Investment in the European Union since the pandemic has been stronger than expected and has outperformed historical trends. This is thanks in part to a resilient economic recovery and a sharp increase in corporate profits (EIB, 2024). Tighter external financing conditions have also been offset by cash buffers from policy support, higher profits during the fast post-crisis recovery and the success of firms in passing on their costs to customers.
A working paper by European Investment Bank economists, “Investment decisions in a high inflation environment” analyses the association between inflation, which began to soar in 2021, and company investment decisions, particularly those of small and medium sized enterprises (SMEs).
How inflation hurts investment
In the short term, inflation increases the cost of materials and wages relative to revenues, unless firms can adjust their prices immediately. This squeezes profit margins, reducing the availability of liquid assets that could be used for investment.
In the long term, high inflation hurts real incomes, eats into household savings, and depresses demand. In such an environment, lower demand leads to lower sales and lower profitability, and companies stop investing. Downward pressure on demand, expectations that the economic outlook will get worse, and greater uncertainty about price stability and the evolution of real incomes (incomes adjusted for inflation) are likely to prompt firms to scale back their investment plans (EIB, 2023; Kolev & Randall, 2023). This is supported by other studies, which show that inflation rates over 10% are more likely to reduce investment (Asab & Al-Tarawneh, 2018).
High inflation also hits corporate profitability and access to external financing. This is because central banks raise interest rates to fight inflation, which makes it more expensive and difficult to borrow. Tighter monetary policy also indirectly puts pressure on demand, which puts further pressure on sales, revenue and profits.
High inflation, increased investment. How?
Rising energy prices and supply chain disruptions fuelled high inflation in 2021 and 2022, which peaked at an annual rate of 11.5% in October 2022 (Eurostat). Most EU firms, however, were profitable during this time – 79% in 2022 and 80% in 2023, according to the European Investment Bank Investment Survey. This is thanks to support they received during the pandemic and the rapid recovery in demand, which allowed firms to build up the necessary financial reserves for investment (EIB, 2024). Aggregate investment over this time (2021 and 2022) rose strongly and remained around 4% above pre-pandemic (2019) levels in 2023.
While the link between high inflation and investment is generally expected to be negative for the reasons described above, there are a few factors that may explain the positive investment dynamic during the recent period of high inflation.
First, the working paper finds evidence that investment decisions depend on the ability of firms to pass on higher costs to consumers. When firms can pass on rising costs it lowers the hit to profitability and corporate finances.
Another factor is that the spike in inflation was strongly driven by energy costs and other input prices that gave firms an incentive to invest in energy efficiency as a cost-saving strategy.
Moreover, as liquid assets are more vulnerable to the negative impacts of inflation, it made sense for firms to invest, so as to protect their value.
Statistical data show that European firms substantially increased their cash buffers in the run up to the energy price shock and were helped also by massive liquidity support programmes brought in during the pandemic. These high cash reserves may provide a buffer to support ongoing investments or for beneficial investments in energy efficiency (Ampudia et al., 2023). Studies also show that firms with large cash reserves or easier access to external financing may be relatively better positioned to weather periods of high inflation (Cleary, 1999; Cleary et al., 2007).
The chart below summarises the empirical results of the paper. It shows that high profitability from the ability of companies to pass on their costs (the pass-through rate) and cash accumulation (helped also by policy support) allowed for the higher rate of investment observed, particularly for energy efficiency. High energy prices were at the root of both inflation and the need to invest, especially in the green transition, offsetting the negative impact on investment from uncertainty and lower access to external financing.
Higher profits for firms that passed on the cost of higher energy prices to customers and invested in energy efficiency
The fact that the high inflation environment actually allowed some companies to increase their profits may also help to explain the positive relationship observed between inflation and investment. The chart below shows that firms in industries that managed to pass on the rise in energy prices were also more likely to invest, especially in energy efficiency.
High inflation still detrimental for firms and the economy
Although many European firms were able to increase their profits and sustain investment during the recent period of high inflation, the negative effects of high levels of sustained price increases and interest rate rises are expected to emerge over the longer term. Once cash buffers are used up and current lending contracts come to an end, the cost of financing new investments with external funding will be significantly higher. Overall, the by-products of inflation, such as higher interest rates, tighter external financing conditions and greater uncertainty due to repeated shocks, are found to have a significantly negative effect on firms’ investment decisions and their impact may become visible after short-term positive effects fade.
Moreover, there are certain groups of liquidity-poor firms whose ability to invest is impeded even more by structural bottlenecks than external financing conditions. Firms that are small, young and innovative, with a higher share of intangible assets, or those that are unable to pass on higher costs, may find it harder to fund their investments, which could delay their green and digital transition compared to average firms.
To sustain the green and digital transformation process even as the economy slows, policy support should focus on the business environment with measures to reduce economic uncertainty and the structurally higher level of financing constraints faced by SMEs. This could include offering alternative financing sources beyond traditional bank lending. This would fit the risk profile of such firms in their longer-term investments, thus counterbalancing the investment dampening effect of cyclical tightening. Moreover, a special focus should be accorded to those SMEs operating in highly competitive markets, or those whose products/services are strongly price-elastic and who are therefore unable to pass on higher production costs.
References
Ampudia, M., Eren, E., & Lombardi, M. (2023). Resilient risk-taking in financial markets—Non-financial corporates’ balance sheets and monetary policy tightening. Bank for International Settlements. https://www.bis.org/publ/qtrpdf/r_qt2309a.htm
Asab, N. A., & Al-Tarawneh, A. (2018). The impact of inflation on the investment: the non-linear nexus and inflation threshold in Jordan. Modern Applied Science, 12(12), 1913–1844.
Cleary, S. (1999). The Relationship between firm investment and financial status. The Journal of Finance, 54(2), 673–692.
Cleary, S., Povel, P., & Raith, M. (2007). The U-shaped investment curve: theory and evidence. Journal of Financial and Quantitative Analysis, 42(1), 1–40.
EIB. (2023). Investment Report 2022/2023: Resilience and renewal in Europe. European Investment Bank. https://www.eib.org/publications/20220211-investment-report-2022
EIB. (2024). Investment Report 2023/2024: Transforming for competitiveness. European Investment Bank. https://www.eib.org/publications/20230323-investment-report-2023
Kolev, A., & Randall, T. (2023). The effect of uncertainty on investment: evidence from the EIBIS. EIB
Working Paper 2024/02. EIB. https://www.eib.org/publications/20240131-economics-working-paper-2024-02
