France: 2016 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for France
Author: International Monetary Fund. European Dept.
Publication Date:
12 Jul 2016
eISBN:
9781498359665
Language:
English
Keywords:
ISCR; CR; financial market condition; staff appraisal; growth; banks' exposure; Banque de France; structural adjustment; IMF staff calculation; labor market; headline inflation; Labor markets; Global; Europe
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This 2016 Article IV Consultation highlights that economic recovery in France is solidifying. The economy is projected to expand by 1.5 percent in 2016, primarily driven by strong consumer spending. There are also signs of a cyclical recovery in investment, and the slump in residential construction appears to be bottoming out. By contrast, net exports are declining as demand from trading partners has slowed. Private sector job creation has remained lackluster, and the unemployment rate has hovered at about 10 percent. The government has continued to advance important reforms to help create the conditions for improved economic performance. As for budget policies, there are ongoing efforts to contain spending growth at all levels of government while easing taxes.

Abstract

This 2016 Article IV Consultation highlights that economic recovery in France is solidifying. The economy is projected to expand by 1.5 percent in 2016, primarily driven by strong consumer spending. There are also signs of a cyclical recovery in investment, and the slump in residential construction appears to be bottoming out. By contrast, net exports are declining as demand from trading partners has slowed. Private sector job creation has remained lackluster, and the unemployment rate has hovered at about 10 percent. The government has continued to advance important reforms to help create the conditions for improved economic performance. As for budget policies, there are ongoing efforts to contain spending growth at all levels of government while easing taxes.

Context—Recovery and Reforms

France’s economy is recovering. But unemployment remains stubbornly high and public debt is still rising. To address these challenges, the government has pushed forward an agenda of tax cuts, spending restraint, and supply-side reforms against significant political resistance.

1. Gradual reform progress against political resistance. Since 2013, the government has advanced a number of supply-side reforms, including services liberalization and income, labor, and corporate tax cuts (Box 1). The fiscal consolidation strategy switched from tax increases to spending restraint. These reforms were implemented against significant political resistance and in the context of rising anti-establishment sentiment as evidenced by the results of the December 2015 regional elections. The El Khomri reform of the labor code, unveiled earlier this year, has faced even stronger opposition, and the government relied on a constitutional procedure to move a modified version of the law through the lower house of parliament, triggering a confidence vote. This was followed by union-led strikes and fuel blockades. The political climate and social dialogue appear increasingly tense as France approaches the May 2017 Presidential elections.

2. Recovery underway, but job creation still limited. France’s economy grew 1.3 percent in 2015, the fastest pace in four years. While the strong first quarter this year partly reflected one-off factors, growth appears to be solidifying and catching up with the euro area average. The recovery has been driven primarily by private consumption, which picked up in early 2015 as households gained purchasing power from falling energy prices and flat consumer price inflation against steady moderate wage growth, while some benefited from mortgage refinancing at lower interest rates. Corporate investment has also picked up alongside the cyclical recovery, supported by improved profit margins, low borrowing costs, phased-in tax cuts, and temporary fiscal incentives for amortization. By contrast, net external demand has remained weak, in part reflecting slower growth in trading partners. Despite the recovery, private sector job creation has remained lackluster, with the unemployment rate hovering around 10 percent. Headline inflation has remained flat, and core inflation was only 0.6 percent in May 2016, below the euro area average, pointing to continued economic slack.

A01ufig1

GDP by Demand Components

(Percent contribution to annual growth)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: Haver Analytics and IMF Staff calculations.

3. Continued credit growth despite volatility. A bout of global financial volatility in the first quarter hit French banks’ equity prices but CDS spreads remained far below 2011/12 peaks. The impact on France’s banks was broadly similar to other euro area countries and stock prices have recovered since then. Despite the volatility, bank credit growth has remained positive—at around 4 percent in 2015 for both households and companies, well above the euro area—and larger firms have significantly stepped up bond market financing, supporting a pickup in investment by French companies both at home and abroad. Access to credit does not appear to be a major hurdle for France’s SMEs.

Figure 1.
Figure 1.

A Subdued Recovery

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: France Authorities, IMF World Economic Outlook, Haver Analytics, and IMF staff calculations.

4. Lower headline deficit, but slower structural adjustment and rising debt. After a pause in 2014, the overall fiscal deficit fell by almost half a percentage point to 3.6 percent of GDP in 2015, overperforming the authorities’ projections (3.8 percent of GDP). Consolidation was supported by nominal containment measures, including the continued wage scale freeze and reduced central transfers to local governments, which in turn sharply curtailed investment spending for the second year in a row. However, policy measures explain less than a third of the improvement, with real primary spending continuing to grow faster than GDP. The main drivers of consolidation were the cyclical recovery and savings from lower interest rates, with the 10-year bond yield averaging 0.8 percent in 2015, supported by the ECB’s quantitative easing program. Public debt continued to rise, reaching 96.1 percent of GDP at end-2015.

5. Some progress on competitiveness and external imbalances. France’s share in world export markets has declined substantially over the past decade, while resilient domestic demand has sustained import growth throughout the crisis. The current account deficit narrowed to less than ¼ percent of GDP in 2015, partly on account of improved terms of trade. This was ½ to 2½ percent of GDP lower than staff’s assessment of the cyclically-adjusted norm, with the real exchange rate 3 to 9 percent overvalued (Appendix IV). Competitiveness has been impaired by a prolonged period during which real wage growth remained solid despite declining productivity growth, combined with regulatory barriers and a high tax burden. A weaker euro and low oil prices, together with cuts in the labor tax wedge, have helped strengthen the external position somewhat but some of the underlying causes of the external imbalance remain, including elevated unit labor costs and a sizeable fiscal deficit.

