Luxembourg - 2009 Article IV Consultation, IMF Concluding Statement
IMF News, March 30, 2009
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Bibliographic details
- Authors: Gradual Recovery Notwithstanding
- Published: March 30, 2009
Context and overarching assessment
- Mission location and date: Luxembourg, March 30, 2009.
- Situation summary:
- Ongoing financial turmoil and the first global recession in 60 years pose daunting challenges to Luxembourg’s small open economy.
- The financial sector hosts 152 mostly foreign-owned subsidiary banks, Europe’s largest investment fund industry and second largest money market industry, and is fully exposed to the turmoil.
- Contraction in European demand is weighing heavily on Luxembourg’s traditional export sectors.
Key elements of a comprehensive crisis management strategy
- Core priorities:
- Resolving home-host country issues and seeking burden sharing commitments:
- The systemic nature of the crisis has called into question the axiom that parent companies would always support subsidiaries.
- Authorities need to advance burden sharing discussions with parent companies and home countries to achieve burden sharing commitments.
- Addressing risks from close integration of Luxembourg-based subsidiaries with parent groups:
- Intragroup exposures and group-level liquidity management have shifted liquidity risk onto subsidiaries.
- Requires comprehensive and continuous monitoring of liquidity at the local level and a regulatory framework with sufficient flexibility to account for bank-specific circumstances.
- Mission notes joint efforts of the central bank (Banque Centrale du Luxembourg) and the regulator (Commission de Surveillance du Secteur Financier) but stresses success depends on cooperation between these institutions.
- Reining in excessive leverage:
- More than half of Luxembourg’s banking system was overly leveraged at end-2008, with gearing ratios in excess of 20 times.
- While system-wide capital levels are sufficient, the mission calls for strengthening the regulatory regime, tightening capital requirements, and introducing binding limits on leverage.
- Such steps need international coordination and careful phasing to facilitate an orderly adjustment of banks’ balance sheets.
- Safeguarding Luxembourg’s reputation as a well run financial center:
- Money market funds (MMFs) provided more than 100 billion euro in mostly short-term financing to euro area banks, making MMF instability a systemic risk to the euro area.
- Authorities should seek international cooperation focused on burden sharing arrangements that would allow—the mission states—in case of strong redemptive pressures—the immediate issuance of a credible, multilateral guarantee to cover those funds’ liabilities.
- Weakened capitalization limits scope for banks to take MMFs’ assets onto their balance sheets; the need for a liquidity facility should be further explored.
Financial sector findings and vulnerabilities
- Structural features and risks:
- Large, internationally integrated financial center with substantial intragroup exposures and liquidity centralized at group level.
- Excessive leverage in a sizable portion of the banking system (see: more than half overly leveraged at end-2008; gearing ratios in excess of 20 times).
- MMFs' significant short-term financing role (more than 100 billion euro) poses systemic risk to the euro area.
- Regulatory implications:
- Need for enhanced local liquidity monitoring and a flexible yet robust regulatory framework.
- Coordination between Banque Centrale du Luxembourg and Commission de Surveillance du Secteur Financier is critical.
- International coordination required for capital and leverage measures and for multilateral crisis response mechanisms.
Growth outlook and macroeconomic projections
- Recession severity:
- Luxembourg faces its most severe recession since the steel crisis in the mid-1970s.
- Growth came to a sudden halt in the third quarter of 2008; contraction spreading across key export sectors, notably manufacturing and transport.
- Profitability in the financial sector is likely to decline in 2009 as banks’ interest income is adversely affected by appreciable declines in interest rates.
- IMF-based projection:
- Based on the IMF’s current growth forecast for the euro area (-3.2 percent for 2009), the mission projects Luxembourg’s real growth to fall by 3.8 percent this year.
- A recovery is expected to begin in mid-2010, but annual growth is still likely to stagnate.
Fiscal position, stimulus, and transparency
- Fiscal stance and recent developments:
- Luxembourg’s public finances are much better positioned than most other EU countries; public debt stock remains low by international standards despite bank rescue efforts.
- Fiscal surplus fell to an estimated 1.4 percent of GDP in 2008 from 3.2 percent of GDP in 2007.
- 2009 fiscal outlook:
- The combination of growth-induced revenue declines and fiscal stimulus of about 3 percent of GDP is projected to lead to an overall deficit of 3.2 percent of GDP in 2009.
- This exceeds the authorities’ revised budget forecast (-0.7 percent of GDP).
- Mission recommendations on fiscal policy:
- The mission unequivocally supports the full functioning of the automatic stabilizers, given the economic situation and the favorable state of public finances.
- To enhance fiscal transparency, underlying budget assumptions—especially for GDP growth—and the projected fiscal deficit should be once more revised.
Need for post-crisis fiscal adjustment and structural reforms
- Fiscal sustainability risks and recommendations:
- Expenditures are rising: despite fiscal adjustment from the 2006 Tripartite Agreement, current spending returned to buoyant growth in 2008.
- Planned return to full indexation of wages and social benefits will likely exacerbate spending growth and hamper competitiveness.
- Uncertainties on medium-term fiscal revenues arise from potential global deleveraging and legal, prudential and regulatory changes—including those governing bank secrecy—affecting financial sector profitability and tax contributions.
- Changes in EU tax regulation, including the 2015 introduction of the end-user principle that will curtail VAT revenues, are noted as a concern.
- Specific policy recommendations:
- Reconsider reintroduction of full inflation indexation of wages and benefits.
- Prioritize far-reaching reforms of the public, pay-as-you-go pension system to address substantial funding gaps and improve long-term viability.
International Monetary Fund — Luxembourg, March 30, 2009.