UNCLAS SECTION 01 OF 04 FRANKFURT 008257

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STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA
STATE PASS FEDERAL RESERVE BOARD
STATE PASS NSC
TREASURY FOR DAS SOBEL
TREASURY ALSO FOR ICN COX, STUART
PARIS ALSO FOR OECD
TREASURY FOR OCC RUTLEDGE, MCMAHON

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: Economic Forecast for Germany: Waiting for a
Recovery Abroad to Spark Recovery, but Reform Debate Shows
Something Happening Domestically


T-IA-F-03-0052

This cable is sensitive but unclassified. Not/not for
Internet distribution.


1. (SBU) Summary: The German economy is expected, at
best, to stagnate in 2003. Since GDP declined by -0.3% in
the first half of the year compared to the previous half-
year, positive GDP growth in 2003 is no longer achievable.
Driven by improving net exports, German economy will pick up
in 2004, reaching seasonally-adjusted 1.3% GDP growth.
Domestic demand will increase only moderately, despite the
Government's big reform package. The key limiting factor for
domestic demand in Germany is lack of confidence by
consumers and producers. Germany will breach the Stability
Pact's 3% ceiling in both 2003 and 2004. An improvement of
the state's financial situation can be expected only in
2005, after economic recovery has gathered momentum and the
reform package begins to yield cost savings. While prospects
beyond the forecast horizon are not overwhelming, something
is stirring in Germany that might just signal the economy
is coming out of its three year hibernation.

Prospects for 2003/04: Waiting for Recovery Abroad
(again)!
-------------- --------------


2. (SBU) In 2003, the German economy is expected to
stagnate at best, given the seasonally-adjusted -0.3%
decline in GDP in the first half of the year, compared to
the last half of 2002. Driven by improving net exports,
German economy will pick up in 2004, reaching seasonally-
adjusted growth of 1.3% GDP. 2004 growth on a non-seasonally
adjusted basis is estimated at 1.8% due to four more working
days in the calendar year.

Bad Starting Point: Germany in Recession!
--------------


3. (SBU) Germany is now in a recession: German GDP fell in
the second quarter for the third time in a row, this time by

a real, seasonally and calendar adjusted -0.1% compared to
the first quarter.


4. (SBU) The decline of GDP was mainly due to a decrease
in exports (-2.3%), which was much stronger than the drop in
imports (-1.1%), causing a reduction of net exports. The
resulting negative contribution to economic growth (-0.5
percentage points) could not be completely compensated by
the positive growth contribution of domestic demand (+0.3
percentage points). The strong Euro against the US dollar,
the disruption of production in the automobile industry
triggered by strikes in East Germany and modest growth in
the world economy combined to dampen German exports. The
reduction of imports was a counter movement to the strong
increase at the beginning of the year due to rising oil
demand in view of the threatening Iraq war. The fall in
imports was mitigated by the strong Euro.

However, Indicators and Financial Markets are Encouraging
-------------- --------------


5. (SBU) The ZEW indicator, in an upward trend since
December 2002, recently recorded hefty increases and is
therefore well above its historical average. The more highly
regarded ifo index has also continued to increase, now for
the third month in a row. The development of both indicators
merely signals improving business expectations. The current
economic situation is still assessed as poor by the majority
of those interviewed. The German Economic Sentiment
Indicator, developed by the EU, shows a similar picture: its
trend line is a weak positive despite deterioration in July.
Increasing share prices on the German stock market reflect
the optimistic expectations as well -- within three months,
the DAX index increased by 16.6% and the TecDAX rose by
35.9%.

... Though Real Data is Disappointing,
--------------


6. (SBU) Favourable indicators are not yet backed by
fundamental data. Industrial production and industrial
orders decreased significantly in the second quarter of

2003. Nor are the improving July numbers meaningful, since
they mainly reflect compensating up ticks for the production
losses in June caused by strikes in East Germany.

... Confidence is Still Missing,
--------------


7. (SBU) The key problem for modest domestic demand in
Germany is still the lack of confidence, both for consumers
and producers.


8. (SBU) Consumer confidence increased initially in the
period after announcement of the government's plan to
advance the third step of the income tax reform. However,
after the summer holidays, as consumers heard more about the
government's plans to cut subsidies and tax privileges, the
health minister's decision to increase the financial burden
for the insured and to further increase pension
contributions, any glimmer of confidence has been destroyed.
Consumer uncertainty is reflected to some extent by
significant fluctuations in retail sales. It is not expected
that consumers will regain confidence in the near future so
long as unemployment remains high and uncertainty persists
regarding changes in the existing social system.


9. (SBU) For their part, producers are awaiting definitive
implementation of the proposed reforms. Until then, they are
unlikely to invest in additional capital stock. The reforms
would release entrepreneurs from some mandated payments,
decreasing payroll costs. The question remains, however,
whether the Bundestag and the Bundesrat will approve the
reform plans. Apart from that, producers hope for more
reforms to follow.

... Negative Forecasts Risks Have not Vanished, but are
Weakening,
-------------- --------------
-


10. (SBU) Risks on the downside still exist, but with lower
weights.


11. (SBU) The risk of deflation in Germany, the top subject
among German economists, has decreased due to the high oil
price and the easing of the euro/US dollar valuation, both
leading to rising producer prices. For this reason, annual
CPI in 2003 is expected to be higher than initially
forecast, reaching 1.1% instead of 0.8%. For 2004 prices
should increase 0.9% on average due to low advances early in
the year, gradually accelerating with economic recovery.


