Thursday, November 8, 2012

How Is France's Credit Risk Looking Right Now?

Rather than focus on the election results like everyone else has been doing since Tuesday evening, I wanted to write about something with an international theme. Today, I would like to focus on France's economy and assess their long-term risk in the financial markets. The importance of France is due to the fact that its nominal GDP is fifth worldwide and second to Germany in the Euro Zone. Although France is not the power it once was under Napoleon, France still has influence in the global markets. If the French economy was dealt a coup, it would affect the Euro Zone, at the very least, and at the most, would adversely affect the global economy. With that to consider, let's take a look a France.

On the whole, France is a country with sound, democratic institutions. Freedom House has given France a superior ranking on its index that measures political and civil freedoms. Even with some issues such as Internet censorship and the burqa ban, France enjoys overall institutional stability, which is great because France's resilience to external shocks and a seemingly stable monetary policy [with the ECB] helps set the minds of investors at ease because instability leads to a more inefficient use of resources. This sentiment is additionally affirmed with France's reasonably high rating on the Corruption Perceptions Index (CPI) or France's overall inflation rate. Even when looking at the credit-default swaps market, France's government bonds hold comparably well to Germany (as of date, 80.05 versus 32.50, respectively), which is a solid indicator of confidence in the French government.

My confidence wanes a bit when I look at the economic freedom indexes from Heritage/Wall Street Journal and the Fraser Institute, not to mention France's anemic GDP growth. I would summarize France's economic issues into three main issues:
  1. Government spending. France's debt to GDP ratio shot up six percent points during the last two quarters. Currently, France's debt to GDP ratio is at 91%, which is above the Euro Zone average. The increase of government spending is problematic because it signals a lower probability that a country can pay off its debt obligations without doing things like printing more money to create a de facto default, expropriate more property, or raise taxes. Also, if the citizenry demands, or the government continues to provide more welfare-based services, then the amount of government spending will only ascend to insolvent rates. 
  2. Tax Rates. In order to be able to supplement a welfare state, a country needs to tax higher. When looking at the OECD database for tax rates, the value-added tax (VAT) sits at 19.6%, which is above average. Tax revenue as a percent of GDP is 44.2%, which is bothersome because it suggests a lack of financial depth brings brings up issues mentioned in my first point. Fran├žois Hollande recently unveiled his intent to tax those making more than a million euros at an astonishing 75%. France's above average tax rates are problematic because such levels of taxation greatly diminish, if not outright destroy, incentives to save, invest, or even work.
  3. Labor Rigidities. As if France's fiscal policy wasn't bad enough, there is one last issue that makes the French markets even more problematic: its labor markets. Looking at the Index for Doing Business compiled by the International Finance Corporation and the World Bank, it is not easy to do business in France. Why is that? For one, France's labor laws are based off of Le code du travail, which was first established in 1910 (i.e., their ways of perceiving the labor markets are arcane and obsolete, to say the least). It is impossible to fire an employee at will. Back in 2006, France tried to pass a bill that stated that an employer could fire an employee under 26 years of age if he didn't work out. The result? The bill got rejected. One has to fill out all the proper paperwork immaculately and jump through all of the proper loopholes to get someone fired. It is usually cheaper to keep an incompetent employee on the job than firing him and hiring a new employer. This causes employers in France a huge disincentive to hire new labor, which would explain why it had high unemployment rates even prior to the recession. Not only that, hiring is expensive. France mandates a thirty-five hour work week, which is the lowest amongst developed nations. The French government also mandates that employers give eight weeks of paid vacation. France also has this crazy law where if you hire a 50th employee, there is a ridiculous amount of oversight and bureaucratic intervention. Since the marginal cost to hire a 50th employee is so high, France has a lot of 49-employee companies, and thus would have to endure the cost of creating a new company to get around the loophole. Without a flexible labor market, not only have you made it undesirable to hire more employees, but productivity goes downwards because complying with all these regulations creates inefficiencies in which the money could have been better allocated elsewhere. 
Conclusion: The extent of credit risk is largely, but not solely, contingent upon the future of the Euro Zone. If Greece or Italy tank, there is a good chance of the contagion effect. Euro Zone notwithstanding, there are still internal worries for France. Remember that the French government couldn't fathom the idea that it could lose its AAA+ credit rating, but it did within the past year. Making the recent decision to increase the VAT didn't help, either. The International Monetary Fund (IMF) recently put out a report telling France that, amongst other things, it needs to reform its labor markets if it doesn't want to exacerbate its current situation. I agree with the IMF: it needs to make serious changes to free up its markets. Since there is currently a socialist as the president, that only increases the credit risk because socialism is just a form of credit risk. I do hope that France decides to make some real reforms in order to maintain its institutional stability, but again, optimism is not an indicator of how France's long-term economic status will turn out. Since I do worry about France's economic policies being "on auto-pilot" or worse (i.e., more socialist policies), I would currently have to rank France's overall credit risk somewhere between Low and Medium.

UPDATE, 11/15: The Economist just published an article about France's heightened credit risk. Worth the read.

No comments:

Post a Comment