France: 2006 Article IV Consultation—Staff Report, Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
01 Nov 2006
eISBN:
9781451813685
ISBN:
9781451813685
Language:
English
Keywords:
ISCR; CR; headline inflation; deficit; director; government; firm; exchange rate; personal income; credit line; job creation; potential GDP
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France’s economic short-term outlook is positive, and long-term prospects have improved. Fiscal adjustment remains high on the government’s agenda. Tax reforms have improved the economy’s growth potential. Reforms in financial, labor, and product markets are necessary to boost job creation, prepare the economy for aging, and allow it to benefit from global activity. The financial sector’s profitability and capitalization put it in a good position to manage increasing risks. Structural reforms in labor and product markets remain essential to boost long-term growth and secure fiscal sustainability.

Abstract

France’s economic short-term outlook is positive, and long-term prospects have improved. Fiscal adjustment remains high on the government’s agenda. Tax reforms have improved the economy’s growth potential. Reforms in financial, labor, and product markets are necessary to boost job creation, prepare the economy for aging, and allow it to benefit from global activity. The financial sector’s profitability and capitalization put it in a good position to manage increasing risks. Structural reforms in labor and product markets remain essential to boost long-term growth and secure fiscal sustainability.

I. Background1

1. Against the backdrop of a cyclical upswing, the economic policy debate is focusing on how to foster the structural reforms necessary to reduce unemployment, address population aging, and allow the economy to benefit fully from dynamic global activity. In a departure from an approach that observers have characterized as “reform by stealth,” the government has in recent years placed increasing emphasis on educating the public about economic choices. This approach has met with success in the area of public finance where the need for curbing spending, debt, and deficits is generally well understood and where pension and health care reforms are advancing. The main challenge now is to convince the public of the benefits of a much more flexible labor market and of further reforms in services and product markets. The 2007 elections provide an opportunity to advance the public debate on these issues.

2. After stagnating in the first half of 2005, economic activity regained considerable momentum, but it remains behind the ongoing global expansion. Driven by domestic demand and a rekindling of exports, GDP growth picked up to a remarkable 4¾ percent (annualized) in the second quarter of 2006 (Figure 1 and Table 1). This uptick was shared across the euro area as demand in Germany and Italy strengthened, joining robust domestic demand in other euro area countries. It permitted French exports to rebound strongly following three years of weakness compared to buoyant global demand. From a longer-term perspective, though, France’s relative performance has lagged, prompting it to fall in the per capita GDP ranking (adjusted for purchasing power) from 12th to 16th position during the past five years.

Figure 1.
Figure 1.

France: Economic Developments 1/

(Percent change)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: INSEE, National Accounts; WEFA; and IMF, WEO.1/ 2006 data are projections.2/ Contribution to growth of GDP.
Table 1.

France: Main Economic Indicators, 2002-11

(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 2006, year-on-year April.

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. For 2006, data available up to April.

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.

Maastricht definition.

Data for 2005 exclude the EDF pension fund transfer (0.5 percent of GDP); in percent of potential GDP.

3. All components of domestic demand contributed to the upswing. Household consumption and investment in housing have remained solid, helped by falling unemployment, real increases in the minimum wage (SMIC), and low interest rates (Figure 2). Still, health reform-induced increases in social security contributions and higher income taxes curbed disposable income growth, prompting households to dip into their savings (Table 2). Fixed capital formation strengthened with the revived cyclical upturn (Figure 3). Profit margins have declined since 2003 as moderation in wage growth was insufficient to offset the impact of higher input prices, while generous dividend payouts and higher tax obligations reduced company savings. Low interest rates encouraged external financing, resulting in a declining self-financing ratio and rising debt, thus ending a four-year period of balance-sheet adjustment (Text Figure).

A01ufig01

Savings and Investment, Nonfinancial Business

(In percent)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Figure 2.
Figure 2.

France: Consumption Determinants

(Percent change)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: IMF, WEO; AMECO; Cronos database; Datastream; national authorities; and IMF staff estimates.
Figure 3.
Figure 3.

France: Determinants of Investment

(Percent change)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: Datastream; OECD; and IMF, WEO.
Table 2.

France: Vulnerability Indicators, 2001-06

(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 institutions aggregated data on a parent-company basis.

