## _cr06164

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### Background and outlook
- The dominant financial sector has supported a steady rebound in economic activity; growth is projected to remain healthy in the near term, but trend growth may decline as the rapid financial sector expansion may decelerate.
- Growth has decelerated this decade to an annual average of 3 percent from 5 percent in the 1980s and 1990s.
- The recovery in 2004–05 averaged nearly 4½ percent.
- General government net financial assets are estimated at 29.5 percent of GDP at end-2005.
- The fiscal deficit widened to 2.3 percent of GDP in 2005.
- Unemployment has edged up to 4½ percent.
- The government plans to announce in May a comprehensive reform package to address fiscal and structural challenges.

### Financial sector importance for growth
- Findings:
  - The financial sector’s shift from traditional banking services to the investment fund industry (IFI) is well advanced.
  - Financial sector and closely linked sectors (real estate, telecommunications, other) accounted for two thirds of GDP in 2005.
  - Services exports grew by an estimated 16 percent in 2005, fueling a substantial current account surplus.
  - Banks facilitated a shift of foreign deposits into investment vehicles exempt from taxation in anticipation of the EU Savings Directive, boosting commission income.
  - Luxembourg’s IFI assets administered reached €1.5 trillion in December 2005.
- Projection:
  - Staff estimates growth may fall short of authorities’ medium-term projection of 4½ percent a year by nearly 1 percentage point as financial sector expansion decelerates.
- Real Growth Scenarios (Annual percent change; 2000-05 / SP 2006-11 / Staff 2006-11):
  - GDP: 4.1 / 4.6 / 3.7
  - Financial sector: 3.9 / 5.3 / 3.8
  - Banks: 2.1 / 2.1 / 2.1
  - IFI: 10.8 / 10.5 / 6.8
  - Insurance: 2.1 / 6.3 / 4.4
  - OFSP: 0.5 / 6.3 / 4.4
  - Sectors related to the financial sector: 5.0 / 5.3 / 3.8
  - Other sectors: 3.4 / 3.4 / 3.4
- Interpretation:
  - Reaching SP GDP growth requires average financial sector growth of 5 ¼ percent.
  - Staff scenario requires close to 4 percent real growth in the financial sector and robust annual IFI growth of slightly less than 7 percent.

### Financial sector soundness and supervision
- Findings:
  - Financial system remains sound, resilient to potential adverse shocks, and well supervised.
  - High foreign ownership and close integration with parent companies tend to enhance asset quality and capital adequacy.
  - Rising commission income, from IFI activity, supports earnings diversification.
  - Banking sector profit growth has fallen short of its long-term average despite higher commission income.
- Structural and comparative indicators (selected exact values preserved):
  - Regulatory capital to risk-weighted assets, Latest: Luxembourg 17.5; EU-15 average 1/ 12.0...
  - Capital to assets, Latest: Luxembourg 5.3; EU-15 average 1/ 6.0...
  - Impaired loans to total gross loans, Latest: Luxembourg 0.3...; EU-15 average 1/ 2.4...
  - After-tax return on average assets, Latest: Luxembourg 0.5; EU-15 average 1/ 0.8...
  - After-tax return on average equity, Latest: Luxembourg 37.8; EU-15 average 1/ 14.5...
- Profitability and earnings quality:
  - Profits—excluding taxes and provisions—rose by an estimated 13 percent in 2005.
  - Exceptional factors buoyed commission income in 2005 (strong equity markets; shift from foreign deposits to investment funds).
- Stress testing and resilience:
  - Off-balance-sheet positions grew by 33 percent during 2005; asset growth was 14 percent in the same period.
  - Under extreme sectoral-loss assumptions, stress tests showed no systemic consequences, though some banks could fall below capital adequacy.
  - Among 17 banks with real estate exposure > 10 percent of own funds, capital of virtually all banks remained above required level under extreme assumptions (100 percent LTV and full losses).
  - Interest rate and exchange rate exposure described as minor.
  - Stress tests modeled as a 2 percentage point variation in rates for 19 banks with highest exposure did not lower capital below regulatory minimum.
- Supervision and crisis management:
  - Supervisory staffing rose from 199 to 256 by end-2005 for the banking supervisory authority.
  - Cooperation with foreign supervisors broadened; planned FSAP update in 2007.
- Insurance sector:
  - Solvency comfortable but coverage ratio declining.
  - A 25 percent fall of equity markets (September 2005) would lower solvency of three companies below standards.
  - Regular stress tests conducted; supervisory staff increased.
- Supervisory standards:
  - Classification of non-performing loans followed parent company standards; unified standard desirable but no immediate steps envisaged.

### Inflation, prices, and real exchange rate
- Findings:
  - HICP headline inflation was 3.9 percent in February (year-on-year), with an upward bias due to consumption weights reflecting nonresidents.
  - Underlying inflation remained subdued; modest widening of underlying inflation differential with euro area as service price inflation exceeded goods price inflation.
  - Rental costs have risen sharply amid a housing market boom.
  - Real effective exchange rate (REER) is near its long-run average.
- Prices and costs (selected):
  - GDP deflator 2001–2006 (percent): 2001: 1.9; 2002: 1.1; 2003: 2.1; 2004: 2.5; 2005 (Est.): 2.5; 2006 (Proj.): 2.5
  - CPI (harmonized), p.a. 2001–2007 (percent): 2001: 2.4; 2002: 2.1; 2003: 2.5; 2004: 3.2; 2005 (Est.): 3.8; 2006 (Proj.): 2.5; 2007 (Proj.): 2.2
  - Average nominal wage growth (overall economy) 2001–2007 (percent): 2001: 4.0; 2002: 3.5; 2003: 2.0; 2004: 2.6; 2005 (Est.): 3.4; 2006 (Proj.): 3.2; 2007 (Proj.): 3.1

### Fiscal policy: developments, risks, and staff advice
- Developments:
  - General government balance deteriorated in 2005 for the fourth consecutive year to a deficit estimated at 2.3 percent of GDP.
  - Contributing factors: rapidly rising social expenditures (pensions, health care), ambitious public investment program (5 percent of GDP), delayed tax effects from slowdown, VAT revenue shortfalls due to large reimbursements after a court order.
  - Budget envisages reducing general government deficit by ½ percent of GDP to 1.8 percent of GDP in 2006 (staff viewed measures as not well defined).
  - Authorities argued deficit target could be reached via temporary slowdown in investment expenditures; last year’s unanticipated VAT refunds reached 1 percent of GDP.
- Staff recommendations:
  - Curtail social expenditure growth to reverse adverse fiscal trends and return to a moderate surplus, given underfunding of future pension liabilities.
  - Adopt a medium-term fiscal framework to anchor policies.
  - Staff supported authorities’ intention to restore budget balance soon after 2008 but noted durable expenditure measures remained to be defined and the adjustment needed strengthening.
- Pension financing and medium-term stance:
  - Official forecasts: funding gap of at least 50 percent of GDP by 2050.
  - Staff baseline projection: funding gap of 100 percent of GDP by 2050.
  - Staff sharp-deceleration projection: funding gap could reach 221 percent of GDP by 2050.
  - Staff estimate: a general government surplus of 1 percent of GDP or more may be required to build pension assets and forestall harmful contribution-rate increases later.
  - Authorities agreed a small general budget surplus might be required; increase of retirement age under consideration.
- Fiscal consolidation measures advised and previously recommended:
  - Curtail social expenditure growth, improve targeting, means testing.
  - Pension and health care reforms: link replacement rates to contribution base; link statutory retirement age to life expectancy; introduce intergenerational solidarity factors; preempt health care contribution increases via reforms (higher co-payments, generic drugs, rationalizing hospitals).
  - Authorities envisaged cumulative expenditure reduction of 2½ percent of GDP during 2006-08 as per 2005 Stability Program; durable measures remained to be defined.

