Lao People’s Democratic Republic: Staff Report for the 2004 Article IV Consultation

The staff report for the 2004 Article IV Consultation on Lao People’s Democratic Republic (PDR) highlights economic developments and policies. Lao PDR’s recent macroeconomic performance has been relatively encouraging. Although some headway has been made in reforming the state banks and state-owned enterprises, progress in mobilizing revenues and strengthening expenditure management has been slow, owing to capacity constraints and difficulty in advancing reforms in a decentralized fiscal structure. IMF staff encouraged the authorities to maintain progress in restructuring the two state banks, as both banks remain vulnerable.

Abstract

The staff report for the 2004 Article IV Consultation on Lao People’s Democratic Republic (PDR) highlights economic developments and policies. Lao PDR’s recent macroeconomic performance has been relatively encouraging. Although some headway has been made in reforming the state banks and state-owned enterprises, progress in mobilizing revenues and strengthening expenditure management has been slow, owing to capacity constraints and difficulty in advancing reforms in a decentralized fiscal structure. IMF staff encouraged the authorities to maintain progress in restructuring the two state banks, as both banks remain vulnerable.

I. Background and Economic Setting

Background

1. In early 2001, when the current PRGF arrangement was approved, Lao P.D.R. had just emerged from an acute period of macroeconomic instability. Although the Asian crisis was a contributing factor, the domestic problems stemmed largely from a breakdown in fiscal management in 1997–98. The government, anxious to accelerate the pace of development, launched a series of large investments in irrigation aimed at achieving rice self-sufficiency. The investments, though well-intentioned, were unplanned and pushed through without adequate financing arrangements. The consequences were severe (Figure 1). Heavy borrowing from the central bank resulted in a rapid expansion of liquidity that caused a collapse of the kip and triple digit inflation.

Figure 1.
Figure 1.

Inflation and Exchange Rate, 1997-1999

Citation: IMF Staff Country Reports 2005, 008; 10.5089/9781451822533.002.A001

2. The government launched a successful stabilization program in late 1999, but significant structural weaknesses remained. Monetary and fiscal policies were tightened, along the lines recommended by Fund staff, and by early 2001 the kip had stabilized and inflation had been reduced to single digits. However, the fiscal position was fragile: budget revenues were low and over dependent on timber royalties, and recurrent spending, especially on social programs and civil service wages, was highly compressed. The state commercial banks (SCBs) were also insolvent, weighed down by high levels of nonperforming loans (almost 90 percent of the SCB loans were nonperforming). The latter arose mainly from noncommercial lending to state-owned enterprises (SOEs), although government arrears to private borrowers were also a contributory factor. The high level of non performing loans (NPLs) from SOEs1 reflected a poor repayment culture, as well as operational weaknesses stemming (in part) from government interference in their pricing policies.

3. The government requested the PRGF arrangement to help advance key reforms to consolidate the recovery from the economic crisis. The primary objective was to strengthen public finances to sustain the stabilization effort and provide a solid platform to address Lao P.D.R.’s substantial development needs. Raising budget revenues and improving expenditure management were the main priority, but the program also focused on reforming SCBs and SOEs to strengthen the broader fiscal position. The program, which was closely coordinated with programs of the World Bank and Asian Development Bank (Annexes III and IV), formed part of a broader strategy, articulated most recently in the government’s PRSP,2 to raise Lao P.D.R. from the ranks of least-developed countries by 2020.

4. Three years on, Lao P.D.R’s macroeconomic performance has been relatively encouraging, but the pace of structural reform has been slow. After a brief hiatus in 2002, macroeconomic stability has been restored and growth has been reasonably robust. The latest data also suggest that poverty has continued to decline (Box 1). Some headway has been made in reforming the SCBs and SOEs, although much remains to be done in both areas. However, progress in strengthening fiscal management has been slow and uneven, due to capacity constraints and a difficulty advancing reforms in a decentralized fiscal structure.3 In particular, a progressive weakening of budget revenues since the start of the program has raised concerns about the sustainability of the fiscal outlook (Figure 2).4 Also, expenditure management remains weak, undermining the capacity of the government to deliver effective social sector programs, and deficiencies in public debt management have persisted, hindering efforts to exert greater control over the contracting of public and publicly guaranteed debt.

Figure 2.
Figure 2.

Trends in Revenue

Citation: IMF Staff Country Reports 2005, 008; 10.5089/9781451822533.002.A001

5. Discussions for the fourth review, which have been ongoing since December 2003, have focused mainly on reforms to strengthen the revenue base. With revenues declining more sharply than expected in 2002/03,5 the focus has been on reversing this decline and advancing key structural reforms to strengthen the revenue base over the medium-term. Time was needed to forge an appropriate consensus on the reform strategy, as some of the revenue reforms, particularly those related to reestablishing a national revenue administration strike at the heart of center-provincial relations. As discussed below, although the authorities have made progress over the last year, policy slippages in a few key areas have prevented the completion of the fourth review at this time.

