France: How close to the edge?

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This post is a guest contribution by Olivier Bizimana of Morgan Stanley.

This note looks at the increasing likelihood of a recession of the French economy. The deep and fast contraction in business indicators suggests that the risks of a recession have materially increased in the near term. We expect growth to stall in 2012, with GDP expanding at 0.9%. The bank funding stresses are likely to lead to a credit squeeze, which may cause the economy to stall. Given the gloomy growth prospects for the French economy, the consolidation of public finances in the medium term is likely to be more painful than expected. More austerity measures would be required to achieve the fiscal deficit target of 4.5% of GDP set by the government. In our view, large tax hikes and or massive cuts in expenditures may lead to an ‘austerity trap’, with further fiscal tightening taking a toll on future growth prospects. Both the more difficult access to credit and the fiscal consolidation were already embedded into our macroeconomic scenario. The developments on the banking and fiscal sides in the coming months may lead us to lower our forecasts again.

On the Brink of Recession?

One should distinguish a technical recession, defined as at least two quarters of a negative GDP growth rate, from a full-blown recession, defined as a meaningful contraction in the economy that would result in negative growth over the whole year. While a technical recession is still likely, a full-blown recession would require additional shocks. Hence, given that we are already forecasting a stagnation, one or two quarters of contraction in activity cannot be ruled out, while a full-blown recession could be considered a bear case.

The evidence to assess the economic downturn is extracted from the expectation components of the INSEE survey in the manufacturing sector.

• The first indicator is the differential between the general and personal production expectations. It reflects the difference between business leaders’ assessments on the situation in the overall French industry and their own companies. This indicator is forward-looking, as it usually signals an economic downturn early. A negative gap, which announces a forthcoming contraction in output, indicates that corporate leaders are more pessimistic on their assessment of the macro situation than the micro situation.

• The second indicator is the gap between the indices of recent output changes and personal production expectations lagged six months. It gives the ‘output surprise’. This indicator is coincident as it plunges along with growth deceleration. These two indicators are currently in a territory that in the past corresponded with a technical recession.

What’s more, economists’ consensus estimates for the French economy in 2012 have decreased sharply this month, getting close to our forecast of 0.9%.

To estimate the probability of a recession, we use a probit model, which relates the probability of being in a recession six months ahead to the yield curve spread – the difference between the ten-year government bond yields and the three-month Treasury bill rate.

For France, historically, an inverted yield curve tends to signal forthcoming weak growth about six months ahead. The model was a good predictor for the recessions of the French economy between the 1970s and 1990s. The results show that the estimated probability of recession was, for example, 70% during the 1992-93 recession and around 50% during the first oil shocks (in 1974 and 1980). However, since the 2000s, the forecasting ability of the model seems to have somewhat diminished. For example, it pointed towards an 11% probability of recession in 2Q08 (the start of the recession), which is almost the same figure as in non-recession periods. The estimated probability for 4Q11 and the months ahead is very low, at about 1%. The signal from the yield curve has been somewhat blurred by the financial crisis, given that it has affected both the short and the long end of the curve.

The French Economy Is Likely to Stall in Early 2012

Given the sharp and fast slump in business confidence, the key question is whether the French economy will fall into recession.

There is a disconnect between activity data and business leaders’ expectations. The ‘hard data’ released in 3Q signaled a relatively strong rebound in activity. Industrial production climbed significantly in 3Q. Household consumption of goods bounced back, though the pace of growth remained moderate. Our GDP indicator, based on industrial production and household spending in goods, points towards GDP growth of around 0.8%Q in 3Q. In light of the strong ‘hard data’ released over the previous three months, we have revised up our official forecast to 0.5% in 3Q, from 0.2%Q.

The key focus now is what will transpire in 4Q and especially whether reality will catch up with expectations. Though we project that activity will only stagnate in 4Q, after a stronger-than-expected growth in 3Q, negative figures for one or two quarters are possible. Hence, a technical recession is likely, but not a full-blown recession.

Our near-term growth forecast is surrounded by high uncertainty generated by the persistent sovereign debt crisis and policy responses at the European level. If measures decided at the October EU Summit convince markets, we believe that this would remove the crisis premium that is baked into the expectations of the private sector somewhat. However, at the time of writing, some details of policy proposals still need to be provided. Hence, the level of uncertainty is unlikely to decline soon.

We think that market tensions will continue to dampen private sector confidence, which, in turn, is likely to hamper investment and consumer spending decisions. Therefore, private consumption growth is expected to be sluggish compared to its historical trend. In the short term, the high level of uncertainty would cause households to increase their precautionary savings. Hence, the household savings rate is expected to remain elevated in the medium term. In addition, a likely deterioration in the labour market going forward will weigh somewhat on income, though the easing in inflation should compensate partly for the erosion in households’ purchasing power. We see inflation slowing to 1.7% in 2012 from an estimated 2.0% in 2011, courtesy of a decline in energy costs.

The adjustment of corporate investment in the current environment remains uncertain. Among the GDP components, corporate investment is probably the one that may react sharply to the current deterioration in business climate and growing uncertainty. Historically, corporate investment tends to react quickly and sharply to a slump in confidence. At the moment, though, there is no concrete sign yet of a sharp downturn in investment. The latest investment survey in the manufacturing sector, released in July, which is a good leading indicator of corporate investment trend, continued to show sustained growth in investment in 2011. The capacity utilization rate in the manufacturing sector declined only marginally in 4Q, remaining around its long-term average. This apparent resilience presumably reflects the fact that the surveys of these indicators were conducted before the escalation of the eurozone financial crisis. Still, the large fall in demand shown by the quarterly survey in the manufacturing sector for October suggests that companies are likely to revise down their willingness to spend and hence their investment going forward.

