German state borrowers in Australian dollars - themes of the last 13 years

In 2006, KangaNews and L-Bank hosted a roundtable to discuss the status of Germany, German regions, and the federal state issuers based in those regions, in global markets – including Australia. The years since have brought unprecedented upheaval, perhaps more so in Europe than anywhere else. Even so, German federal states – the länder– remain among the world’s highest-quality issuers. Two state-guaranteed development banks in particular – L-Bank and NRW.BANK – have returned to Australian dollar issuance.

In December 2019, 13 years on from the original roundtable, KangaNews and L-Bank spoke again to market participants familiar with the länder economies and capital-markets activities. Some themes have fallen by the wayside, others remain topical and still more are entirely new.

RETURNING PARTICIPANTS FROM 2006 ROUNDTABLE

Sven Lautenschläger International Funding Officer L-BANK
Frank Richter Head of Investor Relations NRW.BANK

Clemens Popp Global Head of Debt Origination UNICREDIT

NEW PARTICIPANTS FOR 2019

Tatjana Beuer Director, Long-Term Funding NRW.BANK
Craig Johnston Director and Head of Australian and New Zealand Dollar Syndicate DEUTSCHE BANK

Torben Skopnik Senior Credit Analyst, Financials, Covered Bonds and Agencies LBBW
Bernd Volk Director and Head of Covered Bond and Agency Research DEUTSCHE BANK

MODERATOR

Laurence Davison Head of Content and Editor KANGANEWS

THE GERMAN ECONOMY

Davison In 2006, participants talked about structural changes within the German economy that should improve competitiveness. The intervening years have been pretty traumatic, with the financial crisis, the eurozone debt crisis and now many years of QE and stagnant growth. Yet Germany remains Europe’s powerhouse. How do you assess the German economy and its growth prospects at the end of 2019?

LAUTENSCHLÄGER There is a lot of speculation about a recession in Germany but I do not share this view.

We are, in a way, at a point similar to the beginning of the century, when the German economy needed restructuring or reorganising. The nation is slightly dragging its heels on this front. After the financial crisis, Germany asked other countries to liberalise their labour markets and economies. But Germany itself did not do a lot. In my opinion, much could be done todeliver a positive impact on the economy.

The other thing people are underestimating is that the German federal government has allocated a lot of money over the past 2-4 years to infrastructure projects that have yet to commence. The money is there for the government to use in case the economic situation deteriorates.

I don’t think there is any need for further government spending at the moment, as there is a lack of capacity in the economy. The construction sector is facing a skills shortage, especially given the prospect of further projects. In other words, an automatic stimulus is operating due to the spending mood of the German public sector – which hasn’t been initiated so far.

Despite negativity around the drop in export activities, the balance of public spending and domestic consumption make me quite optimistic. With a few changes around the economy, Germany can remain a powerhouse.

RICHTER We are looking back on a volatile decade of economic and financial turbulence around the world. As well as the global financial crisis and the European sovereign debt crisis, in 2015-16 Europe faced giant refugee flows.

The eurozone in general and Germany in particular weathered the challenges successfully. The common currency is still alive and the institutional framework toward fiscal and banking union has been strengthened. Obviously, we haven’t finished the process but we have made significant progress. The most important new institution is the European Stability Mechanism.

Germany’s performance in these years has been strong. The country benefited from the reform agenda it implemented from the 2000s, including labour-market deregulation, cutting back welfare claims and wage growth below inflation – all of which have turned into productivity gains. Growth picked up in the first stage due to strong export performance. Later, growth forces shifted to the domestic part of the economy. Fuelled by lower interest rates and prevailing strong labour-market conditions, private consumption and construction did well.

I think it’s true that the overall interest rate has been too low for Germany’s economic performance in the last couple of years. But as long as inflation is not a threat, we should be happy to see rising disposable-income levels based on record-high employment levels.

On the other hand, Germany has been growing at 1.5-2 per cent above trend for a couple of years. There is no slack in the economy and, therefore, these growth rates are not sustainable. On the supply side, the economy is facing shortages in skilled labour and this limits growth to roughly 1 per cent.

On the demand side, headwinds from global trade are limiting Germany’s growth outlook as well. I think everybody is familiar with US-China trade tension, but maybe even more relevant are Brexit-related uncertainties.

“Since 2010, there has been an economic recovery all across the eurozone but particularly in Germany. We have had almost a decade of positive economic development. No-one would have expected in 2010 that we would have 10 years of growth and unemployment figures would be down to 2.4 million today (and a record low rate in October 2019).”

