How to fund Europe’s defence and security

Political

Summary:

Time for the three European big institutions to step up.

As Europe embarks on ambitious plans to boost its spending in defence and security in the light of curtailed support from the US, the big question is how this will be funded in a sustainable manner.

This was discussed at OMFIF Sovereign Debt Institute’s 2025 Public sector debt summit earlier this month in Paris. The event brought together senior officials from European sovereign debt management offices and public sector borrowers as well as leading fixed income investors and intermediaries for in-depth conversations on the key priorities for this market.

Historical debt brake reform

‘There is a real willingness to do more, but it is not clear yet what the end game will be,’ said a senior official at the summit. On a national level, governments are looking at how they can raise extra funds to boost their countries’ investments in defence. Germany’s Bundestag, for instance, last week approved plans for a package consisting of a €500bn infrastructure fund while reforming its debt brake to allow for higher defence spending. The landmark ruling allows for defence spending of more than 1% of gross domestic product to be exempted from the debt brake.

Germany’s fiscal capacity is an exception in Europe. Due to its conservative debt brake, which has been in place since 2009, Germany’s debt-to-GDP ratio has been well below the euro area average. This is why the market reaction to Germany’s historic shift in fiscal policy has been largely muted.

However, some analysts reckon the 10-year Bund yield could reach 3% on the back of Germany’s increased borrowing and spending, more than 20 basis points from where it is currently trading at. Higher borrowing by Germany also raises the likelihood that the European Central Bank will restart public sector bond purchases sooner than expected.

Other countries like Italy, Spain and France will find it far more challenging to borrow more without an impact on spreads and credit ratings. France is particularly vulnerable having already suffered downgrades over its rising budget deficit. Further downgrades to France could also have wider repercussions for the European public sector bond market.

Leaning on EU, EIB and ESM

This is where Europe’s three key institutions – the European Commission, European Investment Bank and European Stability Mechanism – come into play.

The ESM was created as a permanent pan-euro area organisation following the 2012 euro sovereign debt crisis to protect the financial stability and prosperity of the euro area. The biggest risk to financial stability would be a war, and so it is natural to look to the ESM to support against this. The ESM also has plenty of firepower with a lending capacity of €500bn, of which €430bn is currently available, meaning there is around 85% of unused capacity.

Europe could call on the ESM as a lender of last resort if countries face widening spreads and financial stability pressure from taking on the burden of defence spending themselves. The ESM also offers an advantage in terms of pricing. It would be able to lend at favourable rates to its member states due its status in the capital markets as not only a well-regarded triple-A issuer but for having one of the tightest spreads among public sector issuers. Among euro area member states, only Germany, the Netherlands, Ireland and Luxembourg borrow more cheaply in the capital markets. This means 16 euro area countries pay more than the ESM.

Extra lending capacity

Of course, it is not just the ESM that has additional firepower at its disposal. The European Commission and the EIB also have plenty of capacity to lend and disburse more to Europe. If the ESM and the European Commission put their full lending capacity to use, and with an extension of the EIB’s balance sheet, an extra €1tn could be made available for supporting Europe’s defence and security investment.

The European Commission has announced a ‘ReArm Europe Plan/Readiness 2030’ plan to enable spending of over €800bn. This includes a new dedicated instrument coined Security Action for Europe, which will allow member states to immediately scale up their defence investments in the European defence industry. To fund this, the Commission will raise up to €150bn extra in the capital markets until 2030.

This new programme further validates the importance of the European Commission in supporting crises following its role during the Covid-19 pandemic and the recovery of Europe (Next Generation EU) in which it became one of the largest borrowers in the capital markets. It also eases concerns from investors in the Commission’s bonds about the permanency of the EU as a large issuer, which has been one of the key drawbacks to its inclusion in sovereign bond indices.

Meanwhile, the EIB has lifted limits on financing for defence projects, broadening the scope of what is eligible, as part of the ReArm Europe Plan/Readiness 2030 plan. To fund Europe’s defence and security, it is imperative that all three European institutions step-up and work together to give the continent the boost it needs.

Source:Burhan Khadbai

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