The recovery in business investment – drivers, opportunities, challenges and risks

Prepared by Malin Andersson, Claudia Di Stefano, Yiqiao Sun and Francesca Vinci

Published as part of the ECB Economic Bulletin, Issue 5/2022.

1 Introduction

The coronavirus (COVID-19) pandemic led to a sharp decline in business investment in the euro area, which was followed by a significant rebound. Euro area non-construction (or “business”) investment – also referred to as “investment” in this article – plummeted at the outbreak of the pandemic. Firms struggled to cover working capital in their day-to-day operational activities and delayed strategic investment objectives when the economies suddenly collapsed in the first half of 2020. Helped by substantial support from monetary and fiscal policy, which also prevented a larger collapse, it has now largely bounced back and is close to its pre-pandemic level.^[1] However, investment has faced a number of headwinds, related to supply bottlenecks, rising energy costs and high uncertainty. The risks to the investment outlook have increased with Russia’s war in Ukraine. Meanwhile, the pandemic has accelerated the structural transformation process taking place in the euro area economy, highlighting the benefits of digital and green investment.

Looking at investment from a medium-term perspective, opportunities, challenges and risks stem from the digitalisation and greening of the economy. Understanding the implications of this twin transformation process is crucial given the important role of investment as a driver of the business cycle and determinant of the productive capacity of the economy.^[2] This article takes stock of the current investment dynamics in the euro area and examines the drivers of the ongoing transformation process as well as its likely consequences for the economic recovery.

The article focuses on these cyclical and structural issues. Section 2 looks at developments in business investment two years after the onset of the pandemic in the euro area. Section 3 focuses on the opportunities, challenges and risks to investment from the ongoing digitalisation and greening of the euro area economy. Section 4 concludes.

2 Business investment: taking stock after the pandemic shock

Two years after the onset of the pandemic, business investment has largely recovered. The pandemic shock caused the largest and fastest fall in investment in modern history. Thanks to extraordinary policy support and the fact that lasting repercussions on the financial markets were limited, however, euro area investment has broadly bounced back (Chart 1), though by less than in the United States (see Box 1). Monetary policy has played a crucial role in supporting investment during the pandemic by providing favourable financing conditions and facilitating credit access for firms.^[3] Evidence indicates that national fiscal policy support has been given predominantly to the firms and sectors with the largest liquidity needs or losses in sales during the crisis.^[4] Fiscal policies have also supported investment over the past two years (in part through guarantees and liquidity support), particularly in digital technologies and the green transition.^[5]

Nevertheless, the recovery in investment appears to have been weaker for countries and types of investment more heavily affected by supply bottlenecks and mobility restrictions. This is especially the case in Germany, which is facing a shortage of microchips, and for transport equipment, which has been hit by a drop in demand for flights (Chart 1, panels a and b). Since early 2022 investment has also faced rising commodity prices and uncertainty related to the war in Ukraine, along with re-intensified supply concerns as a result of the war and the resurgence of the pandemic in Asia.

Chart 1

Real non-construction investment in the four largest euro area countries

a) Total non-construction investment

(index: Q4 2019=100)

b) Breakdown by asset type

(index: Q4 2019=100)

Box 1
Non-construction investment in the euro area and the United States

Prepared by Valerie Jarvis

This box compares the non-construction investment recoveries in the euro area and the United States. The rebound in non-construction investment in the United States from the COVID-19 lockdowns in 2020 was swift, with investment already surpassing pre-COVID levels and broadly back to its pre-pandemic rate of growth by the end of that year.^[6] By contrast, data for the euro area aggregate suggest a significant gap compared with the pre-pandemic level (Chart A, panel a).

