This Selected Issues paper analyzes the performance of French banks and the financial support measures taken by the French government. France has a large and sophisticated financial system, which accounts for 10 percent of the global banking system and 5 percent of global capital markets. This paper presents an overview of the French banking and supervision structure. It conducts comparative analyses of profitability, asset quality, capital adequacy, leverage, quality of capital, funding profile, and liquidity of banks. The paper also analyzes business lines, potential spillovers, and market perceptions of risk.

Abstract

This Selected Issues paper analyzes the performance of French banks and the financial support measures taken by the French government. France has a large and sophisticated financial system, which accounts for 10 percent of the global banking system and 5 percent of global capital markets. This paper presents an overview of the French banking and supervision structure. It conducts comparative analyses of profitability, asset quality, capital adequacy, leverage, quality of capital, funding profile, and liquidity of banks. The paper also analyzes business lines, potential spillovers, and market perceptions of risk.

III. Recession and Recovery: Automatic Stabilizers and Discretionary Fiscal Response in France10

A. Overview

74. Along with most developed economies, France put in place fiscal policy measures to counter the adverse effects of the global financial crisis and the economic downturn on the real economy. While France shows relative resilience to the crisis with a shallower downturn than the average European country, it still faces an unprecedented slowdown. Its GDP is expected to contract by about 3 percent in 2009 and recover only very gradually from 2010 onwards. Hence, the authorities put in place policies to sustain the economy and boost short-term demand.11 Beyond letting automatic stabilizers operate fully, the government implemented discretionary stimulus measures and used public money to bolster the financial sector.

75. The cost of those support measures matters for the success of the fiscal strategy. In the current context of financial crisis and severe downturn, a fiscal stimulus should help prevent a drastic further deterioration in activity. However, fiscal priorities such as keeping the debt under control or promoting policy credibility may outweigh the benefits of fiscal easing. Future public deficits are expected to rise to high levels raising issues of sustainability, potentially generating a negative feedback loop on the economy and aggravating the pre-existing challenges related to population aging. French fiscal policy will have to reconcile the need for short-term stimulus measures with the constraints of medium-term fiscal consolidation objectives.12 A successful fiscal strategy would entail maximizing the short-term effectiveness of the stimulus measures without endangering public solvency and/or damaging the government’s fiscal credibility.

76. This chapter considers short-term benefits and long-term costs of the current fiscal policy in France. It assesses how effective alternative fiscal measures are in promoting macroeconomic stability and welfare. In addition, we take into account that—in an integrated world—the impact of fiscal policy depends not only on the chosen fiscal policy in France but also on the policy stance of its main partner countries. This chapter uses the IMF’s Global Integrated Monetary and Fiscal Model (GIMF), calibrated to France and the euro area to compare the effects on output of different revenue-expenditure mixes and to assess the best ways to improve incentives to invest, work, and enhance fiscal credibility.

77. We show that a pro-active fiscal policy can help soften the downturn, especially when accompanied by an accommodative monetary stance, but that measures safeguarding medium-term fiscal sustainability need to be taken without delay. The most effective policy mix includes increasing productive government investment and targeted transfers. Public infrastructure spending is likely to have the largest impact on real GDP, as direct spending is less likely to trigger saving reactions from the private sector. In addition, it helps sustain the purchasing power of firms and prevents unemployment. As credit constraints tighten, household demand becomes more dependent on current income; hence, transfers targeting credit-constrained households are likely to be spent immediately, raising the bang-for-the-buck effect of fiscal policy. In addition, given the high integration of the euro area, a coordinated fiscal response boosts the impact of any discretionary fiscal stimulus measure at the national level. Finally, in this recessionary context, any fiscal discretionary policy should avoid generating additional uncertainties and damaging fiscal credibility to avoid Ricardian backlashes, costly increases in sovereign spreads or credit conditions for the private sector.

78. The remainder of the chapter is organized as follows. Section B reviews the current economic environment, Section C describes briefly the model, Section D assesses the impact of various fiscal measures, taken alone or in coordination with trade partners, and the role played by monetary policy. Section E looks into the effectiveness of stimulus measures during recession and contributes to the debate on the state-contingency of fiscal policy. Section F discusses the fiscal costs and the required adjustment to return to sustainability. Section G concludes and provides policy implication.

B. Economic and Fiscal Challenges

79. France is confronting a severe recession. While the French economy is somewhat shielded from the global downturn by its relatively low trade openness and large social safety net, output is nonetheless expected to contract by 3 percent this year followed by a tepid recovery in 2010.

Figure III-1.
Figure III-1.

France: Contribution to Growth, 2001–2009

Real GDP experienced a sharp contraction at end-2008 and early-2009.

Citation: IMF Staff Country Reports 2009, 233; 10.5089/9781451813739.002.A003

Source: Eurostat and Fund staff estimates.

