Mission Concluding Statement 

Luxembourg: Staff Concluding Statement of the 2023 Article IV Mission

March 10, 2023

Washington, DC:

Despite a challenging external environment in 2022, the Luxembourgish economy has proven resilient. However, 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, with the implemented energy price controls and a VAT rate cut temporarily reducing pass-through to domestic prices. With persistently high core inflation and strong labor markets, fiscal policy for 2023-24, including the recent tripartite measures, risks overstimulating demand, limiting incentives for energy savings, and impeding an adjustment in housing prices to more affordable levels. Accordingly, staff recommends a broadly neutral fiscal stance for this and next year, and better targeted support measures to help people in need, while allowing price signals to work. Over the medium term, significant fiscal risks and increasing ageing-related costs call for more prudent recurrent spending than envisaged and fiscal reforms to preserve fiscal buffers. Financial sector risks have intensified since the last Article IV but the financial system appears in a good position to weather adverse shocks. Pockets of vulnerabilities (especially in real estate and investment funds) should continue to be closely monitored and action taken as needed. Luxembourg’s automatic wage indexation has not posed major challenges in a low inflation environment. However, the high inflation environment has reignited concerns about wage-price spirals and the ability of firms to adjust. Reforming the wage indexation, together with measures to contain the increase in the cost of living, in particular housing, could help continue attracting talent, while preserving competitiveness.

Context

Following a strong recovery from the pandemic, the fallout of the war in Ukraine is posing new challenges to the Luxembourgish economy. Growth momentum has slowed somewhat, though from strong levels, reflecting mostly weaker external demand and investment in real estate, while consumption remains robust and the saving rate high. High energy prices in European markets caused inflation to rise to multi-decade highs by mid-2022, increasing risks of a wage-price spiral and potential competitiveness pressures in a context of automatic wage indexation. To reduce these risks, the government, in agreement with social partners, adopted mostly untargeted fiscal support packages for households, with price controls and subsidies temporarily limiting the pass-through to domestic prices. Tighter and volatile global financial conditions are starting to affect the financial sector, albeit with some heterogeneity across segments. Housing price growth, both real and nominal, has moderated but remained high even as demand has declined.

Outlook and risks

The reverberations of the war in Ukraine are expected to continue through 2023 and possibly beyond. 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. Yet, the large fiscal stimulus and wage indexation will bolster growth of real disposable income and reduce the impact of higher interest rates. Inflation is also expected to moderate, mostly due to lower energy prices and price controls, but core inflation is projected to remain high at around 3½-4 percent, with risks to the upside.

Uncertainty is high and risks to growth, although less prominent recently, are to the downside. Risks are mainly external and stem from: i) potentially deeper recessionary pressures in major economies, ii) de-anchoring of inflation expectations resulting in a tighter-than-anticipated monetary policy and a worse growth-inflation trade-off, and iii) a disorderly market adjustment to central bank decisions, which could pose challenges to financial stability. On the upside, a more resilient global economy and pent-up domestic demand could boost growth.

Policies

Fiscal

Despite the slower growth, the planned fiscal stance appears overly loose given still elevated core inflation and the households’ strong aggregate financial position. Staff recommend significantly reducing the fiscal impulse by keeping the cyclically adjusted overall balance (excluding the one-off quota transfer to the EU) broadly unchanged in 2023 and 2024. Also, given the high uncertainty, fiscal overperformance (for example, due to lower energy prices or low uptake of the measures) should be saved or redirected to accelerate the energy transition and to support public housing supply. To avoid fueling demand and increasing inflation persistence, the authorities should refrain from additional stimulus, especially with permanent effects. Finally, fiscal policy should remain nimble and in case recessionary pressures turn out to be greater and inflation falls by more than expected, the authorities should allow automatic stabilizers to fully operate and consider targeted stimulus in case of severe demand shocks.

Given uncertainty about the persistence of the energy shock, staff recommend switching to more targeted measures, allowing stronger price signals to lock-in energy savings, and strengthening energy security. Block pricing (where only a basic amount of consumption is subsidized), possibly complemented with targeted cash transfers, or social tariffs could be envisaged instead of the current price caps. The extension of the targeted energy bonus and tax credit to low-income households would alleviate the impact of block pricing on the most vulnerable. Technical difficulties to distinguish the bills of multi-family residences would favor linking the support to the unit’s share of their past energy use. Efforts to promote transition to renewables and energy efficiency are welcome and should continue to boost energy security.

