How will Europe compete for investment amid ongoing turbulence?

A snapshot of 2021

In 2021, businesses around the world announced 5,877 FDI projects in Europe, a 5% annual increase. The uptick followed a particularly weak year for investment in 2020, when the COVID-19 pandemic caused the number of projects to fall 13% on 2019. The subdued recovery still left investment in 2021 8% below 2019 levels, the last full year before the pandemic hit Europe, and 12% below 2017, a record year for FDI in Europe.

The gradual pace of recovery was in stark contrast to the immediate rebound in FDI after the global financial crisis. Following a sharp 11% decline in 2009, investment levels bounced back strongly in 2010 to record highs. The data for 2021 suggests that the shock of the COVID-19 pandemic may take longer to recover from than first expected.

Headwinds remain that could impact the FDI trajectory

It’s no exaggeration to say that businesses face a more complex and rapidly evolving set of technological, environmental, organizational and societal challenges than ever before.

Although the situation is very fluid, the most likely outcome of the war in Ukraine is a scenario in which the majority of international sanctions and supply chain disruptions persist. Continued geopolitical uncertainty and other second-order impacts, such as commodity price inflation and heightened risks of cyber-attacks on large businesses and critical infrastructure, would also continue to weigh on business.

The survey launched before the war in Ukraine began, so the war and its impacts were not included as an answer option when participants were asked to select their top risks to Europe’s attractiveness. That said, the war caused other risks to rise up the agenda. For example, surveyed businesses ranked high volatility in currencies, commodities and other capital markets as the joint-second top risk to Europe’s attractiveness during the next three years (Figure 2). Last year it ranked fifth.

Businesses ranked the legislative framework for digital services and markets as the second greatest risk to Europe’s attractiveness, up from fourth place last year. This likely stems from uncertainty about the impact of the Digital Markets Act, which is designed to stimulate competition within Europe’s digital sector, and the Digital Services Act, which is a range of regulations that protect technology users from misinformation, cyber threats and market dominance.

Shifts in European environmental legislation and policies ranked as the fourth-greatest risk to Europe’s attractiveness. This is likely a result of fears that climate change policies will push up energy prices, which have already increased significantly in some European countries since the beginning of 2022.

Then of course there is the risk that a new vaccine-resistant COVID-19 variant could materialize. If this resulted in the scale of lockdowns in 2020 and corresponding decline in economic activity, then FDI could be materially impacted.

Europe remains an attractive long-term destination

Foreign investment levels in Europe started to recover in 2021, but the survey data indicates that this may be short-lived given the war in Ukraine.

Some 53% of businesses planned to establish or expand operations in Europe during the next year, a significant increase on 40% in 2021 and 27% in 2020. However, the timing of respondents’ answers – in other words, whether they replied before or after the war in Ukraine began – played a major role. Just 25% of those surveyed after 15 March said they planned to invest in Europe. If the appetite of those surveyed with full knowledge of the war truly represents business sentiment, then appetite to invest during the next 12 months is actually at a three-year low.

Although businesses have throttled back on their investment plans, respondents said they were still positive on the long-term prospects for investment in Europe (Figure 3).

Why did investors say they were optimistic about Europe’s attractiveness given the war in Ukraine and future geopolitical uncertainty? Perhaps counterintuitively, the geopolitical situation may even increase FDI in Europe if supply chains are disrupted to the point that businesses begin to either re-shore or nearshore operations back to Europe. Investment could also recover quickly because the COVID-19 restrictions have impeded investment for the past two years, causing pent-up demand on the ability to initiate projects.

France shines: mapping European FDI in 2021

In 2020, France, Germany and the UK were virtually tied in first place as the largest recipients of FDI within Europe. That changed in 2021.The number of announced projects in France rocketed 24% to 1,222 projects. In stark contrast, the number of projects in Germany tumbled 10% to 841. Investment in the UK remained steady, increasing 2%. As a result, there is now a clear gold, silver and bronze placing in the country FDI rankings.

Although France outperformed every other country in terms of the number of announced projects, these projects are typically smaller than elsewhere. Based on projects where the number of jobs created is disclosed, the average foreign investment created 68 jobs in the UK, 45 in Germany and just 38 in France. In fact, the UK attracted more investments that created more than 100 jobs than France in 2021.

The picture was mixed outside of Europe’s three major markets:

• In Southern Europe, Italy (+83%), Portugal (+30%) and Turkey (+27%) experienced a sharp increase in the number of projects due to the reshoring and nearshoring of global supply chains.
• In Western Europe, countries that were traditionally attractive but more service-oriented, such as the Netherlands (-22%) and Ireland (-8%), lost ground because of the decline in services projects following the surge in remote working.
• In Eastern Europe, the stagnation in the number of projects suggests that this historically very strong FDI destination during the past decade is not benefiting from industrial and logistical reconfigurations as much as elsewhere.

