Forecast for Germany: Moderate Growth, High

UNCLAS SECTION 01 OF 04 FRANKFURT 008717 SIPDIS SENSITIVE STATE FOR EUR PDAS, EB, EUR/AGS, AND EUR/ERA STATE PASS FEDERAL RESERVE BOARD STATE PASS NSC TREASURY FOR DAS LEE TREASURY ALSO FOR ICN COX, HULL PARIS ALSO FOR OECD TREASURY FOR OCC RUTLEDGE, MCMAHON E.O. 12958: N/A TAGS: ECON EFIN EUN SUBJECT: Forecast for Germany: Moderate Growth, High Deficits; Clear, Consistent Reform Efforts Still the Key T-IA-F-04-0023 This cable is sensitive but unclassified. Not/not for Internet distribution. ¶1. (SBU) Summary: Our forecast for Germany shows moderate real GDP growth of 1.7% in 2005 after 1.8% in 2004. The government deficit should top 4% of GDP this year, then decline to 3.5% in 2005, based on current policies. Persistent joblessness in western Germany, and even more so in the East, is a strong Government concern. Typically German recovery is fueled by export growth that feeds back into investment, then employment, then consumption. The investment link is the weakest this time around. Supplementary labor costs borne by enterprises, relatively high tax rates, and burdensome regulations are among impediments to investors. These drawbacks seem to have become relatively more pronounced as investment options in central European countries continue to improve. Fiscal policy has not produced the demand side effects anticipated, despite a deficit well beyond "restraints" of the EU Stability and Growth Pact. Perhaps a partial answer lies in the quality of public expenditure, which is consumed by social and financing costs and not investment. Spending smarter while cutting taxes or social charges through coherent, consistent, and comprehensive reforms could help boost both investment and the government's bottom line. There is German public support for reform, but the discord among the country's political leaders as well as the round of state and local elections in the run-up to the 2006 national campaign is sapping the government's will and ability to make the long-needed reforms. End Summary Forecast: Moderate Growth in 2004 and 2005 -------------- ¶2. (SBU) Our recent forecast points to German real GDP growing by 1.7% in 2005 after an increase of 1.8% this year. Growth in both years will be mainly driven by exports. Softer growth in the Euro area next year will be compensated by a pick up in German domestic demand. Consumer Demand to Pick Up -------------- ¶3. (SBU) In a typical German economic recovery, export growth triggers higher investment, raising employment, consumer confidence and retail sales. The recovery we see this time around will by pass strong investment growth. Private consumption has been stagnating in 2003 and 2004 due to a slow rise in disposable income and a noticeably higher savings rate, up from 9.6% in 2000 to 11% in 2004. Consumer confidence has been soft, employment declining, unemployment raising and high contributions to social security systems continuing. Businesses blame uncertainty over Germany's economic outlook and confusion over the course of reforms for causing Germans to boost their already high level of savings. There may be a moderate up tick in 2005 consumption stemming from stronger growth in disposable income caused by lower income taxes (the last step of the income tax reform) and higher self-income. However, current consumer behavior makes this more difficult than usual to predict. Next year's boost to consumption should stem from stronger growth in disposable income caused by lower income taxes (the last step of the income tax reform) and higher self-employed income. Investment Weakness a Puzzle -------------- ¶4. (SBU) Investment continues to be a partial puzzle. The prolonged drag on overall investment by the construction sector, which accounts for 50% of all investment, will not disappear next year. Machinery and equipment investment will rise 4.6% -- much better than recent years, barely pushing growth in overall investment activity past the 0.5% mark. Recent en vogue explanations for poor investment performance include "credit crunch" and "outsourcing." Bundesbank officials argue that the rise in German overseas investment, which does not register in the available statistics, is financed by capital German firms are raising outside the Federal Republic. ¶5. (SBU) The Bundesbank makes a credible argument that demand for loans is what is lacking, not supply. With respect to outsourcing, it is true that share of imported materials in German exports has risen from around 30% in 1995 to almost 39% in 2002. This phenomenon has generated a heated debate on whether Germany has become a "bazaar economy," with industrial production hollowed out as investors make needed inputs in other countries. A lower share of industrial output in overall economic activity, however, does not necessarily mean a decline in overall output. That is, unless workers cannot find new jobs in other, equally or higher productive jobs such as in the service sector. Unfortunately, that seems to be the case according to a McKinsey report cited by USB Warburg research economists. While for each euro of outsourcing, the German economy gains only 79 cents, for each dollar of outsourcing the U.S. economy realizes 1.13 dollars. The difference is that nearly 70% of the displaced workers in the U.S. found new jobs with higher productivity within six months. In Germany only 40% do. ¶6. (SBU) There are some bright spots on the horizon that support even our modest pick up for investment in equipment and machinery. Real interest rates stand at historically low levels, bank profitability is going up (suggesting a possible increased emphasis in lending to the less marginal credit cases) and wage rounds have yielded labor cost increases of only 1.5%. Government efforts to reduce some of the institutional rigidities will help next year with labor market reform (Hartz IV, i.e., the merger of unemployment and social aid programs) and loosening of firing restrictions for small and medium-sized enterprises. Recent labor agreements add to some cautious optimism, resulting in longer hours and more flexible tariff wage contracts. These can help constrain unit labor costs, bolstering Germany's price competitiveness. These trends will be working against the headwind of managers doubting that the global recovery will continue next year, as suggested by recent sentiment indicators. Budget Deficits Continue -------------- ¶7. (SBU) A best-case scenario for 2005 puts the government deficit at 3.5% of GDP, more than spitting distance from the 3% Maastricht mark. The