France’s growing debt woes: How bond markets set countries’ borrowing costs

France’s borrowing costs have surged amid the worst social unrest in the country in decades.

Yields on French bonds have risen to their highest levels in nearly a quarter of a century as investors demand higher returns for taking on government debt. The surge reflects a growing conviction in bond markets that lending to France is becoming an increasingly risky proposition.

While France is grappling with a widening gap between government spending and revenues, the country’s fragmented political landscape is bitterly divided on how to plug the hole.

Meanwhile, hundreds of thousands of protesters, some of whom have participated in rioting and looting, have taken to the streets to oppose proposed budget cuts and demand greater spending on cost-of-living relief and public services such as education.

France’s national debt is now at its highest level since the immediate aftermath of World War II, nearing 120 percent of gross domestic product (GDP).

How do bonds work and why are France’s borrowing costs rising?

Bonds are a type of loan to a government or corporation. Countries routinely borrow from bond markets to allow spending that is not covered by tax revenues.

In exchange for buying a bond, an investor is paid regular interest payments, plus the original borrowed sum at a set date in the future. These bonds can be traded on the bond market to other investors in the meantime.

Bond prices are influenced by interest rates, inflation and confidence in the issuer’s ability to repay the loan, among other factors.

When bond prices rise, bond yields fall, and vice versa.

France’s 10-year bond yield has risen more than 130 basis points since June, topping 4.9 percent.

France’s borrowing costs now stand at their highest levels since 2002, swallowing up a growing share of tax revenues that could otherwise be directed towards essential services such as education and healthcare.

While France’s debt levels are relatively high, the amount that a country owes is just one consideration for investors pricing the risk of its bonds.

Market confidence in a country’s ability to meet its obligations is shaped by a range of factors, including the economy’s strength, the amount of its external debt versus domestic debt and the ability of the political system to govern effectively.

“The sustainability of sovereign debt is rarely determined by its absolute level alone,” Victor Lequillerier, president of BSI Economics, a think tank in Paris, told Al Jazeera.

“It depends far more on its trajectory, structure, and broader economic and financial context.”

In France’s case, the paralysis of the country’s political system is a key driver of concern in the bond markets currently.

In the fragmented National Assembly, French Prime Minister Ssbastien Lecornu, who was appointed by President Emmanuel Macron under the country’s semi-presidential system, is mired in a legislative battle to pass a budget for next year that includes 54 billion euros ($61bn) in savings.

Marine Le Pen of far-right National Rally and Jean-Luc Melenchon of far-left France Unbowed, the two leading candidates in next year’s presidential election, are opposed to Lecornu’s proposals, though the government could invoke a constitutional clause to bypass parliament if deemed necessary.

Antonio Fatas, a professor of economics at INSEAD in Fontainebleau, France, told Al Jazeera: “Are the French numbers much worse than other countries? No, but marginally they are worse, and the real difficulty here is that the political situation is such that the current government does not have an easy path to put together a budget that makes sense from a debt sustainability point of view.”

He added: “That’s what makes France a special case now, that’s why markets are very much worried about what France is going through and why you see a lot of the noise.”

What is the state of France’s finances?

France’s national debt, at about 3.6 trillion euros ($4 trillion), is equivalent to 119 percent of GDP, up from 98 percent in 2019, the year before the start of the COVID-19 pandemic.

Of greater concern to markets than the total debt is France’s ballooning deficit, however, which is expected to reach 5.4 percent of GDP in 2026 – far above the European Union average of just more than 3 percent. This is the amount by which a government’s spending exceeds its income.

France, which has a strong tradition of left-wing politics and activism, has long had one of the biggest public sectors in the developed world.

Government spending is equivalent to about 57 percent of GDP, second only to Finland among Organisation for Economic Co-operation and Development (OECD) countries.

Public pensions make up a particularly large proportion of expenditure, amounting to 14 percent of GDP, a figure that is likely to rise as the country’s working-age population shrinks in the coming decades.

