## _cr14118 ## Source details **Canonical URL:** [_cr14118](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14118.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14118.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14118.pdf.json) --- ### Luxembourg’s financial sector — resilience and structure - Banking sector size and composition - A large banking sector (15 times GDP). - Financial sector contributed 22 percent of GDP and 11 percent of employment in 2012. - Investment fund industry manages assets amounting to 2.6 trillion euro. - Insurance sector has total assets over 5 times GDP. - Internationally‑oriented banks represent about 80 percent of assets; intragroup exposures account for half of the sector’s assets. - Activities and orientation - Sector focus: wealth management, intragroup treasury and liquidity management, custody services to investment funds, international wholesale lending. - System is a net provider of liquidity; overall non–resident deposits remained stable after the April 2013 announcement on automatic exchange of information. - Domestically‑oriented banks: less than 20 percent of total banking assets but about 250 percent of GDP; half are stand‑alone domestic banking groups, the rest owned by European banking groups. - Soundness indicators (selected) - Regulatory capital to risk-weighted assets (All banks): 20.9 (2013). - Regulatory Tier 1 capital to risk-weighted assets (All banks): 18.3 (2013). - Capital to assets (All banks): 6.4 (2013). - Nonperforming loans to total gross loans: 0.2 (2013). - Household debt to GDP: 56.5 (2013). - Domestically‑oriented banks: Residential real estate loans to total loans = 24.0 (2013); Capital to assets = 9.0 (2013). - Investment funds and product mix - UCITS funds dominate (around 80 percent of assets). - CNAV funds account for only 5 percent of total fund assets. - Large part of funds’ products sold outside the euro area; funds invest substantially in non‑euro area assets. ### Housing market and household vulnerability - Prices and credit - House prices rose by almost 9 percent in 2013. - Mortgage credit rose from 12 percent of domestically‑oriented banks’ assets in 2008 to 24 percent in 2012, or almost 50 percent of GDP. - Real estate exposures have risen to 22 percent of domestically‑oriented banks’ assets; these banks’ assets account for 2½ times GDP. - Demand and supply drivers - Structural demand: continuing population and employment growth; non‑resident workers ≈ 40 percent of employment. - Mortgage interest rates at record lows. - Government policies: interest subsidies, tax deductibility of mortgage loan interest payments, other assistance favor home ownership. - Supply constraints: environmental and zoning rules; low recurrent taxation on immovable property reduces turnover. - Household risks - Household debt to GDP ≈ 55 percent (overview figures: 55.1 (2012), 56.5 (2013)). - Much household wealth held in real estate; most loans at floating interest rates — interest rate increases or higher unemployment could pose risks. ### Outlook, risks, and spillovers - Baseline growth outlook - Growth forecast: 2 to 2½ percent over 2014–19, broadly in line with potential. - Staff medium‑term projection: output gap broadly closes by 2016 given gradual recovery in potential and slow TFP pick‑up. - Short‑ to medium‑term risks (tilted to the downside) - External: protracted low growth in the euro area could hold back Luxembourg’s recovery. - Domestic: failure to address e‑VAT revenue losses and strong spending growth could worsen fiscal position and threaten AAA rating. - Longer‑term and financial sector risks - Reorientation of banking sector toward other regions and high net‑worth clients could negatively affect growth, employment, and public finances. - Rising residential real estate exposures could pose risks in a sharp correction; three largest mortgage lenders are sizeable relative to the economy and support would add significantly to public debt. - Contagion risk from parent European banks for some domestic banks (example: Dexia). - Spillovers - Luxembourg is mainly a recipient of inward spillovers and a conduit for outward spillovers. - The 2.6 trillion euros managed by the fund industry almost entirely invested in foreign assets; large reallocations could affect many countries. ### Fiscal outlook, scenarios, and key fiscal projections - Unchanged policy scenario projected outcomes (selected, in percent of GDP) - Revenue: 2013 = 43.6; 2014 = 43.8; 2019 = 41.9 - Expenditure: 2013 = 43.5; 2014 = 43.4; 2019 = 44.9 - Balance: 2013 = 0.1; 2014 = 0.3; 2019 = -3.0 - Structural balance: 2013 = 0.5; 2014 = 0.4; 2019 = -3.0 - Public debt: 2013 = 23.1; 2014 = 24.1; 2019 = 37.8 - GDP (memo, percent change): 2013 = 2.1; 2014 = 2.6; 2019 = 2.2 - Consolidation scenario projected outcomes (selected, in percent of GDP) - Revenue: 2013 = 43.6; 2014 = 43.8; 2019 = 43.4 - Expenditure: 2013 = 43.5; 2014 = 43.4; 2019 = 42.4 - Balance: 2013 = 0.1; 2014 = 0.3; 2019 = 1.0 - Structural balance: 2013 = 0.5; 2014 = 0.4; 2019 = 0.8 - Public debt: 2013 = 23.1; 2014 = 24.1; 2019 = 28.6 - GDP growth relative to baseline: 2015 = 0.0; 2016 = -0.5; 2017 = -0.3; 2018 = -0.3; 2019 = -0.2 - Add'l consolidation relative to baseline (2015-19 average) = 0.6 - Without corrective measures - Structural deficit projected to worsen by as much as 3½ percent of GDP over 2015–2019 under unchanged policies. - Staff noted public debt could reach close to 40 percent of GDP by 2019. - Staff consolidation recommendation - An annual effort of around ½ percent of GDP in structural terms (excluding the effect of e‑VAT losses) over 2015–2019 would stabilize debt below 30 percent of GDP and allow return to medium‑term objective of ½ percent of GDP structural surplus by 2018. ### Revenue measures and e‑VAT impact - e‑VAT rule change (E‑Business Directives) effect - From 2015, VAT on digital content charged where the customer resides. - 70 percent of the revenue (1½ percent of GDP) will be lost starting in 2015, an additional 15 percent in 2017, and the full amount in 2019. - Authorities’ announced VAT measure - Planned 2 percentage point hike applying to all rates except the lowest 3 percent rate on basic goods. - Estimated yield of the VAT hike = ¾ percent of GDP. - VAT hike expected to be adopted by Parliament in the second half of the year, with rate increases to take effect in January 2015. - Staff view - Staff supported the VAT hike; Luxembourg would still maintain the lowest VAT rate in the EU despite the 2 percentage point increase. - Property taxes recommended: current income from such taxes < 0.1 percent of GDP; euro area average = ¾ percent of GDP. Suggested updating property valuations (dating back to 1941) to raise yields. ### Expenditure control, public sector reform, and fiscal institutions - Expenditure measures and process - Authorities announced consolidation measures equivalent to 0.5 percent of GDP for 2014: 60 percent via reduction of public investments; 21 percent via reduction of central government operating costs; remainder from new student grants/loans scheme. - Authorities aim for front‑loading measures in 2015 and an expenditure review in four phases with 20 working groups; analytical phase finalization in June. - Fiscal consolidation needs an amount of 1 billion euro in structural terms for 2015–2018 per 2014 Stability Program update. - Expenditure control tools - Planned introduction of multi‑annual budgeting and expenditure ceilings for central government. - Public sector reform bill (including wage agreement for 2014–16) expected to generate short‑term costs but slow seniority system; move toward flexible public servant deployment. - Recommendation to partially means‑test family benefits and review social benefits that create inactivity traps. - Fiscal institutions - Law establishing a multi‑year budgetary framework undergoing legislative procedure. - Steps taken to set up an independent Fiscal council with resources and expertise. - Staff: output gap estimates should be conservative and assessed independently; improve capacity to assess tax revenues from multinationals. ### Social benefits, labor incentives, and structural policies - Inactivity traps and METRs - Unemployment benefits: 80 percent replacement rate, maximum 12 months. - Minimum guaranteed income (RMG) available to those ineligible for unemployment benefits. - Family benefits are not means‑tested. - METR examples: - For unemployment benefits, METR only declines below 100 percent at 90 percent of average wage for a single person, and at 150 percent of average wage for the second earner of a two‑earner couple. - For the RMG, METR above 100 percent for singles earning below 50 percent of average wage and for single earner couples up to 70 percent of average wage. - Policy recommendations - Combine active labor market policies with reform of social benefits to address high METRs. - Consider reduction in social transfers associated with introducing a well‑targeted earned income tax credit system. - Continue efforts to align skills to private sector needs and reduce dropout rates; facilitate training in targeted growth areas. - Reduce barriers to entry and competition; improve administrative processes to start a business. ### Pension reform and long‑term fiscal sustainability - Status and recommendations - Pension reform adopted in December 2012 but further measures needed; pension obligations expected to remain unsustainable without deeper reforms. - Staff encouraged considering measures ahead of the 2017 scheduled review, including permanently limiting indexation of pensions to inflation only. ### Financial supervision, macroprudential policy, and AML/CFT - Regulatory and supervisory changes - Move toward banking union and Single Supervisory Mechanism (SSM); transposition of Basel III; harmonization of recovery/resolution and deposit guarantee schemes. - Basel III CET1 minimum 7 percent from 2014 (front‑loaded); banks generally expected to meet this. - Each bank to be required to provision at least 1 percent of their insured deposits by end‑2016 (aggregate provisioning already exceeds 2 percent). - Work to transpose EU Deposit Guarantee Schemes and Bank Recovery and Resolution Directives started; banks to prepare resolution plans. - Supervisory capacity and coordination - CSSF staffing increased to around 500 full‑time equivalent staff; stress‑testing techniques enhanced; cooperation between BCL and CSSF strengthened for SSM preparations. - Foreseen set‑up of a national Systemic Risk Committee involving supervisors, BCL, and Finance Ministry; SRC expected to conduct system‑wide stress testing covering funds and banks. - Recommendation to strengthen operational independence of the CSSF as part of SSM‑related legal revisions. - Macroprudential monitoring and recommendations - Supervisors raised risk weights for mortgages with LTV > 80 percent and require frequent stress testing. - Authorities should be ready to take additional macro‑prudential measures if exposures continue to rise; consider maintaining higher capital requirements for domestically‑oriented banks in collaboration with European authorities. - Monitor interconnections