The risk of France is not the one you think

Posted on 13. Jan, 2014 by Jean Jacques Ohana in Weekly Focus | Comments Off

Once again, the discussion regarding a plausible attack on the French debt comes back to the surface. The same thing had already happened in July 2013, when Fitch downgraded the French debt. These warnings had proved wrong, exactly as we had predicted.

Investors willing to short France put forward a number of (politically-charged) arguments to support their dire predictions: France, unlike its neighbors, has not shrunk its fat state, it has not modernized its administration, flexibilized its labor market… As a consequence, say the conservative crowd, it is promised to economic stagnation, while its “courageous” partners will now harvest the fruit of their sacrifices, enjoying a buoyant recovery. In this electoral year for Britain, David Cameron judged necessary to blast France’s lack of reforms to help Britons swallow the sour pill of austerity. “If you doubt how disastrous a return to Labour-style economics would be, just look at countries that are currently following that approach,” he recently said. “They face increasing unemployment, industrial stagnation and enterprise in free-fall. The opposite of what’s happening here.” Cameron forgets to mention that, in spite of its “impressive” 1.4% growth in 2013 (coinciding with the easing of austerity), the British economy is still 2% below its 2008 level, while the French GDP has been above the 2008 level since 2011…

Here is why we think that the likelihood of an attack on French debt is extremely low:

  1. First, since Italian and Spanish debts have flipped to the risky side (positive correlation to equities), only 60% of the Eurozone public debt can now be deemed “safe”. The long-term scarcity of euro-denominated safe assets is further aggravated by the fact that all core countries are simultaneously trying to shrink their debt to GDP ratios.
  2. France benefits from the implicit guarantee of the ECB. The GIPSI’s debt crisis was in large part due to the fact that, up to the launch of the OMT, the peripheral countries had no lenders of last resort. Hence, investors started panicking on whether they would be repaid at all. This resulted in a self-fulfilling interest rate rise. The same phenomenon cannot happen to France today, for two reasons. First, the OMT changed the whole picture, reassuring the investors that a lender of last resort existed (see Figures 1, 4 and 5). Second, should France be attacked, Germany will be left as the sole guarantor of all other Eurozone countries. The ESM will lose all credibility as a backstop of Eurozone sovereign debts. The Eurozone would immediately collapse unless the ECB starts buying sovereign bonds unconditionally to keep the monetary union in one piece (this is why we advise shorting the euro to bet on the demise of France rather than shorting the OAT). As a result of the ECB guarantee, the French CDS is very modest compared to the peripheral ones, even though it is still higher than the ones of monetarily sovereign countries such as the US or the UK (Figure 2).
  3. Thanks to ECB guarantee, the French debt dynamics is supported by lower level of interest rates and higher nominal growth rates relative to its Latin Eurozone peers. When nominal growth is too low compared to borrowing costs, the primary surplus required to stabilize the debt ratio increases. This means more spending cuts and tax hikes, hence even less inflation and growth prospects for the future due to hysteresis effects. This is a bad equilibrium that Germany and, to a lesser extent, France, have so far largely avoided. As a result, their growth rates have outstripped the ones of other Eurozone countries since 2010 (Figure 8). French nominal growth stands at 2.1%, just 50 bps below the 10-year nominal interest rate. Italy’s and Spain’s nominal GDP respectively grow at 1.7 and 1.4%. This is respectively 240 bps and 220 bps lower than their 10-year borrowing costs (Figure 3).
  4. The French OAT has a much better “carry” than the German Bund, which makes a short position in the OAT very costly (Figure 7). Indeed, both its yield and roll down (curve slope) are significantly higher than the ones of its German counterpart. As a result, for an investor shorting the French OAT to start making money on his gamble, the 10Y rate has to increase by 44 bps (33 bps only for Germany). Given the equality in the volatilities (Figure 6), there is a higher chance to make money by shorting the Bund than by shorting the OAT.

In the Greek mythology, the Delphos oracle predicted to Oedipus that he would kill his father and marry his mother. Oedipus, to avoid killing his (supposed) father, left Corinth. But by heading to Thebes, he met an older man in a chariot coming the other way on a narrow road. The two quarreled over who should give way, which resulted in Oedipus killing the stranger, in fact his father…

This myth sounds as a useful warning for France. If, to avoid being attacked, France starts slashing spendings, a wave of social and political unrest would ensue that could eventually fulfill the gloomy “French demise” prediction.

 

Figure 1: 5 years Credit Default Swaps in euro zone main countries

Figure 2: Solvency indicators on main developed countries

Figure 3: Real interest rates of main developed countries

Figure 4: German debt vs. French debt total return

Figure 5: Ratio of French debt / German debt


Figure 6: Compared volatilities of German and French government debts


Figure 7: Total return carry including yield and roll down effect on various sovereign debts


Figure 8: GDP per capita in constant prices on various euro zone countries (base 100 in 2007)


 

 

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