Transcript of a Conference Call on the 2005 Article IV Consultation Report on Germany, with Ajai Chopra, Deputy Director of the European Department and Mission Chief for Germany, IMF

January 18, 2006

with Ajai Chopra, Deputy Director of the European Department and Mission Chief for Germany
International Monetary Fund
Washington, D.C.
Wednesday, January 18, 2006

MS. MBOTO FOUDA: I'm Lucie Mboto Fouda, Senior Press Officer with the IMF, and I would like to welcome all of our participants to this press conference of Mr. Ajai Chopra, Deputy Director of the IMF's European Department and Mission Chief for Germany.

Mr. Chopra is here to discuss the 2005 Article IV Consultation Report for Germany, which as you may know, was reviewed by the IMF's Executive Board on January 11, 2006. The staff report and the Public Information Notice (PIN) summarizing the Board's discussion were posted on our password protected Media Briefing Center last night. I hope you all have had a chance to cast a look over them.

Before we begin, let me go briefly over some ground rules. This is indeed an on-the-record conference call. Mr. Chopra's remarks as well as the staff report and the selected issues paper are embargoed until 9 o'clock a.m. Washington time. Mr. Chopra will now offer a few opening remarks and then will take your questions. Thank you.

MR. CHOPRA: Thank you, Lucie. Welcome, and thank you for joining us in this conference call at the conclusion of the 2005 Article IV Consultation with Germany. I am Ajai Chopra and I led the consultation discussions. With me is Mr. Bob Traa who is the Division Chief for Germany, and he handles much of the day-to-day work on the country. We would both be happy to answer your questions a bit later, but first I would like to make a few remarks to get things started and provide perspective.

This year's documentation for the consultation has one unusual feature compared to previous years. This is because the consultation discussions were covered in two rounds rather than the usual one visit. Our first round of discussions took place in June 2005, just after Chancellor Schroeder had called for early selections. Even though we had good discussions with the previous administration, we felt that we also needed to provide our Executive Board with a view on the policy intentions of the new Grand Coalition Government. Hence, the initial staff report was followed by a more substantive than usual supplement where we described the key economic objectives of the new government led by Mrs. Merkel. Indeed, as may be expected, the Executive Board focused especially on the policies in the Coalition Agreement.

Also included in the package being released is the Public Information Notice which includes the Executive Board's assessment. This Executive Board assessment is the official Fund view. What I will provide you with is more of the IMF's staff perspective, and although the Executive Board agreed with the thrust of the staff's appraisal, it does not necessarily mean that Directors agreed with all aspects.

Let me now touch briefly on the key issues for Germany as we see them. As we said in the Executive Summary of our main report, problems in Germany manifest themselves in three interrelated features. First, low and declining trend growth. Second, high and long-lasting unemployment. Third, persistent fiscal pressures. To tackle these problems which are not new, we believe that Germany should adopt a strategy that encompasses fiscal consolidation, labor market reforms, product and service market reforms and financial sector reforms. If done in a cohesive way, reforms in these areas can be mutually reinforcing. I would touch on each of these areas, but before I do so, I'd like to say a few words about current economic developments in the near-term outlook.

On current developments and outlook following several years of weak growth, Germany is now poised to experience and uptick in economic activity. The recovery in our view is still hesitant and unbalanced because it continues to be heavily dependent on exports, but high-frequency indicators are at least showing some increase in investment spending on machinery and equipment, the decline in construction seems to be leveling off, and consumers also seem to be in a better mood as judged from confidence indicators.

In 2005, we found that the economy was regaining some strength in the second half of the year, and we projected this would continue to be the case in 2006. There is some uncertainty still about the quarterly path in 2005 because the Federal Statistics Office has not released the path, but there seems to have been some strengthening, and as I said, we expect this to continue in 2006.

As you know, the Coalition Agreement called for the implementation of a 3 percentage point increase in the VAT rate in January 2007, and we believe that this will bring forward some consumer spending to the latter part of 2006 and boost growth a bit. As a counterpart, however, we believe that growth in 2007 will ease down again as the main effort of fiscal adjustment is put in place.

To put some numbers on this picture, we project output growth to increase from 0.9 percent in 2005, to 1.5 percent in 2006. These are unadjusted numbers and after one corrects for variations in the number of working days, the calendar adjusted numbers are just a bit higher in both years. For 2007, there is still considerable uncertainty, but for now we are forecasting that growth would slow to a range of three-quarters percent to 1-1/4 percent depending on how households react to the VAT increase and how well the external environment holds up for Germany.

