Luxembourg: Staff Concluding Statement of the 2022 Article IV Mission
IMF News, March 11, 2022
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- Published: March 11, 2022
Context and recent developments
- Real GDP surpassed its pre-COVID trend; GDP is estimated to have rebounded by 6.9 percent in 2021.
- Employment and unemployment returned to pre-pandemic levels amid record high vacancies.
- Share of long-term unemployment has been rising, reflecting skills mismatches.
- Inflation picked up notably, driven mostly by energy prices; automatic wage indexation triggered in October 2021.
- Core inflation, so far muted, has been rising amid supply bottlenecks and labor shortages.
- The 2021 fiscal position was better than expected, supported by revenue overperformance.
- Financial sector has been resilient, but rapidly growing housing prices for the third consecutive year raise concerns about affordability and medium-term financial stability.
Outlook and risks
- The Russia-Ukraine conflict is expected to weigh on the recovery mainly through effects on global financial conditions, confidence, and lower growth of trading partners.
- Staff will revise growth projections down relative to the October 2021 World Economic Outlook; risks clearly tilted to the downside.
- Higher energy and commodity prices will fuel inflationary pressure further this year.
- Elevated demand, rising construction costs, and persistent supply constraints will likely maintain pressure in the housing market.
- Medium-term outlook is more positive but hinges on decisive action to address housing imbalances and navigate the green and digital transitions.
Fiscal policy — findings and recommendations
- Current stance:
- Moderately accommodative stance in 2022 and recently adopted fiscal measures to shield households from rising energy prices are broadly appropriate.
- Measures noted: increase in the cost-of-living allowance; subsidy to stabilize electricity prices and cover the distribution costs of gas providers.
- Guidance:
- Fiscal policy should remain flexible given uncertainty about the magnitude and impact of shocks.
- Measures should, to the extent possible, be targeted (to low- and middle-income households) and timebound.
- Consider other measures in line with those proposed by the EC as needed.
- In close consultation with social partners, consider temporarily limiting the frequency of wage indexation to one per year while using targeted support to protect the most vulnerable.
- Postpone non-urgent public hiring to help relieve pressures in the labor and housing markets.
- If risks dissipate, resume gradual policy normalization next year to promote non-inflationary growth; if downside risks materialize, consider additional support measures.
- Fiscal reform priorities:
- Reforms to diversify sources of revenue and improve equity while preserving attractiveness for workers.
- Address revenue risks from changes to international taxation, impact of carbon taxation, and remote/hybrid work.
- Reform areas: property and environmental taxation, the corporate wealth tax, and personal income taxation (in line with past Article IV recommendations).
- Better target social spending (including homebuyers assistance) and improve efficiency of public investment to help rebuild fiscal buffers.
Financial sector — findings and recommendations
- System resilience and vulnerabilities:
- On aggregate, banks remain well capitalized and liquid.
- Asset quality improved somewhat as the economy rebounded; pandemic did not result in higher bankruptcies and unemployment.
- Banks’ structurally low profitability remains a source of concern.
- Investment funds benefited from global risk appetite in 2021 but remain vulnerable to market corrections and abrupt increases in risk premia.
- Direct exposures of banks and investment funds to Russia and Ukraine are very limited as a share of assets.
- Risks and monitoring:
- Impact of the conflict will mainly depend on spillovers to global financial conditions and confidence.
- Rising inflation could complicate the trade-off between price and financial stability.
- Continue close monitoring of evolving risks (including cyber security), coordination between supervisors, and communication with financial sector participants.
- Macroprudential and supervisory recommendations:
- Consider further tightening of borrower-based limits given rapidly rising house prices and households’ indebtedness.
- Authorities rightly kept the countercyclical capital buffer unchanged during the pandemic.
- Introduced loan-to-value limits (LTV) in January 2021 reduced the LTV ratio; however, debt-service-to-income and debt-to-income ratios remain high.
- Staff suggests:
- Introducing debt-service-to-income and debt-to-income limits.
- Clarifying objectives of the differentiated LTV limits.
- Accelerating implementation of the credit registry.
- Considering sectoral concentration limits (on real estate loans).
- For investment funds, continue active engagement in international fora for the design and calibration of a macroprudential toolkit.
- Enhance liquidity stress tests, including accounting for second-round effects; implemented ESMA guidelines on alternative investment funds.
Housing market and structural policies
- Risks and priorities:
- Rapid housing price growth for the third consecutive year poses medium-term financial stability risks, affects affordability, and could reduce attractiveness for workers.
- Efforts to boost housing supply, including affordable and social housing, and reduce speculation through higher taxation of unused land and empty dwellings are welcome but will take time.
- Multipronged policy recommendations to alleviate current pressures:
- Fiscal measures to contain housing demand pressures:
- Better target assistance for homebuyers.
- Reduce expected returns (e.g., by phasing out deductibility of interest payments).
- Increase efficiency in using existing resources:
- Construct higher, ecologically sustainable buildings with greater density.
- Address bottlenecks in the construction sector (including labor shortages, availability of landfills, and streamlining burdensome administrative processes).
- Strengthen public-private partnerships to enhance sector productivity.
- Other measures:
- Encourage residential mobility by reducing transaction costs for buyers’ main residence and limiting eligibility for exemptions from capital gains tax on inherited properties to 1-2 years.
- Lower geographic concentration of housing demand by decentralizing activities to rural and regional development centers, continuing infrastructure development, and promoting remote work.
Green and digital transitions
- Green transition:
- Luxembourg is well positioned to take advantage of the green transition, especially through sustainable finance.
- Transition may be associated with sizable revenue losses, mainly due to large carbon leakages.
- Recommendations:
- Increase carbon taxation gradually, with clear communication.
- Support transitions with improvements in public transportation and incentives to promote behavioral change (including for cross-border commuters).
- Accompany carbon taxation with compensation for low-income households.
- Complement carbon tax with gradual removal of implicit subsidies (e.g., on diesel) and increases in taxes on non-road carbon emissions and car user fees.
- Make incentives for greener and more energy-efficient products more progressive (increased for lower income).
- Increase investment in climate adaptation and improve financial sector preparedness for transition risks.
- Digital transition and labor market implications:
- Digitalization could increase polarization of the labor market, inequality, and skills mismatches.
- Authorities are focusing on reskilling and investing in digital education (e.g., Future Skills initiative and Ministry of Education efforts).
- Strengthen active labor market policies to focus on cross-sector reallocation through skills development and training programs.
- Extend programs to allow participation by currently employed workers and offer lifelong learning opportunities.
- Monitor and identify occupations at risk of obsolescence with private sector input to adapt educational programs and avoid large-scale skill mismatches.
- Design training programs to reduce future skill obsolescence of aging workers and improve labor participation of the older population.
- Reduce incentives for early retirement.
- Enhance vocational training and apprenticeship programs to increase worker productivity and better match job seekers with opportunities.
Closing
- The IMF team thanks Luxembourg’s authorities and other interlocutors for constructive and insightful discussions.
Luxembourg: Staff Concluding Statement of the 2022 Article IV Mission, March 11, 2022.