## _cr04125

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---

### Background and Prospects
- After two decades with average real GDP growth of some 5½ percent and budget surpluses, real GDP growth slowed to 1¼ percent during 2001-03 and the general government fiscal balance is estimated to have recorded a deficit in 2003.
- Recovery prospects tempered by:
  - Correction of asset prices since 2000, relatively high wage increases recently, and slowing productivity — likely to hold back growth of employment and incomes below the pace of 1980-2000.
  - Authorities have begun to adapt fiscal policy to the less buoyant growth outlook.
- General elections scheduled for June 2004.

### Key Policy Issues (summary)
- Adapting fiscal policy to less rapid growth:
  - Authorities anticipate deficits will persist through 2006 despite a major expenditure deceleration.
  - Given the high level of public assets, staff concurred that fiscal adjustment could be stretched over time, while pointing to advantages of a faster pace of adjustment.
  - Expenditure growth would have to be lower than programmed to achieve the Stability Program objectives.
- Welfare reform to raise resilience:
  - Authorities improving targeting of support for the jobless within existing legal framework; staff favors deeper adaptation to increase work incentives.
  - Reforms of the pay-as-you-go (PAYG) pension system and health care needed to avoid potentially large payroll tax hikes.
  - Authorities view the PAYG system as sustainable on long-run historical real GDP growth rates and intend to reassess the system in 2006, in consultation with social partners.
- Strengthening the financial sector:
  - Banks and insurances have weathered recent turbulence well; focus on medium-run prospects and supervision improvements.
  - EU Directive on savings taxation seen to clear uncertainty; authorities did not expect a large negative impact but expected activity to slow relative to the 1990s boom.
  - Agreement on sustaining strong AML/CFT efforts given large cross-border business.

### Background — drivers and risks (detailed)
- Historical drivers of growth: tax and regulatory advantages, early financial market liberalization, responsible fiscal policy, commuting, pragmatic trade unions.
- Since 2001:
  - Growth fell to the EU average.
  - Financial sector (about one quarter of output) was hit by bursting of global equity bubble, compounding weak manufacturing activity during 2001-02.
- Tensions holding back upswing:
  - Equity prices recovered recently, but financial sector still adjusting.
  - Wage settlements did not anticipate slowdown; unemployment over 4 percent (about 6 percent including workers on special work and training schemes).
  - Falling productivity raised unit labor costs during 2001-03; surge in costs likely reduced share of capital in income by about 10 percent since 2000.
- Fiscal deterioration:
  - General government balance shifted into a deficit estimated at about 1 percent of GDP in 2003, following surpluses averaging 4½ percent of GDP during 1998-2000.
  - Income tax cuts during 2001-02 accounted for at least 3¼ percentage points of GDP of the change in the deficit ratio.
- 2004 budget and projections:
  - Authorities target a general government deficit of 1.8 percent of GDP in 2004 with nominal expenditure growth programmed to slow to 4¼ percent (down from about 10 percent in 2001-03).
  - Staff estimates suggest on current policies the deficit could widen to about 2½ percent of GDP.
  - Gross debt would remain low and net financial assets high (close to 50 percent of GDP).

### Economic Outlook and Projections
- Recovery drivers: recovery in world demand, rebounding financial sector, and relatively supportive monetary conditions; forward-looking confidence indicators support a recovery.
- Staff vs. authorities:
  - Staff expects lower labor income growth, less profit margin growth, and a slower nominal GDP deflator than authorities.
  - Authorities see near-term risks mainly in external demand recovery and expect higher longer-run potential; note recent productivity decline concentrated in nontradables and possibly partly statistical.
- Potential growth:
  - Authorities expect potential real GDP growth of about 4 percent annually, almost reached again by 2006.
  - Staff cautioned potential output estimates subject to large margins of error; advised strengthening resilience.
- Selected numeric projections (percent change, unless otherwise noted) — IMF staff and authorities:
  - Real GDP, staff: 2003 1.2, 2004 2.3, 2005 3.3, 2006 3.5
  - Real GDP, authorities: 2003 1.2, 2004 2.0, 2005 3.0, 2006 3.8
  - Output gap, authorities (in percent of GDP): 2003 1/ -1.8, 2004 -4.4, 2005 -6.1, 2006 -6.6
  - GDP deflator, staff: 2003 1.1, 2004 1.7, 2005 1.7, 2006 1.7
  - GDP deflator, authorities: 2003 1.7, 2004 2.7, 2005 2.8, 2006 1.9
  - Memorandum: Euro area GDP deflator, WEO: 2003 2.1, 2004 1.7, 2005 1.8, 2006 1.8
- Productivity:
  - Selected Issues paper finds trend labor productivity growth advantage might now have fallen to only about ¼ percentage point relative to neighboring countries.

### Fiscal Policy Requirements — analysis and recommendations
- 2004 budget stance:
  - General government spending growth to be restrained to about 4¼ percent, down from double-digit rates in recent years.
  - Achieved by across-the-board expenditure restraint, including on infrastructure and the wage bill.
- Staff assessment and recommended actions:
  - Risk that 2004 general government deficit target might be appreciably overshot.
  - Revenue target at risk due to slow growth in labor incomes.
  - Assuming full execution of discretionary spending plans and social expenditure growth consistent with absence of major reforms, expenditure targets would be missed.
  - Need to restrain expenditure particularly on public investment and subsidies (Luxembourg allocates a higher share than other EU countries).
  - To avoid overshooting the 2004 deficit target:
    - Review and prioritize the public investment program with cost-benefit analysis.
    - Keep other discretionary spending under a tight hold.
  - Central Bank estimates: if funds managing public investment projects implement only 90 percent of their expenditure program, the fiscal deficit would be lower by about ¾ percent of GDP.
- Longer-run fiscal strategy:
  - Staff calculation: annual nominal expenditure growth would have to be kept almost 2 percentage points below the SP path for 2005-06, owing to slower labor income and thus nominal GDP growth.
  - At a minimum, all deficits needed to be eliminated soon after 2006 on current growth projections.

### Structural Reforms — pensions, health care, labor and product markets
- Pensions:
  - Directors previously recommended reform of the PAYG system and consideration of a gradual mandatory, actuarially balanced "second pillar."
  - Staff recommendations:
    - Establish formal links between old-age pensions replacement rate and the contribution base, and between statutory retirement age and life expectancy.
    - Continue accumulation of public sector assets to sustain a minimum pension.
    - Raise low effective retirement age by eliminating financial incentives for early retirement.
  - Authorities’ view:
    - Pension system sustainable on historical growth rates; cite ILO study indicating no major difficulties if real GDP growth averaged about 4 percent per annum.
    - Access to disability pensions narrowed; measures foster private retirement saving via tax incentives.
    - Authorities to consider staff proposals during 2006 tripartite evaluation.
- Pension simulations (Box 3):
  - PAYG system balanced only if rising commuters and immigrants maintain real GDP growth at least at 5 percent annually (Simulation A).
  - With growth around 2 percent and absent measures:
    - Pension reserves exhausted in 2015 and replacement rate would have to drop toward 33 percent (Simulation B).
    - Alternatively, contribution rate would have to double to over 50 percent to maintain current replacement rate (Simulation C).
  - Staff calculation: with annual real GDP growth of 2 percent, an increase in retirement age in tandem with life expectancy (by about 1¼ years per decade), and a 2½ percentage points increase in the contribution rate in 2015, the replacement rate could be held at 55 percent in 2050.
  - A further 2½ percentage point increase in the contribution rate could boost the replacement rate by an additional 5 percentage points.
- Health care:
  - Reforms ongoing; staff urged control of entitlement spending to avoid payroll tax hikes.
  - Options: raise copayments, reduce reimbursements on pharmaceuticals when generics available, narrow eligible services list, rationalize hospital services including greater crossborder cooperation.
  - Authorities adopted measures including better targeting of sickness pay; staff urged further action.
- Labor market and participation:
  - High job growth but no significant decline in unemployment of residents expected through 2006; structural unemployment risk due to “wait unemployment.”
  - Staff proposals to raise work incentives and participation:
    - Limit increases in minimum income for those able to work to the rate of inflation rather than wage increases.
    - Make unemployment benefits available only to young jobseekers meeting work-experience requirements; allow those without means to apply for minimum income.
    - Tighten criteria defining an “appropriate” job to deter unjustified rejection.
    - Better targeting of support for jobless residents; intensify education and training.
  - Older workers:
    - Raise very low labor force participation of older workers.
    - Propose stronger on-the-job training, tighten eligibility for sickness pay and employment subsidies for older workers, introduce actuarial fairness in pensions, allow unlimited rollover of temporary contracts for newly-hired older workers.
    - Unify duration of unemployment benefits at 12 months to speed return of older job seekers; in exchange raise replacement rate for long contributors.
- Product markets:
  - State aid at 1.3 percent of GDP in 2001, almost 90 percent to agriculture and transport; staff urged restructuring to limit distortions and accelerate restructuring (e.g., state railways).

