BERLIN--The German economy will probably expand more this year than previously forecast due to strong domestic demand and low unemployment, the International Monetary Fund said Monday, warning however that an escalation of tensions between the West and Moscow could severely hit Europe's economic powerhouse as it has strong trade ties with Russian companies.

The Washington-based fund's staff report on Germany was issued shortly after the downing of a passenger flight in Ukraine last Thursday that led to calls for tougher sanctions against Russia. But the report had been finalized before the shooting down of the Malaysia Airlines Flight 17 over separatist-controlled territory in eastern Ukraine, which the U.S. administration says was brought down with anti-aircraft systems smuggled in from Russia.

"Germany has strong fundamentals, notably the generally healthy balance sheets, strong fiscal position, and historically low unemployment. These, together with accommodative financial conditions and a robust labor market, have underpinned the economic recovery," the Fund said in its executive board assessment.

"Nevertheless...medium-term growth prospects remain subdued against a still weak international environment, lingering uncertainty about future energy costs, and looming demographic changes," the IMF officials said. "An escalation of geopolitical tensions over Ukraine-Russia would hit Germany....In a tail risk scenario in which tensions lead to disruptions in energy supply, Germany would be strongly affected because of its heavy dependence on Russian oil and especially gas."

In its report, the Fund raised its forecast for German economic growth to 1.9% for this year, from 1.7% previously, and predicted growth to come in at 1.7% in 2015, slightly more than the 1.6% increase projected last. This compares with the German government's forecast for 1.8% growth this year and 2% for next year.

A slowdown of the Germany economy, which the IMF sees as an "anchor of stability" in the euro area, could have adverse consequences for a region where the recovery is still fairly fragile.

Also Monday, the German finance ministry warned that the country's industrial sector is already feeling the impact of global crises.

"Uncertainty resulting from geo-political trouble spots in Ukraine and Iraq could have led to companies' restrained business activities," said the ministry's monthly report for July. "The intensification of geo-political risks via notable rising oil prices could dampen private consumption."

In its assessment of the country's overall situation, the IMF staff said Germany's domestic demand growth becomes more broad-based and its current account surplus, long a source of complaints from the Fund and other euro-zone countries, "should begin to decline gradually."

But they also called on Germany to do more to foster more rapid rebalancing in the euro area.

"Policies that focus on strengthening domestic sources of growth, prompting private investment, and reducing the current account surplus would be beneficial for both Germany and the euro area as a whole, while also facilitating external rebalancing," the officials wrote.

"Germany has the fiscal space to finance an increase in needed public investment particularly in the transport infrastructure. Unlike public consumption, this would durably raise German output and have measurable growth spillovers on the rest of the euro area."

The IMF reiterated its call from May and urged Germany to increase public investment by 0.5% of gross domestic product per year over four years. This translates into extra spending of up to EUR14 billion ($18.9 billion) for this year alone, given that Germany's nominal GDP reached EUR2,737 billion last year.

Chancellor Angela Merkel's government has pledged to spend only a combined EUR5 billion extra on infrastructure projects over the next four years.

Write to Andrea Thomas at andrea.thomas@wsj.com

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July 21, 2014 10:25 ET (14:25 GMT)

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