January 13, 2015 / 3:28 PM / in 3 years

EU signals flexibility on budgets, aiding France, Italy

European Central Bank (ECB) President Mario Draghi and European Euro and Social Dialogue Commissioner Valdis Dombrovskis (R) attend a euro zone finance ministers meeting in Brussels December 8, 2014.Francois Lenoir

BRUSSELS (Reuters) - The European Commission said on Tuesday that public investment and structural reforms could win some leeway for countries breaking EU budget rules, reducing the likelihood of tough penalties on France or Italy.

The commission's interpretation of the rules is a balancing act between retaining financial markets' confidence and responding to EU leaders who want to use whatever flexibility there is in the rules to boost meager economic growth.

France has been running a budget deficit above the EU's 3 percent of GDP limit for years despite promises of change and could be facing a fine in March.

Italy, even though its deficit is smaller than 3 percent, has a large public debt and could face disciplinary action for not reducing it. Rome also does not want to cut its deficit as fast as EU rules say.

Both countries say harsh fiscal steps now would only make matters worse for their economies -- contracting in the case of Italy and barely growing in the case of France.

In response, the commission spelled out what leeway EU countries can count on when it assesses their fiscal efforts.

Normally, EU countries should cut deficits by 0.5 percent of GDP a year until they reach balance. But Italy wants to freeze the structural deficit at around 0.8-1.0 percent until 2016.

The commission now offers Rome a way out. If Italy started reforms that would eventually improve its public finances, it might be allowed not to make the annual reduction at all.

The same temporary exemption from the annual deficit cut could be granted if it makes investments to improve finances.

It also said it would make the size of the annual deficit cuts conditional on what shape the economy is in, rather than stick to a one-size-fits-all 0.5 percent a year.

CONSOLIDATION IN SYNC WITH BUSINESS CYCLE

When the economy is in bad shape and the output gap is bigger than -1.5 percent of GDP, the deficit cut can be smaller.

Italy's output gap in 2014 was -4.5 percent and is to be -3.4 percent this year, according to the commission, which would make it eligible for no deficit cuts at all.

"If a country is in more difficult economic times, it can make a smaller fiscal effort," Valdis Dombrovskis, commission vice-president for the euro told Reuters.

If a country was in recession or the output gap was more than -4.0 percent, no deficit cuts would be required. If the output gap was between 1.5 and -1.5 percent, 0.5 percent would apply.

The deficit leeway offered by structural reforms and investment cannot be lumped together and neither allows a country to exceed the 3 percent deficit limit. Both options apply only to those who have deficits below 3 percent.

"So for Italy the room for maneuver is limited, but there is some," Dombrovskis said.

France cannot make use of these options because its deficit is excessive above 3 percent. But, the commission said, Paris can apply for more time to cut its excessive deficit if it presents a detailed and credible plan of structural reforms.

Editing by Louise Ireland

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