Cutting The Franc Loose

It's a humbling moment for France. No sooner had Paris managed to shine up the franc this spring--as a cheeky new rival to the German mark--than skeptical money traders managed to explode French dreams. The late-July currency crisis that they set off, Europe's scariest in years, not only dethroned the franc but also nearly toppled the European monetary system. Yet in the Champagne region east of Paris, corks are popping. The Aug. 2 currency float that ended the crisis "is good for us in every way," says Jean-Jacques de Vriese, president of champagne giant Mo et & Chandon. With Mo et's sales down 12% this year, he hopes that a less fizzy franc will be a help in rescuing exports.

In assenting to a free-floating franc, Prime Minister Edouard Balladur could no longer ignore the woes of France's champagne makers--or for that matter, the problems of all French industry. True, Balladur had vowed to resign rather than cut the franc loose--and thus dash France's dream of financial and monetary equality with Germany. But ending France's withering recession and shoring up his party's popularity are more pressing goals than upholding France's notion of grandeur.

So, over the next few weeks, the government is likely to slash interest rates. And although the franc has budged little since the crisis, traders expect it will soon fall 5% to 7% against the mark.In the end, Balladur had little choice. Sustaining Franco-German parity meant linking interest rates to the Bundesbank's high levels and stifling recovery in France. And the economy, although improved in many ways, is still full of weak spots.

Many lagging state-owned companies are still facing the painful choice of whether to impose massive layoffs. They also badly need cheaper capital if they are to expand and modernize further. French banks are struggling under the weight of bad real estate loans. Even the best-managed companies have seen their exports shrink under the pressure of the strong franc. And small businesses are hurting, as local demand for their products dries up.

The French economy was a highflier in the late 1980s, but since then growth has been sluggish and unemployment has risen (charts). Part of the problem is that many of France's best-managed corporations have become more efficient. Such companies as drugmaker and chemical giant Rh one-Poulenc, tiremaker Michelin, and steel company Usinor Sacilor have been closing plants, laying off workers--and transforming themselves into world-class competitors.

HOME TRUTHS. In today's tough economy, though, the problem is that these rejuvenated companies often prefer to invest abroad rather than in France. And their numerous laid-off workers are increasing the political heat on the Balladur regime. World recession has also badly hurt the demand for French goods, from Louis Vuitton handbags to Renault cars.

Many French exporters are in good shape to come roaring back, if the franc weakens and interest rates in Europe fall far enough to spark a recovery. Astonishingly, Volkswagen Chairman Ferdinand Pi ech says that he fears France's newly lean auto makers--Renault and Peugeot--more than he does the Japanese. But the country is in sore need of a recovery in order to capitalize on the restructuring of recent years--before thegovernment is pressured into intervening.

Balladur, France's conservative leader, had been steering a tight course since becoming Prime Minister on Mar. 30 this year. Taking the long view of French power, he had sought a strong franc by squeezing budget deficits and offering only modest tax incentives to juice the economy. He succeeded for a while. His reputation for sober management let him reduce short-term interest rates from 10% in April to 7% by late July--slightly below the German levels. However, as the perception spreadthat nationalists in the Gaullist party wanted more pump-priming and that France's recovery would trail Germany's, currency traders concluded that the franc was overvalued. Balladur says he is still aiming for a strong franc and therefore doesn't want interest rates to fall fast. Nevertheless, William P. Sterling, international economist at Merrill Lynch & Co., predicts French short rates will fall to 4.5% or even lower in coming months. That could mean an economic upturn by early next year, he says.

"UNDERVALUED." Of course, low interest rates alone do not a strong recovery make--as has been shown in the U.S. Yet most French executives are already breathing easier. The prospect of lower rates should boost confidence and restart investment, predicts Geoff Unwin of French software company Cap Gemini Sogeti. "It's very good news," he says. For example, American chemical companies benefiting from the dollar's earlier weakness have been "very tough competition for us in the European market," says Jean-Pierre Tirouflet, finance director at Rh one-Poulenc. Now, he hopes to gain the export advantage in his rivalry with the Americans, if the franc weakens and financing costs fall on Rh one-Poulenc's high debt. A stronger French economy, Europe's second-largest, can only help the rest of the European Community recover.

France's troubled banks are another clear beneficiary. Credit Lyonnais, Paribas, Indosuez, and others are weighed down by bad loans on Paris office buildings, whose values have plunged nearly 50% over the past four years. Lower interest rates mean lower carrying costs.

Easier money excites the Paris bourse--which jumped nearly 7% during Europe's monetary crisis. A stronger bourse means France can more easily privatize the 21 state-owned companies that it plans to put on the block, starting in September with Rh one-Poulenc, oil producer Elf Aquitaine, and Banque Nationale de Paris. Privatization should strengthen those state companies that suffer from high debt and bloated staffs.

As for the once-potent French franc, some observers in Paris think its day will return. "When France starts growing, people will see that the franc is undervalued," predicts Jean-Paul Betb eze, research director at France's biggest bank, Credit Lyonnais. Yet he thinks high-cost Germany will be struggling to export. So by year-end, Betb eze predicts, "we can force Germany to adopt [growth-oriented policies]." Such swagger helped get France into trouble last month on currency markets. Paris should move more carefully next time in testing its monetary muscle.