View from Frankfurt: Finding unification in Luxembourg's safe haven

DURING THESE testing times in Germany there are few matters on which the Bundesbank and the Finance Ministry in Bonn see eye to eye. The two are usually found casting thinly veiled aspersions on the one's fiscal irresponsibility and the other's monetary brutality. But mention the words Luxembourg and capital flight, and officials from both institutions will quickly make common cause in expressions of righteous indignation and concern. For the midget neighbour to the west has an insatiable appetite for Germany's savings.

Since the summer of 1991 when talks started about re-introducing a German withholding tax on interest income, it is estimated that at least DM110bn ( pounds 46.4bn) has been hauled across the border to the Luxembourg safe haven. This amounts to about half annual new savings.

Last year some DM66bn was shifted into Luxembourg-based funds to escape the 1 January 1993 deadline when the 30 per cent withholding tax came into force. The number of German banks operating in the Grand Duchy jumped by a third last year to 63, as they sought to clamber aboard this gravy train. The familiar picture of sheepish-looking Germans with over-stuffed plastic bags wandering up and down the Boulevard Royal has stayed. Even stories in papers such as Bild-zeitung about German secret service agents sidling through Luxemburg's banking district noting down German car number plates have failed to dampen the spirit of the tax fugitives.

Another DM30bn poured into Luxembourg in the first three months of this year, with the result that funds managed in Luxembourg by German financial institutions, totalling DM125bn, have now exceeded their equivalents in Germany. Christian Humbert, director of the Munich-based Adig fund managers, has predicted the extinction of this type of fund in Germany, should the flood into Luxembourg continue.

Huge influx

In February the Bayerische Vereinsbank's subsidiary in Luxembourg was struggling to cope with 50 new clients a day. According to Deutsche Bank, average first-time deposits amounted to DM400,000. Smaller fry are passed on to 'friendly institutions', such is the force of the influx. Last year the number of clients with Deutsche Bank Luxembourg increased by 164 per cent and the funds managed by its investment arm there doubled to DM28bn.

The advent of the withholding tax also coincided with the virtual abolition of formal border controls, creating an unexpected boon for the plastic-bag brigade. In the midst of all this feverish activity, German banks and investment houses have had little to complain about. As conservatives, Germans have placed most of the funds in the Luxembourg branches of their banks at home, encouraged by full-page newspaper advertisements hinting 'Luxembourg is just around the corner', and 'Luxembourg, the holiday home for your money'. As the chairman of Dresdner Bank said this week: 'One should stop whining about capital flight and rejoice in the progress of European harmonisation'.

Joy does not abound in the Finance Ministry, however, for 'just around the corner' is just too far for its tax collectors. Already fighting a hard battle to make the unification sums add up, the ministry is desperate to pin down every wayward tax pfennig. Meanwhile the Bundesbank is jumpy for other reasons.

With the recession deepening by the day, the conduct of monetary policy, and particularly the maintenance of confidence in the mark, has become more delicate. On the one hand, inflation will probably remain too high this year, averaging about 4 per cent, while the government's efforts to plug the holes in public spending look increasingly unsatisfactory, especially given the prospect of continued sharply rising unemployment. On the other hand, the misery of manufacturing industry cries out for rapid and sharp reductions in interest rates. In judging the balance, the Bundesbank is constantly trying to gauge just how thin confidence in the mark might be. At present nearly all the funds that have left Germany for Luxembourg have been put back into mark equity and bond funds.

But there is something psychologically disconcerting for the Bundesbank about such massive mark amounts being played with over the border. The central bank would far prefer to have its potential speculators within arm's reach.

Greater pressure So the pressure from Germany on Luxembourg has increased. The aggressive advertising virtually dried up after Theo Waigel, the Finance Minister, leant heavily on the German banks. Jacques Santer, Luxembourg's Prime Minister, asked his banks to refrain from drawing excessive attention to the discretion and the high degree of security offered by the Grand Duchy. This has not stopped Luxembourg's Banque Continentale from recently starting a campaign along Germany's high- speed ICE rail routes so that business travellers stopping briefly at stations can see a large hoarding with the message: Luxembourg, 7.5 per cent.

Franz Klein, president of the Federal Finance Court, said yesterday that Luxembourg will soon be forced to introduce a withholding tax of its own because other countries, notably Germany and France, will not tolerate the status quo. Indeed, the Germans have said they will press the point when EC finance ministers meet in Denmark in May. This fervour comes from the same Theo Waigel whose first act upon becoming Finance Minister was to abolish withholding tax. He was later forced to re-introduce it, much to his chagrin, by a German constitutional court ruling based on tax equality.

Luxembourg, unsurprisingly, is not prepared to see this new business snatched away without a struggle. Harmonisation has become their buzzword too. 'We shall only support an EC withholding tax when it covers all of western Europe, including Austria, Switzerland and such exotic tax havens as the British Channel Islands,' said Jean Claude Juncker, Finance Minister.

So we may yet see Theo Waigel and Helmut Schlesinger joining ranks with French fishermen in besieging St Peter-Port, Guernsey.