UNCLAS SECTION 01 OF 04 FRANKFURT 000174

SIPDIS

SENSITIVE

STATE FOR EUR PDAS, EB, EUR/AGS, AND EUR/ERA
STATE PASS FEDERAL RESERVE BOARD
STATE PASS NSC
TREASURY ALSO FOR ICN COX, HULL

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: EU's Stability and Growth Pact: Tidying Up the
Books - the Corrective Tonic of Transparency


This cable is sensitive but unclassified. Not/not for
Internet distribution.


1. (SBU) Summary: In December the European Commission (EC)
issued several statements for member states under the
Stability and Growth Pact's (SGP) excessive deficit
procedures (EDP). For Germany and France, the Commission
acknowledged that (a) both would get an extra year, to 2005,
to correct their deficits and (b) their proposed 2005
budgets might barely do the trick, thanks to one-off
measures. For Greece, the EC, weaving through the haze of
statistical corrections and mid-year budget adjustments,
declared the draft 2005 budget "insufficient" to correct the
deficit. Similarly Hungary was cited by the EC as having
taken "insufficient action" to put the 2005 budget on a
trajectory to get the deficit below 3 percent by 2008. The
Czech Republic, Cyprus, Malta, Poland, and Slovakia were
judged by the EC as having put forward 2005 budgets that are
in line with their respective convergence programs. The
Council will have to decide what steps to take on Greece and
Hungary, a difference being that Hungary is not subject to
the SGP sanctions provisions since it has not yet adopted
the euro.


2. (SBU) The EC's published reports and willingness to
challenge budget proposals of member states are important
for the SGP's "soft law" to be effective. A recent European
Central Bank (ECB) paper suggests that the member state
"contracting parties" to the SGP will never act as
collectively through ECOFIN as an independent enforcement
agency. Rather, they are likely to be pressured into
avoiding big mistakes by the public scrutiny through
transparency. The corrective tonic of transparency is, in
this case, being administered by the Commission. End
Summary

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Tidying Up the Books: Year End Commission Reports
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3. (SBU) In December the EC published conclusions on the
2005 budgets for member states subject to EPD. These
reports set the stage for ECOFIN's meetings in January and

February. Two countries are likely to require further
action by the Council: Greece and Hungary. A summary of the
actions follows.


4. (SBU) Greece: In July ECOFIN recommended that the
deficit be reduced to 3 percent in 2005. That was before
statistical revisions due to under-recorded expenditures on
military equipment and interest expenditures and over-
estimations on social security. While these pushed up the
2004 deficit from 3.0 to 4.1 % of GDP, in September the
Greek authorities reported that the deficit would be 5.3%.
While the Greek official 2005 budget shows a 2.8% deficit,
the Commission's analysis suggests this is overly optimistic
on both the revenue and expenditure accounts. Thus, the EC
reckons a deficit of 3.6% and is of the opinion that "there
has been no effective action" in response to the Council's
recommendation. The Commission recommends the Council
agree.


5. (SBU) Hungary: In July ECOFIN recommended that the
deficit should be reduced in line with the Hungarian
convergence program. Specifically, that means that the
deficit is to be under 3% of GDP by 2008, and that the
Hungarian authorities are to "introduce additional measures,
if necessary," to hit the 2004 budget target of 4.6%.
Despite several corrective measures taken by the Hungarian
authorities in 2004, the deficit officially is estimated to
be 5.3% of GDP while Commission staff estimate it to be
5.5%. (Preliminary December revenue data suggest that the
deficit may hit the government's projection). The
government's budget for 2005 has a deficit of 4.7%, but the
Commission also waves this off as too optimistic,
forecasting a deficit of 5.2%. The EC is also critical that
structural reforms contained in Hungary's convergence
program were not fully reflected in the 2005 budget, thus
failing to put into place measures that would restrain
expenditures over the longer term. In conclusion, the
Commission believes that the action by Hungarian authorities
has been "inadequate," and is of the opinion that "there has
been no effective action" in response to ECOFIN's
recommendations. It recommends that the Council agree.


6. (SBU) Germany and France: ECOFIN recommendations date
from 2003, January for Germany and June for France. Both
called for the excessive deficits to be corrected in 2004.
The Council's conclusions in November 2003 to give both
Germany and France an extra year were annulled by the
European Court of Justice in July 2004 on procedural
grounds. Nonetheless, the Commission reasons that both
countries had the "right to assume" that the Council
conclusions were valid and, accordingly, had set a path for
adjustment in 2005 that "cannot be ignored." "In light of
the unique circumstances created by the Court judgment" the
Commission concedes that 2005 should be the target year for
correcting the deficit.


