Analysis of Developments in EU Capital Flows in the Global Context - CEPS
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Analysis of Developments in EU Capital Flows in the Global Context Increasing uncertainty in the wake of the Covid-19 pandemic December 2020 A study prepared by Cinzia Alcidi with contributions by Angela Capolongo, Daniel Gros, Marvin Jahn and Roberto Musmeci. Mattia di Salvo provided excellent assistance in data analysis and visualisation
EUROPEAN COMMISSION Directorate-General for Financial Stability, Financial Services and Capital Markets Directorate E – Financial systems and crisis management Unit E4 – Economic analysis and evaluation Contact: FISMA-E4@ec.europa.eu European Commission B-1049 Brussels
EUROPEAN COMMISSION Analysis of Developments in EU Capital Flows in the Global Context Increasing uncertainty in the wake of the Covid-19 pandemic A study prepared by Cinzia Alcidi with contributions by Angela Capolongo, Daniel Gros, Marvin Jahn and Roberto Musmeci. Mattia di Salvo provided excellent assistance in data analysis and visualisation. Directorate-General for Financial Stability, Financial Services and Capital Markets Union
EUROPEAN COMMISSION EUROPE DIRECT is a service to help you find answers to your questions about the European Union Freephone number (*): 00 800 6 7 8 9 10 11 (*) The information given is free, as are most calls (though some operators, phone boxes or hotels may charge you) LEGAL NOTICE This study has been prepared for the European Commission under contract Service Contract FISMA 2019/049/E. However, it reflects only the views of the authors and the Commission cannot be held responsible for any use which may be made of the information contained therein. More information on the European Union is available on the Internet (http://www.europa.eu). Luxembourg: Publications Office of the European Union, 2019 ISBN 978-92-76-17255-0 doi:10.2874/158998 © European Union, 2019 Reproduction is authorised provided the source is acknowledged. Directorate-General for Financial Stability, Financial Services and Capital Markets Union
Table of Contents Table of Contents .............................................................................................. 5 List of Figures ................................................................................................... 7 List of Tables .................................................................................................... 8 Executive Summary ........................................................................................... 9 List of Acronyms .............................................................................................. 13 1 Introduction .............................................................................................. 14 2 Global trends and developments in a highly uncertain landscape ...................... 16 2.1 An overview of global flows and stocks ....................................................... 17 2.2 Global net and gross flows by investment class ........................................... 20 Foreign direct investment ................................................................... 20 Portfolio investment........................................................................... 23 Other investment .............................................................................. 25 2.3 Capital flows of emerging market and developing economies under the Covid-19 pandemic ......................................................................................................... 26 Remittances ..................................................................................... 30 Commodity prices: the great fall of oil ................................................. 31 Capital flows, debt and debt relief in EMDEs ......................................... 33 3 The international role of the euro ................................................................. 36 3.1 Demand for reserves ............................................................................... 36 Foreign exchange reserve holdings and other official holdings ................. 37 Does the current account matter? ....................................................... 38 3.2 Determinates of currency composition of foreign exchange reserves .............. 40 Global trade invoicing: the role of the dollar and the euro ...................... 41 3.3 A forward-looking perspective ................................................................... 44 Next Generation EU ........................................................................... 44 Capital Markets Union ........................................................................ 44 4 Intra-EU capital movements ........................................................................ 46 4.1 Components of the EU-27 financial account: gross and net flows ................... 48 Foreign direct investment ................................................................... 48 Portfolio investment........................................................................... 50 Other investment .............................................................................. 51 The net international investment position ............................................. 53 4.2 East-West and North-South flows .............................................................. 54 4.3 The state of EU financial integration........................................................... 58 4.4 Intra-Eurosystem positions and the role of TARGET2 in financial integration ... 61 5 Disentangling EU-28 FDI ............................................................................. 66 5.1 Methodology ........................................................................................... 68 5.2 EU-28 FDI: real and phantom investment ................................................... 70 5.3 The real EU-28 FDI network ...................................................................... 71 5.4 Another look at intra-EU FDI and financial integration .................................. 77 6 EU FDI under policy uncertainty ................................................................... 79 6.1 EU-US FDI and the role of trade policy uncertainty ...................................... 82 The impact of the US Tax Cuts and Jobs Act ......................................... 85 6.2 Investment protection and FDI .................................................................. 85 6.3 Remarks on FDI and uncertainty ............................................................... 86 7 Implications and conclusions ....................................................................... 88 7.1 Implications from recent developments in capital movements ....................... 88 7.2 High uncertainty and downside risks ahead ................................................ 89
7.3 Policy priorities and challenges .................................................................. 90 References...................................................................................................... 91 Annex I – Decomposition of FDIs, sampling procedure using ORBIS data ................. 95
