Germany: Article IV Consultation, Concluding Statement of the IMF Mission

1. Bold reforms have strengthened the German economy. From the economic doldrums early in the decade, Germany has staged a remarkable and enviable recovery. GDP growth has been strong, employment gains have been substantial, the share of longer-term jobs with social security benefits has risen, and the fiscal position is in the best shape since unification. Wage moderation has helped competitiveness and, hence, the ability to profit from the global upswing. The turmoil in major credit markets, including Germany’s, did raise serious concerns about stability and economic prospects. However, and despite continued risks, the after shocks have so far been limited—testimony to the economy’s resilience.

2. A pause in the reform process would, however, be premature—and reversals risk undermining the gains achieved. In the second half of the electoral cycle, the next generation of reforms will no doubt confront difficult political challenges and pressures for a frontloaded sharing of the “reform dividend.” However, economic performance in the current cycle has not yet been evidently stronger than in past upswings. Moreover, the recent strength has been aided by an unusually long and strong global cycle. As such, continuation of the buoyant performance is far from assured.

3. To build on the hard-won gains, the outstanding challenges must be tackled. Notwithstanding the successes, a significant unfinished policy agenda remains—in labor markets, the general investment climate, financial sector stability and efficiency, and fiscal policy. Persevering with this agenda holds the enticing promise of substantial improvements in living standards for all. This goal can be met by fostering efficiency and growth, while enhancing the sustainability of the Soziale Marktwirtschaft (Social Market Economy).

Short-term outlook—moderating growth, with downside risks

4. The economic cycle is weakening. The strong third quarter ensures that GDP growth in 2007 will register another impressive performance at an estimated 2.5 percent. Noteworthy in the third quarter was an encouraging pick up in consumption. Despite some signs of “decoupling,” the direct and indirect effects from U.S. economic developments continue to have an important bearing on Germany’s growth. Consequently, along with a slowing U.S. economy, German growth is also projected to moderate to 1.9 percent in 2008. Growth will also be dampened, though to a more modest extent, by the stronger euro and higher oil prices. Headline inflation (HICP) rose to an estimated 3.3 percent in November on the back of higher energy and food prices. But core inflation remained contained at 2.2 percent, indicating that the energy and food prices had not spilled over into other sectors. Average headline inflation is expected to decline from 2.2 percent in 2007 to 1.6 percent in 2008.

5. The uncertainties have increased. A sharper-than-projected economic deceleration in the U.S. would further dampen German growth. While the effect of euro appreciation should remain modest if the global imbalances continue to unwind in an orderly way, a disruptive unwinding of global imbalances and, hence, sharply lower world growth would also amplify the consequences of a strong euro. Higher-than-expected oil prices also remain a possibility.

6. The greatest uncertainty, however, arises from the unfolding international financial developments. After stabilizing somewhat, markets have turned cautious again. Banks continue to hoard liquidity to insure themselves against the possibility of renewed financial market turmoil. As a result, interbank markets remain strained, as evidenced by elevated three-month rates. In this context, the authorities have taken welcome steps to assess the exposures of German banks. Consistent with the authorities’ conclusion that the exposures are limited and have not impaired the banks’ capital positions, credit flows remain relatively unaffected. However, another wave of turbulence could further impact asset valuations and capital levels at some banks—with adverse consequences for credit availability and growth.

Enhancing Germany’s growth potential and resilience

7. Stepping up productivity remains key to sustaining growth. The current cycle does not provide clear evidence of a step-up in productivity growth. While the export sector has experienced cyclical gains, most services (nontraded) sectors have recorded weak, and even declining, productivity growth rates. In part, this reflects the welcome absorption of unskilled labor in service sectors. Looking ahead, therefore, an array of labor market and business climate measures will be needed to fulfill the objective of rising employment accompanied by acceleration of productivity.

8. Skill shortages need to be addressed. These shortages are already proving costly and are expected to increase rapidly as the German society ages. With a stronger labor market, a paradoxical phenomenon has emerged. While vacancies have increased especially in skilled occupations, the inflow of immigrants to fill these positions has remained subdued and highly-trained Germans have chosen to seek employment abroad. The reasons for German emigration are complex and often specific to particular professions, but include a search for lower tax rates, higher returns to expertise, and more robust economic opportunities. A two-pronged strategy is necessary: invigorating education and training, and encouraging skilled immigration.

9. Instead of reversing direction, labor market initiatives should cement the gains in competitiveness. The minimum wage for postal workers is already having unintended consequences by forcing competitors to cut back on their staffing and, thus, potentially undermining competition in postal services. If the pressures to broaden the application of sectoral minimum wages continue, the adverse effects could be widespread. Also, the proposed extension of the unemployment benefit period for the elderly, while justified on grounds of fairness, could open more such demands and signal a weakening commitment to improving incentives for work. These steps come at a time when further efforts are needed to derive the continued benefits of the Hartz reforms. The authorities’ intent to rationalize active labor market programs and assistance in placement is laudable and needs to be implemented with greater vigor. And, child care programs will help increase the participation of women in the labor force, although care will be needed to keep them well targeted.

