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.
1. I would like to convey my authorities’ gratitude for productive and insightful discussions. My authorities found the assessment candid, comprehensive, and well-balanced. It is highly appreciated that staff has reached out to a broad range of stakeholders during the consultations. The authorities’ views have been well-documented in the staff report so that I can focus on a couple of key issues.
2. The German economy is in good shape as evidenced by strong labor market and wage developments, elevated consumer sentiment, healthy public and private balance sheets, and very favorable financing conditions. The German government plans to prudently build on these favorable developments of the recent years while ensuring that the progress achieved is not jeopardized. My authorities share the thrust of the staff appraisal and agree in particular that the challenge is to further strengthen productivity growth and improve the conditions for stronger private investment.
Recent Economic Developments and Outlook
3. Staff’s growth projection of 1.6 percent this year and 1.7 percent next year is in line with my authorities’ view. This is true for the growth rates as well as for the composition of growth. However, when discussing current economic developments and the outlook, I would put more emphasis on favorable domestic conditions, notably the very strong labor market. As staff rightly notes, there is no doubt that the economy has benefitted from external factors such as the drop in crude oil prices, the depreciation of the euro, and the recovery in export markets. At the same time, robust real wage growth and higher employment have bolstered consumption while investment has picked up in a context of solid capacity utilization and good business sentiment. As a consequence, growth in 2015 and 2016 is expected to be mainly driven by private consumption and to substantially outpace potential output growth of around 1 ¼ percent.
4. Against the favorable economic background, the German government will continue to implement its strategy of prudent, medium-term oriented, and growth-friendly fiscal policies. My authorities see Germany as an important anchor of stability within the euro area and the EU and for this reason plan to maintain the solid fiscal position keeping EU and national fiscal rules with a safety margin. This means concretely that the government will increase public investment while maintaining balanced budgets.
5. Balanced budgets will help to further reduce the government debt ratio (which is still substantially above the 60% “Maastricht” ceiling), safeguard the fiscal position against increasing interest rates (which have already started to rise from historically low levels), and prepare for upcoming demographic challenges (that will kick in heavily at the end of this decade). Also from a cyclical point of view an additional fiscal stimulus is not advisable, and not least the IMF, for example in the latest Fiscal Monitor, is advocating a symmetric fiscal policy over the business cycle and the need to build buffers in good times.
6. Within the fiscal envelope, the German government has committed to increasing public expenditures in particular in education, research, and infrastructure. Decisions have been taken to increase expenditure in these areas by around €44 billion until 2019.
7. With regard to staff’s recommendation to even further expand public investment, I would like to highlight the following: While there is a need for public investment, in particular at the municipal level and in transport infrastructure, the overall public infrastructure in Germany is still considered to be very good in international comparisons. The challenge is to maintain infrastructure quality and to expand it where there is a clear need. To do this and in order to use funds efficiently, a case by case approach for projects is needed. For one, the administrative capacities for planning and implementing investment projects are limited. Further to this, high short-term pressure to spend public funds carries the risk of fund misallocation. In this respect, it is more a question of the need for structural or institutional approaches to strengthen resources and knowledge transfer for the implementation of investment projects. Against this background and in line with staff’s advice, the German government currently assesses proposals to create a service agency for municipalities to help them with planning, procuring and managing infrastructure projects and to strengthen investment efficiency.
8. I welcome the detailed external assessment. The refined external balance analysis better captures demographic effects which is welcome. It is worth emphasizing, however, that the model leaves a substantial degree of ambiguity in the case of Germany. The unexplained residual remains significantly larger than any “policy gaps” (about 3 percentage points compared to “fiscal policy gaps” of 0.9 percentage points in other countries and 0.6 percentage points in Germany). There are many possible explanations for the large residuals, such as specific shocks to the savings rate or to world demand for German exports. Furthermore, despite the general uncertainty around attempts to estimate external positions implied by medium-term fundamentals or equilibrium REER, the estimated undervaluation of the REER seems to be too pronounced in my view. In addition, I would like to stress that the German current account surplus is likely due to a complex set of factors and the result of market processes and not the result of distortions or targeted policy measures of the German government.
9. Simple explanations or recommendations how to reduce the current account surplus would therefore be misleading. Staff simulations of the spillover effects of directly targeting higher wages and similar previous studies on the effects of fiscal expansion through lower taxes or higher consumption spending are helpful in this regard. They confirm that positive spillovers are very limited or can become even negative if they result in lower employment and weaker economic activity in Germany. In contrast staff simulations show that policies fostering potential growth would also generate meaningful positive outward spillovers not least within the EU and the euro area. Against this backdrop, my authorities would like to put emphasis on market-driven rebalancing.
10. The recent increase of the current account is driven to a large extent by lower oil prices. Looking ahead, given the fact that Germany enjoys solid growth and strong nominal and real wage growth, which is further supported by policies like the introduction of a federal minimum wage and public investment initiatives, my authorities expect a decrease of the current account surplus over the medium term and a continuation of the rebalancing process.
