The great retrenchment in euro area external financial flows in 2022 – insights from more granular balance of payments statistics

Prepared by Lorenz Emter, Mariadolores Schiavone, Martin Schmitz

Published as part of the ECB Economic Bulletin, Issue 4/2023.

This box provides an analysis of the retrenchment in euro area external financial flows in 2022 – the largest since the global financial crisis – making use of new breakdowns of the euro area balance of payments and international investment position statistics.^[1] A major development in 2022 was the shift in the euro area current account balance to a deficit of €137 billion (-1.0% of GDP) after a surplus of €285 billion (2.3% of GDP) in 2021. This constituted the biggest annual change in the euro area current account balance on record.^[2] In the same period the financial account surplus fell from €312 billion to €14 billion, amid a sharp reversal in euro area financial flows on both the asset and the liability side. The analysis of the financial account has become increasingly complicated in recent years owing to the expansion of international financial intermediation chains, which often involve non-bank entities located in international financial centres.^[3] As recommended in the international statistical manuals, the ECB has developed new breakdowns of the euro area balance of payments and international investment position statistics to facilitate enhanced analysis of risk exposures and interconnectedness.^[4]

The sharp retrenchment in euro area external financial flows in 2022 was mainly driven by developments in portfolio investment and foreign direct investment (Chart A). In 2022 euro area investors’ net transactions in non-euro area assets reversed from a multi-year peak recorded in 2021 (net investment of €1.4 trillion) to net disinvestment of €0.3 trillion in 2022. This sharp reversal in financial flows on the euro area asset side was mainly due to developments in portfolio equity (listed shares and investment fund shares) and portfolio debt. Moreover, foreign direct investment (FDI) flows contributed notably to the retrenchment following a period of uncharacteristically high volatility in recent years.^[5] Similarly, on the liability side, non-euro area investors turned from being net buyers of euro area assets in 2021 to being net sellers in 2022. The largest net disinvestments occurred in FDI, while net purchases of euro area portfolio equity securities dried up almost completely, following a record high in 2021. At the same time, net sales of euro area debt securities by foreign investors declined in 2022, following several years of strong net disinvestments.^[6] Overall, the net sales observed for both assets and liabilities and the reversal in financial transactions in 2022 were the strongest recorded since 2009. The remainder of this box focuses on the main drivers of the retrenchment – portfolio investment and FDI – in more detail.

Chart A

Euro area financial account

a) Assets

(four-quarter moving sums, EUR billions)

b) Liabilities

(four-quarter moving sums, EUR billions)

Euro area investors’ retrenchment from portfolio investment assets in 2022 was mainly driven by investment funds – which tend to be procyclical investors – while insurance corporations and pension funds offset the reversal in outflows to some extent (Chart B). The newly available series in the euro area balance of payments and international investment position statistics provide a breakdown of the non-bank financial intermediaries sector.^[7] The breakdown reveals, in particular, the importance of euro area investment funds as holders of portfolio investment securities issued by non-euro area residents (accounting for 59% of total equity and debt holdings at the end of 2022).^[8] In line with this, the change in the euro area portfolio investment pattern from net purchases (€790 billion in 2021) to net sales (€235 billion in 2022) of debt and equity securities was driven to a large extent by the investment fund sector. Generally, investment funds tend to be procyclical investors, i.e. they sell securities in periods of high risk aversion, thereby inducing volatility in financial flows, while insurance corporations and pension funds tend to act countercyclically, in line with the patterns observed for the euro area in 2022.^[9] Moreover, the shifts in investment patterns in 2022 marked an end to a protracted phase of large-scale portfolio rebalancing towards extra-euro area securities that began in 2014 when the ECB introduced negative interest rates and launched its asset purchase programmes.^[10]

Chart B

Euro area financial account: selected items by resident sector

(four-quarter sums, EUR billions)

Geographically, the portfolio investment retrenchment in 2022 was mainly concentrated on securities issued by advanced economies in the case of equity, while for debt securities it was most pronounced for those issued by emerging market economies, in line with deteriorating global investor sentiment (Chart C). The new breakdown of the euro area’s counterpart countries allows for a better coverage of both advanced economies (with the addition of Australia, Norway and South Korea) and emerging market economies (now also including Argentina, Indonesia, Mexico, Saudi Arabia, South Africa and Türkiye). These new statistics reveal that euro area investors reduced their exposure to equity securities issued by residents of the United States, the United Kingdom and other advanced economies in 2022. For debt securities the picture is more nuanced: euro area investors on balance sold a significant amount of securities issued by residents of emerging market economies, offshore financial centres and the United Kingdom. Among emerging market economies, these net sales were driven by disinvestments of securities issued in China, Mexico and Russia.^[11] In addition, the net sales of securities issued by offshore financial centres are likely to consist mostly of securities issued by subsidiaries of corporations based in emerging markets, in particular China.^[12] At the same time, euro area investors made sizeable net purchases of securities issued by other advanced economies, in particular by residents of Canada and Japan, possibly driven by a stronger preference for safe assets.

Chart C

Euro area financial account: selected items by counterpart location

(four-quarter sums, EUR billions)

As regards foreign portfolio investment in the euro area in 2022, net purchases of euro area investment fund shares dried up, while foreign investors’ appetite for euro area debt securities picked up as the ECB’s monetary policy stance tightened (Chart B). Mirroring the reversal on the asset side of euro area investment funds, investors from outside the euro area turned into net sellers of shares issued by euro area investment funds amid the lower risk appetite prevailing in global financial markets following the outbreak of the war in Ukraine. The combination of the sizeable euro area investment fund industry and the strong extra-euro area investor base – especially for those funds based in Ireland and Luxembourg – had a large impact on euro area financial flows in 2022.^[13] At the same time, foreign investors’ sentiment regarding euro area debt securities improved in 2022. While the period since 2015 was marked by high net sales of euro area debt securities (in particular of government bonds, partly reflecting the important role of non-residents as counterparts to the Eurosystem asset purchase programmes), net sales abated in 2022 as the key ECB interest rates started to rise and the Eurosystem discontinued net asset purchases. In an environment of rising interest rates, extra-euro area investors became net buyers of debt securities issued by entities in the euro area other financial institutions (OFI) sector, which include financial vehicle corporations, following net sales in previous years.

The retrenchment in FDI mainly reflected transactions by multinational enterprises in euro area financial centres, often linked to special-purpose entities, while FDI transactions of the non-financial corporate sector – which are more closely related to the real economy – remained more stable (Chart B).^[14] On the euro area liability side, foreign direct investors’ disinvestments amounted to €317 billion in 2022 (2.4% of euro area GDP). These disinvestments were driven by investors resident in the United States and the United Kingdom, as well as those in offshore financial centres (Chart C), and took place exclusively vis-à-vis the OFI sector (€403 billion), which includes special-purpose entities such as holding companies.^[15] In contrast to these more volatile “financialised” FDI flows, FDI in euro area non-financial corporations continued at a steady pace, recording €74 billion in net investments (Chart B). Turning to net acquisitions of FDI assets by euro area residents, the observed retrenchment was also predominantly driven by the OFI sector. The strong positive correlation between gross FDI asset and liability transactions related to OFIs suggests that these flows often “pass through” without being absorbed in the domestic economy. The retrenchment in FDI assets was largely driven by transactions vis-à-vis the United Kingdom related to the corporate restructuring of a single multinational enterprise.^[16] The additional breakdowns included in the euro area balance of payments and international investment position statistics highlight that economic analysis of FDI benefits from a more detailed separation of “financialised” flows.^[17]