Fiscal Policy Shift in Germany

Implications for the Economy and Financial Markets

In early March 2025, Germany’s Chancellor-in-waiting, Friedrich Merz, announced a transformative fiscal policy shift, marking a departure from the nation’s longstanding fiscal conservatism. Merz, who is in talks to form a coalition government with the Social Democrats (SPD), plans to recall parliament very soon to seek approval of the lawmakers. The proposed measures include significant amendments to budgetary rules, relaxation of the “debt brake,” and the establishment of a substantial infrastructure spending fund. These initiatives have notably influenced market sentiment and financial markets, with implications for Germany’s economic landscape, debt-to-GDP ratio, and various sectors.

Key Components of the fiscal shift:

• Relaxation of the debt brake: Germany’s constitutional “debt brake,” which traditionally limited borrowing to 0.35% of GDP, is set to be relaxed. More specifically, this relaxation is meant to exempt defence spending over 1% of GDP from the “debt brake,” a rule introduced in 2009 to cap the government’s structural budget deficit at 0.35% of GDP. The proposed changes aim to exclude defence expenditures from these strict debt limitations, allowing for increased borrowing to bolster military capabilities. This move is driven by growing concerns over Europe’s security landscape and the need for enhanced defence spending. With a GDP of around 4.3 trillion euros in 2024, 1% would be around 43 billion euros and all defence spending above that will be exempt from the debt brake. This move widely considered as a push to reach the NATO goal of 2% of economic output.

• €500 billion infrastructure fund: A central element of the fiscal overhaul is the creation of a €500 billion infrastructure fund for the federal government, states and municipalities, equivalent to approximately 11.6% of Germany’s 2024 GDP. This proposed fund represents one of the largest stimulus packages in Germany’s recent history. The fund is designed to be disbursed over the next decade, targeting improvements in infrastructure and stimulating economic growth. Roughly €100 billion of the infrastructure fund would be available to the federal states and municipalities that have been struggling with financial deficit for years. The funds would be used for civil and population protection, education, energy, transport, healthcare and science infrastructure, in addition to hospital investments and research, and digitisation.

• Increased fiscal flexibility for federal states: The reforms propose allowing federal states to run small deficits, moving away from the previous mandate to maintain balanced budgets. This proposal would extend the deficit allowance of 0.35% of GDP to German states, which currently must run a balanced budget, potentially doubling the government’s borrowing cap to 0.7% of GDP per year. This change aims to provide regions with greater fiscal autonomy to address local needs and invest in critical projects. 

Impact on market sentiment and financial markets

The announcement of these fiscal measures has had a pronounced impact on financial markets:

• Equity markets: The anticipated economic stimulus has buoyed equity markets, particularly sectors poised to benefit directly from increased government spending. German stocks experienced a significant rally following the news. The DAX index surged over 3%, reaching a one-week high, reflecting investor optimism about the anticipated economic stimulus. The rally in Germany’s DAX following this news took the index’s year-to-date gain to over 16%, making it one of the best-performing stock markets in the world in 2025 (YTD as at 17 March 2025). Cyclical, infrastructure, and defence-related sectors led the rally in broader stock index. Despite this recent rise, German and European equities are still considered cheap in relative terms, with multiple catalysts on the horizon. The newly elected German government looks pro-growth and has exhibited an inclination to reform the debt brake, a move reinforced by Germany’s healthy fiscal position.

• Currency Markets: The euro strengthened notably, rising 0.5% against the dollar after the announcement. The euro has gained over 5% against US dollar year to date. This appreciation indicates increased confidence in the eurozone’s economic prospects in light of Germany’s expansive fiscal policies. 

• Bond Markets: German government bond yields rose, with the 10-year yield increasing to 2.93%. Although there is no imminent risk to Germany’s AAA credit rating, this uptick reflects market expectations of higher future growth and inflation resulting from the fiscal expansion plans. The rise in bond yields reflects market adjustments to the expected increase in debt issuance. While higher yields indicate increased borrowing costs, they also suggest investor confidence in Germany’s capacity to manage and service its debt.  

Implications for the economy and Debt-to-GDP ratio

The proposed fiscal measures are expected to have several implications:

• Economic growth: Analysts have revised Germany’s growth forecasts upward. Goldman Sachs, for instance, now anticipates GDP growth to rise by 0.2 percentage points to 0.2% in 2025, by 0.5 points to 1.5% in 2026, and by 0.6 points to 2% in 2027. This suggests that the fiscal stimulus could boost German growth by more than one percentage point per year. 

• Debt-to-GDP ratio: The substantial increase in borrowing is expected to elevate Germany’s debt-to-GDP ratio. While specific projections vary, the relaxation of fiscal constraints indicates a willingness to accept higher debt levels to finance critical investments. Furthermore, this ambitious spending plan will meaningfully increase Germany’s debt levels. The country’s debt ratio, which stood at around 64% of GDP last year, may rise by 10 percentage points due to the special infrastructure fund, with potentially additional rises from further defence spending. Over the long run, this could uplift Germany’s debt ratio to 90% over the next decade.

Key beneficiaries of the fiscal policy changes

Several sectors are poised to benefit from the fiscal reforms:

• Defense Industry: The exemption of defence spending from borrowing limits is expected to lead to significant investments in military capabilities, directly benefiting defense contractors and related industries. 

• Infrastructure and construction: The €500 billion infrastructure fund aims to revitalize Germany’s infrastructure, providing substantial opportunities for construction companies and related sectors. 

• Telecommunications and digital infrastructure: Germany has lagged in broadband and 5G deployment, affecting economic growth and digital transformation. The fund will support nationwide rollout of fiber-optic networks, expansion of 5G infrastructure to improve connectivity, and development of smart city projects with AI-driven urban planning.

• Automotive and Electric Vehicles (EVs): Germany’s automotive sector is undergoing a massive transformation toward electrification and digital mobility. The €500 billion fund will support expansion of EV charging stations nationwide, investment in battery production and R&D, and subsidies for EV production and infrastructure.

• Green energy and technology: Concessions made to the Green Party include allocating a portion of the infrastructure fund to the green transition, benefiting renewable energy projects and environmental initiatives.

In conclusion, Germany’s proposed fiscal shift represents a significant departure from its traditional fiscal policies, aiming to stimulate economic growth, enhance defense capabilities, and modernize infrastructure. While these measures have positively influenced market sentiment, their long-term success will depend on effective implementation and the broader economic environment. Germany’s €500 billion infrastructure fund is a game-changer for the country’s economy. Construction, defense, energy, transportation, and digital infrastructure will be the biggest beneficiaries, with major German and European companies positioned to gain significantly. The fund is expected to accelerate economic growth, boost employment, and improve Germany’s long-term competitiveness, making it one of the most significant fiscal initiatives in recent history.

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