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Transcript of a Conference Call on Germany
on the Release of the Article IV Consultation Staff Report,
Public Information Notice, and Selected Issues Paper
Tuesday, November 2, 2004

MS. LOTZE: Good morning, everyone, and welcome to the conference call on Germany. I'm Conny Lotze of the External Relations Department, and with me are the Mission Chief to Germany, Mr. Ajai Chopra, and the Division Chief responsible for Germany, Mr. Bob Traa. Here I just want to point out quickly that we had Mr. Traa's first name mistakenly as Robert yesterday on the note. So, please, if you quote him, please quote him as Bob Traa.

Most of you will have seen the documents on the Article IV consultation with Germany, which include the Public Information Notice, the Staff Report, and the Selected Issues Paper.

Before we go to your questions, Mr. Chopra will make some introductory remarks. Mr. Chopra?

MR. CHOPRA: Thank you. Good morning, or if you're calling from Europe, good afternoon. I'm Ajai Chopra and I led the Article IV consultation discussions with Germany.

In my opening remarks, I'm going to touch on four main areas: first, a few words on current economic developments and the outlook; second, I'll talk about fiscal issues, including the work we have done on federalism and how budgetary institutions can be strengthened; third, following the forceful start of needed structural reforms in Agenda 2010, I'll speak briefly about the remaining challenges on the structural front; and, finally, it has been a year since the IMF did an in-depth analysis of Germany's financial sector, so we'll look back at what was achieved in the last year.

On the current developments and outlook, following three years of stagnation, Germany is now experiencing a moderate cyclical recovery. The recovery, as you well know, is being driven by exports, and domestic demand still remains dormant. This unbalanced nature of the recovery contributes to uncertainties about its strength and sustainability.

Our latest forecast, which incorporates the impact of recent oil price increases, is that the economy will grow by 1.9 percent in 2004 and by 1.5 percent in 2005. This is a downward revision from the last World Economic Outlook forecast.

I should point out that the underlying expansion from 2004 to 2005, after correcting for the number of working days, is about a half percent. In other words, even though the headline number falls between 2004 and 2005, we actually see a slight acceleration in the pace of growth in 2005.

The spillover from external demand to domestic demand has been slower than in previous upswings. There are some hypotheses for this, some of which link to confidence effects. For example, some of the pension and health care reforms, important as they were, have likely induced some precautionary savings. Also, past policy reversals may have led to some uncertainty because people do not know what to expect. People might be wondering if there are going to be additional changes in the future that will affect disposable income.

Consumers are also likely to be worried about job security, and wage moderation has been an important feature of the adjustment process in Germany, but this also slows the growth of disposable income. That said, we did not find evidence that the links between external demand and domestic demand would not eventually come into play and boost investment and employment. I'll come back to these issues again at the end of my opening remarks.

Turning now to fiscal issues, for 2004 we are projecting a general government deficit of 3.9 percent of GDP. This will be the third year that Germany exceeds the 3-percent Maastricht limit. The government's goal is to reduce the deficit to 3 percent in 2005, which will be challenging. Our latest estimates suggest that if no additional measures are taken before the budget is passed in December, and if the government relies only on the measures that are in the pipeline, then the 2005 deficit will likely be about 3.4 percent of GDP.

The Fund staff's advice on fiscal policy is typically couched in terms of underlying structural adjustment, and their advice for 2005 is to aim for structural adjustment of three-quarters percent of GDP. The measures that are already in the pipeline from the 2004 budget will help in 2005 as well, but the yield will still fall short of the three-quarters percent of GDP we recommend. Therefore, in our view, additional measures of about one-third percent of GDP should be identified and implemented with the 2005 budget before it is passed.

Why do we feel that fiscal adjustment is a priority? Well, public debt is growing, population aging will put new pressures on public finances, and sound public finances are a prerequisite for growth.

On the issue of how the adjustment should be achieved, we think that the Koch-Steinbrück list of tax exemptions and subsidies offers the most promising avenue. Our preference has consistently been for high-quality and durable measures to reduce expenditure, and we do not favor one-off measures to bring down the deficit.

Leaving aside these near-term fiscal issues, one of the new features of our analytical work this year was to look at issues concerning fiscal federalism in Germany and the political economy of adjustment. There is a Selected Issues Paper on this, and a box summarizes the main points in the Staff Report.

