Statement by Willy Kiekens, Executive Director for Luxembourg and Amela Hubic, Advisor to the Executive Director, June 27, 2012

This 2012 Article IV Consultation highlights that economic growth in Luxembourg slowed in 2011 amid the euro area sovereign debt crisis. Reflecting sluggish external demand, economic activity is expected to further weaken, with growth projected to decline to ½ percent in 2012. Executive Directors have welcomed the continued stability of Luxembourg’s economy despite the turbulence in the euro area. They have commended the authorities on measures taken to strengthen the financial sector and to implement recommendations from the Financial Stability Assessment Program update.


This 2012 Article IV Consultation highlights that economic growth in Luxembourg slowed in 2011 amid the euro area sovereign debt crisis. Reflecting sluggish external demand, economic activity is expected to further weaken, with growth projected to decline to ½ percent in 2012. Executive Directors have welcomed the continued stability of Luxembourg’s economy despite the turbulence in the euro area. They have commended the authorities on measures taken to strengthen the financial sector and to implement recommendations from the Financial Stability Assessment Program update.

The Luxembourg authorities would like to thank staff for their comprehensive and useful analysis that provides an objective view of the macro-economic situation in Luxembourg and the challenges the economy is facing. However, the authorities note that the structure of the staff report is not rightly balanced as financial sector issues cover a significant part of the report. The FSAP update, that took place in September 2011, has already tackled in detail the current state of the financial sector and the remaining challenges. More analysis and advice on macro-policy and on public finances would have been appreciated. The authorities broadly share the views of the staff.

The country’s stable political, social and regulatory environments have helped its economy and financial sector to endure the recent global financial and the ongoing European sovereign debt crisis. The authorities have followed prudent macroeconomic policies and have paid careful attention to developing a business friendly climate and will continue to do so. They are committed to take all the necessary measures to further ensure the stability of the financial sector; long-run fiscal sustainability; and continued growth and employment. Diversification of the forward-looking financial sector across business types, investment destinations and customer bases has helped the economy to weather the crisis. Looking forward, the authorities are committed to pursue efforts to diversify the structure of the economy by developing new lines of business outside of financial sector realm (e.g. ICT, logistics or clean technologies). Finally, Luxembourg is among the very few European countries to maintain an AAA credit rating assessment with stable outlook, clearly demonstrating the market’s trust in the country.

Recent economic developments and outlook

After a severe downturn in 2009, the Luxembourg economy recovered in 2010 and registered a real GDP growth of 2.7 percent. In 2011, growth decelerated to 1.6 percent in the context of the slowdown of European economies. During the last quarter of 2011, the Luxembourg economy grew by only 0.8 percent. This deteriorating situation primarily reflects weaker export demand resulting inter alia from a restricted fiscal stance at the European level, a substantial deterioration in both business and consumer confidence stemming from the sovereign debt crisis and the negative effect that all these developments had on financial markets. In 2012, the Statistical Office (Statec) and the Central Bank of Luxembourg (BCL) project real growth to be 1 percent of GDP, 0.5 percent higher than staff’s projections, before recovering to just above 2 percent in 2013.

In this difficult economic environment, employment growth has been decelerating, although remaining positive at 1.9 percent in April 2012. Close to one third of new jobs were created in the public sector (broad definition) while employment growth in the private sector was more subdued. Nonetheless, the seasonally adjusted unemployment rate is on the rise, reaching a historical peak of 6.1 percent in April 2012. Unemployment tends to become more structural as rightly emphasized in the staff report. Almost half of the unemployed are low-skilled and a quarter of them are older than 50. The authorities are aware of this tendency and are planning to adopt measures to address it. The Ministry of Labor has already put in place some policies designed to preserve labor market participation among individuals over 50 who have recently lost their job.

Public finances

The economic and financial crisis has weakened the state of public finances in Luxembourg. Despite this negative evolution, Luxembourg has maintained its relatively low level of public debt as well as a budgetary safety margin in relation to the Maastricht reference value of 3 percent of GDP. Nevertheless, the country is facing a series of challenges of a structural nature that will have an impact on public finances. Potential growth is declining, and so will be the growth of public revenues. The high degree of openness of the economy and its specialization in financial services make public revenues subject to high volatility. At the same time, public expenditures are sticky downwards with a significant part being growing autonomously, independent of the business cycle. Finally, public finances in Luxembourg are highly exposed to population ageing.