Lao P.D.R.: Poverty Situation

Lao P.D.R. has made progress in reducing poverty during the last decade. Poverty (as measured by the percentage of population living below the poverty line) declined from 45 percent in 1992-93 to 39 percent in the late 1990s, and the latest survey suggests that it is now at 30 percent. High economic growth has been a key factor behind poverty reduction. In addition, the results on the composition of the consumption basket suggest a shift away from food items (especially own food consumption), which is consistent with a growing economy.

Nevertheless, Lao P.D.R. remains as one of the poorest countries in the world with GDP per capita estimated at around $369 for 2003. The majority of the population depends on subsistence agriculture. Moreover, there is considerable variation in poverty across regions and between rural and urban areas; the largest reductions were in urban areas, especially Vientiane, where poverty was more than halved. In particular, the poverty gap between Vientiane and other regions widened significantly, with the north of the country, where large groups of ethnic minorities are located, continuing to show the highest incidence of poverty.

Poverty in Lao P.D.R. is also linked to a number of socio-economic characteristics. Data from the latest survey shows a correlation between illiteracy and poverty. Households with illiterate heads are disproportionately poorer. Also, poor households tend to be larger than non-poor households and they tend to be concentrated in areas where infrastructure is less developed. There is also a link between limited access to health care facilities and poverty. The proportion of people with temporary health problems is higher for rural areas with limited access to healthcare facilities and transportation. This contributes to poverty by limiting their ability to work and disrupting income generating activities.

Income inequality in Lao P.D.R. is low compared to most other Asian countries. However, it has increased, as measured by the Gini coefficient, providing further evidence that the benefits of economic growth have not been sufficiently spread to the bulk of the population in poor rural areas.

The main causes of poverty include: (i) a legacy of physical devastation during the Vietnam war, with unexploded ordinances still affecting half of the country’s territory; (ii) weak public service delivery, especially in the health and education sectors; (iii) inadequate communication infrastructure; and (iv) shortcomings in governance. Poor road access to markets, low productivity and insufficient support services to farming especially in upland areas, limited access to credit and weak marketing chains are the main bottlenecks facing the rural poor.

The government’s strategic goal is to graduate from the group of least developed countries by 2020. The government’s strategy to achieve this goal rests on three key pillars: (i) the development of a market oriented economy; (ii) building up the country’s infrastructure; and (iii) improving social welfare through greater food security, extension of social services, and environmental conservation.

The government has finalized its National Growth and Poverty Eradication Strategy (NGPES), its equivalent of the PRSP. It provides a good framework on its strategy to reduce poverty and meet other developmental objectives. The joint staff assessment to this report is also being discussed at the Executive Board along with the staff report.

6. Preparations for the Nam Theun 2 (NT2) hydroelectric project are entering into a critical phase. This huge project has the potential to significantly boost Lao P.D.R.’s development provided that the resources it will generate are managed effectively. The deadline for finalizing the project is approaching, as the consortium of investors has until May 2005 to secure all the financing. The main outstanding issue concerns the financing of the government’s equity stake in the project ($80 $100 million) and the provision of partial-risk guarantees to cover creditors against sovereign risk. The government has approached the World Bank and other agencies to assist with the remaining elements of the financing package. In addition to a satisfactory macroeconomic situation, this support is conditional on appropriate environmental and social safeguards, the establishment of effective revenue management mechanisms, and assurances relating to Lao P.D.R.’s external debt outlook.

Recent developments

7. The economy has held up well in 2004 (Table 1). Although economic growth dipped in 2003 to 5¼ percent, half a percentage point lower than in 2002, the latest indicators suggest that activity has rebounded in 2004, with growth projected to rise to 6 percent of GDP. Agriculture and hydroelectricity output have recovered from a drought in 2003, and tourism has recovered from last year’s SARs outbreak. Manufacturing activity has also been boosted by a pick-up in consumer demand, driven in part by buoyant informal sector activity.

Table 1.

Lao P.D.R.: Selected Economic and Financial Indicators. 2001-2005

Nominal GDP (2002): $1,818 million

GDP pet capita (2002): $329

Population (2002): 5.53 million

Fund quota: SDR 52.9 million

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Sources: Data provided by the Lao P.D.R. authorities, and Fund staff estimates and projections.

Latest data are for September 2004 unless otherwise indicated.

The government estimates real GDP and deflator growth in 2003 to be 5.8 percent and 15.8 percent respectively.

