## _cr0880

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---

### Macro performance and outlook
- GDP growth in 2007 was 2.5 percent.
- GDP growth is projected to slow to 1.7 percent in 2008, with greatly increased uncertainties imparting substantial downside risks.
- From the cyclical trough in 2004, GDP growth accelerated to 2.9 percent in 2006.
- Output is now close to potential.
- Collective wage agreements imply an average gross wage increase of about 2 percent in 2008.
- Inflation:
  - Headline inflation in the first 11 months of 2007 was 2.2 percent (annualized rate).
  - Core inflation in the first 11 months of 2007 was 2.0 percent.
  - The VAT hike in January 2007 pushed up core inflation smoothly by 0.7 percentage point rather than the expected 1.1 percentage points.
  - Year-on-year headline inflation rose to 3.3 percent in November 2007, while core inflation was 2.4 percent.
- Executive Board macro outlook (summary):
  - GDP growth projection: slow to 1.5 percent in 2008 from 2.5 percent in 2007.
  - Inflation projection: expected to slow moderately to 2.2 percent in 2008.
  - Potential growth estimate: 1½-1¾ percent annually; likely to slip unless total factor productivity growth rebounds.

### Achievements and remaining challenges
- Achievements:
  - Strong employment gains; full-time employment started picking up in mid-2006.
  - A sound fiscal position: general government deficit reached balance in 2007 after improvement from a trough of 4 percent of GDP in 2004.
  - Structural adjustment of about three percent of GDP between 2003 and 2007.
  - Robust competitiveness and sustained export growth supported by decade-long wage moderation.
- Remaining and emerging challenges:
  - Moderation of the global economic cycle coincided with heightened financial tensions and a pause in the domestic reform process.
  - Sustainable increase in potential growth has not yet been secured.
  - Wages remain high for unskilled labor; low returns to human capital contribute to skilled emigration.
  - Aging costs threaten fiscal sustainability.
  - Prospects for further reforms have dimmed; recent labor market measures motivated by “fairness” may create distortions adverse to employment and output growth.

### Financial sector stability and efficiency — findings and immediate priorities
- Immediate priorities: preserving the integrity of the financial system and maintaining economic confidence.
- Financial tensions and events:
  - Rescue of two German banks in summer 2007 (IKB and Sachsen Landesbank) raised concerns of wider problems.
  - International subprime fallout and subsequent write-down revelations continued to generate risks to confidence and short-term prospects.
  - German banks were placed under close market scrutiny with credit default spreads rising sharply.
  - In November 2007, the German share of main and longer-term ECB refinancing operations fell below 50 percent from about 55 percent in the first seven months of 2007.
  - Many banks had not released year-end statements and further negative surprises seemed likely.
- Staff recommendations and policy proposals:
  - Bank restructuring consistent with international financial integration to ensure unviable banks do not take excessive risks.
  - A bank resolution policy to permit prompt action while maintaining incentives for prudent management.
  - Reduce overlap in responsibilities and improve coordination between BaFin and Bundesbank to increase accountability in banking supervision.
  - Further corporate governance reforms needed for capital market and productivity growth.
- Crisis prevention and management recommendations:
  - Require banks to file financial statements on a quarterly basis and encourage more widespread use of IFRS reporting.
  - Regular stress tests sensitive to newly revealed vulnerabilities.
  - Bank resolution framework should recognize banks’ payment-system role and allow quick resolutions and dilution of shareholders’ equity when appropriate.
- Supervision structure and capability:
  - BaFin is consolidated supervisor; Bundesbank performs on-site and off-site monitoring under BaFin guidance.
  - Staff suggested consolidating supervision in one agency to increase accountability; authorities resisted full consolidation.
  - Capability upgrades needed for IFRS and Basel II implementation, norms on disclosure, liquidity risk management, reduced reliance on external auditors, and attracting skilled supervisors.

### Capital markets and corporate governance
- Capital markets:
  - Underdeveloped and not widely used for firm and household investment.
  - Significant public bond market; stock market small but improving.
  - Equity market dominated by relatively few firms; high share of closely held stocks.
  - Germany lags in nontraditional financing, including nonbank intermediation and asset-backed securitization.
  - Pfandbrief credit spreads traded below benchmark yields; other covered bond spreads widened by up to 50 basis points during turmoil.
- Corporate governance recommendations:
  - Reform two-tier board structures and explore wider use of one-tier or smaller boards (permitted under the 2004 Societas Europea law).
  - Distribute the annual report on self-dealing to all shareholders to strengthen internal control.
  - Be cautious with draft Risk Limitation Law and the draft Law on Modernizing the Framework for Venture Capital and Private Equity to avoid legal uncertainty or undue revenue losses.
  - Staff cautioned against legislating profit sharing; voluntary arrangements preferred.

### Employment, productivity, and labor market policies
- Employment gains significant, particularly full-time employment since mid-2006.
- Labor market tightening signaled by rising vacancy rates and a pick up in wage growth.
- Staff concerns on recent measures:
  - Wage floors are not an efficient instrument for social goals.
  - Minimum wage for postal workers has produced unintended consequences; additional sectoral minimum wages would raise costs and reduce demand for low-skilled labor, especially in high-unemployment regions.
  - Extension of unemployment benefits for older workers could encourage further demands and weaken work incentives.
- Staff support:
  - Rationalize job training and placement programs and urge more vigorous implementation.
  - Child care programs expected to help increase female labor force participation if well targeted.
- Policy implication: focus on measures that boost participation and employment without undermining competition or work incentives; invigorate education and training and encourage skilled immigration.

