Having grown at twice the speed of the average developed nation for over four years, Luxembourg has become a model of economic stability that many nations aspire to. Gaston Reinesch, Governor of the Central Bank of Luxembourg, explains how the ECB’s eased monetary policy has enabled enviable growth despite economic worries elsewhere in the euro zone.
Can you provide some facts and figures that best illustrate Luxembourg’s current macroeconomic conditions as of September 2017?
The real GDP growth rate of the Luxembourg economy has averaged around 4% since 2013. Although 4% is somewhat less than the pre-crisis trends, it is still high in light of the severity of the global financial crisis. In 2017 and 2018, growth should remain robust and possibly accelerate further as the international environment has improved considerably. As a small export-oriented economy, Luxembourg should benefit from the economic recovery in the euro area, which is growing at its fastest pace since 2007 and is Luxembourg’s main trading partner. The growth momentum in the euro area itself has been above the trend rate throughout 2017 and it is a clear sign that the ECB’s monetary policy measures have been taking effect. The financial markets environment has also turned more favourable and, as a result, the financial services sector, which accounts for about 25% of the economy, should do better in 2017 than in 2016. Assets in the mutual fund industry are expected to increase by more than 10% in 2017, compared to only 1% in 2016. In the first half of this year the banking sector has experienced positive growth rates again, albeit in the single digits only, in its operational activities, compared to stagnation in 2016.
In this rather favourable cyclical context, employment has increased by about 2.5% on an annual basis since 2013 and unemployment has edged down to around 6% of the labour force. Wage growth had been low for a couple of years as, in the adjustment phase that followed the financial crisis, all sectors, including the public sector, tried to keep a lid on their operational costs. However, as of 2017, in the context of a somewhat tighter labour market and an improved financial situation in the various sectors, the BCL is expecting the start of a normalization process. Real wage growth is at least accelerating on what appears a fairly broad basis. Headline and core inflation, which had been low for three consecutive years, have accelerated to close to 2% and are expected to hover around that level in 2018. Public finances are healthy by European and international standards. The general government had a budget surplus of about 1.6% of GDP in 2016 and public debt was around 20% of GDP.
Despite these positive developments, it is important not to be complacent. While the cyclical performance has been good, structural challenges remain. The unemployment rate remains above pre-crisis levels of below 5%. The tax measures that have been introduced in 2017, because of their size, will weigh on the public finances and restrain future governments’ room for manoeuvre. In a small economy with a large financial services sector, healthy public finances are a sine qua non that has to be preserved.
Can you give us some explanations and insights on the ECB’s current monetary policy?
Over the last three years, the ECB deployed a wide range of non-standard measures that have contributed to the current economic recovery in the euro area. In 2014, faced with the risk of inflation remaining low for too long, the Governing Council further lowered key policy interest rates, introducing a negative interest rate on the deposit facility in June. New non-standard monetary policy measures not only addressed impairments in monetary policy transmission, but also moved beyond what could be achieved through reductions in policy rates, in particular to anchor medium to longer-term inflation expectations in line with the price stability objective, i. e. an inflation rate below, but close to, 2% over the medium term. For instance, in June 2014 the Governing Council announced a first series of targeted longer-term refinancing operations (TLTROs) specifically designed to lower bank-lending rates and enhance loan supply. These TLTROs combined low long-term refinancing rates for banks with positive incentives to lend (the exact borrowing terms for banks depend on the volume of loans that they extend to the real economy).
In January 2015, the Governing Council announced an expanded Asset Purchase Programme (APP) that added a new Public Sector Purchase Programme to the Covered Bond Purchase Programme and the ABS purchase programme. Initially, these purchases amounted to a combined monthly total of 60 billion euros and were intended to continue until end-September 2016 or beyond, if necessary. A sequence of external shocks then jeopardized the tentative euro area recovery, prompting several adjustments to the set of monetary policy measures. For instance, in December 2015 the Governing Council decided to extend the net asset purchases under the APP until the end of March 2017 and to reinvest the principal payments on the maturing securities purchased under the APP for as long as necessary. In March 2016, it announced a policy package that extended the intended duration of the APP and expanded the volume of monthly purchases to 80 billion euros. This package also introduced a new Corporate Purchase Programme, further reduced the deposit facility rate (DFR) and reactivated the TLTROs. Between September 2014 and March 2016, the Governing Council gradually lowered the interest rate on the Eurosystem’s deposit facility from -0.10% to -0.40% and the interest rate on the main refinancing operations from 0.15% to 0.00%. In December 2016, the Governing Council decided to extend the APP until the end of December 2017, or beyond if necessary.
The combination of asset purchases and low policy rates currently represents the main source of monetary easing. The Governing Council’s forward guidance on these two instruments clarifies the conditionality that governs them, the sequencing of their phasing out and their expected duration. Appropriate calibration of this set of instruments will allow the Governing Council to maintain favourable financing conditions to foster economic activity and thus contribute to inflation returning towards the price stability objective.
