The authorities thank Mr. De Vrijer and Mr. Breuer, and their respective teams, for the excellent cooperation during the Article IV Consultation and the FSAP exercise in Luxembourg. The analysis presented in their respective reports provides a broadly balanced view of the macroeconomic, fiscal and financial sector developments in the country and the challenges these are facing. The authorities will consider the staff recommendations in the policy decision making.

Macroeconomic outlook

The Luxembourg economy remains strong with buoyant employment and growth prospects. A stable political and social environment, a track record of fiscal prudence and a modern legal and regulatory framework are important factors that support growth, as is the skilled and multilingual workforce. A continuous AAA credit rating with stable outlook confirms the market’s confidence in the country.

Over the last three years, the average real GDP growth was 4.6 percent. In 2016, the economy grew by 4.2 percent, mainly driven by robust domestic demand and strong net exports. In the latest update of the Stability and Growth Program, the government projects the economy to grow by 4.4 percent in 2017 and on average by 3.6 percent over the medium term.

Strong and dynamic job creation led to an increase in employment of 3 percent in 2016. Employment creation is projected to even accelerate to 3.2 percent on average over the medium term. Unemployment is declining thanks to favorable growth dynamics and the government’s active labor market policies that help tackle youth unemployment, as well as the long-term unemployed low-skilled workers. The employment agency’s (ADEM) personalized programs tailored to the needs of unemployed and labor demand, together with reclassifying people with medical conditions, have also helped reduce the unemployment rate, which stood at 6 percent at the beginning of 2017, down from around 6.8 percent in 2015, and is projected to further decrease to about 5.4 percent in 2019.

In line with euro area trends and oil prices, average inflation remains relatively low. However, over the medium term, inflation is projected to an average 1.8 percent. The current account has eased to 5 percent of GDP in 2016. It is expected to remain at this level in the medium term, reflecting a surplus in services partly offset by a negative balance in goods. The authorities agree with staff that the external position is broadly in line with fundamentals.

Despite strong growth prospects, the authorities recognize that some, mostly external, downside risks exist, such as the retreat from cross-border integration and the policy uncertainty at the European and global level. They will therefore continue to maintain sound policies and diversify the economy further, to increase its resilience to shocks. In this context, the authorities were wondering whether the IMF has assessed similar types of global risks for the financial centers/countries comparable to Luxembourg.

Public finances

The fiscal position remains sound, with a 1.6 percent of GDP budget surplus in 2016 and a gross public debt level close to 20 percent of GDP. The country has managed to maintain its low level of public debt, well below European reference values and its own 30 percent of GDP ceiling, as well as budgetary safety margins with respect to the rules of the EU Stability and Growth Pact, demonstrating the government’s commitment to sound fiscal policies.

The government implemented a significant tax reform on January 1, 2017, targeting both companies and households, with the latter being the largest beneficiaries. The reform aims at supporting the competitiveness of companies and at reinforcing households’ purchasing power. The most significant measures were a rebalancing of the personal income tax brackets and the gradual reduction of the headline corporate income tax rate. Other objectives of the reform are to simplify the tax system and to make it fairer. In light of the favorable macroeconomic and fiscal developments, helped by the positive impact of a sizeable consolidation package implemented since 2015, the tax reform is making use of the fiscal space vis-à-vis European fiscal rules while still maintaining sufficient buffers as recommended by staff.

Despite the budgetary impact of the tax reform, the fiscal position is projected to remain close to balance and in slight surplus over the medium-term. The authorities continue to target a high public investment level, at around 4 percent of GDP, in light of the strong population and employment growth projections. The gross public debt stood at 20 percent of GDP in 2016, entirely denominated in euro, and is projected to remain around 23 percent of GDP in the coming years. It is worth noting that significant assets to fund future pension liabilities (32.9 percent of GDP at the end of 2016) have been set aside in a specialized and dedicated fund. And, taking all government assets into account, the public sector remains a net creditor.

Although the fiscal indicators are currently positive, the country is facing some structural challenges that may impact its public finances. Potential growth has somewhat declined and the high degree of openness of the economy and its specialization in financial services make public revenues vulnerable to high volatility. Also, several tax initiatives that are underway - such as the OECD/G20 BEPS project or EU rule changes and investigations – may create uncertainty, although Luxembourg could also benefit from a global level playing field given its other competitive advantages. The ageing population may also pose a challenge for public finances over the long-term. The government concurs with staff’s view that a close monitoring of the sustainability of the pensions system is required. At the end of 2016, as provided under the 2013 pension reform, the competent authority has presented the financial situation of the pension system based on an actuarial study. In addition, a pension working group was created, comprised of social partners and government representatives, with the goal to provide, if appropriate, recommendations to reform the pension system.

The Luxembourg government has committed to greater transparency and to the alignment of its tax practices with international standards. In that vein, it has taken important steps over the last three years, such as: (i) a commitment to implement the OECD Standard for Automatic Exchange of Information; (ii) an approval of agreements for the automatic exchange of country-by-country reports as well as advance tax rulings and advance price agreements on transfer pricing; and (iii) a publication of a circular on the tax treatment of intra-group financing aimed at implementing BEPS recommendations.

Financial sector

The authorities appreciate the work done under the 2017 FSAP exercise, and intend to follow up on most recommendations which will help further strengthen Luxembourg’s financial model. Some preliminary reactions are presented in the next paragraphs.

