Public Information Notice No. 00/34

Public Information Notice: IMF Concludes Article IV Consultation with Luxembourg

May 16, 2000

On May 8, 2000, the Executive Board concluded the Article IV consultation with Luxembourg.¹

Background

Luxembourg's growth performance has remained impressive: during 1998-99, real GDP grew at an annual rate of some 5 percent, while employment increased by some 4½ percent. Buoyant private sector services, particularly financial services, remained the main engine of growth and sheltered activity from the adverse effects of the global financial crisis. Moreover, strong labor demand was accommodated by a growing number of cross-border workers.

Price and wage pressures have been subdued, and external competitiveness has been maintained. Reflecting moderate wage increases and, until recently, declining commodity prices, CPI inflation remained at about 1 percent during 1998-99.

Fiscal policy has continued to follow a prudent course, aiming at restraining central government spending growth below projected nominal GDP growth. This has allowed for persistent and sizeable general government surpluses (2.3 percent of GDP in 1999). As a result, general government gross debt was a mere 6 percent of GDP in 1999, while the public sector's net financial assets totaled some 30 percent of GDP. The 2000 budget targets a surplus of some 2.5 percent of GDP.

The financial sector continued its expansion at a healthy pace, despite the removal of some regulatory advantages, such as the introduction of minimum reserve requirements following the advent of Stage 3 of European Economic and Monetary Union (EMU). In addition, the establishment of the Central Bank of Luxembourg, and new regulatory frameworks for mortgage banking, funded pension schemes, and Internet banking and E-commerce are expected to add to the growth potential of the financial sector.

Luxembourg's impressive growth experience since the early 1980s reflects a virtuous circle between sound policies, cooperative social partnership arrangements and, most of all, external economies based on regional specialization. The latter have underpinned the rapid expansion of Luxembourg's specialized cluster of service industries, particularly financial services. Short- to medium-term prospects are bright, and the staff projects real GDP growth during 2000-2003 to average about 5 percent. The longer term outlook for continued fast-paced growth is, however, much less assured: (i) experience elsewhere shows that the growth dividends from regional specialization accrue at the cost of increased vulnerability to largely idiosyncratic and unpredictable shocks; (ii) ongoing European integration is likely to eat into Luxembourg's remaining locational advantages, in particular those based on regulatory structures and taxation; and (iii) environmental and social constraints could eventually act as brakes to continued fast-paced growth.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They warmly commended Luxembourg's macroeconomic and fiscal performance: real activity had continued to expand vigorously; unemployment was low and stable; there were no underlying price or wage pressures; and Luxembourg's fiscal performance was unmatched among European Union (EU) countries. Directors commented that Luxembourg's impressive performance reflected a virtuous growth circle driven by sound domestic policies, social consensus, and economic specialization in a regional environment of high labor mobility.

Looking ahead, Directors generally thought that the economic prospects for the next few years were bright. At the same time, they noted that the long-term prospects for strong output growth were less assured. In this context, Directors noted that the scope for effectively counteracting by fiscal demand management any shocks that might occur would be limited in view of the openness and specialization of Luxembourg's small economy.

Against this background, Directors recommended a proactive policy approach, focused on institutional reforms, to strengthen the robustness of Luxembourg's economy and public finances. In this connection, they welcomed the authorities' progress in diversifying the services sector of the economy. Directors noted that the favorable fiscal outlook for the next few years would provide a wide window of opportunity for implementing reforms. They recommended that the authorities resist pressures to further expand the large-scale social security system, and that they build the needed social consensus to underpin a proactive reform agenda.

Directors welcomed the Government's plans to implement a significant income tax reform by 2002--as a lower tax burden would boost competitiveness and a more neutral tax system would improve the overall functioning of the economy. They also urged the authorities to improve the management of the public sector's holdings of financial assets, and welcomed the authorities' plan to review present constraints on investment policies.

Directors observed that the exceptionally favorable economic performance in recent years appeared to have blunted the effects of Luxembourg's pervasive labor market rigidities. Nevertheless, they recommended that the authorities pursue greater labor market flexibility: such reforms could include promoting more flexible labor cost structures, especially at the lower end of the labor market, and tightening eligibility criteria for social benefits, particularly the early retirement scheme.

Directors noted that the Central Bank of Luxembourg, established in June 1998, had been quick and skillful in acquiring the necessary competencies to fulfill its tasks within the European System of Central Banks. They underscored that maintaining effective supervision and governance of the financial sector should remain a priority of public policy. Directors noted that the Financial Sector Surveillance Commission, which took over supervisory responsibilities from the central bank in 1998, appeared to be well equipped to meet the challenge of supervising Luxembourg's large, evolving, and mostly foreign-owned financial sector. Some Directors thought that full consolidation of financial sector supervision, by integrating insurance supervision, could be considered in due course. Directors welcomed the recent steps to strengthen anti-money laundering measures.

Directors welcomed the recent substantial increases in budgetary resources for addressing the remaining weaknesses in Luxembourg's economic statistics. In particular, they emphasized the need to close the remaining gaps in national accounts and balance of payments data. Directors also encouraged the authorities to take additional measures to allow Luxembourg's subscription to the Special Data Dissemination Standard.

Directors warmly welcomed Luxembourg's determination to live up to, and go well beyond, its commitments regarding official development assistance, noting in particular that, in 2000, Luxembourg was likely to join the exclusive circle of countries whose assistance met the United Nations' target.

It is expected that the next Article IV consultation with Luxembourg will be held on the 24-month cycle.