What will happen to Eurozone if Germany and France face a crisis?

While many analysts doubt a Greek-style situation for France, the euro is feeling the pressure even after we account for the weakness driven by the US election outcome.

To refresh memories, Greece had to be bailed out in the spring of 2010 as its debts soared in the wake of the global financial crisis. Government debt rose from just over 100% of GDP in 2007 to around 150% of GDP by the end of 2010; a huge and rapid increase. But Greece was not alone, as other countries such as Ireland and Portugal had to go cap-in-hand to the euro zone as well.

The region put together a number of initiatives to end the crisis, including a EUR750bn rescue plan in May 2010, but it was not until ECB president Draghi pledged to do “whatever it takes” to end the crisis with potentially unlimited bond purchases under the Outright Monetary Transactions (OMT) plan that the turnaround started.

This period saw huge increases in bond yields for the affected countries with Greek 10-year yields rising to near 40% at one point. The euro was impacted as well, falling from around 1.50 in late 2009 to the 1.20 area by the time Draghi delivered his “whatever it takes” rescue act. Although the euro was pressurized, it was clear that the vast bulk of the pressure fell on bonds, not the euro.

The reason for this owes much to the fact that eurozone governments issue debt but not currency; that’s issued centrally by the ECB. Such a separation means that, while government’s might play fast and loose with budget policy and so rack up huge debts, they cannot rely on a national central bank to print their way out of the difficulty. This leaves the bond market vulnerable but the euro relatively safe.

Should other small periphery countries in the euro zone get into similar difficulties again, we might expect the same sort of market impact, with bond yields soaring but relatively modest harm to the euro. But what if a ‘big’ country gets into difficulty, as France has done, for instance. Its problems lie in the fact that the government has no effective majority in parliament and cannot pass a budget as things stand.

PM Barnier has threatened to use a law that will enable the government to push through the budget without any parliamentary support but opposition parties, led by the far-right National Rally have threatened a no-confidence vote that could easily pull the government down. An added problem is that French election rules dictate that parliamentary elections cannot occur within a one-year period meaning that, if the government were to fall now, new elections would not be possible until next summer and that would turn up the heat on President Macron to resign.

In short, it is a mess, but is it one that could force a Greece Mark II? It seems unlikely, not least because France has not seen debt rise anything like as dramatically as we saw in Greece. The French debt-to GDP ratio has risen from around 100% of GDP before the pandemic to about 112%. There is also the issue of size, as France is so much bigger than Greece. This, plus the bailout mechanisms put in place by the euro zone since 2010, might make it hard for the bond vigilantes to strike the sort of decisive blow that we saw with Greece twelve years ago. But what if we are wrong? What if the market really attacks France, and perhaps even Germany as well given its budgetary and political travails?

The Standard Bank might conclude that yields will soar in these countries while the euro might prove less vulnerable for the reasons we mentioned earlier in the case of Greece. But size matters here. For if a large and integral country (or countries) is really challenged it might be seen as too big to bail and that, in turn, would mean a market focus not on a bailout but, instead, a pullout from EMU and that’s something that would surely have a massive impact on the euro. So, in some ways things are different this time to Greece in 2010.