80. The authorities reacted to the downturn by addressing financial sector vulnerabilities and supporting aggregate demand. The government supported the financial sector, including through recapitalization and a bank refinancing scheme, let automatic stabilizers operate fully, and implemented a relatively well diversified stimulus package (about 1.6 percent of GDP over 2009–10), front-loaded with investment measures.

81. France entered the recession with relatively weak public finances and a limited fiscal credibility. The fiscal stance had already eased in 2008 when the fiscal deficit exceeded the Maastricht ceiling. In addition, rising government expenditures related to the aging of the population put pressure on the public finances in the medium term. Historically, French fiscal policy has shown a deficit bias, responding asymmetrically to shocks by loosening during downturns but only modestly consolidating during expansions. Stimulus measures enacted during downturns have often become permanent, placing upward pressure on the public debt. Therefore, the benefits of the current fiscal stimulus must be balanced against its costs.

C. Methodology and Model Description

82. The IMF’s GIMF allows us to measure the effectiveness of fiscal policy in the current downturn while taking into account the global environment and the limited scope for monetary policy. The model is a new large-scale macroeconomic model with microfoundations based on optimizing consumers and producers. It allows for real and nominal rigidities as well as imperfect competition, therefore capturing structural characteristics of the French and European economies. The economic agents in GIMF do not exhibit Ricardian behavior being either forward-looking but with a finite planning horizon or hand-to-mouth consumers subject to cash constraints; this makes the model well equipped to measure the impact of fiscal policy because changes in fiscal instruments would not be neutral. We use a two-country model calibrated for France and the euro area, reflecting the context of a monetary union.13

83. The model is calibrated using the standard procedure that combines several macroeconomic ratios that match historical averages over the last five years with structural parameters from the relevant literature. National accounts and fiscal data were used to determine key ratios, such as, the size of the French economy compared to the rest of the euro area; public and private consumption and investment; relative importance of labor income, consumption, and capital taxes; government consumption; and other factors that affect the steady-state values. Structural parameters are largely adapted from the literature on France and the EU (OECD, 2009; De Bandt, Herrmann, and Parigi, 2006; Freedman and others, 2009). In particular, one of the key structural parameters of the model—the share of hand-to-mouth consumers—was set to 25 percent of the population for both France and the euro area in line with other studies.

84. We focus on evaluating the short-term effectiveness and long-term costs of fiscal policy in the current recessionary context. We first assess the effectiveness of alternative fiscal stimulus measures—public investment, targeted transfers, and tax cuts—by deriving the respective fiscal multipliers. We verify the additional impact of an accommodative monetary policy and of simultaneous European fiscal stimulus. Then, we simulate a recession scenario where the financial crisis triggers financing difficulties for the private sector, increasing firms’ risk premia and leading to an output reduction. In this recessionary context, we simulate the impact of the available fiscal measures and measure the costs associated with the stimulus as well as the consolidation strategy required to come back to the Maastricht public debt sustainability target (60 percent of GDP).

D. Impact of a Discretionary Fiscal Stimulus

85. This section analyzes the effects of a discretionary fiscal package consisting of public investment, targeted transfers, and general tax cuts at the steady state. Estimating a fiscal multiplier provides a measure of the effectiveness of fiscal policy, i.e. the impact of the discretionary fiscal impulse on output. The type of fiscal instrument used will affect the results, as will the size and duration of the stimulus, the response of monetary policy, trade openness, and other characteristics of the economy. In line with other recent studies addressing the fiscal stimulus impact, we normalize the fiscal expansion to increase discretionary spending by 1 percent of GDP in the first year and by 0.5 percent in the second year. This broadly reflects the size of the announced stimulus plan of the French authorities for 2009–10. In addition, we consider two scenarios of monetary policy—with and without monetary accommodation. In terms of the policy mix, we analyze the instruments most prominent in the actual French stimulus package, namely public investment, targeted transfers to cash-constrained households, and tax cuts.14 For clarity, we measure and compare the impact of three stimulus packages, each consisting of one of those instruments.

86. In terms of impact on real GDP, public investment provides by far the biggest “bang for the buck” followed by targeted transfers. Infrastructure spending has the biggest impact on growth because direct government spending risks less being mitigated by a Ricardian reaction of the private sector. Transfers or tax cuts increase the purchasing power of private agents but can potentially be used by those agents to increase their saving rate; such a reaction is most likely for those agents that will foresee an increase in taxes at a later stage and are in a position to save part of their income. Hence, income support measures targeted to vulnerable households are more efficient that general tax cuts.15

87. The response of monetary policy plays a significant role in determining the impact of any fiscal policy mix. As shown in Figure III-2 below, all multipliers are higher when monetary policy is accommodative. The baseline scenario of monetary policy involves no monetary policy accommodation and the Taylor rule in the GIMF model continues to operate during the two years of the fiscal impulse. Under the alternative scenario, monetary policy does not react to the fiscal expansion and there is no change in the nominal interest rate for one year. Lower real interest rates then help promote economic activity. It is however noteworthy that such a policy is difficult to implement in the current context of very low inflation.

