During the late 1980’s and early 1990s, the Government of the Lao P.D.R adopted many important policies, including the one widely known by the international community as the New Economic Mechanism (NEM), to transform the country towards a more market-oriented economy. The NEM has received important support from the international community including the Bretton Woods institutions, the Asian Development Bank, the UNDP and bilateral donors. In the first half of the 1990s, real GDP growth averaged 7–8 percent, per capita income increased significantly, and inflation remained largely in single-digits.
The Government also adopted an open door policy in 1988. This policy was supported by the adoption and the promulgation of the Foreign Investment Law in that year. Since then, foreign investment has played a critical role in the Lao economy. The main activities the foreign investors have engaged in so far, besides the hydropower, are the garment manufacturing industry, telecommunications and the wood product industry. The Government has given top priority to develop hydropower projects for export, including Nam Theun 2 that has a great potential for contributing to economic growth in the medium-and long term.
Recent economic development and macro-economic prospects
The latest estimate of the GDP growth rate in 2001 was 5.7 percent, which was in line with the Fund staffs estimate, due to the sluggish global economic situation. However, the economic developments in the first quarter of 2002 have generally been favorable. The salient areas of buoyant economic activity so far are: stronger external demand, a pick up in construction activity, and a renewed domestic and foreign investment.
The ongoing reforms of the foreign investment framework have attracted new foreign investment in telecommunications, manufacturing, mining and aviation. An Australian mining company, with an IFC loan of US$30 million, is exploring gold and copper ores in the Southern part of Lao P.D.R. In addition, Millicom, a Swedish company, has invested in mobile phones.
The Bank of the Lao P.D.R (BOL) has managed to contain average inflation for the seven months of 2002 at 7.99 percent. Since September 2001, the exchange rate has remained broadly stable against the US dollar.
The macro-economic outlook for 2002 is expected to reflect a pickup in regional activity and investment. Real GDP growth is expected to increase to about 6.0 percent in 2002 and the CPI inflation is expected to decline to 6 percent by end-2002. The current account deficit (including official transfers) is expected to be about 3.15 percent of GDP, due to stronger net exports. Gross official international reserves are expected to reach 2.5 months of import coverage.
While net credit to the government was under the March 2002 ceiling, revenue performance remains weak and the budget situation remains fragile. Owing largely to weaker than expected profits and turnover taxes, timber and hydropower royalties and dividends, revenue (excluding grants) for the first half of 2001/02 was five percent less compared to last year’s achievement. However, current expenditures are broadly in line with seasonal patterns, and end-March 2002 bank financing ceiling was met by containing expenditures to only 27 percent of the program target.
During the second half of the fiscal year 2001/02, the Government will enhance the revenue collection by focusing on large taxpayers, especially on indirect taxes. The Government will further restrain expenditure where they can, to compensate for budget slippages in June and July. They also intend to step up the clearance of the budget arrears, especially the arrears on capital expenditures, which will be financed by government securities. In addition, in order to limit the recent BOL financing of the budget, the Government will sell the government securities in the amount of Kip 15 billion in August and September to offset the amount of BOL financing of the budget in the preceding month.
For the 2002/03 budget, the government will do its best to avoid government arrears to the construction enterprises, which have led to non-performing loans in the banks. To facilitate the process, the Government will prepare realistic revenue projections on the basis of the most likely outcome of revenue collection. To increase the revenue, the Government will strengthen tax administration by (i) reinforcing the central tax department; (ii) reorganizing the tax and customs departments on a functional basis; and (iii) integrating large provincial customs offices into the national administration. In addition, the Government will adjust the tax policy and curtail ad hoc exemptions and rate reductions to raise additional revenue to maintain future budget outcomes on a sustainable path. Preparations for the introduction of a VAT have begun and will be accelerated in 2002/03, including through continued improvements in administrative systems.
On the expenditure side, the Government is committed to strengthen public expenditure management reform and has requested technical assistance from the IMF in this regard. This assistance will focus on strengthening the treasury and budget management systems, and linking them to accounting and capacity building.
Monetary and exchange rate policy
Monetary developments through end-March 2002 were generally consistent with the program. The ceiling on the net domestic assets (NDA) of the BOL was observed, reflecting improved control on budget financing and the sharp reduction in the BOL credit to banks. In addition, stronger export growth and restrained monetary policy enabled gross international reserves to reach 2.5 months of import coverage, enabling the target for net international reserves to be met. However, after being restrained in 2001, the net domestic assets of state-owned commercial banks (SCBs) grew substantially in late 2001 and early 2002, due to expansion in other net items related to irregular lending, while formal credit grew moderately. As a result, the ceiling on NDA of the SCBs for March was not met.
In the remaining period of 2002, the monetary policy will continue to be tight in order to reduce the inflation rate to the target of 6 percent by end-2002. In response to the recent rise of inflation, the BOL, in July, increased the required reserve from 6 percent to 8 percent for Kip liability deposits and from 12 percent to 15 percent for foreign currency liability deposits. This measure was aimed to signal the banks to increase their interest rates and to act as an indicator to the banks to reduce their lending and bring net domestic assets back under the program ceiling.
The exchange rate policy will remain flexible, by allowing the banks’ rate to adjust so as to maintain the margin with the parallel market rate at less than 2 percent. The Government has issued higher denomination notes of Kipl0,000 and Kip 20,000 in late June this year to facilitate financial transactions. As a result, the use of Kip as a medium of exchange by the general public is increasing. The resulting psychological effect has led the Kip to slightly depreciate. The authorities have taken measures and are closely monitoring this development.
