Germany
Staff Report for the 2012 Article IV Consultation

This 2012 Article IV Consultation reports that the German economy’s performance has been remarkable despite facing considerable headwinds. Several conditions are now in place in Germany for a domestic demand-led recovery. Employment creation has been robust and unemployment at 5.3 percent is at a postreunification low. Executive Directors have commended Germany’s strong macroeconomic management, which has resulted in a favorable economic performance despite the uncertain external environment. Directors have underscored Germany’s pivotal role in reducing euro area and global imbalances.

Abstract

This 2012 Article IV Consultation reports that the German economy’s performance has been remarkable despite facing considerable headwinds. Several conditions are now in place in Germany for a domestic demand-led recovery. Employment creation has been robust and unemployment at 5.3 percent is at a postreunification low. Executive Directors have commended Germany’s strong macroeconomic management, which has resulted in a favorable economic performance despite the uncertain external environment. Directors have underscored Germany’s pivotal role in reducing euro area and global imbalances.

Introduction

1. Despite facing considerable headwinds, the performance of the German economy has been remarkable. Employment creation has been strong and unemployment has declined to post-reunification lows, in the face of a very challenging external environment. The contraction in activity in the last quarter of 2011 was followed by a sharp rebound in Germany early this year, helping the euro area avoid a technical recession. Several conditions are now in place in Germany for a domestic demand-led recovery. Underpinned by healthy corporate and household balance sheets, higher wages, well anchored inflation expectations, and low borrowing costs, growth is poised to reach potential in the second half of 2012.

2. Policies need to guard against risks to the recovery. The main risk facing Germany is an intensification of the euro area crisis, which would spill over into Germany through real and financial channels. Lower global growth prospects more broadly or an abrupt rise in oil prices due to geo-political shocks are also key downside risks to the outlook.

3. Over the medium term, raising potential growth and its resilience need to be viewed in a multilateral context. Germany is one of the world’s most open large economies, making it susceptible to external developments in both the euro area and more broadly. Germany can play a pivotal role in addressing the challenges faced by the euro area, in addition to implementing its own structural reforms, to secure the region’s stability and raise its growth potential.

Recent Economic Developments and Outlook

A. The Economic and Financial Context

4. Economic growth appears to have bottomed out. Financial market turbulence and weakening external demand led to a broad-based contraction of activity in Germany in the last quarter of 2011, with the notable exception of construction. Activity picked up in the first quarter of 2012, due to a rebound in external demand and strong consumption growth. Germany’s cyclical position is more advanced than other large industrialized economies, and the output gap is expected to close in 2012 (Figure 1).

Figure 1.
Figure 1.

Germany: Real Sector Developments

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

A01ufig01

Germany’s Strong Rebound

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

5. The labor market is exceptionally strong. Employment growth has been underpinned by higher labor force participation and an increase in net migration, and unemployment at 5.3 percent is at a post-reunification low. Helped by the reforms implemented in the 2000s, the labor market is trending towards a lower natural rate of unemployment, and since 2010, the creation of jobs with full social security benefits has grown faster than atypical employment. Reflecting the tighter conditions, wage growth has picked up. While nominal pay rates increased by about 2 percent in 2011, the normalization of working hours and significant one-off payments have pushed overall wage growth to near 3 percent (Figure 2).

Figure 2.
Figure 2.

Germany: Labor Market Developments

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

6. Fiscal consolidation is on track. The overall deficit narrowed to 1 percent of GDP last year (from 4.3 percent in 2010), reflecting in part the phasing out of one-off financial sector support measures. The structural balance improved by about 1¼ percent of GDP in 2011, reflecting the withdrawal of stimulus and consolidation measures, including unwinding of temporary tax and labor market measures, the removal of some exemptions, and reductions in social spending and administrative costs. Overall, however, the financial crisis has led to an increase in public debt from 65 percent of GDP in 2007 to 81 percent in 2011, including due to financial sector support operations.

7. The persistent capital outflows from Germany have reversed course markedly reflecting developments in the European periphery and risks to the global economy. German banks have withdrawn from Europe’s cross border interbank market and investment positions in economies under stress are being unwound. With strong demand for safe assets, German government bond yields have declined to record lows. The net private inflows into Germany are reflected in an increase in the Bundesbank’s claims on the Eurosystem, which had risen to €644 billion by April (approximately 24 percent of GDP).

A01ufig02

Interbank Lending by German Banks

(Year-on-year percentage change)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Deutsche Bundesbank; and IMF Staff calculations.
A01ufig03

Financial Account Reversal in the Euro Area

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

8. Higher inflation in recent quarters has mainly reflected the rise in energy prices. Headline inflation has fallen to 2.2 percent in April 2012, in line with the moderation of fuel price increases, while core inflation remained low at 1.4 percent (y/y, ex energy, food, alcohol, and tobacco). Medium term price expectations remain well anchored below 2 percent, as implied by the break-even interest rate differential on 5-year Bunds (Figure 1).

A01ufig04

Inflation in the Euro Area

(HCPI, yoy percentage change)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Haver Analytics; and IMF staff calculations.

9. Household and corporate balance sheets are healthy, and asset price developments remain benign. Leverage in the household sector is low in comparison to other euro area economies, and indeed has fallen recently. Meanwhile, corporate profitability is high and debt-to-income ratios are lower than the euro area average. Equity prices in Germany have rebounded broadly in line with international comparators, and reversed some of the losses of the second half of 2011. Bond yields for banks and the public sector are at record lows, while yields for corporate bonds have remained largely flat. Nationwide house prices have risen moderately (1–4 percent in 2011) following years of stagnation, with stronger localized increases in some areas, spurring construction activity.

