PARIS (MNI) – The French government is too optimistic about the
strength of domestic economic growth ahead and must go further on fiscal
consolidation to meet its goal for a reduction in the public deficit to
3% of GDP by 2013, the International Monetary Fund said Friday.

France’s recovery is still “fragile”, the IMF said in its annual
Article IV review of economic and fiscal policy, highlighting the
downside risks from weak domestic and foreign demand and the
vulnerability of the banking system to any aggravation in the sovereign
debt crisis.

“The fragile recovery and possible spillovers from the European
sovereign debt crisis are now putting renewed stress on the financial
system,” the report noted. “As a result of the recession, asset quality
has worsened, and large exposures of the French financial system to
southern Europe have raised concerns about spillovers and contagion.”

While welcoming the government’s policy response to the recession
and its initiatives to stabilize the financial system, the IMF warned
that its assumption for a pick-up in GDP growth to 2.5% from 2011 onward
was too optimistic, forecasting instead 1.6% next year after a 1.4%
upturn this year.

“The same features of the French economy that partly shielded it
during the recession – large automatic stabilizers, high social
protection, and long-standing rigidities in labor and product markets –
are also likely to slow the pace of the recovery,” it said.

Moreover, risks to the economy are “slanted to the downside,” it
asserted. The recovery “is being tested … by weakening household
confidence and demand amid market concerns about sovereign risks in the
euro area,” it said.

The export rebound earlier this year may well prove short-lived,
given the moderate recovery of main trading partners and chronic
problems of competitiveness, “with the depreciation of the euro likely
to provide only limited relief,” the report said. Inflation is expected
to remain low at 1.3% this year and 1.6% next year.

“Although financial conditions have improved, credit growth remains
depressed,” the report noted. Despite the relative resilience of the
banking system, “asset quality has worsened and additional write-downs
on risky assets are likely.”

While debt yield spreads to German Bunds have so far remained
“moderate”, French banks have “relatively large” exposures to Greece,
Ireland, Italy, Portugal, and Spain that account for 7% of bank assets
and 30% of GDP, the report estimated. These exposures are largely in
private Italian and Spanish debt, while sovereign debt positions in
Greece are “small”, it said.

Thus, “the direct impact on French banks of the Greek debt crisis
is likely to be manageable,” the report assessed, pegging individual
banks exposures to Greece, Portugal, and Spain at 2-10% of equity,

“However, French banks remain vulnerable to spillovers,” it
cautioned. “Exposure to mature markets represented 83% of total foreign
claims in 2009, dominated by exposures to Belgium, Germany, the U.S.,
and the U.K. France would be vulnerable to spillovers from these
countries too if they were to be affected in the first place, which
would significantly weaken the capital and liquidity position of the
banks.”

The IMF welcomed a shift in government policy focus to fiscal
consolidation, but underscored the need for further measures in order to
hit deficit targets. On the basis of its own growth assumptions, it
projected the public deficit at around 4% of GDP in 2013 without
additional efforts.

“Unless a substantial fiscal consolidation is undertaken, the debt
is bound to further increase over the medium term (including as a result
of population aging), thereby threatening the sustainability of public
finances,” the report warned.

“Under current policies, the primary balance is set to remain in
deficit through 2014 and, as a result, the debt ratio could climb more
than 25 percentage points above its pre-crisis level, reaching 90% of
GDP over the medium term,” it said. In case of “adverse shocks” it could
top 110%.

The economic crisis has cost France a “permanent loss” of about
3.5% of potential output, the report estimated. Potential growth over
the medium-term is likely to be around half a point below that of the
past decade due to the “sharp contraction of investment and the
resulting slowdown in capital accumulation, a rise in structural
unemployment, and a possible temporary reduction in allocative
efficiency that could lower total factor productivity growth.”

–Paris newsroom +331 4271 5540; e-mail: stephen@marketnews.com

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