European Rearmament Plans: National Policy Choices Will Shape Fiscal Impact

France, Germany and the United Kingdom will be among the leading NATO member countries to compensate for the increasingly uncertain commitment of the United States to guaranteeing Europe’s security.

The economic and credit implications of higher defence spending from the three governments will be mixed, however, reflecting their differing fiscal positions, budgetary and socio-political constraints.

Relying on debt-funded military spending would weaken the credit outlooks of France and the UK, but the combination of limited fiscal flexibility and higher bond yields could encourage both governments to make the necessary budgetary adjustments. In addition, Germany’s fiscal stimulus could have favourable broader spillover effects on growth, which would help soften the permanent impact of increased European defence expenditure on public debt ratios.

Germany will rely predominantly on higher debt issuance to offset the decades of under-investment in its armed forces as the incoming administration secured a required two-thirds parliamentary majority to reform the constitutional debt brake. Robust public finances, anchored by a government debt-to-GDP ratio of 63% and a budget deficit of 2.0% of GDP in 2024, provide sufficient flexibility to finance large fiscal stimulus without significant tax hikes or spending cuts in other areas.

The UK is likely to finance higher defence spending through a mix of debt issuance and some budgetary adjustments, given its government debt burden of 100% of GDP and budget deficit of 5.8% of GDP as of 2024. The government’s comfortable majority in parliament could offer the flexibility to reduce non-defence expenditures.

Conversely, France faces limited capacity to absorb higher defence spending through additional debt issuance, given an already high government debt-to-GDP ratio of 113%. Despite a budget deficit of 5.8% of GDP, making other budgetary trade-offs is equally challenging due the country’s minority government, highly fragmented parliament and relatively high risk of further political instability.

Shifting Budget to Finance Higher Defence Spending

Increasing defence spending (Figure 1) towards a potentially revised NATO target of 3% of GDP by 2027 would mean that annual spending allocated to the armed forces increases to about EUR 95bn in France and the UK, and to above EUR 140bn in Germany.

This would represent an increase in defence spending averaging EUR 45bn a year through 2027 in Germany (0.9pp of GDP), which is expected to be almost exclusively covered by higher funding volumes, without material credit implications.

However, increasing annual funding volumes by EUR 30bn in France (0.9pp) and EUR 20bn (0.7pp) in the UK would weigh on fiscal sustainability, particularly amid less favourable funding conditions, calling for potential budgetary trade-offs. Bridging this spending gap towards a 3% of GDP defence target would be equivalent to about 3% of what France and the UK allocate to social welfare spending and less than 2% of revenues.

Figure 1. Defence spending accounts for a small share of government budgets

% of GDP

Bolstering European Defence Will Impact Debt Ratios

Although budgetary trade-offs in France and the UK could partially offset credit implications, we expect increased debt issuance to be the main driver of higher defence spending in the three countries.

Assuming an increase of defence spending to near 3% of GDP by 2027, government debt-to-GDP would rise to 120% of GDP in France, 109% in the United Kingdom, and 69% in Germany (Figure 2). This would be a significant increase from pre-Covid levels, notably for France (21pp) and the UK (23pp).

The debt trajectory of both sovereigns is particularly exposed to wider primary fiscal deficits, and higher interest rates triggered by the market reaction to Germany’s rearmament and infrastructure spending plans. Inflationary pressures could increase further with rising tariffs on critical inputs for the defence industries.

Annual funding programmes are thus likely to remain close to their record highs in the years to 2027. Net interest payments are projected to exceed 5% of revenue in France and 7% in the UK, although remain less than 3% in Germany.

Figure 2. Public debt set to rise, raising pressure for budgetary adjustments

Percentage point changes

Rearmament Plans Could Moderately Support the Growth Outlook

Germany’s decision to take advantage of its large fiscal stimulus could also lead to positive spillovers for growth in France and the UK. Both countries have comparatively stronger military and defence production capacities, including nuclear deterrence.

This could result in slightly higher growth and, together with budgetary trade-offs, mitigate the credit implications from higher defence spending. However, potential regional economic spillovers could be limited by administrative and capacity constraints across European manufacturers. This could result in Germany’s rearmament plans being more reliant on increased US-supplied arms imports.

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Thomas Gillet is a Director in Sovereign and Public Sector ratings at Scope Ratings, and the primary analyst on France’s sovereign rating. Eiko Sievert, Senior Director at Scope and primary sovereign analyst on Germany, contributed to drafting this commentary.