France needs to preserve its political dividend

All eyes are on the French election, and with good reason.

After all, the Franco-German axis has been the driving force behind European integration. As a result, France has benefited enormously from a “political dividend” which caused its sovereign spread to remain more contained than the Italian, Spanish and Portuguese ones over the past few years. Also, deposit flight from the French banking system was hardly visible in 2011-12 while it was a real problem in the other peripherals. The French political dividend was essentially about the fact that markets saw a much smaller risk of France breaking away. To some extent this turned out to be a self-fulfilling prophecy (less pressure on sovereign and bank balance sheets) but up to a point it was also about the calculation that Germany would go to greater lengths to keep France in than it would for the other peripherals. This is probably still the case but of course if the French themselves decide to leave there is nothing Germany can do about it. This is why the risk of Marine Le Pen (or Jean-Luc Mélenchon) becoming President is reflected in the probability that this political dividend will disappear, which is essentially what drives the French spread currently.

It is important to emphasise that France is not a typical peripheral economy for reasons other than the political dividend just mentioned. French sovereign debt is just below 100% and the French banking system is in pretty good shape. Also, the long-run prospects for French growth are pretty good, provided the next president pushes reforms through. The performance of French labour productivity is actually comparable to that of Germany. Still France has a higher structural unemployment rate than Germany, which partly explains this result. A substantial number of low productivity workers are structurally unemployed in France while they are working in Germany. By contrast, French total factor productivity (the efficiency with which the input mix is transformed into output) has performed worse. It thus seems there is ample room for a continued good productivity performance alongside a decline in structural unemployment. Labour market reform will achieve the latter and will, taken in isolation, weigh on labour productivity growth, but product market reform can at the same time accelerate TFP growth. There is a lot of low-hanging fruit in this respect in France and if the next president and government have the guts to pluck it, France could reach a potential growth rate close to 2%, which means that its sovereign debt will be pretty sustainable.

The upshot is that the continuation of the political dividend in French sovereign spreads will, not surprisingly, depend on political developments. In the near term the question is whether Marine Le Pen can become president, but in the more distant future the political dividend will depend crucially on an economic reform dividend. Emmanuel Macron’s program suggests he intends to import the Nordic model into France. The essence of this model is a combination of structural reforms that make the economy more flexible and providing state support/incentives for an increase in investment and human capital. The latter implies that Macron envisages a larger size of the state than François Fillon, which is not necessarily a bad thing as long as state intervention acts as a complement to markets. Part of this would be to maintain a larger social security safety net which would surely reduce the potential for economic and political backlashes in response to the reforms. This would hold especially if social security is targeted at programs that actively guide unemployed workers towards new jobs. Macron would probably favour a less strict interpretation of the Fiscal Compact, e.g. by exempting public sector investment from the deficit calculations.
In contrast to Macron and Fillon, the political dividend would turn sharply negative immediately under Le Pen and erode further because of a negative economic dividend over time. The main themes of her program are very similar to those of Donald Trump, i.e. sharp reduction in immigration and an increase in French sovereignty. Le Pen wants a referendum but remains ambiguous on whether this would be a referendum on EU membership or the euro. She wants to introduce the franc in parallel to the euro. The aim is to face “unfair competition”, which simply means she wants a devalued currency to improve competitiveness. If carried out, this plan is likely to have negative outcomes because at the same time she wants to take away the independence of the Banque de France and instruct the central bank to directly fund the Treasury. The result will be an increase in French inflation (expectations) that will wipe out any initial competitiveness gain. What’s more, all this will make the French debt burden unsustainable because the Treasury will receive tax revenues in the new devalued franc while the debt remains in euros . Alternatively she can default on the debt and face very high sovereign borrowing costs for the increase in fiscal deficits triggered by the inevitable recession and her program of fiscal expansion. Of course all this economic mayhem will be enhanced by deposit and capital flight out of France that will cripple the banking system.

I expect that Le Pen would face a lot of probably insurmountable hurdles before she could call a referendum. However, this does not mean that a Le Pen presidency would be favorable to the French economy and French assets. Domestically, the reform momentum would stall completely because of “cohabitation” (a president with a parliamentary majority of a different colour) which would reduce the French economic dividend rapidly. Furthermore, the French president has a lot of power when it comes to foreign policy, and Le Pen is unlikely to cooperate well with whoever becomes Germany’s new chancellor. As a result, the political dividend that has supported French assets and French banks would deteriorate significantly as well. Finally, the region would be deprived of badly needed further progress on fiscal and banking union, which would ultimately be detrimental to its stability.

Willem Verhagen – Senior Economist, Macro & Strategy – NN Investment Partners