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The Grand Duchy of Luxembourg, strategically placed at the conjunction of the most prosperous parts of Belgium, France and Germany, has long benefited from this culturally neutral niche. It is also proud of its role as one of the six founders of the EU. But as Luxembourg and the other qualifying EU member states prepare for monetary union, there are undercurrents of concern in the Grand Duchy about the threat to its thriving financial centre from a single currency and other harmonization proposals.
Over the years, Luxembourg's place financièrehas prospered as a result of comparative advantages such as free cross-border capital flows, the absence of monetary policy instruments such as minimum reserve requirements, and a favourable tax environment. The fear is that further European integration may level the playing-field and threaten the competitiveness of the Grand Duchy's financial sector.
Financial services account for an estimated 20% of Luxembourg's GDP, four times the proportion in most other EU countries. It hosts 220 banks, almost twice as many as a decade ago. The Grand Duchy is the fourth-largest centre for investment funds, private banking and syndicated loans. Euromarket activities are increasingly big business there, especially among large German banks such as Deutsche Bank, Dresdner Bank and Commerzbank. The Luxembourg franc bond market has almost tripled in size over the past three years. Anything which appears to endanger these industries is viewed with concern.
Luxembourgeois say they will still be able to compete in the new environment, given the widely acclaimed financial expertise and efficient technical-logistical support they have developed over the years. But with operating costs rising all the time and corporate taxes higher than anywhere in Europe apart from Germany, there is a danger that the country may find its remaining assets priced out of the market. Unless it is able to curb the escalating costs of banking activities, entry into European monetary union (Emu) is likely to inflict a serious blow to its financial services industry.
Whatever Emu brings, though, this tiny country of 400,000 souls and 1,000 square miles cannot do without its status as an EU member state. Unlike Switzerland, for example, it could not hope to maintain a viable exchange rate outside the EU. It is hardly surprising that Luxembourg has expressed no qualms about a single currency or a European central bank, in view of the fact that it signed up to monetary union with Belgium in the inter-war period; and it was only too happy in 1990 when the Benelux countries (Belgium, the Netherlands and Luxembourg) decided to peg their currencies more tightly to the Deutschmark than was required by the rules of the EU's exchange rate mechanism.
Luxembourg is now closer than any other nation to fulfilling the criteria in the EU's Maastricht Treaty for entry into Emu, needing only to establish its own independent central bank as part of the European system of central banks: "We are the only country which is actually gaining sovereignty as a result of all this," jokes Paul Meyers, president of the Luxembourg Bankers Association (ABBL).
However, harmonization reforms suggested for later implementation, such as the imposition of European-wide minimum reserve requirements on banks and the universal application of withholding tax, are making Luxembourg's bankers uneasy. The absence of minimum reserve requirements has long been one of the factors encouraging foreign banks to set up in Luxembourg, particularly those intent on arranging syndicated loans. When Germany imposed minimum reserve requirements in the 1960s, many German banks established Luxembourg affiliates to enable them to bypass the requirements. Large German banks such as Deutsche and Dresdner arrange almost all of their international syndicated loans from the Grand Duchy. Now Germany is among those EU member states pushing for the universal application of minimum reserves.
Threat to tax-haven status
Luxembourgeois make no secret of their opposition to any change. "We are against minimum reserves," says Serge Kolb, head of monetary policy at the Institut Monétaire Luxembourgeois (IML). "Their function can easily be performed in more market-conforming ways, such as buying and selling securities on the market."
This stance is the more understandable given Luxembourg's failure to maintain its share - compared with those of its three principal competitors, the UK, Ireland and Switzerland - of the increase in international loan volumes recorded in the past three years. Foreign bankers based in Luxembourg argue that this is at least partly a result of high operating costs (currently the second-highest in Europe after Switzerland) and a 40% corp-orate tax burden.
