Explainer-Could the ECB help France if borrowing costs surge further?

FRANKFURT (Reuters) – The European Central Bank is once again facing questions over whether it would shore up France’s rattled bond market as Prime Minister Michel Barnier is facing a budget test that could topple his unpopular government.

Barnier’s government could fall before Christmas, perhaps as soon as next weak, and French borrowing costs soared this week on prospects of political instability over the failure of the 2025 budget.

The following looks at the ECB’s options to help France.

WHAT COULD THE ECB DO FOR FRANCE?

The ECB’s Transmission Protection Instrument (TPI) allows it to buy an unlimited number of bonds from any euro zone country experiencing a disorderly and unwarranted tightening of its financing conditions.

The risk premium investors demand to hold French debt rose to a 12-year high of roughly 84 points this week but that level is not far from the 80 basis points hit this summer, when the current bout of political instability started. 

SO, IS THE ECB GOING TO STEP IN? 

Probably not. 

Ultimately it is the Governing Council’s decision. But France fails to meet several key criteria, which makes an ECB intervention legally contentious.

First off, the market move is driven by political turmoil and concerns over budget finances, making it difficult to claim it is not warranted.

Spreads over German debt, the de facto benchmark for the euro zone, have not risen much further than before the parliamentary election in the summer, so it is difficult to claim it is disorderly. 

France is also under an EU excessive deficit procedure, failing a key ECB criteria. It is running large budget deficits and its debt level is rising, so it is also hard to argue it has “sound and sustainable macroeconomic policies,” as demanded by the ECB.

“We think the ECB would be unlikely to activate the Transmission Protection Instrument and buy French government bonds if the budget is rejected and the government collapses,” Barclays (LON:BARC) said a note.     

However, the ECB did leave itself a loophole saying that these criteria are merely an “input” in the decision making and they will be “dynamically adjusted” in light of unfolding risks.

Still, to date, no ECB policymaker has even suggested the bank should help France. 

IS THE RECENT MARKET MOVE EXTREME?

When TPI was created in 2022, Italy complained that its spreads were too high. The Bank of Italy governor complained that spreads in excess of 200 basis points were unwarranted and it should be no more than 150 basis points. The ECB, however, did not budge and to date TPI has never been used.

Nomura predicts that a French government collapse could push the spread to 100 to 120 basis points. 

“Fiscal and political uncertainty would surge,” it said. “Nobody, not even the domestic (investors), would be ready to catch the falling knife.”

WHAT ABOUT CONTAGION?

The ECB has not publicly explored this idea raised by financial market participants. However, the ECB could have the legal power to help other countries in case they suffered from a disorderly and unwarranted rise in borrowing costs because of turmoil in France.

Indeed, ECB board member Isabel Schnabel recently argued that bond buys are a powerful tool for stabilising financial markets during periods of stress. 

“Stabilising financial markets typically requires only short-lived interventions,” she said. “Purchases can be limited in volume and unwound quickly, which also helps limit moral hazard.”    

However, Italian spreads have not moved much this week, suggesting no fear of contagion for now.

In case of contagion, the ECB could also cut interest rates somewhat quicker than markets now think to compensate for a market driven rise in financing conditions.