## _cr06438 ## Source details **Canonical URL:** [_cr06438](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06438.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06438.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06438.pdf.json) --- ### Executive summary — key messages and challenges - Germany benefiting from a cyclical upswing driven by buoyant world demand and exports; rebound in investment and uptick in employment. - Three interrelated challenges: - Low trend growth, with lackluster productivity improvements in the more sheltered domestic (services) sectors. - High and long-lasting unemployment, with high reservation wages limiting job opportunities for the poor and lower skilled. - Risks to long-run fiscal sustainability despite commendable progress in recent years. - Recent drivers: - Private sector restructuring and wage moderation underpin export-led recovery. - Fiscal deficit reduction and entitlement reforms implemented to improve fiscal solvency. - Recent adjustment centered on wage moderation and fiscal containment rather than comprehensive efficiency-enhancing structural reforms. ### Growth outlook, cyclical setting, and near-term projections - Cyclical and policy factors: - Coalition Agreement’s €24 billion (1 percent of GDP) stimulus package for 2006-2009 has begun to take effect. - VAT increase from 16 to 19 percent in January 2007 estimated to boost growth in 2006 by ¼–½ percentage points (and lower it by the same amount in 2007). - Staff central projection and forecasts: - Real growth: 2.3 percent in 2006 (from 0.9 percent in 2005); projected to slow to 1.4 percent in 2007. - Underlying growth estimated to be between 1½-1¾ percent for 2006–2007. - Inflation: 1.7 percent in 2006 rising to 2.3 percent in 2007 (jump in early 2007 reflecting the VAT); core inflation projected to remain between 1-1½ percent. - Forecast table highlights (Real GDP 2005–2007): - Staff (latest): 0.9 2.3 1.4 - WEO (Sept): 0.9 2.0 1.3 - Authorities (Oct): 0.9 2.3 1.4 - Consensus (Oct): 0.9 2.2 1.2 - Standard Deviation: 0.1 0.3 ### Risks to the recovery and near-term behaviour - Downside risks: - Volatile oil prices and geopolitics. - Unexpected tightening of euro-area monetary policy. - Disorderly unwinding of global imbalances leading to sharp euro appreciation and lower growth. - Faster-than-expected slowing in trading partners softening German exports. - Fragile consumption and failure to implement structural reforms could dampen confidence. - Upside risk: - Recovery could strengthen if employment growth continues to gather pace and boosts household incomes. - High-frequency indicators peaked in Q2 2006 but are holding up; uncertainty about demand brought forward into 2006 ahead of the VAT increase and the dip in early 2007. ### Medium- and long-term potential and decomposition of potential growth - Medium-run projection: - Recovery of domestic demand expected to close the output gap by 2008 and external current account surplus to fall. - Long-run constraints: - Slowing demographics expected to reduce potential growth to just over 1 percent a year absent stronger reforms. - Long-run per capita growth projected in the range of 1½-1¾ percent a year given successful policies to raise labor utilization. - Decomposition table (average percentage change a year — selected rows across periods): - Real GDP: 2.0 1.3 1.4 1.1 1.1 1.2 - Total Factor Productivity (TFP): 1.4 0.8 1.0 1.0 1.0 1.0 - Total Hours Worked: -0.3 -0.2 -0.3 -0.8 -0.7 -0.4 - Real capital stock: 2.0 1.4 1.5 1.4 1.2 1.2 - Population, e.o.p. (thousands): 82,087 82,643 82,498 81,046 78,459 75,124 - Growth with lower unemployment rate 1/: 2.0 1.3 1.6 1.1 1.1 1.2 - 1/ Baseline scenario assumes a steady-state unemployment rate of 7.5 percent; lower unemployment scenario drops to 5 percent in the next decade and then remains at this lower level. ### Labor market — diagnosis and recommended measures - Diagnosis: - Generous entitlements have kept reservation wages high, limited labor force participation (especially elderly and female workers), and raised long-term unemployment. - Hartz reforms improved job placement incentives but implementation issues left benefits more generous than intended; about two-thirds of the 4½ million unemployed are in the UB-II system. - Key labor market indicators: - Full time employment picked up for first time in five years. - Unemployment rates: 10.6 percent (national definition), 8.2 percent (ILO definition); unemployment in East Germany remains over 16 percent (national definition). - Staff policy recommendations (mutually reinforcing with other reforms): - Reinstate momentum on reforms to reduce structural unemployment. - Reduce benefits for the long-term unemployed who are unwilling to work; staff supported lowering UB-II benefit level by 30 percent for noncompliant claimants in welfare-to-work proposals. - Avoid introducing minimum wages, selective wage subsidies, and tighter regulation of temporary work agencies. - Cull ineffective active labor market programs (Germany has around 80 ALMPs with fiscal costs of €16 billion a year (0.7 percent of GDP)); focus spending on effective programs. ### Product market reforms and productivity-enhancing measures - Diagnosis: - Regulatory barriers and public ownership impede firm entry in product and services markets; domestic sectors (retail, wholesale, liberal professions) show low productivity growth relative to manufacturing. - Barriers to IT adoption tied to lack of competition in telecommunication and network industries. - Recommendations: - Improve contestability of markets in network industries by stepping up privatization and reducing access costs. - Deregulate liberal professions and the guild system to lower incumbents’ market power; implement Monopolkommission recommendations (revoking fixed-price lists, modifying licensing). - Reduce administrative burden targeting a cut by a quarter (equivalent of 1 percent of GDP) by 2009 via cost-benefit reviews of new proposals. ### Financial sector, capital markets, Landesbanken, and REITs - Financial sector diagnosis: - Profitability below peers; ongoing restructuring and capital market development needed to improve allocation of capital and resilience. - Landesbanken (LBs): - LBs hold 20 percent of banking assets and their book equity represents 9 percent of assets on the public sector balance sheet. - Staff estimates opportunity costs of LBs at ¼ percent of GDP annually (½ percent of tax revenues) since the early 1990s. - Staff simulations: equalizing LBs’ returns to market-based returns could improve public sector net worth by 10 percent of GDP (PV terms); public sector gross debt is 68 percent of GDP (for comparison). - Staff conclusion: LBs represent inefficient use of public assets; case for disengagement by Länder governments strengthened. - Sparkassen: - Staff concerned the regional principle fragments the system and limits efficiency and risk diversification; authorities do not share this view and emphasize Sparkassen’s role in local finance and inclusion. - Supervision and standards: - Support for risk-oriented supervision; recommend guiding supervision solely by prudential criteria and reinforcing BaFin’s operational independence; IFRS adoption for listed financial institutions from 2007; Basel II legislation approved. - Capital markets, private equity, and REITs: - Mergers and acquisitions involving German firms could reach 9 percent of GDP in 2006 (€200 billion). - Staff supports establishment of REITs including residential and nonresidential property; cautioned against excluding residential real estate and recommended addressing social concerns via budget transfers. - Authorities aim to introduce REITs in early 2007; negotiations on scope and tax issues ongoing. ### Residential real estate market — features and constraints - Residential real estate accounts for over half of all real estate. - Homeownership rate: 43 percent of households. - Contributing factors to weak housing prices: - Real disposable income grew by 1.2 percent per year since 1991. - Long-term mortgage rates among the highest in the euro area despite a decline by 0.7 percentage points since end-2002. - Average rental yield is 3½ percent. - Rent controls cap cumulative rent increases to 20 percent over three years; restrictions favor tenants. ### Fiscal consolidation, near-term path, and sustainability - Near-term fiscal outcomes and staff projections: - Staff projects deficit to decline to 2.4 percent of GDP in 2006 from 3.2 percent in 2005. - Authorities (mission time) projected deficit of 2.8 percent of GDP in 2006 and 2.3 percent in 2007; staff view for 2007 assuming no expenditure slippage: deficit could be reduced further to at most 1.6 percent of GDP. - Structural deficit reduction in 2006-07 estimated at about 1¼ percent of GDP (two-thirds expenditure-based). - Staff cautions that beyond 2007 there is a risk the deficit will get stuck at 1¾ to 2 percent of GDP unless additional measures taken. - Fiscal projection highlights (in percent of GDP): - Revenue: 2005 43.5; 2006 43.4; 2007 43.4. - o/w Taxes: 2005 22.0; 2006 22.4; 2007 23.3. - Social contributions: 2005 17.7; 2006 17.4; 2007 16.8. - Primary Expenditure: 2005 44.0; 2006 43.1; 2007 42.5. - Social benefits: 2005 26.7; 2006 26.2; 2007 25.9. - Primary balance: 2005 -0.5; 2006 0.4; 2007 1.1. - Interest: 2005 2.8; 2006 2.7; 2007 2.7. - Overall balance: 2005 -3.2; 2006 -2.4; 2007 -1.6. - Structural balance: 2005 -2.8; 2006 -2.4; 2007 -1.5. - Debt-GDP ratio: 2005 66.4; 2006 67.5; 2007 67.4. - Policy recommendations: - Continue expenditure restraint and proceed with the VAT increase (shift from direct to indirect taxes). - Implement additional cuts in subsidies and tax expenditures and in spending on ineffective ALMPs. - Emphasize measures that reduce distortions; any additional revenue should be used to reduce borrowing, not to increase spending. - Implement structural adjustment of at least ½ percent of GDP a year to achieve structural balance by 2010 and anticipate aging pressures. ### Corporate income tax and health care reform — design and cautions - Corporate income tax reform: - Objective: lower statutory corporate tax rate from 39 to 29 percent. - Current proposals aim to limit the annual revenue loss to ¼ percent of GDP. - Base-broadening measures under consideration include reducing depreciation allowances; narrower limits on interest deductibility targeted at profit-shifting cases. - Intended implementation date: January 2008. - Health care reform: - Cabinet proposals include creating a central health fund (to be launched in 2009) to pool wage-based contributions and disburse to insurance funds, allowing insured to switch funds. - Financing of child healthcare will be gradually shifted to general taxes with a budget impact of ¾ percent of GDP per year; no offset indicated. - Staff cautions current proposals unlikely to substantially slow upward trajectory of long-run health costs; need to decouple healthcare