### Financial Sector and AML/CFT
- Recent performance and risks:
  - Banks and insurance companies weathered recent turbulence; financial sector detracted from growth during 2001-02.
  - Banks cut expenditure and tightened lending standards; profits remained healthy.
  - Profits in 2002 would have been some 11 percent lower absent exceptional capital gains related to one large transaction.
  - Life-insurance and reinsurance premium growth might have reached double-digit levels in 2003.
- Resilience:
  - Stress tests confirmed robustness and efficiency; limited exposure to risky sectors and strong capitalization/profitability underpin resilience.
- EU Savings Taxation Directive implementation:
  - Rapid implementation would reduce uncertainty.
  - Luxembourg would maintain bank secrecy and, assuming timely adoption of the Directive, levy a tax on interest earnings of nonresidents at rates: 15 percent in 2005, 20 percent in 2008, and 35 percent in 2011.
  - Authorities argued only part of comparative advantage at risk; EU Directive not covering dividend earnings.
- Supervision and AML/CFT:
  - Scope of supervision widened, more staff and on-site inspections, refined 2002 FSAP stress tests, internal Code of Conduct for bank supervisory staff adopted.
  - Insurance supervisory authority added staff and developing new stress tests.
  - AML/CFT ROSC mission concluded a solid legal and implementation structure is in place (draft report under review).
  - Vulnerabilities from predominance of crossborder business; need to supplement reliance on customer identification by regulated institutions abroad.
  - Financial intelligence unit well regarded but would benefit from additional resources.
  - Key recommendation: rapidly implement a new draft AML/CFT law reflecting the highest international standards.

### Fiscal arithmetic, Stability Program, and alternative scenarios
- Fiscal arithmetic highlights:
  - Income tax cuts during 2001-02 accounted for at least 3¼ percentage points of GDP of the change in the deficit ratio.
  - General government deficit estimated at about 1 percent of GDP in 2003; authorities target 1.8 percent of GDP in 2004; staff projection about 2½ percent of GDP in 2004.
  - Gross debt low and net financial assets close to 50 percent of GDP.
  - Nominal expenditure growth programmed to slow to 4¼ percent in 2004, down from about 10 percent in 2001-03.
- SP (authorities) vs. Staff vs. Scenario with tighter expenditure (selected rows, percent of GDP, 2002–2006):
  - Revenue (authorities SP): 46.7, 47.1, 45.7, 44.9, 44.9
  - Expenditure (SP): 44.2, 47.7, 47.5, 47.2, 46.4
  - Balance (SP): 2.4, -0.6, -1.8, -2.3, -1.5
  - Staff projection — Balance: 2.4, -1.0, -2.6, -3.1, -2.8
  - Scenario with tighter expenditure — Balance: 2.4, -1.0, -2.1, -1.7, -1.1
- Memorandum items:
  - Nominal GDP growth (in percent): 1.9, 2.3, 4.1, 5.1, 5.2
  - General government expenditure growth (SP, percent): 15.2, 9.6, 4.3, 5.6, 3.7
  - General government expenditure growth (Staff projection, percent): 15.2, 9.6, 5.0, 5.8, 4.6
  - Scenario with tighter expenditure (in percent): 15.2, 9.6, 3.8, 3.8, 3.8

### Debt sustainability, stress tests, and public sector assets
- Public sector debt about 5 percent of GDP in 2003; public sector financial assets about 60 percent of GDP in 2003, held largely by social security.
- Conclusion: Debt sustainability is not an issue over the medium run; conclusion holds upon excluding financial assets.
- Projections:
  - Public sector net financial assets projected to decline through 2008, reflecting general government budget deficits.
  - Over longer run, age-related expenditures projected to rise considerably.
- Policy implication: prudent to return central government budget to balance over the medium run, consistent with a modest general government budget surplus.
- Stress test scenarios include:
  - A1. Key variables at historical averages in 2004-08
  - A2. Primary balance under no policy change in 2004-08
  - A3. Country-specific shock in 2004 with reduction in GDP growth of one standard deviation
  - B1–B6. Bound tests: shocks to real interest rate, real GDP growth, primary balance, combinations, a one-time 30 percent real depreciation, and a 10 percent of GDP increase in other debt-creating flows.

### Selected historical and projected indicators (selected rows, percent of GDP or specified)
- Public sector debt (1993–2008): 7.2, 6.5, 6.6, 7.2, 6.8, 6.2, 5.8, 5.5, 5.5, 5.7, 4.9, 6.1, 5.9, 5.8, 3.8, 3.2
- Revenue and grants (percent of GDP): 50.0, 49.2, 47.6, 47.5, 46.5, 45.1, 44.8, 44.9, 45.3, 46.7, 46.4, 45.2, 45.0, 45.0, 45.0, 45.0
- Public sector financial assets (selected values, memorandum): 51.3, 55.5, 52.8, 53.2, 54.9, 56.6, 62.5, 63.5, 59.5, 57.2, 53.4, 49.9, 47.6, 46.0

### Selected financial soundness indicators (1999–2003)
- Capital adequacy:
  - Total regulatory capital ratio: 12.9, 13.1, 13.7, 15.0, 16.1
  - Tier 1 regulatory capital ratio: 10.4, 11.0, 11.4, 13.1, 13.9
- Asset quality:
  - Value adjustments on credit to total gross credit: 0.7, 0.5, 0.4, 0.4, 0.4
  - Non-performing large exposures to total large exposures2/: 1.5, 0.8, 0.6, 0.4, 0.5
- Credit growth:
  - Real credit growth towards the non-financial corporate sector3/: 18.7, 6.6, 9.8, -7.9, -13.6
  - Real credit growth towards Luxembourg households3/: 5.5, 18.5, 6.5, 9.1, 23.8
- Asset composition:
  - Overall exposure to Luxembourg households in total exposures: 1.2, 1.3, 1.3, 1.3, 1.4
  - Overall exposure to financial corporations in total exposures: 67.6, 68.4, 69.5, 70.0, 70.9
  - Equities portfolio to own funds: 25.1, 21.1, 17.6, 15.5, 13.8
- Profitability and liquidity:
  - Return on assets (Net after-tax income to total assets)4/: 0.4, 0.5, 0.5, 0.4,...
  - Return on equity (Net after-tax income to paid-in capital): 34.0, 36.7, 40.7, 36.4,...
  - Liquidity ratio: 62.0, 61.0, 63.0, 63.0, 63.0