Luxembourg's high costs owe much to its salary-indexation mechanism, which increases what has been low structural inflation in recent years. Another problem is the long-standing system of incremental seniority-based (as opposed to performance-related) salary increases. The ABBL's attempts to give greater weight to performance have been strongly resisted by the trade unions. Their demands for general pay increases, automatic rises for seniority and a reduction in the working week from 40 to 35 hours would, according to the ABBL, raise costs by 40% over the next two years. The unions' position, though, is strengthened by fears that although its unemployment rate (under 3%) is low by EU standards, Luxembourg may soon import unemployment, as EU regulations demand free movement of labour across borders.
Luxembourg's opposition to minimum reserves is weakened by the fact that its main ally on this issue, the UK, is for the moment a peripheral EU player when it comes to the single currency and harmonization. "The Bank of England is arguing against minimum reserves," says the ABBL's Meyers, "but as they are not really in the game it is difficult for them to be convincing." The negative impact of minimum reserves will be less dramatic if interest is paid on them. This is likely because the proposed European central bank will be obliged to operate according to market principles. Whatever the precise impact, says Meyers, "we lose our competitive advantage".
Another of Luxembourg's advantages threatened by closer European integration is its tax-haven status. No matter how much Luxembourg's bankers play down the fact, it is clear that the absence of withholding tax on investment is a principal attraction for foreign investors. The imposition of a 30% withholding tax in Germany in 1992, for example, resulted in an estimated capital outflow of Dm100 billion ($71 billion) to Luxembourg. In 1990 there were 38 German banks in Luxembourg. There are now 72. Luxembourgeois wince when they see German bank advertisements extolling the tax advantages of Luxembourg. They know how much this infuriates the German authorities.
Tax harmonization has long been on the EU's agenda and is likely to remain a priority for a long time. "It's one of the biggest challenges facing the union," says the ABBL's Meyers. But the issue is complex and has led to lengthy negotiations since the EU was established. The measures approved generally include compromises in the form of options and derogations that can be taken up by specific member states. The EU's voting rules require unanimity of the Council of Ministers for tax measures to be adopted. "In other words," says Meyers, "it's unlikely that the commission will propose radical and controversial new measures."
Such confidence seems to be for public consumption. In fact, the withholding-tax issue is of sufficient concern for the ABBL to have commissioned academic studies on the subject. In a 1994 report - marked "confidential", but now widely disseminated as anti-harmonization propaganda - London Business School economist Andrew Sentance concluded that an EU-wide withholding tax would raise the cost of capital by 0.3%, discouraging investment at the margin and reducing European GDP. It would, Sentance argued, discourage cross-border flows, impede the efficient working of the capital markets and encourage substantial capital flight from the EU. And it would reduce the competitiveness of an important European business sector. Sentance wrote: "The experience of the growth of the Euromarkets in the 1960s and 1970s, following the imposition of the Interest Equalisation Tax and capital controls in the United States, suggests that such a shift could develop considerable momentum."
Sentance concluded: "Many of the problems associated with the tax stem from the fact that capital is not only mobile within the EU but can also move to non-European financial centres. Unless these centres can be persuaded to cooperate with the European authorities, by reporting payments to EU residents or even imposing a similar tax themselves, a withholding tax will not be successful in reducing the tax evasion that European governments fear. Instead, it will simply lead to a transfer of investments outside the EU, to the detriment of its financial industries and the European economy as a whole."
Emboldened by this report, the Luxembourg government's firm stance is that it will accept a uniform withholding tax only if it applies to all OECD countries. "Taking measures which would drive capital outside Europe only to enter at a higher cost doesn't make sense," says treasury minister Ive Mersch. "A lot of capital has flown to Switzerland just to hide from the threat. If we are going to harmonize withholding tax, we have to do it on a broader basis."
Mersch makes a similar point about banking secrecy, on which Luxembourg's private banking business is heavily reliant. "I've never seen private banking in the absence of confidentiality agreements," he says. "Why should we leave this business to non-European countries?"
Private banking has an important place in Luxembourg's strategy. Two months ago, Société Générale Trust Bank (Sogenal) became the latest in a long line of foreign banks that have transferred their private banking business to the Grand Duchy. "Private banking is the future of financial business here," says a local banker.
