Germany: Staff Report for the 2015 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
15 Jul 2015
eISBN:
9781513511160
Language:
English
Keywords:
ISCR; CR; DAX stock market index; article IV report; stock market index; staff appraisal; euro depreciation buttresses export; oil price drop; potential GDP; labor market; output gap; banking sector; Current account surpluses; Global
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KEY ISSUES Context: Growth is benefiting from lower energy prices and euro depreciation, and the labor market is strong. The external position remains substantially stronger than implied by medium-term fundamentals as the current account surplus reached another historical high. The fiscal position is healthy, corporate and household balance sheets are sound. Low interest rates are compounding chronically weak bank profitability and hurting life insurers’ solvency. The population is aging fast despite record immigration, which will increasingly harm growth prospects after 2020. Policy priorities: Further progress is urgently needed to raise potential growth while generating beneficial spillovers to the rest of the euro area and lowering the large current account surplus: Step up investment addressing weaknesses in public infrastructure to strengthen potential output and domestic demand. To facilitate this process, put in place new institutions that enable better planning and coordination of public investment at the local level. Enhance competition to foster a more productive services sector. Reduce disincentives for women to work full time as a way to mitigate the adverse effects of an aging population on labor supply. Expand the macroprudential toolkit to better address potential future excesses in the housing sector. Ensure that life insurance companies maintain sufficient capital buffers to withstand a prolonged period of low interest rates.

Abstract

KEY ISSUES Context: Growth is benefiting from lower energy prices and euro depreciation, and the labor market is strong. The external position remains substantially stronger than implied by medium-term fundamentals as the current account surplus reached another historical high. The fiscal position is healthy, corporate and household balance sheets are sound. Low interest rates are compounding chronically weak bank profitability and hurting life insurers’ solvency. The population is aging fast despite record immigration, which will increasingly harm growth prospects after 2020. Policy priorities: Further progress is urgently needed to raise potential growth while generating beneficial spillovers to the rest of the euro area and lowering the large current account surplus: Step up investment addressing weaknesses in public infrastructure to strengthen potential output and domestic demand. To facilitate this process, put in place new institutions that enable better planning and coordination of public investment at the local level. Enhance competition to foster a more productive services sector. Reduce disincentives for women to work full time as a way to mitigate the adverse effects of an aging population on labor supply. Expand the macroprudential toolkit to better address potential future excesses in the housing sector. Ensure that life insurance companies maintain sufficient capital buffers to withstand a prolonged period of low interest rates.

Recent Economic Developments and Outlook

A. The Economy Remains on an Uptrend

1. An upturn is under way as the economy is enjoying the benefits of the euro depreciation and lower energy prices. The anticipation of the ECB’s quantitative easing (QE) significantly lowered interest rates and term spreads, weakened the euro, and, together with the drop in energy prices, helped overcome the unexpected slowdown of mid-2014 (Figure 1). By the end of last year and into the first quarter of this year, investment picked up again while consumption was supported by above-trend real disposable income growth. The latter benefited from robust real wage growth, a strong labor market, and the positive demand effects of the pension reform implemented last year (higher pensions for some mothers, and earlier statutory retirement for some categories of workers). The regained domestic demand momentum boosted imports, while the weaker euro during the second half of the year helped strengthen export performance in spite of a slowdown in emerging markets.

Figure 1.
Figure 1.

Germany: Growth Outlook

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Source: Destatis, Haver Analytics, IFO Institute, INS, IMF World Economic Outlook, Markit, and IMF staff calculations.Note: EA5=Euro area economies (Greece, Ireland, Italy, Portugal, Spain) with high borrowing spreads during the 2010-11 sovereign debt crisis.
A01ufig1

The Effect of QE on Financial Markets

(Cumulative changes from August 22, 2014)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Sources: Bloomberg and IMF staff calculations.

2. The oil price drop brought inflation temporarily close to zero, contributing to lift real wage growth to a twenty-year high. Core inflation is low and stable at around 1 percent, while real compensation per employee increased by 1.7 percent in 2014 (Figure 2). Employment kept growing strongly—though the trend in total hours worked has been less dynamic—and the unemployment rate hit another post-reunification low at 4.7 percent, while Germany became the second largest migration destination in the world after the U.S. last year. Recent collective agreements and ongoing wage negotiations suggest continued significant real wage growth this year. The new minimum wage, introduced on January 1, 2015 and implemented over two years, has had no visible impact on total employment so far.

Figure 2.
Figure 2.

Germany: Prices and Labor Market

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Source: Bundesbank, Federal Statistical Office, Eurostat, Haver Analytics, and IMF staff calculations.
A01ufig2

Germany: Current Account and Sectoral Saving-Investment Balances

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

3. The current account surplus continued to grow in 2014, reaching 7.6 percent of GDP. The narrowing of the oil and gas trade deficit was the main contributor to the expansion in the surplus (Figure 3), which was the largest in the world in USD terms. The surplus vis-à-vis euro area economies (Greece, Ireland, Italy, Portugal, Spain) with high borrowing spreads during the 2010-11 sovereign debt crisis was stable after declining substantially during the crisis. Regarding saving-investment balances, non-financial corporations and the general government increased their surpluses in 2014 relative to 2013. In fact, the surplus of non-financial corporations, at 2.2 percent of GDP, reached its highest level since reunification. The CPI-based real effective exchange rate was roughly stable in 2014, but has since depreciated by 6 percent from its 2014 average primarily because of nominal depreciation vis-à-vis the dollar and the renminbi. The net international investment position (NIIP) continued to grow in 2014, reflecting stronger direct and portfolio investment positions. Yet, monetary and financial institutions cut back their net foreign lending position, continuing a trend observed since 2009.

Figure 3.
Figure 3.

Germany: Balance of Payments

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Source: Bundesbank, DOTS, GDS, Haver Analytics, IMF World Economic Outlook, and IMF staff calculations.1/ Countries included in the calculations are Australia, Austria, Belgium, Canada, Colombia, Denmark, Estonia, Finland, France, Greece, Hong Kong SAR, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Singapore, Slovak Republic, Slovenia, South Africa, Spain, Suriname, Sweden, Switzerland, Taiwan Province of China, United Kingdom, and United States. Note: EA5= Euro area economies (Greece, Ireland, Italy, Portugal, Spain) with high borrowing spreads during the 2010-11 sovereign debt crisis.

