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International perspective: reunification in Germany - its economic and financial implications.

West Germany will pay a huge price for reunification by subsidizing the social security system in East Germany, by supporting and financing investments in the presently extremely poor infrastructure in the GDR and by offering attractive fiscal incentives to au who are ready to make direct investments in the GDR. Expansive fiscal measures will cause some acceleration in the inflation rate. The German Bundesbank will tighten its restrictive policy somewhat further. Capital market rates already have increased by more than I percent; not much further increase is expected. The DMark exchange rate will be kept quite stable by high (real) interest rates and positive long-term economic prospects of reunification.

WHEN THIS COPY of Business Economics reaches its readers, German monetary union (GMU) will have been realized. But at the time of writing this article (late April), only the general set of rules for this undertaking is as yet defined. There is no modern credit system in place in the GDR. There is no financial bureaucracy that has experience in collecting VAT or individual or corporate taxes on the basis of clearly defined laws. The GDR has huge long-term delivery contracts with other East European countries, especially with the USSR, based on nonconvertible transfer-rubles and at fixed prices. Who will take on the inherent risks * Klaus Wieners is Chief Economist, Westdeutsche Landesbank Girozentrale, Dusseldorf, West Germany. He also is Vice Chairman of the German Association of Business Economists and a council member of the European Federation of Business Economists. of these contracts after reunification? On the corporate level, even top management has no idea whether the products of its company are competitive in a free market, because present cost and price structures are hopelessly distorted by politically motivated interventions. The top manager of a big Kombinat (state-owned combine) has an annual income of 30,000 East German marks, a foreman in the same company of 20,000 marks. Compare this with the 500,000 deutschmark annual income of a top manager and the 60,000 deutschmark income of a foreman in a West German company of similar size. And now imagine what will happen when, from july 1, 1990 onwards, companies of the two German states will compete with each other within the same economic and monetary framework. AN UNPRECEDENTED EXPERIMENT

What is going on in Germany is an incredible and unprecedented undertaking. Most economic experts argued for a long time that this would lead to an economic disaster; they recommended a step-by-step-approach over three to five years with a common currency only at the end, not right at the beginning. It is still a controversial issue in the inner-German debate whether a clear-cut program with a fixed medium-term time table, proposed and decided by the two German governments in january 1990, would have succeeded in calming the political and economic unrest in East Germany and in stopping the outflow of 2,000 to 3,000 people per day to West Germany. But the interim government in East Germany felt it had no political mandate for such wide-ranging decisions, and finally there seemed to be no alternative to offering the GDR the fast realization of economic, social and monetary union.

What will happen from july I onwards? Will it be the starting point of a second German economic miracle (as the government hopes) or will it end in disaster? Nobody can give a precise answer yet. There is absolutely no parallel in the past to such an undertaking. Therefore, we have no prior experience and - as you may imagine - under these circumstances models cannot be of any help, either. Some argue that the first economic miracle in Germany, which started in 1948, demonstrated that it is sufficient to give people a fair chance of realizing their economic ambitions in a market economy to create an economic breakthrough. But don't forget that the newly established Federal Republic of Germany started in a sort of a closed shop, with strict controls on all trade and financial relations to the outside world and with only limited competition from abroad. And, what should be stressed too, there was no real alternative for the people than to make the new beginning a success story.

Today, people in the GDR have the right and the possibility to move to the prosperous FRG-area where skilled workers, engineers, nurses and many other committed people can find an attractive job very easily. Because of the short distances between East and West Germany, it is no problem to communicate even daily from Magdeburg (East Germany) to Wolfsburg, home of the VW-company, which is only thirty-five miles away, not to mention Berlin, where already today around 50,000 people from the East are working in West Berlin, mainly in the underground economy. There will be the problem of convincing the people in East Germany, especially the young, ambitious and well qualified, to stay at home and to work hard for - at present - less than 50 percent of West German real income, and on top of it to stay in an area that is terribly polluted, that has an extremely poor infrastructure, and that will be a huge and permanent building site for the next five to ten years.

But fortunately, rational economic considerations are not the only motive for people to decide what to do and where to go. Germans are not very mobile; they prefer to stay in their home area with their family, their friends and their soccer team. It will therefore be more important to give people in the GDR a positive perspective than to close the gap between East and West Germany with respect to real income and general economic conditions in a very short period. Is that feasible? FAST RESTRUCTURING OF THE GDR ECONOMY NEEDED

One thing is obvious: The two German states can't afford not to make reunification a success. If an economic crisis were to result, this would have serious implications for political and social stability in Germany.

