## 1luxea2024001

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### Context and recent developments
- Growth and GDP:
  - Real GDP contracted by 1.1 percent in 2023.
  - Nominal GDP increased; corporate profits declined on aggregate (-5 percent) despite record strong performance by banks.
- Labor market:
  - Unemployment rose by +0.9 percentage points from its 2022 lows to reach 5.5 percent at end-2023 (5.6 percent in February 2024).
  - Vacancies have fallen by 36 percent.
  - Skills mismatches persist (ICT, accounting, management).
- Inflation:
  - Headline inflation 3.5 percent at end-2023 (3.2 percent in February 2024), down from 5.4 percent a year earlier.
  - Services inflation increased to 4¾ percent following three consecutive indexations (+2.5 percent each).
  - Core inflation persistently elevated at 4 percent y/y.
- Fiscal sector:
  - Overall deficit widened from 0.4 percent of GDP in 2022 to 1¼ percent in 2023.
  - Cyclically adjusted deficit (excluding one-off EU budget contribution) rose from ½ to 1.1 percent of GDP.
  - Revenues increased by 10 percent through December 2023.
  - The wage bill increased by 1 percentage point of GDP in 2023.
  - Public debt 25¾ percent of GDP in 2023.
- External sector:
  - Current account surplus estimated at 6.8 percent of GDP in 2023.
  - NIIP declined by about 13.2 percentage points of GDP but expected to strengthen gradually.
  - Staff’s EBA-lite indicates a current account gap of 3.1 percent of GDP and an undervalued real effective exchange rate.
- Credit, housing, financial cycle:
  - Credit to the nonfinancial resident private sector contracted 3 percent y/y at end-2023.
  - Countercyclical capital buffer (CCyB) maintained at 0.5 percent.
  - Residential real estate: house prices declined -14½ percent y/y in 2023Q4; existing single-family houses down 19 percent; new apartments down 7½ percent; overvaluation reduced to a range of (10–25 percent).
  - Commercial real estate transaction activity frozen, prices under pressure.
- Financial sector resilience:
  - Banks’ profitability almost doubled compared to 2022.
  - CET1 at 23 percent; LCR above 180 percent.
  - NPL ratio increased to 1.9 percent in 2023Q4 from 1.6 percent a year earlier.
  - Investment funds: NAV slightly improved but net flows negative for a second consecutive year.

### Outlook, assumptions, and scenarios
- External assumptions (aligned with April 2024 WEO for euro area):
  - Growth this year to increase slightly to 0.4 percent, driven by private consumption.
  - Inflation to continue easing.
  - Short-term bond rates to fall to 3.5 percent in 2024 and 2.6 percent in 2025.
  - Long-term bond yields to remain broadly stable at around 2.5 percent.
- Policy assumptions in baseline:
  - Authorities will reduce the corporate income tax by 1 percentage point and adopt automatic indexation of the tax brackets for inflation in 2025.
  - Cost-of-living measures set to expire at end-2024.
- Domestic projections:
  - Growth expected to rebound to 1¼ percent in 2024.
  - Inflation expected to recede in 2024; rebound to 3.1 percent in 2025 once administrative energy price measures expire; fall to 2 percent in 2026.
  - Potential growth assumed to be slightly over 2 percent (average over 2015–23).
  - Real credit forecast broadly stable in 2024 and turn positive thereafter.
  - Credit-to-GDP gap expected to remain negative.
- Scenarios and risks:
  - Downside external risk: geopolitical tensions could reignite supply disruptions, impede disinflation, cause higher-for-longer interest rates, asset repricing, and global systemic financial instability with spillovers to Luxembourg.
  - Alternative risk: sharp global slowdown could accelerate disinflation and rate cuts but dampen growth, employment, investor confidence, and affect banks and investment funds, pressuring fiscal revenues.
  - Domestic risk: disorderly correction in the property market could cause construction sector difficulties, higher NPLs, and banks’ losses.

### Housing-sector support and government package (February 2024 and related measures)
- Actions in February 2024:
  - State of crisis in the construction sector for six months.
  - Extended short-term work schemes to firms in the sector.
  - Temporary and permanent measures to stimulate housing demand, mainly buy-to-let.
- Main elements:
  - Temporarily increase accelerated depreciation rate and other tax incentives for house purchases.
  - Raise and extend interest payment deductibility thresholds.
  - Extend public purchase program of new residential dwellings until 2027 with a cost of EUR480 million (0.6 percent of 2023 GDP).
  - City of Luxembourg increasing stock of rental housing with cost of EUR240 million.
- Other measures and programs:
  - Adjustment to personal income tax brackets for four indexation tranches expected to boost purchasing power.
  - Special Fund for Affordable Housing to invest over €900 million between 2024–26.
  - VEFA program extension and reinforcement (allocation €480 million to buy new dwellings between 2024–27).
  - Time-limited tax credits and structural tax changes (see Annex IV list of tax and structural measures).

### Fiscal outlook, stance, and recommendations
- Near-term staff assessment:
  - Cyclically adjusted deficit excluding the one-off EU budget contribution expected to widen by 1.1 percentage points to about 1.6 percent of GDP in 2024.
  - Public debt projected to increase by 6–7 percentage points of GDP in the next five years under staff’s baseline.
  - Given negative output gap and large fiscal space, a moderately expansionary policy in 2024 is adequate but should favor targeted and time-bound measures.
- 2025 recommendation:
  - Move fiscal policy into contractionary territory as growth strengthens and monetary policy eases.
  - Phase out all temporary measures while cushioning impact on the most vulnerable through targeted transfers if needed.
  - Avoid measures that distort price signals in a prolonged manner, notably in residential real estate.
  - Use automatic stabilizers and frontloading of public investment in case of a negative demand shock; if (core) inflation persists, pursue a more contractionary stance with targeted and temporary relief.
- Medium-term consolidation:
  - Gradual consolidation of 0.15–0.2 percent annually (compared to the baseline) to stabilize debt.
  - Composition mainly expenditure-driven with reprioritization of public spending.
  - Suggested measures: contain the wage bill, improve efficiency of social spending, further means-testing for social benefits, greater efficiency in education and health, early pension reform.
- Tax design guidance:
  - Personal income tax: welcome transition to individual taxation and frequent adjustment of tax brackets for inflation, but recommend budget-neutral implementation and avoid retroactive adjustments.
  - Corporate taxes: reducing statutory CIT rate to OECD average could erode revenues; prefer targeted tax incentives for R&D, green transition, and digitalization.
  - Property taxation: expedite establishment of land taxation; consider gradual phasing out of increased interest payment deductibility.

### Social security and pensions sustainability
- Key figures:
  - Pension system reserves: 32 percent of GDP.
  - Pension costs expected to rise by 2 percentage points of GDP by 2040.
  - Institutional safeguards and stabilizers not foreseen to be triggered before 2028.
- Staff recommendations:
  - Proactive action: lower the replacement rate (noted as the highest in Europe) and disincentivize early retirement.
  - Address AMM deficit: options include increasing contribution rates, capping contributory income, containing expenditures via spending caps and reassessment of priorities.

### Financial sector resilience, stress tests, and macroprudential policy
- FSAP stress-test highlights (by business model):
  - CET 1 Ratio Before Stress: Universal/ Retail & Commercial 20.9%; Private Banking 25.2%; Custodian & Activities Linked to Investment Funds 42.2%; Corporate Finance 14.6%; Other 42.4%.
  - CET 1 Ratio–Baseline (end of 1st year): 22.0%; 26.7%; 43.5%; 15.2%; 47.6% respectively.
  - CET 1 Ratio–adverse (end of 1st year): 17.0%; 16.8%; 42.6%; 13.8%; 46.5% respectively.
  - Capital Depletion in the Adverse Scenario: -3.8%; -8.5%; 0.4%; -0.9%; 4.1% respectively.
- Liquidity stress test summary:
  - LCR: Number of banks below threshold (<100%): Baseline 0; Deposit Run 5; Combined 6; Weak Bank/ Same-name Funds 3.
    - Share of total sample assets (%) for those below threshold: Baseline 0; Deposit Run 21.7; Combined 23.8; Weak Bank 17.6.
  - NSFR: Number of banks below threshold (<100%): Baseline 0.
  - Cash-flow Based net funding gap (CBC<0): Baseline 1 bank; Deposit Run 3; Combined 6; Weak Bank 5.
    - Share of total sample assets (%) for those with net funding gap: Baseline 0.5; Deposit Run 14.2; Combined 23.8; Weak Bank 19.0.
  - Scenarios: “Deposit Run” uses run rates from Credit Suisse and First Republic Bank episodes; “Combined” = Deposit run + market stress; “Weak Bank” = higher deposit run rates + market stress for sub-sample of 16 banks with weak global parents or same-name funds.
- Assessment:
  - Banking system overall resilient; banks can sustain retail deposit outflows up to 20 percent.
  - Under adverse scenario, share of weak banks in total assets would double; recapitalization needs manageable.
  - Investment funds and insurance sectors have sufficient liquidity buffers; majority of money market funds could absorb up to 300 basis points increase in rates.
- Macroprudential recommendations:
  - Preserve resilience against real estate vulnerabilities, preferably via sectoral systemic risk buffers.
  - Use existing capital headroom to increase macroprudential capital requirements through targeted capital-based measures.
  - Consider a sectoral systemic risk buffer on households and corporates real estate exposures.
  - Maintain nimble policy: if credit worsens, reduce stress-test requirement of 200 basis points and relax CCyB while avoiding loosening LTV.
  - Evaluate adoption of a positive neutral CCyB (PNCCyB) in the medium-term.
- Household measures:
  - Introduce stressed-DSTI around 45–50 percent, possibly tied to CSSF 200-basis points sensitivity analysis.
  - Consider gradually reducing maximum LTV for first-time homebuyers.
  - Model evidence: income-based limits with supply rigidity could reduce house prices and indebtedness in medium term; affordability cost for low-income households could be compensated via social housing measures.

