Press Release-Concluding Statement AIV PPM

LUXEMBOURG: Concluding Statement of the 2016 Article IV Consultation Mission
March 1, 2016
A Concluding Statement describes the preliminary findings of IMF staff at the end of an
official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken
as part of regular (usually annual) consultations under Article IV of the IMF's Articles of
Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part
of discussions of staff monitored programs, or as part of other staff monitoring of economic
developments.
The authorities have consented to the publication of this statement. The views expressed in
this statement are those of the IMF staff and do not necessarily represent the views of the
IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare
a report that, subject to management approval, will be presented to the IMF Executive Board
for discussion and decision.
Growth prospects remain strong but are subject to increasing downside risks from
weakening international activity and stress in financial markets. Implementation of the
international tax transparency agenda, which Luxembourg has embraced, could weigh on
economic activity and tax revenue. At the same time, various other competitive advantages,
such as Luxembourg’s triple-AAA rating and its qualified labor force, would continue to
benefit the country. Against this backdrop, the fiscal stance should remain prudent and
contingency measures should be prepared for the event negative shocks occur. The limited
fiscal space should be used to bolster growth prospects, while adapting the tax regime to the
changing international environment and ensuring the long-term viability of the pension
system. Implementation of the Banking Union will help to increase the stability and resilience
of the banking system. Financial sector risks need to be monitored closely and, where
necessary, Luxembourg should advocate appropriate international regulation. Building on
past experience, active labor market policies should focus on integrating refugees in the
labor market and further reducing unemployment.
Fiscal Policy
The revenue risks of the international tax transparency initiatives and volatile financial
flows make it appropriate for Luxembourg to keep the public debt ratio on a slightly
declining path, in order to maintain sufficient buffers in case of need. This requires targeting
a small fiscal surplus of around ½ percent of GDP in 2016 and over the medium term.
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Vigorous economic activity has opened some fiscal space, which should be used to
bolster long-term economic growth. In 2015, buoyant tax revenues and lower-thanexpected capital outlays have contributed to a significant improvement in the fiscal balance
compared to budget. Under unchanged policies, including full implementation of the
Zukunftspak, the fiscal position is expected to remain in surplus over the medium term.
Available fiscal space of almost ½ percent of GDP should be used for growth-friendly
measures such as infrastructure investments.
The tax reform proposals unveiled at end-February contain a significant reduction in
personal taxation and also in the corporate income tax starting in 2017. Preliminary
estimates indicate that these measures would reduce total fiscal revenue by up to 1 percent of
GDP, fully using up the projected fiscal surpluses. It is advisable to limit the size of the tax
reduction to the available fiscal space. While some of the tax measures aim to increase
housing supply, the envisaged tax relief for home buyers would aggravate existing
imbalances given that demand for real estate structurally outstrips supply.
The ongoing tax reform is an opportunity to solidify the tax base in a revenue neutral
way and adjust to the changing international taxation environment. The international tax
transparency initiatives—including those spearheaded by Luxembourg during its EU
presidency in the second half of 2015—call for closing loopholes used for tax avoidance. The
tax reform should aim at widening the corporate tax base and eliminating special tax regimes
while lowering statutory tax rates. The decision to phase out the IP Box tax regime from mid2016 is a step in this direction. Moreover, the government should develop contingency
measures, including revisiting the low real estate taxes, in case negative revenue risks
materialize.
Continued reform of the pension system is advisable. The pension system is currently
generating surpluses due to advantageous demographics. However, population ageing is
expected to put significant pressure on the system in the future, especially when cross-border
workers begin to retire. Accordingly, the upcoming 2016 pension review should propose
additional parametric reforms of the pension system—such as of the minimum contributions
period and conditions for early retirement—to safeguard its long-term sustainability and
promote fairness across generations.
Financial Sector Policy
Luxembourg’s world-class financial sector benefits from a stable regulatory and fiscal
environment, prudent oversight, and a skilled workforce. The expansion of the
investment funds industry, the second largest in the world, has benefited from the EU
passport. Since end-2008, about 1/5 of all worldwide net inflows into mutual funds came to
Luxembourg. The mostly outward oriented banking system, well-capitalized and with very
low non-performing loans, is characterized by a high level of intra-group flows and the
collection of corporate and high net-wealth clients’ deposits.
