SNAPSHOT OF GERMAN ECONOMY ? RECOVERY IN

UNCLAS SECTION 01 OF 04 BERLIN 000884

SIPDIS

SIPDIS

STATE FOR EUR/AGS
LABOR FOR ILAB

E.O. 12958: N/A
TAGS: ECON EFIN ELAB PREL GM
SUBJECT: SNAPSHOT OF GERMAN ECONOMY ? RECOVERY IN
FULL SWING



1. Summary: The German economy is expected to
grow 2.4% in 2007 according to the spring
consensus forecast of Germany?s six leading
economic institutes. After half a decade of
below-average economic performance, Germany has
finally caught up with the general growth trend
in the Euro zone, overcoming its ?sick man?
image. The recovery is no longer a purely
export-led phenomenon as improved domestic
consumption and investment have increased the
domestic component of overall growth to two
thirds. This positive development has gone hand-
in-hand with a larger than expected fall in
unemployment and the largest creation of new
?regular? jobs subject to social security
contributions since 2000. In the first months of
2007, unemployment fell below 4 million or 9%, a
full 2 percentage points below levels seen a year
ago. However, economic institutes caution the
positive trend is almost entirely due to cyclical
factors and that the German structural problems
have yet to be fully addressed. They warn
against relenting on efforts for reform and make
the point adjustment costs are more readily
accepted in a positive economic environment than
during a downturn. Public finances in particular
need to be reformed further to remove continued
structural imbalances. End summary.

CONSUMPTION PICKKING UP AFTER YEARS OF STAGNATION


2. Private consumption, the main area of concern
for many years on the domestic side of the
economy, finally picked up speed in 2006. Since
real wages stagnated in 2006, the 0.8% increase
in private household consumption was mainly
attributable to rising non-wage capital income
derived from portfolio investment. Advance
purchases of consumer durables ahead of the
January 2007 VAT rise also contributed to the
increase. The savings rate also decreased
slightly, reflecting improved consumer optimism
about the economy. Despite slightly lower levels
of consumption in first quarter 2007 due to the
?advance purchase effect? ahead of the VAT
increase, consumption is expected to improve by
0.9%, in line with a 0.9% increase in disposable
household income in 2007, and by 1.4% in 2008.
The rise in consumption has been a surprise to
the German economists who had expected a deep
once the higher VAT rate went into effect. Trade
unions are negotiating higher wage increases for
their members, which could also stimulate
domestic consumption.

CAPITAL INVESTMENT GROWS AS PRODUCTION EXPANDS


3. Capital investment grew 7.3% in 2006, the
largest increase since the boom year 2000. A
positive business climate, tax incentives,
favorable financing opportunities, and high
levels of capacity utilization are expected to
sustain this trend into 2008 at an average annual
increase of 6.2%. As further proof of economic
improvement, companies cited expansion of
capacity, rather than labor restructuring or
increased efficiency, as the main reasons for
increased capital investment in a recent poll.
In addition, corporate tax reform, which is set
to come into effect in 2008, will provide further
incentives to reinvest profits.

CORPORATE TAX REFORM TO IMPROVE GERMAN
COMPETITIVENESS


4. The corporate tax reform bill, currently
before Parliament, would lower tax rates by
almost ten percentage points while also closing
existing loopholes. The current tax rate for
corporations of 38.6% will fall to 29.8%. The
bulk of the savings will come though culling the
corporate tax rate, from 25% to 15% (the
remaining balance consists of the communal
business tax). The phase-out of many tax write-
offs will particularly affect companies that in

BERLIN 00000884 002 OF 004


the past were able to offset their profits with
losses, which significantly reduced the tax-base.
It also includes controversial elements like the
taxation of the relocation of production
facilities out of Germany. This proposal has
triggered criticism from industry and Federal
Economics Minister Michael Glos (CSU). Given the
benefits to larger corporations as a result of
the tax reform, Glos would like more to be done
for small and medium size companies. At the same
time, Federal Finance Minister Peer Steinbrueck
(SPD) -- who expects a net revenue loss of about
5 billion Euro as a result of the reform -- is
under attack from the left wing in his own party
who view the 5 billion loss as a give-away to big
business at a time of high profits. The reform
would bring Germany's tax rate closer to that of
other big EU countries, although it would still
be higher than the rates in some of the new EU
member states. Most experts agree however, that
more companies will pay their taxes in Germany as
a result of the reform. Steinbrueck expects the
revenue loss of the first two years following the
implementation to be more than off-set by the
higher number of companies paying taxes beginning
in 2010.

DECADE-LONG SLUMP OF CONSTRUCTION SECTOR FINALLY
ENDS


5. This year, the German construction industry
made its first significant contribution to
economic growth since 1994. While increases in
private construction were largely due to imminent
changes in taxation and allowances, business
investors clearly based their decisions on the
improved economic climate. Private investment is
expected to grow more slowly in 2007, despite new
tax incentives to make homes more energy
efficient. However, it is forecasted to pick up
speed again in 2008 when higher disposable
household incomes are expected to increase demand
for new housing. Construction sector growth is
crucial for reducing unemployment among low-
skilled workers.

