Germany: Staff Report for the 2005 Article IV Consultation

This 2005 Article IV Consultation highlights that economic activity in Germany is slowly picking up, and there is scope for some further firming of growth in the course of 2006. The recovery, however, remains unbalanced, and strong exports have yet to feed through into higher household spending. Although the risks to the outlook are broadly neutral, an unwinding of global imbalances and higher oil prices could yet provide headwinds for the recovery. On balance, headline growth is forecast at 1 percent in 2005 and 1.5 percent in 2006, implying a gradual recovery in working-day-adjusted terms.

Abstract

This 2005 Article IV Consultation highlights that economic activity in Germany is slowly picking up, and there is scope for some further firming of growth in the course of 2006. The recovery, however, remains unbalanced, and strong exports have yet to feed through into higher household spending. Although the risks to the outlook are broadly neutral, an unwinding of global imbalances and higher oil prices could yet provide headwinds for the recovery. On balance, headline growth is forecast at 1 percent in 2005 and 1.5 percent in 2006, implying a gradual recovery in working-day-adjusted terms.

I. Introduction

1. The discussions took place against the backdrop of low trend growth, persistent fiscal pressures, and Chancellor Schröder’s call for early elections. Since the 2004 Article IV consultation, the authorities’ main policy initiative has been implementing the far-reaching Hartz IV labor market reforms in January 2005.1 These were part of Agenda 2010, which provided a forceful start in addressing Germany’s deep seated structural problems (Box 1). Implementing Hartz IV, however, has proved more challenging than expected and continued high unemployment has sapped public confidence. Following the ruling coalition’s loss in the key state elections of North Rhine-Westphalia in May, just prior to the consultation mission Chancellor Schröder called for federal elections in September, one year early in the government’s term, to seek a new mandate for reforms. These surprise elections restricted the depth and specificity of the forward-looking policy discussions. Nevertheless, the authorities welcomed the opportunity to assess economic policy challenges that need to be tackled by any future government, and it was agreed that the discussions would continue in November following the elections. A supplement will report on these follow-up discussions.

II. Background

2. German exports are flourishing but domestic demand continues to languish, resulting in a tepid and unbalanced recovery. Weak domestic demand is driven in large part by necessary adjustments as Germany rebuilds its competitiveness through wage moderation and other efforts by companies and government to improve efficiency and lower costs. Considerable progress has been made in this adjustment process, but persistent weak economic performance—despite strong global growth, accommodative interest rates, and a broadly neutral fiscal policy—suggests that Germany’s problems are structural rather than cyclical.

3. Labor market conditions are difficult and sentiment is weak. The creation of new jobs continues to be stifled by wage rigidities and regulatory hurdles, and the increase in the labor force resulting from the Hartz IV reforms triggered a rise in unemployment to 12 percent (5 million persons, national definition; 9.5 percent on Eurostat definition) in early 2005. This damaged consumer sentiment and muted the government’s enthusiasm for additional reforms. High unemployment continues to restrain wage demands, keeping core CPI inflation low at 1 percent, although rising commodity prices have lifted headline inflation to about 2 percent so far this year (Figure 1).

Figure 1.
Figure 1.

Germany: Economic Performance, 1992-2006

(In Percent)

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Source: IMF, World Economic Outlook.

Past Fund Policy Recommendations and Implementation

In recent consultations, Directors have welcomed the path breaking reforms of Agenda 2010, which were in line with longstanding Fund recommendations. At the same time, they noted that these initiatives needed to be augmented to help overcome the high costs of unification, cope with globalization, and anticipate the pressures from aging.

Fiscal consolidation: Directors endorsed the objective to reduce the structural deficit by 1.5 percent of GDP during 2004–06, but the structural deficit is projected to decline only by 0.4 percent of GDP over this period. Efforts to cut tax expenditures and subsidies have met with little success, and discussions by a parliamentary commission to reform Germany’s complex federal structure and intergovernmental relations were broken off without agreement.

Labor market reforms: Directors have supported Germany’s sustained wage moderation and the successive Hartz (I-III) reforms to help overcome the labor cost shock of unification and strengthen incentives to work. Also, wage determination has become more decentralized de-facto, but there are still constraints on firm-level bargaining. Employment protection legislation, although streamlined, continues to be tight. Most recently, the authorities proceeded with the implementation of the difficult Hartz IV reform. However, political compromises complicated operational aspects of the reform, including overlapping responsibilities between different agencies, incomplete enforcement of eligibility requirements, and some rollback of the reform for elderly workers.

Pension reforms: The introduction of a “sustainability formula” to slow future pension increases was a central feature of Agenda 2010. However, the formula was suspended for 2005, its first year of operation, due to a safeguard clause intended to prevent nominal pension cuts. The recommendation to shift the pensionable age from 65 to 67 has not been followed up.

Financial sector: Supervision is improving in line with the 2003 FSAP recommendations, including by strengthening regulations for reinsurance. Directors also called for reducing impediments to a market driven restructuring of the banking system. Although some Landesbanken have converted into joint-stock companies, overall restructuring is proceeding slowly and the system remains segmented. Good progress is underway in bolstering capital markets, as demonstrated by the fast growth in asset-backed securities.

4. Exports are the bright spot, based on improved competitiveness and a favorable product mix (Box 2). Business restructuring, cost cutting, sustained wage moderation, and low inflation and unit-labor cost growth have helped rebuild competitiveness after the surge in costs associated with unification. Germany’s export mix—dominated by capital goods—has been favored by the global upswing in investment, which has been an additional important factor underlying this success. Moreover, Germany’s exports are oriented to fast growing and oil producing countries, and have gained market share both outside and inside the euro area (text charts and Figure 2). The external current account surplus is projected to be over 4 percent of GDP in 2005.

Figure 2.
Figure 2.

Germany: Competitiveness and Exports 1980-2005

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Sources: Direction of Trade Statistics; and IMF staff calculations.1/ Excludes Belgium and Luxembourg.2/ Three-quarter moving averages.
uA01fig01

Competitiveness has improved…

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Source: INS and WEO.
uA01fig02

…and exports are doing well.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

5. By contrast, household consumption remains weak. Slow growth in household consumption is consistent with fundamentals as wage moderation contributed to slow disposable household income growth and wealth formation was weak in part due to stagnant real asset prices (Box 3). At the same time, saving has increased as households have been lowering their high debt and scaling down their earnings expectations in view of permanently lower growth and cuts in future entitlement benefits.

uA01fig03

Households are lowering debt.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Source: Bundesbank.

