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Germany

Author(s):
International Monetary Fund
Published Date:
February 2008
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I. The Context

1. The economy has made major strides, helped by wide-ranging reforms. From the doldrums of 2001-03, strong external competitiveness generated a robust recovery, with beneficial spillover effects for Europe. With strong performance in 2006 and much of 2007, a welcome decline in unemployment is ongoing. These developments have been aided by extensive reforms, including in labor and capital markets. Determined fiscal consolidation has enhanced policy credibility.

Reform Initiatives and Implementation
SectorDate
Labor market
Administration and program reform Hartz (I-III)2003-04
Unemployment benefit reform (Hart IV)2005-06
Fiscal
Tax reform (VAT, CIT)2007-08
Pension reforms 1/2004, 2007
Fiscal federalism reform (Phase I)2006
Health care reform1/2/2004, 2007-09
Structural
Network industry regulation2005
Banking sector and capital markets
Supervision reform (Bafin establishment)2002
REITS legislation2007
German Code of Corporate Governance2002, 2007

Different reforms.

Phased in over time.

Different reforms.

Phased in over time.

2. Germany, however, faces key challenges, with a growing risk that these may interact in insidious ways:

  • The rescue of two German banks in the summer of 2007 raised concerns that the problems may be more widespread. With the international subprime fallout still ongoing, the drip of bad news has continued, generating appreciable risks to economic confidence and short-term prospects.

  • These developments come at a time when—despite progress—a sustainable increase in potential growth has not yet been secured and German consumers remain ambivalent about future prospects.

  • The hard-won competitiveness gains could be eroded without an impetus to productivity growth. Wages remain high for unskilled labor and low returns to human capital contribute to skilled emigration. Aging costs remain a threat to fiscal sustainability.

  • The prospects for further reforms have dimmed with no major policy proposals in the pipeline. And recent labor market measures motivated by “fairness” create distortions and incentives inimical to employment and output growth.

3. Pressing ahead with reforms, therefore, remains crucial. The immediate priorities are preserving the integrity of the financial system and maintaining economic confidence. However, significant medium-term challenges remain (Box 1). These include further efforts to foster employment and growth, while confronting the pressures from global movement of labor and capital and also achieving regional balance within Germany. This, in turn, will require a continued reorientation of traditional, corporatist institutions—wage bargaining, relationship banking, insider-dominated corporate governance, and federal decision making. Preserving solidarity through shared gains, while accommodating the forces of global competition, is the overarching challenge.

Germany’s relative decline

1/ EU-15 Excluding Germany, Ireland, and Luxembourg.

Box 1.Past Fund Policy Recommendations and Implementation

Following much progress in implementing policies recommended by Directors, the reform momentum has slowed noticeably:

Foundations for employment and growth. The authorities regard rationalization of programs under Hartz IV as a priority, but implementation has lagged. There has also been no progress in reforming employment protection legislation. Despite Directors’ urging to refrain from introducing minimum wages, a sectoral minimum wage has been instituted for postal workers.. The proposed extension of unemployment benefits for elderly workers also goes against the Directors’ advice to increase the incentives for work. Initiatives for cutting red tape are, however, proceeding through the Normenkontrollrat.

Financial sector efficiency. Directors have underscored the importance of an efficient financial sector. To date, bank restructuring initiatives have been limited, as has been the role of private capital—which Directors have seen as vital. The authorities are exploring rationalization of banking supervision. Following the introduction of real estate investment trusts, a push on capital market development is not imminent; indeed, risks are associated with some proposed measures.

Fiscal consolidation and reforms. Directors have welcomed the authorities’ strong expenditure-based measures for fiscal consolidation and the substantial progress in reducing long-term aging costs. But they have cautioned that fiscal sustainability will not be assured even if the structural deficit were to be eliminated by 2010. Accordingly, they have encouraged the authorities to pursue a broad-based approach, encompassing both fiscal adjustment and growth-enhancing reforms.

II. Recent Economic Developments

4. The upswing maintained traction in 2007. From the cyclical trough in 2004, GDP growth accelerated to 2.9 percent in 2006, the highest rate since unification (except in 2000). Output grew by 2.5 percent in 2007, with an unexpectedly strong third-quarter performance, despite the onset of the financial turbulence. Output is now close to potential. Growth in 2007 was not dented by high oil prices, fiscal consolidation, or first-quarter contraction in consumption (following purchases in 2006 in advance of the VAT hike). Reductions in social contributions and a boost in investment driven by the impending elimination of a depreciation allowance in 2008 helped temper the contractionary effects.

Comparison of Real GDP Projections(percent)
20062007
IMF staff
Staff report December 20062.31.4
WEO April 20072.71.8
WEO July 20072.82.6
WEO September 20072.92.4
Authorities October 20072.92.4
Consensus October 20072.92.6

5. The external competitive position remained strong. Price competitiveness (helped by decade-long wage moderation) has permitted sustained export growth (Figure 1). Export earnings and their stimulative effect on investment have contributed to growing corporate profitability (Figure 2).

Figure 1.Germany: Exports and Competitiveness

Sources: IFS, WEO, OECD, Direction of Trade Statistics, and IMF staff calculations.

1/ Excludes Belgium and Luxembourg.

Figure 2.Germany: Corporate Profitability Trends1/

Source: Bundesbank

1/ Nonfinancial corporate sector.

2/ Debt over depreciation plus corporate savings and transfers.

6. Employment—especially full-time employment—started picking up in mid-2006. Protracted labor shedding and wage moderation were instigated by the pressures to remain competitive. With wage moderation legitimized and reinforced by the Hartz IV reforms, short-term unemployment has fallen. Indeed, the labor market has shown signs of tightening with increasing vacancy rates and a pick up in wage growth (Figure 3). Collective wage agreements imply an average gross wage increase of about 2 percent in 2008.

Figure 3.Germany: Labor Market Developments

Source: Federal Statistical Office, Federal Labor Office, and Bundesbank

1/ Difference between actual and negotiated wage rate.

7. A balanced budget is the result of sustained effort. From 4 percent of GDP at the trough of the cycle in 2004, the general government deficit reached balance in 2007. Although this adjustment coincided with the upswing, substantial policy effort contributed to a structural adjustment of about three percent of GDP between 2003 and 2007. Much of this adjustment reflected cuts in discretionary, aging, and welfare expenditures. In 2006, the structural balance improved by more than one percentage point, meeting the target set under the excessive deficit procedure ahead of schedule. The adjustment continued in 2007 with the VAT hike, reduction in the deductibility of interest income, expenditure restraint, and increase in healthcare premiums.

Nominal Compensation Per Employee

German Fiscal Adjustment

(Percent of GDP)

8. Inflation has remained moderate despite domestic and global pressures. In the first 11 months of 2007, headline inflation was 2.2 percent at an annualized rate, and core inflation was 2.0 percent. The sizable VAT hike in January 2007 (from 16 to 19 percentage points) had a relatively benign effect, pushing up core inflation smoothly by 0.7 percentage point rather than the expected 1.1 percentage points (Box 2). Renewed energy price inflation and a jump in food prices raised year-on-year headline inflation to 3.3 percent in November but core inflation was 2.4 percent.

HICP Annual Inflation Rate

(Percent)

9. International financial turbulence hit Germany with force, casting a cloud on the sustainability of the gains achieved. Last summer, IKB (a private bank, but with a one-third ownership by the government-owned KfW) and Sachsen Landesbank (a state-owned bank) had to be rescued after they were unable to meet their liquidity commitments to their off-balance-sheet “conduits.” German banks were placed under close market scrutiny, with credit default spreads rising sharply (text figure and Figures 4 and 5). Thereafter, concerns about the German financial sector softened, especially relative to the magnitude of the problems revealed in the United States. In November, the German share of main and longer-term ECB refinancing operations fell below 50 percent from about 55 percent in the first seven months of 2007. However, revelations of further write-downs have continued and German banks—notably West LB, another state-owned bank—remain under watch (text table below). Moreover, many banks have not released year-end statements and further negative surprises seem likely.

Figure 4.Germany: Financial Indicators

Source: Thomson Financial/DataStream.

Figure 5.Germany: Corporate Spreads, Money Market Rates, and Lending Standards

Source: DataStream and Deutsche Bundesbank.

Changing perspectives on crisis centers

Exposure of Select European Banks to Conduits and Special Investment Vehicles(SIVs)
Ownership 1/Conduit- and SIV-Financed AssetsLiquidity Facilities 2/Liquidity Facilities 3/
(Percent)(US$; billions)(In percent of funding)
Over EquityOver Assets
Germany:
Sachsen-FinanzgruppePublic1,12630.324.031.6
West LBPublic54212.721.15.7
IKB (until 29 July 2007, i.e., before bailout)Private49420.519.528.8
Dresdner Bank (mitigated by integration into Allianz group)Private3649.939.86.2
Landesbank Berlin (mitigated by integration into S-Group)Public1792.22.41.3
BayernLB (mitigated by integration into S-Verbund Bayern)Public1705.127.76.6
HSH NordbankPublic1264.07.02.9
Deutsche BankPrivate1143.369.74.8
HVB (mitigated by integration into UCI group)Private1056.6
NORD LBPublic892.96.92.8
CommerzbankPrivate852.218.72.4
Helaba (mitigated by integration into S-Verbund HT)Public681.14.32.0
DZ-BANK (mitigated by integration into Cooperative Network)Private611.39.91.8
LBBWPublic591.78.71.6
KfW (mitigated by unlimited sovereign guarantee)Public582.6
Europe:
ABN AmroPrivate107.510.7
Lloyds Bank GroupPrivate39.17.2
Societe GeneralePrivate42.06.2
FortisPrivate39.95.6
Rabo BankPrivate32.25.2
BarclaysPrivate43.54.5
RBS GroupPrivate47.93.9
INGPrivate34.23.6
CSFBPrivate14.23.1
HSBC HoldingsPrivate33.72.8
BNPPrivate20.02.4
SantanderPrivate7.11.1
Intesa San PaoloPrivate2.70.9
Source: Fitch Ratings.

Majority ownership.

Maximum commitments.

Funding defined as deposits plus senior and subordinated debt as of end-December 2006, or end-March 2007.

Source: Fitch Ratings.

Majority ownership.

Maximum commitments.

Funding defined as deposits plus senior and subordinated debt as of end-December 2006, or end-March 2007.

Box 2.The Smoothing of the VAT Increase

The smaller-than-anticipated inflation spike following the January 1, 2007 VAT hike was the consequence of a long announcement period—13 months. Consumers made advance purchases, and retailers raised prices prior to the VAT-hike implementation. An econometric analysis of sectoral inflation trends shows that 0.3 percentage point of the increase in core inflation in 2006 can be attributed to the anticipated VAT hike.1 Advance price increases were higher for durable goods and commodities with less competitive markets.

