COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Luxembourg 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: Euro Group (euro area), Luxembourg, competitiveness, economic growth, financial services, macroeconomics, property market, real estate credit, stability pact, trade balance













EUR-Lex - 52014SC0084 - EN











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52014SC0084

COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Luxembourg 2014 /* SWD/2014/084 final */









Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances
The macroeconomic challenges of Luxembourg
have not been identified as imbalances in the sense of the MIP. They
stem from a growth model based on an efficient financial sector, which has
weathered the crisis well. Still, losses in the manufacturing
competitiveness, the evolution of the housing market and the high level of
indebtedness of the private sector deserve continued monitoring. 
More specifically,
the analysis of the current account surplus shows that it does not stem from an
anaemic domestic demand, but is rather the result of the particular growth
model of the country strongly based on financial services. Still, it masks a
large and steadily increasing deficit in merchandise trade, which broadly comes
from disappointing exports. Losses of export market shares are largely
associated with unit labour costs rising much faster than in trading partner
countries, driven to a certain extent by the wage setting mechanism. In such
regard, finding a structural solution to the temporary modulation of the
automatic wage indexation constitutes a challenge. Risks to the domestic
financial stability stemming from the presence of a large financial sector
exist, but they are relatively contained as the sector is diversified and
specialised at the same time. Furthermore, domestic banks post sound capital
and liquidity ratios. The high level of indebtedness of the private sector and
in particular of the non-financial corporations mainly reflects the presence of
a large number of multinational firms that use their branches or subsidiaries
in Luxembourg for intra-group financing operations. The dynamism of house
prices represents an increasing source of concern. Finally, the current
favourable position of public finances is highly dependent on the
sustainability of the growth model based on a buoyant financial sector and
presents a high sustainability risk in the long term. In this vein, the
recently implemented pension reform is insufficient to cope with the challenge.
However the structural balance is above the medium-term objective.
Excerpt of country-specific findings on Luxembourg, COM(2014) 150
final, 5.3.2014
Executive Summary and Conclusions 7
1.       Introduction  11
2.       Macroeconomic
Developments 13
3.       Imbalances
and Risks 17
3.1.     Analysis of
the existence of EXTERNAL imbalances 17
3.1.1.  The evolution
of the current account and its main components 17
3.1.2.  A general
overview of the evolution of exports 19
3.1.3.  The evolution
of market shares 20
3.1.4.  Geographical
and product specialisation of exports of goods 24
3.1.5.  Cost
competitiveness 25
3.1.6.  The wage
setting mechanism   27
3.1.7.  Non-cost
competitiveness 28
3.1.8.   Conclusion on external imbalances 29
3.2.     Assessment
of the existEnce of internal imbalanceS  29
3.2.1.  The financial
sector 29
3.2.2.  Impact of the
financial crisis on the financial sector 31
3.2.3.  The domestic
dimension of the financial sector 32
3.2.4.  The Outlook
for the financial sector 34
3.2.5.  Conclusion on
internal imbalances 34
3.3.     Indebtedness
of non-financial companies and households 34
3.3.1.  Households'
indebtedness 35
3.3.2.  House prices 37
3.3.3.  Indebtedness
of non-financial corporations 39
3.3.4.  A
cross-country perspective  39
3.4.     Sustainability
of public finances 41
4.       Specific
Topics 43
4.1.     the
financial sector: economic impact, investment funds and private banking  43
4.2.     The
financial sector at the heart of the economic model of Luxembourg  43
4.2.1.  The
contribution of the financial sector to the economy of Luxembourg  43
4.3.     Risks
inherent to the structure and specialisation of the financial sector in
Luxembourg  44
4.3.1.  Subsidiaries
have large exposures to the same entity and this concentrates the risks 44
4.3.2.  Stronger
requirements on liquidity will have to be observed with Basel III, reinforcing
the current supervisory framework  45
4.3.3.  Credit
institutions have large exposures to the investment funds 46
4.3.4.  Home-host
country cooperation and cross-border regulation and supervision are important
for the financial stability in Luxembourg  47
4.3.5.  Money market
funds are relevant to the financial stability and would benefit from a better
prudential framework  47
4.3.6.  The size of
the investment fund industry  47
4.4.     Challenges
ahead for the asset management sector 48
4.4.1.  International
presence of UCITS  48
4.4.2.  The emergence
of AIFs 48
4.5.     Challenges
ahead for the private banking business for international tax and regulatory
changes considerations 49
4.5.1.  Past
advantages no longer prevail 50
4.5.2.  Private
banking is being affected by international tax and regulatory changes 50
5.       Policy
Challenges 53
References 55
LIST OF Tables
2.1.     Key
economic, financial and social indicators - Luxembourg  16
3.1.     Main
trading parterns (in % of total) 24
3.2.     Luxembourg,
neighbouring countries and EA-17 : productivity, wages and labour costs (2000 –
2012) 26
3.3.     Households
net financial assets 36
LIST OF Graphs
2.1.     Overall and
youth unemployment rate  13
2.2.     Current
accound composition  14
2.3.     Total Banks
Assets 15
3.1.     GVA
breakdown by sector, annual changes 17
3.2.     Decomposition
of external position  17
3.3.     Domestic
demand developments, index 2000=100  18
3.4.     Trend in
Gross Fixed Capital Formation  18
3.5.     Decomposition
of NIIP  19
3.6.     NIIP by
sector 19
3.7.     Export
market share decomposition  20
3.8.     Trade of
goods as % of World Trade (BoP data) 20
3.9.     Share in
EA17 export in %, Goods 20
3.10.   Decomposition
of nominal export market growth  21
3.11.   Share in EA17
export in %, Services 21
3.12.   Sectoral
Export Market Shares (% of World Market share) 24
3.13.   Trade balance
contribution by Broad Category  24
3.14.   Real
effective exchange rate versus 35 industrialised countries 25
3.15.   ULC-deflated
real effective exchange rates 25
3.16.   Productivity
level (2012) - GDP per person employed - EA17=100  26
3.17.   Productivity
growth (2012) - GPD per person employed - EA17=100  26
3.18.   Evolution of
nominal ULCs 26
3.19.   Relative ULC
of the main trading partner vis-à-vis euro area   27
3.20.   Share of
High-Tech Products in exports (% of total) 28
3.21.   Breakdown of
high-tech export by product 28
3.22.   Participation
rate (%) 28
3.23.   Duration of
working life  29
3.24.   Fund Industry
Assets and Number of Funds 30
3.25.   Insurance
Premiums paid by type and origin  30
3.26.   Banks by
Country of Origin  30
3.27.   Financial
Sector as % of GDP  31
3.28.   Size of
Financial Sector (EUR billion) 31
3.29.   Share of
Domestic Banks (as % of Total Assets ) 31
3.30.   Bank Assets
Dynamics (EUR billion) 32
3.31.   Banking
sector :Total and Domestic Banks Assets (EUR billion) 33
3.32.   Private
Sector Credit in Luxembourg (EUR billion) 33
3.33.   Bank Product
Composition  33
3.34.   Net assets
decomposition of public and private debt (non-consolidated) 35
3.35.   Debt
decomposition, All sectors, consolidated   35
3.36.   Net
lending/borrowing by sector 35
3.37.   Leverage of
households 36
3.38.   Interest
burden on Households and NFC   36
3.39.   Households
balance sheet by instrument 37
3.40.   Households
balance sheet by instruments (EA) 37
3.41.   Breakdown of
households wealth  37
3.42.   Net financial
assets per capita (euros) 37
3.43.   House price
developments 38
3.44.   House price
cycle  38
3.45.   MFI loans to
households 38
3.46.   Price to rent
and price to income  38
3.47.   Ratio
Liabilities to Assets 40
3.48.   Ratio Debt to
Total liabilities 40
3.49.   Short-term
versus Long-term liabilities 40
4.1.     Financial
Sector Direct Contribtion to the Economy  43
4.2.     Financial
Subsectors (% od Sectoral Value Added, 2012) 43
4.3.     Financial
Sector as % of Total Gross Value Added, 2011  44
4.4.     Value Added
by Sector as %of Gross Value Added (2011) 44
4.5.     Fund
Industry Total Assets and Annual Change (EUR billion) 47
4.6.     Share of
Luxembourg in International Private Banking  49
4.7.     Geographic
Origin of Private Banking Clients in Luxembourg  50
LIST OF Boxes
3.1.     A more
detailed view of the services balance  23
4.1.     Luxembourg's
Deposit Guarantee Scheme had to intervene for the three failed Icelandic banks. 46
4.2.     Newly
created wealth by origin and destination. 52
LIST OF Maps
No table of contents
entries found.
In the Alert Mechanism Report (AMR)
published on 13 November 2013, the Commission found it useful to examine the
existence of imbalances in Luxembourg. To this end, this In-Depth Review (IDR)
provides an economic analysis of the Luxembourg economy in line with the scope
of the surveillance under the Macroeconomic Imbalance Procedure (MIP). The main
observations and findings from this analysis are:
·       Luxembourg has been pursuing a particular growth model, strongly
based on financial services. The strength of its
financial services sector has allowed the country to create and sustain a
generous welfare state without excessively high taxes and without jeopardizing
public finances with budgetary surpluses over the cycle keeping public debt at
a very low level. While the financial sector has been the main growth driver
for decades, the manufacturing industry has also been expanding steadily until
the beginning of the crisis. Nonetheless, the economy’s strong reliance on
financial services comes with an inherent risk of overexposure to a single
sector.
·       The large current account surplus has been accompanied by strong
domestic demand. It also masks a big and steadily increasing trade deficit,
which stems from disappointing exports of goods.
Luxembourg's current account surplus is exclusively the result of the
extraordinary performance of services, notably from the financial sector.
Exports of services have more than offset robust imports, boosted by a dynamic
domestic demand. Concerning goods, persistent losses in overall export market
shares are associated with comparatively high real wage increases, pointing to
the existence of labour market rigidities. Unit labour costs in Luxembourg have
been rising much faster than in trading partner countries, driven to a certain
extent by the wage setting mechanism. The authorities have sensibly reacted to
these developments by implementing a modulation of the automatic indexation of
wages for the period 2012-2014. However, this only addresses the concern in a
temporary way and more structural action will be necessary. Luxembourg's export
performance also highlights competitiveness problems in a larger sense, both in
terms of geographical orientation and product specialization, with intermediate
goods dominating other types of manufactured exports.
·       Although the challenges for the manufacturing sector cannot be
assessed as risk-free for the Luxembourgish economy, they do not seem to
constitute a major threat. A prolonged decline of
manufacturing could negatively impact on the authorities' current strategy of
reorienting the economy towards knowledge-intensive activities. Preserving a
solid manufacturing base would support R&D activities and the necessary
transition to the new sectors. Still, two additional factors need to be taken
into account when qualifying the impact of the trade deficit for goods on the
overall economy. First, non-financial services are dynamic enough and in such a
strong positive external position that they can fully compensate for the trade
of goods' deficit. Second, the weight of the manufacturing industry in the
economy as a whole has become relatively small.
·       Nevertheless, Luxembourg would benefit from a more diversified
economy. For this to happen, it is essential for
Luxembourg to speed up the transition towards a more knowledge-intensive
industrial sector by enabling the full exploitation of the strengths of its
research system. The relative importance of the non-financial services is often
neglected due to their small size compared to the financial ones. However, the
evolution of these service categories, which encompass areas such as transport,
logistics, IT or satellite technology, might be pointing to a certain success
of the diversification strategy of the country.
·       The financial sector in Luxembourg is at the same time diversified
and specialised and the inter-linkages with the domestic economy are limited. While Luxembourg is hosting the biggest banking sector of the euro
area relative to the size of its economy, the absolute size is not as big as in
other financial hubs such as London or Switzerland. While their results and
profitability have not returned to pre-crisis levels, banks have weathered the
crisis well. Overall, the vast size of the sector is the result of a successful
strategy and has become a strong feature of the country's economic structure.