### Real estate sector developments, risks, and policy guidance (Annex IV)
- Market dynamics:
  - Transactions declined about 43 percent in 2023; new apartments ~68 percent decline.
  - House prices between 2018–22 increased on average 10 percent annually; in 2023 prices declined on average 10 percent (14½ percent y/y).
  - Declines by dwelling type in 2023: existing dwellings down 12.4 percent; new apartments down 3.6 percent.
- Construction and activity:
  - Real GVA in construction fell by 7 percent in 2023.
  - Overall investment fell by 4.6 percent in 2023; residential investment declined by 9.4 percent; other buildings and civil engineering down 2.4 percent.
  - Job losses due to bankruptcies ~1100 people in 2023, a 60 percent increase versus prior year.
- Financial exposures:
  - NPLs in construction and real estate increased by 4.3 percentage points from end-2022 to reach 6.1 percent.
  - CRE loan exposure: 6–7 percent of total bank loans; CRE loan coverage ratio 94 percent; CRE average LTV 54 percent; domestic-oriented CRE exposures EUR3 billion.
  - Real estate funds’ exposures <5 percent of NAVs; funds’ leverage 130 percent.
- Policy implications and recommendations:
  - Allow orderly market rebalancing while expediting supply-side measures to enhance affordability.
  - Favor cost-efficient supply interventions (e.g., frontloading public projects on public land) over untargeted demand supports.
  - Temporary demand supports risk producing suboptimal distributional outcomes and moral hazard; consider conditional or temporary assistance to viable developers and completion guarantees under strict underwriting standards.
  - Phase out interest payment deductibility gradually; expedite land taxation to reduce land hoarding.

### Productivity, competitiveness, and sustainable finance
- Productivity trends:
  - Productivity growth slowed: average productivity growth 0.4 percent in Luxembourg vs. 0.9 percent for neighbors between 1995–2022.
  - Labor productivity stagnation since the GFC; TFP contributed negatively to labor productivity growth.
  - Between 2011–22: unit labor costs increased by 3.5 percent on average; labor productivity declined by 0.2 percent.
  - Finance sector contributed negatively to productivity growth post-euro crisis; information and communication sector contributed positively.
- Policy priorities to rekindle productivity:
  - Catalyze technology innovation and increase R&D.
  - Raise investment in intangible assets (R&D, computer software, intellectual property products), historically stagnant at about one percent of GDP.
  - Harness generative AI potential; invest in re-skilling and up-skilling.
  - Reduce productivity dispersion via innovation diffusion, reduce administrative burdens, and facilitate firm entry/exit.
  - Increase wage indexation flexibility to boost competitiveness.
- Sustainable finance:
  - Luxembourg green exchange capitalization topped the EUR 1 trillion mark in February 2024.
  - Luxembourg domiciled funds: 34 percent of assets under management of Article 8 funds and 51 percent of Article 9 funds.
  - Average charge for Article 9 investment funds: 0.21 percent.
  - Recommendations: attract ESG talent (ESG finance curriculum), harness fintech/AI synergies for ESG data and risk management, mutualize compliance costs.

### Governance, institutions, AML/CFT, and FSAP implementation
- Governance and macroprudential decision-making:
  - Recommendation to reduce role of Ministry of Finance in macroprudential decisions and strengthen accountability and transparency (systematic communication on decisions and inaction).
  - Improve coordination between financial stability and fiscal/housing policies to reduce costs of macroprudential measures.
- Supervisory and regulatory improvements:
  - Increase legal safeguards to future-proof independence of CSSF and CAA.
  - Enhance inter-agency cooperation on bank group information sharing, risk-based onsite supervision of investment funds’ foreign delegates, and AML/CFT monitoring of cross-border flows.
  - Finalize Memorandum of Understanding between CSSF and BCL on liquidity supervision of Less Significant Institutions.
  - Increase CSSF enforcement powers in investment funds with higher fines and harmonization across fund types.
- AML/CFT:
  - Monitor cross-border payments data combined with macroeconomic data to detect unusual patterns.
  - Ensure sufficient resources for AML/CFT supervision.
- FSAP implementation:
  - Maintain momentum implementing FSAP recommendations; future-proof operational independence of supervisors; fill remaining crisis management and deposit insurance gaps.

### External sector (Annex II) and FX
- NIIP and external balances:
  - NIIP declined from 47 percent of GDP in 2022 to 33.8 percent in 2023.
  - Key 2023 (% GDP) statistics: NIIP 33.8; Gross Assets 14711.4; Debt Assets 3219.3; Gross Liabilities 14677.6; Debt Liabilities 1076.3.
  - Current account surplus narrowed to 6.8 percent of GDP in 2023 from 7.6 percent in 2022; services balance 34.4 percent of GDP; net factor income deficit 26.9 percent of GDP.
  - EBA-lite CA gap 3.1 percent of GDP; CA norm should be viewed with caution for Luxembourg.
- Real exchange rate:
  - Staff assessed CA gap implies a REER undervaluation of 2.3 percent; REER index model suggests undervaluation of 9.3 percent (including policy gap 4.2 percent).
- Capital and financial accounts:
  - Financial account surplus narrowed from 7.9 percent of GDP in 2022 to 6.5 percent of GDP in 2023.
- FX and reserves:
  - Euro is free floating; reserves held by euro area countries typically low relative to standard metrics.

### Administrative and data notes
- Fund relations:
  - Membership joined December 27, 1945; Article VIII.
  - Quota: 1,321.80 SDR million 100.00 percent of quota.
  - Fund holding of currency: 965.03 SDR million 73.01 percent of quota.
  - Reserve Tranche Position: 356.83 SDR million 27.00 percent of quota.
- Article IV and FSAP:
  - Last Article IV consultation concluded on May 17, 2023; Luxembourg on standard 12-month cycle.
  - FATF recognized the AML/CFT framework quality in September 2023 and placed Luxembourg under regular monitoring.

*Source: IMF staff report excerpt, "Cementing Luxembourg’s Leadership Position in Sustainable Finance."*

### 1. Cementing Luxembourg’s Leadership Position in Sustainable Finance ________________________ 26

### 1. Cementing Luxembourg’s Leadership Position in Sustainable Finance

### Context and recent developments
- Luxembourg entered the hiking cycle in a strong position with a post-pandemic recovery stronger than peers; firms accumulated cash buffers despite sectoral heterogeneity.
- Recovery started to fade in late 2022 and financial volatility increased, weighing on activity.
- Preliminary figures show real GDP contracted by 1.1 percent in 2023, driven mainly by weaker external demand and residential investment.
- Nominal GDP increased, supported by higher wages (+10½ percent), while corporate profits declined on aggregate (-5 percent), despite record strong performance by banks.
- Households’ real income and savings were boosted by a tight labor market, generous fiscal support, and automatic wage indexation; the households' saving rate remains 3 percentage point above pre-pandemic levels.
- Labor market:
  - Unemployment rose by +0.9 percentage points from its 2022 lows to reach 5.5 percent at end-2023 (5.6 percent in February 2024), close to pre-COVID levels.
  - Vacancies have fallen by 36 percent and firms’ expectations of future employment have dropped.
  - Skills mismatches persist, especially in ICT, accounting, and management occupations.
- Inflation:
  - Headline inflation stood at 3.5 percent at end-2023 (3.2 percent in February 2024), down from 5.4 percent a year earlier.
  - Services inflation increased to 4¾ percent following three consecutive indexations (+2.5 percent each).
  - Core inflation has been persistently elevated at 4 percent y/y, with some sequential softening since August 2023.
- Fiscal sector:
  - Overall deficit widened from 0.4 percent of GDP in 2022 to 1¼ percent in 2023.
  - Cyclically adjusted deficit (excluding one-off EU budget contribution) rose from ½ to 1.1 percent of GDP.
  - Revenues increased by 10 percent through December 2023.
  - The wage bill increased by 1 percentage point of GDP in 2023.
  - Public debt stood at 25¾ percent of GDP in 2023.
- External sector:
  - Current account surplus estimated at 6.8 percent of GDP in 2023.
  - Net international investment position (NIIP) declined by about 13.2 percentage points of GDP but expected to strengthen gradually.
  - Staff’s EBA-lite indicates a current account gap of 3.1 percent of GDP and an undervalued real effective exchange rate.
- Credit, housing, and financial cycle:
  - Credit to the nonfinancial resident private sector contracted 3 percent y/y at end-2023 (first contraction in more than two decades).
  - Countercyclical capital buffer (CCyB) maintained at 0.5 percent.
  - Residential real estate: house prices declined -14½ percent y/y in 2023Q4; prices of existing single-family houses and new apartments declined by 19 percent and 7½ percent, respectively; overvaluation reduced to a range of (10–25 percent).
  - Commercial real estate: transaction activity frozen and prices under pressure, especially for offices.
- Financial sector resilience and stresses:
  - Banks’ profitability almost doubled compared to 2022 due to high interest rates boosting interest margins.
  - CET1 at 23 percent; LCR above 180 percent.
  - NPL ratio increased to 1.9 percent in 2023Q4 from 1.6 percent a year earlier.
  - NPL increase larger for domestically oriented banks (2.6 percent in 2023 against 1.8 percent in 2022).
  - Investment funds: net asset value slightly improved but net flows negative for a second consecutive year.

