FYI | Aug 30 2011
– A downgrade of French debt would be extremely detrimental to global sentiment
– A new French budget is due next month
– Economists fear the government is too optimistic
By Greg Peel
2011's version of the 2010 euro-debt sell-off began in April as Greece once again hit the spotlight, followed rather ominously by Spain and Italy. Then pathetic posturing in the US Congress drew attention and just when markets were starting to think it couldn't get any worse, Standard & Poor's downgraded US debt. There followed a period of extreme turmoil but as a of last night, Wall Street is higher now than at the point of initial collapse on August 8.
Japan has since been downgraded by Moody's, to AA3 from AAA, but no one was too surprised given Japan's debt is proportionately higher than that of the US, and rival S&P already had Japan at AA-.
What was really rather scary amidst the earlier week of turmoil was a rumour that France was also about to be downgraded. The rumour was soon proven to be false, and each of the three major agencies have since ratified their AAA ratings and stable outlook for France, but the logic of the rumour was simple enough. If French banks were the most exposed to toxic sovereign euro-debt, how could French debt be rated more highly than that of the US? Surely this discrepancy would need to be addressed.
One presumes we could simply carry that logic to the nth degree and ask how can any country's debt be rated above that of the US, in which case the agencies might as well downgrade every AAA to AA+ or below. Then, presumably, we could call AA+ the new AAA, rebase the system, and return to where we started before all the unnecessary turmoil. Most notably, as soon as S&P downgraded the US the world bought US debt with a vengeance, rather making a mockery of the whole ratings concept.
That's not going to happen of course, so we're stuck with the reality that every time sovereign debt is downgraded somewhere, markets run away in panic. Given the fear generated by the potential for Italy to face default, a downgrade of France would not be very beneficial to sentiment. The French economy was the fifth biggest in the world in 2010 according to the IMF.
To put that into context, US GDP in 2010 was US$14.7trn, with daylight down to China at 5.9, then Japan at 5.5, Germany at 3.3 and France at 2.6. So the French economy is only about a sixth as big as the US economy, although the combined EU GDP was 16.3 in 2010, putting it collectively ahead of the US. So it's clear as to why European contagion is a matter of grave concern.
We can thus assume a downgrade of French debt right now would hit global markets very hard. So what are the chances?
When the aforementioned rumour hit the press, President Sarkozy was forced to rush back to Paris from his summer break in urgent response. The French cabinet had been preparing a new 2012 budget before the break, but suddenly progress was hastily required to calm the waters. As it now stands, the French government will present its draft budget late next month in which the public deficit is to be cut from 5.7% of GDP in 2011 to 4.5% in 2012.
Underpinning the new budget are downward revisions to the government's expectations for French GDP growth, to 1.75% in 2011 from 2.0% previously and to 1.75% in 2012 from 2.25%. The revisions came after France posted a shock 0% growth result for the June quarter. Were France not to achieve the new forecasts then nor will the targeted 4.5% deficit figure be achieved. This is what has the economists from leading French bank Credit Agricole concerned, given their own forecasts are for only 1.6% growth in 2011 and 1.3% in 2012. CA cites the expected slowdown in the US, volatility in financial markets and the impact of Europe's sovereign debt crisis as reasons to be more conservative.
CA believes the French government is being too optimistic with its forecasts and that new, tougher budget cut measures will be required to sufficiently reduce French debt and thus, by implication, ward off the ratings agencies.
The economists at Danske Bank agree with CA's economists in principle, and note there are other factors which could come into play. Firstly there is the simple risk of euro-debt contagion but also a risk, suggests Danske, that an increased European Financial Stability Fund (EFSF) could actually prove a “contagion carrier”. Contagion or not, one cannot dismiss the psychological follow-through to France were, for example, Italy's debt to be downgraded.
Closer to home, Danske notes French house price indicators have begun to turn downward. Were there a significant collapse in house prices this would impact heavily on French banks, which already have enough problems as the largest holders of eurozone peripheral sovereign debt.
Possibly the biggest threat, nevertheless, is the fact there is a French general election due in 2012. For the past two years we have seen the impact on incumbent governments of fiscal measures taken to deal with the euro-debt crisis. In the troubled nations, severe austerity packages which have been deemed more hurtful to the poor rather than the rich have led to mass protests and rioting, and a surge in popularity of any opposition party prepared to denounce government policy. In the stronger nations such as Germany and Finland, opposition parties have captured large slices of the vote in elections by running against the governments' intentions to contribute extensively to proposed bail-out funds for the “Club Med” (and Ireland, and actually Portugal is on the Atlantic) recalcitrants.
The bottom line is thus that Sarkozy's incumbency is not guaranteed, and whoever were to take his place would probably do so by running on some form of anti-eurozone platform. Indeed, if sovereign debt is not about to cause a fracturing of the common currency zone, popular resistance may well prove the system's early downfall.
In all developed nations, and particularly those of Europe, the US, Japan and the UK, politicians are fining themselves between a very big rock and a very hard place. How does one stimulate the economic growth required to reduce debt when the first step is to cut fiscal budgets to avoid downgrades or default?
President Obama is going to give it a shot. Next week he will unveil his Administration's new policy to create jobs, despite having had to sign off on budget cuts enforced by the Tea Party in order to raise the US debt ceiling. One might say good luck.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
