MACROECONOMICS

"...we share a common commitment to a medium-term strategy: credible fiscal consolidation programs, successful anti-inflationary policies...".

Grade: +1

(a) Anti-inflation policies - score: +1

France has been very successful in meeting this commitment. CPI inflation in France has steadily declined through the decade from 3.5% in 1990 to 1.6% in 1994. It has increased over the past two years to average 1.8% and 2% in 1995 and 1996 respectively. Inflation is expected to moderate again in 1997 falling back to 1.6%. Although CPI inflation has increased in 1996, the level of inflation remains within the bounds considered to be price stability. It also remains well within the bounds set by the Maastricht agreement.

Policy operation

Monetary policy in France is the responsibility of the Banque de France which was given autonomy from the central government in 1994. The Banque de France adheres to an annual CPI inflation target of less than 2%. The Banque conducts its policy by targeting an annual growth of M3 around 5% as well as supporting the stability of the French franc versus the major currencies in the European Exchange Rate Mechanism (ERM). The Banque implements its policy by intervening in the interbank market to set upper and lower interest rate limits.

Maastricht inflation target

The Banque currently faces an inflation target for 1997 as part of the Maastricht agreement leading to the first stage of the EMU in 1999. The criterion is that inflation should be less than the average of the three lowest inflation rates plus 1.5%. The average of the three lowest inflation rates - in Finland, Sweden and France - was about 0.5% in 1996 which implies a Maastricht target of not more than 2.0%. However, according to the IMF, the reference for 1997 has now probably increased to about 3.1%. barring some crisis, it is now all but certain that France will meet the inflation target.

The economy and inflation

The maintenance of low inflation through the decade has been assisted by the weak state of the economy following the recession in 1992. This weakness has been abetted by stringent fiscal cuts to meet the Maastricht fiscal target. France has also had to contend with the Maastricht inflation target, but unlike Germany did not have to cope with the inflationary implications of unification. Interest were raised substantially in 1990 (the call money rate topped 11%) and remained high into 1993. The combination of high interest rates and fiscal retrenchment pushed the economy into recession in 1992. Interest rates have since been eased and the call money rate has fallen to almost 3%, a level unseen since the 1960s. However, fiscal retrenchment has continued. The economy did show signs of strength and real GDP growth probably topped potential in both (2.8%) and 1995 (2.2%). However, output growth weakened again in 1996 falling to a mere 1.3%. The IMF estimates that the level of economic activity moved below potential in 1992 and has remained below since. In 1996, the negative output gap is estimated to have averaged 3.3% of potential output. This has provided a strong downward drag on inflation. The outlook calls for only a modest pick up in output growth to 2.2% in 1997, so that only a modest improvement of the negative output gap to 2.7% is expected.

Monetary Conditions

Interest rates have been steadily reduced since 1993 and by the start of 1997, the call money rate had fallen to almost 3%. This is the lowest level since the 1960s. However, the decline in interest rates provides a misleading picture of the easing of monetary conditions. This is because inflation is now also at a historically very low level. Once adjusted for inflation, the real call rate on money remains historically high. This is also true for long term bond rates. Due to the magnitude of the trade sector, monetary conditions in France are also very vulnerable to movements in the external value of the French franc. The franc gained steadily against the German DM through the early 1990s, reinforcing the high interest rates before 1993 but offsetting lower interest rates in 1993 and 1994. Concerns about the French commitment to meeting the Maastricht fiscal and inflation targets led to an sharp drop in the franc versus the German DM in early and mid-1995. This exerted a sharp easing in monetary conditions that contributed to the mild build up in inflation in 1996 . Since 1995, the franc has appreciated versus the DM but the appreciation and consequently the offset to lower interest rates has been modest.

Outlook

Despite the pick up in 1996, the outlook for inflation remains very good and, baring any mishap, France will almost certainly meet the Maastricht inflation target. CPI inflation in 1997 is expected to average 1.7%. The outlook for the economy in 1997 remains somewhat uncertain since the Socialists won over the government in the recent May elections. The new government remains committed to the Maastricht agreement in principle. However, with France likely to miss the Maastricht fiscal target it is not at all clear whether the government will be willing to countenance further fiscal retrenchment. And this has implications for the currency, interest rates and ultimately for inflation. Assuming no change in policy, the outlook is for a modest pick up in real GDP growth to 2.2% in 1997, implying only a modest improvement in the output gap. With the output gap in 1997 still expected to be 2.7% and the unemployment still almost 13% there are few inflationary pressure in the economy. Neither is monetary policy expected to provide any stimulus to inflation. This is because, the Banque de France has only limited room to reduce interest rates since short rates are already on a par with German rates.

(b) Fiscal consolidation - score: +1

The French government has made strong efforts to reduce the fiscal deficit and has met this Lyons commitment towards fiscal consolidation. However, the recent take over of the government by the Socialists place any further fiscal consolidation in doubt.

The Maastricht fiscal criteria call for the general government deficit and debt to fall below 3% and 60% of GDP respectively. Since the Maastricht fiscal criteria refer to the general government account and not just to the federal government, this should be a consideration in the assessment of the central government's compliance with the Lyons commitment towards fiscal consolidation.

