France: Slower Growth, Accelerated Reforms

Soon after winning the presidential election this year, Nicolas Sarkozy said, “If growth does not come, I will seek and find it.” In this regard, 2008 is likely to be quite challenging for the first reformist leader elected by the French people since Jacques Chirac became prime minister as a result of the general elections of 1986. The macro headwinds ― credit crunch, euro, and oil ― that we think will take a large toll on domestic demand in Europe next year will not have the politeness to stop at France’s borders. And despite his impressive energy to move things and convince people that the status quo is not an option, the president will not be able to lean against these headwinds, I am afraid. Could this unfavourable macro outlook kill the reform process, as some political analysts are already predicting? To some extent, Prime Minister Francois Fillon has already answered: “Slower growth is another strong reason to reform our economy.” Because Messrs. Sarkozy and Fillon have bet their political futures on successful reform, I tend to believe that bad economic news could actually accelerate, rather than slow, the reform process.

No shadenfreunde and a budget deficit bordering Maastricht limits

On our current forecasts, GDP growth should slow from 1.9% in 2007 to 1.5% next year. This is a relatively modest loss compared with Germany, where we anticipate a much sharper downturn, from 2.6% to 1.5%, due to the higher sensitivity of the German economy to global trade gyrations. However, this will not create any sentiment of shadenfreunde in French government circles. The reform agenda for next year is heavily loaded, with at its top the critical reform of labour laws, followed by the downsizing of the government, and, less certain, a first attempt to deregulate the retail sector. A view I have often heard from government advisers is that if reforms have a cost ― understand a budgetary cost ― then one has to pay the price, considering that the long-term gains resulting from lower spending and enhanced growth will outstrip the initial cost. However, there is a catch: We estimate the general government deficit (which includes, on top of the central government shortfall, the ballooning deficit of social protection funds) is likely to reach 2.6% of GDP at the end of this year. By itself, the 0.5pp slowdown we anticipate for next year would probably raise the deficit to 2.8%. In addition, the 2008 budget bill includes a fiscal stimulus worth 0.2% of GDP. Hence, the overall deficit is likely to rise to 3.0% of GDP, the ceiling allowed by Maastricht rules in normal business cycle conditions. In plain English, the French government will have practically no fiscal room for manoeuvre next year.

The dilemma: pay for or postpone reforms?

Some of the reforms initiated this year, such as the reform of universities, the merger of the unemployment bureau and the unemployment benefit service, or even the special pension schemes reform, may have a budgetary cost next year. This might also be the case with some of the reforms to come. For instance, the labour law reform should remove most of the red tape that makes redundancies so tricky in France. But imagine that, in order to make the reform more palatable to wage earners, the government offers to supplement severance paid by companies, or tailor-made services to find another job to fired workers. This would make sense: making the labour market more flexible is not about increasing the number of redundancies, even if this is a likely outcome, but about boosting employment growth. Would the government back off because of the Stability Pact rules? My conviction is that Paris would instead argue in Brussels that the purpose of the Stability Pact was not to block reforms ― and that it would get the support of its peers, provided that the labour market reform is a real one.

The main risk: excessive wage demands

If, as I believe, the reform process is immune to sluggish growth, provided that the slowdown does not turn into a full-blown recession (see “What Could Go Wrong” in this issue), there is nevertheless another macro risk for the French economy. The hottest topic in French debates, from the National Assembly to TV shows to Internet blogs is about the purchasing power of wage earners. With inflation up to 2.5%Y in November, mostly because of higher food and energy prices, a growing majority of French consumers believe that their real income is falling, even though the hourly wage rate is up 2.9%Y. It seems that, in France like in other European countries, consumers are more sensitive to inflation when it comes from items such as dairy products or bread. But in France the political debate is adding to the populace’s anxiety. Would higher wages help offset the coming slowdown by boosting consumer spending? This might be true in Germany, after several years of real wages decline, but it would be quite the opposite in France, where competitiveness has become ― again ― a serious issue, as shown indirectly by the rise of the non-oil trade deficit. Higher wages, in the context of a strong euro, would erode competitiveness further and lead to job losses, not to stronger growth. So far, the government has smartly diverted the political pressure for higher wages by answering that the best way to increase one’s pay check is to work more, and thus by loosening the 35-hour workweek straitjacket. Yet, the political pressure is likely to increase next year.

Overall, France is, in my view, the best reform play in Europe at a time when reforms are losing momentum in Germany and Italy, and when Spain and the UK are likely to be hit by the housing downturn. Even if GDP growth slowed more than we currently anticipate, I would stick to my view. Slower growth might not be that bad for the reform process, as we saw in Japan and Germany.

By Eric Chaney London
Morgan Stanley
December 16, 2007