EU Stability and Growth Pact: Commission Wakes to

UNCLAS SECTION 01 OF 05 FRANKFURT 008852 SIPDIS STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA STATE PASS FEDERAL RESERVE BOARD STATE PASS NSC TREASURY FOR DAS SOBEL TREASURY ALSO FOR ICN COX, STUART PARIS ALSO FOR OECD TREASURY FOR OCC RUTLEDGE, MCMAHON E.O. 12958: N/A TAGS: ECON EFIN EUN SUBJECT: EU Stability and Growth Pact: Commission Wakes to Reality, Treads Fine Line Between Reluctant France and Robust Enforcers - Germany Next in Line Ref: (A) Frankfurt 06409; (B) Lisbon 1831 T-IA-F-03-0056 1.(SBU) Summary: "We wake from one dream into another dream," mused Emerson. The European Commission has awoken from the dream that France would reduce its deficit below 3% of GDP in 2004, as recommended by Finance Ministers in June. The French budget plan provides for a deficit of 3.6%, at best. The Commission is not satisfied. Nonetheless, economic times are tough. So the Commission has recommended to Ministers that France reduce its deficit below 3% in 2005, but with an extra effort in 2004 to reduce its structural deficit by one percentage point rather than the 0.7 percentage points contained in the French budget. The Commission is treading a fine line between France, who only reluctantly plays along with what it probably regards as surreal Stability and Growth Pact (SGP) procedures, and the Netherlands and Austria who have called for robust enforcement of the SGP, including sanctions. 2.(SBU) Action on Germany is likely to follow. The Commission staff is not pleased with implementation of measures promised by Germany last May. The Commission's new forecast for Germany, to be released October 29, will show the German deficit also remaining above rather than below 3% of GDP in 2004, also contrary to EU Ministers' recommendation. 3.(SBU) Would giving France, and maybe Germany, an extra year mark the final nail in the coffin of the SGP? German Finance Ministry officials bluntly confess they are "playing for time" since brighter economic prospects forecast for 2005 make hitting the target more likely for them. The Commission's realization of that reality, however, has not lessened its pressure. Rather, the Commission staff seems to be pressing for more reforms in France and Germany, keeping Portugal on the hook for a sustainable deficit reduction, and upping public pressure on Italy that has slipped from its commitment to reduce its high debt. If Ministers agree at their November 3-4 meeting in Brussels with something close to the Commission's recommendations on 
France, there could be more SGP and Commission in member states' budget coordination life rather than less. Therein would lie yet another problem. The outcome is far from clear. France: The Last Shall Be First 4.(SBU) EU Finance Ministers determined that France had an excessive deficit in June following earlier excessive deficit decisions on Germany and Portugal. France's reluctance to accede to Ministers' recommendations, however, has propelled it to the role of trail blazer. Portugal moved (or sold) heaven and earth to get its deficit below 3% of GDP. Germany, as founder and firm believer in the SGP, has talked a good game. But France is France. The French Finance Minister and others have been openly disdainful of the SGP deficit rules applied to The Hexagon. Nonetheless, the GOF's 2004 budget announced at the end of September envisaged a more significant deficit reduction than mooted with the IMF staff last summer. The structural deficit would be reduced by 0.7 percentage points, the nominal deficit would be 3.6% based on real growth of 1.7%. On this basis the GOF met the October 3 deadline to report that it had taken appropriate measures to correct its deficit in accordance with EU Minister's recommendations four months earlier. 5.(SBU) The European Commission was not impressed. On October 8 the Commission shot back with its recommendation to Ministers that "France has taken no effective action in response to the Council Recommendation." The phasing should not be taken literally. It is lifted directly out of Article 104c(8) of the Treaty, reflecting more legalese than reality. In fact, the Commission explains that the GOF has taken some measures to mitigate the deficit in 2004. These include reforming the pension system, increasing tobacco taxes, and raising the social contributions for the fund responsible for the payment of wages of workers in companies in bankruptcy. In addition, the proposed reduction in the structural deficit by 0.7 percentage points was consistent with the Council's recommendation. The GOF, however, let the 2003 budget slip away, in the Commission's view, racking up a 4% deficit. This is contrary to what EU Finance Ministers had recommended. 6.(SBU) This "no effective action" assessment is the first ever under the SGP's excessive deficit procedures. Portugal and Germany's reports passed Commission staff scrutiny. Dubbing its efforts as ineffective has propelled France from a follower in the excessive deficit procedure to a leader. Now what? Commission Walks Thin Line: Expedites Process and Asks for More, But Over Longer Time 7.(SBU) The Commission's assessment begs the question: "So what?" If Ministers were to agree with the recommendation, what would happen next? The Commission dropped the other shoe on October 21. It issued a companion recommendation to Ministers of new measures for France to take in 2004. This recommendation is in accord with Article 104c(9) of the Treaty which states that if a member states persists in failing to put into practice the Council's recommendations, the Council may decide to give notice to the member state to take measures within a specified time-limit to remedy the situation. 8.