Germany's fiscal expansion may enhance economic growth across Europe, but for its debt-laden neighbors, rising borrowing costs are limiting their ability to increase defense spending.
Country borrowing costs in Italy, France, and Spain have mirrored the recent 20 basis-point increase in Germany's benchmark rates since the country committed to significant ramp-ups in infrastructure and defense expenditure.
To bolster defense spending more effectively and equitably, increased joint European Union borrowing for grants is needed, according to economists and investors.
Eiko Sievert, executive director at Scope Ratings, noted that rising borrowing costs already affect spending decisions, particularly as this increase is assumed to be permanent.
It is estimated that EU member states will collectively allocate about 500 billion euros ($541 billion) for defense over the next four to five years, constrained by fiscal limitations. This amount falls short of the potential 800 billion euros that could be mobilized by adjusting fiscal rules to enable greater national spending.
Recent market shifts indicate that elevated financing costs in Europe will complicate government spending decisions in the coming years, as stated by Federico Barriga-Salazar, senior director of sovereigns at Fitch. He emphasized that this would restrict spending options, particularly given the reluctance to increase taxes or reduce expenditure elsewhere.
By 2028, Fitch predicts France will allocate 2.5% of its output to defense, while Italy and Spain are expected to remain below the NATO target of 2%, which is being considered for an increase to over 3%. Germany, on the other hand, is projected to reach 3.2%.
Earlier in March, borrowing costs for Germany and related economies rose by approximately 40 basis points before attention shifted to U.S. tariffs. In France, where fiscal concerns had previously unsettled markets, 10-year yields soared to their highest levels since the euro zone debt crisis. Italy's yields reached 4%, while it currently spends below 2% of its output on defense.
Some analysts anticipate that Germany's borrowing costs could rise by more than a percentage point in the coming years, reaching levels not seen since 2008. As the largest economy in the bloc and a benchmark borrower, any further increase in Germany's yields is likely to affect its peers.
While stronger growth may make higher borrowing costs manageable and support increased defense spending, many economists are skeptical about whether the gains from German growth will outweigh the rising costs faced by other nations. Morgan Stanley's chief European economist, Jens Eisenschmidt, noted a potential negative net effect, suggesting that the higher interest costs might negate the benefits of increased growth.
Despite these challenges, BNP Paribas anticipates stronger growth in Europe, particularly if defense spending shifts toward home production, as articulated by head of developed market economics Paul Hollingsworth.
Currently, the risk premia that Italy and France pay relative to German debt have stabilized at slightly over 100 basis points and 70 basis points, respectively, aided by domestic investors capitalizing on higher yields. Amundi, Europe's largest investor, has favored Italian debt, viewing limited prospects for increased spending outside Germany, according to fund manager Reine Bitar.
However, concerns may arise if there are signs of changing dynamics. So far, fiscal authorities in Italy and France have expressed caution about increasing expenditure.
Raising defense spending to 3% of output, without counterbalancing measures, could elevate Italy's debt from around 135% of GDP last year to 145% by 2029, according to Scope Ratings, which projects Germany's debt ratio will remain at just 73%.
Slower growth in defense spending in countries like Italy and France would hinder the overall European defense effort given their significant contributions to the economy.
The EU is prepared to provide 150 billion euros in loans to countries in need by borrowing on the bond market. However, Societe Generale does not foresee full utilization of this funding, as it would contribute to national debt figures and offer limited cost savings for major economies beyond Italy, where borrowing costs are only slightly higher than the EU's.
Instead, economists advocate for further common borrowing to offer grants, modeled after the EU's COVID-19 recovery fund, as it would not count towards national debt and could facilitate more equitable increases in spending.
BNP Paribas' Hollingsworth emphasized that grants would enhance fiscal flexibility. Chris Jeffery, head of macro strategy at Legal & General, has recently invested in Italian bonds, believing that the bloc's defense proposals may fall short and that Italy stands to gain significantly from more common borrowing.