Strengthening existing safe assets should be a strategic priority for any new joint borrowing to meet Europe’s looming defence spending needs. This will impose new demands on public policy and the public purse. To address these demands, European Union member states and regional allies will need to collaborate for collective security. As new methods of building and managing defence capacity emerge, new funding mechanisms will likely be required. Three primary options for joint defence spending may be available: procurement and purchasing of EU-owned assets, procurement and purchasing of assets owned by a new mechanism such as a European Defence Mechanism (EDM), and purchases of assets ultimately held by participating countries.
In the case of EU-owned assets, funding would be expected to come via the EU, with allied neighbours such as the United Kingdom and Norway potentially participating by paying user fees or through similar arrangements. These assets could be managed entirely by the EU or in consultation with a future EDM. An EDM could further procure assets for itself or assist in the procurement process for assets that will eventually be held by individual participating governments. For example, willing countries could collectively order weapons, and the EDM could use capital market borrowing to defray costs. Countries could take out upfront EDM loans that would be repaid as they take delivery of the assets. Such innovative ideas could effectively unite countries that use the euro, countries that do not, and non-EU allies, including the United Kingdom and Norway, while also providing opt-out options for some EU countries.
Politics and Governance
When it comes to politics and governance, European allies should approach negotiations with an open mind. However, when borrowing money becomes necessary, Europe should adhere to proven methods. Once an EDM decides to raise debt for joint research and development, procurement bridge loans, or other purposes, it should contract with either the European Union, managed by the European Commission, or the European Stability Mechanism (ESM), an international financial institution owned by euro-area countries.
The EU and the ESM both enjoy AAA bond ratings and have a mature investor base. They issue debt across the yield curve and are sources not only of ‘safe assets’ but also of potential true ‘safe assets’ that can provide a capital markets benchmark. This would decouple market pricing from domestic sovereign bonds, help banks meet liquidity requirements, and serve as a monetary policy instrument. Additionally, it would boost the international role of the euro, which has been hampered by the short-term nature of EU borrowing programmes.
Bond Market Scale
Bond market scale is crucial to consider. Outstanding marketable US Treasury debt is around $29 trillion. Total outstanding euro-denominated institutional debt is around €1.1 trillion, even when all sources are tallied. Adding in euro-denominated sovereign bonds pulls the total over €10 trillion, but most of that debt is not top-rated.
Given these considerations, it is essential to explore the trade-offs and possible workarounds for connecting a future EDM with EU bonds, ESM bonds, or a hypothetical new issuing entity. Since the EDM would be making loans to sovereign countries rather than individual companies or procurement projects, development banks such as the European Investment Bank and the European Bank for Reconstruction and Development (EBRD) are not appropriate comparisons. They have different risk profiles, and in the case of the EBRD, membership includes the US and China, which would presumably not want a direct connection to funding European defence.
EU Bonds
EU bonds are the best option for tapping capital markets. The EU has about €650 billion in outstanding debt, enjoys a top credit rating, and is assigned to haircut category I in the European Central Bank’s risk-control framework for collateralised credit operations. The EU has a strong primary dealer network and a diversified funding strategy that combines issuances for all EU programmes in one stream. This is a significant asset for a future EDM or similar entity, as defence programmes can ramp up at their own pace and enjoy top-quality market access in any amount at any point. The questions then are: can this be done within the EU Treaties, and can it be done if some countries refuse to participate?
The experience of the euro crisis demonstrates that with political will, the answers could be affirmative. In December 2010, the European Council approved using the EU budget to create a European Financial Stabilisation Mechanism (EFSM), solely for use by euro-area countries. This facility was intended to be opt-in, allowing non-euro-area member states to decide to participate in operations on an ad hoc basis. The EFSM issued loans to Ireland and Portugal alongside the International Monetary Fund and the European Financial Stability Facility, a special-purpose vehicle that was the ESM’s predecessor. The EU added extra protections for non-euro-area countries in July 2015, when the EFSM was un-mothballed to extend a €7 billion bridge loan to Greece.