Strengthening Potential Output
11. My authorities agree with the staff assessment that potential output growth in Germany was more or less unaffected by the global financial crisis. In addition, they broadly agree with the stylized evolution of potential growth and its sub-components, with a declined growth contribution of capital compensated by a larger contribution of labor, thanks to a higher participation rate and strong net migration.
12. In the medium to long term population aging will weigh on potential output growth in Germany. This notwithstanding, assuming constant contributions of trend factor productivity and fixed capital formation probably overstates the slowdown in potential growth. According to my authorities’ assessment, for instance, trend factor productivity could well be more dynamic in the medium term than currently observed, as migrants are currently unlikely to already tap their full potential on the labor market. As tasks can be performed more and more efficiently over time, language skills improve and mismatch declines, aggregate productivity is likely to accelerate again in the longer term and should contribute more strongly to potential growth.
13. Nonetheless, my authorities strongly agree that policies should be implemented to strengthen potential growth. Staff’s suggestions on service sector reform, increasing labor market participation and reducing uncertainty regarding the energy transition point in the right direction.
14. The German government agrees that there is some scope for further service sector deregulation, e.g. in professional services, to increase efficiency, lower entry barriers and reduce red tape. This can contribute to greater competitiveness and better structural framework conditions for investment. However, in the German government’s opinion, it is necessary to find the right balance as it should still be possible to retain justified and appropriate regulations which, for example, guarantee the quality of a service, ensure adequate consumer protection, or serve a social or health purpose. Currently the government is examining – inter alia within the context of the Transparency Initiative at EU level – whether the applicable regulations fulfill these purposes or whether other measures could achieve this goal in a better or more efficient manner.
15. With regard to rail transportation the “Act to Strengthen Competition in the Rail Sector” will further promote competition in the rail markets, provide incentive to boost efficiency, and help create a single European market. It should be noted that – in spite of a mixed picture depending on the individual transport service segments - the share of competitors to the incumbent operator in the total turnover of railway undertakings has increased steadily in recent years.
16. My authorities fully agree with staff on the importance to successfully manage the energy transformation. They see that the Renewable Energy Act from 2014 contributes to put the reforms on sound footing and improves the planning reliability for investors. It also contributes to dampen the cost increases for final users of electricity. However, my authorities agree that this is only a first step and further measures have to be taken. Therefore the government has started to implement further measures such as in the fields of grid expansion, security of supply, and the future of the electricity market.
17. Increasing labor market participation is an important objective. Notwithstanding the fact that female labor participation in Germany is one of the highest among advanced economies, my authorities agree that the sufficient and high-quality provision of child care facilities remains a priority. The German government is already providing a total of €5.95 billion in support to the Länder and municipalities for the expansion of child care facilities for children under three. Starting in 2015, it will provide €845 million annually towards ongoing operating costs of child day care, as well as an additional €100 million each year for 2017 and 2018. Disincentives of the tax system are certainly an issue, with social security contributions and free co-insurance of non-working family members often being more relevant than the treatment of couples in the income tax code.
18. Overall, the increase of female labor supply will not be sufficient to address the effects of adverse demographics. Measures to increase the labor force by increasing the effective retirement age and integrating highly skilled migrants can also help to tackle possible future labor supply shortages.
19. My authorities are very alert to potential risks associated with low interest rates. Banks not directly supervised by the ECB have been asked to run bottom-up stress tests, which will enable supervisory analysts to get a comprehensive picture how the earning situation could evolve in the next five years. The authorities and banks are aware that, depending on the specific case, low profitability warrants corrective action. Mergers can be one option to cut costs. Recent evidence points to the fact that the consolidation process among saving banks and cooperative banks is ongoing. In addition branch networks have been further reduced. And announcements of two large banks to reduce the size of their branch networks at a larger scale indicate that this process is still not over yet.
20. My authorities agree that house price developments should be monitored closely while signs of overvaluation are limited to big cities so far. They fully concur with staff that the macro-prudential toolkit available as of today may not be sufficient to address financial stability risks emanating from the residential mortgage market and should be further developed. In line with this assessment, last week the German FSC recommended that the federal government provide for the legal foundations for applying additional macroprudential tools to regulate loans for the construction or purchase of residential real estate. Specifically and fully in line with international as well as European practices, it recommends to create the option of activating LTV, DTI, DSTI, and an amortization requirement should such restrictions be deemed necessary to safeguard financial stability in Germany. Also, my authorities stepped up efforts to collect data from commercial lenders which will help to apply and calibrate macro-prudential measures.
21. My authorities agree with staff that a persistent low-interest environment is a source of risk for the stability of German life insurers. They also concur that Solvency II will make this challenge more salient. Regarding measures to increase the resilience of the insurance sector, my authorities agree that insurers should reinforce their capital buffers, manage the policy holders’ profit participation share and reduce the dependence on interest rate risk by means of selling more policies with a flexible guaranteed return or no guaranteed return at all. Concerning the Life Insurance Reform Act, my authorities agree in general with staff’s evaluation that this act is an important contribution to improve the resilience of life insurers and thus the stability of the life insurance sector as a whole.