05 March 2014

IMF: Luxembourg—Concluding statement of the 2014 IMF Article IV consultation

The Luxembourg economy is rebounding, the fiscal position remains sound, and the large financial sector has been resilient. But trend growth has slowed substantially, and fiscal, financial and structural challenges lie ahead.

Securing Luxembourg’s economic and social model calls for a three-pronged approach: safeguarding the healthy fiscal position, managing the risks associated with the diversification of financial sector activities, and preserving competitiveness, including by adjusting the automatic wage indexation mechanism to allow for alternative sources of growth.

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The Economic Outlook (following sections mostly abridged).

1. Thanks to sound policy management, Luxembourg has weathered the crisis relatively well.

2. The outlook is for growth to gradually firm up, yet without returning to pre-crisis trend. 

3. Going forward, the economy faces several challenges, with risks tilted to the downside. 

Adapting Fiscal Policy

4. 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 per cent 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 stabilise 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.

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

6. Pension reforms remain an unfinished agenda. 

7. The fiscal framework still needs adjustment to fulfil EU commitments. 

Navigating the Changing Financial Landscape

8. The financial sector appears resilient and, faced with new challenges, is moving toward diversification. Banks’ capitalisation 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.

9. 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.

10. 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.

11. Supervisors need to continue to closely monitor domestic residential real estate exposures.

12. Interconnections and emerging risks from more financial diversification should be carefully scrutinised. 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

13. Despite the strong external position, Luxembourg might be pricing itself out of some activities. 

14. The expiration of the temporary agreement on wage indexation offers an opportunity to adjust this mechanism.

15. Measures to strengthen labour skills and the business environment would further support Luxembourg’s efforts to diversify beyond the financial sector. 

Full press release

© International Monetary Fund