The FINANCIAL — Germany’s open and innovative economy has been performing well, underpinned by prudent economic management, past structural reforms, and a well-developed social safety net.
Employment growth is strong, the unemployment rate is at a record low, growth is above potential, and the fiscal position keeps strengthening. However, despite high and rising capacity utilization and job vacancy rate, wage growth and core inflation so far remain subdued and business investment lacks momentum, while adverse demographics weigh on long-term growth prospects. The large and persistent current account surplus reflects high domestic savings and better investment opportunities abroad, as well as external factors. Germany should embrace a set of coordinated fiscal and structural policies to safeguard its strengths and address remaining challenges, including reducing external imbalances, according to IMF.
Key policy recommendations
The available fiscal space should be used for initiatives that enhance the growth potential, such as investment in physical and digital infrastructure, child care, refugee integration, and relief of the tax burden on labor.
Pension reforms that make it attractive to work longer would increase old-age income, boost potential output, improve the fiscal outlook, and reduce the need to save for retirement.
Productivity growth and business investment would benefit from a faster pace of competition-enhancing reforms in some network industries and professional services, as well as a continuing policy focus on innovation and the digital economy.
While disposable income inequality has been broadly stable, relative poverty risk merits continued attention. Anti-poverty policies should seek to preserve the achievements of past labor market reforms.
As housing prices accelerate, developments in the mortgage market warrant close monitoring, which will require addressing important data gaps.
The cyclical upswing is expected to continue in the near term. GDP growth firmed in 2016, driven by strong public and private consumption, as well as construction activity, while exports and investment in equipment were held back by weak external demand. In 2017, growth should remain stable as foreign demand is expected to strengthen and consumption to soften as higher commodity prices will curb real income growth. Economic immigration should continue to provide a significant contribution to employment growth. The inflow of asylum-seekers slowed down from its peak in 2016, and the refugees are gradually entering the labor force. Rapid house price increases should continue to bolster investment in construction. The risks to the outlook are balanced in the short term, but predominantly tilted to the downside in the longer run. Anti-globalization policies abroad could negatively affect long-term prospects for the very open German economy, while in the euro area, an insufficient progress in the reform agenda may rekindle stress.
The labor market continues to perform strongly. Following the Hartz reforms, labor force participation has been rising and unemployment falling, resulting in large gains in employment, also fed by immigration. The surge in labor supply triggered by the reforms initially reinforced pre-existing downward pressures on low wages, but did not result in an increase in labor income inequality because of its powerful positive effect on employment. In addition, both wage and labor earnings inequality have been broadly stable since 2010, as the labor market strengthened further and the level of the minimum wage proved sufficiently prudent not to significantly harm employment while providing a higher floor to hourly wages. However, average wage gains have been subdued, despite increasing signs of labor market tightness.
Looking forward, a sustained rise in wage and price inflation in Germany is needed to help lift inflation in the euro area and facilitate the normalization of monetary policy. Our baseline forecast envisages a gradual demand-driven rise in wage, core, and headline inflation, consistent with the tight labor market conditions. There is a risk, however, that, after a long period of moderation, wages will not respond sufficiently to these conditions. This would result in protracted low inflation in Germany and a slower-than-expected normalization of inflation and monetary conditions in the euro area. In this scenario, financial stability risks associated with ‘low for long’ interest rates would increase, and the rebalancing of competitiveness in the euro area would be delayed. To help ward off such risks, the authorities could usefully emphasize in their public communication the importance of robust wage and price growth in the current conjuncture, while respecting the autonomy of the social partners in wage setting.
External rebalancing would be facilitated by higher wage and price growth, but its pace would remain slow without policy action. In 2016 Germany’s current account surplus was the world’s largest in U.S. dollar terms, while its ratio to GDP edged down from 8.6 to 8.3 percent. The surplus is expected to narrow slowly over the medium term, as energy and other import prices recover, private investment strengthens, and wage growth supports both domestic demand and a realignment of external competitiveness. However, under current policies, the projected adjustment is limited – about 1 percent of GDP by 2022. Policies that boost public and private investment and reduce the need for private saving (such as through promoting longer working lives) would accelerate the necessary external rebalancing process.
The fiscal position continues to strengthen, and debt has fallen to 68.3 percent of GDP in 2016. The prudent management of the fiscal accounts has led to a protracted reduction in the debt-to-GDP ratio after the crisis. In 2016, the general government surplus climbed to 0.8 percent of GDP. Primary spending rose, including to provide for the refugees, but this was more than compensated by higher tax revenues from favorable labor market performance and buoyant corporate tax receipts, as well as a decline in the interest bill. Despite the moderate fiscal stimulus expected this year – with higher social spending, some income tax relief, and larger public investment – current fiscal plans still preserve a comfortable buffer above the European and national fiscal rules. We forecast this buffer to rise over the coming years.
Existing fiscal space should be used to raise Germany’s growth potential by encouraging investment, promoting labor supply, and boosting productivity. Policies to relieve the tax burden and increase growth-enhancing spending can complement each other. On the revenue side, there is space to reduce Germany’s large and increasing tax burden on labor with a view to support labor supply. On the expenditure side, overcoming barriers to expanding investment in public infrastructure remains important. The financial relief already extended by the federal government to the regions and municipalities is useful, but ongoing initiatives to overcome capacity constraints should be accelerated, including to rebuild staffing capacity (particularly at the local level) for the planning and administration of investment projects. The proposed Federal Infrastructure Corporation for Highways is welcome and should ensure a more stable and efficient framework for investment in transport infrastructure. In addition, as recommended in the past, policies to expand labor supply through an enhanced provision of childcare and after school programs, and to provide suitable vocational training to refugees, would be a good investment in Germany’s future, as are initiatives to foster digitalization and innovation.
