## 1luxea2023001 - 2025. Risks are mainly external and are tilted to the downside, notably after the recent stress in the global banking.

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### Outlook and Risks
- Risks are mainly external and are tilted to the downside, notably after the recent stress in the global banking sector.
- War in Ukraine and energy:
  - About 25 percent of Luxembourg gas imports were sourced from Russia in 2020.
  - Higher energy prices increased imported inflation and domestic energy price pressure.
  - Acceleration of monetary policy tightening by major central banks and heightened volatility of global financial conditions affected Luxembourg’s financial sector performance and confidence in trading partners.
- Inflation developments:
  - National headline inflation peaked at 7.4 (5.1) percent year on year (yoy) in June 2022 before easing to 4.3 percent in February 2023.
  - Core inflation persisted at 4.8 percent.
  - The share of items with inflation exceeding 4 percent grew to 63 percent.
  - Annual average inflation in 2022 was 6.3 percent.
- Growth and labor market:
  - Growth moderated to 1.5 percent in 2022, from 5.1 percent in 2021.
  - Unemployment reached 4.8 percent in December 2022 (stable in February 2023).
  - Vacancy rates remain elevated; a large share of firms report labor shortages.
- Housing and real estate:
  - Housing price growth averaged 9½ percent in 2022, 5 percentage points lower than in 2021.
  - Staff estimates indicate housing prices remain overvalued (around 17 percent in 2022Q2).
  - Construction costs and project postponements rising due to higher input prices.
- Financial market stress and spillovers:
  - Investment funds’ net assets declined by 14 percent year on year in December 2022.
  - Investment funds recorded net outflows of about 2½ percent of total assets.
  - Aggregate exposures of Luxembourg investment funds to Credit Suisse securities are 0.1 percent of the sector’s total assets.

### Fiscal Policy — Findings
- Fiscal stance and aggregates:
  - Fiscal stance was expansionary in 2022.
  - Central government deficit estimated to have widened to about 1 percent of GDP in 2022.
  - Cyclically-adjusted fiscal balance deteriorated by about 0.4 percent of GDP in 2022.
  - Public debt stayed broadly stable at 24½ percent of GDP at end-2022 due to a favorable interest rate-growth differential.
- Discretionary measures (percent of GDP):
  - COVID: 4.0 (2020), 1.1 (2021), 0.2 (2022)
    - Revenue: 0.8 (2020), 0.0 (2021), 0.2 (2022)
    - Expenditure: 3.2 (2020), 1.1 (2021), 0.2 (2022)
  - Energy shock: 1.3 (2021), 2.2 (2022), 0.4 (2023)
    - Revenue: 1.0 (2021), 1.4 (2022)
    - Expenditure: 0.3 (2021), 0.7 (2022), 0.4 (2023)
  - Total measures: 4.0 (2020), 1.1 (2021), 1.5 (2022), 2.2 (2023), 0.4 (2024)

### Fiscal Policy — Recommendations
- Short term:
  - Significantly reduce the fiscal stimulus to contain aggregate demand and inflation pressure by keeping the cyclically adjusted balance broadly unchanged.
  - Shift to more targeted and less price-distortionary energy support measures.
  - Continue investing in energy efficiency and renewables.
  - In case of severe demand shocks, allow automatic stabilizers to fully operate and consider targeted support.
  - In case of supply shocks, complement targeted support with a suspension of wage indexation.
- Medium term:
  - Preserve buffers through prudent spending and an early pension reform.
  - Better anchor fiscal policy and reduce procyclicality by adopting a medium-term objective based on the overall balance and a ceiling on expenditure growth.
  - Increase the frequency of tax bracket adjustments for inflation in a budget-neutral way.
  - Undertake a comprehensive review of the tax and social benefits system to enhance efficiency and distributional impact.

### Financial Sector — Findings
- Banks:
  - Strong capital and liquidity buffers.
  - Average LCR (NFSR) at end-2022: 154 percent (LCR) and 130 percent (NFSR).
  - Net interest income benefited from higher interest rates in 2022; profitability improved slightly despite lower non-interest revenue and higher operating costs and provisioning.
  - NPLs remain low but stage 2 loans have increased, especially for the nonfinancial corporate sector.
- Investment funds:
  - Net assets declined by 14 percent yoy in December 2022.
  - Net outflows about 2½ percent of total assets, concentrated in corporate, high yield and emerging market bond funds.
  - Daily outflows manageable and did not trigger liquidity stress and asset fire sales.
  - Impact of the U.K. LDI turmoil and Credit Suisse stress has been isolated with limited spillovers.

### Financial Sector — Recommendations
- Macroprudential and supervisory measures:
  - Continue monitoring potential pockets of vulnerabilities, especially in real estate, liquidity, and interest rate risks.
  - Maintain the countercyclical capital buffer (CCyB) unchanged for now.
  - Consider introducing income-based limits to avoid further buildup of vulnerabilities.
  - Increase resilience to a severe real estate downturn through targeted capital measures:
    - Apply a sectoral systemic risk buffer.
    - Increase minimum risk weights and link them to LTV.
  - If the credit cycle deteriorates considerably, consider relaxing the CCyB while keeping the LTV limit unchanged.
- Investment funds resilience:
  - Bolster resilience by enhancing the effectiveness of swing pricing through better calibration to stress episodes.
  - Tailor redemption terms to asset liquidity and investment strategy.
- Cross-border coordination:
  - Continue active coordination with other supervisors on cross-border spillovers.
  - Contribute to international efforts to strengthen oversight and regulatory and macroprudential requirements, especially concerning liquidity and leverage.

### Structural Policies — Findings
- Housing affordability under pressure due to supply bottlenecks, excess savings, historical low interest rates, and construction sector bottlenecks.
- Wage indexation and recent wage developments:
  - Two wage indexations occurred in October 2021 and April 2022.
  - Government agreed public wage increases for 2023-24 of 50 and 80 million euros, respectively—a total of 0.2 percent of GDP.
  - Minimum wages raised by 3.2 percent in January 2023 (on top of wage indexations).
  - Government committed to compensate firms until January 2024 for the cost of a third indexation should it happen in 2023 and extended energy price measures to end-2024.

### Structural Policies — Recommendations
- Housing:
  - Boost housing supply by frontloading public construction projects, reducing bottlenecks, and increasing density.
  - Avoid measures that boost housing demand and impede adjustment of housing prices to more affordable levels.
- Wage indexation reform options:
  - Consider indexing to core inflation, complemented as needed with targeted support for the poorest.
  - Consider introducing progressive wage indexation.
  - Consider switching to a rule-based suspension of the wage indexation system (e.g., based on competitiveness indicators) to encourage greater decentralization of wage bargaining.

### External Position and Recent Developments
- Current account surplus estimated to have widened to 5 percent of GDP in 2022.
- Net international position dropped by about 12 percent of GDP as positive valuation effects (euro depreciation) in net FDI and other investments were more than offset by net portfolio investment outflows.
- Authorities intend to channel 20 percent of the SDR1.3 billion allocation to countries in need.

### Outlook and Baseline Projections and Assumptions
- Staff baseline assumptions:
  - Global supply bottlenecks continue easing and lower international energy prices, notably for gas, aid disinflation globally and in Europe.
  - Price pressures remain elevated in the near term; natural gas prices expected to remain above historical levels.
  - Major central banks expected to continue with policy rate hikes consistent with WEO assumptions.
  - Following recent global banking stress, financial conditions expected to tighten further.
  - Authorities expected to lift energy price controls in 2025; controls projected to remain binding through that period.
- Near-term projections and dynamics:
  - GDP growth projected to slow to about 1.1 percent in 2023.
  - Headline inflation projected to halve to 3¼ percent in 2023, aided mainly by energy price caps/controls.
  - Core inflation would remain elevated above 3¾ percent in 2023.
  - Real disposable income likely to increase in 2023 with three indexations projected and large stimulus, supporting private consumption.
  - Credit growth expected to slow, especially for mortgages, but remain positive.
  - 2024 growth expected to rebound to 1¾ percent.
  - Output gap projected to remain slightly negative, with growth converging to its potential of 2¼ percent in the medium term.
  - Inflation likely to be around 3 percent until 2025, as authorities lift the VAT rate cut in 2024 and the energy price controls in 2025.
- Authorities’ projections:
  - Authorities project GDP growth of 2.2 percent in 2023 and 3.2 percent in 2024.

### Risks and Scenarios
- Downside external risks:
  - An abrupt global slowdown or recession.
  - Miscalibration of monetary policy in major economies leading to de-anchoring of inflation expectations.
  - Systemic financial instability and an intensification of the war in Ukraine with associated energy supply disruptions.
- Impacts if shocks materialize:
  - Lower growth and fiscal revenue, exacerbated growth-inflation tradeoff, risk of wage-price spiral given automatic wage indexation.
- Financial sector risks:
  - High inflation, tighter financial conditions, and recessionary risks could impair asset quality and collateral valuation, damp credit growth, and prompt larger-than-expected house price adjustments.
  - Greater market volatility could dampen asset growth in investment funds, custodian banks, and private banking, increasing probability of market dysfunction and liquidity risks.

### Fiscal Policy: Near-Term Stance and Recommendations
- 2023 fiscal stance:
  - Fiscal policy expected to be expansionary in 2023.
  - Deficit forecast about 2¾ percent of GDP in 2023.
  - Structural balance excluding one-offs worsening by 1¾ percent of GDP, reflecting permanently higher current spending.
  - Authorities restored indexation of family benefits, made after school care and school meals free for all, and introduced tax credits to single parent households and measures to increase attractiveness for talent workers.
- Staff recommendation for 2023-24:
  - Adopt a broadly neutral fiscal stance in 2023-24.
  - Significantly reduce the fiscal impulse by keeping the cyclically adjusted balance (excluding the one-off quota transfer to the EU) broadly unchanged.
  - Possible measures include postponing public sector hiring, rationalizing intermediate consumption spending, preserving capital spending, and better targeting energy support measures.
  - Refrain from any additional stimulus with permanent fiscal effects.
  - Any fiscal overperformance should be saved or redirected to accelerate the energy transition and support housing supply.
- Conditional fiscal flexibility:
  - In case of additional supply shocks, consider suspending automatic wage indexation or reforming it in consultation with trade unions.
  - In case of a deep demand shock, consider targeted stimulus and allow automatic stabilizers to operate fully.
- Assessment of energy support measures:
  - Energy price caps reduced headline inflation in the short term but are costly, can increase core inflation persistence, and limit incentives for energy savings.
  - VAT rate cut is regressive, may not be fully passed through to prices, and could support firms’ profit margins; once removed, pass-through could be relatively high and contribute to higher inflation in 2024.
  - Price caps distort price signals and impede needed adjustment of energy consumption where part of the shock could be permanent.
- Recommended design improvements:
  - Better-targeted, less distortionary measures such as block pricing or social tariffs targeted to the vulnerable.
  - Where technical difficulties exist (e.g., multi-family residence billing), link support to the unit’s share in past energy use.
  - Accelerate investment in renewable energy and support energy efficiency.
  - Between August 2022 and January 2023, gas consumption dropped by 19 percent relative to the 2017-21 average; milder weather accounted for one third of the reduction, remainder due to lower demand by energy-intensive firms (equally split between the closure of one old manufacturer and lower activity and transition to alternative energy).

### Medium-Term Fiscal Stance and Structural Reforms
- Medium-term projections and pressures:
  - Under baseline, fiscal deficit projected to gradually narrow towards ½ percent of GDP, barring additional shocks.
  - Expenditures will remain about 2¾ percent of GDP higher than pre-COVID levels, driven by higher wage-related spending and interest payments.
  - Financed by higher revenue, mostly from personal income taxation, which could be temporary.
  - Projected deficit expected to stabilize debt to GDP close to 30 percent.
  - Staff suggests somewhat more prudent recurrent spending — about ¼ percent of GDP lower spending over the medium term.
- Pension sustainability:
  - Pension system expected to increase the general government deficit by 8 percentage points of GDP by 2070, and reserves would be depleted by around 2047, if no action taken.
  - Staff recommends early pension reform: increase effective retirement age (currently around 60 years) towards statutory retirement age of 65 years, disincentivize early retirement, and make the pension system less generous.
- Strengthening fiscal frameworks:
  - Suggested measures:
    - Implement a medium-term objective (MTO) based on the general government fiscal balance, adjusted every 3-5 years.
    - Adopt an expenditure ceiling rule as an operational target to reduce procyclicality of spending.
    - Keep debt to GDP as a long-term debt anchor while being prudent given ageing costs.
    - Enhance medium-term budgeting and strengthen the fiscal risks framework.
  - Expenditure rule could include an escape clause for severe idiosyncratic shocks.

### Tax-Benefit System and Distributional Policy
- Issues identified:
  - Low frequency of tax bracket adjustment for inflation combined with automatic wage indexation producing suboptimal distributional effects.
  - Historically, tax brackets adjusted ad-hoc; revenue windfalls often financed additional spending, contributing to procyclical fiscal policy.
- Staff recommendations:
  - More frequent adjustment of tax brackets (additional budgetary cost should be offset by better targeting of other tax expenditures/benefit measures).
  - Offset measures: gradual phasing out of interest payment deductibility, means-testing family benefits and housing support.
  - Pursue comprehensive review and simplification of tax-benefit system to enhance distributional impact and avoid overlapping support.

