Analysis-Spending U-turn puts Germany back in Europe's driving seat

By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) - Germany's bold step to rip up its fiscal rulebook could be a game-changer for Europe's stuttering economy, reestablishing its biggest nation as the powerhouse of a lethargic bloc that has fallen behind global peers.

Faced by the threat of losing its military guardian and biggest customer in the United States, Germany announced a defence and infrastructure spending bonanza, one of its biggest political shifts since the 1989 fall of the Berlin Wall.

The move came hours after a European Commission proposal to change EU budget rules to borrow up to 150 billion euros for rearmament and also let countries spend more on their own.

Both moves were driven by fears that, with Donald Trump in the White House, Europe can no longer be sure of U.S. protection as Russia threatens Europe's eastern flank.

The two moves are nothing short of transformational, particularly for Germany, mocked as the sick man of Europe after two straight years of economic contraction and criticised for its government's refusal to spend despite ample fiscal capacity.

"Everything you thought you knew about Germany's economic prospects 3 months ago, or even 3 weeks ago, should be ripped up and you should start your analysis from fresh," Deutsche Bank's Jim Reid said. "This is game changing if it goes through."

TS Lombard analyst Davide Oneglia said it was a historic fiscal policy pivot which "may well also mark a sea change in fiscal attitudes at EU level", especially when taken in combination with the greater leeway afforded by the new Commission stance.

The German proposals - which must still secure backing of a two-thirds majority in parliament - would set up a 500 billion euro infrastructure fund, exempt defence spending over 1% of the GDP from the debt brake and allow Germany's regional states to run a small deficit.

Given that German debt is just above 60% of GDP - half of the level of the United States and two thirds the euro zone average - there is little concern for now that Germany is heading on an unsustainable path, even if debt could now hit 70% by the end of the decade.

Bank of America called the move big, bold and a game changer, which would catapult German growth closer to 1.5-2% for 2027 onwards, a huge shift given its current stagnation.

POSITIVE RECEPTION

If Germany grows so does Europe since its vast industrial sector relies on suppliers across the EU - or at least that was the conclusion reached by financial markets on Wednesday.

European stocks surged from Madrid to Budapest, the euro jumped and spreads between Germany and other euro zone debt narrowed, all suggesting that investors see the move as a positive for growth across the entire bloc.

The extra spending is also not seen coming at the cost of higher borrowing rates: investors are still expecting three more rate cuts from the European Central Bank this year with the first on Thursday, suggesting more debt is not a worry for now.

This is probably because the Trump administration continues to threaten the EU with tariffs, likely triggering retaliation that would weaken growth and keep a lid on inflation.

"The fiscal news has not moved the needle on European Central Bank policy expectations," ING said in a note. "No doubt this is a function of the global tariff threat which looks like it will be coming Europe's way next month."

While few EU states have space to raise borrowing, they also enjoy some protection from the ECB which has promised to shield them from unwarranted increases in bond yields as long as they meet EU budget rules.

The change in the fiscal rulebook proposed by the Commission effectively expands the protective umbrella of the ECB, which proved during the pandemic that it can move at moment's notice to quell disorderly markets.

(Editing by Toby Chopra and Mark John)