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.

Luxembourg—2009 Article IV Consultation
IMF Concluding Statement

Luxembourg, March 30, 2009

Luxembourg Amidst the Financial Crisis

Ongoing financial turmoil and the first global recession in 60 years pose daunting challenges to Luxembourg’s small open economy. The financial sector—hosting 152 mostly foreign-owned subsidiary banks, Europe’s largest investment fund industry and second largest money market industry—is fully exposed to the turmoil. Besides financial service exports, the contraction in European demand is also weighing heavily on the economy’s traditional export sectors.

Continued economic success crucially hinges on the maintenance of financial stability. The authorities’ rescue of Fortis and Dexia bank, and the intervention in three other insolvent banks were appropriate and decisive. However, these events also highlighted the need for a more effective multilateral response. Given that Luxembourg’s financial center is testimony to Europe’s advanced financial integration, the authorities would be well advised to spearhead an initiative to develop an effective multilateral crisis management strategy.

Key Elements of a Comprehensive Crisis Management Strategy

• Resolving home-host country issues and seeking burden sharing commitments. The systemic nature of the financial crisis has called into question the longstanding axiom that parent companies would always support their subsidiaries in difficulty. Therefore, the authorities need to advance burden sharing discussions with both parent companies and home countries with the aim of achieving burden sharing commitments.

• Addressing the risks stemming from the close integration of the Luxembourg-based subsidiaries with their parent groups. While intragroup exposures are essential to banks’ business models, liquidity management has been largely shifted to the group level, imposing undue risks of a liquidity shortage on subsidiaries. Addressing these risks requires comprehensive and continuous monitoring of liquidity at the local level; and devising a regulatory framework that embeds sufficient flexibility to take due account of bank-specific circumstances. In this regard, the mission is encouraged by the joint efforts of the central bank (Banque Centrale du Luxembourg) and the regulator (Commission de Surveillance du Secteur Financier). Nevertheless, the success of this important initiative will stand or fall with the degree of cooperation between these institutions.

• Reining in excessive leverage. Luxembourg’s financial center has not escaped some of the excesses that have bedeviled the global financial system. More than half of Luxembourg’s banking system was overly leveraged at end-2008, with gearing ratios in excess of 20 times. While system-wide capital levels are sufficient, these developments call for a further strengthening of the regulatory regime, tightening of capital requirements, and the introduction of binding limits on leverage. However, such steps need to be coordinated internationally, and care needs to be taken in regards to the speed with which these measures are phased to facilitate an orderly adjustment of banks’ balance sheets.

• Safeguarding Luxembourg’s reputation as a well run financial center. The continued flow of liquidity from Luxembourg’s financial sector is important to financial stability in the euro area (EA) and, consequently, the country’s reputation as a well run financial center. With money market funds (MMFs) having provided more than 100 billion euro in mostly short-term financing to EA banks, any instability in money market funds would represent a systemic risk to the EA. The authorities should therefore seek international cooperation to forestall such a possibility. Efforts should be focused on burden sharing arrangements that would allow—in case of strong redemptive pressures—the immediate issuance of a credible, multilateral guarantee to cover those funds’ liabilities. In addition, weakened capitalization limits the scope for banks to take MMFs’ assets onto their balance sheets and provide liquidity to these funds, in case of redemptive pressures. The need for a liquidity facility, therefore, should also be further explored.

Worst Recession Since The Steel Crisis To Be Followed By Gradual Recovery

Notwithstanding the government’s sizeable and well-targeted stimulus efforts, Luxembourg faces its most severe recession since the steel crisis in the mid-1970s. Growth came to a sudden halt in the third quarter of 2008, and recent indications suggest that the contraction in activity is spreading decidedly across key export sectors. The reported declines in the manufacturing and transport sectors are symptomatic for contracting output in neighboring countries and plummeting international trade. Profitability in the financial sector—the main driver of economic growth—is likely to decline this year, in large part as banks’ interest income is adversely affected by appreciable declines in interest rates.

The adverse impact of these developments on the growth outlook is partly mitigated by the government’s comprehensive stimulus package, particularly its subsidies aimed at stabilizing employment (chômage partiel). Nevertheless, the effect of any fiscal stimulus on domestic demand is limited by the high share of trade in GDP. Based on the IMF’s current growth forecast for the euro area (-3.2 percent for 2009), the mission projects Luxembourg’s real growth to fall by 3.8 percent this year. While a recovery is expected to begin in mid-2010, annual growth is still likely to stagnate.

Appropriate Fiscal Stimulus and Functioning of Automatic Stabilizers

Major financial events aside, Luxembourg’s public finances are much better positioned than those of most other European Union countries to weather the recession. Notwithstanding recent bank rescue efforts, the public debt stock remains low by international standards, providing ample scope to finance near-term budget pressures. Nevertheless, a range of tax and expenditure measures contributed to a fall in the fiscal surplus last year to an estimated 1.4 percent of GDP from 3.2 percent of GDP in 2007.

Looking ahead, a substantial deterioration of the fiscal accounts is expected. This year, the combination of growth-induced revenue declines and fiscal stimulus of about 3 percent of GDP, in the form of tax and expenditure measures, is projected to lead to an overall deficit of 3.2 percent of GDP. Although this exceeds the authorities’ revised budget forecast (-0.7 percent of GDP), the mission unequivocally supports the full functioning of the automatic stabilizers, given the current economic situation and the favorable state of public finances. To enhance fiscal transparency, underlying budget assumptions—especially for GDP growth—and the projected fiscal deficit should be once more revised.

Need for Post-Crisis Fiscal Adjustment

Once the economy begins to emerge from recession, appreciable efforts are needed to enhance medium- and long-term fiscal sustainability.

• Expenditures are rising—in spite of fiscal adjustment undertaken as part of the 2006 Tripartite Agreement, current spending returned to buoyant growth in 2008. The planned return to full indexation of wages and social benefits will likely exacerbate this trend, and also hamper efforts to improve competitiveness.

• At the same time, uncertainties have arisen concerning the evolution of medium-term fiscal revenues .These stem primarily from the potential impact of global deleveraging and of legal, prudential and regulatory changes—including those governing bank secrecy—on the profitability of the financial sector and on its contribution to tax revenues. Changes in EU tax regulation, including the 2015 introduction of the end-user principle that will curtail VAT revenues, are also a concern.

In light of these risks and uncertainties, the mission recommends that reintroduction of full inflation indexation of wages and benefits be reconsidered. Furthermore, far-reaching reforms of the public, pay-as-you-go pension system remain overdue, and should proceed with priority, given that substantial funding gaps continue to threaten its long-term viability.


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


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