PARIS France vowed to defend its triple-A credit rating on Tuesday after a warning shot from ratings agency Moody's which prompted Paris to acknowledge growth would probably miss its targets and more belt tightening could be needed before elections next year.
Moody's raised the prospect on Monday of one of the pillars of the euro zone losing its coveted triple-A status, saying it could place France on negative outlook in the next three months if the costs for helping to bail out banks and other euro zone members overstretched its budget.
Moody's also warned of a weakening in France's economic growth outlook, which could complicate efforts to cut a budget deficit forecast for 5.7 percent of gross domestic product (GDP) this year -- roughly the same level as bailed out Portugal.
Economic growth in France, the euro zone's second-largest economy, ground to a halt in the second quarter. While most economists expect a pick-up this year, they see weak growth continuing in the medium-term as unemployment remains mired at around 9 percent, undermining domestic consumption.
Finance Minister Francois Baroin acknowledged the government's 2012 growth target of 1.75 percent was too high and would have to be adjusted, without saying by how much or when.
"It is probably too high compared to the development of the economic situation ... We will adapt it, that much is clear," he told France 2 television.
He said, however, that France's triple-A -- essential to the euro zone's 440 billion euro ($605 billion) EFSF rescue fund, which is largely underwritten by Germany and France -- was safe because Paris stood ready to take additional budgetary steps.
"It's not in danger because...we will even be ahead of schedule in passing deficit reduction measures," he said.
President Nicolas Sarkozy announced a 12 billion euro deficit reduction package two months ago, consisting mostly of cutting tax breaks. But with a tough re-election battle looming in April, he has avoided politically unpopular spending cuts.
France is increasingly seen by investors as straddling the divide between the euro zone's solid core and its fragile periphery. French banks' exposure to periphery sovereign debt has fueled fears Paris could be dragged into a costly bank bailout -- despite government denials -- which would weaken its finances and dash hopes of a quick fix to the debt crisis.
"(Germany) is, if you want, the only honest triple A rated sovereign in the G7," Willem Buiter, Citigroup chief economist and former Bank of England policymaker, told a UK parliamentary committee. "The rest are there but for the grace of God and the ratings agencies."
Moody's announcement, which came two months after Standard & Poor's stripped the United States of its prized triple-A rating, helped push the risk premium of French debt over German bunds to a 16-year high.
Prime Minister Francois Fillon said a European leaders' summit this weekend could be decisive in re-establishing confidence. He noted that next year's budget would work even if France's growth fell to 1.5 percent.
"If Europe in the next two weeks can put together measures strong enough to stop the speculation...then there will be growth in 2012 and we will reach the 1.5 percent," he told France 2. "If we fail, then it's serious because the world will be at risk of a recession and we'll have to take new measures."
CONFIDENCE IS KEY
Moody's sovereign credit analyst Alexander Kockerbeck said it would carefully analyze how France's EU commitments to tackle the euro zone crisis would impact its debt and deficit.
"The question is ... what can the government do to offset these negative effects?" he told Reuters, noting the government's financial position had worsened since 2008 when it bailed out banks. "The room for maneuver now is much less without jeopardizing the fiscal consolidation targets and that is putting pressure on an otherwise stable outlook."
Michel Martinez, an economist at Societe Generale in Paris, said France still had room to safeguard its rating with deficit-cutting steps but needed to take action before year-end.
"The adjustment needs to be made in the next three months or so, before the presidential election campaign gets into full swing," he said. "If that does not happen, it will be too late and the 2012 deficit targets will not be respected."
With Sarkozy's main opponent for next year's election, Socialist candidate Francois Hollande, also pledging to meet France's EU commitment to cut its deficit to 3 percent of GDP by 2013, Moody's said political risk was not a factor for France.
A Reuters poll last week predicted French growth would slow to 1.0 percent next year -- forcing whoever wins the elections to find billions in additional savings.
France also faces the prospect of guaranteeing up to 33 billion euros of Franco-Belgian lender Dexia SA's toxic debt. French government officials say there will be no major impact on the public deficit.
With European Union leaders considering further steps to recapitalize the region's banks, Paris has insisted French banks like BNP Paribas and SocGen must get capital from retained earnings, dividend cuts, or private investors.
Shares of French banks, which had rallied 30-40 percent since September lows on hopes of a coordinated response to the euro zone debt crisis, tumbled on Moody's announcement. BNP dropped 7 percent, while smaller rival SocGen lost 6 percent.
"If the agencies cut France by one notch, they would probably do the same with the French banks, which would mean a rise in financing costs," said Christophe Nijdam of Alphavalue.
But analysts noted it was France's anaemic growth, not its banks, which posed the long-term threat to its creditworthiness.
"The banks' recapitalization is just a one-shot operation. This would impact the debt, but the real problem is the trajectory of public finances and therefore growth," said Jean-Louis Mourier of brokerage Aurel Leven BCG.
($1 = 0.727 Euros)
(Additional reporting by Geert De Clercq and Marc Joanny; writing by Daniel Flynn; editing by Anna Willard/Mike Peacock)