Beggar Thy Neighbor

by Andrew Stuttaford

Via AFP:

RENNES, France — The head of the French central bank criticised the British economy on Thursday, arguing that ratings agencies are targeting the wrong country for a debt downgrade.

“They should start by degrading the United Kingdom, which has greater deficits, as much debt, more inflation and less growth than us,” Christian Noyer told the regional newspaper Le Telegramme.

Noyer warned that Britain, which clashed with France at last week’s EU crisis summit and refused to join the members of the eurozone single currency bloc in a new fiscal pact, was facing a credit crunch.

Ratings agencies Standard & Poor’s and Moody’s have warned that France is close to losing its triple-A debt rating over fears that eurozone members can not control their rising debt and deficits.

Regardless of whether any responsible central banker should be saying this sort of thing (nope), Noyer  leaves something out of the equation.  Both France and Britain are in bad shape financially, but most of Britain’s debt is in its own currency whereas France’s debt is (effectively) all denominated in “foreign” money.

What this can mean was explained in a brilliant paper by the University of Leuven’s Paul De Grauwe that I first linked to back in the happy days of May. The key can be found  these passages that contrast the UK and Spain (but the arguments about Spain apply just as well to France.

The UK:

Let’s first trace what would happen if investors were to fear that the UK government might be defaulting on its debt. In that case, they would sell their UK government [Sterling-denominated] bonds, driving up the interest rate. After selling these bonds, these investors would have pounds that most probably they would want to get rid of by selling them in the foreign exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds. The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets. Put differently, the UK money stock would remain unchanged. Part of that stock of money would probably be re-­‐invested in UK government securities. But even if that were not the case so that the UK government cannot find the funds to roll over its debt at reasonable interest rates, it would certainly force the Bank of England to buy up the government securities. Thus the UK government is ensured that the liquidity is around to fund its debt. This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default…


Suppose that investors fear a default by the Spanish government. As a result, they sell Spanish government bonds, raising the interest rate. So far, we have the same effects as in the case of  the UK. The rest is very different. The investors who have acquired euros are [in the absence of a truly dramatic increase in Spanish interest rates]  likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. There is no foreign exchange market, nor a flexible exchange rate to stop this. Thus the total amount of liquidity (money supply) in Spain shrinks. The Spanish government experiences a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates. In addition, the Spanish government cannot force the Bank of Spain to buy government debt. The ECB can provide all the liquidity of the world, but the Spanish government does not control that institution. The liquidity crisis, if strong enough can force the Spanish government into default. Financial markets know this and will test the Spanish government when budget deficits deteriorate. Thus, in a monetary union, financial markets acquire tremendous power and can force any member country on its knees… 

And that M. Noyer,  is why France may be ahead of the UK in the race for a downgrade.

There’s also something else to consider. As the Eurozone lurches from bailout to bailout, all of them so far, partly funded by France or by vehicles that France has in one way or another (partly) underwritten, the contingent threats to France’s balance sheet are growing.

Attendez, there’s more,  the little matter of the European Central Bank , an institution that has been  busy buying up junk sovereign debt and which is again, yes,  you guessed it,  partly underwritten by France.

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