Germany: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund
Publication Date:
02 Nov 2004
eISBN:
9781451810479
Language:
English
Keywords:
ISCR; CR; deficit; growth outlook; outlook; growing; potential GDP; General government; output gap; banking system; reservation wage; Global
Download PDF (382.1 KB)

The staff report for the 2004 Article IV Consultation on Germany highlights economic developments and policies. Profitability in nonfinancial firms has picked up, and corporate balance sheets are being repaired. On the policy front, Germany has made important headway over the past year in addressing deep-seated structural problems. The financial sector is recovering, and updated stress tests confirm the system’s resilience, but progress in market-driven restructuring has been slow. Notably, important strides have been made in pension and health care reform, and in reforming unemployment benefits.

Abstract

The staff report for the 2004 Article IV Consultation on Germany highlights economic developments and policies. Profitability in nonfinancial firms has picked up, and corporate balance sheets are being repaired. On the policy front, Germany has made important headway over the past year in addressing deep-seated structural problems. The financial sector is recovering, and updated stress tests confirm the system’s resilience, but progress in market-driven restructuring has been slow. Notably, important strides have been made in pension and health care reform, and in reforming unemployment benefits.

I. Introduction

1. The discussions took place as a cyclical recovery of economic activity was gaining strength, but with continued concerns about longer run prospects. On the policy front, the authorities have been implementing their three-pronged policy strategy initiated last year, as discussed by Directors in the 2003 Article IV consultation. This strategy comprises phased tax cuts, expenditure-based fiscal consolidation, and reforms laid out in “Agenda 2010” to begin addressing key structural weaknesses (Box 1). Parliament approved the last major component of Agenda 2010, a far-reaching reform of long-term unemployment assistance, in June 2004. The authorities remained committed to reduce the general government deficit below 3 percent of GDP in 2005 provided the upswing is sustained, but so far fiscal consolidation has been elusive.

II. Background

2. After three years of stagnation, the German economy is showing signs of life:

  • Activity is up, albeit unevenly and at a moderate pace. The recovery is driven by export growth, as the rapid pace of world economic activity has dominated the effect of euro appreciation.

  • Profitability in nonfinancial firms has picked up and has been used to strengthen balance sheets; firms remained cautious with their investment plans and again posted a financial surplus in 2003. Profitability has also improved in the financial sector, placing banks in a better position to support the recovery.

  • Nevertheless, with output static since 2000, the output gap is wide and inflation is low (Table 1 and Figure 1).

Table 1.

Germany: Basic Data

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

IMF staff projections.

Growth contribution.

National accounts definition

Eurostat definition.

Deflated by the national accounts deflator for private consumption.

Table 1.

Germany: Basic Data

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

IMF staff projections.

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 (2.5 percent 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 2004 refer to June.

Data for 2003 refer to a change from May 2003 to May 2004.

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

Data for 2004 refer to September 15.

Data for 2004 refer to August.

Based on relative normalized unit labor cost in manufacturing.

Figure 1.
Figure 1.

Germany: Output Gaps and Inflation, 1984-2003

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations.

3. The latest trough followed a secular decline of the economy’s potential growth, and was exacerbated by major shocks. For many years after World War II output grew rapidly, making the generous entitlement system funded by payroll taxes appear sustainable. However, convergence and adverse incentive effects for labor then led to a considerable decline in potential output growth from 4½ percent a year in the 1960s to 1½ percent in the 1990s (see table on page 8), and overall growth is now below the rate of euro-area partner countries (Figure 2). The underlying weaknesses mainly originated in the labor market and were exacerbated by reunification. The structural rigidities made adjustment to the shocks a drawn out process that was manifested in declining labor and capital input:

Figure 2.
Figure 2.

Germany: Economic Performance, 1992-2004

(In percent)

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Source: IMF, World Economic Outlook.

Past Fund Policy Recommendations and Implementation

Fiscal consolidation: During the 2003 Article IV consultation, Directors endorsed the government’s commitment to reduce the structural deficit by 1½ percentage points during 2004-06, focused on durable expenditure cuts in subsidies and ineffective labor market programs. Although some measures have been implemented, they are not sufficient to meet these consolidation goals given cumulative tax cuts of some 1 percent of GDP.

Structural reforms: The Agenda 2010 reforms put forward in March 2003 were in line with longstanding Fund recommendations. Implementation status is as follows:

The labor market reforms have been adopted: (i) eligibility and maximum duration of unemployment benefits have been tightened; (ii) long-term unemployment and social assistance have been merged into a more narrowly targeted program with means testing (commonly referred to as the Hartz IV law); (iii) part-time work has been deregulated; (iv) job protection regulation has been streamlined; and (v) job intermediation is being improved.

Pension reforms have also advanced, focusing mainly on the replacement rate. Pensions will remain almost unchanged in 2004-05. Furthermore, benefit levels were linked to the old-age dependency ratio (steady state savings: ¾ percent of GDP), and early retirement programs are being phased out. However, the Rürup pension commission’s proposal to phase in a higher statutory retirement age, which Directors supported, has not yet been adopted and remains under review.

Important health care reforms were adopted in September 2003 and are being implemented (steady state savings: ½ percent of GDP from 2005). They include increased patient copayments; higher contributions for pensioners; cuts to some benefits; and the shifting of funding of sickness pay to employees. Directors also called for measures to boost efficiency and competition, which is now on the policy agenda.

Financial sector: Directors recommended a reduction in barriers to restructuring both within and across the public and private pillars of the banking system, but only limited headway has been made on this front due largely to legal impediments at the sub-national level. However, supervision is being improved in line with FSAP recommendations.

Germany: Potential GDP Growth and its Components, 1962-2009

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Sources: Federal Statistical Office; and IMF staff calculations.Notes: Potential GDP growth is based on trend growth of components, where trends are derived using an HP filter. The 2004-09 period is a staff forecast and is described in the text (Section III.A).

  • The most troubling development in potential growth has been a decline in total hours worked.1 High and inflexible labor costs, generous support for the jobless (high reservation wages), and deliberate policies for early retirement in response to adverse labor demand shocks played key roles in reducing labor utilization. These policies led to sustained high unemployment rates and payroll taxes when the entitlement system was fully extended to the new and less productive Länder of the former East Germany.

  • Growth in the capital stock has been decelerating, following convergence after World War II—and, again, in the early 1990s after reunification—when the capital-to-GDP ratio was relatively low. However, excessive wage growth, especially in the first half of the 1990s, also played a role through its harmful effects on profit margins and disincentives to expand capacity.

  • Total factor productivity (TFP) growth slowed over the past decades, a characteristic shared by most industrial economies, although some have recently managed a reversal.

4. The economy is still in a process of adjustment, with adverse consequences for domestic demand.

  • Wage setting is becoming more flexible and increases have been moderate since the mid-1990s, which is helping to address Germany’s comparatively high real wages (Figure 3). However, domestic employment growth continues to be weak, reflecting structural problems in the labor markets, including generous unemployment benefits, high payroll taxes, and tight job protection legislation. As a result, household income and consumption have lacked momentum—private consumption growth has been well below the euro area average since 2001—which has delayed the response of the job market to wage moderation.

