By Yoruk Bahceli
(Reuters) - Markets are tentatively optimistic France's budget may eventually pass its fractured parliament, but remain sceptical of how quickly the country can tidy up its finances, a worry reiterated by Fitch's downgrade of the country's rating outlook.
France's government outlined plans for 60 billion euros ($66 billion) of spending cuts and tax rises on Thursday in a belt-tightening budget to rein in a deficit it expects to exceed 6% of GDP this year.
The budget's blueprint was well flagged, so the yield premium France's bonds pay over top-rated Germany has held steady at around 77 basis points.
"They will probably get it approved. But the path to get it approved is likely to be bumpy," said Danske Bank chief analyst Jens Peter Sorensen, expecting volatility as parliament debates the budget.
The budget squeeze, equivalent to two percent of national output, has to be carefully calibrated to placate opposition parties, who could band together to topple Prime Minister Michel Barnier's minority government with a no-confidence motion.
This uncertainty has left the French/German bond spread near the peak of around 85 bps it hit over the summer - the highest since the euro zone debt crisis - when a snap election heightened concern around France's creaky finances.
So, passing the budget and improving state finances are crucial for France to restore investor confidence and avoid further credit rating downgrades.
Highlighting the risks, Fitch Ratings revised the outlook on the country's AA- rating to negative on Friday, a move that indicates a rating downgrade is possible down the line.
Fitch cited a much higher deficit than it previously expected, adding France's high political fragmentation complicates its ability to consolidate its finances.
BLURRY PICTURE
Citi and Goldman Sachs said on Friday the budget was likely to pass, with the government probably using special powers to bypass a parliamentary vote.
The key issue, investors said, was how Marine Le Pen's far-right National Rally party, which helped the government survive a no-confidence vote last week, would react.
Before Thursday's budget details were announced, Le Pen said she wanted to give Barnier a chance, but set out red lines, including the need for tax rises to be offset by increased spending power for lower and middle classes.
Far-right lawmaker Jean-Philippe Tanguy called the budget proposal a "horror gallery" on Friday, lamenting its "fiscal injustice" and saying it would bring no durable improvement in the nation's finances.
Some investors, however, reckon France's far right has little reason to torpedo the budget, given the possibility of fresh parliamentary elections next year.
"Their incentive is to do everything they can to just try and seem more credible, more responsible in the eyes of the electorate," said Chris Jeffery, head of macro strategy at Legal & General Investment Management, which turned overweight French bonds in recent weeks.
The bigger question for markets remains whether France can curb its deficit as quickly as outlined.
The government expects to bring down France's budget deficit from 6.1% of output this year to 5% next, but markets reckon that's too optimistic.
Fitch also expects a 5.4% deficit next year and in 2026. It included only part of the belt-tightening package in its assessment, citing political uncertainty and implementation risks.
Barnier has said he is open to lawmakers tweaking the budget provided they don't go too far, and still needs to add some measures.
"The most important part, how they can really reduce expenditure, this is not clear enough today," said Candriam's chief investment officer Nicolas Forest.
Even a proposal to save 4 billion euros by postponing pension indexation to inflation for just half a year triggered an outcry. Tax increases are also a sticking point within the government, highlighting the challenges.
Headwinds to growth from the belt-tightening measures add to the risks, investors say. And some economists argue the plan is more reliant on revenue increases than the government has officially suggested, adding to caution as revenues fell far short of expectations this year.
France's national fiscal watchdog has also said next year's deficit target looks "fragile" and is based on optimistic economic assumptions.
RATINGS PRESSURE
Ratings will remain in focus with Moody's (NYSE:MCO), which scores France higher than peers at Aa2, reporting on Oct. 25.
France was downgraded by rival S&P in May to AA-.
Yet markets already price in lower ratings, investors said.
France's bonds pay a higher yield than Spain's even though its ratings are 2-5 notches higher.
"With the budgetary issues France is facing, it is becoming semi-periphery, it is at risk of losing its status as a core country in the euro area," said Christian Kopf, Union Investment's head of fixed income and FX.
For longer-term reform prospects, the question remains how long Barnier's government, which envisions the deficit reaching the EU's 3% limit in 2029, will last.
"We are not sure that this government will stay more than 10 or 11 months. So what is the credibility of this government to talk about the deficit in five years?" said Candriam's Forest.