### Fiscal consolidation, sustainability, and fiscal framework
- Fiscal stance and targets:
  - Balanced budget achieved in 2007.
  - Authorities plan to achieve a structural surplus of ½ percent of GDP by 2011.
  - Following structural balance in 2007, the 2008 budget projects a deficit of more than ½ percent of GDP.
  - Deterioration in 2008 primarily due to:
    - corporate income tax reform: 0.3 percent of GDP,
    - reduction of the unemployment insurance rate from 4.2 to 3.3 percentage points of personal income: 0.2 percent of GDP.
  - Healthcare reform and R&D subsidies will increase spending by 0.1 percent of GDP.
  - Medium-term Stability Program targets:
    - structural surplus: ½ percent of GDP,
    - primary surplus: 3½ percent of GDP.
- Recent and projected fiscal balances (general government, selected figures):
  - Overall balance (Percent of GDP): 2003 -4.0; 2004 -3.8; 2005 -3.5; 2006 -1.6; 2007 0.0; 2008 -0.6 (Proj.).
  - Revenue (Percent of GDP): 2003 44.5; 2004 43.3; 2005 43.5; 2006 43.8; 2007 44.0; 2008 43.2.
    - Direct taxes (Percent of GDP): 2003 10.4; 2004 10.0; 2005 10.1; 2006 10.8; 2007 10.9; 2008 10.6.
    - Indirect taxes (Percent of GDP): 2003 11.8; 2004 11.8; 2005 11.8; 2006 12.1; 2007 12.9; 2008 12.8.
  - Primary expenditure (Percent of GDP): 2003 45.5; 2004 44.3; 2005 44.1; 2006 42.6; 2007 41.3; 2008 41.1.
    - Social benefits (Percent of GDP): 2003 27.5; 2004 26.8; 2005 26.6; 2006 25.8; 2007 25.0; 2008 24.7.
      - Pensions (Percent of GDP): 2003 12.4; 2004 12.2; 2005 12.0; 2006 11.6; 2007 11.1; 2008 10.9.
      - Health (Percent of GDP): 2003 7.7; 2004 7.4; 2005 7.5; 2006 7.5; 2007 7.4; 2008 7.5.
    - Other expenditures (Percent of GDP): 2003 18.1; 2004 17.5; 2005 17.5; 2006 16.8; 2007 16.3; 2008 16.5.
  - Structural balance (Percent of GDP): 2003 -3.2; 2004 -2.8; 2005 -2.4; 2006 -1.2; 2007 0.0; 2008 -0.7 (Proj.).
- Risks and aging sensitivity:
  - Staff estimate: accumulated shortfall by 2011 in the primary balance goal could be as much as 1 percent of GDP on announced policies.
  - Authorities forecast a rise in healthcare costs of 1.2 percentage points of GDP over the next 45 years; staff view this as likely too low.
  - Alternative estimates of increase in public health expenditures due to aging and corresponding total aging costs:
    - Authorities/AWG: 1.2 percent of GDP (corresponding to 2.7 percent of GDP total aging costs).
    - Staff “medium” scenario: 3.0 percent of GDP (corresponding to 4.0 percent of GDP total aging costs).
    - IFO Institute / “large” scenario: 5.6 percent of GDP (corresponding to 7.8 percent of GDP total aging costs).
  - Staff consider a 3.0 percent of GDP increase as highly likely.
- Scenario outcomes (General Government Indicative Balance Sheet for 2007; comprehensive net worth and financial net worth):
  - Comprehensive net worth:
    - Authorities' Scenario Low Aging Costs and Planned Adjustment by 2011: -3.
    - Medium Aging Costs and Planned Adjustment by 2011: -25.
    - Large Aging Costs and Planned Adjustment by 2011: -93.
    - Medium Aging Costs and Slower Adjustment: -34.
    - Large Aging Costs and Slower Adjustment: -110.
  - Comprehensive financial net worth (alternative measure):
    - Authorities' Scenario Low Aging Costs and Planned Adjustment by 2011: -55.
    - Medium Aging Costs and Planned Adjustment by 2011: -77.
    - Large Aging Costs and Planned Adjustment by 2011: -145.
    - Medium Aging Costs and Slower Adjustment: -96.
    - Large Aging Costs and Slower Adjustment: -162.
  - Notes: scenarios assume primary surplus targets (3 1/2 percent of GDP or alternatives of 2 1/2 percent of GDP) achieved by 2011; comprehensive net worth defined over a 50-year rolling period using 2007 population projections.
- Staff fiscal recommendations:
  - Identify and implement subsidy-cutting measures and rationalize tax expenditures to create room for reducing tax rates responsibly.
  - Review reimbursement arrangements of insurers by the Health Fund to create stronger cost-saving incentives.
  - Continue increasing private burden for some publicly financed services while ensuring basic coverage.
  - Link retirement age more automatically to population longevity and expand options for employee savings into financial instruments (third pillar).
  - Embed systematic program evaluation into fiscal decisions and standardize fiscal reporting at all government levels.
- Fiscal federalism:
  - Existing “golden rule” has lost credibility; authorities proposed a new rule close to structurally-balanced budgets for central government and states.
  - Staff view new rule as better aligned with the Stability and Growth Pact but effectiveness depends on transparency and discretionary use.
  - Reform options: greater Länder tax autonomy (surcharges within bands), centralization of tax administration, timely data on Länder finances, and a package of measures to secure political compromise.

### Box 2 — The Smoothing of the VAT Increase
- Cause of smaller-than-anticipated inflation spike: long announcement period of 13 months for the VAT hike led to advance purchases and pre-implementation retailer price rises.
- Quantitative findings:
  - An econometric analysis attributes 0.3 percentage point of the increase in core inflation in 2006 to the anticipated VAT hike.
- Sectoral patterns:
  - Advance price increases higher for durable goods and commodities with less competitive markets.
  - Core inflation increases in 2006 higher among VAT items, especially versus the euro area.
- Implication: long announcement period smoothed the direct inflationary impact by shifting price adjustments and consumption into 2006.

### Labor market caution on minimum wages (paragraphs 19 and related)
- Staff cautioned wage floors are not efficient instruments for social goals.
- Authorities’ measures characterized as pursuing “fairness”: minimum wage for postal workers; extended unemployment benefits for the elderly.
- Unintended consequences identified:
  - Postal-worker minimum wage undermined competition in postal services where competitors cannot match wages.
  - Additional sectoral minimum wages would raise costs and reduce demand for low-skilled labor, especially in high-unemployment regions.
  - Extending unemployment benefit periods for older workers could weaken incentives to work.
- Staff recommendations:
  - Rationalize active labor market programs and placement services; implement child care programs that are well targeted to raise female participation.

### Executive Board assessment and policy priorities (summary)
- Directors’ macro and fiscal guidance:
  - GDP growth projected to slow; vigilance urged given global slowdown and financial tensions.
  - Fiscal loosening in 2008 seen as appropriate to cushion slowdown; completion of reform process and consolidation encouraged.
  - Tackle healthcare expenditures to secure long-term fiscal sustainability.
  - Move to a fiscal framework centered on maintaining overall deficit close to balance in cyclically-adjusted terms.
  - Press ahead with second round of fiscal federalism reforms.
- Structural reform priorities:
  - Continue medium-term reforms in labor markets, investment climate, financial sector, and fiscal policy.
  - Address skills shortages via education, training, and encouraging skilled immigration.
  - Preserve openness to foreign capital and reduce red tape; consider tax reductions on capital and labor offset by expenditure cuts.
- Banking sector supervision and resolution:
  - Adopt transparent bank resolution framework allowing quick resolution and dilution of private shareholders’ equity where needed.
  - Require more frequent financial statements and wider use of IFRS to capture off-balance-sheet activities.
  - Improve supervisory accountability; welcome recent Bundesbank–BaFin coordination protocol.

### Key statistics and indicators (selected and reported)
- Country and population:
  - Total area 357,041 square kilometers
  - Total population (2005) 82.4 million
  - GDP per capita (2006) US$ 35,439
- Growth and demand (percentage change, selected series):
  - Real GDP (2000–2008 series include): 3.1, 1.2, 0.0, -0.3, 1.1, 0.8, 2.9, 2.5, 1.5
  - Private consumption (2000–2008 include): 2.4, 1.9, -0.8, 0.1, 0.2, -0.1, 1.0, -0.3, 1.2
  - Exports of goods and nonfactor services (series): 13.5, 6.4, 4.3, 2.5, 10.0, 7.1, 12.5, 8.3, 5.6
  - Imports of goods and nonfactor services (series): 10.2, 1.2, -1.4, 5.4, 7.2, 6.7, 11.2, 5.7, 5.9
- Labor market (series):
  - Labor force: 41.9, 42.1, 42.2, 42.3, 42.7, 42.6, 43.2, 43.3, 43.3
  - Employment: 39.1, 39.3, 39.1, 38.7, 38.9, 38.8, 39.0, 39.6, 39.8
  - Unemployment rate (Eurostat definition): 6.9, 6.9, 7.7, 8.8, 9.2, 10.6, 9.8, 8.4, 8.1
- Prices and incomes (selected series):
  - Harmonized CPI index (2003–2007): 1.0, 1.8, 1.9, 1.8, 2.3
  - Unit labor cost (industry) series: -1.7, 0.5, 1.5, -1.3, -3.1, -2.5, -2.8, -1.5, -0.5
  - Personal saving ratio (percent): 9.2, 9.4, 9.9, 10.3, 10.4, 10.5, 10.5, 11.1, 10.8
- Public finances (selected):
  - General government expenditure (percent of GDP): 45.1, 47.7, 48.1, 48.5, 47.1, 46.9, 45.4, 44.0, 43.8
  - General government revenue (percent of GDP): 46.4, 44.7, 44.4, 44.5, 43.3, 43.5, 43.8, 44.0, 43.1
  - Overall balance (percent of GDP): 1.3, -2.8, -3.7, -4.0, -3.8, -3.5, -1.6, 0.0, -0.7
  - General government debt (percent of GDP): 58.7, 57.9, 59.6, 62.8, 64.7, 66.3, 66.0, 63.3, 62.6
- Balance of payments:
  - Current account (percent of GDP): -1.7, 0.0, 2.0, 1.9, 4.3, 4.6, 5.0, 5.6, 5.2
- Selected 2003–2007 headline items:
  - Real GDP: 2003 -0.3, 2004 1.1, 2005 0.8, 2006 2.9, 2007 2.5
  - Harmonized CPI index: 2003 1.0, 2004 1.8, 2005 1.9, 2006 1.8, 2007 2.3
  - General government balance (percent of GDP): 2003 -4.0, 2004 -3.8, 2005 -3.5, 2006 -1.6, 2007 0.0
  - General government gross debt (percent of GDP): 2003 62.8, 2004 64.7, 2005 66.3, 2006 66.0, 2007 63.3
  - Exports (billions of euros): 2003 770.0, 2004 846.5, 2005 915.9, 2006 1,042.2, 2007 1,137.4
  - Imports (billions of euros): 2003 685.7, 2004 736.8, 2005 805.1, 2006 921.2, 2007 990.8
  - Current account (billions of euros): 2003 40.9, 2004 94.9, 2005 103.1, 2006 117.2, 2007 135.0
  - Euro per US dollar (period average): 2004 0.88, 2005 0.80, 2006 0.80, 2007 0.80, 1/2008 0.73

