Chapter

Chapter 8. Germany: Niche Exports and Improved Competitiveness

Author(s):
Hamid Faruqee, and Krishna Srinivasan
Published Date:
August 2013
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Author(s)
Vladimir Klyuev1

Germany has had large external surpluses over the past decade, while the public debt level has remained high. Large current account surpluses can be attributed to a confluence of factors, including a cyclical surge in global demand for exports and modest domestic wage growth that has helped strengthen competitiveness. An improvement in the private savinginvestment balance has been driven by a decline in investment following the reunification boom and higher precautionary saving. High public debt can be traced in a fundamental sense to reunification efforts and policy measures in response to the financial crisis. Structural policiesincluding tax and financial sector reformscould help boost growth and reduce external surpluses. Fiscal space needs to be rebuilt, but the pace of consolidation can be measured.

Germany has a long history of external surpluses, and its fiscal record has been relatively strong except during the period of reunification. Merchandise trade has been in surplus continually since the early 1950s. Meanwhile, the current account has stayed positive, with a few exceptions, notably in the 1990s (Figure 8.1). Germany enjoys a solid reputation for fiscal prudence. Nonetheless, the general government deficit has often exceeded the 3 percent Stability and Growth Pact (SGP) limit, and public debt stands well above the 60 percent ceiling (Figure 8.2). Developments in external and fiscal positions can be viewed across four broad time periods, as described below: pre-unification, reunification, the 2000s, and the financial crisis and its aftermath.

Figure 8.1Germany: Current Account Balance and Trade Balance

(Percent of GDP)

Source: IMF staff calculation.

Note: Pre-1991 data refer to West Germany.

Figure 8.2Germany: General Government Balance

(Percent of GDP)

Source: IMF staff estimates.

Note: Pre-1991 data refer to West Germany.

There are considerable similarities between pre-unification during the 1980s and the run-up to the recent financial crisis, but also key differences. During both periods, the trade surplus improved dramatically, buoyed by strong global demand. At the same time, national saving increased, helped in part by fiscal consolidation, while private investment declined as a share of GDP. Previous analysis of the reasons for the strong trade performance, coupled with generally subdued growth in output, investment, and employment, pointed to structural rigidities rather than macroeconomic policies (Figure 8.3) (Lipschitz and others, 1989).

Figure 8.3Germany: Investment Components

(Percent of GDP)

Source: IMF staff estimates.

German reunification in 1990 had longlasting implications for growth, external balances, and public finances. Efforts to reduce the income gap between east and west (including the one-for-one currency conversion) led to a construction boom and a surge in wages. This was buttressed by generous unemployment support and a narrowing of wage differentials, despite large productivity gaps between the east and the west. At the same time, an increase in fiscal deficits and public debt levels reflected large transfers to the east, a liberal early retirement scheme, and the cost of converting East German enterprises into private firms. Alongside this transition was a shift away from external surpluses to deficits as domestic demand exceeded production.

Subsequent correction of the excesses of the early 1990s laid the groundwork for a stronger external position. Both residential and nonresidential construction declined steadily as a share of GDP. Wage growth slowed, owing to changes in worker bargaining behavior in the face of rising unemployment.2 And a combination of tax and expenditure measures helped contain fiscal deficits even as the economy decelerated after the unification boom. In the meantime, the consumer price index (CPI)-based real exchange rate depreciated 18 percent in the second half of the 1990s, more than reversing the appreciation that had occurred in the first half of the 1990s.

In the 2000s, after a decade of deficits, Germany’s external position moved into surplus, while the fiscal position improved in the run-up to the crisis. The current account balance rose sharply from a deficit of 1½ percent of GDP in 2000 to a surplus of 7½ percent in 2007, owing largely, but not exclusively, to an increase in the merchandise trade surplus,3 noticeably against other euro-area members. The dramatic improvement in the current account primarily reflected a sharp swing in private saving–investment balances.

