Russia's 2022 invasion of Ukraine has exposed Europe's security vulnerabilities. Despite almost doubling their defense expenditure since 2014, European nations on average still spend below NATO's 2% of GDP guidelines, while the U.S. finances nearly two-thirds of NATO's military budget. At the national level, fiscal constraints limit European sovereigns' capacity to boost military expenditure. As a consequence, European governments are exploring joint financing options for defense, such as EU-backed bonds or other supranational issuances. Increasingly, member states argue that for this collective security guarantee to be credible, NATO's European nation states together need to find a way to coordinate and increase defense spending at the supranational level.

Chart 1

In the aftermath of the Second World War, after a series of late 1940s conflicts--including the 1946-1949 Greek civil war, the 1948 Soviet-backed coup d'etat in what was then Czechoslovakia, and the 1948 Soviet blockade of West Berlin--the U.S. and Europe created the North Atlantic Treaty Organization. Critically, Article 5 of the treaty commits NATO signatories to consider an attack against one member of the Alliance to be an attack against all, and to take necessary actions to underpin the security of the North Atlantic area. This joint security guarantee has stuck for over half a century. Increasingly, member states argue that for this collective security guarantee to be credible, NATO's European nation states together need to find a way to coordinate and increase defense spending at the supranational level.

NATO funding is structured around direct and indirect contributions.  Direct funding, which is relatively modest, is projected to be €4.6 billion for 2025 (0.3% of total allied defense spending). This supports NATO-wide initiatives such as command systems, air defense, operations, and administration. It is allocated via a cost-sharing formula tied to Gross National Income (GNI), with the U.S. and Germany contributing the most (15.8% each).

Indirect contributions, on the other hand, make up 99.7% of NATO's military funding.  These come from national defense budgets, with member states providing troops and military capabilities for missions. Given that NATO itself lacks a standing army, national military spending--which varies sharply between the U.S. and Europe--is central to the Alliance's operational strength.

Chart 2

The European Average Masks Big Differences In Defense Spending Commitments

As a percentage of GDP, European NATO members' defense spending is less than 60% of that of the U.S. (1.9% of GDP in 2025 versus 3.3%). But the EU average masks large differences. Frontline states like Poland and the Baltics, as well as Greece, spend over 3.0% of GDP on defense. Italy, Portugal, and Turkiye, in contrast, spend around 1.5% of GDP, while Belgium, Slovenia, and Spain spend even less. Proximity to Russia appears to be the key driver--the further west you go, the lower the average spend. With NATO's June 2025 summit approaching, and the Trump administration calling for NATO members to increase spending to 5.0% of GDP--and U.S. tariffs on European exports a distinct possibility--even Western European states now seem more supportive of a European solution to increase defense expenditure. They also see this as part of a strategy to convince the U.S. government not to put tariffs on key European exports.

Chart 3

Scenario Analysis: The Cost To European NATO Members Of Increasing Defense Spending

In our scenario analysis, we calculate the impact of increasing European defense budgets from the current 1.9% of GDP to:

• Scenario I: 2.67% of GDP (NATO GDP-weighted average)
• Scenario II: 3.30% (current U.S. level), and
• Scenario III: 5.00% (recently suggested by U.S. policymakers).

Under these scenarios, the EU as a whole would have to increase defense spending by $242 billion (scenario I) and $875 billion (scenario III) annually--far beyond what individual states can finance without offsetting such outlays with other spending reductions or likely pressuring their creditworthiness.

In the absence of changes to EU fiscal rules, most individual member states would have to reprioritize their budgets to absorb this level of increase in defense spending.  Moreover, the political consequences of cutting social spending to offset higher spending on defense would likely be significant.

Excluding defense spending from budgetary deficit calculations under EU fiscal rules has no implications for debt levels or cash borrowing requirements.  This is because it does not alter net or gross cash borrowing needs or overall debt levels, meaning it has no effect on our evaluation of a sovereign's budgetary position. Many European governments are already grappling with high debt and large deficits and remain sensitive to market conditions. Even Central and Eastern European sovereigns, notwithstanding their increased defense commitments, would likely struggle to sustain further military spending amid slowing economic growth, aging populations, and rising social costs.

Increased Military Spending Is Not likely To Spur Economic Growth

The fiscal multiplier of defense spending in the EU remains modest, often below 0.4-0.5x in some of the largest countries, yielding limited economic stimulus.  In the U.S., in contrast, higher multipliers translate into greater economic expansion. This is because Europe's defense spending is import-intensive and only one third is dedicated to investments. The region's fragmented defense industry employs less than 0.3% of the European workforce, and national defense procurement favors national champions rather than seeking economies of scale and efficiency. As of 2024, only 19 of the top 100 defense firms are EU-based, compared to 48 being based in the U.S. Further inefficiencies arise from Europe's excessive diversity of weapons systems, which, in categories like main battle tanks and fighter jets, is over five times that of the U.S., complicating logistics and interoperability. These structural weaknesses continue to impede the EU defense industry's competitiveness and integration.

