Business investment in euro area countries: the role of institutions and debt overhang

ABSTRACT

The recovery of business investment in the euro area has been sluggish, thereby hampering aggregate demand in the short term and potential growth in the long run. While we show that business investment can be associated to cost and supply of credit, cyclical demand conditions and economic uncertainty. But we also find evidence of additional factors. We suggest that there exists a link between excess leverage and weak economic institutions on the one hand and subdued investment growth on the other hand. Moreover, in euro area countries with both larger excess leverage and weaker economic institutions, the link with business investment is found to be stronger. The link between investment and weak institutions or excess leverage highlights the importance of structural reforms aimed at easing business regulations, reducing administrative burdens and increasing the efficiency of insolvency frameworks. These reforms are thus expected to reduce distortions in the allocation of resources and be supportive of a smoother deleveraging process, hence fostering business investment.

KEYWORDS:

• Business investment
• quality of institutions
• excessive leverage
• economic uncertainty
• structural reforms
• panel data

JEL CLASSIFICATION:

• D92
• E22
• D8
• L51
• O17

Acknowledgement

Many thanks to an anonymous referee and the editor of this journal for comments that considerably improved the paper. Thanks also to Beatrice Pierluigi, Isabel Vansteenkiste, to the participants of two internal ECB seminars for helpful comments and suggestions. This paper presents the author’s personal opinion and does not necessarily reflect the views of the European Central Band or Banca d'Italia.

Disclosure statement

No potential conflict of interest was reported by the authors..

Supplementary material

Supplemental data for this article can be accessed here.

Notes

¹ The level of capital in equilibrium is also dependent on some other assumption such as the functional form of the production function and the parameters governing the elasticity of substitution between capital and labour (see e.g. Bean 1981; or Jorgenson 1963).

² Finland however drops out for some regressions as it is the only country which does not provide data for the Bank Lending Survey, from which we derive our indicator of credit supply restrictions.

³ If we include a time fixed effect in our model, uncertainty loses significance, while all the other variables are still significant (see Tables A3 and A4 in the online annex). The explanation for this result is that, in our sample, time dummies capture the behaviour of our measure of uncertainty which is highly correlated across countries (see Chart A3).

⁴ Some studies (e.g. Rodriguez-Palenzuela, Dees, and Savings and Investment Task Force 2016) find that the leverage ratio is particularly sensitive to thresholds, above which leverage is a particular drag on investment. Such threshold effect were not present using the specific variable definition (i.e. the excess leverage ratio) and our model specification.

⁵ Results using the three other indicators are nearly identical and therefore not shown here, but available from the authors upon request.

⁶ The chart shows the contributions estimated excluding the lending rate from the model which was not significant.

⁷ We report in the online annex (Charts A7–A10) the estimates of the contribution of these different factors to the cumulative drop in business investment for some selected countries.