Global Insight Perspective | |
Significance | The centre-right government, headed by President Nicolas Sarkozy, presented its first state budget yesterday, as criticism of the state of French public finances continues to grow. |
Implications | Delivering on ambitious electoral promises for reforms and popular tax cuts will not be easy, as the government struggles to meet its Eurozone commitments and maintain public support at home. |
Outlook | Rather than the promised “rupture” with the past, this budget is an over-optimistic document of continuity. |
Bad Timing?
France’s first state budget under the presidency of Nicolas Sarkozy was presented yesterday by Economy Minister Christine Lagarde and Budget Minister Eric Woerth. The proposals were unveiled just a few days after Prime Minister François Fillon caused controversy by claiming that he was head of a country in a “state of bankruptcy”, in a reference to the increasingly untenable budgetary deficit (see France: 24 September 2007: PM Forced to Explain Remarks on State of French Economy). Yesterday’s proposals, however, have largely left France open to further criticism, both from the European Central Bank (ECB) and its Eurozone partners, for failing to address its “critical” public finances.
Ambitious Objectives…
The state budget for 2008 is based on hefty tax breaks but very few and limited spending cuts. France has repeatedly fallen behind on promises to cut its deficit and debt to comply with Eurozone Stability and Growth Pact (SGP) limits, and the 2008 budget suggests that the country will continue to ignore the SGP rules and has little intention of putting its Eurozone commitments ahead of its domestic interests. This is despite the fact that France considers itself to be a crucial player among the Eurozone countries, and Sarkozy himself clearly stated, prior to becoming president, that adherence to the SGP was an important part of the single currency's financial architecture.
Disappointingly, just when many thought that things would change under the new presidency, the 2008 budget continues to avoid the significant adjustments that are needed to correct the large structural deficits. As we have repeatedly pointed out, public expenditure already absorbs 54% of GDP, so an improvement in the overall balance needs to be achieved through the continued reduction of this share (expenditure growth has instead come from social security expenditures on health, pensions and social transfers, as well as from expenditure by sub-national governments, at the levels of the regions, departments and communes, and spending by the social security administrations accounts for more than half of consolidated general government spending). However, this is not going to happen this time around.
Moreover, the budget is predicated on forecast GDP growth next year within a range of 2.0-2.5%, but we believe that this will be difficult to achieve, even the bottom end of the government's forecast. We agree with the government that consumer spending will continue to be the main growth driver of the French economy in 2008, with expansion seen at 2.5% for the year as a whole; and, indeed, the tax cuts, combined with muted inflation, should sustain real personal income. However, we believe that the downside risks to this outlook stem from the fact that subdued inflation, together with further monetary tightening, will contribute to push up real interest rates. Growth in wages is expected to remain moderate, given continued weaknesses in the French labour market. Moreover, the current liquidity crunch could feed through to dampen French domestic demand by making borrowing for businesses and consumers more difficult and costly.
…Optimistic Export Assumptions
Furthermore, the government sees exports expanding by 5.7% in 2008, up from growth of 3.6% in 2007. We think that this is a very optimistic assumption. Our scepticism is significantly influenced by the belief that the ongoing financial-market turmoil will cause some slowdown in global growth, thereby weighing down on French exports in conjunction with the strong euro. In this regard, we expect the euro to strengthen against the U.S. dollar to a much greater extent than the French government predicts. Specifically, we see the euro standing at US$1.46 by the end on 2008 and averaging US$1.43, as opposed to the US$1.37 end-of-year projection by the French government. This, together with the fact that the strength of private consumption will continue to have significant spill-over effects on imports (as price developments remain unfavourable to France), means that net exports will make a more significant negative contribution to growth in our forecast than projected by the French government.
Where Does the Money Come From?
The budget also contains estimated tax cuts of 9 billion euro (US$12.7 billion) intended to help homeowners and students, as well as to encourage people to work overtime, as envisaged in a new law that offers tax-free overtime for those working an additional two hours a week (see France: 2 August 2007: French Deputies Approve Controversial Tax Bill and University Reforms in Extraordinary Session). The fiscal package has been attacked by opposition parties, which claim that it is a sweetener for tough reforms, several of which were announced last week (see France: 19 September 2007: French President Outlines Ambitious Social Reform Plans, Unions Prepare for Battle). Additional expenditure on research and higher education has also been earmarked, worth an extra 1.8 billion euro compared to last year.
The government has countered the criticism by claiming that savings will come from cuts to public-sector jobs, as nearly 23,000 retirees or voluntary leavers will not be replaced next year. Furthermore, a raft of privatisations and planned increases in medical charges and incentives to discourage early retirement are together estimated to raise 600 million euro.
Outlook and Implications
All in all, the government has based its targeted deficit on GDP growth of 2.0-2.5% in 2008, whereas it currently seems likely to us that growth will struggle even to reach 1.7%. Consequently, we believe that the French deficit in 2008 will come in above the 2.3% of GDP predicted by the government.
The political fall-out from the state of the economy is expected to grow. Opposition parties to the left of the political spectrum have denounced the budget as “idealistic”, and are predicting a series of tax increases and other spending curbs after the March 2008 local elections, in which the ruling Union for the People's Movement (UMP) wants to extend its power over municipal councils. This is indeed somewhat likely in light of the spotlight on France from its European partners and the ECB, which until now have given Sarkozy quite a lot of room for action.
Tensions within the ruling party are also likely, with Sarkozy having been keen to downplay his premier’s comments. Ironically, Fillon was selected precisely for his straight talking and sensible approach to reform. The threat of social resistance to the recently announced reform ideas is significant, but with well-presented arguments, and large public support, this can be overcome. If, on the other hand, Fillon is restricted in his room for manoeuvre by an over-zealous president, the outlook for the necessary changes becomes hazy once more. Sarkozy has to prove he can act as well as talk, and the clock is ticking.