The coming months will prove crucial to Germany as an investment destination, with all eyes on the pace and sustainability of recovery in Europe’s largest economy.

The German economy has been in the doldrums for years, despite being the world’s third largest. Until recently, the country had struggled to create jobs and get back on the road to economic recovery. Now economists are predicting that it will have even stronger economic growth in 2007 than had previously been forecast. After years of bad news, Germany is finally getting back into its stride, with GDP set to achieve at least 2.8% growth this year, its highest level since 2000, and unemployment expected to drop below the 3.75 million mark.

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Germany seems to be on the right track; the turnaround will require a sustained growth in domestic investment, which is essential to raise the economy’s growth potential. Economists maintain that strong investment growth will lead to a faster expansion in the capital stock and a correspondingly strong rise in production capacities. Gross fixed capital formation hit a high of 21% of GDP in 2000, and then started its steady decline to 17% at the beginning of 2005. Since then, it has recorded a steady rise to 18% in the third quarter of last year.

This year’s growth is expected to be driven by strong domestic demand, and Joachim Scheide, chief economist at the Institut für Weltwirtschaft, predicts that this will “remain the main pillar of the upswing”.

The IMF has also lent its voice to the chorus of praise for Germany’s recovery, saying in a recent report that it expected robust, sustained growth. “I am optimistic the recovery in Germany will continue for some time,” says IMF deputy managing director John Lipsky. “There is still room for improvement, room for growth.” Mr Lipsky says that economic reforms are beginning to bear fruit, German companies are becoming more competitive and the country is attracting investment again.

Capital stock boost

The strength of the recovery is the key factor influencing badly needed foreign investment in the German economy. “FDI is important for increasing the overall capital stock in the German economy, which is the net result of capital retirement and additional investment,” says Jean-Michel Six, chief economist at ratings agency Standard & Poor’s. “This has been declining fairly steadily since the beginning of the present decade. FDI, in the sense that it is being directed into non-financial assets, is contributing to an increase in the overall capital stock. This is a crucial aspect of the prospects for Germany because, with an ageing population, having higher potential growth is going to be critical for supporting the economy in the long term.”

Mr Six says that the turnaround so far, while welcome, is still insufficient and that the country’s ability to attract more FDI is going to be important for continued economic progress. This, he says, leads to the discussions about fiscal policy and the ability to reduce corporate taxes and make the overall environment more investor friendly. “Typically, corporate taxes were on the high side versus the rest of the eurozone,” he says. “There is still some way to go in lowering taxes. In terms of skilled workers and overall operating conditions, it remains an attractive market, but it’s caught in a bit of a vicious circle.

“In the first part of this decade, Germany was considered as not too an attractive market as domestic demand was very weak. This is why it is important to move from a vicious to a virtuous circle by having more support for domestic demand, which we are only starting to see now. They have to carry on doing the right thing, by making it more investor-friendly with a more deregulated labour market. They’ve made a bit of progress in making the labour market more flexible, and unemployment has declined somewhat, which is a positive sign. But, compared with a country like the UK, which is a point of reference in Europe, you’re still looking at a fairly regulated market,” says Mr Six.

More competitive

Thanks to economic reforms, Germany’s competitiveness has gained considerably in recent years and is now one of the highest in the eurozone. Within the EU, Germany now has the lowest increase of unit labour costs. This is a far cry from the days when the single currency came into effect. At that time, Germany’s unit labour costs were the highest in the eurozone. But since 1999 they have fallen by 10% compared with the EU average. In contrast, relative unit labour costs in the same period have risen by 9% in Italy, Spain and the Netherlands.

At the same time, Germany’s real trade-weighted effective exchange rate against the dollar has risen only 4% since early 2002. Hence investors get more value for their euros in Germany than in most of the other eurozone countries.

“Germany’s major economic institutes all agree that the improving economic situation is sustainable,” says Eva Henkel, project manager marketing and communications, at investment promotion agency Invest in Germany. “These forecasts are based not only on the strength of the export market, which still remains a major force despite the strong euro, and where Germany has always been a world leader, but also on investment and domestic consumption. Seeing strength in all three of these areas makes it fairly clear that this upswing is a broad-based expansion that will have long-term effects.”

Labour reforms

Ms Henkel says that labour market reforms, such as those initiated following the Agenda 2010 initiative begun in 2003 by former chancellor Gerhard Schröder, have encouraged former recipients of unemployment benefits to return to the labour market. “At the same time, this political change was accompanied by wage restraint in agreements between labour and management,” she says. “This restraint has meant that Germany’s unit labour costs have been some of the lowest in Europe in the past decade and this is one of the reasons why some industrial jobs that have left other locations in Europe have remained in Germany.”

One area that is likely to attract foreign investment is the non-residential real estate market, with the introduction of real estate investment trusts (REITs). “A lot of money has been invested in commercial property by non-German investors,” says Mr Six. “The introduction of REITs is going to become more of an attraction for foreign investors in commercial property.”

Real estate prospects

Last year, Germany’s federal ministry of finance released draft legislation to create REITs, which are publicly quoted and are exempt from German corporate income tax, trade tax and solidarity surcharge. At least 75% of a REIT’s assets must consist of real estate and at least 75% of its gross revenues must be derived from the rental, leasing or sale of real estate. A REIT has to distribute at least 90% of its distributable profits to shareholders.

“For foreign shareholders, the withholding tax of 25% would constitute final and definitive German taxation,” says Stefan Schmidt, a partner at KPMG. “However, many tax treaties provide for reduction of German withholding tax to 15%. Foreign investors would thus in many cases be able to derive income from a German REIT with only a 15% German tax burden, or less under certain treaties.”

The Angela Merkel government, in coalition with the Social Democrats, has taken steps to encourage foreign investment, according to Ms Henkel. “Firstly, the federal government is aiming to bring the contribution rate for social insurance, which is equally financed by the employee and the employer, permanently below 40% of the employee’s gross pay,” she says. “This would bring the employer’s contribution level below 20% and eliminate a potential barrier for employers to add more staff. The government took the first step this year when it reduced the contribution rate for unemployment insurance from 6.5% to 4.2%.”

Corporate tax cuts

The Merkel government is also promoting a corporate tax cut that will bring Germany’s corporate tax rates below 30%, rather than their current rate of nearly 40%. And it is implementing a high-tech strategy to make resources available for research and universities, to help high-tech intensive new businesses and to promote Germany as a location of high-tech research and development.

The government is providing the right incentives but concerns linger in areas in which it exercises limited control, such as exports. Last year’s strong economic performance was fuelled largely by the booming export sector. Growth in 2008 is expected to fall back slightly to 2.4% because of a slowdown in exports, which have been hit by the rising value of the euro against the dollar. Last year, exports were up 12.5% but this is forecast to decline to 11% this year and to 6.8% in 2008.

“There is always the risk that this recent recovery, which is 18 months old, will be short-lived and that the economy will revert to a slow-growth path,” says S&P’s Mr Six. “This cannot be ruled out and it poses a risk, especially when compared with more vibrant economies based on services and the financial sector, such as Britain, or those whose demographics have been more an incentive for growth, like Spain.”