Chapter

III Recent Macroeconomic Performance and Structural Reforms

Author(s):
Ichiro Otani, and Chi Pham
Published Date:
May 1996
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Against the background summarized in the previous subsection, the Government adopted a major medium-term adjustment program in 1989, followed by another in 1993. This section summarizes the main objectives and reform strategy pursued during the period 1989—94, as well as the performance of the Lao Government under the programs. Sections IV-VII examine in greater detail economic developments in each of the major policy and reform areas.

First Medium-Term Structural Adjustment Program (1989–92)

Objectives and Reform Strategy

In mid-1989, the Government resumed a medium-term adjustment program with support under the IMF's structural adjustment facility (SAF) and a World Bank structural adjustment credit, with the objective of establishing domestic and external financial stability while implementing the structural reforms. Specifically, the program aimed to (i) achieve an average annual rate of real GDP growth of 5–6 percent: (ii) reduce the rate of inflation by 1992 to that prevailing in major trading partner countries (about 5–6 percent); and (iii) make progress toward balance of payments viability.

The 1989–92 program was framed to tackle a wide range of issues. To promote production, the program envisaged an improvement in producer incentives, accompanied by actions to rehabilitate productive enterprises and improve the socioeconomic infrastructure. In this connection, private sector investment was promoted by privatizing state-owned enterprises and introducing a legal framework for foreign direct investment, while public sector investment was undertaken by the Government with assistance from the donor community. The increased investment was to be financed by additional foreign resources and expanded public and private sector savings. To enhance domestic resource mobilization, the tax system was to be reformed, the finances of public enterprises improved, and financial sector reform initiated. To restrain demand pressures, the program emphasized the need to adopt cautious demand-management policies that entailed the elimination of bank borrowing by the Government and the curtailment of credit to state enterprises. Finally, to strengthen the external position, the exchange rate was to be managed flexibly, the trade and payments system further liberalized, and the contracting of new nonconcessional external debt strictly limited.

Policies and Performance

Macroeconomic Policies

With a view to achieving the medium-term macro-economic objectives, the Government initiated a number of steps in macroeconomic policy areas. In the fiscal area, a fundamental reform of the tax system was begun to reflect the increased autonomy of state-owned enterprises, equalize tax treatment between the public and private sectors, and introduce tax incentives for foreign investment. On the expenditure side, priorities were substantially reordered. In particular, consumer subsidies and subsidies to civil servants and to enterprises were eliminated. The role of monetary policy was confined to limiting the state-owned enterprises' demand for credit and credit expansion by the banking system. In the external area, the official exchange rate was set generally at a rate close to the parallel market rate, while the trading system was rationalized further.

Macroeconomic Performance

A strong recovery of rice and electricity production in 1989 from earlier drought-stricken levels was followed by continued buoyant growth, apart from a small drop in rice production in 1991. At the same time, the relatively small construction and manufacturing sectors witnessed strong growth as domestic and foreign investors responded to the new opportunities opened up by the reforms. The pickup in output growth, along with the tightening of financial policies, brought about a dramatic reduction in the inflation rate (end-of-period basis) from about 82 percent in 1989 to about 10 percent in 1991. The rate fell further to about 6 percent in 1992, largely reflecting the continued pursuit of prudent demand-management policies and a bumper harvest. This improvement occurred despite a large increase in electricity tariffs and rents during the year (Table 3 and Chart 2).

Chart 2.Overall Macroeconomic Performance

Sources; Lao authorities; and IMF staff estimates.

1Excluding official transfers.

2Gross reserves of the banking system.

3Excluding grants.

