Can France find a way out of its political and fiscal problems?

Paul Diggle

Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen. My name is Paul Diggle.

Luke Bartholomew

And I'm Luke Bartholomew.

Paul Diggle

Today on the podcast we are talking about France. It's been going through something of a political crisis, cycling through prime ministers and struggling to pass a fiscal budget through a very divided parliament. And all that, against a backdrop of fairly low growth, high debt and, therefore, growing market concerns, which has seen French bond yields increase. So we're going to be talking about what's gone wrong with France, in an economic and political sense? What comes next? And to what extent there are, or are not, comparisons with the European sovereign debt crisis to be made? So I'm joined by Lizzie Galbraith and Felix Feather here from Aberdeen Investments. Welcome, Lizzie.

Lizzie Galbraith

Thanks for having me back on.

Paul Diggle

Welcome, Felix.

Felix Feather

Hi, Paul. Thanks for having me back.

Paul Diggle

So, Lizzie, let's just level set and talk us through, if you will, some of the latest developments. France, as I say, under Macron has been cycling through a number of different prime ministers. Bring listeners up to speed on what's happened politically and where we're at right now.

Lizzie Galbraith

Yeah. So we've really seen the last year or so in France be quite turbulent. And the cause of that is that the gamble that President Macron took last year to call snap legislative elections did not pay off. Instead of giving him a stable parliamentary majority to work with, instead what we have is a parliament that is essentially split into three, pretty even thirds, actually – that does not really compromise with one another. So we regularly get impasses over fiscal policy in particular. And we've had one of those, quite seriously, actually over the past few weeks. So what we've seen over the past month or so is that President Macron appointed his fourth prime minister in 12 months, Sébastien Lecornu. And, when the wider cabinet was named for that new government, there was a really big push back from the opposition parties that resulted in Lecornu's resignation 14 hours later. That then triggered, an even more serious crisis. France needs to pass a budget this year. And it hasn't yet done so. So by the end of the week, what we seem to have got to is Lecornu actually back as prime minister, but with an agreement with the Socialist Party to suspend Macron's flagship pension reform in exchange for their abstention on confidence votes, at least for now. So what we have at the moment is Lecornu has the space to attempt budget negotiations over the next few weeks. But the outlook for French fiscal policy is still extremely uncertain, and it is still a bit of an open question as to whether or not this French government can pass a full budget for 2026.

Luke Bartholomew

So Lizzie, where does that leave us in terms of what comes immediately next? I mean, there was a lot of talk about the possibility of another snap election during the height of this crisis. That seems to have receded a little bit now, but are fresh elections still possible? And you said there's a lot of uncertainty about whether the budget will pass or not. I mean, what's your best guess on that at the moment?

Lizzie Galbraith

I certainly don't think that we can completely rule out snap elections. But in the immediate term, what we're going to see is an attempt at substantive budget negotiations. Now, as part of that, it is very important to note that the socialists have been clear that there is not a full deal with Lecornu to pass a budget. Their support is conditional on the suspension of Macron's pension reforms actually going through. That requires a parliamentary vote in of itself. So that's not necessarily a done deal yet either. And we're also likely to see further amendments being made to Lecornu’s budget blueprints over the next few weeks as well. And the opposition parties don't necessarily all agree on what those amendments should be. So there is going to be a bit of push and pull here. It's still not entirely clear as to, you know, what exactly we're going to end up with here, or if it can, actually garner a majority. But certainly, for now, pension reform is dead. Certainly, up until 2027, it's become effectively the problem for the next president. And we're going to see the budget negotiations continue over the next few weeks. There is a timeline in France that requires the negotiations to take less than 70 days. So we do have a bit of a hard stop coming up on those negotiations. But I'd expect that over the next month or so, there will be talks, in the next few weeks we’re likely to start seeing some votes taking place and we'll see if we can actually cobble together a majority for any form of budget. But suffice to say, deficit reduction in France is going to continue to be really quite tricky, and it's likely to be less than this government would ideally like it to be, given all of the different interests at play.

