Country Report Luxembourg
Luxembourg, which has the highest GDP per capita across OECD countries, weathered the financial and economic crisis relatively well. Although the austerity effort is limited, in combination with the slow recovery in the eurozone, it will hamper economic growth in Luxembourg during 2013. The extremely large size of the financial sector does not only result in fiscal contingencies, but it also creates a dependency on this sector regarding economic growth and employment. Although recent supervisory reforms in both Luxembourg and Europe, including European steps to set up a banking union, help monitor large banks with cross-border activities, they may also have an impact on the competitive position of Luxembourg in the international financial sector.
Luxembourg, which has the highest GDP per capita across OECD countries, weathered the financial and economic crisis relatively well. In the absence of an austerity effort until 2011 and backed by solid non-financial private sector balance sheets, domestic demand was able to contribute robustly to GDP growth. The resulting growth of employment helped to keep the country’s unemployment rate (5.0% in 2012) among the lowest in Europe.
However, since mid-2011 the economy slowed down considerably as a result of both external economic headwinds, especially arising from the eurozone, and a shift in fiscal policy towards modest tightening. Despite the country’s strong fiscal position –gross public debt ratio of 21%-GDP in 2012, and a budget deficit of 1.5%-GDP- the government launched an austerity package in April 2012 and announced further measures at the end of the year. The government shows it still aims to reach a balanced budget in 2014. Although the austerity effort is limited, together with the very slow recovery in the eurozone, it will hamper economic growth in during 2013. That said, note that the growth forecast of the European Commission for 2013 (+0.5%) and 2014 (+1.6%) is still substantially better than the eurozone average.
Although Luxembourg’s fiscal position remains one of the country’s strengths, there are a few long term challenges which need to be addressed. Similar to many other industrialized countries, the country will be confronted with an ageing population in the coming decades. Although the rise of the old-age dependency ratio (persons over 65 years divided by working-age population) from 2010 till 2060 is average from a European perspective, the pension system is very generous. The pension reform that was passed by the parliament in December 2012 is only a small step in the right direction. A positive element is that it encourages longer working as it introduces lower entitlements in case of early retirement. However, the current minimum age for early retirement (57 years) and full pension entitlement (65 years) remains the same. Although it is difficult to assess the exact impact of the reform at this stage, it is generally considered as insufficient to restore long term fiscal sustainability. Next to the pension discussion, the IMF and the OECD have for many years called for labor market reforms. Generous unemployment benefits take away incentives to find jobs, which leads to a small group of structurally unemployed people. Besides that, the automatic wage indexation allows high inflation to feed into higher wage growth. This has resulted in a loss of international price competitiveness, although the drop in export world market share during the last decennium was still limited compared to the other eurozone countries. A cap on the automatic wage indexation for the period 2012-2014 will help to partially restore the lost competitiveness. Although positive, this is only a temporary solution, and the wage bargaining process should still be changed in a more structural way.
The exceptionally large size of the banking sector (around 22 times GDP by end-2012, even if we exclude asset management firms) –a result of specialized expertise and an attractive regulatory and legal framework- can potentially lead to fiscal contingencies and makes the country’s economy dependent on future developments in this sector. Regarding the former, it should be noted that the sector is generally well-capitalized and has been relatively stable throughout the financial crisis. Even more important, the fact that a very large proportion of credit is granted by banks that are subsidiaries of foreign institutions (more than 90% of total bank assets are foreign-owned) means the sector as a whole only poses a moderate risk as a contingent liability to the state. The direct involvement of the state in the Belgian-led bailout of Fortis Bank in 2008 (costing it USD 2.5bn or 6%-GDP) shows that the country is not always fully insulated. However, this should be seen as an exception as in contrast to most other foreign bank subsidiaries in Luxembourg, Fortis had large local retail operations which led to burding-sharing.
Besides fiscal contingencies, the extremely large size of the financial sector makes the country dependent on it for future economic growth (the sector contributes about one fourth to GDP) and employment (one-eighth of the labor force). Going forward, it cannot be excluded that the role of Luxembourg in the international financial sector will be impacted by future (European) reforms, for example regarding taxation and bank secrecy. In reaction to mounting political pressure after the Cypriot bailout, Luxembourg announced that it will change the rules of its bank secrecy for citizens of the European Union from 2015 onwards. Although details are unclear at this stage, Prime Minister Juncker stated that the impact on Luxembourg’s banking sector will be limited. It is important to note that there has been an international development towards more transparency and harmonization already for years. Although future developments should be monitored closely, it should be noted that regulatory steps also bring clear benefits to Luxembourg’s banking sector. The creation of the European Supervisory Authorities (ESAs) already made it much easier for domestic regulators to assess foreign institutions with local activities in Luxembourg. The future creation of a Single Supervisory Mechanism and a bank resolution fund –although the setup and contribution to the fund are unclear at this stage- will also help monitor large banks with cross-border activities and should eventually increase transparency and financial stability, both in Luxembourg and across Europe.