Bank of France Governor Emmanuel Moulin has warned that France could be gradually strangled by rising interest rates if it fails to put its public finances in order.

Last week, the selloff in French government bonds intensified and spread across Europe, with the 10-year yield briefly approaching 5%, the highest since 2002, and French borrowing costs now exceeding those of Greece and Italy.

The France-Germany 10-year yield spread, a gauge of the risk premium on French debt, widened by 32 basis points last week to 141 basis points. Deutsche Bank's Jim Reid noted this was the largest weekly widening in Bloomberg data going back to 1990, a period spanning German reunification, the eurozone debt crisis and the COVID-19 pandemic.

More troubling is the simultaneous deterioration on both the buy and sell sides. The Bank of France has stopped purchasing bonds, Japanese funds that had long been steady holders of French debt are starting to loosen their grip, and France must issue a record amount of government bonds next year. Goldman Sachs argues the European Central Bank's anti-fragmentation tool is a last resort, not the next step.

France has not always lacked chances to turn things around.

In early April 2024, Macron hosted a small group of lawmakers at the gilded 茅lys茅e Palace. According to Sylvain Maillard, a lawmaker from Macron's centrist party who was present, the president, over plates of seafood, delivered his verdict on the corrective budget pushed by Finance Minister Le Maire:

I hear people talking about a corrective budget. I don't see the point.

At the time, internal memos from the Finance Ministry had already warned that the deficit that year could rise to 5.7% of GDP, far above the 4.4% in the budget. Two months later, Macron dissolved the National Assembly, and the ruling camp lost a large number of seats in snap elections, failing to secure a majority. A then-prime minister's economic adviser later said 2024 might be France's last, or one of its last, chances to cut the deficit in a reasonable way.

Two and a half years later, the costs are beginning to show.

On one side, decades of overspending, whatever-it-takes bailouts and prime ministers toppled by parliament over spending cuts are colliding with rising global interest rates.

On the other, the Bank of France has stopped buying bonds, Japanese funds that had long been stable holders of French debt are starting to waver, and France must issue a record amount of government bonds next year.

Why the selloff is concentrated in France

The war with Iran has pushed up energy prices and inflation, and record sovereign and corporate issuance is weighing on global bond markets, driving borrowing costs higher across the board. The European Central Bank has raised rates twice in recent months and the Federal Reserve hiked in September, with both central banks due to announce rate decisions in late October.

France has been hit hardest. According to the Financial Times, since the outbreak of the Iran war, French government bond yields have risen the most among the Group of Seven nations, with investors worried about the government's inability to control the deficit as well as an upcoming budget fight and next year's presidential election. According to Bloomberg data, French government bonds have returned -4.9% year to date, the fourth-worst in the world. The 10-year yield approached 5% on Friday before easing to 4.86% on Monday.

France was once seen as a relatively stable oasis in European financial markets. Today it is one of the bloc's weakest links, with a budget deficit second only to the United States among comparable countries. A popular high-risk hedge fund trade that suddenly unwound in recent months has amplified the latest selloff.

Bank of America takes a relatively measured view. Its economists believe the portion of the move in French bonds driven by France-specific factors may be only about 20 basis points, referring to the widening in the spread of French debt over Italian debt since July; the bigger issue may be the repricing of global bond markets, plus France-specific technical factors. But BofA also acknowledges:

If everyone is staring at France, it shows sentiment is very fragile and could deteriorate sharply even without a substantive trigger.

A deep-rooted problem: how France got here

For years, even decades, France has been a free rider in Europe, said Kevin Thozet, a portfolio adviser at French asset manager Carmignac. As long as no one noticed, it worked. Now people are starting to notice.

Temporary bailouts became permanent spending. France has not balanced its budget since 1974, and its vast welfare system has accustomed citizens to relying on the state in crises. Early in Macron's tenure, loosening labor market rules, cutting corporate taxes and scrapping the wealth tax helped push the deficit below the EU's 3% ceiling at one point, his camp says. He then spent at least 10 billion euros to quell the Yellow Vest protests and invoked whatever-it-takes during the energy crisis sparked by the pandemic and the Russia-Ukraine conflict.

Many measures continued to weigh on the finances long after the pandemic, such as an extra 10 billion euros a year in corporate tax cuts and pay raises for staff across the public health system. Paid furlough subsidies, originally life support during lockdowns, were claimed by many companies for years; energy price cap subsidies cost tens of billions of euros and kept flowing even after European gas supply stabilized. After public money flows in, no one in government has the courage to pull the plug, said Jean-Fran莽ois Husson, the conservative senator who led a related Senate investigation. Maillard added: In France, we have a reflex of always asking the state for a little magic money.

Prime ministers who try to cut spending cannot stay in office. In recent years, the National Assembly has successively toppled prime ministers who sought to restore fiscal order through spending cuts, and annual budget reviews have repeatedly descended into chaos. Behind this selloff is precisely the worry that France has become hard to govern and its political system can no longer correct itself. Now, the 43 billion euro budget of spending cuts and tax increases the government proposed last week also lacks majority support in parliament, and measures such as ending the automatic inflation link for pensions and partially freezing civil servant pay will face opposition resistance.

A missed window for correction. According to internal documents reported by media, in December 2023 Finance Ministry officials warned then-Finance Minister Le Maire that tax revenue was short and the deficit that year could widen to 5.2% from an expected 4.9%, and recommended not making it public yet. By February 2024, new memos showed the deficit gap had widened further.

