LONDON (Reuters) - Britain's public finances, strained by growing debt and sluggish growth, face a crucial test this month that investors say could prompt another market shock to an economy that is increasingly reliant on fickle foreign funds.

Finance minister Rachel Reeves will deliver an update on the public finances on March 26, based on an assessment by the Office for Budget Responsibility, Britain's fiscal watchdog.

Reeves says her fiscal rules, which aim to balance day-to-day spending against revenues and reduce public sector net financial liabilities as a share of the economy in future years, are non-negotiable.

But investors fear Britain risks falling into a painful trap in which enforcing those rules - through spending cuts or higher tax - hurts the investment needed to improve long-term growth.

Britain has the biggest current account deficit among advanced economies, bar the United States. And capital flows from the rest of the world have increasingly taken the form of short-term money, rather than stickier forms of capital such as direct investment.

That reliance on short-term capital, which can be pulled away easily in a sell-off, has been greater in Britain than for any other major advanced economy running a current account deficit, Reuters calculations show.

Bank of America strategist Kamal Sharma said Reeves' fiscal rules risked becoming a target for traders, similar to exchange rate pegs during the late 1990s Asian crisis.

"A big question for many countries is how do you grow your economy to the extent where you can reduce your debt profile? Now the UK is certainly at the forefront on that issue," said Sharma.

"As the Asia crisis and the recent tumult in the UK and France have shown, markets have tended to gravitate towards some form of notional anchor - be it fixed exchange rates or fiscal rules."

Felipe Villarroel, partner, portfolio management at TwentyFour, agreed there were some similarities between the UK fiscal rules and a currency peg - even if comparisons with emerging markets were overstated.

"It is a bit dramatic. The UK is still a highly rated sovereign nation," Villarroel said.

But he added that markets could still test the rule.

"The similarities are having a hard rule that you tell people you are going to abide by no matter what," he said.

"When the situation evolves and it looks like you will have to break (the rule) then the consequence could be a lot of market volatility."

Britain's economy expanded just 0.1% in the fourth quarter of 2024 and output declined unexpectedly in January. The Bank of England last month halved its 2025 growth forecast to 0.75%.

"It's an economy that seems to have lost the ability to grow," said former Bank of England policymaker Willem Buiter.

"The reason that people are worried about the budget in the UK is that the prospects for generating greater revenues, given tax rates, are extremely poor."

VULNERABLE

A sharp selloff in bonds and sterling in January - when markets around the world worried about U.S. President Donald Trump's programme - highlighted the vulnerabilities in UK markets. Last week's surge in German government borrowing costs also dragged UK gilt yields higher.

Outflows from UK stock funds hit an eight-month high in February, Lipper data showed, while the domestically-focused UK FTSE 250 share index is down roughly 5% since the end of January.

And while U.S. Treasury bond prices have increased compared with a month ago as Trump's policy plans raised growth fears, gilts - which usually track Treasuries closely - have sold off.

Brexit turmoil and the 2022 "mini-budget" episode under former prime minister Liz Truss briefly brought some comparisons from investors between Britain and emerging markets. Prime Minister Keir Starmer and Reeves promised before July 2024's election that they would bring stability back.

But the 10-year gilt yield has also shown more volatility over the last six months - measured by its standard deviation - than any other Western European equivalent.

Asked if she was worried about a possible adverse market reaction to her March 26 statement, Reeves said she would not give a running commentary on preparations.

"We took the action that was necessary in October to secure our public finances," she told Reuters on the sidelines of a recent G20 summit in South Africa, referring to the Labour government's first budget.

Reeves says she will act if needed to meet her budget rules.

REEVES' REACTION

BNP Paribas said the market might view drastic action on March 26 as panicky. Instead, Reeves could commit to spending cuts in the near future and possibly even tax measures later in the parliament.

"Ultimately, we think the government will take a combined approach, not reacting too quickly to market pressures, nor putting all its eggs in one basket," BNP Paribas economist Dani Stoilova said.

Van Luu, head of currency and fixed income strategy at Russell Investments, said sterling and government debt would react better to spending cuts than tax hikes.

"It's a political choice in the end, what the government does, but market participants would certainly prefer spending cuts," he said.

Artemis fixed income manager Liam O'Donnell said gilts were not unattractive at current yields.

"But the most important swing factor," he said, "is the lack of fiscal room available to the Labour government."

(Reporting by Naomi Rovnick and Andy Bruce; Editing by Dhara Ranasinghe and Catherine Evans)