financing from payroll charges and increase competition among providers and insurers. ### Long-run public balance-sheet indicators and aging costs - Selected balance-sheet figures (percent of GDP; sequences in source): - Financial net worth: -45 -49 -51 -53 -53. - Gross debt: -63 -65 -66 -68 -68. - Nonfinancial net worth: 55 55 55 54 54. - Current net worth: 10 5 3 1. - 50-year projection of change in net worth (NPV): -191 a/ -150 b/ -114 c/ -30 d/ -7 e/. - Comprehensive net worth = budget constraint: -181 -145 -111 -28 -5. - GDP (billions of euros): 2,163; 2,207; 2,241; 2,306; 2,306. - Structural fiscal balance: -3.4; -3.4; -2.8; -2.4; -2.4. - Aging cost projections and scenarios: - 2003 estimate: incremental aging costs by 2050 were 6.5 percent of GDP. - Agenda 2010 and coalition agreement reduced aging costs through 2050 to about 4 percent of GDP. - If government achieves budgetary balance by 2010, shortfall in comprehensive net worth could be reduced to about 30 percent of GDP. - EU Aging Working Group assumption (aging costs reduced to 2.75 percent of GDP) would make comprehensive net worth close to zero. - Risk scenario by IFO suggests aging costs could still rise by over 7 percent of GDP if health care price trends persist. ### Staff appraisal — overarching priority and integrated strategy - Overarching priority: transmit external strength to the domestic economy to broaden the recovery and create conditions for sustained high growth. - Strategy should exploit three mutually reinforcing elements: - (i) Improve labor market flexibility and bolster employment to boost household income and domestic demand. - (ii) Raise productivity in product and financial markets. - (iii) Reform entitlements and adjust fiscal policies to strengthen confidence in the sustainability of the welfare state. - Staff recommended sequencing and complementarities: - Labor market reforms to increase employment and labor utilization. - Product and financial market reforms to raise productivity and improve capital allocation. - Fiscal consolidation anchored in expenditure restraint and structural measures (VAT shift, entitlement reform) to secure long-run sustainability. *Source: Executive Summary, _cr06438.* ### Executive Summary ...................................................................................................... ### Executive Summary ### Key messages and challenges - Germany is benefiting from a cyclical upswing driven by buoyant world demand and exports, which have triggered a rebound in investment and an uptick in employment. - Three interrelated challenges require policy attention: - Low trend growth, with lackluster productivity improvements in the more sheltered domestic (services) sectors. - High and long-lasting unemployment, with high reservation wages limiting job opportunities for the poor and lower skilled. - Risks to long-run fiscal sustainability despite commendable progress in recent years. ### Recent performance and drivers - The private sector’s sustained restructuring and wage moderation have underpinned export-led recovery. - Fiscal deficit reduction and entitlement reforms have been implemented to improve fiscal solvency. - Adjustment in recent years centered on wage moderation and fiscal containment rather than comprehensive efficiency-enhancing structural reforms. ### The current setting - A strong and gradually broadening cyclical recovery is underway, with fast export growth and record corporate profits rekindling investment demand. - Temporary and policy-support factors: - The Coalition Agreement’s €24 billion (1 percent of GDP) stimulus package for 2006-2009 has begun to take effect. - The World Cup soccer tournament provided a boost to the service sector. - Phasing out of homeowner subsidies is stimulating residential construction. - The VAT increase from 16 to 19 percent in January 2007 is estimated to boost growth in 2006 by ¼–½ percentage points (and lower it by the same amount in 2007). - Interest and capacity conditions: - Improved sales and profit expectations and higher capacity utilization have driven strong spending on plant and equipment despite an increase in real interest rates by 1 percent in the last six months. - Labor market and demand: - Real growth is projected to rise to 2.3 percent in 2006 (from 0.9 percent in 2005), with nearly three-quarters of the contribution to growth coming from domestic demand. - Full time employment has picked up for the first time in five years. - Unemployment rates: 10.6 percent (national definition), 8.2 percent (ILO definition). - Unemployment in East Germany remains over 16 percent (national definition). - Consumption remains tepid; households increased precautionary savings during earlier fiscal restraint. - Competitiveness and external accounts: - Germany has been the only G7 country to gain overall market share in world exports in recent years. - Fund staff and the Bundesbank find the real exchange rate broadly in line with fundamentals, with a small undervaluation in the range of 3 to 6 percent. - The external current account surplus averaged 4 percent of GDP in 2000-05, largely reflecting a sharp reduction in domestic investment by nonfinancial enterprises and households. - The household saving ratio is expected to fall in the course of 2006 with advance purchases prior to the VAT increase; business net saving is expected to drop as the domestic investment cycle turns; the public sector is projected to increase its saving. ### Inflation and costs - Headline inflation has been close to 2 percent in recent years due to energy and administered prices; core inflation has been around 1 percent a year. - Unit labor costs: - Unit labor costs in manufacturing have declined. - Unit labor costs have continued to increase in the more sheltered domestic sectors. ### Policy recommendations (mutually reinforcing) - Labor market reforms to reduce structural unemployment: - Reinstate momentum on reforms to reduce structural unemployment. - Reduce benefits for the long-term unemployed who are unwilling to work. - Avoid introducing new distortions such as sectoral minimum wages, selective wage subsidies, and tighter regulation of temporary work agencies. - Cull ineffective active labor market programs. - Product market reforms to increase competition and productivity: - Improve contestability of markets in network industries by stepping up privatization and reducing access costs. - Deregulate liberal professions and the guild system to lower the power of incumbents. - Capital markets and financial sector reforms to improve allocation of capital: - Improve effectiveness of legislation for private equity. - Establish REITs that include both residential and nonresidential property. - Open public sector banks more to private capital to facilitate market-driven restructuring and improve profitability. - Fiscal policy to achieve structural balance and strengthen long-term sustainability: - Aim to achieve structural balance by 2010 and further improve long-run sustainability. - A sizeable reduction of the deficit is in train for 2005-2007; additional high-quality measures are needed thereafter to continue lowering the deficit. - Health care reforms should strive to reduce the burden on payroll taxes, increase competition, and lower costs. - Corporate income tax reform should be designed to avoid new budgetary burdens or distortions for firms. ### Assessment of past Fund recommendations and implementation - Directors previously called for comprehensive policies to achieve fiscal sustainability and reduce structural rigidities. - Fiscal consolidation: - Directors endorsed reducing the fiscal deficit below 3 percent of GDP by 2007; the deficit will be reduced to well below 3 percent in 2006. - The structural adjustment of over 1 percent of GDP in 2006-07 is spread more evenly than thought earlier, with a significant expenditure component. - Fiscal federalism: - A first round of fiscal federalism reforms has been adopted to streamline the legislative process and give Länder more autonomy; more fundamental intergovernmental changes remain to be addressed. - Labor and entitlement reforms: - Directors welcomed the Hartz labor market reforms but noted effectiveness has been hampered by design flaws and weak implementation. - No progress in reforming employment protection legislation; the decision to gradually raise the pension age remains to be enacted in law. - Productivity-enhancing reforms: - Progress has been slow in product and service markets; in the banking system private investors were recently allowed to buy shares in one Landesbank, but overall structural efficiency gains have been slim. *Source: Executive Summary, _cr06438.* ### 8. Although the VAT hike is projected to slow growth in 2007, the authorities and ### _cr06438 - 8. Although the VAT hike is projected to slow growth in 2007, the authorities and ### Growth outlook and fiscal measures - The 3-point VAT increase is part of a package in which unemployment payroll taxes will be reduced from 6 ½ to 4 ½ percent. - The stimulus package (see ¶4) is phased to have a larger impact in 2007. - Global economy projected to remain strong, favoring German (capital good) exports. - Staff central projection: - GDP growth to slow to 1.4 percent in 2007. - Underlying growth estimated to be between 1½-1¾ percent for 2006–2007. - Inflation expected to rise from 1.7 percent in 2006 to 2.3 percent in 2007, with a jump in early 2007 reflecting the VAT. - Core inflation projected to remain between 1-1½ percent. - Wage demands for 2007 are picking up due to strong corporate profitability and the VAT increase. ### Forecasts and forecast dispersion - Real GDP forecast (2005–2007): - Staff (latest): 0.9 2.3 1.4 - WEO (Sept): 0.9 2.0 1.3 - Authorities (Oct): 0.9 2.3 1.4 - Consensus (Oct): 0.9 2.2 1.2 - Standard Deviation: 0.1 0.3 - Medium-Term Projections, 2005–2011 (Percentage change from the previous period, unless otherwise indicated): - Real GDP: 0.9 2.3 1.4 1.7 1.8 1.4 1.3 - Total domestic demand: 0.5 1.6 1.3 1.7 2.0 1.7 1.5 - Private consumption: 0.1 0.8 0.2 0.8 1.4 1.2 0.9 - Gross fixed investment: 0.8 5.4 4.8 3.9 3.7 3.4 3.1 - Foreign balance (contribution): 0.4 0.7 0.2 0.1 -0.1 -0.2 -0.1 - Unemployment rate: 9.1 8.0 7.8 7.6 7.5 7.5 7.5 - Employment growth: -0.2 0.6 0.3 0.3 0.3 0.3 0.3 - CPI inflation: 2.0 1.7 2.3 1.6 1.6 1.6 1.6 - Saving-investment balances (in percent of GDP): - Private: 5.0 4.2 3.4 3.5 3.3 2.9 2.7 - Public: -0.9 0.0 0.7 0.5 0.5 0.5 0.4 - Current account balance: 4.1 4.2 4.1 4.0 3.8 3.4 3.1 - Sources: Fund staff estimates. 