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Luxembourg and the IMF
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The IMF Executive Board on May 13, 1998 concluded the Article IV consultation1 with Luxembourg.
Luxembourg’s economy has continued to perform exceptionally well by the standards of other industrial countries. The growth of output and employment remain well above the European average, inflation is low, and the public finances are in surplus. Economic policy has emphasized the creation of a business-friendly tax and regulatory environment and the diversification of the economy in order to reduce reliance on the financial sector, which has been coming under increasing competitive pressure in recent years and whose special position could be eroded by the leveling of minimum reserve requirements under EMU and possibly by the progress of tax harmonization in the EU.
Real GDP growth accelerated to 4¾ percent in 1997. The pickup in activity was led by exports of steel and other industrial products. Financial sector activity also strengthened further, though probably at a somewhat slower pace than in previous years. Domestic demand firmed, with investment accelerating to 14 percent in real terms, and the growth real private consumption holding steady at 2½ percent. As in past years, the current account of the balance of payments showed a large surplus in 1997 (some 15 percent of GDP), reflecting mainly a large surplus on the investment income account. Unemployment has been rising gradually, from 1½ percent in the early 1990s to 3¾ percent in 1997, despite domestic employment growth averaging almost 3 percent annually during 1990-97. Most of the new jobs have been filled by cross-border commuters. Jobless domestic residents are mainly low-skilled, or have skills that do not match changing labor market requirements, partly owing to shortcomings in education and training. The employment of these persons has been further rendered difficult by a high minimum wage, while their incentive to seek work or training may have been dampened by generous social benefits.
The conduct of monetary policy within the Belgium-Luxembourg monetary association remains the sole responsibility of the Belgian National Bank, whose policies have been guided for well over a decade by link of the Belgian and Luxembourg francs to the deutsche mark in the context of the ERM. Against this background, inflation in Luxembourg has not diverged significantly from that in Belgium and Germany in recent years; it averaged 1.4 percent in both 1996 and 1997.
Fiscal policy has followed a prudent course. Since the early 1990s, the general government (consisting of the central government, local governments, and the social security funds) has shown surpluses averaging more than 2 percent of GDP; and the public sector has accumulated substantial net financial assets. The government has begun to use some of the scope provided by these surpluses and assets to reduce the tax burden and improve public infrastructure. The surplus in 1997, at 1.7 percent of GDP, was about 1 percentage point less than in 1996, reflecting a 1 percentage point cut in the corporate tax rate, the lagged effects of the abolition of the business capital tax in 1996, and higher public investment. The budget surplus is expected to decline further in 1998, to 0.6 percent of GDP, reflecting an additional 2 percentage point reduction in the corporate tax rate, substantial reductions in average and marginal personal income tax rates, and continuing increases in infrastructure outlays. Although the decline in the budget surplus is imparting a substantial fiscal impulse to activity, this does not appear to have led to economic overheating, owing to the ready availability of a pool of underutilized labor in the regions bordering Luxembourg.
Even though there are no serious short- or medium-term risks to the stability of the public finances, population aging, as in most other industrial countries, is expected to place a growing burden on the public finances in the longer term. The share of pension expenditure in GDP is projected to increase by some 5 percentage points to 16 percent of GDP in 2030, while overall social outlays could increase by 9 percentage points to 33 percent of GDP.
The short-term outlook remains good, though the adverse impact on Europe of the Asian crisis may still turn out to be larger than currently envisaged. Reflecting a robust expansion in the financial sector and industry, real GDP is expected to grow by 4 percent in 1998. Net exports of goods and non-factor services are expected to make a contribution to growth of about 1 percentage point. Inflation should remain broadly stable, in line with developments in most core ERM countries. Employment growth is projected to remain strong; and theunemployment rate is expected to remain unchanged. It is worth bearing in mind that economic projections in Luxembourg are subject to a large margin of uncertainty, owing to the small size of the economy and the limited data on current economic activity.
Executive Board Assessment
Executive Directors commended the authorities on Luxembourg’s excellent economic performance: growth had remained very strong, inflation and unemployment had been kept low, and the public finances were sound. This record reflected to a considerable extent the authorities’ skillful management of economic policy and had made a smooth entry into the European Monetary Union possible.
