Defence spending presents mountainous challenge to public sector debt issuers

The heads of government of the 32 member states of the North Atlantic Treaty Organisation (Nato) are expected to commit to monumental change when they meet for their annual summit in June.

“If we don’t spend more together now to prevent war, we will pay a much, much, much higher price later to fight it,” Mark Rutte, Nato secretary-general, said in December 2024.

At his first summit leading Nato, which will take place in his home country in The Hague, Rutte will be expected to extract a commitment from members of the alliance to increase their defence spending to levels not seen in the post-Cold War era. “I assume that in The Hague we will agree on a higher defence spending target of in total 5% [of GDP],” he said at the start of June.

Under the previous spending target, alliance members were expected to meet a minimum of 2% GDP spending on defence by 2024. A commitment of 5% is therefore an increase of more than double — a significant step upwards for Nato, especially considering that it forecast only 24 of its members would meet the 2% threshold last year.

The US, which, behind Poland and Estonia, was the third largest Nato spender on defence in 2024 at 3.4% of GDP, has been pressuring its allies to spend more on their militaries since Donald Trump became US president for the second time in January. Trump believes that Europe has largely been free riding under the US defence umbrella, underspending on its military to prop up generous welfare states.

Europe has been responding in the way Trump wanted.

“The era of the peace dividend is long gone” Ursula von der Leyen, European Commission president, said in March. “The security architecture that we relied on can no longer be taken for granted. Europe is ready to step up. We must invest in defence, strengthen our capabilities, and take a proactive approach to security.”

With a brutal war raging on its landmass and global geopolitics more uncertain than in recent memory, defence investment has become a priority for Europe. However, economics are constraining what it can do on the journey to security on the continent and some observers believe Nato countries may be unable or unwilling to get to 5%.

“I would find it quite astonishing if a figure of 5% of GDP is agreed on for European countries at the Nato summit,” says Marco Buti , who was director-general for economic and financial affairs at the European Commission between 2008 and 2019.

“And if they do, it will be more to appease the US than out of conviction,” he adds. “The Europeans will struggle very much to get to 3.5%, so I find it hard to believe that this is a sensible commitment to make over a relatively short time period.”

Speculation is rife that Rutte will propose that Nato members allocate 3.5% of GDP to ‘hard defence’ and a further 1.5% for cyber, intelligence and other military-related spending, and that he may push for a deadline as soon as 2030 to achieve this.

The membership of the EU and Nato overlaps almost exactly, though not quite.

Twenty-three of the 27 EU member states are also in Nato, so the level of support among these countries for Rutte’s vision could be a good indication of how far the EU will go in boosting its defence capabilities and how quickly they will do so. In 2024, the 23 EU-Nato members spent just under 2% of their collective GDP on defence.

“Entering 2025, EU member states faced low growth, rising interest rates and an obvious need to increase defence spending,” says Alvise Lennkh-Yunus, head of sovereign and public sector ratings at Scope Ratings.

“While most member states are absolutely committed to 3% defence spending, the speed with which this happens is dependent on the perceived threat level and the fiscal capacity to fund the expenditures,” he says. “Both of these aspects vary significantly across member states.”

Each EU member state has their own incentives to increase their defence budgets. The closer a member state is to Moscow correlates strongly with its military spending, for example, and is likely to do so in the future. But the most crucial difference is probably the state of the public finances in each member state and the constraint this places on how much they can invest in their defence.

Italy and France, two of the three largest economies in the bloc, are severely fiscally constrained, with already high levels of debt relative to GDP. France’s finance minister, Eric Lombard, has said that defence spending and fiscal pressures “don’t cancel each other out”.

“France last year got a clear signal from the market that there were problems with its budget, which pushed OATs wider,” says Peter Schaffrik, chief European macro strategist at RBC. “If France comes out and says that it will widen its deficit by a certain amount to fund for defence, it is very plausible that OATs would trade in a similar way.”

Oliver Rakau, chief Germany economist and deputy head of the European macroeconomics team at Oxford Economics, says that “reallocating spending is politically hard and if [countries like Italy and France] choose to borrow more then it will likely have to be ramped up gradually.”

Rakau notes that there are no guarantees of even Germany increasing its defence spending to the levels described, though it has ample fiscal space to do so, as well as the legal infrastructure to borrow for its military after reforming its debt brake in March. Boris Pistorius, the country’s defence minister, intends to increase defence spending at a pace of 0.2% of GDP per year. In 2024 Germany spent 2% of its output on defence.

“Despite this being a steady pace, it probably makes sense, as Europe does not currently have the necessary production capacity for a larger boost,” says Rakau.

To help EU member states meet what is clearly a mountainous fiscal challenge, the European Commission has proposed its own initiative to help countries get access to credit.

