V Exchange Rate Policy and Trade Liberalization

Ichiro Otani, and Chi Pham
Published Date:
May 1996
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Prior to 1985, when the Lao P.D.R, embarked on the new system of economic management, the exchange and trade regime was characterized by strong centralization. Trade operations were dominated by the state sector, where a small number of trading organizations and public firms held a monopoly on the bulk of exports and imports. The composition of trade was mainly determined by the Ministry of Commerce on the basis of national priorities, and foreign exchange was allocated according to planned needs through the central government budget or the BCEL. Exchange rates for official transactions were administratively determined and, in general, bore little relation to the scarcity value of foreign exchange. Market-oriented transactions were limited to the small private sector, which engaged in limited import and export operations and bought and sold foreign exchange on the parallel market, where rates were much more depreciated.

In addition, more than half of the volume of trade was accounted for by the nonconvertible area (primarily members of the Council for Mutual Economic Assistance (CMEA), and, in particular, the former Soviet Union). This trade was carried out on a bilateral clearing basis and was thus outside the system of exchange rates altogether.

On the Eve of Reform

During the early reform years 1986–87, trade arrangements were liberalized somewhat; the Lao authorities allowed the formation of joint-venture trade enterprises, the sociétés mixtes, which were permitted some autonomy in export and import operations. These enterprises were allowed to retain their foreign exchange earnings and were given access to official exchange markets at a rate closer to that prevailing in the parallel market. State exporting enterprises were also allowed greater retention of foreign exchange and broader access to import markets. As before, however, most trade remained firmly centralized; in particular, exports of a number of important “strategic” goods, undertaken primarily in fulfillment of trade contracts with the nonconvertible currency area, continued to be reserved for state trading companies.

Initial reform efforts were accompanied by a proliferation of exchange rates; by 1987, external transactions were conducted at seven different rates, ranging from KN 35 per U.S. dollar and KN 95 per U.S. dollar for most official transactions to more than KN 450 per dollar for informal transactions through the parallel exchange market. This system was highly dislortionary, deterred exports for a number of goods, and gave rise to shortages of goods and their administrative rationing.

Given the tentative nature of the early reform measures, trade performance remained subdued during 1986–87. The total value of exports increased at an annual rate of 6 percent—roughly the same rate of growth as in the pre-reform years 1982—85—owing primarily to increased exports of wood and wood products. Imports were even more sluggish, growing at an annual rate of 3½ percent during the same period.

Exchange Reforms and Exchange Rate Policy After 1987

Exchange Market Reforms

In order to stimulate exports, increase the share of foreign exchange transactions occurring at market rates, and channel a larger proportion of transactions through the emerging banking system, the Lao authorities began a dramatic reform of the exchange regime in late 1987.

The system of multiple exchange rates was eliminated, and a new, unified official rate was established at the beginning of 1988. The initial rates (KN 350 per U.S. dollar for buying and KN 380 per U.S. dollar for selling) were set close to the rates prevailing in the parallel market, representing a devaluation of nearly 400 percent for transactions of state enterprises (which were responsible for more than two thirds of the total trade volume) and lesser devaluations for private remittances and certain commercial transactions.

In tandem with the liberalization of trade (see below), the authorities also removed barriers to exchange market access in 1988. Virtually all current account transactions were freed,12 and exporting firms were allowed to retain their foreign exchange earnings. With the adoption of a new foreign investment law in mid-1988, restrictions on foreign investment inflows, outward profit remittances, and the repatriation of foreign investment capital were also lifted.13

Further exchange market reforms were undertaken in late 1990, when the Government authorized the establishment of nonbank foreign exchange dealers and lifted restrictions on residents holding bank accounts denominated in foreign currency.

