September 2014

INSIDE VIEW: Quick fixes or difficult solutions?

FigsAmid slowing growth in the eurozone, France’s economic situation remains particularly concerning. Patrick Artus of Natixis, looks at the options available to the Hollande government, in order to re-energise the French economy. For the past decade, France has shown visible signs of weakness, including a steady deterioration in competitiveness, rising unemployment and diminishing productivity.  Now, its stagnant growth prospects and excessive debt levels could affect investor confidence and consequently weigh on the prospects of a wider eurozone recovery. For France, maintaining long-term economic stability can only become a reality with serious policy reform in tow.  So it’s opportune that long-awaited changes now lead the political agenda, as decision-makers attempt to reverse current public perception and boost the economy. No doubt, it will be a lengthy journey for President François Hollande and Prime Minister Manuel Valls.  The recently announced budget-deficit target of 3% of GDP next year is ambitious to say the least, while other policies introduced as part of the government’s flagship reform – The Responsibility and Solidarity Pact – focus on the long-term. Yet, the government is all too mindful of the repercussions of a major weakening in France’s GDP growth, including the danger of losing political clout in Europe or a widening of the domestic conflict between proponents of demand-side policies and those who advocate supply-side policies. Therefore, more needs to be done. Two significant problems are hindering France’s economy at the moment.   The first – soaring unemployment – isn’t helped by the high minimum wage and the disconnect between labour supply and demand. And the second – incredibly low profit margins in the manufacturing sector – is largely related to the rigidity of supply and unsophisticated production lines, caused by the continued inability of all sectors to modernise. In order to fix the economy, the government should pursue one of two routes (or a combination of both); a “quick fix” route – incorporating key policy choices targeting currency, labour costs and competitiveness – or a “difficult solutions” route that focuses on eliminating France’s main structural issues over time.  What “quick fix” solutions exist for France? The first policy choice on this route would involve offsetting high labour costs by subsidising companies, using public money (and therefore fiscal deficits) to do so.  This policy is especially worth considering when the strict regulation of the labour market plays a significant role in France’s economic quandary. If France could withdraw from the eurozone and lose the euro as a currency, a second policy choice could be targeted exchange-rate depreciation, aimed at restoring competitiveness and profitability. Although depreciation was used with success in the 1980s (to the franc) to correct the handicaps that had built up since the mid-1970s, this solution is not realistic in the current context of the euro.  The government would need to bear in mind the additional – and rather hefty – costs of depreciation in a more globalised financial market today, including higher prices for imported products, a loss in the country’s wealth expressed in foreign currencies, a lack of incentive to move upmarket, and a rise in interest rates due to currency risk. A third policy would be the implementation of protectionist policies against competition from the US, Europe and emerging countries, to halt the market share of imported products. COMPLEX SOLUTIONS
Of course, this fails to take into account the nature of international trade, where the production of goods is segmented between countries due to the suitability of value chains. Due to its EU membership, it is another unrealistic suggestion for France. Instead of quick fixes – which in reality are either extremely costly or impractical – France would do well to consider implementing more difficult, long-term solutions. Reforms to the labour market, for instance, could ensure that wage formation becomes more flexible and reacts to the economic situation more accurately. This would increase profitability, competitiveness and the “value-added” of unskilled or young employees. The fall in wages would balance the gap between wage and productivity. The second difficult policy worth considering is a reduction in government spending to finance tax cuts. This would involve drastically cutting detrimental taxes in legislation today. Of course, small reductions in spending across all areas will not be enough to reduce government spending sharply. In financing a marked reduction in companies’ social charges, the government would need to make strategic choices within its finance books, perhaps by abandoning or privatising certain public functions. And finally, the government could remove the obstacles preventing companies from growing. A good example of this is the “social thresholds” regulation, for instance, which dictates the size of a company above which its regulatory obligations increase (10 or 50 employees), or its tax incentives are reduced (20 employees). Certainly, whether or not France can return its economy to order depends on the efficiency of political action. Under Hollande, the pact – which seeks to build a pro-business stance to boost growth – offers some respite for these burgeoning issues. Announced at the start of this year, the pact is designed to help return competitiveness to companies, tackle the reduction of tax and labour costs, provide better wages and open social negotiation on commitments, among other objectives. In addition, the government plans to slash an unprecedented €50 billion in public expenditure between 2015 and 2017. These recently announced policies are the first step on what will no doubt be a long journey. And crucial choices regarding its implementation still need to be made – particularly while momentum for reform exists. Of course, public spending has long-been a point of concern for France. And even with its new goals announced, France remains hesitant to make significant cuts in public expenditure, compared to other European countries. Therefore, to correct France’s economic situation – especially the mismatch between the high level of labour costs and a down market economy – the government could choose either a quick-fix scenario, such as subsidies to companies, or more difficult, lengthy solutions. These include the reformation of wages, strategic choices in government spending, or the elimination of regulatory obstacles to growth, which can be impoverishing in the short-term but can have a payback when the supply effects have had the time to be efficient. Certainly, these efforts should also be considered as long-term policy. And when looking at these solutions it is crucial to draw a distinction between policies that will increase employment and policies that will improve profitability – two problems that hinder the economy. But we should recognise the government faces a tough agenda. Patrick Artus is chief economist at Natixis ©2014 funds europe

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