Some politicians and economists in the GDR are predicting an increase in the unemployment figure from the current 250,000 to 2 million for 1991.

East German industry presently employs some 4 million people. The managers of aH East German "combines" agree on one thing: They are overstaffed by an average of 20 to 30 percent. The GDR has a relatively high degree of concealed unemployment, a reflection of the "right to work" that socialism grants to the people.

A similar situation probably exists in agriculture, in the state bureaucracy and in many other sectors of the economy. To put it bluntly: When the East German economy is exposed to competition with the high-performing economies of the Western world, it has no choice but to streamline and upgrade its facilities. Inevitably, redundancies will be the first step in this process.

Yet trimming corporate structures alone will not be enough to resolve the GDR's economic problems. Many outdated production facilities will have to be closed because they are absolutely unproductive. Seen from this angle, forecasts of one or even 2 million unemployed GDR citizens in the initial phase after reunification should not be discounted offhandedly. Until a few weeks ago, East Germany had no unemployment insurance plan, and, in its present economic and financial condition, the country lacks the resources for supporting the unemployed. What this means is that the social welfare system of the present Federal Republic would have to carry the resulting financial burden. Instead of paying unemployment benefits to 2 million people in West Germany, this system would have to support 3 or even 4 million. jobless in a reunited Germany - a scenario that spells crisis" rather than "economic miracle."

On the other hand, the GDR has immense deficits in the services sector:

1. There are a mere 600 lawyers because people

had reconciled themselves to the fact that they

did not stand a chance against the omnipotent

state anyway.

2. There are few tax advisors, because the inland

revenue used to fix taxes arbitrarily and their

assessments were final anyway.

3. The number of doctors in private practice is

below 1,000.

4. The country's ratio of hotel beds is some 5 per

1,000 people compared to 30 in West Germany.

5. Restaurants and pubs are few and far between.

People preferred to eat and drink at home to

prevent the ubiquitous State Security agents

from listening to their conversations.

6. East Germany's entire banking industry employs

a mere 40,000 persons, compared to

615,000 in the Federal Republic. If you apply

West German standards to the present East

Germany, you see that in the medium term

100,000 jobs could be created in banking


7. Taxis, commercial tour operators, beauty parlours

and other services that have come to be

taken for granted in the West are hard to find

in the GDR.

Quite evidently, East Germany is facing tremendous changes in its economic structure. Many operations will have to slim down or close down altogether, and hitherto practically nonexistent sectors will have to be created.

In a normal case, an economically underdeveloped region or nation - take Spain as an example - that seeks to catch up with its neighbors' levels of productivity and affluence by joining a prosperous economic community, takes some ten to twenty years to accomplish this. In the case of the GDR, the introduction of the deutschmark and the ensuing adoption of western economic rules will subject the country's economy to a downright brutal process of adjustment. So what would normally take ten or twenty years will have to be accomplished within three, or five years at the latest. For the German people, this represents a considerable test of political, social and economic strength. But for foreign investors this definitely represents some fascinating business prospects. BRIGHT PROSPECTS IN THE LONG-TERM

The government must do everything to close the economic divide between East and West Germany. The politicians will not leave everything to the forces of the market but will help East Germany catch up with the West by transferring funds, investing enormous sums in the infrastructure and by offering generous state incentives to investors willing to set up modern, efficient operations and create jobs to run them.

At the same time, the integration of the GDR into the Federal Republic - and an integration is what it comes down to - means that the foreign investor will find himself in a stable economic environment:

1. There will be no transfer risk.

2. There will be no stability risk because the

Bundesbank will stick to its course also in a

reunited Germany,

3. There will be a stable labor market, i. e., there

will be no incalculable risk of industrial conflicts.

Add to this East Germany's strategically placed position as a basis for trade with Eastern Europe. (Until now nearly 70 percent (or $65 billion U.S.) of all foreign trade is transacted with Comecon countries, 60 percent of that with the USSR alone. The GDR/FRG trade volume was only 15 billion DM last year).

But substantial problems still have to be overcome until the economic divide between East and West Germany is closed.

Some major prerequisites for successful business in East Germany are not yet in place. Getting a telephone call from Dusseldorf to Dresden resembles playing roulette; your secretary may have to spin the dial for some four hours, and even the PTT's exchanges sometimes simply give up. A poor traffic and transport infrastructure, patchy public services, water and electricity shortages, inadequate sewage systems and sewage treatment plants - all these problems await the foreign investor, West German companies and East Germans alike. In addition, there are still many legal and administrative problems; 99 percent of all industrial operations are owned by the state. Until now the new government has not decided definitively when, how and under what conditions these companies will be sold to private investors. It does not take long to strike a deal with the managing director of a VEB, a "people-owned company," but they lack the final authority.

