Since Russia’s full-scale invasion of Ukraine in 2022, European defense investments have surged by +75%, with the majority funneled into equipment purchases (+85% increase). In contrast, defense R&D expenditures have grown more modestly, by +26%. In 2023, for the first time, European defense orders surpassed EUR 100 billion, accounting for nearly one-third of total defense spending that year.
Toward the 3.5% GDP Target: A Strategic Shift
Europe is now aiming for a benchmark of 3.5% of GDP in core defense spending (within a broader 5% target including 1.5% for critical infrastructure). Reaching this goal will require Germany to spend USD 64 billion more annually, France USD 45 billion, Italy USD 47 billion, and the UK USD 41 billion, based on 2024 GDP levels.
If this benchmark is permanently adopted and GDP grows at a conservative average rate of +1.5% from 2026–2029, cumulative defense spending could reach EUR 2.6 trillion, with EUR 660–925 billion allocated to procurement and innovation. If 2024 trends continue, investment spending may total EUR 845 billion by 2030 – roughly in line with EU rearmament targets. But if the pace reverts to 2023 levels, total investments could fall short.
Spending More Is Not Enough: Spending Smarter
According to Allianz Trade, personnel costs absorbed 42% of European defense budgets in 2023, compared to the U.S., which spends 37% on procurement and R&D. Europe must pivot to industrial investments, setting a minimum baseline of 30% of total defense budgets, to modernize capabilities and align with transatlantic standards.
Reaching 3.5% GDP in defense spending is uneven across countries:
- Germany aims to meet the target by 2029,
- France by 2030,
- UK by 2035,
- Italy has committed but warns it may take a decade.
Poland has already exceeded the benchmark, spending 4.1% of GDP on defense in 2024.
Funding Challenges: Debt, Taxes or EU Instruments?
Only Belgium plans to raise taxes to fund increased defense spending. The UK opted to cut foreign aid. Most countries are likely to rely on new debt, as tax hikes or spending cuts are politically costly. However, debt-financed defense increases of 1–2 percentage points of GDP could raise debt ratios by +10–20 points over the next decade. This could widen sovereign bond spreads by 10–40 basis points, particularly within the eurozone, straining fiscal positions.
EU-level financing mechanisms offer limited relief, as interest payments on common EU debt would still come from national budgets.
Europe’s Defense Industry: Booming Orders, Lagging Investments
Europe’s defense sector is under pressure. Orders for the top 30 European defense firms rose by +70% since late 2021, while backlogs soared by +60%, exceeding EUR 1 trillion in 2024. Firms now hold backlogs equal to 6.5 times their annual revenues, suggesting they are near full capacity.
- Rheinmetall, a major supplier of artillery and ammunition, tripled its backlog to EUR 33 billion by Q1 2025.
- However, investment remains stagnant: in 2023, defense firms reinvested just ~5% of their revenues, the same as in 2020, and far below capital-intensive sectors like automotive or tech.
This reluctance stems from uncertainty over whether defense spending increases are temporary or structural. A formal EU commitment to the 3.5% GDP target could help anchor expectations and unlock broader investment in industrial capacity.
External Dependencies and Technological Gaps
Despite fears of overdependence on foreign suppliers, trade data show a more nuanced picture:
- From February 2022 to July 2023, 78% of EU military imports came from outside the EU, mainly the U.S..
- Yet countries like France, Germany, Italy, Spain, and Poland still source about 50% of arms and ammunition from within the EU.
- Imports from the U.S., Israel, and South Korea rose modestly from 28% to 32%.
Still, Europe lags in key tech areas: drones, semiconductors, cloud services, and advanced sensors.
For example, 95% of drones used by Ukraine in early 2025 were imported from China, highlighting the lack of a competitive European alternative. To achieve strategic autonomy, Europe must invest in AI, robotics, cybersecurity, and advanced communications, not just short-term battlefield needs.
Long Timelines, High Stakes: The Need for Industrial Strategy
Development of new military platforms can take 5–15 years. Without coordination, defense funds risk being wasted on duplication and inefficiency. Europe needs a clear roadmap and industrial strategy, encompassing naval, aerospace, and space systems – along with new technologies.
Financing Rearmament Without Blowing Up Deficits
The return of EU fiscal rules in 2024 (including national corrective clauses) gives limited flexibility. For the seven EU countries still below NATO’s 2% target, excuses are running out.
Currently, most governments turn to:
- Debt issuance (Germany, Sweden),
- Budget reallocation (Greece),
- Tax hikes (Belgium),
- Aid cuts (UK).
These are stopgap solutions. EU fund reallocations could provide temporary relief. For example:
- EUR 90 billion from the Next Generation EU (NGEU) program could be redirected to dual-use defense projects.
- Poland’s model: EUR 6 billion was reclassified from green to defense spending via its development bank, avoiding NGEU disbursement timelines. Other countries (Germany’s KfW, France’s CDC, Italy’s CDP) could follow.
A proposed ReArm Europe plan, possibly backed by SAFE (Strategic Technologies for Europe Platform) bonds, could mobilize up to EUR 150 billion. Looser debt rules could help Italy, Spain, and others participate.
In theory, the EU could jointly mobilize up to EUR 800 billion, but implementation depends on national political will – and the bond market’s appetite.
Defense Spending Is Structural, Not Temporary
Defense spending is not a one-time stimulus; it implies long-term structural increases. A 1–2 percentage point annual rise in defense budgets, if debt-financed, could lift debt-to-GDP ratios by 10–20 percentage points in a decade.
- Even if defense spending boosts GDP (fiscal multiplier >1), this raises spending levels too, keeping the ratio unchanged.
- Bond spreads, which have declined due to improved fiscal management, would likely rise again.
- A 1 pp rise in debt/GDP can raise bond spreads by 1–2 basis points, translating into 10–40 bp over ten years, depending on credit ratings.
Investor confidence, once lost, is slow to regain. Resorting to EU-level mechanisms only offers temporary relief, as interest payments still fall on national budgets.
SAFE: The EU’s New Framework for Defense Investment
The SAFE instrument offers:
- Joint procurement mechanisms for defense orders involving at least one EU country and one eligible partner (e.g., EEA/EFTA, Ukraine, Canada),
- VAT exemptions,
- A EUR 900,000 threshold for small defense contracts, exempting them from EU procurement rules,
- Inclusion of subcontractors only if based in eligible countries and not under foreign control.
SAFE aims to streamline cross-border defense investment, strengthen European SMEs, and foster industrial cooperation.
Source: CEO.com.pl article on defense spending and debt
Analysis by: Allianz Trade