B. Outlook and Risks—Domestic Demand-Led Growth but External Risks Remain

Staff’s Views

10. Several elements are in place for a private sector-led rebound. The recovery from the 2008/09 recession has already shown the resilience of consumption, underpinned by the strong labor market. Strong growth in Q1 is also encouraging, but the genuine switch to a domestic-led growth is yet to be seen. With rising household income and stable employment, strong balance sheets among households and firms, and a supportive financing environment, both consumption and investment, including residential investment, are expected to gather pace and propel growth to around potential by the second half of 2012. For the year as a whole, activity is expected to expand by 1 percent in 2012, and rise further to 1.4 percent in 2013 (Figure 1). Reflecting Germany’s advanced cyclical position, net foreign demand is expected to contribute significantly less to growth in 2012 and 2013 compared to previous years. With structural gains in employment having largely run their course and demographic pressures taking hold, the pace of employment creation is expected to fall to near zero over the medium term, and the decline in the unemployment rate is expected to level off. In view of the loose monetary conditions for the euro area as a whole, the economy is projected to operate at slightly above capacity in the medium term. Consistent with these dynamics and a healthy growth in wages, headline inflation is projected to settle slightly above 2 percent.

A01ufig05

Private Consumption

(Real, index = 100 in quarter preceeding the recession)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Haver Analytics; Federal Statistical Office; and IMF staff estimates.1/ Lasts 4 quarters.2/ Lasts 2 quarters.
A01ufig06

Unemployment Rate

(Percent)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Haver Analytics; Federal Statistical Office; and IMF staff estimates.1/ Lasts 4 quarters.2/ Lasts 2 quarters.

11. The downside risks to the near-term outlook are mainly external. The baseline outlook is predicated on less volatile financial conditions and improving prospects for some of Germany’s large trading partners. There are, however, numerous interrelated risks surrounding this baseline:

  • The German economy is heavily exposed to an intensification of the euro area crisis. Given its high trade and financial openness, together with still significant cross-border bank exposures (see Policy Theme #2, Figure 6, and Box 4), an escalation of financial stress and further deterioration of confidence in the euro area periphery could lead to a sharp downturn in Germany. Under such an adverse scenario, domestic banks are likely to face higher funding costs and may incur trading losses; private demand would be reduced due to tighter financing conditions and deteriorating consumer and business confidence, while exports would suffer from weaker external demand. Depending on the precise nature of the shock, an intensification of the crisis could also lead to more abrupt deleveraging by the banks, and unlike in the baseline, this may involve a sharp cutback of banks’ lending domestically.

  • Broader downside risks relate to a slowdown in global growth or a sharp rise in oil prices. Given Germany’s direct trade linkages, particularly with the United States and Asia, an unanticipated slowdown in activity would directly lower the demand for Germany’s exports, in addition to the indirect linkages through other euro area trading partners. A sharp rise in oil prices due to geo-political factors would depress aggregate demand and put upward pressures on prices. More medium-term risks relate to a slowdown in potential growth if progress on structural policies proves insufficient. Lower growth would also have negative consequences for public debt, which is highly sensitive to growth dynamics. The risk that accommodative monetary conditions lead to a mispricing of assets is seen as low at the current juncture.

Figure 3.
Figure 3.

Germany: Credit, Interest Rates, and Lending Standards

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Figure 4.
Figure 4.

Germany: Balance Sheets and Asset Price Developments

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Figure 5.
Figure 5.

Germany: Vulnerabilities of Large Banks

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Datastream, Worldscope, Bloomberg, and IMF staff calculations.1/ Simple averages, based on a sample of 83 large global financial institutions, incorporated in 21 countries, representing almost 75 percent of global banking system assets. Germany is represented by seven institutions. Sample composition changes over time as institutions are merged or delisted.
Figure 6.
Figure 6.

Germany: External Position

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

A01ufig07

Primary Balance Path Under Alternative Scenarios

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: German Federal Statistical Office; and IMF staff estimates.1/ “No policy change” scenario assumes that the primary balance remains unchanged from 2011 onwards, while all other macroeconomic variables are the same as under the baseline.2/ “Historical average” scenario assumes that all variables, including the primary balance, growth and interest rates, are at historical averages.
A01ufig08

Government Debt Path Under Alternative Scenarios and Stress Tests

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: German Federal Statistical Office; and IMF staff estimates.1/ “Growth shock” scenario assumes real GDP growth at baseline minus one-half standard deviation.2/ “Real interest rate shock” scenario assumes baseline interest rate plus one standard deviation.3/ “No policy change” scenario assumes that the primary balance remains unchanged from 2011 onwards, while all other macroeconomic variables are the same as under the baseline.4/ “Contingent liability shock” scenario assumes a 10 percent of GDP increase in other debt-creating flows in 2012.5/ “Historical average” scenario assumes that all variables, including the primary balance, growth and interest rates, are at historical averages.

The Authorities’ Views

12. The authorities broadly agreed with the staff’s baseline. They concurred with staff that conditions for a rebalancing of the economy towards domestic demand are in place, noting the strong performance of the labor market and sustained gains in real disposable income. The authorities were of the view that over the medium term, the net contribution of foreign demand to growth could approach zero. The authorities also shared staff’s view that anticipated wage and price increases are part of the rebalancing of the German economy, and could help the euro area more broadly.