### Authorities’ Views (selected)
- Authorities highlighted effectiveness of adopted packages in containing inflation in context of automatic wage indexation and remain committed to fiscal discipline.
- Time-bound direct price controls tamed headline inflation and avoided several tranches of wage indexation that would have hindered competitiveness.
- Limited effects of wage indexation on inflation in a small open economy emphasized.
- Authorities agreed stronger price signals would help lock-in energy savings and indicated block pricing could be envisaged.
- Agreed on need for early pension reform without giving a timeline and broadly agreed with more frequent inflation adjustment of tax brackets, stressing budget neutrality and part of a comprehensive tax-benefit review.

### Nonfinancial Corporate Sector
- Overall assessment: strong liquidity position and fiscal support will moderate recent shocks’ impact.
- Vulnerabilities:
  - Leveraged firms with weak pricing power at risk.
  - Real wage rigidity reduces firms’ capacity to adjust.
  - Sectoral risk: construction and manufacturing show increases in NPL ratio.
  - Cross-border exposures require greater scrutiny; review of waivers to large exposure limits should continue.
- Evidence: ECB analysis shows corporate sector loans from Luxembourgish banks sensitive to higher energy and financing costs.
- Bankruptcies increased significantly in Q4, although from low levels.

### Households
- Key statistics:
  - Share of variable rate mortgages: 42.5 percent (overall); for bottom 20 percent: 17 percent.
  - High household indebtedness noted.
- Stress sensitivity:
  - A 200 basis point increase in interest rates could triple the mortgage debt at risk (to 30 percent).
- Mitigants:
  - High net worth, excess saving, low unemployment, wage indexation, increases in minimum wages, and large fiscal support.
- Probability of default on aggregate: assessed as relatively low in the short term.

### Banks’ Profitability and Risks
- Outlook:
  - Net interest margins likely to increase but historically associated with lower net fees and commissions.
  - Funding costs likely to rise following TLTRO repayment and recent global banking pressures.
  - Custodian and private banks highly dependent on capital market developments and vulnerable to market corrections.
  - Deteriorating asset quality and collateral revaluation will increase provisioning needs.
  - High inflation and related increases in operating costs could weigh on profitability.
- Staff expectation: any potential gains from higher interest rates to be short-lived.
- Policy implication: address structurally weak profitability by incentivizing diversification of activity and mutualization of compliance costs.

### Real Estate Sector
- Short-term outlook: sharp correction in real estate prices unlikely in short term, but vigilance required.
- Structural factors:
  - Housing prices historically resilient due to structural supply deficit.
- Downside risks:
  - Tighter financial conditions and changes in real estate taxation could trigger selling when demand subdued, producing larger-than-expected correction.
  - Hoarding behavior, construction delays, and financial difficulties of builders could depress supply and sustain high prices.
- Commercial real estate: activity resilient, vacancy rates fallen, transaction volumes lower than pre-crisis.
- Data gap: longer-term trends in retail and office markets should be monitored; prices data gaps remain.

### Banking Sector Resilience and Stress Tests
- CSSF top-down stress tests (based on 2021 data and preliminary 2022 information):
  - Under adverse scenario, CET1 buffers would decline by 4 percentage points by end-2024 to 19½ percent, well above required levels.
  - Corporate, private, and universal banks more affected than other business models.
- Liquidity: immediate impact of recent global banking stress on Luxembourg bank liquidity limited; authorities monitor daily liquidity and require reporting of any breaches (including possible future LCR breaches).
- Held-to-maturity securities: stress tests assessing hidden losses following an interest rate shock show banks are, on aggregate, in good position to absorb these losses should they materialize.

### Macroprudential Policy Recommendations
- Current stance: CCyB kept unchanged at 0.5 percent, appropriate given closing credit gap, tightening credit standards, and uncertain outlook.
- Measures implemented by CSSF include required sensitivity analysis (+200, +300, +400 bps on RRE stock exposures).
- Further options:
  - Assess effectiveness of measures and impact on banks’ lending standards.
  - If mortgage risk profile does not improve, consider income-based limits (DSTI, DTI), calibrated to reduce excessive risk-taking while avoiding significant activity depression.
  - Targeted capital-based measures: higher minimum risk weights (noted as relatively low by EU standards), linking them to loan risk or a real estate focused systemic risk buffer.
  - If credit cycle deteriorates considerably, consider relaxing CCyB but keep LTV limit unchanged.

### Investment Funds
- Liquidity and redemptions:
  - Most fund categories increased HQLA with higher share of cash holdings.
  - CSSF stress tests show most equity and bond funds able to honor a 20 percent redemption request in less than 5 days.
- Vulnerable categories: high-yield, emerging market, and mixed funds remain vulnerable to liquidity risk.
- Liquidity management tools (LMTs):
  - Swing pricing reduced first-mover advantage; effectiveness could be improved by better calibration in stress episodes.
  - Complementary measures: align redemption terms with asset liquidity and investment strategy (notification periods, lower redemption frequencies, larger liquidity buffers).
- Supervisory actions: monitor large redemptions, regular liquidity stress-tests, implement system-wide stress testing.
- Cross-border coordination: continue coordination with peers given Luxembourg’s central role.

### Alternative Investment Funds and Leverage
- Systemic importance of AIFs growing rapidly.
- Risks:
  - Pockets of elevated leverage (notably in real estate and other alternative funds) could increase vulnerability.
  - Synthetic leverage embedded in derivative positions should be carefully monitored.
- Data gaps: investor base, unregulated funds, low frequency of reporting, and inconsistencies should be addressed.

### Interconnectedness between Banks and Funds
- Key linkages:
  - Investment funds’ deposits increased as a share of banks’ liabilities, reaching 20 percent.
  - Funds’ assets account for over 90 percent of financial sector assets.
  - Connections concentrated on some banks (mainly custodian banks), creating potential contagion channels.
- Mitigants:
  - These banks generally subject to systemic capital requirements and have large liquidity and capital buffers.
  - Historically, funds tended to transform liquid assets into cash in stress episodes, increasing deposits in banks.

### Insurance Sector
- Life insurers:
  - Risk of decrease in tied assets leading to lower technical provisions, mostly for unit-linked life insurance liabilities which represent more than 70 percent of the Luxembourg life insurance market.
  - Fees mostly proportionate to technical provisions; medium-term profitability issues possible.
- Non-life (re)insurers:
  - Main risk stems from rising claims due to inflation.
  - Impact of rising interest rates depends on duration gaps and level of reserves.
- Recommendation: continued monitoring of risks in insurance sector and its interconnectedness with other financial institutions.

### Structural and Operational Risks
- Climate-related and environmental (CR&E) risks:
  - Implementation of Circular 21/773 (management of CR&E risks, June 2021) is at early stages; assessment underway.
  - Will support development of macroprudential approach for systemic aspects of climate-related risks.
  - For investment funds, more harmonization of definitions at global level needed to limit greenwashing.
- AML/CFT:
  - Luxembourg undergoing AML/CFT mutual evaluation by FATF; report to be discussed in June 2023.
  - An AML/CFT questionnaire sent yearly to banks and other financial entities to collect information on risk; cross-border flows information considered.
  - Beneficial Ownership Registry (BOR): following ECJ decision from November 2022, public access to BORs invalidated. In December, an application process introduced by Luxembourg Business Registers to restore access for professionals and journalists. Luxembourg working on amending BOR law to provide access to other legitimate interest users.

### Housing Market: Demand Measures vs. Supply Focus
- Planned reforms:
  - Reform of land taxation and vacant dwelling taxation, and reduction of accelerated depreciation rate welcomed but effects likely over medium term.
- Demand-support measures:
  - Increase in tax credit for first-time homebuyers and increase in ceiling of interest payment deductibility are not targeted and could impede housing price adjustment.
  - Staff cautioned against public purchases of dwellings under construction by private sector.
- Staff recommended:
  - Frontload public investment in social and affordable housing.
  - Expedite efforts to reduce supply bottlenecks, allow greater density, and reduce administrative costs.

### Lease Contract Reform and Rental Affordability (bill provisions)
- Proposed changes:
  - Reform of rent ceiling: cut maximum increase in rental prices from 5 percent of capital invested to 3.5 percent.
  - Tenants and landlords equally split real estate agency fees.
  - Security deposits limited to two months’ rent (down from three).
  - Charges for furniture in furnished dwelling limited to 1.5 percent of purchase price per month.
- Assessment: Costs/benefits difficult to assess; risk reforms impede supply in medium term.

### Automatic Wage Indexation (AWI): Risks and Reform Options
- Objectives for reform: mitigate wage-price spiral risks, assuage distributional concerns, preserve firms’ ability to respond to shocks.
- Policy options:
  - Switching indexation benchmark to exclude volatile components (e.g., energy) reduces probability of indexation events and second-round inflation effects.
  - Consider targeted compensatory measures to protect most vulnerable if indexations less frequent.
  - Make scheme more progressive (e.g., tapering wage increase or excluding higher quantiles).
  - Define competitiveness benchmarks to automatically suspend AWI application and encourage decentralized bargaining.
- Distributional considerations:
  - Energy, food, alcohol and tobacco weights in national price index higher for lower income quantiles.
  - Ad-hoc suspensions/postponements disproportionately hurt poorer households.

### Labor Force, Education, and Participation
- Education and dropouts:
  - Dropout rate elevated for immigrants.
  - Authorities extended mandatory schooling by 2 years (to 18).
  - Complementary measures suggested: orient youth to other pathways and facilitate employment.
- Gender gap:
  - Female part-time employment: about 30 of percent of employed women (7 percent for men); 38 percent for female Luxembourgers.
  - Luxembourg has lowest adjusted gender pay gap in Europe at 0.7 percent, but sectoral heterogeneity remains (e.g., 22 percent in financial services).
  - Women underrepresented in STEM: 4 percent in STEM occupations vs. 28 percent for men.
  - Suggested measures: enhance work flexibility, relax work permits for spouses, develop apprenticeships and internships (STEM), promote female entrepreneurship in STEM, and individualize taxation.

### Staff Appraisal: Outlook, Fiscal Stance, and Financial Sector Vigilance
- Outlook and risks:
  - Economy resilient but uncertain with downside growth risks.
  - GDP growth expected to slow; labor market and private consumption likely to remain robust.
  - Energy support measures will reduce number of wage indexations and firms’ need to adjust.
  - Headline inflation projected to moderate; core inflation expected to remain persistently high.
  - Recent global banking stress added uncertainty and downside risks.
- Fiscal policy:
  - Planned fiscal stimulus assessed as excessive and should be significantly reduced.
  - Recommendation: keep cyclically adjusted overall balance broadly unchanged in 2023 and 2024; switch to more targeted and less-distortive price measures.
  - If recessionary pressures greater and inflation falls more than expected, allow automatic stabilizers to operate and consider targeted stimulus.
  - Medium-term: control wage bill, improve targeting of social benefits, early pension reform, adopt MTO based on general government balance and a ceiling on expenditure growth.
- Tax policy:
  - Tax brackets should be adjusted more frequently for inflation within a comprehensive tax-benefit reform.
- Financial sector and real estate:
  - Banking system appears resilient but requires close monitoring, especially real estate vulnerabilities.
  - Continue prudent provisioning and consider income-based limits and targeted sectoral capital measures if needed.
  - Investment funds: bolster resilience, calibrate liquidity management tools, monitor large redemptions, address data gaps, and coordinate with peers.
- Reiterated recommendation:
  - Boost housing supply while avoiding measures increasing housing demand; frontload public investment in social and affordable housing and expedite efforts to reduce supply bottlenecks.

### Selected Economic Indicators and Projections (highlights)
- Real GDP growth (percent change): 2019: 2.3; 2020: -0.8; 2021: 5.1; 2022: 1.5; 2023: 1.1; 2024: 1.7; 2025: 2.5; 2026: 2.4; 2027: 2.3; 2028: 2.3.
- CPI (harmonized), p.a. (percent change): 2019: 1.7; 2020: 0.0; 2021: 3.5; 2022: 8.1; 2023: 2.6; 2024: 3.1; 2025: 3.4; 2026: 2.0; 2027: 2.0; 2028: 2.0.
- Unemployed (average, thousands): 2019: 15.4; 2020: 18.7; 2021: 17.1; 2022: 14.6; 2023: 15.7; 2024: 17.1; 2025: 18.2; 2026: 18.4; 2027: 18.7; 2028: 19.1.
- General government balance (percent of GDP): 2019: 2.2; 2020: -3.4; 2021: 0.7; 2022: 0.2; 2023: -2.8; 2024: -1.8; 2025: -1.0; 2026: -0.5; 2027: -0.4; 2028: -0.5.
- General government gross debt (percent of GDP): 2019: 22.4; 2020: 24.5; 2021: 24.5; 2022: 24.6; 2023: 27.5; 2024: 29.2; 2025: 29.6; 2026: 29.6; 2027: 29.4; 2028: 29.2.
- Current account (percent of GDP): 2019: 3.4; 2020: 3.2; 2021: 4.6; 2022: 5.0; 2023: 4.5; 2024: 4.4; 2025: 4.5; 2026: 4.5; 2027: 4.5; 2028: 4.5.
- NIIP 2022: 28.2 percent of GDP.

### Annex II — Impact of Financial Tightening (highlights)
- Indicators:
  - CLIFS compiled by ECB and VIX used to capture domestic and global financial conditions.
  - CLIFS increased by more than the VIX since early-2022 due to energy price surge in Europe.
  - Correlation CLIFS–VIX around 0.2 since the Covid-19 pandemic; CLIFS highly correlated with euro area CISS (around 0.8 full sample, 0.9 since pandemic).
- Impact on GDP:
  - CLIFS insignificant for Luxembourg real GDP growth; VIX highly significant and negatively associated.
  - One standard deviation tightening of the VIX (roughly 10 points) impacts real GDP growth by around -0.8 to -1.1 percentage points.
  - Financial sector accounts for about ¼ of gross value added in Luxembourg.
- Differential effects:
  - Banks: bank total assets negatively correlated with domestic financial conditions (CISS/CLIFS); correlation with VIX insignificant.
  - Investment funds: net asset growth not correlated with domestic conditions but highly correlated with global conditions (VIX), reflecting global investor linkages.

