France: Staff Report for the 2004 Article IV Consultation

The staff report for the 2004 Article IV Consultation on France highlights economic performance and near-term outlook and policies. On structural issues, a health care reform has established the key instruments to gain control over the system’s budget. Ongoing civil service reform and decentralization are providing the opportunity to realize efficiency gains. Pension and health care reforms have improved the long-term fiscal outlook against the background of the impending demographic shock, while ongoing reforms in product markets are likely to boost growth.

Abstract

The staff report for the 2004 Article IV Consultation on France highlights economic performance and near-term outlook and policies. On structural issues, a health care reform has established the key instruments to gain control over the system’s budget. Ongoing civil service reform and decentralization are providing the opportunity to realize efficiency gains. Pension and health care reforms have improved the long-term fiscal outlook against the background of the impending demographic shock, while ongoing reforms in product markets are likely to boost growth.

I. Background

1. The cyclical recovery is well under way, but structural weaknesses and adverse demographics inhibit long-term growth. Triggered by foreign demand in mid-2003, the rebound in activity is now firmly led by private domestic spending, reflecting, inter alia, supportive policy conditions and the unwinding of a household savings overhang. Beyond the cyclical recovery, growth is impeded by structural factors, such as a high tax burden, adverse demographics, and low productivity growth. Moreover, fiscal sustainability is not yet secured, owing to a high structural deficit, rising dependency ratios, and increasing public spending on health care and labor market policies.

2. Policies have had mixed results in achieving the intertwined objectives of fiscal sustainability and higher long-term growth, in part owing to concerns about social cohesion (Box 1). Key reforms of the pension and health care systems have been tackled and steady advances are being made in product markets. However, rigid labor markets stand in the way of reaping full benefits from the latter and prevent higher labor utilization from translating into fiscal consolidation. Indeed, measures to promote labor supply and demand—while having contributed to a positive record on employment—are weighing heavily on the budget. This is particularly the case for those measures taken to mitigate the adverse consequences on labor costs and supply of the implementation of the reduction in the workweek. The gradual approach to reform reflects a tension between widely held recognition of the need for change and equally widely spread concern that the associated retreat of the state would place low- and middle-income citizens at a disadvantage. This tension was evident in discussions of the mission with social partners, with labor unions indicating that reforms (and the adoption of Fund advice) would raise social exclusion and inequity, and employers noting that high labor costs and regulatory burdens put them at a competitive disadvantage.

II. Policy Discussions

3. The discussions focused on the outlook and where to strike the balance between up-front fiscal adjustment and structural reforms in the pursuit of fiscal sustainability. With the authorities perceiving confidence as still fragile, they favored a strategy of continued support to consumers, measured fiscal adjustment, and selected labor and product market reforms. For fiscal sustainability, they emphasized growth-enhancing structural reforms with moderate up-front consolidation. The staff saw a need for deeper reforms, especially in the labor market.1 As such reforms were not in the offing, it argued for a heightened focus on fiscal adjustment.

Past Fund Policy Recommendations and Implementation

Successive governments have concurred broadly with the direction of the Fund’s economic policy advice but have underscored the importance of social cohesion, expressed in generous welfare arrangements and a narrow income distribution. Policies have been marked by the tension between this focus and the concomitant quest for fiscal discipline and higher long-term growth, resulting in a gradual approach to reform. The dialogue with staff on these issues has been traditionally open and frank.

Fiscal policy: The Fund’s long-standing advice to consolidate at an annual average pace of 0.5 percent of GDP until structural balance or surplus is achieved was not followed during 2000–03. Tax cuts induced by an overestimation of the strength of structural revenues and expenditure overruns increased the structural deficit. In line with Fund advice, pension reform has appreciably diminished the projected cost of aging and health care reform is making inroads, but civil service reform is yet to start in earnest. The authorities do not see room for sizeable expenditure cuts that would permit a much-needed early reduction in the tax burden.

Labor and product markets: The Fund has called for increasing flexibility in labor markets, especially in the context of the reduction of the workweek to 35 hours. The attendant increase in labor costs is being mitigated by cuts in social security contributions and improved labor organization, allowing more people to find jobs, but the overall net effect on potential output is negative while the costs to the budget are high. In line with Fund advice, additional flexibility was introduced, especially for smaller firms. Reform of labor market institutions and entitlements (other than pensions) remains to be tackled. In product markets, divestiture and deregulation are ongoing, albeit at a slower pace than advised by the Fund.

Financial sector: In line with Fund advice, the financial sector has been subject to strong supervision. The authorities have been reluctant to phase out widespread administrative interventions in financial markets, but some saving schemes have become more market-oriented.

Trade policy: The Fund has called on France to help advance trade liberalization, partly through a reform of the Common Agricultural Policy (CAP). Though the authorities agree in principle, and CAP reform is to be implemented in 2007, they have publicly voiced strong reservations about recent proposals, which they see as unbalanced.

