Germany's Defense Spending Boom: A Boost for the Economy and AAA Rating

Germany's planned increase in defense spending, driven by geopolitical concerns and the need to modernize its military, is set to have a significant impact on the country's economy and its AAA credit rating. The proposed spending boost, which includes a €500 billion fund for infrastructure and a relaxation of debt rules to allow for higher defense expenditure, is expected to bring substantial economic benefits while also presenting challenges in terms of debt management and inflation control.

Economic Benefits

The increased defense spending is expected to have a positive impact on Germany's economy, particularly in terms of job creation, GDP growth, and technological advancements.

1. Job Creation: EY estimates that raising defense spending to 3% of GDP would create 245,000 direct and indirect jobs in Germany. This would be a significant boost to the economy, as the defense industry currently employs around 387,000 people, compared to the auto sector's 800,000 jobs in 2022. The defense industry is expected to play a more significant role in the German economy, with companies like Hensoldt already planning to hire workers from the struggling auto industry.
2. GDP Growth: The IfW Kiel Institute for the World Economy estimates that the European Union's GDP could grow by 0.9-1.5% annually if EU countries raise military spending to 3.5% of GDP. For Germany, with its existing industrial infrastructure, GDP growth would likely be at the upper end of that range. This growth would help Germany's economy, which has been lagging behind other European peers due to high energy costs, red tape, and aggressive competition from abroad.
3. Technological Advancements: Increased defense spending can lead to technological advancements, as seen in the U.S. military-industrial complex. In Germany, defense companies like Rheinmetall and Hensoldt are already investing in new technologies, such as the TRML-4D radar system, which is being used by Ukraine in its war with Russia. These advancements can have spillover effects, benefiting other sectors of the economy.

Impact on AAA Credit Rating

While the increased defense spending is expected to bring significant economic benefits, it also presents challenges in terms of debt management and inflation control, which could impact Germany's AAA credit rating.

1. Debt-to-GDP Ratio: The spending plans could increase Germany's debt level to around 72% of GDP by 2029, according to Scope analyst Eiko Sievert. This is below the previous high of 80% seen in 2010 following the global financial crisis, when Germany was able to maintain its AAA rating. However, the yield on the 10-year German government bond rose from around 2.5% to 2.7% as investors digested news of the debt and spending plans, indicating that interest costs for the state would likely rise.
2. Long-term Debt Implications: Commerzbank chief economist Joerg Kraemer expects Germany's debt ratio to climb noticeably in the coming years, by around 10 percentage points due to the new special fund alone. Increasing defence spending would push up the debt ratio even further, by an extra 2.5 points annually if, for example, it was ramped up to 3.5% of GDP. ZEW economist Friedrich Heinemann predicts that Germany's indebtedness could even surpass the 100% mark in 2034.
3. Potential Impact on AAA Rating: While the spending plans could increase Germany's debt level to around 72% of GDP by 2029, below the previous high of 80%, it is not guaranteed that Germany will maintain its AAA rating. Investors are likely to demand higher risk premiums for German government debt, as indicated by the rise in the yield on the 10-year German government bond. The ECB will have to take into account that inflationary pressure will rise again as a result of the planned expansionary fiscal policy in Germany, which could also impact the country's credit rating. In the long term, if Germany's debt-to-GDP ratio surpasses the 100% mark, it could put additional pressure on its AAA credit rating, as higher debt levels typically make it more difficult for a country to service its debt and maintain its creditworthiness.

In conclusion, Germany's defense spending boom is expected to bring significant economic benefits, particularly in terms of job creation, GDP growth, and technological advancements. However, the increased spending also presents challenges in terms of debt management and inflation control, which could impact Germany's AAA credit rating. The balance between these benefits and costs will depend on the successful implementation of the planned spending and the ability of the German economy to absorb the increased investment.