Net exports contributed about four-fifths of the 9½ percent increase in Germany’s real GDP over that period, while domestic demand increased modestly by around 1½ percent. Despite the export boom and strong corporate profits, private fixed investment declined as a share of GDP by 2½ percentage points. All major investment components declined as a share of GDP between 2000 and 2007, with construction continuing its long post-unification slide (with a tentative recovery starting just before the crisis), while machinery and equipment investment went through a major cycle (Figure 8.3).4

Private saving as a share of GDP rose 5¼ percentage points, owing largely to an increase in corporate saving. Household saving increased modestly (one percentage point), even as the labor share of national income fell. In contrast to the large turnaround in the private saving–investment balance, the general government saving–investment balance improved only modestly (by 1¼ percentage points). This was driven by spending cuts (including pension reform and a reduction of unemployment benefits, public-employee fringe benefits, and various subsidies) and supported by strong growth in output and corporate profits. Nonetheless, the ratio of general government debt to GDP has remained in excess of 60 percent since 2002.

The current account and merchandise trade surplus narrowed noticeably during the financial crisis and its aftermath. Surpluses are projected to decline further through 2016 in line with maturing global recovery and some deterioration in the terms of trade. The contribution of net exports to real GDP growth is expected to remain positive, but substantially smaller than in the run-up to the crisis.

The crisis delivered a significant blow to public finances. Fiscal deficits reappeared and exceeded 3 percent of GDP in 2009 and 2010, reflecting the impact of automatic stabilizers and a relatively large stimulus. Public debt was also boosted by financial system support measures and peaked at 83½ percent of GDP in 2010. The government has specified a set of consolidation measures, largely on the expenditure side, to bring the fiscal balance in line with its commitments under the SGP, its G20 Toronto commitments, and the national fiscal rule. As a result, the debt ratio is projected to decline to 74½ percent by 2016, which is still above the SGP limit.

Root Causes of Imbalances

External imbalances in Germany reflect a number of factors, such as improvements in competitiveness, niche exports, low investment rates, and increased national saving. Some of these factors are clearly more important than others. Public debt increased largely due to reunification costs, the weak economy in the first half of the 2000s, and the recent financial crisis.

External Imbalances

The rapid increase in Germany’s current account surpluses before the crisis reflects a combination of factors, led by wage behavior and the structure of exports. In particular, favorable product specialization and wage moderation positioned Germany well to take advantage of a cyclical surge in global demand in the years preceding the crisis. Even as exports boomed, the private saving–investment balance improved, as discussed above. Behind this was a slowdown in private investment following the reunification boom and a rise in precautionary saving due to increased policy uncertainty as a result of the reforms in the late 1990s and the early 2000s.

Niche exports allowed Germany to benefit from a cyclical boom in global demand. Exports benefited from strong demand for capital goods, consumer durables, and pharmaceuticals—products in which Germany specializes and enjoys a significant market share (Figure 8.4). Capital goods accounted on average for 45 percent of German merchandise exports in the 2000s, while motor vehicles and parts constituted another 18 percent. Unlike most other advanced economies, Germany was able to maintain its share of key markets, with the rise in world trade translating one-for-one into a rise in German exports.

Figure 8.4Germany: Manufacturing Exports, 1995–2005

(Percent)

Source: UN Comtrade database.

Note: Size of bubbles is proportional to share in total goods exports. Figure excludes food and chemicals.

Wage moderation boosted competitiveness, supporting exports, while dampening domestic demand. Wage growth remained moderate during the expansion, helping firms maintain a competitive edge (Figure 8.5).5 The euro appreciated nearly 50 percent against the U.S. dollar between 2000 and 2007. However, since roughly half of its exports go to other euro-area countries, Germany’s nominal effective exchange rate strengthened only 14 percent, the CPI-based real exchange rate only about half of that amount, and the unit-labor-cost-based real effective exchange rate declined slightly by 2007. At the same time, wage moderation resulted in a declining labor income share, which dampened consumption and domestic demand, while boosting net exports by improving relative unit labor costs (Figure 8.6).

Figure 8.5Average Salary per Worker

Sources: Organization for Economic Cooperation and Development; and IMF staff calculations.

1In thousands of euros.