13. The authorities assessed the downside risks somewhat differently and noted some upside potential. They saw the identified risks as being of low probability, but rightly noted that several of them are interrelated and could materialize at the same time. They also noted another medium term risk stemming from insufficiently ambitious policies in the euro area, should they lead to contingent pressures on Germany’s public finances or delayed progress on the needed restructuring of financial sectors in the euro area. On the upside, the authorities noted that growth may turn out to be higher as uncertainty recedes more quickly than anticipated and factors such as higher migration raise the economy’s growth potential.

Policy Discussions

A. Policy Theme #1: Steering the Recovery in an Uncertain Environment

Background

14. The 2012 budget implies a modest fiscal withdrawal, less than half of that last year. Staff estimates an improvement of about ½ ppt of GDP in the structural balance, but automatic stabilizers are expected to operate fully. Consolidation plans envisaged for 2013 and beyond have been scaled back, given the strong performance last year. Germany, however, is well on track to achieve the national fiscal rule target of a deficit not exceeding 0.35 percent of GDP for the federal government from 2016 and a balanced budget for the Länder from 2020. The fiscal path is also likely to be in line with the requirements of the pan-European Fiscal Compact, since the German structural fiscal deficit is expected to fall below 0.5 percent of GDP already in 2013.

A01ufig09

Selected Items of the Bundesbank’s Balance Sheet

(EUR billion)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Source: Deutsche Bundesbank.

15. Despite ample liquidity, credit growth remains moderate. Bank balances with the Bundesbank are high, and lending rates are lower than elsewhere in Europe. German banks have also used LTRO funds both in December and February though the uptake was rather small despite the large number of participating banks. Nevertheless, the rise in bank lending is moderate, reflecting still low demand from households and firms.

A01ufig10

Germany: Lending to the Economy by German Banks, December 2001 - February 2012

(12 months rolling growth)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations.1/ Includes negotiable money market paper, securities, equalisation claims2/ Includes bills of exchange
A01ufig11

Germany: lending to Various Sectors by German Banks, Q4 2000 - Q4 2011

(4 quarters rolling growth)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Deutsche Bundesbank; and IMF staff calculations.

16. The strength of German banks has improved but vulnerabilities remain. German banks are generally meeting the minimum levels of required regulatory capital and have ample liquidity. However, some remain highly leveraged and dependent on wholesale funding, have low capital quality and profitability (Figure 5), and some institutions are significantly exposed to the euro area periphery. Six larger banks were called upon to strengthen their capital position as a result of the latest European Banking Authority’s (EBA’s) stress test, and are well on their way to meet EBA requirements (one bank is in the process of being wound down). Some large international financial institutions also have substantial cross-border operations, and significant counterparty risk exposures related to their large derivative portfolios. As banks seek to deleverage, they are focusing on reducing exposures outside their core business lines and regions, generating outward spillovers. German banks have made some progress on raising core capital in line with Basel III, and in meeting the new liquidity and leverage ratios.

17. As a backstop, the financial stability support mechanism (SoFFin II) was reintroduced on a preemptive basis with an overall amount of €480 billion available through end-2012. Outstanding balances of public financial support to banks under the original Special Fund for Financial Market Stabilization (SoFFin I) continue to decline. Capital support to banks has been reduced by about one third, and few liquidity guarantees remain outstanding. The size of the portfolios of the two winding-up institutions remains high at just under 10 percent of GDP and a further increase is anticipated by mid-year with the transfer of a residual portfolio of non-core assets as part of the restructuring of a large Landesbank. As of end-2011, operational losses of SoFFin I are estimated at €22.1 billion, approximately half of it linked to the restructuring of Greek sovereign bonds.

18. The institutional framework for macroprudential policies is evolving. Building on initial recommendations set out in the authorities’ 10-point plan, which envisaged a stronger role for the Bundesbank in macroprudential supervision, a recent legislative initiative proposes a Financial Stability Commission (FSC) for crisis management coordination and to address financial stability risks, to be established by early 2013. The FSC will comprise the Federal Ministry of Finance (BMF), the Bundesbank, the financial supervisor (BaFin), and a non-voting representative from the Federal Agency for Financial Market Stabilization. The FSC will be chaired by the BMF and draw on the financial stability analysis prepared by the Bundesbank. While no menu of instruments for macro-prudential purposes has been defined yet, and discussions are ongoing at the European level, measures such as prescribing effective loan-to-value ratios for mortgages and adjusting capital buffers (e.g., countercyclical capital buffer, systemic risk buffer) are under consideration.

A01ufig12

Advanced Economies and Germany: Capital to Assets, 2005–2011

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Source: IMF Global Financial Stability Report.

Staff’s Views

19. The formally limited fiscal room should be deployed carefully under the baseline. Within the constitutionally binding fiscal rule, the available fiscal room in 2012 is estimated at around ½ percent of GDP, unless the escape clause is invoked under exceptional circumstances. Fiscal spillovers from Germany would contribute only a small amount to real GDP growth in the rest of the euro area, concentrated in small and open neighboring countries (the Czech Republic, Austria, the Netherlands and Belgium) with limited impact on the euro area periphery economies (Box 1). Even in the absence of the fiscal rule, the benefits to the euro area periphery of a greater fiscal expansion in Germany would be limited. Moreover, Germany’s status as a guarantor of the EFSF/ESM and potentially large contingent liabilities associated with the resolution of the euro area crisis, and medium-term concerns about aging pressures, also weigh on the room for short-term stimulus. In light of these considerations, and with the virtually closed output gap under the baseline, a deviation of fiscal policy from the 2012 budget is not called for, although automatic stabilizers should be allowed to operate fully. Any available fiscal resources could, instead, be used to facilitate reforms in the euro area periphery, including through increasing the lending capacity of the European Investment Bank, and enhanced and better targeted EU structural funds. This could help stabilize the external environment facing Germany over the medium term and facilitate reforms in the periphery economies.