Luke Bartholomew

Felix, as Lizzie has just outlined there, debt and deficits are clearly a huge part of the current impasse. So could you just remind us what the current fiscal situation is in France, and what conditions the EU has put on France's fiscal outlook?

Felix Feather

Yeah, it looks like quite a tricky situation, both in absolute terms, but also relative to its European partners, for France. So the budget deficit as a percentage of GDP for this year is projected to be around 5.4%. That would be the largest in the Eurozone. Likewise, the debt ratio is also very high, around 116%. So that deficit is adding to [a] really quite big debt pile already. And government spending as a percentage of GDP is also well over 50%. And it's proving very hard to get down. Because the stability growth pact dictates that the maximum deficit should be 3% of GDP, this actually puts France in violation of the EU's rules. And for that reason, the European Commission has put France under the terms of an excessive deficit procedure – an EDP. Now, there are lots of binding constraints on that. I think the most important one is that it requires France to reduce its structural deficit – so its cyclically adjusted primary deficit by 0.5 percentage points a year. And also to reduce that deficit ratio number down below 3% by 2029. Now, the current plans suggest that the government, thinks it can do this. But it's getting harder and harder. As we've heard, the pension reforms have gone out the window, and they were, contributing to quite a lot of this consolidation. And markets are starting to take notice as well. So after Lecornu’s resignation yields on French debt spiked quite noticeably and spreads to Bunds became quite a lot higher. So prior to the initial calling of a snap election last year, those were trading around about 50-55 basis points or so. Nowadays, that number’s nearer 80. 30 basis points might not sound a lot, but in terms of setting a base rate for the entire French economy, that's really quite significant.

Paul Diggle

And what are you expecting, Felix, to be the deficit that ends up in that 2026 budget? Lizzie's outlined the various political challenges and where the compromises have been made, including around pension reform. So what sort of deficit are we talking about for next year?

Felix Feather

So, Bayrou, Lecornu’s predecessor, was aiming for 4.6% of GDP. When he came in Lecornu changed that to be 4.7% of GDP, which is a smidge less ambitious. Since then, the pension reforms have obviously gone, but he's still looking to hit this 4.7% of GDP target. Now, the way that's coming in is, because the effect of losing the pension reforms is relatively small in 2026, it actually gets much larger in 2027/28 because it was going to be phased in over time. In its place come some tax raising measures. So, wealth tax on holding companies of 2% over €100 million. And also some taxes on some large companies with, with very large revenues. These are projected to raise about €17 billion in revenue, offset with… spending cuts of a similar magnitude, pulling together a significant fiscal tightening for 2026. The problem is that further down the line, because a lot of these tax measures are temporary and because of the building impact of losing pension reform, the fiscal consolidation further down the road is going to be made quite a lot more tricky by this budget, as it's currently been proposed.

Luke Bartholomew

So taking a step back outside of these current fiscal, budgetary, political issues, to think a little bit about some of perhaps the deeper causes and issues with the French economy that have got us to this point. I mean, Lizzy, maybe, maybe a good place to start with that is just to remember that back in 2017, when Macron was first elected, that was, at least in part, on a platform of some degree of economic liberalisation, supply-side reform, welfare reform. And at the time, I think there was an idea that maybe that was part of a grand bargain with Germany. There's this thought that perhaps if France could take some steps on economic liberalisation, fiscal reform, then maybe Germany would be more willing to do burden sharing or taking on a bigger role in combined European institutions. Now, a lot has moved on since then. I think that idea of a grand bargain has certainly been superseded, but just narrowly on this economic reform agenda, how successful have Macron and his various governments been on that front?

