OECD Economic Outlook, Volume 2022 Issue 2

Luxembourg

Luxembourg’s economic growth is set to slow to 1.5% in 2023, before picking up again in 2024. Activity has slowed due to broadening inflationary pressures, falling manufacturing activity, and the uncertain outlook on the back of the Russian war of aggression against Ukraine. Financial services growth will slow in 2023 and high interest rates will delay business investment and housing purchases. Government support to households will underpin incomes and spending. Annual public investment of 4% of GDP will continue into 2024. The labour market will remain tight despite the growth slowdown. Rising prices of services will lift core inflation.

Income support to households should be targeted on the most vulnerable, be limited in time to avoid raising domestic demand pressures, and designed to preserve incentives to save energy. Reforms to the wage indexation system should be undertaken in consultation with the social partners to take account of the productivity, employment and investment effects. To enhance resilience, economic diversification requires stepping up investments in R&D and ICT, and in the transition to a low-carbon economy.

The economy is slowing

After a buoyant start to the year supported by the end of lock-down restrictions, the economy has slowed amidst rising uncertainty and inflation, exacerbated by the war in Ukraine. Retail trade volumes rose by 2.1% year on year in the first eight months of 2022, and employment remains robust. The unemployment rate stood at 4.8% in September 2022. Nonetheless, consumer confidence has fallen to its lowest point since 2002, as high inflation and interest rates weigh on sentiment. Business confidence has fallen from a high in early 2022 and manufacturing and residential construction activity have slowed. Consumer price inflation eased to 8.8% in October from a peak of 10.6% in June. Inflation was initially driven by energy prices, but price pressures are broadening, with core inflation rising to 5.2%. House price inflation has remained high. Salaries in the second quarter were 7.8% higher than a year earlier, after automatic indexation increased all wages and social benefits by 2.5% on 1 April.

Luxembourg

Source: Eurostat, Consumer Prices database; Statec, Business opinion survey in services; European Commission, Consumer confidence indicator; and Refinitiv.

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Luxembourg: Demand, output and prices

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Total trade exposure to Russia is minimal. Luxembourg imports almost all of its energy, with oil accounting for 60% of all energy consumption and natural gas for about 15%. Natural gas meets about 46% of heating needs. Most natural gas comes through LNG facilities in Belgium, primarily sourced from Norway and the United Kingdom, and gas shortages are not expected in the near term. Luxembourg has access to a gas storage facility in Germany and more storage through a multilateral agreement with neighbouring countries. The impact of the war is tangible through high gas prices, which are affecting energy-intensive firms, such as steel, glass and cement, and consumers. Luxembourg has taken in some 4 500 Ukrainian refugees, mostly women and minors, with temporary hosting facilities at full occupancy.

Fiscal policy will remain supportive

In response to the energy price shock, the government is implementing a total support package of around EUR 2.5 billion over 2022-23 (3.3% of GDP), including EUR 500 million in business loan guarantees. Measures include capping household gas prices at September 2022 levels and electricity prices at 2022 prices from January 2023; reducing most VAT rates by 1 percentage point; subsidising domestic heating fuel as well as energy-intensive firms; and giving cash allowances to disadvantaged households. The energy price cap and reduced VAT rates aim to limit the pace of future wage indexation tranches as agreed with social partners, and the potential associated loss of competitiveness. Public investment of over 4% of GDP annually between 2022 and 2024 will continue to support infrastructure, the green transition and innovation. The magnitude of public support means that there will be small fiscal budget deficits in 2022-24. Although the government will embark on fiscal consolidation in 2024, energy prices are likely to remain high into 2024, which is assumed to result in the government continuing the support measures.

Economic growth will slow significantly before gradually recovering

GDP will slow to 1.7% in 2022 and 1.5% in 2023, before picking up to 2.1% in 2024. High inflation is eroding confidence as well as disposable incomes, but government measures will support consumption in 2022-23. Public sector investment will support growth. Private investment will be held back by labour shortages and rising interest rates and only recover slowly. Export growth will moderate in 2023, as global financial market conditions remain difficult, and some supply-chain restrictions remain. The measures to contain inflation will have some impact, but a tight labour market will maintain wage pressures and keep core inflation high in 2023. Risks to the outlook are mainly on the downside. Higher-than-anticipated inflation could trigger further wage increases, sustaining upward pressures on prices and undermining competitiveness. The overheating of the housing market poses risks for some borrowers on variable rates as interest rates rise, particularly those with lower incomes. A sharp weakening of financial markets could negatively affect activity and exports.

To embed resilience, policy should focus on productivity and investment

Policies to mitigate inflation impacts on households should be better targeted, time-bound, and maintain incentives for energy savings. The wage indexation system risks exacerbating high inflation when large shocks occur, potentially harming longer-term competitiveness. In the longer run the system should be reformed in consultation with social partners to account better for productivity, employment and investment effects. Efforts to reform pensions and implement spending reviews would help maintain fiscal space over the longer term. Encouraging greater investment by the business sector in R&D and innovation would boost productive capacity and lift productivity growth, thereby also helping to reduce inflationary pressures. The bankruptcy bill currently before parliament should help restructure failing firms, and allow exit for non-viable ones.