Luxembourg-Concluding Statement of the 2014 IMF Article IV Consultation

The Economic Outlook

Thanks to sound policy management, Luxembourg has weathered the crisis relatively well. After a shallow recession in 2012, growth is expected to have picked up to 2 percent in 2013—a much stronger performance than euro area peers. The stabilization in European financial markets supported a rebound in service exports. A healthy fiscal position, accommodative credit conditions, and continued employment growth shielded domestic demand from the depressed euro area environment.

The outlook is for growth to gradually firm up, yet without returning to pre-crisis trend. Supported by a more conducive regional outlook, growth is forecast to reach 2 to 2½ percent over 2014-19, broadly in line with potential. The financial sector is expected to continue to contribute to growth, but at a slower pace than pre-crisis.

Going forward, the economy faces several challenges, with risks tilted to the downside. Protracted low euro area growth as well as a larger-than-expected impact on banks from euro area deleveraging trends and from the move to automatic exchange of information constitute the main downside risks. EU-driven regulatory changes may also curtail growth of the financial sector. The fiscal position will soon come under strain from losses in e-VAT revenues. The global push to increase transparency in corporate taxation could affect Luxembourg, as it hosts large multinational activities.

Adapting Fiscal Policy

A moderate but sustained consolidation effort is essential to preserve the current healthy fiscal position. As the authorities are well aware, without corrective measures, the fiscal position would deteriorate substantially, driven by the loss in e-VAT revenues and continued buoyant expenditure trends. Debt could reach as much as 40 percent of GDP by 2019. Instead, an annual consolidation of slightly below ½ percent of GDP in structural terms (excluding the effect of e-VAT losses) over the next five years would stabilize debt below 30 percent of GDP. It would also allow Luxembourg to return to its medium-term objective by 2018—a European commitment—while mitigating the negative impact on growth. The consolidation effort should also apply to 2014.

Curbing public spending growth, however, will be critical—even after current plans to raise VAT are implemented.

• Given low current rates, we support the planned VAT hike. An increase in property tax revenue, which is low compared to neighboring countries, could also be considered.
• A specific area of focus should be social benefits, as they absorb about half of public spending and are the highest per capita in the region. A thorough assessment of these benefits should also aim to reduce existing disincentives to work. To encourage labor participation, a reduction in social transfers could be associated with the introduction of a well-targeted earned-income tax credit system.

But these steps need to be complemented by measures to significantly curtail expenditure growth, which has consistently been above that of both revenues and GDP since 2009. We welcome the comprehensive expenditure review currently underway as a tool to prioritize savings, and the plan to introduce expenditure ceilings in the context of multi-annual budgeting. Public sector staffing and compensation policies should be consistent with these efforts.

Pension reforms remain an unfinished agenda. Despite the steps taken in 2012, pension costs are still expected to increase substantially in the medium term. We encourage the authorities to plan for measures well ahead of the 2017 review, including by limiting indexation of pensions to inflation only.

The fiscal framework still needs adjustment to fulfill EU commitments. The independent fiscal council to be created should have the expertise and resources to monitor deviations from fiscal targets. With the main target now defined in structural terms, output gap estimates will need to be made conservatively—to avoid overstating the structural balance—and assessed independently—to prevent politicization. A better capacity to assess tax expenditures and revenues stemming from multinational activities would increase transparency and help inform fiscal policy decisions.

Navigating the Changing Financial Landscape

The financial sector appears resilient and, faced with new challenges, is moving toward diversification. Banks’ capitalization and liquidity remain high. While activities geared to the euro area are likely to grow only moderately, Luxembourg has been able to attract new institutions from emerging markets, thanks to its extensive financial infrastructure. Banks are retooling private banking activities toward high net-worth individuals to mitigate the effects of the switch to automatic exchange of information—which could be challenging for some institutions. The investment fund industry has continued expanding, and the rapid transposition of the Alternative Investment Fund Managers Directive is seen as a way to develop new activities.

The switch to the Single Supervisory Mechanism (SSM) offers an opportunity to further strengthen financial sector oversight. Since the 2011 FSAP, supervisory capacity has been increased and investor protection has been stepped up. Cooperation between the central bank (BCL) and the financial supervisor (CSSF) is being enhanced in the context of the preparations for the SSM and through the proposed Systemic Risk Committee. Going forward, the operational independence of the CSSF could be strengthened as part of the SSM-related revision of the legal framework. A smooth transition to supervision under the SSM will require the continued involvement of the national competent authorities in the supervision of banks and their participation in decision-making within the Supervisory Board and the Governing Council.

As diversification proceeds, the resilience of the sector should be preserved. We support the decision to frontload the implementation of Basel III’s capital requirements. Over time, supervisors should also consider additional buffers to reflect the systemic size of a number of banks. Meanwhile, we would urge the authorities to move ahead expeditiously to set up the ex ante deposit guarantee scheme and resolution fund required by European legislation.

Supervisors need to continue to closely monitor domestic residential real estate exposures, as these have been steadily rising since 2008. While several positive steps have been taken, supervisors should stand ready to take additional actions if exposures continue to rise. Consideration should also be given to maintaining higher capital requirements for domestically-oriented banks in the new Basel III framework.

Interconnections and emerging risks from more financial diversification should be carefully scrutinized. Given the international orientation of financial activities, Luxembourg would mostly be a conduit of global shocks. But strong and growing links between the various domestic financial actors warrant close monitoring of potential spillovers, with the Systemic Risk Committee well-placed to be given that mandate. Emerging risks related to financial diversification should receive enhanced attention as well. To maintain the strong confidence in the financial sector and ward off reputational risks, the authorities are encouraged to communicate more actively their focus on investor protection.

Supporting Economic Diversification beyond the Financial Sector

Despite the strong external position, Luxembourg might be pricing itself out of some activities. Wages have continued to increase rapidly, even after the crisis, and despite slower employment growth. The increase in labor costs has far outpaced that of euro area neighbors. The automatic indexation mechanism has played a critical role, as it has made it difficult for real wages to adjust to the productivity declines experienced since 2008.

The expiration of the temporary agreement on wage indexation offers an opportunity to adjust this mechanism. We would support permanently capping annual indexation, but the cap should be set closer to the ECB price stability objective (close but below 2 percent) than the current 2½ percent threshold. The reference index could be reviewed to exclude volatile prices, and escape clauses considered when inflation among the main trading partners drops significantly below 2 percent. As high real estate prices put pressures on wages, measures to support housing supply would complement these efforts, including through more flexible rules on land use and higher holding costs on unused properties.

Measures to strengthen labor skills and the business environment would further support Luxembourg’s efforts to diversify beyond the financial sector. The authorities should continue their efforts to match workers’ skills with private sector needs, including through support for training in the areas of targeted growth. The emergence of new firms could be facilitated by improving administrative processes to start a business.

The mission wishes to thank the authorities and other counterparts for their warm welcome and the open and fruitful discussions.