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# 52014SC0081

**COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - France 2014 /\* SWD/2014/081 final \*/**

  

Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances

France continues to experience macroeconomic imbalances,
which require specific monitoring and 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 continuous policy attention. The need for decisive action so as to
reduce the risk of adverse effects on the functioning of the French economy and
of the euro area is particularly important given the size of the French economy
and potential spillovers onto the functioning of the euro area. Given the need
for policy action already called in the 2013 IDR, the Commission will put in
motion a specific monitoring of the policies recommended by the Council to
France in the context of the European Semester, and will regularly report to
the Council and the Euro Group.

More specifically,
the growing trade deficit reflects the long-term decline in export market
shares which is linked to persistent losses in both cost and non-price
competitiveness. Despite measures taken to foster competitiveness, so far there
is limited evidence of rebalancing. While wages have developed in line with
productivity, the labour cost remains high and weighs on firms' profit margins.
The low and decreasing profitability of private companies, in particular in the
manufacturing sector, may have hampered their ability to grow and improve their
export performance. The unfavourable business environment, and in particular
the low level of competition in services, further aggravate the competitiveness
challenge. In addition, rigidities in the wage setting system result in difficulties
for firms to adjust wages to productivity.  Despite measures taken to reduce
the government deficit since 2010, public debt has continued to increase, which
calls for continued fiscal consolidation and, given the high level of public
expenditure, for specific focus on spending cuts, notably through the search
for efficiency gains. France is projected to miss both headline deficit and
structural adjustment targets over the entire forecast period.

Excerpt of country-specific findings on France, COM(2014) 150 final,
5.3.2014

Executive Summary and Conclusions 7

1.       Introduction  11

2.       Macroeconomic
Developments 13

3.       Imbalances
and Risks 19

3.1.     External
imbalances: sustainability of the current account and NIIP developments 19

3.1.1.  Current
account developments 19

3.1.2.  A
deteriorating export performance  20

3.1.3.  Impact on the
international investment position  21

3.2.     Interlinkages
with other euro area Member States and potential spillovers 22

3.2.1.  Trade and
financial linkages between France and the rest of the euro area   22

3.2.2.  France's
imbalances and spillovers to the euro area   23

3.3.     Developments
in the cost of labour in France and their consequences for competitiveness 24

3.3.1.  Cost of labour 24

3.3.2.  Development in
wages 26

3.3.3.  Tax burden on
labour 28

3.3.4.  Wage
bargaining system   29

3.3.5.  Minimum wage  31

3.3.6.  Impact on the
wage distribution  32

3.3.7.  Impact on
social indicators and poverty  34

3.4.     Non-cost
competitiveness: Low profitability and non-cost factors 35

3.4.1.  The low
profitability French firms 35

3.4.2.  A lack of
medium-sized companies and the decreasing technology intensity  36

3.4.3.  An unfriendly
business environment 38

3.4.4.  A lack of
Innovation  42

3.5.     Public and
private indebtedness 44

3.5.1.  Stability of
the banking sector 44

3.5.2.  Household
financial situation  45

3.5.3.  Non-financial
corporations 46

3.5.4.  Public sector
indebtedness 47

4.       Policy
Challenges 51

References 53

LIST OF Tables

2.1.     Key
economic, financial and social indicators - France  17

3.1.     Share of
French SMEs absorbed each year by a group   41

LIST OF Graphs

2.1.     GDP in
volume (2000=100) 13

2.2.     Contribution
to GDP growth (2007-2015) 13

2.3.     Debt
decomposition, consolidated   15

2.4.     Decomposition
of external position  16

3.1.     Current
account balance and variation in the Cyclically adusted CA (% of GDP) 20

3.2.     Geographical
and sectoral composition of nominal (USD) rate of change of goods exports -
France  20

3.3.     Decomposition
of Net International Investment Position  21

3.4.     Exports to
France as a % of GDP in reporting country (2011) 22

3.5.     Decrease in
exports as a result of 10% decrease in French domestic demand   24

3.6.     Hourly
labour cost - Industry (EUR/hour) 25

3.7.     Hourly
labour cost - Services (EUR/hour) 25

3.8.     Unit labour
cost in selected euro area economies (2000=100) 25

3.9.     ULC
developments in the tradable and non-tradable sectors (2000-2012) 26

3.10.   Gap between
REER on export price and on ULC (compared to IC-37, 2000=0) 26

3.11.   Contribution
of explanatory factor to growth in real wages 27

3.12.   Employer's
social security contributions (in % of total compensation, 2012) 29

3.13.   Tax wedge by
level of wages, 2012, in % of gross wage  29

3.14.   Mean monthly
earnings of employees with upper secondary education compared to workers with
only primary or pre-primary (2012) 33

3.15.   Social
security contribution by sector, 2012, in % of total compensation  33

3.16.   Profit
margins in selected European countries 35

3.17.   Investment
and gross operating surplus (NFC, % annual change) 36

3.18.   Average
number of employees by firm (2012) 36

3.19.   Share of
value added in high and medium-high technology sectors (selected countries, in
% of VA) 37

3.20.   Most
problematic factors for doing business in France  38

3.21.   Percentage
change in the number of firms between contiguous size bracket (2012) 40

3.22.   Average
annual growth of firms' value added (before absorption) depending on whether
they are absorbed or remain independent 41

3.23.   Share of
absorption of SMEs according to technology level 41

3.24.   R&D
spending in France, Germany and in OECD countries (% of GDP) 42

3.25.   Number of
researchers in the private sector (per 1 000 employees, 2011) 42

3.26.   Balance Sheet
by Instrument, Households 45

3.27.   Profit
margins, non-financial corporations 46

3.28.   General
government deficit and debt 47

3.29.   Public Debt -
Medium- and long-term debt projections 47

3.30.   Interest
rates to NFCs compared with 5-year yields on French sovereign bonds 48

LIST OF Boxes

3.1.     Modelling
wages using an error correction model 28

3.2.     A recent
reform of the wage bargaining process - the 'accords de maintien de l'emploi' 31

3.3.     The tax
credit on competitiveness and employment 34

3.4.     Regulatory
thresholds related to the number of staff in French firms, under the labour law
or under accounting regulations. 39

3.5.     The
Research Tax Credit (RTC) 40

3.6.     The
Competitiveness Poles 44

LIST OF Maps

No table of contents
entries found.

In April 2013, the Commission concluded
that France was experiencing macroeconomic imbalances and indicated that
decisive policy actions were necessary. The imbalances concerned in particular
the deterioration in the current account and in competitiveness as well as the
high general government sector debt. In the Alert Mechanism Report (AMR)
published on 13 November 2013, the Commission found it useful, also taking into
account the identification of an imbalance in April, to examine further the
persistence of imbalances or their unwinding. To this end this IDR provides an
economic analysis of the French economy in line with the scope of the surveillance
under the Macroeconomic Imbalance Procedure (MIP). The main observations and
findings from this analysis are:

· The determinants which supported the French economy at the height of
the economic crisis are now hampering the recovery.
France was initially less affected by the crisis than neighbouring economies.
The relatively limited openness to external trade, the large automatic
stabilisers together with the absence of a significant credit bubble in the
years ahead of the crisis, translated into a comparatively stronger resilience.
In 2011 and 2012, GDP growth remained subdued, albeit significantly above the
euro area. The pace of recovery has been insufficient to put the unemployment
rate on a downward path. Moreover, the rising imbalances related to export
competitiveness and to the high and increasing level of public indebtedness
cast doubts on the sustainability of the French economic recovery.

· The on-going deterioration in the current account and the
international investment position represents a risk for the long-term
sustainability of the French growth model. France
has experienced important losses in export market shares over the past few
years (-14.0% between 2007 and 2012). While the current external position
remains rather benign, the eroding export performance has resulted in a
continuous deterioration in the current account which recorded a deficit of
2.2% of GDP in 2012 compared to a 1.0% of GDP surplus 10 years before. Contrary
to developments in other deficit countries, limited signs of a durable
rebalancing can be seen in France so far.

· The high cost of labour and rigidities in the wage setting process
weigh on the profitability of firms and on their ability to weather shocks. While wage developments have generally followed the trend in productivity,
France is among the euro area economies where the cost of labour is the
highest. In particular, the high tax burden on labour reduces firms'
profitability. The high minimum wage, together with policies which reduce the
tax burden on labour for low-skilled workers result in a distortion in the wage
distribution which may limit incentives for workers to increase their skills.
In addition, rigidities linked to the wage setting process continue to limit
the ability of firms to adjust wages in economic downturns.

· The efforts to improve the non-cost competitiveness of French
companies are hampered by their low profitability and increasing indebtedness. While French exports are significantly sensitive to price
developments, non-cost factors have also played a critical role in the
deterioration in export performance. The low profit margins of French
companies, which continued to deteriorate in 2012 notably due to a still
increasing tax burden, led them to increase their indebtedness in order to
finance investment. Although credit constraints appear moderate at this stage,
such a situation may reduce their ability to invest and to effectively engage
in export activities.

· The relatively unfavourable business environment also contributes to
the poor export performance of French firms.
France's ranking in the various international business environment surveys has
deteriorated substantially over the last few years. The administrative burden
continues to represent a limitation to the growth potential of companies, with
a negative impact on their propensity to export. The low level of competition
in services increases the cost of intermediary consumption and distorts the
incentive structure between the tradable and non-tradable sectors.

· The high general government deficit, together with a still rising
public debt constitutes a major vulnerability, which calls for further
adjustment. France's government deficit increased
sharply in 2009 as a result of the economic crisis. Since then, fiscal
consolidation has been undertaken in order to bring the deficit below 3% of GDP
by 2013, a deadline which has been extended to 2015. While risks to the
medium-term sustainability appear moderate, the increase in public debt
following the financial crisis means that the economy has become more sensitive
to potential adverse economic events.

· As the French economy is tightly interconnected with the other
Member States, through both trade and financial channels, negative developments
in France would potentially have a significant impact on the other euro area
economies. A failure to effectively address
competitiveness challenges in France would result in a weaker potential growth
domestically. The impact on the euro area of competitiveness enhancing reforms
in France would also be positive as the increase in demand for trade partners
would prevail over the relative loss in export performance they would suffer
from. As the French GDP represents 21% of that of the euro area, sluggish
demand growth in France would weigh significantly on the export potential of
other euro area economies. In addition, France has played throughout the
financial crisis a financial intermediation role, channelling in particular
much needed financial flows to euro area peripheral economies. A deterioration
in the financing conditions for France, which could eventually result from the
growing imbalances, would have a destabilising impact on other euro area Member
States.

The IDR also discusses the policy
challenges stemming from these imbalances and possible avenues for the way
forward. A number of elements can be considered:

· Efforts to reduce the government deficit need to be enhanced, in
line with the trajectory recommended by the Council, and specific attention
should be given to reducing public expenditures. Beyond
the objective of bringing the nominal public deficit below 3% of GDP in 2015,
further efforts will be necessary to durably put the public debt on a downward
path. The high tax burden necessary to finance public expenditures, which are
set to represent 57 % of GDP in 2013,  leaves limited room to further
increase public revenues. Therefore, the government needs to deliver on its
commitment to achieve significant expenditure savings over the period
2014-2017, especially in the areas of social security and local governments. 
In light of the modest results of the efforts to increase the efficiency of
public spending so far, ambitious actions will be needed to ensure that
expenditure cuts are commensurate with the targeted deficit reduction and the
announced further reduction in the cost of labour.

· Beyond the measure already adopted to reduce the tax burden on
labour, additional efforts are needed to support the profitability of
companies. The tax rebate for competitiveness and
employment (CICE) which was adopted in 2012 is equivalent to a reduction in the
cost of labour for companies of close to EUR 20 billion (1% of GDP). This
measure only bridges part of the profitability gap of French companies compared
to peers in the euro area. In addition, cost reductions are focused on the
lower part of the wage distribution. While this aims to maximise the effect on
employment, it reduces the impact on exporting companies as they generally pay
higher wages. Measures to further reduce the cost of labour have been announced
in January 2014 but little detail is available at this stage. If the targeting
adopted for these additional measures is similar to that of the CICE, the
impact on competitiveness will most likely be limited.