1/ See Selected Issues, Chapter I. The model controls for common price shocks within the euro area, seasonal factors, and onetime effects

III. Outlook And Risks

A. Short-Term Outlook

10. In the currently evolving situation growth is projected to slow with the weakening global cycle. In the first half of 2007, forecasters presumed that the German and U.S. economies were “decoupling” (text figure). However, the fourth-quarter signals presaging a slowing German momentum (Figure 6) are now tied to weaker U.S. growth (Box 3). Both sides agreed that the weaker U.S. economy—through slower world trade—would be the primary factor pulling down German GDP growth, given its strong external dependence. Growth would be more modestly dampened by the stronger euro—cushioned by the reliance on imported inputs. On the positive side, employment gains are projected to fuel the beginning of a consumption recovery, holding GDP growth up at 1.7 percent in 2008 (text table).1

Figure 6.Germany: Sentiment, Orders, and Production

Source: Bundesbank, IFO institute, and GfK.

Consensus forecast of 2008 growth

Comparison of the 2008 Forecasts(Percent Change)
Real Gross Domestic productReal Private Consumption
Corrected institute projections (Dec. 13)
IfW – Kiel Institute1.9
IFO – Munich Institute1.81.5
IMF (internal: WEO, Dec 13, 2007)1.81.6
IMF (Interim WEO update, January 2008)1.71.4
Bundesbank (Dec. 18, 2007)1.91.6
Federal Government (Jan. 23, 2008)1.71.1
IMF (Jan. 25, 2008)1.71.4

Box 3.Germany’s Growth Linkages1

U.S. and European growth impulses have a significant bearing on German growth. A vector autoregression (VAR) of real GDP growth in the U.S., Japan, Germany, the rest of the euro area, and new EU members finds that changes in U.S. GDP growth affect activity in Europe but not vice versa.2 Growth impulses from other euro area countries translate almost one for one into higher growth in Germany and the rest of Europe.

Growth spillovers from Germany were limited in the past but are more prominent now. Estimates for the most recent period (1998-2007) indicate that a ½ percent increase of German GDP raises growth in the rest of the euro area by ¼ percent and by about ½ percent in the new EU member countries after three quarters. These effects point to increasing economic integration especially with the new member states (e.g., offshoring).

Source: Response of GDP growth (DY) to one S.D. Innovation based on Cholesky decomposition. The top six panels refer the period 1993q1-2007q2, the bottom two panels refer to 1998q1-2007q2.

1 See Selected Issues, Chapter 2.2 For similar results see WEO April 2007, Chapter 4.

11. However, the uncertainties have increased considerably and risks are firmly on the downside. A sharper-than-anticipated slowdown in the United States would have a potentially sizeable impact on German growth, all the more so if it undermined confidence. Strong external production linkages imply significant spillovers from Germany to the rest of Europe, especially emerging Europe (text figure). Euro appreciation associated with a disruptive unwinding of global imbalances and, hence, sharply lower world growth would also amplify the consequences of a strong euro (Box 4). Higher-than-expected oil prices would act directly and, by dampening sentiments, weaken the consumption recovery; the oil-price effect, however, would be mitigated if the euro also appreciates.

Box 4.Growth Consequences of the Euro Appreciation

Real exchange rate movements have limited growth effects during periods of robust global growth. The current real appreciation of 3.9 percent (between January 2006 and October 2007) is moderate compared with past fluctuations. Staff econometric analysis suggests that this adjustment could dampen annual growth by less than 0.2 percentage point.

The negative effects can, however, increase significantly in a global downturn. Staff estimates show that a real exchange rate appreciation in Germany has up to twice the direct effect when the global output is well below potential. Although such events have been rare, the risks to global growth raise the possibility of a more significant negative growth effect of a euro appreciation.

Real effective exchange rate appreciation

(yoy growth rate)

Source: Staff estimates. Global output gap measured as percent deviation from HP filtered trend.

1 Measured in CPI terms based on the IMF methodology: http://www.imfstatistics.org/imf/IFSExcha.htm.

12. The authorities are acutely conscious that the greatest uncertainty arises from the unfolding international financial developments. In this context, they have taken valuable steps to assess the exposures of German banks. Consistent with their preliminary conclusion that the exposures are limited and have not impaired capital positions, credit flows thus far have remained relatively unaffected. Banks came into the crisis well capitalized and with cyclically strong profits. Moreover, the reliance of German businesses and households on financial credit is relatively modest and apparently declining (text figure). However, the authorities recognize that the turmoil has proved to be a moving target and, hence, the findings from bank examinations and stress tests can become quickly outdated. Recent indications are that lending standards have tightened, although less than elsewhere in the euro area. The continuing turbulence could further impact asset valuations and capital levels—with adverse and cascading consequences for credit availability and growth.

German credit demand has been low relative to euro area.

13. Inflation should slow somewhat, to 2.1 percent in 2008, but the risks are on the upside. The price increase following the 2007 VAT hike will exert a dampening base effect. Oil and food price inflation are projected to add an inflationary bias, though the effects are expected to ease slowly. Higher outcomes from the new wage bargaining create risks of second-round spillovers, which, however, are likely to be mitigated by slower growth.

B. Competitiveness

14. Germany’s competitiveness is adequate, with some evidence of a modest undervaluation. This conclusion, which the authorities broadly agreed with, is based on several considerations:

  • The current account surplus is largely structural and is expected to contract in the medium term. Despite strong investment trends, the current account surplus widened to an estimated 5.6 percent of GDP in 2007 (Tables 1 and 2). The surplus was, however, boosted by temporary factors, in particular, the increase in the VAT rate that increased private and public savings. Stripping out these and other temporary factors from long-term trends, staff’s estimate of the current underlying surplus is about 4¼ percent of GDP.

  • For Germany, the CGER exercise estimates a medium-term current account norm (reflecting long-term trends in a multilateral setting) of 3.3 percent of GDP. This norm is higher than that of other major European countries, reflecting mainly savings for old age and European financial integration that generates capital flows from Germany to the less advanced European economies. The authorities’ estimates show that about half of Germany’s current account surplus derives from within the euro area, with a surplus on the trade account, reflecting competitive strength in manufactured goods, and a deficit on the services account.

  • According to CGER estimates, the real exchange rate is close to equilibrium. These estimates show that the valuation of the real effective exchange rate (REER) to range from 3 percent overvaluation (equilibrium real exchange rate approach) to a 10 percent undervaluation relative to equilibrium (external sustainability approach, see text table), with large standard errors. The mid-point of the range—suggesting a 3-5 percent undervaluation—is normally considered a reasonable benchmark and also coincides with the estimate from the macroeconomic balance approach.

  • The implication is that the depreciation during the late 1990s and early this decade has mainly corrected the overvaluation of the mid-1990s. As that overvaluation declined, Germany gained market shares; these shares have now begun to stabilize. The authorities emphasized the uncertainties in measuring equilibrium exchange rates. Their favored approach—treating the average over the past three decades as the “equilibrium”—also finds a small undervaluation.

Table 1.Germany: Basic Data
Total area357,041 square kilometers
Total population (2005)82.4 million
GDP per capita (2006)US$ 35,439
20002001200220032004200520062007 1/2008 1/
(Percentage change)
Demand and supply
Private consumption2.41.9-0.80.10.2-0.11.0-0.31.4
Public consumption1.40.51.50.4-1.50.50.92.00.9
Gross fixed investment3.0-3.6-6.1-0.3-0.21.06.15.51.7
Construction-2.4-4.6-5.8-1.6-3.8-3.14.32.80.7
Machinery and equipment10.7-3.7-7.51.14.66.08.37.42.1
Final domestic demand2.30.4-1.40.1-0.20.32.01.41.3
Inventory accumulation 2/-0.1-0.9-0.60.50.00.1-0.1-0.30.1
Total domestic demand2.2-0.5-2.00.6-0.20.31.91.11.5
Exports of goods and nonfactor services13.56.44.32.510.07.112.58.36.2
Imports of goods and nonfactor services10.21.2-1.45.47.26.711.25.76.4
Foreign balance 2/1.01.72.0-0.81.30.51.11.50.3
GDP3.11.20.0-0.31.10.82.92.51.7
Output gap (In percent of potential GDP)1.81.3-0.2-1.7-2.0-2.4-1.00.00.0
(In millions of persons, unless otherwise indicated)
Employment and unemployment
Labor force41.942.142.242.342.742.643.243.343.5
Employment39.139.339.138.738.938.839.039.739.9
Unemployment 3/3.13.23.53.94.24.64.23.63.6
Unemployment rate (in percent) 4/6.96.97.78.89.210.69.88.48.2
(Percentage change)
Prices and incomes
GDP deflator-0.61.21.41.21.10.70.61.80.2
Consumer price index (harmonized)1.41.91.41.01.81.91.82.32.1
Average hourly earnings (total economy)2.82.72.01.70.31.01.1-0.20.6
Unit labor cost (industry)-1.70.51.5-1.3-3.1-2.5-2.8-1.5-0.5
Real disposable income 5/2.12.1-0.20.50.30.10.90.41.1
Personal saving ratio (in percent)9.29.49.910.310.410.510.511.110.8
(In billions of Euros, unless otherwise indicated)
Public finances 6/7/
General government
Expenditure9301,0051,0311,0491,0421,0531,0551,0661,085
(In percent of GDP)45.147.648.148.547.146.945.444.043.8
Revenue9579459539629589771,0171,0651,070
(In percent of GDP)46.444.744.444.543.343.543.844.043.2
Overall balance27-60-78-88-85-79-370-15
(In percent of GDP)1.3-2.8-3.7-4.0-3.8-3.5-1.60.0-0.6
Structural balance-25-54-62-69-62-55-270-18
(In percent of potential GDP)-1.2-2.5-2.9-3.2-2.8-2.4-1.20.0-0.7
Federal government
Overall balance28-27-36-40-51-58-30-16-24
(In percent of GDP)1.4-1.3-1.7-1.8-2.3-2.6-1.3-0.7-1.0
General government debt1,2111,2241,2781,3581,4301,4891,5331,5331,548
(In percent of GDP)58.757.959.662.864.766.366.063.362.5
Balance of payments
Trade balance 8/50.188.1124.2118.8139.1139.7143.4167.6153.4
Services balance-49.0-49.9-35.7-34.5-29.4-28.9-22.4-21.0-14.5
Net private transfers-9.3-10.5-11.8-10.0-11.1-10.9-12.1-14.0-12.9
Net official transfers-18.7-16.4-15.7-18.3-16.8-17.7-14.7-20.9-19.3
Current account-35.20.443.040.994.9103.1117.2135.0130.6
(In percent of GDP)-1.70.02.01.94.34.65.05.65.3
Foreign exchange reserves (e. o. p.) 9/53.449.540.532.533.833.728.627.7
Monetary data(Percentage change)
Money and quasi-money (M3) 10/11/-1.06.13.52.25.24.810.5
Credit to private sector 10/5.83.20.90.0-0.22.13.51.8
(Period average in percent)
Interest rates
Three-month interbank rate 12/4.44.33.32.32.12.13.74.8
Yield on ten-year government bonds 12/5.34.84.84.14.13.63.84.3
Exchange rates
Euro per US$ (annual average) 12/1.081.121.060.880.800.800.800.69
Nominal effective rate (1990=100) 13/100.0101.5104.7112.6115.8114.7116.6120.0
Real effective rate (1990=100) 14/100.099.3101.6106.0105.4100.197.599.2
Sources: Deutsche Bundesbank; Federal Statistical Office; IMF, World Economic Outlook; IMF, International Financial Statistics; and staff estimates and projections.

