EurozoneEY Eurozone Forecast September 2014

AustriaBelgiumCyprusEstoniaFinlandFrance

GermanyGreeceIreland

ItalyLatvia

LuxembourgMalta

NetherlandsPortugalSlovakiaSlovenia

Spain

Spain

Portugal

France

Ireland

Finland

Estonia

Latvia

Belgium

Slovakia

Austria

Slovenia

Italy

Greece

Malta Cyprus

Netherlands

Luxembourg

Germany

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Outlook for Luxembourg

Non-financial sector gains momentum

Spain

Portugal

France

Ireland

Finland

Estonia

Latvia

Belgium

Slovakia

Austria

Slovenia

Italy

Greece

Malta Cyprus

Netherlands

Luxembourg

Germany

1EY Eurozone Forecast September 2014 | Luxembourg

Highlights

• Luxembourg’s economy is on track for GDP growth of 2.8% this year, outperforming much of the rest of the Eurozone. This rather robust performance is due to an improved contribution from the non-financial sector. For 2015, we expect a slowdown in growth to 2.3% due to fiscal tightening, in response to the loss of value-added tax (VAT) revenues from e-commerce. For 2016–18, we expect average annual growth of 2.8%.

• The important financial sector will post more subdued growth, held back by the slow recovery in banking, which continues to face restructuring and regulatory challenges. In contrast, asset management is set to continue to grow strongly, benefiting from established infrastructure advantages and expertise. Financial sector expansion will also be driven by opening up new lines of non-European Union (EU) business, such as Islamic real-estate bonds and Chinese offshore currency trading.

• Consumers will benefit from rising real incomes this year, thanks to low inflation, which should support ongoing spending growth. In anticipation of higher VAT rates in 2015, consumers are also likely to shift some spending to this year, at the expense of next. We forecast spending growth of 1.9% in 2014, 1.8% in 2015 and 2.4% on average in 2016–18.

• Favorable fiscal developments, especially revenues that are higher than anticipated, mean that the Government should post a small surplus this year, beating its own earlier target of a small deficit. In 2015, the fallout from lost e-commerce VAT will lead to a 1.2% of GDP deficit, after which the government budget should gradually improve again and be close to balance in 2018.

GDP growth

2014

2.8% GDP growth

2015

2.3%

Unemployment

2014

6.2%

Consumer prices

2014

1.1%

2 EY Eurozone Forecast September 2014 | Luxembourg

Non-financial sector gains momentum

Outlook improves for this year and next …

Luxembourg’s economy is on track to achieve solid GDP growth this year, outperforming much of the rest of the Eurozone. We expect this rather robust performance despite a below-average contribution from the financial sector. In view of this, we have raised our GDP growth forecast for 2014 to 2.8% from the 2.4% projected in our June report.

For 2015, we forecast growth to slow to 2.3% due to the negative impact of the fiscal tightening that will be implemented to offset the loss of VAT revenue in e-commerce. However, we expect the recent positive development of the fiscal position to carry over to 2015. This means

that less tightening than we previously expected will be required and the impact on growth will be less severe. As a result the outlook for 2015 has improved compared to our June report, when we projected GDP growth of 1.9%. For 2016–18, we forecast an average annual growth rate of 2.8%.

… as growth in the non-financial sector accelerates

The non-financial sector saw a rather patchy recovery from the 2008–09 crisis, but performance has recently strengthened across a broad range of sectors. Most sectors posted positive growth in Q1 2014. Improvements in demand conditions should boost non-financial sector performance this year and beyond.

A cyclical upswing of European construction demand is set to boost output in the steel sector and stabilize prices, after years of restructuring and price weakness. The steel sector also benefits from a high degree of vertical integration with the global iron ore supply chain and strong demand from fast-growing emerging markets, although Europe and North America still account for the largest share of sales for the time being.

The recovery of car sales in Western Europe will also boost the expanding automotive-components industry, which now employs almost 10,000 people and focuses on high-value-added components that can be quickly dispatched to plants in neighboring countries.

Table 1

Luxembourg (annual percentage changes unless specified)

2013 2014 2015 2016 2017 2018

GDP 2.1 2.8 2.3 2.8 2.9 2.8

Private consumption 1.7 1.9 1.8 2.3 2.5 2.4

Fixed investment –4.3 8.6 5.2 3.8 3.1 3.0

Stockbuilding (% of GDP) 2.1 2.4 1.8 0.9 0.9 1.1

Government consumption 4.3 0.8 1.7 1.9 1.9 1.9

Exports of goods and services 2.6 5.0 5.9 4.3 3.5 3.1

Imports of goods and services 1.3 5.9 6.2 3.9 3.4 3.1

Consumer prices 1.7 1.1 2.3 2.0 2.0 1.9

Unemployment rate (level) 5.9 6.2 6.2 5.8 5.3 4.9

Current account balance (% of GDP) 5.2 4.2 5.1 5.7 5.7 5.7

Government budget (% of GDP) 0.1 0.2 –1.2 –0.9 –0.4 –0.1

Government debt (% of GDP) 23.1 22.2 22.4 22.2 21.5 20.6

ECB main refinancing rate (%) 0.5 0.1 0.1 0.1 0.2 0.8

Euro effective exchange rate (1995 = 100) 120.8 123.6 119.9 118.8 118.8 118.4

Exchange rate (US$ per € ) 1.33 1.34 1.27 1.24 1.24 1.23

Source: Oxford Economics.