Finally, a higher degree of sectoral concentration is not atypical of a small
economy, given the importance of economies of scale.
·       The presence of a large financial sector makes Luxembourg more
vulnerable to external shocks. The overall good
results and profitability of the financial sector are exposed to the volatility
of the financial markets, to pressures emanating from changes in the regulatory
environment and to increasing international competition. Two important pillars
of the financial sector have suffered during the crisis: financial
intermediation and to a lesser extent fund administration. In addition, the
regulatory changes yet to come in response to the crisis are expected to be a
game changer for private banking. The adoption of the automatic exchange of
information in 2015 will likely trigger some outflows in the private banking
area. But this activity has also the potential for further expansion and
Luxembourg is trying to create new products and attract new customers in order
to take advantage again of its "first mover" strategy by
substantially further developing the private banking business.
·       Luxembourg records the highest level of private sector indebtedness
in Europe. Concerning non-financial corporations
(NFCs), vulnerabilities at sub-sector level cannot be discarded, although
several aggregate indicators appear favourable. Specifically, an important
share of debt is constituted by intra-group loans with non-resident affiliates,
significant for multinationals in Luxembourg. Mortgage loans represent the bulk
of household indebtedness but come hand in hand with a high amount of financial
assets owned by the Luxembourgish households. The steady increase in house
prices and the high share of variable rate loans could pose some threat in the
case of an increase of interest rates, mostly to the low-income households.
Finally, the housing market might be put under strong pressure, should the
financial sector find it increasingly difficult to remain the country's main
growth driver as this may result in downward pressure on employment and gross
disposable income of households.
·       The current position of Luxembourg’s public finances is reassuring
although it is highly dependent on the sustainability of a growth model based
on a buoyant financial sector. In addition, the low debt level conceals a
substantial risk of sustainability in the long term. Against this background, Luxembourg recently implemented a first
pension reform. The latter is, however, clearly insufficient to cope with the
magnitude of the challenge as it misses key elements such as a link between the
statutory retirement age and life expectancy.  
The IDR also discusses the policy
challenges stemming from these developments and what could be avenues worth
exploring in terms of policy actions. It is worth underlining that relevant
policy responses were reflected and integrated in the country-specific
recommendations (CSRs) issued for Luxembourg in June 2013.  
·       Concerning the challenge of improving external competitiveness, the
country would benefit from an improvement in cost competitiveness and labour
costs. One key element is the role of the wage
formation mechanism and how it takes into account developments in labour
productivity and competitiveness.
·       Regarding the challenge linked to the large financial sector, the
country would also benefit from further intra sectoral diversification as this
would limit exposure to a small number of financial sector activities. Further developing private banking is welcome as this activity
provides a reliable and stable source of revenues. The existence of a body
promoting best practices and stimulating initiatives is a positive aspect that
Luxembourg could further encourage.
·       In view of the strong increase of credit to households, mainly
mortgages, and rapidly increasing house prices, economic and financial risks
would diminish by the strict observance of a prudent loan–to-value ratio by
financial institutions based in Luxembourg.
Considering the important number of subsidiaries and branches operating in
Luxembourg, the supervision of the regulatory capital and liquidity ratios that
credit institutions have to respect could be done at the entity and group
level, allowing thus for enhanced supervision and, if any, early identification
of weaknesses.
On 13 November 2013, the European
Commission presented its third Alert Mechanism Report (AMR), prepared in
accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention
and correction of macroeconomic imbalances. The AMR serves as an initial
screening device helping to identify Member States that warrant further
in-depth analysis to determine whether imbalances exist or risk emerging.
According to Article 5 of Regulation No 1176/2011, these country-specific
'in-depth reviews' (IDR) should examine the nature, origin and severity of
macroeconomic developments in the Member State concerned, which constitute, or
could lead to, imbalances. On the basis of this analysis, the Commission will
establish whether it considers that an imbalance exists and what type of
follow-up it will recommend to the Council.
This is the first IDR for Luxembourg.
Overall, in the AMR the Commission found it useful to examine whether
macroeconomic developments in Luxembourg constitute or could lead to
imbalances. To this end this IDR takes a broad view of the Luxembourgish
economy in line with the scope of the surveillance under the Macroeconomic
Imbalance Procedure (MIP).
Against this background, Section 2 of this
IDR looks more in detail into these developments covering both the external and
internal dimensions. Section 3 presents an analysis of whether these
developments represent an imbalance, as well as its associated risks. Section 4
focuses on certain aspects of the financial sector. Finally, Section 5
discusses policy challenges.
Recent macro-economic developments and
outlook
Potential growth has been revised down
compared to the period before the crisis, when it was computed at around 4.7%. According to the most recent estimate, potential growth would
situate below 2%, dragged down by the drop in the labour contribution, as well
as by the negative contribution of total factor productivity, probably
reflecting difficulties encountered by the country to further expand
productivity. GDP is projected to post a growth rate just above 2% in upcoming
years, meaning that the currently negative output gap, built up during the
crisis, would narrow.
From a sectoral perspective, most of the
recent increase in output is still due to the strong performance of the
financial sector. Its diversification and the
recent worldwide recovery of financial markets are likely factors behind its
resilience. Looking into the near future, and on the basis of its
diversification and the proactive behaviour of sectoral and national
authorities, the financial sector is expected to successfully adapt to the
challenges linked to the wave of new international regulations (Basel
III ([1])), though
its  potential could be dented. 
The labour market has continued to
create jobs throughout the crisis, a unique performance in the euro area. The strong performance of the labour market is confirmed by the
figures for total hours worked, which has the steepest increase across the euro
area since 2007. Employment and total hours worked increased during the crisis
years with the sole exception being 2009 when the increase in total employment
was not supported by a parallel increase in total hours worked due to labour
hoarding. The outlook for employment growth over the next years is positive,
though a slow-down in the pace of job creation is expected, in line with GDP
projections.
Unemployment increased quite
substantially over the recent years, partly on the back of a buoyant population
increase. Luxembourg remains nevertheless amongst
the countries with the lowest overall unemployment rate. Youth unemployment is
almost four times as high as overall unemployment (see Graph 2.1). While these ratios should also be
viewed in the light of an overall low labour force rate of this age cohort,
they hint to the existence of skills mismatches between demand and supply in
the labour market. The measures recently introduced or in the pipeline with a
view to increasing the participation of older workers in the labour market
(among the lowest in the EU), could also bring about an increase of the
unemployment rate if not counterbalanced by decisive active labour market
policies, aiming at increasing the employability of the people concerned.
Labour productivity remains high
compared to the euro area average, though its growth rate has slowed down and
even became negative in recent years. This can be
partly explained by labour hoarding practices, encouraged by national policies
supporting employment. A specific feature of the country is the sizeable
divergence of labour productivity across economic sectors, with the financial
sector posting by far the highest level. Productivity is expected to timidly
return to positive territory in upcoming years with the decoupling between
employment and productivity growth projected to come to a halt. 
The inflation differential with the EA
average is slowly narrowing. Apart from less
dynamic oil prices, the modulation of wage indexation adopted in 2012, limiting
annual wage increases at 2.5%, has played a role, albeit temporarily. This
process of convergence is set to continue, subject to the condition that a
similar agreement for wage modulation would be maintained by the new
government.
Risks of poverty in Luxembourg are among
the lowest in the EU. However, it is worth
underscoring that the number of people earning the minimum wage or the minimum
guaranteed revenue has risen to 3% of the total population as compared with 1%
a few years ago. Although poverty rates have increased in Luxembourg, the
change can still be considered small and income inequality remains low. Among
the factors that are likely to have contributed to this outcome is the
existence of a generous social benefits system.
External developments
The current account balance recorded on
average a surplus of around 10% of GDP during 2001-2007. It lost some ground
afterwards but has stabilised around 7% (see Graph 2.2).  This large and persistent current
account surplus is driven by financial services and harbours a persistent and
gradually increasing deficit in the trade balance for goods. The latter stems
more from anaemic export growth than from an increase in imports as is also
reflected in the important loss in export market share for goods in the
aftermath of the financial crisis. This trend is likely to reflect not simply
the increasing "tertiarisation" of the economy, but also a more
structural loss of cost competitiveness.  
The increase in nominal unit labour
costs (ULCs) has doubtlessly contributed to these developments. These ULCs rose by 53.2% in Luxembourg between 2000 and 2012, more
than twice as fast as the EA17 average of 23.3% and compared with 8.8% in
Germany over the same period. The stagnation of labour productivity and the
steady increase in nominal wages explain this notable development. 
The current account surplus is dragged
down by the widening deficit on the income balance.
This net outflow increased to 31% of GDP in 2012 (from 14.8% of GDP in 2002),
mirroring the increasing success of the financial services industry in placing
its products abroad and the large number of  foreign workers. The Net
International Investment Position remains highly positive. Fluctuating around
the level of 100% of GDP, it is the largest in the EU.
The financial sector and credit
The financial sector in Luxembourg
remains very large relative to the size of the economy. Yet, balance sheets have shrunk following the decrease in the
intermediation activity (see Graph 2.3) and profitability is lower that before
the crisis. This decline has been counterbalanced by the thriving of investment
funds. In spite of the slowdown, the soundness of both capital and liquidity ratios
are broadly reassuring. Potential risks for the sector stem from its capacity
to adapt to changes in regulation, as well as to increased competition from
emerging financial centres.
Conditions for lending to corporations
have remained tight since the onset of the financial crisis, even if less so
than in the euro area on average. The additional
conditions (such as higher collateral) that banks are demanding in order to
grant a loan have been tightened. Small enterprises are most affected, while
medium-sized and large corporations can finance their needs directly on the
bond market. Small enterprises in Luxembourg, especially innovative small and
medium-sized enterprises (SMEs), would benefit from tapping into alternative
sources of finance.
As regards lending to households for
housing, conditions have also tightened recently.
It is the result of both an increase in the financing costs faced by banks and
an increase in the risk perception associated with this kind of operation. Such
tightening is often reflected in a reduction in the loan to value ratio.
However, lending for house purchase remains dynamic and is on an upward trend
with respect to the years 2010-2011. 
Domestic debt is mainly a private debt concern

Although still at a very low level
compared to the EA average (92.7% of GDP), public debt increased from 6.7% in
2007 to 21.7% in 2012 and the trend is not expected to be reversed in the near
future, with public finances facing challenges such
as the change in the VAT on e-commerce. In light of the low level of public
debt and its relatively solid economic fundamentals, Luxembourg enjoys an
environment of very low interest rates, with the spread to German bonds being
close to zero. Together with Finland and Germany, Luxembourg is one of the
three countries in the euro area still enjoying an "AAA" rating.
Existing public guarantees amount to 8.8% of GDP, of which 4.9% are related to
the financial sector.
Although on a decreasing trend since
2009, the private sector debt is still at a level well above the euro area
average. Household debt is on a stable path but
indebtedness of non-financial corporations increased sharply in 2009 to reach
344% of GDP, on consolidated terms, and has failed to decrease to the
pre-crisis levels. However, it should be noted that this measure includes
intra-group debt with non-resident affiliates, which is significant for
multinationals in Luxembourg. Before 2007, the overall private sector debt
stood at similar levels when compared to the euro area (132% of GDP). 
In this context it can be noted that the
continuous increasing housing prices could represent a nascent threat to the
economy. Since 2000 house prices increased, in
nominal terms, by 173%, or 8.1% on average annually. According to the latest
figures prices rose by 6.5% on an annual basis in Q3-2013, the steepest
increase since the start of the financial crisis. Concerns also refer to the
fact that the majority of mortgages are subscribed at variable rates, putting debt
service constraints on households should interest rates normalize and align
again with historical average levels.