A. Economic Performance and Near-Term Outlook and Policies

4. Domestic demand has become the engine of growth. Following a weak first half of 2003 marred by geopolitical uncertainties, rising unemployment, faltering income growth, sticky downward adjustment of domestic retail interest rates and low overall confidence, a rebound in exports in mid-2003 initiated the current cyclical upturn (Figure 1 and Table 1). The subsequent strength of domestic demand, also in comparison to other major euro-area countries, was seen to owe much to the favorable starting point of the French economy: household savings were atypically high; the financial sector was very profitable; corporate balance sheet difficulties were confined to a limited number of large companies; and the housing sector was relatively robust (Table 2).2 Moreover—a point that the authorities emphasized—policies had been geared to inspire confidence. Pension reform had preserved the level of benefits, albeit at the expense of working longer; minimum wage increases had boosted income of the cash-constrained; the suspension of a tax on productive assets for new investments (the taxe professionnelle) helped investor confidence; and several minor fiscal measures taken in 2004 supported household consumption (e.g., an interest deduction for consumer credits, a suspension of a tax on wealth transfers to the younger generation, and an agreement with the distribution sector to decrease prices on brand name products to break higher-than-actual inflation perceptions).3 In the authorities’ view, these policies had paid off in the form of a relatively early and robust recovery compared to other large euro-area economies.

Figure 1.
Figure 1.

GDP and Demand Components

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: INSEE, Quarterly National Accounts; and IMF, WEO.1/ Contribution to GDP growth.
Table 1.

France: Main Economic Indicators, 2000-09

(Annual percentage change; unless otherwise indicated)

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Sources: Bank of France; data provided by the authorities; and IMF staff estimates.

Data from the INSEE quarterly national accounts system.

Change as percentage of previous year’s GDP.

Harmonized CPI.

For 2004, year on year, July.

In percent of labor force; harmonized index.

GDP over total employment.

Personal disposable income deflated by the implicit deflator for private consumption.

In percent of household disposable income.

In percent of potential GDP.

Index; Base 2000=100.

In percent of GDP; data for 2001-02 excludes the proceeds from the sale of UMTS licenses, which amount to about 0.1 percent of GDP.

Table 2.

France: Vulnerability Indicators, 1999-2004

(In percent of GDP)

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Sources: Banque de France; IMF, International Financial Statistics; Bloomberg; FNAIM; and Commission Bancaire.

This index combines the effect of real disposable income, repayment conditions for loans, real estate prices, and public incentives for the purchase of houses.

Refers to metropolitan France.

All credit insitutions aggregated data on a parent-company basis.

5. The strength of private consumption was seen as reflecting both fundamental and exceptional factors (Figure 2 and Box 2). During the initial phases of the downturn, household saving had, somewhat paradoxically, continued to rise, despite a decline in real disposable income as a result of job losses, moderate wage increases, lower nonwage income, and higher energy and food prices. There was consensus that wealth effects were weak in France while higher-than-actual price perceptions and low confidence had delayed spending. Consequently, when the economy turned, this backlog of consumption began to unwind. Declining real interest rates also buttressed the rise in the propensity to consume. The authorities stressed that exceptional factors—subnormal temperatures, extended sales, and higher out-of-pocket medical expenses—boosted household consumption in the first quarter of 2004 and saw a need to sustain it, while staff saw somewhat greater underlying strength, subsequently confirmed by second quarter data.

Figure 2.
Figure 2.

Private Consumption

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: INSEE, Quarterly National Accounts; and IMF, WEO.

6. Fixed investment is benefiting from a catch-up. As noted at the time of the 2003 Article IV Consultation, business investment had been weaker than expected during the downturn, with replacement investment being postponed (Figure 3). Partly because of accounting scandals, which had raised perceptions of heightened balance-sheet risk, companies were strengthening self-financing capacity, prompting widespread deleveraging. With presently healthier balance sheets, improved demand prospects, and equity markets well off their post-bubble lows, corporate investment is rebounding strongly. Residential construction has moved up, reflecting several years of sustained real house price increases and low interest rates.

Figure 3.
Figure 3.

Gross Fixed Investment

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: INSEE, Quarterly National Accounts; and IMF, WEO.

7. Employment held up better than in previous downswings, especially initially, and the rise in unemployment appears to have ended already in early 2004, helped by a slowing of labor supply growth (Figure 4). Payrolls fell modestly in 2003 as cyclical and secular layoffs in industry exceeded the services sector’s capacity to create jobs. The end of the adoption of the shorter workweek and the phasing-out of some public employment programs also played a role.

Figure 4.
Figure 4.

France: Employment and Unemployment

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: OECD, Economic Outlook; and GDS, Quarterly Accounts.

Household Consumption: is its Recent Strength Enduring?

Following a sharp increase during the 1990s and the initial phase of the recent cyclical downturn, the conventionally-measured household savings rate has dropped sharply since mid-2003, raising the question of the sustainability of the rebound in private consumption.

A01ufig01

Inflation Perception and Reality

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: European Commission Business Confidence Survey; and INSEE.

Perceptions of stronger-than-reported inflation, uncertainties surrounding social security reforms, and poor employment prospects appear to have restrained spending through most of 2003. These factors opened a gap between long-term equilibrium and actual consumption. The first one, as reported in surveys, has been attributed to sharp price increases in some highly visible consumption goods and services after the introduction of euro notes and coins. With the wedge between measured and perceived inflation no longer widening, pension and health care reforms clarified, and economic recovery under way, the current strength of household consumption (abstracting from the exceptional factors in early 2004) is not too surprising. In addition, income support and wage increases at the bottom of the income distribution are likely to have temporarily elevated the propensity to consume.

A01ufig02

Consumption and Total Wealth

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: INSEE; and IMF staff calculations.

Moreover, equilibrium consumption may well be lower than it could be because of incomplete financial markets which limit the possibility of converting gains in nonfinancial wealth into liquidity. Indeed, the secular increase of French household savings in the 1990s contrasts sharply with the observed decline in other countries, attributed to gains in wealth of which France also benefited.

