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International Country Risk Guide June 2013

Reproduction without permission of the Publisher is strictly forbidden 41

FRANCERISK ASSESSMENTS

One Year

Ahead

Five Years

Ahead

Risk Category YearAgo

Current06/13

WorstCase

BestCase

WorstCase

BestCase

Political Risk 74.5 69.5 68.0 77.5 68.0 85.5

Financial Risk 33.5 36.0 34.0 37.0 31.0 40.0

Economic Risk 35.5 35.5 33.5 38.0 30.0 40.0

Composite Risk 71.8 70.5 67.8 76.3 64.5 82.8

Risk Band Low Low Mod. Low Mod. V. Low

POLITICSGovernment Stability

A Battle for Hearts and Minds

Having completed one year in office since the last elections in May 2012, the

center-left Socialist Party President Francois Hollande has overseen one of themost catastrophic declines in a president’s popularity ratings in the history of the

Republic. Unfairly affected perhaps by a loss of faith in his demeanor, given that

he had been viewed as a more welcome, comforting alternative to the brassy,

over-friendly approach of his center-right predecessor, Nikolas Sarkozy,

Hollande has been afflicted by a litany of problems, albeit not all of his making.

They include a weak economy pushing up unemployment (which he partly

inherited), political infighting and scandals (not all associated with the present

administration), and fervent opposition from traditionalists toward the

legalization of same-sex marriage that has proven a divisive issue in other

countries; the latter has given the far-right a new cause célèbre and French

citizens another opportunity to protest.

Hollande’s lack of conviction has not helped his cause either. First came the

controversial 75% tax rate proposed for the super-rich previously discussed in

ICRG (January 2013), which was rejected by the French Constitutional Court,

belying the fact that a solid parliamentary majority creates few problems for

policy execution. The episode has hardly endeared Hollande to the nation’s

entrepreneurs; some have sought refuge in the UK, which has carefully avoided

such upset by partially retracing a corporate tax increase imposed by the

previous British administration. Then the French government promised to

reverse (for some workers) the increase in the retirement age from 60 years to a

still-favorable 62, as proposed by its predecessor, before realizing that it made no

sense and would need to be raised after all in light of the fiscal pressures

associated with population ageing and the advice of experts. Hollande’s

proclamation defending the ArcelorMittal steel plant in Lorraine from closure

also seems more than a political inconvenience in hindsight, with the factory’s

fate apparently sealed regardless.

Whether angry at the abandonment of Socialist principles (as those on the left

are more inclined to believe, and have demonstrated as such on the streets of

Paris), or merely distraught at the wavering over key structural reforms (an issue





more for the right), Hollande’s lot cannot possibly get any worse – or can it?

Garnering a 24% approval rating in the latest polls, he is not only the most

unpopular president of all time, but is also trailing Marine Le Pen, the caustic

blonde former lawyer and member of the European Parliament, who took over

from her father as leader of the French National Front in 2011. Though not quite

the xenophobic nationalist her father was (she favors limiting immigration rather

than repatriation), Le Pen junior may lose some trust by facing charges for a pastepisode of inciting racial hatred after the EU has removed her immunity from

prosecution.

Internal/External Conflict

Discontent from Several Quarters

But all of this will provide little consolation to Hollande in his ambition to

improve France, and by implication his own and his party’s standings,

particularly with the military also expressing rumblings of discontent. The

government is, moreover, facing greater pressure from the European Union to

sort out its economic problems. But rather than punish France for the failure to

meet its fiscal targets, the country has been given more time (as other member

states have) to enact change, under the proviso that in return for less stringent

austerity, reforms will be tackled more forcefully. Yet even this advice, though

endorsed by the OECD, Banque de France (the central bank) and the IMF,

appears to be falling on deaf ears.