Manufacturing and logistics recovery offsets downswing in office-based FDI

Countries welcome all forms of foreign investment, but industrial projects (manufacturing, logistics and R&D) are most sought after due to their ability to create jobs and stimulate growth. Encouragingly, the number of announced projects in all three of these areas increased significantly in 2021 to the extent that they are now above pre COVID-19 investment levels (Figure 4).

The increase was in part caused by the rebound effect: investors making up for lost time after not logistically being able to execute projects during the pandemic. It could also represent a degree of supply chain reorchestration. Burnt by lockdown-induced supply chain bottlenecks, some businesses were perhaps starting to bring industrial supply chains closer to home. 

On the other hand, the COVID-19 pandemic also forced employees around the world into remote working. After a year of broadly positive experiences, many businesses began adopting hybrid working practices, where employees work on a more flexible basis, as the new norm. This led to lower FDI because businesses could already mostly fulfill their office-based activities from existing locations. This materially impacted investment in sales and marketing offices, which fell 25% in 2021.

Sectors in focus: automotive, transport and aeronautics lead the way

In 2020, foreign investment fell in every major sector apart from life sciences. Transport manufacturing was most significantly affected, with FDI decreasing 35%. The picture was very different in 2021 (snapshot below).

Many sectors bounced back, including transportation and utilities. Following a 35% decrease in 2020, foreign investment in the automotive, public transport equipment and aeronautics sectors rocketed 65% to eclipse pre-pandemic levels last year.

In contrast, the business and professional services sector announced 557 foreign investment projects in Europe in 2021, a 19% and 28% decrease from 2020 and 2019 respectively. Office-based sectors such as this throttled back on investment as they determine their real-estate strategy.

Supply chain reorchestration comes to fruition

As a direct result of the war in Ukraine, businesses are seriously considering upending their supply chains. Fifty-three percent are considering nearshoring closer to customers, a significant increase on 23% last year. In parallel, 43% are considering reshoring activity back to their domestic market, compared with 20% last year.

The relocation of industrial activity back to Europe would certainly be a boon to Europe. But is it realistic? After all, as COVID-19 struck, a staggering 83% were considering reshoring or nearshoring. This sentiment rapidly dissipated, perhaps as businesses realized the hefty cost implications of shifting supply chains back to Europe.

Today, there is greater reason to believe that supply chain reorganization will take place. For a start, businesses will be forced to seek alternatives to sourcing components and materials from Russia. And although many factories still operate in the west of Ukraine, output has been disrupted to the extent that businesses may be forced to seek alternatives if the war persists and spreads.

Second, energy prices have risen such that transporting materials and components from Asia has started to erode the region’s cost competitiveness. Linked to this is the issue of sustainability. Regulatory and consumer pressure to decarbonize supply chains makes local sourcing more compelling.

Finally, the war in Ukraine has exposed deeper geopolitical tension between Europe and other countries. None of these issues by themselves would necessarily be a sound reason to relocate supply chains, but collectively they create a compelling business case.

Intellectual property rights protection is the second most important technology-related factor that influences location decisions. This is understandable. Businesses will not invest in R&D if they perceive that their creations will not be protected.

Encouragingly, 56% of investors believe Europe is more attractive than other regions when it comes to technology-related factors. Just 12% say it is less attractive.

Policymakers also need to build a democratic consensus for Europe’s sustainability drive and ensure that businesses and individuals that might be adversely affected, such as those that work in “brown industries,” are protected as much as possible. Urgent action is required to make a green and innovative Europe a reality.

Priority three: Create the skills needed to transform European business

Businesses rank the presence of a skilled workforce as the number one HR-related factor that determines location decisions (Figure 6). 

Digital communication channels also enable more frequent and direct interactions with tax authorities, which helps to resolve complex matters  ̶  all the more critical in a time when they need to adapt quickly.

Businesses rank the scope and rate of environmental taxes as the second-most important tax-related factor that determines location decisions. This likely reflects concerns that governments will introduce new taxes or raise existing taxes to fund the transition to the green economy.

The availability of R&D tax credits ranks third. This is likely because it is one of the few remaining areas of tax competition in Europe, and an important lever that governments can pull to attract investment and boost their country’s competitiveness.

Priority five: Refresh support for small and medium-sized companies (SMEs)

The survey reveals that the perception and outlook of executives of small and medium-sized companies (SMEs), which includes enterprises below €1.5 billion in revenues, is less positive than those of multinationals. For example, 34% of small businesses’ 2022 investment plans are still delayed or curtailed due to the COVID-19 pandemic. This is only the case for 13% of large businesses.

Small companies may need a different form of government support. All large companies report that the RRF has been a deciding factor in their decision to maintain or expand their operations in Europe, compared with only 54% of small companies. 

Although the RRF will undoubtedly indirectly benefit smaller organizations, the survey data indicates that they need additional support. Policymakers must work closely with SMEs to understand their challenges and requirements, and design support packages appropriately.

Useful support might include enhanced protection for late payments, improving access to financing and reducing regulatory burdens. This is vital: SMEs employ about 100 million people, account for more than half of Europe’s GDP and play a key role in creating value in all sectors.