Lizzie Galbraith

So I think there is quite a clear line that we can draw between Macron in his first term as president and Macron in his second. And crucially, when we think about his first term, where there was quite a lot of reforms going through, so abolishing the wealth tax, loosening labour laws, reducing benefits in some areas. Macron did actually do a lot. It wasn't necessarily always popular, but he did actually make a lot of progress in enacting that agenda that he was elected on, crucially, with a strong majority in parliament that enabled all of that to actually happen. Now, if you look at his second term, he campaigned on enacting pension reform during the presidential campaign. But we haven't actually seen the effects of that really be received well by the public despite his re-election. So really the only thing that we can point to in his second term, I think, that sort of aligns with that reformist domestic agenda is that pension reform, which, as I said, is now been at least delayed, and probably scrapped, given its unpopularity with the other parties. So I think we're seeing a bit of an erosion of some of the reforms that Macron actually did undertake – some of the tax cuts that Macron has previously passed may well come under pressure as part of this budget process as well. So I think there is an extent to which, possibly, we reached peak Macron-ism actually towards the end of his first term and actually since then we've seen the edges sort of chipped away at that, as the opposition parties have become more influential in the political process, despite Macron's continued presidency.

Paul Diggle

And, Felix, in what ways are these challenges in France just the same as in the fiscal and economic and political challenges of many ageing, highly indebted, relatively low-growth Western democracies? One could draw obvious parallels with the UK and in what ways are they perhaps unique to France and the particular structures of its economy?

Felix Feather

Yeah. Well, I'm sure plenty of your listeners internationally will have been…their ears will have been pricking up with comparisons to their own countries – similarly large deficits in the UK, in the US and globally, that is becoming a much bigger concern for investors. You might also draw comparison with Japan and other European countries – yields spiking in response to much higher expected issuance. But there are some structural factors [that] are common to most of these developed countries, for example, ageing population putting big strain on pension payments, relatively slowing productivity growth, perhaps AI innovations will reverse that, but we will see. Another important one is the legacy of higher interest rates after the 2022 shock, meaning the debt service costs are just much higher. And maybe as we’re moving into a more multipolar world, a world in which there are problems of climate change, you could possibly see a lot more inflation volatility. And that could plausibly mean that interest rates, long-term yields, need to stay a lot higher going forward than they were perhaps in the 2010s. There are probably some factors which are more specific to France. So, you can think about its position within the monetary union – not having control of its own monetary policy. You can think of the political culture in favour of quite a large state, and especially, the importance, political salience, of entitlements – pension payments are making France a really difficult place to consolidate. Perhaps, the experience of two Macron presidencies is what we've learned from that. So I think for the whole world, this, this theme of debt becoming a real issue is going to stick around. But in France, the problems are even more acute. And perhaps in that regard, it could be something of a canary in the coal mine, and we see some of these problems come to some of those other developed markets a little bit further down the road.

Paul Diggle

Yeah. That particularly regulated labour market, large state, sort of a social model, combined with a protest culture, even a strike culture. I think that is very much a unique French feature, at least a strong French feature. It may be, a little more controversially, you could say that it has a sort of a linguistic cultural history that's not leaning into the sources of economic and cultural dynamism in the world at the moment, which is, sort of, a lot of the English-language internet-tech driven in a way. But I think fundamentally the one you identify, Felix, of not having its own central bank, [not] having a sovereign printing press -- that one is really crucial, not having the global reserve currency, which to be fair, no one but the US has. But those are features that, you know, in the US’ case, allow it to run larger debt and deficits than it might otherwise be able to, for a lower borrowing cost – having the reserve currency and the global safe asset. But even having a sovereign printing press – and of course, you’ve got to realise that the ECB is not France’s central bank, it's the Eurozone’s central bank – means that France and all the Eurozone countries do face these sort of unique questions about whether the central bank is the ultimate backstop for government debt issuance, or not. And I think that, of course, is very tied up with the deep, deep history of the Eurozone sovereign debt crisis.