Fiscal Spillovers1

Fiscal stimulus in Germany is likely to have a relatively small impact on the rest of the euro area. The results presented in Figure 1 are based on three alternative approaches described in Ivanova and Weber (2011), Vitek (2012) and the GIMF model described in Kumhof et. al. (2010). These simulations suggest the maximum impact of a two-year 1 percent of GDP fiscal stimulus in Germany on the rest of the euro area at 0.2 percentage points if all the stimulus is concentrated in public investment and accommodated by monetary policy. In contrast, the impact on German domestic GDP can be potentially quite large ranging between 0.7 and 0.9 percent of GDP on average over two years, if stimulus is concentrated in public consumption and investment.

A01bx01ufig01

The Impact of Fiscal Stimulus in Germany on Eurozone GDP

(Two-year average percent deviation of real GDP from the baseline)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Direction of Trade; IMF World Econominc Outlook; and staff calculations.
A01bx01ufig02

The Impact of 1 Percent of GDP Fiscal Expenditure Stimulus in Germany on Individual European Countries

(Two year average derivation of real GDP from the baseline, monetary policy accomodation)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Direction of Trade; IMF World Econominc Outlook; and staff calculations.

Fiscal spillovers from Germany are concentrated in small and open neighboring countries while the impact on the euro area periphery is limited. Economies with whom Germany has strong trade links, such as the Czech Republic, Austria, the Netherlands and Belgium are estimated to benefit most from a German fiscal stimulus. In contrast, the impact on real GDP in Greece, Italy, Ireland, Portugal and Spain is estimated not to exceed 0.15 percent with a particularly small impact on Greece given the offsetting monetary tightening that a procyclical fiscal loosening in Germany would entail. The relatively small fiscal spillovers to the euro area periphery in Ivanova and Weber (2011) can be explained by the relatively weak trade links with those countries that are relatively small compared to Germany (Greece, Portugal) while the countries with relatively stronger trade links (Italy and Spain) are also the ones that are closer to Germany in economic size. Spillovers can thus be expected to be small as only a portion of fiscal stimulus in Germany is transferred to these countries. Ireland is relatively small and has relatively strong trade links with Germany, implying larger spillovers.

1 This box was prepared by Anna Ivanova (EUR), Stephen Snudden (RES) and Francis Vitek (SPR). The three alternative methodologies are explained in Ivanova, A. and S. Weber (2011), “Do fiscal spillovers matter?” IMF working paper WP/11/211; Kumhof, M., D. Laxton, D. Muir and S. Mursula, 2010, “The Global Integrated Monetary Fiscal Model (GIMF) — Theoretical Structure”, IMF Working Paper 10/34 (February 2010); and Vitek, F. (2012), “Policy analysis and forecasting in the world economy: A panel unobserved components approach”, International Monetary Fund Working Paper, forthcoming.

20. Only in the event of a renewed downturn would more active fiscal policies be needed. Under such circumstances, and depending on the size and nature of the shock to the economy, invoking the escape clause under the fiscal rule could be appropriate to support activity and employment in Germany and help stabilize the euro area. To be timely and effective, a contingency plan should be developed, prioritizing revenue and expenditure measures with the highest payoff that could be quickly implemented. In the event of a negative shock, priority should be given to measures that could also spur long-term potential growth, including reduction in labor and corporate income taxes, and reorientation of social spending towards education and childcare support. The labor market could be supported through an expanded short work scheme.

21. Ensuring financial stability remains a key priority. In particular, it will be important to ensure that risks from the global activities of the large German banks are fully understood and internalized. In this regard, strengthening cross-border supervision and cooperation will be important. Some institutions, including the Landesbanken, remain vulnerable to increases in wholesale funding costs. The pre-emptive reactivation of the financial stability support mechanism (SoFFin II) is welcome as a backstop to limit the impact of deleveraging on the domestic economy and in other countries where banks retain significant exposures, and to ensure the system’s stability, if downside risks materialize. The banks identified as having a capital shortfall are expected to comply with EBA requirements without resorting to Soffin II. Looking ahead, meeting Basel III requirements will create further pressure on banks to strengthen their balance sheets.

22. Some progress has been made on the implementation of the 2011 FSAP Update recommendations, but much work remains (text table). The current favorable macroeconomic conditions provide an opportunity to accelerate reforms. Among the key priorities, overall momentum in the reform of the Landesbanken needs to be stepped up, the crisis management framework should be strengthened by establishing resolution plans, and the challenges inherent in the fragmented deposit insurance regime should be addressed.

23. Macroprudential policy frameworks should be put in place, but policies should not be tightened at this juncture. Establishing a financial stability committee is a welcome step, and its independence from potential political influence should be ensured in line with the recommendations by the European Systemic Risk Board (ESRB). There is however no need to tighten macroprudential policies at the current juncture, and the near-term priority is to support the rebound of domestic demand accompanied by a natural relative price adjustment process. The potential deployment of additional macro-prudential instruments in the future will need to take into account ESRB guidelines and be regionally consistent.

Main Outstanding 2011 FSAP Update Recommendations

article image
article image

The Authorities’ Views

24. The authorities see continued fiscal consolidation in Germany as a key credibility anchor in Europe. They do not see any need or space for fiscal relaxation in Germany given favorable macroeconomic developments, small potential spillovers to the southern euro area periphery, and the constraints of the fiscal rule. The authorities also pointed out the potentially negative implications in the periphery economies if the ECB were to tighten monetary policy in response to fiscal relaxation in Germany given its cyclical position. They also saw the role of Germany as a fiscal anchor in the euro area as a strong motivation for delivering on their fiscal commitments. The authorities do not see the immediate need to have a contingency plan for a fiscal stimulus, and view the experience with the stimulus during the past crisis, which relied to some extent on capital expenditure, as a mixed success.

