Cablegate: Economic Forecast for Germany: Slow Growth And

Published: Thu 10 Jul 2003 02:38 PM
This record is a partial extract of the original cable. The full text of the original cable is not available.
E.O. 12958: N/A
SUBJECT: Economic Forecast for Germany: Slow Growth and
High Government Deficits Continue; Deflation Outside
Risk; Building Confidence is Key
This cable is sensitive but unclassified. Not/not
for Internet distribution.
REF: Berlin 2415
1. (SBU) Summary: Our forecast for Germany for this
year and next is for continued slow growth with a
modest pick up in 2004 driven by net exports. While
1.3% real growth in 2004 might be deemed a "recovery"
after 0.1% growth in 2003 it is mostly closing a part
of the output gap that has opened during three years of
stagnation. Unemployment will remain in the 10.7%
range and the government deficit will remain above 3%
of GDP. This forecast incorporates possible effects of
structural reforms announced in the agenda 2010 package
(reftel), but these are likely to cause a drag on
growth in their first year of implementation, with
positive effects following in 2005 and later. End
2. (SBU) Risks to this forecast are principally on the
downside - that is the balance of risks suggest that
the actual situation is more likely to worsen than
improve. The absence of robust bank lending, weaker
external demand, faster appreciation of the euro
against the USD are some of the risks. Deflation is
another, which we give only an outside chance of
materializing next year.
3. (SBU) This forecast incorporates budget data from
the Government's recently released 2004 budget,
including bringing income tax cuts a year forward from
January 2005 to January 2004. We have not yet
estimated the possible effects on growth, although
other estimates range from 0.3 to 0.6 percentage points
of higher growth. Stimulus from income tax cuts could
help offset some of the drag from structural reforms
but carry other risks, e.g. higher deficits and debt
4. (SBU) Taking a broader view, investment will be a
key to turning over Germany's growth engine. Declining
investment has been a contributing factor to Germany's
lackluster growth performance in the 1990's.
Investment growth could be supported by relatively
lower price and wage increases in Germanythan in its
euro area partners and lower non-wage labor costs
promised by structural reforms. Combined with income
tax reductions, the announcement effect of such a
comprehensive program on investors as well as consumers
could be positive. This, then, would be the upside
risks to the forecast.
Growth Prospects for 2003 and 2004: Slow Growth, Modest
5. (SBU) Seasonally adjusted real GDP is likely to grow
slower than previously forecast: 0.1% in 2003, down
from 0.7% and 1.3% in 2004 down from 1.8%. The first
quarter's unexpected 0.2% decline compared to the
fourth quarter last year has made even modest growth
improbable for 2003.
6. (SBU) After years of flat growth a modest pick up in
net exports in 2004 should spark growth of 1.3%, hardly
a recovery as the economy has been stagnating and the
output gap between actual performance and potential has
widen. 2004 growth on a non-seasonally adjusted basis
should improve to 1.8% due to four more working days in
the calendar year.
Indicators and Sentiment Show No Sign of Recovery
7. (SBU) Business climate indicators do not signal any
significant upswing. The ZEW indicator has flattened
after rising for six months and is still will below its
historical average. The ifo index rise in May, the
first up tick since January, was weak, driven by
expectations. But the assessment of current economic
conditions remains poor. The economic sentiment
indicator (ESI) for Germany from the EU Business and
Consumer Survey shows stagnation at a very low level.
Expectations concerning production, unemployment and
the general economic situation over next 12 months have
deteriorated, underpinning our forecast for continued
stagnation in 2003.
Is there evidence that something will trigger a change
in current trends? At the moment we do not see any.
8. (SBU) The increase in private consumption in the
first quarter was unique and will not continue in the
next three quarters (see below). One factor driving
weak private consumption is a lack of confidence in a
better outlook. New paper reports suggest that
consumers are wary and anxious about high unemployment,
climbing social taxes, financial difficulties of the
Government and states and that the operational
effectiveness of economic politics has declined.
9. (SBU) Recapturing the population's trust will not
be easy. The controversy over economic reforms that
began last September shows no sign of abating. Clear
outcomes that could contribute to more confidence , as
well as a conviction that a comprehensive economic
program is being put into place, could help restore
consumers' trust and interest.
