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ItalyRestrictive monetary policy is hitting economic growth sharply, while purchasing power of households remains relatively high
Luxembourg's economy was relatively stable throughout the pandemic and the global recovery thanks to its specialisation in financial services (30% of GDP), which has been generally strong. The country is the world's second-largest investment fund centre (EUR 5,368 billion in assets under management in Q2 2023) behind the US. The financial sector is mainly composed of foreign banks (subsidiaries of European banks). While the numbers of banks shrank from 130 in 2019 to 120 in June 2023, the number of employees in the sector has increased. What was a strength in economic uncertain times has turned against economic growth in Luxembourg in times of global monetary tightening. The ECB increased its key interest rates by 200 basis points from the beginning of 2023 until the autumn of the same year, taking the marginal lending rate to 4.5%, its highest level since July 2001 and one of the highest-ever levels in the history of the ECB. In addition, the ECB stopped all reinvestments in its Asset Purchase Programme in early summer of 2023, which has resulted in a decrease of the assets on its balance sheet of an average of €30 billion per month in 2023 and 2024. The Fed is bent on an even tighter monetary policy path, which resulted in the collapse of some single US banks in the spring of 2023. Credit Suisse also fell due to a confidence crisis that was followed by liquidity outflows. While banks in Luxembourg have still remained in good shape, the effect of tighter monetary policy on a global basis can be observed in decreased investments in the Luxembourg-based financial market and in some mergers.
GDP plummeted over 2022, especially towards the end of the year, sending the economy into a recession. However, it will be only visible in the yearly growth rate in 2023. After some ups and downs in the first half of 2023, economic growth should have stabilised and may even inch up in the second half of the year. Recovery is only likely to be visible in yearly growth for 2024. Monetary policy continues to play an important role. From autumn 2023 onwards, the ECB should go into “wait-and-see” mode. However, the first rate cuts are not likely to occur until the second half of 2024, (probably Q4). In terms of quantitative easing, the ECB will keep on with reinvestments of the maturing papers under its Pandemic Emergency Purchase Program (PEPP) until at least the end of 2024. While the restrictive monetary policy remains a drag on private investments and banking activities (especially lending), positive support is coming from private consumption as households in Luxembourg have higher purchasing power compared to those in neighbouring countries. The main reason for this is wage indexation on inflation. Luxembourg’s law says that wages must be automatically upwardly adjusted if during the last six months the average inflation is 2.5% higher than the level at the time of the last wage adjustment. In 2022, the adjustment was postponed until 2023 to limit excessive financial pressures on businesses. To level out the impact for private households, the government decided to cap gas prices, freeze electricity prices in 2023, place a rebate on fuel prices and reduce VAT by 1 percentage point across all VAT-classes. In addition, there was a special support package for low-income households and retirement homes. In addition to these measures, wage increases of 2.5% were implemented in February, April and September of 2023. Furthermore, the government decided on a credit on income tax to reduce the impact of the cold weather. From 2024, the tax credit will be replaced by a permanent adjustment to the tax scale that includes a tax cut of 6.3%. Given that all household support measures except for the VAT reduction will be extended in 2024, private consumption should remain solid. Foreign trade curbed economic growth in 2023 due to lower demand from the main Luxembourg trading partners; France, Germany and Belgium account for 54% of goods exports. As Germany is poised for a mild recovery in 2024 and the Belgian economy is expected to pick up mildly as well, external trade could contribute positively to growth in Luxembourg at this time.
Public accounts will remain in deficit in 2024
The public deficit widened sharply in 2023, driven by large-scale support measures and lower tax revenues due to tax credits and slower activity in the finance sector. 2024 will see most support measures extended so the public accounts will probably remain in deficit despite a slight improvement in tax revenues thanks to a rebound in activity. The deficits, together with an increase in the interest burden, will deepen public debt. However, it will remain one of the lowest in the eurozone – below the 30% of GDP threshold – which was the political objective endorsed in the 2018 coalition agreement.
However, the current account is expected to remain in surplus. While the trade in goods surplus will show some small improvement in 2023 and 2024 on back of a better terms-of-trade situation and slightly stronger foreign demand for goods from Luxembourg, the main impact will come from the substantial services surplus (31% of GDP in 2022, mainly attributable to banking and financial services). After losing some steam in 2023, it should recover gradually in 2024. This large-scale surplus usually more than offsets the large deficit in the balance of primary income attributable to the repatriation of dividends from massive portfolio investments in the country (29% of GDP).
New government for Luxembourg, inevitably with the CSV
As expected, the Christian-Democratic CSV, under the leadership of Luc Frieden, won the general election in October 2023 with 21 out of 60 seats in Parliament. The CSV is traditionally the strongest party in Luxembourg, but has lost some ground over the years, especially when newer parties like the populist-right ADR (Alternative Democratic Reform Party) or the libertarian Pirate Party entered the party system. Due to the CSV’s decreasing share of votes in the past two elections, the social democratic LSAP, the liberal Democratic Party (DP) and the Greens were able to form a government under the leadership of Prime Minister Xavier Bettel (DP) from 2013. However, in the 2023 election, while the share of the CSV remained unchanged, the Greens reached only 4 seats (down from 9), while the DP (14 seats, +2) and the LSAP (11 seats, +1) could not balance out this decrease. The ADR (5 seats), the Pirates (3 seats) and the Left (2 seats) play only a minor role in Parliament. On the next day, the government officially stepped down, but will remain in office until a new government is sworn in. For the new government two coalition combinations are probable, both with the CSV. The latter can form a coalition with the LSAP (which has been the case in 10 out of 18 cabinets since 1951) or with the DP (which was the case for 5 cabinets). While the LSAP has a programme slightly more focused on social issues than the DP, the identity of the CSV’s coalition partner will not be a game-changer regarding the political orientation of the government during this term of office. The political system in Luxembourg is very stable, therefore the forming of a new government should work without major issues and the next general elections are expected for 2028.
