France is to experience a ‘shallow’ recession according to Central Bank

9th August 2012

France's central bank forecast a contraction of 0.1% in GDP in the three months to September. A similar picture was seen in the second quarter and the economy is now unlikely to meet the Government's 0.3% growth target for the year. Particularly weak was France's trade deficit, "which widened to €5.99 billion in June, from a downwardly revised €5.47 billion in May, dashing economists' expectations for the deficit to narrow. Exports to Italy, Spain and Britain slumped, with sales of cars and transport materials particularly weak."

But the country's poor growth is not its only problem. The banks are loaded with Greek assets and would suffer disproportionately if the country were to depart the Euro: "France's central bank, the most heavily exposed, may need to be recapitalised because of the scale of its potential losses."

This is in spite of recent attempts to reduce exposure, both through the sale of peripheral bonds and the divestment of Greek assets. For example, the Financial Times reports: "Crédit Agricole received offers Wednesday evening from three Greek banks for selling its local lossmaking subsidiary Emporiki Bank in a signal of disengagement from the country."

Historically, the strong relationship with Germany has been crucial to the strength of France. However, while 'Merkozy' proved a strong partnership, there are doubts that Hollande/Merkel will form such a bond. They stand on opposite sides of the economic fence and Hollande has led the pan-European charge against austerity.

This piece in the Guardian examines the rather frosty early body language between the two leaders.

A number of policy measures have not helped the overall picture in France. For example, reducing the pension age in a country with relatively weak demographics is likely to be an expensive policy in the long term.

The conclusion for many investors has been that France is simply best avoided. Brian Dennehy, managing director of recently warned that France had become one of the biggest risks to investors' portfolios due to its exposure to the Eurozone crisis and said many investors had failed to spot the threat:

"Debt growth in France is on a remarkably similar trajectory to Greece. Investors are taking risks of which they are unaware" he said. "We recommend selling any fund over-weighting France, and remain cautious of all European funds."

"Dennehy says that French banks are highly exposed to the debt of the peripheral European countries, leading to the often-repeated accusation that austerity in those countries is a way to bail out French and German banks."

And yet the debt markets most definitely do not agree. The French benchmark 10 year bond yield is trading at just 0.67% above bunds and 0.43% above treasuries. This could be compared to 5.42% above bunds on the equivalent Spanish bonds.

Marius Zaharia at Reuters highlights the contradiction between the treatment of Spain and France in the bond markets: "With 10-year borrowing costs of around 7 percent, Spain may soon be forced out of capital markets. France, on the other hand, looks like one of the world's safest debt markets with its debt costs some 500 basis points lower.

"On Thursday, investors even got to the point of paying what amounts to a parking fee – a negative yield – on short-term French debt.

"This contrasts with the picture in November last year when France was seen as the next weakest link in the euro zone after Spain and Italy and the spread, or difference, between French and Spanish 10-year yields was about half what it is now."

Zaharia suggests a number of reasons why this unequal treatment may be happening: "France's slightly stronger economy, its history of being close to Germany politically, and recent moves by the European Central Bank."

Yet it raises the prospect of a significant hike in French bond yields if any of these factors begin to wane. For example, its relationship with Germany may no longer be secure, its economy may now be flagging. This article on zerohedge gives a frightening picture of French debt.   – the country is extremely vulnerable to any hike in yields. If Eurozone policymakers think they have problems now…

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