France takes first steps to defuse 'time bomb'
France has been in the spotlight in recent weeks, after a number of high-profile reports that cast a critical eye on the economy’s long-term growth prospects. The unwanted attention bubbled to the surface following the unveiling of a government-commissioned report on French competitiveness during the first week of November that warned of an “emergency situation”, and called for a “competitiveness shock”.
The dust had barely time to settle when a second wake-up call was delivered in a report by the International Monetary Fund (IMF), which noted that the “growth outlook for France remains fragile”, and that “the ability of the French economy to rebound is undermined by a competitiveness problem”. The IMF called for – among other things – a quality fiscal adjustment and labour market reforms.
The urgent need for change emanating from the two reports was echoed by a much-publicised supplement in the Economist just days later, which warned of a “time bomb”. The costliest blow was reserved for the credit rating agency, Moody’s, which stripped the French sovereign of its triple-A rating, citing the economy’s lack of growth and loss of competitiveness.
Investors took the spate of French economy-bashing in their stride, and sovereign bond prices barely registered a reaction. Indeed, the yield on the 10-year bond is unchanged since the start of November, and almost 150 basis points below the levels recorded 12 months ago. The lack of a market response begs the question: Is France really the “sick man” of Europe?
On paper, the French sovereign looks no worse than its euro zone neighbours and far better than either Japan, the US, or the UK, with a projected fiscal deficit amounting to 4.7 per cent of GDP in 2012, and a public debt ratio of 90 per cent. However, the economy is beset by numerous structural problems that are certain to surface sooner or later.
The concern must be that the benign view taken by the financial markets will contribute to a sense of complacency that precludes any meaningful reforms, such that the gap with other euro zone countries will continue to widen – and particularly so, given the measures taken in the periphery.
Nowhere is the deterioration in the French economy’s competitiveness more visible than in the current account position, which swung from a small surplus in 1999 to an expected deficit of almost €100 billion in the current calendar year. The adverse shift in the external account occurred as the export sector suffered a dramatic decline in market share. Indeed, France’s share of exports to the rest of the European Union declined by more than 25 per cent from 2000 to 2011, while the European Commission observes that its share of world exports fell by a fifth between 2005 and 2010.
The French economy’s lack of competitiveness can be traced to labour market rigidities that have contributed to stubbornly high unemployment. Indeed, the unemployment rate has dropped below 8 per cent just once over the last 20 years, while the rate of youth unemployment has never been below 15 per cent over the past 30 years.
Although union membership is relatively low by EU standards at just 8 per cent, a relatively militant leadership tends to dictate labour market terms, which means that any downward adjustment in employment tends to fall disproportionately on young workers on temporary contracts. Labour market duality is amply demonstrated by the fact that the unemployment rate and real wage growth are positively correlated, and as a result, it is no surprise that private business is reluctant to hire.
Further, relatively high wage costs have contributed to a structural decline in profit margins, which has hampered private investment in the productive capital stock. Expenditures on research and development remain marginally above the EU average relative to GDP, but should recent trends persist, this will soon change. All told, a relatively low investment rate could lead to a decline in labour productivity with a corresponding fall in the economy’s sustainable growth rate.
It is widely believed that the political establishment is far too complacent in the face of these concerning trends, such that meaningful supply-side reforms will not be implemented.
However, in response to the commissioned report on competitiveness, the Socialist government announced that it would give € 20 billion of tax breaks to companies in an effort to compensate for the heavy burden of payroll charges.
The measure was less than the private sector had called for and will be phased in only gradually, but importantly; it is to be financed through an increase in value-added tax and a reduction in public spending. The shift in the tax burden away from business and towards the consumer marks an important break in prevailing government policy for at least the past 40 years, and should not be dismissed lightly.
France risks becoming the “sick man” of Europe, but new measures announced by the government represent a step in the right direction. The time for more meaningful reforms is now.