Introduction

Over the past decade, Lao P.D.R has made good progress in economic reforms. The Government has taken various measures to transform the country towards a more market-oriented economy under its New Economic Mechanism (NEM), which has the broad support of the international community, particularly the Bretton Woods institutions and the Asian Development Bank. 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.

While agriculture remains the dominant sector of the economy, the other areas in generating growth such as manufacturing, construction and services are becoming more dominant. Foreign investment has played an important role in the economy since the Government’s open door policy in 1988. In particular, the foreign investment in hydropower generation for export, which has ranked first in terms of value has a high potential for contributing to growth in the medium- and long-term.

Recent economic development and macroeconomic prospects

Despite many economic difficulties confronted by the authorities in 2001 due to the economic slowdown in the region and the world, the authorities managed to maintain the economic stability throughout the year. The real GDP growth is estimated to be at 6.4 percent.¹ The inflation rate continued to decrease and remained at about 7.5 percent at end-2001, in line with the program while the kip depreciated by about 13 percent in the nine months to September 2001, and thereafter remained stable.

In the fiscal year 2001/02, the National Assembly approved the National Socio-Economic Development Plan (NSEDP) with a target for real growth in the range of 6-6.5 percent.² Inflation should be reduced to 6 percent by September 2002.³ The current account deficit is projected to remain manageable at 4.5 percent of GDP (including grants), as weaker export prospects are offset by reduced import demand. By creating a favorable environment for investment, and with anticipated recovery in external demand by 2003, medium-term growth in real GDP would be at least 6 percent, inflation would be reduced to about 5 percent, and gross official reserves should reach three months of import coverage.

Fiscal policy

The total revenue for the fiscal year 2000/01 improved at the level of 13.5 percent of GDP compared to 13.2 percent for 1999/00. However, the small shortfall to the target of 13.9 percent under the program was mainly due to weaker performance in direct and turnover taxes and import duties.

The Government acted quickly to restrain the current expenditures in response to the revenue shortfall. But, the extra investment spending of the provincial authorities, due to the recent launch of decentralization, caused the domestic bank financing of the budget. Compared to the end June 2001 target, there was an excess of kip 150 billion or 1 percent of GDP, and to the end September target, an excess of kip 246 billion or 1.7 percent of GDP. Since then, the Government has taken substantial corrective measures to strengthen the fiscal position, including through quick tax audits and tighter controls on expenditures and Government bank accounts.

In 2001/02 budget, the Government will improve fiscal discipline. The overall deficit in the program is targeted to be at about 5 percent of GDP and would be financed largely through concessional external loans with limited recourse to domestic bank financing. However, given the uncertainty of the economic environment and the effect of administrative measures, the authorities have projected at 13.9 percent of GDP revenue or an increase of 0.4 percent, from the previous year. Some of the key measures to increase revenue during the fiscal year include: the full adjustment of customs valuation in accordance with the monthly bank exchange rate, the implementation of the recently amended Tax Law and the making of customs revenue a fully national tax. The technical assistance from the Fiscal Affairs Department has been extremely important in implementing these reforms.

On the expenditure side, the Government will focus more on social sectors and human resource development by increasing its current budget spending, while spending on the capital investment will be reduced. This will keep the ratio of total expenditure to GDP broadly constant. If revenue falls short of the program expectations, the Government will take offsetting measures through restraint on domestically funded capital expenditures, while keeping operations and maintenance, local counterpart funds, and key social sector spending at the budgeted level.

Some of the key measures to strengthen the public expenditure management during the fiscal year are: the Budget Department approval of quarterly allocations of funds for the main current expenditures and separately for large capital expenditures, the rationalization of provincial and line ministry bank accounts, closure of unauthorized accounts, and upgrading of the information system of the budget.

Monetary policy

In 2001, monetary policy remained relatively tight and was successful in reducing inflation. Despite the Government’s withdrawal of the deposits from the Bank of the Lao P.D.R (BOL) for budgetary purposes as mentioned above, the BOL managed to limit in the net domestic assets of the BOL to Kip 46 billion as of June 2001, or one third of the fiscal slippage. In the September quarter, the BOL issued additional securities to further limit the monetary impact of the budgetary slippage.

State commercial banks’ (SCBs) credit growth was in line with the program through June 2001. However, as a result of the incidence of a temporary loan for the Lao Brewery share purchase⁴, SCBs credit increased substantially by $24 million. In any event, this amount was fully repaid on February 21, 2002. Therefore, excluding this transaction, the increase in credit of the SCBs, as measured by their net domestic assets, was only 1.7 percent by end December 2001.

In 2002, the monetary policy will continue to be tight and the exchange rate policy will remain flexible in order to further restrain the inflation rate to the target of 6 percent by end September. The BOL financing for the budget will be eliminated since the Government will use increased sales of treasury bills (with greater flexibility in treasury bill yields) to finance the domestic requirement of the budget and will monitor the central Government’s fiscal position more closely. Moreover, the BOL will continue to reduce its credit to banks so as to keep the BOL’s net domestic assets broadly constant.

The BOL will continue to manage the exchange rate regime flexibly, allowing the banks’ exchange rate to adjust so as to maintain the margin with the parallel market rate at less than 2 percent and avoid multiple currency practice. The Government and the BOL will adjust macroeconomic policies to correct any persistent weakness in the kip. The Government will also continue to improve the functioning of the interbank foreign exchange market by strengthening the foreign exchange operation and management of the banking sector, in particular, the state-owned commercial banks.

