Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances

Germany is experiencing macroeconomic imbalances, which require monitoring and policy action. In particular, the current account has persistently recorded a very high surplus, which reflects strong competitiveness while a large amount of savings were invested abroad. It is also a sign that domestic growth has remained subdued and economic resources may not have been allocated efficiently. Although the current account surpluses do not raise risks similar to large deficits, the size and persistence of the current account surplus in Germany deserve close attention. The need for action so as to reduce the risk of adverse effects on the functioning of the domestic economy and of the euro area is particularly important given the size of the German economy.

More specifically, relatively low private and public sector investment together with subdued private consumption over a longer period contributed to modest growth, falling trend growth, increased dependence of the economy on external demand and the build-up of the external surplus. The challenge is, therefore, to identify and implement measures that help strengthen domestic demand and the economy's growth potential. Higher investment in physical and human capital, and promoting efficiency gains in all sectors of the economy, including by unleashing the growth potential of the services sector, which would also contribute to further strengthening of labour supply, are central policy challenges.

Excerpt of country-specific findings on Germany, COM(2014) 150 final, 5.3.2014

Executive Summary and Conclusions 11

1. Introduction 15

2. Macroeconomic Developments 17

3. Imbalances and Risks 23

3.1. A perspective on Germany's current account surplus 24

3.2. A closer look at household consumption and savings 29

3.3. A closer look at private investment dynamics 40

3.4. A closer look at corporate sector savings 53

3.5. A closer look at the fiscal stance and public investment 59

3.6. Interlinkages with other euro area Member States and potential spillovers 65

3.6.1 Trade and financial linkages between Germany and the rest of the euro area 65

3.6.2 Exchange rate sensitivity analysis: Germany versus Italy 66

4. International Financial Flows and the Role of the Financial Intermediations 69

4.1. Anatomy of Germany's cross-border financial flows 70

4.2. The intermediating role of the German banking sector 73

4.3. The pre-crisis period: push and pull factors 74

4.4. Since the financial crisis: deleveraging pressure led to a retreat from foreign investment 77

4.5. The role of credit demand and credit supply in German private sector deleveraging 80

5. Germany's external position and Trade Performance 83

5.1. Anatomy of Germany's current account 83

5.2. Germany's export and import performance 85

5.3. Price competitiveness 89

5.4. Non-price competitiveness 90

6. Policy Challenges 93

Annex 96

References 101

LIST OF Tables

2.1. Potential growth 19

2.2. Key economic, financial and social indicators - Germany 21

3.1. Change in current account and contribution of savings and investment by sector, in pps. of GDP 26

3.2. German fundamental current account estimates from various sources 26

3.3. Annual average differences between the growth rate in compensation per employee and wage benchmarks 35

3.4. Shares in total monthly household savings by income decile. Saving rates by income decile 36

5.1. Change in German exports and imports vis-à-vis selected countries (% change) 88

5.2. World Economic Forum Competitiveness Indicators - Ranking of Germany 91

LIST OF Graphs

2.1. Gross Domestic Product in constant prices (2000=100) 17

2.2. Average annual GDP growth and contributions of demand components (%, perc. points, per annum) 17

2.3. Domestic demand in constant prices (2000=100) 17

2.4. Labour market and cost developments 18

2.5. Real wages (2000=100) 18

2.6. Productivity developments 18

2.7. Potential output growth and contributions by production factors (%, perc. points, per annum) 18

2.8. Population projections (in million persons) 19

2.9. Main components of GVA by type of activity (% of total GVA) 19

2.10. Value Added in services (avg. annual growth, 2000-2012, %) 19

2.11. Current account balance by geographical counterpart (% of GDP) 20

2.12. Composition of debt by institutional sector (consolidated, % of GDP) 20

2.13. General government deficit and debt (% of GDP) 20

2.14. Credit flows by institutional sector (consolidated, % of GDP) 20

3.1. Current account balance, national savings and investment (in % of GDP) 24

3.2. Change in excess savings and sectoral contributions (in pps. of GDP) 25

3.3. Sectoral excess savings and currrent account balance (in % of GDP) 25

3.4. Non-financial corporate sector - savings, investment and excess savings (in % of GDP) 27

3.5. Financial corporate sector - savings, investment and excess savings (in % of GDP) 27

3.6. Households and NPISH - savings, investment and excess savings (in % of GDP) 27

3.7. General government - savings, investment and excess savings (in % of GDP) 27

3.8. Shock decomposition of Germany's trade balance (% of GDP) 28

3.9. Private consumption in current prices (index, 2000=100) 29

3.10. Private consumption in constant prices (index, 2000=100) 30

3.11. Nominal and real disposable income of households (index, 2000=100) 30

3.12. Real gross disposable income of households - annual % change and contributions by component 30

3.13. Compensation of employees and property and entrpreneurial income (index, 1991=100) 31

3.14. Adjusted wage share at market prices 31

3.15. Employees, hours worked, hours worked per employee (total economy, 2000=100) 33

3.16. Hours worked (total economy, 2000=100) 33

3.17. Regular employment, non-regular employment, self-employed and unemployed (in millions) 34

3.18. Growth in hourly real wages by sector (%) 34

3.19. Compensation per employee in tradable and non-tradable sectors (2000=100) 35

3.20. Gross households saving rate 36

3.21. Household savings rate per income quartile 36

3.22. Share of private sector GFCF in GDP in current prices 40

3.23. Potential growth, 2013 estimate and earlier vintages 40

3.24. Net investment as share in GDP and per employee 41

3.25. Investment gap1 vis-a-vis EA w/out IE and ES, contributions by investment good type 44

3.26. Share of machinery and equipment investment in GDP in current prices 44

3.27. ME investment -levels, volumes and deflator (index, 2000=100) 44

3.28. ME investment and goods exports in constant prices (annual % chg., nsa) 45

3.29. ME investment in current prices: annual % chg. and contributions by branches 45

3.30. Share of construction investment in GDP in current prices 45

3.31. Share of other investment in GDP in current prices 45

3.32. Housing and non-housing investment to GDP ratio (index, 1991=100) 46

3.33. Real house prices (index, 2008=100) 46

3.34. Nominal house prices in selected countries (index, 1995=100) 47

3.35. House prices vs. private consumption growth 47

3.36. Decomposition of non-housing investment (index, 1991=1000, volumes) 47

3.37. Non-housing investment (% of GDP, values) 47

3.38. Change of banks' credit standards for loans to firms over previous 3 months (net percentage) 48

3.39. Non-financial corporate sector - share of gross savings in GVA 53

3.40. Financial corporate sector - share of gross savings in GVA 53

3.41. Non-financial corporate sector - share of gross operating surplus in GVA 55

3.42. NFC- net aquisition of fin. assets and net incurrence of fin. liabilities 55

3.43. NFC - net incurrence of fin. liabilities and componenets 55

3.44. NFC - net aquisition of fin. assets and components 56

3.45. Total revenue, total expenditure and net borrowing (% of GDP) 59

3.46. Fiscal Stance according to the structural balance and Discretionary Fiscal Effort (% of GDP) 59

3.47. Debt-to-GDP ratio (% of GDP) 60

3.48. Gross fixed capital formation of general government (% of GDP) 61

3.49. Net fixed capital formation of general government (% of GDP) 61

3.50. Gross fixed capital formation of general government (% of GDP) 61

3.51. Net fixed capital formation by layer of government (% of GDP) 63

3.52. Exports to Germany (2011, % of reporter GDP) 65

3.53. Imports from Germany (2011, % of reporter GDP) 65

3.54. Countries' financial exposure to DE (ultimate risk basis, in billions EUR) 66

3.55. DE financial exposures to countries (in billions EUR) 66

3.56. First year impact of 5% real appreciation on exports (% of GDP) 67

3.57. GDP impact of 5% real appreciation DE (% of GDP) 67

3.58. GDP impact of 5% real appreciation IT (% of GDP) 68

4.1. Balance on financial account and components (% of GDP) 70

4.2. German other investment abroad by sectors (% of GDP) 70

4.3. Inward and outward portfolio investment and financial derivatives (% of GDP) 71

4.4. Inward and outward direct investment (% of GDP) 71

4.5. Outward direct investment and components (% of GDP) 71

4.6. Inward direct investment and components (% of GDP) 71

4.7. Germany's NIIP by sectors (% of GDP) 71

4.8. Foreign claims of consolidated German banks in trillion EUR 73

4.9. Net acquisition of foreign assets by German banks, in % of GDP (net outflow: +) 74

4.10. Banks return on assets (in %) 75

4.11. Share in total assets and number of institutes across banking categories 75

4.12. Foreign claims of banks (1999=100) 76

4.13. Ratio of foreign investment to exports (annual flows) 76

4.14. Total foreign investment returns: investment income from capital account to previous year's asset investment position 77

