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By Daniel Flynn
PARIS, Dec 3(Reuters) - President Nicolas Sarkozy has regained the initiative in his re-election run thanks to political fumbling by his Socialist rival Francois Hollande. But rising unemployment and threats to France's AAA rating are clouding Sarkozy's bid.
Polls show Sarkozy, expected to declare his candidacy early in 2012, has eaten into Hollande's lead in the last month as he portrays himself as a proven statesman who can steer France through its worst economic crisis in decades. Hollande has a disadvantage in never having held a cabinet post.
But with less than five months until the first round of the presidential elections in April, unemployment has hit its highest level since 1999 and economists predict the euro zone's second-largest economy is heading for a shallow recession.
The end of France's G20 presidency in November leaves Sarkozy's government freer to concentrate on the euro zone crisis, where Paris is working on proposals with Germany for a revision of the EU treaty to create a stronger fiscal union.
With France's cherished AAA credit rating under ever greater pressure as the euro crisis batters banks, stifles the economy and pushes up borrowing costs, the Socialists have vowed to stick to a French goal to cut the public deficit to below 3 percent of GDP by 2013 and want to repeal tax exemptions, especially to the rich.
An adviser to Hollande told Reuters that a Socialist government would launch an austerity plan worth 50 billion euros if it were to win office.
EURO ZONE CRISIS, BANKING TURMOIL
Sarkozy and German Chancellor Angela Merkel are to present a joint plan for an overhaul of the EU treaty to an European summit on Dec. 9, with the aim of tightening fiscal union within the bloc and restoring confidence to panicked debt markets.
The European Commission has already put forward proposals to grant it intrusive powers of approval over euro zone countries' budgets before they are submitted to national parliaments, while
Berlin is pushing for changes so that rule-breakers to be sued in the European Court of Justice.
Both proposals would cause an outcry within the conservative Gaullist wing of Sarkozy's ruling UMP party, which is highly sensitive to any loss in French autonomy.
Socialist rivals have already accused him of selling out to emerging market powers like China by requesting their help to leverage the euro zone's EFSF bailout fund -- thereby making it even harder to ensure that Beijing accepts competing on fairer terms, notably via a more flexible currency.
Euro zone finance ministers agreed the mechanisms to0 leverage the European Financial Stability Facility, their 440 billion euro (${esc.dollar}600 billion) bailout fund set up last year, and hope private investors and sovereign wealth funds may invest.
But the EFSF's head, Klaus Regling, has already suggested it may not reach its 1 trillion euro target and the market is increasingly focusing on the European Central Bank as the sole solution to the crisis in the near term.
While France has openly called for the ECB to do more, Germany has insisted the central bank is completely independent and its mandate would not allow it to prop up government debt.
With a new Frenchman, Treasury chief economist Benoit Coeure -- due to take a seat on the ECB's six-member executive board in January alongside fellow newcomer Joerg Asmussen, currently Germany's deputy finance minister, this could change the nature of the organisation.
What to watch:
-- Will Sarkozy overcome resistance in his own party and agree on a far-reaching reform of European rules to allow a fiscal union to calm market fears the euro zone could collapse?
-- Will France's view of the role of the ECB prevail, allowing it to take sweeping action to lower rising debt yields in euro zone countries?
"TRIPLE-A TROUBLE"
Concern has grown that France could lose its coveted AAA status, following a warning from Moody's that it was placing the stable French outlook under review, which could potentially crank up the cost of servicing French sovereign debt and put further pressure on the euro zone's bailout plans.
France has come under the spotlight for having the highest debt and deficit levels of the six AAA-rated euro zone countries, and many economists expect its metrics to worsen as it enters recession at the end of this year.
Fitch ratings recently warned that, although France's metrics remained consistent with a top rating, the budgetary situation leaves the government with little room to manoeuvre if it wants to keep its AAA status. La Tribune newspaper reported that Standard & Poor's could also be poised to change its outlook on France's top rating to negative.
France announced 65 billion euros of tax hikes and budget cuts over five years in early November in a bid to shore up its rating, but economists said the package was undermined by its overly optimistic 1 percent growth target for 2012, already revised down from an earlier 1.75 percent.
Finance Minister Francois Baroin said a 6 billion euro buffer in the 2012 budget means the figures will add up even if growth is only 0.5 percent next year -- but many economists feel even that may be optimistic. Baroin has ruled out any more austerity measures, however.
The OECD warned in its latest twice-yearly review in November that France would need a further 8 billion euros in cuts next year to meet its deficit targets -- something the government has so far categorically ruled out.
Sarkozy's efforts to write a budget-balancing rule into France's constitution has been blocked by the Socialists, who won control of the Senate and argue the vague measure proposed by the government is just window dressing.
What to watch:
-- Further announcements by ratings agencies on France000
-- Will France take any steps to address perceived budget shortfalls for next year?
-- Union attempts to mobilise protests over budget policy
2012 ELECTION
Sarkozy remains on the losing end of opinion polls, which still indicate voters prefer Hollande, winner of a U.S.-style primary election by the left, and want a change of government.
Paradoxically, polls also suggest most French people expect Sarkozy to eventually win the second-round runoff in May.
In recent weeks, Sarkozy's popularity ratings have crept up, with the gap between him and Hollande narrowing as the president casts himself as a leader with the experience and international clout to confront Europe's debt woes head on.
Despite the new momentum, Sarkozy's party has not been helped by negative headlines over the so-called "Karachi Affair" inquiry into commissions linked to a mid-1990s submarine deal with Pakistan, in which some of the president's closest allies have been placed under investigation.
Sarkozy has denied any involvement in the affair, in which magistrates aim to find out whether commissions were recycled to finance the 1995 election campaign of Sarkozy's mentor and ex-prime minister Edouard Balladur.
At the same time, Hollande has disappointed some voters, backtracking on details of a pre-election pact between the Socialists and the Greens over nuclear policy, and raising eyebrows in his own camp. The co-head of the hardline Left Party, Jean-Luc Melanchon, has described Hollande as playing "pedal boat captain" in storm season.
The presidential election takes place in two rounds, on April 22 and May 6. Parliamentary elections follow on June 10 and 17.
What to watch:
-- Opinion poll fluctuations in the weeks ahead
-- Inflation and economic growth data
-- Developments in the Karachi
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