Luxembourg: Staff Report for the 2015 Article IV Consultation
Author:
International Monetary Fund. European Dept.
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Publication Date:
08 Jun 2015
eISBN:
9781513530802
Language:
English
Keywords:
ISCR; CR; center; budget proposal; government; EU law; Luxembourg subsidiary; Banque Centrale du Luxembourg; EU directive; EU level; Financial sector; Global
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EXECUTIVE SUMMARY Luxembourg’s main challenge is to strengthen an economic model that has served it well. Growth was close to 3 percent in 2014, and is projected at 2½ percent in 2015, with continued strong job creation. The model emphasizes maintaining fiscal stability and openness, practicing conservative prudential oversight, and responding to investor needs. This combination has been a magnet for international financial business, nowhere more so than in the investment fund industry, where assets under management have more than doubled since 2008, to €3½ trillion. Recent challenges to this model necessitate a proactive approach to adjust to a changing landscape. The authorities’ commitment to positive engagement in the international tax transparency agenda supports a proactive approach. Having adjusted fiscal policy for lower revenues from electronic commerce, they should also address the additional base erosion that could now arise, exploring options to make the tax system more robust. At the same time, they should pursue further reforms to make the pension system more resilient to population aging. These policy initiatives, along with the authorities’ commitment to a modest budget surplus over the medium term, should fortify Luxembourg’s ‘AAA’ sovereign credit standing. Equally, Luxembourg also plans a series of actions to uphold its reputation as a firm and sophisticated financial regulator. These include faster passage of EU banking laws, where the banking union promises to be especially beneficial for Luxembourg, operationalizing a purposeful systemic risk committee, and being a voice for strong cross border oversight. On the latter, effective EU regulatory arrangements for nonbank companies that control banks should form a particular focus, given the large volume of intragroup activity transiting through Luxembourg. Provided the challenges ahead are well managed, growth in the near term could beat staff’s baseline, helped by a firmer euro area recovery. In the medium term, however, the success of the authorities’ initiatives to diversify the economy will play out against a backdrop of lower potential growth. It is doubly important, therefore, that efforts are also underway to better equip workers with relevant skills and to lift youth and women’s participation in the labor force.

Abstract

EXECUTIVE SUMMARY Luxembourg’s main challenge is to strengthen an economic model that has served it well. Growth was close to 3 percent in 2014, and is projected at 2½ percent in 2015, with continued strong job creation. The model emphasizes maintaining fiscal stability and openness, practicing conservative prudential oversight, and responding to investor needs. This combination has been a magnet for international financial business, nowhere more so than in the investment fund industry, where assets under management have more than doubled since 2008, to €3½ trillion. Recent challenges to this model necessitate a proactive approach to adjust to a changing landscape. The authorities’ commitment to positive engagement in the international tax transparency agenda supports a proactive approach. Having adjusted fiscal policy for lower revenues from electronic commerce, they should also address the additional base erosion that could now arise, exploring options to make the tax system more robust. At the same time, they should pursue further reforms to make the pension system more resilient to population aging. These policy initiatives, along with the authorities’ commitment to a modest budget surplus over the medium term, should fortify Luxembourg’s ‘AAA’ sovereign credit standing. Equally, Luxembourg also plans a series of actions to uphold its reputation as a firm and sophisticated financial regulator. These include faster passage of EU banking laws, where the banking union promises to be especially beneficial for Luxembourg, operationalizing a purposeful systemic risk committee, and being a voice for strong cross border oversight. On the latter, effective EU regulatory arrangements for nonbank companies that control banks should form a particular focus, given the large volume of intragroup activity transiting through Luxembourg. Provided the challenges ahead are well managed, growth in the near term could beat staff’s baseline, helped by a firmer euro area recovery. In the medium term, however, the success of the authorities’ initiatives to diversify the economy will play out against a backdrop of lower potential growth. It is doubly important, therefore, that efforts are also underway to better equip workers with relevant skills and to lift youth and women’s participation in the labor force.

Background and Recent Developments

1. Luxembourg’s economic success rests on the twin pillars of stability and openness. Its responsive, low tax, financially centered economic model has served it well, with growth outpacing the euro area in most years (Box 1 and Figure 1). Latest figures show real GDP expanding by 2½ percent y/y in the first three quarters of 2014, with net service exports as the largest driver.

Figure 1.
Figure 1.

Luxembourg: Economic Activity

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Luxembourg: Some Defining Traits

  • A stable political environment with a tradition of consultation with social partners. After 19 years under Prime Minister Juncker, a coalition of three other parties took office in late 2013. In its Programme Gouvernemental, the new government committed to focus on policies to manage the public finances soundly and keep gross debt below 30 percent of GDP; promote growth, sustainable development, and social cohesion; and fight unemployment.

  • A demonstrated ability to adapt to large economic shocks and reposition the economy. This has included early steps to embrace capital account openness and adapt prudential and legal frameworks, making Luxembourg a center for eurobond issuance and many other financial flows and activities.

  • A complex financial hub that serves all of Europe. The focus is on low margin, high volume business, especially valuation, custody, settlement, and legal services to funds. The sector includes:

    • ➢ A banking system with assets of some 16 times GDP. Dominated by units of foreign banks, some with key roles in group liquidity management, the system also houses locally active banks (that lend domestically) with assets of about 2¾ times GDP.