· The business environment in France continues to constitute a barrier
to firms' growth and export potential. The
"simplification shock" announced by the authorities has not yet
resulted in significant measures for companies. There is still considerable
room to enhance competition in services with a positive impact on intermediary
costs. On the other hand, while important resources have been dedicated to
innovation policy, in particular to the research tax credit and the
competitiveness poles, the outcomes appear modest and the efficiency of these schemes
would need to be reviewed.

· Rigidities and distortions on the labour market limit the
possibility to adjust wages to productivity developments and may reduce
incentives to increase skills. The measures adopted
in 2013 to increase flexi-security seem insufficient to ensure that wages can
be adjusted for companies facing difficulties. The importance of the minimum
wage in the overall wage setting framework and the limited existing exemptions
contribute to wage rigidities and impact on the employment prospects of workers
with low productivity. In addition, the social security contribution
exemptions, which mitigate the negative impact of the minimum wage on
employment for low-skilled workers, may distort the wage distribution and
reduce incentives to increase skills. The on-going reflection on a further
reduction in the cost of labour could represent an opportunity to foster a wage
structure which better rewards skills and productivity improvement.

On 13 November 2013, the European
Commission presented its third Alert Mechanism Report (AMR), prepared in
accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention
and correction of macroeconomic imbalances. The AMR serves as an initial
screening device helping to identify Member States that warrant further in
depth analysis to determine whether imbalances exist or risk emerging.
According to Article 5 of Regulation No. 1176/2011, these country-specific
“in-depth reviews” (IDR) should examine the nature, origin and severity of
macroeconomic developments in the Member State concerned, which constitute, or
could lead to, imbalances. On the basis of this analysis, the Commission will
establish whether it considers that an imbalance exists in the sense of the legislation
and what type of follow-up it will recommend to the Council.

This is the third IDR for France. In the
previous IDR, which was published on 10 April 2013, the Commission concluded
that France was experiencing macroeconomic imbalances and indicated that
decisive policy actions were necessary. The imbalances concerned in particular
the deterioration in the current account and in competitiveness as well as the
high general government sector debt. Overall, in the AMR the Commission found
it useful, also taking into account the identification of an imbalance in
April, to examine further the risks involved and progress in the unwinding of
imbalances in an in-depth analysis. To this end this IDR provides an economic
analysis of the French economy in line with the scope of the surveillance under
the Macroeconomic Imbalance Procedure (MIP).

Section 2 provides a broad overview of
macroeconomic developments in France. Section 3 focuses more specifically on
the potential imbalances. It looks in details at developments in the current
account and the impact on the external position. It discusses potential
spillovers in the euro area. An analysis of the cost of labour and its main
determinants is provided as well as an assessment of the potential impact on
trade performance. The main drivers of non-cost competitiveness are also
examined, with a specific focus on innovation. The section then concludes by
reviewing developments in private and public indebtedness. Finally, based on
the analysis presented in the previous section, Section 4 discusses policy
avenues to address the imbalances identified.

The economy was considerably weakened by the
global financial crisis

The impact of the global financial
crisis was initially less dramatic in France than in the rest of the euro area. The sizeable automatic stabilisers, the absence of a pre-crisis
credit boom as well as the relatively limited weight of exports (27% of GDP in
2007 compared to 42% in the euro area), all contributed to limiting the impact
on the French economy of the sharp slowdown in international trade in 2009.
Private consumption, which increased steadily in 2007-2010 at an average rate
of 0.7% p.a., contributed to supporting economic growth. As a consequence, while
the aggregate GDP for the euro area (in volume) is still below its 2008 level,
the French GDP drop was more modest and it rebounded above its 2008 level
already in 2011 (Graph 2.1).

However, some of the factors which
helped the economy weather the crisis now represent a drag during the recovery
phase. The sluggish economic growth since 2010 has
translated into a rapid increase in the unemployment rate which reached 10.8%
in 2013, close to the 1997 record. The large general government deficit in 2009
and 2010 translated into a rapid increase in public debt to above 90% of GDP in
2012. Private indebtedness, driven in particular by the poor financial
situation of non-financial corporations, continued to increase to 141% of GDP
on a consolidated basis in 2012.

The continuous deterioration of export
competitiveness and the financial constraints for domestic agents are expected
to weigh on the recovery. Although France has
avoided a prolonged recession, its growth pattern will remain irregular as
limited impetus for growth exists. Notwithstanding the exceptional 1 pp.
contribution of net exports to growth in 2012, export shares have declined
steadily over the last few years (-13.6% in the last 5 years). This
deterioration is rooted in both the low cost competitiveness and in the
decreasing quality of French exports. Despite policy efforts, this development
will therefore not be corrected in the short term (Graph 2.2).

Social indicators show that the crisis took
its toll on the most vulnerable groups

Unemployment in France has increased
rapidly as a consequence of the sluggish economic growth since 2010. In particular, as was the case in the euro area as a whole, the
share of long-term unemployment increased significantly, from 2.9% of the
labour force in 2008 to 4.1% in 2012. The situation of young people has
particularly deteriorated, with the youth unemployment rate reaching 24.7%. In
2012, 12.2% of people aged 15 to 24 were neither in employment, education nor
training, a 2 pps. increase since 2008. Evidence on the quality of employment
shows that the situation has also deteriorated since 2008. The share of
unemployed people obtaining a permanent contract, which was already on a
decreasing trend, fell from 31.4% in 2008 to 30.3% in 2012. Conversely, the
share of part-time workers increased from 16.8% to 17.7% of employment over the
same period.

Accordingly, the difficulties faced on
the labour market are reflected in increasing poverty rates since 2008. 19.1% of the French population was at risk of poverty ([1]) in 2012, representing 11.8 million people. Thanks in particular to
relatively generous social transfers, this ratio is below the euro area
average. However, the number of people at risk at poverty has increased since
2008 (by close to 600 000). In particular, in-work poverty has increased
in the last two years with 8.0% of employees being at-risk-of-poverty in 2012.
Such a development suggests that both the unemployment level and the conditions
of employment are at stake. In particular, the Gini coefficient of equivalised
disposable income, which measures the degree of inequality in the income that
households receive once taxes and social contributions are taken into account,
has increased in France between 2007 and 2012 from 26.6 to 30.5. This signals a
significant increase in income inequality. By comparison, in the European Union
as a whole, the Gini coefficient has remained stable and has decreased in
Germany and Italy.

Medium-term growth prospects remain bleak
despite a relatively strong potential

According to the Commission Winter 2014
forecast, GDP growth is expected to remain below potential in 2014 and to
accelerate only moderately in 2015. Despite a
rebound in external demand, net trade is set to contribute only marginally to
growth in the medium term. Regarding domestic demand, the high and increasing
unemployment level is expected to weigh on disposable income while
precautionary savings limit the potential for private consumption growth.
Moreover, up to 2015, investment is expected to remain constrained by the lack
of demand and the poor profitability of companies. Finally, the continued
fiscal consolidation provides little space for a public boost to growth.

While growth will remain anaemic in the
short term, France exhibits a stronger potential growth than the euro area,
albeit much below pre-crisis levels. Potential
growth in France is expected to stay at 1.0% over 2013-2015. This is clearly
above the potential growth rate for the euro area (0.4% in 2013, rising to 0.7%
in 2015). However, this represents an important slowdown compared to the 1.8%
p.a. average growth between 2000 and 2007 and point to a permanent impact of
the financial crisis. Much of this slowdown comes from a fall in total factor
productivity growth, from about 1% in 2001 to 0.4% in 2013. In addition, the
rising structural unemployment weighs on labour contribution and partly offsets
the increase in working age population and in the participation rate. On the
contrary, capital accumulation supported potential growth throughout the
crisis. In the longer term, while total factor productivity growth will remain
close to its 2013 rate, the 0.5% p.a. increase in working age population,
together with a relative stabilisation in structural unemployment and a slight
increase in the participation rate, is expected to translate into a positive
contribution of labour to potential growth.

Deleveraging needs in the private sector
appear moderate

The level of consolidated private debt
has continuously increased over the last decade to reach 140.7% of GDP in 2012
(Graph 2.3). While
high in a historical perspective, this ratio remains slightly below the euro
area average. This is mainly explained by the relatively lower level of
household debt in France. However, household debt, which rose during the years
leading up to the crisis has not fallen since 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 both weigh on household credit
worthiness over the medium run.

While the level of debt to GDP of French
non-financial companies has kept rising over the last few years, their leverage
is not particularly high compared to euro area peers. Debt to GDP of French non-financial companies (NFC) continued
increasing in 2012 to a level above the euro area average. In contrast, debt to
equity fell in 2012 (50%) below the euro area average (68.9%). 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 translate into
difficulties for firms to service their debt as reflected in the increase in
the number of bankruptcies in 2013.

French banks generally resisted well
during the financial crisis and made progress in meeting new solvency
requirements although potential risks remain. The
French banking system, which is dominated by five large institutions, remained
resilient during the financial crisis years due to the robust retail sector.
With a 6.8% return on equity and a 0.4% return on assets in June 2013 ([2]), the profitability of French banks, while lower than in 2012,
remains above the average in the euro area. Furthermore, progress in meeting
solvency requirements as banks strengthened their balance sheets and the
reduction in liquidity risks, together with the measures adopted by the ECB
were reflected in the improvement of banks' financing conditions via a
reduction in bank yields in 2012. Despite banks' deleveraging, there have been
no signs pointing towards a credit tightening by banks to enterprises.
Investment constraints indeed appear to be mostly explained by weakened loan
demand and more reliance on market financing by NFCs. However, downside risks
to the French banking sector may arise from banks' over-reliance on wholesale
funding. This could potentially translate into liquidity risks in the event of
a shock in wholesale funding. Furthermore, the exposure of French banks to
peripheral economies of the euro area could also be a source of concern if
tensions in sovereign debt markets were to arise.

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

France has experienced increasing fiscal
imbalances for the last 40 years: the general
government balance was last at surplus in 1974. In the last 20 years, the
public deficit has systematically remained close to 3% of GDP if not above.
France entered the Excessive Deficit Procedure in 2009 but this was only partly
due to the impact of the economic and financial crisis, with the deficit
already very close to the 3% of GDP threshold in 2007. The deadline for
correcting the excessive deficit has since been extended twice notably due to
worse than expected macroeconomic developments. The current deadline is 2015.
Importantly, the cyclically-adjusted balance has also been systematically
negative over the last few decades (-3.3% of GDP on average over 1978-2013).
This means that, beyond the effect of the economic cycle on fiscal metrics,
expenditure has systematically exceeded earnings. The ratio of public
expenditure to GDP, forecast at some 57.2% in 2013, is the third highest in the
euro area after Slovenia and Finland.

As a consequence, the general government
debt has increased almost continuously since 1990, a trend which has
accelerated since the start of the crisis, with the debt ratio expected at
93.9% of GDP in 2013. This was slightly below the
euro area average of 95.5% of GDP but clearly above the reference value of 60%
specified in the scoreboard and referred to in Article 126(2) TFEU. The
threshold was first exceeded in 2003 and the debt has been almost continuously
on an upward trend since then. Despite this trend France has weathered the euro
area sovereign debt crisis without experiencing major tensions on sovereign
yields so far. The latter have actually fallen below historical levels, with
increased risk aversion supporting German bunds and filtering through to other
euro area economies including France to the detriment of peripheral economies.
This has helped contain interest payments but also prevented negative spillover
effects to the financial sector and the real economy. According to the
Commission Winter Forecast, the debt ratio is set to continue increasing up to
97.3% of GDP in 2015.

