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### Impact of External Headwinds — Context, recent developments, and outlook
- Fundamentals and headwinds
  - Luxembourg’s fundamentals remain strong; public debt is low and ample—albeit declining—fiscal space.
  - Headwinds: ECB monetary policy tightening; cost-of-living shock; high private sector indebtedness; past house price overvaluation and real estate correction; automatic wage indexation raising labor costs faster than peers; declining productivity; demand-focused fiscal policies less effective in creating momentum.
- Growth and demand
  - GDP: contracted by 0.7 percent in 2023 and turned positive at 1 percent in 2024.
  - Private consumption: remained lackluster.
  - Investment: declined notably amid subdued real estate activity.
- Labor market
  - Employment growth decelerated despite robust public sector employment growth; number of hours worked declined; vacancies returned to pre-COVID levels.
  - Unemployment: increased for the second consecutive year.
- Inflation and prices
  - Headline inflation: 2.1 percent in 2024 (down from 3.7 percent a year ago).
  - GDP deflator: +5.2 percent in 2024 (reflecting improved nominal profit margins in the financial sector).
  - Disinflation continued in the first three months of 2025 despite an electricity price adjustment in January.
- Fiscal position (high-level)
  - Fiscal balance: surplus of 1 percent of GDP in 2024, boosted by one-off revenues.
  - Structural surplus: fell from 1.8 percent in 2023 to 0.8 percent of GDP in 2024.
  - Public debt: estimated at 26.3 percent of GDP at end-2024.
- Discretionary measures (totals as reported)
  - Total (millions of euros): 1,209 (2023), 1,608 (2024), 1,429 (2025), 1,288 (2026), 1,291 (2027), 1,205 (2028).
  - Total (%GDP): 1.5 (2023), 1.9 (2024), 1.6 (2025), 1.4 (2026), 1.3 (2027), 1.2 (2028).
  - Permanent measures (%GDP): 0.1 (2023), 0.8 (2024), 1.4 (2025), 1.4 (2026), 1.3 (2027), 1.2 (2028).
  - Temporary measures (%GDP): 1.4 (2023), 1.1 (2024), 0.2 (2025) [table truncated for later years].

### Financial cycle and real estate dynamics
- Credit and lending
  - Credit to the nonfinancial resident private sector: -4¾ percent y/y at end-2024.
  - Loans to corporates: fell by 13.1 percent.
  - New mortgages: bounced back in 2024H2 as borrowing costs eased.
- Real estate
  - Residential real estate prices: stabilized after correction; some segments increased.
  - Transactions on existing homes: returned to pre-crisis levels; new housing activity subdued due to developer bankruptcies, delays, and cost overruns.
  - Building permits: plummeted as large developers paused and smaller developers faced financing constraints.
  - Commercial real estate: activity remained weak, hindering price discovery.

### Financial sector resilience and vulnerabilities
- Banks
  - NPL ratio: continued to rise but remains at manageable levels; increase concentrated in domestic banks and driven mainly by the non-financial corporate sector (SMEs and real estate companies).
  - Capital and liquidity: strong buffers maintained.
  - Profitability: heterogeneous across business models but still exceeds pre-COVID averages.
- Investment funds
  - Net assets: grew by 10 percent in 2024.
- Systemic indicators (selected)
  - Regulatory capital to risk-weighted assets (All Banks, 2017–2024 series): 25.9 24.8 22.6 24.8 23.9 23.0 24.0 23.0.
  - Return on assets (All Banks, 2017–2024 series): 0.7 0.6 0.5 0.5 0.6 0.6 1.1 1.2.
  - Nonperforming loans to total gross loans (All Banks, 2017–2024 series): 0.8 0.9 0.7 1.0 1.3 1.6 1.9 2.3.
  - Household debt to GDP (All Banks, 2017–2024 series): 59.5 59.8 64.3 69.7 71.0 72.0 72.0 72.0.

### External position and assessment
- Current account and NIIP
  - Current account surplus: improved to 13.8 percent of GDP in 2024 (from 11.2 percent in 2023).
  - Drivers in 2024: trade balance (+1.3 percent of GDP), net remittances (+0.6 percent of GDP), current transfers (+0.7 percent of GDP).
  - NIIP and external stocks (2024, % GDP): NIIP: 37.6; Gross Assets: 14917.7; Debt Assets: 3346; Gross Liabilities: 14880.1; Debt Liabilities: 1111.6.
- EBA-lite assessment (selected)
  - EBA-lite CA norm (adjusted): 3.6 (percent of GDP).
  - CA-Actual (adjusted): 13.6 (percent of GDP).
  - CA Gap: 10.0 (percent of GDP).
  - Relative policy gap: 3.2 (percent of GDP).
  - Staff-assessed REER gap: -7.2 (in percent) (undervaluation).
  - REER index model gap: -7.0 (in percent) (undervaluation, with a policy gap of 2.3 percent).
- Caveats: EBA-lite partially captures Luxembourg’s financial-hub features; BOP and national accounts inconsistencies may lead to future revisions.

### Outlook, scenarios, and risks
- Baseline projections
  - Growth: projected to increase to 1.6 percent in 2025 and accelerate in 2026–27.
  - Inflation: average inflation expected to decline to about 2 percent in 2025 and stay at that level.
  - Output gap: projected to close by 2030.
  - Current account: expected to narrow as domestic demand increases faster than external demand.
- Illustrative external shock (April 2025 WEO Box 1.1, Scenario A)
  - Combined effect: decrease in Luxembourg’s growth by about 1 percentage point in 2025 and 2026 relative to the baseline.
  - Fiscal impact: allowing automatic stabilizers while maintaining recommended fiscal structural effort projected to lead to a deficit increase of about 0.5 percent of GDP in 2025–26 annually before gradually improving.
  - Debt impact: modest increase in public debt around 3 percent of GDP by 2030.
- Key downside risks
  - Weaker external demand; tighter/volatile financial conditions from trade policy uncertainty and geopolitical tensions; potential higher-for-longer interest rates.
  - Domestic risks: confidence not returning to new housing market; supply capacity constraints; competitiveness challenges; possible macro-financial feedback loop from higher NPLs to credit supply.

---

### Fiscal outlook, projections, and vulnerabilities
- Baseline and staff projections
  - Defense spending: baseline assumes increase by 0.5 percent of GDP (0.7 percent of GNI) to reach the 2 percent of GNI target in 2026 (instead of 2030).
  - Medium-term spending pressures: projected increase of 2.1 percent of GDP from aging, climate and digital transitions, and higher interest payments.
  - Drivers of recent revenue gains: banks’ profitability and higher labor income share expected to wane; tax buoyancy revert to historical averages from 2025 onward.
  - Staff projections: structural deficit of 0.7 percent of GDP in 2025; structural deficit widening to over 2 percent of GDP in the medium term.
  - Debt trajectory: debt would remain below 30 percent of GDP by 2030 but on an upward path.
- Revenue risk scenarios (aggregate impact)
  - Aggregate impact of risks equals a revenue loss of 3 percent of GDP in 2030.
  - Scenario 1 — PIT: labor income share around 50 percent in 2024; if labor income share drops to historical average of 48 percent → 0.8 percent of GDP decline in annual PIT revenue in 2030.
  - Scenario 2 — CIT: 0.8 percent of taxpayers contribute 75 percent of revenue; idiosyncratic adverse shocks and financial sector profitability returning close to pre-COVID levels could reduce annual CIT revenues by 1.1 percent of GDP in 2030.
  - Scenario 3 — Excises: excise on petroleum products declined by about 2 percent of GDP since peak in 2005; stood at 0.8 percent of GDP at end-2024; if excise taxes converged to average OECD level, revenues would drop by 1 percent of GDP.
- Fiscal metrics (2020–2030 series selected)
  - General government revenues (percent of GDP): 43.9 43.4 44.5 46.2 47.9 47.4 47.6 47.6 47.7 47.9 48.2.
  - General government expenditures (percent of GDP): 47.0 42.4 44.3 47.0 46.9 48.3 49.0 49.0 49.7 50.0 50.3.
  - General government balance (percent of GDP): -3.1 1.0 0.2 -0.8 1.0 -0.8 -1.3 -1.4 -1.9 -2.0 -2.1.
  - General government gross debt (percent of GDP): 24.5 24.2 24.9 25.0 26.3 26.7 27.6 28.0 28.6 29.2 29.5.

