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Both the carmaker and its home country are suffering from high costs, eroding tech leadership and a reliance on China

Volkswagen VOW3 0.61%increase; green up pointing triangle is going through its deepest crisis in years. So is Germany. And that’s no coincidence.

While the carmaker’s travails are exposing missteps, they also show how Germany’s economic model is struggling to keep up with a changing world. Fixing these problems will require changes both for the carmaker and the world’s third-largest economy.

“VW’s problems mirror to a degree the problems of the German economy, and the problems of the German economy are reflected in VW,” said Moritz Schularick, president of the Kiel Institute for the World Economy, an independent think tank. “Resistance to change is something that hangs over both.”

Tepid sales, mounting foreign competition, and an expensive electric-vehicle strategy that hasn’t wowed buyers have left VW’s stock trading around 14-year lows. On Tuesday, the company canceled a 30-year agreement to avoid compulsory redundancies at the VW brand, setting up a battle with workers as it looks to rightsize its cost base.

Meanwhile, Germany’s economy is stagnating. Its GDP, almost flat since 2019, shrunk 0.3% last year, and some economists expect it to contract again this year.

VW is Germany’s largest employer and car making is the country’s flagship industry, accounting for 5% of gross domestic product, according to several estimates.

“VW is to Germany what Nokia was to Finland or Samsung is to South Korea…There’s a scenario where that sector will shrink significantly and replacing those jobs with equally well-paid jobs will not be easy,” said Dirk Schumacher, Europe economist at Natixis.

Germany’s economic malaise and the crisis at VW have joint roots, according to economists and analysts: Heavy reliance on China, high costs and an eroding technological leadership.

Excessive reliance on China

Manufacturing accounts for a fifth of Germany’s gross domestic product, about twice the U.S. level, with a focus on capital goods and cars. For years, this was a good fit for a globalizing world: German companies built factories in emerging markets, dug Chinese subways and made cars for the new middle classes. While the Midwest was ravaged by deindustrialization, Germany’s industrial base grew.

Nowhere was the boom clearer than at VW. A decade ago, the company recorded €5.2 billion, equivalent to around $5.7 billion, of operating profit from its Chinese joint ventures, and that doesn’t include income from brand licensing, parts sales or exports of high-end models from Germany.

Covid-19, geopolitics and China’s maturing economy changed that. As tariffs and other trade barriers rose around the world, German exports began falling. China had been Germany’s largest trade partner since 2015, so slowing growth there hit German companies hard, as did the rise of Chinese competitors. “China,” said Schularick, “turned from tailwind to headwind.”

EV giant BYD overtook VW last year as China’s bestselling car brand. VW has relaunched its China strategy and expects its joint ventures there to bring home as little as €1.5 billion in operating profit this year.

“When Western executives returned to China after the pandemic…everybody expected the country to be sitting in a deep Covid hole but they had used the time to invest, become more competitive, cheaper and faster,” said Ulrich Ackermann, head of foreign trade at Germany’s VDMA mechanical engineering industry association.

In 2020, China overtook Germany as the biggest exporter of machinery and equipment, according to German trade statistics. Today it produces more industrial machines than the U.S., Germany and Japan together.

High costs at home

China isn’t alone to blame. The scale, cost and inflexibility of VW’s operations in Germany mean the company has thinner profit margins than its rivals despite owning a lucrative portfolio of luxury badges including Audi and Porsche. That makes the company vulnerable to macroeconomic or industry challenges. The tepid post-Covid recovery in European car sales, no longer masked by cash flows from China, is just the latest example.

In the year through July, roughly 17% fewer vehicles were registered in the eurozone and U.K.—key markets for the VW brand—than in 2019. Justifying its call for compulsory redundancies, management said the division had lost two plants’ worth of production.

While European peers Stellantis and Renault have trimmed staff in recent years, VW’s head count has grown modestly.

VW finds it hard to let workers go because of its unusual governance. The State of Lower Saxony owns 20% of the company’s voting shares, and a special “Volkswagen law” sets a high bar for significant changes to its operations.

“It is more like a state-owned company than a private one,” said Ferdinand Dudenhöffer, director of Germany’s Center Automotive Research.

Volkswagen’s operational skew toward its high-cost home territory is unusual. Germany accounted for 57% of its assets and 44% of its employees in 2023 but only 19% of revenue. At Toyota, VW’s closest rival in terms of scale, Japan accounted for 23% of revenues, 27% of assets and 18% of employees in the year through March.

After years of wage restraint boosted its competitiveness in the early 2000s, Germany briefly became the world’s largest exporter of goods. This advantage has since faded. German labor is now among the most expensive in the West, and labor productivity has been flat since 2019.

In Germany, Europe’s top car producer, an auto worker cost roughly €62 an hour last year, compared with €29 in second-ranked Spain, according to an analysis by the German Association of the Automotive Industry.

The Ukraine war and Berlin’s decision to forgo nuclear energy have also left Germany with high energy costs. Natural gas is three to five times more expensive than in China and the U.S., and electricity is 60% to 75% more pricey than before the pandemic, according to the BDI Federation of German Industry.