The deterioration in trade performance has
resulted in an increasing current account deficit

The trade balance has been decreasing
steadily since 1997 from a surplus of 3.2% of GDP to a deficit of 1.9% of GDP
in 2012 (a slight improvement compared to the
record deficit of 2.3% of GDP in 2011). Most of this development is due to the
rapid deterioration in the trade balance for goods (Graph 2.4). The energy deficit, linked in
particular to increasing oil prices, contributed to 50% of the increase in the
trade deficit between 2004 and 2012. However, France has also lost ground in
non-energy goods and services. A review of cost developments shows that export
prices explain a limited share of these developments. In 2013, the trade
balance deficit has decreased due to a contraction of both imports and exports
in goods and to a good performance of services. In its Winter forecast, the
Commission expects that, despite measures to reduce the cost of labour and
improve competitiveness, the trade deficit will remain stable in 2014 and 2015
due to a recovery of internal demand which will lead to higher imports.

As a consequence of the deteriorating
trade balance, the current account balance, which was still at a surplus of
2.8% of GDP in 1998, recorded growing deficits from 2005 on, reaching 2.2% in
2012. While current transfers have remained steady
over the last 10 years, the income balance, which still remains positive thanks
to the revenues from French investments abroad, has decreased by 44% in 2012.
Within the forecast horizon, the current account balance is expected to
stabilise, in line with the trade balance. After an improvement in 2013 to 1.9%
of GDP, the current account deficit is set to increase somewhat to 2.0% of GDP
in 2014 and 2.2% in 2015.

The evolution of the current account is
mirrored by a sharp decrease in the net international investment position
(NIIP) over the last five years. The NIIP, which
was in surplus still in 2006, recorded a deficit of 21% of GDP in 2012. Large
valuation effects, which have not been compensated since then, contributed to
the drop in the NIIP seen in 2008. However, these do not fully explain the deteriorating
trend and the still significant current account deficit will continue to weigh
on the NIIP in the medium term. In terms of composition, the NIIP is
increasingly financed by interest-bearing instruments, as the increase in
external debt shows. This development is in particular driven by the increasing
holding of public debt securities by foreign investors (representing close to
50% of GDP). The increasingly negative NIIP will impact on the income balance
which could become negative in the future, making the rebalancing of the
current account even more difficult.

3.1.      External
imbalances: sustainability of the current account and NIIP developments

3.1.1.   Current
account developments

The French current account balance has
been on a downward trend for most of the last 10 years. After a slight improvement in 2009 and 2010 as a result of the
crisis, the on-going deterioration in the current account resumed, up to a
deficit of 2.2% of GDP in 2012. As mentioned in the previous IDR, most of this
deterioration comes from the increasingly negative trade balance which showed a
deficit of 1.9% of GDP in 2012. More precisely, trade in goods has shown
increasing deficits while net service exports have remained positive. In 2013,
the trade balance deficit narrowed significantly to 1.4% of GDP. This positive
development is mainly linked to an improvement in the good balance on the back
of lower domestic demand. This suggests that the improvement is mostly of a
cyclical nature. Indeed, the Commission Winter forecast projects that, after a
significant improvement in 2013, the current account deficit will stabilise in
2014 and 2015 as domestic demand picks up.

A sectorial decomposition of the current
account developments 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 increasing borrowing needs of the government and
of non-financial companies. The government budget has recorded a deficit every
year since 1974. In 2009, as a result of the financial crisis, the government
deficit spiked at 7.5% of GDP in 2009 from 3.3% one year earlier. The
government deficit has gradually abated since then but remains high (4.8% of
GDP in 2012). The difficulties met by non-financial companies have also
resulted in increasing borrowing needs, although they have also resulted in a
slowdown in investment.

In 2012, the improvement in the French
trade deficit for goods and services, to 1.9% of GDP, appears smaller than in
most other countries in the euro area. This
improvement reflects a slight contraction in imports together with a modest
expansion in exports (+0.2 pp. of GDP). Such an improvement in the trade
balance is observed in a majority of euro area countries and in most cases, its
magnitude is larger than in France. The trade balance increased for example by
0.8 pp. in Germany, 2.6 pps. in Italy and 1.8 pps. in Spain. In
addition, a number of euro area economies experienced a significant increase in
exports (e.g. by 1.8 pps. and 1.4 pps. of GDP in Spain and Italy
respectively) suggesting that improvements in export competitiveness since the
start of the crisis have been much more significant in these economies than in
France. In 2013, the deficit in the trade balance for goods, driven by a
contraction of imports sharper than that of exports, decreased by 0.5 pp.
of GDP. Meanwhile, the service balance increased by 0.1 pp, leading to a
28% improvement in the current account deficit.

The reduction in the trade balance
deficit in 2012 was offset by a sharp decrease in the income balance. Revenues from French investment abroad brought the income balance
to a record 2.3% of GDP in 2011. In 2012, the lower profitability of direct
investment abroad and the slump in net revenues on debt securities, which
became negative, contributed to a close to 10% fall in net revenues from investment.
Consequently, the income balance fell back to its 2006 level. In 2013, a slight
recovery of the income balance was recorded although its level remains
significantly below the 2010-2011 historical high. In the longer term, the
increasingly negative NIIP should lead to eroding net revenues from investment.
Such a phenomenon will only add to the challenge of rebalancing the current
account.

Cyclical conditions seem to have played
a minor role in the deterioration of the current account. Imports in France are strongly impacted by the sluggish growth of
domestic demand. In 2012, the output gap in France was much wider (-2.1% of
GDP) than the average in the 40 largest trading partners (-1.5% of GDP). The
poor export performance is therefore comparatively less accounted for by a low
cyclical demand from trading partners. Overall, as shown in Graph 3.1, adjusting for the position in the cycle
actually deteriorates the current account balance (by 0.3% of GDP in 2012).
Such a feature is common to most other euro area Member States except Germany,
Ireland and Malta. However, France stands out as the only deficit country in
the euro area where the structural deficit of the current account has increased
since 2008 (by 0.5 pp. of GDP). In Spain and Italy, the large current
account correction observed in the past few years is also partly due to
cyclical conditions. Still the structural adjustment in the current account
since 2008 for these two economies (7.1 pps. and 1.6 pps. of GDP
respectively) suggests that rebalancing efforts have been much more pronounced
than in France.

3.1.2.   A
deteriorating export performance

The poor trade performance reflects
increasing difficulties for French products to compete on international
markets. The French market share in exports of
goods and services has been on a decreasing trend since 2004. While export
growth has been positive every year except in 2009, its pace has been
insufficient to keep up with the increase in international demand. Regarding
goods, as can be seen from Graph 3.2, the geographic specialisation of
France, whose exports are focused on the euro area, has played a negative role
in the market share developments since 2008. Similarly, despite the importance
of the high-tech sector in total exports (18.6% in 2011 compared to 13.4% in
Germany and less than 10% in Italy and Spain), the product specialisation of France
contributed negatively to its export performance. However, only a minor part of
the poor goods export performance is linked to the initial specialisation and
most of the deterioration comes from losses in the product and geographical
markets where France is present.

Both price and non-price developments have contributed to the poor
export performance of French goods. Estimating export
equations for France, Spain, Italy and Germany, INSEE (2013) shows that French
exports are quite sensitive to price-competitiveness developments with a close
to one-to-one impact of an increase in the real effective exchange rate (REER)
on exports in the long term. By contrast, German exports are only marginally
impacted by REER developments. While France and Germany experienced an
appreciation in their REER based on consumer prices of a similar magnitude
between 2000 and 2008, the negative impact on export performance was much more
pronounced in France. The relatively strong sensitivity of French export to
cost competitiveness is consistent with the findings by Sautard et al (2014)
that a significant share of French exports focuses on price-sensitive product
categories. Since 2000, export performance for these products has experienced a
slump which the increasing exports of quality-related products could not
offset. Still, econometrics studies indicate that the direct contribution of
price factors to export performance is significantly lower than that of
non-price related indicators. Estimates of the impact of cost developments on
export market shares, in particular through the real effective exchange rate,
show that price developments have only played a limited role in the
deterioration of the French trade performance (European Commission, 2011).([3]) Together, these findings confirm that improving France's export
performance requires a two-pronged policy strategy based both on efforts to
reduce costs and to promote non-cost competitiveness.

3.1.3.   Impact
on the international investment position

The net international investment
position (NIIP) which was still in surplus in 2006, has recorded an increasing
deficit since then. In 2012, the NIIP reached -21%
of GDP while the net external debt represented 35% of GDP. The NIIP, which
experienced a slump in 2008 due in particular to changes in valuation, has
further deteriorated since then due to the current account deficit. In terms of
composition, the net stock of foreign direct investments (FDI) 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 NIIP is financed by portfolio investments (Graph 3.3).

While the net FDI stock has been
relatively stable, inward FDIs, an indication of the attractiveness of France
for foreign investors, are decreasing. In 2012,
France ranked as the world's tenth largest direct investor in the rest of the
world and the 15th largest receiver of FDI.([4]) This position, which reflects the internationalisation of French
corporates, remains strong but it has deteriorated substantially compared to
2008, a year when France was the 7th largest receiver and the 4th
largest investor. Between 2008 and 2012, France's ability to attract investors
was outperformed in particular by some large developing economies such as
Brazil and India while, in the European Union, only the United Kingdom,
Ireland, Luxemburg, and Spain appeared more attractive in 2012. Banque de
France's monthly data on the balance of payments show that in 2013, inward FDI
decreased by 82% compared to 2012. However, this was more than compensated by
strong disinvestment abroad by French companies, bringing the net inflow of FDI
into positive territory. This turnaround compared to historical trend may weigh
on the NIIP.([5])

The stock of portfolio investment has
been increasingly negative, reflecting the increasing borrowing needs of the
French economy. In particular, since 2010, French
financial institutions have reduced their exposure to foreign markets both by
reducing their indebtedness vis-à-vis foreign sources and by selling foreign
securities. This has resulted in rising net claims, recorded in the investment
portfolio, together with a reduction in the foreign stock of "other
investments", which include cross-border loans. Claims vis-à-vis public
administrations represent the bulk of the flow in portfolio investment with the
purchase of public securities by foreign investors contributing for EUR 21.8
billion to the overall EUR 39.2 billion flow. In 2012, foreign investors held
for EUR 1 092 billion of the public debt, 62.2% of the total marketable
public debt. ([6])

While the current level of the NIIP does
not point to significant risks, the dynamics could become worrying as the
external debt burden could weigh on future growth.
Notwithstanding future potential valuation effects, stabilising its NIIP would
require France to cut its current account deficit to 0.7% of GDP, a level last
recorded in 2007. In order to halve the NIIP deficit by 2023, a current account
surplus of 0.4% of GDP would need to be maintained for the next 10 years. On
the contrary, if the pace of deterioration in the current account over the past
5 years (close to 0.2 pp. per year) was to persist, the NIIP deficit would
reach 40% in ten years, excluding valuation effects. All things being equal,
such an increase would mean that a larger share of domestic income is dedicated
to paying interests and dividends to foreign investors. In addition, this would
result in risks regarding the market perception of external debt, a large share
of which consists in claims on the government. The potential hike in interest
rates which could result from a change in the market perception of French debt
would deeply affect public finances, making it necessary to record significant
primary balances to cover an increasing interest burden. This could result in
either a sharp contraction in public expenditure or even further tax increases,
both with a recessionary impact. Moreover, if debt sustainability concerns were
to increase in such a scenario, asset depreciation as well as more general
financial contagion could hit France’s euro area peers.

3.2.      Interlinkages
with other euro area Member States and potential spillovers

3.2.1.   Trade
and financial linkages between France and the rest of the euro area

France accounts for around 22% of
overall euro area output, and is thus an important export destination for the
other euro area countries. As shown in Graph 3.4, France is the main export destination
for the large euro area countries such as Germany and Spain (exports to France
amount to roughly 4 and 5% of their respective GDP) or the second most
important for Italy (exports to France are approximately 3% of GDP). In Belgium
and Luxembourg, exports to France even account for roughly 17% of GDP.
Developments in the French domestic demand have strong spill-overs for euro
area partners and a sudden drop would result in a significant slowdown for the
area as a whole.

France exports large volumes of final
and intermediate goods and services to other euro area countries. In particular, French exports to Belgium and Luxembourg account for
over 12% of their respective GDP and in both cases France is their third most
important trade partner. French exports are also important for a number of
other euro area countries, including the large economies such as Spain, Germany
or Italy. In all of these countries' imports from France account for around 3%
of GDP and France is their second biggest source of imports.