Luke Bartholomew

Although perhaps to be a little bit devil's advocate or contrarian on this, I mean, you might also argue that the straitjacket of being inside these European institutions, of lacking a sovereign printing press, does potentially come with some benefits. You know, perhaps the market would be much more concerned about France running an inflationary policy in this kind of debt crisis, that the printing press would be put to work to monetise those deficits. And so inflation expectations would move higher, funding costs would be higher as a consequence, or, you know, an independent franc or whatever it might be, could be experiencing a currency crisis in this environment. Obviously, it's just not the case when you're part of the Eurozone. And then more generally, I guess, you know, looking at the structure of the French economy, I mean, it has this heavy nuclear energy mix, maybe that could turn out to be quite important in the context of a fragmenting energy shock-dominated world. France has got a long history of industrial policy, some of which has been reasonably successful and [there] has been this fashionable turn towards industrial policy recently. So perhaps France is well suited in that respect? So, you know, just to do a little compare-and-contrast against some of the countries that you mentioned as potential peers to France there, Felix, I mean, there is a positive spin that you might put on them. You know, compared to Germany, maybe you would say France doesn't have the same China-dependency kind of problem and the same energy mix kind of problems. You know, if you're looking at the…UK and therefore, their relationship with the EU being quite significant in that sense, both, you know, the pluses and minuses of being inside institutions that provide straitjackets, but also potentially the trade benefits of being inside the EU, as well – France has, the UK doesn't. And then maybe if you distinguish from Japan, you'd say that, you know, it has lower debt and a less favourable demographics than Japan does. So, you know, if you line it up against what you might think of as these peer developed market countries, it's not unambiguously the case that the French position is worse. Now, notwithstanding those kind of, devil's advocate style arguments, Felix, you've written some research in the past arguing that France is more peripheral than core as a sovereign debt market. Tell us, kind of, what do you have in mind when you say things like that?

Felix Feather

Yeah, this is a little quote that always raises a couple of eyebrows. But the point is really that, if you look at the features associated normally with periphery markets, those might include relatively high debt pile, quite large fiscal deficits, maybe weak internal EU trade position and the competitiveness and relatively poor economies versus the EU average. Well historically France has been firmly in the core side of that divide, right? But you can actually model this formally, and we have, over the past few years, France has been drifting more towards the periphery side of that divide, along most of those metrics it's now got more in common with your Spains and your Italys than it might do, say, with the Netherlands, for example. So in that regard, it's more like a periphery country. Now, there's obviously a sense in which France is a core country – it's one of the two biggest and most indispensable members of the European project. So it's core to the European project, right. But the way we're really interested in this is how markets are going to be thinking about the core/periphery divide. And because France meets the periphery criteria in other ways, it's going to be treated like a periphery country by markets. And we can see that in the way the OAT spreads over Bunds have risen vertiginously since 2024. And they are now, depending on the term at which you look, the widest or the second widest in the entire Eurozone. And that's something which we think can persist, if the structural fiscal, and indeed political, problems of France, if they're not addressed, could be maintained.

Paul Diggle

So 10- year French bonds are trading, depending on exactly what day you look, something like 80 bps, 80 basis points, over German ones, relative to, you know, average of something like 20 bps or so for the post-financial crisis, pre-pandemic era. They’re trading with a spread equal to and at certain points higher than Italian bonds. But of course, Felix, during the Eurozone sovereign debt crisis, those spreads for the peripheries were larger still, right? Italy was at points trading 500 basis points over Bunds in 2012, Greece much, much more so again. And that obviously represented, or incorporated, genuine credit risk or even re-denomination risk – the idea that those currencies with those countries may leave the Eurozone, or the debt of those countries may be re-denominated from euros into their original currencies. And then that spread was there to compensate investors for that sort of risk. That's of course why Draghi had his ‘whatever it takes’ moment to try and bring those spreads back in, to remove that re-denomination risk, that existential risk to the Eurozone. Is it right to think about the way in which France today is trading, a bit like a periphery, to think that that is incorporating default or re-denomination risk, or is it something else that's causing that spread?