“German industry is slightly more energy intensive than the average and Germany depends more on industrial production, so that higher energy costs have a strong impact,” said Clemens Fuest, president of the IFO economic institute in Munich.

An example of Germany’s problems feeding into each other is Thyssenkrupp. The steelmaker has been beset by low demand from carmakers and falling steel prices because of Chinese exports. Meanwhile, a project to switch its fuel from coal to green hydrogen is increasing capital expenditure and threatening to push production prices even higher.

Losing the tech race

VW outspends industry peers—and any other European company—on research and development. Analysts expect it to shell out the equivalent of almost $19 billion on R&D this year, more than double Toyota. Yet it hasn’t had much to show for it lately.

VW’s decades of excellence in combustion engines was little help in developing EVs, whose performance depends largely on batteries and software. With those technologies led by Tesla and China, Volkswagen is struggling to stand out.

“Whereas a decade ago the Golf enjoyed a comfortable premium to all of its competitors, I’m not sure that is true for their electric vehicles. They’ve lost some of the fairy dust,” said HSBC analyst Mike Tyndall.

Some German manufacturers offer cutting-edge products ranging from sophisticated lasers to advanced optics that few foreign rivals can match. But many others have struggled to maintain a technological advantage.

Despite its engineering tradition and research institutions, Germany doesn’t have a sizable tech sector. SAP, the only software company in the DAX-40 blue-chip stock index, was created in 1972. The number of patents filed by German entities has dropped every year since 2018 except in 2023, World Intellectual Property Organization data shows. Corporate investment in the country fell 5% last year, according to the Kiel Institute for the World Economy, with many companies focusing on faster-growing markets.

R&D spending “in Germany amounts to about 3% of GDP, more than the European average, said Fuest. “The problem is that a large part of this is concentrated in the automotive sector.”

While China tapped German industrial know-how for decades, technology transfers are now flowing in the opposite direction too. Several German companies are building R&D capacity there to take advantage of local know-how, government subsidies or the absence of red tape, according to a German industry lobbyist based in China.

Ironically, expensive labor isn’t the only reason VW’s production costs are higher in Germany than in China, analysts say. Another is that its Chinese plants tend to be more automated and digitized.

Policymakers need to implement global standards if we are to scale up the role of credits

One of the thorniest talking points in climate right now is the carbon credit market. This remains a critical mechanism for funding projects that help offset greenhouse gas emissions at scale. Nevertheless, some areas — namely, the so-called voluntary credit markets — have an integrity problem, which is holding back adoption of the whole. Stakeholders can help supply a solution by moving the entire market towards a compliance-based approach.

Despite recent controversies, carbon credits continue to enjoy a bedrock of international support. Ten west African nations recently reiterated support for projects that generate carbon credits and the critical role they play in meeting climate, nature and finance needs. And several US government agencies announced the principles for high-integrity voluntary carbon markets, which aim to address some of the issues.

However, the fact remains that voluntary carbon markets are fragmented and do not have to comply with uniform global standards. This has made them uneven, hampering supply and demand. Although the principles are welcome, they should be a stepping stone towards compliance-based markets with mandatory standards.

As the impact of climate change and nature loss on our economy grows, the size of the carbon market is projected to double to $2tn by 2030. But despite these tailwinds, scaling up projects has been difficult, and many nations are still struggling to trade their first set of credits beyond small pilot projects.

Prices are important here. Today, the average price of carbon dioxide emissions is only $5 per tonne. Only the EU and UK within compliance markets have average prices of over $50 per tonne. The IMF estimates the equilibrium price at over $80 by 2030. There is clearly a big discrepancy between where prices are and where they need to be. Higher-quality credits will be critical.

These markets are not a losing proposition. Carbon pricing programmes now cover a quarter of global emissions, double the figure in 2015. But to meet long-term needs, they must change their governance and the administration of carbon prices. For a commodity with the potential to save the planet, it is perplexing that the administration of the clearing price is voluntary and only regulated by civil society organisations.

Authorities globally need to collaborate on a broad-based compliance system. This will help lower-income countries meet their own needs but also allow companies to do more. They also need to agree standards for projects that generate carbon credits and certification under one international body.

Policymakers must focus on turning national and corporate carbon-reduction targets into actionable plans embedded in transition strategies and underpinned by binding regulation. Carbon market revenue must accrue more benefits to local communities. An example might include carbon capture projects that boost smallholder farmers’ resilience and productivity (while also reducing methane emissions).

In this context, the World Bank’s International Development Association presents a huge opportunity. IDA provides lower-cost financing for lower-income countries at scale and is replenishing its funds this year, to the tune of over $100bn. Using this money to help developing countries plug into carbon markets could unlock a huge supply of credits, as well as demand from organisations looking for trustworthy credits to buy. Over time, this investment would have the potential to pay itself back many times over.

Carbon markets fully deserve the attention that the US government and others have given them. It is now up to policymakers globally to take the baton and implement uniform interoperable standards. The fate of our climate, our natural world and our economy depend on it.

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