Contagion risks from the Euroland periphery

There’s lots of talk about ‘risk’ but it’s clear that when we think in detail about risk, we really need to focus on where exactly things can go wrong and what then happens. This is important as often risk is contagious, and an event which may of itself and on a standalone basis have a low probability of occurring, may be much more likely to come to pass if other events happen.

Specific risks which are visible include the unwinding credit booms in newly emerging economies and the Euroland crisis, but almost all of the Euroland commentary relates to the peripheral economies themselves and the Euroland banks, and to a lesser extent Germany with little consideration as to what else may follow.

Certainly there is plenty of detail on the situation with the peripheral economies, covering Portugal, Ireland, Italy, Greece and Spain, and it is apparent that conditions are continuing to deteriorate. Equally, the problems for Germany, and the Bundesbank as lead funder for the European Central Bank, have been aired and Germany’s economic data have of course softened of late. But if we think though the sensitivities and second order risks associated heightened peripheral economy tensions, arguably it is France’s situation that is of most concern.

Despite the public statements of its former president, France has over the years exhibited a tendency towards fiscal profligacy and has experienced high levels of private sector indebtedness. In particular, there has been a long history of housing booms driven off mortgage finance. During the 1970s, the result was weakness of the franc, and even during the so called ‘franc fort’ policy in place in the 1980s, the country underwent occasional downward currency re-alignments in order to offset the inflationary implications of its property cycles. The advent of the single currency has prevented such currency re-alignments but as evidenced by the credit data, there have continued to be credit booms and bouts of house price inflation.

As a consequence of these dynamics, whilst France’s ratio of outstanding public debt relative to its GDP does not appear extreme relative to some economies, it is still extended. Similarly, the private sector is heavily in debt, although not at the extreme levels that ensure significant public attention. Taking government and private indebtedness together, France is a highly indebted economy and within the global top ten, and the outlook is not healthy given weak underlying competitiveness within Euroland. We should therefore not be surprised to find that the French economy is proving intensely vulnerable to the global slowdown in general and Euroland contagion in particular. Certainly, the recent flow of data from France has been relatively disappointing but, as capacity utilisation falls away, we must wonder whether France will be able to sustain and support its high existing debt burdens.

Joining the dots suggests that the French economy, like those of Spain and Italy, is already well on its way back towards the cyclical lows seen during the Global Financial Crisis, and as a result, we may suspect that markets will soon begin to wonder about France’s financial stability.

In the near term, the fact that French government bonds (OATS) remain eligible collateral for many transactions may provide some support but if the rating agencies realise just what is going on in the economy at present, and downgrade the country’s credit rating, then the local bond markets could be highly vulnerable.

We maintain a distinctly cautious attitude to French banks and assets.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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