Felix Feather

Well, Paul, spoiler alert, I don't think that. But let me first set up a very brief argument that it might be. So back in 2009, Italy's debt-to-GDP ratio was 118%, and its deficit ratio was 4.9% of GDP. Now, for those who have been listening closely, those numbers are strikingly similar to the sort of fiscal ratios that France is putting up today. So it does invite the question: is France headed for the same sort of fiscal crisis that the periphery did back in the 2010s? But let me give you a few reasons why I don't think that is the case. So one would be the global context. So can you think of anything else that was going on [in] 2009? Well, the global banking system was reeling from really bad crisis and the global economy was going to be in a recession, really deep recession for a number of years. And that's not the case this time around. Obviously, these global factors could change, but I don't think there's any suggestion that we’re on the brink of something like that. The second point is that banks are much more securely capitalised than they were back before the euro-periphery crisis and indeed, the global financial crisis, and that French banks in particular, are not overexposed to French sovereign debt. Compare that with, Greek or Portuguese banks back in 2011 also – a very, very sizable chunk of those balance sheets were taken up by exposure to domestic sovereign debt. And that meant you could get this doom spiral of selloffs in those sovereign debt assets leading to bank insolvencies, leading to further worries, and it goes downhill from that. There's nothing in French banks’ balance sheets today to suggest that that sort of dynamic is going to be repeated. The third point is that the ECB is a very different institution than it was back when these sovereign debt crises first kicked off. So since then, we've had very large-scale quantitative easing. We've got tools like the Transmission Protection Instrument, which we saw in action in 2022 that can be used to close spreads where the ECB feels that spread widening is disorderly or not warranted. And the fourth point to keep in mind is that these periphery countries, back in 2011, a large part of the debt pile was held abroad – so this was external debt which could be [xxx]. But for France today, actually, most of this build up in government debt has been funded by private sector [xxx]. So it’s still inside France, which means it's not as exposed to an external shock. That said, it's not unthinkable that something could go really badly wrong. Maybe an exogenous shock of some sort? Something happening to the global economy or the global financial system that sets off a chain reaction that puts France into a proper fiscal crisis? But we can tell that markets are not pricing that at the minute, because if they were, and they were thinking about re-denomination risk, we would be seeing a lot more contagion to other periphery markets. In fact, since Lecornu’s first attempts at putting together a government started to fall apart, Italian spreads and Spanish spreads are actually down a touch. So they've tightened a little bit. That says to me that investors aren't worried about re-denomination and contagion to other markets just yet.

Paul Diggle

I mean, if you wanted to keep pushing this negative part of the story, you might also tell a story that a lot of the ECB’s new tools might not be able to be used in a crisis, for example, technically speaking. Outright Monetary Transactions, the tool that sits behind Draghi’s ‘whatever it takes’ statement, can't be deployed when a country's in an excessive deficit procedure, as France is. But it's just very unlikely that that sort of technocratic limit would actually hold in a genuine crisis. And you might also, you could tell a story about a future president, Le Pen, genuinely just wanting to leave the Eurozone, although that is, of course, not policy at the moment. But there's nothing that the ECB could intervene to do to prevent a political desire to exit – although that's of course very unlikely. But I think, as you say, Felix, like that, those aren't the type of concerns investors have. The main concern is just the amount of supply of French debt to the market. It's very large, and the market has to be incentivised to absorb that duration. And that means an increase in the yield they offer to incentivise investors. And I think the story can be told as simply as that, without necessarily appealing to these crisis-like existential risks.

Luke Bartholomew

All right. So, Lizzie, let's turn to the future now. Because on current schedule, there is a presidential election in 2027. Macron can't stand because of term limits. Currently, Le Pen can't stand pending a court ruling. So we are missing lots of the pieces that you might need for speculation. But let's not allow that to stop us, it never has in the past on Macro Bytes. So, on that topic, I mean, what do you think is likely to be at stake in that presidential election? What are the big questions around that election?