10. (SBU) On the business side the sentiment is not
any better. Entrepreneurs have been coping with high
non-wage labour costs and structural restraints. Agenda
2010 reforms should help somewhat, provided the
promised reforms are put into place. Heated debates
over the reforms, and rumors of possible tax hikes to
ease the government budget deficit, put into doubt what
the government will actually end up doing, contributing
to uncertainty and delays in investment decisions.
Enterprises place their hope, once again, on foreign
demand. Such demand will be only slightly affected by
the euro appreciation as most German exports go to the
euro area; imports should pick up, leaving a small net
trade surplus to drive recovery in 2003 and a larger
one in 2004.
First Quarter of 2003: False Start - Domestic Demand
Not Sustainable
11. (SBU) Analysts note that despite the first quarter
decline, the composition of demand was encouraging.
Domestic demand grew while net exports declined, a
potential sign that Germany could begin to grow its own
way of economic stagnation rather than relying on a
revival of external demand. We are not so optimistic.
12. (SBU) First quarter dynamics were attributable to
one-off factors that will reverse in the course of the
year. The savings rate was drawn down from 10.6% to
10.4% and net disposable incomes were higher due to a
raise in entrepreneurial and interest income. Net
income actually shrank by 0.4% compared to the previous
quarter due to January's increases in payroll taxes
(higher pension contributions (from 19.1% to 19.5%) and
health insurance (from 14.1% to 14.4%) and higher taxes
on petroleum, electricity, (i.e. the next step of the
"Eco-tax" reform) and tobacco.
Other elements of domestic demand provide little
13. (SBU) Investment declined significantly by 1.7% in
the first quarter due to a tremendous fall in
construction investment. Taking into account capacity
utilization, production and order entries, investment
is unlikely to advance in the second quarter.
Manufacturing capacity utilization is still under its
long-term average, although the trend is up.
14. (SBU) Construction decreased in the first quarter
by 3.3% due in part to the extremely cold weather.
Even though the sector continues to work off its
overcapacity, a gleam of hope in the first quarter was
an increase in building permits. This rise may be
attributed to the heated political discussion about
cutting housing subsidies, provoking an unusual amount
of applications for permits. Those with building
permits would be entitled to the subsidy. Low interest
rates provide an incentive for immediate construction
even though the building permit is valid for five
years. Thus, construction in the housing sector should
rise in the second and third quarters. Nonetheless,
continued reduction in overall capacity will still
result in a drag on GDP growth.
Government consumption, constrained by rising budget
deficits, will remain modest.
The Story is Still External Led Growth
15. (SBU) The base scenario of the forecast remains
for net exports to drive a gradual recovery in 2004:
the rest of Euro area - taking 54.7% of German exports
-- will grow faster than Germany. Thus, German exports
are insulated to a significant extent from much of the
effects of the euro's appreciation. In nominal terms,
the euro is up 16.5% against the USD during the first
half of 2003. A revival of foreign demand in 2004 both
inside and outside the euro area should help override
some of the price effects of more dear euro outside the
euro area as German exports compete in high-end,
quality and custom markets and between related firms
where product substitution is difficult.
Fiscal Deficit: Over Maastricht Threshold
16. (SBU) The Government deficit will climb to 3.9% of
GDP in 2003. Revenue is likely to decline as suggested
by the results of the May tax estimate and our new GDP
forecast. The result: a fiscal deficit of euro 41
billion. For 2004 the deficit will continue to be
driven by revenue losses and draws by social insurance
programs. The planned 2004 budget contains euro 15.9
billion in measures to reduce the deficit to around
euro 26 billion. However, bringing forward the income
tax cut would add another euro 7 billion to the Federal
deficit and the same amount to the state deficits and
around euro 2.5 billion deficit at the local levels.
Thus, the overall government deficit will stay around
3.8% of GDP. Germany would neither meet its political
commitment to reduce the nominal deficit below 3% in
2003 nor in 2004, the year in which Germany's excessive
deficit is to be corrected under the rules of the EU
Stability and Growth Pact.
CPI: Practically Price Stability
17. (SBU) Consumer price increases will remain
subdued, even declining on a quarterly basis for some
of the year due to the euro appreciation and lower oil
prices, but rising overall at an annual average rate of
0.8% in 2003 and 0.9% in 2004 as demand begins to rise.
18. (SBU) Consumer prices rose in the first quarter
2003 by 0.7% over the previous quarter and by 1.1%
compared to a year ago. In April and in May prices
declined slightly on a monthly basis due to strong
price declines in heating oil and gas (oil prices
decreased immediately after the end of the Iraq war;
the price decline was reinforced by Euro appreciation).
