Complacency Sowing Seeds Of Disaster

BMI View: Despite all of the tough rhetoric, the 2014 French budget represents no more than a modest adjustment to government spending, coupled with further tax hikes. We believe that having passed through the outbreak of the eurozone sovereign debt crisis relatively unscathed, France has been deprived of any impetus to undertake the structural reform it urgently requires. Coupled with an executive lacking a proper reform mandate, France is on a collision course with Germany which carries negative wider implications for eurozone stability going forward.

Echoing the ambitious rhetoric of last year's budget, Hollande promised the 2014 budget would contain 'unprecedented' spending cuts , but once again has failed to undertake more than modest adjustments to state spending, while maintaining a reliance on further tax hikes to narrow the deficit. While even Hollande is starting to acknowledge the limits of further taxation, and has announced his intention for a 'fiscal pause', this will not feature in the 2014 budget . Indeed, Finance Minister Pierre Moscovici described the new budget as achieving a 'quasi-stabilisation of taxation' - in our opinion, a euphemistic way of saying that state spending w ill not fall next year , leaving France's am ong the highest in the eurozone, at 57% of GDP in 2012.

It increasingly appears that Hollande's strategy is to hope that the deep reforms undertaken by other countries will be sufficient to restore economic activity , allowing France to ride on the tailcoats of stronger regional growth without having to push through any painful domestic reforms and risk further damaging his party's credibility.

Government Spending Is Still Among The Highest
Government Spending In 2012, % GDP

BMI View: Despite all of the tough rhetoric, the 2014 French budget represents no more than a modest adjustment to government spending, coupled with further tax hikes. We believe that having passed through the outbreak of the eurozone sovereign debt crisis relatively unscathed, France has been deprived of any impetus to undertake the structural reform it urgently requires. Coupled with an executive lacking a proper reform mandate, France is on a collision course with Germany which carries negative wider implications for eurozone stability going forward.

Echoing the ambitious rhetoric of last year's budget, Hollande promised the 2014 budget would contain 'unprecedented' spending cuts , but once again has failed to undertake more than modest adjustments to state spending, while maintaining a reliance on further tax hikes to narrow the deficit. While even Hollande is starting to acknowledge the limits of further taxation, and has announced his intention for a 'fiscal pause', this will not feature in the 2014 budget . Indeed, Finance Minister Pierre Moscovici described the new budget as achieving a 'quasi-stabilisation of taxation' - in our opinion, a euphemistic way of saying that state spending w ill not fall next year , leaving France's am ong the highest in the eurozone, at 57% of GDP in 2012.

Government Spending Is Still Among The Highest
Government Spending In 2012, % GDP

It increasingly appears that Hollande's strategy is to hope that the deep reforms undertaken by other countries will be sufficient to restore economic activity , allowing France to ride on the tailcoats of stronger regional growth without having to push through any painful domestic reforms and risk further damaging his party's credibility.

Arguably more alarmingly, France is also failing to impose long-term fiscal discipline too. While the EU Commission has allowed France extra time to meet its fiscal targets due to exceptionally weak growth, Hollande is unlikely to be given the same breathing space if the fails to narrow France's fiscal deficit. Hollande's pension reform proposals, aimed at plugging the EUR20.7bn shortfall in the pension system, were sent to lawmakers in September. The proposals outlined have fallen well short of the mark, mean ing that that the deficit for public sector workers would fall by just EUR0.8bn, leaving the state with a EUR7.9bn public sector pension liability by 2020 (versus EUR8.7bn without the reform).

Set To Remain Above Spain
Public Debt/GDP Ratios, %

Hollande's high risk strategy of waiting it out is likely to infuriate Berlin. While the issues surrounding smaller troubled economies such as Ireland and Portugal are ultimately now seen as manageable , Germany regard s the possibility of a French sovereign debt crisis as fundamentally insurmountable. As a result, Hollande's strategy has placed him and his administration on a crash course with a newly re-elected Angela Merkel. While prevailing regional economic conditions are partly to blame, France has undertaken the least reform out of any of the Western European states, despite having a public debt to GDP load now in excess of 90% and an unbroken fiscal deficit spanning more than three decades.

