Moody's warned France on Monday that a sustained rise in its debt yields coupled with weakening economic growth could harm its ratings outlook, fuelling concern the euro zone's second largest economy might lose its coveted AAA status.

Worries about a high fiscal deficit and banks' exposure to other troubled European sovereign debt have drawn France into the firing line of the bloc's escalating crisis, despite the government's insistence it would do everything necessary to protect its top rating.

Moody's announced in mid-October it could place France's AAA rating on negative outlook in three months if the costs for helping to bailout French banks and other euro zone members overstretched its budget.

On Monday, the rating agency said that a worsening in the French bond market -- amid fears the sovereign debt crisis was spreading to the euro zone's core -- posed a threat to its credit outlook, though not at this stage to its actual rating.

Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications, Senior Credit Officer Alexander Kockerbeck said in Moody's Weekly Credit Outlook dated November 21.

The premium investors charge on French 10-year debt compared to the German equivalent was up around 20 basis points at 163 bps following publication of Moody's report but remained well short of the 202 bps hit last week, a new euro-era high.

The news also helped to drive European stocks to close at six-week lows amid concern over flagging global growth prospects and the health of the United States' finances.

Moody's said that at last week's record level, France pays nearly twice as much as Germany for long-term funding, adding that a 100 basis point increase in yields roughly equates to an additional three billion euros in yearly funding costs.

Many investors have already discounted a downgrade to France's AAA rating, given expectations its economy will enter recession next year.

When you look at the valuations in the market, France has de facto lost its AAA. If the United States was stripped of its AAA by S&P, one wonders why France still has it, said Raphael Gallardo of asset manager Axa IM. He noted that, unlike the United States, France did not have control over its monetary policy: Right now, we need a lender of last resort.

CAUGHT IN AN AUSTERITY TRAP

Finance Minister Francois Baroin said that, despite a recent increase in the spread of French yields over benchmark German debt, France continued to finance itself in the market at very favourable levels and modest austerity measures announced last month would not harm economic growth.

France's average medium- and long-term financing for the first 11 months of the year stood at 2.78 percent, its second lowest level since the creation of the euro, after hitting 2.53 percent in 2010, national debt agency AFT told Reuters.

Despite recent market turbulence, the average financing rate of 2.43 percent in the third and fourth-quarter was well below a historical average of 4.15 percent over the period 1998-2007, the AFT said.

Economists, however, said that France risked being sucked into a vicious circle where slowing growth necessitated more austerity measures, which in turn slowed growth even further.

Fiscal consolidation in an economic downturn may lead to an 'austerity trap', with fiscal tightening taking a toll on the short- to medium-term growth outlook, Olivier Bizimana of Morgan Stanley said in a research report.

France's government recently cut its growth forecast for next year to 1 percent, from 1.75 percent, but most private economists still consider that far too optimistic.

Budget Minister Valerie Pecresse said the government would not take further austerity measures, after announcing a 65 billion euro package of deficit cuts this month, saying a budgetary buffer of 6 billion euros next year would give it breathing room even if growth underperformed.

We must above all avoid taking measures that plunge the country into recession, Pecresse said.

But Moody's said that slowing growth combined with rising interest rates would make it hard for France to hit its target of cutting the fiscal deficit from an estimated 5.7 percent at the end of this year to an EU ceiling of 3 percent by 2013.

The French social model cannot be financed if the French economy's potential is not preserved. With further weakening GDP growth the political scope for the government to generate further savings in this case would be tested, Monday's note from Moody's said.

(Additional reporting by Raoul Sachs and Brian Love; editing by Patrick Graham/Anna Willard)