Figure 3.
Figure 3.

Germany: Wages and Competitiveness, 1980-2004

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Direction of Trade Statistics, and IMF staff calculations.1/ Wages that are adjusted for productivity and cyclical pressures in the labor market.2/ Excludes Belgium and Luxembourg.3/ Three-quarter moving averages.
uA01fig01

Euro Area: Private Consumption Growth

(Percent change from a year earlier)

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

  • Nevertheless, slowing wage growth is improving competitiveness, and exports are responding well to expanding world demand (Figure 4). This is visible in strong exports of machinery and equipment, which are tied to investment spending in the global cycle, a component that was slow to recover but is now rebounding. The external current account has swung from a deficit to a substantial surplus (in line with Germany’s large output gap and equilibrium savings-investment balance), and staff estimates of the equilibrium exchange rate do not point to an external competitiveness problem.

Figure 4.
Figure 4.

Germany: Export Determinants, 2000-2005

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations and estimates.Note: The demand effect measures Germany’s share of world import demand, while the price effect captures changes in the share due to changes in the REER.

5. Monetary conditions have been accommodating for the euro area, but low underlying inflation in Germany has resulted in real interest rates that are somewhat above average (Figures 5 and 6). Loan growth has been anemic (Figure 7), reflecting a combination of weak demand as firms continue to adjust their balance sheets, and supply factors as banks tightened lending standards while rebuilding capital. Nevertheless, there is no evidence of an outright credit crunch because firms’ cash flow has permitted increasing dividends alongside improving the balance sheets (Figure 8). Loan margins are now easing and asset prices have rebounded (Figure 9).

Figure 5.
Figure 5.

Interest Rate Developments, 1992-2004

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundes bank; and IMF staff calculations and estimates.1/ Assumes inflation target of 1.75 percent and equilibrium real interest rate of 2.5 percent.2/ Subtracts percent REER appreciation in the last two quarters relative to the preceding four quarters with a weight of 1/3.
Figure 6.
Figure 6.

Real Interest Rates, 1992-2004

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations.1/ Monthly averages; inflation expectations measured by 12-month change in core CPI (excluding energy and food).
Figure 7.
Figure 7.

Germany: Real Bank Credit to the Private Sector, 1972-2004

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations.
Figure 8.
Figure 8.

Germany: Non-Financial Corporate Financial Accounts, 1980-2003

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank; Federal Statistical Office; and IMF staff calculations.
Figure 9.
Figure 9.

Germany: DAX 30, 1991-2004

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Source: Bloomberg.

6. The fiscal stance is not weighing on activity. With tax cuts equivalent to 0.7 and 0.2 percent of GDP in 2004 and 2005, the structural deficit is expected to increase slightly in 2004 and decline by almost ½ percentage point of GDP in 2005 (Table 2). In any event, emerging demographic pressure, a public debt ratio already exceeding 65 percent of GDP, and a large structural budget deficit, leave no scope for expansionary fiscal policy.

Table 2.

Germany General Government Finances

(In percent of GDP)

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Sources: Ministry of Finance; and IMF staff estimates based on policy measures already in place.

7. All in all, a modest cyclical recovery is underway, driven by external demand. Real GDP increased at an annualized rate of nearly 2 percent in the first half of 2004, marking four successive quarters of growth. However, consumption was flat—in line with slow growth in disposable income—and investment (in construction) remained weak. High-frequency indicators continue to show this mixed picture (Figure 10), with exports and manufacturing output holding up and orders strengthening further, but with weak confidence, retail sales, and construction spending still holding back domestic activity (Figure 11).

Figure 10.
Figure 10.

Germany: Implications of Monthly Indicators for Quarterly GDP Growth, 2000-2005

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank, IFO Institute; and IMF staff calculations. The GDP data are seasonally and calendar-day adjusted.
Figure 11.
Figure 11.

Germany: Summary of Monthly Indicators, 1996-2004

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank; and IFO Research Institute.

III. Policy Discussions

8. The discussions took place against the backdrop of a difficult political environment. Household confidence indicators and polls pointed to a sense of adjustment fatigue and uncertainty among economic agents, rooted also in the poor job market, sluggish wages, stagnant pension benefits, and rising health care costs. Following losses in regional elections, the government no longer controls the upper house and there is little agreement on how to proceed with fiscal consolidation. Although general elections are not due until the autumn of 2006, the political landscape is already affected by a heavy schedule of regional elections between September 2004 and May 2005.

9. In this setting, and to avoid any risk of undercutting the recovery, the authorities were reluctant to augment Agenda 2010 or announce additional fiscal measures. However, they underscored their commitment to the full implementation of Agenda 2010 despite popular opposition (including large street protests), pointing to the fundamental restructuring of support for the long-term jobless as evidence. The authorities viewed this as a major policy change that needed to be absorbed by the public before embarking on new reforms. They also stressed their intention to consider new budget measures later in 2004 if required to reduce the 2005 fiscal deficit to 3 percent of GDP.

10. The mission argued that the improved short-term outlook provided an opportunity to accelerate fiscal consolidation and deepen structural reforms. Public debt is high and rising, and fiscal adjustment had already been postponed. At the same time, under German law, higher entitlement expenditure eventually tends to trigger higher payroll taxes to balance the social security system.2 Without welfare reform, efforts to raise labor utilization, and fiscal consolidation, the impending demographic change and associated crippling payroll tax hikes will further stifle growth. Thus, the policy response needed to be forward looking to boost potential growth and deal with population aging, which will accelerate after 2010. As past policy reversals were one reason for the uncertainty among economic agents, the mission stressed the confidence benefits of casting the required policies in a coherent framework that focuses on longer-term prospects.

A. The Economic Outlook

11. There was agreement that the short-term outlook had improved. The official forecast sees real GDP growth between 1½-2 percent in 2004-05, and there was concurrence that growth is likely to be at the upper end of this range in both years. Adjusting for the effects of additional working days in 2004 and fewer working days in 2005, this implies an acceleration in underlying growth of ⅔ percentage points in 2005. This scenario is built on a strong external impulse, consistent with the latest WEO forecast for global expansion, and assumes that this impulse will only gradually spill over to investment and employment, and then to consumption (Figure 12). Core inflation would remain subdued with continued wage moderation, although headline inflation would be affected by the rise in oil prices and one-off increases in health premia and tobacco taxes.

Figure 12.
Figure 12.

Germany: Comparison of Business Cycles, 1970-2005

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Federal Statistical Office; and IMF staff calculations.Note: All values are relative to trough equal to 100, except the contribution of external demand, where trough is equal to 0. The average of previous cycles is an unweighted average of troughs occuring in 1975, 1982, and 1994. The trough for the current cycle is assumed to be 2003 Q4.

12. However, the unbalanced nature of the recovery, with domestic demand still dormant, adds uncertainty to the projection, and there was agreement that the downside risks bear close watching. Specifically:

  • Disposable income might continue to be held back by weak employment and slow wage growth, with adverse consequences for consumption (Figure 13). The reform effort may also be causing uncertainty about future prospects, prompting households to save much of the 2004-2005 tax cut. Furthermore, construction was seen to remain weak for some time. At the same time, although the link between external and domestic demand was assumed to be weaker than in previous upswings, there was no evidence that the pass-through would not come into play and boost investment and employment. Indeed, interest rates continued to be moderate and banks were in better shape to support growth. Firms’ balance sheets and profitability were also improving, which should facilitate investment.

