Luxembourg 'AAA/A-1+' Ratings Affirmed; Outlook Stable


  • Luxembourg's prosperous economy is backed by an effective institutional framework, robust economic growth, and a large net asset position.
  • Net services exports drive current account surpluses, in turn supporting the large net asset position, while low government debt reflects persistent fiscal surpluses.
  • We expect pressure from changing international tax regulation will be effectively managed.
  • We are therefore affirming our 'AAA/A-1+' ratings on Luxembourg, and keeping the outlook stable.
RATING ACTION
On March 15, 2019, S&P Global Ratings affirmed its 'AAA' long-term and 'A-1+' 
short-term foreign and local currency sovereign credit ratings on Luxembourg. 
The outlook is stable. 


OUTLOOK
The stable outlook reflects our expectation that, over the next two years, 
Luxembourg will maintain strong credit metrics while effectively managing 
changing international fiscal regulation.

We could consider a negative rating action if the effects of tighter 
regulation of corporate taxation frameworks were more pronounced than we 
expected. This would likely weaken the country's economic growth prospects and 
fiscal performance, and could weigh on sovereign creditworthiness. The ratings 
could also come under pressure if credit growth accelerated to levels that 
would risk undermining Luxembourg's economic and financial stability by, for 
example, encouraging unsustainable acceleration in asset valuations.


RATIONALE
Our ratings on Luxembourg reflect its prosperous economy, transparent and 
effective institutional framework, prudent budgetary policies, and recurrent 
external surpluses. The financial and business services sectors are 
Luxembourg's key industries, supporting its role as a financial hub and 
contributing to its prosperity. At the same time, however, they expose 
Luxembourg to changing international financial regulations and potential 
external shocks. Those potential shocks are somewhat mitigated by the 
diversity of activities within the financial sector and by the government's 
efficient policy responses, which are consistent with a 'AAA' rating.

Institutional and Economic Profile: Strong institutions underpin effective 
policy-making and robust economic growth 
  • Luxembourg is adapting to changes in the international tax environment.
  • Financial sector exports and increasingly, domestic demand, drive robust economic growth.
  • The main risks to growth are a hard landing in housing prices and reduced attractiveness to foreign companies in a context of stricter international tax regulation.
The ratings on Luxembourg benefit from the institutional framework, which, in 
our view, supports economic policies oriented toward sustainable economic 
growth. The state has promoted growth of the financial sector (almost 30% of 
GDP) and continues to identify areas for its expansion, while at the same time 
aiming to diversify the economy into nonfinancial sectors. The direction of 
economic policies has not changed materially following the October 2018 
election, which put the ruling coalition in office for a second term.

Luxembourg's GDP per capita--estimated at $113,000 in 2019--is one of the 
highest among the sovereigns we rate. Its economy has enjoyed strong growth 
compared with other developed countries. We expect real GDP growth to average 
2.2% per year in 2019-2022, slightly lower than our previous baseline scenario 
but higher than most European countries. This favorable growth outlook is 
supported by the recent expansionary tax reform and the automatic wage 
indexations triggered in 2017 and 2018, which should continue boosting 
consumption, as well as a €100 net increase in the minimum wage in 2019. In 
addition, growth in financial services exports (63% of services exports in 
2017) should stay vigorous throughout the period, in part because some 
financial institutions are relocating European headquarters to Luxembourg from 
London in anticipation of Brexit, as well as continued expansion of the 
eurozone, although we expect a slowdown in momentum. Investment should be 
supported by still favorable lending conditions, as well as a further 
one-percentage-point decrease of the headline corporate tax rate in 2019 and 
an extension of the lower bracket to which the minimum rate is applied, which 
should be particularly favorable to small and midsize enterprises.

Employment growth, the expanding population, and supply-side constraints, have 
pushed up house prices. Favorable financial conditions, and tax incentives for 
house purchases may have also contributed to price increases. Although we 
expect population growth to continue, the rate of increase could somewhat 
diminish as lending conditions become more restrictive and as the government 
continues to take measures in order to increase the supply of affordable 
housing. Nevertheless, if the affordability of housing deteriorates, it could 
undermine consumption growth and reduce Luxembourg's attractiveness for 
foreign labor, while overvaluation could create risks of financial 
instability. 

Other risks to growth are related to the external environment. Were Brexit to 
have a significant negative impact on the eurozone economy as a whole, 
Luxembourg's economy could also slow. Nonetheless, in the short term, Brexit 
also represents an opportunity, as financial institutions consider whether to 
move their operations totally or partially from the U.K. to Luxembourg. 
International and European anti-tax avoidance initiatives, as well as the 
recent U.S. corporate tax reform, which incentivizes U.S. companies to 
repatriate their offshore profits, could also represent downside risk, but the 
impact is not likely to be felt in the near term.