3.1.      Analysis
of the existence of EXTERNAL imbalances
Luxembourg is enjoying a strong current
account surplus, which is the result of a particular growth model based on
financial services that have been expanding over recent decades. The overwhelming importance of the financial sector in the overall
economy is clearly inferred from Graph 3.1 that shows the contribution of each
economic sector to the evolution of gross value added. The
large and persistent current account surplus is thus mainly driven by exports
of services, mostly financial services. 
This overall positive external position
hides a big and steadily increasing trade deficit, which broadly stems from
disappointing exports of goods. Persistent losses
in overall export market shares for goods are associated with eroding external
competitiveness as a result of comparatively high unit labour costs (ULCs),
pointing to the existence of labour market rigidities. While productivity
levels are very high, productivity growth has been very low and helps explain
why ULCs are growing faster in Luxembourg than in trading partner countries.
Despite these negative developments in
the trade of goods balance, the Net International Investment Position (NIIP) of
the country is strongly positive, fed by the
continuous net lending capacity of the country over time. 
3.1.1.   The evolution of the current
account and its main components
Both Luxembourg's external trade (goods
and services) and current account balances continuously recorded large
surpluses over the period 1990-2013. Until the
emergence of the crisis the current account surplus averaged around 10% of GDP
without a clear upward or downward trend. It fell to 6.3% of GDP on average in
2008 and 2009. Preliminary figures for 2013 point to a positive position just
below 7% (see Graph 3.2).
The balance of goods was always strongly
negative and broadly stable at a deficit of about 10% of GDP up to 2009, but
has deteriorated recently to attain -14.8% in 2012.
The surplus of trade in services steadily increased from about 15% of GDP in
the early 1990s to almost 50% in 2009 and reached 54.4% in 2012. This led to
rising surpluses in the overall balance of goods and services, which reached
about 40.1% of GDP in 2009, broadly remaining at that level thereafter.
However, these surpluses were increasingly offset by the growing deficit in the
income balance, which changed from a surplus of about 10% of GDP at the
beginning of the expansion phase decades ago to a deficit of more than 30% in
2009 and 31.9% in 2012. This change partly reflects the rising recourse to
cross-border workers, who now account for more than 40% of the total labour
force compared with about 10% in the early 1980s. 
In the future, and given the structure
of the pension system, the increasing flow of pensions to be paid to retired
cross-border workers will add to the negative net income from abroad.   Moreover, the deficit of the investment income balance ([2]) has become increasingly negative since it changed sign in 2002,
reflecting higher outflow of incomes (dividends, interests, etc.) paid to the
rest of the world and it has increased up to the point that the deficit is
almost equal to that of compensation of employees. Finally, the balance of
current transactions has exhibited a fairly stable and small deficit. It cannot
be excluded either that this negative position becomes larger in the future.
The large current account surplus was
accompanied by strong domestic demand. As Graph 3.3 shows, since 2000 Luxembourg has seen a
much more dynamic domestic demand than the euro area with an average of 2.6%
real growth per year compared with an average of 0.8% in the euro area. In
particular, high wage increases, partly linked to the automatic indexation
mechanism, (see section 3.1.6) have supported private consumption, well above
the average of the euro are. In parallel, investment from corporations and
households has also been dynamic, largely outpacing developments in the euro
area or in Germany (see Graph 3.4).  Therefore, the Luxembourgish current
account surplus cannot be attributed to an anaemic domestic demand, but rather
to its particular financial-services-based growth model.
In line with continuous and strong
current account surpluses, the NIIP of the country lays comfortably in positive
territory. It has been constantly improving,
representing in fact the highest positive position in the EU (see Graph 3.5). This strong overall NIIP encompasses,
on the one hand, a large and persistent borrowing position from the
non-financial private sector, which is more than offset by a sizeable surplus
of the financial sector, including the central bank. The external position of
the general government is in slight surplus, though this is very small compared
to the magnitudes of the private sector (see Graph 3.6).
3.1.2.   A general overview of the evolution of exports
Exports of goods and services as a
percentage of GDP rose from slightly more than 100% in 1990 to about 162% in
2009 and to 177.4% in 2012, by far the highest percentage in the whole EU. Exports of services represent the lion's share of Luxembourgish
exports: they rose from about half of both GDP and total exports in the early
1990s to more than 147.1% of GDP and about 83% of total exports in recent
years. 
Exports of goods have been dynamic for
many years. Between 1990 and 2008 export growth was
at 4.9% on average, below euro area export growth of 6.5% but superior to
average GDP growth rate of 4.3%. Consequently, the export-to-GDP ratio
increased from 35% in 1990 to 39% in 2008. However, since the onset of the
crisis, Luxembourgish exports of goods have lost ground. Between 2008 and 2012
their performance has been dismal, contracting on average by an annual rate of
2.8% compared to a still positive rate of 1.8% for the EU, resulting in an
important loss in market shares, both with respect to the world and to the euro
area. Specifically, the market share of goods in world trade shrunk from 0.13%
in 2007 to less that 0.09% in 2012. The share of exports of goods in total
Luxembourgish exports declined from about half of total exports to around 20%
since 1990. Obviously, the contrary can be stated for services, which now
represent 80% of the country's exports. However, and also taking into account
the rapid expansion of financial services, the importance of good exports
should not be understated: boosted partly by re-exports, they still amounted to
30.2% of GDP in 2012, which was just below the EU-27 average (33.8%) but is
more than in France (21.4%) or Italy (24.9%).
3.1.3.   The evolution of market shares
Luxembourg's market shares have been
continuously growing between 1998 and 2007 for both goods and services, on the back of strong contribution from the trade of services that
more than compensate losses in market share for goods (see Graph 3.7).  However, since 2008 the evolution of
total export market shares has entered red territory on the back of less
dynamic or even negative contribution from the trade of services and even
sharper losses in goods.
Luxembourgish exports of goods have been
growing slower than global trade and performed worse than the euro area average. As a large majority of euro area countries have experienced losses
in export market shares since 2003, netting out Luxembourg's losses from this
shift in global patterns could shed some light on the specific situation of the
country vis-à-vis its peers (see Graph 3.8). Changes in market shares at constant
prices confirm that Luxembourg lost ground. As a percentage of world trade they
contracted by 40% over the period 2002-2012, with the bulk (30%) of the
deterioration happening after the start of the financial crisis.
The country started losing market shares
in euro area exports already before the beginning of the crisis. The share of Luxembourg exports of goods in the euro area total
increased between 1996 and 2006. Since then, it has decreased in value terms up
to 2012, while in volume it started decreasing already in 2004 (see Graph 3.9). However, it was compensated in value
terms by a sharp rise in prices, which might perhaps also help explain why the
volume started to decline itself, given that the Luxembourgish industry is
mostly price-taker, thus subject to fierce competition.
 
The European Commission’s Surplus Report
(2012) looked into changes in export market shares by decomposing total nominal
export growth per country (net of the global import growth) into four
components (see Graph 3.10) ([3]).  According to this analysis, in pre-crisis years (2006-08),
Luxembourg did not benefit much from its initial export specialisation in terms
of products and destination compared to other ‘surplus countries’ ([4]).  However, competiveness changes in product specialization as well
as in geographical destination were much more outspoken drivers behind the drop
in nominal export growth between 2006 and 2008. The concentration on
slow-growing euro-area countries and on less dynamic category of products
played an additional negative role in the performance of export market share in
the after-crisis years (2008-2012).
Unsurprisingly, the loss in export
market shares has only been substantial for goods, with a remarkable
performance by services (see Graph 3.11). Indeed, the 5-year change in export
market shares for goods and services combined showed a drop of 18.3% in 2012([5]) with the loss in export market shares for goods at 33.5% and of
only 9.2% for services (using the 5-year change compared with 2007, when the
financial markets reached their top; the change would be more favourable when
compared with any other year). Service sector exports are mainly driven by the
financial sector and are much less price elastic ([6]). However, Box 3.1 provides some insights on the increasing
and not negligible importance of the non-financial related services.
3.1.4.   Geographical and product specialisation of exports of goods
Since the crisis erupted, the strong
orientation towards the slow growing EU market has contributed to Luxembourg's
loss in market shares. Also product specialisation has played a negative role,
though to a lesser extent. All in all, both
geographical specialisation and competitiveness developments have caused
Luxembourg to suffer a loss in market share. 
Exports of goods are for the most part
directed to the EU (86.7%), mainly to the neighbouring countries Germany
(27.9%), France (14.8%) and Belgium (12.8%) (see
Table 3.1). They are essentially composed
of metal-made manufactures (33.2%), machinery and equipment (18.1%) and
"other" or "diverse" products (25.3%). In contrast, exports
of services seem to be chiefly directed towards countries where the economic
weight of the financial sector is more important, namely Germany (18%), the UK
(13%), Switzerland (11%), as well as to Belgium, France and Italy (10% each).
Luxembourgish exports of goods consist
largely of intermediary products explaining why trade takes mostly place with
neighbouring (or other) euro area countries. Graph 3.12 highlights Luxembourg's product
specialisation in intermediate goods and its recent evolution. Metals, and
other intermediate materials such as rubber, plastic or glass, represent the
bulk of its exporting capacity. However, even for this category, the trade
balance has reverted into deficit as shown in Graph 3.13. This evolution goes hand in hand with
anecdotal evidence of several enterprises choosing to reduce production or to
relocate outside the country.
3.1.5.   Cost competitiveness
The deterioration of the trade balance
and the loss in export market shares can be attributed at least partially to
Luxembourg's declining cost competitiveness. As
Graph 3.14 and Graph 3.15 show, the price and cost
competitiveness of Luxembourg, as measured by the real effective exchange rate,
have deteriorated substantially since the beginning of the current decade.
Part of this deterioration is due to the
appreciation of the euro, but this factor has
influenced the cost-competitiveness of all countries of the euro area and
probably less that of Luxembourg, whose exports exhibit a greater concentration
on the euro area. Moreover, Graph 3.15, which compares ULC-deflated REERs for
some countries of the euro area, shows that since the beginning of the current
decade, the cost-competitiveness of Luxembourg has deteriorated more rapidly
than is the case for most neighbouring countries, especially in the last few
years. 
This faster rise in ULCs, in turn, is
due to less favourable developments both in wages and productivity. Table 3.2 decomposes developments in real GDP,
employment, productivity, wages and unit labour costs in Luxembourg and
neighbouring countries since 2000. The main conclusions that may be drawn from
these data are the following:
·       Since 2000, real GDP and employment grew substantially faster in
Luxembourg than in neighbouring countries and about three times faster than in
the euro area as a whole;
·       Employment growth outpaced output growth between 2000 and 2012, a
quite exceptional development inside the EU, explained in part by labour
hoarding. As a result, real GDP per person employed, though remaining the
highest in the EU, decreased over the period.
·       Wages rose during that time about one and a half time faster in
Luxembourg than on average in the EU-15 and more than twice as fast as in
Germany, the country where they increased the least.
·       As a result of both the stronger increase in wages and the decline
in labour productivity, unit labour costs rose one and a half times faster in
Luxembourg than on average in the EU-15 and more than four times faster than in
Germany, the best performer in the EU.
Productivity growth has been
disappointing. International comparison shows that
while in terms of productivity levels Luxembourg belongs to the top EU
countries (see Graph 3.16), in terms of productivity growth
Luxembourg is one of the worst performers (see Graph 3.17). This may be related to already very
high average productivity levels. Although subdued productivity growth
constitutes a general challenge for euro area countries, this does not take
away Luxembourg's competitiveness problems. Given that capital intensity of
production is already high, further increases are unlikely to yield the strong
productivity gains that warranted rapid wage increases in the past. 
This highlights the importance of both
wage development and total factor productivity, as the factors able to curb the
current competitiveness deteriorating trend.
Moreover, Luxembourg's particular growth model adds an additional challenge to
cost-competitiveness for the manufacturing industry, given that employment in
the financial sector includes a relevant number of high-skilled workers for
whom the remuneration is usually higher than the average. It cannot be
discarded then that, due to the small size of the country, they put upward
pressure on the general price level of the economy and, via the automatic
indexation of wages, push all salaries up.
