The economic situation in Luxembourg and the need for staying watchful

Speech by Yves Mersch
President of the Banque centrale du Luxembourg
at the NOBELUX Chambre of Commerce
28 January 2004

Seule la Parole prononcée fait foi

Ladies and Gentlemen,

I should first like to thank the organisers for having invited me to this "Get together lunch". It is a real pleasure to address today's audience and to be able to discuss Luxembourg's economic situation with all of you afterwards.

First let me draw a quick picture of the economic situation in the euro area. As a matter of fact, the last published data show a recovery in the euro area. The 0.4% GDP growth in the third quarter of 2003 evidences the strong dynamism of the world economy, which should go on in 2004.

The Governing Council of the European Central Bank expects an improvement of domestic demand. Private consumption should remain steady, in particular because of the appreciation of the euro. Positive effects on the employment situation will most probably follow in due time. Productive investment will improve progressively mainly because of stronger external demand, low interest rates and financing conditions which are generally speaking favourable. Moreover, private companies' efforts to increase their productivity and profitability should support this trend.

In general, the Governing Council expects a progressive economic recovery of the euro area in the coming quarters. Nevertheless, in the long term, the Governing Council remains concerned about the possibility of external imbalances in certain regions of the world, which could jeopardise the stability of the world's economic growth.

With regard to prices, most recent information confirms previous economic projections. According to Eurostat, the euro zone annual inflation was 2.0% in December 2003, following a rate of 2.2 % in November. HICP inflation rates over the short term are still expected to fluctuate around the 2% level.

Now, let me turn to the economic situation in Luxembourg.

The activity in the industrial sector has been quite volatile in 2003. It grew by 2.3% in the first quarter of 2003 compared to the previous quarter. It then fell by 1.4% in the second quarter and finally increased by 2.7% in the third quarter.

Public works are also slowing down after the end of a certain number of large-scale works. As to the construction industry, economic surveys indicate a decline in demand as shown by the guaranteed activity period, which has dropped from 3.7 months in December 2002 to 3.5 months in December 2003.

In general, statistics with regard to residential building are positive. Building authorisations in particular have experienced a big increase for the last quarters, as they have been promoted by the government's will to correct the imbalance between housing offer and demand and by low mortgage rates. As for non-residential construction, future does not seem as bright. Office buildings are increasingly empty, which increases the pressure to reduce rents.

The favourable trade situation in 2002 seems to have continued throughout 2003. During the first half of 2003, turnover has increased in all three sectors of trade. This growth rests on a broad basis, as practically all segments of the various sectors recorded a progression in sales in 2003. Only hotels and restaurants seem to suffer from a fall in the number of clients as evidenced by a decrease of their annual turnover.

As regards the financial sector, the confirmation of good conditions on the stock markets and the recovery of bond yields have allowed the banks of the financial centre to generate a gross profit before provisions and taxes of 3 974 million euros as at 31 December 2003, which represents, however, a decrease by 7.8% compared to 31 December 2002.

Faced with reduction of revenues, credit institutions have continued with their cost reduction programs in order to be able to limit the pressure on their net results. Thus, operating costs have been reduced by 3.6% (-113 million euros) over 12 months. The downward evolution of the headcount in the credit institutions reflects in the evolution of personnel costs which fell by 3.6% (-58 million euros) during the same period of time.

The number of credit institutions has continued its decrease which started back in June 1996. During 2003, this number moved down from 177 on 1 January 2003 to 169 on 31 December 2003. This downward trend is partly due to the merger and acquisition process among parent banks, but also to reorganisations within banking groups. We expect this number of credit institutions to continue its decrease in the next years.

The Luxembourg economy taken as a whole will experience a third year of low growth and recovery will only be slow and gradual afterwards. In the medium term, the evolution of growth will be determined by international demand which is accelerating. The clearing of uncertainties, the stabilisation of financial markets and the progression of domestic demand underlie this scenario. The growth rates of the end of the 1990s, however, will probably not be achieved. Thus, according to our projections, Luxembourg's real GDP will grow by 0.8 to 1.4% in 2003 and by 1.7 to 2.7% in 2004 and probably more in 2005.

Despite recovery, economic growth will unfortunately not be strong enough to stop unemployment's growth. The unemployment rate could reach 4.5% of active population in 2004 and even 5.2% in 2005.