Staff analysis, using aggregate time series econometrics, confirms that consumption (of nondurables) tracks real disposable income closely in France, but that wealth effects matter as well (see Selected Issues paper). The latter are, however, smaller than in the United States, and the impact of nonfinancial assets (housing) remains uncertain. These results are compatible with strong risk aversion of households and incomplete financial markets. Consequently, while the outlook for consumption remains bright, there is also a role for policies to improve the working of consumer and mortgage credit markets and strengthen confidence through growth-oriented structural reforms.

Conversely, labor hoarding and wage moderation contributed to a higher labor intensity of output, particularly during the initial phase of the downswing (Figure 5). Targeted cuts in social security contributions helped sustain employment, resulting in a substitution of low-skilled labor for capital and high-skilled workers, and in a slowdown in measured labor productivity growth. Consequently, unemployment increased less rapidly than in the past, helped also by diminishing labor supply growth owing to demographics and early retirements.

Figure 5.
Figure 5.

Labor Intensity of Output

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: OECD, Economic Outlook.

8. There was agreement that the recovery was well under way with downside risks centered on external factors. The authorities concurred that growth would be close to 2.5 percent in 2004, significantly higher than the 1.7 percent underlying the 2004 budget—but new official forecasts will not be available until the fall. Risks to the outlook seemed balanced between external factors on the downside (oil prices, the euro, and demand in the rest of the euro area) and domestic factors on the upside (mainly private consumption). It was noted that the direct effect of higher oil prices would be dampened somewhat by France’s high reliance on nuclear power, but that indirect effects through slower partner country growth could be significant. Similarly, further euro appreciation and weaker-than-envisaged domestic demand in Germany and Italy could adversely affect growth. On the other hand, house prices were not considered a key risk as their wealth effects were small (Box 2); recent price increases were seen to be largely driven by fundamentals; and household indebtedness was low by international standards. In addition, with household savings still high, private consumption could surprise on the upside, especially if employment prospects improved more rapidly. Since the mission, some elements of both up-and downside risks have materialized: domestic demand has been stronger than expected, while oil prices have been much higher. The staff projects GDP growth of 2.6 percent in 2004, in line with confidence indicators (Figures 6 and 7) and 2.3 percent in 2005.

Figure 6.
Figure 6.

Business Indicators

(Dispersion Index)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: WEFA Database.
Figure 7.
Figure 7.

Consumer Indicators

(Dispersion Index)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: WEFA Database.

9. The current account surplus is projected to turn into deficit in the near term, partly for cyclical reasons. There was consensus that the cumulated effect of euro appreciation, though not of major concern, had been leaving its mark on the external accounts, especially via tourism. Export performance had recently been comparatively weak (Figure 8), owing to the real appreciation of the exchange rate vis-à-vis other EU countries and structural factors, in particular the pattern of regional trade (with the high weight of Germany where domestic demand remained weak) and product specialization (e.g., the airline industry, affected by geopolitical turmoil). In the near term, with domestic demand running ahead of that of major euro-area trading partners, the trade balance and current account are projected to move into a deficit.

Figure 8.
Figure 8.

Real Effective Exchange Rates and Export Shares

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: IMF, IFS and DOT.

10. Inflation is expected to remain persistent for some time. Headline inflation has continued to run well above 2 percent, buffeted by energy and service price rises and increases in regulated prices and indirect taxes (Figure 9). The authorities underscored that the latter had accounted for over one-third of overall inflation by early 2004, contributing to a large French-specific inflation component (Figure 10). Some of these factors as well as low productivity gains and increases in minimum wages also explain the persistence of underlying inflation (at about 1.6 percent), despite the slack in the economy and past euro appreciation. Looking ahead, health care reforms were likely to sustain underlying inflation in the near term. In addition, higher-than-expected oil prices foreshadow higher headline inflation. The staff nonetheless sees the latter retreating to less than 2 percent in the course of 2005. As emphasized by the authorities, it will be important to avoid second-round effects from energy and regulated price hikes.

Figure 9.
Figure 9.

Inflation Components

(Annual growth rates)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: Cronos Database.
Figure 10.
Figure 10.

France: Harmonized Consumer Price Inflation 1/

(Annual percent change)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: Cronos Database; and IMF staff estimates.1/ The common and idiosyncratic components are estimated using the generalized dynamic factor model proposed by Forni and others (2003), which uses the dynamic covariance structure of a panel of 12 euro-area HICP from January 1997 to July 2004.

11. The authorities agreed that monetary conditions were supportive and that a closer link between administered and market interest rates would facilitate monetary transmission. The decline in real interest rates had offset most of the impact of the euro’s appreciation (Figure 11). Short-term real interest rates were close to zero, and long-term rates appeared consistent with growth at potential rates. Nonetheless, the staff observed that domestic retail interest rates had adjusted very slowly to reductions in the ECB’s policy rates, owing to administrative interventions in financial markets. Consequently, during the recent easing cycle, this sluggishness was estimated to have caused consumption to be lower by 1.7 percentage points compared to the counterfactual of immediate pass-through (see Selected Issues paper). It was agreed that the new interest rate adjustment mechanism in place since mid-2003 would strengthen the response of domestic interest rates,4 though the authorities recognized that it still did not render it instantaneous and did not apply to all administered rates. While generally disposed toward closer alignment of administered and market rates, the authorities were not inclined to phase out administered savings schemes in the near term, inter alia pointing to their use to finance social housing.

Figure 11.
Figure 11.

France: Monetary Conditions

(Using underlying CPI)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: Datastream-Thomson Financial; Cronos database; and IMF, IFS.1/ The monetary conditions index is a weighted average of the real effective exchange rate and the short-term real interest rate, with weights, 1 and 2.5, respectively. A higher index implies tighter conditions.

