Ratings agencies, sovereign credit, structural factors and the French presidential election are all contained in the latest thoughts of César Pérez, EMEA chief investment strategies at JP Morgan Private Bank.
France needs to restore its competitiveness in exports…
France’s export market share has been steadily decreasing over the past decade. The country has relied on domestic demand to drive growth, leading to increased imports. As a result, exports have been on a declining trend and now stand at about 25% of GDP in France against around 50% in Germany. The weakness of French exports relative to Germany also appears to be related to the latter’s ability to sell to the emerging world. France’s current account balance has deteriorated gradually from a surplus in 1999 to a deficit of 1.7% of GDP in 2010. Germany has turned from a current account deficit to a surplus of 5.7% of GDP over the same period (see chart). This was led by a worsening of the trade balance, while income and transfers balances have been relatively stable.
…and needs to address its structural issues in the labour market
The high cost of labour is one of the factors that helps explain the loss of competitiveness of the French economy relative to Germany. In Germany, wage growth has been significantly lower than productivity gains, enabling companies to increase margins as well as gain market share. Contrary to Germany, France has used productivity gains to boost wages to the detriment of corporate margins and competitiveness. This has resulted in a loss of competitiveness for France of more than 20% relative to Germany since 2000 (as measured by unit labour costs).
The loss of competitiveness driven by the high unit labour costs led to rising unemployment. French unemployment rose to 10% at the beginning of 2012, the highest level since 1999. In contrast, Germany’s unemployment rate dropped to 5.8% in January 2012, close to the lowest level since German reunification.
Where does France stand in terms of austerity plans?
The public sector is a major part of the economy: France stands out in the Euro area with government expenditures at 56% of GDP. Reducing the public sector fiscal drag will take time, although the country has already started reforms of its public services, such as the Pensions Reform in 2010. The government launched two austerity packages in 2011. The first one, launched in August 2011, consisted of a EUR 12 billion deficit cutting package that raised taxes for wealthy individuals and closed tax loopholes. The second one, announced in November 2011, aims at saving EUR 65 billion through 2016; half of the savings are spending cuts. The package is aimed at ensuring the government meets its target of reducing the budget deficit to 3% of GDP in 2013. The measures would enable France to eliminate its deficit in 2016 and stick to its aim of cutting public debt, set to peak at around 86% of GDP in 2012. We note that the austerity programmes depend on the elections’ result. Both main candidates are supporting tax increases. However, Sarkozy forecasts to balance the budget in 2016, while Hollande aims for balance in 2017.
The French budget deficit dropped from 7.1% of GDP in 2010 to 5.2% in 2011. This evolution is the largest improvement in France’s modern history. We note that this decrease was achieved with lackluster growth (a 3.3% increase in nominal terms) and was driven by larger tax receipts (50.7% of GDP from 49.5 %) and reduced public spending (55.9% of GDP from 56.6%). For 2012, the fiscal effort seems less daunting, given the 4.5% target. GDP growth is the key variable for determining how France will reach this goal.
If we consider the long term outlook, the deficit of social security administrations is one of the major pending structural adjustments. By law, the social security accounts should be balanced each year. However, in 1993, prime minster Édouard Balladur allowed for the sector to accumulate debt. Since then, social security debt reached 10.3% of GDP last year, against 2.3% in 1993. Current prime-minister François Fillon has already limited social security spending growth in the past years. However, in order to achieve a structural fiscal deficit of 0.5% of GDP, as required by the Fiscal Compact, a fall in the social security deficit (especially that of the healthcare system) will need to appear on the reform agenda.
Growth is still a downside risk
Disappointing growth is a major risk for France and partly explains why S&P carries a negative outlook on the country. With a primary balance of -2.5% of GDP and weak nominal growth in the near term, the French debt to GDP ratio is likely to be trending up. The current government plans to generate a primary surplus in 2014 to turn the debt to GDP trend, but it has been criticised for relying on overly optimistic forecasts for growth. Although in January the government revised its 2012 growth forecast down a second time to 0.5% (from 1.75% initially), the IMF still sees slower growth for France in 2012 at 0.2%.
With French industry surveys contracting since Q3 2011 and industrial production slowing down, France could be heading for a mild recession in 2012. Even allowing for increased fiscal efforts, the data suggests that the government is likely to miss its deficit targets and debt to GDP would rise (see chart). Adding mild shocks to the official scenario1 makes debt dynamics clearly more explosive (see chart). On the other hand, debt dynamics in Germany look less challenging. Thanks to a primary surplus close to 1% of GDP, the debt to GDP ratio has likely peaked in 2010. Even if we assume that the German economy is about flat this year, its debt to GDP ratio will be on a downtrend (see chart). But if we apply the same shock scenario parameters as for France, the German debt to GDP ratio will be also on a rising trend.