France: Staff Report for the 2005 Article IV Consultation
Author: International Monetary Fund
Publication Date:
07 Nov 2005
eISBN:
9781451813678
Language:
English
Keywords:
ISCR; CR; spending; authority; price distortion; scenario; director; structural adjustment; headline inflation; IMF staff calculation; financial market; labor contract; real interest rate; Labor markets
Download PDF (630.6 KB)

This 2005 Article IV Consultation highlights that the cyclical recovery of the French economy was interrupted in the first half of 2005, as previously strong domestic demand faltered and the external sector continued to exert a drag on growth. In 2004, growth was faster and more consumption-driven than in other large euro area countries. Employment growth in hours, increases in minimum wages, and some fiscal measures supported private household incomes. The 2006 draft budget targets a reduction in the general government deficit to 2.9 percent of GDP.

Abstract

This 2005 Article IV Consultation highlights that the cyclical recovery of the French economy was interrupted in the first half of 2005, as previously strong domestic demand faltered and the external sector continued to exert a drag on growth. In 2004, growth was faster and more consumption-driven than in other large euro area countries. Employment growth in hours, increases in minimum wages, and some fiscal measures supported private household incomes. The 2006 draft budget targets a reduction in the general government deficit to 2.9 percent of GDP.

I. Introduction

1. Achieving fiscal sustainability, full employment, and higher trend-growth remain the key challenges facing the French economy. Economic policies to meet these challenges have followed the direction of Fund advice, but the pace of implementation and scope of reform, particularly in the labor market, have been insufficient to achieve decisive results (Box 1). Nonetheless, pension and health care reforms have made inroads toward fiscal sustainability, and the recent adoption of a new labor contract signals a novel direction in reform. Reflecting the authorities’ preference for a gradual approach to preserve social cohesion, the new initiative is too limited to significantly boost long-term employment growth, though it is likely to have positive short-run effects in lowering unemployment. Moreover, its implementation at a time of slowing growth and public discontent with policies, which culminated in the rejection of the EU constitution treaty, signals the authorities’ intent to proceed with needed structural reforms.

France: 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. The dialogue with staff on these issues has been traditionally open and frank.

Fiscal policy: Budgetary execution in 2004 concurred fully with the staff recommendation to use growth-induced revenue windfalls for fiscal adjustment. However, the Fund’s long-standing advice to consolidate at an annual pace of 0.5 percent of GDP until structural balance or surplus is achieved was not followed during 2000-04 on average. The 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 sizable expenditure cuts that would permit a much-needed early reduction in the tax burden.

Labor and product markets: In line with Fund advice, additional flexibility was introduced in labor markets, especially in the context of the reduction of the workweek to 35 hours. The new employment contract (contrat nouvelle embauche, CNE) represents a first step to reforming labor market institutions, but entitlements (other than pensions) remain to be tackled. In product markets, divestiture has been accelerated and deregulation is ongoing, albeit at a slower pace than advised by the Fund, and liberalization of trade in services needs new impetus.

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 an early implementation of Common Agricultural Policy (CAP) reform, now planned for 2007.

II. Background

2. Following a strong year, the economic recovery stalled in early 2005. In 2004, growth was faster and more consumption-driven than in other large euro-area countries, though the recovery remained weaker than in the previous cycle (Figures 1 and 2 and Table 1). Private consumption benefited from a rebound in employment growth (in hours), increases in the minimum wage, and some fiscal measures, though the overall fiscal stance was contractionary (Figure 3). A key difference with other euro area countries lay in the willingness of the French consumer to dip into savings, reflecting more dynamic demographics, rising financial wealth, and a confidence-preserving execution of pension and health care reforms. A sound financial sector permitted a rapid expansion of mortgage credit in support of residential construction. Direct effects on consumption were limited though, as refinancing is costly and home equity lending nonexistent (Table 2).1 Household indebtedness, while rising, remains comparatively low (at about 60 percent of GDP). Against this background, the fall in household consumption in the second quarter of 2005 surprised. It is most likely related to stagnating employment and the turmoil surrounding the rejection of the EU constitution treaty.

Figure 1.
Figure 1.

GDP and Demand Components

(Percent change)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Source: French authorities.
Figure 2.
Figure 2.

GDP Across Cycles

(Index trough=1)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Source: IMF staff calculations.
Figure 3.
Figure 3.

France: Consumption Determinants

(Percent change)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: OECD Economic Outlook; AMECO; Cronos database; national authorities; and IMF staff estimates.1/ The consumption gap measures the difference between actual consumption and its estimated long-run equilibrium. A negative gap implies that consumption will be higher in the near term.
Table 1.

France: Main Economic Indicators, 2001–10

(Annual percentage change; unless otherwise indicated)

article image
Sources: Banque de 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 2005, 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 exclude the proceeds from the sale of UMTS licenses, which amount to about 0.1 percent of GDP; data for 2005 exclude the EDF pension fund transfer (0.4 percent of GDP).

Table 2.

