|| EUROPEAN COMMISSION ||

Brussels, 26.2.2015

SWD(2015) 29 final

COMMISSION STAFF WORKING DOCUMENT

Country Report France 2015 Including an In-Depth Review on the prevention and correction of macroeconomic imbalances {COM(2015) 85 final} This document is a European Commission staff working document . It does not constitute the official position of the Commission, nor does it prejudge any such position.

Executive summary 1

1. Scene setter: economic situation and outlook 3

2. Imbalances, Risks, and Adjustment 10

2.1. Competitiveness developments 11

2.2. Public and private indebtedness 26

2.3. Euro Area Spillovers 34

3. Other structural issues 38

3.1. Taxation, Sustainability of public finances and Fiscal framework 39

3.2. Labour market, social policies, skills and education 45

3.3. Improving the business environment and enhancing competition 50

A. Overview Table 59

B. Standard Tables 68

LIST OF Tables

1.1. Key economic, financial and social indicators 9

1.2. The MIP scoreboard 10

2.1.1. Decomposition of goods export market share, France 12

2.1.2. OECD Product Market Regulation in services, 2013 22

2.1.3. Profit margins in manufacturing per technology 25

2.1.4. Long-term elasticity of exports to cost-competitiveness 26

B.1. Macroeconomic indicators 70

B.2. Financial market indicators 71

B.3. Taxation indicators 71

B.4. Labour market and social indicators 72

B.5. Labour market and social indicators (continued) 73

B.6. Product market performance and policy indicators 74

B.7. Green growth 75

LIST OF Graphs

1.1. Contribution to GDP growth (2007-2016) 3

1.2. GDP in volume (2000=100) 4

1.3. Composition of the external position 5

1.4. Non-cyclical current accounts 6

1.5. Composition of the net international investment position 6

1.6. Debt decomposition, all sectors, consolidated 7

2.1.1. Component contributions to change in CA balance 2007-2013 12

2.1.2. Average yearly export market share loss/gains per sector (2001-2008) 13

2.1.3. Average yearly export market share loss/gains per sector (2008-2013) 14

2.1.4. Market share losses in goods 2012-2013 15

2.1.5. Nominal unit labour costs (total economy) 16

2.1.6. Decline in productivity growth in the market economy 17

2.1.7. Spare capacity without additional recruitment in manufacturing 19

2.1.8. Capital accumulation contribution to potential growth 20

2.1.9. TFP growth in selected countries 20

2.1.10.TFP growth in the tradable and non-tradable sector 20

2.1.11.Product-times labour market regulation, 2013 21

2.1.12.Price developments per sector 22

2.1.13.Profit margins in selected European countries 23

2.1.14.Profit margins 25

2.1.15.Gross Fixed Capital Formation 25

2.1.16.Equipment investment 26

2.2.1. General government deficit and debt 29

2.2.2. Net financial assets of the government 29

2.2.3. Components of gross debt variation 30

2.2.4. General government debt under various scenarios 30

2.2.5. Spreads between France and selected euro area Member States(10-years maturity bonds) 31

2.2.6. Correlation of the French 10-year sovereign rates with selected euro area Member States 32

2.2.7. French bank's consolidated exposure to euro area general government securities 33

2.2.8. Loan deleveraging pressure 35

3.1.1. Effective marginal tax rate on equity and debt-funded new corporate investments, 2014 43

3.1.2. Environmental tax revenue by type of tax (2012, % of GDP) 44

3.2.1. Unemployment rates total and of people aged under 25 - comparison France EU average 47

LIST OF Boxes

1.1. Economic surveillance process 8

2.1.1. Distribution of export products by quality in France, Spain and Germany 27

2.3.1. The financial intermediation role of France 38

3.3.1. Main measures included in the draft Law on Growth and Economic Activity 56

A modest recovery is expected in 2015. After three years of slow activity, GDP grew by 0.4 % in 2014 supported by public consumption and inventories. A modest recovery is expected in 2015 which will gain traction in 2016, on the back of stronger private consumption. The unemployment rate, at 10.2 % in 2014, is not expected to decline significantly in the coming years. The general government deficit and debt, at 4.3 % and 95.2 % of GDP respectively in 2014, continue to be at high levels. Investment contracted in 2014 as companies' profit margins remain under pressure, but is set to increase in the coming years. The euro depreciation and recent reforms will not be sufficient to reverse the losses in export market shares. Inflation is projected to decrease to zero in 2015 before increasing moderately to 1 % in 2016. France's recent price developments reflect external factors but also weak aggregate demand.

This Country Report assesses France's economy against the background of the Commission's Annual Growth Survey which recommends three main pillars for the EU's economic and social policy in 2015: investment, structural reforms, and fiscal responsibility. In line with the Investment Plan for Europe, it also explores ways to maximise the impact of public resources and unlock private investment. In March 2014, the Commission concluded that France was experiencing macroeconomic imbalances requiring decisive policy action, in particular regarding the deterioration in the trade balance and in competitiveness as well as the implications of the high level of public sector indebtedness. The Country Report also builds on the specific monitoring of policy reforms taken to unwind the macroeconomic imbalances, which was set in motion by the Commission in 2014. Finally, it assesses France in light of the findings of the 2015 Alert Mechanism Report, in which the Commission found it useful to further examine the persistence of imbalances or their unwinding. The main findings of the In-Depth Review contained in this Country Report are:

· Despite some improvement since 2012, France has lost 13 % of its export market shares in the past 5 years. The manufacturing industry has suffered export market share losses across all sectors, except for the high-tech sector. Overall, French exports seem sensitive to deteriorations in cost competitiveness indicating a lower ability of exporting firms to compete on non-cost factors. The low profitability of exporters limits their capacity to invest and to innovate and hence to improve their non-cost competitiveness. The industry’s low profitability is in part due to the high cost of labour. The measures to reduce the labour cost, namely the tax credit for competitiveness and employment and the Responsibility and Solidarity Pact, may only have limited effects on competitiveness and be partially offset by sustained wage growth. The latter poses a risk of a further deterioration of cost competitiveness.

· The high and rising overall indebtedness of the French economy, in a context of low growth and low inflation, increases the country's vulnerability to potential adverse economic events. General government debt has increased rapidly since 2000, notably due to the high deficit recorded during the global financial crisis. Since then, expenditure growth has proved difficult to contain and the headline deficit remains high. In the private sector, the poor profitability of companies may affect their ability to service their debt.

· Negative developments in France would have a significant impact on the other euro area countries. The French economy has strong trade, financial and banking linkages with other Member States. Failure to effectively address the French structural challenges may thus affect adversely euro area partners. Conversely, a recovery of consumer confidence in France would benefit the euro area as a whole.

Other macroeconomic issues which point to particular challenges of the French economy are:

· Services market rigidities, together with the high administrative burden, weigh on the business environment and, ultimately, on investment. Regulatory and other barriers continue to limit competition in the services sector in general and in professional services, retail trade and network industries in particular. These have a detrimental impact on productivity both in services and in the manufacturing sector. Investment in research and development in the private sector has increased, although it remains below the best EU performers.

· At 57 % of GDP in 2014, public expenditure remains high, leading to a high tax burden which weighs on investment and on economic activity. Taxes continue to increase from already high levels; labour taxes are high from an EU perspective and high corporate taxes weigh on investment and favour the build-up of debt over capital.

· French unemployment has increased, with young people, older workers and the low-qualified being particularly hit. The measures adopted by the government in 2013 to introduce some flexibility in the labour market have had a modest impact. The labour market remains segmented with increasing difficulties to move from temporary to permanent contracts and a constant reduction in the length of temporary contracts.

In a letter sent to the Commission in November 2014, the French authorities committed to a number of structural reforms implementing the 2014 country-specific recommendations issued by the Council in July 2014. These structural reforms were further specified in a communication on the National Reform Programme on 18 February 2015.

Overall, France has made limited progress in addressing the 2014 country-specific recommendations. During the past year, France has undertaken reforms aimed at reducing the cost of labour, mainly through the tax credit for competitiveness and employment and the Responsibility and Solidarity Pact. The draft Law on Growth and Economic Activity and the Reform of Local Administrations are currently discussed in Parliament. Efforts to simplify the regulatory burden have also been reinforced. These initiatives represent some progress in promoting competition in services, in particular in the retail sector, and for improving the business environment. Conversely, insufficient action has been taken to further improve the sustainability of the pension system. The effectiveness of the expenditure reviews has proved limited while beyond short-term savings, limited effort has been made to curb the long-term increase in healthcare expenditures. Moreover, there is an insufficient policy response to improve the efficiency of innovation policies and of the tax system. Furthermore, there is little progress in combating labour market rigidity, reforming the unemployment benefit system or improving the employment opportunities for older workers. As regards recommendations related to active labour market policies, education and vocational training, some progress has been made.

The country report shows the policy challenges stemming from the analysis of macro-economic imbalances, namely:

· Fiscal consolidation remains an important challenge for France. Together with the high tax burden, it weighs on France's economic prospects. The expenditure review strategy has not resulted so far into a significant improvement in public spending efficiency and the long-term sustainability of the healthcare and pension systems faces challenges.

· Rigidities and distortions on the labour market weigh on the competitiveness of the French external sector. Given the current low inflation, the rigidities in the wage formation process and the indexation of the minimum wage contribute to the difficulty to adjust wages to productivity developments. The skills mismatches and the prevailing rigidities on the labour market result in a segmented labour market which makes it more difficult to improve productivity.

· Despite the government’s simplification strategy, complex regulation continues to weigh on the growth potential of firms and product market regulation limits competition in services. Moreover, the current policies do not sufficiently support innovation and the shift towards a more knowledge-intensive economy.