12. With growth exceeding expectations, staff stressed that a resumption of fiscal consolidation would not threaten the recovery. In 2003, against the weak economic environment, the fiscal stance had been supportive, as automatic stabilizers had been allowed to play fully, and no structural adjustment took place. As a result, the deficit widened from 3.3 percent of GDP in 2002 to 4.1 percent of GDP in 2003. For 2004–05, the fiscal stance was set to be moderately restrictive. The staff noted that the fiscal measures implemented in early 2004 to boost consumption seemed unnecessary, but agreed that they had been confidence-enhancing and would have virtually no impact on the budget.

B. Fiscal Consolidation Strategy

13. Concerned with rising public debt, the authorities were keen to resume fiscal adjustment (Figure 12). They agreed that without adjustment, the debt ratio was vulnerable to significant increases over the next five years, especially if growth faltered, as brought out by the standard debt sustainability analysis (Table 3). While higher-than-anticipated growth could allow the nominal 2004 budget deficit objective to be achieved (3.4 percent of GDP), the envisaged structural adjustment will be lower than originally targeted (0.6 instead of some 0.8 percentage point of GDP). At the central government level, freezing credits and postponing some expenditure, as in 2003, will allow spending to respect nominal budget limits. But slippages continue in health care, and the delay in lowering the duration of unemployment benefits will also weigh on the budget.5 Nonetheless, spending is falling as a share of GDP, in part due to higher-than-projected inflation (Text Table 1). There was agreement that all revenue windfalls from higher nominal growth in 2004 should be fully saved. Furthermore, the authorities saw scope to reduce gross debt through divestiture and sold part of their stake in France Télécom in September.

Figure 12.
Figure 12.

General Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: INSEE.
Table 3.

France: Public Sector Debt Sustainability Framework, 1999-2009

(In percent of GDP, unless otherwise indicated)

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Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π(l+g) - g + αε(l+r)]/(l+g+π+gπ)) times previous period debt ratio, with r = interest rate; n = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and s = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/as r - π (1+g) and the real growth contribution as -g.

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and primary balance) remain at the level in percent of GDP/growth rate of the last projection year.

Text Table 1.

General Government - Current Policies

(In percent of GDP)

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Sources: Data provided by the authorities; and IMF staff calculations.

Staff projections are based on the authorities’ 2004 budget, plans for freezing central government level spending, health care reform, and cuts in social security contributions, adjusted for the staff’s macroeconomic assumptions and judgment on social security spending.

Through upfront fiscal consolidation, this scenario allows growing pension spending over the next 50 years to be offset by lower interest payments due to the declining public debt burden. Sustainability is defined as the public debt-to-GDP ratio stabilizing at the same horizon as the dependency ratio.

Same as in footnote 2 but with structural reforms raising the employment rate to 70 percent by 2010. The public debt-to-GDP ratio stabilizes at a higher level, requiring less fiscal consolidation.

14. The authorities’ principal near-term objectives are to reduce the overall deficit to less than 3 percent of GDP in 2005 and to 2.5 percent of GDP in 2006, which on current projections implies only a modest structural adjustment. Though no final decisions had been made, the authorities generally agreed that there was no room for new tax cuts over this horizon. They also felt that it would be difficult to reach these budget objectives without higher-than-anticipated growth or the help of one-off factors, such as the transfer of pension funds from the public utilities. Keeping central government spending constant in real terms would not suffice to cover the start-up costs of health care reforms, while the reforms might not succeed in reducing the health system’s deficit as much as planned (¶18). In the event, growth now looks stronger than envisaged, bringing the nominal targets within reach without other measures. However, achieving them would represent a cumulative structural adjustment of only about 0.5 percentage points of GDP over 2005–06. Consequently, the staff called for more ambitious consolidation (¶16). A supplement to this report covering the 2005 budget will revisit these issues.

15. The emphasis of the authorities’ long-run fiscal consolidation strategy appears to have shifted away from medium-term budget balance and toward growth-enhancing structural reforms. While the latest Stability Program update (December 2003) aimed for a near structural balance by 2007, in this year’s preparatory document for the 2005 budget, the authorities argued that the fiscal consequences of aging should be dealt with mainly through reforms (about two-thirds), but less (the remaining one-third) through direct fiscal adjustment. Assuming successful pension and health care reform—which had been completed—and further to-be-identified structural reforms, the document presented as sustainable a scenario based on a long-term average structural deficit of about 1 percent of GDP. The authorities underscored that this however required a considerable adjustment from the present structural deficit, estimated at about 2.5–3.0 percent of GDP. In setting compliance targets under the Stability and Growth Pact, whose usefulness they stressed, they argued against a “one-size-fits-all approach” (represented by the close-to-balance rule) and in favor of taking into account country-specific circumstances, such as the initial level of public debt and the remaining unfunded costs of aging.