2007 estimate, 2008 IMF staff projections.

Growth contribution.

National accounts definition

Eurostat definition.

Deflated by the national accounts deflator for private consumption.

Data for federal government are on an administrative basis. Data for the general government are on a national accounts basis. Debt data are end-of-year data for the general government in accordance with Maastricht definitions.

Government expenditure in 2000 includes, as a negative entry, the proceeds from the sales of mobile phone licenses of euro 50.8 billion (2.5percent of GDP). The proceeds also affect the financial (but not structural) balances and the government debt.

Including supplementary trade items

From 1999 onward data reflect Germany’s position in the euro area. Data for 2007 refer to December.

Data for 2007 refer to the change from December 2006 to December 2007.

Data reflect Germany’s contribution to M3 of the euro area; data not shown for 2002 because of a series break.

Data for 2007 refer to December.

Data for 2007 refer to December.

Based on relative normalized unit labor cost in manufacturing. Data for 2007 refer to December.

Sources: Deutsche Bundesbank; Federal Statistical Office; IMF, World Economic Outlook; IMF, International Financial Statistics; and staff estimates and projections.

2007 estimate, 2008 IMF staff projections.

Growth contribution.

National accounts definition

Eurostat definition.

Deflated by the national accounts deflator for private consumption.

Data for federal government are on an administrative basis. Data for the general government are on a national accounts basis. Debt data are end-of-year data for the general government in accordance with Maastricht definitions.

Government expenditure in 2000 includes, as a negative entry, the proceeds from the sales of mobile phone licenses of euro 50.8 billion (2.5percent of GDP). The proceeds also affect the financial (but not structural) balances and the government debt.

Including supplementary trade items

From 1999 onward data reflect Germany’s position in the euro area. Data for 2007 refer to December.

Data for 2007 refer to the change from December 2006 to December 2007.

Data reflect Germany’s contribution to M3 of the euro area; data not shown for 2002 because of a series break.

Data for 2007 refer to December.

Data for 2007 refer to December.

Based on relative normalized unit labor cost in manufacturing. Data for 2007 refer to December.

Table 2.Germany: Medium-Term Balance of Payments, 2005-13
Projections
200520062007200820092010201120122013
(In billions of Euros, unless otherwise indicated)
Current account103117135131122117114112104
In percent of GDP4.65.05.65.34.84.54.24.03.6
Trade balance140143168153152156162166167
Exports7879009821,0471,1051,1661,2301,2971,366
Imports-647-757-815-894-953-1,010-1,068-1,131-1,199
Nonfactor services-29-22-21-15-22-32-40-49-57
Exports129142155165174184194204215
Imports-158-164-176-179-196-215-234-253-272
Balance on Factor Income289353373398412426441457473
Credit155188198211218226234242251
Debit-134-165-175-187-193-200-207-214-222
Current transfers, net-29-27-35-32-33-34-35-33-35
Capital and financial accounts-125-146-132-131-122-116-115-112-106
Capital account, net-100000000
FDI, net-16-29-30-31-32-33-34-35-36
Portfolio investment, net-31-5-5-5-6-6-6-6-6
Other-79-115-97-94-85-78-75-71-63
Reserve assets230000000
Errors and omissions2229-3000111
Source: WEO.
Source: WEO.
Comparison of the Real Exchange Rate Assessment and Current Account (CA) Positions and Current Account Norm Contributions for the Three Largest Euro Area Countries 1/
CGER Assessment2007 CA/GDPCA/GDPCA Norm Contributions
MB 2/ERER 3/ES 4/ActualUnderlying 5/normCA lagDependency ratioPopulation growthPer capita growthRelative incomeOther 6/
Germany-2.03.0-10.05.64.23.31.30.80.50.0-0.51.2
France-2.02.06.0-2.0-1.6-1.80.0-0.50.00.0-0.5-0.8
Italy5.06.05.0-2.3-1.9-0.5-0.50.90.50.0-0.6-0.8

CGER (Consultative Group on Exchange Rate Issues). Values between -10 and +10 means the real exchange rate (RER) is close to balance. International Monetary Fund, 2006, Methodology for CGER Exchange Rate Assessments (available at www.imf.org).

Macroeconomic balance approach.

Equilibrium real exchange rate approach.

External sustainability approach.

The underlying CA/GDP balance is calculated as ratio of Hodrick Prescott filters of current account balances and for nominal GDP for 1970 until 2013.

Oil balance to GDP, and dummies for the EMU creation and if the country is a financial center, etc.

CGER (Consultative Group on Exchange Rate Issues). Values between -10 and +10 means the real exchange rate (RER) is close to balance. International Monetary Fund, 2006, Methodology for CGER Exchange Rate Assessments (available at www.imf.org).

Macroeconomic balance approach.

Equilibrium real exchange rate approach.

External sustainability approach.

The underlying CA/GDP balance is calculated as ratio of Hodrick Prescott filters of current account balances and for nominal GDP for 1970 until 2013.

Oil balance to GDP, and dummies for the EMU creation and if the country is a financial center, etc.

German Real Exchange Rate 1/

(Percentage deviation from long-term average=100 of real exchange rate index using export sales deflators)

1/ Lower values denote an increase in competitiveness.

C. Medium-Term Outlook

15. Growth is projected to slow to the potential rate of 1¾ percent annually, unless measures are taken to step up total factor productivity growth. The strength of the current upswing has not clearly surpassed previous ones (although it is notable in its unusual composition—buoyant investment and lagging consumption) (Figure 7). The output gap, created following the poor performance earlier in the decade, is just about closed. Looking ahead, productivity growth—crucial to maintaining the growth momentum—is difficult to predict, but recent trends are not comforting. Labor productivity rose by about 2½ percent in 2006 from a substantial fall earlier in the cycle (text figure), but increased by less than 1 percent in 2007. Moreover, productivity has been sustained mainly in the manufacturing sector, which accounts for a quarter of value added (Figure 8). The much larger services sector—with two-thirds of the value added—has shown little improvement, this being especially true for real estate and financial services. German firms are highly innovative, measured, for example, by the production of patents (Figure 9). However, the translation of the innovation into productivity increases has been weak (text figure).

Figure 7.Germany: Comparison of Business Cycles, 1990-20071/

Sources: Federal Statistical Office; and IMF staff calculations.

1/ All values relative to trough equal to 100. The trough of the current cycle is Q4 2004. Average of previous cycles is an unweighted average of cycles with troughs in 1993Q2, 1996Q1, and 1989Q4. Troughs identified using largest negative distances between real GDP and trend GDP (HP filter).

Figure 8.Germany: Labor Productivity Growth, Contributions From TFP, and Capital Deepening

Source: Federal Statistical Office and staff calculations.

Figure 9.Selected Countries: Patent Developments

Sources: European Patent Office; OECD; and IMF staff calculations.

Labor Productivity Growth (2000-06) and Patents Granted, 2000

Medium-Term Projections, 2003-13(Percentage change from the previous period, unless otherwise indicated)
20032004200520062007200820092010201120122013
Real GDP-0.31.10.82.92.51.71.81.71.71.61.6
Total domestic demand0.6-0.20.31.91.11.52.01.81.81.82.0
Private consumption0.10.2-0.11.0-0.31.41.61.71.61.61.5
Gross fixed investment-0.3-0.21.06.15.51.73.23.33.33.33.2
Foreign balance (contribution)-0.81.30.51.11.50.3-0.10.00.10.0-0.2
Unemployment rate8.89.210.69.88.48.28.08.08.07.97.7
Employment growth-0.90.4-0.20.71.70.60.40.30.20.20.2
CPI inflation1.01.81.91.82.32.11.91.81.81.81.8
Saving-investment balances 1/
Private3.25.65.54.43.43.62.72.32.01.41.2
Public-1.3-1.3-1.00.72.21.62.12.22.22.62.5
Current account balance 1/1.94.34.65.05.65.34.84.54.24.03.6
Source: Fund staff estimates.

In percent of GDP.

Source: Fund staff estimates.

In percent of GDP.

IV. Policy Discussions

16. Against the background of short-term uncertainties and medium-term challenges, the discussions focused on:

  • strengthening employment and growth;

  • safeguarding financial stability and reforming the financial sector; and

  • consolidating fiscal progress to deal with near-term uncertainties and aging pressures.

17. The authorities were cautious about the likely pace of further reforms. They emphasized that recent policy measures had entailed sacrifices, generating a demand for “dividends.” Staff cautioned against policy reversals and suggested that an appropriate balance was possible between efficiency and inclusiveness—to support growth, equity, and stability. Fairness is better achieved by continuing in the spirit of the Hartz IV reforms to focus on people rather than on specific labor market outcomes. Also, while maintaining their commitment to the Soziale Marktwirtschaft (social market economy), the authorities had allowed more options outside the framework of traditional institutions. Both sides agreed that striving for this balance would continue to prove fruitful.

A. Strengthening Employment and Productivity

18. Skills shortages need to be addressed. 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 elsewhere in Europe (Figure 10). 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. These shortages are expected to increase rapidly with aging. The authorities agreed that a two-pronged strategy is necessary: invigorating education and training, and encouraging skilled immigration (Box 5). Immigration is politically sensitive, but restrictions for engineers from the new member states have been relaxed.

Figure 10.Germany: Labor Market and Migration Trends

Source: Federal Statistical Office; and IMF staff calculations.

1/ Inward migration less outward migration of foreigners.

Box 5.Alleviating Shortages of Skilled Labor1

A dynamic general equilibrium model was used to simulate the long-term effects of increasing the labor force by 100,000 persons a year (a 0.3 percentage point increase). The model incorporates demographics, life-cycle earnings, and savings dynamics. Skilled labor can be increased through domestic measures (such as retraining) or by increasing immigration. The two experiments lead to similar consequences for growth, but increased immigration also increases the size of the population and mitigates the aging problem; hence the focus on the latter scenario here.

This annual increase in immigration of 100,000 adults compared with the baseline could raise real GDP by 0.2 percentage point a year. With more adults joining the workforce, investment and capital stock would rise. A virtuous cycle of increases in income and consumption would then follow. The current account would deteriorate initially, but improve later as individuals start saving for retirement and older cohorts become more numerous.

Effects of Relaxing Immigration Restrictions: Allowing 100,000 More Young Adults Per Year

(Deviations from baseline)

Source: Dynamic general equilibrium model with demographic and life-cycle earnings dynamics calibrated for Germany. Based on Blanchard-Yaari-Weil framework. Faruqee, Hamid (2002) Population Aging and Its Macroeconomic Implications: A Framework for Analysis, IMF Working Paper 02/16.

