The scale of the European investment crisis and why it matters

OCTOBER 6, 2016 

by: Valentina Romei

Investment in Europe, both public and private, dropped dramatically following the international financial crisis, and in its aftermath growth has been weak in some countries and non-existent in others. The lack of investment growth is particularly worrying in peripheral countries where it hampers the chances of future economic and productivity growth, as well as limiting employment expansion.

Just how steep was the drop?

It’s pretty serious. The Eurozone economy is now about six per cent larger than it was ten years ago, but the real value of investments is still six per cent below its 2006 levels. When compared to the pre-crisis peak in the first quarter of 2008 the drop is even larger, about twelve per cent.

The investment crisis hit the peripheral countries — Greece, Italy, Portugal and Spain — particularly hard. The real value of investments in Portugal, Spain and Italy is about 30 per cent smaller than ten years ago, while that of Greece shrank by 70 per cent.

Were it not for the contraction of investment, the Portuguese economy would have expanded by five per cent in the last ten years instead of contracting; the Italian output would have been flat rather than six per cent smaller and the Greek economy would be 8 per cent, rather than 24 per cent, smaller than ten years ago. And this is without taking into account the multiplying effect of investment on consumption and productivity.

Most peripheral countries are now showing signs of recovery. In Spain, gross fixed capital formation rose by 17 per cent since its lowest point in 2013. In Italy the sector started expanding again in 2014, but only marginally, while in Portugal investment started declining again after a couple of years of recovery. All of them have a long way to go to return to ‘normality’.

The drop is partly due to the collapse of the housing bubble in some of those countries, particularly Spain. And “a swift return to those investment levels would not to be expected or desired” writes a McKinsey report aptly titled “Investing in growth”.

In Greece, investment in dwelling dropped in real terms from €5.3bn ten years ago to just €300m now, a staggering 94 per cent drop. Investment levels in dwellings were halved in Portugal and Spain.

But the drop was not confined to dwellings. Investment in other buildings including factories and schools also fell, as did spending in buying and updating machinery and equipment.

Experts are growing concerned

Economists agree that it matters a great deal, and say it could actually be instrumental to European stability.

The lack of investment growth “is a big concern in terms of demand but also in terms of productivity and potential growth” explains Sebastian Barnes, a senior economist at the OECD and head of its EU desk.

“Low investment reduces aggregate demand, thus lowering short-term growth, and it also hampers medium-term growth through its effect on the capital stock” writeMarco Buti and Philipp Mohl from the Economic and Financial Arm of the European Commission.

“The EU investment crisis means obsolescence of capital, losses in terms of technological advances and potential constraints affecting an effective reallocation of resources” warned a report from the European Investment Bank.

So why is investment not growing?

There is little appetite to invest when demand – both domestic and international — is sluggish, banks are burdened with a heaping pile of bad debts, alternative forms of lending are limited, and uncertainty about the future is high as is the case in peripheral Europe, to varying degrees.

It’s a vicious circle. Until investment growth doesn’t pick up, demand is likely to remain sluggish and the proportion of non-performing loans has little chances of declining. As a result, confidence is unlikely to pick up: “a low growth trap”, as the OECD put it.

The way out? Reforms

In order to escape the low-growth trap and foster investment, governments should work on making their countries more attractive to investors and make investments easier by introducing labour and product-market reforms. This has been repeatedly advocated by both the IMF and the OECD.

These countries did start a process of reforms to improve their competitiveness, including major labour market reforms in Italy and Spain, albeit with little uplift in investments so far. Mr. Barnes encourages governments to do more, particularly in terms of product reforms.

Another major challenge is the financing glut

Stacked with mountainous bad debts, banks can hardly focus on financing new investments. The Capital Market Union, the European project aimed at developing alternative sources of finance firms across the member states, would come in handy at this time. But after the UK voted to leave the EU the project slowed down, to say the least.

Shaking up the status quo

European countries, particularly in the periphery, cut public investment following the financial crisis. As conditions improved, many governments began adopting looser policies, but this barely affected spending in investment. Instead, taxes were cut and administrations focused on encouraging consumption. But, says Barnes, these initiatives won’t do much to promote longer-term growth.

One way public investment could be bolstered is by rethinking the European Union’s fiscal rules and exclude net investment from the spending limit of three per cent of GDP. This is a controversial suggestion, but as they say sometimes stirring the boat is the only way to keep it from sinking.

Why Europe’s banks will never be the same again

European banks have been shrinking since the financial crisis, dwindling both in terms of their market value, number of branches and staff. Their fortunes have suffered and profits fallen as a result of stricter regulations, general economic weakness and low interest rates.

It’s unlikely that they will ever be the same again. All the more so as the decline in Europe’s over-reliance on banks could present new opportunities for the region to develop much-needed alternative financing channels.

Financial companies lost one trillion euros in market value

Since August 2007 the 471 financial companies that form Datastream’s financials equities sector lost over one trillion euros in market value. That’s the equivalent of Spain’s yearly GDP wiped out.

No other EU sector suffered a comparable loss, not even Oil & Gas contending with low oil prices.

Back in 2007, financial service companies were by far the largest EU Datastream sector by market value, roughly 64 per cent larger than the consumer goods sector. Now they are about the same and the latter was even briefly bigger in the aftermath of Britain’s EU’s referendum.

The worst performing sector in the EU since 2007? Banks

Datastream’s EU financials index has halved since its pre-crisis peak. By comparison, healthcare and consumer goods stocks indices are 70 per cent higher.

This is truly a pan-European story. Bank stocks are traded at less than 40 per cent of their August 2007 prices across all major European countries. German and Italian banks are traded at about 15 per cent their 2007 levels, while the Portuguese banks index is at an incredibly low 2 per cent of its pre-crisis price.

Back in 2007, there were 15 banks among the largest companies by market value of the European Stoxx 600. Today they are down to five.

Thousands of job cuts and axed branches

In 2015 there were more than 27,000 fewer bank branches in the Eurozone than in 2007, a drop of 13 per cent. There were 212,000 fewer people employed in banking, a 10 per cent drop since before the crisis according to the ECB.

The downsizing was particularly dramatic in France – where the number of banks halved to 360 – and Spain where it was exacerbated by a poor recovery in overall employment.

The largely fragmented German banking sector was not left unscathed. In July this year it counted 1,745 credit institutions, 14 per cent less than in the same month in 2007.

The European banking sector needed to downsize

Up until the 1990s the EU banking sector was comparable in size to other advanced countries. But soon after it “became extraordinarily large” and now “Europe is home to the world’s largest banking system” according to Sam Langfield and Marco Pagano, authors of ‘Is Europe overbanked?’.

Behind this disproportionate growth were government policies:

“Eurozone banks (..) benefited from a greater reduction in funding costs owing to government support than US banks” they write.

This meant that alternative forms of funding were hard to come by and to this day they are notoriously weak. The EU’s equity market is about half the size of that of the US, its securitisation market is less than a quarter – this is despite their economy being roughly the same size.

Time for change

According to Langfield and Pagano, the downsizing of the banks has created a slack which “security markets have partly taken up”.

It’s about time. Mario Draghi, president of the ECB, has said that “it’s better to have a plurality of channels financing the real economy than to rely on just one”. And indeed, the point of a Capital Market Union is to “diversify and amplify sources of finance”.

But there is change in the horizon. Langfield and Parano believe the shift from the old bank-based model to market-based finance “is likely to prove structural”.