Public Information Notice No. 03/132

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Germany

November 6, 2003

On November 3, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Germany.¹

Background

Following three years of stagnation, the government has adopted a revised economic strategy consisting of enhanced structural reforms, more-targeted budget savings, and advancing tax cuts originally scheduled for 2005. The structural reforms aim primarily at improving the flexibility of the labor market and easing demographic pressures on social security programs, which threaten to add considerably to already-high non-wage labor costs over time. A health care reform package has already been legislated. The legislative process is also well advanced regarding other key reform proposals, including reducing the duration of unemployment benefits, merging unemployment and social assistance, cutting public subsidies, and reforming the pension system.

With global growth prospects brightening, business confidence has revived somewhat in recent months, pointing to prospects for recovery in the period ahead. However, the appreciation of the euro is likely to restrain the pace of growth. Advancing the tax cuts will interrupt fiscal consolidation in 2004, making it difficult to bring the general government deficit below the 3 percent of GDP limit under the Stability and Growth Pact. The deficit exceeded the limit in 2002 and is also estimated to do so this year.

The Executive Board also reviewed the findings of an IMF Financial Sector Assessment Program (FSAP), which Germany has taken part in over this past year. Financial sector strains came to a head in 2002 when bank profits contracted sharply and insurance companies suffered losses. Improved financial market conditions in 2003 have reinforced restructuring efforts, thereby easing strains on the financial sector. Stress tests confirm the system's resilience.

Executive Board Assessment

Directors strongly welcomed the turn that Germany has taken toward addressing the structural rigidities that, along with the prolonged adjustment to reunification, have contributed to a decade of weak growth and high unemployment. Together with the more structural approach to public expenditure restraint, the government's economic strategy embedded in Agenda 2010 should help strengthen the supply-side and growth potential of the economy, put public finances on a more sustainable footing, and better equip Germany to cope with the challenges of population aging.

Directors urged the authorities to work toward full implementation of all elements of the policy strategy. This will require strong efforts to strengthen and maintain the required political and public consensus in favor of reforms. In the period immediately ahead, the authorities will need to make further efforts to ensure that fiscal consolidation will be achieved in the medium term. This should help promote confidence, without which the demand effect expected from advancing planned tax cuts would be limited. The enactment of health care reforms and the substantial progress already made in bringing labor market and pension reforms close to implementation are encouraging. These reforms should be complemented with additional steps in the future to make further headway in addressing the demographic challenge and to further enhance the flexibility of the labor market.

Directors concurred with the assessment that the prospects for a moderate recovery of the German economy in 2004 have significantly improved. Short-term GDP growth is, however, likely to remain subdued because of the appreciation of the euro, the still weak demand conditions in Europe, and fiscal constraints. The risks to the outlook appear to be balanced. Some Directors saw upside potential from a stronger-than-expected pick-up in external demand. But the dampening effects of a possible sharp euro appreciation and the still-high corporate leverage cannot be dismissed. Against this background, Directors urged the authorities to work toward further strengthening business and consumer confidence by fully delivering on their structural reforms and fiscal consolidation commitments. Although most Directors did not see the need arising, some Directors suggested that, with inflation not far from zero, additional temporary fiscal stimulus might need to be considered if the economy were to take an unexpected and marked turn for the worse.

Directors stressed that durable fiscal consolidation aimed at achieving structural balance as early as possible needs to remain a core priority on the policy agenda. They welcomed the authorities' move toward a more structural approach to public expenditure restraint, with emphasis on targeted cuts in subsidies and the curtailment of tax expenditures and entitlement programs. Clearly, this will provide a better framework for fiscal consolidation and create efficiency gains, compared with the across-the-board approach to expenditure restraint, topped up with ad hoc tax policies, that has characterized previous efforts.

Most Directors considered that the government's commitment to reduce the structural deficit by an accumulated 1.5 percent of GDP over the period 2004 to 2006 lays out an appropriate adjustment path, taking into account Germany's still fragile economic situation. Given the planned tax cuts, however, little consolidation is expected in 2004, and some Directors regretted that a faster adjustment to bring the general government deficit below 3 percent of GDP appears to be unlikely. To retain credibility in the consolidation process, Directors urged the authorities to move swiftly in identifying the additional high-quality measures that will be needed to fully and durably meet their consolidation goals over the next three years. Expanding on the measures already announced, priority areas for additional savings are deeper cuts in subsidy programs, as well as further downsizing of expensive but inefficient labor market programs.

Directors strongly welcomed the focus of the structural reform agenda on health care, pensions, and the labor market. The health care package is a promising start, but further efforts—including efficiency gains and enhanced competition—will be needed to contain rises in contribution rates over the medium term. On pensions, Directors particularly welcomed the recent cabinet approval for adding a sustainability factor to the pension formula, and looked forward to further steps to ensure the system's long-term sustainability, including through phasing in a higher retirement age.

Directors viewed the shortening of the duration of unemployment benefits as a well-targeted measure to help strengthen incentives for unemployed workers. To further enhance work incentives, they encouraged the authorities to follow through with their plan to merge unemployment and social assistance at a level of benefits no higher than those currently available under social assistance. To complement these reforms, Directors called for tighter enforcement of benefit eligibility. They looked forward to implementation of the proposals under Agenda 2010 to reform job protection legislation and to liberalize the trades, crafts and professions. Some Directors also pointed to the need for enhanced flexibility in the wage setting process, and for broadening the reform agenda to encourage entrepreneurship and competition.

In reviewing the findings of the FSAP, Directors were encouraged that Germany's financial system has weathered considerable strains in the past two years quite well. There are signs that pressures are easing, helped by strenuous restructuring efforts. They commended the high quality of supervision and compliance with international standards, and welcomed the authorities' efforts to continue to refine the supervisory framework.

Going forward, the authorities face a key challenge in fostering restructuring in the banking sector with a view to improving its low and declining profitability. This will require maintaining a healthy balance between competition and financial stability. To further the process of bank restructuring that is already underway, Directors encouraged the authorities to take steps toward creating a legal framework that will reduce barriers to restructuring both within and across the various public and private pillars of the system. However, a number of Directors acknowledged the need to move cautiously in this area. Directors also saw a case for privatization over the medium term of the public sector banks, which account for nearly half the assets intermediated by the banking system. In the insurance sector, Directors saw a need for consolidation and efforts to strengthen the sector's capital base. They welcomed the authorities' plan to strengthen supervision of the reinsurance sector in line with the FSAP recommendations.

Directors welcomed Germany's commitment to trade liberalization, and called on Germany to work with European and other partners toward a successful conclusion of the Doha Round. Many Directors also looked forward to Germany's leadership in working to reduce agricultural subsidies in the context of the reform of the Common Agricultural Policy, which should have positive effects both in terms of budgetary savings and for developing countries' exports. Directors also encouraged the authorities to make good on their intentions to raise official development aid.

While Germany's economic statistics are of high quality, Directors saw scope for further improvements, including to facilitate the monitoring of financial sector vulnerabilities.