The Luxembourg authorities thank the staff for their comprehensive analysis and constructive discussions during the mission in Luxembourg. The staff’s analysis provides an objective view of the macroeconomic situation in the country and its economic challenges.
The economic performance has been strong over the last three years, with an average real GDP growth of 4.4 percent and close to 5 percent in 2015. Growth was mainly driven by robust domestic demand and strong net services exports. Also, an AAA credit rating with a stable outlook, a stable political and social environment, and sound public finances are key elements that support Luxemburg’s economic growth.
The government projects the economy to grow by 2.9 in 2016 and on average by 3.8 percent over the period 2017–2020. The somewhat lower projected medium-term growth compared with the historical averages before the crisis is due to: (i) slower recovery of the euro area economies; (ii) progressive exit from accommodative monetary policy in the euro area; and (iii) less favorable stock exchange developments. However, this lower growth profile is accompanied by positive developments in the labor market.
Strong and dynamic job creation led to an increase in employment of 2.5 percent. Employment is projected to increase by 2.8 percent over the medium-term. Unemployment is on a downward path thanks to the government’s active labor market policies that help tackling the long-term unemployment of low-skilled workers. The unemployment rate was at 6.5 percent at the beginning of 2016, down from around 7 percent in 2014 and is projected to continue to decrease over the medium-term to about 6 percent.
In line with the euro area trends and lower oil prices, average inflation remains low. This low inflation environment limited the impact of the 2 percentage point increase in VAT rates in 2015. Over the medium term, inflation is projected to average 1.6 to 2 percent. The current account recorded a surplus of 5.5 percent in 2015 and is expected to stay close to 5 percent in the medium term, reflecting a surplus in services partly offset by a negative balance in goods.
Luxembourg’s fiscal position remains sound and is one of the strongest in the euro area. The budget balance recorded a surplus of around 1.3 percent of GDP on average over the last three years, and the gross public debt level remains stabilized slightly above 20 percent of GDP. The country has managed to maintain its low level of public debt as well as a significant budgetary safety margin with respect to the Maastricht deficit reference value of 3 percent of GDP, demonstrating the government’s commitment to sound fiscal policies. In this context, the government decided to adopt a lower medium term objective (MTO), a structural deficit of 0.5 percent of GDP, over the period 2017–2019, which is in line with new minima-requirements calculated by the EC.
In 2015, public finances were characterized by three main factors: (i) the entry into force of the new regime for the VAT on e-commerce that resulted in a loss of 1 percent of GDP of VAT revenues; (ii) the implementation of a multi-annual counter-financing strategy with an impact of 0.7 percent of GDP in its first year; and (iii) the improvement of the macroeconomic conditions with a positive impact on the government revenue. The conjunction of these three elements allowed the general government balance to reach a surplus of 1.3 percent of GDP—a much better outcome than initially estimated.
On February 29, 2016, the government announced the details of the tax reform which were further specified on April 21. With this reform, the government wanted to improve the tax system by making it more simple, competitive, efficient, and fair. The reform targets both the companies and the households, but the latter are the largest beneficiaries. It will be implemented as of January 1, 2017, and its cost is estimated around 0.6 and 0.8 percent of GDP for the period 2017–2020. The non-neutral impact of this reform is justified by a favorable general government balance over the last three years, the positive economic outlook and the relatively low level of public debt.
The fiscal position is projected to remain in a small surplus over the medium term, even with the cost of tax reform taken into account, well above the newly adopted MTO, and for the entire 2017–2020 period. Public investment will also remain high over this period as the government considers it to be important for the development and the potential growth of the economy. The high level of investment is also justified by the population growth as well as by the continuous increase of employment.
The debt-to-GDP ratio is at 21.6 percent of GDP in 2015, entirely denominated in euro and well below the Maastricht debt reference value of 60 percent of GDP. It is worth noting that significant assets to fund future pension liabilities -29.4 percent of GDP at the end of 2015-have been set aside in a specialized and dedicated fund. Also, taking all government assets into account, the public sector is a net creditor. The public debt is projected to remain around 23 percent of GDP over the period 2016–2020, demonstrating the government’s commitment to keep the public debt below 30 percent of GDP.
Although the fiscal indicators are currently positive, the country is facing some structural challenges that may impact its public finances. Potential growth has declined and the high degree of openness of the economy and its specialization in financial services make public revenues vulnerable to high volatility. Also, several tax initiatives—such as the OECD/G20 BEPS project or EU rule changes and investigations - that are underway might have some consequences for the public revenues. The ageing population will also impact public finances over the long-term. The government concurs with the staff’s view about the need to place the old-age pension system on a sustainable path, and recognizes that a close monitoring of this issue is required. As provided under the 2013 pension regime, the government can assess, using actuarial studies, every 5 years, the consistency between the assumptions underlying the reform and the updated financial trajectory of the scheme. This review has been advanced by a year and is now taking place in 2016. In this context, the government took note of staff’s recommendations and stands ready to consider them in this review. It is also worth highlighting that the government has already put in place several initiatives with an objective to delay the effective retirement age, such as, but not limited to, the reform of the preretirement regime, professional reclassification and the complementary pension amendments.
