.  While projections for 2008 point to continued growth 
of the German economy, all forecasters have revised their 
expectations downward, lower than the government's prediction of 
just below 2%.  Despite strong fundamentals, downward risks loom: a 
strong euro, above-target inflation, and demand for large wage 
increases.  While central bankers deserve credit for maintaining 
macroeconomic stability to date, financial markets remain unsteady. 
"This is not a textbook situation," the ECB's chief economist said 
in describing the current state of affairs.  END COMMENT. 
 
¶13.  This cable was coordinated with Embassy Berlin. 
POWELL