### Article IV timing, basic data, and selected macro indicators
- Proposed timing: next Article IV consultation with Luxembourg to be held within 24 months.
- Basic data:
  - Land Area: 2,586 square kilometers
  - Population (2002): 446,200
  - GDP per capita (2002): US$47,384
- Selected demand and supply (real growth rates, series 1999–2005 as presented):
  - Private consumption: 1999–2005: 2.6, 4.6, 4.5, 2.3, 1.8, 2.4, 2.5
  - Public consumption: 7.3, 4.8, 7.0, 4.2, 3.8, 2.1, 2.8
  - Gross fixed investment: 14.6, -3.5, 10.1, -1.4, 0.7, 2.1, 5.9
  - Gross domestic product: 7.8, 9.1, 1.2, 1.3, 1.2, 2.3, 3.3
- Employment and unemployment (levels and rates):
  - Unemployed (thousands): 5.4, 5.0, 4.9, 5.8, 8.1, 10.0, 11.3
  - Unemployment (percent of total labor force): 2.9, 2.6, 2.6, 3.0, 4.1, 4.9, 5.5
  - Resident employment (thousands): 178.3, 183.2, 188.0, 191.1, 192.9, 194.1, 195.9
  - Cross-border workers (net, thousands): 70.0, 79.0, 89.1, 94.5, 97.9, 100.6, 103.5
- Prices and costs:
  - GDP deflator: 2.2, 3.9, 2.2, 0.6, 1.1, 1.7, 1.7
  - Harmonized consumer price index: 1.0, 3.2, 2.7, 2.1, 2.6, 2.1, 1.7
  - Average nominal wage growth (overall economy): 3.6, 4.7, 3.7, 3.1, 3.0, 3.1, 3.2
  - Nominal unit labor costs: 1.2, 1.7, 8.5, 5.2, 3.6, 2.2, 1.4
- Public finances (percent of GDP):
  - General government financial balance: 3.5, 6.4, 6.2, 2.4, -1.0, -2.6, -3.1
  - General government gross debt: 5.8, 5.5, 5.5, 5.7, 4.9, 6.1, 5.9
  - General government net financial assets: 49.1, 51.2, 57.0, 57.8, 54.6, 51.1, 47.5
- Current account and external balances (percent of GDP):
  - Trade balance: -2.4, -2.6, -2.7, -2.1, -2.3, -2.5, -2.7
  - Nonfactor service balance: 5.0, 7.3, 7.0, 7.2, 6.9, 7.3, 7.7
  - Factor income balance: -0.5, -1.4, -1.8, -2.5, -2.7, -2.5, -2.4
  - Current account balance: 1.5, 2.7, 1.8, 1.8, 1.4, 1.7, 2.0
  - (In percent of GDP): 8.3, 12.8, 8.4, 8.2, 5.9, 6.9, 8.0

### Supplement (fiscal outcome 2003) and legislative update
- New data (Eurostat-submitted): general government deficit contained to 0.1 percent of GDP in 2003 — about 0.8 percentage point of GDP lower than staff’s projection and 0.5 percentage point below earlier official estimate.
- Revenue and expenditure developments in 2003:
  - Modest revenue overperformance due to higher VAT and excise tax receipts; expenditure appreciably lower as major investment projects delayed.
  - Social spending grew faster than staff’s projection in 2003.
- Staff assessment: much of the overperformance likely temporary; SP medium-term targets remain at risk unless discretionary spending plans are scaled down or entitlement programs reformed.
- Table highlights (2002 and 2003, percent of GDP; columns SP / Staff Est. / Update):
  - 2002 Revenue: 46.7 46.7 47.0; Expenditure: 44.2 44.2 44.3; Balance: 2.4 2.4 2.7
  - 2003 Revenue: 47.1 46.4 46.6; Expenditure: 47.7 47.4 46.8; Balance: -0.6 -1.0 -0.1
- Legislative update: draft law broadening scope for investment of social security assets has recently been passed.

### Staff appraisal and Executive Board assessment (summary)
- Overall assessment:
  - Strong past performance and sound policies leave Luxembourg well-placed to address challenges from the global slowdown.
  - Immediate priority: adapt fiscal policy to a less buoyant medium-run growth outlook.
  - Second priority: strengthen resilience through entitlement and factor market reforms.
- Directors’ key observations and recommendations:
  - Supported objective to run a small general government surplus over the medium run without increasing tax burden, but stressed difficulty given slowdown.
  - Attaining objective will require expenditures lower than planned in the Stability Program update.
  - Several Directors emphasized benefits of more rapid adjustment and importance of observing the 3 percent of GDP deficit ceiling.
  - Urged comprehensive post-election strategy centering on expenditure restraint (notably subsidies), better targeting of jobless support, and health care and pension reforms.
  - Encouraged action to address aging-related pressures to limit risks of payroll tax hikes (options include raising out-of-pocket medical payments or building a mandatory fully-funded pension pillar; alternatively link replacement rates/statutory retirement age to contribution base/life expectancy).
  - Supported improvements in financial sector supervision and endorsed efforts to strengthen AML/CFT legal and implementation structure; commended high level of ODA.

*Source: _cr04125 - Executive Summary; IMF staff report and supplementary information (IMF staff report for the 2004 Article IV Consultation).*

### Executive Summary ......................................................................................................

### _cr04125 - Executive Summary

### Background and Prospects
- After two decades with average real GDP growth of some 5½ percent and budget surpluses, real GDP growth slowed to 1¼ percent during 2001-03 and the general government fiscal balance is estimated to have recorded a deficit in 2003.
- A recovery is at hand, but:
  - The correction of asset prices since 2000, relatively high wage increases recently, and slowing productivity will likely hold back the growth of employment and incomes to below the pace of 1980-2000.
  - The authorities have begun to adapt fiscal policy to the less buoyant growth outlook.
- General elections are scheduled for June 2004.

### Key Policy Issues (summary)
- Adapting fiscal policy to less rapid growth:
  - Authorities anticipate that, owing to the exceptional depth and duration of the growth slowdown, deficits will persist through 2006, despite a major expenditure deceleration.
  - Given the high level of public assets, staff concurred that fiscal adjustment could be stretched over time, while pointing to the advantages of a faster pace of adjustment.
  - Expenditure growth would have to be lower than programmed to achieve the Stability Program objectives.
- Welfare reform to raise resilience:
  - Authorities are improving targeting of support for the jobless within the existing legal framework; staff favors deeper adaptation to increase work incentives.
  - Reforms of the pay-as-you-go (PAYG) pension system and health care are needed to avoid potentially large payroll tax hikes in the future.
  - Authorities view the PAYG system as sustainable on long-run historical real GDP growth rates and intend to reassess the system in 2006, in consultation with social partners.
- Strengthening the financial sector:
  - Banks and insurances have weathered recent turbulence well; discussions focused on medium-run prospects and improvements in supervision.
  - The EU Directive on savings taxation was seen to clear uncertainty; authorities did not expect a large negative impact but expected activity to slow relative to the 1990s boom years.
  - Agreement on sustaining strong AML/CFT efforts given large cross-border business.

### Background (detailed drivers and risks)
- Historical drivers of growth (post-1970s): tax and regulatory advantages, early financial market liberalization, responsible fiscal policy, commuting fueled by depressed surrounding regions and higher payroll taxes, pragmatic trade unions.
- Since 2001 the economy:
  - Growth fell to the EU average.
  - The financial sector (about one quarter of output) was hit by the bursting of the global equity bubble, compounding weak manufacturing activity during 2001-02.
- Tensions likely to hold back upswing:
  - Equity prices have recovered recently, but the financial sector is still adjusting to the earlier stock market correction.
  - Wage settlements did not anticipate the slowdown, interacting with generous welfare benefits and raising unemployment to over 4 percent (about 6 percent including workers on special work and training schemes).
  - Falling productivity raised unit labor costs during 2001-03; this surge in costs likely reduced the share of capital in income by about 10 percent since 2000.
- Fiscal deterioration:
  - General government balance shifted into a deficit estimated at about 1 percent of GDP in 2003, following surpluses averaging 4½ percent of GDP during 1998-2000.
  - Income tax cuts during 2001-02 accounted for at least 3¼ percentage points of GDP of the change in the deficit ratio.
- 2004 budget and projections:
  - Authorities target a general government deficit of 1.8 percent of GDP in 2004 with nominal expenditure growth programmed to slow to 4¼ percent (down from about 10 percent in 2001-03).
  - Staff estimates suggest that, on current policies, the deficit could widen to about 2½ percent of GDP.
  - Gross debt would remain low and net financial assets high (close to 50 percent of GDP).

### Policy Discussions — Overview
- Discussions occurred amid unusually sluggish activity and before general elections scheduled for June 13; policymaking is temporarily on hold but authorities supported maintaining sound public finances.
- Agreement that a less buoyant medium-run growth outlook called for reduction in recently very expansionary public expenditure growth.
- Need to control entitlement spending (notably health care), strengthen work incentives (particularly for older workers), and sustain strong AML/CFT efforts.

### Economic Outlook
- Recovery prospects:
  - Recovery in world demand, a rebounding financial sector, and relatively supportive monetary conditions expected to spur growth.
  - Forward-looking confidence indicators support a recovery.
- Staff vs. authorities views:
  - Staff: Lower labor income growth and less profit margin growth than authorities; slower nominal GDP deflator.
  - Authorities: Near-term risks seen mainly in recovery of external demand rather than appreciation of the euro; more optimistic about longer-run growth, noting recent productivity decline concentrated in nontradables and possibly partly statistical.
- Potential growth and risks:
  - Authorities expect potential real GDP growth of about 4 percent annually, almost reached again by 2006.
  - Staff cautioned potential output estimates are subject to large margins of error and advised policies to strengthen resilience rather than rely on uncertain potential output estimates.