    • ➢ The second largest investment fund industry in the world. Global assets of almost €3½ trillion amount to some one-tenth of the global total or 70 times GDP, with most funds enjoying EU “passports.”

    • ➢ A systemic international central securities depository, Clearstream Banking S.A.. Active in custody, settlement, collateral management (including triparty repo and securities lending), and issuance services, Clearstream is an infrastructure platform of similar importance as Belgium’s Euroclear and the U.S. Depository Trust & Clearing Corporation.

    • ➢ A modestly sized insurance industry with assets of about 4 times GDP. Life insurance dominates with some two-thirds of total assets, followed by reinsurance, then property and casualty.

  • A record of fiscal conservatism. A central government net asset position of about 20 percent of GDP leaves Luxembourg as one of two euro area sovereigns rated ‘AAA’ by all major rating agencies.

  • A large share of cross border workers. Commuters from neighboring Belgium, France, and Germany account for more than 40 percent of domestic employment. Luxembourg thus provides important benefits to the regions immediately around it.

A01ufig01

Bank and Fund Liabilities, 2014

(Billions of euros)

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Sources: BCL, ECB, Haver Analytics, and IMF staff calculations.

2. The large role of commuting workers leaves unemployment among residents relatively elevated despite strong job creation, while falling inflation has tracked euro area trends (Figure 2). Job growth has exceeded 2 percent y/y, although almost half of the new jobs go to cross border workers, leaving the domestic unemployment rate at 7 percent. Residents’ incentives to take low paying jobs are limited by a generous welfare system. Inflation has tended to exceed that in neighboring countries, reflecting in part wage indexation and, this year, a VAT rate increase.

Figure 2.
Figure 2.

Luxembourg: Unemployment, Employment, and Inflation

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

3. The banking system appears well capitalized, although profit conditions are tight (Figure 3). There were 143 credit institutions as of February 2015. Capital ratios are high, as is capital quality, with fully loaded Basel III capital requirements easily met by most banks. The ECB’s Comprehensive Assessment identified an end 2013 capital shortfall at one bank operating in Luxembourg (an Italian bank with a Luxembourg subsidiary), but deemed this eliminated by capital raisings during 2014. Although only a few banks lend locally, credit to domestic households and firms amounts to some 90 percent of GDP. Declining interest margins are partly offset by growing fee income from various services for the investment fund industry. Banks with negative net income in 2014 accounted for some 4 percent of system assets.

Figure 3.
Figure 3.

Luxembourg: Financial Sector Developments

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

4. Search-for-yield inflows and buoyant equity markets are driving strong growth in the investment fund industry (also Figure 3). The total number of funds stood at 3,893 as of February 2015. Assets under management have more than doubled since 2008, increasing by half a trillion euros in the last seven months alone. With some 85 percent of these assets in products compliant with the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive, equity is sourced through extensive distribution networks across the EU and beyond, and the proceeds are mostly invested abroad. Strong net investment inflows reflect a search for yield at a time of falling bank deposit rates, with corporate cash pools playing a significant role.

5. The central bank is a net creditor to the Eurosystem, and has asked the government for more capital. Large TARGET2 net claims (reflecting banking system net foreign assets) expand the monetary authority’s balance sheet, helping reduce its capital to asset ratio to the lowest in the Eurosystem. The government has pledged to augment the central bank’s capital base going forward.

A01ufig02

Central Bank Own Funds, 2013

(Percent of total assets)

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Sources: Haver Analytics and central bank annual reports for 2013.

6. Luxembourg’s external accounts confirm its role as a financial hub (Figure 4). The large surplus on financial and other services is increasingly offset by growing deficits on investment income linked to growth in investment fund assets. Staff’s External Balance Assessment-lite (EBA-lite) suggests the current account surplus is somewhat below norm, and the real effective exchange rate remains close to its long-term equilibrium value (Appendix I). The positive net international investment position is dwarfed by gross asset and liability positions reflecting the domiciliation of multinational corporations (MNCs), securities issuers, banks, and funds.

Figure 4.
Figure 4.

Luxembourg: External Sector Developments

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Outlook and Risks

7. Staff’s baseline has growth slowing from almost 3 percent in 2014 to 2¼ percent over the medium term (Figure 5). Near-term prospects have brightened with those for the euro area. Potential growth has likely fallen from pre crisis levels, however, including as a result of financial sector activity shifting from banks to funds, where value added is smaller. Combining filtering techniques and production function approaches, staff puts potential growth at 1½–2¼ percent.

Figure 5.
Figure 5.

Luxembourg: Growth Projections, Trade Links, Sentiment, and Potential

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

8. The macroeconomic projections are fraught with more than the usual degree of uncertainty. As a city state economy, Luxembourg displays all the attendant patterns of strong growth, high output volatility, and sometimes large revisions to historical data. Migration, commuting, and financial services activity are especially difficult to forecast.

Luxembourg: Baseline Macroeconomic Framework, 2012–20

article image
Source: Staff estimates.

