EU relaxes budget rules amid Iran war ‘turbulence’

The European Commission has loosened the EU’s fiscal rules to allow countries to reduce their dependence on fossil fuels, as the energy shock unleashed by the Iran war continues to reverberate throughout the bloc’s economies.

The EU executive will allow capitals to spend up to 0.3% of annual GDP per year on measures that strengthen their “structural resilience” to energy shocks without breaching Brussels’ 3% budget threshold, Valdis Dombrovskis, the bloc’s economy commissioner, told reporters.

The additional fiscal room will apply until 2028 and is capped at a total of 0.6% of annual output, he said.

“We’re going through a particularly challenging and turbulent period,” Dombrovskis noted. He added that the closure of the Strait of Hormuz – a critical energy chokepoint that is currently subject to a double blockade by Iran and the US – has sparked “broadening, negative implications” for European inflation and economic growth.

Wednesday’s move marks a major reversal by Brussels, which has previously denied that the current crisis – which the International Energy Agency has described as the largest in history – warrants relaxing the rules. It comes less than a fortnight after the Commission slashed its EU growth forecast for 2026 from 1.4% to 1.1% and raised its inflation outlook from 2.1% to 3.1%.

It also represents a significant victory for Italy, whose prime minister, Giorgia Meloni, has repeatedly urged Brussels to set aside concerns about the EU’s fiscal sustainability and allow capitals to cushion the economic damage wrought by soaring oil and gas prices.

The specific way in which the flexibility will be granted – permitting countries to use extra fiscal space currently earmarked for defence spending – has also been previously floated by Rome.

In particular, countries wishing to access the additional flexibility – which could be used to boost battery storage capacity, subsidise electric vehicles, and increase heat pump installations, among other measures – will be required to activate the so-called national escape clause: a provision that allows capitals to spend an extra 1.5% of annual GDP on defence.

Seventeen of the EU’s 27 member states, including Germany, have already invoked the escape clause, which Brussels encouraged countries to activate last year in response to America’s waning commitment to European security and Russia’s growing military threat.

But Italy – which has traditionally been one of the EU’s defence laggards and is currently subject to an ‘excessive deficit procedure’ (EDP) for breaching the bloc’s 3% fiscal limit – has not invoked the provision.

In essence, the Commission’s proposal allows “member states to extend the scope within the national escape clause for defence to… measures that are helping the transition away from our dependency on fossil fuels”, Dombrovskis said.

All member states, including those that have already activated the escape clause, will be required to formally apply to Brussels before being allowed to spend more on energy-related measures, Dombrovskis said.

Countries that have already fully used up the extra fiscal room may also be allowed to spend beyond the 1.5% ceiling, subject to an “additional debt sustainability assessment” by Brussels, he added.

Lithuania and Estonia have already exhausted the extra flexibility provided by the escape clause, according to Commission officials.

Capitals that have not used up the additional fiscal room will likely face a “quite light” assessment procedure, Dombrovskis said. However, he warned that no country will be granted the ability to “subsidise fossil fuel use”.

Dombrovskis also said he would not “speculate” on which specific countries would apply for the extra budget space. But he added: “Given Italy’s strong interest in this additional fiscal flexibility, I assume that Italy will be willing to use it.”

The Italian finance ministry did not immediately respond to a request for comment.

Berlin’s narrow escape

Meanwhile, Dombrovskis said Brussels would recommend closing its excessive deficit procedure against Malta, which reduced its deficit to below 3% last year. He also confirmed that the Commission would propose opening an EDP against Bulgaria, just months after Sofia became the 21st EU country to join the euro area.

The nine other EU capitals currently subject to an EDP have all taken “effective action” to curb their deficits over the past year, Dombrovskis said. However, he warned that Hungary remained at risk of “material noncompliance” with the rules, which could see Brussels “stepping up” disciplinary action against Budapest later this year.

Germany’s activation of the escape clause also helped it narrowly avoid being hit with an EDP. Brussels attributed 0.8 percentage points (pps) of Berlin’s forecast 3.7% deficit this year to higher defence spending.

“If you subtract the 0.8 [pps] increase in defence spending, it comes to 2.9%, so it’s relatively close,” a Commission official said.

(bw, cs)