1. This supplement reports on information that has become available since the issuance of the staff report (SM/01/290) and on additional discussions with the authorities that took place in Washington on October 6, 2001.1 The new information does not alter the thrust of the staff appraisal. In the discussions, the authorities and staff broadly concurred on the assessment of recent economic developments. Staff and the authorities also agreed that the terrorist attack on the United States on September 11, 2001 had considerably increased the uncertainty surrounding near-term economic prospects.
2. Recent data provide further evidence that economic activity was, as expected at the time of the staff report, weak in the third quarter of 2001 while headline inflation continues to fall:
In July-August, industrial production was 0.2 percent below its level in the second quarter on a seasonally adjusted basis. Industrial orders in July-August were one percent lower than in the second quarter.
Unemployment edged up further in September to reach a seasonally-adjusted rate of 7.9 percent (EU-definition) and 9.4 percent (national definition).
Imports continued to contract in August, leaving them 1½ percent lower in nominal terms in July-August than in the second quarter.
On the other hand, exports held up well through September and retail sales indices for August suggest a moderate increase of private consumption.
Consumer price inflation fell somewhat faster than the staff expected in September to 2.1 percent from 2.6 percent in August.
3. Business confidence tumbled in September, although indicators of economic sentiment suggest that a large part of the decline may be a temporary reaction to the events of September 11. The Ifo assessment for September of both the current business situation and business expectations dropped sharply, in the latter case cutting short the nascent revival of the preceding two months (Figure 1). The composite index was at its lowest level for eight years, a level consistent with falling output in the period ahead. By contrast, the ZEW indicator of economic sentiment does not show a significant deterioration in September or October when its level was above its lows of the first half of this year. Nor does consumer confidence appear to have been shaken dramatically by the events of September 11, although staff analysis suggests that consumer confidence is a poor predictor of actual consumption or economic activity in Germany.
4. Germany’s stock markets have broadly regained losses sustained in the days immediately following the terrorist attack (Figure 2). The DAX index nevertheless remains about 30 percent below its level at the beginning of the year. Prompt monetary easing by the ECB has led to a steepening of the yield curve as long-term bond yields have fallen only slightly since September 11 (Figure 3).
5. Even before the September Ifo survey was released, staff projected that recovery would be postponed until the first half of 2002. Based on the assessment that output will stagnate in the fourth quarter, staff estimates that annual average growth in 2001 will be 0.7 percent (0.8 percent in the staff report). For 2002, the growth projection will be heavily influenced by the duration of the setback to business expectations. Assuming it is quickly reversed—and confidence then begins to strengthen—growth would resume at a below-potential rate in the first half of the year, aided by a turnaround in global growth, recent interest rate cuts and the drop in oil prices.2 Growth would strengthen as the year progresses. Nonetheless, average annual growth in 2002 would be well below 1.5 percent (1.8 percent in the staff report). Lower oil prices and weaker economic growth are expected to moderate inflation. Despite indirect tax increases scheduled for January to pay for anti-terrorist expenditures, the staff would see average inflation in 2002 of no more than 1¼ percent.
6. The margin of uncertainty is wide. Business confidence is highly precarious, investors and consumers are understandably nervous about the extent and consequences of further terrorist and military actions, and the path of global demand is hard to predict. The dramatic fall in business confidence in September tilts the risks, at this stage, decidedly to the downside. If confidence does not rebound quickly, the economy could experience a much more prolonged period of weakness than expected. However, uncertainty is not all one-sided, as indicated by the more sanguine ZEW business sentiment reading and the potential for the German economy to respond positively to lower interest rates and oil prices.
7. The authorities broadly shared staff’s interpretation of recent developments. They agreed that the latest data and the structure of demand during the downturn highlighted that recovery depended heavily on a revival in external demand and business confidence. They also emphasized that there was very little hard data on which to evaluate the consequences of the events of September 11. On October 18, the Minister of Finance indicated that the official growth projection for 2002 would be in the range of 1 to 1.5 percent. That would be in line with the staff’s projection. The official forecast will be formally released later this month.
8. The authorities agreed that the latest ECB interest rate cuts had been fully justified. From a purely German perspective, the inflationary risks of further rate cuts would appear to be very low. The additional economic weakness had further increased the likelihood of subdued wage demands in the upcoming wage round.
9. The authorities stressed that the weakened economic outlook had not changed their thinking on fiscal policy. They would shortly start to review the budget outcome for 2001 and refine revenue projections for 2002. Therefore, at this stage, they were unable to discuss adjustments to either the 2001 or 2002 budgets. Nevertheless, fiscal consolidation remained the priority in view of the high debt burden and the medium-term strains arising from population ageing. The authorities continued to place importance on meeting their Stability Program deficit targets, noting that the targets were particularly useful for instilling confidence in market participants and reassuring them that consolidation was on track.
10. Staff pointed out that the downward revision to growth would make it even more difficult to meet the deficit targets in 2001 and 2002, and reasserted its advice to stick to current expenditure plans but allow the automatic stabilizers to operate fully. According to staff projections, the general government deficit would then be about 2 percent of GDP in 2002, compared to 2¼ percent of GDP in 2001 and the Stability Program target of 1 percent of GDP. Whereas the deficit in 2002 would be larger than projected at the time of the staff report (1.8 percent of GDP), and the decline in the deficit between 2001 and 2002 would be less than the ½ percent of GDP envisaged in the Stability Program, the additional slippage would be entirely cyclical. With a projected drop in the general government structural deficit relative to GDP of ½ percent, fiscal policy would be contractionary in 2002.
11. With a reasonably strong recovery still projected (albeit occurring later than expected at the time of the mission), staff remains of the view that the economic outlook does not require a more active fiscal response that would, for example, overturn next year’s contractionary stance. In staff’s view, assuming the drop in business confidence reverses quickly and a global recovery occurs, the fundamentals are healthy enough for growth to pick up to above its potential rate in the second half of next year. Nonetheless, the next reading of business confidence will be telling. If confidence fails to recover substantially, consideration should be given to bringing forward into 2002 tax cuts that are already factored into medium-term fiscal plans. Tax cuts of the order ½ percent of GDP would still leave the general government deficit below the 3 percent of GDP Stability and Growth Pact ceiling, unless growth in 2002 were to fall to close to zero.
12. Since September 11, the authorities have taken steps to bolster the fight against money laundering and the financing of terrorism. The government has approved changes to the draft Fourth Financial Promotion Act, which, if passed by parliament, will among other things: create a central agency to track down money laundering; set up with the banking supervisory agency a central registry of bank and custodian accounts; and extend money laundering provisions to the credit card industry.