VZCZCXRO3389
PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV
DE RUEHRL #0884/01 1221556
ZNR UUUUU ZZH
P 021556Z MAY 07
FM AMEMBASSY BERLIN
TO RUEHC/SECSTATE WASHDC PRIORITY 8138
INFO RUEATRS/DEPT OF TREASURY WASH DC
RUCPDOC/USDOC WASHDC
RUEHC/DEPT OF LABOR WASHINGTON DC
RUCNMEM/EU MEMBER STATES
RUCNFRG/FRG COLLECTIVE

UNCLAS SECTION 01 OF 04 BERLIN 000884 
 
SIPDIS 
 
SIPDIS 
 
STATE FOR EUR/AGS 
LABOR FOR ILAB 
 
E.O. 12958: N/A 
TAGS: ECON EFIN ELAB PREL GM
SUBJECT: SNAPSHOT OF GERMAN ECONOMY ? RECOVERY IN 
FULL SWING 
 
 
¶1.  Summary:  The German economy is expected to 
grow 2.4% in 2007 according to the spring 
consensus forecast of Germany?s six leading 
economic institutes.  After half a decade of 
below-average economic performance, Germany has 
finally caught up with the general growth trend 
in the Euro zone, overcoming its ?sick man? 
image.  The recovery is no longer a purely 
export-led phenomenon as improved domestic 
consumption and investment have increased the 
domestic component of overall growth to two 
thirds.  This positive development has gone hand- 
in-hand with a larger than expected fall in 
unemployment and the largest creation of new 
?regular? jobs subject to social security 
contributions since 2000.  In the first months of 
2007, unemployment fell below 4 million or 9%, a 
full 2 percentage points below levels seen a year 
ago.  However, economic institutes caution the 
positive trend is almost entirely due to cyclical 
factors and that the German structural problems 
have yet to be fully addressed.  They warn 
against relenting on efforts for reform and make 
the point adjustment costs are more readily 
accepted in a positive economic environment than 
during a downturn.  Public finances in particular 
need to be reformed further to remove continued 
structural imbalances.  End summary. 
 
CONSUMPTION PICKKING UP AFTER YEARS OF STAGNATION 
 
¶2.  Private consumption, the main area of concern 
for many years on the domestic side of the 
economy, finally picked up speed in 2006.  Since 
real wages stagnated in 2006, the 0.8% increase 
in private household consumption was mainly 
attributable to rising non-wage capital income 
derived from portfolio investment.  Advance 
purchases of consumer durables ahead of the 
January 2007 VAT rise also contributed to the 
increase.  The savings rate also decreased 
slightly, reflecting improved consumer optimism 
about the economy.  Despite slightly lower levels 
of consumption in first quarter 2007 due to the 
?advance purchase effect? ahead of the VAT 
increase, consumption is expected to improve by 
0.9%, in line with a 0.9% increase in disposable 
household income in 2007, and by 1.4% in 2008. 
The rise in consumption has been a surprise to 
the German economists who had expected a deep 
once the higher VAT rate went into effect.  Trade 
unions are negotiating higher wage increases for 
their members, which could also stimulate 
domestic consumption. 
 
CAPITAL INVESTMENT GROWS AS PRODUCTION EXPANDS 
 
¶3.  Capital investment grew 7.3% in 2006, the 
largest increase since the boom year 2000.  A 
positive business climate, tax incentives, 
favorable financing opportunities, and high 
levels of capacity utilization are expected to 
sustain this trend into 2008 at an average annual 
increase of 6.2%.  As further proof of economic 
improvement, companies cited expansion of 
capacity, rather than labor restructuring or 
increased efficiency, as the main reasons for 
increased capital investment in a recent poll. 
In addition, corporate tax reform, which is set 
to come into effect in 2008, will provide further 
incentives to reinvest profits. 
 
CORPORATE TAX REFORM TO IMPROVE GERMAN 
COMPETITIVENESS 
 
¶4.  The corporate tax reform bill, currently 
before Parliament, would lower tax rates by 
almost ten percentage points while also closing 
existing loopholes.  The current tax rate for 
corporations of 38.6% will fall to 29.8%.  The 
bulk of the savings will come though culling the 
corporate tax rate, from 25% to 15% (the 
remaining balance consists of the communal 
business tax).  The phase-out of many tax write- 
offs will particularly affect companies that in 
 
BERLIN 00000884  002 OF 004 
 
 
the past were able to offset their profits with 
losses, which significantly reduced the tax-base. 
It also includes controversial elements like the 
taxation of the relocation of production 
facilities out of Germany.  This proposal has 
triggered criticism from industry and Federal 
Economics Minister Michael Glos (CSU).  Given the 
benefits to larger corporations as a result of 
the tax reform, Glos would like more to be done 
for small and medium size companies.  At the same 
time, Federal Finance Minister Peer Steinbrueck 
(SPD) -- who expects a net revenue loss of about 
5 billion Euro as a result of the reform -- is 
under attack from the left wing in his own party 
who view the 5 billion loss as a give-away to big 
business at a time of high profits.  The reform 
would bring Germany's tax rate closer to that of 
other big EU countries, although it would still 
be higher than the rates in some of the new EU 
member states.  Most experts agree however, that 
more companies will pay their taxes in Germany as 
a result of the reform.  Steinbrueck expects the 
revenue loss of the first two years following the 
implementation to be more than off-set by the 
higher number of companies paying taxes beginning 
in 2010. 
 