### Box 4 — Preserving the Sustainability of the Pension System
- Overview:
  - Despite current surpluses, strains are building on the public pension system; rapid employment growth of young cross-border workers lowered current dependency ratio but raises future liabilities.
  - Authorities’ 2005 actuarial review: slowdown in growth and employment would open sizeable funding gap threatening pensions of those below age 40.
- Projections and scenarios:
  - Net asset position of pension fund in 2005: 25 percent of GDP.
  - Minimum projected pension system debt by 2050: 50 percent of GDP.
  - Staff baseline projection: funding gap of 100 percent of GDP by 2050.
  - Sharp deceleration projection: funding gap of 221 percent of GDP by 2050.
- Key drivers:
  - Replacement rates exceeding 100 percent of last salary on average.
  - Low effective retirement age.
  - Automatic benefit indexation to inflation and wage growth.
  - Pension fund asset allocation: three quarters are held in time deposits.
- Policy recommendations (priority actions):
  - Align pension replacement rates with contribution base; introduce a “solidarity factor”.
  - Raise the retirement age and relate early retirement benefits to standard retirement age.
  - Terminate subsidies for pre-retirement pensions.
  - Build up pension fund assets by running budget surpluses and improve returns on pension fund assets (reduce low-yield time deposits).
- Fiscal implications:
  - Assuming moderate pension reforms, staff estimates expenditure cuts of 1.7 percent of GDP are needed for pension fund income to cover all liabilities from 2050.
  - Required expenditure savings could drop to 1 percent of GDP if returns on pension fund assets increase by 100 basis points on average (depending on trend growth).
  - Authorities’ expenditure reduction target: cumulative 2½ percent of GDP during 2006-08.
  - Absent comprehensive reforms, achieving long-term fiscal sustainability requires a sustained general government surplus of 1 percent of GDP or more.
- Complementary measures:
  - Intensify health care reforms (raise co-payments, increase efficiency) to prevent harmful payroll tax increases.
  - Enhance targeting and means testing of social expenditures.
  - Maintain monitoring and stress testing of financial sector; improve pension fund asset returns.

### Labor market and structural unemployment
- Findings:
  - Unemployment is rising and becoming increasingly structural; unemployment rate increased to 4.2 percent in 2005 and projected 4.5 percent in 2006.
  - Cross-border employees fill two out of three vacancies.
  - Widening entitlement gap between resident and foreign job seekers has intensified regional competition and increased resident unemployment.
  - Structural unemployment increase largely owing to a labor supply shock from neighboring countries’ benefit reforms.
  - Working hours declining; labor participation—especially of older people—remains low.
- Staff recommendations:
  - Align unemployment aid and minimum guaranteed income more closely with regional levels to prevent wage-competition-driven long-term unemployment.
  - Revise wage indexation to reflect neighboring countries’ wage developments.
  - Review early retirement schemes to raise participation; tighten access to unemployment aid for young people.
  - Expand on-the-job training to address the apparent skills gap.

### Near-term growth outlook, risks, and competitiveness
- Near-term outlook:
  - Consensus that near-term growth outlook is positive; staff projection for 2006 GDP growth: 4.0 percent.
  - Authorities indicated their 2006 forecast might need lowering to staff’s 4.0 percent projection.
- Drivers and constraints:
  - External demand expected to remain a major driver.
  - Domestic demand and consumption uncertain amid planned social expenditure restraint, disappointing retail sales, limited real wage gains, and continued weak consumer sentiment.
  - Monetary conditions described as supportive.
  - Investment demand expected to strengthen gradually, largely driven by replacement investments.
- Downside risks:
  - Higher-than-expected oil prices or disorderly unwinding of global imbalances could choke euro-area recovery, posing serious risks for capital markets and financial sector profits.
  - Domestic risk: potential decline in housing prices; authorities viewed repercussions as manageable because house price inflation concentrated in upper segment.
- Competitiveness considerations:
  - Structural features complicate competitiveness analysis: financial services and steel exports combined ~ two thirds of total exports in 2005.
  - CPI-based REER provides little insight for price-taking exporters; unit labor costs not available for dominant financial sector.
  - Financial sector shifting to lower-margin activities increases competition risks, especially custody business.
  - ULC in manufacturing have been decreasing since late 2001; large steel industry faces rising global capacity and competition, notably in Asia.

### External sector, balance of payments, and key macrostatistics
- Selected macro indicators and projections (exact values preserved):
  - Population (2004, thousand): 451.6
  - Land Area: 2,586 square kilometers
  - GDP per capita (2004): $70,654
  - GDP per capita plus commuters (2004): $57,548
  - Real GDP volume changes (percent): 2001: 1.5; 2002: 2.5; 2003: 2.9; 2004: 4.5; 2005 (Est.): 4.3; 2006 (Proj.): 4.0; 2007 (Proj.): 3.8
  - Current account balance (percent of GDP): 2002: 11.6; 2003: 6.8; 2004: 11.1; 2005 (Est.): 7.9; 2006 (Proj.): 7.3; 2007 (Proj.): 7.3
  - Balance of trade in goods and services (percent of GDP): 2002: 28.4; 2003: 26.1; 2004: 28.2; 2005 (Est.): 30.1; 2006 (Proj.): 31.7; 2007 (Proj.): 32.9
  - Exports of goods and services (percent of GDP): 2002: 139.2; 2003: 134.4; 2004: 146.8; 2005 (Est.): 152.8; 2006 (Proj.): 157.2
  - Factor income balance (percent of GDP): 2002: -15.3; 2003: -17.0; 2004: -13.0; 2005 (Est.): -18.9; 2006 (Proj.): -20.9
- Financial account (percent of GDP, selected): 2002: -12.7; 2003: -6.2; 2004: -11.0; 2005 (Est.): -9.3; 2006 (Proj.): -6.5
- Financial sector assets (euro billion, selected):
  - Banks total assets: 2000: 648; 2001: 721; 2002: 663; 2003: 656; 2004: 695; 2005: 792
  - Investment funds assets: 2000: 875; 2001: 928; 2002: 845; 2003: 953; 2004: 1,106; 2005: 1,525
  - Investment fund industry at end-February 2006: about EUR 1,600 billion (an increase of nearly 40 percent compared to same period in 2005).

### Public finances and debt dynamics (selected figures)
- General government (percent of GDP):
  - Revenues: 2001: 45.2; 2002: 45.8; 2003: 45.2; 2004: 44.5; 2005 (Est.): 44.2; 2006 (Proj.): 44.2; 2007 (Proj.): 44.1
  - Expenditures: 2001: 39.1; 2002: 43.7; 2003: 45.0; 2004: 45.6; 2005 (Est.): 46.5; 2006 (Proj.): 46.4; 2007 (Proj.): 46.2
  - General government balance (percent of GDP): 2001: 6.1; 2002: 2.1; 2003: 0.2; 2004: -1.2; 2005 (Est.): -2.3; 2006 (Proj.): -2.2; 2007 (Proj.): -2.1
  - General government gross debt (percent of GDP): 2001: 6.7; 2002: 6.8; 2003: 6.7; 2004: 6.6; 2005 (Est.): 6.7; 2006 (Proj.): 7.6; 2007 (Proj.): 8.4
- Public sector debt projections (percent of GDP):
  - Baseline public sector debt: 2000: 6.6; 2001: 6.7; 2002: 6.8; 2003: 6.7; 2004: 6.6; 2005: 6.7; 2006 (Proj.): 7.6; 2007 (Proj.): 8.4; 2008 (Proj.): 9.4; 2009 (Proj.): 10.6; 2010 (Proj.): 12.1; 2011 (Proj.): 13.5

### Statistics, data dissemination, and IMF relations
- Statistical improvements:
  - ESA95 national accounts data extended back to 1985.
  - Central government accounts compiled on ESA95 basis.
  - Quarterly balance of payments statements (BPM5) compiled and disseminated since 2002.
- Remaining gaps:
  - General government accounts not available quarterly.
  - Publication of quarterly national accounts data beginning in 2005 interrupted; inclusion of FISIM delayed.
  - Luxembourg has yet to produce quarterly financial accounts as specified in ECB/2005/13; authorities agreed in principle to prepare them.
  - Authorities intend to subscribe to the Fund’s Special Data Dissemination Standard (SDDS); main obstacle is sub-annual national accounts requirement.
- IMF relations:
  - Membership: Joined December 27, 1945; Article VIII.
  - Quota: 279.10 (SDR Million; 100.00)
  - Fund holdings of currency: 252.31 (90.40)
  - Reserve position in Fund: 26.80 (9.60)
  - SDR Department: Net cumulative allocation 16.95 (100.00); Holdings 11.71 (69.04)
  - Outstanding purchases and loans: None
  - Financial arrangements: None
  - Exchange rate arrangement: Entered EMU on January 1, 1999 at a rate of 40.3399 Luxembourg franc per euro.
  - Proposed next Article IV consultation: within 24 months.