Turning to fiscal issues, the new Coalition Government has put considerable priority on fiscal consolidation, and we believe this is entirely appropriate. A quick side note over here, I would like to point out to you that there's quite a bit of material in the documents that look at the structural factors behind Germany's fiscal difficulties.

To be sure, the announced fiscal measures are significant, and if these measures are implemented, we expect the objective to reduce the deficit below 3 percent of GDP, the Maastricht limit, will be achieved in 2007. There are, however, some additional points that need to be mentioned about near-term fiscal plans and the policy package in the Coalition Agreement.

First, the fiscal path for 2006 and 2007 is choppy and back-loaded. There is little consolidation in 2006, followed by a sharp contraction in 2007. We understand that the authorities want to be cautious with the recovery in 2006 and don't want to risk pinching off growth, but we believe that some smoothing of the adjustment path between these two years would have been feasible and preferable. Specifically, a small additional fiscal effort of a quarter percentage point of GDP in 2006 would have allowed Germany to reach the recommended goal of underlying fiscal adjustment of a half percent of GDP which is the adjustment effort called for under the Stability and Growth Pact when a country has an excessive deficit.

Second, there is some risk that the preannounced VAT measure could be time inconsistent. What this means is that on the one hand if the economy is strong toward the end of 2006, it may seem that the full 3 percentage point increase in the VAT is not necessary. On the other hand, if the economy remains weak, the concern that the VAT might pinch off growth too strongly in 2007 would be heightened. In both cases, political opposition could grow. The government has said that it intends to gain legislative approval for the VAT adjustment in the next few months. In our view, this is a good idea and it would strengthen the confidence in the adjustment plan.

Third, the reform of health care financing and the corporate tax system are both important. These are difficult reforms, and the government is doing the right thing to take the time to design them properly. On health care financing, a system that at least partially moves away from payroll taxes is preferred. On tax reform, our view is that this should aim at simplifying the system by scrapping exemptions and tax expenditures and possibly lowering headline tax rates, but the most important thing is that this should be done without reducing the effective revenue to the government, because the priority should remain fiscal consolidation.

Fourth, we strongly welcome the efforts to tackle federalism issues because managing the adjustment effort within the various levels of government is a recurring difficulty. Better agreements on expenditure responsibility by different levels of government and some changes to approval of new laws by Parliament are good policy objectives. However, as the Executive Board assessment says, it would be important for the government to build on these by introducing greater leeway for competition between states and strengthening the Internal Stability Pact, thus facilitating efficiency and fiscal discipline.

Finally, the move to extend the pensionable age goes in the right direction. This reform, however, will take very long to implement, and we believe that it could be accelerated. Indeed, because life expectancy is growing as quickly as the pensionable age, more in the pension area will be needed.

I now turn to longer-term fiscal issues, particularly aging and long-run fiscal sustainability. The debt ratio continues to creep up, so it's clear that Germany needs a full-fledged fiscal plan for the years beyond 2007. The Coalition Agreement really touches on the next 2 years, but as I just said, the fiscal plans need to go beyond that. In this Consultation Report, we have highlighted the large task that still awaits Germany to prepare the economy, and especially public finances for population aging. To get an indication of the stress on public finances over the long-term, we have calculated a baseline path for the fiscal deficit for the period through 2050. To do this, we tried to assess how much debt Germany may need to place in the future if policies were to remain unchanged. Please note that we did these simulations before the Coalition Agreement was announced by the new government.

By adding this measure of potential future debt to the stock of debt already issued, we found that the so-called intertemporal financial position of the government is not sustainable. We also looked at this issue by putting together an illustrative public-sector balance sheet, and there's a Selected Issues paper on this and also a box in the staff report. The conclusion of both these exercises is that further adjustment measures are required, part of which was started in the Coalition Agreement. Looking at just the next few years, our main recommendation is that the government should aim to achieve fiscal balance by the end of this decade, that is abstracting from cyclical variations, we are talking about the underlying structural deficit here.

Let me now turn to the ever-important issue of structural reform. The Coalition partners have spent many years opposing each other, and not surprisingly, this is an area where they found it difficult to frame concrete plans. However, labor, product and service market reform is crucial to boost Germany's low potential growth and to safeguard the economic basis for Germany's social model. By raising labor utilization, reforms in these areas would also help ease fiscal pressures.

In labor market reforms, much has been done to bolster the supply of labor with the Hartz IV reforms and also the reforms that took place before that. The merger of social welfare and long-term unemployment programs was a very important step. Means testing of those that qualify for benefits is being improved. The organization of tasks between the Federal Labor Office and agencies of the municipalities is also an important focus of attention.

