French-German bond spread hits widest since 2012 debt crisis

France is fast becoming the epicenter of a new European debt scare. The spread between French and German 10-year government bond yields widened to around 85 basis points in early September, approaching levels not seen since the euro zone debt crisis of the early 2010s. With public debt topping 117.5% of GDP and the economy stalling, investors are reassessing the risks of holding French sovereign debt just as the European Central Bank prepares to raise interest rates again.reuters+1

A Fiscal Storm With No Political Fix

French public debt exceeded 3.5 trillion euros in the first quarter, and the International Monetary Fund projects the ratio will surpass 120% by 2027. Growth contracted 0.2% in the first quarter and was flat in the second, leaving the government with a shrinking base from which to service its obligations.sedaily

Rather than addressing the deterioration, French politicians are focused on next year's presidential election. Far-right leader Marine Le Pen has pledged 125 billion euros in spending cuts while promising to lower the retirement age to 62. On the left, Jean-Luc Mélenchon of France Unbowed has proposed a more radical solution: having the Bank of France simply cancel its holdings of French government debt. "All we have to do is take the 18% held by the Bank of France and chuck it in the fire," Mélenchon said on the campaign trail, according to Reuters Thomson Reuters Corporation ↘ 4.44%.reuters

The proposal drew a sharp rebuke from Bundesbank President Joachim Nagel, who told Le Monde that no central bank in the Eurosystem is permitted to cancel national debt, calling such action monetary financing of governments — a practice barred by European treaties that could trigger hyperinflation.fortune+1

Foreign Investors and Japan's Shadow

What makes France particularly vulnerable is its heavy reliance on foreign capital. Outside investors held 57.5% of French government bonds in the first quarter, far above the roughly 32% share for U.S. Treasurys or U.K. gilts. Analysts at ABN AMRO estimate that about 35% of French bondholders are highly sensitive to price moves, meaning even a modest pullback in foreign buying could amplify volatility.sedaily

Japan's Government Pension Investment Fund, the world's largest pension fund, is a particular concern. GPIF held French bonds valued at about 5.8 trillion yen as of its March disclosure, second only to U.S. debt in its foreign bond portfolio. Speculation that Tokyo may revise GPIF's asset allocation to support the weakening yen has rattled markets. Finance Minister Satsuki Katayama said in June that authorities "could consider adjusting the asset allocation of public pensions".sedaily

ECB Rate Hike Adds Pressure

The ECB is widely expected to raise its deposit rate by a quarter point to 2.50% at its September 10 meeting, according to a Reuters poll in which all 65 economists surveyed predicted the move. Euro zone inflation jumped to 3.3% in August, well above the 2% target. A third hike in December remains a possibility, which would further increase borrowing costs across the bloc. "I do think France is heading toward a crisis, even if not right away," John Stopford, head of multi-asset income at Ninety One, told CNBC.reuters+1