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The trouble with France

November 17, 2011: 5:00 AM ET

France's problems go well beyond its 35-hour work week. Efforts to preserve its triple-A credit rating may not go far enough.

By Cyrus Sanati, contributor

Nicolas Sarkozy

Nicolas Sarkozy

FORTUNE -- The cost to insure French debt soared this week as traders started to shift their attention away from the economic health of Europe's more profligate periphery to that of its core members. France has been scrambling for months to come up with a plan to save its coveted triple-A credit rating and convince the markets that it is in fine economic shape. While the country is better off than Italy, it is certainly not as healthy as its perfect credit rating suggest. France knows what it needs to do to get its fiscal house in order, but it risks facing an Italian-like crisis to finally bite the bullet.

Italy has dominated the headlines out of Europe this week as its government fell into chaos and its largest bank, Unicredit, reported a record loss. But many traders in New York and Europe seemed more interested in the news coming out of Paris than Rome. On Monday, French Prime Minister Francois Fillon revealed a much anticipated austerity package that was meant to save France's coveted triple-A credit rating and help spur growth.

The market was not impressed. After the announcement, the cost to insure French debt using credit default swaps jumped to a record 236 basis points, according to brokers in the City of London. That meant it would cost as much as 236,000 euros per year for an investor holding 10 million euros of French bonds to protect themselves from a sovereign default. That's a considerable payout on debt that should ostensibly be considered risk free given the nation's perfect triple-A credit rating.

The jump in CDS spreads probably shocked many French politicians who thought that the measures they had proposed were extremely tough. The plan would see corporate tax rates go up by 5%, while the value added tax on services would go up from 5.5% to 7%. It would bring forward by one year the implementation of a controversial plan to raise the retirement age in France from 60 to 62 years old. The plan also eliminated some tax deductions and state assistance.

Fillion said he hoped the plan would bring about 7 billion euros in budget savings in 2012 and a further 11.6 billion euros in savings for 2013. In total, he said the plan would produce 65 billion euros in savings by 2016.

Slower growth, smaller tax base

That might seem like a tough plan, but it looks pretty weak when one drills down a bit. The bulk of the "savings" in the plan come from tax hikes as opposed to cuts in the country's bloated welfare state. Such large tax increases will most likely slow France's already anemic economic growth rate. As the country's growth rate stalls, so will its tax base, negating any possible "savings" it might receive.

France's problem is that it simply has been living beyond its means for way too long. While not as bad as Italy, France has a very high debt compared to its economic output. Its total government debt of around 1.3 trillion euros equates to a debt-to-GDP ratio of around 83%. That is relatively low in comparison to the likes of Greece, which is at 140%, and Italy, which is at 120%, but it is high for a country that has a perfect triple-A credit rating – much higher than the United States, which lost its triple-A rating earlier this summer.

If France's economic growth prospects were strong, then its debt-to-GDP ratio wouldn't be an issue, but the country is facing some serious challenges on that front. France's once strong manufacturing sector has decayed in recent years causing it to import increasingly more goods. Where once the country ran large trade surpluses, it now runs large deficits. In the first six months of this year France had a trade deficit of 37.5 billion euros. While that's a large number, what's really troubling is how fast it has grown, up 36% compared to the same time last year.

France's high labor costs seem to be behind the drop off in exports. The Germans have trounced the French in both internal and external eurozone trade. France is actually helping the Germans win in two ways. First, it has allowed its workforce to become less competitive. In 2000, French workers were paid 8% less than German workers. Now, French workers are paid 10% more than German workers. Second, France runs a trade deficit with Germany of around 1 billion euros a month. That is a complete reversal from 2004 when it was Germany that was running the billion-euro-a-month trade deficit with France.

The real reason for Germany's optimism

What has happened to the French economy? The 35-hour government mandated work week surely hasn't helped matters much, but it goes deeper. France has the highest level of government spending in the eurozone at around 54% of GDP. That high level of spending goes to support the generous French welfare state, which is funded through borrowing and high taxes. Those taxes are passed through businesses, making French goods very expensive and ultimately uncompetitive on the world market. Today, around half of the gross labor costs in France go to prop up the French welfare state, while it is just 28% in neighboring Germany, according to MEDEF, France's largest union of employers.

The market was looking for France to finally announce plans to reduce its spending and force through meaningful cuts in its social safety net. Instead, it got a plan where France would try to tax its way out of its problems. Meaningful cuts in government spending, followed by liberalization of the nation's labor laws, will go a long way to solving France's fiscal dilemma. That would require a showdown with the country's powerful unions, something that not even conservative President Nicolas Sarkozy seems to have the stomach for at this point.

The cost to insure French debt jumped again on Wednesday to around 255 basis points. Yields on French debt are now well above 4% and are at historic highs versus German bonds. Until France gets real about its economic issues, it will see its borrowing costs continue to increase until it becomes way too expensive to maintain. Such a crisis would definitely put the euro's future in peril.

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