Foreign Direct Investment is a Key Factor in Fostering Economic Growth and Risk-sharing in the Euro Area

First published November 2014

Cross-border ownership of businesses is a key characteristic of a truly integrated economic area. In the euro area, however, foreign direct investments have been badly hit in recent years. In particular, there was a sharp drop in investment flows from the northern member countries to the southern periphery from already low levels before the crisis.[1] This disintegration of bilateral foreign direct investments can be seen as a symptom of the structural weaknesses and the meager economic performance in many countries. At the same time, however, FDI can be a catalyst for productivity and economic growth. Hence, low FDI can also be a potential cause for disappointing economic developments. In addition, cross-border corporate ownership enhances macroeconomic risk-sharing because gains and losses that arise in one country are shared across borders. This characteristic is all the more important when considering that other potential risk-sharing mechanisms cannot be expected to play their role in the near future. Labor markets will remain fragmented because of language and cultural barriers. In addition, no large-scale fiscal transfer mechanisms can be expected to be implemented. Governments should therefore set incentives for higher bilateral FDIs. An important measure would be to enhance a common market for services – a policy measure opposed by many interest groups – but that should be especially appealing to European policy-makers because it does not require an increase in public spending.

Policy measures to foster intra-European FDI become even more important when we consider how dramatic the decrease in FDI flows has been. Since the beginning of the crisis, foreign direct investment flows to the crisis countries in the European periphery have decreased from more than 40 billion euros in 2008 to less than one billion euros. Moreover, in relation to economic output, the stock of foreign direct investment was already persistently lower before the crisis in the southern peripheral countries than in the rest of the monetary union. The low FDI inflows reflected the relatively high barriers to FDI and the absence of significant investment opportunities. Moreover, because of the outbreak of the crisis, political and economic uncertainties have discouraged international investors.

Instead of FDI, capital flows to the European periphery have often taken the form of debt, thereby financing the past current account deficits. In this way, the euro area has suffered from what turned out to be a fatal financial integration characterized by debt. Bonds or bank loans usually pay fixed interest rates, which implies that international creditors do not instantly bear any losses in times of stress. In contrast, equity capital tends to yield high returns in booms and losses in downturns, thereby allowing for macroeconomic risk sharing across countries through market-based mechanisms. Therefore, it is crucial to promote financial integration characterized by cross-border ownership of businesses. At the same time, FDI can considerably increase productivity because it is an important vehicle for the transfer of technology and managerial skills. Obviously, one should bear in mind that FDI is no panacea and there are no automatic gains from it. However, it has the potential to contribute to innovation convergence and a higher investment rate in equipment and structures, which has fallen by approximately three percentage points in the euro area since the beginning of the crisis.

Obviously, one may ask how policy can foster economic growth and intra-European FDI, if at all. For example, public investment funds have been proposed. However, another measure can foster FDI without leading to significant costs for governments. This measure involves the integration of national services markets. Currently, services are still highly regulated in many countries, which deters cross-border acquisitions and mergers in services across countries. Moreover, these obstacles probably cause the low productivity growth rates in services that can be observed in many European countries. So far, the EU’s Services Directive has not sufficiently succeeded in opening up services markets.

Because services account for approximately 70 percent of output in most countries, productivity growth in services must be at the heart of any growth strategy for the euro area. A genuine common market for services has the potential to foster cross-border acquisitions and investments, thereby promoting economic growth and macroeconomic risk sharing across countries. Such reforms are often associated with considerable political obstacles, but in times of budgetary pressures, such costless reforms would almost be a free lunch for the economy as a whole. Why not implement them sooner rather than later?

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