7. (SBU) The German budget for 2005 aspires to a 2.9%
deficit. To get there, the government relies on several one-
off measures. These include securitization of pension
receipts of an off-budget pension fund from the privatized
Deutsche Post and Telekom (to the tune of euro 5.45 billion
or 0.25% of GDP) and the repayment of illegal subsidies by
state banks to state governments (euro 4.3 billion, around
0.2% of GDP). While the Commission is critical of such one-
off measures, its own calculations suggest the budget
deficit should drop to 3%, but remains "vulnerable" should
programs or economic growth not materialize as forecast. Its
conclusion is that the actions by German authorities are
"broadly consistent" with a correction of the excessive
deficit by 2005 and that "no further steps are necessary" at
this point.


8. (SBU) The French budget projects a deficit of just under
3% for 2005, an estimate with which the Commission roughly
agrees. Deficit reductions are based on one-off measures,
particularly a payment linked to the transfer of the
responsibility for pensions in the electricity and gas
companies to the social security sector (about 0.5% of GDP).
Thus, the deficit projection is "vulnerable" to changes in
program implementation and economic growth. Moreover, based
on an assumption of no policy changes, EC staff forecasts
the deficit to bounce back up to 3.3% in 2006 in sharp
contrast to the French government projection of 2.2%. In
conclusion, the Commission believes that actions by the
French authorities are "broadly consistent" with a
correction of the excessive deficit by 2005 and that "no
further steps are necessary," at this point.


9. (SBU) Czech Republic, Cyprus, Malta, Poland, and
Slovakia: In July ECOFIN recommended that these countries
take the necessary steps in 2004 and 2005 to put them on the
path of their convergence programs designed to correct the
excessive deficits. The Czech Republic has taken effective
action to achieve the 2005 target of 4.7% on the way to get
under 3% by 2008. Cyprus has taken action to bring its 2005
budget under 3%. Malta has taken effective action, although
somewhat belatedly, to hit its budget deficit target of 3.7%
in 2005 and to get it under 3% in 2006. Poland has taken
effective action to achieve a deficit of 4.2% in 2005 on the
way to correct its excessive deficit by 2007. Slovakia also
has taken effective action to achieve a 3.9% deficit in 2005
consistent with its objective of reducing the deficit below
3% by 2007. In all cases, the Commission concludes, "no
further steps are necessary at this point."

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Next Steps: Greece and Hungary in the Dock; Germany and
France on the Hook
-------------- --------------


10. (SBU) ECOFIN will have to decide whether it agrees with
the Commission's recommendations on Greece and Hungary. In
both cases, the basic approach would be to revise the
Council's earlier recommendations with alternative, extra
measures. For Hungary this would mean a revised convergence
program, taking account of the Commission's assessment.
Since Hungary has not yet adopted the euro, it is not
subject to provisions on intensive surveillance and
sanctions (paragraphs 104(9) and 104(11) of the Treaty,
respectively).


11. (SBU) For Greece the issues are likely to be more
complex. A special Eurostat report for 1997-2003 reveals
that the deficit has been revised up by an average of 2.1%
of GDP and was never under the 3% of GDP reference value.
On December 1 the Commission launched an infringement
proceeding to ensure Greek authorities address "a number of
problems in its reporting and control of deficit-related
data." This proceeding carries no sanctions but, according
to Commission staff, applies public pressure on the Greek
authorities. ECOFIN's own take at its December session was
that there was blame to be shared by all: Greek authorities,
Eurostat, the Commission and ECB and the Council itself for
not paying sufficient attention to the quality of the data.


12. (SBU) Even if the implications of Greece statistical
problems could be put aside, if ECOFIN agrees with the
Commission's recommendation that insufficient steps have
been taken to correct the deficit, then ECOFIN will have to
decide on the next steps. Commission staff initially had
suggested that Greece be subject to more intense
surveillance under paragraph 104(9) of the Treaty, the last
step before sanctions. This approach would be consistent
with the ill-fated Commission recommendations for Germany
and France in November 2003. However, this approach did not
appear in the final Commission report. A German Finance
Ministry official suspects that the Commission wants to ease
ECOFIN along, first agreeing with the insufficient action
recommendation, then spring the 104(9) recommendations on
the Council. The Greeks then could take a page out of the
German book and argue that when the Council made it policy
recommendations in July 2004, the deficit was only 3.2% and
that statistical revisions and other extraordinary
developments (Olympic expenditures) require new
recommendations under 104(7) rather than ratcheting up the
procedures to the next level.


13. (SBU) For their part, the Germans would like the Council
to think more about cutting off cohesion funds to Greece,
which are around euro 550 million. In their view, Article 6
of Council Regulation (EC) No 1164/94 of 16 May 1994 is
clear: "In the event of the Council deciding, in accordance
with Article 104(6) of the Treaty, that an excessive
government deficit exists in a Member State, and if that
decision is not abrogated in accordance with Article 104(12)
of the Treaty within one year or any other period specified
for correcting the deficit in a recommendation under Article
104(7), no new projects or, in the case of large multi-stage
projects, no new stages of a project shall be financed from
the Fund for that Member State." The German Finance Ministry
recalls that Greece's voted against the Council's
conclusions to give Germany an extra year to correct its
deficit. Germany is a net contributor to the EU budget (an
expenditure that contributes to its excessive deficit), from
which the Greek authorities benefit.


