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Sustaining resilience and renewal in Europe: The facts shaping the way forward

A series of shocks have battered the European economy. At the same time, European countries need to accelerate their response to linked structural challenges, including the climate transition, digitalisation, and competitiveness. This column argues that Europe’s economic future depends on being able to compete internationally based on innovation, particularly in strategic technologies linked to the climate transition. The current macroeconomic and policy environment is making this harder, however, particularly via fiscal consolidation pressures and the impact of uncertainty on private sector investment.

According the European Commission’s Winter Forecast, the European economy looks set to avoid recession, having made impressive progress in weaning itself off Russian energy imports (Verwey and Dieckmann 2023, European Commission 2023). While this is very welcome, the macroeconomic legacy of the ongoing energy shock, following on the heels of the pandemic, will still be substantial.

The invasion of Ukraine and the energy crisis compounded existing supply constraints, delivering a severe blow to Europe’s terms of trade, with additional energy import costs amounting to around 3.5% of EU GDP during the first six months of the conflict. The EU trade surplus in non-energy goods also slumped, reflecting a mix of higher import costs and weaker global demand (Figure 1). Aside from the dramatic effect on inflation, this shock also represented a significant negative income effect that has had to be allocated among, and absorbed by, Europe’s households, businesses, and governments. Indeed, euro area discretionary fiscal support in 2022, in response to the war in Ukraine, has been estimated at close to 1% of GDP (Checherita-Westphal et al. 2022). 

Figure 1 EU trade balance, 2016-2022 (€ billion, per month)

Figure 1 EU trade balance, 2016-2022

Source: Eurostat.

The ability of European economies to absorb the energy shock has been complicated by the fiscal legacy of the pandemic. The strong fiscal policy response in 2020 and 2021 shielded households and business from an extensive loss of income and protected productive capacity in a way that enabled a rapid rebound once COVID-19 restrictions were lifted. It also effectively reallocated a large share of net wealth from the public to the private sector, a situation that is yet to be reversed, and that greatly limits the fiscal space on many EU governments in the current context (Figure 2).

Figure 2 Net lending by sector in the EU, 2019-2022 (% of GDP)

Figure 2 Net lending by sector in the EU, 2019-2022

Source: Eurostat.

The European Investment Bank’s Investment Report 2022/2023: Resilience and renewal in Europe (EIB 2023) examines the question of how, in this context, Europe can sustain and accelerate the investment needed to tackle the challenges of the climate transition, digitalisation, innovation, and competitiveness. 

Europe cannot afford to delay its response to structural challenges

Despite the improving outlook, there can be no hope of getting back to ‘business as usual’, with European economies facing tremendous, urgent needs to invest to address the challenges of the climate transition, digitalisation, and maintaining competitiveness. Dealing with the climate emergency alone will require annual climate-related investment in this decade to rise by €356 billion above the yearly average from 2010-2020 (European Commission 2021, Wolff et al. 2021).

Comparatively low levels of investment in innovation and machinery and equipment also risk compromising Europe’s ability to compete in the long term. When investment in housing is excluded, data show that a gap in productive investment of around 2 percentage points of GDP opened up between Europe and the US after the global financial crisis, and still persists. This gap is driven by greater US investment in machinery and equipment and innovation, particularly in information and communication technology equipment (in the service sector) and intellectual property (in the public and defence sectors) (Figure 3). Data from the EIB Investment Survey (EIBIS) also show that EU firms are substantially less likely to invest in the adoption of new technologies and practices than US firms (Delanote et al. 2022).

Figure 3 Productive investment (GFCF excluding residential, % of GDP)

Figure 3 Productive investment

Note: Data for EU exclude Ireland. Source: Eurostat and OECD.

In fact, issues of sustainability and competitiveness are now merging, with leadership in green technology becoming critical to future competitiveness. While Europe is trailing behind the US in digital innovation, green technologies have so far stood out as an area where the EU is at the forefront of innovation. In patenting green technologies, Europe’s main strengths lie in the areas of sustainable mobility, smart grids, and wind energy, while it is neck and neck with the US and China on energy storage and, to a lesser extent, solar. To stay competitive, Europe will need to consolidate its position and expand its involvement in more cutting-edge innovation, such as hydrogen technologies. However, the US Inflation Reduction Act, which is expected to provide almost $369 billion for energy and climate change projects, will strengthen the competitive challenge from US firms and has the potential to encourage international firms to move innovative green industries to the United States.

Amid pressures for fiscal consolidation, protecting targeted public investment will be critical

Historically, public investment has proven particularly vulnerable in times of fiscal consolidation. To follow this pattern would be counterproductive, however. Analysis of the past five decades shows that maintaining or accelerating public investment during crises is associated with less economic scarring in the medium term, as measured by economic output (Larch et al. Wielen 2022) (Figure 4).

Figure 4 Degree of scarring three to seven years after a crisis (% of GDP)

Figure 4 Degree of scarring three to seven years after a crisis

Source: Larch et al. (2022).

Local government investment can be particularly effective at crowding in private sector investment. This effect is particularly strong during downturns, while investments in education, research and development, efficient administration, and local infrastructure are the most effective at promoting growth. In the current context, in which untargeted increases in public spending may contribute to inflationary pressures, it is important to focus on such investment areas that increase the productivity and productive capacity of the economy and reduce reliance on scarce resources. 

