IMF Concludes 2009 Article IV Consultation With Luxembourg

by Ulrika Lomas, Tax-News.com, Brussels

12 June 2009

The IMF has concluded an Article IV consultation with Luxembourg. As a small open economy, hosting Europe’s largest investment funds, second largest money markets and many foreign-owned subsidiary banks, Luxembourg is fully exposed to the ongoing financial turmoil and global recession, reports the IMF.

Luxembourg’s economy has outperformed most of the euro area in the recent past, but with weakening activity in the financial system and falling export demand, the IMF expects output to decline in excess of the euro area average in 2009, and changes to the global and European financial architecture could lower potential growth over the longer term. GDP declined by almost 1% in 2008, while reduced demand pressures and the easing of commodity import prices sharply reduced inflation. Despite forecasts of real GDP growth decline by another 5.25%, a further contraction in the financial sector and continued weakness in external demand, the substantial and well-designed fiscal stimulus measures are projected to result in a budget deficit this year only marginally in excess of the Maastricht ceiling. The public debt stock remains low by international standards and provides ample scope to finance budgetary pressures over the near term. The increase in the near-term financing requirement is not expected to call into question fiscal sustainability.

The IMF regard financial stability to be a precondition for continued economic success, and supported the recent successful interventions in the banking sector, including the rescue of two major banks, and the initiative to improve banks’ liquidity management. The IMF was happy to receive a request for a Financial Sector Assessment Program update. While noting that system-wide capital levels appear adequate, strong cooperation between the central bank and the regulator will be vital for success, the IMF believes. Banks’ capital, still comfortable, is thinning, while leverage remains relatively high, notes the IMF, going on to highlight that there are systemic risks to the euro area as a whole emanating from Luxembourg as a result of the large volume of money market and other short-term financing provided by this financial hub.

The IMF Directors made the following recommendations:

In light of the large size of the financial sector and its systemic importance, a multilateral and cooperative approach to crisis preparedness was recommended for the resolution of home-host country banking issues. A proactive pursuit of burden-sharing arrangements, that should also cover the large money market fund industry, is needed in the view of the IMF. The IMF stated that it could explore the need for a liquidity facility, but current arrangements in the European Union may provide an adequate framework for cross-border cooperation on crisis management and resolution of financial stability issues.

The IMF called for a further strengthening of the regulatory regime, a tightening of capital requirements, and the introduction of binding limits on leverage. Such measures need to be phased in carefully warn the IMF, and coordinated internationally, especially at the level of the European Union. Luxembourg’s public finances are well positioned to weather the recession in the opinion of the IMF. Once recovery begins, medium-term fiscal sustainability needs to be pursued vigorously the IMF warns, as expenditures are rising and the evolution of medium-term fiscal revenues is uncertain. The IMF recommends that the authorities should reconsider the planned return to full indexation of wages and social benefits in 2010, as this could exacerbate budgetary pressures, and also hamper efforts to improve competitiveness. Far-reaching reforms of the public, pay as you go pension system remain overdue, and should be a high priority, the IMF urges, given that substantial funding gaps bring into question its long-term viability.

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