Economic Situation

The upswing of the German economy continued in 2007, supported by sound fundamentals. At 2.5 percent, real GDP grew considerably faster than initially expected. The unemployment rate declined by 1½ percentage points and external competitiveness remained strong. Furthermore, the general government posted a balanced budget for the first time since reunification and well ahead of schedule. Economic activity remained largely unaffected by the fiscal contraction, high oil prices, the euro appreciation, and the financial market turbulences. Meanwhile, inflationary pressures have clearly intensified and are expected to moderate only gradually.

The German economy is increasingly benefiting from the sustained adjustment efforts in the private sector and the broad and far-reaching reforms implemented over the past several years. Unfortunately, these reforms go largely unmentioned in Box 1 discussing previous policy implementation. They essentially comprise policy measures in the labor market and structural changes in the social security system, combined with a phased strategy of expenditure-based fiscal consolidation. At the same time, my authorities are well aware that further challenges lie ahead.

For 2008, the government projects economic activity to slow to 1.7 percent, which is somewhat above the staff projection. Growth will be driven mainly by private investment and a gradual strengthening in private consumption. Factors supporting consumption include higher employment, a pick-up in wage growth, and a further lowering of unemployment insurance contributions.

My authorities consider the risks to their forecast to be broadly balanced. They agree that developments in – international and domestic – financial markets give rise to particular uncertainty at this juncture. The economy appears, however, well-placed to weather tensions in this context, given high capacity utilization and a large order backlog in the manufacturing sector. Also, sentiment among businesses remains fairly positive and balance sheets are generally strong. Reliance of German businesses and households on external financing is relatively low. Moreover, available evidence points only to a moderate tightening of lending standards, also when compared to the rest of the euro area. Furthermore, growth of credit to businesses remains undiminished. That being said, vigilance is warranted going forward.

Fiscal Policy

The steep reduction of the fiscal deficit ratio by 3½ percentage points since 2005 has been the result of buoyant revenues and sustained expenditure restraint, and was supported by improving cyclical conditions. The public spending ratio declined from 48½ percent to 44 percent of GDP over the last five years. This has been accompanied by efficiency-enhancing reforms strengthening both the tax structure and the composition of spending.

My authorities are keenly aware of the remaining challenge of securing long-term fiscal sustainability in the face of rising aging-related costs. As laid out in the latest Stability Program, Germany is going to keep the general government budget close to balance or in surplus, in line with the Stability and Growth Pact. As a part of this policy, the government intends to eliminate the deficit at the federal level by 2011. Among the reforms needed to ensure long-term sustainability are further measures to increase competition and transparency in the healthcare system.

The government is confident that the modest and temporary increase in the deficit expected this year is consistent with their proven strategy of growth-oriented fiscal consolidation. The temporary loosening is mainly the result of the coming-into-effect of the corporate income tax reform at the start of this year as well as the further round of reductions in unemployment insurance contributions, which will further foster employment. Both steps, along with the ongoing redirection of spending towards R&D and education, will promote growth and thus fiscal consolidation down the road.

Indeed, the fiscal loosening that is already in the pipeline for 2008 may prove opportune from the point of view of cushioning the incipient softening of economic activity. In the event of a stronger-than-expected downturn, automatic stabilizers would be the effective way to further support the economy.

Strong fiscal institutions are an important element in promoting prudent policies. The existing constitutional golden rule has shortcomings in that it leaves undue room for discretion and lacks symmetry between cyclical upswings and downturns. Building on the first round of federalism reforms of 2006, my authorities plan a revised deficit rule in a second round of reforms next year. They are of the view that, by ensuring a structurally balanced budget, the new rule is sufficiently ambitious. They are not convinced of the need for a contingent requirement of further belt-tightening as suggested by the staff. The government will continue to update its estimates of aging-related costs, including through its periodical sustainability report, and take corrective measures as needed. Moreover, it considers that the necessary trigger and quantification of a further belt-tightening requirement would be difficult to operationalize.

Structural Reforms

The recent economic upswing is not just cyclical but also a reflection of the sustained restructuring efforts in the business sector and the far-reaching reforms undertaken in the labor market and in other areas. Mainly on account of the reforms, potential output growth is estimated to have risen over the last years by around a quarter percentage point to between 1½ and 1¾ percent.

Looking ahead, further increases in trend economic growth are both achievable and necessary to confront the challenges posed by globalization and population aging. The most recent steps to this end include the above-mentioned lowering in social security contributions and the corporate income tax reform involving a steep reduction in effective tax rates to below 30 percent. These measures, along with the ongoing expansion of child care facilities, will help boost the investment climate, job incentives, and labor participation going forward.