France features very strong financial
linkages with other euro area countries and it plays an important financial
intermediation role in the euro area. This can be
seen from the geographical decomposition of the NIIP. The mildly negative
overall NIIP is hiding rather significant net positions with different groups
of countries, which points to its role as an intermediator of financial flows.
In 2010, France held sizeable net foreign assets in the euro area countries
which posted significant current account deficits before the onset of the
crisis, amounting to around 30% of GDP. These were mirrored by important net
liabilities to countries outside of the EU. A large share of these liabilities
was with the US and also foreign central banks, which held French government
bonds.

Throughout the crisis, France channelled
much needed capital to euro area peripheral countries. Before the financial crisis, France, which was already among the
important net originators of financial flows for deficit countries, became the
main source of financing once the crisis started and other investors withdrew.
These flows predominantly took the form of debt instruments. Following the
onset of the financial crisis, this exposure to the euro area periphery
translated into the important valuation losses recorded on the French foreign
portfolio.

Strong interlinkages exist between the
banking sectors in France and in other euro area countries. In 2012, claims on France represented close to 35% of GDP in the
Netherlands and in the United Kingdom and almost 20% in Germany and Belgium.
Regarding sovereign bond holdings in particular, 60 major non-French EU banks
held EUR 75 billion of French public debt as of June 2013.([7]) A hike in financing rates on French securities could trigger a
downward re-evaluation of asset prices which would have an important impact on
these economies. Such a shock would also impact on French banks both through
their holdings of French bonds and through the cost of capital. As French banks
hold close to 45% of the total foreign liabilities of Italy, 20% of those in
the Netherlands and Spain, and 10% in Germany, these potential difficulties
could lead French banks to deleverage rapidly, with a significant destabilising
impact on the external debt in other Member States.

3.2.2.   France's
imbalances and spillovers to the euro area

In the long term, failure to tackle
structural challenges in France can adversely affect not only the French
economy itself but also its euro area partners. So
far, the French trade deficits have contributed to increasing the aggregate
demand in the euro area, with limited negative spill-overs at this stage.
Through its current account deficit, France actually helped boost the sluggish
aggregate demand in the euro area. Indeed, most of the increase in the trade
deficit in the last few years is related to trade with other euro area
countries. Moreover, the French potential growth is expected to remain higher
than that in the euro area up to 2015. However, in the longer run, the
deteriorating external position could durably weigh on the French growth
performance. The relative distribution of trade losses among France's trade
partners associated with sluggish growth in France can be simulated based on a
simple input-output framework following the recent work on the World
Input-Output Database. Such an exercise takes into account the complex
inter-sectoral and inter-regional links, which are important to properly assess
the extent to which economic activity in one country spills over across
borders. On the other hand, this linear exercise fails to reflect the general
equilibrium effects and neglects other transmission channels for cross-border
spill-overs such as FDI or other financial flows or labour flows.

The negative spill-over effects on other
euro area countries of a deterioration in final demand in France are
significant. As can be seen from Graph 3.5, a 10% decline in French domestic demand
would result in exports decreasing by some 1.6% in Spain while Belgian and
Portuguese exports would decrease by 1.1% and 1.0% respectively. Other euro
area countries would also be affected although the magnitude of the impact
would be lower. For example Italian, German, Slovenian, Dutch and Slovak
exports to France would decrease by more than 0.5%. The overall effect for the
euro area would be a reduction of total exports by 0.8%. The impacts on non-EU
countries are more modest.

Conversely, the benefits of policies to
increase potential growth would benefit France itself and would also have
direct and indirect effects on the rest of the euro area. Simulations based on the Commission's QUEST III model show that
measures to bring France closer to best practices in the euro area on a number
of policy areas (including market competition and regulation, Research and
development (R&D), taxes, labour market and education) would result in a
substantial boost to GDP growth (European Commission, 2013a). Such reforms
would also have tangible positive spill-overs on other euro area countries.([8]) In general spill-overs of supply shocks are more muted than those
of demand shocks as, in the former case, the impact on trade partners of an
increase in domestic income is gradually offset by competitiveness effects.
More precisely, spill-overs are higher in the short run as structural reforms
would increase domestic demand in France, and hence imports. In the longer
term, increased income in the partner economies would stimulate higher imports
and reduce the positive impact on partners' trade balance. In addition, the
supply side reforms would lead to a decrease in relative costs and prices in
France, which would boost its competitiveness and also induce some expenditure
switching towards domestic production. Last, the improved returns on
investments linked to higher competitiveness would increase capital inflows to
France, including from outside of the euro area, exerting upward pressure on
the euro. This could have an additional, albeit limited, dampening impact on
the other euro area members. Countries that would benefit most from reforms in
France in the first two years would include Portugal, Spain, Slovakia or
Greece. Over the longer term, the spill-overs would weaken considerably but
remain broadly positive (European Commission, 2013a).

3.3.      Developments
in the cost of labour in France and their consequences for competitiveness

While non-cost factors play a major role in
France's poor export performance (see section 3.1.2), the price sensitivity of
French exports suggests that efforts to regain competitiveness require
improvements in cost factors. In particular, the cost of labour, which is
higher in France than in most other economies in the euro area could be an
impediment for exporters. Accordingly, this section will review the development
in the cost of labour in relation to productivity and discuss its drivers. In
particular, the institutional setting guiding wage dynamics will be reviewed in
order to assess whether it entails rigidities which may impact on wage dynamics
and competitiveness.

3.3.1.   Cost
of labour

France is among the euro areas economies
where the hourly cost of labour is the highest. In
the industrial sector, the hourly cost of labour stands at EUR 32.60 per hour
(see Graph 3.6), second only to Belgium in the euro
area and EUR 5.6 above the average. With a cost of labour of
EUR 31.80 per hour in services (see Graph 3.7), France is even further away from the
average in the euro area (EUR 25.5 per hour) in this sector. Moreover, hourly
labour costs experienced strong increases over the last 10 years. Between 2000
and 2008, the hourly labour cost in the industrial sector rose by EUR 9.20
per hour, the second largest increase in the euro area after Ireland. In
services, the hourly cost of labour also increased (by EUR 6.60 per hour)
although to a lesser extent. These developments contrast with the moderate
growth observed for example in Germany and Austria.

While the hourly cost of labour
increased at a relatively rapid pace in France, so did productivity. As a consequence, over the last 20 years, the growth in nominal
unit labour costs (ULC) has not significantly outpaced developments in other
European economies (Graph 3.8). Three periods can be differentiated in
the French nominal ULC growth historical trend. Up to 2000, ULC growth was more
moderate in France than in most other larger euro area economies except
Germany. Between 2000 and 2008, nominal ULC accelerated significantly growing
by 2.0% per annum on average. Since 2008, the sluggish inflation and the rise
in unemployment have resulted in moderate nominal wage dynamics and in a
relative slowdown in nominal ULC developments. While ULC developments in France
are mostly in line with those observed in the euro area as a whole, they stand
in stark contrast with developments in Germany and Austria. In particular, over
2000-2008, wage moderation in Germany resulted in negative ULC growth (and
below 1% in Austria). The difference between ULC 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 17% of the French ULC.

Nominal unit labour costs in France
experienced contrasted developments in the tradable and non-tradable sectors. Indeed, between 2000 and 2012, unit labour costs increased by 35%
in the non-tradable sector and by only 17% in the tradable sector. While
employees' compensation in the tradable and the non-tradable sectors increased
at similar paces (2.6% and 2.7% p.a. respectively between 2000 and 2012),
productivity in the non-tradable sector increased at a much slower pace than in
the tradable sector. Indeed, the gap in unit labour costs between France and
Germany appears to result from significantly higher wage inflation in France,
both in the tradable and non-tradable sectors, despite somehow similar productivity
developments in the two countries. Conversely, in Italy, poor productivity
developments, in particular in the tradable sector, are the main contributor to
the faster ULC growth (Graph 3.9).

The diverging developments in the cost
of labour and export prices suggest increasing constraints on exporters'
margins. While developments in the cost of labour
appear to be in line with productivity and are comparable to developments in
other euro area economies, France has experienced an increasing gap between the
real effective exchange rate based on ULC and based on export prices (compared
to IC 37). Indeed, between 2000 and 2012, the REER based on ULC increased by
12.1%, a sign that unit labour costs increased slightly faster in France than
in other industrial countries. In comparison, export prices remained steady,
decreasing by 1.7% between 2000 and 2012 (Graph 3.10). While the change in relative cost and
price competitiveness could result from a change in the export product mix and
from a change in the structure of employment, it still suggests that exporters
have increasing difficulties to pass through domestic cost increases to
customers. This would result in a decreasing profitability of French companies
with a negative impact on growth and competitiveness. Such difficulties are not
specific to France. However, in other economies, the gap appears much smaller
and in some cases, such as Spain and the UK, it has much decreased since 2008.
In Germany, the wage moderation in most of the 2000s has led to an improvement
in the relative prices compared to the relative unit labour costs which is
currently fading out.

3.3.2.   Development
in wages

While nominal wages are mainly what
matters for international competitiveness purposes, equilibrium on the domestic
labour market rather depends on developments in real wages. In a competitive setting, these are driven by productivity with a
significant deviation from this yardstick indicating an increasing wage share,
to the detriment of profitability. In France, the wage share for the total
economy decreased strongly between 1981 and 1989 mainly due to strong increases
in productivity (+3.0% on average over the period) not matched by real wage
increases. Since then, the wage share for the total economy has been on a
slightly downward trend, from 68% of GDP in 1990 to 66% in 2008 before
returning to 68% in 2012, suggesting that labour hoarding occurred during the
crisis. Since 2008, the lower price inflation has only partially passed through
to nominal wages, resulting in an uptick in the wage share in the last 4 years.

Wage equations for France suggest that,
except in the early 2000s and in the aftermath of the crisis, wage increases
over the last 10 years do not diverge from fundamentals. In order to estimate the contribution of the various drivers of
wages to developments in the last few years, a wage equation, based on a
wage-setting model, is estimated. The wage level depends on (expected)
inflation, the level of unemployment and productivity. Moreover, the
wage-setting framework suggests that, beyond short-term dynamics, real wages
converge towards a long-term equilibrium (see for example Bardaji et al, 2010).
Such a model for real wages (see Box 3.1) suggests that developments in real
wages are mostly accounted for by traditional drivers. Over the last 10 years,
the period which saw France's loss of market shares accelerate, two episodes of
wage growth above what fundamental drivers would suggest can be seen: in 2000
as an aftermath of the reduction in working hours, and in 2009 as downward
rigidities limited the adjustment of real wages to the fall in productivity
(see Graph 3.11). This latter finding is common to
several EU economies (ECB, 2009).

However, the actual wage level seems
above the level suggested by fundamentals. A
cross-country assessment of the determinants of the wage level, in purchasing
power standards, reveals that average wages are about 10% higher than the level
consistent with the underlying fundamentals (European Commission, 2013b).
Indeed, based on the level of productivity, unemployment and education, a wage
benchmark for European economies can be built. The difference between nominal
compensation per employee and this wage benchmark in France has increased
between 2009 and 2011. These findings suggest that wages have been overvalued
in France and that, due to the absence of wage moderation, no adjustment has
taken place yet. This is consistent with the observation that, while
developments in the wage share suggest that significant wage moderation took
place in the 1980s, developments have remained muted since then. By comparison,
in a number of euro area economies, a significant decrease in the wage share
continued to be observed throughout most of the 1990s. At 68% of GDP in 2012,
the wage share in France is higher than that in Germany, Italy and Spain (65%,
64% and 60% respectively).

3.3.3.   Tax
burden on labour

The high level of social contributions
in France contributes to the relatively high cost of labour. Indeed, while the wage negotiation focuses on gross wages, the high
level of social security contributions in France also weighs on the cost of
labour. In France, employers' social security contributions represented 27% of
compensation paid to employees in 2012, among the largest shares in the EU (see
Graph 3.12). The weight of employers' social
security contributions decreased from 27.5% in 1990 to 26.2% in 2008 as a
result of the increasing weight of social contribution exemptions on lower
wages. Since then, the rate of employer's social contributions has gone up by
0.7 pp.