Fiscal year basis (October to September).

Numbers fur 2004 are estimates and far. 2005 are staff proposal.

Money and credit data are evaluated at constant exchange rates.

Russian debt for 2003-2005 is based on the agreement reached in December 2003 between the Lao P.D.R. and Russian governments. Prior to 2003 the Russian debt is excluded.

Data as of November 10, 2004.

Base Year 2000–100.

Data as of July 2004.

8. Inflation, which had surged into double digits in 2002, has been on a downward trend since mid 2003 (Figure 3). With the kip remaining stable, core inflation has fallen steadily over the last year to just over 6½ percent (12-month basis). Sharp increases in food (mainly rice), fuel and utility prices kept headline inflation relatively high for most of 2004, but with food prices starting to ease in recent months, headline inflation has also began to decline, falling to 7½ percent in September. Despite the recent increase in oil prices, headline inflation should stay in single digits for the remainder of the year, provided food prices remain subdued.

Figure 3.
Figure 3.

Consumer Price Inflation

(year on year percentage change)

Citation: IMF Staff Country Reports 2005, 008; 10.5089/9781451822533.002.A001

9. The external position has improved, but Lao P.D.R.’s external debt remains high (Table 2). Relatively brisk export growth, combined with buoyant donor and foreign direct investment inflows, is expected to lift external reserves to around $240 million by end 2004, sufficient to maintain reserve cover at around 4 months of imports. Public external debt has continued to rise over the last couple of years, mainly as a result of concessional borrowing from multilateral donors. Including Lao P.D.R.’s debt to Russia, the net present value (NPV) of public external debt stands at 220 percent of exports (Table 3).

Table 2.

Lao P.D.R.: Balance of Payments, 2001-2008

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Sources: Data provided by the Lao P.D.R. authorities: and Fund staff estimates and projections.

Includes debt service to official creditors and estimates for debit service to commercial creditors.

The financing gap in 2004 and 2005 are covered by disbursements under the PRGF program, and program loans from the World Bank and AsDB.

Imports for NT2 start in late 2005. supported mainly by external financing.

Table 3.

Lao P.D.R.: External Debt and Debt Service 2001–2008

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Sources: Data provided by the Lao P.D.R. authorities: and Fund staff estimates and projections.

Based on the December 2003 agreement between Russian and Lao authorities.

10. Monetary policy has generally been restrained over the past year (Table 4). Net domestic assets of the Bank of Lao P.D.R. (BoL) have been broadly stable. Both reserve money and broad money have been growing relatively fast—broad money grew by 20 percent in the year to September—but the recent decline in inflation suggests that this reflects mainly an increase in demand for kip, prompted by the recent stability of the exchange rate.6 Tighter credit controls under the bank restructuring program kept state bank credit within the program path established for 2003/04 for much of the year. However, credit by the SCBs has expanded rapidly in the last quarter, raising concerns that the previously tight controls on credit allocations by the SCBs may be weakening, potentially undermining a key element of the monetary policy framework (Table 5).

Table 4.

Lao P.D.R.: Monetary Survey, 2003-2005 1/

(in billions of kip, unless otherwise indicated)

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Sources: Data provided by the Lao P.D.R authorities; and Fund staff estimates and projections.

All figures evaluated at program exchange rate.

The first column is evaluated at a program exchange rate of 10,800. while the second is evaluated at 10,600.

Revised targets agreed with the authorities in December 2003 (for June 2004) and in July 2004 (for September 2004).

Adjusted for the impact of Debt Clearance/Bank Recapitalization Bonds.

Net Foreign Assets of Bol minus foreign currency component of reserve money.

In millions of U.S. dollars, cumulative since March 2003.

Cumulative since end-June 2003.

Table 5.

Lao P.D.R.: Quantitative Perform ante Criteria and Indicative Targets. 2003-2004

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Sources: Data provided by the Lao P.D.R. authorities. Definitions of terms are contained in the Technical Memorandum on Program Monitoring.

Performance criteria.

Revised program agreed with the authorities in December 2003 (for March 2004).

Revised targets agreed with the authorities in December 2003 (for June 2004) and in July 2004 (for September 2004).

The ceilings for net domestic assets of the BOL and net bank credit to the government will be adjusted upward (downward), and the floor of net official international rescues will be adjusted downward (upward) by any shortfall (excess) in nonproject budget loans.

The ceilings for net credit to the government will be adjusted upward to the extent that issues of Debt Clearance/Bank Recapitalization Bonds exceed program assumptions.

The state commercial banks include BCEL and LDB. Net domestic assets exclude net claims on government and BOL. The ceiling on net domestic assets of slate commercial banks will be adjusted downward to the extent that issues of Debit Clearance/Rank Recapitalization Bonds exceed program assumptions.

