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.
The German style labour market reforms
President Sarkozy singled out high labour costs as the Achilles’ heel of the French economy. He announced in January a new set of German style labour market measures that would cut France’s labour costs by EUR 13 billion and insisted that France should follow Germany’s example of structural reforms to regenerate its weak competitiveness and stimulate growth. Again, we keep in mind that the implementation of these reforms is conditional upon Sarkozy’s re-election.
In our view, the most important measure is the “social VAT”, which represents a shift from labour contribution to VAT. In 2007, Germany increased the VAT rate from 16% to 19% to shift part of the burden of social welfare onto consumers. The standard French VAT rate would increase from 19.6% to 21.2% from 1 October, only slightly above the European average of 21%. This increase in VAT along with an increase of 2% in financial income tax for households will finance a decrease in social contributions for employers to lower labour costs, which would help boost the competitiveness of French companies. The broader reform package announced includes more flexible working hours, a financial transaction tax of 0.1% (to be levied from August onwards on shares, high frequency trading and derivatives, including CDS) and the creation of an “industrial investment bank”. The government expects the financial transaction tax to raise EUR 1 billion in revenues for a full year.
We believe that the social VAT could boost French competitiveness; similar international experience also suggests a positive impact (Denmark in 1987, Germany in 2007, proposal by the IMF for Portugal).
2012 French elections
With less than 20 days to go, French presidential elections will be held on 22 April (first round) and 6 May (second round). Legislative elections for the Parliament will follow on 10 and 17 June. In the presidential race, the two main candidates are current president Nicolas Sarkozy from the UMP, the major right-wing political party and Francois Hollande, representing the French socialist party. Sarkozy has trailed Hollande consistently in second-round polling since January 2012 and only at the end of March has their popularity started to converge. Hollande has proven a strong contender to Sarkozy and managed to gather endorsements with promises to renegotiate the Fiscal Compact. One of Hollande’s perceived shortcomings is his lack of experience in government affairs (he has never held a ministerial role).
The election campaign started with 10 candidates running for president but is likely to be a two-horse race, as third-placed Marine Le Pen has lost some ground on her inclination to leave the euro zone. Sarkozy’s manifesto focuses on deficit reduction and measures to restore competitiveness such as the social VAT (see table below). Although Hollande also focuses on debt reduction in his manifesto, he said that he would cancel the social VAT and reverse the retirement age to 60 in some special circumstances. He also intends to separate banks’ deposit-taking and investment-banking activities. More importantly, he intends to renegotiate the Euro area Fiscal Compact to include a Tobin tax and introduce Eurobonds to stimulate growth via investment in energy, education and urban development. In the table below we discuss the differences between the programs of the two main candidates.
The uncertainty around the elections is a source of downside risk for France in the near term. Credit rating agencies are watching how Europe evolves towards a fiscal union in order to re-assess their current ratings on the individual sovereigns.
In the short term, France must prove that it can deliver on fiscal austerity to bring its deficit back to 3% of GDP, sooner rather than later, and without spiralling into a deep recession. In the medium term, the country must address its structural issues and deal with its entrenched lack of competitiveness and high level of unemployment. Fiscal austerity and growth will therefore be the key challenges for France to avoid further downgrades in the next two years.
Fitch pointed out recently that “a more radical structural reform agenda would underpin greater confidence.” We believe France is addressing the urgent need for structural reforms using the German model. The “social VAT” is another step in the right direction – if Sarkozy wins – but deeper structural reforms that boost productivity will be necessary to restore the competiveness of French businesses.