4. Fiscal policy was mildly contractionary in 2014, while it is expected to turn mildly expansionary in 2015. The government presented a balanced federal budget for 2015, one year ahead of schedule (Figure 4). The general government surplus rose to 0.6 percent of GDP in 2014—a structural improvement of 0.3 percent relative to 2013—owing to lower-than-expected interest payments and one-off revenue items. A negative interest rate–growth rate differential pushed the debt ratio further down, to 74.7 percent of GDP. The structural fiscal position for 2015 is expected to remain comfortably within the boundaries set by the constitutional debt brake rule at the federal level and the European Medium-Term Objective (MTO) at the general government level (maximum structural deficits of 0.35 percent and 0.5 percent of GDP, respectively).

Figure 4.
Figure 4.

Germany: Fiscal Developments and Outlook

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Sources: Federal Statistical Office, Ministry of Finance, and IMF staff calculations and projections.

5. Credit growth remains tepid despite record-low interest rates. The yield on 10-year bunds, after reaching a trough of 0.1 percent in mid-April, recently rebounded sharply as market volatility suddenly jumped—possibly reflecting lower market liquidity—but remains very low from a historical perspective, with negative yields extending up to the 3-year maturity. Already historically low bank lending rates have fallen further with the anticipation of QE (Figure 5), while stock prices have accelerated sharply. So far, however, credit growth has remained subdued, especially in the corporate sector, where companies can finance a large share of their investment needs from retained earnings and cash reserves, resulting in low credit demand. A more dynamic housing market (especially in some “hot spots”) over the past few years has been accompanied by tepid aggregate mortgage lending growth, although there are signs of acceleration in recent months.

Figure 5.
Figure 5.

Credit Conditions and Asset Prices

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Source: ECB, Haver Analytics, and IMF staff calculations.

6. The Single Supervisory Mechanism’s (SSM) Comprehensive Assessment revealed only minor shortcomings in loan classification or provisioning but showed relatively low capital quality and leverage ratios in the large-bank segment of the banking sector. As expected, the higher provisioning needs identified by the asset quality review were concentrated in shipping finance and commercial real estate portfolios. All assessed banks, except a relatively small one, passed the stress tests. This very positive outcome was partially due to the fact that some types of capital that are being phased out under the new European regulation were still counted as eligible for the exercise.1 Furthermore, while banks’ leverage ratio is currently not subject to EU-wide regulation, SSM disclosures showed that many of the largest German banks had leverage ratios close to or below 4 percent (Figure 6), a level emerging as the new regulatory minimum in a growing number of European countries (Netherlands, Switzerland, U.K.).

Figure 6.
Figure 6.

Germany: Recent Developments in the German Banking Sector

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Source: Bloomberg, ECB, IFS, SNL Financial, and IMF staff calculations.1/ Includes capital raised during January- September 2014.

B. Outlook and Risks

7. The more favorable external environment should support the growth momentum. The robust private consumption dynamics of the past three quarters is projected to persist with the help of lower energy prices and strong real wage growth. The euro depreciation and lower real interest rate (as QE pushes up inflation expectations) should buttress exports as well as the long-awaited recovery in machinery and equipment investment. Although corporate credit demand is expected to remain muted in a context of cash-rich corporate balance sheets and increasing profit margins for exporters, QE-induced lower real interest rates should translate into somewhat firmer credit growth. The fiscal stance should remain slightly expansionary in 2016 (see below). Employment growth should slow down as the adverse effect of the lower statutory retirement age for some categories of workers on labor force participation kicks in fully and the already low unemployment rate becomes harder to reduce further. All in all, GDP is expected to grow by 1.6 percent this year and 1.7 percent next year. The output gap should close this year and remain positive but small in the medium term. Together with a better anchoring of expectations because of QE (and despite only limited expected pass through from the exchange rate depreciation and the introduction of the minimum wage) this positive output gap should gradually push up core and headline inflation. Although German inflation is expected to exceed that in the rest of the euro area throughout the forecast horizon, it is not projected to rise above the ECB price stability objective.

8. Fiscal balances are set to remain comfortably within the boundaries of the fiscal rules. For the remainder of the legislature (2015–17) and beyond, budget plans are centered on a zero balance at the federal level with small surpluses for the general government, backed by buoyant revenue forecasts. Staff expects larger surpluses than the authorities, mostly on account of lower projected interest payments (Table 2), enough to bring public debt below 60 percent of GDP by 2020. Although the structural fiscal balance is expected to decline by 0.6 percent of GDP through 2015–17, debt sustainability analysis shows that the medium-term position is well anchored by the fiscal rules (see Appendix IV).

Table 1.

Germany: Selected Economic Indicators, 2012-16

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

Contribution to GDP growth.

ILO definition.

Deflated by national accounts deflator for private consumption.

Net lending/borrowing.

Excluding supplementary trade items.

Data refer to end of December.

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

Table 2.

Germany: General Government Operations, 2012-20

article image
Sources: Ministry of Finance; Bundesbank; Federal Statistical Office; and IMF staff estimates and projections.

Includes one-off proceeds from June 2015 auction of mobile-phone frequencies.

9. The current account surplus is projected to grow further in 2015 and decline only moderately in the medium term. The oil and gas trade balance is expected to continue to improve as energy prices remain lower on average than in 2014. In addition, the real exchange rate depreciation (of 6 percent in effective terms relative to 2014) will also put upward pressure on the external balance. As a result, the surplus is expected to exceed 8 percent of GDP, a record high, and decline gradually to 6.7 percent in 2020, as the terms of trade windfall is gradually spent, private investment recovers modestly, and stronger wage growth relative to euro area trading partners contributes to realign competitiveness.

10. Risks to the baseline are more balanced than a year ago, but important sources of uncertainty remain. There is upside risk to the outlook if the stimulus from monetary policy and oil prices that is in the pipeline proves more effective than expected. On the downside, a number of external risks could affect Germany, with possible impact ranging from low to moderate (see Appendix I):

  • A protracted period of slower growth in key advanced and emerging economies or a deeper-than-expected slowdown in China would dampen economic activity in Germany. Unusually for a large economy, Germany is very open, with an exports-to-GDP ratio over 45 percent, and thus highly sensitive to external demand fluctuations. While the geographic structure of exports is well diversified, a simultaneous shock to major emerging economies would have a sizable impact on Germany (Box 1).

  • Renewed stress in the euro area, triggered by policy uncertainty, faltering reforms, or political unrest in some countries might erode confidence and postpone once again the projected investment recovery. Further monetary stimulus at the euro area level would be forthcoming in this scenario, but it may need to be reinforced by demand-support measures in Germany.

  • Uncertainty about the persistence of the oil supply shock and the underlying price decline could undo part of the recent improvement in consumer and business confidence, both domestically and in key trading partners. This would be a low-impact shock.

  • An escalation of trade sanctions with Russia would hurt Germany because of its heavy dependence (30 percent) on oil and gas imports from that country and might require a reform of the energy strategy. Other direct trade ties and financial exposures are limited. Germany could also experience safe haven inflows if tensions rise.

