Defense: Bank of Portugal warns of risks of budgetary deterioration

An increase in defence spending in a European Union Member State, “keeping all other variables unchanged”, “inevitably implies a deterioration in its budgetary position, reflected in the deficit and public debt, even if the escape clause is triggered to avoid non-compliance with European rules”, states an analysis by the Bank of Portugal (BdP). “In terms of budgetary impacts, the following should be highlighted: the direct impact, resulting from the amount of expenditure made; and the increase in interest charges, resulting from the increase in public debt issuance. The use of Security Action for Europe (SAFE) could mitigate this effect, as loans granted by the EU could offer more advantageous financing conditions than those available to countries on the market”.

The bank also highlights the impact of “future budgetary pressures arising from ongoing costs for the maintenance, operation and updating of acquired equipment, as well as the costs associated with the possible hiring of more military personnel, the expense of which tends to be long-lasting and difficult to reverse.

As for indirect effects, via macroeconomic impacts, “their size depends on the multipliers associated with defence spending. The literature indicates that, on average, these multipliers are lower than those of other public expenditure, mainly due to the high import content of a significant part of defence spending, such as military equipment, which reduces the impact on the national economy. Furthermore, multipliers vary significantly depending on the type of expenditure”.

The recruitment of military personnel tends to have, in the short term, a more direct and relevant effect on the domestic economy than investment in advanced military technology, the study indicates. “The latter could, however, generate greater impacts in the medium and long term, especially if it involves national producers and boosts productivity gains and technological development in other sectors. It is important to highlight that, as collective security is a European public good, the investment effort in defence benefits the Union as a whole, regardless of where the expenditure occurs, which reinforces the importance of common financial instruments and European coordination mechanisms”.

In any case, the Portuguese government has committed to bringing forward its defence spending target, at a time when new European rules are being introduced. “The way in which these two developments interact is crucial to understanding the effects on public finances,” says an analysis by the Bank of Portugal.

For the central bank, “the worsening of external threats, in particular the invasion of Ukraine by Russia, has placed the need to strengthen the European Union's defence capabilities at the heart of the European agenda. At the same time, the implementation of the new budgetary rules has raised concerns about the margin available to accommodate this additional effort without compromising the sustainability of public finances”.

Thus, according to Eurostat data (COFOG classification, which organizes public expenditure by function), public expenditure on defense in Portugal reached 0.8% of GDP in 2023, compared to 1.3% in the EU. “Since 2000, there has been a downward trend in this expenditure in Portugal, with the exception of 2010, in which there was a peak in expenditure associated with the registration of two submarines, the amount of which amounted to 0.5% of GDP”.

By main headings of the economic classification, the highest weight of personnel expenditure compared to the EU average stands out, while, conversely, the lowest weight of investment and intermediate consumption in defence. Between 2000 and 2023, personnel expenditure represented on average 69% of public expenditure on defence in Portugal, compared to 51% in the EU, while investment and intermediate consumption corresponded to 18% and 12% in Portugal, compared to 25% and 20% in the Union. “Throughout this period, the expenditure structure remained relatively stable, both in Portugal and in the EU aggregate”.

The 'remedies'

The BdP recalls that the first proposed instrument is SAFE, a temporary mechanism that will make up to €150 billion in loans available to Member States for urgent investments in the European defence industrial and technological base. “The financing will be provided through the issuance of debt by the EU, although the responsibility for its repayment will fall on the individual borrowing Member States. To reinforce European strategic autonomy, SAFE establishes specific criteria for the eligibility of financed projects, encouraging joint acquisitions in priority areas such as air defence, drones and cybersecurity, and promoting the participation of European companies in the supply of equipment”.

The second measure consists of a “proposed temporary exception to the budgetary rules of the Stability and Growth Pact, through the activation of the so-called national escape clause. According to the proposal, Member States may increase their defence spending by up to 1.5% of GDP annually for four years, with the possibility of extension, without violating EU budgetary rules. This clause covers expenditure classified in the COFOG defence category, but differences with the NATO definition will also be analysed. In order to ensure similar treatment for Member States that have recently increased this expenditure, the clause will cover the amount of expenditure in excess of that observed in 2021. Member States do not need to revise their medium-term budgetary plans following these requests”. So far, some Member States, including Portugal, have already requested the activation of this clause to accommodate the increase in their defence spending.