Germany's Defense Spending Surge: Can a 5% GDP Target be Sustained?

Germany's defense spending is undergoing a historic transformation. After decades of austerity, the country has embarked on a bold plan to boost military expenditures to 5% of GDP—a target initially proposed by NATO in 2023. But with its debt-to-GDP ratio projected to hit 65% by 2025 and rising political tensions within its governing coalition, the feasibility of this goal is far from certain.

The Current Path: From 2% to 3.5% by 2029

Germany's defense spending has already begun its climb. In 2024, it stood at 2% of GDP, or €88.5 billion. For 2025, the budget has been raised to €86 billion, or 2.4% of GDP—a small but symbolic increase. The government's stated goal is to reach 3.5% of GDP by 2029, with the full 5% target envisioned as a long-term aspiration. This 3.5% figure aligns with NATO's revised framework, which splits the 5% goal into 3.5% for “classic” defense spending (equipment, personnel, etc.) and 1.5% for broader defense-related expenditures like cybersecurity and infrastructure.

The Cost of War Readiness

The financial burden is staggering. Chancellor Friedrich Merz has stated that each additional percentage point of GDP dedicated to defense would require an extra €45 billion annually. To reach the 5% target, Germany would need to spend roughly €170 billion annually by the mid-2030s—more than double current levels.

The government's strategy hinges on suspending its constitutional “debt brake,” which previously limited deficits to 0.35% of GDP. This suspension, paired with exemptions under EU fiscal rules, allows borrowing to finance defense spending. But experts warn that this approach carries risks.

Debt Dynamics: A Balancing Act

Germany's public debt-to-GDP ratio, already projected to hit 63.8% by the end of 2025, is expected to climb further. By 2030, it could reach 74.85%, according to IMF estimates.

The fiscal math is grim. Even the intermediate 3.5% target by 2029 would require reallocating funds from other areas—healthcare, pensions, or education—or raising taxes. The latter is politically fraught, given Germany's already high tax burden and the reluctance of the SPD, a key coalition partner, to approve sweeping austerity measures.

The Political Tightrope

The ruling coalition is divided. While the CDU/CSU supports the defense buildup, the SPD has expressed skepticism. As one SPD official remarked, the 5% goal is “off the scale.” This tension could delay or dilute spending plans, especially if economic growth stagnates.

Meanwhile, the EU's fiscal rules remain a constraint. Germany has sought exemptions under the “Readiness 2030” initiative, which permits defense spending increases up to 1.5% of GDP through 2028. But beyond that, Brussels may demand stricter compliance with the 60% debt-to-GDP target—a goal now seen as unattainable.

Investment Implications

For investors, the story bifurcates:

1. Defense Contractors: Short-Term Winners
   Companies like Rheinmetall, Thyssenkrupp, and Airbus Defense & Space stand to benefit from procurement booms. Orders for Leopard tanks, Patriot missile systems, and cyber infrastructure are already flowing. A surge in military aid to Ukraine—€8.3 billion in 2025—also supports defense exporters.

However, execution risks loom. The Bundeswehr's chronic recruitment shortfalls and bureaucratic delays could slow project timelines, tempering profits.

1. Government Bonds: Proceed with Caution
   Rising debt levels may pressure German Bund yields, especially if markets doubt fiscal sustainability. While the ECB's dovish stance and Germany's AAA credit rating provide a buffer, long-term bunds face headwinds as debt ratios climb.

2. Equities: Focus on Productivity Plays
   The €500 billion infrastructure fund, part of the 2025 reforms, targets sectors like energy, transport, and digitalization. Investors should prioritize firms with exposure to high-productivity projects—think Siemens Energy for grid modernization or SAP for defense IT systems.

The Bottom Line: A High-Risk Gamble

The 5% GDP target is a political commitment, not an economic inevitability. While the 3.5% goal by 2029 is achievable with fiscal acrobatics, the full 5% remains a distant dream without major tax hikes or spending cuts elsewhere.

Investors should treat defense stocks as tactical bets rather than core holdings. For bonds, the focus shifts to liquidity and creditworthiness—Germany's fiscal flexibility is narrowing. Above all, the real test will be whether the infrastructure fund's investments in productivity can offset the debt drag. Without that, the Bundeswehr's modernization could come at the cost of long-term economic stability.

Final Takeaway: Germany's defense push offers pockets of opportunity in specific equities but poses risks to its fiscal health. Monitor debt trends closely—and keep an eye on the SPD's stance.