By Andrew Osborn
LONDON (Reuters) - German Chancellor Angela Merkel told Prime Minister David Cameron she did not support the kind of fundamental reform of the European Union he wanted, but said Britain should stay inside the bloc to help make it more competitive.
In a speech to both houses of Britain's parliament - only the third time a German leader had spoken there since World War Two - Merkel, the leader of the EU's most powerful state, ruled out the prospect of a far-reaching overhaul of the bloc's treaties, signaling she was open to modest reforms only.
"Some expect my speech to pave the way for a fundamental reform of the European architecture which will satisfy all kinds of alleged or actual British wishes. I am afraid they are in for a disappointment," Merkel said in English.
"Others are expecting the exact opposite and they are hoping that I will deliver the clear and simple message here in London that the rest of Europe is not prepared to pay almost any price to keep Britain in the European Union. I am afraid these hopes will be dashed," she said.
In London for a one-day visit, Merkel was speaking at a time when uncertainty about Britain's future in the EU is rising because of a promise by Cameron to offer Britons a referendum on whether to leave the 28-nation bloc or not, if he wins a national election next year.
Under pressure from eurosceptics in his Conservative party and from the anti-EU UK Independence Party (UKIP) ahead of European elections in May and next year's national vote, Cameron has promised to try to reshape Britain's EU ties first.
He has not spelt out all the reforms he wants, but made clear he wants to curb freedom of movement for people from poorer new EU member states, combat pan-EU "welfare shopping", cut swathes of EU red tape and improve competitiveness.
"QUEEN OF EUROPE"?
Switching between her native German and English, Merkel delivered her speech in one of the British parliament's most ornate rooms with Cameron and the rest of the country's political elite sat in the front row hanging on her every word.
Hers was a delicate balancing act: To be seen to be giving Cameron, a center-right ally, some support in his politically fraught quest to claw back powers from Brussels, while making it clear that her backing went only so far.
Dressed in a trademark trouser suit with a blue jacket, Merkel praised Britain for its role in safeguarding freedom in World War Two, for its pivotal role in transatlantic relations, as an important German ally, and a vital member of the EU.
"We need a strong United Kingdom with a strong voice inside the European Union. If we have that we will be able to make the necessary changes for the benefit of all," she said.
She indicated she supported Cameron's bid to clamp down on abuse of the EU's freedom of movement rules when it came to welfare benefits and partially backed his drive to rein in the European Commission. She said Britain would have a chance - along with everyone else - to submit proposals for reform once deeper integration of the euro zone had happened.
"It is not a piece of cake, it will be a lot of work," Merkel said. "If we want Britain to remain in the European Union, which is what I want, if one also wants a competitive union that generates growth, one can find common solutions."
Proposals would then be judged on whether they bolstered the euro's "economic strength," she said.
In comments that will please Cameron, who later called her speech "excellent", she said she thought that EU red tape should be cut, that unnecessary EU laws should be junked, and that the EU principle that member states do things at national level where that makes more sense should be respected.
A joint news conference after her speech was awkward, however. Merkel ignored a reporter's question asking her if she regarded Cameron as her "naughty nephew", appeared unimpressed with another asking her if she was "the Queen of Europe", and a joke by Cameron about the European Parliament fell flat.
Merkel's visit is seen as a test of how far Cameron is likely to get in persuading the rest of the EU to sign up to his reform ideas, since Germany is the bloc's most powerful state and its biggest economy.
Cameron has so far garnered only limited backing for his plans among other EU states and, though encouraging in places, some regarded Merkel's speech as a sign he would struggle to deliver any radical change.
"The chancellor sent an unmistakable message to London: We hear you and we're with you, tinkering and tailoring yes, but upending and overhauling the European treaties, no way," was how one EU diplomat summarized her speech.
Douglas Alexander, the opposition Labour party's spokesman for foreign affairs, was also skeptical. "Sense that Chancellor Merkel's speech today offered much less to David Cameron than he had hoped or expected," he said on Twitter.
But if he was disappointed, Cameron didn't show it. "I have great confidence the sorts of changes that we're talking about are achievable and will be achieved over the coming years," he told the news conference.
After her address to parliament, Merkel had lunch with Cameron in his offices before taking tea with Queen Elizabeth.
That pomp and circumstance contrasts sharply with an Anglo-French summit last month when President Francois Hollande and Cameron held a news conference in an aircraft hangar before sharing a low-key pub lunch.
Hollande poured cold water on the prospect of EU treaty reform saying it was not a French priority.
Merkel has said repeatedly that she does favor EU treaty change. But she sees it as much more limited in scope than Cameron and as a way of deepening euro zone integration.
"Only through close, binding coordination of economic policy can we avoid, in the longer term, suffering another deep crisis in the euro area. For this I believe we need to adapt the legal foundations of the monetary union in a limited, targeted and speedy way to stabilize the union for the long term," Merkel said.
(Additional reporting by Kylie MacLellan, Julia Fioretti and William James in London, Paul Taylor in Paris, Luke Baker in Brussels, Noah Barkin, Andreas Rinke and Madeline Chambers in Berlin; Editing by Guy Faulconbridge and Mark Heinrich)