Against this background, Directors noted that the authorities face the challenge of sustaining recovery while preparing to exit, as part of an international coordinated strategy, from the extraordinary measures introduced during the crisis. Directors agreed that over time fiscal policy will have to transition from support to credible consolidation. In the financial sector, repair and restructuring of balance sheets must continue, but it is now also necessary to make more permanent improvements to the framework of institutions designed to safeguard financial stability and manage financial crisis in concert with ongoing EU initiatives. Special labor market policies introduced to maintain employment during the crisis will need to be phased out and structural reforms undertaken to raise longer-term growth and domestic demand. A few Directors noted that designing structural policies to raise domestic demand will not be easy.

Directors welcomed the authorities' fiscal strategy that combines short-run support for the economy with a firm commitment to fiscal consolidation in the medium term. They supported the continued fiscal stimulus in the 2010 budget in light of the still fragile recovery. Directors saw a need to start fiscal consolidation once the recovery becomes self sustaining, which is projected for 2011. Turning to the medium term, they agreed that meeting the national and European fiscal goals would help Germany prepare for the challenges of its aging population and anchor the fiscal policy consolidation in the euro area. Directors stressed that a credible consolidation plan with strong measures, focused on expenditures, will be needed to reach the medium-term targets. In this context, any tax cut in 2011 should be accompanied by compensating budgetary measures. They generally welcomed the authorities' decision to establish a new fiscal constitutional rule that imposes limits on the government's structural deficit.

Directors called for continued financial sector restructuring and welcomed plans to overhaul the financial stability framework. While banking sector health has improved, vulnerabilities persist. They considered that strengthening capital buffers should be a priority for most banks. Directors noted that the larger public banks (the Landesbanken) will require additional restructuring and major consolidation to enhance financial stability and reduce fiscal support for this sector. They also welcomed the authorities' intention to make the Bundesbank the sole prudential bank supervisor, stressing the need to ensure accountability and operational independence. Directors commended the efforts to install a strong and effective regime for bank resolution building on the temporary measures introduced during the crisis. At the same time, they pointed out the advantages of strengthening and unifying Germany's fragmented deposit protection scheme in light of evolving EU initiatives. Directors noted the authorities' commitment to undertake a Financial Sector Assessment Program (FSAP) update.

Directors welcomed the authorities' intention to adjust labor market policies to the pace of the recovery and called for additional structural reforms to help Germany's adjustment to the post-crisis world. Simultaneous measures to increase labor market flexibility and reduce obstacles to product and service market development would enhance efficiency and foster domestic demand. Directors noted that strengthening domestic sources of growth will help cushion the German economy against external shocks as well as benefit the euro area countries and the global economy by reducing trade and payments imbalances.

Background

Germany was hit exceptionally hard by the global crisis, but strong policies helped to avoid an even deeper recession. After a sharp fall in real GDP in the first half of 2009, broad-based policy support and an uptick in global demand lifted the economy in the second half, keeping the GDP contraction to 4.9 percent for 2009. The recovery is expected to continue at a moderate pace, with real GDP growth projected to reach 1.2 percent in 2010 and 1.7 percent in 2011. There are substantial downside risks, however, reflecting remaining banking weaknesses and the possibility of weaker-than-expected global trade.

The authorities used the available fiscal space to implement countercyclical policy measures. Direct spending, tax cuts, the cash-for-clunkers scheme, and employment subsidies boosted demand in 2009, but also increased the general government deficit to 3¼ percent of GDP from a broadly balanced budget the year before. In 2010, implementation of remaining stimulus measures and additional tax cuts and transfers are projected to bring the deficit to 5½ percent of GDP, nearly twice the limit set by the European Union's Stability and Growth Pact (SGP). The deficit is large also by the standards of the new constitutional rule to secure long-term fiscal sustainability, which requires the structural federal fiscal balance to be near zero starting in 2016.

Financial sector measures helped stabilize financial markets and mitigated systemic risk, but vulnerabilities remain. Crisis measures included recapitalizations and credit guarantees through the Sonderfonds Finanzmarktstabilisierung (SoFFin) and public commitments to protect household bank deposits. While the overall health of the financial sector has improved since the crisis, several sources of vulnerabilities linger, including the credit risks from a still fragile recovery and sizeable remaining write-downs, and banks' exposure to emerging and Southern European markets. The structurally unprofitable Landesbanken continue to pose systemic risks.

Unemployment has increased slowly so far—owing to past labor market reforms and crisis policies. The Hartz IV reforms have strengthened employment going into the crisis; and the improved possibility to adjust work time under collective wage agreements and the short-time work scheme helped firms to avoid dismissals. However, with a diminished growth outlook, firms will eventually adjust their work force, especially in the hard-hit manufacturing sector. This could severely test the overall flexibility of the German labor market, which is still characterized by high employment protection. Moreover, existing obstacles to services sector development and product market competition increase the danger of a drawn-out structural adjustment to the post-crisis world.