Chart 4

Collective action could be an answer, even if consensus has not built yet.   Several member states, including Germany, remain opposed to joint EU issuance. Nevertheless, given the various messages coming out of Washington D.C., a subset of member states wants to move ahead with a shared solution.

Europe currently enjoys a larger financial buffer, but structural limitations hinder its ability to match U.S. currency and market flexibility.  EU government debt and deficits--while significant--remain below that of the U.S. Debt to GDP is 88% in the euro area, and the overall budget deficit is estimated at 3.2% of GDP for 2025, compared to the U.S.'s 6.0%. Private savings rates in Europe are also higher than in the U.S., with households saving 16% of disposable income on average across the EU, compared to below 5% in the U.S. While this suggests more fiscal space in Europe, the disparities between monetary flexibility, economic growth prospects, and capital markets depth in Europe and the U.S. are vast--underpinning the dollar's role as the dominant global reserve currency and highlighting the absence of a well-functioning capital markets union in the EU, as well as intra-EU fiscal transfers being low. Nevertheless, if EU policymakers decide to issue more pan-European debt, this could benefit the euro, at least at the margins, by increasing the supply of pan-European assets.

The process for agreeing on the issuance of a common European instrument is complex.  One potential impediment is the unanimity required for all decisions taken by the EU Council, which represents all 27 member states on matters of EU finances and common foreign and security policies. At the Feb. 3 summit in Brussels, European leaders discussed the possibility of creating such a fund structured as a special-purpose vehicle financed via instruments jointly or severally guaranteed. This would bypass unanimity and treaty amendments, as it would be voluntary set-up and guaranteed by a coalition of willing members, eventually joined by non-EU members, namely the U.K. and Norway.

The details of any collective funding arrangement--which could also include non-EU members such as Norway and the U.K.--will determine its creditworthiness.  We understand that European leaders are looking at several options. While the initial issuance amount might be modest, and therefore not cover the EU's immediate challenges, such an instrument could serve as a precedent in the EU's financial architecture and help build political solidarity, as well as signalling the EU's changed attitude toward military spending.

The guarantee arrangement would be a key factor in our credit assessment of any supranational issuance.  In this case, under our methodology our ratings on guaranteed debt generally depend, among other things, on whether the funding instruments are severally or jointly guaranteed. If there are several guarantees (where each guarantor only guarantees a proportional amount portion of the obligation), we typically rate the obligation at the level of the lowest-rated guarantor. In contrast, under a jointly guaranteed structure, our rating on an issuer would reflect the highest rating among its guarantors.

Potential Sources Of Defense Funding, And Their Credit Implications

European Stability Mechanism (ESM; AAA/Stable/A-1+)

The ESM was founded in October 2012 by treaty and endowed with significant paid-in capital. The ESM provides stability and support to euro area countries in times of crisis and uncertain capital markets access. We view the entity as a key pillar of the euro area's financial architecture, alongside the European Central Bank and the European Investment Bank. Our rating on the ESM reflects our criteria, "Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology," published July 26, 2024. In our view, the organization's policy importance is also strengthened by its preferred creditor treatment, which the treaty grants. The ratification of the amended treaty came to a standstill after the Italian parliament voted to reject it in late 2023. While we think the amended treaty would have further underpinned the ESM's unique role, its current treaty and mandate remain very strong, in our view. S&P Global Ratings believes shareholders remain committed to the ESM and its role in Europe's financial architecture.

After providing nearly €300 billion in loans to support the economies of Greece, Ireland, Portugal, and Cyprus, as well as assisting Spanish banks between 2012 and 2015, the ESM's activity has been relatively limited in scope during the past decade. At present, the ESM's total shareholder equity exceeds €700 billion, with €80 billion in paid-in capital, little of which is currently deployed. Expanding the ESM's mandate to include defense financing would require unanimous approval from its board of governors (the eurozone's finance ministers), making it a politically complex process.

The European Financial Stability Facility (EFSF; AA-/Stable/A-1+) involves a guarantee-based financing structure. Under its framework, individual guarantors set upper limits on their obligations, with our rating on the facility constrained by the lowest-rated sovereigns covering 100% of outstanding debt. The 'AA-' rating on the EFSF reflects that its obligations are 100.8% backed by irrevocable, unconditional, and timely guarantees from sovereigns rated 'AA-' or higher.

