Business conditions in Germany, Europe's largest economy, have unexpectedly improved. This may spell good news for Irish exporters to Germany, while lowering the chances of a cut in interest rates.

The Ifo index, which measures business sentiment in Germany, rose to a level of 95.0 in July from 93.3 in June. The index gauges sentiment amongst 7,000 firms in retailing, manufacturing, wholesale and construction. Its updates are closely followed within Germany and internationally.

The index was expected to rise modestly to 94.0 in July. Earlier this month, industrial output and trade pointed to the possibility of a return to a decline in the German economy. The Ifo index averaged 100 in the year 2000. Since then Germany's economy has faced a range of long-term challenges, including globalisation, falling competitiveness, an ageing population and weak consumer activity and confidence.

Germany is Ireland's fourth largest export market. The value of exports to Germany amounted to €6.5 billion during 2004.

Latest trade statistics suggest that although Ireland's total exports grew by 2.6 per cent on an annual basis in the first five months of 2005, exports to Germany actually fell by 6.6 per cent.

A general election, engineered by Chancellor Gerhard Schröder, will take place on September 18th and the positive trend in the index reflects growing optimism on the economy, in spite of recent negative data.

The opposition conservative Christian Democrats are proposing to shift the burden of taxation from income tax to VAT, in an attempt to make the German tax system more employment friendly. A similar policy shift occurred in Ireland during the 1990s.

But in spite of the general strength of the Ifo index, its retail sector component registered weakness, with respondents citing opposition tax proposals as a factor behind negative sentiment.

Germany accounts for over 28 per cent of the euro zone's total gross domestic product, which measures the value of goods and services produced each year. Germany exerts a strong influence on economic indicators that are used by the ECB's governing council in setting interest rates.

The president of the Ifo Institute, Hans-Werner Sinn, said that his institute's latest indicator lowered the case for a reduction in interest rates. The next meeting of the ECB's governing council is on September 1st.