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April 2016

France The sick man of Europe?

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Contents

The French Economy……………………………………..…………………………………………………………..5

Unemployment & the Labour Market………………….………………….….……………………………..7

Fiscal Issues – Spending..……………………………..…...………………………………….…………………..9

Fiscal Issues – Taxation…………………..…………………………………..……………………………………10

Society ………………………………………….………………………………………………………………….......11

Security……………………………….….………………….……………………………………………………………12

EU-level Challenges…………………………………………………………………………………..……………..13

Political Risk…………………………………………………………………………………..…………………………14

Conclusions……………………………………………………………………………..………………………………16

Consequences and Opportunities…………………………………………………………………………….17

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This report examines the key problems faced by France’s lackluster economy. In order to assess

whether France has any hope of restored vitality and becoming an attractive investment

destination in the foreseeable future, we shall look at the government’s attempts to deal with the

specific problems they face. We shall compare what needs to be done with what is actually being

accomplished, looking at what the key obstacles are, and ultimately evaluate the prospect of

success.

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Currency Euro (EUR)

Language French

Population 66 million

Literacy 99%

Luxury products* 10% Planes, helicopters, spacecraft 9% Packaged medicaments 5% Cars 4% Vehicle parts 3% Refined petroleum

3%

Germany Benelux

15% 13%

UK 7% Italy USA China Japan

7% 7% 3.5% 2%

France’s export markets France’s export products

* Includes wine, liquor, cheese, textiles, perfume, cosmetics, trunks, glassware, jewellery. arts & antiques, watches & clocks

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The French Economy

France is one of the world’s wealthiest countries, with a GDP per capita in the top thirty – USD 41,663 - and its standard of

living ranking in the top twenty globally. France has high quality infrastructure and public services, and many of its

industries are world leading, such as automotives, aerospace, luxury goods and pharmaceuticals, as well as tourism. 31 of

the Fortune 500 companies are French, which is more than for any other country except the US, China and Japan.

France’s current macroeconomic situation, however, is fairly bleak. It has been in an economic malaise for some time now,

and never truly bounced back from the 2008 global financial crisis, even though it was hit relatively mildly compared to

some it its European neighbours. According to the Organization for Economic Cooperation and Development, France’s per

capita GDP has grown more slowly since 1990 than that of any other wealthy nation, except Italy.

We shall look more closely at some of the critical problems France faces in the main body of this report, but a snapshot of

some of its fundamental economic indicators reveals the trouble France is in:

GDP growth was just 1.1% in 2015, with an anaemic average rate of 0.86% since 2011 (compared to 2.05% for

Germany ans 2.07% for UK)

Unemployment is currently at 10.3%, having reached a record high last year

Currently at 97% of GDP, public debt is very high and is forecast to increase further this year

The government budget deficit stands at around 3.7% of GDP, exceeding the EU’s deficit threshold of 3%, having

not been in surplus since 1980

There are deflationary pressures, with inflation just 0.1% in 2015

Gross fixed capital formation reached its lowest point last year since 2010

Industrial output is weak, falling by 1% MoM in February, despite low oil prices

According to Eurostat’s export volumes index for manufactured goods, France is now at 102, down from 117 in

2007, a decline of almost 13%

GDP growth YoY GDP per capita comparison

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Largely for these reasons, both consumer and business confidence are low and there’s a feeling of pessimism, particularly

among the young, and the lower and lower-middle classes. There’s a gloomy, disillusioned mood in France that goes

beyond the economy and permeates society more generally.

In addition, over recent years France has been downgraded by the three major ratings agencies, losing its triple A (or

equivalent) status.

If France is to again become an economy with real prospects, and an attractive choice for investors, major change is

required. As shall be detailed in this report, systemic, structural reform is necessary to foster economic expansion. Change

is also required given that the French economy is inextricably tied in with the broader European story; as the Eurozone’s

second largest economy and a key driver of policy, France’s fate is important beyond its own borders. A weak France

weighs down on growth in Europe as a whole. Some would even go so far as to describe France as ‘the sick-man of

Europe’ – a title for which, with the likes of Greece and Italy in the running, it has strong competition.

So what specifically needs to be done to heal France and to significantly and sustainably improve its economic prospects?

This report explores the key problems France faces, namely:

- Unemployment

- Public debt and overspending

- Misguided taxation policy

- Social fragmentation

- Terrorism and security

- EU-related challenges: Brexit and the migrant crisis

- Political risk

For each, we look at the economic impact, possible solutions, and what’s actually being done, in order to draw broader

conclusions about France’s economic future.