### Fiscal Policy Requirements (analysis and recommendations)
- Authorities’ 2004 budget stance:
  - General government spending growth to be restrained to about 4¼ percent, down from double-digit rates in recent years.
  - Achieved by across-the-board expenditure restraint, including on infrastructure and the wage bill.
- Staff assessment and recommended actions:
  - Risk that the 2004 general government deficit target might be appreciably overshot.
  - Revenue target at risk due to slow growth in labor incomes.
  - Assuming full execution of discretionary spending plans and social expenditure growth consistent with absence of major reforms, expenditure targets would be missed.
  - Need to restrain expenditure particularly on public investment and subsidies (Luxembourg allocates a higher share than other EU countries).
  - To avoid overshooting the 2004 deficit target:
    - Review and prioritize the public investment program with cost-benefit analysis.
    - Keep other discretionary spending under a tight hold.
  - Central Bank estimates: if funds managing public investment projects implement only 90 percent of their expenditure program, the fiscal deficit would be lower by about ¾ percent of GDP.

### Structural Reforms — Labor Market, Pensions, and Health Care
- Labor market:
  - To combat rising unemployment, authorities are improving targeting of jobless support within existing legal framework; staff favors scaling back generous benefits to increase work incentives.
  - Authorities have reformed disability pensions to boost labor force participation and are intensifying strict implementation of existing eligibility requirements for benefit support.
- Pensions:
  - Directors previously recommended reform of the PAYG pension system and consideration of a gradual mandatory, actuarially balanced "second pillar."
  - Authorities prefer continuing to accumulate assets, fostering private retirement savings, and raising the effective retirement age; major changes to the entitlement system are to await the 2006 review.
- Health care:
  - Reforms are ongoing; staff urged control of entitlement spending, notably on health care, to avoid future payroll tax hikes.

### Financial Sector and AML/CFT
- Financial sector performance:
  - Banks and insurances have weathered recent turbulence well.
  - Activity expected to slow relative to 1990s boom years due to rising global competition.
- Policy focus:
  - Improvements in supervision were discussed.
  - The EU Directive on savings taxation was expected to reduce uncertainty.
  - Agreement on sustaining strong AML/CFT efforts given the large amount of cross-border business.

### Boxes and Projections (selected numeric projections preserved)
- From Stability Program update and IMF staff projections (percent change, unless otherwise noted):
  - Real GDP, staff: 2003 1.2, 2004 2.3, 2005 3.3, 2006 3.5
  - Real GDP, authorities: 2003 1.2, 2004 2.0, 2005 3.0, 2006 3.8
  - Output gap, authorities (in percent of GDP): 2003 1/ -1.8, 2004 -4.4, 2005 -6.1, 2006 -6.6
  - GDP deflator, staff: 2003 1.1, 2004 1.7, 2005 1.7, 2006 1.7
  - GDP deflator, authorities: 2003 1.7, 2004 2.7, 2005 2.8, 2006 1.9
  - Memorandum item: Euro area GDP deflator, WEO: 2003 2.1, 2004 1.7, 2005 1.8, 2006 1.8
- Productivity:
  - A Selected Issues paper finds the trend labor productivity growth advantage might now have fallen to only about ¼ percentage point relative to neighboring countries.
- Fiscal arithmetic:
  - Income tax cuts during 2001-02 accounted for at least 3¼ percentage points of GDP of the change in the deficit ratio.
  - General government deficit estimated at about 1 percent of GDP in 2003; authorities target 1.8 percent of GDP in 2004; staff projection about 2½ percent of GDP in 2004.
  - Gross debt low and net financial assets close to 50 percent of GDP.
  - Nominal expenditure growth programmed to slow to 4¼ percent in 2004, down from about 10 percent in 2001-03.

*Source: _cr04125 - Executive Summary*

### 12.      The authorities conceded that their objective for the medium run––maintaining

### _cr04125 - 12.      The authorities conceded that their objective for the medium run––maintaining

### Fiscal outlook and Stability Program (SP)
- Authorities aim to maintain a modest general government budget surplus over the medium run without raising the tax pressure, but acknowledged this would be challenging.
- SP update could not foresee a return to fiscal balance through 2006 (Table 2, SP targets).
- Staff view:
  - Gross debt would remain very low and net assets high, with net assets around 50 percent of GDP.
  - Public sector net asset position offers room to stretch adjustment, but staff argued for faster adjustment to safeguard savings needed for an aging population.
  - At a minimum, all deficits needed to be eliminated soon after 2006 (the end of the SP planning horizon) on current growth projections.
- Expenditure policy tensions:
  - Staff calculation: annual nominal expenditure growth would have to be kept almost 2 percentage points below the SP path for 2005-06 (Table 2, Scenario with tighter expenditure), owing to slower labor income and thus nominal GDP growth.
  - Social spending had expanded by over 8 percent annually during the past decade and represents a large share of total expenditure (Figure 6).
  - Authorities more optimistic on revenues, citing expected higher returns from social security assets after imminent law broadening investment scope.
  - Authorities did not identify specific measures immediately, arguing expenditures would be reviewed as necessary and that public support for adjustment was traditionally strong.
- Staff projection: proposed expenditure policy would not be tight enough to eliminate the general government deficit soon after 2006 (Table 2, Staff projection).

### Pensions and health care reform
- General findings and risks:
  - Reforms necessary to attain long-run fiscal objectives and strengthen resilience to shocks; without reforms shocks could require significant contribution rate increases that would adversely affect migration and create a vicious circle.
  - Staff preferred development of a mandatory fully-funded pension pillar but recognized authorities’ reservations.
- Staff recommendations (pensions):
  - Establish formal links between the old-age pensions replacement rate and the contribution base, and between statutory retirement age and life expectancy (Table 3 and Box 3).
  - Continue accumulation of public sector assets to sustain a minimum pension and enhance credibility of low tax/contribution commitment.
  - Raise low effective retirement age by eliminating financial incentives for early retirement.
- Authorities’ view:
  - Pension system sustainable on historical growth rates; highlighted an ILO study indicating no major difficulties if real GDP growth averaged about 4 percent per annum (the past four-decade average).
  - Access to disability pensions has been narrowed; measures foster private retirement saving via tax incentives.
  - Authorities would consider staff proposals during next tripartite evaluation in 2006.
- Staff recommendations (health care):
  - Additional reforms needed soon to avoid payroll tax hikes.
  - Options: raise copayments (currently low relative to neighbors), reduce reimbursements on pharmaceuticals when generics available, narrow eligible services list, rationalize hospital services including through greater crossborder cooperation.
  - Authorities have adopted measures including better targeting of sickness pay; staff urged further action.

Box 3 — Key pension simulations and policy implications
- PAYG system balanced only if rising commuters and immigrants maintain real GDP growth at least at 5 percent annually (Simulation A).
- With growth around 2 percent and absent measures:
  - Pension reserves would be exhausted in 2015 and replacement rate would have to drop toward 33 percent (Simulation B).
  - Alternatively, contribution rate would have to double to over 50 percent to maintain current replacement rate (Simulation C), risking a vicious circle of falling workforce and further contribution increases.
- Staff calculation: with annual real GDP growth of 2 percent, an increase in retirement age in tandem with life expectancy (by about 1¼ years per decade), and a 2½ percentage points increase in the contribution rate in 2015, the replacement rate could be held at 55 percent in 2050.
- A further 2½ percentage point increase in the contribution rate could boost the replacement rate by an additional 5 percentage points.

