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Italy's debt woes could affect French bonds

The French bond market is starting to flash warning signals. There's no reason for France to remain immune to Italian contagion; its banks are exposed to the Italy's economy, and the possibility of a collapse in the world's third-largest bond market is bound to make investors nervous.

But bond markets are sending worrying signals that French woes aren't only the consequence of the Italian flu. The spread between French and German 10-year bonds is now at 160 basis points – roughly where Italy's was in June. What's more, French and German 10-year yields are now less correlated, suggesting that investors are starting to see France as less of a safe haven and more of a credit risk.

A serious bout of contagion in France would change the dimensions of the euro zone crisis altogether. The Italian situation is serious, but manageable – just about. If the political stalemate in Rome ends, Europe can prop up Italian debt markets and bring down funding levels through central bank buying and bailout facilities. But these props would be of little use if flames of contagion reach Paris. The European Financial Stability Facility's creditworthiness hinges on France, the euro zone's second-largest triple-A rated member. Even the ECB's balance sheet is only as good as its strongest and biggest shareholders. And Germany cannot carry the load alone.

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Any form of Italian bailout will heap further contingent liabilities on France, whose debt will come at just under 90 per cent of GDP next year. The country's presidential campaign will hamper its ability to pass further austerity, even though both Nicolas Sarkozy and his socialist opponent seem intent on keeping the country's rating intact. But the European Commission forecasts France will have higher unemployment and current account deficits than Italy in 2012. The government is aiming at a budget deficit of 4.5 per cent, but is pinning its hopes on optimistic (yet lowered) growth rates of 1 per cent, compared with the Commission's target of 0.6 per cent.

The warning signals are flashing amber, not red; French bonds have been negatively correlated with Germany in the past, and recovered. Italy's spreads hovered between 1.2 and 2 per cent for over a year before its bond markets imploded. France has already passed two rafts of austerity measures in the last three months to placate markets. If conditions don't improve soon, it will have to become even more convincing.

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