Political stagnation will increase economic risks in France

One thing was clear after the surprise results of Sunday’s French election: Any new government formed by President Emmanuel Macron will face months of political paralysis. Less certain is whether that gridlock will push France’s debt-ridden economy further into distress.

The unrest has once again highlighted France's ballooning debt of €3 trillion and a deficit that has grown to more than 5 percent of economic output, prompting Standard & Poor's to immediately issue a warning on Monday about France's sovereign debt rating.

The agency, which had already downgraded France’s debt rating on May 31, said “uncertainty looms over the future of the French government structure,” unnerving a government whose economic credibility has been one of its most important political assets. If polarization in the new French parliament weakens the government’s ability to fix its finances, France’s debt could be downgraded again, the agency added.

France faces uncharted territory after left-wing parties made an unexpected surge in national legislative elections, edging out the anti-immigration National Rally to secure the most seats in the lower house of parliament. The result left no party — including Mr Macron’s centrist coalition — with a majority and split the lower house into three bitterly opposed blocs.

The French economy was already going through a tough patch. Unemployment, which fell last year to a 15-year low of 7%, is rising again as manufacturers cut production and exports slow. Consumers, fed up with persistent inflation, are cutting back on spending, the main driver of growth.

Mr. Macron’s government recently warned that growth would be weaker than expected this year as it looks to cut spending by more than 20 billion euros (about $21.5 billion). The European Union rebuked France late last month for flouting fiscal rules that restrict spending and borrowing. France’s debt has soared to more than 110 percent of economic output and it has a big budget deficit after the government spent heavily to protect consumers and businesses from pandemic-related lockdowns and soaring energy prices.

Macron’s opponents on both the right and left have used the debt issue to attack him during their election campaigns. But the main parties are in no mood to reach a consensus, and investors are worried that the new parliament may fail to pass a budget in the fall that includes deep spending cuts and avoids the risk of further French sovereign debt downgrades.

“Once the dust settles, the pending parliamentary deadlock will prove more damaging than initially anticipated,” Alex Everett, investment director at Aberdeen, a London-based investment firm, wrote in a note to clients. “France’s budget problems have not gone away. Macron’s attempt to impose unity has instead fueled further discord.”

Investors have already pushed up the government’s borrowing costs. The spread between the interest rates that investors charge on French debt and those of Germany has widened to its widest since the financial crisis, a sign that investors are worried about France’s ability to manage its finances. The risk is that French debt will grow even larger, which could lead to faster rises in interest payments.

The picture is further complicated by the left-wing alliance, the New Popular Front, which won the largest number of seats in the lower house on Sunday. The party, a bloc that includes communists, Greens and socialists, seeks to impose “heavy taxes on the rich and redistribute wealth.” agenda Inspired by the far left, France Insoumise has said it is prepared to challenge EU fiscal rules if necessary to implement its programme.

Indeed, unless the government raises taxes on corporations and the wealthy, the left-wing bloc is likely to reject any national budget that honors France’s pledge to Brussels and ratings agencies to cut the deficit next year to 4.4% of GDP, from 5.1%, Mujtaba Rahman, managing director of Eurasia Group in Europe, wrote in an analysis. The group would also seek to boost spending on education and health care and perhaps push for a rise in France’s minimum wage, he added.

But the left, while bold, will lack overall control, so their agenda has little chance of approval. This has eased concerns among some investors about the economic cost of the New Popular Front’s spending program. The cost is estimated at €187 billion a year, a total that would be supported by tax increases on corporations and wealthy individuals of up to €150 billion, and the elimination of a variety of corporate tax breaks.

“A hung parliament is likely to be the best solution for European equities,” said Claudia Panseri, chief investment officer for France at UBS Global Wealth Management.

On Monday, Macron’s finance minister, Bruno Le Maire, warned in a post on X that the left-wing bloc’s economic program could push France into a financial crisis and economic decline. “It would destroy the results of the policy we have pursued for seven years, which has given France jobs, attractiveness and factories,” he said.

The legislative deadlock “spells the end of Macron’s pro-growth reforms,” said Holger Schmieding, chief economist at Berenberg Bank. Macron’s centrist coalition may instead have to accept a rollback of some of his key initiatives — possibly including his move to raise France’s retirement age to 64 from 62, which sparked nationwide protests in 2022, he added.

Such repercussions and dissatisfaction among global investors are likely to dampen growth and increase inflation in France in the long run, Mr Schmieding added. “Along with a possible downgrade, this would raise financing costs and exacerbate France’s financial problems,” he said.