List of Figures Figure 1. Quarterly GDP (2019Q1=100, dashed lines indicate WEO estimates from April 2020).................................................................................................................. 14 Figure 2. Current account balances, % of world GDP, 2005-2019 & 2020Q1-2 ............. 17 Figure 3. Financial account balances, % of world GDP, 2005-2020Q2 (annual and quarterly) ............................................................................................................ 18 Figure 4. Reserve and related items, % of world GDP, 2005-19 & 2020Q1-2 ................ 19 Figure 5. Net International Investment Position, % of world GDP, 2005-19 .................. 20 Figure 6. Global FDI inflows, 1990-2019 (Indexed, 2010 = 100), average growth rates over the sub-period ..................................................................................................... 21 Figure 7. Net Foreign Direct Investment Flows, % of World GDP - 2005-2020Q2 .......... 22 Figure 8. Foreign direct investment flows, assets, % of World GDP - 2005-2020Q2 ....... 23 Figure 9. Foreign Direct Investment Flows, Liabilities, % of World GDP - 2005-2020Q2 . 23 Figure 10. Net Portfolio Investment Flows, % of World GDP, 2005-2020Q2 .................. 24 Figure 11. Portfolio Investment Flows, Assets, % of World GDP, 2005-2020Q2............. 24 Figure 12. Portfolio Investment Flows, Liabilities, % of World GDP, 2005-2020Q2 ......... 25 Figure 13. Net Other Investment Flows, % of World GDP, 2005-19 (quarterly data for 2020 are not yet available) ............................................................................................ 25 Figure 14. Other Investment Flows, Assets, % of World GDP, 2005-2020Q2 ................ 26 Figure 15. EMEs: Net inflows in Funds, billion USD .................................................... 27 Figure 16. Emerging Markets Bond Index (basis points) ............................................ 28 Figure 17. Global Current Account Balance % of World GDP, IMF Forecasts for 2020 ..... 28 Figure 18. Exchange rates – selected EMEs, January-October 2020 ............................. 29 Figure 19. Real Effective Exchange Rate, changes April-September 2020, selected EMEs countries ............................................................................................................. 30 Figure 20. FDI and remittances in southern countries neighbouring the EU .................. 31 Figure 21. Primary Commodity Indices, quarterly, 1995Q1-2020Q3 (2016=100) .......... 32 Figure 22. Commodity prices (index, 2014 =100): 2014-2020M8 ............................... 33 Figure 23. Regional breakdown of USD-denominated international debt issuance .......... 34 Figure 24. Snapshot of the international monetary system (2019Q4), % of total .......... 36 Figure 25. Foreign currency reserves, by country groups based on current account balance (excluding euro area), $ billions ............................................................................. 38 Figure 26. Foreign exchange reserves and cumulated current account (2008-19): persistent surplus countries ($ billions) ................................................................... 39 Figure 27. The USD dominates global trade invoicing (2017) ...................................... 42 Figure 28. Trade invoicing: export weighted average percentage share, 2018 .............. 43 Figure 29. Share of the euro in the invoicing of extra-euro area trade in goods (left panel) and in the invoicing of extra-euro area trade in services (right panel), in % ................. 43 Figure 30. Number and share of funds by type and portfolio allocation ........................ 45 Figure 31. EU28 Gross flows, intra- vs extra-EU28EU-28, € millions EUR (2008Q4-2019Q4) .......................................................................................................................... 46 Figure 32. EU27 Gross Flows, intra- vs extra-EU27, million EUR, (2015Q4-2020Q2)...... 47 Figure 33. Brexit impact: comparison of EU-27 and EU-28 (2015-2019, quarterly moving averages) ............................................................................................................ 48 Figure 34. Gross FDI, EU-27, intra and extra, € millions, 2008Q4-2020Q2 ................... 49 Figure 35. EU FDI assets (left panel) and liabilities (right panel) by country, % of EU GDP .......................................................................................................................... 49 Figure 36. Gross Portfolio Investment, EU-27, intra and extra .................................... 50 Figure 37. Portfolio investment Assets (left panel) and liabilities (right panel) by country, % of EU GDP ........................................................................................................ 51 Figure 38. Gross Other Investment, EU-27, intra and extra ........................................ 52 Figure 39. Other investment, assets (left panel) and liabilities (right panel) by country, % of EU GDP............................................................................................................ 52 Figure 40. EU-27 countries NIIP, % of EU-28 GDP (annual) ....................................... 53 Figure 41. Country groups: Core, East and South ..................................................... 54 Figure 42. EU assets vis-à-vis EU country groups: Core, South and East, averages 2000- 09 and 2010-19, % of EU GDP ............................................................................... 55
Figure 43. Core countries: FDI asset flows towards Eastern and Southern member states, averages 2000-09 and 2010-19, in € millions ........................................................... 55 Figure 44. Core countries asset flows towards East: % of EU GDP .............................. 56 Figure 45. Core countries asset flows towards South: % of EU GDP ............................ 57 Figure 46. Quantity- and price-based indicators of financial integration in the euro area (1999-2019M9) .................................................................................................... 59 Figure 47. Intra-EU27 cross-border holdings of equity and debt, 2002Q1-2020Q2 ........ 60 Figure 48. Intra-EU27 FDI and portfolio investment ratio, 2002Q1-2020Q2.................. 61 Figure 49. Target2 balances, end of month position, € millions, 2008M5- 2020M10 ...... 62 Figure 50. Intra-Eurosystem positions, € million, 2016M6-2020M10 ............................ 65 Figure 51. Correlation between quarterly FDI inflows and Outflows, 2013-Q1 to 2019Q1 .......................................................................................................................... 67 Figure 52. FDI Inward Positions of the EU28EU-28 by immediate investor (€ billion) ..... 70 Figure 53. FDI Inward Positions of the EU-28 by type of recipient entity (€ billion)........ 71 Figure 54. Real FDI: Share of FDIs in non-SPEs, by EU member state (2018)............... 71 Figure 55. Real FDIs, direct and indirect (2018) ....................................................... 72 Figure 56. Investor and recipient economies of direct FDIs (2018) .............................. 72 Figure 57. Investor and recipient economies of indirect real FDIs (2018) ..................... 