4. Despite the strong rebound of exports since mid-2005, concerns about competitiveness have not disappeared, mainly because structural factors seem to hamper export performance. The external sector subtracted between 0.7-1 percent from annual growth in 2003–05, and—together with adverse terms-of-trade effects—led to a shift in the current account into a deficit of about 1.5 percentage points of GDP. However, export volumes have perked up markedly since mid-2005, in line with the rebound in partner demand (Text Figure), and the foreign balance contributed positively to growth in the first half of 2006. The prior weakness of manufactured goods exports seems to reflect structural issues (Box 1). France’s cyclical position has not been far ahead of that of its main trading partners, its real effective exchange rate has changed little, and the exchange rate is estimated to be broadly in line with fundamentals. Geographical and sectoral compositions of trade have only limited explanatory power. The authorities and the staff agreed that structural rigidities in product and labor markets—in the staff’s view including high minimum wages—were important explanatory factors as they reduced the economy’s ability to rapidly adjust to developments in trade partners and take advantage of robust global growth.

A01ufig02

French Exports and European Import Demand

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

5. The pace of job creation, while picking up, has been hampered by sustained real minimum wage increases, and participation remains low. Strong activity in the nontradable sector supported labor demand, while the secular decline in manufacturing employment was exacerbated by rising wage costs. Labor market reforms (such as the new contract for small enterprises (CNE) and reinforced job search requirements and employment services) have helped job creation, but they have not yet undone the adverse effect of high (and, on the OECD’s measurement, rising) employment protection and the workweek reduction. Government-aided jobs, which were being phased out during 2004–05, are staging a comeback, contributing again to employment growth. Conversely, minimum wage increases are exerting a drag, keeping the pace of job creation well below that of previous recoveries (Text Figure). 2 Hence, while the overall unemployment rate has been declining, its structural component has fallen much less (Figure 4). With pension reforms allowing people to retire on the basis of career length rather than age, many have taken the opportunity to retire early, while the effect of introducing an actuarially fairer system is expected to play in the opposite direction only over time. 3

Figure 4.
Figure 4.

France: Labor and Product Market Indicators

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: OECD; Datastream; Nielsen; and IMF staff calculations.

France: External Performance—Demand, Competitiveness, and Structural Factors

Developments in exchange rates, relative unit labor costs, and demand are insufficient to explain the recent decline in the current account and France’s export market share. Indeed, residuals from econometrically-estimated equations indicate a substantial drag on exports since 2001, not attributable to the standard global demand and price/cost factors (Figures A and B). 1 However, the buoyant trade of the first half of 2006 is not reflected in this analysis, though it seems mostly related to the upswing in the euro area. Geographically, trade with Germany and China contributed most to the deterioration in the manufacturing trade account. At the sectoral level, exports of automobiles and intermediate goods slumped, but investment and consumer goods exports held up well. Strong import growth was partly due to more dynamic investment than in other European countries (Figures C and D). Finally, oil price increases caused a considerable rise in the import bill.

Figure A.
Figure A.

Exports of Manufactured Goods

(Cumulative percent change since 1998) due to:

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Figure B.
Figure B.

Nonmanufactured Exports

(Cumulative percent change since 1998) due to:

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Figure C.
Figure C.

Investment and Savings

(In Percent of GDP)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Figure D.
Figure D.

Private Capital Spending

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Standard equilibrium exchange rate analysis indicates that the current real effective exchange rate is largely in line with fundamentals. Multilateral analysis conducted by the IMF’s Research Department suggests that the real exchange rate does not significantly deviate from equilibrium based on saving-investment balances (less than 5 percent) and is essentially in equilibrium using the methodology calculating purchasing power parities. These findings are subject to considerable uncertainty, however.

In this context, it is important to note that changes in export margins have cushioned the effects of exchange rate fluctuations. Cost competitiveness of French producers worsened in 2005 and early 2006, though it remains in line with its long-term average (Figure E). Price competitiveness was maintained as producers lowered export prices in euro (Figure F). This behavior is indicative of the limited pricing power of exporters in increasingly competitive markets. Moreover, despite such pricing-to-market, the external position deteriorated during the period.

Figure E.
Figure E.

Real Effective Exchange Rate Indices

(2000=100)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Figure F.
Figure F.