In addition to the challenges related to macroeconomic imbalances, the impact of the reform on unemployment schemes appears to be limited, and adequate incentives to return to work are not yet in place. Moreover, the reform of education and training is on-going.

A moderate acceleration in growth is expected

According to the 2015 winter forecast, GDP growth is expected to gain momentum after having stagnated for the last three years. The gradual economic recovery in 2015 and 2016 (1.0 % and 1.8 % GDP growth, see Graph 1.1) is set to be mainly driven by private consumption, as low inflation and sustained wage growth should support consumer spending. The steep fall in oil prices (almost 50 % since mid-2014) should improve the financial position of households and businesses, hence stimulating activity growth in 2015 and 2016.

A slight acceleration in investment is projected from 2015 onwards. Investment will mainly be supported by the gradual recovery of aggregate demand, against a background of favourable credit conditions, reinforced by measures recently announced by the European Central Bank (ECB). Policy measures to reduce labour costs and improve firms' profit margins, i.e. the EUR 20 billion tax credit for competitiveness and employment (CICE) and the EUR 10 billion additional cuts in employers' social contributions planned under the responsibility and solidarity pact (RSP), are expected to further boost investment only from 2016 onwards. However, equipment investment will not return to its pre-crisis level in the medium term, so the extent of the recovery will be limited.

Despite a rebound in external demand, net exports are set to dampen growth in the medium term. The expected increase in foreign demand is projected to boost exports slightly from 2015, while the continued depreciation of the euro, together with the tax credit for competitiveness and employment and the responsibility and solidarity pact, is expected to gradually reduce the pace of losses in export market shares, but not reverse them. As a result, net exports will continue to weigh on GDP growth, as the rise in domestic demand leads to more imports.

Unemployment is expected to remain high in the next two years. The slow recovery and the measures to reduce labour costs referred to above are likely to have only a limited positive impact in the short term. The employment gains will not be large enough to absorb the growth of the labour force, and unemployment is therefore expected to remain high.

Recent price developments in France reflect external factors but also weak aggregate demand. Inflation has gradually fallen since the last quarter of 2012 to 0.1 % in December 2014, driven by lower domestic demand and energy prices, though core inflation has not fallen and remains above 0.6 %. Inflation is thus projected to fall to zero in 2015, before rebounding moderately to 1.0 % in 2016, as the output gap starts to narrow down and inflationary pressures generated by the euro depreciation and the ECB's accommodative monetary policy are felt. These price developments are not likely to represent an immediate deflationary risk, especially against a background of dynamic wages. However, they make it more difficult to achieve the deleveraging necessary to ensure the sustainability of public and private finances.

Graph 1.1: Contribution to GDP growth (2007-2016)

Source: European Commission

In the long term, growth prospects remain subdued, as the supply side of the economy has weakened

Growth is expected to remain subdued in the longer term, as France exhibits relatively low potential growth. Potential growth is expected to amount to 1.1 % in 2016 while the working age population would grow by 0.4 %. By comparison, the potential growth rate for Germany is projected at 1.5 % while its working age population is set to decrease by 0.1 %. The figure for France is markedly lower than the 1.9 % average annual growth between 2000 and 2007 and points to a lasting impact of the financial crisis. Much of this slowdown comes from a fall in total factor productivity growth, from about 1.3 % in 2000 to 0.3 % in 2016. In addition, rising structural unemployment (see Section 3.2) has weighed on labour's contribution, partly offsetting the increase in the working age population and in the employment rate, caused by a rise in the number of older workers. Meanwhile, the contraction of investment in 2013 and 2014 has slightly affected the contribution of capital accumulation to potential growth.

Resilient demand helped the French economy weather the global economic crisis in 2008 and 2009. The absence of a credit boom and the relatively limited weight of exports in nominal GDP (27 % in 2007 compared with 42 % in the euro area) helped to limit the impact of the credit crunch and of the sharp slowdown in international trade on the French economy. Consumption (public and private), which increased steadily from 2007 to 2010 at an average rate of 0.8 %, acted as an automatic stabiliser. As a result, the fall in French GDP was more modest and it rebounded above its 2008 level as early as 2011 (see Graph 1.2).

Graph 1.2: GDP in volume (2000=100)

Source: European Commission

However, these domestic factors may now represent a drag on growth during the recovery phase. Economic growth has come to a standstill since the second quarter of 2011. As a result, unemployment has soared with the number of unemployed reaching three million in early 2013, business and household confidence declined while public and private indebtedness increased rapidly to 92 % and 137 % of GDP respectively by 2013, on the back of large general government deficits and the weak financial situation of corporations.

The persistent weakness of equipment investment points to the fragility of the recovery. Equipment investment remains 12 % below its pre-crisis level and lower than in other countries. Several studies highlight the structural weakness of equipment investment, which declined as a percentage of total gross fixed capital formation from 28.5 % in 2000 to 21.5 % in 2013. In particular investment in modernisation, rationalisation, and innovation have fallen, although they are conducive to higher productivity. Weak profit margins of firms, particularly in manufacturing, continue to weigh on investment.

Drivers of growth should be diversified, in particular by supporting investment. In a globally competitive environment, consumption alone cannot support long-term growth, if not followed by a stronger supply side of the economy. Manufacturing industry, the main tradable sector contributing to exports, has seen its share of total value added contracting from 16 % in 2000 to 11 % in 2013, compared with a steady 17 %-18 % in Germany. This shows the fragility of French manufacturing firms and their decreasing ability to capture aggregate demand for goods. Productive investment, in France is too low to support productivity, potential growth and competitiveness.

The persistent fall in external competitiveness originates in cost and non-cost factors

The losses in market share over the last decade have coincided with a deterioration in cost competitiveness. Notwithstanding a temporary improvement in 2012 and 2013, export shares have declined steadily over the last few years (-13.0 % in the last 5 years), partly driven by cost factors (see Section 3.1). Indeed, France is among the euro area countries where the hourly cost of labour is highest mainly due to the high labour tax wedge (i.e. the level of the employees' and employers’ social contributions taken together). Moreover, nominal wage growth has remained sustained since 2008 in spite of high and increasing unemployment and decreasing inflation. Recent policy measures implemented to reduce the cost of labour will have a more positive impact on employment than on competitiveness, as the benefit to non-exporting firms, which tend to pay lower wages, will be greater than the benefit to exporters. Together with the euro depreciation, they will have a significant positive impact, but it will not be sufficient to reverse the losses in export market shares. The difference between unit labour cost ([1]) developments, which also take into account productivity, in France and in Germany since 2000 shows a deterioration in France's cost competitiveness vis-à-vis Germany, equivalent to 18 % of the French unit labour costs. In addition, the strong deceleration of unit labour cost in certain euro area peers such as Spain since 2008 results in increasing divergence between the trends seen in France and in the euro area.

Non-cost factors are important in explaining the deterioration of the French export performance since 2000. Non-cost competitiveness encompasses a variety of micro-economic factors such as product quality, innovation, design, after-sale service and distribution networks. In France, companies’ ability to perform well on these aspects is hampered by their low profit margins, which continued to decline in 2013 to 29.7 % of their value added, the lowest level in the euro area. Weak corporates' profit margins can partly be explained by low productivity growth in the non-tradable sector and an overall lack of pricing power in the tradable sector. This poor profitability of firms, in particular in the manufacturing sector, has not only weighed on corporate indebtedness, but more importantly has hampered companies' ability to invest and move upmarket. The manufacturing sector as a whole cannot fully compete on quality, with the exception of certain high-technology manufacturers. Furthermore, some purely non-cost factors such as the relatively unfriendly business environment together with the lack of innovation investment in the private sector and the complex tax system may be additional obstacles (see Sections 3.1 and 3.3).

The weak trade performance has resulted in increasing external deficits

Despite some improvement in 2012 and 2013, the current account balance has been on a downward trend since 1997, following the deterioration of the trade balance for goods, only temporarily alleviated by foreign investment revenues. The trade balance account deteriorated in most of the past 12 years falling from a surplus of 2.5 % of GDP in 1999 to a deficit of 2.0 % in 2011. Most of this development is due to the rapid deterioration in the balance for goods. However, if increasing oil prices contributed to half of the rise in the trade deficit between 2004 and 2012, France also lost ground in non-energy goods and services. In 2012 and 2013, the trade balance deficit decreased from 1.4 % of GDP in 2012 to 1.2 % in line with a deceleration in imports following sluggish domestic demand, but the improvement of the euro area trade balance was larger (1.5 pps. in Italy and 1.8 pps. in Spain). The external deficits are expected to improve further until 2015 on the back of favourable terms of trade, before deteriorating again in 2016.

The downward trend in the current account reflects the developments in the trade balance, partly mitigated by incomes of foreign investments. The increase in the surplus of the primary income balance slightly reversed the decreasing trend from 2006 to 2011. Indeed, high incomes from French investment abroad brought the primary income balance to a record 2.8 % of GDP in 2011. In 2012, the lower profitability of direct investment abroad and the slump in net revenue from debt securities, which turned negative, contributed to a close to 10 % fall in net revenue from investment. Consequently, the primary income balance fell back to its 2000 level. Meanwhile, the persistent decrease in the balance of secondary income (from -1.3 % in 1999 to -2.1 % in 2013), which records the amounts transferred abroad by resident workers and contributions to the EU, steadily lowered the current account.