9. Foreign tax policy initiatives that could diminish Luxembourg’s tax base and financial sector events that could blemish its strong reputation are the main country-specific risks. EU and OECD initiatives to tighten tax transparency standards, along with U.S. proposals to tax offshore cash pools of U.S. firms, could hurt Luxembourg’s standing as a destination for FDI and a center for corporate treasury operations (Box 2). The failure of the Espírito Santo group of companies last year reminded that Luxembourg’s reputation for strong prudential oversight can be tested in unexpected ways even when other competent authorities are in charge under EU law. Although such processes or events could see some activities migrating away—with adverse impacts on total factor productivity, exports, jobs, and revenues—the authorities’ strategy of engagement in the relevant international fora is the correct risk management approach.

10. Near-term growth risks are broadly symmetric around staff’s baseline. Assuming the Luxembourg-specific challenges are well managed, domestic demand and net exports could beat the baseline. While the impact on disposable incomes of lower oil prices is largely offset by higher VAT (a rate hike took effect on January 1, 2015), that on investment from cheaper term funding and lower threshold returns on projects related to the ECB’s quantitative easing (QE), and from the EU Investment Plan, could surprise positively. Goods exports would suffer should there be a protracted period of slow growth in advanced economies. Service exports are tied to demand from global investors for asset management services, where the positive effects of QE are tempered by expectations of U.S. tightening.

11. Should geopolitical tensions or renewed financial stress in the euro area trigger a surge in global financial market volatility, the effects for Luxembourg could be mixed. On the one hand, a severe reversal of benign financial conditions would hurt equity market performance and risk appetite, triggering valuation effects and outflows from the fund industry. On the other hand, the banking system could once more receive safe haven inflows, as was the case during the global financial crisis in 2008–09.

Luxembourg: Selected Tax and Tax Transparency Initiatives

Several tax initiatives underway abroad have ramifications for Luxembourg:

  • The OECD/G20 Base Erosion and Profit Shifting (BEPS) project. Launched in 2013 at the G20’s request, the project identifies 15 areas for action. In late 2014, the OECD issued recommendations in seven of these, proposing measures to curb hybrid mismatch arrangements that exploit differences in tax treatment across countries as well as “treaty shopping” and other forms of arbitrage. The OECD also called for automatic information sharing on the allocation of profits, economic activity, and taxation of MNCs. Recommendations in the remaining eight areas are due later in 2015.

  • EU rule changes and investigations:

    • ➢ In 2014, the Directorate General for Competition launched probes into whether transfer pricing at four MNCs in the EU, two of which are in Luxembourg, could involve impermissible state aid.

    • ➢ In January 2015, new anti abuse provisions were added to the Parent-Subsidiary Directive that governs intragroup profit distribution, closing loopholes related to hybrid loans and mandating other steps to ensure that “tax arrangements reflect economic reality.”

    • ➢ In March 2015, the Commission presented a package of tax transparency measures as part of its agenda to tackle corporate tax avoidance and harmful tax competition in the EU, including a legislative proposal for automatic sharing of advance cross border tax rulings.

    • ➢ Going forward, the Commission also plans to present an action plan on corporate taxation, which could include a re-launch of the Common Consolidated Corporate Tax Base proposal and ideas for implementing the BEPS recommendations.

  • U.S. overseas taxation. The U.S. federal budget for fiscal 2016 proposes a one-time 14 percent tax on the stock of accumulated overseas profits of U.S. corporations and a 19 percent tax on future profits. These profits are currently not subject to U.S. taxation until repatriated, which motivates U.S. firms to hold an estimated $2 trillion abroad, including in jurisdictions such as Luxembourg.

Luxembourg, in turn, is increasing tax transparency. The authorities have commenced automatic exchange of information on interest payments under the EU Savings Directive (from 2015). They will extend this to other sources of income as well as account balances (from 2017), and are committed to implementing the OECD Standard for Automatic Exchange of Financial Account Information in Tax Matters (by 2017). They also exchange, upon request, firm specific tax rulings with other EU countries, and have strengthened information requirements for tax ruling applications and related procedures.

Luxembourg has also made progress in AML/CFT in recent years. Next steps will need to center on the 2012 Recommendations of the Financial Action Task Force, where effective implementation would necessarily include stricter approaches to tax crimes and transparency.

12. In the macroprudential domain, there is some risk that a protracted period of low interest rates could spawn a credit fueled housing bubble (Figure 6). Credit to households has been growing by about 7 percent y/y, yet household debt seems managable (data vary by source). If a bubble were to develop, housing prices could correct, compressing household consumption or triggering defaults and possibly disrupting credit to the economy. With rising housing prices spanning decades, reflecting population and job growth combined with zoning and other rules that constrain supply, there seems no immediate reason to expect a correction, although pockets of risk are possible. Separately, volatile aggregate credit to firms reflects the prevalence of MNCs with cross border financing arrangements and treasury operations run out of Luxembourg.

Figure 6.
Figure 6.