In March, the Commission unveiled its ReArm Europe – Readiness 2030 plan, which it said had the potential to mobilise close to €800bn for defence purposes across the EU. This sizeable amount of capital is intended to be unlocked through two avenues: a temporary activation of the national escape clause in the bloc’s Stability and Growth Pact is expected to release €650bn, while Security Action for Europe (SAFE), a new jointly financed loan instrument, would provide €150bn.

Buti, who also served as chief of staff for former economy commissioner Paolo Gentiloni, does not think that what the EU has put on the table has generated much traction. He notes that only 14 member states, excluding France, Italy and Spain, the three biggest economies in the EU after Germany, have requested to use the national escape clause.

“From a credit rating perspective, the exemption of defence spending from the Commission’s fiscal rules is not overly relevant to us,” says Scope’s Lennkh-Yunus. “The funding has to come from somewhere, and even if you are not penalised institutionally, it still has an impact on your public finances and debt sustainability.”

The Commission has never financially sanctioned a member state for breaking its fiscal rules. Those who criticise the EU’s optimism over the activation of the national escape clause tend to point out that the bond market is the real constraint on extra borrowing.

“The tools put on the table by the Commission both have one thing in common: they create more national debt,” says Buti. “Either via direct borrowing by governments or through the fact that the EU loans have to be repaid by those countries receiving them.

“One conclusion that I think can be drawn is that – contrary to the global financial crisis and Covid – EU instruments based on loans are not very effective. At the moment, we are also not seeing the large spreads that we have over Bunds, which makes these loans less appealing to other countries.”

Many think that for the Commission to make a significant impact grants would be needed, opposed to loans, alongside a larger programme size. “The EU defence package seems a little like a power play from Brussels to stay in the discussion and put an EU-level solution on the table,” says Rakau.

The political barriers to joint borrowing are high across the bloc. More frugal EU countries, such as Germany and other Northern European states, are concerned that they may take on added risk for limited reward if their borrowing costs are below the Commission’s.

However, some of the frugal states, such as Finland or Denmark, or even those known for fiscal responsibility, such as the Baltic states, are the ones who are feeling the most acute security pressures. It could make states who have been traditionally stiff about joint projects warm up to the idea.

“The German government has crossed some painful red lines given its classic position on public spending and defence,” says Buti. “So it remains to be seen if it has sufficient political capital for crossing another one in terms of further EU common instruments. Hopefully this is the case, as there is no way round to a common defence policy financed by common tools, including EU bonds.”

Scope for collaboration is not just limited to the EU and its member states. The idea of a new supranational institution focused on security, modelled on the multilateral development banks, and inclusive to Nato members and their allies, has created some momentum in international circles.

The Defence, Security and Resilience Bank (DSR Bank) is an idea developed by Rob Murray, former head of innovation at Nato. The institution would, according to its founder, act as a strategic supplement to its member’s national budgets while building their defence industrial base.

By obtaining triple-A credit ratings the bank would aim to lend to shareholder countries and defence manufacturers at preferential rates relative to what could be achieved on the market.

“When you look at the numbers for some countries, like Canada for example, a change of this kind [with respect to defence spending] is very significant,” says Kevin Reed, president and chief operations officer at DSR Bank. “These changes in spending are also expected to be implemented over a relatively short period of time while many nations have constrained public finances.

“The DSR Bank plays a crucial role in solving this puzzle,” he adds. “It will be able to complement the spending in the budgets of its members, co-ordinate procurement processes and build defence industries by ensuring access to credit for its participants.”

One of the benefits of developing DSR Bank, its supporters argue, is the opportunity that it presents to build production capacity – something badly needed in Europe. By providing loan guarantees to commercial banks, the institution can ensure smaller defence contractors can have the capital they find tough to access in a stringent regulatory environment.

John Cummins, special advisor to DSR Bank and former CEO of Aviva Capital Partners, notes that by building industrial capacity, the multilateral institution will help accelerate the ability of governments to meet the challenge at hand.

Despite the claims about the benefits of setting up a defence-related lending and borrowing entity, some observers point out that the process of developing a new supra still has drawbacks: “A new institution means that investors would need to get new lines and see how the bonds would fit in with their relative value considerations. It would probably be better to consolidate this funding under one name, such as the EU,” says RBC’s Schaffrik.

“However, from a politics point of view I accept that this is quite difficult,” he adds. “It would require an additional NGEU [NextGenerationEU]-type structure which may be hard for states to accept. There are also the benefits of being able to add the UK and Norway to the project.”

David Marks, a member of the DSR Bank leadership team, spent 38 years working in the capital markets for JP Morgan. He says that it is too early to talk about the relative value of DSR Bank but thinks that its “unique mission will provide investors with a product that will be very desirable to have in their portfolios”.

“A lot of investor work will have to be done, and this will take time, but the infrastructure will absolutely be in place to allow this institution to deliver at scale,” he says.