73 Figure 58. Intermediate country of real indirect FDIs ................................................ 73 Figure 59. World Trade Uncertainty Index, 1996Q1 to 2020Q2 ................................... 80 Figure 60. Trade Policy Uncertainty at country level (2005Q1-2020Q2), selected countries .......................................................................................................................... 82 Figure 61. EU-28 assets vis-à vis the US (lhs) and TPU in the US and the EU (rhs) ....... 83 Figure 62. EU-28 liabilities vis-à-vis the US (lhs) and TPU in the US and the EU (rhs) .... 83 List of Tables Table 2. Estimation of real FDIs .............................................................................. 69 Table 3. Real FDIs in EU-28 (€ billions and %) ......................................................... 74 Table 4. Real FDIs in EU-28 by recipient and type (€ billions) ..................................... 75 Table 5. Real FDIs in EU-28 by type of investor (€ billions) ........................................ 76 Table 6. Real FDIs in EU-28, by recipient country groups (€ billions) ........................... 77 Table 7. Real Core FDIs by recipient country groups (€ billions).................................. 78 Table 8. Sampling procedure using ORBIS data ........................................................ 95
Analysis of Developments in EU Capital Flows in the Global Context Executive Summary This report presents an analysis of the main trends and developments in global and EU capital movements up to 2019 and the challenges brought about by the Covid-19 pandemic. The global overview of capital flows and the impact of the Covid-19 pandemic Covid-19 has been a major shock across the world in 2020, and the impact on individuals, the society and the economy has been pervasive. Most countries are now trying to recover from the GDP collapse of the first half of the year, but there are significant obstacles to full recovery. Capital movements are not independent of such developments. While coordination and policy measures in advanced economies have helped to restore calm on financial markets and restart capital flows quickly, the impact of the pandemic has been sudden and large on flows, especially for emerging market economies (EMEs), and the shock continues. Even though further sudden stops are unlikely, it is very difficult to predict if and when flows will return to previous levels. Furthermore, the pandemic shock is adding to a context already characterised by high policy and political uncertainty at global level. This may lead to an amplification of pre- existing trends but also of vulnerabilities, especially in emerging market and developing economies (EMDEs). Overall, all these factors are very likely to result in higher volatility of financial flows and, at least in the short term, lower flows. Real economy investments, which are relatively small in size but are important for economic growth, are also likely to contribute negatively as they may remain on hold. The latter consideration also applies to advanced economies. The virus containment measures, namely the lockdown and social distancing, have resulted in the collapse of three crucial sources of income for several EMEs and developing countries: exports of commodity, tourism and remittances. For several countries, the fall in domestic income combined with weaker growth prospects may hamper the ability to finance expenditure and even to borrow. This will certainly be the case for those countries that have been cumulating increasing amounts of debt over the past few years and may struggle to find a counterpart to finance current account deficits. The IMF projects current account deficits to decline in all EMDEs in 2021. In addition, the plunge in oil prices by reducing, or even wiping out, the surplus of oil exporters is likely to have a substantial impact on capital inflows in EMEs. A significant part of the capital inflows into EMEs comes from sovereign wealth funds (SWFs) in West Asia and in Europe. China is the only country for which the current account is expected to expand in 2021. Uncertainty dominates the euro area surplus, which may be shrinking substantially because of the widespread lockdown measures in Europe. Against this background, the US, with its expansionary fiscal policy, may become the main counterpart of the Chinese surplus – a reminder of the situation before the great financial crisis, though financial accounts’ conditions are very different today than they were in 2007. While the world economy is expected to expand strongly in 2021, longer-term prospects for growth point to a weak outlook because of the persistence of social distancing (from people’s attitudes as well as policy measures), the need for sectoral restructuring, much higher debt levels, both private and public, and a protracted period of lower investments. Intra- and extra-EU flows and the state of EU financial integration The study looks in detail at intra- and extra-EU flows. The pandemic has not been the only major change in 2020. At the time of writing, yet no agreement has been reached between the EU and the UK on the latter’s exit from the EU block, but Brexit has become a reality 9
Analysis of Developments in EU Capital Flows in the Global Context in the statistics. Data for EU aggregates have been updated to include 27 member states instead of 28. By definition the change will result in a reduction of intra-EU capital flows and, in principle, an increase in extra-EU flows. In the absence of a clear deal between the EU and the UK, however, it is difficult to predict the extent to which Brexit will simply mean a shift from intra- to extra-EU capital flows, with no impact on the size, or whether flows will decline as a result, and herald a lower degree of financial integration. The study contributes to better understanding of EU capital flows on four main points. First, intra- and extra-EU flows fell substantially from the last quarter of 2017. While portfolio investments performed quite well (especially the intra-EU category), foreign direct investment (FDI) dropped quite dramatically. This effect appears to be temporary in nature, however, having been driven by a one-off change in US tax policy. The US Tax Cuts and Jobs Act of December 2017 strongly incentivised the repatriation of profits from abroad. The impact on intra-EU flows is likely to be related to US investment in the EU sometimes being channelled through a different country from the final destination of the investment. As the effect of the policy measures fade, all things being equal, flows should return to normal. However, because of the pandemic shock, any return to normal is likely to be offset by other factors. Second, the state of financial integration in the EU appears strong. Following the ECB approach, we compute indicators of resilience of financial integration to cover the EU-27. Overall, the resilience of EU financial integration appears to have improved strongly since the financial crisis. In the past couple of years, however, it seems to have levelled out, and some indicators even point to a slight deterioration from late 2018. The data for