Germany -- 2003 Article IV Consultation, Concluding Statement of the IMF Mission

July 14, 2003

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

1. The added emphasis on structural reforms in the government's policy strategy is entirely right. The economy has continued to falter for a third year and the outlook remains uncertain with prospects for only a modest recovery. A rebalancing of policy priorities was thus urgently required to revitalize the stagnant economy and raise growth over the medium term. The government's strategy now emphasizes three elements: reforms to labor markets and social benefits aimed at correcting longstanding structural weaknesses in the economy; more concerted efforts to achieve durable fiscal consolidation through public expenditure restraint; and the advancement of the tax cuts scheduled for 2005 to provide short-run support to demand and enhance supply-side incentives. We support the strategy, which will require vigorous implementation of all three elements to be successful. In particular, without major measures to address the supply-side problems of the economy and place the structural budget deficit on a firm declining path, tax cuts are likely to prove at best a temporary palliative and there would be risks of a damaging backlash on confidence.

The core of the strategy: reforming labor markets and entitlement programs

2. Germany needs to seize the moment and implement the bold plans under discussion in Agenda 2010 and elsewhere. Many of Germany's economic difficulties—low growth and high unemployment—can be traced to the postponement of reforms, perpetuating structural rigidities. Inflexible labor markets and overly generous entitlement programs are at the root of the problem. Because benefits to the jobless last too long and are too high, they dampen incentives to work, while the cost of pensions and health care imposes a tremendous burden on the current working generation. Moreover, this burden is set to spiral upward as the population structure ages. Entitlements account for over half of public spending. Thus their reform has a vital role in fiscal consolidation, which can benefit not only from direct savings but also from the synergies created by faster growth and higher employment. And setting entitlement spending on a sustainable path will provide breathing room for policy to react to unexpected economic developments in the future. Momentum for change has been building and what is under consideration would, if implemented, make a strong beginning. But given the depth of the problems, it will not be the final word.

3. The proposals in Agenda 2010 to reform support for the unemployed are impressive and far-reaching. A significant reduction in the duration of unemployment benefits and the alignment of unemployment assistance with social assistance would go a long way toward strengthening incentives to work and reducing structural unemployment over the medium term. With about 4½ million unemployed, early and undiluted implementation of these reforms should be a high priority.

4. Proposals to ease labor market and business regulations also represent steps in the right direction, but need to be taken further. Agenda 2010 contains useful suggestions to free up dismissal procedures and allow more scope for temporary work contracts. They will enhance the Hartz Commission measures aimed at strengthening job placement services. Further, the proposals in Agenda 2010 to begin dismantling restrictions on trades, crafts, and professions would provide a useful complement to labor market reforms. But there is considerable scope to do even more, particularly to encourage hiring and to support more options for wage bargaining to respond better to local economic conditions and reduce regional imbalances. More generally in the area of product markets, Germany is encouraged to maintain its leadership role within Europe in helping complete the single market agenda.

5. Pension reform needs to center on long-term sustainability. The contribution rate is already closing in on 20 percent, a level viewed as the acceptable long-term ceiling, and is likely to ratchet up further next year, absent measures. In this regard, the 2001 reform did not go far enough to accommodate the long-term pressures of an aging population. The reality is that people will have to work longer in the future and benefits in the statutory public pillar cannot always grow fully in line with wages. Consistent with our own analysis and the preliminary proposals coming out of the Rürup Commission, a higher retirement age needs to be phased in and benefits scaled back, for example by adding a sustainability factor to the pension formula that links benefits to the ratio of pensioners to contributors. Delay in making such changes will make it increasingly difficult to avoid further increases in contribution rates, will lead to falling confidence in the soundness of the pension system, and, by failing to address fundamental concerns about fiscal sustainability, will diminish the room for maneuver of fiscal policy in the near term. For these reasons, we hope the Rürup Commission findings will lead to an informed public debate and the early implementation of meaningful pension reform.

6. High and rising contribution rates also argue for prompt passage of health care reform. It is encouraging that concrete proposals have already been put forward and the political process of finding common ground is underway. Pruning benefits and shifting their financing away from contributions will alleviate much of the short-term pressure on the system. However, the harder task is to unlock efficiency gains and to contain demand as well as scale back unnecessary services. In this context, a system of more substantive co-payments with selective rebates for efficient providers is worth considering.

Ensuring durable fiscal consolidation and accommodating tax cuts

7. Recent steps toward a more structural approach to restrain public expenditure are welcome. The approach to date has been ad hoc and relied too much on across-the-board spending restraint with some important areas, notably public investment, being pared to low levels. It has not delivered consistent savings, especially in years when economic conditions have been relatively favorable. A better strategy would eliminate programs or tax expenditures that impose efficiency losses on the economy or provide little value for money. By locking in budget savings, there would also be greater assurances that deficit reduction goals will be met. Current proposals to reduce or eliminate subsidies for commuters and housing construction, and to make deeper cuts in general subsidy programs including those for industry and agriculture, provide the starting point for a more coherent consolidation strategy. However, more will need to be done to identify high-quality savings measures. For example, greater scrutiny should be applied to active labor market programs and their administration, where even after Hartz reforms the returns to substantial public spending remains unclear.

