standard poors etude-france-2013

Economic Research:

The French Economy Exits RecessionBut Remains Fragile

Primary Credit Analyst:

Jean-Michel Six, Paris (33) 1-4420-6705; [email protected]

Media Contact:

Mark Tierney, London (44) 20-7176-3504; [email protected]

Table Of Contents

Taxes And Unemployment Are Weighing On Consumption

Export Performance Is Likely To Improve Only Slowly

The Outlook For Corporate Investment Is A Major Uncertainty

The Task Ahead Is Finding Strong Sources Of Long-Term Growth

Related Criteria And Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 22, 2013 1

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Economic Research:

The French Economy Exits Recession ButRemains Fragile

After eight consecutive quarters of stagnation, France posted real GDP growth of 0.5%, marking an official end to

recession. Temporary factors are part of the explanation for this turnaround, including the cold winter that boosted

consumption of energy products. Meanwhile, higher inventories contributed 0.2 percentage point to the quarter's GDP

growth. More importantly, public consumption rose by a strong 0.5%. On the other hand, the corporate and

construction components of investment continued their decline. And more than 35,000 jobs were lost in the private

sector.

The second-quarter improvement in French economic conditions coincided with a broader one across the eurozone

(0.3% real GDP growth). However, more recent data suggest that the momentum is diminishing in the second half of

2013. September's French Purchasing Managers Index, an indicator of economic strength for the manufacturing sector,

continued to trail behind the eurozone overall average, stuck below the critical 50 line that separates recession from

expansion (see chart 1 below). Industrial production contracted 1% a month in May, June, and July. And exports of

goods dropped 4% in value terms year on year over that same three-month period. Those indicators support our

expectations of relatively flat overall growth in the second half.

Overview

• French economic conditions picked up in the second quarter, but in our view the sources of a strong,

long-term recovery are not yet in place.

• Consumption and exports are stabilizing, and corporate margins should widen on the back of proposed tax

measures.

• However, our projections show that the economy will be still be approximately 3.5% below its growth potential

at the end of 2014.


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Chart 1

Yet the French economy faces a big task: the recovery needs to be much more robust if only to close the output gap

that's developed since 2007 (the beginning of the financial crisis) and which the Organization for Economic

Cooperation and Development estimates at about 4%. More robust growth would also contribute to a meaningful

inflection in the rising public debt trajectory (see chart 2). Meanwhile, the French unemployment rate at 11% in July

stands well above those of the other so-called "core countries" in the monetary union--The Netherlands (7%), Belgium

(8.9%), Germany (5.3%), and Austria (4.8%)--though it is below the eurozone average (12.1%. Between 1998 and 2007

real GDP growth averaged 2.3%. Is such a level of growth now out of reach?


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Economic Research: The French Economy Exits Recession But Remains Fragile

Chart 2

Taxes And Unemployment Are Weighing On Consumption

We expect only a slight 0.4% rise in consumption for full-year 2013, thanks to slower inflation and a slight acceleration

in nominal wages. In 2012, real disposable income contracted 0.9%, a drop unseen since the 1980s. Yet the immediate

effect on consumption was somewhat offset by a 0.5 point decline in the household savings rate. This effect is typical:

households tend to smooth out the effects of a loss in purchasing power initially. However, over time, consumption

readjusts to real disposable incomes. We believe this is the reason household spending was flat in the first half of this

year. We expect consumption to remain flat in the third quarter but pick up in the final three months of the

year--especially if consumers bring forward purchases ahead of the January 2014 increase in the valued-added tax

(VAT) rate, to 20% from 19.6% for the standard rate.

The outlook for consumer demand in 2014 and beyond is subject to other conflicting factors. France's budget for

2014--which the parliament still needs to approve--aims to shift the additional tax burden to households from

corporations. The tax burden, according to this budget, which is still subject to revision, should increase by the

equivalent of 0.15% of GDP to a record high of 46.1% of GDP. In absolute amounts, that's a €3 billion net increase in

taxes. The breakdown is a €12.5 billion tax hike for households, mainly through the VAT rate hike (€6 billion), an


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increase in property transfer taxes (€1.3 billion), and a reduction in certain tax exemptions (€1 billion). For business,

the budget would represent a contraction in corporate taxes of about €10 billion.

Higher direct taxes and social contributions between 2011 and 2014 are adding up to a cumulative reduction in

purchasing power on the order of 2% of disposable incomes, a significant drag on consumer spending. A modest rise in

consumer spending next year (0.2% according to our forecast) will therefore have to come from a drop in the savings

rate. As for 2015, assuming fiscal pressure on households stabilizes, the beginning of an improvement in employment

should allow for more robust growth in consumption (1.2% according to our forecast), although still below long-term

trends.