### Annex V — FSAP Update 2017 Implementation Status (selected)
- Resource allocation and supervision:
  - CAA grew by approximately 13 units (FTE) in 2021 and by 12 units (FTE) in 2022.
  - BCL expanded resources dedicated to direct supervision and risk analysis by 30 percent.
- Macroprudential toolkit and BBMs:
  - Law of 4 December 2019 established legal framework for borrower-based measures.
  - CdRS Recommendation 9 November 2020 led to CSSF Regulation N°20-08 introducing differentiated LTV limits:
    - First-time buyers (FTBs): LTV limit 100 percent.
    - Non-FTBs primary residence: LTV limit 90 percent (banks may provide up to 15 percent of annual portfolio with LTV 90–100 percent).
    - Buy-to-let: maximum LTV 80 percent.
- Data and monitoring:
  - Since June 2020, new data on residential real estate loans available quarterly in FINREP, including LTV distributions.
  - BCL assessed Luxembourg as Largely Compliant for residential real estate and Fully Compliant for commercial real estate with ESRB recommendations.
- Investment fund oversight:
  - CSSF contributed to ESMA, IOSCO, ESRB initiatives; implemented annual liquidity stress testing framework and published working papers (e.g., 9 March 2023 working paper on liquidity stress testing).
  - Art. 25 AIFMD analyses performed quarterly, focusing on highly leveraged funds.

### Institutional Framework and Recommendations (selected)
- Recommendation: Strengthen institutional framework and consider enshrining in law the de facto leading role of the BCL. Timeframe: MT.
- Publish risk dashboard and note assessing systemic risk; CdRS publishes overview and subset of risk dashboard indicators in annual report.
- Banking supervision: increase monitoring of intra-group exposures, require banks to demonstrate waiver eligibility; CSSF strengthened monitoring, weekly/daily monitoring of parent ratings and CDS in crisis.
- Harmonize data reporting standards: CSSF circulars formalized harmonized definitions for LTV and DSTI; national working group on real estate data gaps chaired by BCL.

### Social Inclusion and Gender Participation (annex highlights)
- Progress:
  - Female participation (employment) rate increased by 9 percentage points (ppt) over 2010-21.
  - Gender participation gap declined by 11 ppt.
- Remaining disparities:
  - Activity rate for non-EU female workers remains well below male and other females.
  - Senior women (55-64) participation improvements less impressive.
- Employment patterns:
  - About 30 of percent of employed women work part-time compared to 7 percent for men; 38 percent for female Luxembourgers.
- Wage inequality and sectoral heterogeneity:
  - Adjusted gender pay gap 0.7 percent in Luxembourg; sectoral variation (22 percent in financial services).
- Recommendations to boost participation:
  - Facilitate work permits for spouses of expatriates; extend language support.
  - Reduce disincentives to work in pensions: average retirement age 59 ½ years vs statutory 65.
  - Increase work flexibility, invest in public transport, promote apprenticeships and internships in STEM, and consider individual taxation to boost female labor supply.

*International Monetary Fund staff report for Luxembourg (discussions held February 27–March 10, 2023).*

### 2025. Risks are mainly external and are tilted to the downside, notably after the recent

### 1luxea2023001 - 2025. Risks are mainly external and are tilted to the downside, notably after the recent stress in the global banking.

### Outlook and Risks
- Risks are mainly external and are tilted to the downside, notably after the recent stress in the global banking sector.
- The war in Ukraine poses new headwinds mainly through indirect spillovers:
  - About 25 percent of Luxembourg gas imports were sourced from Russia in 2020.
  - Higher energy prices have increased imported inflation and pressure on domestic energy prices.
  - Acceleration of monetary policy tightening by major central banks and heightened volatility of global financial conditions have affected Luxembourg’s financial sector performance and confidence in trading partners.
- Inflation developments:
  - National headline inflation peaked at 7.4 (5.1) percent year on year (yoy) in June 2022 before easing to 4.3 percent in February 2023.
  - Core inflation persisted at 4.8 percent.
  - The share of items with inflation exceeding 4 percent grew to 63 percent.
  - Annual average inflation in 2022 was 6.3 percent.
- Growth and labor market:
  - Growth moderated to 1.5 percent in 2022, from 5.1 percent in 2021.
  - Unemployment reached 4.8 percent in December 2022 (stable in February 2023).
  - Vacancy rates remain elevated; a large share of firms report labor shortages.
- Housing and real estate:
  - Housing price growth averaged 9½ percent in 2022, 5 percentage points lower than in 2021.
  - Staff estimates indicate housing prices remain overvalued (around 17 percent in 2022Q2).
  - Construction costs and project postponements are rising due to higher input prices.
- Financial market stress and spillovers:
  - Investment funds’ net assets declined by 14 percent year on year in December 2022.
  - Investment funds recorded net outflows of about 2½ percent of total assets.
  - Aggregate exposures of Luxembourg investment funds to Credit Suisse securities are 0.1 percent of the sector’s total assets.

### Fiscal Policy — Findings and Recommendations
Findings:
- The fiscal stance was expansionary in 2022.
- The central government deficit is estimated to have widened to about 1 percent of GDP in 2022.
- The cyclically-adjusted fiscal balance deteriorated by about 0.4 percent of GDP in 2022.
- Public debt stayed broadly stable at 24½ percent of GDP at end-2022 due to a favorable interest rate-growth differential.
- Discretionary measures in response to COVID and energy shocks (in percent of GDP) include:
  - COVID: 4.0 (2020), 1.1 (2021), 0.2 (2022)
    - Revenue: 0.8 (2020), 0.0 (2021), (blank) 0.2 (2022)
    - Expenditure: 3.2 (2020), 1.1 (2021), 0.2 (2022)
  - Energy shock: 1.3 (2021), 2.2 (2022), 0.4 (2023)
    - Revenue: 1.0 (2021), 1.4 (2022)
    - Expenditure: 0.3 (2021), 0.7 (2022), 0.4 (2023)
  - Total measures: 4.0 (2020), 1.1 (2021), 1.5 (2022), 2.2 (2023), 0.4 (2024)

Policy recommendations:
- Short term:
  - Significantly reduce the fiscal stimulus to contain aggregate demand and inflation pressure by keeping the cyclically adjusted balance broadly unchanged.
  - Shift to more targeted and less price-distortionary energy support measures.
  - Continue investing in energy efficiency and renewables.
  - In case of severe demand shocks, allow automatic stabilizers to fully operate and consider targeted support.
  - In case of supply shocks, complement targeted support with a suspension of wage indexation.
- Medium term:
  - Preserve buffers through prudent spending and an early pension reform.
  - Better anchor fiscal policy and reduce procyclicality by adopting a medium-term objective based on the overall balance and a ceiling on expenditure growth.
  - Increase the frequency of tax bracket adjustments for inflation in a budget-neutral way.
  - Undertake a comprehensive review of the tax and social benefits system to enhance efficiency and distributional impact.

### Financial Sector Policies — Findings and Recommendations
Findings:
- Banks:
  - Banks have strong capital and liquidity buffers.
  - Average LCR (NFSR) at end-2022: 154 percent (LCR) and 130 percent (NFSR).
  - Net interest income benefited from higher interest rates in 2022; profitability improved slightly despite lower non-interest revenue and higher operating costs and provisioning.
  - NPLs remain low but stage 2 loans have increased, especially for the nonfinancial corporate sector.
- Investment funds:
  - Net assets declined by 14 percent yoy in December 2022.
  - Net outflows were about 2½ percent of total assets, concentrated in corporate, high yield and emerging market bond funds.
  - Daily outflows were manageable and did not trigger liquidity stress and asset fire sales.
  - The impact of the U.K. LDI turmoil and Credit Suisse stress has been isolated with limited spillovers.

Policy recommendations:
- Macroprudential and supervisory measures:
  - Continue monitoring potential pockets of vulnerabilities, especially in real estate, liquidity, and interest rate risks.
  - Maintain the countercyclical capital buffer (CCyB) unchanged for now.
  - Consider introducing income-based limits to avoid further buildup of vulnerabilities.
  - Increase resilience to a severe real estate downturn through targeted capital measures:
    - Apply a sectoral systemic risk buffer.
    - Increase minimum risk weights and link them to LTV.
  - If the credit cycle deteriorates considerably, consider relaxing the CCyB while keeping the LTV limit unchanged.
- Investment funds resilience:
  - Bolster resilience by enhancing the effectiveness of swing pricing through better calibration to stress episodes.
  - Tailor redemption terms to asset liquidity and investment strategy.
- Cross-border coordination:
  - Continue active coordination with other supervisors on cross-border spillovers.
  - Contribute to international efforts to strengthen oversight and regulatory and macroprudential requirements, especially concerning liquidity and leverage.

### Structural Policies — Findings and Recommendations
Findings:
- Housing affordability is under pressure due to supply bottlenecks, excess savings, low interest rates (historically), and construction sector bottlenecks.
- Wage indexation and recent wage developments:
  - Two wage indexations occurred in October 2021 and April 2022.
  - Government agreed public wage increases for 2023-24 of 50 and 80 million euros, respectively—a total of 0.2 percent of GDP.
  - Minimum wages were raised by 3.2 percent in January 2023 (on top of wage indexations).
  - The government committed to compensate firms until January 2024 for the cost of a third indexation should it happen in 2023 and extended energy price measures to end-2024.

Policy recommendations:
- Housing:
  - Boost housing supply by frontloading public construction projects, reducing bottlenecks, and increasing density.
  - Avoid measures that boost housing demand and impede the adjustment of housing prices to more affordable levels.
- Wage indexation:
  - Consider indexing to core inflation, complemented as needed with targeted support for the poorest.
  - Consider introducing progressive wage indexation.
  - Consider switching to a rule-based suspension of the wage indexation system (e.g., based on competitiveness indicators) to encourage greater decentralization of wage bargaining.

### Key Recent Developments and Contextual Points
- Luxembourg emerged from the pandemic in a strong position with limited GDP loss: GDP dropped by only 0.8 percent in 2020.
- Exceptional performance of exports of financial and nonfinancial services and expanding public services underpinned the rebound in 2021.
- Pre-election pressures led to generous public interventions, including energy support, tax relief, and wage commitments.
- The financial sector impact from recent global banking stress has been manageable so far, though vulnerabilities in certain pockets exist (real estate, liquidity, interest rate risks).

*International Monetary Fund staff report for Luxembourg (discussions held February 27–March 10, 2023).*

### 12.      The external position is assessed to be broadly in line with medium-term fundamentals

### 12.      The external position is assessed to be broadly in line with medium-term fundamentals

### External position and recent developments
- Current account surplus is estimated to have widened to 5 percent of GDP in 2022.
- Net international position dropped by about 12 percent of GDP as positive valuation effects (euro depreciation) in net FDI and other investments were more than offset by net portfolio investment outflows.
- The authorities have reiterated their intention to channel 20 percent of the SDR1.3 billion allocation to countries in need.

### Outlook and baseline assumptions
- Staff’s baseline projections assume:
  - Global supply bottlenecks continue easing and lower international energy prices, notably for gas, aid disinflation globally and in Europe.
  - Price pressures remain elevated in the near term; natural gas prices expected to remain above historical levels.
  - Major central banks are expected to continue with policy rate hikes consistent with WEO assumptions.
  - Following recent global banking stress, financial conditions are expected to tighten further.
  - Authorities are expected to lift energy price controls in 2025; controls projected to remain binding through that period.

- Near-term macroeconomic projections and dynamics:
  - GDP growth is projected to slow to about 1.1 percent in 2023.
  - Headline inflation is projected to halve to 3¼ percent in 2023, aided mainly by the energy price caps/controls.
  - Core inflation would remain elevated above 3¾ percent in 2023.
  - Real disposable income will likely increase in 2023 with three indexations projected and large stimulus, supporting private consumption.
  - Credit growth is expected to slow, especially for mortgages, but remain positive.
  - In 2024, growth is expected to rebound to 1¾ percent.
  - Output gap is projected to remain slightly negative, with growth expected to converge to its potential of 2¼ percent in the medium term.
  - Inflation is likely to be around 3 percent until 2025, as the authorities lift the VAT rate cut in 2024 and the energy price controls in 2025.

- Authorities’ own projections:
  - Authorities project GDP growth of 2.2 percent in 2023 and 3.2 percent in 2024.

### Risks and scenarios
- Downside external risks to growth include:
  - An abrupt global slowdown or recession.
  - Miscalibration of monetary policy in major economies leading to de-anchoring of inflation expectations.
  - Systemic financial instability and an intensification of the war in Ukraine with associated energy supply disruptions.
- If such shocks materialize, they would lower growth and fiscal revenue, exacerbate the growth-inflation tradeoff, and—given automatic wage indexation—could hinder external competitiveness via a wage-price spiral.
- Financial sector risks:
  - High inflation, tighter financial conditions, and recessionary risks could impair asset quality and collateral valuation, damp credit growth, and prompt larger-than-expected house price adjustments.
  - Greater market volatility could dampen asset growth in investment funds, custodian banks, and private banking, and increase the probability of market dysfunction and liquidity risks.