Outlook—Modest Growth with Risks

A subdued medium-term outlook implies that unemployment and public debt will remain elevated for some time to come. France remains exposed to global financial stress, a protracted period of low growth in the euro area, and confidence losses from regional or domestic political developments.

6. Solidifying recovery, with some uncertainty and downside risks. We project real GDP to grow by 1.5 percent this year. The latest data point to continued strong consumer spending, suggesting that consumer confidence continues to improve despite recent terrorist attacks and the still poor labor market. There are also clear signs that investment is picking up and that the slump in residential construction may be bottoming out. The slowdown in structural fiscal adjustment, while problematic for fiscal sustainability (see below), removes another headwind to growth. Conversely, net external demand remains weak, reflecting in part slow growth in trading partners, including in the euro area. Among the areas of uncertainty are the potential effects of strikes and blockades, the upcoming Presidential elections, and a number of regional risks (see below).

7. Inflation outlook still subdued. Despite higher energy prices, headline inflation is projected to remain just marginally above zero in 2016, reflecting continued economic slack and flat import prices. As the recovery firms up, wage growth accelerates, and energy prices rise, inflation is expected to increase to around 1 percent in 2017, still well below the rate consistent with medium-term inflation objectives for the euro area.

A01ufig2

Composite Leading Indicator

(Amplitude adjusted index; right scale in y-o-y growth)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: Haver Analytics, OECD, and IMF Staff calculations.
A01ufig3

Business Climate and Household Confidence

(Index, long-term average = 100)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Source: Haver Analytics.

8. Modest medium-term growth prospects. Over past decades, growth has been supported by rising government spending, robust wage dynamics and productivity growth, and a steady expansion of the labor force. But the crisis has taken a toll and past drivers of aggregate demand are fading. Alongside a subdued euro area recovery, France’s growth trajectory has flattened, with the level of output around 8 percent below the (hypothetical) pre-crisis trend line by 2021. Potential output growth—projected to rise gradually from around 1 percent in 2015 to 1½ percent by 2021—is held back by slowing productivity as in other advanced economies, but also by structural rigidities as discussed in last year’s consultation. Apart from regulations in the services sector and the high tax burden, a key obstacle to growth remains the labor market, where structural unemployment is projected to remain high in the absence of additional reforms. On the demand side, growth is projected to be supported mainly by robust private consumption and accelerating investment as the recovery gains pace and confidence solidifies along with stronger growth in the euro area. This should prompt some catching up with respect to long-postponed durables consumption and machinery and equipment purchases. The subdued growth and inflation outlook implies that unemployment and public debt will remain elevated for some time to come.

A01ufig4

Loss in Potential Output Since the Crisis

(In index number, 1999 = 100)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: French Authorities and IMF Staff calculations.

9. Risks. There are a number of important downside risks that could have significant adverse effects on growth, financial stability, fiscal sustainability, and unemployment (see also the Debt Sustainability Analysis (DSA, Appendix II) and the Risk Assessment Matrix (RAM, Appendix III)):

  • Global financial stress and severe downturn. An investment demand shock in the euro area caused by weaker confidence and financial stress, combined with a near-term global slowdown, could reduce French output by 3 percent cumulatively in real terms relative to baseline, and raise unemployment by about 1½ percentage points by 2021 (Appendix I). Global financial stress would transmit to France’s real economy via export demand, confidence effects, and through the impact on France’s banks, which (as some other euro area banks) remain exposed to such shocks in part due to modest profitability, elevated leverage, and still above average reliance on wholesale funding (see financial section below). Based on historical data and assuming no changes in the business model, this could imply a substantial loss in profitability for the globally systemic banks, according to staff’s analysis (see paragraph 26).

  • Protracted stagnation in the euro area. A prolonged demand shock from lower investment intentions and higher risk premia—reflecting low growth expectations, financial fragmentation, and balance sheet concerns—could push the euro area into a low growth, low inflation equilibrium, reducing potential output while leaving the output gap open and further eroding the profitability of the banks. In this scenario, real output in France could drop in cumulative terms by 1¾ percent by 2021 relative to baseline, and unemployment could rise by over ½ percentage points. This could squeeze banks’ profitability and their ability to lend to the real economy (see paragraph 26).

  • Confidence losses due to domestic or regional politics. Domestically, the possibility of an extended period of strike actions, social unrest, or a strengthening of populist forces in the run up to the 2017 Presidential elections could hurt investor and consumer confidence, hinder fiscal and structural reform efforts, and create a more euro-skeptical environment. At the regional level, there are a number of risks that could contribute to the above downside scenarios. The British referendum on EU membership could trigger financial volatility—France’s direct banking system exposure to the UK is estimated at about 10 percent of GDP—and an extended period of political uncertainty, possibly compounded by other regional challenges such as refugees, Ukraine, Greece, and terrorism.

10. Potential spillovers. The above risks can create outward spillovers. A protracted period of economic stagnation or domestic political tensions in France could have an adverse effect on the euro area, both directly on aggregate demand and indirectly via confidence effects. Failure to deliver on fiscal consolidation and structural reform commitments could be seen as weakening the credibility of EU economic governance. Given their size and interconnectedness, French banks could create adverse effects if global financial stress forced them into further retrenchment from retail operations abroad (e.g., Italy, emerging Europe), trade and project finance, and correspondent banking activities (though de-risking is less relevant for global French banks than for some global peers).