The tax wedge, which measures the gap
between the cost of labour for employers and the revenues for workers, is
higher in France than in most other EU economies.
In France, the tax wedge on labour reaches 54% of the labour costs for workers
paid 1.67 times the average wage, one of the highest ratios in the EU (see
Graph 3.13). At the average wage, it still
represents 50% of the labour cost. However, as a result of the exemptions and
of various schemes to reduce income tax for the least paid workers it
represents a much more moderate 36% of labour costs for workers paid half the
average wage. With the implementation of the tax rebate on competitiveness and
employment (CICE), which will reduce employers' contributions by 6% of gross
wages for workers paid less than 2.5 times the minimum wage from 2014 on, the
tax wedge at 50% of the average wage will further decrease to close to 30%,
bringing it below the tax wedge for Spain.

3.3.4.   Wage
bargaining system

Besides the traditional drivers of wages
developments, institutional factors can have a strong impact on wage dynamics. Indeed, the adjustment of wages to the evolution of fundamentals
very much depends on the wage bargaining process. The wage bargaining in France
is characterized by the importance of industry level agreements. Three main
groups of countries can be distinguished in the European Union (See ECB, 2008).
In some countries, including Belgium, Finland and Greece, wages are
predominantly determined at the central level. At the other end of the spectrum
the UK and Czech Republic for example have largely deregulated and
decentralised wage bargaining systems. France belongs to an intermediary group,
which comprises most EU Member States, where wages are determined by the
interaction of industry-wide agreements and company-level negotiations.

Compared to other countries, France is
characterized by the relatively stronger role played by the industry-wide
agreements. Indeed, branch agreements in France
apply to unionised and non-unionised workers and extension mechanisms, which
make the agreement reached by social partners within a branch compulsory for
all workers in that branch upon a decision by the Ministry of Labour, are
widespread. Moreover, the Ministry can take the decision to "extend"
the agreement beyond its initial domain. In large companies, which generally
set specific company-level agreement, the negotiated wages are much higher than
the ones resulting from the branch agreement. Actual wages are therefore less
impacted by changes in the wage floors than in smaller companies. Similarly,
branch agreements have a much stronger impact for blue-collar workers than for
managers as wages for the latter are often negotiated on an individual basis.
For workers, a 1% increase in the branch level agreement is associated with a
0.8% increase in the actual wage perceived (André, 2012b). Accordingly, the
importance of industry-wide agreements on wages has contributed to limiting the
ability of firms to negotiate downward wage adjustment throughout the crisis
(Askenazy et al, 2013).

Recent reforms have created only limited
flexibility for employers to depart from sectorial agreements. A number of countries in the European Union, notably Germany and,
more recently, Spain, have introduced opening clauses which give a more prominent
role to company-level agreement. In France, the 2004 Fillon law created general
mechanisms providing for derogations on collectively agreed wages. Until then,
a collective agreement at company level could only improve the employees'
rights: the so-called "favourability principle". 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 (Ramos-Martin, 2011). The
recent law on securing employment (loi de maintien de l'emploi) for
companies experiencing economic difficulties now provides for reductions in
wage levels but under specific conditions. In particular, wage reductions
cannot apply for workers earning less than 1.2 times the minimum wage, which
may reduce the effectiveness of these derogation clauses (see Box 3.2).

3.3.5.   Minimum
wage

The minimum wage in France, which is a
key component of the wage setting, is among the highest in the EU. Among the 21 Member States with statutory minimum wages, France is
among the ones with the highest minimum wage both in nominal and relative
terms. In 2013, the gross minimum wage in France stood at EUR 9.43 per hour and
EUR 1,430.22 per month, the fifth highest nominal level in the euro area
following Ireland, the Netherlands, Belgium and Luxembourg. Based on purchasing
power parity, the minimum wage in France offers the second highest living
standards in the EU. Such a high level has various impacts on the situation of
the labour market and, on a wider perspective, on social outcomes. Relative to
the national median wage, the minimum wage in France is the highest in Europe
having risen to more than 60% of the median wage in 2012.

Developments in the French minimum wage
are guided by an automatic indexation mechanism which can be complemented by
discretionary hikes decided by the government.
Annual automatic indexations of the minimum wage take place every year on
January 1st; automatic increases may also take place during the year
if price inflation exceeds 2% since the previous revision. The revaluation is
based on inflation of the consumer price index plus half of the increase in the
purchasing power of hourly average wages for workers and employees. In theory,
the strict implementation of the indexation formula would gradually lead to a
gap between the minimum wage and the average. However, the government can
decide on discretionary increases of the minimum wage beyond the required
automatic increases. Since 1990, these hikes have pushed the minimum wage close
to 20% beyond the level prompted by the automatic revaluation. In order to
better take into account the impact of potential discretionary increases, a
group of economic experts on the minimum wage was established in 2009. Since
its inception, this working group has consistently advocated limiting hikes to
the legal requirement.

The minimum wage in France is also
characterized by a high degree of uniformity. Very
few exceptions exist to the minimum wage in France. Firms can reduce the level
of the minimum wage by 20% for workers under 17 and by 10% for employees
between 17 and 18. Reduced rates also apply for apprenticeships and
professionalization contracts. However, while some Member States such as
Ireland, the United Kingdom and the Netherlands have set up differentiated rates
for specific categories, no general exception exists in France besides those
relatively limited cases.

Increases in the minimum wage have a
detrimental impact on employment. In spite of
significant social contribution reductions, France has one of the highest costs
of labour at the minimum wage level in Europe (OECD, 2013a). In this sense,
increases in the minimum wage can have a significant impact on the level of
structural unemployment. Econometric evidence suggests that a 1% increase in
the French minimum wage leads to a reduction in employment at the minimum wage
of 1.5% (Kramarz and Philippon, 2001). As 12.3% of employees are directly
affected by increases in the minimum wage, the impact on overall employment is
significant.

3.3.6.   Impact
on the wage distribution

Developments in the minimum wage impact
the overall wage growth. Sensitivity analysis shows
that a 1% increase in the minimum wage translates in the next few quarters into
a 0.4% increase in wages between 1 and 1.1 times the minimum wage and into a
0.1% increase for wages between 1.4 and 1.5 times the minimum wage (Koubi and
Lhommeau, 2007). In the longer run, a 1% hike in the minimum wage appears to
have one-to-one effect on wages between 1 and 1.1 times the minimum wage, an
impact which gradually decreases for higher wages down to a 0.5% impact for
wages between 1.4 and 1.5 times the minimum (Cette et al, 2012, also see Goaran
and Muller, 2011). The impact of minimum wage increases on the overall wage
level suggests that circularity exists between the minimum wage and the
benchmark used to compute the legal revaluation (Cette et al 2012). As a
consequence of this circularity, discretionary hikes can result in an upward
spiral of the minimum wage with potential inflationary impact on the average
wage (Cette and Wasmer, 2010).

Past increases in the minimum wage,
together with exemptions from social security contributions on lower wages,
have resulted in a distortion of the wage structure. The high level of the French minimum wage means that, in the lower
band of the wage distribution, employers have limited scope to adjust wages in
line with productivity. In addition, exemptions from social security
contributions, which represent up to 26% of the cost of labour at the minimum
wage level and decrease gradually up to 1.6 times the minimum wage, contribute
to increasing the marginal costs of increasing wages. In 2012, 10.4 million
workers benefitted from these exemptions, close to 40% of the labour force.
Between 2002 and 2006, a period when the minimum wage increased rapidly, the
gap between the median wage and the lowest decile narrowed significantly. As a
result, the overall cost of social security contribution exemptions for low
wages soared (Ourliac and Nouveau, 2012). Since 2006, despite the ending of
discretionary hikes in the minimum wage,([9]) the gap between the lowest decile of the wage distribution and the
median wage has not significantly widened.

Such a development may have had a
detrimental impact on the incentives for employees to increase their
productivity and to invest in human capital.
Employees with an upper secondary education are paid 18% more than workers with
only primary or pre-primary education. As can be seen in Graph 3.14, such a premium seems rather low in a
European perspective. Indeed, although the unemployment rate of people with
only primary education is much higher (16.6% in 2012 compared to 9.9% for
people with secondary education), the premium that one can expect from
completing upper secondary education in France is close to the one in Spain
(19%) and much below the ones in Italy (34%) and in the euro area as a whole
(34%). ([10]) Preliminary
findings of the PIAAC survey (OECD, 2013b) also show that the increase in wages
with skills is weaker in France than in the average OECD economy. Lower returns
to skills may have contributed to the low adult participation in life-long
learning. In the long term, a compression of the wage distribution could result
in a distortion of the skill structure towards less qualified jobs with a
detrimental impact on productivity. This may have contributed in particular to
the significantly higher share of workers with a low level of skills in France
(22.7% in 2012) compared to Germany (14.0%). There are risks that the limited
incentives to increase skills in France may result in a long-term skill deficit
and contribute to the deterioration in non-cost competitiveness. In addition,
the sizeable reduction in social security contributions on low wages means that
sectors which employ a large share of low-skilled workers benefit from a
comparatively lower tax burden on labour (Graph 3.15). For example, in the accommodation and
the construction sectors, social security contributions represent respectively
17% and 21% of compensations while in the industrial sector, whose export
potential is significantly higher, they amount to 28% of total compensations.
Similarly, the CICE, which seeks to further reduce the cost of labour for
workers paid less than 2.5 times the minimum wage does not primarily support
exporting companies (see Box 3.3). In the long term, such discrepancies
may impact on the industrial structure.

3.3.7.   Impact
on social indicators and poverty

The high level of the minimum wage
contributes to limiting inequalities in France. At
60% of the median wage, the level of the minimum wage effectively reduces the
dispersion of wages at the lower end of the distribution. Accordingly, the
income for the last quintile of the wage distribution represents 4.5 times the
income of the first quintile, compared to 5.1 in the euro area.([11]) In the first quintile of the wage distribution, 75% of people are
at risk of poverty, compared to 86.2% in the euro area as a whole.

The social and fiscal redistribution
system also has a strong impact on poverty reduction. Taking into account social transfers and taxation reduce the Gini
coefficient, which measures the degree of inequality in the distribution of
earnings, by 20 pps. in France (compared to 18 pps. and 17 pps.
in Italy and Spain respectively and 21 pps. in Germany). In particular,
the existing tax exemptions and income subsidies for workers earning low wages,
in particular the active social revenue (Revenu de solidarité active) and
employment bonus (Prime pour l'emploi), partly compensate for wage
inequalities. These two schemes contribute to increasing the living standards
of workers paid the minimum wage by 6% on average while, for the other workers,
taxes and social contributions reduce earnings by 5% (Rapport d'experts sur le
SMIC, 2013).

The increase in in-work poverty shows
that, despite measures to support earnings, the situation of employees on the
French labour market is increasingly difficult.
While 6.5% of French employees earned less than 60% of the median revenues in
2008, this share has increased to 8% in 2012. While the overall level remains
lower than the euro area average (8.9%), it increased at a faster rate. In-work
poverty is often linked to the large share of part-time employment within the
lowest deciles of revenues. Only about half of the workers earning the minimum
wage are actually working full time (Rapport d'experts sur le SMIC, 2013). For
a single worker working half a full-time, net wages represent only 57% of total
income, compared to 94% for a single worker working full-time. For workers with
part-time jobs paid close to the minimum wage, wage increases reduce social transfers
as those are based on revenues. Altogether, the impact of wage increases and of
hikes in the minimum wage on actual earnings is marginal for this category of
workers (Rapport d'experts sur le SMIC, 2013).

