Fulcrum of Europe is starting to look less stable

A striking landmark was reached in the eurozone’s sovereign debt markets this week. Investors are now charging a higher premium to the French government for holding its bonds compared with the former bailout nations of Spain and Greece.
The yield on France’s ten-year debt, which reflects the government’s borrowing costs, has climbed to 2.97 per cent, above Spain’s 2.95 per cent. It is the first time that French bonds have eclipsed those of Spain since before the financial crisis hit in 2007.
In further ignominy for the eurozone’s second largest economy, the yields on its five-year bonds are 2.56 per cent, higher than the 2.38 per cent on equivalent Greek debt, a feat that until now hadn’t happened since the start of the single currency 23 years ago.
The diverging performance of Europe’s sovereign bonds reflects a new truth about the single currency area. Its largest and formerly mightiest economies, France and Germany, have become its weakest links, often at the expense of a resurgent south.
• Bond yields reach highest levels since Liz Truss mini-budget
The climb in French bond yields this week coincided with a spate of recessionary warnings and worrying data from Germany, the traditional growth powerhouse of the Continent. New figures for September showed that Germany’s manufacturing downturn has deepened, with industrial output at its lowest since 2020. A measure of business confidence also has declined to the weakest level since the start of the year, putting Germany on the brink of a recession again after growth fell outright in 2023.
According to Carsten Brzeski, global head of macroeconomics at ING, the Dutch bank, Germany is in the throes of a “macroeconomic nightmare” marked by slowing economic growth, industrial malaise, a weakening labour market and the prospect of unprecedented factory closures by Volkswagen, the carmaker. The economic gloom has been coupled with political anxiety after regional electoral triumphs for the country’s hard right this month, reflecting growing discontent at Berlin’s three-party coalition government. It is “a perfect vicious cycle”, Brzeski said.
Germany’s travails, in contrast with the steadily improving fortunes of southern member states, were underlined this week when Olaf Scholz, the chancellor, lashed out at UniCredit, the Italian group that steadily has built up its stake in Commerzbank, Germany’s second largest lender. Scholz called the covert stake-building an “unfriendly attack” by Italy’s largest bank, which wants to scoop up cross-border assets to become one of the Continent’s biggest financial institutions.
Germany and France are two of the five founding members of the European Union and together they make up 40 per cent of the bloc’s economy. Despite having expanded to include 27 member states, the Franco-German relationship remains the fulcrum of the project, reflecting the union’s origins as a postwar peace endeavour. It has become a truism to say that Franco-German consent is a necessary condition for getting anything done in the EU.
The two countries have boasted complementary assets, Germany’s size and economic might being set against France’s diplomatic clout, nuclear weapons and its seat on the United Nations’ Security Council. In the past two years, though, diplomatic relations between Paris and Berlin have worsened after disputes over energy and financial policy, defence and Israel’s war in Gaza. Meanwhile, Scholz and President Macron are engulfed in their own domestic political woes and economic headaches.
The recent rise in French bond yields, which pushes down the value of the assets, was triggered by a warning from the country’s new finance minister that the government’s deficit was likely to be worse than estimated at above 6 per cent of GDP this year. This would make it the highest in the single currency area and far above an already revised 5.5 per cent estimate made last month.
France has cobbled together a fragile minority government, led by Michel Barnier, a former European commissioner, who was cherry-picked by Macron to end a three-month impasse after snap elections delivered no outright winner in July. Barnier has the unenviable task of delivering a draft budget by October 9 that satisfies a divided parliament, financial markets and the European Commission. The latter two want to see significant attempts at fiscal consolidation to chip away at the deficit, while the far left is resisting spending cuts and controversial pension reforms and the hard right has rejected further tax rises.
With the budget up in the air and amid the prospect of imminent ratings downgrades, analysts at Barclays are advising investors to continue buying Spanish debt at the expense of France. Spain’s debt ratio is projected to fall over the rest of the decade, but that of France is on course to rise to more than 115 per cent of GDP, according to the International Monetary Fund. France also will record the largest net bond supply in a single year by any sovereign since the euro started, with an estimated €220 billion needing to be absorbed by the market in 2025.
As France wrestles with its public finances and a caretaker government, Germany is suffering from structural economic woes that have decimated its export-oriented industrial model, which for decades was powered by cheap Russian gas and insatiable Chinese demand for German wares.
Economists warn that Europe’s largest country is also ageing at one of the fastest rates in the developed world and is most exposed to the fracturing of global trade and tariff protectionism. In addition, China has transformed from being a destination for high-end German goods to a rival that is developing its own advanced manufacturing technologies, such as electric cars and renewables.
“We are seeing some permanent closures of German industries that shifted their production to regions such as China and the United States, where energy prices are lower, labour costs are lower or the policy backdrop is more supportive,” Guillaume Jaisson, at Goldman Sachs said.
Germany is on course to be one of the worst-performing big economies in the world this year, with estimates for growth in a range of -0.1 per cent to -0.3 per cent. Compare that with the likes of America, Britain and Spain, where growth is on course to accelerate over the next two years.
Policy solutions are in short supply. Paris could be stuck in years of political paralysis, since no election can be called before 2027. In Berlin, government attempts to revive the economy through expansive fiscal policy are hemmed in by a constitutional debt brake that limits the federal deficit to 0.35 per cent of GDP.
In the absence of political remedies, the European Central Bank is likely to be forced to cut interest rates more aggressively to help to prop up its two biggest member states. The ECB has lowered its borrowing costs twice this year and could carry out an outsized half-percentage-point cut in December, according to analysts at Deutsche Bank. The German bank thinks that borrowing costs will fall from the present 3.5 per cent to a low of 2 per cent by the middle of next year, much more quickly than the rate generally expected by the markets at the moment.
“There are no signs that the recent weak patch of data is ending,” Mark Wall, chief economist at Deutsche Bank, said. “There are potentially three negative stories playing out: a drag on Germany from weak competitiveness; a drag on France from political and fiscal uncertainty; and a drag on Italy from the fading of the ‘superbonus’ stimulus.”