Public Information Notice No. 06/04

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Germany

January 18, 2006

On January 11, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Germany.¹

Background

Economic activity in Germany is slowly picking up, and there is scope for some further firming of growth in the course of 2006. The recovery, however, remains unbalanced and strong exports have yet to feed through into higher household spending. Firms invest cautiously, with some uptick in spending on machinery and equipment. However, structural labor market weakness, giving rise to slow employment and wage growth, is inducing cautious consumer spending. While the risks to the outlook are broadly neutral, an unwinding of global imbalances and higher oil prices could yet provide headwinds for the recovery. On balance, headline growth is forecast at 1 percent in 2005 and 1.5 percent in 2006, implying a gradual recovery in working-day-adjusted terms.

On the policy front, the Coalition Agreement that was issued on November 11, 2005, contains several valuable objectives, such as lowering the fiscal deficit to below the Maastricht criterion by 2007, increasing gradually the pensionable age, restarting federalism reforms, and lowering slightly the nonwage labor costs. Nevertheless, domestic markets remain hampered by rigidities, especially the labor, product, and services markets, and the coalition partners need to use the coalition agreement as a stepping stone to make further progress in structural reforms. More attention must be paid to improving the structural conditions for labor demand.

The fiscal deficit is projected to be about 3¾ percent of GDP in 2005, with a small improvement in 2006. Revenues have been held back by a secular decline in wage income, Germany's major tax base, while costs for labor market reforms and pension outlays were turning out higher than expected, and savings from healthcare reform were somewhat lower than expected.

The authorities' stress tests suggest that the likelihood of systemic difficulties in Germany's financial system is small, and confirm that the financial sector is recovering from the weakness experienced in 2003. Nevertheless, there is a continued need for market-driven restructuring and defragmentation of the banking sector, which has underperformed its EU peers.

Executive Board Assessment

Executive Directors commended the new German government's agenda to meet the challenges of globalization and demographic change. The authorities have appropriately placed high priority on fiscal consolidation with the articulation of policies to reduce the fiscal deficit substantially. Directors welcomed the authorities' perseverance in introducing far-reaching and politically difficult labor market reforms in 2005 that have improved incentives to work, and their plans to make further reforms in the labor market and entitlement programs. Successive structural changes in these and other areas are bearing fruit, increasing the economy's competitiveness and flexibility. At the same time, Directors noted that, despite growing signs of economic recovery, substantial challenges lie ahead, as trend growth is low and unemployment remains high. To secure a durable improvement in economic performance, and better position the German economy to help support global growth, Directors urged the authorities to build on the initiatives already announced, and implement a bold, comprehensive, and mutually-reinforcing set of policies to reduce distortions and structural rigidities and achieve fiscal sustainability over the medium term.

Directors welcomed the signs that output growth is gaining momentum in 2006. They commended the ongoing business restructuring, cost cutting, and sustained wage moderation that have helped rebuild competitiveness and underpin strong export growth. However, the recovery remains overly dependent on external demand. Although there is still insufficient support from domestic demand, Directors were encouraged that investment in machinery and equipment is slowly turning up and labor market trends are improving. To ensure a broad based and sustained recovery, Directors underlined the importance of following through with a reinforced and clearly communicated medium-term reform strategy.

Directors stressed the importance of actions to address persistent fiscal pressures, and welcomed the authorities' articulation of policies to reduce the fiscal deficit below 3 percent of GDP in 2007. They took note of the authorities' consolidation strategy implying a lowering of the structural deficit by ¼ percent of GDP in 2006, and their plans aiming toward additional durable adjustment equivalent to at least ¾ percent of GDP in 2007. They acknowledged the variety of considerations that have shaped the authorities' objectives, including the importance of securing a political consensus to ensure the achievement of their medium-term fiscal goals, and of avoiding undercutting the still-fragile economic recovery. At the same time, several Directors considered that a more ambitious frontloading of fiscal adjustment could have been contemplated. This is especially so in the current circumstances of an improved economic outlook, as well as the greater popular acceptance of the need to set the public finances on a firmer footing on which the new government's fiscal objectives are founded. A number of Directors, noting the dampening effect of the preannounced VAT increase on consumption growth, urged the authorities to rely more heavily on expenditure cuts.

