EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1004 final COMMISSION STAFF WORKING DOCUMENT Country Report Germany 2019











Including an In-Depth Review on the prevention and correction of macroeconomic imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2019) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Overall findings regarding imbalances, risks and adjustment issues 4.Reform priorities 4.1.Public finances and taxation* 4.2.Financial sector 4.3.Labour market, education and social policies* 4.4. Competitiveness reforms and investment* Annex A: Overview Table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Cohesion Policy Funding 2021-2027 for Germany References LIST OF Tables Table 1.1:Key components of income and final demand of non-financial corporations: contributions to the economy-wide net lending Table 1.2:Key components of household income and final demand: contributions to the economy-wide net lending

Table 1.3:Key components of government revenue and expenditure: contributions to the economy-wide net lending Table 1.4:Key economic and financial indicators - Germany Table 2.1:Summary table on 2018 CSR assessment Table 3.1:Outward spillover heat map for Germany Table 1:Spillover effects of structural reforms – Germany closing half of the structural reform gaps Table 3.2:MIP Assessment Matrix Table 1:Budgetary impact of the reform scenarios (in million EUR) Table 4.2.1:Quarterly financial soundness indicators Table 4.4.1:Emissions Effort Sharing sectors Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: Demand components of GDP growth Graph 1.2: Prices and costs in construction Graph 1.3: New dwellings completed

Graph 1.4: Contributions to headline inflation Graph 1.5: Improving labour market Graph 1.6: Economic performance by regions, compared to the EU average Graph 1.7: Sectoral net lending Graph 1.8: Current account and component balances Graph 1.9: Current account balance and components of the financial account Graph 1.10: Factors explaining the current account surplus Graph 1.11: General government budget balance and gross debt Graph 2.1: Overall multiannual implementation of 2011-2018 CSRs to date Graph 4.1.1: Correlation between gross investment and debt in 2017 Graph 4.1.2: Regional debt and investment shares in 2017 Graph 4.1.3: Cost of tax compliance (as % of turnover) Graph 4.1.4: Paying taxes: time to comply (hours per year) Graph 4.1.5: Environmental tax revenues (% GDP) Graph 1: Overview of simulation results Graph 4.2.1: Mortgage debt, volume and % of GDP Graph 4.3.1: Beveridge curve Graph 4.3.2: Real unit labour cost, real compensation per employee and real productivity - compared to 2000 Graph 4.3.3: Poverty and social exclusion Graph 4.4.1: Labour and total factor productivity

Graph 4.4.2: Expenditure for R&D&I in Germany Graph 4.4.3: Start-up rates in Germany Graph 4.4.4: Change in GDP per head (PPS), 2007-2016 LIST OF Boxes Box 1.1: The automotive sector in Germany Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Germany Box 3.1: Spillovers of structural reforms – the case of Germany Box 4.1.1: Tax shift from labour to inheritances and gifts Box 4.1.2: Reform options for the German pension system Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 4.4.1: Investment challenges and reforms in Germany Executive summary Sizeable investment efforts and innovation combined with structural reforms, would make the German economy more resilient to unfavourable external and domestic developments and ensure a sustainable and inclusive growth model. The German economy is facing challenges in a number of sectors, which have traditionally performed well internationally. Stronger investment and innovation efforts are needed to boost productivity and help diversify Germany’s growth model, keeping up with technological change and demand shift and dynamics. Boosting both private and public investment would be a way to address challenges related to sustainable transport, decentralised renewable energy production, digitalisation and demographic change. Higher investment in and expenditure on education and skills, very high-capacity broadband and research and development are key to raising long-term growth potential. Structural reforms promoting better use of the labour market potential of groups that have so far been inactive or under-represented could help address the already noticeable shortages of skilled labour and support income, especially for low-income earners. ( ) The German economy continues to grow, driven by domestic demand in an increasingly challenging external environment. After a 2.2 % rise in 2017, GDP grew by only 1.5 % in 2018. The contribution of net exports turned negative, as solid domestic demand pushed up the import-to-GDP ratio and export growth was weaker than in previous years. The current account surplus declined from 8.5 % in 2016 to 8.0 % in 2017 and 7.4 % in 2018. Underpinned by the continued economic expansion, unemployment fell to a record low of 3.2 % by the end of 2018, despite the increase in the labour force. Despite very low unemployment and high job vacancy rates, real wage growth has edged up only moderately, to around 1 %. Core inflation was at 1.5 % in 2018 and is expected to edge up to 1.6 % by 2020, in the context of moderate domestic demand. The government budget surplus increased during the reporting period, and public debt continues to fall, providing ample space to boost public investment. In 2017, the government surplus reached 1.0 % of GDP, rising further to a record high of 1.7 % of GDP in 2018.() The budget is expected to remain in surplus in 2019 as well, but at a lower level. The gross debt-to-GDP ratio is expected to decrease from 63.9 % in 2017 to 60.1 % in 2018 and to fall further below the Treaty reference value over the next couple of years. Given its economic importance and strong integration in EU value chains, structural reforms in Germany could both raise its potential for growth and trigger positive spillovers in other EU countries. Structural reforms in Germany, such as lowering the heavy tax burden on labour, would increase its GDP and, to some extent, that of other EU countries as well, as higher demand for foreign products in Germany is expected to outweigh the increase in competitiveness. Germany also plays an important role in further developing the Single Market. However, some obstacles remain, such as the lack of competition in business services and the underinvestment in network industries. Focusing private and public investment on network industries and services such as digital, energy and transport infrastructure, as well as on education and innovation, could improve Germany's growth potential. Despite some acceleration in public investment, the country’s investment ratio in 2017 was still below the average of the rest of the euro area. It is lagging behind in deploying very high-capacity broadband, which could improve productivity growth and boost convergence in regional living conditions if more were invested. Stronger public and private investment in sustainable transport and electricity infrastructure is crucial to meet climate, energy and environmental targets. Higher investment in research and innovation, especially among small and medium-sized enterprises, could increase total factor productivity. Higher expenditure on education and skills could help to tackle short-term labour shortages and demographic ageing, while ensuring growth that is inclusive.. Annex D identifies key priorities for EU cohesion policy funding over 2021-2027 in Germany, building on the analysis of investment needs and challenges outlined in this report.

Overall, Germany has made limited ( ) progress in addressing the 2018 country-specific recommendations. There has been some progress in the following areas: ·Public and private investment, including R&D expenditure has increased, partly as a result of the increase in resources allocated to infrastructure programmes. ·Disincentives to work more hours are being reduced as changes in social security contributions and certain benefits are increasing net wages. ·Wage increases reflect improved conditions, but the increase remained limited in real terms. There has been limited progress in the following areas: ·The availability of very high-capacity broadband infrastructure nationwide has improved only slowly, despite promising announcements. ·Only a few measures have been taken to make the tax system more efficient and investment-friendly. ·Only a few, skills related measures have been taken, e.g., to promote longer working lives. Regarding progress in reaching the national targets under the Europe 2020 strategy, Germany is performing well on: ·the employment rate ·reducing early school leaving and poverty ·investment in research and development (R&D) ·increasing the share of renewable energy. However, it is unlikely to reach its national indicative energy efficiency and climate targets by 2020. Germany performs well on the indicators of the Social Scoreboard supporting the European Pillar of Social Rights. It has low unemployment, including youth unemployment. However, it scores only averagely on the Social Scoreboard as regards the gender employment gap. The social dialogue functions well, and the social partners are overall closely involved in policy-making. The main findings of the in-depth review contained in this report and the related policy challenges are as follows: ·The current account surplus has declined for the last three years, but is expected to remain high, contributing 2.3 pps. to the euro area surplus of 3.3 % of euro area GDP. Strong domestic demand is expected to keep import growth above export growth, further easing the current account surplus. The domestic saving-investment imbalance, which has been growing since 2008, reached a turning point in 2016. Since then, private sector net lending has been coming down, but partially offset by the public surplus which has continued to rise. Despite the efforts made, the factors which keep investment low relative to savings remain largely in place. ·Private investment has increased noticeably, but not across all asset types. Equipment investment has grown robustly in response to record-high capacity utilisation. Housing investment continues to boom, even if the construction sector reports capacity constraints and price increases. However, significant challenges loom. The manufacturing sector faces a slowdown in foreign demand dynamics, in tandem with a need to adapt to new consumer preferences and technological change (e.g. low-emission cars). Non-residential construction has been increasing sluggishly in real terms, suggesting that essential infrastructure may not have kept up with the economy’s needs. ·Real public investment is increasing after a period of reduction, but more efforts are still needed to clear the large investment gap, particularly as regards investment in infrastructure and education. Public investment in 2018 grew by 7.7 % nominally and 3.8 % in real terms. Real public investment growth has been positive for the last three years, after showing negative growth rates before that. This reflects government efforts to boost investment. However, as in the years before, net investment at municipal level remained negative in 2018 and the investment backlog accumulated by 2018 rose to 5 % of GDP. The biggest shortfalls are in education and infrastructure. Investment in public infrastructure is still held back by capacity and planning constraints at municipal level. Measures initiated to overcome these have yet to show tangible results. Moreover, there is scope to improve digital public services and public procurement.

