Luxembourg: Staff Concluding Statement of the 2024 Article IV Mission
IMF News, March 26, 2024
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- Published: March 26, 2024
Overview
- Despite robust consumption growth, the Luxembourgish economy contracted in 2023 due to weak external demand and residential investment.
- Growth is expected to rebound in 2024; headline inflation will continue subsiding but remain somewhat above the ECB’s target.
- The moderately expansionary fiscal stance is broadly appropriate to reinvigorate growth, but more targeted and temporary measures would have been more efficient.
- The 2024 Financial Sector Assessment Program (FSAP) found the financial sector to be largely resilient against severe shocks.
- An early pension reform is recommended to ensure long-term sustainability and intergenerational equity.
Context
- New government took office amid a challenging economic context driven by a steep rise in interest rates and elevated uncertainty.
- GDP contracted by 1.1 percent in 2023, driven by external demand and residential investment.
- Unemployment increased and vacancies dropped from historical records.
- Robust disposable income growth, following several wage indexation tranches and fiscal support, boosted private consumption.
- Headline inflation is subsiding; underlying inflation, while declining, remains high.
- Credit growth turned negative as demand dropped and credit standards tightened.
- Real estate prices declined but remain overvalued.
- Banks’ profitability increased, boosted by higher net interest margins; capital and liquidity buffers remain higher than in EU peers.
- Asset quality is deteriorating notably (especially in real estate related exposures), albeit from low levels.
- Authorities announced a package of measures to support purchasing power and housing demand.
Outlook and risks
- Growth:
- Expected to rebound moderately in 2024 along with receding inflation pressure.
- Fiscal support to households, unwinding of high savings, and continued disinflation will boost consumption and residential investment.
- With expected monetary policy easing and improving confidence, growth is projected to strengthen further in 2025, converging to its potential in the medium term.
- Inflation:
- Headline inflation will decline below 3 percent this year but is expected to rebound next year, once administrative energy price measures expire.
- Core inflation is forecasted to remain somewhat above the ECB target until 2026.
- Risks (tilted to the downside):
- External: rising geopolitical tensions, renewed supply chain disruptions, sharp global slowdown, global financial instability.
- Uncertainty from changes to international taxation and/or financial regulations.
- Domestic: potentially disorderly correction of asset prices, including overvalued housing prices.
- Upside: more resilient global economy, faster unwinding of excess savings, pent-up demand for residential real estate.
Fiscal policy — findings and recommendations
- Assessment:
- Moderately expansionary fiscal stance broadly appropriate given negative output gap, weakening labor market, and high uncertainty.
- Rapid growth of households’ real disposable income and consumption, and saving rates well above pre-pandemic levels, warranted more targeted fiscal support to help disinflation.
- Several measures are permanent and have worsened the medium-term fiscal outlook.
- Public debt outlook:
- Country has ample fiscal space; public debt is one of the lowest among AAA rated countries.
- Under announced policies, staff project public debt to increase by 6-7 percentage points of GDP by 2029.
- Policy recommendation — gradual consolidation:
- Staff recommend a gradual fiscal consolidation to stabilize public debt over the medium term.
- Illustration: a consolidation of about 0.2 percent of GDP per year for the next five years would keep the debt at around 30 percent of GDP by 2029.
- Tax policy guidance:
- Support regular adjustments of tax brackets for inflation but recommend they be done in a budget-neutral manner.
- Advise against retroactive changes to the tax schedule without compensatory measures.
- Warn that intended reduction of the corporate income tax (CIT) rate could potentially result in lower revenues, without necessarily attracting new businesses.
- Recommend streamlining tax expenditures (e.g., interest rate deductibility).
- Expenditure-side guidance:
- Pressures from rising ageing costs, defense requirements, and investment needs in the digital and climate transition.
- Authorities’ intention to contain spending, including the wage bill, is welcome and should be underpinned by specific measures.
- Example: improve spending efficiency, including social protection spending.
- Fiscal framework:
- Plan to strengthen national fiscal framework, complementing the EU Economic Governance Framework, is commendable and should be expedited.
- Suggest setting a national MTO based on a structural fiscal balance that considers ageing costs, in line with new EU methodology.
- Recommend using net primary expenditure path from national MTO as an operational limit.
- Consider strengthening the role of the fiscal council in assessing budgetary forecasts and monitoring compliance.
- Legislating a national framework would help maintain credible commitment to the AAA rating.
- Pensions and health:
- General pension scheme’s reserves are comfortable (about 32 percent of GDP), but long-term sustainability is not guaranteed.
- Pension costs projected to rise significantly (to about 18 percent of GDP by 2070 for general and special schemes).
- Revenues expected to plateau as net migration flows slow down.
- Institutional safeguards and stabilizers for the general scheme are not expected to be triggered before 2027 when annual contributions are forecasted to no longer cover annual pension expenditures.
- Planned public consultation on pensions is welcome.
