Investors brace for a French fracas

As scepticism grows over Francois Hollande's new eurobonds advocacy and ability to rein in his own budget, fears are emerging that France may be the next country hard hit by the crisis.

Certainly, French bond yields have climbed sharply in recent weeks. Yields on French 10-year bond hit 2.7 per cent overnight, or almost 30 per cent higher than the euro-era low of 2.07 per cent they reached at the beginning of the month.

Hollande’s supporters point out that France’s borrowing costs remain well below those of Italy (yields on 10-year Italian bonds are 6.2 per cent), and Spain, where the 10-year bond yield is now hovering around the critical 7 per cent rate – the level at which Greece, Portugal and Ireland were forced to seek bailouts. What’s more, the country’s borrowing costs have fallen from a year ago, when French 10-year bonds were trading at 3.3 per cent.

Still, there’s little doubt that investors are becoming more anxious about the Socialist Hollande, who took office on May 15, and this is causing the spread between French and German borrowing costs (yields on German 10-year bunds are at 1.5 per cent) to widen.

Some investors were dismayed by Hollande’s changes to the country’s state-financed pension system. Although he didn’t fiddle with the standard retirement age, which is set to gradually increase from 60 years to 62, he did change the rules so that people who started work at a young age will be able to retire at 60. The move, which will be paid for through higher payroll taxes, outraged French business leaders, who pointed out that it comes at a time when most eurozone countries were trying to cut labour costs and improve their competitiveness.

Similarly, Hollande’s decision to boost France’s minimum wage by 2 per cent (or around €21.50 a month) has also drawn fire. Union leaders slammed it as being far too modest, while business leaders worried that it will further bloat the cost structure of French industry.

There’s also widespread scepticism as to whether Hollande will be able to cut the French budget deficit to 3 per cent of GDP next year (from an expected 4.5 per cent this year) at a time when the French economy is moribund, and the unemployment rate is at 10 per cent. The new socialist government, which will unveil its budget plans next month, has said that it will raise some taxes (particularly on the wealthy), and cut spending, but has promised not to resort to harsh austerity measures that would plunge the economy into recession.

Finally, many investors are far from convinced that Hollande made the right move in siding with Italy and Spain in an effort to convince Germany to agree to eurobonds. As they see it, there is a basic choice – either eurozone debt is mutualised, and controls are put in place to stop countries running up big budget deficits, or else debt remains a national problem. Hollande, however, wants eurobonds but is deeply reluctant to hand over control of the French budget to Brussels.

In contrast, markets have some sympathy for German Chancellor, Angela Merkel. If Berlin agrees to eurobonds, it will become the guarantor of last resort for all of Europe’s debts. It’s a sacrifice that no other country would even contemplate and, not surprisingly, Merkel’s position is that Germany will only take this step if she’s convinced there’s little chance that the German guarantee will be called on. As a result, the message from Berlin remains the same: no eurobonds unless debt-laden countries introduce painful reforms to boost their competitiveness, and agree to controls on their budgets.

Hollande can’t help but notice that his spat with Merkel is making him increasingly unpopular in the markets. As a result, in recent days he’s dropped his demand for eurobonds, and is instead trying reach a truce with Merkel.

No doubt Italy’s Mario Monti and Spain’s Mariano Rajoy will be deeply disappointed by Hollande’s change of heart, but at this point, Hollande appears to have decided that saving France is a much higher priority than demonstrating solidarity with Italy and Spain.


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