3.1.6.   The wage setting mechanism
The steady increase in unit labour costs
is clearly hurting the country’s competitiveness,
and this independently from geographical orientation, product specialization or
productivity developments. 
The adoption at the beginning of 2012 of
the law on the temporary modulation of the automatic indexation mechanism until
2014 is intended to improve the cost
competitiveness of Luxembourg's economy by preventing an upward spiral of cost
and price increases. The automatic indexation of March 2012 was postponed to
October 2012. 
The automatic indexation steps make that
wages increase each time the cost of living increases by 2.5%. However, until
end-2014 at least 12 months should elapse between each indexation step. This means than between October 2012 and the end of 2014 there will
be at most three indexations. However, the composition of the reference basket
for calculation of the annual cost of living index still needs to be modified
(as announced) by taking out the more volatile components (alcohol, tobacco and
fuel). 
From 2015 onwards, the automatic
indexation system will be applied in the standard way again. In addition, as the counter clock for the next automatic
indexation will be set to zero before returning to the normal system, some of
the gains in cost competitiveness could become permanent. This implies that, in
case inflation surpasses 7.5% (i.e. three indexation steps) during the period
2012-2014, this will not be taken into account for the next automatic wage
indexation in 2015. 
Nevertheless, further action will be
necessary in order to better link wage and productivity developments so as to ensure long-term price competitiveness. The measures
described above are temporary and thus not designed to address cost
competitiveness in a structural way. While the government has not announced its
intention to reconsider the principle of wage indexation, the possibility of
differentiating wage increases in function of sectorial productivity
differences would be beneficial to the economy's overall functioning and its
export capacity. This is because the drop in productivity has been particularly
sizeable in the industrial sector and much larger than in the financial sector.
In the latter, the level of productivity is more than double that of the
non-financial sectors.
A crucial question relates to the impact
of the high productivity levels of the services sector on the economy as a
whole. It cannot be ruled out that the most
competitive parts of the services sector (in particular financial services) are
setting the tone for wage increases in the whole economy. This would
particularly hamper the manufacturing industry given its position as a
price-taker on international markets. In such an economic context, a system of
automatic indexation on the basis of inflation substantially increases the
difficulty for manufacturers to remain competitive.
3.1.7.   Non-cost competitiveness
There are a number of additional,
non-cost factors, such as technological competitiveness driven by innovation
and efficiency that need to be taken into account when analysing the reasons
behind the deterioration of the current account and the loss of market shares. The technological content of manufactured products reflects a
country's ability to translate innovation into exportable products with a
higher value added. The availability of sufficient appropriately skilled labour
is another important factor with regard to external performance. 
Exports contain less high-tech products. Looking into the developments of the share of high-tech exports, a
declining trend can be observed since 2006 (see Graph 3.20). At that time most of high-tech
exports referred to computers and office machines, falling in the category
electronics and telecommunication (see Graph 3.21).
Furthermore, certain sectors might be
suffering from structural mismatches between labour demand and supply, leading to a high number of vacancies. Also financial disincentives
to work stemming from the existing tax and benefit system, suboptimal
activation policies and the so far continuation of early retirement schemes
contribute to Luxembourg's labour market problems, reflected, amongst else, in
a weak participation rate (see Graph 3.22), in particular of older workers and in
an equally low duration of working life (see Graph 3.23).
 
Luxembourg is not on track to reach its
R&D intensity target for 2020 of 2.3-2.6% of GDP as its R&D intensity
is on a declining trend. This declining trend is
explained by the sharp decrease in business R&D intensity (from 1.53% of
GDP in 2000 to 0.98% in 2011). Public sector R&D intensity on the contrary
steadily increased from 0.12% in 2000 to 0.45% of GDP in 2011([7]), reflecting Luxembourg authorities’ willingness to build up public
research capacity. 
Luxembourg’s research and innovation
system remains weak, with its public parts not yet
able to play a decisive role in fostering innovation-driven economic activity,
although the efforts carried out and the policy of attracting foreign
researchers to work in Luxembourg have already allowed for a good level of
scientific performance to be reached ([8]). The performance of Luxembourg as regards the indicators on
cooperation between public research institutions and firms is well below the EU
average, reflecting the current disconnection between private sector R&D
and the public research system. The many actions taken to foster public-private
cooperation and more generally business R&D and innovation have so far had
limited impact([9]). Objectives
in terms of spin-off creation specified in the performance contracts of public
research organisations are not being met.
3.1.8.      Conclusion
on external imbalances
Luxembourg is exhibiting a strong
current account surplus, which stems exclusively from the services sector, both financial and non-financial. It does not seem to have its
origin in an insufficient domestic demand. On the contrary, Luxembourg's
internal demand has been one of the most dynamic ones in the euro area. The
current account surplus is thus largely the result of a particular growth model
strongly based on the financial sector.
The deficit in the trade balance is
persistent and on an increasing trend. In fact,
Luxembourg has been suffering losses in export market shares for goods over the
past decade. While the manufacturing sector would need an improvement of its
cost-competitiveness to secure its future, a general boost of the innovative
capacity of economic agents will increase the attractiveness of the country for
higher-technology products, less price dependent, therefore less subject to
fierce international competition.
3.2.      Assessment of the existEnce of
internal imbalanceS
3.2.1.   The financial sector
Luxembourg's financial sector has been
growing since the 1920s, when the Grand Duchy decided to embark upon
specialization in this area. Since then, it has
developed activities in three main areas: investment funds, insurance and
banking, and became a prominent international financial centre. The importance
of the financial sector for the domestic economy is such that it contributed to
around a quarter of the total gross value added and employed 44,000 persons
representing 12% of Luxembourg's labour force.
The non-banking financial sector,
especially the investment fund administration expanded rapidly since the
introduction of the UCITS directive in 1985 creating a European passport for
funds. Luxembourg is today an international hub for
the administration and distribution of funds and the second largest centre
judged by the assets under management, after the United States. This activity
now covers more than 3900 funds and over EUR 2.6 trillion of assets. After the
sharp decline in assets in 2008 (-24% over the year), the fund industry
regained steam and since then, strong positive inflows have prevailed except
for 2011 when the negative value effect due to poor market performance
outweighed the positive volume effect (Graph 3.24). 
The insurance sector has increased
steadily since 2006 mainly thanks to life-insurance activities and at the end
of 2012 it reached roughly 4 times GDP. Akin to
other financial sector activities, Luxembourg insurers sell mainly to
non-residents who prefer life-insurance products, a close substitute of bank
deposits. The reinsurance activity is less significant and represents about 30%
of overall insurance sector (Graph 3.26).
The banking sector development began in
the 1920's as a reaction to stricter regulation in foreign jurisdictions. It was supported by the flexible and sound regulatory framework
that Luxembourg chose to implement over time. There were 147 credit
institutions operating in Luxembourg at the end of 2013, the majority of which
are subsidiaries or branches of foreign banking groups. 38 branches, 104
subsidiaries and 5 domestic banks make up the financial sector of Luxembourg
and the home country of the parent group is generally European (Graph 3.26).
In November 2013, total assets in the
Luxembourg financial sector amounted to nearly EUR 736 billion or more than 17
times GDP. Judged by the size of the total assets
of banks as percentage of GDP, Luxembourg's financial sector is the largest in
the euro area and appears as an outlier (Graph 3.27). In absolute terms however, the
aggregate size of the balance sheets of banks operating in Luxembourg is
inferior to banks in Belgium or France (Graph 3.28). 
A significant share of the large
financial sector of Luxembourg is internationally-oriented and with a high
level of foreign ownership. More than 87% of the
assets in Luxembourg are in subsidiaries or branches that belong to
international banking groups. In Belgium, the same share is nearly half of the
total, while in France or Germany foreign ownership is below 5% of the total
assets of the financial sector (Graph 3.29). From this perspective, Luxembourg is
exposed to exogenous developments that can threaten the financial stability but
that are outside the control of local authorities. The activities of the
foreign banks are mainly cross-border interbank operations and require strict
supervision mechanisms.
The Commission de Surveillance du
Secteur Financier and the Central Bank of Luxembourg are in charge of the
micro- and macro-prudential supervision of the banking sector, the health of which is of course of utmost importance for the
sustainability of both economic growth and public finances. The supervising
capacity and the financial sector have evolved in parallel and the supervising
authorities were wisely given the necessary means to ensure effective
supervision.
3.2.2.   Impact of the financial crisis
on the financial sector
The performance of the financial sector
has been affected by the crisis but the effects on the economy as a whole have
been contained. The financial sector which is
internationally oriented contracted sharply. The impact of the crisis has been
mainly seen on the banks' balance sheets through a reduction in international
financial operations and on the investment fund industry that suffered from the
lower value of the assets and outflows.
As the effects of the financial crisis
became more visible, distinct parts of the financial system became affected by
the turmoil, including Luxembourg's financial
centre due to its structure and specialisation. The activity of credit
institutions slowed down and the aggregate balance sheet contracted by 27%
between 2008 and 2013, mainly as a result of the 23% reduction in interbank
lending between cross-border institutions. 
The crisis also revealed a certain
vulnerability of Luxembourg's banks in times of scarce liquidity. A large part of assets and liabilities on the banks' balance sheet
is represented by interbank operations and many cash–rich subsidiaries act as a
conduit for lending to their parent groups. At the height of the crisis when
short-term funding markets dried up, many foreign subsidiaries pledged
collateral to the ECB to benefit from the liquidity facilities for their parent
banks. Today, the situation is normalized and only around 15 banks of the 147
use the ECB deposit and borrowing facilities. 
Luxembourg had to contribute to several
bail-out operations. The effectiveness of the
cross-border cooperation and of the existing deposit guarantee scheme allowed
for uneventful outcomes. Although the foreign banking groups' subsidiaries were
in good health, due to their importance for the domestic market, Luxembourg had
to participate to the cross-border capital injections in the groups Dexia (EUR
376 million), Fortis (EUR 2.5 billion) and ING jointly with Belgium, France and
the Netherlands. The cross-border co-operation and a specific winding-up
procedure for banks have allowed effective crisis resolution in the banking
sector. These difficulties appear to have been successfully resolved without a
significant impact on credit supply as there is little evidence of credit
tightening in the domestic economy.
The Luxembourg Deposit Guarantee Scheme
covers only deposits up to EUR 100,000 in subsidiaries and banks, but not in
foreign branches. The total amount of deposits
covered by the scheme represents roughly two thirds of GDP. The existing scheme
had to intervene successfully on a limited number of cases, the last one being
the collapse of the three Icelandic subsidiaries located in Luxembourg. On this
occasion, Luxembourg had to disburse about EUR 310 million to compensate the
clients who had deposits in the three subsidiaries and all cases were handled
smoothly.
3.2.3.   The domestic dimension of the
financial sector
The banking sector in Luxembourg is
diversified and specialized at the same time.
Luxembourg is mainly active in financial intermediation and fund administration
but is also present to a lesser extent in insurance, private banking and
Islamic finance. The domestic banks' assets as per cent of GDP, an indicator of
potential contingent liabilities for the sovereign in case domestic entities
need to be rescued, are on the low side compared to European peers (Graph 3.29). The assets of the 5 domestic banks
amount to EUR 90.5 billion as of 2012 and represent 210% of GDP, below the euro
area average of 283.9% of GDP (Graph3.31). These banks are mainly retail
oriented, well-capitalised and profitable. The bulk of the domestic market is
catered for by 5 banks, 3 from Luxembourg and 2 foreign ones. From all the
banks operating in Luxembourg, only 6 are systemically significant and will be
subject to ECB's Asset Quality Review in 2014.
The inter-linkages of the financial
sector with the domestic economy are limited. While
Luxembourg is hosting the biggest banking sector of the euro area as a share of
GDP, most banks play a marginal role in the financing of the domestic economy.