1 See Selected Issues, Chapter III.

19. Staff cautioned that the remarkable turnaround on the labor market was jeopardized by a misplaced focus on minimum wages to pursue social objectives. The authorities viewed the minimum wage for postal workers and extended unemployment benefits for the elderly as measures to achieve “fairness.” Staff cautioned that wage floors were not an efficient instrument for social goals. The minimum wage for postal workers was already having unintended consequences: with competitors unable to match these wages, competition in postal services could be undermined. Additional sectoral minimum wages would raise the costs of, and reduce the demand for, low-skilled labor, especially in regions with endemic unemployment. Also, extension of the unemployment benefit period for older workers could open more such demands and signal a weakening commitment to improving incentives for work.

ILO unemployment rate 1992-2007 1/

Source: Federal Statistical Office

1/ Revised series Oct. 2007

Unemployment Rate by State1/

1/ Percent of civilian labor force; not seasonally adjusted; national accounts definition.

Source: Haver Analytics.

20. Perspectives on other labor market initiatives converged more. Staff supported the authorities’ intent to rationalize job training and placement programs and urged more vigorous implementation. Staff also noted that the proposed child care programs will help increase the participation of women in the labor force, although care will be needed to keep them well targeted.

21. The authorities agreed that a broad range of measures are needed to boost the investment climate. They reported progress in the efforts of the national Normenkontrollrat as part of the government’s program to reduce red tape and simplify regulations. They recognized that reducing the corporate tax rate (which remains one of the highest in Europe) and tax wedge on labor would eventually be desirable, but noted that, following the measures recently undertaken, a further fiscally responsible reduction in capital and labor taxes was not feasible in the short run. They were clear that any amendments to the Foreign Trade and Payments Act would be undertaken in a manner that preserves Germany’s long-standing reputation for openness to foreign capital. Staff also noted that a financial sector that efficiently finances innovation can complement the high patent rates to spur growth while also improving economic welfare by allowing greater consumption smoothing than recently achieved (text figure).

Consumption-Income Correlations and the Financial Index, 1985–2005

(Correlations between quarter-on-quarter growth rates)

Note: The financial index ranges between 0 and 1 for each country, with a higher value representing a greater arm’s length content in the financial system.

B. Financial Sector Stability and Efficiency

22. The ongoing turbulence has served as a wake-up call. Despite the progress achieved, long-standing concerns about the relatively low profitability of the still-fragmented banking system have—by creating incentives for excessive risk taking—intersected with new concerns about financial stability (Tables 3 and 4).2 The size of the capital market and its ability to enhance efficient allocation of resources and improve consumption smoothing leave room for considerable progress.

23. Against this background, the mission held extensive discussions on financial sector issues, with emphasis on:

  • banking sector restructuring;

  • crisis prevention and management;

  • supervision; and

  • continued strengthening of capital markets.

Banking sector restructuring

24. Both sides were concerned that, absent further banking sector restructuring, systemic and fiscal risks could rise. In line with international trends, the number of banks has fallen sharply in recent years and the number of employees per bank has increased (Table 5 and text table). The sector’s fragmentation contributes to low interest rate margins and still modest income from nonbanking services (Figure 11). Banks unable to generate adequate profits are likely to take on greater risks. The recent turbulence has again raised the question of whether many banks, especially the Landesbanken, have viable business models. Although the banking and financial system faces major challenges, the authorities stressed that it had nonetheless proved to be stable and functionally viable, even in a clearly stressful operational setting. They recognized, however, that the domestic banking system could come under further pressure with the globalization of finance and the framework set by European competition policies. Besides creating wider systemic concerns—as it briefly did this past summer—staff noted that the fragility also generates contingent fiscal liabilities, which can turn only too real as in the case of the State of Saxony, Sachsen LB’s owner.

Table 3.Germany: Core Set of Financial Soundness Indicators for Banks, 1998-2006(In percent)
199819992000200120022003200420052006
Capital adequacy
Regulatory capital to risk-weighted assets10.510.810.911.211.912.412.412.212.5
Commercial banks10.110.911.312.012.712.812.511.612.5
Landesbanken9.69.910.010.411.513.012.212.111.7
Savings banks10.810.810.610.711.111.412.012.513.0
Credit cooperatives11.011.111.010.910.911.612.012.112.2
Regulatory Tier I capital to risk-weighted assets 1/6.86.97.07.27.88.28.08.08.2
Commercial banks6.77.37.68.28.79.08.37.98.4
Landesbanken5.55.65.55.87.07.87.17.37.1
Savings banks7.07.06.97.07.27.47.78.08.4
Credit cooperatives7.27.27.37.37.58.08.38.59.1
Asset composition and quality
Sectoral distribution of loans to total loans
Loan to households33.331.230.629.729.529.729.328.527.6
Commercial banks31.029.227.526.826.125.824.823.9
Landesbanken8.38.27.97.57.57.16.86.2
Savings banks63.863.662.461.962.962.362.261.1
Credit cooperatives66.668.066.467.068.168.369.368.5
Loans to non-financial corporations19.417.317.417.116.616.015.214.514.3
Commercial banks22.320.719.317.715.614.313.312.6
Landesbanken18.919.519.718.918.517.816.717.0
Savings banks17.718.518.818.618.318.017.617.3
Credit cooperatives13.013.613.413.212.912.412.012.1
NPLs to gross loans4.44.14.64.55.05.24.94.03.4
Commercial banks5.25.05.75.25.25.14.53.32.6
Landesbanken2.82.52.72.83.74.44.12.92.0
Savings banks6.15.75.65.96.46.86.96.65.9
Credit cooperatives6.56.46.97.28.08.18.27.36.6
NPLs net of provisions to capital41.438.644.045.447.850.444.534.628.7
Commercial banks39.038.540.751.247.254.541.230.624.5
Landesbanken 2/32.526.029.627.931.634.937.425.016.1a)
Savings banks56.451.649.252.153.658.054.250.443.3
Credit cooperatives47.849.751.953.561.058.357.249.043.0
Earnings and profitability
Return on average assets (after-tax)0.30.20.20.20.1-0.10.10.30.3
Commercial banks0.60.30.30.20.0-0.3-0.10.50.3
Landesbanken0.10.10.10.10.1-0.20.00.20.3
Savings banks0.30.20.30.20.20.20.20.30.2
Credit cooperatives0.20.20.20.20.30.30.30.50.5
Return on average equity (after-tax)10.26.56.14.62.9-1.51.99.27.5
Commercial banks15.27.07.34.20.0-6.6-1.415.59.1
Landesbanken6.35.94.24.01.9-5.2-0.85.69.7
Savings banks6.56.16.15.14.74.05.05.65.0
Credit cooperatives5.14.74.14.46.65.25.39.08.5
Interest margin to gross income75.073.267.869.873.470.273.568.268.2
Commercial banks64.761.752.756.263.756.564.955.361.8
Landesbanken72.077.672.475.075.879.079.483.270.3
Savings banks81.981.380.980.881.380.679.679.077.7
Credit cooperatives79.077.176.578.379.175.475.574.765.3
Noninterest expenses to gross income63.666.068.471.467.266.565.561.062.3
Commercial banks67.873.975.480.474.274.073.559.866.0
Landesbanken46.554.855.957.156.153.153.559.353.6
Savings banks66.565.768.969.966.566.464.966.065.8
Credit cooperatives72.471.274.576.773.169.668.770.064.4
Liquidity
Liquid assets to total short-term liabilities 3/120.9121.1121.0123.5124.4122.0120.9
Commercial banks109.0111.0110.9111.7110.2110.7111.8
Landesbanken110.2104.0107.1115.5129.9122.4118.8
Savings banks202.5212.6211.6207.8221.6224.2206.9
Credit cooperatives178.8184.0193.4189.6193.4181.4174.8
Sensitivity to market risk
Net open positions in FX to capital14.511.311.010.711.46.76.96.96.7
Commercial banks19.811.97.37.25.26.14.45.710.1
Landesbanken12.310.111.711.614.74.66.75.64.2
Savings banks9.511.913.614.313.812.211.111.710.1
Credit cooperatives19.919.721.821.720.816.115.614.011.3
Source: Deutsche Bundesbank. The authorities provide annual data only and disseminate them once a year.

According to Capital Adequacy Regulation, Principle I.

Limited comparability of 2006 data with prior years

2005-06 data in accordance with IMF’s FSI Compilation Guide.

Source: Deutsche Bundesbank. The authorities provide annual data only and disseminate them once a year.

According to Capital Adequacy Regulation, Principle I.

Limited comparability of 2006 data with prior years

2005-06 data in accordance with IMF’s FSI Compilation Guide.

Table 4.Germany: Encouraged and Other Financial Soundness Indicators, 1998-2006(In percent, unless otherwise indicated)
199819992000200120022003200420052006
Corporate sector
Total debt to equity 1/94.380.697.5106.0152.8130.9121.2111.2103.2
Total debt to GDP136.6144.6159.9162.6165.0163.2154.2152.3154.0
Return on invested capital 3/4/8.36.56.37.48.88.38.99.19.1
Earnings to interest and principal expenses 1/5/635.6561.9495.6513.8536.9570.8709.4760.9731.1
Number of applications for protection from creditors 1/6/17,94118,00618,38921,01923,64223,84022,47419,54015,704
Deposit-taking institutions
Capital to assets4.03.73.73.84.14.24.04.14.3
Commercial banks5.75.04.74.95.25.04.44.44.4
Landesbanken3.73.33.43.83.84.04.04.03.9
Savings banks4.13.83.94.04.24.34.54.64.8
Credit cooperatives4.94.64.94.74.95.15.35.45.7
Geographical distribution of loans to total loans
Germany85.385.483.681.380.078.676.875.272.6
EU-member countries8.48.69.611.613.214.616.917.319.5
Others6.36.06.87.16.86.86.37.57.9
FX loans to total loans9.17.89.310.29.69.19.610.210.5
Personnel expenses to noninterest expenses56.054.854.153.153.153.854.455.156.4
Commercial banks54.151.350.449.248.549.449.750.752.5
Landesbanken52.851.051.949.849.649.050.250.555
Savings banks59.959.960.059.359.560.661.361.861.5
Credit cooperatives58.258.557.858.459.059.059.260.160.9
Trading and fee income to total income25.026.832.230.226.629.826.531.831.8
Commercial banks35.338.347.343.836.343.535.144.738.2
Landesbanken28.022.427.625.024.221.020.616.829.7
Savings banks18.118.719.119.218.719.420.421.022.3
Credit cooperatives21.022.923.521.720.924.624.525.334.7
Customer deposits to total (non-interbank) loans63.563.964.065.467.170.071.875.2
Commercial banks62.663.068.674.278.485.385.595.7
Landesbanken35.238.434.330.132.835.440.642.9
Savings banks104.7101.8101.1100.399.8101.0102.2103.3
Credit cooperatives113.6108.0110.3110.8111.7113.2113.6113.1
Spread between highest and lowest interbank rates 7/2.02.6
Spread between reference loan and deposit rates 8/379366353317
Insurance sector
Solvency ratio, Life199170176177190n.a.
Solvency ratio, Non-life350343337346286255n.a.
Return on average equity, Life 9/11.911.412.57.03.45.78.7n.a.n.a.
Return on average equity, Non-life 9/8.17.38.78.92.84.16.8n.a.n.a.
Market liquidity
Average bid-ask spread in the securities market (government bills)0.00.0
Average bid-ask spread in the securities market (corporate securities)0.10.1
Households
Household debt to GDP 1/69.772.973.472.772.472.571.269.967.4
Household debt service and principal payments to income 1/5/4.94.75.15.04.74.23.93.73.9
Real estate markets
Real estate prices, new dwellings9999100101102100100100101
Real estate prices, resale991001001009897959393
Residential real estate loans to total loans13.716.216.416.116.218.017.817.817.7
Commercial real estate loans to total loans6.86.46.46.26.26.66.46.15.8
Source: Deutsche Bundesbank. The authorities provide annual data only and disseminate them once a year.