Graph 1.3: Composition of the external position

Source: European Commission

A breakdown of current account developments by sector shows that while households and financial companies are net lenders to the economy, the government and non-financial companies have continuously recorded deficits since 2000. Since the beginning of the 2000s, households have actually slightly increased their lending to the economy thanks in particular to the increase in precautionary savings. Most of the deterioration in the net borrowing position of the economy during that period came from the increasing borrowing needs of the government and of non-financial companies. The government budget has been in deficit every year since 1974. In 2009, as a result of the financial crisis, the government deficit peaked at 7.5 % of GDP in 2009 compared with 3.3 % the previous year. It has gradually fallen since then but remains high (4.1 % of GDP in 2013). The difficulties met by non-financial companies have also resulted in increasing borrowing needs and in a slowdown in investment.

Graph 1.4: Non-cyclical current accounts

Source: European Commission

Cyclical conditions seem to have played a minor role in the deterioration of the current account (see Graph 1.4). France stands out as the only deficit country in the euro area where the structural deficit in the current account ([2]) has increased since 2008 (by 0.6 pp. of GDP, to 1.9 % at the end of 2013). By comparison, in Spain and Italy, while cyclical conditions have also supported the current account correction, the structural adjustment since 2008 has been large (8.5 pps. and 3.3 pps. of GDP respectively).

The evolution of the current account is mirrored by a sharp decrease in the net international investment position over the past seven years (see Graph 1.5). The net international investment position, which measures the difference between external financial assets and liabilities, was still in surplus in 2006. It recorded a slump in 2008 due in particular to changes in valuation and, since then, it has deteriorated further due to the persistent current account deficit. In 2013, the net investment position posted a deficit of 15.6 % of GDP, while the net external debt represented 35.1 % of GDP. In terms of composition, the net stock of foreign direct investments continues to remain positive as, in the past, net flows of French investment abroad have been consistently higher than net flows of investment in France. Accordingly, most of the negative net international investment position is financed by portfolio investments.

Graph 1.5: Composition of the net international investment position

Note: In the absence of available data, figures for before 2008 are expressed in BPM5/ESA95, resulting in a slight breaking point in levels, but general trends remain consistent. Source: European Commission

While the net foreign direct investment stock has been relatively stable, inward foreign direct investments, an indication of the attractiveness of France for foreign investors, is decreasing. In 2013, France was absent from the world Top 20 direct investors and investment receivers. Its ranking, mainly due to intra-firm foreign direct investment, has dramatically deteriorated compared to 2008, a year when France was the seventh largest receiver and the fourth largest investor. Between 2008 and 2013, France was outperformed in particular by some large developing economies which attracted more investors.

Public deficits, which were already high before the crisis, remain excessive and affect the government debt adversely

Based on the 2015 winter forecast, the deficit is expected to remain well above 3 % of GDP between 2014 and 2016. More specifically, the general government deficit is expected to reach 4.3 % of GDP in 2014 and 4.1 % in 2015 and 2016. These figures are close to the government target for 2014 and 2015 (4.4 % and 4.1 % of GDP respectively). According to the programming law on public finances adopted in December 2014, the general government deficit would only come below the 3 % of GDP benchmark by 2017.

As a consequence, the general government debt has increased almost continuously since 1990, a trend which has accelerated since the crisis, with an expected debt-to-GDP ratio of 95.3 % in 2014 (see Section 2.2). This was slightly above the euro area average of 94.3 %. Despite this trend France has weathered the euro area sovereign debt crisis without experiencing major tensions on sovereign yields, and the latter have actually fallen below historical levels. This has helped contain interest expenditure and also prevented negative spillover effects to the financial sector and the real economy so far. According to the winter forecast, the debt ratio is set to continue increasing to 98.2 % of GDP in 2016.

In relative terms, private debt does not appear excessively high

The level of consolidated private debt has continuously increased over the past decade to reach 140.7 % of GDP in 2012 (see Graph 1.6). While historically high, this ratio remains slightly below the euro area average. This is partly explained by the lower level of household debt in France compared with the rest of the euro area. However, household debt, which rose during the years leading up to the crisis, has not fallen since then as adjustments in the real estate sector are still ongoing. While household debt does not appear particularly worrying, the increasing debt service and potential deleveraging pressures could potentially affect private consumption. Finally, the continuous rise in unemployment and sluggish GDP growth will weigh on household credit-worthiness over the medium term.

While the level of debt to GDP of French non-financial companies has kept rising over the past few years, their leverage is not particularly high compared to euro area peers. In 2012, the debt–to-GDP ratio of French non-financial companies increased to a level above the euro area average. In contrast, the debt-to-equity ratio (53 %) fell below the euro area average (67 %) in 2013. However, the moderate potential for further private consumption growth combined with the poor profitability of French companies is a potential source of concern. The reduction in non-financial companies' gross operating margins has indeed affected companies' ability to invest and innovate but may also make it more difficult for firms to service their debt as reflected in the increase in the number of bankruptcies in 2013.

Graph 1.6: Debt decomposition, all sectors, consolidated

Source: European Commission

Imbalances in France may generate spillovers to other Member States

The large size and the close economic and financial linkages of the French economy with the rest of the EU, in particular with the neighbouring euro area countries and with the United Kingdom, make it a potentially important source of spillovers to other Member States through the trade, banking and financial channels (see Section 2.3). Conversely, a recovery in consumer confidence and a reduction in policy uncertainty in France would have a positive impact on the euro area confidence cycle. Structural reforms in France would also support activity in the euro area in general.

Box 1.1: Economic surveillance process The Commission’s Annual Growth Survey, adopted in November 2014, started the 2015 European Semester, proposing that the EU pursue an integrated approach to economic policy built around three main pillars: boosting investment, accelerating structural reforms and pursuing responsible growth-friendly fiscal consolidation. The Annual Growth Survey also presented the process of streamlining the European Semester to increase the effectiveness of economic policy coordination at the EU level through greater accountability and by encouraging greater ownership by all actors. In line with streamlining efforts this Country Report includes an In-Depth Review — as per Article 5 of Regulation no. 1176/2011 — to determine whether macroeconomic imbalances still exist, as announced in the Commission’s Alert Mechanism Report published on November 2014. Based on the 2014 In-Depth Review for France published in March 2014, the Commission concluded that France was experiencing macroeconomic imbalances requiring decisive policy action. In particular the deterioration in the trade balance and in competitiveness as well as the implications of the high level of public sector indebtedness deserve continued policy attention. This Country Report includes an assessment of progress towards the implementation of the 2014 Country-Specific Recommendations adopted by the Council in July 2014. The Country-Specific Recommendations for France concerned ensuring the sustainability of public finances, reducing the cost of labour, improving the business environment and promoting innovation, enhancing competition in services, simplifying the tax system, reducing the labour market rigidities and improving the education and vocational training systems.

Table 1.1: Key economic, financial and social indicators

(1) Domestic banking groups and stand-alone banks. (2) Domestic banking groups and stand-alone banks, foreign-controlled (EU and non-EU) subsidiaries and branches. (3) Real effective exchange rate (*) Indicates BPM5 and/or ESA95 Source: European Commission, 2015 winter forecast; ECB

Table 1.2: The MIP scoreboard

Flags: e: estimated. Note: Figures highlighted are the ones falling outside the threshold established by EC Alert Mechanism Report. For REER and ULC, the first threshold concerns Euro Area Member States. (1) Figures in italic are according to the old standards (ESA95/BPM5). (2) Export market shares data: the total world export is based on the 5th edition of the Balance of Payments Manual (BPM5). (3) Unemployment rate i=Eurostat back calculation to include Population Census 2011 results. The unemployment rate has been revised downwards. The revision is mainly due to methodological changes to the LFS. Source: European Commission.

There is no sustainable improvement in export performance in France

The performance of French exports has been relatively weak over the past seven years. French exports have been growing since 2007 by an average annual rate of 2.1% per year, contributing to the change in the current account balance-to-GDP ratio by 1.9 pp, against an average contribution of 5.2 pp in the euro area, 4.8 pp in Germany and 4.1 pp in Spain (see Graph 2.1.1).

France's export market share for goods and services declined by 13% over the period 2008-2013 according to the Alert Mechanism Report 2015. The decline in France's export market share can be attributed mainly to goods, with goods exports representing about 60 % of total exports in France. While world goods exports grew by 15 % over 2008-2013, France goods exports declined by 5% over the same period. This can be decomposed into two effects which can be looked at from a product and a country destination perspective (see Table 2.1.1). From a product perspective, product markets in which France is exporting have grown 1 pp slower than the world export markets (this is called the market dynamism effect). Moreover, within these product markets, French exports have been growing 18 pp slower than the total growth of these markets. This indicates that French products were less competitive than those of their competitors on these product markets. Similarly, from a country destination perspective, country destinations to which France exported grew 8 pp slower than global export markets. So, first, France exported to country destinations that are less dynamic than worldwide trade (e.g. the euro area) and, second, in these country destinations, French exports grew 11 pp slower than the total growth in these markets.

Table 2.1.1: Decomposition of goods export market share, France

Source: European Commission Calculations based on the UN COMTRADE data ( HS 1992 Commodity Classification), Nominal USD. Note: The components of the decomposition should be interpreted as weighted market share gains (columns D2 and D4) or weighted dynamism of the specific market (columns D1 and D3).

Graph 2.1.1: Component contributions to change in CA balance 2007-2013

Source: European Commission

Differentiating the export market share losses for the high tech (HT), medium tech (MT) and low tech (LT) sectors helps explain some of these developments. Graph 2.1.2 and Graph 2.1.3 provide a picture for the period 2001-2008 and 2008-2013 in France, Italy, Germany and Spain.

