Mission Concluding Statement 

Berlin, May 11, 2015

The German economy is in a favorable cyclical position underpinned by strong balance sheets and partly buoyed by short-term factors. This is a good time to look at the future and strengthen the foundations of continued economic success and financial stability, which are also of key importance to the euro area as a whole.

Key policy recommendations:

• Step up investment to address weaknesses in public infrastructure – including through new institutions to enable better planning and coordination at the local level.

• Reduce disincentives for women to work full time to as a way to mitigate the adverse effects of an aging population on the labor supply.

• Enhance competition to foster a more productive services sector.

• Strengthen the macroprudential toolkit to better address potential future excesses in the housing sector.

1. The upturn is expected to continue in 2015, with growth lifted by the double stimulus of low energy prices and quantitative easing (QE) by the ECB. Private consumption should be the largest contributor to growth, underpinned by a strong increase in real disposable income, while net exports are also expected to support the momentum. Inflation should remain subdued in the medium term, consistent with an output gap close to zero. A further decline in the historically low unemployment rate and sound wage growth point to a tightening of the labor market. Growth could be higher than forecast if the transmission of lower energy prices and QE proves more powerful than expected. Notable downside risks include weaker than expected growth in trading partners, or renewed stress in the euro area triggered by policy uncertainty or faltering reforms in some countries. 

2. Lower interest rates and the strong labor market will continue to support the fiscal position. For the remainder of this legislature, budget plans are anchored on a zero balance at the federal level with small surpluses for the general government, on the back of buoyant revenues. We expect somewhat larger fiscal surpluses than the authorities, mostly on account of lower projected interest payments, which would bring public debt below 60 percent of GDP by 2020. The structural fiscal balance should decline through 2015-17 while remaining comfortably above the Medium Term Objective of the Stability and Growth Pact.

3. The fall in energy prices and the exchange rate depreciation will also boost the already large current account surplus. We project the surplus to exceed 8 percent of GDP this year and decline slowly in the medium term, as the energy price windfall is gradually spent and macroeconomic rebalancing in Germany and within the euro area strengthens. Recent solid wage and unit labor cost increases (against the background of rising employment) are welcome in this regard, as they facilitate this process. Nevertheless, the persistently large current account surplus is a source of concern in the current context of weak demand across advanced countries in spite of ultra-expansionary monetary policies. It may also reflect reluctance by the corporate sector to invest more in Germany, which hurts future growth prospects.

4. Recent commitments to boost public investment are very welcome, but there is still scope for more ambitious action. During the last consultation, we recommended a public investment increase of some 2 percent of GDP over four years to address needs identified by expert studies. Such a program would stimulate private investment by removing infrastructure bottlenecks, thereby strengthening future growth potential. It would also support domestic demand in the short-to-medium run, help reduce the current account surplus, and generate positive spillovers to the rest of the euro area. The federal government recently announced that it intends to act along these lines in the coming years. Additional funds will be spent mostly on public transportation, the digital infrastructure, and energy efficiency improvements. While these plans target important priorities, they do not fully address existing needs and a stronger effort would be warranted. This expenditure could be accommodated under the existing fiscal rules. In addition to infrastructure, the Energy Transition remains a source of regulatory uncertainty and high electricity costs for parts of the corporate sector which should continue to be addressed so as to improve the investment climate.

5. Infrastructure investment can benefit from initiatives to improve planning processes and take advantage of private sector expertise. For instance, sector-specific infrastructure companies, as proposed by the Expert Commission on “Increasing Investment in Germany,” would be helpful, as long as the associated fiscal risks are appropriately managed, either by a transfer of project risks to the private sector or by including the company in the general government perimeter. To boost investment at the municipal level we support the use of alternative financing/execution mechanisms such as public-private partnerships alongside the investment fund recently announced by the federal government. However, as local authorities may have limited expertise to contract with the private sector, and the planning process for infrastructure is seen as fragmented and less efficient than at the federal level, the creation of a coordinating agency could be explored. Such an agency would advise on contract design and inform the public debate on project selection by centralizing information, enhancing transparency, and highlighting fiscal risks and cross-project externalities.