This offers a basis for technical work on providing guarantees to any EU countries that do not wish to participate in funding the defence mechanism, should EU borrowing be involved. It is important to note that a decision to join the EDM would be separate from whether or not to seek a guarantee from the EU budget. EU countries that are not part of NATO, such as Austria and Ireland, might choose not to join the EDM but also not oppose the EU acting as the legal borrowing agent for bridge loans issued through the facility. Countries such as Germany, which enjoy lower borrowing costs than the EU itself, could choose to finance their shares directly and reduce the amount of needed joint debt. Importantly, Germany declining defence loans in favour of paying its own way would not hurt the liquidity or credit rating of EU debt, because security programmes would be only one part of the EU’s consolidated borrowing strategy.
The EU bonds option would not allow for borrowing to be extended to the UK, Norway, or other allied countries that join a prospective EDM. However, those countries could certainly join EDM programmes and make arrangements to pay their own way, via user fees or purchases arranged with whatever financing makes sense to them.
European Stability Mechanism (ESM)
If it proves impossible to utilise the EU’s borrowing capacity, the ESM is the next best option and would offer many of the same advantages. It is not quite as good at being a safe asset: it was only ever used to finance €109 billion in programme lending, and it has a total borrowing capacity capped at €500 billion (€428 billion of which is currently available). It comes with some governance challenges. First, to contract with an EDM, euro-area countries probably would need to authorise creation of a new ESM instrument. Second, ESM activity generally requires more consent from national parliaments than is necessary for operations carried out by the European Commission. For example, Germany has so far required that every ESM loan disbursement receive sign-off from its parliament’s budget committee or a designated sub-panel. That said, the fact that the ESM is outside the EU treaties also offers some built-in flexibility. Its Luxembourg-based staff are highly trained and benefit from expertise from around the world. If euro-area countries want to deploy the ESM for this purpose, they can have confidence that a top-quality technical solution could be found to make the link to an EDM work, despite differences in organisational membership.
Guarantees have a history here, too. Finland asked for and ultimately received extra guarantees in exchange for support for Greece’s rescue programmes. Austria and Slovakia have also sought similar guarantees at various points, although they have ended up not following through. This precedent shows that guarantees are possible and can be part of political negotiations, whether or not they are required when final decisions are made. Also, as with EU bonds, if some countries chose to pay on their own rather than borrow through the EDM, the ESM’s liquidity and creditworthiness as an issuer would not be affected.
Hypothetical New Rearmament Borrowing Facility
A hypothetical new rearmament borrowing facility is by far the weakest option from a financial perspective. Its strength is that it only would need to include the countries taking part in a new collective defence initiative. However, of the ‘Big 5’ European countries that might serve as the core of such a proposed facility—Germany, France, Italy, Poland, and the UK—only Berlin has a top-quality credit rating. That means that participants would need to provide extensive ‘overguarantees’ and extra capital to enjoy the same amount of lending capacity. Any paid-in capital would be unavailable for other uses. If Germany chose not to route its participation through joint funding efforts, the new facility would issue fewer bonds and, depending on the scope of the opt-out, could face further ratings and capital challenges. It would take time to establish a new issuer, and further time to agree on the first purchasing programme. This first programme is unlikely to call for borrowing at scale, meaning initial borrowing would be in the tens of billions of euros at best. If the hypothetical facility would have a total capacity measured in hundreds of billions of euros, the amount of paid-in capital could exceed the amounts borrowed. In that case, participating countries would be economically better off just writing cheques to each other. If, politically, the choice comes down to a defence mechanism with its own special-purpose vehicle or no deal on collective financing, the SPV option could very likely be more expensive than options that involve no joint borrowing at all. It is also possible that time and money could be wasted developing a facility that ultimately lacks market access, or is not tapped or does not have enough long-term political backing to be useful.
Summary
In summary, the EU and its allies can achieve significant progress by pooling their collective expertise and procurement potential. When it comes time to borrow on capital markets, however, their efforts will be better served by strengthening the EU’s existing safe asset, rather than spending political capital, time, and money building something that will work less well.
