The writer is chief economist Emea at S&P Global Ratings
This year marks the 30th anniversary of the European single market. In many ways it has been a success and has generated significant economic growth across the region. However, it is not yet a full-fledged economic union. The Banking and Capital Markets Union is still incomplete, and that is holding the EU back.
As a result, the free movement of goods and workers in the bloc is not matched by the free movement of capital. Facts shows that intra-EU private capital flows across borders have not increased since the global financial crisis, with cross-border financial claims accounting for almost 100 percent of EU gross domestic product in 2022, the same as in 2007.
Moreover, this private investment, driven by private savings, is not reaching the areas that really need it. Capital flows move within the north and core of the EU as investors see risk in eastern and southern Europe as too high despite better potential returns.
Southern European countries received about 50 percentage points less funding from other European countries in 2022 than in 2008. The growth of domestic piggy banks across Europe seems to be at odds with this picture.
Why is this a problem? The East and South need investment to catch up with the rest of the EU. Without such investments, the EU will not be able to take full advantage of its internal market. The current situation also limits the bloc’s ability to respond to external shocks as the union remains financially fragmented. With some European countries staring into a recession, it is more important than ever for the union to withstand shocks.
There are two ways in which the EU can solve this financing problem.
First, it could close the private investment gap with public grants, similar to the Next Generation EU plan for post-pandemic recovery. Evidence shows that increased public investment in developing regions can maintain private investor interest, although there is mixed evidence to date that this can be increased.
Years of financing for cohesion and regional development have undoubtedly led to economic growth in the south and east of the EU, but they have done little to improve the risk perception of capital markets there, as financial progress within the EU has stagnated since the global financial crisis. To support the development of these regions and ensure that the bloc can withstand further shocks, more government funding is therefore needed. The north and the core of the EU will bear these costs – the scale of which is difficult to quantify and it will be politically unpopular for national leaders.
Alternatively, the EU may decide to complete the Banking and Capital Markets Union. This would increase private risk-sharing, making it easier for pools of private capital to distribute it to countries that need it. It would help poorer EU countries avoid becoming increasingly dependent on public transfers and is also a cheaper solution.
There are indications that the EU can leverage private risk sharing within its original framework of the Banking Union and the Capital Markets Union. While bond financing and bank lending to southern EU countries has declined significantly – by 50 percentage points of southern countries’ GDP since the global crisis, according to our calculations – cross-border equity has been a much more stable source of funding. Unfortunately, cross-border equity is also the most marginal source of capital. Cross-border equity invested in southern EU economies accounts for less than 7 percent of those countries’ GDP. The Capital Markets Union, which aims to promote equity financing, is therefore a wise political choice.
The emergence of Luxembourg and Ireland, both small economies in terms of EU GDP, as hubs for cross-border funds is another sign of hope. Thanks to a competitive legal and regulatory environment, Luxembourg has become Europe’s leading location for Undertakings for Collective Investment in Transferable Securities (UCITS) and Alternative Investment Funds, with a market share of 27%, ahead of Ireland (19%).
Of course, completing a banking and capital markets union is not easy. We have already made progress, but we must move forward for the next crisis. The less progress we make between now and the next crisis, the more likely it is that public risk sharing will have to increase to absorb that shock.
If another crisis breaks out, the governments of the EU countries could be faced with a stark choice. Allocate more government money to provide fiscal and monetary stimulus to support the bloc’s fragile economies. Or make the banking and capital markets union work. The stability and prosperity of the EU depend on such improvements.
