The prospect of a sovereign bond purchase program by the ECB is widely anticipated and priced in by financial markets, as shown by the record lows of yields on the sovereign bonds of Eurozone countries. The French 10-year bond yield is currently below 0.65%, not far away from Germany’s 0.50%. Is this low yield justified and can France truly be considered one of the strongest links in the Eurozone chain? Or are investors massively overestimating the strength and future prospects of the French?
Graph 1: French 10-year bond yield
The French economy weathered the global financial crisis relatively better than most of its European peers. However, the French economy has hardly grown since the beginning of 2013 in contrast with the rest of the Eurozone. In 2014, the French economy grew with 0.3%, while it is expected that the French GDP grows with only 0.9% in 2015. This lag in growth is caused by a stagnating household consumption and a weak corporate sector, both in terms of profitability and competitiveness. Especially the two biggest growth driving industries of the French economy, car manufacturing and construction, are suffering without any signs of improvement. Housing starts have been steadily declining since early 2012 and in 2014 were down 11.7% compared to 2013, while French car manufacturers are quickly losing market shares to foreign competitors. Furthermore, both French business confidence and consumer confidence have been low since 2012 without early signs of a recovery.
Graph 2: French housing starts and building permits
The stagnating household consumption is mostly caused by the French unemployment rate. The unemployment rate has risen to 10.2% in the second quarter of 2014, from 7.2% at the start of 2008. This increase is smaller than in many other Eurozone countries, but at the peak of the previous economic cycle, the unemployment rate still was higher than 7%. This observation suggests that France copes with a structurally high unemployment rate, which has a negative effect on disposable household income. Youth unemployment is structurally high as well. In the last ten years, youth unemployment has always been above 17% and is currently just above the 25%. This structurally high youth unemployment means that the future prospects of the French corporate sector are negative, since it suggests a higher risk of losing one’s job. The unemployment is expected to remain high through 2015, which adds up to the future negative economic outlook of France.
Graph 3: French unemployment rate
In the years between 2000 and 2007, French wages grew more rapidly than productivity, which meant that firms had to squeeze their margins to stay competitive. Especially innovation and R&D expenses were cut to keep the prices of French goods competitive. This had positive effects on the short term, but on the long term French companies have been unable to keep up with international competition. Now, French companies face substantial competitive disadvantages compared to their European peers, which makes it very unlikely that the underperformance of the French economy will change soon.
Just like every other Eurozone country, France has to cope with an aging population. The aging of the population is less severe than in countries like Germany and the Netherlands, but it is a significant problem due to the low average retirement age in France. In the Netherlands and Germany, the average retirement age is well above 60, while the French retire at an average age of 59 years. This will have negative implications for the future economic situation, since there will be fewer young workers to support each retiree. This means that healthcare costs will rise substantially for the French government in the coming years, which adds up to the already high public spending to GDP ratio in France.
The French government has a high percentage of public spending to GDP of 57.1% compared with the Eurozone average of 49.4%. As a result of the high public spending to GDP ratio, the debt to GDP has increased strongly in the past years. The current debt to GDP ratio increased more than 35% since 2008, as shown in the graph below. The high amount of public spending results in a structurally high government budget deficit for France. While the debt treaty of the Eurozone prescribes that a Eurozone member should structurally have a fiscal budget deficit of less than 3%, the French have failed to meet that requirement since 2010. Although the situation is slowly getting better, the French government forecasts that it will fail to meet these fiscal standards in both 2015 and 2016 with -4.4% and -3.9% respectively, thus carrying over the fiscal pain into 2017. This will cause the French debt to GDP level to rise above the 100% in the coming years, a level that currently is only exceeded by second-tier Eurozone members such as Italy, Greece, Ireland and Portugal. This finding underlines the statement that France is falsely considered a top-tier Eurozone country. Furthermore, the year 2017 will be increasingly important for France, as government elections are being held in that year. The rise of extreme populism in France could pose serious problems for the political stability and policy making, which could hamper economic recovery even more.
Graph 4: French government debt to GDP
Graph 5: French government budget deficit
Both Moody’s and S&P have a negative outlook for the credit status of France. The French credit status is now at AA/Aa1 and, given the negative outlook, it is highly possible that the credit status will be lowered within the next year due to its high debt to GDP ratio and the poor economic prospects. The expectation that the French will fail to meet the standards of the European tax treaty for at least the next two years, in combination with the weak economic prospects explained in the first part of this article, makes a downgrade of French sovereign debt very likely. When the downgrade is announced, investors in French government bonds will demand to be compensated more due to the increased implied riskiness, which will cause an increase in French interest yields.
Last December the consumer price inflation in France was 0.1% and it has been steadily decreasing since the start of 2012. Given the decreasing oil price and the slowdown in domestic demand, it is expected that France will slide into deflation early 2015. Furthermore, food and healthcare prices are decreasing in France. The low inflation is not a problem for France alone, the majority of the Eurozone countries have to cope with low inflation and Spain already happens to have deflation. Since consumer spending in France is very resilient, the expected deflation will have more negative than positive effects. Most importantly, deflation will increase the debt burden that the French government carries. Furthermore, to battle deflation, the French central bank cannot intervene by lowering the interest rate, since it is already at a historically low rate. The resilience of spending that helped the French economy in 2008 will now be structural problem in the battle against deflation.
Graph 6: Inflation rates Eurozone countries (Harmonized Index of Consumer Prices)
This article shows that France is falsely considered one of the most stable European countries, since its economic situation is more like that of the second-tier Eurozone members. The expected economic impact of a European bond purchase program is far too optimistic and the monetary actions of the ECB cannot replace government policy. Although policymakers expect that a full blown QE by the ECB will push inflation back up and bring back economic growth to the Eurozone, the market already priced in the purchase program by the ECB. The structural economic problems in the Eurozone and specifically France cannot be solved by monetary stimulation. Without proper structural reforms on country level, the French economy will suffer in the long term, no matter what the ECB does. Structural economic and fiscal reforms are the only way to turn around the French economy, although those reforms will take a lot of time to produce positive effects. For the coming two years, I expect that the economic growth of France will keep on lagging behind its Eurozone counterparts. I also expect the fiscal situation to worsen, which will result in an increasing sovereign bond yield. In my opinion, the current historically low French sovereign bond yield is unjustified.
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Jauke de Jong
Jauke is always looking for the hidden gems of the financial markets.