Exchange Rate Policy

Following the unification of the official exchange rate of the kip in 1988, the central bank has maintained a “managed float,” adjusting the official rate broadly in line with the parallel market rate. Under this policy, the official rate was changed numerous times in 1988 and 1989, resulting in a cumulative depreciation of the nominal effective rate of nearly 50 percent. The difference between the official and the parallel rate for the U.S. dollar generally remained below 10 percent in domestic currency terms during this period (except during August—October 1989, when the differential widened to as much as 19 percent).

The exchange rate stabilized in late 1989 despite the continued high level of inflation; a slowdown in underlying monetary expansion, as well as substantial inflows of foreign exchange owing to the increased disbursement of external assistance, contributed to the achievement of this stability. From January 1990 through mid-1991, the authorities were able to revalue the official rate of the kip against the U.S. dollar, and the parallel rate also appreciated in nominal terms. From mid-1991 to the end of 1994, tight financial policies kept inflation down, and the Bank of the Lao P.D.R. maintained the official exchange rate at about KN 718 per U.S. dollar while accumulating foreign reserves. At the same time, liberal access to foreign exchange, together with a continued rise in the number of authorized banks and foreign exchange bureaus, minimized the difference between the parallel and the official exchange rates; the average spread was 2.7 percent in 1992 and less than 2 percent during 1993 and 1994.

Trade Liberalization and Performance After 1987

Trade Reforms

The partial trade reforms of 1986—87 were followed by a more fundamental liberalization of external transactions during 1989–90. In late 1989, the authorities widened the access of state and joint-venture firms to broad import licenses, which allowed the import of all but a small list of goods.14 Then, in 1990, permission to engage in nonstrategic import and export activity was granted to all firms, whether state or private. Eligibility criteria for trade operations were limited to a registration procedure, whereby a potential exporter or importer obtained a permit from the Ministry of Commerce.

At the same time, specific licensing and quantitative restrictions were lifted on all but a small number of products. Such licenses are required for imports of petroleum, cement, steel, automobiles, motorcycles, rice, and a few locally manufactured items, as well as for exports of timber, wood products, rattan, coffee, and livestock. In practice, quantitative restrictions apply primarily to limber exports and motor vehicle imports.15 In addition, the public sector monopoly on exports has been reduced to only two “strategic goods,” logs and minerals, which only specially authorized public enterprises and provincial trading companies are allowed to export. All other goods can be freely exported (with proper licenses) by the private sector.

Trade Performance

Continued domestic liberalization and growth, together with developments in trading partner countries, have led to enormous changes in the size and structure of external trade. Major developments have been the collapse in trade with the former Soviet Union and other former CMEA countries (which had previously accounted for one third to one half of total trade), and the tremendous growth in trade with the convertible area, led both by rising exports of primary products and by a surge in trade in domestic manufactures and imported consumer goods.

During 1988–90, in addition to the trade liberalization discussed above, there was a substantial shift in the direction of trade from the nonconvertible to the convertible currency area (Tables 6 and 7). The decision of the CMEA countries to discontinue providing their traditionally high levels of concessional financing led to a 50 percent decline in imports from the nonconvertible area from their peak in 1987. As a result, the trade deficit with the nonconvertible area declined from over $100 million in 1987 to $50 million in 1990.

This decline was offset by rapid growth in imports from the convertible area, which increased by 60 percent between 1987 and 1990 (Table 7). Much of this increase came from imports of petroleum, machinery, and raw materials, which were needed to make up for the decreased supply from the CMEA. In addition, imports of other categories (for example, consumers' goods) became more important during this period, reflecting the continued liberalization and the role of private importers in consumer goods trade. The trade deficit with the convertible area grew steadily from 1987 through 1990, financed to a large extent by the increased provision of aid and concessional lending.

The collapse of the CMEA in 1991 and the reorientation of the Eastern European economies toward market-based trade resulted not only in the termination of their bilateral trading agreements with the Lao P.D.R. but also in the complete disappearance of these markets for Lao exports and of financing for CMEA imports. As a consequence, total trade vis-à-vis the former nonconvertible area plummeted from over $90 million in 1990 to $4 million in 1992–94 (Tables 6 and 7); the latter figure comprises small amounts of coffee and metals that continue to be exported primarily to the former Soviet Union as payment for debt service. Thus, the withdrawal of CMEA support entailed a pronounced reorientation of the Lao P.D.R.'s trade, as the country was forced to look elsewhere for supplies of fuel and production inputs.

