Europe's Flight to Quality Is Leaving France Behind

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Fears of government debt default in Europe have spread to FranceFears about a government debt default in Europe have now spread to France, one of the founders of the common European currency and long considered as safe as Germany. On Monday, the difference between the yield on 10-year French bonds and Germany's 10-year bunds widened to 49 basis points, the biggest difference since April 2009.

In addition to the spread on bonds, the cost of insuring against a French government debt default also rose sharply on Monday. According to research firm Markit, the cost of five-year credit default swaps on French debt, a form of insurance against default, rose to 100 basis points from 92 basis points on Friday, an increase of more than 8%.

"I think France is no longer seen as a safe haven," says Simon Johnson, a professor of economics at the MIT Sloan School of Business and the co-author of new book on the U.S. financial crisis titled 13 Bankers. "There is a flight to quality in Europe and around the world, and it's much more going just to Germany and just to the U.S. If France is going to lose that status, that's a big deal."

"Pressure for Austerity"

Johnson says one likely outcome of the flight to quality is that big institutional investors like insurance companies and pension funds will now be pulling back from French bonds and sitting on the sidelines to see what happens.

"Then you get pressure for austerity, and you have to look at the social dynamics of what would happen if they try to cut the budget deficit in France," he says. "What would happen -- what sort of street protests would there be? That's just a very different way of thinking about the economy."

Win Thin, a senior currency strategist at Brown Brothers Harriman in New York, says the danger is that the European crisis, previously confined to so-called peripheral countries like Greece and Portugal, will now affect the European core, the countries that made up the eurozone at its founding.

"It has turned into a classic emerging markets-type contagion with investor sentiment," Thin says. "France per se is not a huge issue -- it's closer to Germany than Portugal. But it's not just France, it's Belgium and Austria. What worries me is this contagion is spreading."

Is a Debt Restructuring in the Cards?

Why are the markets so nervous? There is general disillusion with the European Union response to the crisis that began in Greece. While EU governments and the International Monetary Fund agreed to a $900 billion rescue plan, it really just replaced one type of debt with another. The problem is that many of these smaller European countries now have more debt than they can pay back. So delaying payment will just make the problem worse, not better.

Thin thinks the solution would be a general European agreement on debt restructuring for Greece and Portugal. Restructuring is a euphemism for repudiating a part of these countries' debt, so that banks wouldn't get back all the money they are owed. This idea has prompted huge concerns about the health of European banks, which are the main holders of Greek government debt. And in turn, these concerns have contributed to share prices plunging around the world.

Simon Johnson says he believes a "substantial and significant depreciation" of the euro is likely because of the continued lack of a coherent European policy response to the crisis. While he declines to set a number, he doesn't rule out the possibility of parity with the dollar, meaning one euro for one dollar. The euro, which traded as high as $1.50 only last December, dropped to $1.18 at one point on Monday, near a four-year-low.

Thin believes the euro is actually still overvalued by a purchasing-power parity measure, with fair value somewhere around $1.15. "This move still has a way to go," he says.
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