Household investment is likely to reflect the deterioration in spending power and, starting in 2014, a rise in long-term

interest rates--partly resulting from tighter international financial conditions when the U.S. Federal Reserve begins to

taper its securities-buying program. We expect household investment to contract 4% in 2013 (after a decline of 0.5% in

2012) and dip a further 2.5% in 2014, before stabilizing the following year.

Export Performance Is Likely To Improve Only Slowly

The share of French exports in total eurozone exports has been declining steadily from a peak of 17% in early 1999 to

a low of 12.8% at the end of 2012, where it settled in the first half of 2013 (see chart 3).


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Chart 3

Unlike other countries in the eurozone, France's current deficit hasn't markedly shrunk since 2007. While the level

remains low, the country has been steadily running deficits since 2005 after two decades of surpluses (see chart 4).


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Chart 4

France's deteriorating foreign competitiveness has two key components. The first is a decline in cost competitiveness,

as reflected by trends in unit labor costs (ULCs), which measure the average cost of labor per unit of output.

Productivity is a key factor influencing ULCs. On that score, the difference between Germany, the world champion in

terms of trade surplus, and France is not striking at all. In fact, productivity dropped less in France than in Germany

during the worst of the crisis in 2009. But in terms of labor costs differentials, France lost a lot of ground against

Germany between 2000 and 2008. Since then, the gap has stabilized and could somewhat diminish in 2013 as German

wage growth accelerates (see chart 5). On the other hand, the gap between French and Spanish labor costs has

become much more favorable to Spanish exporters since 2009.


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Chart 5

The second key component of foreign competitiveness is more structural and relates to product differentiation.

Competitive countries, simply put, sell products to the rest of the world that are more expensive than those they buy

from the rest of the world. This is where the difference between Germany and France is striking. German exports are

positioned in segments (particularly capital goods, but also luxury cars, for instance) where price elasticities are

relatively low. Econometric models typically estimate the price elasticity of German exports at about 0.3 against more

than 1.0 for France. German exports are therefore much less vulnerable to a rise in the euro exchange rate than their

French competitors. In turn, strong product differentiation has allowed German manufacturers to increase their prices

and therefore the overall value of their exports (see chart 6).


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Chart 6

As an aside, the French luxury goods industry (food and beverages, and fashion in particular) contributes significantly

to the prestige of the country overseas. However, it accounts for just 1.4% of total exports, compared with 2.1% for

Italy. What's more, France's market share in exports to the fast-growing BRICs (Brazil, Russia, India, and China) at

10%, is well below those of Switzerland, Italy, and Germany (33%, 16%, and 13%), according to 2011 data (Source:

Direction Générale des Douanes, "Etudes et Eclairages 38," March 2013).

Although many factors explain the differences between France and Germany regarding trends in product

differentiation, we believe that one of the main reasons has to do with domestic demand. This has been more buoyant

in France, essentially driven by household consumption, than in Germany since the late 1970s. A trade-off emerged

between strong domestic demand and weak export performance as French producers relied on their domestic

markets. Meanwhile, their German competitors were making forays into new markets abroad.

Foreign demand, especially from the rest of Europe, should gradually improve in the coming 24 months, underpinning

a rebound in French foreign sales. But stronger competitors, such as Spain, could harm the French performance.

Outside the single currency union, the strong euro--now trading at about $1.36 and rising--will be a further handicap.

And we believe that the single currency is likely to remain strong well into the first part of next year, since the Fed

delayed its plan to wind down its securities purchases.


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The Outlook For Corporate Investment Is A Major Uncertainty

Corporate investment in France reached a bottom in the second quarter after 18 months of consecutive declines.

Meanwhile since February, the business climate has been improving (see chart 7). Yet indications pointing to a

recovery in capital expenditures remain fragile. Loans to nonfinancial companies have steadily declined since

September 2012, and the latest data from the European Central Bank shows a 1.7% contraction in the 12 months to

August 2013. In real terms, corporate investment was still 6.3% below its 2007 average at the end of the second

quarter.

Chart 7

Unlike in previous recoveries, investment has not been leading but rather has been lagging behind the pickup. True,

this observation does not apply only to France. Germany's capital spending is down 7.8% over the same period, while

Italy's has dropped 27.2%. Outside the eurozone, and despite stronger economic growth than in these other countries

since the beginning of the year, U.K. investment has remained 15.5% below its 2007 average.

What's more unique to France is the steady deterioration in corporate margins since 2007. They touched 28.2% of

value added in the second quarter, the lowest since 1985, and 2.5 points below the 1988-2007 average (see chart 8).


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Chart 8

We think corporate margins may stabilize, however, as the economy picks up and productivity modestly accelerates.

Energy prices should also bring a more positive contribution as the euro strengthens while oil prices edge lower.

Beyond these cyclical factors, the French economic authorities are placing a lot of hope in a new tax cut for

nonfinancial corporates, equivalent to a reduction in employers' social security contributions. This tax reduction, the

"credit d'impot pour la compétitivité et l'emploi" (CICE), which started to phase in at the beginning of this year, is to

amount to €10 billion in 2014 and €20 billion the following year. It should lead to a significant increase in corporate

aftertax profits of about 7%.

