NEWS / Foreign Exchange

German VAT hike deals a blow

Germany?’s VAT hike on January 1 has delivered a se-vere blow to retail sales. January retail sales fell 10% compared to the previous month ?– the biggest monthly fall ever and considerably greater than the normal re-action to a VAT hike. Consumer surveys point to an even more negative outlook for February, when we ex-pect another moderate fall in retail sales.

Germans hate inflation, and indeed the huge effect on consumption is very much psychologically driven. The VAT hike has pushed consumer prices just 1% higher, equivalent to a reduction in real incomes of the same order. However, the stabilisation of the oil price means that the net effect on real incomes of oil prices and the VAT hike is the same this year as in the past couple of years. Real incomes will actually grow more in 2007 than in 2006 due the developments in wages and em-ployment. This is why we expect private consumption to pick up again in the second quarter of this year.

While the downturn in consumption should prove tem-porary, we expect a considerable spillover effect on the important business confidence indicator, the ifo index, in the coming 3?–6 months. Meanwhile, German export growth has also fallen somewhat, and combined with the current unrest on equity markets, this will add to the negative impact on the ifo index. The superopti-mism that has pervaded in Germany over the past year or so will, in our opinion, be replaced by a more normal level of optimism in the coming months. In other words, the German upswing will survive the VAT hike, but growth will be in a slightly lower gear than in 2006.