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France: The quiet sick man of the Eurozone

France’s fiscal deficit and public debt are at worrying levels. If structural reforms prove difficult, the country might be dragged into the eurozone crisis.

The distinction between the strongest and weakest economies in the Eurozone has become especially marked over the past 18 months. But what about the country whose financial reputation is second only to Germany’s but which has some fiscal indicators that are closer to those of Greece, Portugal and Ireland? The country in question is France.

In 2007 France’s then prime minister, François Fillon, claimed that the country was broke. "I am at the head of a state that has not once passed a balanced budget in 25 years," he bemoaned. eur

If France was bust before the onset of the global financial crisis, it is safe to assume it is bust now but with its public finances in an even more perilous state. Yet while the world wonders where the Eurozone crisis will spread next – with Spain, Italy and Belgium the likeliest candidates – France has avoided the bond market’s guillotine.

France’s fiscal deficit at the end of 2010 was 7% of GDP, compared with 3.3% in 2008, and its public debt had risen to 81.7% from 67.5% two years earlier. And that’s before the state’s contingent liabilities are taken into account. Both its fiscal deficit and debt-to-GDP ratio are way above the levels normally associated with countries moving into danger territory.

Potentially even more worrying is France’s dependence on international creditors to service its high funding needs. One of the reasons why the UK’s large debt burden is manageable is because it is mostly financed by domestic institutions. France does not have that safety net.

If a comparison is made of a country’s gross funding needs for 2011 as a percentage of GDP and the amount of government debt held by non-residents, the only more vulnerable sovereign borrowers than France, according to this metric, are Greece, Ireland and Portugal. In other words, the pressure could easily build on France given that its gross funding needs for this year are greater than 20% of GDP yet only about 35% of its debt is held by local creditors.

There are three reasons why French government bond yields have stayed relatively stable: its public finances are not quite terrible enough – thus, ironically, its bonds are seen as a safe haven; its economy is growing, albeit at a crawling pace; and its banks are relatively solid.

The biggest lenders are making profits and have access to funding, although costs are high. Their capital ratios, however, fall short of the best international standards and could yet prove to be their Achilles heel given their big exposure to Eurozone debt. Last month Standard & Poor’s lowered Crédit Agricole’s credit rating thanks to its exposure to Greece.

Whether the ratings agencies will take similar action against the sovereign remains to be seen. For the moment they are standing firm over France’s triple-A rating. That could change, however, if public debt levels were to continue to accumulate without signs of stabilizing at an affordable level.

Structural reforms, including a binding constitutional fiscal rule and an increase in the formal retirement age, will help. But in a country where the labour unions are strong, passing and implementing these measures will not be easy.

France might yet be dragged into Europe’s crisis.

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