Figure 13.
Figure 13.

Germany: Household Consumption and Income Growth Rates and Household Savings Rate, 1980-2005

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations and estimates.Note: Growth rates are percent changes, and the savings rate is in percentage points.

  • The authorities noted that the external impulse might subside before igniting the domestic economy in the event of even higher oil prices or new security disturbances.3 Although the latest WEO forecast for global expansion has indeed become more cautious, it continues to point to strong world activity in 2005 (import demand growth relevant for Germany in excess of 6 percent). The staff agreed, however, that exports could slow if these risk factors were to disrupt the global upswing.

13. Beyond the near term, however, the mission saw the upside potential for output growth constrained by poor labor utilization. In contrast to most other European countries, Germany’s working age population had already begun to decline (Figure 14).4 After the current slack is worked off, this would impede growth unless incentives are improved and participation rates are raised to achieve better utilization of labor. The mission’s analysis suggests that, based on the Agenda 2010 reforms so far, potential growth over the next five years or so would accelerate from only about 1½ percent to 1¾ percent a year, and this assuming that: (i) after the current cyclical slump, TFP resumes a 1 percent growth pace as in the 1980s and 1990s; (ii) the drop in total hours worked slows to 0.2 percent a year, from 0.4 percent rate in recent years; and (iii) the growth rate of the capital stock rebounds to 2 percent, consistent with improved fundamentals. Therefore, reforms beyond Agenda 2010 needed to be developed and implemented to support higher potential growth, which would also have important synergies with fiscal consolidation.

Figure 14.
Figure 14.

Germany: Dynamics of Working Age Population, 1950-2050

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Source: German Authorities; Eurostat; OECD; and IMF staff calculations.Note: Data from 1950 to 1990 for Germany as a whole have been interpolated backwards by splicing estimates for East Germany onto the available data for West Germany.

B. Fiscal Policy and Entitlement Reform

Fiscal consolidation

14. There was agreement on the need to consolidate public finances as the upswing unfolds. On real GDP growth of 1½ -2 percent in 2004-05, the authorities projected the general government deficit at 3.7 percent of GDP in 2004 and just under 3 percent in 2005. This adjustment would be driven by rising yields from past measures and tight budgeting. New measures would not make a significant contribution: savings from the proposed elimination of the subsidy for residential property—about ½ percentage point of GDP in the steady state—were small in the short run and would serve partly to fund higher spending on research and development. For 2006, the authorities targeted a deficit of 2 percent of GDP, followed by further reductions in 2007-08.

15. The mission supported the authorities’ fiscal objective for 2005 but questioned its attainability without further measures. In 2004, the deficit would likely be somewhat higher than the authorities’ estimate because of disappointing tax collections associated with sluggish wages and consumption; the structural deficit would widen slightly. For 2005, the mission’s estimates of the yield from measures and macroeconomic effects on tax receipts were also more cautious than those of the authorities. Assuming a recovery of Bundesbank profits—which were unusually low in 2004—the deficit would still be lowered only to 3.3 percent of GDP. Further, on current policies, a large structural deficit would remain over the medium run.

16. The mission recommended reducing the structural deficit by at least 1½ percentage point of GDP during 2004-06, in line with past advice. After compensating for the 2004-2005 tax cuts (amounting to close to 1 percent of GDP), the carry-over impact of expenditure measures already implemented with the 2004 budget and one-off effects will yield a structural improvement of about ½ percentage point of GDP over 2004-06. Additional measures equivalent to 1 percent of GDP would thus be needed in 2005-06. With the adjustment in 2005 already sizable and the recovery still tentative, about two thirds of the additional adjustment could be backloaded to 2006, when growth is projected to be above potential. In any case, the automatic stabilizers should be allowed free play around the resulting 2005-06 structural adjustment path of ¾ percent of GDP per annum. Structural consolidation would need to continue beyond 2006, at a pace of ½ percentage point of GDP annually, to reach the structural surpluses of about 1 percent of GDP foreseen in the authorities’ June 2001 Guiding Principles of Fiscal Policy before aging accelerates in 2010.

Germany: Fiscal Adjustment

(In percent of GDP)

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Impact of weaker (-) or stronger (+) growth in labor income and consumption tax bases, which differs from estimates of cyclical effects that focus solely on GDP.

Germany: General Government Balances

(In percent of GDP)

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Sources: Ministry of Finance; and IMF staff estimates and projections.

Conventionally measured, using OECD elasticity estimates and staff estimates of the output gap.

17. The authorities believed that the 3 percent deficit goal was achievable in 2005 on present policies, but admitted that it would be a close call. They indicated additional measures would be specified before the budget is passed in December if the upswing had become entrenched and the achievement of the deficit goal remained in doubt. The authorities agreed that further measures would be needed to attain the medium-run targets and move to a small surplus over the cycle.

18. For adjustment measures, the mission proposed a continuation of the structural approach with durable expenditure cuts launched by the authorities in 2004. Under this approach tax relief had been supported with cuts in entitlement expenditure, notably on pensions and health care. But efforts to cut tax expenditures and subsidies had not brought major savings. Using a broad definition, a bipartisan commission had estimated total expenditure on these items to be as much as € 120 billion (6 percent of GDP). However, the commission then proposed (and the government adopted) across-the-board cutbacks that cumulated to only ¼ percentage point of GDP over 2004-06. The mission felt that much deeper cuts were possible and warranted. Similarly, active labor market policies (ALMP) had proven costly (1 percent of GDP) but not very effective, and could be streamlined.

19. The authorities agreed that the subsidies were good candidates for pruning and that across-the-board expenditure restraint was becoming increasingly difficult. After a number of tight budgets, the room for further trimming of discretionary items had become limited. They would try again to abolish residential property subsidies, a difficult endeavor in the current political setting. Beyond that, they argued that the structural reforms to the entitlement system and labor markets might well have larger-than-presently estimated payoffs, as they might significantly alter the behavior of agents. These developments were difficult to forecast and thus prudent assumptions had been made in the budgetary projections.

Tax and entitlement reforms

20. The mission cautioned against embarking on further tax reform before the requisite expenditure cuts and fiscal consolidation are well in hand. Several proposals are being discussed in policy circles, aimed at reducing distortions in the tax system and lowering tax rates. However, they also entail a significant risk of revenue losses in the short run, raising questions about their sustainability. Furthermore, the mission argued that, in view of the high labor costs, limits on growth in entitlements combined with payroll tax cuts would be more effective in reviving labor markets and fostering employment and output.5

21. The authorities shared the staff’s position, explaining that their main priority was to limit the expansion of nonwage labor costs and improve labor utilization. In this regard, several interlocutors saw merit in moving the funding of entitlement systems away from payroll taxes to consumption taxes but this debate was ongoing and no decision was expected soon. A specific area of discussion involved two proposals for changing the funding of health care to lessen the pressures on labor costs. This debate considers whether: (i) to replace the payroll tax with a lump-sum contribution per adult, while using the income tax to compensate those with low earnings (Gesundheitsprämie); or, (ii) to widen the contribution base to include capital income and individuals presently in private health care programs to allow a lower average payroll tax rate (Bürgerversicherung). However, any agreement on these proposals across the political spectrum was unlikely before the 2006 general elections.

uA01fig02

Germany: Payroll Taxes in Percent of Gross Wages

In percent

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

22. Accordingly, the authorities’ efforts to slow the rise in payroll taxes were focused mainly on pension and health care expenditure. They elaborated that:

  • The recent introduction of a sustainability factor—which slows pension increases by ¼ percent for every percentage point increase in the old-age dependency ratio—would lower expenditure by about ¾ percent of GDP in the long run. In addition, efforts are underway to promote corporate and private (Riester) pension accounts, but these pillars are still small compared to the public pay-as-you-go system.