Figure III-2.
Figure III-2.

Impact of a Fiscal Stimulus in France

Citation: IMF Staff Country Reports 2009, 233; 10.5089/9781451813739.002.A003

Source: Fund staff estimates.

88. A simultaneous European fiscal effort will significantly enhance the benefits of stimulating the economy. In the open French economy, highly integrated in the monetary union, any given fiscal stimulus is expected to produce “leakages” as public money will increase imports and raise output in partner countries.16 The French “demand-enhancing policy” conducted in 1981 is a perfect example of how such leakages can deteriorate the external current account balance. However, simultaneous efforts at the level of the Euro zone can circumvent the problem. If all trading partners adopt a fiscal stimulus, domestic demand is boosted in all countries, and hence, the part of the stimulus that falls on imports is compensated by the rise in exports provoked by the increased demand of partner countries. Figure III-3 below shows our estimate of fiscal multipliers when France and its partners simultaneously adopt a fiscal stimulus of the same size. Table III-1 below shows the values of fiscal multipliers in France under two different scenarios: (i) when France undertakes a fiscal expansion alone and (ii) when its partners in the euro area expand too. Our estimated fiscal multipliers are in line with results from the empirical literature and other estimates on the French economy (see Table II-1, Chapter 2). For all types of policy measures, the benefits are considerably larger when the effort is simultaneous.

Figure III-3..
Figure III-3..

The Impact of Coordinated Europe-Wide Fiscal Stimulus

Citation: IMF Staff Country Reports 2009, 233; 10.5089/9781451813739.002.A003

Source: Fund staff estimates.
Table III-1.

The Impact of Coordinated Europe-Wide Fiscal Stimulus

article image
Source: Fund staff estimates.

89. Ensuring that the fiscal stimulus is temporary is critical for its effectiveness. For discretionary fiscal policy measures to be able to boost output effectively, agents must not be increasing their savings in reaction to the government’s spending spree. To that effect, fiscal credibility over the medium run is crucial. Most measures in the current stimulus are designed to be temporary but not all, placing upward pressure on the public debt.17 To simulate the persistence of some of these stimulus measures, we run a scenario where the fiscal stimulus lingers for an additional third year by a further 0.5 percent of GDP. As Table III-2 below shows, the peak response on the economy is actually lower- as some of the forward-looking agents react to the deterioration of the fiscal stance and increase their precautionary savings.

Table III-2.

The Impact of French Fiscal Stimulus Extended by 1 Year

article image
Source: Fund staff estimates.

E. Fiscal Policy in Dire Times

90. Whether the effectiveness of fiscal policy varies with the state of the economy is becoming a particularly relevant issue as the fiscal instruments are so widely used to counter recession. So far, little research has been done on the state-dependency of fiscal policy. Theoretically, two sorts of effects are possible: fiscal multipliers could be bigger, since the disruption of financial markets could lead more households and firms to base their spending on current income, thus making public spending more efficient. On the other hand, it can also be argued that impaired credit markets will not allow private agent to leverage income earned from government spending, thus undermining the effectiveness of fiscal action.

91. We contribute to the debate by measuring fiscal multipliers in a global recession scenario and show that fiscal policy instruments remain effective in the current downturn. We first simulate a recession, and then apply a fiscal stimulus to the slumping economy. Our results show that fiscal multipliers stay close to their historical values at the steady state. The composition of the policy package also remains important and monetary policy continues to play an important role in amplifying the impact of fiscal measures. In a context of heightened uncertainty, lifting the Taylor-rule and bringing lower real interest rates will increase the effectiveness of any fiscal stimulus.

92. Our recession scenario mimics the current crisis suffered by the French economy. As shown below, distressed financial markets lead to financing difficulties for firms and therefore increase the risk premium for the private sector. In turn, private investment plummets while consumption drops but less so as it is upheld by the relatively large automatic stabilizers and the social safety net. Job destructions imply a loss in human capital and a drop in labor productivity. Those factors depress real GDP by up to 5 percent compared to the historical average, a plunge, which corresponds to the -3 percent output contraction expected in 2009.18 Forward-looking consumers are able to adjust their consumption pattern more than liquidity-constrained ones. On the public finances side, the recession worsens the deficit as automatic stabilizers are allowed to operate fully and increases the public debt.

Figure III-4..
Figure III-4..

France: Global Recession

Citation: IMF Staff Country Reports 2009, 233; 10.5089/9781451813739.002.A003

Source: Fund staff estimates.