POPP More or less, 2010 marked the point at which the German economic situation shifted to positive. I still remember the cover page of an economic magazine that labelled Germany the “sick man of Europe”. Germany had lost economic power to an extent and unemployment was climbing – although it was still better than in the rest of continental Europe.

Since 2010, there has been an economic recovery all across the eurozone but particularly in Germany. We have had almost a decade of positive economic development. No-one would have expected in 2010 that we would have 10 years of growth and unemployment figures would be down to 2.4 million today.

I agree with Sven Lautenschläger about capacity. In many areas of Germany the search for skilled labour is more pronounced than ever. We have full employment in certain regions and this can be seen in the reduced funding requirement of the German states. It is down to the simple reason that tax collection has increased.

VOLK Most economists are arguing for the government to be more active through deficit financing. But I am in the complete opposite camp, because I agree with Sven Lautenschläger that Germany is suffering from too much regulation and too much government intervention. How can you argue for deficit-financing in an economy that has essentially been booming for the past 10 years?

If anything, Germany should have less spending. There is no need for even more government intervention. If there is recession risk, it comes from external factors like the weakening global economy and Germany being too dependent on exports. These are issues on which the government should act.

Davison Is this the school of thought that governments and central banks are trying to iron out what were previously thought of as normal fluctuations? That is, using crisis tactics for the normal economic cycle.

VOLK Yes. In the past, central banks and governments acted only when there was a recession. Now they – particularly the central banks – want to prevent any chance of recession, despite having something like a 50-year low in the unemployment rate.

The central bank wants to cut rates in an attempt to never have a recession again. But I’m not sure you can have an always-booming economy through accommodative policy and more government intervention.

There was an interesting article from Fitch Ratings in December 2019 about how the supranational sector’s funding is booming and has been for the past 10-20 years. This is a quasi-form of fiscal stimulus by these entities. The point is that there is so much intervention already I am not sure what more can be done to prevent recession.

“Germany’s performance in these years has been very strong. The country benefited from the reform agenda from the 2000s, including labour-market deregulation, cutting back welfare claims and wage growth below inflation – all of which have turned into productivity gains.”

POPP This is one of the most important questions. All the economic rulebooks have been completely rewritten since the financial crisis because the European Central Bank (ECB), as well as many other central banks around the world, said, ‘Okay, we will do whatever it takes to fix the market.’ The pure academic view is that this would normally create incredible inflation – but of course it didn’t happen.

The transmission mechanism between the amount of money available and the demand for goods was no longer working.

More money doesn’t automatically mean people start to spend it or that industry starts to demand more loans.

In this context, it was a brave thing for Mario Draghi to introduce unorthodox measures that no-one had previously deployed. What is going to be even more interesting, and this is something Christine Lagarde has to address, is how to phase it out – especially considering we are in an environment with little to no gunpowder left.

The ECB did not take the opportunity to increase rates throughout the last economic upswing. We had an interest rate that was too low for Germany, Austria, the Netherlands and Luxembourg, but much too high for Portugal, Italy, Greece and Spain.

We are now facing an economic slowdown with little room to manoeuvre.

RICHTER I agree with Bernd Volk that Germany’s prospects would be better without such an extreme accommodative policy. This type of monetary policy is not designed for the German economy.

From my understanding, potential growth is a function of productivity, labour and capital supply. Productivity is determined by technical progress. In the German case I see this factor contributing to potential growth of around 1 per cent. Labour supply is quite stable, due to an improved fertility rate and immigration. Large numbers of educated people have moved from other parts of the EU to Germany. The labour force is not shrinking and lifelong working time has increased. I am not afraid that Germany will go through a Japanification.

GERMAN STATE ISSUERS

Davison How have German state funding needs fluctuated since 2006?

POPP Capital markets are sensitive to economic developments. It is interesting to compare 2006 with 2019 when it comes to cross-funding requirements of German states.

On the surface, not a lot has happened. In 2006, we had €74.8 billion (US$82.4 billion) of German state cross-funding and in 2019 we had €68.4 billion. Looking at these figures in isolation, one could easily come to the conclusion that nothing happened in between. But the funding requirement of the German states actually peaked in 2010 with approximately €104.6 billion required.

The financial crisis had happened, followed by the sovereign crisis. This was a huge economic slowdown, and, of course, a slowdown results in a massive drop in tax collection that, in this case, propelled the funding requirement of the German states. They also rescued and recapitalised their Landesbanks and put money into the economy to counterbalance the downturn.

Davison Sovereign and subsovereign ratings have been under pressure in recent years but German state ratings have held up well, despite the economic challenges. What has supported this?