### Fiscal policy recommendations (short- and medium-term)
- 2025 stance and short term
  - A less expansionary fiscal stance would have been preferable in 2025; structural balance expected to weaken and turn into a deficit of 0.7 percent of GDP in 2025.
  - Review effectiveness and fiscal cost of support measures (e.g., energy subsidies; increase in mortgage deductibility).
  - Preserve savings from under-executed spending or higher-than-expected revenues to lower the fiscal impulse.
  - In a sharp downturn: allow automatic stabilizers and supplement with temporary, targeted discretionary measures for vulnerable groups.
- Medium term and MTFSP support with caveats
  - MTFSP assumes robust revenue growth (plus 1.4 percent of GDP in 3 years) and increase in expenditure (plus 1.2 percent of GDP).
  - Using staff revenue projection, debt would stabilize in the medium term provided a cumulative fiscal effort of 0.2 percent of GDP.
  - Any revenue overperformance beyond staff’s projections should be saved.
  - Expenditure trajectory implies a 0.3 percent of GDP medium-term reduction in current expenditure excluding social security spending and interest payments.
  - Further defense spending increases could be accommodated short term, but compensatory medium-term measures should be considered.
- Measures to underpin expenditure path and improve equity
  - Contain wage bill growth, including possibly slowing rapid increase in public sector employment.
  - Rationalize other current expenditures while mindful of rise in population at-risk-of-poverty, especially for the young.
  - Consider further means-testing for social benefits (e.g., family benefits); greater efficiency in health and education spending.
  - Regular spending reviews, improved cost-benefit analyses, and better targeting rather than universal support.
- Tax, pension, and fiscal framework reforms
  - Tax: diversify tax base; options include higher property taxation (e.g., land mobilization tax), environmental taxes; implement planned individual tax reform in a budget-neutral manner; more frequent and budget-neutral adjustments of PIT brackets.
  - Pension: pension expenditure projected to grow significantly and exceed contribution income next year; pension reserves expected to be depleted by 2045; recommended: disincentivize early retirement, increase retirement age, reduce pension generosity, consider increasing contribution rates.
  - Fiscal rules and governance: support for a national fiscal rule combining a Luxembourg-specific debt anchor with an operational rule; make rule legally binding and include coverage and escape clauses; strengthen role of fiscal council.

---

### Financial stability: vulnerabilities, stress tests, and policy tools
- System-wide stress tests and buffers
  - CSSF stress test: system generally adequately capitalized and liquid but vulnerabilities in some banks under adverse scenarios.
  - Weighted average CET1 by asset size would remain at 19–20 percent under adverse scenarios after capital depletion of 6.1–6.9 percentage points.
  - Under SSM adverse: five banks representing 7.7 percent of total banking assets would fall under their total CET1 capital requirement.
  - Under CSSF adverse: eight banks representing 10.4 percent of banks assets would fall under their total CET1 capital requirement.
  - Integrating solvency-liquidity interactions: additional capital depletion due to liquidity stress estimated at 2.4 percentage points (SSM scenario) and 1.2 percentage points (CSSF scenario).
- Investment funds and liquidity
  - Liquidity indicators improved overall; share of cash in high-quality liquid assets has somewhat declined.
  - CSSF liquidity stress test: under a 20 percent redemption shock, only 4 percent of bond funds would need more than 5 days to liquidate assets.
  - Larger high-yield bond funds are less liquid; money market funds’ sensitivities to interest rates increased in 2023.
- Interconnectedness and exposures
  - Banks’ liabilities exposures to funds: about 17 percent (declined in recent years).
  - Exposures concentrated in custodian banks with limited connections to other banks, reducing potential contagion.
- Prudential and macroprudential recommendations
  - Microprudential: ensure sufficient loss absorption via proactive provisioning; conservative profit distribution; scrutiny of credit risk management and collateral valuation; implement law of July 2024 on transfer of non-performing loans.
  - Macroprudential capital-based measures: current CCyB described as "broadly appropriate"; maintain releasable buffers; consider sectoral systemic risk buffers or gradual CCyB increases if credit cycle turns decisively; relaxation of CCyB could be considered if downside risks materialize.
  - Household measures: do not renew loosening of LTV limit expiring in June 2025; introduce income-based measures early in recovery (staff suggest DSTI of 45–50 percent with a speed limit adjustable over the cycle); CSSF guidance alternative: residual income after stress should be 50–55 percent.
  - Housing support: increase investment in social housing to mitigate adverse impact on low-income households.
  - Investment funds: strengthen MMF framework via anti-dilution liquidity management tools (LMTs) and decouple regulatory thresholds from mandatory suspension/gates/redemption fees.

### Operational resilience and AML/CFT
- Operational risks: increase in cyber-attacks and AI use heighten operational risks; reference to a "CrowdStrike incident".
- Digital resilience: welcome implementation of Digital Operational Resilience Act effective January 2025; continue improving readiness.
- AML/CFT: continue efforts to enhance understanding of ML/TF risks; update national risk assessment; obtain more cross-border ML/TF threat information; ensure sanctions sustain compliance.

---

### Structural reforms and supply-side priorities
- Productivity and technology adoption
  - Luxembourg’s productivity growth has lagged peers; gross domestic expenditure on R&D as a share of GDP among the lowest in the OECD.
  - Adoption of digital technologies including cloud computing, big data, and AI behind EU peers.
  - Recommendations: promote investment in intangible assets; provide tax credits to R&D; facilitate innovation diffusion; expand indirect financing to R&D.
- Labor market reforms
  - Findings: real wage rigidity from automatic wage indexation; low job-to-job transition; large public-private wage premium.
  - Recommendations: reform automatic wage indexation; continue collective bargaining reforms; reduce public-private wage premium; widen labor market participation (facilitate third-country national access; reduce incentives for early retirement; financial incentives for hiring/retaining seniors); reduce gender gap (work flexibility; switch to individual taxation); upskill and reskill workforce; expand vocational training.
- Housing and cross-border infrastructure
  - Housing affordability: temporary demand-support measures should be gradually withdrawn; help-to-buy policies better targeted; streamline building permits; increase productivity in construction; implement planned land tax reform carefully; use housing stock more efficiently (vacant property tax; tackle under-occupation; repurpose commercial real estate).
  - Cross-border infrastructure: improve transportation infrastructure and decentralize activity to border areas to ease congestion.
- Authorities’ actions and concurrence
  - Authorities broadly concurred with staff recommendations; priorities include simplifying regulation (building permits, once-only principle), enhancing technological diffusion (digital support program for SMEs), and expanding free online training.

---

### Risks, Annex highlights, and data issues
- Annex III — Risk Assessment Matrix (selected)
  - Trade policy and investment shocks: Relative Likelihood: High; Impact if Realized: High/Medium.
  - Sovereign debt distress: Relative Likelihood: High; Impact if Realized: Low for banks’ exposures; Medium for global asset managers.
  - Tighter financial conditions and systemic instability: Relative Likelihood: Medium; Impact if Realized: High.
  - Regional conflicts and commodity price volatility: Relative Likelihood: Medium; Impact if Realized: Low/Medium to Medium.
  - Cyberthreats: Relative Likelihood: High; Impact if Realized: Low/Medium.
  - Luxembourg-specific: slower-than-expected recovery in real estate: Relative Likelihood: Medium; Impact if Realized: Medium.
- Annex IV excerpts — sovereign stress and pension notes
  - Overall sovereign stress assessment: "Overall...Low".
  - Debt projection: "Debt is projected to stay at 28-29 percent of GDP over the medium-term."
  - Pension system: reserves projected to be depleted by 2045; pension expenditure expected to exceed social contributions by 2026.
  - Debt Fanchart index (DFI): 0.9 — Risk signal: Low.
  - GFN financeability index (GFI): 1.6 — Risk signal: Low.
  - Final assessment metrics: "Prob. of missed crisis, 2025-2030, if stress not predicted: 0.0 pct. Prob. of false alarms, 2025-2030, if stress predicted: 87.5 pct."
- Data adequacy and issues (Annex V)
  - Overall assessment: "The data provided to the Fund is adequate for surveillance."
  - Key caveats: National accounts and BOP data subject to large revisions and inter-sectoral inconsistencies; fiscal revenue granularity needed to disentangle one-off, cyclical and structural developments.
  - Data adequacy assessment ratings (selected): Median Rating: AAAABBA; Data Adequacy Assessment Rating 1/: A.
  - Suggested improvements: move fully to accrual accounting for fiscal stats; include identification of special purpose entities in corporate micro data for monetary and financial statistics.
  - Use of alternative data: staff used private sector estimates (Cushman and Wakefield) in absence of CRE price index.

