A reason for concern

Marco Flaccadoro is an Economist at the Bank of Italy

The surge in energy prices, which started at the end of 2021, has severely impacted the euro area manufacturing sector, the output of which has declined below its pre-pandemic level in late 2024 (Figure 1). German industry was strongly affected (Bachmann et al 2022) and experienced an even steeper contraction, reducing its output by approximately 10 percentage points.

The weakness of the industrial sector in Germany is a reason for concern for the whole euro area: given the tight integration of manufacturing activity across euro area economies (Amador et al 2015), developments in the German industry may generate significant externalities.

Figure 1. Manufacturing production indices (2019Q4=100)

Note: all data are seasonally adjusted and in 3-term moving averages. Last observation: November 2024.

Source: Eurostat and author’s calculations.

In a new paper (Flaccadoro 2024)¹, we shed light on three main factors that contributed to Germany’s relatively weaker performance in the past few years and analyse the spillover effects to other euro area economies.

The energy crisis

First, the rise in energy costs in Europe affected manufacturers more severely in Germany than it did in other euro area countries.  Energy-intensive industries – i.e. those displaying a relatively high natural gas content in their production process² – account for a similar share of manufacturing in Germany and in the euro area overall.

Likewise, there were no significant differences in gas prices between Germany and the euro area when looking at non-household heavy energy users over the past few years. Thus, it is plausibly the higher intensity of gas consumption in Germany’s gas-intensive industries that disrupted production there more than in other euro area countries, particularly in the chemical sector.

Indeed, the chemical sector in Germany is more reliant on natural gas as an intermediate input than in other euro area countries because of its technological characteristics. Due to the chemical industry’s significant connections with other sectors, its weakness passed through to other energy-intensive industries, causing a more pronounced decline in production within German energy-intensive sectors compared to the euro area as a whole (Figure 2).

Figure 2. Production in energy-intensive sectors (2019Q4=100)

Note: the industrial production index relating to the energy-intensive industries is computed using the following sectors (NACE 2-digit classification): C17, manufacture of paper and paper products; C20, manufacture of chemical and chemical products; C23, manufacture of other non-metallic mineral products; and C24, manufacture of basic metals. All data are seasonally adjusted and in 3-term moving averages. Last observation: November 2024.

Source: Eurostat and author’s calculations.

Weak demand conditions

Second, the slowdown in global demand for goods, rising trade fragmentation, and intensified competition from Chinese producers have impacted German manufacturing firms more than those in other major euro area countries, due to Germany’s greater trade openness.

In fact, in 2023 goods exports accounted for 34% of GDP in Germany, against 27% in Italy and 23% in France. Furthermore, Germany’s goods exports were more tilted towards China (6.1% of total goods exports, compared to 4.2% in France and 3.1% in Italy)³.

In addition, price competitiveness indicators computed by the Bank of Italy (Felettigh and Giordano 2018) show a deterioration for German manufacturers since mid-2022 with respect to other euro area countries, associated with the increase in energy costs and, later, the faster wage dynamics. This dynamic stood in contrast to the significant competitiveness gains achieved by German firms in the early 2000s following the Hartz labour market reforms (Fadinger et al 2023).

Consistently, German exports of goods have lost momentum: after increasing in the aftermath of the pandemic crisis, they declined below pre-pandemic values in the summer months of 2024 (Figure 3). In contrast, euro area exports increased by approximately 5% above their pre-crisis levels in the same period.

The slowdown in global demand for goods, rising trade fragmentation, and intensified competition from Chinese producers have impacted German manufacturing firms more than those in other major euro area countries, due to Germany’s greater trade openness

Figure 3. Exports of goods (2019Q4=100)

Note: chain-linked values; last observations: 2024Q3.

Source: Eurostat, and author’s calculations.

Decline in the automotive industry

The third factor is the downturn in the automotive industry, the weight of which is twice as relevant in Germany than in the euro area as a whole. This sector is affected by low demand and increasing competition from Chinese carmakers.

Accordingly, quantitative demand-side indicators for the motor vehicle sector are consistent with lacklustre domestic demand for cars, as shown by the downward trend in car registrations in the euro area as a whole (Figure 4). Al-Haschimi et al (2024) show that between 2019 and 2023, the euro area car industry faced adverse developments in its relative producer prices and a reduction in market shares with respect to Chinese manufacturers⁴.

In particular, China is a fierce competitor for European car manufactures, as its low-cost electric vehicles (EVs) are exported to Europe in large numbers. Given that the EU represents the most important market for the exports of German EVs (85% of exports, almost $20 billion), China represents a critical source of competitions for German carmakers.

