Euro faces lingering drag from France's high borrowing costs

Few subjects have dominated conversation across Europe over the past few weeks more than France, and the riots over the weekend have raised the topic's profile further. If there is a bright spot, it is that French fiscal strains have not quite spun out into a fully fledged debt crisis. Yet even with no change in the situation, France's difficulties remain, in my view, a serious danger to the shared currency.

The gap between French and German 10-year bond yields has moved out once more, to roughly 147 basis points as of yesterday, with investors still asking a noticeably bigger premium for French paper. That reading remains just shy of the 150 bp level touched at the peak earlier this month. In other words, the recent events are not yet triggering a fresh euro-area debt crisis.

That said, I would not describe the current spread as anything close to comforting.

French borrowing is already on the brink of 5%, whereas German rates sit nearer 3.5%. Given that Paris is still struggling to rein in its budget deficit, investors have little cause to suddenly stop demanding the extra premium. That, in turn, is where the euro could run into trouble.

Even if French fiscal stress does not spread into a continent-wide debt emergency, borrowing costs that stay high can still inflict substantial harm.

If that persists, France will face larger debt-servicing bills as outstanding bonds come due and are rolled over. Those funds would otherwise be available for investment and expanding the economy. To put that in perspective, the European Commission projects French growth of only 0.8% this year. That leaves very little space for flexibility.

Beyond that, investors could also begin seeking a bigger premium in other parts of the currency bloc. Highly leveraged states such as Italy may be particularly at risk — the memories are hard to avoid. This does not automatically mean contagion has begun, but it does make the wider euro zone a notably less appealing place to put money.

There is also the matter of the delicate balancing act confronting the European Central Bank. Price growth that is stronger translates into higher financing costs, and that weighs on the growth picture. For the purpose of discussion, suppose the ECB had no inflation objective to manage. Even then, lower policy rates would not necessarily fix the fiscal worries that are pushing French yields up.

This, then, is the euro's problem even with no fresh sovereign debt crisis immediately on the horizon.

Should investors keep challenging France's fiscal trajectory at a time when the rest of Europe is battling weak growth, the euro could stay under strain even without a renewed major selloff in French bonds. And in that context, the point to remember is that a lack of crisis is hardly the same as a sound market.