(Corrects financial prosecutor to she not he in first paragraph)
* New step opened up in probe surrounding Fillon
* Fillon's lawyers confident of his innocence
* Process unlikely to be concluded before election
* If Fillon elected, process would be suspended
* Merkel says ready to meet Macron
* Le Pen faces her own legal issues
By Chine Labbé and Michel Rose
PARIS, Feb 24 (Reuters) - French presidential challenger Francois Fillon will face a full judicial inquiry into allegations he paid family members for fake parliamentary jobs after the country's financial prosecutor said she was appointing a magistrate to lead a deeper probe.
The escalation is another blow to the conservative candidate whose status as favourite to win the presidency has faded since the "Penelopegate" affair - named after Fillon's wife - first surfaced a month ago. But it may not stop him from standing in April-May vote.
By involving a magistrate in what had so far been a preliminary probe led by police, the prosecutor is putting more resources into the investigation.
The inquiry will examine possible misuse of public funds and a lack of full and proper disclosure, according to the prosecutor's statement that was issued as Fillon took to the stage at a campaign rally near Paris.
The judge can decide to drop the case, place the 62-year-old former prime minister under formal investigation, or send the case to trial.
It was not clear, however, if the inquiry could be concluded before the two-round election, scheduled for April 23 and May 7, but the French judicial process would not typically wrap up such a case in the nine weeks between now and the poll.
Under French law, if Fillon were to win the presidential race the investigation would be suspended during his time in office.
Fillon has denied any wrongdoing and says his wife was paid hundreds of thousands of euros for genuine work as his parliamentary assistant, though he has acknowledged giving her the work was an error of judgement.
INVESTORS CONCERNED BY ELECTION
Fillon made no reference to the prosecutor's decision at his rally, at which his supporters cried out "Fillon, President!".
Fillon has pledged to stay in the race come what may, after saying for weeks that he would step down if he were put under formal investigation.
"You are my companions, and with you at my side I can feel your energy that will give me the strength to win," Fillon told the rally.
Nevertheless, the issue has unnerved investors who fear Fillon's campaign woes have handed the anti-euro, anti-immigration Marine Le Pen of the National Front a higher chance of winning the presidency.
Opinion polls show Le Pen leading a fragmented field in the first round but then losing to independent centrist Emmanuel Macron in a second round run-off. Macron has been favourite to win the presidency since the Fillon scandal broke on Jan. 25.
Fillon - who has long cultivated an image of probity and criticised people for taking government handouts - has been heckled for weeks by protesters at campaign outings.
Macron got a boost on Friday when German Chancellor Angela Merkel said she was ready to meet him.
Le Pen, however, was roundly criticised by the French mainstream political establishment after she refused to attend a summons for questioning by police over allegations that she made illegal EU payments to her staff.
(Additional reporting by Michaela Cabrera; Writing by Sudip Kar-Gupta and Richard Balmforth; Editing by Andrew Callus and Richard Lough)