the first half of 2020 point a continuation of such trend without any major change. Third, longer-term trends in intra-EU capital flows have experienced some major changes. By looking at three geographical clusters of countries: Core (north and continental EU member states), East (new EU member states) and South (euro area southern member states), macro trends over the past two decades seem to point to the financial crisis as a major turning point. For the Southern member states, the crisis marked the end of large portfolio investment and a new era of substantial disinvestments from Core countries. By contrast, FDI and other investment remained quite resilient. For Eastern countries, FDI has represented a major source of flows and average figures do not suggest much change over the past two decades. Only data for the past year point to a fall, which for several reasons may indicate the beginning of a new trend. In addition, 15 years after the first Eastern enlargement, capital markets seem to have made limited progress in terms of capacity to attract other investment than FDI. A final point is that while Core countries have always been the main source of capital flows, since 2010 they have also become the main destination of investment. This group of countries is both home and host to the largest part of intra-EU flows, which have strongly increased in size over time. Four, TARGET2 balances provide an additional perspective for monitoring financial integration in the euro area. Since the debt crisis in the euro area, TARGET2 balances have received systematic attention as an indicator of imbalances that cannot be ‘naturally’ compensated by market funding streams and require resorting to the Eurosystem. In this perspective, TARGET2 balances are a useful indicator of the attractiveness of euro area countries and are monitored as a key indicator of the interbank market’s normalisation. The study notes that since 2015 imbalances have started to grow again and at the end of 2016 were larger than at the peak of the financial crisis. Lack of market liquidity and falling financial integration, however, are not the explanation for such an increase. This suggests that, at least partly, imbalances reflect the way transactions are recorded and are not necessarily a situation of financial distress. The study also highlights that while TARGET2 is the primary – in terms of magnitude – consolidation adjustment mechanism of the Eurosystem, it is not the only one. Considering intra-Eurosystem positions as a whole 10
Analysis of Developments in EU Capital Flows in the Global Context suggests that cross-country imbalances are overall smaller and have been changing in a much smoother fashion than the TARGET2 balances. EU FDI The study contributes an important analysis of the size and counterparts of EU FDI. FDI is usually considered an important driver of international economic integration and of economic growth. There is growing consensus, however, that current statistics about total FDI substantially overestimate their expected productivity gains. The study looks in depth at EU member states inward FDI positions driven by intra- and extra-EU flows, with the purpose of distinguishing ‘real’ FDI from those channelled by Special Purpose Entities (SPEs). The latter are often empty shells and inward FDI have no or limited impact on the real economy of the receiving country. In 2018, according to Eurostat data, the stock of inward FDIs in the EU-28 countries amounted to approximately €15 trillion. More than half of this (some €8.4 trillion) originated in other EU-28 countries, while 45% (about €6.7 trillion) came from non-EU economies. Following the approach of Dagmaar et al. (2019), we calculate ‘real’ EU FDI positions by netting FDI involving SPEs. The study finds that just less than half (47.5%) of the total inward FDI positions in the EU-28 involves SPEs. In Luxembourg, Malta and Cyprus, the stock of inward FDIs is almost entirely (more than 90%) directed into SPEs, in the Netherlands more than two thirds and in Hungary close to half. By contrast, in the larger EU economies such as France, Germany, Italy and also Spain, inward FDIs are totally or almost totally real. Based on EU company level data, the stock of ‘real’ FDIs is decomposed by immediate and ultimate investors. Standard statistics that rely on the location of the immediate investors could be misleading in identifying the actual source of investment. The study finds that for about €2.1 trillion of the stock of real FDIs in the EU-28 (about one quarter of the total), the country of the ultimate investors is different from that of the immediate investors, i.e. the investment decisions and the associated risks are ultimately borne by companies residing in a different country from the one from where the FDI position is reported under the official statistics. The US is not only the most important direct investor (where immediate and ultimate investor country coincides) but also indirect investor into the EU- 28. The US accounts for about 40% of the indirect real EU FDIs. Overall, it is estimated that about €1.1 trillion of FDI in the EU (about 14% of the total real FDIs’ position in the EU-28) originates from ultimate investors residing outside of the EU- 28 countries, while the investment is intermediated by one of the EU-28 countries. Such an amount is typically included in official statistics as intra-EU FDI. Among EU countries, the largest difference between real immediate and real ultimate FDI investors is registered in Luxembourg and the Netherlands. Real FDI with ultimate owners resident in Luxembourg and the Netherlands are much lower than the total. On the contrary, the real ultimate FDIs from the US are estimated to be some 75% larger (€1.8 trillion) than real immediate FDIs (€1 trillion). With the exception of Switzerland, for all non-EU countries, FDI (into the EU) based on ultimate investor location, is substantially larger than real immediate FDI. While these results are based on estimations and exact numbers should be taken with a pinch of salt, their magnitude leaves little doubt about the importance. This exercise has important wider implications. A very clear one is that standard statistics based on FDI overestimate financial integration links between EU-28 member states and underestimate the integration between large EU economies and non-EU countries. The international role of the euro and the asset composition of reserves 11
