France's fiscal strain in focus

Is France headed for a debt crisis? Prime Minister Francois Bayrou has put his austerity-minded government on the line, calling a Sept. 8 confidence vote. If his administration falls, which seems likely, France could be left adrift as investors demand higher bond yields at a time when the country's fiscal metrics are some of the worst in Europe.

The first chart shows how France combines one of the eurozone's highest government debt ratios (114% of GDP, trailing only Greece and Italy) and largest budget deficits (running at 5.8% of GDP). The latest projections from the IMF suggest that by 2030, France's debt level could surpass that of Greece — the poster child for the early 2010s crisis on the eurozone's periphery.

Greece is notable for having turned its deficit into a better-than-expected budget surplus, though it retains a heavy hangover of past debt. Post-crisis Italy is also notable for having reduced its deficit, while the Germans and Dutch remain paragons of relative fiscal rectitude. (Meanwhile, Britain's soaring deficits make it only somewhat less stretched than France.)

The second chart further breaks down the structural deficit trap that France faces. There's limited room for tax hikes to plug the budget gap; France already has the second-highest tax revenue as a share of GDP in Europe, trailing only Austria. Its large welfare state puts France no. 2 in spending as a share of GDP, trailing only defense-minded Finland.

Bayrou wants to implement a EUR 44 billion austerity plan that would tame the deficit somewhat by freezing public spending and eliminating two public holidays. However, with the government holding only a minority of seats, political gridlock would likely block its implementation. Should Bayrou's government fall, France would lose its third prime minister in less than two years; President Emmanuel Macron would then be forced to either appoint a new prime minister or call fresh parliamentary elections, which could again result in gridlock or an even higher-spending coalition of other parties.

Investors are likely to question the country’s fiscal sustainability and demand higher yield premiums if the confidence vote fails. The French-German 10-year yield spread, a gauge of risk, has been surging recently, marking one of the largest divergences since 2012. But unlike the early 2010s crisis, French yields are surpassing their Spanish equivalents and moving closer to Italian levels.

Given that France is the euro area’s second-largest economy, signs of severe stress — whether fiscal deterioration or political turmoil — would likely spill into the currency itself. Historically, the EUR/CHF exchange rate has strongly correlated with wider French–German sovereign spreads.

France’s perceived creditworthiness in the credit-default-swap market has also deteriorated -- and the gap with Greece is narrowing. A decision by Fitch on the nation's credit rating is worth watching; it's scheduled to assess France on September 12 — just days after the parliamentary vote.

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