Policy change needed to accelerate investment in structural transformation

Laurence Boone, Debora Revoltella 06 December 2019

a

A

For the past two years, global growth outcomes and prospects have steadily deteriorated, dragged down by persistent policy uncertainty and weak trade. Investment growth has collapsed in tandem, just when it needed to speed up in response to historic challenges: digitalisation, climate change, trade relations. Urgent policy action is needed to enable the necessary investment for a successful transformation that benefits all. 

This is especially the case in Europe (European Commission 2019, Boone and Buti 2019). The OECD’s latest Economic Outlook and the 2019 Investment Report of the European Investment Bank (EIB) highlight how policies need to change to address these challenges. 

Structural factors are a drag on investment and growth

Global GDP growth is projected  to remain around 3% for 2020-21, down from the 3.5% rate projected a year ago and the weakest since the global financial crisis (OECD 2019). GDP growth in the US is expected to slow to 2% by 2021, while growth in Japan and the euro area is expected to be around 0.7 and 1.2%, respectively. China’s growth will continue to edge down, to around 5.5% by 2021. Other emerging market economies are expected to recover only modestly, amidst imbalances in many of them. Overall, growth rates are below potential.

The bigger concern is the deterioration of investment and future prospects, reflecting unaddressed structural changes:

  • China’s structural rebalancing away from exports and manufacturing towards more consumption and services means that its traditional contribution to global trade growth is set to slow. India is set to grow rapidly, but its growth model is different and its contribution to global trade growth will not be enough to substitute for China. 
  • Trade is also changing structurally as a result of digitalisation, the rise of services, and geopolitical risks (WTO 2018). The past two years have seen a surge in trade-restricting measures (OECD-WTO-UNCTAD 2019) and government support across a range of sectors, and an erosion of the rules-based global trading system, which exert a drag on current demand by reducing incentives to invest and undermine medium-term growth. 
  • The lack of policy direction to address climate change weighs on investment. The number of extreme weather events is on the rise, which may lead to significant disruptions to economic activity in the short term and long-lasting damage to capital and land, as well as to disorderly migration flows. Adaptation plans are in their infancy, while mitigation – moving away from fossil fuels through measures such as carbon taxes – has proved technically and politically challenging (UNEP 2019). Without a clear sense of direction on carbon prices, standards and regulation, and without the necessary public investment to accelerate the energy transition, businesses may put off investment decisions, with dire consequences for growth and employment (Fried et al. 2019). 
  • Digitalisation is transforming finance, business models, and value chains. Only a small fraction of businesses appear to have successfully harnessed the strong productivity potential of digital technologies, which partly explains why digitalisation has been unable to offset other headwinds on aggregate productivity (Sorbe et al. 2019). Reaping the full benefits of digital technologies requires complementary investments in computer software and databases, R&D, management skills and training, which remains a challenge for too many firms. Digitalisation is also affecting people, granting a huge advantage to workers with cognitive and creative skills while penalising routine tasks, and at the same time generates new forms of contractual arrangements that escape traditional social protection. But the policy environment concerning skill upgrading, social protection, access to communication infrastructure, digital platform development, competition in digital markets and regulation of cross-border data flows lags behind, making it difficult to reap the benefits of digitalisation in full.

Against this backdrop, investment growth has slowed dramatically, from above 5% a year in 2017 down to less than 1% in 2019 in G20 economies, and it could fall further as the slowdown spreads to the service sector. It would be a policy mistake to consider these shifts as temporary factors that can be addressed with monetary or fiscal policy – they are structural. In the absence of clear policy directions, uncertainty will continue to loom high, damaging investment and growth prospects. 

Signs of slowing investment in Europe

In Europe more specifically, investment over GDP is back at long-term average levels in the North and the East, but well below in the South of Europe (EIB, 2019a). However, the EIB Investment Survey (EIBIS) of 12,500 firms across the EU reveals that they have become more pessimistic about the political and regulatory environment and expect the macroeconomic climate to worsen and to weigh negatively on investment. The number of EU manufacturing firms planning to decrease investment in the current year has risen for the first time in four years, to 27% (EIB 2019b). 

Figure 1 Firms’ perceptions of political and economic climate (percent of firms expecting improvement minus percent expecting deterioration)

Source: EIBIS 2019.

An investment slowdown in Europe is not just a short-term concern, but could undermine the pace at which underlying structural challenges are addressed. 

Bold direction-setting is needed for European climate policy

Investments needed to achieve the energy transition are progressing, but R&D lags behind. The EU invested €158 billion in climate change mitigation in 2018. At 1.2% of GDP, this is now marginally less than the US (1.3%) and little over a third of China’s performance (3.3% of GDP). Europe leads in energy efficiency investments, but lies behind the US and China in climate-related R&D, which will be critical for the deployment of new technologies as well as for future competitiveness (EIB 2019a). 

Figure 2 Climate change mitigation investment per sector, in billions of euros (left-hand side) and percent of GDP (right-hand side)

Source: IEA, BNEF, Eurostat, and EIB estimations.

