Abstract
This 2008 Article IV Consultation highlights that the financial market turbulence has exposed vulnerabilities in the German financial system. The German consumer’s conservatism under the current uncertain conditions will amplify the export slowdown, and investment decisions are likely to be postponed. Executive Directors have welcomed the German authorities’ continuing priority to maintain financial stability and stabilize the real economy. Directors have also noted that the global financial crisis has highlighted important vulnerabilities of the German financial system, which could be intensified by the economic slowdown in Germany.
We would like to thank the staff for a concise and focused report which offers a balanced reflection of what my authorities considered to be a very constructive and candid dialogue during the consultations.
We broadly share staff's assessment that the environment for conducting economic and fiscal policy has become extremely challenging given the worsening of economic indicators as the financial crisis spills over to the real ecnomy. However, employment and real disposable income have expanded in Germany almost up to the end of 2008 as some key elements which have triggered and reinforced the crisis of the global economy have not featured highly in the past course of the German economy: housing prices remained stable in recent years, predominantly deposit-based financing of lending, low exposure of pension system to capital market developments, low debt ratios of corporates and households. To be clear, however, my authorities have and will act forcefully to the abrupt change in economic conditions. Essentially, this crisis will be temporary and the crisis response of the German government is being carefully framed in order to protect the economy from harm, yet not foregoing the commitment to credible economic and fiscal policies based on sound principles which my authorities deem crucial to master the long-term budgetary challenges and to maintain confidence in a sustainable fiscal policy.
Economic Situation
Highly integrated in the world and European economies, Germany faces severe strains from a global demand shock as the financial crisis leaves its marks on the real economy. The economy has entered a recession in 2008 and GDP is likely to contract sharply in 2009 as production will continue to decline following a reversal in export demand. Revised growth forecasts of major economic research institutes range between 1.4 percent and 1.6 percent for real GDP growth in 2008 and between -2.7 percent and -1.2 percent for 2009. For 2010 the economy is expected to gradually stabilize. The government will issue a revised official growth forecast on 21 January.
The high degree of uncertainty at the current juncture notwithstanding, my authorities consider the fundamentals of the German economy as still being reasonably strong. The corporate sector has in recent years moved forward with consolidation of balance sheets and the maintenance of strong cash-flows while price-competitiveness has been favorable. Thanks to higher wage growth and a turnaround in commodity prices, aggregate demand conditions have been upheld. Nevertheless, domestic demand will not be able to make up for the drastic drop in German firms' foreign order volume – identified as the primary shock and principle source of the current slowdown.
Although the private sector has until recently resisted the economic downturn, a significant fall in demand for capital investment goods and tighter credit conditions will leave their mark. A credit crunch triggered by financing shortfalls in the banking sector is however unlikely at the current juncture. Nevertheless, corporate sector investments will be scaled back significantly given lower capacity utilization, revised profit forecasts and more restrictive financing conditions as corporate bond spreads have increased.
My authorities concur with staff that business sentiment has been deteriorating more rapidly than in previous downturns. Yet, they emphasize that the danger of self-fulfilling pessimistic expectations is clearly prevalent. Against this background, “proactive” projections are to be avoided as indicators more directly mirroring real developments draw a more benign picture. For example, in October, industrial capacity utilization was still slightly above its long-term average. Furthermore, the projected decline in the output gap is not exceptionally strong compared with the previous downturn.
Financial sector
The current situation in the financial sector remains strained. Interbankmarkets are still not functioning properly and confidence is still lacking. The profit situation of financial institutions remains depressed by the high losses ascribed to structured and other products, and falling interest margins. Yet, an important segment of the market has based its business model mainly on deposits and is therefore more shielded against the risks of the wholesale market. Overall, financial sector stress is nevertheless expected to persist for the next quarters as the economy is not likely to recover before 2010.
The government has responded speedily and decisively to the financial crisis. The new financial market stabilization law has been implemented rapidly and the stabilization fund (Sonderfonds Finanzmarktstabilisierung - SoFFin) is increasingly used by banks. From the start, the financial rescue package has had a dual approach aimed at promoting liquidity and solvency. In order to eliminate liquidity shortages and to support refinancing in the capital markets, SoFFin has been authorized to guarantee newly issued refinancing instruments. The Fund may also recapitalize financial institutions, in particular through the purchase of shares or silent participations. With the option of acquiring problematic assets, it can also improve capital ratios. At present, 95 bn euros of guarantees are committed (out of an overall envelope of 400 bn euros) and 8.2 bn euros in recapitalization support (out of maximum envelope of 80 bn euros).
The central principle of SoFFin – its balanced focus and voluntary participation – has so far proven adequate. The originally feared stigmatization of participating institutions cannot be confirmed. The principle of voluntary participation ensures that primarily the owners are accountable for the solution of individual problems of their institutions. SoFFin is only intervening on a subsidiary basis. In fact, several banks managed a recapitalization on their own without using the recapitalization credit line of SoFFin. In 2009, a new asset-class will be established (government-guaranteed bank bonds) clearly improving incentives for banks to participate in SoFFin.
