Column-There’s likely no such thing as ‘Frexit’: Mike Dolan

06/21/2024

4 minutes read

2024.06.21 04:48

By Mike Dolan

LONDON (Reuters) – Any sustained bet against French government debt can only hinge on a belief in the improbable end of the euro – even if the European Central Bank needs to walk a fine line in how and when it responds.

The playbook from the existential euro crisis of 2010-2012 suggests that even if investors feel emboldened enough to speculate about smaller peripheral euro countries being forced to exit the bloc, a euro zone without France most likely means no euro zone at all.

In other words, there is no such thing as “Frexit” in isolation – if by Frexit people mean France could leave the currency union while a functioning euro zone still exists. France’s central position to the entire construct, for most investors, renders it a binary all-or-nothing outcome.

And that’s a big punt given the firepower loaded against it.

Framed by 2012’s pivotal “whatever it takes” moment from then ECB chief Mario Draghi, the ECB has shown repeatedly ever since it will do all in its remit to sustain its only “raison d’etre” as guardian of the single currency and its functioning.

Even though the root of the latest French political upheaval and snap election is the rise of far-right and left parties much less favourable to the whole European Union project, membership of the euro per se is likely not up for debate – not even by the far-right that once questioned it.

While surveys on French attitudes towards the EU do show up a mixed bag of dissatisfaction towards various aspects of the Union’s workings, more than 70% remained in favour of the single currency through last year.

‘HAND IN HAND’

That doesn’t escape the concern about the French deficit and debt – crystallized by the EU itself this week in kicking off protracted disciplinary procedures against France and others and also by S&P Global in downgrading France’s sovereign credit rating to AA- last month.

And the spending plans of parties leading opinion polls ahead of the June 30-July 9 assembly election appear ready to throw fuel on the flames rather than chime in with EU rules on lowering the annual deficit to 3% of GDP from the whopping 5.5% last year.

But France won’t be alone in that among G7 peers. The issue is whether there’s a peculiar twist within the euro zone to the wider global angst about mounting public debts.

And that rests on what level of risk premium the ECB is likely to tolerate between major member states.

For the ECB, the widening French debt spreads relative to Germany has its limits if it were to threaten French debt sustainability, fragment euro credit provision or hamper the smooth working of its monetary policy evenly across the bloc.

The latest in a long line of ECB initiatives aimed at curbing what it deems unwarranted speculation against individual euro country’s debt is 2022’s so-called Transmission Protection Instrument (TPI).

ECB chief economist Philip Lane this week made clear he saw no grounds yet for considering TPI as French market repricing to date had been modest and based on reasonable fundamentals. ECB President Christine Lagarde was more cryptic, saying: “Price stability goes hand in hand with financial stability.”

ECB sources told Reuters it was first for the French government to reassure investors that all fiscal plans were in order and that would need the election to play out first.

What’s more, activating the TPI is conditional on action on addressing the EU deficit rules and likely stays the ECB’s hands for now in using it.

So there’s a delicate balance to be drawn on how far this can go – even if there are clear limits.

“The ECB’s intervention mechanisms mean that the eurozone does not face the same existential threats as its sovereign debt crisis of a dozen years ago,” asset manager Lombard Odier said this week, adding the “moment of truth” might have to come if further spread widening forces any incoming government to comply with EU deficit demands in order to get the ECB to act.

LOOP THE LOOP

For all the disturbance – and perhaps reflecting investors awareness of the limits – we’re not at critical points yet.

Even though the French-German debt spread widened to as much as 77 basis points after the snap election was called – the widest risk premium since 2017 – it’s still half the peaks of the 2011-2012 shock.

And more significantly for any worries about debt sustainability, nominal French yields have done very little – rising about 15 basis points over the past month to 3.15%, still well below peaks of 3.6% seen only last October.

That, so far, likely distinguishes the episode from the 2022 British bond blowout under then Prime Minister Liz Truss that many have evoked as a possible comparison.

Demand for French debt at Thursday’s latest auction, while affected by the turbulence, showed no sign yet of cratering.

Potentially more worrying has been the 10-15% drop in French banking stocks – as national bank stocks have often been the favoured route of euro debt speculation, in part due to the long-feared “doom loop” that could bind the two in a spiral.

That doom loop riffs off the idea that domestic banks hold disproportionately large sovereign debt holdings for regulatory capital and collateral purposes that could hamper their balance sheets in the event of big marked-to-market losses. It was at the heart of the 2010-2012 euro ructions.

Fears of a spiral then build if that bank exposure hits their equity and debt financing, liquidity or even solvency, putting the state on the hook for bailout of systemically important banks – further damaging the sovereign debt profile.

While a blow – not least to many global investors who had moved overweight euro zone banks lately – the near 20% drop in the French bank stocks over the past month so far just reverses the move higher from March to mid-May.

And the latest European Banking Authority stress tests showed the largest French banks still well insulated even in extreme adverse scenarios assuming a 5.7% drop in French GDP, 9.7% inflation and interest rates at 5.9%.