·Labour productivity growth in Germany has slowed and turned negative in the second half of 2018.. Given the reduction in labour force potential caused by demographic change, productivity growth will increasingly depend on investment in productive capital and innovation, including in digitalisation. Firm-level data show that the gap between the most and the least productive companies has widened, suggesting that there are obstacles to the spread of technology. ·Germany’s electricity networks are still slow to adapt to higher shares of renewables, and there has not been enough investment in transmission and distribution grids. The lack of appropriate grid infrastructure is causing financial losses to Germany and other EU countries in terms of congestion management. Efforts are being made to improve internal networks, but the need for investment in additional transmission capacity is likely to grow even further. The inadequate transmission capacity of Germany's north-south electricity lines strains the grid capacity of neighbouring countries. ·More investment in sustainable transport is needed to tackle air quality challenges, support climate change mitigation and adaptation and improve productivity. Low emissions cuts mean Germany is likely to miss its Effort Sharing Decision target. The transport sector has done particularly badly at cutting emissions of both greenhouse gases and local air pollutants. ·Germany’s tax system is not particularly efficient and favourable to growth and investment. More distortive direct taxes, notably on labour income, as a share of GDP are higher than the EU average, while revenues from consumption and environmental taxes are lower. Employment incentives are dampened by the heavy tax burden on labour including that on low-income and second earners, also impacting household income and consumption. The statutory corporate tax rate and effective average tax rates are high. The tax system remains complex and compliance costs are relatively high. The effective tax rate on inheritance and gifts is low, at about 2 %, thereby maintaining Germany's high wealth inequality. ·Even though labour shortages are increasing, there has been little real wage growth and some labour market potential remains underused. The German labour market is performing well, with strong employment growth and record-low unemployment. With a high job vacancy rate, skilled labour shortages are increasingly limiting economic development. At the same time, real wage growth has been modest. Weaker coverage of collective agreements may have contained wage growth. Despite growing skilled labour shortages, the labour market potential of under-represented groups such as women and people with a migrant background, including refugees, remains under-used. Although some measures have been taken to reduce the heavy tax burden on low-income earners, disincentives to work persist for this group. Other key structural issues analysed in this report, which point to particular challenges for Germany's economy, are the following: ·Risks to the financial sector seem to be contained but cost structures need to be tackled. Although the banking sector has relatively good capital and liquidity levels, it needs to tackle its cost structure. A fragmented market structure weighs on profits, but capitalisation ratios are satisfactory, and the ratio of non-performing loans is half the euro area average. House price increases are not yet causing macro or financial stability risks. Squeezed revenues from the low interest rate environment, costs incurred through digitalisation, regulatory requirements and the emergence of new competitors are intensifying the challenges faced by banks. ·Germany’s social protection system works well overall, but there are some concerns about the future, also because of demographic change. The number of people at risk of poverty or social exclusion is falling, but the children of low-skilled people continue to fare much worse than average, pointing to challenges in equality of opportunity and a long term persistence of disadvantage across generations. Recent government measures are associated with commitments to guarantee adequate social protection. However, ensuring this in the long run may require structural measures. Demographic change will strain public finances and challenge both the sustainability and the adequacy of pensions. In addition to adequacy and sustainability, the fairness and the regressive nature of the pension system need to be considered. Healthcare efficiency could be improved, especially in hospital and pharmaceutical care, by providing the same price signal across different patient groups to suppliers for the same treatment, and by making better use of eHealth. ·The education system is slow to respond to rapid changes in the labour market and society. While Germany has addressed relatively well some recent challenges, such as integrating refugees into the education system, others, such as digital skills, school infrastructure and teacher shortages, are mounting. In view of technological transformation and increasing shortages of skilled labour, this is of concern. 1. Economic situation and outlook GDP growth The German economy is expected to maintain solid growth for the foreseeable future, driven by domestic demand in an increasingly challenging external environment. Germany’s GDP growth came out at 1.5 % in 2018 preceded by 2.2 % in the two preceding years. The slowdown was driven by weaker export growth amid rising protectionism. Private consumption declined in the second half of the year despite solid employment and income growth. Investment in both equipment and construction stayed robust, however economic sentiment, especially in manufacturing, has cooled down and latest survey data suggest a downward revision of orders and the export outlook. High capacity utilisation and order books may help the economy rebound and sustain growth in the short run. However, the external environment is becoming less favourable. The strong labour market and ample fiscal space are expected to support the domestic demand this year and next. Overall, real GDP growth is expected to cool down to 1.1 % in 2019 and rebound mildly to 1.7 % in 2020, helped not least by a higher number of working days, according to the 2019 winter interim forecast. Graph 1.1:Demand components of GDP growth Source: European Commission Steady growth in domestic demand is expected to help reduce the high external surplus. The export outlook has worsened over the past year. At the same time, the solid domestic demand could keep import growth high and result in a further easing of the current account surplus. Investment Public investment effort is increasing against a backdrop of a significant investment backlog. Overall public investment rose by around 6 % in 2015 and 2016 and by close to 8 % in 2017 and 2018 in nominal terms. In real terms, the increase for the last four years was around 4.5 % on average. In 2017 and 2018, overall government net investment has turned positive for the first time since 2012. Since 2018, public investment growth has been driven by the municipal sector, where however investment remains much lower than depreciation. Private investment is expected to expand as a result of high capacity utilisation and replacement needs, but uncertainty has increased considerably. Above-average capacity utilisation and changing consumer preferences should spur the effort to renew and expand the capital stock, though economic sentiment in the manufacturing sector has cooled markedly during 2018. Housing investment posted strong growth in 2018 and is expected to continue increasing, although at a slower rate, given ample order book backlogs and a still-high level of new building permits. House prices are set to rise further, owing to the inadequacy of the housing supply in large cities. This has implications for rent levels. Despite a pick-up in residential investment, the housing supply still lags behind demographic change, especially in conurbations and big cities. As a result, a housing shortage has built up over the past decade. This is probably one of the main factors pushing up house prices in large cities and the country as a whole. While house prices stagnated in the 2000s, the widening supply gap correlates with the 30 % nominal rise in house prices that took place between 2010 and 2017. ( ) Graph 1.2:Prices and costs in construction Source: European Commission

The construction sector is operating at full capacity, as reflected by the rising prices of construction services and rising profit margins. Inflation in construction investment rose from 1.4 % in early 2016 to 5.2 % in the third quarter of 2018. Inflation in the value added of the construction sector has tended to be significantly stronger, suggesting that the prices of construction output rise faster than input prices. At the same time, real unit labour costs (i.e. the labour share) are actually falling, implying that building firms are maintaining some degree of wage moderation and becoming more profitable (see Graph 1.2). The completion of new dwellings has risen strongly since the crisis, yet remains considerably below potential demand. Numbers completed rose from 158 000 in 2011 to 285 000 in 2017, although owner-occupied dwellings rather than rental flats accounted for the lion's share of the increase (See Graph 1.3). New residential investment thus expanded from 1.5 % of GDP to 2.0 % of GDP during that period. Yet the number of dwellings completed remains below the annual target of 400 000 unit completions. ( ) Moreover, stagnating building permits suggest that annual dwelling completions will plateau at 300 000 units over the coming years (Gornig and Michelsen, 2018). The weak supply response is likely to keep pressure on house prices and rents, especially in major and southern cities. Although demographic pressures have been building up since the late 2000s, weak building activity has resulted in a housing gap put by most estimates at one million units (GdW, 2017) or significantly higher (Holm et al., 2018), with a particular focus on big cities and conurbations. Graph 1.3:New dwellings completed Source: Destatis, German Federal Government, Association of German Cities Clearing the housing supply gap would raise investment significantly. Commission estimates based on regional data suggest that just reaching a target of 350 000-400 000 annual completions would require additional construction investment of 1.0-1.5 % of GDP, compared to 2017 levels.