Housing. Taxation. The financial centre. During the election campaign, future coalition partners the CSV and the DP both made a host of promises in these areas. To what extent can those promises be funded, however? At a time when the economic horizon is darkening, there is less room for manoeuvre in the budget. The future government will inevitably have to resort to borrowing.
For the time being, the grand duchy is in good stead: “At 24.6% of GDP (at the end of 2022), Luxembourg’s debt ratio is the lowest among AAA-rated sovereign states, and well below the current median debt ratio for the category, which is 36.1%,” wrote the financial rating agency Fitch Ratings in June. However, the situation is becoming more fragile. According to one of the scenarios circulating, with unchanged policies, public debt could exceed 30% of GDP after 2026.
The markets seem to regard Luxembourg as riskier than Ireland.
Are things dire enough to threaten Luxembourg’s sacrosanct triple-A rating? Julien Pénasse, professor of finance at the University of Luxembourg, believes the question is a legitimate one: “I wouldn’t be surprised to see a downgrade in the years to come. Yield spreads are higher on Luxembourg government bonds than on those of other countries. The markets seem to regard Luxembourg as riskier than Ireland, for example… even though Ireland has a lower rating than Luxembourg!”
And these differences in returns are widening, continues the professor. “In absolute terms, this is not a good sign. There is less and less room for manoeuvre when it comes to borrowing.” Is Luxembourg a risky country? Pénasse qualifies his observations: “These higher spreads do not necessarily reflect a fear of debt. They may be of a technical nature, linked to the low volume of Luxembourg government bonds and the small number of players on this market.”
At present, according to the latest available figures, the stock of Luxembourg government bonds stands at €21.9bn. In comparison, Ireland has a stock ten times larger (€239 bn in 2022).
Luxembourg doesn’t meet the conditions to be on the radar of the rating agencies.
Philippe Ledent, an economic expert at ING, sees no immediate threat to the triple-A rating. “Luxembourg doesn’t meet the conditions to be on the radar of the rating agencies or the financial markets,” he says.
The first condition, according to this specialist: a context of tension over public finances in the eurozone. “If the situation deteriorates in Italy, France, Belgium… and Luxembourg makes a big mistake at that point, if it pursues a high-spending policy with no payback, the spotlight will quickly turn on it too. I can imagine a situation where, for example, the difficulties in the property sector are combined with permanently weak growth, with no policy to revive the economy.”
Ledent insists on the term “sustainable.” “A country’s rating is not an assessment of its current economic situation. A temporary deterioration in public finances, due to the economic cycle or a stimulus plan, will not immediately impact the rating. The rating only represents the probability of default on a debt in the medium and long term: the lower the risk, the higher the rating. What matters for the rating, therefore, is what can affect the long-term trajectory of the debt.”
Luxembourg is very well equipped for this situation.
Christopher Dembik, senior investment strategist at Pictet AM, expects “this trajectory to be questioned in the years to come, with possible reforms to be carried out, particularly on pensions.” But this is not enough to threaten Luxembourg’s rating, he says. And even if it were, things nevertheless should be put into perspective: “For the past ten years or so,” he says, “the loss of a triple-A rating has not systematically led to a significant rise in the cost of borrowing. The triple-A universe has shrunk so much that investors have no choice but to fall back on lower-quality debt.”
To put it another way: the rating agencies have lost influence. “They are slow to react,” explains the strategist. “It is the market, through rising borrowing rates for example, that will consider a country to be at risk. The agencies then simply acknowledge this state of affairs.”
Dembik concludes: “In any case, the cost of debt will be higher in the years to come. And Luxembourg is very well equipped for this situation.”
This article was originally published in Paperjam. It has been translated and edited for Delano.