June 30 (Bloomberg) -- German unemployment rose to the highest since 2007 in June as falling demand and rising bankruptcies forced companies to cut jobs.

The number of people out of work increased a seasonally adjusted 31,000 to 3.5 million, the Nuremberg-based Federal Labor Agency said today. Economists forecast an increase of 45,000, according to the median of 28 estimates in a Bloomberg News survey. The adjusted jobless rate rose to 8.3 percent from 8.2 percent.

Germany’s deepest recession since World War II led to a 14 percent increase in insolvencies in the first half of the year, according to Creditreform e.V. While Chancellor Angela Merkel’s government is paying companies to hold on to workers as part of its 85 billion-euro ($120 billion) economic package, layoffs are mounting the longer the slump lasts.

“The unemployment time bomb’s ticking away,” Holger Schaefer, a Berlin-based labor-market analyst at the IW economic institute, said in a phone interview. “Unemployment, protected so far by government relief to companies and stimulus programs, will rise sharply in the second half, it’s a dead certainty.”

The German economy, Europe’s largest, will shrink 6.1 percent this year, the Organization for Economic Cooperation and Development said June 24. The unemployment rate will rise from 7.3 percent in 2008 to 8.7 percent this year and 11.6 percent in 2010, it said.

Insolvencies

German unemployment began to increase in November after falling steadily for more than three years and the Bundesbank estimates that the number of people out of work will rise to 4.4 million next year.

The country’s engineering and electrical sector has shed 124,000 jobs since December, half the number of positions it created between 2006 and 2008, the Gesamtmetall employers group said on June 20.

Hypo Real Estate Holding AG, the German lender that almost collapsed last year, said on June 22 it will cut 1,000 jobs by 2013. Around 40,000 jobs have been put in jeopardy after retailer Arcandor AG filed for insolvency last month.

Insolvencies cost the German economy 20.8 billion euros in the first half and eliminated 254,000 jobs, Creditreform said on June 22. For the full year, the number may rise to 540,000, it said.

Political Fallout

Lengthening jobless lines may undermine Merkel’s chances of forming a coalition government with the pro-business Free Democratic Party in September elections. Her government is trying to limit the unemployment increase by subsidizing the cost of retaining workers. Labor Agency aid under the plan was extended from six months before the crisis to 24 months.

Combined support for Merkel’s Christian Democratic Union, its Christian Social Union Bavarian sister party and the FDP rose to 51 percent, a Forsa poll for Stern magazine and RTL television showed June 24. Support for the Social Democratic Party, Merkel’s current coalition partner, rose 1 percentage point to 22 percent.

Even as unemployment rises, confidence is starting to improve, with GfK AG’s consumer sentiment index rising for a second month in July. Still, the market research company said it is “unclear” whether the improvement marks the beginning of a “sustained recovery.”

‘Stabilization Phase’

“With regards to the downward dynamics, I think we’ve left the worst behind and currently are in a stabilization phase,” Bundesbank President Axel Weber said on June 16. “However, we’re far away from a significant pick-up of the economy.”

The economic slump has prompted the ECB to cut its benchmark interest rate to a record low 1 percent and lend banks as much money as they want for 12 months to get credit flowing. Business confidence in Germany rose for a third month in June, the Ifo institute in Munich said June 22.

According to the latest comparable OECD data, Germany’s jobless rate rose to 7.7 percent in April from 7.6 percent a month earlier. Unemployment in the U.S. and France was 8.9 percent that month.

In western Germany, the number of people out of work rose by a seasonally adjusted 27,000 in June, while the number in eastern Germany grew by 4,000, today’s report showed.

To contact the reporters on this story: Rainer Buergin in Berlin at rbuergin1@bloomberg.net; Christian Vits in Frankfurt cvits@bloomberg.net

Last Updated: June 30, 2009 04:42 EDT