“From a macroeconomic standpoint, understanding the motives behind the rise in interest rates is crucial,” François Koulischer told Delano in an interview.

Koulischer served as an economist at the central banks of Luxembourg and France before joining the University of Luxembourg in 2018. He was speaking to Delano about the Luxembourg government’s , which has been hit by high inflation.

He asserted that a part of the persistent and excessive inflation can be attributed to the robust fiscal support during the pandemic, which, coupled with low interest rates, has heightened aggregate demand and resulted in increased consumer and housing prices.

In order to mitigate inflation, “we should [adopt both] a restrictive monetary policy and a restrictive fiscal policy,” Koulischer said.

Consequently, the decline in activity and real estate prices “may not necessarily be a bad thing,” but rather “a necessary adjustment” in response to prior overheating.

Support measure

Considering the prevailing circumstances, Koulischer stated that “the fiscal support of the government to the housing sector is a little bit against the current environment where fiscal and monetary policy are being tightened throughout Europe.”

One plausible argument for localised fiscal support could be the desire to “avoid a hard landing.”

Should house prices experience a crash, it could result in financial instability and a drastic reduction in demand, leading to an economic crisis, the worst case scenario.

Koulischer emphasised that “[this] risk should not be underestimated in Luxembourg,” which possesses one of the most heavily indebted household sectors in Europe.

Additionally, another argument could be made based on the fact that “two-thirds of workers in the construction sector reside outside of Luxembourg.” Koulischer pointed out that there is a risk that these workers may altogether exit the market in the event of a sustained downturn, which would have detrimental long-term consequences.

Mortgage payments

The mortgage market in Luxembourg has typically featured a high share of variable rate mortgages, including in the recent years when interest rates were very low. Now, as interest rates increase, this leads to higher monthly payments for households.

“If the rate quadruples from 1% to 4% on a €100,000 loan, this represents €3,000 additional interest to be paid, which is sizeable.” However, it should be noted that monthly repayments also encompass the repayment of the principal. Therefore, repayments will not quadruple in magnitude.

“The main issue in my view here is the distinction between liquidity and solvency.”

If the interest rate burden becomes so large that a “household simply cannot afford its loan anymore, even just to pay the interest, then there is a problem.”

However, in most cases, households may be capable of repaying the mortgage over the long term but may struggle to meet the monthly payment obligations. In such scenarios, “the mortgages could be restructured to lengthen the maturity of the mortgage so as to reduce the monthly payments, without costs to the bank.”

Regarding the government’s fiscal stimulus and its potential to revive the housing market, Koulischer contemplated, “it depends on [the type of] buyers.”

He explained that households purchasing properties for primary residence purposes may be less sensitive to short-term price fluctuations and interest rates. However, the same may not hold true for investors and buy-to-let transactions.

Considering the optimistic economic growth forecast by Statec, the grand duchy’s statistics bureau, demand from the first category of buyers is expected to remain supportive.

“My understanding is that the government measures further support ‘main residence buyers’ through social housing measures and targeted tax reductions, while support for investors is relatively limited.”

Commercial real estate

“The measures for businesses are probably the most interesting, as the commercial real estate sector is still reeling from the impact of the pandemic and experiencing sharp downturns in many countries.”

“These targeted measures encourage businesses, particularly SMEs, to renovate their buildings in order to reduce their carbon footprint. This is particularly useful, as some observers have argued that one of the significant challenges faced by the commercial real estate sector is transitioning to the new demands of firms and employees, which requires substantial investments.”

Koulischer observed that the measures also include support for large public infrastructure projects, which should stimulate engineering activity.

Employment

Referring to his , conducted in collaboration with Pauline Perray and Huyen Tran from Statec, which showed that around two-thirds of construction workers are cross-border workers, Koulischer said, “Just as for the hospitality or health sector during the pandemic, there is a real risk that if activity falls and firms reduce their workforce, non-local workers could migrate to other places or sectors to find alternatives.” This means that “once activity ticks up again, [employers] will face labour shortages.”

Subsidies

In collaboration with Anastasia Girshina from the Stockholm School of Economics and Ulf von Lilienfeld‐Toal from the University of Luxembourg, Koulischer  that tax subsidies lead to price increases. Moreover, the distribution of the subsidies can often deviate from the “announced” objective.

For instance, “Suppose the government provides €10,000 to every house buyer. If house prices rise by €10,000 as a result of the measure, the government is essentially subsidising the seller.”

Furthermore, “gains from the appreciation in land prices are unevenly distributed, as the distribution of land itself is quite unequal.”

He supported this by stating, “the top 10% of households, based on real estate ownership, capture 22% of tax subsidies in the real estate market.”

Koulischer summarised by stating, “tax subsidies benefit most households; however, those who benefit the most from the subsidies are not necessarily the ones who need them the most.”

Past lessons

In 2002, the government introduced a tax credit on registration fees and transcription for homeowners, entitling homebuyers to a tax credit up to €20,000. This amount is doubled if the accommodation is purchased by a couple.

According to the ministry of housing, the reductions granted under this scheme amounted to €1.5bn between 2006 and 2016, with €164.4m in alone.

Additionally, “the government facilitates real estate transfers for owner-occupiers by not taxing the capital gain realised when the dwelling is sold.”

Another tax expenditure in favour of owner-occupiers is the application of the super-reduced VAT rate on construction and renovation work on a dwelling used as a primary residence.

According to a from the Luxembourg central bank, the budgetary cost of this measure amounted to €195.4m in 2016.

In other words, in 2016, the tax break (Beleggen Akt) and the reduced VAT for construction represented lost resources for the government to the tune of €164.5m and €195.4m, respectively.

“While these figures are not directly comparable, a package of €150m is certainly significant for Luxembourg,” commented Koulischer.

With more than 2% of GDP allocated to tax relief for homebuyers, he cautions, “Luxembourg is one of the highest spending countries in terms of housing subsidies, and this will not help bring it in line with other countries.”

Fiscal versus monetary policies

A conundrum has been created, given that national elections are on the horizon and further support is not off the table, but at the same time, the European Commission has asked governments to reduce support so that the European Central Bank’s monetary policy takes effect.

“This is indeed an unconventional decision, and the government should justify it.”

He continued, “I see at least two potential justifications for the measures: financial stability concerns or the specificities of the Luxembourgish construction sector.”

Whether these concerns are sufficient to justify the budgetary expansion requires further analysis, and Koulischer suggested that two institutions are equipped to do so. “The country’s systemic risk committee could potentially provide an opinion on crash risks in the national housing market. The national statistics agency, Statec, would also be well positioned to study whether the specific features of the Luxembourgish construction sector warrant such fiscal measures.”

Koulischer concluded that “the measures seem relatively well targeted. However, one should always beware of equilibrium effects and unintended consequences of such policies.”

Delano requested comment from the ministries of economy and housing, as well as the general directorate for small and medium-sized enterprises, but had not heard back by publication time.