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IMF Executive Board Concludes 2005 Article IV Consultation with France
On November 2, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation with France.1
The cyclical recovery of the French economy was interrupted in the first half of 2005 as previously strong domestic demand faltered and the external sector continued to exert a drag on growth. In 2004, growth was faster and more consumption-driven than in other large euro area countries. Employment growth in hours, increases in minimum wages, and some fiscal measures supported private household incomes. Consumers also dipped into savings, reflecting relatively favorable demographics, rising financial wealth, and a confidence—preserving execution of pension and health reforms.
Against this background, the fall in private consumption in the second quarter of 2005 was unexpected, possibly related to stagnating unemployment, rising oil prices, and political turmoil surrounding the rejection of the EU constitution. Fixed investment and residential construction continued to expand. Net exports have been reducing annual growth by about 1 percentage point. Several factors play a role: the recent appreciation of the real exchange rate dampened exports, and partner demand has been cyclically weak. Conversely, domestic demand has been strong, boosting imports. However, as indicated by the staff's econometric work, these factors cannot fully explain the weak external performance.
While short-term indicators, e.g., consumer confidence, have improved somewhat, high oil prices dampen the outlook, prompting the staff to forecast growth rising from 1.5 percent in 2005 to 1.8 percent in 2006 as domestic demand and exports recover. The authorities foresee higher growth in a range of 1.5 to 2 percent for 2005 followed by 2 to 2.5 percent in 2006. High oil prices have pushed headline inflation above 2 percent, but underlying inflation has remained stable at a lower level. The staff projects inflation to decline from an average of 2.1 percent in 2005 to 1.9 percent in 2006. Reflecting adverse demographics, potential output growth is projected to fall to 1.9 percent from 2006 onward.
The 2006 draft budget targets a reduction in the general government deficit to 2.9 percent of GDP from 3.0 percent of GDP in 2005 and 3.6 percent of GDP in 2004. Following a structural improvement of about 0.4 percentage point of GDP in 2005, the staff estimates the structural balance to improve by 0.3 percentage point of GDP in 2006. Structural adjustment is achieved through expenditure restraint at the central government level and in health care. The net tax burden remains roughly constant, because the increase in social security contributions, largely related to the health care reform, is offset by tax relief favoring investment and a variety of smaller tax cuts in other areas. For 2007-09, the authorities present a high- and a low-case scenario, with cumulative structural fiscal adjustment over three years of 2.1 percent of GDP and 1.1 percent of GDP, respectively, achieved through different paces of reduction in real general government spending growth. Taking into account known measures only, the staff sees no improvement in the structural deficit over this period.
On structural issues, a new labor contract without firing restrictions has been introduced for small firms, and social partners have agreed on a special fixed-term contract for workers aged 57 or older with the aim of raising their employment rate. The earned income tax credit (PPE) is being increased, relocation subsidies are being offered to those who accept work far from home, and fiscal incentives have increased for the return of the long-term unemployed to the labor market, and in support of employment in personal services. At the same time, public employment services and job search obligations have been strengthened. In product markets, divestiture from commercial activities has been accelerated. In the distribution sector, margin regulations have been relaxed.
Regarding the financial sector, a new bankruptcy law has been enacted, improving creditor rights; the prohibition to remunerate sight deposits has been lifted; a postal bank is being created by separating mail activities; and transaction costs in mortgage markets are set to be reduced. Bank profitability increased, and nonperforming loans declined. Supervisors urged banks to improve their internal control systems and closely watch exposure to mortgage risk, especially in light of possible increases in interest rates.
Executive Board Assessment
Directors commended the authorities for their continued progress on fiscal consolidation and pursuit of structural reform in an environment of weak economic growth and difficult political circumstances. They welcomed the larger than expected fiscal adjustment in 2005 and the new labor market initiatives, which they felt would foster job creation. Similarly, the ongoing product, services, and financial market reforms would underpin support for labor market reforms. To raise the growth potential further and achieve fiscal sustainability, Directors urged the authorities to sustain the recent pace of fiscal consolidation in 2006 and beyond and to build further structural reform momentum, especially by broadening recent labor market initiatives.
On the near-term economic outlook, Directors noted that growth is likely to pick up from its trough earlier in 2005, driven by an improvement in the external environment and a return of domestic demand to a normal pace following the clarification of the direction of economic policies in mid-year. However, compounding downside risk from oil prices and trade partner weakness, export growth could remain sluggish, underscoring the importance of structural reforms to contain labor costs and preserve competitiveness. In this context, it will be important to avoid second-round effects from high oil prices on wages. Directors saw the authorities' fiscal response to high oil prices as appropriately balancing the need to provide income support to selected groups with the need to preserve budget discipline and avoid significant price distortions.