*Italic: IMF staff report content provided in the source PDF.*

### Executive Summary

### Executive Summary

### Macro performance and outlook
- GDP growth in 2007 was 2.5 percent.
- GDP growth is projected to slow to 1.7 percent in 2008, with greatly increased uncertainties imparting substantial downside risks.
- From the cyclical trough in 2004, GDP growth accelerated to 2.9 percent in 2006.
- Output is now close to potential.
- Collective wage agreements imply an average gross wage increase of about 2 percent in 2008.
- Inflation developments:
  - Headline inflation in the first 11 months of 2007 was 2.2 percent at an annualized rate.
  - Core inflation in the first 11 months of 2007 was 2.0 percent.
  - The VAT hike in January 2007 pushed up core inflation smoothly by 0.7 percentage point rather than the expected 1.1 percentage points.
  - Year-on-year headline inflation rose to 3.3 percent in November 2007, while core inflation was 2.4 percent.

### Achievements and remaining challenges
- Achievements reflected in:
  - Strong employment gains (full-time employment started picking up in mid-2006).
  - A sound fiscal position: the general government deficit reached balance in 2007 after improvement from a trough of 4 percent of GDP in 2004; structural adjustment of about three percent of GDP between 2003 and 2007.
  - Robust competitiveness and sustained export growth supported by decade-long wage moderation.
- Remaining and emerging challenges:
  - The moderation of the global economic cycle coincided with heightened financial tensions and a pause in the domestic reform process.
  - Sustainable increase in potential growth has not yet been secured.
  - Wages remain high for unskilled labor and low returns to human capital contribute to skilled emigration.
  - Aging costs remain a threat to fiscal sustainability.
  - Prospects for further reforms have dimmed; recent labor market measures motivated by “fairness” may create distortions adverse to employment and output growth.

### Financial sector stability and efficiency (immediate and medium-term priorities)
- Immediate priorities: preserving the integrity of the financial system and maintaining economic confidence.
- Financial tensions and events:
  - Rescue of two German banks in summer 2007 (IKB and Sachsen Landesbank) raised concerns of wider problems.
  - International subprime fallout and subsequent write-down revelations continued to generate risks to confidence and short-term prospects.
  - German banks were placed under close market scrutiny with credit default spreads rising sharply.
  - In November 2007, the German share of main and longer-term ECB refinancing operations fell below 50 percent from about 55 percent in the first seven months of 2007.
  - Many banks had not released year-end statements and further negative surprises seemed likely.
- Staff recommendations and policy proposals:
  - Bank restructuring consistent with international financial integration to ensure unviable banks do not take excessive risks.
  - A bank resolution policy to permit prompt action while maintaining incentives for prudent management.
  - Reduce overlap in responsibilities and improve coordination between BaFin (the regulator) and Bundesbank to increase accountability in banking supervision.
  - Further corporate governance reforms needed for capital market and productivity growth.
- Conduit- and SIV-financed assets and exposures: tabled data indicate varying degrees of exposure across German and other European banks (data presented in source).

### Employment, productivity, and labor market policies
- Employment gains have been significant, particularly full-time employment since mid-2006.
- Labor market tightening indicated by increasing vacancy rates and a pick up in wage growth.
- Authorities recognize the need to address emerging skills shortages and committed to reducing red tape and openness to foreign capital.
- Staff concern: recent labor market measures motivated by fairness were seen as a step back with possible adverse effects on employment and growth.
- Structural reforms remain central to sustain and raise potential growth, including addressing skills shortages and reforming corporatist institutions (wage bargaining, relationship banking, insider-dominated corporate governance, and federal decision making).

### Fiscal consolidation and sustainability
- A balanced budget was achieved in 2007.
- Structural improvement: about three percent of GDP adjustment between 2003 and 2007; structural balance improved by more than one percentage point in 2006.
- Key measures contributing to adjustment: VAT hike, reduction in the deductibility of interest income, expenditure restraint, and increase in healthcare premiums.
- Staff view:
  - Authorities’ medium-term fiscal goals are appropriately ambitious.
  - Additional measures are needed to achieve these goals; authorities were not persuaded new measures were needed or feasible in the short term.
  - Long-term sustainability will require attention, especially further healthcare reform.
- Directors’ past advice and implementation status (Box 1):
  - Progress on Hartz reforms and other structural measures; implementation lagged for some measures.
  - Directors urged refraining from minimum wages; a sectoral minimum wage was instituted for postal workers.
  - Directors cautioned fiscal sustainability would not be assured even if the structural deficit were eliminated by 2010 and encouraged a broad-based approach combining fiscal adjustment and growth-enhancing reforms.

### Policy priorities and overarching challenge
- Policy recommendations center on:
  - Fostering a resilient financial sector.
  - Raising growth potential through productivity-enhancing reforms.
  - Securing fiscal sustainability through further measures, notably in healthcare.
- The overarching challenge: preserve solidarity through shared gains while accommodating forces of global competition and continued reorientation of traditional institutions.

*Source: IMF staff Executive Summary (text as provided).*

### Box 2. The Smoothing of the VAT Increase

### Box 2. The Smoothing of the VAT Increase

### Overview
- The smaller-than-anticipated inflation spike following the January 1, 2007 VAT hike was the consequence of a long announcement period—13 months.
- Consumers made advance purchases, and retailers raised prices prior to the VAT-hike implementation.
- September 2006: advanced price increases in anticipation of the VAT hike; January 2007: actual VAT increase.

### Quantitative findings
- An econometric analysis of sectoral inflation trends shows that 0.3 percentage point of the increase in core inflation in 2006 can be attributed to the anticipated VAT hike.
- Core Inflation Excluding Energy (seasonally adjusted, annual percentage change) rose through 2006 into 2007 as advance price changes occurred.
- Private Consumption Expenditure (quarter on quarter real growth rate, sa.) accelerated in late 2006 coinciding with advance consumption.

### Sectoral patterns
- Advance price increases were higher for durable goods and commodities with less competitive markets.
- Core inflation increases in 2006 were higher among VAT items, especially when compared to the euro area.

### Methods and controls
- The model controls for common price shocks within the euro area, seasonal factors, and onetime effects.
- Reference: See Selected Issues, Chapter I (model description and controls).

### Implications
- The long announcement period effectively smoothed the direct inflationary impact of the VAT increase by shifting some price adjustments and consumption into 2006.
- Advance purchasing behavior and pre-implementation retailer pricing contributed to a smaller-than-expected inflation spike in January 2007.