My authorities share staff's recommendation to move forward with the restructuring of the Landesbanken. They consider that substantial reform including a downsizing and the development of a viable business model is needed. State governments have indicated that they would like to preserve their decision autonomy with respect to the future role of their institutions. The institutions concerned have also already considered various options by themselves.
My authorities consider the German bank resolution framework as broadly adequate. Section 46b of the Banking Act provides the possibility to (i) issue a ban on sales and payments by the concerned institution and (ii) prohibit the acceptance of payments not intended for the discharge of debts to the institution (moratorium). Objections by the institutions (and their shareholders) have in principle no postponing effect. This moratorium allows the supervisor, shareholders, and other stakeholders to negotiate a rescue plan. Therefore, my authorities consider that BaFin as the supervisor has sufficient instruments at hand to deal with a quickly evolving problem situation in an institution.
As to supervision, the revised guideline governing the respective responsibilities of BaFin and the Bundesbank ensures the clear division of labor in the field of banking supervision in Germany. Cooperation during the recent financial crisis has proven to be efficient. The division of responsibilities ensures on the one hand that the Bundesbank has access to all supervisory information. On the other hand, synergies from banking supervision and monetary policies can be gained without questioning the independence of the Bundesbank.
Fiscal policy
The German government is fully committed to the rules of the Stability and Growth Pact at EU level. This pact provides the framework under normal circumstances to achieve and maintain a budgetary position of close to balance or in surplus. For exceptional circumstances, it provides the budgetary space to weather any economic downturn, in the first place through the full operation of automatic stabilizers and, if needed, also through additional fiscal policy measures.
EU level coordination of additional fiscal policy measures requires primarily a common understanding on the application of the Pact at the current juncture – given the exceptional circumstances. In light of the unusual degree of uncertainty about the impact of any specific measures, it is crucial to give due account of countries' individual circumstances. For my authorities, structural consolidation of public budgets remains the key objective given the challenges to long-term sustainability of public finances. Framing short-term (temporary) policy responses accordingly will avoid putting hard-won structural consolidation at risk. This is crucial for confidence-building underpinning that policies are viable to guarantee sound public finances in the monetary union.
The government has responded to the global economic slowdown speedily and decisively with an important fiscal stimulus package - which is already in effect -designed to secure growth and employment. The package adopted by the Cabinet on 7 October and 5 November 2008 predominantly contains growth-oriented measures that can be implemented in a timely manner. The objective is to create strong stimuli for private and public-sector investments, inter alia by investment funding to SMEs, tax incentives, targeted support to families and infrastructure investment. Furthermore, the Federal Constitutional Court has reinstated the commuting allowance (tax subsidy) which has an additional stimulus effect. The total volume of both, the package and the commuting allowance in 2009 and 2010 will amount to approximately 40 bn euros (or over 1 ½ percent of GDP).
My authorities underline that the decisive factor with regard to actually stimulating economic activity is not solely the level of public sector spending, but the economic impact of the measures adopted. The high degree of uncertainty on the impact of specific policies notwithstanding, the measures adopted by the federal government are targeted and will mainly remain in effect for a limited time only, while having a lasting impact. In the coming years, some measures of the package will facilitate investments and orders from enterprises, private households and regional and municipal governments. The measures will cost 11 bn euros in two years but are expected to trigger 50 bn euros in private investment. An additional fiscal stimulus package is currently under consideration.
My authorities emphasize that a short-term fiscal spending strategy - without ensuring medium-term fiscal sustainability - may not deliver the effectiveness wished for. A loss of confidence in fiscal sustainability would significantly aggravate the crisis. The government is considering the implementation of a new constitutional fiscal rule which would ensure a compensation of short-term discretionary fiscal policy measures in the next upswing. My authorities explicitly welcome the staff's assessment on the usefulness of such a rule which is currently being discussed in the Federalism Commission II.
Furthermore, my authorities welcome the staff's recommendation for a new preventive budget surveillance mechanism. To this end, my authorities have recommended the establishment of a stability council. On the other hand, staff recommends that fiscal rules at the level of individual states need to be altered to ensure greater tax autonomy and to avoid pro-cyclical expenditure behavior at state level. My authorities are more cautious to these recommendations as, (i) the expenditure fluctuations of individual states would be higher without the federal financial equalization and (ii) the revenue base, in particular between east and west German states, is very different so that more tax autonomy would reinforce revenue shortfalls and render budget consolidation in the end more difficult.
Structural Reform
The structural position of the German economy remains sound, but reform challenges remain. German economic policy has – over the recent years preceding the crisis – been targeted (i) at further increasing trend growth and implementing policy responses to the challenges posed by population ageing, while (ii) at the same time anchoring reforms in a sufficiently broad consensus balancing efficiency considerations with social security concerns. The strategy has served Germany well and will remain valid over the medium-term. Going forward, the government will advance further reforms in the health care sector as cost-saving measures and efficiency-enhancing competition in the health care system are important to ensure sustainable public finances.
Continual effects of previous growth-oriented structural reforms. The structural reform measures referred to in the context of last year's Article IV consultation, the business tax reform and the significant reduction of contribution rates to unemployment insurance result in the coming years in a relief for enterprises and individuals of well above 1 percent of GDP per annum. In addition, federal budget spending for research and development will continue to increase in 2009 and 2010.