Luxembourg: Credit and Housing Market Developments

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

13. The authorities shared staff’s assessment of macroeconomic risks, but viewed the challenges to Luxembourg’s economic model and growth prospects more favorably. Considering improving indicators for the euro area, boosted by QE, they view growth of almost 3 percent in 2014 as a reasonable guide to medium-term performance. The strength and diversity of the financial sector as well as government efforts to diversify the nonfinancial economy were highlighted as supporting factors, as were the commitment to fiscal prudence, the track record of political and social stability, the region’s skilled multilingual labor force, and the business friendly environment with responsive authorities and modern infrastructures. Recognizing the importance of reinforcing financial sector oversight arrangements and engaging fully in EU and international processes to enhance tax transparency standards, and having refined the scope of advance tax agreements (or so-called rulings) for Luxembourg resident taxpayers, they expressed confidence that any resulting changes would serve to strengthen Luxembourg’s economic model. To illustrate, they pointed to the fact that the move toward tax transparency had had no material impact on the level of bank deposits: inflows from high net worth clients and nonfinancial corporations attracted by sophisticated one-stop-shop services have smoothly offset outflows from smaller depositors.

Policy Discussions

A. Fiscal Policy

14. Luxembourg’s strong general government net asset position of over 40 percent of GDP affords some flexibility in tackling significant revenue and long-term pension challenges (Figure 7). Budget deficits, when they occur, are driven by the central government, with the social security fund generating surpluses and borrowings by other arms of government limited by law. Gross debt, which has risen from single digits pre crisis to 23 percent of GDP in 2014 (driven in part by state support for Fortis, where shareholdings are now profitable), is still among the lowest in the EU. The long-term pension position is challenging, however, and international tax transparency initiatives could have adverse implications for the revenue base. As a small open economy, it is appropriate that the authorities are targeting a budget surplus over the medium term.

Figure 7.
Figure 7.

Luxembourg: Fiscal Sector Developments

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

15. Budget 2015 launches a multi year fiscal consolidation to address falling e-VAT revenues. Under a phased shift in EU taxation on e-commerce from domicile of seller to residency of purchaser as legislated in 2008, retained e-VAT revenue is set to more than halve in 2015, to about 1 percent of GDP, and halve again by 2018. In response, the authorities have raised VAT rates by 2 percentage points, expected to yield ½ percent of GDP in 2015 with the full impact kicking in from 2016, and have introduced a temporary personal income tax to balance the budget, set at ½ percent of income. After an expenditure review in 2014, some paring down of social spending is also to begin in 2015. Based on the authorities’ macro framework, the budget targets a general government deficit of 0.2 percent of GDP in 2015, after a surplus of 0.6 percent in 2014. Based on staff’s more conservative macro framework, the deficit for 2015 is projected at 0.5 percent of GDP, still consistent with the medium-term objective.

Impact of 2015 Budget Measures on Fiscal Balance

(Percent of GDP)

article image
Source: Staff estimates.

16. Luxembourg’s first medium-term budgetary plan envisages additional cost savings, and should restore surplus by 2016. On this plan and staff’s macroeconomic framework, by 2018 the authorities will have completed a fiscal adjustment averaging about ⅓ percent of GDP annually. The contribution of spending measures is expected to increase as additional savings are realized. Total spending is slated to grow by 4 percent annually through 2018, down from about 5 percent in 2010–14. By 2018, the general government would reach a surplus of about 0.2 percent of GDP, with gross debt still below 26 percent of GDP. The new fiscal framework covers all three sub sectors of the general government, with adherence to the fiscal rules to be monitored by a newly established Fiscal Council, as required under the EU Fiscal Compact.

A01ufig03

Fiscal Consolidation Measures

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Sources: Luxembourg MoF and IMF staff calculations.

17. The government’s fiscal package also includes a small wealth fund. Recognizing the transient nature of certain revenues, the plan is for fuel duties and remaining e-VAT totaling about €50 million annually to flow to the fund, which has a target size of €1 billion (just over 2 percent of 2014 GDP) by 2035. Observing that this is small relative to the projected future financing needs of the pension system, and too small to exert a meaningful disciplining impact on fiscal policy, staff suggested options be considered to transfer some central government financial assets to the fund, and that all future extraordinary receipts (divestment proceeds, principally) be channeled to it.

18. Deeper pension reforms remain essential to make the benefits system more resilient to population aging. New projections being prepared by the EU Working Group on Ageing suggest annual pension obligations will increase by only 2 percent of GDP through 2050, down sharply from the 8 percent of GDP increase projected by the OECD. These should be treated with caution, as almost half of the improvement comes from Eurostat demographic projections that assume net immigration will almost double Luxembourg’s population by 2050. Staff underscored the need to contain future liabilities by implementing OECD recommendations to: (i) abolish early retirement schemes to raise the effective retirement age; (ii) introduce progressive reductions of the replacement rate; (iii) limit credits for time spent outside work; (iv) institute actuarial neutrality around the statutory retirement age; and (v) index the retirement age to longevity. The authorities could use the upcoming review of pension finances in 2016 to adopt at least some of these changes.

A01ufig04

Projected Public Pension Expenditure

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Source: OECD.

