ROI-Smouldering debt risk haunts French markets: Mike Dolan

France isn't in a debt crisis yet. But it's running out of time, ​money and political space to avoid one. For impatient sovereign debt markets, a resolution to France's smouldering budget and political crises ​may still be months away, as the two reinforce each other.

Weekend street riots and ‌subsequent ​curfews are just the latest instalment in a slow-burn budget mess that's been building for at least a year, intensifying again last month. No clear picture is likely to emerge for at least another eight months. Most immediately, the direct cost of damage to business and confidence is substantial, although economists caution against equating repair costs with lost gross domestic product (GDP). That said, estimates derived from similar periods ‌of unrest in France over the past 10 years suggest the initial hit to GDP could be 0.1 to 0.2 percentage points before being recouped.

In the wider French fiscal and political story, however, that is significant when annual GDP is growing by only about 0.5%. Dutch bank ING warns France is entering a "difficult circle."

"France has neither the fiscal room to buy social peace nor the political room to impose adjustment easily," ING economist Charlotte de Montpellier wrote on Tuesday. "Weak growth worsens the fiscal position, budgetary concerns push interest rates higher, and tighter financial conditions weigh further ‌on activity." The absence of extraordinary, and at this point unlikely, European Central Bank action to stabilize the situation means market bargain hunters may pass for now.

Extreme market moves during social or political unrest can build a risk premium, offering long-term investors extra compensation while ‌they wait for normalization. But long-term buyers face strong headwinds. Short-term hedge funds hold a growing share of major bond markets, while France relies heavily on foreign capital, against the backdrop of a drawn-out political crisis ahead of April's presidential election.

LOOP THE LOOP The heart of the matter is that a divided French parliament can't pass the annual government budget plan needed to keep a lid on a ballooning budget deficit and debt pile.

If it can't muster agreement, Goldman Sachs thinks the wrangling could run well into December, and the annual budget gap could hit 6.4% of GDP. Even if the government succeeds in getting its €54 billion ($60.7 billion) savings package through, the deficit will ⁠still be 5% ​of GDP or more for a third year running, sending debt above ⁠120% of GDP for the first time — second only to Italy in the euro zone. Pension reforms that could have changed that picture were scrapped a year ago in the first budget standoff.

The bond market reaction has been to catapult French 10-year sovereign borrowing costs almost 1.4 percentage points higher since midyear and nearly doubled ⁠the 10-year spread over Germany to more than 150 basis points. The French 10-year discount to US Treasuries, meantime, has shrunk by 50 bps to less than 20 bps. That feeds back into budget calculations. Estimates now suggest these elevated borrowing rates may mean French annual debt-servicing costs alone could almost double ​from last year's 2.2% of GDP to 4% by 2030.

That puts even greater pressure on the annual primary deficit, which excludes servicing costs, if the overall deficit is to hit the euro zone's 3% target by 2030. Further fiscal pressure on ⁠the already slow-growing economy would also inflate debt-to-GDP ratios. French stocks have shuddered, losing 10% over two months, with leading bank stocks losing more than twice that.

French credit default swaps now suggest a sovereign credit rating four notches below the single A it has now — placing it in BBB territory, just above junk status and below Italy's. So ⁠much ​for the budget wrangling. The politics is even more complicated and the street unrest merely adds another twist.

Far-right presidential candidate Marine Le Pen appears to have the edge in opinion polling, but her likely runoff opponent come April will be far-left leader Jean-Luc Melenchon, who has advocated an effective default by cancelling French debt held by the Bank of France. Neither would thrill investors, given the political and policy tail risks involved. Whoever wins would then likely have to call snap parliamentary elections in June to seek a workable majority to ⁠tackle the budget.

Natixis' election primer cautions that it may be too early to rely on opinion polls this far out, citing many instances over recent decades in which early polling proved wide of the mark, particularly in a two-round system. It may yet ⁠be premature to rule out leading centrist Edouard Philippe, it says.

Either way, ⁠what candidates say about controlling the budget may now be as important as the outcome of the election itself. But if you're looking for a magic solution to this saga, prepare for a long, nervy wait.

(The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary.

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($1 = 0.8902 euros) (By Mike Dolan; Editing by Marguerita Choy)