UPDATE 1-EU leaders signal shift from austerity of euro crisis

Fri Jun 27, 2014 2:07pm EDT

* Italy, Germany reach deal on flexible use of fiscal rules

* Italian PM Renzi hails "turning point" for Europe

* Low growth, high unemployment prompts shift from austerity focus (Recasts with quotes from Renzi, Merkel)

By Noah Barkin and Jan Strupczewski

BRUSSELS, June 27 (Reuters) - In the latest shift away from the austerity of the euro zone crisis, European Union leaders signalled at a summit that they were ready to give member states extra time to consolidate their budgets as long as they pressed ahead with economic reforms.

Under pressure from Italian Prime Minister Matteo Renzi, the leaders adopted a text which pledged to make "best use" of the flexibility built into the bloc's fiscal rule book - the so-called Stability and Growth Pact.

Renzi, whose country has the second biggest debt in Europe at more than 135 percent of gross domestic product (GDP), has been pushing for a more growth-friendly interpretation of the fiscal rules since taking office in February, because without faster growth Rome won't be able to pay down its debts.

"If a country enacts serious structural reforms, it has the right to flexibility, which is the most important political point," Renzi told reporters at the end of the two-day summit. He called the new language a "turning point" for Europe.

In reality, Europe has been shifting towards a softer fiscal stance since last year in an effort to revive growth in struggling southern states, and combat high unemployment, particularly among young people.

Countries like France and Spain have already been given extra time to reach the EU's deficit target of 3 percent of gross domestic product (GDP). In parallel, the European Central Bank (ECB) has cut interest rates to record lows to ward off the threat of Japanese-style deflation in the 18-member euro zone

Germany, the most ardent defender of tough budget policies, has been worried that fiscal leniency could lead to a new spending spree by governments taking advantage of low borrowing costs and open the way for a new crisis.

ITALIAN-GERMAN DEAL

But Renzi and German Chancellor Angela Merkel reached a deal late on Thursday which stresses the need for a flexible interpretation of fiscal rules, while stopping short of any change to the EU pact.

Merkel stressed at a news conference that it would be up to the European Commission, not member states themselves, to decide whether extra time was granted.

"The best use of flexibility means the best use, not the fullest use but the best, the most appropriate for the situation," Merkel said.

Under EU rules, governments have to strive towards a budget close to balance or in surplus, excluding one-off revenue and spending and the effects of the business cycle. They also have to reduce public debt.

But the rules also say that governments can be given more time to reach budget balance if they undertake reforms that have a verifiable positive impact on economic growth -- an option that has so far never been used.

"Structural reforms that enhance growth and improve fiscal sustainability should be given particular attention, including through an appropriate assessment of fiscal measures and structural reforms, while making best use of the flexibility that is built into the existing Stability and Growth Pact rules," the text agreed by leaders read.

The structural reform option, however, will be of little use to France, which has been backing Renzi's push for more flexibility, because it only applies to countries that have a budget deficit smaller than 3 percent of GDP.

Paris, which has a deadline of 2015 to cut its budget shortfall below that level, will have to wait until then to take advantage of that option.

Some EU policymakers worry that using the structural reform clause opens the way for a more political approach to the rules.

This is because it is very difficult to quantify with any degree of accuracy what effect a structural reform will have on growth, especially in the longer-term.

The amount of leeway granted in structural deficit reduction can therefore be politically influenced.

"The rules are fine. The way in which they are policed and enforced is not. The challenge is to improve the process in a way that minimises the inevitable political strains," Berenberg Bank chief economist Holger Schmieding said. (Reporting By Noah Barkin in Berlin, Giselda Vagnoni, Alastair Macdonald, Gregory Blachier and Jan Strupczewski in Brussels; Editing by Paul Taylor)

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