August 29, 1997
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| Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. |
The IMF Executive Board on August 25, 1997 concluded the 1997 Article IV consultation1 with Germany.
Background
Cyclical recoveries in Germany have become progressively less vigorous over the past three decades as they have been hampered by structural rigidities, especially in the labor market. Faced with relatively high labor costs in the 1990s, firms have engaged in domestic downsizing and international outsourcing which has reduced employment and raised the unemployment rate to record postwar levels.
In 1996, annual GDP growth slowed to 1 1/2 percent. But with a real exchange rate correction during the year, German manufacturers capitalized on robust demand outside of continental Europe and restarted the recovery in the second half of the year. This pickup continued in 1997: real GDP grew by 1.8 percent during the first quarter (seasonally adjusted annual rate). In the second quarter, industrial production rose further, while manufacturing orders increased sharply (especially from abroad) and business confidence was buoyant. Consumer confidence, however, has remained low. Labor market conditions deteriorated in 1996 and through the first half of 1997 with additional employment contraction, extending the string of consecutive annual declines since 1991. The unemployment rate increased in 1996 and reached a postwar record of 11.5 percent in July 1997. Inflation was subdued in 1996: consumer prices rose by 1 1/2 percent, but with the currency depreciation and higher administrated prices, the 12-month change in consumer prices reached 2 percent in July 1997.
Weak cyclical conditions led to a deficit of the general government of 3.6 percent of GDP in 1996. To shore up the public finances, substantial discretionary fiscal measures (estimated at about 1 1/2 percent of GDP) were adopted as part of the budget for 1997. These measures were expected by the authorities to reduce the general government deficit to 2 1/2 percent of GDP--safely under the Maastricht reference value. In the event, less favorable labor market developments and weaknesses in the tax system increased the deficit above budgeted levels. In July 1997, the Government, therefore, proposed a supplementary budget that sought to limit the fiscal deficit to 3.0 percent of GDP in 1997. The federal budget for 1998 was submitted to Parliament at the same time. On the basis of this budget and estimates for other levels of government and the social security funds, the authorities projected a general government deficit of 2 1/2 percent of GDP in 1998.
Monetary conditions eased during 1996 and have eased further thus far in 1997. In April 1996, the Bundesbank lowered its discount and Lombard rates to historical lows of 2 1/2 percent and 4 1/2 percent, respectively. In August 1996, the repurchase rate was reduced to 3.0 percent where it has since remained. Long-term interest rates have also fallen; the yield on 10-year bonds was 5.6 percent in July 1997 compared with 6.5 percent in July 1996. Broad money (M3) grew by 7.9 percent at end 1996 (compared with the fourth quarter of 1995), exceeding the upper limit of its (4-7 percent) target range. In December 1996, the Bundesbank broke with tradition and set a two-year M3 growth target of 5 percent with a 3 1/2 - 6 1/2 percent range for 1997. The move was motivated by a desire to reassure financial markets by providing a stable reference point during the run up to stage three of EMU. The annualized (seasonally adjusted) rate of M3 growth in July 1997 was 5.7 percent (compared with the fourth quarter of 1996), well below the upper limit of its target range.
From December 1995 to July 1997, the deutsche mark depreciated by about 8 percent in nominal effective terms (by 29 percent against the U.S. dollar) and 10 percent in real effective terms. Nonetheless, the real effective exchange rate (in terms of unit labor costs) remained above its pre-unification level (by about 10 percent). With weak domestic demand and an improvement in cost competitiveness, the current account deficit narrowed from 1.0 percent of GDP in 1995 to 0.6 percent in 1996. The trade surplus in the first half of 1997 increased to DM 58.0 billion from DM 42.5 billion during the same period of 1996. The current account deficit in the first half of 1997 narrowed to DM 4.8 billion from DM 6.3 billion during the first half of 1996.
Executive Board Assessment
Executive Directors welcomed the increasing signs of recovery, but expressed concern about its unbalanced character: a high reliance on export growth, with weak domestic demand. The correction of the real exchange rate and the growth of foreign demand had boosted exports, strengthened manufacturing activity, and improved the investment climate, but entrenched structural weaknesses, especially in the labor market, had contributed to lower employment, stagnant domestic demand, and increases in the unemployment rate to historically high levels, and had undermined efforts at fiscal consolidation. In that regard, some Directors observed that the serious structural rigidities had contributed to progressively less vigorous cyclical recoveries--especially with respect to employment--over the past three decades. Directors emphasized that to achieve a more balanced and sustainable expansion and to make a credible attack on the unemployment problem, the authorities should press ahead with rigorous structural reforms--most importantly in the labor market, the tax system, and the social security system--together with a mix of fiscal and monetary policies compatible with the government's commitment to EMU.