DECADE-LONG SLUMP OF CONSTRUCTION SECTOR FINALLY 
ENDS 
 
¶5.  This year, the German construction industry 
made its first significant contribution to 
economic growth since 1994.  While increases in 
private construction were largely due to imminent 
changes in taxation and allowances, business 
investors clearly based their decisions on the 
improved economic climate.  Private investment is 
expected to grow more slowly in 2007, despite new 
tax incentives to make homes more energy 
efficient.  However, it is forecasted to pick up 
speed again in 2008 when higher disposable 
household incomes are expected to increase demand 
for new housing.  Construction sector growth is 
crucial for reducing unemployment among low- 
skilled workers. 
 
SUBSTANTIAL FALL IN UNEMPLOYMENT EXCEEDS 
EXPECTATIONS 
 
¶6.  With the improving economic climate, 
unemployment has fallen at surprising speed.  In 
2006, unemployment decreased by 597,000 over the 
course of the year.  Average unemployment in 2006 
was 4,487,000, about 374,000 fewer than in 2005. 
The average unemployment rate for 2006 dropped 
0.9 percentage points to 10.8 percent.  The 
growing economy is expected to see unemployment 
figures drop by another 700,000 this year and 
270,000 in 2008 to below the 3.5 million mark, 
reducing the average unemployment rate to 8.7% 
this year and to 8.0% in 2008.  Nevertheless, the 
problem of long-term unemployed unable to find 
jobs is highlighted by their proportional 
increase among the total of unemployed.  Although 
there were 257,000 fewer long-term unemployed in 
March 2007 compared to the same month a year 
before, their relative weight increased from 
39.8% to 41%.  This trend is likely to lead to 
slower reduction in unemployment even as the 
economy continues to improve. 
 
WAGES RISING SLOWLY AS EXPERTS CAUTION RESTRAINT 
 
¶7.  Wages increased by only 1.1% in 2006, despite 
an improved economic environment, partly due to 
the relatively few collective bargaining 
agreements up for renewal last year.  However, 
after years of wage moderation, unions and 
workers are now demanding their share in the 
economic upswing.  The powerful Metal and 
Electronics Workers? Union, IG Metall, is calling 
for a wage increase of 6.5 percent for its 3.4 
million members in this year?s collective 
bargaining round, which started in early March. 
The employers? association Gesamtmetall, however, 
 
BERLIN 00000884  003 OF 004 
 
 
has countered with an offer of only 2.5 percent, 
plus a 0.5 percent lump-sum payment for the year. 
IG Metall has begun to stage warning strikes and 
the two sides will likely narrow their 
differences.  Unions and employers in the 
chemical sector, which also enjoyed healthy 
profits last year, quietly hammered out a deal 
giving 550,000 employees a 3.6 percent pay hike 
plus a lump-sum payment of 0.7 percent of their 
annual salary.  In the construction industry, 
employers and unions agreed on a 3.5 percent wage 
increase covering nearly 700,000 workers starting 
May 1.  Economic experts caution against any 
increases that go beyond 2.5% to 3.0%, arguing 
these would undo the achievements in wage 
competitiveness of recent years and are likely to 
lead to job cuts in the future.  They recommend 
lump sum payments to account for the cyclical 
upswing rather than wage increases across the 
board.  Unions counter that cost-of-living hikes 
like the VAT hike are not lump-sum increases.  On 
average, wages are expected to rise 2.0% this 
year and by a further 2.8% in 2008, when wage 
agreements of public sector employees run out. 
 
TRADE CONTINUES TO GROW RAPIDLY 
 
¶8.  Germany?s exports in 2006 grew a remarkable 
12.5%, almost attaining the benchmark record 
rates of 2000 (13.5%).  Trade with the new EU 
member states grew particularly strongly, and 
East Asia and Russia were the fastest growing 
markets for German exports outside of the E.U. 
For 2007 export growth is expected to slow down 
in the first half year, due to statistical 
reasons and lower orders in late 2006, and to 
pick up again in the second half of the year. 
Export growth is expected to be 8.4% in 2007 and 
8.1% in 2008.  A further boost is expected to 
come from the increased competitiveness of 
exports due to the reduction of social security 
contributions which were introduced in tandem 
with a 3 percentage point VAT increase at the 
beginning of the year (exports are not subject to 
VAT; as a result, relative unit labor costs have 
decreased).  Imports rose sharply as well; at 
11.1%, the rate surpassed that of the record year 
2000 (10.5%).  Improved domestic consumption 
after an initial drop due to the VAT increase at 
the beginning of 2007 is expected to drive a rise 
in imports by 7.5% in 2007 and 8.4% in 2008. 
 
PUBLIC FINANCES IMPROVE AS STRUCTURAL PROBLEMS 
REMAIN 
 
¶9.  Public finances improved markedly in 2006 due 
to continued moderation in expenditures, lower 
spending on unemployment and social costs, and an 
unusual increase in revenue by 7.5%.  The budget 
deficit decreased from 73 billion to around 40 
billion Euros.  The corresponding deficit ratio 
fell from 3.2% to 1.7%, well within the limits 
set by the EU on government spending (Maastricht 
criteria).  The trend is expected to continue 
this year as the deficit is projected at 13.2 
billion or 0.6% of GDP.  The six institutes are 
cautiously optimistic as additional revenue and 
reduced spending are the result of cyclical 
improvements while many of the structural 
problems of the economy have yet to be addressed. 
They are very critical of the high level of 
consumption spending and decreasing state 
investment which fell from 1.9% in 1999 to 1.3% 
¶2005.  They draw attention to research and 
development as well as education as the focus for 
more spending, especially since the spending 
target of 3% of GDP imposed by the EU-Lisbon 
Agenda has not yet been achieved.  The institutes 
demand a further cut in social security 
contributions and eventually in the level of 
income tax.  Although the balanced budget which 
may be realized in 2008 is an improvement, they 
say that a surplus which would allow for greater 
spending during an economic downturn should be 
the government?s objective. 
 
BERLIN 00000884  004 OF 004 
 
 
 
KOENIG