LAUTENSCHLÄGER The debt work implemented during the financial crisis strictly limits German states’ ability to take on more debt, with very few exceptions. The tax-income ratio was one of the reasons for Baden-Württemberg’s downgrade but it will now be relevant only if tax revenue drops significantly. We certainly don’t expect it to drop by 30 per cent, which would bring it down to the ratio we had in 2004.

SKOPNIK Baden-Württemberg returned to triple-A status in S&P Global ratings in 2012 and it is one of the most economically healthy regions in Germany. It is dependent on the export market, though. And this exposure to the world economy is why it had one of the largest dips among the German länder during the financial crisis.

The other side of this is that the Baden-Württemberg economy turned back up within a year. This is the reality of having a strong economy but one that is quite dependent on exports. It is similar for Bavaria.

Over the past 13 years any rating changes for the German länder have been upwards.

In September 2019, S&P Global Ratings upgraded the state of North Rhine-Westphalia. This reflects the improved economic situation in Germany and for the länder. Germany profited a lot during the recovery after the financial crisis and as a result of the “Agenda 2010” policy Gerhardt Schröder put into place to decrease labour costs.

The latter made German products comparatively cheap in the EU and the rest of the world. This has helped the German economic situation a lot in recent years.

“When I look at what is sold in the Australian market, generally risk appetite has grown so significantly that risk pricing seems almost to have vanished. We are now in a period where it is not credit quality that counts but absolute yield. Investors seem to be looking at how they can get maximum yield irrespective of the credit.”

LAUTENSCHLÄGER The thing about export-led economies is that they are similar to the concept of being married – there are good times and bad times. In good times, we are proud of our export activities and in bad times we say it is not something we should focus on.

Baden-Württemberg operates on the basis that open and free markets and global trade are best for everyone. This is why we have adjusted our economy according to the idea of open markets.

It is a problem, however, when politicians in other countries have different agendas and want to go back to how the situation was 40 or 50 years ago when markets were isolated.

People underestimate the quantitative impact of open markets. If you want to reduce the cost of living for a significant part of your population on a long-term basis – and it’s fair to say even the majority of the US population is not wealthy – you have to progress with the concept of open or opening markets.

We are of the view that, on a long-term basis, open markets are the right way to go. We have to focus on our strengths and this means that external factors hit us sometimes. This is where we are with the export market right now.

A different world: issues and challenges from 2006

There are some similarities between 2006 and 2019, including a growing sense that the end of a cycle may be imminent and asset prices are probably overextended. As this review of talking points from the 2006 roundtable shows, however, more has changed than remains the same.

DAVISON Budget performance at German federal state level is a key factor for the agency sector, and in 2006 we talked about a number of budgetary challenges. States were confronting significant deficits. How have things changed?

RICHTER While it took some time to get there, the North Rhine-Westphalia budget is now balanced and has been since 2016.

THE LÄNDER HAVE USED THE POSITIVE ECONOMIC SITUATION EXPERIENCED OVER THE POST-CRISIS PERIOD TO DECREASE THEIR OVERALL DEBT LEVELS. ONLY TWO STATES PLANNED TO INCREASE NET DEBT IN 2019 AND MOST HAVE ALREADY REDUCED OUTRIGHT DEBT LEVELS.

TORBEN SKOPNIK LBBW

Read the full story

CAPITAL MARKETS

Davison We asked at the 2006 roundtable what European investors focus on when they assess German state credit. In today’s ultra-low rate environment, do investors still analyse states like Baden-Württemberg and North Rhine-Westphalia on a credit basis? Has relative pricing become purely a function of liquidity?

BEUER The number of ‘real’ triple-As in the world has fallen but Germany is still one of them. I think international investors view North Rhine-Westphalia and NRW.BANK as substitutes for the Bund, being the same credit quality with a spread pickup. From my perspective, pricing is more a function of liquidity.

LAUTENSCHLÄGER The rating is not as important for public-sector issuers as it is for the private sector. This is even more the case because of the unusual situation with QE buying. If any issuer suffers from a downgrade, it might lose a couple of investors that are allowed to buy only triple-A, but the ECB would easily take up any shortfall.

It is difficult for the ECB to find the volume it needs in each QE round, so it will generally buy any loose paper in the market. This is why it is not difficult for issuers to handle downgrades as long as they are in the public sector and rated at least single-A.

“We have growing interaction with Japanese lifers, Australian bank treasuries and asset managers, as well as central banks around the globe. Line sizes have grown from A$50 million (US$34.4 million) to A$180 million to A$550 million. Our curve now covers the five- and 10-year segments.”

