France: Under pressure as fear builds in bond markets

The attention of Europe’s spooked bond markets has slowly started to turn to France, which some commentators believe could be the next eurozone country to see spiking bond yields and acute economic nervousness.

The spread between yields on French and German bonds – the extra cost of financing French debt – has increased by more than one per cent in the last month to the highest level since the creation of the euro.

Other commentators point out, however, that the fundamentals of the French economy and debt position are much stronger than those of Italy or Greece. And although French banks are hugely exposed to the sovereign debt of Italy and Spain, a default by either of those countries would not just be a French problem. It would push the entire global economy over a cliff.

All the same, the structural weaknesses in France’s position are encouraging the same pattern of fear, and speculation, on bond markets seen at the beginning of the Greek and Italian debt crises.

President Nicolas Sarkozy has been struggling – belatedly according to some – to prove that he is a fiscal reformer in an attempt to preserve France’s triple-A debt rating. Earlier this week, his government announced new cuts and tax increases of €7bn next year, on top of a €12bn austerity package unveiled in August.

The harsh medicine is intended to preserve France’s pledge to reduce its annual budget deficit to 4.6 per cent next year, to 3 per cent in 2013 and to zero by 2017. Last month the Moody’s credit rating agency announced that it would scrutinise France’s triple-A rating (the same as Germany and the UK but better than the US) for three months.

The loss of the top rating would cause another spike in the yield demanded by the market for French bonds, now running at over 3 per cent for 10 year securities. It could also be the final nail in the coffin for President Sarkozy’s chances of re-election next April and May.

The prospect of a change to a centre-left President is also a background anxiety for markets. The Socialist candidate Francois(cedilla on C) Hollande has promised a rapid debt-reduction programme, but he has also promised to spend substantially more on education and pensions.

The other great preoccupation of markets is French banks. France has over €600bn of exposure to Italian, Spanish and Greek debt - by far the largest figure in the eurozone. Even a partial default in Italy could cause acute problems for French banks, but also for British and German banks.

In other terms – such is the ratio of its deficit and debt to national output and agreed reform plans – France is ahead of the struggling southern eurozone nations. “France is undoubtedly the weakest triple-A state ... but it is still credible, while Italy isn't,” said Russell Silberston at Investec AM. “They have time to make adjustments and we believe they will take those measures.”