across banks, funds, specialized providers, financial holdings, infrastructures; communicate investor/depositor protection commitment to limit reputational risks. - AML/CFT and transparency shortcomings - Shortcomings: inadequate treatment of tax offenses, limited transparency of ownership of legal persons and arrangements, weaknesses in detection/exchange of financial intelligence and tax information on non‑residents. - Recommendations: include tax crimes among predicate offenses to money laundering; increase transparency for legal persons and legal arrangements; strengthen exchange of financial intelligence and supervisory effectiveness. - Authorities await adoption of EU 4th AML/CFT Directive to revise legal framework; preparatory steps underway (bearer share immobilization bill submitted October 4, 2013). ### Exchange rate assessment - Staff findings - Exchange rate estimated broadly in line with fundamentals; no evidence of substantial misalignment. - Average REER gap of three methods: - Macroeconomic balance (MB): -2.0 - Equilibrium real exchange rate (ERER): 6.5 - External stability (ES): -1.3 - Memorandum: Current account Norm 2019 (% of GDP) = 1.9; Projected current account 2019 (% of GDP) = 4.0 - Elasticity of REER to current account = -1.0 ### Real sector projections (selected series) - GDP (in billions of euro): 41.7 (2011), 42.9 (2012), 45.5 (2013), 47.4 (2014), 49.2 (2015), 51.4 (2016), 53.3 (2017), 55.6 (2018), 57.8 (2019). - Real GDP growth (change in percent): 1.9 (2011), -0.2 (2012), 2.1 (2013), 2.6 (2014), 2.0 (2015), 2.1 (2016), 2.2 (2017), 2.2 (2018), 2.2 (2019). - Output gap (percent deviation): -0.3 (2011), -1.8 (2012), -1.1 (2013), -0.2 (2014), -0.2 (2015), -0.1 (2016), 0.0 (2017–2019). - CPI (harmonized), p.a.: 3.7 (2011), 2.9 (2012), 1.7 (2013), 1.4 (2014), 1.8 (2015–2016), 1.8 (2017), 1.9 (2018–2019). - Unemployment rate (percent): 5.7 (2011), 6.1 (2012), 6.9 (2013), 7.1 (2014), 7.0 (2015), 6.7 (2016), 6.4 (2017), 5.9 (2018), 5.5 (2019). ### Risk Assessment Matrix — selected risks and policy responses - More protracted recovery in the euro area - Likelihood: High; Impact: High. - Policy response: Diversify toward non euro area markets; preserve competitiveness. - Failure to address forthcoming fiscal revenue losses and dynamic public spending - Likelihood: Low; Impact: High. - Policy response: Articulate clear medium‑term consolidation strategy. - Sharp correction in housing prices - Likelihood: Low; Impact: High. - Policy response: Monitor risk; stand ready to deploy additional macro‑prudential measures. - Reemergence of euro area financial stress or regulatory changes larger than expected - Likelihood: Medium; Impact: Medium–High. - Policy response: Maintain buffers; coordinate with European authorities; proactively pursue diversification while managing new risks. ### Staff appraisal — priority policy recommendations (summary) - Fiscal - Implement a moderate but sustained consolidation: consolidation of ½ percent of GDP for next five years recommended to stabilize debt below 30 percent of GDP and return to ½ percent of GDP structural surplus by 2018. - Adopt the planned VAT hike and consider boosting property tax yields (update property valuations). - Curtail public spending growth via expenditure review; introduce multi‑annual budgeting and expenditure ceilings. - Improve fiscal institutions: independent Fiscal council and conservative output gap estimation. - Financial sector and supervision - Front‑load Basel III capital requirements (welcome decision); require banks to provision for insured deposits; set up ex‑ante deposit guarantee scheme and resolution fund. - Conduct stress tests covering entire financial sector, including investment funds. - Strengthen CSSF operational independence and establish Systemic Risk Committee to monitor interconnections and conduct system‑wide stress testing. - Address AML/CFT and tax information exchange shortcomings (include tax crimes as predicate offenses; improve transparency of legal persons and arrangements). - Structural reforms - Reform social benefits to reduce inactivity traps; combine with active labor market policies; consider an earned income tax credit. - Adjust wage indexation mechanism: make one indexation round per year permanent, set annual cap closer to ECB price stability objective, introduce escape clauses and modify reference index to exclude volatile prices. - Pursue diversification strategy (logistics, ICT, bio‑ and eco‑technologies) and reduce barriers to entry and competition. *Source: IMF staff report — excerpts from Luxembourg Article IV Consultation (content unit _cr14118).* ### 1. Luxembourg’s Financial Sector _________________________________________________________________ 6 ### 1. Luxembourg’s Financial Sector ### Resilient so far, but challenges looming - Growth and recent performance - After a shallow recession in 2012, growth reached 2.1 percent in 2013—the second best performance in the euro area. - The gradual improvement in the euro area supported a rebound in exports. - Credit has been particularly dynamic for mortgage purposes, but less so to non-financial corporates. - A new government based on a three-party coalition took office following early elections in October 2013. - Trend growth and productivity - Pre-crisis average growth was 4¾ percent over 2000–08. - Potential growth is estimated to have been cut to half the pre-crisis period, at about 2–2¼ percent. - Labor costs have risen substantially more than in trade partners, and underlying productivity has been dented by the crisis. - External and fiscal position - The current account surplus reached 5.2 percent of GDP in 2013. - The exchange rate is estimated to be broadly in line with fundamentals. - General government debt was 23 percent of GDP in 2013. - The fiscal position is characterized by a structural surplus and very low general government debt; Luxembourg remains one of the few AAA-rated sovereigns in the region. - Fiscal pressures identified: upcoming losses in e-VAT revenue, rapidly growing public expenditures, and potential effects from the G20-driven push to increase transparency in corporate taxation. ### Box 1 — Characteristics of Luxembourg’s Financial Sector - Size and composition - The banking sector is large: about 15 times GDP (banking sector size described as "a large banking sector (15 times GDP)"). - In 2012, the financial sector contributed 22 percent of GDP and 11 percent of employment. - The investment fund industry manages assets amounting to 2.6 trillion euro. - The insurance sector has total assets over 5 times GDP. - Activities and orientation - Sector mostly focused on cross-border businesses: wealth management, intragroup treasury and liquidity management, custody services to investment funds, and international wholesale lending. - System is a net provider of liquidity; overall non–resident deposits remained stable even after the April 2013 announcement on automatic exchange of information for tax purposes. - Domestically-oriented banks: only a handful provide credit to the economy—less than 20 percent of total banking assets but about 250 percent of GDP—and have generally limited links with the internationally-oriented sector. - Half of domestically-oriented banks are stand-alone domestic banking groups; the rest are owned by European banking groups. - Investment funds and product composition - UCITS funds dominate, with around 80 percent of assets. - CNAV funds account for only 5 percent of total fund assets. - A large part of funds’ products are sold outside the euro area; a substantial part of the funds are invested in assets from non-euro area countries. - Comparative advantages listed - Stable political and economic conditions, AAA sovereign rating, central location within the euro area, multi-lingual society. - First-mover advantage from flexible regulations historically. - EU and euro area financial integration (European passport, single rulebooks such as UCITS). - Wide range of advisory and ancillary services. ### Housing Market Challenges (Box 2) - Recent price and credit dynamics - House prices picked up strongly in 2013, by almost 9 percent, following moderate growth between 2003 and 2011 and a slight decline in 2012. - Mortgage credit rose from 12 percent of domestically oriented banks’ assets in 2008 to 24 percent in 2012, or almost 50 percent of GDP. - Demand-side drivers - Continuing population and employment growth, and a very large group of non-resident workers (around 40 percent of employment), are pushing up structural demand. - Mortgage interest rates at record lows and accommodative financial conditions support demand. - Government policies (interest subsidies, tax deductibility of mortgage loan interest payments, and other assistance) strengthen incentives for home ownership. - Supply-side constraints and tax incentives - Supply is held back by environmental and zoning rules. - Low recurrent taxation on immovable property reduces opportunity cost of holding unused land or property, especially amid expectations of continuous price increases, further reducing turnover. - Household vulnerability - Household debt to GDP is around 55 percent. - Much household wealth is held in real estate, making it sensitive to valuation changes. - Most loans are at floating interest rates; increases in interest rates or higher unemployment could pose risks for households with more fragile positions. ### Outlook, Risks, and Spillovers - Baseline outlook - Growth is forecast to reach 2 to 2½ percent over 2014–19, broadly in line with potential. - The financial sector will continue to contribute to growth but at a slower pace than pre-crisis. - Short- to medium-term risks (tilted to the downside) - External: a protracted period of low growth in the euro area could hold back Luxembourg’s recovery given strong trade and financial linkages. - Domestic: failure to address forthcoming revenue losses and strong spending growth would worsen the fiscal position, potentially undermining the AAA rating. - Longer-term risks - Risk that banking sector reorientation (toward more dynamic regions and higher net-worth individuals) may have larger-than-expected negative impacts on growth, employment, and public finances. - Rising residential real estate exposures could pose risks in the event of a sharp correction in housing prices; three largest mortgage lenders are sizeable relative to the economy, and support to any would add significantly to public debt. - Contagion risk from parent European banks for some domestic banks (example cited: Dexia). - Spillovers - Luxembourg is primarily a recipient of inward spillovers and a conduit for outward spillovers rather than an originator of spillovers. - Internationally-oriented banks represent about 80 percent of assets. - Intragroup exposures account for half of the sector’s assets; treatment of these exposures in any bail-in decisions would be critical in a systemic shock to parent banks. - The 2.6 trillion euros managed by the fund industry are almost entirely invested in foreign assets; large reallocations could affect many countries where these funds are invested. ### Uncertainty in Potential Output Growth