Policies—Tackling Unemployment and Debt

Reforms have progressed in recent years but more efforts are needed to bring down debt and unemployment. Limiting spending growth through efficiency reforms would help rebuild fiscal buffers and eventually allow alleviating France’s high tax burden. Reforming unemployment insurance, strengthening training, and supporting creation of new enterprises would help support job creation. The health of the financial sector should be protected by adapting to a modest growth and low rate environment.

11. The government has made significant policy progress. In an environment with modest medium-term growth prospects at home and in the euro area, France faces two central policy challenges: (i) to support a more rapid creation of new private sector jobs and (ii) to ensure the sustainability of public finances via more efficient government spending growth. The authorities have made progress on both fronts in recent years, notably through the reduction in taxes under the Pacte de Responsabilité et de Solidarité (PRS) and the Crédit d’Impôt pour la Compétitivité et l’Emploi (CICE) and the competition-enhancing structural reforms under the Macron law. Building on earlier labor market reforms, the El Khomri law currently in parliament, would be another step forward, increasing the scope for company-level labor agreements and reducing judicial uncertainty around dismissals. As for budget policies, there has been progress on efforts to contain spending growth at all levels of government while easing taxes. These were necessary steps that, taken together, have created the conditions for improved economic performance.

12. Further efforts will be needed to secure a durable reduction in debt and unemployment. First, despite the ongoing recovery, the public debt ratio is still rising and approaching triple digits, while structural fiscal adjustment is slowing to around zero. To rebuild fiscal buffers and place debt on a firm downward trajectory, it will be important to bring down the deficit further, and to do this based on deep reforms that make government spending much more efficient in order to safeguard important services and social protections, while eventually making room for alleviating the high tax burden. Second, with unemployment entrenched at a high level, recent tax cuts and labor reforms should be followed by other growth-friendly measures to improve the functioning of the labor market, while supporting growth opportunities for start-ups and SMEs and further deregulating regulated professions. Finally, it will be important to protect the health of the financial sector in an environment of modest growth and low margins.

A. Fiscal Policy on Knife’s Edge

13. Fiscal consolidation is slowing and debt keeps rising. Structural fiscal adjustment, as measured by staff, fell from an annual average of 1 percent of GDP in 2011–13 to 0.3 percent in 2014–15, and is projected to be around zero in 2016–18. The slowdown reflects the effects of tax cuts and failure to curb real spending growth, which has been at the heart of France’s fiscal problems. The government’s consolidation strategy—relying heavily on broad-based nominal spending containment—has not delivered the hoped-for fiscal savings in the context of low growth and inflation.

Figure 2.
Figure 2.

Fiscal Adjustment Slowing and Debt Rising

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: France Authorities, IMF World Economic Outlook, and IMF staff calculations.

  • In 2016, real structural primary spending will continue to increase by more than 1¼ percent, partly reflecting inflation shortfalls, the recent decision to end the public sector wage-scale freeze, and new spending pressures such as increased security needs in the wake of recent terror attacks.

  • Despite very favorable financing conditions, France will just barely meet the EDP deficit target of 3 percent of GDP in 2017 without further efforts.

  • Structural adjustment over 2015–18 is projected to average 0.1 percent of GDP, well below the EC’s recommendation. Without further efforts, France will not reach the structural balance objective within the five-year projection horizon.

  • Debt is projected to peak at close to 98 percent of GDP in 2017, and decline only slowly thereafter.

14. Fiscal dynamics could easily derail. The fiscal strategy faces two major risks: implementation shortfalls and growth shocks. The government has committed to a sharp reduction in real spending growth over the medium term—this would require substantial additional policy measures that are not yet fully specified. Moreover, it is increasingly difficult to find offsets for new spending needs. To illustrate the implementation risks: if real structural primary spending was to continue growing at its current pace, the structural deficit would rise to 3.1 percent of GDP by 2021, against a baseline projection of 1.2 percent of GDP. Even if the necessary measures are taken, France’s Stability Program objectives could still be derailed by growth shocks. Staff has simulated two such shocks—a protracted stagnation for the euro area and a severe global recession with financial stress (see Appendix I). In both scenarios, staff would advocate letting automatic stabilizers work, but this would also mean that the 2017 Excessive Deficit Procedure (EDP) objective will be missed, and that debt will climb to well above 100 percent of GDP (see Appendix II). Moreover, if the scale of the shock is such that coordinated fiscal action is pursued within the euro area, France may need to allow for additional loosening. While a coordinated response in such circumstances would prevent a sharper deterioration in near-term growth and debt dynamics (depending on the size of fiscal multipliers and intra euro area spillovers), it would further delay achieving the medium-term structural objectives, and could raise debt levels over the longer term as the stimulus is eventually withdrawn.

Fiscal Dynamics Could Derail Under Downside Scenarios

(In percent of GDP / Potential GDP)

article image
Sources: French authorities and IMF Staff calculations.

The scenarios are described in Appendix I.

