Bank sceptical over whether new rules will be applied with any more rigour

The European Central Bank (ECB) is preparing the ground for battle over budget deficits in what could prove a major test for monetary union in the years ahead.

In its first lengthy critique of the revised Stability and Growth Pact rules, the ECB in its August bulletin expressed a healthy dose of scepticism over whether European politicians would apply the new flexible budget rules adopted in March with any more rigour than the earlier failed pact.

As usual, the ECB warned that if budgetary looseness threatens inflation, the central bank would have to keep short-term interest rates higher than otherwise.

Perhaps more unusually, said Goldman Sachs chief European economist Erik Nielsen, the ECB also said publicly that the structure of monetary union itself was part of the problem.

Debt market discipline has virtually disappeared since the launch of the euro in 1999. A country such as Portugal, facing a 6.2 per cent budget deficit this year, pays scarcely any higher rates on its debt than Finland with a healthy budget surplus.

The reason? The ECB said that getting rid of exchange rate risk when the 12 countries united into one currency reduced interest rate premia, "blunting the discipline normally exerted by financial markets on governments' fiscal behaviour".

The phenomenon has been widely commented on before, but Nielsen said for the ECB to publicly acknowledge the problem was a "revolution". "This is a significant change in tone," he said.

Up until now, the ECB has been quite restrained in reacting to the March changes to the budget rules that underpin the euro.

It has called for ambitious implementation of the new pact and strict enforcement to "restore the framework's credibility".

Recognising the new political reality, this was notably toned down from the ECB's earlier warnings that the pact was a cornerstone of monetary union that must remain firm.

Mr Nielsen said he viewed the detailed critique in the monthly bulletin, and its remark that the market discipline had been blunted, as a sign of firm ECB resolve to focus on budgetary issues to ensure that fiscal problems did not undermine the euro.

In its bulletin, the ECB laid out its arguments for tough medicine on budgets, especially given population ageing. Its simulations showed that even if politicians did stick to the new rules, slow-growing, high-debt countries would not get their debt ratios below the 60 per cent of gross domestic product (GDP) limit within 15 years.

"The implication is that merely keeping deficits below the 3 per cent of GDP reference value will not be sufficient to stabilise debt ratios," it said.

Moreover, the ECB warned that the more flexible pact lacked clarity and left huge room for interpretation.

For instance, the long list of exceptions for when a country is in violation of the 3 per cent deficit ceiling increases the likelihood that countries will not be penalised for spending overruns, it said.

The real test on budgets, however, is not likely to come for several years. Finance ministers have given Italy until 2007 to get its 4.3 per cent budget deficit in line, and Portugal is expected to get three years for its 6.2 per cent budget gap.

But market analysts say if politicians fail to apply the new rules effectively, the day will gradually approach when the ECB may have to reconsider what it can do to protect monetary union.