### Outlook, assumptions, and key projections
- External assumptions (in line with April 2024 WEO for euro area):
  - Growth this year to increase slightly to 0.4 percent, driven by private consumption.
  - Inflation to continue easing.
  - Short-term bond rates to fall to 3.5 percent in 2024 and 2.6 percent in 2025.
  - Long-term bond yields to remain broadly stable at around 2.5 percent.
- Policy assumptions included in baseline:
  - Authorities will reduce the corporate income tax by 1 percentage point and adopt automatic indexation of the tax brackets for inflation in 2025.
  - Cost-of-living measures are set to expire at end-2024.
- Domestic outlook:
  - Growth is expected to rebound to 1¼ percent in 2024.
  - Inflation is expected to recede in 2024; then rebound to 3.1 percent in 2025 once administrative energy price measures expire, before falling to 2 percent in 2026.
  - Output gap will continue widening as growth falls short of potential.
  - Potential growth assumed to be slightly over 2 percent (average over 2015–23).
  - Real credit forecast: broadly stable in 2024 and turn positive thereafter as mortgage demand regains momentum.
  - Credit-to-GDP gap expected to remain negative.
- Scenarios and transmission:
  - Softer global financial conditions and lower inflation improve the outlook, but near-term risks tilted to the downside.
  - Downside external risk: rising geopolitical tensions could reignite supply disruptions and commodity price volatility, impeding disinflation and causing higher-for-longer interest rates, asset repricing, and global systemic financial instability with spillovers to Luxembourg.
  - Alternative risk: a sharp global slowdown could accelerate disinflation and rate cuts but dampen growth, employment, investor confidence and affect banks and investment funds, pressuring fiscal revenues.
  - Domestic risk: disorderly correction in the property market could cause construction sector difficulties, higher NPLs, and banks’ losses.

### Authorities’ views
- Authorities broadly agreed with staff on the outlook and risks and emphasized:
  - 2023 was challenging but initial conditions were strong and the economy remains resilient.
  - Early signs that the cycle is bottoming out and confidence in a rebound in 2024.
  - Main immediate domestic risk identified as the real estate sector; vigilance to potential spillovers from geopolitical tensions.
  - Upside risks include strength in financial services recovery, saving rates, and impact of government support measures.

### Policy discussion and recommendations
- Policy objective: efficiently and durably reinvigorate growth, help disinflation, and manage vulnerabilities in the real estate sector.
- Fiscal policy:
  - A credible gradual fiscal consolidation would help stabilize the debt in the medium term and create additional room for fiscal priorities.
- Structural reforms and priorities:
  - Address longer-term challenges: housing affordability, competitiveness, and ageing population.
  - Ensure timing and calibration of measures to reinvigorate growth (including in real estate) are well-defined to avoid exacerbating vulnerabilities.
- Financial sector policy:
  - Maintain bank resilience given rising asset-quality pressures; continue monitoring NPLs and exposure to real estate.
  - Keep countercyclical buffers and macroprudential stance aligned with evolving credit and property market dynamics.

*Source: IMF staff report excerpt, "Cementing Luxembourg’s Leadership Position in Sustainable Finance."*

### 16.      In response to the downturn and difficulties in the real estate sector, the new

### 16.      In response to the downturn and difficulties in the real estate sector, the new government has deployed a large package to stimulate demand.

### Housing-sector support and demand measures
- In February 2024 the new government:
  - declared a state of crisis in the construction sector for six months;
  - extended short-term work schemes to firms in the sector;
  - tabled a mix of temporary and permanent measures to stimulate demand for housing, mainly the buy-to-let segment.
- Main elements of the package:
  - increasing temporarily the accelerated depreciation rate and other tax incentives for house purchases;
  - raising and extending of the interest payment deductibility thresholds;
  - extending the public purchase program of new residential dwellings until 2027 with a cost of EUR480 million (0.6 percent of 2023 GDP).
- Additional public housing action:
  - The City of Luxembourg is increasing its stock of rental housing with a cost of EUR240 million.
- Other context:
  - These measures come on top of a package announced by the former government and the expected boost to purchasing power from the adjustment to the personal income tax brackets for four indexation tranches.

### Competitiveness, tax policy, and structural priorities
- Government five-year program priorities:
  - Boost competitiveness, notably of the financial sector.
  - Lower the tax burden for corporations by bringing statutory corporate tax rates down towards the OECD average.
  - Maintain a high level of investments in the digital and climate transition through public investment, public and private partnerships, and tax incentives.
  - Lower the subscription tax for active ETFs.
  - Modernize state functions and administrative procedures; strengthen public services such as health and education.
- Measures under consideration (design unclear):
  - Smoothing the phasing out of administrative energy price measures (set to expire at-end 2024) to reduce potential impact on inflation and purchasing power.
  - Exploring options to transition to individual taxation.
  - Other tax cuts to attract highly-skilled non-resident workers; no compensatory measures discussed at this stage.

### Fiscal outlook, projections, and near-term stance
- Staff projections and key figures:
  - The cyclically adjusted deficit excluding the one-off EU budget contribution is expected to widen by 1.1 percentage points to about 1.6 percent of GDP in 2024.
  - Public debt is projected to increase by 6–7 percentage points of GDP in the next five years under staff’s baseline.
- Near-term assessment:
  - Given the negative output gap, worsening labor market outcomes, high uncertainty in 2024, and large fiscal space, a moderately expansionary policy seems adequate.
  - However, universal support for purchasing power would benefit disproportionately the most affluent; more targeted and time-bound measures would have been preferable to help disinflation.
  - Some measures to support the real estate sector could have been temporary or conditional on market situation.
- 2025 stance recommendation:
  - As growth strengthens and monetary policy eases, fiscal policy should move into contractionary territory.
  - Phase out all temporary measures, while cushioning the impact on the most vulnerable through targeted transfers if needed.
  - Avoid measures that distort price signals in a prolonged manner, notably in residential real estate.
  - In case of a negative demand shock, use automatic stabilizers and frontloading of public investment; if (core) inflation persists, pursue a more contractionary stance with targeted and temporary relief.

### Medium-term consolidation and composition
- Staff suggestion:
  - A gradual consolidation of 0.15–0.2 percent annually (compared to the baseline) to stabilize the debt over the medium term.
- Composition of consolidation:
  - Mainly expenditure driven, with reprioritization of public spending.
  - Government spending (share of GDP) has increased by +8 percentage points of GDP relative to the 2011–16 average, driven by personnel, transfers, and social benefits.
  - Suggested measures: contain the wage bill, improve efficiency of social spending, further means-testing for social benefits (e.g., family benefits), greater efficiency in education and health, early reform of the pension system.

### Design and calibration of tax measures
- Personal income tax:
  - Staff welcome planned transition to individual taxation and frequent adjustment of tax brackets for inflation, but recommend achieving this in a budget neutral manner and avoid retroactive adjustment of tax brackets.
- Corporate taxes:
  - Reducing the statutory CIT rate to the OECD average could erode revenues and may not attract new investments; targeted tax incentives for R&D, green transition, and digitalization are preferable.
- Property taxation:
  - Authorities should expedite establishment of land taxation.
  - The decision to increase caps in interest payment deductibility could have unintended distributional consequences and longer-term impact on house prices and financial stability; consider gradually phasing it out.

