Italy and Spain pay 2.3% more than France on their debt, whilst their (GDP-weighted) current account is “just” 5.6% lower than that of Germany, compared to a French current account which is 9% worse (upper chart). In fact, France runs a -2.2% current account deficit, whereas Spain and Italy have been in surplus since the end of last year.

Current accounts versus bond yields: France, Italy & Spain differential with Germany

In addition to its deteriorating solvency, France’s growth potential has shrunk considerably over the past two decades. This is mostly due to a massive reduction in its industry base, which now accounts for just 12.8% of the economy versus 24.1% in 1980. The country has indeed suffered a huge loss of competitiveness. While unit labor costs have increased by 46% since 1991 –  versus 25% in Germany, productivity has improved by only 21%, compared to 36% in Germany (middle chart). The combination of increasing debt levels – due to large deficits – and low growth potential means that debt ratios can only go one way: up, which is a source of upward pressure on bond yields.

Unit labor costs and productivity: France versus Germany

Another potential source of higher yields lies in the banking system. French banks are too large, too leveraged (with too little equity in their capital), and – in a context of overvalued housing – are increasingly exposed to the real estate market with rising doubtful debt (bottom chart); they are also highly exposed to foreign assets. With a total asset base of EUR 8.5 trn, French Monetary Financial Institutions represent 4.2 times GDP versus 0.9 in the US, and French banks’ overseas exposure represents 102% of GDP versus 21% in the US, exposing the country’s banking system to a weak global recovery. The recent rise in non-performing loans in Italy and Spain, for instance, is a good illustration of the potential threats, given French banks’ USD 56 bn combined exposure to these banks.

Household loans for house purchase and households doubtful debt, French MFIs (stock)

_¹ Monetary Financial Institution

So why have yields stayed in check so far? First, there is an “incompressible” demand for OATs, with strict regulatory requirements in the pension industry. French yields have likely also benefited from euro fixed income investors fleeing the peripheral bond market. In addition, the backstop provided by the ECB has ruled out default risks and higher yields in investors’ minds. However, with 56% of French government bonds owned by foreigners, any loss of confidence could lead to a quick sell-off in the French bond market. Admitting that in such an event the ECB manages to cap yields, it is nevertheless difficult to envision that they would stay as low as their current 2.3%.

Barring considerations of central bank-induced distortions, current tight spreads between French and German yields are not justified. Deficits are unsustainable, the growth potential is being dragged down by reduced competitiveness and an ailing industry sector, and the banking sector is too large, too leveraged, and exposed to an overvalued real estate market and to global fragilities. Such weaknesses could trigger a loss of confidence among investors anytime, and result in a fair adjustment in French bond yields. “A suivre…”