Woolly-headed

Fund Strategy - 9 Jul 2012 | By Rodrigo Amaral

So they finally said “nein” to Angela Merkel, the German chancellor, and her obsession with austerity. In a meeting that was lauded as surprisingly productive for an European summit, leaders of the eurozone announced in late June a new programme to boost economic growth in the region.

The news was enthusiastically received by the markets, which have apparently identified a new eagerness to find a solution for the long-running debt crisis that has brought several countries to their knees. The summit also marked the début on the European scene of the new president of France, François Hollande. He is a socialist and an avowed enemy of the belt-tightening measures that have haunted Europeans of late. So has his arrival to the table been enough to change the course of economic policy in the eurozone?

Supporters of Keynesian solutions to the crisis are certainly hoping that the answer is a resounding “Oui”. Germany has the full pockets and the moral authority, in terms of economic policy, to demand a balancing act from its partners in the euro.

But it was the close alliance between the German chancellor and Hollande’s predecessor, Nicolas Sarkozy, that gave it the political muscle to overcome the protests of affected parties. Merkel even campaigned ostensibly for the re-election of the conservative president, a decision that has not helped her to gather friends in the Hollande field.

As the French socialists compound­ed the grabbing of the presidency with the election of a comfortable majority in parliament, conditions appear to be in place for a break-up between the austerity and spending teams in Europe. (Cover story continues below)

Fears about the influence of Hollande on the necessary financial adjustments of the eurozone, however, may well have been overblown. In fact, his first concrete actions in economic policy indicate that the Hollande from the campaign could very well have been a socialist sheep dressed as a tough left wolf to draw rebellious voters.

The government is increasing taxes on the rich and on large companies, as well as other groups of economic actors. But it has also expressed a commitment to balance the books that could lead to more drastic measures such as - horreur, horreur - the slashing of public expenditure.

The more sanguine analysts suggest that Hollande may use the political capital and the sense of urgency created by the crisis to dwell, in the future, with unpopular issues like the reforms of the country’s rigid labour markets and generous and fully state-funded pension system. Now that would be a French Revolution for the 21st century.

“The truth is that we have to rebalance the budget”

If such hopes sound excessively optimistic, that is because they probably are. But at least for the moment, the government has striven to make the right sounds. In early July, prime minister Jean-Marc Ayrault used his first speech in parliament as the head of the cabinet to press the point that the socialists are not there to put French finances in disarray. He warned that France faces an unprecedented crisis that threatens the social model of the country.

He said high levels of debt, which have reached 89.3 per cent of GDP in the first quarter of 2012 compared with about 60 per cent a decade before, is a main cause of the problems. “The weight of debt has become devastating,” he said. “The state pays almost €50 billion [£40.2 billion] every year to its creditors.”

In other times, or elsewhere in the world, a sentence like this in the mouth of a top socialist official would sound like “default” to the ears of many people. But in the Europe of 2012, this is more likely to indicate at least an acknowledgement that the French government needs to do something to sort out its bloated finances. Such utterances by socialist officials could indicate that Hollande’s team is aware they cannot meet the expectations of many of his voters about turning the economy around without tightening their belts first.

“They are waking up to the economic realities of France and Europe,” said Nicolas Lescassin, the head of free-market think tank IREF. “And the reality is that the French government spends far too much money.”

If the socialists needed any reminder about the challenges to come, the latest economic statistics released by INSEE, the office of data-crunchers, have surely done the trick. According to the body, the economy did not grow from January to March - a regression from a small increase of 0.1 per cent in the previous quarter. INSEE has forecast that GDP growth will be 0 per cent again in the second quarter and that the economy should barely increase by 0.4 per cent for the year.

This is bad news for the French government. The stabilisation programme presented by the previous administration to the European Union earlier this year was based on considerably more upbeat GDP growth. A slower economy, of course, means lower tax revenues, which reduces the scope for the government to balance its books without implementing spending cuts.

The lower rate of GDP growth makes a big difference, as noted a few days later by Cour des Comptes, the government’s auditors’ office. France has promised Brussels that it will bring public deficit down from 5.2 per cent in 2011 to 4.4 per cent in 2012 and 3 per cent next year. But the previous government made its projections with the understanding that GDP would increase by at least 0.5 per cent in 2012, and perhaps even more.

