The European Commission has warned that Ireland's financial deficit is above EU limits and the Government's forecasts for improvement are ‘somewhat optimistic’.

The commission made the comments in a report launching a special monitoring regime because of the rate of Govt borrowing.

Known as an 'Excessive Deficit Procedure', it is applied to countries where government borrowing in any year exceeds 3% of GDP.

The Government deficit this year is projected to be 11% of GDP without cuts to spending.

The limits set under the Stability and Growth Pact are designed to avoid wide disparities between national economies in the eurozone, and the Commission is making allowances for ‘exceptional’ and ‘temporary’ economic circumstances across Europe.

However, in Ireland's case, today's report says the ‘exceptional’ Irish deficit above the maximum 3%, is not even close to the 3%, and cannot be considered temporary.

The report says the Irish Stability Programme envisages a progressive reduction of the deficit to below 3% in 2010, ‘assuming a recovery of economic activity after 2010’.

It goes on: ‘The measures adopted by the government can be regarded as welcome and adequate given the high deficit and a sharply-increasing debt position and are in line with the European Recovery Plan.

‘But the growth scenario is somewhat optimistic and the consolidation measures presently lack detail. Further risks stem from the measures in place to support the financial sector, in particular bank guarantees and, concerning the debt ratio, the possibility of further capital injections or nationalisations of banks’.

Last month, Government published an outline plan to bring borrowing below this target over a five year period – longer than the usual term because of the severity of the economic slowdown and the scale of the problem in the government finances.

The Stability and Growth Pact, the basic rules for membership of the single currency, requires countries to keep annual government borrowing levels below 3% of GDP.

Countries that go above this level are subjected to what is known as an excessive deficit procedure – a special monitoring regime to ensure countries act to reduce their borrowing level back below 3%.

This usually takes place over a number of years.

Under the EU treaties, the Commission has to make a report if it believes a country has exceeded this level of borrowing.

The report then goes to the Economic and Finance committee, which is made up of senior Finance Ministry officials from the member states.

The EFC opinion and the Commission report then goes to a meeting of the Ecofin Council, the national finance ministers meeting in Brussels. It is the ministers who decide if the procedure is to go ahead, and set a deadline for completing the move back to below 3%.

The Commission will start that process today in the case of Ireland and five other states, France, Greece, Latvia, Malta and Spain.

Reducing the deficit

The state concerned then deals with the commission and the council on an ongoing basis, to agree a plan to reduce the deficit. Usually the council expects states to cut their deficit by at least 0.5% of GDP each year.

The Department of Finance’s stability programme envisages reductions in borrowing of 1% of GDP this year and 2% of GDP the following two years.

The implementation of the plan is closely monitored by the Commission and the other member states. In effect it is a form of group peer pressure, to try and ensure states do not backslide on their commitments.

The regulation on Excessive Deficits does provide for sanctions if states effectively refuse to make cuts, which can in theory lead to a fine of 0.5% of GDP (about half a country’s contribution to the EU budget).

This has not happened so far, and is thought most unlikely to be applied in the current circumstances, especially after the 2005 reform of the stability and growth pact.

Ireland's revised stability programme, published last month, says the Government intends cutting borrowing by €2bn this year, €4bn next year, €4bn the year after, €3.5bn the year after that, and a further €3bn in 2013.

Most of this year’s reduction will come from the public service pension levy. Borrowing reductions in future years will have to be met by further cuts and increases in taxation.

The Commission will monitor the Government’s performance towards hitting those targets, and issue annual reports.

Five other states are expected to be included in the excessive deficit procedure today, including France, Greece and Spain.

Britain and Hungary are subject to ongoing procedures. (Non-Eurozone member states like Britain are required to operate under the same budgetary rules under what is known as the Convergence Programme).

There have been 16 excessive deficit procedures taken by the Commission since the regulation came into effect in 1999, involving 14 different states.

The UK and Portugal have each had two procedures. This is the first time Ireland will have faced the procedure.