Furthermore, the effect of the crisis on the credit to the private sector has
been contained. While the access to private sector credit in the euro area was
hindered in the aftermath of the financial crisis, this tightening was not felt
in Luxembourg as credit standards have tightened only marginally. Demand and
supply weighted on the growth of credit to non-financial corporations. Both
weak demand for new loans and the slowdown in economic activity led to a sharp
decline in credit growth to non-financial corporations compared to pre-crisis
levels (Graph 3.32). Credit to households continued its
upward trend mainly due to the expansion of credit for house acquisition.
While the results and profitability of
the banks have not returned to pre-crisis levels, they have weathered the
crisis well. The low rates environment squeezed the
interest rate margin, upon which banks rely for half of their results (Graph3.33). The performance of the portfolio of
securities and the amount of collected commissions correlated with the
financial market movements are thus more volatile. At end of 2012, domestic
banks posted a ROE of 3.95% and a ROA of 0.37% while their cost to income ratio
of 48.84% is among the lowest in the EA.
Despite challenging business conditions,
banks in Luxembourg post sound solvency and liquidity indicators in aggregate
terms although at the individual level the results can be more dispersed. Despite rapid credit growth before and after the crisis, the NPL
ratio of 0.5% is still one of the lowest in the euro zone.
3.2.4.   The Outlook for the financial
sector
The economic developments in Luxembourg
are tightly linked to the evolution of the demand for the financial services
offered by the financial institutions operating locally. Output level and growth rates have been historically dependent on
the performance and dynamism of the financial sector and Luxembourg has largely
benefited from the expansion of the financial services industry. For a long
period, Luxembourg has enjoyed sustained growth, fuelled by the emergence and
dynamism of its financial sector. The increase in living standards and the path
of public finances were particularly underpinned by the development of the
financial industry. But even if Luxembourg weathered the crisis well, it
remains vulnerable to external shocks and needs to increase its awareness with
regards to longer term challenges linked to both its growth model and the
sustainability of its public finances. 
In the years that followed the financial
crisis, the growth rate of the economy slowed and the prospects for the longer
term have become more uncertain. The future
prospects of the financial sector, which are central to the outlook for the
economy of Luxembourg, are affected by changes in the financial industry and in
the regulatory environment. On the one hand, a fall of revenues from banks
would put public finances under strain and might be permanent. 
The international, regional and local
regulation changes and the competition among financial centres will impact
further on the potential for growth which will likely settle at a lower level
compared to the pre-crisis one. The volume of the
activity and the size of Luxembourg banks' balance sheets look set to stay
lower than before the crisis. On the other hand, it cannot be discarded that
other areas will manage to compensate for the loss in bank revenues due to the
decrease in financial intermediation: the assets under management in the
investment fund industry increased strongly after 2008 and private banking has
a high growth potential.
Concerning private banking, the
regulation changes yet to come are expected to be a game changer. Private bankers in Luxembourg argue that the adoption of the
automatic exchange of information in 2015 will trigger outflows in the private
banking area. However, based on the new global wealth creation forecasts this
activity also has the potential to grow, unlike other areas of finance that
have come to a standstill or even regressed. Even if Luxembourg has
traditionally targeted mature markets such as Western Europe, it has built
expertise in related activities like wealth management, investment funds and
investment advice. With its know-how and skilled workforce, Luxembourg is
striving to take advantage again of its "first mover" strategy and
develop the private banking business in promising areas like the Family Offices
that target very wealthy individuals.
3.2.5.   Conclusion on internal
imbalances
Luxembourg has developed an economic
model that gravitates around the financial sector, which is adapting to a
changing world. The reliance on its results became
even more pronounced during the volatile years that have followed the onset of the
financial crisis as the very generous public finances and welfare system rely
on the revenues generated by the financial sector. While in good times this
would be no issue, the crisis revealed cracks in the mirror. The dynamism of
the last decades in the financial sector revenues could not to return in the
near future, at least not in the same areas of business. The new regulatory
environment and increased competition between financial centres will represent
a challenge, but also an opportunity, for further expansion.
3.3.      Indebtedness of non-financial
companies and households
Concerns about the sustainability of
debt have been at the origin of the crisis in many countries. 
Consolidated debt of the Luxembourg
non-financial private sector stood at 317% of GDP in 2012, much above the indicative threshold in the macroeconomic scoreboard
of 133% of GDP([10]). A breakdown of the private debt between households and
non-financial corporations (NFCs) shows that households' debt, mainly related
to house acquisition, is in line with the euro area average, although growing
rapidly. Conversely, borrowing of the NFCs is much higher than in the other
euro area countries (see Graph 3.35). Household debt represents 56.8% of
GDP, compared to 63.9% in the euro area. NFCs account for the remaining 260.6%
of GDP, compared to 81.4% in 2012 in the euro area. 
3.3.1.   Households' indebtedness
Household indebtedness has been
increasing steadily since 2001. As can be observed
in graph 3.37, the increase in the debt/asset ratio
is less pronounced than that of GDP, given that the accumulation of debt has
been accompanied by a concomitant increase of assets. More than 80% of
household indebtedness is mortgage related, and the rising indebtedness path can
be explained by increasing house prices (see section 3.3.2). However, the low
interest rates environment and the more favourable tax treatment of mortgage
loans since 2005 can help explain the capacity of households to absorb a higher
debt burden (see Graph 3.38). 
Net financial assets of Luxembourgish
households are lower than in the euro area. They
amount to about 73.9% of GDP in 2012, well below the average of the euro area
at 136.1%. However the gap narrows in case the net financial assets are
compared to the national income: the figures for Luxembourg households shoot up
to 108.5%, while for the euro area they remain almost unchanged (see Table 3.3), even if they remain below. Looking at
the evolution in recent years, net financial assets have not been impacted by
the fall in equity prices in 2008 while the contrary can be observed for the
euro area. This could be partly due to the more conservative behaviour of the
Luxembourg households that invested a larger share of their net financial
wealth in risk-averse instruments (see Graph 3.39 and Graph 3.40). In 2008 currency and deposits
represented a 56.1% share of net financial assets compared to 36.1% on average
for the euro area. Net financial wealth jumped in nominal terms from EUR 40.9
bn. at the end of 2006 to EUR 56.1 bn. at the end of 2013. The increase was
just sufficient to compensate for inflation, implying therefore a broad
stagnation in real terms.  
The evidence coming out from these data
that Luxembourg households are worse off than their corresponding euro area
peers needs to be qualified. First, it is likely
that the ratio is biased by the evidence that GDP per inhabitant (and even GNI)
is much higher than in the euro area. Second, a breakdown of households' wealth
shows that financial assets represent for Luxembourg households a smaller
fraction of the overall wealth than for the corresponding households in the
euro area (see Graph 3.41). Actually, according to the figures
provided by the BCL the Luxembourg households' net financial assets per capita
would be the highest in the euro area, just above the Belgian (see Graph 3.42). Real estate assets have increased
over the years in line with developments in housing prices and represented
around 81%  of the overall wealth in 2012, compared to 68.0% in the euro area([11]).
 
3.3.2.   House prices
House prices in Luxembourg have
increased almost without interruption since 2000 including during the crisis year. After a peak in the third quarter of 2007, prices have recorded a
small drop in the two consecutive quarters, having returned to grow already in
the second quarter of 2008 (see Graph 3.43). Graph 3.44([12]) confirms the dynamism of the real estate market in Luxembourg.
Real prices at end of 2012 were above the level recorded during the previous
peak.
Several additional factors might be
pointing to overvaluation pressures. Graph 3.44
presents the evolution of the price-to-rent and the price-to-income ratios.
Both are following a firm upward trend since year 2000, with just a minor
correction at the beginning of the crisis. In the particular case of the
price-to-income ratio, it situates since 2011 above its long-term average,
meaning that Luxembourgish households have to face an increasingly higher
effort to pay back their mortgages. In other words, their affordability or
capacity for real estate acquisition is declining. If current levels do not
represent an excessive burden for households, as witnessed by the very low
level of non-performing loans, the constantly upward trend represents a source
of concern.
3.3.3.   Indebtedness of non-financial
corporations
The analysis of NFCs debt is important for
a number of reasons. Firstly, high levels of indebtedness can make NFCs more
vulnerable to interest rate increases, shocks or unexpected economic events.
Secondly, if NFCs debt is impaired, this can negatively impact the balance
sheets of those that lent to those companies. Finally, when NFCs with a high
debt burden need to deleverage, it can act as a drag on economic growth. 
In order to cast some light on the
potential vulnerabilities represented by a high level on indebtedness, our
analysis will scrutinize the issue from different angles. An international
comparison will provide information on where Luxembourg stands compared to
other countries.
3.3.4.   A cross-country perspective
Indebtedness of NFCs has increased
substantially in most of the EU countries,
including Luxembourg, in the years preceding the financial crisis. The leverage
ratio of NFCs, measured as percent of GDP, rapidly increased from 90.3% in 2006
to 349.7% of GDP in 2008, since then a deleveraging process has started with
the ratio decreasing to 260.6% of GDP in 2012. Luxembourg non-financial-sector
debt to GDP ratio is however still more than double the threshold in the
scoreboard at 133% of GDP. While a certain level of debt is considered a
desirable feature, excessively high private sector indebtedness can imply
significant risks for growth and financial stability and increase overall the
vulnerability of a country ([13]). 
The definition of debt to GDP ratio
adopted by the MIP uses a consolidate measure of sectoral debt. This measure includes all liabilities in the form of securities
other than shares, plus loan liabilities, net of intra-company loans. In some
countries, intra-company loans are a significant element of financing for large
NFCs. Loans between companies may represent a large part of the NFC debt. Group
loans are often motivated by tax optimisation strategies. This reflects, in
part, diverging tax regimes, which, by leading to a high inter-company loans
level, will present a distorted image of NFC debt. By comparing
non-consolidated and consolidated measures of debt to GDP, it is possible to
obtain an estimate of this effect, that also  partly reflect the potential
increasing importance of intra-company loans during the crisis to compensate
for constraints in access to traditional financing from the banking sector.
However, Luxembourgish NFCs had the
highest level of debt to GDP, both in non-consolidated and consolidated terms. Other countries such as Belgium and Malta also have a significant
number of multinational companies with dynamic intra-group lending flows. But
the consolidated data do not exclude inter-company debt with non-resident
affiliates, which play a particularly significant role for multinationals in
Luxembourg. 
While the debt-to-GDP ratio is
frequently applied for international comparison, aggregated measures of
affordability such as GDP does not provide the most accurate picture on the
ability of economic agents to service their debt. A
significant amount of research, notably by the ECB([14]) and the European Commission ([15])has been performed using a wider set of indicators, amongst else
the ratio of NFC debt to financial assets. An analysis of debt relative to
financial assets provides a more complete understanding of the NCF balance
sheet and its capacity to service debt. The ratio of NFC debt ([16]) to total financial assets at the end of 2012 is presented in Graph
3.47. Under this measure, Luxembourg NFCs
had a ratio of 34.6%, implying that debt levels are less than one third of the
sector's stock of financial assets. The average debt-to-total financial assets
ratio for the 17 countries in the euro zone was 59%. However, this indicator
should not be taken directly, given that valuation effects of financial assets
should also be taken into account as they are much more volatile than debt
instruments, especially in a downturn when indebtedness adjustments tend to
last longer on average (EC, 2013). 
A single measure may be misleading and
it is then warranted to complete the picture using more ratios linked to the
balance sheets. Indeed, NFCs financing and
investment decisions impact both sides of the balance sheet. NFCs reacted to
the financial crisis by reducing their debt levels or following the ongoing
deleveraging in the banking sector that is likely to make bank financing
durably more expensive, changing the type of financing. This results in an
increased use of alternative sources of finance such as equity, unquoted equity
and other accounts payable. The ratio of debt to total liabilities provides a
measure on the reliance by the enterprise on alternative sources of funding
than debt. A lower ratio of NFC debt to total liabilities indicates a reduced
reliance by NFCs on funding from loans and debt securities, compared with funding
from equity and other accounts payable. Graph 3.48 shows that NFCs in Luxembourg were the
second lowest with a ratio of 27.5%. 
