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- Preliminary Conclusions for the 2012 Article IV Consultation

Luxembourg, May 14, 2012

1. Amid the euro area debt crisis, Luxembourg’s growth slowed notably last year. In the first half of 2011 private consumption and investment held up despite an external slowdown. But as the crisis and uncertainty lingered, consumer and manufacturing business confidence plummeted and slowed domestic demand. Reflecting the waning impact of global fuel price increases and postponements in automatic wage indexation, inflation has eased. In recent months, employment growth has remained stable but the unemployment rate has risen. Long-run joblessness has also increased and accounts for about 40 percent of overall unemployment.

2. Luxembourg’s economy is poised to slow further in 2012. Economic activity is projected to continue weakening in the first half of the year and mildly recover in the second half. Sluggish external demand—reflecting persistent uncertainty and fiscal consolidation in the euro area—will hold back exports. Volatile financial markets and unclear economic prospects will likely continue to weigh on domestic demand.

3. Downside risks to the outlook remain. An intensification of the euro area crisis would spill over into Luxembourg through real and financial channels. A slowdown in the euro area would increase unemployment, possibly impair households’ ability to service their loans, and thereby weaken the quality of domestically-oriented banks’ assets. This could also burden fiscal accounts. Moreover, a political accident in the euro area could trigger a financial crisis engulfing the region. In this regard, while exposures to distressed euro area sovereigns have declined, Luxembourg-based banks’ cross-border intra-group transactions have remained large and continue to expose banks to substantial counterparty and liquidity risks. Still, a better-than-expected outlook could materialize if efforts to address the euro area sovereign debt crisis quell market uncertainty and lead to a quicker euro area recovery.

4. Against this background, Luxembourg faces the challenge of safeguarding its hallmark economic stability by limiting financial sector vulnerabilities, ensuring fiscal sustainability, and promoting growth and employment.

Limiting Financial Sector Vulnerabilities

5. The financial sector has endured the euro crisis and remained stable. Having declined sharply from their 2008 peak, Luxembourg-based banks’ assets have increased at a modest pace in the second half of 2011 and stabilized more recently. Market conditions have hurt securities portfolios but banks have remained profitable. Moreover, the spillover effects on Luxembourg from the breakup of Dexia group last year were limited to its local subsidiary, which is slated to be sold later this year. For its part, the volume of assets under management in Luxembourg’s investment fund industry has recovered following the global financial crisis and surpassed pre-crisis highs.

6. Luxembourg has meanwhile made strides to strengthen its financial center. Of note, increases in the staff and resources of the Commission de Surveillance du Secteur Financier (CSSF) have enabled it to conduct more frequent on-site inspections and increase enforcement actions. The financial industry has recognized the value of strong supervision for financial stability as well as the constructive dialogue with supervisors. Luxembourg has also made progress in improving its regulatory frameworks, notably by sharply reducing the deposit guarantee’s payout period.

7. Still, continued efforts to safeguard the financial system are needed, particularly aiming at boosting cross-border supervisory coordination. The outward orientation of the banking industry and its exposure to foreign parent groups underscore the need for close cooperation with home supervisors. In this regard, the authorities should continue to take advantage of supervisory colleges for EU banking groups, which provide an ideal venue to exchange data, analyze financial groups using a common methodology, and develop coherent group-level strategies. As these structures are less developed for non-EU financial groups, continued efforts are necessary to procure the needed data and coordinate group-level recommendations. Similarly, Luxembourg could benefit from a multilateral supervisory framework for UCITS funds to complement existing arrangements.

8. In addition, there are several areas where progress in EU-level regulatory initiatives is crucial but continued delays pose a dilemma for Luxembourg. Specifically, these include the EU’s efforts to improve and harmonize bank resolution mechanisms as well as deposit guarantee schemes. These are essential for Luxembourg given the banking sector’s cross-border exposure. On the investment fund side, the UCITS V Directive can provide an opportunity to strengthen depository regimes, including asset segregation. The slow progress in these initiatives, however, creates a tradeoff. Implementing reforms ahead of EU guidance runs the risk of having to revisit reforms should these contravene EU-level Directives. But continuing to place on hold needed reforms can leave Luxembourg’s financial system ill-prepared to deal with potential risks.

9. On balance, Luxembourg should push ahead with actions not requiring legislation. For instance, bank resolution can be strengthened by Recovery and Resolution Plans (RRPs) that will be required for all major EU banks. Regarding the deposit guarantee scheme, consideration should be given to require banks to provision the needed contributions, and thus ensure the availability of resources.

10. Looking ahead, financial sector reform initiatives at the global and EU levels may have a significant impact on Luxembourg’s financial sector. Given Luxembourg-based banks’ strong capital position, Basel III’s capital adequacy requirements and their implementation in Europe through the Capital Requirements Directive IV would not likely pose difficulties. But tougher liquidity standards could be challenging. Likewise, the European Commission’s recent legislative proposal to harmonize central securities depositories regimes foresees stricter rules for those depositories providing banking services, such as, Clearstream Banking Luxembourg. This may require revising Luxembourg’s supervisory framework for Clearstream when the EU Directive is finalized. In the meantime, the authorities are urged to continue discussions on ways to strengthen contingency planning for this financial institution.