### Fiscal policy: near-term stance and recommendations
- 2023 fiscal stance and outlook:
  - Fiscal policy is expected to be expansionary in 2023.
  - Deficit is forecast to be about 2¾ percent of GDP in 2023.
  - The structural balance excluding one-off measures (energy and COVID-related ones) is worsening by a 1¾ percent of GDP, mostly reflecting permanently higher current spending, including a sharp increase in the public wage bill and social measures.
  - Authorities restored indexation of family benefits, made after school care and school meals free for all, and introduced tax credits to single parent households and tax measures to increase attractiveness for talent workers.

- Risks to the fiscal position:
  - Revenue could fall more than expected if economic performance, particularly in the export sector, is weaker.
  - Fiscal cost of solidarity packages uncertain and depends on wholesale energy prices and inflation persistence.

- Staff recommendation for 2023-24:
  - Adopt a broadly neutral fiscal stance in 2023-24.
  - Significantly reduce the fiscal impulse by keeping the cyclically adjusted balance (excluding the one-off quota transfer to the EU) broadly unchanged.
  - Possible measures to achieve this include postponing public sector hiring, rationalizing intermediate consumption spending (e.g., energy), preserving capital spending, and better targeting energy support measures.
  - Refrain from any additional stimulus with permanent fiscal effects.
  - Any fiscal overperformance should be saved or redirected to accelerate the energy transition and support housing supply.

- Conditional fiscal flexibility:
  - In case of additional supply shocks, consider suspending automatic wage indexation or reforming it in consultation with trade unions.
  - In case of a deep demand shock, consider targeted stimulus and allow automatic stabilizers to operate fully.

- Assessment of energy support measures:
  - Energy price caps reduced headline inflation in the short term but are costly, can increase core inflation persistence, and limit incentives for energy savings.
  - The VAT rate cut is regressive, may not be fully passed through to prices, and could support firms’ profit margins; once removed, pass-through could be relatively high and contribute to higher inflation in 2024.
  - Price caps distort price signals and impede needed adjustment of energy consumption where part of the shock could be permanent.

- Recommended design improvements:
  - Better-targeted, less distortionary measures such as block pricing (subsidize only a basic consumption amount) or social tariffs targeted to the vulnerable.
  - Where technical difficulties exist (e.g., multi-family residence billing), link support to the unit’s share in past energy use.
  - Accelerate investment in renewable energy and support energy efficiency to lock in consumption reductions and reduce energy import dependence.
  - Between August 2022 and January 2023, gas consumption dropped by 19 percent relative to the 2017-21 average; milder weather accounted for one third of the reduction, with the remainder due to lower demand by energy-intensive firms (equally split between the closure of one old manufacturer and lower activity and transition to alternative energy).

### Medium-term fiscal stance and structural fiscal reforms
- Medium-term projections and pressures:
  - Under the baseline, the fiscal deficit is projected to gradually narrow towards ½ percent of GDP, barring additional shocks.
  - Expenditures will remain about 2¾ percent of GDP higher than pre-COVID levels, driven by higher wage-related spending and interest payments.
  - This will be financed by higher revenue, mostly from personal income taxation, which could be temporary given pressures to index tax brackets and the ending of the VAT rate cut in 2024.
  - Projected deficit expected to stabilize debt to GDP close to 30 percent.
  - The European Commission’s latest MTO estimate, accounting for ageing-related costs, is for a balanced budget.
  - Luxembourg’s large financial sector, ageing-related costs, fiscal risks, and rising borrowing costs may put further pressure on public debt.
  - Staff suggests somewhat more prudent recurrent spending — about ¼ percent of GDP lower spending over the medium term.

- Pension system sustainability:
  - Current estimates indicate the pension system is expected to increase the general government deficit by 8 percentage points of GDP by 2070, and reserves would be depleted by around 2047, if no action is taken.
  - Staff recommends early pension reform, prioritizing increasing the effective retirement age (currently around 60 years) towards the statutory retirement age of 65 years, disincentivizing early retirement, and making the pension system less generous.

- Strengthening fiscal frameworks:
  - Need to better anchor fiscal policy and strengthen the medium-term fiscal framework given public debt tripled relative to the pre-GFC level and growing rigidity in primary expenditures.
  - Suggested measures:
    - Implement a medium-term objective (MTO) based on the general government fiscal balance, adjusted every 3-5 years; the MTO should be ambitious to take into account fiscal risks.
    - Adopt an expenditure ceiling rule as an operational target to reduce procyclicality of spending, focusing on central and local government outlays while accounting for relatively predictable Social Security spending.
    - Keep debt to GDP as a long-term debt anchor, being prudent given country vulnerabilities but not too restrictive given ageing costs.
    - Enhance medium-term budgeting and strengthen the fiscal risks framework.
  - The expenditure rule could include an escape clause activated in response to severe idiosyncratic shocks such as large growth falls, major natural disasters, or national emergencies.

### Tax-benefit system and distributional policy
- Need for a comprehensive review of the tax and benefits system to enhance the distributional role of fiscal policy.
- Issues identified:
  - Low frequency of tax bracket adjustment for inflation combined with automatic wage indexation has produced suboptimal and unintended distributional effects.
  - Historically, tax brackets adjusted ad-hoc; revenue windfalls have often financed additional spending, sometimes contributing to procyclical fiscal policy.
  - Evidence suggests more frequent adjustment of income tax brackets for inflation reduces the persistence of the relationship between inflation and income inequality and supports employment, savings, and output.

- Staff recommendations:
  - More frequent adjustment of tax brackets (the additional budgetary cost should be offset by better targeting of other tax expenditures/benefit measures).
  - Examples of measures to offset cost: gradual phasing out of interest payment deductibility, means-testing family benefits and housing support.
  - Pursue a comprehensive review and simplification of the tax-benefit system to enhance distributional impact and avoid overlapping support.

### Authorities’ views on fiscal measures
- Authorities highlighted the effectiveness of adopted packages in containing inflation in a context of automatic wage indexation and remain committed to fiscal discipline.
- They emphasized time-bound direct price controls successfully tamed headline inflation and avoided several tranches of wage indexation that would have hindered competitiveness.
- Authorities noted limited effects of wage indexation on inflation in a small open economy where inflation is mostly externally driven.
- Authorities agreed stronger price signals would help lock-in energy savings and indicated block pricing could be envisaged.
- On Economic Governance Review, authorities stressed changes should promote prudent and forward-looking decision-making across EU member states.
- Authorities agreed on the need for early pension reform without giving a timeline and broadly agreed with more frequent inflation adjustment of tax brackets, stressing it should be budget neutral and part of a comprehensive tax-benefit review.

### Financial sector policies and resilience
- Financial risks increased following recent global banking stress, with vulnerabilities in the real estate sector and non-bank financial institutions.
- Banks benefit from strong capital and liquidity buffers; risks appear manageable but require close monitoring.
- Suggested policy actions:
  - Continue close monitoring of credit, liquidity, and interest rate risks.
  - Fine-tune macroprudential policy given high household indebtedness and mortgage concentration to avoid further buildup of vulnerabilities.
  - Monitor investment funds vulnerable to disorderly market corrections; carefully monitor liquidity and leverage risks and calibrate liquidity management tools to deal with stress episodes.

*Source: IMF staff summary of the Luxembourg Article IV consultation (excerpts).*

### 30.      Higher inflation and borrowing costs, and lower activity are likely to increase credit

### Higher inflation and borrowing costs, and lower activity are likely to increase credit risk, but several factors will mitigate the impact.

### Nonfinancial corporate sector
- Overall assessment: strong liquidity position and fiscal support will moderate the impact of recent shocks on firms.
- Vulnerabilities:
  - Leveraged firms with weak pricing power could be at risk.
  - Real wage rigidity reduces the capacity of some domestic firms to adjust.
  - Sectoral (concentration) risk: construction sector and manufacturing show increases in NPL ratio.
  - Cross-border exposures require greater scrutiny; review of waivers to large exposure limits for intra-group transactions (in line with the 2017 FSAP) should continue.
- Simulation evidence: ECB analysis shows corporate sector loans from Luxembourgish banks are sensitive to higher energy and financing costs.
- Bankruptcy trend: Bankruptcies have increased significantly in Q4, although from low levels.

### Households
- Key statistics and exposures:
  - Share of variable rate mortgages: 42.5 percent (overall); for bottom 20 percent: 17 percent.
  - High household indebtedness noted.
- Stress sensitivity:
  - A 200 basis point increase in interest rates could triple the mortgage debt at risk (to 30 percent).
- Mitigating factors supporting resilience in short term:
  - High net worth, excess saving, low unemployment, wage indexation, increases in minimum wages, and large fiscal support.
- Probability of default on aggregate: assessed as relatively low in the short term.

### Banks’ profitability and risks
- Outlook: impact of tightening global financial conditions on banks’ profitability is uncertain.
- Dynamics:
  - Net interest margins are likely to increase, but historically associated with lower net fees and commissions.
  - Funding costs likely to rise following TLTRO repayment and recent global banking pressures.
  - Custodian and private banks are highly dependent on capital market developments and vulnerable to market corrections.
  - Deteriorating asset quality and collateral revaluation will increase provisioning needs.
  - High inflation and related increases in operating costs, including wages, could weigh on profitability.
- Staff expectation: any potential gains from higher interest rates to be short-lived.
- Policy implication: structurally weak profitability should be addressed by incentivizing diversification of activity and mutualization of compliance costs.

### Real estate sector
- Short-term outlook: a sharp correction in real estate prices is unlikely in the short term, but authorities should remain vigilant.
- Structural factors:
  - Housing prices historically resilient to downturns and interest rate shocks due to structural supply deficit.
- Downside risks:
  - Tighter financial conditions and changes in real estate taxation could trigger selling when demand is subdued, producing larger-than-expected correction.
  - Hoarding behavior, delays in construction projects, and financial difficulties of builders and developers could depress supply and sustain high prices.
- Commercial real estate: activity remained resilient and vacancy rates have fallen, though transaction volumes are lower than pre-crisis levels.
- Data gap: longer-term trends in retail and office market should be monitored; remaining data gaps (notably prices) should be filled.

### Banking sector resilience and stress tests
- Capital and liquidity buffers: overall banking sector appears resilient, but close monitoring of credit, liquidity, and interest rate risks is paramount.
- CSSF top-down stress tests (based on 2021 data and preliminary 2022 information):
  - Under the adverse scenario, CET1 buffers would decline by 4 percentage points by end-2024 (mostly due to credit losses) to 19½ percent, well above required levels.
  - Corporate, private, and universal banks would be more affected than other business models.
- Liquidity: immediate impact of recent global banking stress on Luxembourg bank liquidity has been limited; authorities monitor daily liquidity and require reporting of any breaches (including possible future LCR breaches).
- Held-to-maturity securities: authorities’ stress tests assessing hidden losses following an interest rate shock show banks are, on aggregate, in good position to absorb these losses should they materialize.

### Macroprudential policy recommendations
- Current stance: countercyclical capital buffers (CCyB) kept unchanged at 0.5 percent, appropriate given closing credit gap, tightening credit standards, and uncertain outlook.
- Measures implemented by CSSF:
  - Required sensitivity analysis including a 2 percentage points increase in rates at loan origination and (+200, +300, +400 bps) on RRE stock exposures.
- Considerations and further options:
  - Assess effectiveness of measures and impact on banks’ lending standards.
  - If mortgage risk profile does not improve, consider complementing with income-based limits (DSTI, DTI), calibrated to reduce excessive risk-taking while avoiding significant activity depression in the real estate sector.
  - Targeted capital-based measures could be warranted: higher minimum risk weights (noted as relatively low by EU standards), linking them to the risk of the loan or a real estate focused systemic risk buffer to enhance loss absorption capacity.
  - If credit cycle deteriorates considerably, authorities could consider relaxing the CCyB but the LTV limit should not be loosened.

### Investment funds
- Liquidity and redemptions:
  - Most investment fund categories increased their high-quality liquid assets (HQLA) with a higher share of cash holdings (demand deposits).
  - CSSF stress tests show most equity and bond funds would be able to honor a 20 percent redemption request in less than 5 days.
- Vulnerable categories: some funds with less-liquid assets remain vulnerable to liquidity risk—particularly high-yield, emerging market, and mixed funds.
- Risks: credit and duration risks remain high despite some de-risking.
- Liquidity management tools (LMTs):
  - Luxembourg has good availability and usage of LMTs, notably swing pricing, which reduced first-mover advantage and lowered redemptions and volatility in normal times.
  - Effectiveness could be improved by better calibration in stress episodes to transfer trading costs to transacting investors.
  - Complementary measures: align redemption terms with asset liquidity and investment strategy (e.g., notification periods, lower redemption frequencies, larger liquidity buffers on assets).
- Supervisory actions: continue close monitoring of large redemptions, regular liquidity stress-tests, and implement system-wide stress testing.
- Cross-border coordination: CSSF should continue to coordinate with peers given Luxembourg’s central role and contribute to international efforts to strengthen oversight and regulatory requirements, especially concerning liquidity and leverage.

### Alternative investment funds and leverage
- Systemic importance of AIFs has been growing rapidly in Luxembourg and globally.
- Risks:
  - Pockets of elevated leverage (in particular in real estate and other alternative funds) could increase vulnerability to market and duration risks and amplify liquidity risks.
  - Synthetic leverage embedded in derivative positions should be carefully monitored.
- Data gaps: investor base, unregulated investment funds, low frequency of some reporting, and reporting inconsistencies (identified by AIF analysis under art. 25 of the AIFMD) should be addressed.
- Regulatory implication: the UK bond market turmoil highlighted the need for better assessment and global regulation of leverage and liquidity for AIFs.

