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Luxembourg and the IMF
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On June 5, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Luxembourg.1
Reflecting the global slowdown, but taking into account supportive policy conditions and an expected regional recovery by mid-year, the staff projects real GDP to grow by 2¾ percent in 2002, after 3½ percent in 2001. Underlying trend growth is estimated at about 4¾ percent by the staff. With some slack returning to labor markets and barring further oil price shocks, the staff projects headline inflation to fall to 2 percent in 2002. Underlying inflation is expected to decline more gradually from 2¾ percent in 2001 to about 2 percent by 2003.
Policies have been medium-term oriented. Fiscal policy has been guided by the objectives of balancing the central government budget, keeping spending growth in line with trend-GDP growth, and running a general government surplus. Consequently, the public sector holds net assets equivalent to about 50 percent of GDP. Nonetheless, the pay-as-you-go social security system requires high long-term growth and continuing worker inflows for its sustainability.
The government is proceeding with multi-year tax cuts and stepping up the pace of spending. Tax cuts aim to lower marginal rates, maintain an internationally attractive corporate tax system, reduce inactivity traps, and promote individual pension savings. On the expenditure side, infrastructure, research and development, and education received a boost, and pension benefits have been increased. With growth expected to be lower than budgeted, the staff estimates that the central government is likely to post a deficit in 2002, and that the general government budget surplus will be less than envisaged in the authorities' latest stability program.
The financial sector has continued to expand, with asset and liquidity management taking over from private banking as the main source of strong growth of the sector. Nonetheless, activity weakened in 2001. In the area of supervision, upgrading of supervisory capabilities and efforts to combat money laundering have continued, and in addition, the implementation of a comprehensive anti-money laundering Action Plan has started.
Structural reforms are proceeding. Progress has been made in removing legal obstacles to part-time employment, introducing more flexible working time arrangements and work week averaging, and expanding child care facilities. The authorities have adopted the legal and regulatory framework needed for the launch of an electronic commerce sector.
Executive Board Assessment
Executive Directors commended the authorities for the excellent economic performance of the past decade, in particular the high rates of GDP and employment growth and the low unemployment rate. They agreed that the outlook remained bright, although the recent global slowdown had slowed growth, and medium-term growth would likely be somewhat less than during the past decade. With the relaxation of labor market tightness and the waning of the effects of indexation, wage and price pressures were likely to ease during 2002.
Directors commented that economic performance had been underpinned by sound policies, as well as by several features specific to Luxembourg, such as specialization in financial services, a strong social partnership, and openness to worker inflows from the region. At the same time, the importance of the financial services sector in the economy made Luxembourg vulnerable to negative exogenous sectoral developments. Also, the funding of Luxembourg's generous social welfare system required continuous high growth and worker inflows. Policies had been prudent, however, and the accumulation of an appreciable net public asset position provides a cushion in the event of shocks.
In light of recent increases in public spending and emerging constraints on growth, Directors encouraged the authorities to return fiscal policy to a more cautious course and ensure continued soundness of the financial sector. They supported the ongoing tax cuts and the authorities' intention to moderate public spending as needed to ensure that the central government budget is in balance or surplus in 2003 and over the medium term. They cautioned against basing budget projections on overly optimistic trend-growth assumptions. Directors underscored the need to secure the sustainability and robustness of the pension system, including by accumulating reserves in the social security system and, if needed, by scaling back benefits. Consideration might also be given to converting part of the current pay-as-you-go component into a funded pillar, in part to shield the budget from pressures to spend surpluses on higher social benefits. By keeping general government spending somewhat below trend-GDP growth, resources could be freed for such a conversion. Directors also recommended that rapid further progress be made in managing social security system assets.
Directors welcomed the findings of the Financial System Stability Assessment that Luxembourg's financial sector is robust, efficient, and well supervised, and took note of the authorities' intention to implement the Assessment's recommendations. They emphasized the need for a continued high degree of vigilance in the area of supervision in order to preserve Luxembourg's outstanding reputation as a financial center. Directors were encouraged by Luxembourg's commitment to implement quickly and smoothly the EU financial directives, and they also appreciated the fact that the authorities support the effective taxation of cross-border interest income in Europe as a common objective.
Directors praised the authorities' intensified efforts to combat money laundering and the financing of terrorism, and stressed the need for the authorities to complete the implementation of their comprehensive anti-money laundering action plan.
Directors recommended a more comprehensive and proactive approach to labor, product, and land market reform, which would increase the economy's efficiency and adaptability. While Luxembourg's labor market had shown considerable flexibility, it would be important to observe wage moderation in the period ahead, and further reduce disincentives to participate in the labor force. An acceleration of product and land market reform, combined with the planned increase in infrastructure spending, would also be key to raising productivity and removing emerging constraints on growth.
Directors commended the authorities for their commitment to promote trade liberalization as a means to foster economic development, and for the increase in official development assistance, noting that Luxembourg was among the few countries that exceeded the United Nations' target in this regard.
Directors endorsed the authorities' intention to continue to improve economic statistics and encouraged them to take the necessary steps to subscribe to the Fund's Special Data Dissemination Standard in the near future.
1 Under 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 Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the June 5, 2002 Executive Board discussion based on the staff report.
IMF EXTERNAL RELATIONS DEPARTMENT