Mission Concluding Statements
Luxembourg and the IMF
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Concluding Statement of the Mission
March 13, 2002
1. Luxembourg is continuing its long-running, impressive economic expansion, and medium-term prospects remain bright. Over the past decade, real GDP and employment growth have exceeded EU averages by a large margin and the unemployment rate has been the lowest in the EU. The economy has weathered the global slowdown well in the course of 2001, though average growth is likely to post a low in 2002. Energy price developments have dominated inflation behavior since 1999 and subsequent wage increases have pushed core inflation above the regional average. These pressures are expected to dissipate during 2002.
2. Some of the key features of the Luxembourg economy that underpin its excellent economic performance also shape its vulnerabilities. Openness to workers from the surrounding region and strong social cohesion have permitted Luxembourg to draw in labor resources to sustain a fast-paced expansion while maintaining competitiveness. This social partnership has been cemented by the build-up of a generous welfare system that nonetheless requires high long-term growth and an increasing share of cross-border workers or immigrants to secure its sustainability. Small size and geographic location have induced a high degree of specialization, but have at the same time raised the economy's exposure to shocks.
3. The economic policies implemented by the authorities over the past decade have clearly addressed these vulnerabilities. Recognizing that the scope for discretionary responses to shocks is very limited, policies have been oriented toward the medium term, aimed at supporting growth, raising the adaptability of the economy, and ensuring the viability of the social security system. Tax policies and focused sector-specific measures have promoted the rapid development of a cluster of service industries. Fiscal policy has been successfully guided by the principles of broadly balancing the central government budget; keeping spending growth on average in line with trend-GDP growth; paying off public debt falling due and; building up and maintaining a reserve in the social security system. Effective supervision has safeguarded the soundness of the financial sector and structural reforms have begun to address labor and product market issues.
4. Looking ahead, some recent policy decisions appear to have reduced safety margins. The sharp rise in expenditure at the central government level will be consistent with budget balance objectives only if the assumed high nominal and real GDP growth rates materialize. Pension benefits are set to be raised significantly this year, which under the current pension system will bring forward the time when contribution rates will need to be increased or benefits lowered.
5. At the same time, economic developments point to an outlook that is unlikely to match the extraordinary performance of the 1990s. Indeed, the high average growth observed during 1995-2000 included a substantial cyclical component and should not be considered representative of medium-term growth. In addition, the expansion in recent years has become based mainly on factor accumulation, while productivity growth has been decelerating, a phenomenon that has contributed to strains on infrastructure. Finally, in the context of increased synchronization of the regional business cycle, a shift has been occurring in the structure of the domestic economy that is likely to heighten its sensitivity to this cycle. Such a shift implies that Luxembourg may become more susceptible to tightness of the regional labor market, raising the importance of domestic institutions for labor market performance.
6. Against this background, it is advisable to take steps to: return fiscal policy to a more cautious course, based on prudent projections of trend growth and focused on raising the robustness of the social security system; adopt a proactive approach to labor and product market reforms to increase the adaptability and efficiency of the economy and; continue to support the financial sector through effective supervision.
7. The 2002 budget and the fiscal policies expressed in the 2002-04 Stability Program are medium-term growth oriented, but include spending increases at an above average pace, as was already the case in 2001. To support efficient growth, tax reforms have lowered the tax burden, promoted private pension savings, and resisted the introduction of new tax incentives. Higher expenditure on infrastructure and education will alleviate bottlenecks and skills mismatches over time. Nonetheless, in the staff's view, with real GDP growth of about 3 percent in 2002 and slightly higher-than-trend rates thereafter, the general government surplus would average about 1 to 1½ percent of GDP during 2002-04, significantly less than envisaged in the Stability Program. The central government budget is likely to record a deficit, starting in 2002. While this is not an immediate concern given the comfortable asset position of the public sector, the case to keep the central government budget in balance over the medium term remains strong: it would safeguard the integrity of the principles guiding fiscal policy and address demographic pressures that require the current social security surplus to be fully preserved. Moderating the pace of spending compared to current plans would be the best strategy to return the central government budget to balance.
8. Consideration should be given to a somewhat different fiscal strategy that, together with pension reforms, would greatly improve the robustness of the social security system. This strategy would consist of keeping expenditure growth somewhat below trend-GDP growth and using thus freed resources to introduce a funded component in the pension system. Such an approach has several advantages. First, it would recognize explicitly the intertemporal aspects of the rising share of cross-border workers: these workers are contributing fully to productive activities and budgetary revenues, but they are not, or not yet, claiming a proportional share of public services and social benefits. In these circumstances, spending at the rate of GDP growth is prone to lead to overinvestment or more generous welfare benefits than can be afforded in the long term, and an inflexible expenditure structure. Second, this approach would help define the overall balance objective, thus clarifying it to the public and shielding the budget from pressures to spend surpluses. Third, a funded component would limit the vulnerability of the social security system to idiosyncratic shocks, which could be large given the highly specialized nature of the economy. In addition, other pension reforms as noted in the recent ILO study should also be implemented.
