European Signals of Defense Splurge Put Pressure on Sovereign Debt

A member of Ukraine's 72nd Brigade Anti-air unit points to the direction of a Russian Zala reconnaissance drone sighted overhead as they prepare to fire a Strela -10 anti-air missile system on February 23, 2024 near Marinka, Ukraine. February 24 will mark two years since Russia's large-scale invasion of Ukraine, which has left tens of thousands dead and many more wounded, although neither country releases official casualty figures. The war has also sparked economic insecurity around the world, further isolated Russia from the West, and, while initially galvanising NATO countries, has exposed tensions between Western allies over the scale and duration of military support to Ukraine. Two years on, the war shows no sign of ending, even while the frontlines have changed very little in recent months. Photo by Chris McGrath/Getty Images

News Analysis

Europe’s attitude towards its defense has substantially shifted in recent months, pivoting away from dependence on American assistance to making the continent more self-reliant.

As a result, many nations across the continent have started seriously talking about substantial increases in defense spending, in some cases for the first time in decades.

The diverse economic situation facing the various nations of the European Union means that any uniform increase across the 27-nation bloc would be more than challenging, with significant potential impacts on sovereign debt.

Given any increase in defense spending will almost certainly be financed by increasing national debt, investors have already begun to buy accordingly, sparking a rise in the yields on bonds across the continent, most notably in Germany, which saw them experience their steepest climb in two years last week.

Geza Sebestyen, head of the Economic Policy Centre at Mathias Corvinus Collegium in Budapest, told The Epoch Times that increased European defense spending would lead to higher deficit levels in many countries, resulting in more borrowing and, consequently, higher government bond yields.

“This effect will likely be amplified by the inflationary impact of the additional spending. Since government bond yields influence other interest rates, corporate bond yields will rise as well,” Sebestyen said. “However, this effect will not be uniform. Countries with stronger fiscal positions [such as Germany] may see smaller increases in yields, whereas highly indebted nations [such as Greece, Italy, or France] will likely experience a more significant rise in bond returns.”

A continent-wide spending brake could be lifted, with European Commission President Ursula von der Leyen telling the Munich Security Conference on Feb. 14: “I will propose to activate the escape clause for defense investments. This will allow Member States to substantially increase their defense expenditure.”

Such a clause was previously enacted in the wake of the COVID-19 outbreak.

Under the Stability and Growth Pact, member states are obligated to implement a fiscal policy aimed at keeping the government deficit below 3 percent of GDP and debt below 60 percent of GDP or face potential fines from the European Commission.

Eight of the bloc’s 27 member states, including France, Italy, and Poland, are under formal rebuke by the Commission for breaching the 3 percent threshold.

Such a rise could have an inflationary impact on some European economies, which cannot afford an increase in the cost of living for an already financially stressed populace.

Last month Tim Ripley, a defense analyst and author of “Little Green Men: The Inside Story of Russia’s New Military Power,” expressed similar concerns to Sebestyen. He told The Epoch Times that big increases in defense spending will be unpopular in most European countries because they can only be funded by tax increases, cuts in services, or more borrowing.

“If you borrow the money, that will quadruple everybody’s interest rates,” he said. “So everyone will pay for it that way, or you put taxes up to pay for it as well. So it’s a massively unpopular thing to do that across Europe.”

The push for higher defense spending was accelerated by U.S. President Donald Trump’s call for European NATO partners to increase their defense budgets, as well as the start of negotiations between Washington and Moscow to end the war in Ukraine.

German soldiers stand in front of a Puma infantry fighting vehicle at the Bundeswehr Panzergrenadierbataillon 122 armored infantry battalion in Weiden, Germany, on February 28, 2024. Leonhard Simon/Getty Images

Statements from both U.S. Vice President JD Vance and U.S. Defense Secretary Pete Hegseth also underlined Washington’s warning to Europe’s leaders that the United States was undergoing a reorientation.

All of this has prompted investors to start predicting an imminent increase in European defense spending is on the cards.

At the beginning of this week, Euro area benchmark Bund yields, a fixed-interest euro-denominated bond issued by the German federal government, edged up as a result of the weekend’s German general election, which reinforced expectations for pro-growth policies. Traders also reacted to a Bloomberg report citing anonymous sources that Europe’s largest economy is discussing a 200 billion euro ($209 billion) emergency defense fund.

Investors have pinned hopes on the new government in Berlin reforming the so-called debt brake to increase fiscal spending to allow for a boost in defense expenditure.

On Tuesday, a close ally of incoming Chancellor Friedrich Merz said the outgoing Parliament could still greenlight a new special fund to boost defense spending but reforming strict limits on state borrowing will be deferred.

Thorsten Frei, a parliamentary leader of the conservative bloc, told Deutschlandfunk radio that Berlin had to move fast.

“Very quick decision[s] are needed, quite specifically in security and foreign policy,” he said.

He added that any wider changes to constitutional limits on state borrowing, known as the “debt brake,” would not be rushed.

Carsten Brzeski, global head of macro research at ING agreed that increased German defense spending was likely.

“I think there will be more spending on infrastructure investments and defense no matter what happens with the debt brake,” Brzeski said. “That should increase the Bund supply.”

The situation may become clearer next month, after EU leaders meet for an extraordinary summit on Mar. 6 to discuss additional support for Ukraine, European security guarantees, and how to pay for their defense.

A recent study found that the EU would need to spend about 250 billion euro ($261.6 billion) annually to defend itself against Russia without U.S. support.

The study’s authors from the Bruegel think tank in Belgium and the Kiel Institute for the World Economy in Germany said this would require spending the equivalent of 1.5 percent of the EU’s GDP to mobilize 300,000 more soldiers.

Last week, the Stoxx Europe Aerospace and Defense Index reached its highest level since at least the early 1990s, with German arms manufacturer Rheinmetall’s stock jumping 14 percent, the UK’s BAE Systems rising 9 percent, and the French group Thales climbing 7.8 percent.

Reuters and Chris Summers contributed to this report.