3.4.      Non-cost
competitiveness: Low profitability and non-cost factors

Although French exports are sensitive to
cost factors, non-cost factors are the main driver behind the deterioration of
the French export performance since 2000 (see section 3.1.2). Non-cost
competitiveness is manifold and encompasses a variety of micro-economic factors
such as product quality, innovation, design, after-sale service and
distribution networks. In France, the ability of companies to perform well on
these aspects is hampered by their low profitability. Furthermore, the
relatively unfriendly business environment together with the lack of innovation
in the private sector may be additional obstacles to the non-price
competitiveness of French firms.

3.4.1.   The
low profitability French firms

The profit margins of French
non-financial companies reached a trough of 28% of value added in 2012, a lower
level than what they had registered in 2009. This
trough is particularly worrying when compared to the situation in other EU
countries. As shown in Graph 3.16, French firms are the least profitable
in the EU (37% for the EU average), and in particular are far less profitable
than their German counterparts (40%). This situation may be linked in
particular to the high cost of labour which, although it has increased at par
with most other economies in the euro area, has constrained the profit margins
of French companies in a context of decreasing export prices.

Weak profitability may have contributed
to the low investment and to the deterioration in the price competitiveness of
French companies. After a short-lived pick-up in
2010, equipment investment decelerated and has kept on decreasing since 2012
and remains 9% below its pre-crisis level. Apart from expected demand, profit
margins as well as financing conditions are significant explanatory factors for
investment (Herbet, 2001). Indeed, in the case of France, low profitability has
contributed to the poor confidence of entrepreneurs, who have in turn focused
on the short-term restoration of their financial situation through cost
controls, to the detriment of their investments in equipment (Graph 3.17). Conversely, developments in Germany
in the 2000s illustrate how improving profit margins can contribute to
fostering investment and innovation in the long term (COE-Rexecode, 2011). The
reduction in production costs in Germany through wage moderation, both in the
industry and intermediary services, as well as off-shoring practices have
durably restored profit margins from 2000. This may have strengthened
entrepreneurs' expectations, which have translated into a recovery in business
investment from 2005 and in improvements in competitiveness. In France, the tax
rebate on competitiveness and employment adopted in December 2012 (see Box 3.3) goes in the right direction. The amount
of the tax credit represents close to 7% of the gross value added of
non-financial corporations. In that respect, even if the full amount was used
to increase the profitability of firms, it would not be sufficient to bridge
the profitability gap compared to the EU average. Furthermore, this measure
only offsets part of the corporate tax increases since 2010. Furthermore, it
seems poorly targeted to the manufacturing sector. While an indirect impact on
the industry through a price reduction in services could be expected, the
magnitude of this effect remains uncertain due to the low level of competition
in many services.

3.4.2.   A
lack of medium-sized companies and the decreasing technology intensity

A particular structural feature of
French firms is the lack of medium-sized companies.
In 2012, the average French firm employed 5.8 people, compared to 6.4 in the EU
and 12.2 in Germany (Graph 3.18). In the same year, medium-sized
enterprises, i.e. employing between 50 and 250 employees, represented 0.9% of
all French companies, against 1.1% in the EU and 2.6% in Germany. In
particular, in the manufacturing sector, which accounts for the largest share
of total export turnover, medium-sized companies account for only 3.8% of all
companies, compared to 8.2% in Germany.

The French industrial firms may find
themselves handicapped when exporting, due to their relatively small size, as
engaging in export activities entails significant fixed costs. These costs are diverse and include for example the cost of
establishing a representative office, administrative burden or logistic costs.
Therefore, small firms will find it particularly difficult to export to distant
regions where most dynamic markets lie. A recent study from the French Customs
(2013) highlighted that the medium-sized firms represented 4% of exporters in
2012, but achieved 33% of the value of exports, while the 96% smaller exporting
companies only achieved 23% of exports. Large companies, which only represent a
marginal share of the total number of firms, account for the remaining 44% of
exports. Furthermore, 10% of their exports go to emerging countries, against
only 7% for smaller SMEs. Moreover, several studies based on microeconomic data
suggest a strong correlation between firm size and export performance.
Altomonte, Aquilante and Ottaviano (2012) show that firms need to reach a
minimum performance threshold, i.e. a minimum size of activity, in order to
achieve internationalisation. In the case of France, Ceci and Valeirsteinas
(2006) empirically established at around 100 employees the critical size for a
firm to start exporting to distant emerging countries. In addition, their
smaller size might be a hampering factor for innovation which is not simply
related to R&D but also to other expenditures on intangibles, such as
training, design or marketing. Indeed, larger companies benefit from a better
access to finance, better internal resources, economies of scale and higher returns
on R&D expenditures (Ciriaci and Hervas, 2013).

The crisis seems to have particularly
hit French medium-high technology sectors. Before
2008, in France, like in most OECD countries, the technology intensity of
production was on an upward trend. The share of manufacturing value added in
high and medium-high technology sectors([12]) rose from 40% to 46% between 1999 and 2007. However, it fell again
to 41% in 2010, while it continued increasing in Germany, Italy and Spain, i.e.
France's main competitors (Graph 3.19). This weakness is mainly due to the
decreasing weight of medium technology sectors. On the contrary, high
technology sectors, in particular the aeronautical and pharmaceutical sectors,
have remained relatively resilient. This trend suggests that there is a risk
that the technology intensity of French goods may decrease, with a negative
impact on the ability of French firms to compete on products which are less
sensitive to price developments.

3.4.3.   An
unfriendly business environment

The relatively unfriendly business
environment may weigh on firms' growth potential. The global ranking of France in a number of international business
environment surveys has deteriorated. In particular, the 2013 World Economic
Forum (WEF) puts France at the 23rd rank compared to 21st last year and 18th
the year before. In particular, France's relative position has deteriorated on
the perceived efficiency of the labour market, with the survey highlighting the
rigidities of the rules on firing and hiring, a criterion on which France is
ranked 144th out of 148 countries. The low quality of labour-employer relations
(135th), a tax regime which is perceived as highly distortive to
decisions to work (127th), and the burden of government regulation
(130th) are also pointed out as the most problematic factors for
doing business in France (Graph 3.20). This relatively unfriendly
environment may have contributed to the 82% fall of FDI recorded in 2013 in a
context of increasing global investment.

In particular, insufficient competition
in some product and service markets increases prices and hampers the reallocation
of resources to the best performing firms. Business
services are indeed an essential input for the industrial sector and represent
an important share of production costs. Market services represent 25% of the
cost of production in the manufacturing sector. High wages in services
therefore affect all sectors, through the interplay of intermediary
consumption. As a consequence, the 26% increase in unit labour costs in the
service sector in France over the last decade has put pressure on the
profitability of manufacturing companies, hence negatively affecting the
competitiveness of the whole economy. Furthermore, the lack of competition in
services which hampers services’ productivity impact manufacturing productivity
and ability to innovate, as competition in services may generate spillovers and
create incentives to innovate in the manufacturing sector (Ciriaci, Montresor
and Palma, 2013). Conversely, increasing competition and removing barriers in
product markets can be expected to result in a substantial increase in output
(Roeger, Varga and In't Veld, 2008). According to Bouis and Duval (2011)
improving the regulation of product markets would enable France to increase
total factor productivity in the next ten years by more than 3%. Although
competition in services has become stronger, in particular as a result of the
implementation of the Services directive, a number of sheltered sectors remain
(including the retail sector, network industries such as transport or energy
but also some regulated sectors). A strengthening of competition in these
sheltered markets could contribute to lowering the cost of these services,
hence indirectly improving the competitiveness of the French economy.

In particular, several regulations are
associated with specific size thresholds that may hamper the growth of French
firms and play a role in the difficulties of SMEs to reach the size that would
allow them to export, as well as to innovate. These
size thresholds either stem from the labour code or from accounting rules (see
Box 3.4). The exact impact of these
administrative discontinuities on the demography of French companies is
difficult to assess, as the available corporate databases (fiscal, social or
statistical) are not always fully consistent. However, the "10
employees" threshold and above all that of "50 employees" can be
considered as significant. Indeed, using firms' fiscal database, Ceci and
Chevalier (2010) highlighted that the number of firms with "10
employees" was 48% lower than that of "9 employees" firms, and,
similarly, the number of firms with "50 employees" was 58% lower than
that of companies with "49 employees". They also assessed the effects
of administrative thresholds on firms' growth and on the long-term corporate
distribution as statistically significant. Furthermore, according to the
INSEE's SIRENE corporate directory, there are 24% fewer firms of
"50-54" employees than companies of "45-49" employees
(Graph 3.21). The accumulation of regulations at
the "50 employees" threshold, in particular the obligation to
establish a works council, seems to make it particularly difficult for firms to
cross this threshold.

Most likely as a consequence of these
difficulties to grow, French SMEs, in particular the most dynamic ones tend to
be prematurely absorbed by larger groups, resulting in a loss of dynamism
especially if their creators leave them. Nefussi
(2007) pointed to the high share of French SMEs yearly absorbed by a group. On
average a French SME is absorbed by a group six years after its creation (Table
3.1). The absorbed SMEs tend to be growing
faster and to have a higher technological level, before being sold (Graphs 3.22 and 3.23). As pointed out by Artus (2011), these
early absorptions may not only stem from the willingness of large groups to
acquire the new technologies developed by innovative SMEs, but also by the
increasing difficulties met by entrepreneurs as their firms become larger,
which encourage them to sell their own enterprise. In the end, these early
absorptions may dampen the particular dynamism of these innovative SMEs, as the
managing teams are changed and the drive stemming from their independent status
may be reduced.

The authorities have implemented some
limited reforms to improve the business environment, but further action needs
to be taken. The Warrsmann report (2011) pointed to
the need of business simplification and a "shock" of simplification
was announced in July 2013. While still in the implementation phase, the
simplification initiative has translated into a law of administrative
simplification and the announcement of the revision of the complex labour
regulation and taxation system, composed of not less than 153 different taxes
on businesses, need to be undertaken.

3.4.4.   A
lack of Innovation

R&D intensity is lower in France
than in innovation leaders in the EU such as Germany or the Scandinavian
countries, mainly due to weak corporate R&D.
France does not appear to invest enough in R&D activities. With R&D
spending accounting for 2.2% of GDP in 2011 (Graph 3.24), France's R&D intensity is well
below that of Germany (2.9%), the Scandinavian countries (3.4% in Sweden, 3.8%
in Finland and 3.1% in Denmark), the United States (2.8%) and Japan (3.4%). The
gap between its main partners is entirely linked to low R&D in the private
sector. Indeed, while the level of public R&D spending in France amounts to
0.8% of GDP, as much as in Germany and slightly above the OECD average,
private-sector spending only accounts for 1.4% of GDP, compared with 1.9% in
Germany and 2.6% in the OECD. Furthermore, it has remained flat since 1994,
while the OECD average rose slightly (by 0.3 pp. of GDP). This average
performance of French firms in terms of R&D spending is linked to the
declining share within the whole economy of the industrial sectors the most
likely to invest in R&D. These sectors do not seem to find an environment
suitable for their development. In the medium term, the lack of private R&D
could compromise the future position of France among the knowledge-based
economies.

The low level of business R&D may
stem from some reluctance of firms to hire researchers, as well as from the
lack of medium-sized companies. Researchers account
for only a small share of industrial employment in France compared with
countries where firms spend heavily on research. There are 7.6 researchers per
1 000 jobs in industry in France, compared to 13.1 in Finland, 12.4 in
Denmark, 10.5 in the United-States and 9.3 in Japan (Graph 3.25). The limited number of researchers in
the private sector may be partly explained by the relatively small size of
companies, as large industrial corporations generally account for the vast
majority of private-sector R&D. In the case of France, large companies in
car manufacturing, pharmaceuticals and the aerospace sectors represent 37% of
overall private R&D spending according to the Ministry of Research. In
order to stimulate private research, the authorities have implemented a
research tax credit (see Box 3.5). This measure may have contributed to
support corporate investments in R&D, but at a significant cost of
EUR 4 bn. Its efficiency needs therefore to be further evaluated to
ensure that the substantial resources dedicated actually translate into
stronger innovation activity.