Directors noted that further deficit reduction, coupled with entitlement reform, will be needed after 2007 to secure sustainable public finances and safeguard the economic basis of the German social model. They urged the authorities to eliminate the structural deficit by the turn of the decade, when the costs of an aging population begin to accelerate. This will require a sustainable deficit reduction strategy focused on expenditure cuts, especially deeper and broader reductions in subsidies and tax expenditures. Directors welcomed the corporate income tax reform planned for 2008, but cautioned that it should be revenue-neutral to avoid compromising fiscal consolidation goals.

Directors underscored that current entitlement programs will exert growing pressure on payroll taxes if left unaltered. They welcomed the steps taken under Agenda 2010 to start reforming the entitlement system, and the authorities' intention to develop plans to strengthen health care financing in 2006. While commending the authorities' recent decision to increase the statutory retirement age by two years, many Directors viewed the planned pace of the increase as too gradual, and called for its acceleration. Directors saw scope for recalibrating entitlement benefits further, and encouraged the authorities to pursue additional steps to limit spending growth on pensions, long-term care insurance, and health care.

Directors supported the planned federal reforms aimed at clarifying the responsibilities of the various entities and streamlining the process of passing new legislation. They encouraged the authorities to build on these by introducing greater leeway for competition between states and strengthening the internal stability pact, thus further facilitating efficiency and fiscal discipline. Directors welcomed the Government's Long-Run Fiscal Sustainability Report, which will help make the public more aware of the need for reform. With regard to the possible role of a fiscal council, Directors felt that such a function was already served by a number of well-regarded institutions in Germany, including the Council of Economic Advisors, the Bundesbank, and research institutes.

Directors emphasized the need to raise the rate of labor utilization to mitigate the impact of a decline in the working-age population on growth and the public finances, and in that light they supported the reforms to boost labor supply. They welcomed several recently announced initiatives—including those to improve the welfare-to-work aspects of the Unemployment Benefits II program, reduce the tax wedge on labor, and loosen employment protection legislation further—and they looked forward to the effective implementation of these proposals. To complement these reforms, Directors called for additional steps to promote greater wage differentiation and thus help increase labor demand, including by reducing centralized wage bargaining in favor of more decentralized and firm-level bargaining.

Directors encouraged the authorities to proceed more vigorously in deregulating product and service markets to foster job creation and reinforce labor market reforms. While good progress has been made in product market reforms over the years, relatively high barriers and impediments persist in certain areas. Directors recommended a further reduction—both domestically and in the EU context—of service regulations and administrative hurdles in regulated professions and crafts.

Directors noted that financial sector soundness continues to improve, with better bank profitability and a reduction in nonperforming loans, and they agreed that the risk of systemic difficulty is small. They welcomed the removal of state guarantees in the banking sector and the intensified cooperation within the public banking pillar. However, the performance of large German financial institutions still lags behind that of many of their foreign peers. To improve banking sector soundness and performance further, Directors recommended amending its legal framework to support market-based restructuring in both the public and private pillars. Directors commended the authorities for increasing supervisory capacity in and strengthening the regulation of the reinsurance sector. They took note of the authorities' commitment to ensure strong prudential oversight going forward.

Directors welcomed Germany's commitment to trade liberalization, and called on Germany to work with European and other partners toward the successful conclusion of the Doha Round. Directors commended Germany's intention to increase its official development aid.

Directors considered that Germany's economic statistics are of high quality. At the same time, they saw scope for further improvements, including with regard to inventory data. Directors welcomed the authorities' commitment to start providing a full set of core financial soundness data.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the January 11, 2005 Executive Board discussion based on the staff report.