The general government deficit declined from 0.9 percent of GDP in 2010 to 0.6 percent in 2011. Spending growth was kept below nominal GDP growth. New tax measures are estimated to have yielded 0.5 percent of GDP additional revenues. The debt-to-GDP ratio declined from 19.1 percent to 18.2 percent.

With weak GDP-growth this year, the fiscal deficit is allowed to increase to 1.5 percent of GDP in 2012. For next year, in line with the country’s latest update of its Stability and Growth Program (April 2012) fiscal consolidation measures have been announced for the period 2013 – 2015. These measures should reduce the deficit to 1.2 percent of GDP in 2013 and by an additional 1 percent of GDP annually thereafter, compared to unchanged policies. Adjustment measures include expenditure reductions for ⅔ and revenue increases for ⅓. The authorities would have appreciated a clearer presentation of this consolidation package in the staff report for the period 2013 – 2014, as it is not clear whether staff’s projections include the government’s consolidation package or not.

The authorities are skeptical about staff’s suggestion to let automatic stabilizers operate since in Luxembourg fiscal multipliers are rather low or close to zero, as recognized by the staff. Given the political difficulties in reducing the fiscal deficit, the authorities are reluctant to allow deviations from the nominal consolidation path.

The general government balance is projected to continue to improve in 2014. However, in 2015, despite a favorable macroeconomic context, a structural change in the VAT regime will cause a revenue loss of about 1 percent of GDP due to a shift from the domicile of the e-commerce service provider to the residence of the consumer. This revenue drop will gradually increase as the change in the VAT regime is introduced gradually. In line with the European directive, 70 percent of the VAT receipts will be transferred to the ‘consumer’ countries during the first two-year period, 85 percent in 2017 and 2018, and 100 percent only in 2019. The staff estimate of these revenue losses seems to neglect this gradual phasing in.

If Luxembourg has not achieved its medium-term objective of a structural surplus of 0.5 percent of GDP in 2015, the authorities are committed to adopt additional measures in order to bring public finances back towards the medium-term fiscal objective.

The staff report rightly points out that the debt-to-GDP ratio has almost tripled in the period 2007-2011, from 6.7 to about 18.2 percent. Let us nonetheless observe that Luxembourg’s debt level remains well below the 60 percent level of the Maastricht criteria, that the net public debt is significantly lower (Luxembourg’s participation in PNB Paribas alone amounts to 6 percent of GDP) and that the public debt is entirely denominated in euros. The authorities are committed to keep the public debt at low levels as the only sustainable trajectory for Luxembourg.

Short-term public finances indicators in Luxembourg are favorable when compared with peer countries. Nonetheless, there are long-term challenges. The authorities are aware of the importance of putting the public finances on a sound footing in the long term. Since Luxembourg is a small open economy, from the authorities’ point of view, public debt levels should remain well below the Maastricht criteria, even in case of a renewed downturn. This will preserve long-term economic stability and business attractiveness of the country. Therefore, several initiatives have been taken. An important healthcare reform has become effective from January 1, 2011. Further reforms are being developed, including the restructuring of the hospital sector starting in 2013. A draft pension reform will be discussed in Parliament in the second half of 2012. The government concurs with the staff’s view about the urgent need to place Luxembourg’s old-age pension system (public and private) on a sustainable path. The existing pension system suffers from a number of costly rigidities, including the indexation of benefits to both price and real wage developments. The authorities are aware that this reform might not be sufficient to solve the problems of the pension system. Under the new pension regime, the government’s reassessment every five years should prompt corrective measures in case of expected shortfalls. Finally, the authorities are working on establishing a multi-year budgetary framework to deliver the needed fiscal consolidation. The framework would apply to all levels of the government, and include multi-year expenditure ceilings, consistent with the new EU requirements under the legislative “six pack” (to be transposed by the end of 2013) and the Fiscal Compact.