### Interconnectedness between banks and funds
- Key linkages:
  - Investment funds’ deposits have increased as a share of banks’ liabilities, reaching 20 percent.
  - Funds’ assets account for over 90 percent of financial sector assets.
  - Connections are concentrated on some banks (mainly custodian banks), making them potential vehicles of contagion.
- Mitigants:
  - These banks are generally subject to systemic capital requirements and have large liquidity and capital buffers, reducing systemic risk.
  - Historically, investment funds tended to transform liquid assets into cash in stress episodes, increasing deposits in banks.

### Insurance sector
- Life insurers:
  - Risk of decrease in tied assets leading to lower technical provisions, mostly for unit-linked life insurance liabilities which represent more than 70 percent of the Luxembourg life insurance market.
  - Because fees are mostly proportionate to technical provisions, this could cause medium-term profitability issues.
- Non-life (re)insurers:
  - Main risk stems from rising claims due to inflation.
  - Impact of rising interest rates depends on duration gaps and level of reserves.
- Recommendation: continued monitoring of risks in insurance sector and its interconnectedness with other financial institutions.

### Structural and operational risks
- Climate-related and environmental (CR&E) risks:
  - Implementation of Circular 21/773 (management of CR&E risks, June 2021) is at early stages; assessment of challenges is underway.
  - This will support development of a macroprudential approach for systemic aspects of climate-related risks.
  - For investment funds, more harmonization of definitions at the global level is needed to limit greenwashing despite taxonomies and disclosure requirements.
- AML/CFT:
  - Luxembourg is undergoing an AML/CFT mutual evaluation by the Financial Action Task Force; the resulting report will be discussed in June 2023.
  - An AML/CFT questionnaire is sent to banks and other financial entities yearly to collect information on risk; cross-border flows information is also considered.
  - Authorities plan to enhance tools for monitoring cross-border payments to maintain up-to-date understanding and mitigation of related risks.
  - Beneficial Ownership Registry (BOR): following European Court of Justice decision from November 2022, public access to BORs in the EU was invalidated. In December, an application process was introduced by the Luxembourg Business Registers to restore access to the BOR for professionals and journalists. Luxembourg is working on amending the BOR law to provide access to other legitimate interest users.

### Authorities’ views
- Broad agreement with staff assessment that financial risks have increased domestically and globally due to slower world growth and tighter, more volatile financial conditions.
- Authorities’ observations:
  - Luxembourgish banking sector has comfortable capital and liquidity buffers to absorb severe shocks.
  - Positive short-term impact of interest rate rises on banks’ profitability noted; longer-term impact unclear given high non-financial private sector indebtedness.
  - Contagion risks from investment funds to banks assessed as manageable.
  - Mitigating factors exist for real estate vulnerabilities; income-based limits are possible but authorities caution against procyclical risks and favor sensitivity analysis at loan origination as a substitute currently.
  - Increase in debt service to income ratio masks a shift of new loans to higher income borrowers.
  - Capital-based measures could be considered but not all would be appropriate due to procedural complexities.
  - Agreed that liquidity mismatches and financial leverage are main risks for some investment funds and supported staff recommendations to mitigate those risks.

### Structural policies: bolstering socio-economic resilience
- Policy challenge: balance maintaining high wages and living standards to attract talent (including foreign workers) with ensuring competitiveness of firms in global markets; balance may be fiscally costly under persistent supply shocks.
- Wage indexation:
  - Automatic wage indexation could lead to higher and more volatile inflation, while failing to fully compensate the most vulnerable, and possibly lock-in unsustainable nominal wage increases—harming external competitiveness and increasing fiscal costs.
  - Reform of the indexation scheme, together with measures to reduce housing imbalances and enhance employability and participation of the domestic labor force, may ensure a more sustainable balance and improve outcomes for the domestic labor force.

### Contain the increase in housing costs
- Risks to affordability:
  - Persistent housing market imbalances and higher mortgage rates could further worsen affordability.
  - High mortgage rates and tighter credit standards make access to credit more difficult for new buyers in the short term as prices adjust slowly.
  - Increased demand for rental properties will put pressure on rents and penalize already overburdened tenants.
- Supply-side constraints:
  - Slowdown in construction activity—potentially driven by insolvencies in the sector and delays due to high construction costs—may hinder price moderation.

*Source: INTERNATIONAL MONETARY FUND.*

### 43.      Building on their efforts to curb speculative demand and land hoarding, the authorities

### Building on their efforts to curb speculative demand and land hoarding, the authorities

### Housing market: demand measures vs. supply focus
- Planned reform of land taxation and vacant dwelling taxation, and the reduction of the accelerated depreciation rate, are welcome but effects are likely to be felt only over the medium term.
- Recent measures to support demand (increase in the tax credit for first-time homebuyers and in the ceiling of interest payments deductibility) are not targeted and could impede adjustment of housing prices to more affordable levels.
- Staff cautioned against public purchases of dwellings under construction by the private sector.
- Staff recommended:
  - Frontload public investment in social and affordable housing.
  - Expedite efforts to reduce supply bottlenecks, including by allowing greater density of buildings and reducing administrative costs.

### Lease contract reform and rental affordability
- Bill provisions:
  - Reform of the rent ceiling, cutting the maximum increase in rental prices from 5 percent of the capital invested to 3.5 percent.
  - Tenants and landlords equally split fees paid to real estate agencies.
  - Security deposits limited to the value of two months’ rent (down from three currently).
  - Charges for furniture in a furnished dwelling limited to 1.5 percent of their purchase price per month.
- Assessment: Costs/benefits are difficult to assess and there is a risk these reforms impede supply in the medium term.

### Automatic wage indexation (AWI): risks, objectives, and reform options
- Objectives of reforming AWI:
  - Mitigate inflationary spiral risks, assuage distributional concerns, and preserve firms’ ability to respond to shocks.
- Policy options and considerations:
  - Mitigating wage-price spiral risks:
    - Very high inflation led the government to delay AWI application, possibly to avoid triggering a wage-price spiral.
    - Model-based analyses: in the face of a supply shock, changing the indexation rule to exclude volatile components leads to a relatively lower probability of an indexation event and lower second round effects on domestic inflation.
    - Switching to a less volatile benchmark that excludes energy prices would make the system more resilient.
    - Targeted compensatory measures can be envisaged to protect the most vulnerable if indexations are less frequent.
  - Assuaging distributional concerns:
    - The weight of energy, food, alcohol and tobacco in the national price index is significantly higher for lower income quantiles than for higher income quantiles.
    - Ad-hoc suspensions or postponements of indexation imply poorer households will suffer disproportionately more from higher cost of living.
    - Given relatively high marginal tax rates applied to the middle class, AWI may be too generous for top earners, which may put upward pressure on housing demand.
    - Reform options include making the scheme more progressive (e.g., tapering the wage increase or excluding higher quantiles of the income distribution from proportional adjustment).
  - Safeguarding external competitiveness:
    - Indexation may lead to unsustainable employment costs for firms unable to adjust prices or hit by supply shocks, potentially causing employment losses or reduced external competitiveness.
    - Government could define competitiveness benchmarks to automatically suspend AWI application and possibly trigger more decentralized bargaining.

### Labor force employability, participation, and targeted reforms
- Education:
  - Dropout rate is particularly elevated for immigrants.
  - Authorities extended mandatory schooling by 2 years (to 18).
  - Complementary measures suggested: orient youth to other pathways and facilitate their employment.
- Gender gap (Annex VI):
  - Luxembourg made remarkable progress in reducing the gender gap, but one third of employed women is working part-time.
  - Participation is lower for female foreigners and seniors.
  - Females are underrepresented in technical and scientific studies.
  - Suggested measures: enhance work flexibility (e.g., remote work), relax access to work permits for spouses of immigrants, develop apprenticeships and internships (in STEM firms) for female students, promote female entrepreneurship in STEM fields, and transition toward the individualization of taxation.
- Participation of seniors:
  - Labor force participation of the 55+ years old is among the lowest in Europe.
  - Suggested reforms: reduce generosity of the pension system by lowering the replacement rate—the highest in Europe—and disincentivize early retirement, while promoting long-life learning.

### Authorities’ views
- On housing:
  - Authorities emphasized the trade-off between supporting the construction sector given the sharp drop in demand and allowing housing price adjustment.
  - Recent measures to support demand, including buying private projects under development at a discounted price, are meant to reduce the risk of a sharp fall in construction activities that would exacerbate imbalances.
  - Increase in the interest payment deductibility is intended to provide relief for households facing increasing debt service.
  - Authorities agree with staff proposals to frontload public investment and reduce bottlenecks to supply, including increasing density of buildings, as a medium-term objective.
- On AWI:
  - Authorities reiterated attachment to AWI and welcomed proposals to overcome shortcomings during supply shocks.
  - They noted the system has contributed to social peace, predictability for firms, and talent attraction.
  - Broad agreement that AWI could pose more challenges during supply shocks, and merit exists in exploring options to improve calibration.

### Staff appraisal: outlook, fiscal stance, and financial sector vigilance
- Outlook and risks:
  - Economy appears resilient but outlook is uncertain with downside growth risks.
  - GDP growth expected to slow from strong levels, but labor market and private consumption likely to remain robust.
  - Energy support measures will reduce number of wage indexations and firms’ need to adjust.
  - Headline inflation projected to moderate; core inflation expected to remain persistently high, though slightly lower than in other euro area members.
  - Recent global banking stress added uncertainty and downside risks.
- Fiscal policy:
  - Planned fiscal stimulus assessed to be excessive and should be significantly reduced.
  - Recommendation: keep the cyclically adjusted overall balance broadly unchanged in 2023 and 2024 by switching to more targeted and less-distortive price measures.
  - If recessionary pressures are greater and inflation falls by more than expected, allow automatic stabilizers to fully operate and consider targeted stimulus.
  - In the medium term, high fiscal risks and increasing ageing-related costs call for more prudent current spending and fiscal reforms:
    - Better control the wage bill and improve targeting of social benefits.
    - Early action on the pension system to enhance intergenerational equity and long-term fiscal sustainability.
    - Consider adopting a medium-term objective based on the general government balance and a ceiling on expenditure growth as an operational rule.
- Tax policy:
  - Tax brackets should be adjusted more frequently for inflation, within a comprehensive tax-benefit reform.
  - Delaying tax brackets indexation has led to a notable increase of the real tax burden with potential unintended distributional effects.
  - Merit seen in increasing frequency of tax bracket adjustments in a budget-neutral way within a comprehensive review and simplification.
- Financial sector and real estate risks:
  - Banking system appears resilient but close monitoring of risks and vulnerabilities, especially in real estate, should continue.
    - Banks’ capital and liquidity buffers are well-above minimum requirements; heightened vigilance warranted.
    - Authorities appropriately kept countercyclical capital buffers unchanged given the closing credit gap, tightening of credit standards, and high uncertainty.
    - Continued prudent provisioning encouraged.
    - Consider introducing income-based limits to avoid further buildup of vulnerabilities in real estate.
    - Consider targeted sectoral capital measures to address risks of unexpected losses on real estate exposures.
  - Investment funds:
    - Continue efforts to bolster resilience.
    - Calibrate liquidity management tools to stress episodes and investment strategy.
    - At supervisory level, continue close monitoring of large redemptions and regular liquidity stress tests.
    - Address data gaps and coordinate with peers given Luxembourg’s central role in the global financial architecture.
- Reiterated recommendation:
  - Continue focus on boosting housing supply while avoiding measures that increase housing demand; frontload public investment in social and affordable housing and expedite efforts to reduce supply bottlenecks.

*Source: 1luxea2023001 - 43.      Building on their efforts to curb speculative demand and land hoarding, the authorities*

### 58.      It is recommended that the next Article IV consultation be held on the standard 12-

### 1luxea2023001 - 58.      It is recommended that the next Article IV consultation be held on the standard 12-

### Recommendation
- It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

### Selected economic indicators and projections (highlights from Tables)
- Real GDP growth (percent change): 2019: 2.3; 2020: -0.8; 2021: 5.1; 2022: 1.5; 2023: 1.1; 2024: 1.7; 2025: 2.5; 2026: 2.4; 2027: 2.3; 2028: 2.3.
- Total domestic demand (percent change): 2019: 4.1; 2020: -2.8; 2021: 8.2; 2022: 2.0; 2023: 2.5; 2024: 2.3; 2025: 2.7; 2026: 2.6; 2027: 2.5; 2028: 2.5.
- CPI (harmonized), p.a. (percent change): 2019: 1.7; 2020: 0.0; 2021: 3.5; 2022: 8.1; 2023: 2.6; 2024: 3.1; 2025: 3.4; 2026: 2.0; 2027: 2.0; 2028: 2.0.
- GDP deflator (percent change): 2019: 1.4; 2020: 4.7; 2021: 6.2; 2022: 6.4; 2023: 3.6; 2024: 3.1; 2025: 2.9; 2026: 2.1; 2027: 2.0; 2028: 2.0.
- Unemployed (average, thousands): 2019: 15.4; 2020: 18.7; 2021: 17.1; 2022: 14.6; 2023: 15.7; 2024: 17.1; 2025: 18.2; 2026: 18.4; 2027: 18.7; 2028: 19.1.
- Resident labor force (thousands): 2019: 287.0; 2020: 294.1; 2021: 298.8; 2022: 303.8; 2023: 309.3; 2024: 315.5; 2025: 321.8; 2026: 328.0; 2027: 334.4; 2028: 341.0.
- General government revenues (percent of GDP): 2019: 45.4; 2020: 43.3; 2021: 43.6; 2022: 43.5; 2023: 43.4; 2024: 44.2; 2025: 44.5; 2026: 44.8; 2027: 45.1; 2028: 45.5.
- General government balance (percent of GDP): 2019: 2.2; 2020: -3.4; 2021: 0.7; 2022: 0.2; 2023: -2.8; 2024: -1.8; 2025: -1.0; 2026: -0.5; 2027: -0.4; 2028: -0.5.
- General government gross debt (percent of GDP): 2019: 22.4; 2020: 24.5; 2021: 24.5; 2022: 24.6; 2023: 27.5; 2024: 29.2; 2025: 29.6; 2026: 29.6; 2027: 29.4; 2028: 29.2.
- Current account (percent of GDP): 2019: 3.4; 2020: 3.2; 2021: 4.6; 2022: 5.0; 2023: 4.5; 2024: 4.4; 2025: 4.5; 2026: 4.5; 2027: 4.5; 2028: 4.5.
- Net international investment position (NIIP) 2022: 28.2 percent of GDP (Annex I figures).