Authorities’ Views

11. The authorities agreed with staff that the moderate expansion of the German economy is likely to continue. They expressed confidence in a consumption-led upswing, amid lower energy prices as well as solid wage growth underpinned by a tight labor market and closed output gap. While they concurred with staff that inflationary pressures would be muted this year, the Bundesbank underscored that prices were likely to accelerate owing to pass-through from exchange rate depreciation as well as the introduction of the minimum wage and recent wage dynamics more generally, so that inflation would reach close to 2 percent in 2016. The authorities agreed that the current account surplus would decline only gradually. They also concurred that public debt is well-anchored by EU and national fiscal rules, although they foresaw convergence to the 60 percent Stability and Growth Pact objective at a slower pace than in staff’s projections.

12. The authorities saw the risks to the outlook as generally balanced. On the upside, they noted that private investment could turn out stronger than expected and drive a more forceful recovery. On the downside, the authorities saw instability in the euro area as a result of renewed sovereign stress, possibly amplified by relatively low liquidity in some market segments, as the most relevant risk at the moment, though they noted that the system was now much more resilient than in the past. They also pointed out that heightened exchange rate volatility was a source of risk, and was seen as such by many German corporations.

Impact on Germany of Slower Growth in Emerging Markets

Growth in emerging markets (EMs) was disappointing in the last two years and there is mounting evidence that a sizable part of the growth slowdown may have been structural (see World Economic Outlook, April 2015). Based on simulations using the Fund’s G20-MOD model, this box analyses the consequences on the German economy of a further slowdown in EMs (Brazil, China, India, Indonesia, Mexico, Russia, South Africa, and Turkey). In this scenario, the EM deceleration is due to a permanent decline in the level of total factor productivity (with respect to baseline) that is initially perceived as cyclical. As a result, EM monetary policy is loosened and currencies depreciate. As successive negative growth surprises occur, agents gradually become aware that the slowdown is in fact structural and the monetary loosening is gradually reversed.

Germany is among the most affected economies in the euro area under this scenario. Lower growth in EMs (GDP is 3 percent lower than in the baseline at the end of the fourth year) spills over to the global economy, including through a significant negative impact on commodity prices. Among Advanced Economies (AEs), the negative impact is the largest for Japan and the euro area given their trade exposures to EMs and their lack of (conventional) monetary policy space, though lower commodity prices help soften the blow somewhat. The drop in German GDP (-1.5 percent at the trough) is sizable and reflects Germany’s large exposure to EMs. The current account surplus is almost unaffected (-0.4 pp of GDP) as domestic demand and imports also drop. Lower exports translate into lower labor demand, higher unemployment, lower wages, lower inflation, and higher real interest rates (given the zero lower bound on nominal interest rates), which combined with lower growth prospects, income and wealth lead to a permanent decline in investment and consumption compared with the baseline. Moreover, looser monetary policy in EMs initially depreciates their currencies against the euro, which further impacts Germany’s competitiveness and weighs on exports. As EMs’ central banks gradually realize that the slowdown is structural, they start normalizing policy thereby progressively correcting domestic and external imbalances. Germany’s real exchange rate converges back to the baseline as does its current account, but the negative impact on consumption, investment and real GDP of the slowdown in EMs is much more persistent.

A01ufig3

Emerging Markets

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

A01ufig4

Germany

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

External Assessment

13. Germany’s external position is substantially stronger than implied by medium-term fundamentals and desirable policy settings.

  • The cyclically adjusted current account balance stood at 8.1 percent of GDP in 2014, while staff assesses the norm at 3–5 percent of GDP. Hence, the current account is 3–5 percentage points of GDP stronger than the value implied by fundamentals and desirable policies. While the EBA model attributes 0.6 percentage points of the current account gap to Germany’s fiscal policy gap and 0.9 percentage points to the fiscal policy gaps in other countries, 3 percentage points remain unexplained and may be due to factors not fully captured by the model.

  • The REER is assessed as undervalued by 5–15 percent in 2014. Applying standard trade elasticities to the current account gap yields a REER undervaluation of 7–12 percent, while the EBA REER level model suggests an undervaluation of 16 percent.

  • Developments as of May 2015, notably the lower energy prices and depreciated REER, point to a further strengthening of the external position. Preliminary estimations of EBA REER models based on projections point to a larger undervaluation in 2015 if the current depreciation of the euro is sustained. While the current account surplus is projected to expand in 2015, the current account gap may remain stable because the EBA model norm is projected to increase as well, partly reflecting the evolution of demographic factors.

14. Germany’s current account surplus has been associated with a weaker domestic demand than in typical large and sustained current account surplus episodes in advanced countries. Even though the size and the duration of Germany’s surplus so far are in line with those of a typical episode, the weakness of domestic demand and, especially, the relatively strong fiscal position stand out (see Selected Issues). Real exchange rate or terms of trade movements did not play a major role in Germany’s episode or elsewhere, with the exception of the ULC-based REER which depreciated in the run-up to and early years of the German episode. Exits from large and sustained current account surpluses, where they occurred, were typically accompanied by faster GDP growth—reflecting both higher potential growth and a stronger cyclical position.

Authorities’ Views

15. The authorities broadly agreed with the external sector assessment. While they emphasized the difficulty of identifying the ultimate drivers of the CA surplus, they praised the refinements and expansions of the EBA methodologies, particularly the more sophisticated treatment of demographic factors and the improved methods to explain cross-country differences in REERs. They noted that the methodological improvements reduced the size of the unexplained regression residual for Germany and gave a more reasonable model estimate of the equilibrium REER. They broadly agreed with the ESR assessment, though the Bundesbank saw the REER undervaluation at the lower bound of the staff’s range (around 5 percent for 2014).

Policy Discussions

With the economy in a favorable cyclical position underpinned by robust balance sheets and partly buoyed by short-term factors, progress is urgently needed on policies to strengthen growth in the medium and long term, while also generating much needed positive outward spillovers and reducing the large current account surplus.

A. Strengthening Both Growth Potential and Domestic Demand while Reducing External Imbalances

16. The working–age population is set to decline soon, which will put downward pressure on potential growth. For now, stronger immigration and a modest upward trend in labor market participation by female and older workers have compensated for the adverse effects of aging on the labor force (Box 2). However, this will become increasingly challenging as aging will accelerate. Also, currently high immigration flows may not be sustainable, and further increases in labor force participation by older workers may be difficult to achieve in the future, as suggested, for instance, by the government’s decision to lower the statutory retirement age for some categories of workers last year. Thus, if trend total factor productivity remains constant (as it has been in the recent past) and capital accumulation continues at its current modest pace, potential growth will decline rapidly after 2020.2 Muted prospects for long-term growth, in turn, may be holding back domestic private investment despite very favorable financial conditions and healthy corporate balance sheets; they might also help explain the large domestic savings-investment surplus in the corporate sector—a major contributing factor to the current account surplus.

