September 6, 2012 / 6:23 AM / in 5 years

Analysis: French budget may duck reforms, frustrate markets

PARIS (Reuters) - Investors and governments from Beijing to Berlin regard France's 2013 budget this month as the acid test of President Francois Hollande's credibility but those hoping for long-overdue reforms and bold spending cuts are likely to be disappointed.

While Italy and Spain have swallowed painful austerity and reformed pensions and labor laws under pressure from bond market vigilantes, the new Socialist government in Paris has so far escaped higher borrowing costs despite raising billions of euros in extra taxes to plug a deficit gap this year.

That may not last.

With Europe's number two economy on the brink of recession and public debt nearing 90 percent of gross domestic product, Hollande knows he must convince investors of his deficit-cutting mettle to avoid being dragged deeper into the euro zone crisis.

"French debt is significantly overvalued," John Gilbert, chief investment officer for General Re, a unit of Warren Buffet's Berkshire Hathaway, warned in August.

"We do not know if the markets will turn on France," he said in a research report, arguing that Paris should be paying 4.5-5.0 percent on 10-year bonds, rather than the current 2.25 percent, based on its fiscal performance.

Hollande's pledge to set an example of budget responsibility by hitting a deficit target of 3 percent of GDP next year stirred hopes he would at last rein in public spending, second only to Denmark's in Europe at 56 percent of economic output.

Instead, the signs are that the government will fall back on traditional French tactics of basing the budget on overly optimistic growth forecasts and loading yet more taxes on the rich and big firms, while trimming spending only lightly.

The draft budget goes before the cabinet on September 26. But there is little sign that Hollande is considering profound changes to an economic model built on a large public sector, domestic consumption rather than exports, protected labor markets and generous health and welfare benefits.

That could strain the vital partnership between France and economic powerhouse Germany at the heart of the European Union, potentially weakening the capacity of the euro zone's core to support troubled states on its periphery.

Berlin enacted its own painful labor and welfare reforms in the last decade and has reaped stronger growth, booming exports and low unemployment since 2009. It is impatient to see Paris follow suit.

ECONOMISTS SCEPTICAL

Economists are skeptical that France will meet the EU-ordained deficit goal with its 2 trillion euro ($2.52 trillion)economy stagnating and unemployment at a 13-year high and rising.

"I don't see how they can reach the 3 percent target next year. Even if they get to 3.6 percent, that's not bad," said Gilles Moec, senior economist at Deutsche Bank.

"Hollande can't risk ditching the deficit target because there would be market consequences so, without cuts, there are only two ways to make the figures add up: the growth target and taxes," he added.

With his approval ratings in a tailspin, Hollande promised on Tuesday to keep the number of civil servants stable next year in a sop to powerful public sector unions and freeze spending in nominal terms - a real cut of around 2 percent after inflation.

It is unclear if that will stay the hand of credit ratings agency Moody's, which has set an end-September deadline to decide on a possible cut in France's AAA rating. Standard & Poor's, citing high government debt and labor market rigidities, was first to downgrade France in January.

The MEDEF employers' lobby blames heavy payroll charges, a 35-hour statutory work week and over-rigid hiring and firing rules for eroding France's competitiveness, helping to drive the trade deficit to a record 70 billion euros last year.

Successive governments have brushed off warnings over the gaping current account deficit, most recently from the European Commission in May, prompting criticism that France is in denial.

Inside Hollande's administration, there are rumblings of a struggle between pragmatists led by Finance Minister Pierre Moscovici who want the budget built on realistic foundations, and left-wingers such as industry minister Arnaud Montebourg pressing for more public money for job-creation.

After government spokeswoman Najat Vallaud-Belkacem said on Wednesday there was no plan to cut the official 2013 growth forecast of 1.2 percent -- more than double the consensus of private forecasters -- Prime Minister Jean-Marc Ayrault's office issued a clarification, saying a decision had yet to be taken.

"The budget bill is based on a growth estimate that has not yet been agreed on," Ayrault's spokesperson said.

GERMANY, CHINA WATCHING

Chancellor Angela Merkel said in June that France's loss of competitiveness with Germany was becoming a problem, and she is eager to see Hollande go beyond populist tax measures such as a 75 percent income tax on those earning over 1 million euros.

"The 2013 budget is the real test," said one senior German government official.

"I can't say what will happen, but I can tell you that the millionaire's tax won't suffice," another source close to Merkel said.

Emerging economic powers look askance at Paris' resistance to change. Chinese policymakers have told European visitors they regard France as one of the euro zone's problem countries - alongside Greece - because of its persistent failure to reform.

Hollande has acknowledged France needs to make steps to improve its competitiveness and has given timid indications he could address the social charges weighing on unit labor costs.

But with hardline labor unions already showing resistance, the issue seems likely to become bogged down in negotiations well into 2013, holding back a "competitiveness shock" that MEDEF says the economy desperately needs.

So far, markets have given France the benefit of the doubt. Perceived as a safe haven implicitly linked to Germany, French bonds are trading near historic lows, benefiting from a rush of capital away from strained Spanish and Italian debt markets.

"France has a strong state which is able to raise tax revenues when it needs to and investors appreciate that," said Michel Martinez, chief economist at Societe Generale in Paris. He expects the government will be forced to revise the budget next year as growth slows to zero, but will still miss the deficit target even after that correction.

Mindful that a broad shift in market sentiment could drag France into the market's crosshairs, Hollande has discretely nudged Spain towards requesting an EU bailout to calm investors.

"Ultimately, France's fate probably depends on what happens elsewhere in the euro zone," said Nicholas Spiro of Spiro Sovereign Strategy.

($1 = 0.7935 euros)

Additional reporting by Leigh Thomas, Jean-Baptiste Vey and Yann Le Guernigou in Paris, Andres Rinke and Noah Barkin in Berlin; editing by Paul Taylor

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