Luxembourg's banking secrecy laws prevent foreign tax authorities from inspecting bank records, except in a limited range of judicial actions. Although tax fraud is a criminal offence in Luxembourg, tax evasion is not. Like Swiss banks, those in Luxembourg do not see why they should act as policemen for the tax authorities. The knowledge that tax authorities can't snoop is a powerful attraction. Should banking secrecy be compromised, say Luxembourg bankers, many customers would scurry for cover to Switzerland or offshore centres.
The Grand Duchy has periodically come under pressure from other EU member states to fight tax evasion by loosening the limits on banking secrecy. This reached a height in the early 1990s following the collapse of the Bank for Credit and Commerce International (BCCI), which was registered in Luxembourg but conducted most of its business from London.
Having weathered the BCCI storm, though, local bankers appear confident that Luxembourg's secrecy legislation is no longer in jeopardy. "We should always stress that banking secrecy is not a means for protecting tax evasion and laundering," says Meyers. "It is a means for protecting the privacy of citizens, for whom financial dealings are a very private matter. If European citizens are to take advantage of cross-border investment opportunities as allowed under the law, they must not be for that very fact open to challenge and suspicion. A banker who offers his customers the usual services is not aiding or abetting tax evasion." Adds Mersch: "Banking secrecy does not apply vis-à-vis the judge, only vis-à-vis the executive."
Keeping fund managers happy
It's arguable that whatever the secrecy regime, Luxembourg's cross-border asset management operations are here to stay, given the expertise developed over the years and the reputation bankers here have for offering high-quality advice without being biased towards any type of domestic instrument. "We've reached critical mass with Lfr10,000 billion [$324 billlion] under management," says Meyers. In 1990 it was Lfr2,900 billion.
Luxembourg took the opportunity to encourage fund management groups to market their funds in the EU by early implementation of the community's directive on Ucits (undertakings for collective investments). These pooled, open-ended investments, similar to unit trusts (mutual funds), enable small investors to put money into a range of shares or bonds. They can be marketed across the EU - for example, a German or UK fund manager is free to sell its products to French or Belgian investors.
Luxembourg's favourable tax environment (there is no stamp duty on securities transactions, no withholding tax on distributions and no income tax on the fund) has made it a relatively cheap place to set up Ucits. Many of the large fund management groups, such as Fidelity and Fleming, have their administrative offices in Luxembourg. There are now 1,325 funds officially based there, even though in many cases the day-to-day fund management transactions are carried out in such financial centres as London, New York or Tokyo.
Other centres are now competing for this fund management business. Low-tax Dublin is one such, its particular advantage being a corporate tax rate of 10% in the docklands zone and labour that is around 20% cheaper than Luxembourg's. What Ireland lacks is a private banking infrastructure and client base and, perhaps, the expertise. "There is no doubt that Dublin is becoming a competitor on the investment-fund map," says a Luxembourg banker, "but if you talk to clients they complain about the quality of service." Adds the IML's Kolb: "People come here for other reasons: the know-how, the sophistication of products, and the good advice. We have a more sophisticated clientele." But as centres such as Dublin hone their skills, such arguments may become tenuous, and competitive advantage will again come down to cost.
More to bonds than Belgium
The precise effects of the changes to EU regulations discussed above are open to speculation, but other measures are bound to cause losses to Luxembourg's place financière. Its foreign exchange trading business, for example, will take a hit from the implementation of a single currency. The ABBL, though, says it is heartened by a recent Bank for International Settlements survey indicating that 74% of spot forex transactions and 83% of OTC derivatives contracts carried out in Luxembourg are against the US dollar rather than EU currencies. More significantly, the burgeoning Luxembourg franc bond market will soon be a thing of the past.