4.15. Return from foreign other investment positions and German banks' total returns in % 77

4.16. Banks deleveraging and reduction in foreign claims, peak 2008Q1 (=100) to 2013Q2 78

4.17. German banks 'supply of credit to non-German banks, contribution to annual change in % 78

4.18. Interest rates on loans (1 to 5 years maturity) 80

4.19. EC investment survey: Financial factors supportive to investment in manufacturing, Balance of replies 80

4.20. Loans by households and non-financial corporations (NFCs) in % of GDP 81

4.21. Credit and assets across banking categories, contribution to total change 2011-2013 in % 81

5.1. Decomposition of current account balance (% of GDP) 83

5.2. Current account balance vis-à-vis Euro area, rest of EU and extra EU (% of GDP) 84

5.3. Current account balance vis-à-vis selected European countries (% of GDP) 84

5.4. Current account balance vis-à-vis selected European countries (% of GDP) 84

5.5. Decomposition of current account balance vis-à-vis the Netherlands (% of GDP) 84

5.6. Current account balance vis-à-vis selected countries (% of GDP) 85

5.7. Decomposition of current account balance vis-à-vis China (% of GDP) 85

5.8. Exports and imports (goods and services, 2000, in % of GDP) 85

5.9. Export market share (goods and services) 86

5.10. Market share growth decomposition (%, goods), Germany 86

5.11. Market share decomposition (%, goods), selected European countries 86

5.12. Decomposition of services balance (% of GDP) 88

5.13. Exports, imports (2000=100, goods) 88

5.14. Trade balance (% of GDP, goods) 89

5.15. Germany's price competitiveness based on deflators of total sales (99Q1=100) 89

5.16. ULC, labour productivity and labour cost annual growth rate (%), 2000-2007 90

5.17. ULC, labour productivity and labour cost annual growth rate (%), 2008-2012 90

5.18. Germany's export market share vs. G7 excl. DE (cumulated, in pp.) 90

LIST OF Boxes

3.1. Increasing flexibility in the German labour market 32

3.2. Households' financial balance sheets and consumer credit growth 38

3.3. Competition in the services sectors 42

3.4. House prices in Germany 50

3.5. Energiewende 54

3.6. Quantifying the infrastructure investment gap in Germany 62

4.1. The impact of valuation changes on the NIIP 72

4.2. The role of the Target2 balances 79

A.1. A model-based analysis of trade balance drivers: a detailed interpretation of the shock decomposition 96

A.2. A Current account norm for Germany 98

In the Alert Mechanism Report (AMR) published on 13 November 2013, the Commission decided to conduct an In-Depth Review (IDR) of the German economy to determine whether imbalances exist. In particular, the dynamics of Germany's external position warranted further investigation with a view to better understanding the role of certain domestic features and financial flows, for the current account developments. To this end this In-Depth Review provides an economic analysis of the German economy in line with the scope of the surveillance under the Macroeconomic Imbalance Procedure (MIP). The main observations and findings from this analysis are:

Germany has recorded a large current account surplus of about 6-7% of GDP since 2007. The surplus has remained stable throughout the crisis and is not projected to fall below 6% over the coming years. In fact, even if projected by the Commission services to recede slightly, there is a risk that the surplus could grow even further. The expansion of Germany's current account surplus can predominantly be traced back to the private sector. It owes both to an increase in households' net savings and to firms turning from being borrowers to becoming lenders in net terms. A current account surplus is in line with the structural characteristics of the German economy. However, the pace at which it has been accumulated and its persistence even during a time of adjustment within the euro area cannot be explained by factors that usually drive the current account. This is a priori a sign that the country's economic resources are not being allocated fully efficiently, which ultimately could be to the detriment of German economic welfare. The IDR shows that the German current account surplus does not lend itself to one explanation, but domestic economy developments are crucial in explaining Germany's persistent and large current account surplus. The surplus is the result of an interplay of various factors and developments in Germany as well as globally and among its euro area partners, which affected saving and investment in the domestic economy. Over the course of a decade these factors caused household savings to increase and have tamed consumption growth, while at the same time denting business investment and driving up firms' net savings. Regarding public sector developments, a persistently low and declining level of public sector investment stands out. The result has been muted domestic demand and a weaker growth performance than what could have been attained with a more balanced growth pattern.

External drivers have also contributed to the surplus by increasing the demand for German exports and strengthening capital exports. The increase in the German current account surplus coincided with the introduction of the euro, which reduced sovereign risk premia across the euro area, while financial market integration in the EU progressed and some euro area countries were catching-up. The current account position has also been supported by the increase in the size of the single market due to EU enlargement and the expansion in world trade. Moreover, before the crisis, competitiveness gains from labour costs and prices resulted in a rising surplus with euro area trading partners. In the aftermath of the recent crisis, Germany's price competitiveness recovered with respect to industrialised economies outside the EU, facilitating a redirection of exports towards the rest of the world. Germany's trading prowess is supported by the strong export focus of its manufacturers and their success in reaping the benefits of globalisation through global value chains that enhance non-price competitiveness. Additionally, many German manufacturers are leaders in niche markets. While these reasons explain the strength of Germany's exports, relatively subdued import growth has also contributed to the size and persistence of the country's trade surplus. Still, the current account surplus vis-à-vis the rest of the euro area has nearly halved since the peak in 2007.

Households' consumption and investment patterns reflected the situation of unusually subdued domestic demand, most markedly so until the crisis. Anaemic growth in disposable income caused sluggish private consumption growth. This in turn was due to high unemployment, significant wage moderation and a fall in the total amount of hours worked. These developments in part reflect policies, which should be seen in the context of Germany's post-reunification situation. Changes to the social security system and fiscal incentives encouraged households to save more, which coincided with rising income inequality and increasing precautionary savings, also reflecting uncertainty. These factors raised the household saving rate. Higher household savings need not result in a rising current account surplus if they are used to finance higher investment. This did not happen in Germany, where weak income growth, adverse demographics and the effects of the property bubble in the 1990s caused subdued residential investment.

The decline in business investment has also contributed significantly to Germany's current account surplus. Investment in Germany has been significantly lower than in the rest of the euro area, although the gap has narrowed moderately in recent years. Business investment in buildings and civil engineering facilities in particular has been consistently low. Low trend growth in Germany, relatively restrictive bank lending conditions in the beginning of the 2000s and pressure on companies to improve their balance sheet and to earn a higher return on their investments all reduced the incentive for domestic investment. Nevertheless, the continued weakness of business investment in recent years is at odds with highly supportive conditions for capital formation, such as healthy corporate balance sheets, very low interest rates and a stronger cyclical position. While uncertainty as a consequence of the crisis is one reason why companies hold back on investment, there is a tangible risk that persistently low investment by companies could hamper Germany's economic growth in the longer run. A rise in corporate sector savings explains a large part of the rise in Germany's current account surplus. The savings of non-financial companies peaked in 2010, but the saving rate remains at an unusually high level. The increase in company savings has taken place amid a strong increase in operating profit before the crisis that was supported by wage restraint. Rather than investment, the increase in savings was used to acquire financial assets and reduce debt. A range of factors motivated this, such as a desire to hold more liquid assets, a voluntary reduction of companies' dependence on bank financing, strengthened capital requirements, the initially weak balance sheets of especially SMEs and changed company structures and strategies due to globalisation. Corporate tax reforms also had an impact by further raising companies' incentives to retain a larger part of their earnings. Public sector investment has been falling for a long time in Germany, resulting in a sizeable investment gap compared to the euro area accumulating over time. The low investment rate in particular reflects the gradual scaling back of public infrastructure investment, for both maintenance and expansion of infrastructure. This has occurred almost entirely at the level of municipalities, due also to limited funding, which investment planning and financing mechanisms have not been able to remedy. Moreover, despite a slight increase in expenditure, education spending in Germany remains low by international standards, particularly for primary and lower secondary education. Although Germany's overall fiscal stance is appropriate, its public sector has not in all respects invested sufficiently in the future growth and efficiency of the economy. In the pre-crisis period, international financial integration and low profitability prompted many German banks to focus on foreign investment and accept higher risk. The rapid pace of global economic and financial integration pulled the expansion of German banks' international activity before the crisis. Low profitability at home, where growth was among the weakest in the EU, also incited many German banks to focus on foreign investment. The financial crisis eventually revealed an imbalance in the form of excess risk-taking that German banks had accumulated in their foreign investment positions. In this sense a misallocation of capital had occurred. In the aftermath of the financial crisis, deleveraging pressure led to a retreat from foreign investment. However, the lower foreign lending by German banks in recent years has not led to any noticeable increase in domestic credit provision, despite banks' excess liquidity and low lending rates. Recent surveys show that there are no serious credit constraints. Therefore, the continued weakness in credit growth seems to be the result of low demand rather than credit supply constraints. While the observed developments are not exclusively policy-induced, policies have impacted on outcomes. Various structural reforms, including those undertaken to restore competitiveness after the boom and bust that followed re-unification, have delivered significant long-term gains in terms of job creation and sound public finances. These reform choices were considered necessary and have overall proven beneficial for Germany. At the same time, they have had, in some instances, unintended effects and impacted saving and investment decisions in a way that has contributed to a low-growth trajectory.