France: Vulnerability Indicators, 2000-05

(In percent of GDP; unless otherwise indicated)

article image
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 interest subsidies.

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

3. Fixed capital formation revived during the upturn but stumbled in the second quarter of 2005. Strong productivity growth, low interest rates, and subdued wage pressures strengthened enterprise margins and increased internally-generated funds. Fixed investment moved up in line with its usual determinants, as elsewhere in the EU (Figure 4), while the suspension of the taxe professionnelle (an implicitly high marginal tax rate on the profits of capital-intensive industries) on new investment seems to have contributed only marginally. Stocks have been behaving somewhat erratically, in part owing to the weight of developments in specific industries (e.g., aeronautics) but also because of measurement issues. Their contribution to growth should therefore best be read in conjunction with that of the external sector.

Figure 4.
Figure 4.

France: Determinants of Investment

(Percent change)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: Datastream; OECD; and IMF, WEO.

4. In contrast with previous cycles and some other euro area countries, the external sector exerted a drag on growth, raising questions about competitiveness. Cyclical differences in private domestic demand between France and its key trading partners (Germany and Italy) explain most of the sudden evaporation of the trade surplus, while fiscal stimulus in 2002-03 and exchange rate appreciation also played a role (Box 2). Reflecting these developments, the current account turned into deficit in 2004 for the first time in more than a decade. Competitiveness does not seem to be an issue at this stage as its recent deterioration is partly cyclical and has so far only slightly dented the trend improvement that took place between the late 1980s and 2000. Still, part of the weakness in trade appears structural and part is unexplained.

5. The recovery created fewer jobs than usual, and unemployment continued to rise until recently as enterprises favored increasing hours worked per employee (Figure 5). To some extent, this mirrors the resilience of employment during the downswing, reflecting past trend-wage moderation and uncertainty about the strength of the outlook, factors affecting other countries similarly. However, firms have been reluctant to hire as minimum wage increases continue to outstrip the growth of low-skilled workers’ productivity, while proposals to raise the flexibility of hiring and firing took time to materialize. In addition, the reversal of some of the workweek restrictions, while beneficial in the long run, favors increasing hours over adding workers in the short run. Unemployment appears to have crested in May 2005 at slightly more than 10 percent of the labor force, one of the highest levels in the EU but well below historical peaks. Its increase affected disproportionally the young and the low-skilled. It is too early to draw firm conclusions from the moderate fall in the unemployment rate in June-July 2005, as salaried employment stagnated in the second quarter.

Figure 5.
Figure 5.

France: Employment and Wages in Selected Countries

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: OECD; INSEE; WEO; and IMF staff estimates.

France: External Competitiveness

After a decade of significant surpluses, France’s trade balance moved into deficit in 2004 as net trade contributed negatively to growth for the third year in a row. Conversely, Germany, for example, posted a record export performance. While much of this divergence can be attributed to differences in domestic and foreign demand, the recent real appreciation of the exchange rate has adversely affected French exports.

  • The evolution of the euro has contributed to an appreciation of the real effective exchange rate, but not more than elsewhere. Developments have been in line with those in Germany and less worrisome than for Italy.

  • Weaker export performance is linked to lower foreign demand and geographical orientation. Since 2001, France has faced consistently lower foreign demand than its large euro area neighbors and the United Kingdom. Furthermore, its elasticity of exports to foreign demand, while near unity, is much smaller than Germany’s, partly reflecting Germany’s relative specialization in capital goods, which are more cyclical. The geographical orientation of French exports is also structurally less geared toward fast-growing areas, with a share of exports to the United States and Asia (excluding Japan) of 11.6 percent in 2004, compared to 13.7 percent in Italy, 15.9 percent in Germany, and 22.4 percent in the United Kingdom.

  • Strong domestic demand in France in 2004 led to buoyant imports. Since 2001, France has had the most dynamic domestic demand among the three main euro area countries, exceeding that of Germany by 2½ percent per year on average over 2001-04.

Econometric analysis for four European countries points to a significant impact of the euro’s appreciation on exports, and to a lesser extent on imports.1 During 2001-04, real exchange rate appreciation in France is estimated to have reduced export growth on a cumulative basis by about 4 percentage points. This is more than in Germany, but less than in Italy, where the cumulative impact reaches 9 and 16 percentage points, for goods and services exports, respectively. At the same time, in France, a reduction in export margins mitigated the loss of market share. On the import side, the econometric analysis confirms the dominant role of domestic demand on import growth in France and in the United Kingdom; the importance of exports in explaining German imports; and a small boosting effect from the currency appreciation in all three euro area countries.

uA01bx2fig2

Econometric analysis allows to compute by how much, over 2001-04, the growth of their determinants contributed to the growth of...

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

1/ Manufactured goods for France.2/ Goods excluding oil for the United Kingdom.3/ Nonmanufactured goods and services, and excluding oil for imports, for France.4/ Including utilization rate.

