September 26, 2012 / 8:37 AM / in 5 years

French euro credibility at stake with 2013 budget

France's President Francois Hollande looks out at the north reflecting pool of the September 11 Memorial at the site of the World Trade Center in New York September 25, 2012. REUTERS/Chip East

PARIS (Reuters) - President Francois Hollande will commit to the sharpest cut in France’s public deficit in three decades on Friday with a budget that could make or break its credibility with euro zone allies and financial markets.

While the 2013 budget will disappoint reformers by favoring tax hikes over painful spending cuts, Hollande aims to convince doubters that France is pulling its weight in efforts to resolve Europe’s sovereign debt crisis.

At stake is not only the level of trust between France and fellow euro founder Germany in vital months ahead, but whether bond markets continue to let Paris borrow at record low yields despite a public debt of around 90 percent of national output.

France has been treated by investors as part of the euro zone core, almost akin to Germany, but its finances are more reminiscent of the debt-strapped periphery economies.

“It is important for the president to ensure that France remains bracketed with Germany, rather than Italy and Spain,” JP Morgan said in a research note of the north-south split in perceptions of the EU powerhouse and weaker southern economies.

The aim is to reduce the deficit from 4.5 percent of gross domestic product this year to 3.0 percent next - a goal which economists said could still be missed if France fails to match its already modest 2013 economic growth target of 0.8 percent.

The French budget comes a day after Spain unveils its 2013 budget with new austerity measures which on Tuesday triggered clashes between protesters and police in Madrid, highlighting the potential for social unrest across in Europe as governments seek to tackle years of overspending.

Hollande’s room for maneuver is tight with Europe’s second largest economy already close to recession, his own popularity ratings in free-fall and left-wing allies and unions ready to cry foul at anything which smacks of austerity.

Elected four months ago on a platform of growth and jobs, he is promising to reconcile those goals with an effort to win 30 billion euros ($38.75 billion) for the budget on top of seven billion worth of measures already passed through this year.

Two-thirds of the extra cash will come from higher taxes on business and individuals, with the remainder to be recouped via a simple freeze at nominal rates of most France’s heavy government spend rather than actual cuts to it.

“I don’t want a policy of austerity, hitting salaries, weakening the state and turning it into a pauper,” Finance Minister Pierre Moscovici said, contrasting Friday’s package with more painful measures taken in Italy and Spain.

A BET ON GROWTH

Tax hikes are due to include a temporary 75 percent levy on earnings over one million euros which, while raising fears of an exodus of local captains of industry, is likely only to reap around 200 million euros. A new rate of 45 percent on incomes over 150,000 euros will bring in 300 million euros.

Officials say most existing income tax brackets will not rise with inflation as usual, leading to an extra 1.5 billion euros in revenues. A number of longstanding tax breaks will either be scrapped or reduced.

Business will face measures including a reduction in the rate of tax deductibility of loan interest, a move which by itself will swell state finances by around four billion euros.

“We view this budget, and the way it is being prepared, with consternation,” Laurence Parisot, head of the employers group Medef said of fears it will damage the competitiveness of French businesses already struggling with high labor charges.

While critics say that raising the tax burden only stores up trouble for further down the line, the initial focus will be on whether France can actually achieve the 3 percent target.

So far, markets have given France the benefit of the doubt and are currently buying its medium- and long-term debt an average yield of 1.98 percent, a record low which this year has already led to savings of 1.4 billion euros on debt repayments.

But that market indulgence - which comes despite France having lost its triple-A rating - could end fast if Paris is seen unable to make good on its promises of budgetary rigor.

The risk of France missing the 3 percent deficit target is particularly acute if the economy gets worse next year. Each 0.1 percentage point by which it under-performs its 0.8 percent growth forecast implies an extra one billion euros in savings to maintain the deficit target.

While the government hopes that focusing tax hikes on higher incomes will leave most consumers unaffected, economists say data such as last week’s downbeat purchasing manager’s index suggest 2013 growth to slow to as little as 0.3 percent.

The gloom was compounded on Wednesday by news that consumer confidence slipped further in September and confirmation from Labour Minister Michel Sapin that the number of unemployed rose for a 16th month running in August to top three million.

If economic growth falls short of target, some argue it may be better for France to slip slightly on the three percent deficit target rather than to tighten the fiscal screw further and tip into recession.

“A 3.5 percent deficit would continue to reassure markets,” said economist Ludovic Subran at credit insurer Euler Hermes.

Additional reporting by Jean-Baptiste Vey, Yann Le Guernigou and Raoul Sachs; Editing by Brian Love/Jeremy Gaunt

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