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Germany and the IMF
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On September 2, 1998, the Executive Board concluded the Article IV consultation with Germany.1
Over the past year and a half, the recovery has become better balanced and gathered steam. In 1997, weakness in final domestic demand, due to fiscal consolidation and a prolonged slump in employment and construction, was more than compensated for by a depreciation-assisted increase in exports. Real GDP growth quickened to 2¼ percent (a near-potential rate) in 1997. Special factors increased the volatility of GDP during the first half of 1998. In the first quarter growth was very strong, especially domestic demand owing to, most notably, purchases of consumer durable goods made in anticipation of the April increase in the VAT rate. However, in the second quarter, GDP was nearly flat as consumer spending declined following its previous surge. After reaching a record 11.8 percent in late 1997, the unemployment rate dropped to 10.9 percent in August 1998 supported also by active labor market programs. Inflation, which had risen to 1¾ percent in 1997 owing to pubic sector price increases, receded to about 1 per cent in the April-August period despite the 1 percentage point increase in the VAT rate in April.
Short-term prospects are favorable, though risks remain. Real growth should continue at a moderate but slack-absorbing pace of 2½ percent in 1998 and 1999. Inflation is expected to remain subdued, owing to lower import prices and the still large output gap. The current account should move into surplus for the first time since unification. However, the realization of these prospects hinges on external developments, especially those in emerging market economies, strengthened domestic labor market trends, and on the policy agenda of the next government.
The Bundesbank increased its repurchase rate by 30 basis points in October 1997—the first increase in five years; the rate has remained at 3.3 percent since then. Meanwhile, yields on long-term bonds have declined by 130 basis points to 4.3 percent in August 1998. During the first half of 1998, broad money grew at a 5¼ percent seasonally adjusted annual rate, which was within the Bundesbank’s target corridor of 3-6 percent. Since mid-1997, while the DM/dollar exchange rate has fluctuated trendlessly, the nominal effective exchange rate has appreciated modestly. All in all, although monetary conditions have firmed somewhat, they are still modestly expansionary.
Despite some worrying moments, the Maastricht fiscal deficit criterion was met with room to spare as the general government deficit declined to 2.7 percent of GDP in 1997. Fiscal consolidation totaled nearly 1 percentage point of GDP (including one-off measures equivalent to about ¼ percentage point). For 1998, the fiscal stance has shifted and become slightly expansionary mainly reflecting the unwinding of one-off measures from the previous year. Nevertheless, cyclical forces should dominate, narrowing the general government deficit to slightly more than 2½ percent of GDP in 1998. Based on estimates of the Financial Planning Council and the draft federal budget, the general government deficit would decline by nearly ½ percentage point of GDP to just above 2 percent in 1999.
The distinguishing feature of Germany’s economic performance during the 1990s has been the extent of the contraction in employment (5¼ percent between 1992 and 1997), which accounts for the steep rise in unemployment and the sluggishness of demand growth. The labor shakeout can in good part be attributed to sizable country-wide increases in labor costs since unification. The percentage decline in employment was roughly the same in western and eastern Germany (although owing to historical circumstances the unemployment rate in eastern Germany was almost twice as high as in western Germany in 1997). The employment contraction was concentrated among the lower paid and lower skilled as job growth for the higher paid/higher skilled was substantial during the 1990s. As of mid-1998, labor market conditions appear to be stabilizing, with employment no longer falling and unemployment declining. Nonetheless, the key challenges remain reabsorbing the record level of unemployed and minimizing employment vulnerability, especially of the low paid, to future shocks.
Executive Board Assessment
Executive Directors welcomed the improvements in Germany’s economy since last year: real GDP growth had picked up and become better balanced; unemployment was declining; and inflationary pressures were absent. They commended the authorities for their successful efforts to fulfill the conditions of the Maastricht Treaty and to launch, along with the other initial participants, the final stage of economic and monetary union (EMU) on January 1, 1999. With a timely start of EMU and generally favorable leading indicators, a moderately paced recoverywas in prospect. Nonetheless, the recent turbulence in the Russian Federation and the price declines in equity markets of industrial and emerging market countries increased downside risks. Moreover, Directors noted continuing uncertainty about the strength of private consumer demand in Germany.