On a national accounts basis, the central government deficit fell from 3.9% of GDP in 1995 to 3.5% in 1996. Under current policies, the central government deficit is expected to fall to 2.7% of GDP. On a national accounts basis, the general government deficit fell from 5.0% of GDP in calendar 1995 to 4.1% in 1996. Under current policies, the general government deficit is expected to fall in 1997 but only to 3.3% of GDP - thereby missing the 3% GDP Maastricht deficit target.

Government structure

The general government accounts are divided into three major components. These are the central government (or the 'state'), the social security system and the regional and local governments. In contrast to countries like the US or Germany, the structure of French government is very centralized - although there have been recent attempts to move towards greater decentralization. The central government accounts for about 40% of general government expenditures but is the source of almost all the general government deficit. The second largest source of the general government deficit is the social security account. The deficit for the local government sector is negligible. The fiscal year is the calendar year.

Fiscal laxity 1991-1994

In the early 1990s, the government under the left wing Mitterand continued to eased the stance of fiscal policy to offset the impact of the recession induced by tight monetary conditions. Driven primarily by the central government, the structural deficit of the general government increased 1.3 percentage points from 2.4% of GDP in 1991 to 3.7% in 1994. The weakness in the economy and the widening output gap, the rising unemployment and the high interest on the high debt service charges led to an even larger percentage point increase in the central and general government deficits. By 1994, the central and general government deficits had risen to 4.6% and 5.8% of GDP respectively. The general government debt had risen to almost 50% of GDP. The uncertainty over France's commitment to the EMU process prompted a currency in early 1995.

Fiscal consolidation 1995-1996

The course of fiscal policy was changed in May 1995 when the right of centre Chirac took over as President with Juppe as Prime Minister. The government announced a fiscal consolidation package, buttressed by fiscal targets that sought to reduce the actual general government deficit to 5% of GDP in 1995, 4% in 1996 and 3% in 1997. The reduction in the deficit was to be attained through expenditure cuts. However, in both 1995 and 1996, the performance of the economy turned out to be weaker than expected requiring supplementary budget expenditure cuts and some tax increases, including an increase in the VAT in 1995. The budgets resulted in the first decline in the structural deficit since the late 1980s and the structural deficit of the general government fell from 3.7% of GDP in 1994 to 1.9% of GDP in 1996. Despite the weaker than expected performance of the economy, the deficit target was met exactly in 1995 and only closely missed in 1996 - the general government deficit for 1996 was 4.1% of GDP rather than 4.1%..

Social security reform

In November 1995, the government announced a sweeping reform to the social security system (regime centrale) whose finances have deteriorated sharply in recent years, primarily because of health costs. Most of the planned measures were enacted by Spring 1996. The plan deficit reduction measures but also included structural changes.

First, the most important included a change to the constitution allowing parliament to place annual ceilings on social security spending. The second was the creation of new consolidated fund to take over the accumulated debts of the social security scheme, to be financed and paid off by a special tax. The third reform was the creation of a unified national health insurance system.

In October 1996, the government passed the first annual social security finance law. The law transferred responsibility for the financing of the social security system to the government.

In November 1996, the government passed a bill permitting the creation of complementary private sector pension funds. This law is to come into effect in 1997. The new pension schemes are designed to alleviate the pressure on the existing private pension fund schemes (as well as the public sector scheme) which are organized on pay-as-you-go principle.

Tax reform

In early 1996, the government set up a special Commission to consider tax reform. The main difficulty with the French tax system is that it has a low revenue yield and that social security taxes are very high. In September 1996, the Commission made three sets of proposals:. The first was to eliminate certain personal tax exemptions, including the low-income tax deduction; tax harmonization of non-labour income. The second was the replacement of the employee health insurance contributions by a tax on a broader range of incomes. Third, the harmonization of local business taxes across local jurisdictions.

Crisis in 1997

The deficit reduction program met strong resistance because of its impact on the economy and the unemployment rate in particular - this had topped 12% in 1996, a post-war high. In early 1996 a preliminary budget for 1997 incorporated a spending freeze in nominal levels, some tax cuts to be offset by an increase in the indirect tax rate. The budget projected a general government deficit of 3.6% of GDP - far above the Maastricht 3% fiscal target. However, as the economy remained weak in 1996, it became clear that the deficit would be even larger. As a stop-gap measure to reduce the deficit, the government transferred the pension fund of France Telekom worth 0.5% of GDP. The general and central government deficits in 1997 are expected to fall to 3.3% of GDP and 2.7% respectively.

Despite the stringent fiscal cuts - the structural deficit of the general government is expected to fall to 1.4% of GDP - France is now likely to miss the Maastricht fiscal target. However, the possibility of another bout of fiscal cuts to meet the target have been put off by the takeover of the government in May 1997 by the socialists. It is still too early to know what the course of action will be. However, during the election campaign the Socialists under Lionel Jospin campaigned on the apparently irreconcilable platform of commitment to EMU but not necessarily to the targets in the Maastricht agreement. In particular, the Socialists promised to create 700,00 new jobs over an undefined period targeting youth and the long term unemployed. The promise to create half the jobs inside the public sector does not bode well for fiscal consolidation.