Public Information Notice No. 02/124

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Germany

October 31, 2002

On October 23, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Germany.¹

Background

Germany's economy is poised for a fragile recovery, after having barely grown since mid-2000. The earlier price shocks and interest rate hikes that contributed to the current slowdown have now unwound. But sluggish global growth, stock market declines, weak credit growth, and the withdrawal implied by planned fiscal consolidation may stand in the way of a strong recovery. Real GDP growth this year is estimated at about 0.5 percent, with the general government deficit set to exceed 3 percent of GDP, owing largely to cyclical weaknesses in revenue collection. Inflation in 2002 is expected to average 1.4 percent.

Germany's current slowdown comes on the heels of a decade of low growth, during which the economy had to cope with important adjustments related to unification. The subdued growth performance reflects the unwinding of the boom around the time of unification, together with generous benefits for the jobless and an insufficiently flexible labor market. Although the unemployment rate is still not high by European standards, net job creation has been below that recorded in many other European countries and the underlying unemployment rate rose during the 1990s. To improve the functioning of the labor market, the newly re-elected government has endorsed proposals of the so-called Hartz Commission to enhance job matching and strengthen incentives for job creation.

Executive Board Assessment

Executive Directors noted that the German economy is recovering from last year's slowdown, albeit slowly, due to continued weak domestic and external demand. Directors observed that although the decade since unification has been one of difficult adjustments against a backdrop of subdued real GDP growth, the authorities have also achieved a number of distinct successes. Foremost among these are the integration of the new Länder, the liberalization of product markets, and major tax and pension reforms. Notwithstanding these achievements, Directors stressed that, going forward, a considerable strengthening of reform efforts, particularly in labor markets and in fiscal matters, will be needed to create conditions for stronger, resilient growth in the context of continued fiscal adjustment.

In particular, Directors emphasized that decisive and complementary actions are now required in two priority areas: ambitious reforms to improve the flexibility of the labor market and a substantial reduction of entitlements and subsidies, which will be key to correcting the fiscal imbalance permanently. They considered that a well-sequenced and coordinated policy approach proceeding on both these fronts would have potentially powerful synergies. Credibility gains resulting from lasting expenditure reform would minimize the output costs of adjustment, and comprehensive labor market reforms would raise growth and thus make fiscal adjustment more palatable.

Directors noted that, in 2003, GDP growth is expected to pick up, but is likely to remain weaker than previously projected and subject to considerable risks. These include global uncertainties and a complex set of domestic factors. Among the latter are the continued fragility of consumer and business confidence, tighter credit conditions that have affected corporate financing, monetary conditions which—although accommodative for the euro area as a whole—are on the tight side from Germany's cyclical perspective, and the substantial fiscal consolidation in the pipeline. In view of the likely moderate strength of the recovery, the current wide output gap and high unemployment will likely persist, underscoring the need to build a broad public consensus now in favor of the structural reforms needed for boosting Germany's growth potential.

Looking forward, Directors saw continued fiscal consolidation over the medium term as essential, in particular to prepare Germany's public finances for looming demographic pressures. They commended the authorities' firm commitment to adhere to their fiscal objective of achieving and maintaining a budgetary position close to balance or in surplus over the economic cycle in line with the Stability and Growth Pact requirements, and generally supported their plan to reduce the cyclically-adjusted deficit by at least 0.5 percent of GDP annually to achieve this objective. Directors expressed more varied views on the authorities' plans for 2003 where they intend to frontload adjustment to ensure that the general government deficit falls back below 3 percent of GDP. Many Directors were of the view that such a sizeable fiscal correction in 2003 will further affect already weak domestic demand, and recommended that the authorities opt for a more moderate pace of deficit reduction while gaining credibility from a sharper focus on medium-term fiscal priorities. A few Directors also expressed concern about the temporary postponement of tax cuts. A number of Directors, however, considered that the front loading of the adjustment effort implicit in the authorities' plans will be the best way to establish credibility and improve confidence, while securing the scope for automatic stabilizers to play fully in the future.

Directors agreed that, given Germany's still high tax burden, the sustainability of the fiscal consolidation effort will critically hinge on further permanent reductions in the expenditure-to-GDP ratio. Furthermore, they emphasized that it will be important to give high priority to the quality of expenditure reforms to provide the maximum boost to the supply side of the economy. Directors saw considerable scope, in this context, for achieving expenditure savings on subsidies, social transfers and labor market programs.

Directors commended the recent steps to improve the sustainability of the German pension system, and encouraged the authorities to prepare further pension and health care reforms aimed at addressing the future fiscal challenges raised by population aging. They noted that this will require careful consideration of measures to reduce the generosity of entitlements, which could include—in the pensions area—increases in the statutory retirement age and a lower pension replacement ratio, and—in the health care area—higher cost recovery rates.

Directors strongly welcomed the current public policy debate on labor market reform, noting that decisive progress in this area will be key to reviving Germany's growth and re-establishing high employment levels. They looked forward to the early implementation of measures under consideration that will improve job matching. Many Directors in this context cautioned against proposals to subsidize job creation. Directors considered that these initial steps will need to be followed by a more comprehensive package of reforms focusing on improving work incentives and deregulating the labor market. In particular, a reform of the benefit system should remove a key obstacle to raising employment, especially of the low skilled and older workers, and could be achieved without creating major social hardship by narrowing the targeting of benefits and offering tax credits to low-income earners. Directors also encouraged the authorities to pursue proposals to merge unemployment and social assistance programs with a view to streamlining and better-targeting benefits. A number of Directors highlighted the need for greater differentiation in wages across skill levels and regions.

Turning to the financial system, Directors urged the supervisory authorities to remain particularly vigilant in the face of the pressures on banks and insurance companies resulting from the confluence of cyclical and structural weaknesses and from the downturn in equity prices. They welcomed the ongoing developments that will ultimately strengthen the financial system, in particular the phasing out of guarantees to public sector banks and the prospective introduction of Basel II standards. Directors stressed that allowing bank consolidation to continue unhindered will be important to strengthen the future health of the banking system. They also saw the implementation of the new Law on Integrated Financial Services Supervision as an essential step ensuring that the latitude and resources of the newly created single supervisory agency are sufficient to keep abreast of financial market developments. Directors noted that the upcoming Financial Sector Assessment Program will provide a timely opportunity to review the lines of defense against sector vulnerabilities. They commended the comprehensive measures that the authorities are taking to further strengthen their ability to combat money laundering and the financing of terrorism.

Directors commended Germany's progress on implementing product market reforms, and encouraged the authorities to build on Germany's leadership role in the EU context by pushing forward product market reforms that will better position Germany to meet the challenges of intensified global competition and improve productivity growth. A few Directors also looked for more forceful action to liberalize Germany's retail sector. Directors appreciated the recent introduction of a corporate governance code, and looked forward to further steps underway to enhance transparency and supervision.

Directors welcomed Germany's support for multilateral trade liberalization and the elimination of trade barriers for poor countries. Some Directors encouraged the authorities to work vigorously with Germany's EU partners toward an ambitious reform of the Common Agricultural Policy aimed at removing distortionary transfers that are harmful globally and costly at home. Directors encouraged the authorities to raise ODA spending to the UN target of 0.7 percent of GNP.

Directors commended Germany for the openness and transparency of fiscal policy and looked forward to the issuance of the Report on the Observance of Standards and Codes (ROSC) Fiscal Transparency module. Germany's statistics are more than adequate for the purposes of effective surveillance. Directors suggested that further statistical improvements to facilitate the monitoring of fiscal policy and financial sector vulnerabilities would be helpful.