*Source: Executive Summary and selected chapters of IMF staff report (_cr06164).*

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

### _cr06164 - Executive Summary

### Background and outlook
- The dominant financial sector has supported a steady rebound in economic activity; growth is projected to remain healthy in the near term, but trend growth may decline as the rapid financial sector expansion may decelerate.
- Growth has decelerated this decade to an annual average of 3 percent from 5 percent in the 1980s and 1990s.
- The recovery in 2004–05 averaged nearly 4½ percent.
- General government net financial assets are estimated at 29.5 percent of GDP at end-2005.
- The fiscal deficit widened to 2.3 percent of GDP in 2005.
- Unemployment has edged up to 4½ percent.
- The government plans to announce in May a comprehensive reform package to address fiscal and structural challenges.

### Financial sector importance for growth
- Findings:
  - The financial sector’s successful shift from traditional banking services to the investment fund industry (IFI) is well advanced.
  - The financial sector—together with closely linked real estate, telecommunications, and other sectors—accounted for two thirds of GDP in 2005.
  - Services exports grew by an estimated 16 percent in 2005, fueling a substantial current account surplus.
  - Banks facilitated a shift of foreign deposits into investment vehicles exempt from taxation in anticipation of the EU Savings Directive, boosting commission income.
  - Luxembourg’s IFI assets administered reached €1.5 trillion in December 2005.
- Projection:
  - Staff estimates that growth may fall short of the authorities’ medium-term projections of 4½ percent a year by nearly 1 percentage point as the pace of financial sector expansion decelerates.

### Financial sector soundness and supervision
- Findings:
  - The financial system remains sound, resilient to potential adverse shocks, and well supervised.
  - The close integration of Luxembourg’s mostly foreign-owned financial institutions with their parent companies tends to enhance soundness, including asset quality and capital adequacy.
  - Rising commission income, spurred by the shift into the IFI, supports diversification of earnings and financial sector stability.
  - Banking sector profit growth has fallen short of its long-term average in recent years despite increased commission income.

### Inflation, prices, and the real exchange rate
- Findings:
  - HICP headline inflation was 3.9 percent in February (year-on-year), but this measure exhibits an upward bias due to consumption weights reflecting nonresidents.
  - Underlying inflation has remained subdued; there has been a modest widening of the underlying inflation differential with the euro area as service price inflation exceeded goods price inflation.
  - Rental costs have risen sharply amid a housing market boom.
  - The real effective exchange rate (REER) is near its long-run average.

### Fiscal policy: developments and staff advice
- Developments:
  - The general government balance deteriorated in 2005 for the fourth consecutive year, to a deficit estimated at 2.3 percent of GDP.
  - Contributing factors include rapidly rising social expenditures (especially pensions and health care), an ambitious public investment program (5 percent of GDP), delayed effects of the economic slowdown on corporate taxes, and shortfalls in VAT revenues due to large reimbursements following a court order.
- Staff recommendations:
  - Curtail social expenditure growth to reverse adverse fiscal trends and return to a moderate surplus, given the underfunding of future liabilities of the public pension system.
  - Adopt a medium-term fiscal framework to anchor policies.
  - Staff supported the authorities’ intention of restoring budget balance soon after 2008 but noted durable expenditure measures remained to be defined and the adjustment needed to be strengthened.
- Past Fund advice and implementation (Box 1):
  - Fiscal policy: longstanding advice to curtail social expenditure growth to bring public finances back into surplus; some measures taken include tightened access to disability pensions and better enforcement of eligibility criteria for sickness allowances, but scaling back unemployment benefits or the minimum guaranteed income was not pursued. The latest Stability Program envisages a return to near balance by 2008.
  - Pension and health care reform: advice to address pay-as-you-go sustainability risks by linking replacement rates to the contribution base, linking statutory retirement age to life expectancy, introducing intergenerational solidarity factors, and preempting health care contribution rate increases through reforms (higher co-payments, generic drugs, rationalizing hospital services). An increase of the retirement age is under consideration; a reform plan to lower health care costs is under preparation. A payroll tax increase became necessary in 2005.
  - Financial sector: continuous strengthening of supervision, including higher frequency of stress testing for the insurance sector.

### Labor market and structural unemployment
- Findings:
  - Unemployment is rising and becoming increasingly structural.
  - Cross-border employees are filling two out of three vacancies.
  - A widening gap in entitlements between resident and foreign job seekers has heightened competition in Luxembourg’s regional labor market and pushed a growing number of resident workers into unemployment.
  - There has been a steady increase in structural unemployment, largely owing to a labor supply shock triggered by benefit reforms in neighboring countries.
  - Working hours are declining and labor participation—especially of older people—remains low.
- Staff recommendations:
  - Address structural unemployment by modifying major entitlement benefits, including unemployment assistance and the minimum guaranteed income.

### Other issues highlighted
- The IFI’s growth has supported a shift in bank income composition toward commission income, but portfolio management activities remain abroad due to stiff competition.
- Luxembourg has not participated in the rapid growth of the hedge fund industry despite strong IFI expansion.
- The share of domestic demand and consumption in GDP is falling steadily, increasing dependence on financial services exports.

*Source: Executive Summary of IMF staff report (_cr06164).*

### 8.      The discussions focused on the policies required to overcome challenges to

### _cr06164 - 8.      The discussions focused on the policies required to overcome challenges to

### Near-term growth outlook and risks
- Consensus that the near-term growth outlook is positive (Table 1).
- Staff projection for 2006 GDP growth: 4.0 percent; authorities indicated their 2006 forecast might need to be lowered to the staff’s 4.0 percent projection.
- Drivers and constraints:
  - External demand expected to remain a major driver of growth.
  - Domestic demand and consumption prospects uncertain amid:
    - planned restraint of social expenditures,
    - disappointing retail sales,
    - limited real wage gains,
    - continued weak consumer sentiment (Figure 7).
  - Monetary conditions described as supportive.
  - Investment demand expected to strengthen gradually, largely driven by replacement investments.
- Downside risks identified:
  - Higher-than-expected oil prices or a disorderly unwinding of global imbalances could choke the recovery in the euro area (the destination for nearly all of Luxembourg’s exports), with serious risks for capital markets and financial sector profits.
  - Domestic risk: potential decline in housing prices; authorities viewed repercussions as manageable because house price inflation concentrated in the upper price segment of the market.