No Stabilisation Until 2016/17
Public Debt/GDP Ratios, %

Ultimately, France is being lulled towards disaster by complacency . Having survived the outbreak of the eurozone sovereign debt crisis without a severe recession, an explosion in unemployment or a blowout in borrowing costs, France has been deprived of a sense of urgency to undertake the structural reforms it requires to achieve a sustainable growth and debt trajectory . S uccessive budget s under Hollande have been characterised by an overreliance on tax hikes, overoptimistic growth assumptions and minor adj ustments to government spending while France's deep and liquid OAT d ebt markets have also helped to stabilise borrowing costs, which has amplified the govern ment's complacency.

EDP Exit Remains A Long Way Off
France - Fiscal Deficit, % GDP

This laissez-faire attitude towards restraining expenditure is unlikely to be tolerated for much longer by Germany and the EU Commission. While France has been at a less severe risk of sovereign debt crisis since 2008 , its structural problems are deeply ingrained and will take years of concerted action to resolve. Hollande's Socialist Party has complete dominance of the legislative, but his mandate puts him directly at odds with a deep reform agenda, which would provoke stiff resistance from within his own ranks. Intervention by the EU (and particularly Berlin) is likely to generate indignation and resentment, rather than engendering a cooperative respon se . Deep and far-reaching reform under Hollande's administration therefore remains a remote possibility over the near-term.

As a result, we expect tensions between Paris and Berlin to grow over the next few years. Merkel is likely to become frustrated with France's lack of reform, with German taxpaye rs liable to turn ever more indignant at the inability eurozone's second largest economy to pull its weight in the increasingly strained partnership . The instability generated from a fallout between the eurozone's two key founding members is hard to overstate. With the ECB having done almost all it can to stabilise the single currency, the need for coordinated action between eurozone governments on issues such as banking and fiscal union is higher than ever.

Opinion Polling For The Next French Presidential Election In 2017
Le Pen Dupont-Aignan Sarkozy Cheminade Bayrou Joly Hollande Mélenchon Poutou Arthaud
Source: BMI, Bloomberg
FN DLR UMP SP MoDem EELV PS - Inc. FDG NPA LO
24% 2% 29% 0% 10% 2% 20% 11% 1% 1%

Drastic as this outcome may sound, we note that with the eurozone crisis now entering a chronic phase, the time frame to seek solutions is arguably more generous than the volatile 2009-12 period. It may be that Merkel, having recognised Hollande's inability to reform France, will simply seek to wait until the next French Presidential election in 2017. The Socialist's inability to restore growth has seen Hollande's popularity drop to the lowest recorded for any French President, while former President Nicolas Sarkozy, frequently described as the most disliked president in French history, is currently polling 29% in recent surveys. Support for far right parties has also soared, with Marine le Pen of National Front polling 24% in the same survey. Unless economic reform is pushed through, a return to robust growth and employment will be hard to come by, and popular support for Hollande will remain low.

On a positive note, the government has begun to incorporate more conservative growth assumptions into the budgeting framework, reducing the risk of 'unexpected' fiscal slippage. Nevertheless, based on our recent fiscal forecast revisions, France's pu blic debt load will now hit 95.5 % of GDP by 2014 and continue rising until 2016, based on the government's current spending patterns. Each year pushes France closer towards peripheral Europe, and further away from the core. The high debt level also leaves it increasingly exposed towards higher borrowing costs. While we do not expect to see a sudden blowout in yields, borrowing costs are not currently reflective of France's true economic health, and a steady rise in French yields as US rates are tightened is a near-certainty.

As a result, the longer economic reform and fiscal tightening is delayed, the more painful and protracted France's recovery will be. While the return of a centre-right leaning government in 2017 with a strong reform agenda remains entirely possible, this could be too late. As we previously noted, the issues at the heart of France's economic malaise are more than just superficial, and will require many years to push through. Indeed, it is not implausible to imagine a scenario where peripheral states such as Spain have overtaken France in competitiveness and growth by 2017. Until future budgets start to do more than tinker around the edges of France's issues, we retain our negative outlook towards the country's economic prospects and highlight France as becoming a growing catalyst for eurozone instability.

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Sector: Country Risk
Geography: France
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