Competitiveness

Export strength. Germany became the world’s largest exporter in dollar value in 2004, surpassing the U.S. This development is seen as an indication of recovering competitiveness, following the cost pressures incurred in the early 1990s with unification.

Improving labor productivity. Labor productivity in Germany has grown faster than the EU-15 average. Combined with sustained wage moderation, this has resulted in Germany’s ULC falling by 8 percent relative to the EU-15 since the start of EMU.

Global demand strength. While adjustment efforts have contributed to slow domestic demand, strong global demand boosted Germany’s export volume growth to 9 percent in 2004, substantially higher than the previous year. Econometric estimates suggest that Germany’s exports are more elastic to changes in global demand than to price and REER developments.1

uA01fig04

Export Market Share in Real Terms

(percent)

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Source: Bundesbank
uA01fig05

Labour Productivity Growth

(percent)

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Source: US Conference Board

Favorable trade linkages. In addition to the strength in global demand, Germany’s ties to fast growing markets were also major factors for Germany’s export success. Germany has greater exposure to new EU members, Asia, and the U.S. than most EU partner countries.

Composition of Exports, 2004

(Shares, in percent)

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Source: IFS, IMF.
1 See “Explaining Differences in External Sector Performance Among Large Euro Area Countries” being issued as a background paper for the France, Germany, Italy, and Spain consultations.

German Consumption Growth—a Regional Comparison

Consumption growth has been slow. In the last three upswings, during a period of six quarters following the trough, German consumption rebounded by more than 4 percentage points. By contrast, in the six quarters since the last trough in the fourth quarter of 2003, consumption has stagnated. Other EU members have had much stronger consumption growth.

Income growth has been weak. During 1996–2004 real disposable household income grew by 0.6 percent a year, reflecting slow employment growth and wage moderation. This underperformed the euro area by 1 percentage point a year.

Household saving edged higher. Difficult but necessary cuts in entitlement and unemployment benefits reduced income. Fears about potential job losses may have also led to higher precautionary savings. Household savings rose by 1.4 percentage point to 10.6 percent between 2000 and 2004. The increase in the household saving rate in the EU was about 0.6 percentage points through 2003.

Wealth formation in Germany trailed the international average. Net wealth, mainly comprising housing stock, increased little during 1996–2003, reflecting flat housing prices. In France, Italy, Spain and the U.K., rising home prices boosted wealth.1

uA01fig06

Germany’s household consumption is weak…

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

uA01fig07

…reflecting slow growth in wealth and income.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

1 French net wealth to household disposable income rose by 14 percent during 1996-03, as housing prices rose by 59 percent over this period.

6. Despite improvements in profitability, companies are still cautious about investing in Germany (Figure 3). Salient factors are:

  • Profit growth is concentrated in large export companies, which are integrating their operations into global production chains. This has been illustrated by the steady rise of imports of intermediate inputs for exports. Thus, a growing share of investment is taking place abroad where cost bases are lower2—and where demand is expanding faster—thereby dampening the stimulus from exports to domestic demand.

  • Capacity utilization is below average and domestic cost cutting—rather than demand growth—has been the main factor driving profitability. Against this background, manufacturers continue to reduce domestic employment.

  • Small and medium-sized enterprises (SMEs) have weaker finances and are more oriented toward domestic activity. SMEs undertake about half of domestic investment. With low equity, they depend heavily on the banking system for their financing, which only recently began relaxing lending standards after a period of tightening with the advent of risk-weighted lending and other structural changes in the financial sector. SME financial ratios under perform those of large enterprises in Germany and fall short in international comparisons.3 Thus, adjustment in SMEs appears incomplete.

  • Balance sheet repair is unfinished. The business sector debt-GDP ratio has improved but remains elevated by historical and international standards. Corporate cash flow is still mostly used for debt reduction rather than investment.

  • Finally, construction investment continues to dwindle. Concerns about household income and job losses, combined with excess capacity in the business sector, continue to depress construction.

Figure 3.
Figure 3.

Germany: Profitability, Leverage and Capacity Utilization 1991-2004

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Sources: Bundesbank; German Statistical Office; and IMF staff calculations.1/ In percent of corporate GDP.
uA01fig08

Construction continues to decline.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

7. Fiscal policy has been complicated by structural shifts in the tax bases and moderate growth. Automatic stabilizers have been allowed free play and the fiscal stance has been broadly neutral in recent years. Discretionary expenditure was contained as intended to offset the income tax cuts (amounting to 1 percent of GDP) phased in during 2004–05. Nevertheless, the trend decline in Germany’s main tax base (labor income) and rising aging-related social security expenditures have put considerable pressure on the structural deficit.

uA01fig09

The structural deficit has widened.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

8. Private sector credit has been declining in real terms. Although monetary conditions are accommodating, survey data suggest that the demand for credit has continued to decline owing to a combination of weak economic activity and the efforts by firms and households to reduce debt. Analysis also suggests that banks with weaker capitalization curtailed the supply of credit in 2003–04, although these constraints are now beginning to ease.4 More generally, preparation for Basle II has been a force for changed behavior by German banks, especially the greater focus on risk differentiation. Falling demand for credit, combined with a renewed targeting by private sector banks of SMEs, has heightened competition, triggering a narrowing of lending spreads (Figures 4 and 5).

Figure 4.
Figure 4.

Germany: Interest Rates and Credit Developments

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations.1/ In percent of responses.
Figure 5.
Figure 5.

Germany: Financial Indicators

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Sources: Deutsche Bundesbank, Data Stream; and IMF staff calculations.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 1/3.3/ Yields minus consumer price inflation.4/ Ten-year Bund rate minus 3-month interbank rate.

III. Policy Discussions

9. In the staff’s view, a comprehensive forward-looking strategy is needed to raise employment, investment, and output growth. This strategy needs to be decisive, but implementation could be graduated along a well-specified path, with particular focus on dealing with aging and consolidating public finances and reducing distortions, especially in the labor markets. The call for early federal elections, however, constrained the authorities’ ability to outline concrete policy plans for the future. Nevertheless, the authorities agreed that moving beyond the reforms of Agenda 2010 is imperative to confront the challenges of low growth and high unemployment and address strains on the generous welfare system from demographic change, and also to make full use of the opportunities from greater economic integration both in the expanded EU and worldwide. Moreover, given its size and importance for the region, firm policy leadership by Germany to tackle structural constraints on domestic demand would help reinvigorate growth in Europe, contribute to a reduction in global imbalances, and also encourage reform elsewhere. Against this background, the discussions provided an opportunity to take stock and to discuss the outlines of a possible time-consistent fiscal and structural reform strategy for the post-election period.

