Moody's stripped France of its prized triple-A badge on Monday, cutting the sovereign credit rating on Europe's number two economy by one notch to Aa1 from Aaa, citing an uncertain fiscal outlook and deteriorating economy.
The downgrade, which follows a cut by Standard & Poor's in January, was widely expected but is still a blow to Socialist President Francois Hollande as he strives to convince the world he can fix France's public finances and stalled economy.
Moody's said it was keeping a negative outlook on France due to structural challenges and a "sustained loss of competitiveness" in the country, where business leaders blame high labour charges for flagging exports.
"The first driver underlying Moody's one-notch downgrade of France's sovereign rating is the risk to economic growth, and therefore to the government's finances, posed by the country's persistent structural economic challenges," Moody's said.
"These include the rigidities in labour and services markets, and low levels of innovation, which continue to drive France's gradual but sustained loss of competitiveness and the gradual erosion of its export-oriented industrial base."
Finance Minister Pierre Moscovici told Reuters the downgrade was a motivation for the 6-month-old Socialist government to pursue reforms, but he noted that even after the S&P downgrade French debt has enjoyed record low yields.
He also said the government was committed to meeting its target of cutting the public debt to 3% of economic output next year from an estimated 4.5% this year.
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The euro slid against the US dollar after the downgrade, by 0.30% from nearly a 2-week high to $1.2770, even though analysts said the downgrade was largely factored into bond markets.
The S&P downgrade had little impact on French yields, which have been trading at record lows of just over 2% in recent weeks despite the concern about France's sickly economy.
"There is probably more downside until the knee jerk reaction is out of the way. But on the whole it seems likely that this more reflects an existing reality than new information for the market," said Steven Englander, global head of G10 FX strategy at Citi.
Reforms Ahead
Moody's had been waiting to examine Hollande's 2013 budget and his response to a review of industrial competitiveness before adjusting its view on France as a sovereign lender.
Standard & Poor's has rated France AA-plus, with a negative outlook, since downgrading it by one notch in January. Fitch Ratings still has France at AAA, also with a negative outlook.
The loss of its Aaa rating from two agencies poses a problem for France, as investment funds often require their best assets to have at least two top notch ratings to remain in their portfolios.
Any rise in borrowing costs will be painful as the French government is already battling to rein in its deficit with potentially painful cuts to public spending.
"France is paying the price for not engaging in reform," said Axel Merk, president of Merk Investments in Palo Alto, California, saying he was not surprised by the downgrade.
With France's 2 trillion euro economy teetering on the brink of recession, Hollande surprised many this month by unveiling measures to spur industrial competitiveness, chief among them the granting of 20 billion euros in annual tax relief to companies, equivalent to a 6% cut in labour costs.
The government had already announced 30 billion euros in budget savings next year in an effort to meet its deficit goal and is working on reforms to labour laws to enable companies to hire and fire more easily with economic swings.
French bond yields are close to record lows of just over 2%, nearly one percentage point lower than at the time of the S&P downgrade, allowing France to roll over its debt for free, in inflation-adjusted terms.
Analysts expect a limit to any automatic selling by investors whose mandate only allows them to hold AAA bonds.
"The amount of index-driven selling would be near zero. France is fair value relative to other euro-area sovereigns," Morgan Stanley, a primary dealer, wrote in a report last week.