US embassy cable - 05FRANKFURT174

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 
 
--------------------------------------------- ----- 
Tidying Up the Books:  Year End Commission Reports 
--------------------------------------------- ----- 
 
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." 
 
--------------------------------------------- ----------- 
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 
 
Bodde