Figure 8.6Relative Unit Labor Costs

(Index; 1999 = 100)

Source: European Commission.

Cyclical divergence within the euro area also contributed to intra-area imbalances. Domestic demand in Germany was considerably weaker than demand growth in several euro-area members, notably in the periphery. Thus, the euro-area-wide policy interest rate was arguably too low for the periphery and too high for slow-growing Germany, hindering equilibration of demand across the member states. In addition, because of structural rigidities in the euro area, wage and price adjustments were slow to operate and did not compensate for the lack of an exchange rate adjustment channel.

The private saving–investment balance improved between 2000 and 2007. Both lower investment and higher saving contributed to the large increase in the current account balance before the crisis. Despite booming exports and rising corporate profits, private investment remained particularly lackluster, including relative to Economic and Monetary Union partners. Indeed, investment as a share of GDP declined between 2000 and 2007. This is true not only for construction—which could be attributed to a longlasting hangover from the reunification boom—but also for machinery and equipment. Moreover, as a share of GDP, investment fell not only in services, but also in the booming manufacturing sector. The reasons for low investment in Germany are not entirely clear. Several explanations have been suggested, including uncertainty about the durability of the expansion, gaps and distorted incentives in the financial system, and low productivity growth, particularly in the nontradable sector. Further research would be needed to pin down the reasons behind the low investment rates in Germany, but the three possibilities suggested above can be explained more specifically as follows:.

  • Caution in the face of a surge in external demand. The weakness of investment possibly reflected the fact that the strong export expansion may not have been viewed as durable. Germany’s growth is linked to external developments to a greater extent than in most other large countries, and strong foreign demand may have been viewed as reversible. Indeed, soon after private investment finally started picking up, the global financial crisis broke out.

  • Gaps and distorted incentives in the financial system. A relatively underdeveloped framework for venture capital and private equity, as well as an inefficient insolvency process, has impeded investment in high-risk, high-growth sectors (Figure 8.7). At the same time, a broader issue concerning access to financing may have played a role, although supporting evidence is limited. In particular, it has been suggested that following the phasing-out of state guarantees, large state-owned banks have been more inclined to invest overseas—including in structured products originated in the United States and in sovereign and bank debt of peripheral euro-area nations, without adequate consideration of risk—rather than financing domestic investment.6 While there may be some merit to this hypothesis, given high corporate saving and a wide network of savings and cooperative banks that are geared toward financing domestic investment, including small and medium-sized enterprises, the ill-conceived investment strategy of Landesbanken may be a more relevant consideration for issues pertaining to financial stability than for access to financing.

  • Low productivity growth in nontradables. Germany’s labor and total factor productivity growth have been relatively low, dragged down by a lackluster performance of the services sector. Fairly restrictive regulation of professional services (Figure 8.8), remaining barriers to entry and exit of firms, and certain deficiencies in the education system impede productivity growth in the nontradable sector.7

Figure 8.7Availability of Venture Capital

(Survey index 1–7)

Figure 8.8Regulation in Professional Services

Source: Organization for Economic Cooperation and Development.

Note: The higher the index the stricter the regulation.

Higher saving reflected both public and private sources. National saving rose about 6 percentage points as a share of GDP between 2000 and 2007. Government, corporate, and household saving all increased, as described below.

  • Government saving increased in the years just preceding the crisis. Fiscal consolidation efforts were undertaken both on the expenditure side (including via pension reform) and on the revenue side (an increase in the value-added tax). In addition, government finances were boosted by rapid growth.

  • High corporate saving reflected an increase in profits during the export boom. Dividend payouts increased less than profits, possibly because of doubts regarding the sustainability of that boom. High profits did not fuel greater investment but rather were used to strengthen corporate balance sheets. While profitability was helped by wage increases that fell short of productivity growth over a sustained period, there were various factors that encouraged the strengthening of corporate balance sheets. These included changes to the tax regime, changes to the close relationship between corporates and banks, regulatory changes (Basel II), and the increased globalization of production that required access to international bank financing. The effects of regulatory changes and the impact of globalization were likely more pronounced for German corporates due to their heavy reliance on bank-based financing. In contrast to saving, investment was slow to respond. Almost a whole decade of disappointingly low growth, unfavorable demographic trends, and interest rate developments vis-à-vis many European countries likely contributed to the cautious investment response of the corporate sector.

