Transcript of Conference Call on the Completion of Article IV Consultation with Germany

June 29, 2016


Enrica Detragiache, Assistant Director, European Department

Michaela Erbenova, Division Chief, Financial Supervision & Regulation Division, Monetary & Capital Markets Department

Wiktor Krzyzanowski, Senior Communications Officer, Communications Department

MR. KRZYZANOWSKI: Thank you for joining us for this media call on the 2016 Article IV Consultation with Germany. We've met more than a month ago in Berlin, when the missions concluded their work. Now Executive Boards of the IMF has also concluded this consultation with Germany. This year, the consultation includes the annual Article IV review of the economy as well as the update after five years of the financial sector stability assessment for Germany.

Let me introduce the speakers: Enrica Detragiache is the IMF Mission Chief for Germany for the Article IV, and Michaela Erbenova is the IMF Mission Chief for Germany for the Financial Sector Stability Assessment (FSSA).

Let me now ask the Mission Chiefs to introduce their findings, and then we'll be happy to answer your questions.

MS. DETRAGIACHE: The German economy continue its recent path of moderate growth, and we expect this growth to be led by domestic demand rather than foreign demand, supported by good wage growth, low energy prices, and expansionary fiscal and monetary policies. Having said that, I should also add that this forecast, although we just released it, is already under review because it was prepared before the U.K. vote last Friday.

In the report, we indicate that the decision by the U.K. to leave the European Union would be a downside risk for Germany. The U.K. is an important economic partner for Germany, so a significant change in the economic relationship between the two countries would, of course, have repercussions on Germany. And we will not know what this new relationship will look like for some time, as you certainly understand. In the short term, the events may affect the outlook through increased financial market turbulence as well as the increased uncertainty.

We are preparing a new set of forecasts, not just for Germany but for all our member countries, in the context of the forthcoming update to the World Economic Outlook. And that forecast will be released in a few weeks, so it will give a first assessment of the effect of the U.K. vote. Let me also say, that beyond the short-term forecast, our report emphasizes the medium-term challenges for Germany.

Population aging is a well-known challenge, and it is a concern in Germany because it's going to happen faster than in any other country. It also comes within time, in which productivity growth seems to have slowed in many advanced countries, as well as in Germany. So, there is a double down-draft on long-term growth, one coming from the fact that there would be fewer workers and the other problem is lower productivity.

We think that this not so favorable outlook for the long run is also keeping the economy from staging a more robust recover in the short-term. So, we encourage German authorities to deal more forcefully with the challenging structural reforms, which are described in the report. We emphasize three of them in the blog that will be published together with the report, particularly incentivize women to work longer hours, prolong working lives for all the workers, as well as better labor market integration for immigrants.

MS. ERBENOVA: I would like to summarize the conclusions of the FSSA, the regular financial sector health check, which we have completed over the last 12 months. Germany is a country with systemically important financial sector and it has to undergo this assessment every five years. It is also first such an assessment by the IMF staff in the euro area countries since the launch of the Single Supervisory Mechanism and the Single Resolution Mechanism. This is a profound institutional change in the euro area. We have, of course, analyzed how these mechanisms have worked in the context of Germany and how they affected German banking supervision and German crisis management framework. There are some conclusions in the documents, which are more general about the functioning of these mechanisms, but those necessarily would have to be complemented by judgment of our missions in other euro area countries, where the financial stability assessments are now ongoing. Our assessment was informed about the German context at this stage.

Our reports have been finalized on June 10, so similarly to the Article IV documentation, it was before the results of the recent U.K. vote were known.

In terms of the overall message, we concluded that Germany's financial system as a whole appears resilient to risks that we have identified, but it also faces a longstanding profitability challenges. Those challenges are exacerbated for banks and insurers by prevailing low interest rate environment. That necessitates, going forward, an increased effort to review the business models of the industry, in facing this low interest rate environment.

It is also important that authorities keep focus on completing regulatory and supervisory reforms. First, that they ensure that the new bank resolution and crisis management framework, which has been put in place in Europe and translated into German legislation by implementing all of the relevant directives, is effective and practiced. Second, there is a need to expand the authorities’ capacity to monitor financial stability risks and cross-sectoral spillovers, based on more granular and comprehensive data, which would also allow to put in place necessary macro-prudential instruments. Third, it is important to continue the reforms of banking supervision, while maintaining focus on improving banks’ risk management practices, corporate governance, by more thorough regulation and supervision of related party exposures and of operational risk.