The IDR discusses the policy challenges stemming from the analysis. A number of elements could be considered:

Since Germany's large and increasing external surplus stems primarily from a lack of domestic demand, it would be important to identify and implement measures that help strengthen domestic demand and the economy's growth potential. Germany's low and falling trend growth demonstrates that the reliance on external demand as the main driver of growth does not secure the country's future economic potential. The capacity to grow in the future, provide jobs and ensure rising living standards in an era of ageing and fierce global competition depends crucially on bolstering domestic sources of future growth, in particular via private and public investment. Additional measures appear needed to address the backlog in public investment and in particular to step up infrastructure investment. Given the sound public sector balance sheet, Germany would be well-advised to use the window of opportunity provided by very low interest rates to invest in sound future-oriented projects. In particular, it will be important to further strengthen recent years' increase in infrastructure investment and education spending. Given that the bulk of the investment backlog is at the municipal level, a reform of fiscal relations between layers of government may be needed to ensure a sustainable funding of public infrastructure. Steps to further reduce disincentives to work would be welcome, with a view to supporting labour supply and raising the income of workers, in particular those at the bottom of the income distribution. As recommended to Germany under the European Semester, challenges include a reduction of the relatively high tax burden on labour (especially on low-wage earners), reviewing the favourable fiscal conditions of mini-jobs to eliminate possible distortions, and reducing disincentives for second earners to increase their working hours. More efficient corporate taxation and further steps to improve the business environment would support private investment. It would be useful for Germany to review the effects of its tax system, e.g. a possible discouragement of companies from paying out dividends and the impact of taxation on different types of financing. Avoiding policy steps that may have a negative impact on investment will be important. A credible and cost-effective strategy for the "Energiewende" would have a long-lasting positive effect on investment. Also, mapping out initiatives that could ensure investment and productivity growth in the services sector is a challenge with large potential gains. Further efforts to develop the services sector may enhance domestic demand in Germany and could have a positive effect on wages and real consumption. Reducing the administrative burden also remains important. Appropriate conditions should be secured in order to enable wage growth to further contribute to domestic demand. Real wages have risen in recent years, reflecting favourable economic and labour market conditions. The new government has announced plans for introducing a general minimum wage. In detailing the proposal, it will be important that the level and scope of the minimum wage take into account the potential impact on employment. Germany is encouraged to ensure that the banking sector has sufficient loss absorption capacity to withstand economic and financial shocks and to address any impediments to further consolidation. Full implementation of the new capital requirements and follow up of the forthcoming comprehensive capital needs assessment will be essential. Renewed activity of, in particular large, German banks on international markets would contribute to reversing the fragmentation of the EU banking market. For all German banks, it may be appropriate to reduce the exposure to financial intermediaries and to refocus on channelling domestic savings to the real economy. An increase in aggregate demand in Germany would raise growth domestically, but would also entail the additional benefit of helping the economic recovery in the euro area. Potential risks to growth in the euro area remain. Countries remain at different positions in the adjustment process, which limits their ability to contribute to growth. Spillovers from higher domestic demand in Germany could support overall aggregate demand in the euro area. An increase in German public and private investment and steps to open up and further develop services and energy markets would have a positive effect on domestic growth, while at the same time providing a positive impetus to the rest of the euro area.

On 13 November 2013, the European Commission presented its third Alert Mechanism Report (AMR), prepared in accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention and correction of macroeconomic imbalances. The AMR serves as an initial screening device helping to identify Member States that warrant further in depth analysis to determine whether imbalances exist or risk emerging. According to Article 5 of Regulation No. 1176/2011, these country-specific “in-depth reviews” (IDR) should examine the nature, origin and severity of macroeconomic developments in the Member State concerned, which constitute, or could lead to, imbalances. On the basis of this analysis, the Commission will establish whether it considers that an imbalance exists in the sense of the legislation and what type of follow-up in terms it will recommend to the Council.

The AMR suggested the need to look more closely at whether Germany is exhibiting macroeconomic imbalances of an external and internal nature. On the external side, the AMR highlighted that the current account surplus has persistently been high and is expected to continue being so over the next years. The German surplus accounts for most of the euro area's surplus. The surplus reflects higher savings than investment in the German economy. Regarding domestic demand, the household saving rate is among the highest in the euro area and private sector deleveraging has continued. Against this background, an in-depth analysis of certain domestic features, including financial flows, and of their role for the sectorial savings-investment balances appears warranted. To this end, in line with the scope of the surveillance under the Macroeconomic Imbalance Procedure (MIP), this IDR takes a broad view on the German economy during the period where the current account surplus built up and in recent years where it has remained persistently high.

Chapter 2 provides a first overview of the general macroeconomic developments. Chapter 3 looks more in detail into the main imbalances and risks from the perspective of saving-investment patterns in the various parts of the German economy. This is followed by an analysis of the role and functioning of the financial sector in Chapter 4, and a discussion of the drivers of Germany's trade performance in Chapter 5 Chapter 6 discusses policy considerations.

Growth and labour market performance

Germany's economy weathered the economic crisis remarkably well. After the severe slump of 2008/09, it enjoyed a rapid rebound in 2010-11 followed by more moderate growth in 2012-13 (Graph 2.1). The latest Commission forecast projects private consumption to remain a key driver of the German economy in the coming years, as it has been in the aftermath of the crisis, notably since 2011. Amid reduced uncertainty, pent-up investment demand is also expected to gradually be unleashed.

In a longer term perspective, however, Germany still has room for improving and rebalancing its growth performance. The relative resilience shown by the economy during the crisis was due to a previous prolonged adjustment process to correct unfavourable post-reunification developments. This involved wage moderation to restore cost competitiveness, labour market reforms to address high structural unemployment, and public and private sector balance sheet repair, following the 1990s construction boom. This process took place in conditions of high growth of other euro area countries. At the same time, growth was until recently largely driven by external demand, while domestic demand was marked by low private and public investment, and muted private consumption growth, also on the back of stagnating real wages (Graphs 2.2 and 2.3).

Morose labour market conditions in the early 2000s gave way to a sustained upswing in employment growth, with unemployment declining to well below the euro area average. Job creation has been significantly more vigorous than in the euro area since the mid-2000s, resulting in declining unemployment and growing employment rates (Graph 2.4). Contained unit labour costs for most of a decade enabled continuous job growth, but the share of long-term unemployed remains high and increasingly difficult to reduce. The sustained advances in the employment rate mask job market disparities with a growing share of non-regular contracts. The at-risk of poverty rate has increased by 1% over the past five years, but this and other standard social indicators have been in line with or more favourable compared to the euro area average.

Real wages fell for a decade but have grown more rapidly than in the euro area since 2010. On the back of weak labour market conditions and in the context of far-reaching reforms, real wages decreased in the early and mid-2000s (Graph 2.5). In the aftermath of the crisis, the record-low unemployment rate and rising labour demand has yielded robust growth in the compensation of employees. Together with contained inflation, this has supported real wage growth.

Wage restraint has kept unit labour cost growth low, but the German economy has at the same time sustained a certain hourly productivity edge over euro area-peers, despite increasing employment of low-skilled workers (Graph 2.6). The economic adjustment has borne fruit, strengthening in the first instance Germany's international competitiveness and eventually re-starting domestic demand.

Germany's potential growth has declined markedly and demographic change is a key challenge going forward. A spurt in labour supply helped prop up potential growth in the aftermath of the crisis compensating still modest investment (Graph 2.7 and Table 2.1). However, intensifying population ageing is imminent (Graph 2.8).

Sectoral developments

Germany's manufacturing sector has maintained a strong position, while productivity growth in the services sector has stagnated. Since 2000, manufacturing has maintained a near-stable share in gross value added, contrary both to earlier decades and to other highly industrialised economies (Graph 2.9). At the same time, the services sector's performance appears weak in international comparison, suggesting that a significant potential remains untapped (Graph 2.10).

On the back of a growing trade surplus, Germany's current account balance strengthened by more than 9% of GDP between 2000 and 2012. It is not projected to decline substantially any time soon. ([1]) In the aftermath of the financial and economic crisis, the surplus with the euro area countries has declined (Graph 2.11). This has been more than outweighed by an increasing surplus with the rest of the world, especially emerging economies. Strong export competitiveness and the ability to redirect exports have proved valuable in a challenging external demand environment. At the same time, limited import growth has also contributed to the external surplus.

Private debt developments are of little concern, but public debt should be kept on a steady downward trend. Private sector indebtedness is significantly below euro area peers', with continuous deleveraging for more than a decade. Fiscal consolidation has helped rein in public debt.

Credit growth has been subdued and remains muted in spite of very favourable financing conditions. The provision of credit to the household and corporate sector has been negligible for over a decade. Net credit continues to expand at a comparatively slow pace in spite of healthy balance sheets and very favourable financing conditions, which should have been supportive to more buoyant private demand.

More than 20 years after reunification, economic East-West disparities remain significant. Although slowly narrowing, wide gaps in economic performance persist most notably in unemployment rates and per capita income.

Recommendations to Germany under the European semester have focused on the need to strengthen domestic sources or potential growth. Complementing the earlier surveillance work, this in-depth review examines in particular how certain domestic features impact on sectoral savings-investment balances and thereby determine the dynamics of Germany's external position.

(Continued on the next page)

Box (continued)

3.1. a perspective on Germany's current account surplus

Dynamics in both savings and investment contributed to the build-up of the excess savings ([2]), which were mirrored in Germany's persistent current account surplus. The current account balance is often analysed by looking at trends in the balance of trade in goods and services and the income balance. While it is useful to understand trends in trade flows (see Chapter 4), key insights about the underlying economic forces in the various parts of the economy can be gained by analysing sectoral developments in national savings and investment.

The build-up of the current account surplus in the period until 2007 reflected both a trend increase in savings and a decline in investment relative to GDP. These dynamics contrast with developments at the euro area ([3]) level, where the saving share remained broadly flat while a slight increase in investment relative to GDP was observed. After a crisis-related fall in savings and investment in both Germany and the euro area, both aggregates have followed a parallel movement in Germany, implying a broadly unchanged current account balance.

