Nicolas Sarkozy pledges drastic austerity measures as French bank shares crash

Mr Sarkozy returned from the Riviera to chair an emergency meeting in Paris with his inner cabinet and the central bank chief, Christian Noyer, breaking the sacrosanct August holiday.

The key ministries were given one week to draw up radical austerity measures.

"Whatever the impact of global uncertainty, or the S&P's downgrade of America's debt, or the turbulence of the markets, we will take the necessary steps, " said finance minister François Baroin.

The political drama came as swirling rumours set off a collapse of French bank shares.

Société Générale fell 21pc before recovering partially, plagued by fears that it may be heavily exposed to tumbling global stockmarkets through its role in the equity derivatives market. Credit Agricole closed down 13pc, and BNP Paribas fell 10pc.

French banks have €410bn (£360bn) of exposure to Italy alone according to the Bank for International Settlements. The twin crises in France and Italy are now intimately linked and appear to be feeding on each other.

The MIB index on the Milan bourse fell 6.7pc as the euphoria following the European Central Bank's intervention in the Italian bond markets gave way to angst that the EU bailout machinery may not be large enough to back stop the whole of southern Europe.

France's CAC 40 closed down 5.5pc.

Morgan Stanley said the flight from French bank equities was "overdone".

BNP Paribas does not need to tap the capital markets this year, while SocGen is 93pc funded. The European Central Bank has kept its lending window open and offered a 6-month tender.

Julian Callow from Barclays Capital said the credibility of the €440bn rescue fund (EFSF) depends on France retaining its AAA rating.

That is now highly questionable despite assurances from all three rating agencies on Wednesday that nothing had changed.

"The debt ratios of the US and France are very similar. France also suffers from economic rigidities and now has this extra burden of the EFSF. People are asking themselves whether S&P can downgrade US without downgrading France," he said.

Mr Callow said France has a current account deficit of 3pc of GDP, unlike other members of the eurozone core. This is a sign of slipping competitiveness and a warning that France may struggle to carry the burden of escalating bail-outs.

French industrial output fell by 1.6pc in June and economic growth ground to a halt in the second quarter, further eroding budget finances.

The fiscal deficit was running at 7pc of GDP in the first half. It will take draconian cuts at this point to meet the 5.7pc target agreed with the EU.

With Spain, Britain, and even Italy now forcing the pace on austerity, France cannot appear nonchalant. Italy's premier Silvio Berlusconi met union leaders on Wednesay to forge a deal on €20bn of anti-deficit measures and labour reforms demanded by the ECB.

He has recalled parliament to vote on a balanced budget amendment to the constitution.

The ratings agencies are under intense pressure in Europe and may no longer be able to carry out their work effectively. Italian prosecutors have raided the offices of S&P and Moody's in Milan, accusing them of issuing "false and unfounded judgements" on the Italian financial system.

S&P said the accusations are "without any merit"

The Procura di Trani said the agencies had jumped the gun by issuing a report in early July on draft budget proposals.

Three analysts from S&P are accused of "market manipulation" and "abuse of privileged information" by issuing "inaccurate" reports over a period of several months.

This sort of judicial action against rating agencies is highly unusual. If it is shown in any way that the charges are politically motivated, the episode may inflict damage to Italy's reputation as a safe place to conduct business.

Marchel Alexandrivich from Jefferies Fixed Income said investors are worried that the latest contagion to France could bring the eurozone's bubbling problems to a head in a dramatic fashion.

"If France is dragged into the problem, then we will hit crisis point. They will either have to move to a full-blown eurobond -- and German politicians are set against that -- or face a break-up. There is a significant chance that the euro will no longer exist in its current form within twelve months," he said.

President Sarkozy said France would include a "golden rule" in its constitution to restore fiscal probity, adding that the fiscal targets for 2011 and 2012 were "untouchable".

The new budget measures will be introduced on August 24 and are expected to include the closure of 500 tax loopholes, .