19. In light of global tax initiatives, staff recommended the authorities develop options to make the revenue system more robust and achieve additional expenditure savings (Selected Issues, Chapter I). Taxes on the financial sector and on cross border retail trade (in fuel, tobacco, and other goods) yield over a quarter of total revenues. Significant receipts could prove susceptible to changes in EU and OECD tax standards and U.S. moves to tax U.S. firms’ profits held abroad. The tax challenge should be quantified as details evolve, with the 2015–16 tax policy review providing a good opportunity to assess options, including adjusting property related taxes, corporate tax exemptions, and selected financial sector levies. Further expenditure savings should also be sought, informed by regular expenditure reviews. On both the revenue and expenditure sides, the effort should be to identify measures that are equitable and durable and minimize the drag on growth.

20. Staff also advised that care be taken to ensure that firm specific tax rulings avoid encouraging unduly complex structures, especially in the financial sector. Demand for such rulings often reflects the lack of harmonization across national tax regimes, and there are benefits in providing certainty to firms. Recently, however, it has become apparent that some rulings could give rise to layers of holding companies transacting with each other in hybrid instruments, which in the financial sector can multiply challenges for regulators and supervisors.

21. The authorities stressed their commitment to sound fiscal policies. They expressed confidence that their budget targets for 2015 and the medium term will be met or exceeded, with planned consolidation measures either implemented in full or substituted with equally strong alternatives. On pensions, they agreed that long-term population projections by Eurostat that assume large net immigration should be viewed with caution, and acknowledged the importance of further structural reforms.

22. They underlined their commitment to engaging fully in EU and OECD standard setting on tax transparency, but maintained that it is still early to assess revenue impacts if any. With most rules still evolving, they held that the various initiatives have not yet translated into specific risks to the revenue base that would warrant a policy response. The Ministry of Finance emphasized that it is closely monitoring developments in the EU and OECD in order to make adjustments as necessary to be fully compliant with international standards. In any event, Luxembourg is participating fully in exchanges of tax information, including for firm specific rulings upon request. Regarding corporate taxes, the Ministry of Finance noted that rates and exemptions are being analyzed in detail in view of the envisaged tax reform. Regarding taxes on fuel and tobacco, it asserted that initiatives aimed at EU harmonization have not gained traction and that rates are finely tuned to avoid increasing CO2 emissions while preserving fiscal revenues. Regarding indirect financial sector taxation, the Ministry of Finance stressed that no comparable tax exists in other financial centers and hence any adjustment must be carefully pondered. Stressing the merits of approaching the tax policy review as a consultative process, the Ministry also emphasized the need for a continued strong role for expenditure measures.

B. Financial Sector Policies

23. The European banking union should be especially positive for Luxembourg, and the transition to it needs to be accelerated. Financial stability issues center on the banking system given maturity transformation and leverage. Given the system’s large size and extensive foreign ownership, Luxembourg will benefit particularly from the common backstop of the Single Resolution Fund, which will eventually exceed 100 percent of Luxembourg GDP. The more integrated prudential oversight under the Single Supervisory Mechanism (SSM) should help remove blind spots for Luxembourg supervisors, shedding light on potentially important risks emanating from foreign operations of large complex banking groups with units in Luxembourg. Resource constraints and other factors have delayed Luxembourg’s transposition of the Fourth Capital Requirements Directive and the Bank Recovery and Resolution Directive (BRRD). Further delays should be minimized, and efforts made to also promptly adopt the Deposit Guarantee Schemes Directive.

24. In anticipation of BRRD requirements, the authorities are proactively putting in place new bank resolution arrangements. Hitherto, failing credit institutions have been resolved under Luxembourg’s Banking Act of 1993, which provides a few bank specific provisions that prevail over the corporate bankruptcy code. The nascent resolution function is being assembled at the Commission de Surveillance du Secteur Financier (CSSF), the national competent authority for bank and investment fund regulation and supervision. The new resolution department in the CSSF is already collecting and reviewing bank information for resolution planning purposes, using existing supervisory powers to gather information. Once the BRRD is transposed into national law (which must occur by end 2015 at the very latest), the CSSF will become the recognized national resolution authority for both banks and bank holding companies and will interact closely with the Single Resolution Mechanism at the EU level.

25. Recently exposed limitations in EU oversight arrangements for cross border banking groups suggest Luxembourg should move proactively to reinforce sound approaches (Selected Issues, Chapter II). Banco Espírito Santo, Portugal’s third largest bank, was brought down in mid 2014 by weaknesses at its Luxembourg based holding companies, at the bank itself, and other group entities. The experience highlighted potential lacunae in EU oversight arrangements for cross border banking groups, where the identification of nonbank companies exercising “dominant influence” over banks is principles based, and the approach to the mixing of banking and commerce is permissive. EU laws do not directly apply requirements on nonbank companies that control banks to hold capital and thus be a source of strength to their bank subsidiaries. However, although the EU Capital Requirements Regulation does not mandate such norms, it does not forbid member states from writing these or other rules for such companies into national law. Luxembourg’s reputation for prudential conservatism would be well served by taking measured action at home, while also leading a broader debate at the EU level.