Indicator compiled according to definitions of the Compilation Guide on FSIs.

2/ Return defined as net operating income less taxes, where net operating income and taxes are compiled according to the FSI Compilation Guide.

Invested capital estimated as balance sheet total less other accounts payable (AF.7 according to ESA 1995).

Excluding principal payments.

Resident enterprises that filed for bankruptcy.

Spread between highest and lowest three month money market rates as reported by Frankfurt banks (basis points)

Spread in basis points.

Profits after tax devided by equity.

Residential property index (yearly average, 2000 = 100); aggregation of data for new dwellings and resale is not available.

Source: Deutsche Bundesbank. The authorities provide annual data only and disseminate them once a year.

Indicator compiled according to definitions of the Compilation Guide on FSIs.

2/ Return defined as net operating income less taxes, where net operating income and taxes are compiled according to the FSI Compilation Guide.

Invested capital estimated as balance sheet total less other accounts payable (AF.7 according to ESA 1995).

Excluding principal payments.

Resident enterprises that filed for bankruptcy.

Spread between highest and lowest three month money market rates as reported by Frankfurt banks (basis points)

Spread in basis points.

Profits after tax devided by equity.

Residential property index (yearly average, 2000 = 100); aggregation of data for new dwellings and resale is not available.

Table 5.Germany: Financial System Structure, 1998-2006(In billions of euros and percentage)
1998200020022003200420052006 1/
NumberAssetsPercentNumberAssetsPercentNumberAssetsPercentNumberAssetsPercentNumberAssetsPercentNumberAssetsPercentNumberAssetsPercent
EurototalEurototalEurototalEurototalEurototalEurototalEurototal
Private depository institutions3,2465,13982.22,7095,99579.92,3376,29079.12,1996,29978.12,1476,48078.12,0896,90378.42,048.07,187.780.6
Commercial banks3281,29620.72941,70422.72731,83023.02611,80422.42521,87922.62521,93322.0256.02,046.623.0
Of which
Big banks35629.0497012.941,05613.341,04513.051,21814.751,22713.95.01,296.914.5
Regional and other banks24163410.12006138.21866658.41736718.31635686.81586036.8158.0620.27.0
Branches of foreign banks84too1.6901211.6831091.484881.184931.1891031.293.0129.51.5
Landesbanken1394015.0131,22316.3141,32416.7131,34616.7121,28215.4121,36515.512.01,440.316.2
Savings banks59491014.656295412.752099812.64911,00012.44771,00212.14631,01411.5457.01,027.011.5
Regional institutions of credit cooperatives42013.242273.021992.521872.322012.422242.52.0242.52.7
Credit cooperatives2,2565208.31,7925347.11,4895607.01,3935667.01,3365766.91,2945926.71,257.0608.06.8
Mortgage banks3379512.73189211.92587311.02587210.82586610.42488710.122.0878.89.9
Banks with special functions184777.6134616.1145066.4145246.5166748.1166967.916.0750.58.4
Building and loan associations 2/34311542.1281642.1271732.1271842.2261922.226.0193.92.2
Insurance companies68490914.56631,06014.16571,22415.46491,28716.06421,32816.06411,36915.6612.01,199.713.5
Life1235178.31236058.11146598.31096888.51087168.61077348.3102.0666.57.5
Nonlife2711292.12571381.82461521.92411531.92371591.92331641.9225.0132.31.5
Other2902634.22833174.22974135.23014465.52974535.53014715.4285.0400.94.5
Investment funds 3/8052063.31,0192984.01,1332713.41,1083043.81,1033083.71,1293383.81,248.0333.83.7
Money market funds39180.339200.342370.543360.442310.442310.443.031.00.3
Pension investment mutual funds3100.04530.04920.04020.04020.03720.032.02.00.0
Securities-based funds7181442.39152263.01,0181572.09961782.29871842.21,0122182.51,132.0223.02.5
Open-end real estate funds17440.720490.724750.929881.134911.138871.041.077.80.9
Total financial system4,7356,254100.04,3917,353100.04,1277,785100.03,9567,890100.03,8928,116too3,8598,610100.03934.08915.2100.0
Memorandum items:
Majority foreign-owned banks721262.0561301.7492763.4452933.6423213.9416237.146.0669.07.5
Foreign banks1562253.51462513.21323864.71293804.71264145.01304144.7139.0799.39.0
Majority public sector owned banks6252,32737.25882,63835.15482,82835.65182,87035.65052,95835.65052,95833.6485.03,217.836.1
Sources: BaFin, Deutsche Bundesbank and staff estimates.

Final data for private depository institutions; preliminary for other financial instituitons.

Assets are not included in Bundesbank statistics until 1999.

Data refer to funds open to the public.

Sources: BaFin, Deutsche Bundesbank and staff estimates.

Final data for private depository institutions; preliminary for other financial instituitons.

Assets are not included in Bundesbank statistics until 1999.

Data refer to funds open to the public.

Figure 11.Selected Countries: Traditional Bank Financing

Sources: World Economic Outlook 2006; Financial Sector Development Indicators; and IMF staff calculations.

European banks are tending to converge in size.

Number of credit institutionsEmployment per institution (Persons)
Country1997200619972006
Belgium131105585647
Denmark213191226243
Germany3,4202,050224338
Greece55621,0311,003
Spain416352591744
France1,258829329525
Ireland7178-502
Italy909807377421
Luxembourg21515489161
Netherlands648345172338
Austria9288098094
Portugal238178271327
Finland3483617766
Sweden237204182231
United Kingdom5374018481,130
Source: European Central Bank.
Source: European Central Bank.

25. However, views differed on how to achieve further restructuring. Staff supported a market-based process of takeovers and exits, cautioning that the current ad hoc approach to public mergers may not achieve viable business models. Policy measures must, therefore, ensure that market forces and private capital can play their legitimate role. The authorities saw scope for restructuring through consolidation mainly within “pillars” in the three-pillar system of private, state-owned, and cooperative banks. Indeed, some of the stronger Landesbanken have forged deeper vertical links with the local Sparkassen (savings banks) and, as such, are thought to be viable. But staff argued that these vertically integrated but regionally oriented banks may not offer a long-term solution. Policy commitment to such vertical, state-based silos could prove unsustainable and pressure for market-based restructuring will continue to increase in an era of global finance and the European Commission’s initiatives to create a framework for integrating retail financial markets in the context of its financial services policy. The authorities recognized that breaking the regional restrictions for the Sparkassen may be needed. However, given the rights of the Länder, the federal authorities noted their constraints in influencing the process. Staff nevertheless sees a role for the federal authorities in pushing the reform agenda and cautioned that interim measures (for example, vertical integration within the public pillars) could have unintended consequences that close future restructuring option

Crisis prevention and management

26. The authorities regarded the developments at Sachsen LB and IKB as unforeseeable “tail events.” While staff was concerned about gaps in the Germany supervisory system, and the authorities did recognize gaps that needed to be addressed, they nevertheless stressed that the problems at the two banks that needed to be rescued were the consequence of failures in mortgage origination in the United States and an internationally accepted rating methodology. The unusual nature of the banks’ off-balance-sheet activities and the liquidity commitments to their conduits were, at least in broad terms, known to the Bundesbank and Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), but were not viewed as alarming at the time. As elsewhere, the risk that the commercial paper market could freeze up was not recognized.

27. They agreed, however, that more transparency was needed. Looking ahead, staff recommended that supervisors should require banks to file financial statements on a quarterly basis and encourage a more widespread use of IFRS reporting (which mandates consolidation of group activities). The authorities agreed that regular stress tests, which were sensitive to the newly revealed vulnerabilities, were needed. They noted that the Sarkozy-Merkel-Brown initiative and the Ecofin decisions will likely establish further norms for enhancing transparency and other arrangements for financial stability.

28. Staff argued for a bank resolution framework with better incentives for prudent operations. As the two German banks felt the full force of the U.S. subprime crisis, rapid action by the authorities helped preserve confidence in the system. Nevertheless, broader questions about Germany’s resolution policy remain. The authorities noted that 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 authorities explained that, in the case of IKB, private shareholders stakes had not been diluted, in part because the process would have entailed considerable delays under the corporate insolvency procedures. Staff recommended that the German insolvency framework should recognize the role of banks in the payment system and the macro economy and incorporate greater flexibility to allow for quick resolutions and dilution of the equity claims of all shareholders.

Supervision

29. Prompted by recent events, the authorities are reviewing ways to improve coordination between BaFin and Bundesbank. BaFin is the consolidated financial sector supervisor, similar to that found in some other countries. Enforcement actions can only be taken by BaFin based on its sole determination of the circumstances at a bank. Under the law, the Bundesbank performs on-site and off-site monitoring of banks under the guiding principles issued by BaFin in agreement with the Bundesbank. BaFin can accompany Bundesbank staff and can also commission auditors to perform special audits. These overlapping mandates have been viewed by banks as unnecessarily duplicative. More important, the coordination problem inherent in the existing structure weakens accountability and risks poor decisions and delays in problem situations. The Finance Minister has called on BaFin and the Bundesbank to revise the above-mentioned guiding principles.

30. Though agreeing that enhanced supervisory accountability should be a principal objective, the authorities were not persuaded by staff’s structural suggestions. Staff recommended that accountability would be increased by consolidating supervision of banks in one of the two agencies. The supervising agency should also have enforcement powers to lower a bank’s risk profile, recognizing that the ultimate step of closing a bank could require a joint decision involving the Ministry of Finance. Thus, if the Bundesbank were to supervise, BaFin would retain its regulatory role, but not its enforcement powers. If accountability were better achieved by consolidating supervision under BaFin, the Bundesbank would still need full access to information on systemically important banks and on other banks as needed, given its financial stability and lender-of-last-resort responsibilities. The authorities were not persuaded that such a consolidation of supervision was practical. Giving the Bundesbank additional authority would, they felt, dilute the BaFin model of integrated supervision. And BaFin could not in the near term take on the full task of supervision, especially given the need to attract skilled supervisors at premium wages. Staff conceded that even a partial streamlining of the current arrangement could improve accountability but remained concerned that coordination problems would continue.

