European Parliament, MEP, Committee on Economic and Monetary Affairs
European Investment Bank, Vice-President
European Parliament, MEP and Chair, Committee on Economic and Monetary Affairs
De Nederlandsche Bank, President
National Bank of Bulgaria, Governor
1. Cross-border capital flows in the EU: recent evolution and stakes
1.1. What is at stake?
The Chair stated that financial integration promises many benefits, such as the potential of diversification, risk sharing and a more efficient allocation of capital. A monetary union has been established so that the disappearance of the exchange risk within member countries can enable savings from all the monetary union countries to be used to finance the most effective investments within the monetary area.
The financial crisis has shown that capital mobility was not without a dark side: during the decade from 2000 to 2010, the Eurozone’s capital mobility funded primarily inefficient investments - budget deficits in Greece, Italy and Portugal, real estate bubbles in Spain and Ireland – and contributed to massive current account deficits. Capital inflows that were not used productively amplified existing vulnerabilities in the monetary union. The current account deficits were increased as the wages and prices generated by the capital inflows eroded competitiveness and productivity gains.
The 2011-2012 sovereign debt crisis halted the circulation of capital flows between eurozone countries and the European Union, which led to large financing problems for banks and sovereigns and an amplification of the economic downturn. The ‘great retrenchment’ of cross-border capital flows has only been partly reversed. They still remain well below their pre-crisis levels.
Introducing the debate, the Chair recalled two figures from the Eurofi prep note; the first was that the euro area benefits from a savings surplus of more than €200 billion a year, or 2% of GDP. One of the questions for discussion was what should be done with this money, knowing that, in 2008, Europe had €2 billion cross-border capital flows while nine years later, the figure is just €1.26 billion. Something has gone wrong, and there needs to be a discussion on how it can be fixed.
There are five proposals to be discussed: firstly, reinforcing the Investment Plan for Europe, possibly with the assistance of the European Fund for Strategic Investments (EFSI); secondly, whether there is a need for a European product, such as a savings, retirement or investment product; thirdly, whether there should be pan EU banks; fourthly, increasing cross-border equity flow; and fifthly, whether it would help solve the non-performing loans (NPL) question to go back to the cross border investment. The Chair asked whether the new EFSI would help solve this problem.
1.2. A completion of the single financial market and a reinforcement of the Juncker Plan are necessary to restore cross-border investments
1.2.1. The European Investment Bank (EIB) is contributing to restore cross-border investments within the EU
An official stated that this topic is something that is well known in terms of the consequences of the crisis, especially deleveraging and the impact of the correction of current account imbalances, as well as more fundamental problems related to underdeveloped equity markets in Europe. Interestingly, however, in a recent poll, the EIB asked 12,000 non-financial companies throughout Europe what the major and minor obstacles to investment are. The first was uncertainty about the future; the second, surprisingly, was the lack of availability of staff with the right skills, which is an issue that is not directly linked to the day’s discussion, but is very important; and the third was business and labour market regulations, followed by the availability of finance. This is considered by 40% of European companies to be a major obstacle to investment.
There is also considerable dispersion across countries. In particular, one group of countries causes concern, namely those countries where companies do not have very many internal resources and have difficulty accessing external resources, or funding outside the company. These companies are mostly in Southern and Eastern Europe and this emphasises the importance of what the Juncker Plan is trying to implement. In terms of investment, Europe has now mobilised 58% of the total €315 billion target that was set by the Plan. The investments approved under the EFSI are in all the 28 countries, and around 400,000 SMEs have been financed; The EIB has provided support notably to projects in energy, transports, research, digital, social infrastructure or environment and resource efficiency. The European Investment Fund (EIF) has significantly increased its volume of operations in support of SMEs and mid-caps. At EIF, a co-investment equity platform with 30 national commercial banks and institutions from 19 countries in Europe has been created. This is something that will help these institutions to invest in projects that will be brought by fund managers to the EIF in other countries in Europe. These kinds of projects will help in the future to develop cross-border investment. There is also an idea for the next initiative, which can be delivered later, related to ELTIF.
