In November, soon after France and Belgium were forced to pump another 5.5 billion euros into bailed out lender Dexia, the ratings agency Moody’s stripped France of its AAA sovereign debt rating. The interesting bit was that Moody’s maintained its negative outlook. The ratings agency reckons France has poor longer-term economic growth prospects and a poor fiscal outlook. According to recent data, the outlook is still just as dim, probably worse.
I would also add that France has a poorly capitalised banking system and a frothy housing market. In my view, it is not inconceivable that after a few more rounds of bailouts and austerity-enlarged deficits, France could be in the 120-130% government debt to GDP range that Italy is now in. And where Italy’s problems are related to demographics and high real effective exchange rates, making the country look like a less efficient Germany, France adds in the housing and banking problems that make it look more similar to Spain.
The Economist was onto this in November, with a cover story that was much-maligned in France showing a bunch of baguettes wrapped in a French flag with a lit bomb fuse attached. The article was titled subtly “The time-bomb at the heart of Europe“. While the French thought of this as Anglo Saxon bombast and sabotage, the prose had the ring of truth:
France still has many strengths, but its weaknesses have been laid bare by the euro crisis. For years it has been losing competitiveness to Germany and the trend has accelerated as the Germans have cut costs and pushed through big reforms. Without the option of currency devaluation, France has resorted to public spending and debt. Even as other EU countries have curbed the reach of the state, it has grown in France to consume almost 57% of GDP, the highest share in the euro zone. Because of the failure to balance a single budget since 1981, public debt has risen from 22% of GDP then to over 90% now.
The business climate in France has also worsened. French firms are burdened by overly rigid labour- and product-market regulation, exceptionally high taxes and the euro zone’s heaviest social charges on payrolls. Not surprisingly, new companies are rare. France has fewer small and medium-sized enterprises, today’s engines of job growth, than Germany, Italy or Britain. The economy is stagnant, may tip into recession this quarter and will barely grow next year. Over 10% of the workforce, and over 25% of the young, are jobless. The external current-account deficit has swung from a small surplus in 1999 into one of the euro zone’s biggest deficits. In short, too many of France’s firms are uncompetitive and the country’s bloated government is living beyond its means.
Yet bond investors act as if France has almost no default risk. Spreads are only 62 basis points to Bunds and a full two percentage points lower than Italy and almost three points lower than Spain.
But there’s more. The Economist strikes yet again with data that shows the rot in France. According to the Economist, judged on the income one can earn investing in French residential property, France has the most overvalued market in all of the largest global economies at 35% overvaluation. The overvaluation is even larger when comparing purchase prices to rents at 50%. This compares extremely unfavourably to Italy where the income ratio shows 12% overvaluation and the rent ratio shows an undervaluation of 1%. Again, I see no reason for France to trade 200 basis points inside of Italy given these numbers and the contingent liabilities they represent when France bails out its banks. As Matthew Klein puts it:
Most of what we call money is actually short-term debt created by banks when they make loans. This means that banks are the stewards of our savings and manage the payments system. As a result, they have a privileged place in our society: governments never deliberately choose to liquidate the banking system. It always appears preferable, in the short term at least, to preserve the incumbent institutions and personnel through bail-outs. (Lending to “solvent but illiquid” firms at below-market rates is another kind of bail-out, even if it is not always called one by the authorities.)
Bankers thus have every incentive to become as “systemic” as possible and to take as much as risk as possible—they know that they can almost always get these bail-outs when they need them.
This is a worry in France because the housing market is now starting to fall as the French economy slips. French President Hollande has stepped up the political rhetoric. First, at the beginning of the month, Hollande said that he believes Europe has condemned itself to a “never-ending austerity”. He requested that France’s deficit targets to be relaxed and that Germany to provide more economic stimulus as a counterbalance. This got a favourable mention in Spanish daily El Pais, as the Spanish Prime Minister is looking for the same deal. Hollande then went on to talk about excessive euro strength, saying “the euro should not fluctuate according to the mood of the markets” and suggesting that their needed to be some fixing of rates to stop this. But, of course the euro is a fixed exchange rate system. Mr. Hollande already has the fixed exchange rates he wishes and they aren’t benefitting him since his country is clearly losing competitiveness. So this makes no sense whatsoever.
Now it has come to light that the French are going to have to cut their growth forecast for 2013. They will not hit their targets and so either they will need to re-double efforts or get the targets relaxed. I believe it will be the latter as opposed to the former because I suspect at least the Netherlands, Spain and Portugal will all need their targets relaxed as well. But the problem here is clearly that France’s economic outlook is poor and nothing on the horizon says it is going to get any better. This will mean higher debt and deficits and an unraveling of France’s housing market, inviting systemic fragility in French banking. I am not bullish on France in the least. I think the country is Europe’s next big problem and expect yields to rise accordingly.