*Source: Box 2, "The Smoothing of the VAT Increase."*

### 19.      Staff cautioned that the remarkable turnaround on the labor market was

### 19. Staff cautioned that the remarkable turnaround on the labor market was jeopardized by a misplaced focus on minimum wages to pursue social objectives.

### Labor market: assessments and risks
- Staff view: wage floors are not an efficient instrument for social goals.
- Authorities’ measures characterized as pursuing “fairness”:  
  - minimum wage for postal workers;  
  - extended unemployment benefits for the elderly.
- Unintended consequences and risks identified by staff:  
  - Minimum wage for postal workers already having unintended consequences: with competitors unable to match these wages, competition in postal services could be undermined.  
  - Additional sectoral minimum wages would raise the costs of, and reduce the demand for, low-skilled labor, especially in regions with endemic unemployment.  
  - Extension of the unemployment benefit period for older workers could open more such demands and signal a weakening commitment to improving incentives for work.
- Source data note: Federal Statistical Office; 1/ Revised series Oct. 2007.

### Labor market initiatives with convergence
- Staff support and recommendations:  
  - Support for authorities’ intent to rationalize job training and placement programs and urged more vigorous implementation.  
  - Proposed child care programs expected to help increase participation of women in the labor force, with caution that they must be well targeted.

### Policy implication
- Broad range of labor market measures needed; focus on instruments that boost participation and employment without undermining competition or incentives to work.

*Source: IMF staff report text.*

### B. Financial Sector Stability and Efficiency

### Overall assessment
- Ongoing turbulence described as a wake-up call.  
- Long-standing concerns about relatively low profitability of the still-fragmented banking system—by creating incentives for excessive risk taking—intersected with new concerns about financial stability.
- The size of the capital market and its ability to enhance efficient allocation of resources and improve consumption smoothing leave room for considerable progress.

### Emphasis of mission discussions
- Key focus areas:  
  - banking sector restructuring;  
  - crisis prevention and management;  
  - supervision; and  
  - continued strengthening of capital markets.

### Banking sector restructuring: findings and positions
- Concern: absent further restructuring, systemic and fiscal risks could rise.  
- Recent trends: number of banks has fallen sharply and number of employees per bank has increased (referenced table/text). Sector fragmentation contributes to low interest rate margins and still modest income from nonbanking services.  
- Risks: banks unable to generate adequate profits are likely to take on greater risks; fragility generates contingent fiscal liabilities (example: State of Saxony, Sachsen LB’s owner).
- Staff view on restructuring approach:  
  - Support for a market-based process of takeovers and exits.  
  - Caution that ad hoc public mergers may not achieve viable business models.  
  - Policy measures must ensure market forces and private capital can play their legitimate role.  
  - Vertical integration within public pillars may be unsustainable; interim measures (e.g., vertical integration) could have unintended consequences that close future restructuring options.
- Authorities’ view: see scope for restructuring mainly within “pillars” (private, state-owned, cooperative banks); some stronger Landesbanken forging deeper vertical links with local Sparkassen seen as viable. Authorities recognized the need to consider breaking regional restrictions for the Sparkassen but noted constraints due to Länder rights.

### Crisis prevention and management
- Authorities characterized Sachsen LB and IKB developments as unforeseeable “tail events.”  
- Staff concerns: gaps in Germany’s supervisory system need addressing; risks included failures in mortgage origination in the United States and internationally accepted rating methodology.  
- Observations: unusual off-balance-sheet activities and liquidity commitments to conduits were broadly known to Bundesbank and BaFin but were not viewed as alarming at the time; the risk of the commercial paper market freezing up was not recognized.
- Staff recommendations:  
  - Increase transparency: require banks to file financial statements on a quarterly basis and encourage more widespread use of IFRS reporting (which mandates consolidation of group activities).  
  - Regular stress tests sensitive to newly revealed vulnerabilities.  
  - Bank resolution framework should provide better incentives for prudent operations: German insolvency framework should recognize the role of banks in the payment system and the macro economy and incorporate greater flexibility to allow for quick resolutions and dilution of the equity claims of all shareholders.
- Authorities’ practice: rapid action by authorities preserved confidence during rescues; in the case of IKB, private shareholders’ stakes were not diluted in part because corporate insolvency procedures would have entailed considerable delays.

### Supervision: structure and capability
- Current structure: BaFin is consolidated financial sector supervisor; Bundesbank performs on-site and off-site monitoring under guiding principles issued by BaFin in agreement with the Bundesbank. Overlapping mandates viewed as duplicative and weakening accountability.
- Staff structural suggestion: consolidate supervision of banks in one of the two agencies to increase accountability; supervising agency should have enforcement powers to lower a bank’s risk profile. Possible approaches discussed:  
  - If Bundesbank supervises: BaFin retains regulatory role but not enforcement powers.  
  - If BaFin supervises: Bundesbank needs full access to information on systemically important banks and others as needed.
- Authorities’ response: not persuaded that consolidation is practical—concerns that giving Bundesbank additional authority would dilute the BaFin model; BaFin could not in the near term take on full supervision given staffing constraints and premium wage needs. Staff acknowledged partial streamlining could improve accountability but remained concerned that coordination problems would continue.
- Capability upgrade imperatives:  
  - IFRS and Basel II will aid transparency and liquidity risk management; Capital Requirements Directive (CRD) will fully introduce Basel II in Europe from 2008.  
  - Pillar 2 requires a more integrated approach to risk management; Pillar 3 fosters further disclosure.  
  - Implementation requires establishing norms on extent and frequency of disclosure (especially of complex financial products), management of liquidity through access to adequate contingent funds, and greater emphasis on risk models and risk management.  
  - Need to reduce reliance on external auditors and step up efforts to attract and retain skilled supervisors.  
  - Authorities’ measures to strengthen staff: the 9 percent add-on to civil service salaries available to the Bundesbank’s staff, flexible contracts targeting specialized skills, and training programs.

### Capital markets

### Current state and challenges
- Capital markets remain underdeveloped and not widely used for investment by firms and households.  
- Germany has a significant public bond market; the stock market is still small but has made strides with greater liquidity and more new capital raised. Nonetheless:  
  - The equity market is dominated by relatively few firms; the share of closely held stocks remains high.  
  - Germany lags in nontraditional sources of financing, including nonbank intermediation and asset-backed securitization.
- Authorities’ actions: barriers to domestic asset securitization and flexibility of mortgage markets essentially removed, including recent introduction of real estate investment trusts.
- Market behavior during turmoil: Pfandbrief credit spreads traded below benchmark yield curves; other covered bond spreads widened by up to 50 basis points.

### Corporate governance and market development
- Further corporate governance reforms would spur capital market development and investments in productivity growth.  
- Observations: German companies achieve relatively low market value in relation to their investments (Tobin’s-Q comparisons).  
- Suggested internal and external controls:  
  - Two-tier (supervisory and management) board structure at many companies viewed as cumbersome; more efficient boards are important for value maximization and productivity growth.  
  - Option to operate under a one-tier board or smaller board sizes (permitted under the 2004 law governing the Societas Europea) could be extended to more companies.  
  - Continued ownership concentration creates risk of self-dealing; current practice limits availability of the annual report on self-dealing to the supervisory board—staff suggested distributing that report to all shareholders to strengthen internal control.  
  - Concerns that lengthy court proceedings related to self-dealing could undermine shareholder rights.
- Staff cautions and authorities’ positions on new governance initiatives:  
  - Staff concerned the draft Risk Limitation Law may create legal uncertainties and stifle legitimate shareholder opposition to management; authorities intend to clarify the draft to ensure a level playing field.  
  - Authorities aware that the draft Law on Modernizing the Framework for Venture Capital and Private Equity could have been stronger to establish a unified legal and regulatory framework; they want to target tax relief to activities that truly merit it. Staff noted a more far-reaching law would result in higher revenue losses, reinforcing the need for expenditure moderation.  
  - Staff cautioned against legislating profit sharing—suggested such arrangements might be best undertaken on a voluntary basis rather than through legislation.

