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Wall Street Journal features Stephen Pope & Spotlight Ideas

Tuesday April 24th 2012


France and the Bond Market

Investors are waking up to the risks of owning French debt.

By Nicholas Spiro & Stephen Pope

A disenchanted French electorate has delivered its preliminary verdict. It wants change and is expected to grudgingly back François Hollande, the Socialist candidate, in the decisive second round of the presidential election on May 6. Antipathy toward his opponent, President Nicolas Sarkozy, was always going to be the key factor swaying French voters. Yet if anti-Sarkozy sentiment will decide the outcome of the election, what does a Hollande presidency hold in store?

Judging by the nervous reaction of financial markets to Sunday's first round of voting, investors are waking up to the risks posed by a lurch to the left under a Hollande presidency and are starting to reprice French risk accordingly. Doubts have already been cast over France's creditworthiness. The premium it pays to borrow over Germany leapt more than fivefold between June and November as the euro-zone crisis escalated. Although it has narrowed since, it is up nearly 35 basis points this month alone.

Fears that Mr. Hollande, if elected, will make a significant leftward shift in economic policy are exaggerated. But this misses the point. The election has thrown into sharp relief France's long-standing weaknesses and the unwillingness of the two finalists to address these failings head-on. The contest is also taking place just as the euro-zone crisis is flaring up again, leaving France once again vulnerable to contagion because of its banks' heavy exposure to the bloc's troubled periphery.

Yet it is France's own "peripheralness" that is now under scrutiny. While Spain is the latest focal point for investor anxiety about the euro zone, France is sailing dangerously close to the wind. Despite being burdened with the highest level of public expenditure as a share of GDP in the euro zone (and among the OECD club of advanced economies for that matter), France still ran a fiscal deficit last year that was larger than Portugal's as a percentage of output.


France's current account balance, relative to the size of its economy, is closer to the substantial deficits recorded by Italy and Spain than the small surplus for the euro zone as a whole. The unemployment rate is higher than in Italy while GDP growth in 2012 and 2013 is expected to be the second-lowest in the G-7 group of rich nations, according to the IMF. Although France has been flirting with austerity recently, its economy is looking more like those of its southern neighbors and ess like Germany's.

French banks are particularly at risk. According to figures from the Bank for International Settlements (BIS), they account for 30% of European banks' consolidated claims on the euro zone's five peripheral economies, a higher exposure than that of their German peers because of their much larger holdings of Italian public and private debt. French stocks even managed to miss out on this year's global equity rally, having fallen by 4% in the last three months as bank shares underperformed.

Investors are aware of all these risks. The question is whether they are pricing them correctly. We believe there has been a degree of market complacency about France, partly because of the country's strategic importance and perceived status as a relative safe haven in the euro zone. The more the markets have questioned France's creditworthiness, the more President Sarkozy has sought to nail France's colors to the mast of German fiscal rectitude.

These efforts have always rung hollow. They now strain credulity. The presidential election is, if anything, a truer reflection of France's instinctive and growing dislike of financial orthodoxy. That both finalists, in particular President Sarkozy, are now forced to appeal to the far-right National Front, an anti-euro party with nearly one-fifth of the vote, says a lot about the zeitgeist in France. François Bayrou, the reform-minded candidate who won 9% of the vote, is now on the fringe of French politics.

All eyes are now on the Socialist front-runner. Should he win the election, Mr. Hollande is unlikely to "do another 1981"—a reference to the extreme leftist policies pursued by France's last Socialist President, François Mitterrand, in his first two years in office—but would give the markets reasons to be even more concerned about France's creditworthiness. It is not that his policies would differ sharply from those of Mr. Sarkozy. Rather, Mr. Hollande would be even less disposed to push for the kind of fiscal and structural reforms that France sorely needs.

Even if Mr. Sarkozy is re-elected, he is likely to be more constrained in his second term. Although the bed on which French bonds are resting may not be soaked in nitroglycerin, to paraphrase a prominent fund manager, it is becoming increasingly unstable. Sentiment is starting to turn against France once again. Only this time the correction could be more severe and longer-lasting. If Mr. Hollande triumphs on May 6, he could be facing a baptism of fire.

Mr. Spiro is managing director of Spiro Sovereign Strategy. Mr. Pope is managing partner of Spotlight Ideas.

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