8. Durable expenditure restraint is a necessary complement to the policy of advancing the tax cuts. As the tax cuts are legislated to take place anyway, there is a case for bringing them forward to 2004 when their support to the economy is needed most. This will make the fiscal arithmetic for 2004 difficult: the general government deficit is headed toward 4 percent of GDP in 2003, and total tax cuts next year amount to about 1 percent of GDP. Returning below the Stability and Growth Pact (SGP) 3 percent limit will thus be a challenge. If the recipients of the tax cuts are to believe that the cuts are affordable, and if Germany is to meet its SGP obligations, clear assurances are needed that long-lasting fiscal consolidation is indeed in the pipeline.

9. For the next three years, the fiscal consolidation plan should incorporate high-quality measures on the expenditure side cumulating to at least 2 percent of GDP to reduce the structural deficit by about 1½ percent of GDP. Such consolidation would deliver an annual reduction in the structural deficit averaging ½ percent of GDP a year in 2004-06. With strong expenditure measures in place, consolidation thus defined could be suspended in 2004, although the clear aim should still be to prevent a rise in the structural deficit. We see elements of the strategy on the expenditure side starting to take shape for the 2004 budget. But the precise measures (for example, cuts in subsidies and tax expenditures) still need to be tied down and implemented. Many of these measures will build up savings over time and are estimated to yield about half the required adjustment for 2004-06. Therefore, they will need to be augmented in future budgets.

The outlook: foundations for recovery amid short-term uncertainties

10. Assuming the strategy is fully implemented, we are cautiously optimistic that the economy will begin to recover in 2004. This year, growth is expected to continue to stagnate amid weak demand in Europe, the emerging impact of the euro's rise on exports, and poor business and consumer confidence. But recent interest rate reductions and the tax cuts should gradually filter through to domestic demand and, assuming a steadily improving global economy, support a resumption of growth during 2004. However, the strength and timing of the recovery is difficult to predict. Although implementation of the strategy will establish the climate for recovery, its effects on growth will build over the medium term. Indeed, the forecast for 2004 depends on intangible confidence effects and the demand impact of the measures. That said, postponing reforms would, in our view, put a major question mark over confidence and create more serious risks for the prospect of recovery. On balance, we project growth of about 1½ percent in 2004.

11. Sizable risks to the outlook remain. Many risks are beyond Germany's control—for example, the world economy may remain in the doldrums and the euro could appreciate more, consistent with the need to correct global external imbalances. In such circumstances, inflation pressures would abate further in the euro area, thus providing the ECB scope to reduce interest rates more, while the automatic fiscal stabilizers could provide some support to demand. Even so, expected recovery might once again be postponed, thereby putting additional downward pressure on already-low inflation in Germany. A short period of mild price declines would not be of concern, and at this stage prospects for the onset of deflation appear remote. Nonetheless, if the economic situation were to take a pronounced turn for the worse, temporary fiscal stimulus beyond the tax cuts might need to be considered. Its effectiveness, however, would be considerably enhanced if a strong package of structural reforms has been implemented and there is an established pipeline of durable public expenditure cuts.

Ensuring the continued stability of the financial sector

12. There have been encouraging signs of late that the deterioration in the condition of the financial sector has been arrested, but it is too early to tell whether a decisive turning point has been reached. The IMF has been examining the financial system in more depth in 2003 in the context of its financial sector assessment program (FSAP). Last year was one of the worst on record for German banks and insurance companies. Nonetheless, the financial system has shown resilience and stress tests provide some comfort that it could weather additional shocks. With cost cutting and better pricing of risk, partly in response to Basel II, modest improvements were registered by banks in the first quarter of this year. Further, an incipient recovery in financial markets may have eased the situation of insurance companies, which have suffered from weak equity markets, low interest rates, and surges in claims. A delay in the recovery, however, would impose additional strains on a system that is already stretched.

13. In this context, the FSAP team's overall assessment of financial supervision and regulation is largely positive. Moreover, the identified areas for refinement are essentially those where the authorities also see a need for change. These include the need to: expand the resources of the new supervisory body, BaFin; enhance on-site supervision and increase oversight of bank auditors; broaden supervision to include holding companies for financial institutions; strengthen reporting standards through more timely publication of a broader set of financial sector indicators; and enhance supervision of reinsurance. The planned reduction in the guaranteed rate of return for life insurance products is appropriate, and consideration should be given to phasing it out.

14. Notwithstanding recent efforts, further restructuring is essential to address the long-term decline in the profitability of all three banking pillars, lest it undermine financial stability in the medium term. Already lower than in other European countries, profitability threatens to soon reach a level where it is too thin a buffer to absorb future shocks to the system. The phasing out of guarantees for the Ländesbanken adds immediacy to the issue. Although low profitability is partly a sign of competition and carries benefits for customers, a better balance needs to be struck to ensure the fundamental soundness of the banking system as a whole. It is encouraging that some public sector banks are already exploring various alternatives for restructuring, including through corporatization and consolidation within pillars. It is not possible to define one single best bank model, but flexibility is crucial to adapt to ongoing changes in the financial landscape and to help address future shocks. Such flexibility can be fostered through a reduction of legal and other barriers to consolidation in order to facilitate market-based solutions within or across pillars.

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We would like to thank all our interlocutors for productive and friendly discussions. The prospect for meaningful structural change is finally in the air. If proposed reforms are implemented and fiscal consolidation put on firmer ground, we are optimistic that Germany's economy can put a long period of weak performance behind it.


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