With its ‘AAA’ credit rating hanging by a thread and an economy lurching back to recession, France faces the choice of driving through reforms that have eluded governments for decades or risk the debt crisis dragging it down.
France, which came under fire again in markets on Wednesday, has a far more robust economy than the likes of Greece or Portugal but a deficit running at nearly 6 percent of GDP, and heavy banking exposure to the euro zone periphery means it will come under mounting pressure the longer the crisis drags on.
While economists say France still has fiscal room for manoeuvre, President Nicolas Sarkozy has ruled out fresh steps after a modest austerity package last week aware that, with voters’ strongly attached to generous welfare, it could prove disastrous ahead of elections next year, Reuters reports.
And with household consumption providing the motor for French growth — just as exports drive Germany’s economy — the government knows austerity measures would have painful repercussions for growth.
“France is stuck between a rock and hard place,” said Gilles Moec, senior European economist at Deutsche Bank. “If they go for additional austerity, the recession may become deeper. If they don’t, the risks are the spread will continue to widen.”
French 10-year bond yields have ballooned in the last week, pushing the spread over German benchmark Bunds to a new euro-era high of 195 basis points on Wednesday, from 40 bp in early July.
Yields of around 3.7 percent are below historic highs but are approaching levels at which some risk-wary investors say they would start to feel uncomfortable due to France’s large structural deficit.
Though it would take years of high rates to significantly shift the average cost of France’s 1.6 trillion euro debt, nervous markets are prone to panic selling, analysts warn.
“For France the danger zone is at 4 percent, because of the size of its structural deficit,” said Bertrand Lamielle, head of asset management at Paris-based B*Capital.
Sounding an alarm bell, the Lisbon Council think tank warned in a report on Tuesday that France’s position was by far the least healthy of the euro zone’s AAA-rated countries and it urged reforms to the labour and product markets and public sector cutbacks. France has the euro zone’s highest level of government spending at around 54 percent of GDP.
France’s generous social model has long been a sacred cow. In 1995, an attempt by then Prime Minister Alain Juppe to reform the welfare state caused the biggest social conflict since 1968 and helped jettison the right from power.
While analysts say a looming recession and spiking yields could force Sarkozy to open a debate on the social model ahead of April’s election, fears of France being forced out of monetary union are wildly overstated.
“Anyone saying that France isn’t strong enough to be in currency union with Germany is getting it wrong,” said Julian Callow, chief European economist at Barclays Capital.
“That said, there are going to be challenges for France: There needs to be a lot more fiscal adjustment.”
The roots of France’s current problems run deep. Since the birth of the euro in 2002 — and while Germany undertook tough labour and welfare reform — France ploughed productivity gains into higher wages and persisted with its 35-hour working week.
French manufacturing labour costs, once a competitive advantage, have long since overtaken Germany’s. From running 8 percent below German salaries in 2000, French wage costs now stand 10 percent higher at 33.40 euros per hour, according to the MEDEF employers federation.
In a lost decade for French industry, its share of world trade in goods went from 4.7 percent in 2000 to 3.5 percent in 2010, while Germany stayed roughly steady around 8.5, according to MEDEF.
“France’s trade position has gradually weakened … and it’s hard to see how consumption can continue to drive the economy,” said Silvio Peruzzo, European economist at RBS, which is predicting flat to negative growth for France next year. “Risk-wise, there is plenty of downside.”
Underlying the problem of France’s rising wages is the hidden cost of one of Europe’s most generous welfare systems. MEDEF said that for every 100 euros of gross labour costs in France, half goes on social charges, versus 28 euros in Germany.
The employers group called on French politicians on Tuesday to follow Berlin’s 2007 move to use value-added tax to fund welfare, while shifting more of the burden of social payments from firms to employees.
“Lowering debt involves dynamising the economy by giving our companies the chance to invest, spend and hire,” said MEDEF President Laurence Parisot.
Sarkozy — who trails his Socialist presidential rival Francois Hollande in polls — has so far steered clear of tough labour and welfare reforms, preferring to cut tax exemptions rather than government spending.
However, there are signs of change. On Tuesday, he launched a high commission on welfare funding, saying France’s system of levying social fees on salaries was hurting the economy.
Polls suggest voters, alarmed that the deepening crisis could touch France, are ready to tighten their belts and unions have been low-key in recent months.
“We need a much more rigorous handling of our public finances. We need to cut spending and put in place an austerity programme,” said Philippe Caffiot, a business executive in his 50s. “There will be a social backlash, but it’s what we need to move things forward more quickly.”
Analysts say the example of a 1983 “austerity turn” to slash spending and fight inflation under former Socialist President Francois Mitterand shows France is capable of knuckling down in times of crisis — something the current generation of politicians would still remember.
“In the past, France has demonstrated that it can get its fiscal house in order … I don’t think we’re looking at a situation where France gets shut out of debt markets,” said Malcolm Barr of JP Morgan, which predicts an economic contraction of 0.2 percent next year but still sees France in a very different position to Italy.
“I don’t think you look at France and say the only way that you can make it out of this is by restructuring,” said Barr. “The rise in French yields is more to do with contagion … which plays into the argument that the ECB should be playing a bigger role to calm markets.”
With an economic downturn looming, many investors are already discounting the loss of the ‘AAA’ rating after a warning from Moody’s that France’s stable outlook was under review. That would have knock-on effects for the efficacy of the euro zone’s EFSF rescue fund which relies on France’s rating for its own ‘AAA’.
For Deutsche’s Moec, the ECB is therefore likely to be called into a more active role, meaning that the fate of euro zone countries like France may not rest in their own hands.
“The market is waiting for something global in Europe,” said Moec. “National government action is a prerequisite to anything but it is not necessarily sufficient.”