### Factor markets and labor policies
- Employment and unemployment:
  - High job growth but no significant decline in unemployment of residents expected through 2006; structural unemployment risk due to “wait unemployment” for lucrative services jobs.
  - Wage moderation needed in the public sector and elsewhere to secure jobs.
  - Legal minimum wage and wage indexation not seen by authorities as major concerns.
- Staff proposals to raise work incentives and participation:
  - Permanently limit increases in minimum income for those able to work to the rate of inflation rather than wage increases.
  - Make unemployment benefits available only to young jobseekers meeting regular scheme work-experience requirements; allow those without means to apply for minimum income.
  - Tighten criteria defining an “appropriate” job to deter rejection without cause.
  - Better targeting of support for jobless residents; intensify education and training.
- Older workers:
  - Raise very low labor force participation of older workers (Table 3).
  - Propose stronger on-the-job training programs; tighten eligibility for sickness pay and employment subsidies for older workers; introduce actuarial fairness in pensions; allow unlimited rollover of temporary contracts for newly-hired older workers.
  - Unify duration of unemployment benefits at 12 months to speed return of older job seekers; in exchange raise replacement rate for long contributors.
- Product markets:
  - State aid at 1.3 percent of GDP in 2001, with almost 90 percent flowing to agriculture and transport; staff urged restructuring to limit price/quantity distortions and accelerate restructuring (e.g., state railways) to pave way for competition.

### Financial sector stability and supervision
- Recent performance:
  - Banks and insurance companies weathered recent turbulence amid falling business volume growth (Table 4).
  - Financial sector detracted from economic growth during 2001-02: fees and commissions fell after the equity market collapse; interest margins reduced by a flattening yield curve.
  - Banks cut expenditure and tightened lending standards; profits remained at healthy levels (Figure 8).
  - Profits in 2002 would have been some 11 percent lower in the absence of exceptional capital gains related to one large transaction.
  - Preliminary data suggested life-insurance and reinsurance premium growth might have reached double-digit levels in 2003.
- Risks and resilience:
  - Prospects less bright than 1990s; ongoing consolidation will weigh on employment and bank numbers.
  - Stress tests confirmed robustness and efficiency; limited exposure to risky sectors and strong capitalization/profitability underpin resilience.
- EU Savings Taxation Directive implementation:
  - Rapid implementation would reduce uncertainty.
  - Luxembourg would maintain bank secrecy and, assuming timely adoption of the Directive, levy a tax on interest earnings of nonresidents at rates: 15 percent in 2005, 20 percent in 2008, and 35 percent in 2011.
  - Authorities argued only part of comparative advantage at risk due to continued incentives to hold interest-earning assets in Luxembourg, EU Directive not covering dividend earnings, and an “accumulated” know-how advantage.
  - Authorities committed to improving financial sector regulation and supervision.
- AML/CFT and supervision enhancements:
  - Scope of supervision widened, more staff and on-site inspections, refined 2002 FSAP stress tests, internal Code of Conduct for bank supervisory staff adopted.
  - Insurance supervisory authority added staff and is developing new stress tests.
  - AML/CFT ROSC mission concluded a solid legal and implementation structure is in place (draft report under review).
  - Vulnerabilities from predominance of crossborder business; need to supplement reliance on customer identification by regulated institutions abroad.
  - Financial intelligence unit well regarded but would benefit from additional resources.
  - Key recommendation: rapidly implement a new draft AML/CFT law reflecting the highest international standards.

### Other issues
- Trade and ODA:
  - Authorities strongly support multilateral trade liberalization and ODA.
  - Luxembourg benefited from trade liberalization and increased trade with EU accession countries; supportive of Doha talks momentum, EU everything but arms initiative, and free trade agreements with Mediterranean and Mercosur partners.
  - Luxembourg’s ODA at 0.8 percent of GNI.
- Statistics:
  - Statistical database improved further since last Article IV consultation; preliminary quarterly national income accounts (main missing element for SDDS subscription) would be made available soon.

### Staff appraisal (summary)
- Overall assessment:
  - Strong past performance and sound policies leave Luxembourg well-placed to address challenges from the global slowdown.
  - Immediate priority: adapt fiscal policy to a less buoyant medium-run growth outlook.
  - Second priority: strengthen resilience through entitlement and factor market reforms.
- Outlook and policy advice:
  - Recovery in 2004 likely to be aided by global demand and equity markets offsetting a stronger euro, but medium-run real GDP growth likely to settle appreciably below recent high rates.
  - Public sector net asset position provides room to stretch adjustment, but faster fiscal consolidation than in the SP would better prepare for demographic pressures.
  - Maintain official policy objective to run a small general government surplus over the medium run without raising the revenue burden.
  - Attaining this objective will be difficult; expenditure policy must ensure the general government deficit is at least eliminated soon after 2006, unless real GDP growth disappoints significantly.

*Source: _cr04125 - 12.      The authorities conceded that their objective for the medium run––maintaining (IMF staff report text).*

### 31.      Returning the budget to balance soon after 2006 will require a tighter-than-

### 31. Returning the budget to balance soon after 2006 will require a tighter-than-proposed expenditure policy.

### Fiscal adjustment and expenditure policy
- The Stability Program’s emphasis on holding back expenditure to safeguard the favorable fiscal position is well placed.
- The 2004 budget, with its emphasis on slowing discretionary spending, represents a good start.
- The proposed medium-run expenditure slowdown––to an annual average growth rate of about 4½ percent in nominal terms over 2004-06 from double-digit rates in recent years––likely would not suffice to attain the deficit objectives.
- The adjustment strategy should be reinforced, starting with a tight control of discretionary spending in 2004, to avoid an overshoot of the general government deficit target, and continuing in 2005 and beyond to encompass cutbacks of the relatively high level of subsidies and further reforms to entitlement programs.

### Health care and pension reforms
- Sustaining the planned deceleration in spending and reinforcing the economy’s resilience to shocks will require health care and pension reforms.
- In the health care system, various measures could be considered to forestall deleterious payroll tax hikes, including raising out-of-pocket payments.
- For old-age pensions, building-up a mandatory fully-funded pillar would mitigate risks related to the mobile workforce.
- Alternatively, the replacement rate should be formally linked to the contribution base and the statutory retirement age to life expectancy, thereby locking in Luxembourg’s payroll tax advantages over neighboring regions.
- A continued build-up of financial assets would support the resilience of the system and might later serve to protect the pensions of poorer retirees.

### Labor market, unemployment, and participation
- Another key challenge is to avoid an increase in structural unemployment, while boosting the labor force participation of older workers.
- The efforts to improve the targeting of the support for the jobless and curtail the abuse of disability pensions are welcome but more fundamental changes are likely to be necessary.
- For young workers, the work experience requirement for access to unemployment benefits should be aligned with that for other workers.
- For older workers, on-the-job training will have to be improved and various incentives to drop out early of the labor force, notably in the pension system, be eliminated.
- To improve work incentives for those who are able to work, gradual reductions in the replacement rate of the minimum income should be considered.

### Financial sector supervision and anti–money laundering
- Financial sector activity is already recovering and the main demand on supervisors will be to maintain its robustness as global competition intensifies.
- Since the 2002 FSAP, important steps have been taken to improve supervision, a development that should continue.
- A solid legal and implementation structure is in place to combat money laundering and the financing of terrorism.
- Because of the large volume of crossborder business, the new draft law to strengthen this structure further should meet the highest international standards.

### External assistance and trade policy stance
- Luxembourg’s high level of official development assistance is commendable.
- Luxembourg should continue to foster development, including by lending its support within the EU to reducing agricultural subsidies and import restrictions.

### Statistics and data dissemination
- Luxembourg’s economic statistics are adequate for surveillance and have continued to improve.
- Nonetheless, further efforts are needed to allow it to subscribe to the Fund’s Special Data Dissemination Standard.

*Source: _cr04125 - 31.*

### 37.      It is proposed that the next Article IV consultation with Luxembourg be held within

### _cr04125 - 37. It is proposed that the next Article IV consultation with Luxembourg be held within 24 months.

### Article IV consultation timing
- It is proposed that the next Article IV consultation with Luxembourg be held within 24 months.
- The last Article IV consultation was concluded at EBM/02/56 (6/5/02).

