France’s government bond market offers a timely warning for Chancellor of the Exchequer John Healey ahead of the delivery of the budget at the end of the month: Fiscal credibility can deteriorate quickly once investors doubt a government’s ability to control borrowing.
The global surge in government bond yields has created a difficult fiscal problem for Healey, but spare a thought for his French counterpart, Roland Lescure.
The yield on 10-year gilts has risen by a full percentage point this year, while the yield on a 10-year French government bond—an OAT—has increased by almost 1.4 percentage points, to around 5%.
Get Joe Brusuelas’s Market Minute commentary every morning. Subscribe now.
Even so, France is still paying less than the UK—around 4.9% versus 5.4%—despite having a higher debt-to-GDP ratio, a larger deficit, slower growth and arguably even more dysfunctional politics.
This partly reflects lower eurozone interest rates and the implicit backing of other eurozone countries, especially Germany.
A better gauge of investor concern is the spread over German Bunds, which has reached around 150 to 160 basis points, levels not seen since the eurozone debt crisis in 2010-12.
The problem is not simply the size of France’s deficit, although that matters. France is targeting a deficit of 5.0% of GDP next year, after an estimated 5.4% this year, while public debt has risen to around 119% of GDP.
The government has proposed substantial fiscal consolidation, but political fragmentation has raised doubts about whether it can deliver those measures.
Those doubts about politicians’ willingness and ability to deliver fiscal consolidation are behind much of the recent turmoil in French bond markets, especially given the recent political chaos.
France also shows how political uncertainty can turn a manageable fiscal problem into a much larger one.
The lesson for the Budget is clear, and echoes the one the former British Prime Minister Liz Truss learned at her peril. The UK’s fiscal headroom is already extremely thin. We estimate it has fallen from £23.6 billion in March to around £12 billion, with higher gilt yields accounting for roughly £10 billion of the deterioration.
That leaves little room for a Budget that raises spending, and makes unconvincing promises of future tax increases, leaving markets unsure how resulting borrowing will be contained.
Tempting though it may be, Healey should avoid placing too much weight on “temporary” measures that increase borrowing over the next year or two, but expire before they affect the fiscal rules.
France’s experience suggests that the composition and credibility of fiscal consolidation matter almost as much as its headline size.
A package setting out a credible medium-term path for debt, based on realistic spending assumptions and measures to raise potential growth, could reassure investors.
A crucial part of this will be the amount of headroom he leaves himself with. Going back toward £10 billion may be politically appealing, but would be fiscally risky.
By contrast, a Budget that pushes fiscal policy in several directions at once could expose the UK to the same combination of rising yields, higher debt-servicing costs and shrinking fiscal headroom now confronting France.
It’s a reminder that once confidence begins to erode, the numbers can move very quickly.