31. Under any arrangement, the urgent need for upgrading supervisory capability is evident. IFRS and Basel II should help deal with evolving issues of greater transparency and liquidity risks, but new challenges will also arise. The Capital Requirements Directive (CRD) will fully introduce Basel II in Europe from 2008. Pillar 2 of Basel II requires a more integrated approach to risk management, and pillar 3 fosters further disclosure. Implementation will require establishing new norms, including on the extent and frequency of disclosure (especially of complex financial products), management of liquidity through access to adequate contingent funds, and increased emphasis on the use of risk models and management. With the growing sophistication of financial markets and the complexities introduced by Basel II, the authorities agreed that the reliance on external auditors must decline with stepped-up efforts to attract and retain skilled supervisors. The same skills will be demanded by banks. The 9 percent add-on to civil service salaries available to the Bundesbank’s staff, flexible contracts that offer targeting of specialized skills, and training programs are the authorities’ means to deal with these challenges.

Capital markets

32. Despite steps taken to strengthen capital markets, these remain underdeveloped and not widely used for investment by firms and households. Traditionally, Germany has had a significant public bond market. The stock market, though still small, has made strides helped by regulatory easing, with greater liquidity and more new capital raised (Figure 12). Yet the equity market is dominated by relatively few firms and the share of closely held stocks remains high (Figure 13). Also, despite progress, Germany lags in nontraditional sources of financing, including nonbank intermediation and asset-backed securitization (Figure 14). The authorities noted that barriers to domestic asset securitization and flexibility of mortgage markets had been essentially removed, including through the recent introduction of real estate investment trusts. The continuing lag in Germany’s capital markets was seen by them as reflecting inertia and the inherently conservative financial preferences of the population. The authorities noted that the conservatism was something of a blessing in the second half of 2007. Notably, even through the recent market turmoil, Pfandbrief credit spreads traded below benchmark yield curves, whereas other covered bond spreads widened by up to 50 basis points.

Figure 12.Selected Countries: Capital Markets in Comparative Perspective

Sources: World Economic Outlook 2006; and Financial Sector Development Indicators.

Figure 13.Selected Countries: Equity Market Efficiency

Source: Financial Sector Development Indicators; and IMF staff calculations.

Figure 14.Selected Countries: Nontraditional Financing

Sources: World Economic Outlook 2006; IMF staff calculations.

1/ Measures the evolution of banks into new area of financial intermediation. The components of this index are: bank noninterest income, bank liabilities vis-à-vis nonbank financial institutions, and bank assets with nonbank financial institutions.

2/ Measures the relevance of nonbank financial intermediaries. The components of this index are: household assets with nonbank financial institutions, loans by nonbank financial institutions, and bonds issued by nonbank financial institutions.

10-Year Spread

(Covered bonds - Government bonds)

Value addition by German firms: The Tobin’s-Q ratio in comparative perspective1/

1/ Tobin’s Q: Market value of a firm’s assets relative to the replacement value of the firm’s assets.

33. Further corporate governance reforms would add impetus to capital market development and investments in productivity growth by firms. A comparison across OECD economies suggests that German companies achieve relatively low market value in relation to their investments (text figure). Both internal and external controls on company management can potentially be strengthened. First, the operation of the two-tier (supervisory and management) board structure at many companies is widely viewed as cumbersome, if not ineffective. Recent studies point to the crucial importance of efficiently functioning boards for value maximization and productivity growth. The authorities noted that several supranational companies (text table below), responding to global pressures, had exercised the option of operating either under a one-tier board or smaller board sizes permitted under the 2004 law governing the Societas Europea (the European Company Law) and such an option could be extended to a wider range of companies.3 Second, continued ownership concentration, albeit declining, creates the risk of self dealing—diversion of assets by insiders at the cost of minority shareholders. While selfdealing transactions need to be declared in an annual report, staff suggested that the current practice of limiting the availability of this report to the supervisory board should be changed and the report distributed to all shareholders to strengthen internal control. The authorities were concerned that lengthy court proceedings related to self-dealing could undermine shareholder rights. Finally, while they agreed that activity in the takeover market remained sluggish, they were less concerned than staff about management’s scope for defensive measures.

German Societas Europea: Changes in Board Structure
SEEmploymentBoard StructureLabor Participation in Supervisory BoardLabor Participation Centers
Allianz177,000Two-tier6 out of 12Yes
Conrad Electronic2,314One-tierNot applicableNo
Donata Holding3,922One-tierNot applicableNo
Fresenius100,000Two-tier6 out of 12Yes
MAN Diesel6,625Two-tier5 out of 10Yes
PCC3,756One-tierNot applicableNo
Porsche Holding11,500Two-tier6 out of 12Yes
Surteco2,109Two-tier3 out of 9Yes
Source: ETUI-REHS.
Source: ETUI-REHS.

34. New governance initiatives carry risks. Staff expressed concern that the draft Risk Limitation Law may create legal uncertainties and stifle legitimate shareholder opposition to management. The authorities agreed on the need to ensure a level playing field, and intend to clarify the draft in this respect. The authorities were aware of views that the draft Law on Modernizing the Framework for Venture Capital and Private Equity could have been stronger, to establish a unified legal and regulatory framework for this important industry. They pointed to the need of targeting the law at those activities that truly merit tax relief. Staff acknowledged that a more far-reaching law would result in higher revenue losses, another reason for continued expenditure moderation to accommodate such initiatives. Staff also cautioned against the proposal to introduce profit sharing, which, though consistent with the authorities’ objective of Soziale Marktwirtschaft, could further complicate corporate governance. Such arrangements might be best undertaken on a voluntary basis rather than through legislation.

C. Strengthening Public Finances

35. After absorbing the costs of two tax reforms in 2008, the authorities plan to achieve a structural surplus of ½ percent of GDP by 2011. Following structural balance in 2007, the current year’s budget is projecting a deficit of more than ½ percent of GDP. The deterioration is primarily due to two tax measures: a corporate income tax reform (0.3 percent of GDP) and a reduction of the unemployment insurance rate from 4.2 to 3.3 percentage points of personal income (0.2 percent of GDP). Healthcare reform and research and development subsidies will increase spending by 0.1 percent of GDP. Moving forward, in their latest Stability Program, the authorities have set the medium-term target of a structural surplus of ½ percent and a primary surplus of 3½ percent of GDP. Achieving this objective would aid long-term sustainability; in fact, the present discounted value of government’s net worth would be almost balanced assuming that such adjustment is maintained and, importantly, that the authorities’ estimates of aging costs hold (text table balance sheet).

36. The slippage in 2008 is regrettable and achieving the appropriately ambitious medium-term goals remains a challenge. To be sure, the benefits from past reforms will continue to pay dividends. Thus, changes in the pension formula for benefits and indexation of long-term care benefits will achieve incremental reductions over time. The expenditure containment will continue through public sector wage moderation and the phasing out of homeowners subsidies. Nevertheless, staff estimates that the accumulated shortfall by 2011 in the primary balance goal could be as much as 1 percent of GDP on announced policies (Table 6). 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. In particular, corporate taxes tend to increase on the upswing, but can decrease dramatically during a downturn. As such, the downside risks to growth create a corresponding risk to fiscal outcomes, even in structural terms.

Table 6.Germany: General Government Finances, 2002-12
Est.Staff projections
20022003200420052006200720082009201020112012
(In billions of euros)
Revenue952.5961.9958.1977.01,017.41,065.31,069.71,099.81,120.71,139.91,173.6
Current944.0952.9948.6967.11,008.11,055.91,060.11,089.91,110.61,129.41,162.8
Direct taxes227.2226.1221.1227.6250.0265.2262.3270.1275.1281.7290.5
Indirect taxes250.3255.7260.2265.5280.4312.0317.0325.3334.9341.4352.0
Social security contributions390.7396.3396.9396.9401.1401.9409.3423.2431.0438.7450.6
Other current75.874.970.577.276.676.771.571.369.567.669.7
Capital8.59.09.59.99.39.49.69.910.210.510.8
Primary expenditure968.2984.9979.3990.1989.71,000.31,019.41,038.41,058.81,076.41,103.4
Current899.2916.5915.3926.1927.5937.6953.9970.7988.71,004.61,029.3
Wages168.7169.2169.5168.5167.7167.7169.5170.8171.7173.3174.7
Goods and services88.490.491.296.997.8101.0104.5107.2109.3108.8111.2
Subsidies31.729.728.727.226.828.230.131.933.833.934.9
Social benefits579.8594.2592.7598.2600.1605.3611.9620.3631.4646.0663.8
Other current30.632.933.235.335.235.337.940.642.542.644.7
Capital69.068.464.064.062.162.765.667.770.171.874.1
Primary balance-15.7-23.0-21.2-13.127.865.050.261.561.963.570.2
Interest62.764.362.462.565.165.465.466.564.664.160.8
Overall balance-78.3-87.3-83.6-75.6-37.3-0.4-15.2-5.0-2.7-0.69.3
(In percent of GDP)
Revenue44.444.543.343.543.844.043.243.342.842.242.2
Current44.044.042.943.143.443.642.842.942.441.841.8
Direct taxes10.610.410.010.110.810.910.610.610.510.410.4
Indirect taxes11.711.811.811.812.112.912.812.812.812.612.6
Social security contributions18.218.317.917.717.316.616.516.616.516.316.2
Other current3.53.53.23.43.33.22.92.82.72.52.5
Capital0.40.40.40.40.40.40.40.40.40.40.4
Primary expenditure45.245.544.344.142.641.341.140.840.439.939.6
Current42.042.441.441.339.938.738.538.237.837.237.0
Wages7.97.87.77.57.26.96.86.76.66.46.3
Goods and services4.14.24.14.34.24.24.24.24.24.04.0
Subsidies1.51.41.31.21.21.21.21.31.31.31.3
Social benefits27.127.526.826.625.825.024.724.424.123.923.9
Other current1.41.51.51.61.51.51.51.61.61.61.6
Capital3.23.22.92.92.72.62.62.72.72.72.7
Primary balance-0.7-1.1-1.0-0.61.22.72.02.42.42.42.5
Interest2.93.02.82.82.82.72.62.62.52.42.2
Overall balance-3.7-4.0-3.8-3.4-1.60.0-0.6-0.2-0.10.00.3
Memorandum item:
Structural fiscal balance-2.9-3.2-2.8-2.4-1.20.0-0.7-0.3-0.10.00.3
Gross public debt end-year59.662.864.766.366.063.362.561.159.459.359.1
Sources: Ministry of Finance; and Fund staff projections.
Sources: Ministry of Finance; and Fund staff projections.

Risks to overall fiscal balance are linked to growth risks, and implementation of reforms.

General Government Fiscal Position(Percent of GDP)
Proj.
200320042005200620072008
Overall balance-4.0-3.8-3.5-1.60.0-0.6
Revenue44.543.343.543.844.043.2
of which
Direct taxes10.410.010.110.810.910.6
Indirect taxes11.811.811.812.112.912.8
Primary expenditure45.544.344.142.641.341.1
Social benefits27.526.826.625.825.024.7
of which
Pensions12.412.212.011.611.110.9
Health7.77.47.57.47.47.5
Other expenditures18.117.517.516.816.316.5
Structural balance-3.2-2.8-2.4-1.20.0-0.7

37. Staff therefore proposed that additional measures be taken to create a precautionary buffer. Since delays in achieving the primary balance target have longlasting implications, identifying and implementing subsidy-cutting measures and rationalization of tax expenditures remain important tasks—also to create the room for reducing tax rates in a responsible manner. Although the Stability Program identifies potential savings from a wide range of measures, the authorities felt that the likelihood of their implementation was low, given the current “reform fatigue.” If, however, the risks to the fiscal position did materialize, there could be more appetite for these measures.