1/ In percent of GDP. ### Risks to the recovery - Downside risks: - Volatile oil prices and geopolitics. - Unexpected tightening of euro-area monetary policy. - Disorderly unwinding of global imbalances leading to sharp euro appreciation and lower growth. - Faster-than-expected slowing in trading partners softening German exports (partly mitigated by increased diversification of destinations). - Fragile consumption and failure to implement needed structural reforms could dampen confidence and restrain household spending. - Upside risk: - Recovery momentum could strengthen if employment growth continues to gather pace and boosts household incomes. - High-frequency indicators peaked in Q2 2006 but are holding up well; uncertainty remains about the extent to which spending was brought forward into 2006 in anticipation of the VAT increase and how pronounced the dip will be in early 2007. ### Medium- and long-term potential - Absent stronger structural reforms, improved cyclical prospects do not change Germany’s low long-term growth potential. - Staff medium-run projection: - Recovery of domestic demand expected to close the output gap by 2008 and external current account surplus to fall. - Domestic demand expected to rebound as consumption, investment, and total factor productivity recover to longer-run steady states. - Long-run constraints: - Slowing demographics expected to reduce potential growth to just over 1 percent a year. - Progress in labor, product, financial sector and (CIT) tax reforms could improve the outlook. - If policies successfully raise labor utilization and reduce unemployment, growth could speed up for some years, but declining population would eventually constrain headline growth. - Long-run per capita growth projected in the range of 1½-1¾ percent a year. ### Germany: Decomposition of Long-Run Potential Output Growth (Average percentage change a year) - Historical and projected averages by period (1990-99; 2000-09; 2010-19; 2020-29; 2030-39; 2040-49): - Real GDP: 2.0 1.3 1.4 1.1 1.1 1.2 - Total Factor Productivity (TFP): 1.4 0.8 1.0 1.0 1.0 1.0 - Total Hours Worked: -0.3 -0.2 -0.3 -0.8 -0.7 -0.4 - Working Age Population: 0.4 -0.1 -0.2 -0.8 -0.7 -0.5 - Participation Rate: 0.1 0.3 0.1 0.1 0.1 0.0 - Employment Rate: -0.2 0.0 0.0 0.0 0.0 0.0 - Hours per Employee: -0.7 -0.5 -0.3 -0.1 0.0 0.0 - Real capital stock: 2.0 1.4 1.5 1.4 1.2 1.2 - Memorandum items: - Labor share of income (percent): 0.61 0.60 0.60 0.60 0.60 0.60 - Population, e.o.p. (thousands): 82,087 82,643 82,498 81,046 78,459 75,124 - Growth with lower unemployment rate 1/: 2.0 1.3 1.6 1.1 1.1 1.2 - Source: IMF staff calculations. - 1/ Baseline scenario assumes a steady-state unemployment rate of 7.5 percent; lower unemployment scenario drops to 5 percent in the next decade and then remains at this lower level. ### Policy discussions — overarching priority - Priority: transmit external strength to the domestic economy to broaden the recovery and create conditions for sustained high growth. - Strategy should exploit three mutually reinforcing elements: - (i) Improve labor market flexibility and bolster employment to boost household income and domestic demand. - (ii) Raise productivity in product and financial markets. - (iii) Reform entitlements and adjust fiscal policies to strengthen confidence in the sustainability of the welfare state. - Political environment: grand coalition partners have difficulty agreeing on substantial reforms; decisive fiscal stance but limited consensus on structural reforms. ### A. Fostering Employment Growth — findings and proposed measures - Diagnosis: - Generous entitlements have kept reservation wages high, limited labor force participation (especially elderly and female workers), and raised long-term unemployment. - Hartz IV reforms aimed to improve job placement, lower average benefit levels, and tighten means testing, but administration has been difficult, benefits remained more generous than intended, job placements few, and means testing inadequate. - Some two-thirds of the 4½ million unemployed are in the UB-II system. - Authorities’ recent actions and outcomes: - Short-term unemployment (UB-I) is declining. - Duration of unemployment benefits shortened from 18 to 12 months (except for elderly workers). - Revenues for UB-I are firming as full-time jobs recover. - Policy options under consideration: - Welfare-to-work: government-commissioned study recommends lowering UB-II benefit level by 30 percent for those unwilling to accept jobs with local authorities; those who accept would retain full benefit. - Wage subsidies: selective wage subsidies (Kombilöhne), with a pilot program for elderly workers being prepared. - Minimum wages: under consideration to “protect” against competition from immigrants from low wage countries and to limit potential fiscal costs of wage subsidies. - Capturing unregulated sectors: contemplate new regulations for temporary work agencies; concerns about abusive labor practices because temporary agencies are not covered by collective labor agreements and absence of minimum wage legislation. - Staff assessment and recommendations: - Staff supported welfare-to-work proposals and saw merit in lowering UB-II benefit level by 30 percent. - Staff opposed minimum wages as a serious policy error, arguing they would introduce subfloors in wage setting and reduce job chances for low-skilled labor where UB-II already determines too high a reservation wage. - Staff cautioned against wage subsidies due to risk of rent seeking and high fiscal costs. - Staff advised against regulating temporary work contracts, arguing this would cut flexibility in an already overburdened labor market. - Review of ALMPs: - Germany has around 80 active programs; preliminary assessments indicate most are ineffective. - Fiscal costs amount to €16 billion a year (0.7 percent of GDP). - Staff strongly supported intention to cut ineffective ALMPs and focus on effective ones. ### B. Raising Productivity to support growth and wages - Diagnosis: - Regulatory barriers and significant public ownership impede firm entry in product and services markets, limiting competition and restraining productivity growth. - Productivity growth uneven: manufacturing has benefitted from foreign competition, but domestic sectors (especially retail and wholesale trade and liberal professions) show less productivity growth, contributing to a labor productivity shortfall relative to the U.S. - Lower productivity gains in trade and retail related to barriers to IT adoption stemming from lack of competition in telecommunication and other network industries. - Authorities’ initiatives and issues noted: - Electricity: Federal Regulatory Agency starting to use expanded powers to regulate pricing and enhance access for smaller operators. - Postal services: last vestiges of postal monopoly to be removed on January 1, 2008. - Railways: discussions on whether privatization will be limited to rolling stock or include concession to rail network itself; decision expected soon. - Telecommunications: Deutsche Telecom requested restrictions on access to its new high-speed fiber network; decision dependent on whether the fiber network establishes a new market. - Liberal professions and guilds: - Regulation for liberal professions is more restrictive than in the EU-15; Monopolkommission recommended revoking fixed-price lists and certain master’s licensing requirements. - Authorities comfortable with guild system for crafts because it provides quality control and apprenticeship positions; no policy initiatives planned to reform guild system. - For liberal professions, authorities plan to lower bureaucratic hurdles within existing framework. - Deregulation and administrative burden: - Chancellery initiative to reduce regulation costs; OECD analysis shows administrative burden on enterprises exceeds EU-15 average. - An independent group of experts reviewing costs; new proposals will be subject to a cost-benefit review before submission to parliament. - Authorities target lowering regulatory costs by a quarter, or the equivalent of 1 percent of GDP, by 2009. ### C. Improving the allocation of capital and financial sector issues - Diagnosis: - Financial sector profitability continues to fall short of peers; strains in the banking system could reemerge in the next downturn. - Capital market activity increasing but substantial untapped potential remains. - Without restructuring and innovative products to boost revenue, profitability will remain subdued. - Observations: - Cyclical upswing and abundant liquidity have improved earnings for banks and insurance companies. - Cost cutting and lower provisioning have aided bank earnings but are unlikely to be repeatable. - Revenue growth and return measures continue to compare unfavorably to the EU average. - Ratio of unprovisioned nonperforming loans (NPLs) over capital has declined since 2003 but remains high; part of this reflects Germany’s tighter NPL definition. - Implication: - Staff stressed need for banking sector restructuring and capital market development to improve allocation of capital and enhance financial sector stability. *Source: IMF staff report text provided in content unit _cr06438 - 8.* ### 25. Staff welcomed the increase in competition and the regulatory changes that are ### _cr06438 - 25. Staff welcomed the increase in competition and the regulatory changes that are ### Banking sector developments and competition - Foreign banks are becoming more active in Germany through takeovers and direct banking (including via the internet). - Banks are experiencing heightened price competition for mortgage, consumer, and business lending, which is lowering lending margins. - The mortgage banking sector is consolidating following last year’s liberalization of the Pfandbriefe market, which is no longer reserved for mortgage banks and Landesbanken. ### Landesbanken (LBs): performance, costs, and reform - LBs hold 20 percent of banking assets and their book equity represents 9 percent of assets on the public sector balance sheet. - Staff analysis finds LBs have imposed a large opportunity cost on the economy (Box 3). - Opportunity cost estimates: - Staff analysis suggests these opportunity costs have been ¼ percent of GDP annually (½ percent of tax revenues) since the early 1990s. - Staff simulations suggest that if LBs’ returns were equalized from now on to market-based returns of comparator banks, the public sector net worth would improve by 10 percent of GDP (in present value terms). - For comparison, public sector gross debt is 68 percent of GDP. - Observations on incentives and behavior: - Withdrawal of government guarantees in 2005 is spurring LBs to reformulate business strategies. - Funding costs are rising and arbitrage opportunities are decreasing. - Traditionally wholesale-oriented LBs are examining relationships with retail-based Sparkassen; responses include vertical integration into single banking conglomerates, looser cooperation with market-based fees, or expanding retail operations. - There is greater willingness to lower public sector stakes in LBs; in some cases ownership is already changing, including participation of private equity investors. - Staff conclusion: LBs represent an inefficient use of public assets and findings strengthen the case for disengagement by Länder governments from banking in favor of higher yielding