A policymaker stated that Europe needs to do all of the things that the Chair listed. This is a very ambitious programme, and there is also a need to be pragmatic at the same time, because of the need to not only design perfect solutions, but to implement practical and successful solutions. To address the problem, there are cross border capital flows far below the pre-crisis level. Europe will need to return to these levels, but also address volatility issues, because the pre-crisis model was not perfect. That is why well regulated financial integration is needed. To be pragmatic, there is a need to start with banking, because Europe is clearly a bank-based economy. Unless Europe builds a true banking union, it will never solve this problem or achieve a practical and successful solution.
1.2.2. The completion of the Banking Union and the implementation of the Capital Markets Union (CMU) should increase the efficient allocation of capital within the EU
According to this policy maker, Europe needs to move forward in these two areas. Some of the issues to be addressed are politically very controversial, but are nevertheless required. These include the permanent backstop of the Single Resolution Fund (SRF) that would increase the credibility of the EU crisis management framework and the European Deposit Insurance Scheme (EDIS), which would underpin trust in the euro and achieve a uniform system whereby the same confidence in bank deposits as in money applies throughout the whole euro area. The banking package proposed by the EU Commission in November 2016, of which work has already begun, is balanced; an EU agreement on the combination of risk reduction and a better design of incentives in order to boost growth needs to be achieved. There is still much to do but, if EU Institutions do it well, they will make a significant contribution towards building up a well-regulated and integrated banking system, which is essential to developing cross-border flows. And this should also facilitate the completion of the Banking Union.
There is also the CMU side, and here, equity is the key word; equity financing in Europe needs to be improved. The current mid term review of the CMU might help. 16 out of 37 actions have been taken so far, which have been useful, but some measures were only recently approved, so the prospectus that is completed will develop its effects gradually. Clearly, however, more should be done, especially to address the problem, and a fiscal treatment of the famous debt equity bias is essential.
1.2.3. In addition, market failures need to be properly addressed
Third, Europe needs to address market failures; if it does not, it will achieve nothing. Here, the Juncker Plan is fundamental, and is doing well. However, it will have to be improved in terms of its capacity to merge a grant component with a guarantee component. If this can be achieved, Europe will be able to provide additionality, address market failures and have investment across the whole EU area. If this grant component is combined and developed with the idea of a European savings and investment fund, trying to channel savings, together with a macroeconomic policy that is more growth-oriented and which is also capable of addressing imbalances, this combination might end up addressing this saving and investment gap by making a strong and effective contribution to growth and jobs.
The Chair noted that uncertainty had been listed as a concern, and this was shared by other panellists. The second concern was staff skills. The Chair wondered how to address this question, because this has nothing to do with the Banking Union or with CMU, so it is not being discussed around the table. In countries like Greece, this is not a minor issue, so it should be asked whether those represented around the table could do something about it. She added that on the Banking Union, everybody agrees on what the loopholes are and that they need to be fixed.
2. Addressing underlying issues of cross-border investment in the EU
A central banker stated that, in general, the background from the perspective of cohesion countries, including Bulgaria, is generally the same. Capital mobility helped boost investment growth in these countries in the pre-crisis period. At the same time, large capital inflows contributed to some vulnerabilities and imbalances: for example, in the real-estate market and in Bulgaria’s external position. Trends are also generally the same; for example, capital inflows in cohesion countries collapsed from their peak in 2007, from about 27% of GDP to around 5% of GDP after 2012. This background is well known.
The reduction in capital inflows to cohesion countries was not necessarily a bad thing. There are some observers who refer to this process as ‘normalisation’. Research shows that the negative impact on the economy of the post crisis correction of the imbalances was less dependent on the size of the flows, and more about the structure or type of capital inflows. For example, in cases where capital inflows were intermediated with the banking system, the adjustment was more painful, usually coinciding with the banking turmoil. An example of this is a substantial drop in real GDP. In cases where capital inflows were in the form of foreign direct investment (FDI), an orderly adjustment was possible, since these inflows were contracted in a smoother manner compared to other types of capital inflows. As the experience of Bulgaria shows, this secured the orderly adjustment of the current account deficit at a low cost for the economy.