Banking Funding Stresses and Risk of Credit Squeeze

Our view remains that one of the key risks associated with the ongoing eurozone crisis is a transmission of the stresses in the banking sector to the real economy. Indeed, market tensions have spread to the banking system, affecting French banks’ funding costs (see French Banks: Short-Term Headwinds or New Paradigm? August 17, 2011 and French Banks: Liability Management and ECB Reliance in the Loop, October 19, 2011). The banks are likely to respond by raising loan rates and/or by tightening credit, should pressure on their funding costs persist. What’s more, they are likely to be more cautious in their lending practices, as credit risks have materially increased with the deterioration in activity. Looking ahead, the requirement to achieve a higher core Tier 1 capital ratio could also lead to banks restraining credit.

However, so far, the impact of the eurozone crisis on private sector financial conditions is not clear cut. The latest bank lending survey, released in October, indicated that the degree of net tightening of credit standards on loans to non-financial corporations as well as households increased significantly in 3Q. In addition, the survey also indicated that French commercial banks expect to tighten credit conditions further in 4Q, especially for large firms and small and medium-sized enterprises (SMEs). The degree of net tightening of credit standards for loans to the corporate sector anticipated in 4Q is almost of the same magnitude as in 2007, at the beginning of the global financial crisis.

The interest rates charged to new loans to households and non-financial corporations have increased since the beginning of the year. But this increase reflects more the impact of the normalization of monetary policy than the transmission of the spike in banks’ funding costs. More generally, interest rates remain relatively low, compared to their average levels before the global financial crisis. The recent developments in new loans to the private sector don’t show any evidence of the impact of the sovereign debt crisis. The downward trend in new loans for households, which started at the beginning of the year, is continuing, while new lending to non-financial corporations remains soft.

The absence of evidence of the impact of the sovereign debt crisis on credit data is probably due to transmission lags. We believe that the current market tensions might ultimately affect financial conditions and lead to a credit squeeze. Should this happen, given that bank lending is the main source of external financing for non-financial corporations, especially small and medium-sized enterprises (SMEs), but also households, the impact on real activity is likely to be protracted. Hence, the risk is a prolonged period of stagnation.

Further Fiscal Tightening in the Cards

What are the implications of these gloomy economic prospects on public finances? Lower growth prospects would certainly reduce fiscal revenue and increase public outlays. The main concern is that France cannot afford any fiscal slippage going forward. Its initial fiscal position is unfavorable for a AAA rated country, with a high deficit and growing public debt. In addition, France’s fiscal position remains subject to high scrutiny by rating agencies, especially given the renewed tensions in the sovereign debt markets and the risk of contagion.

In October, the French government unveiled the 2012 budget, which plans a further reduction in the fiscal deficit to 4.5% of GDP, after 5.7% estimated for 2011. Yet, the macroeconomic assumptions underlying the 2012 budget look quite optimistic, as the government projects GDP growth of 1.75%.

Given the sharp deterioration in activity, President Sarkozy subsequently announced that the government will slash its growth forecast for 2012 to 1%, which would be close to our own forecast of 0.9% in 2012 (the consensus report for October forecasts 0.9% as well). Hence, as growth expected in 2012 is lower than previously assumed by the government, additional measures will be required to compensate the deterioration in the cyclical component of the budget balance in order to achieve the fiscal deficit target of 4.5% of GDP in 2012. On our estimates, the government should take additional austerity measures of around €7-8 billion (0.4% of GDP).

The question is whether this additional fiscal tightening can be achieved without hurting growth and/or increasing uncertainty about the future course of fiscal policy. That may cause households to increase their savings rates and companies to postpone their spending, which may ultimately dampen domestic demand.

More importantly, this could lead to an ‘austerity trap’, where further fiscal austerity lowers growth, thereby lowering tax revenues and necessitating more austerity. For example, the additional austerity measures of around 0.4% of GDP, which are likely to be announced in the coming weeks, would cut growth by about 0.4pp (assuming a fiscal multiplier of 1). This, in turn, would require extra austerity measures of around €4 billion (0.2% of GDP) to meet the fiscal deficit target of 4.5% of GDP.

Ultimately, if the current government and the following government resulting from the 2012 election are determined to do whatever it takes to meet the fiscal deficit of 4.5% of GDP in 2012, this may, paradoxically, put additional pressure on France’s AAA debt rating. Indeed, this could reduce the short to medium-term growth outlook and hence weaken fiscal sustainability in the medium term.

Meanwhile, Standard and Poor’s and Fitch affirmed France’s ratings at AAA with a stable outlook. Only Moody’s warned about the stable outlook of France’s AAA debt rating, on the back of weaker ‘debt metrics’ and potential further contingent liabilities that could emerge. Moody’s said that, over the following three months, it will monitor and assess the stable outlook in terms of the government’s progress in implementing necessary economic and fiscal reforms, while taking into account any potential adverse economic or financial market developments.

Source: Olivier Bizimana, Morgan Stanley, November 1, 2011.

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