France's public debt, which slightly exceeds €3.5 trillion, is now equivalent to almost 120% of GDP. The welfare state has become increasingly unsustainable, economic growth is weak, and budget deficits remain persistently high. Therefore, it seems practically inevitable that the debt-to-GDP ratio will continue to rise. After resisting significant reforms for a long time, France has become the latest source of concern for the eurozone. Presidential elections are scheduled for next spring, adding another layer of uncertainty for investors.
A default by France - in the sense of a restructuring or a write-off of its debt - remains highly unlikely. Ultimately, France benefits from the implicit backing of the entire eurozone through the European Central Bank. The euro crisis demonstrated that preserving the integrity of the single currency is a firm political and monetary policy commitment: "whatever it takes". France is also widely regarded as too big to fail: a sovereign default would almost certainly trigger a severe financial crisis.
Therefore, investors can assume that, in an extreme scenario, the ECB would intervene and purchase French public debt to prevent yields from soaring further. The most likely outcome is that this would require the activation of the Transmission Protection Instrument (TPI), which aims to safeguard the effective transmission of monetary policy across the euro area and to prevent unjustified divergences in sovereign debt yields.
In principle, the ECB would need to determine that the high yields on French bonds are not justified by economic fundamentals, that the country's debt remains sustainable, and that France complies with the EU's fiscal framework. At this moment, these conditions are either not met or only partially met. In practice, however, this could prove to be less restrictive than it seems. The ECB retains a wide margin of discretion in interpreting the criteria, making the TPI, in practice, a very flexible instrument.
However, for the ECB to justify direct support for France, market conditions would first have to deteriorate significantly. The spread over German bonds would need to widen further, pushing French debt yields to considerably higher levels. This type of intervention would not only be humiliating for France; it would also place the ECB in a complicated position. By intervening, it would risk creating a significant moral hazard.
If investors come to believe that the ECB will always act as a backstop in a crisis, why should they continue to favour bonds from fiscally prudent issuers that offer significantly lower yields? The message for eurozone governments would also be problematic: fiscal discipline would cease to be rewarded and, in practice, would be penalised.
There is no need for it to come to that. The bond market could still play its traditional role as the ultimate disciplining mechanism for governments, exerting enough pressure on France to implement reforms before ECB intervention becomes inevitable.