### Fiscal framework, institutions, and safeguards
- Rationale:
  - The new EU fiscal framework is not binding for “safe” countries like Luxembourg. Complementing EU rules with a national fiscal framework would better anchor policy after discontinuation of the self-imposed notional debt limit of 30 percent.
- Recommendations:
  - Adopt a medium-term objective (MTO) based on structural fiscal balance that accounts for ageing, climate, and security spending.
  - Use multi-year expenditure ceilings as an operational rule; draw lessons from Netherlands and Sweden examples (multiannual expenditure ceilings, independent macro-fiscal forecasts, coalition agreement on ceilings).
  - Strengthen the role of the fiscal council: ex-post assessment, medium-term macroeconomic projections, debt sustainability analysis, fiscal risk assessment, recommendations on budgetary policy, and evaluation of budgetary implications of proposed measures.
  - Improve medium-term budgeting framework and quality of government finance statistics by adopting fully accrual accounting.

### Social security and pensions sustainability
- Key figures:
  - Pension system reserves: 32 percent of GDP.
  - Pension costs expected to rise by 2 percentage points of GDP by 2040.
  - Existing institutional safeguards and stabilizers are not foreseen to be triggered before 2028.
- Staff recommendations:
  - Proactive action: lower the replacement rate (noted as the highest in Europe) and disincentivize early retirement.
  - Address increasing deficit of Assurance maladie-maternité (AMM): options include increasing contribution rates, capping contributory income, containing expenditures via spending caps and reassessment of priorities.

### Authorities’ views
- Authorities’ stance:
  - More optimistic about the fiscal outlook; view the 2024 budget deficit as transitory.
  - 2025 budget will identify medium-term savings on the expenditures side, including on public wage bill and other efficiency gains.
  - Believe tax relief measures will generate positive economic impulse that will limit potential revenue losses.
  - Strong commitment to preserve the AAA sovereign rating and to complement the EU framework with a more stringent national fiscal framework.
  - Exploring different options for potential pension reform to be discussed with social partners at a later stage.

### Financial sector risks, macroprudential assessment, and stress tests
- Cyclical and housing-related risks:
  - Cyclical systemic risks have abated somewhat following contraction in GDP, credit, and house prices in 2023 and supportive fiscal measures.
  - CSSF estimates house price at risk at around 10 percent over the next year, with a 10 percent probability.
  - Risk profile of new mortgages improved: share of variable rate new mortgages fell from 58 percent in September 2022 to 42½ percent in February 2024, aided by CSSF requirement of a 200-basis points sensitivity analysis at mortgage origination.
- Household vulnerabilities:
  - Households’ indebtedness: debt to income of 180 percent and a debt service to income of 14 percent.
  - Under a severe adverse scenario, the share of “financially vulnerable households” increases to 14 percent and debt at risk increases to 30 percent.
- Corporate sector vulnerabilities:
  - Macro-micro simulations: 50 percent of firms (holding 40 percent of NFCs debt) would face a liquidity gap in the adverse scenario.
  - Firms in real estate and construction account for 62 percent of domestically oriented banks’ exposures to NFCs and have weak initial conditions.
- Commercial real estate (CRE):
  - CRE loan exposure: 6–7 percent of total bank loans.
  - CRE loan coverage ratio: 94 percent.
  - CRE average loan-to-value (LTV): 54 percent.
  - Domestic-oriented CRE exposures: EUR3 billion.
  - Real estate funds’ exposures: comprise less than 5 percent of NAVs of the investment fund sector; funds’ moderate leverage: 130 percent; liquidity shortfalls limited; longer notice periods (quarterly or longer) mitigate liquidity risks.
  - Domestic insurance and pension sectors have low exposures to real estate.
  - Authorities have stepped up data collection and monitoring of lending practices following the ESRB recommendation on CRE vulnerabilities; Luxembourg assessed as fully compliant.
- Bank solvency stress test highlights (by business model):
  - CET 1 Ratio Before Stress: Universal, Retail and Commercial Banking 20.9%; Private Banking 25.2%; Custodian Banking and Activities Linked to Investment Funds 42.2%; Corporate Finance 14.6%; Other 42.4%.
  - CET 1 Ratio–Baseline (end of 1st year): 22.0%; 26.7%; 43.5%; 15.2%; 47.6% respectively.
  - CET 1 Ratio–adverse (end of 1st year): 17.0%; 16.8%; 42.6%; 13.8%; 46.5% respectively.
  - Capital Depletion in the Adverse Scenario: -3.8%; -8.5%; 0.4%; -0.9%; 4.1% respectively.
- Bank liquidity stress test summary:
  - LCR: Number of banks below threshold (<100%): Baseline 0; Deposit Run 5; Combined 6; Weak Bank/ Same-name Funds 3.
    - Share of total sample assets (%) for those below threshold: Baseline 0; Deposit Run 21.7; Combined 23.8; Weak Bank 17.6.
  - NSFR: Number of banks below threshold (<100%): Baseline 0; Share of total sample assets 0.
  - Cash-flow Based (number of banks with net funding gap (eop CBC<0)): Baseline 1; Deposit Run 3; Combined 6; Weak Bank 5.
    - Share of total sample assets (%) for those with net funding gap: Baseline 0.5; Deposit Run 14.2; Combined 23.8; Weak Bank 19.0.
  - Notes on scenarios: “Deposit Run” uses run rates based on Credit Suisse (Switzerland) and First Republic Bank (US) episodes. “Combined” = Deposit run + market stress. “Weak Bank” = higher deposit run rates + market stress for sub-sample of 16 banks with global parent banks found weak or banks with same-name funds.

*Source: IMF staff summary of content unit 1luxea2024001 - 16.*

### 32.      The financial sector is assessed to be largely resilient against severe shocks.

### 1luxea2024001 - 32.      The financial sector is assessed to be largely resilient against severe shocks.

### Financial sector resilience—baseline and adverse scenarios
- Baseline scenario: the banking system, overall, will benefit from high interest rates, with a small share of weak banks.
- Adverse scenario (higher interest rates accompany a severe recession):
  - Banks overall have enough capital and liquidity buffers to absorb the shocks.
  - The share of weak banks in total assets would double.
  - Recapitalization needs would remain easily manageable.
  - All banks can sustain retail deposit outflows up to 20 percent.
  - Only a few banks would need to dip into their liquidity buffers in the more severe scenario, mainly those affected by potential weakness in some foreign parent banks (identified in the 2023 October GFSR).
- Investment funds and insurance sectors:
  - Have sufficient liquidity buffers to withstand large shocks and minimize second-round effects on international securities markets and spillbacks on the economy.
  - The majority of money market funds could absorb significant increases in interest rates (up to 300 basis points).
  - Larger shocks would expose vulnerabilities in a few funds.

### Macroprudential policy recommendations and capital buffers
- Preserve resilience against real estate vulnerabilities, preferably through sectoral systemic risk buffers.
- Current stance and tools:
  - Countercyclical capital buffer (CCyB) kept unchanged at 0.5 percent despite the negative credit-to-GDP gap; this de facto acts as a positive neutral CCyB.
- Recommended actions:
  - Use banks’ existing capital headroom to increase macroprudential capital requirements, preferably through targeted capital-based measures.
  - Staff recommends a sectoral systemic risk buffer on households and corporates real estate sector exposures for more precise targeting.
  - Maintain nimble macroprudential policy:
    - If credit worsens significantly, the stress-test requirement of 200 basis points could be reduced and the CCyB relaxed, while avoiding loosening the LTV.
  - Evaluate adoption of a positive neutral CCyB (PNCCyB) in the medium-term given the openness and complexity of the financial system.
- High banks’ profitability and comfortable capital headroom reduce procyclical risks.

### Household indebtedness and borrower-based measures
- Structural households’ indebtedness should be addressed early in the recovery cycle through borrower-based measures.
- Timing: income-based measures should be introduced early in the recovery cycle—with preparations on calibrations and targeting starting immediately.
- Specific policy proposals:
  - Introduce a stressed-DSTI around 45–50 percent, possibly tied to the current interest rate stress test required by CSSF for mortgages.
  - Consider gradually reducing the maximum loan-to-value for first-time homebuyers.
- Model evidence:
  - A heterogeneous agent model calibrated for Luxembourg shows that income-based limits in a context of supply rigidity could reduce house prices and households’ indebtedness in the medium term.
  - This effect outweighs the financial constraint for middle income households, suggesting mitigation of the middle-income squeeze.
  - Affordability cost for low-income households could be compensated through social housing measures and housing supply-side considerations.

### Governance, accountability, and addressing inaction bias
- FSAP recommends upholding the primacy of the financial stability objective of macroprudential decision-making authorities by:
  - (i) reducing the role of the Ministry of Finance in macroprudential policy decisions deliberated in the CdRS; and
  - (ii) strengthening accountability and transparency by systematically communicating on macroprudential policy decisions and underlying factors, even where no action is taken, while enhancing accessibility to the general public.
- Greater coordination between financial stability and fiscal and housing policies could enhance effectiveness and minimize potential costs of macroprudential measures.
- Identified risk: inaction bias given housing affordability is high on the political agenda.