### Basic data and macroeconomic projections (selected)
- Land Area: 2,586 square kilometers
- Population (2002): 446,200
- GDP per capita (2002): US$47,384

Demand and supply (real growth rates)
- Private consumption: 1999–2005: 2.6, 4.6, 4.5, 2.3, 1.8, 2.4, 2.5
- Public consumption: 7.3, 4.8, 7.0, 4.2, 3.8, 2.1, 2.8
- Gross fixed investment: 14.6, -3.5, 10.1, -1.4, 0.7, 2.1, 5.9
- Inventory accumulation (contribution to GDP)1/: 1/, -0.3, 2.3, -1.6, -1.9, 0.2, 0.2, 0.2
- Total domestic demand: 6.4, 4.9, 4.3, -0.6, 2.2, 2.5, 3.7
- Exports of goods and nonfactor services: 14.8, 16.8, 2.6, -0.3, 1.7, 3.7, 3.8
- Imports of goods and nonfactor services: 14.6, 14.8, 4.8, -1.6, 1.9, 4.0, 4.1
- Foreign balance1/: 2.0, 4.7, -2.3, 1.6, 0.0, 0.2, 0.2
- Gross domestic product: 7.8, 9.1, 1.2, 1.3, 1.2, 2.3, 3.3

Employment and unemployment (levels and rates)
- Unemployed (thousands): 5.4, 5.0, 4.9, 5.8, 8.1, 10.0, 11.3
- Unemployment (percent of total labor force): 2.9, 2.6, 2.6, 3.0, 4.1, 4.9, 5.5
- Resident employment (thousands): 178.3, 183.2, 188.0, 191.1, 192.9, 194.1, 195.9
- Cross-border workers (net, thousands): 70.0, 79.0, 89.1, 94.5, 97.9, 100.6, 103.5
- Domestic employment (thousands): 248.3, 262.3, 277.1, 285.9, 290.8, 294.8, 299.3
  - Domestic employment change (percent): 5.0, 5.6, 5.6, 3.2, 1.7, 1.4, 1.5

Prices and costs
- GDP deflator: 2.2, 3.9, 2.2, 0.6, 1.1, 1.7, 1.7
- Harmonized consumer price index: 1.0, 3.2, 2.7, 2.1, 2.6, 2.1, 1.7
- Average nominal wage growth (overall economy): 3.6, 4.7, 3.7, 3.1, 3.0, 3.1, 3.2
- Nominal unit labor costs: 1.2, 1.7, 8.5, 5.2, 3.6, 2.2, 1.4

Public finances (percent of GDP)
- General government financial balance: 3.5, 6.4, 6.2, 2.4, -1.0, -2.6, -3.1
- General government gross debt: 5.8, 5.5, 5.5, 5.7, 4.9, 6.1, 5.9
- General government net financial assets: 49.1, 51.2, 57.0, 57.8, 54.6, 51.1, 47.5

Exchange rates and interest rates (averages / notes)
- U.S. dollar per euro (averages): 1999–2004: 1.07, 0.92, 0.90, 0.95, 1.13, 1.22...
- Nominal effective rate (1995=100): 96.5, 95.5, 95.5, 95.6, 96.9......
- Real effective rate (CPI based; 1995=100): 95.5, 95.3, 95.5, 96.0, 97.7......
- Short term interest rates (3-month euro deposits): 3.0, 4.4, 4.3, 3.3, 2.3, 2.1...
- Long-term bond yield (average of long-term bonds traded on Luxembourg Stock Exchange): 4.8, 5.9, 5.4, 5.3, 4.3......

Sources for these tables: Data provided by the authorities; IMF, WEO database; and Fund staff calculations.
- Notes: 1/ Contribution to GDP growth. 2/ Overall economy. 3/ The projection for 2004-05 reflects staff's assumptions about budget execution. 4/ In 2001, improved by a one-off transaction that amounted to 2 percent of GDP and that was recorded as negative capital expenditure. 5/ For 2004, data refer to March 25. 6/ For 2004, data refer to February. 7/ Short-term rates are for 3-month euro deposits. 8/ Average of long-term bonds traded on Luxembourg Stock Exchange. Long-term government bond yields are not available (the only 10-year government bond matures in 2007).

### Current account and external balances (percent of GDP)
- Trade balance: -2.4, -2.6, -2.7, -2.1, -2.3, -2.5, -2.7
- Nonfactor service balance: 5.0, 7.3, 7.0, 7.2, 6.9, 7.3, 7.7
- Factor income balance: -0.5, -1.4, -1.8, -2.5, -2.7, -2.5, -2.4
  - Employees' compensation: -1.9, -2.3, -2.9, -3.2, -3.2, -3.5, -3.8
  - Net investment income: 1.5, 0.9, 1.0, 0.7, 0.6, 1.0, 1.4
- Transfer balance: -0.5, -0.5, -0.6, -0.7, -0.6, -0.7, -0.7
- Current account balance: 1.5, 2.7, 1.8, 1.8, 1.4, 1.7, 2.0
  - (In percent of GDP): 8.3, 12.8, 8.4, 8.2, 5.9, 6.9, 8.0

### Medium-term projections of general government finances (2002–2006) (In percent of GDP)
Authorities' Stability and Growth Program (SP) targets (2002–2006)
- Revenue: 46.7, 47.1, 45.7, 44.9, 44.9
- Expenditure: 44.2, 47.7, 47.5, 47.2, 46.4
- Balance: 2.4, -0.6, -1.8, -2.3, -1.5
  - Central government: -0.2, -2.5, -3.2, -3.6, -3.1
  - Local governments: 0.2, 0.1, -0.2, -0.2, -0.1
  - Social security: 2.4, 1.8, 1.6, 1.5, 1.7

Staff projection (2002–2006)
- Revenue: 46.7, 46.4, 45.2, 45.0, 45.0
- Expenditure: 44.2, 47.4, 47.8, 48.1, 47.9
- Balance: 2.4, -1.0, -2.6, -3.1, -2.8

Scenario with tighter expenditure (2002–2006)
- Revenue: 46.7, 46.4, 45.2, 45.0, 45.0
- Expenditure: 44.2, 47.4, 47.3, 46.7, 46.1
- Balance: 2.4, -1.0, -2.1, -1.7, -1.1

Memorandum items
- Nominal GDP growth (in percent): 1.9, 2.3, 4.1, 5.1, 5.2
- Nominal GDP growth (SP, in percent): 1.9, 2.7, 4.8, 6.2, 5.5
- General government expenditure growth (SP, percent): 15.2, 9.6, 4.3, 5.6, 3.7
  - Of which: Social expenditure (SP): 10.5, 9.3, 5.3, 6.2, 3.6
- General government expenditure growth (Staff projection, percent): 15.2, 9.6, 5.0, 5.8, 4.6
  - Of which: Social expenditure (Staff): 10.6, 9.3, 6.4, 6.5, 4.0
- Scenario with tighter expenditure (in percent): 15.2, 9.6, 3.8, 3.8, 3.8

Sources: STATEC; Ministry of Finance; and IMF staff estimates and projections.
- Note: SP refers to the authorities' Stability and Growth Program update of November 2003.

### Selected financial soundness indicators (1999–2003)
Capital adequacy
- Total regulatory capital ratio: 12.9, 13.1, 13.7, 15.0, 16.1
- Tier 1 regulatory capital ratio: 10.4, 11.0, 11.4, 13.1, 13.9

Asset quality
- Value adjustments on credit to total gross credit: 0.7, 0.5, 0.4, 0.4, 0.4
- Non-performing large exposures to total large exposures2/: 1.5, 0.8, 0.6, 0.4, 0.5

Credit growth
- Real credit growth towards the non-financial corporate sector3/: 18.7, 6.6, 9.8, -7.9, -13.6
- Real credit growth towards Luxembourg households3/: 5.5, 18.5, 6.5, 9.1, 23.8

Asset composition
- Overall exposure to Luxembourg households in total exposures: 1.2, 1.3, 1.3, 1.3, 1.4
- Overall exposure to financial corporations in total exposures: 67.6, 68.4, 69.5, 70.0, 70.9
- Overall exposure to non-financial corporations in total exposures: 13.0, 13.8, 14.0, 13.3, 12.8
- Large exposures to total exposures2/: 94.0, 94.6, 94.6, 94.1, 93.5
- Share of mortgage lending in total lending to private customers: 10.7, 13.3, 14.2, 17.8, 21.7
- Equities portfolio to own funds: 25.1, 21.1, 17.6, 15.5, 13.8

Profitability and liquidity
- Return on assets (Net after-tax income to total assets)4/: 0.4, 0.5, 0.5, 0.4,...
- Return on equity (Net after-tax income to paid-in capital): 34.0, 36.7, 40.7, 36.4,...
- Liquidity ratio: 62.0, 61.0, 63.0, 63.0, 63.0

Notes and sources
- 1/ Data for 2003 refer to an average ratio from June 2002 to June 2003.
- 3/ Are considered Luxembourg banks including foreign branches; branches of Luxembourg banks abroad are excluded.
- 4/ Assets = total balance sheet - prepayments and accrued income.
- 2/ According to Luxembourg banking regulations, large exposures are defined as exposures above 6.25 million euros or its equivalent amount or 10 percent of the bank's own funds.
- Sources: Banque Centrale du Luxembourg.

