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Investors Struggle to Figure Out Schizophrenic France

The French economy has proved tough for investors to figure out.

France’s Danse Macabre in the demonology of the euro zone crisis was a brief one. In late 2011 the yield on 10-year French government bonds rose to 3.7 percent, before the government quashed fears of an ever-widening deficit through a series of austerity measures. At the close of European trading on Thursday it was only 2.09 percent — putting it squarely among the choir of angels in the euro zone core. Is this heavenly safe-haven territory a suitable home for French government bonds? 

Those who say France’s low borrowing rates are justified can point to its high productivity and stable political system.

Output-per-hour-worked in France is 96 percent of the U.S. level compared with only 92 percent in Germany and 76 percent in Italy, according to the Organization for Economic Cooperation and Development. By keeping costs down, high productivity should make French products and services competitive. This should boost exports, which would in turn generate economic growth, providing a strong underpinning for debt reduction.

In contrast to the U.S., France also currently enjoys the advantage of a political system where, if the man at the center pulls a lever, the desired switches come on and off — albeit with unpredictable timing and intensity. The new president since May, François Hollande, is on the left of the political spectrum and the left’s victory in the presidential election was matched by the June elections to the National Assembly, where parties supporting him won an overall majority. Moreover, although Hollande is to the left of his predecessor, Nicolas Sarkozy, the relative moderation of his administration has, for the most part, pleasantly surprised those critics who had expected a war on business to wreak damage to the economy. France has, therefore, enjoyed a smooth transition from one regime to the next, which has spared it the political ructions that have cursed peripheral euro zone countries.

Nevertheless, skeptics shake their heads at the cheapness of France’s borrowing costs.

The starting point for skepticism is a fear that despite high productivity, France is irredeemably uncompetitive. Average French earnings are high — in 2009 they rose even above Germany’s — and have stubbornly stayed there. Moreover, productivity is growing more slowly than in Europe’s largest economy. The combination of resilient wage growth and disappointingly low productivity growth has increased unit labor cost — the cost of producing a given amount of work — by 12.5 percent since 2005, more than three times the German rate of increase. 

Largely because of this, France’s export sector, centered around its manufacturing industry, has underperformed. Although Wednesday’s industrial production figures, which are largely based on manufacturing, were better than expected, industrial output in the three months to the end of August is down 2 percent on the year. Hampered by industrial weakness, the economy as a whole has failed to grow at all since the third quarter of 2011.

The conventional solution for an uncompetitive economy performing poorly in export markets is currency devaluation — but this option disappeared with the birth of the euro zone in 1999. This leaves France with option B — cutting costs by keeping wage growth below its competitors’ for many years ahead. There is, at least, no formal legal bar to this, but the highly unionized nature of French society makes it a tall order.

France’s structural lack of competitiveness and the lack of a clear route away from it raise questions about the growth rates, which the French government uses to explain how tax revenue is going to rise fast enough to allow it to whittle down its debt ratio. According to the International Monetary Fund’s report last Tuesday, this will rise to 90 percent of gross domestic product this year — a milestone identified by some economists as marking the dividing line after which debt risks spiraling out of control. The Hollande administration’s belief that it can start stabilizing and then cutting the debt ratio is based on steady GDP increases, including a return to 2 percent growth from 2014. This is a long way from the IMF’s Tuesday estimate of 0.1 percent this year and a scarcely less anemic 0.4 percent in 2013. Substantial growth will be all the harder to achieve because Hollande is increasing taxes and cutting government spending to reduce France’s deficit.

Responding to France’s problems, Jim Leaviss, fund manager at M&G Investments in London, describes its combination of weak growth, poor competitiveness and fiscal tightening as “the toxic French economic cocktail.”

Despite such concerns, aggressively bearish strategies on France have fared badly in recent months. Some analysts had predicted that an Hollande victory would widen the spreads between French and German bonds, for example. To the contrary, since his election they have halved from 124 to 60 basis points (bp), as fears that Hollande would prove to be antibusiness have not been realized.

However, the IMF predicts that Germany’s fiscal balance will be minus 0.4 percent for this year, compared with a hefty minus 4.7 percent for France. A 60bp spread in yields looks unsustainably wafer-thin to some skeptics, given the gaping 4.3 percentage point gap between government deficits.

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