Another different approach to assessing
NFC debt is to compare the maturity profile of the types of debt by sector. If companies rely on short-term loans or securities, this may
result in higher liquidity risks and greater sensitivity to increases in
interest rates (ECB, 2012). Generally, a smaller share of short-term debt
reduces corporate vulnerabilities as debt repayments and a prolongation of debt
occur less frequently. NFCs in Luxembourg have the lowest ratio at 4.4% (see
Graph 3.49). 
Overall, while NFCs debt levels in
Luxembourg can appear striking compared with other EU countries in debt-to-GDP
ratio terms, the use of a wider set of indicators provides a broadly reassuring
picture of the NFCs indebtedness, although risks cannot be fully ruled out
given their extremely high debt levels. 
3.4.      Sustainability of public
finances
Luxembourg's public finances are not
isolated from the particular growth model of the country. The strength of financial services has allowed the country to create
and sustain a generous welfare state without excessively high taxes.
Simultaneously the country managed to keep public finances in a sound position
with the fiscal balance generally in surplus and public debt at a very low
level.
Luxembourg does not appear to face a
risk of fiscal stress in the short term, but it is at high risk in the long
term. The latter refers mainly to the budgetary
impact of ageing costs. Concerning the short run, government debt (21.7% of GDP
in 2012 and expected to rise to around 28% in 2015) is well below the 60% of
GDP threshold. The focus should, therefore, be on curbing age-related
expenditure in general and pension expenditure in particular.
On 5 December 2012, the Luxembourgish
Parliament finally adopted a pension reform
proposal submitted in January 2012. The reform entered into force on 1 January
2013. However, the new calculation method will be implemented only gradually
over the next 40 years. According to data from the 2012 Ageing Report, which
had already anticipated most of the aspects of the forthcoming reform,
Luxembourg would still need to implement long-term sustainability-enhancing
policies equivalent to a permanent improvement of 8.6 pps. of GDP in the
primary balance to close the fiscal gap. This is an effort significantly above
the average improvement required for the EU as a whole (3.0 pss.). Thanks to
its lower initial debt, Luxembourg has some time to adjust policies to account
for the impact of age-related expenditure. Moreover, the country has
accumulated public reserves of around 27% of GDP, but this only reduces risks
for sustainability in the short to medium term.
The recently legislated pension reform
does not include a reference to a link between the statutory retirement age and
life expectancy. Moreover, given the projected high
increase in expenditure by 2060, it is likely that additional reform steps will
be necessary to further boost sustainability in the future, considering that
the impact of the 2012 pension reform is likely to be very small compared with
the funding gap as projected in the 2012 Ageing Report.  
Even after the reform, in order to
guarantee the financial viability of the pension system, a substantial increase
in the contribution rate after 2020 would be necessary, in addition to the built-in moderation of the adaptation of
pensions to the standard of living.  This would entail a significant increase
in the burden on labour supported by the future active population and
consequently a loss of cost competitiveness. Given the currently high
replacement rate (87% compared to between 42% and 49% in the neighbouring
countries) and even for high wage earners, several measures could have been
taken so as to ensure that future generations do not have to bear an excessive
burden or simply a substantial reduction in benefits.
Rising spending on long-term care is
projected to contribute by 2.1 pps. to the aforementioned sustainability gap. The 2012 Ageing Report shows a high expected increase in both the
number of elderly and the number of self-assessed dependents in Luxembourg.
Therefore, a continued focus on cost-saving prevention and rehabilitation
measures, and on improved conditions for independent living, combined with
increased efficiency and effectiveness of long-term care services would prove
useful as a means to contain the expected need for long-term care services.  In
addition, Luxembourg does not appear to apply a means-tested eligibility
criterion for either in-kind or cash long-term care benefits. Finally, the
objectivity of the existing eligibility criterion on the basis of dependency
could be strengthened, as it is assessed by individual medical doctors, nurses
or care workers. 
Fiscal governance in Luxembourg is
essentially not rules-based. Neither the debt nor
the expenditure agreements is established in law and there is no identified
monitoring body and no predefined action in case of non-compliance.  Luxembourg
does not have a medium-term budgetary framework underpinning multi-annual
fiscal planning by providing guidelines for smooth revenue and expenditure
evolution, thereby contributing to budgetary discipline in the medium and long
term. A multi-annual programme exists for investment expenditure but has only
an indicative character.
Government revenues in Luxembourg are
relatively low and particularly volatile, notably
because of the country’s openness and because of the economy’s strong
specialisation in the financial sector. With tax revenues amounting to 37.9% of
GDP in 2012, Luxembourg stands out with a tax level both below the EU-27
average (39.9 %) and below that of its three neighbouring countries −
Belgium, France and Germany. The structure of the Luxembourg tax system, in
terms of the proportion of revenues collected by the different taxes, has
remained relatively stable since 2000. Less than one third of tax revenue is
raised from consumption taxes, which places Luxembourg among Member States with
the lowest share in the EU-27, partially owing to moderate nominal VAT rates
and reduced rates. Labour taxation is among the lowest in the EU, with the tax
wedge on labour for an average single earner without children amounting to
36.0% in 2011, substantially lower than the EU-27 average (41.1%). Revenues
from capital taxes as a percentage of total taxes (28.1%) are among the highest
in the EU (20.5%). The revenues from corporate income taxation are among the
highest in the EU, which is partly due to the importance of the financial
sector in the economy. Taxes are collected in a relatively efficient way, with
Luxembourg’s administrative costs for tax collection standing at the EU-27
average. 
Overall, while in the short to medium
term Luxembourg's public finances appear to have absorbed the shock induced by
the burst of the financial crisis, sizeable challenges remain in the long-run. 
4.1.      the
financial sector: economic impact, investment funds
and private banking
Although the financial sector faces major
challenges, this section will discuss how the sector responded to challenges
during the financial crisis. This relates to the means the sector has given
itself to build a solid reputation, as well as to the recent regulatory
initiatives at the local, regional and global level. 
We will begin by establishing the
contribution of the financial sector to the Luxembourgish economy. Then we will
make an overview of the most significant features that characterised the local
financial market at the height of the financial crisis. Finally, we will look
at two areas for further development chosen by Luxembourg: asset management and
private banking. 
4.2.      The financial sector at the heart of the economic model of
Luxembourg
Even if the sector weathered the crisis
well, the intense specialisation in the financial area has drawn attention to
Luxembourg since the onset of the crisis. This because its economic performance
is dependent on international developments, is subject to the volatility of
financial markets and may be dented by increased competition with other financial
centres. The deleveraging and the market effect have been the main drivers of
the shrinking of the banks' balance sheets but Luxembourg has also benefited
from the flight-to-quality movement in the financial markets. Thanks to its
favourable institutional framework, Luxembourg has continued to attract capital
into the investment fund industry. The absolute size of the domestic banking
sector is on the low side compared to the EU average and the credit
institutions are profitable and well capitalized by international standards.  
4.2.1.   The contribution of the financial sector to the economy of
Luxembourg
The social development of Luxembourg
went hand in hand with the progress in the financial services industry and today it has the highest per capita income in the OECD. The
direct economic contribution of financial services is significant in many
aspects (Graph 4.1): contribution to value added (25% of
GDP), to the fiscal revenues (25% of the total, according to ABBL) and to employment
(12%). The financial and insurance activities continue to play a central role
in the economy of Luxembourg despite a declining economic impact, consequence
of the financial and economic crisis. The development of the fund industry led
to the development of activities auxiliary to the financial industry and today
their share in total value added is significantly above the euro area average
(Graph 4.2). 
Luxembourg stands out as highly
dependent on its financial sector (Graph 4.3 and 4.4). In absolute terms, the financial
sector contributed to value added up to EUR 149 billion in the UK, EUR 100
billion in Germany or EUR 48 billion in Switzerland, while its contribution of
EUR 9 billion in Luxembourg is not that impressive. The financial sector
generating a quarter of total value added implies that shrinking the sector
represents a big challenge for a small economy.
4.3.      Risks inherent to the structure and specialisation of the
financial sector in Luxembourg
Luxembourg hosts numerous foreign credit
institutions specialised in financial intermedia­tion and asset management. A financial intermediary is a financial institution connecting
surplus and deficit agents. Luxembourg subsidiaries are generally cash rich
thanks to the deposits they collect and are liquidity providers to their parent
group through intra-group lending. The banking sector is also characterised by
the strong links with the fund industry, through their role as funds’
depositaries. Despite the specialisation in financial activities, the share of
the domestic market is small as only five banks are from Luxembourg and their
main activity is directed to the local retail market. 
4.3.1.   Subsidiaries have large exposures to the same entity and
this concentrates the risks
By the nature of the interbank
operations, subsidiaries and branches in Luxembourg are exposed to the
intragroup risks and subject to the group's strategy. For example, if a Dutch banking group has to provide a loan in
Germany, the loan can be channelled through the Luxembourg subsidiary of the
group. The subsidiary established in Luxembourg would either borrow the amount
from its Dutch parent bank, thus increasing its liabilities, or use its excess
liquidity to lend it to the German operations of the bank, increasing thus its
assets.
Of the total lending operations realised
by banks in Luxembourg, financial intermediation represents 52%, a high figure
compared with the euro area average of 28%. While
prudential rules call for an upper limit on the exposure of a single entity, in
Luxembourg the average exposure to the parent group fluctuated around the 50%
(of total assets) mark, but for some financial institutions this figure can be
much higher. A cap on exposure is supposed to limit the risks incurred by the
lender in case the borrower defaults. The Luxembourg state of play and the
current level of exposure to a single entity were made possible by the
exclusion of short-term intra-group and interbank exposures from this rule, as
is the case in many other countries.
4.3.2.   Stronger requirements on liquidity will have to be observed
with Basel III, reinforcing the current supervisory framework 
By the nature of their activities, banks
operating in Luxembourg are exposed to the risk that liquidity might not be
available on the financial markets. According to
the local practices, Luxembourgish banks have to post on a permanent base a
liquidity ratio of minimum 30%. According to the Central Bank of Luxembourg,
the average liquidity ratio was unchanged over 2012 at 69%. This ratio is
however static and it offers very limited information on future developments so
that, to fill the gap, the Central Bank performs stress tests in order to
assess banks' resilience and provides a daily reporting on the short term
liquidity status of the banks.
The implementation of Basel III
regulation will ensure that a uniform approach is used for the assessment of the
liquidity position of banks. The foreign banks
intra-group lending operations require an assessment of the liquidity positions
at the entity level so as not to discriminate between domestic banks and
international banking groups. In anticipation of the future Basel III Liquidity
Coverage Ratio, the Central Bank in cooperation with the CSSF performs impact
studies on the new liquidity rules on Luxembourgish banks. According to the
data as of June 2012, 36% of banks comply with the Liquidity Coverage Ratio and
46% comply with the Net Stable Finding Ratio. Thus, despite a healthy liquidity
position and the easing of the Liquidity Coverage Ratio computation rules set
by the Basel Committee, some Luxembourgish banks will have to adjust their
stock of liquid assets in order to comply with this ratio at the 2015 horizon.
The financial crisis underlined the need
and the benefits of having an efficient deposit guarantee scheme. By itself, Luxembourg could hardly meet the needs in case of bank
failures or sudden withdrawal of deposits, but the existence of these
mechanisms to prevent or deal with failed banks gives credibility to the
existing framework.
 The general perception is that a
deposit guarantee scheme is a reliable backstop which will prevent bank runs in
times of trouble for the credit institutions. The deposits guarantee scheme
in Luxembourg should evolve from the current ex-post funding towards an ex-ante
funding. The overall customer deposits reached EUR 280 billion in Nov 2013 but
the deposits guarantee scheme only covers a fraction of them as a large share
of deposits go above the threshold of EUR 100,000. Since its creation in 1989,
the scheme had to intervene in a limited number of cases and they were handled
smoothly (Box 4.1).