To improve fiscal planning, a reexamination of revenue projection models should be undertaken. Tax revenue projections (especially for personal income taxes) have proven overly conservative over the post-crisis period, resulting in a tighter fiscal stance than originally intended. To some extent, the persistent bias is explained by an underestimation of employment growth in the official macroeconomic forecasts. A re-examination of both the macroeconomic relationships underlying revenue projections and estimated tax sensitivity to macroeconomic developments is warranted to enable more precise fiscal planning.
Pension reforms to prolong working lives would foster long-term fiscal sustainability while helping external rebalancing. If the fiscal space under the rules is fully used, and considering a wide range of realistic macroeconomic shocks, government debt would still decline rapidly with high probability. However, in the long term fiscal sustainability is challenged by rising aging costs. Further pension reforms that make it more attractive to extend working lives, as recommended in the past, would lower the pension bill and raise growth. By reducing the need for households to save, these reforms would also help lower external imbalances. The resulting sustainability gains would also facilitate some relaxation of fiscal targets in the medium and long term.
Despite a well-developed social safety net and strong employment gains in recent years, relative poverty risk warrants continued attention. Disposable income inequality (measured by the Gini coefficient) has remained broadly stable over the last decade and is near the European median. Nevertheless, there has been a slow secular rise of the at-risk-of-poverty rate. To address this problem, new social cohesion measures (described in the authorities’ Fifth Poverty and Wealth Report) were put in place, but it is too early to assess their impact. If poverty risk does not recede, a review of the targeting and effectiveness of some social benefits should be considered. Anti-poverty policies should seek to preserve the achievements of past labor market reforms. Measures to enhance labor force participation of women with children and facilitate the labor market integration of refugees would go in this direction.
Competition-enhancing reforms in some network industries and professional services should be accelerated. Since the last consultation, a new law (implementing a EU directive) was put in place to boost the efficiency of the railways sector and strengthen the power of the regulator. The law is a step in the right direction, but will have little effect on the long-distance passenger segment, where competition is currently lacking. No new competition-enhancing measures have been taken in postal services, where the incumbent retains a dominant positon. In both areas, the regulator should make maximum use of its powers to avoid discrimination against smaller competitors and new entrants. The government’s 2016 National Action Plan on access to and practice of regulated professions, produced in the context of a European Union initiative, contains only a limited number of policy measures, and some professions remain overregulated.
Measures to speed up digitalization and stimulate venture capital investment are welcome. Germany is an innovation leader in Europe. Digitalization in the business sector is moving forward, though the network infrastructure and a shortage of skilled labor are holding back progress. The average stock of capital per worker in information and communications technologies is low in international comparison, and Germany ranks only 25th in the world in average download speeds. The federal government is providing financial support to the deployment of fast broadband in remote areas, and launched an ambitious new public/private initiative to promote ultrafast internet. Last year’s Digital Networks Act will reduce the cost of rolling out optical fiber cables, while rules on competition and regulatory frameworks for business activities are being adapted to advances in digitalization. In addition, the government has implemented several initiatives under its “High-Tech Strategy” to promote innovation and foster venture capital investment, including the provision of grants, equity financing, and preferential tax treatment. These measures and financial commitments are welcome, and the current momentum should be sustained.
Housing prices remain in line with fundamentals at the aggregate level although some hot spots are developing as prices continue to accelerate. To help balance supply and demand and maintain affordability, the government adopted a package of measures including stepped-up sales of federally-owned land and properties below market price for affordable housing projects, more funds for social housing, and the promotion of building code harmonization. To significantly boost supply in the short term, these measures must be complemented by further encouragement for local authorities to relax zoning and height restrictions
New legislation introducing additional macroprudential instruments for the real estate market is a step in the right direction, but leaves the toolkit incomplete and important data gaps unaddressed. The new legislation will introduce loan-to-value ratios and amortization requirements, but will not include debt-to-income and debt-service-to-income ratios, which are important to limit borrower vulnerability to income and interest rate shocks. Most importantly, the new law does not grant supervisors the power to request access to loan-level data, a key pre-requisite for the effective implementation of these macroprudential instruments. To partially overcome data gaps, a regular (at least annual) survey could be conducted in the country’s hotspots to assess households’ leverage, loan affordability, and the concentration of bank exposure.
The German banking and life insurance sectors must accelerate their restructuring to shore up profitability and resilience. In the banking sector, while regulatory capital is generally comfortable, cost-to-income and leverage remain high, and restructuring efforts are ongoing. Low profitability reflects structural inefficiencies, persistent crisis legacy issues, provisions for compliance violations, and the need to adjust to the new regulatory environment. Lower and flatter yield curves are compounding these issues by gradually eroding margins, especially in smaller retail banks. In the life insurance sector, low interest rates hurt solvency ratios, and large duration gaps must be reduced through changes in investment strategy and less reliance on guaranteed return products. In this context, recent supervisory attention to interest risk both in banking and insurance is welcome. Bank supervisors closely monitor interest rate risk on the banking book via regular stress tests and simulations of several scenarios, including ‘low for long’, and have imposed additional capital requirements on the most exposed banks. In the life insurance sector, supervisors closely monitor companies where the share of guaranteed return products is high, the duration gap is large, and the reserves for unrealized gains on the asset side are low.