Flexibility and Performance Profile: Low debt and a large net asset position 
  • Luxembourg has a history of budget surpluses, which supports its low level of debt.
  • Changes in the international tax environment are a challenge to Luxembourg's budgetary position, but large general government assets and low debt represent a significant buffer if risks materialize.
  • Large current account surpluses support the country's large external net asset position.
Luxembourg has mostly posted general government surpluses since 1995, in part 
owing to surpluses in the social security system, and to the government's 
ability to weather pressure on its fiscal performance. Luxembourg's e-commerce 
revenues gradually eroded in the wake of the EU's measures to reduce VAT 
competition in the EU, which reduced the incentive for e-commerce companies to 
locate themselves in member states with low rates of VAT. However, 
Luxembourg's budgetary measures, including the 2% VAT rate increase and the 
spending containment plan, helped absorb this shock and limit the impact on 
the central government balance. More recently, fiscal expansion, with in 
particular a decrease in income tax rates, has put only moderate pressure on 
the fiscal balance, given strong overall revenue growth. We expect new 
measures announced under the 2018-2023 coalition agreement--in particular a 
further reduction of the corporate tax burden--combined with a slight slowdown 
in fiscal revenue growth and higher spending on infrastructure, will put 
pressure on the general government balance, although it should remain in mild 
surplus. Under our base case, the general government balance will stand at 
0.8% of GDP on average over 2019-2022. Social security surpluses will keep 
offsetting gradually increasing deficits at the central government level under 
this scenario. 

Luxembourg raises a significant share of tax revenues from the financial 
services industry, in particular from banks, holding companies, insurance 
companies, and investment funds, in part thanks to a competitive tax 
environment. As in other EU countries, the corporate tax regime is changing as 
a result of various international initiatives, such as the recently adopted 
EU-wide Anti-Tax Avoidance Directive, which has been incorporated into 
Luxembourg law since the beginning of 2019. Moreover, several of Luxembourg's 
tax rulings have been or are currently under investigation by the European 
Commission (EC) under EU State Aid rules. In this context, changes to the 
headline corporate tax rate are part of the government's changing approach to 
international tax competition, with a greater focus on headline tax rates than 
on tax exemptions. Luxembourg is thus adjusting to the changes in the 
international tax environment. This does not insulate the country from further 
risks stemming from the international tax framework, but such changes are 
likely to be gradual, and we expect the government to respond to them 
proactively to maintain a sound budgetary position over the medium term. 

We regard Luxembourg's 2013 pension reform as an important step toward 
increasing the long-term sustainability of the system. However, we find that 
the current framework is not sufficient to contain the long-term budgetary 
pressure. Early retirement schemes are still widespread and the effective 
retirement age is below the EU average.

Under our 2019-2022 forecasts, we expect that gross general government debt 
will average 19% of GDP, excluding guarantees related to the European 
Financial Stability Facility (see "S&P Clarifies Its Approach To Accounting 
For EFSF Liabilities When Rating The Sovereign Guarantors," published Nov. 2, 
2011). The cost of debt should remain low, at around 0.7% of revenues. We also 
forecast that general government assets will remain relatively high, ensuring 
an overall net asset position for the government. This represents a 
significant buffer in light of the challenges highlighted above. 

We expect Luxembourg to continue posting large current account surpluses in 
2019-2022, supported by strong service surpluses and offset by negative net 
income, although we forecast a slight reduction in light of a slowdown in 
growth momentum among eurozone members. Luxembourg's financial account flows 
reflect its role as a financial hub. These flows amount to significant gross 
assets and liabilities on the international investment position. These could 
represent an economic risk, rather than a balance-of-payments risk. For 
example, a reduction of inflows into special-purpose vehicles or funds would 
be matched by a reduction of corresponding outflows, but the service exports 
associated with these activities would also decline, undermining growth and 
current account performance. 

As a member of the eurozone, Luxembourg's monetary policy is managed by the 
European Central Bank (ECB). We view the ECB's policy-setting as broadly 
appropriate for Luxembourg, in synchronization with its policies and those of 
major members of the area, such as neighboring France and Germany. That said, 
given relatively high growth in Luxembourg, as well as the ongoing rise in 
house prices, the ECB continuing its loose monetary policy may become less 
appropriate for Luxembourg in the medium term.
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