France gets sucked into the debt crisis. Here’s why.

LONDON, UK — In Europe’s sovereign debt crisis, the powers that be are playing yet another round of the ratings game. This time the action is in France. The country's AAA bond rating — a key pillar for Europe’s bailout — is being loudly questioned.

It's a bad time for France to be "it" in the ratings game. French banks are heavily exposed to Greek and Italian debt. The government of Nicolas Sarkozy is trying to push through a second round of labor market reforms, to include raising the age at which people can collect their state pensions.

Meanwhile, French bond yields are going up, as the markets seem to be lining the country up for a sustained attack.

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This does not come as a surprise to France's political leaders. "The French government has been well aware for some time that France is the least AAA of all AAA countries in the euro zone," said Thomas Klau, director of the Paris branch of the European Council on Foreign Relations. "Now the markets are no longer treating France as AAA worthy."

The French themselves don't seem bothered, according to Paris-based political commentator Agnes Poirier. "If anything it's getting irritating being told of our supposed ratings by inept agencies."

The latest round of the ratings game began a week ago, with the ineptitude of one agency, Standard & Poor's. S&P sent a message to some subscribers that it was downgrading France. The message was a mistake, the agency later claimed. No decision had been made. S&P apologized for the error, but it was too late. France’s creditworthiness was back in the spotlight.

Then on Tuesday this week, the Lisbon Council, a Brussels-based think tank, issued a comparative study of all the euro zone countries' economic "health." Its findings were surprising in light of the current crisis engulfing the euro.

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Many of the countries in the single currency, according to the data-driven study, had already taken significant steps to improve their competitiveness in ways that bond investors approved. Even Greece was applauded for its "heroic" efforts in "fiscal adjustments" and lowering its labor costs.

France, however, received a slap on the wrist. "Alarm bells should be ringing for France," the report stated. "Among the six euro zone countries with a AAA rating, France achieves by far the lowest ranking in the study … "

The S&P error, combined with the stern analysis from the Lisbon Council is one factor behind a steady rise this week in the bond yields of the euro zone's second largest economy. The accepted measure of how the markets view French sovereign debt is to compare the interest France pays on its bonds to what Germany pays. Yesterday, the difference, or spread, between the two nations' bonds reached a euro-era high. If France loses its AAA rating that spread will grow. The cost of borrowing for France could go way up.

The political reaction to the ratings drama has been quintessentially French. Officials and commentators have been bashing the agencies for months. Now, politicians are trying to rein in and regulate the ratings agencies.

Frenchman Michel Barnier is the EU commissioner with oversight of financial markets and the ratings agencies. He has been trying for months to pass new rules that would ban credit ratings of sovereign debt in "exceptional circumstances" like the present crisis. Yesterday, his idea was shot down by his fellow commissioners in Brussels.

German economist Holger Schmieding, author of the Lisbon Council study, says that's a good thing, because there's no point in shooting the messenger. Schmieding explains, "Ratings agencies have a very narrow mandate. It is simply to provide a judgment on whether there may be an 'event' regarding a country's debt."

Schmieding acknowledges that ratings reports often have consequences in excess of their substance. "What over-amplifies their impact is that certain financial clients can only buy bonds with a certain rating, or they have to sell bonds when they are downgraded. So an advisory function becomes a de facto market arbiter."

He says any reform should look at ways to stop the amplification of ratings in this way.

This is easier said than done at a time when fear and greed are dominating the bond market for euro zone nations. Institutional investors are selling their bond holdings out of fear, speculators are shorting bonds out of greed.

Still the question of why France might lose its AAA rating seem odd to a layman. In a time of global economic slowdown French economic performance is not all that bad. It is slightly better than Britain's, for example, yet the interest France has to pay on its 10-year bonds is about one-third higher

The answer is that Britain can "monetize" its debt. That is, the Bank of England can buy the bonds issued by the British government, back-stopping its liquidity. France cannot do that because it is part of the euro zone. Only the European Central Bank in Frankfurt has the financial muscle needed to buy French bonds in the quantity needed to keep interest rates low. The ECB has no plan to buy up French debt at the moment. It is too busy buying up Italian and Spanish bonds.

This is leading to tension between France and Germany — not a reconstruction of the Maginot Line-type tension, but an increasingly public argument about the role of the ECB.

Following a cabinet meeting yesterday in Paris, government spokesperson Valerie Pecresse told reporters, "The ECB's role is to ensure the stability of the euro, but also the financial stability of Europe. We trust that the ECB will take the necessary measures to ensure financial stability in Europe."

France would like the European Financial Stability Facility to be given the status of a bank. Then the ECB could lend it money and that money could be used to purchase sovereign debt. The German government is against that particular scheme.

Ultimately, the resolution of France and Germany’s dispute over the ECB will largely decide how the euro crisis plays out. But in the meantime, the French government's struggle to keep its AAA rating is a useful way to keep France walking along the path of reforming its labor markets and pension commitments.

Economist Holger Schmieding points out, "For France its a matter of national pride [not] to lose its AAA when Germany retains it. France might be willing to take the necessary steps to avoid that."

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Whether or not France keeps its AAA status, the markets seem determined to make the country pay more for borrowing. At an auction of five-year bonds today the yield jumped by 49 basis points over a similar auction last month. Interest rates on 10-year French bonds were also up on where they traded yesterday.