France: Inflation-linked Bond Supports Funding Flexibility but With Higher Near-term Debt Costs

France has historically pioneered inflation-indexed sovereign bonds as the first euro-area country to issue one in 1998 and has continued to issue them on a regular basis. In doing so, the French Treasury has enhanced its status as a sovereign benchmark issuer responsive to rising investor demand for a hedge against inflation and lowered its debt costs at issuance.

Still, with the recent rapid increase of inflation, costs associated with these instruments have risen. Should inflation exceed expectations and persist longer run, France could be among the euro-area countries for which debt service increases the most as consequence of such higher-for-longer inflation. The increased volatility of interest costs for inflation-linked bonds has been highlighted recently by the Cour des Comptes, the body with oversight over the use of public funds.

Inflation-linked debt amounts to around EUR 246bn, about 11.3% of outstanding debt (Figure 1), matched only by Italy among major euro-area countries. Currently, France has six bonds linked to the French consumer price index (OATi, 3.2% of the aggregate debt stock), and twelve bonds linked to euro-area inflation (OAT€i, 8.0%). It is currently contemplating pioneering issuance of a first inflation-linked green bond, reflecting an innovative debt management strategy.

Figure 1. Inflation-linked securities outstanding
EUR bn (LHS), % total debt (RHS)

Inflation-linked bonds can lower Treasury’s cost of financing

Inflation-linked bonds can lower the cost of financing as investors are willing to pay a premium for protection against inflation, thus lowering yields. They can also help diversify the investor base given that inflation-linked bonds may be more attractive to institutional investors with longer investment horizons such as insurers or pension funds. Even so, empirical evidence on the cost benefits of such instruments is mixed, as the premium investors pay to benefit from the hedge on inflation is typically offset by the premium sovereigns pay to compensate for lower liquidity of the instruments.

Under a current context of rising inflation, demand for these types of instruments is rising. The issuance programme of Agence France Trésor for 2022 (as released in December 2021) expects inflation-indexed bonds to account for approximately 10% of net medium- and long-term debt issuance. In January 2022, France launched a new 30-year bond linked to euro-area HICP inflation at an all-time low yield of -0.926% at the point of issuance.

However, inflation-linked bonds can result in additional costs if inflation rises above expectations

However, inflation-linked bonds can cause additional costs for issuers if there is a higher-than-expected rise of inflation. This has been the case so far following price pressures due to the Covid-19 recovery, lingering supply-side bottlenecks and the Russia-Ukraine war. The implicit interest rate on French debt increased for a first time since 2012, from 1.14% as of end-2020 to 1.37% in 2021 (Figure 2).

Figure 2. Implicit interest rate on French debt versus euro area inflation
%

As a mitigating factor, a short-term increase in domestic inflation may have a positive effect on the headline fiscal balance – absent an increase in discretionary spending to support purchasing power, as the nominal rise in fiscal receipts, primarily via higher VAT proceeds, could outpace that of budget expenditure, the latter which are only partly indexed on inflation.

OAT€i bonds are likely to present higher fiscal costs as French inflation has so far been comparatively moderate

OAT€i bonds are likely to present higher fiscal costs as inflation has so far been more moderate in France than in the remainder of the euro area, with 2021 HICP inflation (excluding tobacco) averaging 2% for France versus 2.6% for the euro-area aggregate. This differential has widened over recent months, up to 1.6pps in February 2022. If this gap is sustained or even further grows, there is a risk that the increase in OAT€i bond payments outpaces that of fiscal revenue and further increases an aggregate cost of public debt.

Inflationary pressures could drive up France’s additional cost of inflation-linked debt by EUR 4-5bn this year

The ECB’s latest macroeconomic forecasts project euro-area inflation to reach 5.1% in 2022 (up from 2.6% in 2021), while the Banque de France projects domestic inflation to reach 3.7% (up from 2.1% last year). Based on estimates from the Agence France Trésor, according to which every 1pp rise of inflation increases debt service by around EUR 2bn (~0.1% of GDP), inflationary pressures could drive up France’s additional cost of inflation-linked debt by circa EUR 4-5bn (~0.2-0.3% of GDP) in 2022, offsetting the estimated EUR 800m of gains secured during 2020 from lower inflation.

The cost of inflation-indexed bonds is seen by the ECB declining progressively over following years, with inflation returning to under 2%, in line with the ECB’s target. However, a more adverse scenario than this with persistently elevated inflation could result in higher debt service costs for France over the medium run.

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Thomas Gillet is Senior Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Thomas Gillet, Associate Director at Scope Ratings, contributed to writing this commentary.