SCENESETTER FOR DEPUTY TREASURY SECRETARY

C O N F I D E N T I A L SECTION 01 OF 03 BERLIN 000532

SIPDIS

NOFORN
SIPDIS

TREASURY FOR DEPUTY SECRETARY KIMMITT
STATE FOR EUR/AGS, EUR/ERA

E.O. 12958: DECL: 03/14/2015
TAGS: ECON EFIN ETRD ETTC GM
SUBJECT: SCENESETTER FOR DEPUTY TREASURY SECRETARY
KIMMITT'S VISIT TO BERLIN

Classified By: EMIN Robert F. Cekuta for Reasons 1.4 (b) and (d).


1. (SBU) Summary: Your return to Berlin comes at a point in
the German EU and G-8 presidencies when German policy makers
and top officials across the government are evaluating
progress and looking to make needed midpoint course
corrections for the final sprint to the June G-8 summit and
the conclusion Germany's EU Presidency. Building upon your
previous meetings with German officials, your engagement with
Berlin on Iran sanctions, transatlantic economic partnership
(the U.S.-EU Air Transport Agreement),and the status of
Germany's structural economic reforms will address key issues
ahead of the April 30 U.S.-EU Summit in Washington. End
summary.

CONTINUING GERMAN ECONOMIC GROWTH -- FINALLY


2. (SBU) Germany's economic performance continues to
improve after years of economic stagnation. Growth figures
for 2006 have been revised upwards to 2.7%, the highest rate
since 2000. Estimates for 2007 now range from 1.5% in the
official (probably understated) projection to 2.8% in the
most optimistic forecasts. Continued business confidence in
most sectors and increasing consumer optimism due to expected
wage increases and falling unemployment have alleviated fears
about a strong negative impact from the three percentage
points VAT increase in January. Finance Minister Steinbrueck
wrote an Op-Ed for the March 15 Wall Street Journal Europe
entitled "Germany Rising" which emphasized that Germany is
"meeting its responsibilities, not only as Europe's growth
engine, but also as a driving force for the world economy."


3. (U) Economic institutes expect real GDP to expand faster
than potential output throughout 2007. Production growth is
likely to be stimulated by growth in business investment --
partly as a result of the more restrictive depreciation rules
for tax purposes that will come into effect in 2008. Private
consumption should increase as the labor market continues to
improve, with real disposable incomes of private households
growing. Exports are expected to expand more slowly than in
2006, in line with slowing global demand. Public finances
have improved significantly, due to increased tax revenues
that exceed intentionally conservative government forecasts.
Taking into account the effect of lower expenditures on
social security payments due to increased employment, the
government's budget deficit ratio is expected to improve to
0.7% of GDP.

REFORMS


4. (SBU) The government, continuing its course of needed
economic reforms, intends to use the robust economic upswing
for further reform measures. Specifically, the government
will take advantage of its increased revenues to reduce wage
and salary costs by lowering labor-related contributions.
Insiders report those tasks are difficult, however, due to
deep philosophical differences between the CDU/CSU and the
SPD. Ambitious economic and social reforms are also underway
that foster innovation, competition, and an investor-friendly
environment. Beyond Chancellor Merkel's intent to cut
bureaucracy and her government's goal of continued
privatization and budgetary consolidation, current reform
endeavors are the second stage of the federalism reform
initiative, concentrating on readjusting budgetary revenue
levels, redistributing equalization funds, and burden-sharing
between federal and state governments. The government also
finalized major tax reform legislation in March 2007,
reducing corporate taxes from 36 to 30 percent. To address
social reform, an ambitious health reform bill emerged
reflecting a paradigm shift in the German health sector by
creating new financing mechanisms, including tax-based
supplements and contributions. Deliberations towards a
modern framework for education, research and development are
still underway as the government seeks to encourage
innovation and job creation. At the same time, Chancellery
officials suggest the scheduled regional elections in 2008
will make it harder for the Merkel government to make major
progress on structural reforms after the end of 2007.

TRANSATLANTIC ECONOMIC PARTNERSHIP


5. (SBU) Chancellor Merkel's Transatlantic Economic
Initiative fits both with the need for further economic
reforms and with her international political/economic
framework. Her initiative to integrate more closely the U.S.

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and EU economies seeks to leverage common values to deepen
regulatory cooperation, cut restraints on business, boost
growth and the Doha talks, and to build a model for other
global economic actors, particularly among emerging market
countries. When so many of the EU,s leaders are paying lip
service at best to the transatlantic partnership, Merkel has
actually sought to do something to broaden and revitalize it.
She also views it as a chance to cut some of the red tape
that limits business activity and growth in Europe, something
we have long been advocating. Through this initiative, the
Chancellor wants to establish fixed points of contact at top
political level between the EU and Washington to ensure
cooperation between regulatory bodies continues beyond the
April 30 Summit and the German Presidency. The German
Presidency's goal for this Summit is for the U.S. and EU to
establish a work program for joint cooperation with the goal
of realizing a more integrated transatlantic marketplace.
The program would accelerate work in the following areas:
regulatory cooperation, energy and climate change,
intellectual property rights, investment, securities trade,
financial markets, and innovation and technology.


