A view from London

The German economy has barely grown since the COVID-19 pandemic. The last several years have been characterised by little improvement to real incomes, falling industrial employment and elevated energy costs driving up inflation. Germany's, otherwise successful, manufacturing and exports-driven economic model has left it particularly vulnerable to recent global developments, resulting in this underperformance.

Its outsize manufacturing sector includes sizeable chemicals, metals, glass and ceramics industries that are especially energy intensive. Berlin's decision to wind down nuclear power generation left the sector heavily reliant on cheap Russian gas. The cessation of supplies since Russia's invasion of Ukraine has squeezed industrial output. Crucially, higher energy prices have prompted large industrial companies to reduce domestic capacity and pursue investment abroad.

For much of the previous decade, Chinese investment and industrialisation generated strong demand for German goods such as machinery, chemicals and cars. That tailwind has reversed. Slower construction activity and weakening Chinese consumption has reduced demand, while policies promoting domestic supply chains have enabled Chinese producers to replace imports and move into the higher-value industries in which Germany specialised. This has driven a long-term decline in German exports to China. Alongside this, sharply higher US tariffs have introduced greater friction in trade with the US - Germany's largest export market.

China has also emerged a major competitor to German exports across the world. As Chinese producers have moved up the value chain in vehicles, machinery, electrical equipment and chemicals, they have not only displaced German imports in the Chinese market but are also taking market share from German exporters elsewhere. Nowhere is this more evident than in the automotive sector, with soaring sales of Chinese EVs in Europe squeezing the market shares of German and other European carmakers.

These factors alongside skills shortages, weak digital infrastructure and heavy administrative burdens have all reduced expected returns from investing in Germany. That has driven a slump in private investment, which, adjusting for inflation, remains below levels last seen in 2015.

So, what will drive German growth in the near future?

Despite these structural challenges, Germany has one significant advantage over its developed-economy peers - comparatively strong public finances. Lower levels of indebtedness, lower cost of borrowing and it safe-haven status mean that it has substantial room to borrow and spend on drivers of growth.

And it is doing exactly that, with a huge fiscal expansion underway. Last March, chancellor Merz announced a €500bn fund for investing in infrastructure and the energy transition, equivalent to around a tenth of GDP, to be deployed over 12 years. He also lifted constraints on borrowing to invest in defence, with the goal of delivering a substantial rise in defence spending. Although significant additional spending has already been authorised, as part of these packages, slow implementation pipelines, planning bottlenecks and offsetting private-sector drag mean headline GDP figures have yet to reflect the bulk of it.

The good news is that this fiscal boost is becoming apparent in business sentiment and corporate activity data. The closely followed Ifo business-climate index has risen to its highest level in more than three years. Purchasing managers indices now point to expansion overall, driven by a continued improvement in manufacturing orders. Large contracts account for much of the increase, suggesting that defence and infrastructure procurement is starting to feed through to demand. Economists are upgrading their growth forecasts as a result. The Ifo Institute now forecasts growth of 1.4% in 2026 and 1.2% in 2027, well above its summer projection of 0.8% in both years.

GDP growth in the first half of this year also points to another encouraging development - stronger exports of electronics and electrical equipment, driven by the global boom in AI infrastructure investment.

Germany's fiscal expansion finally looks set to accelerate near-term activity. Chancellor Merz will be hoping that this pickup feeds quickly through to employment and real incomes, despite the energy shock from the war in Iran.

But expanding productive capacity through investments in defence and infrastructure is just one prerequisite for faster long-term growth. A crucial counterpart to it are the structural reforms proposed by Mr Merz. Cutting red tape, increasing labour market flexibility and overhauling the pension system to unlock private investment will be key to an enduring uplift in Germany's economic trajectory. Yet, the outcome of recent local elections suggests it would be politically challenging to push through these reforms, which now seem likely to be diluted.

Faced with years of low-to-no growth, German policymakers have succeeded in effecting the changes needed to spark an economic recovery. But to sustain it, they will need to develop a consensus on restoring Germany's export competitiveness. And adapt its economic model to a western world increasingly wary of the side-effects of free trade.