Directors viewed the deep-seated structural problems, especially in the labor market, as the main challenges that should be at the forefront of Germany’s economic agenda. In that context, full advantage should be taken of the current upswing to consolidate the public finances further and to implement comprehensive structural reforms to bolster employment growth, especially among the low skilled. Those policies would help consolidate the recovery and create a virtuous circle in which job gains bolster increased income and investment, paving the way for sustained strong growth and further improvements in fiscal balances.
Directors commended the Bundesbank for having led the way in establishing price stability in Germany as well as throughout much of the European Union. Price stability provided propitious conditions for the introduction of the euro and the transfer of monetary policy responsibility to the European Central Bank. In this connection, Directors welcomed the increasing weight given by the Bundesbank to euro–area-wide, as well as German, indicators in assessing monetary requirements and its recognition that Germany was already de facto in a monetary union. With inflationary pressures absent, the recovery still in its early stages, and external downside risks increasing, Directors considered that the present somewhat accommodative stance of monetary policy was appropriate. For the near term, Directors supported a wait-and-see posture on policy interest rates. In that regard, a few Directors did not rule out reductions in interest rates in the event of a significant weakening in global, and hence German, activity. Any increase in interest rates would have to await a further maturing of the recovery in the euro area as well as a clarification of the consequences of recent international developments.
Turning to fiscal policy, Directors considered that it would need to play a more prominent stabilization role under EMU. In that connection, they emphasized the importance of allowing automatic fiscal stabilizers to have their full effect once a sustainable fiscal balance was achieved, and the need to avoid procyclical offsets. Toward that end, Directors broadly supported the authorities’ objective of reducing the fiscal deficit to ½ of 1 percent of GDP in 2002, but felt that the authorities’ fiscal objective could be more ambitious over the medium term, so as to take account of prospective demographic pressures and to provide room for discretionary policy action. All Directors urged the government to use the present cyclical upswing to full advantage to undertake durable fiscal consolidation. They underscored the need to guard against the past tendency of the underlying fiscal position to weaken during cyclical upturns.
Directors endorsed the authorities’ objective of decreasing the size of the public sector by reducing the expenditure/GDP ratio to its pre-unification level. Spending cuts should be directed toward making the entitlement system more effective and less distortionary, reducing various subsidies, increasing user fees, and transferring activities to the private sector. Directors felt that such actions could complement efforts to reshape incentives in the labor market, as well as free up needed budgetary resources.
Notwithstanding the decline in the unemployment rate thus far in 1998, Directors considered that Germany’s most pressing economic problem was unemployment, especially the task of reabsorbing into gainful employment the low paid and the low skilled. Directors stressed that an effective attack on labor market problems required a comprehensive package of structural reforms. Income tax reform—a central pillar of any such package—should strengthen incentives, limit tax avoidance, equalize the tax burden across various types of economic activities and sources of income, and shore up the public finances by restoring predictability to tax receipts. In light of the relatively high marginal income tax rates, cuts in tax rates should be as large as could be afforded by base-broadening measures and expenditure restraint. While some Directors took the position that income tax reform should be revenue neutral, at least initially to avoid any unneeded procyclical impulse, other Directors supported modest net tax relief, noting the benefits it could have for boosting the confidence of investors and consumers; but they stressed that corresponding spending cuts would be necessary to preserve the authorities’ deficit reduction path. To achieve a lasting reduction in social contribution rates, pension and health care benefits would need to be scaled back further, given the prospective adverse demographic trends.
As to labor market reforms, there was broad support—in addition to income tax reform—for generalized measures across a wide front: continuing wage moderation; increasing wage dispersion and more flexible work rules; lowering social contribution rates to reduce nonwage labor costs; restructuring social benefits to enhance job search and encourage a return to gainful employment; and raising labor productivity by strengthening training and education programs. Recognizing that the brunt of the recent labor shedding had fallen on the low paid and low skilled, some Directors also supported policy measures targeted at those groups to facilitate their reabsorption into the work place. Several Directors considered inappropriate wage levels and structures—negotiated by employers and trade unions, and underpinned by social policy—to be the root cause of Germany’s employment problem. Some of those Directors recommended that the government seek to build a consensus among the social partners to facilitate a more fundamental reshaping of labor market incentives and institutions. Some others, however, were concerned that government interventions could create distortions in the incentive structure and would tend to undermine accountability; they stressed, instead, the continuation of efforts to increase the flexibility of labor markets.