---

### Concise policy checklist (from staff guidance and recommendations)
- Macroeconomic management
  - Adopt prudent and agile macroeconomic management to navigate external headwinds and financial volatility.
  - In 2025, prefer a less expansionary fiscal stance; review and target support measures; save any revenue overperformance.
- Fiscal framework and public finances
  - Support national fiscal rule combining a Luxembourg-specific debt anchor with operational rule (e.g., multi-year expenditure ceilings); make it legally binding with escape clauses.
  - Strengthen fiscal council capacities for macro fiscal projections, risk assessment, and debt sustainability analysis.
  - Frontload pension reforms: reduce generosity, increase retirement age, consider calibrated increases in contribution rates.
- Financial stability and macroprudential policy
  - Maintain adequate loss absorption and provisioning; implement transfer-of-NPLs framework.
  - Keep CCyB at broadly appropriate level while maintaining releasable buffers; consider sectoral systemic buffers if needed.
  - Activate income-based borrower measures early in recovery (DSTI 45–50 percent suggested) and not renew temporary 100 percent LTV arrangements beyond June 2025.
  - Strengthen investment fund liquidity tools and MMF framework; enhance data collection on OFIs and interconnectedness.
- Structural reforms
  - Increase labor market flexibility (reform wage indexation); boost productivity via R&D, digital adoption, competition in professional services; address housing supply bottlenecks and cross-border infrastructure.
- Resilience and operational risk
  - Continue strengthening cyber resilience and operational readiness under the Digital Operational Resilience Act.
  - Enhance AML/CFT cross-border information sharing and supervision.

*Source: IMF staff report — chapter "1. Impact of External Headwinds" and accompanying chapters, annexes, and boxes in the provided content unit.*

### 1. Impact of External Headwinds _________________________________________________________________ 13

### 1. Impact of External Headwinds

### Context: structural strengths and drag factors
- Luxembourg’s fundamentals remain strong, but economic performance in recent years has been lackluster.
- Public debt is low and Luxembourg has ample—albeit declining—fiscal space.
- The large financial sector has weathered recent shocks well; the 2024 FSAP found it sound and well-diversified.
- Headwinds and structural constraints:
  - ECB monetary policy tightening and the cost-of-living shock precipitated a cyclical downturn.
  - High private sector indebtedness and past house price overvaluation caused a substantial—though orderly—correction in the real estate market and depressed confidence in construction.
  - Automatic wage indexation raised labor costs faster than in peer countries.
  - Productivity has been declining, potentially reducing competitiveness.
  - Demand-focused fiscal policies smoothed shocks but were less effective in creating momentum.

### Recent developments and outlook — A fragile and uneven recovery
- Growth and demand
  - GDP contracted by 0.7 percent in 2023 and turned positive at 1 percent in 2024, mainly driven by public consumption and a rebound in net exports.
  - Private consumption remained lackluster, weighed down by high real interest rates, uncertainty, and structural factors (e.g., remote work).
  - Investment declined notably amid subdued real estate activity.
- Labor market
  - Labor market has softened after declining productivity and an increase in unit labor costs.
  - Despite robust public sector employment growth, overall employment growth decelerated; the number of hours worked declined; vacancies returned to pre-COVID levels.
  - Unemployment increased for the second consecutive year.
- Inflation and prices
  - Headline inflation declined to 2.1 percent in 2024, down from 3.7 percent a year ago; service prices remain the main driver.
  - GDP deflator grew by +5.2 percent in 2024, reflecting improved nominal profit margins in the financial sector.
  - Disinflation continued in the first three months of 2025 despite an electricity price adjustment in January.
- Fiscal developments
  - Fiscal balance improved to a surplus of 1 percent of GDP in 2024, boosted by one-off revenues.
  - Corporate income tax (CIT) revenues rose sharply (+41 percent year-on-year) driven by receipts related to previous years and large one-off payments.
  - Public wage bill was lower than budgeted as lower-than-expected inflation did not trigger automatic wage indexation.
  - Part of revenue overperformance financed higher current spending, a “retroactive” adjustment of the PIT, and extensions of discretionary support measures.
  - Structural surplus fell from 1.8 percent in 2023 to 0.8 percent of GDP in 2024.
  - Public debt estimated at 26.3 percent of GDP at end-2024.
- Discretionary measures in place (Table 1, totals, as reported)
  - Total (millions of euros): 1,209 (2023), 1,608 (2024), 1,429 (2025), 1,288 (2026), 1,291 (2027), 1,205 (2028).
  - Total (%GDP): 1.5 (2023), 1.9 (2024), 1.6 (2025), 1.4 (2026), 1.3 (2027), 1.2 (2028).
  - of which: permanent measures: 0.1 (2023), 0.8 (2024), 1.4 (2025), 1.4 (2026), 1.3 (2027), 1.2 (2028).
  - of which: temporary measures: 1.4 (2023), 1.1 (2024), 0.2 (2025) [table truncated for later years].

### Financial cycle and real estate dynamics
- Credit and lending
  - Credit to the nonfinancial resident private sector continued to drop: -4¾ percent y/y at end-2024.
  - Loans to corporates fell by 13.1 percent, amid tight financing conditions, higher capital requirements, lower asset quality, and larger risk perception.
  - Signs suggest easing monetary policy is gradually lowering borrowing costs and improving loan demand; new mortgages bounced back in 2024H2.
- Real estate market
  - Residential real estate (RRE) prices stabilized after correction from an overheated position; some segments even increased.
  - Transactions on existing homes returned to pre-crisis levels, but new housing activity remained subdued due to developer bankruptcies, delays, and cost overruns.
  - Building permits plummeted as large developers paused and smaller developers faced financing constraints.
  - Commercial real estate (CRE) activity remained weak, hindering price discovery.

### Financial sector resilience and vulnerabilities
- Asset quality and profitability
  - The NPL ratio has continued to rise but remains at manageable levels; the increase concentrated in domestic banks and driven mainly by the non-financial corporate sector (SMEs and real estate companies).
  - Banks have maintained strong capital and liquidity buffers.
  - Profitability, while likely past its peak and heterogeneous across business models, still exceeds pre-COVID averages—buoyed by high interest margins, increased fees and commissions, lower operating costs, and a limited increase in cost of risk so far.
- Investment funds
  - Investment funds benefited from favorable market valuations and positive net investments, with net assets growing by 10 percent in 2024.

### External position and assessment
- Current account and NIIP
  - Current account surplus improved to 13.8 percent of GDP in 2024, mainly driven by higher net exports of goods and services and valuation-driven increases in assets managed by investment funds (+8 percent y/y) and increased revenues on foreign direct investment.
  - Net international investment position (NIIP) trends shown in figures (data caveats apply).
- External assessment caveats
  - The EBA-lite model partially captures Luxembourg’s specific economic features (large financial center; large share of commuters), generating large residuals.
  - Data inconsistencies exist between the balance of services in the national accounts and in the BOP, suggesting potential future revisions.
- Gaps (as reported)
  - Current account gap estimated at 10 percent of GDP.
  - Policy gap estimated at 3.2 percent of GDP, reflecting a fiscal stance looser than the country-specific norm but not relative to the average world fiscal stance.

### Outlook, scenarios, and risks
- Global and regional drivers
  - In 2025, uncertainty about trade policy and the geopolitical situation in Europe is expected to weigh on consumer confidence and business sentiment and lead to tighter financial conditions.
  - Beyond 2025, adverse impacts of trade tensions on euro-area growth would be partly offset by Germany’s infrastructure stimulus, higher defense spending in Europe, and lower energy prices.
- Baseline growth and inflation projections
  - Growth projected to increase to 1.6 percent in 2025 and accelerate in 2026–27, supported by fading financial volatility and a gradual recovery in external demand.
  - The output gap is projected to close by 2030.
  - Average inflation expected to decline to about 2 percent in 2025 and stay at that level.
  - The current account surplus is expected to narrow as domestic demand increases faster than external demand; services and income balances projected to deteriorate.
- Transmission and near-term dynamics
  - Direct impact of tariffs small due to low share of goods exports to the US; indirect effects through spillovers from other European countries and export-oriented services are larger.
  - Heightened financial volatility is expected to mute the contribution of net exports.
  - Lower interest rates and improved confidence would help lift household consumption (especially durable goods) and residential investment, albeit from a historically low level.
  - Labor hoarding unwinding and lingering uncertainty would weigh on job creation; unemployment likely to rise in the near term before slowly declining to its historical average.

### Policy guidance (as emphasized in the chapter)
- Near term
  - Prudent and agile macroeconomic management to navigate external headwinds and financial volatility.
  - Address confidence issues in the real estate sector to revive private investment.
- Medium term
  - Make fiscal policies more effective and better anchored in a medium-term perspective to enhance policy predictability.
  - Accelerate and broaden reforms to lift productivity, reduce labor and housing supply constraints, and tackle aging-related challenges to better position Luxembourg for global economic transformation and sustain living standards.

