Germany

OECD Economic Outlook, Dec, 2007

After slowing in the second quarter, growth has picked up in the third quarter on the back of strong domestic demand. The output gap is likely to be almost closed. Going forward, growth is projected to advance at near trend rates during 2008 and 2009. Following some near-term headwinds, unemployment may continue to edge down but at a much slower pace than in the recent past. The slower projected expansion largely reflects a diminishing contribution from net exports that is not fully compensated by stronger private consumption.

Helped by strong revenue increases, the general government budget is projected to reach balance this year. In 2008, fiscal policy will turn slightly expansionary due to the corporate tax reform. Further pro-cyclical easing should be avoided. As the supply of skilled labour will become a bottleneck, the government should avoid taking any measures that could impede incentives to take up work.

Growth has slowed in the second quarter ...

Economic growth slowed somewhat in the first half of 2007 compared with the second half of 2006. While the negative impact from the value-added tax (VAT) rate increase on overall growth in the first quarter of 2007 was masked by a surge in construction activity due to exceptionally mild weather conditions, this effect reversed in the second quarter, resulting in a quarterly growth rate of only 0.3%. Both exports and to a lesser extent equipment investment continued to act as the main engines of growth. The expansion has gone hand in hand with strong employment gains and a significant fall in unemployment and household consumption recovered from the VAT rate increase.

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... but the upswing remains intact

The upswing resumed in the third quarter with GDP rising by 0.7%. Available evidence so far suggests that the recovery will continue. Manufacturing orders remain at high levels and demand from abroad is particularly strong, notwithstanding the appreciation of the euro exchange rate against the US dollar. This strong demand reflects the combination of past gains in competitiveness, the specific product mix offered by German exporters and solid growth of Germany's export markets. Although business sentiment has declined somewhat over the summer, it remains at high levels, suggesting that investment growth will continue. Recent turbulence in financial markets has worsened financing conditions, as financing costs have increased somewhat and banks have tightened their credit standards. The overall effects of this development on investment are surrounded by considerable uncertainty. However, due to past improvements in their balance sheets as well as their solid profit situation, domestic companies in aggregate may be less dependent on external financing than in prior years and thus somewhat insulated from the financial turmoil, at least in the short term. In addition, investment in the remainder of the year will be supported of generous depreciation allowances due to expire in 2008. In contrast to business investment, residential investment is weakening this year after having benefitted in 2006 from the phasing out of subsidies and higher demand in anticipation of the VAT rate hike. Growth momentum is also supported by a pickup in consumer spending on the back of continued employment creation.

Fiscal policy will be expansionary in 2008

The fiscal position has improved markedly during the current upswing and the budget will most likely be balanced in 2007. In addition to robust increases in direct tax revenues as well as additional revenue from the rise in the VAT rate, this improvement also reflects structural gains on the expenditure side of government finances. The headline budget balance is seen to improve further and may register a surplus of 0.3% of GDP by 2009, barring the emergence of additional discretionary spending. The structural fiscal deficit, however, is not expected to improve further over the projection horizon. This mainly reflects the corporate tax reform in 2008, which will lower the tax burden for most firms; the base broadening measures will only partially offset the revenue loss. Also, the slow growth in government consumption may not continue as in previous years because wages in the public sector are expected to rise.

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Employment creation remains strong

While employment growth had lagged the upswing to a somewhat greater extent than in past cycles, recent job creation has been strong and unemployment has fallen significantly, the recent upward revision of past unemployment data notwithstanding. Over the projection period, the unemployment rate (national accounts definition) is envisaged to decline by a further 1/2 percentage point. Some part of the strong upswing on the labour market is likely to reflect a structural improvement as a result of past reforms. The strong increase in employment rates of older workers, for example, might be interpreted as one success of the reforms.

Growth is set to move towards trend

The expansion is projected to lose some steam over the projection period with annual growth rates declining from 2.6% (adjusted for the number of working days) in 2007 to 1.6% in 2009. The output gap will be closed from end 2007 on. As a result of the reduction in economic slack and in response to the strong euro, imports are expected to increase and the contribution from external trade will decline significantly. Despite tightening capacity constraints, fixed investment by enterprises is also expected to grow at lower rates, reflecting the change in depreciation rules at the beginning of 2008 and the lagged impact of past tightening in monetary conditions. The overall weakening in the dynamism of exports and investment, however, is likely to be partly offset by some rebalancing of growth towards private consumption. Such a development would be in line with the experience from previous upswings and would also reflect the income gains of households from the ongoing improvements in the labour market. In addition, the savings rate may decline gradually, lending further support to consumption. Residential investment is also likely to benefit from a strengthening of households' spending power, although to a smaller extent.