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Capital Markets

France’s triple-A rating remains on a knife-edge

France’s triple-A rating is under threat as concerns grow about the country’s economy and government bond market, coupled with its position as the largest European holder of Greek debt.

Debt markets have already priced in the probability that France will lose its triple-A status, as the country’s ailing economy and government bond market threaten to strip the country of its top rating.

Despite being the largest holder of Greek debt, experts say that domestic issues are at the heart of the problem, rather than wider eurozone concerns.

At the end of July, a UK tabloid newspaper reported France had been warned by the IMF that it was in danger of losing its triple-A rating. However, this was not quite what was said at a press conference by Anne-Marie Gulde-Wolf, the IMF’s mission chief for France.

When pressed about whether or not a Damoclean sword was hanging over France’s rating, her response was equivocal. “We have not taken a view on how much the rating was at risk,” she said. “But we have taken the view that we very much clearly understood from markets that the measures that have been put in place are consistent with maintaining the triple-A rating.”

“There are some issues to be
addressed in France. But we
are not dealing with the same
problems that we see in Italy" 

- Elisabeth Grandin, director of
financial services at Standard &
Poor’s in Paris

Each of the leading agencies was quick to reassure the market that France’s triple-A rating was in no immediate danger. These reassurances were in line with what Elisabeth Grandin, director of financial services at Standard & Poor’s in Paris, told Euromoney in July, before its action on the US rating sent analysts scurrying to find the next cab on the downgrade rank. “There are some issues to be addressed in France,” she said. “The debt burden is clearly one of these. But we are not dealing with the same problems that we see in Italy, which we rate A+ with a negative outlook.” Whichever way you spin it, however, France looks shaky. And it seems to be getting shakier. Witness the dreadful performance of its banks’ share prices since the early summer. Some of the more precipitous declines, it is true, have been driven by press coverage that has been mischievous and – at least on one occasion – downright inaccurate. But they may also have reflected the perception that French banks seem to have had an uncanny knack of investing too often in the wrong countries at the wrong times. It was not so long ago that Crédit Agricole, for example, was proudly reminding investors in its roadshow presentations that it had three domestic markets – France, Greece and Italy.

Today, that may not look like a domestic franchise worth making much noise about. Equity analysts generally seem to agree, however, that French banks’ exposure to Europe’s troubled periphery is manageable and has probably been exaggerated by jittery stock markets that have magnified the problem by staring at it. Morgan Stanley commented in May that the market-implied haircuts on French banks’ Greek, Irish and Portuguese debt would be “manageable” at between zero and 30 basis points of core tier 1 capital. “On our calculations, all [French] banks would be able to maintain CET ratio at or above 8%,” added the Morgan Stanley note.

Largest concerns

The bigger concern may be France’s economy and the off-colour performance in recent months of its government bond market. Growth ground to a halt in the second quarter, making official forecasts for expansion this year look unlikely, even after August’s revisions from the government. This stated growth for both this year and next year is likely to be 1.75%, rather than 2% in 2011 and 2.25% in 2012. “We welcome the downward revision in the government’s growth forecasts, which now look more realistic,” says Francois Cabau, of the European Economics Team at Barclays Capital in London.

Nevertheless, Cabau says, growth will still need to be monitored as a risk factor in terms of fiscal consolidation, with BarCap’s forecast standing 0.55bp below the government’s for 2012. As he says, there is nothing very new about France failing to deliver on this front. The Republic, he says, has posted a primary balance only five times in the last two decades, during which time its debt has expanded more or less consistently. In the last decade alone, the general government deficit has risen from 1.5% to 7% of GDP, while the debt-to-GDP ratio has ballooned from 57.3% to 81.7%.

This figure remains lower than Germany’s and is below the euro area’s average of 85.1%. But the trajectory of France’s debt-to-GDP ratio is unnerving. “France has a debt-to-GDP figure that will be above the magic 90% level within a few years, so although it is probably in a stronger fiscal position than Italy or Spain, it has many of the same characteristics,” says Gary Jenkins, head of credit strategy at Evolution Securities.