In addition to the policy-controlled short-term interest rates, a central bank can also affect financing conditions by acting on long-term interest rates through their expectations component or the term premium. Forward guidance on short-term interest rates specifies that key interest rates will remain “at their present levels for an extended period of time.” This serves to anchor market interest rates at short-to-medium term maturities of the yield curve – those most sensitive to short-term interest rate expectations– keeping them steady around current low levels. In this respect, a mildly negative DFR has proved particularly effective in controlling and anchoring short-term money market rates, which are key determinants in the pricing of bank credit in the euro area. At longer maturities, the APP also applies pressure on bond yields, leading to compression in the term premium. By purchasing long-dated bonds, the ECB extracts duration risk from the market and decreases the desired compensation for hedging. This in turn activates a portfolio-rebalancing channel, facilitating the propagation of quantitative easing to the entire economy. In practice, distinguishing between the effects of the APP and of forward guidance on the two components of long-term interest rates is not straightforward, with the different policy tools acting as complementary elements of a package.
Through this wide range of measures, the Governing Council ensures a substantial degree of monetary accommodation, providing very favourable financial conditions to the broader economy. Lending rates to non-financial corporations and households have fallen significantly. The dispersion of lending rates across countries has also diminished, contributing to the solid, broad-based recovery gaining ground in the euro area. Deflation risks have essentially disappeared and HICP inflation rose from 0% in 2015 to almost 1.6% in 2017 (Jan-Sep). However, inflationary pressures remain subdued and a sustained adjustment in the path of inflation towards the medium-term objective is yet to be achieved. Such a “sustained adjustment” is the objective of the expanded asset purchase programme (APP) as well as the other components of the current accommodative monetary policy stance. More evidence of progress towards this sustained adjustment will be required before this extraordinary monetary stimulus can be withdrawn.
Following its monetary policy meeting in September 2017, the Governing Council recognised that a very substantial degree of monetary accommodation is still needed to support inflation developments in the medium term. The Governing Council decided to review the monetary policy stance in autumn 2017, probably in October, and, where necessary, to re-calibrate its instruments, in particular its Asset Purchase Programmes, to deliver the monetary policy stimulus required ensuring a sustained adjustment in the path of inflation.
How is it impacting the economy of Luxembourg?
Both standard and non-standard monetary policy measures contributed to easing borrowing conditions for non-financial corporations and households, leading to an increase in lending volumes. Monetary policy transmission operates through three main channels, namely the direct pass-through channel, the portfolio-rebalancing channel and the signalling channel.
Following the direct pass-through channel, central bank purchases of asset-backed securities and covered bonds boost demand for these assets, raising their price. This provides banks with an incentive to expand their supply of new loans, lowering lending rates for both enterprises and households. TLTROs, which provide banks with long-term funding at attractive conditions, are also designed to foster bank lending and further compress bank-lending rates.
According to the portfolio-rebalancing channel, sovereign bond purchases under the APP fuel the demand for these assets, raising their prices as well as those of other assets that are close substitutes. This reduces long-term yields, leading to lower bank lending rates and encouraging banks to expand their loan portfolio. The increase in asset values will also operate through the wealth effect, encouraging household consumption and firm investment and thus leading to higher output and inflation.
Could you explain how Luxembourg’s Financial Center is benefitting the economy, and why Luxembourg is a competitive financial hub?
The financial sector directly benefits the Luxembourg economy, which is evidenced by its important contributions to GDP. As of end-2016, financial services accounted for 27.3% of GDP of which 16.8% can be attributed strictly to the banking sector. If we put this in an historical perspective, then during the global financial crisis spanning 2009 until 2012 we see that the financial services sector exhibited a negative contribution to value added in real terms. The contribution of the financial sector to GDP during the crisis reached a low of 25.9% of total value added, which nevertheless, still constitutes a significant contribution to Luxembourg’s economy in comparison to other European countries. However, recent data for 2016 tentatively suggest that after the post-crisis adjustment process, we are observing a new period in which there will be a positive contribution to GDP growth from the financial services sector.
As far as employment is concerned, the financial services sector currently employs around 32,000 people and accounts for around 8% of total employment in Luxembourg. Over the course of 2016, employment in financial services grew at a rate of 2.6%, which is the highest growth rate observed since the 2008 crisis period during which there was much lower growth coinciding with the global downturn. The skilled work force in financial services, through their economic activity, also helps to support the domestic economy. There are also indirect benefits that arise from other areas of economic activity. For example, the presence of ancillary service providers to the financial services sector, such as legal and accountancy businesses, further help to support economic growth and bolster employment. In addition, the latest data from the national statistics office suggests that insurance services have exhibited promising results through positive returns on term premiums collected over the second quarter of 2017.
Concerning Luxembourg’s competitiveness, it is difficult to attribute Luxembourg’s success as a competitive financial hub to any single factor. The Luxembourg financial sector benefits not only from an established financial services infrastructure, but also from the developed skills and long-standing expertise of a diversified work force. Combined, these qualitative factors may play an important role in reducing operational costs, thereby enhancing Luxembourg’s competitiveness as an international financial hub.