Figure 4. Car registrations (2019Q4 = 100)

Note: All data are seasonally adjusted and in 3-term moving averages. Last observation: December 2024.

Source: Eurostat and author’s elaborations.

Finally, recent developments in the regulatory framework have sparked further uncertainty for car producers, both in Germany and in the EU. First, duties on the imports of electric vehicles from China, imposed by the European Commission in October 2024, could possibly induce some retaliation, dampening European car exports. Second, the potential re-opening of the 2035 zero emissions target for new cars and vans, which was adopted by the European Commission in March 2023 within the ‘Fit for 55’ deal, may induce EU households to postpone spending.

Spillover analysis

We now present the results of a spillover analysis that allows us to quantify the interdependence of manufacturing activity across the main euro area economies. In particular, we follow the approach of Diebold and Yilmaz (2009) and measure spillovers via the variance decomposition associated with a vector autoregressive (VAR) model. According to this approach, we estimate the spillovers from country i to country j as the fraction of the forecast error variance decomposition at a six-month horizon in country j due to shocks originated in country i.

Our baseline estimates focus on the period January 2010 to December 2019, to avoid our results being affected by the global financial crisis and the pandemic-related disruption to economic activity, and use data referring to the manufacturing production index of nine economies (Germany, Italy, France, Spain, Netherlands, Belgium, Austria, Finland, and Portugal).

Our findings are robust to extending the period of analysis up to July 2024, or backward to January 2000, and to controlling for industrial developments in the US and China. The spillovers from the German industry to the manufacturing sector of other euro area economies are large.

In fact, the shocks originated in the German industrial sector explain almost 31% of the forecast error variance of the Italian manufacturing activity six months later; while, shocks originated in the Italian manufacturing sector explain roughly 11% of the variability in German industrial activity.

Spillover effects from Germany are also sizable for France and Spain; while the innovations originating in these two countries determine more attenuated spillovers in the German manufacturing sector.

Looking ahead

The challenges presented above are not likely to dissipate soon. First, EU gas prices are set to remain above pre-energy crisis levels in the years to come. Second, the outlook for demand remains subdued and geopolitical factors pose a downward risk for economic activity. Third, demand is particularly weak for firms in the automotive sector, whereby the competition from Chinese manufacturers is set to intensify in coming years, especially in the green energy technology segment.

Endnotes

1. The main results of this contribution were also featured in the box entitled “The recent weakness of manufacturing in Germany and its impact on the rest of the euro area”, Economic Bulletin, Issue 1, 2025, Bank of Italy.

2. We measure the energy content of the production process for each industry by the ratio between the sectorial gas consumption and value added.

3. For an analysis of trade developments between Germany and China in the past decades, see Marin (2017).

4. A similar analysis by the Deutsche Bundesbank (2024) shows that since 2017 Germany has experienced a reduction in its market shares for motor vehicle products in several countries, owing to also the rising competitive pressure from China.

References

Al-Haschimi, A, L Emter, V Gunnella, I Ordoñez Martínez, T Schuler and T Spital (2024), “Why competition with China is getting tougher than ever”, ECB Blog.

Amador, J, R Cappariello and R Stehrer (2015), “Global value chains: a view from the euro area”, ECB working paper no. 1761.

Bachmann, R, D Baqaee, C Bayer, M Kuhn, A Löschel, B Moll, A Peichl, K Pittel and M Schularick (2022), “What if Germany is cut off from Russian energy?”, VoxEU.org, 25 March.

Deutsche Bundesbank (2024), “Recent developments in Germany’s automotive industry”, Monthly Report, November.

Diebold, FX and K Yilmaz (2009), “Measuring financial asset return and volatility spillovers, with application to global equity markets”, Economic Journal 119: 158 – 171.

Fadinger, H, P Herkenhoff and J Schymik (2023), “Lessons from the Germany shock: Consequences of uncoordinated economic policies in a currency union”, VoxEU.org, 10 September.

Felettigh, A, C Giordano (2018), “Rethinking prices and markets underlying price-competitiveness indicators”, Bank of Italy Occasional Paper no. 447.

Flaccadoro, M (2024), “The recent weakness in the German manufacturing sector”, Bank of Italy Occasional Papers no. 902.

Marin, D (2017), “The China shock: why Germany is different”, VoxEU.org, 7 September.

Author’s note: The opinions expressed in this column are those of the author and do not necessarily reflect the views of the Bank of Italy. This article was originally published on VoxEU.org.