### Balance of payments and external sector (highlights)
- Balance on goods and services (percent of GDP): 2019: 32.6; 2020: 32.7; 2021: 34.7; 2022: 28.4; 2023: 27.3; 2024: 27.0; 2025: 26.8; 2026: 26.7; 2027: 26.6; 2028: 26.5.
- Services exports (percent of GDP): 2019: 161.4; 2020: 163.5; 2021: 175.1; 2022: 163.6; 2023: 162.3; 2024: 163.1; 2025: 162.9; 2026: 163.3; 2027: 163.5; 2028: 163.6.
- Net factor income (percent of GDP): 2019: -29.5; 2020: -29.3; 2021: -31.0; 2022: -24.2; 2023: -23.5; 2024: -23.4; 2025: -23.0; 2026: -23.0; 2027: -22.9; 2028: -22.7.
- Financial account (percent of GDP): 2019: 1.6; 2020: 2.7; 2021: 8.6; 2022: 5.1; 2023: 4.9; 2024: 4.9; 2025: 5.0; 2026: 5.0; 2027: 5.0; 2028: 5.0.
- Direct investment, net (percent of GDP): 2019: 107.6; 2020: -32.6; 2021: 176.5; 2022: 47.2; 2023: 42.5; 2024: 38.3; 2025: 34.4; 2026: 31.0; 2027: 27.9; 2028: 25.1.
- Portfolio investment, net (percent of GDP): 2019: -160.0; 2020: -5.6; 2021: -240.8; 2022: -120.5; 2023: -120.5; 2024: -120.5; 2025: -120.5; 2026: -120.5; 2027: -120.5; 2028: -120.5.
- Capital account (percent of GDP): 2019: -0.1; 2020: -0.1; 2021: 1.2; 2022: 0.5; 2023: 0.5; 2024: 0.5; 2025: 0.5; 2026: 0.5; 2027: 0.5; 2028: 0.5.

### General government operations (highlights)
- Revenue (percent of GDP): 2019: 45.4; 2020: 43.3; 2021: 43.6; 2022: 43.5; 2023: 43.4; 2024: 44.2; 2025: 44.5; 2026: 44.8; 2027: 45.1; 2028: 45.5.
- Taxes (percent of GDP): 2019: 28.2; 2020: 26.6; 2021: 27.4; 2022: 27.3; 2023: 26.9; 2024: 27.6; 2025: 27.9; 2026: 28.2; 2027: 28.5; 2028: 28.9.
  - Corporate income taxes (percent of GDP): 2019: 6.0; 2020: 4.8; 2021: 4.5; 2022: 4.4; 2023: 4.1; 2024: 4.0; 2025: 4.0; 2026: 4.0; 2027: 4.0; 2028: 4.0.
  - Personal income taxes (percent of GDP): 2019: 10.8; 2020: 11.0; 2021: 11.3; 2022: 11.5; 2023: 11.8; 2024: 12.2; 2025: 12.5; 2026: 12.8; 2027: 13.1; 2028: 13.4.
- Expenditure (percent of GDP): 2019: 43.1; 2020: 46.8; 2021: 42.9; 2022: 43.3; 2023: 46.1; 2024: 46.0; 2025: 45.4; 2026: 45.2; 2027: 45.5; 2028: 45.9.
- Gross public investment (percent of GDP): 2019: 4.1; 2020: 4.7; 2021: 4.1; 2022: 4.1; 2023: 4.6; 2024: 4.6; 2025: 4.4; 2026: 4.1; 2027: 4.1; 2028: 4.1.
- Net lending / borrowing (percent of GDP): 2019: 2.2; 2020: -3.4; 2021: 0.7; 2022: 0.2; 2023: -2.8; 2024: -1.8; 2025: -1.0; 2026: -0.5; 2027: -0.4; 2028: -0.5.

### Financial soundness indicators (selected)
- All Banks: Regulatory capital to risk-weighted assets (percent): 2016: 25.0; 2017: 25.9; 2018: 25.0; 2019: 22.0; 2020: 24.8; 2021: 24.0; 2022: 23.0.
- All Banks: Return on assets (percent): 2016: 0.8; 2017: 0.7; 2018: 0.6; 2019: 0.5; 2020: 0.5; 2021: 0.6; 2022: 0.7.
- All Banks: Nonperforming loans to total gross loans (percent): 2016: 0.9; 2017: 0.8; 2018: 0.9; 2019: 0.7; 2020: 1.0; 2021: 0.8; 2022: 1.0.
- Liquidity (All Banks): Liquid assets to total assets (percent): 2016: 21.2; 2017: 22.9; 2018: 24.9; 2019: 24.7; 2020: 29.8; 2021: 31.8; 2022: 33.0.
- Domestically Oriented Banks: Regulatory capital to risk-weighted assets (percent): 2016: 23.0; 2017: 23.0; 2018: 22.9; 2019: 22.5; 2020: 22.9; 2021: 23.1; 2022: 22.0.
- Domestically Oriented Banks: Nonperforming loans to total gross loans (percent): 2016: 2.4; 2017: 2.0; 2018: 1.8; 2019: 1.7; 2020: 1.9; 2021: 0.8; 2022: 1.0.

### External sector assessment (Annex I — summary and policy implications)
- Overall assessment: The external position of Luxembourg in 2022 was broadly in line with the level implied by medium-term fundamentals and desirable policies (EBA-lite and staff judgement), subject to uncertainty due to the war in Ukraine.
- NIIP and trajectory:
  - NIIP declined to around 28.2 percent of GDP in 2022 from around 40.4 percent in 2021.
  - Decline driven by a decline in net portfolio inflows and valuation effects arising from euro depreciation, partly offset by improvements in FDI, financial derivatives, and net other investment.
  - FDI as a percent of GDP remains below 2017 levels, linked in part to international taxation changes (notably the U.S. tax reform).
  - Assessment: NIIP is positive and projected to improve in the medium term; current NIIP and projected path do not imply risks to external sustainability.
- Current account (CA):
  - CA surplus averaged around 4.1 percent of GDP over 2015-20; CA was 5 percent of GDP in 2022 (4.6 percent in 2021).
  - Drivers: improved net factor income balance; decline in net goods and services exports in 2022 due to higher goods import values and financial conditions affecting services.
  - Staff adjusted EBA-lite explanatory variables (e.g., output per worker) to account for over 40 percent non-resident labor force.
  - Adjusted CA for 2022: 3.8 percent of GDP; CA norm (adjusted) for 2022: 2.9 percent of GDP; CA gap: 0.9 percent of GDP.
  - Policy gap component of CA gap: 3.0 percent of GDP, reflecting lower-than-expected public health expenditure and a fiscal stance somewhat looser than country-specific norm.
  - Projection: CA surplus to recover to about 4.5 percent of GDP over the medium term.
- Real exchange rate (REER):
  - CPI-based REER depreciated in 2022 (CPI-based REER down about 3.3 percent yoy compared to December 2021).
  - ULC-based REER remained relatively unchanged; ULC-based REER appreciated by around 3 percent yoy.
  - Assessment: REER broadly in line with fundamentals; REER gap from CA gap model indicates overvaluation of 0.7 percent; REER index model suggests overvaluation of 5.7 percent.
- Capital and financial accounts:
  - Financial account declined to 5.1 percent of GDP in 2022 from 8.6 percent of GDP in 2021 due to lower net direct investment.
  - Capital account around 0.5 percent of GDP in 2022.
  - Assessment: risks related to capital flows assessed to be small.
- FX intervention and reserves:
  - Euro is a global reserve currency; IMF allocation of 1,321 million SDRs in 2021 (around 2.1 percent of GDP) noted as channeled to help other countries manage the pandemic.
  - Assessment: Reserves held by euro area countries typically low relative to standard metrics; currency is free floating.

*Sources: Luxembourg authorities; IMF staff estimates and projections; STATEC; Haver Analytics; Financial Soundness Indicators Database; BCL; CSSF.*

### Annex II. The Impact of Financial Tightening in Luxembourg

### Annex II. The Impact of Financial Tightening in Luxembourg

### Measures and background
- Market-based financial conditions used:
  - Country-level indicator of financial stress (CLIFS) compiled by the ECB.
  - Global financial conditions captured by the Chicago Board Option Exchange volatility index (VIX).
- Timeline and context:
  - Market-based financial conditions tightened in early-2020 at the onset of the Covid-19 pandemic, then eased towards mid-2021 following monetary and fiscal stimulus.
  - Since early-2022, major central banks have steadily hiked policy rates to levels not seen over the past decade, tightening both the VIX and the CLIFS.
  - The CLIFS increased by more than the VIX, probably due to the sharp increase in energy prices in Europe and in Luxembourg in particular.
- Correlations:
  - The correlation of the CLIFS and the VIX has been low at around 0.2 since the beginning of the Covid-19 pandemic, dropping from around 0.6 over the full sample period (2000Q1:2022Q4).
  - The CLIFS is highly correlated with euro area financial conditions (EC’s CISS index) with the correlation at around 0.8 over the full sample and 0.9 since the pandemic.
- Data/sample:
  - Growth of all variables is in year-on-year terms. The sample extends from 2000Q1: 2022Q4.

### Impact on GDP and macroeconomic activity
- Regression results (dynamic OLS linear regressions of real GDP growth in Luxembourg):
  - The CLIFS is insignificant for real GDP growth in Luxembourg.
  - The VIX is highly significant and negatively associated with real GDP growth in Luxembourg.
  - Impact magnitude: The impact of a one standard deviation tightening of the VIX (roughly 10 points increase of the VIX) on real GDP growth varies from around -0.8 to -1.1 percentage points.
  - External demand: Real euro area GDP growth is highly significant and positively correlated with domestic GDP growth in Luxembourg.
- Sectoral importance:
  - The financial sector accounts for about ¼ of gross value added in Luxembourg, implying global financial tightening has a significant association with GDP.

### Differential effects on banks and investment funds
- Key stylized findings from dynamic linear regressions of financial-sector variables:
  - Banking sector:
    - Bank total assets (bank balance sheet asset growth) are significantly negatively correlated with domestic financial conditions (the CISS index / CLIFS proxy).
    - The correlation between bank asset growth and the VIX is insignificant.
    - Luxembourg bank asset growth is positively correlated with real GDP growth in the euro area.
    - Similar results are obtained for real bank GVA and bank credit (not reported in the Annex).
  - Investment funds:
    - Growth of investment funds’ net assets is not correlated with domestic financial conditions but is highly correlated with global financial conditions (VIX).
    - This reflects that funds domiciled in Luxembourg are highly interconnected with global investors and destinations and are more affected by global financial conditions.
- Interpretation:
  - CLIFS matters more for banks (and is closely tied to euro area conditions), while global financial conditions (VIX) matter more for investment funds and aggregate economic activity.

### Robustness and supporting checks
- Robustness checks corroborating the results include:
  - Using an alternate sample to exclude the Covid-19 pandemic.
  - Using the VIX and CISS in non-standardized terms.
  - Estimating regressions in (log) levels.
  - Using growth of real bank GVA as the dependent variable to proxy for bank profitability.
  - Using growth of bank credit to residents as a dependent variable (finding similar results).

*Source: Annex II. The Impact of Financial Tightening in Luxembourg (IMF staff calculations, sample 2000Q1:2022Q4).*

### Annex V. Implementation Status—FSAP Update 2017

### Annex V. Implementation Status—FSAP Update 2017

### General/Cross-Cutting
- Recommendation 1: Continue resource allocation toward risk-based supervision at BCL, CSSF and CAA. (Timeframe: NT)
  - The CSSF assesses the correspondence between resources and needs from a risk-based perspective on an ongoing basis.
  - The CAA regularly hires new staff—all will be involved in risk-based supervision. The CAA grew by approximately 13 units (FTE) in 2021 and by 12 units (FTE) in 2022.
  - BCL has expanded resources dedicated to direct supervision of credit institutions and general risk analysis on the financial sector by 30 percent.

- Recommendation 2: Increase engagement with supervision and resolution authorities in countries where Luxembourg’s Less Significant Institutions (LSIs) and investment funds conduct significant activities. (Timeframe: NT)
  - Banking supervision: CSSF participation in joint supervisory teams and colleges and annual meetings covers 80 percent of bank assets; memoranda of understanding concluded for the remainder.
  - Resolution: CSSF has bilateral contacts and participates in resolution colleges, either as group level resolution authority or resolution authority of a subsidiary.
  - Investment funds: CSSF holds regular bilateral meetings and exchanges with EU/third-party supervisory authorities (France, Ireland, Germany, Switzerland, the United Kingdom, the United States and Asian jurisdictions). Since 2020, CSSF requests standardized information from regulators of jurisdictions to which Luxembourg fund managers mostly delegate portfolio management activities; in 2021 this also covered distribution activities performed by delegates abroad.
  - CSSF plans a thematic inspection in 2023 on oversight performed by IFMs on delegated portfolio managers based outside Luxembourg and foresees active engagement with regulators in relevant jurisdictions.