Export Price-Cost Margin, Manufactured

Goods (1999Q1=100)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: INSEE; and IMF staff estimates.

Hence, the relative underperformance of exports in past years points to structural factors that leave French firms behind the global expansion. A more flexible economy should be able to reorient its geographical orientation and product mix toward fast-growing economies and sectors. Indeed, the staff finds evidence that labor market rigidities hamper such adjustment. A sectoral study of total factor productivity (TFP) growth in manufacturing finds that, while France does not lag significantly behind the United States in terms of level, its TFP growth is hampered by the high ratio of minimum to median wages. 2 In this observation, the staff’s analysis is joined by a KPMG study that finds that the high cost of low-skilled workers constituted France’s main disadvantage in reference to other G-7 countries. The staff’s study further shows that more spending on R&D and more trade with technologically advanced countries tends to positively influence TFP growth.

1

Export equations (see IMF Country Report No 05/401) have been re-estimated using the new rebased dataset from INSEE and additional data for 2005.

2

Khan, Tehmina, “Productivity Growth, Technological Convergence, R&D, Trade and Labour Markets: Panel Data Evidence from the French Manufacturing Sector,” IMF WP, forthcoming.

A01ufig03

Real GDP and Employment Growth

(Annual percent change)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

6. Energy prices have kept headline inflation up through the middle of 2006, while underlying inflation has been well-behaved. Core and headline inflation declined to slightly below the euro area average as the effect of a previous tobacco excise tax hike evaporated in mid-2005. Factors other than oil prices, in particular strong international competition in manufactured goods and the liberalization of distribution margins, had on balance a dampening impact on inflation. Rents edged up, as they are legally tied to the construction price index, 4 which was pulled by a strong housing market. Services provided by unskilled labor imparted slight cost-push pressures, reflecting higher minimum wages. Economy-wide unit labor costs have risen somewhat, in part because of a cyclical decline in productivity growth (Figure 5).

Figure 5.
Figure 5.

France: Inflation Analysis 1/

(Percent change over same period of previous year)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: Cronos database; and IMF staff calculations.1/ Permanent (common) and transitory (idiosyncratic) components extracted with a Generalized Dynamic Factor Model applied to 4-digit categories of the HICP.

7. Despite fiscal tightening, overall, policies have been supportive of growth (Figure 6). Monetary conditions remain accommodative as increases in real interest rates were partly offset by the depreciation of the real effective exchange rate, at least until very recently. The structural fiscal deficit decreased by about ¾ of 1 percentage point of GDP in 2005 and is likely to continue to fall, but by somewhat less than ½ of 1 percentage point in 2006 (Table 3). This fiscal tightening had only limited impact on growth as private domestic demand continued to outpace GDP.

Figure 6.
Figure 6.

France: Policy Conditions

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: Datastream-Thomson Financial; Cronos database; and IMF, IFS and WEO.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 (using underlying CPI).
Table 3.

France: General Government Accounts, 2000-05 1/

(In percent of GDP)

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Sources: INSEE; and IMF staff calculations.

Data for 2001-02 exclude the proceeds from the sale of UMTS licenses, which amount to about 0.1 percent of GDP. Annual national accounts.

Maastricht definition.

Data for 2005 exclude the EDF pension fund transfer (0.5 percent of GDP).

8. By regional comparison, the economy has been performing well, but several structural weaknesses stand out, and progress in tackling them has been mixed (Box 2). GDP per capita is high, and growth per capita has been exceeding the euro area average, though the difference seems to be evaporating. Globally, France’s relative position has deteriorated substantially, particularly as it failed to keep up with the United States. Pension reforms have limited the increase in age-related spending (excluding long-term care) to 2.9 percent of GDP between 2004 and 2050, compared to an EU average of 4 percent (according to the EC Aging Working Group), but its level (12.8 percent of GDP in 2004) will remain above the EU average (10.6 percent of GDP), and public debt has risen (to some 67 percent of GDP). Labor markets have become more flexible, though employment protection has increased, and taxes, unemployment benefits, and minimum wages are high. Consequently, employment rates have improved much less than elsewhere.

