France: Tangled Web

France is in a difficult position.  It has not had a sufficient spur to reform, despite the platitudes by both Sarkozy and Hollande.  The fall of the Berlin Wall was a great spur to Germany, though it took it a few years to realize it.    A capital strike against the periphery by both creditors in the eurozone and international investors forced the periphery to adopt policies they would not have otherwise.

Large pools of capital, including central banks and sovereign wealth funds continue to buy French bonds, keeping yields near German levels.  The logic is not so much about fair value based on economic fundamentals. Instead, it is a political judgment.  Despite the divergence between German and French economic prowess, the two remain the twin pillars of Europe.    As long as one is confident that EMU remains intact, then France's credit is as good as German credit.

That same logic, of course, can be applied to other euro area countries.  On one hand officials want investors to distinguish between different credit conditions.  On the other hand, they insist they will not allow EMU to fail.  As we have learned over the last couple of years, this does not preclude sovereign debt restructuring (Greece and Cyprus), and even capital controls (Cyprus).

The peripheral premium over Germany was narrower prior to the crisis.  There was even a brief shining moment that Spain traded through Germany (this is to say that yields slipped marginally below German yields). Continued easing of ECB monetary policy can see spreads compress further.  However, it is unreasonable to think the spreads can return to status quo ante as the risk of debt restructuring must be perceived as higher than before.

Managers of large pools of capital recognize there are not sufficient bunds available.  Recall that next year, the German coalition government has committed itself to a balanced budget.  That means new supply is not going to be forthcoming.  French bonds are seen as the next best alternative, and they offer a slightly higher yield to boot.  Simply, if crudely put, French bonds are to German bunds, what Agency debt is to US Treasuries.

Without the push of necessity, French politicians find it difficult to do the right thing.  They are reluctant to declare a break from the German ordo-liberalism's drive for fiscal austerity, but refuse to embrace it.  Last month, Hollande unilaterally declared no more effort to reach the EC budget targets that had already been postponed.  The EC implicitly threatened to reject it, but reports suggesting that Merkel was reluctant to push France hard, possibly fearing to do to the AfD, what Cameron has done for the UKIP.  

Instead, the EC accepted some cockamamie sleight of hand.  France would cut its structural deficit by 0.5% instead of 0.2% as Hollande initially proposed.  This would be accomplished by 1) assuming lower debt servicing costs, 2) reducing its EU budget contribution, 3) proposing nearly a billion euro savings from a crackdown on tax evasion.    Recall that Brussels had expected, and France had previously agreed to a 0.8% reduction in its structural deficit.  

Perhaps Merkel was worried about the rise of the National Front in France.  Le Pen  embraces the social welfare state of France.  It sees the biggest threat to it, not coming from the discipline being imposed by what Thomas Friedman has called the "golden straightjacket", but by the encroachment of French sovereignty.  The culprit is the  German fist inside the EC glove and enshrined in the monetary union.  

Yet the leaders of France's main political parties are doing more to boost the National Front than anyone, including arguably Marine Le Pen.  She often claims that there is significant collusion between the major parties.  She says that the Socialists and the UMP are a single self-interested group.  The developments in France this week provide her with the proverbial smoking gun.  

Consider this:  Hollande's chief of staff Jouyet is a personal friend of the French President.  He also served in the Sarkozy government.  He reportedly had lunch with Sarkozy's rival in the UMP, Fillon, who was also a prime minister in Sarkozy's government.  Among the things they talked about was the investigation into overspending by the Sarkozy re-election campaign in 2012.  

What is not agreed upon are the reports that suggest Fillon, threatened by Sarkozy's attempt at a political comeback, wanted the Hollande government to expedite the investigation.  The idea was hit Sarkozy quickly and hard to derail his hope to be elected as the head of the UMP next month. Yet, it does seem Sarkozy himself is struggling without any help.    Ever since he threw his hat in the ring, his support in the polls has deteriorated.  Last month, his candidate to head the Senate lost, suggesting Sarkozy's support in the UMP is not insurmountable.  

Hollande's has the lowest support of any French president since the end of WWII.  He is half-way through his five-year mandate, and he recently indicated he would not seek re-election if there were no improvement in the unemployment rate.  It is an idle threat.  Barring a miracle, he cannot win, and the Socialist Party may dump him.   We might be witnessing the slow and painful death of the Fifth Republic.  The other republics ended by war or a coup, but this one may be ending due to self-immolation.   The Socialist candidate who ran against Sarkozy in 2007, S. Royal, who was once Hollande's life partner, used to talk about a Sixth Republic.  

Although Merkel is recognized as the outstanding leader in Europe, she is playing with a strong hand, the hand that holds the purse.  France has a weak hand, and yet despite the lack of strong leadership, it has done remarkably well in pursuing its agenda.  It has been given more time to reach the 3% deficit/GDP  mandate. After years of complaining about the strong euro, in word and deed the ECB is now driving the euro lower.  

France has wanted the ECB to pursue aggressive monetary policy, which it now is.  The ECB will likely increases the range of assets it is buying under its version of QE and if may include corporate bonds.  Given that the French capital markets are more developments than most in the euro area, including Germany, its corporate bond market is among the largest.   Almost 45% of the corporate bonds issued  by eurozone companies are accounted for by French businesses.  

After Russia occupied two areas in Georgia after the 2008 conflict, and its continuous in attempts to intimidate it neighbors,   France thought it reasonable to sell Russia two ships that can be used for amphibious assaults.  France has been reluctant to renege on its contract, which reportedly has penalty clauses for failure to deliver.  However, within weeks of the expected delivery of the first ship, there is talk of an alternative.  Reports suggest that NATO could be favorable disposed to buy the ships from France.  Perhaps the logic is that it is better to own them then possibly fight against them.

Asset managers are unlikely to declare a capital strike against France.  The premium France pays over Germany for 10-year money is about 36 bp presently.  In the past six months, the premium has approached 30 basis point a few times, but never penetrated. The mid-September low of 31 bp was the smallest French premium in three years.  This seems to be the floor.  

The ceiling seems to be about 47 bp, which it neared three times in the past six months, most recently on October 20.   Recall that in the four years before the crisis, there were several occasions that the French yield dipped slightly below the German yield.  In any event, pre-crisis, France did not pay more than a 10 bp premium.  

Neither international capital, represented by asset managers nor the EC is going to force France to enact structural reforms.  And there is even less of a chance that Hollande makes a clean break and announces an aggressively pro-growth fiscal initiative. This means the continuation of the charade, yet the status quo is toxic. The political elite are committing a French version of hari-kiri.   What fertile terrain for the National Front.