Analysis of Developments in EU Capital Flows in the Global Context The study contributes to the growing academic and policy debate about the international role of the euro by looking into one specific aspect of the international role of a currency, namely, demand for reserves. Evolving features of this demand, in terms of asset composition, and the inclusion of official holdings other than foreign reserves, as demand for international currencies, can offer a wider perspective on the potential of the euro. Central banks that hold very large amounts of reserves are unlikely to need all their reserves to intervene in foreign exchange markets. Some of these central banks de facto manage the savings of their own country. This situation is similar to one in countries, most often commodity exporters, where an SWF manages the income generated by exports. Such central banks and SWFs manage a huge amount of resources, which, through their investment, massively affect the international role of a currency. Yet, unlike in the case of official reserves, the currency composition may be less important than the instrument composition. Interestingly, when managing savings instead of the exchange rate, the target of the investment tends to be different from traditional safe, liquid, short-term assets, i.e. sovereign bonds. The typical instruments of official reserves are likely be replaced by others yielding higher returns. In practice, SWFs mostly invest in equities. In recent years, some central banks appear to have extended the maturities of their purchase and to have moved towards riskier assets. Both points suggest that development of equity markets in the EU could, among other objectives, contribute to boosting the international role of the euro. Capital Markets Union (CMU) developments can contribute to increasing the supply of euro-denominated equities in international markets. In global markets, equities are by far and large denominated in US dollars (USD). For investors, USD-denominated equities may not be a choice out of preference but rather from lack of opportunities, given the limited availability of euro- denominated assets. In a similar vein, euro-denominated EU bonds with long maturities to be issued under the Next Generation EU (NGEU) programme are also likely to be attractive to official holders. Conclusions In the short term the key policy priority for governments will be to mitigate the impact of the pandemic and counter the recession. Yet many countries, both EMDEs and advanced economies, are already facing the difficult dilemma of how to implement measures to support growth (over a protracted period of time) while avoiding further build-up of debt that will be hard to service in the future. Such developments are important for capital flows. Investors may become more selective when choosing the destination of their funds than they have been in the past. A key insight from the study is that policy implications based on the analysis of statistics that do not properly represent reality (any more) may be disappointing. The in-depth analysis on the nature of FDI suggests that what is called FDI includes capital flows, which have little to do with FDI in a traditional sense. This general finding is not new, and the OECD, IMF and Eurostat are very aware of the need to improve available statistics. Our findings show that as much as 50% of total inward FDI positions in EU countries are directed in SPEs, and that as much as 1 trillion of FDI inward positions, believed to be intra- EU investment, are in reality coming from abroad and intermediated by an EU country. Disregarding this aspect can lead to serious double counting and misleading calculations. The finding has several implications from the policy perspective: i) growth and employment creation associated with FDI is much lower than one would expect from simply looking at sheer numbers; ii) FDI flows, which should be a source of resilient financial integration, may be less stable than assumed and unable to deliver international risk sharing in the face of asymmetric shocks; and iii) tax policy measures may be more powerful than growth strategies in affecting FDI. 12
Analysis of Developments in EU Capital Flows in the Global Context List of Acronyms APP Asset Purchase Programme BIT Bilateral investment treaty CDIS Coordinated Direct Investment Survey COFER Currency Composition of Official Foreign Exchange Reserves CMU Capital Markets Union ECB European Central Bank EMDEs Emerging Market and Developing Economies EMEs Emerging market Economies EMU Economic and Monetary Union EPU Economic Policy Uncertainty FDI Foreign Direct Investment NCB National Central Banks NGEU Next Generation EU NIIP Net International Investment Position SPEs Special Purpose Entities SWF Sovereign Wealth Fund SWIFT Society for Worldwide Interbank Financial Telecommunication TARGET Trans-European Automated Real-Time Gross Settlement Express Transfer System TPU Trade Policy Uncertainty USD US Dollar WEO World Economic Outlook WTO World Trade Organization 13
Analysis of Developments in EU Capital Flows in the Global Context 1 Introduction This study aims to monitor and analyse capital movements in the European Union in the global context. Free movement of capital is a condition for economic growth and a key pillar of the EU single market. Views about capital movements have often fluctuated over time between seeing them as highly desirable or a source of vulnerability, as a driver of economic growth or disconnected from the real economy. While different judgements can hold in different periods or regions, there is no doubt that macroeconomic conditions, uncertainty and policies strongly interact with capital flows and affect their size, direction, instrument and outcome. In recent years, changes in global economy conditions have altered cross-border flow and, most likely, more change is to come. The major, unforeseen shock of Covid-19 in 2020 has had a pervasive impact on individuals, the society and the economy, with massive human loss across the entire world. Most countries, in the absence of a vaccine or a cure, have been forced into lockdown and social distancing to contain the spread of the contagion. This has led to the collapse of economic activity and the extent of the consequences are still uncertain, not least because the pandemic is ongoing. Unfortunately, there is no doubt that GDP losses are larger than those of the global financial crisis of 2009 and the range of impacts will be unlike anything experienced in the past century. In April 2020, just two months after the outbreak of Covid-19, the IMF forecasted severe falls in GDP for all countries, and negative real growth rates everywhere except China (and India). The updated estimates realised in June, and which accounted for the impact of the lockdown in Q2, forecasted even larger falls in almost all countries. This appears to be the case especially for advanced economies, where the decline has a double-digit number and is expected to be persistent, leading to a level of GDP below 2019Q4 until the first quarter of 2021 (see Figure 1). In EMDEs, the revision of the estimates has been less substantial, but it may take until 2022 to return to the level of 2019. Figure 1. Quarterly GDP (2019Q1=100, dashed lines indicate WEO estimates from April 2020) 115 110 AE April 105 2020 100 AE June 2020 95 EMDE 90 April 2020 85 EMDE June 2020 80 Source: Based on IMF, WEO April 2020 and update June 2020. 14