Chart A

Real non-construction investment

a) Total non-construction investment

(index: Q4 2019=100)

b) Breakdown

(index: Q4 2019=100)

There are several factors behind the euro area’s slower recovery in investment. First, the pandemic began somewhat earlier in Europe than in the United States, and lockdown measures in the spring of 2020 were stricter and more protracted, resulting in less bad outcomes in terms of health but a larger contraction of economic activity and investment, as well as stronger headwinds for the recovery.^[7] Second, and more importantly, euro area investment patterns have been more volatile than in the United States, reflecting irregular inflows of intangible investment by US multinationals, particularly for Ireland. By far the largest inflow to date occurred in the final quarter of 2019, artificially boosting the yardstick by which the subsequent recovery would be measured.^[8] Adjusting for this starting level (Chart A, panel a), the euro area recovery is closer to the profile in the United States, albeit merely edging back to pre-crisis levels by mid-2021. This evolution is common across asset types, with a gap having built up between the euro area and the United States both for machinery and equipment and for intellectual property products (Chart A, panel b).

There are additional explanations for the faster rebound in investment in the United States than in the euro area. The swifter economic rebound in the United States may have increased confidence in the strength of the recovery, thus reducing the downward drag of uncertainty on investment relative to the situation in the euro area. More lay-offs in the United States during the most restrictive period of the pandemic may also have been compensated for by higher investment than in the euro area. At the same time, a potentially larger share of jobs open to teleworking in the United States may have helped to boost investment in IT-related equipment more than in the euro area.^[9] Some euro area investment may also have been postponed during the second half of 2020 and early 2021 as the private sector waited for details related to the workings of the Next Generation EU instrument (see Box 2).

Over the past two years investment has continued to fall short of corporate savings. The euro area non-financial corporate sector has been a net lender for most of the period since the global financial crisis, meaning that firms generated savings in excess of their investment in most years (Chart 2). These dynamics reflect a range of factors which have curbed investment and spurred savings.^[10] For example, investment has been dampened by: structural rigidities in product and labour markets; episodes of balance sheet adjustment to reduce a high corporate debt burden; the expansion of the services sector, causing shifts from tangible capital to labour-intensive production; as well as a secular fall in returns on investment, which has incentivised firms to shift towards financial assets and away from fixed capital assets.^[11] Savings have been boosted by firms increasing the cash buffers needed to finance intangible investment and leaner inventories.^[12] The corporate net lending position increased further during the pandemic and reached record levels in 2021, with non-financial corporations increasing liquidity and capital buffers to better withstand future shocks.^[13]

While internal funds have increased, the timing of their future use is uncertain. Both internal and external financing as a share of value added have increased over recent years (Chart 2). Ample availability of funding should support business investment and the financing of both digitalisation, which relies more on internal funds, and green investment, which is both equity and debt-financed. However, firms may choose to retain precautionary savings when faced with continued high uncertainty, particularly as a result of the war in Ukraine (given its potential impact on the future energy mix or globalisation forces), the uncertainty about the need for investment as a result of climate-related policies, the fading of fiscal support measures or, more recently, high inflation. Other challenges and risks to the investment outlook stem from the expected normalisation of the cost of financing, high corporate indebtedness, and an expected increase in insolvencies.^[14]

Chart 2

Nominal investment, savings and financing

(four-quarter moving averages as a percentage of value added)

Domestic demand and profits are key drivers of business investment dynamics. A structural vector autoregressive (VAR) model shows that the main determinants of investment growth since 2008 have been shocks from domestic demand and gross operating surplus (Chart 3). Together with weak demand, news-based uncertainty has curbed investment in past crises as well as during the pandemic. Estimations based on micro data point to the relevance of demand (sales) and profits (cash flow), but with different sensitivities depending on the firm’s financial soundness, sector and size, see Box 2.

