Key Takeaways
- In the first 30 years of the EU's single market, while the movement of goods and workers between EU member states has increased, capital flows have continued to lag. They have stagnated since the 2008-2009 global financial crisis, and their geographic scope has narrowed, moving from the east and south of the EU to the core and north.
- One encouraging development is that the COVID-19 pandemic has not led to a decrease in capital flows between EU countries. The bold and coordinated policy response to the pandemic has helped maintain private risk sharing.
- Also positive is the rise of Luxembourg and Ireland, both small economies in terms of EU GDP, as large hubs for cross-border funds.
- In terms of non-EU capital flows into the EU economy, we see that U.S. investment in European equities has grown significantly over the past decade. Meanwhile, the U.K.'s financial claims on the EU economy have stagnated, which is mainly due to the European Central Bank buying bonds from foreign investors as part of its quantitative easing program, rather than the U.K.'s exit from the EU in 2020.
Thirty years ago, Europe established a single market, abolishing internal borders to ensure the free movement of goods, workers, and capital across EU member states. There is no doubt that Europe has benefitted from the single market in those first two areas of movement (see chart 1):
- Intra-EU trade in goods rose substantially, particularly in the first half of the single market's existence. It increased from 15% of GDP in the early 1990s to 21% just before the pandemic. The surge in exports over the past two years is due to the restarting of European supply chains in a context of sluggish recovery in final domestic demand, rather than to a deepening of the EU single market.
- The share of the working-age population that was born in one of the 27 member countries and resides in another EU country has almost tripled over 30 years, nearly reaching 4% today compared with 1.3% in the early 1990s.
Chart 1
But has the intra-EU movement of capital progressed in the same way as the movement of goods and workers?
While it has been relatively straightforward to abolish customs and physical barriers to create a single area of movement, unifying capital and banking markets among European countries has been more challenging. This has led to policy agendas--such as the banking union and the capital markets union--that are still largely unfinished. The incompleteness of the banking and capital markets union has been well documented (see "The Five Presidents Report: Completing Europe's Economic and Monetary Union," published June 2015). In this report, we therefore investigate how intra-EU movement of capital has progressed in the context of an incomplete banking and capital markets union.
What Kind Of Capital Do We Mean?
We focus on cross-border movements of financial capital of a private nature, to see whether private sharing of risk is improving: a key metric for the completion of the capital markets union. The low willingness and ability of European banks to lend, and of capital markets to invest in their immediate neighbor countries, have in the past hindered Europe's ability to form a genuine economic union. Private risk sharing is low in Europe compared with the U.S., where domestic savings circulate more fluidly from one U.S. state to another, allowing asymmetric (regional) shocks on consumption to be better absorbed than they are in Europe (see "Enhancing private and public risk sharing - lessons from the literature and reflections on the Covid-19 crisis, ECB Occasional Paper Series, N.306," published September 2022). We therefore leave aside the aspects of cross-border movement of physical capital--so called foreign direct investments (FDIs)--as well as cross-border flows of financial capital of public nature, such as those resulting from bond purchases by central banks in the context of quantitative easing programs. Our focus is private capital flows among European countries.
We also look at intra-EU flows at the constant perimeter of the 27 EU member states. This to see whether EU membership makes a difference. The question of whether the U.K.'s exit from the EU in 2020 has altered intra-EU private capital flows is a separate one, which we therefore address only briefly in this report.
In our assessment of intra-EU flows, we extend an analysis conducted by the IMF four years ago on cross-border outstanding financial claims between EU countries (see "A Capital Market Union for Europe, IMF Staff Discussion Note," published September 2019). We look at cross-border outstanding claims in bonds and equity among EU countries from the IMF's Coordinated Portfolio Investment Survey (CPIS) as well as cross-border outstanding bank loans from the Bank for International Settlements' (BIS) locational banking statistics (that is, based on bank residency rather than ultimate risk) and bring them in relation to EU GDP (see chart 2 and the box below for an explanation of the data used).