The methodology used in this study does not fully explain recent export developments. For France, substantial residual weakness in exports (about 6¾ percentage points over 2001-04) remains unexplained, but it is too early to interpret this as a structural loss in competitiveness. Italy suffers from an even larger negative residual while Germany seems to be enjoying some unexplained gains, at least for goods. The United Kingdom appears to have shifted its export specialization from goods toward services.

1 See Selected Issues paper: “Explaining Differences in External Sector Performance Among Large Euro Area Countries.”

6. Slack in the labor market has not resulted in declining inflation, due to mostly temporary factors. Core and headline inflation have exceeded the euro area average since 2003, owing to increases in indirect taxation and administered prices, including health care (Figure 6).2 Energy prices played a key role in pushing up headline inflation but did not trigger second-round effects. Rents edged up, as they are legally tied to the construction price index, in turn pulled by a strong housing market. Services provided by unskilled labor imparted some, albeit marginal cost-push pressures, reflecting higher labor costs in the context of the workweek reduction. Overall unit labor costs appear well behaved, in part because of exceptionally strong productivity gains, which may, however, be hard to sustain (Figure 7).

Figure 6.
Figure 6.

France: Inflation Analysis

(Percent change over same period of previous year)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: Cronos database; and IMF staff calculations.
Figure 7.
Figure 7.

France: Inflation and Unit Labor Costs

(Annual growth rates)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: Eurostat; INSEE; OECD, Analytical Database; and IMF, IFS.

7. Policy conditions have been supportive. In 2004, against a background of buoyant domestic demand, they tightened as the euro appreciated (Figure 8) and the structural fiscal balance improved considerably (by about 0.8 percentage point of GDP). With growth weakening, but still projected to exceed the euro area average in 2005, and the euro having lost some strength, monetary conditions have remained supportive from the perspective of the French economy. In addition, a key administered interest rate declined by 25 basis points on August 1, 2005, in accordance with its automatic adjustment formula.3 Initial fiscal plans for 2005 were for a modest consolidation (0.2 percentage point of GDP), with the automatic stabilizers being allowed to operate fully on the revenue side.

Figure 8.
Figure 8.

France: Monetary Conditions

(Using underlying CPI)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.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.

8. Potential growth has been subject to opposing forces, which on balance constitute a drag. The secular decline in labor utilization, mainly due to a fall in hours worked per person, seems to have ended. Capital utilization has risen, reflecting the lower relative price of capital and more shift work. Still, these phenomena have been accompanied by an unexplained trend decline in total factor productivity growth. While aging will reduce the labor force, recently-observed higher-than-expected fertility and lower mortality indicate that the impact on potential growth may be less than anticipated. Consequently, without reforms, annual potential growth is projected to decline moderately from 2.1 percent at present to 1.9 percent in the medium term and 1.8 percent by 2040.

III. Policy Discussions

9. Discussions focused on the outlook and the pace of fiscal consolidation and of structural reform in the context of the authorities’ priority to tackle unemployment. The authorities saw the lack of confidence expressed in the rejection of the EU constitution treaty as stemming from fears of unemployment and the failure of past reforms to provide job security in an era of global change. Hence, they focused on promoting job creation in the runup to the 2007 elections. They agreed with the staff’s call for broader reform efforts, lest results remain limited or temporary, but underscored that they would tread carefully to nurture confidence and reform momentum and thus proceed at a slower pace than advocated by the staff. Similarly, the authorities emphasized that their approach to fiscal consolidation would be measured as growth remained fragile. With high deficits and rising public debt, the staff saw a need for somewhat stronger and more sustained fiscal adjustment.

A. Near-Term Economic Outlook

10. At the time of the mission, it was agreed that the near-term outlook held promise, though data released subsequently point to a weaker second quarter than expected. Industrial output was rising in May, and forward-looking indicators were pointing to a mild expansion, but first estimates showed GDP growth in the second quarter slowing unexpectedly to 0.1 percent, quarter-on-quarter. Consequently, the staff lowered its growth outlook by 1/4 of one percentage point in both 2005 and 2006, to 1.5 percent and 2 percent, respectively, reflecting less robust domestic demand. This projection, which implied quarterly growth rising to somewhat less than potential, seemed plausible as consumer and business confidence appeared to be recovering (Figure 9). For households, the July increase in the SMIC,4 the acceleration of assisted employment programs, and the continuing rise in wealth should allow private consumption to regain composure. For businesses, the signal of continuing structural reform should support investment, a point underscored by the authorities, though the July decline in industrial production does not bode well.

Figure 9.
Figure 9.

France: High Frequency Indicators

(Dispersion index)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Source: WEFA Database.