VOLK Generally, I am positive on the federal states. The pickup federal states offer against Bund, despite being similar entities, is quite attractive. If there is a crisis, I would expect the federal states – especially L-Bank and NRW.BANK – to outperform even the supranationals. They are less liquid than KfW Bankengruppe (KfW) and Bunds but they are a good investment.

JOHNSTON In the Kangaroo market, investors outside Australia tend to look at relative pricing between German agencies in US dollars and euros, and try to apply them to Australian dollars. This provides opportunities when agency paper looks cheap in Australia relative to global curves. Things like the L-Bank-KfW spread are pretty important in this context.

I think the success L-Bank and NRW.BANK have had in the Australian market in the last few years shows that investors are fundamentally willing to look beyond KfW and Rentenbank in the German agency sector to pick up some spread.

Investors for the most part are very comfortable with all the German agency credits, including with the support mechanisms. The deals L-Bank and NRW.BANK have done in Australia have increased in volume and had easier access.

As the market continues to rally, all the German agencies’ spreads to government bonds have remained relatively static. Spread as a component of absolute yield has increased, of course, as rates have gone lower. Investors that benchmark agencies to government bonds have found the agencies increasingly attractive.

Davison L-Bank and NRW.BANK had some early success in the Kangaroo market in the period 2004-07, then were absent until 2014, for L-Bank, and 2016 for NRW.BANK. How has the Australian dollar market lived up to the expectations and hopes issuers might have had going back to 2006?

BEUER It has been a bumpy road for NRW.BANK. We have tried hard to create confidence and interest in our Kangaroo bonds and now, more than three years after relaunching our market engagement, we are quite pleased with the results.

We have growing interaction with Japanese lifers, Australian bank treasuries and asset managers, as well as central banks around the globe. Line sizes have grown from A$50 million to A$180 million to A$550 million. Our curve now covers the five- and 10-year segments.

JOHNSTON I think it has become clear that Australian investors prefer supranational, sovereign and agency (SSA) issuers, like L-Bank, that bring deals when there is real demand, rather than just when the basis swap works. This type of issuance approach really does resonate with local investors.

On the other hand, the reality is that investors are pretty focused on spread product at the moment. It’s simply a function of where rates are now.

Taking a snapshot of the market, the currency has been stubborn, there hasn’t been a lot of SSA issuance – which tends to get investors interested – and swap spreads haven’t moved much. It’s no great surprise in this context that investors are focused on credit.

This didn’t stop Australian semi-governments doing successful deals in 2019, but these issuers have some advantages SSAs lack.

For one thing, the 5-10 year part of the curve has been artificially flat for a couple of years. This is starting to normalise, and if investors are rewarded for going to 10 years, we might see some of them looking at the type of deals SSAs issue in Australian dollars.

LAUTENSCHLÄGER When I look at what is sold in the Australian market, risk appetite has generally grown so significantly that risk pricing seems almost to have vanished. We are now in a period when it is not credit quality that counts. Investors seem to be looking at how they can get maximum yield irrespective of the credit.

The hunt for yield is not unique but the situation in the Australian market is, because it is not as international as, for example, the US dollar market. In a global market, developments can change some investors’ perspectives on certain asset or credit-quality classes but demand in other regions tends to balance this. Overall, global demand tends not to change much.

The Australian market is not as big and not as diverse, so a change in investors’ views cannot be balanced by other regions. This is one of the reasons we are seeing a less fruitful market for SSAs – because one major source of demand is not as active as in the past.

Additionally, the Australian market does not seem to have been able to develop an investor base that is more concerned with credit quality than absolute yield.

“If Australian QE happens, and if semi-government securities are involved, there will be a tightening effect across the market as well as a possible crowding-out effect for semis. SSAs won’t be included in any local QE programme but it’s hard to imagine that the second-order effects of QE wouldn’t include a positive impact for SSAs.”

Davison The Australian domestic investor base seems to typically regard the SSA sector as a pure relative-value play – especially regarding smaller issuers. Has anything changed on this front, and might German state names have hoped for a more engaged Australian domestic investor base?

JOHNSTON The potential for Australian QE is interesting in this context. If it happens, and if semi-government securities are involved, there will be a tightening effect across the market as well as a possible crowding-out effect for semis. SSAs won’t be included in any local QE programme but it’s hard to imagine that the second-order effects of QE wouldn’t include a positive impact for SSAs.

LAUTENSCHLÄGER Investors welcome issuers but there doesn’t seem to be much reward for putting long-term effort into the Australian market. We take a long-term approach to every market but, in an environment in which triple-A quality no longer counts and only yield is important, issuers from the triple-A sector are by definition losing out because we cannot compete on yield. It is a structural market development that Australia has become so much more credit-focused.