  • The 2003 bipartisan health care reform, which was still under implementation, would lower spending by about ½ percent of GDP. The introduction of co-payments for doctors’ visits and various improvements related to pharmaceuticals had already shown success. Moreover, limits on dental coverage would become effective in 2005. Steps to liberalize the pharmacy sector and to allow hospitals more freedom in deciding what services to offer were also under consideration.

23. The mission supported these reforms but argued that additional steps are needed to bolster confidence in the long-term viability of the entitlement system. Various studies project that on current policies age-related spending would rise between 4-6 percentage points of GDP before peaking in 2050. Absent additional entitlement reform, payroll taxes would need to rise significantly to compensate, stifling growth (Box 2). Cutting discretionary spending further to offset higher entitlement outlays is not feasible either as it would jeopardize the efficiency of government.6 Thus, further entitlement reform was inevitable to avoid unsustainable increases in the tax or debt burden.

24. To help increase labor supply, the mission recommended linking the statutory retirement age to life expectancy rather than focusing narrowly on achieving benefit cuts. Specifically, the 2003 Rürup pension reform commission had already recommended increasing the statutory retirement age from 65 to 67 years—by one month a year starting in 2011. Adopting this measure could contain future pension costs by another ½ percentage point of GDP. With life expectancy projected to rise by about one year per decade, the authorities acknowledged that raising the statutory retirement age would eventually be inevitable, but preferred to work first on the effective retirement age, which stood just over 60 years. Accordingly, they would gradually lift the age at which unemployed workers qualify for early retirement to 63 years, from 60 years presently. The statutory retirement age would be reexamined following the publication of sustainability reports at regular intervals, starting in 2006.

C. Budgetary Institutions and Intergovernmental Fiscal Relations

25. Budgetary institutions and intergovernmental fiscal relations have had a significant impact on the pace of reform and consolidation. A background paper shows that over the past three decades all of Germany’s governments faced an opposition-controlled upper house—which has to approve most economic reforms—for lengthy periods of their terms (Box 3). During such periods, little progress was made with fiscal consolidation, particularly in curtailing expenditure.

26. Accordingly, the mission suggested measures to establish firmer commitments among different levels of government and introduce a degree of competition in fiscal federalism, thereby improving fiscal discipline and the allocation of resources between the levels of government and among Länder. In particular:

Effects of Pension Reform on Growth

Most projections of social security finances ignore feedback effects on labor supply and capital accumulation and may hence underestimate the costs of aging. This is particularly important in Germany, where social security deficits, by law, eventually tend to lead to higher payroll tax rates. This could slow real GDP growth more sharply than currently envisioned.

uA01fig03

Social Security Contributions 1/

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

1/ In percent of GDP.

Higher payroll taxes decrease real wages and reduce labor supply. Nickell (2003) estimates an elasticity of labor supply to payroll taxes of up to -0.3. This adds to the projected demographic decline of the labor force (even after allowing for immigration). With less labor input, GDP growth would slow. This would lower capital accumulation, which slows GDP growth further. Fiscal revenues would fall and require a further rise in contributions rates, leading to a downward spiral that could choke output growth after 2020.

The recent pension reform links benefits to the dependency ratio. Although this dampens the pressure on payroll taxes, it still leaves a substantial adverse growth effect, particularly from 2010 onward, when aging accelerates. The active generation still bears most of the financial burden of aging, and real wages may barely grow over the coming 20 years. Employment and GDP, and hence revenue, would be depressed, keeping pressure on contribution rates.

Raising the effective retirement age from currently 60 years to 65 by 2030 would support the labor force and output growth, and would distribute the financial burden more equally. Simulations suggest that with such a policy, both wages and pensions would be able to advance by about 10 percent in real terms over the coming 20 years. The employment ratio would stabilize, allowing GDP growth to be higher by about 1 percentage point per year relative to the “recent reform” scenario. The required increase in payroll taxes would be cut in half.

uA01fig04

GDP Growth

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Political Economy Aspects of Fiscal Consolidation and Reform

As discussed in the accompanying Selected Issues Paper, the structural fiscal balance has tended to be closely related to the government’s combined margin of support in the lower and upper chambers of parliament. The lower chamber selects the government but the upper chamber can veto most tax laws and many structural reforms. Staggered regional elections change the majorities in the upper chamber in between the general elections. As a result, structural balances have usually improved in the early “honeymoon” years of a new administration. However, they have then eroded with losses in regional elections, as the central governments needed to accommodate a more diverse set of political interests.

uA01fig05

Government Margin and Fiscal Consolidation, 1970-2004 1/

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

1/ The margin is the majority in votes for the government in both chambers of parliament.

This phenomenon puts added emphasis on ensuring that budgetary institutions and intergovernmental fiscal relations provide better incentives for fiscal management. Specific measures in this regard are outlined in Section III.C.

It was also found that since reunification structural reforms have lacked consistency. For example, new long-term care insurance was established in 1995, although the welfare state was already being stretched by reunification-related challenges. Many benefits were then cut back in 1997, including pensions through the introduction of a demographic factor. With a change in government, these cutbacks were repealed in 1999, but then re-introduced again in 2003-04 as part of Agenda 2010. Such swings in policy have likely disoriented the public about the direction and objectives of economic policy.

  • The mission supported the government’s plan to produce fiscal sustainability reports, but noted that the report’s credibility would be boosted if it was prepared by a nonpartisan independent body that reported to the legislature. These reports should provide a comprehensive and long-run view of the general government accounts based on current policies.

  • In framing its fiscal objectives, the government should make the accounting conventions and rules more consistent with the Stability and Growth Pact (as opposed to the current focus on a golden rule for the cash budget of the federal government).7

  • The Internal Stability Pact (ISP) should be bolstered by spelling out and firming up the commitments of various levels of government, including individual Länder.

  • The mechanism for allocating revenue across Länder could be reformed to provide stronger incentives for fiscal consolidation by Länder.

  • Länder should be given leeway to attune their regional public sector wage and welfare expenditures as well as revenues (through surcharges or discounts) to local circumstances, thereby improving the business environment for new investment.