16. The staff supported the emphasis on growth-enhancing structural reforms, but stressed that the current reform agenda would need to be strengthened appreciably to meet the challenge and that direct fiscal consolidation would also need to contribute. To illustrate the magnitude of the challenge, assuming that current structural reforms are on track to lower the NAIRU to 7 percent in the next 5 years6, fiscal sustainability through up-front adjustment would require an overall structural surplus of 0.7 percent of GDP by 2008, 2.2 percentage points more than under current policies (Figures 13 and 14 and Text Table 1).7 A decisive reform strategy that would raise the employment rate from 63.4 percent8 in 2003 to 70 percent by 2010, significantly reduces, but does not eliminate, the need for up-front fiscal adjustment. It requires lowering the structural deficit to about 0.5 percent of GDP by 2008, implying additional adjustment of 1 percentage point compared to current policies.9 Such an ambitious reform strategy, while highly desirable in the staffs view, is, however, not currently on the agenda. Consequently, until it is, the staff saw a need for sustained expenditure-based adjustment at a pace somewhat more than three-quarters of one percent of GDP per year until a small structural surplus is achieved. However, given the high tax burden, as future structural reforms are implemented and pay off in terms of higher long-term growth, further growth-enhancing tax cuts should be moved up on the agenda. Such a move could be considered when a small, enduring structural surplus is achieved.

Figure 13.
Figure 13.

Overall Balance Scenarios

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: Data provided by the authorities; and IMF staff calculations.
Figure 14.
Figure 14.

Public Debt Scenarios

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Sources: Data provided by the authorities; and IMF staff calculations.

17. Progress on structural adjustment will require breaking the pernicious link between the budget and labor market policies. The authorities had become well aware of the high budgetary cost of their active labor market policies (mostly cuts in social security contributions and to a lesser extent the earned income tax credit—together estimated to amount to 1 percent of GDP by 2005). These policies had been instituted to offset the adverse consequences on labor costs and employment of high and rising minimum wages, the mandatory 35-hour workweek, and high marginal tax and benefit replacement rates. This circle was set to take another vicious turn in 2005 with a large step increase in the minimum wage (SMIC) (3.8 percent in real terms), accompanied by partly offsetting cuts in social security contributions.10

To mitigate the budgetary impact of these policies, the authorities were considering various options: (i) spreading the minimum wage increases over time; (ii) narrowing the salary range over which social security contributions are reduced (it currently reaches up to 1.7 times the SMIC); (iii) reducing the upper income limit of the earned income tax credit; and (iv) reforming the workweek restrictions and employment protection.11 However, at the same time, a new “social cohesion” plan had been announced at significant budgetary cost and with uncertain implications for labor market performance (¶25). The staff urged the authorities to fund this plan out of existing resources and to focus on reforming employment protection and entitlements, which would have large benefits in terms of employment and possibly positive effects on the budget.

18. There was consensus that effective health care, pension and civil service reforms and well thought-out decentralization would be key avenues for fiscal consolidation:

  • Health care reform had been well designed but its ultimate effectiveness would depend on its implementation (Box 3). The reform establishes the instruments to gain control over the system’s budget, by putting in place mechanisms that can adjust key parameters to influence behavior of patients, providers, and insurance agencies and the revenues of the system. Nonetheless, there was a general perception that the initial parameters chosen were too timid to ensure the stated objective of a return to balance of the health system’s budget by 2007, though it was agreed that estimating the budgetary impact of measures designed to affect behaviors was difficult.

Health Care Reform

Total and public health care spending (three quarters of total) are relatively high in France, and public spending has been growing faster than targeted. Between 1997 and 2004 (March), it rose by 4.7 percent per year, compared to a norm of 3 percent and disposable income growth of 3.3 percent. Health care is generally perceived to be of high quality.

A01ufig03

Health Care Spending in 2001 (Per Capita, PPP Based)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: OECD, 2003 Health Data.

The sources of spending pressure have included widening coverage, increasing tariffs of consultations, escalating prices of pharmaceuticals, mounting personnel costs due to the workweek reduction, and rising service volumes related to technological progress and an increase in the share of population closer to death.

Following several piecemeal measures, a comprehensive health care reform was approved in mid-2004 with the aim of balancing the books by 2007, while increasing quality and preserving equal access. The reform introduces the possibility to modulate all key parameters governing the behavior of patients, medical professionals, and insurance agents. The initial values of the parameters chosen, together with measures taken to raise revenues, are officially estimated to yield budgetary savings of about €15 billion in 2007, equivalent to the ministry of health’s projection of the deficit before measures:

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The measures appear insufficient to eliminate the projected budget deficit, which itself may be underestimated. The impact of expenditure control measures is highly uncertain, transfers from the state do not lower the general government deficit, and the higher costs of operating an improved administration of the health care system have not been taken into account. Moreover, the system’s trend deficit before measures is projected by the health insurance agency (CNAM) to reach €23 billion by 2007.

  • The 1993 and 2003 pension reforms have brought the projected costs of aging in France to well below the euro-area average and established regular five-year reviews to secure the system’s sustainability.12 While these reforms need to mature before considering further changes, the staff argued for phasing out early retirement schemes and reducing the generosity of some special retirement regimes, particularly when funded by the taxpayer.

  • The nonreplacement of retiring civil servants had so far been used only symbolically, far short of the guideline that on average only one out of two positions should be retained.13 With personnel expenses topping 40 percent of the budget envelope (Table 4), the authorities agreed that more efforts were needed in this area, but political appetite was lacking.

  • The authorities saw decentralization as an opportunity to better tailor public services to local needs and achieve efficiency gains, particularly in the areas of education, infrastructure, and social programs. Acknowledging the merits of such an approach, staff urged the authorities to allow sufficient fiscal autonomy and own resources to local governments so as to induce them to improve spending efficiency. To this end, staff suggested the introduction of a local surcharge on either the personal income tax or the general social security contribution (CSG), but the authorities felt that implementation difficulties would offset potential gains.

Table 4.

France: General Government Accounts, 1996-2003 1/

(In billions of euros)

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Sources: INSEE; and IMF staff calculations.

Excludes UMTS receipts.

