UPDATE 1-Germany ready to dilute austerity medicine for reform-minded France
(Adds comments from German Finance Minister)
By Michelle Martin
BERLIN Aug 28 (Reuters) - After ramming austerity medicine down the throats of smaller euro zone countries for the past four years, Germany is showing clemency towards its closest ally, France.
Dubbed 'KRANKreich' or 'ill empire' - a pun on the German word for France - by mass-selling daily Bild, Germany is worried by its neighbour's health, not least because the Ukraine crisis to the east is hurting its own economy.
The last thing Germany needs is deeper trouble to its west.
The upshot is that Berlin is willing to cut Paris some slack in the form of a quid pro quo: a commitment by French President Francois Hollande to implement reforms is likely to see Germany give him more time to put France's public finances in order.
Germany is encouraged by Hollande's shake-up of his government this week and the commitment to push ahead with reforms and spending cuts.
The Socialist, the most unpopular French president in over half a century, has ousted maverick Economy Minister Arnaud Montebourg over a tirade against Germany's "obsession" with austerity, and shown he is finally prepared to tackle sceptics.
Speaking in Paris on Thursday, German Finance Minister Wolfgang Schaeuble said he agreed with Hollande that public and private investment was needed to boost growth.
"I think that we are pushing in the same direction," he said at a news conference with his French counterpart Michel Sapin, who stayed on after the cabinet reshuffle to continue the role in which he has tried to convince EU partners France will fix its public finances.
Carsten Schneider, a senior member of the Social Democrats who share power with Chancellor Angela Merkel's Christian Democrats, stressed the importance of France implementing rather than just announcing reforms. But he hinted at some help.
"We have a vital interest, whether we're Social or Christian Democrats, in France getting back on its feet," he said.
"I can only cross my fingers that (French Prime Minister Manuel) Valls will now get support for his reforms. We need to support France in that so it remains stable," he added.
Germany has already shown some signs of softening the tough stance on fiscal discipline it took during the early years of the euro zone crisis.
Last year, Berlin shifted its focus to "growth-friendly consolidation", whereby it continues to encourage countries to balance their budgets and cut deficits, but also to take measures to tackle unemployment and boost growth.
The German government is also tolerating higher wages in Germany, potentially boosting domestic demand and reducing its relative competitiveness, a fillip for other euro zone economies.
Momentum is also building for greater fiscal leniency after European Central Bank President Mario Draghi, in a landmark speech last Friday, put more emphasis on fiscal stimulus than austerity by calling for governments to boost demand.
Draghi's speech picked up on a drive away from austerity that is being led by Italian Prime Minister Matteo Renzi.
Under pressure from Renzi, European leaders agreed in June to make "best use" of the flexibility built into the euro zone's fiscal rules - as long as countries carry out reforms.
Another game-changing factor is the macroeconomic backdrop.
Until earlier this year, the German economic juggernaut had forged ahead despite problems elsewhere in the euro zone. But a contraction in Germany in the second quarter, slowing inflation, and the dampening effect of the Ukraine crisis on European business has strengthened the case for greater fiscal leniency.
On Thursday Schaeuble said crises abroad and signs of an economic slowdown meant it was "important to stay the course" on investment, adding that increasing investment and improving the legal framework for it would be one of the main subjects of discussion when European ministers meet in Milan next month.
Hollande's stated determination to undertake reforms is likely to give Berlin the reassurance it needs to loosen the fiscal reins slightly. This could come in the form of a new let-off for France.
France has already been granted a two-year reprieve to get its deficit in line in 2015. It says it will press ahead with a 50-billion euro spending cut for 2015-2017 but go no further.
Norbert Barthle, budget committee leader for the German Christian Democrats (CDU), told Reuters France was Germany's "biggest headache" and he hoped the government crisis would put pressure on Hollande to carry out announced reforms.
But he suggested Germany would agree to give France another reprieve to bring its deficit under the EU's 3 percent ceiling.
Barthle said another extension "will only be acceptable if the EU Commission says clearly what is expected of France. We assume that France to stick to the things it has signed, including the fiscal pact."
EU rules stipulate that governments must aim for a budget close to balance or in surplus and they also have to reduce public debt. But the rules also say governments can get more time to achieve a balanced budget if they implement reforms that have a demonstrable positive impact on growth.
Marcel Fratzscher, president of the DIW economic institute, said France was unlikely to be able to bring its deficit below 3 percent of GDP before 2016 so Germany would probably have little choice but to agree to give France more time.
"The German government knows that, so the issue will be more what the French government commits to in return - if it can really prove it's making a lot of progress on structural reforms there may be more willingness," he said.
Germany may offer France some concessions but it does not want to be taken for a ride.
To guard against any slippage, Berlin is still keen to maintain pressure on euro zone strugglers to cut their deficits and work towards budget balance to avoid opening the flood gates to more lax fiscal policy.
"The danger is that France, possibly with Italy, will tear down from behind what we have worked so hard to build," one senior German official said.
Martin Koopmann, managing director of the Genshagen Foundation, an institute for German-French cooperation in Europe, said the German government would approach France's problems with "a significant dose of pragmatism" and probably reluctantly give it another extension.
Ultimately, Germany has a vested interest in not squeezing too hard on France, which is its biggest export market.
While Germany will continue to call for countries to stick to structural reforms and achieve balanced budgets, its dependence on European demand for its products meant it could not afford to be too harsh on France, said Koopmann.
"It's not in Germany's interests to bring France to its knees with an excessive austerity policy - it's more a question of reforming France and even if that takes ages, the main aim will be to win back France as a strong sales market," he added. (Additional reporting by Matthias Sobolewski in Berlin and Leigh Thomas in Paris; Editing by Paul Carrel and Tom Heneghan)
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