A01ufig5

Working-Age Population Projections

(Millions of people aged 15-74)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Sources: Federal Statistical Office’s 13th Coordinated Population Projection and IMF staff calculations.

17. In light of the continued weakness in global demand, stronger domestic demand in Germany, where balance sheets are healthy, would have important positive spillovers. Global demand remains weak as reflected by inflation below central banks’ targets across advanced countries and especially in the euro area, where the need to repair balance sheets in the private and public sector continues to weigh on the recovery in vulnerable countries.3 There is a concern that ever-looser monetary policy might be insufficient to bring about a lasting recovery, or that low interest rates for long might lead to financial instability.4 A host of policies are needed to address these problems, but stronger demand in Germany, where public and private balance sheets are sound, would be helpful. Stronger demand would also speed up adjustment in the current account surplus, reducing external imbalances.

Potential Output in Germany

Re-estimating the trajectory of potential output in EU countries is particularly relevant at the current juncture, in light of the introduction of the ESA 2010 national accounts methodology as well as the need to reliably identify the permanent damage to potential output inflicted by the crisis (World Economic Outlook, Spring 2015). Staff, therefore, re-estimated potential output for three large euro area countries (France, Germany, Spain) using the new multivariate filter (MVF) developed by Blagrave et al. (2015). 1/2/ The MVF improves upon commonly used univariate filters (e.g., the HP filter) inter alia by modeling relationships between GDP, potential GDP, unemployment and inflation. Judgment based on information outside of the model can be incorporated to improve the plausibility of results.

In Germany, in contrast with other advanced countries, the scars left by the global financial crisis on potential GDP growth appear limited. The MVF suggests that potential GDP growth in 2011-14 was at the same level as in 2005-07. Furthermore, a decomposition of potential GDP growth shows that the same is true for total factor productivity (TFP) growth. However, the contribution of capital has been small since 2009, reflecting a downward level shift in investment during 2009-10. This has been compensated by a larger contribution of labor, reflecting several cross-currents: high immigration has momentarily put a brake on the previously negative contribution of working age population; in parallel, continuous increases in the labor force participation rate have more than offset the decline in average hours worked per employed; finally, the employment rate has kept increasing following the Hartz reforms (see Box 3).

A01ufig6

Germany: Output Gap and Inflation, 1993-2020

(Percent)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Sources: Staff calculations
A01ufig7

Germany: Potential Output Growth and Contributions, 1993-2020

(Percent)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Sources: Staff’s calculations based on MVF model with judgmentNote: TFP=total factor productivity

Under current policies, German potential GDP growth should remain stable around 1.3 percent over the next few years but start a secular decline at the end of the projection horizon. Given the lack of major ongoing structural reforms, stable R&D investment rates, and no acceleration in international TFP spillovers, TFP growth is expected to remain steady, while a modest investment recovery will gradually push up the contribution of capital. This will offset a smaller labor contribution driven by a deceleration of the labor force participation rate and of the employment rate. However, looking beyond 2020, the 13th demographic projections recently released by the Federal Statistical Office suggest that the decline in the working-age population will resume as immigration flows normalize and larger cohorts reach the age of 75, resulting in lower potential growth.

1/ See “Potential Output in France, Germany, and Spain: A Reassessment,” Chapter IV, Selected Issues for the 2015 Spain Article IV Consultation (forthcoming).2/ Blagrave P., R. Garcia-Saltos, D. Laxton, and F. Zhang (2015), “A Simple Multivariate Filter for Estimating Potential Output,” IMF Working Paper 2015/79.

18. Policies should therefore focus on fostering potential growth while generating positive demand spillovers. Using model simulations, last year’s staff report argued that increased spending on public investment in needed infrastructure, policies to reduce regulatory uncertainty regarding the energy transition, and reforms to increasing productivity in the nontradable services sector would lift potential output and generate meaningful positive outward spillovers to the rest of the euro area, while reducing the current account surplus. In particular, higher public and private investment (the latter brought about by energy sector reforms) were found to have especially large spillover multipliers.5

19. Policies that directly target higher wages may generate negative outward spillovers if they result in lower employment and weaker economic activity in Germany. The widening current account surplus in the mid-2000s coincided with labor market reforms that strengthened incentives for the unemployed to return to work. The reforms were accompanied by declining real wages and unit labor costs (Box 3). While real wages and unit labor costs began to rise in 2008 and the labor share is back to its long-term average, the current account surplus has not declined, raising the question of whether policies should try to achieve faster wage growth to foster external rebalancing. Model simulations indicate that policies that directly target wage increases (such as a social pact or measures to strengthen the negotiating power of workers) would lead to a REER appreciation and a modest fall in the current account surplus, but would also bring about reductions in employment and production in Germany as well as negative growth spillovers to the rest of the euro area (see Selected Issues). By contrast, wage increases resulting from positive demand shocks would be associated with higher output and employment and a lower current account surplus in Germany as well as positive growth and economic activity in the rest of the euro area.

Authorities’ Views

20. The authorities agree that population aging is a primary concern and would be comfortable with a lower current account surplus, but emphasized that the current account balance is not a specific policy goal. They shared concerns about declining long-term growth rates and lackluster private investment in spite of low interest rates, and were thus open to policies that might improve the corporate sector’s willingness to invest in Germany and, through that avenue, reduce the current account surplus. However, they rejected any notion of fiscal stimulus citing the closed output gap and limited outward spillovers. They also emphasized that in a monetary union, monetary policy—but not fiscal policy—should be set for the union as a whole. Overall, they were comfortable with current nominal and real wage growth, which they saw as reflecting the tightening labor market and bringing about the needed realignment of competitiveness within the euro area at an appropriate pace.

The Hartz Labor Market Reforms 10 Years on

As other European countries, beginning in the mid-1970s Germany experienced an upward trend in the unemployment rate as increases in recessions were only partially reversed in expansions. In 2003-05, with unemployment at new highs, Germany embarked on a sweeping set of reforms (the Hartz reforms). The reforms eased regulation on temporary work agencies, relaxed firing restrictions, restructured the federal unemployment agency, significantly reduced benefits for long-term unemployed (which were high in international comparison), and tightened job search and acceptance obligations for benefit recipients. Following the reforms, the unemployment rate declined steadily and is now at its lowest level since reunification. Were the Hartz reforms a key factor in reducing structural unemployment or did other factors play a role?

