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UNCLAS SECTION 01 OF 04 FRANKFURT 008717 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EUR PDAS, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS LEE 
TREASURY ALSO FOR ICN COX, HULL 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT:  Forecast for Germany: Moderate Growth, High 
Deficits; Clear, Consistent Reform Efforts Still the Key 
 
 
T-IA-F-04-0023 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
¶1.  (SBU) Summary:  Our forecast for Germany shows moderate 
real GDP growth of 1.7% in 2005 after 1.8% in 2004.  The 
government deficit should top 4% of GDP this year, then 
decline to 3.5% in 2005, based on current policies. 
Persistent joblessness in western Germany, and even more so 
in the East, is a strong Government concern.  Typically 
German recovery is fueled by export growth that feeds back 
into investment, then employment, then consumption.  The 
investment link is the weakest this time around. 
Supplementary labor costs borne by enterprises, relatively 
high tax rates, and burdensome regulations are among 
impediments to investors.  These drawbacks seem to have 
become relatively more pronounced as investment options in 
central European countries continue to improve.  Fiscal 
policy has not produced the demand side effects anticipated, 
despite a deficit well beyond "restraints" of the EU 
Stability and Growth Pact. Perhaps a partial answer lies in 
the quality of public expenditure, which is consumed by 
social and financing costs and not investment.  Spending 
smarter while cutting taxes or social charges through 
coherent, consistent, and comprehensive reforms could help 
boost both investment and the government's bottom line. 
There is German public support for reform, but the discord 
among the country's political leaders as well as the round 
of state and local elections in the run-up to the 2006 
national campaign is sapping the government's will and 
ability to make the long-needed reforms.  End Summary 
 
Forecast: Moderate Growth in 2004 and 2005 
------------------------------------------ 
 
¶2.  (SBU) Our recent forecast points to German real GDP 
growing by 1.7% in 2005 after an increase of 1.8% this year. 
Growth in both years will be mainly driven by exports. 
Softer growth in the Euro area next year will be compensated 
by a pick up in German domestic demand. 
 
Consumer Demand to Pick Up 
-------------------------- 
 
¶3. (SBU) In a typical German economic recovery, export 
growth triggers higher investment, raising employment, 
consumer confidence and retail sales.  The recovery we see 
this time around will by pass strong investment growth. 
Private consumption has been stagnating in 2003 and 2004 due 
to a slow rise in disposable income and a noticeably higher 
savings rate, up from 9.6% in 2000 to 11% in 2004.  Consumer 
confidence has been soft, employment declining, unemployment 
raising and high contributions to social security systems 
continuing.  Businesses blame uncertainty over Germany's 
economic outlook and confusion over the course of reforms 
for causing Germans to boost their already high level of 
savings. There may be a moderate up tick in 2005 consumption 
stemming from stronger growth in disposable income caused by 
lower income taxes (the last step of the income tax reform) 
and higher self-income.  However, current consumer behavior 
makes this more difficult than usual to predict.  Next 
year's boost to consumption should stem from stronger growth 
in disposable income caused by lower income taxes (the last 
step of the income tax reform) and higher self-employed 
income. 
 
Investment Weakness a Puzzle 
---------------------------- 
 
¶4.  (SBU) Investment continues to be a partial puzzle.  The 
prolonged drag on overall investment by the construction 
sector, which accounts for 50% of all investment, will not 
disappear next year.  Machinery and equipment investment 
will rise 4.6% -- much better than recent years, barely 
pushing growth in overall investment activity past the 0.5% 
mark.  Recent en vogue explanations for poor investment 
performance include "credit crunch" and "outsourcing." 
Bundesbank officials argue that the rise in German overseas 
investment, which does not register in the available 
statistics, is financed by capital German firms are raising 
outside the Federal Republic. 
 