25. The authorities were in broad agreement with the staff’s assessment of the financial system. They agreed that strengthening cross-border regulation and supervision will be important. They see the banks well on their way towards Basel III implementation and see EBA capital requirements as within close reach, but agreed that more progress on financial sector reforms is needed. The authorities share the staff’s view on the importance of stress testing and the need for forward-looking monitoring of banks’ balance sheet strength, and recognize the merits of strengthening reporting requirements. Concerning initiatives to vet in advance bank acquisitions of subsidiaries, the authorities expressed some reservations on potential interference with bank business interests. Further reforms of the business models of the Landesbanken were deemed useful but challenging given the need to attain consensus at the sub-national level.

26. The authorities agreed with the recommendation to establish a macroprudential policy framework, and shared the view that there is no need to tighten macroprudential policies at the current juncture. The authorities expect to move forward quickly with the establishment of the FSC, well within the timetable set by the ESRB for mid-2013. The authorities envisage coordinating macro-prudential instruments consistent with European Union initiatives.

B. Policy Theme #2: Securing Higher and Stable Growth in an Interconnected World

Germany in an Interconnected World

27. Background. Germany has close links with the euro area through the common currency, which facilitated trade and closer financial integration, and as a regional safe haven (Box 2). More broadly, trade as a share of German GDP has risen from 62 percent in 2000 to 94 percent by 2011, in part reflecting in particular burgeoning Eastern European supply chains and higher exports to Emerging Asia. Financial linkages are also extensive, including through the cross- border activities of German banks and exposures to the Eurosystem (Target 2) of about 24 percent of GDP as of end-April 2012.

Staff’s Views

28. The German economy is sensitive to macroeconomic and financial market developments in the rest of the world. Due to its high and rising trade and financial openness, business cycle dynamics in Germany are driven in large part by foreign shocks (see Box 3 and Vitek 2012). Trade linkages with the United States, United Kingdom and emerging Asia are particularly important in transmitting macroeconomic shocks. Trade linkages within the euro area are significant, but the transmission of shocks through this channel is mitigated somewhat by monetary policy stabilization within the currency union. Regarding financial shocks, the United States, United Kingdom and Japan are important from a portfolio channel, while banking sector linkages and related flows are important within the euro area and with the United States and the United Kingdom.

Balance of Payment Linkages to Greece, Ireland, Italy, Portugal, and Spain

Germany’s current account surplus with select economies—Greece, Italy, Portugal, and Spain—has fallen back to levels observed before the boom period of 2005–07. Following the demand adjustment in these economies, their deficits with Germany fell by about half from its peak in 2008 back to levels observed in 2004. Given the demand driven nature of the boom and subsequent adjustment, exports from Germany to these economies fell during the adjustment, while imports to Germany from these countries barely changed.

A01bx02ufig01

Exports to and Imports from Greece, Italy, Portugal, and Spain

(Percent of German GDP)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Bundesbank; and IMF Staff calculations.

The financial account has had more significant swings. While the current account remains in surplus with most of the peripheral countries (except Ireland), the variation in the financial account between Germany and the economies under stress has been three times larger than the current account variation and has changed signs. Moreover, there is almost no correlation between these two balances. Bilateral trade in goods and services has only a limited influence on bilateral cross-border financial flows.

For much of the last decade, net private capital flows from Germany to these economies were—on average—lower than the current account balances. Financing by Germany in excess of its current account surplus vis-ã-vis these economies was limited to short periods of time. From the perspective of Greece, Ireland, Italy, Portugal and Spain, current account transactions with Germany since 2003 represent about ¼ of their combined current account deficit. Net financial private inflows from Germany financed about one fifth of the current account deficit over the same period.1 The change in the direction of private capital flows is primarily driven by German residents.

A01bx02ufig02

Financial and Current Account of Germany and Greece, Ireland, Italy, Spain and Portugal

(Billions of euros, 4 quarter rolling sum)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Deutsche Bundesbank; Haver Analytics; and IMF staff calculations.
A01bx02ufig03

Financial Flows Between Germany and Greece, Ireland, Italy, Spain and Portugal

(Billions of euros)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Deutsche Bundesbank; and IMF staff estimates.
1 Changes in claims on the Eurosystem (TARGET2) are not part of private bilateral capital flows.

Spillovers Through Cyclical Fluctuations

Empirical analysis that takes into account trade linkages as well as international money, bond and equity market linkages (Vitek 2012) suggests that the German economy is sensitive to macroeconomic and financial market developments in the rest of the world (inward spillovers).1 For example, financial shocks in the United States which increase its output gap by one percent are estimated to raise the output gap in Germany by 0.52 percent. It also suggests that Germany is an efficient transmitter of business cycle fluctuations to its regional supply chain, but has not been a major originator of such shocks (outward spillovers). Within the euro area, outward spillovers are mitigated by monetary policy responses, explaining the small effects on countries such as France and Spain. The empirical analysis, however, does not account for trend growth in demand and, hence, the potential benefits from a permanent increase in potential growth.

A01bx03ufig01

Inward Spillovers to Germany

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

A01bx03ufig02

Outward Spillovers from Germany

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

1 The inward/outward spillover coefficients measure the percent increase in the output gap in the recipient economy (Germany/other countries), which occurs in response to macroeconomic or financial shocks in the source economy (other countries/Germany) which raise its output gap by one percent, on average over the business cycle. Inward and outward spillover coefficients for Germany with respect to itself are one by definition.