  • The increase in household saving reflects the needs of an aging society and, possibly, policy uncertainty. Germany has one of the highest household saving rates among member countries of the Organization for Economic Cooperation and Development (OECD), and it remained high even as it declined in many other advanced economies, in some cases spurred by overly easy access to credit. Moreover, after a decade-long post-unification slide, the saving rate rebounded over the course of the 2000s, even as disposable income fell as a share of GDP. This reflects both tradition and the life-cycle needs of an aging society. At the same time, it is quite likely that the rise in household saving also reflects the impact of pension and labor market reforms in the first half of the 2000s, which reduced the generosity of pension and unemployment benefits.

Fiscal Imbalances

The factors leading to accumulation of public debt have shifted over the years. The cost of reunification largely explains the big leap in the debt-to-GDP ratio that occurred in the 1990s. A run-up in debt in the first half of the 2000s was mostly due to the weak economy and attempts to improve growth prospects by cutting taxes. Inter-governmental relations also played a role, with federal cofinancing of regional projects skewing the incentives toward their expansion and resulting in high administrative costs (OECD, 2006).

In addition, the SGP has not prevented Germany from maintaining a debt ratio above 60 percent during the past decade. Between 2008 and 2010, the increase in the debt ratio was largely driven by financial sector support, which added 13 percentage points to the debt-to-GDP ratio. Discretionary measures and cyclical factors also contributed, as the fiscal balance deteriorated by 3.4 percent of GDP due to a combination fiscal stimulus (1.5 percent of GDP in 2009 and 0.7 percent in 2010) and automatic stabilizers, while nominal GDP was nearly unchanged.

Are Germany’s Imbalances a Problem?

Factors behind Germany’s external surpluses do not primarily reflect market failures or policy-induced distortions. Wage moderation was a reasonable reaction to its earlier excessive growth, which had led to a surge in unemployment, and there is little reason to believe that German institutions or government policies are holding wage growth down. While wage moderation may have led to some overshooting on the competitiveness front, such moderation may well dissipate now that the unemployment rate is at all-time lows. The strong growth of Germany’s export markets was a development that was largely exogenous to Germany. Finally, with unfavorable demographic projections, it is not unreasonable for the country to run current account surpluses, although—as IMF staff estimates indicate—they should not be as large as those observed recently (IMF, 2012).

This said, from a domestic perspective there are good reasons for boosting private demand and reducing vulnerability to external shocks. Low output and productivity growth reflect a trend decline in investment relative to GDP (Figure 8.9). The impact is twofold—on demand in the short run and on productive capacity in the longer term.

Figure 8.9Germany: Private-Fixed-Investment-to-GDP Ratio and Potential Growth

(Percent)

Source: IMF staff calculations.

Specifically, lackluster productivity growth in the nontradable sector dampens growth prospects. An acceleration of productivity in services would strengthen incentives to invest in the sector and also stimulate consumption, boosting domestic demand, by raising permanent income. This would improve the standard of living, while reducing current account surpluses over the medium term.

From an external perspective, Germany has benefited from its dependence on foreign markets, but this makes it more susceptible to external shocks. While exports have so far remained largely isolated from low-wage competition, the country’s position is likely to be challenged as emerging market economies move up the technological ladder. Accordingly, this may result in sluggish GDP growth going forward if domestic demand remains weak.

To some extent, these factors are mutually reinforcing. Weak productivity growth, particularly in the nontradable sector, lowers incentives to invest, holding back potential output and income and thus consumption. In turn, lower domestic demand reduces the incentive to invest, notably in the services sector, thus dampening demand for labor and keeping wages and consumption in check.

High public debt has well-known vulnerabilities associated with it. However, it should be noted that Germany’s public debt (both gross and net in percent of GDP) is among the lowest in advanced G20 economies. German bunds continue to be the benchmark asset in the euro area, and credit default swap spreads on German debt remain low. Thus, while fiscal space needs to be reestablished, fiscal consolidation can afford to proceed at a measured pace, helping output recover from the crisis.

