The European Union's highest court yesterday annulled a controversial decision by the bloc's finance ministers to suspend budget disciplinary action against Germany and France last year.
The move had dented credibility of the Stability and Growth Pact on budget discipline and was challenged by the European Commission, guardian of the pact which underpins the euro.
The European Court of Justice said ministers had the right to change Commission recommendations on budget policy but that they had failed to respect the rules when they suspended disciplinary action against Berlin and Paris.
The two largest eurozone economies are expected to break the EU deficit cap for the third year running in 2004 and the Commission had recommended that ministers tell Germany and France to take steps to bring their deficits below the budget pact's limit of three percent of gross domestic product in 2005.
The Commission welcomed the ruling, which was seen strengthening its hand at a time when it expects six of the eurozone's 12 members to run 2004 budget deficits above the EU cap.
"The council tried to sidestep the process and came up with a political compromise but the court said they must follow the rules of the game," said William Robinson, partner at Freshfields Bruckhaus Deringer in London, where he is a member of the EU group dealing with dispute resolution.
"This is a brave decision that upholds the rule of (procedural) law. The Council (of ministers) will be horrified, but the Court has simply held them to their procedural bargain."
Excessive deficit procedures may now be restarted against Germany and France but they need not fear fines, the ultimate sanction in the budget disciplinary procedure which may now have to be restarted against them, analysts said.
"The credibility of the Stability Pact is pretty much shot to pieces as there have been abuses left, right and centre. Moreover, it is clear that there will always be a way out of fines," said Nick Eisinger, director in Fitch's sovereign ratings group.
The court decision provoked little immediate reaction in financial markets.
"This is bond positive as the European Commission is in a stronger position and we could expect a tighter fiscal policy in countries like France and Germany and less government bond supply," said Kornelius Purps, fixed income strategist, Hypovereinsbank.
"Nevertheless, the discussion that will take place in the coming weeks will be more academic than market moving."
Mr Eisinger said the focus should now be on the need to revamp the Stability Pact - a project on which the Commission is already working.
"It illustrates that the Stability and Growth Pact is a model that needs some adjustment and people realise that already," he said. The EU executive has already said some elements of the pact are too rigid and presented ideas for improving its application.
Among these was the suggestion that the scope of a crucial get-out clause could be widened to introduce more flexibility.
Eurozone finance ministers have also already agreed economic upswings should be used to improve budget positions, on the need for structural reforms, and that more attention should be paid to growth-friendly steps that did not lead to budgetary costs.