and Output Gap Estimates (Box 3) - Key challenges in measurement - Luxembourg’s output is highly volatile; national accounts data can be significantly revised. - TFP growth turned negative during the crisis period and has yet to recover sustainably. - Staff methodologies and 2013 estimates (data back to 1995) - Hodrick-Prescott (HP) filter on quarterly data: output gap around 1 percent of GDP in 2013. - Production function using annual HP-filtered inputs: output gap around 3½ percent in 2013. - Production function using an estimated capital series (perpetual inventory method) with labor decompositions and views on structural unemployment, participation, and hours: output gap of 2¼ percent in 2013. - Authorities’ view - Authorities used various techniques (including adapted European Commission methodology) and accounted for large pool of cross-border workers; the 2013 output gap used in the budgetary framework was 2¾ percent. - Authorities saw short-term growth prospects slightly better than staff, viewing risks as more balanced due to optimism on financial sector adjustments. - Staff projection guidance - Given uncertainties and data revisions that tend to reduce measured output gaps over time, a conservative approach is warranted. - Staff’s medium-term projections assume a very gradual recovery in potential growth and a slow pick-up in TFP; the output gap is projected to broadly close by 2016. ### Policy priorities highlighted - Preserve healthy fiscal position - Address forthcoming losses in e-VAT revenue and rapidly growing public expenditures to avoid pressure on the structural surplus and low debt position. - Manage financial sector transition and associated risks - Support banking sector reorientation while containing downside risks from deleveraging, regulatory changes, and increased transparency of cross-border flows. - Monitor domestically-oriented banks’ growing mortgage exposures and potential systemic implications of housing market corrections. - Shore up competitiveness and diversification - Contain wage and cost pressures (temporary adjustment to automatic wage indexation limiting it to one tranche every twelve months mitigated erosion in cost competitiveness; agreement expires at end of 2014). - Encourage diversification beyond the financial sector given slowdown in potential growth and headwinds to TFP. *Source: IMF staff report — 1. Luxembourg’s Financial Sector* ### 11. Without corrective measures, the fiscal position would deteriorate substantially over ### _cr14118 - 11. Without corrective measures, the fiscal position would deteriorate substantially over ### Fiscal outlook and scenarios - Under unchanged policies the structural deficit is projected to worsen by as much as 3½ percent of GDP over 2015–2019. - The deterioration is driven broadly equally by: - the loss in e-VAT revenues, and - continued buoyant expenditure growth (which has outpaced revenue and GDP since 2009). - Public debt projections (selected): - Unchanged policy scenario: Public debt 2019 = 37.8 (percent of GDP). - Consolidation scenario: Public debt 2019 = 28.6 (percent of GDP). - Staff noted public debt could reach close to 40 percent of GDP by 2019, substantially higher than the new government’s target. - Staff consolidation recommendation: - An annual effort of around ½ percent of GDP in structural terms (excluding the effect of e-VAT losses) over 2015–2019 would stabilize debt below 30 percent of GDP and allow a return to the medium-term objective of ½ percent of GDP structural surplus by 2018. - Table highlights (Unchanged policy vs Consolidation scenario, selected years and items, in percent of GDP): - Unchanged policy scenario (2013–2019 excerpt): - Revenue: 2013 = 43.6; 2014 = 43.8; 2019 = 41.9 - Expenditure: 2013 = 43.5; 2014 = 43.4; 2019 = 44.9 - Balance: 2013 = 0.1; 2014 = 0.3; 2019 = -3.0 - Structural balance: 2013 = 0.5; 2014 = 0.4; 2019 = -3.0 - Fiscal stance (excluding e-VAT loss): 2013 = -0.1; 2014 = -1.0; 2019 = -0.3 - Public debt: 2013 = 23.1; 2014 = 24.1; 2019 = 37.8 - memo: GDP (in percent change): 2013 = 2.1; 2014 = 2.6; 2019 = 2.2 - Consolidation scenario (2013–2019 excerpt): - Revenue: 2013 = 43.6; 2014 = 43.8; 2019 = 43.4 - Expenditure: 2013 = 43.5; 2014 = 43.4; 2019 = 42.4 - Balance: 2013 = 0.1; 2014 = 0.3; 2019 = 1.0 - Structural balance: 2013 = 0.5; 2014 = 0.4; 2019 = 0.8 - Fiscal stance (excluding e-VAT loss): 2013 = -0.1; 2014 = 0.6; 2019 = 0.5 - Public debt: 2013 = 23.1; 2014 = 24.1; 2019 = 28.6 - memo: GDP (in percent change): 2013 = 2.1; 2014 = 2.6; 2019 = 2.0 - GDP growth relative to baseline: 2015 = 0.0; 2016 = -0.5; 2017 = -0.3; 2018 = -0.3; 2019 = -0.2 - Add'l consolidation relative to baseline (2015-19 average) = 0.6 - Consolidation scenario assumptions (2015-19): - (i) VAT adjustment totalling ¾ percent of GDP, spread over 2015-2016; - (ii) increase in recurrent property taxes yielding ¾ percent of GDP spread over 2015-17; - (iii) moderation in expenditure growth in social benefits, purchases of goods and services, wages and salaries, current transfers, and subsidies of 2½ percent of GDP. - Total current expenditures assumed to grow by 1¾ percent per year on average in real terms as opposed to 3½ percent, over 2015-19. ### Revenue measures and e-VAT impact - e-VAT rule change (E-Business Directives) effect: - From 2015, VAT on digital content will be charged where the customer resides. - 70 percent of the revenue (1½ percent of GDP) will be lost starting in 2015, an additional 15 percent in 2017, and the full amount in 2019. - Authorities’ announced measure: - VAT hike expected to be adopted by Parliament in the second half of the year, with rate increases to take effect in January 2015. - Estimated yield of the VAT hike = ¾ percent of GDP. - Planned 2 percentage point hike would apply to all rates but the lowest 3 percent rate on basic goods. - Staff view: - Staff supported the VAT hike, noting Luxembourg would still maintain the lowest VAT rate in the EU despite the 2 percentage point increase. - Property taxes recommended as another preferred revenue source: - Current income from such taxes < 0.1 percent of GDP; euro area average = ¾ percent of GDP. - Suggested update in property valuations (dating back to 1941) to raise yields and increase holding costs of unused properties. ### Expenditure control and public sector reform - Staff emphasised need to curtail rapid expenditure growth: - Welcomed comprehensive expenditure review to prioritize savings for the 2015 budget. - Planned introduction of multi-annual budgeting and expenditure ceilings for central government as part of EU commitments. - A public sector reform bill including a wage agreement for 2014–16 is expected to generate short-term costs but allow slowdown in the seniority system. - Over the medium term, public sector staffing and compensation policies should be consistent with the new budgetary framework. - Specific area of focus: - Social benefits absorb about half of public spending, are the highest per capita in the region, and some create disincentives to work. - Consideration could be given to partially means-testing family benefits. - Authorities’ planned actions: - Achieve consolidation mainly by slowing expenditure growth. - Limit on expenditure growth at central government level already started in 2014. - Preference for front-loading measures in 2015. - Ongoing expenditure review and recommendation on property taxes noted. - Strategic review of tax and expenditure policies planned; committee of experts to be established with measures expected in 2017. - Move toward more flexible public servant deployment to respond to evolving needs. ### Social benefits, inactivity traps, and labor incentives (Box 4) - Inactivity traps occur when additional net income from work is less than social benefits foregone, producing marginal effective tax rates (METR) exceeding 100 percent. - System features contributing to inactivity traps: - Unemployment benefits: 80 percent replacement rate, for a maximum of 12 months. - Minimum guaranteed income (RMG) available to those ineligible for unemployment benefits; RMG includes a small housing benefit portion. - Family benefits are not means-tested. - Cost-of-living allowance (“allocation de vie chère”) and a minimal income tax credit for work. - METR findings (examples): - For unemployment benefits, METR only declines below 100 percent at 90 percent of average wage for a single person, and at 150 percent of average wage for the second earner of a two-earner couple. - For the RMG, METR is above 100 percent for singles earning below 50 percent of the average wage and for single earner couples up to 70 percent of the average wage. - Policy recommendations: - Focus on incentives to participate in economic activity. - Combine more active labor market policies with reform of social benefits to address high METRs. - Consider reduction in social transfers associated with the introduction of a well-targeted earned income tax credit system. - Additional note: The authorities have revamped the employment agency to more actively tackle the challenge. ### Pension reform and fiscal framework - Pension reforms remain unfinished; pension obligations expected to remain unsustainable in the long term without deeper reforms. - Staff encouraged consideration of measures ahead of the 2017 scheduled review, including permanently limiting indexation of pensions to inflation only. - Fiscal framework adjustments: - A fiscal council to monitor deviations from fiscal targets is to be constituted. - With the main fiscal target defined in structural terms, staff underlined the importance of estimating output gaps conservatively. - Need to develop better capacity to assess tax revenues stemming from multinational activities given patchy data and potential changes in international corporate taxation. ### Financial sector: changing landscape, resilience, and oversight - European regulatory and supervisory changes: - Move toward banking union and Single Supervisory Mechanism (SSM). - Transposition of the Basel III framework and harmonization of recovery/resolution processes and national deposit guarantee schemes. - Automatic exchange of information under the EU Savings Taxation Directive on savings income from 2015. - Financial sector condition and diversification: - Despite balance sheet contraction since the crisis, banks remain highly capitalized and liquid, and NPLs are low. - Diversification efforts: - Attraction of institutions from emerging markets as euro area hubs. - Retooling private banking toward high net-worth individuals ahead of automatic exchange of information in 2015. - Investment fund industry continued expanding; rapid transposition of the Alternative Investment Fund Managers Directive seen as an opportunity. - Oversight and preparedness: - CSSF staffing increased since the 2011 FSAP; stress-testing techniques enhanced; investor protection stepped up. - Cooperation between BCL and CSSF enhanced for SSM preparations. - Foreseen set-up of a national Systemic Risk Committee involving supervisors, BCL, and Finance Ministry. - 80 percent of total assets expected to be supervised by the SSM, either directly or through parent