Published by Global Banking and Finance Review
Posted on April 1, 2025
By Yoruk Bahceli
LONDON (Reuters) - Germany's fiscal bonanza may boost European economic growth, but for its debt-laden neighbours the accompanying higher borrowing costs are eating into their already limited ability to ramp up defence spending.
Borrowing costs in Italy, France and Spain have mostly matched the 20 basis-point rise in benchmark Germany, the bloc's largest economy, since it agreed on a historic debt-rule overhaul in early March enabling it to ramp up infrastructure and defence spending.
Pushing up defence spending further and more evenly would require more joint European Union borrowing to provide grants, economists and investors say.
Rising borrowing costs "influence spending on interest already, especially as we assume this is a permanent increase," said Eiko Sievert, executive director at Scope Ratings.
Fitch Ratings estimates EU member states will only manage to spend about 500 billion euros ($541 billion) combined on defence in the next four to five years, partly due to fiscal constraints.
That's less than the bloc's plans for creating room to spend up to 800 billion euros, mainly by tweaking its fiscal rules to enable more national spending.
Recent market moves show "financing costs in Europe will be higher and this will mean that the offsetting (spending) choices for a government four or five years down the line are more challenging," said Federico Barriga-Salazar, senior director of sovereigns at Fitch.
That will limit spending given there is little appetite to raise taxes or cut spending elsewhere, he said.
By 2028, Fitch sees France spending 2.5% of output on defence, Italy and Spain remaining below the 2% target, which NATO is looking to raise to above 3%, while Germany will be reaching 3.2%.
GROWTH SPILLOVERS
Germany and its peers' borrowing costs increased around 40 bps earlier in March before the focus shifted to U.S. tariffs.
In France, where fiscal concerns rocked markets last year, 10-year yields hit their highest since the euro zone debt crisis.
They reached 4% in Italy, the bloc's second most indebted state, which is currently spending well below 2% of output on defence.
Some analysts expect Germany's borrowing costs could rise more than a percentage point in the coming years to around 4%, a level not seen since 2008.
As the bloc's biggest economy and its benchmark borrower, a further rise in Germany's yields could continue spilling over to its peers.
Stronger growth would make higher borrowing costs more affordable and help increase defence spending, but many economists are unsure if the benefits from German growth would offset higher borrowing costs elsewhere.
"For the other countries you can have a suspicion that the net (effect) is actually negative. The interest rate cost may outweigh the additional growth these countries are getting from more German growth," said Morgan Stanley's chief European economist Jens Eisenschmidt.
The former European Central Bank economist expects a 0.4 percentage point increase in German growth next year to lead to just 0.1 percentage point of additional euro zone growth on top of the direct German impact.
But BNP Paribas expects stronger growth especially if Europe overall gears defence spending towards home production, head of developed market economics Paul Hollingsworth said.
JOINT BORROWING
For now, the risk premia Italy and France pay over Germany's debt has largely stabilised at just over 100 bps and 70 bps respectively, helped by domestic investors buying to take advantage of higher yields, two traders said.
Europe's biggest investor Amundi is overweight Italian debt, seeing little scope for higher spending outside Germany, fund manager Reine Bitar said.
But concerns could grow on signs that might change. So far, Italy and Spain have sounded cautious about additional spending.
Raising defence spending to 3% of output without offsetting measures could raise Italy's debt to 145% of GDP by 2029 from around 135% last year, Scope Ratings estimates, while it expects that debt ratio to reach just 73% in Germany.
Economies like Italy and France raising spending more slowly would limit the overall defence effort given their big share in the European economy.
The EU is ready to provide 150 billion euros of loans to countries that need it by borrowing on the bond market.
But Societe Generale doesn't expect full take-up as this money would count towards national debt figures and cost savings aren't significant for major economies beyond Italy given their borrowing costs are only slightly higher than the EU's.
Instead, further common borrowing to offer grants following the blueprint of the EU's COVID-19 recovery fund - which wouldn't count towards national debt - would help raise spending more evenly, economists said.
Grants "would allow the fiscal space to be shared a little bit more," said BNP Paribas' Hollingsworth.
Chris Jeffery, head of macro strategy at asset manager Legal & General, has bought Italian bonds recently taking the view that the bloc's defence proposals won't suffice and Italy would benefit the most from further common borrowing.
"The direction of travel here is going to be more (debt) mutualisation," he said.
(Reporting by Yoruk Bahceli; editing by Dhara Ranasinghe and Hugh Lawson)
Explore more articles in the Finance category