4.3.3.   Credit institutions have large exposures to the investment
funds
Investment funds domiciled in Luxembourg
have to appoint a locally established credit institution to perform depositary
activities. At the end of 2013, 63 custodians were
operating in Luxembourg, meaning that around one out of two banks (147 banks in
total) in Luxembourg are performing custodian activities. The depositary market
is dominated by branches of US and French credit institutions, with the largest
depositary of UCITS funds having around €500 billion of assets under custody.
The depositaries usually perform a wide range of activities, from the obligatory
custody functions to fund accounting, fund administration, transfer agency,
foreign exchange agent or securities lending agent. The profitability of the
depositary function is directly linked to the amount of assets under management
in Luxembourg and is therefore exposed to the risk that assets managed in
Luxembourg domiciled funds decrease. 
Even if the assets under custody do not
represent a direct risk for the bank balance sheets due to their segregation,
depositaries remain exposed to operational risks linked to this activity. Depositaries are liable for a number of events, including the loss
of assets belonging to the funds. To avoid being held financially responsible,
depositaries need to implement robust monitoring of their internal procedures
but also of their delegation arrangements with sub-custodians.
4.3.4.   Home-host country cooperation and cross-border regulation
and supervision are important for the financial stability in Luxembourg
The international dimension and the
openness of the Luxembourg financial sector have limited the links and the
involvement of credit institutions in the domestic economic and financial
network. The high foreign ownership of the
financial entities operating in Luxembourg is another dimension defining the
financial landscape. A number of them are of systemic importance and carry
significant risks for the local economy, not only from the perspective of
credit to the private sector but also for contingent liabilities and wider
spill over effects considerations. From this perspective, cross-border
cooperation between home and host countries is essential and a common recovery
and resolution framework as well. 
The recent progress made towards the
creation of the banking union engaged Luxembourg in the creation of a resolution
fund and authority and of an authority for macro-prudential surveillance. . The banking union and the ECB as the sole supervisor for
systemically important banks are big steps in harmonising the approach to
common banking supervision. 
4.3.5.   Money market funds are relevant to the financial stability
and would benefit from a better prudential framework
The systemic relevance of the money
market funds industry emerged during the financial crisis as they are potential
amplifiers of a financial turmoil. Money market
funds represent a convenient tool for investors because they offer features
analogous to bank deposits: instantaneous access to liquidity and stability of
value. On the other side, money market funds are important short-term funding
providers to banks, companies and governments. This type of funds is highly
sensitive to investor redemptions, which can turn in massive runs in times of
market stress. On the one hand, in case of significant withdrawals from the
funds, the short term funding of banks and companies would suffer. On the other
hand, it will affect the sponsors of such funds which are mainly banks.
Experience shows that sponsors prefer to financially support the value of their
money market fund instead of letting the value dropping. This strong link with
the banking sector has forced governments to intervene during the crisis.
Notably, Luxembourg announced that it would take all necessary steps needed to
stabilize the national money market funds.  The money market funds activity in
Luxembourg of around EUR 200 billion as of November 2013 has steadily decreased
since the end of 2008 mostly as a result of low interest rates. As Luxembourg
cannot guarantee the important amounts invested in the money market funds,
regulation is all the more important to avoid putting the country at risk. 
4.3.6.   The size of the investment fund industry 
The fund industry has shown a remarkable
resilience despite the significant contraction of the balance sheet of the
investment funds as asset prices tumbled and market
investors became more risk averse in 2008. Since 1990, 2008 was the only year
when the fund industry registered net outflows and when the net value of the
assets under management fell due to the decline in stock markets (Graph 4.5).
The size of the investment fund sector
in Luxembourg raises a number of questions regarding the supervisory and
regulatory environment. As most investment funds
domiciled in Luxembourg comprise assets belonging to investors from other
countries, continued confidence in Luxembourg as a major fund domicile rests on
the effectiveness of its financial supervision. Media coverage of investor
disputes and fund failures have the potential to affect the reputation of the
Luxembourgish investment funds centre. The independence and the quality of the
supervisory work are crucial to ensure that investors continue to trust
Luxembourg as a host for their assets. In line with the strong growth of the
asset management sector in Luxembourg, efforts need to be redoubled in order to
ensure that asset managers and investment funds are supervised in an effective
manner and that applicable rules (notably the harmonised UCITS and AIFMD
frameworks) are properly enforced. 
4.4.      Challenges ahead for the asset management sector
The real boom in the financial industry
came with the creation of the internal market through the Single European Act and this was the moment when Luxembourg started its ascension to
the top of the fund administration industry. Luxembourg has made from the first
mover strategy a comparative advantage, especially in creating the regulatory
framework necessary to the development of specific activities.  Luxembourg was
a first mover when it transposed into local law the European Union directives
that created the European passport for funds, also known as the Undertakings
for Collective Investment in Transferable Securities (UCITS) regulation.
Initially designed to commercialize funds in the European Union, the UCITS
framework is today a global distribution gateway for fund promoters from all
over the world. The legal framework as well as the skilled workforce initially
attracted foreign banks looking to develop their asset management activities
and continues to do so, transforming the Grand Duchy in a financial hub for the
funds distribution and administration.
The bulk of the Luxembourgish asset
management industry is composed of UCITS funds. Out
of €2.6 trillion, €2.1 trillion of assets under management are managed
according to the UCITS rules. Luxembourg hosts one third of the total UCITS
assets in Europe. This domination in the UCITS sector has largely contributed
to establish Luxembourg as a leading financial centre in Europe and abroad. The
challenge for the Luxembourg industry is to find new sources of growth, either
in the UCITS sector or in the emerging alternative investment fund sector.
4.4.1.   International presence of UCITS
The UCITS brand has established itself
as the global reference in terms of investment funds. Currently around 45% of the UCITS assets are marketed on a
cross-border basis and Luxembourg hosts 75% of these funds. These cross border
assets are mainly sold within the European Union but UCITS are marketed also
outside Europe. From these cross border assets, around 40% are sourced from
third countries with Switzerland accounting for 16%, Asia 15% and South America
6%. The Luxembourg asset management sector is seeking to increase the presence
of UCITS funds in these third country markets. Even if the funds are invested
in third country assets and managed mostly out of the EU, a fund domiciliation
generates side activities such as depositary activities, audit or legal
activities. The association representing the interests of the sector, ALFI, is
holding discussions for opening the Chinese market to funds domiciled in
Luxembourg. 
Competing investment platforms are emerging
in Asia and Asian regulators are in the process of setting up mutual
recognition agreements between themselves. The creation of fund passports in
Asia could in the long-term alter the prospects for the marketing of UCITS
funds in Asia. 
4.4.2.   The emergence of AIFs
With the entry into application of the AIFM
directive in July 2013, the European single market is equipped with a second
fund passport, for the so-called Alternative Investment Funds (AIFs). Once
the manager of such AIFs is authorised under the AIFM directive, it can market
its AIFs to professional investors throughout the Union. 
The Luxembourg AIF sector is currently
not very large in comparison to the size of its UCITS sector (EUR 0.5 trillion of assets under management). At the beginning of
2014, 90 AIF managers had asked for an authorisation and 12 had received an
authorisation so far.
The introduction of this new fund
passport is a major challenge for the Luxembourg financial sector. Up to now, the AIF market was mostly national with little
cross-border flows. As Luxembourg did at the end of the 80’s with the UCITS
directive, Luxembourg can largely profit from this new passport for hedge
funds, private equity funds or real estate funds. Based on the UCITS
experience, it is not unrealistic to target for Luxembourg an increase of the
assets under management in the AIF sector that needs however to be accompanied
by a robust supervision and regulation in order to avoid reputational damages.
4.5.      Challenges ahead for the private banking business for
international tax and regulatory changes considerations
The long run prospects for the financial
sector are closely linked to its ability to adapt to the changing regulation as
well as to the increased competition from other international financial
centres. The development of Luxembourg as an
international financial centre is related to its "first mover"
strategy in implementing international regulation, low taxation and strict
banking secrecy rules. In this vein, Luxembourg is considering the further
development of private banking as a way forward. This is an activity at the
crossroads of financial intermediation, portfolio management and investment
advice where Luxembourg has traditionally been active in. While the phasing-in
of the automatic exchange of information will also weigh on private banking,
the extent of the impact of the new regulatory environment is still unclear.
The small share of private banking in the Luxemburg economy today and its
potential for growth might mitigate, at least partially, the effects of the new
regulation. In fact, the sector already targets the Family Office niche seeking
a positioning as a provider of sophisticated services to complex profile
clients. 
Private banking is one of the most
promising avenues to be explored within the financial sector of Luxembourg for at least three reasons. First, Luxembourg can build on the
already existing experience, products and legal framework. Secondly, the
revenues in private banking are still high compared to other financial
activities where the margins continue to shrink. Finally, private banking still
has the potential to expand based on the projections for growth of the new
investable wealth.
Private banking can be seen as an
investment-advisory branch of financial services,
incorporating retail banking, financial planning, portfolio management, legal
resources, tax and investment advice. It can be performed by banks, wealth
managers (part of the professionals of the financial sector) or by Family
Offices. A Family Office is a form of private banking by which an entity
provides on a professional basis a wide range of patrimonial, administrative,
financial or legal services for well-off clients belonging to the same family.
Private banking targets the share of the global wealth which is investable,
either onshore or offshore and it is addressed to high-net-worth individuals,
small-business owners and well-off families. Offshore wealth is defined as the
assets booked in a country where the investor has no legal residence or tax
domicile. The revenues in private banking are generated by fees. In good times,
financial market activity driven by risk appetite would boost the
transaction-based fees while the appreciation of assets and the new inflows
would increase the asset-based fees.
According to Private Banking Group,
Luxembourg, private banking in Luxembourg reached EUR 305 billion in 2012, or
roughly 6% of the global offshore wealth (Graph 4.6), slightly increasing from EUR 300
billion in 2011 and divided between private banks (79%), wealth managers (18%)
and Family Offices (3%). Although the leader in private banking in the euro
area, Luxembourg is far smaller in terms of assets compared to Switzerland
which is five times bigger. 
 Luxembourg
has initially attracted mainly small to medium sized clients from Belgium,
France and Germany because of its tax system. A decade ago, these three
countries represented 90% of the offshore assets but over the last ten years,
their share fell to 56%. Today Luxembourg is still oriented towards continental
Europe with 87% of the total assets being European (Graph 4.7). 
4.5.1.   Past advantages no longer prevail
For a long time, a combination of
macroeconomic stability, friendly business environment, sound business
practices, low taxes and strict banking secrecy rules (Article 458 of the
Criminal Code) has been the recipe that attracted
flows into private banks in Luxembourg. Furthermore, the confidentiality that
guided the business relationships, the stricter tax policies in neighbouring
countries and also the expertise of the local workforce and elaborated product
offer reinforced the growth of private banking from the 1980s on.
The international push for transparency
has put under the spotlight countries like Luxembourg, which have made banking
secrecy a commercial argument. While having shown
resistance to the initiatives targeting banking secrecy in order to preserve its
financial sector, the Grand Duchy has been looking for alternative sources for
growth. Private banking, accounting for 5% of the economy, has been a
traditional pillar of the financial sector.
4.5.2.   Private banking is being affected by international tax and
regulatory changes
Since 2008, the industry has embarked on
a series of adjustments in order to meet the new global banking rules setting
the capital adequacy framework. The global
financial crisis and the fiscal consolidation in many countries has put an
emphasis on fairness and led to a global push for more transparency in order to
maximize tax revenues (the United States Foreign Account Tax Compliance
Act-FATCA, the European Directive 2003/48/EC on the taxation of interest income
from savings). Furthermore, in November 2013 Luxembourg failed the transparency
test performed by the Global Forum on Transparency and Exchange of Information
for Tax Purposes overseen by the OECD. 
