By Jan Strupczewski

BRUSSELS (Reuters) - Fines for Spain and Portugal for failing to bring their budget deficits below the EU's ceiling will be canceled and deadlines to meet the rules extended under a European Commission proposal that officials said is backed by Germany.

The proposal made on Wednesday underlines the EU executive's reluctance to impose fiscal discipline while anti-EU sentiment is rising and economic growth remains slow. It took a similarly lenient view when France missed deficit targets last year.

"Taking into account past efforts of Spain and Portugal, the current challenging environment, and arguments laid out in the recent requests, the college (of Commissioners) agreed today to propose a cancellation of the fines," Commission Vice-President Valdis Dombrovskis told a news conference.

The decision not to fine Madrid and Lisbon was made by European Commissioners using a provision for exceptional circumstances, after both countries pleaded for clemency in letters to the EU executive.

Under EU rules, governments cannot run budget deficits higher than 3 percent of gross domestic product, a legal safeguard to ensure that excessive government borrowing does not undermine the common euro currency.

If the shortfall is greater than 3 percent, the Commission and EU ministers set a deadline for its reduction. If steps aren't taken to meet the deadline, the government can be fined.

EU finance ministers last week backed a Commission view that neither Spain nor Portugal had taken effective action to meet deficit reduction targets agreed with the EU and that therefore the next step was to fine them 0.2 percent of GDP.

Portugal was meant to cut its deficit to below 3 percent last year, but the gap turned out to be 4.4 percent.

Spain was meant to bring its deficit below 3 percent this year, but is likely to miss the target in 2016 and next year, according to Commission forecasts.

But fines are highly sensitive politically. Spain has been without a proper government since the inconclusive elections in December 2015 and could therefore argue it was and is unable to quickly implement spending cuts.

Moreover, there is rising anti-EU sentiment across Europe which heavy-handedness from Brussels on budget rules could fuel further, especially at a time when many economists are calling for more spending to stimulate economic growth.

On the other side of the argument is the need to uphold the budget rules laid out in the Stability and Growth Pact that underpins the euro currency, which were sharpened during the sovereign debt crisis to curb over-spending by governments.

The credibility of the rules has already been badly damaged by the Commission's decision last year not to fine France for its repeated abuse of the Pact.

The Commission had been divided over what course of action to take, with some arguing the fines should be canceled and others insisting they must be imposed, even in a token amount, to uphold the credibility of the rules.

EU officials said it was German Finance Minister Wolfgang Schaeuble, usually seen as a fiscal disciplinarian, who had tipped the balance in favor of no fines. They said he had called several Commissioners from the same political family -- the centre-right European People's Party -- and asked them to help Spain's centre-right acting Prime Minister Mariano Rajoy.

"Satisfied with the decision of the European Commission. Fiscal consolidation, growth and employment are priorities for Spain," Rajoy tweeted after the decision.

Socialist-ruled Portugal was let off the hook because it would have been too difficult to fine one country and not the other, EU officials said.

Schaeuble said last week that suspending payment of EU structural funds -- another step envisaged by the beefed-up Pact -- could be a more effective way of influencing a government's budget policy than levying fines.

Economic Commissioner Pierre Moscovici seemed to echo that view, tweeting on Wednesday: "Fines would not have corrected the past and would have been counterproductive at a time when people doubt in Europe."

Structural funds are paid from the EU budget to less wealthy member countries for projects, ranging from infrastructure development to fighting youth unemployment -- an important issue for Spain.

The Commission said it would start a discussion on a partial freeze of the structural funds that would normally go to Spain and Portugal in 2017 in September, after the European Parliament -- which has to be consulted -- returns from its summer break.

It is not clear yet how much of the funds could be suspended. But the money can be unfrozen quickly once, for example, the two countries adopt 2017 budgets that show they intend to meet their commitments under EU rules.

(Reporting By Jan Strupczewski; Editing by Philip Blenkinsop and Catherine Evans)