Inflation (CPI % change YoY) 2

0.9

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.3

8.7

6.2

5.1

4.9

4.1

S P A I N F R A N C E I R E L A N D G E R M A N Y U K U S A S O U T H K O R E A

Unemployment rates

Source: Thomson Reuters

Gross fixed capital formation

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Unemployment & the Labour Market

The stubbornly high rate of unemployment is

perhaps the greatest threat to the French

economy. Currently at 10.3%, according to the

latest figures from the ILO, it’s over twice the

rate of the UK and is at a record high in terms

of the number of people out of work - 3.6

million. Youth unemployment (15-24 year

olds) is at 25%. As is clear from the chart on

the right, while in most other European

countries this rate is falling, if gradually, in

France it continues to rise.

This is a crucial problem for France, where household consumption is the driving force behind economic growth. Its high and rising level of unemployment is clearly weighing heavily on France, keeping GDP per capita lower than in most other similar western European countries. It’s also a waste of human capital; France has real potential in this regard, with a stable, gradually rising, working-age population. Furthermore, it will be fiscally problematic down the line, as jobless people require benefits and don’t pay income taxes.

With the French economy growing so slowly, and the outlook for the global economy looking gloomy as well, there’s very little incentive for businesses to expand and hire new staff, especially since they already have to bear the substantial fixed cost of the permanent employees they took on in better economic times. The lack of business confidence and investment also mean that natural job creation is considerably reduced; before the 2008 crisis, business investment grew by an average of 3.8% (2003-07), compared to just 2% last year. The high level of government borrowing is also serving to crowd out the private sector. Even though businesses are generally in better financial health now, and low fuel prices are reducing costs, when there is investment it generally focuses on modernization - upgrading outdated equipment - rather than expansion.

Clearly, something needs to be done to remedy this situation. To determine exactly what, we need to look at the root of the problem; France’s inflexible labour market. It’s burdened by an overwhelming amount of regulation and red tape, including a 3,800-page labour code, in which the collective-bargaining agreement for hairdressers alone covers 196 pages. This code makes it extremely difficult to lay off workers on permanent contracts - about 80% - and ensures that they receive generous benefits. While this is naturally very popular with workers and the unions, it is a thorn in the side of French firms, who often need to make their case to a labour tribunal if they want to lay off staff. This is a lengthy procedure that can cost up to EUR 310,000.

French firms are therefore generally very reluctant to hire new permanent staff, with around 80% of new employees on short-term contracts. It’s particularly difficult for young workers with little or no experience to get hired, as they haven’t yet proven themselves and are hard to fire if they turn out to be no good. A further negative impact of the complexity of the labour laws is that rather than dealing with them, lots of good start-ups leave France; around 350,000 French entrepreneurs have relocated to England due to the stifling bureaucracy across the Channel.

Other crucial labour market impediments to France’s economic revival include the legally safeguarded 35-hour working week. A recent study by the French publication Le Point observed that the number of hours worked per year, per person in France is among the lowest of any developed economy - 11% lower than in Germany and almost 40% lower than South Korea. French workers’ hourly productivity, though, is near the top of the charts, and is the highest of the Eurozone ‘big four’ (France, Germany, Italy, Spain).

Youth unemployment (15-24 years)

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Productivity statistics should be treated with a measure of caution; they are skewed toward higher productivity in economies, like France, that have lots of large firms and fewer SMEs, as well as lots of companies producing higher value items. They’re also skewed by a higher level of unemployment. Nevertheless, the French labour force clearly has potential to achieve more than it currently is. The high number of young people leaving school without qualifications and not in any kind of education, employment or training (NEETs) is also a problem. At 19%, it’s almost double the rate of Germany, and is also considerably higher than the UK’s 11.8%.

Structural changes to the labour market are clearly needed if unemployment is to be reduced and French workers’ potential fully realized. Such reforms helped considerably in reducing youth unemployment in Spain, where the government introduced a law in 2012 to give firms more leeway to lay off workers on economic grounds and to reduce severance pay. In Germany too, the Hartz labour reforms under Gerhard Schroeder adapted arrangements for collective bargaining, allowing many firms to strike deals with their workforces, and made it easier to hire young people on lower wages. They also shortened the maximum period for receiving unemployment benefits, made it harder to refuse job offers, and let small firms reduce staff more easily. These were unpopular at the time, and partially responsible for Schroeder’s loss of the chancellorship, but Germany’s labour market now functions much better. While in 2001, before Germany’s reforms, unemployment in France and Germany was comparable, at just under 8%, now it is below 5% in Germany and over 10% in France.