( ) Conversely, had 400 000 units been completed annually since 2011, investment would have been 2.0 % higher over 2011-2014. Input-output tables suggest that the current account surplus would then have been 0.5 pps. of GDP lower during that period. Filling the housing supply gap could thus have a significant impact on the current account surplus. The deep dip in construction investment (as a share of GDP) from the late 1990s to 2015 was the most significant change in German investment during the emergence of the current account surplus. Graph 1.4:Contributions to headline inflation Source: European Commission Inflation HICP inflation increased to 1.9% in 2018 driven by energy prices, while core inflation remained unchanged at 1.5%. Inflation is expected to average 1.5% in 2019-2020, as energy inflation moderates further. Wage growth has been strengthening but would likely moderate again if the outlook remains subdued, which should keep core inflation from rising much further. Labour market Labour market performance improved further, with record low unemployment and high employment rates. On the back of strong labour demand resulting from continued economic growth, the employment rate reached 79.7 % (age 20-64) in the third quarter of 2018, one of the highest in the EU. This helped push unemployment down to a record low of 3.2 % in 2018. In 2018, GDP growth cooled off somewhat. Nevertheless employment growth (1.3 %) slowed down only marginally compared to 2017 (1.4 %) and the labour market has been showing increasing signs of labour shortages. Graph 1.5:Improving labour market Source: European Commission Despite record low unemployment and a high job vacancy rate, real wage growth has edged up only slightly. After nominal compensation growth hovered at around 2.5 % between 2014 and 2017, the relative scarcity of labour had some impact on wage settlements and contributed to a nominal compensation growth of 3 % in 2018. (See section 4.3). Given somewhat stronger inflation, this implies that real wage growth remains in the ballpark of somewhat above 1 %. Social developments The relative inclusiveness of growth continues to pose challenges. Households' real gross disposable income grew by 1.7 % in the year to 2017. However, this was below GDP growth (2.2 %), confirming a persistent pattern (see Table 1.2) and raising questions about the inclusiveness of growth. In 2017, the richest 20 % of society had an income 4.5 times higher than the poorest 20 %. The disparity was slightly less than in the previous year (4.6 in 2016). This was consistent with the change at EU level, from 5.2 to 5.1. Graph 1.6:Economic performance by regions, compared to the EU average Source: Eurostat Regional disparities Disparities in GDP per head between German regions have narrowed over time, but the eastern part of Germany remains weaker in many respects. Convergence was driven mainly by the catching up process of the eastern Länder. As a result, disparities between the eastern and the western Länder, which have been the focus of development policy since unification in 1990, are narrowing. However, in 2016 GDP per head in the east, in purchasing power standards, was still only 73 % of the figure for the west. Moreover, the east is facing challenges for future growth, including the lack of private sector research, ageing population and a shrinking labour force. Disparities in unemployment between east and west have narrowed, yet persist. When the registered unemployment rate peaked in 2006, it was 18.7 % in the eastern Länder and 9.9 % in the western ones ( ). The gap had narrowed by January 2019, with registered unemployment down to 7.1 % in the east and 4.9 % in the west. Though regional disparities in unemployment have narrowed, in January 2019 the registered unemployment rate was as high as 9.8 % in Bremen and 8.1 % in Berlin, well above that of the best performing Länder, Bavaria and Baden-Württemberg (3.3 %). Youth unemployment was also particularly high in Berlin in 2017, at 11.6 %, compared to the national average of 6.8 %. The reduction in unemployment in the east has not been accompanied by an increase in employment numbers, as the working age population has fallen considerably (see Section 4.4.2). Graph 1.7:Sectoral net lending Source: Destatis, European Commission

Sectoral balances Private sector net lending has edged down. Private borrowing rose further in 2018 above GDP growth, benefiting from declining interest rates, and private sector deleveraging slowed down. Corporate investment rose consistently, in line with or at a slightly more rapid rate than GDP growth, in response to rising capacity utilisation. Thus the corporate investment share of GDP has edged up. In addition, corporate savings have been declining somewhat as a share of GDP since 2016. The decline in the share of corporate savings in GDP in recent years is the consequence of a combination of multiple factors: slight declines in operating profitability, (foreign) investment income, and at the same time a moderate rise in dividend pay-outs from a historically low level, after a long post-crisis spell of strengthening equity buffers, and an ongoing increase in the share of labour costs (see Table 1.1). As a result, corporations, which have a level of indebtedness among the lowest in the euro area, reduced their net lending position and thus contributed to reducing the savings surplus. This contrasts with earlier years, when their behaviour was key to explaining the rise in the current account. Table 1.1:Key components of income and final demand of non-financial corporations: contributions to the economy-wide net lending Source: European Commission Households’ net lending has stayed largely unchanged. The gross household savings rate rose further to 17.3 % of disposable income in 2017, the highest in the euro area (average: 11.9 %), and is expected to stay high, partly driven by provision for ageing and propped up by rising labour incomes. The latter have been driven both by rising employment and somewhat stronger wage growth. Meanwhile, household investment growth was maintained, which has stabilised households’ net lending position. The improvement in labour income has not offset or countered the long-term trend of a decline in the share of household disposable income in GDP. Following the social security and labour market reforms of the 2000s, social transfers account for a permanently lower share of GDP. The share of non-labour income has also continued to decline as a result of two factors. The strong labour market has made dependent employment relatively more attractive in comparison with self-employment. Net property income has remained lower as a share of GDP than in earlier years, as corporations' dividend pay-outs remain low in the aftermath of the crisis (see Tables 1.1, 1.2). The proportion of income that comes from interest has continued to decrease in the context of low interest rates and has been below 0.5 % of GDP since mid-2016. Although the share of GDP accruing to households has been falling, the household propensity to save has actually increased slightly. The fluctuation of the ratio of household savings to GDP has thus been limited, as the decline in the private consumption share of GDP has largely followed income trends (see Table 1.2). Table 1.2:Key components of household income and final demand: contributions to the economy-wide net lending Source: Destatis, European Commission The public sector surplus is increasing. The sector whose net lending has been growing since the peak of the current account surplus in 2015 is general government. The strong cyclical position of the economy has favoured public savings. It has helped contain social transfer payments, while tax revenue grew strongly (almost 3 pps. of GDP by mid-2018 compared to 2010) (see Table 1.3). Table 1.3:Key components of government revenue and expenditure: contributions to the economy-wide net lending Source: European Commission Meanwhile the public investment ratio has not kept pace with growth in public revenue. A more pronounced correction of the current account surplus from its peak was constrained by relatively weak public investment. This seems to have been changing lately, as the capacity to plan and implement investments at municipal level is showing first signs of improvement, though starting from a low level. Graph 1.8:Current account and component balances Source: Deutsche Bundesbank, European Commission External position The current account surplus has been gradually declining since 2015. According to Bundesbank data, the current account surplus for 2018 stood at 7.4 % of GDP, suggesting a further decline compared to 2015 (8.9 %), 2016 (8.5 %) and 2017 (8.0 %). The fall in 2017 is due to an increase in net foreign transfers abroad (-1.7 % net compared to -1.3 % in 2016), and a narrowing of the trade balance from 8.5 % in 2016 to 8.2 %, whereas the primary income balance improved slightly to 2.1% of GDP. Compared to 2017, the trade balance for 2018 deteriorated by another 0.9 pps of GDP, while the secondary income balance and the services balance improved by a total of 0.4 pps and the primary income balance( ) stayed stable. The trends observed in the current account balance can be also explained by the developments in the terms-of trade effects. The increase in the current account to its peak in 2015 was importantly driven by positive terms-of-trade effects (especially falling oil prices). Terms of trade improved further in 2016: however, domestic demand was strong while exports slowed down and the current account surplus decreased nonetheless. In 2017, with rebounding energy prices, deteriorating terms of trade narrowed the surplus further despite a positive growth contribution of foreign trade. In 2018 terms of trade effects continue to exert a downward pressure on the surplus. The trade balance has been affected by structural and cyclical issues in the automotive sector. The disclosure that the environmental compliance test results of a number of German brands of diesel cars had been manipulated (the Diesel scandal) may have slowed down growth in car and parts exports since 2015. At the same time, the German car market became more open to imported brands. This caused net exports of cars to decline from 4.2 % of GDP in 2015 to 3.4 % for the year ending in September 2018. The slump was precipitated in the 3rd quarter of 2018 by delays in complying with a newly introduced testing procedure. (See also Box 1.1.) Graph 1.9:Current account balance and components of the financial account Source: Deutsche Bundsebank Net capital exports comprise mainly flows of debt assets and direct investment into offshore centres. In recent years, the main channel of German foreign investment has been portfolio investments, which have accounted for roughly two thirds of the financial account balance since 2014. Since 2015, around half of these flows have consisted of German securities returning home (e.g. in the context of the Eurosystem’s Asset Purchase Programme). Thus, the acquisition of debt assets has roughly halved compared to the years before that (see Graph 1.9). Net foreign direct investment has picked up somewhat since 2014. The key destinations during the period in question were the Netherlands (2014-15) and Luxembourg (2016-17). These two countries have tended to host large amounts of FDI through special purpose entities, driven by tax-planning motives (European Commission, 2017c). Other major destinations were the United States (2015 and 2018) and Spain (2018). All in all, however, it is difficult to infer to what extent capital exports are used to finance productive activities abroad. Graph 1.10:Factors explaining the current account surplus Source: European Commission