Beyond R&D spending, innovation
remains low in France. The European Commission's
report on innovation output in Europe (2013c) places French innovation as
'average'. France ranks 10th for innovation output, behind its main
European competitors such as Germany, Sweden and the United Kingdom. The number
of triadic patents([13]) in France
is 59% below that in Germany, 84% below the United States and 85% below Japan.
Again, the weakness in innovation may stem from the relatively small size of
firms. As Cohen and Levinthal (1990) pointed out, the "absorptive
capacity" of firms, i.e. their incentives to embark on innovative projects
depends to a large extent on their ability to exploit the knowledge produced by
their competitors or by publicly-funded research centres. French firms seem to
face some particular difficulties in absorbing the knowledge available, which
can be linked not only to their relatively small size and the low share of
researchers among their staff, but also to an environment that insufficiently
enables the diffusion of innovation (Ciriaci, 2011). The European Commission's
2013 innovation competitiveness report (2013e) recommends to focus on framework
conditions in order to elicit the creation of innovation-driven clusters,
similar to the Silicon Valley in the US, that may generate high-growth
innovative enterprises. In addition, as innovation is increasingly based on
comprehensive solutions that integrate manufacturing and services, the
development of high-tech knowledge-intensive services is a key factor of
international competitiveness. Cluster policies need to encourage such
integrated approaches as well as partnerships between public and private
sectors. In France, competitiveness poles (see Box 3.6) have effectively supported R&D
spending but have generally failed to generate strong network dynamics. By
comparison with the 2006 German "high-tech strategy", which focuses
on fewer clusters and thematics, the large number of poles may reduce network
and scale effects. Therefore, the French clusters could be efficiently
reorganised and further efforts could be made to support the emergence of
"geographic concentrations of interconnected companies, specialized
suppliers, service providers, and associated institutions" (Porter, 1998)
with an enhanced positive impact on the diffusion of innovation and
productivity.

3.5.      Public
and private indebtedness

The level of consolidated private debt,
which was above the threshold of 133% of GDP in 2011, continued rising to reach
140.7% of GDP in 2012. While a number of economies
in the EU have experienced significant deleveraging since 2009, private
indebtedness in France has continued to grow at a relatively rapid pace
throughout the crisis.

3.5.1.   Stability
of the banking sector

The French banking sector is very
concentrated on a few large, and well capitalised, institutions. Large banks in France hold 98% of the total assets compared to 74%
in the EU and 67% in the euro area. The four largest French banking
institutions are considered of global systemic importance by the Financial
Stability Board. Overall, French banks appear more profitable than their
counterparts in the euro area, with a return on assets which amounted to 6.8%
in 2013, a slight decrease compared to 2012, compared to 1.8% on average in the
euro area. With an average solvency ratio of 14.7% and their Tier 1 ratio of
12.6%, the capitalisation of French banks appears in line with that of their
euro area counterparts (15.0% solvency ratio and 12.6% Tier 1 capital ratio).
Their loan portfolio appears also slightly less risky, with non-performing
loans representing 4.5% of the total portfolio in June 2013 compared to 5.4% in
the euro area. This ratio has increased in the last two years as a consequence
of the rather sluggish growth but remain below its 2009 level.

The main weaknesses of the French banks
are their dependence on wholesale funding as well as their international
exposure. Credit represented 144% of total deposit
in June 2013. While part of the difference with the euro area originates from
the weight of life-insurance and off-balance sheet savings instruments, French
banks depend significantly on market-resource for refinancing. Such dependence
can prove a weakness when inter-bank markets experience difficulties. Starting
in 2011, French banks engaged in significant deleveraging in order to reduce
their loans-to-deposit ratio. Although cyclical conditions, which are marked by
a low demand for credit from both companies and households and by high levels
of precautionary savings, contributed to the reduction in loans-to-deposit
ratio, structural measures were also adopted. More emphasis was put on
developing the domestic retail banking activities and credit activities in USD
were reduced. While they remain significantly exposed to sovereign debt of
peripheral economies, and in particular from Italy, French banks have also
significantly reduced activities. The overall exposure of the 6 largest banks
to Spain, Greece, Ireland, Italy and Portugal decreased from close to EUR 70
billion in 2010 to little over EUR 30 billion in 2012. While such an effort
weighted on profitability, it contributed to the reduction in the yield of
credit-default-swap on French banks bonds, an indicator of the perceived
riskiness of the underlying securities.

While further efforts are granted due to
regulatory changes, French banks seem able to adapt. So far, French banks have performed well in the various stress test
exercises. Recapitalisation needs of the French banks involved in the exercises
organised by the European Banking Authorities have generally been modest.
However, the changing regulatory environment has prompted measures to
strengthen balance sheets. In particular, French banks have confirmed their
forecast that they would be able to reach a common equity tier 1 ratio of 9% by
the end of 2013, as computed according to the upcoming European methodology
(CRD 4). The recent law adopted in France to insulate the most risky activities
from the main business of the banks has so far had limited impact on their
profitability and on their capital structure.

3.5.2.   Household
financial situation

The indebtedness of French households
has continued to rise in 2012 although the pace has slowed down significantly
since 2010. Household debt represented 56.7% of GDP
in 2012, a ratio which has increased by 2.7 pps. since 2009. By contrast,
household debt in the euro area, which represented a significantly higher 63.9%
of GDP in 2012, has reached a peak in 2009 and has started to decrease since
then. Comparing the level of debt with gross disposable income, a measure of
the affordability of household debt, yields similar results, with French
household leverage on the rise but still below the euro area average. In
particular, in 2012, although credit growth slowed down, so did gross
disposable income, notably as a consequence of the tensions on the labour
market.

Despite the increase in the debt level
over the last ten years, the financial balance sheet of French households
continues to exhibit a rising level of net financial assets. In 2012, net financial assets, which accounts for financial assets
and liabilities, reached 139.4% of GDP, 0.5 pp. above its pre-crisis level
(see Graph 3.26). Moreover, on average, the interest
burden represented 1.7% of gross disposable income, a significantly lower share
than in the euro area. Overall, the credit worthiness of French households
remains unproblematic at this stage when compared to European peers. However,
the slowdown in credit growth could be a sign that households are starting to
reduce their debt, with potential impact on private consumption and investment.

The main driving force behind household
indebtedness dynamics over the last ten years was the continuous growth in real
estate credit, sustained in particular by dynamic housing prices and low
interest rates in the years leading up to the crisis. Real estate prices, which continued to rise after 2009, reached a
peak in 2011 and have started to decrease since then. However, the magnitude of
the correction has remained limited (-4% between the third quarter of 2011 and
the first quarter of 2013). Consequently, the outstanding volume of loans for
house purchase (41.7% of GDP) has remained stable and the share of households
exposed to real estate credit increased slightly from 31.0% in 2011 to 31.4% in
2012 despite the sharp fall in transaction volumes. Recent indicators suggest
that activity on the real estate market has started to pick up. Transaction
volumes have rebounded and, possibly due to a further decrease in interest
rates, real estate credit recovered in 2013 after falling by 32% in 2012.

While real estate credit explains most
of the increase in household indebtedness in the past few years, limited risk
seems to arise from a potential deflation in real estate prices. First, structurally strong demand supported by positive demographic
trends and the absence of excess housing supply together with prudent credit
supply by banking institutions suggest that the current soft landing of real
estate prices could continue. A rise in interest rates on loans or a further
correction in prices could potentially translate into credit volumes and
transactions falling again. However, such a development is unlikely to have a
strong impact on deleveraging pressures as France is characterised by the low
level (approximately 10%) of variable interest rate real estate credit loans
and by credit standards based on revenues rather than on asset value.

The main pressure for households to
reduce indebtedness rather results from uncertainties on cyclical conditions. Indeed, the high level of unemployment, together with the weak GDP
growth in the coming years (0.9% in 2014 and 1.7% in 2015), is expected to
weigh on disposable income. Thus, facing uncertainties on future revenues,
households may be prone to reduce indebtedness. The slump in consumer loans
since 2009, both in volumes and the share of household holding such a loan, is
a sign that cyclical factors are the main constraint for credit growth.

3.5.3.   Non-financial
corporations

The non-consolidated debt of
non-financial companies increased in 2012 to reach 105.0% of GDP, slightly
above the euro area average (97.3%). Netting out
intercompany loans, the consolidated level of non-financial corporations
reached a peak of 84.0% of GDP in 2012 (compared to 80.9% in the euro area).
Despite the somewhat higher level of debt, the leverage of companies,
particularly measured through the debt to equity ratio (50%) is not
particularly worrying as it remains below the euro area average (68.9%). In
2012, net assets of non-financial corporations represented 116.4% of GDP in
France and 94.5% of GDP in the euro area. The leverage of companies which
spiked in 2008 as a result of a sharp decrease in equity, has somewhat
decreased since, despite the continuously growing debt.

The decreasing level of profitability
for non-financial companies may also affect companies' ability to service their
debt. As pointed out in the 2013 IDR, although the
actual financial structure of non-financial corporations does not point to
specific weaknesses, the erosion of their profit margins is a source of concern
(Graph 3.27). The financial difficulties
experienced by firms are partly reflected in the increasing number of
bankruptcies. In September 2013, the number of bankruptcies cumulated over the
last 12 months rose by 5.5% compared to September 2012. The rise in
bankruptcies was more pronounced for SMEs and was particularly strong in the
retail and real estate sectors. Overall, the low and deteriorating
profitability of French non-financial companies compared to other euro area
countries, together with the increasing number of bankruptcies, point to
potential vulnerabilities.

3.5.4.   Public
sector indebtedness

France's public debt rose further in
2013, reaching an estimated 93.9% of GDP, on the back of a still high general
government deficit relative to nominal GDP growth.
This was slightly below the euro area average of 95.5% of GDP but clearly above
the reference value of 60% specified in the scoreboard and referred to in
Article 126(2) TFEU. The threshold was first exceeded in 2003 and the debt has
been almost continuously on an upward trend since then (Graph 3.28).

The ratio of general government debt to
GDP is expected to further increase in 2014 by 2.2 pp. to 96.1%, although
this is a smaller increase than in previous years.
Indeed, the forecast improvement in the deficit, to 4.0% of GDP from 4.2% in
2013, together with higher nominal GDP growth will curb the rise in debt but
will not suffice to reverse the trend. The government plans to put the ratio on
a downward path from 2015 and bring it close to 90% of GDP by the end of its
five-year term (2017). However, past experience shows that risks are clearly on
the upside. Debt targets contained in the successive stability programmes and
state budgets have regularly been revised upwards and often missed. For
example, the budget for 2013 targeted a debt ratio of slightly above 80% of GDP
in 2017, nearly 10 pps. lower than current plans.

The fiscal side of the economy continues
to pose potential challenges in the medium term.
France does not appear to face a risk of fiscal stress in the short term
(European Commission, 2012b). However, under a no-policy change assumption,
public debt would not be reduced below 95% of GDP by 2030. Moreover, different
sensitivity tests show that adverse economic events (such as a 1 pp.
permanent increase in interest rates) may have a significant negative impact on
debt dynamics in the long run (see Graph 3.29).

France's high public debt could
adversely affect the country's banking system, whose exposure to French
sovereigns has increased over the last year. As of
June 2013, the four major French banks had a total of EUR 150 billion in French
government bonds according to the European Banking Authority([14]), up by around a third compared to June 2012 levels (EUR 115
billion). Although sovereign yields have somewhat increased over the past year,
they still remain below historical levels. This has so far prevented domestic
banks from experiencing significant losses on national government bond holdings
and additional funding and liquidity constraints. While it is difficult to
predict the timing, speed or direction of any change to this situation, a
significant increase in sovereign yields is likely to raise financial stability
concerns and lead to a fall in bank equity prices as experienced in 2011.
French banks had then seen their access to short-term funding sharply curtailed
because of fears about their exposure to peripheral EU countries and in
particular to sovereign debt.