15. It is thus important to use the current economic upturn for rebuilding fiscal buffers, based on sustained efforts to slow spending growth. To anchor the needed fiscal consolidation, general government spending growth should be limited to the rate of inflation—as is broadly envisaged in the government’s latest Stability Program from 2017 onwards. This would imply an annual structural adjustment of about ½ percent of GDP—a moderate effort by both international and historical standards—striking a reasonable balance between anchoring fiscal sustainability and limiting the impact on demand. It would help reach the medium-term target of structural balance in four years. Despite the impact on aggregate demand, the proposed adjustment path would place public debt on a firmer downward trajectory, and eventually make room for lowering France’s still heavy tax burden.1 A set of near-term measures that limit the impact on growth by addressing structural inefficiencies, duplication, and poorly targeted spending, in line with the broader agenda of spending reforms (see below), could include: (i) slowing recruitment and limiting the wage drift; (ii) further tightening budget constraints for local governments (e.g., tightening of the caps on local taxes and borrowing); (iii) enhancing means testing of social benefits; (iv) further curtailing the growth in health spending; and (v) saving any additional windfall from lower interest rates or excess revenues.

16. Deep reforms to enhance spending efficiency will be critical to ensure sustainability. The recent experience highlights the limits of a spending containment approach to consolidation. Efficiency-oriented reforms would help underpin the needed adjustment and fiscal sustainability while limiting its impact on growth and protecting the French social model. Staff’s recently published study shows that such reforms could yield significant savings (Box 2).2 In particular:

  • Streamlining the large civil service and limiting the wage drift at all levels of government would help reduce the wage bill, which at 13 percent of GDP is appreciably above the levels in EU peer countries.

  • Increasing the targeting of social spending, for instance by expanding means-testing (notably for family and housing allowances), could yield significant savings without adversely affecting social outcomes. For illustration, if the redistributive efficiency of social benefits was at the EU average, France could achieve the same reduction in income inequality at a fiscal cost that is lower by 3.5 percentage points of GDP.

  • While demographics and recent reforms make France’s pension liabilities more manageable than in some other EU countries, there is still room to further increase the effective retirement age and rationalize special regimes.3

  • Slowing the growth in the cost of public health care, which already amounts to 8 percent of GDP, could be helped by further enhancing use of generic medicines, rationalizing hospital services and costs, and strengthening cost effectiveness evaluations.

17. Authorities’ views. The authorities underscored their commitment to a fiscal consolidation strategy that is fully based on expenditure efforts. They agreed that general government spending should be kept broadly flat in real terms, as the 2016 Stability Program stipulates for 2017–19. They acknowledged that structural fiscal adjustment is slowing, although less so than measured by staff, and that real spending is continuing to increase, while noting that the spending ratio partly reflects tax credits. They saw the slowdown in adjustment as necessary to preserve the economic recovery and noted that the public ratio would soon start declining. They agreed that strong spending control and additional measures will be required in 2017, but expressed confidence that the headline deficit would come in below 3 percent of GDP. They appreciated staff’s recently published study on expenditure efficiency in France, and reiterated their objective to gradually reduce France’s spending and tax ratios. To achieve this, they stressed that the approach of keeping tight budget constraints on all levels of government should help encourage spending units to seek efficiency gains. They also saw value in continuing the targeted annual spending reviews in selected areas initiated in 2015. Regarding euro area fiscal governance, they indicated support for simplifying the rules to increase their transparency and predictability.

B. Tackling Structural Unemployment

18. Much of France’s high unemployment is structural, presenting a major social and economic challenge. Unemployment appears less responsive to the business cycle, see Selected Issues Paper (SIP) Chapter I, A. The unemployment rate has hovered around 10 percent for four years. Despite steady public sector hiring, employment rates in France have stagnated, underperforming peer countries, as job creation lagged behind previous recoveries. In April 2016, the number of unemployed reached 3.5 million, and those out of a job for more than one year numbered almost 2.5 million, more than double the pre-crisis level. The unemployment rate is projected to decline only very slowly, converging with the NAIRU (to around 8½ percent) over the medium term.

A01ufig5

Unemployment by Duration

(Thousands of persons)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: DARES and IMF Staff calculations.

19. The poor labor market performance reflects deep-rooted structural rigidities, not just a weak recovery. Several factors seem to have made France’s labor market less adaptable to an evolving global economy—centralized labor agreements for over 700 branches; long and uncertain judicial procedures around dismissals; relatively easy access to unemployment and welfare benefits; a relatively high minimum wage; and a sizeable labor tax wedge. Moreover, real wages and unit labor costs have grown steadily since 2000, including during the crisis years, contributing to a labor cost competitiveness gap. Together with barriers to private sector growth, this has made it difficult for job creation to match the dynamically growing labor force. The adverse effects cut across the population but are particularly pronounced for the young, the low-skilled, and immigrants.

Figure 3.
Figure 3.

Lack of Dynamism in the Labor Market

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: Europ’Info, 2012: “L’assurance chômage en Europe,”—Edition N°9, July 2012; France authorities, EuroStat, Haver Analytics, and IMF staff calculations.

20. Reducing unemployment has been the authorities’ long-standing goal—and important steps have been taken in recent years. The labor tax wedge has been reduced significantly for low wage earners through the PRS and CICE, helping reduce unit labor costs The Rebsamen law has streamlined regulations for social dialogue in small and mid-sized companies and strengthened activity incentive schemes for lower wage earners. The Macron law has taken a step toward reforming the labor arbitration system (prud’hommes). 4 A new hiring subsidy for lower wage earners in small firms and a new training program for the unemployed were introduced earlier this year. Building on these reforms as well as the earlier labor law in 2013, the El Khomri law would increase the scope for company-level labor agreements and further reduce judicial uncertainty around dismissals—these measures should encourage more hiring on open-ended contracts and improve labor market dynamics as the recovery gathers pace.