Luxembourg’s forward-looking financial sector remains resilient and sound. It is a financial hub in the euro area that serves private and institutional clients around the world, and its diversification continues with Fintech activities as the latest effort. The ongoing regulatory changes at European and international levels represent challenges, closely monitored by the authorities who stand ready to take the necessary measures aimed at consolidating and strengthening the competitiveness and resilience of the financial sector in the long term.
Banking sector. The aggregate banking sector balance sheet has overall stabilized in the last few years, reflecting an increase of asset values but also some new inflows. The capitalization and liquidity ratios are sound, and the NPLs are very low. The banking sector continues to be profitable and remains an important liquidity provider. The authorities share the staff’s view that the European banking union is good for the euro area and is especially beneficial for Luxembourg as the more integrated prudential oversight under the SSM will eliminate potential ‘blind spots’ for the national supervisors, and strengthen the resilience of the banking system. In this regard, the authorities believe that it is essential to complete the banking union by putting in place a common European backstop for the single resolution fund as well as the third pillar of the banking union, the common European deposit insurance scheme. As for the oversight of nonbank holding companies of banks, discussed in 2015 Article IV Consultation, measures are taken to monitor ownership links at the time of authorization.
Investment fund industry. As the staff rightly point out in their report, the growing investment fund industry remains an important component of the financial system in Luxembourg. Over the last few years, the industry has benefited from favorable financial markets and has increased the amount of assets under management, also thanks to new inflows. It continues to invest in a diversified class of assets and caters to a diverse pool of investors without any major concentration risks. This diversification has been an important factor for the observed resilience of the overall financial sector during past crises and continues to help buffer the impact on financial market volatility on Luxembourg.
For this year’s Article IV consultation, the staff has used the investment fund industry in Luxembourg as a case study. They presented a very detailed and thorough analysis of the industry, and have taken a close look at the linkage between the investment fund industry and the banks in Luxembourg. The authorities took note of the risk factors identified by staff. However, they believe that it would have been beneficial to also present the benefits of a growing investment fund industry for Luxembourg and for the euro area. Next to that it is important to emphasize that a lot is already in place, and that the investment strategies of investment funds are laid down in their prospectus and the management companies must perform mandatory liquidity risk management and stress tests which are reviewed by the Commission de Surveillance du Secteur Financier (CSSF). The existing EU Directives provide a solid framework for risk monitoring, risk management and supervision of Luxembourg’s investment funds. Furthermore, the authorities welcome the UCITS V and AIFM Directives which have clarified and strengthened the role and the responsibilities of the depository banks.
The recently established Systemic Risk Committee (SRC) will, among other duties, closely monitor the links between the banks and the fund industry as well as the developments in the housing market. This committee has already had its first discussions on this linkage on the basis of the study conducted by the Banque centrale du Luxembourg (BCL)—who provides the Secretariat to the SRC. In addition, the IMF’s FSAP exercise, which will take place this year, is expected to cover this linkage. The authorities are looking forward to working closely with the IMF staff during this exercise which will help strengthen Luxembourg’s financial model further - proven to be resilient in the recent global crisis.
The increase of the capital of the BCL. The government has committed to finding a progressive and sustainable solution to endow the BCL with adequate capital. The discussions between the government and the BCL are ongoing.
Diversification of the economy continues. The government continues to pay careful attention to developing a climate conducive to business and investment, which should help pursuing efforts to diversify the structure of the economy. Specific sectors of growth such as logistics, ICT and bio- and eco-technologies have been chosen for this purpose. These diversification efforts are already starting to bear fruit, in particular in the rapidly growing logistics sector. The government continues to encourage innovation, looking for possible niches by using some of the existing frameworks/infrastructure: a pan-European project to build a supercomputer and a plan to create a legal framework for space mining are some of the latest examples. Lastly, the diversification of the forward-looking financial sector across the business activities, investment destinations and the customer bases is expected to further enhance the diversification of the financial sector itself.
Recent influx of refugees from the Middle East. Luxembourg hosts around 3500 asylum seekers since mid-2015, which account for nearly 0.5 percent of its population. The past experience in handling refugee and migration flows as well as the population’s positive attitude towards refugees, have helped the government to rapidly mobilize resources. Drawing on this past experience, the government is aware that it is extremely important to integrate refugees as quickly as possible. This is achieved by enrolling the children in schools from day one, providing intensive language courses and issuing work permits rapidly. To be able to do so - given the rapid influx of refugees - the government called on retired teachers to return to part-time work. As for the diploma recognition, the government is eyeing the German example. The government also reduced the time between the asylum application and the work permit granted to refugees from 9 to 6 months, in order to allow them to enter the labor market more quickly. Lastly, while it successfully managed to cope so far with the refugee influx, thanks also to the sound fiscal position, any renewed strong influx of refugees would likely put pressure on the country’s capacity to host.