Luxembourg: Staff Concluding Statement of the 2023 Article IV Mission
IMF News, March 10, 2023
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- Published: March 10, 2023
Context and recent developments
- Despite a challenging external environment in 2022, the Luxembourgish economy has proven resilient.
- The reverberations of the war in Ukraine will continue to be felt in 2023 and possibly beyond.
- An expansionary fiscal policy, including generous and costly support packages, has alleviated the impact of the cost-of-living shock on demand.
- Implemented energy price controls and a VAT rate cut temporarily reduced pass-through to domestic prices.
- Persistently high core inflation and strong labor markets have raised risks that fiscal policy for 2023-24, including the recent tripartite measures, could:
- overstimulate demand,
- limit incentives for energy savings, and
- impede an adjustment in housing prices to more affordable levels.
- Luxembourg’s automatic wage indexation has not posed major challenges in a low inflation environment, but high inflation has reignited concerns about wage-price spirals and firms’ ability to adjust.
Outlook and risks
- GDP growth is forecast to slow moderately in 2023-24 (to around 1½ to 2 percent), reflecting mostly weak external demand and real estate activity.
- Inflation dynamics:
- Inflation is expected to moderate, mostly due to lower energy prices and price controls.
- Core inflation is projected to remain high at around 3½-4 percent, with risks to the upside.
- Uncertainty is high; risks to growth are primarily to the downside and include:
- potentially deeper recessionary pressures in major economies,
- de-anchoring of inflation expectations leading to tighter-than-anticipated monetary policy and a worse growth-inflation trade-off,
- a disorderly market adjustment to central bank decisions posing challenges to financial stability.
- Upside scenario: a more resilient global economy and pent-up domestic demand could boost growth.
Fiscal policy findings and recommendations
- Current assessment: the planned fiscal stance appears overly loose given still elevated core inflation and households’ strong aggregate financial position.
- Staff recommends:
- keeping the cyclically adjusted overall balance (excluding the one-off quota transfer to the EU) broadly unchanged in 2023 and 2024 to significantly reduce the fiscal impulse;
- saving or redirecting fiscal overperformance (for example, due to lower energy prices or low uptake of the measures) to accelerate the energy transition and to support public housing supply;
- refraining from additional stimulus, especially with permanent effects, to avoid fueling demand and increasing inflation persistence;
- remaining nimble and allowing automatic stabilizers to fully operate, and considering targeted stimulus in case of severe demand shocks if recessionary pressures turn out greater and inflation falls by more than expected.
- Energy support: given uncertainty about persistence of the energy shock, staff recommend switching to more targeted measures to allow stronger price signals to lock-in energy savings and to strengthen energy security. Options include:
- block pricing (where only a basic amount of consumption is subsidized), possibly complemented with targeted cash transfers, or social tariffs instead of current price caps;
- extending the targeted energy bonus and tax credit to low-income households to alleviate block pricing impacts on the most vulnerable;
- linking support for multi-family residences to the unit’s share of their past energy use due to technical difficulties distinguishing bills.
- Medium-term fiscal stance:
- More prudent recurrent spending and fiscal framework reform are needed to preserve buffers and increase space for capital spending.
- Expenditures have been growing rapidly since mid-2010s and will remain around 3 percent of GDP higher than pre-COVID levels in the medium term.
- No tax brackets indexation since 2017 has contributed to revenue gains that have been difficult to sustain economically and politically.
- Early action on the pension system would improve intergenerational equity and long-term fiscal sustainability, while creating space for higher investment.
- Authorities could better anchor fiscal policy by adopting a medium-term objective based on the general government balance and a ceiling on expenditure growth as an operational rule.
- Tax policy:
- The tax brackets should be adjusted more frequently for inflation, within a comprehensive tax-benefit reform.
- Delaying tax brackets indexation for a prolonged period has led to a notable increase of the real tax burden and potential unintended distributional effects.
- Staff sees merit in increasing the frequency of tax bracket adjustments in a budget-neutral way as part of a comprehensive review and simplification of the tax and social benefits system.