Secondly, uncertainty and risk aversion from the perspective of cohesion countries are major factors. Unfortunately, many current developments, including with regard to the future of EU integration, seem to add to this uncertainty rather than to address it. There remains notably a potential conflict between the prospects of “multiple speed” developments and advancing real convergence between the euro area and the rest of the EU. The EU needs to move promptly on this issue, in order to address uncertainties. An important dimension of this uncertainty is that the post-crisis saving-and-investment mismatch is not only within the EU but also within cohesion countries, which limits their investment opportunities; for example, the current account surplus in Bulgaria reached 4.2% in 2016.
Thirdly, national authorities have the responsibility to tackle their reform agendas, with a focus on financial stability, fiscal soundness and structural reforms. Those measures are a pre- requisite to attract effective and productive cross- border investments in these countries. The background note prepared by Eurofi rightly refers, for example, to how capital mobility has been used to finance budget deficits and inefficient investments in some member countries; so the question is whether more of this is needed. Of course, there are some positive examples, but not many. The Bulgarian Deputy Minister of Finance and people from the Ministry of Finance will present Bulgaria as a positive example. Bulgaria was running a broadly balanced budget for 10 years in a row until 2008, and is now back on the path of fiscal consolidation, balancing its budget for 2016 and keeping the debt-to-GDP ratio well below 30%.
To conclude, there is a need to focus on not only the size of capital flows but, more importantly, their effective and productive use. There is a need to adequately address uncertainties; otherwise, ongoing and new initiatives will have mixed results. Finally, Europe needs to effectively enforce rules in the banking sector as well as in the fiscal area, which involves the responsibilities of both the EU and the national authorities.
3. Towards more sustainable capital mobility within the euro area
3.1. In view of the accumulation of large macro-economic imbalances in some Eurozone countries between 2000 and 2007, financial integration in the euro area proved unstable in the context of a financial crisis
A central banker stated that from a macroeconomic perspective, regarding the question of intra-EMU capital flows, Eurofi is discussing the right topic. Private risk sharing is much more important for the smooth functioning of the EMU than public risk-sharing. Looking, for instance, at successful monetary unions like the United States, private risk-sharing takes on four or five times the role of public risk-sharing in relation to smoothing out asymmetric shocks across the various states. The Banking Union and the Capital Markets Union are the two central policy initiatives to foster private risk sharing in Europe and to catalyse financial integration in Europe.
Secondly, since there are significant differences in levels of GDP per capita and in living standards across the different member states of the euro area, there is nothing wrong with having consistent current-account patterns that show a surplus in the more advanced countries and a current-account deficit in the countries that are engaged in a process of catch-up or of convergence towards the richer countries. Where theory and practice started to deviate was the hubris of free capital mobility: for too long it has been believed that if there is free capital mobility, capital will always automatically flow to these investment opportunities that are the most productive and that have the most value-added to raising productivity, creating new assets and thereby fostering the convergence process.
Looking back on the crisis, this did not happen. Capital inflows were not used for investment that would benefit productivity; rather, they went into real estate. The growth of the less productive, non-tradable sector pushed up wages in this non-tradable sector. There was then arbitrage within these economies, so wages in the tradable sector also went up, and that combined to erode competitiveness and productivity gains. At some stage, this became unsustainable and a sharp reversal of cross-border flows followed, leading to large scale financing problems for banks and sovereigns. Capital flows led to an amplification of the economic downturn. At this point, public authorities stepped in. As of today, there are instruments like fixed rate full allotment and longer-term refinancing operations in the toolbox of European central banks, still effective in having taken over some of the private capital flows. This, of course, cannot be a sustainable policy indefinitely.
3.2. Since the crisis, European policy makers have been taking many measures meant to alleviate the dark side of financial integration
The speaker added that since the crisis, first of all, the Macroeconomic Imbalance Procedure (MIP) has been created, which is a very important procedure. Unfortunately, there are still some issues with compliance with the procedure, which is a phenomenon that is being seen more broadly with European procedures. In and of itself, however, it is a procedure that is pointing out the right issues. Second, Europe has strengthened prudential policies; on the macro side, these are countercyclical capital buffers and loan-to-value ratios. There is also strengthened micro prudential banking supervision at the European level, with the coming into being of the SSM. One can have many debates about NPLs and about ‘too little, too late’, but at least the issue is now under consideration, and there seems to be a consistent approach emerging from within the SSM about how to tackle NPLs. That is also good news.
