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.
1. This supplement reports on information that has become available since the issuance of the staff report and reflects contacts with the authorities during the Annual Meetings in early October 2004 and more recently. The new information does not change the thrust of the staff appraisal.
Economic developments and outlook
2. Monthly economic indicators show some tentative signs of firming in domestic demand but a slowing in net export growth:
Retail sales in the third quarter of 2004 were up slightly from the previous quarter, but still below activity of a year earlier. Value-added taxes in real terms also increased slightly in the third quarter.
Business investment in machinery and equipment has resumed growing, albeit at a moderate pace, as profitability continues to strengthen. However, construction spending is still falling.
Employment on a seasonally adjusted basis increased slightly in the last four monthly observations from May to August. However, labor supply also increased and headline unemployment has risen by 0.1 percentage point to 9.9 percent (ILO definition).
Manufacturing output and exports have been closely linked and have provided the impetus behind growth this year, reflecting strong global demand for German capital goods and machinery. Orders for manufactured goods, however, have slowed somewhat in recent months, alongside export orders, from high levels earlier in the year—consistent with moderating expectations for the coming months.
The IFO business climate index has declined somewhat from the first quarter of the year, reflecting an easing of the expectations component of the index, while the current business conditions component has remained stable. This development is consistent with strong orders already on the books for exporters, but with increasing concern about oil prices and the pace of global economic expansion leading into 2005. Indeed, the ZEW index of investor and analyst sentiment fell sharply in October and is at a 16-month low.
3. The rise in oil prices will affect Germany via lower external demand growth and also as a supply shock. Through about mid-2004, the growth impulse for Germany from the global expansion surprised on the upside. However, early indicators for the third quarter showed the emergence of some softening, and the new sharp rise in oil prices to above US$50 a barrel (which has triggered an update of WEO baseline assumptions) is now causing a downward revision in output growth for 2005 in many trading partners—suggesting some slowing in Germany’s net export growth next year. In addition, although the appreciation of the euro had dampened considerably the rise in domestic energy prices in the early part of the year, this effect is now receding and oil prices are also rising in euro terms. Thus, the risk factor for the outlook involving oil mentioned in the staff report is now materializing.
4. On balance, with domestic demand still fragile and export growth likely to slow, the projections for output growth have been revised downward. Specifically, the staff projection for real GDP growth is revised from 2.0 percent to 1.9 percent for 2004; and from 1.8 to 1.5 percent for 2005 (in line with the latest consensus forecast of the main German research institutes for 2005). Even with these revisions, the growth outlook remains within the range of 1½-2 percent for 2004 and 2005 envisaged by the authorities.1 The underlying expansion from 2004 to 2005, corrected for the number of working days, is now just under ½ percentage point of GDP, down from an estimate of ⅔ percentage point in the staff report.2
5. Inflation and wage setting continue to be moderate. Headline inflation in the period July-September 2004 (annualized) was 1.5 percent; excluding energy it was 1.1 percent. Moreover, there has been no evidence of oil price increases spilling over into wage setting behavior so far.
Fiscal developments and outlook
6. In early October, the authorities issued a supplement to the 2004 federal government budget, and obtained authorization to widen the borrowing requirement for 2004. The supplementary budget reflects that tax revenue had been below original budgetary projections, and that expenditure on unemployment benefits had been above projections, leading to a larger deficit than was embedded in the 2004 budget. These effects were already anticipated in the staff report projection of the 2004 general government deficit of 3.9 percent of GDP, which remains unaltered.
7. The revision to the growth outlook does not alter the key fiscal policy recommendations for 2005 outlined in the staff report. Germany needs to take the opportunity of the upswing to bring down the structural deficit and stem the rise in debt. In the staff report, the structural deficit was projected to be cut by ½ percent of GDP in 2005 on the basis of measures already in the pipeline (implemented in the 2004 budget) and some one-time effects such as the normalization of Bundesbank profits from an unusually low level in 2004. To attain the goal of reducing the structural deficit by at least 1½ percent of GDP over the period 2004–2006, the staff recommended adopting additional policy measures totaling about ⅓ percent of GDP for 2005 before the budget is finalized. With the downward revision to growth, the overall general government deficit would then likely be 3.1 percent of GDP in 2005, reflecting the free play of automatic stabilizers.
8. Although near-term prospects have weakened, the staff continues to believe that a structural adjustment of ¾ percentage point in 2005 is appropriate. In assessing the tradeoffs, the staff is of the view that longer run considerations dominate the restraining effect this adjustment will have on the recovery in the short run. Further, the latest source of weakness is linked to a supply shock (oil prices) that may well be lasting. And, to the extent that the additional fiscal measures focus on corporate subsidies and tax exemptions, this would affect mainly buoyant profit income, mitigating the contractionary implications. Thus, reducing the structural deficit and bringing underlying debt dynamics under firmer control, combined with reforms to boost potential output growth, remains the priority. A clear indication that Germany is consistently tackling its long-run challenges could also have positive confidence effects. As adjustment was not pursued with sufficient vigor during the last upswing, and with 2006 being an election year, postponing the additional adjustment recommended for 2005 could lead to another missed opportunity to consolidate as the growth rate returns to potential and the economy continues to recover.