The Chair offers you a summary of the 4th edition of the webinar series “Les entretiens de l'ECODEF”, which focused on the financing of the defence effort in the 21st century. new economic and financial context.
In order to give its audiences a better understanding of the economic challenges of defence activities, the Chair offers The ECODEF talks, a series of webinars in which the results of its researchers' work are presented in the form of an interview, followed by a discussion with a leading practitioner on the subject in question and a question-and-answer session with the audience.
The 4th edition of this webinar, entitled «New economic and financial context: how to finance the defence effort?», was broadcast live on Wednesday 6 July.
Hosted by Olivier Martin (Chairman of the Steering Committee of the Chair), he proposed an exchange with Christian de Boissieu (Chairman of the Chair's Scientific Advisory Board).
Why this theme?
La Ukrainian crisis showed the the need for European countries to prepare for the return of the risk of war and to increase their defence efforts. In recent months, the economic and financial environment has also undergone profound changes (rising interest rates, inflation, debt, etc.).
The Chair offers you the summary of key findings of this webinar, as well as the answers to participants' questions.
Before discussing the new economic and financial context, Olivier Martin recalls the changes in Europe's defence budget requirements that have been emerging for several months. Faced with the war in Ukraine, which began in February, and the clear confirmation of the emerging risk of a return to high-intensity conflict on European soil, many European countries have announced major increases in their defence budgets, aiming for new targets in terms of % of GDP: Poland (3%), the United Kingdom (2.2%), Spain, Sweden, Denmark and Italy (2%) but above all Germany with a 5-year €100 billion catch-up plan that will enable it to exceed the 2% mark. Even if these NATO-standard rates often cover major expenditure that is not really part of the defence effort (pensions, for example), this trend nevertheless marks a major turnaround in European countries' defence budgets, at least in terms of announcements.
As far as France is concerned, at this stage we are living on the budgetary trajectory programmed since 2017 of a growing budgetary effort of €3 billion a year from 2023 to 2025, which will increase the defence budget from €41 billion to €50 billion in 2025. However, last June President Macron asked the Minister of the Armed Forces and the Chief of Staff of the Armed Forces «to conduct a reassessment of this Military Programming Law in the coming weeks in the light of the geopolitical context». He added that France had «entered an economy of war in which I believe we are going to organise ourselves for the long term» and «in which we can no longer live with the grammar of a year ago».
Furthermore, in the face of these challenges, which seem inevitably to lead to a significant increase in defence budgets, our country is faced with a complex economic and financial environment, greatly exacerbated by the Ukrainian crisis.
1. What can you tell us about the new economic and financial environment we have been experiencing for the past few months and the reasons for these changes?
As far as prices are concerned, we have moved from too low to too high inflation. There are many reasons for this: firstly, we have seen disruptions in global supply chains due to Covid and its duration (catching up with increased demand but reduced supply). This led to imbalances between supply and demand for many products. Inflation was then accentuated by the crisis in Ukraine and its impact on energy and food prices. However, this new level of inflation is not comparable to that reached in the 1970s following the oil shocks. Back then, the inflation rate was in double figures, whereas in France it is currently around 5.8% and remains lower than in the eurozone thanks to the measures taken. Inflation may rise further, but this will depend on two things. Firstly, we will have to see whether we enter a price-wage loop (price rises leading to wage rises, which in turn lead to further price rises). Wages have started to rise in France, but for the moment the price-wage loop has not been triggered. Next, we will have to see how inflation expectations stabilise. Will agents (households, businesses, public authorities) anticipate that this inflation will be sustainable and change their behaviour, or will they think that this rise is transitory? My expectation is that there will be average inflation of 5 or 6% in 2022, but it should be noted that there is a great deal of uncertainty at the moment, as can be seen from expectations about commodity prices.
Are we on the verge of a recession? To be in recession, we need two consecutive quarters of negative GDP growth. The GDP growth rate in the first quarter was negative. The results for the second quarter will depend on household consumption and expectations, but in any case we can anticipate a scenario of a sharp slowdown in activity.
As far as interest rates are concerned, we are in the process of normalising (real rates were negative). The ECB will raise rates by 25 basis points at the end of July (+0.25%), and a further 50 basis point increase (+0.5%) is likely in September. The rate at the end of the year could reach 1.5% for short-term nominal rates, meaning that real rates (nominal rate - inflation rate) are still very low. As the ECB may have been slow to act, the euro has fallen against the dollar, but its level is not worrying at this stage, even if it is increasing our energy bill.
2. What, then, are the foreseeable consequences for the financing of the defence effort, in terms of both State budget expenditure and business financing?
First of all, it should be noted that the increase in defence prices is higher in the long term than the increase in prices in the economy in general, mainly because of their innovation content. Before revision, the LPM provided for an increase of €3 billion per year, i.e. an increase in the defence budget from 7 to 8%. However, the increase in prices in France is already 6%, and it is likely to be higher in the armaments sector. This budget increase will therefore only compensate for current inflation and will only enable the current budget to be maintained in real terms.
French debt at the end of 2021 will amount to 2,800 billion euros, with 12% of this debt in inflation-linked bonds. For this reason, inflation will already lead to an additional cost of 15 billion euros for 2022. Rising interest rates will increase the cost of debt by €2 to €3 billion a year. Debt servicing costs will therefore rise from €35 billion in 2021 to over €50 billion in 2022. Problems of trade-off between different necessary investments will arise: debt servicing, defence spending, spending on the environment, spending on hospitals or schools, and so on. The question of the effectiveness of public spending will then arise.