A. The Economic Outlook

10. There was agreement that growth in 2005 would be subdued and the outlook was one of only gradual strengthening into 2006. Investment in machinery and equipment is slowly turning up and rising employment and progress in balance sheet repair are expected eventually to assist a broader recovery. The staff forecasts growth of 0.8 percent in 2005 and 1.2 percent in 2006 (the authorities project slightly higher growth in both years). Adjusting for differences in working days, this implies a slow recovery as signs of accelerating activity are still tentative.5 With continued support from the global expansion (albeit at a decelerating pace) and low euro area interest rates, domestic demand is projected to become stronger moving into 2006 (Figures 6 and 7).

Figure 6.
Figure 6.

Germany: Quarterly GDP Growth Contributions, 2004-2006

(Calendar and seasonally adjusted, at annualized rates, in percent)

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Figure 7.
Figure 7.

Germany: Comparison of Business Cycles, 1970-2005

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.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.

Germany: Real GDP Growth, 2003–2006

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Sources: Data provided by the authorities; and Fund staff calculations.

11. The risks to the outlook are broadly neutral, but with domestic demand still weak there is considerable uncertainty about the projections. On the positive side, adjustment efforts are beginning to improve the conditions for a recovery and the downbeat mood might give way to renewed confidence, especially if the elections provide impetus for reform. Exports could yet spark a stronger response in domestic demand and productivity gains spurred by recent reforms may also be greater than assumed. On the downside, the reliance on cyclical exports, combined with the slow response of domestic demand despite strong foreign demand, amplifies Germany’s vulnerability to external developments. Firms’ wait-and-see stance about new investment may persist. Companies may also wait to see what effect higher oil prices will have on consumer and external demand.6 Further, despite signs that the labor market is stabilizing, fears about job security and slow wage growth continue to hurt consumer confidence. The authorities were in broad agreement with this assessment and were particularly concerned about the impact of stubbornly high oil prices and a sudden unwinding of global imbalances and associated risks for German exports. They were also apprehensive about the euro appreciating and becoming more volatile, but expected that greater flexibility in Asia’s managed exchange rate regimes might alleviate some of the risks for the euro.

12. For the longer term, the most critical element in the outlook is the impact of aging on potential output growth. A growth-accounting framework shows that on current policies potential output growth would fall from 1.4 percent a year at present to about 1 percent in the long run, although per capita growth would be more robust at 1-1½ percent a year.7 This decline is largely due to the forceful headwinds from the aging-related decline in labor supply and hours worked.8 This is a problem not only of the future but also of the present, because, in contrast to most other European countries, Germany’s working age population has already begun to decline.9 Deeper reforms that boosted participation rates and triggered a sharp decline in unemployment would attenuate the decline in potential output growth. However, such an outcome cannot be realized with current policies and relative factor prices. The mission therefore stressed that it will be important for the next government to build on the Agenda 2010 reforms by improving incentives and fostering higher labor utilization and potential output growth, which would also ease the strain on public finances.

uA01fig10

Potential output growth is projected to slow as aging unfolds.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Source: Staff calculations.1/ The baseline scenario assumes unchanged policies and a long-run unemployment rate of 8 percent. The optimistic/reform scenario assumes the implementation of policies sufficient to obtain an unemployment rate of 3.3 percent.

B. Fiscal Policy

Fiscal consolidation

13. Germany’s high fiscal deficit is largely structural, reflecting adverse trends in the main tax bases and a generous welfare system. The weakness in labor markets and the need for wage moderation, in the context of an increasingly competitive global environment, have contributed to a secular decline in the labor share of national income. With two-thirds of all revenue derived from wage income, there has been a steady erosion of the fiscal revenue base (Box 4).10 Moreover, social transfers and unemployment insurance costs have increased sharply in recent years, underscoring the feedback from poor labor utilization to the fiscal position.

14. These adverse trends will intensify in the future, making corrective action urgent. The mission’s projections suggest that, on current policies, the structural deficit will widen further in the future because of the acceleration in population aging starting in 2010 and the corresponding slowing of the economy. These widening deficits would lead to long-run debt sustainability problems. Even in more optimistic scenarios with higher growth and lower unemployment, as in the authorities’ first Long-Run Fiscal Sustainability Report, the fiscal gap would still widen sharply, making it necessary to take action to bring public finances in line with long run sustainability (Figure 8).11

Figure 8.
Figure 8.

Germany: Fiscal Projections, 2000-50

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Source: IMF staff calculations.

Why is Germany’s Fiscal Deficit so Large?

The recent fiscal deficits of 3½–4 percent of GDP are the largest in the last six decades. They are also larger than in the 1990s during unification. No sudden shocks explain the current deficits, but the persistent pressures from globalization and aging are changing the structure of production and forcing firms to contain wage costs. The procyclical fiscal policies during 1998–2000, when growth was strong, have also contributed to current difficulties.

Changes in Germany’s economic structure have gradually eroded the tax base and caused new spending pressures. The main tax base is labor income, which yields about two-thirds of all fiscal revenue. This dependence exceeds even that of the Scandinavian countries. However, the labor income share in GDP has been declining over time, while the cost of unemployment insurance has increased. In response, and under German legislation, payroll tax rates have increased from 26 percent in 1970 to 42 percent at present, putting further pressure on labor markets. Employment gains have shifted to low-wage and part-time jobs, away from full-time/full-benefits jobs. Correspondingly, the number of jobs subject to social security contributions has declined. As a policy implication, shifting some revenue collection toward indirect taxes combined with further entitlement reforms could alleviate the pressure on payroll charges and lower employment costs.

uA01fig11

Labor Income as a Tax Base

In percent of total fiscal revenue

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

uA01fig12

Labor Income Share

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Thus, despite adjustment efforts in 2003–04, the structural deficit remains high. Tight management of public investment, the wage bill, and other discretionary spending, and the unanticipated benefit of low interest rates have helped to offset the revenue losses associated with the income tax cuts. But the additional pressures on the deficit from a changing structure of production and aggregate demand and aging have not yet been overcome. Efforts to address these new pressures have included limits on pensions, health, and unemployment benefits. Nevertheless, the structural fiscal deficit remains over 3 percent of GDP. Without further steps, demographic shifts and rising interest rates are likely to continue to intensify the fiscal headwinds in future.