*Source: IMF staff report — chapter "1. Impact of External Headwinds".*

### 13. Under unchanged policies, the structural fiscal balance is projected to deteriorate. The

### 1luxea2025001-print-pdf - 13. Under unchanged policies, the structural fiscal balance is projected to deteriorate. The

### Fiscal outlook and projections
- Baseline assumes an increase in defense spending by 0.5 percent of GDP (0.7 percent of GNI) to reach the 2 percent of GNI target in 2026 (instead of 2030), financed by reprioritization and postponing some projects.
- Pressures from aging, climate and digital transitions and higher interest payments are projected to lead to a spending increase of 2.1 percent of GDP over the medium term.
- Drivers of recent revenue gains (banks’ profitability and a higher labor income share) are expected to wane, with tax buoyancy gradually reverting to historical averages from 2025 onward.
- Staff projections:
  - Structural deficit of 0.7 percent of GDP in 2025.
  - Structural deficit widening to over 2 percent of GDP in the medium term.
  - Debt would remain below 30 percent of GDP by 2030 but on an upward path.

### Short-term downside risks and volatility
- Downside headwinds: weaker external demand; tighter and/or more volatile financial conditions from trade policy uncertainty, geopolitical tensions, and possibly higher interest rates for longer.
- An increase in the VIX would:
  - Affect growth and employment.
  - Expose banks and investment funds to sudden repricing of asset prices and risk premia.
- Domestic risks: lack of confidence returning to the new housing market; supply capacity constraints; competitiveness challenges; potential macro-financial feedback loop from higher NPLs to credit supply.

### Illustrative external shock (Box 1)
- Under an illustrative sensitivity analysis (based on the April 2025 WEO Box 1.1, Scenario A):
  - Combined effect would imply a decrease in Luxembourg’s growth by about 1 percentage point in 2025 and 2026 relative to the baseline.
  - Allowing automatic stabilizers while maintaining recommended fiscal structural effort is projected to lead to a deficit increase of about 0.5 percent of GDP in 2025–26 annually before gradually improving.
  - Resulting modest increase in public debt is around 3 percent of GDP by 2030 and could be accommodated given ample fiscal space and low debt.

### Medium-term risks and fiscal vulnerabilities
- Growth risks: persistently elevated policy uncertainty; global economic fragmentation; divergence in financial regulation between the US and Europe.
- Upside growth possibilities: faster domestic structural reforms; progress toward EU capital markets union; productivity gains from AI; reforms on competitiveness, housing affordability, and labor supply.
- Fiscal vulnerabilities:
  - CIT receipts rely on a concentrated base and international companies; financial sector accounts for one third of CIT revenues.
  - Additional fiscal pressures from higher defense and age-related spending.
  - Financial sector could be a source of implicit contingent liabilities.

### Revenue risk scenarios (Box 2)
- Aggregate impact of risks presented equals a revenue loss of 3 percent of GDP in 2030.
- Scenario 1 — PIT:
  - Labor income share around 50 percent in 2024.
  - Assuming labor income share drops to historical average of 48 percent would result in a 0.8 percent of GDP decline in annual PIT revenue in 2030.
- Scenario 2 — CIT:
  - 0.8 percent of taxpayers contribute 75 percent of revenue.
  - Idiosyncratic adverse shocks and financial sector profitability returning close to pre-COVID levels could reduce annual CIT revenues by 1.1 percent of GDP in 2030.
- Scenario 3 — Excises:
  - Excise on petroleum products declined by about 2 percent of GDP since peak in 2005; stood at 0.8 percent of GDP at end-2024.
  - If excise taxes converged to the average OECD level, revenues would drop by 1 percent of GDP.

### Fiscal policy recommendations
- 2025 stance:
  - A less expansionary fiscal stance would have been preferable in 2025; structural balance expected to weaken and turn into a deficit of 0.7 percent of GDP in 2025.
  - Review effectiveness and fiscal cost of some support measures (e.g., energy subsidies; increase in mortgage deductibility).
  - Preserve savings from under-executed spending or higher-than-expected revenues to lower the fiscal impulse.
  - In a sharp downturn, allow automatic stabilizers to work and supplement with temporary, targeted discretionary measures for vulnerable groups.
- Support for authorities’ MTFSP with caveats:
  - MTFSP assumes robust revenue growth (plus 1.4 percent of GDP in 3 years) and increase in expenditure (plus 1.2 percent of GDP).
  - Using staff revenue projection, debt would stabilize in the medium term provided a cumulative fiscal effort of 0.2 percent of GDP.
  - Any revenue overperformance beyond staff’s projections should be saved.
  - Expenditure trajectory implies a 0.3 percent of GDP medium-term reduction in current expenditure excluding social security spending and interest payments.
  - Further defense spending increases could be accommodated short term, but compensatory medium-term measures should be considered.

### Measures to underpin expenditure path and improve equity
- Contain wage bill growth, including possibly slowing rapid increase in public sector employment.
- Rationalize other current expenditures while being mindful of rise in population at-risk-of-poverty, especially for the young.
- Consider further means-testing for social benefits (e.g., family benefits), greater efficiency in health and education spending.
- Regular spending reviews, improved cost-benefit analyses, and better targeting rather than universal support.

### Tax, pension, and fiscal framework reforms
- Tax reforms to reduce revenue uncertainty:
  - Diversify tax base and improve tax-benefit system to raise revenue and enhance fairness.
  - Options: higher property taxation (e.g., land mobilization tax), environmental taxes.
  - Implement planned individual tax reform in a budget-neutral manner and comprehensively review tax credit and benefits systems to enhance equity and boost labor supply.
  - More frequent and budget-neutral adjustments of PIT brackets to reduce procyclicality and revenue uncertainty.
  - Reduce delays in collecting corporate income taxes and improve estimates of VAT refunds.
- Pension reforms:
  - Pension expenditure projected to grow significantly and exceed contribution income next year under current policies; pension reserves expected to be depleted by 2045 amid rising old-age dependency ratio.
  - Recommended: disincentivize early retirement, increase retirement age, reduce pension generosity, consider increasing contribution rates (weighing labor market impacts).
  - Early enactment would allow gradual implementation and improve intergenerational equity.
- Fiscal rules and governance:
  - Support for a national fiscal rule combining a Luxembourg-specific debt anchor with an operational rule (e.g., fiscal balances, multi-year expenditure ceilings, or an expenditure rule).
  - Debt anchor could be calibrated with a safety margin to minimize likelihood of exceeding the 60 percent of GDP EU threshold.
  - Operational rule should provide flexibility to manage shocks (exclude automatic stabilizers) and accommodate public investment needs; make rule legally binding and include coverage and escape clauses.
  - Strengthen role of fiscal council for macro fiscal projections, risk assessment, and debt sustainability analysis.

### Budgeting and fiscal risk management
- Improve fiscal reporting and quality of government finance statistics.
- Disentangle one-off and cyclical tax drivers from structural ones given large delays in tax collection.
- Develop a fiscal risk framework prioritizing revenue risks, aging- and climate-related challenges, and contingent liabilities.
- Strengthen macroprudential framework and continue addressing housing market, household indebtedness, and pockets of vulnerabilities in banks and nonbanks.

*Source: 1luxea2025001-print-pdf*

### 24. The authorities reiterated their commitment to fiscal discipline, while stressing

### 24. The authorities reiterated their commitment to fiscal discipline, while stressing political and social stability as key pillars of Luxembourg's economic model

### Fiscal position and reforms
- Authorities committed to maintaining a prudent fiscal stance amid growing spending pressures and revenue uncertainty.
- Supporting measures noted: tax credits, reduction in CIT rate, and reduction in subscription tax — described as measures that "could boost demand, maintain attractiveness and limit potential revenue losses."
- Authorities exploring ways to contain expenditure growth and improve spending efficiency, including "increase of local content of defense spending," while keeping social expenditure intact.
- Commitment to gradual fiscal reforms to ensure long-term sustainability.
- Considering adoption of a national expenditure rule, given its "relative simplicity and flexibility of implementation," but modalities not yet decided.
- Authorities concurred with the need for pension reforms and emphasized broad consultations of stakeholders on possible reform measures.

### Financial sector: cyclical and structural risks
- Cyclical domestic systemic risks described as "moderate, as at the time of the last Article IV."
- Credit cycle:
  - Indications of a slow entry into an expansionary phase, contingent on smooth transmission of monetary policy easing.
  - Risk of excessive risk-taking if there is a significant drop in interest rates; risk of hampered transmission if risk premia reprice or credit supply tightens.
- Real estate cycle:
  - Imbalances remain between house prices and fundamentals, especially for newly built properties.
  - BCL estimate: house price-at-risk in 2025Q4 at 16 percent, down from 22 percent a year earlier.
  - Risk of a disorderly correction in house prices unless confidence in real estate developers is restored.
  - Commercial real estate (CRE) prices appear stabilized; rents held up amid relatively low vacancy rates, but structural challenges (telework, e-commerce, green transition) and anticipated delivery of new projects could raise vacancy rates and weigh on yields.
- Global financial market volatility risks:
  - Rising trade tensions could cause abrupt repricing of assets, including CRE, tighter financial conditions, and higher corporate risk premia.
  - Open-ended funds exposed to large net redemptions and procyclical fire sales of illiquid assets under abrupt changes in risk appetite.
  - Drop in asset prices has historically impaired profits for private banks.