21. Important barriers to job creation remain, however (see SIP Chapter I, B). Certain aspects of the unemployment and welfare benefits systems may contribute to inactivity traps, with relatively easy qualification for benefits and weak job search incentives.5 Moreover, the education and training system has not kept up with a changing labor market, creating an increasing mismatch between the existing skills of the jobless and those sought by employers. Bringing down the high level of structural unemployment and raising the stagnant employment rate will be critical both for growth and social objectives. With a view to supporting a job-rich recovery, staff recommends a set of specific reforms that should raise France’s medium-term employment and growth potential while improving opportunities for vulnerable groups without creating a drag on short-term demand:

  • Reforming unemployment insurance rules to strengthen work incentives, including by (i) lengthening the minimum contribution period to qualify for unemployment insurance from the current four months; (ii) unifying the maximum unemployment benefit period to two years; (iii) changing the formula for calculating unemployment benefits to balance the treatment of part-time work and alternating short-term work contracts; and (iv) introducing “degressivity” of unemployment benefits.

  • Enhancing job search support for unemployment and welfare benefit recipients, while tightening rules for accepting suitable job offers and strengthening enforcement of rules.

  • Changing the minimum wage formula to limit indexation to inflation while unemployment is high.

  • Further improving education and professional training to better match the skills of the young and unemployed to the needs of the labor market.

22. Product market reforms remain an important complement to fostering job creation and growth. The Macron law has liberalized legal professions and intercity bus transport, and opened the way for extending retail trade opening hours, while the Rebsamen law increased certain employee thresholds including for mandatory social dialogue, lifting the administrative burden on SMEs. Building on these reforms, there is still ample scope to boost potential growth and job creation, both in the short and medium term, by reducing red tape and enhancing competition:

  • Easing regulations for start-ups and the self-employed, enhancing data transparency, and streamlining qualification requirements for regulated professions, as envisaged in the “Sapin II” law on economic transparency.

  • Reducing barriers to competition for regulated professions other than in the legal area, and further liberalizing retail trade (including by reviewing zoning restrictions).

  • Enhancing the efficiency of the “Business Simplification” process aimed at cutting red tape, with additional monitoring from a new unit in the Ministry of Economy.

23. Authorities’ views. The authorities broadly agreed that a large share of unemployment is structural. They stressed their strong commitment to combat unemployment, noting that the El Khomri law builds on a series of reforms and fiscal measures that were all aimed at improving the functioning of the labor market. The law would be the first step in redrafting the labor code in order to increase the scope for collective bargaining. It would reduce the fragmentation of the labor market by enhancing incentives for hiring on open-ended contracts. It would also give more flexibility to firms while providing security to workers. They agreed that in order to bring down unemployment decisively, continued efforts are needed to strengthen education and professional training (such as through the recent presidential initiative to create a new training program for the unemployed), reform the unemployment insurance system, and further encourage the creation of new enterprises, growth, and development (as is the intent of the Sapin II law on economic transparency).

C. Strengthening Financial Sector Resilience

24. France’s large financial sector plays a key role in the domestic economy, with institutional shock absorbers for households. Banking assets are roughly 375 percent of GDP, with domestic claims accounting for about 60 percent of the total. Despite the financial volatility in recent years, access to credit has generally not been a major problem for French enterprises compared to some other euro area countries, partly reflecting relatively low sovereign risk and bank funding costs, and households have benefited from continued access to mortgage credit at low interest rates. Historically, financial conditions have impacted the economy mainly through private investment and exports, while private consumption appeared less affected—in contrast to the UK and the US (see SIP Chapter II, A). The lower impact on consumption may reflect smaller wealth effects because of lower direct holdings of stocks or corporate debt securities by households, and relatively small reliance on consumer credit to finance consumption. Moreover, given the prevalence of fixed-rate mortgages, homeowners are cushioned from adverse financial shocks, while being able to benefit from lower rates through refinancing. Saving accounts are typically renumerated at rates which are regulated and insulated from financial stress, while life insurance saving instruments are tax advantaged and often guarantee investors’ capital.

A01ufig6

Financial Stress Index Correlation with GDP Growth

(Since 2008Q1; in q-o-q growth, over different lags, sorted by Q4 correlation)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Source: IMF Staff calculations.

25. France’s big banks have buttressed their balance sheets since the global financial crisis, which has helped them cope with recent bouts of financial volatility. The four global systemically important banks (G-SIBs) have strengthened their capital and liquidity buffers in line with tighter European regulations and global standards.6 France’s global banks have also reduced their leverage and their reliance on wholesale funding since the crisis. However, several banks are still more leveraged, with continued low risk weights, and still have a higher share of wholesale funding, than most G-SIBs.7 Moreover, profitability remains fragile, as for other euro area banks. Staff’s analysis of how recent periods of financial volatility affect the group of thirty G-SIBs suggests that wholesale funding, leverage, and profitability have been associated with greater equity price responses to shocks, although this was not observed for all French banks (see SIP Chapter II, B).

A01ufig7

Measures of Capital, 2015

(Percent)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: GFSR, SNL, Bankscope, and IMF Staff calculations.Note: Leverage ratio adjusted for accounting differences (US GAAP versus IFRS)
A01ufig8

Bank Profitability

(Percent, average 2013-15)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: EBA and IMF Staff calculations.