### Statistical issues and data improvements
- Recent improvements:
  - ESA95 national accounts data extended back to 1985 (previously from 1995).
  - Central government accounts compiled on an ESA95 basis.
  - In 2002, the Central Bank of Luxembourg began compiling and disseminating quarterly balance of payments statements including current and financial accounts, compiled in the framework of BPM5.
- Remaining data problems impeding analysis:
  - National accounts data based on ESA95 are not available at a quarterly frequency.
  - A full set of accounts is not available for some institutional sectors (households, financial and nonfinancial corporations).
  - General government accounts are not available at a quarterly frequency.
- Authorities intend to subscribe to the Fund’s Special Data Dissemination Standard (SDDS); main obstacles include SDDS requirements to provide sub-annual national accounts and central government data.
- Publication of quarterly national accounts will begin soon, following clarification of methodological issues; preliminary data were discussed in a seminar hosted by STATEC.

### Debt sustainability (overview and projections)
- Public sector debt was about 5 percent of GDP in 2003.
- Public sector financial assets were about 60 percent of GDP in 2003, held largely by the social security system.
- Conclusion: Debt sustainability is not an issue over the medium run; the conclusion would also hold upon excluding financial assets.
- Projections indicate:
  - Public sector's net financial assets are projected to decline through 2008, reflecting general government budget deficits.
  - Over the longer run, age-related expenditures are projected to rise considerably.
- Policy implications and recommendations:
  - It would be prudent to return the central government budget to balance over the medium run, consistent with a modest general government budget surplus.
  - The pension system would have to be reformed to avert the risk of a vicious circle of rising contribution rates and falling migration and activity.
- Selected historical and projected indicators (1993–2008, percent of GDP, selected rows):
  - Public sector debt (1993–2008): 7.2, 6.5, 6.6, 7.2, 6.8, 6.2, 5.8, 5.5, 5.5, 5.7, 4.9, 6.1, 5.9, 5.8, 3.8, 3.2
  - Change in public sector debt: 1.6, -0.7, 0.1, 0.5, -0.4, -0.5, -0.4, -0.4, 0.0, 0.2, -0.8, 1.1, -0.2, -0.1, -2.0, -0.6
  - Identified debt-creating flows (4+7+12): -2.0, -3.5, -2.6, -2.2, -3.9, -3.8, -4.1, -7.0, -6.3, -2.6, 0.8, 2.4, 2.8, 2.6, 1.5, 0.8
  - Primary deficit: -2.0, -3.2, -2.4, -2.3, -3.6, -3.5, -3.8, -6.6, -6.4, -2.7, 0.8, 2.4, 2.8, 2.6, 1.6, 0.9
  - Revenue and grants (percent of GDP): 50.0, 49.2, 47.6, 47.5, 46.5, 45.1, 44.8, 44.9, 45.3, 46.7, 46.4, 45.2, 45.0, 45.0, 45.0, 45.0
  - Primary (noninterest) expenditure (percent of GDP): 48.0, 45.9, 45.2, 45.2, 43.0, 41.6, 40.9, 38.2, 38.9, 44.0, 47.2, 47.6, 47.9, 47.6, 46.6, 45.9
  - Residual, including asset changes (2-3): 3.6, 2.7, 2.7, 2.8, 3.5, 3.2, 3.7, 6.7, 6.4, 2.7, -1.6, -1.3, -3.0, -2.6, -3.5, -1.4
- Key macro and fiscal assumptions (selected averages and projections)
  - Real GDP growth (selected years/historical): 8.5, 4.1, 3.5, 3.3, ... projected 3.3, 3.5, 3.9, 4.0, 3.0
  - Average nominal interest rate on public debt (in percent): 6.7, 5.7, 5.9, 5.6, 5.3, 5.9, 5.4, 5.1, 5.1, 4.7, 5.5,...
  - Inflation rate (GDP deflator, in percent): -0.2, 4.9, 4.3, 2.0, 2.7, 2.7, 2.2, 3.9, 2.2, 0.6, 2.5, 1.6, 1.1, 1.7, 1.7, 1.7

Stress test scenarios (debt-stabilizing primary balance and alternative shocks)
- Baseline debt-stabilizing primary balance: 4.9 (and other projected outcomes shown in table)
- Alternative scenarios include:
  - A1. Key variables at historical averages in 2004-08
  - A2. Primary balance under no policy change in 2004-08
  - A3. Country-specific shock in 2004 with reduction in GDP growth of one standard deviation
  - B1–B6. Bound tests: shocks to real interest rate, real GDP growth, primary balance, combinations, a one-time 30 percent real depreciation, and a 10 percent of GDP increase in other debt-creating flows
- Memorandum item: Public sector financial assets (selected values): 51.3, 55.5, 52.8, 53.2, 54.9, 56.6, 62.5, 63.5, 59.5, 57.2, 53.4, 49.9, 47.6, 46.0

### Fund relations and institutional notes (as of February 29, 2004)
- Membership Status: Joined December 27, 1945; Article VIII.
- Quota: 279.10 SDR Million (100.00 percent)
  - Fund holdings of currency: 168.07 (60.22 percent)
  - Reserve position in Fund: 111.05 (39.79 percent)
- SDR Department:
  - Net cumulative allocation: 16.95 (100.00 percent)
  - Holdings: 8.69 (51.23 percent)
- Outstanding Purchases and Loans: None
- Financial Arrangements: None
- Projected Obligations to Fund: None
- Exchange rate arrangement:
  - On January 1, 1999, Luxembourg entered Stage 3 of EMU at a rate of 40.3399 Luxembourg franc per euro.
- Exchange restrictions:
  - Luxembourg is an Article VIII member and maintains an exchange system free of restrictions on payments and transfers for current international transactions, except for reasons related to security.
  - Authorities implemented measures freezing accounts and banning payments for the Taliban, listed terrorists, persons and organizations related to terrorism, and restrictions on payments/transfers to UNITA, Iraq, certain individuals in Myanmar, Serbia and Montenegro, and Zimbabwe (detailed listing on central bank website annex to Circulaire BCL 2002/172).

*International Monetary Fund. Staff Report for the 2004 Article IV Consultation — Supplementary Information (Prepared by the European and Policy Development and Review Departments; Approved April 23, 2004).*

### 1.      This supplement reports on data on the fiscal outcome for 2003 that has become

### _cr04125 - 1.      This supplement reports on data on the fiscal outcome for 2003 that has become

### Fiscal developments and outlook
- New data since the staff report do not change the thrust of the staff appraisal; other economic indicators evolved broadly in line with staff projections.
- Eurostat-submitted data: general government deficit was contained to 0.1 percent of GDP in 2003.
  - This outcome is about 0.8 percentage point of GDP lower than the staff’s projection.
  - This outcome is 0.5 percentage point below the earlier official estimate.
- Revenue and expenditure developments in 2003:
  - Modest revenue overperformance relative to the staff’s projections due to higher VAT and excise tax receipts; this does not materially alter staff revenue projections for 2004-06.
  - Expenditure was appreciably lower as major investment projects were delayed; at this stage, there are no plans to cancel these projects.
  - Social spending grew faster than the staff’s projection in 2003.
- Staff assessment and risks:
  - Much of the overperformance is likely to be temporary.
  - The Stability Program (SP) medium-term targets remain at risk, including possibly a temporary breach of the Maastricht 3 percent ceiling in 2005, unless discretionary spending plans are scaled down or entitlement programs reformed.
- Table: Luxembourg: General Government Finances, 2003-03 (In percent of GDP)
  - Columns shown: SP 1/, Staff Est. 2/, Update 3/ for 2002 and 2003
  - 2002 (SP 1/; Staff Est. 2/; Update 3/):
    - Revenue 46.7 46.7 47.0
    - Expenditure 44.2 44.2 44.3
    - Balance 2.4 2.4 2.7
    - Social expenditure growth (in percent) 10.6 10.6 10.4
    - Gross debt 5.7 5.7 5.7
  - 2003 (SP 1/; Staff Est. 2/; Update 3/):
    - Revenue 47.1 46.4 46.6
    - Expenditure 47.7 47.4 46.8
    - Balance -0.6 -1.0 -0.1
    - Social expenditure growth (in percent) 9.3 9.3 9.8
    - Gross debt 4.9 4.9 4.9
  - Sources: Eurostat; and IMF staff estimates and projections.
  - Notes:
    - 1/ SP refers to the authorities' Stability and Growth Program update of November 2003.
    - 2/ See Staff Report, Table 2.
    - 3/ Notification to Eurostat by STATEC.
- Legislative update:
  - The draft law that broadens the scope for the investment of social security assets (see Staff Report, §14) has recently been passed.

