Authored by Charles Gave of GK Research, A Gavekal Company,
Last month we laid out the reasons why France was On The Brink Of A Secondary Depression—in short, due to a deadly collision of French politics with Frankensteinian monetary union. Unfortunately, subsequent data confirms the bleak trajectory:
The INSEE Business Climate Survey has fallen below 88 (or two sigma below the mean). This indicates France is entering into a recession as nasty as 1993 and perhaps as nasty as 2008-2009. She will enter into this recession with government spending at 57% of GDP, an all-time high, and with a debt-to-GDP ratio close to 90%—and that’s not including the liabilities for civil servant pensions. If they were included, the debt to GDP ratio could double, according to some estimates (see the report on public finances by Michel Pebereau).
Even Francois Hollande is beginning to wake up to just how destructive and anti-business the French agenda is. On Monday, Hollande announced measures designed to encourage the French entrepreneurial spirit - essentially by watering down programs he himself imposed after winning the presidential election last year.
The new agenda includes cuts in capital gains taxes. The effective capital gains tax will now decline by 2 percentage points, to 32.5%. This is better than last year’s outlandish move to effectively bump up the capital gains tax to as high as 62% in some cases. But the president’s reversal is the desperate move of a cornered politician, not a sign that we will see a steady hand on the tiller of reform in coming years.
- Between 2000/2011, the overall tax to GDP ratio went down about -1.6 percentage points across the European Union: -2.6pp in Germany, -1.4pp in the UK, and -7.2pp in Sweden. In France it contracted by just -0.3pp. France is now poised to overtake Sweden as the most heavily taxed major country among the 27 nations in the European Union, with an overall rate of 44% vs 39% for the EU as a whole.
- French implicit taxes on capital gains rose by 4.3pp in 2000-2011, an increase surpassed only by Italy and sharply at odds with the declining trend in Germany (-5pp), the UK (-9.1pp), Sweden (-16pp) and the Netherlands (-7pp), not to mention euroland as a whole (-2.7pp).
- In absolute terms French implicit taxes on capital are a gigantic outlier at 44.4%, compared to an average of 27.2% among the 17 nations in the euro area.
In this context, Hollande’s reversal on capital taxes reminds me of the guy walking up the steps to be hanged, who slips, falls and says “could have been worse.” France remains one of the deadliest environments for entrepreneurs.
As France crashes into a secondary depression, tax revenues will shrink and automatic stabilizers will kick in. The French budget deficit is going to explode upwards. See the chart overleaf: the recession in 1980 saw the primary balance deteriorate by 2% of the GDP, and the 1993 recession led to a deterioration of 4%. By 2008-2009, the stakes had risen to 6%.
If we compute the average deterioration for the last three recessions, we get a 4% target, which would take the French primary deficit by the beginning of 2014 to 7% of GDP (that is more than 16% of the private sector GDP). If we instead extrapolate the trends (2, 4, 6...) we arrive at a primary balance equivalent to 11% of GDP, which is not to be ruled out since, as I have already said, France is going into a depression.
Needless to say, the government “forecast” of the budget deficit falling this year and next is totally risible, and on par with forecasts made by the Spanish or Greek governments over the last few years.
Typically, the cost of borrowing rises as a country sinks deeper into the quagmire: thus the “trap” in debt trap. It should be noted this time interest rates are very low in France, and may remain so. But even so, French debt ratios will keep exploding, since the growth rate of the nominal economy will be much lower than the average interest on public debt. See the black bars on the chart below: this will surge big time. Moreover, this will occur around a time (2015) when, the past debt issued to deal with the economic collapse of 2008-2009 will become due.
France may thus have to issue debt equivalent to a large percentage of her declining GDP (15% to 20%?) year after year and for the foreseeable future.
Knowing this, why then are French rates so low? The usual explanations (purchases by the Swiss National Bank and Mrs. Watanabe buying) have some merit, but other factors may also be at play. France has a large financial sector, with huge international positions. Some entities may be selling international holdings which demand large reserve requirements. The proceeds are then brought back in France to buy French government bonds—against which there are no reserve requirements.
The economic impact of such a trend would indeed be benign for interest rates. But ultimately, it raises the risk on the French financial balance sheet: less diversity, and more vulnerability to a problem with the local sovereign.
In any case, in a bond market, one should look at two things: the return ON capital and the return OF capital. The return ON capital is pitiful and the return OF capital is far from certain. Sell the financials in Europe - and in France especially.
Really, the euro is on its last legs. France is in play.