France economy being reassessed
FROM THE ECONOMIST INTELLIGENCE UNIT
Until recently the debt crisis in the euro area had largely spared France, which had benefited from financing conditions only slightly less favourable than those for Germany. Since the end of May, however, spreads between French and German 10-year bonds have widened, while CDS rates on French government debt have also drifted upwards. Investors may be beginning to reappraise France’s status as a relative safe haven.
A record of lax fiscal control spanning decades provides few grounds for confidence over the dynamics of French public debt. There is a very real risk of a steep rise in the interest burden in the future, so that France not only loses its cherished “AAA” rating on its sovereign debt, but also its ability to control its finances and avoid a debt trap in the longer term.
The French government’s targets in its Stability Programme (2010-13) are aimed firmly at addressing such concerns—they are certainly ambitious. Public expenditure is projected to decline by three percentage points of GDP between 2010 and 2013, from 55.8% to 52.8%, while the tax burden is projected to rise from 47.6% of GDP in 2010 to 49.8% in 2013. Thus the general government financial deficit is expected to fall from a (revised) target of 8% of GDP in 2010 to 3% by 2013. This implies that the government needs to make an adjustment of around €100bn in the budgets for 2011-13.
There is no historical precedent for an adjustment of this magnitude. France has experienced a period of deficit reduction in each of the last four decades, but in every one of these periods the average annual rate of reduction of public deficit was between 0.5 and 0.7 percentage points of GDP, compared with a planned adjustment of 1.7 percentage points of GDP per year during 2010-13. Moreover, in the past, deficit reductions have been achieved during periods of strong growth, and more often than not through higher taxes, rather than cuts in public expenditure. The situation facing the current French government is very different. Growth is likely to be weak. The government expects that the reduction in the deficit will be largely structural in nature, and predominantly through a reduction in primary spending.
There are at least some signs that past French foot-dragging over budgetary consolidation is giving way to a firmer resolve. In May the prime minister, François Fillon, ordained that central government expenditure will be frozen in nominal terms during 2011-13, once interest on government debt and pension payments are excluded. This marks a break with the government’s previous goal to freeze expenditure only in real terms, and could bring additional savings of around €4bn. A number of steps will be taken. The government will maintain its established policy of replacing only one out of every two civil servants that retire (resulting in the elimination of 100,000 posts during 2011-13). Another key aim will be to cut back substantially on both state operating expenditure, notably by government ministries, and state intervention expenditure, which covers social transfers and sector subsidies.
On the revenue side, until May the government had been planning to raise an additional €2bn over three years by reducing tax breaks and eliminating tax loopholes (which are worth around €75bn per year). The prime minister has raised this target to €5bn over two years, with the brunt likely to bear on the taxation of personal savings and other personal investments.
Still, it is doubtful whether these steps will be sufficient to keep France on track to meet its targets. The government is assuming real GDP growth of 2.5% per year during 2011-13, compared with the Economist Intelligence Unit’s forecast of an average of around 1.4%. On the spending side, deeper welfare reforms will probably be needed, given that social security accounts for just under one-half of total public spending. Another source of concern is the potential for higher debt-servicing costs: the government assumes that interest costs will rise by a total of 0.4 percentage points of GDP during 2011-13, based on an unrealistic assumption that the average interest rate will stay at the record low level predicted for 2010 (of 3.5%).
On the tax side, the fairly buoyant recovery in receipts envisaged is unlikely to materialise. This is not only because of weaker growth, but also because estimates of the size of the tax base may have been flattered by unsustainable, debt-fuelled growth in the run-up to the financial crisis. The government predicts that the tax burden will stand at around 49.8% of GDP in 2013, compared with 49.6% in 2007, before the onset of the financial crisis. This is despite the introduction of tax cuts worth around 1% of GDP in recent years.
On balance, we expect the deficit to remain higher than projected by the government, at 5.3% in 2013, with the result that public debt will also rise faster: from 77.6% of GDP in 2009 to 94.8% in 2013. Our baseline scenario is that a small primary surplus will be achieved in 2014, with the result that debt should stabilise and fall gradually thereafter. However, the risks that the French economic recovery gets blown off course are high. Moreover, if the rescue plans for Greece and other indebted euro area member states do not work as intended, the French government will be forced to issue new debt in order to recapitalise French financial institutions. It is not difficult to envisage a situation in which debt rises above 100% of GDP during the current decade.
Following Germany’s lead?
While the French government is keen to avoid implementing severe austerity measures ahead of the 2012 presidential and legislative elections, it is also mindful of the increasing international concerns over the long-term viability of the euro area. Such concerns help to explain the recent announcement by France’s president, Nicolas Sarkozy, that he intends to seek a revision of the French constitution to introduce a binding constitutional procedures on the size of future deficits.
At first sight, this appeared to hold out a prospect that France would emulate the example of Germany, which in 2009 adopted a constitutional change limiting the federal government’s structural deficit to 0.35% of GDP from 2016 onwards. However, what Mr Sarkozy has in mind is somewhat different. He suggested that an incoming government should be obliged, at the beginning of every five-year legislature, to pass a law setting out a clear, year by year strategy for managing the public finances, with a view to eliminating any structural deficit. How this would work remains unclear. And there is no guarantee that such a rule can even be introduced, given a constitutional amendment would first have to be approved in an identical version by the National Assembly and the Senate, and then subsequently validated either by referendum (which would be highly unlikely) or by a three-fifths majority in a Congress of both houses of parliament (which may prove difficult).
The development of France’s public finances over the medium term could be heavily influenced by how the campaign for the 2012 presidential election unfolds during 2011. On the one hand, if Dominique Strauss-Kahn, the IMF’s current managing director, were to both seek and win the nomination as the presidential candidate of the opposition Parti socialiste (PS), a wide political consensus cutting across the left-right divide could generally be said to favour a more vigorous pursuit of budgetary rigour. On the other hand, if Martine Aubry, the PS first secretary, were to secure her party’s nomination, the debate over the public finances would remain polarised.