Lizzie Galbraith

I mean, I think the big one is going to be whether or not France sees the election of, effectively, a populist president – whether that comes from the right on National Rally or whether, more unlikely, it comes from the left. As you said, we don't actually know exactly who the candidates are going to be, by and large, in that election. So there is an element to which this is slightly, kind of, finger in the air speculation. However, what we do know about the French political landscape is that the population in general is deeply unhappy with the current status of politics. It's become a source of significant frustration, I think. And what we have seen as a response to that is that support for centrist parties, particularly President Macron's party, has really, really fallen away quite sharply. And we've seen voters move out to, both the right and the left, partly in response, I think, to some of the political impasse that we've seen, and a lot of the frustration being directed at President Macron himself. Now, as you said, President Macron cannot run and it is currently unclear which of the centrist politicians we're going to see, attempt to sort of run as a kind of replacement centrist. But I think beyond that, really what we're looking at is whether or not the ‘cordon sanitaire’ – this sort of agreement that we have traditionally seen in French politics where you get an element of tactical voting between centrist and left-leaning voters to try and keep out right-wing candidates from high office – whether that holds. It did in 2022 and you could argue that it also held up pretty well in the 2024 legislative elections as well. Both of those elections saw an element of underperformance from National Rally in second-round voting. And that is something that we need to be mindful of when we're looking at French polling. The polling always relates to first-round voting intention. And that can tell you something about the immediate instincts of the French public. But it doesn't really tell you a lot about second-round voting which can often be quite different. So yeah, the big question is going to be, I think, whether or not all of this political turmoil, all of this frustration, all of this, you know, pulling away from centrist political figures, actually does mean that that ‘cordon’ breaks down this time, or whether or not, actually when push comes to shove, voters are still going to behave in similar ways because they do still want to try and box out National Rally candidates from actually winning elections in great enough numbers. And that, I think, is going to be, yeah, a very, very important question and not necessarily one that we're going to have a clear answer to until we get election results themselves, given, as I said, the particular intricacies of the two-phase system in France.

Luke Bartholomew

And in the scenario where the ‘cordon’ doesn't hold. And so, there is a Le Pen presidency or perhaps some other National Rally candidate. I mean, what would that mean? I mean, is it, as Paul sort of alluded to there, the possibility of Frexit – France's position in the Eurozone, is that back on the table? And I suppose even NATO as well, for what that's worth. I mean, is it more like a Meloni kind of situation where, how they govern turns out to be quite different to how they campaigned and the historical nature of the party? You know, is it possible that France is forming some sort of awkward squad with Hungary and other countries in the EU? Is it some other fourth scenario? I mean, what do you think it might mean?

Lizzie Galbraith

So, National Rally has evolved politically since its sort of earlier years and we have seen them tone down the euroscepticism somewhat. They're certainly still not particularly inclined to be vocally supportive of the EU and its institutions. And it's still very pro, what they would term, ‘reform’. But really, I think, means a shrinkage of the EU and its responsibilities. But they're not really advocating for leaving the EU anymore. Most of the parties that had previously advocated for that did tend to stop talking about it quite so much, post-Brexit. But one thing that they have really stuck to their guns to is quite a lot of fiscal loosening, I think. So you're really seeing them advocate broadly speaking for lower taxes but also quite generous public spending. So I think in the event that we do see National Rally begin to actually win elections, then you could actually see concerns about the French fiscal trajectory become even greater because it’ll limit the extent to which markets have any confidence that the French governments can alleviate the trajectory, their role, and indeed, it may be that, you know, deficits actually go higher, rather than lower, and you start getting pushback against the European Commission's efforts to try and enforce that. So I think there is possibly a potential for some conflict there. In the event that you get a National Rally government, just because the European Commission is going to have certain expectations around fiscal policy that don't necessarily seem to align with National Rally policy priorities, that could be an issue. And as you said, France has traditionally been a major player in the European Community more broadly, you know, interested in trying to create, you know, coalitions – whether that's on defence or on other issues. And you may see that fall away in the event that you get, you know, a party elected that's less interested in creating that kind of consensus around common European policy.

Luke Bartholomew

All right. Well, I think that is all we have time for this week. So, as ever, please do allow me to remind you to like and subscribe to the podcast if you have not already done so. And all that remains is for me to thank Lizzie and Felix for joining us today, and to thank you all for listening. So thanks very much and speak again soon.

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