Europe’s investment vicious circle

#CriticalThinking

Picture of Angel Gurría
Angel Gurría

In 2008, the bottom dropped out of European investment. It wasn’t just a European problem as foreign direct investment declined globally. This is far from uncommon for individual countries, but at a global level is rare and it showed how broadly the financial crisis had affected international investments. Eight years after that collapse, global flows of foreign direct investment (FDI) are still 40% below the pre-crisis levels in 2007, with OECD countries generally experiencing the sharpest drops and a good many emerging economies welcoming increased FDI.

Europe has been among the worst affected. Foreign investment into the EU has declined by 72% since the outset of the financial crisis, and even its outflow of FDI has declined by 80%. This dramatic collapse has far-reaching economic and social implications, so we have to understand its root causes if we are to craft the right policy response.

Europe needs to create a more supportive environment for productive international investment that reflects the changing needs of investors

Data compiled here at the OECD show that in 2013 FDI inflows into the EU stood at around $240bn, down from $857bn at the peak of the global FDI cycle in 2007. Outflows were $252bn in 2013, down from $1.3 trillion in 2007. So this investment crisis is to an extent a very European one. Global FDI inflows outside Europe began to recover strongly in 2010 and reached new record heights in 2011 at just over $1.2 trillion, while in 2009 outflows outside Europe experienced a relatively modest decline of 20%.

Part of the strong investment performance outside the EU has been due to emerging markets, China particularly, as both sources and recipients of FDI. In 2012, emerging markets for the first time received more than half of global FDI. China is now consistently among the world’s top three sources of foreign investment. Given this relatively robust investment climate globally, why has the collapse been so severe in Europe?

The answer lies in European companies’ loss of faith in their own market as an investment destination. The greatest declines in inward FDI in the EU originated from within Europe itself. Before the financial crisis, around 70-80% of inward foreign investment in Europe consisted of intra-EU investment. By 2013, this figure had fallen to 30%. In contrast, non-European investment into the EU has held up well, and by 2011 was back again to its 2007 peak.

It might be tempting to explain away these declines as having been concentrated in those EU countries that experienced particularly difficult economic conditions during the crisis – such as Greece, Ireland, Portugal and Spain. But this is not the case. The collapse of cross-border investment flows within Europe has been broadly based, with the bulk of the declines in FDI flows concentrated in the largest EU national economies. France, Germany and the UK accounted for half of the $600bn drop in FDI inflows within Europe between 2007 and 2013. Over the same period, Greece, Ireland, Portugal, and Spain accounted for only $14bn, or 2%, of the declining inflow. As to outflows, France, Germany and the UK accounted for 59% of the $1 trillion decline between 2007 and 2013, with Greece, Ireland, Portugal, and Spain contributing only 12% of the decline.

A major new OECD publication uses data from companies to build up a sharper picture of the collapse of cross-border investment in Europe. Just as was the case for FDI, the EU was the region where cross-border mergers and acquisitions (M&A) declined the most when the financial crisis first hit. In 2008-2009, inward cross-border M&A in European economies shrank by 70%. Since then, the recovery has been modest but steady, with inward M&A rising in 2014 to $350bn and accounting for about 40% of the global share.

The structural changes taking place in the global economy require more innovative policy responses beyond the basics of a healthy investment environment

Looking at outward cross-border M&A, European companies seem to be undergoing a major international restructuring, and it is reflected in their high levels of international divestment. This has resulted for the third year running in near-zero levels of net outward cross-border mergers and acquisitions. Having sold off in 2014 around $300bn worth of their international assets, EU companies accounted for 60% of global international divestment. This trend is one of the factors that also sheds light on the investment collapse now holding back Europe’s economic recovery.

We need to analyse Europe’s investment collapse to ensure that the right measures will prevent it from being repeated. The challenges of breaking out of this regional investment slump are daunting but urgent. The EU Investment Plan launched last year by the incoming European Commission President Jean-Claude Juncker is a sign of the growing awareness of Europe’s need to respond to these challenges. It aims to unlock public and private investments in the real economy of at least €315bn by 2017, and has been heralded as an “investment offensive to get Europe growing again”. It is hoped this will boost investment partly via the traditional demand channels but also by raising companies’ confidence in Europe’s economic recovery.

From a longer-term perspective, Europe needs to create a more supportive environment for productive international investment that reflects the changing needs of investors, and it’s an environment that has several distinct dimensions. Investors favour predictable, open, transparent, rules-based regulatory environments, much along the lines put forward by the recently updated OECD Policy Framework for Investment. When impediments to investment are not addressed by governments, this often has more to do with implementation difficulties rather than disagreements over principles. It is widely accepted that excessive red tape is an obstacle to investment, and in many European countries this is often cited by business as being one of their greatest impediments. Europe also needs to relax excessive product market regulation, especially in the services sector. Europe’s regulatory restrictiveness is captured well in the OECD’s index of product market regulation and services trade restrictiveness. Many of these barriers to investment are low-hanging policy fruits whose abolition offers relatively easy ways to improve the investment climate.

The collapse of cross-border investment flows within Europe has been broadly based, with the bulk of the declines in FDI flows concentrated in the largest EU national economies

The pension funds and life insurance companies that are natural long-term investors represent a category that policymakers increasingly see as potential contributors to the financing of infrastructure projects, yet they face a long list of obstacles preventing them from playing this role. At the OECD we are addressing these issues, and contributing to the G20 and EU-related debates on them.

Beyond Europe, there have been some important changes in the structures and patterns of global investment flows, and also in the way multinational companies organise their international operations. This is reflected in such new phenomena as investment de-globalisation and “vertical disintegration”, which has seen some multinationals focus more on their core lines of business and rely more on international contractual relationships when organising their global value chains.

The structural changes taking place in the global economy require more innovative policy responses beyond the basics of a healthy investment environment. In a world where international production is increasingly broken down into specialised activities, and in which global value chains demand more complex logistics, countries must ask themselves whether they are investing enough in the right kinds of infrastructure.

Europe seems confronted with a puzzle in which declining competitiveness is discouraging investment, and declining investment is undermining competitiveness. Areas which the OECD has been highlighting as ways to bring back competitiveness are worth repeating because they also hold the key to getting back onto a sustainable investment path.

  • Further developing the Single Market, in particular in the energy and telecoms sectors, because it is one of the most powerful tools the EU has for stimulating growth and competitiveness.
  • Continuing to repair banks’ balance sheets to ensure the smooth functioning of banks’ lending channels.
  • Investing more in R&D and stepping up innovation to boost Europe’s competitiveness, especially in the southern and eastern EU countries.
  • Improving education and training institutions to make sure that they deliver much sought-after skills in the increasingly competitive global economy.
  • Increasing labour market participation, particularly among women and older people, and making labour markets more inclusive with a view to addressing social inequalities.
  • Reforming tax systems, including by reductions of high average and marginal tax wedges on labour.

The collapse in international investment flows in Europe, both outward and inward, is more than just a passing cyclical phenomenon. It must be taken into consideration in the policy responses designed to restore investor confidence and to revive investment flows. Through tools like the OECD Policy Framework for Investment and our policy recommendations on education and innovation systems, we are fully committed to supporting European policymakers’ efforts to design and implement better investment policies.

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