Monday, June 18, 2012

Sometime Soon France May Be Europe's Biggest Basket Case

We've seen the results of yesterday's vote in Greece, and today we're looking at solvency issues for Spain. After Spain may come Italy. Anybody else?

 Well, as a matter of fact, yes. Led by new President Francois Hollande, socialistic France may soon be in the spotlight, although the issue may take some time to develop fully.

Hollande Wins: Now What for France? tells the unfolding French story in brief:

"Greece wasn't the only euro-zone nation voting at the weekend. Perhaps more significantly for Europe, President Francois Hollande's Socialist Party won 314 of the 577 seats in France's lower house, meaning the government won't need to rely on support from other parties. While that gives an advantage in policy implementation, the question for investors is whether Mr. Hollande will use his grip on power to address France's economic challenges, or defer them. . . .

Mr. Hollande talks a lot about growth—which both bond and stock investors should welcome—but it isn't clear his policies will deliver it. He proposes to pay for spending through higher taxes on companies, banks and high earners, and is aiming only to stabilize the size of France's public sector rather than cut it, Moody's notes.

The government is sticking to a budget deficit target of 3% for 2013, but that is becoming more challenging as the economy stagnates. After zero growth in the first quarter, the Bank of France now forecasts a contraction of 0.1% in the second. And in the longer term, France needs to run a persistent budget surplus before interest payments to stabilize debt. This will be a challenge: The last time France had a balanced budget was 1974.

On structural reform, key to growth in the longer term, Mr. Hollande has said little beyond proposing public consultations. But he has already cut the retirement age for some workers back to 60 from 62. This will only affect 20% of retirees, but will cost €1 billion ($1.26 billion) in 2013, rising to €3 billion a year by 2017. This can only send the wrong signal to markets and other governments. France's rating, already cut to double-A-plus by Standard & Poor's, may come under renewed pressure.

Hesitation on structural reform is bound to cause tensions with Germany, raising questions about the relationship at the heart of the euro project and prospects for deeper integration. And it remains to be seen how far Mr. Hollande will countenance a sacrifice of sovereignty in the name of deeper integration—especially as that would probably mean reform dictated from outside. As long as that's the case, questions about whether France deserves its status as a member of the core of the euro zone will persist."

My Take

The relationship between France and its next door neighbor Germany has long been a contentious and difficult one.

Once upon a time they challenged each other for the number one spot among European countries, but now Germany very much stands alone.

So while today Germany is in reasonably sound financial shape, France isn't.

Over the years France has been much more socialistic than Germany as it actively promoted social welfare policies such as the 35 hour work week and a normal retirement age of 60. As a result, France's financial condition, compared to Germany's, is considerably weaker.

Accordingly, while France in fact may not be any more socialistic than many, if not most European sovereigns, it's the biggest one to embrace socialism so completely.

So now let's watch carefully how the newly formed relationship of French President Hollande and German Chancellor Angela Merkel develops as we see whether France and Germany will walk together or take different fiscal paths in the future.

While what the French choose will mean a great deal both to Europe and to the rest of the world, today it sure looks like the French are headed the wrong way.

Thanks. Bob.

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