Directors agreed that the monetary association with Belgium had served Luxembourg well. Monetary policy in the association has been geared toward lower inflation and greater exchange rate stability vis-à-vis Luxembourg’s major trading partners in the Exchange Rate Mechanism of the European Monetary System.
Although Luxembourg’s past economic performance has been exceptional, Directors thought that prudent policy in the years ahead would require the authorities to guard against the risk of a slowdown or reversal in the financial sector, which had for many years been a mainstay of economic growth and public revenue. The adoption of a common minimum reserve policy following the inception of EMU, and changes in the tax and regulatory environment in Europe—notably the movement toward greater tax harmonization—could weaken the position of Luxembourg’s financial services industry over time. In this context, Directors commended the efforts to diversify the economy to lessen dependence on the financial sector. They praised the recent implementation of corporate tax cuts and measures to stimulate competition in telecommunications, improve the transport infrastructure, and pursue a more business-friendly environment. However, Directors urged the authorities to reduce reliance on subsidies and special fiscal incentives targeted at industries, noting their lack of transparency, their distortionary impact, and the difficulty of reversing them once in place.
Directors underlined the importance of ensuring the long-run sustainability of Luxembourg’s extensive social security system. They recommended the reform of the pension system and suggested that consideration be given to achieving a more balanced system of old age security by reducing reliance on the present pay-as-you-go (PAYG) system in favor of a mandatory, actuarially balanced, and privately managed "second pillar."
Directors noted that there appeared to be no evidence of systemic weaknesses in Luxembourg’s financial sector, and that exposure to Asia had been provisioned for to a reasonable extent. They commended the increase of resources devoted to prudential supervision, particularly in light of the new risks stemming from financial market globalization.
Although recorded unemployment in Luxembourg is low by the standards of other European countries, Directors noted that there is substantial hidden unemployment. They advised the authorities to contemplate more fundamental action to combat unemployment, notably by scaling back generous social benefits that dampen work incentives and by removing rigidities in the wage formation process, including by abolition of wage indexation.
Directors welcomed the continuing increases in the official development assistance of Luxembourg and the authorities’ commitment to raise it to 0.7 percent of GDP by 2000.
Directors encouraged the authorities to take early steps to remedy the shortcomings in Luxembourg’s economic data, in order to be able to subscribe to the Fund’s Special Data Dissemination Standard at an early date.
|Luxembourg: Selected Economic Indicators|
|Real GDP (percent change)||4.1||3.5||3.5||4.8||4.1|
|Domestic demand (percent change)||0.0||3.7||-0.6||4.8||3.7|
|CPI (year average)||2.2||1.9||1.4||1.4||1.2|
|Unemployment rate (in percent)||2.7||3.0||3.3||3.7||3.7|
|Gross national saving (percent of GDP)||39.2||39.3||37.9||37.3||39.0|
|Gross national investment (percent of GDP)||20.4||21.2||20.8||22.4||23.4|
|Public finance (percent of GDP)|
|Federal government balance (deficit = -)||1.0||0.0||0.9||0.4||-0.8|
|General government balance (deficit = -)||2.8||1.9||2.5||1.7||0.6|
|Money and interest rates|
|M3 (end of year, percent change)||1.6||3.1||3.0||-4.5||...|
|Money market rate (in percent )2 3||5.7||4.8||3.2||3.5||3.6|
|Government bond yield (in percent)3||7.8||7.3||6.3||5.6||5.1|
|Balance of payments (in percent of GDP)|
|Trade balance (percent of GDP)||-12.0||-9.2||-10.6||-10.8||-11.0|
|Current account (percent of GDP)||18.8||18.1||17.1||14.9||15.6|
|Official reserves (US$ million)4||75.7||75.0||73.7||64.1||61.8|
|Exchange rate||Member of ERM (Monetary association with Belgium)|
|Present rate (April 17, 1998)||Lux F 37.2=US$|
|Nominal effective exchange rate (1990=100)||102.1||104.0||102.8||100.9||...|
|Real effective exchange rate (1990=100)||101.3||103.2||101.4||99.2||...|
Sources: Data provided by the authorities; and IMF staff estimates.
2Three-month interbank money rate in Belgium, as there is no separate money market in Luxembourg.
3For 1998, first quarter average.
4These figures include only the official
reserves of the IML, while Luxembourg is in a monetary association with Belgium. Data for 1998 are for January.
1Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.
IMF EXTERNAL RELATIONS DEPARTMENT