May 17, 2019
A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.
Germany’s economic fundamentals are sound, public and private balance sheets are healthy, unemployment is at a historical low, wages have finally accelerated, and the large current account surplus is slowly shrinking. However, a slowdown in global demand and other temporary setbacks hit the economy unexpectedly hard in the second half of last year, highlighting its vulnerability to external shocks, notably growing international trade tensions. From a longer-term perspective, Germany’s population is aging and its technological edge is being challenged, while lower incomes have remained stagnant and the energy transition is progressing only slowly. With euro area inflation still below the European Central Bank’s objective, long-term interest rates have fallen back near or below zero, putting additional pressure on banks and life insurance companies. Against this background, the team’s key policy recommendations are:
- Continue to use the space within the fiscal rules to bolster long-term growth and help rebalance the economy. Priorities include lowering the burden of taxation on low-income households further while also reducing disincentives to work for secondary earners; expanding Research & Development credits for companies to speed up innovation; and continuing to invest in public infrastructure.
- Facilitate the upgrading of the digital infrastructure, push ahead with the e-government project to reduce the bureaucratic burden of doing business, and reduce uncertainty related to the energy transition.
- Encourage the banking sector to accelerate restructuring plans to bolster profitability and reduce risks. The life insurance sector should continue its adjustment to the low interest rate environment to improve resilience.
- Activate macroprudential instruments to enhance banking sector resilience and guard against imbalances in the real estate sector. Urgently address data gaps to allow for a fuller assessment of financial stability risks.
Context and key challenges
1. Economic performance has been strong over the last decade, but its benefits have been unevenly shared. The sharp decline in structural unemployment has been an important success. However, as wage growth lagged behind, lower incomes stagnated, and a rising share of national income took the form of savings inside the corporate sector, particularly in family-owned and -managed firms. These trends, together with fiscal consolidation after 2011, fueled the rise in the current account surplus, which peaked at 8.5 percent of GDP in 2015.
2. More recently, imbalances started to slowly unwind as unemployment reached a post-reunification low. With the tight labor market, wage growth picked up, and the labor share in national income began to recover. The introduction of the national minimum wage in 2015 also bolstered wages for unskilled workers. The current account surplus began shrinking gradually and reached 7.3 percent of GDP in 2018.
3. The short-term outlook is still good, but the long expansion could come to a halt if the current slowdown is compounded by new shocks. Real GDP growth slowed sharply in the second half of 2018, reflecting a mixture of weak external demand and special circumstances, notably the slow rollout of new emission tests for cars. But the underlying momentum of domestic demand is still robust, driven by low unemployment, solid wage increases and investment, and supportive fiscal policy. We expect a gradual increase in output growth by the end of 2019 as external trade recovers. However, risks are significant, including further escalation of trade tensions, a more pronounced China slowdown, a disorderly Brexit, and renewed stress in the euro area.
4. Continued strong wage growth is key for the economy to continue to rebalance. Though the external surplus has come down from its peak, it remains well above the level consistent with fundamentals and is expected to remain so in the medium term. This contributes to global imbalances at a time when trade tensions threaten Germany’s export-dependent economy. Faster wage growth, which would be consistent with the very tight labor market, could help accelerate real exchange rate appreciation and speed up external rebalancing, while also ensuring that the benefits of growth are widely shared.
5. Unfavorable demographics, weak productivity growth, and the challenges of the energy transition will continue to weigh on long-term growth potential. Against the backdrop of a rapidly aging population, and on the heels of a long economic expansion, reported labor shortages are widespread. A new immigration law, which aims to attract skilled labor from outside of the European Union, could provide some relief. And there are still margins to expand domestic labor supply through increased participation by older workers, mothers, and refugees, but the aging labor force is expected to decline in the medium run. As in other advanced countries, Germany’s labor productivity growth has been declining over the last two decades. The decline is broad-based, including in the manufacturing sector, reflecting in part limited capital deepening. On the energy front, Germany is on track to meet its renewable energy target. But building the necessary internal electricity transmission capacity remains a challenge. At the same time, there is still uncertainty about how the ambitious goals to cut greenhouse gas emissions will be met.
6. Limited access to high-speed internet and obstacles for startups—especially at the growth stage—contribute to slow productivity growth and may erode Germany’s technological edge. Relatively low high-speed internet coverage prevents Germany from taking full advantage of the digital transformation. Only 2.5 percent of broad-band connections in Germany are fiber optic, more than 20 percentage points below the OECD average. Germany’s venture capital investment as a share of GDP was only 60 percent of the EU average in 2017.
7. Fiscal policy is set to turn expansionary in 2019. After recording the largest surplus since reunification (1.7 percent of GDP) last year, the 2019 budget includes a welcome increase in family support and further resources for needed public investment (which grew by almost 8 percent in nominal terms in 2018), as well as income tax relief in the form of a higher basic tax allowance and correction of bracket creep. The fiscal expansion measures amount to around 2/3 of a percent of GDP.
8. Beyond 2019, remaining space under the fiscal rules should be used to strengthen the economy’s growth potential. Including all of this year’s budget measures as well as additional measures in the coalition agreement, Germany’s fiscal position is expected to remain well within the limits imposed by the national and European fiscal rules, while the public debt ratio will continue to decline rapidly. These budgetary resources should be deployed from 2020 onwards to strengthen the economy by promoting innovation, expanding labor supply to counter population aging, and continuing to fill infrastructure gaps.