6. With the prospect of a declining working–age population putting downward pressure on future growth, reducing existing disincentives for women to work full time is necessary. Although female labor force participation is relatively high, about half of working women work only part time. While this may reflect individual and social preferences, the tax-benefit system likely discourages labor supply, given the high overall marginal tax burden faced by secondary earners. In addition, provision of additional and higher quality child care services and after-school programs could facilitate the choices of working parents. Faster progress in these areas is essential to broaden opportunities for women in the labor market. It may also help address bottlenecks in the availability of qualified labor which may be holding back private investment. In this regard, reviewing policies that favor early retirement would also be important.

7. Fostering a more dynamic services sector through greater competition should be high on the structural reform agenda. While a strong manufacturing sector has been the backbone of the German economy, sluggish productivity growth in services may hinder future potential growth as this sector continues to expand in relative size. In the area of regulated professions, the ongoing transparency exercise led by the European Commission (EC) is an opportunity to review which parts of the existing regulations are too restrictive. Pilot proceedings recently initiated by the EC against Germany regarding price regulation in some professions (architects, engineers and tax advisors) might lead to some welcome relaxation. In rail transportation, reinforcing the regulator’s powers to stop discrimination against the incumbent operator’s competitors should be a key objective of the new regulation law being prepared.

8. In the financial sector, the new European bank supervisory and regulatory landscape is taking shape in Germany, while the favorable domestic macroeconomic conditions support structurally weak bank profitability. Banks are now supervised by the pan-European Single Supervisory Mechanism (SSM), recovery and resolution planning is progressing, and safety nets are being strengthened in line with European directives and regulations. As long-term lending interest rates have fallen further, structurally low profitability is under greater pressure, and banks will have to address it by reducing costs or stepping up fee-based activities. However, the continued good performance of domestic loan portfolios has been partially offsetting these pressures through lower loan loss provisions.

9. The mission welcomes steps recently taken by large banks to improve their capital position. The SSM’s Comprehensive Assessment last year revealed rather modest additional provisioning needs for large banks. However, the stress test showed that some capital buffers were thin when capital adequacy is measured on the basis of the fully-implemented new European standards. In addition, leverage remains high in some banks. Against this background, Germany’s two largest banks’ recent measures to catch up with their international peers are reassuring. Nevertheless, profitability challenges remain beyond those related to the low interest environment and, depending on the bank, reflect various combinations of persistent crisis legacy issues, litigation costs, as well as the need to adjust the business model to the post-crisis regulatory environment. Close cooperation and coordination within SSM joint supervisory teams is particularly important in this context.

10. A moderate upward trend in housing prices continues and the appropriate response at this stage remains close monitoring and readying the macroprudential toolkit. There are no signs of overheating at the aggregate level and mortgage loan growth remains modest. Nonetheless, developments in hot spots bear monitoring, and efforts to step up data collection on mortgage loan terms and conditions need to continue, including in light of the significant share of loans with high loan-to-value ratios in segments of the market as revealed in a recent Bundesbank survey. We reiterate our recommendation to introduce in the macroprudential toolkit instruments constraining mortgage loan eligibility, such as loan-to-value and debt-service-to-income ceilings. We also welcome the publication by the Financial Stability Committee of a strategy document.

11. Further actions need to be taken to tackle vulnerabilities in the life insurance sector in spite of the beneficial effects of the reform passed last year. The German life insurance sector is particularly vulnerable to a prolonged low interest rate environment as investment income may not be sufficient to meet returns guaranteed to policyholders over the medium-to-long term. This challenge will only be made more salient by the transition to the new Solvency II regulatory framework which is set to begin next year. The 2014 life insurance reform, which includes inter alia a reduced obligation to share unrealized gains with policyholders upon lapsing of their contract, is expected to have significantly positive effects on the sector’s solvency according to Bundesbank simulations. However, the fall in yields since last summer requires that the industry exert great prudence in the management of profit participation with policyholders and promote new products that embed much more limited interest rate guarantees. In parallel, supervisors should make full use of the additional early intervention powers granted to them by the new law to ensure prudent behavior.