France's debt alarming markets: memories of eurozone crisis resurface

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France’s borrowing costs are surging as investors around the world wake up to the risk of a full-blown public debt crisis in Europe’s second-largest economy.

Stress in financial markets has now started to spread beyond its borders, raising fears that political dysfunction in France could cause a broader, regional problem.

Memories of the sovereign debt crisis that threatened the single currency’s survival 15 years ago are starting to stir. But is it really going to get that bad again?

Read on to find out. Alternatively, you can simply skip it and pretend it isn’t happening — but, hey, that’s what got us here in the first place …

Why is this happening?

France hasn’t run a balanced budget in more than 30 years.

It hasn’t been able to keep its budget deficit within the EU-agreed limit since 2019, due to the soaring costs of its pension system and challenges such as rearmament and the green transition. France’s debt burden is now so great — and growing so quickly — that some are starting to worry it can’t repay it all.

What happens if French woes get worse? Is Europe facing another existential crisis? Will the European Central Bank run to the rescue with “whatever it takes”? And will it be enough?

How bad is it?

Investor concerns about France’s fiscal and political impasse have ballooned.

For many years, investors considered Germany and France as roughly equivalent credits: The premium they demanded to hold 10-year French bonds over comparable German ones was measured in pennies. But since the pandemic, and more recently since President Emmanuel Macron’s disastrous gamble on early elections two years ago, it has started to increase — first gradually, now suddenly.

From 0.55 percentage points in mid-September, it had risen to 1.45 by Monday morning. It hasn’t been that high since the 2012 debt crisis. In absolute terms, the French 10-year bond yield is nearly at 5 percent, the highest it’s been since 2008.

Concerns are serious enough for Bank of France Governor Emmanuel Moulin to warn that “everything must be done” to avert a debt crisis ahead of the 2027 presidential election.

You said it was spreading to the rest of Europe?

Well, it’s starting to.

EU flags fly outside the European Central Bank in Frankfurt, Germany on Dec. 15, 2022. | Andre Pain/EPA

France has been an outlier within Europe in recent weeks, but sovereign yield spreads — those country-specific risk premiums that investors demand — have also started to widen for Italy, Belgium and Greece. And there are signs that the markets are turning more negative on Europe in general as a result: the single currency hit a 17-month low against the dollar on Monday.

Are we in a crisis already?

The moves have been sharp, but the risk premium remains what one would consider crisis level.

The trouble is, bond prices — which move inversely to yields — can fall quickly when investors reassess risk. The ownership structure of French debt could also amplify a sell-off. Unlike Italy, where most government debt is held domestically, more than half of French debt is held by foreign investors who tend to head for the exit faster when things become shaky.

Sumitomo Mitsui DS Asset Management, one of Japan’s largest asset managers, said at the weekend it had sold all its French debt. In case of accelerated sales — or even worse, forced sales — the risk of contagion to other eurozone member countries rises further.

Who ya gonna call? Spread-busters!

The widening so-called spreads between national sovereign bond yields have raised questions about whether and how the European Central Bank might stop the rot. The ECB’s Transmission Protection Instrument (TPI) allows it to buy government bonds in the secondary market to counter “unwarranted, disorderly” market dynamics — but only under certain conditions. Before the ECB can use it, the Bank has to determine that a country is pursuing sound and sustainable fiscal and economic policies. For France, that would require big adjustment measures that will be nigh-impossible to pull off ahead of the 2027 elections.

“Help would likely require real commitment to stability, through fiscal discipline, reforms or both. Getting that support won’t be easy politically,” said Allianz Global Investors. Chief Economist Christian Schulz.

Stop (in the name of love for the euro)?

The ECB could also, in theory, intervene by using its balance sheet. For the last couple of years, it has allowed the bonds that it bought during years of “quantitative easing” to “run off” its balance sheet at the end of their lifetimes. That has forced governments to refinance the maturing debt in the markets instead. That increases the net supply of bonds to the market and adds to the upward pressure on yields.

Carsten Brzeski, ING’s global head of macro research, argued that the ECB could “pause quantitative tightening temporarily and reinvest maturing bonds in its portfolio ‘flexibly,’ sending a positive signal to bond markets.”

That possibility was also floated on Monday in an op-ed by Lorenzo Bini Smaghi, an Italian former member of the ECB’s board. It’s also at the heart of an appeal by Jean-Luc Mélenchon , the far-left’s presidential candidate in France, for the ECB to put a chunk of government debt “in the freezer.”

What about interest rates?

Should the wider region be affected, the ECB could also use its other big, blunt instrument — interest rates — to keep borrowing costs down, analysts say.

“ECB action still looks a way off, but an early step would be to talk back some of the hikes priced in the market,” analysts at Mitsubishi UFJ Financial Group wrote in a recent note. Markets have already sharply scaled back their bets on additional tightening, but ECB President Christine Lagarde took pains to leave the door open to further rate hikes at her last press conference — and with eurozone inflation hitting a three-year high of 3.8 percent in September, there will be a limit to how relaxed Frankfurt can be.

What’s the doomsday scenario?

As Brookings Institution Senior Fellow Robin Brooks put it in a recent Substack post, the ECB cannot rush into every bailout.

“There’s got to be a period of demurral, like a debutante at the ball playing hard to get,” he argued. “This is the period we’re in right now.”

But he added, if supporting France is the only way to keep the euro together, that is what it will do — even at the cost of “outright horror in Germany and the rest of Northern Europe.”