But now this number looks positively Panglossian, and the auditors noted that if the economy grows by 0.4 per cent instead, the revenues of the state will fall by between €6 billion and €10 billion. In fact, the Cour des Comptes says the government will have to find about €33 billion to meet next year’s deficit reduction targets. The reality could be even worse: the government itself has revised downwards its growth forecasts, to 0.3 per cent in 2012 and 1.2 per cent in 2013. Coe-Rexecode, a think tank, goes as low as 0.8 per cent for 2013, which would mean an even harder task for Hollande’s team.

The instinctive answer by the government has been to announce several tax hikes, which are not really unpopular in France. A revised budget proposal in­creases taxes on the wealthy and on large companies.

The expectation of the government is to raise more than €7 billion this year alone. That could fill some holes in the budget, but the head of the Cour des Comptes, Didier Digaud, has been one among many analysts to stress that a long-term solution for the debt problem relies on reducing the levels of expenditure by the state. That is where French governments in general often stumble and the task of trimming the fat should be particularly challenging for a centre-left politician like Hollande.

Of course, the precedents for a socialist government are not good for free market supporters in France. The country’s previous socialist president, François Mitterrand, kicked off his

14-year reign by promoting the nationalisation of strategic companies, a sig­nificant hike to the minimum salary and other distinctly left-flavoured ­meas­ures. But Hollande would find it difficult to follow a similar route.

In truth, three decades ago, Miterrand was compelled to become more market friendly as his mandate went on. So fears fuelled by the socialism of the the president and parliamentary majority should not be overblown.

It is worth remembering that the supposedly market-friendly government of Sarkozy did very few of the things that critics say Hollande is unlikely to do. It promoted sharp increases in public deficit as it tried to boost the economy with spending. Hollande does not seem to have this choice. Lescassin notes that markets have become particularly unforgiving with free-spending governments and have the means to put pressure on France.

About 65 per cent of the debt issued by the country is held by foreigners, says Lescassin - the third highest ratio in the eurozone behind Portugal and Greece. With economic growth and tax revenues doomed to remain low for quite a while, if the government does not show that it is on top of spending, markets may turn against France.

The revised budget has brought some indications that the government is not deaf to the demands of the markets. Expecting that a newly-elected socialist cabinet would slash public expenses in France sounds like hoping that England will one day win a penalty shoot-out in a major football tournament.

But Pierre Moscovici, the economy minister, and Jérôme Cahuzac, the budget minister, announced that they will freeze expenditures by the state for five years to limit annual spending increas­es to 0.8 per cent above inflation. That may sound modest, but it is well below the 1.1 per cent hikes of spending promised by Hollande during the presidential campaign.

As newspaper Les Échos pointed out, it means extra help worth €3 billion a year in the effort to reduce the public deficit. The revised budget aims to keep government spending stable as a ratio of GDP at 56.1 per cent in 2012, and to bring it gradually down in the following years.

“We are living in a situation that is similar to Brazil under president Lula,” says Radu Vranceanu, a professor of economics at the ESSEC business school in Paris. “Markets are scared about the arrival of a socialist president. But now that he needs to make real-life decisions, he is being rigorous in the management of the economy.”

In Vranceanu’s view, although it is still early to say that the government is fully sold on the idea that there is no alternative to a responsible fiscal policy, it seems to be moving in the right direction. “Hollande is not augmenting government spending and he will increase taxes, which the previous government was reluctant to do, but the truth is that we have to rebalance the budget.”

Markets appear to have either priced a socialist win before Hollande took over or accepted that the socialists had little scope to drift away from the line pursued by Sarkozy. France’s main stock market index, the CAC 40, chang­ed little after Hollande’s victory was confirmed. It was bumped up by the positive outcome of the European summit in late June, where the French president is believed to have been an important force behind the agreements reached. The market has been moving more according to European developments than domestic ones. But the first budget measures announced by the socialist government in early July have failed to interrupt the wave of optimism generated by the summit.

“In the past few years, France has not been able to adapt to the new patterns of global demand”

This does not mean investors have no doubts. Britta Weidenbach, a senior portfolio manager for European equities at DWS, says Hollande seems to be putting more emphasis on tax hikes than would be desirable. “For example, the government wants to increase taxes on dividends to force companies to invest in France,” she says.

“I am very sceptical that this is the right incentive. They have also an­nounc­ed a desire to increase tax on share trading from 0.1 per cent to 0.2 per cent. What I am missing are efforts to in­crease the competitiveness of the economy.”