10. In addition, a range of complementary reforms would further strengthen the foundation for employment and growth in Germany. Improving the business climate will, over time, require a fiscally-responsible reduction in the personal tax rates and a further reduction in corporate tax rates. In the meantime, the authorities’ efforts to reduce red tape, through the formation of the Normenkontrollrat, hold promise. Any amendments to the Außenwirtschaftsgesetz (Foreign Trade and Payments Act) should be undertaken in a manner that preserves Germany’s long-standing reputation for openness to foreign capital. Incentives for research and development are likely to have less pay-off than improving the conditions for better exploitation of innovations. To this end, the role of the financial sector is vital.

Financial sectordealing with rapid global change

11. Recent events have raised the broader question of strategy for responding to global integration. Two German banks felt the full force of the U.S. sub-prime crisis. Rapid action by the authorities helped maintain confidence in the system. While write-downs have continued as assets have had to be revalued, systemically-important banks have so far dealt with these write-downs without impairing their core capital. Nevertheless, these events have raised broader questions. The authorities have rightly used the opportunity to initiate a discussion of streamlining bank supervision. The actions of the two rescued banks have led to questions about the viability of the business strategies of Landesbanken. And, as the pace of global financial integration accelerates, it is important also to assess the continued pressures that banks will face and how German capital markets will evolve.

12. The changes to banking supervision should be based on well-founded principles. Minimizing the overlap of responsibilities between BaFin and the Bundesbank will help increase accountability. This principle implies a consolidation of bank supervision in one of the two agencies. That agency should have enforcement powers to lower a bank’s risk profile, while the ultimate step of closing a bank would require a joint decision involving the Ministry of Finance. Under any supervisory arrangement, the Bundesbank must have full access to all information on systemically important banks and on other banks as needed, given its financial stability and lender-of-last-resort responsibilities. With the growing sophistication of financial markets and the complexities introduced by Basel II, this streamlining will need to be complemented by continued efforts to attract and retain skilled supervisors through flexible contracts that offer adequate compensation. Also, supervisors should require to file financial statements on a quarterly basis and encourage a more widespread use of IFRS reporting (which mandates consolidation of group activities).

13. A bank resolution policy is needed to permit prompt action while maintaining incentives for prudent management. As always, recent measures to contain the damage from potential bank failures sought to balance the need for quick action with maintaining incentives for prudent behavior by bank managers and owners. The German insolvency framework needs to recognize the unique role of banks in the payment system and the macro economy and incorporate greater flexibility to allow for resolutions that can be done quickly while diluting the equity claims of all shareholders.

14. Policy on banking sector consolidation should be mindful of, and consistent with, the forces of international financial integration. The recent events highlighted the concern that the fragmented banking structure generates only modest profits and, therefore, creates incentives that risk destabilizing the system. Following the withdrawal of state guarantees in 2005, some Landesbanken have sought new, riskier businesses to maintain profits. Measures to foster bank restructuring should be guided by the goal of creating robust and sustainable banks, while allowing private capital to play its legitimate role. As global competition intensifies, eroding the traditional businesses of banks that only serve targeted communities (Sparkassen and Genossenschaftsbanken), their market share will likely continue to diminish and the structure of German banking will evolve. While such localized services are important, these banks should operate in response to market demand. Where political compromises are made, these should not be at the cost of constraining future options.

15. Gains in the development of capital markets can be enhanced by further reforms centered on corporate governance. German capital markets have made important strides. Today, a wide variety of capital market instruments are available to businesses and households to finance their activities and manage their risks. The further development of capital markets will be aided by creating additional options for, and greater transparency in, corporate governance—steps that hold the promise of raising economic productivity. In particular, the large size of the supervisory boards slows decisions. Recent studies point to the crucial importance of efficiently functioning boards for value maximization and productivity growth. In this respect, some German companies have acted to rationalize their boards where made possible by operating under the Societas Europea rules. The implication is that such options should be more widely extended to improve internal controls. Internal and external discipline can also be fostered through further improvements in disclosure standards, especially on board members’ financial dealings, and by lowering barriers to takeovers.