Over the past three years, the Luxfranc bond market has almost tripled in size. Last year a record Lfr450 billion was placed, much of it in Belgium to retail investors. This was despite fears, reported this time last year in Euromoney, that fiscal changes in Belgium would remove the comparative advantage of the Luxfranc market. Bankers in Luxembourg argue that competition from Belgium is unlikely to materialize. "It won't make sense two years ahead of the euro [the likely name of the new single currency]," says one.
The disappearance of the Luxfranc market will hurt Luxembourg's 15 domestic banks, which stand to lose their niche business as lead managers. The replacement single-currency bond market is likely to be dominated by between 15 and 25 global players, with Luxembourg's banks only getting a look in as co-lead managers.
The Grand Duchy's bankers are doing their best to sound bullish on the opportunities that spring from operating in the single market. One factor in their favour is their active role as co-lead managers in other markets - Banque Internationale à Luxembourg (BIL), for example, is active in 20 bond markets. "We consider ourselves to be excellent at distribution," says BIL's head of capital markets, Gilles Reiter. "We have a strong investor base, particularly in the Benelux countries. A lot of borrowers will also have smaller financing needs which we could serve well. Some of the larger banks cannot really do small issues because of the size and liquidity requirements of their institutional clients."
BIL's core clientele demands portfolios with a good balance between high- and low-yielding instruments. "The euro will be a strong currency and investors will be looking for alternatives," says Reiter. "There, BIL could play a role even as a lead manager. We've been lead managing Canadian dollar- and Ecu-denominated deals since the early days."
Another institution that will be affected by the demise of the Luxfranc market is the Luxembourg Stock Exchange, half of whose turnover is in Luxembourg franc bonds. But the exchange, which began automated trading in January and is now looking to introduce remote membership, expresses confidence that past activity has created a relationship between Luxembourg banks and their clients that can be exploited when the single currency is introduced. "The greater variety in maturities within the single currency will offset the loss of different currency options," says the stock market's managing director, Michel Maquil. "Issuers have been using the Luxembourg stock market for the past 30 years. I see no reason why they shouldn't go on doing so."
Luxembourg's bankers are rather weary of predictions of its downfall as a financial centre. "They've been doing that for 30 years," says one, "but Luxembourg has survived in the past and will survive in the future, come what may, thanks to the skills and expertise of its financial staff."
"Emu will have an impact on our banks," adds Mersch. "But it might be less than in those countries where banks have a huge captive market. Banks here have always been under pressure from international competition, especially European."
Other bankers question why, if they were not intent on staying here, foreign banks should be spending so much money erecting new buildings on the Kirchberg plateau (home to the European Court of Justice and now a thriving out-of-town financial centre). "If a bank invests Dm100 million in bricks and mortar, it suggests they believe in the future," says Swiss-born Rico Barundun, managing director of Credit Suisse (Luxembourg) and chairman of the committee for the promotion of the financial centre.
Well-established foreign banks show few signs of shifting their operations. "We could do what we do here in London," says Peter Kaul, director of Dresdner Bank Luxembourg, "but it's easier here given the language and the proximity to Germany. Besides, it would be expensive to move - there would have to be a massive amount of added value to be gained. To be characterized as a financial centre you need the tradition, a clear-cut regulatory environment and capable people in the banks. I think Luxembourg fulfils all those criteria and I don't see any reason for this to change."
But looking beyond those whose interest it is to extol Luxembourg's attractions, there are signs that the best is over. The change in mood is especially noticeable among Italian banks, whose number has grown steadily over the past few years, but some of which, such as the Banca Popolare di Novara and Banco di Napoli, have recently trimmed their operations in the Grand Duchy because of declining returns on equity. Other Italian banks that were expected to establish themselves in Luxembourg, such as CRT (Cassa di Risparmio di Torino) and the Verona and Firenze savings banks, have held back on a decision.
Flexibility and an ability to adapt effectively to change are among Luxembourg's acknowledged hallmarks. But the country is going to need these qualities in abundance over the next few years. Because if the place financièreis going to maintain its swagger, it seems, it will have to find some new selling points.
Number of investment funds
Number of banks in Luxembourg
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