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—2010 Article IV Consultation: Preliminary Conclusions

April 19, 2010

The global financial crisis posed a severe test to Luxembourg.

1. The “great recession” delivered a severe shock to Luxembourg’s exceptionally open economy and internationally-integrated financial center. Private investment plummeted and consumption weakened in the face of slowing employment growth. As a result, the economy registered its worst performance in 30 years and contracted by 3½ percent. Inflation declined sharply and, helped also by falling world energy prices, briefly turned negative in mid-2009.

Still, a prompt and aggressive policy response safeguarded the financial sector and mitigated adverse economic effects.

2. The authorities’ decisive actions early on in tackling troubled banks—in concert with the authorities of Belgium, France, and the Netherlands—quelled potential spillover effects. A five-fold increase in the deposit guarantee, combined with the ECB’s emergency liquidity provision, served to restore confidence in the financial sector. No bank rescues were required in 2009 and investment fund assets have rebounded to close to their pre-crisis peak. In addition, Luxembourg’s enviable fiscal position at the outset of the crisis enabled fiscal policy to provide substantial support to the economy, including by boosting social transfers to soften the impact on the labor force and protect household income.

The economy has stabilized but the global financial crisis will have lasting effects.

3. In line with global developments, systemic financial risks have abated and bank deleveraging has remained orderly and gradual. A number of institutions have continued unwinding non-core activities, refocusing their business models and improving efficiency. Reflecting also developments in neighboring countries, the economy has started to recover faster than expected. In the second half of 2009, growth resumed and labor markets showed initial signs of stabilizing. Growth will remain, however, below its pre-crisis pace as export markets, while strengthening, are not likely to rebound vigorously and domestic demand is expected to remain subdued. Improved conditions in trading partners and budgetary support in 2010 underpin projections envisaging growth to average about 3 percent in 2010–11.

4. Risks to this scenario stem primarily from lingering uncertainty in global financial markets and potential knock-on effects on neighboring countries. Despite the ongoing restructuring in the banking system, risks stemming from the financial center’s business model—including large and concentrated cross border positions with foreign parent banks—have not changed substantially. Also, global financial turmoil and adverse developments in trading partners are transmitted quickly to Luxembourg’s economy.

Against this background, Luxembourg faces three main challenges:

Strengthening the financial sector

5. Although Luxembourg-based banks had low direct holdings of impaired assets abroad, some institutions displayed many of the weaknesses uncovered by the crisis, notably excessive risk-taking, high leverage, and over reliance on short-term wholesale funding. In this regard, the EU incorporation and business orientation of the majority of parent banks and long-standing collaboration between Luxembourg and home country supervisors provide some reassurance. Still, revisions in key aspects of the supervisory and prudential frameworks are needed to tackle tail liquidity and credit risks. Specifically,

• Assessing and containing liquidity risks originating from sizable interbank positions. In particular, the authorities are encouraged to deepen their focus on liquidity risk originating from large intra-group exposures and interconnections with the investment fund industry, and take action when needed to prevent unwarranted liquidity transformation by local bank subsidiaries. The recent regulations on qualitative aspects of liquidity risk are an important step in this regard and should be used to support this process and improve the quality of banks’ liquidity management. In parallel, there is also a need to revamp the prudential framework governing quantitative aspects of liquidity risk and bank reporting processes. The joint bank inspections and liquidity assessments carried out by the Banque Centrale du Luxembourg (BCL) and the Commission de Surveillance du Secteur Financier (CSSF) are welcome. Ensuring an effective collaboration and exchange of information between the BCL and the CSSF in monitoring and assessing liquidity risk will benefit from the support of a formal agreement.

• Strengthening credit risk management frameworks and revisiting capital buffers in the context of ongoing international initiatives. Despite improvements in banks’ capital buffers, leverage ratios remain high and disperse. In this regard, the authorities are encouraged to further step up efforts in assessing banks’ credit risk management practices and, if needed, take action to ensure the adequacy of bank capital. Promptly transposing into local regulation forthcoming EU directives and Basel Committee of Banking Supervision recommendations on the level and quality of capital buffers and possible restrictions on leverage will be essential.

6. Improvements in the supervisory process and regulatory environment should go hand in hand with increased reliance on joint work and information exchange with home supervisors. In this regard, long-standing relationships between the CSSF and peer supervisors proved extremely useful during the crisis and should continue to be actively pursued. Given the cross-border nature of a number of banking groups in Luxembourg, the importance of strengthening collaboration with fellow supervisors and actively engaging in the work of relevant supervisory colleges cannot be overstated. The CSSF’s participation in such colleges provides a new avenue to deepen collaboration with home supervisors.