Financial sector and developments in supervision

The banking sector has recently suffered from the ongoing sovereign debt crisis in the euro area. The aggregate bank balance sheet, after having recovered to more than euro 800 billion in January 2012, receded again in the following months to stabilize in April 2012 at a level slightly higher than the yearly average observed in 2011 (780 billion euros). This contraction follows declining asset values and reduced exposure on sovereigns and other banks. Bank profits before taxes, depreciation and provisions, declined by more than 11 percent in the first quarter of 2012 to around 1.4 billion euros. Still, Luxembourg-based banks remain well capitalized, profitable and liquid.

While some banks are retreating from Luxembourg, mainly because of restructuring measures or because their business model does not fit the Luxembourg financial sector, large banking groups expand their presence in Luxembourg because of its role and expertise as a hub for back-office and custodian services. Private banking is also undergoing a transformation, becoming more service oriented and catering increasingly to a more sophisticated clientele.

The investment fund industry is an important component of the Luxembourg’s financial system. Although affected by the recent global financial crisis, the fund industry has recovered well. With over 2.2 trillion euro in April 2012, assets in Luxembourg-domiciled regulated funds reached a historical ceiling1. This is a result of both revaluation of assets held and new inflows. The number of investment funds has increased by 178 units between end 2010 and 2011 (from 3667 to 3845). Anecdotal evidence also suggests that investment funds that used to be offshore before the crisis are now seeking the safety of a regulated product like the UCITS brand and of a domicile in Luxembourg. Overall, it seems that the Luxembourg fund industry is weathering well the ongoing sovereign euro area debt crisis – both from a financial stability point of view and with regard to its reputation as a well regulated product. Moreover, the authorities do not share staff’s point of view that euro area turbulence could result in outflows of funds. If the investors want to change their investment portfolio and invest in other regions rather than in the euro area, they will probably opt for another Luxembourg-domiciled fund offering exposure to that specific region which in the end would not cause any outflows from the fund industry. The experience in recent crisis (e.g. Irish case) provides some evidence. Both the authorities and the fund industry’s management are confident about the outlook. The data of the first four months of 2012 indicate that the net asset value as well as the number of units has continued to increase. The industry management indicated that it does not expect any significant new inflows of assets for the rest of the year but is confident that the industry is able to maintain the current level.

Luxembourg financial sector exposure to European periphery countries has declined significantly since the last consultation, as rightly noted in staff report, and represents a small share of overall assets. Moreover, the authorities are confident that, in an extreme tail event, the banking sector’s strong capital position provides comfort in this regard. Regarding Luxembourg Fund industry, the exposure to distressed sovereigns is limited.

Solvency, Tier 1 capital and liquidity indicators are traditionally high in Luxembourg and remain so. Although Luxembourg-based banks have registered losses in their securities portfolios in 2011, they remain highly capitalized. Moreover, following the EBA recommendation of 8 December 2011 on the recapitalization of European banking groups, the banking supervision authority (CSSF) has increased the capital requirements for all Luxembourg based banks (not just those required by EBA) to a minimum 9 percent of risk-weighted assets in Core Tier I capital. The authorities acknowledge that the liquidity standards under Basel III (CRDIV/CRR in Europe) could be challenging if applied at the solo/sub-consolidated level. The CSSF and the BCL are closely following developments on that front.

Regulatory issues. The authorities have made substantial progress in strengthening financial sector supervision and the regulatory framework. To improve the financial stability policy framework, the authorities followed the FSAP recommendation by further enhancing on-site supervisions and by hiring highly qualified staff. Indeed, the staff and resources of CSSF have been significantly increased and resulted in more frequent on-site inspections (from 38 in 2009 to 85 inspections in 2011 of banks) and augmented enforcement actions (from 4 in 2009 to 72 inspections of investment funds). Similarly, the BCL has vastly expanded its supervisory activities by also recruiting additional staff and expending the financial stability and prudential supervision department resources. The latter integrates one unit in charge of liquidity surveillance, one in charge of oversight of payment and settlement infrastructures and the financial stability unit tackling the macro-prudential aspects and assessing systemic liquidity risk. The BCL liquidity monitoring and surveillance framework at the institutional level comprises qualitative and forward-looking quantitative analysis, which includes both off-site analysis and on-site inspections. In this context, the BCL has conducted in 2011 nine on-site inspections in close cooperation with the CSSF. In addition, the central bank requires from a large proportion of banks to provide their liquidity gap projections on a daily basis. As regards the bank resolution regime and deposit insurance scheme, the authorities would like to emphasize the importance of moving in lockstep with EU-level regulations which is consistent with Luxembourg tradition of regulatory stability but also with other EU countries.