SUBSTANTIAL FALL IN UNEMPLOYMENT EXCEEDS
EXPECTATIONS


6. With the improving economic climate,
unemployment has fallen at surprising speed. In
2006, unemployment decreased by 597,000 over the
course of the year. Average unemployment in 2006
was 4,487,000, about 374,000 fewer than in 2005.
The average unemployment rate for 2006 dropped
0.9 percentage points to 10.8 percent. The
growing economy is expected to see unemployment
figures drop by another 700,000 this year and
270,000 in 2008 to below the 3.5 million mark,
reducing the average unemployment rate to 8.7%
this year and to 8.0% in 2008. Nevertheless, the
problem of long-term unemployed unable to find
jobs is highlighted by their proportional
increase among the total of unemployed. Although
there were 257,000 fewer long-term unemployed in
March 2007 compared to the same month a year
before, their relative weight increased from
39.8% to 41%. This trend is likely to lead to
slower reduction in unemployment even as the
economy continues to improve.

WAGES RISING SLOWLY AS EXPERTS CAUTION RESTRAINT


7. Wages increased by only 1.1% in 2006, despite
an improved economic environment, partly due to
the relatively few collective bargaining
agreements up for renewal last year. However,
after years of wage moderation, unions and
workers are now demanding their share in the
economic upswing. The powerful Metal and
Electronics Workers? Union, IG Metall, is calling
for a wage increase of 6.5 percent for its 3.4
million members in this year?s collective
bargaining round, which started in early March.
The employers? association Gesamtmetall, however,

BERLIN 00000884 003 OF 004


has countered with an offer of only 2.5 percent,
plus a 0.5 percent lump-sum payment for the year.
IG Metall has begun to stage warning strikes and
the two sides will likely narrow their
differences. Unions and employers in the
chemical sector, which also enjoyed healthy
profits last year, quietly hammered out a deal
giving 550,000 employees a 3.6 percent pay hike
plus a lump-sum payment of 0.7 percent of their
annual salary. In the construction industry,
employers and unions agreed on a 3.5 percent wage
increase covering nearly 700,000 workers starting
May 1. Economic experts caution against any
increases that go beyond 2.5% to 3.0%, arguing
these would undo the achievements in wage
competitiveness of recent years and are likely to
lead to job cuts in the future. They recommend
lump sum payments to account for the cyclical
upswing rather than wage increases across the
board. Unions counter that cost-of-living hikes
like the VAT hike are not lump-sum increases. On
average, wages are expected to rise 2.0% this
year and by a further 2.8% in 2008, when wage
agreements of public sector employees run out.

TRADE CONTINUES TO GROW RAPIDLY


8. Germany?s exports in 2006 grew a remarkable
12.5%, almost attaining the benchmark record
rates of 2000 (13.5%). Trade with the new EU
member states grew particularly strongly, and
East Asia and Russia were the fastest growing
markets for German exports outside of the E.U.
For 2007 export growth is expected to slow down
in the first half year, due to statistical
reasons and lower orders in late 2006, and to
pick up again in the second half of the year.
Export growth is expected to be 8.4% in 2007 and
8.1% in 2008. A further boost is expected to
come from the increased competitiveness of
exports due to the reduction of social security
contributions which were introduced in tandem
with a 3 percentage point VAT increase at the
beginning of the year (exports are not subject to
VAT; as a result, relative unit labor costs have
decreased). Imports rose sharply as well; at
11.1%, the rate surpassed that of the record year
2000 (10.5%). Improved domestic consumption
after an initial drop due to the VAT increase at
the beginning of 2007 is expected to drive a rise
in imports by 7.5% in 2007 and 8.4% in 2008.

PUBLIC FINANCES IMPROVE AS STRUCTURAL PROBLEMS
REMAIN


9. Public finances improved markedly in 2006 due
to continued moderation in expenditures, lower
spending on unemployment and social costs, and an
unusual increase in revenue by 7.5%. The budget
deficit decreased from 73 billion to around 40
billion Euros. The corresponding deficit ratio
fell from 3.2% to 1.7%, well within the limits
set by the EU on government spending (Maastricht
criteria). The trend is expected to continue
this year as the deficit is projected at 13.2
billion or 0.6% of GDP. The six institutes are
cautiously optimistic as additional revenue and
reduced spending are the result of cyclical
improvements while many of the structural
problems of the economy have yet to be addressed.
They are very critical of the high level of
consumption spending and decreasing state
investment which fell from 1.9% in 1999 to 1.3%

2005. They draw attention to research and
development as well as education as the focus for
more spending, especially since the spending
target of 3% of GDP imposed by the EU-Lisbon
Agenda has not yet been achieved. The institutes
demand a further cut in social security
contributions and eventually in the level of
income tax. Although the balanced budget which
may be realized in 2008 is an improvement, they
say that a surplus which would allow for greater
spending during an economic downturn should be
the government?s objective.

BERLIN 00000884 004 OF 004



KOENIG