Financial sector reform:

In 2001, the Lao authorities prepared a comprehensive plan for state commercial bank restructuring in connection with the conditionality under the current PRGF arrangement and a possibility of concessional loans from the World Bank (WB) and the Asian Development Bank (AsDB) in 2002 to develop the Lao financial sector. During this process, the authorities have consulted with the staff of the Fund, WB and AsDB.

The main elements of the banking reform are:

• Financial and operational restructuring will be implemented in the period 2002-05 through phased recapitalization, conditional on meeting qualitative and quantitative targets which would be specified by May 2002 as part of the banks’ business plans.

• The two smaller Lao May and Lane Xang Banks will merge and rationalize their operations to reduce operational costs and accelerate the adoption of modern banking procedures.

• To support the restructuring efforts, the Government will use the role of a small number of foreign advisors in providing technical assistance in each of the two SCBs, the merged Bank (Lao May and Lane Xang) and the Banque Pour Le Commerce Exterieur Lao (BCEL). In addition to providing advice on internal bank practices, they will have a role to review proposed large credit decisions. The bank management may override the objections by the advisor, but the process would be transparent and such credits would be subject to special monitoring; and if the new management team do not meet the performance indicators, a form of management support would be strengthened.

• Bank supervision will be strengthened for the phased implementation of bank supervision regulations, focusing first on those that affect credit quality. The Monetary and Exchange Affairs Department (MAE) is in the process of fulfilling the Government’s request for technical assistance in banking supervision.

Other structural reforms

In 2001, the authorities adjusted upward the prices of three major state-owned enterprises (SOEs) to reach a cost recovery level before end 2002. The water prices were adjusted in April 2001 by an average of about 100 percent and further adjustments will be in June 2002; the electricity prices were adjusted by 3-3.5 percent per month through end-2001 and a decision on the future price adjustments required for cost recovery price is expected in April 2002; the Lao Aviation air fares were raised in July 2001 by 20 percent, will be raised again in April 2002 and further adjustments would be made to reach the cost recovery level by October, 2002.

In conjunction with the WB, the authorities will begin the restructuring process of five large state-owned enterprises (SOEs), three are large defaulting borrowers namely: the Phoudoi conglomerate, Nam Papa (Water) and Lao Aviation; one large loss maker, that is Pharmaceutical Factory #3, and Electricité Du Laos (EDL), a main revenue earner. Drafting of the restructuring plans of an additional five large defaulters is scheduled to start by October 2002.

Safeguard assessment

Stage One safeguard assessment conducted by the Fund staff at the Headquarters was completed in December 2001. The authorities appreciate the concerns and the recommendations of the IMF Safeguards Report. In particular, the recommendations for five categories of vulnerabilities namely: the external audit mechanism, legal structure and independence, financial reporting framework, internal audit mechanism and internal control system. The authorities will fully implement as soon as possible in order to move to Stage Two assessment this year.

Poverty reduction strategy

The authorities are planning to finalize their National Poverty Reduction Program (NPRP) by August 2002. The NPRP will be fully consistent with the requirements of PRSP and builds on the interim PRSP (I-PRSP). The elaboration of NPRP will be both nationally owned and participatory, involving all segments of society, including the Lao Women’s Union, the Lao Youth Organization, the Trade Union Federation, and the Lao Front for Reconstruction, and most importantly, the poor themselves.

In order to have the sources of poverty better analyzed and to help the authorities better assess and monitor the impact of policies on poverty reduction outcomes, the authorities have given a mandate to the National Statistical Center (NSC) to prepare a follow-up household expenditure and consumption survey (LECS-III) to finalize poverty measurements; and to draft guidelines for a poverty reporting system (PRS) in developing criteria for defining poverty at household, village and provincial levels. Both of these instruments (LECS-III and PRS) are in the process of being developed with the assistance of the WB and the support from Sweden.

The PRSP Committee is elaborating specific poverty-reducing measures in the areas of food security, rural development, forestry, road infrastructure, and health and education, and their budgetary impact. It is expected that the full PRSP will be finalized by August, 2002 as scheduled.

Other areas

In view of the Lao P.D.R’s vulnerabilities external position, the authorities will limit the contracting or guaranteeing of new noncessional external debt. In addition, the authorities will continue to upgrade the monitoring of the external debt through the External Debt Monitoring Unit in the Ministry of Finance.

The debt negotiations with the Russian Federation are ongoing. The authorities are doing their best to reach an acceptable agreement for the repayment of the debt to the Russian Federation, taking into account the debt payment capacity of Lao P.D.R over the medium term. At least, another round of negotiations is planned for 2002. On February 5, 2002 Lao Vice Minister of Finance sent a letter to the Russian authorities restating the Lao authorities are sincerely interested in solving the debt issue in a mutually acceptable manner and would like to conduct another meeting at the earliest convenience with the Russian authorities.

Closing Remarks

Despite numerous internal constraints and economic downturn of the region and of the world in 2001, the Lao authorities managed to maintain the hard-won macroeconomic stability. The authorities recognize that there remains much to be done and much assistance will be needed to achieve a sustained economic growth over the medium term in order to support the poverty reduction strategy of the country. As such, they remain committed to implement all necessary measures under the PRGF arrangement. They are hopeful that their request for the completion of the first review under the arrangement, waivers for the nonobservance of three quantitative performance criteria for end-June and one structural performance criterion for end-September, and modification of one structural performance criterion for end-March 2002 will be supported by the Board. They, hereby, wish to express their appreciation and gratitude once again to the Board and the Management of the Fund for the continued support to the endeavors of Lao P.D.R.

Regarding the publication of the staff report, we are pleased to inform the Board that the Lao authorities have consented to the publication of the staff report dated February 11, 2002. They also have consented to the publication of staff report and the selected issues and statistical appendix thereof dated April 9, 2001.