### Other issues (exchange restrictions / security measures)
- In accordance with IMF Executive Board Decision 144-(52/51) dated August 14, 1952, the authorities formally notified the Fund on April 15, 2004, of measures taken for the preservation of national and international security that give rise to exchange restrictions subject to Fund jurisdiction.
- In addition to measures listed in the Staff Report (Appendix I), restrictions in place relate to:
  - Somalia (per EU Council Regulation No. 147/2003)
  - Democratic Republic of Congo (per EU Council Regulation No. 1727/2003)
  - Assets of some residents of Kuwait and Iraq
- Restrictions relating to Angola, mentioned in the Staff Report, are no longer in place.

### Public Information Notice (PIN) No.04/49 — IMF Concludes 2004 Article IV Consultation with Luxembourg (May 4, 2004)
Background and recent developments:
- After a prolonged slowdown, an externally-driven upswing appears in the offing, though obstacles limit a return to the 5.5 percent average real GDP growth of 1980-2000.
- Financial sector still adjusting to the bursting of the global equity bubble.
- Relatively generous wage settlements and falling productivity increased unit labor costs, reducing corporate profitability and competitiveness; competitiveness also weakened by euro appreciation.
- Sluggish activity and generous welfare benefits raised unemployment; labor force participation remains relatively low, particularly among older residents.
- Authorities are adjusting policies to the slowdown; major new initiatives on hold ahead of June 2004 general election.
- Tax cuts, high expenditure, and weak activity are estimated to have caused a general government deficit in 2003, the first in two decades.
- Expenditure growth programmed to slow to about 4.3 percent in 2004, down from near double-digit growth rates in previous years.
- Some reforms and entitlement adjustments are supporting the deceleration in spending.
- Absent further measures, general government deficit projected to rise through 2005 as corporate tax receipts react with a lag to the slowdown.
- Gross debt remains low and net assets high.

Executive Board assessment — key observations and recommendations:
- Directors welcomed indications of real GDP growth rebounding but noted medium-run growth prospects are less buoyant than past decade performance due to slower productivity growth and financial sector expansion.
- Two key challenges:
  - Adapt fiscal policy to slower growth via marked deceleration of expenditure increases.
  - Enhance resilience through entitlement and labor market reforms.
- Directors urged a comprehensive post-election strategy to address these challenges to preserve Luxembourg’s attractiveness for business.
- Fiscal stance:
  - Directors supported the objective to run a small general government surplus over the medium run without increasing the tax burden, but stressed difficulty given the slowdown.
  - Attaining the objective will require expenditures lower than planned in the Stability Program update.
  - Several Directors emphasized benefits of more rapid adjustment; several pointed to importance of observing the 3 percent of GDP deficit ceiling.
  - Directors encouraged elimination of the general government deficit soon after 2006, unless real GDP growth disappoints significantly.
- Expenditure policy recommendations:
  - Expenditure restraint is key; tight control of discretionary spending needed in 2004 to avoid overshooting the deficit target.
  - Comprehensive adjustment strategy should center on cutbacks in subsidies, better targeting of jobless support, and health care and pension reforms.
- Entitlement and aging-related recommendations:
  - Address aging-related pressures proactively to limit risks of deleterious payroll tax hikes.
  - Health care measures could include raising the proportion of medical expenses paid out-of-pocket.
  - For old-age pensions, consider building up a mandatory fully-funded pillar to mitigate risks from high workforce mobility.
  - Alternatively, link the rate of replacement of pre-retirement income to the pension contribution base, and link statutory retirement age to life expectancy.
  - Some Directors recommended reviewing the pension system before 2006 and more often than every 7 years thereafter.
- Labor market recommendations:
  - Employment growth supported by commuters, but resident unemployment rose and older-worker participation is low.
  - Support efforts to improve targeting of jobless support and curtail abuse of disability pensions.
  - Consider aligning shortened work experience requirement for young workers’ unemployment benefits with that for other workers.
  - Improve on-the-job training for older workers and eliminate incentives to exit the labor force early (notably in the pension system).
  - Consider gradual reductions in the replacement rate of minimum income to strengthen work incentives for those fully able to work.
- Financial sector and AML/CFT:
  - Luxembourg’s financial sector is robust, efficient, and well supervised (as per 2002 FSAP).
  - Directors welcomed steps to improve financial sector supervision and endorsed efforts to strengthen AML/CFT legal and implementation structure.
  - Directors commended authorities’ commitment to ensure the new AML/CFT draft law meets the highest international standards.
- Other:
  - Directors praised Luxembourg’s high level of official development assistance and encouraged support for multilateral reductions of agricultural subsidies and import restrictions.
  - Directors observed economic statistics are adequate for surveillance and encouraged efforts to subscribe to the Fund’s Special Data Dissemination Standard.

### Selected economic indicators (as presented)
- Real economy:
  - Real GDP (change in percent): 2000 9.1; 2001 1.2; 2002 1.3; 2003 1.2 1/; 2004 2.3 2/
  - Domestic demand (change in percent): 2000 4.9; 2001 4.3; 2002 -0.6; 2003 2.2 1/; 2004 2.5 2/
  - CPI (in percent, year average): 2000 3.2; 2001 2.7; 2002 2.1; 2003 2.6 1/; 2004 2.1 2/
  - Unemployment rate (in percent): 2000 2.6; 2001 2.6; 2002 3.0; 2003 4.1 1/; 2004 4.9 2/
  - Gross national saving (in percent of GDP): 2000 32.9; 2001 32.2; 2002 26.2; 2003 25.9 1/; 2004 25.6 2/
  - Gross fixed investment (in percent of GDP): 2000 20.9; 2001 22.9; 2002 22.5; 2003 22.5 1/; 2004 22.4 2/
- Public finances (percent of GDP):
  - General government balance: 2000 6.4; 2001 6.2; 2002 2.4; 2003 -1.0 1/; 2004 -2.6 2/
  - General government gross debt: 2000 5.5; 2001 5.5; 2002 5.7; 2003 4.9 1/; 2004 6.1 2/
- Interest rates (in percent):
  - Short term rate 3/ 4/: 2000 4.4; 2001 4.3; 2002 3.3; 2003 2.3; 2004 2.1
  - Long-term bond yield 5/: 2000 5.9; 2001 5.4; 2002 5.3; 2003 4.3; 2004 ...
- Balance of payments (in percent of GDP):
  - Trade balance: 2000 -12.4; 2001 -12.2; 2002 -9.6; 2003 -10.2; 2004 -10.5
  - Current account: 2000 12.8; 2001 8.4; 2002 8.2; 2003 5.9; 2004 6.9
- Exchange rates:
  - Euro per US dollar 6/: 2000 1.08; 2001 1.12; 2002 1.06; 2003 0.88; 2004 0.82
  - Nominal effective rate (1995=100): 2000 95.50; 2001 95.40; 2002 95.63; 2003 96.89; 2004 ...
  - Real effective rate (CPI based; 1995=100): (no values shown)
- Notes:
  - Sources: Data provided by the authorities; and IMF staff calculations.
  - 1/ Data for 2003 are estimates as of April 6, 2004.
  - 2/ Projections.
  - 3/ For 2004, data refer to February.
  - 4/ Short-term rates are for 3-month euro deposits.
  - 5/ Average of long-term bonds traded on Luxembourg Stock Exchange. Long-term government bond yields are not available (the only 10-year government bond matures in 2007).
  - 6/ For 2004, data refer to March 25.

*IMF staff report supplement and Public Information Notice (PIN) No.04/49 (May 4, 2004).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04125.pdf_