Analysis of Developments in EU Capital Flows in the Global Context The partial return to economic activity over the summer resulted in better than anticipated performance and a further revision of the forecasts. As we write, the world economy is projected to fall by 4.4% and the euro area by 8.3%, compared with 4.9% and 10.2% respectively, as forecasted in June (see Table 1). Table 1. Real growth rates comparison (selected regions and countries) Projection Projection June October 2020 2020 2019 2020 2021 2020 2021 World 2.8 -4.4 8.5 -4.9 5.4 Advanced economies 1.7 -5.8 3.9 -8.0 4.8 US 2.2 -4.3 3.1 -8.0 4.5 EA 1.3 -8.3 5.2 -10.2 6.0 Germany 0.6 -6 4.2 –7.8 5.4 France 1.3 -9.8 6 –12.5 7.3 Italy 0.3 -10.6 5.2 –12.8 6.3 Spain 2.0 -12.8 7.2 –12.8 6.3 UK 1.4 -9.8 5.9 –10.2 6.3 Japan 0.7 -5.3 2.3 –5.8 2.4 Emerging market and 3.7 -3.3 6 -3.0 5.9 developing economies China 6.1 1.9 8.2 1.0 8.2 Source: IMF, WEO, October and June 2020. Yet the further spread of the virus since the beginning of the autumn has meant an increase in the downside risks. Many countries are reinstating lockdown measures, and uncertainty remains extremely high for the last quarter of the year. Policymakers have taken unprecedented measures to offset the negative impact of such a double shock to demand and supply, and to foster the recovery. The magnitude and the length of the shock, however, make the shape of the recovery unclear and highly dependent on the waves of the pandemic. This will be the case even if governments – and this is clearly the case in the EU – are committed to maintaining support measures for as long as they are necessary. The recovery that took place over the summer exposed the strong sectoral impact of the crisis and changes in people’s behaviour that are likely to remain even after the pandemic is under control. In addition, the longer the pandemic lasts, the higher the probability that more countries will face a combination of economic, financial and social crises. Capital movements are certainly not independent of such developments. The impact of the pandemic has been sudden and immediate. News about the spread of the virus in early 2020 led to a very quick and deep fall in cross-border flows. They stabilised in the following months but it is still unclear if and when they will return to previous levels. In the short run, it is also difficult to predict whether the new waves of pandemic will lead to new falls or long lasting effects. As will be argued throughout the study, the pandemic shock is exacerbating uncertainty in a context of already high policy and political uncertainty. All in all, these factors are very likely to result in higher volatility for financial flows and, at least in the short term, lower flows, as real economy investment is put on hold. The rest of the study is organised as follows. Section 2 monitors global trends and developments in international capital movements over the past 15 years. This is complemented by an overview of the situation in EMEs and developing countries, with a focus on two aspects: exchange rate and current account developments, and the ongoing debate on debt relief in Africa. 15
Analysis of Developments in EU Capital Flows in the Global Context Section 3 looks at the recent debate on how to enhance the international role of the euro. It investigates two specific aspects with a novel dimension: the accumulation of foreign assets by SWFs, which has been growing over time and has similarities with central bank reserves’ accumulation, and the use of international currencies in global trade invoicing. Section 4 first offers an overview of intra-EU capital flows, then focuses on the evolution of flows across clusters of member states over the past two decades. The third part gives an overview of the measures of resilience of financial integration. The last part focuses on the euro area and inspects intra-Eurosystem positions, including TARGET2, and their meaning for financial integration. Section 5 is devoted to EU FDI. First, it develops an in-depth analysis of EU inward FDI positions, driven by intra- and extra-EU flows, with the purpose of distinguishing real flows from those channelled by SPEs. The latter are often empty shells with no string links with the local economy. In such cases, inward FDIs have no or limited impact on the real economy where the SPEs is located. Following Dagmaar et al. (2019), we call these flows phantom FDI. Once real flows are disentangled from phantom FDI, a full EU-28 FDI network position (as well for each EU member state) is estimated. We distinguish positions in countries hosting the ultimate and immediate investor. This is the basis for redefining a real network of FDI. Section 6 investigates the potential impact of trade policy uncertainty on EU FDI, in particular EU-US FDI, as the US is the main source of trade uncertainty at global level and the main investment partner of the EU. Section 7 concludes by drawing policy considerations based on the evidence provided in the study and highlighting the risks to capital flows associated with the pandemic. 2 Global trends and developments in a highly uncertain landscape This section presents a global overview of the main components of the balance of payments, namely current account and financial account, to show the broad direction of capital flows across countries and over time. For clarity, countries are clustered into groups based on similar characteristics, as shown in Box 1. Box 1. Definition of the country groups The identification of the country groups follows Claeys et al. (2019). Such clustering is reasonable, makes the data visualisation readable and ensures no disruption compared with the analysis in previous reports on EU capital movements. Criteria for the groups are mainly common characteristics and global relevance, as measured by GDP. The groups are: • China • Deficit advanced economies: Australia, Canada and New Zealand • Deficit emerging economies: India, Indonesia, South Africa and Turkey • Euro area: 19 countries • Financial centres: Hong Kong, Singapore and Switzerland • Japan • Latin America: Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico and Uruguay • Non euro-area Central and Eastern Europe (CEE) countries: Bulgaria, Croatia, the Czech Republic, Hungary, Poland, and Romania • Non euro-area Nordics: Denmark and Sweden • Oil exporters: Norway, Russia and Saudi Arabia • Surplus Asia: Philippines, South Korea and Thailand • United Kingdom • United States of America 16
Analysis of Developments in EU Capital Flows in the Global Context 2.1 An overview of global flows and stocks In modern economies, the current account balances, which reflect savings and investments, are not equivalent to capital flows, which reflect the ability of a country to lend, borrow and perform financial intermediation. Yet before moving to the detailed analysis of the different categories of capital flows, it is instructive to look at global trends and the state of current account balances. These are informative about resource availability and potential constraints in lending and borrowing associated with the real economy. Until the outbreak of Covid-19, the two countries with the largest world current account deficit since 2009 (see Figure 2) have shown limited change in their balances. The US deficit continues oscillating around 0.6% of the world GDP and the UK’s at around 0.12%. Other deficit countries have slightly reduced their negative position. On the surplus side, over time, the large current account surplus of China has almost disappeared, and it shows a mild rebound in 2019. China’s place was taken by the increasing surplus of the EU and of other Asian countries, including Japan. In 2019, the euro area current