All domestic sectors contributed to the increase in excess savings in 2000-2007. The build-up of the current account surplus was initially driven by private sector excess savings dynamics, while public sector developments partially offset this. The level of excess savings was especially high in the household sector, also reflecting a traditionally high saving rate which gives an indication that Germans appear to be relatively patient and willing to shift consumption over time. ([4]) By contrast, excess savings dynamics were to a large extent driven by the non-financial corporate sector. The net lending position of the public sector started to improve in 2004 and became the main driver of the further widening in the current account surplus in 2005-2007, when the private sectors' contributions subsided. Overall, the improvement in the current account balance by 9.3 pps. of GDP in the period 2000-2007 was largely driven by higher savings (see Table 3.1). The non-financial corporate sector's contribution to this was especially large. ([5]) In the aftermath of the crisis, the net lending position of the non-financial corporate sector and the consolidation of public finances are the main reasons for the surplus having remained at 6-7% of GDP.

The underlying economic reasons for the persistently very high surplus remain, however, difficult to explain. Based on an analytical approach that decomposes the German current account into different factors (see annex 2), it appears that the surplus in recent years has reached a level well-above what is implied by the common "fundamental" determinants of current accounts. Within the model, fundamentals such as relative GDP/worker, (low) expected growth, the (tight) fiscal stance, and (tight) credit can explain a German current account surplus, but not the large part of its level or its persistence, as shown in Table 3.2. Although methodologically difficult to calculate, the analysis is qualitatively in line with other attempts to examine the German surplus. Table 3.2 summarises the results of other studies based on comparable methodology. The literature thus confirms the view that a substantial part of the German surplus remains unexplained.

Moreover, adjusting for the position in the business-cycle, Germany's current account surplus could increase further. The decomposition analysis shows that at 7% of GDP in 2012, the surplus was lower than an estimate of its cyclically-adjusted level, which was around 8%. This is due to the fact that although Germany has effectively closed its output gap, its partners remain below their respective potential output. This implies that as Germany's trading partners recover from their currently low level of demand, Germany's current account surplus could increase further.

From a sectoral perspective, an in-depth analysis is required to decipher the heterogeneous developments over time (Graphs 3.4-3.7). A differentiated look at respectively savings and investment patterns in each sector is required, not least since the broadly constant excess savings in the aftermath of the crisis mask important swings at sectoral level. In the non-financial corporate sector, excess savings in the very early 2000s reflected a marked decrease in investment combined with an equally steep rise in savings, whereas later, the pick-up in investment dampened the effect of the further increase in savings. After countervailing movements in the context of the 2009 recession and ensuing rebound in 2010, both shares have seen a parallel decrease in the most recent past. In the financial corporate sector, fluctuating savings combined with a slight trend decline in investment have led to large swings in excess savings. As far as households are concerned, their excess savings rose markedly in the first half of the 2000s, when the sector reduced its investment while increasing savings. Since then, investment has seen a very slight pick-up while savings peaked in 2008, resulting in a slight reduction in households' excess savings since 2009. Finally, general government excess savings were largely driven by saving dynamics, which in turn reflected both changes in the fiscal stance and cyclical effects. At the same time, the public investment share in GDP saw a trend decrease. Summing up, a complex interplay of savings and investment trends with marked sectoral differences has shaped aggregate excess savings and current account dynamics.

A model-based analysis supports the view that the saving and investment behaviour of domestic economic agents has been an important determinant of the surge in Germany's current account surplus. An estimated multi-country version of the European Commission's QUEST macroeconomic model allows quantifying the relative importance of different drivers for the build-up and persistence of Germany's trade surplus, which has been the main contributor to the strengthening of the current account. ([6]) The model framework allows the trade surplus development to be considered in conjunction with other features in the German data over the sample period, such as stagnant investment, increased savings, and low inflation and output growth. The contribution of the possible drivers is fundamentally determined by the estimated size and sign of the associated shocks to the model and their transmission to the various endogenous variables.

The model-based analysis shows that the German trade surplus does not lend itself to a mono-causal explanation, but rather represents a sequence of demand and supply shocks. These shocks have had a varying quantitative importance over time for the German trade balance, which has been driven by domestic and foreign factors alike. More precisely, according to the model-based analysis (see annex) the main forces driving the German trade balance can be summarised as follows:

In the period 2001-04, expanding foreign demand in the rest of the euro area and the rest of the world played an important role for the rise in the trade balance, but domestic demand factors were also at play. The impact of external demand expansion was complemented by a deterioration of corporate financing conditions which coincided with the end of the "dot-com" boom and widened the savings-investment gap from the investment side. A shock to private savings made an increasingly important contribution to the trade surplus since 2002. The decline of risk premia in the rest of the euro area in the context of EMU contributed to Germany's trade surplus by promoting capital outflows, but does in itself not explain the steep increase in the surplus after the year 2000.

During 2004-08 an increasing contribution came from an apparent shock to savings, which implied lower domestic demand and kept the trade balance surplus persistently high. The model-based analysis gives ground to believe that the savings shock originated in developments in the labour market and social security system. A prolonged fall in real wages and the impact of reduced benefit generosity (a key element in the German labour market reforms) appear to have made a positive and growing contribution to the trade surplus by strengthening the price competitiveness of German exports and initially dampening domestic demand. Strong foreign demand leading to high exports continued to play a large role, while improving corporate sector financing conditions worked in the direction of supporting investment and lower trade surplus after 2005.

After 2009, the contribution of external demand has declined and the positive contribution of the savings shock has stabilised, while the surplus has been upheld by the impact of earlier reforms. After a temporary reduction in 2009, associated with the fall in external demand in the global recession, the German trade surplus has returned to and persistently remained at pre-crisis levels. The contribution of external demand has declined compared to the pre-2009 period particularly as a consequence of demand contraction in the rest of the euro area. Hence, the decline in Germany's trade surplus with other euro area Member States in recent years has seen in isolation contributed to reduce the current account surplus, as has to a lesser extent an abating contribution from the savings shock, but these changes in bilateral trade flows have on the whole not had a major impact on the current account position. The model-based analysis suggests that this is because the surplus has been upheld at pre-2009 levels by the growing impact on wages and labour supply of the reforms to the unemployment and social benefit system. Tighter financing conditions for firms during the financial crisis have also contributed to the trade surplus by reducing domestic investment demand. The effect of interest rate convergence in the euro area has vanished with the widening of euro area interest spreads over German rates. Finally, fiscal policy shocks have played a fairly limited role for the German trade surplus according to the model estimates, tending to reduce the aggregate savings-investment gap until 2005, and contributing positively to the surplus since 2011 on the back of the fiscal consolidation.

The high level of current account surplus, including during a period of significant swings in world trade and the composition of global import demand, give support to the notion that the drivers of the surplus are first and foremost found in the saving and investment behaviours of domestic economic agents. A sector-by-sector analysis is therefore at the centre of understanding the nature of Germany's surplus and identifying possible imbalances in the German economy. In this light, the following sections aim at a closer look at consumption, savings and investment patterns in the different sectors of the German economy in order to further explore the underlying drivers of the surplus.

3.2. A closer look at household consumption and savings

German households' net lending as a share of gross disposable income is several times higher than the euro area average and the household sector's ([7])contribution to the economy's net lending position explains a large part of the current account surplus. Analysing consumption dynamics is therefore essential to examine if inefficiencies have resulted in overly subdued private consumption growth or if other factors have raised the household saving rate to a level that might have contributed to excessively subdued domestic demand dynamics.

Private consumption growth was slow in the 2000s compared to the euro area. Nominal and real consumption growth was slow even taking into account that the euro area average ([8]) was impacted by developments in countries which were experiencing unsustainable domestic demand booms (Graphs 3.9 and 3.10). Lower consumer price inflation in Germany than in the euro area explains some of the gap, but the pattern of significantly slower relative growth remains valid when looking at consumption volumes. With private consumption being the largest component of domestic demand, sluggish household consumption was a main reason for Germany's relatively weak growth performance throughout much of the 2000s.

Much slower growth in households' disposable income ([9]) in Germany than elsewhere in the euro area explains the weakness in consumption. Throughout most of the 2000s, real disposable income growth in Germany was low, averaging 0.7% in 2000-2007, less than half of the euro area average of 1.7%. It accelerated only after the recession in 2009, averaging 1.2% in 2010-2012, outpacing the euro area average (-0.9%). Households' subdued real disposable income growth in the pre-crisis years is largely explained by a negligible, partly even negative, contribution of labour income (Graph 3.12). Post-reunification imbalances were reflected in weak labour market developments ([10]). With the unemployment rate peaking at above 11% in 2005, net labour income made on average no contribution to disposable income growth in 2000-2007. Pension income (the bulk of monetary transfers) saw minimal increases, reflecting slow growth in wages and salaries and the effects of pension reform steps. Hence, net property income was almost exclusively the driver of disposable income growth before the crisis. A breakdown by components reveals that it was mainly driven by distributed income of corporations on the back of a strong trend increase in corporate profitability in Germany (see Section 3.2.3).

The muted labour income dynamics resulted in property and entrepreneurial income growing very rapidly up to the crisis (Graph 3.13), denting private consumption. ([11]) The corresponding decline in the adjusted wage share was very pronounced in Germany (Graph 3.14). ([12]) As the propensity to consume out of wages is well above that out of capital income, the steep fall in the wage share over a longer period of time is likely to have exercised a downward pressure on household consumption (see for example the review of recent literature by Papadia, 2013). Since reaching its historic trough in 2007, the German wage share has recovered somewhat, in line with developments at the euro area level, and has recently developed more dynamically. Comparing wage share and unemployment rate in Germany suggests some role for the labour market reforms implemented in the first half of the 2000s. The wage share has also been falling in most other industrialised economies, inter alia due to labour-saving technical progress through ICT-related to innovation and via a decrease in workers' bargaining power (OECD, 2012a). However, these factors are common to all euro area Member States. To the extent that the powerful labour market and social security reforms (see Box 3.1) resulted in higher employment, but not necessarily in higher income, they could be a partial explanation behind the fall of the wage share in Germany (Sachverständigenrat, 2012) and the overall weak evolution in labour income.