banks. - Operational independence of the CSSF could be further strengthened as part of SSM-related legal revisions. - Regulatory measures and expectations: - Basel III CET1 minimum 7 percent from 2014 (front-loaded); banks generally expected to meet this. - Each bank to be required to provision at least 1 percent of their insured deposits by end-2016 (aggregate provisioning already exceeds 2 percent of insured deposits). - Work to transpose EU Deposit Guarantee Schemes and Bank Recovery and Resolution Directives has started; banks to prepare resolution plans. - Domestic risks and recommended monitoring: - Domestic residential real estate exposures have risen substantially since 2008; measures taken include higher risk weights for mortgages with LTV > 80 percent and frequent stress testing. - Supervisors should be ready to take additional macro-prudential measures if exposures continue to rise; consider maintaining higher capital requirements for domestically-oriented banks in collaboration with European authorities. - Monitor interconnections across the financial sector (banks, funds, specialized providers, financial holdings, infrastructures) for inward and outward spillovers; Systemic Risk Committee could conduct system-wide stress testing covering both investment funds and banks. - Diversification introduces new risks (e.g., currency mismatch risks); authorities encouraged to publish assessments regularly. - Communicate commitment to investor and depositor protection to maintain confidence and limit reputational risks. - Address remaining shortcomings in AML/CFT and tax information exchange frameworks (treatment of tax offences, transparency of legal persons and arrangements, exchange of information with foreign counterparts). ### Authorities’ views (selected) - Authorities aware of fiscal challenge; plan consolidation mainly by slowing expenditure growth and front-loading measures in 2015. - VAT increase and expenditure growth cap at central government level already in place for 2014. - Preference for strategic reviews: - Committee of experts for a comprehensive tax system review, with measures expected in 2017. - Strategic review of expenditure policies and increased flexibility in public servant deployment. - On international corporate taxation, authorities favor reforms provided a level playing field is established globally. - Authorities and industry optimistic about the financial center’s adaptability to more transparency and EU-driven regulatory changes; highlighted Luxembourg’s financial “eco-system” and multi-lingual workforce as competitive strengths. *Source: IMF Staff Report excerpt (chapter on fiscal and financial sector challenges).* ### 27. Supervisors stressed, though, the importance of moving in collaboration with ### _cr14118 - 27. Supervisors stressed, though, the importance of moving in collaboration with ### Financial supervision and deposit protection - Supervisors stressed the importance of moving in collaboration with European partners. - Authorities were open to consider additional capital buffers for systemic and domestically-oriented banks, but: - such measures would have to be carried out over time and in consultation with EU partners—once the full picture of CRD IV implementation became clearer in the euro area. - Authorities plan to move ahead expeditiously to set up an ex-ante deposit guarantee scheme and saw merit in maintaining the current overall level of protection even as they moved to this ex-ante system. - Recommendation: move ahead expeditiously to set up the ex ante deposit guarantee scheme and resolution fund required by European legislation. ### Financial sector risks and oversight - Authorities broadly shared staff’s views on possible sources of risks for the financial sector. - Agreed need to closely monitor banks’ residential real estate exposure and to consider further measures if need be, but preferred to wait for the full effects of recent measures. - Agreed on the need to continuously monitor risks arising from growing interconnections within the financial sector and from diversification efforts, but at this point did not see those links posing a substantial risk to sector stability. - Authorities agreed on the need to communicate more proactively their focus on investor protection. - Authorities indicated they are waiting for the adoption of the 4th AML/CFT Directive to revise their legal framework in line with international and regional standards, but had already taken preparatory steps with regard to tax crimes and the transparency of legal persons and arrangements. - Recommendation: supervisors should remain vigilant and carefully monitor developments to determine, in collaboration with European authorities, whether specific additional measures may be warranted over time to reflect the systemic size of a number of banks. - Recommendation: stand ready to take additional actions if domestic real estate exposures continue to rise. - Recommendation: the future Systemic Risk Committee should play a leading role in monitoring interconnections between domestic financial sector actors and new emerging risks from financial diversification. - Recommendation: a more proactive focus on investor protection in authorities’ communication strategy to ward off reputational risks. ### Supporting economic diversification beyond the financial sector - Authorities are implementing a diversification strategy beyond financial activities, targeting sectors: logistics, ICT, bio- and eco-technologies; efforts beginning to bear fruit, notably in the fledgling but rapidly growing ICT sector. - Despite a strong external position, underlying trends are less benign: - Wages have continued to increase rapidly, even after the crisis, despite a decline in productivity and slower employment growth. - Increase in unit labor costs has outpaced that in euro area neighbors by about 20 percent since 2007. - The automatic wage indexation mechanism played a critical role, making it difficult for wages to adjust to declining productivity since the crisis. - Staff analysis suggests the indexation mechanism contributed to more than half of the persistent wedge between Luxembourg and euro area inflation (see Box 5). - Structural problems: continuous increase in long term unemployment and skills mismatch at the lower end of the wage scale could erode competitiveness and hamper long-term growth potential. ### Wage indexation: findings and recommended adjustments (Box 5 highlights) - Evidence and findings: - The inflation differential between Luxembourg and the euro area has been relatively persistent, at close to 1 percentage point per annum. - The wedge has almost always been positive since the inception of the euro, even during recessions. - The bi-annual review of the official minimum wage can contribute to wage dynamism; the minimum wage in Luxembourg is one of the highest among advanced economies. - An econometric analysis suggests that at least half of the inflation differential with the euro area can be attributed to the automatic indexation mechanism. - In a model linking Luxembourg inflation to euro area inflation and idiosyncratic effects, the automatic indexation and the review of minimum wages are found to contribute ½ to 1 percentage point to the annual inflation rate. - Spikes in inflation are found to occur the quarter directly following an episode of automatic wage indexation. - Recommended adjustments to the indexation mechanism (staff suggestions): - Make the limit of one indexation round per year a permanent feature after the current arrangement expires, but set the annual cap closer to the ECB price stability objective (close but below 2 percent) than the current 2½ percent threshold, with additional wage increases left to negotiations between employers and employees to reflect productivity developments. - Supplement the current mechanism with escape clauses when inflation among the main trade partners falls significantly below the annual cap on automatic indexation. - Modify the reference index to exclude volatile prices (notably food and fuel prices). - Temporary arrangements until end–2014 limiting frequency of adjustment have helped contain unit labor costs; staff emphasized need for a permanent system less conducive to high inflation persistence. ### Labor participation, skills, and business environment - Steps to increase labor participation, strengthen labor skills and reinforce the business environment recommended: - Review social benefits to strengthen work incentives: - 2012 pension reform increased number of contribution years for full pension but did not touch existing early retirement schemes that result in a low effective retirement age. - Review existing social transfers, including unemployment insurance benefits and minimum guaranteed revenue, to increase incentives to participate in the labor market. - Continue efforts to align skills to private sector needs: - Growing skill mismatches at the low end of the wage scale suggest reviewing features of the education system to reduce dropout rates and increase efficiency. - Continue collaboration with the private sector to support training in areas of targeted growth. - Reduce barriers to entry and competition: - Luxembourg has more stringent product market regulations than other EU members, notably for professional services and network industries (i.e. retail distribution). - Facilitate emergence of new firms by improving administrative processes to start a business. - Authorities’ position: - Agreed some social transfers create disincentives to work and that competitiveness had deteriorated due to rising labor costs amid declining productivity. - Viewed the business environment as conducive to attracting skilled foreign workers. - Diversification strategy focused on improving overall productivity through increased public investment in targeted growth areas and training rather than narrowly on cost competitiveness. - Consideration given so far to making the current arrangement permanent and limiting full indexation to the lower end of the wage scale. ### Staff appraisal: fiscal, financial, and structural policy priorities - Outlook and risks: - Luxembourg economy is rebounding. - Fiscal position remains sound. - Large financial sector has been resilient. - Outlook: growth to gradually firm up, yet without returning to pre-crisis trend. - Main downside risks: protracted low euro area growth; larger-than-expected impact on banks from euro area deleveraging trends and from the move to automatic exchange of information; EU-driven regulatory changes may curtail growth of the financial sector. - Fiscal policy recommendations: - A moderate but sustained consolidation is essential. - Consolidation of ½ percent of GDP for the next five years would allow public debt to stabilize below 30 percent of GDP, and the authorities to meet their medium-term objective by 2018, while mitigating impact on growth. - Given current low rates, the planned VAT hike is appropriate; consideration should be given to increasing the yield of property taxes. - Even after revenue measures, curb public spending growth; the expenditure review underway should identify savings. - Changes