Rising interest rates will also have an impact on businesses and their financing, particularly those that finance at variable or short-term rates.
3. Faced with these difficulties, which amount to squaring the circle, what could be the main recommendations for strengthening our defence budget despite this particularly constrained economic and financial context?
There are several options. The first would be to let deficits run at full speed, but this option is neither tenable nor acceptable, particularly at European level. So this scenario does not seem realistic. Whatever it takes« is not tenable in the long term. Current measures to support purchasing power are financed by increases in tax revenues due to inflation, but government spending (notably interest and debt repayments) will also increase in the long term.
The second option would be to define new budgetary rules in Europe. First of all, the rules of 3% of deficit or 60% of GDP now seem outdated and new rules will have to be defined. It will be necessary both to look at debt sustainability and to set rules for increasing public spending. One rule could be that real public spending should increase less quickly than real GDP. Secondly, some expenditure might not be taken into account. The debate on the inclusion of defence spending in the deficit must therefore be opened and an agreement reached at European level, as defence is considered to be a common good.
The third option would be to partially pool some defence spending. We have taken this route in the fight against climate change with the €750 billion joint aid plan, a third of which is earmarked for the environment. On the other hand, the public-private partnership that we experimented with 15 years ago does not seem to be an option, as the experiment proved inconclusive in the end.
Finally, we will have to study how the Germans, who are rather orthodox when it comes to budgetary matters, do things. The German defence spending announced (100 billion euros) will not be channelled through the budget of the Ministry of the Armed Forces (off-budget) but will have an impact on the level of indebtedness and debt repayment. The creation of these specific funds must be studied.
Questions from the audience :
1. With the economic crisis, isn't there a risk that defence will once again be put through the mill by Bercy as budgets tighten?
This risk exists, but given the geopolitical context, public opinion is aware of defence and security issues. This is why we think that Bercy will have to accept most of the requests from the Ministry of Defence, but the funding methods will have to be studied carefully.
2. What are the consequences of the rise in interest rates on the financing of defence companies, and are certain companies, such as innovative SMEs, likely to be more affected?
Many SMEs are financially fragile, in defence and elsewhere. They have benefited from State aid, but we can expect an increase in bankruptcies in general. Commercial court activity has been picking up since 2022. What is important in determining the impact of rising interest rates on defence companies is the structure of their debt (fixed or variable rate and short or long-term).
Olivier Martin points out that defence pure players generally have very little recourse to bank financing, given the nature of their business (R&D activities are financed by customers) and the way defence contracts are financed, particularly export contracts (generally positive cash flow).
3. At a time when the defence industry is sometimes finding it difficult to raise finance (ESG criteria, taxonomy, etc.), isn't there a risk that rising interest rates will exacerbate this problem?
ESG criteria and, above all, banking regulations (Basel III) are forcing banks to be more selective, and this may lead to credit rationing. Rising interest rates will increase financial constraints and credit rationing, particularly for SMEs.
4. Won't the increase in demand and defence budgets exacerbate the rise in defence prices?
We're back to the classic problems of balancing supply and demand. Given the increase in defence budgets, which are expected to be consumed in the short term, there will undoubtedly be a sharp rise in demand, with supply taking time to adjust: prices are therefore likely to rise.
We are also likely to encounter recruitment difficulties in the defence sector. In order to attract talent, we will have to take into account not only working conditions but also salaries. The pressure on salary demand will therefore increase, especially as inflation seems to be picking up strongly, which may also increase prices.
5. To what extent would the acculturation of Bercy staff facilitate budgetary trade-offs?
First of all, the President of the Republic, as head of the Armed Forces, is perfectly aware of the geostrategic context and its consequences for defence policy. So, even if the budgetary trade-offs will be complicated, I think that given the dangerous context in which we find ourselves in Europe today, the defence dossier seems defensible to Bercy and better placed than it has been at certain times. Nevertheless, we will have to arbitrate because we will not be able to invest in all areas.
6. Wouldn't it be possible to borrow for national defence using the savings accumulated by households during the crisis?
This is indeed a possibility, but in the current context, if the State indexes this loan to inflation (to protect small savers and encourage them to invest), this will lead to a high level of interest rates and therefore a significant cost for public finances. In short, as market financing is much less expensive for most governments, it seems unlikely that they will choose this option in the end.
7. What do you think of the sums needed to modernise France's deterrent system?
This is not the time to let go of what enables us to maintain France's position on the international stage. France has become an intermediate power in many areas, but in a few major areas such as defence, France maintains and must maintain its position. It is a permanent member of the Security Council and a nuclear power. Deterrence must therefore not be sacrificed, especially as the threats are growing at Europe's borders.
8. How effective is the competitiveness and employment tax credit (CICE) or the research tax credit (CIR) in defence?
In general, the CIR has proved its effectiveness, as several reports by the Conseil d'analyse économique (CAE) have emphasised, but there is still the debate between SMEs and large companies, with SMEs finding it more difficult to exploit it given the complexity of the process (lighter structures and lower earnings prospects). On the other hand, studies show that there are windfall effects and the impact of the CICE on employment is unclear. Christian de Boissieu is more sceptical about the CICE than he is about the CIR.
