The European Central Bank is facing mounting speculation that it could intervene if the French election triggers widespread market panic, as policymakers prepare for their annual conference in Portugal next week.
French bonds have been sold off in recent weeks as investors fear that Marine Le Pen’s far-right Rassemblement National or the leftwing Nouveau Front Populaire (New Popular Front) alliance will win a parliamentary majority in the upcoming elections.
The success of one of the extreme parties leading opinion polls could lead to a deeper sell-off, with the spread on French government borrowing costs relative to Germany’s — a key measure of political risk — already at the highest level since the Eurozone debt crisis more than a decade ago.
Germany’s finance minister Christian Lindner this week urged the ECB to stay on the sidelines, warning that if it stepped in to ease any financial turmoil following the French vote, it would “raise some economic and constitutional questions”.
But market-watchers are checking the fine print of the ECB’s latest bond-buying scheme to see what it could do if the next French government goes on a spending spree that leads to damaging clashes with the EU and financial markets over its rising debt.
In particular, investors fear that a wider sell-off in French debt could spark contagion in other European countries, with national interest rates starting to diverge from each other.
“If the risk of fragmentation in France were to increase to alarming levels, the ECB would intervene as necessary and preserve the integrity of the euro,” said Sabrina Khanniche, senior economist at Pictet Asset Management.
Fabio Panetta, the head of Italy’s central bank, said this week that the ECB should be “prepared to deal with the consequences” of shocks caused by “an increase in political uncertainty within countries”.
The Italian also sits on the ECB governing council and added that the bank should be ready to use its “full range of tools”.
When the ECB announced the “transmission protection instrument” two years ago — giving itself the power to help a country in crisis by buying unlimited amounts of its debt — most policymakers hoped it would keep markets in check without ever needing to be used.
France’s election threatens to provide the first test of the TPI, which had the aim “to counter unwarranted, disorderly market dynamics” that threaten Eurozone monetary policy.
Economists disagree, however, over whether the design of the ECB’s still untested asset-purchase scheme would prevent it from buying French bonds.
The central bank has set out four criteria for activating the TPI and the first says that a country should be in “compliance with the EU fiscal framework”.
However, the European Commission announced earlier this month it would open an “excessive deficit procedure” against Paris for running a budget deficit of 5.5 per cent of gross domestic product, well above the 3 per cent limit under EU rules.
Some assume this means France is already excluded. “It would be illegal for the ECB to use the TPI in the case of France,” Eric Dor, an economics professor at the IESEG School of Management in Paris, wrote on social media site X.
Yet ECB officials are privately confident they have enough wriggle room to use the new scheme even if a country like France is officially judged to be breaching EU fiscal rules. The central bank has also said the four criteria would only “be an input” into any decision by its governing council.
The key yardstick in deciding whether to activate the TPI is likely to be whether the market reaction is judged to be “disorderly”.
ECB chief economist Philip Lane hinted at this recently when he downplayed the sell-off in French markets that followed the election’s announcement as investors “reassessing fundamentals”, contrasting it with what he called “a disorderly market dynamic”.
If the policies of France’s next government spook investors and cause a sharp but orderly repricing of French assets, the ECB is unlikely to act, especially as officials hope market discipline will encourage countries to respect the EU’s fiscal rules.
But if it causes a full-blown market panic with investors indiscriminately selling not just French assets but those of other high-debt Eurozone countries like Italy, the central bank seems certain to act.
“I’m sure at the ECB they are already asking themselves the question,” said Ludovic Subran, chief economist at German insurer Allianz. “If France goes into a crisis then it means Italy is also likely to be in a crisis and the ECB will have to act.”
In the past, such shocks have prompted the ECB to intervene. Former chief Mario Draghi made a memorable promise in 2012 to do “whatever it takes” to settle markets after a Greek debt crisis threatened to destroy the euro.
“If Italian spreads were to widen massively, the ECB could activate TPI to prevent a crisis from spreading to innocent bystanders,” said Christian Kopf, head of fixed income at German investor Union Investment Management. “But my sense is that we’re still a long way from such market intervention.”
When ECB executives meet on Monday to start their annual showpiece event at a luxury hotel in Sintra, southern Portugal, the results of the first round of the French parliamentary election will have just been announced.
ECB president Christine Lagarde, herself a former French minister, seems certain to be quizzed about how it would respond to a potential financial crisis stemming from Paris.
Such questions can be treacherous. Lagarde slipped up in 2020, when she caused a bond market sell-off by saying at the start of the pandemic “we are not here to close the spreads”.
The ECB president is likely to be much more cautious this time, especially as the outcome of the election will not be known until after the second round next weekend.
