Uncertain Winds

The surprise snap general elections called by the French President have affected markets beyond French borders. Sovereign spreads have widened in the Euro area periphery as well as in France. There are no immediate existential threats to the monetary union – far-right Rassemblement National, which firmly holds the top position in the polls after its victory in the European elections, no longer wants France to exit monetary union – but uncertainty over the macro-financial outcome on 7 July is high as fiscally spendthrift agendas from both the far-right and the left alliance compete with the more orthodox offer from the struggling incumbent centrist majority. We walk our readers through the quirks of the French electoral and institutional system. Based on the few relevant polls, the most likely scenario is a hung parliament. We explore how France could operate without a majority, especially from the point of view of its capacity to pass a budget, a key concern given the recent downgrade of French public debt by S&P. France has much more capacity than the US to avoid “government shutdown” situations. Yet, a proper majority would be needed to deliver the significant discretionary fiscal correction measures implied in the current French Stability Programme. We also explore the scenario with the second highest probability according to the polls, i.e., a RN-led government. The outcome would essentially depend on whether such administration would focus on “social/cultural issues” while taking little risk with economic policy – the “Meloni model” – or try to deliver on its spendthrift 2022 manifesto.

There has been some discussion about what the ECB could do if spreads continue to widen. This is where the collision with Brussels could materialise. Indeed, for the ECB to deploy its TPI tool, compliance with the EU fiscal surveillance framework would be needed, always a challenge for a populist government. For now, the decline in long-term interest rates in the US and globally, triggered by another month of good news on the US inflation front, offers some protection. Separately, the populist push in France and Europe as a whole cannot not have an impact on Brussels policy. This makes the Commission’s targeted approach to imports of EVs from China even more delicate.