27. The authorities were sympathetic to these proposals and drew attention to the work of a parliamentary commission that was studying Bund-Länder relations. Amid a perception that the federal system was contributing to reform gridlock, the commission was seeking to reduce the overlap of responsibilities between the various levels of government. Further, under the ongoing labor market reforms more scope would be given for innovative policies at the local level. The authorities acknowledged that an agreement with the Länder on how precisely to share the responsibility for conforming with the Stability and Growth Pact, including possible sanctions, would be desirable. They thought that they had taken a successful step in this direction with the ISP of 2002, and did not see much scope for further progress at this time.

D. Labor Policies and Developments in the New Länder

Labor market developments and policies

28. Rising wage flexibility has contributed to the increase in unemployment being below previous peaks, unlike in earlier slowdowns. Continuing a trend since the mid 1990s, the vast majority of collective wage agreements concluded recently set pay increases around 2 percent, with actual pay hikes likely falling below the agreed headline number (Figure 15). The authorities observed that many collective wage bargaining agreements included clauses that allowed adjustments in working conditions to address firm- or sector-specific problems, flexibility they were actively encouraging. They also drew attention to contracts concluded recently by some large firms that stipulate an increase in the length of the workweek from 35 to 40 hours without additional pay, responding in part to intensified competition from the new EU member states. More generally, the majority of companies and close to half of all employees are no longer covered by collective wage bargaining.

Figure 15.
Figure 15.

Germany: Negotiated and Actual Pay Increases, 1992-2003

(In percent)

Citation: IMF Staff Country Reports 2004, 341; 10.5089/9781451810479.002.A001

Source: Deutsche Bundesbank.1/ Wage drift is the difference between negotiated and actual wage increases.

29. Combined with improved wage flexibility, the authorities thought their reforms to lower reservation wages and strengthen job intermediation would boost employment. In January 2006, the duration of unemployment benefits would be cut, from a maximum of 32 months to 18 months for people aged 55 and over; others would continue to receive benefits for at most 12 months. Furthermore, as a key element in the Hartz IV reforms, in January 2005 open-ended unemployment assistance (UA) would be merged with social assistance into a new unemployment benefit II program (UB II). The authorities explained that this reform entailed much tighter means tests for the 2.2 million UA recipients, probably withdrawing support from some 500,000 individuals. Those who remain eligible would receive lower benefits and would have to meet stronger job acceptance requirements. These reforms are significant, and successful implementation will require far-reaching changes by the Federal Labor Agency (FLA) and municipal agencies in charge of benefit administration and job intermediation.

30. The mission supported these well-targeted reforms and cautioned against their dilution, noting also that there is still an unfinished agenda. The authorities underscored their strong commitment to the full implementation of the UB II program, dismissing calls to introduce legal minimum wages to soften the effect of tighter job acceptance criteria. Nonetheless, they thought that regions with unemployment rates above 15 percent needed special support within the framework of existing ALMPs to better manage the transition to UB II. The mission stressed that ensuring a strict, rules-based, interpretation of the job acceptance requirement—and sanctions for those who refuse a job offer—was key for the success of the reforms. This required a proper incentive structure within the FLA and municipalities. Regarding the next steps of the reform agenda, the mission noted that hiring and firing regimes are still rigid and costly, and impede flexible labor management. Further, more flexibility could be introduced in the legal framework for wage bargaining, which currently restricts the right to conclude firm-specific and collective wage agreements solely to trade unions.

31. The mission also emphasized that labor force participation needs to be raised to mitigate demographic pressure on growth and public finances. Labor utilization is particularly low for workers older than 55 years, women, and the young. The authorities explained that the few remaining early retirement schemes were being phased out and that the cut in the duration of unemployment benefits would make it harder to focus downsizing on older workers. The mission noted that this should be complemented by removing financial disincentives and other obstacles to working beyond the statutory retirement age. Regarding labor force participation of women, the authorities pointed to recent measures that lower social security contributions on part-time work, thereby mitigating tax-related disincentives for secondary income earners, and to programs that foster full-day schooling.

Developments in the new Länder

32. Labor market problems are particularly acute in the new Länder but gradual adjustment is underway. Union membership and collective wage bargaining are far less widespread in the new Länder. Labor costs continue to fall relative to those in the old Länder—in manufacturing they are now below western levels, fostering rapid expansion of output—and per capita incomes are catching up. However, the bursting of the subsidy-induced construction bubble is still weighing heavily on activity.

33. Discussions focused on policies that might accelerate economic convergence. Enterprise surveys suggest that lower wages and longer workweeks are now key reasons to locate in the new Länder, but a 2003 progress report points to public infrastructure gaps, particularly in the area of transportation. Rather than replacing old special incentive schemes for investment with new ones, the mission advocated allocating a larger share of public expenditure to investment, which is presently being rolled back by many local governments. Furthermore, in the context of the discussions on federalism, the mission also argued that more freedom for individual Länder to shape their public sector wage and welfare policies, together with some independence in setting tax rates, might allow them to improve their business environment. The authorities viewed the sluggish growth in the old Länder as a key obstacle to a better performance of the new Länder. Policies thus had to be the same across Germany, targeting lower nonwage costs through entitlement reforms and less generous support for the jobless. Ultimately, these reforms would create the room for more public investment.

The Catch-up of the New Länder

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Source: Die Lage der Deutschen Wirtschaft in Fruejahr 2004.

E. Product Markets and Trade Policy

34. The authorities pointed to progress in liberalizing network industries and agreed on the need to reform crafts and services to boost more labor-intensive growth. Competition in the telecoms sector was strong; in energy, difficulties with respect to network access and high electricity prices were being addressed by moving from a model of industry self-regulation to supervision by a regulatory authority; and in the postal sector the gradual elimination of the national monopoly had created some 24,000 jobs among competitors. Furthermore, work was ongoing on adapting German to EU competition law. The key outstanding issues were (i) the restructuring of the national railway company; (ii) the liberalization of fees for services provided by selected professions; and (iii) the removal of barriers to entry in crafts. The mission underscored that liberalizing the crafts and services sector provides a promising avenue to foster more labor intensive growth. The authorities pointed to a recent reform that had opened entry into crafts that accounted for roughly 10 percent of craft employment.

Regulatory Reform in Product Markets, 1978-1998 1/

(Scale 0-6 from least to most restrictive)

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Source: Nicoletti et al. (2001).

Average of indicators for 7 industries: gas, post, electricity, telecoms, air transport, railways, freight.

35. The authorities reiterated their strong support for multilateral trade liberalization and agricultural reform. They welcomed the EU initiative to put on the table all export subsidies, to show flexibility on various Singapore issues, and to give the poorest and most vulnerable WTO members a “round for free.” They were also pushing to liberalize the trade regime covering bananas, rice, and sugar. Regarding the CAP, Germany had strongly advocated decoupling support from production, most recently for tobacco, olives, and cotton.

36. The authorities saw major benefits from EU enlargement, together with the full adoption of Agenda 2010 reforms to foster speedy restructuring. Various studies found that the catch-up of incomes of the new EU members would further boost trade flows and incomes in Germany, particularly in the new Länder. Jobs in low-skill sectors faced increasing competition for many years but the authorities saw outsourcing as beneficial for competitiveness. They emphasized that the economy had to be made more flexible, notably through Agenda 2010 reforms. To help manage the flow of workers from the new member states, Germany would continue applying for now the national restrictions (i.e., work permit schemes) and provisions from bilateral agreements on labor migration with the new member states.