¶5.  (SBU) The Bundesbank makes a credible argument that 
demand for loans is what is lacking, not supply.  With 
respect to outsourcing, it is true that share of imported 
materials in German exports has risen from around 30% in 
1995 to almost 39% in 2002.  This phenomenon has generated a 
heated debate on whether Germany has become a "bazaar 
economy," with industrial production hollowed out as 
investors make needed inputs in other countries.  A lower 
share of industrial output in overall economic activity, 
however, does not necessarily mean a decline in overall 
output.  That is, unless workers cannot find new jobs in 
other, equally or higher productive jobs such as in the 
service sector.  Unfortunately, that seems to be the case 
according to a McKinsey report cited by USB Warburg research 
economists.  While for each euro of outsourcing, the German 
economy gains only 79 cents, for each dollar of outsourcing 
the U.S. economy realizes 1.13 dollars.  The difference is 
that nearly 70% of the displaced workers in the U.S. found 
new jobs with higher productivity within six months. In 
Germany only 40% do. 
 
¶6.  (SBU) There are some bright spots on the horizon that 
support even our modest pick up for investment in equipment 
and machinery.  Real interest rates stand at historically 
low levels, bank profitability is going up (suggesting a 
possible increased emphasis in lending to the less marginal 
credit cases) and wage rounds have yielded labor cost 
increases of only 1.5%.  Government efforts to reduce some 
of the institutional rigidities will help next year with 
labor market reform (Hartz IV, i.e., the merger of 
unemployment and social aid programs) and loosening of 
firing restrictions for small and medium-sized enterprises. 
Recent labor agreements add to some cautious optimism, 
resulting in longer hours and more flexible tariff wage 
contracts.  These can help constrain unit labor costs, 
bolstering Germany's price competitiveness.  These trends 
will be working against the headwind of managers doubting 
that the global recovery will continue next year, as 
suggested by recent sentiment indicators. 
 
Budget Deficits Continue 
------------------------ 
 
¶7.  (SBU) A best-case scenario for 2005 puts the government 
deficit at 3.5% of GDP, more than spitting distance from the 
3% Maastricht mark.  The Finance Minister's "Project 3%" 
will be working full tilt to avoid the European Commission 
from cranking up the Stability and Growth Pact again - this 
time taking up Eichel on his own November 2004 pledge to get 
the deficit below 3% in 2005. 
 
¶8.  (SBU) The 2005 budget is encumbered with several risks. 
Among these are high-expected revenues from planned 
privatization (15.5 billion euros) and the still-to-be- 
proven heavy truck highway toll (3 billion euros).  The 
costs of merging the unemployment benefit and social welfare 
systems is probably underestimated.  One welcomed feature 
for 2005 should be that the social security programs are 
unlikely to have to draw on the budget. 
 
¶9.  (SBU) For 2004 the deficit is likely to top 4%.  Poor 
revenue performance from weak domestic demand is the primary 
reason.  Also, rosy revenue scenarios have not panned out as 
dreamed for the highway toll for heavy trucks (zero instead 
of 2.8 billion euros), Bundesbank profit (only 248 million 
euros instead of 3.5 billion euros) and tax amnesty (3-400 
million euros rather than 5 billion euros). 
 
Lower Prices and Gains In Employment 
------------------------------------ 
¶10.  (SBU) German inflation will decline, despite current 
energy and raw material price rises, as no administrative 
price or tax hikes are expected and assuming oil prices 
moderate.  Labor market statistics will be difficult to 
interpret as 900,000 recipients of social welfare will have 
to register as unemployed to get the new unemployment 
benefits.  No reliable estimates exist as to how many of 
these are already so registered.  Some estimates suggest 
that the number of unemployed might increase by 300,000. 
Employment should increase slightly.  The unemployed should 
be attracted by mini-jobs that will allow them to boost 
their net income by retaining government benefits plus the 
earned income and should be deterred by the prospect of 
losing benefits if they do not accept a job offer. 
 
Investment and Government Demand Side Policies: A Closer 
--------------------------------------------- ----------- 
Look 
---- 
 
¶11.  (SBU) Investment weakness, a prominent feature of this 
forecast, deserves a bit of a closer look.  Recent wage 
settlements have highlighted the gulf between what workers 
contribute to production and what employers pay.  USB 
Warburg economic research estimates that for the engineering 
industry in 2003 pay for value-added labor was 30,425 euros. 
The firm then paid an extra 37.4% for non-working days (paid 
holidays) and bonuses (the "thirteenth month").  Compulsory 
contributions to social security added another 27.2%, 
pension schemes and other supplementary costs accounted for 
another 13.2%.  Total wage costs amounted to 50,095 euros or 
177.8% of the pay for value added labor.  Wage agreements 
and government reforms could help close a portion of this 
divide that contributes to make Germany a relatively less 
attractive investment location. 
 
