Lao People's Democratic Republic
Recent Economic Developments

This report discusses major developments in the Lao People’s Democratic Republic (PDR), and updates the statistical tables on recent economic developments and provides an overview of the real sector. Factors that have limited revenue collections and developments in the monetary and financial sectors have been presented. The paper discusses the weakness of monetary policy as well as the financial sector and recent efforts to reform the banking system. Foreign direct investment and foreign exchange regime in Lao PDR have been examined.

Abstract

This report discusses major developments in the Lao People’s Democratic Republic (PDR), and updates the statistical tables on recent economic developments and provides an overview of the real sector. Factors that have limited revenue collections and developments in the monetary and financial sectors have been presented. The paper discusses the weakness of monetary policy as well as the financial sector and recent efforts to reform the banking system. Foreign direct investment and foreign exchange regime in Lao PDR have been examined.

I. Introduction and Overview

1. Economic reforms in the Lao P.D.R. started in 1986 and were supported by Fund arrangements in the period 1989-1997. Responding to initial reforms, the economy grew annually at between 5-8 percent, and the government achieved broadly stable macroeconomic conditions through prudent policies. The basic elements of a market economy were introduced through implementation of tax, trade, state enterprise and other market reforms. However, as the authorities relaxed monetary and fiscal policies in 1997, economic conditions started to deteriorate and structural reforms slowed. The inability to tighten macroeconomic policies, and the authorities’ attempts to contain foreign exchange and price pressures largely through administrative measures, exacerbated the situation in 1998. Inflation increased rapidly, from a 12-month rate of 26 percent in December 1997 to 142 percent in December 1998.

2. This report discusses major developments in 1998, and parts of 1999, and updates the statistical tables in last year’s report on recent economic developments.1 It also discusses selected issues relating to the fiscal, FDI and foreign exchange regimes.

  • Chapter II provides an overview of developments in the real sector. It notes that real growth declined to an estimated 4 percent in 1998, as domestic policies weakened and the negative effects of the Asian crisis became more pronounced.

  • Chapter III discusses fiscal developments in 1997/98 and developments so far in 1998/99.2 It also provides an analysis of factors that have limited revenue collections since 1995/96.

  • Chapter IV presents developments in the monetary and financial sectors. It discusses the continued weakness of monetary policy that contributed to an inflation-depreciation spiral. It also explores the weaknesses in the financial sector and recent efforts to reform the banking system.

  • Chapter V deals with external sector developments in 1998. The current account deficit narrowed significantly with rising power exports and falling FDI related imports as a result of reduced regional investor activity. An more detailed examination of FDI developments is provided in Chapter VII.

  • Chapter VI examines the institutional framework and historical experience of foreign direct investment in the Lao P.D.R.

  • Chapter VII details the evolution of the foreign exchange regime.

II. Real Sector

A. Overview

3. Real GDP growth declined in 1998, to 4 percent from the recent average of 7 percent. This deterioration primarily reflected weak domestic policies exacerbated by the continued effects of the regional crisis. Agriculture sector growth was an estimated 3.7 percent, over 3 percentage points lower than growth achieved in 1997, partly as a result of adverse weather conditions. Growth in the industrial sector increased slightly, from 8.1 percent in 1997 to 8.5 percent in 1998, but growth in the service sector declined to 4.8 percent from 7.5 percent, reflecting both weaker domestic and regional activity.

B. Developments by Major Sector

4. Agriculture. Agriculture accounts for over 50 percent of GDP, employs 80 percent of the workforce, and remains predominantly subsistence in nature (Table 3, Chart 1). Crop production grew by an estimated 6.6 percent in 1998, partly affected by drought conditions and far below the unusually high 14 percent growth recorded in 1997 which reflected recovery from floods. Total rice output stagnated as declines in rainy season rice output were offset by increases in dry season production, benefiting from improved irrigation under the government’s large scale irrigation project accelerated in 1997 (see below). Output of cash crops increased substantially, mainly due to a doubling of sugarcane production to meet demand in the Thai market. Coffee (for European markets) and peanut production also experienced significant growth. Livestock production rose 2.5 percent in 1998 but this masks a significant stock depletion because large numbers of buffalo, cattle and pigs were exported to neighboring countries. The decline in logging production continued in 1998 and the forestry sector contracted by 4.4 percent. This was due to the continued weak regional demand and low world prices resulting from the Asian crisis. However, the harvest of 500,000 cubic meters was in line with the government’s estimate of sustainable logging.