In a typical demonstration of French political obstinacy toward external

influence, both Hollande and his Prime Minister, Jean-Marc Ayrault, have

indicated that the country may well reform, but only at their own pace,

potentially putting the government more at loggerheads with Europe’s other key

policymakers. The government’s intransigence is nonetheless in line with public

opinion, as support for the EU in France has fallen alarmingly, highlighting the

deep divisions between France and the southern Mediterranean countries on theone hand, and Germany and other core countries on the other; French migration

into the former camp (having previously been viewed as part of ‘the core’) is

perhaps one of the more startling outcomes of the current crisis.

Under the guise of an assessment of its National Reform and Stability Programs

issued in April this change of policy by the European Commission, it is hoped,

will allow economic growth to surface and pacify disquiet across the EU at the

incessant rise in unemployment, which reached a new record high in April. At

the same time it will also introduce a more credible path toward fiscal

sustainability. It is not known whether the recent Rogoff-Reinhart controversy

has made a major contribution to this policy change, as the mistakes in their

path-breaking academic research have indelibly weakened the arguments forausterity as a path back toward economic growth. The Commission has in any

event been forced to alter course in reaction to the grave economic situation

being faced across Europe, with no end in sight to the downturn and with

conditions worsening in euro zone countries especially. Either way the austerity

program has been scaled back.





Investment Profile

Deficit Target Pushed Back

France will now be able to reach the 3% of GDP general government deficit

target in 2015, rather than this year, as part of a program that sets individual

targets and recommendations for other member states (specifically Belgium,

Italy, Malta, the Netherlands, Portugal, Spain and Slovenia, such are the

difficulties being faced right across Europe). France, a key element in the singlecurrency equation given its size and importance within the euro zone, faces the

most pressures in terms of structural reforms required, notably to its labor market

which the government has hardly dared tackle for fear of stirring up strong trades

union antipathy that so often results in labor force activism and street protests in

a country still embedded to its old Socialist ways. The latest walk-out by air

traffic controllers has brought European air traffic to a standstill.

The EU’s targets are thus more credible, picturing a more gradual decline in the

deficit from 4.8% of GDP in 2012 to 3.9% this year, before easing to 3.6% in

2014 and 2.8% a year later. But this all assumes a return to growth, which is not

guaranteed in the light of recent confidence indicators and the need to ensure

sufficient structural adjustment, particularly as the government’s projection of

1.2% growth for 2014 has been described, correctly in our view, as “overly

optimistic” by the Commission. To meet the new target, fiscal measures

exceeding 1% of GDP per year will be required in both 2014 and 2015. The

bond markets have welcomed the new plan with France still able to secure 10-

year sovereign borrowing at an interest rate of around 2.2%. However, the new

trajectory still appears ambitious, especially if the government does not stick to

the structural adjustment plan.

The government has a solid majority in parliament and political pressures for

higher spending will not kick in until closer to the 2017 election date, but it will

still face opposition (including rising social instability) if these reforms are nothandled appropriately; not all French citizens are convinced that its country

needs to be reformed at all, such is the entrenched status of regulation in

everyday life, though discordantly public opinion is also vastly biased in favor of

public spending cuts, a situation that can only be squared by making good on

these pledges, something which citizens are still not fully prepared to accept.

The recommendations for reform are wide-reaching, but consequently with

considerable opportunity for stalling. Apart from labor market measures that

focus on apprenticeships and the participation of older workers, the Commission

also urges simplification of the tax system and more competition through

deregulation. Many areas of French economic life, from its railways to

professional services, involve some sort of bureaucracy that runs contrary to thespirit of the free market. Improving the efficiency of public spending, notably to

pensions and pharmaceutical spending, are also on the government’s “to-do” list.

The key question is whether voters will give the government time and the benefit

of doubt. Public confidence has been rocked lately by the news that Jerome

Cahuzac, Hollande’s former budget minister, lied about a savings account he

possessed in Switzerland in which it transpires he squirrelled away €600,000 in

personal savings over the past two decades without having to pay any tax in





France. Although Hollande has tried to distance himself from the scandal many

allege he may well have known about it. However, with Sarkozy also damaged

by allegations of impropriety concerning illegal campaign financing the French

are becoming increasingly tired of the political orthodoxy, which will only play

into the hands of more extremist views.