The authorities expect that this measure will improve corporate price competitiveness through a reduction in unit

labor costs as well as non-price competitiveness as it fosters a recovery in capital spending. Plus, the government

estimates that this measure could directly result in some 90,000 additional jobs in 2014. In the first instance, we expect

an increase in corporate margins and an upturn in capital spending. But the effect on hiring is likely to take time, we

believe, because at the end of a recession productivity is typically low.

In October, France's Commissariat général à la stratégie et à la prospective (a high-level strategic policy group),

published an initial assessment of CICE's impact on the corporate sector. It shows that the manufacturing and retail


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sectors are benefitting, but that the nonexporting part of the manufacturing sector has benefitted the most so far.

Overall, we anticipate that corporate investment should rise by about 1.8% in 2014 (versus a decline of 2% in 2013)

and gain further momentum in 2015 (4%). In that case, by the end of 2015, capital spending in real terms would still be

2.9% below its 2007, pre-crisis level.

The Task Ahead Is Finding Strong Sources Of Long-Term Growth

Our forecast has French GDP growth averaging 0.7% in 2014 and 1.4% in 2015 (see table 1 below). Official estimates

suggest that the post-2007 economic and financial crisis caused a loss in France's production capacity equivalent to

about 5% of GDP. The loss corresponds to the effects of long-term unemployment, the lack of productive investment,

and bankruptcies in the nonfinancial corporate sector particularly during the 2009 and 2012 recessions. Based on our

projections, the economy at the end of 2014 will still be approximately 3.5% below its growth potential.

The French economy will likely be playing catch-up for several years beyond 2014. In particular, whether exports can

regain competitiveness and increase their market shares abroad remains a major source of uncertainty. What's more,

the recovery in capital spending remains subject to a return of confidence that fiscal uncertainty could further delay.

The same can be said about consumer demand: Households in the recent past have offset a drop in their real incomes

through variations in their savings rates. But if they perceive that the fiscal bite is likely to extend beyond 2014,

households could modify the way they arbitrage between consumption and savings. But the path toward sustainable

long-term growth, similar to what France experienced a decade earlier, is mired in risks and uncertainties.

Table 1

Main European Economic Indicators

Central forecast Germany France Italy Spain Netherlands Belgium Eurozone U.K. Switzerland

Real GDP (% change)

2012 0.7 0.0 -2.5 -1.6 -1.2 -0.1 -0.6 0.1 1.0

2013(f) 0.5 0.0 -1.8 -1.5 -1.2 -0.1 -0.7 1.5 1.7

2014(f) 1.8 0.7 0.5 0.5 0.5 0.8 0.9 2.1 1.8

2015(f) 1.7 1.4 0.9 1.1 1.3 1.5 1.3 2.0 1.7

CPI inflation (%)

2012 2.1 2.2 3.3 2.4 2.8 2.6 2.5 2.8 -0.7

2013(f) 1.6 1.0 1.5 1.8 2.6 1.3 1.6 2.7 -0.2

2014(f) 1.8 1.5 1.6 1.4 1.4 1.6 1.6 2.3 0.5

2015(f) 1.7 1.4 1.2 1.3 1.2 1.9 1.5 2.0 1.0

Unemployment rate (%)

2012 5.5 10.3 10.7 25.1 5.3 7.6 11.4 8.0 2.9

2013(f) 5.4 11.0 12.2 26.7 6.7 8.5 12.4 7.9 3.2

2014(f) 5.2 11.0 12.5 27.0 7.2 8.6 12.5 7.8 3.1

2015(f) 5.1 10.3 12.0 26.0 7.0 8.1 12.0 7.5 3.0


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Table 1 (cont.)

Central banks policy

rates (yearly

average)

European

Central Bank

Bank of

England

2012 0.8 0.5

2013(f) 0.6 0.5

2014(f) 0.5 0.5

2015(f) 0.5 0.6

10-year bond yield

(yearly average) Germany U.K.

2012 1.5 2.0

2013(f) 1.8 2.5

2014(f) 2.3 3.1

2015(f) 2.8 3.5

Alternative Scenario:

Extended recession

Real GDP (% change) Germany France Italy Spain Netherlands Belgium Eurozone U.K. Switzerland

2013(f) 0.1 -0.5 -2.6 -2.0 -1.4 -0.3 -1.2 1.4 1.5

2014(f) 0.5 -0.4 -0.7 -1.0 -0.4 -0.5 -0.4 0.5 0.4

2015(f) 0.6 0.2 -0.5 -0.4 0.1 0.4 0.1 0.6 0.8

Related Criteria And Research

• Special Report: Global Economic Outlook: Taking Stock Five Years On From The Great Financial Crisis, Oct. 8,

2013


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