By Paul Taylor
PARIS (Reuters) - It was the week the euro zone debt crisis reached France, one of the twin pillars of the European currency alongside Germany.
As jitters over Paris' prized top-notch AAA credit rating took hold, President Nicolas Sarkozy returned from the beach to order up new austerity measures. Then panic selling of French bank shares and an abrupt halt to economic growth added to France's plight.
The sight of the euro zone's number two economy buffeted by rumors and investor anxiety in the midst of the holiday season raised existential questions about European monetary union that will confront Sarkozy and German Chancellor Angela Merkel when they meet in Paris next Tuesday.
The fragile edifice of support for weaker European states would start to crumble if France, the second contributor to the euro zone's rescue fund, were to face a debt downgrade.
"The implicit hypothesis is that the countries that have the financial means to support the countries that are in trouble do not run into difficulties themselves," Morgan Stanley economist Olivier Bizimana said.
All three major ratings agencies reaffirmed this week that no French downgrade was in the works, but that didn't suffice to calm markets.
Up to now, Sarkozy has projected himself as an energetic statesman orchestrating the rescue of the euro zone. Suddenly he had to turn to crisis management at home.
This week's perfect summer storm wiped 10 billion euros ($14.2 billion) off French banks' market value on Wednesday and left France looking at times like the country in need of help itself.
The disclosure that the economy failed to grow at all in the second quarter, after a healthy 0.9 percent spurt in Q1, amplified concerns about the government's ability to meet its target of cutting the deficit to 5.7 percent of GDP this year.
Worryingly, household consumption fell by the biggest amount in a decade, suggesting consumers are reining in spending because they fear hard times and higher taxes ahead.
"If growth is slowing, questions arise about the public finances of those countries that are supposed to help the countries that are in trouble," Bizimana said.
Just eight months before the first round of a presidential election, Sarkozy faces unpalatable choices between removing more tax breaks to increase revenue and cutting public spending, both of which could further depress anemic growth.
The center-right president has tried to upstage his Socialist opposition by proposing to introduce a German-style fiscal rule on deficit reduction in the constitution. Socialist votes would be needed to achieve the required super-majority.
Socialist leaders have refused so far to cooperate with what they call Sarkozy's "trap" and sought instead to blame him for increasing the deficit with tax give-aways for the rich.
The issue is bound to be one of the major battlegrounds of the campaign for the presidential election next April and May.
Sarkozy's approval ratings have improved since Socialist front-runner and former IMF head Dominique Strauss-Kahn was forced out the race after his arrest in New York on sexual assault charges.
But both main contenders for the Socialist nomination, Francois Hollande and Martine Aubry, are still ahead of the president in the polls at the moment.
IRRATIONAL AND RATIONAL
French authorities are still not entirely sure what hit them this week. There were both rational and irrational reasons for the market attack.
When Standard & Poor's knocked the United States off its triple-A perch last Friday, markets started looking for who else might be in line, turning a spotlight on France, with the biggest debt and deficit ratios among the six AAA-rated euro zone countries.
Economist Jacques Attali, a former top aide to President Francois Mitterrand, noted that S&P had specifically compared France with the United States, saying it was the only other AAA country that would have a similar debt ratio in 2015.
"Contrary to what everyone says, we are explicitly singled out," Attali told the daily Le Monde in an interview.
"Hence we must a bring our debt down below 85 percent of GDP by the end of 2013, and get back to 70 percent in this decade. That won't be easy."
The cost of insuring French public debt against default reached a new peak during the week yet by Friday, France's 10-year bond yield had fallen back below 3 percent for the first time since November 2010, hardly a sign of imminent meltdown.
The country does have an Achilles' heel: stress tests have shown that its banks are among the most heavily exposed to debt in the euro zone periphery, particularly Greece and Italy.
The sight of the European Central Bank buying Italian bonds on the secondary market to prevent Rome's borrowing costs rising to unsustainable levels, and reports that Greece's debt swap would be extended to bonds maturing up to 2024, combined with wild market rumors to hit French lenders.
Shares in Societe Generale plunged as much as 23 percent on Wednesday before closing 15 percent lower. BNP Paribas and Credit Agricole suffered lesser hits.
A senior SocGen executive told Reuters the bank was worried that heightened market tensions could lead to a 2008-type credit crunch in which banks stop lending to one another.
French regulators, joined by their Italian, Spanish and Belgian counterparts, banned short-selling of financial shares on Thursday in a temporary response to try to halt rumor-driven herd behavior. Bank shares rose modestly on Friday.
A senior risk manager at a large European bank, speaking on condition of anonymity, said one reason for the losses on French and European bank shares was that short sellers were targeting banks instead of government bonds.
"Because it's increasingly difficult to trade CDS on sovereign debt, short sellers take bank shares as proxy for sovereign bonds of the respective countries. If you bet on losses of French sovereign bonds for instance, short selling of French banks is very promising," he told Reuters.
Under cover of anonymity, several traders and government officials suggest hedge funds had shorted French debt in anticipation of a downgrade and turned on the banks when it became clear this was not going to happen.
A French fund manager said he clearly witnessed a "France bashing session" on Wednesday.
He said a U.S. bank had sent a market-wide message citing six reasons to sell shares of a French investment firm. The reasons invoked were "because it is French," six times.
(Additional reporting by Philipp Halstrick, Sophie Sassard, Elena Berton and Geert De Clercq; editing by Mike Peacock)