The decision to partially revert a modest pension reform passed by Sarkozy and bring down the minimum retirement age for some workers to 60 from 62 has not gone down well either. Weidenbach also regrets that Hollande has discarded a campaign proposal by Sarkozy to replace some of the costs that companies have to face as social benefits by a VAT increase.

“The president and the prime minister have said that they are committed to balancing the budget, and at least two thirds of the effort will be done via tax increases,” she says. “Studies have shown that to pursue economic growth, government spending should be cut instead of increasing taxes.”

Keeping the confidence of markets in the short run is one thing. But promoting reforms that France requires to resume economic growth is a different matter. Excessive regulation, a labour market that is too rigid and high taxes on companies are among the hurdles to economic recovery that require quite a lot of reforming, Lescassin says.

He adds that it is hard to believe France is the only country in Europe where pension funds do not exist, making the state liable to pay a mammoth pension bill for decades to come.

Of all the issues above, labour market reform is likely to be the thorniest for any effort of reform. Centre-right, supposedly business-friendly presidents led France, sometimes with parliamentary majorities, for 17 years until Sarkozy’s defeat last May. But they were never too brave when it came to making it easier for business to dismiss employees or to keep wages under control.

If Hollande had even hinted during the campaign that he considered touching this wasps’ nest, he would most likely be watching eurozone summits from his living room.

But Vranceanu says developments at the European level may end up pushing his hand, as the severity of the crisis has already forced some workers’ paradises, like Italy, Spain and Portugal, to relax labour laws.

“The president may follow the example of Italy if things go well over there,” he says. “Nobody is talking of labour market reforms right now. But we will have to increase labour market flexibility in the next three or four years, as we keep losing competitiveness.”

Competitiveness is key as, according to Denis Ferrand, the head of Coe-Rexecode, most of the economic growth that France will post this year and next will come from the products and services companies sell abroad.

“Factors to sustain domestic demand are not there yet,” he says. The purchase power of households is on the way down this year and set for further reductions in 2013. Companies’ results remain well below 2007 levels and continue to deteriorate, he says, so investments by the corporate sector are unlikely to do the trick, either.

So global demand boosted by a weakening euro should provide the main drive for growth, and one that could be more important if the competitiveness of French companies was higher.

“In the past few years, France has not been able to adapt to the new pat­terns of global demand,” says Ferrand.

Among other things, addressing the lack of competitiveness requires boosting incentives to innovation, something that was already kicked off by the previous government with the creation of new tax incentives. And also reducing the cost of doing business in the country, of which labour markets are once again a major factor.

“Labour-related costs in France have increased compared to Germany in the past 10 years,” Ferrand says. “Now those costs are also rising compared to the southern European countries that have already started to reform their labour markets.”

A similar process took place in Germany after it joined the euro. Centre-left chancellor Schroeder convinced his party of the need to promote some rather unsocialistic reforms. So maybe all hope is not lost for France, analysts say.

Doing things right on the economic policy side is also important if Hollande wants to maintain the ability of France to influence the way the EU goes.

“At international level, Hollande wants to show himself to be more independent from Germany,” Vranceanu says. “But he knows that France can only take the lead if it is a model of financial stability.”

In fact, Hollande and Merkel may have already found some common ground to keep the French-German locomotive working. Newspaper Le Figaro, for instance, has reported that France and Germany are discussing the possibility of boosting the role of the president of the Eurogroup, to the point of giving to the holder of the post a seat in G20 meetings, which would create a politically more relevant spokesperson to defend the euro in tandem with the more technical European Central Bank.

In fairness to him, it was not Hollande, but the Italian leader, Mario Monti, who claimed credit for forcing Merkel to make concessions in the late June meeting. Once the rare sight of the chancellor yielding to other European leaders lost its initial impact, it became clear that her stance on the major issues, like the mutualisation of European debt, has not changed.

So Hollande would probably do well to stay on the good side of the German chancellor anyway, even though he may gather support from other leaders to press Merkel to soften her views.

For all the talk of common fiscal policies and strengthening federalism in the EU, a short-term solution for the crisis probably rests on Germany agreeing to foot a large part of the bill. And a solution is of the greatest interest for France as the pressure of international markets on the country is only going up while the turmoil lasts.

Credit rating agencies have warned that the top rating of France’s debt is not safe and the most pessimistic analysts fear that the country could soon overtake Italy as the likely next domino in the crisis. It is up to Hollande to make sure France avoids such a fate.

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