Draghi’s downside risk: Marine Le Pen victory

Robert Sierra - 12 April 2017

With less than two weeks to go, the outcome of the French presidential election has been plunged into uncertainty by the strong showing of radical left candidate Jean-Luc Mélenchon. Japanese investors, among others, are fleeing for the exits. Mario Draghi must contend anew with the risk of an existential threat to the European monetary project. In recent weeks, Marine Le Pen has toned down her rhetoric on taking France out of the Euro, seeking to broaden her electoral appeal. She has insisted that reinstating border controls and preventing the loss of French jobs will be her priorities, rather than leaving the Euro. This shift in presentation does not mean the policy has been abandoned. It remains at the core of her party’s manifesto and a referendum has been promised within six months should Le Pen become president. Unlike David Cameron, she can be confident that her referendum will be defeated: the vast majority of French people remain opposed to leaving the euro (72 per cent).

Based on a softening of Le Pen’s anti-EU rhetoric and the surge in support for Emmanuel Macron, suggesting victory over Le Pen in the second round of polling on 7 May, the spread between French and German government bond yields narrowed in February. Alas, recent polling shows support for both Macron and Le Pen fading and the emergence of another credible radical, the communist-backed Mélenchon. Mélenchon, who also wants to take France out of the Euro, has benefited from strong performances in two televised debates. A Kaantar Sofres poll for Le Figaro showed the centre right candidate Macron and Le Pen tied on 24 per cent in the first round while Mélenchon has taken third place for the first time on 18 per cent, an increase of 6 percentage points since March.

Should Le Pen (or indeed Mélenchon) perform better than expected in the first round of polling, on 23 April, financial markets would surely be thrown into turmoil in the succeeding fortnight. A win for either of these candidates in the second round would be a monumental political shock and lead to massive capital outflows and a likely run on French banks. The ECB has ready responses to any liquidity crisis, allowing French banks to access temporary liquidity and perhaps direct its asset purchases towards French government bonds, but these may not be sufficient. An aggravation of the imbalances in the Target 2 payment settlement system would sound the alarms. These imbalances are already being skewed by the ECB’s asset purchasing programme, as most non-EU residents choose to deposit proceeds in German banks.

These balances or claims are not worrisome in normal times given that they represent ledger entries on the central bank balance sheet which may reverse naturally over time. However, if the future of the Euro was in doubt, the legal nature of those claims would lead to significant political pressure in Germany for these balances to be capped, or for a higher interest rate to be levied. If France was threatening to leave the Euro and Germany refusing to allow Target 2 imbalances, it is unlikely that any assurances from Draghi would be sufficient.

The worst of all worlds, for financial markets, would be a second-round run-off between Le Pen and Mélenchon. Japanese fixed interest investors, among others, are deciding to the leave the cinema before the movie ends.

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