Mission Concluding Statement 

Germany: Staff Concluding Statement of the 2018 Article IV Mission

May 14, 2018

Germany’s economic performance is impressive, supported by prudent economic management and past structural reforms. Growth is robust. The unemployment rate has fallen to levels not seen in decades and employment is rising. Household and corporate balance sheets are strong and the public debt ratio is declining rapidly. Inflation remains low but wage growth is picking up, reflecting the strength of the labor market. Looking beyond these positive cyclical developments and in an environment of unfavorable demographics, boosting productivity growth and investment would raise the long-term growth potential and reduce the persistently large current account surplus. The new government’s coalition agreement contains several welcome measures which will continue to address some of these challenges. Yet, the current favorable economic environment provides an opportunity for the new government to take more forceful policy actions.

Key policy recommendations

• Use the ample available space within the fiscal rules to enhance the growth potential of the economy by further increasing public investment in physical and human capital and fostering labor supply.

• Reinvigorate competition-enhancing reforms in network industries and professional services and enhance the environment for entrepreneurship and venture capital. This would help boost productivity growth and further spur private domestic investment.

• Consider pension and labor market reforms to lengthen working lives, which would increase labor force participation of older workers, reduce aging-related fiscal pressures, mitigate the need for workers to save as much for retirement, and lower risks of old-age poverty.

• Complete the toolkit for managing financial stability risks and urgently address data gaps. For banks and insurance companies, continued supervisory attention to interest rate risk and restructuring plans remains appropriate.

The German economy is performing well. Real GDP growth accelerated in 2017 as exports rebounded and investment picked up after a prolonged soft patch. The short-term outlook is for continued robust growth, on the back of solid consumption, rising investment, and dynamic exports. Looking ahead, growth is expected to revert toward its long-term potential, which is limited by Germany’s unfavorable demographics and still-low productivity growth. Headline and core inflation, which are still low, are expected to pick up, reflecting tight market conditions. But there are risks on the horizon: a rise in protectionism, geopolitical uncertainty, or a stalled reform agenda in the euro area may negatively affect export prospects, weigh on investment, and rekindle financial stress.

The unemployment rate has reached post-reunification lows, resulting in a welcome rise in wage growth . Recent negotiated agreements suggest somewhat higher wage increases than in past years, consistent with the tight labor market. Despite continuing immigration and good progress in integrating refugees in the labor market, workforce shortages, including in construction, IT and the care sectors, are expected to put added pressure on wages and prices in the coming years. Further rises in wage and price inflation—reflecting Germany’s strong cyclical position—would help lift inflation in the euro area and facilitate the normalization of monetary policy, and the authorities could usefully emphasize this in their public communications, while respecting the autonomy of the social partners.

Continued higher wage growth would help reduce Germany’s large current account surplus, but the adjustment will be limited without further policy action . The current account surplus remained very high in 2017, at 8 percent of GDP, reflecting positive net savings by households, non-financial corporations, and the general government. Based on current policies and higher projected demand in trading partners, the current account surplus is expected to remain high, especially in the near term, before declining by ½ to 1 percent of GDP by 2023. As discussed below, policies that foster domestic investment and reduce incentives for precautionary savings would contribute to external rebalancing.

Germany’s fiscal position strengthened further in 2017 and the public debt ratio is rapidly declining . The general government surplus rose to 1.3 percent of GDP—its highest level since reunification—on the back of favorable cyclical tax revenues and a declining interest bill. Public investment increased by about 5 percent in nominal terms or 0.1 percentage point of GDP. Take-up of the Municipal Investment Fund has improved and Partnerschaft Deutschland (PD) is providing advisory services for an increasing number of investment projects, which are welcome developments. But capacity constraints are arising at PD itself, pointing to the need to further strengthen planning capacity at the municipal level. In 2018, fiscal policy at the general government level is expected to be mildly expansionary, reflecting already-budgeted increases in spending on health and families, as well as a moderate increase in public investment. The impact of the measures outlined in the new government’s coalition agreement is expected to be marginal in 2018, but to lead to a moderate fiscal stimulus in the following years. Even taking into account these measures, we estimate that the public debt ratio will decline to well below 50 percent of GDP by 2023 and that Germany will preserve substantial fiscal space within the European rules.

The positive near-term economic outlook provides an opportunity for Germany to more forcefully address its long-term challenges and prepare for the future . Germany’s demographic outlook remains unfavorable and the labor force is expected to begin shrinking already in 2020 even after accounting for immigration. Productivity growth has been lackluster, especially in the service sector, and investment growth has been low. Recent studies suggest that a large share of German jobs is vulnerable to skill-based technological change. At the same time, Germany’s high labor tax wedge creates disincentives to work and, while female labor force participation is relatively high, about half of women work only part-time. Taken together, these factors weigh on long-term growth.

