UPDATE 1-France raises concerns about budget rules at EU summit
* Draft agreement aims for balance of growth, strict budgets
* Germany expected to reinforce need for fiscal discipline
* France, Spain, others seek space to stimulate economies
* Cyprus expected to raise its situation for discussion
BRUSSELS, March 14 (Reuters) - French President Francois Hollande raised the prospect of a showdown with Germany at a European summit on Thursday, calling for more room in budgets to help stimulate growth, a challenge to Berlin's faith in tight fiscal controls.
Arriving at the two-day meeting, where discussion will focus on economic policy and the social fallout from three years of debt crisis, Hollande said it was essential that governments had enough budget flexibility to kick-start growth with spending.
That is unlikely to sit comfortably with Germany, which is concerned that any straying from the path of deficit cutting will increase the debt burden and stir financial market turmoil.
"We need flexibility if we want to ensure that growth is the priority," Hollande told reporters, adding that while he was committed to gradual budget consolidation, that did not mean that there was no room for manoeuvre.
"It is precisely because of this commitment that there must be flexibility because the only priority right now, aside from the budgetary commitments, is growth... Too much rigidity would mean too much unemployment," he said, touching on one of the region's most sensitive issues, with 27 million unemployed.
Hollande said this week that France's budget deficit this year would come in at 3.7 percent of gross domestic product, 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.
A draft statement prepared for the summit appeared to offer some wiggle-room on budgets, saying there should be "an appropriate mix of expenditure and revenue measures, including short-term targeted measures to boost growth" and create jobs.
But diplomats said that formula was not fully backed by Germany, the Netherlands, Finland and other northern countries worried about backsliding on budget goals.
German Chancellor Angela Merkel skirted the issue on arrival at the meeting, saying only that leaders would discuss "general conditions concerning budgets, growth and unemployment".
But 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.
Diplomats said they did not expect 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 galvanise 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, crystallising the debate between austerity and economic stimulus.
"The problem is, I don't know where most euro zone countries would find the fiscal space to stimulate if they were allowed."
While the focus of Thursday's discussions was on budget policy and tackling youth unemployment, leaders were also expected to touch on Cyprus and Italy at a gathering of just the 17 euro zone leaders later in the evening.
Cyprus has said it intends to raise its request for a bailout of up to 17 billion euros. A discussion may help guide negotiations among their finance ministers, who are due to meet on Friday evening to thrash out the outlines of the bailout.
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 draft 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.
Olli Rehn, the European commissioner for economic affairs, who has been attacked by Nobel economist and New York Times commentator Paul Krugman for sticking too rigidly to austerity, said there was a way to strike a balance.
"There is no real contradiction between sustainable growth and the sustainability of public finances," he said. "We have to keep both objectives in mind and that is what the European Council will, I trust, do today."