Downgrade Raises Stakes for France to Reform Economy

Pressure piled up on France on Tuesday to reform its economy following a critical debt downgrade from ratings agency Moody's but initial market reaction was muted and the government stood by promises that change is underway.

Moody's is now the second of the three major ratings agency to cut France's top-notch triple A rating, noting it down to "Aa1" with a warning that a further downgrade could be on the cards.

In a night of turbulence and shock for Europe's second biggest economy, including an unexpected realignment of the old Gaullist right-wing opposition, Moody's warned about several big challenges, pinpointing the highly contentious issue of labor reforms.

Moody's declared: "France's long-term economic growth outlook is negatively affected by multiple structural challenges, including its gradual, sustained loss of competitiveness and the long-standing rigidities of its labor, goods and service markets."

But President Francois Hollande's Socialist government immediately sought to reassure financial markets while reaffirming its determination to control public finances and pursue reforms.

Government spokeswoman Najat Vallaud-Belkacem said the decision should be seen in perspective.

"France still represents sound value, it is in second place just after Germany," she told France Inter radio.

"Even today, investors lend to France at very favorable conditions," she said.

"The markets do not seem to be very worried by the decision."

She noted that Moody's had recognized efforts by the current government to control public finances and the recent national pact for "competitiveness and growth."

Finance Minister Pierre Moscovici told Agence France Presse earlier that France was still "well rated" and that the decision concerned the situation left by the previous government.

A source close to Hollande said the downgrade "sanctions the errors of the past" by successive governments.

France has not run a balanced budget since the 1970s.

The economy has been stumbling along at almost zero growth for about a year but in the last quarter rallied to show 0.2-percent growth, the same as in Germany which has been hit by a late slowdown.

"Poor" track record on reform

The Moody's downgrade is also problematic for the eurozone which still faces big problems with its debt crisis and notably how to absorb a debt mountain in Greece, a broad point underscored by Moody's.

The agency said that despite a change of policy stance in France two weeks ago with a switch in emphasis to competitiveness, a long slide of flagging efficiency hangs over the country's future. However, it also noted that the country had many points of strength, including a broadly based economy.

But Moody's, referring to the reforms it considered necessary, stressed: "The track record of successive French governments in effecting such measures over the past two decades has been poor."

In initial trading on Tuesday, The French stock market slipped by 0.27 percent, but this was after a strong rise of 2.93 percent on Monday before the late-night announcement by Moody's.

France has been able to borrow at record low interest rates in recent months since tensions in the eurozone eased and since the switch of policy tone towards a competitiveness pact two weeks ago. But the yield or interest rates indicated on the market for benchmark French debt edged up on Tuesday to 2.096 percent from 2.073 percent.

At French bank BNP Paribas, one bond strategist said: "France is now considered to be a country between AAA and AA. Consequently there could be a slight upward adjustment (of borrowing rates) on the market in the short term."

However, some other analyst comment suggested that this second downgrade meant that the underlying climate of exceptionally low borrowing rates for France had now begun to change.

At CMC Markets in London, analyst Michael Hewson noted: "Ten months after ratings agency Standard and Poor's, Moody's pulled the trigger on France's triple-A rating last night, downgrading it to Aa1 with a negative outlook citing an uncertain fiscal outlook along with a gradual sustained lack of competitiveness and deteriorating economic prospects."

"The agency also warned that the ability of the French economy to respond to further shocks was diminishing due to the country's high exposure to the rapidly deteriorating Spanish and Greek economies."

The warning from Moody's comes close on the heels of several external pressures on France to move quickly on reforms.

The International Monetary Fund has warned that France risks falling behind Spain and Italy on radical reform.

And Germany, the main powerhouse in the eurozone but also the twin pillar with France at the center of the zone and of the European Union, has sent strong signals that it is deeply concerned about the state of the French economy and outlook for reforms.

These pressures led the Economist magazine, widely read in financial circles, to devote a special section last week to France which, it suggested, was a "time bomb" at the heart of Europe.

The Moody's downgrade, being the second after similar action by SandP, means that some fund managers, under the terms of their contracts with savers, may now have to readjust their holdings of French government bonds.

The last finance minister under Sarkozy, Francois Baroin told i>TELE said that the decision, being the second downgrade, "triggers automatically and legally a change in the trend for borrowing rates."

It is estimated that about two thirds of French debt is financed from abroad.