The Luxembourg authorities would like to thank staff for their comprehensive analysis. It provides an objective view of the macroeconomic situation in Luxembourg and the challenges the economy is facing. The authorities broadly agree with the staffs analysis and recommendations.

The country’s continued stable political, social and regulatory environment has helped the economy and financial sector to weather the recent global financial and the European sovereign debt crisis well. The authorities have followed prudent macroeconomic and counter-cyclical fiscal policies, and have paid careful attention to developing a climate conducive to business and investment. Luxembourg is among the few European countries to maintain an AAA credit rating assessment with stable outlook from all three major credit agencies, clearly demonstrating the market’s confidence in the country, and its macroeconomic and financial fundamentals. The new three-party coalition government took office in December 2013 following early elections in October 2013.

Recent economic developments and outlook

After a slight contraction in 2012, the economy recovered in 2013 and registered a real GDP growth of 2.1 percent in the context of the rebound of euro area economies. The authorities project the economy to grow by 3.2 percent of GDP in 2014 and on average by 3.5 percent of GDP over the period 2015-2018 - better medium-term prospects than estimated by staff. The projections are based on a number of factors, among others: (i) sustainable pick-up of the euro area growth; (ii) a recovery in the global economy; and (iii) favorable stock exchange developments. Nevertheless, the authorities are aware that the trend growth slowed down markedly from the pre-crisis period. Growth projections for the medium term, produced by the independent national statistical authority, are hence being considered with the necessary prudence. The authorities will carefully analyze and consider different policy options - to be included in the 2015 budget - which will be growth friendly and at the same time reflect the new economic reality, in particular in terms of public spending.

Inflation is expected to be 0.9 percentage point higher in 2015 than estimated by staff, on the account of a 2 percentage point increase of VAT. Employment has recorded an increase of 1.7 percent in 2013, less than its trend level. Close to one third of new jobs were created in the public sector. The government’s latest projections show that the employment growth will accelerate in the coming years and amount to 1.9 percent in 2014, and will stabilize at 2.3 percent beyond 2015. The seasonally adjusted unemployment rate is on the rise, reaching a historical peak of 6.9 percent at the end of 2013. Unemployment tends to become more structural as rightly emphasized in the staff report. Almost half of the unemployed are lowskilled and a quarter of them are long-term unemployed. The authorities, conscious of this problem, have already adopted several measures in order to address it. For example, the employment agency is operating under new management with more staff and an upgraded IT system, with a new organizational system and a more proactive approach allowing for better matching. Further measures are in preparation, and these will tackle in particular theinactivity and unemployment traps.

Public finances

The economic and financial crisis has weakened public finances. Nevertheless, Luxembourg has maintained its relatively low level of public debt, 23 percent of GDP in 2013 - among the lowest in the euro area - as well as a significant budgetary safety margin with respect to the Maastricht deficit reference value of 3 percent of GDP. The budget balance remained consistently well above this reference value. Moreover, significant assets to fund future pension liabilities - these amounted to 26.9 percent of GDP at the end of 2013 - have been accumulated and set aside in a dedicated Fund.

However, the country is facing a series of challenges of a structural nature that will have a direct impact on the public finances. Potential growth is declining and the high degree of openness of the economy and its specialization in financial services make public revenues vulnerable to high volatility. The recent move to automatic exchange of information adds additional uncertainty on revenues; and the entry into force of the new regime for VAT on e-commerce of the 2008 EU Council Directive (2008/8/EC) will generate a loss of around 1.5 percent of GDP of VAT revenue beginning 2015. At the same time, public expenditures display downward rigidity with a significant part growing autonomously, independent of the business cycle. The ageing population also impacts public finances over the long term.

The general government balance increased from a neutral stance in 2012 to a small surplus of 0.1 percent of GDP in 2013. Given the early elections in October 2013, the 2014 budget had to go through two steps. The first four months were run under a so-called ‘current procedure’, with a partial continuity of the 2013 budgetary articles to allow for the smoothing functioning of the State. Second, the 2014 budget was voted on April 24. In this budget, consolidation measures of 0.5 percent of GDP were announced: 60 percent of these savings are to be achieved through a reduction of public investments; 21 percent through a reduction of the operating costs of the central government; and the remaining part represents savings from a new scheme of financial grants and loans for students in higher education. These additional consolidation measures will lead to a surplus of 0.2 percent of GDP in 2014.