II. Outlook

9. Near-term growth is expected to remain solid, somewhat stronger than anticipated at the time of the mission. The staff projects GDP growth to remain broadbased and settle at an annual pace of about 2.5 percent during the second half of 2006, yielding average growth of 2.4 percent for the year. In 2007, higher oil prices and interest rates and lower trade partner growth will reduce growth slightly to about 2.3 percent. In particular, the staff does not expect households to further reduce their savings rate from current levels and sees residential construction growth slowing. The unemployment rate should decline, reflecting healthy growth, increased subsidized job creation, and the impact of pension and labor market reforms. In line with surveys, business investment is likely to keep expanding firmly while export growth should ease somewhat from its recent buoyant pace. While expressing some concerns about the impact on the outlook of fiscal reforms and adjustment planned in Germany, the authorities expect that the economic impact on France was likely to be small.

10. Risks to this baseline are broadly balanced and related to external shocks and the impact of ongoing structural reforms (Text Figure). Staff analysis suggests that France has become more sensitive to the global economy and reacts more through changes in employment and productivity than through wage flexibility, strengthening the case for more structural reforms. 5 The authorities and the staff concurred that recent structural reforms had likely increased potential growth (see ¶13), but the timing of their effect on actual growth was hard to pin down. The elections, scheduled for the second quarter of 2007, constitute some source of uncertainty about the future course of economic policies.

A01ufig05

Real GDP Growth: Risks to the Forecast

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

The fan chart includes the following risks to the baseline projections of growth (2.4 percent in 2006 and 2.3 percent in 2007): a 15 percent euro appreciation, a 20 percent increase in oil prices, a 1 percent higher trading partners growth, a 1 percent lower household saving ratio, an avian flu pandemic and a disorderly unwinding of global imbalances. They are weighted by the staff’s subjective probability assessment of their occurrence.

11. After five years of strong increases, house prices show signs of cooling, which represents a small risk to the economy (Figure 7). Construction activity is expected to slow in line with the market for existing houses. The authorities and the staff agreed that there was no evidence of any significant impact of housing wealth on consumption. 6 The real estate boom was accompanied by strong credit expansion to households, though the authorities saw only limited risks to financial sector stability, as house prices have been largely in line with fundamentals, household indebtedness has remained low by international comparison, and equity withdrawal has hitherto been absent (see ¶28).

Figure 7.
Figure 7.

France: Housing Market

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: Banque de France; and BIS-National Sources.

12. The authorities favored a coordinated effort to ensure an orderly resolution of global imbalances, which remained a risk to sustained growth in Europe. They agreed that the main role for Europe would be to proceed with structural reforms to raise growth. At the same time, they cautioned against policies that would import the imbalances into the euro area, for example by creating an excessive current account deficit for the area. They also underscored the need to strengthen economic policy governance and policy coordination at the EU level.

13. Headline inflation is expected to average about 2 percent for the next few years. This projection implies a slowing from 2.2 percent in July 2006 as the pace of oil price increases eases. Conversely, underlying inflation—at 1.3 percent in July 2006—is expected to edge up gradually, as the effect of the reforms that led to a decline in distribution prices in 2005 wanes and the room to offset minimum wage increases by further cuts in social security contributions is being exhausted. Upside risks pertain to health care costs, discretionary minimum wage increases, and oil prices, while additional structural reforms could have a dampening effect.

14. Current demographic trends and ongoing structural reforms suggest that potential growth could be higher than previously estimated. Recently-observed fertility rates and immigration suggest that the labor force, previously expected to begin to fall in 2007, will continue to grow into the next decade. At the same time, higher-than-expected female mortality signals a slower rise in the dependency rate, slightly easing the increase in aging costs from previous projections. The authorities estimate that the pipeline effects of structural reforms could add 0.1–0.2 percent to potential growth over the medium term and see some evidence that the secular decline in total factor productivity growth has ended. Together with the effects of the recent uptick in investment, this suggests that annual potential growth could temporarily rise to 2¼–2½ percent, before—in the absence of further reforms—settling at somewhat less than 2 percent per year in the long run. On the basis of this information, the staff has revised its annual potential growth projections up from 1.9 percent to 2.2 percent for the next five years.

