German upset opens way for ECB rate cuts

Prospects of growth-boosting cuts in the eurozone's interest rates rose yesterday after the German government announced that Europe's biggest economy all but ground to a halt last year, posting its weakest performance since 1993.

Financial markets were braced for an early response from the European Central Bank, following news that growth in Germany slipped to 0.2% in 2002, leaving the country that accounts for 30% of eurozone GDP the laggard of the 12 nations included in monetary union.

Chancellor Gerhard Schroeder's government, facing key regional elections on February 2, put a brave face on the news. "There is no reason for pessimism about the economy," the economics ministry said. Sources admitted, however, that 2003 would be another tough year, and the government would cut its growth forecast from 1.5% to 1%.

Mr Schroeder's popularity has plummeted as evidence of Germany's economic woes has accumulated since he pulled off a surprise win in last September's election. Adding to the gloom, the country was yesterday affected by the latest strike called by the Verdi public sector union, which led to disruption of domestic flights following a lightning walk out by Lufthansa staff.

David Brown, chief European strategist at Bear Stearns, said: "Germany is in deep trouble and there is a good chance that the economy has already slipped halfway back into double dip recession. All the signs are that the eurozone's bellwether economy is losing the growth plot.

"With the German and eurozone downturns deepening, inflation slowing and the euro set to go higher in future, we would not rule out the chances of the repo rate target being set at 2% in the first half, if the situation really does go pear-shaped."

The ECB cut rates by 0.5 percentage points in December but, despite the threat to inflation from higher oil prices, analysts believe the impact of a stagnant Germany on the rest of the eurozone may force the bank's hand.

Without the boost from exports, the government said that the economy would have contracted by more than 1.3% in 2002. Private consumption fell by 0.5%, while investment in plant and machinery was down by more than 8%. Higher government spending also helped to underpin the economy, but pushed Germany's budget deficit to 3.7% of GDP, well above the 3% limit imposed by the eurozone's stability and growth pact.

Economists believe action by the Schroeder government to reduce the deficit will hamper growth this year and put further upward pressure on unemployment, already standing at more than four million. Gerd Hassel, analyst at ING-BHF bank in Frankfurt, said the economy appeared to have contracted by 0.1% in the final three months of 2002 and would be even weaker in the first quarter of 2003 as tax increases affected demand.