Where does this leave the outlook for France’s rating? On a knife-edge, according to a recent analysis published by Citigroup Global Markets. In a piece published soon after the US downgrade, Citi identified France as being the G7 country most at risk of losing its triple-A rating. This danger, Citi explained, reflects France’s “high public debt and deficimt, and popular resistance to cutbacks in its even by euro standards extremely large welfare state.”

By early August, the Citi analysis suggests, debt markets were already pricing in the real threat of a downgrade, with French 10-year spreads over German bunds reaching more than 90bp, a level not tested since the last of the major ERM crises in December 1994. The French five-year CDS spread, meanwhile, hit 160bp on August 8, 2011, more than three times the US level.

Short and long term impacts

A downgrade for France would be a stinging rebuke. It would also be a blow to national pride for a country that some once believed would challenge Germany as the new benchmark in the context of a single European currency. How much it would matter, in the much longer term, is a different question altogether. After all, as the Citi analysis says, with Germany’s rating itself not carved in stone, “we could be moving towards a world without triple-A G7 sovereigns.” That, adds Citi, suggests that “for portfolio allocation, relative risk will be the driver now that ‘risk free’ is no longer an option.”

‘Relative’ is clearly the operative word, because as most analysts appear to agree, any negative rating action on France is likely to be driven as much by events within France itself as by developments elsewhere in Europe. Most obviously, if Spain or Italy lurches towards a default, France’s banking system and its public finances will inevitably be subject to fresh scrutiny. “Clearly, if there is a requirement for a substantial increase in the size of the European Financial Stability Fund (EFSF), that will put a burden on the core Eurozone countries, creating an additional contingent liability,” says Huw Worthington, European fixed income strategist at Barclays Capital.

True enough. But as Jenkins at Evolution points out, a Spanish or Italian default would be a universal game-changer. “The truth is that if Spain or Italy has a problem, we all do,” he says. “France will not be impacted in isolation.”

In the meantime, and in spite of the noise about France’s rating and the widening of OAT [Obligations assimilables du Trésor] spreads versus bunds, nobody appears to be questioning the ability of the Trésor to fund itself efficiently. Granted, on a relative basis foreign investors’ appetite for French government bonds has been waning over the last two years. As Worthington at Barclays Capital points out, the share of non-resident holdings in the OAT market has fallen from a peak of 71.4% in June 2010 to 65.2% at the last count. This need not be a negative signal. There has been a retrenchment towards domestic government bond markets by investors throughout Europe since the crisis, and there is more than ample demand among very liquid French institutions to take up any slack created by reduced international demand.

In any event, while a foreign share of 65% may be down on the peak, and well below overseas investors’ holdings of bunds; it is still higher than in Spain or Italy. It is also much higher than in the UK or Japan, both of which continue to fund themselves at very competitive levels.

Bankers certainly seem unconcerned about international investors abandoning the OAT market. “It’s true that we have seen a widening of spreads versus Germany, but we are many miles away from France being under the same pressure as the peripheral European sovereign borrowers,” says Pierre Blandin, head of sovereign and supranational debt capital markets at Crédit Agricole in London. “By July, the Trésor had completed about 75% of its borrowing programme for the year, which is among the highest in the eurozone. That leaves about €50 billion for the rest of 2011, which is not an insignificant amount, but even in a worst-case scenario France will be able to raise this without any problem.”

Over the much longer term, a worst-case scenario leading to the break-up of the single European currency might paint a very different picture, and in extremis lead to the sort of apocalyptic outcome described recently by Brendan Brown, head of research at Mitsubishi UFJ Securities. “Italy or France will never default on their own government bonds,” he wrote in early August. “But plausibly the situation could arise where the only way not to default is to withdraw from EMU and apply a national money printing press to debt servicing (meaning French or Italian government bonds would be serviced in national euros, no longer convertible 1:1 into German euros but at a freely floating exchange rate). And investors fearful of that possible scenario would pull their funds out of Italian or French banks and put them into German banks instead.”

That unsettling narrative may be tomorrow’s story. For the time being, the world has plenty of things to worry about. In isolation, the state of the French economy is not foremost among them.

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