Feb. 7 (Bloomberg) -- German Chancellor Gerhard Schroeder's government and public workers expect to sign an agreement on pay and conditions that includes performance-related compensation for as many as 2.1 million employees in Europe's largest economy.

``I remain optimistic that we will reach a swift result,'' Interior Minister Otto Schily told reporters after six hours of talks in the eastern German city of Potsdam. ``Basic sentiment remains upbeat, I believe there is a commitment toward reaching an agreement,'' Ver.di labor union chief Frank Bsirske said.

Schroeder's government has budgeted for a wage freeze for 500,000 federal employees to help cut Germany's budget deficit below European Union limits for the first time since 2001. The EU Commission last week said Germany's 2005 budget may be based on undue forecasts for economic growth and social spending.

For the first time since collective wage bargaining for public- sector staff began half a century ago, union negotiators are not seeking a fixed percentage increase in the talks, which will resume tomorrow at 10 a.m. Berlin time. Still, Ver.di, Germany's largest union, says it wants an increase that reflects pay rises for other groups of workers, such as bank staff and those in the chemical and engineering industries.

Germany's DGB union federation, which represents 7.4 million workers, says wage increases in 2004 averaged about 2 percent, more than offsetting a 1.6 percent increase in consumer prices.

Growth Forecasts

Schroeder's government is forecasting that economic growth of 1.6 percent this year will help keep the budget deficit to 2.9 percent of GDP, compared with 3.9 percent last year. Five of Germany's six state-funded economic institutes are predicting slower growth.

Government spending on unemployment may also be higher than expected after the number of people out of work in Europe's largest economy rose above 5 million in January -- the highest total since the 1930s.

The government's call for a wage freeze mirrors developments at some of Germany's largest companies last year. Volkswagen AG, Europe's biggest carmaker, agreed to a 28-month pay freeze with unions in November in return for a guarantee to preserve jobs.

Schroeder's government, Ver.di and the VKA association of local employers are seeking to revamp compensation rules for workers including garbage-truck drivers and nurses as well as office staff. Both sides are aiming to replace a system that sets over 17,000 separate wage brackets and benefit levels, in an effort to increase efficiency and stem job cuts.

``We still have to overcome several high hurdles'' to reach an agreement, Schily said.

Jobs Lost

More than 250,000 positions in Germany's public sector have been eliminated since 2000. Ver.di has lost more than 200,000 members since it was formed four years ago by the merger of five other unions.

Employers and Ver.di ``are agreed in principle'' on the introduction of performance-related pay from 2006 to replace increases based on age, years of service and marital status, union spokesman Jan Jurczyk said in an interview. Both sides want to raise the performance-related share of compensation from an initial 2 percent of annual pay to 8 percent.

A new wage contract won't affect all 3 million of Germany's public employees, as 16 regional governments employing 900,000 staff -- including teachers and police -- aren't taking part in the talks. The states pulled out of existing contracts last April, saying collective wage bargaining was costing them too much while blocking attempts at lengthening weekly hours.

Working Hours

Most state governments, which spend more than a third of their budgets on pay, have since extended the working week for their staff to between 40 and 42 hours from 38.5 hours. The states also reduced holiday and Christmas pay for newly hired staff.

``Nearly all the states are battling with gaping deficits,'' said Ulrich Konstantin Rieger, the executive director of the TdL association of German states, in an interview. ``We felt we couldn't afford another exorbitant pay accord,'' He said the states will have to hold separate pay negotiations with Ver.di.

The previous public-sector wage accord, agreed in January 2003, earned workers 2.4 percent more pay that year and another 2 percent in 2004. Ver.di had demanded a 3 percent increase.

Schily last year scrapped 14-year-old rules restricting federal civil servants' weekly working hours to 38.5, forcing employees to work 90 minutes longer.

Ver.di has already said it opposes any move toward lengthening weekly hours, saying such a policy is wrong at a time when joblessness is rising. Employment can only be boosted by limiting, not lengthening, working time, Jurczyk said.

Other wage contracts to be negotiated this year in Germany will affect 1.8 million retail workers, 1.1 million employees at wholesalers and companies involved in foreign trade, 555,000 staff in the chemical industry and 193,000 insurance workers. A pay accord for 160,000 workers at Deutsche Bahn AG, Germany's state- controlled railway, expires at the end of this month.

To contact the reporter on this story: Andreas Cremer in Potsdam, Germany at acremer@bloomberg.net.

Last Updated: February 7, 2005 13:41 EST