Existing studies have argued that the reforms helped reduce unemployment and increased the efficiency of job search but lowered average wages and increased wage inequality. An alternative view is that the favorable labor market developments in Germany mainly reflected wage moderation induced by the competition from Eastern Europe. To shed further light on these questions, staff research (Niklas Engbom, Enrica Detragiache, Faezeh Raei, “The German Labor Market Reforms and Post-Unemployment Earnings,” IMF Working Paper, forthcoming) using data from a detailed administrative dataset compares the pre- and post-reform labor market experience of two groups of workers: those in stable employment and those re-entering from unemployment from short-term unemployment (displaced workers). The chart below plots the median earnings of the two groups (normalized so that the two series have the same average during the pre-reform years), and shows that after the reforms the earnings of displaced workers fell markedly while those of other workers remained flat. This suggests that displaced workers were more willing to accept lower paying jobs to exit from unemployment after the reforms. The same result is confirmed when tested in a rigorous regression framework, in which observable and unobservable worker characteristics and macroeconomic factors are controlled for. These findings suggest that the reforms succeeded in strengthening incentives to return to work, thereby contributing to the sharp reduction in unemployment observed in Germany since 2005. As they achieved this goal, however, they imposed a higher burden on workers experiencing unemployment in terms of reduced post-unemployment earnings.

A01ufig8

Normalized Earnings of Workers in Stable Employed and Displaced Workers

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Note: Log monthly real labor income (12-month moving average). Full-time employed males age 25-62. Displaced workers had spent at least three years in continuous full-time employment prior to unemployment, transited from a full-time job to unemployment at some point 12 months ago and are currently full-time employed. Non-displaced workers have spent at least four years in full-time employment. The vertical bars denote the period of the Hartz reforms.Source: Sample of Integrated Labor Market Biographies (SIAB).

B. Public Investment

21. The government stepped up initiatives to boost public investment, although there is scope for more ambitious action. Last year, the Fund called for a 2 percent increase in investment in infrastructure over four years to address needs identified by expert studies. The federal government recently announced plans to raise public investment. These include 0.1 percent of GDP allocated to a new infrastructure fund for financially weaker municipalities in 2015 (plus a new allocation of about ½ this year’s size for 2017) as well as new spending mostly in public transportation, the digital infrastructure, and energy efficiency improvements totaling 0.4 percent of GDP over 2016–18. All in all, the 2015 German Stability Program foresees the general government public capital spending to increase on average by 4.6 percent per year during 2015–19, against an average growth rate of 1.7 percent in 2011–14, and going from 2.2 percent of GDP in 2014 to 2.3 percent of GDP in 2019. A further boost to public investment is expected to come from financial relief granted to municipalities, although this effect cannot be quantified yet. Additional increments in infrastructure spending outside the general government (for instance, by public enterprises or private-public partnerships) may also be forthcoming. Overall, however, the new plans appear to be well short of last year’s Fund advice. Delivering on the reminder of the proposed increase would be desirable. If fully financed through the budget, and implemented during the current legislature, such a program would utilize most of the fiscal space available under the MTO, bringing the general government structural balance down to -0.3 percent of GDP by 2017 (Figure 4). The medium-term fiscal position, however, would remain well anchored. The additional investment expenditure would also complement ongoing centralized investment initiatives at the European level, such as the European Fund for Strategic Investment (Juncker Plan).

22. To facilitate ratcheting up public investment, new initiatives to improve the planning process at the local level and facilitate public private partnerships (PPPs) would be useful. A third of public investment is executed at the municipal level. Stretched public finances in some regions have constrained investment budgets in the past and will likely continue to do so in the medium term, as regions need to reach zero structural balance by 2020. In addition, at the federal and general government level mounting aging costs and a normalization of real interest rates are likely to make meeting the fiscal rules in the future more challenging than at present, possibly putting renewed pressure on public investment budgets. Hence, alternative financing mechanisms such as PPPs may be useful to boost public investment now and help ensure adequate investment levels in the future. However, as local authorities may have limited expertise to contract with the private sector, and the planning process for infrastructure is seen as fragmented and less efficient than at the federal level, the creation of a coordinating agency could be particularly beneficial (see Selected Issues). Such an agency would advise on contract design, help improve information transparency, and inform the public debate on project selection by highlighting fiscal risks and cross-project externalities. In addition, sector-specific infrastructure companies, as proposed by the Expert Commission on “Increasing Investment in Germany,” would be helpful as long as the associated fiscal risks are appropriately managed, either by a transfer of project risks to the private sector or by including the companies in the general government perimeter.

Authorities’ Views

23. The authorities noted that public investment had been stepped up substantially by the government and underlined the need to maintain buffers under the fiscal rule. The Ministry of Finance viewed the new initiatives of the current government as a substantial investment expansion package, and did not see merit in further increases also in light of other priorities, such as income tax relief after years of “bracket creep.” It also stressed the need to maintain some margins under the fiscal rules in case of adverse budgetary surprises and the benefit of having a budgetary anchor, such as a balanced federal budget, which can be easily explained to the public. The Ministry agreed that a coordinating agency could help mobilize investment at the local level, but pointed out that creating such an agency would take time (hence the importance of support from federal transfers in the short run), and it may prove challenging given the German federal framework.

C. Structural Reforms: Services Sector and Energy

24. Competition-enhancing reforms in the services sector are very slow to materialize. Labor productivity growth in the services sector remains low, particularly in business services. Barriers to competition have been documented by the OECD and the Monopolies Commission in several large sub-sectors, and their removal would boost productivity and potential growth. 6 Germany’s leadership in this area would also likely help catalyze reforms in other European Union members. In the area of the regulated professions, the European Commission (EC)-led transparency and mutual evaluation exercise—focused on access conditions—will be completed in January 2016 and no conclusions have been drawn yet. The government has initiated a review of the restrictions on equity investment in the field of selected professions (e.g., architects and engineering companies) and results are expected by the end of the year. Regarding price regulation, the EC initiated pilot proceedings against Germany last December, inter alia posing questions with respect to the scale of fees of some professions. It is yet unclear whether this procedure will lead to any significant change. In the area of rail transportation, a new draft of the regulation law is being discussed, which is a not-to-be-missed opportunity to enhance regulatory powers to limit discriminatory practices by the incumbent operator and thus promote greater competition in all business segments.

A01ufig9

Sectoral Labor Productivity Growth and Share of Total Gross Value Added

(Percent)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Sources: Federal Statistical Office and IMF staff calculations.