29. Germany also generates outward spillovers through real and financial channels. Given its regional supply chains, Germany is a conduit for the distribution of real and financial shocks to its immediate European neighbors, and also generates financial spillovers to other economies where its banks play a significant role. Given the German economy’s large size, it also is a source of more stable demand for exports from key trading partners generated by domestic consumption and investment and not linked to its regional manufacturing supply chain. This suggests that raising domestic demand will be supportive of raising the level of exports from these trading partners. The large exposures of German banks through their overseas operations (Box 4) also generate outward spillovers to economies in Europe and beyond.

A01ufig13

Importance of Demand Components and Import Content

(2000–2007 Average)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Federal Statistical Office; Deutsche Bundesbank; and IMF staff estimates.

30. Germany’s traditional current account surplus increased substantially in the mid- 2000s, peaking at 7½ percent of GDP in 2007 (Figure 6). This reflected a rise in exports, particularly to economies outside the euro area, which was only offset partly by higher imports from these economies. The rise in external surpluses translated into a steady improvement in Germany’s net international investment position (IIP) to a positive 35 percent of GDP at end- 2011, from near-balance a decade ago. About ½ of the net IIP position at end-2011 reflected net claims on the Eurosystem.

31. The increase in the external surplus was largely driven by the corporate sector (Figure 6). Corporate savings increased significantly by the mid-2000s, on the back of strong profits (Figure 7). While profitability was helped by wage increases which fell short of productivity growth over a sustained period, there were various factors that encouraged the strengthening of corporate balance sheets. These included changes to the tax regime, changes to the close relationship between corporates and banks, regulatory changes (Basel II), and the increased globalization of production which required access to international bank financing. The effects of regulatory changes and the impact of globalization were likely more pronounced for German corporates due to their heavy reliance on bank-based financing. In contrast to savings, investment was slow to respond. Almost a whole decade of disappointingly low growth, unfavorable demographic trends, and interest rate developments vis-à-vis many European countries, likely contributed to the cautious investment response of corporates. Nevertheless, the level of investment has been consistently below that predicted by traditional determinants, beginning in the mid-80s.

Figure 7.
Figure 7.

Germany: Corporate Sector Developments

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Outward Financial Spillovers

German banks have large foreign exposures concentrated in advanced economies. Their foreign exposures comprised about USD 2.8 trillion at the end of Q4 2011, representing ¼ of total assets of German monetary financial institutions and about 4½ times their total capital. More than ¾ of total bank exposures are concentrated in advanced economies with the majority in Europe and the United States. Total exposures to Greece, Ireland, and Portugal, at USD 139 billion, comprise almost 10 percent of exposures to advanced Europe. Exposures to emerging Europe are relatively small and concentrated in Poland, Russia, Turkey and Hungary.

In 2011 total exposures to Europe declined substantially while those to the US have edged up. Exposures decreased substantially in Spain, Ireland, Italy, Portugal, Greece, Norway, Denmark, Belgium, Austria, France, and Luxembourg. Exposures to the United States, however, rose after the decline during 2009–2010. Exposures to emerging Europe, in particular to Hungary, have also declined, while those to emerging Asia and Latin American have risen.

German bank exposures are concentrated in advanced Europe and the US.

A01bx04ufig01

Exposures of German Banks by Region

(Billions of USD)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: BIS; and IMF staff calculations.

Exposures to advanced Europe were reduced substantially in 2011 while exposures to the US, and to a lesser extent emerging Asia and Latin America increased.

A01bx04ufig02

Change in Total German Bank Exposures in 2009, 2010 and 2011

(Billions of USD)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: BIS; and IMF staff calculations.

The potential for further outward spillovers from bank deleveraging in Europe remains. Total exposures to advanced European countries remain large (15 percent of total assets of German banks and over 250 percent of their total capital). Looking forward, German banks will likely continue deleveraging in Europe particularly with regard to their respective non-core businesses in each country, while preserving their core businesses abroad, including in emerging Europe.

A01ufig14

Germany: Equity Ratio of Enterprises, 1995–2010, Median Value 1/

(percent)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Source: Deutsche Sparkassen - und Giroverband1/ Equity ratio is the ratio of comapny’s equity to total assets.
A01ufig15

Corporate Reliance on Bank Financing, 2000–2009

(Share of loans in total liabilities, percent)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Source: EUROSTAT.

32. Overall, Germany’s external position remains substantially stronger than that implied by medium-term fundamentals and global economic policy settings. In part, this reflects the lack of an exchange rate adjustment mechanism within the currency union and developments in other euro area countries. Staff estimates suggest that Germany’s real effective exchange rate is undervalued by 0–10 percent. Looking ahead, part of the adjustment will therefore reflect policy changes elsewhere—including reigning in large fiscal deficits in some large advanced economies as well as fiscal and structural adjustments in the euro area periphery. The rebalancing of domestic sources of growth that is expected to occur to a large extent naturally as a reflection of tighter labor markets, high liquidity, and low interest rates, will also help by boosting domestic demand and reduce the current account balance to around 4 percent of GDP in the medium term. With disinflationary pressures incipient in the periphery economies over the medium term, and monetary conditions in Germany accommodative from a cyclical perspective, inflation in Germany could be somewhat higher than the euro area average, which would help narrow the competitiveness gap between the economies at the core and in the periphery. Beyond the natural process, implementing policies to encourage higher investment and increase potential growth through domestic sources (discussed below) could play a role. Staff sees an additional reduction in the current account balance by 2 percent of GDP over and above the natural rebalancing process as appropriate.1

33. Germany can play a pivotal role in supporting the adjustment process in the euro area and helping restore market confidence. Articulating more clearly the European Union’s shared vision of the post-crisis architecture of the union would help in durably restoring market confidence by providing an anchor to medium-term market expectations. A key element of this post-crisis Economic and Monetary Union (EMU) architecture is common understanding on greater financial and fiscal integration (see forthcoming 2012 Euro Area Article IV staff report). While the natural rebalancing process in Germany will help, efforts on structural reforms in the periphery could be reinforced through pan-European actions. These could include boosting and better targeting EU structural funds and increasing the lending capacity of the European Investment Bank.