The low contribution of labour income to disposable income growth occurred partly as a result of a fall in the total volume of work in the first half of the 2000s. The volume of total hours worked in Germany remains at the level of the early 2000s despite high employment rates (Graph 3.15). While the average hours worked per employee is trending downwards like in other euro area countries, the rise in part time work and in particular the decrease in full time work explain to a large extent the decrease in the total volume of work in the first half of the 2000s. In other euro area countries the volume of total hours worked increased sharply before the crisis, but has also decreased afterwards (Graph 3.16). The average working hours in part-time jobs remains among the lowest in the euro area, while the average hours worked by full-time workers is among the highest in the euro area.

The high tax burden on low-wage earners and fiscal disincentives for second earners discourages from taking up a job or working more hours. The tax wedge for workers earning 50 % and 67 % of the average wage is among the highest in the EU (single person without children, data for 2012). Inactivity and unemployment traps are also relatively high. The high labour taxation at low income levels tends to reduce the volume of work of low-wage earners through higher labour costs and weaker work incentives. Moreover, the joint taxation of income for married couples (Ehegattensplitting) and the free public health-insurance coverage for non-working spouses

discourage women in particular from participating in the labour market or increasing the number of hours they work. The pension reform proposals of the new federal government including additional benefits for certain groups of pensioners, imply that the contribution rate could not be further reduced in 2014 as initially planned and will increase in the medium term, raising further the tax burden on labour with a potentially negative impact on employment and income in particular of low-wage earners. The allowance for families with children under three who do not make use of formal childcare facilities (Betreuungsgeld) may create an additional disincentive to work for parents. The still insufficient availability of full-time childcare facilities and all-day schools is also an obstacle to full-time labour participation of parents.

Germany's labour market has changed profoundly in the direction of more differentiated employment conditions, which has created many jobs while exercising downward pressure on wages. The situation in Germany's labour market at the beginning of the last decade was marked by high and rising unemployment, with regular employment on a downward trend (Graph 3.17). Far-reaching reforms were undertaken (see Box 3.1) and from the mid-2000s the situation improved and both regular and atypical employment have since increased (Graph 3.17). Employment relationships based on non-regular contracts, including part time jobs, have been growing in importance since the 1990's, but rose markedly during the mid-2000s.([13]) Part-time represents close to one fourth of all employees in 2012) ([14]) and is more widespread among women.

The total number of people working in so-called mini-jobs, i.e. jobs with a monthly wage lower than EUR 450 is high. ([15]) The group of employees working only in mini-jobs has increased only slightly since the 2003 reform, while the group of employees with a job subject to social contributions and a mini-job increased strongly over the whole period. This suggests that the 2003 reform did not occur at the cost of standard full-time employment, even if there is some evidence that regular jobs are crowded out by mini-jobs, in particular in small companies. ([16]) The favourable fiscal conditions of mini-jobs may create some distortions, for instance by causing lower upward wage mobility, discouraging people from increasing the number of hours they work, or increasing involuntary part-time work by discouraging companies from opting for other types of contract. ([17]) Furthermore, the reforms have had an effect on wage formation by keeping reservation wages in check (see Box 3.1)

Wage growth in Germany has fallen significantly behind its peers and wage moderation in the services sector stands out as unusual in a euro area perspective. In recent years, wages have increased, after the long period of wage moderation. Wage moderation started already in the 1990s following the reunification shock that had resulted in strong wage increases, followed by increases in social security contributions, as well as migration, stronger competition from low-wage post-transition economies and changes in wage bargaining that shifted the bargaining power of employers and workers. During the last decade, wage dispersion has grown and hourly wages increased very moderately before picking up in recent years. This has resulted in real wages and real unit labour costs declining in the pre-crisis years before recording increases in recent years (see Graph 2.5). The overall low growth in compensation per employee has been more pronounced in the services sectors than in manufacturing and construction (Graph 3.18). As shown in European Commission (2012a), sectoral developments in Germany differed from other surplus countries. In Germany, wage moderation in the pre-crisis period was stronger in the non-tradables than the tradables sector, while compensation per employee in other surplus countries grew on average at the same rate in tradables and non-tradables (Graph 3.19). This was likely enhanced by developments in the labour market and the labour market reforms that incentivised the take up of low-paid and part-time employment. ([18]) Moreover, the share of workers earning less than two thirds of the median wage in Germany appears to be high in comparison with other European countries and has been increasing. ([19]) Using data from the Survey on Income and Living Conditions (EU-SILC), Rhein (2013) finds that in 2010 almost one quarter of employees and self-employed earned less than two thirds of the median wage, which is higher than in other European countries. Low wages are more extended among certain groups, e.g. workers with non-regular contracts and workers in certain services sector professions. ([20])

Germany stands out as having recorded more moderate wage dynamics than what benchmarks would indicate. ([21]) A comparison of the growth rate in compensation per employee against three wage benchmarks shows that wages in Germany grew below what could have been expected, in particular in the period that preceded the crisis (Table 3.3). First, Germany recorded lower wage growth than needed to prevent the real exchange rate from depreciating in all three sub-periods considered. Second, real compensation per employee grew well below productivity before the crisis. Third, nominal wage growth was lower than implied by average historical macroeconomic trends. The strong wage moderation in Germany over a longer period, both in comparison with other European countries and according to the three benchmarks is a sign that wage restraint possibly caused excessively subdued private consumption dynamics. Still, when comparing wage levels in Germany with benchmarks in other countries, they appear to exhibit broadly balanced positions after 2009 (European Commission, 2012a).

Germany's household saving rate is high in comparison with other major developed economies and increased by more than two percentage points up to 2008 (Graph 3.20). ([22]) The saving rate has on average stood at above 16% of disposable household income since 2000, thereby persistently exceeding the euro area average by more than 2 pps. Since 2009, a slight decline in the saving rate has occurred. From a savings-investment perspective, the increase in the household saving rate in the 2000s was one of the key factors and contributed around one quarter to the build-up of the current account surplus in the run-up to the crisis. From the perspective of the life cycle hypothesis, individuals build up assets (save) and run them down (dissave) over their lifetime in order to smooth lifetime consumption, independently of current income. Under this hypothesis, fundamental drivers of the household saving rate include income, wealth and real post-tax interest rates. ([23]) To the extent that losses in wealth or income are perceived as permanent, they reduce possible lifetime consumption – to smooth this over time, savings are increased.

Changes in the social security system in the context of demographic change and increasing precautionary savings are possible factors explaining the increase in household savings in the last decade. ([24]) The beginning of the 2000s was marked by increasing awareness of demographic change and its impact on the sustainability of the social security system. In a lifecycle-perspective, demographic change influences the saving rate by increasing the post-retirement lifespan for which wealth has to be accumulated and via the effects of a lower birth rate. ([25]) Changes to the social security system are another important factor since less generous provisions increase the need to accumulate buffers for old age.

A major pension reform ("Riester-Reform") was implemented in 2001, which implied a gradual reduction of the replacement rate under the statutory old-age pension scheme, in line with demographic developments. OECD (2013a) finds that today, net pension replacement rates in Germany for future retirees are among the lowest in the OECD. Together, these factors are likely to have raised the need for private savings in view of longer life spans and lower public pension rates, thereby increasing the saving rate. ([26]) This is supported by the fact that despite higher per capita income, German households' net financial asset stock was lower than the euro area average (see Box 3.2). In a similar vein, in the presence of uncertainty consumption smoothing in itself leads to precautionary saving. The subdued economic development and rising unemployment in Germany at the beginning of the decade may have led to an increase in perceived uncertainty and higher precautionary savings. ([27]) The compound effect of these motives for higher savings could be expected to lead to a gradual upward shift in the saving rate towards a new level, but without continuing the upward movement in the longer-term, which seems consistent with the pattern observed. Finally, negative wealth effects following the end of the dot-com bubble could also have temporarily played a role, see Deutsche Bundesbank (2007a).