### Increased credit risk and sectoral vulnerabilities
- Corporates:
  - Debt service to EBIT ratio rose significantly since the start of monetary policy tightening, "exceeding 52 percent for the median firm at end-2024."
  - Resulted in liquidity pressures, higher NPLs, and increased bankruptcies in 2024.
  - Recent deleveraging and lower interest rates may soften pressures, but peak NPLs "may not yet have been reached."
  - Sectoral concerns: low interest coverage ratio, low profitability, high refinancing risks (50 percent within one year), and large domestic banks exposures — real estate sector warrants close monitoring.
  - Increasing share of NFCs debt vis-à-vis nonbanks is a concern.
- Households:
  - Recent decline in stage 2 loans suggests some abatement in pressure on households’ debt service capacity.
  - Households’ indebtedness remains elevated despite a decline in the debt-to-income ratio.
  - Debt service-to-income on new mortgages remained high at 44 percent, even as maturities lengthened.
  - Credit risk could resurface if unemployment rises more than expected; automatic stabilizers would buffer against adverse income shocks.
  - Household assets predominantly illiquid and susceptible to valuation effects.

### Financial sector resilience: banks, funds, and interconnectedness
- Overall assessment: "The financial sector is overall well positioned to weather shocks with some pockets of vulnerability."
- Banks:
  - Large liquidity and capital buffers and high—though declining—coverage ratios.
  - CSSF stress test finds system generally adequately capitalized and liquid but highlights vulnerabilities in some banks under adverse scenarios.
  - Weighted average CET1 by asset size would remain at 19–20 percent under adverse scenarios, even after capital depletion of 6.1–6.9 percentage points compared to baseline.
  - Under SSM adverse: five banks representing 7.7 percent of total banking assets would fall under their total CET1 capital requirement.
  - Under CSSF adverse: eight banks representing 10.4 percent of banks assets would fall under their total CET1 capital requirement.
  - Highest capital depletion by business model: custodian banks; lowest CET1 average level: retail and commercial banks — both still above minimum requirements.
  - Integrating solvency-liquidity interactions estimates additional capital depletion due to liquidity stress/activation of counterbalancing capacity at 2.4 percentage points in the SSM scenario and 1.2 percentage points in the CSSF scenario.
  - A few banks would face a funding gap.
- Investment funds:
  - Liquidity indicators overall improved, but share of cash in high-quality liquid assets has somewhat declined, increasing market sensitivity.
  - CSSF liquidity stress test: under a severe scenario with a 20 percent redemption shock, only 4 percent of bond funds would need more than 5 days to liquidate assets.
  - Larger high-yield bond funds are less liquid and more likely to need extra time for liquidation.
  - Money market funds’ (MMFs) sensitivities to interest rates increased in 2023 due to rising weighted-average maturity.
  - Leverage remains moderate except for hedge funds and, to a lesser extent, real estate funds (which have low exposure to the domestic economy: EUR 5 billion) and longer notice periods.
- Interconnectedness:
  - Banks’ liabilities exposures to funds remain high at about 17 percent but have declined in recent years.
  - Exposures concentrated in custodian banks, which have limited connections with other banks, reducing potential contagion.

### Prudential, macroprudential, and borrower-based policy recommendations
- Microprudential policy:
  - Continue ensuring sufficient loss absorption capacity via adequate and proactive provisioning of expected losses, conservative profit distribution, and scrutiny of credit risk management and collateral valuation practices (noting "one-third of CRE collateral has been revalued upward by banks in 2024").
  - Continue close monitoring of risks from parent banks and enhance banks’ operational readiness for central bank liquidity support per FSAP recommendations.
  - Implement the new framework on transfer of non-performing loans (law of July 2024) to help reduce NPL ratios and their potential impact on credit supply.
- Macroprudential capital-based measures:
  - Current level of the countercyclical capital buffer (CCyB) described as "broadly appropriate" given expected turn in the credit cycle; need to maintain releasable buffers.
  - If credit cycle turns decisively, consider increasing releasable buffers, preferably via sectoral systemic risk buffers or gradual increase in CCyB and formalizing the positive neutral CCyB framework.
  - When calibrating PNCCyB, assess interactions with other instruments.
  - Work with banks and industry to address sources of lack of confidence in real estate companies (e.g., reform completion guarantee scheme) and consider contingency measures if confidence does not return (example: purchase guarantees of unsold properties from viable projects and firms).
  - A relaxation of the CCyB could be considered should downside risks materialize.
- Household resilience and borrower-based measures:
  - Risk profile of new mortgages "leaves no room for cyclical accommodation."
  - Recommendation: do not renew the loosening of LTV limit expiring in June 2025.
  - Introduce income-based measures early in the recovery cycle to reduce households’ indebtedness; gradually reduce maximum LTV limit of 100 percent (for first-time homebuyers and owner-occupied properties).
  - Staff suggest a DSTI of 45–50 percent with a speed limit adjustable over the cycle.
  - Second-best option: CSSF guidance on residual income after interest rate stress test (50–55 percent of income should remain after stress).
  - To mitigate adverse impact on low-income households, increase investment in social housing.
- Strengthening macroprudential framework and data:
  - Commended progress implementing 2024 FSAP recommendations on bank and investment funds supervision.
  - BCL is developing a system-wide stress test and increased analysis of OFIs interlinkages with investment funds and banks.
  - Enhance data collection on housing supply, household creditworthiness (credit registry), and NFC micro-data (better identify special purpose entities).
  - Strengthen macroprudential governance by reducing Ministry of Finance’s role in decision-making and enhancing communication and coordination with other policies (e.g., housing policy).
  - For investment funds: strengthen MMF framework through availability of anti-dilution liquidity management tools (LMTs) and decoupling regulatory thresholds from mandatory implementation of suspensions, gates, and redemption fees where applicable.

### Operational resilience and AML/CFT
- Operational risks:
  - Increase in cyber-attacks and AI use heighten operational risks; referenced "CrowdStrike incident."
  - Staff welcome implementation of the Digital Operational Resilience Act effective January 2025 and recommend continued improvement of readiness of domestic financial entities.
- AML/CFT:
  - Continue efforts to enhance understanding of money laundering and terrorist financing (ML/TF) risks and effectiveness of AML/CFT supervision.
  - National risk assessment update is continuous and sequenced by national priorities.
  - CSSF evaluates sector- and institution-level risks under its purview and allocates supervisory resources accordingly; compiled data on cross-border flows and is integrating anti-corruption measures into AML strategy.
  - Recommendation: obtain further information on cross-border ML/TF threats from domestic and foreign authorities to enhance understanding of cross-border flows.
  - Ensure sanctions addressing breaches of AML/CFT regulations sustain effective compliance by financial institutions.

### Authorities’ views
- Authorities broadly concurred with staff’s assessment that systemic risks exist but the financial system "remains resilient."
- Emphasized low cost of risk in domestic banks and large capital buffers as cushions for potential shocks.
- Will remain vigilant to credit risk and confidence challenges in the real estate sector; have started engaging with stakeholders and signaled readiness for additional action as needed.
- CdRS position on macroprudential policy:
  - Given uncertainty about credit cycle position, CdRS considers maintaining the CCyB rate at 0.5 percent appropriate.
  - Authorities will continue considering staff advice on capital-based measures and recent ECB and ESRB analyses on positive neutral CCyB.
- On borrower-based measures: CdRS indicated the portfolio allowance applied on "buy-to-let" loans in response to the cyclical downturn "had not any significant impact on household debt or financial stability."
- Authorities reiterated support for advancing the savings and investments union, emphasizing reduction of administrative and regulatory burden and complexity to channel more investments into the European economy and unleash EU capital markets’ potential.
  - Emphasized using EU authorities’ current powers and following evidence-based convergence of supervisory practices.
  - Considered that centralization of powers at EU level would not help achieve savings and investments union objectives nor improve EU competitiveness.

*Source: 1luxea2025001-print-pdf - 24. The authorities reiterated their commitment to fiscal discipline, while stressing*

### 36. Finally, the authorities look forward to participating in the IMF’s voluntary assessment

### 36. Finally, the authorities look forward to participating in the IMF’s voluntary assessment of transnational aspects of corruption, highlighting the government’s ongoing efforts to prevent the supply and facilitation side of corruption.

