Transcript of a Conference Call on Germany Article IV ConsultationSubir Lall, IMF Mission Chief to Germany
Fabian Bornhorst, IMF Desk Economist for Germany
Conny Lotze, Division Chief, IMF Media Relations
Tuesday, July 3, 2012
MS. LOTZE: Good morning, everyone, and good afternoon if you’re calling in from Europe. We are doing this conference call on Article IV Consultation and the release of the report. We’re going to start with some brief introductory remarks by the Mission Chief, Subir Lall, and we also have here the Desk Economist, Fabian Bornhorst to answer your questions. Mr. Lall, please.
MR. LALL: Thank you very much and good morning to all of you on this conference call. I will begin by making very brief introductory remarks before we take questions from you. But before I start, let me point out that this conference call is to discuss the Article IV Consultation report for Germany, which will be released in about an hour. We’re not talking about the broader euro area for which there will be a subsequent event later this month.
Let me start with a few remarks on the outlook. The performance of the German economy has been remarkable so far despite a very difficult external environment. Employment creation has been strong and unemployment has declined to post-reunification lows. So we see several conditions now in place for a domestic demand-led recovery in Germany, and this is because household and corporate balance sheets are healthy, wages are higher, and borrowing costs from banks are low.
That being said, there are several risks to the recovery, and we should be mindful of these risks. The two most important ones that I would like to highlight are coming from a potentially strong intensification of the euro area crisis, all from slowing global growth. Now these are not in our baseline outlook, but should any of these risks or both these risks materialize, then the outlook for Germany and for German growth would be lower than what we have in the baseline. Germany is, after all, one of the world’s most open large economies, and its fortunes are tied very closely to what happens outside its borders.
Coming very briefly to policies and policy recommendations, we think that the fiscal policy stance in Germany is appropriate at the current juncture. And given the rebound in activity, we are projecting the receive/output gap is closing this year. Any available fiscal room, therefore, should be deployed very carefully. At the same time the financial sector reform agenda is unfinished, and although significant progress has been made since the 2011 FSAP, the Financial Sector Assessment Program of the IMF, more work needs to be done.
Turning to the medium term, Germany faces a couple of challenges that should be addressed. This is a very good time to embark on structural reforms to address the problem of maintaining potential growth and, in fact, to raise potential growth above its current level and to diversify its sources. The main elements of the structural reform agenda should include increasing labor force participation; stepping up investment, especially in areas outside of Germany’s traditional strengths; and raising productivity. Broadening the channels of financial intermediation in particular may help in stepping up investment in new and emerging areas of growth and new engines of growth beyond traditional manufacturing and in areas more oriented towards the domestic economy.
With those remarks, we will be happy to take your questions. Thank you.
QUESTIONER: I have two questions concerning your analysis. The first question is you say on the one hand that the fiscal stance is appropriate and on the other hand you say any fiscal space should be used carefully. Can you comment a little bit further on that, specifically a space and how should it be used?
And my second question concerns this last idea you mentioned in the report as though broadening the channels of financial intermediation. Could you clear up a little bit what you mean by that? Thanks.
MR. LALL: Thank you. What we mean by the fiscal stances appropriate is that under Germany’s debt brake rule, at the moment the fiscal space is relatively small, the room for additional fiscal measures. And from a macroeconomic perspective, we don’t see the need to deploy any such measures. So what we are essentially arguing against is any fiscal stimulus for Germany at this point.
I also should underscore that our analysis, as you can see in the report, shows that a fiscal expansion in Germany would have very small spillover effects to the rest of Europe. However, we do caution that should any of the downside risks materialize and the outlook for growth or employment worsens significantly, then the authorities should be prepared to consider other fiscal measures. But in the baseline, we think that the fiscal stance contained in this year’s budget is appropriate and in line with the cyclical conditions facing Germany.