### Supervisory, regulatory and oversight frameworks
- Progress since 2017 FSAP:
  - Resources have increased in supervisory agencies.
  - Data collection, reporting, and analysis of systemic risks monitoring (especially on real estate and investment funds) have appreciably increased.
  - Significant steps in aligning regulatory frameworks with international standards and reinforcing on-site inspections for banks and investment funds.
  - More active international collaboration during stress episodes.
- Further supervisory and regulatory improvements recommended:
  - Consider legal amendments to protect procedural safeguards to future-proof independence of CSSF and CAA from potential government influence.
  - Enhance inter-agency cooperation given large cross-border connections, particularly on:
    - (i) information sharing for bank group entities;
    - (ii) risk-based onsite supervision of investment funds’ foreign delegates;
    - (iii) monitoring cross-border flows for money laundering/financing of terrorism risks.
  - Finalize the draft Memorandum of Understanding to formalize division of responsibilities between CSSF and Banque centrale du Luxembourg (BCL) on liquidity supervision of Less Significant Institutions.
  - CSSF supervisory risk assessment should incorporate group links between depositaries and investment fund managers as risk factors into the risk-based approach and enhance monitoring of linkages with other financial institutions.
  - Increase enforcement powers of CSSF in investment funds with higher fines and harmonization between types of funds to reduce regulatory arbitrage.
  - Continue to strengthen the financial safety net framework.

### Anti–money laundering / counter–terrorist financing (ML/TF) risks
- As understanding of ML/TF risks advances, consider additional measures for cross-border flows:
  - Monitor and analyze cross-border payments data combined with macro-economic data to highlight unusual payment patterns for further scrutiny.
  - Benefit from information exchanges with key financial institutions and foreign and domestic authorities.
  - Ensure sufficiency of resources available to AML/CFT supervision.

### Real estate sector and housing policies—supply capacity and market rebalancing
- Recent developments:
  - Real estate activity has dropped significantly, accompanied by a sharp drop in building permits.
  - Bankruptcies in the sector have increased, especially among structurally weak firms; layoffs doubled.
  - Risk of more permanent disruptions to downstream activities and higher concentration of real estate developers.
- Policy guidance:
  - Allow orderly rebalancing of the housing market while expediting supply-side measures to enhance structural affordability.
  - Short-term demand supports (untargeted tax incentives, buy-to-let) could help construction sector but risks:
    - Benefits likely short-lived and could produce a suboptimal equilibrium where affluent households benefit disproportionately.
    - House prices may continue to grow faster than income levels, potentially increasing households’ indebtedness and moral hazard.
  - Staff proposes frontloading public projects using public land with greater private sector involvement, and expedite supply-side measures to reduce costs and delays (e.g., densification, reduce red tape).
  - Extend coverage of short-term work scheme to construction firms and facilitate worker reallocation within the sector to mitigate supply disruptions (authorities have taken such measures).
  - Consider additional assistance to viable real estate developers under strict conditions and support completion of unfinished projects (e.g., guarantees under strict underwriting standards).
  - Once the cycle turns, better target help-to-buy policies, phase out interest payment deductibility gradually, reduce rent controls, and expedite passage of the law on land taxation to reduce land hoarding.

### Structural policies: productivity, labor supply, and sustainable finance
- Productivity challenges:
  - Broad slowdown in productivity growth since the Global Financial Crisis: productivity growth on average 0.3 percent between 1995–23, compared with 0.9 percent for neighbors.
  - Decomposition shows most changes driven by within-sector productivity developments.
  - Increasing productivity dispersion between frontier (80th percentile) and laggard (20th percentile) firms; in non-financial services frontier firms were about five times more productive than laggards in 2009, with the ratio increasing since.
  - Total factor productivity has had a negative contribution to labor productivity.
- Policy priorities to rekindle productivity growth:
  - Catalyze technology innovation and increase R&D spending.
  - Raise investment in intangible assets (R&D, computer software, and other intellectual property products) which has been stagnant at about one percent of GDP for the past two decades.
  - Harness generative artificial intelligence (AI) potential and invest in relevant skills and infrastructure for re-skilling and up-skilling.
  - Reduce productivity dispersion by ensuring innovation diffusion within sectors and reducing skill mismatches; reduce administrative burdens and facilitate entry and exit of companies to improve allocative efficiency.
- Labor market and wage indexation:
  - Increasing flexibility of the wage indexation system would boost competitiveness and enhance labor mobility.
  - Between 2011–22:
    - Unit labor costs increased by 3.5 percent on average.
    - Labor productivity declined by 0.2 percent.
  - Rising unit labor costs and automatic wage indexation could impact investment and capital accumulation and exacerbate productivity dispersion.
- Sustainable finance and fintech:
  - Luxembourg is a first mover in sustainable finance and an ESG finance hub.
  - Box 1 summary highlights:
    - Luxembourg green exchange established in 2016; capitalization topped the EUR 1 trillion mark in February 2024.
    - Luxembourg domiciled funds: 34 percent of the assets under management of Article 8 funds and 51 percent of Article 9 funds.
    - Luxembourg domiciled funds on average charge 0.21 percent for Article 9 investment funds.
  - Recommendations:
    - Accelerate efforts to attract talents (e.g., create an ESG finance curriculum).
    - Better harness synergies between fintech, AI, and sustainable finance (e.g., digital solutions for ESG data and risk management).
    - Mutualize compliance costs to preserve competitive advantage.

*Source: IMF staff.*

### 48.      The authorities acknowledged that there has been a discernible slowdown in

### 1luxea2024001 - 48.      The authorities acknowledged that there has been a discernible slowdown in

### Productivity slowdown and policy priorities
- Authorities and Luxembourg’s national productivity board (Conseil national de la productivité) identified a discernible slowdown in productivity growth since the GFC and the need for differentiated policies by sector.
- Key priority areas emphasized:
  - Research and development
  - Innovation
  - Reskilling of the workforce
  - Relaxation of the regulatory framework
- Existing programs:
  - Free training programs (focusing of specific sectors), including language training to reduce skill mismatches.
  - A research program in STATEC focused on understanding determinants of productivity to aid evidence-based policy making.

### Economic outlook and risks (Staff appraisal)
- Outlook:
  - Gradual recovery expected, with buoyant consumption and gradual recovery of residential investment lifting growth in 2024 and strengthening it in 2025.
  - Output gap will remain negative.
  - Inflation expected to recede further in 2024 but remain somewhat above the ECB’s target until 2026.
- Risks:
  - Outlook highly uncertain with risks predominantly to the downside.
  - Heightened geopolitical tensions and risks in the domestic real estate sector noted as key downside risks.

### Fiscal policy stance and recommendations
- Assessment:
  - The moderately expansionary fiscal stance in 2024 is broadly appropriate.
  - Composition of the stimulus could have been more efficient given robust consumption growth and historically high saving rate.
- Recommendations:
  - Use more targeted and temporary measures rather than broad stimulus.
  - Consider a contractionary stance in 2025 while keeping fiscal policy agile:
    - Slow adjustment if growth surprises to the downside.
    - Accelerate adjustment and provide targeted temporary support if inflation becomes more entrenched.
- Medium-term fiscal prudence advised despite ample fiscal space:
  - Gradual fiscal consolidation to stabilize debt in the medium term.
  - Improve spending efficiency by:
    - Better targeting social benefits.
    - Containing the wage bill.
    - Expediting pension reform.
  - Carefully calibrate tax reforms to avoid revenue losses while boosting labor supply, investment, and productivity.

### National fiscal framework and fiscal governance
- Authorities intend to complement the EU’s Economic Governance Framework with a national fiscal framework including a medium-term objective (MTO).
- Suggested enhancements:
  - Strengthen the MTO with an operational rule based on net primary expenditure ceilings.
  - Enhance the role of the national fiscal council.
  - Require a stronger multi-year budgeting framework, better assessment of fiscal risks, and improvement of fiscal statistics.

### Macroprudential policy and household indebtedness
- Objectives:
  - Preserve short-term resilience and address elevated structural household indebtedness early in the recovery.
- Recommendations:
  - Introduce a systemic risk buffer on real estate exposures to preserve resilience with minimal procyclical impact.
  - Continue close monitoring of real estate risks, ensure adequate provisioning, and enforce sound lending practices.
  - Be ready to activate income-based measures (e.g., debt-service to income) once the cycle turns.
  - Consider gradually reducing the maximum LTV limit of 100 percent.
  - If credit supply tightens significantly:
    - Reduce the stress test requirement of 200 basis points.
    - Relax the CCyB while keeping LTV limits unchanged.
  - Improve institutional setting to reduce inaction bias by:
    - Reducing the role of the government in macroprudential decisions.
    - Strengthening communication, including in case of inaction.
    - Strengthening coordination with other policies.

