Europe's new challenge: Eroding foreign investment

Today foreign direct investment (FDI) is driven by emerging nations and the impending unwinding of US monetary stimulus. In Europe, the lingering debt crisis is reflected in the dramatic plunge of FDI inflows.

In the postwar era, the degree of global economic integration was still relatively low. As a result, international trade played a vital role in global growth. Today, the degree of globalization is broader and deeper. Consequently, foreign direct investment (FDI) is vital to global growth.

The United States has a huge and diversified economy. Nonetheless, FDI stocks account for 26 percent of US GDP. In the UK, the corresponding figure is significantly higher, 54 percent, as against 40 percent in France and 21 percent in Germany.

As advanced economies struggle with their debt crises and as large emerging economies are no longer immune to these crises, the typical drivers of growth - consumption, government, net exports - are ailing in many countries, particularly in Europe. As a result, many nations hope to rejuvenate their economies through investment.

In crisis conditions, domestic investment is lingering. So countries try to attract foreign investment.

Since FDI inflows can re-energize economies, the rivalry for FDI has increased rapidly. Before the debt crisis, Europe attracted much of global FDI. Last year, however, FDI in Europe plunged.

Optimists believe that it was a cyclical setback. In reality, eroding investment in Europe is a structural trend. It is another reflection of the relative decline of the region.

Reset of investment in Europe

Before the global recession, FDI inflows peaked at more than $2 trillion in 2007. As the US subprime market collapsed, the crisis spread to other major advanced economies and global FDI inflows shrank to $1.2 trillion in 2009.

During the brief rebound, global FDI was driven by stimulus packages and recovery measures in the advanced world. But as these policies expired, so did the rebound. Accordingly, global FDI inflows plunged again to less than $1.4 trillion in 2012.

Currently, observers anticipate a gradual rebound to almost $1.8 trillion around 2012-2015. In view of present realities in the West, that is aspirational but not necessarily realistic.

Europe’s decline as investment destination comes after years of success. At the turn of the 2000s and 2008, the region was the main beneficiary of two boom-and-bust cycles. In the aftermath of the global crisis, Europe was able to reverse FDI inflows. But another plunge followed after 2010, when the region was swept by its sovereign debt crisis.

Historically, most FDI in Europe has focused on Western Europe. In 1980, the latter accounted for more than 90 percent of FDI stocks, in contrast to barely 10 percent in Southern Europe. Last year, some 75 percent of FDI stocks were still in Western Europe rather than in Southern (15%) or Eastern Europe (9%).

Unlike FDI stocks, which illuminate the past, the story of FDI flows, which reflect the present, is similar, but far more volatile.

In 1980, Western Europe accounted for 70 percent of FDI flows, as opposed to 30 percent in Southern Europe. But last year, Western Europe accounted barely 32 percent of FDI inflows, as against Southern (29%) and Eastern Europe (14%). In 2007, FDI inflows in Europe soared to $860 billion; last year, they amounted to just $260 billion – less than in 1998.

The erosion of investment in Europe has been amplified by the regional debt crisis. But it also reflects longer-term structural trend.

Which European countries attract investment?

From 1980 to the present, most FDI stocks in Europe have focused on the UK. It was only in the late 1990s that France managed to attract more FDI. Before the global crisis, FDI stocks to the UK and France were almost identical, but in the aftermath FDI to France ($1.1 trillion) has fallen behind that to the UK ($1.3 trillion) and Belgium ($1 trillion).

Smaller FDI players include Germany, Spain and Netherlands.

The story of FDI flows has been far more volatile. In 2000, FDI flows in Germany amounted to almost $200 billion, but plunged dramatically thereafter. In 2007, FDI flows in UK experienced a very similar expansion and bust.

Last year, the UK attracted some $62 billion, far more than any other European economy, including Ireland ($29 billion), Luxembourg ($28 billion), Spain ($28 billion), or France ($25 billion).

FDI prospects in the future

In 2012, global FDI flows plunged by a whopping 18 percent. Europe alone accounted for two thirds of the global FDI decline.

Since 2008, FDI flows from advanced economies have been supported by liquidity-driven growth; record low interests and the use of non-traditional monetary instruments.

Starting in the fall, this growth pattern will be reset as the US Federal Reserve is likely to start gradual unwinding of quantitative easing, which will be followed by rising interest rates by mid-decade. Along with US fiscal challenges, this period will be characterised by significant downside risks.

The merciless FDI environment will require greater focus on the bottom line – cost efficiencies in poorer nations, innovation in richer economies, and greater investment attraction efforts in all countries.

In the absence of vital structural reforms, investment in Europe is living on borrowed time.

The writer is the research director of international business at the India, China and America Institute (USA) and a visiting fellow at the Shanghai Institutes for International Studies. This article was first published at EU Observer.