Directors welcomed the continuing fiscal consolidation in 2005, whereby the objective of reducing the deficit to 3 percent of GDP was now within reach despite slow growth. For 2006, Directors urged the authorities to step up the pace of underlying adjustment and avoid recourse to one-off measures. They supported the intent to keep central government expenditure constant in real terms and sustain the decline in health spending growth. Directors noted, however, that achieving the targeted deficit of 2.9 percent of GDP in 2006 relied on an official growth projection on the high end of the current range of forecasts, increases in social security contributions, and nonrecurring nontax revenues. Consequently, Directors encouraged the authorities to consider additional measures to ensure that the underlying deficit falls by ½ of one percentage point of GDP in 2006.
To prepare decisively for the consequences of an aging population, Directors urged the authorities to be ambitious in reducing the share of public spending in GDP and in implementing growth-enhancing structural reforms. They urged the authorities to aim for structural budget balance before rising costs of aging set in at the end of the decade. As illustrated in the authorities' high case scenario, which would deliver this objective, this would require a reduction in central government spending in real terms and a sharp decline in local spending growth. Given the magnitude of this challenge, Directors urged the authorities to begin to implement durable expenditure measures early on.
Directors encouraged the authorities to focus fiscal consolidation squarely on expenditure restraint. With the tax burden already high, renewed increases in social security contributions to cover the deficits of the health care and unemployment systems would further discourage work effort. Instead, Directors saw scope for exploiting synergies between structural reforms and fiscal adjustment, especially in the area of labor market programs. Furthermore, while Directors acknowledged that short-term benefits of civil service reform are limited, they underscored that the ongoing wave of civil servant retirements provided an opportunity to reap efficiency gains that should be fully explored.
Directors supported the planned tax reforms as they would raise economic efficiency. They welcomed the permanent reform of the taxe professionnelle (a tax on enterprises), noting that in the long run, this tax should ideally be eliminated in the context of a broader reform establishing alternative revenue sources for local authorities. Directors supported the reduction in marginal income tax rates and the simplification of the rate structure, although they pointed out that the associated revenue loss should not derail the authorities' fiscal consolidation plans. In this context, Directors also underscored that use of budgetary resources to mitigate structural problems should be restrained and they saw, at present, no room for further targeted reductions in social security contributions to reduce labor costs.
To help achieve fiscal consolidation objectives, Directors saw merit in a further strengthening of the framework for fiscal governance. In this context, they welcomed the new objective-oriented budgeting framework for the central government, which came into effect with the 2006 budget, and the outreach approach to controlling health care spending. To help build momentum for fiscal adjustment and ensure buy-in from all levels of government, Directors welcomed the authorities' efforts to closely involve local governments in fiscal consolidation plans. In this context, further strengthening of domestic institutions to provide forward-looking budget assessments would be helpful.
Directors congratulated the authorities on their successful consensus-building approach to structural reform, encouraging them to take advantage of the benefits of a coordinated package of labor and product market reforms. A few Directors cautioned that this approach should not be allowed to lead to undue delays in implementing needed reforms. Directors observed that when reforms had been well prepared they had been well accepted by the public. They felt that, as current labor market reforms might involve some transitional costs and uncertainty, it would be useful to enact accompanying product market reforms to boost consumer welfare. Also, coordination of the timing of reforms within the euro area could allow monetary policy to respond, thus mitigating transition costs.
Directors strongly supported the recent labor market initiatives. They considered that the new labor contract for small enterprises would facilitate job creation and that the strengthening of employment services, job search compliance, and the earned income tax credit would help lower unemployment. They were also encouraged by social partners' agreeing to adopt a contract to promote employment of older workers. Directors urged the authorities to adopt more flexible labor contracts throughout the entire labor market to secure a durable and significant reduction of unemployment. In this context, Directors saw a need to restrict future minimum wage increases to underlying consumer price inflation so as to bring low-skilled workers back into employment.
In product markets, Directors welcomed the steps toward divestiture of network industries, the deregulation of retail margins, and the reduction in the administrative burden on enterprises, which would all enhance the growth potential of the economy. They encouraged the authorities to make similar determined efforts on economic deregulation and to open up further the services markets to competition, both domestically and within the EU context.
Directors observed that the financial system had been performing well and that supervisors had been appropriately focused on the sector's provisioning behavior, the adoption of new accounting standards, and the rising exposure to the residential housing market. Most Directors welcomed the impending establishment of the postal bank and the end to the prohibition to remunerate sight deposits, as it would promote competition. Most Directors encouraged the authorities to phase out remaining administrative interventions in the financial system to improve overall efficiency.
Directors urged France to show the flexibility necessary to contribute to a successful conclusion of the Doha round, which was at a critical stage. Particularly important will be achieving greater liberalization of the agricultural sector, which would benefit consumers as well as the international community.
Directors welcomed France's commendable contribution to development assistance and its intention to reach the U.N. target level.
IMF EXTERNAL RELATIONS DEPARTMENT