11. More broadly, there is a growing need to revisit Luxembourg’s institutional setting for its supervisory and regulatory frameworks. In line with the FSAP update’s recommendations as well as forthcoming EU requirements, this will entail:

  • clarifying the respective roles and duties of the CSSF and Banque Centrale du Luxembourg (BCL) relating to liquidity risk supervision. While this has worked smoothly in practice, forthcoming Basel III requirements will call for a clear demarcation on these matters.
  • establishing a national macro-prudential authority following European Systemic Risk Board recommendations. Regardless of the authority’s specific modality, its proper functioning will require the ability to identify, monitor, and assess systemic risks, and to take risk-mitigating actions.
  • strengthening the operational independence of the CSSF. While there is no evidence of political interference, the supervisor’s operational independence needs to be strengthened to be better aligned with international standards. Steps have been taken to enhance the CSSF’s operational independence. But it remains under the “direct authority” of the Minister of Finance; its senior management can be dismissed by the government over policy disagreements; and the licensing authority lies with the Minister.

A number of institutional settings can address these issues. Regardless, it is important that the revised framework provides clear roles and responsibilities of the relevant authorities. The framework should also ensure operational independence and accountability of the macro-prudential authority as well as of the CSSF.

Ensuring Fiscal Sustainability

12. With the economy slowing, the widening fiscal deficit can provide some support to the economy in 2012. The mission estimates that the 2012 budget will result in an increase in the general government deficit from about ½ of 1 percent of GDP to roughly 2 percent of GDP. Overall expenditures will increase reflecting current expenditure—largely increases in the wage bill and social benefits—that are partly offset by reinstating a public investment cap. While the fiscal stance is broadly consistent with cyclical developments, its expansionary impact is limited by the economy’s openness. Moreover, though the investment cap may have helped arrest trend increases in recent years, it is a blunt tool to prioritize investment in the short run and can hurt growth prospects in the long run. Regardless, should downside risks materialize, automatic stabilizers should be allowed to operate while maintaining credibility.

13. But as growth resumes, there will be a need to implement high-quality fiscal consolidation supported by a multi-year budgetary framework. In the absence of corrective measures, public debt would increase sharply in the next five years, largely reflecting structural declines in revenues, including those from e-commerce. Consistent with stabilizing debt at manageable low levels, the authorities have reaffirmed their goal of reaching a balanced budget by 2014. Despite the recently announced fiscal measures, the mission estimates that additional measures of about 1 percent of GDP would be needed to reach the authorities’ target. In this regard, fiscal consolidation should focus primarily on rationalizing current expenditure that can also contribute to an efficient resource allocation. A medium-term fiscal framework—including binding expenditure ceilings for all levels of government—can play a central role in effecting a high-quality adjustment and should be implemented without delay.

14. Looking ahead, fiscal sustainability will require, however, comprehensive old-age pension reforms beyond proposed modifications. The generosity of Luxembourg’s old-age pension system will result in the largest aging-related expenditure increases in the EU. Recently, Luxembourg has thus sought to better align benefits to contributions through so-called “pension à la carte” that seeks to increase the effective retirement age by three years. But given grandfathering, this will take 40 years to be fully in effect. While a step in the right direction, this alone will not place the old-age pension system on a sustainable footing. The latter will require increasing the statutory retirement age, as in other European countries, curtailing, if not eliminating complementary periods, and limiting benefit indexation to cost-of-living adjustments (COLA). Reforms to the benefit indexation rule would thus eliminate the existing double-indexation of benefits to wages and prices and contribute to a fairer intergenerational distribution of the adjustment burden. Social security reserves should only be used to phase in comprehensive reforms that ensure the sustainability of the old-age pension system. In addition, Luxembourg is encouraged to fully implement the 2011 health care reform.

Promoting Growth and Employment

15. Luxembourg’s long-run growth and competitiveness will largely depend on its ability to use its resources fully and efficiently. Beyond safeguarding macroeconomic stability, this will require addressing trend increases in unemployment, particularly long-term unemployment. While the global financial crisis prompted policies to support employment, these have skewed work incentives—at the expense of active labor market policies—and accentuated labor market skill mismatches. Labor market programs and the social safety net should be revamped to better target subsidies, minimize adverse work incentives and, by focusing on training and education, address growing skill mismatches. In addition, long-standing labor market rigidities should be addressed. Delays in the automatic backward-looking wage indexation have helped limit adverse competitiveness effects. Going forward, however, further efforts in this regard are needed—including by excluding food and fuel prices from the reference index—with the view of eliminating indexation in the medium term. It is also important to review product market regulations to foster competition, fuel productivity growth, and possibly support economic diversification.


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


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