The financial industry had recognized the value of stronger supervision for financial stability, which provides an additional safety net for investors, and has welcomed the constructive dialogues with supervisors (CSSF and BCL) as well as with Luxembourg authorities.

The authorities take note of staff recommendations for refinements in Luxembourg’s institutional frameworks for financial supervision and regulation – in line with the FSAP update as well as forthcoming EU requirements – namely: clarifying the respective roles and duties of the CSSF and BCL on liquidity risk supervision; establishing a national macro-prudential authority with a central bank taking a leading role; and strengthening the CSSF’s operational independence. They take all these three issues very seriously and intend to take legislative actions to address them in a holistic manner. They stress that operational independence of institutions should go hand in hand with accountability and responsibility. The legislative actions will probably take place in the second part of 2012.

At the international level both the BCL and the CSSF are engaged in exchange, discussion and analytical work on the new European supervisory infrastructure EBA and ESRB. Moreover, exchange of supervisory information and home-host coordination takes place at the level of supervisory Colleges and Cross Boarder Stability Groups for all important banking groups with cross border activities. In addition, the BCL and the CSSF are engaging intensively with banks to prepare them for potential future changes in regulation.

Other issues

Diversification of the economy. The authorities are committed to pursue efforts to diversify the structure of the economy which is currently largely based on the financial sector activities (close to 30 percent of GDP) that contribute significantly to fiscal revenues (around 25 percent of total revenues) as well as to employment (around 10 percent of employment). At the beginning of 2012, the authorities founded a Luxembourg Future Fund to support the diversification and sustainable development of the economy. The Fund should invest directly or via other funds in innovative small and medium enterprises in a start-up or development phase in technology sectors (e.g. ICT or clean technologies). The government will invest 120 million euro in the Fund via the ‘Société Nationale de Crédit et d’Investissement (SNCI)’ and the European Investment Fund will contribute another 30 million euros. In addition, the government will invest in health sciences and technology via an existing private fund.

Competitiveness and unit labor cost. The authorities have noted the deterioration in price competitiveness over the last decade (unit labor costs rising much faster than in neighboring countries) due to high wage increases coupled with low productivity growth. Wages and benefits are linked to inflation through an automatic indexation mechanism. The authorities took steps to improve competitiveness by adjusting the system of wage indexation. In December 2011, Parliament adopted a law to temporarily modify the automatic indexation of wages. The automatic indexation of wages, which would have occurred in March 2012, has been postponed to October 2012. Moreover, until 2014, at least 12 months should elapse between each indexation step of 2.5 percent. With the introduction of this minimum interval, wages and benefits will no longer be fully indexed to the cost of living in the event that inflation exceeds 2.5 percent. This so-called ‘modulation of the wage indexation system’ prevents an upward spiral of cost and price increases and will have a temporary effect on cost competitiveness, especially in times of high inflation. From 2015 on, the automatic indexation will return to its previous mode, but the counter for the next automatic wage indexation will be set to zero. As a consequence, some of the gains in cost competitiveness will be permanent. The authorities are aware that this modulation is only temporary and that the room of manoeuvre in terms of productivity gains is getting smaller. Therefore, it is essential to ensure the competitiveness by limiting the growth of unit labor costs. During this temporary modulation period, the authorities will be working with unions and employers’ representatives on a more permanent solution which should not undermine social cohesion in Luxembourg.


The country is the second largest investment fund domicile in the world after US.