It's not Italy that should spook us - it's France

The euro debt crisis increasingly resembles a teenage horror film. As soon as you think it is all over, the monster springs back to life. This week it was the turn of Italy to be spooked. Thecountry's bond yields started to spike upwards, a serious issue for a nation that has vast debts on which to pay interest. After flying under the radar for much of the crisis, the Italian debt market looks close to unravelling. Spain is coming under increasing scrutiny as well. It might well be next. But in fact, the markets are looking in the wrong place. The real testing ground for the euro is going to be their northern neighbour, France.

Monetary union was, of course, largely a French idea. The country's industrial and financial establishment had long been unhappy with floating exchange rates. As one of the major exporters within the European Union, they could see that constantly shifting currencies made life very difficult for their companies. While Germany primarily exports to the rest of the world, France is a eurozone manufacturing hub. A fixed currency system was in its interests. Indeed, some see the creation of the euro as a deal between France and Germany. Germany accepted merging its currency with France's in exchange for French support for re-unification after the fall of the Berlin Wall. It is ironic, therefore, that it isn't working out the way France planned.

But could France seriously have a problem staying in the euro? After all, it is a big, successful economy. It is not a peripheral nation like Greece or Portugal, neither of which ever really industrialised, or a chronically financially-chaotic country like Italy. Then again, Ireland was a successful, wealthy economy, and that didn't stop the country going bust as a result of monetary union.

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In reality, France is steadily losing competitiveness within the euro. That was confirmed last week with the latest trade data, which showed a widening deficit. The April trade gap rose to €7.42bn. Britain, by contrast, ran a deficit of £2.8bn, or €3.1bn, in April. The French deficit now amounts to 3% of GDP and has been hitting fresh records month by month. France's trade deficit with Germany, its main trading partner, is now €1bn a month. "Within euroland, France is losing competitiveness to Germany, and it has no option for devaluation to help itself out," noted High-Frequency Economics in an analysis of the figures. "A potential rift between France and Germany on trade would be a far more serious challenge to EMU's political fabric than a disagreement over how to restructure loans to euroland's second-smallest economy [Greece]."

Indeed so. There is no great mystery about what is happening. French wages have been rising at a faster rate than German wages and its productivity is not as good. The country is steadily becoming a less attractive place to make things. Persistent and rising trade deficits are clear evidence that France is struggling within the single currency in precisely the same way as the Greeks it's the same explosion, just with a much longer fuse. As it runs bigger and bigger deficits, the money will have to be re-cycled through the banking system. Eventually that will lead to a financial crisis. It may happen sooner than anyone thinks. While a country such as Italy has a greater stock of outstanding debt, France is racking up new debts at a far faster rate. Last year it ran a deficit of 7% of GDP. French debt will total 90% of GDP this year and 95% in 2012, according to estimates by Capital Economics. That isn't exactly running out of control, but it is getting very close.

There are other problems on the horizon. A presidential election is due next year. That may turn into a competition for who can make the most extravagant promises. The far-right National Front leader Marine Le Pen has pledged to bring back the franc. If she continues to do well in the polls, then pulling out of the euro will be on the agenda. That is not true of any other euro area country, not even Greece.

At any point, the bond markets may well take fright. It will start pricing in the possibility of France pulling out of the euro, or defaulting on some of its debt. Yields on French debt will start to spike upwards. That will be the point at which the crisis becomes scary. While Greece, Portugal and Ireland don't matter very much to the global capital markets, France does. In fact, it matters much more than Italy and Spain. It has $1.7trn of outstanding public debt, making it the fourth-largest debtor in the world, according to data from the Bank for International Settlements (BIS). (The US, Japan and Italy are ahead of it.) That debt is widely traded 37% of French debt is held internationally, which is a lot more than Italy (24%), the US (19%), or Japan (1%), again on BIS figures. In truth, French bonds are held by institutions right around the world and have always been regarded as rock-solid.

At some point, the bond markets are going to get very nervous about French debt, the same way they did about Greek and Portuguese and Spanish debt. Then the losses to the financial system could be very nasty indeed. The euro was created in France. It may well be in France that it finally starts to unravel as well.