Is France next?

François Hollande’s victory in the presidential election gives investors reason to be even more concerned about France’s creditworthiness, writes Nicholas Spiro.

  • 09 May 2012
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The victory of François Hollande in the second and decisive round of France’s presidential election on Sunday is a historic event in French politics and a seminal development in European policymaking. The eurozone’s second-largest economy and its third-largest government bond market has just elected a Socialist president who is determined to make his mark domestically and abroad by challenging German financial orthodoxy. Make no mistake about it, these are defining moments in the two-year-old eurozone crisis.

President-elect Hollande is a pragmatist by nature. His centre-left economic programme is a far cry from the “let-it-rip-socialism” pursued by François Mitterrand, France’s last left-wing president, in the early 1980s. Yet while his Socialist bark is worse than his bite, his understanding of “growth” differs sharply from that of the German government and the European Central Bank (ECB).

What is more, France’s new head of state is emboldened by a growing consensus in European policymaking circles that austerity has gone too far and by bond markets’ increasingly dim view of fiscal retrenchment in recession-plagued southern Europe. Hollande is convinced that he is the right man at the right time.

Bond market psychology

Market reaction to Hollande’s victory has been fairly muted so far. The premium France pays to borrow over Germany is now some 10bp lower than on April 23, the day after the first round of the election, in which outgoing president Nicolas Sarkozy won almost as many votes as Hollande. Bond investors appear to be taking a relatively sanguine view of the likely implications of Hollandisme and, in any case, are far more concerned about the radicalisation of Greek politics in the wake of Sunday’s inconclusive parliamentary election result.

Hollande’s economic policy team, led by former finance minister Michel Sapin, claims there are deeper forces at work. It believes that bond market credibility in the eurozone has undergone a dramatic shift over the past year or so and is now more about policies to foster growth than efforts to shrink fiscal deficits. Indeed part of the reason why Hollande’s victory is so significant is because it is likely to provide a crucial litmus test of investor sentiment towards growth-supportive policies. If Mr Hollande is correct, his socially oriented programme will be more credible from a market standpoint.

Clearly non-stop austerity in Greece (and possibly Spain) has become self-defeating. Yet just because investors are increasingly concerned about a lack of growth in the eurozone's periphery does not mean that Keynesian policies would be well received by the markets. On the contrary. Any short-term fiscal stimulus could fan concerns that the crisis will drag on even longer and risks undermining the credibility of Germany and the ECB. Moreover, even the latest growth-focused initiatives being discussed in Brussels would fail to offset the contractionary drag of austerity and deleveraging.

While Hollande’s team has correctly diagnosed the schizophrenia in the bond market — a growing fear of too much austerity juxtaposed with perennial concerns about too much debt — it risks drawing the wrong conclusions. Rather than proceeding cautiously at the outset, France’s new president is more likely to want to set a new tone in eurozone policymaking and push the envelope at the cost of vexing Berlin.

The most probable outcome is a Franco-German compromise in which Hollande grudgingly agrees to ratify the eurozone’s “fiscal compact” in exchange for some leeway on budget deficit targets and increased spending on infrastructure. But it is at home where the “Hollande effect” is likely to be more pronounced.

Drifting towards the periphery

Hollande is taking office at a critical juncture for France and the eurozone. Greece’s membership of the euro is hanging by a thread, while yields at Spanish and Italian bond auctions are rising again. As the soft underbelly of the core of the eurozone, France is vulnerable to a further deterioration in sentiment. Doubts have already been cast over the country’s creditworthiness. During the election campaign, neither of the two finalists addressed France’s long-standing economic weaknesses. While Sarkozy was a timid reformer at best, Hollande plans to reverse some of his predecessor’s reforms.

This is a perilous time to be testing the resilience of France’s already shaky creditworthiness. While France has been able to get away with ducking the kind of product and labour market reforms that are needed to boost the country’s flagging competitiveness, there is no room for complacency — and even less for costly spending pledges. France is “peripheral” enough as it is. It is burdened with the highest level of public spending as a percentage of GDP in the OECD group of industrialised economies and ran a fiscal deficit last year that was larger than Portugal’s as a share of output.

French banks, moreover, are dangerously exposed to southern Europe, and account for a bigger share of consolidated claims on the eurozone’s peripheral economies than that of their German peers (mainly because of their large holdings of Italian debt). Hollande believes investors will grant his government some leeway for populism. Yet there is no honeymoon period awaiting him. The escalation of the Greek crisis may bring things to a head much faster than he would like. France is sailing very close to the wind right now.

A bond market rout in France is very unlikely for the time being. Perceptions are everything in sovereign risk, and most investors are taking the view that Hollande will change tack after auditors report on the state of public finances next month.

But this misses the point. Doing the bare minimum to shore up France’s questionable creditworthiness is becoming less and less credible as the eurozone crisis rumbles on — and now appears to be taking a turn for the worse. Hollande is, if anything, raising the stakes further by seeking to ease off the austerity. There is ample scope for the markets to misinterpret Hollande, and for Hollande to misread the markets.


 10 year government bond spreads


Source: Thomson Reuters


Nicholas Spiro is managing director of Spiro Sovereign Strategy, a specialist consultancy in sovereign credit risk.

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  • 09 May 2012

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