Where we have seen less progress is in improving the demand side of labor markets. By that we mean permanently reducing restrictions or obstacles to unemployed workers finding a job. This involves difficult steps that range from allowing wages to be set more closely to productivity levels, at the firm level rather than by central collective bargaining, and also to achieve further liberalization in the hiring/firing decisions of firms. We welcome the extension of probationary periods from 6 months to 2 years, and labor regulations for full-time social security paying jobs remain quite a bit more restrictive than, for instance, those for part-time employment. Moreover, with the very high regional unemployment experienced in some parts of the country, increased differentiation of incomes across regions is also necessary.

On product and service market reforms, the key message from this year's consultation is that these are important complements to labor reform. Indeed, when one reforms only labor markets, the gains from liberalization may accrue primarily to firms. If Germany were to simultaneously carry out bold product and service market reforms, the gains from liberalization would be passed on in the form of lower prices and high growth and output volumes. This helps employment.

Product markets are fairly liberal in Germany, so the emphasis should be on service market reforms. The Coalition Agreement suggests some steps for the liberal professions including the guilds and skilled crafts, but these appear to go in the direction of more licensing and regulation. Also Germany's rejection of the E.U.'s Services Directive is a missed opportunity in our view. Thus we feel that deregulation was a weak point in the Coalition Agreement that requires further work, especially to allow the full payoff from the important labor market reforms that have already been done.

Finally, on the banking system, we are encouraged that banks continue to make progress with profitability and cost efficiency. However, the segmentation associated with Germany's three-pillar banking system continues and impedes revenue growth, and a large share of banking activity is still directed through the public sector. On a range of indicators, German banks tend to lag behind other E.U. countries. In our view, abolishing limits in interregional competition and opening up public sector banks to private capital would facilitate market-driven restructuring, offer higher returns to scale and bolster profitability. Overall, progress is being made prompted in part by the phased removal of guarantees for Landesbanken, but this progress is slow. The reason we stress more ambitious changes in this area is because a more dynamic financial system would be better able to support growth by helping direct funds more readily to areas of highest investment needs.

This concludes my introductory remarks. Mr. Traa and I will try to respond to questions that you may have, so please go ahead.

QUESTION: Hello, Mr. Chopra. It's Christiana with the Germany Press Agency. My question is the following. If you were in the German government, what would be the two top priorities, what policies would you change immediately in a very concrete and practical way?

MR. CHOPRA: That's a very good question. What we have been emphasizing consistently is that to durably improve German economic performance, actions are needed on a number of fronts because these policy actions tend to be mutually reinforcing so it's very hard to sort of pick and choose individual elements. But nevertheless, I think you're quite right, a politician does indeed have to prioritize, and I think at this stage, the way I would look at it is where is less being done? I think in the area of fiscal consolidation, we would prefer that it be not quite so back-loaded, so we would put more emphasis on getting the process of fiscal consolidation started in a more measured way, but get it started early, so that's one area.

As we've said in our supplement, we think this can be done by advancing the VAT by a few months and getting some more consolidation in 2006. We do not see a very strong rationale for waiting on fiscal consolidation. I think that would very much enhance the credibility of the fiscal package. As I've said earlier, a lot has been done in the area of labor markets, not enough has been done in the area of service sector reform. So to get the full benefits of the labor market reforms, we would also put more emphasis right now on starting to move on deregulation and on service markets so that some of those benefits from the labor market reforms do begin to accrue.

But coming back to my original point, there is a great deal more that needs to be done, including in labor markets, and it's important to design these policies in a way that is mutually reinforcing, and given Germany's long-term problems. the key issue is that policies need to be designed to improve labor utilization.

QUESTION: I have a follow-up. If you are talking about liberalization of the service markets, can you also give me maybe two very concrete examples of what you would suggest.

MR. CHOPRA: To be specific, in the liberal professions by which I mean for instance architecture, engineering, crafts and other trades, Germany has a comparative advantage in the European context. I think, firstly, deregulation in these areas making entry easier and making it easier to set up small businesses that employ people, since small businesses that tend to be more employment intensive, would be very helpful. And also in the context of E.U. Services Directive, we think Germany has a lot to gain because, as I said, these can be very high value-added professions and Germany could benefit quite a bit if it liberalized them.

I should say in this context that, of course, the German authorities are concerned about quality of workmanship when liberalizing these professions. I think that is an important concern, but these things do need to be appropriately balanced because there are a number of other benefits that do accrue from having a more liberal environment that allows the creation of some of these service-oriented businesses.

