Despite a financial sector that contributes 25% of GDP and the presence of 124 banks, the Luxembourg economy remains disconnected from the financial centre. (Photo: Shutterstock)

Despite a financial sector that contributes 25% of GDP and the presence of 124 banks, the Luxembourg economy remains disconnected from the financial centre. (Photo: Shutterstock)

While the real economy is beginning to suffer second-round effects in the wake of the pandemic and the war in Ukraine, Luxembourg's financial sector has so far been spared. It has even helped the economy keep up, but could soon show signs of weakness.

The European Commission has closely examined the macroeconomic stability of each member state as part of its spring semester package. it is concerned about the consequences of the pandemic and the geopolitical crisis on the real economy, particularly in terms of the rate of household over-indebtedness, the impact of oil prices on inflation and pension expenditure. The commission gives a much more positive rating for the country’s financial services sector. 

Before the covid-19 pandemic, between 2013 and 2019, Luxembourg’s GDP grew by an average of 2.8% per year. A good post-recession recovery is explained by an upturn in international trade, leading to faster growth in transactions, particularly in the financial services sector.

With financial activities in constant expansion, the financial industry now contributes to more than 25% of Luxembourg’s GDP, notes the European Commission in its report on the country’s macroeconomic stability. It even points out that the country’s financial services sector is the largest contributor to national income per capita, one of the highest in the world.

Banking institutions

The size of the financial industry in the country’s economy has helped cushion the impact of the pandemic. Calls to work from home have been facilitated “by the very high proportion of financial services jobs (...) that can be done from home and the high quality digital infrastructure.” With more than half of employees working remotely, the government was able to contain covid-19 infections, the commission’s report notes.

The EU executive also notes that coordinated action at international level “is the basis for the good performance of the financial sector.” For example, banks have received financial support, including grants and guaranteed credits from national emergency programmes and European financial instruments.

The support received by banking institutions has therefore helped to stabilise commercial and financial market conditions. As a result, while improving in 2021, the Luxembourg banking product continued to attract more investment. Among these investments was a significant part of the savings accumulated by households during periods of confinement.

The fund industry

Although the profitability of banks has weakened in recent years, the commission points out that they have also continued to show strong capital ratios.

Luxembourg is a financial centre of global importance, the commission also states, with its banks having €955bn in assets, “about 20 times the size of the economy”. On the other hand, the commission notes that “only a small proportion of Luxembourg’s financial institutions have direct links with the national economy.” Of the 124 banks registered in Luxembourg, about seven of them deal directly with domestic retail customers.

In turn, the investment fund industry has benefitted particularly from the facilitated trading environment at the time of the pandemic. In this respect, the European Commission reports that the value of assets reached an all-time high in December 2021, reaching €5.9trn--a figure that grew by 17.8% in 2021. Luxembourg is the second largest fund administration centre after the US.

The uncertainty factor

Luxembourg’s fund industry expansion in 2021 has largely benefitted from the economic recovery, higher valuations in the equity markets and a significant reallocation of household and corporate savings into investment funds. The report also highlights the capacity of the European financial centre to have positioned itself “as one of the preferred residences for sustainable investment funds in the EU.”

While the business climate has been favourable for the Luxembourg financial industry during the pandemic, the European Commission notes that Russia’s invasion of Ukraine should only have an indirect impact on the industry. The direct exposure of the Luxembourg financial system to Russia and Ukraine, in terms of total assets, remains “very limited”.

The good performance of the Luxembourg financial sector during the pandemic could, however, quickly fade in view of the increased uncertainty as to the duration of the Russian invasion, the potential escalation of sanctions and retaliation. The higher the degrees of these risk factors, the more the value of the funds’ assets could fall.

Finally, the European Commission also points out that Luxembourg, as an international financial centre, faces the inherent risk of money laundering. Noting that reforms to the beneficial owners register are well underway, it raises the issue of improving the supervision of professionals providing trust services.

Even if their reports of suspicious activities have increased, the commission criticises the fact that “not all categories of professionals report according to high risk exposure and some categories do not report any suspicions.” This will certainly fuel the discussions in preparation for the inspection of Luxembourg by the Financial Action Task Force (FATF) in November.

This story was first published in French on . It has been translated and edited for Delano.

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