15. A public sector balance sheet showing the government’s unsustainable intertemporal position under current policies provides further insight into the size of this fiscal challenge (Box 5).12 An illustrative balance sheet estimated by the mission combines information on government assets and liabilities with the net present value (NPV) of future fiscal deficits from the long run fiscal baseline described above. At over 300 percent of GDP, the resulting estimate of the net liability position of the public sector underscores Germany’s unsustainable intertemporal fiscal position and the need to address the issue head-on. The long run impact of the measures of Agenda 2010, which are estimated to have reduced the NPV of future deficits by 70 percent of GDP, is large but insufficient to address the threat to fiscal sustainability. Nevertheless, bringing this information to the public, with regular updates, would help to show the long run benefits of such difficult reforms.13

16. The authorities agreed that future deficit pressures are a serious concern and have ruled out expansionary fiscal policies to boost growth, but indicated that the deficit would still remain high in 2005 and 2006. They noted that substantial discretionary spending cuts had been implemented over the past two years during a period of weak growth to compensate for tax cuts, but they were reluctant to make significant additional cuts in a period of slow recovery. On current policies, the staff projects a general government deficit of 3.9 percent of GDP in 2005 (compared with 3.7 percent projected by the authorities), and little improvement in 2006. Apart from growth being weaker than originally forecast, the authorities explained that unexpected developments had complicated budgetary execution in 2005, resulting in a wide deviation from the original 2005 fiscal deficit objective of 3 percent of GDP:

  • The Hartz IV labor market reforms turned out more expensive than expected. Instead of lowering costs, additional outlays of about ⅓ percent of GDP are expected. Means-testing had been deficient and income support turned out to be more costly than expected.

  • Weakness in employment subject to social security contributions put pressure on the pension system. Further, the sustainability formula, designed to decouple growth in pensions from nominal wages as the dependency ratio rises, had been suspended for 2005—its first year of operation. As wages have been flat, applying the pension adjustment formula would have resulted in a reduction in nominal pensions, triggering a safeguard clause in the legislation to prevent such cuts.

  • The 2004 reform had improved health care finances only temporarily. Current trends suggest a shift back into deficit in the health care programs in the coming years.

A Preliminary and Illustrative Public Sector Balance Sheet

A public sector balance sheet can be a useful indicator of intertemporal health of the public finances. The balance sheet is intended to reflect all assets and liabilities of the general government. In addition, the long-run projections of future fiscal balances can be discounted and their net present value can be entered in the balance sheet to capture implicit liabilities.

A preliminary balance sheet for Germany suggests intertemporal fiscal inconsistency. Combining the debt already issued with estimates of the net present value of debt to be issued in the future under current policies provides information on the intertemporal net financial position of the general government. This approach suggests a negative net worth of the public sector of 324 percent of GDP.

The balance sheet can provide guidance to policy options. By systematically quantifying the future impact of fiscal and structural measures, the balance sheet can help to show the costs and benefits of fiscal and structural measures and thus promote transparency.

It can also help to clarify public debate. The public can assess progress toward safeguarding fiscal solvency if policy options are presented within the time-consistent framework of a balance sheet. Without such a framework, the confidence boosting effect of economic policies may be lost, because the benefits would become visible only in the long run. For example the entitlement reforms in Agenda 2010 have yet to gain public recognition for their large improvement (some 70 percentage points of GDP) in net worth between 2003 and 2004.

General Government Balance Sheet (preliminary)

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Sources: Bundesbank; Ministry of Finance; and Fund staff calculations.

Staff projections of fiscal balances for a rolling 50-year period (baseline scenario) discounted at the average interest rate on government debt. Figures for 2004 include the impact of reforms of Agenda 2010.

Germany: Fiscal Balance under Current Policies

(In percent of GDP)

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Takes into account trend changes in tax bases relative to GDP.

The change in the structural balance equals the change in the overall balance minus the cyclical and one-off effects.

17. In view of these pressures, the authorities have resorted to one-time financing measures to meet the constitutionally-mandated golden rule.14 In the pension system, the government plans to advance the collection of contributions by half a month in 2006, thus receiving 13 installments next year. In addition, the securitization of future debt service payments on Russian Paris Club debt owed to Germany provided cash-flow relief in 2004 and 2005, and the securitization of pension receipts in the postal system will reduce financing needs in 2005 and 2006. Meanwhile, Länder are benefiting from the reimbursement by the Landesbanken of their interest subsidies, which were prohibited in the context of the abolition of public guarantees for these banks. Even though most Länder will return a similar amount of funds to public banks to avoid their decapitalization, these outlays are registered as an equity injection on market terms below-the-line,15 resulting in one-off receipts of ¼ percent of GDP over two years.

18. The mission stressed that such one-off policies should be avoided and replaced by a comprehensive forward-looking fiscal strategy to deal with the structural changes in the economy. Specifically, the mission recommended early action to bring the structural fiscal position to balance by 2010 when aging accelerates, and to forestall adverse market reactions if structural and fiscal problems remained unaddressed. This goal will require annual structural fiscal measures of at least ½ percent of GDP, a reasonable pace with the rate of growth at or above potential. Further fiscal measures would be needed beyond 2010 to keep the fiscal balance in an appropriate range because expenditure pressures will continue to grow as aging unfolds. Adjustment should focus on high-quality durable expenditure cuts rather than increases in tax rates, and take advantage of the important synergies between fiscal reform, recalibrating entitlements, and reforming the labor market.

Durable adjustment and tax reforms

19. Future adjustment policies need to put priority on spending cuts and expanding the tax base. The mission noted that there is room for cuts in all three of the main welfare/entitlement blocs:

  • Households and workers receive generous benefits including housing and commuter subsidies, tax exemptions for work on Sundays and holidays. These benefits have grown over time to become an integral part of the welfare state.

  • Corporate welfare is also a burden, with special depreciation rules, loss carryovers, energy and sectoral subsidies (e.g., in agriculture).

These subsidies and tax expenditures for households, workers, and corporations amount to as much as 6 percent of GDP (as estimated by the Koch-Steinbrück Commission). They need to be cut drastically but have proven politically resilient.

