By Luke Baker and Julien Ponthus
BRUSSELS (Reuters) - France and Italy won support for a slightly more growth-friendly interpretation of European Union budget rules at a summit on Thursday after French President Francois Hollande challenged German-driven fiscal austerity.
The 27 EU leaders agreed, after debating how to overcome mass unemployment and recession unleashed by three years of the euro zone's sovereign debt crisis, to allow greater leeway for public investment when reducing government deficits.
"The possibilities offered by the EU's existing fiscal framework to balance productive public investment needs with fiscal discipline objectives can be exploited in the preventive arm of the Stability and Growth Pact," the summit conclusions said.
Exceptions would have to be approved by the executive European Commission and fellow euro zone states, but Hollande and Italy's Europe minister drew encouragement from what they depicted as a concession.
"We are meeting our (deficit reduction) commitments but in a way that does not contradict our objective of growth," the Socialist French leader said.
"That's the debate that is now going to start with the Commission, and the guidance we were given today allows us to approach this discussion with confidence," he said.
Hollande said on arrival it was essential that governments had budget flexibility to kick-start growth with spending.
Germany, the leading stickler for fiscal discipline, is concerned that any straying from the path of deficit reduction will raise debt burdens and reignite financial market turmoil.
But Chancellor Angela Merkel avoided any clash with France, telling reporters: "We made clear in a very consensual discussion that budget consolidation, structural reforms and growth are not in contradiction but are mutually reinforcing."
Hollande acknowledged this week that France's budget deficit would hit 3.7 percent of gross domestic product this year, missing the 3 percent it had promised EU partners, due to a flat economy. That drew criticism from Germany's central bank chief, who said French economic reforms seemed to have floundered.
In Berlin on Wednesday, senior German officials trumpeted their finances as the "envy of the world" and said their structural deficit, which factors out the economic cycle, would be eliminated by next year.
European Council President Herman Van Rompuy, who chaired the summit, said that while reconfirming their existing economic strategy the leaders had focused on the urgency of fighting unemployment, with 26 million Europeans including 7 million young people out of work.
"We are all fully conscious of the debate, the mounting frustrations and even despair of the people," he told a news conference. "We also know there are no easy answers. The only way out of the crisis is to keep tackling its root causes."
Diplomats said they had not expected any major policy shift at the summit, but Hollande may be preparing the ground for a more substantial assault against austerity, together with Spain and Italy, after German elections in September.
Between now and then France, Spain and Portugal may also be given more time by their EU peers to meet their deficit goals, as long as they stick to a debt-cutting trend.
While the worst of the debt crisis may have passed, the conundrum leaders face is how to galvanize anaemic growth and create jobs for millions of unemployed without undermining budget discipline.
"Markets kill you if you lose fiscal credibility, and they also kill you if you don't have any growth, so it's quite a narrow path to tread," said one EU diplomat.
"The problem is, I don't know where most euro zone countries would find the fiscal space to stimulate if they were allowed."
Leaders were also expected to touch on Cyprus and Italy at a late-night meeting of just the 17 euro zone countries.
Cyprus said it intended to raise its request for a bailout of up to 17 billion euros. A discussion may help guide negotiations among their finance ministers, who will meet on Friday evening to thrash out the outlines of the bailout.
But German officials played down any expectation of a quick Cyprus solution this weekend, saying it could take weeks longer.
Outgoing technocratic Italian Prime Minister Mario Monti was expected to face questions about prospects in his country after an indecisive general election last month which raised the prospect of prolonged political instability in Rome.
But the central debate is the deepening social crisis across Europe, with more than 50 percent of young people unemployed in Greece, Spain and parts of Italy and Portugal, a scourge that threatens to have a long-term economic and demographic impact.
In their statement, EU leaders highlighted their concern over the issue and committed to a "youth employment initiative" that sets aside nearly 6 billion euros for the worst-affected regions of the EU over the coming seven years.
Analysts say that is far too little to make an impact, amounting to barely 100 euros for each young person without a job across the 27 countries in the European Union.
(Additional reporting by Andreas Rinke, Jan Strupczewski, John O'Donnell, Robin Emmott, Annika Breidthardt, Teddy Nykiel and Charlie Dunmore in Brussels, Writing by Luke Baker, editing by Mike Peacock and Paul Taylor)