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.

Continue reading France: How close to the edge?

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