38. Securing a sound fiscal position today will protect against the risk that healthcare costs have been underestimated. While pension reforms have helped greatly, the authorities recognize that the costs from healthcare will pose an increasing burden. Since the trajectory of the public debt-to-GDP ratio is very sensitive to long-term assumptions (text table4 and Figure 15), higher rates of cost increase implying rapid debt accumulation. Staff was concerned that the authorities’ forecast of a rise in healthcare costs of 1.2 percentage points of GDP over the next 45 years may be too low. Other estimates show increases of up to 5.6 percent of GDP (for example, the IFO Institute), while staff considers a 3.0 percent of GDP increase as highly likely, given past cost dynamics, the structure of age-related benefits, and the costs of new treatments. The authorities plan to review their estimates in the context of the 2008 long-term sustainability report.

Figure 15.Germany: Healthcare Expenditures and Aging

1/ Federal Statistical Office, Hagist, Christian and Laurence Kotlikoff (2005) Who’s Going Broke? Comparing Growth and Health Care Costs in Ten OECD countries, NBER Working paper 11833.

2/ For different scenarios descriptions see text table General Government Indicative Balance Sheet for 2007.

Sources: Staff calculations and Hagist and Kotlikoff (2005).

General Government Indicative Balance Sheet for 2007(In percent of GDP)
Authorities’ ScenarioAlternative Scenarios
Low Aging Costs and Planned Adjustment by 2011 1/Medium Aging Costs and Planned Adjustment by 2011 2/Large Aging Costs and Planned Adjustment by 2011 3/Medium Aging Costs and Slower Adjustment 4/Large Aging Costs and Adjustment 5/
Comprehensive net worth=budget constraint 6/-3-25-93-44-110
Comprehensive financial net worth 7/-55-77-145-96-162
Sources: Ministry of Finance, and Fund staff calculations.

Primary surplus of 3 1/2 percent of GDP achieved by 2011 (see Stability Program Dec. 2007) and 1.2 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2050 (corresponding to 2.7 percent of GDP total aging costs, AWG).

Primary surplus of 3 1/2 percent of GDP achieved by 2011 (see Stability Program Dec. 2007) and 3.0 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 4.0 percent of GDP total aging costs).

Primary surplus of 3 1/2 percent of GDP achieved by 2011 (see Stability Program Dec. 2007) and 5.6 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 7.8 percent of GDP total aging costs, IFO current projections. See Martin Werding presentation at Joint IMF-Bertelsmann Foundation Conference, Berlin, Nov. 2006 on Long-term Sustainability of Public Finances in Germany).

Primary surplus of 2 1/2 percent of GDP achieved by 2011 (see IMF projections, Table 3) and 3.0 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 4.0 percent of GDP total aging costs).

Primary surplus of 2 1/2 percent of GDP achieved by 2011 (see IMF projections, Table 3) and 5.6 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 7.8 percent of GDP total aging costs, IFO current projections. See Martin Werding presentation at Joint IMF-Bertelsmann Foundation Conference, Berlin, Nov. 2006

Defined as current financial and nonfinancial wealth and net present value of debt projections of fiscal scenarios for a rolling 50-year period; based on 2007 population projections Federal Statistical Office.

Excludes the nonfinancial net worth as many such assets may not be marketable. Therefore, they would not be available to alleviate the public sector liquidity constraint.

Sources: Ministry of Finance, and Fund staff calculations.

Primary surplus of 3 1/2 percent of GDP achieved by 2011 (see Stability Program Dec. 2007) and 1.2 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2050 (corresponding to 2.7 percent of GDP total aging costs, AWG).

Primary surplus of 3 1/2 percent of GDP achieved by 2011 (see Stability Program Dec. 2007) and 3.0 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 4.0 percent of GDP total aging costs).

Primary surplus of 3 1/2 percent of GDP achieved by 2011 (see Stability Program Dec. 2007) and 5.6 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 7.8 percent of GDP total aging costs, IFO current projections. See Martin Werding presentation at Joint IMF-Bertelsmann Foundation Conference, Berlin, Nov. 2006 on Long-term Sustainability of Public Finances in Germany).

Primary surplus of 2 1/2 percent of GDP achieved by 2011 (see IMF projections, Table 3) and 3.0 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 4.0 percent of GDP total aging costs).

Primary surplus of 2 1/2 percent of GDP achieved by 2011 (see IMF projections, Table 3) and 5.6 percent of GDP increase in public expenditures on health benefits due to aging over 2004-2005 (corresponding to 7.8 percent of GDP total aging costs, IFO current projections. See Martin Werding presentation at Joint IMF-Bertelsmann Foundation Conference, Berlin, Nov. 2006

Defined as current financial and nonfinancial wealth and net present value of debt projections of fiscal scenarios for a rolling 50-year period; based on 2007 population projections Federal Statistical Office.

Excludes the nonfinancial net worth as many such assets may not be marketable. Therefore, they would not be available to alleviate the public sector liquidity constraint.

39. Several options to deal with aging costs were discussed. Staff proposed that 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. Addressing the greater challenge of escalating healthcare costs, the authorities noted, would require stronger incentives for cost savings by insurers. This would require revisiting the arrangements through which insurers are reimbursed by the Health Fund. They also recognized that, while ensuring basic health coverage for all, the private burden for traditionally publicly financed services would have to continue to rise to ensure the sustainability of the social security system.

40. Past breaches of the Maastricht budget deficit criteria and enforcement problems with the existing fiscal rule have led to a review of the fiscal framework. The existing “golden rule” requires that borrowing at the central government level not exceed gross investment. With reduced public investment needs, the rule implies a close-to-balance budget, leaving little room for automatic stabilizers; it has lost credibility since an escape clause (declaration of macroeconomic disequilibrium) was repeatedly invoked. The authorities have proposed a new fiscal rule, which calls for a (close to) structurally-balanced budget for the central government and states every year but with some room for the operation of automatic stabilizers. Staff agreed that the new rule would be better aligned with the 30 Stability and Growth Pact and would serve to anchor and improve incentives for fiscal selfdiscipline. Staff recommended, in addition, that the rule should require further belt tightening when necessary for long-run sustainability. Moreover, the effectiveness of the rule will depend on how the discretion is used—or abused. Imparting greater transparency remains crucial. In this regard, staff welcomed the authorities’ effort to embed more systematic program evaluation into fiscal decisions (for example, assessment of tax expenditures, as presented in the Stability Program) but also called for standardized fiscal reporting at all levels of government.

41. Reform of fiscal federalism is also needed. The medium-term fiscal targets are based on the assumption of budget surpluses at the subnational level. Ensuring this goal requires increased fiscal efficiency at the subnational level, necessary also to control subnational debt and prevent budget crises. The authorities and staff shared the diagnosis. The current system, based on the cooperative principle of uniform spending standards, is inefficient and is also not achieving the authorities’ goal of greater equality across states (Box 6). Spending is financed by horizontal transfers across the Länder (primarily from shared taxes with the federal government), together with vertical transfers from the federal government. Most Länder have few incentives to manage their public finances efficiently, given the rigidity in spending, the limited authority over tax policy, and a de facto bailout guarantee. The system encourages unproductive tax competition through Länder tax administration decisions. The arrangement is under stress, with the surplus Länder disinclined to subsidize those with deficits.

42. But the politics for achieving the needed reforms is unfavorable. Greater Länder tax autonomy (for example, by allowing them to set personal income tax rate surcharges within defined bands), along with centralization of tax administration, could help establish greater accountability at the subnational level. As 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, including on subnational debt, are needed for transparency and monitoring of general government finances. The difficulty is that each measure, taken in isolation, faces considerable opposition from a number of states. A package of measures in line with other countries’ experiences may help achieve the necessary compromises to move ahead on the broad agenda.

Box 6.Why Has Economic Convergence Across the Länder Stopped?1

Following reunification, consumption across German states converged rapidly at first (figure; larger negative numbers imply faster convergence). But the convergence rate has declined steadily, and recently there has actually been divergence (positive values on the convergence axis). Because consumption growth rates are now similar across states, citizens in poorer states are not catching up but have greater insurance: a temporary decline in income does not imply a corresponding decline in consumption.

Why has the rate of convergence declined? Following reunification, investment flowed to the poorer states, helping capital accumulation and raising labor productivity and growth (figure below).

The changing trade-off between insurance and convergence.

Changes in direction of investment flows.

Labor Share and Investment Growth.

However, since the late 1990s, the richer states are achieving higher investment growth rates, reinforcing their already high incomes. The data suggest that, despite increased productivity in the poorer states, their high wages have implied high labor shares of income. In turn, the lower profitability has apparently resulted in low (even negative) investment growth rates.

1 Prepared by Akito Matsumoto.

V. Staff Appraisal

43. Bold reforms have strengthened the German economy. From the economic doldrums early in the decade, Germany has made valuable gains. These include strong GDP growth, substantial employment gains, an impressive increase in the share of longer-term jobs with social security benefits, and fiscal position in the best shape since unification. Wage moderation helped competitiveness, in turn, allowing firms to profit from the global upswing. With the improved competitiveness, the real exchange rate is estimated to be close to equilibrium, with some evidence of a modest undervaluation.

44. The economy has so far withstood the financial turmoil—but downside risks are substantial. Strong cyclical bank profitability before the turbulence and the low reliance of enterprises and households on credit have helped maintain normalcy in lending. Writedowns have continued as assets have had to be revalued, but systemically important banks have dealt with these without impairing their core capital. However, the tightening lending standards and the deepening turbulence raise the risk of a cascading decline in lending and growth.

45. To protect against the unfolding risks and build on the hard-won gains, the outstanding challenges must be tackled. The authorities have stepped up their assessment of bank exposures to credit and liquidity risks, a vigilance that must continue in view of the yet unknown dimensions and fast-moving nature of the current turmoil. 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).

46. A pause in the broader reform process would be unfortunate, 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 front-loaded 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.

47. Enhancing Germany’s growth potential and resilience requires interrelated measures. To alleviate skills shortages, a two-pronged strategy is necessary: invigorating education and training, and encouraging skilled immigration. Sectoral minimum wages will not serve the goal of fairness and risk distorting competition; and diluting work incentives could hurt the progress of Hartz IV. Instead, more vigor in rationalizing active labor market and placement assistance programs and enhanced child care availability for women to participate in the labor force would strengthen the labor market. Finally, the investment climate would be strengthened by continued reduction of red tape, a reduction of taxes on capital and labor (offset by expenditure reductions), and preserving Germany’s reputation for openness to foreign capital.

48. Policy on banking sector restructuring 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. Measures to foster bank restructuring should be guided by the goal of creating robust and sustainable banks, while allowing private capital to play its role. As global competition intensifies, eroding the traditional businesses of banks that only serve targeted communities, 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.