At the same time, rapid economic liberalization and growth in neighboring countries (in particular, China, Thailand, and Vietnam) provided ready markets for many products. These developments, together with the continued domestic economic decentralization and the improvements in infrastructure and border access (in particular, the completion in early 1994 of the first bridge across the Mekong, which provided an overland shipping route from Thailand to Vientiane), spurred large increases in recorded trade volume with the convertible area.

Exports to convertible markets more than tripled between 1990 and 1994 (Table 6).16 Part of the increase was due to a considerable expansion in wood exports; while strict controls over wood harvesting continued to apply, sales of both logs and limber rose substantially with the authorization of logging in areas where large-scale hydroelectric projects, in particular the Nam Theun reservoir project, were begun. With respect to other agricultural exports, coffee exports declined, owing to the disappearance of markets in the former CMEA, and exports of fruits and vegetables grew rapidly, owing to the expansion of outlets in Thailand.

Table 6.Composition of Exports
19791980193119821933198419851986198719881989199019911992Est. 1993Est. 1994
(In millions of U.S. dollars)
Total exports19.413.519.440.040.843.853.655.062.157.863.378.796.6132.6232.3277.7
Convertible area19.413.514.027.827.830 034.639.433.036.847.258.194.2130.2228.5273.9
Wood and wood products8.
Hydroelectric power6.15 37.923.924.025.225.729.811.611.315.019.221.317.019.624.8
Nonconvertible area5.412.213.013.819.015.629.
(In percent of total exports)
Total exports100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Wood and wood products44.346.726.310.07.411.420.914.
Other (including re-exports)2 85.933.
Convertible area72.269.568.168.564.671.653.163.774.673.897.598.298.498.6
Nonconvertible area27.830.531.931.535.428.446.936.325.426.2251.81.61.4
Sources: Lao authorities; and IMF staff estimates.
Sources: Lao authorities; and IMF staff estimates.

The bulk of the export expansion, however, was concentrated in the nontraditional manufacturing sector. From a very small level in 1989–90, and despite quantitative restrictions on imports of Lao garments into certain industrial markets, garment exports increased tenfold to about $50 million (one fifth of total exports) in 1993–94, as new, partly foreign-financed companies began operations.17 In tandem with economic reforms in China and Vietnam, the Lao P.D.R. has developed a large-scale transit trade, consisting primarily of re-exports of assembled motorbikes and automobiles to these neighboring countries. Finally, “other” exports (mainly manufactures and semimanufactures) increased dramatically—the effect of virtually complete decentralization of production and trade activities, as well as rapidly rising foreign investment.

Following buoyant electricity exports in 1990 and 1991, receipts fell in 1992, owing to the lagged effects of a drought, before recovering in 1993–94. To augment the export potential, which is now constrained by the capacity of existing dams and the rapidly increasing domestic demand, several large hydroelectric investment projects are under way and should substantially increase total generating capacity in the next few years.

Total imports have also increased dramatically (Table 7). Increases in imports were fueled by rising exports, as well as by very high levels of foreign direct investment in 1993–94 (see Appendix II for further discussion); in addition, grants and project aid from industrial countries rose substantially, financing primarily inputs for infrastructural investment projects. Convertible area imports of fuel and machinery more than doubled between 1990 and 1994, not only because of a reallocation of demand away from the CMEA but also because of the strong growth in project financing and foreign direct investment. Even more impressive was the growth in imports of foodstuffs, consumer goods, and other manufactures, which more than tripled over the four-year period.