  • General entitlement benefits also need further cuts. Options here include cuts in long term care insurance, new steps to limit growth in health care spending, lowering the high cost of unemployment benefits, and shifting the pensionable age from 65 to 67 years of age (as had been proposed by the Rürup Commission). Increasing discounts for early retirement and premia for delayed retirement to improve the actuarial balances, as in France, should also be considered. Such steps could help limit the adverse effect on aggregate demand as they would simultaneously improve labor utilization. The authorities noted that the effective retirement age is going up gradually, including by increasing the age at which unemployed workers qualify for early retirement. Raising the statutory retirement age would need to be considered again by the next government.

20. There was agreement that significant increases in payroll taxes should be avoided to combat the erosion in full time employment and bolster labor utilization. The authorities, however, noted that there are differences of view across the political spectrum about how this should be achieved. Regarding the funding of healthcare, one proposal is to widen the contribution base by including capital income and contributions from individuals presently in private health care programs (Bürgerversicherung). An alternative proposal is to replace the healthcare payroll tax with a lump sum contribution per adult, while using general revenue to compensate those with low earnings (Gesundheitsprämie). Draft legislation on any of these proposals will have to wait until after the elections. The election has also generated a debate about the pros and cons of raising the VAT to finance a reduction in the unemployment insurance contribution rate.

21. Corporate income tax reform has moved higher on the policy agenda. Earlier this year, the government sought a six percentage points cut in the federal corporate income tax (CIT) rate (bringing the overall rate to 32 percent), financed by reducing corporate deductions and exemptions. However, political parties did not agree on how to distribute the burden of offsetting measures and the proposal was not implemented. Noting that Germany has a high CIT rate but low revenue yield, the mission said that reform would be worthwhile but emphasized that any cut in tax rates should be fully compensated as fiscal consolidation needs to be the top priority. Further, tax reform should be framed in a comprehensive way to avoid further complicating the tax system, with the emphasis on broadening the tax base. The authorities noted that the Council of Economic Experts has been asked to prepare a CIT reform proposal by the end of 2005.

uA01fig13

The Statutory corporate tax rate is high, but the revenue yield is low because of widespread exemptions

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Fiscal institutions

22. Views differed on whether an independent fiscal council could play a useful role in fostering sound policies. The mission suggested that an annual review by such a council that reports to parliament could enhance transparency by vetting the government’s policies from a long term perspective and also help make the case for reforms. Although the authorities saw merit in these goals, they noted that Germany already enjoys an extensive outside review of policies, including by the Council of Economic Experts and through twice yearly consultations on tax projections with a group of renowned economic research institutes. Therefore, they felt that installing a fiscal council would add to costs while offering small benefits. Instead, the government intended to update periodically the new Long-Run Fiscal Sustainability Report to strengthen communication and transparency. The mission noted that as macroeconomic and budgetary forecasts generated by non-partisan entities tend to be more accurate than those produced by governments, they could contribute to the formulation of more realistic budgets and long-range projections. Further, to be effective the proposed fiscal council should have a formal mandate, democratic legitimacy, accountability, and clear channels for policy dialogue and communication.

23. Amending features of Germany’s fiscal federalism will be essential to strengthen fiscal management and overcome reform gridlock. The authorities concurred that aspects of the system had outlived their usefulness and needed to be modernized. Reform proposals had consistently run into difficulty because of the relative ease with which these can be blocked in the Bundesrat, which is controlled by the Länder, who have diverging interests.16 The mission recommended that modernizing the system should be a priority, with emphasis on the following areas: (i) reducing the number of laws that need the approval of both chambers of parliament; (ii) creating some leeway for competition between subnational governments to make tax and expenditure policies more efficient and to encourage fiscal consolidation; (iii) strengthening the Internal Stability Pact by including clear commitments of various levels of government, including individual Länder, to help ensure consistency in the overall policy framework; and (iv) cutting redundancies and aligning better the tasks among different parts of government to improve fiscal management.17

C. Labor Market Issues

24. Higher employment growth holds the key to stronger potential output growth. Disequilibria in labor markets have been persistent, with significant underutilization of labor (both in persons and hours worked) because of high costs and rigidities. These employment barriers and high reservation wages induced by the generous welfare system especially affect elderly workers, women, and those with lower productivity. Valuable progress has been made to begin tightening unemployment and welfare benefits and improve incentives to work with the Agenda 2010 reforms, and large enterprises have taken the lead to begin expanding the average hours worked per week. The challenge now is to improve structural conditions to boost the creation of jobs and labor demand.

25. The Hartz IV reforms have boosted labor supply. The authorities noted that the merger of the open-ended unemployment assistance and social assistance into a new unemployment benefit (UB-II) program in early 2005 had brought former welfare recipients into the labor force. Consequently, labor supply rose by nearly half million persons (1 percent of the labor force), and the unemployment rate jumped by a full percentage point in the national definition in the first few months of the year (Figure 9).

Figure 9.
Figure 9.

Germany. Employment Growth and Coverage of Collective Wage Agreements

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Sources: Federal Agency for Employment; and Institute for Labor Research (IAB).1/ Share of employees directly and indirectly covered by wage agreements in 2003: 85 percent (West) and 77 percent (East).

26. However, the Hartz IV reforms on their own appear insufficient to yield durable improvements in the labor market. Although the government’s perseverance in introducing these reforms is commendable, employment growth has so far been concentrated in temporary work and the self-employed. High labor costs and labor market rigidities still hold back demand for full-time employment. In particular, Germany’s tax wedge on labor income remains among the highest in advanced countries.

uA01fig14

Payroll taxes remain very high

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

27. Further reforms are needed to revitalize labor demand. The mission called for policy adjustments in two areas. First, formal wage determination is centralized and responds insufficiently to local labor market imbalances and productivity differentials. Second, high reservation wages supported by the generous welfare system for entry level and low skill jobs prevent adequate job creation, considering that most of the long term unemployed have low productivity. Reducing central controls on wage bargaining in favor of more firm level bargaining should therefore be a priority. The mission also recommended loosening employment protection legislation (EPL) to boost employment by lowering job turnover costs and reducing labor court involvement, which has become more prominent over time. In the authorities’ view, however, wage bargaining has already become more flexible because of widespread “opening clauses,” resulting in large intersectoral pay differentiation. Moreover, they noted that EPL had been relaxed in 2004, but considered it too early to draw firm conclusions about its impact.

uA01fig15

Unemployment-II recipients July 2005

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

28. The UB-II system created by the Hartz IV reform has the potential to become an effective welfare-to-work program. The authorities explained that of the 4.8 million participants in UB-II, 40 percent were employed and received “top up benefits” to raise their income to a social minimum. The program thus has some features of a negative income tax and its design now needs to be fine-tuned to improve incentives to work. High marginal income taxes for those that qualify for UB-II are a disincentive to look for work and need to be reduced. Moreover, it will be important to apply means testing and job search requirements more firmly. The mission recommended against diluting the reform by prolonging the duration of unemployment benefit payments for older workers, as such actions create uncertainty about the government’s resolve. Nevertheless, the duration of benefits for elderly workers was subsequently extended to limit social hardship.

