Despite concerns about the ability of the Grand Coalition government to deliver on reform, a booming world economy has helped Germany confound doubters and boost economic growth. Scott Livermore of Oxford Economics surveys the politico-economic scene and assesses the potential for further reform.
Angela Merkel’s Grand Coalition and its opening shots at economic policy were given a less than rapturous welcome by economic and political commentators alike. The uncomfortable coalition partners were not expected to deliver much more than the gradual reform process of the Schroeder government, let alone preside over a strong rebound in the economy. But a somewhat surprising success now seems likely, as even the 3% VAT hike in January looks to have passed off smoothly with the economy still on track
This is partly thanks to beleaguered retailers absorbing much of the pain as consumers chug along steadily, though at a pace that makes the high street one of the least exciting places in the economy. It will be fortunate for the coalition if consumption proves less of a rollercoaster than many feared, but even more fortunate is the prolonged boom in the world economy. Exports remain the key driver of Germany’s upswing, unaffected by the vagaries of its fiscal policy and coalition politics.
Clearly, actual economic performance in 2006 exceeded that of even the most optimistic forecaster – growth reached 2.9% after just 1.1% in 2005. Does this strength mean the German economy now is better equipped to withstand the VAT hike?
The Ifo index – probably the most closely watched business confidence indicator – remains close to a 15-year high. But this masks a sharp divergence between businesses' assessment of the current situation and their view of the coming six months. The question boils down to whether the high-growth sectors will remain buoyant, and whether consumers continue to be merely reluctant to spend, rather than cutting back. As long as the economy keeps up its performance, Angela Merkel looks to be the main winner of the coalition gamble. But could the economy still derail? What are the risks here?
So far, the long-feared hike in VAT at the beginning of 2007 has proven to be a bit of a non-event. The expected sharp climb in inflation did not occur. Inflation in January rose to just 1.6%, from 1.4% in December. Had the VAT hike been passed on to consumers in full in January, then inflation would have risen to 2.8%. The modest rise in inflation suggests that some retailers had passed on part of the VAT rise before end-2006 – it has been estimated that around 30% of the VAT-hike had been implemented before 1 January 2007 – and that lower energy prices offset some of the VAT impact on inflation.
The smaller than expected uptick in inflation also reflects retailers absorbing the VAT-hike as part of the winter sale season. Price competition is quite tough in some sectors of the German high street, but it is questionable how long the higher VAT can be held back from the consumer as retailer margins are tight. We still expect most of the VAT hike to feed through to end prices, but it appears likely that it will be more of a trickle than a step change. For 2007 as a whole, inflation is expected to average 2.1%, following 1.7% in 2006.
One consequence of a slower feed through of higher VAT is that it will feel less of a shock to consumers, and other positive factors to support household demand will be allowed to emerge. Most important is the continued improvement in the labour market. Unemployment has now dropped below the psychologically important 10% mark. The downward trend in unemployment is being support by a pick-up in "real" jobs – rather than just reflecting "mini-jobs" and other government measures – which are nearly half a million above their low point at end-2005. The Ifo employment barometer shows firms intending to continue hiring, backing the evidence from the PMI surveys.
The improved labour market is supporting consumer confidence. The GfK consumer confidence index did fall at the beginning of 2007 as consumers were less willing to make major purchases, but consumers’ income expectations and their assessment of the economic outlook improved markedly.
Improved income expectations also stem from belief that the shackles of wage restraint will be loosened. IG Metall has announced that it is aiming for an increase of 6?% in the upcoming wage round, and the outcome in the engineering sector sends an important signal to the rest of the economy. With some government support, strong labour demand and shortages in some sectors, the unions' bargaining position is much stronger now. While IG Metall is unlikely to achieve a 6?% wage increase, it will probably succeed in improving on the 3% wage increase attained in 2006, and this will have a knock-on effect elsewhere.
Overall, consumer demand is likely to take only a moderate hit in response to the VAT hike. Although household demand will hold back GDP growth in 2007, the continued strength of exports and investment should ensure GDP expands by around 2%.
Exports have been the fastest growing component of GDP over the past couple of years, boosting industry, and capacity utilisation is now above 2000 levels. Germany has benefited from improved competitiveness following several years of wage restraint and a pick-up in the global investment cycle, especially in emerging Asia and Russia.