Annual national accounts; Maastricht definition.

19. The authorities were examining the scope for closing tax niches, but in the absence of room for tax cuts were reluctant to make wholesale changes to the tax structure. They nonetheless felt the need to remove the taxe professionnelle (TP)—a highly distortionary tax on capital that had been suspended in January 2004, initially for 18 months and now through end-2005—but found it difficult to identify workable alternatives. This tax is a major source of financing for local governments and is seen to establish a politically important link between industry location and local tax revenues. The staff argued that more reliance on charges and fees for services provided to enterprises, as well as households, should be considered. The mission’s call for higher real estate taxes and the abolition of preferential VAT rates14 to replace some of the TP along with a local surcharge on income taxes were met with little enthusiasm.

20. The authorities recognized that preserving cyclical revenue windfalls would be key to fiscal consolidation, but their proposed rule fell short of full operation of automatic stabilizers. Mindful of previous episodes when cyclical windfalls had given rise to permanent tax cuts (e.g., the “cagnotte” episode in 2000), the authorities were seeking to enshrine in law a mechanism that would avoid such events. Their proposal would earmark at least (authorities’ emphasis) two-thirds of higher-than-budgeted revenues for deficit reduction, and limit use of the remainder to temporary tax cuts or investment spending, and only in the year following the windfall. The staff advocated full play of automatic stabilizers and noted that the authorities’ proposed rule was asymmetrical and procyclical, which in other countries (e.g., the Netherlands) had given rise to structural slippage. The authorities responded that the staff proposal left policy-makers with no room for maneuver and would not be politically enforceable. Their simulations showed that application of the rule even with permanent tax cuts or spending increases would lead to a structural budget deterioration over a typical cycle of only about 0.1 percentage point of GDP per year. Moreover, they stressed that no windfalls would be spent in 2004 and, more generally, until the deficit fell below an acceptable threshold. The staff welcomed this intention—which it felt would need to be adhered to well beyond 2004—and questioned the political feasibility of “temporary” tax cuts or spending increases as envisaged under the authorities’ proposed rule.

21. Other measures were under way or under consideration to strengthen the fiscal framework. The new budget law would be fully applied in 2006 requiring zero-base budgeting and multi-year programming for spending agents. The preparation of its implementation was already improving spending control at the central government level, including through early interministerial coordination. The budget law would also promote using spending ceilings in terms of levels. A multiyear budgeting approach for social security and an internal stability pact with local authorities are under consideration. The authorities saw merit in the staff proposal to establish an independent agency to conduct forward-looking budget assessments. The staff also called for a higher frequency of publication of government accounts, including by sub-levels, to improve transparency and accountability.

C. Labor and Product Markets

22. There was agreement that labor and product market reforms were needed to lift potential growth prospects. Key weaknesses lie in low participation and employment rates and declining numbers of hours worked. Moreover, adverse demographics would soon reduce the labor force, and total factor productivity growth had declined, though this was seen as a likely transitory phenomenon while low-productivity workers were being absorbed in the labor force. High minimum wages were pricing the low-skilled out of employment, and high replacement income reduced labor supply, both requiring costly budgetary intervention to mitigate adverse effects on employment. In turn, high public expenditure perpetuated the heavy tax burden with likely negative implications for potential growth.

23. The staff pressed for comprehensive reform of labor market institutions to raise the labor utilization rate. It argued for reshaping the employment protection system to clarify the role of the judiciary and reduce firing costs15 and a reorientation of the entitlement system toward encouraging job search. Indexation of benefits and minimum wages should henceforth be linked to underlying inflation and not to wages and the duration of benefits could be further shortened. Regarding active labor market policies, staff encouraged measures that emphasized training, especially on the job, and facilitated the hiring of low-skilled youth (Box 4). It also underscored that product market deregulation had raised the potential returns from increased labor market flexibility but that, aside from wage moderation, labor market rigidities appeared to have increased in the 1990s (Figure 15).

Figure 15.
Figure 15.

(De)regulation of Labor and Product Markets (1982=100)

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Source: OECD.The labor market policy indicator covers employment protection, benefit replacement rates, and benefit duration. The product market reform indicator covers product market reforms over the 1975–98 period in the nonmanufacturing sector (see Chapter IV in the April 2003 World Economic Outlook for details).

24. The authorities responded that several of the staff’s suggested labor market reforms were under way or under consideration, but saw the lowering of benefits and replacement rates as running counter to the government’s emphasis on social solidarity. In addition, they stressed that recent increases in benefits and minimum wages had helped sustain confidence and household consumption. They had also extended the possibility for social partners to negotiate derogations from the strictures of the 35-hour workweek—which so far has been used only marginally—and allowed for the establishment of private employment agencies. They agreed that cumbersome labor laws and excessive court involvement in layoffs offered “employment protection” in the short run, but ultimately reduced labor demand by making firing decisions costly and uncertain. For the time being, they had deferred the initiative for modifications in this area to social partners, which seemed however reluctant to take up negotiations in earnest. The staff acknowledged that several of these measures were beneficial, while emphasizing that increases in benefits and minimum wages would have adverse long-term effects on labor market performance.

Youth Unemployment, Job Mobility, and Wage Growth

Over the last decade, similar average unemployment rates in France and Germany have masked large differences in youth unemployment. While the latter matched the average in Germany, in France it has been about twice as high (Figure).

