WASHINGTON, DC: On May 27, 2022, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Luxembourg and endorsed the staff appraisal without a meeting on a lapse-of-time basis.11
Luxembourg recovered rapidly from the pandemic and its financial sector remained resilient. More recently, however, the war in Ukraine, rising inflationary pressures, and shifts in monetary policy globally have started to weigh on confidence and increased financial markets volatility. Growth is expected to slow to less than 2 percent this year, while inflation is likely to soar due to high energy and food prices and rising wages. The labor market remains tight and housing imbalances continue. To shield households’ purchasing power and support affected firms, the government announced a fiscal package of more than 2 percent of GDP in March.
The outlook is highly uncertain, and near-term risks are tilted to the downside. While direct exposures to Russia and Ukraine are limited, Luxembourg’s economic prospects depend on the reverberations of the war in Ukraine and monetary policy normalization throughout the globe. Domestically, persistent supply bottlenecks, including labor shortages, and a sharp drop in consumer confidence could weigh on prospects. Changes in international taxation, carbon taxation, and remote work could lower fiscal revenues in the medium term.
Executive Board Assessment
Given the ample fiscal space and prevalence of downside risks, maintaining an accommodative fiscal stance this year is broadly appropriate. The authorities’ measures to support households and affected firms, promote the green transition, and the tripartite decision to limit automatic wage indexation to once per year for 2022–2023 are welcome. Going forward, fiscal policy should remain nimble and strike the right balance between safeguarding the recovery and avoiding to fuel imbalances in a context of constrained supply. Additional support, if any, should be targeted and timebound and price distortions should be avoided. Looking beyond the war, the authorities should continue to gradually normalize fiscal policy and accelerate reforms to diversify revenues and increase equity through better targeting of tax expenditures and social transfers.
Given that direct exposures to Russia and Ukraine are limited, financial stability risks are broadly manageable. However, it is important to continue to closely monitor the indirect effects of the pandemic and the war and further enhance coordination with other jurisdictions to manage risks from cross-border exposures. At the same time, the structurally-weak profitability of the banking sector should be addressed by incentivizing diversification of activity and mutualization of compliance costs. Recent progress in strengthening the oversight of the investment fund sector, including stress testing methodologies, is welcome. The authorities should continue to engage actively in international fora on the design and calibration of a macroprudential toolkit for investment funds. Building on recent progress, Luxembourg should further strengthen the AML/CFT framework.
Addressing housing is key for social cohesion and the country’s attractiveness and requires decisive actions on both the demand and supply side. The increased focus on boosting supply of affordable and social housing, and plans to tax unused lands and vacant dwellings are welcome. In complement, it is essential to build higher, denser, and with reduced costs, and address supply bottlenecks. Measures to boost productivity in the construction sector and property taxation reforms to foster mobility are also needed. Given supply constraints, the authorities should refrain from demand supportive measures and better target housing assistance. The authorities should also continue to closely monitor real estate risks in the financial sector and consider macroprudential measures to curb those risks.
The authorities have ambitious targets to reduce greenhouse gas emissions and a comprehensive strategy to deal with climate change. The increase in carbon taxation should be gradual, well-timed, and clearly-communicated, supported by further improvements in public transportation and compensation for low-income households. The authorities should gradually remove implicit subsidies, raise taxes on non-road carbon emissions and car user fees, and further increase the progressivity of incentives to transition to greener economy. To enhance resilience to climate shocks, the authorities should boost infrastructure investment and further improve the financial sector’s preparedness to deal with climate risks.
The authorities’ active labor market policies to reduce skills mismatches and improve employability of jobseekers, including through upskilling and reskilling programs are welcome. They should extend those measures to existing workers and promote within and inter sectoral reallocation, and enhance vocational training and apprenticeship programs in close coordination with the private sector. Finally, incentives for early retirement should be reduced to improve the labor market participation of seniors.
It is expected that the next Article IV consultation with Luxembourg will be held on the standard 12-month cycle.
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