In terms of the effect of the U.K. referendum vote last week, in the FSSA, which was completed on June 10, we identified as potential contributor to growth slowdown risk scenario and an increase in global financial market strains. Bottom line so far is that we only know when the immediate market reaction, markets do have a tendency around events like these to overshoot, so we are observing immediate market movements. It is true that they were massive, but also not excessively disorderly. Communication and steps by major central banks to provide the liquidity and curtail excess volatility appear to have been helpful so far. In the medium-term, one would have to see the overall impact, which will depend on the future economic relationship between the United Kingdom and the European Union.

Meanwhile, I would like to stress just a few things. First of all, direct bank exposures to the United Kingdom, while second-largest after the exposures to the United Starts, are small in absolute terms. Second, we have observed already flight to quality effects, which we have discussed also in the FSSA documentation. German government bonds are retaining their safe haven status that results in reduced yields, which would lead to cheaper refinancing for banks, but also further pressure on interest rates and returns from domestic sovereign portfolio and other exposures.

And finally, we do not expect that these developments would have any significant direct impact on the solvency ratios of German insurers, while they also enjoy long, stable and well-diversified liabilities, which reduce potential liquidity risks. The second-round effect will, of course, be a function of the changes in the macroeconomic framework. Market movements themselves can impact individual institutions, as they can impact also the equity holders, and this period of uncertainty will inevitably have adverse economic effects potentially also in the medium-term.

Finally, a few words about our assessment of how the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) function in Germany. We recognize in the FSSA documentation the progress for both of these new frameworks, but these are also very early stages. SRM was only launched at the beginning of 2016, while SSM has been in operation for a little over a year. So, whatever we say about their functioning, is necessarily a judgment call by the team of experienced experts, as practical experience with their functioning is so far very short. Both SSM and the new resolution framework and SRM made great progress and both have the potential to greatly improve supervision and crisis management framework in Germany. We are concerned that the existing decision-making structures may lead to lengthy and very complex decision-making, and we advise the authorities to consider, within the existing legal framework, ways to simplify routine decision-making to make both supervision and potentially resolution timely and more efficient and more responsive to the needs, whatever they could be. I would like to stop here with my summary.

MR. KRZYZANOWSKI: Thank you very much. We are now ready to answer questions.

QUESTIONER: I have a question about the growth outlook. If I’m not mistaken, the growth forecast for this year has been revised up from the World Economic Outlook and down for next year. Please confirm and maybe you can say just anything about the potential impact of Brexit on the forecast, especially for this year. I mean, there’s already been a lot of financial market turbulence and uncertainty has already gone up. So, in all likelihood, the forecast will be revised down. Maybe you can confirm that.

MS. DETRAGIACHE: In terms of the revision from the World Economic Outlook, they’ve been really minimal in this round. And in terms of the new forecast, of course, we are thinking of a downward revision. We already indicate in the report that the U.K. referendum was a downside risk.

QUESTIONER: I wonder: you’ve given more calls for structural reforms in Germany. Do you see Germany’s position internationally weakened when it calls for structural responses and other countries in Eurozone and also globally?

MS. DETRAGIACHE: We do think that Germany was more proactive in forthcoming with respect to its own structural reform agenda, it’s calls for structural reforms from its economic partners would probably be more credible. So, we put it a bit as a provocation, in the blog and the report. But I think it’s a fair point.

QUESTIONSR: I would like to Michaela a question. It’s about the banks’ exposure to the U.K. Could you please elaborate a bit more? And also, you said something about the insurers and I wanted to clarify: you said that the financial movements -- the recent movements, the sharp movements we’ve seen, have not significantly impacted the solvency ratios. Could you please maybe elaborate or repeat this, because it wasn’t kind of quite clear to me.

MS. ERBENOVA: If you look at our FSSA report, you will see some information on page 14 about Germany’s cross-border banking exposure: the top chart there shows exposures of German banks of foreign countries on the left, and exposure the other way around by foreign countries to Germany on the right hand side. What you will see there is that the exposures to the U.K., while second largest after U.S. are small in absolute terms, and the largest share of those exposures is to non-bank private sector in the United Kingdom, where the effect of any developments which we’ve observed in the last few days will take some time to materialize in terms of the impact on German banks.

