Mission Concluding Statement 

Luxembourg: Staff Concluding Statement of the 2024 Article IV Mission

March 26, 2024

Luxembourg:

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, while headline inflation will continue subsiding, albeit 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. Over the medium term, given ageing costs and fiscal risks, a gradual fiscal consolidation, mainly by enhancing spending efficiency and streamlining tax expenditures, would free space for investment in the digital and green transition while stabilizing the debt. The 2024 Financial Sector Assessment Program (FSAP) found the financial sector to be largely resilient against severe shocks. Financial sector’s cyclical systemic risks have somewhat abated, but the higher interest rate environment exposed stock vulnerabilities in banks’ real estate exposures. Most banks are able to absorb large shocks, and their resilience should be preserved, preferably through targeted sectoral systemic risk buffers. Close monitoring of real estate risks should continued, and sound lending practices maintained. Households’ indebtedness should be addressed through income-based measures early in the recovery cycle. Support to the real estate sector should allow an orderly adjustment of still overvalued housing prices. Supply-side measures should be expedited, and, over the medium term, help-to-buy policies should be better targeted. An early pension reform would ensure long-term sustainability and intergenerational equity.

Context

The new government took office in a challenging economic context. The steep rise in interest rates and elevated uncertainty has taken a toll on economic activity. GDP contracted by 1.1 percent in 2023, driven by external demand and residential investment, while the unemployment rate increased, and vacancies dropped from historical records. Robust disposable income growth, following several wage indexation tranches and fiscal support, has boosted private consumption. Headline inflation is subsiding, but underlying inflation, while declining, remains high. Credit growth turned negative—as demand dropped and credit standards tightened—and real estate prices declined, although they are still overvalued. Banks’ profitability increased, boosted by higher net interest margins, and capital and liquidity buffers remain higher than in EU peers. While household and corporate sectors entered the monetary policy tightening with strong balance sheets, liquidity pressure has been rising. Asset quality is deteriorating notably (especially in real estate related exposures), albeit from low levels. To reinvigorate growth, the authorities announced a package of measures to support purchasing power and housing demand.

Outlook and risks 

Growth is 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. 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 are tilted to the downside amid heightened geopolitical tensions. External factors, including rising geopolitical tensions, renewed disruptions in supply chains, sharp global slowdown, and global financial instability, dominate downside risks. Uncertainty also arises from the impact of changes to international taxation and/or financial regulations. Domestically, risks stem mainly from a potentially disorderly correction of asset prices, including overvalued housing prices. On the upside, a more resilient global economy, faster unwinding of the excess savings, and pent-up demand for residential real estate could boost growth.

Policies

Fiscal

The moderately expansionary fiscal stance is broadly appropriate, but more targeted and temporary measures would have been preferable. With a negative output gap, weakening labor market, and high uncertainty, the authorities rightly decided to support the economy. However, the rapid growth of households’ real disposable income and consumption, and saving rates well above pre-pandemic levels, warranted a more targeted fiscal support to help disinflation. In addition, several measures are permanent and have worsened the medium-term fiscal outlook.

Given spending pressures and uncertainty about fiscal revenues, a more prudent fiscal policy is needed to stabilize debt in the medium term. The country has ample fiscal space and public debt is one of the lowest among AAA rated countries. Under announced policies, however, staff project public debt to increase by 6-7 percentage points of GDP by 2029. In addition, some intended policies and materialization of fiscal risks could lead to a worse outcome. Accordingly, staff recommend a gradual fiscal consolidation to stabilize public debt over the medium term. As an 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.  

• Given uncertainty regarding revenues, tax reforms should be carefully designed to avoid revenue losses. Staff support regular adjustments of the tax brackets for inflation but recommend they be done in a budget-neutral manner. Staff advise against retroactive changes to the tax schedule without compensatory measures. In addition, the intended reduction of the corporate income tax (CIT) rate could potentially result in lower revenues, without necessarily attracting new businesses. Finally, streamlining tax expenditures (e.g., interest rate deductibility) is important.
• On expenditures, pressures are stemming from rising ageing costs, defense requirements, and much-needed investment in the digital and climate transition. The authorities’ intention to contain spending, including the wage bill, is welcome and should be underpinned by specific measures. Examples include improvement in spending efficiency (e.g., social protection spending, a key factor in reducing inequality).

The authorities’ plan to strengthen the national fiscal framework, complementing the EU Economic Governance Framework, is commendable and should be expedited. While the Excessive Deficit Procedure is expected to remain unchanged, the new EU economic governance reforms do not prescribe a fiscal adjustment path for Luxembourg, given its low debt and deficit. To help better anchor fiscal policy, the authorities intend to adapt the national framework by complementing the EU rules with a medium-term objective (MTO). A national MTO could be set based on a structural fiscal balance that considers the changes in ageing costs over a longer horizon, in line with the new EU methodology. In this context, the net primary expenditure path derived from the national MTO could serve as an operational limit. In addition, the authorities could consider strengthening the role of the fiscal council in assessing budgetary forecasts and monitoring the compliance with the fiscal framework (both the EU and domestic rules). A national framework along these lines, legislated in national law, would allow Luxembourg to set its own paths within the EU obligations, while helping maintain a credible commitment to the AAA rating.