Table 1.

Lao P.D.R.: Selected Economic and Financial Indicators, 1994-98

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Sources: Data provided by the Lao authorities; and staff estimates and projections.

Fiscal data are on a fiscal year basis (October-September).

GDP figures for 1998 have been revised.

Excludes debt to nonconvertible area; includes debt to the Fund (SAF and ESAF).

As a ratio of exports of goods and nonfactor services.

Average of buying and selling rate.

Table 2.

Lao P.D.R.: Real GDP Growth, 1994–98

(In percent)

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Source: Data provided by the Lao authorities; and staff estimates.
Table 3.

Lao P.D.R.: GDP by Industrial Origin, 1994–98

(In billions of kip, at 1990 constant market prices)

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Sources: Data provided by the Lao authorities.

Alternative staff estimates of deflator in 1997 and 1998 result in different estimates for nominal GDP in these years.

CHART 1.
CHART 1.

LAO P.D.R. REAL GDP AND MAIN ECONOMIC SECTORS, 1994-98

Citation: IMF Staff Country Reports 2000, 003; 10.5089/9781451822427.002.A001

Source: Data provided by the Lao authorities and staff estimates.

5. Irrigation. Under the five year plan adopted in 1996 and following food supply problems in 1997, the government embarked on an ambitious irrigation project to make the Lao P.D.R. self-sufficient in terms of rice by 2000. The irrigated rice area was planned to expand from 22,000 ha in 1997 to 100,000 by 2000 and further to 130,000 ha by 2003. The government estimates that for the 1998 dry season the irrigated rice area increased to 53,000 ha as planned, nearly doubling the output of irrigated rice from 114,000 tons in 1997 to 212,000 tons in 1998. Up to December 1998 over KN 220bn (5 percent of 1998 GDP) of the project costs were financed by the central bank, the Bank of the Lao P.D.R. (BOL). For 1999, some 89,000 ha of irrigated rice were planted, yielding 289,000 tons.

6. Industry. The continued impact of the regional economic crisis restricted growth of the industrial sector (mining, manufacturing, construction and electricity), which accounts for 22 percent of GDP. 1998 growth is an estimated 8.5 percent, similar to that recorded in 1997, but well below the double digit growth enjoyed during the period 1993-1996. The manufacturing sector, accounting for three quarters of industrial output, grew at 9.6 percent, similar to growth in 1997. Among the major manufacturing outputs, garment production expanded modestly in 1998 following the reinstatement of the European Union’s Generalized System of Preferences (GSP) and appears to have responded further in 1999. Beer production also continued to expand. These were offset by declining output in the cement, plastic and furniture sectors (Table 4). Activity in the construction sector declined significantly in 1998 with the completion of existing hydropower projects and the continued delay of Asian investment projects. The dramatic increase in electricity generation reflects the coming on-stream of the Theun Hinboun hydropower plant in April 1998 with annual output of 1,660 GWH.

Table 4.

Lao P.D.R.: Output of Major Commodities, 1994-98

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Sources: Data provided by the Lao authorities,

7. Services. Growth in the service sector, that accounts for 25 percent of GDP, is estimated to have fallen to below 5 percent in 1998, from 7.5 percent in 1997. The transportation and retail related sectors displayed continued strength but the problems of the largely insolvent banking sector led to a collapse of output in the financial services sector, an 87 percent decline. Growth in tourist arrivals fell from 15 percent in 1997 to 8 percent in 1998. In particular, regional tourist arrivals grew by only 3 percent in 1998 down from 12 percent in 1997. This impacted on hotels and restaurants reducing growth in this sector for a second consecutive year. It should be noted that the service sector component of the GDP statistics remains a weakness of the statistical base.

