France Downgraded But Markets Don’t React

Credit ratings agency, Moody’s Investor Services downgraded France’s government bond rating by one notch to Aa1 from Aaa and maintained its outlook that it had changed to negative on February 13, 2012. This move has come in after Standard & Poor’s stripped the country of its AAA credit rating in January 2012. Moreover, last week, German Finance Minister Wolfgang Schaeuble termed France as the sick man of Europe. However, the key reasons for this downward stature of France can be attributed to the external environment more than France’s domestic issues.

It does stand true that France has a series of structural challenges to face. These challenges, considered by Moody’s include France’s gradual sustained loss of competitiveness relative to Germany, the UK and the U.S. and long-standing rigidity of its labour, goods and services markets. Moreover, elevated taxes have been hurting consumption. This situation combined with legislations that make dismissals difficult have been raising the implicit cost of labour and in turn creating disincentives for hiring making inherent problems grave.

France’s economy is large and diversified. Moreover, the government has a strong commitment towards bringing out structural reforms and fiscal consolidation. Among these intentions are budget forecasts that target a reduction of headline deficit to 0.3 per cent of GDP by 2017 and a balancing of structural deficit by 2016.

However, France has a particularly large exposure to weaker European economies due to trade linkages and resources provided. The ECB (European Central Bank) has deployed EFSF (European Financial Stability Facility) and ESM (European Stability Mechanism) to provide funds to aid weak economies. But, there is a larger chance that France bears a greater burden if Spain declares the need of funding, especially because Spain’s economy and government bond market are double the combined size of Portugal, Ireland and Greece.

France has been facing stagnant GDP, rising unemployment and a drop in industrial production. Due to a weak European environment that becomes all the more difficult with trading partners like Italy and Spain, recovery seems to be on a lethargic path. Amidst this situation, Moody’s considers the growth assumptions of 0.8 per cent in 2013 and 2 per cent from 2014 onwards highly optimistic.

However, we think the downgrade would have little impact on borrowing costs or on equity markets since these issues have already been priced. Economic data has long been indicative of troubles and a downgrade by Standard and Poor’s has already been adjusted for.  European markets are likely to focus more on issues surrounding Greek woes, the Spanish situation and developments over the fiscal cliff.