Can EU defence bonds strengthen Europe’s defences?

Europeans urgently need to strengthen their militaries. However, funding European defence is a major challenge. In many member-states, it is unclear whether political consensus for raising defence budgets in inflation-adjusted terms can be sustained for long. At the same time, the availability of private credit for defence is contingent on demand for defence capabilities, which will always remain driven by governments.

European policy-makers are therefore looking for new financial tools to enhance their defences. One proposal is the creation of EU defence bonds. The taboo over EU joint borrowing was broken during the Covid-19 pandemic, when member-states agreed to establish a €800 billion Recovery and Resilience Facility (RRF), which provided a mix of grants and low-interest loans to individual EU countries. Some countries are now advocating a repeat of the experiment for defence. France and Estonia were the original proponents of defence bonds early this year, but the idea has since gathered support from other members, including Italy, Spain and Poland.

There are a range of potential uses for defence bonds. They could be used to support Ukraine by funding weapons purchases. They could be used to boost production of defence equipment in the EU and bring down funding costs for defence firms. They could also help finance research and development of next-generation military equipment, and help fund the joint procurement of specific military capabilities such as air and missile defence. Finally, defence bonds could fund dual-use infrastructure and measures such as the upgrading of critical civilian infrastructure to make it more resilient, and to finance border defences such as anti-tank obstacles in countries bordering Russia.

Defence bonds have the potential to address three key obstacles to strengthening European defence. First, they can raise aggregate defence spending. EU countries with relatively high debt levels, or whose debts are perceived as risky, have higher borrowing costs than the EU as an issuer. These countries would be able to invest more in defence if they drew on EU debt, as it could bring down their cost of funding.

Second, as Draghi argues in his report, the fragmentation of defence R&D and procurement spending into small national programmes leads to inefficiencies and duplication. If directed at commonly agreed priorities, defence bonds would therefore enable joint spending that would provide more bang-for-the-buck in terms of defence capabilities.

Third, defence bonds would help address the issue of free-riding. Poland’s large defence investments, for example, also increase security for its neighbours. Despite this, there is a temptation for each member-state to free-ride on the defence capabilities of other European countries (as well as of the US).

There are essentially three options for bond design: 1) injecting additional funding into existing EU instruments such as the European Defence Fund, many of which are part of the EU budget; 2) setting up a structure like the RRF; 3) establishing a new off-budget vehicle. There are trade-offs between the three options, examined in detail in a CER paper.

The big challenge for EU defence bond issuance is that the EU’s resources are already committed to guaranteeing the repayment of the EU’s pandemic recovery bonds. This is why, when member-states agreed to give EU budget support to Ukraine, they had to provide additional national guarantees to the EU to ensure repayment of bond holders. If the EU wants to issue additional bonds for defence, member-states will have to provide new national guarantees. Alternatively, they will have to amend the EU’s ‘own resource decision’ by unanimity – essentially committing more resources to the EU to guarantee the issuance of additional EU debt.

There is considerable opposition to the idea of defence bonds. First, a group of wealthy, fiscally hawkish countries opposes joint debt in principle, insisting that the EU debt issuance for the pandemic recovery fund was a one-off. Second, there are political hurdles in the form of differing threat perceptions and scepticism about greater EU defence spending in neutral member-states. It will not be easy to persuade countries that are far away from Russia and do not feel they need to spend much on defence to agree to defence bonds. And the idea of mutualising (parts of) defence spending, let alone doing so through EU debt, could be a difficult sell to neutral member-states and to eurosceptic voters.

Third, there are challenges related to who would benefit from defence bonds. The biggest European defence companies tend to be in the largest and most industrialised countries. Large member-states with big defence industries, like France, will insist that funds raised through defence bonds should be channelled exclusively or near-exclusively to EU firms. Meanwhile, countries without large defence industries of their own have little incentive to adopt such buy-European provisions, as they may wish to use money to buy primarily from outside of the EU to fill capability gaps quickly.

These challenges are not insurmountable. A rapid Russian advance in Ukraine could persuade many countries that increasing defence spending is urgent – and that defence bonds are a good way to do that, after all. In some countries, the public may accept higher defence spending more easily if this is done co-operatively rather than at a national level. It may be possible to structure defence bonds in a way that excludes unwilling member-states, for example by granting neutral countries an opt-out. It should also be possible to design defence bonds so that all member-states will feel they can benefit. For example, defence bonds could focus on only a few priorities such as improving air defences and supporting Ukraine. Defence bonds could also fund a mix of off-the-shelf joint purchases from EU and non-EU suppliers, while also financing the expansion of production capacity and fostering long-term innovation.

Defence bonds can greatly improve EU co-ordination, but they are not a free lunch. The political capital and the creditworthiness the EU would use for them are scarce resources. Political resistance to further debt mutualisation, varying national security priorities, and legal barriers pose significant obstacles. Yet, as Europe’s security environment becomes more precarious, the need for innovative defence funding solutions is undeniable.