assets or debt reduction. ### Sparkassen: staff concerns and authorities’ stance - Staff concerns: - Fragmentation associated with the three pillar banking system and the Sparkassen system continues to impede revenue growth. - The regional principle, confining Sparkassen to their communities of origin, limits efficiency and impedes risk diversification. - With new competition (including direct banking), Sparkassen could come under increasing pressure, arguing for creating a legal framework to open the door for private capital and mergers across pillars. - Authorities’ response: - Authorities do not share staff views on need for reform of Sparkassen. - Sparkassen are exploring efficiency gains through cost-sharing, including in back-offices. - Authorities are skeptical that liberalizing the regional principle would yield larger efficiency gains. - Authorities view the system as competitive due to wide-spread presence of Sparkassen and low concentration ratios; they see no need to open the banks to private capital. - Authorities emphasize Sparkassen’s role in access to banking in remote areas, service to lower-income households, provision of credit to the Mittelstand, and support for local cultural and community services. ### Regulation, supervision, and standards - Staff supported the move toward risk-oriented supervision of banks, insurance companies, and financial services companies, and encouraged publication of the methodology underlying this approach. - Recommendation: supervision should be guided solely by prudential criteria determined by supervisory authorities and avoid outside interference. - Staff recommended using the ongoing review of the supervisory agency (BaFin) to reinforce its operational independence. - Regulatory and accounting developments noted by authorities: - Listed financial institutions will need to adopt IFRS for their consolidated accounts from 2007 onward. - Legislation to implement Basel II capital adequacy standards has been approved by parliament. - A number of insurance groups are internalizing models for assessing risk under Solvency II and participation in the relevant Quantitative Impact Studies is high. - These actions are in line with the 2003 FSAP recommendations. ### Capital markets, private equity, and REITs - Capital market activity: - Analysts estimate mergers and acquisitions involving German firms could reach 9 percent of GDP in 2006 (€200 billion). - Opportunities for further private equity participation are large due to a fragmented business landscape. - Role of venture capital for new startups appears more constrained. - Authorities are formulating a more effective legal framework to mobilize additional market financing, including by streamlining tax incentives. - Real Estate Investment Trusts (REITs): - Authorities attach high priority to establishing REITs to increase flexibility of property markets and deepen capital markets. - Staff welcomed initiatives to introduce REITs and noted multiple benefits: - The property market and construction industry are important sources of jobs; Germany stands out for not using its potential to boost growth and productivity. - Improvement in the real estate market would bolster financial sector stability because a large share of NPLs is collateralized with real property. - Experience in other countries has shown that REITs are superior to the open-ended real estate funds in Germany, which had liquidity problems earlier in 2006, and thus would improve the availability of long-term saving instruments. - Local governments and enterprises appear ready to divest large real-estate holdings to free up liquidity and focus on core activities. - Staff caution: - Activities of REITs should not be unduly limited; calls to exclude residential real estate should be resisted. - Social concerns (e.g., potential impact on rental prices) should be addressed through other policy channels, such as budget transfers. - Authorities aim to introduce REITs in early 2007; negotiations are continuing on scope and outstanding tax issues (e.g., liability as property is transferred into REITs and the tax to be paid on dividend distributions). ### Germany’s residential real estate market (Box 4): features and constraints - Residential real estate accounts for over half of all real estate. - Housing price performance: - Housing price increases have lagged peer countries since the early 1970s. - Homeownership rate is 43 percent of households, trailing Western Europe. - Contributing factors: - Sluggish income growth: real disposable income grew by 1.2 percent per year since 1991. - Borrowing costs are high: long-term mortgage rates are among the highest in the euro area, despite a decline by 0.7 percentage points since end-2002. - Rental yields are low: the average rental yield is 3½ percent. - Rent controls in federal law cap yield and limit cumulative rent increases to 20 percent over three years. - Restrictions favor tenants; landlords can terminate leases only under narrowly defined circumstances. - Large blocs of property are owned by local governments and corporations, many seeking to unload properties to remove low-yielding assets from balance sheets. ### Advancing fiscal consolidation and long-run sustainability - Progress and measures: - The grand coalition maintained previous government’s approach of cutting expenditure and complemented it by raising the VAT in 2007. - Prominent expenditure measures: phasing out the home construction subsidy, reducing the commuter subsidy, lowering public sector employment, and freezing wage rates. - Aging-related expenditure reductions: lower pension indexation, tighter eligibility for early retirement, gradual extension of pensionable age from 65 to 67 starting in 2012, and higher co-payments in health care. - Recent fiscal outcomes and staff projections: - For 2006, staff projects the deficit to decline to 2.4 percent of GDP from 3.2 percent in 2005. - Authorities (at mission time) cautiously projected the deficit to fall to 2.8 percent of GDP in 2006 and 2.3 percent in 2007, with a net contribution of ⅓ percent of GDP from the VAT hike and the partially offsetting cut in unemployment insurance contributions. - Staff view for 2007: assuming no expenditure slippage, the fiscal deficit could be reduced further to at most 1.6 percent of GDP. - Taking 2006 and 2007 together, the structural deficit would be reduced by about 1¼ percent of GDP, with about two-thirds of the improvement based on expenditure containment. - Beyond 2007, staff sees a risk that the deficit will get stuck at 1¾ to 2 percent of GDP. - Policy recommendations from staff: - Continue expenditure restraint and proceed with the VAT increase (shift from direct to indirect taxes). - Implement additional cuts in subsidies and tax expenditures and in spending on ineffective ALMPs. - Emphasize measures that reduce distortions in the economy. - Fiscal projections table highlights (in percent of GDP) — staff assessment of current measures and authorities' plans: - Revenue: 2005 43.5; 2006 43.4; 2007 43.4. - o/w Taxes: 2005 22.0; 2006 22.4; 2007 23.3. - Social contributions: 2005 17.7; 2006 17.4; 2007 16.8. - Primary Expenditure: 2005 44.0; 2006 43.1; 2007 42.5. - Social benefits: 2005 26.7; 2006 26.2; 2007 25.9. - Primary balance: 2005 -0.5; 2006 0.4; 2007 1.1. - Interest: 2005 2.8; 2006 2.7; 2007 2.7. - Overall balance: 2005 -3.2; 2006 -2.4; 2007 -1.6. - Structural balance: 2005 -2.8; 2006 -2.4; 2007 -1.5. - Debt-GDP ratio: 2005 66.4; 2006 67.5; 2007 67.4. - Memorandum—Authorities' targets for overall balance: 2005 -3.2; 2006 -2.8; 2007 -2.3. - Staff assessment: the largest tax bases (wages and consumption) have structurally weakened, implying revenue buoyancy problems in the outer years; interest rates on the debt have been low recently and may be expected to increase. ### Global Fiscal Model (Box 5): scenarios, tax reforms, and macro effects - GFM was used to analyze implications of Germany’s fiscal plans on public debt and economic activity. - Three tax reform initiatives in 2007 and 2008 analyzed: - (i) a VAT increase from 16 to 19 percent, - (ii) some offsetting reduction in unemployment insurance taxes, - (iii) a reduction in corporate income tax rates with base broadening. - Key findings: - Achieving structural balance over the medium term would significantly improve debt dynamics by prefunding future aging-related liabilities. - A combination of expenditure cuts, entitlement reform, revenue enhancement through base broadening and tax reform is most efficient and realistic. - Eliminating the structural deficit by 2010 with such a policy mix would hold back short-run growth by about 0.2 percent a year relative to a scenario with no adjustment, but will bring compensating benefits in the long-run. - The proposed tax policy measures imply a shift from direct to indirect taxation; GFM suggests this will increase economic efficiency over time but will cause some sacrifice in growth and consumption in 2007 (higher VAT), while increasing labor demand and incentives to save and invest over the medium term. - The tax reforms would lower the long-run debt ratio, but not enough to offset aging-related fiscal pressures; further adjustment in entitlement expenditure is needed. *Source: IMF staff report content as provided in the supplied PDF excerpt.* ### 36. The authorities have put high priority on reforming the corporate income tax ### The authorities have put high priority on reforming the corporate income tax ### Corporate income tax (CIT) reform: design and fiscal implications - Objective: lower statutory corporate tax rate from 39 to 29 percent. - Current proposals aim to limit the annual revenue loss to ¼ percent of GDP. - Most recent proposal (finalized after the mission) narrows limits on deduction of interest costs to specific cases where there is evidence of borrowing from foreign subsidiaries to shift profits abroad. - Earlier, broader limits on interest and leasing cost deductions were moderated because they could induce unintended distortions in business decisions. - Base-broadening measures under consideration include reducing depreciation allowances. - Increasing revenue from the tax on business property was considered but rejected because the overall reform would be substantially different for proprietorships and corporations. - Intended implementation date: January 2008. ### Health care reform: proposals and risks - Cabinet proposals include creating a new central health fund (to be launched in 2009) to pool wage-based contributions and disburse to individual insurance funds, allowing the insured to switch funds. - The central issue of changing the funding of healthcare to reduce pressure on labor costs has not been tackled. - Although reform aims to introduce competition among health providers and insurers, the upward trajectory of long-run health costs is unlikely to slow significantly. - Financing of child healthcare will be gradually shifted to general taxes, but there is