The Authorities’ Views

34. The authorities noted that while the German current account surplus may not be fully explained by fundamentals in models, this does not imply the conclusion that the current account position is stronger than implied by fundamentals. They noted that the price competitiveness of the German economy is currently quite favorable, but saw the elements for rebalancing in Germany as largely in place. They agreed that some policy levers to raise potential growth could be beneficial. They agreed that monetary policy settings appropriate for the EMU may imply somewhat higher inflation in Germany, and this is consistent with the natural adjustment process.

35. While agreeing with Germany’s importance in the EMU, the authorities offered some nuances regarding pan-European actions. While acknowledging some of the shortcomings of the current institutional design of the EMU, they believed that rigorous adherence to reform plans underway in the crisis economies is key to restoring market confidence, and that patience is needed in seeing the payoff from reforms. They were of the view that discussions on redesigning the architecture of the EMU would be premature before a solid track record had been established on policy implementation and its beneficial outcomes. Overall, they stressed their commitment to more rather than less integration in Europe, and saw ample space to improve the quality of spending of common pools of resources.

Structural Reforms to Raise Potential Growth and Diversify its Sources

36. Background. Germany’s potential growth at around 1¼ percent is low and has been highly dependent on external sources of demand. Moreover, with the aging of the population, the shrinking of the labor force would adversely affect potential growth over the longer term. In addition, productivity growth in the services sector unrelated to manufacturing, which provides some 60 percent of private employment and about 70 percent of value added, was about a quarter of that in goods production during 2000–07. Investment has also lagged and has contributed to external imbalances despite healthy corporate balance sheet positions.

A01ufig16

Germany: Average Annual Growth in Labor Productivity

(Per hour worked by persons in employment)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Federal statistical office of Germany (Destatis); and IMF staff calculations.
A01ufig17

Germany: contribution of various sectors to value added, 2010

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Sources: Federal statistical office of Germany (Destatis); and IMF staff calculations.
Staff’s Views

37. Policies to increase labor force participation, investment, and productivity growth, especially in areas outside Germany’s traditional strengths, need to be stepped up. As discussed in detail in the 2011 Article IV consultation report, tax reform priorities include reduction of labor taxes at the participation margin and further improvements in the corporate tax regime, including the possible introduction of in-work and earned income tax credit programs and a reform of the regime of income splitting, reforms of the local level trade tax and the introduction of an allowance for the normal return on new equity.2

38. Reforming the financial sector will be an essential complement to raise the economy’s growth potential and increase its resilience. Broadening the channels of financial intermediation would facilitate the allocation of resources towards innovation and new engines of growth. This would require a greater development of intermediation outside traditional banking channels, using so-called arms-length finance. Changes to regulation and supervision would have to keep pace with the development of a more arms-length system in order to ensure financial stability. In addition, ambiguities in the tax treatment of venture capital firms should be addressed and consideration should be given to the reduction of differences in the tax treatment of venture capital firms with other European countries. The regulatory framework may also need to be reexamined with a view to encouraging a larger investor base for risk capital. The intellectual property held by universities and research institutions needs to be deployed in industry more easily. Recent reform initiatives in the area of corporate and personal insolvency are welcome, and in addition it may be useful to explore the feasibility of out-of-court restructuring procedures to reduce the stigma associated with business failure. Strengthening the resilience of the financial system will also be important, and will also require efforts to reduce outstanding capital support to banks and the sizeable balance sheets of the two winding-up institutions, while seeking to minimize potential losses to the state.

A01ufig18

Financial Index Capituring the Degree to Which Financial System is “Arm’s Length” 1/

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Source: September 2006 WEO, chapter 4.1/ Lower value means more relationship-based.
A01ufig19

Cross-country Comparison: Private Equity-Investment

(Percent of GDP, 2010)

Citation: IMF Staff Country Reports 2012, 161; 10.5089/9781475506082.002.A001

Source: German Private Equity and Venture Capital Association.
The Authorities’ View

39. The authorities agreed with the need to continue structural reforms to raise potential growth. They noted the need for further progress on raising labor force participation, particularly for women, improving education infrastructure and improving competition in services, while underscoring that these need to be undertaken while adhering to broader fiscal objectives. The authorities also expressed interest in the staff’s recommendation on developing arm’s length financial systems in Germany and were in broad agreement with the recommendation on improving conditions for venture capital financing.

Staff Appraisal

40. Several conditions are in place in Germany for a domestic demand-led recovery following the downturn at end-2011. The drag from last year’s decline in external demand is receding, while domestic labor market conditions have continued to strengthen. Underpinned by healthy corporate and household balance sheets, higher wages, well anchored inflation expectations, and low borrowing costs, growth is poised to reach potential in the second half of 2012.

