RaboResearch - Economic Research

Country Report Luxembourg

Country Report


Flag Luxembourg

Economic growth in Luxembourg remains strong, but international regulatory changes could challenge the country’s economic model and strong fiscal position in the future.

Strengths (+) and weaknesses (-)

(+) Solid fiscal position

Modest budget surpluses and deficits have kept the public debt very low (21% of GDP in 2014), while the government holds a positive net asset position. This 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 of around 200% of GDP 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.

(-) 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 27% of GDP, around (excluding income tax paid on wages by the financial sector) 13% of tax revenue, and 12% of employment, the economy is highly susceptible to developments in the sector.

Key developments

1. Economic growth remains strong, but is moderating

Economic growth picked up in 2014 and thereby remained above the EU average, but the rate is expected to moderate in 2015. Growth accelerated from 2% in 2013 to 2.9% in 2014, on the back of strong external demand and domestic consumption growth. Especially life insurance and investment fund services performed well. Still, the economy showed signs of weakening towards the end of 2014 and in 2015 economic growth is expected to moderate to about 2.2%, as a VAT hike implemented in 2015 is set to hurt private consumption, while fiscal consolidation is poised to constrain government consumption. Monetary easing by the ECB and the Investment Plan for Europe could support growth. Still, there are downside risks such as a larger than expected impact from changes in the regulatory environment, e.g. international initiatives to prevent tax evasion and EU harmonization of banking system legislation.

Figure 1: Growth remains strong
Figure 1: Growth remains strongSource: EIU
Figure 2: Budget balance to slide into small deficit
Figure 2: Budget balance to slide into small deficitSource: EIU

2. Several challenges for Luxembourg’s business model and fiscal position

There are several developments that pose challenges to Luxembourg’s business model and fiscal position. First, a new EU VAT regime for e-commerce was implemented in January 2015 and shifted tax collection from the country of sale to the country of consumption. Luxembourg’s low VAT taxes had attracted a significant number of e-commerce companies and the new regime is set to reduce government revenues by 1.5% of GDP in 2015. Meanwhile, the government embarked on an extensive austerity programme that includes tax hikes and spending cuts. Nevertheless, the budget balance is estimated to slide into a small deficit of 0.5% of GDP in 2015.

Another development that could have a negative impact on the fiscal position and the economy is increased international scrutiny of Luxembourg’s favourable tax regime. In June 2014, the European Commission started an investigation on whether the tax rules of Luxembourg, Ireland and the Netherlands represent illegal state aid. Advanced tax agreements with companies received particular attention. Though these agreements represent legal and common practice, leaked information on 500 such agreements signed by Luxembourg indicates the government might have been very generous in some cases. Ongoing international initiatives to prevent tax base erosion and profit shifting, led by OECD and the European Commission, could have negative consequences for Luxembourg’s tax regulation. That could hurt its attractiveness to multinationals, and thereby reduce government income. 

Future fiscal sustainability is also challenged by the increasing costs of an ageing population, only partially addressed by measures implemented so far. Therefore, Luxembourg’s fiscal position could come under increasing pressure in coming years. Fortunately, the low level of public debt (21% of GDP in 2014), the net creditor position (estimated at 48% of GDP) and the existence of social security reserves (estimated at 30% of GDP) provide comfort.

3. Shift to the East in the financial sector

In 2014 Luxembourg strengthened its ties with China, and that should support the country in becoming a leading European hub for renminbi cross-border business. The Grand Duchy has a track record of adjusting its financial sector to tap on arising opportunities. For example, the early adoption of the EU directive on Undertakings for Collective Investment in Transferable Securities in the mid-1980s helped Luxembourg become the second largest investment fund centre in the world. Currently, Luxembourg seems to positioning itself as a leading European centre for cross- border business in renminbi in order to tap on China’s efforts to internationalise the renminbi. The country is already an important gateway for Chinese FDI into Europe, accounting for a quarter of such inflows, and a leader in the following renminbi denominated services: retail and corporate banking, bond listings, settlement, derivatives and investment funds. Luxembourg’s position was strengthened in 2014, when the two governments agreed to establish a renminbi clearing house in Luxembourg, Chinese financial organisations increased their presence in the country and the Grand Duchy hosted the issue of the first renminbi corporate bond in the Eurozone. Such diversification of the financial sector is a welcome development as it provides some mitigation against regulatory changes that could hurt the sector, such as the end of banking secrecy this year.

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. Infrastructure, institutions and industrial relations are of the highest standard. Luxembourg hosts a large financial sector, built upon a favourable tax regime and regulation. 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 were 20 times GDP in 2013, the largest ratio in Europe. However, banking is dominated by foreign-owned banks, which serve as foreign investment vehicles for their parent companies and have few ties to the local economy. Hence, the contingent liabilities for the sovereign are estimated to be low, while the sector’s good health makes such claims unlikely. EU regulatory harmonisation could hurt the banking sector, but thanks to the highly skilled financial workforce, the sophisticated and adaptive regulatory system Luxembourg’s attractiveness as a financial centre is likely to remain. Besides, diversification towards fund and wealth management and insurance services, which account for 80% of total assets in the financial sector, reduces vulnerability. Luxembourg has been a front runner in regional cooperation, 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. Foreign residents account for 45% of the population and, together with cross border workers, account for the lion share of the private sector workforce.

Economic indicators of Luxembourg
Economic indicators of LuxembourgSource: EIU
Alexandra Dumitru
RaboResearch RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 2326 6856

naar boven