Indicative target.

Cumulative from start of fiscal year (October to September).

Excludes foreign currency component of reserve money.

Continuous performance criterion.

From March 2003 onwards. Excludes the three-year lease contracted by Lao Airlines on May 27, 2003 as well as debt contracted from the Asian Development Bank and the European Investment Bank to finance the government’s equity portion of Nam Theun 2 hydroelectric project.

Cumulative from end-September 2002.

Cumulative issues from end-June 2003.

11. The preliminary fiscal outturn for 2003/04 indicates that the budget deficit declined to 3.9 percent of GDP, almost 2 percentage points lower than in 2002/03 (Table 6). The latest data suggest that revenues have performed relatively well, rising from 11.1 to 11.3 percent of GDP. Stronger administrative efforts, combined with the full year effects of last year’s increase in petroleum taxes, raised tax revenues (excluding timber royalties) from 8.1 to 8.9 percent of GDP, despite the impact of tariff reforms related to the ASEAN Free Trade Arrangement (AFTA). However, these gains were partly offset by lower timber royalties and nontax revenues. Expenditures fell by 1.8 percent of GDP, due mainly to lower foreign financed capital expenditures, following the completion of a number of large projects. Domestic spending also contracted, as sharp cuts in the domestic capital budget, following tight controls over new projects, more than offset higher current spending.

Table 6.

Lao P.D.R.: General Government Operations 2001/02-2004/05

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Sources: Data provided by the Lao P.D.K, authorities: and Lund staff estimates and projections.

Reflects staff provisional understanding of treatment of wages, salaries, and allowances and pensions in 2004/05 budget.

In 2002/03 and 2003/04 the bonds were Debit Clearance Bonds issued to state banks to settle budget obligations to contractors with NPLs. In 2004/05 includes bank recapitalization bonds.

In 2001/02 includes a transfer of $33 million from EDL to the government from the Theun-Hinboun Power Company refinancing.

12. The authorities have implemented most of the original structural benchmarks for the fourth review, albeit some with delay (Table 7). The benchmarks related to onsite bank inspections (performance criterion), improving the budget classification, and transferring tax payers to the central large taxpayer unit were implemented on schedule. Implementing regulations for the presidential decree on tax incentives were issued, albeit with considerable delay.7 However, progress has been slower in the core fiscal reforms related to the centralization of the customs and treasury departments. The amendments to the commercial bank law to permit foreign banks to operate nationwide have yet to be finalized.

Table 7.

Lao P.D.R.: Structural Benchmarks under Third Annual Program

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Performance criterion.

Table 8.

Lao P.D.R.: Strategy for Structural Fiscal Reforms.

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13. Completion of the fourth review has been delayed pending the resolution of a number of issues. These include: (i) clarification of the 2004/05 budget plan approved by the National Assembly in mid October; (ii) confirmation that the scope of tax incentives provided under new investment laws conforms with understandings reached on the presidential decree on tax incentives; (iii) satisfactory progress in centralizing the customs administration; and (iv) corrective actions to contain credit expansion at the SCBs. Staff have also sought understandings on the external auditing of the BoL’s accounts and to update the status of the rescheduling of Lao P.D.R’s Russian debt. Discussions on these outstanding issues are still ongoing and a staff team plan to visit Vientiane after the conclusion of the Article IV Consultation to resume discussions on the fourth review.

II. Policy Discussions

14. The Article IV Consultation, which comes on the heels of the authorities’ PRSP, provided an opportunity to take a medium-term perspective on reform. The joint staff advisory note (JSAN) for the PRSP has been separately circulated for consideration by the Executive Board (EBD/04/122). In line with the PRSP, discussions focused on fiscal reforms to solidify macroeconomic stability, expand the revenue envelope, and improve expenditure management, which are essential to the government’s goal of achieving growth with equity. Complementary reforms in SCBs and SOEs were also addressed, as were potential sources of growth and steps to meet the competitive challenges of regional integration.

A. Fiscal Issues

15. Policy discussions focused on advancing the process of fiscal reform. The priority was to reach understandings on the 2004/05 budget framework and to review the government’s medium-term plans for structural reform.

2004/05 budget

16. The staff reached understandings on a sound budget framework for 2004/05 in August. The authorities agreed to aim at raising revenue from 11.3 to 11.6 percent of GDP. The main tax measures included the reversal of the turnover tax reduction enacted in 2002/03, and a rationalization of excise duties. On the spending side, the staff encouraged the authorities to raise recurrent spending on health and education. Higher spending on the wage bill (0.4 percent of GDP), consistent with a mid-year increase in base salaries of 20 percent, was also justified, given that civil service wages have remained low. The overall budget framework was consistent with maintaining the budget deficit at around 4 percent of GDP, which could be fully financed through concessional loans.