The European Investment Bank (EIB; AAA/Stable/A-1+)

Established in 1958 under the Treaty of Rome, the EIB was founded to finance projects that promote European integration and development. It has become the largest multilateral lender, financing European integration and development, especially since the Ukraine crisis, where it committed €1.7 billion for urgent needs and €4.0 billion for EU refugee integration. We expect the EIB to expand its financing to the European security and defense sectors over 2025, building on the revised guidelines for project approval implemented in 2024. Specifically, the bank has adopted more flexible guidelines regarding the requirement of dual-use project eligibility and recorded €1.0 billion in loan signatures to the security and defense sectors in 2024. For 2025, we understand the bank intends to double its financing contribution, with signatures reaching about €2.0 billion for the full year. However, EU member states are now pushing for a broader mandate to directly include defense spending, aiming to address Europe's defense shortfalls. We understand that this would require a qualified majority of the board of governors, which means 18 members voting in favor and 68% of the subscribed capital.

The European Union (EU; AA+/Stable/A-1+)

European Union treaties mandate that the EU can borrow from international capital markets to finance programs that benefit the economies of all 27 member states, which together make up a single market for goods, services, and workers, with a combined GDP of over €16 trillion. Our rating on the EU is supported by our assessment of its 'aa-' anchor, which reflects the weighted-average sovereign foreign currency ratings on its member states, and our view that member states rated two notches above 'AA-' would be able and willing to cover any potential shortfall in the EU's debt service.

Following the pandemic, the EU swiftly approved the €750 billion Next Generation EU fund to revitalize national economies and prevent further downturns. Simultaneously, it upscaled resources for the 2021-2027 Multiannual Financial Framework. These actions not only demonstrated the EU's enhanced funding capacity but also its strengthened political cohesion, key factors that contributed to our May 2022 upgrade of the EU and Euratom to AA+/Stable, from AA/Positive. While the EU might not act swiftly to issue jointly guaranteed defense bonds to bolster European defense, some leaders have suggested that such a solution could become viable in the longer term, offering an opportunity to enhance the EU's funding capacity and market strength. Should joint funding be extended to defense and military purposes, it could serve to reaffirm European political cohesion while also potentially identifying additional revenue streams.

We believe there could be a strong appetite for the EU issuance of permanent, rather than temporary, programs and ultimately additional issued paper could further strengthen its market presence and build its yield curve to become more aligned with the largest highly rated EU sovereigns. That said, our rating on the EU could face pressure if member states' (rated two notches above the 'aa-' anchor) contributions to the EU fail to cover its debt service by more than 1.0x, including potential additional debt from defense spending. We forecast the EU's debt-service coverage at 1.5x in 2026 with no additional defense bond issuance. We define these contributions as the difference between the own resources ceiling (2% of member states' GNI) and the actual amount appropriated each year by these member states for the EU's budget, which we estimate at 0.91% of GNI for 2024-2026.

The rating would not come under immediate pressure if the EU were to explore joint bond initiatives. However, EU members' current inability to identify and agree on additional government revenues to transfer annually to the EU, to bolster its own resources, could, if unresolved, weigh on the EU's financing capacity. This is particularly notable given aspects of its financial structure, such as its large pension liabilities and limited paid-in capital. As of the end of 2023, the EU's financial liabilities exceeded its assets by €212.3 billion, including pension obligations. This lack of own funding could pressure the supranational rating, particularly if joint financing is pursued.

European Defense Requires Long-Term Fiscally Sustainable Solutions

EU policymakers are eager to demonstrate that Europe is taking greater financial responsibility for its own defense, and also to counter potential U.S. tariffs on European exports. However, defense spending is not a one-off adjustment--it is an ongoing financial commitment that will weigh heaviest on the largest and most indebted European economies. In the end, given the significant annual funding requirement to upgrade defense commitments, especially in large countries, any increase in defense spending is likely to be gradual and via a combination of more borrowing at both the national and supranational levels.

To ensure the sustainability of higher defense expenditure, this debt would have to be supported by new revenue sources, offsetting expenditure cuts, or additional capital transfers to EU supranational institutions. While Europe has options to demonstrate its revamped political commitment, the litmus test will be whether it can establish a lasting financial framework to support its defense ambitions year after year.

Current Ratings And Outlooks

Related Research

• European Investment Bank, Feb. 10, 2025
• European Stability Mechanism, Feb. 3, 2025
• European Financial Stability Facility, Feb. 3, 2025
• Central And Eastern Europe Sovereign Rating Outlook 2025: Now More Complicated, Dec. 12, 2024
• European Developed Markets Sovereign Outlook 2025: At A Crossroads, Dec. 18, 2024
• EMEA Emerging Markets Sovereign Rating Trends 2025: Upward Momentum Despite Persistent Geopolitical Risks, Dec. 19, 2024
• Economic Research: Global Economic Outlook Q1 2025: Buckle Up, Nov. 27, 2024
• Economic Research: Economic Outlook Eurozone Q1 2025: Next Year Will Be A Game Changer, Nov. 26, 2024
• EU And EURATOM Ratings Affirmed At 'AA+'; Outlook Stable. May 28, 2024