Table 3.Economic and Financial Indicators
1985198619871988198919901991199219931994
(Annual percent change, unless otherwise specified)
National income and prices
Real GDP6.99.2-2.9-0.714.36.74.07.06.18.4
Agriculture7.49.4-1.9-4.210.88.7-1.78.32.77.6
Industry12.06.6-16.0-2.435.016.219.97.510.38.7
Real GDP per capita4.06.2-5.6-3.511.03.71.04.03.15.3
Nominal GDP (in billions of kip)761242102354276137228489861,159
Consumer price index (annual average)106.037.16.014.459.535.713.49.86.36.7
Consumer price index (end of period)136.815.09.813.082.117.710.46.09.06.8
External sector
Exports, f.o.b.22.42.612.9-6.99.524.322.737.375.223.3
Imports, c.i.f.19.3-3.916.4-24.929.7-4.36.623.554.630.6
Nominal effective exchange rate-2.8-57.8-2.1-69.6-37.3-17.71.5-3.5-0.92.6
Real effective exchange rate92.7-42.21.8-72.818.49.710.02.01.23.9
Kip per U.S. dollar (end of period)
Official exchange rate9595368453714696712717716719
Parallel market rate339423388412628735721737732729
Government budget1
Revenue and grants91.064.35.893.127.460.127.817.426.530.6
Total expenditure134.235.111.2154.341.834.85.314.811.138.5
Current129.156.68.375.042.474.917.323.19.520.5
Capital139.215.214.9248.741.410.7-6.15.013.262.9
Money and credit2
Net domestic assets15.782.636.229.84.57.626.238.933.044.2
Broad money35.670.079.037.189.77.515.849.064.631.9
Velocity (GDP/broad money at year end)33.132.113.210.810.413.814.111.17.88.1
(In percent of GDP)
Government budget1
Revenue and grants16.216.210.217.512.313.714.814.816.117.9
Total expenditure26.021.314.132.024.923.420.920.419.523.0
Budgetary current balance1.13.01.90.2-1.0-1.5-1.0-1.00.90.8
Overall balance (cash basis)-12.4-6.5-4.5-19.6-16.6-14.4-11.3-11.7-7.8-11.0
External sector3
Current account balance4-5.6-6.9-9.8-13.7-15.8-9.0-4.3-3.5-2.2-4.7
External debt outstanding59.613.114.934.432.535.732.934.836.236.8
Debt service50.80.81.01.71.6111.20.80.70.7
(In percent of exports)6
External debt service5
Including IMF18.016.716.813.113.89.19.55.52.92.2
Excluding IMF4.97.311.18.611.37.68.84.72.72.1
(In millions of U.S. dollars)
External current account balance4-93.8-90.6-117.7-79.2-115.6-77.8-44.1-41.0-29.5-72.5
Overall balance of payments20.78.6-11.3-1.8-4.3-18.132.14.7I3.9-10.1
Gross international reserves7
(End of period)25.932.621.229.459.864.857.285.8150.9158.2
(Equivalent months of imports)61.92.11.22.23.43.93.23.94.43.5
Sources: Lao authorities; and IMF staff estimates.

Data from 1992 onward are adjusted to calendar-year basis from original fiscal-year (October-September) basis.

1987 data are partly adjusted for a major change in the valuation of foreign-exchange-denominated assets and liabilities.

Domestic currency values converted at official exchange rate (for commercial transactions). Data before and after 1988 are not entirely comparable, owing to massive realignment in the context of the exchange rate unification.

Including official transfers.

Excluding debt to the nonconvertible area.

Exports of goods and nonfactor services.

Including foreign exchange holdings of the banking system.

Sources: Lao authorities; and IMF staff estimates.

Data from 1992 onward are adjusted to calendar-year basis from original fiscal-year (October-September) basis.

1987 data are partly adjusted for a major change in the valuation of foreign-exchange-denominated assets and liabilities.

Domestic currency values converted at official exchange rate (for commercial transactions). Data before and after 1988 are not entirely comparable, owing to massive realignment in the context of the exchange rate unification.

Including official transfers.

Excluding debt to the nonconvertible area.

Exports of goods and nonfactor services.

Including foreign exchange holdings of the banking system.

The external position strengthened considerably during 1989–92. Early on, export receipts were boosted by a rebound in electricity sales to Thailand and growing timber earnings, and, in 1992, by a strong growth in garment exports. With buoyant exports and a slowdown in import growth (owing to tighter domestic financial policies and the underim—plementation of capital expenditure), as well as higher private transfer flows attracted by a renewed confidence in the Government's policies, the current account deficit contracted by 2 percentage points of GDP. At the same time, stepped-up aid inflows from multilateral and bilateral donors more than offset the sudden loss in 1991 of financial assistance from the former Soviet Union. Although the overall balance shifted into deficit in 1991 as a result of temporary delays in program loan disbursements, a surplus position was restored in 1992. Gross foreign reserves of the banking system almost quintupled from $17 million at the end of 1988 to about $80 million at the end of 1992, equivalent to four-and-a-half months of total imports, although official reserves remained at only two months of imports. The increasing proportion of highly concessional debt and the improvement in exports facilitated a decline in the debt-service ratio from 20 percent in 1988 to under 15 percent in 1992.

