Stern test lying round the corner for 'franc fort'

ECONOMIC VIEW

Ever since Jacques Chirac became French president in May, it was clear that the 10- year-old commitment to the franc fort would be tested. The policy of tying the franc to the German mark through hell and high water was simply inconsistent with the absolute priority he gave in the election campaign to reducing unemployment.

Round one of the battle between the new government and the foreign exchange markets went to the Banque de France. The pessimists who predicted an immediate devaluation of the franc were confounded. Instead the French central bank was able to ease interest rates down over the summer against a background of an appreciating franc.

Round two has just as clearly gone to the "gnomes of London". The run on the franc earlier this month forced the central bank to push up short- term interest rates, which fed through to bank lending rates last week.

Now the third and probably decisive round of the battle is on the verge of being joined. As in earlier European exchange-rate crises, the first exchange of fire has occurred over a peripheral currency, in this case the Italian lira. Silvio Berlusconi's tabling of a no-confidence motion in Lamberto Dini's administration has been upstaged by a resounding vote of no confidence by the currency markets.

Before long, they will switch attention again to the French franc. Neil MacKinnon, currency strategist at Citibank, now projects a fall in the franc to 3.75-3.80 to the mark within the next couple of months. Other economists, like those at Paribas, predict a more modest fall to 3.60 by the end of the year.

Yet there is no consensus among economists that the franc is overvalued. Unsurprisingly, officials say that the franc is fundamentally strong. This view is supported by the fact that the economy is running a healthy current account surplus of about 1 per cent of gross domestic product.

Trends in unit labour costs suggest that the franc is not overvalued against the German mark. Even against weaker currencies like the pound, you can make an argument that the franc is fair value. The pound has depreciated by some 20 per cent against the franc since Britain exited the exchange rate mechanism three years ago.

However, since then unit labour costs in manufacturing have fallen by 5 per cent in France while they have risen by about 3 per cent in Britain. If you accept that the pound was overvalued by about 10 per cent when Britain was in the ERM, that suggests that the franc is about where it should be against the pound.

The case for the sceptics is that the apparent health of the current account is misleading: it indicates a slackness of domestic demand. The franc is indisputably stronger against the peripheral currencies, compared with the position three years ago.

The strength is most palpable against the Italian lira - something that matters, given the fact that Italy is France's second most important trading partner.

On balance, the case of those who argue that the franc is overvalued, certainly against the peripheral currencies, seems more convincing. As British tourists have found out the hard way this year, France is a very expensive country to visit nowadays - something that matters, given the significance of tourism to the economy.

And given the extent of the unemployment problem, what France may now need, as Julian Jessop, European economist at HSBC Markets, has observed, is an undervalued currency.

But in large measure the debate over the underlying value of the franc is neither here nor there. For the real misalignment that is hampering the Frech economy is of interest rates rather than exchange rates.

With inflation at around 2 per cent, bank lending rates of over 8 per cent are simply too high. Short-term interest rates are 3.5 points higher than those in Germany and long-term rates 1 point higher. Bear in mind that the French economy emerged out of recession more than a year after the UK, so it is still only in its second year of recovery.

Yet already that recovery is flagging. At the end of last year the economy was bounding along at about 4 per cent. That expansion tapered off to 2.8 per cent in the second quarter and appears to be slowing still further.

The crunch point is the effect of that deceleration on unemployment. When the economy was rattling along, the jobless count was falling quite quickly. Now that the recovery is slowing down, the prospects for making continuing inroads into unemployment - still 11.4 per cent - look bleak.

And yet, when campaigning, Jacques Chirac pledged to make unemployment the absolute priority. The social tensions caused by the continuing blight of joblessness mean that the campaign pledge remains serious.

Earlier this month, the industry minister, Yves Galland, said that if something were not done about unemployment and poverty, France could face an upheaval similar to the riots of May 1968.

Few doubt that France has to tackle some of the structural reasons that account for high unemployment - such as excessive social security costs for employers and a minimum wage that is set too high, particularly for young people. But for structural read long-term - and as Keynes observed, in the long run we are dead. In the short to medium term the best cure for unemployment is strong growth.

If the French government is to meet its objective of 700,000 new jobs by the end of next year, monetary policy has to be relaxed. This is all the more so since fiscal policy is being tightened as part of the plan to conform with the Maastricht convergence criteria.

At 5 per cent of GDP, France's budget deficit is far removed from the 3 per cent level which the Germans are insisting must be observed to the letter of the law by 1997 if monetary union is to go ahead.

Here then is the paradox of the current stance of French economic policy. If France is to come within hailing distance of a 3 per cent budget deficit in just two years, strong economic growth is essential and this involves taking off the monetary brakes.

A simulation by the OECD in its recent report on France showed that the effect of cutting interest rates by 2 per cent would be to raise domestic demand by 1 per cent and cut the budget deficit by a similar amount.Yet that monetary relaxation can only come about if the French abandon the franc fort.

The French have invested enormous social and political capital in the policy of tethering the franc to the mark. But something has to give - that is the message that is coming from the markets. The fact that the French persevered with the policy so assiduously in the 1980s may be less relevant, now that the crucial problem is unemployment rather than inflation.

Before long, the franc fort could well be tested to breaking point.