* Recovery will provide the real test for EU budget rules
* Medium-term commitment to get finances in order is key
* Ministers delay exit plans, unsure of timing of recovery
By Jan Strupczewski
BRUSSELS, May 20 (Reuters) - A future recovery, rather than the current downturn, will be the real test for the European Union's budget rules because after a grace period for recession- fighting, it will put budget consolidation back on the agenda.
Plans for such consolidation, known as an exit strategy, must start to emerge in a few months to show markets there is a commitment to sustainable public finances to limit borrowing costs in the face of soaring demands on the public purse.
The EU's budget rules, the Stability and Growth Pact, say governments must aim to keep budgets in balance or in surplus and should not run a deficit above 3 percent of GDP.
"This fiscal exit strategy will be the biggest test of the Pact," said a source from the EU's Economic and Financial Committee, which prepares monthly meetings of EU finance ministers.
"If by the end of the year we don't have an exit strategy, a clear, credible strategy to have everyone below 3 percent and then everyone quickly at budget balance, then it will be a serious problem for the Pact," the source said.
The consolidation efforts will be made more difficult by the fact that it will not be enough to simply grow a way out of the deficits, economists and policymakers said.
Governments will have to make some tough choices in the coming years, involving pension reforms, withdrawing emergency aid to some industries, investing in education and retraining of workers and a review of welfare policies.
Governments slow to consolidate will face political pressure from other EU members which have already done this.
But the biggest pressure will come from markets which start demanding higher yields to lend money to feet-dragging governments, especially since a recovery would also entail more risk appetite, higher borrowing needs from the private sector and therefore tougher competition for government paper.
"When the economy starts recovering you will probably see governments having difficulties to get money from investors and at that point you get higher yields on bonds and pressure on governments to consolidate budgets," said Jurgen Michels, economist at Citigroup.
Ireland, the Baltics and Hungary already have restrictive fiscal policies because they have no other choice, given the size of their shortfalls. But others will have to follow soon, a senior European Commission official said.
"The majority of other countries will have to restrict fiscal policy in the course of next year and 2011," said the official at the executive Commission who asked not to be named.
But the belt-tightening is unlikely to start before 2011 when the EU and euro zone economies are likely to grow for the first time after contractions expected for 2009 and 2010.
"If you have a choice you would probably not want to start in the early stages of the recovery because you want that recovery to gain some traction," said Dominic Bryant, economist at BNP Paribas.
"Fiscal tightening has a nasty habit of derailing recoveries if it is done too quickly -- we saw that in Japan," he said.
Governments face a tricky balancing act, he said, because if they started reining in spending too soon, their structural deficits would shrink but they would kill the recovery and the cyclical deficit would rise.
"But you don't want to give it too long because you build up big amounts and people start questioning your commitment. And that's when you get into trouble," Bryant said.
DEFICITS FAR OVER LIMIT
Most European Union countries will break the EU budget deficit limit of three percent of gross domestic product this year and next. Some will even go four or five times over the limit in the worst economic recession since the World War Two.
The huge deficits are a result of government spending 1.8 percent of the EU's GDP to try to cushion the economic downturn and replace waning demand, investment and trade. Including welfare outlays, the stimulus is about 5 percent of EU GDP. Governments have spent further billions on bank bailouts.
The European Commission forecasts that 21 out of the bloc's 27 nations will have deficits at or above the ceiling this year. Ireland, Britain and Latvia will have gaps in double digits. Next year, it will be 23 countries and even bigger deficits.
But with uncertainty about the timing of a recovery still high, EU finance ministers want to wait before announcing concrete consolidation plans.
"The discussion in the Council (of EU finance ministers) was that ... it would not be credible to define an exit strategy right now," the EFC source said.
"So it is likely to be in September, when it is more clear if we have found a floor for the economy and if the current projections hold," the source said.
The European Commission has already outlined exit strategies for several countries like Ireland, France, Spain or Greece through the EU's disciplinary budget steps launched when a country exceeds the 3 percent limit, recession or no recession.
The deadlines for curbing the budget gaps below the EU ceiling range from 2010 for Greece to 2013 for Ireland, but meeting these targets depends on economic developments and political will to take tough decisions.
"We may run into big political problems when it comes to reducing the deficits. The real challenge is before us," a second EFC source said.
(Additional reporting by Marcin Grajewski)
(Reporting by Jan Strupczewski, editing by Stephen Nisbet)