Particular tax policies also influenced households' saving decisions. In context of the pension reform, measures were taken to strengthen the second and third pillar of the pension system, inter alia via tax deductions and means-tested subsidies for individuals ("Riester-Rente"). After a dynamic take-up of Riester-pensions in 2001-02, demand flattened temporarily but accelerated again after a design change in 2005, which is likely to have contributed to increasing savings. ([28])

Income inequality has risen in Germany, most notably during the first half of the 2000s, which is likely to also have contributed to driving up the household saving rate. ([29]) Given that the marginal propensity to save increases with income, higher concentration of income results ceteris paribus in higher savings. Changes in the income distribution that took place in the last decade appear therefore to have contributed to the increase in the saving rate. According to Brenke and Wagner (2013) the average saving rate in Germany was 11 % in 2011, with income-specific saving rates ranging from less than 2 % for the lowest income decile to 17 % for the most wealthy (see Table 3.4) ([30]). Out of total savings in Germany in 2011, the ten percent richest stood for close to 38 % of total savings compared with 30 % in 2001, while the lowest income groups of the population made up for a decreasing share of Germany's total savings. Stein (2009) finds that the increase in the saving rate between 2004 and 2007 is mainly due to the increase in the saving rate of the households in the highest income quartile (Graph 3.21). Over the period 2000-07, the period where the rise in the household saving rate contributed more than 2 p.p. to the improvement in Germany's current account balance, the saving rate declined for all but the wealthiest quartile of the population, which by a marked increase in its savings contributed to driving up the national saving rate. ([31])

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Box (continued)

A number of economic and policy developments may have played a role in explaining the trends in income inequality, although it is difficult to firmly establish the exact causality. ([32]) In conjunction with (un)employment developments, the increasing weight of capital income as compared to labour income contributed to rising inequality, as capital income is concentrated in the highest income deciles. ([33]) A number of changes in taxation and social contributions may also have played a role in reducing the effectiveness of redistribution policies. The abolishment of the wealth tax in 1997, the reduction in the top income tax rate from 53 % in 2000 to 42 % in 2004, the flat rate taxation of capital gains since 2009 and the increases in VAT standard rate and social contributions since the beginning of the 1990s may have affected the progressivity of the tax system and possibly income inequality. ([34]) ([35]) The increasing share of pensioners compared to working-age population also tends to increase inequality (Grabka and Goebel, 2013).

The trend increase in the saving rate came to an end in 2008 and some of the factors which contributed to the earlier increase are probably no longer in place. By 2012, households' gross saving rate had declined by more than 1 pp. to a value recorded in the mid-2000s. Most notably, the overall state of the economy including the labour market is significantly more robust and does not seem to imply a need to increase precautionary savings, even if labour market related developments remain relevant for groups with specific difficulties, e.g. the long-term unemployed or persons that have a marginal and precarious affiliation to the labour market. Likewise, the need to save for retirement is unlikely to again exert pronounced upward pressure on the saving rate, although the pension reform proposals of the new federal government could have some effect by reinforcing the downward trend in the average replacement rate. In the long run, demographic developments are likely to gradually contribute to an increase in the household saving rate.

3.3. A closer look at private investment dynamics

German domestic investment has been trending down for more than a decade, coinciding with the economy's growing excess savings. Analysing investment dynamics, notably in the private sector (see Graph 3.22), can cast light on reasons why gross fixed capital formation appears to have been relatively weak since the beginning of the 2000s. Weakness in investment merits special attention because - beyond the pure contribution to aggregate demand – shortfalls in investment are potentially detrimental for the future growth potential of the German economy. Since 2000, Germany's net fixed capital formation has more than halved relative to GDP. The shares of gross and net fixed capital formation (net of depreciation) have seen a trend decrease for long, which was particularly pronounced in the first half of the 2000s and from which it has not recovered. This has implied that the increase in the net capital stock has been muted over 2000-2012 and the expansion of the capital stock per employee has been rather low and on a descending trend (Graph 3.23).

Germany's potential growth rate has been revised down over time, largely due to receding contributions from capital and total factor productivity. In 2013, potential growth is estimated at below 1½ %, compared to 1¾ % in 2000 and more than 3% in the early 1990s. A receding contribution from capital accumulation was one of the main factors behind the gradual decline in potential growth, together with dwindling total factor productivity (TFP) growth (see Chapter 2). This reflects a longer-lasting decline in the investment-to-potential output ratio since the early 1990's until today, which has resulted in lowering Germany's long-run growth path. The estimate of Germany's trend growth has been subject to successive downward revisions, which reflect a continuous reduction in the contribution from capital, combined with a receding contribution from labour in the first half of the 2000s and significant downward revisions of TFP growth in the second half (Graph 3.24 ([36])). TFP growth is a key driver of long-term growth, capturing efficiency gains in the overall management of economic resources and also reflecting technological progress embodied in capital. In 2012, the TFP contribution to potential growth stood at around half the value in year 2000. Going forward, higher contributions from capital accumulation and productivity growth would be necessary to dampen the effect of ageing on trend growth. This would be possible only if reversing the declining investment-to-potential output ratio, thereby shifting the German economy back onto a higher long-run growth path. A turnaround in TFP growth would underpin this development by raising the marginal productivity of capital.

Germany's investment share was broadly in line with the EA17 average ([37]) in 2000. Due partly to weak private sector investment dynamics, it since fell significantly short. When excluding the euro area countries that experienced the most pronounced construction bubble, a sizeable investment gap of on average 1.9 pps has manifested itself over 2000-2012 (Graph 3.25). The first part of this period, where developments diverged significantly, coincided with the build-up of the German current account surplus. A sharp fall in the German investment share by around 4 percentage points by 2005 was only partially reversed, while the euro area investment share by contrast saw a trend increase. The divergence peaked in 2007 at close to 5 pps. A large part of this gap remains when looking at the euro area without Ireland and Spain. Since 2007, developments have reversed somewhat. The investment share saw a rebound in Germany, while it further decreased in the euro area amid difficult economic conditions in vulnerable Member States. This has contributed to a narrowing of the difference in investment rates, but the overall cumulative investment gap continues to increase. In 2012, the total and private sector investment shares remained more than three pps. below their 2000 peak. While investment volumes were also relatively weak, relative price changes played an important role since the fall in investment prices relative to output prices has been more pronounced in Germany than at the euro area level. When evaluating the subdued aggregate investment, it should also be noted that the efficiency of German investment appears relatively high. Using the Incremental Capital Output Ratio (ICOR) as an indicator, Germany can be considered among the most investment-efficient economies (Bach et al., 2013). This implies that the marginal product of capital is high in the sense that a given amount of investment generates relatively higher growth in output in Germany than in many other countries.

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Box (continued)

While following a comparable cyclical pattern, investment in machinery and equipment was markedly weaker in Germany than in the euro area in the early 2000s. In the aftermath of the crisis, machinery and equipment investment has not picked up as expected.([38]) The weakness in the early 2000s has to be seen against the preceding investment upswing in Germany, but it still appears to have been a rather protracted period of weakness which has contributed to the build-up of the current account surplus. To some extent the overall subdued nominal development reflected a strong trend decrease in equipment prices in Germany, which was not observed at the euro area level.

However, taking this effect into account only partially explains the decrease in German equipment investment in the early 2000s, as real investment also fell. At the same time, the upswing during 2005-2008 was more pronounced in Germany than in the euro area. Hence, seen over the full period since 2000, no persistent negative gap to the euro area is observable. That being said, while the machinery and equipment investment share was higher in Germany than in the euro area in recent years, it has remained well below what the long-term trend would imply.

Investment in machinery and equipment is driven by a small number of key branches, notably manufacturing. A small subset of branches accounted for three quarters of the investment in 2000-2012, with manufacturing alone accounting for close to one quarter. In addition, the increasing use of leasing financing arrangements for equipment is reflected in a growing weight of "Administrative and support service activities" ([39]), which partially explains the trend decrease in the share of manufacturing in ME investment. The cyclical investment pattern closely follows goods exports and is generally shared across sectors. This indicates that the goods exports sector plays a pivotal role for total machinery and equipment investment across all key branches (Graphs 3.28 and 3.29). The strong drive in Germany's goods exports to its global markets may therefore explain why the investment weakness has not manifested itself for machinery and equipment throughout most of the last decade. On the contrary, the level of investment in market services remains relatively low, pointing to an important potential for further development and efficiency gains in the services sector (see Box 3.3)

The bulk of the investment gap between Germany and the euro area is due to lower German investment in construction. A disaggregation of the investment share by investment good type shows that the significant gap in the investment share between Germany and euro area peers (excluding Ireland and Spain) is due mostly to a relative underperformance of construction investment in Germany following the reunification-related boom. Investment in other goods, which includes investment in intangible fixed assets, also appears to have been consistently weaker in Germany by a relatively stable margin and contributed on average 0.6 pp. to the aggregate investment gap in 2000-2012 (Graphs 3.30 and 3.31).

Reunification, public subsidy schemes ([40]) and strong net migration fuelled a housing boom in the early 1990s. These factors can, however, not fully explain Germany's remarkably long-lived decline in housing investment. Housing investment represents somewhat more than half of construction investment and reflecting slack in activity after the construction boom in the early 1990s, the share in total investment declined until 2007, which indicates that Germany's construction boom nearly two decades ago had a longer-lasting impact on the construction of new dwelling. Also, average net migration fell during the 2000s to almost one third compared to the preceding decade and net births were on a downward trend. The gradual increase in living space per head could not offset these weak demographics. While the post-reunification events and demographics are important to understand why Germany's housing investment cycle has differed from euro area trends, they cannot fully explain the protracted weakness in housing construction, which overall has expanded at a slower pace than other demand components. This suggests that demand-reducing factors, notably high unemployment and subdued growth in disposable income, have restrained housing investment. Tax policy choices may also have mattered. The elimination of tax incentives for the acquisition of owner-occupied houses as of 2005 (Eigenheimzulage), once the biggest single tax expenditure of the federal budget and abolished on the grounds of inefficiency and high budgetary cost, may also have impacted on private housing investment of low and middle-income households.

Strongly declining house prices until 2009 make Germany an outlier internationally and indicate that housing demand fell permanently short of housing supply. Moreover, weak house price developments might have hampered private consumption. The decline in nominal and real house prices in itself was a disincentive to invest in the housing market, in particular against the background of booming housing markets and price developments in other European countries. Additionally, the implicit wealth effect due to the decline in house prices is likely to have been a drag on private consumption as suggested by a cross-country analysis (see Graph 3.35). Analysis indicates that real house price developments adjusted in order to match housing demand and supply (see Box 3.4).