III. Policy Issues

15. Achieving fiscal sustainability, full employment, and higher trend growth remain priority objectives for economic policy. 7 Reflecting greater public consensus, fiscal adjustment has been progressing faster than expected, and institutional mechanisms have been put in place to secure further progress. Nonetheless, the ongoing cyclical upswing and the upcoming 2007 elections will test both this consensus and these mechanisms. At the same time, the electoral debate provides an opportunity to seek the public’s endorsement of broader and faster structural reforms, particularly in the labor market, much needed to prepare the economy for aging and allow it to benefit from globalization (Box 3). Hence, while no major new reforms will be tabled, the authorities plan to continue implementing ongoing reforms during the preelection period aimed at reducing the budget deficit and creating jobs, especially for the young. More broadly, they intend to foster debate and consensus on the causes and remedies of high unemployment.

A. Fostering Reform

16. The authorities underscored the importance of economic pedagogy and building consensus to promote structural reform. They pointed to the success of this approach in a number of areas, based on studies and stakeholder committees. For example, efforts at fiscal consolidation had benefited from a number of reports, most recently the Pébéreau report on the worrisome level of public debt. In parallel, an annual national conference on public finances involving all levels of government and a new council on public finances (Cofipu), with among its mandates the promotion of expenditure restraint, had been established. As a result, the need for a reduction in public debt and deficits was now widely recognized. Hence, attention is being focused on the pace of consolidation and the distribution of the effort among levels of government. A key issue was now to further build credibility by continuing to meet the spending and deficit targets as had happened for the first time in 2005.

17. Given the public’s high sensitivities, reforms would need to be approached very cautiously in the labor market. The authorities saw the social unrest in reaction to the proposed new labor contract for the young (CPE) and its subsequent withdrawal as an indirect confirmation of the need to follow a gradual, consensual approach. Indeed, while the measure was intended to rapidly improve job prospects for urban unemployed youth, stakeholders had not been consulted sufficiently, and prior consensus had not been achieved. Partly in response, a new council on employment (COE) had been created to establish a common diagnosis of the causes of unemployment among social partners and foster public debate on its remedies.

18. The authorities stressed the need to sustain income growth at a time of structural reform. They noted that they had accordingly balanced fiscal adjustment and pension and health care reforms with increases in the minimum wage and benefits (including the earned income tax credit), greater opportunities for workers to participate in profits, better prospects and financial incentives for working longer, improved access to credit, tax cuts, and measures to prevent income loss for health care providers.

19. The staff recognized the benefits of the authorities’ approach, while suggesting some adjustments to ensure faster progress. Reforms seem to have met with success when they were accompanied by highly visible quantitative objectives, e.g., the expenditure norms for the central government and health care. This approach could usefully be extended to other areas of public finance and to structural reforms as well, for instance by focusing on employment rates for labor market reforms, and product market regulation indicators for reforms in product markets. At the same time, efforts of various councils, useful in advancing a comprehensive understanding by stakeholders, would need to be well coordinated to exploit synergies, particularly in dealing with distinct entrenched interests. While trade-offs are inevitable, significant dilution of the long-term gains should be avoided. It will also be important to apply the pedagogic approach consistently. For example, “economic patriotism” may sound attractive to some, but it has a protectionist guise that runs counter to France’s best interests.

France: Implementation of Fund Recommendations

The authorities have concurred broadly with the direction of the Fund’s economic policy advice, but implementation has been more gradual and subject to more tradeoffs in order to preserve social cohesion, generous welfare arrangements, and a narrow income distribution.

Fiscal policy: Budgetary execution over the past three years has been in line with long-standing Fund advice to consolidate by at least 0.5 percent of GDP annually until structural balance or surplus is achieved. The pension reform has appreciably diminished the projected cost of aging, health care reform is progressing, and civil service reform is picking up but remains more modest than advocated by the Fund. Revenue windfalls are now being fully saved, and fiscal governance has been strengthened considerably.

Labor and product markets: Additional flexibility was introduced in labor markets, especially reversing some of the restrictions related to the reduction of the workweek to 35 hours. The new employment contract (CNE) represents an important step in reforming labor market institutions, but entitlements (other than pensions), judicial uncertainty surrounding labor contracts, and high minimum wages remain to be tackled. In product markets, divestiture and deregulation are ongoing, albeit at a slower-than-advised pace, and there is scope for further liberalization of trade in services.

Financial sector: The financial sector has been subject to strong supervision. The authorities continue to be reluctant to phase out widespread administrative deposit and loan schemes, though some of them 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. The authorities indicated their commitment to a successful conclusion of the Doha round and noted that accelerating CAP reform, planned for 2007, would have disrupted farmers’ preparations.