Directors noted that, since last year, German financial markets had undergone extensive changes to prepare for EMU and the more intense competitive pressures expected to emerge. Directors welcomed the strengthening of financial supervision. While noting that the sizable loan portfolio of German banks to troubled economies in Asia and Russia was covered to a substantial degree by German guarantees and provisioning by banks, Directors emphasized that continued vigilance would be important.
Directors commended the German authorities for maintaining the level of official development assistance (ODA) above the average for OECD countries and for their significant financial support for reforms in the countries of central and eastern Europe, including states of the former Soviet Union. Nevertheless, a few speakers regretted the decline in German ODA as a ratio of GDP in 1997, and encouraged the authorities to raise these expenditures.
|Germany: Selected Economic Indicators|
|Economic activity and prices||Change in percent, unless otherwise noted|
|Real net exports2||0.0||-0.2||0.6||0.8||0.0||-0.2|
|Investment in machinery and equipment||-1.0||1.6||1.9||3.9||8.0||6.8|
|Gross national saving (percent of GDP)||21.3||21.0||20.1||21.1||21.5||21.9|
|Gross domestic investment (percent of GDP)||22.3||21.9||20.7||21.3||21.2||21.5|
|Unemployment rate (in percent)||9.6||9.4||10.4||11.5||10.9||10.6|
|Unit labor cost in manufacturing||-6.0||-1.0||-0.8||-5.4||-3.0||-1.2|
|CPI (year average)||2.7||1.8||1.5||1.8||1.0||1.4|
|Public finance||In percent of GDP|
|General government balance3||-2.4||-3.3||-3.4||-2.7||-2.6||-2.3|
|Territorial authorities balance4||-3.5||-3.2||-3.4||-2.7||-2.0||-2.1|
|General government debt||50.2||58.3||60.8||61.5||61.6||61.7|
|Money and credit||End of year, percent change|
|Domestic bank lending5||8.1||7.2||7.6||6.0||6.2||...|
|Interest rates||In percent|
|Three-month money-market rate6||5.3||4.5||3.3||3.3||3.5||...|
|Ten-year government bond yield6||6.9||6.9||6.2||5.7||4.5||...|
|Balance of payments||In billions of DM, unless otherwise noted|
|Trade balance (percent of GDP)||2.1||2.3||2.7||3.0||3.8||3.8|
|Current account balance||-32.9||-32.4||-20.7||-6.9||11.4||14.2|
|Current account (percent of GDP)||-1.0||-0.9||-0.6||-0.2||0.3||0.4|
|Reserves (in billions of US$)8 9||77.4||85.0||83.2||77.6||79.1||...|
|Exchange rates||Period average|
|Deutsche mark per US dollar6||1.62||1.43||1.50||1.73||1.79||...|
|Nominal effective rate (1990=100)6||106.4||111.8||108.9||103.9||104.7||...|
|Real effective rate (1990=100)6 10||113.7||122.9||122.5||114.3||112.5||...|
Sources: IMF, World Economic Outlook and International Financial Statistics; Statistisches Bundesamt; Deutsche Bundesbank.
1/ Staff projections, unless otherwise noted.
2/ Contribution to GDP growth.
3/ On a national accounts basis, Maastricht definition.
4/ On an administrative basis.
5/ Data for 1998 refer to July 1998 compared with July 1997.
6/ Data for 1998 refer to August 1998.
7/ Merchandise trade, including supplementary trade items.
8/ Total reserves minus gold.
9/ Data for 1998 refer to July 1998.
10/ Based on normalized unit labor
costs in manufacturing.
1Under 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 directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.
IMF EXTERNAL RELATIONS DEPARTMENT