S&P's move this week to cut credit ratings of French banks and signs the government is increasingly reluctant to embark on rapid economic reform are prompting investors to ask whether France can still justify its generous borrowing rates.
As long as France can persuade investors it is serious about cutting its public deficit in line with European Union pledges, it is likely to cling on to bond yields at record lows around two percent, only slightly dearer than those enjoyed by Germany.
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But concerns over the sickliness of the euro zone's No. 2 economy could deepen next year and even lead to President Francois Hollande's nightmare: that of financial markets treating France more like Italy.
"Without significant structural changes France is likely to face continued challenges in attracting capital, generating more exports, as well as meeting government obligations," said Mellon Capital portfolio manager Vassilis Dagioglu.
"This is likely to cause an increase in borrowing rates from the current low level," he added.
French yields have fallen sharply since Hollande's election as investors gave his five-month-old administration the benefit of the doubt and because it remains a relatively safe haven in a euro zone still not out of its debt crisis.
But the premium investors demand to hold its bonds instead of German debt has crept up since mid-October by about 20 basis points to 70. A sequence of events in recent days has raised questions about whether a deeper decoupling is now due.
REFORM PROSPECTS DAMPENED
Citing concerns over the resilience of the French economy, Standard & Poor's cut ratings on giant BNP Paribas and two smaller banks; it also lowered its outlook for 10 banks including Societe Generale to negative from stable.
That came as Hollande played down prospects of a big early shift in France's heavy labour charges onto other forms of taxation -- a move employers say they need to compete worldwide but which the government fears would stifle consumer spending.
Earlier this week, his Socialist government came to the rescue of ailing auto maker PSA Peugeot Citroen's finance arm with state guarantees of up to 7 billion euros -- taking to around 60 billion euros the guarantees it has made available to prop up French banks in recent months.
"This is not a positive development," Yannick Naud, portfolio manager at Glendevon King Asset Management, said of the Peugeot move, which follows similar support for Dexia Bank and smaller lender Credit Immobilier de France (CIF).
"For now, we're not seeing an impact on sovereign credit spreads. But eventually, the differential between Germany and France will grow if we continue to see that the French economy isn't growing," he said.
France may of course not need to deliver on its guarantees if its banks and economy can ride the current slowdown. But reasons to be cheerful are thin on the ground.
Business morale in France's manufacturing sector slumped two its lowest level in two years this month, statistics institute INSEE said on Tuesday, the latest data suggesting France's official 2013 growth forecast of 0.8 percent is ambitious.
S&P warned that France's high public debt, lack of competitiveness on world markets and high unemployment also risked being aggravated by the wider slowdown in Europe and upped its economic risk score for France to "3" from "2".
QUESTION OF TRUST
Hollande's strategy is predicated on taking the time to get a negotiated economic reform package backed by trade unions and employers, thus averting strike threats or mass protests.
But that means in turn avoiding the sharp rise in borrowing rates which could force him onto a steep austerity course and trigger a recession -- the "Italian scenario" his conservative rivals have long predicted.
That is a fate his government has escaped so far.
Markets are waiting for rating agency Moody's' decision on a possible cut to France's AAA rating, a status which Standard & Poor's already downgraded in January citing France's high public debt -- now at a post-war record of 91 percent of the economy.
"A downgrade in France's rating is the real risk," Philippe Delienne, president of Paris-based fund manager Convictions Asset Management said of the impact on its bond market.
Moody's assessment was due some time this month. The agency was not immediately available to confirm that timeframe Friday.
A second trigger for a re-appraisal of France comes in early November when Louis Gallois, former head of the aerospace concern EADS, presents a long-heralded report with proposals to restore France's declining economic competitiveness.
Hollande has made clear he does not feel bound to implement the report's recommendations and his comment on Thursday that a big shake-up of France's fiscal system would have to be done "over time" suggests that investors looking for a major reform leap will be disappointed.
"If France is not able to carry out reforms, then investors are going to start worrying and there could be trouble," Barclays chief European economist Philippe Gudin de Vallerin said.
Perceptions that France's economy will lag further behind Germany's in years to come is one reason why the French CAC-40 stocks index is up just eight percent in 2012 compared to the 22 percent recorded by Germany's DAX, analysts note.
But AXA chief economist Eric Chaney said debt markets were for now more focused on the short term: whether France will keep its 2013 budget target of narrowing its public deficit to three percent of output from a forecast 4.6 percent this year -- a goal that will require 30 billion euros to be taken out of an already struggling economy.
Hollande's government says that target will be met and has firmly slapped down doubters within the ruling coalition who say it is unlikely to be held.
But if France misses its 2013 growth target, as a growing number of economists believe, it will face a shortfall in tax revenues. That in turn will mean a tough choice in early 2013 between an emergency budget to pull in more savings or having to explain to financial markets and EU partners that the three percent deficit pledge will not be met.
"The risk for interest rates is that in four, five, six months people see signs they are deviating from the (deficit) target," said Chaney. "It is all a question of trust."
(Additional reporting by Raoul Sachs, Blaise Robinson, Marc Joanny in Paris, editing by Mike Peacock)