Paris, July 11, 2008

France is indeed on the move. But global headwinds have strengthened. Now is the time to press on the accelerator in implementing the ambitious strategy to shift the country to a more rapid growth path, while also decisively preparing the public finances for the future.

1. The key policy question is how to respond to the present shocks so as to moderate their impact and promote the needed adjustment to a new global setting. The world, and France, currently confront difficult economic challenges. The ongoing financial turbulence and elevated oil and commodity prices have depressed growth and pushed up inflation. For France, we see five key policy responses to these shocks:

First and foremost, pressing rapidly forward with the reform initiatives to free the economy from its long-standing structural fetters. Increasing competition, reducing rents and mark-ups, and raising employment are the best way to enhance pouvoir d’achat. ease inflation, and boost growth. They are pertinent both to the present conjuncture and to longer-term prospects.

Second, recognizing that the increases in fuel and commodity prices largely reflect a permanent shift in relative prices, requiring adjustment via clear price signals and protection limited to the truly needy through well-targeted measures.

Third, ensuring that the current relative price shocks do not result in a generalized increase in inflation by avoiding second-round effects through wages.

Fourth, remedying the regrettable consequences of repeated postponements of fiscal consolidation. Not having adjusted sufficiently when times were good, France now has no room to use fiscal policy to cushion against adverse shocks. It must avoid a perpetuation of this situation, firmly placing the public finances on a sustained consolidation path.

Fifth, enhancing the resilience of the financial system while further advancing its liberalization and modernization.

2. Growth is slowing, but the French economy has proven comparatively resilient. Despite a stronger-than-expected first quarter, we forecast GDP growth to decline to 1.6 percent in 2008 and around 1 percent in 2009, as the effects of the global financial crisis, the shock in energy and commodity prices, the slowdown in partner countries, and the strengthening of the euro play out in France. These annual averages mask a reacceleration of growth to trend in the second half of 2009, making the slowdown a relatively mild one by historical standards. The French financial system has weathered the global market turbulence comparatively well, but pressures persist and the impact on the real economy still has to unfold. Financial conditions remain tight, with continued higher bank spreads and a slowdown in credit growth in prospect. Inflation has accelerated to uncomfortable levels in recent months, but core inflation (excluding food and energy) has risen by much less, suggesting that spillover effects from higher energy and commodity prices have so far largely been avoided, auguring well for inflation prospects looking forward. Risks around this outlook are high, but can be attenuated by appropriate policies.

3. The immediate policy challenge is to ensure that economic efficiency is maintained while protecting vulnerable population groups. The key guiding principles are well-reflected in Minister Lagarde’s letter of May 30 to the European Commission, stating that the first objective should be to prepare our economies for lasting higher petroleum prices, and that this must be done by letting price signals work so that businesses and consumers adapt their behavior. In this respect, while excess VAT revenues mightwhere fiscal space allowsbe suitably used to cushion the shock of higher prices on the most vulnerable households, governments should resist measures that are not targeted to the truly needy, distort markets by favoring specific sectors, or are triggered by some arbitrary notion of an overshooting of energy prices. Because higher-income households consume a disproportionate share of energy, they would also receive an undue share of the benefits from broad measures, which are furthermore difficult to reverse. These considerations should be borne in mind in the study on the feasibility and impact of measures to smooth the effects of sudden energy price increases commissioned by the June European Council.

4. The Loi de modernisation conomique (LME) stands to be a major step in better equipping the economy to face global challenges, clearing rigidities in product and services markets, to the benefit of the consumer. These benefits must be safeguarded, and it will be important that pressures to weaken the LME be resisted in its approval process. The draft law has several notable features, incorporating steps we have long advocated:

In retail distribution. the easing of restrictions on new retail establishments and the greater flexibility given to retailers and suppliers in negotiating prices will allow for lower prices to consumers. Together with earlier steps, such as the recent Loi Chatel. these measures are estimated to permanently lower retail prices by around 2 percent, corresponding to an average gain of 1000 in purchasing power per year for each French household. But international experience indicates that these gains will be realized only if all barriers to entry are effectively lifted. It will thus be crucial that parliament ensures that both the authorities vested with, and the criteria governing, the opening of retail outlets are such as to entail genuine liberalization. At the same time, to guarantee that this results in genuine competition, the new competition authority should be attributed robust powers to dismantle situations of abuse of market dominance and repress predatory pricing.