Graph 2.1.2: Average yearly export market share loss/gains per sector (2001-2008)

(1) On the x-axis the annual average gains or losses due to export competitiveness and on the y-axis the annual average gains or losses in market dynamism are presented, while the size of the bubbles reflects the share in total goods exports. High tech (HT), medium-tech (MT) and low-tech (LT). (2) High tech exports include for instance most exports of "Pharmaceutical products" and of "Optical, photo, technical, medical, etc. apparatus" and of "Aircraft, spacecraft, and parts thereof". As well as a more minor share of "Electrical, electronic equipment". Medium tech exports include for instance most exports of "Nuclear reactors, boilers, machinery, etc.", all "Vehicles other than railway, tramway", most "Electrical, electronic equipment", all "Mineral fuels, oils, distillation products, etc.", almost all "Plastics and articles thereof". Low Tech exports include for instance almost all "Beverages, spirits and vinegar" and a minor share of "Optical, photo, technical, medical, etc. apparatus". Source: European Commission.

France had an overall poor export competitiveness performance between 2001-2008, particularly in medium tech products where lower competitiveness offset by large the market dynamism (Graph 2.1.2). In medium tech and high tech products, France's export competitiveness was the worst of the four Member States. Comparing the performance across sectors, the high tech sector lost the least in terms of export competitiveness and the medium tech sector the most. The performance of the high tech sector in terms of competitiveness was nevertheless significantly better in Germany and Spain and slightly better in Italy. Moreover, in terms of market dynamism, the sectors performed in the same way across the four countries. Over 2001-2008, the fastest and slowest-growing categories in terms of market dynamism were respectively medium tech and low tech goods. As medium tech goods are the most important export products for the four countries, this was a favourable factor. Combining the competitiveness and the market dynamism effects, though, all three French sectors had an annual market share loss between -3.6% (high-tech) and -4% (medium-tech).

Graph 2.1.3: Average yearly export market share loss/gains per sector (2008-2013)

(1) On the x-axis the annual average gains or losses due to export competitiveness and on the y-axis the annual average gains or losses in market dynamism are presented, while the size of the bubbles reflects the share in total goods exports. High tech (HT), medium-tech (MT) and low-tech (LT). Source: European Commission

France's export competitiveness did not improve over the period 2008-2013, except for a small increase in the high tech sector due in particular to the aircraft industry (Graph 2.1.3). France suffered the biggest export competitiveness-related product market losses in medium-tech and large losses in low-tech, together with Italy and Germany. Comparing the performance across sectors, the high tech sector regained slightly in terms of export competitiveness. Excluding the aircraft industry, the export competitiveness of high tech would have decreased by more than 3 pp and performed worse than the three other countries. Furthermore, between 2008 and 2013, market dynamism was less favourable as the biggest sector (medium tech) became less important in world trade. Over this period, the most dynamic product markets were in low-tech, followed by high-tech products. Combining the competitiveness and the market dynamism effects, the medium tech sector had an annual market share loss of 6.4%, whereas the low tech sector had an annual market share loss of 2% and the high tech sector had an annual market share gain of 0.8%. In relative terms, the high tech and, to some extent, the low tech sector have gained in overall importance for the exports of goods since 2008. While it is positive that the high tech sector is not losing export market competitiveness anymore, this sector only represents about 21% of goods exports. For the overall export market developments and competitiveness, the poor performance of the medium-tech sector which represents 6% of the value added of the economy and still 51% of the manufacturing exports, is a matter of concern.

The recent deceleration in export market share losses in the period 2012-2013 is not related to an increase in export competitiveness ([3]). In 2012-2013, the average loss in export market share has been 1% in France, suggesting a deceleration in the export market share losses compared to the period 2008-2012. However, the stabilization is less pronounced than in other euro area countries (Graph 2.1.4). Moreover, France has been helped more than the other countries by the dynamic global growth of its product markets but has continued losing export market shares in its product markets at a relative faster pace than Italy, whereas Germany and Spain are gaining export-competitiveness in the product markets they serve. In addition, early data for 2014 suggest that France continued losing world export market shares in goods. For 2015, the low oil prices may improve the trade balance, and the euro depreciation may support French export growth. Nevertheless, according to the Commission 2015 Winter Economic Forecast, these factors will not be sufficient to ensure a turnaround in the export market shares losses.

Graph 2.1.4: Market share losses in goods 2012-2013

Source: European Commission based on COMTRADE

All in all, France has persistently lost export competitiveness across all technology sectors since 2001, with losses being most important in the medium-tech sector. Moreover, over the period 2001-2008 France's losses have been larger than those of Spain, Italy and Germany. For the period 2008-2013, losses have been more important than in Germany or Spain but similar to those suffered in Italy, at least for the medium-tech and low-tech sector. Based on the analysis presented above it is difficult to discern any sustainable improvement in export competitiveness.

Labour costs are high and unit labour costs have been increasing lately

France is among the euro area countries where the hourly cost of labour is the highest mainly due to non-wage costs. In the industrial sector, in 2013 the hourly cost of labour was the 3rd highest of the euro area (EUR 34.3 per hour), after Luxembourg (EUR 35.7) and Belgium (EUR 38.0). Decomposing the cost of labour in wage and non-wage costs, in 2013 wages and salaries in France (EUR 23.2) were on average in line with those faced by firms in other euro area countries with comparable income levels. Yet, both the overall labour tax wedge and the part of the cost borne by firms (i.e. the employers’ social security contributions) are in France among the highest in the euro area, with only Belgium and Italy posting larger social security burdens for employers.

The reforms implemented to reduce the cost of labour will have a positive impact on employment, but part of their impact on competitiveness could be reduced by an increase in wages. France is among the euro area countries where the tax burden on labour is the highest. The tax credit for competitiveness and employment adopted in December 2012 and the cut in the cost of labour announced as part of the responsibility and solidarity pact in January 2014 are meant to close by half the gap in terms of labour tax wedge between France and the euro area average. Simulations using the QUEST III model indeed suggest that the reduction in the tax burden on labour gradually increases firms' labour demand, especially targeted towards low skilled employees. This increase in labour demand leads to a gradual increase in wages, which in turn attenuates the positive effects of the labour cost reduction on exports, investment and profits, especially in the long term (see box 2.1.1).

Graph 2.1.5: Nominal unit labour costs (total economy)

Source: European Commission

Unit labour costs have decoupled from the trend in the euro area since 2008 ([4]). Between 2001 and 2008, nominal unit labour costs grew by 2.0% per annum on average in France. The unit labour costs in Italy and Spain increased more rapidly due to faster wage growth and slower productivity growth in these countries, whereas wage moderation and somewhat faster productivity growth resulted in negative unit labour costs' growth in Germany. Since 2008, a divergence between unit labour costs' growth in France and the rest of euro area has emerged as wages grew faster in France. In the same period, Spain saw a relatively strong correction of its unit labour costs due to a stronger wage moderation and increase in productivity growth. The difference between unit labour costs' developments in France and in Germany since 2000 has resulted in a deterioration of the relative cost competitiveness of France vis-à-vis Germany with a gap which is now equivalent to 18% of the French unit labour costs. Also the gap between Spain and French unit labour costs is now equal to 5.7% of the French unit labour costs. By contrast, the French unit labour costs are 4.9% lower than the Italian unit labour costs.

The developments in unit labour costs in France can be explained by wage rigidities …

Since 2008, the lower price inflation and higher unemployment have only partially been taken into account in setting nominal wages. Over the period 2000-2013, real wage growth has remained on average relatively dynamic in spite of high and increasing unemployment levels. Even controlling for the fact that the crisis has mainly impacted the low- skilled and other workers with lower wages, real wages have reacted less to unemployment than historically observed([5]). Nominal wages seem to be particularly rigid in France due to rigidities in the wage setting process. Given the current low inflation environment and the slowdown in productivity, nominal wage rigidity holds a risk for a further deterioration of the unit labour costs' dynamics in the future. In what follows we will analyse the underlying factors.

The indexation of the minimum wage to real wage growth, on top of inflation, may be distortionary. The minimum wage is guided by an automatic indexation mechanism: the revaluation is based on the consumer price index plus half of the increase in the purchasing power of hourly average wages for workers and employees at the lower end of the wage distribution. This indexation system, while sound in normal times, may lead to an upward adjustment of minimum wage levels well beyond the preservation of purchasing power, as real wages are growing fast on the back of lower-than-expected inflation, while nominal wages proved relatively rigid. This could in the medium-term affect the employment opportunities of the low-skilled workers and make the whole wage distribution more compressed at the bottom, unless the next wage bargaining rounds at sector- and firm-level take into account the current macroeconomic environment, in particular lower-than-expected inflation.

The wage bargaining process in France is characterised by the interaction of industry-wide agreements and company-level negotiations, with a relatively stronger role played by the industry-wide agreements and few possibilities to derogate by firm-level agreements. As already underlined in the 2014 In –Depth Review, such agreements apply to unionised and non-unionised workers and extension mechanisms are widespread. Recent reforms have created only limited flexibility for employers to depart from industry-wide agreements. Since 2004, a company-level agreement can deviate from the provisions of a sectorial agreement unless such derogations are explicitly forbidden in the sector-level agreement. However, the favourability principle remains in force in terms of minimum wages, job classifications, supplementary social protection and multi-company and cross-sector vocational training funds. In practice, reductions in overall wage costs were mainly obtained by departing from sectoral-level agreements in terms of working time ([6]).

…but lower productivity growth is also weighing on unit labour costs' developments

Productivity growth declined sharply during 2008-2009 and seems to decelerate since then. Even adjusting for the cycle and for employment policies, the level of productivity at the end of 2014 would be 5% below what it could have been expected based on the observed relation between labour productivity, employment and value added in the market economy (Graph 2.1.6). The initial crisis-period, seems to explain most of that difference but in the most recent period there seems to be a deceleration in the observed productivity growth.