9. There is scope to reform the tax system to make it more growth friendly and inclusive. Additional tax relief for low-income households would, alongside continued wage growth, boost their disposable income and consumption, supporting rebalancing. In addition, reducing the high effective marginal tax rate for secondary earners could help promote full-time female labor force participation. Further expanding childcare and after-school programs would also be important in this regard. Budgetary room for these plans, if needed, could be created by reforming property and inheritance taxes.
10. Incentivizing targeted business investment would also help long-term growth. A generous R&D tax credit would support innovation and generate positive growth spillovers. The government’s new proposal of tax credits for R&D is welcome, but the total envelope could be usefully expanded. In the face of changes in the global international tax environment, Germany should maintain its position of leadership in implementing anti-tax avoidance measures and preserve the competitive corporate tax system while not engaging in damaging tax competition. There are, however, adjustments to various provisions—notably regarding controlled foreign corporations—which could be beneficial. Looking ahead, the minimum tax proposed by Germany and France is very welcome, but its modalities need to be developed further.
11. Raising investment in education and life-long learning can expand the quantity and quality of labor. Addressing teacher shortages—in vocational education, training, and primary education—is urgent. In addition, the education system needs to ensure that workers acquire the skills to adapt to rapid technological change. The integration of refugees is gaining momentum. Yet, continuing support to help refugees improve German language proficiency and gain experience in German labor market norms, as well as making selected qualifications transferrable could accelerate integration.
12. Continuing to address infrastructure gaps, particularly at the local government level (Länder and municipalities), will require rebuilding planning capacity and better coordination across levels of government. In the past, local governments prioritized fiscal consolidation at the expense of investment. More recently, budget surpluses have alleviated financial constraints in most localities, but capacity constraints and price pressures in the construction industry have emerged as new obstacles. Now is a good time for local governments to rebuild planning capacity. The ongoing reform of the federal fiscal relations and direct budget support from the federal government (for instance, through the Municipal Investment Promotion Fund and Digital Infrastructure Fund), as well as technical expertise (through Partnerschaft Deutschland) are steps in the right direction, but stronger coordination across various government levels is needed to ensure that larger and longer-term projects get under way.
13. Initiatives to upgrade the digital infrastructure should be strengthened. The budget allocation of up to EUR 12 billion and the strategy to support a nationwide high-performance network through 2025 are welcome. However, progress in expanding the coverage of high-speed internet at the national level remains slow, possibly reflecting capacity constraints and insufficient incentives for private sector participation. Digitalization can also help reduce the administrative cost of doing business and improve the delivery of public services. The “National E-Government Strategy” should be implemented rapidly.
14. A more dynamic start-up environment can also raise productivity and growth. Investment in start-ups has been rising in recent years, also thanks to several government initiatives. But there is scope for further scaling up venture capital by attracting institutional investors and encouraging cross-border investment in the context of the EU-wide Capital Markets Union.
15. A clearer strategy for curbing greenhouse gas emissions would help reduce uncertainty about the energy transition. This should include measures to promote public transportation and sustainable mobility, as well as concrete plans to phase out coal-fired power production by 2038, as recommended by the Commission on Growth, Structural Change and Employment in January 2019 and decided by the government. The introduction of a carbon tax could be part of the solution.
16. Banks and life insurance companies should accelerate their restructuring to boost profitability and resilience. German banks appear to be well capitalized in risk-weighted terms and hold appropriate levels of liquidity, but profitability continues to be low in important parts of the banking sector while leverage is high among large banks compared to peers. Large banks tend to underperform European peers in market valuation, reflecting high costs and operating weakness, and in some cases provisions for compliance violations. The low interest rate environment puts pressure on already thin interest margins at small- and medium-sized banks. Restructuring must be accelerated in the banking sector through further consolidation, cost-cutting, and continued development of fee-based income. In the life insurance sector, low interest rates challenge the sector’s resilience, and the replacement of conventional guaranteed return products with other types of products needs to proceed faster. In this context, supervisors should continue monitoring interest rate risk and progress in implementing adjustment plans in both banking and insurance sectors.
17. Macro-financial vulnerabilities are building up. In recent years, low default rates have led to a substantial decline in risk provisions, and banks that rely on the internal ratings-based approach to calculate regulatory capital have reduced risk weights. Furthermore, there is evidence of various forms of “search-for-yield” behavior. Residential and commercial real estate (CRE) prices have continued to rise further. Although price increases have not been accompanied by strong credit growth at the aggregate level, the lack of granular data covering residential real estate loans hinders a full assessment of potential financial stability risks emanating from specific market segments and geographic locations.
18. To enhance resilience in the banking system and guard against potential imbalances in the real estate market, it is time to activate macroprudential instruments.
- Gradually raise the counter-cyclical capital buffer, which would enhance resilience in the banking system without materially altering credit supply.
- Urgently address data gaps to enable a fuller assessment of possible financial stability risks. The ongoing one-off bank survey on real estate lending and corporate credit underwriting standards is a step in the right direction, but regular collection of granular data is needed for effective macroprudential policy-making.
- Consider an early implementation of the existing borrower-based measures (cap on the loan-to-value ratio and amortization requirements) on residential mortgage lending to prevent the buildup of vulnerabilities in the residential real estate sector.
- Consider expanding the toolkit by introducing income-based instruments (e.g., cap on debt-service-to-income, cap on debt-to-income) residential loans and appropriate borrower-based measures for CRE loans.
Compliments of the IMF