### Competitiveness (Box 2)
- Structural features complicate competitiveness analysis:
  - Financial services and steel exports combined represented about two thirds of total exports in 2005.
  - CPI-based REER provides little insight for exporters that are price-takers.
  - Standard indicators such as unit labor costs (ULC) not available for the dominant financial sector.
- Financial sector dynamics:
  - Sector potentially becoming more vulnerable to competition despite continued export success.
  - Shift from high- to low-profit-margin activities heightens competition risks, especially for the custody business.
  - Financial sector wage developments relatively favorable; cost-income ratios remain low compared to other financial centers.
- Manufacturing and steel:
  - ULC in manufacturing have been decreasing since late 2001.
  - Large steel industry facing heightening competition as global capacity rises, especially in Asia.
  - Decline in relative ULC driven by output gains combined with moderate employment reduction; wage moderation and layoffs may be necessary if steel boom ends.

### Financial sector and the medium-term outlook (Section A and Box 3)
- Prominence: financial sector and its key role were central to discussions.
- Recent developments:
  - Slowdown in traditional banking activities; Luxembourg’s banking sector losing market share within the EU.
  - Authorities attributed part of the slowdown to cyclical decline of credit in Germany.
  - Slowing asset growth also due to banks’ shift into off-balance-sheet activities, especially IFI-related business.
  - Off-balance-sheet positions grew by 33 percent during 2005, more than double the 14 percent growth of assets during the same period.
- Authorities’ view vs. staff:
  - Authorities more sanguine about continued rapid financial sector expansion; expected strong retail and institutional demand for investment funds to continue.
  - Staff argued that less buoyant, albeit still strong, financial sector growth would lower real GDP trend growth to 3¾ percent over the medium term, almost 1 percentage point below assumptions underlying the November 2005 Stability and Program (SP).
- Box 3 scenarios (Real Growth Scenarios, Annual percent change):
  - 2000-05 (1/ 2005 estimate) and 2006-11 (SP 2/Staff) comparisons:
    - GDP: 4.1 / 4.6 / 3.7
    - Financial sector: 3.9 / 5.3 / 3.8
    - Banks: 2.1 / 2.1 / 2.1
    - IFI: 10.8 / 10.5 / 6.8
    - Insurance: 2.1 / 6.3 / 4.4
    - OFSP: 0.5 / 6.3 / 4.4
    - Sectors related to the financial sector: 5.0 / 5.3 / 3.8
    - Other sectors: 3.4 / 3.4 / 3.4
  - Interpretation:
    - Reaching SP GDP growth requires strong financial sector growth (average financial sector growth of 5 ¼ percent).
    - Staff scenario requires close to 4 percent real growth in the financial sector and robust annual IFI growth of slightly less than 7 percent.

### Financial sector supervision and soundness (Section B)
- Comparative strength and structural characteristics:
  - Financial sector soundness compared favorably with the EU average (Table 2).
  - Very high foreign ownership of banking sector and interbank market linkages with foreign parents contributed to high asset quality and liquidity ratios and enhanced capital adequacy ratios.
  - Approximately two-thirds of interbank assets and liabilities resulted from subsidiaries’ involvement in liquidity management with their EU parent companies (Table 3).
  - Interbank deposits accounted for about half of the sector’s total liabilities in 2005 and were typically channeled back into the interbank market as short-term loans.
  - Recording of such transactions on a gross basis inflated assets and lowered capital-to-asset ratios of Luxembourg-based subsidiaries.
- Comparative banking sector indicators, 1999–2005 (selected exact values preserved as presented):
  - Regulatory capital to risk-weighted assets, Latest: Luxembourg 17.5; EU-15 average 1/ 12.0...
  - Capital to assets, Latest: Luxembourg 5.3; EU-15 average 1/ 6.0...
  - Impaired loans to total gross loans, Latest: Luxembourg 0.3...; EU-15 average 1/ 2.4...
  - After-tax return on average assets, Latest: Luxembourg 0.5; EU-15 average 1/ 0.8...
  - After-tax return on average equity, Latest: Luxembourg 37.8; EU-15 average 1/ 14.5...
- Profitability and earnings quality:
  - Structural shift toward commission income improved earnings quality.
  - Exceptional factors buoyed commission income in 2005 (strong European equity markets, shift of foreign deposits into investment funds from the EU Savings Directive).
  - Profits—excluding taxes and provisions—rose by an estimated 13 percent last year; authorities expected profit growth to decelerate in the current year but remain robust.
- Stress tests and resilience:
  - Combination of rising own funds and reduced exposure to credit risks from eight selected sectors limited vulnerabilities.
  - Under extreme assumption of full loss of banks’ claims in any individual sector, stress tests showed no systemic consequences, though some banks’ capital could fall below adequacy requirements.
  - Among 17 banks with real estate exposure exceeding 10 percent of own funds, capital of virtually all banks would remain above required level under extreme assumptions of 100 percent loan-to-value ratios and full losses.
  - Interest rate and exchange rate exposure described as minor.
  - Stress tests for on- and off-balance-sheet interest rate risks—modeled as a 2 percentage point variation in rates—for the 19 banks with the highest interest rate exposure did not lower capital of any of these banks below the regulatory minimum.
- Supervision and crisis management:
  - Improvements in crisis management and cooperation with foreign supervisors via bilaterals and multilaterals; cooperation broadened to involve EU finance ministries.
  - Supervisory staffing rose from 199 to 256 by end-2005 for the banking supervisory authority.
- Insurance sector:
  - Solvency remained comfortable but coverage ratio declining due to expansion in life and nonlife segments (Table 4).
  - A 25 percent fall of equity markets would lower solvency of three companies below standards (September 2005); impact of interest rate shifts limited.
  - Number of supervisory staff increased; regular stress tests conducted in line with FSAP recommendations.
- Supervisory standards:
  - Classification of non-performing loans followed parent company standards; authorities agreed a unified standard would be desirable but no immediate steps envisaged.
- Planned FSAP update: authorities agreed it would be timely to review developments through an FSAP update in 2007.

### Fiscal policy (Section C)
- 2006 deficit target and measures:
  - Budget envisages a reduction in the general government deficit by ½ percent of GDP to 1.8 percent of GDP.
  - Staff viewed underlying expenditure measures as not well defined and saw the deficit stabilizing rather than declining (Table 5).
  - Authorities argued deficit target could still be reached through a temporary slowdown in investment expenditures.
  - Noted last year’s unanticipated VAT refunds reached 1 percent of GDP largely due to a single company and were unlikely to be repeated.
- Reform package orientation:
  - Authorities emphasized core of forthcoming reform package would include measures to improve fiscal developments.
  - Broad agreement that maintaining Luxembourg’s attractiveness for foreign labor and capital is paramount; adjustment should primarily rely on expenditure measures (Figure 8).
  - Measures should be front-loaded given the strength of the cyclical upswing and the staff’s view of a decline in trend growth.
- Medium-term fiscal stance and pension financing:
  - Authorities stated intention to return the budget to balance soon after 2008; staff supported such a stance due to revenue volatility and need for a safety margin.
  - Public pension system funding gap:
    - Official forecasts projected a funding gap of at least 50 percent of GDP by 2050.
    - Staff considered the official growth trajectory optimistic; under more realistic assumptions, baseline projections showed the gap would reach 100 percent of GDP, excluding aging-related increases in health care costs.
    - Potential closure options:
      - Best closed through cuts in benefits, but required cuts would need to be larger than authorities prepared to consider.
      - Alternatively, smaller cuts in pension benefits combined with a gradual build-up of the pension fund’s asset position so income would cover liabilities.
    - Staff estimates suggested this might require a general government surplus of 1 percent of GDP or more to build assets and forestall harmful increases in contribution rates later.
  - Authorities agreed a small general budget surplus might be required to address pension underfunding and indicated an increase of the retirement age was under consideration.
  - Public sector financial asset position remained comfortable (Table 6).