### C. Structural Policies: Boosting Private Sector-led Growth
- Luxembourg’s past growth was driven by a rapidly expanding labor force, with major contributions from immigrants and cross-border workers; this model is becoming less sustainable due to a rapidly ageing population and infrastructure bottlenecks.
- Widespread skills shortages are present as demand for certain skills increasingly outpaces supply (OECD, 2023b).
- The number of unfilled job vacancies has been trending upward over the past 15 years (Figure 12).
- Luxembourg’s productivity growth on average has lagged peers, partly explained by higher barriers to competition and a gap in innovation and technology.

### Labor market reform
- Findings:
  - Real wage rigidity reduces firms’ capacity to adapt to shocks; greater flexibility in the automatic wage indexation system is more pressing.
  - Job-to-job transition is already low (Figure 12).
  - The public-private wage premium is one of the highest in Europe.
- Recommendations:
  - Tackle labor market rigidities, including reforms to the automatic wage indexation system.
  - Continue ongoing collective bargaining reforms to help labor mobility within and across sectors.
  - Reduce the public-private wage premium to improve skills availability and lower private sector labor costs.
  - Widen labor market participation:
    - The recent law facilitating labor market access for third-country nationals is welcome.
    - Reduce incentives for early retirement to improve senior labor market participation.
    - Consider financial incentives to encourage firms to hire and retain senior workers, including lifelong learning and age-management practices.
    - Reduce the gender gap by enhancing work flexibility and switching to individual taxation.
  - Address skill mismatches:
    - Reform education to better align fields of study with labor market needs (e.g., STEM).
    - Upskill and reskill for high-demand occupations that do not require advanced degrees (e.g., specialized technicians).
    - Expand access to vocational training and improve training quality.
    - Continue reskilling workers with outdated skills and invest in digital education.

### Enhancing technology adoption and strengthening competition
- Findings:
  - Gross domestic expenditure on R&D as a share of GDP is among the lowest in the OECD (Figure 12).
  - Adoption of digital technologies, including cloud computing, big data analysis and AI usage, is behind EU peers (European Commission, 2024).
  - Luxembourg has higher barriers to competition in professional services compared to other OECD countries (Figure 12); public sector participation in several service companies is large.
- Recommendations:
  - Promote investment in intangible assets and complement funding to R&D and innovation with more indirect financing (e.g., tax credits to R&D).
  - Facilitate innovation diffusion within sectors.
  - Reduce entry requirements for professional services while preserving quality to spur competition, lower service costs, incentivize investment and raise labor demand.
  - Reduce administrative and regulatory burdens; streamline processes where they are higher than the OECD average.
  - Continue implementation of insolvency framework reform aligned with the EU Directive to facilitate firm exit.

### Addressing supply bottlenecks to contain high living cost and facilitate cross-border movement
- Housing affordability:
  - Temporary demand-support measures should be gradually withdrawn; help-to-buy policies should be better targeted.
  - Streamlining building permits’ regulations is welcome.
  - Reduce supply rigidity by increasing productivity in the construction sector and alleviating bottlenecks.
  - Carefully design and implement the planned land tax reform to mobilize unused land.
  - Use the housing stock more efficiently by implementing a vacant property tax, tackling under-occupation and repurposing commercial real estate.
- Cross-border infrastructure:
  - Cross-border workers increase labor supply without adding pressure to the housing market.
  - Recent data suggest a lower flow of commuters from Germany and Belgium partly due to lengthy commuting time.
  - Improve transportation infrastructure and decentralize activity to border areas to ease congestion.

### Authorities’ Views
- The authorities broadly concurred with staff’s key recommendations.
- Priorities noted by authorities:
  - Simplifying regulation and administrative requirements (e.g., building permits, once-only principle, EU omnibus initiative).
  - Enhancing technological diffusion: launched a digital support program for SMEs promoting better online communication with customers and improved business management.
  - Expanding free online training to reduce skill mismatches with high take up by participants.
  - Acknowledged the need to expedite supply-side reforms to improve housing affordability.

### Staff appraisal: macro and fiscal outlook, financial sector, and policy priorities
- Economic outlook and risks:
  - Luxembourg’s recent economic performance has been lackluster; a projected recovery faces headwinds.
  - The economy is expected to gradually recover from a protracted slowdown, but risks include weaker external demand, higher financial market volatility, and domestic challenges in the real estate sector and the labor market.
  - Productivity has been declining; Luxembourg faces fiscal pressures and risks.
  - The current external position is assessed to be substantially stronger than the level implied by medium-term fundamentals but is subject to significant volatility due to the country’s small open-economy features and large share of cross-border workers.
- Fiscal policy:
  - For 2025, a less expansionary fiscal stance would have been welcome given low fiscal multipliers and the need to make room for private sector-led growth.
  - Scope exists to review effectiveness and targeting of current measures while preserving possible savings from revenue overperformance or budget execution.
  - The authorities’ medium-term expenditure path is broadly appropriate but should be underpinned by measures to contain wage bill growth, enhance spending efficiency, and avoid further erosion of the tax base.
  - There is scope for increasing revenue resilience by diversifying revenue sources to reduce volatility and uncertainty of fiscal receipts.
  - Public consultations on pension reform are welcome; early reforms are needed, including:
    - Reducing the generosity of benefits—the highest in Europe.
    - Increasing both the effective and statutory retirement ages.
    - A well-calibrated increase in contributions to minimize negative labor market impacts.
  - Strengthen the medium-term fiscal framework; the planned national fiscal rule should combine a debt anchor with a net spending ceiling that considers revenue uncertainty and allows appropriate flexibility.
  - Additional budgeting framework reforms and strengthening of the fiscal council are necessary.
- Financial sector and macroprudential policy:
  - Financial sector appears broadly resilient, but solvency and liquidity risks in the corporate sector—especially in real estate—and the potential impact of rising financial market volatility warrant close monitoring.
  - Authorities should ensure adequate provisioning, collateral valuation, and loss absorption capacity.
  - Continue oversight of the large nonbank financial sector, prioritizing pockets of liquidity mismatches and leverage, and better understand the intermediation role of the OFI sector.
  - The current CCyB level is appropriate.
  - If the recovery firms up, authorities should strengthen releasable capital buffers and address elevated household indebtedness by introducing income-based measures in line with FSAP recommendations.
  - In case of continued credit pressure, some loosening of the CCyB could be envisaged.
  - Continue implementing 2024 FSAP recommendations and strengthen the macroprudential policy framework.
- Structural reform priorities reiterated:
  - Increase labor market flexibility (wage indexation is a key constraint on competitiveness).
  - Boost productivity and contain cost of living by streamlining regulatory and administrative burdens, removing barriers to entry in some sectors, and addressing housing and infrastructure supply bottlenecks.
  - Capitalize on comparative advantages in AI adoption and financial sector development while minimizing transition costs.
  - Continue measures to enhance technology diffusion and upskilling programs.

*Source: 1luxea2025001-print-pdf - 36. Finally, the authorities look forward to participating in the IMF’s voluntary assessment*

### 48. It is proposed that the next Article IV consultation with Luxembourg takes place on

### It is proposed that the next Article IV consultation with Luxembourg takes place on the standard 12-month cycle.

### External position and trajectory
- Overall assessment: The external position of Luxembourg in 2024 is assessed to be substantially stronger than the level implied by medium-term fundamentals and desirable policies.
- 2024 (% GDP)
  - NIIP: 37.6
  - Gross Assets: 14917.7
  - Debt Assets: 3346
  - Gross Liabilities: 14880.1
  - Debt Liabilities: 1111.6
- Trajectory: Projections of continued current account surpluses over the medium term suggest the NIIP will recover gradually to its pre-pandemic level; the large and positive NIIP does not raise sustainability concerns.

### Current account and real exchange rate
- Current account developments
  - CA improved to 13.8 percent of GDP in 2024 from 11.2 percent in 2023.
  - Drivers in 2024: improvement in the trade balance (+1.3 percent of GDP), net remittances (+0.6 percent of GDP), and current transfers (+0.7 percent of GDP).
  - Cyclically-adjusted CA balance is estimated at 13.6 percent of GDP in 2023 (EBA-lite basis).
- EBA-lite assessment and gaps
  - EBA-lite CA norm (adjusted): 3.6 (percent of GDP)
  - CA-Actual (adjusted for cyclical contributions): 13.6 (percent of GDP)
  - CA Gap: 10.0 (percent of GDP)
    - Relative policy gap: 3.2 (percent of GDP)
  - Elasticity: -1.4
  - REER assessment
    - Staff-assessed REER gap: -7.2 (in percent) (undervaluation)
    - REER index model gap: -7.0 (in percent) (undervaluation, with a policy gap of 2.3 percent)
- Methodology caveats: EBA-lite partially captures Luxembourg’s role as a financial hub, large investment fund industry, and share of non-resident workers; BOP statistics subject to large revisions.