The high interconnections of Luxembourg’s financial system with the rest of the world
make it a recipient and conduit of global financial volatility. Investment funds, which
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have benefited from a search for yield, comprise diverse asset classes spread across many
countries. Cross-border and interbank claims account for more than half of banking assets.
Value-added in the financial sector, which accounts for ¼ of GDP, fluctuates with global
market developments.
The Banking Union is particularly beneficial to Luxembourg’s banking system. The
Single Supervisory Mechanism (SSM) is an improvement in supervision, especially of crossborder banks, and establishes a consistent and high level of oversight. The significant
enlargement of the resources of the Commission de Surveillance du Secteur Financier in
recent years is welcome and should remain commensurate with the increasing size and
complexity of the financial sector. Likewise, the Single Resolution Mechanism will ensure
swift intervention ahead of insolvency, with financial support from the industry pooled in the
Single Resolution Fund. The recent transposition of the Deposit Guarantee Scheme Directive
and of the Bank Recovery and Resolution Directive completes the legal implementation of
the Single Rule Book in Luxembourg. The authorities should also advocate for better
oversight at the European level of holding companies that include banks to improve risk
monitoring.
Strong oversight of investment funds and their management companies is necessary, in
line with evolving international standards. The relevant EU directives have strengthened
the framework for risk monitoring, liquidity management, and supervision of investment
funds. The use of derivatives that boost leverage, liquidity mismatches between assets and
redemption terms, and the use of securities lending to improve cash returns should be more
specifically scrutinized. The data reporting should allow identifying funds’ sensitivity to
interest rates and credit market movements.
Linkages between banks and investment funds are an important trait of the financial
system. Depository banks of investment funds are all located in Luxembourg and banks
provide administrative, pricing, brokerage, and accounting services to funds. Investment
funds hold sizable deposits in their depository banks, which may channel the liquidity to the
parent, as well as significant amounts of financial bonds while banks act as counterparties in
derivative contracts. There are also ownership links between Luxembourg fund management
companies and large banking groups.
Risk monitoring and regulatory frameworks should take into account the linkages
between banks and investment funds. Luxembourg should propose to discuss these
linkages in the SSM and include them in the design of joint fund-bank stress test scenarios.
Risks should be assessed not only at the investment fund level but also from a financial
stability perspective. The Comité de Risque Systémique has added the analysis of these
linkages to its work program at the national level and it should also ensure that the linkages
are examined at the EU level in the European Systemic Risk Board.
Risks in the real estate market should be closely monitored. Steadily rising house prices
appear to mainly reflect supply bottlenecks against a growing demand. The authorities should
explore whether further macro-prudential measures such as limits to loan-to-value ratios are
appropriate.
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Policies for Growth and Employment
The government is taking steps to diversify the economy. Expanding activity beyond the
financial sector is important to enhance the resilience of the economy and should be
supported with measures to better align workers’ skills with the economy’s demands.
Structural reforms addressing supply-side constraints, such as easing zoning requirements for
real estate construction, could also help.
Strong growth and active labor market policies have reduced the unemployment rate.
Innovative measures by the public employment service (ADEM), vocational training and
apprenticeship programs, and the Youth Guarantee scheme have helped to create job
opportunities and to increase youth and women’s labor market participation. Additional steps
are needed to reduce inactivity traps while ensuring that real wages remain in line with
productivity.
Luxembourg is well-equipped to cope with elevated refugee inflows. Building on its past
experience, the country facilitates enrollment of the newcomers into language classes,
schools, and other training programs. For faster integration of refugees in the labor market,
the time to obtain a temporary employment authorization could be further reduced to less
than 6 months after the asylum application. In addition, it would be helpful to extend to
refugees who have been granted asylum the employment promotion programs currently
available for the long-term unemployed.
The mission thanks the Luxembourg authorities and representatives from the private sector
for the open and constructive discussions.