*Source: _cr06164 - 8.      The discussions focused on the policies required to overcome challenges to (IMF PDF chapter).*

### Box 4. Preserving the Sustainability of the Pension System

### Box 4. Preserving the Sustainability of the Pension System

### Overview and main concern
- Notwithstanding current surpluses, strains are building on the public pension system.
- Rapid employment growth of young cross-border workers has lowered the current pension dependency ratio, while raising future pension liabilities.
- The authorities’ actuarial review of pension finances in 2005 concluded that a slowdown in growth and its repercussions on employment growth would open up a sizeable funding gap, threatening the pensions of those below the age of 40 years.

### Projections and scenarios
- By 2050 the pension system would accumulate debt of at least 50 percent of GDP, reversing the fund’s comfortable net asset position (25 percent of GDP in 2005).
- Staff projections:
  - Baseline growth scenario: funding gap of 100 percent of GDP by 2050.
  - Sharp deceleration in GDP growth: funding gap could reach 221 percent of GDP by 2050.
- Simulation notes and scenarios:
  - Scenario 1: growth slowdown to 3 percent by 2030 (Stability Program 2005).
  - Scenario 2: growth slowdown to 2 percent below 3 percent by 2020.
  - Cumulative decrease in pension liabilities by 3 percent of GDP in equal increments beginning in 2010 for 20 years (entitlement reform assumption).
  - Increase of return on pension fund assets by 100 basis points relative to baseline projections (improved returns assumption).

### Key drivers of the problem
- Unusually high replacement rates—exceeding 100 percent of the last salary on average.
- Low effective retirement age.
- Automatic benefit indexation to inflation and wage growth.
- Pension fund asset allocation: three quarters are held in time deposits, implying hitherto low returns.

### Policy recommendations (priority actions)
- Priority should be given to pension benefit reform:
  - Align pension replacement rates with the contribution base (staff suggested introduction of a “solidarity factor”).
  - Raise the retirement age.
  - Put early retirement benefits in relation to the standard retirement age.
  - Terminate subsidies for pre-retirement pensions.
- Any remaining funding gap should be closed through income from pension fund assets by building up an appropriate asset position—requiring running budget surpluses.
- Improve returns on pension fund assets (reduce share in low-yield time deposits).
- To forestall harmful increases in contribution rates, build up the asset position of the pension fund gradually.

### Fiscal implications and needed adjustments
- Assuming moderate pension benefit reforms, staff estimates that expenditure cuts of 1.7 percent of GDP are needed for pension fund income to cover all liabilities starting in 2050.
- The required expenditure savings could drop to 1 percent of GDP if returns on pension fund assets increase by 100 basis points on average, depending on trend growth.
- The authorities confirmed intention to reduce expenditures by a cumulative 2½ percent of GDP during 2006-08, as set out in the 2005 Stability Program.
- Absent comprehensive reforms, achieving long-term fiscal sustainability requires a sustained general government surplus of 1 percent of GDP or more.

### Complementary reforms and related policy areas
- Health care reforms need to be intensified to prevent deleterious increases in payroll taxes, including by raising co-payments and improving efficiency.
- Enhance targeting of social expenditures and means testing to curtail social expenditure growth and relieve pressure on pension financing.
- Maintain monitoring and stress testing of the financial sector; improve pension fund asset returns as part of broader financial-sector positioning.

### Selected quantitative items and exact figures from the analysis
- Net asset position of pension fund in 2005: 25 percent of GDP.
- Minimum projected pension system debt by 2050: 50 percent of GDP.
- Staff baseline projection: funding gap of 100 percent of GDP by 2050.
- Sharp deceleration projection: funding gap of 221 percent of GDP by 2050.
- Required expenditure cuts under moderate reforms: 1.7 percent of GDP.
- Required expenditure cuts if returns rise by 100 basis points: 1 percent of GDP.
- Authorities’ expenditure reduction target: cumulative 2½ percent of GDP during 2006-08.
- Required sustained general government surplus for long-term sustainability if reforms absent: 1 percent of GDP or more.
- Pension fund asset allocation note: three quarters are held in time deposits.
- Recent payroll tax level (health care context): 5.4 percent of gross wages (hike in 2005).

*IMF staff box: "Box 4. Preserving the Sustainability of the Pension System"*

### 41.      Reversing the rise in structural unemployment requires reducing regional

### _cr06164 - 41.      Reversing the rise in structural unemployment requires reducing regional

### Structural unemployment and labor force participation
- Reversing the rise in structural unemployment requires reducing regional differences in reservation wages, and further raising labor force participation is essential.
- The authorities’ intention to review early retirement schemes to raise participation is welcome.
- Access to unemployment aid by the young should also be tightened.

### Social benefits and wage competition
- Social benefits, especially unemployment aid and the minimum guaranteed income, should be aligned more closely with those in the region, with a view to preventing wage competition from pushing resident job seekers into long-term unemployment.
- To further enhance the competitiveness of resident job seekers, wage indexation should be revised, at a minimum, to reflect wage developments in the neighboring countries.

### Skills gap and training
- The apparent skills gap should be addressed by on-the-job training.

### Policy recommendations (summary)
- Align unemployment aid and minimum guaranteed income more closely with regional levels to prevent wage-competition-driven long-term unemployment.
- Revise wage indexation to reflect wage developments in neighboring countries.
- Review early retirement schemes to raise labor force participation.
- Tighten access to unemployment aid for young people.
- Expand on-the-job training to address the apparent skills gap.

### Development assistance
- Luxembourg’s high level of official development assistance and its leadership in this field is commendable.

### Statistics and data dissemination
- Although Luxembourg’s economic statistics are adequate for surveillance, improvements are needed, also to allow it to subscribe to the Fund’s Special Data Dissemination Standard.

*Source: _cr06164 - 41. Reversing the rise in structural unemployment requires reducing regional; https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06164.pdf*

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

### _cr06164 - 44.      It is proposed that the next Article IV consultation with Luxembourg be held within

### 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 on April 28, 2004 (IMF Country Report 04/125).

### Macroeconomic outlook and key statistics (selected)
- Population (2004, thousand): 451.6
- Land Area: 2,586 square kilometers
- GDP per capita (2004): $70,654
- GDP per capita plus commuters (2004): $57,548
- Real GDP volume changes (percent):
  - 2001: 1.5
  - 2002: 2.5
  - 2003: 2.9
  - 2004: 4.5
  - 2005 (Est.): 4.3
  - 2006 (Proj.): 4.0
  - 2007 (Proj.): 3.8
- Components of demand (volume changes, percent, selected):
  - Total domestic demand 2004: 1.6; 2005 (Est.): 2.4; 2006 (Proj.): 2.6; 2007 (Proj.): 2.8
  - Private consumption 2004: 1.4; 2005 (Est.): 0.5; 2006 (Proj.): 1.2; 2007 (Proj.): 1.8
  - Public consumption 2004: 5.0; 2005 (Est.): 6.0; 2006 (Proj.): 4.2; 2007 (Proj.): 4.1
  - Gross fixed investment 2004: 3.5; 2005 (Est.): 4.6; 2006 (Proj.): 4.0; 2007 (Proj.): 3.6
  - Exports of goods and nonfactor services 2004: 8.2; 2005 (Est.): 6.1; 2006 (Proj.): 6.5; 2007 (Proj.): 6.1
  - Imports of goods and nonfactor services 2004: 6.8; 2005 (Est.): 5.1; 2006 (Proj.): 6.0; 2007 (Proj.): 5.9
- Employment and labor (in thousands, selected):
  - Resident labor force 2001: 195.3; 2002: 199.2; 2003: 202.9; 2004: 206.7; 2005: 210.9; 2006 (Proj.): 214.8; 2007 (Proj.): 217.9
  - Unemployed (level): 2001: 4.5; 2002: 5.2; 2003: 7.0; 2004: 8.0; 2005: 8.9; 2006 (Proj.): 9.7; 2007 (Proj.): 10.3
  - Unemployment rate (percent of total labor force): 2001: 2.3; 2002: 2.6; 2003: 3.5; 2004: 3.9; 2005: 4.2; 2006 (Proj.): 4.5; 2007 (Proj.): 4.7
  - Cross-border workers (net): 2001: 89.0; 2002: 94.6; 2003: 98.2; 2004: 102.9; 2005: 109.4; 2006 (Proj.): 116.3; 2007 (Proj.): 121.5
  - Total employment 2001: 279.7; 2002: 288.6; 2003: 294.1; 2004: 301.6; 2005: 311.3; 2006 (Proj.): 321.4; 2007 (Proj.): 329.1
- Prices and costs (annual changes, percent):
  - GDP deflator 2001: 1.9; 2002: 1.1; 2003: 2.1; 2004: 2.5; 2005 (Est.): 2.5; 2006 (Proj.): 2.5
  - CPI (harmonized), p.a. 2001: 2.4; 2002: 2.1; 2003: 2.5; 2004: 3.2; 2005 (Est.): 3.8; 2006 (Proj.): 2.5; 2007 (Proj.): 2.2
  - Average nominal wage growth (overall economy) 2001: 4.0; 2002: 3.5; 2003: 2.0; 2004: 2.6; 2005 (Est.): 3.4; 2006 (Proj.): 3.2; 2007 (Proj.): 3.1

