French Reforms: A bumpy road lies ahead

Emmanuel Macron had ambitious plans to reform the French economy during his presidency, but he probably did not expect that these reforms would ignite the devastating ‘gilets jaunes’ protests. The riots highlight how difficult it will be for President Macron to implement more of his planned structural reforms in the future. In response to the protests and in an attempt to regain the confidence of the people a ‘Grand National Debate’ has been launched. These nationwide consultations will end on March 18, after which Macron will announce his new plans by mid-April. The negative sentiment around Macron will not subside after the debate, making it very hard to implement significant policy reforms without causing a new round of disrupting protests.

Economic developments

The immediate impact from the yellow vests protests did not show up in the overall Q4 GDP growth figure of France, mainly because the fall in domestic demand was compensated by a positive contribution of net exports (Figure 1). Exports accelerated significantly because of a one-off surge in naval equipment delivery.

Yet, looking behind the overall numbers we see that household consumption has been sliding, preceded by a major fall in consumer confidence, although consumer sentiment rebounded strongly in the beginning of this year (Figure 2). This rebound was mainly caused by the easing of yellow vest protests. The expectation is that in 2019 domestic demand will grow at a robust pace with household consumption benefiting from a rise in purchasing power.

Corporate investment also slowed in the fourth quarter, notably because of a decline in car purchases by businesses.

The composite PMI indicator in January and February points towards a low growth rate in the current quarter (Figure 3) and possibly even a contraction. The February PMI came out slightly above the growth-neutral level of 50 at 50.4, although it was significantly higher than the 48.2 reading for January. The manufacturing PMI held up quite well in France, but the services PMI was remarkably low at 47.8 in January. Both softer foreign demand and the disruption caused by the yellow vests were named as the reason for the business contraction among service providers. It seems that negative impact from the yellow vests is slowly dwindling, at least for the time being. This suggests that the biggest threat to growth then remains the slowdown in foreign demand.

In response to the protests, Macron announced that the minimum wage will be increased by €100 (6.7%) per month and a planned increase in social charges on pensions below €2000 has been cancelled. Additionally he proposed some tax concessions that included an encouragement for employers to pay tax-free year-end bonuses and a tax exemption on overtime pay. This comes on top of the elimination of the planned fuel tax, whose costs are estimated at around €4 billion.

These measures, totalling around €14 billion should provide a significant boost to household income, which is immediately supportive for economic growth. The 2019 Budget already provided for additional stimulus to economic growth with a lower tax burden for both households and firms. The downside of this increased amount of spending is that this will push-up the budget deficit from the current estimate of 2.8% of GDP to 3.2%. This is a breach of the limit set in the Stability and Growth pact, and the breach is likely to be even larger because the recent slowdown in the Eurozone has not yet been taken into account.

The government received some warning signals from the financial markets, with a modest rise in spreads in the final months of 2018, but this move has already sharply reversed in the first months of this year. The yield on a 10-year government bond is currently around 45bp (the lowest level since October 2016), with the spread relative to the 10-year bund at 35bp.

The latest move by Macron to end the anti-government protests is a ‘Grand National Debate’, lasting from January to mid-March. This debate will be important to get his reform agenda back on track. The litmus test will come at the end of the consultation. The government will then need to communicate what the policy response will be to the signals received from the debate tour. Macron’s approval ratings has been rising a bit lately, indicating that some of the measures were received positively. The approval rating rose from a trough of 20% in in December to 28% in February. President Macron still has three years left to complete his reform plans.

The first and most serious problem of the French economy is an inflexible labor market with relatively high levels of unemployment among the young and low skilled (Figure 5). The second problem is that competitiveness remains weak. The IMF (2017) notes that France lost external competitiveness over the past two decades. This has contributed to a comparatively weak export performance. The IMF notes that despite solid productivity growth, cost competitiveness weakened partly caused by wage and price dynamics in the services sector.

We now turn to discussing some recent reforms in various areas (see table 1 for an overview).

Labor market reforms

The French economy has long been hampered by an inflexible labor market and a high structural unemployment rate. Macron vowed to reduce the structural unemployment rate to 7%, calling the current estimated structural employment rate of 9% “scandalous.”

The IMF (2018) notes that elevated minimum wages relative to median wages hinders access to work for the young and low-skilled. The rise of the minimum wage in response to the yellow vests will aggravate this problem. Generous unemployment benefits and an elevated labor tax wedge are additional factors leading to the current high rate of (structural) unemployment. At 70%, the unemployment benefit replacement rates in France are relatively high, creating disincentives to work.