- Recommendation 3: Enshrine in legislation the operational independence of the CSSF and CAA, and introduce (CSSF, CAA) or update (BCL) board member codes of conduct. (Timeframe: NT)
  - ECB modified in 2022 its 2019 Code of conduct for High-Level ECB Bodies (the “Single Code”); the 2022 Single Code entered into force on 1 January 2023.
  - CAA Board’s internal rules updated in mid-2021 and now include a “conflict of interest” policy.
  - BCL Code of conduct is under review following adoption by the ECB of two Guidelines: Guideline for the Eurosystem (EU) 2021/2253 (ECB/2021/49) and Guideline for the SSM (EU) 2021/2256 (ECB/2021/50), repealing earlier Guidelines.

### Risk Analysis
- Recommendation 4: Examine merits of a regulatory LCR requirement in FX at the group level and step-up monitoring of related FX liquidity risk. (Timeframe: MT)
  - This recommendation is being considered by the ECB and the EC.

- Recommendation 5: Provide industry guidance on liquidity stress test modalities and liquidity management tools for investment funds, and develop internal liquidity stress testing capacity. (Timeframe: NT)
  - CSSF contributions:
    - Actively contributed to IOSCO and EU initiatives, including the ESRB Expert Group on Investment Funds.
    - Supported ESRB Recommendations on liquidity and leverage risks in investment funds (ESRB/2017/6) addressed to the European Commission and ESMA; implementation expected via the AIFMD/UCITS review.
    - Provided guidance to industry during Covid-19 and the Russia-Ukraine crises.
    - Contributed to FSB and IOSCO follow-up analysis in 2022; further work planned in 2023 including revisions to FSB 2017 recommendations and IOSCO guidance. CSSF actively participating in 2023 work.
    - Study on effectiveness of LMTs with BIS published on 14 June 2022.
    - Contributed to ESMA guidelines on liquidity stress testing in UCITS and AIFs published September 2019, applicable end-September 2020; implemented via CSSF Circular 20/752.
    - Contributed to ESMA MMF stress testing guidelines and reporting; contributes to yearly update of ST parameter calibration. ESMA started consultation on review of MMF stress test methodology end of January 2023.
    - Internally implemented an annual liquidity stress testing (LST) framework and continues improvements (2021 exercise: second round effects, extension of asset classes). CSSF published a dedicated working paper on its own liquidity stress testing framework for Luxembourg investment funds on 9 March 2023.
    - Considers recommendation on LST industry guidance and development of internal liquidity stress testing capacity to be finalized; work on guidance on LMTs ongoing within AIFMD/UCITS review and at FSB and IOSCO level.
  - BCL contributions:
    - Contributes to ESRB Non-Bank Financial Intermediation Expert Group; contributed to ESRB Recommendation on reform of money market funds (ESRB/2021/9).
    - Contributed to ad hoc ESRB workstream on market illiquidity after COVID-19 and to ESRB Recommendation on liquidity risks in investment funds (ESRB/2020/4).
    - Contributed to development of a system-wide stress testing framework by ECB Working Group on Stress Testing (combines fund liquidity stress and liquidity-solvency feedback loops for banks) published as an ECB Working Paper.
    - Contributes to ESRB Task Force on Stress Testing developing adverse scenarios for ESMA’s MMF stress testing.
    - Developed forward-looking conditional systemic risk measures for investment funds using a dynamic multivariate copula approach; applied to flows and net asset values of seven fund categories. Published in BCL’s 2022 Financial Stability Review.

- Recommendation 6: Continue to contribute to discussions within ESMA on leverage, with a view to developing a single methodology for measurement of leverage across the fund industry. (Timeframe: MT)
  - IOSCO finalized discussion on consistent measure of leverage; final report published December 2019. IOSCO agreed on global collection/publication of consistent leverage measures (Recommendation 4) and published its second yearly report in January 2023.
  - ESRB Recommendation (Feb. 2018) requested ESMA guidance on macroprudential leverage limits under AIFMD (Art. 25). ESMA finalized guidelines December 2020 with CSSF contribution. CSSF contributed in 2021 to develop a methodology for implementation, applicable on August 23, 2021. CSSF performs Art. 25 analysis on a quarterly basis.
  - ESMA analyzed real estate investment funds re leverage and liquidity risks in connection with AIFMD Art. 25 and ESRB/2022/9 on commercial real estate vulnerabilities. ESRB recommendations dated 25 January 2023 require NCAs (including CSSF) to consider measures to improve monitoring of systemic risks from the CRE market and increase resilience of financial institutions in this area (including investment funds).

### Macroprudential Policy
- Recommendation 7: Expand the macroprudential policy toolkit to include borrower-based lending limits. (Timeframe: I)
  - Law of 4 December 2019 adopted establishing a legal framework for borrower-based measures (BBMs).
  - Systemic Risk Committee (CdRS) assesses developments and may recommend activation of legally-binding LTV limits after BCL/CSSF risk assessment.
  - CdRS Recommendation of 9 November 2020 (CDRS/2020/005) led to CSSF Regulation N°20-08 (December, 2020) introducing differentiated LTV limits:
    - First-time buyers (FTBs): LTV limit is set at 100 percent.
    - Non-FTBs acquiring primary residence: LTV limit is 90 percent (banks may provide up to 15 percent of their annual portfolio of new mortgage loans with an LTV ranging from 90 to 100 percent).
    - Borrowers buying property to be rented out (buy-to-let): maximum LTV limit is 80 percent.
  - Measure applies to residential real estate (RRE) loans contracted by private households and legal entities such as a real-estate company constituted under civil law (“société civile immobilière” – SCI).
  - CdRS monitors BBMs implementation; BCL conducts regular assessments at least quarterly and published a short analysis on effectiveness of differentiated LTV limits in Financial Stability Review 2022 (Box 1.4).

- Recommendation 8: Continue to strengthen risk-based monitoring of the residential real estate market and bank-investment fund interlinkages, and close remaining related data gaps. (Timeframe: I)
  - Risk-based monitoring:
    - CSSF conducts semiannual liquidity stress test of fund deposits for all depositary banks and an annual assessment of maturity transformation between liabilities and intragroup assets at all banks.
  - Investment funds-related data gaps:
    - Discussions ongoing with BCL and ECB on access to the centralized securities data base (CSDB), possibly via an MoU between CSSF and BCL.
  - Bank-investment fund interlinkages:
    - BCL conducts quarterly network analysis based on exposures between banks and investment funds to identify most systemic banks using connectivity and centrality measures (PageRank used as one of twelve indicators in Luxembourg O-SII framework). Inclusion of PageRank led to identification of additional O-SIIs since 2017 assessment.
    - BCL developed an extensive monitoring framework for funds covering liquidity, interest rate, credit and currency risk, and financial leverage.
    - BCL contributed to system-wide stress testing framework for banks and investment funds at ECB; published as ECB Working Paper.
  - Monitoring of risks in real estate market:
    - CSSF conducts annual stress test of banks’ exposures to residential real estate and regular analyses of lending standards based on semiannual bank-level survey (CSSF Circular N°18/703 amended by CSSF circular N°20/737).
    - BCL’s risk assessment framework includes house price growth, overvaluation indicators, mortgage credit developments, household debt, domestic bank exposures and mortgage risk-weights; participates in SSM and ECB/ESRB working groups on residential real estate and BIS CGFS Study Group on housing policies.
  - Real estate-related data gaps:
    - CSSF Circular N°18/703 (Dec. 2018), amended by CSSF circular N°20/737 (19 February 2020), formalizes data collection on real estate indicators based on ESRB recommendation (ESRB/2016/14). Data collected semiannually.
    - Since June 2020, new data on residential real estate loans available quarterly in FINREP, including LTV distributions.
    - BCL participated in ESRB’s Assessment Team for compliance with ESRB/2016/14; Luxembourg assessed as Largely Compliant for residential real estate and Fully Compliant for commercial real estate.

- Recommendation 9: Strengthen monitoring of systemic risk in the investment fund industry and, in alignment with international and European efforts, develop instruments to take preemptive measures to mitigate these as appropriate. (Timeframe: NT)
  - Monitoring of systemic risk:
    - CSSF increased surveillance of systemic risks in the fund sector by closing data gaps via multiple sources (UCITS risk reporting, AIFMD reporting, EMIR, external data providers), developing a risk surveillance framework (risk categories/drivers), building a sector risk dashboard, conducting regular liquidity stress testing, and preparing thematic risk analyses (e.g., bond funds interest rate risk, real estate funds, LDI funds).
    - BCL’s monitoring framework calculates risk indicators monthly for aggregate investment fund sector, fund types, and individual funds using BCL statistical and security-by-security reporting; main results presented in BCL Surveillance Note for CdRS and summarized annually in BCL Financial Stability Review.
    - Ad hoc IT-backed crisis reporting integrated in eDesk platform and a daily Undertakings for Collective Investment (UCI) monitoring dashboard (set up during COVID-19) are continuously used during ongoing Russia-Ukraine crisis and recent bank turbulences.
    - CSSF actively participates in relevant European and international working groups.
    - CSSF performs Art. 25 AIFMD analyses quarterly, focusing on highly leveraged funds and possible macroprudential leverage limits.
    - 2020 common supervisory action in Europe checked compliance with UCITS liquidity risk management rules; CSSF contributed and reported to ESMA end-2020; ESMA final report March 2021; CSSF informed local market of findings June 2021.
    - CSSF contributed to ESRB liquidity risk exercise for funds with significant exposures to corporate debt and real estate assets (ESRB/2020/4); ESMA report published November 2020; follow-up on outliers in 2021 with CSSF industry questionnaire July 2021 and reporting to ESMA by end-October 2021.
    - CSSF published analytical work on large redemptions during Covid-19 (working paper October 2021) and a working paper on effectiveness of LMTs and its internal liquidity stress testing approach.
  - Preemptive measures:
    - Operationalization of ESRB-Recommendations (2018) finalized at ESMA-Level (including implementation of liquidity stress testing guidelines and Art. 25 AIFMD in August of the referenced year).

*Source: Annex V. Implementation Status—FSAP Update 2017 (1luxea2023001), extracted content.*

### 10. Strengthen the

### 10. Strengthen the institutional framework to increase the willingness to act, including by enshrining in the law the de facto leading role of the BCL.

### Institutional framework and risk transparency
- Recommendation: Strengthen the institutional framework and consider enshrining in law the de facto leading role of the BCL. Timeframe: MT (medium term).
- Authorities' stance: "The authorities consider the current institutional framework to be adequate."
- Recommendation 11 (Timeframe: MT): Publish the risk dashboard and a note assessing systemic risk.
  - CdRS actions:
    - "The CdRS has published the substance of the macro-financial risk analysis in 2019."
    - "As part of its annual report, the CdRS publishes each year an overview of its actions and activities as well as a subset of risk dashboard indicators."

### Banking regulation and supervision
- Recommendation 12 (Timeframe: NT): Increase the intensity of supervision over intra-group exposures, with banks required to demonstrate continued eligibility in their use of large exposure limit waivers.
  - CSSF actions and status:
    - Ongoing monitoring strengthened: line supervisors, quarterly monitoring of large exposures (including intragroup), and an escalation process to re-evaluate waiver eligibility, including in SREP context.
    - Since mid-2018: enhanced monitoring with new EU monthly reporting on maturity mismatches.
    - Early-2019: recruited additional resource dedicated to reviewing existing waivers.
    - CSSF monitors Rating and CDS of parent entities and main intra-group counterparties weekly (daily in case of crisis) and conducts an annual horizontal review of intra-group exposures and waivers.
    - January 2021: completed extensive stock taking on treatment of LU banks’ intra-group exposures in case of a bail-in, per jurisdiction of consolidating entity.
    - CSSF has used powers under paragraph 2 of Article 56-1 of the LFS to limit waiver use; limitations have in some cases resulted in complete withdrawal of the waiver or objection to its start for new banks.

- Recommendation 13 (Timeframe: C): Continue monitoring the ability of banks to absorb a real estate market price decline.
  - CSSF actions:
    - Conducts annual stress test analysis based on bank individual LTV distributions, accounting for extreme price declines and high default rates in Luxembourg’s residential real estate market, leading to capital losses and risk-weighted asset increases simultaneously.
    - Results incorporated in the annual CSSF-Solvency Stress Test.
    - Results are shared and discussed with supervisors and considered in ongoing supervision and SREP.

- Recommendation 14 (Timeframe: C): Increase frequency of on-site inspections of subsidiaries of SIs.
  - Status: "This recommendation should be addressed to the ECB as the SSM is implementing this recommendation."

- Recommendation 15 (Timeframe: I): Harmonize data reporting standards.
  - Actions and status:
    - Harmonized definitions for LTV and DSTI ratios and additional indicators included in CSSF circular N°18/0, following ESRB recommendation ESRB/2016/14. Data requested is semiannual.
    - Further harmonization via CSSF circular N°20/737 (18/703 amended).
    - Results of data collection assessed twice a year by CSSF and BCL to identify risks in the residential real estate market. CSSF ensures entities apply harmonized definitions and data quality.
    - BCL (as Secretariat of CdRS) chairs national working group on real estate data gaps ("groupe de travail sur les données immobilières") established in 201_. National working group includes BCL, CSSF, CAA, Ministry of Finance and STATEC, coordinating development of harmonized real estate indicators for banks, funds and insurers and physical CRE market indicators as recommended in ESRB/2016/14 and ESRB/2019/3.
    - 2021: CSSF launched regular data collection on commercial real estate for investment funds after coordination with national working group and BCL.
    - ESRB assessment to date: Luxembourg is "fully compliant" with respect to commercial real estate and "largely compliant" with respect to residential real estate.
    - National working group will continue and complete work on physical CRE market indicators under CdRS Secretariat (BCL).