Graph 2.1.6: Decline in productivity growth in the market economy

Source: Lequien and Montaut (2014), European Commission

One of the explanations for lower productivity growth could be that there is labour hoarding. As Graph 2.1.7 shows, the hike in the spare capacity without additional hiring reported by firms in the manufacturing sector in the initial period of the crisis suggests that they clearly "under-used" labour, a phenomenon coined labour hoarding. This sharp under-use of labour explains the initial drop in labour productivity. However, the current level of spare capacity without additional hiring as remained higher than its long-term average since 2011. This could be one of the explanations why productivity growth is weaker than before the crisis.

Graph 2.1.7: Spare capacity without additional recruitment in manufacturing

Source: INSEE, European Commission

Prolonged periods of labour hoarding may be associated with the costs, faced by firms, to hire or dismiss workers. As firms observed a sharp contraction in demand a first reaction was to maintain more labour than strictly warranted. This is a rational reaction as it is costly to dismiss and costly to hire and train new workers when demand picks up again. The costs of firing and hiring depend on a number of factors such as the type of contract, the scarcity of the profile on the labour market and seniority ([7]). The longer the downward cycle lasts or in case the crisis results in a permanent lower potential growth, these firing and hiring costs can become less important than the cost related to keeping an employee on the payroll. Employees with the lowest firing and hiring costs, which are the low skilled, the young and those in precarious contracts, will be laid off first, whereas employees with the highest firing cost, which are the skilled employees with a permanent contract and high seniority, will remain in their job longest. The prevailing rigidities on the labour market, the scarcity of high skilled and the relatively difficult matching of jobs and workers has resulted in a segmented labour market and could explain why it takes time to fully adjust labour to the production needs ([8]).

…However, factors other than unit labour costs' developments can explain France's weak export competitiveness

The high labour costs and the developments in the unit labour costs cannot fully explain the trends in export performance. The deterioration of the unit labour costs vis-à-vis Germany can be consistent with the differences in export performance of the two Member States, certainly over the period 2001-2008. Also, unit labour costs' developments between France, Italy and Spain over the period 2008-2013 could explain the export competitiveness developments, notably, the better competitiveness performance of Spain. However, the fact that unit labour costs deteriorated faster over 2001-2008 in Italy and Spain, whereas the export competitiveness performance of these two Member States was stronger than that of France, suggests that other factors, be it cost or non-cost, are weighing on France's competitiveness.

The capacity of French firms to innovate and become more efficient with the existing resource mix has declined.

Graph 2.1.8: Capital accumulation contribution to potential growth

Source: Autumn Forecast

Capital accumulation is contributing less to the potential growth of the economy since the crisis, but is relatively strong from an international perspective. Graph 2.1.8 presents the contribution of capital accumulation. It shows that France's capital accumulation was relatively robust before the crisis and has come down since. In an international perspective, the current growth in capital accumulation is higher than in Germany, Spain and Italy. Below, we discuss in more detail the role of investment in France’s competitiveness.

Growth of total factor productivity has declined significantly since 1997 ([9]). In the case of France, total factor productivity growth has declined continuously from 1.3% in 2000 to 0.3% in 2014. From an international perspective total factor productivity growth in France has decoupled from Germany and has been overtaken by Spain (Graph 2.1.9). Looking into the sectoral composition of total factor productivity growth using the EUKLEMS database, it appears that manufacturing, electricity production and Information and Communication Technology are the sectors with the highest total factor productivity growth between 1997 and 2009, all of which are traditionally included in the tradable sector, whereas total factor productivity growth is relatively modest in the non-tradable sector (Graph 2.1.10) ([10]).

Graph 2.1.9: TFP growth in selected countries

Source: Autumn Forecast

Graph 2.1.10: TFP growth in the tradable and non-tradable sector

Source: EUKLEMS, European Commission

Labour and product market rigidities limit total factor productivity growth. At the aggregate level, the high overall level of rigidities in France weighs on productivity growth. Using the overall measure of rigidity of Aghion et al (2009) derived from the OECD indicators, Graph 2.1.11 shows that since the beginning of the crisis France has not made much progress in reducing its level of rigidity and has now the highest level of overall rigidity in the euro area ([11]). Aghion et al. (2009) demonstrate that for OECD countries close to the technology frontier the interaction and combined effect of product and labour market rigidities have a very significant negative effect on total factor productivity growth. As discussed in section 3, France has made some progress to reduce rigidities. However, this progress remains relatively modest and mostly focused on reducing product market rigidities, whereas a combined approach for reducing product and labour market rigidities would yield higher benefits.

Graph 2.1.11: Product-times labour market regulation, 2013

Source: OECD, European Commission

French firms face difficulties to grow, which hampers overall productivity developments as smaller firms have lower growth of total factor productivity. While the number of created companies is relatively high, the survival rate of new firms is lower than in the United States, Germany or the United Kingdom ([12]). The greater difficulty of French companies to survive and develop thus limit the potential productivity gains that could accrue from newly created firms. Moreover, as indicated in last year’s In-Depth Review, France has relatively fewer medium-sized companies than other European countries such as Germany, due notably to the regulatory burden which constrains their growth potential. Typically, smaller firms are also less productive than larger firms. Reducing impediments to the growth of firms would thus also allow firms to become more productive ([13]).

Price developments are unfavourable for the tradable sector

The manufacturing sector was forced to reduce its prices to maintain market shares. Graph 2.1.12 shows the evolution since 1997 of the prices for tradables, manufacturing and non-tradables. The tradable sector, and in particular the manufacturing sector, has not been able to increase its prices. Sectors exposed to international competition in their export markets but also within France, decreased their prices to prevent a further deterioration in their cost competitiveness and to avoid losing additional export market shares. French manufacturing firms decreased their prices more than their European peers. For example, over the period 2001-2008, French manufacturers decreased their prices by 0.6% per year, whereas German manufacturers kept their prices stable and, Italian and Spanish manufacturers increased their prices (+2.8% and +3% respectively per year). These different price developments have translated in lower profitability for French manufacturing firms.

Graph 2.1.12: Price developments per sector

(1) deflator of value added Source: European Commission

Prices in the non-tradable sector has increased fastly putting an additional burden on the tradable sector. With a 30% share, France uses more domestic services than other EU industries in the production of its exported goods. The increase in prices in the non-tradable sector, and in services in particular, added to the deterioration of French cost competitiveness vis-à-vis its peers.

Table 2.1.2: OECD Product Market Regulation in services, 2013

Source: OECD, European Commission

The high level of regulation and protection of services from external competition results in insufficient price adjustments within the non-tradable sector. The OECD Product Market Regulation indicators in services sectors are often used to proxy countries' regulatory framework ([14]). Table 2.1.2 presents the Product Market Regulation indicator for the different services sectors covered. Values span from 0 to 6 with a low value corresponding to a light regulatory burden. Despite the recent reform efforts (see section 3), Table 2.1.2 shows that there is ample room for improvement, given the distance between France and the average of the 3 best EU performers.

These different price developments are accompanied by a move of resources from tradables to non-tradables. The contrasted evolutions of prices and productivity between the tradable and the non-tradable sectors have set in motion a shift of resources from tradables to non-tradables. This can be seen in a reduction in the share of value added, employment, but to a certain extent also investment (see further) of manufacturing to the benefit of the services sector. This process which is observed in all developed countries has led to a smaller manufacturing sector in France than in other euro area countries. While it is normal that resources flow from sectors with high productivity growth to sectors with low productivity growth (Baumol effect), evidence suggests that the shift in resources in France is driven by a wrong incentive structure, notably by the internal exchange rate between tradables and non-tradables ([15]).

Simulations show that high markups in services hold back investment and weigh on the profitability of the tradable sector. Illustrative simulations done with the Quest III model (see Box 2.1.2) suggest that a reduction of the profit margins (or markups) in services could improve competitiveness. A decline in profit margins would stimulate exports and have a relatively high impact on investment and a differentiated impact on the profitability of the manufacturing sector and of the services sector. Finally, such a decline in profit margins in the services sector would be complementary to the impact of the tax credit for competitiveness and employment and the Responsibility and Solidarity Pact, also in terms of timing of their impact.

Profitability is affected by the high labour cost and the unfavourable evolution of prices in the tradable sector

The profit margins of French non-financial companies continued to decline in 2013 reaching 29.7%. In a European perspective French margins have always been lower for at least the last 15 years (Graph 2.1.13). However, the difference in profitability between French and German or Spanish firms seems to have grown in the last years and profit margins in France are now at historically low levels not seen since at least 1990. The high cost of labour and the high corporate tax burden (see section 3.1) are factors that explain a part of the difference in profitability levels whereas recent wage, productivity and price developments but also the loss in export market shares can explain a part of the recent developments.

Graph 2.1.13: Profit margins in selected European countries

Source: European Commission

Profitability in the tradable sector seems to be lower than in the non-tradable sector. Graph 2.1.14 shows the evolution of profitability since 1997 in the manufacturing, the tradable and the non-tradable sector. Non-tradables have succeeded better in maintaining their profitability level of 1997 than tradables. The differences in price evolution and the losses in export market shares suffered by the tradable sector have probably contributed to these differences in profitability.

Graph 2.1.14: Profit margins

(1) gross operating surplus/value added Source: European Commission

The medium-tech sector that performs worst in terms of export competitiveness is also the one that has seen its profitability decline the most. Table 2.1.3 presents the different profitability levels in 2008 and 2012 for the manufacturing industry per technology intensity. The medium-tech sector had already a relatively low profit margin in 2008 but it decreased further to reach 18% in 2012. On the other hand the high-tech and low-tech manufacturing sector, which lost somewhat less market shares, have managed to keep their profitability level at the same level as in 2008 ([16]).