Chart 3

Decomposition of business investment

(annual percentage changes, percentage points)

Box 2
The role of cash flow in business investment on the basis of firm-level data

Prepared by Desislava Rusinova, Lorena Saiz and Jan-Christopher Scherer

This box uses firm-level data to assess drivers of business investment, particularly among financially constrained firms. The literature has found that financial factors such as financial debt or cash flow are key determinants of investment in tangible fixed assets. Other characteristics such as the sector or country where the firms operate, sales growth, expected future profitability and the level of economic uncertainty are also relevant. The present analysis is based on investment equations including most of these determinants, estimated using panel data for firms in the four largest euro area countries for the post-financial crisis period (2013-19). The empirical results confirm the relevance of cash flow, particularly for micro and small firms, and for countries with a larger proportion of small firms, such as Spain and Italy.^[15]

One key driver of investment is related to the extent to which firms have access to external financing, specifically bank credit, or are financially constrained. Proxies for financial constraints are firm leverage, size or age. In the literature, “excess sensitivity” of investment to cash flow is often interpreted as suggesting the importance of financial constraints. Having cash at hand when credit conditions tighten is important, since firms with high debt and low cash holdings could be forced to cut investment when facing adverse shocks. Identifying vulnerable firms as those with simultaneously high levels of debt and low levels of cash or liquid assets suggests that around 15% of firms were in a vulnerable financial position before the COVID-19 crisis on average for the four countries.^[16] In all countries most of the vulnerable firms are micro firms. Since smaller firms tend to be more dependent on bank-based external financing, high leverage ratios represent both high levels of indebtedness (potentially affecting their access to finance) and greater exposure to interest rate risk. Utility companies and firms in the accommodation and food as well as transport sectors are much more frequently represented among vulnerable firms. While utility companies benefit from a stable cash-flow stream, they are highly leveraged to finance potentially large and periodic capital expenditure needs for the purpose of maintaining infrastructures. Accommodation and food services firms, which were among the hardest hit sectors in the COVID-19 crisis, were already relatively highly represented among vulnerable firms in 2019.

When the sensitivity of investment to cash flow before the pandemic is considered separately for vulnerable and for non-vulnerable firms, it is much higher for vulnerable firms (Chart A). This means that unexpected changes in operating cash flow are likely to lead to larger adjustments in investment decisions for those firms. Since some of the sectors most affected by the pandemic (such as transportation and storage, accommodation and food, or real estate services) already had a larger than average share of vulnerable firms, the investment contraction is likely to have been particularly sizeable in those sectors. The predicted decline in the investment ratio given the observed changes in both cash flow and sales in 2020 is largest in those sectors that were most affected by the pandemic (Chart B). Gross fixed capital formation data for 2020 by sector, where available, confirm that investment declined the most in these sectors. Preliminary (but incomplete) micro data for 2020 indicate that the decline in the investment ratio was on average smaller than predicted in all sectors. This suggests that other factors such as monetary and fiscal policy support also had an effect.

Chart A

Investment in tangible assets and cash flow for vulnerable and non-vulnerable firms in each sector

(y-axis: investment in tangible assets over total fixed assets; x-axis: cash flow over total fixed assets)

Chart B

Predicted changes in the investment ratio in 2020

(y-axis: predicted change in investment ratio (percentage points); x-axis: change in cash flow (percentages))

Policy support was fundamental to providing liquidity and cushioning the impact of the pandemic, albeit to a different extent across firms. Among the policy measures, monetary policy played a key role in ensuring the preservation of favourable financing conditions and a continuous credit flow. Nonetheless, financial constraints may mean that individual firms’ investment spending responds differently to changes in monetary policy, and the empirical evidence for this is inconclusive.^[17] Monetary policy shocks proxied either by bank lending rates or changes in three-month EONIA swaps appear, nevertheless, to have more explanatory power for investment decisions of vulnerable firms in Spain or Italy than in other countries.

Box 3
Business investment and the Next Generation EU instrument – crowding in or crowding out?

