Stay informed with free updates

The writer is Rene M Kern Professor at Wharton School, chief economic adviser at Allianz and chair of Gramercy Fund Management

The departure of another prime minister of France adds to a daunting economic outlook for the country. The immediate catalyst for the move was a public disagreement over the composition of the cabinet. But the underlying cause is the government’s persistent inability to secure a functioning parliamentary majority for much-needed fiscal consolidation.

France is running an elevated budget deficit at above 5 per cent of GDP, and has a national debt nearing 114 per cent of GDP. These are both high by historical standards, especially for a “core” Eurozone country.

The impact of Sébastien Lecornu’s resignation after less than a month as prime minister on the government bond market was immediate. Yields on French government bonds (OATs) climbed both in absolute terms and relative to their Eurozone counterparts. The bond market is now pricing in a substantial governance risk premium for France.

It’s particularly worth noting that the yield on the benchmark 10-year French OAT is now trading above its Italian counterpart (BTP) — a once unthinkable inversion. This financial penalty places the Eurozone’s second-largest economy behind a market sometimes characterised in the past as one of the bloc’s “peripheral” economies. This is more than a metric of fiscal imbalance; it is a loss of confidence in the French political system’s ability to govern decisively.

Meanwhile, the sovereign spread between the 10-year French OAT and the benchmark German Bund has widened dramatically, pushing it to more 0.85 percentage points.

This does more than make the French fiscal tightrope harder to walk: it complicates the policy outlook for the European Central Bank. The ECB is already attempting the difficult feat of balancing the need to contain persistent inflation — which remains somewhat sticky in services — with mounting concerns about anaemic economic growth in the Eurozone.

The widening spread between French and German bonds threatens the ECB’s ability to ensure its single monetary policy is transmitted well across the bloc. When dispersion in yields increases, it risks the type of market fragmentation and stress that could become a systemic threat. The market’s current message is clear: if even more persistent, France’s political paralysis might turn out to be a Eurozone financial headache.

France’s instability also has implications for Britain. It might be tempting to ignore this given the country sits outside both the Eurozone and the EU. That would be a profound mistake.

One immediate impact is already visible: higher yields for UK gilts, as Britain, like France, competes in the global capital markets to secure funding. Indeed, the jump in yields on gilts in reaction to the French news outpaced that of all other major European economies. Moreover, as vulnerable as France looks right now, it may be arguably less worse off than the UK if bond markets were truly to lose patience with fiscally-loose countries.

Some content could not load. Check your internet connection or browser settings.

France has a strong potential backstop in the ECB. The 2012 pledge of “whatever it takes” by then ECB president Mario Draghi was instrumental in calming the European debt crisis. The market believed the central bank would use its unlimited financial firepower — a defence mechanism that still gives France a bigger layer of protection, even if it is politically thorny.

The Bank of England could also step in should bond sentiment sour significantly in the UK. After all, it played a pivotal role during the 2022 Liz Truss “mini”-Budget turmoil. Yet, the underlying disturbance then — a shock from unfunded tax cuts — was more easily reversible than what ails the UK today.

An emergency BoE intervention, unlike the ECB’s defence, would risk being viewed by international capital markets as monetising the UK’s persistent fiscal deficits. This carries a higher risk of undermining the central bank’s inflation credibility, resulting in more problematic consequences for the pound and for long-term UK interest rates.

The danger, therefore, is that what is happening in France may not stay in France, especially if the UK Budget in November proves disappointing in delivering not just fiscal consolidation but also the prospects of higher productivity and growth.

For the UK, this episode should serve as a powerful cautionary reminder that the November budget will test whether London can deliver what Paris is failing to provide. The bond markets are losing patience with political paralysis.