26. Maximizing the benefits of participation in the banking union may require additional national supervisory resources and coordination arrangements. Banks owning more than 80 percent of Luxembourg banking assets fall under the direct supervision of the ECB, either individually or through consolidated supervision of euro area parents. Both the CSSF and to a more limited extent the Banque Centrale du Luxembourg (BCL), responsible for liquidity supervision, contribute to SSM joint supervisory teams (JSTs) for these significant institutions. The CSSF’s staff strength increased by one-quarter over 2013–14 while its complement of bank supervisors doubled. CSSF and BCL supervisors are now engaged in 32 JSTs (of which five are for banks headquartered in Luxembourg). Resources should be expanded further as needed, where the increase in CSSF fees from 2013 was helpful. The CSSF and BCL could also consider a memorandum of understanding formalizing their respective responsibilities on JSTs as well as modalities for information sharing.

27. Luxembourg is set to benefit from the Central Securities Depository Regulation and the launch of the ECB’s TARGET2-Securities platform for settlement in central bank money. These developments should help expand the business of Clearstream and other Luxembourg depositories. Here too, CSSF–BCL cooperation will be important, to rigorously enforce requirements for settlement and depository functions, verify that contingency plans are in place to deal with operational risks that might arise in stress scenarios, and ensure that any ancillary banking operations are adequately capitalized.

A01ufig05

Securities in Custody, 2013

(Billions of euros)

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Sources: ECB and IMF staff calculations.

28. The growth of investment funds also requires that the authorities maintain strong oversight and are attentive to spillovers. Regulatory norms are largely determined at the EU level, principally under the UCITS Directive (where Luxembourg was a first mover) and the Alternative Investment Fund Managers Directive of mid 2013 (also swiftly transposed). Enforcement is in the competency of national authorities. Links to banks, direct and indirect, should be closely monitored, primarily through banking supervision. Given the large size of the industry relative to the banking system, funds’ cash balances, while small as a share of their total assets, make up a significant share of bank deposits. With almost 40 percent of fund assets in debt securities, global market liquidity issues could arise, especially in times of stress, with the related risk of sharp drops in fund value. The investor base that would absorb such losses is overwhelmingly in Europe (U.S. promoters are barred from marketing non U.S. fund products to U.S. retail investors and thus also distribute mostly in Europe). By contrast, roughly half of total assets are invested outside Europe, and roughly half of those in the United States. In parallel, the insurance industry’s investment portfolios and profitability also merit close monitoring, where current low interest rate conditions may challenge the life segment in particular.

A01ufig06

Bank and Investment Fund Assets and Liabilities, 2014

(Billions of euros)

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Sources: BCL, CSSF, and IMF staff calculations.1/ U.S. promoters distributing mostly in Europe.2/ Domicile of incorporation of promoter.

29. A systemic risk committee tasked with macroprudential oversight should be formed promptly. After several iterations, recently passed legislation provides for an appropriately broad reach, extending well beyond banking. The committee will bring together the financial sector authorities (the BCL, the CSSF, and the Commissariat aux Assurances for insurance) and the Ministry of Finance, collectively tasked with analyzing and assessing macrofinancial stability and systemic risk and recommending corrective actions. Duties should include not only risk monitoring but also the identification of regulatory gaps and impediments to effective policy action. Thus one focus for the committee could be the housing market, another should be links between banks and funds, and yet another might be arrangements for holding company oversight in a cross border context.

30. Growth in the housing exposures of locally active banks warrants continued monitoring and readiness to deploy additional macroprudential tools if needed. Housing prices and mortgage lending continue to rise, raising concentration risks. Some households could become overstretched. In late 2012, the CSSF took positive steps to dampen these risks, advising banks to limit loan-to-value (LTV) ratios to 80 percent and imposing higher risk weights on mortgages with higher LTV ratios. Staff advised the authorities to step up data collection on property lending, and to prepare appropriately targeted macroprudential tools for deployment if needed.

31. The upcoming Financial Stability Assessment (FSA) will provide an opportunity for a deeper dive into financial sector issues. As a systemic jurisdiction, Luxembourg is subject to mandatory FSAs. The last Financial System Stability Assessment was discussed by the IMF Executive Board on May 13, 2011. Assuming the next Article IV Consultation concludes on or before May 13, 2016, the next FSA may feed into the 2017 Article IV Consultation. Emphasizing the benefits, staff encouraged the authorities to proceed early with the next FSA.

32. The authorities agreed that the banking union presents important opportunities and that delays in transposing related EU directives are regrettable. The CSSF noted that the integrated cross border approach to supervision under the SSM is already engendering a more timely flow of information on risks to the Luxembourg units of foreign banking groups. It stressed both ability and willingness to increase staffing contributions to JSTs, yet pointed out that, as its fees have been calculated for supervision of the domestic system, there may be constraints to its participation in the consolidated supervision of parent banks in other national jurisdictions. The CSSF also observed with satisfaction that the switch to automatic exchange of financial account information has been managed smoothly. The Ministry of Finance, in turn, attributed the legislative delays to the surge in EU directives just as a new national government took office. It assured that the transpositions are now underway. Keen to first build a track record implementing new AML/CFT standards, the Ministry deems a later FSAP more productive, but has not yet taken a formal decision.