25. On the energy front, progress is being made to tackle the challenges from the ambitious program of transition to renewable sources and nuclear phase-out, but several issues remain. The Renewable Energy Act was amended last year to help contain costs for retail electricity users, while the EC decided to allow the continuation of subsidies for large companies competing internationally at least until 2020. However, this controversial subsidy, which is paid for by higher electricity charges on other users, remains uncertain in the long run; also, key decisions are still pending on how to secure conventional back-up capacity as renewable capacity is expanded. A still unresolved issue is how grid expansion can be expedited amid strong opposition by affected parties in some regions. These challenges should be addressed rapidly to ensure that electricity costs, already among the highest in Europe, do not continue to climb, and to remove important elements of uncertainty in private sector investment decisions.

Authorities’ Views

26. The authorities were confident that the energy transition would be successfully managed and acknowledged that progress in the area of professional services was slow. On the energy agenda, they noted that, after many years of rapid growth, in 2015 the electricity price surcharge related to renewable sources had not increased—though this reflected in part statistical factors. They indicated that plans to auction off renewable subsidies would introduce more competition and help curb costs. In the services sector, they indicated that work to identify growth-enhancing product market competition policy measures was ongoing. More specifically, on regulated professions they agreed that there was scope for re-assessing the relevance of parts of the regulation, but noted that political support for these reforms was generally weak and that they required a case-by-case review to ensure that quality standards in the provision of services would not be compromised.

D. Countering Adverse Demographics: Female Labor Force Participation

27. To counter the adverse effect of population aging on labor supply, stronger policies to spur female labor force participation are needed. Although female labor force participation is relatively high in Germany (above 70 percent), about half of working women work part time (in part because women are the main holders of so-called mini-jobs), a pattern which is often attributed to an insufficient supply of good quality child care services and afterschool programs, as well as disincentives from the tax-benefit system (see Selected Issues). Closing this gap could help stem the projected decline in the labor force over the coming decades. Staff estimates that if the difference in average hours worked by men and women were fully closed, potential output would increase by as much as 7.5 percent. The federal government has recognized this as a priority and increased investment in the expansion of child care facilities by 0.1 percent of GDP in total over the last three years. However, faster progress in this area, for instance by making a comparable investment in the expansion of after school programs, is essential to broaden opportunities for women in the labor market. This would also help reduce poverty among single mothers. In addition, reforms to the tax-benefit system aimed at encouraging full-time work would also be beneficial. These could include lowering the tax wedge for secondary earners by moving closer to a system of individual taxation, reducing differences in the health-insurance premiums for working and non-working spouses, and targeting cash support for non-working parents to poorer households. Addressing both types of constraint simultaneously should allow for a more effective response of female labor supply.

A01ufig10

Selected Labor Force Indicators by Gender, 2014

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Source: Eurostat.

Authorities’ Views

28. The authorities stressed progress under way on female labor force participation. They pointed out that female labor force participation in Germany is one of the highest among advanced economies, while the prevalence of part-time work partly reflects social preferences. Although they agreed that fiscal disincentives for secondary earners were high—in particular free health care coverage of spouses not working or working in a mini-job—they noted that the absence of widespread provision of high quality child care and afterschool programs was likely to be a more important constraint to full-time employment. In that context, they highlighted progress made in these areas over recent years, notably increased child care supply.

E. Monetary and Financial Sector Policies

29. Although QE is expected to be very beneficial for the euro area recovery, its perception by the German public is generally negative. A long-standing preference for low inflation and a relatively favorable cyclical position contribute to a concern that current monetary conditions may become too accommodative from a German perspective, a development that does not feature in staff’s baseline macroeconomic scenario and is not seen as a significant risk by staff. In addition, German households hold a large share of their wealth in nontradable fixed income assets such as bank deposits and life insurance policies, typical mortgages have a fixed interest rate, and the rate of home ownership is low relative to other advanced countries.7 Thus, in Germany lower interest rates and higher asset prices following QE do not translate into stronger household balance sheets as much as in other advanced countries.

A01ufig11

Selected Advanced Economies: Composition of Household Financial Assets

(Percent of total financial assets, 2013)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Sources: Haver Analytics and IMF staff calculations.

30. The moderate upward trend in housing prices continues and the appropriate response at this stage is close monitoring and readying the macroprudential toolkit. After years of stagnation, nominal housing prices at the aggregate level have grown at an annual pace of 3–4 percent for the past five years—only marginally faster than the growth in disposable income. In spite of falling lending rates, mortgage loan growth remains modest and lending standards appear stable. Thus, there are no signs of overheating yet. Nonetheless, developments in the most dynamic segments, such as apartments in large cities, deserve particular supervisory attention, and efforts to step up data collection on mortgage loan terms and conditions need to continue, including because of a significant share of high reported loan-to-value ratios (LTVs) in those segments in a recent Bundesbank survey. Last December, the Financial Stability Committee (FSC) announced that it was examining an expansion of the German macroprudential toolkit, as recommended by the FSB and the Fund last year. Introducing instruments constraining mortgage loan eligibility, such as loan-to-value and debt-service-to-income limits, would be very helpful, not only because they might be needed in the future, but also because of the signaling value of this policy decision. A carefully designed communication strategy would help make the most of this signaling value.

31. In the banking sector, large banks’ continued momentum to build up their capital position post SSM Comprehensive Assessment is welcome. Germany’s globally systemically important bank recently announced a new strategic plan whereby it will target a leverage ratio of 5 percent—a significant increase compared to the current level—bringing it more in line with its international peers. Germany’s second largest bank recently completed a capital increase that will also bring its capital ratios closer to its European peers. Most other large domestically owned banks, which cannot rely on markets to raise fresh equity because of their corporate structure, are expected to keep building capital buffers through profit retention and/or continued refocusing on their German core business. A strong capital position is especially important in light of banks’ low profitability. Depending on the bank, the latter reflects a combination of remaining crisis legacy problems (especially among banks under state aid procedures), litigation costs (in the two largest banks), the need to adjust business models to the post-crisis regulatory environment (in all large banks), as well as low interest margins (in the banking sector as a whole). The reform of the Landesbanken, which are particularly exposed to some of these challenges, is still under way, although deleveraging is slowing as non-core legacy portfolios have already shrunk significantly and selective new business is being underwritten.

A01ufig12

Domestic Banks: Net Interest Margin

(Percent)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

Source: European Central Bank.
A01ufig13

Domestic Banks: Return on Assets

(Percent)

Citation: IMF Staff Country Reports 2015, 187; 10.5089/9781513511160.002.A001

32. Close monitoring of the effects of the low interest rate environment on the banking sector is appropriate. Net interest margins remain under pressure and well below those of European peers, and banks are reluctant to charge fees to retail customers. A recent Bundesbank study suggests that banks are increasing term transformation, exposing them to more interest rate risk. To better assess this risk, German supervisors have recently asked banks that are not directly supervised by the ECB to run bottom-up stress tests over five-year horizons under various yield curve assumptions. Further consolidation to cut costs, especially among the large number of small retail-focused institutions, would seem a natural response to the current environment but appears to keep proceeding only slowly.