17. The staff have expressed reservations about the budget plan as approved by the National Assembly. The plan’s revenue target (12 percent of GDP) may be overambitious in the absence of additional revenue-raising measures and the proposed reallocation of domestic expenditures from capital to recurrent, in particular the large increase in the wage bill (1.3 percent of GDP) may not be sustainable. Staff also encouraged the authorities to ensure that world oil market prices were passed onto consumers without delay, as the budget could ill-afford a loss of petroleum revenue.8 The authorities recognize that raising the wage bill would need to be conditional on achieving the revenue targets in the budget and realizing projected cost-savings in other areas of the budget. While staff are working with the authorities to clarify the budget measures proposed in the budget plan, a preliminary analysis indicates that the proposed increase in the wage bill may need to be phased in over a longer time period.9 The staff therefore welcome the authorities’ intention to review the measures at the time of the mid-year budget in April, and to recalibrate them if necessary.

Medium-term fiscal reform strategy

18. The key elements of the medium-term fiscal strategy are well defined in the PRSP.10 There is a broad consensus that revenue mobilization continues to be the main priority and that efforts in this area need to focus on strengthening tax and customs administration, which, inter alia, is essential for moving ahead with the VAT, the main tax policy reform (Box 2). On the expenditure side the priority is to strengthen the planning and execution of the government budget. Progress in both areas is dependent on strengthening central government control over revenue administration and treasury operations in the provinces. While progress can be made in the individual components, these reforms will require a more comprehensive reform of inter-govern mental relations.

19. The main challenge on the revenue administration front has been to re-centralize authority over the tax and customs administration. The focus in 2003/04 had been on centralizing the customs department, starting with the seven main international check points. Some advances have been made in restoring central authority over the staff and revenues at the check points, but the reforms had encountered considerable resistance from provincial governors. Nevertheless, the authorities were committed to the reforms and indicated that the next steps were to: (i) place the provincial staff at the check points on the government’s payroll; (ii) ensure all revenues were deposited directly into central government bank accounts; and (iii) pass a new customs law that would formalize central authority over the customs administration. Once the customs reforms became more deeply entrenched, the authorities would start the process of bringing the provincial large taxpayer units (LTUs) under central control. In the interim, work would proceed with improving the operations of the individual LTUs and strengthening the capacity of the tax department headquarters, with the assistance provided by the Swedish government (SIDA).

20. Introduction of a VAT remains the main tax policy change in the medium-term. The government intends to introduce this long-standing reform in January 2007. To this end, the government has submitted a proposal to the National Assembly to introduce a single rate VAT (10 percent). The staff welcomed this formal commitment to introducing a VAT and encouraged the authorities to finalize and publish their plans for the main parameters of the VAT and the detailed plan for its implementation. The authorities indicated that work on such a plan was underway with assistance from SIDA and regional partners. In this context, the staff also welcomed the reduction in the number of turnover tax rates (from three to two) in the 2004/05 budget, as this is an important step towards a single rate VAT.

Lao P.D.R.: Recent Revenue Developments and Outlook

The poor revenue performance since the start of the program in 2000/01 has been a major concern. Instead of rising by 2 percentage points, as originally envisaged under the program, the revenue-to-GDP ratio has declined significantly, falling to 11.1 percent of GDP by 2002/03, 2 percentage points below 1999/00. The original revenue gain had been based on the assumption that the VAT would be introduced in 2003 and that supporting administrative reforms would bolster revenue collections in the interim.

Although part of the decline reflected external factors, it has also reflected slow progress on revenue reforms (including policy reversals). A significant part of the revenue decline is attributable to a sharp drop in timber royalties, which fell by 1 percent of GDP following the imposition of an export ban on unprocessed logs. A rationalization of the finances of state banks and state-owned enterprises has also reduced taxes from the state sector (before recent reforms, state banks and SOEs continued to pay taxes despite running large underlying losses). However, a deterioration in tax and customs administration, following a decision in 2000 to decentralize fiscal management to the provinces, has been a major contributory factor. The revenue base has also been eroded by tax incentives, such as a reduction in turnover tax rates for domestic producers in 2002/03, and an extension of ad hoc exemptions on excises.

At the same time, it is now recognized that the original revenue objectives may have been too optimistic. Indeed, once account is taken of the large subsistence agriculture sector in Lao P.D.R., the overall revenue effort does not compare unfavorably with its neighbors in the region. The ratio of budget revenue to nonagricultural GDP (excluding revenue from natural resources) is comparable to that in Vietnam and significantly higher than in Cambodia. The challenge of overcoming acute capacity constraints may also have been underestimated, although this has been secondary to the challenge of forging a consensus on key policy reforms.