*Source: IMF staff report text.*

### 35.      After absorbing the costs of two tax reforms in 2008, the authorities plan to

### _cr0880 - 35.      After absorbing the costs of two tax reforms in 2008, the authorities plan to

### Fiscal outlook and targets
- Authorities plan to achieve a structural surplus of ½ percent of GDP by 2011.
- Following structural balance in 2007, the 2008 budget projects a deficit of more than ½ percent of GDP.
- The deterioration in 2008 is primarily due to:
  - corporate income tax reform: 0.3 percent of GDP,
  - reduction of the unemployment insurance rate from 4.2 to 3.3 percentage points of personal income: 0.2 percent of GDP.
- Healthcare reform and research and development subsidies will increase spending by 0.1 percent of GDP.
- Medium-term targets in the Stability Program:
  - structural surplus: ½ percent of GDP,
  - primary surplus: 3½ percent of GDP.
- Staff note: achieving the primary surplus target and maintaining it would make the present discounted value of government’s net worth almost balanced, assuming the authorities’ estimates of aging costs hold.

### Recent and projected fiscal balances (selected figures from general government)
- Overall balance (Percent of GDP): 2003 -4.0; 2004 -3.8; 2005 -3.5; 2006 -1.6; 2007 0.0; 2008 -0.6 (Proj.).
- Revenue (Percent of GDP): 2003 44.5; 2004 43.3; 2005 43.5; 2006 43.8; 2007 44.0; 2008 43.2.
  - Direct taxes (Percent of GDP): 2003 10.4; 2004 10.0; 2005 10.1; 2006 10.8; 2007 10.9; 2008 10.6.
  - Indirect taxes (Percent of GDP): 2003 11.8; 2004 11.8; 2005 11.8; 2006 12.1; 2007 12.9; 2008 12.8.
- Primary expenditure (Percent of GDP): 2003 45.5; 2004 44.3; 2005 44.1; 2006 42.6; 2007 41.3; 2008 41.1.
  - Social benefits (Percent of GDP): 2003 27.5; 2004 26.8; 2005 26.6; 2006 25.8; 2007 25.0; 2008 24.7.
    - Pensions (Percent of GDP): 2003 12.4; 2004 12.2; 2005 12.0; 2006 11.6; 2007 11.1; 2008 10.9.
    - Health (Percent of GDP): 2003 7.7; 2004 7.4; 2005 7.5; 2006 7.5; 2007 7.4; 2008 7.5.
  - Other expenditures (Percent of GDP): 2003 18.1; 2004 17.5; 2005 17.5; 2006 16.8; 2007 16.3; 2008 16.5.
- Structural balance (Percent of GDP): 2003 -3.2; 2004 -2.8; 2005 -2.4; 2006 -1.2; 2007 0.0; 2008 -0.7 (Proj.).

### Risks, sensitivity to aging and long-term fiscal sustainability
- Staff estimate: accumulated shortfall by 2011 in the primary balance goal could be as much as 1 percent of GDP on announced policies (Table 6).
- Downside risks include lower growth and higher-than-expected losses from the corporate income tax reform; corporate taxes can decrease dramatically during a downturn.
- Sensitivity of public debt-to-GDP trajectory to long-term assumptions; higher healthcare cost increases imply rapid debt accumulation.
- Authorities forecast a rise in healthcare costs of 1.2 percentage points of GDP over the next 45 years; staff view this as likely too low.
- Alternative estimates and staff views on increase in public health expenditures due to aging (over 2004-2050 and corresponding total aging costs):
  - Authorities/AWG: 1.2 percent of GDP increase in public expenditures on health benefits (corresponding to 2.7 percent of GDP total aging costs).
  - Staff “medium” scenario: 3.0 percent of GDP increase in public expenditures on health benefits (corresponding to 4.0 percent of GDP total aging costs).
  - IFO Institute / “large” scenario: 5.6 percent of GDP increase in public expenditures on health benefits (corresponding to 7.8 percent of GDP total aging costs).
- Staff consider a 3.0 percent of GDP increase as highly likely given past cost dynamics, structure of age-related benefits, and costs of new treatments.
- Authorities plan to review their estimates in the 2008 long-term sustainability report.

### Scenario outcomes (General Government Indicative Balance Sheet for 2007; summaries as presented)
- Authorities' Scenario Low Aging Costs and Planned Adjustment by 2011: Comprehensive net worth = -3.
- Medium Aging Costs and Planned Adjustment by 2011: Comprehensive net worth = -25.
- Large Aging Costs and Planned Adjustment by 2011: Comprehensive net worth = -93.
- Medium Aging Costs and Slower Adjustment: Comprehensive net worth = -34.
- Large Aging Costs and Slower Adjustment: Comprehensive net worth = -110.
- Comprehensive financial net worth (alternative measure):
  - Authorities' Scenario Low Aging Costs and Planned Adjustment by 2011: -55.
  - Medium Aging Costs and Planned Adjustment by 2011: -77.
  - Large Aging Costs and Planned Adjustment by 2011: -145.
  - Medium Aging Costs and Slower Adjustment: -96.
  - Large Aging Costs and Slower Adjustment: -162.
- Notes used in scenarios:
  - Target of primary surplus of 3 1/2 percent of GDP achieved by 2011 in several scenarios (Stability Program Dec. 2007).
  - Alternative scenarios with primary surplus of 2 1/2 percent of GDP achieved by 2011 are also presented (IMF projections, Table 3).
  - Defined comprehensive net worth as current financial and nonfinancial wealth and net present value of debt projections over a rolling 50-year period; based on 2007 population projections Federal Statistical Office.
  - Financial net worth excludes nonfinancial net worth as many such assets may not be marketable.

### Policy recommendations and staff proposals
- Staff propose additional measures to create a precautionary buffer to guard against delays in achieving the primary balance target.
  - Identify and implement subsidy-cutting measures and rationalization of tax expenditures to create room for reducing tax rates responsibly.
  - Recognize implementation risks owing to current “reform fatigue”; potential greater appetite for measures if fiscal risks materialize.
- On healthcare and aging costs:
  - Propose reviewing reimbursement arrangements through which insurers are reimbursed by the Health Fund to create stronger incentives for cost savings by insurers.
  - Suggest continued increase in private burden for traditionally publicly financed services while ensuring basic health coverage for all, to ensure sustainability.
- On pensions:
  - Propose a more automatic tie between retirement age and population longevity to contain first-pillar pension outlays.
  - Suggest expanding options to place employee savings into financial instruments (third pillar) to improve risk diversification relative to the second pillar.

