France is losing its sanity premium as chaos reigns

France's debt burden, political instability, and looming far-right challenge are causing markets to question whether the country can govern itself. For most of the euro's history, investors believed France would navigate its challenges and remain a safe bet. However, this perception is no longer holding true.

The French 10-year bond has recorded its worst quarterly performance since the birth of the single currency, with the spread over the equivalent German Bund reaching 145 basis points - a level last seen during the depths of the eurozone crisis. This week, the spread over the German Bund touched a level not seen since the eurozone crisis.

The primary reason for this deterioration is simple budgetary arithmetic. Markets had expected fiscal consolidation, but instead, the deficit has widened, now forecast to be at least 5.12%. Public debt is now almost 120% of GDP, almost double that of Germany. Interest payments on this debt have surpassed what France spends on defense or education.

Politically, France is in gridlock. Markets tolerate high debt when they believe a government can manage it, but they cannot tolerate the perception that no one is in charge. France is increasingly rudderless, with the government unveiling spending cuts aimed at reducing the deficit, but facing a fractured National Assembly that has regularly toppled prime ministers since the 2024 snap election. With four governments in under a year, investors question whether Paris can govern itself.

The public mood is darkening as debt climbs the list of voter concerns, bond yields dominate the news, and student protests over deteriorating schools have erupted into violent clashes with police. Domestic pressures are compounded by external factors, such as rising energy prices and the European Central Bank's threat of further interest rate hikes to combat inflation.

The economic costs of political turmoil extend beyond France. The political instability could spread through bond market contagion, weakening the already battered fiscal rules of the eurozone and eroding institutional stability. At a time when Germany is also facing political strain with the rise of the far-right Alternative for Germany (AfD), France's situation could further destabilize the European Union.

France's size and importance mean its economic troubles will not remain domestic. A disorderly repricing of French debt could spread through bond markets, weakening the euro and undermining European integration. While President Emmanuel Macron's far-right challenger, Marine Le Pen, is unlikely to take France out of the euro or EU, she could erode European integration from within, acting as a Trojan horse in Brussels.

The EU may struggle to cope with Viktor Orbán, so managing a similar destructive figure within its traditional engine of integration and second-largest economy poses an even greater challenge.