I Introduction and Summary

Ichiro Otani, and Chi Pham
Published Date:
May 1996
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This paper assesses the experience of the Lao People's Democratic Republic (P.D.R.)1 with systemic transformation during 1989—94; when the IMF provided financial support under the structural adjustment facility (SAF) and the enhanced structural adjustment facility (ESAF), and highlights challenges that the country is likely to face in the coming years in conducting macroeconomic management and making further progress in structural reforms. In this connection, the paper provides brief background information on the country's political history and economic developments during the period preceding the systemic transformation, with a view to contributing to a better understanding of the Lao experience with systemic transformation against its unique historical and political background.

Following a protracted civil war lasting two decades (1955–74), the Lao P.D.R. was declared in 1975, replacing the earlier monarchy, and a centrally planned economy was established. Although some private sector activity was maintained, the economic system was highly regulated. Farmgate prices and trade in agricultural products were administratively determined. Trade among provinces was restricted, and food coupons for public employees were usable only in state shops. In addition, the industrial sector—producing less than 15 percent of GDP—was largely composed of state-owned enterprises under the state planning system. These enterprises had to transfer annual targeted amounts to the budget, regardless of their financial performance, and often had to borrow heavily from the banking system to finance current operations.

The results were disappointing. Domestic price controls and tight restrictions on foreign trade led to the emergence of parallel markets for goods and foreign exchange. Meanwhile, a distorted incentive structure created supply shortages. Moreover, a lax monetary policy, which accommodated borrowing requirements of the state enterprises, fueled rapid inflation.

In 1979, in response to the disappointing economic performance, the Government started liberalizing trade and farmgate prices and depreciated the exchange rate. In 1985, the Government turned more decisively toward market-oriented polices under the system called the New Economic Mechanism (NEM). Public enterprises were given operating autonomy with regard to production levels, product mix, investment, employment, and wages. Agricultural procurement prices were freed, farmers began to receive payments in cash for their produce, and the state monopoly over the procurement and distribution of rice was terminated. Moreover, retail prices, except for certain public utilities and domestic air transportation, were liberalized. In addition, the private sector was authorized to participate in the production and distribution of most goods and services, while the scope of private and mixed enterprises in international trade was expanded. Finally, the exchange system was simplified, as multiple official exchange rates were unified at a level close to the parallel market rate.

During 1985–88, the Lao Government concentrated on further liberalizing prices and trade, both domestic and external, so that production, consumption, and investment decisions by economic agents could be increasingly based on market signals and private incentives. During 1989—91, the Government focused on establishing macroeconomic stability by tightening credit and increasing budgetary control. During 1992–94, while continuing a fairly light monetary policy, the Government placed more emphasis on fiscal adjustment through both revenue-enhancing and expenditure-containing measures. At the same time, structural reforms were accentuated, notably in the areas of (i) banking, including the development of monetary instruments; (ii) privatization: (iii) trade liberalization: and (iv) improvement of the legal and regulatory framework to meet the needs of the emerging private sector. Table 1 summarizes the structural reform and policy measures implemented during the 1985–94 period.

