Speculation is growing that the European Central Bank (ECB) could intervene if the French election causes widespread market panic, as policymakers prepare for their annual meeting in Portugal next week.
French government bonds have been selling off in recent weeks as investors worry that Marine Le Pen’s far-right National Rally party or the left-wing New Popular Front coalition will win a majority in parliament in the next election.
The success of one of the far-right parties leading the polls could lead to further stock selling.The gap between the French government’s borrowing costs and Germany’s, a key indicator of political risk, is already at its highest since the euro zone debt crisis more than a decade ago.
German Finance Minister Christian Lindner this week urged the ECB to stay on the sidelines, warning that intervening to ease financial turmoil after the French vote would “raise economic and constitutional questions.”
But market participants are scrutinizing the fine print of the ECB’s latest bond-buying plan to gauge how the ECB might respond if the next French government embarks on a spending spree that leads to a damaging clash with the EU and financial markets over growing debt.
In particular, investors are concerned that a broader sell-off in French government bonds could spread to other European countries, causing interest rates to start diverging.
“If the risk of a breakup in France rises to alarming levels, the ECB will intervene if necessary to preserve the integrity of the euro,” said Sabrina Kanish, senior economist at Pictet Asset Management.
Fabio Panetta, governor of the Bank of Italy, said this week that the ECB “must be prepared to deal with the consequences” of a shock caused by “increased political uncertainty in various countries.”
He is also a member of the ECB’s governing council and added that the bank should be ready to use “all tools”.
When the ECB unveiled its “contagion protection tool” two years ago, giving it the power to support crisis-hit countries through unlimited debt purchases, most policymakers hoped it would be able to rein in markets without having to use the tool.
The French election could be the first test for the TPI, which aims to “counter unfair and disorderly market trends” that threaten euro zone monetary policy.
But economists are divided on whether the design of the ECB’s untested asset-purchase program would prevent it from buying French government bonds.
The central bank has set four criteria for activating the TPI, the first of which states that a country must be “compliant with the EU fiscal framework”.
However, earlier this month the European Commission announced it was launching an “excessive deficit procedure” against France, finding that the country had a budget deficit of 5.5% of its gross domestic product, well above the EU-regulated 3% limit.
Some have speculated that this means France is already excluded. “In the case of France, it would be illegal for the ECB to use the TPI,” Eric Dole, a professor of economics at the IESEG School of Management in Paris, wrote on social media site X.
But ECB officials are privately confident that there is plenty of room for a country like France to use the new system, even if it is officially found to be in breach of EU fiscal rules. The ECB also says the four criteria are only a “reference” for Governing Council decisions.
A key criterion in deciding whether to invoke the TPI will be whether the market reaction is deemed “disorderly.”
ECB chief economist Philip Lane recently downplayed selling pressure in the French market after the election results were announced, saying investors were “reassessing fundamentals,” contrasting this with “disorderly market movements.”
If the policies of France’s next government scare investors and trigger a sharp but orderly revaluation of French assets, the ECB is unlikely to act, especially since officials hope market discipline will encourage countries to respect EU fiscal rules.
But if a full-blown market panic were to occur, with investors indiscriminately selling not only French assets but also those of other highly indebted euro zone countries such as Italy, the central bank would surely be forced to act.
“The ECB must already be asking itself this question,” said Ludovic Subran, chief economist at German insurer Allianz. “If France is in crisis, Italy is likely to be in crisis too and the ECB will have to act.”
Such shocks have forced the ECB to step in before: In 2012, former president Mario Draghi made a dramatic promise to “do whatever it takes” to calm markets after the Greek debt crisis threatened to bring the euro to its knees.
“If Italian spreads widen significantly, the ECB could trigger TPI to prevent the crisis from spreading to uninvolved bystanders,” said Christian Kopf, head of fixed income at German investment firm Union Investment Management L.P. “But my sense is that we’re still a long way from such market intervention.”
By the time ECB officials meet on Monday to kick off their annual event at a luxury hotel in Sintra, southern Portugal, the results of the first round of France’s parliamentary elections will be announced.
ECB President Christine Lagarde, a former French minister, is sure to be asked about how to respond to a potential financial crisis emanating from Paris.
Such questions can be dangerous: In 2020, Ms. Lagarde made a gaffe at the start of the pandemic when she said, “We are not here to close spreads,” sparking a sell-off in bond markets.
The ECB President is likely to be more cautious this time around, especially since the election outcome will not be known until the second round of voting next weekend.
