Washington, DC:
Luxembourg weathered the pandemic well and its economy has recovered rapidly, with real GDP surpassing its pre-crisis trend. Yet, inflation is picking up amid labor shortages, housing prices have been growing at a fast pace, and the share of long-term unemployment is rising. While the financial system has been resilient, some structural vulnerabilities persist, such as low profitability. The Russia-Ukraine conflict is expected to weigh on the recovery and poses significant downside risks—uncertainty is high. Direct exposures of Luxembourg’s financial system to Russia and Ukraine are very limited as a share of assets, but the overall impact will depend on the spillovers to global financial conditions and confidence. The moderately accommodative fiscal stance this year and the recently adopted fiscal measures to shield households from rising energy prices are broadly appropriate. Going forward, while remaining flexible to address shocks, additional support should, to the extent possible, be targeted and timebound to promote non-inflationary growth. Close monitoring of emerging risks in the financial sector should continue. Given persistent residential real estate risks, the authorities should consider further tightening of borrower-based limits. To mitigate imbalances in the housing market, efforts to increase supply should be accelerated. Also, further action is needed to address factors that contribute to high demand pressures, use existing resources more efficiently (e.g., by constructing higher buildings with greater density), and tackle bottlenecks in the construction sector. Policies to support labor market participation, reallocation, and employment of disadvantaged groups should be strengthened. The authorities should continue to adapt their policies to take full advantage of the green transition and digitalization, while minimizing costs, such as carbon leakages.
Context
Luxembourg’s economy has recovered rapidly from the pandemic’s impact, with real GDP surpassing its pre-COVID trend. Following a milder-than-expected contraction in 2020, GDP is estimated to have rebounded by 6.9 percent in 2021. Employment and unemployment returned to their pre-pandemic levels amid record high vacancies. Nonetheless, the share of long-term unemployment has been rising, reflecting skills mismatches. Inflation picked up notably, driven mostly by energy prices, triggering automatic wage indexation in October 2021. Core inflation, so far muted, has been rising amid supply bottlenecks and labor shortages. The 2021 fiscal position was better than expected, supported by revenue overperformance. The financial sector has been resilient. Rapidly growing housing prices, for the third consecutive year, raise concerns about affordability, attractiveness for workers, and medium-term financial stability.
Outlook and risks
The war in Ukraine is expected to weigh on the recovery mainly through effects on global financial conditions, confidence, and lower growth of trading partners. Although the magnitude of the impact is difficult to forecast at this stage, staff will revise growth projections down relative to the October 2021 World Economic Outlook, with risks clearly tilted to the downside. Higher energy and commodity prices will fuel inflationary pressure further this year. Elevated demand, rising construction costs, and persistent supply constraints will likely maintain pressure in the housing market. The medium-term outlook, while uncertain, is more positive, and hinges on the authorities acting decisively to address housing imbalances and navigating successfully the green and digital transitions.
Policies
Fiscal
The moderately accommodative stance in 2022 and the recently adopted fiscal measures to shield households from rising energy prices are broadly appropriate. The increase in the cost-of-living allowance and the subsidy to stabilize electricity prices and cover the distribution costs of gas providers will help protect people’s purchasing power. Fiscal policy should remain flexible, as the magnitude and impact of various shocks are uncertain. The measures should, to the extent possible, be targeted (to low- and middle-income households) and timebound. Other measures in line with those proposed by the EC could also be considered as needed. Given uncertainty around the duration of the energy price shock, automatic wage indexations could increase inflation persistence and hamper competitiveness, leading to higher unemployment. In close consultation with social partners, the authorities could consider, for example, temporarily limiting the frequency of wage indexation to one per year, while using targeted support to protect the most vulnerable. Additionally, postponing non-urgent public hiring could help relieve pressures in the labor and housing markets. Should the risks from the conflict dissipate, the authorities should resume gradual policy normalization next year to promote non-inflationary growth. On the other hand, if downside risks materialize, additional support measures could be considered.
In parallel, fiscal reforms are needed to deal with potential revenue losses and distributional costs associated with the green and digital transitions. Tax and spending policies should be adjusted in ways that diversify sources of revenue and improve equity, while preserving attractiveness for workers. Risks on the revenue side are non-negligible and stem mainly from changes to international taxation, the impact of carbon taxation, and remote/hybrid work becoming the new norm. Accordingly, reforms should cover property and environmental taxation, the corporate wealth tax, and personal income taxation, in line with past Article IV recommendations. On the expenditure side, it is important to better target social spending (including homebuyers assistance) and further improve the efficiency of public investment. These measures should help rebuild fiscal buffers.