Financial sector reform
By end May 2002, the authorities completed the draft of Restructuring and Business Plans (RBPs), including performance targets of the SCBs. The RBPs are formulated in conjunction with the conditionality under the current PRGF and the recently approved Financial Management Adjustment Credit (FMAC) of the World Bank (WB) and the Asian Development Bank’s proposed Banking Sector Reform Program Loan (BSRPL).
As a result of the recent problem of NPL in Lao May Bank, the cost of bank restructuring, originally estimated at US$50 million for the cost of addressing the pre-2000 NPLs, has increased by US$14 million. To address this problem, the Government is developing a plan for upfront restructuring. This plan basically comprises the centralization of credit decisions at headquarters and limitation on new risk activities, including credit and contingent liabilities. Should the SCBs balance sheet and performance deteriorate further in the coming months, the pace of bank restructuring would be increased.
Assisted by an advisor from the Fund (MAE), bank supervision is being strengthened for the phased implementation of bank supervision regulations, focusing on those that affect credit quality. To promote competition and to improve banking services, the Government is considering allowing foreign banks to operate outside Vientiane in 2003. Under this plan, the minimum capital requirement for such banks would be gradually raised to $10 million.
Under the umbrella of the World Bank’s FMAC, the restructuring and the strengthening of the SCBs is being closely coordinated with the reform of key large SOEs. The SOEs reform includes (i) restructuring of the largest SOE debtors to support the recovery of NPLs by banks (Pharmaceutical Factory No. 3; Phoudoi and DAFI conglomerates); and Lao Aviation; (ii) enhancing oversight and accountability of SOEs; and (iii) strengthening the financial position of key utility companies through further tariff increases to achieve cost recovery in 2003 for Nam Papa and Lao Aviation, and slightly later for EDL.
Trade and exchange system reform
The Government is committed to reform the trade system to support the development effort of the economy. Since October 11, 2001, import and export procedures have been further simplified. Within indicative annual import plans proposed by importers at the start of the year, all goods can be freely imported by making declarations at the customs point, except for six product groups subject to quantitative restrictions (fuel, vehicles, cement, steel bars, sugar, and fertilizers), and those restricted for health and security reasons. Looking ahead, the Government will remove sugar and fertilizers from the list of controlled goods by end 2002. In addition to the requirements related to the accession of the World Trade Organization (WTO), the Government will continue to liberalize their trade regime based on their commitments to the ASEAN Free Trade Agreement (AFTA).
The new Foreign Exchange Decree Law, which aims at providing a more efficient foreign exchange system, is expected to be promulgated in the near future. To pave the way for accepting the obligations under Article VIII, the Government will request technical assistance from the IMF to review the foreign exchange system under the new Foreign Exchange Decree Law.
External debt management
In view of the Lao P.D.R’s limited debt -servicing capacity, the Government will maintain a prudent debt management policy. The authorities will limit the contracting or guaranteeing of new nonconcessional external debt. Consistent with this policy, the authorities are in the process of renegotiating the borrowings from Exim Bank of China for EDL’s Nam Mang 3 hydroelectric project, and at the same time try to reduce the project costs and improve environmental and social safeguards. Since the completion of the negotiation could not be expected until after end September 2002, the Government will examine the consistency of the outcome with the debt policy in the third review of the PRGF arrangement. In addition, the authorities will continue to upgrade the capability of the Ministry of Finance to monitor closely the external borrowings made by SOEs. In a renewed attempt to resolve our outstanding debt with the Russian Federation, the Government has invited a Russian delegation to visit Vientiane in the near future.
The weaknesses in internal audit and control systems of the BOL, as identified in the Stage One Safeguards Assessment Report, are being addressed. In April, a high level review was undertaken, based on a report by an expert from the Bundesbank. The report that recommended the necessary improvements over the next few months was forwarded to the Fund in June. In the meantime, the National Audit Office has begun the audit of the BOL’s 2001 accounts in accordance with international auditing standards and will prepare pro-forma statements in accordance with international accounting standards. This process was assisted by an international accounting firm. The results will be available by end-August 2002 and will be published by end-September 2002 as scheduled.
Poverty reduction strategy
Progress has been made in the preparations of PRSP as described in the PRSP Status Report. To foster the participatory process, the Government held a workshop on the PRSP in April 2002, which included government officials from line ministries and members of mass organizations. The outcome of these discussions will be used in the preparation of the Government’s National Poverty Eradication Plan (NPEP), which will be fully consistent with the requirements of PRSP. However, significant technical and resource constraints prevent the authorities from completing the PRSP by end August 2002 and the authorities are aiming to finalize the NPEP by early 2003.
The Government will review the prospects for participating in the IMF’s General Data Dissemination System (GDDS) as a means of enhancing statistical development, based on the recommendations of the IMF’s Statistics Department.
The Lao authorities continue to maintain macroeconomic stability despite numerous resource constraints within the country. They remain committed to implement all necessary measures under the conditionalities of the PRGF arrangement. They are hopeful that their request for the completion of the second review under the arrangement, and waivers for the nonobservance of the NDA ceiling for SCBs and the provisioning by banks, will be supported by the Board. Finally, they hereby wish to express gratitude and appreciation once again to the Board and the Management of the Fund for the continued support to the Lao PDR in the poverty reduction process in their country.