Analysts warn of ratings downgrades as French budget focuses on tax hikes

• The French government on Thursday unveiled a draft budget with 60 billion euros ($65.6 billion) in tax increases and spending reductions to reduce its 6.1% deficit to 5% of GDP by next year.
• The budget includes politically-controversial measures such as a levy on electricity consumption, public spending cuts, and a delay to pension adjustments, despite tax hikes being directed towards big corporations and high earners.
• The package may not be sufficient to prevent additional ratings cuts for the economy and could impede economic expansion, according to analysts' warnings.

The French government unveiled a draft budget on Thursday with 60 billion euros ($65.6 billion) in tax increases and spending reductions, but analysts cautioned that the package might not be sufficient to prevent ratings agencies from downgrading the economy.

The 2025 budget has a stronger emphasis on tax-raising measures than anticipated, with analysts highlighting politically complex proposals such as a pension inflation delay and cuts to local government, the civil service, and healthcare.

The government has announced new taxes and charges, including temporary additional taxes on large shipping firms and corporations with revenue of more than a billion euros a year, an income tax surcharge on households with incomes over 500,000 euros, the reintroduction of a levy on electricity consumption, and an increase in taxes and charges on airline tickets and cars with high emissions.

The budget's objective is to decrease France's projected 6.1% deficit for 2024 to 5% of GDP, in order to adhere to EU rules that stipulate a member nation's budget deficit should not exceed 3% of GDP.

The government has set a new target of meeting this rule by 2029, an extension of its previous goal of 2027. Additionally, the government has warned that the deficit could increase to 7% next year if no action is taken.

Political challenge

The government was left with limited options after failing to find 60 billion euros in a year, forcing it to resort to politically complicated solutions, according to Hadrien Camatte, senior economist for France, Belgium, and the euro zone at Natixis, who spoke on CNBC's "Squawk Box Europe" on Friday.

This week, the French government, headed by Prime Minister Michel Barnier, survived a vote of no confidence.

After the July parliamentary election, the government was established following contentious discussions due to the New Popular Front's victory, although it did not provide any party or coalition with a majority.

Barnier described the draft budget as a starting point for discussion among lawmakers and expressed willingness to make adjustments that preserve its financial soundness.

Changes will be made to pensions and social security contributions, sparking heated debate, as the budget debate begins on Oct. 21 and votes on different parts of it will take place from Oct. 29.

"Finding 60 billion in one year is unprecedented and not very credible, given that we have never found such a large amount before, and the relative majority is very fragile."

Tax focus

Analysts at Goldman Sachs stated in a note on Friday that the policy mix supporting the 2025 budget is "more geared towards tax increases than we anticipated," with a decrease in spending cuts.

The proposed consolidation and reliance on tax increases make us less confident in the government's ability to meet its 2025 deficit target of 5.0%. Our previous research has shown that abrupt adjustments and tax-based consolidations have a lower chance of achieving sustainable fiscal improvement.

The government's survival of the Oct. 8 no confidence vote suggests the possibility of near-term political stability.

Their base case is for the government to pass the budget bill by the end of the year, but beyond that point, there is greater uncertainty.

To obtain fresh money urgently, your only option is to raise taxes. However, the issue is that taxes are already high in France, with the country having the second-highest wage tax rate in Europe, as stated by Natixis' Camatte to CNBC.

According to Rabobank's senior macro strategist, Erik-Jan van Harn, the bill's split will result in a 40 billion euro reduction in government spending and a 20 billion euro increase in revenues, despite an emphasis on tax hikes.

Barnier's ambitious plans are risky to implement and his government's commitment until 2029 is uncertain.

Ratings risk

Concerns persist about the impact of the 2025 budget on France's economic growth and the possibility of additional credit downgrades on its sovereign debt, following cuts by S&P and Fitch in the past two years.

Evelyn Herrmann, Europe economist at Bank of America Global Research, stated on CNBC's "Squawk Box Europe" on Friday that the government has taken measures to prevent harming economic growth.

By focusing on upper income groups and profitable companies, there is hope that growth can be temporarily avoided, she said.

Goldman Sachs analysts predict that the impact of the package on economic growth will shift from a 0.3 percentage point increase in 2024 to a 0.5 percentage point decrease in 2025 and 2026, while UBS anticipates that the historically large 2% of GDP fiscal consolidation will negatively affect growth.

The French economy is expected to grow by 1.1% this year, according to a forecast by the statistics agency Insee. However, Camatte of Natixis believes that this growth rate may be slightly overly optimistic, although it is not entirely unrealistic.

The trajectory beyond 2025 is a concern for me because there are no documented measures to reduce the deficit beyond that year, and when conducting debt sustainability analysis, France's trajectory is evidently a risk.

Ratings agencies would adopt a wait-and-see approach due to the absence of specific information about the budget, though a negative outlook from S&P or Fitch could not be ruled out.

Camatte stated that at present, it is more important to remain calm and wait until next year to determine the credibility of the spending cuts. Nevertheless, he anticipates that Moody's, which has given France a better rating, will issue a negative outlook this year before downgrading it in the next year.

Van Harn from Rabobank was even more pessimistic, stating that severe budget cuts would stifle economic growth and that a downgrade by one of the major rating agencies is imminent.

The sharp turn in France's fiscal stance will hinder economic growth, which is already weak, due to stark austerity. The government should consider the economic consequences of their policy, but the lack of political capital may force Barnier to make incorrect decisions.

"Based on the risks mentioned by Fitch and the optimistic nature of its earlier projections, we anticipate a rating downgrade. Although this may not be favorable from a spread perspective, we believe that the market has already factored in such a move."

— CNBC's Charlotte Reed contributed to this story