26. The main challenge is for banks and insurers to operate in an era of modest growth and very low interest rates. While accommodative euro area monetary policy has lowered funding costs and supported the recovery and thereby bank lending, it has also further flattened the yield curve. The resulting pressure on margins, together with continued regulatory uncertainty, tends to constrain profitability of French and other euro area financial companies—likely contributing to the low price-to-book ratios. France’s G-SIBs are vulnerable to a protracted period of low growth and low interest rates, because of (i) fee and commission income, as share of total assets, below non-EU peers (though temporarily boosted by mortgage refinancing in 2015), (ii) regulated savings rates above market rates, and (iii) a high share of fixed rate mortgages that have been refinanced at very low rates, which could become a profit challenge when policy rates and funding costs rise again.8 Against this background, banks are further diversifying into asset management, private banking, and insurance. Banks may eventually be tempted to loosen lending standards or engage in more risky activities involving complex products, which could worsen portfolio quality.9 Staff’s empirical analysis shows that low inflation and growth in France have in the past been associated with smaller spreads, slower credit growth, and deteriorating credit quality. Moreover, for the group of thirty G-SIBs, staff’s panel data regression analysis points to a significant association between growth, inflation, and bank profitability. Under staff’s illustrative downside scenarios (Appendix I), this empirical relationship would suggest that the profitability of France’s G-SIBs would decline appreciably assuming no change in their business models, although the initial degree of diversification and asset quality could be important mitigating factors that would limit the impact (see right chart below, and further details in SIP Chapter II, C). This would have adverse effects on bank’s capital accumulation and lending to the real economy.

A01ufig9

Interest Rates in France

(Percent, March 2016)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: SNL, Agence France Trésor, and IMF Staff calculations.
A01ufig10

Illustrative Medium-Term Impact of Lower Growth and Inflation on Bank Profitability1

(Cumulative percentage point change by 2021)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: Bankscope, World Economic Outlook, and IMF Staff calculations.1 Scenarios based on simulations in Appendix 1. Gross impact on profitability based on past empirical relationships, not taking into account possible changes in the business model or mitigating effects from initial conditions of specific banks.

27. The financial sector will need to continue adapting to this environment, while supervisors should remain vigilant with respect to potential emerging risks. Protracted low growth and interest rates will likely require continued cost cutting, including through branch closures (SIP, Chapter II, D). It may also motivate further deleveraging and possibly sector consolidation within the euro area, although lingering regulatory uncertainty appears to dampen incentives for any larger strategic acquisitions. At the same time, supervisors should remain vigilant with respect to risks related to search for yield. In addition, the macroprudential authority should further study the reasons for the significant increase in corporate debt since the crisis, reaching about 125 percent of GDP in gross terms, though much lower when intra-group debt is consolidated, while carefully monitoring commercial real estate prices in certain locations.10 Continuing the efforts to complete the Banking Union, including through the European Deposit Insurance Scheme proposal (EDIS), together with steps to enhance bank data transparency, will help reduce systemic risks in the euro area. Finally, regulated savings rates in France should continue to be adapted to reflect market interest rate conditions.

28. An additional ongoing challenge for the financial sector is to continue adapting to the evolving regulatory framework. New global requirements such as Total Loss-Absorbing Capacity (TLAC) will require further improvements in the capitalization of France’s G-SIBs. The French authorities have proposed legislation to introduce a new class of senior debt, subordinated to existing senior debt, which will improve the clarity of bank resolution in France and fulfill TLAC requirements, and to add a cap on European Minimum Requirements for Own Funds and Eligible Liabilities (MREL) requirements. There is also a range of other regulatory initiatives that could imply additional capital needs or other adjustments, such as revisions to the treatment of risk-weighted assets and the banks’ use of internal models, and standards on market risk, operational risk, interest rate risk, sovereign debt holdings, and the net stable funding ratio and leverage ratio still to be finalized at the EU and Basel Committee on Banking Supervision (BCBS) levels. After Bank Recovery and Resolution Directive (BRRD) passage in August 2015, interim resolution plans for the four G-SIBs are under preparation.

Figure 4.
Figure 4.

Improved Bank Balance Sheets But Fragile Profits

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

1/ For corporate sector debt, after adjusting for inter-company lending and firms with group treasury operations in France, corporate debt is reduced to 69 percent of GDP (as of 2015).Sources: Bankscope, Haver Analytics, and IMF staff calculations.

29. Authorities’ views. The authorities were confident that France’s banks are well placed to cope with renewed global financial stress. They did not see leverage or wholesale funding as significant sources of vulnerability, noting that leverage is comparable to some other euro area banks, that asset quality is better and the cost of risk lower than for many euro area peers. Moreover, reliance on wholesale funding has declined substantially since the crisis, and U.S. dollar market funding is matched by deposits at the Federal Reserve Bank. They agreed that profitability remains fragile, and that a protracted period of low rates would over time create challenges, as for other banks and insurers in Europe. They saw regulatory uncertainty as a significant challenge, with several European and global regulations still being specified. The combination of low margins and regulatory uncertainty was seen by many as the main reason for low price to book ratios. They agreed on the need to keep regulated savings rates broadly in line with market conditions, while also pointing to the social role of these savings instruments. On macroprudential surveillance, they did not see major risks in the residential real estate market, and noted that they continue to monitor developments in the commercial real estate market and are analyzing the reasons for the increase in corporate debt since the crisis. The authorities stressed their strong commitment to completing the Banking Union, including the EDIS. They proposed to carefully calibrate the MREL at the EU level to ensure the resolvability of all failing or likely-to-fail banks that would apply a bail-in strategy.