Despite considerable up-front fiscal adjustment measures prompted in part by the requirements for Stage 3 of EMU, Directors noted that cyclical conditions and structural weaknesses had combined to hinder the efforts to reduce the general government deficit decisively below the 3 percent of GDP Maastricht reference value in 1997. Indeed, because of the weakness of domestic demand and employment, several Directors thought that there was a risk that the deficit would exceed the Maastricht limit; but the margin was likely to be small and, in those circumstances, a number of Directors thought that the authorities should eschew ad hoc fiscal measures aimed solely at meeting the Maastricht reference value in 1997 in favor of a more resolute medium-term fiscal retrenchment program. The latter was seen by several Directors as more important to the success of EMU than the precise deficit number for 1997, and they favored in that context a small margin of flexibility in interpreting the Maastricht deficit criterion. However, some other Directors were of the view that the criterion should be adhered to strictly, taking into account the possible negative effects of a change in the announced policy.
As regards 1998, however, Directors thought that the government should aim at more ambitious fiscal adjustment than currently envisaged, especially as the government projections were predicated on the recovery being firmly established. More substantial fiscal consolidation was needed to make credible progress toward the government's medium-term fiscal objectives, and thus to provide some headroom for both tax reform and the operation of automatic stabilizers within constraints set by the Stability and Growth Pact.
On the medium-term fiscal strategy, Directors supported the authorities' focus on decreasing the size of government and reducing the deficit to pre-unification levels. Many Directors were of the view that the currently-proposed broad-based expenditure restraint would not suffice to achieve the government's medium-term deficit targets, and that cuts in specific programs and entitlements would be required. Most Directors regarded income tax reform and pension reform as critical to the overall strategy. They encouraged the authorities to pursue efforts to lower marginal income tax rates, to broaden the tax base, and to reduce tax distortions by closing loopholes. On pension reform, Directors thought that the current proposal would go some way toward preparing for the fiscal burdens of an aging population and would slow the rise in pension contribution rates. Some Directors, however, were of the view that demographic trends would require additional reductions in benefits in the future. They argued that a bolder approach, including possibly a larger role for private pension plans and some pre-funding under the current system, warranted further consideration.
Directors noted that the past year had witnessed a welcome easing of monetary conditions: despite the depreciation of the deutsche mark, a low inflation environment had facilitated the substantial fall in German long-term interest rates. The depreciation and lower interest rates together were viewed by most Directors as having established monetary conditions that were appropriately supportive of the recovery. Looking forward, inflation prospects were favorable and fiscal retrenchment was set to continue, both in Germany and across the countries in the ERM. In those circumstances, most Directors believed that the current stance of monetary policy was appropriate, and did not see a case for any tightening of monetary conditions until the economic expansion was well established. Indeed, some Directors argued that there would be grounds for a further easing if the recovery were to falter. However, a number of other Directors advised caution regarding further easing, pointing to the recent uptick in some price indices and the depreciation of the deutsche mark. Directors generally welcomed the recent shift by the Bundesbank to a two-year monetary target as being consistent with the need to provide clear signals to market participants and the monetary institutions of initial participants in EMU. Directors also noted that the Bundesbank had a central role in guiding the transition to EMU. Therefore, Bundesbank monetary policy would need to reflect broader EMU-wide objectives: future price stability in Europe, a sound euro, and an ECB that would be seen as credibly committed to those objectives from its inception.
Directors emphasized that unemployment remained Germany's most pressing problem. Five years of falling employment and an unemployment rate that was at a postwar peak reflected structural rigidities that had reduced the competitiveness of German labor. Signs of more flexible work rules and wage moderation were welcomed, as was the progress under the government's program of structural reform, the 50-Point Program. However, Directors thought that the severity of the unemployment problem required a comprehensive reshaping of the social benefit system and of labor market regulations, including steps to cut the tax wedge on labor incomes, lower reservation wages, reduce unemployment traps, and improve job-search incentives. It was thought that structural reforms in product markets and financial markets would also help to improve Germany's job-creation potential over the medium term.
Directors observed that, despite massive fiscal transfers and tax-induced investment flows, the economic convergence process in the new Länder had slowed substantially. The relatively high cost of labor in the east had discouraged private sector investment and employment. The new initiatives to restart the convergence process by moderating wage increases and focusing support programs were therefore welcomed by many Directors, but most thought that, without a credible phasing out of special support programs and measures to facilitate greater interregional wage dispersion, the integration process would be lengthy and would entail a large fiscal burden for some time to come.
Directors commended the authorities for increasing development assistance in 1996.
