French Budget Outlook

By Yoruk Bahceli

(Reuters) – Markets cautiously anticipate that France's budget may pass its fractured parliament, but remain skeptical about the speed of financial improvements, especially after Fitch downgraded the country's rating outlook.

France's government presented plans for €60 billion ($66 billion) in spending cuts and tax increases on Thursday, aiming to address a projected deficit exceeding 6% of GDP this year.

The budget plans, which were well-publicized, have kept the yield premium on French bonds over top-rated German bonds at around 77 basis points.

Danske Bank chief analyst Jens Peter Sorensen noted, "They will probably get it approved. But the path to get it approved is likely to be bumpy," forecasting volatility as parliament discusses the budget. The budget squeeze, representing 2% of national output, needs careful calibration to appease opposition parties that could unite against Prime Minister Michel Barnier's minority government.

Such uncertainty has kept the French/German bond spread near a peak of 85 bps, matching the highest observed since the eurozone debt crisis, highlighting concerns about France's financial state following a recent snap election.

Passing this budget and stabilizing state finances is vital for restoring investor confidence and avoiding further credit downgrades. Fitch Ratings recently revised France's AA- rating outlook to negative, indicating a potential downgrade.

Fitch cited a higher-than-expected deficit and political fragmentation as major concerns. Meanwhile, both Citi and Goldman Sachs indicated that the budget is likely to pass, possibly through the government's use of special powers to avoid a parliamentary vote.

The reaction of Marine Le Pen's far-right National Rally party, which previously supported the government, remains crucial. Le Pen has acknowledged the need for tax increases but insists that they must be balanced with spendable income for the lower and middle classes.

Some investors believe the far right may refrain from derailing the budget in light of upcoming elections. Chris Jeffery from Legal & General Investment Management suggested that the party’s aim would be to enhance its credibility among voters rather than resist the budget.

Market concerns linger over France’s ability to reduce its deficit in the proposed timeframe. While the government aims to cut it from 6.1% this year to 5% next year, analysts view these projections as overly optimistic. Fitch anticipates a 5.4% deficit for 2024 and 2026, adjusting its outlook based on political instability and implementation risks.

Barnier is open to amendments from lawmakers but has indicated a cautious approach to extensive changes. The focus remains unclear on how the government will effectively reduce expenditures, as highlighted by recent backlash against proposals like delaying pension adjustments.

The projected growth headwinds from these austerity measures further complicate the fiscal outlook. Economists caution that the government’s revenue forecasts might be overly optimistic and that these assumptions could shift significantly.

Ratings Pressure

Attention will be on ratings, particularly with Moody’s, which has assigned France a higher score (Aa2) compared to its counterparts, reporting on October 25. France had faced a downgrade by S&P to AA- in May.

Despite these challenges, markets have begun to account for lower ratings already. France’s bond yields are now higher than Spain’s, despite France’s comparatively better ratings.

The situation's ongoing challenges put France at risk of losing its core country status within the euro area, according to Christian Kopf of Union Investment. Concerns also persist regarding the stability of Barnier's government in the long term as it aims to meet a 3% deficit target by 2029. “We are not sure that this government will last more than 10 or 11 months. So what is the credibility of this government to talk about the deficit in five years?” Candriam's Forest remarked.