The current account surplus remains considerably above what fundamentals suggest. According to the Commission's current account ‘norm’ calculations, fundamental determinants of savings and investment currently suggest a surplus of +3.0 % of GDP (compared to the latest value of 7.8 % of GDP). Though this is mostly due to ageing (+1.6 pps), the manufacturing intensity of German exports is another relevant factor (+0.8 pps). ( ) Yet most of the surplus (+3.4 pps) and its dynamics is explained by factors that can be more directly influenced by policies. Private-sector deleveraging since 2000 explains a large part of the surplus — although its impact did not increase further in 2017 (+1.2 pps, unchanged) along with the fiscal stance (+0.9 pps, slight increase), and an increasing net international investment position that gave rise to a sizeable positive income balance (+1.6 pps, down from +1.9 pps in 2016). Graph 1.11:General government budget balance and gross debt Source: European Commission Public finances Germany is expected to meet the debt criterion, as government debt is projected to fall below the Maastricht Treaty reference value of 60 % of GDP. For the first time since 2002, Germany will fulfil again the debt criterion (see Graph 1.11). The introduction of the ‘debt brake’ in 2009 seems to have had a considerable and sustainable effect in reducing overall government debt and turning the budget balance from deficit to surplus. Since public debt peaked at 80.9 % of GDP in 2010, the figure has fallen continuously, and it is expected to fall below the 60 % threshold in 2019. Also benefiting from cyclical effects and low interest rates, the headline deficit fell significantly after 2010. In 2014 it gave way to a surplus, which has been sustainably increasing since then. In 2018, the headline budget surplus reached a peak at 1.7 % of GDP and is projected to remain positive in the years thereafter.() As the debt brake became binding for the Federal Government in 2016 and will become binding for the Länder from 2020, general government debt can be expected to fall further over the coming years. Box 1.1: The automotive sector in Germany The automotive industry is a backbone of the German industry and has grown in importance. It is a significant contributor to German GDP and employment. The sector has continuously increased its share of total value added from 3.1 % in 1995 to 5.3 % in 2016, well above the EU average of 2.3 % in 2016 (with France, Spain and Italy at 1.5 %, 1.7 % and 1.4 % respectively). Similarly, its share of manufacturing increased from 13.7 % in 1995 to 22.6 % in 2016 (EU average 10.6 %). Motor vehicles and vehicle parts are Germany’s most important export product, accounting for 19.2 % of German exports in 2017. The sector has one of the most internationalised value chains in the world. In 2017, about 66 % of the German-branded vehicles were produced abroad. The success of German original equipment manufacturers (OEMs) also relies on their suppliers, notably from the rest of the EU, representing up to 80 % of the value added. In 2018, car sales experienced significant volatility owing to the move to new emissions test legislation at the beginning of September, which appears to be a temporary disruption. Car registrations were markedly up in July and August in seasonally adjusted terms before the new Worldwide Harmonised Light Vehicle Test Procedure standard came into force. Afterwards, they dropped sharply in September, as car manufacturers were not able to complete in time the certification of most of their car models. It remains to be seen how long bottlenecks related to the new emissions test legislation will persist. Demand for new diesel cars has dropped significantly due to the diesel emissions scandal and the insufficient response by car manufacturers and policy makers. Car manufacturers of diesel-fuelled power trains had reverted to devices that turned off the emission-control technology in most normal uses. When these defeat devices were eventually uncovered and the responses of both policy makers and car manufacturers were perceived as being insufficient, demand for diesel cars slumped, also damaging the ‘Made in Germany’ brand both internationally and domestically. The possibility of city bans on Euro 5 and older diesel cars and the continuing environmental underperformance of diesel cars, including those that underwent a software update, foretell a further decline in demand. In October 2018, the share of new registrations of diesel cars fell below 30 % for the first time (from its peak of about 50 % in 2015). However, overall demand for new cars is expected to remain rather strong in the short run, as the drop in demand for new diesel cars is expected to be largely offset by higher demand for petrol cars. Moreover, external demand appears to be less affected, as exported cars are mainly petrol cars. The shift towards low and zero emission mobility might lead to a global shift in value creation, affecting German car manufacturers and suppliers. A significant transition to alternative power trains (such as e-mobility and fuel cells) and automation is expected to take place in the medium to long term. The German Federal Government has introduced a package of stimulus measures for electric vehicles. However, e-mobility currently faces a number of challenges related to price, distance, charging infrastructure, charging time, and technological competition (e.g. charging batteries as opposed to replacing them). A possible intermediate step for e-mobility might be local ‘island solutions’, such as electric buses, postal lorries or taxis. As electric vehicles are significantly less complex than those with a combustion engine, the competitive advantage of the German OEMs and suppliers might – at least temporarily – diminish. Germany is still an innovation leader in the automotive sector but securing its competitive position will require further investment in training, research and innovation. So far, the competitiveness of the German car industry has been determined largely by the supply of qualified labour and an efficient innovation ecosystem. The technological transformation of the car industry will require even stronger investment in quality education, in-house training, retraining and life-long learning. The automotive industry accounts for about 35 % of business R&D expenditure in Germany and about 40 % of patents. Nearly half of all global patents on automation in the automotive sector come from German firms. However, Germany faces strong competition from the US and China with regard to battery research. Even though R&D in Germany is increasingly focused on new technologies, especially those relating to automation and connectivity, this may not be sufficient to offset potential losses resulting from a lower degree of ambition in the area of e-mobility and other alternative power trains. Table 1.4:Key economic and financial indicators - Germany Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise). 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 51 % of all country-specific recommendations addressed to Germany have recorded at least “some progress”. ( ) Looking at the multiannual assessment of the implementation of the CSRs since these were first adopted, 51 % of all the CSRs made to Germany have recorded at least ‘some progress‘. 49 % of CSRs recorded ‘limited progress‘ or ‘no progress‘ (see Graph 2.1). Overall, for every Semester cycle, multiannual implementation in Germany has remained relatively weak, at or below the average progress made by other Member States. However, implementation scores improved in 2018. Graph 2.1:Overall multiannual implementation of 2011-2018 CSRs to date Source: European Commission While the fiscal position remained sound over time, public finances have been slow to become more growth-friendly. Between 2011 and 2018, Germany’s fiscal position remained sound, showing high compliance with CSRs from the early 2010s as regards compliance with the medium-term budgetary objective and reducing debt. On the other hand, the structure of revenues and expenditure has been made only slightly more growth-friendly. On the revenue side, taxes on labour remained high. On the expenditure side, over-reliance on hospital care has continued, reducing the efficiency of healthcare expenditure. Moreover, expenditure on education and research and development has been falling short of the relevant national target. Overall, public investments remained subdued compared to needs, despite some improvement from the early 2010s. In addition, the tax system has become only marginally more efficient and investment-friendly. However, there were some encouraging developments in 2018, with expenditure on public investment and education increasing. The growth potential of efficient market structures has not yet been exploited to the full. Efficient market structures contribute to higher value added and higher consumer welfare, yet little has been done in response to the relevant CSRs. Policy measures to boost competition in business services and regulated professions have been largely absent. Barriers to competition in railways have been reduced to only to a limited extent. The energy transition is relatively costly, while the development of energy networks has been slow — although the power grid action plan of 2018 may result in future improvements. The labour market situation has been improving further, helped by past structural reforms and a strong economy. Since 2011, Germany has benefited from high employment growth and low unemployment, reflecting the favourable impact of past labour market reforms, employment-friendly social dialogue, the improved provision of early childhood education and care, and a competitive industry, among other factors. Despite the persistently high tax wedge, the overall employment rate rose continuously. The employment rate of older workers (over 50) improved on the back of a good labour market and earlier structural reforms. The introduction of the statutory general minimum wage in 2015 promoted transitions from mini-jobs to standard employment and helped to boost hourly wages at the bottom of the wage distribution. However, its effects have lessened over time. With new reforms, disincentives to work are expected to be reduced somewhat in 2019 and 2020. There is further potential to improve labour market outcomes, reflected in persistently high fiscal disincentives for second earners and an undersupply of early childhood education and care. Table 2.1:Summary table on 2018 CSR assessment Source: European Commission Overall, Germany has made limited progress in responding to the 2018 country-specific recommendations (CSRs) ( ). Some progress has been made towards achieving sustainable growth in public and private investment, a CSR closely related to the euro area recommendation about strengthening domestic demand and growth potential. This has been done by reforming federal fiscal relations and by allocating more resources to the Länder and municipalities and for specific infrastructure programmes. At the same time, despite promising initiatives, limited progress has been made so far with stepping up public spending on education. Although this is increasing in absolute terms, it has largely stagnated as a share of GDP. There has been some progress in raising expenditure on research and innovation. Private investment has increased noticeably as well. However non-residential construction has been increasing sluggishly in real terms, and essential infrastructure may not have kept up with the economy’s needs. Announcements that the nationwide broadband infrastructure is to be improved are encouraging, but so far only small steps have been taken to put this into practice. Limited progress has been made with making the tax system more efficient and investment-friendly. Progress has also been limited in promoting competition in business services and the regulated professions. There has been some progress on issues related to the recommendation on the labour market, including on the advice about reducing the tax wedge for low-wage earners, yet related disincentives remain high. There are no signs that current pension reforms will promote longer working lives, and so far limited progress has been recorded in improving the educational outcomes and skill levels of disadvantaged groups. There has been some progress in creating the necessary conditions to promote higher wage growth.

Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Germany EU solidarity continues to support structural change in Germany. Under the current Multiannual Financial Framework (2014-2020), the financial allocation from the European Structural and Investment Funds (ESI Funds) - assigned to Germany to help the country face development challenges - exceeds EUR 27.9 billion. This is equivalent to about 0.1 % of annual GDP. By the end of 2018, some EUR 18.6 billion (about 67 % of the total) had already been allocated to specific projects. In addition to the ESI Funds, the Connecting Europe Facility has allocated EUR 2.2 billion to projects on strategic transport networks. Moreover, many German research institutions, innovative firms and individual researchers have benefited from other EU funding instruments. An example is Horizon 2020, which has provided EUR 5.6 billion to improve innovation and research in Germany. Part of EU funds contributed to supporting the implementation of Country Specific Recommendations. EU funding have helped to address policy challenges identified in the 2018 CSRs. ESI Funds contributed to improving educational and employment outcomes for disadvantaged groups, supporting over 1.3 million participants by the end of 2017, including more than 390 000 from minority backgrounds. Overall, more than 437 000 people have gained a qualification. The European Social Fund (ESF) has supported human capital investments, including 214 600 disadvantaged people with targeted measures mobilising their economic potential, 89 800 participants with education and training programmes, as well as 7 600 projects promoting employability of women. The European Regional Development Fund (ERDF) has supported closer collaboration between business and research institutions, as well as R&D investment in the private sector. By the end of 2017, 1 510 enterprises had been selected for support by the ERDF in building cooperation with research institutions and 3 860 enterprises in introducing new products to their markets. Horizon 2020 has supported 5 585 research projects covering a very broad thematic spectrum from ‘Innovation in SMEs’ (small and medium-sized enterprises) to ‘Health, demographic change and wellbeing’. ESI Funds also help mobilise private investment through financial instruments. By the end of 2017, EUR 1.06 billion of support from ESI funds had been allocated to financial instruments, including loans, guarantees and equity. This is expected to leverage substantial additional private investment. In addition, the Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help Member States implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. Germany, for example, is receiving support for developing an institutional solution to modernise mechanisms for capturing and processing business data from multinational enterprise groups in the context of a globalised economy. The support measure focuses on the German statistical system, while it is also designed to help improve the quality of core economic data for policy-making purposes. In absolute terms, Germany is the fourth biggest recipient of finance from the European Fund for Strategic Investments, but it ranks 22nd when considering the overall volume of approved operations as a share of GDP. Total financing amounts to EUR 7.3 billion and is set to trigger EUR 35.2 billion in additional private and public investments. For the Infrastructure and Innovation window, 74 projects( I ) were approved at a total value of about EUR 6.4 billion, set to trigger EUR 29.1 billion in total investment. Under the SMEs window, 29 agreements with intermediary banks worth EUR 974 million have been approved. These are set to trigger about EUR 6 billion in investments, with some 30 285 small and medium-sized and mid-cap companies expected to benefit from improved access to finance. One such project in Germany is ‘Evotec medical research’, which benefited from EUR 75 million in EU financing. Evotec is a drug discovery company, and the EUR 75 million loan enabled it to invest in researching and developing treatments for serious illnesses. Further information: https://cohesiondata.ec.europa.eu/countries/ DE 3. Overall findings regarding imbalances, risks and adjustment issues The 2019 Alert Mechanism Report concluded that a new in-depth review should be undertaken for Germany to assess the persistence or unwinding of the imbalances that affect it (European Commission, 2018a). In spring 2018, Germany was identified as having macroeconomic imbalances (European Commission, 2018b). The imbalances identified related in particular to excess savings and weak private and public investment. This chapter summarises the findings of the analyses in the context of the Macroeconomic Imbalance Procedure (MIP) in-depth review that are set out in various sections of this report. ( ) Imbalances and their gravity The German economy’s persistent large current account surplus reflects a subdued level of consumption and investment relative to income. While there is currently a shift towards more domestic demand-driven growth and more investment, the overall shares of consumption and investment remain relatively low, given the favourable labour market, financing conditions and infrastructure investment needs. The persistently subdued investment share of GDP continues to undermine Germany’s future growth potential, and has implications for the euro area. Private investment is lagging behind infrastructure and housing needs. Additional construction investment to meet the targets for new dwellings could lower the current account surplus by 0.5 pps of GDP (cf. Section 1 on investment). Public investment has picked up, but a major investment backlog, with depreciation still exceeding new investment at municipal level, will take longer to make up. Stronger investment in innovation, quality education and skills, very high-speed broadband networks, sustainable transport and electricity infrastructures combined with structural reforms aimed at improving the investment-friendliness and efficiency of the tax system can raise potential growth in future. Structural reforms promoting better use of the labour market potential of so far under-represented groups could help address the already noticeable shortages of skilled labour. This would be of crucial importance especially as population ageing intensifies and immigration may slow down. Growth-enhancing policies could also have positive spillovers for the other EU countries. Evolution, prospects, and policy responses The current account surplus has been gradually declining since 2015. The trade balance has been affected by structural and cyclical issues in the automotive sector. Net capital exports were driven mostly by flows of debt titles, even if on a smaller scale than in earlier periods. Although foreign direct investment is growing, it has, until recently, been directed mostly at offshore centres. This makes it difficult to discern a link with productive activity abroad. Corporate sector net lending has edged down as profitability has weakened somewhat, while investment has remained robust. Households’ net lending has remained largely unchanged, which puts it at a very high level compared with the country's EU peers. Improvements in labour incomes have boosted the saving rate, while increases in households’ income and consumption have lagged behind GDP growth. The public sector surplus has grown as a result of stronger revenues from tax and social contributions and savings on social transfers, thanks to the strong cyclical position of the economy and to low unemployment. The adjustment of the imbalance has been slow so far, but is expected to advance further. With the external environment becoming increasingly challenging for exporters, domestic demand is expected to be the key growth driver in 2018-2020, as set out in the Commission’s Winter 2019 interim Economic Forecast. Efforts to reduce the public investment backlog are set to continue, combined with other expansionary fiscal measures. Private investment is also expected to increase further to keep the economy fit for technological change. The strong labour income and rising wages should support private consumption. Currently, population ageing and concerns about the adequacy of future pension levels contribute to the rise in domestic savings. The demographic transition is pushing up the current account surplus, but should lower savings in the long run. Nevertheless, the current account surplus is expected to remain above the Macroeconomic Imbalance Procedure threshold and to decline only gradually in the medium term. Given the size of the German economy and its strong trade and financial linkages, there are potentially strong spillovers to other EU countries. Germany’s strong exports make it a key trading partner for all EU countries. Indeed, imports from Germany exceed 10 % of GDP in some countries, including the Czech Republic, Hungary, Austria, the Netherlands and Poland (see Table 3.1). Especially in the case of central and eastern Europe, this reflects the importance of international value chains coordinated by German companies, with a significant amount of trade being essentially intra-company transfers. As the most important of these value chains is car manufacturing, the potential negative spillovers can be significant if German carmakers fail to maintain their global competitive advantage. Financial linkages from the country are on average smaller than trade linkages, yet for some countries, they remain very strong. Given the large share of financial assets invested in Germany, economic developments in the country are particularly important for Austria, Ireland, Luxembourg, Malta and the Netherlands. Liabilities to German banks and bank claims on Germany are particularly concentrated for certain financial centres, such as Luxembourg, Malta, the Netherlands, the UK, Ireland and Austria. While structural reforms in Germany primarily increase its own GDP, they also have positive spillover effects on other euro area countries (see Box 3.1) ( ). Table 3.1:Outward spillover heat map for Germany Source: UN, OECD, WIOD, BIS and European Commission More recently, Germany has taken some important policy steps to address its imbalances, but more efforts will be needed in the coming years to fully address Germany's imbalances. There have been policy advances in the area of public investment, though municipal level investment is still lagging behind. There have also been some smaller advances as regards investment in digital infrastructure, reducing disincentives to work and promoting wage growth. However, it remains to be seen if policy action has been decisive enough to produce the desired outcomes.

Box 3.1: Spillovers of structural reforms – the case of Germany Structural reforms tend to have both positive and negative spillover effects on other countries, with uncertainty about the size and direction of the overall impact. While the demand effect (higher demand for foreign products) leads unequivocally to positive spillovers, reforms typically also improve a country’s competitiveness, which can come at the (relative) expense of other countries. Whether the net effect is positive or negative depends on the relative strength of these two opposing channels and is likely to be reform-specific. The European Commission’s QUEST model( II ) was applied to simulate, in a harmonised way, the impact of a comprehensive set of reforms on all EU Member States.