Doubt cast on France's triple-A credit rating by Moody's raised uncertainty over Europe's hopes of drawing a line under its sovereign debt crisis, five days before a crucial EU summit.
The U.S. ratings agency said late on Monday it may slap a negative outlook on France's Aaa rating in the next three months if slower growth and the costs for helping bail out banks and other euro zone members stretch its budget too much.
"The deterioration in debt metrics and the potential for further contingent liabilities to emerge are exerting pressure on the stable outlook of the government's Aaa debt rating," Moody's said in its annual report on France.
The warning, which sent the risk premium on French government bonds shooting up to a euro lifetime high, came as European Union leaders are preparing measures to protect the region's financial system from a potential Greek debt default.
That strategy includes new steps to reduce Greece's debt, strengthening the capital of banks with exposure to troubled euro zone sovereigns and leveraging the euro zone's rescue fund to prevent market contagion to bigger economies.
The October 23 summit is likely to agree to leverage the bailout fund by allowing it to underwrite a portion of newly issued euro zone debt, euro zone officials said.
With about 300 billion euros of its 440 billion-euro capacity still available, by guaranteeing the first 20-30 percent of any losses, the European Financial Stability Facility could stretch three to five times further.
"This idea is the main contender," one official said.
Economy Minister Francois Baroin insisted that France's AAA status was not at risk but acknowledged that the 1.75 percent growth forecast on which the government has based its 2012 budget was over-optimistic and would have to be revised down.
"The triple-A is not in danger because we will be even ahead of schedule on passing deficit reduction measures," Baroin said on France 2 television.
"We will do everything to avoid being downgraded."
Asked if next year's outlook would have to be reduced in light of weak growth prospects, he added: "We will adapt it, that much is clear."
France and Germany, the two strongest economies among the 17 euro zone members, form the backbone of the EFSF rescue fund and are drafting a crisis-fighting strategy for Sunday's summit.
Without France's triple-A rating, the whole edifice of rescue measures for troubled peripheral euro zone states would begin to crumble, putting more weight on Germany, where there is a strong public backlash against bailouts.
German leaders on Monday doused market hopes of a miracle cure at Sunday's Brussels summit, saying no one should expect a "definitive solution."
German Chancellor Angela Merkel told a closed-door meeting of her Christian Democrats she favored having a permanent presence of the so-called "troika" of international inspectors in Greece to supervise its public finances if there were doubts about fiscal management, party sources said.
She also expected agreement on proposals to send euro zone countries that repeatedly breached EU deficit rules to the European Court of Justice, the sources said.
FRENCH SPREAD HITS RECORD
Analysts said Moody's move was unusual, since it had not put France on ratings watch, but it was a signal to the government that it needed to adopt a more realistic growth assumption and adjust its budget measures accordingly.
Monday's review was only a preliminary step, but a negative outlook would be a sign that Moody's could downgrade its rating on France in the next couple of years. It placed the United States's Aaa rating on negative outlook in August.
The two other major ratings agencies, Standard & Poor's and Fitch, reaffirmed Paris' triple-A rating in August when French banks came under fierce market pressure over their exposure to the weakest euro zone sovereigns.
The spread on French 10-year bonds over benchmark German bonds jumped to a 19-year high of 114 basis points, the first time it had breached 1 percentage point in more than a decade. Safe-haven German Bunds rose on ebbing hopes of a quick solution to the debt crisis.
The ratings review was a potential embarrassment for conservative President Nicolas Sarkozy, who is expected to run for re-election next April and May and faces a strong challenge from Socialist candidate Francois Hollande, who won a primary election run-off on Sunday.
Prime Minister Francois Fillon made clear in a television interview that if growth fell short of official forecasts, Paris would take further austerity measures.
But Philipp Waechter, head of economic research at Natixis Asset Management, said: "We're entering an election year. Before May 6, 2012, it will be complicated to take strong measures. The government's ability to respond is reduced."
In Greece, ships were harbored and trains halted on Tuesday as angry workers built momentum for "the mother of all strikes" expected to bring the entire country to a halt in protest against a new package of tax hikes and wage cuts.
Unions representing around half of Greece's 4 million-strong workforce have called a 48 hour general strike for Wednesday and Thursday to protest against a sweeping package of austerity measures due to be passed in parliament this week.
Prime Minister George Papandreou told the cabinet late on Monday: "The nation is at a crucial moment and we have to be united. In this battle, we need everyone."
Hours earlier, a deputy from Papandreou's party quit his seat in protest against what he called "unjust" steps. The lawmaker will be replaced by another socialist, so Papandreou's four-seat majority in the 300-strong assembly is unchanged.
Meanwhile Portugal, which has also received an EU/IMF bailout, announced a draconian 2012 budget that risks a severe recession. The European Commission called it "courageous."
Greece's overall debt is forecast to climb to 357 billion euros ($491.4 billion) this year, or 162 percent of annual economic output -- a level economists agree is unsustainable.
To reduce this mountain, euro zone leaders are racing to convince banks to accept "voluntary" writedowns of up to 50 percent on their sovereign holdings. At the same time, they are trying to agree on a blueprint for recapitalizing financial institutions at risk from the deepening crisis.
Negotiations with the Institute of International Finance, representing the banks, were continuing in Brussels after diplomats said Deutsche Bank chief Josef Ackermann, who is also chairman of the IIF, met EU Council President Herman Van Rompuy to discuss write-downs and recapitalization.
Ackermann has objected to efforts to force banks to raise more capital and IIF lead negotiator Charles Dallara told Reuters on Monday that bigger writedowns on Greek bonds could only happen if policymakers addressed broader sovereign debt issues in Europe.