For 2015, the authorities are keenly aware that, without additional corrective measures, the fiscal situation will deteriorate significantly. This deterioration will be mainly driven by the loss in VAT revenue from e-commerce activities and continued buoyant expenditure growth. Therefore, the authorities are committed to act firmly. On the revenue side, as a first measure, the government has already decided that all VAT rates will be increased by two percentage points with the exception of the 3 percent rate on basic goods, in order to shield the poorest households. This measure is expected to generate 0.7 percent of GDP of additional revenue. Moreover, the 3 percent rate would be henceforth limited to purchases of owner-occupied homes, constituting a first step in reducing excessive government support for housing demand. The planned reduction of this important budget expenditure in the housing market is part of the authorities’ efforts to provide an adequate policy response to the housing market, with a shift from demand-based policies to more supply-based policies. In this context, staffs recommendation to increase property tax is still under consideration. The remaining part of consolidation for 2015 is expected to take place by implementing additional measures with a focus on slowing expenditure growth. On the outlay side, the authorities have initiated a comprehensive expenditure review as a tool to prioritize savings over the next four years. The review is conducted in four phases from conception to implementation, with analysis across both ministerial and functional lines. 20 working groups have been established. The analytical phase will be finalized in June and provide the government with a report that will list a menu of savings measures. In line with the country’s 2014 update of the Stability Program, fiscal consolidation needs an amount of 1 billion euro in structural terms for the period 2015-2018. The aim is to ensure a gradual and sustainable return to balanced public finances by the end of the government’s tenure in 2018.

The staff report rightly emphasizes that the debt-to-GDP ratio has tripled in the period 2007-2013, from 6.7 to about 23 percent. Nonetheless, Luxembourg’s debt level remains well below the 60 percent level of the Maastricht criteria, the net public debt is significantly lower, and the public debt is entirely denominated in euro. The authorities are committed to keep the public debt below 30 percent - as the only sustainable trajectory.

The authorities are aware of the importance of putting the public finances on a sound footing in the long term, including keeping public debt levels low, and have introduced several new initiatives. An important healthcare reform became effective on January 1, 2011 - and further reforms are being discussed - while pension reform was adopted late 2012. The authorities concur with the staff’s view about the need to place Luxembourg’s old-age pension system on a sustainable path. The pension system still suffers from a number of costly rigidities, including the adjustment of benefits to both price and real wage developments. The authorities are aware that the recent reform might not be sufficient to solve the problems of the pension system. But, under the new pension regime, the authorities appraise every five years by means of an actuarial study the consistency between the assumptions underlying the reform and the updated financial trajectory of the scheme. This regular reassessment allows prompt corrective measures in case of expected shortfalls.

A law establishing a multi-year budgetary framework is currently undergoing the national legislative procedure. The framework would apply to all levels of government and include multi-year expenditure ceilings - consistent with the new EU requirements under the legislative “six pack” and the Fiscal Compact. Important steps have been taken to set up an independent Fiscal council that will be provided with sufficient resources and expertise in order to monitor deviations from fiscal targets.

Financial sector

Luxembourg’s financial sector has weathered the recent crises relatively well and remains generally sound. Nevertheless, significant regulatory changes at the European level – in particular those related to the banking union - and the recent move to automatic exchange of information from January 2015 represent challenges. The authorities believe that these challenges could have upside risks as they could strengthen the financial center’s advantages in the long term by ensuring a transparent environment, a level playing field and a more stable European banking system. Luxembourg’s unique ‘eco-system’ – described by staff as ‘a unique concentration of diversified financial institutions and related services, providing services based on the EU rulebook and civil law tradition, and supported by multilingual workforce’ - will also continue to attract new business and support its role as a financial hub within the euro area.

Banking sector. The aggregate banking sector balance sheet has contracted over the last few years, largely driven by a decline of asset values during the peak of the crisis, and more recently, the contraction in intragroup exposures with core euro area parent banks. The total assets recorded a level of 711 billion euro in February 2014. The capitalization and liquidity ratios remain sound, with Tier 1 capital ratio over 16 percent and liquid assets to total assets at around 60 percent. The NPLs are extremely low. The banking sector continues to be profitable and an important liquidity provider.

While some banks are leaving Luxembourg, mainly because of the deleveraging process of parent banks, large banking groups expand their presence in the country because of its role and expertise as a hub for back-office and custodian services within the euro area. Private banking is undergoing a transformation - partly in response to the switch to automatic exchange of information - becoming more service-oriented and catering increasingly to high net-worth individuals. The banking sector is strengthening its ties with emerging market economies. Eight new banks opened a branch or subsidiary in 2013 and a few more have applied for a banking license. The sector, together with the backing of the government, is also working to position itself as a European hub for the Renminbi business. Thus, diversification of the forward-looking financial sector across business activities, investment destinations and customer bases will help support and further develop banking activities.

The investment fund industry remains an important component of the financial system, and it continues to expand. The country is the second largest investment fund domicile in the world after the US. With over 2.6 trillion euro in March 2014, assets in Luxembourg-domiciled regulated funds reached a historical ceiling. This is a result of both revaluation of assets held and new inflows. The industry continues to invest in a diversified class of assets and caters to a diverse pool of investors. Furthermore, the authorities see the recent rapid transposition of the Alternative Investment Fund Managers Directive as another opportunity to develop new activities and support the industry. The authorities take note of staffs recommendation that an enhanced and proactive communication by the authorities and the industry would be beneficial, emphasizing ongoing efforts focused on investor and depositor protection. They stressed that the legal framework was in place but would need to be better communicated.