The central feature of Macron’s ordonnances is that it will become possible to shift collective bargaining away from the industry towards the individual company level. Additional labor market reforms changed the rules governing dismissals, making it easier to lay-off workers and placing a cap on compensating unfair dismissals. Project-based contracts are introduced and non-applicable red tape was removed. The labor tax wedge is reduced by replacing part of the employee social contributions with a hike in the general income tax. This should lead to a lower structural unemployment rate and will stimulate business to hire more people on permanent contracts.

Business environment

The so-called PACTE, the action plan for Business Growth and Transformation consists of a bill with 70 articles and was introduced as a decisive new step in France’s economic transformation. It will simplify the legal environment for SMEs, support innovation and start-ups and export initiatives. The time and costs of bankruptcy proceedings will be reduced and smaller firms will be subject to simpler liquidation standards to facilitate debt restructuring and increase the possibility of restarting the business.

Further privatization of state-owned firms are also part of the action plan. The proceeds from privatization will be put into a state innovation and research fund. Interestingly it also plans to strengthen the procedure for authorisation of foreign investment in France in order to better protect strategic sectors. This was also part of Macron’s Europe-wide proclamation on march 4, which proposed a new era of government intervention in European Union business. On balance it seems that Macron is trying to resurge the amount of state intervention, which most often leads to reduced competition, less efficient firms and is eventually likely to harm consumers.

Pension reforms

The French pension system is highly complex, generous and has one of the lowest statutory retirement ages (62 years) in Europe. This system, which is based on pay-as-you-go financing, places a high burden on public finances, especially in the future with an aging population. The yellow vest protests forced Macron to suspend the planned reforms of the pension system. These reforms would make the pension system more unified by aligning the retirement benefits in the public and private sector. Currently the retirement benefits in the public sector are based on the salary during the last six months before retirement, in the private sector it is based on the average salary over the last 25 years. Macron promised not to raise the statutory retirement age and has kept this promise so far. Given the aging population it would actually be a good and probably necessary step to raise the retirement age closer to that of other European countries. A possibility would be to increase the effective retirement age by stimulating this with fiscal measures.

Fiscal policy

France’s 2019 budget that was passed into law on December 28 2018 forecasts a budget deficit of 3.2% of GDP. This includes the measures the government took, aimed at supporting the purchasing power of lower-income households in reaction to the yellow vests protests. France will therefore become the only country in Europe to breach the 3% deficit ceiling from the Stability and Growth Pact. The treasury argues that it is not an excessive deficit, because it is limited, temporary and exceptional. It remains to be seen whether the European Commission agrees with this explanation or not. The European Commission will make a final assessment of the French budget for 2019 in the next quarter.

After the crisis, French public debt has continued to rise from 65% of GDP in 2008 to an alarming level of over 100% of GDP in 2017. Since then, it has only marginally declined to a still high level of 99% of GDP. Even though there was a strong rise in the government debt ratio, the government bond yield has been going down. The financial markets are clearly not seeing this debt-ratio as a risk for France, obviously influenced by the bond buying programme of the ECB. However, the combination of already high public debt, a PAYG based pension system and an ageing population makes that France’s public finances are moving towards a possible danger zone.

The ‘Grand National Debate’ will end on March 18. Afterwards all the contributions are gathered and a new ‘synthesis’ will be presented mid-April that will shape the second part of Macron’s five-year mandate. This will likely be the most difficult and delicate part. Disappointment about the new plans will fuel support for the yellow vest movement and could lead to more protests and disruption.

Macron’s reforms have never been popular, but they nevertheless addressed important economic problems. Unfortunately there does not seem to be a turn in sentiment among the public regarding these reforms. Macron’s approval rating has been rising slightly, but is still very low, highlighting the fragility of his leadership. The anti-elite sentiment and mistrust in the government will not fade quickly and this will make significant policy reforms hard to implement.

Structural reforms often do not have an immediate positive impact on short-term growth rates, on the contrary, their initial impact is often negative. In the longer term, however, they improve the potential growth rate and labor market conditions. The labor market reforms are likely to have a positive effect on the French labor market, by making it more flexible and boosting employment rates. The measures taken to improve the business environment will also be a positive factor for long-term economic growth.

Depending on the plans announced after the Grand National Debate there could be more growth-enhancing measures. Several plans such as enhancing the professional training system and increasing the skills of young workers by reforming the apprenticeship system will be relatively easy to implement and beneficial for economic growth. Given the weak public support for Macron it will be a difficult task to implement the most important and more painful reforms, such as a less generous unemployment insurance system and a higher legislative pension age.

Regarding the short-term growth outlook we expect growth to be subdued in the coming years. The external environment does not look too rosy with a slowdown in the eurozone and weakening foreign demand. Using a simple nowcast model, based on sentiment indicators, we expect that the economy will grow by 0.2% in the current quarter.