Luxembourg -- 2006 Article IV Consultation, Concluding Statement of the IMF Mission

January 30, 2006

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

January 30, 2006

1. Luxembourg's dynamic financial sector and the overall comfortable position of the public sector leave the country well placed to address future challenges. Key among these is the conduct of fiscal and social polices in light of a potential shift to a lower growth trajectory, as the financial sector matures. The mission views the latest Stability Program as a major step in the right direction, but the targeted consolidation of ½ percent of GDP may not be met in 2006, barring further measures. More broadly, it recommends frontloading fiscal adjustment and adopting a budget framework that maps long-term sustainability requirements—including those arising from aging—into consistent general government budget targets. On this basis, the government should strive for a general government surplus of at least 1 percent of GDP over the medium term. The required adjustment should rely on expenditure measures. These should be flanked by social policies rendering the labor market more flexible in order to forestall a further rise in structural unemployment. Such policies would serve the country well to preserve its dynamism, and foster long-term sustainable growth.

The Near-Term Outlook

2. The economic recovery is well advanced, and growth is likely to remain robust in 2006. Growth in the euro area appears to be gaining traction, and Luxembourg's financial sector performance is expected to remain solid. Nevertheless, financial sector profit growth may slow somewhat, following its strong performance last year. Therefore, we project real GDP growth of 4.0 percent in 2006, broadly in line with our 4¼ percent estimate for 2005. However, domestic demand remains feeble, and in light of rising labor supply in neighboring countries, we expect unemployment to continue to edge up to 5.3 percent by end-2006. Assuming relatively stable energy prices, inflation (IPCN national index) is expected to average 2.3 percent in 2006.

The Financial Sector and the Medium-Term Outlook

3. The medium-term outlook remains favorable, but a shift to a lower growth trajectory appears in the offing. Financial sector growth can be expected to continue to outpace GDP growth, and specialization is proceeding. Nevertheless, the successful shift from traditional—high margin—banking activities to lower margin activities supporting the asset management industry is in an advanced stage. While there remains ample scope for expansion Luxembourg's asset management industry is second largest worldwide, and the speed of the expansion is likely to begin normalizing over the medium term. Against this background, the mission commends intensifying efforts to diversify the economy.

4. At the same time, the financial sector remains well positioned to seize business opportunities, given its flexibility, ability to attract qualified staff, and Luxembourg's business-minded approach to legislation. Cost-cutting and the refocusing of business strategies that ensued after the bursting of the equity bubble in 2000 have raised the competitiveness of Luxembourg's financial center. These developments have further strengthened the sector's ability to attract well qualified staff from a deep and diversified pool of labor. In keeping with its longstanding tradition, the legislature continues to focus on initiatives designed to retain Luxembourg's flexibility and attract foreign business, including recent laws on equity capital funds and private pension funds. Nevertheless, it is premature to assess their impact at this juncture.

5. Contrary to widespread concerns, the EU Savings Directive, which introduced withholding taxes on foreign financial investments in July 2005, seems to have had little impact on private banking activities. Moreover, the Directive appears to have created a level playing field among financial centers, further strengthening Luxembourg's reputation as an investment location.

6. The financial sector remains resilient to shocks, given its prudent capitalization and continued strengthening in supervision. The authorities' preliminary estimates show that solvency in the banking sector has remained at comfortable levels last year (September 2005), notwithstanding somewhat higher risk-taking. Stress-tests carried out by the authorities show that the banking and insurance sectors are well positioned to withstand various market risks, including interest rate risk. Tests by the authorities simulating potentially adverse developments in the real estate market suggest only a negligible impact on banking sector solvency. Staffing for supervision of the insurance and banking business was once more adjusted in 2005, in line with the continued financial sector expansion.

Enhancing Fiscal Sustainability

7. Sound financial policies have made an important contribution to Luxembourg's success in attracting and retaining substantial foreign labor and capital, and safeguarding these achievements should remain a policy priority. The general government balance should, therefore, be brought back into a surplus of no less than 1 percent of GDP over the medium term, also with a view to safeguarding the financial viability of the pension fund. The latest Stability Program is a step into this direction, but does not fully resolve sustainability issues.

8. As far as the 2006 budget is concerned, the targeted consolidation of the general government deficit by ½ percent of GDP to 1.8 percent of GDP is adequate. Nevertheless, the reduction in expenditures and the deficit may fall short of expectations. In any case, the adjustment should be frontloaded, given the favorable growth environment.

9. Over the medium term, the comfortable net asset position of Luxembourg's public sector allows for an overall gradual approach, tightening policies by at least ½ percent of GDP p.a. Such an approach should be embedded in a policy framework, mapping long-term sustainability requirements—including those arising from aging—into consistent general government budget targets over the medium term. To avoid expenditure overruns, clear budgetary priorities need to be set.

10. The adjustment should primarily rely on expenditures, following their deleterious expansion in recent years. The importance of maintaining competitive tax rates—especially for direct income—to continue to attract foreign labor and capital suggests that revenue hikes should generally be avoided. In this regard, the mission's policy advice is not inconsistent with the latest Stability Program. Nevertheless, the adjustment measures underpinning the contraction in expenditures targeted by the government remain to be decided upon. While the mission understands that the political process is in train, it would nevertheless warn against assuming that Luxembourg may grow out of its current deficit.