Insecurity will occur, especially in connection with those companies that were taken over by the state during the 1972 nationalization campaign. In principle, they are to be handed back to their former owners. However, no satisfactory arrangement is yet in sight for this complex process, which also includes the valuation of these businesses. Corporate accounting in the GDR is known to be in a desolate state and cannot at all be compared with western methods. Investment in real estate is another issue being treated with extreme delicacy and reserve.

At the time of writing this article, nobody knew how long it would take to change all this. But when this article will be published, I guess it will already be definite that Western companies will find the same framework for their businesses in the GDR as they have it today in West Germany.

Foreign investments are always more complex and risky than building and expanding one's business at home. But what speaks for East Germany is the fact that an attractive level of productivity and a good standard of living in a stable economic and social environment will be accomplished here much faster than in most comparable countries. Potential investors should be aware that one factor is definitely at a premium here - and this factor is time. I predict a short but marked economic crisis in the GDR during the adjustment period, followed by a boom that may start as early as 1992. Quite obviously, not much time is left to get ready.

What are the regions, industries and markets to invest in first? There is a great pent-up demand for most consumer goods of western quality and appealing styling. Good sales prospects exist for medium-priced products, in particular for products with a low service requirement, given the GDR's relatively underdeveloped service industries.

Should a company build its own distribution channels or systems, or should it use existing sales networks, possibly in cooperation with West German companies? This question can only be answered case to case, of course. U.S. companies already established in West Germany will be able to do business in the GDR just as any West German company.

There is an enormous need for services, and this need will soon turn into concrete demand. Many foreign investors will be able to build on the experience gathered some twenty years ago when they built their positions in West Germany. After all, the GDR today stands where the Federal Republic stood around the end of the 1960s. The construction industry will be booming for many years, because there are enormous deficits in all sectors

housing, infrastructure, sewage systems, pollution control.

Particular problems will occur in the industrial sector. The introduction of the deutschmark will inevitably lead to a forced adjustment of price and income levels to those in West Germany. Companies will not be able to afford this unless they manage to operate just as productively as their counterparts in other industrialized nations of the Western world. Newly established companies working with modern western technology and efficient equipment may be able to accomplish that. Many of the GDR's outdated industrial operations will take years, though, before they can compete on quality and productivity. This leaves the German government with no choice; it will have to subsidize such companies to enable them to bring down their costs to a competitive level, even if West German or foreign investors acquire stakes in them. IMPACTS ON FINANCIAL MARKETS

This leads to the question of what impact economic and monetary union will have on German financial markets and on the deutschmark exchange rate. Rough estimates say that West Germany will have to subsidize the social security system in the GDR (pensions, unemployment benefits, social help) by 20 billion deutschmarks during the first twelve months after the creation of economic, social and monetary union on July 1.

In order to integrate fully the area of the GDR into a future unified Germany, huge investments in the infrastructure, communication network, ecology and the modernization of housing and business will be required.

There are calculations ranging from DM 500 to 1500 billion for these kind of investments. These investments will have to be financed or subsidized in the first instance from public budgets. An estimated burden on public budgets in the FRG of around DM 10-20 billion annually from 1991 onwards is probably not too high.

The financial assistance payments by the FRG to the citizens and factories in the GDR will at first become apparent in the form of a demand for West German products. This will reinforce the slight acceleration in inflation already noticeable in the FRG. During the second half of 1990, the inflation rate will rise to above 3.5 percent; in 1991, a further increase to 4 percent can be expected. For this reason, the German Bundesbank is expected to raise the key lending rates once again, though whether this will be by 0.5 percent or possibly even I percent cannot be said at present. On the capital market, the expectation of an increase in the key lending rates has already led to a distinct rise in interest rates. That's the reason why I don't expect much higher capital market rates.

The strong domestic demand in the FRG will also have clear repercussions for our partners in the EMS. The German trade and current account surplus will decline by DM 15-20 billion during the next eighteen months. This will correspond to an improvement in the balances of the other EMS partners. Against this background, the pressures in the EMS will presumably not increase, in spite of the high DM interest rate. A realignment (which would be positive for the FRG for price level stabilization) is fairly unlikely under these circumstances. For the DM-U.S. $ rate, I don't expect any major changes, either.

But in view of the great uncertainty over the form and realization of the economic reforms in the GDR, and also on account of the continuing election campaign in the FRG, one may assume that all financial markets will be very volatile.
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Author:Wieners, Klaus
Publication:Business Economics
Date:Jul 1, 1990
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