### Financial sector resilience and FSAP implementation
- Maintain momentum in implementing FSAP recommendations to bolster resilience.
- Recommendations:
  - Future-proof the operational independence of supervisory authorities.
  - Enhance inter-agency cooperation on supervision of global banking groups.
  - Ensure adequate supervisory processes for banking groups with funding gaps in FSAP stress tests, including:
    - Effective liquidity risk management.
    - Contingency funding plans at group level when subsidiaries in Luxembourg have not set up separate standing facilities with the BCL.
  - Enhance monitoring of linkages of investment funds with other financial institutions and strengthen CSSF’s enforcement framework.
  - Fill remaining gaps in crisis management and deposit insurance framework.

### Real estate measures and housing policy
- Short-term design:
  - Real estate measures should allow prices to adjust to restore affordability.
  - Temporary support measures should preserve supply capacity and allow price adjustments.
  - Suggested actions:
    - Higher public investment in affordable and social housing using public lands and partnerships with private builders.
    - Higher densification and reduction of administrative/regulatory burden.
    - Continue short-term work scheme in construction sector and targeted support to viable firms.
- Longer-term reforms:
  - Better targeting of help-to-buy policies—especially phasing out interest deductibility.
  - Policies to unlock housing supply, including land tax reform, to reduce structural imbalances.

### Productivity, competitiveness, and short-term reforms
- Sustained growth depends on boosting productivity and competitiveness.
- Policy priorities:
  - Increase investment in intangible assets.
  - Align workers’ skills with current and future demand.
  - Prepare to harness productivity gains from generative AI.
  - In the short term, hasten reduction of regulatory and administrative burdens and enhance wage flexibility.

### Administrative recommendation
- Staff recommend that the next Article IV consultation take place on the standard 12-month cycle.

*Source: IMF staff appraisal and supporting tables and figures from the provided document excerpt.*

### Annex I. Implementation of Past IMF Advice

### Annex I. Implementation of Past IMF Advice

### Fiscal
- Short term IMF advice:
  - Significantly reduce 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 and continue investing in energy efficiency and renewables.
  - In case of severe demand shocks, allow automatic stabilizers to fully operate and consider targeted support, complementing them with a suspension of wage indexation in case of supply shocks.
- Progress/comments:
  - Partially implemented. A worse than expected economic performance led to delayed fiscal consolidation and expansionary fiscal stance.
  - Most of the support has been done through permanent and untargeted measures.
  - The administrative energy prices are expected to be phased out in 2025 or smoothed.
- Medium term IMF advice:
  - Preserve buffers though prudent spending and an early pension reform.
  - Better anchor fiscal policy and reduce procyclicality of fiscal policy by adopting a medium-term objective based on the overall balance and a ceiling on expenditure growth.
  - Increase the frequency of the tax brackets adjustments for inflation in a budget-neutral way, within a comprehensive review of the tax and social benefits system to enhance its efficiency and distributional impact.
- Progress/comments:
  - Partially implemented. The medium-term fiscal outlook has somewhat worsened due to a shift to permanent stimulus measures and other spending pressures.
  - The government is exploring options to contain growth in expenditures.
  - Although abandoning the self-imposed debt limit, the authorities remain committed to preserving the AAA rating.
  - They will complement the EU EGF with a national fiscal rule (a MTO).
  - The income tax brackets were adjusted above inflation and in a non-neutral way.
  - Going forward, the income tax brackets will be adjusted frequently for inflation, but no compensatory measures have been identified yet.
  - Regarding pension reform, discussions with social partners is planned in coming years.

### Financial Sector
- Risks and macroprudential advice:
  - Continue monitoring potential pockets of vulnerabilities, especially in real estate, as well as 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 downturn in the real estate market through targeted capital measures (apply sectoral systemic risk buffer, increase minimum risk weights, and link them to LTV).
  - Should the credit cycle deteriorate considerably, could consider relaxing the CCyB, while keeping the LTV limit unchanged.
- Progress/comments:
  - Partially implemented. Monitoring of real estate risks have been stepped up.
  - The CCyB has been kept unchanged but no other capital-based measures have been undertaken.
  - Income-based measures have not been implemented given the downturn in housing demand and correction of real estate prices but could be considered in case of recovery.
- Investment funds resilience advice:
  - Bolster resilience of investment funds by enhancing the effectiveness of swing pricing through better calibration to stress episodes and tailoring redemption terms to asset liquidity and investment strategy.
  - Continue to coordinate actively with other supervisors, including on cross-border spillovers, and contribute to international efforts to strengthen oversight and regulatory and macroprudential requirements, especially concerning liquidity and leverage.
- Progress/comments:
  - Good progress. The authorities have initiated a joint study with IMF staff on the impact on calibration of swing pricing on the effectiveness of this tool during stress episodes.
  - They continue to participate actively in international fora to develop the regulatory and macroprudential framework for investment funds.

### Structural
- Housing affordability advice:
  - Focus on boosting 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.
- Progress/comments:
  - Little progress. The authorities have added measures to support housing demand in the face of the sharp downturn.
  - Ongoing discussions with the industry to identify supply bottlenecks, in particular regulatory hurdles, with intentions to simplify procedures and increase densification in line with staff.
- Wage indexation advice:
  - Consider indexing to core inflation (complemented as needed with targeted support for the poorest).
  - Consider introducing progressive wage indexation and switching to a rule-based suspension of the system (e.g., based on competitiveness indicators that would encourage greater decentralization of wage bargaining).
- Progress/comments:
  - Not implemented. The authorities have no plans to change the wage indexation system.
  - In case of supply shocks, a tripartite meeting will be held to deal with it.
  - Authorities are focusing on lower taxation and reduced regulatory and administrative burden to support competitiveness.
- Reducing gender gap advice:
  - Transition toward the individualization of taxation.
  - Relax access to work permits for spouses of immigrants.
  - Implement measures to further enhance work flexibility and work-life balance; means-test family benefits.
- Progress/comments:
  - Progress underway. The authorities have eased the obtention of work permits for immigrants’ spouses.
  - The government passed two laws transposing the EU Directive 2019/1158 on work-life balance for parents and carers into local law, introducing paid careers’ leave and paid force majeure leave, as well as an extension to the existing paternity leave entitlement.
  - The government is exploring options to transition to individual taxation by 2026.

*Source: Annex I, Annex II, and Annex III content provided in the supplied IMF document.*

### Annex II. External Sector Assessment

### Overall assessment and near-term policy responses
- Overall Assessment:
  - The external position of Luxembourg in 2023 was stronger than the level implied by medium-term fundamentals and desirable policies.
  - Assessment is based on EBA-lite quantitative models, a review of developments in the balance of payments and net foreign asset positions, with the caveat that the methodology captures only partially Luxembourg’s role as a financial hub and center for intra-corporation cash pooling.
- Potential Policy Responses:
  - In the near term, government’s recently announced measures will delay fiscal consolidation and contribute to narrowing of the current account (CA).
  - In the medium term, greater public sector investment in areas such as affordable housing, infrastructure, digitization, and green transition will help potential growth.

### Foreign assets and liabilities: position and trajectory
- Background:
  - Luxembourg’s net international investment position (NIIP) declined from 47 percent of GDP in 2022 to 33.8 percent in 2023, the lowest level it has been in the past decade.
  - As a share of GDP, the increases in net portfolio investment (10.8 percentage points) and net other investment (10.3 percentage points) were offset by a decline in net direct investment of 33.5 percentage points.
- Assessment:
  - Projections of continued CA surpluses over the medium term suggest that NIIP will recover gradually to its pre-pandemic level.
  - The large and positive NIIP and its trajectory do not raise sustainability concerns.
- Key 2023 (% GDP) statistics:
  - NIIP: 33.8
  - Gross Assets: 14711.4
  - Debt Assets: 3219.3
  - Gross Liabilities: 14677.6
  - Debt Liabilities: 1076.3

### Current account
- Background:
  - The CA surplus narrowed to 6.8 percent of GDP in 2023 from 7.6 percent in 2022.
  - Luxembourg’s surplus reflects a strong services balance (34.4 percent of GDP), which is partly offset by a deficit in net factor income (26.9 percent of GDP), reflecting Luxembourg’s status as a global financial center.
  - The narrowing of the surplus in 2023 is a result of decline in the net export of goods and services as a share of GDP (3.1 percentage points) partly compensated by an increase in net factor income as a share of GDP (2.1 percentage points).
- Assessment:
  - The cyclically adjusted CA balance is estimated to be 6.7 percent of GDP in 2023.
  - The EBA-lite model only partially captures Luxembourg’s specific circumstances as a financial center, including a large investment fund industry and a very small open economy with a large share of non-resident workers.
  - Exports and imports of financial services which drive Luxembourg’s current account are less sensitive to relative prices changes, and the large number of non-resident workers affects net factor income and population-based variables in the models.
  - The EBA-lite explanatory variable “output per worker” is adjusted to reflect that close to 50 percent of Luxembourg’s labor force is non-resident.
  - Even after this adjustment, the CA norm estimated using EBA-estimated coefficients should be viewed with caution since Luxembourg, being an outlier along many dimensions, is not in the EBA sample.
  - The EBA CA gap is 3.1 percent of GDP, which includes a policy gap of 3.6 percent of GDP.
  - The identified policy gap reflects lower-than-desired public health expenditure and a fiscal stance looser than the country-specific norm, but not relative to the average world fiscal stance.
  - Over the longer term the CA surplus will narrow because of rising aging costs that are not accounted for by the CA norm calculated at the desired medium-term policy levels.
  - Pension reforms should therefore be front loaded to reduce fiscal pressures in the long-term.
- Note:
  - There have been large upward revisions in the current account surplus for years between 2018–22 driven by the correction of discrepancies between the national accounts and balance of payments data. Authorities plan to revise the data prior to 2018 over time as well.