C Prices, Wages and Employment

8. Inflation (as measured by the National Statistical Centre index, in 1995 prices) rose rapidly from a twelve month rate of 27 percent in December 1997 to 142 percent in December 1998 and further still to a peak of 167 percent in March 1999 (Table 5). It has since fallen to 123 percent in September 1999. These movements largely reflect BOL credit extension to the economy, initially through the financing of large scale irrigation investments. This money creation and accompanying fiscal expansion were the principal source of both exchange rate depreciation and inflation in 1998. In an undermonetized and dollarized economy3 in which imports from Thailand play a dominant role in price determination, this led to higher prices and the continued erosion of confidence in the kip and flight from it. In the absence of a decisive tightening of monetary and fiscal policies a vicious inflation-depreciation circle emerged. Price increases have been driven by both the food and nonfood components of the CPL Rapid monthly food price increases reached a peak of 28 percent in June 1998 before returning to single digit levels for the second half of 1998. In 1998 monthly non-food price inflation followed a broadly similar trend to that of food prices but with lower volatility. However, the first half of 1999 saw a return to high monthly increases in both food and nonfood prices.

Table 5.

Lao P.D.R.: Consumer Price Indices, 1996–99

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Source: Data provided by the Lao authorities.

9. Real wages for civil servants have declined significantly in the last three years (Table 6). Although the average monthly basic wage has risen nominally from KN 40,700 in 1996/97 to an estimated KN 58,137 in 1998/9, an increase of 43 percent, real wages have fallen by over 50 percent given high inflation. There are no official statistics on unemployment and private sector wages in the Lao P.D.R. The most recent census (1995) reported the unemployment rate at 2.4 percent. The population and employment structure at that time is reported in Table 7.

Table 6.

Lao P.D.R: Personnel and Salaries of Civil Servants, 1995/96-1998/99.

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Sources: Data provided by the Lao authorities; and staff estimates.

Data relate to beginning of fiscal year (October). Military personnel is excluded. Number for 1998/99 is target for the year.

Excludes bonuses and other compensations.

Calculated on the basis of the ratio of (base) civil service salary to total base salary for the 1995/96-1997/98 period.

Includes wages, salaries, and other compensations of military and non-military personnel.

Table 7.

Lao P.D.R. - Population and Employment, 1995

(In thousands of persons)

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Source: National Statistical Centre, State Planning Committee.

Of population age 10 years and above.

III. Public Finance4 5

A. Overview

10. Weak fiscal management has been a major cause of recent macroeconomic instability. Revenues fell from 13 percent of GDP in 1995/96 to 11 percent in 1997/98 in part because of delays in implementing announced revenue measures and in part because of weak tax administration. Despite revenue shortfalls, spending was expanded in 1997/98 leading to a large fiscal imbalance; central bank financing of the budget deficit was required for the first time in six years, creating strong inflationary pressures. Revenue shortfalls and rigidities in the tax system continued in 1998/99, and the authorities severely compressed current expenditures in an effort to reduce the deficit.

B. 1997/98 Budget

11. Revenue. Revenues suffered significant shortfalls in 1997/98. The original 1997/98 budget targeted revenue collection of 13.7 percent of GDP. This target was higher than the 1996/97 outcome by more than 2 percentage points of GDP and was to be achieved through new tax measures including a reduction in turnover tax rates from four (3, 5, 10 and 15 percent) to two (5 and 10 percent) and increasing the rates for most goods; raising excise rates; increasing the minimum income tax from 0.5 percent to 1 percent of revenues; increasing income tax from real estate leasing; introducing a stamp duty, and adjusting fuel prices to reflect market prices.

12. However, the newly announced tax measures were not implemented, and higher than expected inflation reduced revenues further as a share of GDP because of weak tax administration. As a result the actual 1997/98 revenues fell 2.5 percent of GDP short of the revised target (Table 8).

Table 8.

Lao P.D.R.: General Government Operations, 1994/95-1998/99

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Source: Data provided by Lao authorities; and staff estimates

Including grants.

Excluding grants.

Comprising bank and nonbank financing, and receipts from government asset sales.

13. Expenditures. Despite revenue shortfalls, expenditures were allowed to expand. Total expenditure was targeted at 21 percent of GDP in the original budget, a modest increase over the 20.4 percent of GDP in 1996/97. Of the 1997/98 target, current expenditures accounted for 10.4 percent of GDP and capital expenditures 10.7 percent. While the expenditure target was revised in mid-year to 24.1 percent of GDP, this still significantly underestimated actual expenditure in 1997/98, which rose close to 27 percent of GDP. This increase in expenditures was largely because of capital spending that rose to 18.8 percent of GDP reflecting both high spending by the government on irrigation outside the formal budget process and higher valuation of foreign financed projects as a result of the depreciation of the kip. Current spending was compressed to 8.1 percent of GDP, especially civil servants’ wages which fell from a planned 4.4 percent to 3.5 percent of GDP despite significant nominal increases.