41. The near-term outlook is, however, clouded by a number of downside risks from external sources. The main risk facing Germany is an intensification of the euro area crisis, which would spill over into Germany directly through real and financial channels, and indirectly through dampened business and consumer sentiment. Lower global growth prospects more broadly would also cloud the outlook for activity. An abrupt rise in oil prices due to geo-political shocks also remains a downside risk to the outlook.

42. The main policy priority in the near term is to manage the transition to domestic demand-led growth and guard against the downside risks. The fiscal stance, with a modest structural consolidation and the full operation of automatic stabilizers, is appropriate under the baseline, given Germany’s advanced cyclical position, limited fiscal spillovers on growth in the euro area periphery, and Germany’s status as an EFSF/ESM guarantor. Looking ahead, a pickup in wages and some asset prices would be part of the natural process of rebalancing the sources of growth. Allowing these developments to proceed, while adhering to Germany’s macroeconomic policy framework, will also help to appropriately further reduce Germany’s high current account surplus.

43. Securing financial stability in the face of external risks remains a key priority. Despite some gradual progress achieved, the banking system remains vulnerable to external shocks given its high leverage ratios, the low quality of bank capital, significant cross-border exposures, and large reliance on wholesale funding. It will also be important to ensure that risks from the global activities of large banks are fully understood and internalized. The pre-emptive reactivation of the backstop facility for financial institutions (SoFFin II) is welcome, even though banks are expected to meet EBA capital requirements without the use of public support, under the baseline. Steps to establish a framework for implementing macroprudential policies following European Union initiatives are timely, although there is no need to tighten macroprudential policies at this juncture.

44. The current environment provides a window of opportunity to build momentum in financial sector reforms in line with the 2011 Financial Sector Assessment Program (FSAP) Update recommendations. Efforts to reduce outstanding public capital support to some banks and the sizable balance sheets of the two winding-up institutions should be stepped up, while paying due regard to minimizing potential losses to the state. Progress is also needed on a comprehensive strategy aimed at improving the efficiency and stability of the banking system. In particular, greater efforts are needed in restructuring the Landesbanken and reforming their business models. In addition, the crisis management framework should be strengthened by establishing resolution plans and enhancing the deposit insurance regime.

45. As the euro area’s largest economy, Germany can play a pivotal role in addressing the challenges posed by the crisis. Articulating more clearly the Economic and Monetary Union’s shared vision of an appropriate post-crisis architecture will help in restoring market confidence. The positive short-run benefits of the implementation of ambitious structural reform agendas in several euro area countries should be complemented with pan-European measures. These could include using EU structural funds and increasing the lending capacity of the European Investment Bank. Moreover, the reduction of imbalances in the euro area would be helped by the natural rebalancing of Germany’s economy. In this context, consistent with the mandate of the European Central Bank, disinflationary pressures incipient in the periphery economies, essential for their relative price realignment, could imply inflation in Germany that is somewhat higher than the euro area average for some time.

46. Germany should seize the opportunity to undertake its own structural reforms to raise potential growth and diversify its sources, reinforcing reform momentum in the euro area. Higher domestically driven growth would help raise the economy’s potential above that envisaged under the baseline while generating positive outward spillovers. Ongoing efforts to increase the labor force through the higher participation of female and older workers and the migration of skilled workers are welcome. Raising the quality of human capital will require reforms to the system of education and training. Raising productivity in the services sector would be helped by greater competition, including at the regional level in network industries such as transportation and energy.

47. There is a need to broaden the access to risk capital through structural financial reforms. Efforts should be stepped up to develop more arms-length financial intermediation as a complement to the well-established relationship-based system in Germany. Recent reform initiatives in the area of corporate and personal insolvency are welcome. The policy framework needs to be reexamined with a view to encouraging a larger investor base for risk capital. Broadening the channels of financial intermediation would facilitate the allocation of resources towards innovation and new engines of growth.

48. It is recommended that the next Article IV consultation take place on the regular 12-month cycle.

Table 1.

Germany: Selected Economic Indicators, 2008–2013

article image
article image
Sources: Deutsche Bundesbank; Federal Statistical Office; IMF staff estimates and projections.

IMF staff estimates and projections.

Growth contribution.

National accounts definition.

ILO definition.

Deflated by the national accounts deflator for private consumption.

Net lending/borrowing.

Excluding supplementary trade items.

Data for 2012 refer to March.

Data for 2012 refer to March.

Data reflect Germany’s contribution to M3 of the euro area.

Data for 2012 refer to April.

Data for 2012 refer to April.

Based on relative normalized unit labor cost in manufacturing. Data for 2012 refer to February.

Table 2.

Statement of Operations of the General Government

article image
Sources: Government Finance Statistics and IMF staff estimates.
Table 3.

General Government Stock Positions

article image
Sources: Government Finance Statistics and IMF staff estimates.
Table 4.

Germany: Medium Term Projections, 2010–2017.

article image
Sources: Federal Statistical Office, Bundesbank, and IMF staff estimates.
Table 5.

Germany: Core Financial Soundness Indicators for Banks

(In percent)

article image
article image
Source: Deutsche Bundesbank.

A methodological break in the supervisory time series on the capital adequacy of German banks has taken place in 2007 due to changes in the regulatory reporting framework, following Basel II.

1998–2006 according to Capital Adequacy Regulation, Principle I. Since 2007 according to Solvency Regulation.

2000–2009 data compiled in accordance with IMF’s FSI Compilation Guide. Data not available before 1 July 2000.

Due to one off data availability, comparability of 2006 data with other years limited.

A methodological break in the NPL series has taken place in 2009. Due to changes in the regulatory reporting framework *) NPL figures for end-2010 under review