Gibran Watfe, 7 January 2016
More than five years after the onset of the euro area sovereign debt crisis, the EU still struggles to recover in terms of growth and employment. The most important project by the European Commission under president Jean-Claude Juncker that is supposed to boost growth is the Investment Plan for Europe. The core of the plan is the creation of the European Fund for Strategic Investments (EFSI) that is meant to mobilize private investments for viable projects across the EU, based on a guarantee backed by the EU budget. For this purpose, the European Investment Bank (EIB) is supposed to invest funds of an amount that is three times the size of the guarantee fund, generating private investments of 15 times the amount of the fund. The idea behind this setup is that the guarantee fund takes on some of the risk of a project so that private investors are attracted, as they have to bear less risk.
The EFSI regulation was adopted in June 2015. As it is one of the most important priorities of the Juncker Commission, it was adopted in record time. Therefore, the first projects benefiting from the EU guarantee have already been confirmed. This article looks at one particular project that has been approved recently and points at some serious shortcomings of the EFSI.
On 17th of September 2015, the European Investment Fund (EIF) granted a loan to the German national development bank, KfW, worth EUR 1 billion for financing small firms and entrepreneurs. The agreement benefits from the EU guarantee under the EFSI. The Commission’s vice-president Jyrki Katainen commented: “The agreement being signed today by the EIF and KfW is fantastic news for start-ups across Germany. With the EFSI backing, EUR 1 billion of loans will reach those individuals who want to grow their businesses and boost employment locally. This is exactly what the Investment Plan was created for.” But is there really a direct connection between the Commission’s initiative and the fact that German entrepreneurs can now finance their businesses more easily? Did the EFSI involvement make a difference in this case?
A rather long investment chain
To understand the connection between the EIF money and the increase in funds available to start-up companies in Germany, one has to examine the (public) investment chain from its very beginning. It starts with KfW. Since 2008, KfW has funded small firms and entrepreneurs in need of finance under its so-called StartGeld programme. Until 2014, EUR 300 million have thus been disbursed to promising young firms. How does KfW raise the funds for granting these loans? It issues bonds on capital markets benefiting from a guarantee of the German state for all its losses. Consequently, it enjoys favourable financing conditions (i.e. consistently obtains AAA ratings) due to the strength of the German economy and the standing of the German government.
The second element of the investment chain is thus the German government. Earlier this year, as national governments discussed the concrete design of the EFSI, the German government agreed to provide funds not directly to the EFSI, but as a contribution made by KfW. This move has to be understood as a political manoeuvre to maintain the German government’s goal of a balanced budget. The contribution through KfW does not affect the German deficit and was thus a politically feasible solution. So far, so complicated.
The crucial question is whether KfW-funded projects under the EFSI yield additional investments. This takes us to the third level of the investment chain, the European Investment Fund (EIF). Next to facilitating investments in infrastructure projects, the EFSI provides EUR 5 billion worth of guarantees to the EIF for financing small and medium-sized enterprises. The latter is the core business of the EIF anyway, financed mainly on the basis of guarantees coming from the European Union. Naturally, guarantees from the European Union are backed by the EU budget, which is financed by the Member States (including Germany, for the sake of this article’s argument).
On the basis of the two guarantees, the European Investment Fund then made the agreement with the KfW to provide EUR 1 billion in loans for start-up financing. These funds, however, still have not reached the end of the investment chain, i.e. the balance sheets of small businesses. The KfW itself does not lend out to businesses. Instead, it disburses funds to commercial banks that are incentivized to grant loans to small firms given that the KfW takes on 80% of the default risk of the loans. Commercial banks are thus the fourth element of the investment chain. In the end, each start-up company can apply for loans of up to EUR 100,000 with relatively few strings attached. So all in all, there are five different institutions involved in facilitating public investment into start-up companies in Germany, given the EFSI guarantee.
Does the EFSI really make a difference?
A salient question for the assessment of the EFSI is whether the loan that will hopefully end up in start-up companies was really generated above and beyond what would have been granted anyway (i.e. it is additional to the funds that would have been provided anyway). In this particular case, no private investors were involved in facilitating loans to real projects (except those that hold bonds issued by KfW). Thus, the funds that came out of the investment chain are merely funds that are backed by the German government, going through a long investment chain from the KfW, through the EFSI under the participation of the Commission, further through the EIF and back to the KfW, through commercial banks to the ‘end users’. An investment chain that long can only be justified to the extent that it generates extra funds. And, in this case, it seems doubtful whether the EFSI has helped.
However, even if private investors are not involved, additionality could come through another channel, namely a change of the investment behaviour of KfW. In the absence of the EFSI, would KfW have increased its funding programme for start-ups? Or in other words, did the EFSI guarantee enable KfW to take more risk than before? I argue that, in this particular case, the EFSI did not make a substantial difference. First of all, the StartGeld programme is already in place since 2008. The EFSI thus did not trigger a riskier form of business of KfW. Secondly, one might argue that the increased volume of the programme (EUR 1 billion compared to EUR 300 million) could be due to EFSI support. However, KfW has increased its total business volume every year since 2008. Increasing the size of the start-up funding programme is thus in line with the growth of KfW’s overall business. Finally, the increased volume of the programme might also point to a risk-taking attitude due to EFSI support. However, already in 2014, KfW substantially decreased its capital ratio pointing to a partial reorientation in its risk policy. It is thus hard to see how the EFSI support has made a difference in this case.
Of course, this is only one case and the EFSI is still in its starting phase. Other recently backed projects include offshore wind farms in the UK and Belgium, which also included private investors. The case presented here should thus not be representative for the EFSI initiative as a whole. However, it points to a fact that demystifies the desired leverage that the EFSI is supposed to bring about.
Instead of providing more and more guarantees for projects in certain areas that tend to produce long public investment chains, the European Commission should therefore focus on removing barriers to private investments in the European economy. A true single market approach to investments should thus be the first priority.