6. (U) Outside the Chancellery, MdB Matthias Wissmann, who
you know and will meet on March 18, has supported Merkel's
idea of a more integrated transatlantic economic partnership,
consulting with her closely over the past nine months.
Wissmann has emphasized his proposals -- and Chancellor
Merkel's transatlantic economic initiative -- are not in
competition with the Doha Round and would lower the
regulatory barriers that currently exist between the U.S. and
EU through greater cooperation. Germany's leadership as EU
and G-8 president, Wissmann believes, puts it in excellent
position to lay the foundation for a long-term strategy of
closer transatlantic economic cooperation. He said April's
U.S.-EU Summit offers the opportunity to bring renewed focus
to the economic pillar of the transatlantic relationship.
You should be aware, however, that Wissmann's earlier talk of
a transatlantic free trade area has been dropped by the
Chancellery.

FINANCIAL SECTOR ISSUES


7. (SBU) Financial sector regulations and developments
continue to arise at various times in connection with the
Merkel Initiative, the G-7/G-8, and even in Steinbrueck's
March 15 Op-Ed. Government officials closely watched the
February 22 announcement by President Bush's Working Group on
Financial Markets. Germany remains uncertain about financial
sector innovations, a feeling encapsulated in 2005 when Franz
Muentefering, then the Secretary General of the SPD and now
the Vice Chancellor and Minister of Labor and Social Affairs,
referred to hedge funds as "locusts." The public rhetoric
has cooled, but the sentiment persists. Some in the German
financial sector also believe hedge funds need to be watched
carefully. The Bundesbank, for example, expressed concern
about the potential systemic risk posed by hedge funds to
international financial markets. Some of Germany's top
bankers, along with government leaders, argue transparency is
the key to preventing instability in the global financial
services industry, placing greater emphasis on systemic risk
concerns than on investor protection.

CIVIL AVIATION AGREEMENT AND THE MERKEL INITIATIVE


8. (SBU) U.S. and EU negotiators reached agreement on the
Air Transport Agreement on March 2 in Brussels. Signing the
Air Transport Agreement at the U.S.-EU Summit on April 30
would give real momentum to Chancellor Merkel's Transatlantic
Economic Partnership initiative. The Agreement advances her
goal of modernizing and reducing regulation of industry -- in
this case, one that touches one-fourth of companies' sales
according to the Association of European Airlines. The EU's
Transport Council must endorse the terms of the Agreement at
its next meeting March 22-23 in Brussels. British Airways
and Virgin Atlantic are pressing the UK to veto the
Agreement, which would end their exclusivity as the only EU
airlines to fly transatlantic routes from Heathrow, Europe's
busiest airport. As EU Council President, Germany's
continued leadership is critical to persuading other Member
States, particularly the UK, to accept the Agreement.
Government and Lufthansa officials are stating their support
for the Agreement, but we are still working to ensure Germany
does not go wobbly and allow the draft Agreement to fail in
the March Transport Minister's meeting. Encouraging senior
government officials, particularly Chief of the Chancellor's

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Office Thomas de Maiziere, to urge their UK counterparts to
support for the Agreement, will help to ensure success at the
transport meeting.

IRAN


9. (C/NF) Germany, along with its EU3 partners France and
the United Kingdom, has tried since 2004 to bring Iran's
nuclear program fully under IAEA safeguards. Given its EU3
role, Germany was engaged with the UNSC permanent five
members (P5 1) in achieving the consensus resolution, UNSCR
1737, and is working on follow-on actions after the 60-day
period to evaluate Iran's compliance ended February 21.
Germany has tended toward a middle line between the U.S./UK
and the China/Russia positions, with the overriding concern
of not upsetting the consensus.


10. (C/NF) In spite of its engagement with the P5, Germany
faces some internal opposition to sanctions with
working-level officials seeming more grudging about sanctions
on Iran than the ministers and state secretaries. An example
of this is action on Iran's Bank Saderat. Senior-level
officials in the Ministries of Foreign Affairs, Economy, and
Finance agree with U.S. points that the bank is involved with
WMD financing. Nevertheless, working-level officials state
that because the bank is not on the UNSCR 1737 Annex, the
German Government faces legal constraints in sanctioning the
bank and can only block those transactions for which legal
proof in support for WMD activities is available.
Developments in the UNSC debate over further sanctions should
resolve this particular problem.


11. (C/NF) Though German firms continue to do business with
Iran, with a prime example being Siemens' November 2006
signing of a 450 million dollar railway contract, many have
complained to their government that they are being replaced
by lower-cost competitors from Asia. Overall German trade
with Iran decreased approximately 6 per cent in 2006 while
exports and export credit guarantees have fallen over 40
percent since record highs in 2005. Economics Ministry
officials cite increased political risk for the decline. The
OECD decision to drop Iran from category 4 to category 5 last
year -- a step the German Foreign Ministry reports it
generated -- reflected the international view that Iran's
president is a destabilizing force in the region. German
officials also claim that German banks have no interest in
increasing exposure while the government continues to examine
each export project carefully. Government officials expect
the volume of export credit guarantees to drop further in
2007, assuming there is no change in Iranian politics. In
November 2006, the German government increased the punitive
measures associated with violating export regulations.
Should exporters chose to disregard these regulations, they
risk losing the coverage provided through the export credits.
TIMKEN JR