93. In this recessionary context, we simulate the impact of a fiscal stimulus. To the recession shock, we add a fiscal stimulus of the magnitude and type described above, i.e. an increase in public spending of 1 percent the first year and 0.5 percent the second year. Again, we will measure the efficiency of three different instruments, investment, transfers, and tax cuts.

94. Fiscal policy remains effective while monetary accommodation is particularly potent. As shown in Figure III-5 below, multipliers remain in the same range than at the steady state. In addition, the hierarchy of their respective sizes remains unchanged. The impact of a responsive monetary policy is particularly large as it will limit crowding out effects and lower real interest rate will support private sector activity.

Figure III-5..
Figure III-5..

Impact of a Fiscal Stimulus During the Global Recession

Citation: IMF Staff Country Reports 2009, 233; 10.5089/9781451813739.002.A003

Source: Fund staff estimates.

95. A stimulus softens the recession and protects vulnerable households. Expansionary fiscal policy measures reduce the magnitude of the downturn and increases the consumption of vulnerable households. An investment-based stimulus package is the most effective for boosting GDP growth19 but targeted transfers support the purchasing power of vulnerable households.

Figure III-6.
Figure III-6.

Comparison of Different Fiscal Stimulus

Citation: IMF Staff Country Reports 2009, 233; 10.5089/9781451813739.002.A003

Source: Fund staff estimates.

F. The Costs and Consequences of a Stimulus.

96. Discretionary fiscal stimulus helps soften the downturn especially when it is large, without significantly worsening the debt-to-GDP ratio. Compared to the public debt profile under our weak economy scenario, a temporary shock does not seriously worsen public finances as the positive impact on real GDP compensates for the deterioration in the fiscal balances.

97. However, even containing the debt ratio at 10 percent above its target implies a steep adjustment. As interest expenditures rise steeply, they force a correction of the primary deficit. This adjustment would require in turn a steep reduction in transfers.

Figure III-7.
Figure III-7.

Cost of Fiscal Stimulus (Public Investment Scenario) in Global Recession

Citation: IMF Staff Country Reports 2009, 233; 10.5089/9781451813739.002.A003

Source: Fund staff estimates.

G. Conclusion and Policy Implications

98. As France faces an unprecedented growth shock triggered by a collapse of world trade and financial markets turmoil, an expansionary fiscal policy is the appropriate response. With limited scope for monetary policy and no export based recovery to be expected, fiscal policy is the only option to limit the magnitude of the recession. However, as the benefits of fiscal expansion come with future public liabilities, it is essential to protect medium-term fiscal solvency.

99. The optimal fiscal policy needs to promote GDP growth in the short term without damaging fiscal solvency in the medium run. Indeed, putting fiscal sustainability at risk could trigger an adverse reaction from private sector agents and markets. The rise of sovereign spreads and CDS premiums raises funding costs for public intervention. In addition, reassuring economic agents about the temporary nature of the stimulus and signaling clearly and credibly that measures will be taken to reestablish fiscal credibility are essential to avoid Ricardian reactions that will undermine the impact of the stimulus.

100. Our results suggest the following:

  • An investment-based stimulus package will be the most effective in protecting growth while targeted transfers shelter the purchasing power of vulnerable households. In addition, targeted support to vulnerable groups is more efficient than broad based tax cuts. Given the uncertainty associated with any given measure, a well-diversified package that balances different policy goals is the most appropriate.

  • An accommodative monetary policy can help both reducing public funding costs and boosting economic activity.

  • Simultaneous fiscal stimulus with France’s main partners in the euro zone would amplify the effects of fiscal expansion.

  • The effectiveness of fiscal policy does not weaken during recessionary times but support measures need to be accompanied by a credible consolidation strategy to ensure fiscal sustainability.

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10

Prepared by Irina Yakadina and Boriana Yontcheva.

11

If output falls below potential, fiscal policy can help mitigate the decline and bring output back to potential, with a goal of reducing the output gap in a reasonably short period.

12

The trade-off lies between the costs of additional debt and the potential benefit of higher GDP growth, whether fiscal priorities such as keeping debt ratio under control or promoting policy credibility outweigh the benefits of fiscal easing.

13

See Kumhof and Laxton (2007 and 2009a) for a more detailed discussion of GIMF.

14

For more details on the French stimulus package see SR 2009

15

The model emphasizes these results as it takes all government investment as productive. The relative effectiveness of targeted transfers versus general transfers or tax cuts is dependent on the share of cash-constrained households.

16

For more analysis on fiscal policy in Europe, see OECD 2009b.

17

For example, there is no sunset clause for the VAT reduction for restaurants.

18

In figure 4 below, all variables are presented in difference to the steady state values; for example, a drop of real GDP growth of 4.5 percent corresponds to an output contraction of 3 percent.

19

As the model assumes that all public investment is productive, this result may be somewhat overestimated.

France: Selected Issues
Author: International Monetary Fund