Key facts
- France's 10-year bond yield is nearing 5%, the highest since 2008.
- The spread between 10-year French and German bond yields has widened to 1.45 percentage points.
- More than half of French government debt is held by foreign investors.
- Eurozone inflation reached 3.8% in September.
- Sumitomo Mitsui DS Asset Management sold all its French debt holdings.
France's borrowing costs are surging as investors around the world wake up to the risk of a full-blown public debt crisis in Europe's second-largest economy. Stress in financial markets has started to spread beyond its borders, raising fears that political dysfunction in France could cause a broader, regional problem, stirring memories of the sovereign debt crisis that threatened the single currency's survival 15 years ago.
France has not run a balanced budget in more than 30 years and has struggled to keep its budget deficit within EU limits since 2019, due to soaring pension costs and expenses related to rearmament and the green transition. The country's debt burden is growing rapidly, leading to concerns about its ability to repay.
Investor concerns about France's fiscal and political impasse have ballooned. For years, investors considered Germany and France as roughly equivalent credits, with a small premium demanded for French bonds. However, since the pandemic and particularly after President Emmanuel Macron's decision to call early elections two years ago, this premium has increased significantly. The spread between 10-year French and German bonds rose from 0.55 percentage points in mid-September to 1.45 percentage points by Monday morning, a level not seen since the 2012 debt crisis. The French 10-year bond yield is nearing 5%, its highest since 2008.
Bank of France Governor Emmanuel Moulin has warned that "everything must be done" to avert a debt crisis ahead of the 2027 presidential election. While France has been an outlier in recent weeks, sovereign yield spreads have also started to widen for Italy, Belgium, and Greece, indicating a broader negative sentiment towards Europe. The euro hit a 17-month low against the dollar on Monday.
While the moves have been sharp, the risk premium is not yet at a full crisis level. However, bond prices can fall quickly when investors reassess risk. Unlike Italy, where most government debt is held domestically, more than half of French debt is held by foreign investors, who may exit faster in shaky markets. Sumitomo Mitsui DS Asset Management, a large Japanese asset manager, announced it had sold all its French debt, increasing the risk of contagion to other eurozone countries.
The European Central Bank (ECB) has tools to counter "unwarranted, disorderly" market dynamics, such as its Transmission Protection Instrument (TPI), which allows it to buy government bonds. However, using the TPI requires the bank to determine a country is pursuing sound fiscal and economic policies, which would necessitate significant adjustment measures for France that may be politically difficult to implement before the 2027 elections. Allianz Global Investors noted that support would require "real commitment to stability, through fiscal discipline, reforms or both," which will be politically challenging.
Alternatively, the ECB could intervene by using its balance sheet. Currently, the ECB allows bonds bought during quantitative easing to mature and run off its balance sheet, forcing governments to refinance debt in the market and increasing upward pressure on yields. Carsten Brzeski of ING suggested the ECB could temporarily pause quantitative tightening and reinvest maturing bonds to send a positive signal. This idea was also supported by former ECB board member Lorenzo Bini Smaghi and Jean-Luc Mélenchon, a French presidential candidate.
Analysts at Mitsubishi UFJ Financial Group suggested the ECB might "talk back some of the hikes priced in the market." While markets have scaled back bets on further tightening, eurozone inflation hit a three-year high of 3.8% in September, potentially limiting the ECB's ability to be relaxed about interest rates.
Brookings Institution Senior Fellow Robin Brooks noted that the ECB cannot rush into every bailout and must play "hard to get." However, he added that if supporting France is essential to keeping the euro together, the ECB will likely do so, even at the cost of significant negative consequences for Germany and Northern Europe.