Waiting for the other shoe to drop – on France
Geopolitical tension aside – and I recognize that this is a big “aside” – the start of 2014 in the Eurozone looks like the best since 2007. After two consecutive years of recession, growth finally made its comeback in the fourth quarter 2013. It is not only the absolute growth figure that is encouraging, but also the fact that the six largest Eurozone economies have all contributed to it.
Moreover, the large imbalances in the European periphery are currently correcting at a rapid pace. Spain, Portugal and Greece have seen their trade and current account deficits shrinking or even turning into surpluses over the last 18 months thanks to the increased competitiveness afforded by falling unit labor costs. If Italy’s new Prime Minister Matteo Renzi delivers what he has promised, then the country’s prospects will also brighten in this respect.
Finally, interest rates on European peripheral bonds have fallen dramatically over the last couple of months. This has brought welcome relief to the public debt dynamics in the crisis countries and has led rating agencies – behind the curve as usual, and therefore just mimicking market movements – to reassess their outlooks on Eurozone member countries and in Spain’s case even hand out a one-notch upgrade.
This positive outlook also bears some risks. Deflationary pressures have surfaced lately; if they persist, combined with still-decreasing credit activity, it could lead the Eurozone onto a Japanese-style path of secular stagnation.
Moreover, political frustration and social tensions continue to mount and are likely to find expression at the European parliamentary elections from 22–25 May this year. According to the latest polls, anti-European parties could comprise up to a quarter of the European Parliament.
Finally, the fact that the euro crisis is currently on the back burner in market participants’ minds could lead European politicians to become complacent again, unwilling to continue with the reforms necessary to put an end to the inherent instability of the euro once and for all.
In my view, the chief procrastinator here is France. The French government is currently heralding that its public deficit will be back below 3% by 2015. Moreover, it believes that the newly created Pacte national pour la croissance, la compétitivité et l’emploi, a tripartite treaty between the government, trade unions and employers’ organizations, will restore the country’s competitiveness and create jobs.
However, the European Commission remains skeptical that France will reach its deficit targets and still forecasts a public deficit of more than 4% of GDP in 2014 for France. The French competitiveness pact hasn’t really convinced the European Commission, either. This is not too worrisome for this or next year. However, in a longer-term perspective, the country faces two challenges that make it increasingly likely that when the other shoe drops – France could find itself right underneath it.
First, until recently France was in the midfield of European competitiveness, obviously challenged by Germany but holding its own against its southern neighbors. Its position is now becoming more and more precarious with Spain seeing its unit labor costs dropping, and possibly Italy in the near future as well.
Second, France has so far profited from very low interest rates on its public debt. In my view, those low interest rates did not result from fiscal responsibility but from the fact that the euro-denominated bond market cannot meet investor demand if one takes only Germany, the Netherlands, Austria and Finland as the countries of choice. Adding France as a “second-best” country deepens the bond market in euros. However, this second-best status cannot be taken for granted.
With market participants and rating agencies becoming more positive again regarding other large euro-denominated bond suppliers like Spain and Italy, we could well see a sudden reversal in the ranking of the major Eurozone countries at some point down the road. This is a serious risk within the next three to five years – not only for France, but for the Eurozone more generally.