no indication yet of how the budget impact (¾ percent of GDP per year) will be offset. - Parliamentary discussion could change the plan, but the risk that the reform will fall short of requirements is large. ### Long-run fiscal position and balance-sheet indicators - Combined financial and nonfinancial net worth on the public sector balance sheet is nearly exhausted (current net worth in the table). - Staff calculated NPV of projected future fiscal deficits with increasing aging costs under current policies and alternative assumptions about the fiscal balance in 2010. - Two conclusions highlighted: - Major progress has been made in strengthening the comprehensive net worth of general government in recent years. - The job remains incomplete and debt sustainability is not assured even if the government achieves a zero fiscal balance by 2010. - Selected balance-sheet and projection figures (in percent of GDP unless otherwise noted): - Financial net worth: -45, -49, -51, -53, -53 (for 2003–2007 sequence shown). - Gross debt: -63, -65, -66, -68, -68. - Nonfinancial net worth: 55, 55, 55, 54, 54. - Current net worth: 10, 5, 3, 1 (table shows "Current net worth 10 5 3 1" across years). - 50-year projection of change in net worth (NPV): -191 a/ -150 b/ -114 c/ -30 d/ -7 e/. - Comprehensive net worth = budget constraint: -181, -145, -111, -28, -5 (across columns). - GDP (billions of euros): 2,163; 2,207; 2,241; 2,306; 2,306 (table memorandum items). - Structural fiscal balance: -3.4; -3.4; -2.8; -2.4; -2.4. ### Aging cost projections and uncertainty - 2003 estimate: incremental aging costs by 2050 were 6.5 percent of GDP. - Agenda 2010 and coalition agreement reduced aging costs through 2050 to about 4 percent of GDP. - By end-2005, comprehensive deficit in net worth was reduced to just over 100 percent of GDP. - If government achieves budgetary balance by 2010, shortfall in comprehensive net worth could be reduced to about 30 percent of GDP. - Under the EU Aging Working Group assumption that aging costs have been reduced to 2.75 percent of GDP, comprehensive net worth would be close to zero. - Note: the staff table also refers to 2.7 percent of GDP (Authorities) in scenario e/. - Risk scenario by IFO (not yet published) extrapolating recent health care price increases to 2050 suggests total aging costs could still rise by over 7 percent of GDP. ### Additional measures under consideration and staff cautions - Authorities exploring increased use of public-private partnerships (PPPs) to take some infrastructure spending off-budget. - Staff caution: PPPs can result in large contingent liabilities. - Authorities considering reformulating the constitutional “golden rule” under which new debt placement cannot exceed capital spending. - Staff view: scope to improve design exists, but changes should not loosen fiscal constraints. - Staff noted additional potential for discretionary expenditure cuts beyond efficiencies from CIT and health reforms. ### Staff appraisal: structural reforms and policy recommendations - Recent improvements: - Brisk cyclical recovery underway after several years of meager growth. - Corporate restructuring and wage moderation improved competitiveness. - Labor market and social welfare program reforms have been implemented; employment and domestic demand beginning to pick up. - Remaining challenges: - Without deeper structural change, low growth potential persists; domestic efficiency remains low and unemployment is intolerably high. - Labor market recommendations: - Improve labor market flexibility to speed job growth and increase labor utilization. - Modify and strengthen implementation of recent labor market reforms, with priority to improve functioning of the Unemployment Benefit II (UB-II) system. - Recommendation (cited): allowance under UB-II should be cut until there is demonstrated work effort. - Do not introduce minimum wages (would undermine job creation and hurt job seekers). - Avoid new wage subsidies (UB-II already has elements of employment support and acts as a wage floor). - Eliminate ineffective active labor market programs; simplify retained programs to increase transparency. - Product and service market reforms: - Further deregulation to strengthen competition and raise productivity. - Implement Monopolkommission recommendations to liberalize licensing requirements for crafts and price schedules for professional services. - Improve contestability in network industries via privatization and reducing network access costs. - Financial sector and capital markets: - Accelerate adjustment in the large public banking pillar; allow more private capital into public sector banks. - Supervision should be guided solely by prudential criteria; buttress BaFin operational independence and publish methodology underlying risk-oriented supervision. - Formulate a more effective legal framework for private equity to facilitate entry of new firms, spur innovation, and enhance corporate governance. - Real estate market: - Increase flexibility; introduce REITs covering both residential and commercial property to facilitate divestiture and refocus owners on core activities. - Fiscal consolidation: - Good progress in reducing the fiscal deficit in 2006 and policies in place for further adjustment in 2007. - Expenditure-based measures should remain the cornerstone of lasting fiscal adjustment. - VAT increase combined with a reduction in payroll taxes is a positive structural measure. - Goal: reduce the deficit to below 2 percent of GDP in 2007 (achievable without additional discretionary measures provided authorities resist expenditure demands that accompany strong revenue growth). - Any additional revenue should be used to reduce borrowing, not to increase spending. *Source: IMF staff report content provided in the supplied PDF excerpt.* ### 58. Beyond 2007, however, unless additional measures are implemented, there is a ### Beyond 2007: Fiscal sustainability and reform measures ### Near-term fiscal path and structural adjustment - Finding: Beyond 2007, unless additional measures are implemented, there is a danger that the deficit will begin to rise again. - Recommendation: Implement structural adjustment of at least ½ percent of GDP a year to achieve structural balance by 2010 and anticipate pressure from population aging. - Specific measures recommended: - Further reduce subsidies and tax expenditures. - Cut spending on active labor market programs. - Lower unemployment costs. - Continue measures to reduce aging-related structural expenditure by reforming entitlement programs. ### Corporate income tax and health care reform design - Finding: Corporate income tax and health care reforms need to be implemented in a way that meets stated objectives without increasing fiscal risks. - Constraint: The budgetary cost of the planned reduction in statutory corporate tax rates should be capped at the agreed ¼ percent of GDP. - Preferred tax-base measures (policy guidance): - Base broadening such as normalizing accelerated depreciation rates. - Raising revenue from the tax on business assets. - These approaches are preferable to reducing interest deductibility as a business cost. - Health care reform guidance: - Lowering the trajectory of health care costs will require a substantial increase in competition among health care providers and insurers without adding to bureaucracy. - Further efforts are needed to decouple healthcare financing from payroll charges. - Assessment: The current proposals do not meet these objectives. ### Long-run fiscal sustainability and complementary reforms - Finding: Although policies have made a solid contribution to reducing long-run aging costs, long-run fiscal sustainability is not yet assured. - Projection/constraint: Even if the structural deficit is eliminated by 2010 (for which measures are not yet in place), the debt ratio would come under pressure in the long run. - Research need: Further research is needed to pin down better the remaining aging costs. - Recommended comprehensive strategy: - Combine fiscal measures with reforms to increase productivity and labor utilization to secure long-run sustainability. *Source: _cr06438 - 58.* ### 61. It is proposed that the next Article IV consultation be held on the standard 12-month ### _cr06438 - 61. It is proposed that the next Article IV consultation be held on the standard 12-month cycle. ### Economic outlook and national accounts indicators - Real GDP Growth (Y-o-Y): historical and forecast series indicate growth is picking up (Figure 1). - Real Private Consumption Growth (Y-o-Y): consumption remains flat despite pick-up in growth (Figure 1). - Real Gross Fixed Investment Growth (Y-o-Y): investment is recovering (Figure 1). - Real Exports of GNFS Growth (Y-o-Y): exports are strong (Figure 1). - Quarterly GDP Growth Contributions at Annualized Rates 2004-2007: charts show External Demand, Final Domestic Demand, and GDP with historical and forecast series (Figure 5). - Output gap (In percent of potential GDP): 2000: 1.8; 2001: 1.7; 2002: 0.5; 2003: -0.9; 2004: -0.9; 2005: -1.2; 2006 1/: -0.3; 2007 1/: -0.3. - GDP (Percentage change): 2000: 3.1; 2001: 1.2; 2002: 0.0; 2003: -0.2; 2004: 1.2; 2005: 0.9; 2006 1/: 2.3; 2007 1/: 1.4. ### Prices, inflation, and wages - CPI (harmonized) (Percentage change): 2000: 1.4; 2001: 1.9; 2002: 1.4; 2003: 1.0; 2004: 1.8; 2005: 1.9; 2006 1/: 1.7; 2007 1/: 2.3. - Headline inflation projection: expected to jump in January 2007 with the VAT hike; core rate expected to remain subdued given low wage inflation (Figure 5). - Y-o-Y Gross Hourly Wages Growth (In percent, total economy): series shows wage growth has slowed down significantly (Figure 7). - Average hourly earnings (total economy) (Percentage change): 2000: 2.9; 2001: 2.6; 2002: 2.1; 2003: 1.6; 2004: 0.2; 2005: 0.9; 2006 1/: 1.1; 2007 1/: 1.4. - Unit labor cost (industry) (Percentage change): 2000: -1.7; 2001: 0.5; 2002: 1.3; 2003: -1.7; 2004: -4.0; 2005: -3.3; 2006 1/: -1.8; 2007 1/: -0.6. ### Labor market, household income, and savings - Employment and unemployment (millions): Labor force: 2000: 41.9; 2001: 42.1; 2002: 42.2; 2003: 42.3; 2004: 42.7; 2005: 42.6; 2006: 42.4; 2007: 42.4. - Employment (millions): 2000: 39.1; 2001: 39.3; 2002: 39.1; 2003: 38.7; 2004: 38.9; 2005: 38.8; 2006: 39.0; 2007: 39.2. - Unemployment 3/ (millions, national accounts definition): 2000: 2.9; 2001: 2.9; 2002: 3.2; 2003: 3.7; 2004: 3.9; 2005: 3.9; 2006: 3.4; 2007: 3.3. - Unemployment rate (in percent) 4/ (Eurostat definition): 2000: 6.9; 2001: 6.9; 2002: 7.7; 2003: 8.8; 2004: 9.2; 2005: 9.1; 2006: 8.0; 2007: 7.8. - Disposable Household Income Growth and Savings Rate: disposable income weakened while savings increased; personal saving ratio (in percent): 2000: 9.2; 2001: 9.4; 2002: 9.9; 2003: 10.3; 2004: 10.4; 2005: 10.6; 2006 1/: 10.6; 2007 1/: 10.3. - Real disposable income 5/ (Percentage change): 2000: 2.1; 2001: 2.1; 2002: -0.2; 2003: 0.3; 2004: 0.2; 2005: 0.3; 2006 1/: 0.8; 2007 1/: -0.1. ### External