France, The Next Eurozone Domino To Fall?

by: Shareholders Unite

While most of the attention of the recent flare-up of the euro crisis has focused on Spain (and to a lesser extent Italy), now is perhaps as good a time to broaden the view and look at what is still mostly regarded as a central country in the euro zone, France.

Not all is well in France, to put it mildly. The same vicious dynamics which have first plagued Greece, Ireland and Portugal, and then Spain and Italy, are also quite possible here. And the elections this month and next adds another level of uncertainty in the mix.

Here is what more or less happens in euro zone periphery:

  • Recession leading to worse public finances, leading to more austerity which leads to an even worse economy
  • The worsening economy and public finances leading to capital flight out of banks, which leads to worse public and bank balance sheets
  • Overleveraged banks on ECB lifeline, investing in their sovereign debt, which concentrates risks even further
  • Competitiveness problem without possibility of devaluation or monetary ease

Lets see how France is doing on these dynamics.

French economy
Well France isn't in a recession just yet. Actually, its economic growth surprised just a tad on the upside the latest quarter (Q4 2011) with 1.3% growth, almost equal to Germany's 1.5% GDP growth in the same quarter. However, for this year, barely any growth is expected, just 0.1%, and for next year things are hardly much better with 0.8% expected growth (figures from The Economist).

This isn't in Greek territory (-7.5% growth in Q4 2011), or Portugal (-2.8% Q4 2011) or Italy, where the economy is expected to shrink 2.6% this year. But it is clearly not enough to stabilize the public debt/GDP ratio. And the risks are overwhelmingly to the downside, with much of the euro zone periphery (and even central countries like the Netherlands) in deep recession.

Unemployment is at 10% and France has a 2.1% current account deficit. That isn't too bad, comparatively, but it isn't exactly good either. The current account has been gradually worsened during the decade, though, signaling at least some competitiveness loss, most of all to Germany.

The public sector, at 56% of GDP, is considerably larger in France than almost anywhere else in the developed world, reflecting the French mistrust of "Anglo-Saxon" capitalism and globalization, and their view of a benevolent state. The OECD average is 43%.

In an important way, the situation in France is quite different, both worse and better, than that in Spain and Italy. In the latter two countries, reform programs are in place. They know what to do. But this isn't at all the case in France. What's more, this isn't even discussed in the election campaign.

The upside is that in France, there really is a lot of room for reform. The public sector is way too big and markets could do with a jolt of new dynamism, so there is a lot of low hanging fruit. The downside is that this is hardly ever discussed in public, and not without a reason. It isn't at all a popular stance.

Household debt, at 69% of GDP (2010) is average and France didn't really have a housing bubble like Spain or Ireland. Overall debt (households, firms, and public sector), at 321% of GDP is high, though, more especially because of debt of corporate and financial institutions.

Click to enlarge.

French public finances
The budget deficit is estimated at 4.7% for 2012 (estimation from The Economist Intelligence Unit). There have been few years in which public debt/GDP ratio actually declined, this happens only in years of strong economic growth like in 2000 and 2006.

The graph nicely demonstrates how devastating recessions are for the debt/GDP ratio, for instance:

  • In 1982, debt/GDP increased by 15.2% from 22% to 25.35% of GDP
  • In 1993, debt/GDP increased by 16.4% from 39.75% to 46.25% of GDP
  • In 2009, debt/GDP increased by 15.85% from 68.2% to 79% of GDP

You see that another recession would be quite devastating and could easily tip French public finances to 100% debt/GDP, close to Italian territory. Developments are not good:

France increased its public debt forecasts for 2012 and 2013 on Wednesday to take into account the 6.6 billion euros it will have to pay into the ESM euro zone permanent rescue fund. Forecasts presented to the French cabinet said public debt would be 89.1 percent of gross domestic product this year instead of the 88.3 percent previously predicted. Public debt was predicted to rise next year to 89.3 percent of output, higher than the earlier forecast of 88.2 percent. [Expatica]

And the following years, more payments to the ESM (the permanent euro zone rescue mechanism) have to be made, let alone if the size of it is increased from it's present 500 billion euros.

There is some good news though, the public deficit fell from 7.1% of GDP in 2010 to 5.2% in 2011 to an estimated 4.7% this year. However, to a large part this is because of increased taxes, which rose from 42.5% of GDP to 43.8% of GDP.

On the one hand, the public deficit isn't as bad as that of most peripheral countries. However, their economies have all been doing worse. This means that the structural deficit in France (the deficit that would remain if the economy would produce close to capacity) is as bad as in the rest of the periphery, so there are several ways to look at this situation.

French yields
A crucial measure of investor confidence. How did the yields hold?

Not too bad still. But you have to understand two things. This can basically chance in an hour, and because of the election, French politics is ill equipped to respond.

French banks
The French banks are amongst the most leveraged in the world (Credit Agricole is leveraged at 66 times) and have large holdings of peripheral sovereign debt, especially Italian debt.

Now, these figures are from Q3 2011 (from the Bank of International Settlements, the latest available).

The famous stress test showed:

Now it's clear that French banks are more exposed to the Euro crisis than other countries' are, and in fact, banks in France are the #1 most exposed, according to stress tests.

At least we understand a little better now why French banks were so vehemently against new capital requirements. Things could have changed in the meantime, they might even have improved. Indeed, the ECB's Noyer argued that French bank exposure is exaggerated:

"Total exposure of major French banks to the sovereign risk of so-called 'peripheral countries' amounts to...only a limited fraction of their core tier one capital," said Christian Noyer, a member of the ECB's board of governors and governor of the Bank of France. [WSJ]

We'll just ignore the fact that mr. Noyer is French. However, Fitch recently argued that French bank restructuring eased ratings pressure.