The FSAP findings indicate that Luxembourg’s forward-looking financial sector, which is interconnected domestically and internationally, remains resilient and sound. The ongoing regulatory changes and uncertainties at European and international levels may present challenges and are closely monitored by the authorities who stand ready to take the necessary measures aimed at preserving the resilience and stability of the financial sector.

The banking sector has maintained high levels of profitability, capital, liquidity and asset quality, and NPLs are very low – both on absolute levels and compared to peers. The sector continues to be profitable and remains an important liquidity provider. The banking union is good for the euro area and especially beneficial for Luxembourg, as the more integrated prudential oversight under the SSM eliminates potential ‘blind spots’ for the national supervisors, and strengthens the resilience of the banking system. In this regard, the authorities believe that it is essential to complete the banking union, notably by putting in place a common European backstop for the single resolution fund as well as the third pillar of the banking union. The authorities also underscore the importance of retaining the supervisory powers of host countries as long as the banking union is not completed in order to preserve the host country’s financial stability, including the possibility of imposing liquidity and loss absorption capacity requirements at the level of bank subsidiaries.

The growing investment fund industry remains an important component of the financial system in Luxembourg. Over the last few years, the industry has benefited from new inflows and favorable financial markets which increased the amount of assets under management. It continues to invest in a diversified class of assets and caters to a diverse pool of investors without any major concentration risks. This diversification - together with prudent regulatory and sound supervisory regimes - has been an important factor in the resilience of the overall financial sector during past crises and continues to help buffer against the impact of financial market volatility.

The authorities are supportive of staff’s recommendations on the financial sector oversight, including for non-bank holding companies and investment funds and their linkages to banks. The Commission de Surveillance du Secteur Financier (CSSF) has already produced a study on linkages between investment funds and banks, indicating that banks could withstand a sizable redemption shock from investment funds under certain assumptions. Furthermore, the Systemic Risk Committee (SRC) - the national macro-prudential authority - had discussions on this linkage based on a study prepared by the Banque centrale du Luxembourg (BCL), and will continue to analyze and closely monitor this interlinkage considering the CSSF study and the IMF analysis.

Staff’s assessment of the financial system’s ability to withstand severe shocks suggests resilience of the sector, with the principal risk identified as interruptions to real and financial cross-border flows. The authorities take note of the outcome of the stress testing exercise. It is worth noting that the key risk identified pertains mainly to the structure of global financial operations, and probably applies to any financial sector comparable to the one in Luxembourg.

The government supports the recommendation of a code of conduct for regulators’ boards, but disagrees with the recommendation regarding regulators’ board composition and governance arrangements. Luxembourg’s governance model is commensurate to the strategic importance of the financial center and comparable to that of other supervisory authorities. The government supports staff’s recommendation to introduce a formal framework to govern the relationship between the government and banks with a state shareholding. It will look at different models which exist in other euro area member states.

The authorities welcome staff’s thorough assessment of Clearstream, which offers a safe and efficient system of clearing, settlements and custody of securities transactions. Given the importance of this institution, the authorities have asked the ECB to consider designating it as a Significant Institution under the Single Supervisory Mechanism (SSM), alongside Belgium’s Euroclear Bank. This will ensure consistent implementation of supervisory requirements and be in line with FSAP 2017 recommendations.

Other issues

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 play a role, including high demand from residents and cross-border workers, a relatively high population, immigration growth and low mortgage interest rates. On the supply side, administrative constraints and low recurring taxes on real estate property seem to be the restraining factors. However, staff’s analysis shows that the real estate valuations remain broadly in line with economic fundamentals. The authorities recognize the need to continue monitoring this risk - through the SRC - and stand ready to take actions, if needed. In this context, the SRC continues monitoring the domestic residential real estate exposure of domestically-oriented banks, which is important for financial stability, and will recommend additional macro-prudential measures as necessary.

Diversification of the economy. The government continues to pay careful attention to developing a climate conducive to business and investment which should help pursuing efforts to diversify the economy. It remains committed to keep investment levels high. The government has chosen specific sectors of growth such as logistics, ICT and bio- and eco-technologies to support the diversification. It continues looking for possible opportunities by using some of the existing frameworks/infrastructure and encourages innovation. For example, it recently developed a legal framework for space mining which will support the existing ecosystem in this sector. Also, the diversification of the forward-looking financial sector across the business activities, investment destinations and the customer bases is expected to further enhance the diversification of the financial sector itself. Recent efforts by the government to promote fintech and climate finance underline such ambitions.

Educational system. Staff rightly points out that Luxembourg’s trilingual education system can be both an asset and a challenge for the highly diverse student population. Difficulties with language learning have led to difficulties in other disciplines, which is reflected in PISA scores. The government has taken this challenge seriously and has introduced measures to diversify and improve education curricula. Staff’s view that ‘more than half of new jobs created go to cross border commuters, mainly due to skills mismatches, reflecting deficiencies in education and training’ is not fully accurate. More than half of the unemployed in Luxembourg are long-term unemployed with lower education, who have not previously worked in the financial sector. Many newly created jobs stem from the financial sector and need a workforce with a tertiary education. To tackle this issue, the government objectives are two-fold: (i) introduce proactive targeted measures for the long-term unemployed, and employ them in the newly created real sector activities (e.g. logistics); and (ii) improve/adapt the national education system to better prepare students for the needs of the economy.