On the second point on broadening the channels of financial intermediation, Germany is one of the countries that is most heavily reliant on what we call a relationship-based lending system, which is often called more a bank-based lending system because a banks’ business model are usually based on having a relationship with their clients. This system has been in place for a very long period of time and has served Germany extremely well. In general, bank-based systems have performed well in manufacturing-based economies, and certainly Germany is one of the world’s leading manufacturing economies.
However, if we want to look beyond manufacturing—and I’ll refer back to my earlier remarks on additional engines of growth in new and untested areas, for example, where the technology may be unproven or it is unclear whether a certain sector will emerge or not—what we call more arms-length financial systems, which loosely can be interpreted as more market-based systems—can help provide a complement to the bank-based system.
So what we think is that in the financial system there could be an additional channel, not a substitute, but a complement to existing channels of financial intermediation. These arms-length systems are better able to invest risk capital and if Germany were to expand in new and unproven areas worldwide and seek growth opportunities there, an arms-length system may be better able to provide the financing for such projects. As an example, I would think venture capital, risk capital or financing in bond markets—those are the kinds of things that lend themselves well to the pooling of risk. Of course, these have to be accompanied by appropriate measures to maintain financial stability, including supervision regulation. But to have an additional channel of intermediation may help spur growth in new areas.
QUESTIONER: I just wondered if you could sort of explore a little bit more the idea of rebalancing and how domestic demand increasing in Germany can help the rest of the euro zone. I mean, it obviously cannot sort of initiate—but it’s very unlikely that Germany would be willing to make great sacrifices to help the rest of the euro zone rebalance.
And secondly, I just wondered if there was any sort of more short-term thing you can say about how things have changed since you were in Germany, doing the work on this Article IV Consultation back in May? I mean, what we see in indicators in a very short space of time the economic outlook has deteriorated. It would have been sharply, but Germany and for the rest of the euro zone, and I was just wondering about any of your thoughts at the moment. Thank you.
MR. LALL: Thank you. On your first question, on rebalancing, as I mentioned, several of the elements are in place for this rebalancing. And what we mean by that is going back to the labor markets, employment is strong, unemployment is low, wages are rising, so that bodes well for more domestically oriented growth. We’ve already seen some of that in the first quarter where Germany has an astonishingly strong performance. I guess the main question is whether this can be sustained. And, of course, Germany is subject to external shocks, but part of the rebalancing will happen, we think, through these natural sources with prices and wages adjusting and so also helping boost imports. That will go to some extent with rebalancing within the euro area. Clearly, the rebalancing has to be seen in a more global context, and it’s not a bilateral context between Germany and the rest of the euro area, but this is certainly a very helpful element of that.
Now in line with that, what we see in the report is also that with these inflationary pressures insipient in some of the periphery countries and monetary policy set at the euro area-wide level, it is possible that inflation in Germany may be somewhat higher than the euro area average, and this would be again completely part of the normal rebalancing process.
On your second question on how things have changed. In fact, we wrapped up our work in Germany about a month ago or actually more than that, but since then developments have been well in line with what we had anticipated in using our own in-house, high-frequency monitoring and our model. So we expect, for instance, second-quarter developments to be broadly in line with more work we’ve already built into our projections. And we have, in fact, built in obviously a second quarter not as strong as the first quarter. So it doesn’t make us change our baseline assessment at the moment, and what you’re seeing is essentially factored into our forecast. Thanks.
QUESTIONER: My question is about the growth outlook for the second half of this year. You are saying in the report that Germany is going to reach its potential growth rate in the second half of this year. What is this growth rate, and what is going to change for the second half of this year under your projections from the first half of this year?
MR. LALL: Yes, in our potential growth rate for Germany over the longer term, the annual growth rate projection is 1.25 percent. So on a quarterly basis, we expect in the second half growth to be about 0.2 percent each quarter. Remember it was 0.5 percent in the first quarter of this year. And in the second quarter we expect growth to be positive, but not as much, and then picking up pace for the remainder of the year. So we expect it to be around 0.1 percent in the second quarter, and then picking up to 0.2 percent or so—between 0.2 and 0.3—in which on an annualized basis gets you to the potential growth rate of Germany of 1.25. Thanks.