Staff Appraisal

30. The economy continues to improve, but the medium-term outlook is subdued, with several downside risks. The recovery is driven by domestic demand, reflecting purchasing power gains from low import prices, favorable financial conditions, and improved profit margins, including from recent fiscal measures. The external position has improved, but remains moderately weaker than that implied by fundamentals. Medium-term growth prospects are modest and France remains exposed to global financial stress, a protracted period of low growth in the euro area, and confidence losses from regional or domestic political developments.

31. Policies have clearly progressed in recent years, but more is needed to secure a durable reduction in unemployment and public debt. In an environment with modest growth, the two central policy challenges are to support the creation of new private sector jobs and to ensure the sustainability of public finances. The authorities have made progress on both fronts in recent years, notably through labor tax cuts and competition-enhancing structural reforms. There are also ongoing efforts to contain government spending while easing the tax burden. However, unemployment has remained stubbornly high, with structural bottlenecks continuing to hinder private sector growth and job creation. Moreover, the public debt ratio is still rising and approaching the triple digits, while structural fiscal adjustment is slowing to near zero. This makes France vulnerable to shocks.

32. Fiscal consolidation is slowing and could easily derail. High and rising government spending has been at the heart of France’s fiscal challenges—a decisive break is needed to reverse the growth of public debt and make room for eventually alleviating the heavy tax burden on the economy. The government’s expenditure-based adjustment strategy is thus appropriate. However, while the headline deficit is coming down, the structural fiscal effort is slowing to around zero, and real spending is continuing to increase. Without further efforts, France will just barely meet the 3 percent of GDP deficit target in 2017 and not reach the structural balance objective within the next five years. Fiscal risks are high—implementation shortfalls or external shocks could easily throw the fiscal strategy off course, and push public debt to over 100 percent of GDP.

33. Fiscal adjustment should be underpinned by efficiency-enhancing reforms to keep real spending flat. A fiscal anchor of zero real primary spending growth would deliver structural adjustment of about ½ percent of GDP per year, a moderate effort by international and historical standards. While not detracting unduly from demand, this would ensure that medium-term fiscal targets are safely met and debt is placed on a firm downward trajectory by 2017. In addition, consolidation should shift from broad nominal containment to deeper reforms to make spending more efficient at all levels of government, limiting the impact on demand and protecting the French social model. Key reforms include streamlining the large civil service, increasing the targeting of social spending, further increasing the effective retirement age, and continuing to slow the rise in public health care costs.

34. Combating unemployment is rightly at the top of the policy agenda. Much of France’s high unemployment is structural and long-term unemployment is rising, creating major social and economic challenges. The government has advanced a series of helpful reforms to boost job creation, notably by reducing the labor tax wedge, streamlining regulations for small and mid-sized companies, and creating a new training program for the unemployed. The El Khomri law would be another important and necessary step forward—it should encourage more hiring on open-ended contracts and improve labor market dynamics as the recovery gathers pace.

35. Additional structural reforms are needed to boost private sector job creation. To improve the functioning of the labor market, it will be important to reform the unemployment and welfare benefit systems to strengthen work incentives and job search while continuing efforts to target education and professional training to the evolving needs of the young and the unemployed. The minimum wage formula should be reformed. However, to ensure that job creation keeps up with France’s dynamic demographics, it will be critical to continue efforts to raise potential growth through product market reforms, including by supporting self-employment and the creation of new enterprises and further liberalizing regulated professions.

36. The financial sector has become more resilient since the crisis, but needs to further adapt to an era of modest growth and low rates. France’s big banks have buttressed their balance sheets since the global financial crisis, which has helped them cope with recent bouts of financial volatility. They have reduced leverage and reliance on wholesale funding, although for several it remains above most other G-SIBs, and profitability is still fragile. A key challenge for both banks and insurers is to ensure profitability in prolonged period of modest growth and low rates, especially in the context of continued regulatory uncertainty. This will necessitate further cost cutting, diversification, and possibly consolidation within the euro area. Supervisors will need to remain vigilant of risks created by search for yield. Regulated savings rates in France should continue to be adapted to reflect market interest rate conditions. While private sector balance sheets remain generally solid, it will be important to monitor developments in the commercial real estate market and analyze the recent increase in corporate debt levels.

37. It is proposed that the next Article IV consultation take place on the standard 12-month cycle.

Key Structural Reforms

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How to Increase Public Expenditure Efficiency

The fiscal consolidation that started in 2011 was initially supported by revenue-raising measures but is now intended to be fully expenditure-based. However, identifying areas for savings has proved difficult, and there is no clearly articulated consensus on the areas where spending is too high or inefficient. This is in part because of concerns about the social and economic impact of specific spending cuts, in particular the impact on inequality. Spending measures have thus mainly relied on across-the-board savings to limit nominal spending growth. These cuts have focused on central government spending and the health sector, while local governments and social security funds spending have continued to grow faster than GDP.

A shift from a policy of containment to broader and deeper efficiency-oriented reforms would increase the chance of success and the sustainability of the ongoing fiscal consolidation, while protecting the French “social model”. The government has recently initiated some steps for structural savings e.g., family allowances, health, and pensions.