About Our Methodology
The data used for this report's analysis come from three databases. Nominal GDP is extracted from Eurostat; debt securities and equity from the BIS (locational banking statistics); and loans from the IMF (CPIS). The reporting countries are the 27 members of the EU. However, not all countries are available in the last two databases: Croatia does not report in the locational banking statistics of the BIS and in the CPIS of the IMF, while 13 of the 27 EU countries report in the CPIS of the IMF (Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Spain, and Sweden). Furthermore, Croatia is not mentioned as a counterparty country in both databases. All variables are expressed in U.S. dollars. Equity figures take all sectors into account in a "total holdings" form. The same goes for debt securities, from which central banks and general governments are excluded both as reporting sectors and counterparty sectors. This is because we focus on private capital flows. Ideally, we would also exclude from our analysis cross-border financial investments made by public financial institutions, such as the European Investment Bank (EIB) and the European Investment Fund (EIF) in Luxembourg, Banque publique d'investissement (BPI) in France or the KfW banking group in Germany. Unfortunately, this restriction is not possible option in the database we use. That said, we believe that these flows do not fundamentally alter the analysis made below. Loans refer to all claims and include all types of instruments. The data run from 2001 to 2022. When several values are available per year, the latest of the year is used.
The Pandemic Has Not Led To Another Decrease In Intra-EU Private Capital Flows
Chart 2
Outstanding intra-EU private financial claims have increased over the past two decades, accounting for almost 100% of EU GDP in 2022 compared with slightly less than 60% of GDP in 2001 (unfortunately, data is not available for early years of the EU single market in the IMF CPIS). However, part of this increase is due to the valuation of bonds and especially equity--the claims progressing the most over the period--because CPIS data are traditionally marked to market (see "Coordinated Portfolio Investment Survey Guide (Third Edition)," published September 2018), which is not the case for bank loans in BIS data. For instance, the peak values in cross-border outstanding claims reached in 2020 and 2021 primarily reflect a sharp increase in bond and equity prices because of the global revival of central banks' quantitative-easing programs and interest rate cuts to address the pandemic. Their valuation is currently receding--bonds more so than equities--as interest rates rise and cross-border outstanding claims tend to return to pre-pandemic levels.
What's more, the evolution of cross-border private financial claims has not been smooth over time. Most of the build-up occurred before, or more exactly up to, the global financial crisis, with the shares in cross-border loans and bonds almost doubling between 2001 and 2007. This quick build-up was a consequence of the windfall for pan-European savings, which the introduction of the single currency created by eliminating the exchange-rate risk for investments in countries with above-average growth in the region. This episode was not necessarily a success. For example, European private capital flows helped finance the housing boom in Spain and Ireland in the early 2000s and played a role in its crash when they withdrew suddenly. We also remember that several episodes of forced devaluations and revaluations plagued many European economies until a stable solution to the monetary issue was found in the 1990s (see "Making the European Monetary Union," by Harold James, published 2014 by Harvard University Press).
The global financial crisis and the following eurozone debt crisis seem to have put a halt to the build-up of intra-EU private capital flows. The post-crises period coincides with a decline in outstanding claims, especially bonds, as their share dropped from 42% in 2007 to 26% in 2022, and it took the launch of the ECB's quantitative-easing program in late 2014 to reverse this downward trend, at least for cross-border bonds and equity financing. This could be a sign that greater public risk sharing--that is, quantitative easing--encourages private risk sharing.
Intra-EU bank loans' share of private cross-border financing has not only stagnated since 2007, but is now comparable with that of equities, having halved since 2001. This is all the more surprising given that European banks provide the bulk of funding to the European economy, with aggregate total assets of 300% of GDP, while total assets of all other financial institutions in Europe is 240% of GDP (including investment funds, money market funds, pension funds, financial vehicles, and insurance corporations). After the global financial and eurozone debt crises, European banks retrenched from cross-border lending, focusing scarce capital on businesses at home where they had competitive advantage and better understood the risks. In our view, the development of regional branches, which is costly but a practice of some big European banking groups, and the creation of a pan-European deposit insurance scheme (EDIS)--that is, progress in terms of banking union--would create incentives for European banks to increase cross-border lending. Without this, bank lending will retain a national focus and contribute to fragmentation in Europe.