### Public finances and debt (selected)
- General government (percent of GDP):
  - Revenues: 2001: 45.2; 2002: 45.8; 2003: 45.2; 2004: 44.5; 2005 (Est.): 44.2; 2006 (Proj.): 44.2; 2007 (Proj.): 44.1
  - Expenditures: 2001: 39.1; 2002: 43.7; 2003: 45.0; 2004: 45.6; 2005 (Est.): 46.5; 2006 (Proj.): 46.4; 2007 (Proj.): 46.2
  - General government balance (percent of GDP): 2001: 6.1; 2002: 2.1; 2003: 0.2; 2004: -1.2; 2005 (Est.): -2.3; 2006 (Proj.): -2.2; 2007 (Proj.): -2.1
  - General government gross debt (percent of GDP): 2001: 6.7; 2002: 6.8; 2003: 6.7; 2004: 6.6; 2005 (Est.): 6.7; 2006 (Proj.): 7.6; 2007 (Proj.): 8.4
- General Government Operations projections (selected, percent of GDP):
  - Revenue (2005 onward): 44.2 (2005 Est.); projections through 2010 show revenues at 44.1 (2008-2010).
  - Overall balance: 2004: -1.2; 2005 (Est.): -2.3; 2006 (Proj.): -2.2; 2007 (Proj.): -2.1; 2008 (Proj.): -2.1; 2009 (Proj.): -2.1; 2010 (Proj.): -2.2
- Public sector debt dynamics (Table 6, selected):
  - Baseline public sector debt (percent of GDP): 2000: 6.6; 2001: 6.7; 2002: 6.8; 2003: 6.7; 2004: 6.6; 2005: 6.7; 2006 (Proj.): 7.6; 2007 (Proj.): 8.4; 2008 (Proj.): 9.4; 2009 (Proj.): 10.6; 2010 (Proj.): 12.1; 2011 (Proj.): 13.5
  - Change in public sector debt (percent of GDP): 2000: -0.5; 2001: 0.1; 2002: 0.2; 2003: -0.1; 2004: -0.1; 2005: 0.1; 2006 (Proj.): 0.9; 2007 (Proj.): 0.8; 2008 (Proj.): 1.0; 2009 (Proj.): 1.2; 2010 (Proj.): 1.5; 2011 (Proj.): 1.5
  - Primary deficit (percent of GDP): 2000: -6.4; 2001: -6.4; 2002: -2.4; 2003: -0.5; 2004: 0.9; 2005: 2.0; 2006 (Proj.): 1.9; 2007 (Proj.): 1.8; 2008 (Proj.): 1.7; 2009 (Proj.): 1.8; 2010 (Proj.): 1.7; 2011 (Proj.): 1.7
  - Key macro/fiscal assumptions (selected):
    - Real GDP growth (in percent): 2000: 9.0; 2001: 1.5; 2002: 2.5; 2003: 2.9; 2004: 4.5; 2005 (Est.): 4.3; 2006 (Proj.): 4.0; 2007 (Proj.): 3.8; 2008 (Proj.): 3.5; 2009 (Proj.): 3.5; 2010 (Proj.): 3.5; 2011 (Proj.): 3.5
    - Average nominal interest rate on public debt (in percent): 2000: 5.9; 2001: 5.8; 2002: 5.4; 2003: 4.9; 2004: 3.6; 2005 (Est.): 4.4; 2006 (Proj.): 4.2; 2007 (Proj.): 4.2; 2008 (Proj.): 4.2; 2009 (Proj.): 4.3; 2010 (Proj.): 4.3; 2011 (Proj.): 4.3
    - Inflation rate (GDP deflator, in percent): 2000: 4.2; 2001: 1.9; 2002: 1.1; 2003: 2.1; 2004: 2.5; 2005 (Est.): 2.5; 2006 (Proj.): 2.5; 2007 (Proj.): 2.5; 2008 (Proj.): 2.3; 2009 (Proj.): 2.2; 2010 (Proj.): 2.1; 2011 (Proj.): 2.0

### Financial sector soundness (selected indicators)
- Banking system capital adequacy (weighted period average, percent):
  - Total regulatory capital ratio: 1999: 12.9; 2000: 13.1; 2001: 13.7; 2002: 15.0; 2003: 17.1; 2004: 17.5; 2005: 17.5
  - Tier 1 regulatory capital ratio: 1999: 10.4; 2000: 11.0; 2001: 11.4; 2002: 13.1; 2003: 14.4; 2004: 14.7; 2005: 14.1
- Asset quality and provisioning (selected):
  - Net new value adjustments to own funds: 1999: 1.7; 2000: 0.9; 2001: 1.9; 2002: 5.1; 2003: 2.1; 2004: 1.6; 2005: 0.8
  - Value adjustments on credit to total gross credit: 1999: 0.7; 2000: 0.5; 2001: 0.4; 2002: 0.4; 2003: 0.3; 2004: 0.3; 2005: 0.2
- Profitability and earnings (percent):
  - Income before provisions to total assets (return on assets basis): 1999: 0.7; 2000: 0.8; 2001: 0.8; 2002: 0.7; 2003: 0.6; 2004: 0.7; 2005: 0.7
  - Net after-tax income to total assets: 1999: 0.4; 2000: 0.5; 2001: 0.5; 2002: 0.4; 2003: 0.5; 2004: 0.5; 2005: 0.5
  - Return on equity (Net after-tax income to paid-in capital): 1999: 34.0; 2000: 36.7; 2001: 40.7; 2002: 36.4; 2003: 34.9; 2004: 39.8; 2005: 37.8
- Liquidity and exposures (selected):
  - Liquidity ratio: 1999: 62.0; 2000: 61.0; 2001: 63.0; 2002: 63.0; 2003: 63.0; 2004: 62.0; 2005: 62.0
  - Foreign assets as share of total assets: 1999: 84.0; 2000: 84.7; 2001: 82.2; 2002: 86.0; 2003: 79.7; 2004: 83.1; 2005: 81.2
  - Deposit composition—shares in total deposits (percent):
    - Non-residents: 1999: 69.5; 2000: 67.9; 2001: 68.5; 2002: 68.7; 2003: 67.6; 2004: 65.2; 2005: 64.2
    - Banks and other financial institutions: 1999: 76.4; 2000: 74.0; 2001: 77.6; 2002: 78.2; 2003: 77.4; 2004: 77.9; 2005: 81.6
    - Physical persons: 1999: 13.7; 2000: 12.3; 2001: 11.7; 2002: 12.0; 2003: 11.7; 2004: 10.1; 2005: 8.5