In a recent IMF working paper “From containment to rationalization: Increasing public expenditure efficiency”, Hallaert and Queyranne undertake a three-step benchmarking to identify areas where there is scope for greater expenditure efficiency in France, while maintaining or even improving social and economic outcomes consistent with social preferences. First, the level of public expenditure is compared to other European countries with a focus on Germany, Italy, and the United Kingdom. These are large economies with comparable income levels per capita with France. Second, social and economic outcomes in each spending area are assessed against the performance in European peers. Third, the input mix is analyzed to understand what components are responsible for the level of spending and for the quality of outcomes.

This exercise shows that shifting from containment to deeper efficiency-oriented reforms could yield significant fiscal savings. Most could be achieved by rationalizing social benefits and the wage bill, which explain about 90 percent of the difference in the expenditure ratio between France and the EU average as well as the average for Germany, Italy, and the United Kingdom. More specifically:

  • The wage bill accounts for 13 percent of GDP and almost one quarter of public spending. Recent efforts have focused on a wage-scale freeze, but low inflation has limited the effectiveness of this approach. Employment reduction (notably at the local level) and limiting the wage drift would promise greater scope for efficiency gains.

  • There is significant scope to improve the impact of fiscal redistribution on inequalities and poverty through reforms of the welfare and pension systems. France has the largest social spending in Europe and the second highest tax-to-GDP ratio, but the reduction in inequality due to transfers is only slightly above the EU average. If the redistributive power of social benefits was at EU average, France could achieve the same reduction in income inequality at a fiscal cost lower by 3.5 percentage points of GDP.

A01ufig11

Employment by Levels of Government

(In index, 1996 = 100)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: INSEE and IMF Staff calculations.
A01ufig12

The Redistributive Power of Public Spending

(Reduction of the GINI coefficient due to 1 percent of GDP of social benefits spending)

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Sources: EuroStat and IMF Staff calculations.
A01ufig13

Share of Means-tested Social Expenditures in Europe, 2012

Citation: IMF Staff Country Reports 2016, 227; 10.5089/9781498359665.001.A001

Source: IMF Staff calculations.

  • Moreover, the social outcomes and poverty impact are uneven. Social protection benefits mostly the elderly due to a generous pension regime. While long-term demographic trends are more favorable than in many European countries, additional pension reforms would support consolidation and, together with a further increase in means-testing of family-related spending, make room for more resources to address child and youth poverty.

  • Spending on housing is higher in France than in other European countries but outcomes do not appear much better than in other EU countries. This suggests potential for higher means-testing and lower institutional fragmentation and duplication.

  • At over 8 percent of GDP, health spending is high by EU standards. While health outcomes are good, they are similar to comparator countries whose health spending is lower. Building on the National Health Strategy of 2014, France could consider reforms implemented in other countries such as further improving generics market penetration, rationalizing hospital services and streamlining costs, and strengthening cost-effectiveness evaluations to decide which services should be covered by public insurance.

  • The unemployment benefits system, which accounts for about two-third of labor market policy spending, is comparatively generous. The reform of the unemployment benefit under negotiations is expected to lead to fiscal saving and reinforce work incentive (see section on unemployment for specific advice)

  • The allocation of resources in education is less efficient than in many European countries, particularly at the secondary level, and has failed to address deteriorating test scores and rising educational inequalities. Organizational reforms could help improve both education quality and social outcomes, for instance by better allocating teaching resources to the neediest, rationalizing inefficient spending (especially in secondary education), and improving the targeting of vocational education and training for those who have difficulties getting a job.

  • Public investment spending, which is at the European average, should focus more on maintenance rather than expansion given France’s high quality and quantity of infrastructure. Rationalizing local and state-owned enterprises investment would avoid duplication.

Table 1.

France: Selected Economic and Social Indicators, 2012–2021

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Sources: Haver Analytics, INSEE, Banque de France, and IMF Staff calculations.
Table 2.

France: General Government Accounts, 2012–2021

(In percent of GDP unless otherwise indicated)

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Sources: INSEE and IMF Staff calculations.

Maastricht definition.

In percent of potential GDP.

The debt figure, based on Maastricht definition, does not include guarantees on nongeneral government debt.

Table 3.

France: Balance of Payments, 2012–2021

(In percent of GDP)

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Sources: Haver Analytics, Banque de France, and IMF Staff calculations.
Table 4.

France: Vulnerability Indicators, 2008–2015

(In percent of GDP unless otherwise indicated)

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Sources: French authorities; INSEE; BdF; ECB; Haver; Credit Logement; IMF, International Financial Statistics; and Bloomberg.

The debt figure does not include guarantees on non-general government debt.

This index combines the effect of real disposable income, repayment conditions for loans, real estate prices, and interest subsidies.

Table 5.

France: Core Financial Soundness Indicators, 2008–2015

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Sources: Banque de France, ACPR.

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).

2015 data is based on new methodology which is not comparable to older figures.

Table 6.

France: Encouraged Financial Soundness Indicators, 2008–2015

(In percent unless otherwise indicated)

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Sources: Banque de France ; ACPR ; BIS.

In percent of financial firms’ gross operating surplus.

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

Or in other markets that are most relevant to bank liquidity, such as foreign exchange markets.

Other indicators such as additional balance sheet data (e.g. maturity mismatches in foreign currency), data on the life insurance sector, or information on the corporate and household sector may be added where available and relevant.