B. Achieving Fiscal Sustainability and Efficient Taxes

20. Rising costs of aging and high deficits constitute the main threats to fiscal sustainability. While pension reforms and the improved outlook for potential growth have significantly reduced the expected increase in the cost of aging, current policies would still lead to unstable debt dynamics (Box 4). There was agreement that further growth-enhancing structural reforms and fiscal adjustment would be needed and that more of the former would facilitate the latter. Health care costs, while better contained than in the past, will continue to pressure the budget, rendering additional measures inevitable. The general government deficit is still too high to stabilize public debt. The decline in the debt ratio in the course of 2006 is due to asset sales and tighter cash and debt management.

21. Over the past three years, fiscal consolidation has progressed significantly, while fiscal governance and spending restraint have been strengthened. Between 2003 and 2006, the structural deficit has been reduced by more than 1½ percent of GDP (Text Table). The authorities highlighted that France had been the first of the large euro area countries under the excessive deficit procedure to have brought the deficit to less than 3 percent of GDP in 2005 (albeit with the help of a one-off transfer from the electricity sector against its future pension liabilities); real central government spending had been constant for four consecutive years; health care spending had been on target in 2005 for the first time in recent history; and the pace of reduction in the number of civil servants, while modest (only one out of every seven retiring civil servants is not being replaced), was being stepped up. Further, all revenue windfalls are being used to reduce the deficit, a feature embedded in the 2006 budget law, and expenditure margins are being set aside ex ante. The implementation of the new organic budget law is fostering a results-oriented culture in the civil service. Finally, independent budget oversight by the Cour des Comptes had been strengthened, including via more ex ante analysis, though it was felt that it should better focus on the general government.

Text Table.

France: General Government, Current Policies, 2005-11

(In percent of GDP; unless otherwise indicated)

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Sources: INSEE; IMF staff calculations; and Budget Discussion June 2006 Report.

Net of contribution to the EU.

Real growth (in percent) adjusted using CPI excluding tobacco prices.

Maastricht definition.

Data for 2005 exclude the EDF pension fund transfer (0.5 percent of GDP); in percent of potential GDP.

Scenario in line with a delayed Lisbon agenda expected to boost potential growth by 1/4 over the long run.

As indicated in the Budget Discussion June 2006 Report.

22. Nevertheless, continued growth of social security and local government spending has prevented the expenditure-to-GDP ratio from declining and required fiscal adjustment to rely on increased revenues. Public spending has been stuck at over 53 percent of GDP, with local and health care spending growing at about 4 percent per year during the past five years. Fiscal adjustment thus stemmed from higher revenues: two thirds was due to underlying dynamics of the tax base and the fact that the tax elasticity with respect to GDP is slightly higher than one, which more than offset personal income tax cuts. The remainder resulted from increases in health care contributions, partly offset by declining social security contributions elsewhere in the context of policies designed to support labor demand.

France: Fiscal Sustainability

In March 2006, the pension council (Conseil d’Orientation des Retraites, COR) revised estimates of the needs of the pension system by 2050. The COR’s projection, which did not incorporate the most recent revision to the demographic profile, pointed to an increase in budgetary costs of 3.1 percentage points of GDP after taking into account the impact of the 2003 pension reform (estimated to have lowered these costs by 1.2 percentage points of GDP). While providing detailed sensitivity analysis to changes in economic and demographic assumptions, as well as changes to policy parameters, the report highlights the need for further reform to guarantee the sustainability of the system.

The staff analysis concurs with this assessment. 1 Despite the recent revisions to demographic projections pointing to more favorable population aging dynamics than in the COR baseline and the positive effect of the recent health care reforms, aging costs remain the key threat to fiscal sustainability. Under the staff’s baseline scenario, they are expected to add 4.5 percentage points of GDP to fiscal spending by 2050 (2.7 percent for pension and 1.8 percent for health) leading to unsustainable debt dynamics.