To achieve a net zero-carbon economy by 2050, the EU must raise total investment in its energy systems and related infrastructure from the current level of around 2% to more than 3% of GDP, both public and private (European Commission 2018). More will be needed when all investments to decarbonise the transport sector are considered. Some two-thirds of investment will need to come from energy users – including building insulation, improving industrial processes and new transport technologies – potentially adding to the social impacts of change and enhancing the need for a just transition (EIB 2019c). Especially high levels of investment will be required for the Eastern and Southeastern EU countries.

Figure 3 Energy-related investment needed, 2021-2050, for net-zero carbon by 2050 (percent of GDP)

Note: Additional investment required is estimated as the difference btween the scenarios consistent with +1.5oC and a baseline scenario that reflects the current EU decarbonisation trajectory (including 2030 targets). Low-income Member States (GDP <60% of the EU average in 2013): BG, CZ, EE, HR, HU,LT, LV, PO, RO, SL. Source: European Commission (2018), EIB calculations.

Europe needs to accelerate research and digitalisation adoption to keep up

Europe is showing some delays in digitalisation. Some 58% of EU firms have adopted at least one digital technology, compared to 69% in the US. And while 61% of service sector firms in the US can be classified at least as digital adopters, only 41% of European firms in services are ‘digital’. In manufacturing, the gap is narrower. 

The EU also lags behind in terms of R&D and is risking a gradual loss of global competitiveness, with slow firm dynamism, innovation and adoption of digital technologies standing in contrast to rapid technological change worldwide and the emergence of new global players. The US spends almost 1 percentage point of GDP more on R&D than the US (a gap principally explained by lower business R&D spending in Europe), and China’s R&D investment has also now surged ahead, both as a share of total world R&D and as a percentage of GDP. Many European companies are major global R&D players, but most of those are in the automotive sector (which is facing structural change) and relatively few are in fast-growing technological and digital sectors. European companies make up only 13% of those that entered the group of top R&D global spenders since 2014, compared to 34% for the US and 26% for China.” 

Figure 4 Geographical distribution of 2018 R&D spending, by sector and among new global leading firms (%)

Source: EIB calculations based on EU Industrial R&D Investment Scoreboard.

There is an urgent need for much bolder policy action to revive investment and growth 

Reducing policy uncertainty, rethinking fiscal policy, and acting vigorously to address challenges raised by digitalisation, climate change, and persistent inequalities all have the potential to reverse the current slippery trend and lift investment and living standards. 

First, the mix between monetary and fiscal policies is unbalanced. Central banks have been easing decisively and in a timely manner, partly offsetting the negative impacts of trade tensions and helping to prevent further rapid worsening of the economic outlook. Thus, they have also paved the way for structural reforms and bold public investment to raise long-term growth, such as spending on infrastructure to support digitalisation and climate change. However, to date, other than in a few countries, fiscal policy has been only marginally supportive, and especially not of investment, while asset prices have been buoyant. Even in countries where fiscal space is limited, a reprioritising of expenditures looking at structural needs would be important. 

Second, a clear policy direction for transitioning towards sustainable growth amidst digitalisation and climate challenges would trigger a marked acceleration in investment. Governments should focus on the long-term gains. The creation of national investment funds, focused on investing in the future, could help governments design investment plans to address market failures and take account of positive externalities for society as a whole. A number of governments already have dedicated funds of the sort, but their governance could be improved to ensure higher economic and social returns on investment. 

Third, greater trade policy predictability and transparency could go a long way to reduce uncertainty and revive growth. For instance, there is a need to bring more transparency to the numerous forms of government support that distort international markets and to agree global rules on the transparency, predictability, reduction and prevention of such support, as well as on the taxation of multinational enterprises.

The current stabilisation at low levels of economic growth and investment does not warrant policy complacency. The situation remains inherently fragile, and structural challenges – digitalisation, trade, climate change – are daunting. There is a unique window of opportunity to tackle uncertainty, avoid a stagnation that would harm most people, and invest for long-term sustainable and inclusive prosperity. 

References

Boone, L and M Buti (2019), “Right here, right now: the quest for a more balanced policy mix”, VoxEU.org, 18 October.

European Commission (2018), “In-depth analysis in support of the Commission communication COM (2018) 733”, November.

European Commission (2019), European Economic Forecast, Autumn 2019.

European Investment Bank (2019a), Investment Report 2019/2020.

European Investment Bank (2019b), EIB Investment Survey 2019: European Union Overview.

European Investment Bank (2019c), Three Foundations: A competitive, sustainable, inclusive Europe.

Fried, S, K Novany and W B Peterman (2019), “The macro effects of climate policy uncertainty”, paper presented at the Economics of Climate Change conference, Federal Reserve bank of San Francisco.

OECD (2019), OECD Economic Outlook, Volume 2019, Issue 2: Preliminary version.

OECD-WTO-UNCTAD (2019), Report on G20 trade and investment measures, November. 

Sorbe, S., et al. (2019), “Digital Dividend: Policies to Harness the Productivity Potential of Digital Technologies”, OECD Economic Policy Papers No. 26.

UNEP (2019), Emissions Gap report, Nairobi.

WTO (2018), World Trade Report 2018: The future of world trade. How digital technologies are transforming global commerce.

a

A

Topics:  EU policies Europe's nations and regions Productivity and Innovation

Tags:  investment, structural transformation, digitalisation, climate change, Europe

Chief Economist, OECD

Director, Economics Department, European Investment Bank

Events

CEPR Policy Research