### Real exchange rate
- Background:
  - The average real effective exchange rates (REER) based on CPI remained relatively unchanged in 2023, while the ULC-based REER appreciated by 4.5 percent.
  - Between 2022 and 2023, Luxembourg’s CPI-based REER appreciated the least, while the ULC-based REER appreciated the most relative to its neighboring countries.
- Assessment:
  - The staff assessed CA gap implies a REER undervaluation of 2.3 percent.
  - The REER index model suggests an undervaluation of 9.3 percent, which includes a policy gap of 4.2 percent.

### Capital and financial accounts: flows and policy measures
- Background:
  - The financial account surplus narrowed from 7.9 percent of GDP in 2022 to 6.5 percent of GDP in 2023.
  - The capital account deteriorated slightly from a surplus of 0.2 percent of GDP in 2022 to a deficit of 0.3 percent of GDP in 2023.
- Assessment:
  - Risks are limited, given the strength of Luxembourg’s external position.

### FX intervention and reserves level
- Background:
  - The euro has the status of global reserve currency.
- Assessment:
  - Reserves held by euro area countries are typically low relative to standard metrics.
  - The currency is free floating.

*Source: Annex II content provided in the supplied IMF document.*

### Annex III. Slowdown in Labor Productivity Growth

### Key findings on productivity trends
- Despite Luxembourg’s historically high productivity levels, there has been a slowdown in its productivity growth relative to neighboring countries post-Global Financial Crisis (GFC).
- Negative contribution of TFP to labor productivity growth suggests declining efficiency of input utilization.
- Temporary productivity gains from technology integration during the COVID-19 pandemic and structural shifts between industries have been offset by sectoral reallocation post-pandemic.
- The information and communication sector has contributed positively to labor productivity growth, while financial activities contributed negatively post-euro crisis.
- Investing in intangible assets can drive TFP growth, leading to increased productivity within sectors.
- To sustain long-term per capita income growth, Luxembourg should focus on R&D, technological innovation, competitive efficiency, and leverage generative AI.

### Drivers and quantitative observations
- General potential reasons for the observed slowdown:
  - (i) high baseline levels of productivity making incremental gains difficult;
  - (ii) transition from manufacturing to service-based economies where productivity gains are harder to achieve;
  - (iii) limited transformative impact of recent technological innovations;
  - (iv) slower pace of innovation diffusion within sectors;
  - (v) insufficient investment in tangible and intangible assets.
- Specific measures of growth:
  - Real labor productivity (GDP per hour worked) in Luxembourg is high but has been largely stagnant since the GFC.
  - Unlike its neighbors’, labor productivity in Luxembourg in 2022 continues to be below its 2007 level.
  - On average, Luxembourg’s productivity grew (0.4 percent) less quickly than that of neighboring countries (0.9 percent) between 1995–2022.
- Decomposition:
  - Higher levels of productivity can be achieved if more capital is used for production, if labor quality increases, and if labor and capital are used together more efficiently (higher TFP).
  - Decomposing labor productivity growth reveals that relative to its neighbors, TFP in Luxembourg contributes negatively to labor productivity growth.
  - Negative contribution of TFP implies that the efficiency and effectiveness with which inputs are being utilized are deteriorating.
  - Possible causes include decline in or slower adoption of new technologies (contribution of tangible ICT and intangible capital to labor productivity growth is negligible), decreased efficiency, or misallocation of resources.
- Sectoral dynamics:
  - Within-sector developments explain most of the changes in productivity growth in recent years.
  - The rebound in labor productivity in 2020 is a result of both within-sector productivity gains (likely from swift integration of technology and innovation) and between-industry reallocation.
  - These gains partly dissipated because of reallocation of hours to sectors recovering post pandemic (i.e., accommodation and restaurants), which are typically characterized by lower productivity.
  - In the years preceding the pandemic, the within-sector effect dominated and contributed negatively to productivity growth, mostly driven by the financial and insurance sectors and wholesale/retail trade.
  - Between-industry reallocation effect is limited over shorter time horizons.
- Sectoral contributions over 2000–22:
  - Biggest negative contributors to productivity growth were manufacturing (C) and wholesale/retail trade sector (G-I).
  - Information and communication (J) sector and professional activities (M-N) were the largest positive contributors.
  - Since the euro area crisis (2010–22), the financial and insurance activities sector (K) contributed more negatively than manufacturing.
  - The positive contribution of the information and communication sector (J) declined, and that of administrative and support service activities (M-N) increased.

### Role of intangible investment and costs
- Investment in intangible assets:
  - Investments in intangible assets (R&D, computer software, intellectual property products) have a positive effect on TFP growth.
  - Increase in labor productivity in manufacturing between 2010–16 is driven by positive contribution of TFP and corresponds with an increase in investment in research and development starting 2013.
  - In administrative and support services, TFP contributes significantly to labor productivity growth, likely driven by investments in computer software.
  - The slowing of aggregate labor productivity can be linked to stagnation of R&D investment since the GFC.
- Labor costs versus productivity:
  - Real labor productivity has not kept pace with real wages, which have been increasing rapidly because of the wage indexation system.
  - On average, nominal unit labor costs grew by 3.5 percent, while the real labor productivity declined by 0.2 percent between 2011–22.
  - For manufacturing (C) and administrative and support services (N), real labor productivity grew faster than nominal unit labor costs for 2011–22.
  - For financial and insurance services (K), real labor productivity declined (-1 percent) while nominal unit labor costs increased significantly (3.9 percent).
  - Given the importance of the financial and insurance services for the Luxembourgish economy, efforts should be made to close the unfavorably widening gap between productivity and costs to maintain competitiveness.

*Source: Annex III content provided in the supplied IMF document.*

### Annex IV. Developments/Risks in the Real Estate Sector

### Annex IV. Developments/Risks in the Real Estate Sector

### Housing market developments
- After several years of strong growth, the housing market entered a downwards phase in 2023 driven by rising interest rates and sharply falling demand.
- Number of housing transactions in 2023 declined sharply by about 43 percent, with the most pronounced decline being for new apartments (~68 percent).
- House price dynamics:
  - Between 2018–22, house prices increased, on average, by 10 percent annually, until the first quarter of 2023.
  - In 2023, on average, house prices declined by 10 percent (14½ percent y/y).
  - Declines by dwelling type in 2023: existing dwellings down 12.4 percent; new apartments down 3.6 percent.
- Despite the recent declines, housing prices remain overvalued.

### Construction sector and real activity
- Indicators of construction activity have weakened:
  - Confidence indicators declined since early 2022 (both order-book perceptions and employment outlook).
  - Real Gross Value Added (GVA) in the construction sector fell by 7 percent in 2023.
  - Nominal GVA increased by 3 percent in 2023, widening the gap between real and nominal measures.
- Investment in the construction sector:
  - Overall investment fell by 4.6 percent in 2023.
  - Residential investment declined by 9.4 percent in 2023.
  - Investment in other buildings and civil engineering structures declined by 2.4 percent in 2023.

### Labor market, bankruptcies, and bank asset quality
- Sectoral bankruptcies and job losses:
  - Job losses due to bankruptcies in the construction sector in 2023 totaled close to 1100 people, a 60 percent increase compared to the previous year.
  - The share of the ‘construction of buildings’ sub-sector in the number of bankruptcies has increased.
- Non-performing loans (NPLs):
  - Non-performing loans in the construction and real estate sector increased by 4.3 percentage points from end-2022 to reach 6.1 percent.

### Macroeconomic context and assessment
- The construction slowdown should be seen in the context of the euro area economic slowdown and long-run sharp house price increases that have raised affordability concerns.
- The decline in prices is characterized as warranted to facilitate housing affordability, but attention is required to ensure minimal disruptions given structural supply-demand imbalances.

### Government response: measures and assessment
- The government declared a ‘state of crisis’ and introduced a mix of temporary and structural measures aimed at stimulating demand and mitigating downstream disruptions.
- Assessment of measures:
  - Time-limited (2024) demand-side measures could limit the price adjustment needed for affordability and may be inefficient, shifting the burden to the public sector and creating expectations for future public support (moral hazard).
  - Structural supply-side support is welcome; more cost-efficient supply measures (for example ordering new dwellings on government land) would be preferable.

