Vive le franc fort

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The French government will today unveil its new economic programme and the financial markets have already voted it a resounding success. Since the overwhelming defeat for the Socialists in the March election, the franc has recovered strongly in the foreign exchange markets, enabling the Bank of France both to rebuild its reserves and at the same time to reduce three-month interest rates from over 12 per cent to just 7.5 per cent, thus entirely eliminating the long-standing 'risk premium' over German rates. Interest rates in France might soon move below those in Germany for the first time.

The markets' benign mood about France is not simply an infatuation with a new right-wing government. The economic programme to be outlined by the Prime Minister, Edouard Balladur, today will be different only in a few cosmetic items from the programme being followed by the Socialists. Even the promise to make the Bank of France 'autonomous' was made months ago by the outgoing government.

Furthermore, the economic forecasts behind today's budget can hardly be acting as a magnet for foreign capital. The government admits that GDP will fall by 0.4 per cent this year, compared with a forecast of growth of 2.6 per cent six months ago. Meanwhile, it says that the 1993 budget deficit will be about Fr475bn ( pounds 59bn) - 6.5 per cent of GDP.

So how have the French managed to defeat the foreign exchange markets when the British, Italians and others failed last year? Part of the answer is that France was polluted last autumn by the back-wash from the failures of other EC countries to maintain their exchange rate mechanism parities. Throughout the second half of 1993, the ERM appeared to be in the grip of a series of convulsions that could easily have swept away the relatively strong currencies as well as the undeniably weak.

Indeed, for several weeks around the turn of the year, the odds seemed to favour the franc being dragged into the mire. Although there was no reason to believe that the franc was uncompetitive against the mark, the ERM was imposing on the economy an unacceptably high level of real interest rates at a time when it was clearly moving into recession. In other countries, that alone had been enough to unhinge the parity.

Several factors then intervened to save the franc. The Bundesbank was willing to ease German monetary policy with the apparent intention of supporting the franc. The two central banks were able to put on a combined front that impressed the markets. No one in the private sector knew whether the Bundesbank was really ready to underwrite the franc to the limit, and this discouraged speculative positions against the currency. Clever tactics accentuated this effect.

Much more importantly, speculation against the franc was discouraged by a recognition in the markets that the franc was fundamentally very competitive against the mark. The graph shows that France is now at its most competitive position against Germany since the inception of the ERM, and it is German, not French, companies that are squealing about present exchange rates.

Although competitiveness is never the only factor that influences currency movements, it can be important. In this instance, it made the markets uncertain about what might happen if the franc were floated. Many analysts thought that the French currency, after being floated, would fall by only a few per cent, and might actually start to rise again within a matter of months. Therefore the short-term gains that could be made by selling the franc short were not sufficiently large to induce the most aggressive private sector 'players' to enter the market.

So France was never subjected to the sudden tidal wave of currency selling that overwhelmed both Britain and Italy last year. Certainly, there was heavy and steady selling of the franc over several months, but it stemmed from corporations and long-term investing institutions that were eager to hedge themselves against the possibility of a change in the parity. A final massive push from the shorter-term 'speculators' never quite came.

Hence the franc survived to fight another day - or not as the case may be. There is now a good chance that further sieges will not be necessary. Trouble could yet recur if the French economy suffers a deeper recession than Germany, since under those conditions the amount of easing undertaken by the Bundesbank might not be enough to satisfy the needs of the French economy. But at present the opposite seems likely. The recession in Germany is much deeper than in France, where the economy has been relatively robust, considering the extraordinary level of real interest rates over the winter. The recent resilience of the French manufacturing sector compared with that in Germany would again appear to suggest that the franc is fundamentally very competitive against the mark.

And that brings me to the best rationalisation I have yet heard for the 'franc fort' policy. It comes from a French official. The franc, he says, is now clearly competitive against the mark, following several years of successful disinflation within France. If the ERM parity survives, this position can be maintained, since the Germans' pride would never permit the mark to be formally devalued against the franc. Therefore the ERM now permits France to lock in a very competitive position, enabling it continuously to 'steal' market share from Germany.

Contrast this, he continues, with what would have happened if the franc had been floated. Sure, it would have depreciated for a while, temporarily producing even more favourable French competitiveness. But quite soon after floating, the franc would have started to rise as the markets recognised its strong fundamentals compared with Germany. And - this is the crucial part - the Germans would not have allowed France back into the ERM at anything like the competitive exchange rate it now enjoys.

Therefore, the 'franc fort' policy, as applied to the nominal exchange rate was the best way of securing a 'franc faible' policy, as applied to the real exchange rate. Ingenious, n'est ce pas?

(Graph omitted)