Luxembourg—2011 Article IV Consultation Preliminary Conclusions

April 4, 2011

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.

April 4, 2011

Luxembourg’s economy has begun its recovery.

1. Mirroring developments in core-Europe, Luxembourg experienced stronger-than-expected growth in 2010. Economic activity was initially underpinned by investment and restocking, but exports have increased markedly since the second quarter, notably financial services and metal products. Private consumption has also begun to gradually recover despite moderate increases in consumer lending spreads. Employment growth has been gaining pace but, despite enhanced employment support programs, the unemployment rate has not eased and remains at about 6 percent. Weak wage growth has tempered core inflation even though headline inflation has been boosted by global commodity price developments and administered price increases.

Growth will likely slow and remain below its pre-crisis pace going forward.

2. In line with expected developments in core Europe, coupled with ongoing bank restructuring, growth is projected to moderate in 2011. Domestic demand is foreseen to weaken as investment slows and more than offsets a modest recovery in private consumption. Headline inflation is expected to continue rising driven by global food and fuel prices, with core inflation increasing moderately in the face of sluggish labor markets and postponements of automatic backward-looking indexation.

3. Luxembourg could experience stronger growth should global financial markets avoid lasting turbulence and growth in core Europe prove robust. However, on balance, downside risks to activity prevail. Specifically, Luxembourg’s banking sector remains susceptible to liquidity and counterparty risks through its cross-border exposure to foreign parent banks. Luxembourg-based banks, including some active in the domestic market, also maintain large direct exposures to sovereign debt of EU periphery countries. Further distress in parent banks or in sovereign debt markets could thus hasten deleveraging and accelerate restructuring in the domestic banking sector. In turn, a sudden loss of investor confidence could trigger outflows from the investment fund industry, with potential international spillovers.

Against this background, Luxembourg’s main policy challenge is to continue limiting financial sector vulnerabilities, while promoting sustainable growth and employment.

For the financial sector, this challenge entails domestic and EU-wide issues.

4. The financial sector has stabilized. The investment fund industry has experienced a fast recovery with total assets surpassing their pre-crisis peak, reflecting strong investor demand as well as market valuation gains. In the banking sector, no further institution has failed since the peak of the crisis and restructuring has continued, including in the context of EU-approved reorganization plans. Overall, bank capitalization has increased and appears broadly adequate, but remains uneven across banks. Aggregate bank balance sheets have continued to shrink through 2011. While interest margins have declined, bank profits have increased due to strong commission and fee income, and lower provisioning needs.

5. Still, the banking sector remains vulnerable. Stress tests conducted in the context of the recently-concluded Financial Sector Assessment Program (FSAP) have confirmed that Luxembourg-based banks remain susceptible to risks associated with large intra-group exposures and sovereign bond holdings. In an extreme scenario, Luxembourg’s fiscal contingencies stemming from potential banking sector problems could be substantial. This is particularly so in light of size of the financial sector and the lack of burden-sharing mechanisms for cross-border bank resolution.

6. The authorities’ response to the financial crisis has thus far been broadly appropriate but improvements to the financial stability policy framework are needed. Specifically, the FSAP recommended:

• Further enhancing financial sector supervision. Among the priorities are increasing the Commission de Surveillance du Secteur Financier’s (CSSF’s) operational independence from the Ministry of Finance, and strengthening on-site supervision of banks and investment funds, including through speedier enforcement of corrective actions. In addition, the authorities should continue to closely monitor exposures to parent banks, and be ready to take further action to limit such exposures when necessary. The FSAP also recommended clarifying the respective roles of the Central Bank of Luxembourg (BCL) and CSSF as regards liquidity risk supervision.

• Strengthening Luxembourg’s financial safety net. As for the institutional setup and toolkit for bank resolution, areas for improvement include allowing for an earlier control of problem banks and facilitating their restructuring on a going-concern basis. The draft law revamping the deposit insurance scheme and introducing ex-ante funding is welcome, and awaits the issuance of the corresponding EU directive. Finally, given potentially large liabilities from emergency liquidity assistance to Luxembourg-based banks, safeguarding the BCL’s capital remains important.

