Inflation-Linked Bonds Blow Up In Our Face

"How inflation increases the cost of debt for the state", headlines Les Echos on June 30. So, the general belief is that a good wave of inflation will wipe out debts, but this would not be the case after all?

Governments borrow at a fixed rate, which is a real security because they know in advance the interest to be paid each year, and in case of an inflationary episode, they repay with a devalued currency. Except that in France, and in a few other European countries, a little genius from the Ministry of Finance had the idea of issuing inflation-indexed bonds (OATi, Obligation Assimilables du Trésor). Why? In order to gain a few percent of interest at the time of the issuance. In fact, investors who benefit from an additional service (protection against price increases) receive less interest. The idea was launched at the time of the introduction of the euro and it was obviously thought at Bercy (The French Ministry of Economy and Finance) that inflation would be a thing of the past. A small saving for a big risk...

We were the first to warn of this danger back in April 2018, four years ago: "France Issues 10% of its Debt in Inflation-Indexed Securities". At the time, Agence France Trésor (AFT), which manages France's debt, was proud to announce the placement of an 18-year OAT€i. The Treasury was therefore betting that prices would stay low for the next 18 years, which takes us to 2035. And we are not even masters of our own destiny, since it is not the inflation rate in France, but that of the eurozone (hence the €i).

With the return of inflation, the damage is there. Les Echos writes that "Bercy expects the debt burden to rise by €17 billion in 2022, of which €15 billion will be due to inflation-indexed bonds." You have to realize the aberration of the situation: inflation generates, on 90% of our debt stock (issued at a fixed rate), an expense of €2 billion (which comes from the renewal of maturing loans), and on the remaining 10% (issued at a variable rate), €15 billion of additional cost. This 10% of debt (a stock of €250 billion, essentially OAT€i) costs 67.5 times more (15/2 times 9)! Thus, the total cost of the debt for 2022 will jump from €25 billion to €42 billion.

€15 billion in one go, over one year... this means that the 2022 budget has to be revised from top to bottom. If inflation increases further and lasts for several years (this is our scenario), the bankruptcy of France becomes hardly avoidable. And again, these €15 billion are an estimate based on an inflation of 6%, a figure already exceeded in the eurozone, and soon in France. 

What is most incomprehensible is that Bercy continues to issue these bonds when inflation has become a glaring reality. Isn't it time to stop? We denounced it here last February, recalling that the AFT issued a 31-year OAT€i on January 25, 2022. France will therefore be exposed to the inflationary risk of the eurozone until 2053. The latest issue dates from June 16, with an OATi (indexed to inflation in France) and two OAT€i (indexed to inflation in the eurozone) for a total amount of €1.5 billion and running until 2027, 2036 and 2040.

Why this suicidal stubbornness? Let's formulate a hypothesis: France is obliged to do it for those who buy its debt. Let's put ourselves in the shoes of those investors who buy French debt at a fixed rate, and 10% at a floating rate. With the return of inflation, they limit their losses, and the OATi and OAT€i drop a lot of euros in their pockets. If the government were to stop offering these products, which are very profitable for them, they would move away from fixed-rate debt, and France would go bankrupt, like Greece in 2011.

In any case, we must stop this madness that is taking the country straight to bankruptcy.