The National Front, which has long been a bugbear for the center-ground,influencing election outcomes and highlighting the fractious nature of French

society, remains at war with the impoverished immigrant communities, which

provides another focal point of potential conflict, especially over the summer

months when disaffected youths often take to the streets. The far left, too, led by

Jean-Luc Mélenchon, is coming to play a more prominent role, in accusing

Hollande of weakness and of cozying up to the world of finance. Even former

Prime Minister François Fillon, a more moderate political voice, believes that

France is heading for, in his words, “catastrophe”. Given such risks it cannot be

assumed that the government will survive its full term in office and firms should

be prepared for disruptions to normal activities from protests should they spread

and become more violent.

ECONOMY Prognosis Still Gloomy Despite Recent Pick-Up

Discouragingly the economy has brought little cheer for the government or

French citizens of late. GDP stagnated last year (in real terms), and based upon

more negative economic news so far in 2013, including a 0.2% quarter on

quarter contraction in GDP during the first quarter, a rapid improvement is not

expected until the second half of the year, and even then it will be moderate at

best. With rising unemployment and taxes eroding real household disposable

income and consumer sentiment, and with firms lacking the confidence and the

wherewithal to invest, the emphasis is very much on an improving export climate

(of which there is very little sign presently) to revive economic fortunes.

Industrial production did provide a positive surprise in April and the business

sentiment index picked up a touch in May, according to the European

Commission’s regular monthly surveys. However, it remains to be seen if the

former can be sustained, while the latter was insufficient to reverse the

previously declining trend, with the index remaining at 87.3, its low point in

October. Although metals, car production and textiles have shown visible signs

of improvement, many areas of the economy remain depressed - worryingly the

construction sector even more than in previous months according to the EC

survey.

The more moderate pace of austerity, combined with a gradual improvement inexport demand, should help to underpin a recovery, though achieving growth of

more than 1% next year is at this stage seemingly optimistic without any

particular inclination or ability to spend among households; the unemployment

rate, too, will creep above 11% by 2014, perhaps as high as 12% from an

average of 10.2% last year, as corporate restructuring continues. With an

emphasis on productivity growth keeping workforce efficiency foremost in the

minds of corporate leaders, firms will also shy away from costly capital spending





until the economic picture improves. Another year of contracting gross fixed

capital formation in 2014 seems unlikely, but cannot be ruled out entirely.

The macroeconomic stabilization is borne out by a correction in the external

imbalances. Although a common currency removes the direct link between the

balance of payments in France and its currency risk, the current account deficit is

nevertheless moving in the right direction, having narrowed to 1.8% of GDP lastyear from 2.6% in 2011. Moderate improvement is expected to continue in 2013

as import demand remains weak, which, with stable energy costs keeping

France’s import bill in check, and export earnings gradually improving as

external demand supports volume growth.

Inflation Risk Diminishes

As in other parts of Europe, the factors causing inflationary pressure to build in

2011 gradually unwound last year and the European Central Bank is now less

concerned by inflation than a lack of liquidity and slow growth in the euro area

to keep it preoccupied with monetary expansion. After averaging 2.2% in 2012,

French inflation is on course to decelerate close to 1% this year. Considerable

spare capacity exists (with actual growth way below potential), and in the

absence of any unforeseen tax hikes, commodity price shocks or sudden euro

depreciation, inflationary pressure should remain comparatively low in 2014 as

well. The prospect of any of those risks transpiring seems unlikely at present, but

should not be completely ignored. The ECB will nonetheless retain its bias

toward monetary stimulus, with little or no prospect of interest rates rising for a

considerable period of time until a recovery is firmly established.

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