France, not Italy, emerges as the next potential debt crisis hotspot as Macron’s French centrists face election drubbing

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The Italian government, led by Prime Minister Giorgia Meloni, can be forgiven for a bit of schadenfreude. For once, it is France, not Italy, that is emerging as the European Union’s main economic trouble spot. France’s political drama – the country goes to the polls on Sunday to start the two-round parliamentary election – could well intensify the risk of a crisis in the bloc’s second-largest economy.

Among the largest EU economies, debt-soaked, reform-allergic Italy has the dubious distinction of being the traditional basket-case-in-waiting.

In 2012, during the peak of the euro-zone crisis, then European Central Bank boss Mario Draghi declared that he would do “whatever it takes” to keep the euro zone intact. While the pledge was aimed at preventing Greece from defaulting and bolting from the euro zone as its finances deteriorated at an alarming rate, the barely hidden agenda was to keep Italy from unravelling as its bonds plunged in value, sending their yields soaring.

At one point during the debt crisis, yields on Italian 10-year debt were 5.6 percentage points north of Germany’s, traditionally the bloc’s safest sovereign bonds. No one feared back then that Greece could pose an existential threat to the euro zone. Italy, a G7 economy equipped with one of the world’s biggest bond markets, certainly could.

Today, the focus is on Paris, not Rome. The headline numbers tell the story.

France’s primary deficit (the budget deficit less interest payments on debt) is about 2.6 per cent of GDP. Italy is running a small primary surplus. France’s overall budget deficit will hit 5.1 per cent in 2024. Italy’s is expected come in at 4.3 per cent. In Italy, inflation is about half of the 2.5 per cent rate that France recorded in June. Italian and French unemployment rates are roughly the same, at just more than 7 per cent. France is running a hefty trade deficit. Italy is running a hefty trade surplus.

Investors still consider Italian debt a greater risk that France’s. But that could change as the expensive Italian debt issued during the debt crisis rolls over at cheaper interest rates, and French economic and political risk rises as Marine Le Pen’s far-right National Rally (RN), currently topping the polls, shows a credible chance of winning the election. (The second round of voting is July 7.) Already, the yields on the debt of Portugal, one of the debt crisis’s bailout victims a dozen years ago, are slightly lower than France’s.

Mr. Macron’s liberal, centrist Renaissance party lost the European elections earlier this month – badly so – triggering his call for a snap election. Some political pundits considered the move suicidal, given Mr. Macron’s sinking ratings, and the rising popularity of the RN and the left-wing coalition called the New Popular Front, composed of firebrand Jean-Luc Mélenchon’s France Unbowed, the Socialist Party, the French Communist Party and the Greens.

Recent polls put the New Popular Front not far behind Ms. Le Pen’s party, and both are well ahead of Mr. Macron’s. He is evidently gambling that French voters will have second thoughts about endorsing the political extremes once they enter the polling booth, and stick with his centrists. The polls say the opposite.

There is no election scenario that will reduce France’s political and economic risk profile, at least in the near term, barring an unlikely win by the centrists. While Mr. Macron will remain President no matter who rises or falls in the National Assembly, his mandate will be largely reduced to foreign and defence matters; he will lose control of the domestic agenda, which would be controlled by the new prime minister appointed by the winning party or coalition.

A parliament dominated by political extremists could turn into a dysfunctional political mess. One dominated by the far right or far left parties could lead to a debt crisis, a scenario that Bruno Le Maire, France’s Finance Minister, has warned about. Both the left and the right are trotting out unfunded spending programs that could raise both the budget deficit and the debt.

Ms. Le Pen’s RN, for instance, has promised to cut the value-added tax on fuel and energy and to reverse Mr. Macron’s increase in the pension age. Her party would send it back to 62 from 64. Various economists and analysts have estimated that those two policies alone could cost as much as €30-billion ($44-billion) a year. The alliance on the left, meanwhile, wants to raise the monthly minimum wage and impose price ceilings on electricity, natural gas, gasoline and essential foods. These policies and others amount to a potential “fiscal drubbing,” Prime Minister Gabriel Attal said.

Unfunded spending could send French bond yields soaring. With a debt-to-GDP of 110 per cent – and climbing – the possibility of a debt crisis could not be ruled out. On Friday, investors hit the road in the expectation that Ms. Le Pen’s party will emerge victorious in the election. French bond yields climbed and the benchmark CAC 40 stock index sank to its lowest level since January.

A French debt crisis in the next year or two could not be contained, given the size of the economy and the country’s banking and investment connections with the rest of Europe. The contagion could easily spread over the Alps and into Italy. In the meantime, Italy is thrilled that the crisis spotlight is shining on France this time, not itself.