Prepared by Roberto A. De Santis, Maximilian Freier and Francesca Vinci

This box assesses the impact of the expected significant increase in EU-funded public investment on business investment. The Next Generation EU (NGEU) fiscal instrument was set up in response to the pandemic, and was designed not only as a temporary measure to support the recovery process but also to make the EU economies more resilient through structural reforms and investment, in line with long-term EU objectives such as the green and digital transitions.^[18] Its core component, the Recovery and Resilience Facility (RRF), will provide the EU Member States with grants and loans of up to €724 billion in current prices over the period 2021-26. RRF funding is conditional on, among other criteria, its use for investment projects complying with pre-defined targets and milestones.

Focusing on the euro area, NGEU is expected to increase public investment by around 2.5 percentage points of GDP in the six-year period to 2026. The largest share of NGEU funding is intended to be allocated to new investment projects (“additional investment”), with a smaller part financing already budgeted projects (“substitutive investment”), as shown in Chart A, first column. Previous studies suggest that NGEU investments and structural reforms are likely to have positive economic effects (e.g. on growth, potential output, cross-country convergence and public finances), but they do not explicitly focus on the effects on private investment.^[19]

Chart A

NGEU funding and its expected cumulative impact on private and total investment in the euro area (2021-26)

(percentage points of euro area GDP)

Whether changes in public investment have a positive or negative impact on business investment remains a contested issue in the literature. Under certain circumstances, public investment may crowd out business investment, either directly, because private economic activity is substituted by public economic activity, or indirectly, because higher public debt pushes up interest rates and thus the real cost of capital.^[20] On the other hand, public investment may have a positive multiplier effect on business investment, for instance if public infrastructure investment leads to a more favourable business investment environment.^[21]

The potential impact of NGEU on private investment can be gauged by estimating the historical multipliers of the European Structural and Investment Funds (ESIF) for private investment. While there are differences between the ESIF and NGEU regarding their governance (for example RRF-funded measures do not require co-financing by the EU Member States), the ESIF and NGEU share two important features in terms of their policy objectives and instruments.^[22] First, funding is directed towards broadly similar goals, including investment in research and development (R&D), the green transition and social cohesion. Second, both the ESIF and NGEU allocate most of their funding to investment (around 80% of NGEU expenditure in the euro area; Chart A, first column). Therefore ESIF flows, which are available from the early 1990s, can be used to estimate the effects of such EU funds on private investment – of which approximately 70% is business investment – relative to GDP on an annual basis, both at impact (h=0) and in the following years (h>0).

According to the historical regularities estimated for the ESIF, NGEU-funded public investment could crowd in sizeable private investment, with a multiplier greater than one. The estimated multipliers of the ESIF – based on a panel of 28 EU countries from 1994 to 2018 – are larger than one, at impact as well as after one year (Table A). This implies that one euro spent through the ESIF is associated with two euro in private investment cumulated over time. The cumulative magnitude of the effect is therefore positive and large. Similar conclusions can be drawn from a study by Canova and Pappa (see footnote 22), which uses alternative econometric techniques and focuses on total (private and public) investment, although the positive impact is smaller. Despite high uncertainty and potential variation across countries, these estimates suggest that the NGEU flows have the potential to increase euro area private investment cumulatively by about 5% of euro area GDP between 2021 and 2026 (Chart A).^[23] However, this conclusion is subject to a number of assumptions, including that the NGEU plans will be implemented in a timely, efficient and effective way.

Table A

European Structural and Investment Funds’ multipliers for private investment

(Cumulative impact of one euro of ESIF funding on private investment expenditure relative to GDP in the current year (h=0) and one year ahead (h=1))

There are several possible channels by which EU-financed public investment stimulates private investment. First, much of EU financing goes into network infrastructure (transport and communication). This has opened up previously isolated rural areas to business investment. Second, EU funding often goes to underdeveloped sectors of the economy, particularly in advanced technologies. Returns in these sectors may be relatively high and attract investor interest. A third explanation for the high ESIF multiplier may be the fact that these projects require national co-financing, by either public or private entities. Nevertheless, identifying the factors behind the positive effects of EU-financed investment on private investment remains an open research avenue.

