Public Information Notice No. 99/101

Public Information Notice: IMF Concludes Article IV Consultation with Germany

November 3, 1999

On October 20, 1999, the Executive Board concluded the Article IV consultation with Germany.¹

Background

By 1998, Germany's latest labor shakeout episode had been completed, and the economy appeared poised for a cyclical upswing. Instead, the upswing was waylaid by the emerging market crisis, which hit German exports particularly hard and stopped growth in its tracks in late 1998, with GDP declining by 0.3 percent in the fourth quarter. The resulting knock to business confidence was exacerbated by uncertainty about the policy direction of the new government elected in late 1998, and economic activity remained sluggish in the first half of 1999.

The recent growth setback stifled the first signs in several years of rising employment. A high proportion of unemployment (some 9 percent on a standardized basis) is structural and concentrated among the low paid, having ratcheted up over time as a result of the interaction of German economic institutions—notably solidaristic wage bargaining and a generous safety net—with a sequence of economic shocks. Inflation has been subdued, with annual average CPI inflation below 2 percent since 1995 underpinned by subdued unit labor cost growth, deregulation measures, and a sharp decline in import prices driven by a decline in world prices of raw materials.

Monetary conditions have eased significantly since late 1998, reflecting both policy actions and exchange rate developments. Short-term interest rates were reduced by the Bundesbank to 3 percent in December 1998 and, in the new context of EMU, by the European Central Bank to 2½ percent in April 1999. The depreciation of the euro against other currencies since its inception in January 1999 has also been supportive of activity. EMU has been associated with a large increase in cross-border capital flows, suggesting rapid financial integration within the euro area.

The general government deficit is projected at just under 2 percent of GDP in 1999, in line with budget estimates and the objectives of the January 1999 Stability Program. In June 1999 the authorities proposed a package of spending measures that would bring the fiscal deficit toward balance over the medium-term while making room for tax reforms that would lower the tax burden.

Short-term prospects are favorable. An improved external environment, easier monetary conditions, and greater clarity on policy should all support short-term recovery. The staff projects GDP growth to pick up from about 1½ percent in 1999 to 2½ percent in 2000.

Executive Board Assessment

Executive Directors observed that, after a rather disappointing year, Germany's short-term growth outlook was reasonably bright in view of the markedly improved external environment and the authorities' recent steps to clarify and strengthen fiscal policy. Most Directors cautioned, however, that Germany's long-standing structural weaknesses, in particular as regards labor market institutions, would need to be addressed to assure strong medium-term prospects.

Directors commended Germany's role in the successful launching of the euro and the Bundesbank's leadership in fostering a climate of low inflation in Europe. Directors noted that, in the new institutional context following the shift of monetary policy responsibility to the European Central Bank, monetary conditions were appropriately supportive of German activity and that external competitiveness was satisfactory.

Directors warmly welcomed the scale, pace, and composition of the government's fiscal program for 2000 and beyond. The package should not only ensure that the fiscal position stays in line with the Maastricht requirements, but also help regain room for fiscal maneuver and improve the conditions for private initiative and job creation. Directors endorsed, in particular, the emphasis on targeted cuts in current spending, noting that the focus on cuts in structurally significant areas lent credibility to the authorities' overall strategy of consolidation and tax reform. If firmly implemented, the fiscal program would bring the medium-term fiscal position close to balance, confirming Germany's commitment to fiscal consolidation and to the undertakings of the Stability and Growth Pact. Directors added that automatic fiscal stabilizers would need to play a more prominent role under European Monetary Union (EMU). In that connection, several Directors suggested that Germany allow the operation of automatic fiscal stabilizers if growth deviated from budget projections, particularly once the underlying fiscal situation had strengthened.

Directors also welcomed the authorities' tax reform proposals. They observed that cuts in Germany's high statutory business income tax rates, financed by base broadening, would increase the efficiency of the tax system. At the same time, Directors pointed to significant areas of unfinished business, notably as regards personal income taxation, where rates would remain high. Directors therefore encouraged the authorities to remain focused on expenditure restraint, which would make room for further lowering of the tax burden.

While thus welcoming the authorities' recent fiscal initiatives, as well as their implementation of a number of structural reforms, Directors cautioned that these policies were unlikely to prove sufficient to address Germany's deep-seated labor market problems and especially the task of absorbing the lower skilled into gainful employment. Moreover, a number of Directors considered that some of the government's initial labor market actions, for example, increased restrictions on "DM630 jobs," appeared to be in the wrong direction. Directors were concerned that, in the absence of decisive labor market reforms, Germany's medium-term macroeconomic prospects could again be undermined by labor shake-out, rising unemployment, and eventually renewed fiscal pressures.

Avoiding these pitfalls would, in the German context, necessarily require a cooperative approach, and Directors were encouraged that the authorities had initiated an "Alliance for Jobs" as a forum for reaching labor market solutions with the social partners. In this context, many Directors noted that several smaller European countries with like-minded distributional concerns had adopted policies that could offer useful benchmarks for reform, while recognizing that effective and workable solutions would need to take into account Germany's own circumstances and institutions. The key was to focus on encouraging employment through the establishment of appropriate incentives for all the economic agents in the labor market, with distributional objectives pursued through a well-targeted tax and transfer system, rather than through the workings of the labor market. Such an employment-oriented approach was preferable to efforts to reduce labor supply, for example, through the schemes to promote early retirement. Directors accordingly called for steps to reduce the cost of employing lower-skilled workers, both through greater flexibility in wage setting and nonwage work conditions, and lower social contributions for lower-skilled workers; to tighten eligibility requirements for social safety net benefits; to shift to a less comprehensive coverage of public social insurance through the development of a larger private insurance pillar, as foreshadowed by recent proposals; and to implement income safeguards in the form of in-work benefits for the lower-paid. While most Directors encouraged speedy and comprehensive action, some thought that a more gradual approach might be necessary, pointing to the time needed to change time-honored institutions and practices and to foster ownership by the social partners. Directors underscored that the fiscal costs of a labor market reform package would need to be consistent with medium-term fiscal consolidation targets.

Directors welcomed the recent steps toward deregulation in the product markets—notably in the energy and telecommunications sectors—but urged further action, including pruning the massive number of business regulations and liberalizing shop opening hours. Directors noted that Germany's financial markets had continued to undergo extensive changes in response to competitive pressures brought about by EMU and global financial trends. While Directors recognized that banks had increased their provisioning against risk and that a sizable share of the exposures to emerging market economies was covered by government guarantees, they nevertheless emphasized the need for continued supervisory vigilance. Several Directors suggested that the authorities publish more aggregate information on the nonperforming loans and risk exposures of the German banking system.

Directors noted that Germany's statistics, while generally adequate for surveillance, are in a period of transition following the welcome adoption of new European national accounting standards. In this connection, Directors took the view that the authorities should attempt to close transitional gaps related to the labor market and national accounts data as soon as possible.

Directors commended Germany for its prominent role in strengthening the Initiative for Heavily Indebted Poor Countries, as well as for its significant financial support for transition economies. However, they noted with regret that the level of official development assistance was projected to decline in coming years, and urged the authorities to reconsider their plans for such assistance.