In France, there is an increasing awareness among the more business-minded, such as economic minister Emmanuel Macron, of the need for major structural reform. Hollande has promised reform on a number of occasions now, having pledged to reduce unemployment in his election campaign, but very little has actually been accomplished. Indeed, in France there are now 3.6 million people out of work, compared to 3 million when Hollande took office in 2012. The government have tried pumping money into subsiding jobs, but as is clear from the charts and figures, the trend is still going in the wrong direction. Measures like the the rupture conventionelle, a slightly simplified process for mutually agreed job terminations, and extended shop opening hours in tourist areas, are not enough and have had a negligible impact. In January of this year the government promised to train 500,000 job-seekers through apprenticeships and other schemes, but this seems to be too little, too late.

Nor has there been any change to the 35-hour working week policy, even though it’s so clearly to France’s detriment in our internationally competitive, globalised world. There is a proposal, currently under review, that would make the 35-hour limit more of a trigger for overtime payment than a rigid cap on hours, and would generally increase flexibility for firms with regard to laying off workers and controlling their pay. However, a number of similar proposals have been put forward in the past, and have been abandoned or heavily watered down due to the extent of opposition. It’s unlikely to be any different this time round. Nor is there any sign on the horizon of change to the labour code, despite Prime Minister Valls having called it ‘unreadable’ and promised to simplify it. On the whole, there has been some half-hearted tinkering, but no meaningful reform.

The main reason for this is political opposition. Fears over upsetting France’s powerful trade unions and the Socialists’ far-left allies, as well as their voters, stand in the way of effective reform. These fears are only going to become more pronounced in the run up to the 2017 election. The types of reforms discussed here are heavily criticised by the left for putting business interests ahead of those of ordinary people, and being in conflict with France’s constitutional values. France’s biggest unions are talented defenders of insider privileges. They, and many others in France, see the 35-hour week as a mark of progress; an entitlement. Even the timid reforms that have been implemented, as mentioned above, created huge controversy on the left of French politics, and had to be pushed through parliament. Many proposals were negotiated on to the extent that they were virtually ineffectual by the time they were acceptable to their left-wing opponents. This doesn’t bode at all well for the working week reform currently under consideration; the presentation of the draft law to the cabinet has already been postponed due to discontent within the party, strikes, and major street protests. Ultimately, Hollande is the head of a socialist government; market-friendly reform proposals are not going to be well received by the majority of their support base.

3 million people

were unemployed in

France when

Hollande took office

in 2012. Now, 3.6

million are

unemployed.

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Fiscal Issues - Spending

The last time a French government balanced its budget was in 1980, under Prime Minister Raymond Barre, a professor of economics. Since then, the deficits have been mounting and public finances significantly worsening, as governments have continued to overspend. France currently has one of the largest budget deficits in the Eurozone, and one of the highest ratios of state spending to GDP in Europe, at 57%, compared with 45% in the UK and around 41% for the OECD average. Even directly after the 2008 crisis, French government spending constituted a lower percentage of GDP than last year.

This problem developed, in part at least, because as a European Economic & Monetary Union member, France are unable to devalue their currency or use monetary policy to increase competitiveness. They have therefore had to rely on a high level of public borrowing to maintain living standards and try to stimulate economic activity. France has an excessively large public sector with an inefficient welfare system. Social expenditure, including on health care and benefits, constitutes a third of French national income, compared with a quarter in the UK. With France’s aging population to support and unemployment so high, state spending levels are only likely to increase.

This is particularly problematic in an economy that is barely growing and which faces deflationary pressures. Debt, measured as a percentage of GDP, has risen above critical levels by virtually any standards. It’s currently at 97%, while the Maastricht criterion of eligibility for the European single currency states that public debt to GDP does not exceed 60%. Economists Reinhart and Rogoff, authors of ‘This Time is Different,’ concluded, based on historical data, that the debt to GDP ratio ceiling is 90%. For rates above this, economic growth rates tend to plummet. France may incur a fine for its persistent imbalance, which would only serve to worsen the problem. France’s debt level makes the country highly vulnerable, which is a particularly undesirable position for a country that doesn’t control its own monetary policy. Even if low interest rates enable France to manage its debt burden for the time being, the global macroeconomic climate is volatile and uncertain.