### Financial system structure and insurance sector (selected)
- Banks (number): 2000: 202; 2001: 189; 2002: 177; 2003: 169; 2004: 162; 2005: 155
  - Domestic banks (2005, number): 4
  - Foreign banks (2005, number): 151
  - Majority foreign owned (2005, number): 108
  - Branches of foreign banks (2005, number): 45
- Investment funds (number): 2000: 1,785; 2001: 1,908; 2002: 1,941; 2003: 1,870; 2004: 1,968; 2005: 2,060
- Assets (euro billion, selected):
  - Banks total assets: 2000: 648; 2001: 721; 2002: 663; 2003: 656; 2004: 695; 2005: 792
  - Investment funds assets: 2000: 875; 2001: 928; 2002: 845; 2003: 953; 2004: 1,106; 2005: 1,525
- Insurance sector indicators (selected):
  - Coverage ratio (available solvency margin over required solvency margin) 1999–2004 (selected): 1999: 2.1; 2000: 2.3; 2001: 2.2; 2002: 2.5; 2003: 2.0; 2004: 1.9
  - Life insurance profitability (return on average equity, in percent): 1999: 13.3; 2000: 8.2; 2001: 6.0; 2002: -4.7; 2003: 0.1; 2004: 5.3
  - Non-life insurance profitability (return on average equity, in percent): 1999: 23.2; 2000: 13.4; 2001: 9.5; 2002: 0.8; 2003: 19.3; 2004: 11.9

### External sector and balance of payments (selected)
- Current account balance (percent of GDP):
  - 2002: 11.6; 2003: 6.8; 2004: 11.1; 2005 (Est.): 7.9; 2006 (Proj.): 7.3; 2007 (Proj.): 7.3; 2008 (Proj.): 7.2; 2009 (Proj.): 6.9; 2010 (Proj.): 6.6
- Balance of trade in goods and services (percent of GDP): 2002: 28.4; 2003: 26.1; 2004: 28.2; 2005 (Est.): 30.1; 2006 (Proj.): 31.7; 2007 (Proj.): 32.9; 2008 (Proj.): 33.5; 2009 (Proj.): 34.0; 2010 (Proj.): 34.5
- Exports of goods and services (percent of GDP): 2002: 139.2; 2003: 134.4; 2004: 146.8; 2005 (Est.): 152.8; 2006 (Proj.): 157.2; 2007 (Proj.): 159.8; 2008 (Proj.): 162.2; 2009 (Proj.): 164.8; 2010 (Proj.): 168.0
- Factor income balance (percent of GDP): 2002: -15.3; 2003: -17.0; 2004: -13.0; 2005 (Est.): -18.9; 2006 (Proj.): -20.9; 2007 (Proj.): -22.0; 2008 (Proj.): -22.8; 2009 (Proj.): -23.6; 2010 (Proj.): -24.4
- Financial account (percent of GDP, selected): 2002: -12.7; 2003: -6.2; 2004: -11.0; 2005 (Est.): -9.3; 2006 (Proj.): -6.5; 2007 (Proj.): -6.5; 2008 (Proj.): -6.4; 2009 (Proj.): -6.1; 2010 (Proj.): -5.8

### IMF relations, membership, and statistics
- Membership: Joined December 27, 1945; Article VIII.
- Quota (SDR Million and percent of quota): Quota 279.10 (100.00)
  - Fund holdings of currency: 252.31 (90.40)
  - Reserve position in Fund: 26.80 (9.60)
- SDR Department: Net cumulative allocation 16.95 (100.00); Holdings 11.71 (69.04)
- Outstanding purchases and loans: None
- Financial arrangements: None
- Projected payments to Fund (SDR Million; based on existing use of resources and present holdings of SDRs):
  - Charges/Interest: 2006: 0.13; 2007: 0.18; 2008: 0.18; 2009: 0.18; 2010: 0.18
  - Total: 2006: 0.13; 2007: 0.18; 2008: 0.18; 2009: 0.18; 2010: 0.18
- Exchange rate arrangement: Entered EMU on January 1, 1999 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 notified the Board on April 15, 2004, that they had imposed exchange restrictions solely for preservation of national and international security with respect to specified countries and persons.

### Statistical developments and data dissemination
- Recent improvements noted:
  - ESA95 national accounts data extended back to 1985, 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 (BPM5 framework).
- Remaining gaps and issues:
  - General government accounts are not available at a quarterly frequency.
  - Publication of quarterly national accounts data beginning in 2005 has been interrupted and the work to include FISIM has been delayed.
  - Luxembourg has yet to fulfill obligations to produce quarterly financial accounts as specified in the Update of the Guideline on Monetary Union Financial Accounts (ECB/2005/13). The ECB Governing Council took up the matter in 2005; Luxembourg agreed in principle to prepare the accounts and the National Statistical Institute will compile them.
  - Authorities intend to subscribe to the Fund’s Special Data Dissemination Standard (SDDS); main obstacle is SDDS requirement to provide sub-annual national accounts.

### Miscellaneous
- Table of Common Indicators (as of February 28, 2005) lists frequencies and timeliness for key series (exchange rates, reserve assets, monetary aggregates, central bank and banking system balance sheets, interest rates, CPI, government finance, GDP/GNP, gross external debt) with latest observations and dates received as summarized in the source.
- Statement by the IMF Staff Representative dated April 26, 2006: provides information available since the staff report was issued; the thrust of the staff appraisal remains unchanged.

*Sources: Data provided by the authorities; IMF, WEO database; Fund staff calculations; Banque Centrale du Luxembourg; Luxembourg Statistical Office; and staff estimates as reported in the source document.*

### 1.      National accounts data for the period of 1995-2004 were revised, in large part

### IMF Executive Board Concludes 2006 Article IV Consultation with Luxembourg

### National accounts and data revisions
- National accounts data for the period of 1995-2004 were revised, in large part reflecting the inclusion of financial intermediation services indirectly measured (FISIM), in line with European System of Accounts 1995 standards.
- Given the importance of the financial sector, the level of nominal GDP was revised upwards by about 6 percent in 2004.
- GDP data for 2005 remain to be released.

### Recent macroeconomic developments and outlook
- Real GDP growth:
  - Authorities’ estimate for 2005: 4.5 percent.
  - Authorities’ forecast for 2006: 4 percent (in line with staff forecast).
  - Staff medium-term projection: growth to slow to about 3½ percent.
  - Staff/authorities forecasts for 2006 and 2007 in authorities’ statement: 4 percent (2006) and 4.5 percent (2007).
- External sector:
  - Current account surplus in 2005 reached 10 percent of GDP (noted in PIN main text).
  - Selected table values: Current account balance — 2002: 11.6; 2003: 6.8; 2004: 11.1; 2005: 7.9 (percent of GDP).
  - Balance of trade in goods and services — 2002: 28.4; 2003: 26.1; 2004: 28.2; 2005: 30.1 (percent of GDP).
- Inflation and prices:
  - Harmonized CPI index, p.a. — 2002: 2.1; 2003: 2.5; 2004: 3.2; 2005: 3.8.
  - Measured by the National Index of Consumer Prices (NICP), inflation increased by 2.5 percent (authorities’ statement).
  - Assumption: if oil prices remain at current levels, inflation is unlikely to come down in 2006.
- Demand and output composition:
  - Private consumption grew by 1.2 percent (2005).
  - Real total domestic demand — 2002: -0.2; 2003: 2.9; 2004: 1.6; 2005: 2.4 (change in percent).
  - Gross fixed investment (in percent of GDP) — 2002: 21.9; 2003: 19.8; 2004: 19.3; 2005: 19.4.