to design of some social benefits should be a specific area of focus; a reduction in social transfers could be associated with introduction of a well-targeted earned-income tax credit system. - Fiscal framework improvements: - Introduce expenditure ceilings in the context of multi-annual budgeting, in line with EU commitments. - Future fiscal council should have expertise and resources to monitor deviations from fiscal targets in full independence. - Output gap estimates should be made conservatively and assessed independently. - Improve information on tax expenditures and revenues stemming from multinational activities. - Financial sector resilience and transition: - Decision to front-load the implementation of Basel III’s capital requirements is welcome. - Supervisors should monitor developments and coordinate with European authorities on potential additional measures. - Move ahead expeditiously to set up the ex ante deposit guarantee scheme and resolution fund required by European legislation. - The switch to the SSM offers an opportunity to strengthen oversight; smooth transition requires continued involvement of national competent authorities in bank supervision. _International Monetary Fund — Luxembourg country report excerpts provided in the source content unit_ ### 40. It is recommended that the next Article IV Consultation with Luxembourg be held on ### _cr14118 - 40. It is recommended that the next Article IV Consultation with Luxembourg be held on ### Recommendation - It is recommended that the next Article IV Consultation with Luxembourg be held on the standard 12-month cycle. ### Real sector: developments and projections - The economy is recovering gradually, helped by resilient exports and private consumption; the recovery has become more broad-based. - GDP (in billions of euro): 41.7 (2011), 42.9 (2012), 45.5 (2013), projections: 47.4 (2014), 49.2 (2015), 51.4 (2016), 53.3 (2017), 55.6 (2018), 57.8 (2019). - Real GDP growth (change in percent): 1.9 (2011), -0.2 (2012), 2.1 (2013), projections: 2.6 (2014), 2.0 (2015), 2.1 (2016), 2.2 (2017), 2.2 (2018), 2.2 (2019). - Total domestic demand (change in percent): 4.4 (2011), 2.4 (2012), -1.0 (2013), projections: 2.2 (2014), 2.2 (2015), 2.1 (2016), 2.2 (2017), 2.2 (2018), 2.3 (2019). - Private consumption (change in percent): 1.3 (2011), 2.1 (2012), 1.7 (2013), projections: 1.9 (2014), 1.9 (2015), 2.0 (2016), 2.0 (2017), 2.1 (2018), 2.1 (2019). - Gross investment (change in percent): 11.4 (2011), 0.9 (2012), -8.8 (2013), projections: 2.8 (2014), 2.8 (2015), 2.3 (2016), 2.5 (2017), 2.4 (2018), 2.7 (2019). - Exports of goods and nonfactor services (change in percent): 5.4 (2011), -1.9 (2012), 2.6 (2013), projections: 2.2 (2014), 1.6 (2015), 2.0 (2016), 2.2 (2017), 2.2 (2018), 2.3 (2019). - Output gap (in percent deviation from potential): -0.3 (2011), -1.8 (2012), -1.1 (2013), projections: -0.2 (2014), -0.2 (2015), -0.1 (2016), 0.0 (2017), 0.0 (2018), 0.0 (2019). - Potential output growth (percent): 1.2 (2011), 1.4 (2012), 1.4 (2013), projections: 1.7 (2014), 2.0 (2015), 2.0 (2016), 2.1 (2017), 2.1 (2018), 2.2 (2019). ### Prices, wages, and labor market - CPI (harmonized), p.a.: 3.7 (2011), 2.9 (2012), 1.7 (2013), projections: 1.4 (2014), 1.8 (2015), 1.8 (2016), 1.8 (2017), 1.9 (2018), 1.9 (2019). - CPI core (harmonized), p.a.: 2.4 (2011), 2.1 (2012), 2.0 (2013), projections: 1.6 (2014), 1.9 (2015), 1.8 (2016), 1.9 (2017), 1.9 (2018), 1.9 (2019). - Wage growth (overall economy): 2/ 2.4 (2011), 2.0 (2012), 3.7 (2013), projections: 2.5 (2014), 2.5 (2015), 2.2 (2016), 2.2 (2017), 2.2 (2018), 2.2 (2019). - Nominal unit labor costs 2/: 3.4 (2011), 4.7 (2012), 2.8 (2013), projections: 1.4 (2014), 2.4 (2015), 2.0 (2016), 1.8 (2017), 2.1 (2018), 2.0 (2019). - Resident labor force (thousands): 237.7 (2011), 244.7 (2012), 250.9 (2013), projections: 257.7 (2014), 262.5 (2015), 267.3 (2016), 272.3 (2017), 277.3 (2018), 282.5 (2019). - Unemployed (thousands): 13.5 (2011), 15.0 (2012), 17.2 (2013), projections: 18.4 (2014), 18.3 (2015), 17.9 (2016), 17.5 (2017), 16.4 (2018), 15.6 (2019). - Unemployment rate (percent of total labor force): 5.7 (2011), 6.1 (2012), 6.9 (2013), projections: 7.1 (2014), 7.0 (2015), 6.7 (2016), 6.4 (2017), 5.9 (2018), 5.5 (2019). - Total employment (change in percent): 3.0 (2011), 2.5 (2012), 1.7 (2013), projections: 1.0 (2014), 1.9 (2015), 1.9 (2016), 1.9 (2017), 2.1 (2018), 2.0 (2019). - Cross-border workers (net): 142.2 (2011), 145.6 (2012), 148.0 (2013), projections: 149.9 (2014), 152.4 (2015), 154.6 (2016), 156.8 (2017), 159.1 (2018), 161.4 (2019). - The outward shift of the Beveridge curve suggests a growing skills mismatch. ### Credit and housing market - Credit growth: dynamic for households, flat for non-financial corporations (NFCs). - Credit to Households and NFCs (In percent change): NFCs and Households + NPISH shown in figure series (no single summary numeric provided beyond chart). - ECB Bank Lending Survey (percent balance of responses): households and enterprises series indicate accommodative credit conditions with relatively weak loan demand. - Interest rates on loans and ECB policy rate (in percent): mortgage interest rates especially low; charts compare ECB, mortgage, NFCs, euro area mortgage and NFCs. - Mortgage loans of domestic banks: 2008–2012 comparison (percent of assets), Luxembourg shows higher household mortgage lending relative to peers (exact charted values shown in figures). - Residential real estate prices, 1995–2012 (index number, 1996 = 100, nominal): Luxembourg series included among peers; recent trend described as squarely upward. - Real estate exposures have risen to 22 percent of domestically-oriented banks’ assets; these banks’ assets account for 2½ times GDP. ### External sector and labor-cost competitiveness - Current account (percent of GDP): 6.6 (2011), 5.8 (2012), 5.2 (2013), projections: 5.3 (2014), 4.2 (2015), 4.4 (2016), 4.2 (2017), 4.2 (2018), 4.0 (2019). - Balance on goods (percent of GDP): -13.0 (2011), -15.3 (2012), -13.9 (2013), projections: -13.2 (2014), -14.9 (2015), -14.8 (2016), -15.2 (2017), -15.2 (2018), -15.6 (2019). - Balance on services (percent of GDP): 50.7 (2011), 54.4 (2012), 52.5 (2013), projections: 52.0 (2014), 51.8 (2015), 51.4 (2016), 51.5 (2017), 51.4 (2018), 51.4 (2019). - Net factor income (percent of GDP): -28.9 (2011), -30.9 (2012), -32.6 (2013), projections: -32.7 (2014), -32.0 (2015), -31.4 (2016), -31.3 (2017), -31.2 (2018), -31.1 (2019). - Net IIP remains strongly positive. - Total economy ULC developments (index number, 2000 = 100): Luxembourg series shows unit labor cost rising rapidly, outpacing most EU peers. - Annual wage inflation (in percent relative to EA17): Luxembourg listed among highest in chart for 2008-12. ### Financial sector structure and soundness - Luxembourg hosts various large financial industries and diversified banking sector businesses. - Banking sector metrics (All banks, selected years): - Regulatory capital to risk-weighted assets: 18.3 (2009), 18.5 (2010), 16.9 (2011), 18.3 (2012), 20.9 (2013). - Regulatory Tier 1 capital to risk-weighted assets: 16.0 (2009), 16.0 (2010), 14.7 (2011), 15.9 (2012), 18.3 (2013). - Capital to assets: 5.3 (2009), 5.6 (2010), 5.1 (2011), 6.0 (2012), 6.4 (2013). - Return on assets: 0.7 (2009), 0.7 (2010), 0.6 (2011), 0.7 (2012), 0.6 (2013). - Return on equity: 13.6 (2009), 14.0 (2010), 9.6 (2011), 10.9 (2012), 10.1 (2013). - Household debt to GDP: 48.6 (2009), 52.2 (2010), 53.0 (2011), 55.1 (2012), 56.5 (2013). - Nonperforming loans to total gross loans: 0.7 (2009), 0.4 (2010), 0.3 (2011), 0.3 (2012), 0.2 (2013). - Sectoral distribution of loans (residents / non-residents): residents 25.9 (2009), 23.1 (2010), 22.2 (2011), 25.1 (2012), 21.4 (2013); non-residents 74.1 (2009), 76.9 (2010), 77.8 (2011), 74.9 (2012), 78.6 (2013). - Domestically-oriented banks (selected metrics): - Regulatory capital to risk-weighted assets: 23.4 (2009), 24.0 (2010), 22.2 (2011), 24.4 (2012), 26.0 (2013). - Regulatory Tier 1 capital to risk-weighted assets: 20.4 (2009), 21.2 (2010), 20.1 (2011), 21.8 (2012), 23.0 (2013). - Capital to assets: 6.9 (2009), 7.4 (2010), 7.0 (2011), 8.5 (2012), 9.0 (2013). - Residential real estate loans to total loans: 15.9 (2009), 17.4 (2010), 19.5 (2011), 21.5 (2012), 24.0 (2013). - Customer deposits to total (non interbank) loans: 167.3 (2009), 171.5 (2010), 156.5 (2011), 160.5 (2012), 160.0 (2013). - The banking sector has been deleveraging, interbank lending (intragroup exposures) mostly affected; the country is a net provider of liquidity to the outside. - Size of different sectors of Luxembourg financial industry (in multiples of GDP) chart indicates large magnitudes for banks, investment funds, holdings/SOPARFIs, and other financials. ### Fiscal developments and DSA (Public finances) - General government revenues (percent of GDP): 42.7 (2011), 44.0 (2012), 43.6 (2013), projections: 43.8 (2014), 42.3 (2015), 42.2 (2016), 42.0 (2017), 42.1 (2018), 41.9 (2019). - General government expenditures (percent of GDP): 42.6 (2011), 43.9 (2012), 43.5 (2013), projections: 43.4 (2014), 44.5 (2015), 44.3 (2016), 44.5 (2017), 44.7 (2018), 44.9 (2019). - General government balance (percent of GDP): 0.2 (2011), 0.0 (2012), 0.1 (2013), projections: 0.3 (2014), -2.1 (2015), -2.1 (2016), -2.5 (2017), -2.6 (2018), -3.0 (2019). - General government gross debt (percent of GDP): 18.7 (2011), 21.7 (2012), 23.1 (2013), projections: 24.1 (2014), 26.9 (2015), 29.4 (2016), 32.2 (2017), 34.9 (2018), 37.8 (2019). - Public DSA baseline scenario (Table 5 highlights): - Nominal gross public debt *: 11.1 (2012), 21.7 (2013), projections: 22.9 (2014), 24.0 (2015), 26.8 (2016), 29.6 (2017), 32.7 (2018), 35.8 (2019), 39.0 (2019 line included). - Public gross financing needs: 0.8 (2012), 1.9 (2013), projections: 6.5 (2014), 2.0 (2015), 3.6 (2016), 4.8 (2017), 5.5 (2018), 7.3 (2019), 7.8 (2019 line included). - Real GDP growth (in percent) used in DSA: 2.4 (2012), -0.2 (2013), projections: 2.0 (2014), 2.1 (2015), 1.9 (2016), 2.0 (2017), 2.2 (2018), 2.2 (2019). - Inflation (GDP deflator, in percent): 4.0 (2012), 3.0 (2013), projections: 3.0 (2014), 1.9 (2015), 2.0 (2016), 2.3 (2017), 1.5 (2018), 2.0 (2019), 1.8 (2019 line included). - Effective interest rate (in percent): 3.3 (2012), 2.7 (2013), projections: 2.7 (2014), 2.1 (2015), 2.3 (2016), 2.5 (2017), 3.0 (2018), 3.1 (2019), 3.0 (2019 line included). - DSA alternative scenarios (selected projections from Figure 6 underlying assumptions): - Baseline real GDP growth: 2.6 (2014), 2.0 (2015), 2.1 (2016), 2.2 (2017), 2.2 (2018), 2.2 (2019). - Baseline inflation: 1.5 (2014), 1.9 (2015), 2.2 (2016), 1.5 (2017), 2.0 (2018), 1.8 (2019). - Baseline primary balance: -2.1 (2014), -3.7 (2015), -3.7 (2016), -3.8 (2017), -3.8 (2018), -4.0 (2019). - Constant Primary Balance Scenario primary balance: -2.1 for 2014–2019 series. - Contingent Liability Shock scenario projections show larger effective interest rate and primary balance deterioration (e.g., Effective interest rate: 2.0 (2014), 2.7 (2015), 4.8 (2016), 4.9 (2017), 4.8 (2018), 4.5 (2019); Primary Balance: -2.1 (2014), -23.5 (2015) in table context). - Composition