### Fiscal framework, transparency, and fiscal federalism
- Review spurred by past breaches of Maastricht deficit criteria and enforcement problems with the existing fiscal rule (“golden rule”).
  - Existing “golden rule”: borrowing at central government level not to exceed gross investment; with reduced public investment needs, it implies a close-to-balance budget and little room for automatic stabilizers.
  - The rule lost credibility due to repeated invocation of an escape clause (declaration of macroeconomic disequilibrium).
- Authorities proposed a new fiscal rule: (close to) structurally-balanced budget for central government and states every year, with some room for automatic stabilizers.
  - Staff view: new rule better aligned with the Stability and Growth Pact and could anchor and improve incentives for fiscal self-discipline.
  - Staff recommend the rule require further belt tightening when necessary for long-run sustainability.
  - Effectiveness depends on discretion use; greater transparency is crucial.
  - Staff welcome embedding more systematic program evaluation into fiscal decisions (for example, assessment of tax expenditures) and call for standardized fiscal reporting at all levels of government.
- Reform of fiscal federalism required:
  - Medium-term fiscal targets assume subnational budget surpluses; achieving this requires increased fiscal efficiency at subnational level to control subnational debt and prevent crises.
  - Current cooperative system with uniform spending standards is inefficient and not achieving equality across states.
  - Financing relies on horizontal transfers across the Länder and vertical federal transfers; incentives for efficient public finances at Länder level are weak due to spending rigidity, limited tax authority, and a de facto bailout guarantee.
  - System encourages unproductive tax competition via Länder tax administration decisions; arrangement under stress as surplus Länder resist subsidizing deficit Länder.
  - Policy options discussed include greater Länder tax autonomy (e.g., allowing surcharges on personal income tax rates within defined bands) and centralization of tax administration to improve accountability and service delivery.
  - Need for timely and consistent data on Länder finances, including subnational debt, for transparency and monitoring.
  - Political economy: individual measures face opposition from some states; a package of measures may be needed to achieve compromise.

### Regional convergence (Box 6 summary)
- After reunification, consumption across German states converged rapidly initially; convergence rate has declined steadily and recently shown divergence.
- Observations and causes:
  - Initial investment flowed to poorer states post-reunification, raising productivity and growth.
  - Since the late 1990s, richer states achieved higher investment growth rates, reinforcing higher incomes.
  - Despite increased productivity in poorer states, high wages implied high labor shares of income, lowering profitability and resulting in low or negative investment growth rates.
  - The changing trade-off between insurance and convergence: because consumption growth rates are now similar across states, poorer states are not catching up, but citizens have greater insurance (temporary income declines do not imply corresponding consumption declines).
- Box prepared by Akito Matsumoto.

*Italic: IMF staff report content provided in the source PDF.*

### 43.      Bold reforms have strengthened the German economy. From the economic

### _cr0880 - 43.      Bold reforms have strengthened the German economy. From the economic

### Economic performance and competitiveness
- Germany moved from "economic doldrums early in the decade" to gains including:
  - "strong GDP growth"
  - "substantial employment gains"
  - "an impressive increase in the share of longer-term jobs with social security benefits"
  - "fiscal position in the best shape since unification"
- "Wage moderation helped competitiveness," enabling firms to "profit from the global upswing."
- "With the improved competitiveness, the real exchange rate is estimated to be close to equilibrium, with some evidence of a modest undervaluation."

### Financial turmoil, banking sector resilience, and downside risks
- "The economy has so far withstood the financial turmoil—but downside risks are substantial."
- Factors supporting stability:
  - "Strong cyclical bank profitability before the turbulence"
  - "low reliance of enterprises and households on credit" helped "maintain normalcy in lending."
- Ongoing concerns:
  - "Write-downs have continued as assets have had to be revalued, but systemically important banks have dealt with these without impairing their core capital."
  - "Tightening lending standards and the deepening turbulence raise the risk of a cascading decline in lending and growth."

### Outstanding challenges and policy agenda
- Authorities have "stepped up their assessment of bank exposures to credit and liquidity risks" and vigilance "must continue."
- "A significant unfinished policy agenda remains—in labor markets, the general investment climate, financial sector stability and efficiency, and fiscal policy."
- Goal: "fostering efficiency and growth, while enhancing the sustainability of the Soziale Marktwirtschaft (social market economy)."
- Warning: "A pause in the broader reform process would be unfortunate, and reversals risk undermining the gains achieved."
  - Political pressures in "the second half of the electoral cycle" may push for front-loaded sharing of reform dividends, but "continuation of the buoyant performance is far from assured."

### Labor market, skills, and migration
- To "alleviate skills shortages, a two-pronged strategy is necessary":
  - "invigorating education and training"
  - "encouraging skilled immigration"
- Policy cautions:
  - "Sectoral minimum wages will not serve the goal of fairness and risk distorting competition"
  - "diluting work incentives could hurt the progress of Hartz IV"
- Recommended measures:
  - "more vigor in rationalizing active labor market and placement assistance programs"
  - "enhanced child care availability for women to participate in the labor force"
- Investment climate improvements to complement labor measures:
  - "continued reduction of red tape"
  - "a reduction of taxes on capital and labor (offset by expenditure reductions)"
  - "preserving Germany’s reputation for openness to foreign capital"

### Banking sector restructuring, transparency, and supervision
- Restructuring guidance:
  - Policies "should be guided by the goal of creating robust and sustainable banks, while allowing private capital to play its role."
  - Recognition that "the fragmented banking structure generates only modest profits and, therefore, creates incentives that risk destabilizing the system."
  - Localized banks "should operate in response to market demand"; "political compromises" should not "constrain future options."
- Crisis prevention and management:
  - "Greater transparency and stronger incentives for prudent action will support crisis prevention and management."
  - Bank resolution framework recommendations:
    - "allow quick resolution"
    - "improve management incentives by allowing for dilution of private shareholders’ equity"
  - Supervisory reporting improvements:
    - "require more frequent financial statements"
    - "encourage more widespread use of IFRS reporting to better capture off-balance-sheet activity"
- Supervisory accountability and structure:
  - "Consolidation of bank supervision and prudential enforcement in either the Bundesbank or BaFin would increase accountability."
  - "Regulation will need to stay with BaFin to maintain its role as a consolidated supervisory agency"
  - "Under any supervisory arrangement, the Bundesbank would need all necessary information to fulfill its financial stability and lender-of-last-resort responsibilities."
  - Effective Basel II implementation will require:
    - "reduced reliance on external auditors"
    - "stepped-up efforts to attract and retain skilled supervisors"

### Capital markets, corporate governance, and productivity
- Further capital market development aided by "creating additional options for, and greater transparency in, corporate governance."
- Specific governance observations and recommendations:
  - "The large size of the supervisory boards slows decisions."
  - "The option available to some German companies for rationalizing their boards under the Societas Europea rules could be more widely extended."
  - "Internal and external discipline can also be fostered through further improvements in disclosure standards, especially on board members’ financial dealings, and by lowering barriers to takeovers."
  - Caution: "A number of new initiatives in the pipeline carry risks of further strengthening insiders or rendering governance more complex."

### Fiscal sustainability and policy recommendations
- "Building on their significant recent achievements, achieving fiscal sustainability is within reach—and the ingredients for doing so are clear."
- Short-term outlook:
  - "Although the fiscal situation is expected to deteriorate mildly in 2008, the incremental gains from measures already taken should help continued consolidation."
  - "Additional measures now will help mitigate the short-term risks, especially those from an asymmetric decrease in revenues were growth to decline sharply."
  - "Because short-term slippages accumulate, precautionary belt tightening will also aid long-term sustainability."
- Priority reforms:
  - "Tackling healthcare expenditures is the priority."
  - Authorities moved "to a fiscal rule that achieves close to structural balance"—the rule "should also allow for additional measures for preserving long-term sustainability."
  - "The second round of fiscal federalism reforms offers the opportunity for a significant increase in efficiency and mitigation of fiscal risks."
  - Proposed package: "centralized tax administration but increased Länder autonomy on tax policy" to "create better incentives for fiscal management."

### Projections, follow-up, and procedural note
- "It is proposed that the next Article IV consultation be held on the standard 12-month cycle."