11. Subsequently, downside risks from oil prices materialized, prompting the staff to reduce growth projections further, especially in 2006. Oil price assumptions were revised considerably, in particular for 2006.5 Adverse effects are marginal in 2005, leaving average GDP growth at 1.5 percent, but are projected to constrain growth to 1.8 percent in 2006. These estimates take into account indirect effects from lower growth abroad (including the recent reduction in the U.S. growth outlook) and characteristics of the domestic pass-through of oil prices, including the dampening effect from the specific nature of part of oil taxation.6

12. In the staff’s view, risks around this lowered baseline are broadly balanced. Aside from oil prices, there are other external sources of downside risk. The projection relies on a declining negative contribution of the external sector as demand from trading partners strengthens. Though this assumption remains to be verified, recent data from Germany and Italy are encouraging. The authorities felt that the weakness in export performance reflected mainly the different cyclical positions of demand between France and its key trading partners, as well as some structural factors such as the regional pattern of trade and product specialization and that France’s competitiveness position remained sound. However, while the stabilization of the euro at a less appreciated level would help, there was some concern that not all of the weakness in exports could be explained. Hence, the authorities agreed that continuing with structural reforms was also needed to preserve competitiveness going forward in the face of sharply heightening global competition. They shared staff concerns that a disorderly unwinding of global imbalances with euro appreciation would slow growth directly and indirectly, through declines in profits and wealth as France has a net dollar asset position. The financial sector was not a risk as it seemed fully hedged against exchange risks.

13. Domestically, risks appeared limited and mostly related to private consumption. The authorities did not see house prices as a major concern as their wealth effects were small. Recent price increases had been driven by fundamentals rather than by speculative activity, and household indebtedness, while rising, was low by international standards. A decline in house price growth would mainly dampen residential construction activity, which is prudently projected to slow down in the baseline. In addition, with household savings still high (and rising again in the second quarter), private consumption could surprise on the upside, especially if—the authorities emphasized—efforts to boost job creation paid off rapidly.

14. Headline inflation is expected to average about 2 percent in the 12 months ahead, though core inflation will be considerably lower. For inflation, further oil price increases and health care reforms constitute upward risks, while the reform of regulations governing distribution margins could increase competition and lower consumer prices appreciably below baseline. The authorities and staff agreed that it would be important to avoid second-round effects from energy and regulated price hikes.

B. Fiscal Consolidation Strategy

15. Fiscal consolidation progressed significantly in 2004, but the general government deficit remained high, and public debt is rising. The execution of the 2004 budget was exemplary. By projecting growth realistically, keeping central government spending constant in real terms, and—in a break with past inclinations to spend revenue windfalls—allocating all higher-than-expected revenues to deficit reduction, considerable adjustment was achieved (Table 3). Nonetheless, the deficit, at 3.6 percent of GDP, remained high, and the debt-to-GDP ratio reached a historic peak (Figure 10). The staff estimates the structural balance to have been in a deficit of about 2.6 percent of GDP in 2004.

Table 3.

France: General Government Accounts, 1997–2004 1/

(In percent of GDP)

article image
Sources: INSEE; and IMF staff calculations.

Excludes UMTS receipts.

Annual national accounts; Maastricht definition.

Figure 10.
Figure 10.

France: Burden of Government in Selected Euro Area Countries, 2004

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: OECD, Analytical Database; and IMF, WEO.

16. Fiscal consolidation faltered in 2005, mainly because objectives were unambitious. Once exceptional one-off operations are excluded,7 there is no structural adjustment, as modest initial plans (0.2 of one percentage point of GDP) are being scuppered by a lower-than-projected GDP deflator, which, given the nominal spending approved in the budget, contributed to raising expenditure to almost 55 percent of GDP (Text Table 1). In terms of execution, expenditure appears to be broadly on track, especially because health care reform is keeping spending in line with the targeted deceleration, for the first time in several years. The authorities felt uncertain about whether they could still achieve an actual deficit below 3 percent of GDP in 2005, as they did not plan to offset revenue shortfalls due to weaker-than-expected growth. To limit deficit overruns, the authorities had frozen some spending at the central government level, while social partners had renounced the conventional indexation of unemployment benefits. However, the staff projects the actual deficit to reach about 3.5 percent of GDP in 2005. To stem the increase in debt, the authorities were accelerating divestiture, which was expected to yield about 1.5 percentage points of GDP in 2005.

Text Table 1.

France: General Government, Current Policies

(In percent of GDP)

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

Preliminary data due to revisions of the national accounts up to 2004.

17. At the time of the mission, the authorities were aiming for a deficit of less than 3 percent of GDP in 2006. The authorities agreed that this target would be difficult to achieve—especially if growth disappointed, which seems to be the case—because an exceptional revenue item (the assets of the electricity utility’s pension fund) of almost ½ of one percentage point of GDP had to be replaced with durable spending restraint. Central government spending would be kept constant in real terms for the fourth year running—yielding underlying adjustment of ¼ of one percentage point of GDP—and promised income tax cuts would be postponed. It was agreed that continued success of the health care reform and measures to eliminate the deficit of the unemployment insurance system would be imperative. Over the medium term, these reforms would reduce the deficit by ¾ of one percentage point of GDP. While the details of the 2006 budget are not yet available—but will be discussed in a supplement to this report—the authorities wanted to avoid entering the 2007 elections with a deficit in excess of 3 percent of GDP.