### Capital and financial accounts
- Financial account deficit widened from 11.7 percent of GDP in 2023 to 14.0 percent of GDP in 2024.
- Capital account deficit broadly stable at 0.2 percent of GDP in 2024.
- Assessment: Risks are limited given the strength of Luxembourg’s external position.
- FX and reserves: Euro is a global reserve currency; reserves of euro area countries typically low relative to standard metrics; currency free floating.

### Fiscal stance and public finances
- Recent fiscal stance: The fiscal stance in 2025 is expansionary; several discretionary measures extended or made permanent (including housing packages); phasing out of electricity subsidies only partial.
- Key public finances indicators (selected)
  - General government revenues (percent of GDP): 43.9 43.4 44.5 46.2 47.9 47.4 47.6 47.6 47.7 47.9 48.2 (2020–2030 series as presented)
  - General government expenditures (percent of GDP): 47.0 42.4 44.3 47.0 46.9 48.3 49.0 49.0 49.7 50.0 50.3 (2020–2030 series)
  - General government balance (percent of GDP): -3.1 1.0 0.2 -0.8 1.0 -0.8 -1.3 -1.4 -1.9 -2.0 -2.1 (2020–2030 series)
  - General government gross debt (percent of GDP): 24.5 24.2 24.9 25.0 26.3 26.7 27.6 28.0 28.6 29.2 29.5 (2020–2030 series)
- Policy implication from EBA-lite: Identified policy gap partly reflects a fiscal stance looser than the country-specific norm; over the longer term, aging-related costs (+2 ½ percent of GDP by 2040 and +5 percent of GDP by 2050) will narrow the CA surplus and increase fiscal pressures.

### Real economy and labor market (high-level)
- Real economy: GDP and demand dynamics show post-pandemic volatility and projected moderate growth; detailed annual series provided in the source tables.
- Labor market (selected levels/projections)
  - Resident labor force (thousands): 294.2 298.3 302.8 309.2 314.0 319.3 325.1 330.9 336.9 343.0 349.1 (2020–2030 series)
  - Total employment (thousands): 471.6 485.1 501.3 512.0 517.8 524.8 533.9 544.8 556.2 567.7 579.3 (2020–2030 series)
  - Unemployed (average, thousands): 18.7 17.1 14.6 16.2 18.0 19.5 20.1 19.9 19.6 19.6 19.6 (2020–2030 series)
  - Cross-border workers (net, thousands): 196.1 203.9 213.0 219.0 221.7 225.0 228.9 233.8 238.9 244.3 249.8 (2020–2030 series)

### Financial sector and financial soundness
- Progress: Authorities stepped up monitoring of real estate vulnerabilities; countercyclical capital buffer (CCyB) unchanged; no other capital-based macroprudential measures taken; some temporary flexibility on LTV for buy-to-let loans; CSSF temporarily reduced interest rate stress test for new mortgages to 100 bps.
- Financial soundness indicators (selected, percent)
  - Regulatory capital to risk-weighted assets (All Banks): 25.9 24.8 22.6 24.8 23.9 23.0 24.0 23.0 (2017–2024 series)
  - Return on assets (All Banks): 0.7 0.6 0.5 0.5 0.6 0.6 1.1 1.2 (2017–2024 series)
  - Nonperforming loans to total gross loans (All Banks): 0.8 0.9 0.7 1.0 1.3 1.6 1.9 2.3 (2017–2024 series)
  - Household debt to GDP (All Banks): 59.5 59.8 64.3 69.7 71.0 72.0 72.0 72.0 (2017–2024 series)
- Follow-up: Overall good progress on banks and investment funds supervision, including better integrated solvency-liquidity stress tests.

### Structural policies and IMF advice implementation
- Housing affordability
  - IMF advice: Boost supply (frontload public construction, reduce bottlenecks, increase density), expedite land tax reform, avoid demand-boosting measures, phase out interest payment deductibility.
  - Progress/comments: Authorities extended temporary demand-support measures amid housing downturn; efforts to simplify procedures and increase densification underway; land tax reform expected to be submitted to parliament in 2025H1.
- Wage indexation
  - IMF advice: Consider indexing to core inflation, introduce progressive wage indexation, adopt rule-based suspension linked to competitiveness indicators.
  - Progress/comments: Authorities have no plans to change the wage indexation system; measures to enhance competitiveness include reducing the CIT rate and exempting active ETFs from the subscription tax.
- Productivity and digitalization
  - IMF advice: Increase investments in intangible assets, promote AI use, reduce productivity dispersion and skill mismatches.
  - Progress/comments: Authorities launched a digital support program for SMEs and expanded online training courses.
- Fiscal recommendations
  - Short term: Adopt a contractionary fiscal stance in 2025; phase out temporary measures while protecting vulnerable households via targeted transfers; avoid measures that distort price signals.
  - Medium term: Implement gradual fiscal consolidation to stabilize debt and preserve AAA rating; frontload pension reform; avoid revenue-losing tax reforms; strengthen fiscal council and MTBF.
  - Progress/comments: Authorities’ medium-term plan envisages gradual deficit reduction but lacks specific measures; consultation on pension reform launched; permanent tax cuts on CIT and PIT implemented; study on MTBF requested from OECD.

### Key policy recommendations and priorities
- Frontload pension reforms to reduce long-term fiscal pressures from aging.
- Reorient fiscal policy from expansionary 2025 stance to gradual consolidation to preserve sovereign creditworthiness and address the identified policy gap.
- Prioritize public-sector investment (affordable housing, infrastructure, digitization, green transition) and structural reforms to boost private investment and reduce external surplus misalignment.
- Continue close monitoring of real estate vulnerabilities; consider macroprudential measures if vulnerabilities build up once housing demand recovers.
- Maintain efforts to improve MTBF, strengthen the fiscal council, and specify measures underpinning medium-term fiscal consolidation.

*Source: IMF staff report and accompanying tables and annexes as provided in the content unit.*

### Annex III. Risk Assessment Matrix

### Annex III. Risk Assessment Matrix

### Global Risks
- Trade policy and investment shocks
  - Relative Likelihood: High
  - Impact if Realized: High/Medium. "Demand for Luxembourg’s exports of goods and services could weaken. This could reduce growth, increase unemployment, and weigh on fiscal revenue."
  - Policy Response:
    - "Allow automatic stabilizers to work and supplement with temporary and targeted discretionary measures in the event of a sharp downturn to supplement demand."
    - "Accelerate supply side reforms to strengthen competitiveness."

- Sovereign debt distress
  - Relative Likelihood: High
  - Impact if Realized: Low for banks’ exposures. "Banks’ exposures to sovereign debt is limited and concentrated in advanced economies." Medium for global asset managers. "High yield, emerging market and corporate bond funds could face higher redemptions and liquidity pressure."
  - Policy Response:
    - "Lock in capital buffers through targeted capital-based measures. Continue to closely monitor credit, liquidity, and market risks. Further strengthen the liquidity management framework for investment funds and continue to closely monitor interconnectedness."
    - "Allow automatic stabilizers to work and supplement with temporary and targeted discretionary measures in the event of a sharp downturn to supplement demand."

- Tighter financial conditions and systemic instability
  - Relative Likelihood: Medium
  - Impact if Realized: High. "The impact on banks and investment funds is likely to be high but overall, the system would remain resilient due to strong fundamentals. Tighter financial conditions could heighten credit risk, reduce lending growth, which still has not recovered. Higher-for-longer interest rates could adversely affect the performance of non-banks through asset repricing, reduce credit and GDP growth, increase unemployment, and lower fiscal revenue."
  - Policy Response: (implied continuation of monitoring, buffers, and macroprudential vigilance from adjacent entries)

- Regional conflicts
  - Relative Likelihood: Medium
  - Impact if Realized: Low/Medium. "Energy prices may increase weighing on competitiveness of energy-intensive manufacturing. Inflation could rise, putting pressure on wages (because of automatic wage indexation) and weighing on other sectors’ competitiveness."
  - Policy Response:
    - "Allow pass-through to domestic prices while offering targeted support to vulnerable households and firms."
    - "Suspend and/or reform the automatic wage indexation"

- Commodity price volatility
  - Relative Likelihood: Medium
  - Impact if Realized: Medium. "Energy price and/or supply shocks may exacerbate inflation, which will feed into wages through automatic wage indexation. This could hamper competitiveness, dampen production in certain sectors, or lead to a widening of the fiscal deficit."
  - Policy Response:
    - "mechanism to break the wage-price spiral."
    - "Continue investments in renewable energy and defence to increase resilience."
    - "Accelerate supply side reforms to bolster competitiveness."