In light of these developments, the medium-term outlook for budget revenues has been revised downwards significantly relative to that presented at the time of the third review (Table). Staff now propose a medium-term revenue path that would raise the revenue-to-GDP-ratio by 1-1½ percent of GDP over the next three years. This path allows for a more realistic timetable for the introduction of the VAT and takes account of expected losses from the tariffs reduction under AFTA (estimated at 0.7 percent of GDP). It also recognizes that the decline in timber royalties is only partly recoverable and the reduction in taxes from state banks and enterprises will only be reversed once they have been placed on a sound financial footing.

Lao P.D.R.: Revenue Outlook, 2003/04–2007/08

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Sources: Data provided by the Lao P.D.R. authorities; and Fund staff estimates.

Reflects the effect of GDP growing faster than the tax base due to the impact of the large Oxiana mining project.

21. Limiting exemptions and other tax incentives is also important for broadening the tax base. Staff welcomed the promulgation of regulations for the presidential decree on tax incentives, which were issued in August and struck an appropriate balance between promoting investment and protecting the revenue base. Staff welcomed in particular the provisions strengthening the Ministry of Finance’s control over the administration of tax incentives. But the new regulatory framework has recently been superseded by new investment laws approved by the National Assembly in October. The staff have expressed concern that the new investment laws might broaden the scope of tax incentives and weaken the controls over their administration built into the presidential decree. While the staff still need to review the laws, the authorities have assured the staff that they are broadly consistent with understandings reached on the presidential decree.

22. The mission discussed the authorities’ agenda for public expenditure reform. The main priority is to strengthen treasury controls, by bringing sub-treasuries in the provinces under the direct control of the central treasury. Over the longer term, this will require a comprehensive revision to the basic Treasury Law. The authorities agreed that it would be useful to launch this process by preparing a concept paper, with the assistance of FAD and the World Bank, to forge a consensus on the key reforms. In the interim, the authorities indicated that they would develop an integrated cash management plan to improve cooperation and information between the center and the six largest provinces. These reforms would be complemented by efforts to improve information, through the implementation of a revised chart of accounts and budget nomenclature based on international standards. Greater efforts are also needed to prevent and clear domestic budget arrears. The authorities noted that the September 2003 survey on arrears had been helpful in developing a strategy to reduce legitimate arrears and they intended to conduct another survey of arrears as of end-September 2004 to further this process.

23. The authorities recognize that reforms to the broader decentralization framework are essential to strengthening fiscal management. (The provinces are unlikely to cede control over revenues until such a framework is in place). The government is currently reviewing the regulatory framework for fiscal relations between the central government and the provinces, with a view to clarifying the assignment of revenue and expenditure responsibilities between the center and provinces and develop a robust mechanism for inter-governmental transfers. Staff recognize that the reform process is highly sensitive, and have offered technical assistance to explore different options in inter-governmental fiscal relations to help facilitate the ongoing dialogue in this area.

B. Monetary and Exchange Rate Policy

24. The authorities confirmed that monetary policy would remain firmly geared towards reducing inflation. They did not envisage a major shift in monetary operations in 2004/05. They would aim to keep the central bank’s net domestic assets broadly unchanged over the year, a target that would be underpinned by a government commitment to avoid bank financing of the budget. After a period of retrenchment in bank loan portfolios, the authorities expected credit growth to rise to around 14½ percent in 2004/05, in line with nominal GDP. They also saw merit in raising the level of gross international reserves further to around 4¼ months of imports, which would be broadly consistent with reserve money growing at around 12 percent over the year.

25. Staff urged the authorities to maintain tight control over credit expansion at the SCBs. This would be essential until the banks were placed on a sound commercial footing. Staff expressed concern about the rapid credit expansion in the SCBs in the last quarter of 2003/04, which caused the end-September indicative targets on the banks’ net domestic assets to be breached by a significant margin. The authorities reaffirmed their commitment to prudent credit management at the SCBs, but noted that the recent credit expansion had reflected a one-off investment in the domestic cement industry, a high priority area for the government. Staff noted, however, that such a large exposure posed risks to both macroeconomic stability and the bank restructuring process,11 and have encouraged the authorities to recalibrate the financing of this project to reduce the SCBs’ exposure. The authorities are currently reviewing alternative financing options for the project in collaboration with the World Bank.