( III ) For a large set of structural indicators the benchmark is defined as the average of the three best-performing countries, and then in the simulation these gaps are closed by half, for all indicators together, for each country separately. An update of the 2014 exercise for Germany is shown in the table below, based on more recent indicators (but not capturing the most recently introduced reform measures). As the magnitude of the reform ‘shocks’ simulated here is based on a harmonised benchmarking exercise, they clearly do not correspond exactly to past European Semester country-specific recommendations. However, they do illustrate the potential economic impact of structural reforms on Germany itself and on the rest of the euro area. Structural reforms would have a small but positive effect on the rest of the euro area. A broad range of structural reforms are simulated, including improving product market regulation and entry, labour market participation and taxation structure. Germany is a good performer overall, with limited gaps in structural indicators by comparison with EU best performers. The largest ‘reform gaps’ identified for Germany are in the tax structure (as captured by the relative share of labour tax revenues compared to consumption tax revenues), and lower labour force participation of low-skilled women. Altogether, the simulated ambitious reform package could lift GDP by 4 % after 10 years, and 6¾ % after 20 years (see Table 1). The reforms raise competitiveness, boosting exports, while imports also rise as demand increases. As the terms of trade fall by about 3 % after 10 years, the trade balance to GDP ratio actually falls slightly by 0.34 pps. The net spillover effect on the rest of the euro area is small but positive, and total euro area GDP increases by 0.3 % after 10 years. This simulation complements earlier QUEST simulations designed to model a more immediate demand stimulus. Earlier simulations include an increase in public investment and a reduction in personal income tax (European Commission, 2017a) and increases in expenditure on R&D and education (European Commission, 2018a). Overall assessment The German economy’s current account surplus continues to reflect a subdued level of consumption and investment relative to output and thus scope for further policy effort. The size and persistence of the surplus can only be explained in part by the country’s industrial structure (i.e. the highly competitive manufacturing sector) and other characteristics of the economy and society. Thus, the current account surplus is significantly higher than empirical benchmarks, after accounting for these German-specific characteristics in explaining cross-country differences. Subdued investment and private consumption have also contributed to the build-up of the external surplus. The necessary adjustments in the aftermath of the post-unification investment boom have resulted in significant scaling back of construction and planning capacity; this is hampering the renewal and expansion of key infrastructure. While there is currently a shift towards more domestic demand-driven growth, consumption and investment are still muted, given the favourable labour market, financing conditions and infrastructure investment needs. The continuing trend of relatively subdued domestic investment as a share of GDP is also undermining Germany’s future growth potential and has implications for the euro area. Overall, there has been policy progress. However, more efforts are needed to fully address its imbalances, especially in the following ways: ·stepping up municipal investment, as well as investment in education, innovation and digital infrastructure, ·reducing disincentives to work and promoting wage growth, ·improving the tax system, ·stimulating competition in business services and regulated professions, and ·introducing measures to promote longer working lives. Full implementation of declared policy initiatives (e.g. the coalition treaty of spring 2018) could help address macroeconomic imbalances. Table 3.2:MIP Assessment Matrix Source: European Commission 4. Reform priorities 4.1.Public finances and taxation* Public finances Germany’s public finances show a solid surplus and, the debt-to-GDP ratio is projected to comply with the Stability and Growth Pact’s 60 % threshold. Since 2014 the government sector has achieved an overall budget surplus; this continuing trend is now becoming more pronounced. After 0.6 % of GDP in 2014, the headline balance reached 1.0 % of GDP in 2017 and increased to 1.7 % of GDP in 2018. Public debt also continues its sustained decline from a peak of 80.9 % of GDP in 2010. It has reached 60.1 % of GDP in 2018 and is expected to decrease further to 56.7 % in 2019 according to the Commission 2018 autumn forecast, falling below the 60 % Maastricht threshold for the first time since 2002. For a debt sustainability analysis and associated fiscal risks see Annex B. Graph 4.1.1:Correlation between gross investment and debt in 2017 Source: Destatis Public investment by the German Länder shows a correlation with economic activity and, even more, with debt levels. Public investment as a share of GDP varies across the different regions in Germany (average: 1.24 % of GDP). The divide between the former West and East German Länder is still visible, but with some notable exceptions. Three of the regions with poor investment performance lie in the west: Bremen (HB 0.81 %), North Rhine-Westphalia (NRW 0.82 %) and Saarland (SL 0.87 %), whereas two regions with the highest investment rate lie in the east: Mecklenburg-West Pomerania (MV 2.01 %) and Saxony (SA 1.92 %). Investment expenditure is related to the level of economic activity measured by the share of GDP, however the correlation of public investment is even higher with the public debt level of the different Länder where more indebted Länder tend to invest less (see Graph 4.1.1). This negative correlation indicates that Länder having conditions of tight public finances lack the financial resources to invest sufficiently according to their level of economic activity. For example, Saarland and North Rhine-Westphalia, two formerly prosperous regions based on a strong coal and steel industry, struggle with the structural change in the economy, resulting in lower revenues from the local trade tax, higher social expenditures and poor investment levels. Graph 4.1.2:Regional debt and investment shares in 2017 Source: Destatis

Regional disparities in public debt and investment levels are also strong among western Länder. If we divide Germany into four main economic areas (west: North Rhine-Westphalia (NRW), east: former East German regions including Berlin (BE), south: Bavaria (BY) and Baden-Württemberg (BW), north and middle: remaining regions), they show similar population numbers that correspond largely to each economic area’s regional share of GDP (see Graph 4.1.2). However, debt at regional and municipal level per inhabitant is disproportionally higher in the west (145 % of Länder average) and lower in the south (41 % of Länder average), while public investment is inversely lower in the west (65 % of Länder average) and higher in the south (146 % of Länder average). This also shows that disparities within former West Germany are much more pronounced than within former East Germany (93 % of average Länder debt and 86 % of average Länder investment). Comparing absolute debt levels per inhabitant between 2010 and 2017 shows that regions with already low debt levels are improving further, while others are lagging behind, with disparities widening. The consequences for public investment are that regions with more acute investment needs remain financially constrained and continue to accumulate an investment backlog. Taxation The German tax system, with its relatively high tax burden skewed towards labour, does not appear favourable to growth and investment. Germany raises a relatively high share of revenues from more distortive direct taxes, notably on labour. In 2017, the total tax burden was 39.1 % of GDP, equal to the EU average. Revenues from labour taxes as a share of GDP were relatively high in 2017 at 22.2 % of GDP (EU average 19.4 %). Personal and corporate income taxes in Germany (12.1 % of GDP) are equal to the EU average, whereas revenues from indirect taxes (10.7 % of GDP) are below the EU average (13.6 %). Revenues from consumption and environmental taxes (10.1 % and 1.8 % of GDP respectively in 2017) are also below the EU averages (11.1 % and 2.4 %). This is also the case for taxes on capital (6.7 % of GDP, EU average 8.6 %). Taxes on property (1.1 % of GDP v. 2.6 % EU average) are very low, as are recurrent property taxes (at 0.4 % of GDP v. 1.6 % EU average). Despite measures to contain the growth of direct taxes, revenues from personal income and corporate income tax continue to increase. Revenues from direct taxes rose from 10.8 % of GDP in 2010 to 13.0 % in 2017, whereas the amount of indirect taxes collected slightly declined from 10.9 % to 10.7 % of GDP. The increase in direct taxes was driven mainly by personal and corporate income taxes. Over the same period, social security contributions increased slightly from 15 % to 15.3 % of GDP. This means that measures taken in recent years to contain the upward creep due to the ‘cold progression’ (i.e. bracket creep) and the additional income tax allowances have not yet had any impact on the figures. The tax wedge on labour has been stable at about 50 %, above the EU average of 46 %, and is the second highest in the EU. The tax wedge on low-income earners and secondary earners continues to be high compared to the EU average (see Section 4.3.1). Forecasts by the Ministry of Finance in the 2018 draft budgetary plan suggest that direct taxes ( ) will not decrease in 2018 or 2019. The draft budgetary plan includes the abolition of the solidarity surcharge for 90 % of taxpayers as of 2021, which would help reduce the income tax burden. Full abolition of the solidarity surcharge would reduce the implicit tax rate on labour by 1 % (European Commission, 2017a). A number of changes in social security contributions, family benefits and personal income tax will affect taxes on labour from 2019 on and are expected to reduce the tax burden on low-income earners (see Section 4.3.1.). The tax system remains relatively inefficient and is therefore not very conducive to investment. Both statutory corporate tax rates and effective average tax rates are high (European Commission 2018b), which makes the presence of distortions more severe ( ). For example, the debt bias in corporate taxation, which arises from the fact that debt financing costs are deductible from the corporate income tax base, whereas equity financing costs cannot be deducted, is the third highest in Europe (European Commission, 2018b).( ) This could have a disproportionately adverse impact on investment by young, innovative and high-risk companies that usually rely more on equity financing. The same holds for family businesses, which tend to have a higher share of equity financing (Gottschalk et al., 2017). Also, the loss-carry forward provisions are relatively strict, limiting the loss-carry forward to 60 % of taxable income of a given year (ZEW, 2019). The recent reform of loss-carry forward provisions removed only certain limitations applicable to specific cases where the ownership of a young company changes. Other distortions in the tax system concern labour taxation, the fact that Germany’s tax system corrects relatively little for market failures (especially where environmental taxation is concerned) and high tax compliance costs. The German tax system remains complex and compliance costs are relatively high. A recent study (KPMG and GfK, 2018) which examined in detail tax compliance costs incurred by businesses found that Germany ranks 17th out of 20 EU countries in terms of total compliance costs relative to turnover ( ) (see Graph 4.1.3). Similarly, the World Bank finds that the hours needed to comply with tax obligations in Germany come to 218, compared with an average of just 164 hours for 22 other EU countries. This is a reversal of the situation in 2006 (see Graph 4.1.4). Recent measures may have helped reduce tax compliance costs, but they do not address the complexity of the tax system. The current roll-out of the tax administration reform will probably help cut tax compliance costs. The same holds for the recent increase in the upper limit for immediate expensing of assets from EUR 410 to EUR 800. However, the system remains complex, particularly as businesses have to deal with two corporate income tax returns ( ) based on complex legislation and up to 16 tax administrations that exchange too little information. Graph 4.1.3:Cost of tax compliance (as % of turnover) Source: European Commission (2018b). Ensuring a level playing field across businesses is also important to achieve a more efficient tax system. Arrangements, such as the so-called cum-ex and cum-cum trades, aim at unduly obtaining reimbursements of withholding taxes on dividends (Dutt et al., 2018; Buettner et al., 2018) or to benefit from exemptions or a lower rate of withholding tax. This has so far led to an estimated accumulated tax loss for Germany of at least EUR 31.8 billion (Spengel et al., 2017a; Spengel et al., 2017b). While Germany is not the only country affected by such schemes, it is where losses were highest in absolute terms. Although Germany has now also explicitly closed some of the loopholes that were perceived to allow these schemes to operate, further loopholes in the system remain ( ), which might lead to new avoidance schemes in the future. Graph 4.1.4:Paying taxes: time to comply (hours per year) Source: World Bank, Doing Business Database Improving the design of the inheritance and gift taxes could reduce inequality, as inherited wealth preserves the large wealth inequality observed in Germany. The Gini coefficient for net wealth in Germany is one of the highest in the euro area. Wealth in Germany is very unevenly distributed: the richest 10 % of households own almost two-thirds of national wealth, the richest 1 % one-third, the richest 0.1 % have 17 % of assets – that is 41 000 households averaging EUR 40 million. As large income and wealth inequalities may be detrimental to economic growth, to macroeconomic stability, and to social cohesion, well-designed inheritance and gift taxes can combat wealth inequality, supporting social mobility and ensuring equality of opportunities in the least distortive manner and with an acceptable level of administrative complexity (OECD, 2018a; Iara, 2015). In 2017 revenues from inheritance and gift tax accounted for 0.19 % of GDP (about 0.5 % of total taxation). In Germany every year, EUR 250 to 300 billion are inherited or given away, and the trend is rising as the wealth of German households has risen to more than EUR 10 trillion. The distribution of inheritances is strongly unequal. The majority inherits nothing or only a little. 