Public Information Notice No. 10/70

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation with Luxembourg

June 3, 2010

On May 28, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Luxembourg.¹

Background

The global financial crisis posed a severe shock to Luxembourg’s exceptionally open economy and internationally-integrated financial center. Private investment plummeted and consumption weakened in the face of slowing employment growth. At the height of the financial turmoil, the investment fund industry endured large redemptions, two systemically important banks were bailed out, and three smaller Icelandic banks failed. As a result, Luxembourg’s economy contracted by 3½ percent in 2009, its worst performance in 30 years.

Still, a prompt and aggressive policy response safeguarded financial stability and mitigated adverse economic effects. The authorities’ decisive action in tackling troubled banks, combined with increases in deposit guarantees and substantial emergency liquidity provided by the European Central Bank (ECB), helped ameliorate financial contagion and restore market confidence. In addition, Luxembourg’s enviable position of public finances at the outset of the crisis provided the space to provide fiscal support to the economy, boost social transfers, and protect household income.

Systemic financial stability risks have receded in line with international developments, but growth will remain below its pre-crisis pace in 2010–11. Economic activity rebounded in the second half of 2009 led by the manufacturing and financial sectors, and labor markets showed initial signs of stabilizing. Net inflows to the investment fund industry resumed in the second quarter of 2009 with assets rebounding to close to their pre-crisis highs. Emergency liquidity provision has continued unwinding in an orderly manner and no bank failures occurred in 2009. The global financial crisis, nonetheless, is likely to have lasting effects on Luxembourg’s economy. Growth is predicted to reach about 3 percent in 2010, reflecting improving conditions in global financial markets and trading partners as well as sustained fiscal stimulus. Inflation is expected to remain subdued.

Executive Board Assessment

Executive Directors noted that Luxembourg, with its open economy and large internationally-integrated financial sector, experienced a severe shock from the global financial crisis. They commended the authorities’ prompt and forceful policy response, which safeguarded the financial sector. At the same time, Luxembourg’s strong fiscal position provided room for fiscal policy to support the economy and protect household incomes. While the economy has stabilized and growth has resumed, the balance of risks remains on the downside. Directors encouraged the authorities to address the vulnerabilities exposed by the crisis.

Directors welcomed the strengthening of banking supervision and increasing emphasis on the quality of banks’ risk management practices. They recommended a sharper focus on liquidity and credit risks arising from banks’ sizable and concentrated exposures to their foreign parent groups. They highlighted the importance of ensuring that locally-incorporated subsidiaries maintain adequate capital and liquidity buffers. Directors welcomed the joint collaboration between the central bank and the banking supervisor in assessing and monitoring liquidity risks, and encouraged the authorities to establish a formal agreement to support this undertaking.

In light of the prevalence of foreign subsidiaries in Luxembourg’s banking system, Directors encouraged the authorities to remain actively engaged in EU initiatives on the design of formal mechanisms for cross-border bank resolution and burden sharing. They recognized that long-standing collaboration between local and home country supervisors facilitated the response to the crisis, and recommended further enhancing this collaboration. Directors looked forward to timely implementation of the FATF recommendations.

While agreeing that fiscal support continues to be appropriate in 2010, Directors advised the authorities to start consolidation in 2011 and target a balance by 2014 as planned. They welcomed the announced consolidation measures for 2011–12 as broadly appropriate. A few Directors considered that additional adjustment might be needed to achieve fiscal balance. With the need to center consolidation on current expenditure, a medium-term fiscal framework would be important to facilitate expenditure review and prioritization. Directors emphasized that the sustainability of public finances will require substantive pension reform, including a gradual increase in the effective and statutory retirement age and aligning benefits and contributions.

Directors considered that Luxembourg’s economic resilience will depend on continued efforts to boost competitiveness and foster economic diversification. They welcomed the authorities’ intention to revise the backward-looking wage indexation mechanism, and called for further reforms to eliminate wage-setting rigidities over time. Investment in skills development and in research will be important.