The IMF said France has the highest debt ratio of any AAA state this year at 85pc of GDP and may have to tighten further next year. Like the US, France has also built up huge pension debt and contingent liabilities.

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Spain orders drastic caja clean-up to win confidence and fight off EMU debt contagion

 The Spanish media reports that the cajas have yet to come clean on 80bn euros of exposure to property loans Photo: AFP

The weaker banks, or "cajas", must raise Tier 1 core capital to 10pc by September if they depend on wholesale capital markets for more than a fifth of their funding or if less than a fifth of their shares are in private hands. If they fail to do so, the government will seize control through the state bailout fund (FROB).

The demands are even tougher than the broad-brush plans unveiled last month and shows the determination of the authorites to cut out any cancers rather than allowing the sort of drift that bedevilled Japan in the 1990s.

The move comes after yields on Portuguese 10-year bonds punched to a post-EMU high of 7.66pc, renewing fears of a spill-over into Spain. The European Central Bank intervened on Thursday to restore calm but it is clear that Euroland euphoria over Chinese purchases of Portuguese debt has not lasted long.

Jose Manuel Campa, Spain’s economy secretary and the architect of the financial overhaul, acknowledged that the most vulnerable cajas are unlikely to find private investors. "It will be a challenge. They have not taken part in the equity markets for some time," he told The Telegraph.

Only five of the 17 cajas meet the 10pc rule. Caixa Nova is 6.0, Unnim is 6.22, Caixa Galicia 6.43 and Catalyunia Caixa 6.6. Even the giant Caja Madrid with €328bn (£277bn) of assets has core capital of just 7.1, though it is already preparing a stock listing.

Mr Campa is hopeful that cajas will be able to raise "a big chunk" from investors given the strides made in cleaning up their books. He said fresh capital of €20bn will be enough to restore the caja industry to health, disputing claims by City analysts that €40bn to €80bn will be needed. "These high numbers are based on very stretched scenarios, with a fall in house prices by 50pc and land prices by 70pc," he said.

Madrid is basing its estimates on bank stress tests last July that included a severe double-dip recession, with a 3pc fall in GDP over the two years of 2010 and 2011. Since the economy in fact contracted by just 0.1pc last year, it would take a dire relapse at this point to exhaust the safety buffer.

However, there is a risk that Spain may have missed a chance once again to "get ahead" of the crisis. A report this week by the world’s Financial Stability Board (FSB) said the sheer scale of Spain’s property bubble had overwhlemed the country's seemingly tough rules on loss provisions.

While the FSB praised Spain’s latest efforts to strengthen its banking system, there was a sting in the tail. "Such determined actions became necessary partly because of the delay in addressing earlier the structural weaknesses of savings banks," it said.

The Spanish media reports that the cajas have yet to come clean on €80bn of exposure to property loans, and are under fresh scrutiny by central bank inspectors.

Mr Campa blamed the renewed eruption of the bond crisis last Autumn on Franco-German talk of haircuts for holders of EMU sovereign debt, coupled with the failure of the Irish authorities to carry out rigorous stress tests of their banks. "That really hurt us. We had made huge efforts to be transparent, but the Irish crisis devalued the quality of the tests for everybody."

The fate of the cajas is inseparable from the Spanish property market. Mr Campa said construction has fallen from 700,000 homes year during the bubble to around 200,000 until well into the next decade, helping to clear an overhang of properties estimated by consultants RR de Acuna to be as high as 1m.

The uber-bubbles were in the Madrid suburbs and parts of the tourist belt on the coast, but the market is much closer to balance in the rest of the country.

Mr Campa, a free market economist who taught at New York’s Stern School of Business with arch-bear Nouriel Roubini, was brought in to restore Spain’s credibility in world finance after the crisis was in full swing.

He advises astute investors that right now may prove to be the optimal moment to buy a house in Spain. "The Germans are coming back. We need the English, too," he said.

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