33. The German banking sector is adjusting to the new European supervisory and regulatory landscape. ECB staff now coordinates with German supervisory bodies within the framework of the SSM. Work is ongoing within the SSM to improve the consistency of supervisory practices across countries and develop a common supervisory culture. Supervisory priorities this year include a review of business models, governance, and capital adequacy. Initiatives are ongoing to harmonize options and national discretions set out in the European capital regulation and directive, while a process to implement a resource-intensive review of banks’ internal models is being set-up. The Bank Recovery and Resolution Directive (BRRD) has been transposed and its bail-in regulation is in force since January 2015, one year ahead of the EU schedule. The harmonization of the Deposit Guarantee Schemes through the 2014 European Directive is forcing the cooperative banks and savings banks (together with the Landesbanken) to reform their respective joint protection schemes, so that they can be included in deposit guarantee schemes and recognized as statutory schemes. The forthcoming FSAP will be an opportunity to take stock of these transformations.

34. Although a breach of regulatory requirements is not immediately in sight, life insurers still face solvency challenges over the medium term that need to be addressed by ensuring that adequate capital buffers are maintained. The German life insurance sector is particularly vulnerable to a prolonged low interest rate environment as investment income may not be sufficient to meet returns guaranteed to policyholders over the medium-to-long term.8 This challenge will only be made more salient by the soon-to-begin transition to the Solvency II regulatory framework.9 The Life Insurance Reform Act passed in July last year included a reduced obligation to share unrealized gains with policyholders upon expiry of their contract, strict restrictions on dividend payments, and a reduction of the minimum guaranteed rate on new contracts. The Act is expected to have significantly positive effects on the sector’s solvency, according to Bundesbank simulations. 10 However, the fall in yields since the reform was calibrated has made the underlying problem on the stock of existing contracts more challenging. Insurers have reacted mostly by reinvesting into longer duration, higher yielding assets, but this may not be enough and further protection of capital buffers is needed. Thus, vulnerable insurers should manage their profit participation with policyholders very prudently, and the new early intervention powers granted to supervisors by the reform last year should be used to ensure that this is the case. As standard guaranteed rates products still represent about 80 percent of the flow of new contracts, the industry as a whole would also benefit from the greater promotion of new products, such as unit-linked products, which embed much less interest rate risk.

Authorities’ Views

35. The authorities agreed that risks associated with the low interest rate environment in Germany and other advanced economies should be closely monitored. They explained that households displayed strong liquidity preference and risk aversion, which was visible from the growing share of highly liquid deposits in their portfolios since 2008; by contrast, non-bank financial intermediaries showed a certain appetite for yield. They anticipated that the FSC would soon follow up on its announcement made last December that it was reviewing the appropriateness of the current macroprudential toolkit, in particular its ability to fully address possible financial stability concerns in the housing market. They also explained that the FSC strategy document published last year addressed a number of the 2014 FSB Peer Review recommendations, and that work on improving mortgage market databases was ongoing at the Bundesbank. Regarding the domestic life insurance sector, while acknowledging the extent of the challenge for the industry, Bafin emphasized that Germany had been proactive in its policy response over the past few years and recalled the introduction of the so-called interest rate reserve as early as 2011.

36. The authorities emphasized the progress in building stronger capital buffers over the past several years and cautioned about too much harmonization of the capital framework within the SSM. While recognizing that large German banks still had room to catch-up with their European peers in terms of leverage ratio, they emphasized the continued capital building dynamics. They expressed their appreciation for the general goal of harmonizing regulatory policy within the SSM, but noted that the underlying reasons for national options and discretions needed to be examined, as in some cases they might be justified. They also reiterated their position that it would be reasonable to abolish zero risk-weighting and apply a large exposures regime to sovereign bonds, as evidenced by the current experience with the resolution of state-owned Heta (Austria). In the area of bank recovery and resolution, they expected the European Banking Authority to publish technical standards on the minimum requirement for own funds and eligible liabilities (MREL) later this year, and explained that a draft German law currently under discussion would make senior unsecured (tradable) securities subordinated to the bank’s other senior unsecured (non-tradable) liabilities in insolvency so as to provide greater legal certainty.

Staff Appraisal

37. The upturn is expected to continue in 2015, with growth lifted by the double stimulus of low energy prices and QE. Private consumption should be the largest contributor to growth, underpinned by a strong increase in real disposable income. Inflation should remain subdued in the medium term, consistent with an output gap close to zero. A further decline in the historically low unemployment rate and sound wage growth point to a tightening of the labor market. Growth could be higher than forecast if the transmission of lower energy prices and QE proves more powerful than expected. Notable downside risks include weaker-than-expected growth in trading partners, or renewed stress in the euro area triggered by policy uncertainty or faltering reforms in some countries.

38. Lower interest rates and the strong labor market will continue to support the fiscal position. For the remainder of this legislature, budget plans are anchored on a zero balance at the federal level with small surpluses for the general government, on the back of buoyant revenues. Staff expects larger fiscal surpluses than the authorities, mostly on account of lower projected interest payments, which would bring public debt below 60 percent of GDP by 2020. The structural fiscal balance should decline through 2015–17, while remaining comfortably above the Medium-Term Objective of the Stability and Growth Pact.

39. The external position remains substantially stronger than implied by medium-term fundamentals and desirable policy settings. The fall in energy prices and the exchange rate depreciation will boost the already large current account surplus. We project the surplus to exceed 8 percent of GDP this year and decline slowly in the medium term, as the energy price windfall is gradually spent and macroeconomic rebalancing in Germany and within the euro area strengthens. Recent solid wage and unit labor cost increases (against the background of rising employment) are welcome in this regard, as they facilitate this process. Nevertheless, the persistently large current account surplus is a source of concern in the current context of weak demand across advanced countries in spite of ultra-expansionary monetary policies. It may also reflect reluctance by the corporate sector to invest more in Germany, which hurts future growth prospects.

40. Commitments to boost public investment should be more ambitious. During the last consultation, the Fund recommended a public investment increase of some 2 percent of GDP over four years to address needs identified by expert studies. Such a program would stimulate private investment by removing infrastructure bottlenecks, thereby strengthening future growth potential. It would also support domestic demand in the short-to-medium run, help reduce the current account surplus, and generate positive spillovers to the rest of the euro area. While recently announced plans to expand public investment target important priorities, they do not fully address existing needs and a stronger effort would be warranted. This expenditure could be accommodated under the existing fiscal rules. In addition to infrastructure, the Energy Transition remains a source of regulatory uncertainty and high electricity costs for parts of the corporate sector, which should continue to be addressed so as to improve the investment climate.