That said, there is also good news regarding the evolution of outstanding intra-EU private financial claims. The pandemic has not led to another decrease in capital flows between European countries from 2020 to 2022, in contrast with the aftermath of the previous two crises. The bold and coordinated response of monetary policy (the ECB's pandemic emergency purchase program) and fiscal policy (the launch of NextGenEU)--in other words, public risk sharing--prevented a collapse of private risk sharing this time.
Few EU Countries Lend To The Rest Of Europe
Just four countries account for two-thirds of intra-EU funding (see chart 3). Germany, France, Italy, and Luxembourg are the main lenders to the rest of Europe. Such concentration is not abnormal, given that a country's lending capacity normally reflects the size of its economy--that is, the depth of its domestic savings pool--and that the size of EU member states' economies differs considerably. As chart 3 illustrates, the share of cross-border financing from one EU country to another is broadly consistent with that country's own contribution to EU GDP. For example, the Netherlands contributes 6% to EU GDP and 7% of EU GDP to intra-EU cross-border funding, while Germany contributes 24% to EU GDP and 19% to cross-border funding.
Luxembourg and Ireland are two noteworthy exceptions to this principle. Both countries fund other EU countries to a greater extent than than the size of their domestic economies would suggest. Having been part of the European single market and the European monetary union since inception, Luxembourg and Ireland have developed within Europe as hubs for the investment fund industry, thanks to a competitive legal and regulatory framework. Luxembourg has become the main location for undertakings for collective investment in transferable securities (UCITS) and alternative investment funds in Europe with 27% market share, just ahead of Ireland (19%), Germany (13%), and France (10%), according to the European Fund and Asset Management Association. What's more, Luxembourg and Ireland are the champions of Europe in terms of true cross-border funds. These are funds investing abroad and promoted by foreign providers--in other words, funded by foreign savings (see "EFAMA Fact Book 2022"). As an example, the Association of the Luxembourg Fund Industry (ALFI) estimated in 2017 that 21% of Luxembourg funds initiators are from the U.S. and 17% from the U.K. (see "Luxembourg: The Global Fund Center," ALFI, published 2017).
Chart 3
Chart 4 illustrates that the growing role of Luxembourg and Ireland in intra-EU funding predates the U.K.'s exit from the EU. Digging into the data, we can only detect a slight strengthening of Ireland's bank lending to EU member states' economies since Brexit, though this remains to be confirmed over time. We look at U.K. and U.S. financing of the EU economy in the final section of this report.
Chart 4
In addition, the geographical breakdown of lender countries differs by asset class. Among the main lenders, French banks top the list of cross-border intra-EU lenders (see chart 3). France has more global systemically important banks (G-SIBs) than any other European country (four out of 30 G-SIBs are French credit institutions according to the Financial Stability Board (FSB). We also find that Luxembourg is more exposed than other European countries in terms of cross-border debt securities. This seems to confirm EFAMA's estimate that Luxembourg has an impressive 41% market share in UCITS fixed-income funds.
European households still deposit a large share of their financial assets (about one-third) with banks, compared with only 10% with investment funds and 28% with life insurance funds. We saw in the previous section that the share of cross-border funding provided by European banks to other countries has stagnated since the financial crisis, while cross-border equity has improved. The third dimension of the EU single market would benefit from a democratization of investment funds among retail investors, or a democratization of life insurance and pension products among these same retail investors, since the proceeds of life insurance and pension funds products is largely invested in cross-border UCITS funds. By democratization of fund products, we mean a broader dissemination of financial culture among retail investors and the reduction of fees on fund shares, which many in Europe find high (see "Costs and Performance of EU Retail Investment Products 2023," published by ESMA in January 2023). By comparison, U.S. households have only 14% of their financial assets as checkable and savings deposits at credit institutions, 10% in mutual fund shares, 24% in corporate equities, and 27% in pension entitlements, according to Federal Reserve data.