To address this mounting problem, spending cuts are clearly required. With the euro having fallen considerably against the US dollar over 2015 and likely to fall further, this provides France with some breathing space to cut spending without further weakening growth. Nevertheless, not nearly enough is being done to rein in spending; significant cuts are not being made. This is clear from the statistics, forecasts and charts above, which show the trends continuing to move in the wrong directions.

Here too, there is political opposition. The limited measures that have been announced to cut spending in key areas, such as adjusting the pension regime, are met with fierce objections from the left. Many in government are unable to even admit that excessive spending is a problem. Socially too, the majority of French see their extensive welfare system and public services as a right, like their 35-hour working week. Any hint of this being reduced is unpopular and the politicians who would be responsible are afraid of the consequences.

Unless France makes some major debt reductions and begins seriously deleveraging, it is not only holding back a sustainable recovery, but it will also be in serious trouble down the line as it runs the risk of a fiscal crisis.

Budget deficit Public debt (including 2016 & 2017 forecasts)

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Fiscal Issues - Taxation

One way in which the government have attempted to resolve France’s worrisome fiscal situation, and to pull the country out of its economic malaise, is through increased taxation.

In his 2012 election campaign, President Hollande promised that income in the top bracket, above EUR 1 million, would be taxed at a rate of 75%. This would make it the highest effective tax rate in the OECD and would affect around 1,000 staff at 470 companies. The measure provoked pro-business finance minister Macron to describe France as ‘Cuba without the sun.’ It was implemented for two years, from 2013-14, and was then dropped in January 2015. This brought the top income tax rate back down to 45%, on par with most other wealthy European countries.

This policy failed to remedy the fiscal situation, bringing in returns of EUR 260 million and 160 million in 2013 and 2014 respectively, while over this period the budget deficit rose to over EUR 85 billion. In addition, it had a negative impact over the two years it was in place, from which the French economy is still suffering.

By reducing the disposable incomes of the highest earners by such a considerable extent, it led some of France’s best and brightest to move overseas. Significant numbers left for other major European cities such as London, with UK PM David Cameron saying he would ‘roll out the red carpet,’ and also for further afield. France’s richest man, Bernard Arnault, the chief executive of luxury group LVMH, applied for Belgian nationality, although he did then withdraw this, while French actor Gerard Depardieu’s fiery reaction and departure made international headlines. Even though the tax has since been reduced, the feelings of uncertainty about the tax rate that its implementation gave rise to persist. Indeed, it largely for this reason that the French continue to be the fastest growing migrant group in Hong Kong. At the same time, it has deterred foreign talent from moving to France; Jorg Stegemann, the head of the executive search firm Kennedy Executive, said that ‘it clearly has become harder to attract international senior managers to come to France than it was.’

The fact that such a tax was implemented has damaged France’s reputation in business circles and is seen as a red flag by international investors, many of whom were already wary of France, with its ever-changing tax rates.

The attempt at a 75% income tax rate is clear evidence of political concerns leading to poor economic decision-making. The policy is generally understood to have been introduced by Hollande as a symbolic gesture to appease the hardline socialists. Indeed, Hollande continued to defend the tax rate even after it was ruled to be ‘unconstitutional’ by France’s highest court, as he feared a revolt by the most left-wing members of his party.

Ultimately, the ‘supertax’ failed to reduce the deficit, where the focus should instead be on expenditure reduction. Reports by the IMF and the OECD have advised the French government of this. However, as seen in the previous section here, the government are making very little headway in that regard. France’s fiscal situation, therefore, remains worrying, with no credible sign of any significant improvement on the horizon.

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Society

Social fragmentation has become so severe in France that last year PM Valls spoke of a ‘social, ethnic and territorial

apartheid.’ Representative of this problem are the banlieues - isolated and deprived suburbs that surround Paris and other

major cities - which have been a concern in France for some time. They are generally home to ethnic minorities, with a

total of around 10 million people living in these neighbourhoods. Already at over 15% of the French population, this

number is increasing. The banlieues act as something of a social frontier, segregated from the rest of the population, and

are linked to problems such as high levels of crime and also possible Islamic radicalisation. They were the epicentre of the

major urban riots in France in 2005.

From an economic perspective, the issue of the banlieues overlaps with the unemployment situation already discussed

here – they are home to many of France’s NEETs. In some of the most deprived areas, the unemployment rate for young

males is 45%. In France in general, the unemployment rate for all immigrants is around 80% higher than the overall

national rate. People from such areas often face discrimination in the job market which, given the ethnic makeup of the

banlieues and the current climate of insecurity in France following the terror attacks, is only likely to worsen. Relatedly,

the poverty rate is shockingly high; one in five children in France live below the poverty line, and this is much higher in

some areas.