18. The authorities intended to proceed with fiscal adjustment, though specifics remained to be elaborated. They observed that the 2003 pension reform had considerably cut contingent liabilities, reducing the estimated budgetary cost of aging by almost two fifths, and that the structural deficit was well below 3 percent of GDP (Text Table 2). They agreed that, without adjustment, the public debt ratio was vulnerable to significant increases, as brought out by the standard debt sustainability analysis (Table 4 and Figure 11), while in the long run, the remaining costs of aging still threatened fiscal sustainability (Figure 12, current policies8). They affirmed their preference to achieve most of the needed fiscal consolidation through growth-enhancing reforms, some of which would simultaneously reduce budgetary outlays (e.g., the increased flexibility of the new labor contract, if it led to higher employment, would reduce transfer spending). The staff supported this approach, pointing out that even with reforms in line with a (delayed) Lisbon agenda, annual fiscal adjustment by nearly 0.5 percentage point of GDP would be needed over the next five years to secure fiscal sustainability (Figure 12, reform and adjustment9). This implies about 1 percentage point of GDP more adjustment than envisaged under current policies, which could for example be achieved by replacing only one out of two retiring civil servants during 2006–10.10 The staff underscored that it would be crucial to no longer rely on budgetary means to promote employment and product market reforms, e.g., divestiture. Otherwise, upfront adjustment would need to be larger. Moreover, efforts at expenditure restraint would need to be broadened beyond the central government.

Text Table 2.

France: Deficit, Debt, and Cost of Aging

(In percent of GDP)

article image
Sources: WEO, IMF; and EPC, EU.

For Italy, the aging cost increase peaks at 2.1 percent of GDP before 2050.

Table 4.

France: Public Sector Debt Sustainability Framework, 2000–10

(In percent of GDP; unless otherwise indicated)

article image

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

Derived as [(r -π(1+g) - g + αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = 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.

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

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

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Figure 11.
Figure 11.

France: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: IMF, country desk data; and IMF staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ Ten percent of GDP shock to contingent liabilities occur in 2006.
Figure 12.
Figure 12.

Public Debt Scenarios

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

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

19. The staff urged the authorities to proceed with durable expenditure reforms. It was agreed that health care reform had been effective so far, but that the reform would not contribute to overall consolidation as the pace of health spending was unlikely to fall below that of potential GDP. While recognizing that an across-the-board approach to nonreplacement of retiring civil servants was undesirable, the staff called for more efforts to utilize the ongoing wave of retirements to help with medium-term consolidation, but political will appeared to be lacking. The staff emphasized the need to take advantage of synergies between structural reforms and fiscal adjustment and curb local spending to safeguard the credibility of the decentralization process. To improve labor market performance, for example, it would be important to curtail out-of-work benefits and phase out special retirement regimes. In this context, the staff welcomed the authorities’ recognition that the avenue of relying on budgetary resources to solve labor market problems had been exhausted, though implementation of past initiatives (such as the social cohesion plan) continued to weigh on the budget.

20. Awareness is building of the need to overhaul the tax system, and some important tax distortions are being addressed. The distortions involved in the taxe professionnelle (a tax that falls mainly on capital) are being mitigated by capping the tax as a percentage of value added at the level of the enterprise while broadening its base. The authorities agreed that ultimately this tax (which had been suspended for new investments) should be eliminated, but its large yield prevented them from doing so immediately. More generally, the authorities recognized the need to phase out tax exemptions and tax credits (except for the earned income tax credit) and broaden tax bases. They agreed with the staff that a simplification of the taxation of savings products and a shift in focus of tax incentives to the promotion of retirement savings would benefit the budget and the economy’s efficiency.

21. The authorities noted that their fiscal framework was being strengthened and saw no need for an independent fiscal council. For the central government, a new organic budget law, in effect with the 2006 budget, had increased the oversight role of parliament, heightened the accountability of spending agents, and enhanced the assessment role of the Cour des Comptes (the independent audit office). A similar organic budget law is set to be adopted for social security, while for health care spending, a watchdog is in place with the formal powers to ask parliament to adopt corrective measures. The unemployment insurance system is run by social partners and designed to be in balance in the medium term. The authorities argued that under the (modified) SGP, the independent assessment of the EU was a strong safeguard. The staff responded that more national ownership of budgetary analysis through independent forward-looking assessments by a domestic institution could provide added momentum for fiscal adjustment, in line with the approach followed for pension reform. In addition, it could assist in making local authorities and the various watchdogs internalize the overall consolidation requirement.

C. Structural Reforms

Reform Strategy and Impact

22. Mindful of the need to preserve social cohesion, the authorities pointed to the success of their gradual approach to structural reforms. They argued that without building sufficient public awareness of the need and benefits of reform, reforms had often faltered due to public hostility, expressed in strikes or electoral defeats of reform-minded governments. In contrast, when reforms had been well prepared, through well-publicized studies, debate within committees involving all stakeholders, and consensus-building, resistance had been overcome (Box 3). The most striking success had been the 2003 pension reform, while the recent health care reform had followed a similar mold. Consequently, the authorities decided to adopt the same approach for labor market reform through the recently established Advisory Council for Employment. To begin this process for product market issues, they were emphasizing the need to focus on consumer welfare and had initiated studies on the switching costs for consumers in utilities, financial services, and telecommunications.