Table 2.1.3: Profit margins in manufacturing per technology

(1) value added at factor cost Source: European Commission

The low profitability of the tradable sector limits its capacity to invest and hurts its competitiveness

Overall, France invests more than the average of the euro area but investment in equipment is lower. In an international perspective France invests more than Germany or the euro area (Graph 2.1.15). Moreover, investment has been increasing since 1998 and has remained relatively robust during the crisis. France therefore does not suffer from an aggregate investment shortfall. However, equipment investment is lower in France than in Germany or the euro area (Graph 2.1.16)

Graph 2.1.15: Gross Fixed Capital Formation

Source: European Commission

There is some evidence that productive investment in the manufacturing sector is lower than in other countries. The lower percentage of equipment investment in GDP could be due to the smaller manufacturing sector. Hallaert et al (2013) provide firm-level evidence that French manufacturing firms invested less than their counterparts over the period 2001-2009, with an average investment ratio of 8% in France compared to almost 12% in Germany and close to 9% in Italy and the United Kingdom ([17]). INSEE surveys on investment in manufacturing suggest that since 2000, there is less equipment investment in modernisation and rationalisation of the production process, which are conducive for productivity developments, and that most equipment investment is related to the renewal of existing capacity. This is corroborated by statistics on the use of robots in manufacturing, which is lower in France (122 robots per 10 000 employees) than in Germany or Italy (respectively 261 and 159).

The weak profitability of firms, in particular in the manufacturing sector, weighs on investment, also because it limits the capacity of self-financing. As already argued in last year’s In–depth Review, weak profitability of firms weighs on investment. This is confirmed by recent research of Pérez Ruiz and Hallaert (2014) which demonstrates that in the long run a decrease by 1 percent in the profit margin reduces investment by ½ percent ([18]).

Graph 2.1.16: Equipment investment

Source: European Commission

Insufficient investment limits the ability of firms to improve their non-cost competitiveness. Insufficient investment limits the ability of companies to improve their product quality, innovation, design, after-sale service and distribution networks. This weighs on market shares and further erodes profits. Allowing firms to improve profitability would improve the ability to self-finance investment and innovation and to regain non-cost competitiveness.

Non-cost competitiveness factors seem related to the higher sensitivity of Frech exports to cost factors

French exports seem more sensitive to cost-competitiveness than those of other euro area countries. The long-term elasticity of exports to cost-competitiveness is higher in France than in its neighbouring countries. This suggests that even small changes in cost competitiveness can lead to relatively pronounced changes in exports. This makes France vulnerable to deviations in unit labour costs and implies that maintaining sound cost competitiveness is important for France.

Table 2.1.4: Long-term elasticity of exports to cost-competitiveness

Source: INSEE (2013)

This sensitivity to cost factors seems to be related to the non-cost competitiveness position of France. Relating non-cost competitiveness factors to export performance shows that France overall deterioration in the trade balance over the period 2002-2011 was due to a negative evolution in the trade balance for price sensitive "low-quality" and "medium-quality" goods, which was not compensated by the resilience of higher quality goods to the trade balance over that period. These trends were more pronounced towards the end of the period investigated. The distribution of the quality rank of export products in France, Spain and Germany tends to confirm this analysis (Box 2.1.3) ([19]). France is increasingly specialised in medium-high quality export products. However, French exports in the medium quality segment seem unable to compete in terms of cost which could explain a relative shift of the distribution towards the high quality products. Germany is more specialised in middle-quality rank products, often built in value chains and increasingly sold on emerging markets where middle classes are growing. Moreover, a stronger non-price competitiveness of German exports has sheltered the German industry from such price competition based on cost factors and entailed a stronger export performance led by a relatively higher quality and innovation content of German products compared to their cost. ([20])

Box 2.1.1: Distribution of export products by quality in France, Spain and Germany This box analyses the quality positioning of French export products compared to those in Spain and Germany. Quality positioning can be analysed using density frequency distributions. These graphs give an insight into the type of quality goods a country is exporting. It is important to stress that high quality is not necessarily the same as high-tech. For example, French wines are considered high quality whereas it is produced in a sector that is considered low-tech. The quality of a good is given on the horizontal axis by normalised quality rankings, between 0 and 1, and these have been determined within narrowly defined export products. In the case of Spain, a distribution skewed to the left (towards 0) is observed, which indicates that it is specialised in low-quality goods exports. On the other hand, in the case of France a distribution slightly skewed to the right, towards 1, is found, which indicates that France mainly concentrates in medium-high quality goods. German exports are located between France and Spain in terms of quality of its exports. Using this quality indicator, it is possible to observe any developments in the quality of exports. The bold line gives the quality rank distribution in 2005, whereas the dotted line gives the quality rank of exported goods in 2011. By comparing these two lines, one can see the quality dynamics in exports of a country over time. One can see that France specialises in high quality products whereas Spain specialises in low quality goods and Germany is in between. These specialisation patterns were amplified between 2005 and 2011, as indicated by the shifts in the distribution of quality ranks by exports products to the right, for France, and to the left for Spain and Germany. Quality ranks of exports products in France, Germany and Spain Source: Vandenbussche (2014).

France suffers from a lack of competitiveness

The capacity of French firms to innovate and become more efficient with the existing resource mix has declined significantly since 1997. Also price developments have not evolved favourably for the tradable sector, as it saw its prices decline whereas the prices of its services inputs increased significantly. These different price developments, point to an incentive structure in favour of the non-tradable sector in France.

French firms are less profitable than their peers. High labour costs and dynamic wages, high taxation for corporates, low productivity and unfavourable price developments are the main explanatory factors. As these factors affect tradable and non-tradable firms differently, it is no surprise that tradable firms are less profitable. Moreover, the sectors that have lost most export market shares, in particular the medium-tech sector, are also those that have the lowest profitability. The low profitability of the tradable sector limits its capacity to invest in product or process improvements which in turn hurts its competitiveness.

Public debt is on a rapidly increasing trend since 2009

France's general government debt is expected to continue increasing in 2014, reaching 95.3 % of GDP. Based on past developments there are risks of sustainability of public finances. Nonetheless, a forward-looking analysis puts the emphasis on the need to maintain the fiscal consolidation effort in order to bring public debt on a downward path. In the meantime, the low interest, together with the sound structure of the public debt financing, are stabilising factors for debt developments.

Graph 2.2.1: General government deficit and debt

Source: European Commission

The French debt level is clearly above the reference value of 60% of GDP specified in the Alert Mechanism scoreboard. Public debt has been above the threshold every year since 2003 and almost continuously on an upward trend since then. After a sharp increase in 2009 (+11 pp), the debt ratio has continued to increase at a steady pace of close to 3 pp a year. In relative terms, the debt ratio of France is estimated to be above the euro area average in 2014 (94.3 % of GDP) as, despite low interest rates, France continues to record a large general government deficit (4.3 % of GDP in 2014 compared to 2.6 % of GDP in the euro area).

The level of net debt, taking into account financial assets, has also increased sharply since 2009. Over most of the 2000s, the net debt remained relatively stable, close to 40 % of GDP, with the variation in financial assets mitigating the impact of increasing liabilities. Since 2009, financial assets have increased little as a share of GDP, while gross debt has been increasing rapidly. As a consequence, the net financial liabilities of the government have increased, reaching 70 % of GDP in 2012 compared to 51% in 2009.

Graph 2.2.2: Net financial assets of the government

Source: European Commission

The slowdown in nominal GDP growth since 2009 has also weighed on debt developments. In terms of components, the persistently high primary general government deficits since 2009 have been the main factor driving gross debt developments (see Graph 2.2.3). On the other hand, interest rates on the French sovereign debt have decreased strongly since 2009, notably in line with low inflation, although this effect was attenuated by the relatively long maturity of the French debt (7 years). Meanwhile, the slowdown in nominal GDP growth has translated into an increasing snowball effect on public debt.

Public debt is expected to continue increasing up to 2016, coming close to 100 % of GDP. According to the Commission 2015 winter forecast the general government deficit is expected to decrease slightly to 4.1% of GDP in 2015 and in 2016 – under a no policy change scenario. The modest pick-up in GDP growth and inflation, together with still low interest rates, will also decrease the upward pressure on debt in 2015 and 2016. However, the still significant primary deficit expected in the winter forecast (1.9 % of GDP in 2015 and 1.8 % in 2016) clearly shows the challenge that putting the debt on a downward path represents.

Graph 2.2.3: Components of gross debt variation

Source: European Commission

The level of net debt (taking into account financial assets) has also deteriorated sharply since 2009. Over most of the 2000s, the net debt remained relatively stable, close to 40 % of GDP, with the variation in financial assets mitigating the impact of increasing liabilities. Since 2009, financial assets have little increased as a share of GDP, while gross debt has been increasing rapidly. As a consequence, the net financial liabilities of the government have deteriorated, reaching 70 % of GDP in 2012 compared to 51% in 2009.

Fiscal consolidation efforts are required to put public debt on a downward path

France is facing important medium and long-term fiscal sustainability risks which call for continued fiscal restraint. Empirical analysis based on historical data points to significant challenges for the sustainability of public debt ([21]). Based on a composite index computed by the European Commission to predict short-term stress, risks for France appear to be low. However, based on a no-policy-change scenario, general government debt is expected to continue increasing by 2025 (see Graph 2.2.4) to above 100 % of GDP. In the same manner that past developments in the primary deficit have been the main driving force to the French public debt build-up, future developments are critical to ensure a sustainable public debt path. If the primary deficit were to revert to historical trends, general government debt would expand rapidly to above 110 % of GDP in 2025. Conversely, if France were to meet the structural targets set in the Stability and Growth Pact, its debt would start decreasing already in 2017. Altogether, the forward-looking analysis of public debt developments appears very sensitive to the assumptions related to the fiscal deficit, putting the emphasis on the need to rigorously implement the expenditure cuts planned in order to ensure that debt developments remain sustainable.