At the same time, anchoring reforms in a sufficiently broad consensus and balancing efficiency considerations with social security concerns has served Germany well. In the government’s view, there is a need to ensure that citizens increasingly share in the fruits of the upswing. That being said, Germany will stay the course in terms of economic policy and will continue the successful reforms of recent years. This does not rule out selective modifications in distinct cases.

On labor market issues, it is worth noting that the extension of the unemployment benefit period for elderly workers is being accompanied by targeted wage subsidies and strengthened job search requirements to protect job incentives. As regards wage bargaining, the continuing decline of the share of employees covered by collective wage agreements and the more adaptable working hour arrangements testify to increasing flexibility in labor markets.

On the issue of skills shortages, we would caution that the factors contributing to German emigration are difficult to gauge empirically. That said, the staff rightly points to the policy challenges involved. Besides the high priority the government places on improvements in education and training, selective steps were taken last fall to facilitate immigration, and further opening is being considered.

Finally, on the planned amendment to the Foreign Trade and Payments Act in the context of sovereign wealth fund investments, my authorities reiterate their firm commitment to undertake this in a manner that preserves Germany’s long-standing reputation for openness to foreign capital.

Financial Sector

Supervisory authorities continue to monitor financial sector developments closely. Risks related to international financial turbulence remain, and further writedowns cannot be ruled out. However, it is worth underscoring that the German banking system has remained robust and fully functional throughout the turmoil, notwithstanding the subprime-related capital injections that became necessary in a limited number of cases. A supporting factor has been bank profitability, which – while not yet on par with international levels – has improved appreciably over recent years.

The turmoil has highlighted the need for further restructuring of the Landesbank sector and for a review of individual business models. Besides the ongoing process of vertical integration, horizontal integration across regions is an option that attracts increasing attention. Indeed, the reform debate, including on opening the sector to private capital, has picked up considerable momentum of late. While outside of its purview, the federal government welcomes and supports this process.

As regards Deutsche Industriebank (IKB), losses on subprime-related investments necessitated two recapitalizations in 2007. A third package of support, including from the government, is currently being devised. Each time, difficult choices had and have to be made involving trade-offs between the evolving concerns of safeguarding financial stability, containing fiscal costs and moral hazard, and paving the way for selling the shares of IKB held by Kreditanstalt für Wiederaufbau (KfW).

As for the staff’s reservations about relationship banking, we would note that the links between banks and large industrial enterprises were dramatically loosened in the nineties. Capital markets in Germany, including securitization markets, continue to grow at a high pace. As regards SMEs, even in the context of global competition, there are strong economic reasons for maintaining relationship banking, especially to reduce information asymmetries and to stabilize SME’s access to loans over the business cycle.

On the bank resolution framework and possible revisions thereof, this issue should be viewed in a European context to ensure a level playing field across the EU. The relevant EU provision for bank insolvencies, the so-called winding-up-directive, is currently being reviewed.

As regards supervision, an agreement was reached this month on a revised guideline governing the respective competencies of the Deutsche Bundesbank and the BaFin. The revised guideline further specifies the tasks of the two agencies and directs their focus more clearly on the respective mandates of banking supervision on the one side and prudential enforcement and regulation on the other. The revision will thus go a long way towards clarifying the division of labor and eliminating any overlap. It should thereby further improve transparency and efficiency of banking supervision. By contrast, my authorities are not persuaded by the staff recommendation to consolidate bank supervision and enforcement in one of the two institutions. Leaving out BaFin would run counter to the basic principle of integrated financial supervision, a course that the authorities adopted only in 2002. Leaving out the Bundesbank would mean foregoing its extensive infrastructure and bank contacts and weakening it in the performance of its financial stability responsibility. Moreover, the issue thus far has been one of duplication of work, not of lack of accountability, as suggested by the staff.

On corporate governance, a proposal for a new EU statute for private companies similar to the Societas Europea statute is due to be put forward in the near future. It is also worth noting that the draft Risk Limitation Law mentioned by the staff may yet be modified to address concerns about legal uncertainties and undue constraints on shareholder rights.

Finally, on a more general note, my authorities attach great importance to addressing structural issues in international financial markets that may have contributed to excessive risk-taking. They support expedited efforts among relevant international bodies and supervisory authorities, in particular, to review and improve capital requirements and liquidity management standards and to increase transparency in areas such as off-balance sheet vehicles and rating agencies.