Corporate investment faces headwinds from energy costs, uncertainty, and financing conditions

Firms are increasingly concerned about energy costs, and a growing share say those costs are impeding investment. A lack of skills and uncertainty are also challenging investment.  Energy costs are now the second most frequently cited barrier to planned investment, with 82% of firms citing those costs as an issue (just below skills availability). Uncertainty also edged up to 78% of firms.

Heightened uncertainty is likely to have a particularly strong effect on corporate investment. Given the possibility of delaying investments, firms’ worries about uncertainty are a cause for concern. Simulations by the European Investment Bank suggest that corporate investment in 2022 would have been 10% higher (representing around 1.2% of GDP) if uncertainty had remained at its 2021 level, all else being equal.

Finance conditions for smaller businesses also began to deteriorate in 2022, reflecting monetary tightening and investors’ increased reluctance to take on risk. In mid-2022, the cost of corporate bank loans began to rise abruptly. Interest rate spreads between more and less risky loans also rose, which is likely to affect firms that are more indebted following the pandemic.

High energy prices alone will not be enough to accelerate green corporate investment

Overall, green investment by firms advanced in 2022, following a dip during the pandemic. Eighty-eight percent of firms reported some form of investment in climate change mitigation, with most taking action on energy efficiency and on minimising waste. Thirty-three percent of businesses report taking steps to adapt to the effects of climate change.

However, the outlook for corporate investment to tackle climate change is mixed, with uncertainty and administrative barriers weakening investment incentives created by high energy costs. Energy supply disruptions and high prices provide could push firms to invest in energy efficiency, electrification, and small-scale power generation from renewable sources. However, some emergency interventions to maintain the energy supply have also exacerbated uncertainty about policy commitments to the green transition. An analysis of the drivers of green investment by firms suggests that uncertainty may outweigh the incentive effect of higher energy prices. Firm that perceive energy costs as a major obstacle are 3 percentage points more likely to invest in climate measures, but the effect turns negative when uncertainty is also cited as a constraint. Tackling barriers, such as lengthy licencing processes for small renewable energy installations, is also essential.

Figure 5 Impact of energy costs and uncertainty on climate investment (change in probability to invest, percentage points)

Figure 5 Impact of energy costs and uncertainty on climate investment

Source: EIBIS, EIB calculations.

European policymakers need to act decisively to encourage critical investment

Policy clarity and the preservation of incentives to advance Europe’s transformation will be important. The response to the energy shock should lay the foundation for a more efficient and reliable EU energy market, tackling uncertainty and setting out a clear, ambitious path for the green transition.

EU member states also need to take advantage of the catalytic effect of public investment to crowd-in investment by the private sector, drawing on resources such as the Recovery and Resilience Facility to protect public investment from spending cuts and to minimise economic scarring over the longer term. 

In this context, risk-absorbing financial instruments can play a role in helping to shield strategic investment by the private sector. EIB studies show that credit and guarantee instruments for small and medium companies and venture debt for high-growth-potential firms can positively affect investment and innovation, countering market failures affecting smaller firms and higher-risk, innovative investment (Barbera et al. 2022, Gatti et al. 2022).

There is also an urgent need to reduce unnecessary administrative barriers to investment and address technical skills, particularly for firms and municipalities in cohesion regions, and particularly for more complex green and digital objectives. According to the EIB Municipality Survey, lack of funds, the length of regulatory processes, and regulatory uncertainty are the largest barriers to municipal investment and are linked to greater investment gaps, particularly in Central and Eastern Europe. When asked about capacity constraints, 69% of municipalities say that a lack of environmental and climate assessment skills is a barrier. Digital skills, engineering and other technical skills, and regulatory understanding are not far behind.

Figure 6 Municipal capacity constraints (% of municipalities)

Figure 6 Municipal capacity constraints

Source: EIB Municipality Survey.

Lastly, a coordinated European response is needed to enhance support for innovation, which remains crucial at various stages of the climate transition process, while preserving the benefits of the European single market as a level playing field. Uncoordinated responses risk undermining economic convergence, just when EU members are dealing with diverging effects and wider ramifications of the pandemic, climate change and the energy shock.

References

Barbera, A, A Gereben and M Wolski (2022), “Estimating conditional treatment effects of EIB lending to SMEs in Europe”, EIB Working Papers 2022/03.

Checherita-Westphal, C, M Freier and P Muggenthaler (2022), “Euro area fiscal policy response to the war in Ukraine and its macroeconomic impact”, ECB Economic Bulletin, Issue 5.

Delanote, J, D Revoltella and T Bending (2022), “How will European firms respond to new shocks? Latest evidence from the EIB Investment Survey”, VoxEU.org, 18 November.

European Commission (2021), “Impact assessment report”, Staff Working Document SWD(2021) 621 final.

European Commission (2023), “European Economic Forecast – Winter 2023”, European Economy Institutional Paper, February.

EIB – European Investment Bank (2023), Investment Report 2022/2023: Resilience and renewal in Europe.

Gatti, M, S Schich, W van der Wielen and E Sinnott, E (2022), “Impact assessment of EIB venture debt”, European Investment Bank.

Wolff, G, S Tagliapietra and K Lenaerts (2021) “How much investment do we need to reach net zero?”, Bruegel blog, 25 August.

Larch, M, P Clarys and W van de Wielen (2022), “The scarring effects of major economic downturns: The role of fiscal policy and government investment”, EIB Working Papers 2022/14.

Verwey, M and O Dieckmann (2023), “EU economy set to escape recession, but headwinds persist: The Commission's Winter 2023 Economic Forecast”, VoxEU.org, 14 February.