26. The authorities regard exchange rate stability as key to maintaining macroeconomic stability. Although the central bank’s external reserves more than cover base money, the authorities recognize that they have neither the instruments nor sufficient control over the budget to credibly peg the exchange rate. Their interventions in the foreign exchange market would therefore be limited only to smoothing transitory fluctuations in the exchange rate. Sustained pressure on the exchange rate would have to be addressed by correcting the underlying policy slippages. They agreed with staff that exchange rate stability was best preserved through prudent fiscal management and effective control over the SCBs—a major source of credit expansion in the past—both of which were central to effective monetary control. The staff agreed with the authorities that recent trends in exports suggested that the exchange rate was not seriously misaligned.

C. External Debt Management

27. Staff are clarifying the status of negotiations on the rescheduling of Lao P.D.R.’s external debt with Russia. A preliminary agreement was signed in December 2003, which entailed an approximate NPV reduction of 20 percent on the face value of the outstanding debt ($387 million). Given the relatively limited degree of concessionality under this agreement, the authorities have approached the Russian government to secure more favorable terms (an initial payment was made in August, as a gesture of good faith). The Lao authorities are currently awaiting a response from Russia to their request.

28. Staff urged the authorities to strengthen internal control over public debt management. While the Ministry of Finance has made efforts to improve its monitoring and reporting of public external debt, significant weaknesses remain with regard to control over the contracting of external debt. While no new instances of contracting of nonconcessional public debt have been reported, there have been a number of instances of public debt being contracted without the Ministry of Finance’s prior approval. These weaknesses in public debt management pose a significant risk to maintaining a sustainable debt burden.

D. Structural Reform

29. Discussions on the structural reform agenda focused largely on efforts to improve public sector financial management. SCB restructuring and SOE reform have been the two key elements of the reform program supported by the PRGF arrangement, as the finances of these state institutions need to be improved to protect the medium-term fiscal outlook.

Banking issues

30. The authorities reaffirmed their commitment to creating a sound and competitive banking sector. Progress is being made under the restructuring plans established for the two SCBs,12 and the international banking advisers placed in both banks have helped strengthen the banks’ operations and credit management practices. Steady progress is also being made in strengthening bank supervision, with the support from MFD.

31. Staff noted that significant risks remained at the SCBs. Both are still deeply insolvent and their underlying profitability is weak. Moreover, the risk of new nonperforming loans is high, as they are still vulnerable to pressures to extend credits on a non commercial basis. It was agreed that to mitigate these risks, the authorities should maintain close oversight over the banks’ operations. The immediate priority was to finalize the external audit of the banks’ 2003 accounts to help establish appropriate performance targets for the two SCBs in 2004/05. Regular on-site inspections of these SCBs would continue to be important, as would overall credit limits for the SCBs while they are in the process of restructuring. Staff also urged the authorities to introduce new regulations on credit limits and foreign exposure and establish a time table for bringing the SCBs into compliance with prudential regulations.

32. Staff also discussed measures to improve the overall banking environment. The immediate priority was to secure the passage of amendments to the banking laws to equalize the capital requirements for domestic and foreign banks and allow foreign banks to operate branches on a nationwide basis. Staff reviewed preparations for attracting private sector investors into the SCBs. The authorities noted that progress on this front would be difficult until the process of recapitalizing the SCBs was more advanced, and further progress had been made in the ongoing reforms in the legal environment and private sector development, supported by the AsDB and the World Bank.13

Enterprise issues

33. SOE reform has been an essential complement to the banking reform agenda. Although the SOE sector is now relatively small, it accounts for a large share of credit and NPLs at the state banks. The reform program, supported by the World Bank, has focused on addressing the financial weaknesses of the largest and most indebted SOEs. The focus has been on tariff reform to commercialize the large utilities and on operational restructuring, including the sale of noncore assets.

34. The authorities have made progress in SOE reform over the last year. 14 Substantial adjustments have been made in the tariffs for the major utilities and the restructuring for the electric utility (EDL) is almost complete. Time-bound restructuring programs for three of the four other major enterprises have also been launched and are expected to be completed by end-2005. The authorities have also taken steps to address the losses of Lao Airlines, whose financial position had deteriorated sharply over the last year, partly as a result of leasing a new Airbus. The authorities have decided to ground the Airbus, to stem the losses from its operations, and are exploring options to contract the airplane to another airline. The authorities are also proceeding with the strategy agreed with the World Bank to secure a joint venture partner for the airline.

35. The authorities have taken steps to improve the overall climate for private sector activity and stimulate investment. A decree on competition was issued in February 2004, lifting barriers to trade and laying out a framework for dealing with uncompetitive practices, and a further decree was issued in June 2004, abolishing barriers to movements of goods within the country. In recent months, the authorities have also taken a series of initiatives designed to facilitate investment, including the finalization of a decree for setting up a one-stop window for the approval of new investment projects.