Table 1.Chronology of Structural Reforms and Economic Policy Measures, 1985–94
I. Production, Distribution, and Prices
Autonomy granted to public enterprises to determine production levels and product mix, investment, employment, and wages.1985–88
Government procurement prices freed.Mid-87
Most retail prices freed.10/88
Internal trade liberalized.1986–87
Private sector authorized to participate in producing and distributing most goods and services.1987–88
Private sector rights, including long-term land rental, autonomy of private firms, and the retention of after-tax profits, established.3/88
First state-owned enterprise—a steel metal factory—privatized through leasing.5/89
Decrees on arbitration, bankruptcy, and secured transactions enacted.7–10/94
Privatization of 60 state-owned enterprises.1989–94
II. Budgetary Policies
First major tax reform enacted, including (i) replacement of state-owned enterprises' transfers to the budget with profit and turnover taxes; (ii) establishment of profit tax on manufacturing in the 20–85 percent range; (iii) establishment of turnover tax on service enterprises in the 1–15 percent range; (iv) introduction of taxes on export profits in the 50—80 percent range; and (v) reduction of maximum import tax rate from 200 percent to 70 percent.3/88
Log export tax introduced.3/89
Second major tax reform, aimed at correcting design problems of the first, implemented. It included (i) replacement of export tax on gross income with specific export taxes applied to selected exports (timber, animals, and certain scrap metals) and an ad valorem tax at 80 percent on electricity exports; (ii) unification of multiple corporate income tax at 45 percent for nonbank enterprises and 60 percent for banks; (iii) introduction of turnover tax on services, wholesale trade, and imports, with five rates in the 3–20 percent range; (iv) extension of personal income tax to all salaried workers, including civil servants, with a progressive schedule in the 2–30 percent range; (v) introduction of specific ad valorem taxes on exploitation of natural resources; and (vi) introduction of land tax on nonagricultural land.6/89
Permanent unit established at Ministry of Economy to monitor budgetary revenues.6/90
Number of turnover tax rates in the 5–10 percent range reduced from five to two.2/91
Excise taxes on petroleum products and luxury goods introduced.2/91
Registration tax introduced.9/91
Timber royalties restructured.10/92
Land tax on agricultural and urban land replaced agriculture tax.12/92
Minimum profit tax (approved in February 1991) implemented at 1.5 percent of turnover.1/93
Export tax on agricultural products eliminated.6/94
National registry of enterprises established for tax collection purposes.6/94
Granting of “special conventions” in lieu of regular tariff payments terminated.8/94
Number of import tariff bands reduced from 11 to 6, with rates in the 5–40 percent range, plus exceptional rates.1/95
Fiscal Management
Expenditure priorities reordered, including elimination of consumer subsidies and subsidies to civil servants and autonomous enterprises.3/89
1989 budget ratified by the first elected Supreme People's Assembly.6/89
Fiscal centralization adopted, and central and provincial budgets consolidated into a general government budget.8/91
National Treasury established.8/91
1992 budget submitted consistent with framework of centralization and treasury appropriation.3/92
Revised treasury accounting system adopted.6/94
Budget Law defining steps for budget preparation approved.7/94
III. Financial Sector Policies
Two-tier banking system initiated with separation of central bank and commercial banking functions of the State Bank.3/88
Two branches of State Bank transformed into independent commercial banks (Sethathirath Bank and Nakhoneluang Bank).10/88
Preferential interest rates for public corporations and state cooperatives eliminated.10/88
Interest rates on deposits increased from 5.4–15 percent to 7.2–18 percent.10/88
Short-term lending rates increased from 4.2–8.4 percent to 10–15 percent.10/88
Long-term lending rates increased from 3.0–4.2 percent to 6–10 percent.10/88
New deposit and loan instruments introduced on which commercial banks can set interest rates subject to a ceiling of 12.5 percent a month on deposits and 15 percent a month on loans.10/88
Improved monetary data reporting format introduced.2/89
Actual deposit rate paid on new instruments increased from 3 percent a month to 5 1/2 percent; lending rate increased from 6 percent a month to 6–7 percent.5/89
State Bank granted sole right to determine and manage the official exchange rate for foreign exchange on the basis of transactions in foreign exchange markets.7/89
Market determination policy established for interest rates. Interest rates should be higher than inflation, loan rates should exceed deposit rates, and long-term deposit rates should exceed short-term rates.7/89
Use and issuance of checks at State Bank and commercial banks inaugurated.8/89
Interest payments permitted on foreign currency deposits at banks.10/89
Joint Development Bank established (30 percent ownership by Lao Government and 70 percent ownership by Thai investors).10/89
Banque pour le Commerce Extéríeur Lao granted independence from State Bank.11/89
Government bonds issued with State Bank as issuing agent.1/90
Pak Tai Bank established, with offices in Champassak, Saravane, Xekong, and Attopeu.4/90
Central Bank Law approved establishing Bank of the Lao P.D.R. as central bank.6/90
National currency (kip) used for all domestic transactions; guidelines for foreign exchange transactions implemented.9/90
Lao May Bank established.9/90
First privately owned licensed foreign exchange dealer opened.1/91
Lane Xang Bank established.2/91
Aroun May Bank established.9/91
Bonds issued by Bank of the Lao P.D.R.11/91
Rules governing operations of commercial banks and credit cooperatives established.1/92
Credit window opened to commercial banks for short-term credit at Bank of the Lao P.D.R.1/92
Recapitalization of six state-owned commercial banks completed by replacing nonperforming loans worth KN 18 billion with a cash infusion (KN 4 billion) and treasury bills (KN 14 billion).9/94
IV. External Sector Policies
New exchange rates introduced for private transactions; commercial exchange rate at which most official transactions took place devalued.10/85
State monopoly on trade in most goods eliminated; permission to import granted to mixed and private companies.1985–88
Exchange rates further devalued; number of rates reduced from seven to four.9/87
Official exchange rate adjusted in line with movements in parallel market rate.9/87
Exchange rates unified at level close to parallel market rate.1/88
Import tariff rates reduced.3/88
New foreign investment law explicitly allowing profit and capital repatriation adopted.7/88
New Foreign Investment Code promulgated.7/88
Spread between official and private rates reduced to below 10 percent even during2/89
temporary pressure on rate in parallel market.
Implementation guidelines for Foreign Investment Code issued.3/89
Restrictive practice arising from bilateral payments arrangement with two IMF member countries eliminated.5/89
Export quota on high-quality logs introduced.6/89
Difference between official and parallel market exchange rates reduced to 5 percent.6/90
List of strategic goods exportable only by state trading companies reduced. Nonbank foreign exchange dealers authorized; restrictions on foreign exchange holdings removed; and foreign exchange surrender requirements eliminated.9/90
Bilateral payment arrangements with former CMEA countries eliminated.1990–91
Quantitative restrictions and specific licensing requirements for most goods eliminated.2/91
New customs code with revised tariff rates adopted.2/91
New foreign investment code adopted.3/94
New customs law adopted; tariff structure further simplified.1994–95
V. Civil Service Reform
Civil service employment rationalized.1988–89
Civil service reform process begun with goal of reducing overall cost and upgrading quality of civil service.Late 89
Freeze placed on new hiring.11/92
Major salary reform implemented revamping salary structure and reclassifying personnel in accordance with qualifications.4/94