The Chair added that regarding the MIP, this is not only a question of compliance, but it is also a tool that the Parliament has been urging forward 100% and which the Commission is not using as it should.
3.3. Increasing the share of equity and Foreign Direct Investment (FDI) flows in the composition of cross-border flows is of paramount importance. This requires changes to the taxation framework and increasing the efficiency and consistency of insolvency frameworks across the EU
Finally, according to this central banker, a lot of the volatility of these cross-border flows during booms and busts also came from the structure of capital flows, and the fact that these were heavily skewed towards debt financing instead of equity financing. One thing that is within the remit of policymakers to change is the debt-equity bias in fiscal frameworks. It is clear that debt flows go much more quickly into reverse when adverse shocks hit, and amplify business-cycle fluctuations. Therefore, it is of crucial importance that the share of equity and FDI in cross-border flows is increased.
Increasing equity financing requires the changes to the taxation framework and increasing the efficiency and consistency of insolvency frameworks across the EU. On taxation, the Chair stated that there is the project to address the debt equity bias. Indeed the tax deductibility of interest payments in most corporate income tax systems coupled with no such measure for equity financing creates economic distortions and exacerbates leverage. Addressing the preferential tax treatment of debt over equity would encourage more equity investments and create a stronger equity base in companies. The recent legislative proposal of the EU Commission on the debt equity bias is an encouraging step forward.
A central banker stated that the question is about the soundness of ongoing and new initiatives that are under consideration; and the specific measures to address market failure. This has not yet been achieved, so more work is needed in this direction; there has been too much focus on political considerations. With regard to taxation, this is an issue that needs to be resolved in the context of the CMU discussions.
Another central banker stated that much of the CMU concerns issues that are not directly within the remit of the people who are talking about it. Taxation is one of these; insolvency law is another area where finance ministers are a little uncomfortable accepting that it is their problem to deal with. However, it is indeed their responsibility. It is not only the responsibility of justice ministries to make the CMU successful.
3.4. Implementing and enforcing the rules more vigorously is of the essence
A central banker fully agreed with the point relating to compliance with the MIP. The procedure is the right one; unfortunately, fewer than 5% of recommendations are being followed. Some 40% of recommendations get some follow-up, but not the follow-up that was intended, and more than 50% of recommendations have no follow-up whatsoever. Europe needs to cease this practice of presenting big plans, but then having no implementation and no tools to hold policymakers accountable when they do not implement their promises.
An official stated that the new Juncker plan is already a priority for the EIB. As an investment bank, they are not financing the education budget, but they can help by making sure that the universities and the schools improve in terms of efficiency; not only energy efficiency, but also digitalisation. They need to demonstrate to Europe’s citizens that European institutions are there to help them, and that is something that they will try to strengthen in EFSI, as well.
A policymaker stated that the European Parliament looks forward to the Commission’s studies on tax incentives for venture capital and business angels, for instance, coming up in June, and the broader issue of the Common Consolidated Corporate Tax Base (CCCTB). There is indeed a tax dimension in CMU, which requires serious work. In particular, the preferential tax treatment of debt from the deductibility of interest payments causes equity to be less desirable, impeding efficient capital market financing. Addressing this tax bias would encourage more equity investments and create a stronger equity base in companies. Also, there are obvious benefits in terms of financial stability, as companies with a stronger capital base would be less vulnerable to shocks.
NPLs are also a crucial component, and Europe needs a comprehensive solution that does not end up destroying value; an appropriate solution is necessary for the flow, as well as a solution for the stock. There was a discussion on this at Ecofin that afternoon.
Finally, MIP is fundamental. MIP also means addressing symmetry, including in the current-account surplus and the capacity to be combined in a way that gives sense to the concept of a euro-area fiscal stance. MIP and the correct implementation of Europe’s other fiscal rules is a very complex issue and a fundamental one, and should be addressed in this broader framework with a focus on aiming at and overcoming this saving and investment gap, while fully using all of Europe’s new micro/macro prudential tools. Europe needs to avoid returning to the past, where capital went in the wrong place, and to recover and create a truly single, integrated financial market.