France's economic rut deepens, but borrowing is no problem

Hot on the heels of Paris's admission that it would overshoot its deficit target this year and that growth would be a minimal 0.3 percent at best, a survey showed that business activity this month contracted at the fastest pace in nearly four years.

France's 2 trillion-euro economy already suffered a 0.3 percent contraction in the final three months of 2012 and the further loss of momentum raises the specter of extending into formal recession.

But although France's deteriorating economic outlook is increasingly cutting a stark contrast with euro zone powerhouse Germany, its debt drew strong demand at the first bond auction since the government gave up on its deficit target.

Investors sought more than twice the amount of fixed-rate, medium-term bonds on offer and demanded only slightly higher yields than in recent auctions where France has borrowed at record low rates.

It continued a trend seen in France for some time, in which investors put aside concerns about the country's economic and fiscal state to buy bonds seen as part of Europe's core.

BNP Paribas economist Dominique Barbet said the economic gloom presented a conundrum for bond investors by prompting them to seek the safety of bonds in tough times while also straining the state's capacity to pay its debts.

"One doesn't know which way to interpret things and maybe the French bond market doesn't either," Barbet said, noting that the vast liquidity of French bonds made them a favorite with portfolio managers.

Demand for an 11-year index-linked bond at auction on Thursday was oversubscribed.

OFF TARGET

The auction results landed only hours after Markit's preliminary composite purchasing managers index (PMI) showed a fall to 42.3 in February from 42.7 in January, hitting the lowest level since early 2009 when France, like much of the developed world, was mired deep in recession.

"There is a fairly consistent picture showing that the French business sector is suffering its worst downturn since the height of the financial crisis," Markit chief economist Chris Williamson said.

Service sector weakness was the main culprit for the decline while the long-suffering manufacturing sector showed a rare improvement, mirroring a trend seen earlier in a survey from the INSEE statistics agency.

Markit said the PMI surveys pointed to a 0.7 percent contraction in GDP for the first quarter of 2013, placing France's economy on the same playing field as Spain and Italy - and not Germany, which data suggests is picking up momentum.

Two consecutive quarters of contraction is considered the minimum for a recession.

The government is waiting for forecasts from the European Commission on Friday before drafting new economic targets, with French media reporting that Brussels estimated the economy will post nearly flat growth this year and a deficit of 3.6 percent.

Standard & Poor's Chief European economist Jean-Michel Six said that keeping the deficit on a downward trend was more important than hitting the deficit target.

"For a ratings agency like ours, it is the trend that counts much more than a specific level at a specific time which in itself reflects a European economy beyond the control of the authorities," Europe 1 radio quoted Six as saying.

EU Economic and Monetary Affairs Commissioner Olli Rehn has opened the door to giving countries more time to cut their deficits if they prove their underlying deficit-cutting measures are on track.

Though the bond market largely anticipated that the deficit target would be dropped, the admission is a blow to France's fiscal credibility with some of its euro zone partners who are uneasy with giving France more time.

(This story was fixed to correct ninth paragraph to show bond was index-linked, not conventional)

(Editing by Jeremy Gaunt)

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