Despite the progress achieved so far, several structural bottlenecks continue to hamper the full development of the country's economic potential. First, because of the low domestic resource mobilization, the country is still heavily dependent on external assistance. Second, the narrow production and export base—with export earnings depending mainly on electricity, garments, and timber and wood products—makes the economy vulnerable to external shocks and limits development prospects. Third, acute absorptive capacity problems delay the buildup of social and physical infrastructure. Fourth, the early fruits of economic development have remained concentrated in urban centers and have not reached the rural areas, where poverty is still pervasive. (See Box 1 for a discussion of poverty and social issues in the Lao P.D.R.)

Box I.Poverty and Social Issues

As is to be expected in an economy with a per capita income of only about $350, a large rural sector, and weak infrastructure, poverty is widespread in the Lao P.D.R. According to the preliminary result of an extensive expenditure and consumption survey conducted in 1992 and 1993, roughly half the population lives in or near poverty, with a somewhat higher occurrence in the south than in the north, and with a much higher incidence in the rural sector than in urban centers.

Given the limited resources available for improving social infrastructure, government spending on education and health has been very low in the past. Total per capita expenditure on education and health in the 1994/95 budget reached just $15 and $6, respectively, which is among the lowest in the region. The longstanding underfunding of health and education is clearly mirrored in poor levels of key social indicators. While the Government's “education for all” policies—launched in the late 1980s with support from the Asian Development Bank, the World Bank, and bilateral donors—have made some headway in reducing adult illiteracy, in particular among younger females, the overall rate is still high by international standards, at an estimated 36 percent of the adult population. In the health area, some progress was also made as the infant mortality rate continued to decline over the past decade. However, both child and maternal mortality rates have remained stubbornly high, partly reflecting malnutrition and, particularly in remote areas, limited access to health services. To reach the standards of neighboring countries, much more needs to be done. A comprehensive strategy to address the situation remains to be formulated, awaiting the findings of the World Bank's social sector review. Meanwhile, the Government continues to reorient public spending toward the development of human resources. As is evident also from the latest rolling public investment program covering the period 1995–2000, its efforts focus on increasing central government allocations on social services and, with a view to improving delivery to rural areas, on physical infrastructure. Another government aim under this program is to improve recurrent financing of the social sector at the provincial level.

The rest of the paper is organized as follows. Section II provides a brief historic description of political and economic developments through the late 1980s, emphasizing the essential geopolitical features of the country and the rich cultural heritage of its people, and highlighting experience with the reforms during 1979–88. The main finding of the section is that the process of liberalization started in 1979 and continued with the important reforms under the NEM, making the Lao P.D.R. one of the earliest systemic reformers among the former centrally planned economies.

Section III summarizes the main economic objectives and policies under the two subsequent medium-term adjustment programs supported by the SAP and the ESAF, respectively, during 1989–94. These policies represented a major overhaul of the economic system, affecting virtually all sectors of economic activity; they were successful in their aim of shifting the economy to reliance on market mechanisms.

Section IV reviews experience with controlling inflation during 1989–94. The sources of inflationary pressures in the early period and the policy response, in particular the successful implementation of monetary policy, are highlighted. The section also notes that, as inflation was reduced and monetary aggregates brought under control, new instruments of indirect monetary management were introduced, and steps to modernize the financial system were taken.

Section V shows that one of the main results of economic liberalization was to enhance the country's outward orientation. Trade reform, a liberal foreign exchange system, and a stable exchange rate have together contributed to the opening of new export markets.

Section VI discusses experience with fiscal adjustment during 1988–94, noting an early apparent success in fiscal consolidation in the early 1990s. However, the section points to some weaknesses in the consolidation process, particularly those related to patterns of revenue mobilization and the large wage bill.

Section VII notes that, as the economic liberalization progressed, the Government recognized in the late 1980s the urgent need to reduce public sector involvement in state-owned enterprises. The section also describes the Lao P.D.R.'s experience with privatization, including the nature of the public enterprises being privatized and the privatization methods adopted. In addition, the section argues that, despite some success, problems arose from the reliance on leasing as a dominant form of privatization and from the lack of a well-defined strategy.

Section VIII assesses the past reform efforts, underscoring the factors that have contributed to the promotion, as well as the hindrance, of the reform process. This section also identifies major areas of systemic reform that require significant efforts by the Government, thus highlighting the major challenges that the Government will face in the coming years.

This paper is also accompanied by five appendices, providing detailed discussions on (i) real exchange rate movements and external competitiveness; (ii) experience with foreign direct investment; (iii) the process of legal and constitutional reform; (iv) the structure of the tax system; and (v) the Government's policy agenda in the second half of the 1990s.

Formally known as Laos before December 2, 1975.

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