EURO ZONE Finance Ministers freed themselves from the constraints of EU budget rules yesterday by suspending disciplinary action against Germany and France in defiance of an angry European Commission. Berlin and Paris will be asked for no more than a political commitment to cutting deficits that are set to break EU limits for the third year in a row in 2004, rather than being pushed along a disciplinary process whose ultimate sanction is a fine.

At a time of nascent economic recovery, both will also be urged to cut deficits by less than the Commission recommended, under an accord struck after nearly 10 hours of talks and which will be put to a formal vote by EU ministers later on Tuesday. Italian Finance Minister Giulio Tremonti said the deal was in line with the spirit and letter of EU budget rules but Spain, the Netherlands, Finland, and Austria did not back it and the Commission immediately went on the warpath.

The EU executive said ministers were entering uncharted territory that would make it harder to enforce the budget discipline rules that were drawn up before monetary union and were designed to underpin the euro.

?The Commission deeply regrets that these proposals are not following the spirit and the rules of the (EU) treaty and the Stability and Growth Pact (on budget discipline),? European Monetary Affairs Commissioner Pedro Solbes said.

The EU executive, which is responsible for enforcing the pact, declined to spell out its next move but dropped hints that it may mount a legal challenge. ?The Commission, while continuing to apply the treaty, will reserve the right to examine the implication of these conclusions, if they are finally accepted, and decide on possible subsequent actions,? Solbes added.

EU diplomats said European Central Bank chief Jean-Claude Trichet had spoken out against any watering down of EU budget discipline, which he had urged on euro zone Finance Ministers even before arriving in Brussels for the meeting on Monday.

So far financial markets have shown little worry over the gradual loosening of EU budget constraints, with the euro last week hitting record highs against the dollar.

However, prior to the deal some Finance Ministers had voiced concern that a split among the 12 members of the euro zone could send the wrong signals to financial markets, eventually leading to higher interest rates.

Germany, the original architect of the Stability Pact, had triggered Tuesday?s crisis by questioning the validity of the budget disciplinary process and any deficit-cutting steps that might jeopardise a long-awaited economic recovery.

It put a gloss on a compromise that will give it and France until 2005 to bring their deficit below the EU cap of three percent of gross domestic product.

?It?s a compromise which is hard for Germany, but is our commitment to making sure that we stay together and it isalso realistic,? said German Finance Minister Hans Eichel.

?We commit ourselves to get (the deficit) under three percent in 2005, that next year (2004) we reduce our structural deficit by 0.6 percent and 0.5 percent in the following year,? he said.

The Commission had recommended that Germany cut its structural deficit by 0.8 percent of GDP in 2004.

French Finance Minister Francis Mer said Paris would cut its structural deficit ? the deficit that is not affected by economic swings ? by 0.77 percent of GDP in 2004, less than the 1.0 percent recommended by the Commission.

Italy?s Tremonti said the council declaration whose wording was hammered out over the night was ?a clone? of Commission recommendations ? a claim the EU executive rejected.

?The figures are not the same as in our recommendations. The final commitment is made conditional on growth, certainly for Germany,? a Commission official said.

Nevertheless France and Germany insisted that EU rules were being observed: ?We are respecting the spirit of the Treaty while adapting to a situation which is quite exceptional,? France?s Mer said.

Eichel and Belgian Finance Minister Didier Reynders said the threat of further punitive action against Berlin and Paris could be revived if they failed to live up to their new commitments. (Reporting by Ecofin team of Paul Carrel, Douwe Miedema, Swaha Pattanaik, Nick Antonovics, Patrick Lannin and Peter Nielsen)

By Swaha Pattanaik and Nick Antonovics