New Delhi : An International Monetary Fund (IMF) mission, led by Oya Celasun, and comprising Ting Lan, Aiko Mineshima, Galen Sher, and Jing Zhou conducted discussions for the 2022 Article IV Consultation with Germany during May 9 ‒23. Prasad Ananthakrishnan, head of the Financial Sector Assessment Program (FSAP), participated in the concluding meeting. At the end of the visit, the mission issued the following statement:
The fallout from the war in Ukraine and COVID-related disruptions to global supply chains are slowing Germany’s economic recovery from the pandemic, with the spike in energy prices pushing up inflation to multi-decade highs. The recovery is expected to pick up some momentum in 2023 if energy supplies are secured, supply bottlenecks dissipate, and new COVID-induced restrictions are avoided. The immediate policy priorities are to secure gas supplies, cushion the spillovers from the war, and build resilience. The uncertain outlook for fossil fuel supplies makes the government’s plan to fast track the green transition even more critical. A ramp up in public and private investment will be needed to ensure a smooth and cost-effective transition. Looking ahead, population aging and structural transformation call for increasing labor supply and boosting skills.
1. The war in Ukraine has clouded the outlook before output had recovered to its pre-pandemic level. Just prior to Russia’s invasion of Ukraine, Germany’s economic activity was firming up. Easing semiconductor shortages were allowing auto production to regain some momentum. Moreover, in recent months, falling hospitalizations and relaxation of pandemic restrictions were helping services activity to rebound. The war in Ukraine impacts the economy through several channels: higher energy prices; scarcity of a range of products and commodities; and weaker external demand and confidence. The rise in energy prices explains much of the spike in consumer price inflation, although pressures are becoming more widespread.
2. The baseline scenario is for a tepid recovery, but risks are skewed downward. Growth is projected to slow to about 2 percent in 2022, from 2.9 percent in 2021, and pick up in 2023 to slightly above 2 percent if energy prices and supply bottlenecks subside, and COVID infections remain under control. Growth would then decline toward potential after 2024. Output would remain below the pre-pandemic trend in the medium term, given headwinds from elevated energy prices to private investment, weaker external demand, and greater economic and geopolitical uncertainty following the war. Inflation is expected to stay elevated at about 6½ percent in 2022 and moderate to about 3½ percent in 2023. However, growth could prove weaker and inflation higher than in the baseline. The greatest threat is a persistent and complete shut-off of Russia’s gas exports to Germany and Europe more broadly, as it would take at least two years to fully replace the missing supplies in Germany. Other risks include tighter sanctions or disruptions due to the war, or COVID-related restrictions at home and abroad, which can intensify global supply bottlenecks and weaken confidence. Persistently high inflation and fears of a de-anchoring of inflation expectations can prompt major central banks to tighten policies faster than expected, potentially leading to a sharp tightening in financial conditions and corrections in asset prices. Furthermore, delays in securing renewable energy supply or in enhancing digitalization, and fragmentation of global value chains, could weigh on Germany’s potential growth.
3. In this highly uncertain environment, fiscal policy should be flexible in the near term. Key pandemic support measures (such as expanded benefits under Kurzarbeit and grants to firms) are set to expire but a range of measures has been introduced to cushion the war impact. The fiscal stance is projected to be broadly neutral in 2022. This stance is appropriate under the baseline, with vulnerable households and firms receiving generally well-targeted support that should add little to inflation pressures. Also, the government’s plan to return to the debt brake rule in 2023 can be attained by phasing out the remaining pandemic support and energy relief measures as scheduled, which should be manageable under the baseline assumptions of waning drags from the pandemic and energy prices. But if downside risks materialize, the government should—besides allowing automatic stabilizers to operate fully—continue to flexibly provide targeted support, and consider activating the escape clause of the debt break rule for another year.
4. The immediate policy priority is to cushion the spillovers from the war, limit scarring, and build resilience. This means helping vulnerable households and firms cope with spiking energy costs, preparing for potential energy shortages, preventing a surge in bankruptcies and layoffs that could leave permanent scars, and deepening the understanding of the threats to the financial system. The government announced a generally well-designed package of measures to support households and firms in the face of high energy prices. It includes one-off income support payments to vulnerable individuals, which are the ideal way to help the economy as they provide temporary, cost-effective relief to those with the least means to cope with the shock while preserving incentives to conserve energy. However, it also includes broad-based relief measures such as temporary cuts to fuel taxes that are fiscally costly and distort price signals. Importantly, to build resilience, higher gas reserves are needed as soon as possible, which means that the subsidies for firms’ energy expenditures outlined in early April should be phased out as planned, at the latest. In addition, meaningful financial incentives could be considered to encourage voluntary gas-saving behavior. The more and the earlier demand is reduced, the smaller the shortages in the event of a gas shut off and hence the impact on GDP.
5. Efforts to ensure energy security should continue. The government has swiftly taken a range of steps to diversify sources of gas and lessen dependence on Russian energy, including by securing additional liquefied natural gas (LNG) supplies and financing facilities to re-gasify LNG. Activating the first stage of the national emergency plan for gas allowed more intensive monitoring of the market. Laws were amended to require companies to fill gas storage facilities before the winter, and in an emergency, for the government to take control of critical energy infrastructure and order price adjustments. However, more transparency about gas shortfall scenarios and infrastructure bottlenecks would encourage the necessary investment and help firms develop their crisis plans. Cooperation with other EU countries, including in the context of the REPowerEU, is key to secure additional gas supplies, and to ensure that infrastructure and legal frameworks are adequate to share gas between members in the event of a shortage. Germany has signed solidary agreements with Denmark and Austria, and further agreements are possible with other neighboring countries, including to ensure adequate supplies in land-locked countries dependent on flows through Germany.