An early pension reform would ensure long-term sustainability and intergenerational equity. The general pension scheme’s reserves are comfortable (about 32 percent of GDP), but its long-term sustainability is not guaranteed. As a result of demographic pressures, pension costs are projected to rise significantly (to about 18 percent of GDP by 2070 for general and special schemes), while revenues are expected to plateau as net migration flows slow down. The existing 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. Thus, the planned public consultation on the matter is welcome, as it will help ensure ownership of a reform. Action is also needed to address the rapid deterioration of the balance of the National Health Fund (Caisse nationale de santé).

Financial sector

Cyclical systemic risks have abated somewhat, but the higher interest rates exposed some stock vulnerabilities, especially related to real estate. The FSAP analyses suggest that households’ debt servicing capacity would be constrained under the IMF’s baseline scenario, especially for lower income households and those with variable rate mortgages. Under a severe adverse scenario (higher interest and unemployment rates), credit risk could spread to more affluent households, especially since this group contracted mortgages in recent years. In addition, real estate companies, which are already facing higher bankruptcies, could further experience debt servicing challenges. Such problems in the private sector could lead to more volatile consumption and investment.

The financial sector is assessed to be largely resilient against severe shocks. The FSAP shows that in the baseline scenario the banking system can sustain the impact of the high interest rates, with a small share of weak banks. Also in the adverse scenario, banks overall have enough capital and liquidity buffers to absorb severe shocks. Although the share of weak banks in total assets would double, the recapitalization needs would remain easily manageable. All banks can sustain significant retail deposit outflows. Only a few would need to dip into their liquidity buffers, mainly due to potential weakness in some foreign parent banks. The 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), and larger shocks would expose vulnerabilities in a few funds.

Macroprudential policy should aim at preserving banks’ resilience and avoiding build-up of vulnerabilities, especially in the real estate sector. Banks’ capital headroom should be used to increase minimum macroprudential capital requirements to absorb unexpected losses on real estate exposures, preferably through sectoral systemic risk buffers. The risk of constrained credit supply arising from such a measure would be mitigated by banks’ profitability and comfortable capital headroom. In parallel, supervisory authorities should continue to monitor real estate risks, with a focus on valuation and concentration, and ensure adequate provisioning and sound lending practices. Early in the recovery cycle, income-based measures such as a debt-service to income limit under stress should be activated along with considering a gradual reduction of the maximum loan-to-value (LTV) limit of 100 percent. The institutional framework could be enhanced to reduce potential inaction bias by reducing the role of the government in macroprudential decisions. Its effectiveness could be boosted by strengthening communication for greater transparency and accountability, and improving coordination with other policies (e.g., housing).

The well-supervised financial sector could further benefit from targeted regulatory and supervisory improvements. The FSAP did not find evidence of lack of operational independence of the supervisory authorities in practice. Nevertheless, the authorities should 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. Large cross-border connections require further enhanced home-host cooperation, particularly on: (i) information sharing for bank subsidiaries and branches, (ii) risk-based onsite supervision of investment funds’ foreign delegates, and (iii) monitoring cross-border flows for money laundering/financing of terrorism risks. To formalize the division of responsibilities between CSSF and Banque centrale du Luxembourg (BCL) on liquidity supervision of Less Significant Institutions, the draft Memorandum of Understanding should be finalized. CSSF supervisory risk assessment should incorporate group links between depositaries and investment fund managers as risk factors into the risk-based approach. The enforcement powers of CSSF in investment funds should be increased with higher fines and harmonization between types of funds. Separately, the authorities should continue to strengthen the financial safety net framework.

Housing sector

The authorities should allow an orderly rebalancing of the housing market, while expediting supply side measures. Given the slump in housing sector, to reduce potentially durable disruptions to downstream activities, the government has unveiled several measures, temporary and permanent, to stimulate housing demand. These measures could help restore confidence and alleviate pressure on the construction sector. However, given supply constraints, the boost to demand is likely to result in further deterioration of households’ indebtedness and affordability. Over time, these measures may lead to moral hazard and promote risk taking. On balance, staff reiterate the importance of supply-side measures to reduce supply rigidity. Staff propose to frontload public investment in social and affordable housing in cost-efficient ways, with greater involvement of the private sector. Plans to reduce red tape are welcome and should be expedited.

Structural policies

Key reforms are needed to maintain the country’s competitiveness. The authorities should consider more ambitious reforms to break the self-reinforcing spiral between cost of living and wages. These include: i) lowering housing supply-demand imbalances through reducing reliance on demand-support policies and boosting supply; ii) increasing the flexibility of the wage indexation system; and iii) continuing efforts to expand labor force participation, reduce skill mismatches, and remove obstacles to foreign workers. In this context, the authorities’ announced reforms to transition to individual taxation are welcome and could be complemented by a means-testing of family benefits.

A broad slowdown in productivity growth in Luxembourg since the Global Financial Crisis warrants sustained policy efforts to enhance productivity. Luxembourg’s average productivity growth has lagged that of neighboring countries over the past several decades. Meanwhile, as one of the key drivers of productivity growth, investment in the non-financial corporations’ sector fell by 3 percent of GDP. Empirical analysis suggests that spillover from the financial sector’s rapid expansion and high labor cost linked to automatic wage indexation may contribute to the investment decline. Policies that foster wage flexibility, catalyze technology innovation, and increase R&D spending can help rekindle productivity growth. The recently implemented laws that facilitate entry and exit of companies from the market are welcome and should help improve allocative efficiency and enhance competition.

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