Finance Minister's "Project 3%" will be working full tilt to avoid the European Commission from cranking up the Stability and Growth Pact again - this time taking up Eichel on his own November 2004 pledge to get the deficit below 3% in 2005. ¶8. (SBU) The 2005 budget is encumbered with several risks. Among these are high-expected revenues from planned privatization (15.5 billion euros) and the still-to-be- proven heavy truck highway toll (3 billion euros). The costs of merging the unemployment benefit and social welfare systems is probably underestimated. One welcomed feature for 2005 should be that the social security programs are unlikely to have to draw on the budget. ¶9. (SBU) For 2004 the deficit is likely to top 4%. Poor revenue performance from weak domestic demand is the primary reason. Also, rosy revenue scenarios have not panned out as dreamed for the highway toll for heavy trucks (zero instead of 2.8 billion euros),Bundesbank profit (only 248 million euros instead of 3.5 billion euros) and tax amnesty (3-400 million euros rather than 5 billion euros). Lower Prices and Gains In Employment -------------- ¶10. (SBU) German inflation will decline, despite current energy and raw material price rises, as no administrative price or tax hikes are expected and assuming oil prices moderate. Labor market statistics will be difficult to interpret as 900,000 recipients of social welfare will have to register as unemployed to get the new unemployment benefits. No reliable estimates exist as to how many of these are already so registered. Some estimates suggest that the number of unemployed might increase by 300,000. Employment should increase slightly. The unemployed should be attracted by mini-jobs that will allow them to boost their net income by retaining government benefits plus the earned income and should be deterred by the prospect of losing benefits if they do not accept a job offer. Investment and Government Demand Side Policies: A Closer -------------- -------------- Look -------------- ¶11. (SBU) Investment weakness, a prominent feature of this forecast, deserves a bit of a closer look. Recent wage settlements have highlighted the gulf between what workers contribute to production and what employers pay. USB Warburg economic research estimates that for the engineering industry in 2003 pay for value-added labor was 30,425 euros. The firm then paid an extra 37.4% for non-working days (paid holidays) and bonuses (the "thirteenth month"). Compulsory contributions to social security added another 27.2%, pension schemes and other supplementary costs accounted for another 13.2%. Total wage costs amounted to 50,095 euros or 177.8% of the pay for value added labor. Wage agreements and government reforms could help close a portion of this divide that contributes to make Germany a relatively less attractive investment location. ¶12. (SBU) The recent OECD Survey of Germany also points to high corporate taxes. It cites a study by the German Council of Economic Experts based on 2003 tax codes showing that Germany has the highest average effective taxation of returns of investment. ¶13. (SBU) Some recent commentators have suggested the government could do more to help simulate demand. The government's tax reform, a remarkable achievement in its time, has dropped the top income tax rate from 53% to 42% beginning in 2005. In 2004 and 2005 together this should add 1% of GDP back into consumer's pockets, according to OECD estimates. Other fiscal charges or administered price increases have eaten away some of those gains offered in previous stages of the income tax cut. Some of gone into the higher savings rate, as noted above. ¶14. (SBU) Another part of the answer could lie in the quality of the government's expenditures. 57% of the government's expenditures in 2003 went to social welfare programs and only 3% to investment. In the 1980's the government spent 48% of its budget on social systems and 5% on investment. ¶15. (SBU) Transfers amounting to around 4% of GDP to the new states are increasingly ineffective in promoting growth. The OECD judges that subsidies to enterprises in the new states have not increased productivity but have increased dependence on the government and decreased adaptability to market forces. The OECD also estimates that more than half the transfers for infrastructure are used for government consumption (culture, central administration),with the number of government employees per inhabitant in the new states exceeding the ratio in financially weak western states by 25%. ¶16. (SBU) Tax subsidies for construction have contributed to overcapacity in office and residential housing that continue to weigh against investment. Government procurements, which account for 17% of GDP, are highly complex, often broken into small contracts administered at the state level and not subject to open competition at the EU level, according to an OECD analysis. ¶17. (SBU) One theme that runs through discussions on investment and government budget policies is "confidence," or lack thereof. Uncertainty about global demand, employment, and reforms feed into this lack of confidence. Confidence can work wonders. In that bellwether year for German growth, 2000, the business community was optimistic about the future when the tax reforms were adopted, only to turn sour when new policies were adopted that were not so favorable for economic growth. ¶18. (SBU) The European Commission points to research suggesting that even as a government reduces its budget deficits through structural changes, consumers' and investors' expectations can, and have, improved if they sense that the government will pass the gains on through lower taxes (or no tax increases). Consumption goes up and investment goes up if there is a clear, consistence comprehensive and credible reform plan. A recent survey for the German Financial Times suggested that the majority favor reforms. Confidence could follow. Less and smarter government spending is something that most would understand. Forecast for Germany 2003 2004 2005 Percent Avg. Annual Growth GDP -0.1 1.8 1.7 of which Consumption 0.0 0.0 1.4 Investment -2.2 -2.8 0.6 -construction -3.3 -4.1 -2.6 -machinery & equipment -1.4 -1.9 4.6 Net Exports -11.2 36.7 8.8 Consumer Price Index 1.0 1.7 0.9 Employment -1.0 -0.3 0.4 Unemployment Rate (%) 10.5 10.6 10.6 Fiscal Balance (%GDP) -3.8 -4.1 -3.5 ¶19. (U) This message coordinated with Embassy Berlin ¶20. (U)POC: James Wallar, Treasury Representative, e-mail wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 7535-2238 Bodde