Germany’s solid fiscal position is essential for maintaining stability in the euro area. Because of its size and history of (relative) fiscal prudence, demonstrated again by the introduction of a Constitution-based structural balance rule, Germany plays a key anchoring role in the euro area. Should investors lose confidence in Germany’s creditworthiness, the implications may be severe, with borrowing costs going up all across Europe. In addition, respect for the SGP by the largest member state is important for maintaining stability and budget discipline in the euro area.

How to Address Imbalances

Policy Priorities

A number of factors should reduce Germany’s current account surplus going forward. The need for budget consolidation is smaller in Germany than in most of its trading partners, and the smaller fiscal improvement (relative to trading partners) would (all else being equal) lower its current account balance (IMF, 2011, Chapter 4). With anemic growth in advanced economies, the demand for German exports is likely to be low for a protracted period. This may, however, be offset by rising demand from emerging market economies. At the same time, the ongoing increase in productive capacity and technological sophistication of emerging market manufacturers may threaten Germany’s competitive position. And with the unemployment rate at its lowest in nearly 20 years and 5 percentage points below its fairly recent peak, wage moderation may be running its course. In fact, wage growth had picked up just prior to the crisis, interrupting a period of wage discipline, but then the crisis put a lid of wages.

Structural policies directed at promoting growth and stability could also help reduce external imbalances and diversify sources of growth. Importantly, policies that increase labor force participation and productivity growth, especially in areas outside Germany’s traditional strength, can stimulate consumption and investment. This would shift growth toward domestic demand and reduce Germany’s dependence on foreign demand, thus lessening the uncertainty and decreasing vulnerabilities. Ongoing efforts to increase the labor force through greater participation of female and older workers and the migration of skilled workers are welcome. Raising the quality of human capital will require reforms to the system of education and training. Raising productivity in the services sector would be helped by greater competition, including at the regional level in network industries such as transportation and energy. That, in turn, should boost investment, which is key to higher growth and potential output, and lower the need for precautionary saving. Overall, these structural policies, including tax reform, will raise welfare and are likely to lower current account balances over the medium term. Action on several fronts can help achieve these objectives.

Reforming the financial sector will be an essential complement to raise the economy’s growth potential and increase its resilience. Broadening the channels of financial intermediation would facilitate the allocation of resources toward innovation and new engines of growth. This would require a greater development of intermediation outside traditional banking channels, using so-called arms-length finance. Changes to regulation and supervision would have to keep pace with the development of a more arms-length system in order to ensure financial stability.

Lower corporate taxation would stimulate investment. While the 2008 corporate income tax reform improved Germany’s tax competitiveness, abolishing the inefficient, volatile, and geographically uneven trade tax imposed by municipalities would further reduce the marginal effective tax rate. Further development of venture capital and private equity markets would increase the availability of risk capital, spurring investment and productivity growth. The measures could include (1) removing uncertainties regarding the tax treatment of venture capital firms; (2) redesigning the change-of-ownership rule, which eliminates loss and interest carry-forward; and (3) promoting faster restructuring proceedings for insolvent entities.

Reorienting German banks to serve domestic clients could help increase investment and consumption. While the small institutions (cooperative banks and Sparkassen) are domestically oriented, the large, state-owned Landesbanken shifted a considerable part of their portfolio abroad in the run-up to the crisis and now find themselves in a difficult situation and in need of government support. Reducing the states’ ownership of these institutions (direct and via Sparkassen) would spur them to establish a viable business model, which would likely involve greater domestic lending. IMF staff research has found that a smaller public share of the banking system is associated with smaller current account balances (Ivanova, 2012). Even if such reform has an insignificant impact on investment and the current account, it will benefit financial stability.

Less regulation and more measures to improve education would spur productivity growth and domestic demand. In the long run, higher productivity would mean higher output, higher income, and commensurately higher domestic demand without a first-order effect on the current account. However, on the likely protracted transition path, the prospect of higher productivity growth would stimulate additional investment, and higher permanent income would push current consumption up, reducing the trade surplus.

