Features : Country Report: Germany - Global Finance Magazine

TURNING POINT

A few months ago, reeling from an inconclusive general election, Germany was facing an uncertain future. Undaunted, the countrys new chancellor, Angela Merkel, tried to rally enthusiasm and optimism with her promise to get Germany back on its feet.

On the face of it, it now appears her confidence was justified as signs of economic resurgence are sprouting on all sides. In their spring survey, the economic institutes of Kiel, Berlin, Hamburg, Munich, Halle and Essen revised their 2006 growth forecasts up from 1.2% to 1.8%. Investment in machinery and equipment has been expanding since 2004; manufacturing orders have risen since last year. Business confidence for manufacturing, wholesaling and construction all rose in April to the highest levels since unification in 1991.

Of course, these hopeful signs are still preliminary. Id hardly call 1.8% GDP a party, comments James Berman, president of global advisory firm JB Global in New York. He contrasts the upwardly revised growth estimates with the United States, which is growing at 3%, and even Japan, which appears poised to break through the 2% barrier. Skeptics are also concerned that much of the happier news is concentrated in forward-looking indicators, so the data will not be confirmed for a couple of quarters.

Doom-mongers point to some decidedly less speculative figures to back up their opposing views. Unemployment, for example, remains stubbornly high. Despite falling in April, unemployment levels remain at 11.5%, according to the governments Federal Labor Agency. Perhaps because of the persistently high level of unemployment, the government has also been playing down the six institutes rosy economic report, characterizing it as overly optimistic.

It is not entirely surprising that the government is leaning toward pessimism. Ever since it yielded its monetary policy to the European Central Bank, it has been compelled to rely on slower and blunter fiscal tools to control its domestic economy. And faced with a huge hole in its public finances, the new government is having to resort to one of the bluntest tools of alltax increasesto try to stem the flow of red ink. Unfortunately, raising taxes could easily nip the nascent economic recovery in the bud.

Policy Makers Strike a Delicate Balance

Angela Merkel, Germanys prime minister

One of the key proposals to generate additional tax revenues will strike at the heart of Germanys economic growth engineconsumer spending. A hike in the VAT, or sales tax, from 16% to 19% is scheduled for January 1, 2007. While some economists hope the timing will propel shoppers to load up on big-ticket items toward the end of 2006, boosting GDP, others are skeptical, claiming that the regressive increaseswhich disproportionately target the less affluentwill catch up, to result in depressed spending next year. The six institutes themselves suggest a two-stage solution would be preferable, raising VAT initially to 18% in 2007 and then to 19% in 2008.

If the increased sales tax does in fact discourage consumer spending, which accounts for almost 60% of German GDP, it could easily stymie the recovery. Recently, consumer-sentiment numbers have been gradually improving, climbing 1% in 2003 and 2% in both 2004 and 2005. Despite anxiety over rising oil prices and low expectations for growth in personal income, in April consumers propensity to buy reached its highest levels since 1999. Overall consumer optimism has touched its highest levels since 2001, according to a recent survey by German market research group GfK.

That growth in consumer confidence is reassuring to many experts, concerned that Germanys economic resurgence may be founded on too narrow a base. The recovery must broaden from the industrial, export-led sector to a wider consumer base, says Jonathan Loynes, chief economist at London-based Capital Economics. So far, exports have kept the engine running: Germany has been the worlds leading exporter for three years in a row. That pattern looks set to continue, with demand for industrial goods from outside euroland jumping 18.9% since last year, according to the Federal Ministry of Economics and Technology.

The Made in Germany tag remains highly respected. For example, private equity group Clayton Dubilier & Rice bought VWR, a scientific supplies distributor, from German Merck in April 2004. We acquired a valuable, over-engineered jewel of a company, says Bruno Deschamps, a London-based partner at CD&R.; It is no coincidence that Germany spends 2.5% of GDP on research and registers 277 patents for every million people employed (compared to an EU average of 182).

Quality is not enough, however. Capital and labor can shift too rapidly. Like other industrial nations, Germany is moving facilities to lower labor cost regions. Last year, Continental, a tire and automotive component manufacturer, moved production to Slovakia, China and Brazil, while retaining critical functions in Germany. The forces of globalization are changing the equation between labor and management, says Jackson Janes, executive director of the American Institute for Contemporary Studies in Washington, DC.

Fighting To Compete

German companies are attempting to retain their competitive advantage by cutting costs, shedding workers, outsourcing and moving output abroad, as well as negotiating longer hours for less pay. Volkswagen has axed 20,000 jobs. At Daimler, 160,000 workers have agreed to pay cuts and increased hours in return for a pledge of no redundancies before 2012. Metalworkers union IG Metall recently demanded a 5% wage rise for its 3.4 million workers but has since backed down and agreed to a more modest 3%.

For decades, unions and management have been negotiating on the basis of an entire industrial sector, with some companies reserving the right to opt out of the system. But the technology revolution has changed the balance, and the disparity between wages for high- and low-skilled workers is widening. In consequence, more companies are opting out. Behind the scenes, many firms are wriggling out of the rigid rules of sectoral wage bargaining, explains Katinka Barysch, chief economist at the Centre for European Reform.

Reforms must extend beyond labor flexibility in wages, hiring or firing. According to Axel Merk, manager of the Merk Hard Currency Fund in Palo Alto, California, red tape and reams of regulation desperately need cutting. Merk points to excessive power wielded by local bureaucrats. For example, he says, every business is audited every two years. Germans get things done despite these huge distractions, he comments. But they need to spend more time and efforts on genuine productivity.

Mind-boggling numbers from the World Bank and OECD reflect the criticism. German businesses must cope with 2,100 laws, 47,200 rules and 3,100 regulations. This maze of regulations costs the country somewhere between E46 billion and E80 billion a year, with 80% of that burden falling on smaller and medium-size businesses, the Bonn-based Institut fr Mittelstandsforschung (Institute for Small Business Research) says.

Progress is nevertheless under way. In spring this year, a bipartisan parliamentary group, with representatives from both the CDU and SPD, set up an independent advisory body under the auspices of the Federal Chancellery. This Normenkontrollrat has an unenviable task: to examine, and perhaps rationalize, the reams of burdensome existing laws.

Recent economic signals are tentative, and the jury is still out. Reforms are under wayin labor, pensions, health care, regulation and taxesbut the process is painfully slow. Another drag on Germanys growth, the former East Germany, has already absorbed about $1 trillion over the past 15 years. It will remain a burden for the foreseeable future, Barysch warns, costing 4% of GDP in unemployment subsidies.

Vanessa Drucker