DBRS Confirms the Republic of France at AAA, Stable Trend

DBRS, Inc. (DBRS) has confirmed the ratings on the Republic of France’s long-term foreign and local currency debt at AAA, with Stable trends. DBRS has also confirmed the short-term foreign and local currency ratings at R-1 (high) with Stable trends.

The Stable trend on France’s ratings reflects DBRS’s assessment that France possesses a strong capacity to repay its debt obligations and a high degree of resilience to shocks. The French economy continues to face significant headwinds, including weak external demand from key trading partners, fragile domestic confidence, the drag from fiscal tightening, and weak corporate profitability. Nonetheless, DBRS believes that the government has made considerable progress toward achieving structural fiscal balance, and the 2014 stability program suggests that fiscal consolidation will continue throughout the end of the current administration. In addition, while structural factors may be contributing to France’s weak economic performance, France’s debt-to-GDP ratio is likely to stabilize by next year.

France’s credit ratings could come under pressure if weak economic growth persists, held back by structural rigidities in the French economy and a lack of competitiveness. There is also a risk that the government may fail to follow through on additional reforms to foster economic growth, and that fiscal discipline will begin to erode well before the government attains its medium-term objective of structural fiscal balance. Finally, while external risks appear to be receding, a renewed deterioration in Italy or Spain could have significant spillovers to France’s real economy, financial system and corporate sector, and could have an adverse impact on demand for French government securities.

France’s sovereign ratings benefit from the high level of productivity, size, and diversification of the French economy. Output per hour worked is slightly below that of the United States, and France’s economy is the fifth largest in the world. A high savings rate has enabled France to sustain a high rate of investment, and the country benefits from high quality infrastructure. In addition, a generous social welfare system helps to reduce fluctuations in output.

The combination of a large pool of domestic savings and France’s Eurozone membership provides the public sector with a very high degree of financial flexibility. In spite of the cost of supporting weaker Euro zone countries that have lost market access, France’s Euro zone and EU membership provides numerous benefits, including a very large common market, a highly credible central bank and the second-most liquid reserve currency in the world. France’s sovereign debt market attracts considerable safe haven flows during recessions and crises, and both foreign and domestic demand are resilient. As a result, interest payments on general government debt remain low at 2% of GDP and 3.8% of general government revenue, in spite of the steady rise in the public debt to GDP ratio.

After France’s deficit surged to 7.5% of GDP in 2009, the government initiated a substantial fiscal adjustment program. The Hollande Administration has remained committed to that course in spite of economic headwinds. A gradual pace of adjustment was adopted to cushion the economic impact of the adjustment, particularly in light of the recessions in neighboring countries. Still, the IMF estimates that a cumulative structural fiscal adjustment of 3.8% of GDP will have been achieved by end-2014, roughly 2/3 of the adjustment needed to reach structural fiscal balance. It remains unclear whether the government will achieve the 3% nominal deficit target by 2015, given the trade-offs between tax reduction measures intended to support growth and the fiscal cost of these measures. However, DBRS takes comfort in the commitment shown and the progress achieved to date.

Meanwhile, the French banking system has reduced risk exposures and strengthened capital and liquidity buffers. Corporate and household balance sheets remain relatively healthy. Domestic real estate prices are declining at a moderate pace but likely to be supported in the medium term by demographics and strong demand for housing in urban areas. Systemic financial risks stemming from the mortgage market are attenuated by prudent loan-to-value ratios and the diversified balance sheets of French banks. For households, non-real estate financial assets have recovered to well above pre-crisis levels, helping to cushion against further sharp declines in domestic demand amid an environment of depressed real wage growth.

France nonetheless faces significant challenges as it enters its third year of close to zero growth. DBRS remains concerned that cyclical and structural factors could continue to impede the recovery; indeed, preliminary data for 2014 suggests that growth may fall short of government projections this year. While the government has augmented efforts to lower labor costs and alleviate France’s high tax burden, the cumulative impact of government measures taken to support growth may be insufficient to counter high labor costs, high and potentially rising structural unemployment, and weak corporate profitability. Export performance has been somewhat poor, in part because France relies more heavily than neighboring Germany on demand from southern Europe and the UK. Enhancing France’s competitiveness both inside and outside of Europe would likely help to fuel stronger growth.

France’s high burden of debt is also an important challenge, in spite of the currently low debt servicing costs. With gross public debt expected to peak at 96% of GDP next year, France has less space to absorb shocks than it did in the past. A failure to reduce debt over the medium-term, particularly as the economy returns to its potential rate of economic growth, could result in materially higher debt servicing costs as global interest rates rise. Consequently, DBRS considers implementation of the new fiscal framework and adherence to the medium-term objective of structural fiscal balance to be critical to France’s ratings.

France’s high rate of unemployment, particularly among younger workers, also poses a concern. France’s generous social welfare system has traditionally been associated with a somewhat higher rate of structural unemployment, and France’s relatively high labor costs may continue to weigh on the pace of job creation. This carries a substantial fiscal and social cost, and long-term unemployment could have lasting effects on the average level of productivity. In this context, the government is working to improve worker training programs and expand adult education, but additional efforts may be required.

Finally, France’s demographics also reinforce the need for strong budget discipline. Although France has one of the highest fertility rates of any advanced economy, its public expenditures on pensions, health, and long term care are among the highest in the world, accounting for about 23% of GDP. With the old age dependency ratio projected to increase from 25.8% in 2010 to 32.8% in 2020, pressure on fiscal accounts is likely to continue. This could be especially important if health care costs were to increase more than recent trends suggest.

Notes:
All figures are in Euros unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include the Ministry of Economy and Finance, Agence France Tresor, INSEE, Banque de France, IMF, OECD, European Commission, and other analysis and research by private sector entities. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer and did not include participation by the issuer or any related third party.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Thomas Torgerson
Rating Committee Chair: Roger Lister
Initial Rating Date: May 12, 2011
Most Recent Rating Update: August 2, 2013

For additional information on this rating, please refer to the linking document under Related Research.