Inflation in Luxembourg, already moderate, will decelerate slowly. On the one hand, the oil price in euro scenario has become less favourable than in spring 2003. On the other hand, measures regarding indirect taxation have been implemented and these measures will certainly prevent a more significant deceleration of inflation. Nevertheless, a progression of inflation is not foreseen. A moderate imported inflation, promoted by the rising euro-dollar exchange rate in particular, and also decelerating employment costs in the euro area and in Luxembourg will limit future growth of consumer prices. On average, inflation should remain below 2% in 2004 and also in 2005. Our conclusion according to which there will be no automatic indexation of wages in 2004 remains valid.

Now I would also like to spend a few words on the budgetary situation of the Luxembourg general government. Supposing an unchanged policy, our projections show the comfortable surplus of public administrations will almost certainly make room for a financing requirement from 2003 onwards. Deficit could reach 2% of GDP in 2004 and reach 2.8% in 2005.

Deterioration of Luxembourg's public finances is only partly attributable to the weakening of the economic situation. Ignoring this evolution, the balance of public administrations would remain in deficit by 2.4% of GDP in 2005. As a reminder, this corrected balance showed a 5% surplus in 2001.

The deterioration of the public administrations' budget situation is mainly attributable to the increase of the expenses to GDP ratio. After having already increased a lot in 2002, this ratio would be of 47.9% of GDP in 2005, mostly because of the increase of social transfers, of the compensation of employees and of steady public investments during the period 2003-2005. As regards revenues, they reached a maximum of 47% of GDP in 2002, but they would drop to 45.1% in 2005. This evolution is mainly due to the evolution of direct taxes collected from companies, as the strong acceleration of tax collection that took place in 2002 will probably be replaced by an important deceleration in 2004 and 2005.

According to the amended draft budget for 2004, the central State's financing requirement is limited to 84 million euros, despite a striking deceleration of revenues' growth. This result is attributable to a progression of total expenses limited to 2% compared to the final 2003 budget, which is itself a consequence of a 19% reduction in capital expenses. Nevertheless, it should be emphasised that the central State's deficit, as calculated following SEC 95 accounting rules, would be much higher.

In the end of 2003, the Government presented the fifth update of Luxembourg's stability programme. Macro-economic assumptions that prevailed in the programme's elaboration seem realistic. Moreover, the programme foresees the development of significant general government deficits from 2004 onwards. These deficits would be of 1.8% of GDP in 2004 and 2.3% in 2005, while the preceding actualisation banked on a light deficit in 2005.

The programme, however, still seems relatively optimistic with regard to the evolution of local administrations' deficits which would peak at 0.2% of GDP in 2004 and in 2005. As evidenced in the 2004 draft State budget, the revenue from the local commercial tax, which represented almost 40% of local administrations' revenues in 2002, will indeed severely drop in 2004.

Moreover, the programme rests on the assumption of a significant reduction of the expenses to GDP ratio of public administrations, which would move down from 47.7% in 2003 to 47.2% in 2005 and 46.4% in 2006. Such an evolution requires the adoption of new structural measures limiting significantly the increase in expenses. According to our own calculations, public administrations would show important structural deficits from 2004 on. On the opposite, the programme foresees positive balances during the whole period 2002-2006.

In light of these budgetary considerations, I would like to conclude with an analysis of the Luxembourg social insurance system, especially with regard to the pension system and the healthcare. In the past, the social insurance system has recorded important surpluses, but according to our projections, these surpluses will decrease over the period 2003-2005 and reach 1.2% of GDP in 2005 compared to 2.9% in 2001 and to 2.4% in 2002. On the long term, and in the absence of a very high economic growth the budgetary situation of the system would continue to deteriorate. This deterioration would hit the two biggest sectors of the social system: pensions and healthcare.

With regard to the private pension system, assuming notably that Luxembourg achieves a 3% annual growth on average, our long-term projections show that surpluses will continue to grow until 2015 and then they will start to decrease. Around 2040, an annual financing need would arise, and it would reach 8% of GDP at the end of the projection horizon, in 2085. By 2055, the reserves that have been built will have been used up and significant liabilities will accumulate thereafter. This shows the long-term precariousness of the Luxembourg pension scheme.

As to the healthcare system, if the annual growth rate of the real expenses per protected person remains at 3.8%, which was the actual level during the period 1990-2002, social contributions would have to be gradually increased. This would entail a significant increase of labour cost for the companies in Luxembourg. Under the 3% annual growth assumption mentioned before, it would be possible to maintain the social contributions level at the 2003 level only if the annual growth of real expenses per protected person stays below 1.8%. This would mean, however, a very strong decrease of these expenses compared to the period 1990-2002. Thus, the sustainability of this system is also to be questioned.

Thank you very much for your attention.

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