14. The revenue shortfalls and expenditure overruns raised the overall deficit to 10 percent of GDP by the end of the fiscal year against the originally projected 4.7 percent of GDP. Although available foreign financing could have covered the originally targeted deficit, and still allowed an accumulation of government deposits, the increased deficit necessitated government borrowing from the banking system of KN163 billion or 5 percent of (fiscal year) GDP. The budget based spending plans on anticipated disbursements of two balance-of-payment support loans from international financial institutions. However, the authorities did not adjust spending or increase revenues when these disbursements were delayed exacerbating macroeconomic imbalances.

C. 1998/99 Budget6

15. Revenue. The 1998/99 budget set a revenue target of 12.7 percent of GDP, a planned increase of 1.5 percentage points of GDP over the previous years outturn. This was to be achieved by adopting revenue measures that had been announced but not implemented in 1997/98. As in 1997/98, macroeconomic policy continued to be weak and resulting inflation far exceeded levels anticipated at the time of budget preparation. Consequently the authorities revised budget targets in March raising the nominal revenue target by 22 percent. Although it is expected that the authorities will achieve at least their revised target which is more than double that of the nominal 1997/98 outcome, this level of revenue would be 10 percent of estimated GDP, the lowest level in 9 years.

16. Expenditures. Total expenditure was targeted at 21.1 percent of GDP, a reduction of nearly 6 percentage points of GDP from the 1997/98 outturn in an effort to tighten the fiscal position. This was to be achieved by cutting capital expenditures to 12 percent of GDP while raising current expenditures to 9.1 percent of GDP. The mid year budget revision left nominal kip spending levels basically unchanged, reflecting only the increased kip value of foreign funded investment projects.

17. Government efforts to contain the fiscal deficit in the face of revenue shortfalls continued to focus on the compression of current expenditures and the prioritization and postponement of projects7, especially domestically-financed investment projects. Current expenditures, are now estimated to be 6.4 percent of GDP compared with the initial target of 9.1 percent. In particular, wages and salaries are now estimated to be only 2.2 percent of GDP compared with 4-4.5 percent of GDP in the pre-crisis period and 3.5 percent of GDP envisaged in the budget. This pattern is not sustainable as real wages have declined by more than 50 percent over the last three years. Capital expenditures now are estimated to rise to 14 percent of GDP compared with the planned target of 12 percent. This results largely from depreciation effects on foreign financed projects but also weak administrative controls over line ministries and provinces.

18. The original overall deficit was planned to be 8.4 percent of GDP, to be financed entirely by foreign borrowing. The compression of current spending allowed the outturn current surplus to be maintained at an estimated 3.6 percent of GDP, offsetting real revenue declines. The overall deficit is projected at a somewhat higher 10.3 percent of GDP but remains wholly financed by foreign savings while allowing a KN 100 billion government deposit build-up with the banking system.

D. Tax Administration8

19. As discussed above, revenues have continuously declined since 1995/96 as percent of GDP (see chart below). This was mainly due to weak tax administration, which depends to a significant extent on negotiations of tax liabilities with tax payers, exacerbated by an inefficient tax sharing agreement with provinces. In addition, the authorities often used outdated and appreciated exchange rates in customs import valuation to stem inflationary pressures, undermining their own objective of revenue mobilization. The authorities have taken a number of steps including the introduction of new tax measures and establishment of a large taxpayer unit to rectify the sitaution. However, these measures have so far shown little visible impact on increasing real revenues. This section discusses a number of underlying tax administration issues.

uA01fig01

Lao P.D.R: Inflation and Total Revenue

Citation: IMF Staff Country Reports 2000, 003; 10.5089/9781451822427.002.A001

20. Negotiated nominal revenue targets. A significant part of revenues are collected on the basis of nominal payment targets negotiated with taxpayers early in the fiscal year. Given the limited tax administration capacity and paucity of taxpayer records on which to base assessments, tax obligations have often been negotiated on a presumptive and a lump sum basis. A major weakness of this system is that it cannot respond flexibly to changing economic circumstances. These payment targets are not revised regularly to reflect an increase in the tax base when, for example, price increases have been higher than anticipated. In addition, individual tax offices and officers have a substantial amount of discretion in determining how much a given taxpayer must pay.

