France in the crosshairs

For much of the past decade, governments, businesses and households grew accustomed to a world of cheap money. That world appears to be gone for good. The combination of the energy shock, the sharp rise in private-sector financing needs to fund the new wave of AI-related investment and the start of measured monetary tightening by central banks has shifted the entire yield curve upwards. When the cost of money rises, issues that were sidelined for years matter again: the quality of investment projects, the capacity to generate growth and, above all, the sustainability of public finances. This transition is increasing the vulnerability of countries that are entering the new environment with structural fiscal imbalances and limited budgetary room for manoeuvre. At the same time, tighter financial conditions are forcing investors to be more selective between projects, companies and countries. Higher interest rates are therefore changing not only the cost of capital but also its marginal allocation. Every reallocation process creates winners and losers.

France stands to be one of the biggest losers. It combines three factors that bond vigilantes can scarcely ignore: lacklustre potential growth, a highly precarious fiscal position and a complex sociopolitical backdrop. The shift is significant: in the markets’ eyes, France is no longer trading as one of the euro area’s core countries and is moving into what was traditionally known as the periphery. Arithmetic explains much of this transformation. To stabilise debt at around 120% of GDP over a ten-year horizon, France would need to make primary balance adjustments which it has failed to achieve for decades. This therefore appears to be not a speculative attack by financial markets, but a structural reassessment of risk within the euro area. The market is not questioning the irreversibility of the euro, as it did between 2010 and 2012. It is pricing in countries’ differing abilities to navigate a world in which financing high levels of debt once again comes at a cost.

This inevitably raises the question of how far the ECB should go, and more specifically, whether there would ever be grounds for activating the Transmission Protection Instrument (TPI). The TPI was created in 2022 in order to allow government bond purchases in the event that an unwarranted and disorderly rise in risk premia threatens the smooth transmission of monetary policy. It was conceived precisely as a warning: to show that the ECB has tools as its disposable to curb any financial fragmentation that is incompatible with the functioning of a monetary union. It was not, however, intended to quell every rise in a risk premium, especially one driven by deteriorating fundamentals.

That distinction is essential both to understanding the limited contagion to economies that have improved their public finances and to putting the French case in context. The current widening of the country’s risk premium largely reflects its worsening fiscal outlook and political uncertainty. France would therefore need to accompany any monetary support with credible signs of fiscal consolidation in order to become eligible for a potential activation of the TPI. For now, there also appears to be no systemic urgency: the deterioration in French risk has had limited spillover effects on the other large peripheral issuers.

And that is precisely how this episode differs from the sovereign debt crisis of 15 years ago. The problem then was the fragmentation of the monetary union and redenomination risk, which affected much of the periphery. This time – at least for now – the problem is much more conventional: identifying which countries are best placed to withstand structurally higher capital costs.

In short, France is a classic case of being in the wrong place at the worst possible time – a combination that has put it squarely in the sights of international investors. France’s main problem is less about identifying the necessary reforms as it is about building the political and social consensus needed to implement them. The added difficulty is that France is not just another member of the monetary union. Its economic weight and, especially, its political centrality to the European project magnify the implications of any prolonged deterioration in its fiscal position. The good news is that Europe is facing this episode with a much stronger institutional framework than in 2011-12.

That is probably why the battle over the coming months will be fought not in Frankfurt or Brussels, but in Paris. The ECB can prevent a crisis of confidence from becoming a euro crisis, but it cannot replace reforms with bond purchases or manufacture fiscal sustainability through a central bank’s balance sheet. Europe now has stronger defences. France will need to show that it too can respond.