IMF Executive Board Concludes 2007 Article IV Consultation with Germany

On February 22, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the 2007 Article IV consultation with Germany.¹

Background

Far reaching reforms have strengthened the German economy, but a weakening global cycle is dampening near-term growth prospects. Strong external competitiveness generated a robust recovery since 2004 with beneficial spillovers to Europe. A flurry of investment activity and a belated decline in unemployment have held up growth throughout 2007 despite the VAT hike. Policy credibility has been enhanced by determined fiscal consolidation.

GDP growth is projected to slow to 1.5 percent in 2008 from 2.5 percent in 2007. A slowing U.S. economy and weaker world trade is pulling down GDP growth given Germany's strong external dependence. To a lesser extent a strengthened euro and high oil prices are weighing down on output growth. On the positive side, a pick-up in consumption is helped by steady employment gains and limited wage moderation. Inflation is expected to slow moderately to 2.2 percent in 2008.

Productivity picked up in recent years, but sectoral trends are not comforting. Potential growth is estimated at 1½-1¾ percent annually but will likely slip back on account of population aging unless total factor productivity growth rebounds. Labor productivity growth has accelerated only in the manufacturing sector. The much larger service sector has, however, shown little improvement, especially in real estate related and financial services. Moreover, shortages of skilled labor are pronounced and wide ranging, and particularly in the export oriented sector, health care and education, are holding back growth.

The financial sector has made much progress, but the recent turbulence highlighted unmet challenges. Long-standing concerns about low banking sector profitability and incentives for high-risk taking have now come to the fore. On the upside, considerable banking consolidation has already occurred and capital markets are growing rapidly, although from low levels.

Through a sustained effort Germany balanced its budget. Although the adjustment was helped by the upswing, policy efforts contributed in a major way. In 2006, the structural balance improved by more than one percentage point, a year ahead of the excessive deficit procedure schedule, and the adjustment continued steadily in 2007. This considerable up-front adjustment, and the ambitious goals to reach a primary surplus of 3½ percent of GDP by 2011 has improved public finances sustainability significantly. Nonetheless, longer-term fiscal challenges remain, as costs from health care will pose an increasing burden.

Executive Board Assessment

The Executive Directors welcomed the marked strengthening of Germany's economic performance of the past few years, and commended the consolidation and reform policies that have made these gains possible, including an impressive increase in employment and the best fiscal position since unification. Nonetheless, the reform agenda remains unfinished, and the near-term outlook is for slower growth and higher inflation, with the balance of risks modestly on the downside. Looking forward, Directors agreed on the need for the authorities to maintain short-term stability, especially in the financial sector, and to persist with the outstanding medium-term reform agenda.

Directors noted that the global economic slowdown, the strength of commodity prices, and financial tensions are having their impact on Germany. Fortunately, the relatively sound financial position of most banks and the low reliance of enterprises and households on credit have so far helped maintain normal lending, and while growth is slowing, it is expected to remain close to potential. At the same time, consumer and business confidence have weakened, credit standards have tightened recently, and some banks are facing continuing difficulties. In view of the yet unknown dimensions and fast-moving nature of the current global financial market turmoil, Directors urged the authorities to remain vigilant.

Directors observed that the fiscal position is moving from overall balance in 2007 to a moderate deficit in 2008. They generally considered that this fiscal loosening should help cushion the effects of the anticipated economic slowdown. Looking further ahead, Directors viewed fiscal sustainability as within reach, and they encouraged the authorities to move to complete the reform process and associated consolidation steps in order to secure it. In particular, achieving long-term fiscal sustainability will require tackling healthcare expenditures. Directors welcomed the authorities' intention to move to a fiscal framework centered on maintaining the overall deficit close to balance in cyclically-adjusted terms. They urged the authorities to press ahead with a second round of fiscal federalism reforms to improve incentives for prudent fiscal management.

Directors underscored that one of the authorities' key objectives must be to preserve confidence in the financial sector. While this has been achieved thus far by using public resources to rescue banks that faced insolvency, the fiscal costs of these rescues have mounted. Directors recommended adopting a bank resolution framework that is fully transparent and allows for quick resolutions, while providing stronger incentives for prudent management through the dilution of shareholders' equity in recapitalized or intervened banks.

Directors welcomed ongoing discussions to strengthen banking supervision. Looking ahead, they urged more frequent financial statements and more widespread use of International Financial Reporting Standards (IFRS) reporting to better capture off-balance-sheet activity. They considered that despite recent efforts, further measures are needed to enhance supervisory accountability and raise the quality of supervision. Directors therefore welcomed the recent protocol to improve coordination between the Bundesbank and the financial sector supervisory authority (BaFin).

Directors noted that the intensification of international financial integration suggests a need to restructure the German banking sector. Global competition is likely to continue to erode the traditional business models of banks that only serve targeted communities. Directors considered that bank restructuring should be guided by the goal of creating robust and sustainable banks, while allowing private capital to play a role.

Directors called on the authorities to safeguard their hard-won economic gains by pressing ahead with their medium-term reform agenda in the areas of labor markets, the general framework for investment, the financial sector, and fiscal policy. They pointed to the risks attached to any pause in the broader structural reform process for the achievement of long-term sustainability.

Directors recommended that a coordinated effort be made to raise Germany's growth potential. To that end, skills shortages need to be addressed by improving education and training, but also by encouraging the immigration of skilled workers. Directors welcomed efforts to rationalize active labor market programs and make child care more readily available. However, they cautioned that the new sectoral minimum wages could undermine work incentives and the success of Hartz IV labor market reforms. Directors called for enhancing the business climate by continuing to reduce taxes on capital and labor, but in a budget-neutral manner.

Directors welcomed efforts to further develop capital markets, and underscored the importance of promoting transparency in corporate governance. They considered that rationalizing company supervisory board structures could help raise efficiency, and they saw a role for strengthening disclosure standards to improve internal and external discipline imposed on company managements. Directors cautioned against initiatives that would further empower insiders or render governance more complex.