Exports to Poland and to Czech Republic

(Average annual growth, in percent)

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Source: DIW Weekly Report 33/2003.

F. Financial Sector Developments and Policies

37. The authorities reported that financial sector strains had eased and that progress had been made in addressing structural weaknesses (Table 3). The rating downgrades of major banks and insurance companies had ended and they had successfully tapped capital markets over the past year. In the banking sector, operating income had risen moderately within all three banking pillars in 2003, driven mainly by cost cutting.8 Falling loan loss provisions had supported a recovery of earnings which, together with the disposal of risky assets and recovering equity markets, had boosted capitalization. However, the authorities acknowledged that raising revenue remained the “cardinal problem” for German banks.9 Consolidation in the insurance sector was advancing too, although at a slower pace than in banking. Balance sheets had benefited mainly from the recovery in equity markets but also from lower payouts on life insurance policies.

Table 3.

Germany: Indicators of External and Financial Vulnerability

(In percent of GDP, unless otherwise indicated)

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Sources: Deutsche Bundesbank; IMF, International Financial Statistics; and IMF, World Economic Outlook.

Staff estimates and projections, unless otherwise indicated.

Data present Germany’s position in the euro area; data not shown for 2002 because of a series break (from January 2002 M3 excludes currency in circulation).

Deflated by inflation excluding energy and food.

DAX 30 stock market index.

Share of housing loans in percent of total lending to private sector.

Share of housing loans in percent of total lending to nonfinancial sector.

Non-performing loans as identified by bank auditors in line with German commercial law.

Consolidated basis, risk-weighted, national definitions as under principle I of the German Banking Act, comprising all credit institutions reporting thereunder.

After-tax profit as percent of average capital.

In percent of assets.

Insolvencies of only those included in the credit register with loans of greater than Euro 1.5 million.

38. The authorities also pointed to progress in preparing public sector banks for the phase-out of government guarantees in mid-2005. Although the German banking system remains highly segmented along three pillars, they noted that increased cooperation across pillars was emerging, mostly in back-office operations. The public banks (Sparkassen and their head institutions, the Landesbanken) were preparing for the end of government guarantees, which would hit the Landesbanken particularly hard, by: (i) securing more capital from the Sparkassen associations of their own Land;10 (ii) strengthening the institutional protection scheme for Sparkassen and Landesbanken; or (iii) seeking partnerships or mergers with stronger Landesbanken of other Länder. The authorities reported that these efforts had been recognized by rating agencies with shadow ratings on unguaranteed obligations in the single “A” range, except for a few institutions whose ratings were in the “BBB” range. Guaranteed obligations—which can be issued until mid-2005—typically carry a “AAA” rating.

39. Although helpful, the mission noted that the moves by the Landesbanken were insufficient to fundamentally strengthen the banking system. Profits from current business lines of most of the Landesbanken will be largely eliminated as their refinancing costs begin to rise in line with the lower rating on unguaranteed obligations.11 A major restructuring of business lines is thus crucial, driven by a wide set of market forces, including greater transparency about the operations of public sector banks followed by private ownership. Hence, the mission reiterated the key FSAP recommendations to facilitate market-based restructuring by changing the legal framework so as to reduce barriers to restructuring. For example, changing the public law structure of Landesbanken and Sparkassen would permit their transformation into joint stock corporations, opening the door for private capital and consolidation within or across pillars. The authorities agreed on the desirability to open public sector banks to private capital, which also would allow more flexible responses to financial stress. They acknowledged that the restructuring process, especially cross-pillar consolidation, was constrained by legal obstacles, drawing attention to an unsuccessful attempt by one municipality to sell its Sparkasse, but said that removing these obstacles was a matter for Länder governments. The mission indicated that the Federal authorities nevertheless needed to engage the local authorities if the reforms fell short, as persistent inefficiencies in the banking system would have adverse fiscal and financial effects beyond the local level.

40. In Germany’s insurance sector, which is one of the largest in the world, strong competition and large capacity in the life segment continue to weigh on profits. Investment income and solvency recovered with equity markets and property and casualty and reinsurance companies also benefited from rising premium income and falling claims. But in the life insurance sector, large capacity and stiff competition stand in the way of a sustained recovery of profitability, notwithstanding adjustments to the rate of return typically guaranteed to policyholders.12 The authorities explained that the returns paid on life insurance policies had finally fallen to levels in line with “economic” returns of the companies. With the recovery of equity markets, the sector as a whole had moved from holding hidden losses to hidden gains in 2003; regulatory solvency was met with an adequate margin. These improvements had also been borne out by the results for the stress tests, which had been passed by companies accounting for about 90 percent of life insurance business.

41. The mission noted that further adjustments are needed to strengthen the life insurance sector. In particular, it will be important to abolish the mandatory 90:10 profit split (which stipulates that at least 90 percent of profits must be distributed to policy holders) to allow companies to strengthen capital and prepare for the introduction of EU’s Solvency II capital adequacy scheme. The authorities said that companies were already beginning to adjust in anticipation of Solvency II, even if the related EU Directive would not be finalized for several years. In their view, the 90:10 split did not constrain capital, but they agreed that in the context of Solvency II a mandatory profit split had little rationale. Beyond work toward Solvency II, the authorities expected self-supervision of the industry to improve matters. In this context, they pointed to the introduction of Protektor AG—a joint-stock company held by the industry that had the task of taking over insurance policies of insolvent members. The authorities hoped that contributions to Protektor AG would become risk-based and assessed by industry experts.

42. The authorities pointed to several supervisory improvements in response to the FSAP and highlighted initiatives to foster financial intermediation. Although they had not repeated last year’s stress tests for the banking sector, the Federal Agency for Financial Services Supervision (BaFin) and the Bundesbank were developing an early warning system. The Bundesbank had begun publishing a regular financial stability report. BaFin had refined the insurance industry stress tests in an effort to move toward more risk-based supervision. A major project underway was to bring reinsurance business under the umbrella of the supervisory authorities, a key FSAP recommendation. Furthermore, the authorities pointed to the introduction or development of regulatory frameworks for various new financial instruments, including hedge funds, asset backed securities, real estate investment trusts, and inflation-indexed government debt. The goal is to deepen capital markets, providing firms more financing options and allowing for better allocation of risk among market participants.

G. Other Issues

43. A recent FATF Report on the Observance of Standards and Codes for AML/CFT concludes that Germany’s system is comprehensive, effective, and efficiently implemented. However, a few deficiencies should be addressed regarding terrorist financing, including ratification of the UN International Convention of the Financing of Terrorism (1999); criminalization of financing for individual terrorists who are not part of a larger terrorist organization; and specifics related to the freezing of property and wire transfers.

44. Germany’s statistics are generally of high quality and conducive for effective surveillance. Collecting direct national accounts data on inventories and compiling quarterly accounts for the general government would be an important enhancement. In response to an FSAP recommendation to produce more comprehensive and timely data on financial sector soundness, the authorities intend to participate in the IMF’s initiative to compile Financial Sector Soundness Indicators.