### Fiscal developments and public finances
- General government budget deficit:
  - Authorities’ estimate for 2005: 1.9 percent of GDP (versus 1.2 percent of GDP in 2004), 0.4 percentage point stronger than the staff estimate.
  - Fiscal deficit outcome for 2005 better than earlier estimate of 2.3 percent.
  - Consolidation target in 2006 budget: reduction equivalent to 0.5 percent of GDP in the fiscal deficit.
  - The 2006 budget targets a moderate reduction of the deficit and the authorities intend to restore fiscal balance soon after 2008.
  - Achieving the restoration requires cumulative expenditure measures equivalent to 2½ percentage points of GDP during 2006-08, which remain to be defined.
- Public finance ratios (table, percent of GDP):
  - General government revenues — 2002: 45.8; 2003: 45.2; 2004: 44.5; 2005: 42.0.
  - General government expenditures — 2002: 43.7; 2003: 45.0; 2004: 45.6; 2005: 43.9.
  - General government balance — 2002: 2.1; 2003: 0.2; 2004: -1.2; 2005: -1.9.
  - General government gross debt — 2002: 6.8; 2003: 6.7; 2004: 6.6; 2005: 6.0.
  - Note: 2005 ratios reflect revised GDP data.
- Fiscal strategy and measures:
  - Given revenue volatility, consolidation will be concentrated on the expenditure side.
  - Measures emphasized: reducing the level of social transfers, improving efficiency of public spending (notably investment), stricter handling of sick leaves, incentives to increase use of generic drugs, more stringent controls over hospital expenditures, mitigating effect of price increases via wage indexation on social security benefits.
  - Authorities committed to high level of public investment focused on transportation-related infrastructures, education, research and health; exploring Public Private Partnerships (PPPs) and improving costing.
  - Wage moderation in the public sector after current agreement phases out at end-2006 expected to contribute to consolidation.
  - Public debt stood at 6.4 percent of GDP (authorities’ statement); debt-to-GDP ratio expected to reach barely 10 percent by 2009.

### Financial sector soundness and developments
- Sector performance:
  - Banking sector net income increased by around 20 percent in 2005.
  - Interest margin dropped by 3.2 percent; net commission income increased by 14 percent.
  - Investment fund industry: total assets at end-February 2006 reached about EUR 1,600 billion, an increase of nearly 40 percent compared to same period in 2005.
- Supervision and resilience:
  - Financial sector described as sound, resilient, robust, efficient and well supervised (FSAP 2002 conclusion).
  - Stress tests by CSSF and macro-prudential analysis by BCL confirmed resilience.
  - Banking supervision and crisis management strengthened; insurance supervisor (CAA) conducting regular stress tests and increased staff.
  - Authorities considering an FSAP update in 2007.
- Regulatory and AML/CFT:
  - AML/CFT framework strengthened; EU directive 2001/97/CE transposed into law in November 2004.

### Labor market and social policy issues
- Labor market indicators:
  - Unemployment (percent of total labor force) — 2002: 2.6; 2003: 3.5; 2004: 3.9; 2005: 4.2 (table).
  - Resident employment — 2002: 1.7; 2003: 0.9; 2004: 1.5; 2005: 1.6 (change in percent).
  - Total employment — 2002: 3.2; 2003: 1.9; 2004: 2.5; 2005: 3.2 (change in percent).
  - Unemployment rate noted at 4.7 percent in March 2006 (authorities’ statement).
- Key drivers and concerns:
  - Steady increase in structural unemployment largely owing to a labor supply shock triggered by benefit reforms in neighboring countries.
  - Widening gap between entitlements to resident and foreign job seekers has heightened regional labor market competition, pushing resident workers into unemployment.
  - Increase in unemployment mainly confined to unqualified workers; part of the rise attributable to legislative measures in 2002 and 2004 integrating partially disabled and disabled workers (effect accounted for 0.5 percent in unemployment rate at end-2005).
- Policy responses:
  - Initiatives under review: better targeting of employment measures, strengthening unemployment agency, greater focus on education and on-the-job training.
  - Options to mitigate impact of wage indexation mechanism being considered.
  - Directors urged review of social benefits, especially unemployment benefits and the minimum guaranteed income; review of early retirement schemes to raise labor force participation.

### Executive Board assessment and policy recommendations
- Growth and structural challenge:
  - Near-term growth outlook positive, supported by the financial sector; Directors welcomed successful shift into investment fund industry.
  - Directors noted growth prospects could weaken over the medium term as the financial sector matures and value added of new activities is lower.
  - Need to adjust fiscal and social policies; authorities urged to address this comprehensively in forthcoming reform package.
- Fiscal policy and social expenditure:
  - Directors supported returning fiscal accounts to balance over the medium term and welcomed targeted reduction in expenditures over 2006-08; urged specific measures to underpin targets.
  - Called for curtailing social expenditures via enhanced targeting of benefits, means testing, and delinking social expenditures from wage developments.
  - Stressed setting medium-term budget targets consistent with long-term sustainability requirements, including aging; called for sustaining a small general government surplus in absence of deep-seated reforms.
- Pensions and health:
  - Emphasized need for health care and pension reforms to achieve slowdown in expenditure growth.
  - Recommended benefits reform: link statutory retirement age to life expectancy and replacement rate to contribution base; raise returns on pension fund assets; gradually build up pension fund assets to close remaining funding gap and avoid harmful increases in contribution rates.
  - To avoid deleterious increases in payroll taxes, urged intensification of health care reforms, including raising co-payments.
- Financial sector oversight:
  - Directors welcomed diversification of banks’ income and resilience to market and real estate risks.
  - Encouraged timely adjustment of stress tests to changing market conditions and close monitoring of risks from rapid expansion of investment fund industry.
  - Welcomed progress in strengthening AML/CFT regime.
- Labor market policies:
  - Expressed concern over steady increase in structural unemployment; stressed need to raise labor force participation.
  - Urged aligning reservation wages more closely with neighboring countries; review social benefits and early retirement schemes.

### Selected economic indicators (excerpt)
- Real economy (Change in percent unless otherwise indicated):
  - Real GDP: 2002: 2.5; 2003: 2.9; 2004: 4.5; 2005: 4.3.
  - Real total domestic demand: 2002: -0.2; 2003: 2.9; 2004: 1.6; 2005: 2.4.
  - Harmonized CPI index, p.a.: 2002: 2.1; 2003: 2.5; 2004: 3.2; 2005: 3.8.
  - Gross fixed investment (in percent of GDP): 2002: 21.9; 2003: 19.8; 2004: 19.3; 2005: 19.4.
- Public finances (Percent of GDP):
  - General government revenues: 2002: 45.8; 2003: 45.2; 2004: 44.5; 2005: 42.0.
  - General government expenditures: 2002: 43.7; 2003: 45.0; 2004: 45.6; 2005: 43.9.
  - General government balance: 2002: 2.1; 2003: 0.2; 2004: -1.2; 2005: -1.9.
  - General government gross debt: 2002: 6.8; 2003: 6.7; 2004: 6.6; 2005: 6.0.
- Balance of payments (Percent of GDP):
  - Current account balance: 2002: 11.6; 2003: 6.8; 2004: 11.1; 2005: 7.9.
  - Factor income balance: 2002: -15.3; 2003: -17.0; 2004: -13.0; 2005: -18.9.
  - Transfer balance: 2002: -1.5; 2003: -2.3; 2004: -4.1; 2005: -3.4.
- Exchange rate:
  - Exchange rate regime: Member of the Euro area.
  - US dollar per Euro — 2002: 0.94; 2003: 1.13; 2004: 1.24; 2005: 1.25.
  - Nominal effective rate (1990=100) — 2002: 99.5; 2003: 100.8; 2004: 101.1; 2005: 100.8.
  - Real effective rate (CPI based; 1990=100) — 2002: 101.9; 2003: 103.7; 2004: 104.3; 2005: 104.2.

*Public Information Notice (PIN) No. 06/52 — May 8, 2006. Executive Board discussion concluded April 26, 2006.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06164.pdf_