33. The authorities pointed to both national and EU initiatives that will reinforce Luxembourg’s strong brand name in finance. At the national level, the legislation that has established a systemic risk committee will improve financial sector oversight, as will implementation of a proposal to restrict the use of a bank’s franchise name by unregulated and unaffiliated nonbanks, thereby cutting unwanted reputational linkages. The authorities agreed that Luxembourg’s reputation would be well served by initiating and leading a debate on EU regulatory arrangements for nonbank companies that control banks, where Luxembourg is an important home and host jurisdiction, and decided in principle that they would do so. They felt that downside risks to the financial sector and the broader economy had receded with the improving euro area outlook. They underlined that the diversification of the financial sector is contributing to financial stability and is mitigating downside risks to the economy. At the same time, they recognized that the housing market merits continued monitoring, where better data collection is a work in progress.

C. Policies for Growth

34. Education and labor market reforms would help support economic diversification. In the financial sector, several new activities look promising, including alternative investment funds, Islamic finance (where in September 2014 Luxembourg became the first sovereign issuer of a euro denominated sukuk), and renminbi operations (where the same month one Chinese bank subsidiary in Luxembourg was granted clearing privileges with the People’s Bank of China). Beyond finance, the logistics sector has the potential to employ a relatively large number of low skilled workers, which would help lower structural unemployment. The remaining priority sectors (biotech, ICT, green technology) are more specialized, requiring more advanced skills. Staff asserted that the education system should deliver quality commensurable with high public spending. Vocational training, in particular, should be made more nimble. More active labor market policies and better targeting of social benefits could raise labor force participation rates and preserve incentives to work.

35. The authorities agreed that well crafted reforms would support diversification efforts, pointing to various initiatives aimed at improving labor market functioning. They are focusing on increasing women’s participation in the labor force, including by removing disincentives to work, and are continuing to modernize the employment agency so jobseekers can receive more personalized treatment, supported by better links to employers. A raft of training schemes is underway to increase the employability of youth and the long-term unemployed, while reforms of the minimum guaranteed income scheme for households seek to promote participation of second earners in the workforce.

Staff Appraisal

36. The core challenge Luxembourg faces is to strengthen an economic model that has served it well, where reputation is critical. The model emphasizes maintaining fiscal stability and openness to labor and capital, practicing prudentially conservative financial sector oversight, and responding swiftly to investor needs. The main priorities facing policy makers include making the tax system more robust, taking steps to buttress Luxembourg’s reputation as a sophisticated and proactive financial regulator, and making the pension system more resilient to population aging.

37. It is appropriate that Luxembourg, as a small open economy where labor and capital flow freely across borders, is targeting budget surpluses over the medium term. Medium-term fiscal targets and measures to achieve them are broadly appropriate. Periods of strong growth should be used to increase buffers. Budget 2015 and the medium-term fiscal plan are a strong response to falling e-VAT revenues. The new wealth fund, too, is a positive step, although as set up it is too small to exert a meaningful impact on fiscal discipline. At a minimum, future divestment proceeds (including from significant state shareholdings in the financial sector) should flow to it.

38. Deeper pension reforms should not be deferred. Although the government’s large net asset position affords some flexibility, social security assets of about 30 percent of GDP prefinance only part of the large future increase in age related spending. EU projections for very strong population growth should be treated with caution because migratory flows are difficult to predict and are themselves a function of solid macroeconomic, including fiscal, fundamentals.

39. The authorities should continue to engage fully in EU and OECD tax transparency initiatives, assess the impact of any tax base erosion at home, and work to develop options. Taxes on the financial and corporate sectors and on cross border retail trade yield sizable revenues. Tax challenges and risks should be quantified, and the upcoming tax policy review used to identify options. Further expenditure savings should also be sought. On both the revenue and expenditure sides, measures should be found that are equitable and durable and minimize the drag on growth.

40. Turning to the financial sector, the banking union is especially positive for Luxembourg, and no effort should be spared to promptly adopt related EU directives. By taking an integrated approach across countries, the SSM is better able to shine light on important risks. The revised arrangements for a systemic risk committee, with a reach extending well beyond banking, are promising. Duties of the committee should include not only monitoring and containing macroprudential risks but also identifying regulatory gaps. As macroprudential tools are readied for use, the choice of instruments should be informed by relevant data gathering and analysis.

41. Advocating for better EU oversight arrangements for groups that include banks will show Luxembourg in a positive light. Luxembourg’s tradition of capital account openness, itself supported by well articulated policies for exempting banks’ claims on their affiliates from large exposure limits, has fostered large cross border financial flows. As many of these flows are intragroup, effective oversight of banking conglomerates is central to Luxembourg’s standing as a financial hub. All options should be explored, therefore, all steps taken, and all lessons shared on how best to improve oversight of nonbank holding companies that control banks as well as their nonbank subsidiaries. Luxembourg’s proposal to sever unwanted reputational links by restricting the use of a bank’s franchise name by nonbanks claiming no affiliation is a sound starting point and should be implemented. This and other changes should be promoted at EU level.

42. In other policies to lift growth prospects, diversification efforts need to be supported by steps to equip workers with relevant skills. Job creation is strong, yet joblessness among residents remains elevated by historical standards, reflecting the important (and positive) role of cross border workers as well as generous benefits for, and skills mismatches among, residents. Vocational training in particular should be made more nimble. Steps being taken to lift youth and women’s participation in the labor force are welcome.