D. Product and Service Markets, and Trade Policy

29. Further deregulation in product and services markets will be essential to facilitate the structural shift from manufacturing to a more service based economy.18 Numerous studies have pointed to supportive interactions between product and services market reforms and employment growth. Although Germany’s overall regulations rank close to the EU-15 average (Figure 10), a specific breakdown suggests relatively high barriers and impediments in administrative product market regulations, liberal services, and for full time employment.

Figure 10.
Figure 10.

Germany. Market Regulation Indices Relative to the EU-15 Average: 2003 1/

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Sources: OECD; Copenhagen Economics, Institute for Advanced Studies; and IMFstaff calculations.1/ Observations depict the value of Germany’s regulation index relative to the EU-15 average.A value of zero indicates that the regulation index in Germany is at the EU-15 average, a positive (negative) value measures higher (lower) levels of regulation.

30. The authorities reported progress in reforming markets for network industries. Past difficulties in the energy sector with respect to network access and high electricity prices are being addressed. An agency with an expanded mandate to supervise electricity grids, gas and railway networks is scheduled to become operational in August 2005, and has been charged to devise incentive-compatible pricing mechanisms. Moreover, the postal monopoly on letters of up to 50 grams will expire in 2006.

31. Further efforts to lower barriers to entry in the services sector would improve the climate for running small businesses and boost job creation. The mission noted that this is especially important for professional services where the restrictiveness index is substantially higher than the EU-15 average. Opaque rules in administrative regulation, state control, and barriers to entrepreneurship also create unnecessary costs and impede entry. The authorities pointed to progress in the areas of craftsmanship and regulated professions, especially lowering entry barriers and removing master certificate requirements for 53 out of 94 specific activities. They also explained that negotiations on the EU Services Directive were continuing. Preliminary estimates by an expert working group suggest that Germany’s highly skilled engineering, construction, and R&D sectors could benefit substantially from the Directive by generating increased access to other EU markets. At the same time, the authorities remained concerned that the country-of-origin principle could lead to a “race to the bottom” for service sector standards. Hence, they were as yet reluctant to endorse this principle and were seeking adequate safeguards for quality standards and exemptions for key sectors such as health care. The mission encouraged the authorities to preserve the country-of-origin principle, while limiting exemptions only to the most sensitive areas and for a transition period.

32. Regional integration and the lower cost base of the new accession countries have been prominent in the domestic debate. The authorities said that the public perceives increased competition from trade liberalization and migration as a threat to domestic investment and employment. The mission pointed out that it is insufficiently recognized that integration provides opportunities to exploit comparative advantage to mutual benefit, with gains from integration that accrue to consumers as well as exporters in the region over time. If the focus is on protecting current domestic advantage, the accrual of mutual gains will be thwarted. Meanwhile, Germany has invoked limits on the free migration of labor from the new accession countries for a transition period.

33. The authorities support multilateral trade liberalization. In the context of the Doha round, Germany has backed a reduction in tariffs, liberalization of trade in services, and a cut in agricultural subsidies.

E. Financial Sector Developments and Policies

34. Financial sector performance is improving and there has been some progress in addressing structural weaknesses. The authorities noted that recovery of banking profitability has continued into 2005, from the trough experienced in 2003 (Figure 11). Cost-income ratios are improving, there has been progress in cost cutting, and buoyant financial markets are boosting income. Bank capitalization is also improving, partly by disposing of impaired assets, and provisioning has tapered off. The purchase of Germany’s third largest private bank by an Italian bank is seen as a breakthrough in financial sector restructuring and a welcome sign of the German authorities’ openness to such cross-border mergers. The insurance sector is also recording higher earnings and stronger capitalization. The authorities’ stress tests—using the FSAP methodology—have been encouraging for banks and insurance companies. Although Germany’s moderate growth might trigger some instances of strain within the financial sector, the probability of systemic risks are judged to be small.

Figure 11.
Figure 11.

Germany: Relative Market Valuation and Distance to Default 1/

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Sources: Data Stream; and IMF staff calculations.1/ Market valuation relative to the aggregate stock market index. Distance to default approximates financial soundness and is calculated as the sum of the ratio of the estimated current value of assets to debt and the return on the market value assets. The calculations cover the four largest banks and fifteen largest insurance companies (January 3, 2000 = 100).

35. The authorities also pointed to the important steps taken by the Landesbanken to prepare for the phase out of state guarantees. To mitigate the immediate liquidity impact, Landesbanken had stepped up their issuance of long term bonds, which qualify for grandfathering provisions and lock in guarantees until 2015. Moreover, back office and product development cooperation between the Landesbanken and the Sparkassen (savings banks) has been intensifying. The number of Sparkassen and Volksbanken (cooperative banks) is gradually declining. These developments had been recognized by ratings agencies, as most Landesbanken had secured ratings in the single-A range, while Sparkassen tended to be rated somewhat higher.

36. Notwithstanding these developments, the mission noted that Germany’s banking sector performance continues to fall short of international peers. In particular, the banking sector has been one of the least profitable in the EU. Further, impaired loans are over 5 percent of total loans, while unprovisioned (but typically collateralized) impaired loans remain high at nearly 47 percent of capital in 2004 (see table below and also Table 4). The authorities noted that the secondary market for nonperforming loans has grown rapidly and is facilitating the cleaning of banks’ balance sheets.

uA01fig16

Bank profitability is below peers.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

Germany: Comparative Banking Sector Indicators, 1999–2004

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Sources: Data provided by the authorities; and Fund staff calculations.

Based on the German definition of nonperforming loans (“loans with a loss provision requirement”), which differs from the definition proposed in the IMF’s Compilation Guide on Financial Soundness Indicators (“loans with principal and interest payments past due or delayed by 90 days or more”), thus affecting international comparability.

