Germany’s economy, once the growth engine of Europe, has underperformed for some time. But a new reform package known as Agenda 2010 has raised hopes that far-reaching changes in Germany’s generous welfare system and financial sector will reinvigorate it. Camilla Andersen spoke to Ajai Chopra, mission chief for the recently completed Article IV consultation, and Tomas Balino, who led a team conducting an in-depth assessment of Germany’s financial sector under the joint IMF-World Bank Financial Sector Assessment Program (FSAP), about the need for change.
IMFSurvey: The German economy has been stagnating for the past three years, and its fiscal deficit exceeds the limit set under the Stability and Growth Pact. What’s to blame?
Chopra: Germany’s economy has been underperforming for about a decade. Its problems are rooted in structural rigidities, especially inflexible labor markets and liberal benefits for the jobless. The generous welfare system, which was extended to the new lander (states) in eastern Germany following reunification, resulted in high taxes and social security contributions. Reunification also created other imbalances, such as an enormous building boom in the new lander, the adjustment to which is still in train. Taken together, these problems have discouraged investment and the hiring of labor, keeping growth down and unemployment high. More recently, the long-standing structural rigidities have interacted with cyclical weakness in the global economy to magnify Germany’s problems.
Germany’s fiscal deficit appears set again to exceed in 2004 the limit of 3 percent of GDP set by the Stability and Growth Pact, in part because planned tax cuts are being advanced. Despite this, we think that the budget for 2004 is shaping up to be a reasonable compromise between competing fiscal demands—the need to achieve lasting fiscal consolidation, on the one hand, and the need to ensure there is no excessive withdrawal of fiscal stimulus, on the other. Given the nature of Germany’s problems, we are putting a significant premium on long-term reforms that will deliver economic growth and fiscal savings rather than focusing excessively on short-term policies.
IMFSurvey: What about the euro? Has it been a factor?
Chopra:The introduction of Economic and Monetary Union [EMU] in the 1990s had different effects on different countries. For Germany, which already had fairly low interest rates, there was less of an immediate benefit from convergence than in other countries. A number of countries also went through a lot of fiscal and structural adjustment as they were entering EMU. Spain and the Netherlands are good examples. By contrast, adjustment in Germany to strengthen competitiveness has been more drawn out as structural rigidities remained unaddressed.
Taking a more current view, interest rates, especially in real terms, are relatively high for Germany, as cyclical conditions there are more depressed than they are elsewhere in the euro area. But then monetary policy has to be set for the euro area as a whole, not just for Germany. I wouldn’t want to exaggerate the importance of this particular issue, as Germany is challenged not so much by macroeconomic problems caused by monetary or fiscal policy as by microeconomic problems caused by supply-side rigidities.
You also need to look at the exchange rate. Germany is an exporting nation, so it obviously benefited when the euro was weak. The strengthening of the euro does put a drag on the economy, but this was inevitable because it represents a return to a closer-to-equilibrium value for the euro. In the short run, the biggest risk to a recovery is a further appreciation of the euro. But right now the level of the euro is pretty much what we had assumed in our forecast.
Baliño: Another consequence of the introduction of the euro is a greater integration of financial markets. This means, for example, that banks and issuers of bonds in Germany have lost a comparative advantage. When Germany still had the deutsche mark, deposits and bonds were denominated in a national currency that was considered stable and strong. Now, anybody in the euro area can do the same thing. Also, Germans can now take their savings to, say, a French bank and still have it denominated in their currency. They also benefit from the unified EU [European Union] minimum protection of savings up to €20,000.
IMFSurvey: The IMF has for many years pointed to labor market rigidity as one of the factors holding Germany back. Does Agenda 2010 go far enough in tackling these problems?
Chopra: The government’s strategy on labor market reform is impressive. Some people have described it as perhaps the most radical change in Germany’s labor market institutions and the welfare system in the past 50 years. In the labor market, people have been entitled to lengthy unemployment benefits and so have had little incentive to look for a job. One of the major reforms proposed in Agenda 2010 is to limit the duration of benefits to 12 months for all unemployed, except for those aged 55 years or more, who will qualify for 18 months of benefits. This is a well-targeted reform that should have a considerable impact on incentives to seek work.
Germany also provides unemployment assistance, which is related to past wages, after unemployment benefits have expired. A second major reform is to merge unemployment assistance with social assistance. Social assistance is less generous, but it provides subsistence support. The number of workers and firms covered under collective wage bargaining systems is also decreasing—another positive development. All this should encourage job growth.
Can reforms be taken further? Yes. The duration of unemployment benefits could be reduced to 12 months for all. Also, with the merging of unemployment assistance and social assistance, it will be important to cut support to people who turn down acceptable work and to target the program to the truly needy. There is also more work that can be done on job protection laws, because dismissals are very complicated. The threshold for being covered by job protection laws could also be raised. Right now, firms with just five employees are covered by these laws. But the start to labor market reform has indeed been impressive.