of public debt, gross nominal public debt (in percent of GDP): charts project rising debt shares by maturity and currency; medium and long-term versus short-term compositions shown in figure series. ### Risk Assessment Matrix: sources, likelihood, impacts, and policy responses - Surges in global financial market volatility (related to UMP exit) - Relative likelihood: High - Channel: Financial sector impact on the investment fund industry through portfolio reallocation. - Impact if realized: Low (impact deemed limited unless global stress is particularly severe). - Policy response: Conduct stress tests covering the entire financial sector, beyond banks. - Reemergence of financial stress in the euro area - Relative likelihood: Medium - Channel: Luxembourg’s financial sector health linked to euro area financial activities. - Impact if realized: Medium (financial service activities further curtailed). - Policy response: Maintain existing financial sector buffers; preserve competitiveness, especially related to wage growth, to support diversification beyond financial sector. - More protracted recovery in the euro area - Relative likelihood: High - Channel: Strong trade and financial linkages. - Impact if realized: High (economic recovery in Luxembourg held back). - Policy response: Diversify toward more dynamic non euro area markets. - Failure to address forthcoming fiscal revenue losses and dynamic public spending - Relative likelihood: Low - Channel: Losses of e-VAT and spending growth outstripping revenue growth. - Impact if realized: High (could threaten Luxembourg’s AAA rating). - Policy response: Articulate a clear medium term consolidation strategy. - Impact of changes in regulatory European banking landscape larger than expected, and/or diversification strategy fails - Relative likelihood: Medium - Channel: Diminished attraction as a financial center for euro area cross-border activities. - Impact if realized: High (significant impact on growth, employment, and public finances). - Policy response: Proactively pursue diversification strategy while scrutinizing associated new risks. - A sharp correction in housing prices - Relative likelihood: Low - Channel: Real estate exposures risen to 22 percent of domestically-oriented banks’ assets; these banks’ assets account for 2½ times GDP. - Impact if realized: High (credit flows would slow substantially; potential significant addition to public debt if support needed). - Policy response: Monitor risk and stand ready to take additional macro-prudential measures. ### Key projection and memorandum items - Memorandum items: Land area = 2,586 square kilometers; population in 2013 = 537,000; GDP per capita = €83,140. - Exchange rate indicators (selected): U.S. dollar per euro: 1.3911 (2011), 1.286 (2012) (table shows trailing dots for subsequent years); Government bond yield, end period: 2.3 (2011), 1.4 (2012), 1.9 (2013). - Balance of Payments (percent of GDP) highlights: current account surplus sustained (see Current account figures above); exports and imports growth since 2011 charted in figures. ### Policy recommendations (as described in text and risk responses) - Conduct stress tests covering the entire financial sector, beyond banks. - Maintain existing financial sector buffers and preserve competitiveness, especially by managing wage growth to support diversification beyond the financial sector. - Diversify trade and financial links toward more dynamic non euro area markets to mitigate protracted euro area weakness. - Articulate a clear medium term consolidation strategy to address forthcoming fiscal revenue losses (notably e-VAT) and contain spending growth. - Proactively pursue a diversification strategy for the financial sector while closely scrutinizing associated new risks. - Monitor housing market risks and be prepared to deploy additional macro-prudential measures if necessary. *Source: IMF staff report (selected figures, tables, and text from the Luxembourg Article IV Consultation materials).* ### Appendix I. Exchange Rate Assessment ### Appendix I. Exchange Rate Assessment ### Exchange rate outlook and assessment - Luxembourg’s current account gap is expected to narrow over the medium term. - Rising income and transfers, including the loss of e-commerce VAT revenue from 2015 and beyond, will weigh on the current account. - Medium-term projections do not reflect any policy changes and are subject to large uncertainty from the intrinsic volatility in financial service exports. - Staff estimates show that the exchange rate is broadly in line with fundamentals. - The Macroeconomic Balance (MB) and External Stability (ES) approaches indicate a slight undervaluation of the real effective exchange rate (REER) while the Equilibrium Real Exchange Rate (ERER) approach points to a mild overvaluation. - Taking all approaches together, the exchange rate is estimated to be close to the equilibrium value implied by fundamentals, with no evidence of substantial misalignment.1 - Under the MB approach, the initial net foreign asset (NFA) position and relative income growth are the two main contributors to the current account balance norm for Luxembourg, with a prudent fiscal framework also playing a role, although to a lesser extent. 1 Economies that serve as hubs for international financial flows have tended to run substantial current account surpluses and net creditor positions. This effect is captured in the IMF exchange rate assessment framework by a financial center variable that represents the following economies: Belgium, Hong Kong SAR, Luxembourg, Netherlands, Singapore, and Switzerland. ### Quantitative estimates and key statistics - Average REER gap of three methods: - Macroeconomic balance (MB): -2.0 - Equilibrium real exchange rate (ERER): 6.5 - External stability (ES): -1.3 - Memorandum: - Current account Norm 2019 (% of GDP): 1.9 - Projected current account 2019 (% of GDP): 4.0 - Elasticity of REER to current account: -1.0 ### MB approach components (2009–2019) — drivers highlighted in staff analysis - Contributors listed in the MB decomposition include: - Pop growth - Initial NFA - Income growth - Output growth - Oil trade bal. - Fiscal Bal - Grant and Aid - Constant - The MB approach frames the current account norm and its components for 2009–2019, using IMF April WEO 2014 and staff estimates. --- ### Appendix II. Implementation of Past Fund Advice ### Financial sector recommendations and authorities’ responses - Promote cross-border cooperation among supervisors of non-EU banking groups and investment funds. - Cooperation agreements have been signed with a number of countries, particularly regarding AIFMs. - Continue pursuing regulatory enhancements not requiring legislation. - Continue encouraging banks to prepare for tighter liquidity standards under Basel III. - A new minimum provisioning requirement for the deposit guarantee scheme was introduced. - Individual bank-level recovery and resolution plans are being discussed. - Discussion with banks is proceeding, to grant waivers for European bank subsidiaries where the standards will apply at the group-level. - Revisit institutional arrangements for regulation and supervision, to better align these with evolving international standards. - Cooperation between institutions is being enhanced in the context of the preparation for the Single Supervisory Mechanism. - A Systemic Risk Committee will be established. - The legal objectives of CSSF have been clarified. ### Fiscal recommendations and responses - Undertake a more comprehensive reform of the pension and healthcare systems to ensure fiscal sustainability. - A pension reform was adopted in December 2012, but more is needed. - Further reforms to health care are to be formulated. ### Structural recommendations and responses - Improve active labor market policies and the social safety net to minimize work disincentives and address market rigidities. - Luxembourg has reformed the public employment agency, effectively stepping up job search assistance. - Revise or eliminate the wage indexation system in the medium term. - Revisions of the current system are being considered by the new government. - Review product market regulations to foster competition, productivity growth, and economic diversification. - OECD indicators show some progress in reducing barriers to entry and competition for professional services. --- ### Appendix III. Implementation of 2011 FSAP ### Overall financial sector oversight — recommendations and actions - Make the CSSF’s oversight procedures and remedial actions more expeditious and effective. - A number of organizational and procedural changes have taken place to expedite enforcement actions. - Continue to increase resources and skills for supervision to enable risk-focused inspections and reduce reliance on external auditors. - Staff and resources for CSSF were further increased to around 500 full-time equivalent staff. - A new department responsible for AIFMs was created. - Improved supervisory techniques, including stress testing, and preparation towards SSM also contribute to better risk-focused supervision. - Revise the legal framework to ensure full operational independence of the CSSF. - Legal provisions that could be interpreted as giving CSSF an objective to promote the financial center were removed. - Ongoing work to revise the law to prepare for the SSM could further improve operational independence. - Clarify responsibilities of the BCL and CSSF and formalize collaboration and information exchanges. - Cooperation between the BCL and the CSSF is being enhanced in the context of the preparation for the SSM. - The set-up of a national Systemic Risk Committee is expected to further strengthen collaboration and information exchange. ### Banking oversight - Continue to closely monitor intragroup exposures to affiliate and parent banks, and take action to limit them. - CSSF continues to closely monitor intra-group exposures and subjects them to periodic stress testing. - The new law transposing CRD IV will give supervisors the power to restrict such exposures if needed. ### Investment funds/securities markets oversight - Enhance the duties of investment fund depositaries and clarify investment fund shareholder/ownership rights. - Guidance to require investment funds to clarify their shareholder/ownership rights was issued. - The duties of depositories will be enhanced through UCITS V. ### Crisis management - Strengthen the deposit insurance scheme through ex ante funding, speedier and automatic payments, use of funds for bank restructuring, and improved governance. - The payment period for the deposit insurance scheme was shortened. - Work to revise the scheme in line with European requirements is ongoing. - Strengthen the bank resolution framework, including by providing for earlier control of problem banks and enhanced resolution tools. - Work to revise the bank resolution framework in line with European requirements is ongoing. - Finalize contingency plans to ensure the continuity of the ICSD. - Discussion with the ICSD on its contingency plans are ongoing. - Formalize a multipartite domestic framework providing for operational procedures and decisive, quick and early intervention. - A multipartite domestic framework for crisis preparedness consisting of the MoF, BCL, CAA and CSSF resumed its work. (Note: Measures in italics in the source denote those taken before the 2012 Article IV consultation.) --- ### Appendix IV. Financial Integrity and Transparency Issues ### Key findings on vulnerabilities and recent assessments - Luxembourg’s financial center is highly attractive but may be vulnerable to misuse. - Political stability and multilingual, qualified financial services advisors contribute to attractiveness. - The FATF recently decided that Luxembourg had made significant progress in addressing the deficiencies identified in its 2010 AML/CFT mutual evaluation report.1 - However, AML/CFT and tax information exchange frameworks still suffer from shortcomings: - Inadequate treatment of tax offenses (notably in relation to the revised (2012) AML/CFT standard). - Limited transparency of ownership of legal persons and arrangements. - Weaknesses in the detection of and exchange of financial intelligence and tax information on non-residents. - Both the OECD’s Global Forum on Transparency and Exchange of Information for Tax Purposes and the FATF have raised concerns in this regard. - Authorities indicated they were waiting for adoption of the European Union’s 4th AML/CFT Directive to introduce necessary legal amendments. 