3EY Eurozone Forecast September 2014 | Luxembourg

Table 2

Forecast for Luxembourg by sector (annual percentage changes in gross added value) 2013 2014 2015 2016 2017 2018

GDP 2.1 2.8 2.3 2.8 2.9 2.8

Manufacturing –0.8 6.3 3.0 2.7 3.0 2.9

Agriculture 0.6 –3.4 –0.6 –1.2 –0.7 –1.0

Construction 2.8 3.0 2.3 2.5 2.1 2.0

Utilities –5.8 –2.8 –2.1 –1.2 –0.5 –0.6

Trade 2.4 2.2 1.0 1.4 1.7 1.5

Financial and business services 1.3 3.2 2.2 2.9 3.5 3.4

Communications 3.1 4.7 2.8 2.9 4.4 4.2

Non-market services 3.3 2.2 0.6 1.5 2.3 2.3

Source: Oxford Economics.

After years of very moderate growth, construction activity has enjoyed stronger growth in the past few quarters and has almost attained pre-crisis levels. Activity in the sector should remain buoyant in the next few years, helped by an emerging shortage of office space in Luxembourg City, a stronger housing market, the prioritization of energy projects designed to conserve or diversify supply, and a major public transport expansion.

The outlook for satellite and telephone communications also remains strong, as the diffusion of technology (for example cloud computing) expands the user-base for mobile computing, telephony and television. Adding to this, there is likely to be a revival of demand in the defense industry amid growing challenges for NATO with new launches expected for 2014–15.

The improved outlook for non-financial sectors will also be reflected in investment spending. Apart from in satellite and telephone communications, as well as transport (whose pre-committed plans held up investment activity in the past few years), investment spending has already started to gradually shift to other sectors. We forecast investment growth of 8.6% this year, before it slows to 5.2% in 2015 as positive base effects abate, and then to an average of 3.3% a year in 2016–18 as major investment projects are phased out.

Financial sector held back by subdued banking

Although the financial sector, including insurance, remains a significant contributor to the economy’s output (24%) and employment (11%), growth here will remain more subdued than in the economy as a whole, at least for this year, mainly because of the slow recovery in banking. The banking sector’s income rose in 2013, but net profit stagnated and employment continued to fall. Medium-term growth will be tempered by continued restructuring, growing competition for personal banking in the EU, changes required for Eurozone banking union, and regulatory challenges that may arise in the future.

In contrast, asset management has continued to grow strongly, gaining from both new inflows as well as improving markets. Implemented directives on undertakings for collective investment (UCITS) and alternative investment fund management (AIFM) have made Luxembourg a principal channel for European investors. The UCITS format is also helping to attract portfolio inflows from outside the EU, while AIFM rules will translate into a continued reshoring of specialized investment funds that must now find a domicile within the EU in order to distribute across it.

Figure 1Real GDP and employment

Source: Oxford Economics.

% year

–15

–10

–5

0

5

10

15

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Employment

GDP

Forecast

Figure 2Government budget balance

Source: Oxford Economics.

% of GDP €b

–8

–6

–4

–2

0

2

4

6

8

–1.5

–1.2

–0.9

–0.6

–0.3

0

0.3

0.6

0.9

1.2

1.5

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Forecast€b (left-hand side)

% of GDP(right-hand side)

4 EY Eurozone Forecast September 2014 | Luxembourg

Non-financial sector gains momentum

Figure 3Inflation and earnings

Source: Oxford Economics.

% year

–2

–1

0

1

2

3

4

5

6

7

8

9

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Average earnings

Consumer prices

Forecast

Figure 4Eurozone systemic stress indicator

Source: ECB; Haver Analytics.

%

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2000 2002 2004 2006 2008 2010 2012 2014

Although Luxembourg’s historical attractiveness to EU and American investors due to tax-efficiency is gradually being eroded by new disclosure requirements, the expertise and infrastructure advantages built up by the fund management industry while tax advantages existed has left them well placed to retain and expand business even after those advantages fade.

Financial sector expansion will also be partly driven by opening up new lines of non-EU business, with a recent focus on Islamic real-estate bonds and Chinese offshore currency trading. The latter has the potential to increase substantially should China, which currently conducts less than 20% of its foreign trade in its own currency, move further toward convertibility of the yuan, although Luxembourg will be in competition with London and Frankfurt.

Lower inflation this year, but 2015 VAT hike will hit incomes

Nominal wage growth has remained reasonably robust at around 2.7% between Q2 2013 and Q1 2014. Relatively high unemployment at 6.2% (on the International Labour Organization harmonized measure) should exert moderate downward pressure, but wages are still set to rise at rates well above 2% over the next few years. Because of the expected drop of inflation to 1.1% this year (from 1.7% in 2013), this will still translate into increasing real incomes in 2014.

The expected rise in real incomes this year should lead to a pickup in consumer spending, which is also supported by higher consumer confidence on average compared to last year. Moreover, in anticipation of higher VAT rates in 2015, consumers are likely to bring forward part of their spending into this year, especially on big-ticket items. This will further boost private consumption growth, albeit at the expense of spending in 2015. We forecast household spending growth of 1.9% this year, and 1.8% next, much less than we had expected without the increase in VAT. For 2016–18, we forecast that consumer spending will grow at average rates of 2.4% a year.

Government finances developing more favorably

Due to the development of government revenues in 2013, which were more favorable than expected, and indications that this positive trend could at least partly persist this year, we now have a more positive outlook on the government balance. We expect it to show a small surplus this year, beating the Government’s target of a small deficit, announced in April.

However, the fallout in 2015 from lost VAT revenues on cross-border e-commerce will be sizeable and contribute to a budget deficit of 1.2% of GDP, before the deficit improves again in 2016 and returns to balance in 2018. But a more positive underlying trend continuing into 2015 also means that any additional fiscal adjustment measures needed to offset the VAT fallout will need to be less severe. As a result, the negative impact on GDP growth in 2015 will be smaller than we had previously thought.

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