These effects will continue throughout the year (basis
effects), partially offset by rises in services prices.
Unemployment: No Cause for Joy
19. (SBU) The number of unemployed will increase by
9.8% in 2003 and decline by 1.6% in 2004 as economic
growth picks up. The unemployment rate will remain
around 10.7%.
Forecast Risks: On the Downside
20. (SBU) Risks remain as in the previous forecast,
principally on the down side: lack of robust bank
lending, weaker external demand, faster and higher
appreciation of the euro/USD exchange rate.
21. (SBU) The lack of clear, fully agreed government
fiscal and reform policies or actions with attendant
political uncertainties weighs on consumer confidence -
a factor that could continue into 2004. Deflation is
not a feature in our forecast but is an outside risk
toward the latter part of the forecast horizon,
particularly if the anticipated upswing does not take
A Broader View: Growth, Deflation and Fiscal Expansion
22. (SBU) This forecast has been composed in a period
of fluidity: the government has announced a major
structural reform initiative, subsidy cuts, and
significant tax reductions by bringing forward to 2004
income tax cuts scheduled for 2005. This section takes
a step back and seeks to discern a line of logic in
these measures that could give a basis for a more
optimistic scenario than we have assumed. One way to
look at what is going on is that relatively low
inflation and structural reforms with tax cuts could
help counter act the weak investment performance that
has plagued Germany for nearly a decade. Both these
mechanisms, structural reforms and relative price
adjustments, are the "tools" now available to Germany
in the monetary union to adapt to "shocks" it has
suffered during reunification.
Why Weak Growth?
23. (SBU) The European Commisson's 2002 "Review of
Germany's Growth Performance" points to several factors
that account for Germany's prolonged low growth and
vulnerabilities to external developments. Low growth
stems from weak domestic demand: weak consumption and
investment, including in the construction sector.
24. (SBU) Large financial transfers to the new states,
around 4% of GDP annually, initially financed by larger
deficits, now are financed by higher taxes diverting
funds from social funds. These funds, in turn, have
had to increase their contribution rates. Higher taxes
and social charges crowd out private investment as
expected profits are reduced and adversely effect
employment, in the Commission's assessment. Low
construction investment is the product of working off
excess capacity in both the new States and the West
from the heady early 1990 days of reunification and
high immigration.
25. (SBU) The recently released Bank for International
Settlements' Annual Report also highlights the decline
in investment as "the strongest sign (if not cause) of
the underperformance of the German economy." The BIS
believes that while partially cyclical, the low
propensity to invest is due to fundamental or
structural factors such as low rates of return, low
corporate profits, and product and labor market
26. (SBU) A study by Goldman Sachs suggests that the
massive cost shock from higher wages in the new states
and the West associated with reunification encouraged
firms to substitute capital for labor. Lower
profitability reduced the incentive to invest. The BIS
notes that since the early 1990's net investment in
Germany has fallen sharply. Goldman Sachs points out
that compared to 1991 the real level of investment is
only 6.5% higher in Germany while in the rest of the
euro area it is 23% higher. In 2001 and 2002 investment
continued to decline, as we forecast it will this year.
27. (SBU) Lower inflation in Germany relative to that
in its main European trading partners suggests that its
external competitiveness will increase, supporting
exports and growth. This relative price adjustment is
one way regions experiencing relatively slower economic
activity in a monetary union can adjust. Thus,
relatively lower inflation could benefit Germany.
However, it also raises the risk of deflation.
The "D" Word
28. (SBU) While we have not found any economists to
declare that deflation is occurring in Germany, most
all will admit that there are risks, even the usually
reserved Bundesbank. This is playing it safe. There
is a general suspicion that, as the BIS explains, "a
seemingly benign low-inflation environment can turn
into one with disruptive deflation." Deflation can be
there before you know it. Moreover, the costs are
high, more disruptive than inflation. Many of these
adverse effects bear directly on investment.
29. (SBU) One definition of deflation is a decline in
the general price level on a sustained basis that
reduces demand. This definition would rule out the
more benevolent form of price decreases due to supply
shocks, like new sources of supply or higher
productivity, that can drive down prices but contribute
to faster economic growth. Deflation that is pernicious
constricts investment: firms hold off investment as the
real cost of credits increase and profits are squeezed
because consumers hold off purchases and nominal wages
are "sticky," keeping production costs higher than
30. (SBU) It takes more than low inflation to move to
deflation, but Germany has a number of those other
necessary attributes. A growing output gap, weak
credit growth, and soft equity prices are fertile
ground in Germany for deflation, according to a recent
IMF staff assessment. Nonetheless, the IMF paper
concluded that "mild deflation is likely to take hold"
but that "the risks of pernicious deflation are low."