We strongly welcome the LME’s creation of a unified and strengthened competition authority. The new authority should be well staffed; current plans might be overly modest in this regard. It should also be mandated to be a proactive competition advocatea voice now largely absent in the French policy debate. It should accordingly be empowered to study areas where policy changes could boost competition, issuing periodic reports with in-depth sectoral studies and specific recommendations. Several countries’ experience indicates that these can provide helpful signposts for legislative action.

The law’s measures in the financial sector. notably the generalized distribution of the Livret A. complement steps taken in other contextssuch as those reducing banks’ switching costs, allowing the Banque Postale to grant consumer credit, and promoting the Paris-Place Financire initiativesto increase financial sector competition and efficiency.

5. Containing the adverse inflationary effects of the global shocks requires avoiding second-round effects. This has largely been the case to date, thanks to commendable wage moderation, necessary also to address France’s relatively weak competitive position that has depressed growth. The absence of a coup de pouce to the SMIC both this year and last was itself an important contribution to avoiding a detrimental generalization of current inflationary pressures. It should be perpetuated in the future, as halting the secular rise in the SMIC has broader benefits: avoiding pricing young and unskilled workers out of market jobs, decompressing wages at the bottom end, motivating effort and career prospects, and easing the heavy burden on public finances. The recent moderation in the SMIC has already resulted in a noteworthy reduction in the share of SMIC beneficiaries in total enterprise employment (from 16.2 percent in 2005 to 12.9 percent in 2007), enlarging the scope for free wage negotiations between the social partners. We look forward to the work of an independent committee of experts, which could help assure that the minimum wage truly optimizes employment opportunities for low-skilled workers.

6. Raising France’s low labor force participation, employment rate, and annual hours worked is pertinent both to current challenges and longer-term growth. The measures in the Loi de modernisation du march du travail are a positive first step, though they only marginally ease labor market constraints. The law implements the January 2008 agreement between the social partners, which took the present, highly limiting legal framework for labor relations as a given. Still, the legal concept of rupture conventionelle stands to appreciably reduce juridical uncertainty when employers and workers agree on terminating a contract. More promising are the measures in the Loi de reprsentativit syndicale et temps du travail. These have the potential to be path-breaking, enhancing social democracy and improving the collective bargaining process. In addition, while not altering the cost effects of the statutory workweek reduction to 35 hours, the law grants notable freedom to enterprise negotiations to determine working time. Finally, the merger of ANPE and ASSEDIC is a further attempt to coordinate unemployment benefits with job placement efforts, within a return-to-work orientation based on both rights and obligations. Both international and previous French experience (e.g. the PARE-PAP earlier this decade) have demonstrated that the real test lies in effective implementation on the ground, and it will be key to endow the merged agency with a monitorable business plan to which it should be held rigorously accountable. Again, experience suggests that a gradual phase-out of unemployment benefits (degressivit ) and/or the progressivity of sanctions are generally more effective in promoting return to work than a tout ou rien approachan indication that could usefully feature in future negotiations on the unemployment benefits scheme. We would also encourage contemplating an enhanced role for private job placement agencies in the new regime.

7. The public finances have been a relatively weak area in France’s economic performance. The 2007 budget outturn was worse than planned, and fiscal performance in 2008already unambitious in the budgetrisks slipping again due to lower growth, continued expenditure pressures from health care and early retirement schemes, and a higher interest bill. The outlook for 2009, when the lagged effects of lower growth on revenues and of inflation on social transfers will be felt, is potentially even more worrying. We urge the authorities to take prompt action to forestall any worse-than-budgeted outcome this year, and in this regard welcome the early definition of corrective measures in the health sector, even in the absence of a formal alert procedure. The state’s traditional careful management of discretionary spending and vigilant safeguard of the Rserve de Precaution will also be key.

8. France cannot afford to postpone fiscal consolidation yet again. In the current slowdown, EU countries at their medium-term objectives (MTO) have had room to cushion the negative shock, while those, like France, far from their objectives have been comparatively hampered in their response. The repeated slippage of deficit targetsas happened with the revision of the 2008 and 2009 targets as soon as the 2007 outturn was knownhas also undermined the credibility of successive French fiscal plans. Now is the time to reverse this trend, with firm action in the 2009 budget and an unwavering recommitment to achieving fiscal balance by 2012. We welcome the indications in this regard provided in this year’s Rapport Prparatoire au Dbat d’Orientation des Finances Publiques (DOFP), and look forward to its further specification on the basis of realistic growth projections for 2009 and credible assumptions on potential growth for the medium term. Under our growth scenario, achievement of the MTO will require appreciably more restrained growth in general government real spending than that envisaged in the DOFP.