A01ufig04

Aggregate Unemployment Rate by Age

Citation: IMF Staff Country Reports 2004, 343; 10.5089/9781451813463.002.A001

Economic theory does not unequivocally predict the role of early labor market experiences for long-term wage and employment prospects. High youth unemployment rates reflecting excessive job mobility may prevent on-the-job training as human capital theory suggests that experience accumulation depends on the amount of time spent working. Conversely, high job mobility of the young may not be a problem if it reflects search for better employment opportunities. However, high unemployment does not necessarily imply high mobility.

Staff analysis suggests that youth in France are not in a beneficial search-induced high-mobility equilibrium and that returns to on-the-job experience are lower in France (see Selected Issues paper). In fact, job mobility and its contribution to wage growth are similar in both Germany and France. From a decomposition of wage growth in “on-the-job” and “between-jobs” wage growth, it appears that “between-jobs” growth contributes similarly to the wage growth of young workers in both countries. Moreover, differences in the amount of time spent working due to different unemployment spells are insufficient to explain lower on-the-job wage growth in France. Consequently, lower returns to experience seem a likely, if partial, culprit. One implication is that on-the-job experience appears to be an imperfect substitute for explicit training. A comparison of hourly wage profiles suggests that workers with vocational and intermediate level of education might be undertrained in France compared to Germany. For these workers, more explicit training arrangements may be beneficial, provided their cost is shared between the worker and the employer. Recent measures to promote training contain elements that move in this direction.

25. The staff was critical of the new “social cohesion” program. While the plan is commendable in its striving for reduced welfare dependency and exclusion, it falls back into the trap of using fiscal resources to promote employment, initially outside the private sector. Inter alia, the program aims to move a large number of young unskilled unemployed into jobs combined with training with exoneration from social security contributions. Public sector jobs will be created for 100,000 of them. An individual contract is to be signed with revamped local employment agencies, and close follow-up is envisaged, which will require increased budgetary resources. The staff argued for a better balance between rights and obligations of participants so as to enhance the focus on moving people into market jobs.

26. Progress has been ongoing in product market reform, but a broader approach is needed. The authorities noted that the regulatory burden on existing firms had eased and formalities involved in creating new enterprises been simplified appreciably. Network industries were being opened to cross-border competition, and the statutes of the public electricity and gas companies (EDF/GDF) had been changed—in the face of strong employee opposition—to introduce the possibility of private participation in their capital. The authorities saw this change as significantly outweighing the concessions that had been made (such as the retention of a majority stake). A new government agency (Agence de Participations de l’Etat) had strengthened the governance of state participation in enterprises, and divestiture was being accelerated. The authorities concurred with the staff on the benefits of speeding up the transformation of public enterprises and closing the considerable transposition gap in EU internal market and competition directives. They also intended to modify legislation to strengthen competition in the retail distribution sector.

27. The staff welcomed the acceleration of divestiture but was critical of the heightened emphasis on “national champions”. This emphasis was most recently manifested in the support for a French partner in a pharmaceutical merger and the rescue of an engineering firm. The staff noted that such an approach reduced competition, created vested interests, deterred private investors, and constituted a form of protectionism. The authorities dismissed these concerns and made clear they were committed to divesting the state from participation in commercial activities, unless a strategic interest was involved. They felt that, in supporting key industries, France was in practice no different from other countries, but was simply more vocal about it, and that, in contrast to the rhetoric, France was in reality very open to foreign participation. In any event, the new bankruptcy law would make involvement of the state in rescue operations increasingly unnecessary as it would allow easier restructuring of enterprises as going concerns.

D. Financial Sector

28. The FSAP found that supervision and oversight of the financial sector are of high standard and supervisory staff is highly qualified, and the authorities agreed with most of its recommendations (Box 5). With the economic upturn, corporate deleveraging, and equity markets well above post-bubble lows, banks and insurance companies had seen their profitability and solvency strengthen. The FSAP found no immediate systemic risks on present analysis, but recommended further strengthening of supervision through enhanced coordination between the various supervisory agencies and vigilance on banks’ risk exposure. The authorities, while acknowledging that mechanisms that encourage strong corporate governance in joint-stock companies were less effective for mutual banks, noted that such banks had developed equivalent internal mechanisms to underpin good governance. Moreover, they felt that risks were minimal as their management had proven to be trustworthy and often on the conservative side. Risks involved in branching out in nontraditional activities—which had increased recently—appeared limited as it typically occurred in the context of acquisitions, which included the required expertise, and without government guarantees.

FSAP Main Policy Recommendations

While finding the financial sector resilient and its oversight and supervision of high quality, the FSAP made the following main recommendations:

For efficiency reasons, ongoing efforts to diminish state influence over savings allocation through administered savings schemes and fiscal incentives should be accelerated, with a view to eventually establishing a fully market-based system. The key objective should be their orderly phasing out. In the short term, the focus should be on reducing the distortions caused by the schemes.

Given the degree of concentration in the financial system, continued vigilance is needed to preserve strong competition. Ongoing efforts to improve disclosure and pricing transparency for banking services should be continued. The separation of the postal office’s banking activities and their subjection to standard prudential requirements is welcome, but the newly created bank should be put as soon as possible on a “level-playing field” with other banks. Competition at the retail level and the availability of financial services could further be enhanced by eliminating the notion of “national champions” and introducing the positive credit registry.

The corporate governance and risk-taking of banks need to be monitored carefully, particularly when they expand into unfamiliar activities. Potential pressure on banks to overexpand could be eased by reducing barriers to the return of profits to owners.

Creditor rights should be improved to facilitate credit provision. The ongoing reform of the corporate bankruptcy legislation will clarify and limit the liability of creditors, while at the same time enhancing the survival chances of troubled companies. In addition, banks should be allowed to write off nonperforming loans without jeopardizing their legal claim on the debtor.

