The writer is chief Emea economist at S&P Global Ratings
This year marks 30 years of the European single market. In many ways, it has been a success and has driven significant economic growth across the region. However, it is not yet a full economic union. The banking and capital markets union is still incomplete — and this is holding the EU back.
As a result, the free movement of goods and workers in the bloc is not being matched by the free movement of capital. Data shows that private capital flows across borders within the EU have not increased since the global financial crisis, with cross-border financial claims accounting for nearly 100 per cent of EU gross domestic product in 2022, the same as in 2007.
What’s more, this private investment, driven by private savings, isn’t reaching the areas that really need it. Capital flows are moving within the north and the core of the EU, as investors perceive risk in eastern and southern Europe to be too high, despite better potential returns.
In 2022, southern European countries received roughly 50 percentage points less financing from other European countries than in 2008. The growth of domestic savings pools across Europe appears at odds with this picture.
Why is this a problem? The east and the south need investment to catch-up with the rest of the EU. Without such investment, the EU will not reap the full benefits of its single 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 down the barrel of a recession, it’s more important than ever that the union is resilient to shocks.
There are two ways that the EU can solve this financing conundrum.
First, it could fill the private investment gap with public subsidies, similar to the post-pandemic recovery Next Generation EU plan. Data shows that more public investment in developing regions can maintain appetite from private investors, although so far there is mixed evidence to suggest it can be increased.
Years of cohesion and regional development funding have undoubtedly fostered economic growth in the south and the east of the EU, but they have barely improved capital markets’ perception of risk there, as intra-EU financial claims have stagnated since the global financial crisis. Therefore, to support the development of these regions, and to ensure that the bloc is resilient to further shocks, more public funding will be needed. The north and core of the EU will bear this cost — its scale is difficult to quantify and, for national leaders, it will be politically unpopular.
Alternatively, the EU can decide to complete its banking and capital markets union. This would increase private risk sharing, making it easier for pools of private capital to be distributed to the countries that need it. It would help poorer EU countries avoid becoming ever more reliant on public transfers and it is also a cheaper solution.
There is evidence that the EU can leverage private risk sharing within its original banking and capital markets union framework. While bond financing and bank lending to southern EU countries have diminished substantially — by 50 percentage points of the southern nations’ 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 per cent of those countries’ GDP. So the capital markets union, which aims to promote equity financing, is a wise political choice.
The rise 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 framework, Luxembourg has become Europe’s main location for undertakings for collective investment in transferable securities (UCITS) and alternative investment funds, with 27 per cent market share, ahead of Ireland (19 per cent).
Of course, completing a banking and capital markets union is not easy. We have already made progress but we need to move forward before 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 there is another crisis, the governments of EU nations could be faced with a stark choice. Put more public money in to provide fiscal and monetary stimulus to support the bloc’s fragile economies. Or make the banking and capital markets union work. The EU’s stability and prosperity relies on such improvements.