Hollande promised an end to the “ghettos” when he came to power in 2012, as did Sarkozy before him. Both attempted to

renovate, spending a total of around EUR 40 billion over the years on projects such as replacing the brutalist high-rises

with smaller buildings and creating more green spaces. There have also been schemes to encourage public-housing

renters to become home-owners. Much of this money was spent even before 2005, yet the riots that broke out in that

year, and the problems that have persisted since, suggest that this isn’t the answer. A number of studies have shown that

a sense of isolation and marginalisation prevails, and many believe that riots could easily break out again. And given

France’s fiscal constraints, more money for renovation is not a very viable option anyway. With regard to easing social

tensions, Hollande promised to monitor and register the ‘stop and frisk’ police ID checks against non-white people, but he

then reneged on this.

Given that the French schooling system is ranked among the developed world’s most unequal, with students' performance

highly dependent upon their socio-economic background, educational initiatives to rectify this would likely help. There are

examples of universities such as Sciences Po admitting more students from deprived areas. In general, though, while there

has been discussion of programmes in schools to encourage and facilitate integration, language classes, and a civic service

course for all students, there has been negligible change. Reform to the French education system is politically and socially

contentious; a set of government initiatives designed to address the inequality were abandoned when teachers and their

unions went on strike last year. Such initiatives also tend to be expensive, and even if they are to go forward, with such

grass-roots measures it will be some time before the benefits are felt.

Tackling unemployment in the banlieues is key. Not only would this help financially, but it would also break down societal

barriers and promote direct interactions. Labour law reform would be a step in the right direction but, as discussed, this

faces major political obstacles. New private enterprise would also be beneficial – Uber, for example, has created around

15,000 jobs in Paris alone, many for those who are young, relatively uneducated and from deprived areas. With regard to

encouraging entrepreneurship in the banlieues, though, there have been no substantial measures, only token gestures

such as a competition for young entrepreneurs with a maximum prize of EUR 7,000. The heavily-indebted government are

constrained financially, and it’s difficult for start-ups to succeed in France’s current economic climate, with weak growth,

low investment and a lack of business confidence. Currently, in the banlieues, half of all new businesses close within three

years.

On the whole, there has been very little improvement with regard to social fragmentation and the banlieues, and the

economic problems they pose, which are likely to weigh on France for some time to come.

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Security

The recent terror attacks in France and Brussels, with the November shootings in Paris killing 130 people, have shaken Europe and led to a heightened security environment. We shall look here at the impact of this on the French economy.

It should firstly be noted that the direct economic impact of the attacks was not major. The French stock index, the CAC40, closed for a couple of days after the November attack, but only dropped by a small amount when it re-opened, and recovered all of its losses within a month. Quarterly GDP growth for 4Q15 was steady at 0.3%. People generally steered clear of city centres in the immediate aftermath, perhaps even a week or two, but then, on the most part, economic life returned to normal. Consumption was postponed, but not abandoned.

It’s also crucial to consider the economic impact via tourism, which is important for France and for Paris in particular. There was certainly a short term hit, with a number of trips to Paris cancelled and others deterred; booking rates fell. Even here, though, the impact was not too drastic; Air France-KLM posted forecast-beating profits for last year and saw its shares rise to a 9-month high in February of this year. The 7.5% of GDP that does come from tourism in France and the 2 million jobs that depend on it are significant. However, only 2.5% of GDP is linked to foreign visitors, and the French economy is far less dependent on tourism than other recent terrorism targets such as Egypt and Tunisia. The French treasury estimated in November that, largely via the tourism impact, the attacks will cost the French economy around EUR 2 billion. At about 0.1% of France’s annual GDP, this is not ideal, but it’s not a game-changer.

Terrorism will have a serious long term impact on economic growth if a campaign becomes endemic, rather than sporadic. Northern Ireland's troubles lasted for 30 years and resulted in a decline in private sector employment, requiring a very high level of public spending to offset it, and a sharp fall in tourism. Despite continuing threats from IS, this seems unlikely to become the case in France. Two attacks in one year in France is tragic and unprecedented, but this does not make it endemic. Rather, Paris 2015 and Belgium 2016 are added to a list featuring 9/11, London 2005 and Madrid 2004. In such cases, the impact has been one of short term effects followed by a return to economic normality.

