France is suffering from a bad case of downgrade contagion.
Europe's second-biggest economy has seen its debt sell off this week on speculation that it could be the next industrial country to follow the United States and lose its coveted triple-A credit rating. Despite assurances from credit-rating agencies, yields on French bonds have increased, fuelling concern that the European debt crisis is now ensnaring even the strongest economies of the euro zone.
Deflating confidence in France – which with Germany would bear the brunt of any increase in the scope of the European bailout fund – underscores the growing fragility of the 17-country euro zone.
But the worries about France's fiscal health, many economists say, are overblown, and point to investors' heightened anxiety about credit ratings in the days since the downgrade of bonds issued by the United States.
France does have higher debt levels than some of its European peers, and a stalling economic recovery could now hamper its ability to slay its deficit. And France faces the prospect of having to prop up more of the weaker European countries down the road.
But even if France were to face a downgrade, the chances of a default are considered remote by some.
France "has a lot of assets it can sell off," said Jennifer McKeown, senior European analyst at Capital Economics in London. "Its debt is far lower than the likes of the peripheral countries that have already had bailouts." But, she added, "there's strong risk it could lose its triple-A credit rating at some point."
The government has already taken steps to reduce spending and trim the deficit to 5.7 per cent of GDP this year, down from 7.1 per cent in 2010. That's still well above Germany at 2 per cent. France's debt of 85 per cent of GDP is the highest among Europe's triple-A-rated countries. The next highest are the U.K. and Germany, both at about 80 per cent. Luxembourg has the lowest debt at less than 20 per cent.
"France has very high debt and its banks are exposed to the peripheral countries," said Capital Economics' Ms. McKeown. "Those things together make for an environment of general nervousness about public finances."
Earlier this year, the Organization for Economic Co-operation and Development urged the French government to further improve its fiscal outlook through further spending cuts and increases to property and consumption taxes – measures that are sure to be unpopular ahead of the 2012 presidential election.
Investors are also concerned about the size of France's exposure to debt in the euro zone's troubled nations (including Italy, Greece, Ireland, Portugal and Spain) relative to its economy. Any downgrade would also make it more expensive for France to borrow enough to help bail out its neighbours.
Last weekend, France and Germany committed to approving the necessary changes to bolster the European Financial Stability Facility by the end of September. There is, however, mounting criticism that the €440-billion ($617-billion) rescue fund, designed to bail out insolvent countries, is too small.
Peter Westaway, chief European economist at Nomura International in London, said there are worries that expanding the EFSF would put "undue pressure on the remaining creditor countries in the euro area," including France.
Moreover, boosting the EFSF is bound to raise even more questions about France's triple-A rating, said Alastair Newton, senior political analyst at Nomura International. "Clearly if France were to lose its rating with an election eight months away now, it could become an election issue."
French President Nicolas Sarkozy and German Chancellor Angela Merkel will hold talks next Tuesday to discuss improvements to the euro zone. The European Central Bank, which began buying the debt of Italy and Spain this week, is pushing those countries to come up with a permanent political solution. Specifically, it wants governments to broaden the EFSF with an eye to eventually creating a euro bond market.
While voters in both Germany and France may find it unpalatable that their governments have to absorb much of the costs for a bailout fund to support Europe's weakest links, the pressure is building for the euro zone to become a true fiscal union.
"The big difference between Europe and Canada and its provinces is that in Canada, we've gotten used to the strong helping the weak directly through the tax system. And that was not put into place in a formal way when the euro zone countries agreed to adopt a common currency and interest rate," said Avery Shenfeld, chief economist of CIBC World Markets.
"It is a currency union without the necessary fiscal union or fiscal discipline to make a one-size-fits-all monetary policy make sense."
Naomi Powell is a freelance reporter based in Stockholm