14. (SBU) Germany and France are being given a conditional
pass, but also put on warning. If their efforts falter, for
any reason, the Commission staff promise to restart the EDP
under Treaty articles 104(9). This approach is just what
the Council recommended in November 2003. The EC could
initiate such proceedings any time, but are likely to wait
until firm 2005 figures are confirmed in March 2006. Even
if France squeaks by in 2005, EC staff believe that unless
policies change, the deficit will pop back up in 2006,
putting France back into an active EDP.


15. (SBU) Germany also faces risks. Eurostat has not yet
officially ruled whether the securitization of pension
receipts will reduce the deficit on a sustainable basis. If
Germany is merely postponing a liability, the measure would
not reduce the deficit, according to Eurostat rules. German
Finance Ministry experts have engaged directly with Eurostat
staff and are confident that, in economic terms their one-
off measure is like France's. But with a difference.


16. (SBU) In France, Eurostat accounting rules mean that the
transfer of the responsibility for payments of pensions of
former state employees now working in the privatized
electricity and gas companies to the social security system
implies a lump sum revenue inflow for the general government
in 2005. (Under Eurostat accounting conventions, the
government can book all of the imputed pension payments that
would have been made by those companies over the next twenty
years as income as of the date of transfer of the
obligation). Since the government had no liability to pay
pensions in the privatized firms, it is not getting money
now that it would have been obliged to repay later.
However, as the EC points out, the transfer does imply
additional expenditures in future years for the social
security system since that system will assume responsibility
for all of the future pension benefits of these employees.
Although Eurostat has not formally certified the French
transaction, the transaction is very similar to a Belgian
telecom transaction that Eurostat has certified.


17. (SBU) In Germany the pension liabilities of civil
servants working in the privatized Post and Telekom firms
were not ceded with the new firms but rather placed in a
separate "Post Pension Fund." The government supplements
that fund from the budget, if necessary. Last year the
government paid euro 5.5 billion into the Fund. However,
Finance Ministry officials point out that the government has
no standing liability to the Fund. Therefore, like the
French, it is not postponing a liability but at the same
time is admitting that the Post Pension Fund, like France's
social security system, in the future would bear the full
cost of those civil servants' pensions that the government
will have to supplement. Eurostat, according to German
Finance Ministry officials, have reserved judgment until
details of the transactions are finalized, probably by
March.

--------------
Comments: Obfuscation and Transparency
--------------


18. (SBU) The Commission's recommendations set new
benchmarks for fiscal discipline. For Greece and Hungary
the outcomes will likely be new policy recommendations.
Greece runs the risk of being escalated up to paragraph
104(9), one step before sanctions unless, like Portugal did,
it convinces ministers' that its 2005 budget that pushes the
deficit down from 5.3% of GDP to 2.8% is solid and/or that,
in light of all the uncertainty surrounding its statistics,
it should be given a new set of recommendations under the
less-threatening paragraph 104(7).


19. (SBU) On Germany and France, the Commission engages in a
bit of obfuscation. The issue in both cases was not whether
the deficits should be corrected in 2004 or 2005. By
November 2003 the Commission was painfully aware that the
deficits would remain above 3% in 2004. Rather, the issue
was one of process, whether both countries should be subject
to more intense surveillance under 104(9), the last step
before sanctions. By declaring the 2005 budgets credible,
the EC takes a pass on this issue, but sets the hook for
both countries to be caught in 104(9) processes should they
fail.


20. (SBU) More broadly, the Commission's public assessment
and criticism of the budgets sets in motion more public
pressure on all the member states with excessive deficits.
As a recent ECB occasional paper points out, such pressure
is important in applying the "soft law" of the SGP that is
administered by contracting parties themselves rather than
an independent body. While the dynamics of such a mechanism
conditioned by politics is less than precise, it is likely
to curb any egregious cases. In fact, the ECB paper points
to research that indicates that the recent 2001-2003
slowdown has witnessed less "extreme budgetary
deteriorations" than in the early 1990's.


21. (SBU) The ECB's paper also argues that simple rules,
like the 3% GDP reference value, are easier to monitor and
more susceptible to applying public pressure than more
complex rules. It would be comforting to think that ECOFIN
Ministers share that view and that it motivated their ruling
out any changes in the basic framework in the SGP as they
prepare a Council Resolution for March. In any event, the
Commission is doing its job by shining the light on budget
problems and should let ECOFIN take the political decisions
on the "art of the possible," in budget matters.


22. (U) This message coordinated with Embassies Berlin,
Paris, Budapest and USEU Brussels.


23. (U) POC: James Wallar, Treasury Representative, e-mail
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)-
7535-2238

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