PARIS/LONDON France and Britain are most vulnerable within Europe to a rating review following the U.S. downgrade, with anemic growth and hefty borrowing placing them among the shakiest of the world's triple-A rated lenders.
Both countries have stable rating outlooks, making a sudden downgrade unlikely and markets have been so impressed by Britain's debt-cutting strategy that they have pushed its bond yields to record lows.
But a surge in the cost of insuring French debt against default on Monday highlighted alarm sparked by Friday's U.S. rating cut as banks and brokerages warned that rating agencies could now have top-rated European lenders in their sights.
"France has slipped into borderline AA+/Aa1/AA+ (one notch below AAA) territory, so risks to its AAA are rising as stresses spread," financial services firm BBH said in a note to clients.
In another indication of mounting concern over France, spreads between French and German 10-year bond yields hit all-time highs last week and remained wide on Monday.
The most likely trigger for France to be put on negative watch would be a failure by the government to get parliamentary backing for a constitutional limit on future public deficits, with opposition left-wing lawmakers vowing to reject it.
Euro zone outsider Britain looks less vulnerable, having its own currency which could slide in value and its own interest rate, but it could also come under review given its weaker economic fundamentals.
"There are ... lots of countries in Europe that should be downgraded just as the U.S. has been downgraded," U.S. investor Jim Rogers, co-founder of the Quantum Fund, told Reuters Insider as world leaders battled to calm a market rout driven by concern about U.S. and European debt levels.
After making history by stripping America of its AAA-rating, Standard and Poor's reaffirmed France's top-notch status and stable outlook at the weekend. Moody's and Fitch declined to comment, but neither has given any indication they could change their outlooks on the United States, France or Britain.
Providing further comfort, fund managers poured into French and British bonds in early trading as Friday's U.S. downgrade forced them to shift funds out of U.S. treasuries.
However, French five-year credit default swaps (CDS) surged 15.5 basis points on the day to a record-high 160 bps, according to data monitor Markit, taking it closer to the level of AA-rated states such as Belgium, though analysts warned the market often overreacts.
"The CDS market is very dysfunctional," said Mark Schofield, global head of interest rate strategy at Citi.
"Although France from the perspective of fiscal fundamentals looks the weakest of the triple-A issuers in Europe, I still think that given very low levels of yields, the depth of the domestic market, the ability to continue to fund at low levels, it's unlikely France will be downgraded in the near future."
As for Britain, he added: "It's unlikely that the UK will be downgraded. At this point in time, we've seen very significant fiscal tightening put in place."
FRENCH POLITICS IN FOCUS
In the euro zone, only Austria, Finland, France, Germany, Luxembourg and the Netherlands have a triple-A rating, and French debt costs the most to insure.
France also has the highest deficit, debt and primary deficit of any of them and it is the only triple-A euro zone country running a current account deficit.
Its debt to GDP ratio -- set to hit 86.9 percent next year and described by the national audit office as nearing the danger zone -- could be pushed even higher by France's contribution to a new Greece bailout.
S&P said in June it would probably downgrade France in the long term without further reforms and that to preserve its AAA rating France must balance its budget in the next five years, something not achieved since 1974.
It could re-examine its rating outlook as soon as the autumn if President Nicolas Sarkozy fails to win backing for his constitutional budget-balancing rule. Winning would require a three-fifths majority in a two-chamber parliamentary vote and the opposition Socialist Party has vowed to vote against.
"It would be a call for action," for ratings agencies, said Deutsche Bank analyst Gilles Moec.
He said France was "intrinsically in a better situation" than the United States and could stave off a downgrade by accelerating deficit cuts, one idea being to raise value-added taxes and trim social contributions on labor.
Also weighing on France is a possible swing to a left-wing government after a presidential election next April. The Socialists have vowed to tinker, if they win, with a 2010 retirement reform aimed at cutting future pension costs.
WEAK GROWTH UK'S MAIN RISK
Britain has an even bigger deficit, primary deficit and debt to GDP ratio than France, and also runs a current account deficit but weak growth -- and the damaging effect that would have on its debt pile -- is its main threat.
Moody's warned in June that it could reconsider its stance on Britain in the event of lower growth combined with weak fiscal consolidation.
Citi's Schofield agreed, saying: "The big risks would be a very sharp slowdown in growth and/or huge political upheavals, if you started to get a breakdown in the coalition."
Broadly, however, markets have faith in Britain's ability to pay back its debt, despite a budget deficit of some 10 percent, because of an austerity plan that includes tax increases and unprecedented cuts in public spending.
Yields on 10-year gilts hit a record low of 2.59 percent last week and British debt continued to outperform European debt on Monday as investors looked for safe havens.
Yet, the economy has basically stalled over the last nine months and even the government's fiscal watchdog, the Office for Budget Responsibility, has acknowledged its growth forecast of 1.7 percent for 2011 looks too high.
Lower growth means lower tax receipts and maybe a higher welfare bill if unemployment rises, all of which will add to debt.
The opposition has called for emergency tax cuts and some observers were quick to blame riots in London over the weekend on public spending cuts and dire economic prospects.
"Notwithstanding the fact that the UK is still struggling with its own economic recovery, we are pretty confident that the coalition is going to hold in the UK," David Beers, head of Standard & Poor's sovereign ratings, told Reuters Insider.
(Additional reporting by Raoul Sachs and Leigh Thomas in Paris; Marius Zaharia, Christina Fincher in London, Kevin Lim and Harry Suhartono in Singapore, editing by Mike Peacock)