France: Studies, Committees, and Consensus: France’s Approach to Structural Reforms

Since the end of the 1990s, the French authorities have developed an approach to reform that emphasizes consensus-reaching, based on technical studies and committees, before any legislative action is taken. This method has been utilized in areas where strong public resistance had previously prevented the authorities from changing the status quo, such as pensions (2003) and health care (2004), and is ongoing in the area of labor policies.

Preliminary studies were conducted by academics, and committees were created at the beginning of the reform process. Each time these committees bring together all involved actors—members of parliament, social partners, experts, and representatives of the state. Following initial diagnosis by established academics in their fields, these bodies are mandated to reach consensus on a technical assessment of current situations and problems, and make recommendations for policy reform.

Based on extensive consultation and cross-disciplinary expertise, these forums have proved valuable in reaching consensus. They laid the foundations for the actual negotiations between social partners and the government that took place later. Wide-spread dissemination of the academic reports and the councils’ work has also been key in generating a somewhat less politicized debate and public support for the reforms:

  • An initial report (Rapport Charpin, in 1999) followed by one from the Pension Advisory Council, established in 2000, spelled out a detailed financial assessment of the public pension funds that made the need for reform obvious to all its members. Based on these works, consultations were held over 2002-03 and led to a major reform of the pension system in August 2003.

  • The first report of the High Council for the Future of Health Care Insurance, created in 2003, illustrated how unsustainable current health care spending had become. It served as background analysis for the negotiations held in the first half of 2004, leading to the passage of a comprehensive set of measures in August 2004.

  • Well-publicized studies commissioned by the government from Blanchard and Tirole in 2003 put forward new ideas to reshape the employment protection system. An Advisory Council for Employment is scheduled to be set up in September 2005 to help reach consensus on these or other reform proposals to improve the functioning of the labor market.

23. The staff acknowledged that this consensus-building approach had delivered results, while pointing to the benefits of a well-focused and coordinated package of product and labor market reforms. Staff simulations with the Fund’s new Global Economic Model (GEM) suggest that structural reform in France alone could raise French GDP in the long run by more than 10 percentage points (Box 4). Simultaneous implementation of product market deregulation and labor market reforms has significant benefits, particularly in terms of political economy. Product market reforms would allow consumers to benefit from lower prices and higher purchasing power, thus easing the transition cost of labor market reforms which would necessarily involve a period of wage moderation as increased labor supply is put to work. Similarly, reform within the entire euro area would allow larger cumulative effects due to spillovers, while coordination of its timing could permit an easing of monetary policy which would virtually eliminate transition costs. The authorities agreed with the thrust of this analysis, while noting that coordination might be hard to achieve politically.

France: Macroeconomic Impact of Raising Product and Labor Market Competition

Increasing competition in French product and labor markets has potentially very large macroeconomic payoffs. The Fund’s GEM was used to measure the impact of raising competition in France to the average level in Denmark, Sweden, and the United Kingdom—the group of countries in the EU with the most competitive markets (see Selected Issues Paper, “Estimating the Macroeconomic Effects of Higher Competition in Product and Labor Markets” for details). In the GEM, markups are summary measures of competition, reflecting the impact on wages and prices of barriers to market entry, such as regulations, state involvement in markets, and legal protection of incumbents. The experiment involved a reduction in French markups to the level of the above-mentioned group of countries.

Stand-alone reforms in France across all markets raise real GDP by more than 10 percent in the long run. The contribution of higher competition in services is the largest (5.8 percent), followed by labor markets (3.7 percent) and goods markets (1.2 percent). The differences across markets are mainly due to the size of the decline in markups. As a result of the EU’s internal market, the distance between France and the group of best-performing countries is smallest in goods markets. Where progress in deregulation has been slower—services and labor markets—markups in France are much higher than in the comparator group.

Labor market reforms are effective in creating jobs, even if implemented in isolation. However, for the full benefits to workers to accrue, it is better to combine them with measures opening goods and services markets to greater competition. Otherwise, lower labor costs are not completely passed on to consumer prices, and real wages remain permanently below baseline (Figure 1).

Figure 1:
Figure 1:

Stand-Alone Reform in France

(Deviation from baseline in percent)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Table: Stand-Alone Reform in France

(Deviations from baseline in percent)

article image

Coordination of structural reforms within the euro area has important advantages for France. In the long run, real GDP in France increases by an additional 3 percentage points, due to spillovers from higher output in the other euro area member states. In addition, French consumers profit from lower import prices. In the short run, euro area-wide inflationary pressures are significantly reduced, which could allow monetary policy accommodation by the ECB. Production capacities increase with the entry of new firms and higher labor supply; however, due to nominal and real rigidities, demand is slow to adjust, resulting in a negative output gap. If as a result prices decline, monetary authorities would react to allow area-wide interest rates to decline temporarily, which brings forward investment and consumption responses (Figure 2).

