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UNCLAS SECTION 01 OF 04 FRANKFURT 008257 
 
SIPDIS 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS SOBEL 
TREASURY ALSO FOR ICN COX, STUART 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: Economic Forecast for Germany: Waiting for a 
Recovery Abroad to Spark Recovery, but Reform Debate Shows 
Something Happening Domestically 
 
 
T-IA-F-03-0052 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
  ¶1.   (SBU) Summary:  The German economy is expected, at 
     best, to stagnate in 2003. Since GDP declined by -0.3% in 
     the first half of the year compared to the previous half- 
     year, positive GDP growth in 2003 is no longer achievable. 
     Driven by improving net exports, German economy will pick up 
     in 2004, reaching seasonally-adjusted 1.3% GDP growth. 
     Domestic demand will increase only moderately, despite the 
     Government's big reform package. The key limiting factor for 
     domestic demand in Germany is lack of confidence by 
     consumers and producers. Germany will breach the Stability 
     Pact's 3% ceiling in both 2003 and 2004. An improvement of 
     the state's financial situation can be expected only in 
     2005, after economic recovery has gathered momentum and the 
     reform package begins to yield cost savings. While prospects 
     beyond the forecast horizon are not overwhelming, something 
     is stirring in Germany that might just signal the  economy 
     is coming out of its three year hibernation. 
 
  Prospects for 2003/04: Waiting for Recovery Abroad 
  (again)! 
  --------------------------------------------- ------------ 
 
  ¶2.   (SBU) In 2003, the German economy is expected to 
     stagnate at best, given the seasonally-adjusted -0.3% 
     decline in GDP in the first half of the year, compared to 
     the last half of 2002. Driven by improving net exports, 
     German economy will pick up in 2004, reaching seasonally- 
     adjusted growth of 1.3% GDP. 2004 growth on a non-seasonally 
     adjusted basis is estimated at 1.8% due to four more working 
     days in the calendar year. 
 
  Bad Starting Point: Germany in Recession! 
  ----------------------------------------- 
 
  ¶3.   (SBU) Germany is now in a recession: German GDP fell in 
     the second quarter for the third time in a row, this time by 
     a real, seasonally and calendar adjusted -0.1% compared to 
     the first quarter. 
 
  ¶4.   (SBU) The decline of GDP was mainly due to a decrease 
     in exports (-2.3%), which was much stronger than the drop in 
     imports (-1.1%), causing a reduction of net exports. The 
     resulting negative contribution to economic growth (-0.5 
     percentage points) could not be completely compensated by 
     the positive growth contribution of domestic demand (+0.3 
     percentage points). The strong Euro against the US dollar, 
     the disruption of production in the automobile industry 
     triggered by strikes in East Germany and modest growth in 
     the world economy combined to dampen German exports. The 
     reduction of imports was a counter movement to the strong 
     increase at the beginning of the year due to rising oil 
     demand in view of the threatening Iraq war. The fall in 
     imports was mitigated by the strong Euro. 
 
  However, Indicators and Financial Markets are Encouraging 
  --------------------------------------------- ------------ 
 
  ¶5.   (SBU) The ZEW indicator, in an upward trend since 
     December 2002, recently recorded hefty increases and is 
     therefore well above its historical average. The more highly 
     regarded ifo index has also continued to increase, now for 
     the third month in a row. The development of both indicators 
     merely signals improving business expectations. The current 
     economic situation is still assessed as poor by the majority 
     of those interviewed. The German Economic Sentiment 
     Indicator, developed by the EU, shows a similar picture: its 
     trend line is a weak positive despite deterioration in July. 
     Increasing share prices on the German stock market reflect 
     the optimistic expectations as well -- within three months, 
     the DAX index increased by 16.6% and the TecDAX rose by 
     35.9%. 
 
  ... Though Real Data is Disappointing, 
  -------------------------------------- 
 
  ¶6.   (SBU) Favourable indicators are not yet backed by 
     fundamental data. Industrial production and industrial 
     orders decreased significantly in the second quarter of 
     ¶2003. Nor are the improving July numbers meaningful, since 
     they mainly reflect compensating up ticks for the production 
     losses in June caused by strikes in East Germany. 
 