The overall legal and institutional framework for AML/CFT should be further improved in some areas, mainly: the implementation of UN Security Council Special Resolution on terrorism financing; the overall quality of suspicious transactions reporting; AML/CFT regulation, supervision and enforcement for sectors other than credit institutions and certain investment firms; and criteria for when financial institutions should exercise increased diligence.

29. There was consensus that the financial sector should be made more efficient by reducing state intervention. Staff analysis suggests that administered savings schemes interfere with monetary transmission and efficient resource allocation (see Selected Issues paper). Moreover, in light of population aging, it felt it would be sensible to focus budgetary resources on the newly-created voluntary retirement savings plan (the tax exemptions on administered savings schemes cost the budget about 0.25 percentage point of GDP per year). The staff also noted that usury rates, which are set at four-thirds of actual average interest rates, exclude some segments of the population from access to financial services, especially when interest rates are low. The authorities expressed increased readiness to contemplate changes in administered savings schemes and lift other restrictions (e.g., the interdiction of remuneration of sight deposits and the obligation to provide checks free of charge), but felt that this could not be done as immediately as staff suggested. The authorities acknowledged the need for a full and swift implementation of measures to promote disclosure and transparency of pricing of financial services, while considering the recent increases in bank fees a normalization rather than an indication of lack of competition. They emphasized that the creation of a postal bank would level the playing field in terms of supervision as the financial services hitherto provided by the post office would be subject to regular supervision.

30. The removal of obstacles to financial innovation in the area of mortgage and consumer credits is likely to be welfare improving. The authorities, who considered the French savings ratio as structurally too high, were reviewing options to facilitate household access to asset-backed credits such as mortgages and home equity loans. There were no legal obstacles, but cumbersome and expensive approval procedures as well as problems in seizing collateral were considered significant impediments. The supervisory authorities expressed concerns about the volatility of asset prices and its repercussions on the amplitude of cyclical fluctuations in demand and banks’ and households’ financial stability. They placed emphasis on safeguards in the use of instruments such as home equity loans.

E. Other Issues

31. France continues to strengthen its framework to combat money laundering and terrorist financing, remaining proactively involved in these efforts at the European and international levels, but further efforts are needed (Box 5). The OECD has judged France’s legal framework as conforming to the anti-bribery convention’s requirements, but called for a further strengthening of measures for more effective prevention and sanctioning of bribery of foreign public officials.16

32. While supporting the Doha round of multilateral trade talks, the authorities pressed strongly for what they termed a “balanced” result. In their view, the EU initiatives and offers, notably with respect to the abolition of agricultural export subsidies had not drawn an equivalent response from other major trading nations. Singapore issues—in particular trade facilitation and the protection of foreign investment—remained important, although they agreed that successful conclusion of the Round would require flexibility on all issues by all parties. More generally, the authorities expressed concern that unfettered trade liberalization might not benefit developing countries, which often did not have the ability to compete in global markets. France favored the development of local agricultural production in Africa, preferential trade agreements with the ACP countries, insurance mechanisms against volatility in certain agricultural prices such as cotton, and closer regional cooperation, reinforced by regional customs unions. The staff pressed the case for a constructive approach toward the WTO framework agreement then under negotiation, and encouraged early implementation in France of CAP reform (currently set for 2007).

33. The authorities were determined to further increase ODA from the 2003 level of 0.41 percent of GNP to the U.N. target of 0.7 percent of GNP in 2012. They noted that their current level was the highest among G-7 countries and concentrated in Africa.

III. Staff Appraisal

34. The economy has staged a strong recovery and key reforms are making headway in tackling the costs of aging, but serious challenges persist to secure higher potential growth and long-term fiscal sustainability. The recovery is being driven by domestic demand thanks in part to skillful implementation of key structural reforms geared to promoting confidence. Following last year’s milestone pension reform, health care reform—another key step toward fiscal sustainability—has been adopted. Ongoing and planned reforms in product, labor and financial markets are likely to boost growth. At the same time, however, much-needed fiscal consolidation is thwarted by heavy reliance on budgetary resources to raise employment, while an impending demographic shock casts a shadow over long-term growth prospects. The solution lies in an improvement of labor market institutions to raise labor utilization without adverse consequences on the budget and in steadfast fiscal consolidation.

35. The economic recovery appears to be well-sustained, providing the sought-for opportunity to proceed with sustained fiscal adjustment. Growth is set to average about 2½ percent per year during 2004–05, with risks broadly balanced and stemming predominantly from the external side. Monetary conditions are likely to remain quite accommodative as domestic demand is running ahead of that of the rest of the euro area. Consequently, the recovery is unlikely to be threatened by a resumption of appreciable underlying fiscal adjustment. Temporary incentives to promote household consumption could be withdrawn, and all revenue windfalls from higher-than-expected growth should be saved.

36. Securing long-run fiscal sustainability requires growth-enhancing structural reforms and up-front fiscal consolidation. The authorities’ approach needs to be strengthened on both fronts. The emphasis on growth-enhancing structural reforms is welcome, but it needs to be backed up by the specification and implementation of reforms that will effectively raise labor utilization without burdening the budget. In the absence of such reforms, up-front consolidation should be pursued at a pace such as to achieve a small structural surplus by the end of the decade when the costs of aging set in. And even with a more decisive reform agenda, consolidation efforts need to be strengthened compared to current plans. Once a reasonable fiscal down payment has been made, and the structural balance is in a durable small surplus, a larger share of spending re