Where Does Intra-EU Private Capital Go?
Countries at the core and in the north of the EU receive more capital from other EU countries. Chart 5 reveals a clear divide, which has been growing since 2008 in the wake of the global financial crisis and the eurozone debt crisis: while intra-EU private capital flows had progressed uniformly between EU regions until these two episodes of financial crisis, they have been directed mainly toward the core countries of the EU and the northern countries since then, leaving the southern and eastern countries behind. However, southern and eastern countries of the EU are needing increased investment--that is, more capital to flow in--to catch up with the more mature EU economies. In other words, the current orientation of intra-EU private capital flows does not contribute significantly to the real convergence of EU economies.
Southern Europe receives roughly 50 percentage points of their own GDP less financing from other European countries compared with pre-global financial crisis (see chart 6). There is a noticeable difference by type of instrument: cross-border equity has been a much more stable source of cross-border funding than loans and bonds (see chart 6). Unfortunately, it is also the most marginal source of funding compared to the others. Europe would benefit from a rebalancing in favor of equity financing, a key priority of the CMU initiatives.
The resulting capital divide can barely be filled by foreign non-EU private capital. In a perfect world, the opposite would be true: intra-EU capital should flow more to the south and east of the EU, where the return on capital is higher than in the north and core of the union, because of higher potential growth.
Could intra-EU public investment play a role in reducing the capital divide? This is a traditional role of the EIB and the EIF, and exactly what the NextGenEU plan of the European Commission is newly intended to do: invest more in the southern and the eastern part of the EU, to foster the green and digital transition in that area (see "Next Generation EU Will Shift European Growth Into A Higher Gear," published April 27, 2021, on RatingsDirect).
But structural reforms also play a key role. Absent the completion of the banking and capital markets union, fiscal redistribution among EU countries might be needed further, after NextGenEU, to counteract the current centrifugal forces of intra-EU private capital flows.
Conversely, the completion of the banking and capital markets union would minimize the need for fiscal transfers among EU countries.
Chart 5
Chart 6
Non-EU Capital Inflows To The EU Economy
Although foreign capital inflows to the EU are not the main focus of our report, the methodology we have developed can help inform debate, particularly with regard to whether the U.K. referendum on EU membership in 2016 and its subsequent departure in 2020 have altered funding to the EU. Here we examine U.S. and U.K. outstandings in European bonds, stocks, and loans (see chart 7).
Chart 7
Chart 8
U.K. and U.S. flows to the EU together account for less than half of the intra-EU cross-border funding. We can also see that U.S. private holdings of European assets have increased significantly over the past decade, to the point of surpassing U.K. holdings, which have stagnated over the same period having previously declined as a consequence of the global financial and eurozone debt crises. There are two developments at play:
- First, the rise in U.S. holdings is exclusively driven by equity. U.S. holdings in European debt securities and loans have not progressed much over time and remain marginal (see chart 9). The rise in U.S. holding of European equities coincides with the relative drop in European interest rates (therefore in funding costs for European companies) compared with the U.S. It will be interesting to see how these holdigns evolve now that the European economy has exited the zero interest rates policy.
- Second, the stagnation of U.K. private holdings in EU total assets since 2016 is the result of a decline in bond holdings, while equity holdings have grown somewhat and bank lending has not significantly changed (see chart 10). The decline in bond holdings coincides with the ramp-up of the ECB's bond purchase program between late 2014 and late 2016. As the ECB mainly bought these assets on the secondary market from foreign investors–-therefore, also from London--it cannot be concluded that the U.K. referendum on EU membership played a role.
Chart 9
Chart 10
This report does not constitute a rating action.
| EMEA Chief Economist: | Sylvain Broyer, Frankfurt + 49 693 399 9156; sylvain.broyer@spglobal.com |
| Economist: | Aude Guez, Frankfurt 6933999163; aude.guez@spglobal.com |
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