This has seen Germany increase market share. Growth in Germany’s main export markets is expected to slow slightly in 2007 and the rise in the euro will offset the competitiveness gains from wage restraint and productivity growth. The Ifo index shows expectations among manufacturers for exports over the coming months at near post-reunification highs and the impression of continued strong export growth is also backed up by the most recent PMI surveys. Although industrial orders from abroad stuttered at year-end, these numbers tend to be bounced around by the ebb and flow of large orders and export orders generally remain strong.
Rising import growth means that net trade played only minor part in the pick-up in GDP growth last year. But strong export demand does keep production lines rolling, boosting investment and employment. Business investment has benefited from strong external demand but also from new depreciation rules introduced at the beginning of 2006. These rules allowed firms to offset a greater proportion of investment against tax in the first year of purchase. The new depreciation rules run to end-2007 and should also be beneficial for investment this year.
Rising capacity utilisation, low interest rates and healthy corporate balance sheets also speak for continued strong investment growth. Recent business surveys suggest that firms intend to increase investment at a similar rate in 2007 as in 2006: for instance, the latest survey by the DIHK (the German Trade Association) shows firms’ investment intentions at a 15-year high and unchanged from spring.
But what happens in 2008 when the tax break runs out? Much of recent investment has been for replacement purposes and surging export growth has been achieved by utilising spare capacity. Both these factors are likely to ease in 2008 as firms focus more on margins and return to expanding capacity outside of Germany.
However, the government is due to implement a comprehensive reform of the business tax system in 2008. The central plank of the reform is to reduce the marginal rate of corporation tax to below 30% – a level viewed as competitive within Europe – from the current 38.7%. Whether this improves Germany as a place to locate business is open to question. The coalition has agreed that the fiscal cost should not exceed €5bn in the medium-term, although it could be as high as €8bn in the first year of implementation.
In addition, a number of less business-friendly financing measures have been proposed. Not only will the new depreciation rules introduced at the beginning of 2006 be reversed, but there are measures aimed at capping firms’ ability to offset against tax business expenses such as interest, rent and leasing payments. Similarly, restrictions will come into force to limit the degree to which firms can use losses made by subsidiaries to reduce future corporate tax liabilities.
These measures are aimed at plugging leakages from the corporate tax system, but they risk hampering the activities of high investing and capital intensive firms. With fiscal rectitude restored thanks to stronger GDP growth and the VAT hike, the government could be more lenient in investment incentives after all.
But many politicians will be pushing Peer Steinbrueck, the Finance Minister, to loosen the purse strings – especially since the reform agenda and strong economic growth appears to benefiting neither the SPD nor the CDU/CSU significantly in the opinion polls.
Fiscal discipline seems to be guaranteed for this year and another year of strong growth, combined with higher VAT and other measures, should see the deficit fall to around 1?% of GDP. The deficit is forecast to shrink gradually thereafter, but there are a number of budgetary risks, including reform of business taxation, labour market measures and health insurance reform. Indeed, some debate has already begun over whether further tightening measures are needed to meet medium-term budget objectives. The improved fiscal position clearly has the scope to open up cracks within the coalition as pressure for a united front disappears and elections start to loom on the horizon.
The most necessary reforms for Germany remain those in the labour market. Over the past few years there have been a number of measures as part of Agenda 2010 and Hartz IV that made it tougher to be unemployed, while increasing the number of opportunities for benefit-receivers to boost their incomes through mini-jobs.
But gains for employers were mainly achieved by the corporate sector forcing through wage moderation and longer and more flexible working times: there has been very little legislation improving their lot.
The coalition is now working on plans to extend a minimum wage to more sectors and to boost employment in the low-wage sector. But the autonomy of trade unions in determining labour policy is not being threatened, meaning greater flexibility is largely off the agenda and firms will continue to be hesitant in taking on new workers.
The coalition is showing some signs of reform fatigue after the protracted negotiations over reform of the health insurance system that not only showed political cracks in the coalition but also exposed differences within both the CDU/CSU and SPD. The coalition has now tackled most of the issues in its initial agreement and it is hard to imagine that they will go much beyond this agreement. Indeed, Kurt Beck, leader of the SPD, has said that the coalition should now wait and see regarding the impact of the reform agenda on the electorate.
Although Angela Merkel, the Chancellor and leader of the CDU, argues that more reforms are necessary, this is mostly to position the CDU as the party of reform ahead of upcoming elections. There is simply not enough time for further significant reforms to brought onto the political agenda: important regional elections in 2008 limit the timeframe for the coalition to propose reforms and get them through the Bundestag, before campaigning sees the CDU and SPD highlighting differences rather than working on a common agenda.
And after next year’s regional elections, campaigning for the 2009 general election will begin in earnest.