(SBU) Part of this recommendation is to postpone the target date to correct the excessive deficit to 2005. This would be contrary to the Recommendation EU Ministers signed up to in June for France calling for correction by 2004 at the latest. The letter of the law, Article 3(4) of Council Regulation (EC) No 1467/97 ("the regulation"),is more forgiving. It states that the deadline for the correction of the excessive deficit "should be completed the year following its identification unless there are special circumstances." While not citing any special circumstances, the Commission points out that the economic situation has deteriorated since June. That deterioration would make the effort to bring the deficit below 4% in 2004 "significantly larger than envisaged." 9.(SBU) The Commission has proposed the following new measures: (1) Reduction in the cyclically-adjusted balance by one percentage point of GDP; (2) Another 0.5 percentage point reduction in the cyclically- adjusted balance in 2005 or whatever it takes to get the nominal deficit below 3%; (3) Any higher than expected revenue in 2004 to be allocated to deficit reduction; (4) Curbing the increase in health care spending is a possible measure to be included in any deficit reduction package, consistent with the Broad Economic Policy Guidelines that have been approved by Heads of Government and State. 10.(SBU) The Commission also recommends that France report to the Council once every six months, in April and October, over the next two years so the Council can monitor progress. The basis for requiring such reports in found in Article 104c(9) of the Treaty that allows the Council to request reports in accordance with a specific timetable to examine adjustment efforts. 11.(SBU) On process, the Commission is seeking to expedite consideration of the French case. Under the regulation, the Council is supposed to take measures under 104c(9) within one month of its assessment under 104c(8) that no effective action has been taken. The Commission wants both to be considered at the November 4 Ecofin meeting. In the view of Commission staff, the decision on 104c(8) should be "just a formality." If Ministers comply and agree to recommend the new measures (or others) as suggested by the Commission, the Commission has suggested that France report back to the Council by December 15 on the measures it plans to take in 2004 and 2005. This also compresses the time frame envisaged in the regulation. Article 6 permits at most two months between 104c(9) and the next step - sanctions. Why the rush? 12.(SBU) Commission staff point out that Article 7 of the regulation requires that the Council's decision to impose sanctions be taken within 10 months of reporting dates for national accounts, e.g. from March 1 in this case. Delaying the process could make the question of sanctions moot, at least this year. By expediting the process, the prospect of sanctions provides some leverage. 13.(SBU) As noted in reftel, sanctions would be an admission of failure. A senior German Finance official said they had been working to encourage France to make some additional efforts and to encourage the Commission to be more flexible. He believes that "A conflict would be in no one's interest. He interprets the Commission's latest move as "a tough line." "There is still a gap," in his assessment, between the Commission and the French positions. 14.(SBU) Commission staff admit that they are walking a fine line. Will Ministers accept the new recommendation? The German Finance Ministry expert who believes the Commission is too tough points to the larger budget adjustment (he would have preferred more emphasis on structural reforms) and aggressive procedures (resorting to Article 104(9) so quickly and calling for a firm plan by December and semi-annually reporting). The Commission, in his view, is "putting its hands on national fiscal policy," something that, in his opinion, neither Germany nor France would accept. 15.(SBU) Will the Netherlands, Austria and Finland that have called for sanctions in the case of non-compliance go along with providing France an extra year to correct its deficit? Dutch Finance Minister Zalm recently argued that the Commission should have proposed fining France and has threatened to stick to his plan to take the Commission to court, pending the outcome of the November 4 Ecofin meeting. Will France accept the recommendations? And the intrusive reporting requirement? Press reports suggest they have given the Commission's new approach a frosty response. Whatever happens could pave the way for action on Germany. Germany: Slip, Slip, Slipping Away? 16.(SBU) Commission staff reports that they are disappointed with Germany's performance. The measures that Germany had agreed to in its May report have proved ineffective in reducing the deficit has much as anticipated. Slower economic growth has widened the deficit, making adjustment efforts more difficult - as in the case of France. Bringing the income tax cut forward from 2005 to 2004 will create a much larger deficit than anticipated by the Commission last spring. When the Commission releases its EU autumn forecast on October 29, the numbers for Germany in 2004 are likely to look roughly similar to those issued on October 21 by Germany's economic institutes: a deficit of around 3.5% with growth of 1.7%. Even Finance Minister Eichel now has admitted that the deficit in 2004 will exceed the 3% reference rate. 17.(SBU) Commission staff is preparing a new recommendation to Ministers for Germany that is likely to be taken up by Ministers at the December 15 Ecofin. The content is being developed, but is likely to support reforms and subsidy cuts the German government is striving to get through the upper house of Parliament. Since the prospect of Germany's deficit remaining above 3% next year are real, it would not be too much to imagine, as the German press has already begun to speculate based on Commission sources, that the Commission would accept that reality and call for the deficit to be well under 3% in 2005. 