Mission Concluding Statement 

Luxembourg: Staff Concluding Statement of the 2017 Article IV Mission

March 7, 2017

Growth and employment prospects for Luxembourg remain strong and the international economy has shown resilience to shocks, but downside risks have increased. These risks arise from a possible global retreat from cross-border integration with negative consequences for the very open Luxembourg economy; policy uncertainty in the U.S. and associated with the outcome of elections in Europe as well as post-Brexit arrangements; the potential impact on the economy and tax revenue of the international tax transparency and anti-avoidance agenda which Luxembourg is implementing; the still vulnerable recovery in the euro area; and possible intensification of insecurity in parts of the world leading to a renewed surge in refugees. Domestically, high and rising real estate prices and growing affordability issues could affect competitiveness and financial stability, while over the longer term the sustainability of the pension system is at stake.

Against this backdrop, it is critical to maintain sound policies to sustain strong activity in Luxembourg. The fiscal stance should remain prudent to maintain room for policy maneuver, while adapting the tax system to the new environment and pro-actively tackling looming pressures on the pension system from population ageing. In line with the 2017 Financial Stability Assessment Program (FSAP), the authorities should continue to monitor risks and to further enhance regulation and supervision, in view of the increasing complexity of the Luxembourg financial center and international regulatory standards. Product market reforms to support diversification of the economy and targeted active labor market policies are important for strong and inclusive growth.

Fiscal policy

In view of the risks related to the implementation of international tax measures and the volatility of financial flows, the government should stabilize the public debt ratio at about its current level , in order to maintain buffers for use in case of need. This requires targeting a small fiscal surplus in 2017 and a balanced budget over the medium term, broadly in line with the current policy stance.

Strong economic activity has created fiscal space, which has been used in good part for the significant tax reform. In 2016, buoyant tax revenues and somewhat lower-than-expected capital outlays have resulted in a sizable fiscal surplus. Under current policies, including ongoing revenue trends and implementation of the Zukunftspak, the surplus would drop in 2017 and disappear thereafter. Given the vigorous expansion of activity and an already high level of public investment, there is no need for further fiscal stimulus. Instead, it is better to keep room for maneuver for the event downside risks materialize.

The government has taken steps to enhance tax transparency and align its tax practices with new international rules. To bolster Luxembourg’s reputation, it should continue to support and implement the G20/OECD anti-Base Erosion and Profit Shifting (BEPS) initiative and the new EU tax rules, including by promptly transposing the Anti-Tax Avoidance Directive into national law. Further corporate tax reform should aim at widening the tax base by ensuring that special tax regimes and transfer pricing arrangements are aligned with evolving international standards, while lowering statutory corporate tax rates in a revenue neutral manner. With a more level international taxation playing field, the impact on the economy of such measures would be mitigated by the country’s various other competitive advantages such as its triple-AAA rating and qualified labor force. To address fiscal revenue risks, the government should develop contingency measures, including by revisiting the low real estate valuation tax bases and enhancing green taxation.

Continued reform of the pension system is advisable. Population ageing will put significant pressure on Luxembourg’s pension system, with the current surpluses projected to disappear in the medium term and the accumulated reserves to be used up thereafter. This would significantly deteriorate the fiscal position. Therefore, further pension reforms are called for to ensure the long-run sustainability of the system and preserve fairness across generations, while keeping Luxembourg an attractive place to do business. The newly formed Pensions Group, comprised of representatives of the social partners and government, should aim to propose a mix of policy options ahead of next year’s elections, including measures to increase the low effective retirement age.

Financial Sector Policies

A continued pivot towards risk-based supervision and further increase in resources for entities engaged in safeguarding financial stability are needed to complement recent reforms. Potential vulnerabilities arise from the structural characteristics of the financial system—size and interconnectedness—as well as from elevated real estate valuations. In addition to changes at the European level, the Luxembourg authorities have pursued a domestic reform agenda in recent years, including the adoption of key recommendations from the 2011 FSAP and a strengthening of the Anti-Money Laundering/Combating the Financing of Terrorism regime. Rising financial industry assets and ever more complex international regulatory standards require a continued scaling up and deepening of financial sector supervision.