¶12.  (SBU) The recent OECD Survey of Germany also points to 
high corporate taxes.  It cites a study by the German 
Council of Economic Experts based on 2003 tax codes showing 
that Germany has the highest average effective taxation of 
returns of investment. 
 
¶13.  (SBU) Some recent commentators have suggested the 
government could do more to help simulate demand.  The 
government's tax reform, a remarkable achievement in its 
time, has dropped the top income tax rate from 53% to 42% 
beginning in 2005.  In 2004 and 2005 together this should 
add 1% of GDP back into consumer's pockets, according to 
OECD estimates.  Other fiscal charges or administered price 
increases have eaten away some of those gains offered in 
previous stages of the income tax cut.  Some of gone into 
the higher savings rate, as noted above. 
 
¶14.  (SBU) Another part of the answer could lie in the 
quality of the government's expenditures.  57% of the 
government's expenditures in 2003 went to social welfare 
programs and only 3% to investment.  In the 1980's the 
government spent 48% of its budget on social systems and 5% 
on investment. 
 
¶15.  (SBU) Transfers amounting to around 4% of GDP to the 
new states are increasingly ineffective in promoting growth. 
The OECD judges that subsidies to enterprises in the new 
states have not increased productivity but have increased 
dependence on the government and decreased adaptability to 
market forces.  The OECD also estimates that more than half 
the transfers for infrastructure are used for government 
consumption (culture, central administration), with the 
number of government employees per inhabitant in the new 
states exceeding the ratio in financially weak western 
states by 25%. 
 
¶16.  (SBU) Tax subsidies for construction have contributed 
to overcapacity in office and residential housing that 
continue to weigh against investment.  Government 
procurements, which account for 17% of GDP, are highly 
complex, often broken into small contracts administered at 
the state level and not subject to open competition at the 
EU level, according to an OECD analysis. 
 
¶17.  (SBU) One theme that runs through discussions on 
investment and government budget policies is "confidence," 
or lack thereof.  Uncertainty about global demand, 
employment, and reforms feed into this lack of confidence. 
Confidence can work wonders.  In that bellwether year for 
German growth, 2000, the business community was optimistic 
about the future when the tax reforms were adopted, only to 
turn sour when new policies were adopted that were not so 
favorable for economic growth. 
 
¶18.  (SBU) The European Commission points to research 
suggesting that even as a government reduces its budget 
deficits through structural changes, consumers' and 
investors' expectations can, and have, improved if they 
sense that the government will pass the gains on through 
lower taxes (or no tax increases).  Consumption goes up and 
investment goes up if there is a clear, consistence 
comprehensive and credible reform plan.  A recent survey for 
the German Financial Times suggested that the majority favor 
reforms.  Confidence could follow.  Less and smarter 
government spending is something that most would understand. 
 
 
                    Forecast for Germany 
 
                              2003      2004      2005 
 
Percent Avg. Annual Growth 
GDP                                -0.1      1.8       1.7 
  of which 
  Consumption                         0.0       0.0 
  1.4 
  Investment                         -2.2      -2.8 
  0.6 
  -construction                 -3.3      -4.1     -2.6 
  -machinery & equipment             -1.4      -1.9 
  4.6 
      Net Exports                  -11.2     36.7      8.8 
 
Consumer Price Index               1.0       1.7       0.9 
 
Employment                         -1.0      -0.3      0.4 
Unemployment Rate (%)              10.5      10.6      10.6 
Fiscal Balance (%GDP)              -3.8      -4.1      -3.5 
 
 
¶19.  (U) This message coordinated with Embassy Berlin 
 
¶20.  (U)POC: James Wallar, Treasury Representative, e-mail 
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
7535-2238 
 
Bodde