The European Central Bank is facing growing speculation it could intervene if the French election sparks widespread market panic as policymakers prepare for an annual conference in Portugal next week.
French bonds have sold off in recent weeks as investors fear the far-right Rassemblement National Marine Le Pen or the left-wing Nouveau Front Populaire (New Popular Front) alliance will win a parliamentary majority in the upcoming elections.
A victory for one of the extreme poll-leading parties could lead to a deeper sell-off, with the spread of French government borrowing costs compared to Germany’s – a key measure of political risk – already at its highest level since the eurozone debt crisis. than ten years ago.
German Finance Minister Christian Lindner this week urged the ECB to stay away, warning that if it stepped in to mitigate any financial shocks after the French vote, it would “raise some economic and constitutional questions”.
But market watchers are scrutinizing the fine print of the ECB’s latest bond-buying scheme to see what it might do if the next French government starts spending, leading to damaging clashes with the EU and financial markets over its mounting debt.
Investors are particularly concerned that a wider sell-off in French debt could trigger contagion in other European countries, with national interest rates starting to diverge.
“Should the risk of fragmentation in France increase to an alarming level, the ECB would intervene as necessary to preserve the integrity of the euro,” said Sabrina Khanniche, chief economist at Pictet Asset Management.
Fabio Panetta, head of Italy’s central bank, said this week that the ECB should be “prepared to deal with the consequences” of shocks caused by “increasing political uncertainty in countries”.
The Italian also sits on the ECB’s Governing Council and added that the bank should be ready to use “the whole range of its tools”.
When the ECB announced a “transmission protection tool” two years ago – giving itself the power to help a country in crisis by buying an unlimited amount of its debt – most policymakers hoped it would keep markets under control without ever having to be used.
The French election threatens to provide the first test of the TPI, which was designed to “counter the unwarranted, disorderly market dynamics” that threaten the eurozone’s monetary policy.
But economists disagree on whether the proposal for the ECB’s as-yet-untested asset purchase scheme would prevent French bond purchases.
The central bank has set four criteria for TPI to be activated, and the first says that a country should be “in line with the EU’s fiscal framework”.
But the European Commission announced earlier this month that it would launch an “excessive deficit procedure” against Paris for a budget deficit of 5.5 percent of gross domestic product, well above the three percent limit under EU rules.
Some assume this means France is already out. “It would be illegal for the ECB to use the TPI in the case of France,” Eric Dor, professor of economics at the IESEG School of Management in Paris, wrote on social network X.
But ECB officials privately believe they have enough room to use the new system even if a country like France is officially judged to be in breach of EU fiscal rules. The central bank also said the four criteria would only be “input” into any decision by its governing board.
A key measure in deciding whether to activate the TPI is likely to be whether the market reaction is judged to be “untidy”.
The ECB’s chief economist, Philip Lane, hinted at this recently when he downplayed the sell-off in French markets that followed the election announcement, with investors “reassessing fundamentals” in contrast to what he called “disorganized market dynamics”.
If the next French government’s policies spook investors and cause a sharp but orderly revaluation of French assets, the ECB is unlikely to act, especially as officials hope market discipline will encourage countries to respect EU fiscal rules.
But if it causes widespread panic in the market, with investors selling indiscriminately not only French assets but also those of other highly indebted eurozone countries such as Italy, the central bank seems certain to act.
“I’m sure the ECB is already asking this question,” said Ludovic Subran, chief economist at German insurer Allianz. “If France goes into crisis, it means that Italy will probably also be in crisis and the ECB will have to act.”
In the past, such shocks have prompted the ECB to intervene. Former boss Mario Draghi made a memorable promise in 2012 to do “whatever it takes” to settle markets after the Greek debt crisis threatened to destroy the euro.
“If Italian spreads were to widen massively, the ECB could activate TPI to prevent the crisis from spreading to innocent bystanders,” said Christian Kopf, head of fixed income at German investor Union Investment Management. “But I feel like we’re still a long way from hitting the market like that.”
The results of the first round of French parliamentary elections are just about to be announced when ECB managers meet on Monday to open their annual exhibition event at a luxury hotel in Sintra, southern Portugal.
ECB President Christine Lagarde, herself a former French minister, is likely to be asked how she would respond to a potential financial crisis emanating from Paris.
Such questions can be treacherous. Lagarde slipped up in 2020 when she caused a bond market selloff by saying “we’re not here to close spreads” at the start of the pandemic.
The ECB president is likely to be much more cautious this time around, especially since the outcome of the election will not be known until after next weekend’s second round.