competitiveness and balance of payments - Real Effective Exchange Rate, ULC Based (Jan. 1999 =100): Germany has improved competitiveness in the euro zone (Figure 4). - Share of German Exports in Total Imports of Euro Area from Other Euro Area Countries 1/ 2/: Germany regained export market share in the euro zone after losses due to unification (Figure 4). - Balance of payments, Current account (In billions of Euros, WEO Table 2 Prel.Projections): 2005: 92; 2006: 97; 2007: 97; 2008: 98; 2009: 94; 2010: 86; 2011: 81. - Current account in percent of GDP: 2005: 4.1; 2006: 4.2; 2007: 4.1; 2008: 4.0; 2009: 3.8; 2010: 3.4; 2011: 3.1. - Trade balance (In billions of Euros): 2005: 140; 2006: 141; 2007: 136; 2008: 125; 2009: 108; 2010: 88; 2011: 71. - Exports (In billions of Euros): 2005: 782; 2006: 861; 2007: 893; 2008: 941; 2009: 983; 2010: 1,025; 2011: 1,070. - Imports (In billions of Euros): 2005: -642; 2006: -720; 2007: -757; 2008: -816; 2009: -875; 2010: -937; 2011: -999. ### Financial indicators and market sentiment - Nominal yields (Annual rate in percent): Ten-year govt. bond yield and 3 month interbank rate series show interest rates have risen 1% in 6 months (Figure 2). - Real interest rates 1/: real rates rose with nominal rates (Figure 2). - Yield Curve Slope 2/: The yield curve remains positively sloped (Figure 2). - DAX Index: corporate profits continue to be high (Figure 2). - Sentiment indicators (Figure 6): IFO Business Climate Index has jumped; PMI Manufacturing and PMI Services consistent with purchasing managers' optimism; ZEW business expectations have eased; GfK Consumer Climate shows consumers worry about income growth but are buying ahead of the VAT hike. ### Fiscal position, decomposition, and sustainability - General government: Expenditure (In billions of Euros): 2000: 930; 2001: 1,005; 2002: 1,031; 2003: 1,048; 2004: 1,040; 2005: 1,048; 2006: 1,057; 2007: 1,069; 2008: 1,096. - General government: Revenue (In billions of Euros): 2000: 957; 2001: 945; 2002: 953; 2003: 961; 2004: 957; 2005: 976; 2006: 1,002; 2007: 1,032; 2008: 1,053. - Overall balance (In billions of Euros): 2000: 27; 2001: -60; 2002: -78; 2003: -87; 2004: -82; 2005: -73; 2006: -55; 2007: -37; 2008: -43. - Overall balance (In percent of GDP): 2000: 1.3; 2001: -2.8; 2002: -3.7; 2003: -4.0; 2004: -3.7; 2005: -3.2; 2006: -2.4; 2007: -1.6; 2008: -1.8. - Structural balance (In percent of potential GDP): 2000: -1.2; 2001: -2.7; 2002: -3.2; 2003: -3.4; 2004: -3.4; 2005: -2.8; 2006: -2.4; 2007: -1.5; 2008: -1.9. - Gross public debt (In percent of GDP): 1999: 55; 2000: 58.7; 2001: 57.9; 2002: 59.6; 2003: 62.8; 2004: 64.8; 2005: 66.4; 2006: 67.5; 2007: 67.4. - Decomposition points (Figure 11): fiscal balance is in a structural decline; policy component is significant but offset by an eroding tax base; one-off measures are small; gross public debt is stabilizing. - Progress in establishing fiscal sustainability (Figure 12): primary balance and gross debt projections for rolling 50-year scenarios summarized (staff and authorities scenarios noted in footnotes). ### Financial sector soundness and structure - Core FSIs for banks, 1998-2005 (Table 3 highlights): - Regulatory capital to risk-weighted assets: 1998: 11.4; 1999: 11.5; 2000: 11.7; 2001: 12.0; 2002: 12.7; 2003: 13.4; 2004: 13.2; 2005: 12.2 (aggregate). - Regulatory Tier I capital to risk-weighted assets: 1998: 7.4; 1999: 7.6; 2000: 7.7; 2001: 8.0; 2002: 8.6; 2003: 8.8; 2004: 8.7; 2005: 8.0 (aggregate). - NPLs to gross loans: 1998: 4.5; 1999: 4.2; 2000: 4.7; 2001: 4.6; 2002: 5.0; 2003: 5.3; 2004: 5.1; 2005: 4.1 (aggregate). - Return on average assets (after-tax): 1998: 0.3; 1999: 0.2; 2000: 0.2; 2001: 0.2; 2002: 0.1; 2003: -0.1; 2004: 0.1; 2005: 0.3 (aggregate). - Encouraged and other FSIs, 1998-2005 (Table 4 highlights): - Household debt to GDP: 1998: 69.5; 1999: 72.7; 2000: 73.1; 2001: 72.4; 2002: 72.1; 2003: 72.3; 2004: 70.8; 2005: 69.8. - Residential real estate loans to total loans: 1998: 13.7; 1999: 16.2; 2000: 16.4; 2001: 16.1; 2002: 16.2; 2003: 18.0; 2004: 17.8; 2005: 17.8. - Market valuations and distance to default (Figure 10): banks' and insurance companies' relative market valuation and distance to default have recovered since 2003; distance to default approximates financial soundness and is calculated as described in the source. ### Fiscal tables and medium-term projections (selected figures) - Table 1 (Basic Data) highlights: - Total area: 357,041 square kilometers. - Total population (2005): 82.4 million. - GDP per capita (2005): US$ 33, 855. - Demand and supply component annual percentage changes and contributions listed for 2000–2007 1/ (see Table 1 for full series). - Table 6 (General Government Finances) (In billions of euros / In percent of GDP): - Revenue (In billions of euros): 2000: 957.5; 2001: 945.5; 2002: 952.5; 2003: 961.2; 2004: 957.1; 2005: 975.9; 2006 (Staff Proj.): 1,002.1; 2007 (Proj.): 1,031.7. - Primary balance (In billions of euros): 2000: 92.1; 2001: 4.9; 2002: -15.7; 2003: -22.9; 2004: -20.0; 2005: -10.6; 2006: 8.1; 2007: 26.9. - Interest (In billions of euros): 2000: 65.1; 2001: 64.5; 2002: 62.7; 2003: 64.1; 2004: 62.5; 2005: 62.0; 2006: 63.0; 2007: 64.1. - Gross public debt end-year (In percent of GDP): 2000: 58.7; 2001: 57.9; 2002: 59.6; 2003: 62.8; 2004: 64.8; 2005: 66.4; 2006: 67.5; 2007: 67.4. *Italic: Source — _cr06438 (figures, tables, and text excerpts as provided).* ### APPENDIX I. Staff Analytical Work on Germany, 2002-06 ### APPENDIX I. Staff Analytical Work on Germany, 2002-06 ### Growth and Competitiveness — Analytical Work (2002–06) - Research items listed: - Exports and Domestic Demand in Germany: Has the Nexus Been Altered by Globalization? (Forthcoming Selected Issues Paper) - What explains Germany’s Rebounding Export Market Share? (Forthcoming Working Paper) - Long-run Growth in Germany. IMF Country Report No. 06/17. - Does Excessive Regulation Impede Growth in Germany? IMF Country Report No. 06/17. - The Performance of Germany’s Non-Financial Corporate Sector – An International Perspective. IMF Country Report No. 06/17. - Investment Trends in OECD Countries: Long-Term Developments and Future Prospects. IMF Country Report No. 04/340. - Does PPP hold in the Long Run? Germany and Switzerland. IMF Country Report No. 04/340. - Business Investment in the Current Cycle. IMF Country Report No. 03/342. - Growth and Adjustment in Germany. IMF Country Report No. 02/240. - Is Germany Competitive? IMF Country Report No. 02/240. ### Fiscal Policy and Entitlement Programs — Analytical Work (2002–06) - Research items listed: - Tax Reform and Debt Sustainability in Germany: An Assessment Using the Global Fiscal Model. (Forthcoming Selected Issues Paper) - Business Tax Reform. (Forthcoming Selected Issues Paper) - Why is Germany’s Deficit so Large?, IMF Country Report No. 06/17. - A Preliminary Public Sector Balance Sheet for Germany, IMF Country Report No. 06/17. - Germany: A Long-Run Fiscal Scenario Based on Current Policies, IMF Country Report No. 06/17. - Pensions and Growth. IMF Country Report No. 04/340. - Federalism and the Political Economy of Adjustment. IMF Country Report No. 04/340. - The Fiscal Challenge of Aging: What Needs to Be Done. IMF Country Report No. 02/240. - Health Care Reform in Germany. IMF Country Report No. 02/240. ### Labor Markets — Analytical Work (2002–06) - Research items listed: - The Employment Effects of Labor and Product Markets Deregulation and their Implications for Structural Reform. CESifo Working Paper No 1709, May 2006. - Employment, Unemployment, and Labor Supply in Germany. IMF Country Report No. 04/340. - The Unbearable Stability of the German Wage Structure: Evidence and Interpretation. IMF Staff Papers, August 2004. - On Sand and Grease in Labor Markets: How Does Germany Compare? WP/02/164. ### The Financial System — Analytical Work (2002–06) - Research items listed: - Landesbanken: A Measure of the Costs for Taxpayers. (Forthcoming Selected Issues Paper) - The German Banking Sector: Credit Decline, Soundness and Efficiency. IMF Country Report No. 06/17. - Germany’s Three-Pillar Banking System. IMF Occasional Paper 233 (2004). - Germany’s Financial System: International Linkages and the Transmission of Financial Shocks. IMF Country Report No. 03/342. - The Slowdown in Credit Growth. IMF Country Report No. 02/240. ### Fund Relations — Membership and Financial Positions (As of September 30, 2006) - Membership: - Germany became a member of the Fund on August 14, 1952. - Germany has accepted the obligations of Article VIII, Sections 2, 3, and 4. - General Resources Account (SDR Million; % Quota): - Quota: 13,008.20 — 100.00 - Fund holdings of currency: 11,329.00 — 87.09 - Reserve position in Fund: 1,614.74 — 12.41 - SDR Department (SDR Million; % Allocation): - Net cumulative allocation: 1,210.76 — 100.00 - Holdings: 1,336.18 — 110.36 - Outstanding Purchases and Loans: None - Financial Arrangements: None - Projected Payments to Fund (SDR Million; based on existing use of resources and present holdings of SDRs): - Charges/Interest: 2006: 0.09; 2007: 0.07; 2008: 0.07; 2009: 0.07; 2010: 0.07 - Total: 2006: 0.09; 2007: 0.07; 2008: 0.07; 2009: 0.07; 2010: 0.07 - Exchange Rate Arrangement: - Since January 1, 1999, Germany has been a member of the European Economic and Monetary Union; the deutsche mark entered EMU at a value of DM 1.95583 per euro. - Germany is an Article VIII member and maintains an exchange system free of restrictions on payments and transfers for current international transactions. - It maintains measures adopted for security reasons, which have been notified to the Fund for approval in accordance with the procedures of Decision 144. ### Article IV Consultation and AML/CFT - Article IV Consultations: - Germany is on a 12-month consultation cycle. - The staff report for the last Article IV consultation (IMF Country Report No. 06/16) was discussed at EBM 06/2 (January 11, 2006). - AML/CFT developments and assessments: - A 2003 FATF evaluation found that the AML/CFT framework is generally of high quality. - Improvements recommended: make AML/CFT audits and inspections more systematic and frequent. - Between 2003 and 2006, numbers of audits and inspections have not increased substantially due to concerns about costs for supervised institutions. - Authorities moved towards a more risk-based approach where intensity of audits and inspections reflects institutions' AML/CFT risk. - BaFin started a dialogue with associations of certified public accountants and other auditors; the association published a significantly revised AML/CFT assessment methodology in 2005. - Legal revisions under consideration include granting BaFin power to freeze funds without a court order if there is a suspicion of terrorist financing, and requiring financial holding groups and financial conglomerates to develop a coordinated risk management approach for the whole group. ### Statistical Issues and Data Dissemination - General: - Germany’s