The terrorist attacks have added to France’s already worrying fiscal burden; the government’s commitment to reduce the budget deficit down to 3.3% of GDP this year now seems even less likely to be met, given increased costs related to security. The government announced the creation of 8,500 new public sector security jobs, mostly in policing and customs. The extra money spent in these areas and on additional security checks over time may weigh on growth for France and for Europe more broadly. On the other side of the coin, though, it will have a positive impact on unemployment, and means new contracts for surveillance and private security firms, not to mention the cash injections for French aerospace and defense industry manufacturers, with France having stepped up action in Syria.

The attacks and the related security climate are certainly an additional strain that the already beleaguered French economy doesn’t need; they’re a further knock to weak investor confidence. However, they are not the most major concern in the economic realm. If structural reforms related to the labour market and government spending were to get underway, issues relating to terrorism and security would be unlikely to impede a recovery in France’s economic prospects.

The French treasury

estimate that the

November attack

will cost France

around EUR 2 billion

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EU-level Challenges

It was mentioned in the introduction to this report that the fate of France is important for the broader European story.

This relationship works both ways. The current problems in Europe, specifically those related to the European Union, are

felt acutely in France and are important for its economic outlook.

Here we shall look in turn at a couple of the key EU-level risks and challenges and assess what they are likely to mean for

France and its economy.

‘Brexit’ - Ultimately, the possibility of Britain voting to leave the EU this coming summer is not a huge concern for France.

Despite mounting support for the ‘leave’ campaign, it remains highly uncertain which way the vote will fall when the

referendum is held on June 23rd. As shown on the chart below, an average of six of the latest polls indicates that it stands

at 52 to remain, 48 to leave. Most bookmakers currently still put the ‘remain’ camp ahead. Even if Britain does choose to

leave, the economic impact for the EU and for France is only likely to be marginally negative, spread over a number of

years. It’s likely that ad hoc arrangements would be put in place first to preserve bilateral trade agreements and financial

links. It would knock confidence and cause uncertainty though, shaking the institution as a whole. Britain leaving would

set a new precedent that a number of other members are at least likely to consider.

The migrant crisis & ‘Schengend’ - This is a more worrying development for France, and for Europe as a whole. The

arrival of migrants in ever increasing numbers compounds virtually all of the issues examined in this report. It adds to

France’s societal problems regarding a lack of integration, as well as to unemployment and to France’s fiscal burden. The

risks the migrant crisis poses to the Schengen agreement are even more severe and could have extremely negative

consequences for France, and other member states, if the free movement of capital, goods and people across borders is

to be restricted. France is already struggling with its balance of trade and from a lack of foreign investment. Schengen is

currently fraying at the edges, and developments here should be monitored closely over coming months.

Should Britain remain in or leave the EU? (six poll average)

Source: The Telegraph; What UK Thinks

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Political Risk

Given the extreme unpopularity of the current government, and in particular of President Hollande (pictured below),

who’s seen record low approval ratings of just 15%, it’s reasonable to expect that next year’s elections will put France on a

new political trajectory. In attempting to determine the fate of the French economy and its prospects for recovery, it’s

therefore crucial to consider the different possible electoral outcomes and what each would mean for economic policy.

Despite his party’s stronger than expected performance in France’s regional

elections last December, Hollande’s unpopularity and his government’s failures to

solve France’s economic problems mean that it’s certainly an open race.

Discounting for the ‘rally-round-the-flag’ effect, from which Hollande benefited in

December, the Socialist government are likely to enter the presidential contest on

the back foot. And with Hollande’s centre-ground dithering alienating the leftist

segments of his own party, all of whose support he needs to make it through to the

second round of the election, his chances of another term at the helm seem low.

Turning then to his likely challengers, the French right is split between the moderate, mainstream Republican party,

currently led by Nicolas Sarkozy, and the extreme right-wing National Front (FN), led by Marine Le Pen.

National Front

FN have become an increasingly significant force in French politics, due to factors such as the failure of the Socialists to

stimulate the economy and tackle the fundamental problems, as well as the issue of migrants, and the recent terror

attacks.

However, their rise should not be overstated. FN performed worse than many expected in last

year’s regional elections. Despite a string of first round successes, they failed to take any

regional governments. This was largely due to tactical voting in the second round, as Socialist

candidates withdrew from the regions where FN had the best chance, and the leftists rallied

successfully behind the more moderate right-wing candidates, in a ‘lesser of two evils’ play.

