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German Economy Fares Well But Reform Agenda Still Unfinished

Turbine plant in Leipzig, Germany. Relying more on domestic demand for growth would help cut exposure to external risks (photo: Jan Woitas/Newscom)

ECONOMIC HEALTH CHECK

German Economy Fares Well But Reform Agenda Still Unfinished

IMF Survey online

July 3, 2012

  • Germany’s relatively strong performance sets conditions for domestic demand-led growth
  • Downside risks cloud near-term outlook
  • Accelerating structural, financial reforms would raise growth potential, also benefit euro area

Despite looming risks, Germany continues to perform relatively well, the IMF said in its annual report on the state of the economy.

The IMF called for policies to steer the recovery while guarding against downside risks, and noted that speeding up structural and financial reforms—along with rebalancing sources of growth—should help raise both Germany’s growth potential and generate positive outward spillovers.

According to the IMF’s assessment of Europe’s largest economy, economic activity is relatively robust, wages are rising, the unemployment rate (5.3 percent) is at post-reunification lows, and inflation expectations are well anchored. Furthermore, the fiscal deficit is narrowing (from 4.3 percent in 2010 to 1 percent in 2011) while corporate and household balance sheets are healthy. In addition, banks have ample liquidity and maintain adequate levels of regulatory capital, and lending rates are lower than elsewhere in Europe. This implies that the conditions are now in place for a domestic demand-led recovery.

Growth is projected at 1 percent in 2012 and 1.4 percent in 2013, but the outlook remains uncertain due to downside risks, the IMF said, urging measures to ensure financial stability and allowing the rebalancing of sources of growth as a means to protect the economy against external risks. "Germany is one of the world’s largest and most open economies, making it prone to external developments in both the euro area and the broader world economy,” said Subir Lall, IMF mission chief for Germany.

Over the medium term, structural and financial reforms would help raise Germany’s potential growth, with positive spillovers to the rest of the euro area, IMF report said.

Challenges and policy priorities

Germany has strong links with the euro area through the common currency and trade and financial linkages, and is a regional safe haven, the report noted. “The main risk facing Germany is a strong intensification of the euro area crisis. Lower global growth prospects more broadly would also hamper growth prospects in Germany,” Lall said.

“But under the baseline, the fiscal stance is appropriate given Germany’s cyclical position and Germany’s status as a guarantor for the European Financial Stability Facility/European Stability Mechanism”, added Lall. According to the IMF’s assessment, the key near-term policy priorities are to allow the transition to domestic demand-led growth to proceed, secure financial stability, and help address the challenges facing the euro area.

Rebalancing sources of growth: looking ahead, the rise in wages and some asset prices would contribute naturally to the process of rebalancing growth from being dependent mainly on exports to relying more on domestic demand. Allowing this rebalancing to unfold would help further reduce Germany’s high current account surplus and, hence, its exposure to external risks stemming from the euro area and elsewhere.

Securing financial stability in the face of external risks: the banking system remains exposed to adverse external developments given the large size of its loan portfolio, the low quality of bank capital, and significant exposures to other economies in the euro area. Hence, it would be important to take steps to enhance the supervisory and regulatory framework to safeguard the banking system following European Union initiatives.

Helping address the challenges facing the euro area: articulating more clearly the Economic and Monetary Union’s shared vision of an appropriate post-crisis architecture should help restore market confidence. Moreover, the rebalancing of Germany’s economy from being export oriented to relying more on domestic demand would help reduce imbalances in the euro area. Consistent with the mandate of the European Central Bank, the incipient disinflationary pressures in the periphery economies could imply that Germany may have an inflation rate that is somewhat higher than the euro area average.

Accelerating reforms

Germany should seize the opportunity to further strengthen its economy’s growth potential and diversify the sources of growth, reinforcing reform momentum in the euro area. According to the IMF report, the reform agenda should encompass the following components:

Stepping up structural reforms: policies need to focus on increasing the labor force, raising the quality of human capital—through reforms to education and training—and raising productivity in the services sector through greater competition, including at the regional level in network industries, such as transportation and energy.

Building momentum for financial sector reform: this should include accelerating efforts to reduce outstanding public capital support to some banks. There is also a need for a comprehensive strategy to improve the efficiency and stability of the banking system. In addition, establishing bank resolution plans and enhancing the deposit insurance regime would strengthen the crisis management framework.

Broadening the financial system beyond banking: stepping up efforts to broaden the channels of financial intermediation would help facilitate the allocation of resources toward innovation and new engines of growth.