18.(SBU) German Finance Ministry officials will argue that (a) three years of stagnate growth are unusual; (b) they have significant structural reforms in the legislative process; and (c) bringing forward the income tax from 2005 to 2004 will be good for German and EU economic growth and, technically, shouldn't count since it was already in Germany's stability plan for 2005. That would shave a "virtual" 0.7 percentage points off the 2004 deficit. As for getting the deficit under 3% in 2005, the Ministry's top economist confidently declared, "I am certain of it." 19.(SBU) Why can the Commission be less in a rush for Germany than for France? Article 9 of the Regulation notes that the excessive deficit procedure shall be held "in abeyance" if the member state acts in accordance with the EU Finance Ministers' recommendations. Since Germany seemed to be doing so, the 10 month clock was suspended. Portugal and Italy in the Wings 20.(SBU) The Commission continues to assess the budget situations of Portugal and Italy. Even though the Portuguese, through extraordinary effort, reduced their deficit to 2.8% in 2002, the Commission has not recommended that the excessive deficit procedure be "abrogated." Rather, they want to make sure the deficit reduction is sustainable. Given the slowdown in 2003's growth, it won't be. 21.(SBU) However, the GOP has indicated it will, again, use extraordinary measures to push the deficit down. These include real estates sales, selling tax receivables to private investors (a deal being arranged by Citibank),and postal system transfers to the budget for pension obligations (Lisbon, septel). The GOP's 2004 budget, based on a realistic real growth forecast of 1.1%, would deliver a planned deficit of 2.8% in 2004, in the Commission's assessment. The Commission's overall view on Portuguese budget developments will be contained in its October 29 forecast. 22.(SBU) Italy has also attracted the Commission's attention. Last year when the Council was debating ways to improve the operation of the SGP, they agreed that more attention should be given to the stock of debt. So even though Italy has been able to skate under the 3% deficit value by adopting one-off measures, the Commission is looking for more robust action to reduce the debt. In an October 2 statement, Commissioner Solbes opined that the path for deficit reduction in 2004 is "less ambitious" than envisaged in last year's stability program and in contrast with Finance Ministers' assessment that the "pace of debt reduction should be significantly faster." The ECB: A Difficult Moment 23.(SBU) ECB experts are monitoring developments. They believe the Commission is acting in the EU's best interests, but also confess that this is a "difficult moment." In its October Bulletin the ECB expressed "serious concerns" about recent fiscal policy developments. The ECB wrote that it is "worrying" to see that not all countries have introduced sufficient consolidation measures. "It is fundamental that the credibility of the institutional underpinnings of the EMU be maintained." Comment 24.(SBU) Commission staff characterize their approach on France is "very delicate," with no certainty that Ministers or France will accept it. France's initial public reaction, as recorded by the press, would seem to confirm their anxiety. However, we tend to agree with the German Finance Ministry official's view that no one would benefit from a conflict, neither France, the smaller states, nor the EU. France would lose leverage in other major policy debates, such as in the constitution or budget; the Commission would lose its moral authority (by being perceived as either too strict or too loose); member states would lose the center piece for trying to coordinate fiscal policies, leaving the European Central Bank even less of an idea of how to incorporate fiscal policy into its monetary policy. Changing the SGP target, suggested by Italian President Berlusconi as recently as October 22, is not in the cards at present. It would require an amendment to the Treaty, a process that would take too long to make a difference in the immediate case even if there were support to do so. 25.(SBU) All could benefit from a more assertive Commission. Taking up the case of France and apparently not content to let Germany or Portugal easily off the hook without concrete evidence of sustainable deficit reduction could be useful. As the Portuguese Finance Minister noted, the SGP provides an alibi for needed reforms and that budget discipline is good for growth (ref B). Sending signals to Italy also could be useful, as high debt stock can play as much of a role in putting upward pressure on interest rates as rising deficits. 26.(SBU) If the case of France plays out more or less in line with the Commission's recommendation, an outcome that is by no means certain, there could be more rather than less of the SGP in member states' lives in the months to come. Maybe member states will have better budget performance under a watchful eye. It is clear that they did not so while left to their own. However, such intrusiveness would cause yet another problem for member states, giving the Commission more of a bully pulpit on national budgets. Then again, it would be better if member states exercised budget discipline themselves - in good times and bad. 27.(U) This cable has been coordinated with Embassies Berlin, the Hague, Lisbon, Rome, Paris, Dublin, Vienna, and USEU. 28.(U) POC: James Wallar, Treasury Representative, e-mail wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 7535-2238. BODDE