49. Greater transparency and stronger incentives for prudent action will support crisis prevention and management. The bank resolution framework should allow for quick resolution but improve management incentives by allowing for dilution of private shareholders’ equity. Supervisors should require more frequent financial statements and encourage more widespread use of IFRS reporting to better capture off-balance-sheet activity.

50. Structural and coordination improvements are needed for enhancing supervisory accountability. Consolidation of bank supervision and prudential enforcement in either the Bundesbank or BaFin would increase accountability. Regulation will need to stay with BaFin to maintain its role as a consolidated supervisory agency and, under any supervisory arrangement, the Bundesbank would need all necessary information to fulfill its financial stability and lender-of-last-resort responsibilities. Effective implementation of Basel II will require reduced reliance on external auditors and stepped-up efforts to attract and retain skilled supervisors.

51. The further development of capital markets will be aided by creating additional options for, and greater transparency in, corporate governance. Such steps that hold the promise of raising economic productivity. In particular, the large size of the supervisory boards slows decisions. The option available to some German companies for rationalizing their boards under the Societas Europea rules could be more widely extended. 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. A number of new initiatives in the pipeline carry risks of further strengthening insiders or rendering governance more complex.

52. Building on their significant recent achievements, achieving fiscal sustainability is within reach—and the ingredients for doing so are clear. Although the fiscal situation is expected to deteriorate mildly in 2008, the incremental gains from measures already taken should help continued consolidation. Additional measures now will help mitigate the short-term risks, especially those from an asymmetric decrease in revenues were growth to decline sharply. Because short-term slippages accumulate, precautionary belt tightening will also aid long-term sustainability. In that regard, tackling healthcare expenditures is the priority. The authorities’ move to a fiscal rule that achieves close to structural balance is in the right direction, but the rule should also allow for additional measures for preserving long-term sustainability. The second round of fiscal federalism reforms offers the opportunity for a significant increase in efficiency and mitigation of fiscal risks. A package of measures that includes centralized tax administration but increased Länder autonomy on tax policy would create better incentives for fiscal management.

53. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

Appendix I. Germany: Fund Relations

(As of December 31, 2007)

  • Mission: November 28 to December 10, 2007 in Frankfurt, Bonn, and Berlin. The concluding statement of the mission is available at http://www.imf.org/external/np/ms/2007/121007.htm.

  • Staff team: Messrs. Kähkönen (Head), Mody, Odenius, Ms. Carare (EUR) and Messrs. Seelig and Kiff (MCM). Mr. Ahmad (FAD) joined the mission as an expert on fiscal federalism.

  • Country interlocutors: The Bundesbank President Weber, Federal Financial Supervisory Authority (BaFin) Vice-President Caspari, State Secretaries Anzinger (Labor and Social Security), Mirow (Finance), and Pfaffenbach (Economy), members of the German Council of Economic Experts, and senior representatives at the Chancellery, several ministries, the Bundesbank, and BaFin. Mr. von Stenglin, the Alternate Executive Director for Germany, also participated in the discussions. Meetings took place with parliamentarians, Länder representatives, labor unions, employers, research institutes, and financial market participants.

  • Fund relations: The previous Article IV consultation took place on December 8, 2006. The associated Executive Board’s assessment and staff report are available at http://www.imf.org/external/pubs/cat/longres.cfm?sk=20177.0.

  • Selected issues papers: (1) The modest effect of the German VAT hike: The role of inflation smoothing; (2) Growthlinkages within Europe; (3) Alleviating shortages of skilled labor; and (4) Germany’s corporate governance: Turning inside out.

I. Membership Status: Joined August 14, 1952.

II. General Resources Account:

SDR Million% Quota
Quota13,008.20100.00
Fund holdings of currency12,124.6793.21
Reserve position in Fund883.616.79

III. SDR Department:

SDR Million% Allocation
Net cumulative allocation1,210.76100.00
Holdings1,368.05112.99

IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Payments to Fund: (SDR Million; based on existing use of resources and present holdings of SDRs):

Forthcoming
20082009201020112012
Principal----------
Charges/Interest0.060.060.060.060.06
Total0.060.060.060.060.06

VII. Exchange Rate Arrangement:

Germany’s currency is the euro, which floats freely and independently against other currencies.

Germany is an Article VIII member and maintains an exchange system free of restrictions on payments and transfers for current international transactions. It maintains measures adopted for security reasons, which have been notified to the Fund for approval in accordance with the procedures of Decision 144 (EBD/08/5, January 16, 2008) and does so solely for the preservation of national or international security.

VIII. Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT)

The authorities have moved towards a more risk-based approach, in which the intensity of audits and inspections should reflect institutions’ AML/CFT risk. A dialogue with the associations of certified public accountants and other auditors has led to a revised AML/CFT assessment methodology in 2005. Legal revisions also granted the BaFin the power to freeze funds without a court order or other involvement of prosecution authorities if facts suggest that funds serve the purpose of terrorist financing. BaFin can now also require financial holding groups and financial conglomerates to develop a coordinated risk management approach for the whole group.

IX. Staff Analytical Work on Germany, 2003-07

Growth and Competitiveness

  • Alleviating Shortages of Skilled Labor and their Impact on the Economy, forthcoming Working Paper.

  • Growth Linkages within Europe, see Selected Issues Chapter 2.

  • What explains Germany’s Rebounding Export Market Share? CESifo Working Paper No. 1957.

  • Long-run Growth in Germany. IMF Country Report No. 06/17.

  • Does Excessive Regulation Impede Growth in Germany? IMF Country Report No. 06/17.

  • The Performance of Germany’s Non-Financial Corporate Sector – An International Perspective. IMF Country Report No. 06/17.

  • Investment Trends in OECD Countries: Long-Term Developments and Future Prospects. IMF Country Report No. 04/340.

  • Does PPP hold in the Long Run? Germany and Switzerland. IMF Country Report No.04/340.

  • Business Investment in the Current Cycle. IMF Country Report No. 03/342.

Inflation

  • The modest effect of the German VAT hike: Role of inflation smoothing, forthcoming Working Paper.

Fiscal Policy and Entitlement Programs

  • Tax Reform and Debt Sustainability in Germany: An Assessment Using the Global Fiscal Model. IMF Country Report No. 06/436.

  • Business Tax Reform. Forthcoming Selected Issues Paper.

  • Why is Germany’s Deficit so Large?, IMF Country Report No. 06/17.

  • A Preliminary Public Sector Balance Sheet for Germany, IMF Country Report No. 06/17.

  • Germany: A Long-Run Fiscal Scenario Based on Current Policies, IMF Country Report No. 06/17.

  • Pensions and Growth. IMF Country Report No. 04/340.

  • Federalism and the Political Economy of Adjustment. IMF Country Report No.04/340.

Labor Markets

  • The Employment Effects of Labor and Product Markets Deregulation and their Implications for Structural Reform. CESifo Working Paper No 1709, May 2006.

  • Employment, Unemployment, and Labor Supply in Germany. IMF Country Report No. 04/340.

  • The Unbearable Stability of the German Wage Structure: Evidence and Interpretation. IMF Staff Papers, August 2004.

The Financial System

  • Landesbanken: A Measure of the Costs for Taxpayers. IMF Country Report No. 06/436.

  • The German Banking Sector: Credit Decline, Soundness and Efficiency. IMF Country Report No. 06/17.

  • Germany’s Three-Pillar Banking System. IMF Occasional Paper 233 (2004).

  • Germany’s Financial System: International Linkages and the Transmission of Financial Shocks. IMF Country Report No. 03/342.

Corporate Governance

  • Germany’s Corporate Governance: Turning Inside Out, see Selected Issues Chapter 4.

Appendix II. Germany: Statistical Issues

Germany’s economic and financial statistics are adequate for surveillance purposes. Germany has a full range of statistical publications and subscribes to the Fund’s Special Data Dissemination Standard (SDDS). The authorities make substantial use of the Internet to facilitate on-line access to data and press information.

Germany adopted the European System of Integrated Economic Accounts 1995 (ESA95) in 1999. The 2005 ROSC Data Module mission found that the macroeconomic statistics generally follow internationally accepted standards and guidelines on concepts and definitions, scope, classification and sectorization, and basis for recording. However, the sources for estimating value added for a few categories of service industries could be improved. A direct source for quarterly changes in inventories, which is an important contributor to short-term deviation in the trend GDP growth rate, is lacking. There is no systematic, proactive process to monitor the ongoing representativeness of the samples of local units and products between rebases of the producer price index.

Comprehensive data reporting systems support the accuracy and reliability of the government finance and balance of payments statistics. However, although explanatory documentation exists, the lack of a table bridging the general government data in the ESA95 classification and the general government cash data on an administrative basis is impairing fiscal analysis; Germany publishes general government revenue, expenditure, and balance on an accrual basis every six months (ESA95). Monthly data are only disseminated on a cash-basis.

Germany is participating in the Coordinated Compilation Exercise for financial soundness indicators (FSIs). In 2006, as part of this exercise, the German authorities compiled a comprehensive set of FSI data and metadata.

Germany: Table of Common Indicators Required for Surveillance(As of January 30, 2008)
Date of latest observationDate receivedFrequency of Data6Frequency of Reporting6Frequency of Publication6
Exchange RatesJanuary 0801/25/2008DDD
International Reserve Assets and Reserve Liabilities of the Monetary Authorities1December 07January 08MMM
Reserve/Base MoneyDecember 07January 08MMM
Broad MoneyDecember 07January 08MMM
Central Bank Balance SheetDecember 07January 08MMM
Consolidated Balance Sheet of the Banking SystemDecember 07January 08MMM
Interest RatesDecember 07January 08MMM
Consumer Price IndexNovember 07January 08MMM
Revenue, Expenditure, Balance and Composition of Financing3 – General Government4June 07November 07Semi-annualSemi-annualSemi-annual
Revenue, Expenditure, Balance and Composition of Financing3-Central GovernmentDecember 07January 08QQQ
Stocks of Central Government and Central Government-Guaranteed Debt5December 07January 08QQQ
External Current Account BalanceDecember 07January 08MMM
Exports and Imports of Goods and ServicesDecember 07January 08MMM
GDP/GNPQ4 07January 08QQQ
Gross External DebtH1 07November 07Semi-annualSemi-annualSemi-annual

Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

2/ Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes, and bonds.

Foreign, domestic bank, and domestic nonbank financing.

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

Including currency and maturity composition.

Daily (D); weekly (W); monthly (M); quarterly (Q); annually (A); irregular (I); and not available (NA).

Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

2/ Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes, and bonds.

Foreign, domestic bank, and domestic nonbank financing.

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

Including currency and maturity composition.

Daily (D); weekly (W); monthly (M); quarterly (Q); annually (A); irregular (I); and not available (NA).

Subject to ongoing WEO revision.

See Germany: Selected Issues, IMF Country Report No. 06/436.

The issue of codetermination—the representation of labor on the supervisory board in large companies—remains politically contentious. See Selected Issues, Chapter IV.

Traa, Bob, 2006, “A Long-Run Fiscal Baseline and Indicative Public Sector Balance Sheet”, paper presented at the Long-Run Fiscal Sustainability in Germany Berlin symposium.

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