Luxembourg has sufficient fiscal space to accommodate moderate budget deficits due to increased defence spending over the next few years, without putting pressure on its , Morningstar DBRS told Paperjam. However, the global ratings agency noted that rising defence expenditure would likely widen deficits and increase the country’s debt burden beyond current government projections.
Max Dietz, assistant vice president for European sovereign ratings at Morningstar DBRS, told Paperjam on Tuesday 11 March that “Luxembourg faces significant pressures resulting from a faster than-planned increase in defence spending on the back of rising geopolitical tensions. [And] current government plans incorporate only a gradual increase in defence spending with total defence spending projected to rise to 2% of GDP by 2030.” However, prime minister (CSV) has recently that the government’s defence spending trajectory could be revised upwards. Nato figures indicate that Luxembourg’s estimated defence expenditure for 2024 stood at 1.3% of GDP, an increase from 0.5% in 2021, a substantial increase.
According to finance minister (CSV), the general government budget deficit for 2025 is to be €1.29bn. This forecast translates to about 0.6% of GDP, with gross public debt projected to stabilise at 27.5% in 2025 before declining the following year. Morningstar DBRS’ Dietz argued, “Rising needs for defence will likely widen deficits and push up Luxembourg’s debt burden more than currently projected by the government. That said, Luxembourg has ample fiscal space to accommodate moderate budget deficits over the next few years without putting pressure on its AAA, Stable ratings.”
Dietz further noted that any positive effect on economic growth from increased defence spending would be minimal, as most of the country’s defence expenditure was covered by imports.
EU defence spending
EU Nato members have already raised defence spending over the past decade, particularly those geographically closer to Russia. However, Morningstar DBRS found that these increases were relatively modest despite Russia’s full-scale invasion of Ukraine. Between 2014 and 2024, EU countries increased military spending by an average of 1% of GDP, though spending remained fragmented. Poland and Latvia raised expenditures by 2 percentage points of GDP over the period, while Italy, Spain, Belgium and Portugal remained below the 2% threshold. In comparison, Russia increased military spending by nearly 2% of GDP in the same period. Morningstar observed that countries geographically distant from Russia perceived a lower threat level and continued to rely on the US security guarantee.
The European Commission on 6 March €150bn in loans under the Rearm Europe initiative, temporarily waiving EU fiscal rules while mobilising private capital and cohesion funds. Morningstar observed that this would pose greater challenges for countries with high public debt burdens already struggling to meet Nato’s 2% defence spending target. The ratings agency, in a separate market commentary, stated that alternative financing options could mitigate the impact on national budgets, particularly for highly indebted countries, and could encourage greater coordination among EU member states.
Morningstar expected EU countries to reach an agreement by May 2025 on their defence spending strategy, ahead of the Nato summit in June, which was likely to set a new military expenditure target above 2% of GDP. The agency suggested that this target could rise to 3% or even 5% of GDP. It conducted a ‘what if’ analysis to examine the potential impact of rapid and gradual increases in defence expenditure. The rapid scenario projected an increase to 3% of GDP by the end of 2026, while the slow scenario anticipated the same rise by 2029.
Fiscal impact
Morningstar’s analysis modelled the financial impact of defence spending increases based on different scenarios and targets. If countries raised military spending to 3% of GDP by 2026 under the rapid scenario, the impact on public finances could range between 6.2% and 1.3% of GDP. If the target was set at 5% of GDP, the fiscal burden would rise significantly, ranging from 13.9% to 6.2% of GDP. Under a more gradual approach, reaching 3% of GDP by 2029 would result in a fiscal impact of between 4.0% and 1.1% of GDP. If the target was set at 5% of GDP by 2029, the impact would range from 8.9% to 4.2%. However, the overall fiscal strain might be lower than projected, Morningstar reminded, as some countries had already legislated or incorporated military spending increases into their fiscal plans.
Morningstar emphasised that allowing greater flexibility within the new EU fiscal rules could enable countries to raise military spending more quickly, but this approach would be costly and potentially inefficient. The agency found that fiscal multipliers for defence expenditure were low due to supply constraints and that higher military spending would primarily lead to increased imports. European collaborative procurement was also limited, raising concerns that member states could pursue uncoordinated purchases unless centralised procurement was implemented, which would take longer than national procurement.
Alternative solutions
Morningstar explored alternative financing solutions, suggesting that a larger EU budget could be more beneficial overall. This approach could leverage the EU’s credit profile, leading to lower borrowing costs and greater liquidity for EU debt. However, Morningstar warned that expanding the EU budget would require higher contributions from member states or increased EU taxes.
Carlo Capuano, senior vice president of global sovereign ratings at Morningstar DBRS, cautioned that higher military spending could put pressure on credit ratings, particularly for countries relying on national budgets. He added that alternative financing options--such as private capital, cohesion funds and EU loans--could help ease the fiscal burden but would not fully resolve the issue.