I was also saying that there will of course be second round effect, which will stem from the downward revision of the forecast for Germany and potentially other European countries. But those are really very early days now and we are not in a position to quantify those. In terms of direct impact on the insurance sector, beyond the uncertainty factor, which, of course, affects insurers, as well as banks, as well as everybody else, as regards the future arrangements between the United Kingdome and European Union members, our assessment is that the direct impact from developments on the equity market, and on the currency market, on Solvency II capital ratios will not be very large. And we also do not think that there will be material impact on the corporate bonds spread increases, because German insurers to the United Kingdom pound-denominated corporate bonds are not large. Finally, German insurance have long, stable and well-diversified liabilities, and that mitigates risks of potential liquidity pressures on the insurance sector.

QUESTIONER: Given that you already foresee some downward revision to your gross forecast because of the Brexit, do you think that the German government should do more, should maybe increase spending this year, next, to cushion those effects?

MS. DETRAGIACHE: It’s premature to talk about the policy response before we really have an assessment of the impact of the shock. So, I think at this stage, I don’t want to say anything about that.

QUESTIONER: Just a question about the forecast again. You said they’d be issued in a few weeks. Can you give a concrete date, please? And one question, again, about bank profitability: you said the negative interest rates are a problem for banks and insurers too. Do you think the problem caused by the negative interest rates set by the ECB are more pronounced for Germany than for other area member states? Thank you.

MR. KRZYZANOWSKI: Just to clarify, the IMF is updating in a routine way the World Economic Outlook, and the update would happen around the middle of July. We don’t have yet the publication scheduled for that.

MS. ERBENOVA: In terms of bank profitability, first of all, as discussed in the sub-documentation, Germany financial sector is dominated by banks and it’s very heterogeneous. There are large institutions and global players in Germany, but a large number of institutions are savings and cooperative banks, which have very traditional business model, dependent on net interest income as the main source of income. Those banks also tend to have a rather cost-intensive relationship-based model with a large number of branches and employees. The sector has undergone quite sustained consolidation since the previous FSSA, the number of institutions has fallen by about 100, and that trend has continued really since mid-90s. But we think that the new microeconomic environment, parts of which may really be structural rather than cyclical, as discussed also in the Article IV staff report, low interest rates might be a feature of advanced economies going forward for quite some time for a number of fundamental reasons, this model challenges these banks because of their dependence on net interest income, and because of their high expenditures, high cost base.

A similar situation is present for insurers where, again, Germany has a very diversified sector with a high degree of competition amongst a large number of institutions, and differently from many other European countries, the business model is based on the traditional life insurance products which offer relatively high guaranteed rates of returns. So, the possibility of those insurers is, of course, also affected by their inability to earn such high returns in the current interest rate environment.

Now, whether Germany is more impacted than other European countries by this phenomenon, we do discuss this in the Financial Stability Assessment Report: on Page 15, there is a discussion, making the case that banks in Germany may be particularly susceptible to negative side effects of the existing monetary policy. In principal, low interest rates are beneficial for banks because they improve growth prospects, they support loan demand, they can improve customers’ credit worthiness. But it is also true that particularly current negative interest rates may be unique in accelerating margin compression over time. As German banks, on their funding side, have large deposit base, and so far have proven unwilling or even legally unable to pass on these negative rates on to depositors. And that squeezes the interest margin, as mortgages have started repricing to the current prevailing lower interest rates.

As for insurers, of course, they could try to restructure their portfolio of products going forward by offering different types of products, but with insurance liabilities being long, longer-dated, this a process of gradual replacement of the products with guaranteed high return rates will take some time.

QUESTIONER: In terms of ongoing or upcoming negotiations between the European Union partners and the U.K., do you think the European Union, including Germany, should take a measured approach and give the U.K. time to think it all through, or do you think they should step up pressure?

MS. DETRAGIACHE: We didn't want to comment about that.

QUESTIONER: I was wondering if, in your opinion, the German government should allow the Italian government to prop up Italian banks in response to the financial turmoil related to Brexit?

MS. DETRAGIACHE: This is not a topic for the Germany Article IV consultation or the financial sector assessment, so no comments.

MR. KRZYZANOWSKI: Thank you very much, everybody, for joining us for this call on Germany Article IV consultation together with the Financial Sector Stability Assessment.

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