7. A number of critical financial policy areas, however, fall beyond the purview of the Luxembourg authorities. Even though the authorities have taken and, should continue to take, appropriate actions, the presence of large foreign banking groups and sizable cross-border exposures challenge supervision and crisis resolution. Assessing banks’ risk profiles at the consolidated level hinges on joint work of home and host supervisors. The authorities are encouraged to continue their active involvement in relevant supervisory colleges, which may entail additional resources. Regarding the lack of ex-ante burden-sharing arrangements for the resolution of cross-border banks and pending the completion of EU reforms, the authorities should also continue to pursue pragmatic steps to facilitate international collaboration in this area.

On the fiscal front, the challenge entails putting in place sustainable consolidation.

8. With the recovery taking hold, fiscal consolidation is appropriate. The 2011 budget targets cutting the fiscal deficit by roughly ¾ percent of GDP to about 1 percent of GDP. The consolidation is predominately expenditure-based, notably through a public investment cap. In the short run, the cap can help to prioritize projects in light of competing demands on the public purse. But there will be a need to replace it over time with current spending cuts to bolster growth prospects. Regardless, if growth slows more than expected, countercyclical fiscal policy should be pursued.

9. Beyond cyclical developments, fiscal prospects are clouded by aging-related pressures and uncertainties associated with the evolution of the financial sector. Luxembourg faces the EU’s largest age-related expenditure increases, of which about ¾ are associated with old-age pensions. As a result pension reserves—currently almost 30 percent of GDP—will be depleted by 2035. In addition, tax revenues will likely come under pressure reflecting the potential adverse impact of changes in international regulations on financial sector activity. To address these challenges, the authorities have re-affirmed their medium-term target of achieving a balanced budget by 2014. They have also reformed the health care system, notably by establishing a binding two-year overall budget for hospitals and increasing copayments and contributions.

10. In this regard, there is a pressing need to formulate a fiscal consolidation strategy rationalizing current spending and addressing aging-related pressures. In particular,

• Fiscal consolidation. Sustainable consolidation should be articulated to replace temporary measures, safeguard public investment, and achieve the authorities’ medium-term target. In this regard, the levels of public spending ought to be revisited to reflect long-run tax revenue prospects. The focus must center on rationalizing social transfers and subsidies—which are generous even by European standards—while curtailing other current spending, including increases in the public sector wage bill. Expenditure prioritization can be supported by establishing a full-fledged medium-term budgetary framework with binding multi-year expenditure ceilings. Given ongoing uncertainties in global financial markets, tax increases should be viewed with caution also because these may harm perceptions about Luxembourg’s commitment to its business-friendly environment. Regardless, fiscal consolidation cannot substitute for reforms given the magnitude of aging-related spending increases.

• Addressing age-related spending. Parametric reforms are needed to gradually increase the effective and statutory retirement ages to reflect life expectancy gains and align contributions and benefits. Continuing discussions with social partners is desirable with a view to reform the pension system without delay and place its long-term financial situation on a firm footing. This will require working longer to earn a full pension and, to address the inherited burden on the system from existing retirees and entitlements, limiting pension indexation to no more than cost of living adjustments. Also, the authorities are urged to expeditiously implement recently approved health care reforms to ensure the system’s sustainability. Putting in place reforms early will be desirable to facilitate phasing-in adjustments, and establishing periodic automatic reviews of the social security’s financial viability can enable timely adjustments in light of future economic and demographic developments.

More broadly, sustainable growth and employment hinges on boosting competitiveness and promoting labor market flexibility.

11. In light of uncertainties on the evolution of the financial sector, regaining competitiveness, including by fostering a flexible labor market, will be key. Forthcoming changes in the regulatory environment will impact Luxembourg’s financial sector. While the new international capital regime is unlikely to pose major difficulties, changes to the liquidity regime could hamper banks’ role as liquidity conduits, particularly if intra-group exposures are subject to tighter restrictions. More broadly, the financial sector will also continue to face challenges from international efforts to harmonize taxation and enhance transparency. Success in adapting to this new environment will hinge on fostering a competitive and flexible economy. Besides continued attention to infrastructure and education, there is a need to revamp the system of direct transfers—geared at lowering poverty and income inequality—in order to limit adverse work incentives and support human capital investment. Also, even though in the medium term eliminating wage indexation remains necessary, the authorities are urged to exclude food and fuel prices from the reference index. In this regard, there is a continuing need to curb nominal wage increases to avoid eroding competitiveness in the short term.


We thank the authorities for their hospitality and open and fruitful discussions.


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