Figure 2:
Figure 2:

Stand-Alone versus Coordinated Reform

(Deviation from baseline in percent)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Labor Markets

24. Despite improvements in labor market functioning during the 1990s, overall utilization of labor potential remains among the lowest of OECD countries. Legal employment protection is strong, the labor tax wedge is high, and wage flexibility is limited for the low-paid (Figure 13). The staff noted that existing rigidities, while temporarily shielding those with permanent jobs, reduce the capacity of the economy to adapt to changes in technology and preferences. Consequently, structural unemployment is high, labor force participation of the young is low, older workers exit early from the labor market, and annual hours worked per worker are comparatively low. The staff observed that policies dealing with these challenges had thus far focused on fiscally expensive active labor market programs, leaving institutional obstacles to labor market flexibility untackled.

Figure 13.
Figure 13.

France: Labor Market Performance and Institutions in Selected Countries

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: OECD; and IMF staff calculations.

25. Against this background, the authorities saw their new plan to promote job creation as a breakthrough because it directly addressed some key labor market rigidities (Box 5). The plan builds on existing reforms, such as the easing of the 35-hour workweek restrictions, the social cohesion plan to bring long-term unemployed back to the labor market, the promotion of personal services, and the adoption of an enabling framework for life-long learning. The proposed new labor contract with a term of up to two years (CNE) is an innovation as it has no firing restrictions and does not rely on budgetary support to facilitate job creation. It had been focused on small enterprises because of their large number and dynamism and their difficulties to benefit from measures facilitating the workweek reduction. The authorities estimated that this initiative and its associated administrative and fiscal simplifications could reduce the unemployment rate by 0.1 to 0.5 percentage point.

26. There was agreement that additional, supporting reforms would be essential to boost job creation meaningfully in the long term. The authorities did not dispute the staff’s concern that the new labor contract might not have significant long-term effects, but underscored that it should be seen as opening the door to more reforms. In essence, the CNE increases the flexibility of fixed-term contracts without addressing the rigidities involved in open-ended contracts. As shown theoretically and by experience elsewhere, such partial reform may lead to more job turnover and less investment in human capital, ultimately raising rather than lowering unemployment. As suggested in studies initiated by the authorities (e.g., Kramarz-Cahuc), it would therefore be necessary to integrate all existing labor contracts into a single one, with internalization of the social costs of layoffs and as little legal uncertainty as possible.

27. The staff welcomed the authorities’ determination to strengthen employment services and job search incentives and called for a modification of the minimum wage adjustment mechanism. The staff urged the adoption of complementary measures such as the capping and phasing of unemployment benefits and the introduction of sanctions for noncompliance with job search requirements, which were partially enacted shortly after the mission. The staff further argued that future increases in the minimum wage should be limited to changes in underlying consumer price inflation to increase the employability of low-skilled workers and wage dispersion at the low end of the pay scale. The staff saw a need for decreases in benefits in some cases to make the return to work pay and for the removal of incentives inducing premature exit from the workforce. In this context, the staff welcomed the intended elimination of the dismissal tax on older workers (contribution Delalande). The authorities responded that the forthcoming renegotiation of the convention governing the insurance system (UNEDIC) would provide an opportunity to consider the staff’s proposals, but that it was primarily up to social partners to implement changes in this area.

France: Are New Labor Market Initiatives a Breakthrough?1

1. In mid-2005, the government adopted an emergency plan for employment (le plan d’urgence pour l’emploi) and set the reduction of unemployment as the top economic policy priority. Specifically, the plan includes: (i) introducing a new employment contract (CNE) for small enterprises with up to 20 employees, with no hiring and firing restrictions during the first two years; (ii) simplifying administrative procedures and extending certain tax exemptions to more enterprises by raising the eligibility threshold from 10 to 20 employees; (iii) providing an income tax credit to promote youth employment in specific sectors and more support to facilitate job search; and (iv) fiscal incentives and administrative deregulation to improve employment in the personal service sector.

2. Past policy actions to tackle unemployment focused on active labor market programs, while leaving labor market institutions largely unchanged. Remedial actions relied on employment subsidies, earned income tax credits, and cuts in social security contributions—all at considerable cost to the budget. Attempts were made to reduce unemployment also through work redistribution effort such as the reduction in the work week. The results have been modest, as the French unemployment rate remains higher than the euro area average.

3. The new plan, while still relying partly on budget resources, takes an important step toward reforming labor market institutions, but whether it will deliver the desired result is uncertain. While it will facilitate hiring, the CNE represents only a partial reform of the employment protection legislation (EPL). It introduces the needed flexibility for only up to two years and is limited to small enterprises. Academic studies find this type of partial reform an ineffective way to reduce unemployment, with negative implications for workers’ welfare and productivity, the main effect being a high turnover in fixed-duration workers with insufficient investment in human capital, leading in turn to higher, not lower, unemployment.2 Experiences from other countries, including Germany, Spain, and Sweden support this finding. For instance, after a partial reform of employment protection legislation (EPL) in the late 1980s, the Spanish unemployment rate initially fell, but began to rise rapidly in the early 1990s. Unemployment began to fall significantly only after the Spanish government reformed the EPL for permanent contracts in the mid-1990s.