37. The segmentation associated with Germany’s three pillar banking system continues and impedes revenue growth. Moreover, the regional principle, whereby Sparkassen and Volksbanken are confined to do business in their communities of origin, limits competition and concentrates risks. Further, Landesbanken still face the task of developing viable business models in the absence of state guarantees. In some instances, injections of public funds have shored up capital, and further consolidation seems necessary. The authorities agreed further consolidation is likely, but reiterated that fostering regional competition among public entities was largely a matter of state, rather than federal law.

uA01fig17

The banking system is highly segmented.

Citation: IMF Staff Country Reports 2006, 016; 10.5089/9781451810493.002.A001

38. A more dynamic banking system would be better positioned to support growth. The mission reiterated the importance of harnessing market signals to guide restructuring, noting that several Länder still need to adopt legal frameworks that facilitate the mobilization of private capital, including by transforming public sector banks into joint stock corporations. Further, dismantling regional barriers to operating public sector banks would help achieve greater scale economies and diversify risk. The authorities noted that regional barriers had begun to soften, as the nascent market for collateralized debt obligations allowed regional banks to diversify credit exposure. Entry of foreign banks in the retail market had also already instilled more dynamism. In addition, the authorities noted that silent partnerships—akin to placing subordinated debt—have facilitated, at least in principle, the entry of private capital into public banks, but agreed with the mission that private funding is still small.

39. Further steps are needed in the insurance sector, notwithstanding improvements in profitability and solvency. These improvements are mainly concentrated in the nonlife sectors, while a key issue in the life sector remains how to combine strong competition in a fragmented market with the requirement that at least 90 percent of profits be distributed to policyholders. The mission reiterated that eliminating the mandatory 90:10 profit split would provide flexibility to replenish reserves during times of duress, and consumer protection goals could be achieved through other means, including better disclosure requirements. The authorities elaborated that capitalization in the insurance sector would be sufficient to meet higher requirements, which will come into effect with the introduction of Solvency II. At that time, the mandatory profit split could be rescinded.

40. The authorities noted that the financial sector regulatory framework had been further enhanced in response to FSAP recommendations. The number of supervisory staff have been increased and regulation of the reinsurance sector has been enhanced by bringing solvency requirements, licensing, investment rules, and other key regulations on par with direct insurance. The mission welcomed these steps, but noted that financial sector transparency needed to be raised further. Several FSAP recommendations still needed follow up, including publishing more timely financial soundness data, in particular on impaired loans. Adopting minimum quantitative criteria for classifying impaired loans will also be important and the rules for granting and monitoring loans to related parties need to be strengthened. The authorities plan to address these two issues with the implementation of new EU regulations, and have also committed to publishing the full set of core financial soundness indicators by December 2006 building on the good progress in this area in 2005.

41. There have been noteworthy advances in capital market development. The authorities explained that the new Pfandbrief law of July 2005 has leveled the playing field in the mortgage industry, and is expected to foster a competitive mortgage bond market.19 The market for other asset-backed securities and impaired loans is growing quickly, offering institutions additional instruments to manage their exposures. The creation of real estate investment trusts has been held up by tax complications, which are being analyzed. Finally, developments in funded pension schemes such as the second pillar (corporate) and third pillar (Riester) pensions are also likely to stimulate the German financial system, as they have done in other countries.

F. Other Issues

42. AML/CFT legislation has been strengthened, including with ratification of the UN Convention for the Suppression of Financing of Terrorism (1999). The Third EU AML Directive is expected to become part of German law by mid-2007. The German Financial Supervisory Authority (BaFin) is building up its AML/CFT audit unit.

43. Germany’s statistics are adequate for surveillance. Collecting national accounts data on inventories and compiling quarterly accounts for the general government would be an important enhancement. The authorities are participating in the IMF’s Coordinated Compilation Exercise for Financial Soundness Indicators (FSIs); this exercise should produce the first data and metadata as of end-2005. In July 2005, the authorities received a STA mission, which is now preparing a ROSC on statistical and data issues.

44. Germany aims to increase official development assistance from 0.3 percent of GDP in 2003 to 0.5 percent by 2010, depending on economic and fiscal conditions.

IV. Staff Appraisal

45. Germany needs a decisive, forward-looking policy strategy to confront the serious challenges it faces. Adjustment is making the economy more flexible but substantial policy challenges remain to boost potential growth and secure fiscal sustainability. First, high labor costs and rigidities have contributed to intolerable unemployment, especially for the most vulnerable. Second, Germany is at the cusp of a powerful demographic shift and long run simulation show that public finances and long-standing welfare programs are not sustainable under current policies. Third, globalization and the expanded EU offer valuable opportunities and need to be embraced for Germany’s own advantage. Agenda 2010 was a forceful start in reforming entitlement systems and labor markets, and will yield sizeable and lasting benefits. However, the unmet challenges require additional steps that include fiscal consolidation and a reorientation of policies to reduce distortions, especially in the labor markets. The strategy must be decisive, with firm implementation and a clear explanation of the policy steps and their timing. Such an approach offers the best prospect for building confidence and revitalizing growth. And, given Germany’s size and influence, it would also set a powerful example for other countries in the region and contribute to a reduction of global imbalances.

46. Growth is projected to strengthen in the second half of 2005 and in 2006, but it remains unbalanced and is highly dependent on the external environment. The corporate sector is adapting to a more competitive world by cutting costs and wage moderation has been sustained. As a result, competitiveness has improved and exports have been strong. Yet, exports have been slow to ignite domestic demand as firms and households remain cautious about spending. An abrupt unwinding of global imbalances and rising oil prices may yet frustrate the recovery. Revitalizing demand on a sustained basis will require further progress in addressing Germany’s domestic impediments.

47. The fiscal deficit is largely structural and long run projections suggest that current policies are unsustainable. There has been a secular decline in the largest tax base, wage income, while high and long lasting unemployment benefits and social transfers exert pressure on expenditure. More fundamentally, the public debt ratio is projected to increase sharply as aging raises expenditure on pensions and health care. Corrective action is therefore urgent. Policies need to be realigned with what a declining population can reasonably deliver, and expectations on output growth and income need to adjust accordingly. Indeed, important synergies exist between public finances and labor market and social security reform.

48. In light of the increasing pressure from aging, policies should aim to eliminate the structural deficit by 2010. This goal requires high quality measures of at least half percent of GDP a year, with additional efforts after 2010 as aging unfolds. Resorting to one-off measures such as assets sales or bringing forward future revenue streams to meet the golden rule does not address the fundamental fiscal problem and should be avoided. The fiscal strategy should combine three elements: durable expenditure cuts, adjusting entitlement outlays, and tax reform:

  • There is ample room to cut subsidies and tax expenditures. Even moderate but durable cuts can add up to significant savings over a long period.