7. The authorities’ proposal to revamp the deposit guarantee scheme in line with international best practices will strengthen the financial safety net. The funds accumulated in the deposit guarantee scheme (AGDL) proved useful in honoring all insured deposits in bank failures at the height of the financial crisis. The proposal to replace the current system with a pre-funded scheme—with a capacity to borrow and intervene early on a least-cost principle—financed through risk-based contributions is welcome. The implementation of the new scheme should be in line with forthcoming EU guidelines and mindful of not overburdening bank’s profitability and ability to extend credit in the transition phase.

8. The crisis has also highlighted the importance of establishing formal mechanisms for cross-border bank resolution and burden-sharing. Given the size of the financial sector and the prevalence of foreign-owned subsidiaries, the effectiveness of resolution and crisis management efforts in response to a systemic event hinges on an active coordination with home-country authorities. The harmonization of the crisis resolution frameworks across the EU, the formalization of agreements on burden sharing, and the development of consistent mechanisms for crisis management and cross-border bank resolution across the EU are of paramount importance for Luxembourg and extend beyond the domain of its authorities. Luxembourg’s continued active engagement in these discussions is encouraged.

Consolidating fiscal accounts and ensuring fiscal sustainability

9. Fiscal support is appropriate in the short term. Luxembourg’s low gross public debt, while rising, still provides fiscal space for continued counter cyclical policy. Indeed, the 2010 budget foresees the deficit to reach almost 4 percent of GDP, with the bulk of the deterioration associated with weakening revenues. Still, should revenue collections prove to be stronger than projected, the authorities are encouraged to save these revenues.

10. The 2011 budget must, however, set the stage for fiscal consolidation in line with lower medium-term prospects. The economy is projected to strengthen but, reflecting the lagged impact of the recession on taxes, the fiscal deficit is poised to remain high. As the economy gathers strength, revenues will gradually recover and the deficit will narrow but remain above or close to the Maastricht limit and gross public debt would double by 2014.

11. In this regard, there is a pressing need to devise an expenditure-based consolidation strategy articulated within a medium-term fiscal framework. Provided the fiscal consequences of aging are addressed through deep pension reform, the authorities’ target of balancing the budget by 2014 provides an apt benchmark. The recently proposed measures centering on the expenditure side are welcome. Moreover, ongoing tripartite discussions once again provide an opportunity for Luxembourg’s society to come to terms with the politically challenging task of adopting concrete measures to rationalize current expenditure and share the burden of adjustment across social partners. In line with international best practice, fiscal consolidation can be supported by a medium-term fiscal framework characterized by binding multi-year expenditure ceilings and underpinned by a medium-term target and revenue projections. Implementing such a framework would facilitate expenditure review and prioritization and provide a tool for early detection of adjustment needs.

12. Enduring fiscal stability requires, nonetheless, substantive pension reform. Gains in life expectancy combined with generous benefits will place considerable pressure on Luxembourg’s pay-as-you-go pension system. Reforms should aim at gradually increasing the effective and statutory retirement age including by eliminating design features that encourage early retirement and improving the alignment of benefits and contributions. There will also be a need to rein in the rate of increase of existing old-age pensions. In addition, the dire situation in the health care budget will require prompt action to restore its viability. Introducing periodic reviews of the social security’s financial health would enable timely adjustments to reflect economic and demographic developments. The urgency of putting in place reforms early has been heightened by the global financial crisis with its adverse impact on employment growth prospects and social security contributions from cross-border workers and lasting effect on Luxembourg’s growth.

Withstanding the headwinds on Luxembourg’s growth model

13. The resilience of Luxembourg’s economy and financial center will depend on cultivating its flexibility and comparative advantage in high value added niche activities. Besides global deleveraging and the restructuring of the global financial landscape, the international push to harmonize taxation and limit bank secrecy challenges some segments of the financial sector industry. Ongoing international regulatory initiatives on liquidity and leverage also have the potential to weigh on the economy’s cross-border intermediation model. While the investment fund industry continues growing, there is a risk that these challenges will affect disproportionately employment in the financial sector.

14. Years of economic boom, rapid development of the financial sector, and expanding incomes had temporarily masked the need for continued improvements in productivity. An agreement among social partners to moderate wage increases—notably in the public sector—is needed. The authorities’ proposal to adjust the backward-looking wage indexation mechanism represents a welcome step to limit its adverse impact on fiscal sustainability and competitiveness. Still, further adjustments are needed to modernize wage-setting mechanisms with a view of eliminating automatic indexation over time. Gains in competitiveness can also be generated by a business friendly environment that supports investment in research and development and the acquisition of new skills by the labor force. While this may also help alleviate labor skill mismatches, determined efforts would still be needed to safeguard the advantages accumulated through years of experience as a financial center, curtail unemployment among residents and support Luxembourg’s prosperity.


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


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