36. The persistent deficiency of the Lao legal system is one of the major impediments to private sector development and increased foreign direct investment. In order to address the shortcomings in the legal framework and strengthen the operation of the legal system, the authorities have launched several reform projects with assistance from the AsDB and UNDP. These projects aim, inter alia, at simplifying the laws and regulations and increasing their dissemination, ensuring the consistency of the existing legal framework, expanding the body of commercial laws, and strengthening the operation of tribunals.

Trade and exchange system reforms

37. The authorities recognize that reforms to the trade and exchange system are also key for developing the private sector. To this end, quota restrictions on imports have been abolished, and import licensing is required for only four products: fuel, cement, steel, and vehicles.15 The authorities are committed to continuing the process of tariff reform in line with their commitments under AFTA, are moving ahead with their application to the WTO, and have sought to advance the process of obtaining normal trade relations (NTR) with the USA. They are also working with international partners under the Integrated Framework (IF) scheme to integrate trade reform into their national growth and poverty reduction strategy.

38. The authorities are committed to a liberal foreign exchange regime. A joint LEG/MFD mission visited Vientiane in August 2004 to review the exchange system and facilitate acceptance by Lao P.D.R. of the obligations of Article VIII, sections 2,3 and 4. The mission recommended that Lao P.D.R. address a number of issues before accepting the obligations, including measures inconsistent with Article VIII, specifically: (i) the requirement to produce a tax payment certificate before certain payments and transfers for international transactions can be authorized;16 and (ii) maintaining lists of persons to whom payments and transfers cannot be made.17 Staff does not recommend approval of these exchange restrictions. The mission also suggested that the authorities amend the regulations in certain areas to clarify that the kip is convertible for all current international transactions. The authorities are reviewing the recommendations of the mission, with a view to expediting the process of accepting the obligations under Article VIII.

Other Issues

39. The quality of macroeconomic statistics needs to be significantly improved. Efforts have been made this year, with IMF technical assistance, to improve government finance and monetary and financial statistics. Moreover, the authorities have also identified steps needed to participate in the IMF’s General Data Dissemination System (GDDS), and are continuing work on finalizing the metadata. This will also improve data coordination between the agencies in the government. Meanwhile, greater efforts are needed to improve the system of reporting and monitoring of all public debt, including SOE debt. Given significant weaknesses in the balance of payments statistics, it would be useful for the authorities to seek technical assistance in this area.

40. A new issue has arisen regarding the Fund’s safeguards policy. The authorities have indicated that they are not in a position to implement an earlier agreement to undertake a joint audit of the BoL’s 2003 accounts by the state auditor and an international audit firm. Staff have proposed a temporary compromise that involves commissioning a targeted external review of the BoL’s external reserves and reserve money positions by an international audit firm, as a step towards a full-fledged joint external audit at a later stage. The authorities are currently reviewing their position with regard to this proposal.

III. Medium-term Outlook and Debt Sustainability

41. The staff’s medium term scenario envisages the economy growing at 6-6½ percent per annum (Table 9).18 Large foreign invested projects in the mining and hydroelectric power sectors are expected to be the main source of growth, complemented by smaller scale investments in agriculture, manufacturing and service sectors, as the benefits of increased regional integration take hold. Inflation is expected to ease to around 5 percent, provided monetary and fiscal policies remain under tight control. Strong export growth, mainly from a sharp increase in exports from the Oxiana mines, is expected to compensate for high oil prices.19 The external current account deficit would widen to 10–11 percent of GDP, but this reflects primarily large capital imports associated with the NT2 project, that will be matched by increases in foreign direct investment. The underlying external position would remain manageable, with current account deficits declining to 3–4 percent of GDP, and continuing to be financed mainly by concessional medium and long-term borrowings (Table 10).

Table 9.

Lao P.D.R.: Summary Maura economic Framework, 2001-2008

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Sources: Data provided by the Lao P.D.R. authorities; and Fund staff estimates and projections.

It is expected that the construction of the large NT2 hydroelectric project will begin in late 2005.

Fiscal year ending September; Fiscal numbers are based on staff estimates for 2004 and staff proposal for 2005-2008.

The overall budget deficit for 2001/02 includes estimated expenditure arrears of KN I 30 billion.

Estimates for private savings and investment are highly tentative an no expenditure based national accounts have yet been established. In particular, private savings reflect, unrecorded imports.

Comprises government investment and selected enterprise investment.

Table 10.

Lao P.D.R.: External Financing Needs and Sources, 2003–2008

(In millions of U.S. dollars)

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Sources: Data provided by the Lao P.D.R. authorities: and Fund staff estimates and projections.

Excluding the IMF.

Original maturity of less than one year. Includes all short-term outflows.

Includes all other net financial flows, and errors and omissions.

Includes prospective IMF disbursements.