Jean-Pierre Dumas
May 3, 2023
After the IMF warning November 2022, France-staff-concluding-statement-of-the-2022-article-iv-mission, it is the turn of Fitch and tomorrow, S&P and Mody’s.
Unfortunately, the IMF, Fitch and others are right: France's fiscal outlook is not good. Not only is French public debt high by peer standards, but in addition, it is not on a downward trend. According to Fitch, general government debt was 111.6% of GDP at end-2022, the highest among 'AA' rated sovereigns and more than double the 'AA' median of 48.4%. Therefore, the downgrade of the French debt is not over yet.
The French Government finds it difficult to understand that in a monetary union it is important to have a debt ratio close to the other major members. Germany and Netherlands have a debt ratio of 67% and 49% of GDP, respectively, and the gap with France is too wide to make the French authorities credible.
Figure 1 The French debt ratio is high in comparison with peer and is clearly associated with Southern countries
Source: International Monetary Fund, World Economic Outlook Database, April 2023
France is affected by at least three factors:
1) A series of fiscal stimulus measures after the covid (see global fiscal balance in 2020 and 2021 in the table: debt projection) pushed up the debt ratio by 14 percentage points in 2020. The energy shock after the Ukrainian war gave a further boost in spending. Now it is the increase in expenditure due to subsidy to protect the French population against the energy shock (“bouclier tarifaire” for all).
2) The Government shows no serious determination to control the fiscal deficit by reducing expenditure.
3) The French Government is hobbled by permanent street demonstrations, civil unrests, and no majority in an unmanageable Parliament.
Signals that the Government is seriously considering cutting public spending are contradictory. The President and the Prime Minister continue to promise higher spending to appease the unions after the necessary but insufficient pension reform (extension of working time by two years). At the same time, the Finance Minister says, he will reduce the budget deficit, but later. Who is to be believed? The political pressure to increase public spending is as strong as ever, and the Government is afraid of the street to tackle spending seriously.
Borrowing costs are rising since the ECB normalized monetary policy; in addition, the downgrading of France’s sovereign rating by the various rating agencies will contribute to a widening of the spread. We project interest expenditure to rise to 4% of total expenditure during the 2022-27 period, up from 2.5% (2017-2021).
The quasi-permanent strikes in France, led by the unions and civil servants (the private sector is not striking), are giving France a very bad image at home and abroad (the country was unable to receive the King of the United Kingdom for fear of a strike at his venue, and the streets of Paris are littered with rubbish). “Fitch believes that social and political pressures illustrated by the protests against the pension reform will complicate fiscal consolidation. Political deadlock and (sometimes violent) social movements pose a risk to Macron's reform agenda and could create pressures for a more expansionary fiscal policy or a reversal of previous reforms.” Fitch-downgrades-France-to-AA-outlook-stable-28-04-2023
Our forecast for France's debt ratio is 114.5% of GDP in 2026, up from 112.6% in 2021, based on the following assumptions: -a growth rate of 1.4% from 2022 to 2026; -a general government fiscal deficit of 5% of GDP over the period; -a primary fiscal deficit of 2.5% of GDP; -an average nominal interest of 2% over the period; and -a GDP deflator of 2.6%.
Tableau France: Debt ratio projection
Note: Since the primary deficit raises the debt ratio, we set the primary balance to the opposite sign, we call it the primary deficit, -pt is the negative of the primary balance. r-g is negative (except in 2020) but if the primary deficit (-pbt) is above r-g, then the debt ratio increases. In our projection, the primary deficit is above r-g. Therefore, a negative r-g (O. Blanchard) is not a sufficient condition for a declining debt ratio; we must also consider the primary deficit (which Blanchard does not).
The primary deficit needed to stabilize the debt ratio at the high level of 112.6% of GDP would be at 2.1% of GDP. As the projected primary deficit (2.4% of GDP) is slightly above the debt-stabilizing level, public debt will continue to rise (IMF is more pessimistic, forecasting a primary deficit amounting to 3% of GDP over the 2022-27 period).
According to our assumptions, the debt ratio will deteriorate. This is not a large increase, but the debt ratio is likely to remain on an upward trend, widening the gap with European countries. Our projection is based on the traditional procrastination of the government to cut spending.
The pension reform undertaken by the Government is welcome, but completely insufficient to reduce the fiscal deficit caused by the pension spending. Contrary to what the Conseil d’Orientation des Retraites (COR), an official body in charge of advising the Government on the pension projections, writes, the public pension budget is currently in deficit (€72bn), which accounts for 2.9% of the GDP in 2021 or 45% of the general government deficit that year. According to our calculations, the pension deficit accounts for €72bn or 43% of the increase in government debt in 2021. It is the driver of public debt. The President's necessary pension reform is completely insufficient to reduce this amount. It is understandable that, after the turmoil created by two-year extension of the working time, the Government is not ready to consider reducing the vested interests (“droits acquis”) of public-servant pensioners (there is unequal treatment of pensions in favor of public servants compared to the private sector).
The pension bill accounts for 14% of GDP and about 25% of public expenditure, the highest public expenditure.
There is considerable scope for reducing current spending. It is time to phase out all “whatever it costs programs”.
France is surfing with the euro and the ECB as a shield. According to P. de Grauwe in his fascinating book on the Monetary union (2012) when a country joins a monetary union it loses its monetary independence. It issues debt in a currency over which he has no control. When investors fear a default by a member country of the monetary union, they dump government bonds of the country at risk, raising the interest rate of the country relative to other countries. “As a result, euros leave the banking system” of the country at risk, “there is no foreign exchange market and flexible exchange rate to stop this. Thus the total amount of liquidity shrinks” in the country at risk. Investors who have acquired euro can invest them in any other country, member of the Union. The government of the country under attack by the markets “cannot obtain funds to roll over its debt at reasonable interest rates”. The government cannot force the ECB to provide the cash necessary to service its debt. It does not control the ECB. If the liquidity crisis is severe, liquidity outflows can force the government at risk of default to accept a stringent adjustment program under the auspices of the IMF, the troika. De Grauwe’s conclusion is that “in a monetary union financial markets acquire tremendous power and can force any member country onto its knees.”, p. 8. Well, this is a good description of what happened to Greece in 2009 (by the way, the Greece’s public debt ratio in 2009 was the same as France’s today). But Greece is a weak sovereign borrower and the major countries and international institutions agreed to put it on its knees. The situation is likely to be different for big countries such as Italy and France. The ECB independence ends (or at least is significantly reduced) with a large member country. In addition, the practice of QE can be resumed even for a single country at risk (the so-called Transmission Protection Mechanism), which allows the ECB to buy bonds of a single country. This has not been used so far, but it is an “instrument” at ECB’s disposal to bail out distressed countries who refuse to go through the IMF’s wringer. De Grauwe does not consider this as a possibility. The ECB therefore has the potential to significantly weaken the power of the bond vigilantes.
We hope that the various signals sent by the IMF, rating agencies, the peer countries (the virtuous countries within the euro), the markets and even the ECB will prevail over the sound and fury of the street.