Graph 2.2.4: General government debt under various scenarios

Source: European Commission

Financing of the French public debt is a factor of stability

The structure of the French debt attenuates the impact on public finances of potential shocks on interest rates and inflation. The outstanding amount of French sovereign debt reached slightly over EUR 1500 billion (71 % of GDP) in December 2014, representing the largest part of the general government debt. In that respect, the characteristics of the holdings and issuance of the French debt by the Agence France Trésor is a key component of the stability of public finances. First, the maturity of the French debt, which had decreased significantly in 2008 and 2009 due to investors' risk aversion, has increased since then to close to 7 years, significantly above the maturity of the debt in Spain, Italy or Germany. While the government does not have explicit objectives in terms of maturity, the relatively long maturity means that a shock on interest rates would only have a gradual impact on public finances. As 12 % of the outstanding debt consists in inflation-linked securities, inflation developments only have a minor impact on the cost of debt.

Holdings of the negotiable government debt are well diversified. Foreign investors hold 63.7 % of French debt in the 3rd quarter of 2014. This ratio, which is comparable to what is observed in other EU economies, has increased strongly between 2000 and 2010 and has stabilised since then. The base of investors is well diversified, both in terms of geographical origin and of type of investors, with central banks representing a large share of holdings. This reflects in particular the strategy of the government to diversify as much as possible the type of instruments traded, to insulate the debt demand from shocks which would affect one specific type of investors. Reciprocally, it also reduces the risks which could result from an excessive exposure to sovereign bonds.

Graph 2.2.5: Spreads between France and selected euro area Member States(10-years maturity bonds)

Source: Global Insight, European Commission

The yield on French bonds has decreased significantly in 2014 to a record low. Short-term bonds are now trading on negative yields ([22]). Meanwhile, the yields on long-term bonds have also plummeted between 2012 and 2014. While the slowdown in inflation prospects has weighed on rates, yields have also decreased in real terms, showing that risk premiums have also decreased. The low, and in some case negative, correlation between the French sovereign yields and that of countries which were faced with speculative episodes on their sovereign debt suggest that French negotiable debt actually benefitted from a flight to quality. In terms of public finances, the reduction in the interest rate means that, despite the increasing debt ratio, the cost of interest as a share of GDP has continued to decrease, reaching its lowest level since the early 90's.

Despite occasional tensions since 2009, French sovereign bonds continue to be very well-perceived by external investors. In relative terms, while France is no longer within the group of AAA-rated euro area economies, spreads have narrowed in 2014, notably with Germany. As another sign that the French debt is now considered by investors as belonging to the same asset class as the debt of AAA-rated economies([23]), the correlation between the yields for sovereign bonds of these countries and those for France, which had diverged since 2011, has come back to almost perfect correlation in 2014 ([24]). However, in section 2.3, analysis is presented that suggests that in extreme market circumstances France, together with Finland and Belgium, has the highest spill-over impact on other Member States.

Graph 2.2.6: Correlation of the French 10-year sovereign rates with selected euro area Member States

1-year rolling correlations based on daily average yields Source: Global Insight, European Commission Calculations

Private indebtedness

While a number of economies in the EU have experienced significant deleveraging since 2008, private indebtedness in France in 2013 reached 137.2 % of GDP, which is above the threshold set in the Alert Mechanism Report of 133 % of GDP. Although this is a slight decrease compared to 2012, the level of private indebtedness is 15 pps. above its 2008 level.

Stability of the banking sector and credit conditions.

The profitability and capitalisation of French banks appears in line with that of peers in the euro area. Like their counterparts in the rest of the euro area, French banks, of which four are considered as systemic by the Financial Stability Board, are suffering from relatively poor profitability, with a return on equity of 3.3 % in June 2014, a net decrease from 6.8 % in June 2013. With an average Tier 1 ratio of 12.8 % in June 2014, the capitalisation of French banks appears to be in line with that of their euro area counterparts (13.4 % Tier 1 capital ratio). Their loan portfolio appears slightly less risky, with non-performing loans representing 4.4 % of the total portfolio in June 2014 compared with 5.6 % in the euro area as a whole, although a comparison of the ratios of non-performing loans across countries remains difficult given the differences in definition. This ratio has been relatively stable in recent years, while it has increased in the euro area as a whole.

French banks performed well in the ECB stress test, showing resilience to a difficult economic environment. The ECB’s latest comprehensive assessment demonstrated that the French banking system was robust. The Asset Quality Review suggested that only minor adjustments of French bank balance sheets were necessary. The stress test showed that French banks were capable of resisting the simulated shock. In a stressed environment, the Common Equity Tier 1 ratio of French banks would decline by 231 basis points to 9 % by 2016 (compared to a decline of 300 basis points for the euro area). All banking establishments passed the stress test except one credit institution which was recapitalised in the first half of 2014 in response to the results of the stress test.

One of the potential vulnerabilities of French banks is their dependence on short-term wholesale funding. Loans to non-bank euro area residents represented 116.3 % of deposits from non-bank euro area residents in May 2014 ([25]). This relatively large loan-to-deposit ratio is partly explained by the banks’ customers placing a significant portion of their savings in non-banking products (i.e. life insurance and mutual funds). Consequently, French banks depend significantly on short-term interbank funding. Such dependence can prove a weakness when interbank markets experience difficulties. Since 2011, French banks have engaged in significant deleveraging in order to reduce their loan-to-deposit ratio. Part of the reduction in loan-to-deposit ratio is related to cyclical conditions. Indeed, the demand for credit from both companies and households is not very strong and the saving rate is high because of precautionary savings. Nonetheless, structural measures were adopted too to reduce the loan-to-deposit rate. Emphasis was put on developing the domestic retail banking activities and credit activities in US dollars were reduced. According to Fitch’s 2015 outlook for major French banks, the focus of French banks on stable funding sources should help them move towards compliance with the net stable funding ratio under the Capital Requirements Regulation. They will probably continue to have modest recourse to short-term market funding balanced by satisfactory liquidity buffers in 2015. These buffers should exceed the banks’ one-year short-term wholesale funding at all major banks. Large French banks have also been bolstering their stock of high-quality liquid assets, so that reaching a 100 % liquidity coverage ratio should not be an issue for any of them.

French banks are substantially exposed to French general government securities. This exposure, which stood at nearly EUR 200 billion (10 % of GDP) in November 2014, has been increasing since March 2011 and represents 65.5 % of French banks’ exposure to euro area general government securities (see Graph 2.2.7).

Graph 2.2.7: French bank's consolidated exposure to euro area general government securities

Source: ESCB

French banks have a high exposure to neighbouring countries, in particular Italy. Exposure to Russia is relatively limited. French banks’ exposure to foreign countries (to all sectors, public and private, including other banks) stood at EUR 2 317.9 billion (123 % of GDP) in June 2014, and mainly consisted of exposure to neighbouring countries. Exposure to Italy, Spain, Greece, Portugal and Ireland was stable at 19.5 % of French GDP, mainly to Italy (12.78 %), the largest foreign exposure of French banks. Consequently, if there is a material degradation of the economic situation in Italy, this would adversely impact French banks’ profitability and solidity. With 1.65 % of French GDP, exposure to Russia is fairly limited, although some banks’ individual exposure is greater, which could result in direct losses in the event of further deterioration of the situation in Russia. However, these losses would be insufficient to threaten French banks’ stability.

Household financial situation

The indebtedness of French households has continued to increase (2013) although the pace of increase has slowed down significantly since 2010. Household debt represented 55.6 % of GDP in 2013. The increase in the household debt ratio has been slowing down in recent years, with an increase of 1.9 pps. between 2010 and 2013, compared with 7.2 pps. between 2007 and 2010. By contrast, the household debt ratio in the euro area peaked in 2009, and has been falling since then, to 60.7 % of GDP in 2013.

The increasing indebtedness should be seen in the context of a relatively sound net financial asset position and low interest burdens on households. In 2013, net financial assets, which comprise financial assets and liabilities, were expected to reach 152.6 % of GDP, more than 10 pps. above their pre-crisis level and above the level in the euro area (139.3 %). Moreover, on average, the interest burden represented 1.4 % of gross disposable income, less than that in the euro area. However, the holders of the financial assets are not necessarily those who bear the debt burden, and the interest burden has proved to be a weak predictor of deleveraging pressures during the crisis. Nonetheless, the French indicators offer some reassurance as the distribution of debt to income and debt service to income across income quintiles is not alarming.

The real estate market is cooling off and the expected correction of real estate prices is relatively sizeable. The driving force behind household indebtedness dynamics over the last 10 years has been the continuous growth in real estate credit. Growth in real estate lending was sustained by rising housing prices and low interest rates. However, since 2011 there has been a deceleration in the growth of real estate credit (from an annual growth of 9.2 % in May 2011 to 2.5 % in November 2014). From the third quarter of 2011, housing prices also started declining steadily, falling by 1.9 % in 2013. Prices in France rose by about 120 % from the last trough in the first quarter of 1997 to the last peak in the first quarter of 2007. Since then, prices have corrected by 6 %, whereas in the previous house price cycle an eventual correction of 30 % was required. Indeed, using the methodology of Cuerpo et al. (2012) ([26]), the average house price misalignment was of the order of magnitude of 20 % in 2013 ([27]). The International Monetary Fund provides an overview of model-based price misalignment measures that range between 10% and 20 % but arrives at the same conclusion that the pre-crisis misalignment has not unwound to the same extent as in other countries yet ([28]). The correction in house prices is accompanied by a contraction in investment in housing, with a 2.6 % decline in residential investment recorded in 2013. The contraction in residential investment is expected to continue into 2015.