11. Starting with the 2007 budget, an adjustment strategy should be put in place:

• There is ample room to curtail social expenditures through stricter enforcement and means testing without undermining social safety. Tighter controls over disability pensions have already produced positive effects, and the mission welcomes the recent tightening of eligibility criteria for the sick-leave allowance. Eligibility criteria and enforcement should also be tightened for other social benefits, such as the minimum guaranteed income and unemployment assistance, especially for the young.

• More importantly, social allowances need to better target social needs. In this context, we recommend to strengthen means testing, and to review eligibility criteria for child, education, and the flat-rate child rearing allowances. In addition, delinking some of the social expenditures from wage developments should also be considered.

• Notwithstanding infrastructure bottlenecks, Luxembourg's large public investment program should be reviewed on the basis of cost-benefit analysis. Moreover, any shift to Public Private Partnerships and the resultant off-budget financing should exclusively be undertaken on efficiency grounds, and characterized by adequate risk sharing, monitoring, and transparency.

• Finally, Luxembourg's subsidies should be reviewed, including for public transport.

12. The credibility of such a policy approach could be further enhanced by formally adopting it in the format of a Medium Term Fiscal Framework. Such a framework would allow to operationalize the government's expenditure ceilings (of limiting expenditure growth to below GDP growth), adopted in the coalition agreement. At a minimum, the communication of fiscal developments should be improved, including through timely dissemination and analysis of high quality quarterly data for the general government and GDP.

Strengthening the Social Security System

13. Building on the success of attracting and retaining a vast pool of foreign labor requires safeguarding the sustainability of the public pension system. The mission welcomes the authorities' recent actuarial study and shares its main conclusion that on current trends a substantial funding gap is opening up, threatening the pensions of those who are 40-year old and younger. Pension benefits should be reformed as a means of alleviating the funding gap and addressing intergenerational inequities. This could be achieved through the introduction of a "solidarity factor," adjusting the system's replacement rate to the contribution base and the statutory retirement age to life expectancy. The adoption of recent proposals to raise the retirement age would also be a forceful step in this direction.

14. Following a reform of pension benefits, the remaining funding gap should be closed through cutbacks of other public expenditures. While the contribution rates of employers and employees could be raised in principle, the mission advises against such a step with a view to maintaining Luxembourg's non-wage labor costs and tax wedge at their internationally competitive level. Permanent expenditure savings of approximately 1 to 2 percent of GDP p.a.—financing a corresponding transfer to the pension fund—would be sufficient to ensure sustainability, depending on economic developments. Before implementing such a scheme, the moderate returns generated on the assets held by the pension fund should be enhanced, in line with the 2004 amendment to the law governing the pension fund. A permanent 100 basis point increase in pension fund returns p.a. would reduce the needed transfers by about ½ percent of GPD p.a., according to preliminary estimates.

15. Health care reforms need to be intensified, and recent expenditures increases have triggered a hike in payroll taxes. Reforms need to aim at lowering hospital costs, reining in expenditures on pharmaceuticals, and curbing the rapid increase of medical fees. Possible measures include (i) the setting of financial incentives for the use of generic drugs; (ii) raising co-payments for medical services; and (iii) streamlining the list of eligible services while improving the efficiency of existing services.

Enhancing Competitiveness and Improving Labor Market Flexibility

16. Maintaining external sector competitiveness is of paramount importance. Wage indexation, however, creates inflationary pressures, especially in light of widespread second-round indexation of service prices. The indexation mechanism should be recalibrated with a view to mitigating the loss of competitiveness resulting from—everything else equal—the widening wage differential vis-à-vis foreign competitors.

17. Forestalling a further rise of structural unemployment poses a formidable challenge given the deepening segmentation of Luxembourg's regional labor market. In sharp contrast to the high productivity segment, there is persistent excess supply of labor in the low productivity segment. The pool of the unemployed in "la grande region" is about three times as large as Luxembourg's resident labor force. Moreover, labor supply in the neighboring regions is rising as a result of entitlement reforms, and wages are trailing those in Luxembourg, further exacerbating pressures on its labor market.

18. Luxembourg can ill afford not to respond to these labor market disequilibria. It should recalibrate policies and align reservation wages more closely with those in the neighboring regions with a view to preventing that wage competition pushes its job seekers into permanent unemployment. This requires reviewing major entitlement benefits, including unemployment assistance and the minimum guaranteed income. In a first reform step, the major benefits could be decoupled from wage developments. The apparent skill-gap should be addressed in tandem by on-the-job training, primarily funded by employers and workers. Nevertheless, such steps may not achieve a substantial reduction in unemployment, and the level of entitlement benefits may ultimately need to be revised.

19. Labor force participation remains low by international standards, notwithstanding recent improvements. In particular the low participation of older workers adds to fiscal strains. Early retirement programs aimed at facilitating enterprise restructuring are used too extensively and need to be reformed. Financial incentives in the pension benefit formula introduced in 2002 are too weak to induce longer labor force participation and could be strengthened. Female labor force participation is increasing, but lack of affordable childcare facilities remain a bottleneck.

Broadening Services Markets

20. Services markets have an important role to play in the efforts of diversifying the economy and fostering sustainable long-term growth. The mission welcomes the government's commitment to create an integrated, internal EU services market as part of its pursuit of the Lisbon Strategy (The National Plan for Innovation and Full Employment, November 2005). However, the mission encourages the adoption of the principle of origin, as envisaged in the draft EU Services Directive.

Other Issues

21. We welcome continued progress toward subscribing to the IMF's Special Data Dissemination.

22. Luxembourg's leadership in providing official development assistance is commendable.


We would like to thank all interlocutors for their warm hospitality and inspiring discussions.


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