45. ODA was 0.3 percent of GNI in 2003.

IV. Staff Appraisal

46. Germany has made important headway over the past year in addressing deep-seated structural problems. However, yet more difficult reform and fiscal consolidation measures are needed if the improving cyclical conjuncture is to translate into more robust and sustained medium-term growth. Strong German leadership in economic reform is also essential because of the regional and global ramifications of its poor performance.

47. A modest cyclical recovery, driven by the rest of the world, is taking hold, but longer run prospects continue to be of concern. With sustained wage moderation and efforts underway by social partners to make labor markets more flexible, competitiveness has improved and exports are responding well to increased world demand. The recovery, however, remains unbalanced, with domestic demand still dormant. The external impulse is expected eventually to lead to a revival in investment and consumption, but these links may be somewhat weaker than in previous German recoveries. In any event, the longer run is of increasing concern as potential output growth is constrained by poor labor utilization compounded by population aging, which will accelerate sharply after 2010—just one business cycle away—and impose a crushing burden on the economy.

48. Agenda 2010 represents a forceful start of needed reforms in Germany but will need to be augmented to ensure that demographic changes do not stifle growth. Managing a redistributive state is much more difficult in a slow-growing economy with an aging population, increasing the urgency of taking action. It is encouraging, therefore, that policymakers have started to focus on the need to adapt the welfare system and increase potential growth by bolstering labor utilization through sharpened incentives to work.

49. At the same time, with public debt on a disturbing upward trend, fiscal consolidation should be given renewed impetus. The 2004 general government deficit will remain well above the Maastricht reference ratio for the third consecutive year. Although durable measures are being implemented to reduce expenditure, these have been offset by tax cuts. Nonetheless, the high deficit is also a legacy of insufficient expenditure restraint during previous upswings. Achieving small surpluses over the cycle will ease the pressure from debt and put Germany in a better position to face looming demographic changes.

50. The improved near-term outlook provides an opportunity to accelerate fiscal consolidation and structural reform that should not be missed. Complementing fiscal consolidation with labor market and entitlement reforms will not only stimulate important synergies, but also provide the public assurance of the long-run sustainability of government finances and the welfare state. Indeed, communicating a coherent forward-looking strategy should also help revive confidence and support domestic demand in the near term.

51. The objective to reduce the structural deficit by at least 1½ percentage points of GDP over the period 2004-2006 remains appropriate. Measures that are projected to yield about one-third of this improvement are already in the pipeline. Hence, additional durable measures—yielding about one percentage point of GDP—still need to be implemented to meet the 2004-2006 objective. Of this, policy measures totaling about ⅓ percentage point of GDP need to be adopted before the 2005 budget is finalized to lower the deficit below 3 percent of GDP. Additional measures of this magnitude strike the right balance between putting the deficit on a clear downward path and avoiding undue strain on the recovery. After 2006, further steps of at least ½ percentage point of GDP per year would then be needed until a small structural surplus is achieved.

52. Larger cuts in tax expenditures and subsidies are the most promising avenue to obtain durable consolidation. Using a broad definition, these have been identified to amount to as much as 6 percent of GDP by a high-level bipartisan commission, but the agreed reductions so far have been very small. Equity and efficiency consideration call for a more far-reaching approach and the plans to abolish residential property subsidies are thus welcome. A targeted approach is also required because it will help reduce the reliance on across-the-board expenditure restraint, which will be difficult to sustain over the medium run.

53. With the German entitlement system largely based on payroll taxes, and in view of population aging, entitlement reforms are key to creating jobs and growth. The government’s caution about additional tax reforms is thus appropriate because entitlement reforms that contain payroll taxes are the more pressing priority. Moderate budget surpluses should be accompanied by pension and health care reforms to address the impending costs of aging.

  • In the pension system, the recent adoption of the sustainability factor that links the pension benefit replacement rate to the old-age dependency ratio, and steps to raise the effective retirement age, were necessary and important, but are insufficient to balance the system in the long run. Absent further reform, the payroll tax burden is still expected to reach onerous proportions, likely stifling economic growth. Therefore, as is increasingly accepted, the statutory retirement age will have to be raised in line with longer life expectancy. Indeed, with weak domestic demand, greater emphasis needs to be put on raising retirement ages rather than measures that reduce household income. Employees should also be allowed to work longer if they wish to do so, without being financially penalized.

  • In the health care system, efforts could usefully focus on improving supply and funding. Progress so far has focused on transferring selected costs to users and containing demand. The next stage of reform needs to target rigidities in the supply of health care, and the measure being considered by the government, such as allowing hospitals to decide for themselves what services they provide, and liberalizing the pharmacy sector, deserve broad support. It will also be crucial to break the link between health care financing and wages.

54. Improving budget institutions and intergovernmental fiscal relations can provide incentives for better fiscal management. The central tenets need to focus on enhancing transparency, establishing firmer commitments among different levels of government, and introducing a degree of competition in fiscal federalism, thereby improving fiscal discipline and the allocation of resources between the levels of government and among the Länder. Valuable steps in this direction would include the adoption of accounting conventions and fiscal rules that are more consistent with the Stability and Growth Pact, and allowing lower levels of government additional degrees of freedom to raise revenue and pursue independent—but deficit-constrained—expenditure policies. The fiscal sustainability reports to be produced in the near future can be expected to further the public debate about the reform of entitlement programs; having these reports drafted by an independent body will boost their credibility.

55. The labor market is becoming more flexible but wage moderation and longer working hours alone are not sufficient to boost labor supply. The willingness of social partners to adopt innovative wage bargaining agreements that tailor pay and working time to local labor market conditions and global competitive pressures are laudable. Although this has undoubtedly played a role in improving external performance, high long-term unemployment, particularly among older workers and the less skilled, remains a major concern, as does the low labor force participation in general. Further labor market modifications are therefore necessary to cut unemployment and increase participation—especially relevant in view of the already declining working age population. The continued development of flexible wage and employment contracts, including for small and medium-sized enterprises, will be important in this regard.

56. The labor market reforms under Agenda 2010 are path breaking but they are not the last word in this critical area. The shortening of the duration in long-term unemployment benefits and the reduction of their replacement rate are well-targeted. The administrative arrangements for the program now need to be made robust so that it becomes fully functional in early 2005. Familiarity with local conditions and close cooperation among the implementing authorities will be vital to maximize the prospects for reintegrating the long-term unemployed. Strict enforcement of job acceptance requirements will be important to improve work incentives. Complementing this far-reaching reform with further pension and health care reforms that allow lower payroll taxes will encourage job creation and labor demand. Beyond these measures, it will also be important to take further steps to make hiring and firing more flexible, and to support the trend toward greater flexibility by reducing remaining central controls on wage bargaining.

57. Germany has made good progress in liberalizing network industries and product markets, but crafts and service sectors still need far-reaching liberalization. Improving entry and exit conditions in service industries is important to stimulate investment and employment in these labor intensive sectors of the economy. The liberalization of fees for selected professions and the removal of barriers to entry in crafts need to be accelerated. Germany’s support for multilateral trade liberalization, including in agriculture, is welcome.