The real estate price correction is expected to proceed smoothly and the risks for household deleveraging are relatively contained but could weigh on residential investment. As stated in last year’s In-Depth Review, strong demand for housing supported by positive demographic trends and the absence of excess housing supply, together with prudent credit supply by banking institutions, suggests that the current soft landing of real estate prices should continue. Moreover, in the event of a rise in interest rates on loans or a more abrupt price decline, the impact on overall deleveraging pressures should be relatively contained, as real estate credit is mostly at fixed interest rates (83 % of the market). However, in the current low-inflation environment, the fact that most mortgages are fixed-interest and that renegotiation of mortgages is less common in France increases the real burden of interest and capital repayments. As credit ratings are based on income rather than asset value, the mortgage repayment capacity of households is normally sound. The banking system in aggregate also appears solidly positioned to absorb any increase in loan delinquency rates that may emerge from a fall in housing prices. However, confidence could decline and investor perceptions of real estate as a safe haven could shift, triggering asset allocation changes and further price declines ([29]). Moreover, even a gradual decline in real estate prices could hold back residential investment, weighing on construction activity.

Activity in construction is also being hampered by regulation and distorted incentives. In an assessment of the French housing market, distortions caused by regulations such as rent controls, taxation and subsidies, are found to limit the responsiveness of supply and may tend to hinder a fluid and transparent market development ([30]). In this context, French housing policies seem too much oriented towards simulating demand and not enough supply oriented.

Current debt reduction by households is mostly passive and gradual. Using two different methodologies ([31]), French households’ deleveraging needs are estimated at around 15 % of GDP ([32]). The first method determines a sustainable level of debt by estimating debt that is consistent with households’ and firms’ assets corrected for valuation effects. This method takes into account country- and time-specific factors such as the starting level of debt and the extent of the asset price boom in the pre-crisis period. The second method is based on the typical extent of deleveraging in past episodes, and is a function of the preceding debt increase. While deleveraging needs are relatively sizeable, current deleveraging pressure is relatively low. Indeed, France currently faces moderate deleveraging pressures stemming from credit supply and demand (see Graph 2.2.8) and as suggested above the deleveraging in the housing market is also fairly gradual. Therefore, if any deleveraging is to be expected, it is likely to be mostly passive and gradual. However, should overall economic conditions worsen in France, for instance because of a change in market perceptions of the sustainability of public finances, a more active deleveraging of household indebtedness could ensue.

Graph 2.2.8: Loan deleveraging pressure

(1) This graph suggest that there are no deleveraging pressures due to credit but does not provide information on deleveraging needs Source: European Commission

Additional pressure on households to reduce indebtedness could stem from uncertainties about cyclical conditions and the trajectory of public finances. While disposable income is expected to grow relatively robustly in 2015 and 2016, unemployment remains high and uncertainty about economic growth remains quite high. This could lead households to reduce indebtedness by increasing their savings rate, although this is not the main scenario. Also, given high public indebtedness, consumers could anticipate future tax hikes or lower transfers. Faced with these uncertainties about future revenues, households may be prone to reducing their indebtedness by increasing their savings rate.

Non-financial corporations

Credit growth is relatively weak, while credit conditions are favourable. Credit growth to non-financial companies was flat in 2013 but picked up somewhat during 2014, growing at an annual rate of 2.1 % in November 2014. Overall, the cost of finance is not a significant burden on French firms, which continue to borrow at rates slightly higher than in Germany but considerably lower than in Spain and Italy. However, as in the rest of the euro area, big companies have systematically enjoyed better funding conditions, and are able to access capital markets, while smaller ones have primarily relied on the banking system to finance their needs. This reliance on bank loans could make it more difficult for SMEs to finance long-term investment.

Indebtedness of French non-financial companies is above the euro area average but the leverage is lower. The non-consolidated debt of non-financial companies stood at 119.6 % of GDP in 2013, well above the euro area average (94.6 %). Netting out intercompany loans, the consolidated debt level of non-financial corporations amounted to 81.6 % of GDP in 2013 (compared to 78.5 % in the euro area). Net assets of non-financial corporations were somewhat more negative in France than in the euro area in 2013 (at -102.9 % versus -95.1 % of GDP). The picture for leverage was more positive, with company leverage, as measured by the debt-to-equity ratio, at 53.6 %, still well below the euro area average of 66.7 %. Moreover, using the same methodologies as for households, there is no evidence that non-financial corporations need to deleverage.

The declining profitability of non-financial companies may also affect companies’ ability to service their debt. Although the financial structure of non-financial corporations does not point to specific weaknesses, the continuous erosion of their profit margins is a source of concern. The financial difficulties experienced by firms are partly reflected in the historically high number of bankruptcies in 2014, at similar levels to 1994. However, the increase in the number of bankruptcies has slowed down, with the total number of bankruptcies over the last 12 months to October 2014 rising by only 1.5 % compared to October 2013. Overall, the low and deteriorating profitability of French non-financial companies compared with those of other euro area countries, together with the increasing number of bankruptcies, points to potential vulnerabilities. Moreover, based on simulations with the QUEST III model described above, the tax credit for competitiveness and employment and the responsibility and solidarity pact will only provide temporary, limited relief for firms with low profit margins.

High public and private indebtedness make the entire economy more sensitive to potential adverse economic events. The banking sector seems stable although its continued dependence on short-term wholesale funding is a potential vulnerability. French private indebtedness has continued to rise and together with high public indebtedness makes the entire economy more sensitive to potential adverse economic events. Overall, there is little loan deleveraging pressure and the house price correction is gradual. However, should overall economic conditions worsen further the indebtedness of households could lead to active deleveraging, with a detrimental impact on the economy. Finally, companies’ poor profitability may affect their ability to service their debt.

Trade linkages between France and the euro area are substantial

France is a major export market for several Member States. In particular, exports to France account for more than 10 % of the GDP of Belgium and Luxembourg ([33]). Trade linkages with large euro area economies such as Germany, Spain and Italy are likewise strong. France’s economic size gives it an important role within the euro area. Indeed, developments in French domestic demand have the potential for strong spillovers to other euro area partners via trade.

France exports large volumes of final and intermediate goods and services to other euro area countries. Total exports of goods and services represent approximately 28% of French GDP. French exporters depend to a great extent on the German market where imports account for more than 4% of French GDP, on Belgium (more than 2%) and on a group of four medium-to-large EU economies: the United Kingdom, Italy, Spain and the Netherlands (roughly between 1% and 2%). Outside the EU, the United States is a sizeable export market (2%), followed by Switzerland and China (close to 1% each) ([34]).

While net Foreign Direct Investment stock has been relatively stable, inward Foreign Direct Investment, an indication of France’s attractiveness to foreign investors, is decreasing. In terms of composition, the net stock of Foreign Direct Investment continues to remain positive as, in the past, net flows of French investment abroad have been consistently higher than net inward flows. Accordingly, most of the negative Net International Investment Position is financed by portfolio investments. In 2013, France was not among the world’s 20 largest direct investors and investment receivers. Its position has deteriorated compared to 2008, when France was the seventh largest receiver and the fourth largest investor. Between 2008 and 2013, France was outperformed in particular by some large developing economies which attracted more investors. However, the picture is distorted due to intra-company flows.

Financial linkages between France and the euro area are important

France is one of the most important nodes in the network of financial linkages within the euro area, playing a very important role in financial intermediation. Box 2.3.1([35]) shows how France had systematically acted as a major funding intermediary for the economies of southern Europe before reducing its holdings in 2011, leaving an external funding gap that needed to be bridged by official flows. The box illustrates that changes in market participants’ perception or anticipation of economic fundamentals leading to a reassessment of the vulnerability of the French economy would have significant spillover risks affecting the euro area as a whole.

Interlinkages are strongest with Ireland, Belgium and the Netherlands. In 2012, Ireland, Belgium, the Netherlands and Malta had gross financial exposures to France via equity and debt instruments amounting to more than 50% of their respective GDP. Exposure to French equity assets is particularly high in Belgium and the Netherlands, while debt-type instruments were worth 68% of Irish GDP. Five additional Member States, including the United Kingdom and Germany, had exposures greater than 10% of GDP.

Box 2.3.1: The financial intermediation role of France Capital flows from and to France played a central role throughout the crisis. Before the crisis, France acted as an intermediary between euro area debtors, on one side, and creditors from outside the euro area, on the other. Apart from Japanese and UK investors, foreign central banks were particularly keen to hold French bonds, presumably as a reserve asset. On the eve of the crisis in 2007, France found itself in a net debtor position to non-EU countries, while French investors were in a net creditor position to most of the euro area, in particular Italy, Spain and Greece, but also Germany (see Graph 1a). In the first stage of the crisis, until 2010, French bonds were sought after as a safe-haven asset. Foreign central banks increased their holdings of French bonds considerably. At the same time, German investors shifted out of Italian and Spanish debt and used part of the proceeds to purchase French debt assets, turning the French net asset position vis-à-vis Germany from positive to negative. In return, French investors had to invest their savings into assets abroad, and significantly increased their exposure to Italian and Spanish debt. Italian and Spanish investors sold off their holdings of French debt, which compounded the increase in net French exposure to those two countries. Consequently, France intermediated financial flows and financial risk from Germany and outside the euro area to Spain and Italy, which still ran sizeable current account deficits at the time. Notes: In Graph 1a, CB/IO corresponds to aggregate of SEFER central banks and international organisations, as reported by IMF CPIS. RoEU: Remaining EU