France’s budget deficit hit 5.8% of its GDP in 2024, a level that French Prime Minister François Bayrou has stated represents a danger to the country. In an attempt to reduce the deficit, in July he announced  close to €44bn of budget cuts. These plans have proved highly unpopular, with mass protests backed by the unions and the far left planned for 10 September.

In response, the Prime Minister has called a vote of confidence on his fiscal plans. Should he lose, he has said he will resign. 

Why has he taken this decision? He would have been minded of the agonising downfall experienced by Michel Barnier’s government last year, when months of parliamentary debate to agree a budget ultimately proved futile . In a parliament of significant fragmentation and no clear majority, agreeing a budget against a backdrop of a worrying deficit was never going to be easy. As such, he has decided to risk everything on one vote.  

While the general consensus is that Bayrou will lose the vote, there are several possible outcomes, some of which we consider below. All will have implications for investors in French government bonds.

Scenario 1: Prime Minister Bayrou wins the vote (NatWest assigned probability: 15%)

If the government wins the vote we would expect French government bond (OAT) spreads relative to German Bunds to tighten on the news. However, a premium would remain embedded as the situation would probably remain fragile and the likelihood of the government surviving the winter still very low. We would only turn neutral or positive on French government bonds if Bayrou is able to pass a budget after surviving the confidence vote.

Scenario 2: Prime Minister Bayrou loses the vote (probability: 85%)

If the government loses the vote, President Macron has three main options.

    1. Appointing a new government tasked with passing a budget (65% probability)

While this is a better option for markets than snap elections – in which the far right could win more seats – it does not change the fact that France’s parliament is fragmented and any meaningful fiscal consolidation would be hard to implement. Ultimately, we would expect OAT spreads to tighten, but volatility and further widening would be likely in the interim, at least until the risk of a snap election is ruled out.

The best-case outcome for markets in a scenario in which Bayrou resigns would be a new government being appointed and a budget being passed. This would probably involve more limited cuts than Bayrou wants or, if the new government leans left, tax hikes. With the risk of government collapse still there, we believe fair value for 10-year OAT spreads could be higher than 60-65bp, which we saw as the fair value in the absence of acute political risk in H1.

Other possibilities are that a new government is formed but fails to pass a budget, or that President Macron is unable to form a new government, resulting in deadlock and new snap elections. These outcomes might also increase the risk of a new presidential election, and would be likely to result in OAT spreads widening. 

    2. Calling new snap parliamentary elections soon after Bayrou’s resignation (25%)

Dissolving parliament is not President Macron’s favoured option at this stage, but several ministers have hinted that doing so is a possibility. Opinion polls suggest that the political landscape is little changed since the last elections in 2024, so a hung parliament would be a likely outcome. Markets don’t like elections and would probably price in the far right winning more seats, resulting in OAT spreads widening.

    3. Resigning (10%)

With new presidential elections on the way, OAT spreads would widen quickly and significantly.

Fitch will be the first rating agency to review France’s credit rating, on 12 September, followed by Moody’s (24 October) and S&P (28 November). Factors that could lead to a downgrade, according to Fitch, include “failure to implement a credible medium-term fiscal consolidation plan”. 

Rating agencies’ decisions are hard to predict, but the current situation could trigger a downgrade to single A. While 12 September might be too soon to assess whether the political situation warrants a downgrade, we still assign a 30-40% probability of a downgrade by Fitch in September if Prime Minister Bayrou resigns following the 8 September vote. Moody’s could downgrade its outlook to negative on 24 October. Any downgrade would clearly be negative for French spreads on the day, but we would expect any sell-off to be limited given spreads are already high as the market has already priced in the themes that could lead to a lower rating.

Meanwhile, European banks would still assign a zero-risk weight to debt issued by France, so even if France were downgraded to ‘single A’, we wouldn’t expect a significant move out of OATs from that investor base. Neither would we expect French insurers to sharply reduce their allocations to the asset class given current valuations. However, around 55% of French government bonds are held by non-French investors, many of whom may be more sensitive to France’s credit rating. 

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