The government has identified a set of measures to set the public debt ratio on a declining path. The envisaged pace of consolidation is appropriate, although it could be slowed in case of a substantial negative shock to growth. Fiscal adjustment is anchored by a new limit on structural deficits of the federal and state governments, which is enshrined in the Constitution and should therefore improve national implementation of the SGP.

Within the budget envelope, there is scope for making the adjustment more “growth-friendly.” The large labor tax wedge facing low earners could be reduced by introducing in-work and earned-income tax credits or by raising the threshold for low-income tax relief and reducing the speed of benefit withdrawal (Figure 8.10). A reform of the income-splitting regime could improve incentives for labor market participation by secondary earners. Abolishing the inefficient and volatile local trade tax would reduce the burden on corporations, which is among the highest in the world (Figure 8.11). Reduction in direct taxes would promote employment, investment, and growth, and could be paid for by eliminating concessions in the value-added tax, raising property and inheritance taxes, and cutting some poorly targeted social benefits (such as unconditional child support). There is also scope for increasing the efficiency of education spending.

Figure 8.10Labor Tax Wedge, 2010

(Percent of labor costs)

Source: Organization for Economic Cooperation and Development.

Figure 8.11Corporate Income Tax Rate, 2011

(Percent)

Source: Organization for Economic Cooperation and Development.

Toward Global Action

As part of global rebalancing, Germany could contribute to higher and more stable global growth by relying less on exports and more on domestic demand. Increasing the country’s domestic demand could raise global growth, while a lower reliance on external sources could contribute to rebalancing and thus to more sustainable global growth.

Structural reform in the services sector could boost productivity and investment, narrowing the large external surplus while enhancing growth potential. In product markets, gradual convergence to best practices in terms of regulations in retail trade and professional services would increase productivity in nontradables and raise investment. In labor markets, improving the availability of child care, along with tax reform, would increase labor participation of secondary-earner, elderly, and low-skilled workers.

Alongside structural reform, tax reform could further support investment and employment, while minimizing distortions. A revenue-neutral tax reform that shifts taxes away from more distortive direct corporate income and personal income taxes to less distortive indirect taxes would help further promote investment, employment, and growth.8 Tax cuts could be financed by an increase in consumption tax collection achieved by moving toward best practices via eliminating concessions (reduced rates and exemptions) in the value-added tax. These actions to strengthen domestic spending could help support global demand rebalancing and growth.

References

Vladimir Klyuev is a Senior Economist in the IMF Research Department. This chapter was written with guidance from Emil Stavrev and the support of Eric Bang, David Reichsfeld, and Anne Lalramnghakhleli Moses.

The unemployment rate climbed steadily from just over 5 percent in 1991 to nearly 10 percent in 1997. See also Decressin and others (2001).

Over that period both exports and imports rose substantially, as German firms extended their production lines into neighboring countries. About 4 percentage points of the increase in the current account was due to a decline in the deficit of the services account and a turnaround in the income account.

It should be noted that in real terms the growth of machinery and equipment investment looks stronger, as its deflator declined relative to the GDP deflator.

It should be noted, though, that the importance of competing on price has declined for German exporters.

Arguably, public ownership may have distorted their incentives and account for the lack of a viable business model.

The 2010 Organization for Economic Cooperation and Development Economic Survey of Germany identified three main challenges: low tertiary graduation rates among younger cohorts; a vocational training system that provides too much specialized and too little general knowledge, making it hard to adjust to changes in labor demand; and relatively low participation in lifelong learning (OECD, 2010).

For corporations, this includes elimination of municipal trade taxes and introduction of an allowance for the normal return on new equity (to remove the debt bias). For individuals, reforms should target incentives for those marginally attached to the labor force (secondary-earner, elderly, and low-skilled workers), which could have a considerable effect on labor supply. For these groups, incentives should aim to affect the participation margin—the decision of whether to seek employment as opposed to how many hours to work.

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