21. Provincial Revenue Sharing Arrangements. The existing revenue sharing arrangement between the center and the provinces does not give sufficient incentive to provinces to collect additional revenues. Upon the approval of the budget by the National Assembly, each province is assigned a revenue target based on, among other factors, the previous year’s collection. Recognizing that this system was rigid and gave little incentive to provinces to strengthen revenue mobilization beyond the pre-assigned targets, the authorities introduced a new revenue sharing arrangement in 1998/99 (Box 1). In particular, provinces with a budget surplus are now allowed to retain 50 percent of any tax collection above the revenue target for projects approved by the central government. Provinces not in surplus are given a fixed transfer from the center, and must collect the balance of their budget spending; shortfalls must be met by cutting spending.

22. Experience demonstrates several weaknesses with this tax sharing arrangement. First, it still does not provide provinces, in particular those in surplus, with strong incentives to exceed pre-assigned targets because the extra revenue they raise cannot be spent on provincial priorities. Second, the arrangement is inflexible as the target for each province is established through adhoc pre-budget negotiations rather than based on clear policy guidelines. Thus the arrangement does not respond to actual developments during the fiscal year because targets cannot be revised in line with actual growth or inflation unforeseen at the time of budget preparation. Third, the classification of provinces into one of three types is not stable from year to year and is based on historical tax collection in each province. Since surplus provinces have the highest obligations to the central government, an incentive exists for provinces not to exceed their pre-assigned targets and thus avoid being classified as a surplus province.

23. Large Taxpayer Unit. This unit (box 2) has been established to improve tax administration by significantly reducing tax collection based on negotiated targets. It collects taxes from large taxpayers based on their actual business and financial activities. The unit has collected approximately 40 percent of total tax revenues during the past two years. However, its tax collection potential is yet to be fully realised. In particular, the unit’s full time leader has only recently been appointed and the staff of the unit were often diverted away from their primary task of tax collection to administrative work of the tax department of the Ministry of Finance. Furthermore, the coverage of taxpayers is more limited than initially envisaged. For example, about 20-30 large taxpayers were transferred from the LTU to the Vientiane municipality in 1998/99 keeping LTU staff from collecting taxes from these taxpayers. Based on a follow up review, however, the authorities reversed this decision.

Provincial Tax Sharing Arrangement

The tax sharing arrangement introduced in April 1999 classifies provinces into three types:

(a) Provinces in budget surplus (4 provinces)

These must submit 60 percent of revenue to the central government and keep 40 percent for use by the province. If the revenue collection exceeds the target in the budget, 50 percent of the excess amount must be remitted to the central government, and the remaining 50 percent be invested in projects approved by the central government, such as irrigation construction, and/or lent to the central government.

(b) Self sufficient provinces (9 provinces)

If their revenue collection exceeds the target in the budget, 100 percent of the exceeded amount is to be kept in the province for internal construction projects authorized by the central government.

(c) Provinces in budget deficit (4 provinces)

The central government subsidizes their budget deficit on a monthly basis and if the revenue collection exceeds the target in the budget, 100 percent of the excess amount is to be kept in the province to pay salaries and administrative costs.

24. Outdated Exchange Rates. The decline in import duty collection has been the most precipitous among major tax items as percent of GDP, in the recent past (Chart below). The use of outdated and appreciated exchange rates for customs valuation purposes to stem inflationary pressures was a major source of shortfalls in import duty collections. In 1997/98 a rate of 2,000 kip per dollar was used for import valuation while the commercial bank rate averaged 2,700 kip per dollar. In 1998/99, a rate of 4,000 kip per dollar was used for import valuation even when the commercial bank rate fell to 9,000 kip per dollar (an average 6,345 kip per dollar for the fiscal year) depriving the budget of an estimated 2.4 percent of GDP in revenues. Using the weight of imported goods in deriving the CPI mechanically, the price impact of moving to the market exchange rate will be estimated as 5-10 percent. But, as most goods sold in the Lao P.D.R. already incorporate parallel market exchange rates, the actual impact on prices of using market related exchange rates should be much smaller. The use of outdated exchange rates reduced not only import duties but turnover taxes and excise duties on imported goods, taxes on exports, royalties9, and some non-tax revenues.