French banks were hit hard last summer when investors retreated from the euro zone because of deepening concerns over their exposure to sovereign debt in Europe's weaker economies, forcing the main listed players to start reducing assets and to cut funding needs. Fitch said that because of those actions they have since won back some market confidence [WSJ]

Still. What about French bank exposure to French sovereign debt? If the euro crisis hits France, a deadly spiral hitting French yields, hitting both public finances as well as French bank's rather stretched balance sheets, making a bailout of both ever more likely. But bailout by whom exactly?

Policy action
It isn't at all reassuring when influential German ECB board member Jürg Asmussen argues that the worst of the euro crisis is now over and it is up to the politicians and the IMF, as he concluded in an interview on Sunday.

There are two important Spanish bond auctions this week (Tuesday and Thursday). If these meet a reluctant market, 10 year rates in Spain could easily fly way over 6% (at the moment of writing they closed at 6.07%, Monday after market close). This would trigger another round of panic on the markets which we simply can't afford.

If the ECB stands by idle, things could even develop into a rout. We really fail to understand why the ECB doesn't act. Last November, during the last acute phase of the euro crisis, it could be said that the ECB, by intervening, could create a moral hazard problem in which countries simply deferred the hard policies and leave it to the ECB to sort the crisis out.

This time around, that argument is way weaker. Portugal and Ireland are seriously reforming. Greece is off the radar for quite some time, and if anything, Spain and Italy might very well have overdone the austerity part, giving such severe blows to their economies which could very well make it harder, not easier, to get the public finances in order. If you have doubts about this possibility, look again at the figure above what recessions did to the French debt/GDP ratio.

Mr. Hollande
The French elections, the situation in Spain, and the ECB are the main ingredients in whether a French crisis comes to a head. Let's start with the election. The two main candidates, present president Sarkozy and socialist Hollande, do not give the impression that they take the economic problems seriously. They want to close the budget deficit mostly by higher taxes, which are already amongst the highest in the world.

An election victory for Hollande could very well spook the markets. A quick look at some of his ideas will illustrate that:

  • Hollande is in favor of renegotiating the "fiscal compact" (the very hard won agreement to keep public finances within a 1% structural band and prime German wish), adding a "growth" component to it
  • A 75% tax (considerably higher still if one includes social charges) on income over 1 million euro
  • Raising the minimum wage
  • Higher taxes on wealth and dividends
  • 60,000 additional teaching jobs
  • Lower minimum retirement age for some professions
  • He argues that the financial markets are his "enemy"

No, we couldn't find any structural reform either. Nor any reduced public spending. Now, politicians usually say stuff they don't really mean, or even if they mean them, they're not going to implement them. Reality has a way of reasserting itself on policy makers and Mr. Hollande is often described as a pragmatist (although from the above election manifesto, one is hard pressed to take that assessment face value).

Some argue that, as a disciple of Jacques Delors, he will put the euro and the EU first and do whatever is necessary. This remains to be seen. We would have been more comfortable with Mr. Strauss Kahn (ex IMF boss) running, but we all know what happened to him. There are two additional risks:

  • The euro crisis reasserting itself and reaching France in the midst of the election, which makes it very hard for France to respond adequately.
  • A presidential election going one way, but the parliament (elections on June 17) going another, creating a situation of cohabitation which would stifle political decision making.

Politicians everywhere in the euro zone have to take on vested interest and cut spending, none of which is easy, but since France isn't a terribly market friendly country (even the political right has quite a strong statist tradition), this is much more difficult in France, and even more so during elections.

France and Germany
This is the axis of the EU and even more so of the euro zone. There are important differences though. For instance, France is much more in favor of ECB interventions, and strongly in favor of a bigger rescue fund. Why? Because they realize that one day, they themselves might need it.

This would put a bomb under the French-German axis. Germany having to pay for a French bailout, and the French having to accept German conditionality, being treated the way Greece was treated? Can you imagine?

Some investment thoughts
The ECB, once again, seems engaged in a game of chicken with the markets and national policy makers. However, there are other voices in the ECB than that of just Asmussen. If history is any guide, when the crisis becomes acute, the ECB will intervene. But the problem is, they will be seen dragging their feet. It would be so much more effective if they just announced massive support (at least until the ESM and enlarged IMF are operative).

We expect this crisis to linger. Bearish investments can be taken in the euro or euro ETFs. Shorting long euro ETFs, like CurrencyShares Euro Trust (FXE), WisdomTree Dreyfus Euro (EU), iPath EUR/USD Exchange Rate ETN (ERO), or be bold and short leveraged long euro ETFs like: Ultra Euro ProShares (ULE), or Market Vectors Double Long Euro ETN (URR). Or invest in short euro ETFs like Market Vectors Double Short Euro ETN (DRR) or UltraShort Euro ProShares (EUO).

There is a French ETF, the iShares France ETF (EWQ). Its top ten holdings:

We think banks especially are vulnerable, but if France will be thrown into the euro carrousel, basically few asset classes will be spared. Perhaps most notably one you would expect the least. Consider the following headline from Bloomberg on March 16:

Top Money Funds Doubled French Bank Holdings Last Month

According to the article, the survey included: Fidelity Cash Reserves (MUTF:FDRXX), JPMorgan Prime Money Market Fund (MUTF:JRVXX), Vanguard Prime Money Market Fund, Fidelity Institutional Prime Money Market Portfolio, Fidelity Institutional Money Market Portfolio, BlackRock TempFund, Federated Prime Obligations Fund (MUTF:PRSXX), Schwab Cash Reserves (MUTF:SWSXX), Western Asset Institutional Liquid Reserves (MUTF:SVIXX) and Dreyfus Cash Management Fund (MUTF:DVCXX).

You might want to keep an eye on those too.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.