Lacklustre investment in the Eurozone: The policy response

Marco Buti

Weak investment is a key macroeconomic problem in the Eurozone, and the new European Commission has proposed an ‘Investment Plan’ to complement existing policy initiatives. In this column, the Commission’s Chief Economist explains the key rationale behind the Investment Plan.

Weak investment has been the main source of weakness in the Eurozone recovery (European Commission 2014a, Claeys et al. 2014a). While private consumption in the Eurozone in 2014 was at roughly the same level as it was in 2007, total investment was about 15% below its pre-crisis peak (see Figure 1).

Figure 1 Developments in real gross fixed capital and private consumption

(index 2007 = 100)

Note: Investment is measured as real gross fixed capital formation. The group of stressed countries consists of Cyprus, Greece, Ireland, Italy, Portugal and Spain.

Source: European Commission.

The weakness in investment is not confined to the construction and real estate sectors of countries that are grappling with imploding real estate bubbles. It is broad-based and affects the vast majority of the Eurozone economies and most of their sectors, with corporations withholding investment spending more than households or governments. The macroeconomic costs are high: not only does investment weakness affect the short-term outlook via its impact on aggregate demand, it also reduces the economy's potential. The European Commission's estimates show that a 5 percentage point reduction in the investment rate leads to a reduction in potential growth of nearly 0.5%.

As I have argued, the weakness of investment can be explained by a range of both cyclical and structural factors:1

The need to deleverage and reduce overcapacity, especially in the construction sector;

Regulatory bottlenecks in, for example, network sectors;

Sluggish economic growth via the accelerator channel;

The decline in public investment;

Financial fragmentation; and

High levels of economic uncertainty.

A comprehensive set of policies is needed to address this mix of factors. Indeed, a number of policy initiatives have been implemented over the last few months and more are in the pipeline.

Well-designed and properly implemented structural reforms in labour and product markets are the appropriate response to the structural factors. In the standard textbook growth model, the steady-state investment rate is determined by the rate of growth of employment and total factor productivity (TFP). Weak TFP and employment growth are most likely weighing on capital formation, hence the need for structural policies to address these growth factors. In some EU countries, investment demand is still held back by the need to adjust to the macroeconomic imbalances accumulated before the crisis. Far-reaching reforms have taken place in countries such as Spain or Ireland, although the correction of accumulated imbalances will still take time. Furthermore, most EU members face depressed medium-term growth prospects due to population ageing, weak TFP and the impact of the crisis on supply. Also, regulatory bottlenecks in network industries continue to keep private investment levels low. Reforms to restore the sustainability of public finances, complete the single market, cut red tape, and to support job creation and promote growth in general are at the core of the EU's policy agenda, and will provide a key pillar of support to investment.

Other measures that aim to create an appropriate policy mix have the capacity to affect the more cyclical factors, such as widespread economic uncertainty and the persistent weakness of domestic demand. As highlighted by Mario Draghi in his Jackson Hole speech in August this year (Draghi 2014), tackling such problems requires a comprehensive policy strategy that addresses both demand and supply. The ECB has announced non-conventional monetary policy tools to prevent the dis-anchoring of inflation expectations. On the fiscal side, as the recent assessment of Eurozone members’ draft budgetary plans indicates a broadly neutral fiscal stance in the Eurozone in 2015, the balance between fiscal sustainability requirements and cyclical stabilisation concerns appears to be appropriate. The big picture, however, looks rather different under the microscope. While some Eurozone countries still need to do more in order to comply with the EU’s fiscal rules, other countries have the space to provide fiscal support. Importantly, more efforts should be made to prioritise productive investment, raise the quality of public expenditure and make tax systems fairer and more efficient. The progressive phasing in of the banking union – including the recent results of the comprehensive assessment of banks' balance sheets – is contributing to the diminution of policy uncertainty and financial fragmentation.

The Investment Plan for Europe: the €300 billion question and more …

This November, the new Commission, under President Jean-Claude Juncker, put forward an Investment Plan for Europe, which aims to mobilise over €315 billion of additional public and private funds over the period 2015-2017 through targeted actions to remove uncertainty and improve the overall investment environment (European Commission 2014b). This plan needs to be seen as an integral part of the broader policy agenda and it complements the numerous policy actions aimed at addressing different factors hindering investment and ensuring an appropriate short-term policy mix.

The focus of the plan is predicated on two main considerations: first, there are investment needs in some sectors that are not easily met by the private sector due to their risk profile; and second, although there is no real shortage of liquidity at present, this is not translating into real investment.

To achieve this, the plan proposes action on three fronts: (i) catalysing investment finance by expanding the pool of risk bearing capacity; (ii) actions to create a transparent pipeline of investable projects to bring certainty to private investors and provide technical assistance to public investors to better construct their investment projects; (iii) improving the overall investment climate by eliminating barriers to investment at both European and national level. Not surprisingly, the €315 billion financing part of the plan attracted most of the headlines. It is clear though that the additional funding will not deliver all of its potential unless the other strands of the plan are properly implemented.

Figure 2 The Investment Plan for Europe

Source: European Commission (2014b).

How will the plan mobilise extra investment?

The objective is to support (i) long-term investment in areas that are essential for growth in Europe, and (ii) SMEs and mid-cap firms. For this purpose, a new European Fund for Strategic Investment (EFSI) will be created. Its risk-bearing capacity consists of €16 billion of guarantees from the EU budget and €5 billion of commitments from the European Investment Bank (EIB). The EIB will be able to use this €21 billion in risk-absorbing capacity to provide around €60 billion in finance to selected projects. EFSI-supported products will typically target the more complex and riskier parts of a project’s financing, reducing the risks for private investors. Lowering the financial riskiness will make it easier for a project/firm to attract additional financing from private sources. In this way, it is expected to catalyse up to €315 billion of investment in projects over 2015-17. This estimate, which assumes that every euro invested by the EFSI will attract four euros from the private sector, is in line with the historical experience of EU programmes and the EIB, and not overly optimistic.

