RaboResearch - Economic Research

Country Report Luxembourg

Country Report


Luxembourg flag

The economy of Luxembourg took a positive turn in 2013 and the already strong fiscal position improved. However, in the longer term, the country needs to deal with challenges such as legislative harmonisation at the EU level and rising costs due to ageing. 

Strengths (+) and weaknesses (-)

(+) Solid fiscal position

Modest budget surpluses and deficits have kept the public debt low (24% of GDP in 2013), while the government holds a positive net asset position. That gives the government room to adopt an expansionary stance when needed.

(+) Strong external position

Luxembourg runs structural current account surpluses and holds a net creditor investment position with the rest of the world.

(+) Attractive business environment

A favourable regulatory environment, a highly skilled workforce and a high level of regional integration make Luxembourg an attractive destination for investments (e.g. several internet multinationals, such as Skype, serve the European market from here).  

 (-) Small and open economy, highly dependent on the financial sector

The economy of Luxembourg is very open and therefore very vulnerable to external shocks. Since  the financial sector accounts for around 25% of GDP and tax revenue, and 11% of employment, the economy is highly susceptible to developments in the sector.

Key developments

1. Economic performance is improving, but recovery is fragile and challenges remain

After a temporary dip in 2012, economic activity picked up in 2013 and is expected to maintain momentum in coming years. After a weak first quarter, economic activity picked up in the last three quarters of 2013. As a result, economic growth accelerated from -0.2% in 2012 to 2.1% in 2013. Economic growth in 2013 was thus markedly higher than the EU average of 0.1%, though it remained way below the 5% pre-crisis level. While the recovery has been fragile and uneven across sectors, it is positive that the financial sector, the motor of economic growth in the past, showed signs of recovery in 2013. The investment fund industry seems to have performed particularly well. However, the conditions for the financial sector are unlikely to become as favourable as they were before the 2008/2009 crisis, which will constrain the growth potential of the sector and, consequently, the economy as a whole. Looking forward, economic growth is forecast to stabilise around 2% in the coming two years. External demand is expected to benefit from recovery in the eurozone and domestic demand is expected to strengthen on the back of labour market improvements. However, the risks to this scenario are tilted to the downside, as deleveraging in the eurozone and the softening of bank secrecy (after the introduction of an automatic information exchange system on 1 January 2015) could dent growth in the financial sector. In conclusion, while economic growth has picked up and is expected to gain momentum, recovery is fragile and challenges remain.

Figure 1: Economic growth picks up
Figure 1: Economic growth picks upSource: EIU
Figure 2: Budget deficit increases
Figure 2: Budget deficit increasesSource: EC

2. Despite improving in 2013, fiscal balances are set to worsen somewhat

Luxembourg’s budget deficit decreased from 0.6% of GDP in 2012 to 0.2% of GDP in 2013, supported mainly by windfall revenues from VAT on e-commerce. The public debt remained low at 24% of GDP, from 22% of GDP a year earlier, and the government maintained its net asset position (gross financial assets of the government were 84% of GDP in Q313). However, looking forward, Luxembourg’s fiscal position faces numerous challenges. First, a one-off fall in revenue from EU VAT regulation: from 2015, VAT will be charged in the country of residence of the consumer instead of that of the retailer. This is expected to widen the budget deficit of Luxembourg by more than 1.5% of GDP. The shortfall is therefore forecast to soar to 2.4% of GDP and public debt to 28% in 2015. Second, in the absence of reforms,  Luxembourg is faced with a low-growth environment and the high costs of generous social benefit, health and pension systems. The burden from the latter two will be exacerbated by an ageing population. However, given the strong current position, fiscal balances should remain sustainable. Besides, the current low level of taxation gives Luxembourg room to increase public revenues without losing attractiveness to investors. Moreover, the government’s commitment to returning the public balance to surplus and containing public debt below 30% of GDP bodes well for the future.  

3. Elections led to change of power, but had no significant impact on policy direction

Following the release, in July 2013, of a report that accused the secret services of illegal surveillance of politicians, the Socialist Worker’s Party (LSAP) withdrew its support for the government and prime minister Juncker of the Christian Social Party (CSV) resigned. Consequently, early elections were held in October 2013. While the Christian Social Party remained the largest party in the Chamber of Deputies, the results allowed the Democratic Party (DP), the LSAP and the Green Party to form a coalition. The formation of this left-wing government marked an important change of power, since the CSV had led every coalition bar two since 1945. However, the political shift to the left is expected to have little impact on policy, given Luxembourg’s track record of prioritising a favourable business environment and sound public finances. The thin two-seat majority of the coalition will also keep any radical tendencies in check. The change of power is poised to hurt the current insider culture - whereby politicians have close ties with business, the result of decades of CSV political dominance and a small population - which should help to keep corruption relatively low.

Factsheet of Luxembourg
Factsheet of LuxembourgSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

Luxembourg is a small, open economy and one of the wealthiest countries in the world (the highest GDP per capita amongst the OECD countries). The country’s infrastructure, institutions and industrial relations are of the highest standard. A favourable tax regime and regulation, such as bank secrecy, have attracted a large number of financial institutions. The main activities in the sector are insurance, fund management and banking. The fund management industry is the second largest in the world and the banking sector is colossal – bank assets are 18 times GDP,  the largest ratio in Europe. However, banking is dominated by foreign-owned banks, serving as foreign investment vehicles to their parent companies and having few ties to the local economy. Hence, the contingent liabilities for the sovereign are estimated to be low, as only 5 out of the 141 banks are of systemic importance, domestic banks account for a mere 150% of GDP and claims on the Deposit Guarantee Scheme have remained low. In addition, the good health of the sector makes such claims unlikely. While EU regulatory harmonisation could hurt growth in the financial sector, the highly skilled financial workforce, the sophisticated regulatory system and the track record of being a first mover and adapting to regional legislative changes look set to maintain Luxembourg’s attractiveness as a financial centre. Luxembourg has been a front runner in regional cooperation, probably driven by its small size and central location in Western  Europe. It set up a customs and currency union with Belgium in as early as 1922. Later on, it was one of the founding members of the EU, NATO and WTO. Consequently, Luxembourg hosts important EU institutions and a pan-European not-for-profit sector. The country also attracts a large foreign workforce from neighbouring countries, which accounts for around 42% of employment.  

Economic indicators of Luxembourg
Economic indicators of LuxembourgSource: EIU, EC
Alexandra Dumitru
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO

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