QUESTION: I just wondered if you could go over, when you mentioned the new forecast you had about nine-tenths of a percent growth for 2005 and 1.5 for 2006. Then you said for 2007 there's considerable uncertainty because a lot depends on how households react to the VAT. Is that the primary reason? It doesn't seem like it would be that much stronger. It would actually decline if it goes back to three-quarters, correct?

MR. CHOPRA: What I meant is the following. What we've built into our projection is that consumption in the last quarter of 2006 would be stronger than it would have been without the VAT increase because what's likely to happen is that consumers advance some purchases by a few months to take advantage of the existing (lower) tax rate, and then when we come around to the first quarter of 2007, this will be offset because these consumers may buy fewer of these durable goods right after the VAT increase.

How precisely the dynamic works out is very difficult to predict, how much is brought forward and how much of a payback there is, so to speak, in 2007. We've looked at the experience of Japan and the U.K. Both are mentioned in the supplement to our staff report. And we've also looked at the experience of France. In all these cases it does seem that there was some advancing of purchases with a reduction in consumption in the quarter where the VAT was introduced. Of course, the extent of this varied among these three country examples.

There is also some uncertainty in some other areas. For instance, the full extent of the fiscal package even leaving aside the VAT increase for 2007 is unknown. Basically, we see the 2007 fiscal consolidation that's embedded in the government's plans as being at least three-quarters of a percent of GDP, but it could very well be higher. Of course, if the fiscal contraction is sharper, this would have a greater impact on growth. But also it's very hard for us to predict the world environment going out 1 year ahead, and the world environment is very critical for Germany given the export orientation of its growth right now.

Taking all these factors into account, at this early stage, we are a year away now, we are still in January and we felt much more comfortable putting our 2007 forecast in terms of a range. This range is centered on 1 percent, but we see the range as three-quarters to 1,25 percent.

MS. GREG: This is not a negligible difference from the WEO forecast is it for 2006, what do you have now?

MR. CHOPRA: If I remember right, the WEO forecast for 2006 was 1.2 percent, so we've increased it by 0.3 percent for 2006.

QUESTION: I'm not sure you will want to answer this question, but I'll try it anyway. Did you have a chance to meet the new economics team with Mr. Steinbruck in Berlin, and what is your impression?

MR. CHOPRA: We did have an opportunity to talk with the new economic team in Berlin, especially in the Ministry of Finance. The team had just taken office. It's very clear that they're deeply committed. We got the sense that the economic team is very much aware of the problems in Germany. There is, of course, a Coalition Agreement that provides the framework for policies, and the sense that we got is that the economic team intends to pursue the policies that are laid out in the Coalition Agreement. As we said, a lot depends on the implementation of these policies. We were impressed by the determination of the economic team and we wish them all the best.

QUESTION: I also read the reaction that Mr. Bischofberger gave in the Board to most of the recommendations. Do you have the impression that IMF recommendations are taken seriously and looked into or is this more of a slugging match where a country or a government like Germany would say we don't agree with your recommendations and we think what we are doing is just fine?

MR. CHOPRA: By and large on all the key elements we have a great deal of agreement. I think we agree on the diagnostics, we agree on what the key issues are, we very much agree on also the policy prescriptions. Where there may be some difference is, of course, being in the hot seat in Berlin when the government actually has to implement things, it needs to take into account a number of considerations. We at the IMF, of course, try to take these into account, but the German authorities are the best placed to make these ultimate decisions. But by and large, on a number of matters I would say we have very broad agreement. There may be some differences in nuance. I mentioned one when we were talking about service sector reform. As I said, the government doesn't disagree that more liberalization needs to be done in this area, but they are concerned about maintaining the quality of services, and they have to find the right balance here. So it's always the question of finding the right balance and the speed with which to move. I think there are some areas where we feel that the speed could be a little bit faster, but generally things are going in the right direction.

Take the increase in the pension age as another example. This is an important step, but we believe that it can be done a little bit faster. I think the government recognizes this as well, but I think they are constrained as to how fast they can move on some of these matters. So in terms of the broad outlines, there is a very high degree of concordance. And I think Mr. Bischofberger's buff, the Executive Director's buff which is provided at the end, is a very useful complement, and I'm glad that you looked at that because I think it's important to have that perspective as well. In our reports we very much try to present our discussions as a dialogue and to give the authorities' perspective, but it's best to have that also in the government's own words.

MS. MBOTO FOUDA: If there are no further questions, I believe we can conclude this conference call at this point in time. It's 8:35. The embargo will be lifted at 9 o'clock as we stated at the beginning of this conference call.

Thank you all for participating to do this exercise with us and we will see Mr. Chopra again next year.


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