QUESTIONER: Good morning. I’m wondering whether you could just spell out some of the ways in which Germany could spur domestic demands as you suggest it should.
MR. LALL: Okay, thank you. There are two elements to this. One is, of course, the natural process that I talked about earlier. With incomes rising and with healthy balance sheets, you should expect naturally domestic demand to pick up especially driven by consumption and hopefully also by investment, keeping in mind, of course, that investment is also affected by sentiment and the outlook for the rest of the world. Now, so the policy advice there is essentially benign neglect of these developments and letting this natural process take place and not to get concerned by what we expect would be increases in income and wages and somewhat higher prices.
Now over the medium term, a doable increase in domestic demand requires a reorienting of the economy away from exports so there is more balanced growth, and that will require structural reforms on a number of fronts. Let me just pick one of them, which I mentioned earlier, which is increasing labor force participation.
Now naturally, if those reforms take hold, that would increase the domestic consumer base. And with the incomes associated with that, you should expect a permanent increase in domestic demand coming from that. Similarly, if new areas of growth take hold, then you should expect a doable in investment as well. So that’s what we have in mind. So there are two elements: One is a cyclical element, which is natural, and then there is the one over the medium term, which would have to be driven by policy reforms. And as I said earlier, this would be a very good time to make progress on other reforms, given that the macroeconomic environment for Germany at the moment is quite supportive. It is in many ways easier to implement these reforms right now given the cyclical position of the economy. Thanks.
QUESTIONER: I would like to ask again, can you tell us a little bit about how is the progress on these financial sector reforms because going through the report, it seems that you are not too satisfied with what Germany’s doing right now. And what are the main issues which should be addressed, and how would that affect maybe the credit development in Germany?
MR. LALL: Let me begin by saying that a lot of progress has been made on the financial sector. Clearly, German banks are generally meeting regulatory capital requirements. Liquidity is ample. Lending rates are low. You’re not seeing a huge pickup in credit growth, but it is our analysis that this is really given by low demand for credit rather than a restriction in the supply of credit. So from that point of view, the financial sector is in relatively good shape. That being said, German banks obviously have large exposures outside of Germany, and so it does make the banking system as a whole more vulnerable to developments elsewhere.
On the reforms, one of the things that we emphasized this year, more progress could be done on reform of the Landesbanken. Now, we understand that this is a complex issue, but one of the vulnerabilities in the banking system that we’ve identified is the large reliance on wholesale funding, for example, given we’ve seen in the past in the global crisis of 2008-2009 how vulnerabilities to wholesale financing can be a problem. So in that context if you look at the Landesbanken, their business model is not entirely clear, and they need to come up with a new business model. Historically, they had an important role to perform, but that role is less clear right now. And then that is one area where more could be done, to find a role for them in the broader competitive landscape.
In addition, of course, there are efforts underway in the broader European Union to set up a macro-prudential framework. There I would highlight that Germany is doing very well in terms of the initiatives and the steps being taken to establish a Financial Stability Commission. We expect that to be in place by the deadline set euro area-wide of end of June next year.
So I would underscore again progress has been done, but more could be done. A couple of other things on the banking system, leverage ratios remain high and the quality of bank capital could be strengthened. So these are all areas that could benefit from more progress right now.
QUESTIONER: Just a short follow-up, when you say leverage ratios remain high and quality could be strengthened, and you mentioned this dependency on wholesale financing, these are issues you seem to be --beside the Landesbanken, you could see with private banks as well?
MR. LALL: This is true in general for the banking system as a whole outside of the Sparkassen sector. And so clearly it is not just about the Landesbanken, these three points.
MS. LOTZE: Thank you very much for participating in this conference call. We’ll conclude here. Thank you very much.
MR. LALL: Thank you.