We recognize that the basic features of Germany's federal and political system are not going to change and, hence, the focus of our work was on what can be done within the system to improve budgetary institutions and intergovernmental fiscal relations so that we have better fiscal outcomes.

I won't go into details now because they are in the reports you have, but the main thrust is to establish firmer commitments among different levels of governments and introduce a degree of competition in fiscal federalism.

A parliamentary commission is currently studying Bund-Länder relations, so we hope our analysis in this area will feed into the public debate on this matter.

I now turn to the third topic, which concerns the need for additional structural reforms. As I said at the outset, Agenda 2010 contains a number of bold and well-targeted steps to improve the functioning of labor markets and to launch both pension and health care reforms. The various labor market initiatives, including Hartz IV, aim to reduce unemployment and increase employment, and these are certainly very helpful steps. However, from a long-run perspective, the scope to boost employment by raising labor participation rates is larger than from reducing unemployment. Indeed, Germany is already facing a decline in its working-age population, and if corrective steps are not taken, the drag on potential growth and the social system will be substantial.

So what is the biggest future priority on the structural front? I would say that it is bolstering the supply side of the economy by increasing labor utilization. This will not only support potential growth, but it will also broaden the base to finance the welfare state in Germany. Therefore, in our view, there is a need for additional measures to boost labor participation, especially measures geared at elderly workers, women, and the young.

We have done some analysis of pensions and growth that shows quite convincingly the consequences of inaction would be stagnation in growth. Conversely, that analysis shows that if Germany can increase the participation of elderly workers by extending the pensionable age in line with life expectancy, it can have a very powerful effect.

Finally, on the financial sector, the strains of 2002 and the early part of 2003 have eased, and the banking system is in a better position to support the recovery. As we note in the reports you have, profitability has rebounded, write-offs have become less pressing, and higher asset prices have improved balance sheets. However, progress in market-driven restructuring has been slow.

Improving revenue efficiency of banks remains the cardinal problem of the German banking system. This ultimately requires a repositioning of business strategies, and in our view, it would be best if such repositioning was guided by market forces, which in turn requires removing the rigidities inherent in the three-pillar banking system.

In closing, our view is that casting policies in a coherent framework that focuses on a mix of raising labor utilization, welfare reform, and fiscal consolidation can have a beneficial impact on confidence. It is quite possible that spending remains sluggish because people know Agenda 2010 is not the last word. Therefore, once the public is satisfied that the welfare state is sustainable and that additional cuts are not required, and once Germany's high labor costs have been contained so that jobs look more secure, it is likely that spending will pick up again.

Thank you.

MS. LOTZE: Thank you very much. We will go to questions now, please.

QUESTIONER: Good morning, good afternoon. I just wanted to pick up on some of the interesting points you made about Germany's federal system and possible changes to increase efficiency and competition within the system.

I just want to sort of get some sense from you how important you think these are given the emphasis you also put on the need for more structural reform in the labor market. Have you carried out this exercise on the political side? Maybe it's more than an academic exercise. Or do you think this is genuinely an important thing that should be addressed in the near term? Thank you.

MR. CHOPRA: Okay. Just to clarify, our emphasis in this study was, as I said earlier, that we worked within the current system, the current framework, and what we were looking at is are there steps that can be taken within this framework that would increase transparency, that would increase accountability, and that could then lead to better fiscal outcomes. So among the measures that we were supporting in this context, they were primarily on the fiscal side. We weren't looking at labor market issues in this context. So the issues on the fiscal side were issues such as having a fiscal sustainability report, which the government does plan to publish on a regular basis. We feel that these reports should be done by a nonpartisan independent body, and they provide a long-run view of general government accounts on current policies. This could help build the case for additional fiscal consolidation.

There are also aspects of making the fiscal account more consistent with the Stability and Growth Pact. There are issues about improving the internal stability pact between the federal government and the individual Länder. There are issues about revenue sharing and so on.

So it was not so much focused on structural reforms outside the fiscal area; rather, it was focused primarily on how intergovernmental relations can be improved so that fiscal outcomes are better.

QUESTIONER: I mean, some of the things you propose, for instance, increasing competition between the Länder, obviously it would be quite difficult to push through, even within the federal system at the moment. I'm looking at, for instance, tax competition between Länder. Those would be quite radical moves in this country. I mean, are they that important, do you think?