3 Opportunities and challenges for investment

The pandemic has provided major investment opportunities for digitalisation and greening. These are two of EU’s key policy priorities, and NGEU funds are intended to spur such investment (see Box 3). Considerable further investment is necessary to meet targets, and there are several challenges and risks to be overcome.

Digitalising investment

Investment in digital technologies accelerated after the outbreak of the pandemic, with especially larger firms as well as firms in the services sector taking up such technologies.^[24] Survey evidence shows that the adoption of digital technologies increased in the EU between 2018 and 2020, and roughly half of firms surveyed in Germany in February 2021 reported having invested in some form of digital technology during the pandemic, while a third considered the pandemic to have accelerated digitalisation (Chart 4). There is, however, considerable variation across firms and sectors: large firms in the EU were more likely to have invested in digital technologies, while small and medium-sized firms had encountered more financial or logistical barriers than others. Across sectors, while digitalisation in the manufacturing sector was high but had not advanced significantly during the pandemic, the services sector had accelerated investment in digital technologies.

Chart 4

The COVID-19 pandemic and the diffusion of digital technologies

a) European Union

(percentages of firms in the respective survey)

b) Germany

(percentages of firms in the survey)

Digitalisation and R&D efforts in the euro area are making investment more intangible-intensive. Intangible investment has been rising in the euro area as a share of GDP (Chart 5, panel a), driven by R&D, which covers investment to expand the technology frontier, as well as expenditure on software and databases, which tracks the software component of digital investments. Intangible investment intensity rose from 4.1% of GDP in the euro area in 2019 to 4.4% in 2020, according to preliminary national accounts data for 2020. Intangible intensity can also be tracked through balance sheet data for publicly listed firms incorporated in the euro area, which report R&D expenditure as well as firm-specific intangibles expenditure. The latter is based on a broader definition of intangible investment than national accounts data, including also marketing and human capital investment. Such investment is linked to firms’ ability to bring their products to the market, reaching consumers and gaining and retaining market share. Balance sheet data also show that euro area-based firms have been investing increasingly in intangibles, with aggregated intangible investment exceeding 5% of sales in 2020 (Chart 5, panel b). This confirms the relatively small negative impact of the pandemic on intangible investment (Chart 1, panel b).

Chart 5

Intangible investment intensity of the euro area

a) Intangible intensity: national accounts data

(percentages of GDP)

b) Intangible intensity: firm balance sheet data

(percentages of sales)

Increasing intangible intensity and digitalisation have a wide-ranging impact on the business environment. For example, digitally intensive firms tend to spur productivity in their sectors, albeit often with some lag before the full productivity-enhancing effects of digital technologies are felt.^[26] Digitalisation is also intrinsically linked to tax regimes, which could make the tax-base of increasingly digital and intangible-intensive economies more volatile. If multinationals can easily transfer their intangible assets from one location to another, volatility in investment cycles could also increase.^[27] Intangible-intensive firms may face additional funding constraints, as intangible investments may be hard to use as collateral, resulting in uncertainty concerning the ability to raise funding.^[28] As a consequence, firms tend to rely on retained earnings rather than bank loans to fund intangible investment.^[29] A more intangible-intensive economy could thus respond less sensitively to the credit channel of monetary policy.^[30]

The road to digitalisation in Europe is made more difficult by the structural characteristics of the corporate sector. Europe tends to be slow to adopt digital technologies because of its large proportion of small and medium-sized enterprises, which switch to new technologies more slowly than larger firms; a still incomplete single market in services; a preference for debt financing, due to the tax-deductibility of interest payments; and to some extent factors related to regulation and costs.^[31]

Greening investment

The need to develop new technologies to mitigate and adapt to climate change-related risks creates investment opportunities.^[32] Large firms associate climate change not only with risks but also with business opportunities, particularly if they seek to be transition leaders, or develop clean technologies or IT and consulting services that help others transition, according to recent ECB corporate survey evidence.^[33] The survey shows that firms have already increased their investment to mitigate climate-related risks, to ensure compliance with climate policies and to minimise disruptions from possible natural disasters.