As of 2010, housing investment has been experiencing a rebound, underpinned also by the search for safe investments. The latest pick-up in housing investment, with German housing investment exceeding the euro area average, reflects the need for additional dwellings arising from stronger migration inflows as well as a robust labour market and more favourable financing conditions. This development is underpinned by subsidies on refurbishment aiming at CO2 abatement. Moreover, the search for safe investments seems to play a role since real estate can be considered as a comparatively safe and affordable investment type. This might in particular be the case in a situation of low expected return on many alternative assets, thereby supporting housing investment.

Real non-housing construction investment ([41]) has also been going through a long-lasting decline before stabilising in the mid-2000s. The weakness has been generalised, spanning over most private sectors and with the fall in investment in industrial and public buildings engineering being most pronounced. A certain part of the fall in non-housing construction investment can be explained by the preceding boom ([42]), e.g. the earlier hike in construction of infrastructure and buildings in East Germany, but unexplained investment weakness remains. Nonetheless, until the mid of the 2000s, practically all economic sectors contributed negatively to building investment and since then investment activity has remained stagnant in many sectors of the economy. Also in an international comparison non-housing construction investment has been extraordinarily weak. For total building investments, the German average investment ratio falls well short of the average of the euro area benchmark (excl. Spain and Ireland). Although the downward trend stabilised in the mid-2000s, the non-housing construction investment ratio remains very weak and the net stock has continued to decline as a share of GDP.

The downward shift in actual and potential growth and concerns over future demand are likely to have reduced investment incentives. The subdued growth performance of the economy in the first half of the 2000s, driven by weak domestic demand, translated into capacity utilisation that was below the long-term average. This dampened investment incentives. Moreover, Germany's structural difficulties (see scene setter) reduced trend growth, which may have tempered businesses' expectations for future sales in the domestic market. A detrimental effect on investment of pessimism prevailing at the time about the viability of the German business model has been stressed, see Bornhorst and Mody (2012).

Other factors also reduced expected returns on domestic investment, which may have further dented investment. Following the bursting of the dot-com bubble at the beginning of the 2000s, a marked downward correction of expected returns in Germany took place, which took its toll on investment (Sachverständigenrat, 2002). ([43]) In addition, the dot-com bubble also entailed a significant increase in firms' indebtedness. This made access to external finance more difficult in the sense that higher returns on investment projects were required to obtain financing and pressure was exercised on many companies to deleverage (see section on corporate savings). On balance, this created an incentive to curb investment in an attempt at balance sheet repair. Moreover, regulatory changes from the phasing in of Basel II and Basel III may have reinforced the deleveraging trends. As balance sheet repair episodes are generally long-lasting (Ruscher and Wolff, 2013), the effect on investment could have been rather protracted.

Financing conditions, in particular in view of relative interest rate developments, may also have held back investment in the early 2000s. EMU brought about a convergence of nominal interest rates / sovereign bond yields, which also put a floor on relevant interest rates for firms. ([44]) Given remaining inflation rate differentials with lower relative inflation in Germany, this translated into real interest rate developments that implied a decrease in the optimal capital stock in Germany relative to most other euro area countries. Nominal interest rates on loans to corporations in Germany increased in the years to the early 2000s, which also tempered investment demand. ([45]) ([46]). Available indicators point to access to credit from banks - the predominant form of external financing in Germany - having been quite restrictive until the mid-2000s (see Graph 3.38). The share of firms reporting that access to credit was restrictive even exceeded the peak observed in the more recent crisis episode. In the most recent years, there is no evidence of supply side constraints (see Chapter 4).

Globalisation is likely to also have played a role by heightening the required rate of return on domestic investment. Increasing integration of capital and other markets over the last decades has provided investors with opportunities to diversify beyond their home markets, including via investment decisions. Firm location decisions have also become subject to international competition. To the extent that it has made a wide range of profitable investment opportunities elsewhere accessible, globalisation in a broad sense might have raised the required rate of return on investment.

A decreasing capital intensity of Germany's industrial sector, which is especially exposed to such global competition, bears some evidence in this direction ([47]).

There is, however, no indication that German foreign direct investment was conducted during the 2000s at the expense of domestic investment. Foreign direct investments (FDI) in Germany increased visibly in the 2000s compared to the preceding decade. In the same period, German outward direct investments rose slightly as a result of the increasing internationalisation of markets, but not to an extent that could explain the overall subdued investment activity in Germany, especially in a comparison with other countries subject to the same global trends. Even if FDI in some specific instances may have been a substitute for additional domestic investment, overall no crowding out of domestic investment by German outward FDI can be observed, which is supported by empirical analysis (see Deutsche Bundesbank, 2006). At the same time, firms' internationalisation strategies are likely to have played a larger role than reflected in FDI statistics. In particular, outsourcing and portfolio investment ([48]) are among additional options for internationalisation of supply chains (see also Chapter 5) that imply increased production capacities without domestic investment or recording in FDI statistics.

Changes in the tax system are likely to have had an overall supportive impact on firms' investment incentives. In international comparison, the German tax burden on investment has traditionally been very high. The tax reforms of 2001 and 2008 entailed a reduction in statutory and effective corporate income tax rates, reduced the trade tax rates ([49]) and broadened the tax base through modified depreciation rules. ([50])

Overall, these reforms led to a reduction in the tax burden on corporate investment, as measured by effective average and marginal tax rates at the corporate level. ([51]) Despite this, some features of the tax system still hamper investment, notably the tax burden on new investment financed with equity, which remained among the highest in the EU in 2012. ([52]) Also, at around 30% in 2013, the adjusted top statutory tax rate in Germany is still far above the EU (23.1%) and the euro area averages (25.9%). Finally, a relatively high administrative burden associated with the tax system may discourage investment. ([53]) Although the 2011 Tax Simplification Act brought about some improvements, small and medium-sized enterprises in particular would benefit from further simplification and reforms of tax administration.

Most of the key factors which have held back German investment are no longer in place and conditions are in principle there for a robust investment upswing. The economy is enjoying a gradual recovery, with short-term prospects for domestic demand being rather favourable on the back of the robust labour market. German firms benefit from sound fundamentals with healthy balance sheets and substantial profit margins. By the same token, financing conditions are favourable; they deteriorated less in Germany than in other euro area Member States in the financial crisis, reverted more quickly and appear rather accommodating in a historical comparison.

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Box (continued)

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Box (continued)

Yet, Germany recently recorded a 6-quarter stint of declining equipment investment and the overall investment gap to the euro area continues to accumulate, pointing to a risk that investment weaknesses have become entrenched. Machinery and equipment investment has unexpectedly been going through a soft patch, which only ended in the second quarter of 2013. Although housing investment is relatively vigorous, the non-housing investment share remains stubbornly low and also investment in other goods shows little sign of picking up. There is no single factor able to explain the continued subdued investment activity, which points to a real risk that the weakness has become entrenched. One factor most likely holding back a more vigorous and self-sustained pick-up in investment is the impact of uncertainty. Several recent studies have found a detrimental impact of economic policy uncertainty on investment. ([54]) European Commission (2013g) reviews empirical results and provides evidence for a significant negative effect of uncertainty on both investment and private consumption in the post-crisis period for nine euro area Member States. Uncertainty has indeed also been considered a key factor for the weak machinery and equipment investment activity in Germany in 2012. ([55]) Surveys show that uncertainty in relation to future domestic demand growth and domestic policy choices, e.g. regarding the cost of energy and the transformation of the energy sector (see Box 3.5), are factors weighing on business confidence. ([56]) The European debt crisis has also been an important source of uncertainty resulting in some loss of confidence. Policy action and policy clarity that would help dissipate uncertain, including in relation to completing the future design of EMU, could therefore be expected to impact positively on investment activity. Given that investment decisions also reflect firms' sales expectations, bringing an end to the protracted fall in import demand in many EU and euro area countries would also help further boost confidence among German firms.

3.4. A closer look at corporate sector savings

The rise in non-financial corporate (NFC) sector savings made the largest individual contribution to the build-up of the current account surplus before the crisis (5½ p.p. of GDP during 2000-2007). Although coming down slightly after the crisis, the level of corporate savings remains high and it is too early to confirm that a trend reversal has occurred. While the corporate sector’s excess savings are partly due to the decrease in business investment, the increase in savings accounted for more than three quarters of the rise in the corporate net lending position and corporate savings accounted for around half of overall domestic savings until 2012. This warrants an investigation of possible reasons why companies continue to accumulate financial assets and deleverage, not least since investment activity has remained rather weak.

The trend increase in the German non-financial corporate saving rate contrasted with developments at the euro area level up until the crisis, while a certain co-movement has been observed afterwards. Amid pronounced fluctuations, the saving rate saw a clear trend increase throughout most of the 2000s and exceeded the euro area average in 2006-2010 (Graph 3.39). The German financial corporate sector’s saving share has seen a much more uneven development. Savings sky-rocketed in the pre-crisis period to above 50% in 2006, but this was completely reversed in the following years (see Graph 3.40). Due to this absence of a clear trend and the financial sector’s overall small economic weight (6.3% of corporate GVA in Germany in 2000-2012), its contribution to the increase in corporate saving was limited. The remainder of this section therefore focuses on developments in the non-financial corporate sector ([57]).