economic and financial statistics are adequate for surveillance purposes. - Germany subscribes to the Fund’s Special Data Dissemination Standard (SDDS). - Germany adopted ESA95 in 1999; in April 2005 revised national accounts statistics were released to comply with EUROSTAT requirements. - Revisions included: chain-linking to price and volume measures, allocation of financial intermediation services to users, and introduction of new data (e.g., hedonic pricing). - ROSC Data Module (2005) findings: - Macroeconomic statistics generally follow internationally accepted standards. - Areas for improvement: sources for estimating value added for a few service categories; lack of a direct source for quarterly changes in inventories; lack of a systematic, proactive process to monitor representativeness of samples between PPI rebases. - Lack of a bridging table between general government data in ESA95 classification and general government cash data on an administrative basis impairs fiscal analysis. - General government revenue, expenditure, and balance on an accrual basis (ESA95) are published every six months; monthly data are disseminated on a cash-basis. - IMF Statistics Department collaboration: - Working with member states and Eurostat to implement a bridge table for simultaneous reporting for ESA95 and Government Finance Statistics Manual 2001. - Germany has chosen not to use this option for the purposes of the Government Finance Statistics Yearbook (GFSY) 2006. - GFSY reports annual data for Germany using the GFS Manual 2001 framework, covering central, state and local, and general government. - Financial Soundness Indicators (FSIs): - The 2003 FSAP mission found availability and timeliness of FSIs were relatively weak. - Situation improved; Germany is participating in the Coordinated Compilation Exercise for FSIs. - In 2006, German authorities compiled a comprehensive set of FSI data and metadata to serve as a basis for regular compilation of FSIs. ### Common Indicators Required for Surveillance (As of October 20, 2006) — Selected entries - Exchange Rates: Date of latest observation: October06; Date received: 10/10/2006; Frequency of Data/Reporting/Publication: D / D / D - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation: August 06; Date received: September 06; Frequency: M / M / M - Reserve/Base Money: August 06; Date received: September 06; Frequency: M / M / M - Broad Money: August 06; Date received: September 06; Frequency: M / M / M - Central Bank Balance Sheet: August 06; Date received: October 06; Frequency: M / M / M - Consolidated Balance Sheet of the Banking System: August 06; Date received: October 06; Frequency: M / M / M - Interest Rates: October06; Date received: 10/10/2006; Frequency: M / M / M - Consumer Price Index: August; Date received: September; Frequency: M / M / M - Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation: June 06; Date received: September 06; Frequency: Semi-annual / Semi-annual / Semi-annual - GDP/GNP: Q2 06; Date received: August 06; Frequency: Q / Q / Q - Gross External Debt: H1 06; Date received: June 06; Frequency: Semi-annual / Semi-annual / Semi-annual ### Statement by the IMF Staff Representative — Updated Growth and Fiscal Projections (December 8, 2006) - Updated staff growth forecasts: - Staff’s updated forecasts are for growth of 2.5 percent in 2006 and 1.5 percent in 2007. - Revised Quarter-on-Quarter Real GDP Growth (In percent): - SR (SM/06/370): Q1: 0.7; Q2: 0.9; Q3: 0.7; Q4: 0.5 — Annual: 2.3 (2006); 1.4 (2007) - Revised: Q1: 0.8; Q2: 1.1; Q3: 0.6; Q4: 0.6 — Annual: 2.5 (2006); 1.5 (2007) - Key explanations for upward revision: - Higher investment spending in first half of the year than previously estimated. - Bundesbank estimates second-quarter growth includes some ¼ percentage point in one-time demand from the World Cup soccer tournament (mainly tourism exports). - High-frequency indicators remained stronger than expected. - Domestic demand and labor market indicators: - Increasing traction for domestic demand. - Full-time employment continued to expand over the summer months. - Construction sector is expanding after a long decline. - Industrial orders remained strong with a larger weight from domestic orders. - Inflation: - Year-on-year inflation is declining as anticipated. - In October, inflation was 1.1 percent (CPI-HICP), slightly below the rate for August, reflecting lower oil prices. - Preliminary data for November point to an uptick to 1.5 percent as some price categories are increased ahead of the VAT hike in January 2007. - Core inflation, excluding energy prices, is slightly over 1 percent. - Fiscal outlook and structural adjustment: - Recovery and the freeze on pensions and public sector wages are helping to lower the fiscal deficit. - Authorities revised their outlook for the general government deficit to 2.1 percent of GDP in 2006. - The federal budget for 2007 is consistent with a general government deficit target of 1.5 percent of GDP. - Staff had argued that the authorities should aim to reduce the structural deficit by a cumulative 1¼ percent of GDP in 2006-2007; staff’s preliminary estimate is that authorities’ latest deficit figures are consistent with a cumulative reduction in the structural deficit closer to 1 percent of GDP in 2006-2007. - The slightly lower structural adjustment reflects in part an additional cut in unemployment insurance (payroll) taxes: the November 2005 Coalition Agreement envisaged cutting the unemployment insurance contribution rate from 6.5 to 4.5 percent; authorities decided to reduce the unemployment insurance rate further to 4.2 percent instead. - Staff recommendation reiterated: permanent tax reductions should be offset with permanent expenditure cuts. - Outreach and long-run fiscal sustainability: - A one-day symposium on long-run fiscal sustainability was held in Berlin on November 20, 2006, organized with the IFO Institute and the Bertelsmann Foundation to stimulate debate on aging-related issues and fiscal sustainability and to draw attention to the value of a public sector balance sheet. - Symposium findings: German authorities at both federal and Länder level are increasingly focusing on aging and population decline in deliberations of a new fiscal framework, including negotiations on a second round reform of fiscal federalism and possible modifications to the tax revenue sharing arrangements. ### Statement by Klaus D. Stein, Executive Director for Germany (December 8, 2006) — Overview and Outlook - Overview: - The German economy is experiencing a robust upswing in 2006, growing at its fastest pace since 2000. - While exports remain very strong, the main contribution to output growth is expected to come from accelerating domestic demand. - Upswing drivers: solid profit expectations, increased capacity utilization, and ongoing improvement in the labor market. - Authorities’ assessment: - Reforms since Agenda 2010 of 2003 (notably Hartz I–IV and pension, health care, federalism, and capital market reforms) are beginning to show a positive impact. - Fiscal strategy enacted by the Grand Coalition rests on two pillars: the investment stimulating package Impuls and the gradually phased consolidation of the general government budget. - The phased approach aims to help the economy embark on a self-sustained growth path strong enough to endure necessary fiscal consolidation. - Risks and policy stance: - Continued fiscal prudence and structural reforms are essential to address globalization and population aging. - Authorities continue the reform process to ensure medium- and long-term fiscal sustainability, promote employment, and improve the environment for investment and job creation. - Economic outlook: - Government projects real GDP growth of 2.3 percent for 2006 and expects real GDP to expand by 1.4 percent in 2007. - After one-time effects in 2006, the economy will likely slow at the beginning of 2007 due to the fiscal consolidation package, but slowdown expected to be temporary given strong underlying momentum. - Labor market expected to show further improvement. - Inflation expected to move up due to the forthcoming VAT increase, though only on a temporary basis. *IMF Country Report appendices and related statements (selected excerpts).* ### 6. Continued expenditure restraint and accelerating economic activity will pave the way ### 6. Continued expenditure restraint and accelerating economic activity will pave the way ### Public finances and fiscal outlook - The general government deficit is now expected to be at 2.1 percent of GDP, as compared to a projection of 3 ½ percent of GDP at the time of the last Article IV consultation. - As a result, the Maastricht deficit criterion will be met one year earlier than expected. - In 2007, the general government deficit is projected to be at 1 ½ percent of GDP. - The structural fiscal improvement this year and next will in total be well above one percent of GDP, in line with staff recommendations. - Beyond 2007, annual growth of general government spending will be limited to 1 percent in nominal terms over the period of 2006 to 2010. - At the end of this period, the authorities expect a budget deficit of close to balance. ### Fiscal policy measures and tax changes - Authorities plan to implement a fiscal consolidation package, a key element of which is the increase of the VAT rate by three percentage points. - One percentage point of VAT is earmarked to help fund the forthcoming reduction of unemployment insurance contribution rates by one third. - Despite the VAT increase, the revenue to GDP ratio will remain largely unchanged in 2007. - The tax increase reflects a deliberate shift from direct to indirect taxes aimed to enhance economic efficiency. - A number of actions to improve long-term fiscal sustainability have been or will be implemented, including the gradual increase of the retirement age and the phasing out of the homeowner subsidy—these measures will generate increasing expenditure savings over the longer term. ### Entitlement and social insurance reforms - The cabinet decided to gradually raise the statutory retirement age from 65 to 67 years from 2012 onwards. - A health care reform agreement will be phased in from April 2007; it aims to instill more competition and transparency, increase cost efficiency, and preserve the high quality of the German health care system. - A reform proposal to strengthen the financial viability of long-term care insurance will be put forward in 2007. - Legislative changes enacted in August address inefficiencies and cost overruns in the new UB-II system; means testing provisions under Hartz IV will be implemented more rigorously. - Cabinet intends to put forward proposals for further labor market reforms by the first quarter of next year, aimed at improving job incentives. ### Supporting investment, competitiveness, and potential growth - Proposed corporate income tax (CIT) reform: a significant reduction of the composite corporate tax