The new government’s coalition agreement contains several welcome measures to support long-term growth while also addressing poverty risk among some groups . The planned expansion of high-speed internet and the 5G network to improve digital infrastructure should boost productivity growth and enhance returns to domestic investment. The phasing out of the solidarity tax surcharges for low- and middle-income households would reduce the labor tax wedge moderately. Plans to invest in all-day childcare and all-day schooling would make it easier for women to work full-time. Initiatives to continue and expand housing and training for refugees would help them integrate into the labor force. The agreement also provides additional modest support and incentives for schools, vocational training, and R&D activities. These are important steps to prepare Germany for the future. Some of the targeted social benefit increases—such as the supplementary allowance to combat child poverty and additional support for the long-term unemployed—would help reduce poverty risks.

But, further policy action is needed to more decisively boost domestic investment, which would also support external rebalancing . Measures to increase public investment, labor supply, and productivity growth would lift long-term growth directly, through higher inputs, and indirectly, by improving the environment for private investment.

• The still sizable fiscal space should be used to raise public investment which requires alleviating bottlenecks at the municipal level (including actively promoting PD’s services to municipalities where public investment has been delayed the most and addressing staffing shortages); further expand childcare and after-school programs (to provide greater opportunities for women to pursue full-time employment); further reduce the labor tax wedge (to reduce disincentives to work); and provide additional funding for primary education and life-long learning (to enhance skills in today’s and tomorrow’s workforce). To accelerate investment in transport, the Federal Transport Agency should be operationalized without delay.

• Investing in digital infrastructure is essential, and the new government’s plans in this area are welcome and should be implemented without delay. Expanding the nationwide fiber optic network will be crucial to ensuring that Germany is well positioned to take advantage of productivity-improving technologies. Completing Germany’s digital transformation will require additional investment and the government should ensure that incentives, regulations, and funding availability are appropriately supportive.

• Fostering entrepreneurship and venture capital can increase productivity growth and investment. Improving access to venture capital, especially at growth stages for new companies, can make it easier to pursue entrepreneurial activities. Moreover, venture capital can support investment in intangible assets. Initiatives to simplify tax administration and provide tax incentives for R&D to small- and medium-size enterprises are steps in the right direction. Expanding e-government services would further reduce administrative burdens.

• Introducing greater competition in product markets, notably in network industries and professional services, would raise productivity growth and promote private investment. Progress in this area has been limited and should be accelerated.

• Pension and labor market reforms that make it more attractive to extend working lives would reduce the need to save, lower the public pension bill, and raise growth. Future pension replacement rates could thus be sustained at levels consistent with a reduced risk of old-age poverty with less budgetary support. Improving the transparency of future pension payouts at the household or individual level would reduce uncertainty about future pension income and could help reduce household precautionary savings.

House prices remain in line with fundamentals at the aggregate level but appear overvalued in some major cities. Given recent immigration, rising incomes, and the low interest rate environment amid supply constraints, some growth in house prices is to be expected. However, in some large cities, house price growth seems stronger than warranted by these fundamentals. The government has committed funds to increase social housing. However, additional measures are needed to expand supply, including reconsidering zoning restrictions or reducing the effective tax burden on new construction.

Given rapidly rising house prices in some cities, addressing data gaps and completing the macroprudential toolkit are increasingly urgent. Although the increase in house prices is not accompanied by rapid credit growth or a significant easing of credit standards at the aggregate level, the lack of granular data prevents a full assessment of developments—a deficiency which must be addressed. The creation of macroprudential tools focused on real estate—loan-to-value (LTV) and amortization requirements—in 2017 was a welcome step. However, these tools should be complemented with income-based instruments. Taken together, the rapid increase in house prices in some hot spots alongside data gaps and an incomplete macroprudential toolkit suggest that consideration should be given to early implementation of supervisory measures, including LTV caps or amortization requirements, to help preserve financial stability.

The German banking and life insurance sectors should accelerate their restructuring to bolster profitability and reduce risks. In the banking sector, the regulatory capital ratio has increased, but the cost-to-income ratio and leverage remain high. The high cost structure, alongside low net interest margins, provisions for compliance violations, and the need to adjust to the new regulatory environment, continue to weigh on profitability. Restructuring is ongoing in the banking sector, but the process must be accelerated through faster implementation of restructuring plans, continued development of fee-based income, and further consolidation. In the life insurance sector, low interest rates have dented solvency ratios, and further progress is needed to reduce reliance on guaranteed return products. In this context, supervisory attention to interest rate risk and progress in implementing restructuring plans both in banking and insurance should continue.

The mission thanks the authorities for their hospitality, cooperation and willingness to engage in extensive and frank policy discussions.