What would a far-right or left-wing government in France mean for OAT spreads?

In April, French president Emmanuel Macron made a landmark speech calling for a more deeply integrated Europe, alert to the growing challenges of an uncertain world. But its impact was muted by the fragile state of his government, which was further exposed six weeks later at the European Parliament election, where the far-right Rassemblement National (RN) party won 31.4% of the vote, leaving his centrist Renew alliance a distant second.

In a shock to the market, Macron’s next step was to call a snap parliamentary election. In France’s hybrid presidential/parliamentary system, the winner of those elections will hold real power. They can choose the prime minister and control the government budget. Regardless of the intentions behind the move, the gamble does not appear to be paying off.

Polls have so far mirrored those at the European level, with RN consistently winning over 30% of the vote. An alliance of left-wing parties under the name Nouveau Front Populaire (FP) now sits second in the polls. Centrist parties look set to be the big losers when voting commences on 30 June.

France’s deficit in focus

The European Commission last week recommended excessive deficit procedures (EDPs) for seven countries, including France, that have a deficit above 3% of GDP. Should the European Council agree, EDPs will be launched in July. The next step would be for the Commission to work with member states to produce plans aiming to reduce the primary deficit by a minimum of 0.5% per year. However, the 21 June deadline sits right in the middle of the election campaign in France. 

Both the left and right are campaigning on a platform of higher spending, which would make agreement on an adjustment plan difficult to reach. Although RN has not formally released its economic programme, it stands by several of the policies in the 2022 manifesto, which would have cost upward of 3.5% of GDP, according to the highly respected Institut Montaigne. We believe it’s likely their new programme, while more constrained, would still lead to a wider deficit.

FP released its economic programme a couple of weeks ago, and although they intend to increase revenue through various tax rises, this would not even be enough to cover their intended rolling back of pension reforms, reducing the retirement age from 64 to 62. Worse, one of the headline policies is to reject all constraints linked to the EU Stability and Growth Pact, which would immediately put France on a collision course with the Commission.

The exact costs of the programmes of the left and right are difficult to gauge, but a wider deficit looks inevitable to us in either scenario, leading to rising debt and high risk of ratings downgrade. S&P downgraded France to AA- in May citing these concerns, while in April Moody’s and Fitch left their ratings unchanged. Neither agency is due to reassess until October, but there is high risk that we see further downgrades at this point. Moody’s has already stated that the snap election is a negative risk for the credit rating. 

What a downgrade could mean for spreads

This would put further pressure on French spreads. Foreign ownership of French government bonds – known as Obligations Assimilables du Trésor, or OATs – exceeds that of peers, at nearly 50%. For many years, given deep liquidity and limited volatility, French government bonds have been viewed as higher-yielding German sovereign bonds. These holdings may need to be reassessed with credit risk having now been revealed.

Additionally, among the foreign holders, there is likely to be a subset whose ownership is conditional on France retaining an AA rating. We believe the selling of such holdings would likely increase spread widening in a scenario where a less austere fiscal path looks more likely.

If either RN or FP secure an absolute majority at second-round polls, we would expect spreads to widen amid concerns about future spending. If neither party wins an absolute majority, we either get a minority government with limited ability to push through their agenda, or an impasse that could eventually lead to a technocratic government. These scenarios could be less detrimental to spreads, and in the case of the latter could open the door to a return to market levels seen before the election announcement.

But in most other scenarios, the spread is likely to remain permanently wider in our view; once the promise of more spending is unleashed, it’s hard to put back into the box.

The consequences of the election result are not confined to France. Macron has been the loudest proponent of a more integrated Europe for some time. Should France now switch to calling for less Europe, then the dynamic at the heart of the project changes. At best, this means stalling of further progress on the capital markets union, at worst it could mean putting some initiatives into reverse. 

Our views

The challenging fiscal backdrop in France was already of concern to us long before the election was called. For the last 12 months, we had been running underweight against Spain where strong growth has been helping to improve debt dynamics. 

We cut this position after the election announcement once the French spread reflected a high probability of downgrade. However, we remain fundamentally cautious with such pervasive political uncertainty still ahead of us. We continue to prefer other credits where uncertainty is lower.

Broader ramifications

The eruption of French political risk has been associated with a 3% fall in the value of the euro and a 10-basis-point increase in European corporate borrowing costs.¹ French equites have fallen around 7%,² dragging broader European equity indices lower. Those kind of market moves inevitably bring back unpleasant memories of the European sovereign debt crisis.

We don’t think a repeat is likely given that the internal imbalances across the Eurozone are much smaller and the markets have greater confidence in the ECB to stand behind the single currency if necessary. Further distress could potentially present a buying opportunity in broader European assets.

Sources

1. Bloomberg as at 21 June 2024.

2. ibid.