Financial sector findings and recommendations
- Risks have intensified since the last Article IV, but the financial system appears in a good position to weather adverse shocks.
- Key vulnerabilities:
- Higher inflation and borrowing costs, lower activity, and potentially lower collateral valuations will likely increase credit risk and provisioning.
- Persistent house price overvaluation, high households’ indebtedness, and concentration of real estate exposures in some credit institutions pose risks to the banking sector.
- Some investment funds (e.g., open-ended high-yield bond funds and highly leveraged funds) remain vulnerable to liquidity and credit risks in case of disorderly market corrections.
- Bank-fund interlinkages are relatively large, especially on the liability side of custodian banks.
- Mitigating factors:
- Strong initial conditions, substantial capital and liquidity buffers at banks, and funds’ tendency on aggregate to accumulate cash in periods of stress would limit systemic risks.
- Macroprudential recommendations:
- Consider adjustments to increase banks’ resilience and avoid build-up of vulnerabilities, especially in real estate.
- Continued prudent provisioning should be encouraged.
- The CSSF requirement for banks to perform interest rate sensitivity analysis on new mortgages is welcome.
- In addition to existing LTV measures, consider introducing income-based limits (calibrated to reduce excessive risk-taking while avoiding significantly depressing real estate activity).
- To address risks of unexpected losses on the stock of real estate exposures, consider targeted sectoral capital measures.
- Investment funds:
- Continue efforts to bolster funds’ resilience.
- Improve calibration of liquidity management tools, in particular swing pricing, and align redemption terms with asset liquidity and investment strategy.
- Maintain close monitoring of large redemptions and regular liquidity stress tests.
- Address data gaps on investor base composition and interconnectedness with other non-banks.
- Continue coordination with peers to monitor cross-border spillovers and contribute to international regulatory and macroprudential strengthening.
Structural policies and housing market
- Housing market:
- Persistent imbalances and higher mortgage rates are likely to further worsen housing affordability in the short term.
- Staff assess housing prices as overvalued following several years of double-digit growth.
- Recommended actions:
- Continue focus on boosting supply while avoiding measures that increase housing demand (such as the recent increase of the Bëllegen Akt’s tax credit and the deductibility of interest payments).
- Avoid public sector purchases of dwellings under development as this could impede a price correction that would enhance affordability.
- Consider frontloading public investment in social and affordable housing.
- Expedite efforts to reduce supply bottlenecks, including by allowing greater density of buildings and by reducing the administrative burden.
- Automatic wage indexation (AWI):
- Current AWI may not fully compensate low-income households disproportionately affected by large and persistent commodity price increases, while being too generous to relatively more affluent households, potentially generating upward pressure on housing prices.
- Trade-offs:
- Suspending or postponing AWI could adversely impact lower income workers and compensatory measures could be costly.
- Frequent rounds of AWI could limit firms’ ability to adjust, especially those facing external competition.
- Reform options:
- Indexing to core inflation, complemented with targeted support for the poorest segments of the population.
- Introducing progressive considerations in wage indexation.
- A rule-based suspension of the system, based on competitiveness indicators.
- Labor force and inclusiveness:
- Luxembourg needs to more efficiently use its workforce to increase growth potential.
- Recommendations include:
- Increasing work flexibility and reducing commuting time,
- Facilitating work permits for immigrant spouses,
- Promoting female entrepreneurship in science, technology, and engineering,
- Transitioning to individual taxation,
- Means-testing family benefits,
- Reducing the generosity of the pension system while promoting life-long learning to improve senior participation and employment.
Key policy takeaway
- Staff recommends a broadly neutral fiscal stance for 2023 and 2024, better targeted support measures to help people in need while allowing price signals to work, more prudent recurrent spending over the medium term to preserve fiscal buffers, continued monitoring and targeted action on financial sector vulnerabilities (especially in real estate and investment funds), and reforms to wage indexation and housing policies to preserve competitiveness and affordability.
IMF Staff Concluding Statement of the 2023 Article IV Mission for Luxembourg (March 10, 2023).