A01ufig06

Public Debt Scenarios

(Percent of GDP)

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

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

Addressing the long-term costs of aging requires further fiscal consolidation through a combination of fiscal adjustment and growth-enhancing measures. Upfront fiscal adjustment alone, consistent with the authorities’ goal of reaching fiscal balance by 2010, would bring the debt-to-GDP ratio down to about 30 percent by 2030 but would not suffice to stabilize it. However, a reform scenario in line with a (delayed) Lisbon agenda (expected to boost potential growth by at least ¼ percent after 2012) together with an upfront structural fiscal adjustment of 0.3 percent of GDP per year through 2011 would achieve sustainability at a public debt-to-GDP ratio of about 20 percent of GDP by 2050.

1

The current policy scenario reflects fiscal policies as described in Table 1 through 2011. Demographic assumptions are consistent with INSEE’s recent population projections with a fertility rate of 1.9, life expectancy of men and women of 83.8 years and 89 years, respectively, and net migration of 100,000 per year, which compares favorably to previous assumptions of lower fertility (1.8), higher life expectancy (+1.2 years) and lower migration (50,000).

23. In response, plans for fiscal consolidation are being underpinned by ambitious objectives for expenditure restraint, but specific policy choices remain to be made. The authorities aim to balance the budget by 2010. From 2007 onward, real spending at the central government level is set to decline by 1 percent per year, growth of social security spending will not exceed 1 percent in real terms, and local authorities are expected to gradually move toward keeping real spending constant. For 2007, there is a commitment on the central government’s objective, but little or no structural adjustment. In addition, how spending objectives will be achieved for the other components of government, and beyond 2007, remains to be spelled out. 8 Hence, the staff projects the structural balance to remain in a deficit of about 1¾ percent of GDP.

24. Tax reforms have been geared at promoting employment and investment, but tax expenditure initiatives are proliferating (Box 5). The increase in the earned income tax credit, the introduction of a ceiling on tax payments as a share of current revenue (bouclier fiscal), and the reduction in marginal income tax rates in 2007 will boost labor supply across the skills range. A cap on a local tax on capital and the extension of exemptions for new investments until they are on stream will help investment. However, in response to tight spending limits, policy proposals are becoming increasingly focused on granting tax exemptions and tax credits. The authorities acknowledged the need to stem this tide, which could be done by prohibiting such measures from being introduced outside annual budget laws.

25. Current proposals to reform the financing of social security would have little economic impact. Mindful of the high cost of labor, further cuts in employers’ social security contributions are being considered, to be financed by an increase in taxes on consumption or capital. At the technical level, the staff and the authorities agreed that, in France’s institutional context, there are virtually no benefits from such a shift. 9 Shifting to consumption taxes would allow a slight reduction in marginal tax rates, but because social benefits and the minimum wage are indexed to inflation and unions may demand compensation for the loss of purchasing power, there are no other gains. Shifting to capital may have short-term benefits but at the cost of less investment and less output in the long run. Rather than shifting the tax burden, the staff argued for financing the reform through additional expenditure cuts.

C. Combining Financial Sector Stability and Efficiency

26. The financial sector appears sound and well placed to manage some potential vulnerabilities. The sector is highly capitalized and profitable, though a substantial part of the recent rise in profits is likely to be transitory, as it is linked to reintegration of past provisions, low ongoing provisioning, and rapid credit growth (Tables 4–6 and Figure 8). Following a period of rapid expansion of mortgage credit, lending is becoming more balanced as credit to the corporate sector has picked up, while the real estate market shows some signs of cooling. The insurance sector is benefiting from the good stock market performance, rising interest rates, and the reduced incidence of natural disasters.

Figure 8.
Figure 8.

France: Financial Sector Indicators

Citation: IMF Staff Country Reports 2006, 389; 10.5089/9781451813685.002.A001

Sources: Banque de France; and Datastream/Thompson Financial.1/ All credit institutions aggregated data on a parent-company basis.2/ Lehman Brothers Euro-aggregate government, corporate issues redemption yields.
Table 4.

France: The Core Set of Financial Soundness Indicators, 2000-05

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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 (2005, IFRS).

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

Table 5.

France: Encouraged Financial Soundness Indicators, 2000-05

(In percent, unless otherwise indicated)

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

In percent of financial firms’ gross operating surplus.

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

Table 6.

France: Financial System Structure, 2000-05

(End of year)

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Source: Banque de France; and Ministry of Finance.

Including development banks. Nonbank development finance corporations are included separately under “Other credit institutions.”

Number of institutions with 75 percent of total assets.