Different initiatives indicate that the
Grand Duchy is becoming increasingly aware of the need to act in order to
realign economic interests and national choices with international acceptance. In 2009, Luxembourg adhered to the OECD standards on the exchange
of financial information upon request by competent foreign authorities. Since
April 2013, 10 years after the adoption of the Directive 2003/48/EC on the
taxation of interest income from savings, Luxembourg decided to end the
transitional period that it benefited from and to introduce the automatic
exchange of information in tax matters with competent government tax
authorities. This will be out in place as of 1st January 2015.
Private banking is undergoing a
refocusing phase. In this sense, attract newly
created wealth seems to be an important element. A recent trend is for private
banks in Luxembourg to establish subsidiaries in the country of residence of
their clients in order to retain the clients and preserve the client
relationship.
From a growth perspective, the industry in
Luxembourg seems to attract both rich and very rich individuals. As regards
geographical focus, Luxembourg seems to show a stronger presence in Europe, the
Middle East and Africa. Having a stronger foothold and access to the newly
created wealth in these regions is something a well-known European financial
centre like Luxembourg can achieve. However, being less prominent in Asia and
Latin America will limit its potential for expansion in these faster growing
regions. 
The Parliament passed a law by which
Luxembourg became the first EU member state to offer a regulatory framework for
the activities of the Family Offices. With this move, Luxembourg is attempting
to create once again the "first mover" advantage with the aim of
accessing this client niche. In 2009 there were 30 Family Offices in Luxembourg
but given the legislative developments, their number is likely to increase.
Looking at the outlook for newly created
wealth worldwide, the prospects for private banking look promising (see Box 4.2). With already important steps taken
towards developing the private banking activity, Luxembourg could consolidate
its place in private banking and reap economic profits from its dynamism.    
 
Competitiveness
The most important economic challenge
that the country is currently facing refers to safeguarding and even enhancing
its growth model, which has brought about very high
standards of living in Luxembourg. However, the analysis in section 3 indicates
that in the areas of external competitiveness of goods and private
indebtedness, risks are non-negligible.
Concerning the challenge of improving
external competitiveness, the country could benefit from an improvement in cost
competitiveness and labour costs. The analysis in
this IDR has pointed to the paramount importance of cost competitive­ness for
the export performance and how its deterioration can be considered to be at the
origin of the dramatic loss in export market shares for goods. A key aspect to
safeguard competitiveness is to ensure that wage cost developments do not
contribute any more to an erosion of the external position. One key element is
the role of wage formation and how it takes into account developments in labour
productivity and competitiveness. The temporary measures that have been
recently implemented could serve as inspiration for a more structural reform in
the way wages are formed in Luxembourg. Regarding non-cost competitiveness, the
findings of this IDR highlight again the specificities of Luxembourg. In an
economy in which a large and productive financial sector is constantly pushing
up salaries, it becomes increasingly difficult for manufacturers to remain
competitive. As a consequence, it becomes essential for these producers to
shift their output towards goods with a higher gross value added. This can only
be achieved when all economic agents in the country, private and public, agree
on a coherent strategy in all the key areas compounding non-cost
competitiveness, such as research and innovation, business environment, or
ensuring a high-skilled workforce. Decisively implementing measures in that
direction will also bring about other crucial benefits for the country, among
which, reducing the importance of price in the overall marketing strategy.  
Financial sector
Concerning the challenge linked to the
vast size of the financial sector, Luxembourg could further benefit from
fostering IT and business services as this know-how could underpin the
expansion of other areas of activity. The country
could aim at a further intra sectorial diversification, which would limit
exposure to a small number of financial sector activities. Private banking is
for example an activity that generates stable revenues. The beneficial role
played by a body promoting best practices and stimulating initiatives is an
element that Luxembourg should not underestimate in its development strategy. 
A key aspect for healthy credit
practices in view of the strong increase of credit to households, mainly
mortgages, refers to ensuring that prudent loan–to-value ratios are observed by all the financial institutions located in Luxembourg. This seems
to be currently the case but with house prices increasing rapidly, the consequences
of a sudden price correction also become more severe. Therefore, stricter
practices concerning a prudent loan-to-value ratio would help diminish such a
risk. Considering the regulatory capital and liquidity ratios that credit
institutions have to observe, their availability at the entity and not only at
supra-national group level would ensure better supervision and allow, if any,
early identification of weaknesses and equal treatment with domestic banks. 
The need for healthy credit practices is
particularly relevant for NFCs, whose level of indebtedness is the highest in
the EU. While the presence of a large number of
multi-national companies help to explain the high borrowing levels, a
continuously increasing indebtedness path could weigh on future growth
prospects.
Public finances
Although public finances are currently
in good shape, they are highly dependent on the evolution of the financial
sector in the short run. In addition, their long term sustainability is at risk
given a dramatic projected increase of age-related costs. Concerning the former, the key variable relates to a containment of
expenditure growth as to ensure the full respect of the expenditure benchmark
and avoid that the country departs from its already achieved medium term
objective. Regarding long term challenges for public finances, the country
cannot turn the back to the fact that liabilities are growing and that revenue
projections must be prudent and count on modest future growth scenarios. This
could be translated into a new pension reform, which would fully take into
account all parameters.
Abdelaziz Rouabah (2005), "Les determinants du solde de
la balance des transactions courantes au Luxembourg", Banque Centrale du
Luxembourg, Working paper n.13.
BCG (2013) Boston Consulting Group
"Maintaining momentum in a complex world".
Carlo Cuerpos, Inês Drumond, Julia Lendvai,
Peter Pontuch and Rafal Raciborski (2013), "Indebtedness, deleveraging
dynamics and macroeconomic adjustment", European Commission, Economic
Paper n. 477. 
Cussen M. and B. O'Leary (2013), "Why
are Irish non-financial corporations so indebted?", Quarterly Bulletin of
Central Bank of Ireland.
EC (2012), "Current account surpluses
in the EU", European Economy 9/2012.
ECB (2012), "Corporate indebtedness in
the euro area", Monthly Bulletin February 2012.
Edouard Franklin (2010) "Etude. Le marché de la gestion
de fortune à Luxembourg en 2009".
European Fund and Asset Management
Association (May 2012) "European Fund and Asset Management Association:
Asset management in Europe. Facts and figures".
European Fund and Asset Management
Association (May 2013) "European Fund and Asset Management Association:
Asset management in Europe. Facts and figures".
The Financial Times (May 7, 2013)
"Switzerland: Haven feels pressure to conform with global data sharing
rules".
KPMG (2012) "Performance through
focus. Seizing the global private banking opportunity".
Luxembourgforfinance (2012) "Etude d'impact de
l'industrie financière sur l'économie luxembourgeoise".
Luxembourg Ministry of Finance FAQ
"Introducing automatic exchange of information in Luxembourg".
McKinsey (July 2012) "McKinsey Private
Banking Survey 2012. Finding a new footing".
McKinsey (2011) "2011 McKinsey Private
Banking Survey. First signs of renewal".
OECD (2009) "Can the financial sector
continue to be the main growth engine in Luxembourg?".
PwC (December 2011) "Pricewaterhouse
Coopers: Banking in Luxembourg ". 
Ruscher E. and G. B. Wolff (2012),
"Corporate balance sheet adjustment: stylized facts, causes and
consequences", Bruegel.
Saxton, Nicholas and Christensen, John
(2013) "The Finance Curse".
STATEC (2011), "La balance des opérations courantes du
Luxembourg", Bulletin du STATEC  n.1/2011.
STATEC (Nov 2013) "Conjoncture Flash Novembre 2013".
Wintersteller, Markus (2013) "Country
Focus: Luxembourg's financial centre and its deposits".
([1])  "Basel III" is a
comprehensive set of reform measures to strengthen the regulation, supervision
and risk management of the banking sector.
([2])  The income section of the balance of
payments can be distinguished between labour and non-labour related incomes.
The non-labour section is also sometimes reported as investment income as it
reports investment-related flows such as dividends, interests, rents, etc..
([3])  The use of the export decomposition can
contribute to the identification of the factors behind long-term changes in
export market shares. The first two components (initial specialization) are
structural factors, capturing the initial product and geographical
specialization and reflecting whether a country is specialized in sectors with
dynamic global demand and whether destination countries are dynamic markets. As
such they reflect past export strategies and competitive advantages. The other
two, dynamic components (market share gains) capture how successful a country
has been in increasing its exports above market growth in product and
geographical markets as a consequence of competitiveness developments.
Competitiveness is understood in a broad sense, comprising both cost and
non-cost elements
([4])  Surplus countries included: AT, BE, DE,
DK, FI, LU, NL & SE.
([5])  As from the scoreboard table attached
to the 2014 Alert Mechanism Report, available at:
http://ec.europa.eu/europe2020/pdf/2014/amr2014_en.pdf
([6])  BCL (2005), "Les determinants du
solde de la balance des transactions courantes au Luxembourg", Wording
Paper n. 13, for a more in-depth discussion of Luxembourg export elasticity.
([7])  This, however, remains well below the
EU average of 0.74%.
([8])  The programmes ATTRACT and PEARL
2008-2013 of the National Funds for Research (FNR-Fonds national de la
recherché), which aim at attracting and keeping researchers in the country,
involved EUR 3.8 million in the year 2008-2010. For the period 2011-2013 the
amount has increased to EUR 13.7 million.
([9])  e.g. the law of 5 June 2009 organising
state aid for the private sector, the law of 21 December 2007on IP tax
incentives, the law of 18 February 2010 providing public aid to the private
sector in the field of eco-innovation, the setting up of business incubators,
the creation of a partnership with a business accelerator located in Silicon
Valley (Plug and Play Tech Centre), the setting up of a cluster programme, the
creation of a Master’s degree in Entrepreneurship and Innovation, the setting
up of the Luxembourg Future Fund, the specification of IP/spin-off requirements
in public research centre performance contracts, etc..
([10]) Private sector debt is the stock of
liabilities in the form of loans and securities other than shares excluding
financial derivatives.
([11]) This figures has been computed on the
basis of the data collected in the context of the "Households Finance and
Consumption Survey" and are not completely compatible with national
account data. For additional information refer to the methodological note to
the report, available at:
http://www.ecb.europa.eu/home/html/researcher_hfcn.en.html
([12]) Trough/peak: BE 85Q2/11Q3, DE 08Q3/94Q3
IE 97Q1/07Q3, EL 00Q1/09Q1, ES 97Q4/07Q3, FR 97Q1/07Q3, IT 00Q2/07Q3, LU
95Q2/07Q3, MT 00Q2/08Q1, NL 88Q1/08Q3, AT n/a, PT 07Q2/09Q4, SI 03Q2/08Q1, FI
08Q4/10Q3, BG 02Q2/08Q3, CZ 04Q3/08Q4, DK 93Q2/07Q3, EE 03Q3/07Q2, LV
00Q2/07Q3, LT 00Q3/07Q3, HU n/a, PL n/a, RO n/a, SE 96Q1/07Q3, UK 96Q2/07Q3.
Note: due to the specific dynamics of the DE cycle, the vertical axis
represents the cumulated growth from peak to trough and the horizontal axis
yields the cumulated change from trough to latest data.
([13]) European Commission (2011), 'Scoreboard
for the surveillance of macroeconomic imbalances: envisaged initial design,
Commission Staff Working Paper, November.
([14]) ECB Monthly Bulletin, February 2012,
"Corporate indebtedness in the euro area".
([15]) EC (2013), "Indebtedness,
deleveraging dynamics and macroeconomic adjustments", Economic paper 477.
([16]) Debt here is defined as the sum of debt
securities, loans and pension fund reserves. In contrast with the MIP, the ECB
and the European Systemic Risk Board measures NFC debt by adding in pension
fund reserves with loans and securities. There are seven countries in the EU
where NFCs report reserves: Belgium, Czech Republic, Germany, Italy,
Luxembourg, Portugal and Sweden.