More Thoughts on the Importance of the French Elections

The French premium over Germany rose today to a three-month high. Rumors of a rating downgrade proved wide of the mark, but it reflects the market's anxiety about the outlook for France going forward.

As we have argued, the challenges of the euro zone are not limited to the old periphery of Greece, Ireland and Portugal. Clearly, Spain and Italy are problematic, albeit to varying degrees. Yet the contagion is reaching deeper into the core, and this is evident not only in France, but also the Netherlands, where Fitch issued cautionary remarks yesterday; warning that it could lose its coveted triple A status.

The choice confronting French voters is not as the partisans would have it as a choice between the status quo and change. Even the re-election of Sarkozy does not mean continuity. The key fact that the French political elite have to come to grips with is the divergence between France and Germany.

Although we can focus on the relative macro performances and the relative strength of the banks, an issue that captures the divergence is China. China will likely replace France as Germany's largest trading partner this year. Germany has an estimated 5-times more businesses operating in China than France does.

In a word, France has different interests than Germany. Germany wants less ECB and France--both the campaigning Sarkozy and Hollande-- want more ECB. Sarkozy and Hollande, like Germany's SPD, appear considerably more sympathetic to a joint bonds. Sarkozy and Hollande seem to see benefits of a weaker euro, while the euro is already weaker than Germany would prefer.

The fact that nearly a third of the electorate appear to support candidates that want to leave monetary union needs to be understood in the context of French politics, and in the first round, the protest value of the vote is emphasized. Barring a major surprise, voters will have a choice in the second round between Sarkozy and Hollande.  Hollande is likely to draw more of the protest vote in the second round. Hollande has been consistently polling ahead of Sarkozy in the decisive round.

From a non-partisan analytic point of view, Sarkozy seems to want to manage the relative decline of France, while Hollande seems to be in denial; not accepting the limits of the French economy and the constraints of what Thomas Friedman called the "golden straightjacket".

Hollande wants to raise taxes on the wealthy, high income and banks and wants to spend more on the agricultural budget, create 60k teaching positions, and subsidies 150k jobs for young people. He wants to boost state spending by 20 bln euros by 2017, even as France's public spending as a percent of GDP is the largest among the high income countries.

Sarkozy's transformation has been profound. He ran the first time as the French equivalent of Thatcher and over the course of his term became increasing Gaullist in some respects. Over the decades, the French strategy has been to tie Germany into a network of relationships and commitment to keep its future inextricably linked to Europe's. Sarkozy has instead tried tying France's wagon to the German engine. Repeatedly throughout the crisis, Merkel has appeared to run circles around Sarkozy.

There has been no ECB backstop for sovereigns and the bond purchase scheme of the former French head of the ECB has gone to the wayside, after triggering the resignation of not one but two German representatives on the ECB. Germany has also successfully blocked proposals for a joint bond.

The premium France pays over Germany eased a little as it became clear that there was no downgrade forthcoming. However, at 137 bp the spread is still the widest since early January. The 5-year CDS is also at its highest level since mid-January.

Regardless of the outcome of the French presidential election, there is not going back to Paris-Berlin parity and the risk is that instability and uncertainty in Europe increases going forward. In the current environment, higher volatility is likely to be associated with a weaker euro.