45 % of the population can expect to inherit more than EUR 50 000, only 8 % more than EUR 200 000, and 0.1 % more than EUR 5 million, EUR 17 million on average (Bach, 2018). The German inheritance and gift tax grants large tax exemptions when family businesses are transferred to the next generation. This makes the system complex and inefficient, and disadvantages family businesses that change ownership via market transactions. These exemptions are considered fairly high and result in low effective inheritance tax burden for large and very large capital transfers (Bach and Thiemann, 2016; Dorn et al., 2017). Reforms in 2016 and 2018, following a judgment by the German Constitutional Court that such exemptions are too far reaching and unconstitutional, have changed the situation only marginally. Also, the economic rationale behind granting very generous tax exemptions for family owned businesses is questionable, as it is not clear why a change in ownership via inheritance, where a tax of 7 % to 30 % would be due, is harming jobs or the continuity of the business, whereas the acquisition through an independent third party who needs to pay the full market value is not (BMF, 2012; Kiziltepe and Scholz, 2016). So far, the inheritance and gift tax yields about EUR 6 billion a year, corresponding to an effective tax rate of about 2 %. This revenue could be approximately doubled if the tax exemptions were abolished. The additional revenues that would be generated from abolishing or substantially reducing the exemptions could be used to lower the tax rates of the inheritance and gift tax and in this way reduce the burden on smaller family businesses (Bach, 2018; see also Box 4.1.1, scenario 1). Potential perceived liquidity and financing constraints of new business owners could be addressed by allowing for a longer payment period of the tax obligation( ), or by financial market solutions, whereby heirs could borrow at favourable conditions as the sum due would only be a fraction of the linked collateral. Revenues from environmental taxes as a share of GDP are among the lowest in the EU. Germany’s environmental tax revenue as a share of GDP fell from 2.4 % of GDP in 2005 to 1.8 % in 2017, compared to a fairly stable EU average of around 2.4 % of GDP (Graph 4.1.3). Environmental taxation encourages more efficient use of resources, and can boost investments and employment. However, in Germany these taxes do not serve their purpose of sending price signals to all polluters, as they are designed in such a way as to avoid many polluters having to pay, for example via exemptions or preferential rates. Transport fuel tax revenues have decreased as a share of GDP in recent years. Tax rates on motor fuels have not been adjusted since 2003. In addition, there is a favourable tax treatment of diesel compared to petrol, making Germany increasingly an outlier in that it privileges diesel technology through excise duties. Taxation of company cars is also favourable. The implicit tax rate on energy in Germany fell by 26 % to EUR 203.2 per toe between 2005 and 2016, compared with an EU average of EUR 234.8 per toe. Exemptions from the energy taxes and levies for energy-intensive processes were introduced in 2006, when the energy tax law was introduced. Exemptions for sections of the industry from the renewable surcharge add to the electricity bill of other industrial consumers and households and tend to distort price signals. Fossil fuel subsidies have risen over the past decade. Such subsidies include energy tax and surcharges relief for energy intensive companies and various tax exemptions, e.g. for commercial aviation, public transport, and diesel used in agriculture. The abolition (or limitation) of such measures would allow a shift to taxes that are less detrimental to growth and help resolving environmental issues. Distortive tax rates differ widely across energy users, fuels and carbon intensity, slowing down emissions reduction and investments in energy efficiency. Taxes and levies on electricity are higher per unit of energy than those on other energy carriers such as petrol and diesel, natural gas and heating oil in Germany (Agora Energiewende, 2018). Coal use is also taxed at lower rates than natural gas use, while there are income tax subsidies for commuting . Moreover, such taxation divergence may explain the slow progress made by Germany in terms of reducing its greenhouse gas emissions in sectors such as transport and heating and cooling, as covered by the Effort Sharing Decision. Projections indicate that Germany will exceed its 2017 Effort Sharing Decision target by more than 20 MtCO2, which makes it unlikely that the overall 2013-2020 target can be met. Graph 4.1.5:Environmental tax revenues (% GDP) Source: Eurostat Box 4.1.1: Tax shift from labour to inheritances and gifts As in previous years, the 2018 Council CSRs for Germany recommend reducing the high tax wedge for low-wage and second earners and improving the efficiency and investment-friendliness of the tax system. The tax wedge on labour in Germany is one of the highest in the EU, including for low-wage earners. Inheritance and gift tax, on the other hand, grants relatively large tax exemptions when family businesses are transferred to the next generation. This makes the system overly complex, inefficient and subject to tax planning (Bach, 2016; Bach and Thiemann, 2016; Kopczuk, 2012). This box provides a summary of three hypothetical scenarios of tax shifts away from personal income and social security contributions and towards inheritances and gifts. ( IV ) In the current system (baseline), inheritances and gifts are taxed at progressive rates that depend both on the value of a transfer and on the relational proximity of an heir to the deceased person or donor. Furthermore, certain types of wealth, such as business wealth, are partially tax-exempt. In the three hypothetical inheritance and gift tax scenarios, all tax exemptions are removed, but a basic allowance of EUR 400 000 per taxpayer is kept. 1. The first scenario replaces the progressive rates by a proportional rate of 10 %. The additional tax revenue over and above the baseline is used to reduce the personal income tax burden by raising the minimum threshold of the solidarity surcharge from EUR 81 to EUR 156/month (of tax liability).( V ) 2. The second scenario keeps the existing progressive tax rates. The additional tax revenue over and above the baseline, is used to lower the personal income tax and social security burden, by raising the solidarity surcharge threshold further to EUR 316/month and by extending the midi-zone from EUR 850 to EUR 2 000/month, phasing in contributions linearly. 3. The third scenario keeps the existing progressive tax rates, except for the top bracket. The top marginal tax rate, applied to wealth transfers above EUR 26 million, is raised from 30 % to 50 %. The additional tax revenue over and above the baseline is used to flatten the ‘middle-class bulge’ by extending the second tax bracket from EUR 13 996 to EUR 16 500. Static distributional and budgetary impact. The static overnight budgetary effect, in the absence of behavioural responses ( VI ), differs substantially from one scenario to another. While the first scenario yields about EUR 550 million over and above the baseline, the second (+EUR 9.0 bn) ( VII ) and third scenarios (+EUR 12.7 bn) increase revenue significantly more (Table 1). A large share of wealth transfers is tax-exempted and most (second-most) revenue is collected from inheritances of gifts above EUR 20 m. (EUR 500 000 – EUR 2.5 m) in all scenarios (Figure 2.1). All three tax shift scenarios lower the tax burden or social security contributions on labour and lead to higher income. The distributional impact of the solidarity surcharge (‘Soli’) reform (Scenario 1) is very limited, whereas the second scenario ranks highest in redistributive terms. All deciles of the income distribution benefit from flattening the ‘middle class bulge’ (Scenario 3), in particular households located between the fourth and the ninth decile (Figure 1.2). Macroeconomic impact of the labour tax scenarios. There are no sizeable macroeconomic effects under the first scenario. However, the reduction of the tax burden on labour under the other scenarios increases employment and GDP, both in the short run and in the medium term (after 5 years). Employment increases by a similar amount in the medium term under scenarios 2 and 3 (+0.16 % or +0.18 %, respectively). This effect is mainly driven by low-skilled (scenario 2) and medium- and high-skilled employment (scenario 3). After five years, higher employment boosts economic output by 0.11 % (0.15 %), consumption by 0.18 % (0.24 %) and investment by 0.06 % (0.08 %) under scenario 2 (scenario 3) relative to the baseline. Healthcare

Public spending on healthcare and long-term care in Germany is projected to increase in response to demographic developments, but fiscal sustainability risks are low. Total health expenditure per capita is among the highest in the EU, and expenditure as a share of GDP is also the second highest (11.3 % of GDP in 2017), with only France spending more in the EU. As a consequence of population ageing, healthcare expenditure on people insured under the Statutory Health Insurance scheme is projected to increase by 0.7 pps. of GDP, below the expected average growth level in the EU (0.9 pps. of GDP). Taking into account the impact of non-demographic drivers (such as medical and technological advances) on future spending growth, healthcare expenditure on people insured under the Statutory Health Insurance scheme is expected to increase by 1.5 pps. of GDP between now and 2070 (EU: 1.6) (European Commission, 2018d). There is room for efficiency gains, especially in hospital and pharmaceutical care. The cost of in-patient hospital care is on the rise in Germany. Hospital care is characterised by a high density of healthcare facilities, mostly in urban settings, pointing towards a significant oversupply in some urban areas. The number of hospitals and hospital beds per 1 000 inhabitants and the average length of stay in German hospitals are declining only slowly and are still among the highest in the EU. 93 % of hospital expenditure goes on in-patient care involving an overnight stay, the second highest in the EU, while the shares of out-patient and day-care are very low. Better cooperation among the various healthcare services and with services providing social care and care for the elderly could improve efficiency. Expenditure on pharmaceuticals is high and rising, and recent cost-containment reforms have not been able to stop the increase. Expenses incurred for pharmaceuticals by the Statutory Health Insurance funds and co-payments by patients rose by 3.7 % between 2016 and 2017, reaching EUR 39.9 billion. The main reason for the increase was newly licensed patent-protected pharmaceuticals, which account for 45 % of Statutory Health Insurance pharmaceutical expenditure (Schwabe et al., 2018). Germans spend the most per capita in the EU on retail pharmaceuticals. Annual pharmaceutical spending growth in hospital settings in Germany has outpaced that of retail pharmaceuticals in recent years. The Act on the Reform of the Market for Medicinal Products has been only partly effective in containing rising expenditure on pharmaceuticals, mainly because of the one year long free price setting by pharmaceutical companies. Unjustified restrictions of imports of prescription medicinal products from foreign online pharmacies continue. The legal framework for statutory health insurance and private health insurance creates inefficiencies and challenges the solidarity principle in healthcare. Although several reforms have improved the situation, the current legal framework, which allows people on higher incomes, civil servants and the self-employed to opt out of the statutory health insurance scheme, weakens the risk- and income-based solidarity principle in healthcare. Moreover, doctors can charge patients with private health insurance more than those covered by the statutory health insurance scheme. This creates inequalities in waiting times and the accessibility of medical services. It also incentivises