31. (SBU) Deutsche Bank research developed its own
"scoreboard" of 10 indicators that gave Germany a 0.5
compared to 0.7 in Japan where deflation has taken hold
and 0.4 in the US. While they see some negative
inflation during the year, they give a 20-30%
probability that deflation could last for more than a
year, and a lower probability to dangerous deflation
taking hold. This would require continued stagnation
in economic growth, continued low credit growth, a
substantial further appreciation of the euro to around
1.40/usd, inflation expectations would have to fall (no
signs yet that consumers expect lower prices - just
stable prices) and inflation in the euro area would
have to fall below 1%.
32. (SBU) This last point is worth noting. The
European Central Bank asserts that price developments
in Germany cannot be considered in isolation from price
developments in the rest of the EMU. The ECB considers
average euro area inflation and pitches its monetary
policy for price stability, i.e. price increases of 2%
or less, but still close to 2% to protect against
possible deflation (this latter point is an important
clarification recently issued by the ECB). With Euro
area inflation still running around 2% and Germany's
inflation at 0.7%, that means other countries are
running substantially higher inflation than Germany.
As noted above, this should improve Germany's
competitive position within the euro area.
33. (SBU) Deutsche Bank research provides an
illustrative example. The posit that if euro area
inflation were to remain around 2% (the ECB's
definition of price stability), Germany, with a weight
of 30% of the monetary union, would have to have
negative 1% inflation and the rest of the Euro area
would average 3.5% inflation - a gap of 4.5 percentage
points. At such a spread there should be opportunities
for pricing arbitrage for tradable goods, raising
demand in Germany.
Role of Fiscal Policy and Reforms
34. (SBU) Another way to counter the price shocks
adversely affecting investment could be reductions in
taxes and non-wage labor costs that have restrained
demand for labor and investment. The Finance Minister
has politically linked advancing the income tax
reductions to adoption of structural reforms and a
trimmed 2004 deficit that is less than planned
investment. In addition, some short-term stimulus to
economic growth from the tax reductions, estimated to
range from 0.3-0.6 percentage points, could help offset
the drag on growth from the early stages of structural
35. (SBU) At a time when there is a risk of deflation
and confidence is fragile, the Government appears to be
seeking to take economic matters into its own hands.
This, Finance Ministry officials agree, should help
instill confidence in consumers and investors.
36. (SBU) The BIS suggests in its annual report that a
counter cyclical fiscal policy combined with an
expansionary monetary policy and other reforms would
provide a "more potent cocktail" of stimulus to deter
the threat of deflation. However, in Germany a recent
survey (Infratest) suggests, that still 81% of
respondents were less satisfied or not at all satisfied
with the government's economic policies. 81% of the
respondents opposed taking on new debt to pay for
bringing forward the income tax cuts. This suggests
that rather than spending the savings from tax
reductions, many might save them in anticipation of
higher taxes in the future to help reduce the debt.
Forecast- Germany
(Percent Increases - Unless Noted Otherwise)
2002 2003 2004
--------------------------------------------- --------
GDP : 0.2 0.1 1.8
CONSUMPTION: -0.6 0.5 0.9
GOV. CONSUMPTION: 1.5 0.6 1.2
INVESTMENT: -6.7 -2.0 1.0
- MACH. & EQUIP.: -9.4 -0.3 2.7
- CONSTRUCTION: -5.9 -3.7 -0.9
- OTHER INVEST.: 2.5 2.2 6.3
NET EXPORTS: 51.1 -6.5 8.6
- EXPORTS: 2.6 3.0 5.9
- IMPORTS: -2.1 4.5 5.6
NOM. GDP: 2108.2 2127.2 2174.0
(Euro Bill)
CURRT. ACCT. 48.9 44 59
(Euro Bill)
PRICES: 1.3 0.8 0.9
EMPLOYMENT 38,689 38,156 38,300
UNEMPLOYMENT 4,071 4,470 4,400
(nat. definition)
(Pct; nat. def.)
TOTAL FISCAL BALANCE: -3.8 -3.9 -3.8
(Pct. GDP)
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