41. Infrastructure investment can benefit from initiatives to improve planning processes and take advantage of private sector expertise. For instance, sector-specific infrastructure companies, as proposed by the Expert Commission on “Increasing Investment in Germany,” would be helpful, as long as the associated fiscal risks are appropriately managed, either by a transfer of project risks to the private sector or by including the company in the general government perimeter. To boost investment at the municipal level, staff supports the use of alternative financing/execution mechanisms, such as public-private partnerships. However, as local authorities may have limited expertise to contract with the private sector, and the planning process for infrastructure is seen as fragmented and less efficient than at the federal level, the creation of a coordinating agency could be explored. Such an agency would advise on contract design and inform the public debate on project selection by centralizing information, enhancing transparency, and highlighting fiscal risks and cross-project externalities.

42. With the prospect of a declining working–age population putting downward pressure on future growth, reducing existing disincentives for women to work full time is necessary. Although female labor force participation is relatively high, about half of working women work only part time. While this may reflect individual and social preferences, the tax-benefit system likely discourages labor supply, given the high overall marginal tax burden faced by secondary earners. In addition, provision of additional and higher quality child care services and after-school programs could facilitate the choices of working parents. Faster progress in these areas is essential to broaden opportunities for women in the labor market. It may also help address bottlenecks in the availability of qualified labor, which may be holding back private investment. In this regard, reviewing policies that favor early retirement would also be important.

43. Fostering a more dynamic services sector through greater competition should be high on the structural reform agenda. While a strong manufacturing sector has been the backbone of the German economy, sluggish productivity growth in services may hinder future potential growth as this sector continues to expand in relative size. Germany’s leadership in this area would also likely help catalyze reforms in other EU members. In the area of regulated professions, the ongoing transparency exercise led by the EC is an opportunity to review which parts of the existing regulations are too restrictive. Pilot proceedings recently initiated by the EC against Germany regarding price regulation in some professions (architects, engineers, and tax advisors) might lead to some welcome relaxation. In rail transportation, reinforcing the regulator’s powers to stop discrimination against the incumbent operator’s competitors should be a key objective of the new regulation law being prepared.

44. In the financial sector, the new European bank supervisory and regulatory landscape is taking shape, while the favorable domestic macroeconomic conditions support structurally weak bank profitability. Banks are now supervised by the SSM, recovery and resolution planning is progressing, and safety nets are being strengthened in line with European directives and regulations. As long-term lending interest rates have fallen further, structurally low profitability is under greater pressure, and banks will have to address it by reducing costs or stepping up fee-based activities. However, the continued good performance of domestic loan portfolios has been partially offsetting these pressures through lower loan loss provisions.

45. Steps recently taken by large banks to improve their capital position are welcome. The SSM’s Comprehensive Assessment last year revealed rather modest additional provisioning needs for large banks. However, the stress test showed that some capital buffers were thin when capital adequacy was measured on the basis of the fully implemented new European standards. In addition, leverage remains high in some banks. Against this background, Germany’s two largest banks’ recent measures to catch up with their international peers are reassuring. Nevertheless, profitability challenges remain beyond those related to the low interest environment and, depending on the bank, reflect various combinations of persistent crisis legacy issues, litigation costs, as well as the need to adjust the business model to the post-crisis regulatory environment. Close cooperation and coordination within SSM joint supervisory teams is particularly important in this context.

46. A moderate upward trend in housing prices continues and the appropriate response at this stage remains close monitoring and readying the macroprudential toolkit. There are no signs of overheating at the aggregate level and mortgage loan growth remains modest. Nonetheless, developments in hot spots bear monitoring, and efforts to step up data collection on mortgage loan terms and conditions need to continue, including in light of the significant share of loans with high loan-to-value ratios in segments of the market as revealed in a recent Bundesbank survey. Staff continues to recommend that instruments constraining mortgage loan eligibility, such as loan-to-value and debt-service-to-income limits be introduced in the macroprudential toolkit. The publication by the Financial Stability Committee of a strategy document is welcome.

47. Further actions need to be taken to tackle vulnerabilities in the life insurance sector in spite of the beneficial effects of the reform passed last year. The life insurance sector is particularly vulnerable to a prolonged low interest rate environment as investment income may not be sufficient to meet returns guaranteed to policyholders over the medium-to-long term. This challenge will only be made more salient by the transition to the new Solvency II regulatory framework set to begin next year. The 2014 life insurance reform, which includes a reduced obligation to share unrealized gains with policyholders upon lapsing of their contract, is expected to have significantly positive effects on the sector’s solvency according to Bundesbank simulations. However, the fall in yields since last summer requires that the industry exert great prudence in the management of profit participation with policyholders and promote new products that embed much more limited interest rate guarantees. In parallel, supervisors should make full use of the additional early intervention powers granted to them by the new law to ensure prudent behavior.

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

Table 3.

Germany: Medium-Term Projections, 2012-20

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Sources: Federal Statistical Office, Bundesbank, and IMF staff estimates.
Table 4.

Germany: Balance of Payments, 2012–20

(Percent of GDP)

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Sources: Bundesbank, Federal Statistical Office, IMF Statistics Department, and IMF staff estimates.
Table 5.

Germany: International Investment Position, 2006-14

(Percent of GDP)

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Sources:IMF Statistics Department and IMF staff calculations.Note: Based on Balance of Payments Manual 6.
Table 6.

Germany: Core Financial Soundness Indicators for Banks

(In percent)

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Source: Deutsche Bundesbank. The authorities provide annual data only and disseminate them once a year.
Table 7.

Germany: Additional Financial Soundness Indicators

(In percent, unless otherwise indicated)

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Source: Deutsche Bundesbank. The authorities provide annual data only and disseminate them once a year.

Spread between highest and lowest three month money market rates as reported by Frankfurt banks (basis points).

Spread in basis points.

Profits after tax devided by equity.

Total debt to corporate gross value added.

Return defined as net operating income less taxes, where net operating income and taxes are compiled according to the FSI Compilation Guide.

Invested capital estimated as balance sheet total less other accounts payable (AF.7 according to ESA 1995).

Excluding principal payments.

Resident enterprises that filed for bankruptcy.

Residential property index (yearly average, 2010=100);

Commercial property prices (yearly average, 2010=100), source: own calculations based on data from BulwienGesa AG, the index is compiled from retail, office, residential and logistic property.