Structural and Institutional Reforms

Agricultural decollectivization and price liberalization were the most important structural reforms introduced because they permitted a long-overdue adjustment of relative prices in favor of agricultural products. Also, contractual and leasing systems affecting land tenure were introduced.

Financial sector reform entailed the establishment of a two-tier banking system in June 1990, with the promulgation of the Central Bank Law establishing the Bank of the Lao P.D.R. as successor to the old State Bank. The central bank's instruments of monetary management were expanded gradually over 1989–92. During this period, the extension of banking services and improved management of commercial banks bolstered confidence in the banking system and were instrumental in mobilizing domestic savings, increasing financial intermediation, and attracting foreign capital.

State enterprise reform, together with privatization, required hard budget constraints on enterprises (which had previously monopolized bank credit) and severed the link between enterprises and the budget. In 1989, the Government announced its plan to privatize all but about a dozen strategic state enterprises.8 During 1989–90, several enterprises were privatized on an ad hoc basis without sufficient regard to maximizing financial returns. Drawing on the lessons of that experience, a wider program of privatization, involving leasing arrangements, auctions, joint ventures, and improved bidding procedures, was adopted in 1991. Divestiture was rapid at the provincial level, with some larger provinces divesting (in many cases through sales to workers) over two thirds of the small enterprises under their jurisdiction; even though the privatization procedures adopted were less than optimal, this still represented significant progress. However, only limited progress was made in privatizing large and medium-sized state enterprises, where the procedural and administrative problems and the shortage of trained staff seriously hampered negotiations with foreign investors.

In the external area, the authorities built upon actions that had already yielded considerable benefits by further liberalizing the foreign trade system and the foreign investment regime. All exports and imports other than those on specified lists were freed from quantitative restrictions. As of the end of 1992, only timber exports remained subject to quantitative restrictions (for environmental reasons), and only imports of rice and certain types of motor vehicles still required quantitative licensing.

The Government also made some progress in institution building, although it was constrained by the lack of skilled staff and administrative delays. An important action was the promulgation of a new Constitution in August 1991, the first since 1975, which laid the foundation for the adoption of various business laws and important changes in the regulatory framework. The drafts of a number of such laws were prepared but still await enactment. In addition, the Government launched a major administrative reform in early 1992 aimed at streamlining decision making and reducing staffing, but progress has been slow.

Second Medium-Term Structural Adjustment Program (1993–95)

Objectives and Reform Strategy

The objectives and basic strategy embodied in the first medium-term adjustment program for the period 1989–92 remained valid for the successor program, which was supported by arrangements under the IMF's enhanced structural adjustment facility (ESAF) covering the years 1993–95. Accordingly, the program aimed at maintaining high rates of growth and further improving financial stability, but the authorities also recognized the need to address several institutional weaknesses encountered during the first program period. To this end, reorienting public sector operations and completing the establishment of an effective, centralized system of fiscal management were made key priorities. Strong emphasis was also placed on advancing to more comprehensive and genuine forms of privatization, strengthening the commercial basis of the banking system, and building an adequate legal and regulatory framework.

Policies and Performance

Macroeconomic Policies

Not surprisingly, given that the thrust of macro-economic policies during the ESAF arrangement period remained broadly unchanged from that during the SAF arrangement period, the Government continued to pursue macroeconomic policies characterized by a cautious, demand-management approach. Against this background, the Government aimed at further mobilizing domestic savings during 1993–94, mainly by achieving a net saving from the government sector (compared with a net dissaving over the SAF arrangement period). Accordingly, the Government took further revenue measures and contained current spending. At the same time, the authorities maintained a relatively tight monetary policy by keeping real interest rates substantially positive. These cautious financial policies supported the stability of the nominal exchange rate.

Macroeconomic Performance

Macroeconomic performance during 1993–94 was, on the whole, again remarkable. Despite a weather-induced shortfall in agricultural production in 1993, real growth averaged about 7 percent during 1993–94. Broad money growth surged temporarily to about 65 percent during 1993 before falling to 32 percent during 1994. Owing to a considerable decline in velocity, which reflected rising real rates of interest and increasing confidence in the banking system following the opening of several foreign banks, inflation settled at about 6½ percent in both 1993 and 1994. Fiscal performance remained mixed during the period, as bottlenecks continued to weaken administrative capacity, but the external sector performed better than targeted in many areas as exports and foreign trade in general continued to grow strongly, foreign private capital inflows surged, and foreign assistance reached record levels.