account surplus exhibited a small decline compared with previous years but remained the largest on a global scale. According to AMECO and Eurostat balance of payment data, the euro area current account surplus declined from 3.1% of euro area GDP to 2.7% in 2019, and the EU from 3% to 2.8%. In the euro area the decrease was driven by a smaller surplus for services (down from €116 billion in 2018 to €68 billion in 2019) and primary income (down from €95 billion to €81 billion). The latter was largely caused by developments in the investment income balance (down from €65 billion to €55 billion), which mainly reflected a lower surplus in direct investment income. Such developments were marginally offset by an increase in the surplus for goods. Figure 2. Current account balances, % of world GDP, 2005-2019 & 2020Q1-2 2 United States 1.5 United Kingdom 1 Surplus_Asia 0.5 Oil_Exporters NonEuroNord 0 NonEuroCCE -0.5 Latin_America -1 Japan -1.5 Financial_Centre -2 Euro_Area Deficit_Emerging -2.5 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2019-Q1 2019-Q2 2019-Q3 2019-Q4 2020-Q1 2020-Q2 Deficit_Advanced China Source: IMF, International Financial Statistics (IFS) and World Economic Outlook (WEO), October 2020. Note: See Box1 for group composition. It is still too early to say how persistent the changes illustrated by the 2020 data will be, but the first two quarters indicate a quite drastic fall in euro area surplus, an increase in 17
Analysis of Developments in EU Capital Flows in the Global Context the US deficit and the return of a large China surplus. To a large extent they reflect the timing of the impact of the pandemic. China was hit before the rest of the world, and so able to restore supply almost fully in the second quarter while the EU economy was in lockdown and the US undertaking a fiscal stimulus. It should be noted that the figures for 2020 presented above ‘hide’ a large fall in global trade transactions and a fall in world GDP of about 5%. Yet, based on recent data, China’s trade is recovering strongly, and manufactured exports are expected to reach about $2.5 trillion in 2020.1 At the moment, China is the only world country experiencing an increase in exports. The increase has been driven by high world demand for medical and personal protective goods and a boom in office machinery2 to facilitate remote working, two sectors that are strengths of China. The fall in outbound travel is likely to have contributed to an increase in China’ s current account surplus, by reducing the deficit in services. While the drivers of China exports’ expansion look at the moment to be of temporary nature, other world countries have reduced either their surplus or their deficit, and as matter of fact the US deficit is the main counterpart to China’s surplus. If such developments continue, we may see old trends re-emerging and the two main sides of the pre-financial crisis global imbalances, China and the US, resuming their roles. Pre-pandemic, longer-term developments in the current account balances are largely reflected in the net financial account balances, with limited changes in 2019, compared with the previous two years (see Figure 3). By contrast, the data for 2020 point to a substantial reduction in the positive balances, and in particular that of the euro area and Japan, whereas the US, the UK and the financial centres display a negative balance, similar to in the past. More details about the drivers behind these changes are given in the following sections. Figure 3. Financial account balances, % of world GDP, 2005-2020Q2 (annual and quarterly) 2 United States 1.5 United Kingdom 1 Surplus_Asia 0.5 Oil_Exporters 0 NonEuroNord -0.5 NonEuroCCE -1 Latin_America -1.5 Japan -2 Financial_Centre Euro_Area -2.5 Deficit_Emerging -3 2013 2005 2006 2007 2008 2009 2010 2011 2012 2014 2015 2016 2017 2018 2019 2019-Q1 2019-Q2 2019-Q3 2019-Q4 2020-Q1 2020-Q2 Deficit_Advanced China Source: IMF, International Financial Statistics (IFS) and World Economic Outlook (WEO), October 2020. 1 See OECD https://www.oecd.org/sdd/its/International-trade-statistics-Q2-2020.pdf 2 See UNCTAD global trade update https://unctad.org/system/files/official-document/ditcmisc2020d2_en.pdf 18
Analysis of Developments in EU Capital Flows in the Global Context Reserve accumulation activities declined strongly after 2013 owing to changes in China’s behaviour and the fall in surplus of oil-exporting countries (see Figure 4), low negative and positive flows remained quite stable in 2018 and 2019. In 2020, because of the dramatic fall in the price of oil (see next section on this point) and foreign exchange interventions to support currency pegs, reserves of oil exporters declined in both quarters. Also, China registered a fall in Q1, but the signs had already taken a positive turn by Q2. The swing is likely to reflect the current account balance and interventions in the foreign exchange markets to stabilise the renminbi. The largest increase in reserves was registered in financial centres in both quarters of 2020. Financial centres also increased their reserve accumulation in the aftermath of the global financial crisis.3 Figure 4. Reserve and related items, % of world GDP, 2005-19 & 2020Q1-2 2 United States United Kingdom 1.5 Surplus_Asia 1 Oil_Exporters NonEuroNord 0.5 NonEuroCCE Latin_America 0 Japan Financial_Centre -0.5 Euro_Area Deficit_Emerging -1 2010 2016 2005 2006 2007 2008 2009 2011 2012 2013 2014 2015 2017 2018 2019 2019-Q1 2019-Q2 2019-Q3 2019-Q4 2020-Q1 2020-Q2 Deficit_Advanced China Source: IMF, International Financial Statistics (IFS) and World Economic Outlook (WEO), October 2020. Until 2019, when moving from flows to stocks, the Net International Investment Positions (NIIP) show that most individual countries and country groups continued to reinforce their respective position, either as creditor or debtor (see Figure 5). The main exception is the euro area, which eliminated its negative position. Its net international investment position vis-à-vis the rest of the world is now at zero. In a forward-looking perspective, it is reasonable to expect that the international investment positions will continue along the same path as in the past, and possibly widen because of the large fall in GDP (the denominator of the ratio). From next year onwards, the expected strong recovery in GDP, paired with persistent subdued flows, may result in a contraction of both creditor and debtor positions. 3 See Section 3 for a detailed analysis of developments of international reserve assets. 19
