To Maintain Strong Franc France Keeps Rates High

THE flag flying over Matignon, the French prime minister's offices, is indeed the tricolor banner of France. But some economists would not be too surprised to see the blue flag with 12 stars of the European Community there instead, given what they consider Edouard Balladur's pro-European economic policy.

Europe's recent monetary crisis resulted in vastly broadening the bands for fluctuation in the foreign exchange rate of most EC currencies. This change allows countries to lower interest rates without the need to intervene in foreign exchange markets to protect the value of their currencies. But France has kept relatively high rates, slowing recovery.

"The strategy appears to be to resist a precipitous fall in the franc, thus ruling out an important reduction in interest rates until the markets are convinced that the government intends to hold firm," says Pierre-Alain Muet, director of econometrics at OFCE, a French economics center. "It's a very costly policy in a recession."

Mr. Balladur has said French interest rates, still generally higher than before the rush of currency speculation last month, will come down slowly.

The Bank of France has announced three small rate cuts over the past three weeks. Each one was accompanied by a firming of the franc. Despite new bands that allow a 15 percent plus or minus fluctuation from other European currencies, the government is trying to keep the franc close to the former 2.5 percent fluctuation band. That narrower band had been seen as a condition for EC monetary union.

But with French unemployment already at record levels and approaching 12 percent, many economists say the "strong franc" policy is drawing out the country's recession.

"A quick and substantial cut in our interest rates would be very positive for economic activity and for its psychological effect, and after a short period I think it would even be beneficial for the franc," says Dominique Graber, an economic analyst at Paribas Group here. "But it's becoming clear that for political reasons, that's not going to happen."

Some other EC countries, including Denmark and Belgium, have been resisting cutting interest rates for fear of weakening their currencies, despite slow growth and high unemployment.

European economic unity is not Balladur's only motivation. The Bank of France spent more than $30 billion to prop up the franc at the end of July and now has a deficit in its foreign currency reserves. It needs high interest rates to build them back.

BALLADUR also says he wants to safeguard France against a new bout of inflation - although at 2 percent it is already more than two points below Germany's.

Perhaps the major reason is simply philosophy and "economic culture." A strong franc has been French economic policy for a decade, for both the left and the right. Changing would be tantamount to admitting that the strong franc had become a liability in the current context: a European recession with French economic fundamentals, other than unemployment, better than Germany's.

The question now is whether Balladur can resist domestic pressures to abandon, or at least soften, his policy.

"Autumn is going to be very difficult, with unemployment rising further, activity slowing, and a possible rise in social actions" like strikes and demonstrations, Muet says. "Pressure is going to build."

More than 1,000 people a day lost jobs in France during the second quarter. Also, the government cut healthcare benefits to rein in a deepening budget deficit. Salary deductions for unemployment benefits were raised.

The resulting drop in public confidence has led to higher savings and slower consumption, adding to the recession.

To counteract the public's pessimism and head off broad unrest, Balladur this month revealed a cut in income taxes for "the middle classes" next year. And to the surprise of some, the conservative prime minister is firmly defending France's high social protection system, stating recently: "It's not less social protection that we need, but rather more social protection."

Such talk was not welcomed by many business leaders. They say excessive regulation and heavy benefit costs discourage job creation. A five-year employment plan, including more flexible rules on part-time and Sunday work, was revealed last week along with some promised relaxing of company benefit costs and incentives for job training.

Yet what business leaders want are lower interest rates. Some further relief may come this week: Most economists expect the Bundesbank to lower rates Thursday, the same day Balladur visits German Chancellor Helmut Kohl in Bonn. That would allow France to make another small cut.