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November 21, 2013

France’s Latest Downgrade: Cause for Worry or False Alarm?

Standard & Poor’s, which stripped France of its AAA credit rating in January of last year, recently delivered another cut to the country—this time from AA+ to AA causing some concern from international investors. The ratings agency said that measures taken by President Francois Hollande were not adequate to spur growth in the Eurozone’s second largest economy.

The rate on French bonds barely budged after the announcement—up only seven-hundredths of a point to 2.23%—and there was no mad rush to the exits. And Hollande has said that he will not change strategy, but will keep to the course currently held by the French government. Although it is obligated to follow EU rules to keep its spending in check, policy is focused more on tax increases than benefit cuts to cut the government’s deficit.

Other European countries that have aggressively followed a course of austerity have seen unemployment skyrocket, leaving many people without a social safety net in places like Spain, Portugal and Greece. France chose to go a different route, and its economy, while not exactly humming, is still expanding. In the second quarter of 2013, it was up 0.5% from Q1, and its annualized rate is coming in around 2%. Its unemployment rate is currently at 11.1%.

But S&P said it has no confidence in Hollande’s strategy. “We believe the French government’s reforms to taxation, as well as to product, services, and labor markets, will not substantially raise France’s medium-term growth prospects. Ongoing high unemployment is weakening support for further significant fiscal and structural policy measures,” it said in a statement.

Still, neither Fitch nor Moody’s has rushed to join S&P in its action, yet. In particular, Fitch, which was the last of the Big Three to strip the country of its AAA sovereign rating, did so only this past July—with a stable outlook. It has seen no need to join S&P in adding a fresh downgrade to the country’s sovereign debt rating. Fitch spokesman Peter Fitzpatrick said in an e-mail that the July report was “very clear on our outlook for France and the rating drivers; i.e., why it has a stable outlook.”

At the time, Fitch predicted that France’s “GDP [will] contract in 2013 before growing by 0.7% in 2014. Fitch’ projection for long-term potential growth is broadly unchanged at around 1.5%.” Thus far, France’s economy is still expanding.

Fitch also said at the time, “Despite the loss of its ‘AAA’ status, France’s extremely strong credit profile is reflected in its ‘AA+’ rating with a Stable Outlook,” and cited numerous factors. Among them was the very “wide-ranging program of structural reforms, including the ‘National Compact for Growth, Competitiveness and Jobs’ and recent labor market reforms as well as “France’s wealthy and diversified economy and political stability entrenched by strong and effective civil and social institutions.” These civil and social institutions would take the hit should France embark on a course of strict austerity.

So far, the markets have regarded the S&P news with a caution.  Dr. Paul Krugman dismissed it in an opinion piece titled “The Plot Against France.” He pointed out a number of salient factors accounting for his dismissal, such as France’s superior economic performance compared with that of many of its neighbors, Germany excepted; the fact that France’s economic growth currently outpaces “the Netherlands, which is still rated AAA”; and that French workers “were actually a bit more productive than their German counterparts a dozen years ago—and guess what, they still are.”

Krugman also chalked up the S&P’s move more to politics than to economics, saying that since France was criticized as “the time bomb at the heart of Europe” by The Economist last year and other critics added their own disparagements of the country, one might expect to see that French data might reflect such gloomy sentiments. But that is not the case, he said, adding that the country’s budget deficit has fallen substantially since 2010 and even the International Monetary Fund expects that France’s debt-to-GDP ratio to remain relatively stable for the next five years.

So should investors be concerned over the downgrade? There is no clear answer yet. For one thing, it certainly doesn’t have the impact of the very symbolic cut from AAA that the country endured last year, which makes it less likely that the country’s borrowing costs will suddenly soar. For another, since those costs have not yet escalated substantially, there’s no present cause for undue concern about France’s ability to pay its debts.

Still, the French economy is not without its challenges, and there could be warning flags on the horizon. While the country’s services sector was up for the second month in a row in October, as was employment in the sector, Markit Economics’ PMI indicated that manufacturing and retail were not so lucky, with both showing falling numbers for October.

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