rate to just below 30 percent. - The reform will be largely financed by broadening the tax base. - There will still be a reduction of the overall business tax burden by €5 billion. - The reform will simplify the tax system, reduce distortions related to legal company structure, and discourage profit shifting abroad. - The CIT reform is due for cabinet approval in March 2007 and for implementation in January 2008; it is based on a recent working group proposal that abandons earlier limits on interest deductibility and eliminates accelerated depreciation provisions. - Market and regulatory actions: - New regulatory framework on access to networks and unbundling of services in electricity and gas industries is being implemented. - Bureaucratic hurdles for liberal professions are being lowered; several guilds have been deregulated in recent years. - In the first half of 2007, the government will conduct a review of the Monopolkommission’s recommendations. - Ongoing initiative aimed at lowering the overall administrative burden; some Länder plan to further relax restrictions on shopping hours. - R&D and innovation: - From 2006 to 2009 the federal government will invest an additional €6 billion in R&D projects. - This will contribute to increasing total R&D-investment (public and private) from currently 2.5 percent to 3 percent of GDP by 2010. ### Employment and labor market policies - Unemployment has declined by more than half a million and the number of regular jobs subject to social security contributions has risen by more than 300,000 over the past year. - The number of recipients of long-term unemployment assistance (UB-II) has declined markedly. - Further reforms will proceed gradually to balance flexibility and security and ensure public backing. - Active labor market policies (ALMPs): an evaluation including academic input is being finalized; a thorough overhaul of ALMPs is envisaged for 2007 to eliminate policies of limited effectiveness. - Payroll tax wedge reduction in 2007: - The contribution rate for unemployment insurance will be lowered significantly. - This will be offset by a small increase of the contribution rate for pensions. - Net reduction of non-wage labor costs by 1.9 percentage points. ### Financial sector developments and supervision - The government is implementing EU regulations and modernizing national financial sector laws and regulations to enhance effectiveness while maintaining strong prudential oversight. - Financial sector profitability has continued to rise this year and last due to cost cutting, lower provisioning, improved risk management, and cyclical factors; profitability is not yet on par with international levels. - Landesbanken (LBs) restructuring progress: - Vertical integration with regional savings banks (Sparkassen) is at an advanced stage for some LBs. - Others have been transformed into joint stock corporations operating under private law. - Authorities’ perspective on LBs: - Caution advised when extrapolating staff’s findings on LBs’ opportunity costs due to the historic period used and changed regulatory environment after withdrawal of government guarantees. - Opportunity costs should be contrasted with benefits of LBs, including their role in promoting local economies. - Conflicts of interest on the part of supervisory authorities are not considered an issue; owners and supervisors are separate institutional entities. - The FSAP certified supervisory authorities a high degree of independence and stated political interference had not been considered to be an issue. - The savings banks pillar continues to serve the economy well, playing a key role in financing small and medium-sized firms, supported by the regional principle and long-term orientation of business relationships; market trends with potentially procyclical effects have been followed to a lesser extent. *IMF staff report excerpt: chapter 6.* ### 28. The planned introduction of real estate investment trusts (REITs) in Germany will ### The planned introduction of real estate investment trusts (REITs) in Germany will ### REITs and property market implications - The planned introduction of real estate investment trusts (REITs) in Germany will promote flexibility in property markets. - REITs will broaden the range of investment vehicles by complementing the existing open-ended real estate funds, given their different risk-return-profiles. - The recent draft bill proposes to largely exclude the existing stock of residential real estate, but this restriction should not be overestimated. - Experience elsewhere shows that, despite the eligibility of residential real estate, markets for REITs are effectively dominated by commercial property. ### Macro outlook and cyclical recovery (background) - A cyclical recovery is underway with buoyant exports progressively spilling over into stronger domestic demand. - Investment activity is accelerating with high corporate profits and the long contraction in the construction sector has bottomed out. - Full-time employment has started to pick up for the first time since 2001, but overall consumption still remains tepid with slow wage growth. - GDP growth projections: - Growth is projected to accelerate from 0.9 percent in 2005 to 2.5 percent in 2006. - Growth is projected to slow to 1.5 percent in 2007; the deceleration is likely transitory. - Downside risks to the outlook: volatile oil prices, global monetary tightening, and an abrupt unwinding of global imbalances. - Upside channel: faster pickup in employment could lift household disposable incomes and boost growth. ### Structural and labor market issues - Labor productivity growth: - Improved steadily in the exposed manufacturing sector. - Trailed international performance in the more sheltered domestic economy. - Needed reforms: further deregulation and reform of liberal professions and crafts, and network industries. - Labor market recommendations from Directors: - Use the upswing to undertake deeper structural reforms for raising growth potential. - Lower reservation wages to bolster employment of lower skilled labor. - Increase participation rates to reduce structural welfare costs. - Strengthen implementation of the Hartz IV labor market reforms. - Tighten eligibility for unemployment benefits for those unwilling to work. - Cut active labor market programs that are ineffective. - Most Directors urged refraining from introducing minimum wages and cautioned against new wage subsidies. - Encourage relaxation of employment protection legislation. ### Financial sector, capital markets, and REITs - Financial sector developments: - The financial sector has become healthier; abundant liquidity and the cyclical upswing have improved earnings of banks and insurance companies. - Bank profitability still compares unfavorably with the EU average. - Capital market activity has accelerated, led by increased mergers and acquisitions. - Ample scope exists for further growth of capital markets and in the large real estate sector which has stagnated for some time. - Directors’ views: - Underscored importance of an efficient financial sector to improve allocation of capital. - Welcomed changes in ownership structure of several public banks but stressed the need for a larger role for private capital to facilitate restructuring. - Supported review of the supervisory agency, BaFin, to buttress operational independence and shift toward risk-oriented supervision. - Welcomed authorities’ intention to clarify the legal framework for private equity and to introduce Real Estate Investment Trusts, which should cover both commercial and residential property. ### Fiscal policy and long-term sustainability - Fiscal consolidation progress: - In 2006 the deficit will drop below the 3 percent of GDP Maastricht limit one year ahead of schedule under the excessive deficit procedure. - Directors encouraged cutting the structural deficit by around ¾ percent of GDP in 2007 and to eliminate it by 2010. - Directors’ guidance on reforms: - Pursue a broad-based approach encompassing both fiscal adjustment and growth-enhancing reforms to address aging-related fiscal pressures. - On corporate income tax: a reduction in tax rates largely financed by a broadening of the tax base would be appropriate. - On health care: tighten reform proposals to limit rising health costs and continue efforts to decouple health care financing from payroll charges. - Directors welcomed expenditure-based consolidation measures and viewed the increase in the VAT in 2007, combined with the cut in payroll taxes, as a key structural measure to boost employment and strengthen consolidation. ### Selected economic indicators (highlights) - Real GDP: 2005 = 0.9 percent; 2006 projection = 2.5 percent; 2007 projection = 1.5 percent. - Net exports (contribution to GDP growth): 2005 = 0.4; 2006 = 0.8; 2007 = 0.4. - Total domestic demand: 2005 = 0.5; 2006 = 1.8; 2007 = 1.2. - Private consumption: 2005 = 0.1; 2006 = 1.1; 2007 = 0.3. - Gross fixed investment: 2005 = 0.8; 2006 = 5.7; 2007 = 4.0. - Construction investment: 2005 = -3.6; 2006 = 3.1; 2007 = 2.8. - Gross national saving (percent of GDP): 2005 = 21.4; 2006 = 21.9; 2007 = 22.3. - Gross domestic investment (percent of GDP): 2005 = 17.3; 2006 = 17.7; 2007 = 18.0. - Labor force (percent of population): 2005 = 42.7; 2006 = 42.4; 2007 = 42.4. - Employment (percent of population): 2005 = 38.8; 2006 = 39.0; 2007 = 39.2. - Standardized unemployment rate (in percent): 2005 = 9.1; 2006 = 8.1; 2007 = 7.8. - Unit labor costs (whole economy): 2005 = -3.3; 2006 = -2.9; 2007 = -1.5. - GDP deflator: 2005 = 0.7; 2006 = 0.5; 2007 = 1.2. - Harmonized CPI index: 2005 = 2.0; 2006 = 1.7; 2007 = 2.3. - General government balance (In percent of GDP): 2005 = -3.2; 2006 = -2.1; 2007 = -1.5. - Structural government balance: 2005 = -2.8; 2006 = -2.3; 2007 = -1.7. - General government gross debt: 2005 = 66.4; 2006 = 67.2; 2007 = 66.9. - Private sector credit (change over 12 months): 2005 = 2.1; 2006 (Aug) = 4.2. - M3 (change over 12 months): 2005 = 5.2; 2006 (Aug) = 3.9. - Three month money market rate: 2005 = 2.1; 2006 (Sep) = 3.3. - Ten-year government bond yield: 2005 = 3.6; 2006 (Sep) = 3.8. - Exports (billions of euros): 2005 = 909.0; 2006 = 1,019.5; 2007 = 1,075.0. - Imports (billions of euros): 2005 = 796.5; 2006 = 893.5; 2007 = 944.5. - Trade balance (percent of GDP): 2005 = 6.3; 2006 = 6.4; 2007 = 6.1. - Current account balance (billions of euros): 2005 = 92.2; 2006 = 98.6; 2007 = 102.7. - Current account (percent of GDP): 2005 = 4.1; 2006 = 4.3; 2007 = 4.3. - Euro per US dollar (period average): 2002 = 1.06; 2003 = 0.88; 2004 = 0.80; 2005 = 0.80; 2006 (Sep) = 0.79. - Nominal effective rate (1990=100): 2005 = 114.7; 2006 = 115.6. - Real effective rate (1990=100): 2005 = 102.8; 2006 = 102.0. *Public Information Notice (PIN) No. 06/141 — IMF Executive Board Concludes 2006 Article IV Consultation with Germany (December 14, 2006).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06438.pdf_