Forget Cyprus, France is the next EU peripheral country – Danske Bank

Danske Bank has warned that France is starting to look like a peripheral member of the EU in its latest research note on the country.

Among the dangers noted by Danske Bank senior economist Frank Hansen and analyst Pernille Nielsen are:

  – Latest PMI figures point to increasing divergence from the eurozone’s strongest member Germany,

   – Structural issues remain, while the fiscal reforms of president Francois Hollande do not seem to be having any positive effect on growth,

   – Affordability in the housing market looks stretched, threatening the construction sector,

   – Declining house prices could trigger a downward spiral of even slower growth and growing government debt,

   – The country faces the danger of a “lost decade” of very little growth.

“The French PMIs for service and manufacturing point to negative growth of  around 0.8% q/q in Q1 13 while the German PMIs indicate an improvement in growth compared with the decline in Q4 12,” Hansen and Nielsen wrote in their note.

“This could point to a divergence in the French and German conjuncture but the main difference between the two countries seems to be underlying dissimilarities.

“The business climate has stagnated in France whereas in Germany it is improving. France is faced with deep structural challenges: competitiveness is fragile due to high taxes, high unit labour costs and a rigid labour market. France’s competitiveness could also be threatened further by Italy and Spain, who are more engaged in reforms of their labour markets and service sectors.

“In addition, headwinds from fiscal tightening continue in France while they fade in Germany. Finally, a weakening French housing market with low activity, slightly falling prices and declining construction activity has begun to pull growth down.”

They added: “France’s structural challenges within job creation, economic growth and debt sustainability require reforms. President Hollande has reformed the labour market, changed the pension system and adjusted fiscal policy but it has not been enough to significantly improve fiscal sustainability, restore competitiveness or generate growth.”

Housing market threat

Although there is still debate as to the level of danger the French housing market poses to the economy, Danske Bank takes the view that “the housing market could be the most important risk factor to growth.”

“House prices are close to an all-time high but the upward trend appears to have stopped. Bank lending for house purchases, which has decreased since summer 2011, is now lower than in 2009 and even though demand for house loans has been supported by policy initiatives including zero-interest loans for first-time buyers, it has been declining since 2011. Furthermore, new homes for sale are at a high level, whereas new homes sold have fallen. Affordability looks stressed and the construction sectors expectations of future activity have also come down significantly.”

“All in all this may indicate that house prices could decrease in the near future. This would result in a slowdown in construction as well as private consumption and consequently growth will be harmed. The spill-over effect to growth depends on the size of the correction in prices. The housing market might not look particularly overvalued at current low interest rates, but at more normal rates a 20% correction seems reasonable. The Economist sees the housing market as a big risk factor as it argues that European valuations are most stretched in France by as much as 50% judging by rents and by 35% on the basis of incomes. The IMF is much less concerned and concludes in its recent article IV consultation that ‘There is a perception of price overvaluation especially in Paris… However, there is no housing glut or household debt overhang that could trigger a sudden price adjustment'”

Fiscal decisions and government bonds

Danske’s note suggests that the fiscal decisions made by the French government will be crucial in steering a path away from disaster.

Using the IMF baseline prediction of debt/GDP peaking at 91.3% by 2014, it has added three possible scenarios.

   – A 1pp lower GDP growth rate results in a peak in gross debt at 92.8% of GDP in

  – Combining the case of a lower growth with a 1pp higher primary deficit results in an increasing debt to GDP until 2016 where it peaks at 96.2% of GDP.

   – A 1.5pp increase in interest rates, combined with the effects above, implies that the debt ratio will be on an increasing trajectory to 2020.

That said, Danske Bank believes that France could find a positive path out of its low growth/high debt situation, should much needed reform take place.

“Even though an increasing debt to GDP ratio is very concerning, the ratio is not much above 100% and compared with the peripheral countries, this is less alarming. Added to this a loss of investor confidence could put France under pressure to implement the much needed reforms, which would improve growth and possibly start the reverse spiral than described above.”

“France has had historically low interest rates despite the weaker outlook and negative press headlines. The French government bond market is very liquid and generally trades with a small spread to Germany. Foreign investors own about 63% of all French government bonds. Substantial domestic funding sources could be activated to support the bond market if needed.

“The government bond spread to Germany did increase at the end of 2011, reflecting an escalation of the debt crisis only to come down after the ECB’s OMT announcement. A continuation of negative news from France could also result in some spread widening. This may eventually become more pronounced if Hollande abstains from taking the necessary steps to restore France’s competitiveness and improve fiscal sustainability.”


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