IMFSurvey: Although the financial sector in Germany had its worst year ever in 2001-02, it is still well capitalized. What are the challenges facing Germany’s banks?
Baliño: A key challenge is to adapt to the changes that have already occurred, such as reunification and the introduction of the euro. Other challenges include solving some long-standing structural problems, such as the low profitability of the system: banks in Germany are much less profitable than banks elsewhere in Europe.
IMFSurvey: Why is that?
Baliño: One reason is that a large part of the financial system in Germany is not motivated by profit. Its public banks and cooperative sector have been good in terms of providing inexpensive and convenient financial services, although some people argue that these services aren’t very sophisticated. The larger commercial banks have had to compete with the public and cooperative parts of the system, and this has contributed to lower profitability. The public banks have also enjoyed other privileges, such as state guarantees. Following an agreement with the European Commission, these will be phased out starting in 2005, and that is going to be an important challenge to the system.
Banks have also suffered a lot from the poor performance of the stock market over the past few years. What used to be a source of income became less so. Many of these banks will now have to find a niche they can exploit in terms of generating revenue. They have been doing quite a lot of cost cutting, but now they need to act on the other side of the equation.
IMFSurvey: It would seem that the particular structure of the financial sector in Germany, with many small banks and little emphasis on profits, has served the average consumer well for many years. Why should the German public support reform?
Balino: The system has served Germany well in terms of ensuring stability. But it seems unlikely that the system can be sustained in the long run without transformation. Banks will have to adjust. For instance, if the public banks need to increase their capital, their owners—the municipalities and the lander—aren’t in a strong enough financial position to provide more capital. The cooperative banks have served their members well, but this form of capital isn’t very resilient during periods of stress because of the way in which voting power is structured. No matter how many shares you have, you still have one vote. Thus, cooperative banks may have to explore other ways to attract private capital.
There will be changes, and some are already well under way. There isn’t much of a choice except, perhaps, whether the consolidation is going to take place only within, or also across, the three pillars of the system—private, cooperative, and public banks.
IMFSurvey: The weakened financial status of many insurance companies has made the industry vulnerable to a sudden surge in claims. German reinsurance companies, holding 25 percent of the world market, are particularly vulnerable. What can be done?
Balino: The problems of the life insurance companies are to a large extent caused by too much competition, which has led companies to pay rates of return that aren’t sustainable, particularly now that returns on their assets have come down. There are also other rigidities. Life insurance companies are contractually required to transfer a large part of their profits back to policy holders instead of reinvesting. And there is a rate of return that has become a floor for the system; once reached, the companies start to outbid one another in terms of paying high yields to the customers. This means that many are actually operating at a loss. These problems will need to be addressed, lest the companies lose capital strength.
Another concern we raise in the Financial System Stability Assessment (FSSA) report concerns the reinsurance sector, which has been somewhat overlooked in terms of regulation and supervision. While this problem isn’t peculiar to Germany, it still needs to be dealt with. The companies remain quite strong, and quick calculations suggest that the system could handle an event three times that of Hurricane Andrew, which was a big claim on their resources, together with claims already in the pipeline, such as the asbestos cases. But because there has been such an unprecedented accumulation of events over the past couple of years, the system is now weaker than before. The report argues that the authorities should strengthen supervision of the sector—something they are now doing even ahead of the passage of EU legislation to that effect.
IMFSurvey: Germans are savers, not investors. Recent negative trends in stock prices—with the DAX losing 60 percent from its peak in 2000 and the Neuer Markt for high-tech stocks closing down—may have further discouraged investors. Do you see a way to boost participation in Germany’s stock market?
Balino: We aren’t too worried about lack of participation. Nothing much has changed over the past few years. Equity holders are still in the market. But perhaps what is needed over the longer term is a move away from bank financing to a larger role for the equity market. This can be encouraged by strengthening governance and disclosure rules so that investors have an easier time understanding risk. Part of the explanation for the large role of bank financing is that borrowing has been too cheap because of too much competition. Once spreads go up a bit, maybe some of these borrowers will decide to issue equity rather than take on debt.
IMFSurvey: What are the prospects for Germany recapturing its former role as Europe’s economic powerhouse?
Chopra: Much will depend on its success in implementing reforms. While there are political hurdles to overcome, the government appears determined to move forward. If it succeeds in addressing structural rigidities, particularly in the labor market, and other long-term problems related, for instance, to the aging of society, prospects are bright—especially if reforms are taken even further in the coming years. Also, the elements of the policy package work together and can create significant synergies. Labor market, health care, and pension reform should make it easier to achieve fiscal consolidation, which in turn will help reduce tax rates. If all these reforms are implemented, the potential synergies are such that the outlook is quite promising.