- Action needed to address rapid deterioration of the balance of the National Health Fund (Caisse nationale de santé).
Financial sector — findings and recommendations
- Cyclical and stock vulnerabilities:
- Cyclical systemic risks have abated somewhat, but higher interest rates exposed stock vulnerabilities, especially related to real estate.
- FSAP analyses suggest households’ debt servicing capacity would be constrained under the IMF’s baseline scenario, especially for lower income households and those with variable rate mortgages.
- In a severe adverse scenario (higher interest and unemployment rates), credit risk could spread to more affluent households, including recent mortgage borrowers.
- Real estate companies face higher bankruptcies and could experience further debt servicing challenges.
- Resilience:
- Financial sector largely resilient against severe shocks.
- FSAP shows in the baseline scenario the banking system can sustain the impact of high interest rates, with a small share of weak banks.
- In the adverse scenario, banks overall have enough capital and liquidity buffers to absorb severe shocks; share of weak banks in total assets would double but recapitalization needs would remain easily manageable.
- All banks can sustain significant retail deposit outflows; only a few would need to dip into liquidity buffers, mainly due to potential weakness in some foreign parent banks.
- Investment fund and insurance sectors have sufficient liquidity buffers to withstand large shocks and minimize second-round effects on international securities markets and spillbacks on the economy.
- Majority of money market funds could absorb significant increase of interest rates (up to 300 basis points); larger shocks would expose vulnerabilities in a few funds.
- Macroprudential recommendations:
- Increase minimum macroprudential capital requirements to absorb unexpected losses on real estate exposures, preferably through sectoral systemic risk buffers.
- Use banks’ capital headroom to do so; mitigate risk of constrained credit supply by banks’ profitability and comfortable capital headroom.
- Continuously monitor real estate risks with focus on valuation and concentration; ensure adequate provisioning and sound lending practices.
- Early in the recovery cycle, activate income-based measures such as a debt-service to income limit under stress and consider gradual reduction of the maximum loan-to-value (LTV) limit of 100 percent.
- Enhance institutional framework to reduce potential inaction bias by reducing the role of government in macroprudential decisions; strengthen communication and coordination with other policies (e.g., housing).
- Supervisory and regulatory improvements:
- Consider legal amendments to protect procedural safeguards to future-proof independence of Commission de Surveillance du Secteur Financier (CSSF) and Commissariat aux Assurances (CAA) from potential government influence.
- Enhance home-host cooperation given large cross-border connections, particularly on:
- information sharing for bank subsidiaries and branches;
- risk-based onsite supervision of investment funds’ foreign delegates;
- monitoring cross-border flows for money laundering/financing of terrorism risks.
- Finalize draft Memorandum of Understanding to formalize division of responsibilities between CSSF and Banque centrale du Luxembourg (BCL) on liquidity supervision of Less Significant Institutions.
- Incorporate group links between depositaries and investment fund managers as risk factors into CSSF’s supervisory risk assessment.
- Increase enforcement powers of CSSF in investment funds with higher fines and harmonization between types of funds.
- Continue strengthening the financial safety net framework.
Housing sector — findings and recommendations
- Current situation:
- Slump in housing sector prompted government measures, both temporary and permanent, to stimulate housing demand.
- Supply constraints mean demand-boosting measures could further deteriorate households’ indebtedness and affordability and may create moral hazard and promote risk taking.
- Recommendations:
- Allow an orderly rebalancing of the housing market while expediting supply-side measures.
- Frontload public investment in social and affordable housing in cost-efficient ways, with greater involvement of the private sector.
- Expedite plans to reduce red tape.
- Over the medium term, help-to-buy policies should be better targeted.
Structural policies
- Competitiveness and wage dynamics:
- Key reforms needed to maintain competitiveness and break the self-reinforcing spiral between cost of living and wages.
- Recommended measures:
- Lower housing supply-demand imbalances by reducing reliance on demand-support policies and boosting supply.
- Increase flexibility of the wage indexation system.
- Continue efforts to expand labor force participation, reduce skill mismatches, and remove obstacles to foreign workers.
- Complement announced transition to individual taxation with means-testing of family benefits.
- Productivity:
- Broad slowdown in productivity growth since the Global Financial Crisis warrants sustained policy efforts.
- Investment in the non-financial corporations’ sector fell by 3 percent of GDP.
- Empirical analysis suggests financial sector expansion and high labor cost linked to automatic wage indexation may have contributed to investment decline.
- Policies to foster wage flexibility, catalyze technology innovation, and increase R&D spending can help rekindle productivity growth.
- Recent laws facilitating entry and exit of companies are welcome and should improve allocative efficiency and competition.
Closing
- The IMF team thanks Luxembourg’s authorities and other interlocutors for constructive and insightful discussions.
Source: Luxembourg: Staff Concluding Statement of the 2024 Article IV Mission, March 26, 2024.