Green innovation – measured by patents related to climate change mitigation and adaptation technologies as a share of all patents – has seen a notable increase in some sectors. Green patents accounted for the largest share of all patents registered from 2016 to 2018 in the most polluting sectors, such as basic materials, energy and those producing other industrial goods, indicating that a significant proportion of their R&D spending was devoted to green technologies (Chart 6). The process of diffusion of patented technologies through the wider economy is expected to trigger further green investment.

Chart 6

Cumulative R&D investment and green innovation by sector of main business

(left-hand scale: tonnes of CO2 equivalent/USD millions, right-hand scale: EUR billions)

Investment in clean energy constitutes the main pillar of the green transition and depends critically on the availability of clean technologies for energy production. Investment in energy transition is increasing for all technologies and reached some €110 billion in the euro area in 2021.^[34] This is still a small share of overall investment (Chart 7). While the pace of green investment in EU has accelerated over the pandemic period, additional investment of €90-100 billion per year would be needed in the period to 2050 to reach the EU target of zero net emissions.^[35] The investment needs are higher under a policy mix – combining carbon pricing, bans and regulations, and green subsidies – than a policy based on carbon pricing alone.^[36] Across sectors, the investment needs of the residential sector exceed the combined investments needed in transport, industry and services. The energy crisis and the war in Ukraine have strengthened the incentives to pursue green energy investment for reasons of energy security. At the same time, the resulting rise in global commodity prices and resurging supply bottlenecks have increased the risk of investment delays in the clean energy sector by driving up production costs for solar modules, wind turbines and battery packs.

Chart 7

Euro area non-construction investment and investment in energy transition by technology

(percentages of GDP)

There are several challenges for green investment, primarily related to available financing, regulation certainty and staffing. Financing from public and private sources to support green investment is crucial.^[37] EU funding for private investment in new green technologies is provided through the Next Generation EU instrument (see Box 3), the European Fund for Strategic Investments and European Investment Bank loans.^[38] Moreover, the policy mix as well as private returns on such projects need to give the appropriate incentives. To facilitate and incentivise the implementation of the “Fit for 55” package, carbon pricing and regulations in the Green Deal are accompanied by enabling infrastructure, a Just Transition Mechanism and a gradual phasing out of free Emissions Trading System allowances.^[39] Nevertheless, many European firms hesitate to invest owing to uncertainty surrounding the regulatory framework, high investment costs, lack of financing, unavailability of skilled staff and uncertainty about new technologies.^[40] Even though firms surveyed by the ECB mentioned these challenges in a climate change-related special survey this year, all respondents planned to increase their investment in climate mitigation throughout the transition period as part of their strategy to stay resilient.^[41]

4 Conclusions

Euro area business investment plummeted during the pandemic; the rebound has been significant but has varied considerably across countries, firms and types of investment. Nevertheless, the pandemic has accelerated the adoption of digital technologies as a result of the increase in remote working. Green private investment is being spurred by green transition policies and firms’ behavioural changes in response to surging climate risks as well as energy security considerations related to the war in Ukraine. While supported by extraordinary policies, investment has continued to face headwinds over the past two years, which also pose clear risks in the years ahead. The war has intensified risks to the short-term outlook for investment in relation to supply constraints, production costs and uncertainty. Corporate savings have increasingly exceeded investment. It is still uncertain when firms will start spending their accumulated savings on investment.

The continued recovery in euro area investment is heavily dependent on the challenging pursuit of digitalisation and greening of the euro area economy. This twin transformation has created investment opportunities during the pandemic, but investment needs in these areas remain considerable and expenditures are still insufficient. While R&D and new technologies have the potential to boost euro area productivity, particularly given the possible synergies between digital and green investment, challenges remain in terms of financing, regulation and incentives, which require coordinated policies.