6. In a gas-shut off scenario, the economy will need more policy support. Most existing studies put the output loss at up to 6 percent of GDP over one to two years, with the wide range of estimates partly reflecting uncertainty around the potential amount of gas shortages. The mission assesses the likely impact on inflation and output to be sizable. Automatic stabilizers would be the first line of defense.In addition, it would be important to ensure the solvency of energy companies to prevent financial constraints from exacerbating shortages. The plan to allow energy companies to pass on cost increases to end-users in an emergency would help in this regard, and would have to be complemented with greater targeted income support for vulnerable households. Also, firms’ demand for the government’s liquidity support facilities would grow, and further discretionary financial support to firms might be necessary. The authorities’ ongoing assessments of the economic and financial implications of this scenario will help to plan such support. Should rationing become necessary, macroeconomic implications should be considered alongside technical, legal, and social dimensions. The mission welcomes the authorities’ ongoing efforts to plan the distribution of gas in a potential emergency.
7. Removing obstacles to public investment is essential for a green investment push, which is a key priority in view of Germany’s climate and energy-security goals. The new government has set out numerous targets in line with Germany’s ambitious emissions goals, some of which have been made more stringent recently in a bid to boost energy security. Much of the additional green investment must be undertaken by the private sector, for which strong carbon pricing is key. However, as highlighted by the government, scaling up public green investment—e.g., upgrades to the electricity transmission system and an expansion of electric-vehicle charging stations—is vital to tackle network externalities and crowd in private investment. To boost public investment in energy security and decarbonization, digitization, and transportation infrastructure, the government should urgently simplify administration and enhance planning capacity, financing, and coordination across different levels of governments. This investment would also help reduce Germany’s large external imbalances.
8. Increasing labor force participation is critical to counter population aging, and boosting skills would facilitate structural transformation. Germany’s labor force contracted during the pandemic. Unless participation rates—especially for those 40 years and older—resume their pre-pandemic upward trend, or a recovery in immigration augments the working-age population, Germany will have to confront a diminishing labor force and a growing dependency ratio. Expanding high-quality childcare and strengthening incentives to work for secondary earners can further promote female labor-force participation and their working hours. The government’s plan to address the shortage of skilled workers by further easing immigration rules is a welcome step, and should be complemented with continued efforts to integrate migrants. Reducing the labor tax for lower-skilled workers would boost their disposable income and stimulate their labor supply. At the same time, enhancing training and up- or re-skilling workers are key to address skill mismatches, facilitate efforts to green the economy and jobs, and adapt to digitalization.
9. Looking ahead, Germany should continue to use its available fiscal space to invest in its own resiliency. The mission welcomes the government’s plan to ramp up spending to address strategic priorities related to energy security and progress toward net zero emissions. Space available under the fiscal rules should be used to further enhance life-long learning, digitalization, innovation, labor supply, and social protection. Meanwhile, extensive use of extra-budgetary funds outside of the core federal budget—to create borrowing allowances in view of unforeseen needs associated with the pandemic and the war—may undermine the credibility of Germany’s fiscal framework. Structural increases in spending for strategic priorities should be integrated into the core budget over time.
10. The German banking sector was assessed in the FSAP as generally resilient to shocks, but pockets of vulnerability warrant continued close monitoring and some additional action. German banks have so far weathered the pandemic and spillovers from the war well.Stress tests undertaken in the context of the 2022 FSAP find that overall bank capital is generally sufficient to withstand a severe adverse scenario including a three-standard deviation shock to growth over two years. The banking system also appears to be resilient to liquidity shocks. However, stress tests identify shortfalls of capital and US dollar liquidity at some individual banks under the adverse scenario. Furthermore, structurally low bank profitability remains a source of vulnerability. To address vulnerabilities identified in the stress tests, the FSAP has suggested that the authorities continue to closely monitor prudential ratios for large, systemically important commercial banks, establish additional bank-specific buffers for less capitalized banks as needed, and strengthen data collection at less systemically-important institutions about remaining maturity of retail deposits, wholesale funding, and interest-bearing assets, to allow them to perform their own top-down stress tests of interest rate risk. The authorities should also review the design of the fragmented deposit insurance system and consolidate existing mandatory schemes into a single scheme with a government liquidity backstop, which would facilitate greater risk pooling and diversification.
11. The authorities have appropriately tightened macroprudential policy in the face of elevated and rising house prices, but further actions are needed. House prices are estimated to be above fundamental levels for Germany overall, with even greater misalignments in larger cities. Mortgage origination has also been strong and lending standards appear somewhat loose in certain segments. With these vulnerabilities in mind, the authorities appropriately raised the counter-cyclical capital buffer and introduced a sectoral systemic risk buffer on loans secured by domestic residential real estate, with a phase-in period through end-January 2023. These actions should make banks more resilient to house price risks. The authorities have also cautioned banks against taking excessive risk in mortgage lending. Nevertheless, as suggested by the FSAP, precautionary use of borrower-based measures is warranted, and the authorities should address obstacles to their activation by modifying the law on borrower-based measures, while in the interim strengthening guidance on lending standards. The authorities are also urged to accelerate the closure of data gaps and add income-based measures into the macroprudential toolkit.