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