Germany Taking their Foot off the Debt Break

Last week saw the biggest move in German sovereign bond yields (“bunds”) since the fall of the Berlin wall as the government pushes ahead with controversial plans to amend the country’s strict constitutional debt brake. This maneuver, coming just weeks before the newly elected parliament is set to convene on March 25, has triggered sharp movements in bund yields, drawing the ire of investors and bond vigilantes alike. This week, ABSI covers the turmoil in German debt markets.

Enacted in 2009 after the global financial crisis, the debt brake (Schuldenbremse) is a constitutional rule that limits the federal government’s structural budget deficit to 0.35% of the GDP, with even stricter requirements for state budgets. It was a rule designed to prevent excessive borrowing and ensure long-term fiscal discipline amongst elected officials.

However, the debt brake allows exceptions during economic crises or emergencies—an avenue that Germany has repeatedly exploited, particularly during the COVID-19 pandemic and the energy crisis following Russia’s invasion of Ukraine. In these instances, Berlin sidestepped the limit by invoking emergency clauses, enabling substantial fiscal spending.

But even the sidestepping has become too much for German politicians, with Chancellor Olaf Scholz’s government looking to permanently loosen the debt brake’s constraints. The proposed amendments seek to allow greater flexibility in borrowing, particularly for long-term infrastructure and climate projects. The amendments under discussion aim to broaden the definition of circumstances that justify suspending the debt brake. Instead of restricting exceptions to short-term crises, the government is proposing a framework that would enable additional borrowing for long-term investments. This effectively undermines the original intent of the rule, transforming it from a hard fiscal limit into a malleable guideline.

The proposal put forward is a EUR500 billion (11.6% of 2024 GDP) off-budget SPV for infrastructure investment to be disbursed over the next 10 years, amounting to ~1% of GDP in annual infrastructure spending. Additionally, lawmakers want to exempt any defense spending over and above 1% of GDP, effectively permitting open-ended borrowing for defense.

Germany 10Y Bond Yield

Unsurprisingly, the bund market has reacted violently. The yield on 10-year German bunds spiked sharply by ~50bps, marking one of the most significant VAR (Value at Risk) shocks on record. Investors, fearing fiscal profligacy, have aggressively sold off German debt, leading to a sharp repricing across the yield curve. This reaction highlights the credibility crisis Germany now faces. Traditionally seen as the EU’s fiscal anchor, the erosion of the debt brake has markets signaling deep unease over Berlin’s willingness to loosen its fiscal constraints.?

It is important to appreciate that Germany has a debt to GDP of ~63%. To put it into context, Japan is at ~255%, the US at ~122%, and the average for the Euro area is ~87%. However, unlike Japan and the US, Germany doesn’t have control over the printing press of its currency, meaning that spending wouldn’t be able to get too out of hand before the market made it unfeasible to issue more debt. German 10-year bunds currently yield 2.8% compared to the US at 4.28%, Australia at 4.46%, the UK at 4.6%, France at 3.5%, Spain at 3.5%, and Greece at 3.6%. Given that, historically, Germany hasn’t issued much debt, there is potential that this move could impact the Euro. An increase in bunds will broaden the pool and liquidity of investable assets for investors, which should increase the attractiveness of the Euro, resulting in appreciation.

Comparing Global 10Y Bond Yields

Aside from the increase in debt and borrowing costs for Germans, the timing of this move has raised serious ethical and procedural concerns. Last month, Germany held an election which saw the ruling Social Democratic Party (SPD) suffer significant losses to the conservative CDU/CSU alliance and the far-right AfD party. Germany’s newly elected parliament isn’t set to convene until March 25, leaving the previous SPD coalition, led by Chancellor Olaf Scholz, trying to push through a significant fiscal change before the change is made. Critics argue that a decision of this magnitude should be debated and voted on by the new legislature rather than being rushed through by an outgoing government. The Green party seems to agree after rejecting the initial draft debt package, but this is more likely a negotiation tactic to extract more benefits for climate infrastructure.

Germany’s plan to amend the debt brake is a huge change for a country known for being extremely fiscally conservative, for obvious historical reasons. The significance of this is demonstrated in the bund market, which has seen yields rocket up, making debt more expensive for German taxpayers. However, the increase in debt liquidity from the Euro’s largest economy might just be a net-positive for the demand of Euro currency. Finally, the country is potentially setting itself a dangerous precedent by sidelining the voices of a newly elected parliament in trying to rush through this monumental piece of new legislation by an outgoing ruling party.?

Written by Jack Colreavy, Associate Director at Barclay Pearce Capital.