### Structural Risks
- Cyberthreats
  - Relative Likelihood: High
  - Impact if Realized: Low/Medium. "Payment and financial systems are disrupted with potentially reputational risks."
  - Policy Response:
    - "Continue efforts to strengthen the cybersecurity framework. Ensure robust contingency planning for operational risks."

### Luxembourg-Specific Risks
- Slower-than-expected recovery in real estate market
  - Relative Likelihood: Medium
  - Impact if Realized: Medium. "Slow recovery in the real estate market would weigh on growth, dampen confidence in real estate developers and raise unemployment. It also poses risks to the financial sector through higher NPLs and lower collateral value."
  - Policy Response:
    - "These risks are mitigated by high capital buffers, households’ high level of income and financial wealth, as well as automatic stabilizers."
    - "Continue vigilance and close monitoring of risks in the residential and commercial real estate sector, ensure adequate provisioning and collateral valuation. Maintain sufficient level of loss-absorption capacity."
    - "Consider providing purchase guarantees to viable projects and firms at a sufficiently low price to reduce moral hazard."
    - "Allow automatic stabilizers to operate to support growth as sector-specific short-term schemes."

- Changes in international corporate taxation and other risks to fiscal revenue
  - Relative Likelihood: Medium
  - Impact if Realized: Medium. "This could weaken fiscal revenue and reduce Luxembourg’s attractiveness for businesses."
  - Policy Response:
    - "Engage in tax reform to diversify revenue and reduce its volatility, enhance spending efficiency."
    - "Adopt a prudent fiscal policy a national fiscal rule that considers fiscal risks. Strengthen the medium-term budgeting framework, including the fiscal risk assessment."

### Key Cross-Cutting Observations and Metrics (from Annex IV excerpts)
- Overall sovereign stress assessment: "Overall...Low"
- Near term: "Medium termLowLow" (context: DSA summary indicates low overall risk of sovereign stress and debt sustainability)
- Debt projection: "Debt is projected to stay at 28-29 percent of GDP over the medium-term."
- Pension system note: "The authorities actuarial assessment shows that pension expenditure is expected to exceed social contributions by 2026. The general pension scheme's reserves are projected to be depleted by 2045."
- Medium-term tool signals:
  - Debt fanchart index (DFI): 0.9 — Risk signal: Low
  - GFN financeability index (GFI): 1.6 — Risk signal: Low
  - "Final assessment: Prob. of missed crisis, 2025-2030, if stress not predicted: 0.0 pct. Prob. of false alarms, 2025-2030, if stress predicted: 87.5 pct."
- Commentary highlights:
  - "Medium-term risks are assessed as low against a mechanical low signal as well as the strength of institutions, the depth of the investor pool, and adequate fiscal resources."
  - "Notwithstanding the automatic assessment of the pension system, an early reform could create space for much-needed public investment and targeted social spending while achieving intergenerational equity."
  - "Of the two medium-term tools, the Debt Fanchart Module is pointing to higher levels of risk, while the GFN Financeability Module suggests lower level of risk. In both cases, risks of debt distress are low."

*Source: IMF staff (Annex III. Risk Assessment Matrix; Annex IV excerpts).*

### Annex V. Data Issues Annex

### Annex V. Data Issues Annex

### Data Adequacy Assessment
- Median Rating: AAAABBA
- Data Adequacy Assessment Rating 1/: A
- Questionnaire Results 2/: Assessment
- Data Quality Characteristics — Granularity 3/: 
  - National Accounts: AAAAB
  - Prices: BBBB
  - Government Finance Statistics: AA
  - External Sector Statistics: BBBB
  - Monetary and Financial Statistics: AA
  - Inter-sectoral Consistency: B
- Coverage: AAAAB
- Consistency: AA / B
- Frequency and Timeliness: AAAAA / A / B / C / D
- Detailed note: "When the questionnaire does not include a question on a specific dimension of data quality for a sector, the corresponding cell is blank."

### Key Findings and Rationale for Staff Assessment
- Overall statement: "The data provided to the Fund is adequate for surveillance."
- Rationale for staff assessment:
  - "Data provision to the Fund is adequate for surveillance. Luxembourg publishes timely economic statistics and most of the underlying metadata."
  - "National accounts and balance of payments data are subject to large revisions, and recently inter sectoral inconsistencies have widened."
  - "Fiscal revenue are available but more granularity is needed to disentangle one-off, cyclical and structural developments."
  - "As identified by the FSAP, areas of improvement for monetary and financial statistics include identification of SPEs in the corporate micro data to improve vulnerability assessments."

### Data Use, Gaps, and Changes Since Last Article IV
- Use of alternative data: "Use of data and/or estimates different from official statistics in the Article IV consultation. In the absence of CRE price index, staff have used private sector estimates (Cushman and Wakefield)."
- Other data gaps: listed but not itemized in the source.
- Changes since the last Article IV consultation:
  - "Balance of payments and national accounts data have been revised significantly starting 2020."
  - "More efforts have been taken to collect data and reducing data gaps on OFIs, in line with the 2024 FSAP recommendation+B8."
  - "In particular, the BCL has collected data on the interconnectedness between investment funds and OFIs, in particular granular data on direct borrowing and lending activities, as well as investment exposures between counterparties."

### Corrective Actions and Capacity Development Priorities
- Fiscal statistics:
  - "Fiscal statistics could be improved by moving fully to accrual accounting to better assess the fiscal stance (cyclically adjusted balance) and imporving the granularity of reporting about one-off revenues."
- Monetary and financial statistics:
  - "Monetary and financial statistics could be improved by including identification of special purpose entities in the corporate micro data to improve vulnerability assessments."

### Data Standards and Table of Common Indicators (selected publication metadata)
- Table headings and selected entries (as presented):
  - "Table 2. Luxembourg: Data Standards Initiative"
  - "Table 3. Luxembourg: Table of Common Indicators Requires for Surveillance"
  - As of April 28, 2025 — sample entries shown with exact date stamps and frequency codes in the source (e.g., "28-Apr-25", "Mar-25", "Dec-24", frequency codes "D", "W", "M", "Q", "A", "NA").
  - Data items listed include: Exchange Rates; International Reserve Assets and Reserve Liabilities of the Monetary Authorities; Reserve/Base Money; Broad Money; Central Bank Balance Sheet; Consolidated Balance Sheet of the Banking System; Interest Rates; Consumer Price Index; Revenue, Expenditure, Balance and Composition of Financing ‒ General Government; Revenue, Expenditure, Balance and Composition of Financing ‒ Central Government; International Investment Position; Stocks of Central Government and Central Government-Guaranteed Debt; External Current Account Balance; Exports and Imports of Goods and Services; GDP/GNP; Gross External Debt.
  - Footnotes preserved as in source concerning frequencies and definitions (e.g., "6 Frequency and timeliness: (“D”) daily; (“W”) weekly or with a lag of no more than one week after the reference date; (“M”) monthly or with lag of no more than one month after the reference date; (“Q”) quarterly or with lag of no more than one quarter after the reference date; (“A”) annual.;  ("I") irregular; and (" NA")   not available.")

*Source: Annex V. Data Issues Annex (from the provided IMF content).*

### 9. Activate income-based

### 9. Activate income-based macroprudential measures—such as stressed debt-service-to-income limit—early in the recovery cycle and consider gradually reducing the maximum-LTV ratio from 100 percent.

### Recommendation
- Activate income-based macroprudential measures early in the recovery process (example instrument: stressed debt-service-to-income limit).
- Consider gradually reducing the maximum-LTV ratio from 100 percent.

### Authorities responsible
- CdRS, CSSF

### Progress and observations
- Discussions to activate income-based macroprudential measures early in the recovery process have taken place in the CdRS.
- The current macroprudential stance is considered to be appropriate by the authorities.
- The CdRS will remain vigilant to developments in the RRE market in Luxembourg.
- The CSSF regularly assesses bank lending practices including borrower credit standards and the compliance with the 200-basis-point interest rate stress test on variable-rate mortgages.
- Banks’ practices to require a minimum residual income, combined with the 200-basis-point stress test, aim to ensure borrowers can manage potential interest rate increases while maintaining a sufficient standard of living and a loss absorption capacity to potential shocks.
- These measures are considered prudent in mitigating household indebtedness and interest rate risks for borrowers.
- Regarding the upper limit of the LTV-ratio of 100 percent, the CdRS views the current arrangements as appropriate.

*Source: Luxembourg — FSAP 2024, Table 1 (Recommendations 9 and related progress/observations).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2025/english/1luxea2025001-print-pdf.pdf_