  • Current entitlements are too costly and will exert growing pressure on payroll taxes if left unaltered. An equitable recalibration of benefits that includes increasing the retirement age and shifting health care financing away from payrolls can contain nonwage labor costs and other taxes. This will also help raise employment and investment.

  • Tax reform should aim at simplifying the tax code and lowering payroll taxes, possibly with some shift to indirect taxes. However, as the priority should be fiscal consolidation there is no room for uncompensated tax cuts. Hence, any plans to lower tax rates should be fully financed with base broadening and cuts in tax expenditures and subsidies. Piecemeal adjustments should be avoided as they further complicate the tax system and reduce yield.

49. Improved transparency and more effective communication about the need for reforms would help garner public support and strengthen confidence. The government’s Long-Run Fiscal Sustainability Report is an important innovation but it uses assumptions that render its findings too optimistic. Appointing an independent fiscal council to prepare an annual assessment of the public finances for parliament could provide more realistic forward looking perspectives and better identify policy successes and failures. Also, preparing and publishing a public sector balance sheet, which shows the net present value of the path of future deficits, would increase transparency of the intertemporal fiscal position and help convince the public of the need for reforms and their long run value in strengthening public sector solvency.

50. Efforts to reform intergovernmental fiscal relations should be revived to provide incentives for better fiscal management. The current system has become outdated and is hampering consolidation. Reforming federal structures is complex but progress can be made by creating some leeway for competition at the subnational government level to make tax and expenditure policies more efficient and to encourage consolidation; strengthening the internal stability pact by including clear commitments of various levels of government; and cutting redundancies and aligning better the tasks among different parts of government to improve fiscal management.

51. Raising labor utilization is critical to mitigate demographic pressure on growth and public finances. The government’s perseverance in introducing the difficult Hartz IV reforms is commendable because the new system has improved incentives to work. However, by themselves these reforms are not sufficient for durable employment growth as high labor costs still hold back demand for full time employment. To reap the full benefits of the reform, its implementation needs to be improved by reducing the overlap of functions between the Labor Office and local governments, and by tightening means testing and the enforcement of job search requirements. Further, the new UB-II program can become a more effective welfare-to-work program by improving incentives for participants to increase labor income while receiving partial benefits.

52. As more workers are now looking for jobs, greater emphasis needs to be put on reforms that increase labor demand. Wage determination needs to respond better to labor market imbalances and more closely reflect productivity differentials, including by permitting lower wage floors for entry level and low skill jobs. Lowering the wage wedge and reducing remaining central controls on wage bargaining in favor of more decentralized and firm level bargaining will also be essential. Moreover, cutting employment protection legislation would boost participation and employment, in particular for those with little work experience or skills.

53. Product and services sector reforms would reinforce labor market reforms by increasing competition and enhancing productivity. Establishing a business climate that is more favorable to creating and running small businesses, particularly in the service sector, is a priority to boost job creation. This will require a further reduction of service regulations and administrative hurdles in regulated professions and crafts. Germany’s support for an EU Services Directive that preserves the country-of-origin principle and limits exemptions to the most sensitive areas for a limited transition period would also serve the country well because its high skilled engineering, construction, and R&D sectors could gain by obtaining easier access to EU countries.

54. Financial sector profitability is recovering, but a more dynamic banking system would be better able to support growth. Cost cutting, lower provisioning, and favorable financial market conditions have improved performance. Changes in the public banking pillar, including intensifying cooperation between Landesbanken and Sparkassen, are welcome. Landesbanken have shored up their liquidity by raising long term funding prior to the withdrawal of state guarantees in July 2005, but they still need to develop viable business models. Although there may be isolated instances of strain, the likelihood of systemic difficulties is small. Nevertheless, performance of the German financial system tends to lag EU partners because of the sector’s continued fragmentation, which continues to limit economies of scale and growth.

55. Amending the legal framework to support market-based restructuring of the banking system remains a policy priority. Consolidation within and across the three pillars of the banking system continues to be hampered by restrictive Länder legislation. Outdated regional barriers limit risk-pooling and may be unnecessary to protect local banks, which enjoy an information advantage with regards to local clients. Moreover, opening up public sector banks to private capital by transforming them into joint-stock companies more decisively than has been done so far would facilitate market driven restructuring, foster synergies and returns to scale, and help direct funds more readily to areas of highest investment needs.

56. Supervision and regulation have been strengthened, but there is room to enhance transparency. Supervisory capacity has been reinforced and regulation of the reinsurance sector has been strengthened. It will also be important to abolish the mandatory 90:10 profit split between insurers and policyholders as envisaged when the EU Solvency II comes into effect. The transparency of the system would be aided by publishing more timely financial soundness data, in particular on impaired loans. The liberalization of the Pfandbrief law should help further advance capital market development.

57. Germany’s statistics are adequate for surveillance, and its participation in the IMF’s Coordinated Compilation Exercise for FSIs is welcome. Collecting and publishing inventory data would facilitate the monitoring of real sector developments.

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

Table 1.

Germany: Basic Data

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

Growth contribution.

National accounts definition

Eurostat definition.

Deflated by the national accounts deflator for private consumption.

Table 1.

Germany: Basic Data (concluded)

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Sources: Deutsche Bundesbank; Federal Statistical Office; IMF, World Economic Outlook; IMF, International Financial Statistics; and staff estimates and 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)

Including supplementary trade items.

From 1999 onward data reflect Germany’s position in the euro area. Data for 2005 refers to June.

Data for 2005 refer to a change from July 2004 to July 2005.

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

Data for 2005 refer to August. Exchange rate is the average of the year.

Data for 2005 refer to July

Based on relative normalized unit labor cost in manufacturing.

Table 2.

Germany: General Government Finances

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Sources: Ministry of Finance; and Fund staff projections based on continuation of current policies.
Table 3.

Germany: Balance of Payments

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Sources: Deutsche Bundesbank; and Fund staff projections (WEO).
Table 4.

Germany: The Core Set of Financial Soundness Indicators for Banks, 1998-2004

(In percent)

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Sources: Deutsche Bundesbank; IFS; and Fund staff estimates.

According to Capital Adequacy Regulation, Principle I.

Prudential supervision liquidity ratio. Data not available before July 1, 2000.