*IMF staff summary as presented in the source content.*

### APPENDIX I. Germany: Fund Relations

### APPENDIX I. Germany: Fund Relations (As of December 31, 2007)

### Mission and Staff
- Mission: November 28 to December 10, 2007 in Frankfurt, Bonn, and Berlin. The concluding statement of the mission is available at http://www.imf.org/external/np/ms/2007/121007.htm.
- Staff team: Messrs. Kähkönen (Head), Mody, Odenius, Ms. Carare (EUR) and Messrs. Seelig and Kiff (MCM). Mr. Ahmad (FAD) joined the mission as an expert on fiscal federalism.
- Country interlocutors: The Bundesbank President Weber, Federal Financial Supervisory Authority (BaFin) Vice-President Caspari, State Secretaries Anzinger (Labor and Social Security), Mirow (Finance), and Pfaffenbach (Economy), members of the German Council of Economic Experts, and senior representatives at the Chancellery, several ministries, the Bundesbank, and BaFin. Mr. von Stenglin, the Alternate Executive Director for Germany, also participated. Meetings took place with parliamentarians, Länder representatives, labor unions, employers, research institutes, and financial market participants.

### Fund Relations and Membership
- Previous Article IV consultation: December 8, 2006. The associated Executive Board’s assessment and staff report are available at http://www.imf.org/external/pubs/cat/longres.cfm?sk=20177.0.
- Membership status: Joined August 14, 1952.

### General Resources Account (SDR Million and % Quota)
- Quota: 13,008.20 — 100.00
- Fund holdings of currency: 12,124.67 — 93.21
- Reserve position in Fund: 883.61 — 6.79

### SDR Department (SDR Million and % Allocation)
- Net cumulative allocation: 1,210.76 — 100.00
- Holdings: 1,368.05 — 112.99

### 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)
- Forthcoming 2008–2012:
  - Principal: --  --  --  --  --
  - Charges/Interest: __0.06  0.06  0.06  0.06  0.06
  - Total: 0.06  0.06  0.06  0.06  0.06

### Exchange Rate Arrangement
- Currency: euro, which floats freely and independently against other currencies.
- Membership: Article VIII member.
- Exchange system: free of restrictions on payments and transfers for current international transactions.
- Security measures: Maintains measures adopted for security reasons, which have been notified to the Fund for approval in accordance with the procedures of Decision 144 (EBD/08/5, January 16, 2008) and does so solely for the preservation of national or international security.

### Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT)
- Authorities moved towards a more risk-based approach; intensity of audits and inspections should reflect institutions' AML/CFT risk.
- Dialogue with associations of certified public accountants and other auditors led to a revised AML/CFT assessment methodology in 2005.
- Legal revisions granted BaFin the power to freeze funds without a court order or other involvement of prosecution authorities if facts suggest that funds serve the purpose of terrorist financing.
- BaFin can require financial holding groups and financial conglomerates to develop a coordinated risk management approach for the whole group.

### Staff Analytical Work on Germany, 2003–07 (selected items)
- Growth and Competitiveness:
  - Alleviating Shortages of Skilled Labor and their Impact on the Economy, forthcoming Working Paper.
  - Growth Linkages within Europe, see Selected Issues Chapter 2.
  - What explains Germany’s Rebounding Export Market Share? CESifo Working Paper No. 1957.
  - 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.
- Inflation:
  - The modest effect of the German VAT hike: Role of inflation smoothing, forthcoming Working Paper.
- Fiscal Policy and Entitlement Programs:
  - Tax Reform and Debt Sustainability in Germany: An Assessment Using the Global Fiscal Model. IMF Country Report No. 06/436.
  - 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.
- Labor Markets:
  - 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.
- The Financial System:
  - Landesbanken: A Measure of the Costs for Taxpayers. IMF Country Report No. 06/436.
  - 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.
- Corporate Governance:
  - Germany’s Corporate Governance: Turning Inside Out, see Selected Issues Chapter 4.

*Appendix II and statistical material continue in the source document.*

— _International Monetary Fund: APPENDIX I. Germany: Fund Relations (As of December 31, 2007)_

### 5.      Pursuant to the instructions by the Ministry of Finance, BaFin and the

### 5.      Pursuant to the instructions by the Ministry of Finance, BaFin and the Bundesbank have made some progress on their coordination efforts

### Supervisory coordination and accountability
- Progress achieved on reducing duplication of supervisory visits by BaFin and the Bundesbank in response to perceived intrusiveness by banks.
- Staff assessment: the core issue of increasing accountability has not been tackled.
- Supervisory accountability options noted in the staff report:
  - Combining supervision and enforcement actions in either BaFin or the Bundesbank; or
  - Establishing clear protocols for coordination that ensure accountability.
- Authorities’ view (Statement by Klaus Stein):
  - An agreement reached on a revised guideline specifying competencies of Deutsche Bundesbank and BaFin, directing focus on banking supervision vs. prudential enforcement and regulation.
  - Revision expected to clarify division of labor, eliminate overlap, and improve transparency and efficiency.
  - Authorities are not persuaded by staff recommendation to consolidate bank supervision and enforcement in one institution:
    - Leaving out BaFin would contradict the principle of integrated financial supervision adopted in 2002.
    - Leaving out the Bundesbank would forgo its infrastructure and contacts and weaken its financial stability role.
  - Authorities characterize the issue as duplication of work rather than lack of accountability.

### Executive Board assessment and macro outlook
- GDP growth projection: slow to 1.5 percent in 2008 from 2.5 percent in 2007.
- Inflation projection: expected to slow moderately to 2.2 percent in 2008.
- Potential growth estimate: 1½-1¾ percent annually; likely to slip unless total factor productivity growth rebounds.
- Risks and balance:
  - Balance of risks modestly on the downside.
  - Global slowdown, commodity prices, and financial tensions weighing on Germany.
  - Financial position of most banks relatively sound; low reliance on credit by enterprises and households has so far helped maintain lending.
  - Directors urged vigilance given unknown dimensions and fast-moving nature of global financial market turmoil.

### Fiscal position and recommendations
- Fiscal developments:
  - Germany moved from overall balance in 2007 to a moderate deficit in 2008.
  - Structural balance improved by more than one percentage point in 2006 and adjustment continued in 2007.
  - Authorities’ goal: primary surplus of 3½ percent of GDP by 2011.
- Directors’ recommendations:
  - Fiscal loosening in 2008 generally seen as appropriate to cushion slowdown.
  - Encourage completion of reform process and associated consolidation to secure fiscal sustainability.
  - Tackle healthcare expenditures to achieve long-term fiscal sustainability.
  - Move to a fiscal framework centered on maintaining the overall deficit close to balance in cyclically-adjusted terms.
  - Press ahead with second round of fiscal federalism reforms to improve incentives for prudent fiscal management.
- Authorities’ position (Statement by Klaus Stein):
  - Plan a revised deficit rule in a second round of federalism reforms to ensure structurally balanced budgets.
  - Not convinced of need for contingent requirement of further belt-tightening as suggested by staff.
  - Temporary fiscal loosening in 2008 attributed to corporate income tax reform and reductions in unemployment insurance contributions; seen as growth-promoting.

### Structural reforms and labor market
- Assessment:
  - Far-reaching reforms strengthened the economy; employment increased, unemployment fell, and competitiveness improved.
  - Potential output growth estimated to have risen by around a quarter percentage point to between 1½ and 1¾ percent.
- Policy recommendations:
  - Continue medium-term reform agenda in labor markets, investment framework, financial sector, and fiscal policy.
  - Coordinated effort to raise growth potential by addressing skills shortages through education, training, and encouraging immigration of skilled workers.
  - Rationalize active labor market programs and expand child care availability.
  - Enhance business climate by reducing taxes on capital and labor in a budget-neutral manner.
  - Caution: new sectoral minimum wages could undermine work incentives and success of Hartz IV labor market reforms.
- Authorities’ measures and views:
  - Lowering social security contributions and corporate income tax reform to below 30 percent effective tax rates.
  - Extension of unemployment benefit period for elderly workers accompanied by targeted wage subsidies and strengthened job search requirements.
  - Selective facilitation of immigration already undertaken; further opening considered.
  - Commitment to preserve openness to foreign capital in amendments to the Foreign Trade and Payments Act related to sovereign wealth fund investments.