over-provision of health services to private health insurance patients. A working group on the future of the German healthcare system has been commissioned to put forward proposals by 2020, including on how to reform payment for health services. Pension system Demographic change will strain German public finances and challenge the adequacy of pensions. Fiscal sustainability risks are currently low in Germany, due in large part to a relatively high primary surplus. However, a less ambitious fiscal position, more in line with historical averages, would point to medium sustainability risks. The retirement of the baby boomer generation is affecting Germany more than other EU countries. By 2040, the country is expected to be facing one of the largest increases in spending on public pensions in the EU (up by 1.9 pps. of GDP), while the public pension benefit ratio is expected to fall by 4.4 pps., to 37.6, according to the 2018 Ageing Report (European Commission, 2018d) (see Box 4.1.2). Fiscal framework For the first time the macroeconomic forecast underlying the budgetary projections is endorsed by an independent body. In July 2018, the Regulation on the Economic Projections of the Federal Government (‘Vorausschätzungsverordnung’) came into effect. It names the Joint Economic Forecast Project Group, comprising the five leading German economic research institutes, as the independent body responsible for endorsing the macroeconomic forecast underlying the draft budgetary plans. On 16 October 2018, the Joint Economic Forecast project group gave a favourable opinion endorsing the macroeconomic projections underlying the draft budgetary plan for 2019. As regards the upper limit on the general government structural deficit of 0.5 % of nominal GDP, the Stability Council's Advisory Board assesses Germany as complying with the rules (in its report of December 2018). Germany continues to conduct spending reviews to increase the efficiency and effectiveness of government spending. Since 2015, the country has held yearly cycles of spending reviews targeting specific policy areas and ministries. The 2017-2018 cycle covered the topics of ‘procurement of standardised bulk articles’ and ‘humanitarian aid and transition aid, including crisis prevention, crisis response, peace-keeping and development cooperation’, whereas the ongoing review cycle for 2018-2019 analyses the ‘management of receivables’. The implementation of accrual accounting is uneven. Accrual accounting as a public accounting standard provides a comprehensive and transparent overview of a public body’s financial position and performance and can support sustainability and intergenerational equity. A majority of public bodies in Germany at the municipal level have now switched to accrual accounting, but this is not the case at federal level or consistently at the state level. Box 4.1.2: Reform options for the German pension system While recent government measures commit to providing adequacy for certain groups, guaranteeing adequate pensions in the long run may require structural measures. The government has increased pension entitlements for mothers and for people with disabilities (see Section 4.3.2), and set two ‘stop lines’(doppelte Haltelinie), capping the pension contribution rate at 20 % and setting a lower limit for income replacement rates at 48 % up to 2025. However, retaining these upper and lower limits under current policy settings is expected to require significant fiscal transfers. (Börsch-Supan et al., 2018) Since ageing will already affect the labour market strongly as of 2023, the Pension Commission's recommendations, due by March 2020, appear very timely. The pensionable age is a key adjustment variable. Germany currently has an implicit link between pension levels and life expectancy (as pension indexation is linked to the ratio of pensioners to workers). Consequently, higher life expectancy means lower pension levels. Raising pensionable age by two thirds of life expectancy increases would maintain the current ratio of 1:2 in terms of the average time spent in retirement versus time spent working, without compromising pension adequacy. The link could be made explicit and applied to pensionable age, as is the case in the Netherlands, Denmark, and other countries. Broader reforms of pension arrangements could also be considered. For instance, notional defined contribution systems( VIII ) could be one policy solution. Countries such as Sweden have had good experiences with a notional defined contribution system, even though there are also challenges (Weaver and Willén, 2014). Their potential advantages include the fact that they: (1) create a sense of fairness, as annual benefits are in line with life-time contributions; (2) make redistribution transparent, as any non-contributory credits can be clearly shown (credits for education, bring up of children, unemployment etc.); and (3) provide an automatic response to demographic change (longevity, fertility) and developments in employment. However, they need fine-tuning, as there are also disadvantages, including the lack of substitutes for pre-funding and the lack of an automatic balancing mechanism if annuities are frozen at retirement and the contribution rate is fixed. Pension coverage could be improved to secure better retirement outcomes. Making the first public pension pillar more comprehensive, so as to cover self-employed people as well, would be helpful (see section in 4.3.2); however, civil servants still remain outside. In addition, well-designed second and third pillar pensions could significantly supplement the first pillar. Currently, occupational pensions cover about 56 % of workers in Germany and private pensions about 34% (the coverage of occupational and/or private pension is estimated at 70% of workers). There are a number of problems with the design of private pension schemes in Germany (Riester-Rente), such as information gaps, low/negative yields and high administrative costs. The wide variation in administrative costs suggests the existence of market failures, as providers with the highest administrative costs have not left the market. In addition, the current structure of Riester subsidies requires a specific set-up of life insurance plans and related guarantees, which contributed to portfolio allocation oriented towards low-yielding safe debt ( IX ) and foreign debt securities. The tax incentives thus implicitly impede households from switching to third-pillar plans with higher returns and higher equity investment allocation. In addition to adequacy and sustainability, the fairness and regressivity of the pension system also needs to be considered. In Germany, people at risk of poverty (with incomes below 60 % of the median income) live, on average, 10 years less than rich people (those with incomes above 150 % of the median income), and consequently receive their pension for a much shorter time. (Federal Government of Germany, 2017). Furthermore, compared to other OECD countries, net replacement rates for low-wage earners are particularly low in Germany (see Section 4.3.2). These factors lead to strong regressivity in the pension system from a life-time perspective. 4.2. Financial sector Macro-financial stability Germany’s banking sector has appropriate capital and liquidity levels, but is challenged by relatively high costs. Fierce competition among Germany’s various banks weighs on their profits, but, at the same time, finances the real economy on quite favourable terms. Running an extensive branch network, the operating costs of German banks are very high, with a cost to income ratio of more than 71.9 % at the end of 2017. Despite a 3.7 % decrease in staff number, this is 2.6 percentage points higher than in 2016. Banks are still very much dependent on interest income. Interest intermediation income accounted for 69.5 % of bank revenues in 2017, a decline of 1.7 percentage points. Pure intermediation revenue sank by 7 % to EUR 71 billion, as banks are still cautious with negative deposit remuneration, hence reducing the profit margin. Yet the importance of intermediation income differs widely among bank types: it provides for 57.3 % of total operational results for big banks, which earn more trading profits and commissions. For the smaller savings banks, it stands at 73.9 % and at 75.3 % for (even smaller) cooperatives. The net interest margin varies considerably between banking types: 1.90 % for cooperatives, 1.87 % for savings banks compared to the average of 1.04 %. An increasing share of deposits is remunerated negatively. In January 2017, 26 % of sight deposits faced negative interest rates. This rose to 50 % by December 2017. Negative interest rates concern mainly large corporate deposits. Since March 2017, the weighted remuneration of overnight company deposits has been negative. Only 4 % of the volume of households’ deposits earns negative interest, but the number of banks passing on negative rates to clients quadrupled throughout 2017, rising from 3 % to 12 %. Capitalisation is slightly above the EU average. In June 2018, German banks’ Common Equity Tier 1 ratio stood at 15.8 %, compared to 14.9 % in the EU and 14.7 % in the euro area. In September 2018, the capital and reserves of all German banks were EUR 595 billion, a 63 % increase since September 2008, when Lehman Brothers went bankrupt. The ratio of balance sheet capital to unweighted total assets reached a new peak of 5.9 %. Except for the Landesbanken and mortgage banks, total equity rose in all bank categories over 2017. German capitalisation ratios have increased more slowly than elsewhere in Europe, as most banks in Germany are not stock companies able to issue shares, but are rather publicly or cooperatively owned, and tend to rely on organic capital accumulation. The share of non-performing loans is half the euro area average. In June 2018, non-performing loans were 1.7 % of the total loan volume, 60 basis points lower than 12 months earlier. Hence, Germany scores well below the EU’s and euro area’s averages (3.4 % and 4.2 %). Credit grows in line with nominal GDP and passive deleveraging has stopped. Banks’ outstanding credit for the private non-financial sector was EUR 2 696 billion at the end of September 2018, 4.5 % higher than a year before, and something of an acceleration from the 2-3 % yearly increases observed earlier. Measured as a share of GDP, outstanding credit increased by 0.5 pps to 80.5 % of GDP in the year until end of September 2018. This minimal increase is the first time that private non-financial debt is growing again (relative to GDP) since 2001 when private sector outstanding credits peaked at around 103 % of GDP.

Mortgage growth at the aggregate level has been moderate, but some recent acceleration can be observed. Although the overall outstanding stock of mortgages increased (Graph 4.2.1), it did so at a pace similar to nominal GDP growth. Consequently, aggregate mortgages have been hovering around 35 % of GDP over the past six years. More recently, some moderate acceleration can be observed, as the annual expansion of housing credits was 4.5 % in September 2018, compared to 3.9 % 12 months earlier. House price increases are not leading to any macroeconomic or financial stability risks. Whereas increases in recent years could be seen as a price normalisation process, by now housing markets in Germany’s seven biggest cities are estimated to have reached overvaluations of up to 30 % (see also Chapter 1). Still, a real estate price correction of 30 % and the related financial stress is not expected to bring banks below regulatory capital minimums (Bundesbank, 2018). Table 4.2.1:Quarterly financial soundness indicators Source: ECB – CBD2 – Consolidated Banking data; own calculations Graph 4.2.1:Mortgage debt, volume and % of GDP Source: ECB The borrower-based macro-prudential toolkit is not yet complete. The introduction of loan-to-value caps and maturity limits, i.e., amortisation requirements, was enabled in 2017. Yet the macro-prudential toolkit lacks income-based instruments, such as the possibility of introducing debt-to-income and debt-service-to-income limits. The loan-to-value caps’ activation process legislated for by Germany is lengthy and complex. In other countries, supervisors have had to yield to political pressures when restraining the allocation of mortgages for reasons of macro-financial stability. Squeezed revenues from the low interest rate environment, costs incurred through digitalisation, regulatory requirements and the entry of new competitors will intensify the challenges facing banks in the near future. The large number of small banks, coupled with a still relatively strong dependence on interest income, makes the German banking system more vulnerable to current challenges. Digitalisation requires costly upfront investments in software applications, back office, and internet security. Fintech and Bigtech