Analysis of Developments in EU Capital Flows in the Global Context Figure 5. Net International Investment Position, % of world GDP, 2005-19 15 United States 10 United Kingdom Surplus_Asia 5 Oil_Exporters NonEuroNord 0 NonEuroCCE Latin_America -5 Japan Financial_Centre -10 Euro_Area Deficit_Emerging -15 Deficit_Advanced -20 China 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: IMF, International Financial Statistics (IFS) and World Economic Outlook (WEO), October 2020. 2.2 Global net and gross flows by investment class This subsection monitors the evolution of the global distribution of net and gross flows by investment class in the financial account: FDI, portfolio investment and other investment, with special attention to the developments in 2020.4 It should be noted that net financial account balances hide all purely financial transactions, which would be reflected in the gross balances. Net balances thus offer a narrower perspective to capital flows. Foreign direct investment From the perspective of the real economy and economic growth, FDI usually represent the most important investment category of the financial accounts. To better guess how trends in global FDI could evolve in the future, it is instructive to start by looking at the long-term data of global FDI. During the past three decades, FDIs have been characterised by three different phases with very different growth rates (see Figure 6). After two periods characterised by a very high growth rate, FDI have stagnated since the global financial crisis. A slightly negative average growth rate over the decade 2008–19, compared with double-digit rates in the previus two decades, hides higher volatility than in the past. This is caused by several factors, but on a global scale, the sharp fall in 2017 and 2018, which came after a quite strong recovery, is widely attributed to the effect of the US tax reforms on developed economies. The recovery in 2019 is likely to have been driven by the winding down of such effects.5 4 It is worth recalling that net flows correspond to the difference between (net) acquisition of assets, often referred to as gross asset flows, and (net) incurrence of liabilities, often referred to as gross liability flows. A positive net flow (i.e. when the flow of acquisition of foreign assets exceeds the flow of incurrence of liabilities to non- residents), thus translates into net outflows of capital. Equivalently, a negative net flow means an inflow of investment. See Claeys et al. (2019) p. 28. 5 See UNCTAD (2019) https://unctad.org/en/pages/newsdetails.aspx?OriginalVersionID=2118 20
Analysis of Developments in EU Capital Flows in the Global Context Figure 6. Global FDI inflows, 1990-2019 (Indexed, 2010 = 100), average growth rates over the sub-period 180 1990-2000: 22.6% 2000-2007: 2008-2019: -0.3% 12.2% 120 60 0 Source: CEPS (2020) based on UNCTAD data. More generally, the mild nature of the recovery of 2019 and the ups and downs of the past decade seem to point to a lower growth rate in the underlying trend than in previous decades. Reduced growth rates and increased volatility are likely to have been the result of the geopolitical risk, trade tensions and more protectionist policies that have been dominating the global stage and made the context less favourable for cross-border investment. The recovery that marked 2019 is not expected to continue. The Covid-19 pandemic has already showed its impact on investment. According to the OECD, in 2020, FDI will fall by more than 30%.6 UNCTAD estimates an even larger fall, of 40%. If these estimates are correct, FDI would fall from about $1.6 trillion (net inflows) in 2019, to below $1 trillion (close to the level of 2004).7 According to UNCTAD the fall would continue in 2021 with no recovery until the following year. In practice, the actual flows will depend very much on the evolution of the health crisis and the policies in place to limit contagion. The reinstatement of lockdown measures in late 2020 is likely to slow economic activity again and many multinational companies may reassess new projects. When looking at the regional composition of net FDI flows (see Figure 7), while some countries such as China, Latin America, financial centres, and deficit countries (both advanced and emerging) are systematically net receivers of FDI, others such as Japan and, until 2018, the euro area, are net senders. By contrast, the US and the UK seem to alternate positive and negative net positions. For the US, 2015 was the year of the change into negative net. For the euro area the change from net sender to net receiver was 2019. Given that this is the first time in 15 years, it is worth monitoring whether this is occasional or the sign of a more persistent change. 6 https://read.oecd-ilibrary.org/view/?ref=132_132646-g8as4msdp9&title=Foreign-direct-investment-flows-in- the-time-of-COVID-19 7 https://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD 21
Analysis of Developments in EU Capital Flows in the Global Context Figure 7. Net Foreign Direct Investment Flows, % of World GDP - 2005-2020Q2 1.5 United States United Kingdom 1 Surplus_Asia 0.5 Oil_Exporters NonEuroNord 0 NonEuroCCE Latin_America -0.5 Japan Financial_Centre -1 Euro_Area Deficit_Emerging -1.5 2017 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2018 2019 2019-Q1 2019-Q2 2019-Q3 2019-Q4 2020-Q1 2020-Q2 Deficit_Advanced China Source: IMF, International Financial Statistics (IFS) and World Economic Outlook (WEO), October 2020. The preliminary data for 2020 seem to confirm that the euro area will continue to be a net receiver. It should be recalled, however, that the EU is the main FDI partner of the US. The negative spike in US FDI inflows in 2018 and its continuation in 2019 are related to repatriation of previous earnings from US multinationals after the enactment of the Tax Cuts and Jobs Act of 2017.8 The US policy change is likely to have driven adjustments in EU flows (see section 6). Over the past year and half, quarterly data for the euro area exhibit a change of sign from one quarter to another, suggesting very volatile flows. Lastly, the data for the second quarter of 2020 show a very large inflow (worth about 0.75% of world GDP) into the euro area. While this may be driven by the pandemic and some flight to safety, pre-existing volatility makes this hypothesis weak at this stage. Interestingly, when considering the gross flows, both assets and liabilities (see Figure 8 and Figure 9) point to a substantial fall, in 2018 and 2019 and potentially also in 2020, which is not visible in the net FDI flows. As argued in Claeys (2019), and in line with the above, the decrease in gross FDI asset flows in 2018 was mainly driven by the US and the euro area, which both exhibited a decrease in the FDI asset flows for the first time since 2005. The large decrease in the euro area asset and liability gross flows of 2018 disappeared in 2019. In 2019, assets became positive again for both the US and the euro area but remained smaller relative to the past. In the first two quarters of 2020, the same situation seems to continue. Both in 2018 and 2019, Japan was the main source of global FDI. As it will be argued in more detail in section 6, gross flow statistics also include flows that intermediate investment from the country of the ultimate investor to the final destination. This may lead to double counting and an overestimation of gross flows. The collapse in FDI flows in 2018, and to some extent in 2019, captured in the statistics, is very likely to be associated with the activity of SPEs, which are used as a conduit in the EU and in other countries. They are likely to have played a role in the repatriation of profits following the Tax Cuts and Jobs Act. 8 See Claeys at al. (2019) for the significance of the US Tax Cuts and Jobs Act its effect on global capital flows. 22
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