### Investment fund regulation and supervision
- Recommendation 16 (Timeframe: NT): Strengthen guidance on substance in context of delegated activities and actively engage with regulators in jurisdictions where such activities are prominent.
  - CSSF actions:
    - Issued guidance on substance requirements in context of delegated activities in CSSF Circular 18/698.
    - Regular bilateral meetings with EU/third-party supervisory authorities and U.S. securities regulator, often focused also on individual companies and delegation issues.
    - Initiated standardized information requests to regulators of jurisdictions to which Luxembourg fund managers mostly delegate collective portfolio management activities; in 2021 these also cover distribution activities by delegates abroad.
    - Plans a thematic inspection in 2023 on oversight performed by IFMs on delegated portfolio managers based outside Luxembourg and foresees active engagement with regulators in relevant jurisdictions.

- Recommendation 17 (Timeframe: NT): Issue guidance on holdings of directorships of funds and their managers.
  - Status: CSSF issued specific guidance in CSSF Circular 18/698 (published on August 23, 2018).

- Recommendation 18 (Timeframe: NT): Assess whether safeguards to ensure depositary independence are adequate.
  - Status and findings:
    - CSSF revisited issue internally in 2018; discussions with industry via CSSF UCI Committee in early 2019.
    - CSSF concluded it is "neither necessary nor appropriate" to implement depositary independence requirements beyond EU Directive 2014/91/EU (UCITS V Directive) requirements regarding depositary functions, remuneration policies and sanctions.

### Insurance regulation and supervision
- Recommendation 19 (Timeframe: NT): Implement revised early warning system under Solvency II regime.
  - CAA actions:
    - Designed a risk-based early warning system based on a risk appetite level chosen by each insurance and reinsurance undertaking (as part of ORSA).
    - Introduced a new dashboard in 2022: if a direct insurance undertaking shows a solvency ratio under 110% (end of year or end of any given quarter), the case is brought before executive board which can mandate an expert (e.g., statutory auditor) to verify solvency calculations; cost borne by the undertaking.

### Contingency planning and financial safety nets
- Recommendation 20 (Timeframe: I): Develop policies on intragroup exposures and transfer of custodian functions in recovery and resolution.
  - Recovery:
    - CSSF verifies recovery plans include option to sell/transfer custodian functions and assesses impact and credibility per EBA Single Supervisory Handbook's supervisory assessment of recovery plans.
    - Recovery plans include inter-connectedness information on exposure to Group if material.
    - Structural developments: largest depositaries often operate as branches of banks with head-office in another member state and thus may not be required to submit recovery plans to CSSF.
  - Resolution:
    - In absence of SRB formal policy regarding depositary banks (esp. for CIS), CSSF has not put in place its own policy on use of transfer tools for transferring depositary function. SRB has guidance notes and resolution planning manual (RPM) requiring IRTs to assess preconditions for transfer strategies (e.g., sale of business). SRB requires separability analysis and transfer playbook where transfer tool is preferred/variant strategy. New RPM chapter on transfer tools added to support IRTs in assessing separability analysis reports.
    - CSSF and SRB regularly exchange on criticality of depositary function.
    - Resolution plans drafted and approved by CSSF for banks with specialized and custodian functions, covering all LSIs (except recently established ones). Draft plans, including identification of preferred resolution strategy and assessment of transfer tools or winding up, submitted to SRB.
    - BRRD2 (article 1, point (15)(a)(ii) of Directive (EU) 2019/879) added new point (h) of article 44(2) BRRD providing mandatory exclusion from bail-in of certain intragroup exposures; transposed into national law on May 20, 2021.

### Financial market infrastructure oversight
- Recommendation 21 (Timeframe: NT): Reduce Clearstream Banking Luxembourg (CBL)'s exposure to commercial banks vis-à-vis CSDs and central banks.
  - Actions and status:
    - Dependencies reduced for most relevant currencies (EUR, GBP, USD) by appointing multiple (at least three) Correspondent Central Banks (CCBs) to reduce concentration risk. Additional CCBs still required for CHF and JPY.
    - Contingency measures defined to execute switchover from an appointed CCB to another in case of unavailability.
    - Robust testing and communication plans defined for USD; similar contingency measures planned and to be tested for other major currencies within the coming year to ensure CBL can switch payment flows between CCBs with a Recovery Time Objective (RTO) of 2 hours.

- Recommendation 22 (Timeframe: NT): Require establishment of third data center and conduct a full failover test.
  - Status:
    - Establishment of a third data centre: CBL re-evaluating data-centre strategy, including cloud strategy; no final decisions yet; discussions ongoing. "(Note: Situation is currently still the same)"
    - Conduct of a full failover test: CBL performed a failover test on January 29, 2019, covering all critical Clearstream functions based in Luxembourg. Full failover tests are conducted every year as part of Business Continuity testing framework, simulating loss of CBL’s primary facilities in Luxembourg and/or staff according to yearly test plan. Test parameters and simulated scenarios change year-to-year.

### AML/CFT
- Recommendation 23 (Timeframe: I): Ensure the 2016/2017 national risk assessment focuses adequately on Trust and Company Service Provider (TCSP) risks.
  - NRA and follow-up:
    - Luxembourg finalized first National Risk Assessment (NRA) in September 2018 based on data available as end of 2017; NRA covered TCSPs and analyzed inherent risk and mitigating actions. Inherent risk in TCSPs’ activities assessed as "High".
    - Update covering 2018–19 adopted in September 2020 and published in 2020; 2020 NRA confirms inherent risk linked to TCSP activity as "High".
    - Second update of the NRA being finalized, to be published in 2023.
    - NRA assessed inherent risk of "legal entities and arrangements" as "High"; national coordination committee performed a vertical risk assessment (VRA LP&LA) published in early 2022, categorizing different forms of legal persons/arrangements into risk buckets and assessing mitigation measures and TCSP roles.
    - Vertical risk assessment on terrorism financing adopted and published in sanitized form in May 2022, focusing inter alia on specific risks posed by financial sector and non-profit organizations.
  - Legal and supervisory measures:
    - 2004 AML/CFT Law adapted in 2020 requiring every professional providing TCSP activity to register with respective authority/self-regulatory body (SRBs), improving supervision. SRBs given powers for supervision and sanctioning; have implemented fully-fledged risk-based AML/CFT supervision. Exchanges among authorities/SRBs occur for harmonization (e.g., CSSF exchanges with Luxembourg Bar and Ordre des Experts Comptables). Ministry of Justice keeps list of all persons providing TCSP activities in Luxembourg.
    - Transparency measures: 2019 Beneficial owner register and 2020 Register of fiducies and trusts established.
    - CSSF supervises TCSP services in financial sector under its remit. CSSF published sub-sectoral risk assessment (SSRA) in July 2020 to raise awareness and provide guidance; SSRA to be updated in 2023.
    - CSSF AML/CFT questionnaires submitted annually include updated information on inherent risks and mitigation measures linked to TCSP activity for entity-level risk assessment.
    - Example staffing: AML/CFT dedicated team supervising specialized PFS composed of 5 persons (31.12.2022).
    - 2022: Specialized PFS department created an AML/CFT expert working group (EWG) composed of private sector associations, CSSF and Luxembourg FIU to exchange on best practices, typologies and ML/FT risks.
    - Legal framework updates include Law of 29 July 2022 further specifying definition of TCSP in 2004 AML/CFT Law.

### Crisis roles, liquidity assistance and coordination
- Recommendation 24 (Timeframe: NT): Agree on roles and responsibilities in dealing with a system-wide crisis.
  - Status: "This recommendation is being considered by the Ministry of Finance."

- Recommendation 25 (Timeframe: MT): Finalize operational modalities of emergency liquidity assistance provision.
  - Status and actions:
    - "The operational and legal framework for the provision of emergency liquidity assistance s in the process of being completely reviewed."
    - Collateral framework reviewed and monitoring of selected counterparties, including early warning indicators, has been put in place.
    - "The process will be finalized during the first semester 2023."

*Table 1. Luxembourg: FSAP Update 2017: Key Recommendations.*

### annex takes stock of these achievements and offers further actions to build on this success.

### 1luxea2023001 - annex takes stock of these achievements and offers further actions to build on this success.

### Progress in closing the gender participation gap
- Luxembourg has made remarkable progress in closing the gender participation gap over the last decade.
- Policy changes likely contributing to higher female participation include introduction of parental/paternity leave, optional individual taxation, and measures to make childcare costs more affordable.
- Female participation (employment) rate increased by 9 percentage points (ppt) over 2010-21.
- The gender participation gap has declined by 11 ppt, described as one of the best performances in OECD countries.
- The COVID pandemic appears to have benefited female participation, especially for foreign non-EU women, likely reflecting:
  - tighter labor market,
  - higher demand for female-dominated jobs (nurses, teachers, etc.),
  - greater work flexibility (remote work and flexible work arrangements).
- Remaining disparities:
  - The activity rate for non-EU female workers remains well below male and other females.
  - Reduction of gender participation gap for senior women (55-64) has been less impressive and female participation remains well below peer countries.

### Employment patterns and part-time work
- The gender employment gap has narrowed, but part-time employment remains highly gendered.
- About 30 of percent of employed women are working part-time, compared to 7 percent for men.
- The share of women working part-time increases to 38 percent for female Luxembourgers.
- Family care is generally cited as the most important reason for part-time employment.
- Childcare costs:
  - Have been significantly reduced in the past for the low income.
  - Remain significant for couples with average wage, although comparable to peer countries.
  - Authorities have recently made free after-school care and school meals.

### Wage inequality and sectoral heterogeneity
- Wage inequality at work has been reduced significantly, with heterogeneity across sectors.
- Luxembourg has the lowest adjusted gender pay gap (controlling for characteristics such as age, experience, etc.) in Europe at 0.7 percent.
- In adjusted terms, the wage gap varies substantially across sectors, reaching 22 percent in financial services.
- Contributing factors include differences in education levels, experience, occupation, and work time.
- Part of sectoral gaps may reflect underrepresentation of women in managerial positions (e.g., in other financial auxiliaries), although there appears to be an upward trend for female managers.

### Under-representation of women in technical occupations and education pathways
- Women are under-represented in technical jobs:
  - Around a quarter of women work in education, health, and social work, compared to less than 10 percent of men.
  - Women are 7 times less likely to work in science, technology, engineering, and mathematics (STEM) occupations (4 percent compared to 28 percent for men).
- Education pathways mirror occupational patterns despite broadly similar PISA scores in math.
- The phenomenon is common across EU countries; in Luxembourg it may be reinforced by:
  - the large share of public employment,
  - high public wage premium.

*Source: 1luxea2023001 - annex takes stock of these achievements and offers further actions to build on this success.*

### 5. Building on recent progress, the authorities could consider several measures. While

### 5. Building on recent progress, the authorities could consider several measures. While

### Enhancing integration of (non-EU) foreign female workers
- Recommendation: further facilitate work permits for spouses of expatriates and extend language support programs to lock-in gains in participation during COVID.
- Rationale: most measures are not necessarily gender-specific, but potential gains in participation/employment could be more material for women.

### Incentivizing higher participation of seniors
- Finding: Luxembourg has the highest replacement rate in Europe.
- Statistic: The average retirement age in Luxembourg is 59 ½ years old compared to a statutory retirement age of 65.
- Recommendation: Reduce disincentives to work in the pension system and promote life-long learning to help keep seniors in the labor force.

### Increasing work flexibility and reducing commute time
- Recommendation: Encourage traditional flexible work arrangements and remote work to achieve a better work-life balance.
- Recommendation: Continue investing in public transport to facilitate mobility, acknowledging travel hours and patterns, bus-stop proximity to key facilities (schools, daycare), increasing security in public transport, and more generally getting jobs closer to residential areas (spatial planning).
- Supporting evidence: According to EIB and EIGE studies, Luxembourg—the first EU country with free public transport—is the country in which the greatest proportion of women (56 percent) consider that giving up their car would be the hardest choice in contributing to climate action. 10 percent of women in Luxembourg identified public transport as the most likely place for such violence to occur.

### Rethinking education and vocational training
- Recommendation: Develop apprenticeships and internships (in STEM firms) for students to encourage women to choose STEM occupations.
- Recommendation: Promote female entrepreneurship in STEM fields as role models for students and young professionals.

### Taxation reforms to boost female labor supply
- Finding: The increased tax credit for single parent wage earner could increase female labor supply as the elasticity of labor supply is generally found to be considerably higher for women than for men (Evers et al. 2008).
- Recommendation: Switch to individual taxation to be more gender-neutral and less distortive for labor supply of women (by providing incentives for higher labor participation of the second earner).
  - Implementation note: The resultant increase of the average tax burden for married or registered couples could be mitigated through progressive deductions or allowances over the first years.
- Alternative measure: In the absence of full individualization, follow the Netherlands’ example whereby the basic tax deduction of a non-working spouse could no longer be transferred to the breadwinner—an important step towards full individualization.
- Reference for detailed analysis: De Mooij et al. (2020).

*Source: Luxembourg — Staff Report for the 2022 Article IV Consultation — Informational Annex (May 2, 2023).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1luxea2023001.pdf_