Structural and Institutional Reforms

Considerable progress was again achieved in implementing structural reforms during 1993–94. The state enterprise sector, which in the Lao P.D.R. had never reached the significance that it had in many other former centrally planned economies, was rapidly reduced in size. As most of the enterprises were privatized through ad hoc leasing arrangements, the outstanding issue now remains to implement procedures for complete divestiture. In tackling the sensitive problem of further streamlining the bloated civil service, the authorities had to overcome a number of problems, including a disappointingly low rate of voluntary separation, poorly targeted incentives, and uncontrolled hiring at provincial levels. After a reclassification exercise in 1994 that downgraded a number of staff, especially in the higher echelons, the authorities began to identify redundant and unqualified staff for retrenchment. In the area of fiscal management, progress in strengthening administration remained limited. Revenues also fell short of expectations because newly introduced taxes, such as the land and registration taxes, were not immediately implemented and because ad hoc tax breaks were increasingly granted.

In contrast, substantial progress was made in reforming the financial sector. The opening of private sector banks during 1993–94 contributed to increased competition while the state-owned commercial banks were recapitalized in 1994. Additionally, with the commencement of regular treasury bill auctions and the opening in 1994 of a discount window, the central bank made further headway toward installing the instruments of indirect monetary management. Finally, the significant progress made in achieving external sector reform culminated in mid-1994 in the elimination of the last remaining restrictions on international current account transactions. To streamline customs administration, the Harmonized Commodity Description and Coding System was introduced in 1993, and, after the adoption of the Customs Law in late 1994, the Government approved for implementation in early 1995 a comprehensive tariff reform package that halved both the number of tariff bands and maximum rates while ending the practice of granting exemptions on an ad hoc basis. (Box 3 summarizes the reforms in trade taxation made from 1988 to 1995.)

Box 3.Trade Taxation

Prior to 1988, the system of trade taxation consisted of (i) an ad valorem import duty levied on the c.i.f. value of imports, ranging from 5 percent to 200 percent, with numerous exemptions; (ii) a turnover tax levied on imports of state enterprises and trading companies, ranging from 5 percent to 25 percent; and (iii) an export duty levied on the f.o.b. value of exports, ranging from 10 percent to 40 percent (the lower rates applied to private sector transactions), with a number of exemptions. The large number and wide dispersion of tariff rates, together with the then-existing system of multiple exchange rates, nonmarket price determination of trade with the CMEA, and proliferation of exemptions, implied a highly distorted system of incentives for external transactions. Initial steps to rationalize the system of trade taxation were undertaken in 1988–89. Direct export taxes were replaced in 1988 by a system of taxes on profits accruing from exported goods, at rates ranging from 2 percent to 8O percent. At the same time, maximum import duty rates were lowered from 200 percent to 70 percent. The unification of the official exchange rates unified prices in trade with the convertible area, although nonmarket prices continued to apply in trade with the nonconvertible area.

In 1989, a new customs code was adopted, together with a revised tariff structure, with 12 rates ranging from 2 percent to 80 percent. The customs code simplified and strengthened the legal framework for external transactions. However, fixed valuation prices were maintained for many goods, trade with the nonconvertible area remained subject to differential taxation, and the tariff regime was characterized by a myriad of discretionary exemptions that could be granted by various ministries and levels of government.

During 1993–94, the trade taxation system underwent further rationalization. Early in 1993, the Government replaced the taxation of export profits with a simplified system of royalties (applying primarily to timber and electricity). In 1994, the Government adopted a new Customs Law, which strengthened the commitment to a market-based system based on international norms. Significantly, the law formalized invoice-based valuation and adopted a strict definition of allowable exemptions, thereby eliminating the scope for discretionary policy.

In early 1995, the Government adopted a new tariff structure on the basis of the Harmonized Commodity Description and Coding System that had been introduced in 1993. The new tariff structure reduced the number of tariff bands from 12 to 6 and lowered the maximum rate from 80 percent to 40 percent (exceptional tariff rates above 40 percent were limited to three goods categories). The current tariff structure implies a low level of protection in comparison with other countries in the region. On a simple average basis, the average import duty in the Lao P.D.R. is 14 percent, while corresponding levels are 44 percent in Thailand, 12 percent in Vietnam, 20 percent in Cambodia, and 43 percent in China.

Subsequently (in 1995), the Government decided to keep 32 state enterprises in its hands.

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