  ... Confidence is Still Missing, 
  -------------------------------- 
 
  ¶7.   (SBU) The key problem for modest domestic demand in 
     Germany is still the lack of confidence, both for consumers 
     and producers. 
 
  ¶8.   (SBU) Consumer confidence increased initially in the 
     period after announcement of the government's plan to 
     advance the third step of the income tax reform. However, 
     after the summer holidays, as consumers heard more about the 
     government's plans to cut subsidies and tax privileges, the 
     health minister's decision to increase the financial burden 
     for the insured and to further increase pension 
     contributions, any glimmer of confidence has been destroyed. 
     Consumer uncertainty is reflected to some extent by 
     significant fluctuations in retail sales. It is not expected 
     that consumers will regain confidence in the near future so 
     long as unemployment remains high and uncertainty persists 
     regarding changes in the existing social system. 
 
  ¶9.   (SBU) For their part, producers are awaiting definitive 
     implementation of the proposed reforms. Until then, they are 
     unlikely to invest in additional capital stock. The reforms 
     would release entrepreneurs from some mandated payments, 
     decreasing payroll costs. The question remains, however, 
     whether the Bundestag and the Bundesrat will approve the 
     reform plans. Apart from that, producers hope for more 
     reforms to follow. 
 
  ... Negative Forecasts Risks Have not Vanished, but are 
  Weakening, 
  --------------------------------------------- ------------ 
  - 
 
  ¶10.  (SBU) Risks on the downside still exist, but with lower 
     weights. 
 
  ¶11.  (SBU) The risk of deflation in Germany, the top subject 
     among German economists, has decreased due to the high oil 
     price and the easing of the euro/US dollar valuation, both 
     leading to rising producer prices. For this reason, annual 
     CPI in 2003 is expected to be higher than initially 
     forecast, reaching 1.1% instead of 0.8%. For 2004 prices 
     should increase 0.9% on average due to low advances early in 
     the year, gradually accelerating with economic recovery. 
 
  ¶12.  (SBU) The credit crunch risk has weakened as well. 
     There are indications that German banks have begun to relax 
     their tightening of credit standards. Moreover, credit 
     demand is expected to increase as the German economy 
     recovers. 
 
  ¶13.  (SBU) The German government has launched several reform 
     plans, most of which will need the approval of the 
     Bundesrat, the upper chamber of parliament, which is 
     dominated by the opposition. There is risk that parts of the 
     reform plans will be rejected by the Bundesrat. However, a 
     total reform failure is unlikely, given cross-party working 
     groups which were formed with the intention to work out 
     compromises on reforms to achieve agreement. 
 
  ¶14.  (SBU) One higher downside risk threatening German 
     recovery is weak eurozone growth. For example, important 
     German markets like Italy and the Netherlands are also in a 
     recession.  France, too, is suffering from an ailing 
     economy. In contrast, there is one upside risk factor that 
     is looking better: the surprisingly good economic 
     performance of the US economy. 
 
  ... and the Government's budget Deficit Remains High 
  --------------------------------------------- ------- 
 
  ¶15.  (SBU) Germany will breach the Stability Pact's 3% of 
     GDP deficit ceiling this year with 3.9%. The financial 
     misery is not yet under control, but consolidation measures 
     are planned. At the moment, the German budget in 2004 
     appears likely to turn in a deficit of 3.8%. Even in the 
     best case scenario --in which all planned consolidation 
     measures are put into effect, tax revenues meet 
     expectations, and the Government's forecast 1.8% real GDP 
     growth materializes -- the deficit would only improve to 
     3.5% in 2004, according to our calculations. 
 
  ¶16.  (SBU) However, going forward the government's financial 
     situation should improve significantly in 2005 as continued 
     economic recovery will generate high tax revenues and 
     subsidy reductions and Agenda 2010 reforms will begin to 
     have positive effects on public finances for the first time. 
 