More prudent recurrent spending and fiscal framework reform are needed to preserve buffers and to 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. The impact on deficits and debt has been relatively limited, thanks mainly to cyclical and one-off revenues as well as no tax brackets indexation since 2017, which has proved difficult to sustain economically and politically. Higher borrowing costs, significant fiscal risks, and increasing ageing-related costs call for more prudent recurrent spending. Early action on the pension system would improve intergenerational equity and long-term fiscal sustainability, while creating space for higher investment. As the European Commission’s fiscal framework proposal is unlikely to be binding for Luxembourg, the 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.

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. The resulting revenue has only partially been used for targeted spending, with potentially unintended distributional effects. Also, as current developments illustrate, mounting pressure to adjust the tax brackets on an ad-hoc basis could result in a large and procyclical fiscal stimulus. Hence, going forward, staff see merit in increasing the frequency of the tax brackets adjustments in a budget-neutral way. This could be achieved within a comprehensive review and simplification of the tax and social benefits system to enhance its efficiency and distributional impact.

Financial sector

Risks have intensified but there are mitigating factors and the financial system, overall, appears able to withstand severe shocks. Higher inflation and borrowing costs, lower activity, and potentially lower collateral valuations are likely to increase credit risk and provisioning. Persistent house price overvaluation, high households’ indebtedness, and concentration of real estate exposures in some credit institutions pose also risks to the banking sector. Yet, strong initial conditions increase banks’ overall resilience to shocks, albeit with some heterogeneity across banks and business models. Despite some de-risking, 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. However, banks’ substantial capital and liquidity buffers and funds’ tendency, on aggregate, to accumulate cash in periods of stress would limit systemic risks.

Macroprudential policy could be adjusted to increase banks’ resilience and to avoid build-up of vulnerabilities, especially in the real estate sector. The authorities appropriately kept countercyclical capital buffers unchanged, given the closing credit gap, tightening of credit standards, and high uncertainty. That said, continued prudent provisioning should be encouraged. Drawing on the mortgage credit directive, the CSSF requirement for banks to perform interest rate sensitivity analysis on new mortgages is welcome. In addition to the LTV measures currently in place, to further improve the risk profile of new loans, the macroprudential authorities should consider introducing income-based limits (calibrated to reduce excessive risk-taking, while avoiding depressing significantly real estate activity). To address risks of unexpected losses on the stock of real estate exposures, the relevant authorities should consider targeted sectoral capital measures.

The authorities’ efforts to bolster resilience of investment funds should continue. The effectiveness of liquidity management tools, in particular swing pricing, would benefit from better calibrating them to stress episodes as well as aligning redemption terms with asset liquidity and investment strategy. At the supervisory level, close monitoring of large redemptions and regular liquidity stress tests should continue. Data gaps, for example, on the composition of the investor base and interconnectedness with other non-banks should be addressed. Finally, given the central role of Luxembourg in the global financial architecture, the relevant authorities should continue to coordinate with peers, including monitoring cross-border spillovers, and contribute to international efforts to strengthen regulatory and macroprudential requirements.

Structural

Persistent imbalances in housing markets and higher mortgage rates are likely to further worsen housing affordability in the short term. Building on efforts to curb speculative demand and land hoarding, the authorities should continue to 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). In staff’s assessment housing prices are overvalued, following several years of double-digit growth. Public sector purchases of dwellings under development should be avoided as it could impede a price correction that would enhance affordability. In this context, the authorities could consider frontloading public investment in social and affordable housing, and should expedite efforts to reduce supply bottlenecks, including by allowing greater density of buildings and by reducing the administrative burden.

While the automatic wage indexation (AWI) has not posed major challenges during low inflation times, its operation during high inflation could be improved. The current system may not fully compensate low-income households, which are disproportionately affected by large and persistent commodity price increases. At the same time, it has been too generous to relatively more affluent households, which could generate upward pressure on housing prices. On the one hand, suspending or postponing AWI could adversely impact lower income workers, and compensatory measures could prove costly for the government, as the recent experience has shown. On the other hand, frequent rounds of AWI could limit firms’ ability to adjust, especially those facing external competition, which may induce suboptimal employment and investment decisions. The system could be reformed to mitigate inflationary risks, enhance its fairness, and preserve firms’ ability to cope with large shocks. Possible avenues for reform include indexing to core inflation, complemented with targeted support for the poorest segments of the population, introducing progressive considerations in wage indexation, and a rule-based suspension of the system, based on competitiveness indicators.

Luxembourg needs to more efficiently use its workforce to increase its growth potential. The country has made remarkable progress in reducing the gender gap, but more could be done to unlock the full potential of women, including 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, and means-testing family benefits. Senior participation and employment could be improved by reducing the generosity of the pension system while at the same time promoting life-long learning.

The IMF team would like to thank Luxembourg’s authorities and other interlocutors for constructive and insightful discussions.