Luxembourg: Risk Assessment
Country Risk Rating
Business Climate Rating
- Fiscal stability
- Skilled multilingual workforce
- High-quality infrastructure; business-friendly regulation
- Important international financial center
- High standard of living
- Highly dependent on a large financial sector
- Economy vulnerable to eurozone economic conditions
- Long-term budgetary impact of an aging population
- International pressure for fiscal reform threatens to reduce the tax base
A dynamic financial economy exposed to external risks
Underpinned by strong domestic demand and a steady flow of foreign financial income, the economy is running at full potential and will continue to do so in 2020. GDP growth will hover around the 3% mark for the third year in a row and continue to exert inflationary pressure on the labor market, with the unemployment rate already as low as 5% and inflation converging toward the 2% target. Investment continues to benefit from the lower tax burden on companies and favorable financing conditions. Due to the importance of the financial sector in GDP, the Luxembourgish economy remains highly exposed to the volatility of international financial markets. The financial sector accounts for 23% of value added and is mainly composed of foreign-owned banks (subsidiaries of European banks) and alternative investment funds. Thanks to its mixed nature, the Duchy’s financial system will find it easier to weather the effects of negative interest rates on profitability. With a stronger focus on asset management, its margins will suffer less erosion and benefit from the search-for-yield effect typical of monetary easing cycles. Nonetheless, financial returns will not be spared from the European slowdown and remain exposed to the risk of global trade tensions. The impact of a hard Brexit would be more ambivalent, as FDI from firms relocating from the UK would likely more-than-compensate the potential losses. Concerning financial stability, capitalization is strong and the authorities are taking measures to contain real-estate risks, but funds continue to show increasing interest in non-bank financial intermediation, with all the risks and returns this entails. Beyond finance, Luxembourg has become a hub for scientific R/D and developed strong pharmaceutical and chemical industries, which has helped the manufacturing sector withstand the headwinds of more traditional industries such as steel.
Exceptional public finances, but international tax pressure looms
At 1% of GDP, the budget surplus is expected to expand modestly in 2020, reflecting the continuity of sound fiscal policy under the reelected coalition government. In the absence of any major change to the current budget, expenditure and income will both remain stable in the 43-44% range, with slightly higher revenues from social contributions. With a structural fiscal balance above the medium-term objective and public debt well below the SGP threshold (1 and 21% of GDP, respectively) the Grand Duchy sports the healthiest public finances in the Eurozone. Due to their as-of-yet undetermined costs, this scenario does not factor in some important projects announced by the coalition, including infrastructure projects to improve the mobility of cross-border workers as well as increasing housing supply and affordability. The main fiscal challenges lie in potential future losses and FDI and tax revenue related to the EU’s push for harmonization of national tax regimes. In August 2019, lawmakers transposed into national law the second EU Anti-Tax Avoidance Directive, which can hamper the country’s attractiveness for corporate tax planning and will come into effect in January 2020. Otherwise, the current account balance is expected to continue to post a large surplus in 2020 (4.5% of GDP). The deficit in the trade and income balances due to cross-border transfers is expected to remain largely offset by the sizeable surplus in the balance of services resulting from the activity of financial corporations.
A stable ruling coalition and policy agenda
Following the October 2018 elections for the unicameral legislature, the Christian Social Party (CSV) led by former minister Claude Wiseler remains the country's leading political party with 28% of the vote. But with 21 seats out of 60, it is far from enjoying a majority and will remain stuck on the opposition benches. With 31 seats, Xavier Bettel's outgoing coalition returned to power after a deal was made in December 2018 to lock in the DP-LSAP-Déi Gréng government's program for the next five years. The Socialist Party (LSAP) and the Liberal Party (DP) obtained 18% and 17% of the votes respectively. The big winner of the elections was undoubtedly the Green Party, which took 15% of the votes, 5% more than in the previous elections. The concessions accorded by the DP to its junior partners (a minimum wage hike, more green investment financed by energy taxes, anti-speculation property tax reforms) will ensure the coalition’s stability. In return, Bettel’s party has been able to propose legislation poised to improve Luxembourg’s already outstanding business climate: a public debt ceiling of 30% of GDP, a small cut to the corporate tax rate, personal tax reform to attract qualified labor. On the medium term, a key issue will be the aggressiveness of fiscal harmonization at the EU level. In March, the European Parliament described the duchy as “behaving like a tax haven”, and the incoming Commission has signaled a will to intensify efforts in this arena.