  Conclusion: Everything Stays as it was, Waiting for a 
  Recovery Abroad, 
  --------------------------------------------- --------- 
 
  ¶17.  (SBU) Germany's poor economic performance in the first 
     half of the year and the lack of consumers' and investors' 
     confidence will lead at best to stagnation of the German 
     economy in 2003. For 2004, the June forecast of a non- 
     adjusted 1.3% GDP growth is still valid, since the 
     Government's reform package is not expected to have a big 
     effect on real net income. 
 
  ¶18.  (SBU) The eventual recovery will be mainly driven by 
     the export side, as in previous years. Private consumption 
     will only increase by 0.9% due to several factors: (a) the 
     savings rate will remain at the high level of 10.8% as a 
     result of low confidence; (b) no significant change in the 
     labor market is expected (moreover, unemployment benefits 
     will be cut); (c) downward revision of GDP growth in 2003 
     will negatively affect gross income in 2004; (d) the 
     benefits to consumers of bringing forward the third step of 
     the income tax cuts will be partly counterbalanced by other 
     costs and fees. 
 
  ¶19.  (SBU) The latter point requires some clarification. 
     Implementing the 2003 tax cut, which had been postponed to 
     2004, and bringing forward the third step of the income tax 
     cut scheduled for 2005 to 2004 will combine to decrease the 
     introductory tax rate from current 19.9% to 15% and the top 
     rate from 48.5% to 42%. This will release taxpayers from 22 
     bn euro in payments, of which 15.6 bn are due to the third 
     step of the income tax reform. Not all of this will find its 
     way into additional disposable income. Some of the measures 
     that will mitigate the income benefits include (a) higher 
     pension contributions (increase from 19.5% to 19.9% is 
     expected); (b) consumer subsidy cuts (a reduction of tax 
     privileges of about 5.5bn euro are planned - partially 
     compensated by higher expenditures); and (c) a change in the 
     health care system (lower contributions rates, but increased 
     payments for coverage from own funds). 
 
  ...but Something is Happening! 
  ------------------------------ 
 
  ¶20.  (SBU) Although prospects beyond the forecast horizon 
     are not overwhelming, there is something going on in 
     Germany. Should the government be successful in getting its 
     program adopted, results, particularly on the budget front 
     as well as on investment and possibly even consumer 
     sentiment would be positive. The times of the "steady hand" 
     are over. This is already good news. Sentiment indicators 
     and market valuations also reflect improving prospects. 
     Passage of the governments reform plans, coupled with 
     improving expectations that a U.S. led global recovery is 
     underway, are combining to increase the sense that Germany 
     is finally on the way out of its three year stagnation. 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                      Forecast- Germany 
                          (Percent) 
 
 
 
 
                    2002        2003      2004 
                    ACTUAL     FORECAST  FORECAST        --- 
--------------------------------------------- -------- 
GDP :                0.2         0.0       1.8 
 
CONSUMPTION:        -1.0         0.7       1.4 
 
GOV. CONSUMPTION:    1.7         1.1       1.7 
 
INVESTMENT:         -6.7        -1.7       1.4 
 
- MACH. & EQUIP.:   -9.1        -0.7       4.5 
 
- CONSTRUCTION:     -5.8        -3.6      -1.4 
 
- OTHER INVEST.:     1.6         0.7       5.4 
 
NET EXPORTS:        51.4        -17.5      2.6 
 
- EXPORTS:           3.4         -0.2      3.1 
 
- IMPORTS:          -1.7         2.7       3.2 
 
NOM. GDP:           2110.4      2127.3    2165.6 
(Euro Bill) 
CURRT. ACCT.         59.7         44        59 
(Euro Bill) 
 
PRICES:              1.4          1.1        0.9 
 
EMPLOYMENT           38,668      38,200     38,350 
(Thousands) 
UNEMPLOYMENT          4,060       4,500      4,560 
(nat. definition) 
UNEMPLOYMENT RATE      9.8         10.9       11 
(nat. def.) 
 
TOTAL FISCAL BALANCE:  -3.8        -3.9      -3.8 
(Pct. GDP) 
 
¶21.  (U) This cable was coordinated with Embassy 
Berlin. 
 
¶22. (U) POC: Annette Foerster, Economic Specialist, e- 
mail foersterAM@state.gov; tel. 49-(69)-7535-2291, fax 
49-(69)-7535-2238. 
 
BODDE