A significant rise in French sovereign
yields would also have a negative impact on non-financial corporations. As discussed in the 2013 IDR and described in detail in ECB (2012),
developments in benchmark interest rates, including sovereign bond yields, are
the main determinants of the conditions of direct financing in financial
markets for both non-financial and financial corporations. In France as in the
rest of the euro area, bank-based financing is the predominant source of
external debt financing for the non-financial private sector. Therefore,
factors that have an impact on credit intermediation through banks also exert a
particularly strong influence on the financing conditions of firms and households
via banks' lending rates, non-price conditions and lending volumes. As shown in
Graph 3.30 recent developments in French sovereign
yields have indeed translated into similar movements in the financing
conditions for non-financial corporations. In contrast, this means that a
(significant) increase in government bond premiums can become a major obstacle
to granting loans to the real economy, similarly to what peripheral EU
countries have experienced since the start of the sovereign debt crisis.

The debt service would also be
negatively affected in the event of increased market pressure, with a likely
impact on growth prospects and competitiveness.
Despite the rising stock of public debt, the amount of interest payments has
remained broadly unchanged at around 2.5% of GDP over the last few years and
has even slightly decreased compared to the pre-crisis period. This came after
French sovereign yields started to fall mid-2008 and reached historical lows in
2013, with the implicit interest rate on general government debt falling from
an average 4.5% over 2000-07 to an estimated 3% over 2008-13.([15]) This development has so far limited the risk of the debt service
crowding out more productive government expenditure, e.g. public investment
which is generally considered as having a productivity raising effect at
various time horizons. From this perspective, France actually appears in a
relatively favourable position since it is the only country among large euro
area Member States to have kept a stable share of public investment as a share
of GDP (around 3%) over the last 20-30 years; other countries have either
reduced the latter gradually over time (Germany, Italy) or have drastically cut
public investment since the beginning of the crisis (Spain). In contrast, a
sharp rise in sovereign yields would either necessitate cutting expenditure
elsewhere or raising an already elevated tax burden, with the latter further
weakening the competitiveness of French companies. On the other hand, losses of
competitiveness render high debt levels even more problematic as they weigh on
growth prospects, which in turn make it more difficult to put the debt ratio on
a downward path. These two effects are mutually reinforcing and could turn into
a vicious circle. In addition, the fiscal space to tackle further shocks or
severe private imbalances tends to decline with the stock of government debt.

Increasing public debt and related
future developments in sovereign yields warrant close monitoring in France. The debt stock will continue to rise in the short term due to high
deficits relative to nominal GDP growth prospects. As a consequence, higher
interest rates in the short to medium run cannot be excluded, even though a
credible medium-term consolidation strategy can make an important contribution
to averting this. In fact, some rebalancing in sovereign yields has already
taken place, with core euro area sovereigns on an upward trend since mid-2013,
but this has so far remained limited. Most importantly, persistent concerns
from different stakeholders, including investors, international organisations,
rating agencies and think tanks on France's capacity to achieve budget plans
and carry out structural reforms might exacerbate pressures and lead to a
change in market sentiment, with a risk of overreaction of the markets given
the high debt ratio and especially after a protracted period of time that has
not seen any extreme events affecting France materialising. The risk associated
with increasing public debt levels is even bigger when considered in
conjunction with rising private sector debt. Hence the combination of private
and public sector indebtedness could reinforce financial feedback loops.

The analysis in this IDR indicates that
the French economy is subject to a significant deterioration of its export
competitiveness and to risks linked to the high and increasing level of
government debt. While the current level of
external debt is still relatively benign, its increase is a worrying trend
which may weigh on the recovery and could ultimately have a negative impact on
growth in the euro area as a whole. France's poor trade performance is related
both to cost and non-cost competitiveness factors. In particular, a number of
distortions and rigidities on the labour market translate into difficulties for
firms to adapt to changing conditions and may contribute to lower non-cost
competitiveness in the long term. More generally, the unfriendly business
environment in France seems to be an obstacle to the development of a dynamic,
competitive and more innovative private sector. In a context of moderate growth
and low inflation, the level of government debt has continued to increase
despite the significant efforts to reduce the general government deficit.
Specific focus should be put on reducing public expenditure, by systematically
identifying the potential for more efficient and less costly public services.

Cost of labour: Further efforts to reduce the cost of labour appear warranted.
France is among the countries in the European Union where the cost of labour is
the highest. Despite the high labour productivity, the cost of labour impacts
negatively the profitability of companies. The evolution of wages over a long
period indicates that these have increased in line with productivity. The drift
in export performance since 2000 can therefore not be primarily attributed to
an excessive increase in unit labour costs over the last few years. On the
other hand, wage benchmarks provide indications that the wage level itself may
be high. The social security contributions paid by employers in France are also
among the highest in the EU. Despite efforts to maintain competitive prices,
the competitiveness of French firms is hampered by the high cost of labour.
Indeed, French firms' profit margins are the lowest in the EU and restoring
them is a pre-condition for firms to increase investment, improve the quality
of their products, and hence increase their non-cost competitiveness.

Measures planned so far will not be
sufficient to fully restore the profitability of non-financial companies. The tax credit for competitiveness and employment (CICE), which was
adopted in 2012, has contributed to improving the financial situation of
companies. As part of the responsibility pact presented on 14 January 2014, a
further reduction in employers' social security contributions was announced by
President Hollande. While more information is needed on that second step, the
reduction in the tax burden on labour goes in the right direction and will
contribute to restoring private companies' profitability. However, at this
stage, the amounts considered will only bridge part of the profitability gap
vis-à-vis France's main trading partners in the euro area. In particular, it
will be insufficient to compensate for the contrasted wage developments seen in
France and Germany between 2000 and 2008. Moreover, as the measures presented
so far are generally targeted to lower wages in order to increase their impact
in terms of employment, there are risks that they do not primarily benefit
exporting firms as the latter generally pay higher wages.

Rigidities and distortions on the labour
market:  Rigidities in the wage setting remain strong and recent reforms have
only marginally improved the situation. Despite
recent efforts to increase the flexibility of the labour market, wage
developments in France continue to be characterised by significant downward
rigidities. These could accentuate the financial difficulties met by companies
during downturns. In this regard, although the recently adopted reform of the
labour market seeks to increase the possibilities for firms facing temporary
difficulties to adjust wages, preliminary evidence suggests that this new
legislation has not yet reached its objectives. More generally,  the weight of
the minimum wage in the French wage setting system, its relatively rigid
revaluation mechanism as well as the limited number of exemptions have negative
impacts on the labour market outcomes for the most vulnerable populations and
contributes to the overall wage rigidities although it contributes to reducing
wage inequalities. The resulting distortion in the wage distribution could
reduce incentives to increase skills and productivity. The social security
contributions exemptions targeted to lower wages and which aim to compensate
the negative impact of the minimum wage on employment, together with the
current tax credit for competitiveness and employment, increase the relative
costs of highly skilled workers compared to low-skilled ones, with a
potentially negative long-term impact on productivity and competitiveness.

Business environment: There is considerable scope for improving the business
environment despite recent efforts to reduce firms' administrative burden.
Efforts have been made as part of a "simplification shock" launched
in July 2013 to ease the relationships between firms and the administration.
However, a number of barriers to firms' growth persist. In particular, some
size thresholds appear particularly difficult to cross (50 employees). Limited
initiatives to enhance competition, in particular in the service sector, have
been taken. Low level of competition in services translates into higher
intermediary costs for firms and less innovative services. As a result, further
stimulating competition both in the product and services sectors would benefit
exporting firms and contribute to their competitiveness.

Innovation: Policy initiatives to boost
R&D spending and innovation by private companies, in particular the tax
credit on research and the competitiveness poles, have yielded mixed results so
far. A large share of R&D spending remains financed
by public money either directly through public research or indirectly through
subsidies. There is scope for improving the effectiveness of the existing tools
in order to trigger higher R&D expenditures and innovation in the private
sector. In particular, resources allocated to the competitiveness poles could
better foster scale effects and improve the diffusion of innovation. In
addition, the effectiveness of the policy could be strengthened by enabling
these poles to become real networks of firms with positive spillovers.

Government sector indebtedness: Efforts
to put the government debt on a downward trend need to be enhanced. France has weathered the euro area sovereign debt crisis without
experiencing major tensions on sovereign yields. The latter have actually
fallen below historical levels, with increased risk aversion supporting German
bunds and filtering through to other euro area economies, including France.
However, the stock of general government debt has continued to increase and the
trend will not stop in 2014, according to the Commission Winter 2014 forecast.
In order to limit risks of increased market pressure or a reversal in investor
sentiment, which would in turn necessitate additional fiscal tightening and
trigger spillovers to the financial sector and the real economy but also to the
rest of the euro area, it is crucial to put public debt on a steadily declining
path. This requires enhanced efforts at fiscal consolidation, in line with the
trajectory recommended by the Council, which calls for a correction of the
excessive deficit in 2015 and the achievement of the medium-term objective in
2016.

Given France's high tax burden by
international comparisons, and more so regarding the tax burden on labour, the
necessary improvement in fiscal metrics requires stepped-up efforts at reining
in government spending. In this respect, the French
authorities have promised to achieve expenditure savings in the order of EUR 50
billion (2.5 % of GDP) by 2017, especially in the areas of social security
and local governments. Past experiences of expenditure savings initiatives (the
former Revue générale des politiques publiques and the on-going Modernisation
de l'action publique) have not resulted in a significant reduction in
public expenditures. Therefore, a more ambitious approach is necessary to
effectively identify the potential for efficiency gains in public services and
achieve expenditure savings commensurate with the deficit objectives set by the
government.

Financial sector: While the French financial sector has proved resilient
throughout the crisis, its systemic importance calls for specific attention.
The banking sector remains well capitalised and its profitability, though
decreasing, is in line with that of European peers. Its main risks are related
to the refinancing structure, with wholesale funding representing a
comparatively large share of liabilities. While French banks have performed
well throughout the various stress tests organised at the national and European
level so far, the on-going comprehensive review conducted by the European
Central Bank will be instrumental in better identifying potential
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([1])  People at risk of poverty are those
with an equivalised disposable income (after tax) representing less than 60% of
the average.

([2])  Source: ECB's Statistics on
Consolidated Banking Data

([3])  Similarly INSEE (2013) considers that
over 2000-Q2 2008 non-cost competitiveness, which is captured through a
negative trend in export volumes and through the export equation's residual,
contributed -3.6 pps. to the annual export variation (compared to
-0.9 pp. on average for the REER)

([4])  Source: United Nation Conference on
Trade and Development (UNCTAD)

([5])  Due to sign conventions, net inflows of
FDI contribute negatively to the NIIP. Data available from the Banque de France
since 1997

([6])  While the absolute amount held by
foreign investors has increased since 2010, the share of public debt held by
foreign investors has actually decreased. This is mainly due to a lower weight
of short-term bonds, which are favoured by foreign investors, and to increased
holdings by French banks.

([7])  EBA 2013 EU-wide Transparency Exercise.

([8])  This exercise allows capturing full
general equilibrium effects and considers also potential trade spill-overs. The
simulations were based on measures closing half of the gap in structural
indicators (e.g. tertiary education expenditure, share of high-skilled workers,
entry cost, R&D subsidies, etc.) vis-à-vis the three best-performing
countries in the EU. The expected gains in France result in particular from an
increase in the labour market participation of senior workers.

([9])  With the exception of a 2.0%
discretionary hike decided in July 2012, of which 1.4% consisted in an
anticipation of the next revaluation.

([10]) The premium associated with tertiary
education, which is less affected by developments in the lower band of the wage
distribution appears in line with what is observed in other euro area economies

([11]) It should be noted that in 2012,
despite the absence of a national minimum wage, this ratio stood at 4.3 in
Germany.

([12]) High-technology sectors include
aerospace, pharmaceuticals, computers, office machinery,
electronics-communications, and scientific instruments. Medium-high-technology
sectors gather electrical machinery, motor vehicles, chemicals, other transport
equipment and non-electrical machinery.

([13]) Triadic patents are patents filed at
the European Patent Office, as well as at the United States and Japan Patent
Offices, for the same invention, by the same applicant or inventor.

([14]) EBA 2013 EU-wide Transparency Exercise.

([15]) Using the ratio of interest expenditure
to end of previous year debt level as a proxy.

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