MR. CHOPRA: Well, what we suggest specifically is that a Land could consider having a system of discounts or surcharges on their tax system, and this does happen in some other countries, and I think it does lead to fairly healthy competition among the Länder, and this is something that we believe should be considered.

QUESTIONER: Good morning. You were mentioning that rather than to reduce unemployment, economic policymakers should rather focus on enhancing the labor participation rate. What is really the difference here? I mean, in both cases we're talking of strengthening employment.

MR. CHOPRA: The difference here is that, as you know, currently when you look at international definitions, unemployment in Germany is 9 to 9.5 percent using the international definition. Under the German definition, it's about 10—a little over 10 percent.

Now, one can reduce this by a few percentage points, and certainly the Agenda 2010 reforms which aim to do that by restructuring the unemployment benefit system is very, very important. But we think that there's only limited gains that you can get from that. They're limited but they're very important, and we hope that they begin to show up fairly soon. But if you take a much longer span of a decade or longer, then we feel that you need to focus much more on increasing labor force participation, and this links again with the demographic profile in Germany and in a number of other industrial countries. So this is not an unusual recommendation for Germany. It is a recommendation that we've been pressing for the euro zone as a whole, and it's a long-term recommendation. And we feel that if countries focus on improving the labor participation rate and raising that, that itself increases labor supply, and this could have a number of very helpful knock-on consequences by improving the supply side of the economy, making the welfare state more sustainable, and so on.

So it really is a longer-term issue. But it's a longer-term issue, but at the same time we don't think that Germany has the luxury or other countries have the luxury to wait before taking steps on this front, because population aging is going to be something that is already kicking in, but it's going to kick in a much bigger way in 2010, which is just one business cycle away.

QUESTIONER: Could you please take us back to your ideas of how to reduce the deficit? How can that be achieved?

MR. CHOPRA: Okay. As I said in my opening remarks, we think that the most promising avenue on this front is to reduce tax exemptions and subsidies. As you know, the Koch-Steinbrück list from last year, they came up with a list of subsidies and tax exemptions using a very broad definition of about 6 percent of GDP. What was agreed in the 2004 budget was that these subsidies and tax exemptions would be reduced at a very slow pace. If I remember right, it's at a pace of about 4 percent a year, which would mean that it would take 25 years to get rid of all these.

What we suggest is that steps be taken to accelerate reducing these tax exemptions and subsidies. There are obviously some big-ticket items that need to be focused on. like the commuter subsidy, like the subsidy for residential construction. The impact of removing these subsidies will build over time.

I should also point out that within this list, one item that might be worthwhile looking at in a little bit more detail given the current cyclical situation is to look at the tax exemptions and subsidies that are provided to corporations. Out of that 6 percent, our understanding is that corporate subsidies amount to about 2.3, 2.4 percent of GDP. So that is quite a substantial chunk. And as you know, corporate subsidies—corporate profits right now are fairly buoyant, so if these particular subsidies were reduced, it might have a more muted impact on demand at this time.

In addition to these tax exemptions and subsidies on the Koch-Steinbrück list, there is another area that could also be looked at, and that is the spending on active labor market policies, active labor market programs. And these amount to 1 percent of GDP, and I think there are studies within Germany that show that this is quite expensive and it is not necessarily the most cost-effective way of addressing the problems that they're designed to address. So these are the main areas we would suggest that the government look at.

The other attraction of the Koch-Steinbrück list is, of course, that it was put together by a bipartisan committee.

QUESTIONER: Could you please give us some additional information where Germany stands in comparison with the other big economies in the European Monetary Union?

MR. CHOPRA: Well, that's quite a broad question. I think if we were to look simply at our growth forecasts, I think these are being revised right now for a number of the countries. We have missions in the field right now in Italy, and we have missions going out to a number of other countries.

But I would say that the German forecast right now is a little bit lower than the forecast for France. I don't have the exact numbers with me, but, again I think we need to focus on the fact that, as I said earlier, there is a recovery underway. It is more unbalanced in Germany than it is in many other countries, but that's not to say that domestic demand isn't a problem in some of the other countries as well. But I don't have all the latest forecasts in front of me right now, so I'd rather not make very detailed comparisons at this point.

MS. LOTZE: Okay. Thank you very much. We will conclude the conference call at this point. Thank you very much for participating. Bye-bye.

[Whereupon, the conference call was concluded.]


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