### Financial sector: stability, restructuring, and supervision
- Findings:
  - Financial sector progress noted, but recent turbulence highlighted unmet challenges, including low banking profitability and incentives for high-risk taking.
  - Banking consolidation has occurred; capital markets growing rapidly from low levels.
  - Landesbank sector restructuring and review of individual business models needed; horizontal integration across regions and opening to private capital under discussion.
- Specific cases:
  - Deutsche Industriebank (IKB): losses on subprime-related investments led to two recapitalizations in 2007; a third package including government support being devised.
  - Trade-offs in support: safeguarding stability, containing fiscal costs and moral hazard, and enabling sale of KfW-held shares.
- Bank resolution and supervision recommendations:
  - Adopt a bank resolution framework that is fully transparent and allows quick resolutions while providing stronger incentives for prudent management through dilution of shareholders’ equity in recapitalized or intervened banks.
  - Urged frequent financial statements and more widespread use of International Financial Reporting Standards (IFRS) reporting to better capture off-balance-sheet activity.
  - Further measures needed to enhance supervisory accountability and raise quality of supervision.
  - Welcome of recent protocol to improve coordination between Bundesbank and BaFin.
  - Recommendation that bank restructuring be guided by creating robust and sustainable banks, allowing private capital to play a role.
- Authorities’ perspective on supervision and governance:
  - Revised guideline further specifies tasks of Bundesbank and BaFin to clarify division of labor.
  - Authorities oppose consolidating supervision and enforcement in a single institution (see supervisory coordination above).
  - On corporate governance: consider rationalizing company supervisory board structures and strengthening disclosure standards; caution against initiatives that empower insiders or render governance more complex.
  - Support international efforts to review and improve capital requirements, liquidity management standards, and transparency in off-balance-sheet vehicles and rating agencies.

### Key statistics and indicators (as reported)
- Country and population:
  - Total area 357,041 square kilometers
  - Total population (2005) 82.4 million
  - GDP per capita (2006) US$ 35,439
- Growth and demand (percentage change):
  - GDP 2000–2007 and 1/2008 series include: 3.1, 1.2, 0.0, -0.3, 1.1, 0.8, 2.9, 2.5, 1.5
  - Private consumption 2000–2008 include: 2.4, 1.9, -0.8, 0.1, 0.2, -0.1, 1.0, -0.3, 1.2
  - Exports of goods and nonfactor services: 13.5, 6.4, 4.3, 2.5, 10.0, 7.1, 12.5, 8.3, 5.6
  - Imports of goods and nonfactor services: 10.2, 1.2, -1.4, 5.4, 7.2, 6.7, 11.2, 5.7, 5.9
- Labor market (in millions or percent as indicated):
  - Labor force series: 41.9, 42.1, 42.2, 42.3, 42.7, 42.6, 43.2, 43.3, 43.3
  - Employment series: 39.1, 39.3, 39.1, 38.7, 38.9, 38.8, 39.0, 39.6, 39.8
  - Unemployment level series: 3/, 3.1, 3.2, 3.5, 3.9, 4.2, 4.6, 4.2, 3.6, 3.5
  - Unemployment rate (Eurostat definition) series: 6.9, 6.9, 7.7, 8.8, 9.2, 10.6, 9.8, 8.4, 8.1
- Prices and incomes:
  - GDP deflator series: -0.6, 1.2, 1.4, 1.2, 1.1, 0.7, 0.6, 1.8, 0.2
  - Consumer price index (harmonized) series: 1.4, 1.9, 1.4, 1.0, 1.8, 1.9, 1.8, 2.3, 2.2
  - Unit labor cost (industry) series: -1.7, 0.5, 1.5, -1.3, -3.1, -2.5, -2.8, -1.5, -0.5
  - Personal saving ratio series (in percent): 9.2, 9.4, 9.9, 10.3, 10.4, 10.5, 10.5, 11.1, 10.8
- Public finances (selected items, in billions of Euros and percent of GDP):
  - General government expenditure series (billions): 930, 1,005, 1,031, 1,049, 1,042, 1,053, 1,055, 1,066, 1,085
  - General government expenditure (percent of GDP): 45.1, 47.7, 48.1, 48.5, 47.1, 46.9, 45.4, 44.0, 43.8
  - General government revenue series (billions): 957, 945, 953, 962, 958, 977, 1,017, 1,065, 1,068
  - General government revenue (percent of GDP): 46.4, 44.7, 44.4, 44.5, 43.3, 43.5, 43.8, 44.0, 43.1
  - Overall balance series (billions): 27, -60, -78, -88, -85, -79, -37, -17
  - Overall balance (percent of GDP): 1.3, -2.8, -3.7, -4.0, -3.8, -3.5, -1.6, 0.0, -0.7
  - Structural balance series (billions): -25, -54, -62, -69, -62, -55, -27, -21
  - Structural balance (percent of potential GDP): -1.2, -2.5, -2.9, -3.2, -2.8, -2.4, -1.2, 0.0, -0.9
  - General government debt (billions): 1,211, 1,224, 1,278, 1,358, 1,430, 1,489, 1,533, 1,533, 1,550
  - General government debt (percent of GDP): 58.7, 57.9, 59.6, 62.8, 64.7, 66.3, 66.0, 63.3, 62.6
- Balance of payments and reserves:
  - Trade balance series (billions of euros): 50.1, 88.1, 124.2, 118.8, 139.1, 139.7, 143.4, 167.6, 152.0
  - Current account (billions): -35.2, 0.4, 43.0, 40.9, 94.9, 103.1, 117.2, 135.0, 129.6
  - Current account (percent of GDP): -1.7, 0.0, 2.0, 1.9, 4.3, 4.6, 5.0, 5.6, 5.2
  - Foreign exchange reserves (e. o. p.) series (billions): 53.4, 49.5, 40.5, 32.5, 33.8, 33.7, 28.6, 27.7...
- Monetary and interest rates:
  - Money and quasi-money (M3) percentage changes: -1.0, 6.1, ... , 3.5, 2.2, 5.1, 4.7, 10.6, 10.6
  - Credit to private sector percentage changes: 5.8, 3.2, 0.9, 0.0, -0.2, 2.1, 3.5, 1.8, 3.2
  - Three-month interbank rate series (percent): 4.4, 4.3, 3.3, 2.3, 2.1, 2.1, 3.7, 4.8, 4.4
  - Yield on ten-year government bonds series (percent): 5.3, 4.8, 4.8, 4.1, 4.1, 3.6, 3.8, 4.3, 4.1
- Selected 2003–2007 headline items (from Germany: Selected Economic Indicators table):
  - Real GDP: 2003 -0.3, 2004 1.1, 2005 0.8, 2006 2.9, 2007 2.5
  - Harmonized CPI index: 2003 1.0, 2004 1.8, 2005 1.9, 2006 1.8, 2007 2.3
  - General government balance (percent of GDP): 2003 -4.0, 2004 -3.8, 2005 -3.5, 2006 -1.6, 2007 0.0
  - General government gross debt (percent of GDP): 2003 62.8, 2004 64.7, 2005 66.3, 2006 66.0, 2007 63.3
  - Exports (billions of euros): 2003 770.0, 2004 846.5, 2005 915.9, 2006 1,042.2, 2007 1,137.4
  - Imports (billions of euros): 2003 685.7, 2004 736.8, 2005 805.1, 2006 921.2, 2007 990.8
  - Current account (billions of euros): 2003 40.9, 2004 94.9, 2005 103.1, 2006 117.2, 2007 135.0
  - Euro per US dollar (period average): 2004 0.88, 2005 0.80, 2006 0.80, 2007 0.80, 1/2008 0.73

*Italic: Public Information Notice (PIN) No. 08/26 — IMF Executive Board conclusion of the 2007 Article IV Consultation with Germany, February 22, 2008.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr0880.pdf_