French Distraction Manoeuvres
Ralitsa Kovacheva, 14 November 2011
Despite the demonstrated proximity of Nicolas Sarkozy and Angela Merkel, French borrowing costs are rapidly moving away from the German costs. The spread between the 10-year French and German bonds has doubled since the beginning of October, The New York Times noted. The German Bund is considered a baseline and shows an investment risk close to zero. The bigger the difference to the Bund, the higher the price the country concerned pays to gain market financing and, therefore, the riskier the country is perceived by investors. It is the fear that France might be the next victim of the debt crisis that is actually the main driver of the recent political developments in the euro area. Nicolas Sarkozy will do anything to compensate the increasing spreads, an expression of market mistrust to Paris, with political means, even intrigues.
In Paris, everything is calm
According to the autumn economic forecast of the European Commission, France will end the year with economic growth of 1.6%, budget deficit of -5.8% and unemployment rate of 9.8%. Next year, growth will reach a eurozone average of 0.6% and the deficit will remain above 5% within the next two years. France, like most EU countries, is under an excessive deficit procedure and has a deadline to correct the excessive deficit by 2013 but, as is evident from the forecast, it will fail to meet the deadline. EU Commissioner Olli Rehn commented that the Commission is satisfied with the measures adopted by Paris in August but additional consolidation efforts will be required in 2013.
The French debt will increase from 85.4 % of GDP this year to nearly 92% in 2013. According to the Commission the reason for the increase are the guarantees provided by France for the rescue fund EFSF, the bilateral loans to Greece and the participation in the capital of the permanent European Stability Mechanism (ESM). If you look at the recommendations of the Commission to France, in the framework of the European semester, here too the main recommendation is to reduce deficit. The country has a lot of work on the tax system and the labour market but generally there is no reason to panic.
The banking bomb
Obviously, it is not the doubts in the French economy that cause market mistrust and Elysee palace's anxiety. "A bomb" can explode in the banking system, which is vulnerable to the turbulence in the euro area. French banks hold large amounts of peripheral economies' debt and not only. The New York Times quoted a report of an investment bank according to which, among all European banks, it is the French that have the highest exposures to Italy. They are holding government bonds amounting to over 100 billion dollars and additionally 300 billion dollars of private debt - loans to private companies and individuals. The newspaper notes that the dependence of French banks on the situation in Italy is still great, despite the efforts of French banks in recent months to unload their Italian obligations. The problem becomes even more serious because the French banks are strongly dependent on short-term financing, which makes them vulnerable to possible credit markets freeze as a result of the Italian problems, the New York Times notes.
So the horror of the French is that a worsening of the situation in Italy may require the provision of state aid to banks. Remember Nicolas Sarkozy's insistence the recapitalisation of banks, agreed by the European Council on 26 October, to be financed directly with money from the bailout fund EFSF, rather than with national resources. Or imagine what would happen, though European leaders promised that the Greek case was an exception, if part of the Italian debt were to be be written off too, as was agreed for Greece? After all the Greek debt is 350 billion euros,while the Italian is almost 2 trillion euros.
And if Italy requested a bailout? The innovative mechanisms to provide additional funding for the rescue fund EFSF, agreed on 27 October, have not encountered impetuous investor interest, which means that it may ultimately be necessary to increase the guarantees provided by the eurozone countries, no matter how desperately the leaders are trying to avoid it. That will literally blow up the French public finances and will surely deprive France of its AAA credit rating, which in itself will create a problem with the functioning of the rescue fund - it relies on the highest credit rating of only six eurozone countries, and especially France and Germany, to raise market funding.
The political bait "two-speed Europe"
Against this background, Nicolas Sarkozy's behaviour is not at all surprising. In order to shield his country from market pressures, he is trying to turn the spotlight away from Paris, suggesting that the root cause of the problem is elsewhere and it would suffice to get rid of those who create problems. Paris first differentiated itself from the "problem countries" by posing the threat, provoked by Greece, that leaving the euro area could become possible voluntarily or involuntarily. Then a direct proposal came for “two European gears” with a strong integrated core (the eurozone) and a more confederal periphery (the other 10 countries). Along with this, there are persistent rumours that the euro area may be reduced and get rid of some members unable to follow the pace of others. Even lists have appeared of ‘ins’ (Germany, France, Austria, Belgium, Finland, Luxembourg, Netherlands, Slovakia, Slovenia and Estonia) and ‘outs’ (Greece, Portugal, Ireland, Italy, Spain, Cyprus and Malta). As you can see, the division is directly along the North-South axis.
Such a position, however, is not completely shared by Berlin. The talks about greater integration in the euro area are going on for quite some time but Germany, unlike France, has always maintained the position that the EU should not be divided into two parts. For an export country like Germany the destruction of the single market would be disastrous and in this respect Germany's position is much closer to that of the United Kingdom - the country that is protesting most strongly against the usurpation of power in the EU by a separate and formally institutionalised euro area, which will have more votes in the Council and may impose its decisions on the other 10 countries.
Moreover, there is a difference between both countries' visions of the eurozone's governance itself: while France imagines the euro area rather as a separate formation and has long pressed for a president and formal institutions, Germany prefers a stronger role for the European institutions to maintain discipline and policy coordination. According to German Finance Minister Wolfgang Schauble the euro area must pass some of their responsibilities for budget and fiscal policy to the European institutions. The media consistently cite anonymous diplomats in Brussels as saying that Germany is increasingly willing to accept the French vision of a “two-speed Europe” but at this stage the official German position does not allude to it.
It is known that the close connection between Merkel and Sarkozy (Merkozy, as they are called by the media), is far from idyllic and untroubled. While both sides often propose common initiatives, these require tough negotiations, mutual compromises and political bargaining. So it is premature to believe that Merkel necessarily agrees with each of Sarkozy's statements. However, he is running out of time, facing elections next year and has (both the president and his party) a record-low electoral support in the country. An opinion poll has shown that the French trust Chancellor Merkel more than their own president. Sarkozy is hardly inspired by the fate of his colleague Silvio Berlusconi and although sharing his passion for beautiful women he hardly wants to share Berlusconi's political downfall.
Last week it became clear how justified Sarkozy's fears are when the ratings agency Standard & Poor's lowered French credit rating "by mistake". Only in a few hours investors sold out in panic huge amounts of French debt, and the interest rates on the 10-year French bonds reached 3.46%. The increase compared to the German bonds was 21 basis points to a total of 168 points. The French government reacted angrily and started an investigation but it will hardly erase the damage caused by "the mistake". The case clearly shows how thin the confidence of markets has become in terms of France (or maybe the S & P attempted to verify exactly this?), but remember that exactly this "lack of trust" took several heads of governments in the euro area so far. Paris, however, although vehement in teaching others that the return of confidence goes through stable finances and reforms, prefers the tactics of distraction instead of problem-solving.
Against this background, the bidding for the fate of the eurozone is going on at a breakneck speed. On the one side are the financial markets, which have already clearly shown that they measure stability of the euro per country individually. On the other side are politicians, who compete with their ideas for political changes. By the end of the year the first concrete proposals for the eurozone governance will be announced by the member states, meaning France and Germany. European Commission President Jose Manuel Barroso also joined the bidding with a clear request for an enhanced role of the European institutions (there will be a separate analysis on this topic soon). In parallel, countries outside the euro area, led by the UK, Sweden and Poland, are preparing counter strategies to the separation of the seventeen. According to Barroso this is not about power grabbing. Is it?