16. A number of new initiatives in the pipeline carry risks. The envisaged broadening of acting-in-concert provisions in the current draft of the Risikobegrenzungsgesetz (Risk Limitation Law) is likely to create legal uncertainties and stifle legitimate action by shareholders. The draft law on the Modernisierung der Rahmenbedingungen für Kapitalbeteiligungen (Venture Capital and Private Equity Law) should be strengthened to establish a unified legal and regulatory framework for an industry that has an important role to play in the continued economic restructuring. The proposal to introduce profit sharing, though consistent with the Soziale Marktwirtschaft, could further complicate corporate governance. Such arrangements might, therefore, be best undertaken on a voluntary basis rather than through legislation.

Public finances—achieving long-term sustainability

17. Following impressive gains, the government has set itself appropriately ambitious goals. Though cyclical strength helped, structural initiatives have been crucial in bringing the projected budget close to balance this year from a large deficit just a few years ago. Expenditure containment has reduced the size of the government and, despite a projected moderate weakening of the general government’s budget position in 2008, the benefits from past reforms should enable the authorities to continue on a fiscal consolidation path. The ambitious objectives laid out in the latest Stability Program seek to reach a structural surplus of ½ percent of GDP and a primary surplus of 3½ of GDP in 2011. Such gains would be valuable because their accumulation over time would aid long-term sustainability.

18. However, achieving these goals remains a challenge—and will need to be supported by new measures. Absent additional fiscal measures, we estimate that the shortfall in 2011 in the primary balance goal could be as much as 1 percent of GDP; if the many real risks to revenues and expenditures—such as those from lower growth and higher-than-expected losses from the corporate income tax reform—also materialize, the shortfall would be even larger. Since delays in achieving the primary balance target have long-lasting implications, identifying and implementing subsidy-cutting measures and rationalization of tax expenditures remain important tasks. Streamlining labor market programs will make them more effective and achieve savings. Additional measures are also needed in the medium term to create the room for reducing tax rates in a responsible manner.

19. Moreover, the challenges of aging will continue to require further action. With so much achieved on pensions, there is merit in efforts to consolidate the gains. A more automatic tie between the retirement age and population longevity would contain the growth of pension outlays under the first pillar. Also, the second pension pillar, linked to the individuals’ employment, limits the employees’ risk diversification and serves implicitly to subsidize the employer. Hence, more options to place employee savings into financial instruments, as in the third pillar, would help. But the greater challenge lies in containing health and long-term care costs, all the more so since the official estimates are at the lower end of the likely spectrum of long-term cost estimates. A key objective has to be cost discipline through more effective competition in healthcare provision. In turn, this will require creating stronger incentives for cost savings by insurers than are present in the current arrangements under which they are reimbursed by the Health Fund. Finally, while ensuring basic health coverage for all, the private burden for traditionally publicly-financed services will have to continue to rise to ensure the sustainability of the social security system.

20. A new fiscal rule would serve to anchor and improve the incentives for fiscal self-discipline. The so-called golden rule has been observed only in the breach. The authorities’ intention of changing the fiscal rule to be better aligned with the Stability and Growth Pact is a move in the right direction. The new rule would call for a structurally-balanced budget but with some room for the operation of automatic stabilizers. In addition, the rule should permit preservation of long-run sustainability, which may, at times, require further belt-tightening. Moreover, the effectiveness of the rule will depend on how the discretion is used—or abused. For this reason, providing incentives for more responsible fiscal management remains crucial. In this regard, the authorities’ effort to embed more systematic program evaluation into fiscal decisions is a welcome step.

21. The government should use the second round of fiscal federalism reform to improve incentives for increased efficiency and to contain long-term risks to the budget. The current system encourages unproductive tax competition through Länder tax administration decisions. Instead, greater Länder tax autonomy (for example, by allowing them to set personal income tax rates within defined bands) along with centralization of tax administration could help establish greater accountability at the sub-national level. As the international experience shows, tax autonomy and clarification of obligations at different levels of government would also improve effectiveness of local service delivery while maintaining the objectives set within a cooperative framework. Finally, timely and consistent data on Länder finances are needed for transparency and monitoring.

published on IMF website at

3 Responses to "Germany: Article IV Consultation, Concluding Statement of the IMF Mission"

  1. Guest   December 13, 2007 at 3:29 pm

    Very excellent and detailed analysis. But if the US experiences a recession what would happen to German growth? Would it decouple from the US?

  2. Guest   December 14, 2007 at 5:17 am

    Very interesting indeed. The IMF has consistently claimed over the past years that reforms in Germany have not done much to growth potential. Consequently, the IMF has been badly behind the curve in predicting the turnaround in the German economy and the German budget situation as you can see in the WEO 2005, 2006 and of early 2007. Now, they have made a U-turn and claim that the reforms which they have considered as insufficient before are behind the turnaround. I wonder who – under these circumstances – can still take the IMF’s analysis on Germany seriously…

  3. Guest   December 16, 2007 at 9:22 am

    It was the postal workers wot done it!!