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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is dean of the Sciences Po School of Management and Innovation and a former deputy director-general for monetary policy at the European Central Bank
France is about to become a quiet but decisive test for Europe’s markets. The country has long been considered a core anchor of the euro area: too big to fail, too integrated to falter. Yet, that assumption will now be tested.
The political fragmentation is unprecedented in the Fifth Republic. With secular fiscal drift and muted growth, France will become the next barometer of investor confidence in Europe’s ability to manage political risk.
For now, the market reaction remains contained but this apparent calm masks a deeper, slow repricing of sovereign risk. Investors are still testing the credibility of the European policy response. But, as often in such environments,a liquidity event can spark more abrupt adjustments.
France’s challenge is not yet one of solvency. Its debt remains serviceable, underpinned by solid domestic savings and strong institutions. The issue is one of market confidence in the political capacity to govern and deliver fiscal discipline. Investors have long tolerated France’s tendency to systematically miss targets or delay reforms, on the assumption that European solidarity and the support of the European Central Bank would ultimately prevail. That presumption will probably face more questioning.
In France, fiscal choices are becoming hostage to electoral maths. In this context, the repricing and re-rating of French debt will not be driven by sudden fears of default, but by a growing awareness that fiscal consolidation will be postponed indefinitely.
Domestic investors will absorb the financing needs, at least for a while. But as the worries of foreign investors grows, the gap between French debt yields and other states will continue to drift wider, liquidity may thin and tenders of government debt may fail to attract reassuring levels of bids. Something similar happened to Italy in the mid-2010s. Italy survived, but the euro was tested and fiscal discipline had to be restored with a technocratic cabinet.
Since the sovereign crisis a decade ago, the ECB has developed instruments to contain market fragmentation across the Eurozone: the Outright Monetary Transactions (OMT) programme, and the Transmission Protection Instrument (TPI). Both are designed to address “unwarranted” market stress and are subject to strict conditions.
Would France qualify? OMT requires adherence to fiscal discipline under a European Stability Mechanism (ESM) programme — something politically hard to swallow for a core member state. The TPI gives the ECB more discretion, but its activation still depends on an assessment of fiscal sustainability and compliance with EU rules. France might try to stretch these definitions but that is not likely to work.
Why? Mostly because monetary interdependencies across euro area states have evolved to France’s disadvantage. The so-called Target measures of cross-border liquidity flows between national central banks are a subtle signal of this. France’s Target balances have recently remained persistently negative. Germany or the Netherlands, with their positive balances, might not be so happy if the ECB were to activate additional purchases of French debt.
In practical terms, the ECB faces a dilemma. If it intervenes for France, it risks moral hazard and accusations of favouritism. If it doesn’t, markets may test its commitment to the euro. A pledge to do whatever it takes may not be enough this time around.
So what else? In principle, the ESM’s existing precautionary credit lines could be tapped but their use too stigmatised. As an alternative, Europe should design an insurance facility — a European sovereign liquidity insurance — that works like an option rather than a rescue.
Participating member states would pay a modest periodic premium into a pooled fund managed by the ESM. In return, they would receive the right but not the obligation to draw temporary liquidity if spreads rise abruptly beyond predefined thresholds unrelated to fundamentals. The mechanism would be automatic, based on rules ensuring fiscal behaviour and time-limited, avoiding the stigma of political negotiation. The triggers and payouts would be transparent, the coverage capped and the premiums calibrated to each country’s risk profile.
The mere existence of such a mechanism would deter speculative attacks, precisely because it introduces a predictable, automatic liquidity buffer at the heart of the monetary union. In effect, Europe would be insuring itself against political risk, thereby stabilising the system before any panic prevails.