12. (SBU) The credit crunch risk has weakened as well.
There are indications that German banks have begun to relax
their tightening of credit standards. Moreover, credit
demand is expected to increase as the German economy
recovers.


13. (SBU) The German government has launched several reform
plans, most of which will need the approval of the
Bundesrat, the upper chamber of parliament, which is
dominated by the opposition. There is risk that parts of the
reform plans will be rejected by the Bundesrat. However, a
total reform failure is unlikely, given cross-party working
groups which were formed with the intention to work out
compromises on reforms to achieve agreement.


14. (SBU) One higher downside risk threatening German
recovery is weak eurozone growth. For example, important
German markets like Italy and the Netherlands are also in a
recession. France, too, is suffering from an ailing
economy. In contrast, there is one upside risk factor that
is looking better: the surprisingly good economic
performance of the US economy.

... and the Government's budget Deficit Remains High
-------------- --------------


15. (SBU) Germany will breach the Stability Pact's 3% of
GDP deficit ceiling this year with 3.9%. The financial
misery is not yet under control, but consolidation measures
are planned. At the moment, the German budget in 2004
appears likely to turn in a deficit of 3.8%. Even in the
best case scenario --in which all planned consolidation
measures are put into effect, tax revenues meet
expectations, and the Government's forecast 1.8% real GDP
growth materializes -- the deficit would only improve to
3.5% in 2004, according to our calculations.


16. (SBU) However, going forward the government's financial
situation should improve significantly in 2005 as continued
economic recovery will generate high tax revenues and
subsidy reductions and Agenda 2010 reforms will begin to
have positive effects on public finances for the first time.

Conclusion: Everything Stays as it was, Waiting for a
Recovery Abroad,
-------------- --------------


17. (SBU) Germany's poor economic performance in the first
half of the year and the lack of consumers' and investors'
confidence will lead at best to stagnation of the German
economy in 2003. For 2004, the June forecast of a non-
adjusted 1.3% GDP growth is still valid, since the
Government's reform package is not expected to have a big
effect on real net income.


18. (SBU) The eventual recovery will be mainly driven by
the export side, as in previous years. Private consumption
will only increase by 0.9% due to several factors: (a) the
savings rate will remain at the high level of 10.8% as a
result of low confidence; (b) no significant change in the
labor market is expected (moreover, unemployment benefits
will be cut); (c) downward revision of GDP growth in 2003
will negatively affect gross income in 2004; (d) the
benefits to consumers of bringing forward the third step of
the income tax cuts will be partly counterbalanced by other
costs and fees.


19. (SBU) The latter point requires some clarification.
Implementing the 2003 tax cut, which had been postponed to
2004, and bringing forward the third step of the income tax
cut scheduled for 2005 to 2004 will combine to decrease the
introductory tax rate from current 19.9% to 15% and the top
rate from 48.5% to 42%. This will release taxpayers from 22
bn euro in payments, of which 15.6 bn are due to the third
step of the income tax reform. Not all of this will find its
way into additional disposable income. Some of the measures
that will mitigate the income benefits include (a) higher
pension contributions (increase from 19.5% to 19.9% is
expected); (b) consumer subsidy cuts (a reduction of tax
privileges of about 5.5bn euro are planned - partially
compensated by higher expenditures); and (c) a change in the
health care system (lower contributions rates, but increased
payments for coverage from own funds).

...but Something is Happening!
--------------


20. (SBU) Although prospects beyond the forecast horizon
are not overwhelming, there is something going on in
Germany. Should the government be successful in getting its
program adopted, results, particularly on the budget front
as well as on investment and possibly even consumer
sentiment would be positive. The times of the "steady hand"
are over. This is already good news. Sentiment indicators
and market valuations also reflect improving prospects.
Passage of the governments reform plans, coupled with
improving expectations that a U.S. led global recovery is
underway, are combining to increase the sense that Germany
is finally on the way out of its three year stagnation.
















Forecast- Germany
(Percent)




2002 2003 2004
ACTUAL FORECAST FORECAST ---
-------------- --------------
GDP : 0.2 0.0 1.8

CONSUMPTION: -1.0 0.7 1.4

GOV. CONSUMPTION: 1.7 1.1 1.7

INVESTMENT: -6.7 -1.7 1.4

- MACH. & EQUIP.: -9.1 -0.7 4.5

- CONSTRUCTION: -5.8 -3.6 -1.4

- OTHER INVEST.: 1.6 0.7 5.4

NET EXPORTS: 51.4 -17.5 2.6

- EXPORTS: 3.4 -0.2 3.1

- IMPORTS: -1.7 2.7 3.2

NOM. GDP: 2110.4 2127.3 2165.6
(Euro Bill)
CURRT. ACCT. 59.7 44 59
(Euro Bill)

PRICES: 1.4 1.1 0.9

EMPLOYMENT 38,668 38,200 38,350
(Thousands)
UNEMPLOYMENT 4,060 4,500 4,560
(nat. definition)
UNEMPLOYMENT RATE 9.8 10.9 11
(nat. def.)

TOTAL FISCAL BALANCE: -3.8 -3.9 -3.8
(Pct. GDP)


21. (U) This cable was coordinated with Embassy
Berlin.


22. (U) POC: Annette Foerster, Economic Specialist, e-
mail foersterAM@state.gov; tel. 49-(69)-7535-2291, fax
49-(69)-7535-2238.

BODDE