Some commentators argue that the amount of public spending envisaged is too small to have a meaningful effect (Mazzucato and Caetano 2014, Zuleeg 2014). This criticism overlooks two important facts. First, there is at present no lack of investable funds. Institutional investors command very sizeable funds that are looking for deployment under the right conditions. The Plan has been designed to mobilise this private capital. The ratios of public to private capital envisaged in this context are estimates based on past EIB experience. Moreover, the governments and national promotional banks are invited to join the fund or to co-invest alongside it. EU Structural Funds could also be used more efficiently to catalyse more investment and EU countries could reprioritise investment in their budgets.

Another criticism has been that the envisaged contribution of the EU to the EFSI is taken from other EU funds with no net increase in public spending and therefore no possible macroeconomic effect (Gros 2014, Maystadt 2014, Münchau 2014). The guarantee provided by the Commission to the EFSI will indeed be diverted from other EU spending (notably the Connecting Europe Facility and Horizon 2020). However, support to investment will increase, as EU funds previously allocated as grants will leverage considerably more private capital under the EFSI.

How should the additional investment be allocated?

The objective of the ESFI is to support long-term investment of European significance in infrastructure, education, transport, research, innovation, and renewable energy. A key operational challenge is to identify and fund projects that are viable and have a significant impact on growth. An Investment Task Force made up of the Commission, the EIB and the member states has completed a first screening exercise to identify a pool of investable projects. An independent Investment Committee will select the projects2 covered by the EFSI guarantee based on their viability and making sure that public support does not crowd out private investment. The projects will be chosen solely on their merits, irrespective of their geographic location. As regards the support of investment for SMEs and mid-cap companies, the core objective is to help overcome capital shortages by providing higher amounts of direct equity and additional guarantees for high-quality securitisation of SME loans.

The proper selection of projects will be key to minimising the deadweight losses due to financing projects that would have taken place in any case. Some commentators (e.g. Claeys et al. 2014b, Veugelers 2014) have suggested that this could significantly reduce the net macroeconomic effects of the plan. To minimise this risk, the EFSI will target the more difficult segments of the markets, while leaving the plain vanilla products for others to offer. Moreover, all projects will be subject to the EU’s state aid rules, under which the requirements of addressing unmet needs and avoiding private sector crowding out are central.

A key complement: Removing sectoral and other financial and non-financial barriers

A business environment more conducive to investment is still needed in many parts of Europe. This requires further efforts to reduce the administrative burden and simplify the regulatory environment for business. More also needs to be done to remove barriers to investment in the Single Market, with the European Energy Union and the Digital Single Market playing an instrumental role in this respect. The re-launch of transparent securitisation will help convey new financing to SMEs, in particular. Over time, the creation of the Capital Markets Union should also support investment by reducing financial fragmentation and helping European firms to diversify their funding sources away from banks.

Conclusion

Given its persistent weakness, investment must be at the core of any strategy to revive growth in Europe. At the global scale, this chimes with the G20’s focus on investment as a key policy challenge. The Investment Plan presented by the Commission has the potential to stimulate capital spending and kick-start a sorely needed investment recovery. However, it is no silver bullet and will only be effective if implemented properly and accompanied by ambitious structural policies and an appropriate policy mix.

References

Bach, S, G. Baldi, K Bernoth, B Bremer, B Farkas, F Fichtner, M Fratzscher and M Gornig, (2013), “More Growth through Higher Investment”, DIW Economic Bulletin No. 8.

Barkbu, B, S P Berkmen, P Lukyantsau, S Saksonovs and H Schoelermann (2014), Investment in the Eurozone: Why has it been weak?, Eurozone policies, Selected issues, July 26.

Buti, M and P Mohl (2014), “Lacklustre investment in the Eurozone: Is there a puzzle”, VoxEE.org, 4 June.

Claeys, G, A Sapir and G Wolff (2014a), “Measuring Europe's investment problem”, Bruegel, 24 November.

Claeys, G, A Sapir and G Wolff (2014b), “Juncker's investment plan: No risk – no return”, Bruegel, 28 November.

Draghi, M (2014), "Unemployment in the Eurozone", speech at the Annual Central Bank Symposium in Jackson Hole, 22 August.

European Commission (2014a), "European Economic Forecast, Autumn 2014", European Economy 7/2014.

European Commission (2014b), “An Investment Plan for Europe”, Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee, the Committee of the Regions and the European Investment Bank, COM(2014) 903 final, 26 November.

Gros, D (2013), “The Juncker Plan: From €21 to €315 billion, through smoke and mirrors”, CEPS Commentaries, 27 November.

Mazzucato, M and P Caetano (2014), “Juncker’s investment plan: how to radically transform it”, The Guardian, 27 November.

Maystadt, P (2014), “Jump-starting Investment”, Fondation Robert Schumann Policy Paper No. 337, December.

Veugelers, R (2014), “The Achilles' heel of Juncker's investment plan - how will the right investment projects be selected?”, Bruegel, 8 December.

Münchau, W (2014), “The Juncker fund will not revive the eurozone”, Financial Times, 30 November.

Zuleeg, F (2014), “Juncker’s Investment Plan: a New Deal for the EU?”, European Policy Centre (EPC), 17 December.

Endnotes

[1] See Buti and Mohl (2014), and also Barkbu et al. (2014), Bach et al. (2013), and European Commission (2014a) for analyses of factors behind weak investment.

[2] There is no automatic link between the list of investable projects prepared by the Task Force and the selection of projects by the EFSI Investment Committee.