Similar tactics were used in the 2002 Presidential election, and we can reasonably expect to see

this behaviour and outcome again next year. FN caused shockwaves when they entered the

mainstream and their popularity rose quickly, but it may well now have plateaued; they drew

the same share of the vote in both the second and first round regional elections. At a

substantial 27%, they should not be ignored, and further terrorist attacks between now and the

election will be significant, but ultimately we’re highly unlikely to see Le Pen (pictured) in the

Élysée Palace next year.

The Republicans

It therefore seems that the most viable candidate for 2017 is whomever represents the mainstream right. The Republicans

won the most regions in 2015, and took the largest share of the vote. They now face an uncertain primary contest, to be

decided this November.

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Recent polls suggest not only that Alain Juppé (pictured left) will win the Republican candidacy –

a Le Monde poll puts this at 44%, with Sarkozy at 32% – but also, as shown on the chart above,

the presidency.

Juppé benefits from the fact that he’s not Sarkozy, and is popular with the moderate-right, as

well as, increasingly, the left. Indeed, many socialists are disillusioned with their current

representation and agree with Juppé’s relatively liberal social views. He’s seen as a calm,

experienced and stable pair of hands. We believe that in the absence of unexpected

developments over the next year, it will be a very close race, but Juppé will indeed most likely

be the victor.

The other conceivable centre-right candidate is the current Republican leader, and former

President, Nicolas Sarkozy (pictured right). He has a strong support base within the party.

Economically, in theory, this could be good for France; Sarkozy advocates labour market

deregulation, cutting bureaucracy and deficit reduction. During his previous presidency he

attempted reform to the labour market and education, but was unable to overcome social

opposition, including student protests, national strikes and demonstrations. The proposals that

were eventually passed were, on the whole, considerably watered down. There seems to be no

reason why this would not be the case this time round, too.

With regard to what a Juppé presidency would mean for the French economy, he’s pro-business and an advocate of

spending cuts, and is therefore also likely face significant societal resistance for any substantial reform attempts. He, too,

has precedent here; as Prime Minister in 1995, his contested pension changes resulted in around two million people

taking to the streets, paralysing France in the worst strikes since the 1960s.

Juppé has certain advantages, though. At 70 years-old, he has said he will only serve one term, and that he will therefore

be braver in pushing through reforms and less concerned about upsetting the electorate. He’s at a stage in his career

when legacy is likely to be more important than currency popularity. It’s also true that his leftist social leanings might be

enough to appease and to win him the political capital required to pursue pro-business economics and push through

structural reform.

With regard to the legislature, the French National Assembly are also elected every five years, shortly after the

presidential contest. In France’s semi-presidential system, parliamentary support is important if a president is to pass

legislation and fulfill promises. Currently, the Socialists have a slim majority, but as with the presidency, they may well lose

this next year, for the same reasons discussed on page 14. There have only been three occasions when the French

president’s party has both failed to win a majority and to form a coalition with smaller parties. We therefore predict a

legislative majority for the Republicans in 2017.

With a great many variables and uncertainties, the political situation should be monitored closely over the next year.

There’s certainly no reason to celebrate just yet, but it does seem to be the case that France’s most likely 2017 president

might also be its best chance at economic recovery.

32

.40

%

27

.40

%

24

.50

%

18

.40

%

J U P P É L E P E N S A R K O Z Y H O L L A N D E

Presidential election polls (an amalgamation of Ipsos, Ifop & Odoxa polls conducted January - February 2016)

16

Conclusions

The problems facing the French economy are not insurmountable; France has the potential for much stronger economic

performance than recent history suggests. The key obstacle here, observable to some extent in all sections of this report,

is that the French government are being sclerotic with regard to the necessary structural reforms. This is the fundamental

problem in France, that needs to be overcome if the French economy is to be lifted out of its fragile state. This is clear with

regard to labour laws and spending reductions, as well as in relation to France’s seeming inability to resolve its societal

fragmentation. Costs related to terrorism and security, and EU-wide problems, if not the most critical for the French

economy, add to its burden.

The reason for this lack of significant change is both political and societal. Attempts at reform, even relatively minor ones,

have time and again been met with opposition, from dissent with the party, to strikes and street protests. There are

political red lines when it comes to issues like the amount spent on pensions and social welfare, and working hours, that it

is taboo to cross in France. French leadership has been too afraid of challenging and confronting vested interest groups.

Governments on both the left and right have given in to the powerful unions for the sake of popularity and stability.

Despite those like Macron and Valls, and increasingly even Hollande, realising the need for structural reform, they have

failed to push for it, to make the, admittedly tough, decisions required. At the same time, a substantial part of the French

political class and society don’t even recognise the need for change.