58. The financial system has benefited from the cyclical recovery but fundamental reform has progressed only slowly. Profitability has rebounded, write-offs have become less pressing, and higher asset prices have improved balance sheets. Supervision is being strengthened and broadened, notably to reinsurance companies. Furthermore, innovations are being introduced in the capital market. Nevertheless, certain key concerns noted in the 2003 FSAP exercise remain, notably the need for banks to improve their revenue efficiency through the development of new business strategies, and for further restructuring in the life insurance segment.

59. Most importantly, legal and regulatory impediments to market driven restructuring need to be addressed to foster structural change in the financial system. Efforts to strengthen public sector banks—notably the Landesbanken—are being guided by short-term rating concerns and narrow interests of lower levels of government. Instead, it remains vital for the Länder to create legal frameworks that transform public sector banks into joint-stock corporations, which would allow a better harnessing of market signals for restructuring and strengthen the resilience of the banking system to shocks. In the insurance sector, it will be important to broaden the supervisory focus beyond solvency margins. In this regard, the mandatory 90:10 profit split with policy holders is not consistent with the upcoming provisions of risk-based insurance supervision, and this is an opportune time to abolish this regulation.

60. Germany’s statistics are adequate for surveillance. The steps to enhance the production and timeliness of financial sector soundness indicators are welcome. However, some improvements could facilitate the monitoring of fiscal policy.

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

APPENDIX I Germany: Fund Relations

(As of August 31, 2004)

I. Membership Status:

Germany became a member of the Fund on August 14, 1952. Germany has accepted the obligations of Article VIII, Sections 2, 3, and 4.

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Obligations to Fund: None

VII. Exchange Rate Arrangement:

Since January 1, 1999, Germany has been a member of the European Economic and Monetary Union; the deutsche mark entered EMU at a value of DM 1.95583 per euro.

Germany is an Article VIII member and maintains an exchange system free of restrictions on payments and transfers for current international transactions, except for reasons related to security. In accordance with IMF Executive Board Decision No. 144-(52/51), effective December 2001, the authorities put into effect a series of measures freezing the accounts of and banning payments in favor of the Taliban, listed terrorists, and persons and organizations related to terrorism. Pursuant to UN Security Council resolutions and/or EU regulations, restrictions are imposed on payments and transfers to Iraq, Libya, Zimbabwe, and certain individuals in the Myanmar. EU sanctions are maintained against the assets of 13 persons associated with Serbia and Montenegro.

The restrictions against individuals, organizations, or countries have been modified since the last No. 144-(52/51) notification to the Fund.

VIII. Article IV Consultations:

Germany is on a 12-month consultation cycle. The staff report for the last Article IV consultation (IMF Country Report No. SM/03/341) was discussed at EBM/03/100 (November 3, 2003).

APPENDIX II Germany: Statistical Information

Germany has a full range of statistical publications and subscribes to the Fund’s Special Data Dissemination Standard (SDDS). The authorities make full use of the Internet to facilitate online access to data and press information.

Germany adopted the European System of Integrated Economic Accounts 1995 (ESA95) in 1999. Four significant gaps remain:

  • The absence of any pre-1970 ESA95 data complicates time series analysis.

  • Statistics on inventories are unavailable, depriving Germany of a key economic indicator. In the national accounts statistics inventory accumulation is derived as a residual and lumped together with the statistical discrepancy.

  • Flow-of-funds data for the 1970s and 1980s remain patchy. Also, flow-of-funds data are published on an annual basis only and with a nine-month lag. More timely data would facilitate monitoring balance sheet developments.

  • A bridge table between the general government data in the ESA95 classification and the public sector data on an administrative basis should be published to facilitate fiscal analysis.

As other euro-area countries, Germany does not publish quarterly general government revenue, expenditure, and balance on an accrual basis (ESA95)—such data would considerably facilitate fiscal analysis.

Following the adoption of the ESA95 standard for fiscal reporting by member countries of the European Union, Eurostat advised the IMF that the member countries would no longer report cash data for publication in the Government Finance Statistics Yearbook. The IMF Statistics Department is collaborating with member states, Eurostat and the European Central Bank to develop a fiscal data reporting system that accords with the accrual methodologies of the ESA95 and the revised Government Finance Statistics Manual 2001. On a test basis, the Government Statistics Yearbook 2002 Supplement (accessible at http://www.imf.org/external/pubs/ft/gfs/manual/comp.htm) shows data for Germany using the new framework of the Government Finance Statistics Manual 2001: Central Government, State and Local Government, and General Government (1999-2001).

The 2003 FSAP mission found that the availability and timeliness of financial soundness indicators was relatively weak. The Bundesbank and the Banking Supervisory (BaFin) should publish relevant statistics, focusing mainly on credit institutions and insurance companies, and including at a minimum core indicators of asset quality, capital adequacy, earnings and profitability, and liquidity. It would be useful to publish more statistics on off-balance sheet activities of financial institutions, including notional amounts, market replacement values, and bilaterally netted credit exposures. It would also be helpful to consider publishing regularly a financial stability review, which has been found valuable in an increasing number of countries.

Germany: Core Statistical Indicators

(As of September 15, 2004)

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APPENDIX III Germany: Public Debt Sustainability

Germany’s general government net debt/GDP ratio is projected to increase slightly over the next five years. The medium-term scenario is based on a moderate recovery of real activity, and a gradual consolidation of the public finances. Real growth is assumed to pick up to 2 ½ percent over the next two years as the level of GDP catches up to potential, and to slowly subside thereafter. Fiscal adjustment measures introduced in early 2004 are expected to keep primary spending constant in real terms over the coming three years. Important savings are assumed to result from reforms in pensions and unemployment insurance, yielding a slowdown in benefit growth. Staffs fiscal projections in this respect are more cautious than the those contained in the authorities’ Stability Program. Finally, average interest rates on public debt are projected to decline somewhat over the coming years, as high-coupon bonds of the early 1990s are retired. Under the baseline scenario, the net debt ratio stabilizes at 63 percent of GDP from 2006 onward.

A renewed slowdown of activity poses a risk over the medium term. Staffs growth projections are somewhat higher than the historical average of the past 10 years, which was weighed down by the strains of German unification. However, in a stress test that assumes a two-year recession in 2005 and 2006, the net debt ratio would rise to around 77 percent. By contrast, fiscal slippages have a smaller impact on the debt dynamics, as a two-standard deviation shock to primary spending would raise the debt ratio to 67 percent. The debt ratio stabilizes soon after the shock, similar to the other stress tests.

Germany’s fundamental vulnerability stems from aging. Spending on pensions and health will begin to soar after 2010, in particular between 2020 and 2030 when the aging trend reaches a climax. A recent pension reform helps slow the growth of benefits somewhat but will likely prove insufficient. Raising the effective retirement age in line with higher life expectancies will be paramount to ensure fiscal sustainability and healthy GDP growth.

Germany: Public Sector Debt Sustainability Framework, 1999-2009

(In percent of GDP, unless otherwise indicated)

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General government net debt.

Derived as [(r - π(l+g) - g + αε(l+r)]/(l+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π(1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 21 as αε(l+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

The implied change in other key variables under this scenario is discussed in the text.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and primary balance) remain at the level in percent of GDP/growth rate of the last projection year.