The increase in the share of operating profits was not matched by a corresponding rise in the share of profit taxes paid and dividend pay-outs were insufficient to contain the surge in corporate savings. A strong increase in operating profitability before the crisis (see Graph 3.41) was supported by wage restraint. As discussed (Section 3.2.2), corporate tax reforms have lowered marginal and effective tax rates for corporations, thereby supporting higher net profits. This appears to have especially boosted after-tax profits after the 2001 tax reform. Interestingly, the persistently high corporate profits have not been matched by increasing dividends, since distributed income paid rose only slightly until the mid-2000s and receded again in recent years. Net interest developments also contributed to the rise in non-financial corporate savings, reflecting higher interest income received.

Non-financial corporations used their excess savings to strengthen their balance sheets by acquiring financial assets and also by reducing their indebtedness. Following the dot-com boom and bust, i.e. after 2001, German non-financial corporates moved into a net lending position (Graph 3.42 ([58]). Companies reduced their indebtedness (on a net basis) in 2002-2005 and again in 2009-2010 (Graph 3.43). Both deleveraging episodes appear to have been a reaction to a difficult economic situation, facilitated by the profit-generating capacity of companies facilitating a rapid adjustment. Quantitatively, however, corporates' net acquisition of financial assets was more important than their reduction in indebtedness. Notably, firms increased their net holdings of shares and other equity by on average 2% of GDP per year in 2001-2012 and at the same time raised currency and deposit holdings by more than ¾ % of GDP per year (Graph 3.44).

It remains puzzling that firms preferred moving into a net lending position instead of investing more or distributing more profits, which could be interpreted as a sign of inefficiencies. Typically non-financial firms are net borrowers, and although the move of Germany's NFCs into a net lending position is not outstanding internationally ([59]), the persistence is noteworthy with the sector recording a net lending position in most years since 2002. That the increase in savings does not appear to have been motivated by the desire to finance higher investment in physical assets makes it all the more difficult to understand why firms persistently chose to retain an important fraction of their increased earnings rather than distributing it to shareholders. ([60]) ([61])

Several changes to the corporate tax system had an important impact on the capital structure choice and pay-out policy of German non-financial corporates. The 2001 corporate tax reform reduced the tax benefit of debt finance from interest deductibility provisions (by lowering the corporate tax rate) and favoured the retention of profits in the corporate balance sheet by abolishing the earlier tax discrimination of retained profits (by setting a single tax rate of 25% instead of 40% on retained profits and 30% on distributed profits). ([62]) Regarding the taxation of dividends, the reform entailed a shift from an imputation system to a half income system at the household level. ([63]) Recent empirical evidence shows that the resulting double taxation of dividends led to a decrease in the propensity to pay dividends and in pay-out ratios. It also led to an increase in the preference for share repurchases ([64]) (Kaserer et al., 2012). The 2008 reform further reduced the tax benefit of debt finance by lowering the corporate tax rate to 15% and restricting the deductibility of interest payments ("Zinsschranke" applicable to large firms). The latter contributed to lowering the debt-to-assets ratio of German corporations (Buslei and Simmler, 2012, Dreßler and Scheuering, 2012 and Ruf and Schindler, 2012) and further strengthened the incentive to accumulate internal funds to the extent that they are cheaper. ([65]) The deleveraging episodes in 2002-05 and 2009-10 therefore appear to relate to the incentives stemming from the tax reforms in 2001 and 2008. The changes to the tax system appear to have simultaneously reduced the incentives for debt finance and for paying out dividends at the firm level, which could have contributed to the rise in earnings retention. ([66]) While corporate and household sector savings would theoretically be substitutes, they moved in parallel in Germany in the 2000s, giving an indication that households did not "pierce the corporate veil".

Firms' acquisition of equity might to some extent have reflected the increasing internationalisation of German non-financial corporates. As Graph 3.44 depicts consolidated non-financial corporate sector developments, the acquisition of shares and other equity took place vis-à-vis the German financial corporate sector and companies abroad. The latter is likely to have been the larger component. ([67]) To the extent that equity acquired abroad was made up of short-term financial investment, this might have reflected a lack of profitable investment opportunities in Germany raising the question if corporate governance inefficiencies allowed non-financial firms to undertake such investment activities falling outside their core business expertise, instead of letting owners receive and allocate the funds. At the same time equity could also have been acquired strategically in the context of firms’ internationalisation strategy, e.g. through FDI ([68]). Taking into account also unpublished data, Deutsche Bundesbank (2012a) finds that the main recipients were German firms’ foreign affiliates, which covered part of their funding needs using the equity capital provided by their parent companies. A large part of the equity acquisition could thus have been a reflection of the international supply chain integration of German firms, in particular with Central and Eastern Europe, where the build-up of the capital stock of foreign affiliates and the possibly higher financing costs in these foreign markets have motivated a growing importance of intra-group financing structures. At the same time, the German non-financial corporate sector does not appear to have been a particularly successful financial investor. In 1999-2011, the return on its financial assets was much lower than the one earned by its euro area peers, while returns paid on financial liabilities were broadly comparable (based on national accounts data). The pattern does not appear to have been driven by asset composition.

Precautionary motives could have motivated higher holdings of currency and deposits. An increase in non-financial corporate cash holdings has been observed in a number of advanced economies in the 2000s. ([69]) Across countries, this could have reflected higher and more liquid precautionary savings in the face of uncertainty, notably increased sales volatility, inter alia to ensure smooth dividend payments. Crisis-related uncertainty and the currently low opportunity cost of holding such assets could also have contributed to the accumulation of short-term assets. Furthermore, to the extent that firms’ decisions are not fully optimisation-based, an increase in retained earnings combined with limited real investment opportunities might have mechanically translated into higher cash holdings. In a longer-term perspective, the increased cost of external funding due to a higher share of intangible assets in firms' balance sheets could also have stimulated cash holdings for internal financing. ([70])

Firms' wish to reduce their dependence on banks and tighter banking regulation appear to have played a role. Especially in the aftermath of the financial crisis, firms might have wished to reduce their dependence on external financing, notably from banks. ([71]) This could to some extent have reflected a voluntary diversification of financing sources, e.g. in response to the misfortunes of a large subset of German banks during the crisis or a reaction to the deleveraging pressure exercised on companies earlier in the 2000s after the bust of the dot-com bubble. For SMEs, the development can in part be seen as a catching-up process in capitalisation relative to European peers, as the existence of an equity gap in Germany had been widely discussed. ([72])Indeed, the 8½ p.p. average increase in the ratio of equity to total assets between 2000 and 2012, was particularly pronounced for small and medium-sized firms (+14½ pps. vs. +4 pps for large firms) ([73]). At the same time, the role of the run-up to Basel II and III has been stressed by Deutsche Bundesbank (2013c). Notably, banks and business associations appear to have raised firms’ awareness at an early stage about the impact of weak equity capitalisation on financing cost in the context of regulatory tightening, thereby advocating firms' adjustment process. While the tightening in regulatory requirements was not specific to Germany, the relatively weak starting position regarding equity capitalisation of parts of the non-financial corporate sector in conjunction with favourable profitability developments might have accentuated the balance sheet adjustment in the German case. The historically close bank-to-company relationships in Germany may have strengthened banks' role in promoting this adjustment process.

Existing analyses do not provide a conclusive answer to what extent credit supply constraints lie behind the trend of excess corporate savings. The pace of German firms' balance sheet expansion has been much slower than at the euro area level. This might reflect differences in growth strategies, e.g. due to the dominance of family-owned Mittelstand firms, but could also suggest problems with access to bank and capital market financing. Some evidence suggests that indeed access to bank finance in Germany was affected by tighter lending standards than elsewhere, notably in the first part of the last decade, which may explain both the low growth in the corporate sector liabilities and the recourse to own financing and growing excess savings. Nehls and Schmidt (2003) find evidence of credit supply restrictions in Germany particularly in the beginning of the 2000s. Gern and Jannsen (2009) report that estimated demand for bank credit in Germany was higher than actual demand between 2000 and 2003 and a Eurobarometer survey conducted in 2005 ([74]) shows that more than 80% of German SMEs reported that they had found it difficult to obtain bank funding, which was a higher share than in other EU Member States. Puri et al. (2009) find that the German savings banks most exposed to 2007-8 losses in the US through their affiliated Landesbanken tightened their lending standards more than others. However, Deutsche Bundesbank (2009) finds that German credit developments were as high as macroeconomic fundamentals would suggest. In a cross-country analysis based on firm-level data on publically-traded industrial firms for Germany, France, Italy, Japan and the US, Brufman et al. (2013) provide some empirical evidence that the increase in corporate excess savings in 1997-2011 may also have been related to credit constraints, in addition to volatility of the operating environment and firms’ growth opportunities. The signs of credit supply constraints in Germany have been more pronounced at times, notably up to the mid-2000s and broadly coincide in time with the evolution in non-financial firms' equity position, suggesting that at least part of this process can be explained by banks advocating corporate deleveraging and in that light at the same time restricted access to credit.

Some of the factors favouring excess non-financial corporate savings appear to be of a structural nature. The international integration of the German non-financial corporate sector is unlikely to be facing a reversal, implying that firms would continue to accumulate savings to invest in and provide funding to foreign affiliates. To the extent that a desire to reduce the dependence on bank financing and various forms of credit constraints may have motivated the non-financial corporates to strengthen their balance sheets, it would require structural changes in financial intermediation i