We are highly unlikely to see any improvement before the elections next spring. Hollande has created major divisions

within his own party and upset the more left-wing members with moves such as his controversial attempt to reform the

French constitution and strip convicted terrorists of their French nationality. Hollande therefore fears the more left-

leaning elements of his party breaking off and fielding their own candidate, so will be more determined than ever to

appease and neutralise them as his re-election campaign gets underway.

In the near-mid future we are therefore likely to see a continuation of Hollande’s irresolute wavering between the left-

wing and business interests. Not only has he failed to make the necessary changes to benefit the economy, he has also in

some areas made decisions that downright harm it. Hollande recently promised, following the mid-February cabinet

reshuffle, to use this year to ‘act, reform, move forward,’ yet given past performance, such statements are unconvincing.

So what does this mean with regard to the outlook for the French economy? It seems set to continue to grow anemically

for the time being. But at some point, the factors working in its favour, keeping it afloat, like low energy prices combined

with low borrowing costs and a weaker euro, will cease to be. When energy prices start to sustainably turn around,

perhaps some time later this year, if France is still not making any real progress towards structural reforms, the depth of

the problems it faces are going to be brought to the forefront.

A change in governance, perhaps bringing Juppé to the helm, would likely be an improvement, but it would not be a quick fix. Even though Juppé has many of the right ideas, his ability and willingness to stand up to political and societal opposition remains to be seen. We therefore conclude with a broadly pessimistic outlook for France’s economic future.

17

Consequences and Opportunities

Given our pessimistic conclusions, with little sign of light at the end of the tunnel, it seems that the most promising way to

capitalise is by taking short positions.

As shown on the chart here of the French

equities index, the CAC40, over the last

year there’s been a clear gradual

downtrend. Based on our assessment here,

it seems that this is likely to continue.

In our view, the best way to proceed is by

picking the sectors and stocks with the

most downside potential. In light of our

conclusions, those suffering the most are

likely to be those most exposed to France’s

domestic economy. We shall therefore look

here at some of the sectors in the French

economy that are vulnerable to the

domestic market, to see where they may

be opportunities to sell short.

Automobiles & autoparts

Banking & investment services

Energy & chemicals

Cyclical consumer products

Food & beveragesHealthcare & pharmaceuticals

Industrial goods & services

Insurance

Real estate

Retail & personal goods

Telecomms & IT services

Utilities

CAC40 business sector breakdown (by market capitalisation)

CAC40

18

Aerospace & defence

Sectors such as aerospace and defence, deemed strategic and protected by government, would not be the best choice

here. This is also France’s major export sector, consisting of companies like Airbus that see strong and relatively consistent

demand from overseas.

Luxury goods

Luxury goods companies, too, are exposed mostly to foreign markets. LVMH, for example, take only 10% of their revenue

domestically, with around 35% from Asia.

Auto manufacturers

Auto manufacturers, Renault and Peugeot, are perhaps also best to avoid with regard to a short selling strategy. Both have

outperformed the index for some time, benefiting from cheaper oil, and from the emissions scandal that hit rival German

manufacturer Volkswagen.

Retail

The retail sector, however, is more likely to lose out in tougher economic times with weaker consumer spending.

Carrefour, for example, takes almost half of its revenues domestically, with the top source of its international revenues

(15%) coming from Brazil, a country which makes France’s economic problems seem almost trivial.

Banking

France’s banking sector is also of interest here. Even though French banks’ asset quality and capital adequacy ratios have,

on the whole, improved in recent years, they are negatively affected by the gloomy domestic environment. With

consumption and business investment relatively weak, demand for credit has been limited, despite low interest rates. At

the same time, the banks are seeing their margins squeezed by the ECB’s negative interest rate policy. The major listed

banks all recovered the significant losses they saw at the start of this year, but have continued to slide and underperform

the index. They currently face additional headwinds of volatile global markets and EU regulatory pressures.

19

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Copyright © 2016 Apt Capital Management Limited. All rights reserved.

This report was prepared by Apt Capital Management Limited from sources believed to be reliable. No warranties are made to the accuracy of information contained in this report. The content of this report is provided as general information only and should not be taken as investment advice. All content shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed in this report are solely the opinions of the author(s) and do not necessarily represent the opinions of Apt Capital Management Limited. Apt Capital Management group companies may or may not have a position in any security referenced herein. Any action that you take as a result of information or analysis in this report is your responsibility. Consult your investment adviser before making any investment decisions.

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