43. Staff recommends the next Article IV Consultation with Luxembourg be held on the standard 12 month cycle.

Table 1.

Luxembourg: Selected Economic Indicators, 2012–20

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Sources: Luxembourg authorities; and IMF staff estimates.

Percentage point contribution to GDP growth.

Overall economy.

Table 2.

Luxembourg: Balance of Payments, 2012–201/

(Percent of GDP)

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Balance of Payments Manual 6 (BPM6) presentation.

Under the BPM6 methodology, merchanting trade operations previously recorded under the service account have been reclassified into the trade account, resulting in a sharp reduction of the trade deficit.

Sources: STATEC; and IMF staff estimates.
Table 3.

Luxembourg: Risk Assessment Matrix1/

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The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 percent and 30 percent, and “high” a probability between 30 percent and 50 percent). The RAM reflects staff’s views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non mutually exclusive risks may interact and materialize jointly.

Table 4.

Luxembourg: General Government Financial Balance Sheet, 2012–14

(Millions of euros unless noted otherwise)

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Sources: IFS; and IMF staff estimates.
Table 5.

Luxembourg: General Government Operations, 2012–20

(Percent of GDP)

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Sources: Luxembourg authorities; and IMF staff estimates.
Table 6.

Luxembourg: Measures Underlying the Consolidation Scenario, 2015–20

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Sources: Luxembourg authorities; and IMF staff estimates.
Table 7.

Luxembourg: Financial Soundness Indicators, 2010–14

(In percent)

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Sources: Financial Soundness Indicators Database; BCL; and CSSF.

Values for 2011 exclude one bank under restructuring.

Table 8.

Luxembourg: Public Sector Debt Sustainability Analysis Baseline Scenario, 2015–20

(In percent of GDP, unless otherwise indicated)

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Source: IMF staff.

Public sector is defined as general government.

Based on available data.

Long-term bond spread over German bonds.

Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.

Derived as [(r - π(1+π) - π + ae(1 + r)]/(1+π+n+πn)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).

Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Table 9.

Luxembourg: Public Sector Debt Sustainability Analysis Composition of Public Debt and Alternative Scenarios, 2015–20

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Source: IMF staff.

Appendix I. External Sector Assessment

1. The EBA-lite approach extends to more countries than the EBA. The EBA-lite methodology estimates a country’s current account norm based on economic fundamentals, cyclical factors, and desirable policy variables. Using a calculated elasticity, exchange rate misalignment is derived as the adjustment necessary to restore the current account balance to its norm.

2. Luxembourg’s shrinking current account surplus is somewhat below the norm as estimated using the EBA-lite methodology. The growing surplus on financial and other nonfactor services (over 37 percent of GDP) is increasingly offset by deficits on workers’ remittances (17 percent of GDP) and net investment income (15 percent of GDP). The latter reflects the distribution of investment returns linked to the strong growth in investment fund assets booked in Luxembourg. As a result of this and other factors, the current account surplus narrowed from more than 10 percent of GDP in 2006–07 to about 5 percent in 2013–14. Using the EBA-lite approach, it is projected at some 3½ percent of GDP below its norm of 8 percent of GDP in 2015, suggesting scope for modestly higher domestic savings going forward, consistent with the thrust of staff’s policy advice. Nonetheless, the deviation from the norm is relatively small for so open an economy.

3. On staff estimates, the exchange rate remains broadly in line with fundamentals. The EBA-lite methodology indicates Luxembourg’s real effective exchange rate is overvalued by about 2½ percent relative to its equilibrium level. Thus there is no evidence of substantial misalignment.

Summary of EBA-lite Findings

(Percent of GDP unless otherwise indicated)

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Sources: Luxembourg authorities; and IMF staff estimates.
A01ufig07

Current Account (CA) Sustainability Assessment

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 144; 10.5089/9781513530802.002.A001

Sources: Luxembourg authorities; and IMF staff estimates.

Appendix II. Implementation of the 2014 Article IV Recommendations

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Same Series

Other IMF Content

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Cover IMF Staff Country Reports
Luxembourg: Staff Report for the 2015 Article IV Consultation
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2015: Issue 144
Publisher:
International Monetary Fund
ISBN:
9781513530802
ISSN:
1934-7685
Pages:
47
DOI:
https://doi.org/10.5089/9781513530802.002
Figure 1.

Luxembourg: Economic Activity

Bank and Fund Liabilities, 2014

(Billions of euros)
Figure 2.

Luxembourg: Unemployment, Employment, and Inflation
Figure 3.

Luxembourg: Financial Sector Developments

Central Bank Own Funds, 2013

(Percent of total assets)
Figure 4.

Luxembourg: External Sector Developments
Figure 5.

Luxembourg: Growth Projections, Trade Links, Sentiment, and Potential
Figure 6.

Luxembourg: Credit and Housing Market Developments
Figure 7.

Luxembourg: Fiscal Sector Developments

Fiscal Consolidation Measures

(Percent of GDP)

Projected Public Pension Expenditure

(Percent of GDP)

Securities in Custody, 2013

(Billions of euros)

Bank and Investment Fund Assets and Liabilities, 2014

(Billions of euros)

Current Account (CA) Sustainability Assessment

(Percent of GDP)