9. The general review of public policies under way, along with containment of local authority spending, will complement other structural reforms and are vital to healthy public finances. We strongly support the Revue Gnrale des Politiques Publiques (RGPP) to secure lasting expenditure efficiency and reduction, beginning with an unprecedented non-replacement of retiring civil servants. The move to multiyear budgeting is also welcome, but the new framework will be effective only if the target deficit path is not revised with every change in circumstances. The RGPP should also provide the opportunity to advance further in rethinking the role of the state in the economy. This will need to include streamlining the different levels of local and regional government, whereas well-illustrated in the DOFPexpenditures have consistently grown faster than in the central government, and where overlapping responsibilities have been a source of significant inefficiency. Addressing these issues also requires a rethink of the relations between the central government and local authorities and of local authority taxation, including reform of the taxe professionnelle now the main focus of the originally broader general review of the tax system (RGPO). These changes will need to be designed in a way that increases local authorities’ co-responsibility and accountability for fiscal outcomes.

10. France urgently needs to move away from its incessant recourse to tax incentives (niches fiscales ) to influence agents’ behavior. Throughout, the tax system is riddled with tax expenditures costing nearly 4 percent of GDP per year, often adopted in a haphazard way outside the budget process. We urge a moratorium on new tax expenditures until all existing benefits are evaluated and rationalized. We also recommend that any future such benefits be adopted only in the context of the annual budget law, with costs and benefits fully accounted for, and with sunset clauses to assure that they do not become engrained in the tax system. Strengthening the proposed new constitutional wording on tax decisions may be helpful in this respect. Over time, France should move toward a flatter, broader, and much simpler tax system if it is to generate sufficient revenues while providing a tax climate favorable to innovation, investment, and a productive workforce.

11. The French financial system has weathered the recent global market turbulence relatively well, but risks remain. The persistence of the crisis may weigh heavily on the bottom line and capital of banks, as shown in their first quarter results. With the ongoing reintermediation and deleveraging, risks arising from monolines, hedge funds, and LBOs may become significant, requiring continued monitoring by the Commission Bancaire and effective risk management by banks. Banks should use a range of measures to accurately price risk and measure capital and liquidity adequacy. We welcome the timely action to strengthen internal bank controls and measures to raise the currently low level of sanctions. The priority assigned to improving disclosure practices is also well-placed, as is the attention paid to strengthening the governance of risk control, with the involvement of senior management and an appropriate compensation policy. Looking forward, building robust capital and liquidity buffers is of paramount importance. The Banque de France’s periodic Financial Stability Reports have recently been devoted to interesting specific topics, but we would welcome if these were complemented with a detailed analysis of recent developments in the sector. Finally, we warmly welcome the intention to assign a high profile to financial sector issues during France’s EU presidency, and look forward to progress in the EU’s cross-border financial stability framework, inter alia giving teeth to the EU dimension of national supervisory mandates and strengthening the EU Committees of Supervisors.

12. Looking beyond 2008 to the remainder of the legislature, efforts should focus on effective implementation of current reforms, further action in key areas, and a steadfast adherence to the announced fiscal consolidation path. Fiscal adjustment is not just about meeting arbitrary targets. High deficits have heavy costs: they increase the financing burden of the public debt, crowd out private investment and productive spending, increase inflationary pressures, and weigh on future generations. Achieving the MTO by the close of the legislature would significantly alleviate these costs. In other areas, the guiding principle of reforms should be to lower the intrusiveness of the state in the economy by simplifying regulatory and legal frameworks. Over the years, the accretion of niches fiscales and layers of regulatory red-tape have impaired fiscal performance and hobbled private sector innovation. This is the burdensome heritage of a proclivity to address perceived difficulties in the market with interventions that risk creating distortions of their own, which then motivate yet further intervention. This is particularly true in the labor market where, despite recent progress, contractual relations remain highly regulated. Labor mobility should be enhanced by simplifying contracts, addressing the tight constraints on licenciement conomique, and limiting the role of the judiciary in labor relations. The system of worker training is also in need of an overhaul, to make it more efficient and better able to provide appropriate training to members of the labor force who most need it. In product and services markets, attention could usefully be turned to open access to regulated professions, and the liberalizing opportunity of the EU Services Directive should be fully seized. In the financial sector, there is scope for continued modernization, phasing out all administered savings and allowing the Banque Postale to become a full-fledged bank. The role of a modernized financial system as a key driver of economic growth merits continued high attention, with further pursuit of the Paris Place Financire initiative.

IMF EXTERNAL RELATIONS DEPARTMENT