Public Information Notice No. 08/23

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with France

February 20, 2008

On February 15, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with France.¹

Background

Economic growth in France has averaged 2 percent since 2003, lagging both the revival of European growth and past growth performance at the same stage of the economic cycle. While domestic demand has remained robust, net exports have been a significant drag on growth, detracting close to ½ percentage point of GDP per year on average. In 2007, growth was 1.9 percent, down from 2.0 percent in 2006. Domestic demand has remained the driver of growth. As a result of the deceleration in real export growth and the continuation of dynamic import growth, France's current account has deteriorated steadily: from a surplus of 1.4 percent of GDP in 2002 to an estimated deficit of 1.3 percent in 2007.

Inflationary pressures are mounting, but headline inflation remains one of the lowest in the euro area. After ebbing down to 1.2 percent in mid-2007, headline inflation has rebounded to 2.8 percent in December 2007 with the surge in food and energy prices. Unit labor costs have risen, as productivity gains have lagged wage inflation. Monetary conditions have tightened noticeably since 2006, reflecting ECB rate increases and, more recently, euro appreciation and the increase in risk premia due to the fallout from the financial turbulence.

Financial turbulence has had a limited impact on the domestic economy to date, and performance of the banking sector remains solid. French banks' exposure to the U.S. subprime market appears fairly limited and credit default swap spreads have risen less than for some other major European banks. Nonetheless, financial institutions remain vulnerable, particularly with regard to off-balance sheet exposures. In addition, profitability may be further impacted by rising risk in corporate credit, the cooling-off in real estate prices, and generally tighter credit conditions. Recent events at Société Générale have revealed shortcomings in internal control, which the authorities intend to address.

For 2008, GDP growth is projected to reach 1.5 percent, substantially weaker than anticipated earlier. The spike in oil prices, the rise in the euro and weakening economic prospects in partner countries will be a drag on growth. The risks to the staff's forecast are broadly balanced, with downside risks related to the international environment and, on the upside, a possibly stronger rebound in the aeronautics and automobile industries.

The authorities are pursuing an ambitious structural reform program across a wide range of areas. At the center of the program is the need to increase flexibility in labor markets. To date, the government has introduced a number of measures to make the 35-hour workweek restriction less binding. In addition, social partners have reached agreement on key labor market reforms, upon which the government intends to act. Other labor market initiatives include a review of the mechanism for setting the minimum wage (SMIC) and the merger of the unemployment and job placement agencies. The government is also pursuing goods and services market reforms, which could boost potential output and consumer welfare. Among the key priorities, early action is expected in reforming the retail distribution sector.

The 2008 budget represents a pause in fiscal consolidation. The budget maintains spending restraint (including an unprecedented reduction in public employment), but it is offset by the cost of the August 2007 tax package, leaving little deficit improvement. Over the medium term, the government aims for an annual structural adjustment of ½ percentage point of GDP consistent with the objective of reaching fiscal balance by 2012 under its central scenario.

The government has launched a comprehensive general review of public policy. The review aims to achieve a fundamental and lasting improvement in public services while reducing public spending on a sustainable basis. Analogously, a general review of the tax system has also begun. It would be the basis for reform toward a more efficient tax system based on greater stability, a supportive framework for business and investment, and greater use of environmental taxes.

Executive Board Assessment

Directors commended the authorities for their intention to accelerate the economic reform process and to push for simultaneous reforms across different areas. Directors noted that this strategy increases the prospects for an appreciable acceleration in economic growth by exploiting the complementarities of reforms. They welcomed the authorities' focus on reforming areas where market distortions are currently greatest—notably labor and services markets. Such an approach would address the sources of France's growth difficulties which, Directors noted, lie not in deficient consumer demand, but in rigidities that impede supply and impair export performance. Directors stressed that eliminating these rigidities would raise productivity and stimulate growth, and over time yield a greater contribution to improving the purchasing power of French households than short-term measures to boost disposable income.

Directors noted that near-term growth prospects for France have weakened with the onset of the global financial turmoil and the slowdown in advanced economies, with a recovery expected in 2009-10. Growth in recent years has been sustained by domestic demand, with the external sector contributing negatively. Export growth has lagged, producing a widening current account deficit. Directors noted that competitiveness, as reflected in the real effective exchange rate, shows some deterioration. However, the deterioration is modest—suggesting that the exchange rate is not the principal constraint on exports, and underscoring the need to address inefficiencies in factor and product markets to boost performance.

Directors saw labor market reforms as central to a strategy of raising growth, reducing unemployment, and improving the purchasing power of French households. They noted that the government has already taken steps to alleviate the country's highly restrictive labor regulations, including by relaxing the 35-hour workweek requirements and fostering an agreement between employers and trade unions to rationalize labor contracts and improve employment flexibility. Directors also welcomed steps to rationalize public employment services. They highlighted the need for further reforms, including steps to reduce wage compression by limiting future discretionary adjustments in the minimum wage, further relaxing the 35-hour workweek, and making more fundamental improvements in the flexibility of permanent employment contracts. In this context, a number of Directors noted the fiscal costs implied in trying to alleviate labor market rigidities via the budget, and favored an approach that addressed the core problems directly.

Directors viewed goods and services market reforms as having the potential to significantly boost output and consumer welfare. They welcomed steps to liberalize retail distribution, which should lead to a positive effect on inflation, and the planned move to a unified competition authority. More generally, the liberalizing opportunity offered by the EU Services Directive should be fully seized. Directors looked forward to the draft law expected in the Spring taking up the recommendations of the Attali Commission.

Directors noted that, while the 2008 budget contains several commendable initiatives to contain spending, including an unprecedented reduction in public employment, it entails a pause in fiscal adjustment due to tax cuts. While recognizing the challenges to policy making in the present conjuncture, most Directors stressed that fiscal consolidation should proceed in tandem with structural reforms. They accordingly encouraged the authorities to be vigilant to the risk of slippage in the fiscal deficit target in 2008. With lower growth forecast in 2008, the deficit risked moving toward its Maastricht limit, leaving in these Directors' view no room for additional discretionary fiscal stimulus. Several other Directors, however, felt that it was appropriate for fiscal policy to play an active countercyclical role in the face of the weakening global economic environment and other downside risks to the French economy. More generally, Directors urged the authorities from 2009 to return to an ambitious adjustment path for the fiscal deficit, strengthening the credibility of their medium-term objective of budget balance.

Directors strongly welcomed the government's ongoing expenditure and tax policy reviews. They observed that international experience shows that these exercises can provide significant lasting improvements in the fiscal position and in the efficiency of public services. They noted, however, that these improvements take time to materialize, so fiscal consolidation in 2009-10 should be based on tight spending plans.

Directors noted that the French financial system appears to have been only moderately affected by the recent financial market turbulence. The system is well-capitalized, exposure to the U.S. subprime market is limited, and off-balance sheet exposure appears to be moderate. But market conditions have yet to return to normal and risks remain. Directors thus encouraged the authorities to remain vigilant to the possibility of further spillovers from other countries and from other market segments. The recent trading fraud at Societé Générale, while it appears to be an isolated event, points to the need to continue to reinforce risk management controls in banks. Directors welcomed the authorities' prompt investigation of the affair and their commitment to take the necessary steps to ensure that similar problems do not recur. Directors recommended that the authorities move forward with the modernization of France's financial market, moving away from its administered past, as advised also by the recent Camdessus report on regulated savings. A more efficient financial sector could make a significant contribution to boosting economic growth. The impulse that the authorities intend to give to the Lamfalussy process is also welcome.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.