EXPLAINER-Why France's budget problems have driven its bond risk premium to 2012 highs

The premium France pays to borrow on the bond markets compared to Germany rose to more than a ​whole percentage point on Friday for the first time since the euro zone debt crisis, underscoring investor ​unease with its stretched finances ahead of elections next year.

Here's a look at ‌what's ​at stake: 1/ WHY HAS THE PREMIUM INVESTORS DEMAND TO HOLD FRENCH BONDS RISEN OVER 100 BASIS POINTS?

France's 10-year borrowing costs have risen much faster than any other developed economy's in the global bond selloff that has unfolded in recent weeks, as rising energy prices have stoked concern about inflation. The French government must now pay a 104-basis-point premium on ‌its 10-year bonds over Germany's for the first time since 2012 as investors seek more compensation to hold its debt.

Investors are already worried about developed economies' long-term finances, and French bonds are particularly vulnerable given the government's struggle to put its fiscal position on a firmer footing ahead of a presidential election next year that could make that task even harder. This is just the latest milestone for the spread between the two yields, which has doubled since a snap election in ‌2024 delivered a fractured parliament that has made it much harder to cut France's budget deficit, one of the highest in the euro zone.

The government is trying to reduce it from 5.4% of output this year to 5% next ‌year through €54 billion of tough spending cuts. Opposition parties are likely to challenge them in the coming months, potentially bringing the government down. France will miss this year's original 5% target due to lower-than-expected growth. Rising energy prices due to the Middle East conflict, which have prompted investors to bet on further European Central Bank rate hikes, could hurt growth even further.

Concern is also mounting that next year's presidential election could derail efforts to lower the deficit as the far-right's Marine Le Pen and the far-left's Jean-Luc Melenchon are the frontrunners. Melenchon's call on the French central bank to cancel ⁠the government debt it ​holds has rattled investors, while Le Pen, who is leading ⁠the polls, is advocating lowering the retirement age for some people, which would add to the pressure on the country's finances.

Italy's bond spread has also risen, but much less than the 40 basis points rise in France since June. 2/ WHAT DOES IT MEAN FOR GOVERNMENT FINANCES?

It makes ⁠new borrowing more expensive and adds to rising debt-servicing costs. These have already become France's biggest budget expense, as it refinances hundreds of billions of COVID-era debt borrowed at ultra-low rates. The government already expects debt-servicing costs will be €4.5 billion more than expected this year ​because of higher interest rates and a further €10 billion higher next year.

Economists worry that with growth low and interest rates rising, France faces a snowball effect where borrowing costs spiral higher unless the government manages to ⁠post a primary surplus, which it is far from doing. 3/ WHY DOES IT MATTER FOR MARKETS?

It's a particularly telling sign that France's bond market, the euro zone's largest and traditionally regarded as a relatively safe asset, is losing that status. After all, the last time France paid a three-digit premium over ⁠Germany ​was at the height of the euro zone debt crisis in 2012, when the future of the euro was in question.

France is also paying a higher premium than Italy, a country that has higher debt and much lower credit ratings. Many investors say they are reluctant to favour French bonds in their portfolios.

Paying a 100 basis-point spread over Germany shows "France has real problems, and that they're not going to be solved anytime soon," said David Zahn, head ⁠of European fixed income at Franklin Templeton. 4/ COULD THE SPREAD RISE EVEN FURTHER?

Given the scale of the move already, some analysts see limited scope for a significant move higher in the near term. "At some point, unless you ⁠think they're on a road to something really horrible, you've got ⁠to make the judgement that there's enough compensation for taking on the sovereign risk," said L&G's head of macro strategy Chris Jeffery, who recently closed a position betting against French bonds.

But further political uncertainty could still push the spread wider, analysts say, for example if the government falls and leaves France without a budget, or Melenchon and Le Pen ‌face each other in the second round ‌of the presidential election. Societe Generale has not ruled out a move to 120 basis points.