Matthieu de Clermont, CIO Insurance & Regulatory Strategies, AllianzGI.
The French parliament voted on Wednesday night to oust Prime Minister Michel Barnier over his proposed budget. Barnier’s resignation this morning follows snap parliamentary elections in July, which resulted in a hung parliament with no party having an overall majority. New parliamentary elections cannot be held until June 2025.
For now, Mr Barnier will likely stay on as “caretaker” until a new government is chosen. The immediate objective for the next government will be to find a minimum political common agreement to construct a budget. If not passed by the end of December, the 2024 budget will be rolled over, ensuring there will be no shutdown.
However, rolling over the budget could increase the country’s budget deficit– the gap between spending and tax income – even further. Initially forecast at 4.4% of gross domestic product (GDP) in 2024, and then successively revised to 5.1% and 5.6%, the deficit should finally exceed 6% this year. As the government is expecting 2025 growth to be above 1%, any risk of undershooting this target could drive the deficit higher, leading to further deterioration of the debt/GDP ratio above the initial 114.9% targeted.
As Mr Barnier noted before the vote “the French debt will not disappear because of a vote”.
Today’s average sovereign financing costs of 2.1% will likely trend upwards as yields have risen.
Assuming a trend nominal GDP growth of around 3-3.5%, France could afford a primary deficit of 1-1.5% of GDP. As of today, the estimates for the primary deficit are at 2.5%+. In our view, the French budget needs to be cut by around 1.5% of GDP – or EUR 40 billion – to return to a stable debt/GDP ratio.
Impact on risk premium
How will France’s risk premium evolve in the days and weeks ahead? Reflecting growing unease in financial markets, French sovereign borrowing costs have risen sharply since June. The premium over German bonds – at 50 bps in June – reached the highest since the euro zone debt crisis in 2012, with the OAT-Bund spread hitting 90 bps before the government fell. It is down to 80 bps this morning, as the ousting of the French Prime minister was expected by investors. In addition, investors have been shorting French debt since June and may be tempted to reduce their exposure.
Volatility ahead
We expect further market volatility. A spread of 80-100 bps is consistent with a downgrade of France’s credit rating to single A. Whether the spread could go higher is difficult to assess today. Markets will be looking for political stability as a good deficit trajectory.
The financing plan for France will be key next year as, faced with an increased deficit, borrowing needs will increase. The investor base shows non-resident holdings represent 54.6% of the total negotiable debt, and last summer we experienced a large sell-off of French debt. Therefore, it will be interesting to see whether the amount of debt held by foreigners will remain stable in a context where the European Central Bank (ECB) has ceased to be the main buyer post-quantitative easing but could continue to use the lighter PEPP (pandemic emergency purchase programme) reinvestments to support French debt, as observed in recent months.
However, even though France may have little credibility in Europe when it promises to cut spending, we think comparisons with Greece are wide of the mark. We do not expect a genuine financial crisis, and the risk of a default is not part of our scenario planning. France never misled about its deficit, and investors trust the French authorities. Moreover, the household savings rate in France is high, and even increased to 18.16% in the third quarter of 2024 from 17.94% in the second quarter of 2024. So savings could be tapped, as has been proposed by the Left.
Finally, the ECB has started lowering interest rates. While France is now borrowing at higher rates than its neighbours, the cost is still lower than earlier this year, when the five-year interest rate exceeded 3%. Moreover, since the global financial crisis the ECB has put in place a framework for countries in debt trouble that could be used as a last resort.
For investors, good entry points might appear but it is important to be mindful of the inevitable volatility.