Regulatory issues. The authorities have made substantial progress in strengthening financial sector supervision and the regulatory framework. To improve the financial stability policy framework, they followed the FSAP recommendation on this issue, by further enhancing onsite supervisions and by hiring highly qualified staff. Indeed, staffing resources of the supervisory authority (CSSF) have been significantly increased to 500 full-time equivalent staff, which resulted in more frequent on-site inspections and augmented enforcement actions. The CSSF has also improved its supervisory techniques, including stress testing, and its preparation towards SSM also contributes to better risk-focused supervision. Similarly, the Central Bank (BCL) has expanded and strengthened its supervisory activities. Its liquidity monitoring and surveillance framework at the institutional level comprises qualitative and forward-looking quantitative analyses, which include both off-site analysis and on-site inspections. Moreover, the BCL requires from a large proportion of banks to provide their liquidity gap projections on a daily basis. Nonetheless, the increasing number of tasks falling within the remit of the BCL’s responsibilities calls for the strengthening of its human and financial resources. In this context, the Bank’s need for an increase of capital has been brought to the attention of the government and has been corroborated by the BCL’s external auditor.

The cooperation between the BCL and the CSSF is being enhanced through the evolution of institutional arrangements in the context of the preparation for the SSM. The recent proposal to establish a national Systemic Risk Committee (SRC) involving supervisors, the BCL and the Finance Ministry is expected to further strengthen that collaboration and information exchange. The authorities took note of staffs recommendation to closely monitor the links between the various domestic financial actors. Indeed, the SRC would be the right setting to monitor these risks through system-wide stress testing. However, the authorities do not share staff’s concerns/analysis regarding the scenario on possible redemptions from investment funds’ impact on banking sector liquidity needs. Investment funds have a number of options to address an increase in redemption requests: sell assets (highly liquid UCITS funds); suspend redemptions to avoid disruptions; and as a last resort, borrow from liquid banks.

The authorities also do not concur with the description of financial integrity and transparency issues, as they appear mainly in Appendix IV of the staff report. By bundling together AML/CFT, tax offences, transparency of legal persons and arrangements as well as exchange of information with foreign counterparts in a single, mainly negative sentence, the report ignores the very real progress made on all of them. This is discouraging and thus counterproductive. The staff report gives the impression of losing sight of the objective which is to fight money laundering and the financing of terrorism. This should first of all be achieved through efficient prevention and, secondly, through detection and penalizing of offenders. Its effectiveness cannot be measured in numbers of inspections, reportings of suspicious transactions and fines, but only in a decrease of actual money laundering or financing of terrorism. Finally, the authorities have provided staff with answers to show that the framework and actions implemented are effective in avoiding that financial institutions established in Luxembourg are abused for illegal or illicit activities.

Other issues

Diversification of the economy beyond financial activities. The authorities are committed to pursue efforts to diversify the structure of the economy, which is currently largely based on the financial sector activities. 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 ICT sector. As regards logistics, the government decided to re-use the existing facilities, close to railway and highway networks, to expand this sector without making significant investments. It has put in place a training facility to prepare staff for employment in this sector, which will partially tackle the problem of long-term unemployment of low-skilled workers.

Competitiveness and unit labor cost (ULC). The authorities noted the deterioration in price competitiveness over the last decade, due to relatively 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 introducing a law that temporarily modified - until October 2014 - the system of wage indexation. Moreover, this law foresees that at least 12 months should elapse between each indexation step of 2.5 percent. From 2015 on, the automatic indexation will return to its previous mode. The authorities are aware that this modulation is only temporary and that the room for maneuver in terms of productivity gains is getting smaller. Therefore, it is essential to preserve the competitiveness by limiting the growth of ULCs. The authorities will use the coming months to work closely with unions and employers’ representatives on a more permanent solution which should not undermine social cohesion in Luxembourg.

Housing market. Both structural and cyclical factors continue to contribute to the divergence between supply and demand in the housing market. On the demand side, several factors interfere: high demand from residents and cross-border workers; relatively high population and immigration growth; government housing benefits policies; and low mortgage interest rates. On the supply side, administrative constraints and low recurring taxes on immovable property seem to be the restraining factors. As mentioned above, the authorities are in the process of a review of expenditures where housing benefits will carefully be analyzed and if needed reconsidered. A measure on the VAT side, to be implemented in 2015, constitutes already a first step in reducing demand. Furthermore, staff notes that domestic residential real estate exposure of domestically-oriented banks has increased and would require monitoring. In this context, the authorities have taken several important steps such as raising risk weights for mortgage loans exceeding 80 percent LTV ratios as well as requiring frequent stress testing. In addition, the CSSF, in conjunction with the BCL, stands ready to take additional macro-prudential measures if exposures continue to rise.