1 See FATF, 2014, Mutual Evaluation of Luxembourg: 6th Follow-up report. ### Recommendations and specific concerns - Include tax crimes among predicate offenses to money laundering. - The scope of tax fraud2 has a number of limitations; both substance and implementation have been criticized. - Non-residents who bring funds to Luxembourg to evade taxes in their own country may not be deemed to commit the Luxembourg tax offense because using the Luxembourg legal framework does not amount per se to a “systematic use of fraudulent means”. - Tax crimes are not predicate offenses to money laundering; thus the AML/CFT framework is not applicable in cases of tax crimes, hampering detection and international cooperation on tax evaders. - Authorities indicated they are working towards including tax crimes as predicate offenses to money laundering as recommended by the 2012 FATF standards. 2 The main tax crime in Luxembourg is the “escroquerie fiscale” as defined in Articles 396, paragraph 5, and 397 of the Tax Code. Additional tax offenses include the “fraude fiscale” (Article 396, paragraph 1, of the Tax Code) and offenses relating to indirect taxes, and customs and excise duties. - Increase transparency for legal persons and legal arrangements: - A bill providing for the immobilization of bearer shares was submitted to Parliament on October 4, 2013. If adopted, this would play an important role in increasing transparency of legal persons. - Further measures are necessary to ensure beneficial ownership information of legal entities is readily available and may require changes in the Registry of Business and Corporations (RCS) framework. - Beneficial ownership information relating to trusts is only accessible in the course of criminal proceedings and identification of trusts and their beneficial owners is not carried out systematically. - The Committee on Transferable Securities (CSSF) and the Committee on Company Law (Ministry of Justice) are conducting a joint analysis of shortcomings in transparency of legal persons, trusts and other legal arrangements. ### Exchange of financial intelligence and supervisory effectiveness - The framework for exchanging financial intelligence on non-residents potentially misusing Luxembourg’s financial sector is in place but could be strengthened. - AML/CFT inspection missions have increased, suspicious transactions reports have risen, and sanctions pronounced have increased. - Authorities appear to request information from foreign counterparts as soon as a foreign person appears in a suspicious transaction report. - Almost 10,000 AML/CFT-related information requests were sent in 2012, as opposed to less than 3,000 in 2010. - However, concerns include: - Decreasing number of inspections of banks in 2013. - Short length of onsite inspection missions (3-5 days). - Relatively low amount of fines imposed in 2013 (less than EUR150,000). - One single bank disclosed more than 85 percent of all the suspicious transactions in 2012, explaining the high number of information exchanges. - A draft law concerning harmonization and update of the general legal framework on sanctions and prudential powers of the CSSF is being discussed by the authorities. - With regard to exchange of information for tax purposes, the November 2013 Phase 2 Global Forum report indicated significant delays in responses to foreign requests, based on the analysis of the response timeframe for years 2009– (text truncated in source). *Source: _cr14118 - Appendix I. Exchange Rate Assessment (IMF staff report excerpts).* ### 11. The authorities indicate that ### 11. The authorities indicate that ### AML/CFT supervision and enforcement - The authorities indicate that communications with requesting partners have significantly improved in the last years. - Onsite inspection mission duration: - Fund staff experience and indications from some FATF members suggest that onsite inspections missions last 2-3 weeks on average, depending on the size of the financial institution. - Sanctions and fines for AML/CFT non-compliance observed in other jurisdictions: - Several fines higher than US$10 million (examples cited: JP Morgan Chase, TD Bank, TCF National Bank, HSBC Holdings in the US.; Standard Bank PLC in the U.K.; UBS France in France). - Policy note: - Further improvements in transparency and strengthening of the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) framework are called for. ### Macroeconomic performance and outlook - Recent performance: - After a shallow recession in 2012, growth reached 2.1 percent in 2013. - The improvement was driven by recovery in services exports, healthy public finances, accommodative credit conditions, and continued employment growth. - Staff outlook: - Output is forecast to grow broadly in line with potential (2 to 2½ percent) over 2014-19. - Authorities' outlook and projections: - Authorities project the economy to grow by 3.2 percent of GDP in 2014 and on average by 3.5 percent of GDP over the period 2015-2018 — better medium-term prospects than estimated by staff. - Inflation: authorities note inflation is expected to be 0.9 percentage point higher in 2015 than estimated by staff, on account of a 2 percentage point increase of VAT. - Employment: authorities project employment growth of 1.9 percent in 2014 and stabilization at 2.3 percent beyond 2015. - Risks and constraints: - The economy faces challenges from a changing external financial landscape, losses in e-VAT revenue, strong expenditure growth, and erosion of cost competitiveness. - Trend growth has slowed markedly from the pre-crisis period. ### Fiscal position and public finances - Fiscal strengths: - Luxembourg maintained a relatively low level of public debt: 23 percent of GDP in 2013. - General government balance: small surplus of 0.1 percent of GDP in 2013. - Significant assets to fund future pension liabilities: these amounted to 26.9 percent of GDP at the end of 2013 and have been set aside in a dedicated Fund. - Fiscal risks: - The entry into force of the new regime for VAT on e-commerce of the 2008 EU Council Directive (2008/8/EC) will generate a loss of around 1.5 percent of GDP of VAT revenue beginning 2015. - E-VAT revenue losses and rapid expenditure growth could strain public finances. - Public expenditures display downward rigidity with a significant part growing autonomously, independent of the business cycle. - Ageing population impacts public finances over the long term. - Policy recommendations: - A moderate but sustained fiscal consolidation is essential to preserve the sound fiscal position. - Consider revenue measures (including the planned VAT hike) and increasing the yield of property taxes. - Curtail rapid public spending growth; use the expenditure review underway to identify savings. - Reconsider social benefits systems, particularly the pension system. - Introduce expenditure ceilings in the context of a multi-year budgetary framework. ### Financial sector resilience and regulatory measures - Financial sector assessment: - The large financial sector has been resilient; high bank capitalization and liquidity noted. - Strong growth of the investment fund industry observed. - Policy actions and recommendations: - Preserve financial sector resilience as diversification proceeds. - Decision to front-load the implementation of Basel III’s capital requirements is welcomed. - Supervisors should carefully monitor systemic banks, domestic real estate exposures, interconnections in the domestic financial sector, and new emerging risks from financial diversification. - Coordinate monitoring with European authorities to determine whether additional measures may be warranted over time. - Move expeditiously to set up the ex ante deposit guarantee scheme and resolution fund required by European legislation. ### Structural and labor market issues - Competitiveness and diversification: - Luxembourg’s cost competitiveness is being eroded; economic diversification beyond the financial sector is essential to improve growth prospects and create jobs. - Wage indexation: - The expiration of the temporary agreement on wage indexation offers an opportunity to adjust the mechanism to better align wages and productivity movements. - Labor market challenges: - Seasonally adjusted unemployment rate reached a historical peak of 6.9 percent at the end of 2013. - Almost half of the unemployed are low-skilled and a quarter are long-term unemployed. - Policy recommendations: - Strengthen labor skills and address labor market rigidities and skills mismatch to support diversification. - Consider reforms to boost labor participation, including pension and social benefits reforms. - Authorities have adopted measures: employment agency operating under new management with more staff and an upgraded IT system; further measures in preparation to tackle inactivity and unemployment traps. ### Selected economic indicators (excerpt) - Real GDP (change in percent): 2010: 3.1; 2011: 1.9; 2012: -0.2; 2013: 2.1; 2014 (Est./Proj.): 2.6 - Gross investment (percent change): 2010: 29.4; 2011: 11.5; 2012: 1.0; 2013: -9.0; 2014: 2.8 - Unemployment (as percent of the labor force): 2010: 5.8; 2011: 5.6; 2012: 6.1; 2013: 6.8; 2014: 7.1 - Resident employment (thousands): 2010: 220.9; 2011: 224.2; 2012: 229.7; 2013: 233.7; 2014: 239.3 - Total employment (thousands): 2010: 359.2; 2011: 369.8; 2012: 378.9; 2013: 385.5; 2014: 389.2 - CPI (harmonized), p.a.: 2010: 2.8; 2011: 3.7; 2012: 2.9; 2013: 1.7; 2014: 1.4 - General government revenues (percent of GDP): 2010: 42.8; 2011: 42.7; 2012: 44.0; 2013: 43.6; 2014: 43.8 - General government expenditures (percent of GDP): 2010: 43.5; 2011: 42.6; 2012: 43.9; 2013: 43.5; 2014: 43.4 - General government balance (percent of GDP): 2010: -0.8; 2011: 0.2; 2012: 0.0; 2013: 0.1; 2014: 0.3 - General government gross debt (percent of GDP): 2010: 19.5; 2011: 18.7; 2012: 21.7; 2013: 23.1; 2014: 24.1 - Current account balance (percent of GDP): 2010: 7.7; 2011: 6.6; 2012: 5.8; 2013: 5.2; 2014: 5.3 - Balance of trade in goods and services (percent of GDP): 2010: 39.6; 2011: 37.7; 2012: 39.1; 2013: 38.6; 2014: 38.8 - Factor income balance (percent of GDP): 2010: -30.4; 2011: -28.9; 2012: -30.9; 2013: -32.6; 2014: -32.7 - Transfer balance (percent of GDP): 2010: -1.5; 2011: -2.1; 2012: -2.4; 2013: -0.8; 2014: -0.8 - Public debt level noted elsewhere: 23 percent of GDP in 2013 - Pension fund assets set aside: 26.9 percent of GDP at the end of 2013 - Anticipated VAT revenue loss: around 1.5 percent of GDP beginning 2015 *Source: IMF staff report and related materials (2014 Article IV Consultation with Luxembourg).