“Ironically, President Macron has long discussed the reforms needed to improve the fiscal outlook and avoid attracting the ire of bond investors,” Alex Dryden, a macroeconomist at the Centre for Sustainable Finance at SOAS University of London, told Al Jazeera.

“From 2017 onwards, Macron has spoken of the need for pension reforms to ease the fiscal burden, but this is a lightning-rod political issue in France and attempts at reforms have stalled on multiple occasions.”

“Tackling this issue would resolve much of France’s fiscal burden, but that is much easier said than done,” Dryden added.

While France levies some of the highest taxes of any country to support its sizeable welfare state, its budget deficit widened substantially during the pandemic and has remained above the recent historical trend ever since.

Exacerbating the shortfall has been a long-running trend of anaemic growth, which saw the French economy expand by just 59 percent of the OECD average from 2000 to 2025.

GDP is forecast to grow just 0.4 percent this year, following a 0.9 percent expansion in 2025.

BSI Economics’ Lequillerier said the French government has spent years shirking the kind of budgetary reforms that reduced the deficits of heavily indebted peers such as Italy, Spain and Portugal.

“In the post-pandemic period, most European economies managed to normalise their fiscal positions and bring deficits closer to sustainable levels. France, however, failed to do so, with public spending growth persistently overwhelming revenue dynamics,” Lequillerier said.

Lequillerier said investors’ tolerance for the government’s lack of fiscal restraint has finally run out.

“The correction is becoming increasingly painful, and France risks isolating itself within the euro area as its principal fiscal underperformer,” he said.

Why is France under more pressure than countries with higher levels of debt?

While relatively high, France’s debt is lower than that of several other economies, including the United States, Japan and Italy.

But in each of those cases, there are specific circumstances that mitigate the risks.

The US is better positioned than its peers to manage massive debt levels due to the status of the US dollar as the world’s primary reserve currency, which allows it to borrow money relatively cheaply and in greater amounts.

Japan has been able to sustain a debt-to-GDP ratio of more than 200 percent because most of its debt is held by domestic institutions, insulating it from capital flight. Monetary authorities have also kept interest rates at ultralow levels.

Italy’s debt-to-GDP ratio of 140 percent is higher than that of France, but it also has a smaller budget deficit equivalent to about 3 percent of GDP.

“The total debt burden that a government can support depends on quite a few things and varies between countries,” Andrew Kenningham, chief Europe economist at Capital Economics, told Al Jazeera.

“For example, investors will get more anxious if the country’s economy is only slowly growing, or not at all, and if the government deficit is very high, which – all else equal – means the debt ratio will tend to rise. And the debt burden a country can support also depends on who wants to buy that country’s debt,” Kenningham said.

France is also under pressure, in part, because there are more options in the bond market for investors to look at than in the past, said Lequillerier at BSI Economics.

“Germany is now running larger deficits and issuing substantially more debt, while Italy and Spain have strengthened both their fiscal positions,” he said.

“France therefore faces much stiffer competition for international capital within the euro-denominated sovereign bond market.”

Is France headed for a debt crisis?

While France’s finances are far from unsalvageable, the longer the government takes to tighten its belt, the greater the risks of a full-blown debt crisis, economists say.

“What is the likelihood of France going into a debt crisis? Enough that it should worry us,” INSEAD’s Fatas said. “As an economist, I could say the numbers are not too bad.”

“We can find a budget that would put France in a more sustainable position, but that requires certain compromises, and that requires certain political choices, very, very difficult to do in the current environment,” he said.

Lequillerier of BSI Economics said while a French default is not a realistic possibility, the country would suffer a “profound loss of economic credibility” if it had to seek assistance from an institution like the European Central Bank or the IMF.

“This is not the central scenario today,” he said. “Nevertheless, the longer fiscal adjustment is delayed, the less remote such an outcome becomes.”