4. The effectiveness of the new labor contract in promoting job creation and reducing the unemployment rate will depend crucially on broadening its application and adopting supporting reforms. Simulations of a search-matching model, with hiring and firing restrictions calibrated to the French labor market, suggest that a reform, which effectively merges existing contracts into a single one by eliminating firing restrictions and legal uncertainty (e.g., as in the proposal by Kramarz and Cahuc), would lower the structural unemployment rate by 2 percentage points. This effect could be even larger (about 3 percentage points) when firing costs are completely eliminated. The magnitude of these estimates should be interpreted with caution, however, as high and binding minimum wages prevent the internalization of high hiring costs, while inefficient employment services slow down the match of vacancies and unemployed workers. In this regard, further reforms in these areas are needed to yield results of this magnitude.

1 Based on the Selected Issues paper “Employment Protection and Unemployment in France.”2 Blanchard, O., and A. Landier, “The Perverse Effects of Partial Labor Market Reform: Fixed Duration Contracts in France,” NBER Working Paper No. 8219, 2001.

Product Markets

28. Privatization is being accelerated, while other important product market reforms are set to continue. The authorities observed that the gas utility shares had been successfully floated on the stock market, soon to be followed by the electricity utility and further divestiture of highways. Legislation restricting large retailers’ ability to lower distribution margins imposed by suppliers (loi Galland) is set to be modified, which is expected to lead to a significant reduction in consumer prices. The authorities agreed that while good progress had been made in reducing administrative regulation, more deregulation was needed, particularly in the service sector (Figure 14). In this context, they favored services sector liberalization in the EU, though they saw difficulties in accepting the “origin” principle of the Bolkenstein directive as it would erode France’s social model.

Figure 14.
Figure 14.

France: Product Market Reform Indicators

(Ordinal index)

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Source: OECD.

D. Financial Sector

29. Following up on last year’s FSAP, the authorities noted that they were raising the efficiency of the financial sector but were not prepared to swiftly phase out remaining administrative interventions. A bankruptcy law has been enacted, which enables Chapter 11 type procedures and improves creditors rights; the prohibition to remunerate sight deposits has been lifted, which prompted one bank to introduce such remuneration; and administered interest rates are operated mostly by automatic formulas. The planned creation of the postal bank—by separating mail activities—is expected to establish a level-playing field with private institutions. It would increase competition, in particular for mortgage loans, though since this is not a profitable business for banks (¶31), it is unlikely to affect other banks’ profitability. In addition, mortgage markets are set to be reformed with the introduction of home equity loans and the reduction of legal and regulatory transaction costs. The latter will increase mortgage market activity, though only progressively, as changes will became effective only in the course of 2006, and households remain reluctant to engage in mortgages. While agreeing with last year’s FSAP’s observation that publicly-administered savings schemes had lost their relevance and hampered monetary transmission somewhat, the authorities felt that they could not easily unwind them because they enjoyed continued public support.

30. The financial sector performed well over the past year, though part of the increase in profitability stemmed from a transitory reduction in provisioning as risk declined (Figure 15 and Tables 5–7). Underpinning these good results, the authorities listed excellent performances in retail banking, a drop in nonperforming loans, which allowed lower provisioning, and successful diversification. They noted that owing to good preparation, financial institutions and markets had adapted well to new accounting standards, though they and sector representatives underscored that the full extent of the changes would only be visible in a couple of years. While the supervisory body considered that recent losses in derivatives incurred by some institutions did not raise systemic concerns, it urged all banks, including mutual groups, to continue to upgrade their internal control system. With respect to financial markets, the authorities were vigilant about hedge funds operating from less regulated jurisdictions because of their attendant lack of transparency, and about the difficulty of monitoring of risk, which has moved out of the financial sector but may retain significant macroeconomic consequences through their impact on household savings and wealth.

Figure 15.
Figure 15.

France: Financial Sector Indicators

Citation: IMF Staff Country Reports 2005, 399; 10.5089/9781451813678.002.A001

Sources: Haver Analytics; Thompson Financial; and Yahoo.com1/ All credit institutions aggregated data on a parent-company basis.
Table 5.

France: The Core Set of Financial Soundness Indicators, 1999–2004

(In percent; unless otherwise indicated)

article image
Sources: Banque de France; Commission Bancaire; BIS; and ECB.

These may be grouped in different peer groups based on control, business lines, or group structure.

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

Consolidated data for the seven main banking groups (2004).

Impact of creation of euro has to be taken into account.

Table 6.

France: Additional Encouraged Financial Soundness Indicators, 1999–2004

article image
Sources: Banque de France; Commission Bancaire; Agence France Trésor; BIS; and ECB.

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

Consolidated data for the seven main banking groups.

Data cover interbank and customer lending to residents and nonresidents on a metropolitan basis.