Intense supervision of banks’ large cross-border exposures is required. Many foreign bank subsidiaries in Luxembourg aggregate liquidity from investment funds and wealth management operations and ‘upstream’ it to their parents abroad where maturity and currency transformation may take place. Oversight by the Luxembourg authorities may be limited where parents are not regulated under the Single Supervisory Mechanism. In addition to the safeguards in place, more frequent on-site inspections should be introduced and banks should be required to periodically demonstrate their continued eligibility for the waiver to large exposure limits. The authorities should also take the initiative to reinforce the oversight of non-bank holding companies of banks to improve risk monitoring, while continuing to advocate for a coordinated approach at the European level.

The investment fund supervisory regime and risk monitoring should continue to be strengthened to safeguard financial stability. Severe shocks to investment funds could result in a drawdown of bank deposits to help meet redemptions and affect banks’ fee income. The frequency of on-site inspections should be increased, comprehensive inspections introduced, and close engagement sought with regulators in jurisdictions where delegated activities such as portfolio and risk management are prominent.

The new macroprudential policy framework appears to be working well and could be improved further. The legal framework could be enhanced by removing the potential inaction bias stemming from unanimity in voting, and by enshrining into law the leading role of the Banque centrale du Luxembourg (BCL). The instrument toolkit should be expanded as further macroprudential tightening may be required if credit conditions ease and amplify the uptrend in property prices.

Risks in the real estate market should continue to be closely monitored, and further actions should be taken if needed . House prices have risen significantly since the global financial crisis, reflecting demand from employment growth meeting supply constraints. Various recent measures have appropriately discouraged riskier lending practices and have built buffers in the banking system. Measures should be taken to increase the supply of housing, while the merits of setting limits to loan-to-value ratios or debt-service-to-income ratios should be assessed.

Governance arrangements should be strengthened to ensure current good supervisory and financial sector policy practices are preserved well into the future. A formal framework should be introduced to govern the relationship between the government and banks with state involvement. The operational independence of theCommission de Surveillance du Secteur Financier (CSSF) and Commissariat aux Assurances (CAA) should be enshrined in law and their Board members, as well as those of the BCL, should be bound by codes of conduct in line with best practices.

Policies for Sustainable and Inclusive Growth

Economic diversification would help to increase the resilience of the economy. Further expanding economic activity beyond the financial sector is also important to enhance broad-based job creation. The efforts of the government to promote new sectors of activity should be complemented with product market reforms to support firm creation by removing restrictions and alleviating operational requirements in business services and the retail sector. Furthermore, insufficient housing supply poses a bottleneck to the economy. The central and local governments should take measures to increase the supply of housing, such as by easing zoning requirements for construction and shortening the period required to obtain permits. It is also important to maintain adequate and efficient public investment to provide the high quality infrastructure commensurate with the expansion of the economy.

Unemployment is edging down with strong growth and active labor market policies , but remains higher than before the financial crisis while a large share of new jobs is filled by cross border workers, mainly due to skills mismatches. To bring the growth benefits to all, the public employment agency (ADEM) should continue to increasingly target its interventions at the most vulnerable groups in the labor market, notably the young and low-skilled, as well as non-EU immigrants and refugees. Employment subsidies should be limited to avoid providing windfalls to employers without creating durable jobs. Further linking unemployment benefits to job search and training could help reduce inactivity traps. With the resumption of the wage indexation, it is important to ensure that real wages are in line with productivity. Education reforms should focus on upgrading education outcomes in the context of a multi-lingual society with pupils coming from diverse backgrounds, and on improving the quality of vocational training, in order to better ensure that graduates are equipped with the skills needed in the labor market.