Political uncertainty in France risks creating contagion effects in the UK. British banks are exposed to French debt. France is Britain’s fourth largest trade partner and an important source of foreign direct investment. Costas Milas writes that contagion risks and inflation back at the two per cent target might be good reasons for the Bank of England to cut rates by 25 basis point in August.
France’s snap elections and the real prospect of a new government led by Marine Le Pen will likely affect France’s future economic policy (with possible cuts in taxes and spending plans) and its future relationship with Europe and the rest of the world. This scenario has put financial markets on alert.
Analysts point out that France is more likely than not to remain in the Euro currency but act as a “spoiler”, therefore undermining Europe’s stability. The French long-term (10-year) cost of borrowing has been on the rise as has, among others, Italy’s. There are legitimate reasons to worry. France is the second biggest economy in the European Union (EU), accounting for 16.5 per cent of its gross domestic product (GDP). What matters for France matters for the EU.
What matters for France, however, matters also for the UK economy. This is because France is the country’s fourth largest partner, accounting, at the end of 2023, for six per cent of its total trade in goods and services (exports plus imports). At the same time, the inward stock of foreign direct investment (FDI) in the UK from France accounts (data for 2021) for five per cent of the country’s total inward FDI stock.
Stronger trade with our French neighbours is vital for the health of the UK economy. Large inflows of FDI are vital towards solving the country’s long-lasting productivity problem and therefore relaxing the tough fiscal decisions the next government needs to take in order to keep public finances under control. All this suggests that the prospect of negative economic developments in France will also have an adverse impact on the UK economy.
Can the French economic prospects take a turn for the worse? Rising political uncertainty leads to higher borrowing costs, making it more difficult for the French government to “roll over” its debt obligations. The International Monetary Fund predicts that France’s gross government debt will rise from 110.6 per cent of the country’s GDP in 2023 to 115.2 per cent in 2029. These predictions do not consider a financial turmoil scenario.
Uncertainty risks a rapid increase in borrowing costs both for the French government and the financial institutions operating there. Such developments will “hit” hard France’s economy, which is currently predicted to record anaemic growth of only 0.7 per cent in 2024. This has the potential of creating contagion effects for the rest of Europe and the UK through the banking channel. Let me elaborate by looking at the exposure of British and European banks to French private and public debt. Detailed data from the Bank of International Settlements is quite informative.
Figure 1 plots bank exposure to French public and private debt over time. This exposure has risen in recent years. For instance, German banks’ exposure to French debt went from six per cent in 2007 to 9.3 per cent at the end of 2023. The exposure of British, Italian and Irish banks also stands currently close to 10 per cent. Slightly higher is the exposure of Portuguese banks, currently at 11 per cent. Spanish and Greek banks have a lower exposure, currently at five per cent or below their total exposure to the rest of the world.
The figure indicates that there is a risk of contagion effects through the banking channel. Higher government borrowing costs in France lift borrowing costs for the private sector and affect the country’s GDP negatively, while putting upward pressure on unemployment and making it more difficult for French citizens to repay their debt obligations. This, of course, adds to the challenges other European banks face through their exposure.
Let’s put that in historical economic context. When “little” Greece (accounting only for 1.3 per cent of the EU’s GDP), triggered a Eurozone debt crisis and put upward pressure on European borrowing costs, the exposure of European banks to Greek private and public debt was not particularly high. Indeed, in the early 2010s it was less than seven per cent and falling, as my co-authors and I explain in a recent paper. Contrast this with the current situation where, as figure 1 shows, the exposure of European banks to French debt is around 10 per cent and rising.
Figure 1. Exposure of European banks to France (as a percentage of their exposure to the rest of the world)
Source: Author’s calculations based on data from the Bank of International Settlements.
It is reasonable to assume that if the French political crisis takes a turn for the worse, the European Central Bank (ECB) will do “whatever it takes” to bring borrowing costs down. Recent academic research has pointed to the effectiveness of such action by the ECB in the past, noting that quantitative easing policies worth 10 per cent of GDP in the euro area have reduced sovereign yields in the very area by around 72 basis points. The ECB, if necessary, will also proceed faster with interest rate cuts.
Given the notable exposure of British banks to French debt, and depending on how France’s political situation develops over the next few weeks, the Bank of England’s Monetary Policy Committee (MPC) might (also) have a good reason to proceed with a cut in the Bank’s base rate from 5.25 per cent, currently, to 5 per cent when an interest rate decision is made on 1 August, 2024. This interest rate decision will also be justified, of course, by the latest economic developments showing a reversal of the UK’s inflation rate back to the 2 per cent inflation target in May 2024.
Bank of England and ECB policymakers will soon find out whether or not new economic shocks lie ahead…
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