Facing a 40 billion euro shortfall, Le Maire pushed for a corrective budget, but Macron rejected the plan at that April dinner, seeing the problem as falling tax revenue. In June of that year, Le Pen's far-right party scored a big win in European Parliament elections, and Macron promptly dissolved the National Assembly. The new parliament split into three major camps, creating the deadlock. Ales Koutny, head of international rates at Vanguard, sold French bonds in the months that followed, calling the dissolution somewhat of a turning point for us.

The low-rate dividend is over and the debt is snowballing. France has more than $1 trillion of debt maturing by 2030, much of it borrowed in the era of ultra-low rates and now set to be refinanced at higher rates. A study commissioned by the French Treasury shows debt servicing costs are expected to rise 59% by 2030 and could far exceed military spending by the end of the decade. French debt is already close to 120% of GDP, the deficit has been above 5% for three straight years and could rise to 6.8% by 2030. The OECD estimates that without spending cuts, France's debt ratio could reach 200% by 2050. Thozet noted the overall interest rate on France's existing debt is expected to exceed economic growth in coming years, and without big spending cuts the debt burden will only keep rising. The snowball effect has begun.

Buyers retreat, supply hits records

As of July, Japanese investors held about 23 trillion yen ($145 billion) of French government bonds, 6.6% of their overseas bond holdings and the largest overweight position in the euro area relative to the Bloomberg Global Aggregate Index. In past bouts of French political turmoil, Japanese investors had firmly held onto French debt.

Now that is changing. Japanese holdings of French debt are down 2.5% from the end of last year, and a fund run by Shinji Kunibe's global fixed-income team at Sumitomo Mitsui DS Asset Management has fully exited French bonds over fiscal concerns. The yield on Japan's 10-year government bond rose above 3% last month, a 30-year high; after currency hedging, the yield advantage of French 10-year bonds over Japanese ones is only about 40 basis points. Masayuki Nakajima of Mizuho said that combined with worries about France's fiscal path and high FX hedging costs, even if valuations look cheaper, Japanese investors have less incentive to rebuild positions.

Antonio Del Favero of Macro Hive worries about a chain reaction: if Japan is seen trimming an overweight because France is no longer a clean core allocation, benchmark investors in the United States, Asia and parts of Europe may also reassess. Hideo Shimomura of Fivestar Asset Management said: This is just the beginning. If the European Central Bank stands by, based on the experience of the eurozone debt crisis, French 10-year yields could rise to 7%. On Monday during Asian hours, the euro fell to its lowest against the dollar since May 2025. In analyzing the euro's slide, Goldman Sachs's Jonathan Lightowler first mentioned rumors that Asian investors sold European fixed-income assets last Friday.

Other supports are also fading. According to the Wall Street Journal, the Bank of France has stopped buying government bonds, letting its holdings shrink as they mature; hedge funds that recently stepped in to fill the gap have been hurt in the sharp swings.

Pressure on the supply side keeps building. The French Treasury's debt agency, Apollo Senior Floating Rate Fund (AFT), plans to issue 340 billion euros (about $380 billion net of buybacks) of government bonds in 2027, a record and above Goldman Sachs's earlier estimate of 325 billion euros; Japanese investors' French bond holdings are equivalent to about 38% of that plan. Goldman Sachs believes the 5% deficit target underpinning the plan carries upside risk and actual issuance could be larger; it expects French net duration supply (on a DV01 basis) of about 95 million per basis point in 2027, roughly 25% more than this year and tied with Germany for the largest increase in the euro area.

The presidential election is the biggest wild card

Next spring's presidential election is the biggest wild card. Goldman Sachs's poll-based model shows far-right leader Le Pen with a 68% chance of winning, Edouard Philippe at 16% and Melenchon at 6%. Le Pen has promised to lower the retirement age to as low as 60, which she estimates would cost an extra 9 billion euros a year; Melenchon wants the European Central Bank to freeze or cancel the 488 billion euros of French debt held by the Bank of France. Everyone is talking about ways to spend more, Koutny said. France's fiscal position was already not great, and adding these parties' policies makes it worse. Goldman Sachs expects France's deficit at 5.4% this year and 5.3% next year, and has cut its 2027 growth forecast to 0.6% from 0.7% due to significantly tighter financial conditions.

Analysts have begun speculating whether the European Central Bank will step in out of concern about fragmentation in the bloc's financial markets. Goldman Sachs economists Sven Jari Stehn and Alexandre Stott argue the threshold for protecting innocent bystanders like Spain from contagion is far lower than for intervening in a country like France where fiscal policy is incompatible with debt stability; in their view, fundamental sovereign risk requires a fiscal solution.

Moulin also said now is not the time to discuss the European Central Bank, and that the safety net is at home, in whether the French people and their elected representatives recognize the need to fix public finances. He believes rising long-term interest rates, tighter financial conditions and a second energy shock could damp demand and reduce the need for further central bank action; if the government's budget to cut spending and narrow the deficit passes this year, markets would be reassured by such a substantive fiscal consolidation. France is not Greece during the eurozone debt crisis, he said. We must take our destiny into our own hands.

Still, many investors believe a French bond meltdown is not a foregone conclusion, because the euro area now has the European Central Bank as a backstop and is better able to absorb market shocks. But muddling through also has a cost 鈥?rising debt servicing costs are squeezing the government's room for more productive investment. Charles Rodwell, a centrist lawmaker on the National Assembly's finance committee, hopes market pressure will force parties to focus. We need shock therapy, he said.