* ### 0.5 percent of GDP were announced: 60 percent of these savings are to be achieved through a ### _cr14118 - 0.5 percent of GDP were announced: 60 percent of these savings are to be achieved through a ### Fiscal consolidation and 2014–15 outlook - Authorities announced consolidation measures equivalent to 0.5 percent of GDP. - 60 percent of these savings are to be achieved through a reduction of public investments. - 21 percent through a reduction of the operating costs of the central government. - The remaining part represents savings from a new scheme of financial grants and loans for students in higher education. - These additional consolidation measures will lead to a surplus of 0.2 percent of GDP in 2014. - For 2015, authorities expect significant deterioration in the fiscal situation without additional corrective measures, driven by: - loss in VAT revenue from e-commerce activities, and - continued buoyant expenditure growth. - Revenue-side measures for 2015: - All VAT rates will be increased by two percentage points with the exception of the 3 percent rate on basic goods (to shield the poorest households). - This VAT measure is expected to generate 0.7 percent of GDP of additional revenue. - The 3 percent rate would be henceforth limited to purchases of owner-occupied homes. - Staff’s recommendation to increase property tax is still under consideration. - Expenditure-side measures for 2015: - Remaining consolidation expected to focus on slowing expenditure growth. - A comprehensive expenditure review has been initiated, conducted in four phases from conception to implementation, with analysis across both ministerial and functional lines. - 20 working groups have been established. - The analytical phase will be finalized in June and provide a report listing a menu of savings measures. - In line with the country’s 2014 update of the Stability Program, fiscal consolidation needs an amount of 1 billion euro in structural terms for the period 2015-2018. - Aim: ensure a gradual and sustainable return to balanced public finances by the end of the government’s tenure in 2018. ### Fiscal framework, debt, and social spending reforms - Debt dynamics and targets: - Debt-to-GDP ratio tripled in the period 2007-2013, from 6.7 to about 23 percent. - Luxembourg’s debt level remains well below the 60 percent level of the Maastricht criteria. - Authorities committed to keep the public debt below 30 percent. - Net public debt is significantly lower and public debt is entirely denominated in euro. - Structural reforms and fiscal institutions: - Important healthcare reform became effective on January 1, 2011; further reforms are being discussed. - Pension reform was adopted late 2012. - Authorities agree on the need to place Luxembourg’s old-age pension system on a sustainable path. - Pension system rigidities noted, including adjustment of benefits to both price and real wage developments. - Under the new pension regime, authorities appraise every five years by means of an actuarial study the consistency between the assumptions underlying the reform and the updated financial trajectory of the scheme. - A law establishing a multi-year budgetary framework is undergoing the national legislative procedure; framework would apply to all levels of government and include multi-year expenditure ceilings consistent with the new EU requirements under the legislative “six pack” and the Fiscal Compact. - Important steps have been taken to set up an independent Fiscal council with sufficient resources and expertise to monitor deviations from fiscal targets. ### Financial sector—overview and banking sector - General assessment: - Luxembourg’s financial sector has weathered recent crises relatively well and remains generally sound. - Significant regulatory changes at the European level (banking union) and move to automatic exchange of information from January 2015 represent challenges and potential upside risks. - The country’s “unique ‘eco-system’”—a concentration of diversified financial institutions and related services—continues to attract business. - Banking sector key statistics and developments: - Aggregate banking sector balance sheet contraction driven by decline of asset values during crisis and contraction in intragroup exposures with core euro area parent banks. - Total assets recorded a level of 711 billion euro in February 2014. - Capitalization and liquidity ratios remain sound: - Tier 1 capital ratio over 16 percent. - Liquid assets to total assets at around 60 percent. - NPLs are extremely low. - Banking sector remains profitable and an important liquidity provider. - Structural shifts: - Some banks leaving Luxembourg due to deleveraging of parent banks; large banking groups expanding presence for back-office and custodian services. - Private banking transforming toward service-orientation and high net-worth individuals in response to automatic exchange of information. - Strengthening ties with emerging market economies; eight new banks opened a branch or subsidiary in 2013 and additional applications for banking licenses pending. - Sector and government working to position Luxembourg as a European hub for Renminbi business. - Macro-prudential and supervisory measures: - Authorities raised risk weights for mortgage loans exceeding 80 percent LTV ratios and require frequent stress testing. - CSSF and BCL stand ready to take additional macro-prudential measures if exposures continue to rise. - Staff notes domestic residential real estate exposure of domestically-oriented banks has increased and would require monitoring. ### Investment funds and regulatory supervision - Investment fund industry: - Luxembourg is the second largest investment fund domicile in the world after the US. - Assets in Luxembourg-domiciled regulated funds reached over 2.6 trillion euro in March 2014 (historical ceiling), driven by revaluation and new inflows. - Industry invests in a diversified class of assets and caters to a diverse pool of investors. - Rapid transposition of the Alternative Investment Fund Managers Directive seen as an opportunity to develop new activities. - Authorities note staff recommendation for enhanced and proactive communication emphasizing investor and depositor protection; legal framework in place but needs better communication. - Regulatory and supervisory capacity: - Authorities have strengthened financial sector supervision and the regulatory framework, following FSAP recommendations. - CSSF staffing increased to 500 full-time equivalent staff, resulting in more frequent on-site inspections and augmented enforcement actions. - CSSF improved supervisory techniques, including stress testing; preparation for SSM contributes to better risk-focused supervision. - Central Bank (BCL) has expanded supervisory activities; liquidity monitoring and surveillance framework includes qualitative and forward-looking quantitative analyses, off-site analysis and on-site inspections. - BCL requires a large proportion of banks to provide liquidity gap projections on a daily basis. - Increasing tasks for BCL call for strengthening human and financial resources; Bank’s need for an increase of capital has been brought to government attention and corroborated by BCL’s external auditor. - Cooperation between BCL and CSSF is being enhanced in preparation for the SSM. - Proposal to establish a national Systemic Risk Committee (SRC) involving supervisors, the BCL and the Finance Ministry to strengthen collaboration and information exchange; SRC expected to be the right setting to monitor system-wide risks through stress testing. - Authorities’ views on staff concerns: - Authorities do not share staff’s scenario concerns about possible redemptions from investment funds impacting banking sector liquidity; they emphasize funds’ options: - sell assets (highly liquid UCITS funds), - suspend redemptions to avoid disruptions, and - as last resort, borrow from liquid banks. - Authorities dispute staff’s bundled depiction of financial integrity and transparency issues (AML/CFT, tax offences, transparency of legal persons and arrangements, exchange of information) as it ignores progress made and may be counterproductive. - Authorities provided staff with answers asserting the framework and actions implemented are effective in avoiding abuse of Luxembourg-established financial institutions for illegal activities. ### Other structural issues and competitiveness - Economic diversification: - Authorities committed to diversify beyond financial activities, targeting logistics, ICT and bio- and eco-technologies. - ICT sector showing rapid growth. - Logistics expansion strategy: reuse existing facilities near railway and highway networks with limited investments; a training facility established to prepare staff, partially tackling long-term unemployment of low-skilled workers. - Competitiveness and unit labor cost (ULC): - Deterioration in price competitiveness over the last decade due to relatively high wage increases coupled with low productivity growth. - Wages and benefits linked to inflation via automatic indexation. - Law temporarily modified (until October 2014) the system of wage indexation: - Foresees at least 12 months should elapse between each indexation step of 2.5 percent. - From 2015 automatic indexation will return to its previous mode. - Authorities acknowledge modulation is temporary; preserving competitiveness by limiting ULC growth is essential and they will work with unions and employers on a permanent solution that preserves social cohesion. - Housing market: - Divergence between supply and demand driven by: - Demand factors: high demand from residents and cross-border workers; relatively high population and immigration growth; government housing benefits policies; low mortgage interest rates. - Supply factors: administrative constraints and low recurring taxes on immovable property. - Authorities reviewing housing benefits within the expenditure review; VAT measure to be implemented in 2015 is a first step to reduce demand. - CSSF and BCL ready to take additional macro-prudential measures if exposures continue to rise. *Source: _cr14118 - 0.5 percent of GDP were announced: 60 percent of these savings are to be achieved through a (IMF staff report content provided in input).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14118.pdf_