`A Fiasco For Germany'

As Kohl's tax reform stalls, irate CEOs send capital abroad

Just when it seemed things couldn't get much worse for Germany, they did. Despite forecasts of accelerating economic growth, the country's woes--punishing unemployment, a plummeting currency, and government paralysis--have cast a dreary pall over the summer holidays. Then, in late July, the Bundesbank signaled that it might raise interest rates for the first time since 1992. And a political showdown snuffed out Chancellor Helmut Kohl's crucial tax reform package, for which German business had lobbied heavily.

In a country that has waited six years for its economy to regain vitality, the malaise may be reaching a crisis point. It's not just the 4.4 million jobless who feel the system has let them down. The upper echelons of business and academia are growing more negative by the day on Germany's "consensus capitalism," which created one of the world's most affluent postwar societies but has failed to keep pace with the new global economy. And politicians, ever obsessed with the next vote, have so far refused to risk decisive action. Indeed, the impasse over taxes has sent a frightening signal that other needed economic reforms will stay on the back burner until after parliamentary elections in September, 1998.

Executives are openly furious with Bonn. "We need the politicians to give us a reasonable framework and the freedom to [compete]," says Manfred Schneider, chief executive of chemical giant Bayer Group. Adds Peer Schatz, chief financial officer of biotech company Qiagen: "Just when we need leadership, we have a government that can't get anything done. It's very disillusioning." A BMW executive calls the failure of tax reform "a fiasco for Germany."

RIPPLE EFFECTS. Business anger will drive Germany into worse trouble. So far, the fragile recovery has been propelled by exports, made more competitive on world markets by the weak mark. With unemployment stuck around 11%, consumer demand has been sluggish. But as exports boost profits, the government had hoped companies would finally start expanding domestic factories and adding personnel later this year.

Instead, disgusted CEOs are likely to keep sending jobs and capital abroad, where wages and taxes are lower. The outflow of direct investment from Germany hit $25 billion in 1996, double the 1993 level. That stream could turn into a torrent if Europe, as planned, shifts to a single currency in 1999, because German companies will no longer risk any negative exchange-rate effects if they relocate to, say, Spain or Portugal.

Economists had predicted that tax reform would offset the relocation trend, adding up to a percentage point to gross domestic product growth in 1999. No more. "This is a disaster for the German economy," says Bank Julius Baer economist Gerhard Grebe. He predicts GDP growth will top out at 2.7% next year and drop again in 1999 to 2.5%. Such growth rates aren't nearly enough to make a dent in joblessness.

Politically, the ripple effects from the tax reform debacle will also be wide. Kohl has alienated his traditionally supportive corporate constituency. Indeed, as the historically strong cooperation between business and government in Germany breaks down, there's mounting unease over what might take its place. Already, Kohl and Social Democratic Party opposition leader Oskar Lafontaine are trying to blame each other for the deadlock on economic reform. "We are lacking political leadership in Germany," fumes Robert J. Koehler, CEO of SGL Carbon, adding: "We are living beyond our means."

Fears of an interest-rate hike are adding to the negative vibes. The mark has plunged 21% this year, to about 1.88 per dollar (chart). If it keeps dropping, many analysts believe that inflation worries will force the Bundesbank to start phasing in higher short-term bank rates, which lately have been fixed at just 3%. Most analysts figure the central bank will do all it can to avoid raising rates, but "the odds are going up" that it will have to act, says Kermit Schoenholtz, London-based global chief economist for Salomon Brothers Inc. The central bank may not have long to shore up the mark; it will become increasingly constrained as Europe moves toward monetary convergence next year.

No wonder capital is going on strike against Germany. Foreign investment has dried up: Last year, foreign companies repatriated all their German profits, pulling a net $2.6 billion out of Germany. That's the first outflow in years. Domestic companies aren't spending as expected, either. Heinz Greiffenberger, CEO of a Bavarian tool company, says that thanks to exports, his sales were up more than 10% in the first half of this year, and profits have nearly doubled. Even so, he is using new, flexible labor pacts to boost output and has barely added to the company's 1,000-person workforce. Nor is he raising capital investment.

Other companies may take more radical action. Geers Horakustik, a 470-employee German hearing-aid company, may move its purchasing operations to a tax haven outside Germany. "I'm extremely frustrated," says CEO Volker Geers. "It's clear now that costs [in Germany] are only going to rise."

Ironically, some of the near-term weakness in the German economy comes from government austerity measures that many executives applaud. Under the Maastricht Treaty for European monetary union, participating nations must cut their budget deficits to under 3% of GDP this year. Scrambling to meet that goal, Bonn is forcing Germans to pay a higher share of the cost of prescribed medicine. And Finance Minister Theodor Waigel is pushing 16,500 people per month off costly government make-work programs that artificially reduce Germany's unemployment rate.

HOLLOWING OUT. Another irony is the way Germany's stock index keeps reaching new highs. While the government dithers, corporate chieftains have shouldered the burden of becoming more competitive, trimming costs, and focusing on shareholder value. As a result, the DAX is up 49% year-to-date. But since blue-chip companies are boosting profits largely by exporting employees and capital, the stock market's euphoria doesn't reflect the economic climate.

Without reform, more German companies will keep trying to evade taxes, further hollowing out the economy. Winfried Fuest, an economist with Cologne's Institut der Deutschen Wirtschaft, notes that ever more German companies are setting up subsidiaries in tax havens like Luxembourg. And Qiagen recently incorporated in the Netherlands, though it operates out of Dusseldorf. The main reason: Reforms to facilitate stock options and share offerings are under way in Germany but probably will take longer than Qiagen cares to wait. "Speed and flexibility are key," says Qiagen's Schatz. Until German politicians take that mantra to heart, their country's mood will only get more bitter.

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