IMF Survey: France Must Eliminate Drag on Growth

February 12, 2007

  • French economy changing more than commonly perceived
  • France has already implemented important reforms
  • But growth becoming less robust; demographics will not remain favorable

The French economy's performance over the past few years has surprised many observers.

Worker checks cosmetics production in Rambouillet, France—a country grappling with inflexible labor laws (photo: Marlene Awaad/IP3/MAXPPP)


They felt that inflexible labor and product markets and the perceived tendency of government officials to engage in "economic patriotism" would have hobbled progress. But they did not. Behind the appearances and the rhetoric, the French economy has been changing more than is commonly perceived.

The French economy has been performing well (see table). GDP per capita growth has been higher than other countries in the euro area and growth overall has exceeded the euro area average. But the difference seems to be evaporating and, globally, France's position has deteriorated substantially.

Although France has accomplished much, it must tackle many more problems to eliminate the drag on growth.

Recent growth performance

Domestic demand has driven France's economic expansion. Wage increases, employment gains, and low interest rates have supported consumption growth and bolstered the housing market. Fixed capital formation has revived with sales expectations, although profit margins have declined because wages did not moderate enough to offset the higher prices of inputs. Generous dividend payouts and higher tax obligations have further reduced company savings, but low interest rates have encouraged external financing of investment. Despite healthy global demand and the cyclical recovery in Europe, net exports have subtracted significantly from growth since 2002, and wage costs have been rising faster in France than in some of its neighbors.

Current demographic trends and ongoing structural reforms suggest that potential growth (that is, in the absence of shocks) could be higher than previously estimated. Recent fertility rates and immigration numbers suggest that the labor force will grow into the next decade. The authorities estimate that the reforms in goods and services markets implemented between 1998 and 2006 could add 0.1-0.2 percent to potential growth over the medium term, and they see some evidence that the secular decline in total factor productivity growth has ended. Together with the effects of the recent uptick in investment, this suggests that annual potential growth could temporarily rise to 2¼-2½ percent before, in the absence of further reforms, settling at somewhat less than 2 percent a year in the long run.

Reforms have helped...

France has already implemented important reforms. The central government's budget framework has been put on a performance-based footing, making the public sector potentially much more efficient. Between 2004 and 2006, the structural fiscal deficit was halved. The new labor market contract adopted in 2005 represented a breakthrough in labor market reform. And product market and administrative deregulation have made France much more attractive to business.

Should one thus expect smooth sailing henceforth? Not exactly. Despite these reforms, growth is becoming less robust and demographics will not remain favorable. Exporters have been unable to benefit fully from the ongoing global expansion and are increasingly wary of the euro's appreciation. Insiders' resistance to reforms persists. And, all too often, France attributes its difficulties to outside forces.

But the underlying problems are homegrown. The fiscal deficit, at more than 2½ percent of GDP, and the public debt, at 64 percent of GDP, are too high, especially with aging expected to add 4.5 percentage points of GDP to public spending by 2050 (see Chart 1). Similarly, unemployment, while declining, was still 8.6 percent of the labor force at end-December, and participation is low (see Chart 2). To deal with aging, a strategy that is viable and intergenerationally fair requires a rapid balancing of budgets, further reforms to enable the economy to grow at close to 3 percent a year for a while, and an increase of about 8 percentage points in the share of people in jobs.

. . . but more are necessary

A top priority is fiscal adjustment through expenditure restraint, and France's medium-term objectives are ambitious: balance the budget by 2010, reduce central government expenditure by 1 percent a year in real terms, and lower spending growth in other areas. But the 2007 budget essentially marks a pause in adjustment, with no specific policies to deliver the medium-term objectives, whose achievement thus depends entirely on whether the next government takes ownership of them. And, given that taxes will be lowered from their stiflingly high levels, expenditures may have to be reduced much more than the government envisages.

Another top priority is to address labor market rigidities. France will have to reform permanent labor contracts and widen the differential between the minimum and median wages. The contract adopted in 2005 will help create jobs, but it applies only to small enterprises, thus aggravating a key duality in which highly protected permanent jobs coexist with precarious fixed-term and temporary jobs. To resolve this duality, the government needs to reduce the legal uncertainty surrounding permanent labor contracts. In a globalized world, such uncertainty is the enemy of the employee, who correctly fears that once out of a job, he or she will not be rehired easily.

It is also well documented that minimum wage increases that exceed inflation destroy jobs and demoralize a rising share of employees who face the prospect of earning minimum wages for the rest of their working lives. Moreover, higher unemployment means more budgetary outlays and higher taxes, which depress activity. To break this vicious circle, minimum wages cannot be allowed to rise by more than inflation. Adverse social consequences can be avoided through a higher earned-income tax credit, a lower tax burden on labor, and reforms in the services sector that enhance purchasing power.

In product markets, France should enhance competition to put pressure on prices and enlarge the range of consumer products. Deregulating the energy sector, lowering barriers to cross-border activity--including through faster implementation of the European Union services directive--reducing the administrative burden on enterprises, and accelerating the state's withdrawal from commercial activities would all enhance competition and improve the functioning of goods and services markets.

Likewise, financial sector reforms could help boost the economy's growth potential by making financial markets more efficient. Phasing out administrative savings schemes, most of which have long lost their rationale, should increase competition for resources, foster financial innovation, and help the creation of risk capital markets. Mortgage markets need further reforms to permit households a more flexible use of prudently valued real estate gains and enable them to better align their needs with lifetime income. Complete integration of Europe's financial markets will be a boon for growth. To expedite this process, France and other EU countries should swiftly harmonize financial products, regulation, and legislation and should integrate financial market infrastructure.

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