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DBRS Morningstar Confirms Republic of France at AAA, Trend Changed to Negative

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of France’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA and changed the trend to Negative from Stable. At the same time, DBRS Morningstar confirmed the Republic of France’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high) and maintained the trend at Stable.

KEY RATING CONSIDERATIONS

The Negative trend reflects the high uncertainty around the magnitude and duration of the global health and economic crisis brought on by the spread of the novel Coronavirus Disease (COVID-19). France has been under strict confinement measures since mid-March to stem the spread of the virus, resulting in an unprecedented peace-time seizure of the French economy. Even if the spread of the virus steadies enough to end confinement in the next few months, economic growth, the fiscal deficit, and the debt-to-GDP ratio will deteriorate on a scale not seen in generations. France arrived to the crisis not having fully repaired its fiscal balance sheet from the crisis a decade ago, and the shock has caused the government to understandably pause its reform agenda. DBRS Morningstar expects the current crisis will derail France’s pending structural reforms and complicate its plan to return to medium-term fiscal balance.

France’s ratings are underpinned by its wealthy and diversified economy, strong public institutions, and financing flexibility. However, the global pandemic presents clear downside risks to France’s growth prospects, its public finances, and the government’s reform agenda. The government now expects output to contract 8% in 2020. To try to cushion the economic blow, the government has responded with a series of sizeable fiscal aid packages, increasing to EUR 110 billion in the most recent amended budget. As such, the government expects the deficit in 2020 to increase to 9% of GDP and the public debt to reach 115% of GDP. This scenario still appears subject to downside risk, as the convergence of deteriorating public health outcomes, declining economic performance, and increasing public spending could weaken key credit metrics even further.

RATING DRIVERS

The ratings could be downgraded if the impact of the economic shock is severe enough to materially deteriorate the medium-term fiscal outlook and significantly worsen the trajectory of public sector debt dynamics.

On the other hand, the trend could return to Stable if the policy response is successful in limiting the economic fallout from the crisis to a short time period without lasting damage to the productive capacity of the French economy, and in minimizing the medium-term fiscal consequences.

RATING RATIONALE

The Global Health and Economic Crisis has Upended Policy Priorities in France

The spread of COVID-19, first and foremost, is imposing a tragic human cost. As of April 17, 2020, the virus had claimed over 17,000 lives in France and there remains limited clarity around when the spread will peak. To slow the proliferation of the virus, the government on March 17, 2020 issued strict stay-at-home measures that included the closure of schools and non-essential business, as well as a ban on gatherings in public spaces. Furthermore, the government responded to the crisis by taking extraordinary policy measures to try and cushion the economic fallout, it postponed the second round of local elections, and suspended its reform agenda. Pending reforms to the pension system and additional changes to the unemployment system, DBRS Morningstar had expected delivery of both in 2020, have understandably been deferred.

The Crisis Will Cause a Large Contraction of the French Economy in 2020

The confinement measures are also imposing serious economic costs. The Banque de France estimates the economy, operating at two-thirds capacity, contracted by 6% in the first quarter. Economic performance in the second quarter is likely to be worse, before likely improving in the second half of 2020. DBRS assumes economic contraction this year in the range of 6-8%, if confinement is limited to around two months. The economic contraction in 2020 could be greater if confinement is extended. Perhaps more difficult to predict is the nature of the economic recovery once the virus spread is controlled. Pent-up demand may lead to a strong economic rebound late in 2020 and in 2021. Yet, the economic consequences of the shock may prove long-lasting. Adverse second round effects could emerge following the crisis, as firms contract and households deal with higher unemployment.

The global health crisis derailed what had been comparatively resilient economic activity in France. Having grown by an annual average rate of 1.8% between 2017 and 2019, the economy outperformed other large European countries. Domestic demand was supported in recent years by a somewhat expansionary fiscal policy and favourable developments in wage and employment growth. External demand had begun to slow even prior to the crisis, but France has no noticeable external imbalances. The country’s open economy with extensive trade, investment and financial linkages throughout Europe and around the world support DBRS Morningstar’s positive qualitative assessment of the “Balance of Payments” building block.

Large Expansionary Fiscal Policy Will Result in a Wide Fiscal Deficit in 2020

France’s 2019 fiscal deficit of 3.0% of GDP slightly over-performed expectations by 0.1 percentage points. Excluding the one-off transformation of the CICE tax credit into reduced employer contributions, the 2019 deficit would have been a more manageable 2.1%. However, having improved slowly over the course of the last decade, France’s fiscal position had not yet fully repaired at the onset of the current crisis. Numerous tax cuts and other spending amendments were included in the 2018 and 2019 budget bills in response to “yellow vest” protests. As a result, public spending remained above 55% of GDP, despite healthy economic performance and the significant decline in debt servicing costs.

The outbreak of the pandemic, and the macroeconomic implications for France, has radically changed the fiscal outlook and weighs on DBRS Morningstar’s qualitative assessment of the “Fiscal Management and Policy” building block. In the 2020 amended budget presented on March 18, 2020, the government introduced a fiscal aid package worth EUR 45 billion (1.9% of GDP), with immediate fiscal impulse for partial unemployment relief, additional healthcare expenditures, and funding for the self-employed. It also made available EUR 300 billion for corporate loan guarantees.

A second amended budget presented on April 15, 2020 increased the aid package to EUR 110 billion (4.5% GDP) and assumes the deficit in 2020 will increase to 9% of GDP. This includes deferred fiscal and social charges that the government expects to recover. It is worth noting that current assumptions are clouded by a high degree of uncertainty, and the deficit could be larger if some of the tax and social security deferrals are cancelled outright, if confinement measures last longer than the eight weeks currently anticipated under the revised budget, or if the current level of public spending proves insufficient.

Public Debt to Increase by 17 Percentage Points of GDP in 2020, But Debt Servicing Should Remain Affordable

At 98.1% of GDP in 2019, France’s debt ratio has been broadly flat over the last few years, but the trajectory will shift this year. The government’s recently amended budget expects the debt-to-GDP ratio to increase to 115% this year. This rapid deterioration in the debt ratio weighs on DBRS Morningstar’s qualitative assessment of the “Debt Management and Liquidity” building block. The recent forecast is subject to considerable revision, depending on how the crisis unfolds. On the downside, contingent liability risks to the government balance sheet could materialize from calls on loan guarantees or if the sovereign is called upon to support large corporates.

France’s debt ratio will likely remain for the foreseeable future among the highest in its AAA and AA-rated peer group. Nonetheless, accommodative monetary policy and France’s prudent debt management strategy help mitigate risk associated with high public debt. France’s position in Europe provides the Treasury with substantial funding flexibility that allows it to maintain a higher level of indebtedness at low costs. This supports DBRS Morningstar’s qualitative assessment of the “Debt Management and Liquidity” building block.

The French Banking Sector is Resilient, But Will Also Be Challenged by the Current Crisis

The French banking sector arrived to the crisis having delivered a resilient performance in 2019. Banks are profitable, well capitalized, and well positioned to support economic growth. A main challenge for the French financial system prior to the crisis had been for banks to operate in an environment of low interest rates. Bank margins have been squeezed by declining lending rates to households and corporates, in a context of regulated deposit rates. The current economic shock further complicates the environment. Despite the French banks’ strong diversification and balance sheets, DBRS Morningstar expects the banks to suffer a deterioration in profitability and asset quality in the coming quarters (see commentary French Banks: 2020 Outlook Looks Increasingly Challenging).

20 April
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