On May 2, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Luxembourg.
With a strong policy framework, Luxembourg has weathered the crisis well and the economy is rebounding. The fiscal position remains sound, and the large financial sector has been resilient. After a shallow recession in 2012, growth reached 2.1 percent in 2013. The improving economic and financial environment in Europe drove the recovery in services exports. Meanwhile, healthy public finances, accommodative credit conditions, and continued employment growth supported domestic demand.
The outlook is for growth to firm up but without returning to its pre-crisis trend. Output is forecast to grow broadly in line with potential (2 to 2½ percent) over 2014-19. The economy is facing several challenges. The financial sector will have to adjust to a changing external landscape, public finances will soon come under strain from losses in e-VAT revenue and strong expenditure growth, and Luxembourg’s cost competitiveness is being eroded.
Securing Luxembourg’s economic and social model calls for a proactive approach. A moderate but sustained fiscal consolidation is essential to preserve the sound fiscal position. Beyond revenue measures under consideration, steps will also be required to curtail rapid public spending growth. On the financial front, resilience should be preserved as diversification proceeds. The decision to front-load the implementation of Basel III’s capital requirements is welcome, but systemic banks should be carefully monitored, in coordination with European authorities, to determine whether additional measures may be warranted over time. Supervisors also need to continue to closely monitor domestic real estate exposures, interconnections in the domestic financial sector, and new emerging risks from financial diversification. Finally, the expiration of the temporary agreement on wage indexation offers an opportunity to adjust the mechanism in a way that better aligns wages and productivity movements. Measures to strengthen labor skills and the business environment would also further support the authorities’ strategy to diversify beyond the financial sector.
Executive Directors commended the authorities for their strong policy management, which helped Luxembourg weather the recent economic crisis well. Directors noted that while growth is rebounding, the country faces several external and internal challenges. To preserve the main features of Luxembourg’s economic and social model, they agreed that policy priorities ahead should continue to focus on fiscal and structural reforms, adjustment to the changing external financial environment, and economic diversification.
Directors noted that although the fiscal position is reassuring, losses from e-VAT revenues and rapid expenditure growth would pose strains in the coming years. To ensure fiscal sustainability, they called for a moderate growth-friendly fiscal consolidation. Directors supported the planned VAT hike and encouraged the authorities to consider increasing the yield of property taxes. In addition, they saw need to curtail public spending, while preserving social cohesion. Directors welcomed the expenditure review underway as a useful tool to identify savings. They encouraged the authorities to reconsider the social benefits systems, particularly the pension system, as reforms in this area would also help boost the economy’s growth potential through greater labor participation. The planned introduction of expenditure ceilings in the context of a multi-year budgetary framework should also support efforts to moderate spending growth.
Directors took note of high bank capitalization and liquidity, and the strong growth of the investment fund industry. They underscored the need to preserve the financial sector’s resilience as diversification proceeds. Directors commended the authorities for their decision to front-load the implementation of Basel III’s capital requirements. They noted that supervisors should remain vigilant and carefully monitor developments in the sector to determine whether specific additional measures may be warranted taking into account the systemic size of a number of banks. Directors underscored the need to continue to closely monitor domestic real estate exposures, interconnections in the domestic financial sector, and new emerging risks from financial diversification. They also encouraged the authorities to move expeditiously to set up the ex ante deposit guarantee scheme and resolution fund required by European legislation. Further improvements in transparency and strengthening of the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) framework are also called for.
Directors agreed that economic diversification beyond the financial sector is essential to improve Luxembourg’s growth prospects and create new job opportunities. They noted that despite a strong external position, the country might be pricing itself out of some activities because of substantial labor cost increases. Directors encouraged the authorities to adjust the wage indexation mechanism to better link wage and productivity movements. Measures to tackle labor market rigidities and reduce skills mismatch would support the authorities’ strategy to diversify beyond the financial sector.