9. As recognized in efforts currently under way, there is a need to improve asset management in the public sector. Setting clear strategic and risk objectives, employing professional managers, and lifting restrictions on investments abroad are likely to raise rates of return and ensure liquidity. In the social security system, direct involvement in the markets for real estate, mortgages, and lending to the private sector should be phased out. In the rest of the public sector, the merits of continuing the equity participations of the state in commercial activities should be reassessed and financial criteria given due consideration.
10. By international standards, labor market outcomes have been stellar in terms of employment creation and unemployment rates, reflecting the competitiveness of the economy. However, in the last two years, unit labor costs have risen faster than in the region, at least partly owing to wage indexation triggered by a temporary upsurge in energy prices. As this increase has been reversed and labor market tension eased, it will be important to observe wage moderation in the period ahead so as to restore profit margins. This episode illustrates the benefits of insulating the indexation mechanism from terms-of-trade shocks, or more broadly, of adopting a forward-looking approach to wage setting, as in several other small European economies, including the ones relying on social partnership (e.g., Austria).
11. Measures taken to improve labor market flexibility in the context of the National Action Plans for Employment will help economic efficiency and strengthen the economy's adaptability to deal with shocks and cyclical pressures, but more progress is needed. The recent rise in employment rates, especially for women, is encouraging. Active labor market programs, including by labor unions, the expansion of childcare facilities, the possibility to average the work week over a longer period, and the proposal to increase the efficiency in the processes of entry and follow-up in the disability system are all steps in the right direction. Nonetheless, a more comprehensive and hands-on approach is necessary to ensure that these measures are effective in reducing structural unemployment, lifting participation rates, and improving overall economic efficiency. Such an approach should also include a review of the tax-benefit system to identify and remove any remaining disincentives to participate in the work force, the elimination of barriers to part-time employment, and the introduction of actuarial fairness across all pension schemes. Distributional objectives could then still be achieved through the tax-transfer mechanism.
12. To raise productivity growth, product market reforms could be further accelerated, taking the same proactive approach that has proven successful in the financial sector and that was also adopted to support the launch of electronic commerce. Some deregulation of the markets for land and housing should be considered to remove constraints on growth.
13. Luxembourg's financial sector has continued to thrive, asserting its dominant position in the domestic economy as well as its international importance. Asset and liquidity management has become the main source of ongoing growth. The sector is well prepared to take advantage of further international financial market integration. Nonetheless, it is facing challenges from limits to the supply of skilled labor, the prospective withdrawal of tax advantages, and volatile equity markets. Medium-term growth is thus likely to be more in line with recent observations than with the high average growth seen during 1990-2000.
14. A preliminary assessment by Fund staff of the soundness of the financial sector and compliance with supervisory standards under the Fund's Financial Sector Assessment Program has indicated that the sector is solid, efficient, and well supervised. No major weaknesses that could cause systemic risks were identified. Luxembourg conforms strongly with all supervisory and regulatory standards and achieves a high degree of observance of the transparency practices in all relevant areas. Stress tests indicate that banks are resilient to potential shocks stemming from sectors in distressed conditions, sectors affected by the September 11 events, emerging markets, and foreign financial groups. These findings are reassuring, but the financial sector remains nonetheless subject to economic conditions in other countries and very susceptible to reputation risk. This points to the need for a continued high degree of vigilance, including in the area of cross-border supervision.
15. The September 11 events have underscored the role and the vulnerability of the financial system with respect to criminal and terrorist activity. The response of the international community to these events is still evolving, but stepping up efforts to combat money laundering and terrorist financing is seen to be essential. In this context, the authorities' recent adoption of a comprehensive anti-money laundering Action Plan, guided by a committee that includes representatives of all agents involved, and the considerable progress made in the plan's execution are very welcome. It will be important to rapidly complete its implementation. Broadening reporting requirements, swift adoption of the EU directive in this regard, strengthening of the Financial Intelligence Unit, and increased cooperation between supervisory and law-enforcement agencies should send the appropriate signal that combating money laundering remains a key policy priority in the financial sector. Fund staff intends to visit Luxembourg in April to finalize its evaluation of Luxembourg's efforts in this area.
16. Luxembourg's economic statistics have improved appreciably in recent years, especially in terms of coverage and public availability. Further progress in this area is essential to inform policy making. Adherence to the timetable for the production and publication of quarterly national accounts, central government data, and capital account statistics will be key, and should allow Luxembourg to subscribe to the Fund's Special Data Dissemination Standard later in the year.
17. Luxembourg's strong commitment to help the less fortunate is exemplary and highly welcome: official development assistance is estimated to have exceeded the United Nation's target of 0.7 percent of GNP in 2001 and scheduled to rise to 1 percent of GNP by 2005. In this context, the authorities' emphasis on trade liberalization as a building block of their development aid is very encouraging. In line with their liberal stance on trade, the authorities should continue to impress on the EU the need to reduce subsidies and import restrictions.
Luxembourg, March 11, 2002
IMF EXTERNAL RELATIONS DEPARTMENT