The Large Taxpayer Unit (LTU) in the Lao P.D.R

The Large Taxpayer Unit (LTU) was set up in the Tax Department of the Ministry of Finance headquarters in 1991 under the IMF/NORAD/UNDP Tax and Customs Administration Reform project. The unit is responsible for registering large taxpayers, receiving and processing their tax returns and payments, detecting under reporting, and collecting tax arrears.

Current situation

The LTU has recently collected 40 percent of total tax revenue from approximately 800 taxpayers. With the implementation of a number of new initiatives, the LTU is expected to increase revenue collections further. First, self-assessment turnover tax obligations has been introduced, and large taxpayers prepare their own returns and submit their payments directly to the treasury. Because the LTU has enhanced capacity to detect stop-filers, filing compliance on turnover tax has increased to 75 percent from the previous 30 percent. Second, the unit has developed procedures for field audits and has now started to conduct these audits. Third, work has begun to improve arrears collection. Finally, a computerised system has been developed to strengthen tax payer data base.

Current challenges

Organisation: It is important to identify an organisational structure that allow the unit to achieve its full potential of tax collection. The LTU was separated from the Department in 1997 to allow unit to focus on tax collection rather than administrative work of the Department, but it was reorganised into the Department in 1999.

Personnel: Another important task is to appoint unit management that has the qualifications, experience and authority to collect taxes from largest taxpayers.

Coverage: It is also important that the LTU cover all establishments that meet predetermined financial criteria of large taxpayers, and not change the coverage for nonfinancial reasons.

uA01fig02

Lao P.D.R.: Selected Revenue Items as Percent of GDP 1991/92-1998/99

Citation: IMF Staff Country Reports 2000, 003; 10.5089/9781451822427.002.A001

25. Other Tax Exemptions. Other important tax expenditures are more difficult to quantify, as it is believed that ad hoc exemptions are widespread. The one case which has been publicly announced is the case of petroleum products, in which a general exemption from indirect taxes was announced as a measure to avoid raising the local price of fuel in the face of rising world oil prices. This exemption, if continued in foil for an entire year, could amount to as much as ½ percent of GDP. The staff has not been able to confirm report of exemptions given to other enterprises.

IV. Monetary Policy and Financial System

A. Overview

26. Throughout 1998 monetary policy was essentially passive as the government drew on the central bank to finance the budget deficit. Given revenue shortfalls and the limited deposits growth in the banking system, the Bank of the Lao P.D.R. (BOL), was the government’s only ready source of funds for public policy purposes. In response to triple digit inflation, efforts to tighten monetary policy were started late in 1998 and continued into 1999. However, tight policy was abandoned periodically and the decline in the value of the kip and high inflation continued unabated. Only in the third quarter of 1999 did the government take a firm position against resorting to the BOL for financing.

B. Developments in Money and Credit

27. The loosening of monetary policy that started in 1997, with the abandonment of bank by bank credit ceilings, continued in 1998. Growth in broad money during 1998 was 113 percent (51 percent excluding the valuation effects of a rapidly depreciating exchange rate on foreign currency denominated items). This rapid growth occurred consistently throughout the year (Tables 11 and 12).

Table 9a.

Lao P.D.R.: General Government Revenue, 1994/95-1998/99

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Source: Data provided by Lao authorities

1997/98 Other items includes error and omissions for consistency with aggregate totals.

Table 9b.

Lao P.D.R. General Government Revenues 1991/92-1998/99

(In percent of GDP)

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Sources: Data provided by the Lao authorities; and staff estimates.
Table 10.

Lao P.D.R.: General Government Expenditure, 1996/97 and 1997/98 1/

(In billions of kip)

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Source: Data provided by Lao authorities

Most Recent Data

Original budget.

Table 11.

Lao P.D.R: Monetary Survey 1995-98

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Sources: Data provided by the Lao authorities; and staff estimates

Broad money divided by reserve money

Table 12:

Lao P.D.R.: Sources of Broad Money Growth 1997-98

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Sources: Data provided by Lao authorities; and staff estimates