### Key government support measures (as presented)
- Tax Measures Limited to 2024 (January 1–December 31, 2024)
  - Increase in the “Bëllegen Akt” tax credit for principal residence from €30,000 to €40,000.
  - Introduction of a new “Bëllegen Akt” tax credit of €20,000 per individual for investment in rental housing.
  - Increased exemption of the mortgage interest deductible by one-third.
  - Introduction of a 25 percent exemption on premiums paid by employers for rental accommodation for young employees.
  - Other time-limited tax adjustments (see structural measures for additional permanent tax changes).

- Structural Tax Measures (Not limited in time)
  - Increase of the tax exemption of net income from social rental management from 75 to 90 percent.
  - Extension of capital gains tax exemption for the sale of property to the Housing Fund (Fonds du Logement).
  - Decrease of the tax rate to a quarter of the overall rate for capital gains if the property is held for at least two years.
  - Accelerated depreciation rate of 6 percent for 6 years for investments in rental housing, subject to a maximum annual cap of €250,000.
  - Fiscal neutralization of capital gains transferred in housing used for social rental management or belonging to energy performance class A+.

- Other Support Measures — For individuals
  - Adjustment of the income limits for obtaining individual aid to reflect changes in the standard of living.
  - Extension and reinforcement of the VEFA (vente en l’état futur d'achèvement) project acquisition program (allocation of €480 million to buy new dwellings between 2024–27).
  - Increase in income limits for eligibility of home-ownership grants (and by extension savings grants).
  - The Special Fund for Affordable Housing will invest over €900 million in the creation of affordable housing between 2024–26.
  - Adjustment of the maximum amount of the rent subsidy for households with dependent children.
  - Increase the income limit eligible for an interest subsidy and increase in the maximum rate of interest subsidy from 2.45 to 3.5 percent.
  - Adjusting the conditions for a state guarantee for obtaining a mortgage.
  - Temporary increase in eligibility ceilings for affordable housing sales provided by public developers.

- Other Support Measures — For the construction sector
  - Extension and reinforcement of the VEFA program (allocation of €480 million to buy new dwellings between 2024–27).
  - The Special Fund for Affordable Housing investing over €900 million between 2024–26 (see above).
  - Measures to support financing and demand for new construction (detailed tax and subsidy measures listed above).

### Policy implications and recommendations highlighted
- Avoid over-reliance on time-limited demand-support measures that could impede necessary price adjustments and create moral hazard.
- Favor cost-efficient supply-side interventions (for example, ordering new dwellings on government land) to address structural supply constraints and improve affordability with lower fiscal cost.
- Ensure that adjustments in the sector cause minimal disruptions while addressing structural supply-demand imbalances.

*Source: Annex IV. Developments/Risks in the Real Estate Sector (content unit: 1luxea2024001).*

### Annex VI. Data Issues

### Annex VI. Data Issues

### Fund Relations and Membership
- Membership Status: Joined December 27, 1945; Article VIII.
- Quota: 1,321.80 SDR million 100.00 percent of quota.
- Fund holding of currency: 965.03 SDR million 73.01 percent of quota.
- Reserve Tranche Position: 356.83 SDR million 27.00 percent of quota.
- Net cumulative allocation (SDR Department): 1,513.51 SDR million 100.00 percent of allocation.
- Holdings (SDR Department): 1,567.84 SDR million 103.59 percent of allocation.
- Outstanding Purchases and Loans: None.
- Latest Financial Arrangements: None.
- Projected Payments to Fund (SDR Million); based on existing use of resources and present holdings of SDRs:
  - Forthcoming Principal: 2024 0.02, 2025 0.02, 2026 0.02, 2027 0.02, 2028 0.02.
  - Forthcoming Charges/Interest: 2024 0.02, 2025 0.02, 2026 0.02, 2027 0.02, 2028 0.02.
- Exchange Rate Arrangement: The exchange rate arrangement of the euro area is free floating. Luxembourg participates in a currency union (EMU) with 19 other members of the EU and has no separate legal tender.
- Last Article IV Consultation: The last Article IV consultation was concluded on May 17, 2023. Luxembourg is on the standard 12-month consultation cycle.
- FSAP Participation and ROSC: The Financial System Stability Assessment (FSSA) for the last mandatory FSA was discussed by the Board on May 05, 2017.
- AML/CFT: In September 2023, the Financial Action Task Force (FATF) recognized the quality of the existing AML/CFT framework of Luxembourg and placed it under regular monitoring.

### Authorities’ Statement — Overview and Fiscal Context
- Authorities acknowledge staff appraisal and will consider policy advice while offering nuanced perspectives.
- Luxembourg implemented cost-of-living measures in 2022 that helped keep inflation in check:
  - Domestic inflation: +3.7 percent in Luxembourg vs. +5.4 percent in the euro area in 2023.
  - Fiscal cost of measures: approx. 4 percent of GDP until end-2024.
- Government (in office since November 2023) priorities:
  - Attract investment and boost the economy via growth-friendly policies and responsible fiscal management.
  - Increase households’ purchasing power and companies’ competitiveness.
  - Relaunch construction activity and facilitate housing access via a comprehensive policy package.
  - Maintain sustained high investments in the twin transition.
  - Preserve the AAA credit rating as an overarching objective.
  - Use efficient public spending and strengthened budgetary governance to rebuild fiscal buffers and consolidate public finances in the medium-term.

### Macroeconomic Outlook and Risks
- 2023 growth: -1.1 percent (slowdown driven by slump in financial sector performance and sluggish construction sector).
- 2024 outlook:
  - Progressive recovery expected in 2024.
  - Domestic inflation expected to lower in 2024: 2.2 percent (according to STATEC).
- Labor market: unemployment rate hovering around 5.5 percent in the medium-term.
- Key downside risks:
  - Heightened geoeconomic fragmentation and new supply-chain disruptions could slow global recovery and raise inflation pressures.
  - If central banks keep higher interest rates for longer, risks include weaker external demand, slower credit growth and lower investment.
- Upside factors:
  - Authorities cite potential for the financial sector to recover strongly and bolster the economy.
  - Government measures could unlock elevated pandemic-related savings; confidence indicator reached its highest level in a year in April 2024.

### Fiscal Policy Measures and Framework
- Policy objectives:
  - Stimulate investment and demand by alleviating fiscal burden on companies and households.
  - Adjust income tax brackets to neutralize effects of the last four automatic wage indexations caused by record-high inflation; additional adjustments and targeted tax relief planned.
  - Avoid harsh phase-out of energy support measures.
  - Establish a lower nominal corporate income tax (CIT) and support for exchange-traded funds (ETF) to boost competitiveness.
- Housing and construction:
  - Fiscal incentives enacted to invest in housing: tax credits and accelerated depreciation rate for investments in rental housing.
  - Public investment to promote green and digital transitions will be maintained at around 4 percent of GDP.
- Fiscal governance:
  - Introduction of a national medium-term budgetary objective (MTO) as a guidepost to curtail current expenditure and better target social spending.
  - Authorities expect recovery-driven revenue momentum and intend to leverage digitalization to increase tax administrations’ revenue mobilization.

### Financial Sector Assessment and Resilience
- Staff and authorities agree financial sector is resilient due to high capital and liquidity buffers.
- FSAP stress tests:
  - Even under extreme scenarios combining multiple sources of disruptions, share of weak banks remains small and potential recapitalization needs are easily manageable.
  - Investment funds can absorb significant shocks and, in stress tests, have enough liquidity to manage redemptions of up to 40 percent.
- High interest rate environment benefits banks’ profitability and partially offsets NPL risk; overall number of NPLs remains low.
- Supervisory improvements since 2017:
  - More resources and more stringent data collection and reporting requirements improved supervisory effectiveness.
  - Authorities’ response to 2023 market turmoil was quick and efficient.
- Real estate and household risks:
  - Risks from real estate sector vulnerabilities are contained.
  - Increase in NPLs partly reflects conservative forward-looking provisioning.
  - Households’ indebtedness is counterbalanced by high income and wealth levels and a high proportion of fixed loans.
  - Authorities view interest rate stress tests as a suitable substitute for non-targeted income-based measures.

### Structural Policies and Productivity
- Construction sector shock:
  - Rising interest rates caused significant drop in construction activity; high construction costs and a decrease in transactions of apartments under construction led some companies into financial difficulties.
  - Government measures and substantial public investment into new dwellings aim to mitigate social impact.
- Green transition and sustainable finance:
  - Authorities reaffirm commitment to the green transition through high public investments.
  - Focus on construction of an integrated multimodal mobility network.
  - Luxembourg’s role in sustainable finance: pioneering a green exchange and sustainability bond framework; leading listing center for sustainable bonds.
- Labor productivity:
  - Luxembourg’s labor productivity growth has been below peers since the GFC.
  - Authorities will focus on re- and upskilling the workforce, especially in digitalization, language learning, and R&D.

*Source: Annex VI. Data Issues — Staff Report for the 2024 Article IV Consultation (Luxembourg) — Prepared by European Department; as of April 22, 2024 / May 13, 2024.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2024/english/1luxea2024001.pdf_