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Financial markets, high private debt present risk for French financial system

The uncertain direction of financial markets and a high level of indebtedness in the private sector are two major potential risks for the French financial sector, the Bank of France said in a report Dec. 17.

In its six-monthly report on the risks to the French financial system, France's central bank said equity and debt markets remained high due to low interest rates and investor appetite for risk. But the report warned that investors were facing a number of uncertainties such as protectionism in the U.S., the turbulent political situation in Italy and the U.K. and emerging market risks. Any market downturn would have an impact on France because global financial systems are so interconnected, it said.

It pointed to demand for cheap, high-risk debt as one of the potential dangers for the financial system.

"Investors' appetite for risk is still present in the least secure segments of the credit market (high‑risk high‑return bonds, lending to highly‑leveraged companies — especially leveraged loans), which are also susceptible to a sudden exit by investors in the event of a market downturn," the Bank of France said.

"The expansion of low quality debt has been encouraged by strong demand as investors search for yield and by the low interest rate environment, and it has also coincided with an easing of non‑financial lending conditions particularly in the leveraged loans segment," it said.

High levels of borrowing in the private non-financial sector in France are also a risk to the French financial sector, with private sector debt currently standing at 132.2% of gross domestic product, 12.3 percentage points higher than the eurozone average, and 44% of private debt is at variable interest rates, the central bank said, predicting a continuing uptick in the next six months.

"Companies [that] take on too much debt are at the mercy of a potential sharp rise in interest rates," Sylvie Goulard, deputy governor of the Bank of France, said at a news conference to present the report.

Consumer loans rose 6.6% in October, while mortgages were up 5.6%, as banks eased financial conditions, something the authorities were watching, the central bank said. It also said it was monitoring the development of leveraged loans with simpler financial conditions to private companies.

A sharp rise in interest rates could also lead to banks and insurers revaluing their securities, and higher rates in the U.S. "[are] likely to trigger massive capital movements as investors search for higher and safer yields at the expense of riskier asset classes."

"An early indication of the 'Great Rotation' of assets can be seen in the fact that the currencies and stock indices of emerging countries with the most severe external vulnerabilities have fallen sharply in recent months while these countries were affected by capital outflows," it said.

The political situation in some eurozone countries, notably Italy, is resulting in wider spreads on sovereign debt and could create a risk of fragmentation with the euro-denominated sovereign debt market, giving rise to concerns that the doom loop, in which governments develop a potentially unhealthy reliance on banks to buy their debt, would return, the report said.