Table 7.Composition of Imports
19791980198119821983198419851986198719881989199019911992Est. 1993Est. 1994
(In millions of U.S. dollars)
Total imports70.392.390.2132.2149 4161.9193.1185.7216.21621210.7201.6215.0265.6410.7528.0
Convertible area28.350.048.273.776.359.377578.481.790.4135.6130.7210.4265.6410.7528.0
Rice and foodstuffs1.310. 618.428.431 646.460.0
Petroleum products8.812.912.913.814.010.81067.86.46.312.27.321.124.329.541.7
Machinery and raw materials19.819.125.345.640.234.250.349.640.936.668.379.8103.2137.1183.8215.5
Imports for re-export4.89.722.036.043.1
Nonconvertible area42.042.342.058.573 1102.61 15.6107.3134.572.
(In percent of total imports)
Total imports100.0100.0100.0100.0100.0100 0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Convertible area40.354.253.455.751.136.640.142.237.855.764.464.897.9100.0100.0100.0
Rice and foodstuffs1.811.62.24.2422.
Petroleum products12.514.014.310.
Machinery and raw materials13.920.728.034.526.921.126.026.718.922.532.439.648.051.644.841.4
Imports for re-export2.
Nortconvertrble area59.745.846.644.348.963.459.957.862.244.335.635.22.1
Sources: Lao authorities; and IMF staff estimates.

Including unidentified tied-aid imports.

Including private imports and small border trade.

Sources: Lao authorities; and IMF staff estimates.

Including unidentified tied-aid imports.

Including private imports and small border trade.

Finally, the nature of trade in services also changed significantly over the later reform period (Table 8). While inflows of technical assistance and receipts from embassies and international organizations remained an important part of services flows, tourism receipts increased twentyfold from 1990 to 1994; this rise was partially offset by greater travel abroad by Lao residents.

Table 8.Composition of Services(In millions of U.S. dollars)
19881989199019911992Est. 1993Est. 1994
Convertible area, net5.07.113.6-2.520.439.734.8
Embassies and international organizations10.912.213.018.425.230.425.8
Factor payments0.
Embassies and international organizations-0.9-0.7-1.2-4.5-4.9-5.0-5.9
Private travel-6.2-9.7-11.0-18.0
Insurance services-2.1-3.2-3.5-5.4
Technical assistance-9.2-9.6-7.0-19.5-15.8-16.4-16.5
Interest payments-2.5-3.1-3.2-4.4-4.4-4.3-5.8
Nonconvertible area, net-4.5-2.6-2.82.8
Services, net (convertible and nonconvertible areas)0.54.510.8-5.320.439.734.8
Sources: Lao authorities; and IMF staff estimates
Sources: Lao authorities; and IMF staff estimates

The major exception was a limit on travel allowances; this exchange restriction was removed in early 1994.

Outward capital transfers by residents remain restricted: in practice, however, these restrictions have been only weakly enforced.

Previously, licenses had been provided only to state trading companies and certain exporters.

Quantitative restrictions on motor vehicle imports were removed in 1995.

In 1992, the Lao P.D.R. moved to a customs-based reporting system, which improved the quality and coverage of the trade statistics; some portion of the increases recorded in 1992 is due to this improvement. Trade statistics were improved again in 1993, when reporting was introduced for a number of provincial border posts, yielding yet another sharp rise in recorded trade. (The sharp increases between 1990 and 1992 and again between 1992 and 1993 in the “other” trade category in Tables 6 and 7 are thus due in part to improved statistics.) Indeed, estimates indicate that both exports and imports may have been as much as 50 percent higher than officially recorded in 1990 and 1991, and as much as 20 percent higher in 1992. Thus, the sharp growth in recorded trade in the past few years may not have been as pronounced as indicated in Tables 6 and 7.

Most raw materials for the industry were imported, and the contribution to value added is still only about 25 percent of export value.

This period also witnessed an increased transparency in the budgetary accounts following the adoption of market-based prices and exchange rates and the monetization of subsidies.

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