Introduction

On behalf of the Lao’s authorities, we would like to express their appreciation to the staff, management and the Executive Board as well as to the donor community for their advice and continued support. The extensive consultation and discussions during the Fund mission have provided a comprehensive assessment and valuable suggestions to the authorities on Lao’s economic development, including the implementation of the reform program. In this respect, the authorities would like to thank the mission team for the constructive dialogue as well as the well written and balanced Staff Report for the 2004 Article IV Consultation.

Continued implementation of the structural reform program coupled with sound macroeconomic policies, supported by financial and technical assistance from the Fund and other development partners, have contributed to macroeconomic stability and encouraging economic growth in the recent years. Inflationary pressures have subsided and poverty has continued to decline. Despite these positive developments, the authorities are aware that Lao’s economy still faces major challenges. While significant progress has been made, structural weaknesses in a number of areas remain. In view of these challenges, the Lao authorities would like to reiterate their continued commitment to sound macroeconomic management and the reform agenda, consistent with the National Growth and Poverty Eradication Strategy (NGPES), the first full poverty reduction strategy prepared by the government. The NGPES has provided a broad strategic framework under which the Government’s future growth and poverty eradication program will be developed and implemented in order to raise Lao P.D.R. from the rank of least-developed countries by 2020.

Recent Economic Developments

A combination of prudent macroeconomic policies and more favorable external developments contributed to Lao’s favorable macroeconomic performance in the past few years. In 2004, the economy rebounded and growth is expected to reach 6 ½ percent of GDP, attributed mainly to agriculture and hydroelectricity output that have recovered from a drought in 2003. The tourism sector has also recovered from last year’s SARs outbreak. In addition, manufacturing activity has also picked up in response to growth in consumer demand.

Inflation, which had surged into double digits in 2002, has been on a downward trend since mid-2003, reflecting continued prudent monetary policy. A temporary supply shock—mainly resulting in a sharp increase in basic food, fuel and utility prices—has caused headline inflation to be relatively high for most of 2004. However, as food inflation fell rapidly, headline inflation has declined to 7 percent in October 2004, and is expected to stay in single digits for the remainder of the year. With the kip remaining stable, core inflation has fallen significantly over the past year.

Lao’s external position has continued to improve. Rapid export growth and continued buoyant donor and FDI inflows have allowed gross official reserves to increase steadily and are expected to reach US$ 240 million by end 2004, which is equivalent to around 4 months of imports. Nevertheless, with new contracts on concessional borrowings from multilateral donors, public external debt has continued to rise over the last couple of years.

On the structural reform front, the authorities have implemented most of the original structural benchmarks for the fourth review of the PRGF. The benchmarks related to onsite bank inspection, improving the budget classification, and transferring tax payers to the central large tax payer unit were implemented on schedule. However, some delays occurred in the finalization of implementing regulation for the presidential decree on tax incentives.

Fiscal Policy

Recognizing the importance of fiscal sustainability to macroeconomic stability, the authorities remain committed to pursue prudent fiscal policy and to continue the necessary fiscal reforms. However, the adjustment pace should also consider the favorable working environment between central and local government, given the prevailing capacity constraints and the need to ensure sustainability and irreversibility of the reforms.

As highlighted in the staff report, 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 that in 2002/03. At the same time, revenue collections have also performed well, rising from 11.1 to 11.3 percent of GDP. As last year’s increase in petroleum taxes take full effect combined with stronger administrative efforts, tax revenues (excluding timber royalties) increased from 8.1 to 8.9 percent of GDP. In order to further enhance the source of revenues, the authorities have submitted a proposal to the National Assembly to introduce a single rate value added tax (VAT).

The authorities broadly agree with staff that progress in revenue mobilization and strengthening of tax and custom administration will also depend on strengthening of central government control over revenue administration and treasury operations in the provinces. In this respect, the authorities are committed to undertake reform on inter-governmental relations. However, redefinition of central-local relations can only be undertaken on a step-by-step basis according to the capacity of local level officials to assume new responsibilities, and the ability of the Central Government to monitor compliance with national priorities. In this context, the government is committed to improve communication with people especially in the remote areas, clarify the responsibilities for each level of government, redeploy human resources from central to local level, improve capacity building at the local level, and improve the monitoring capacity of the central government.

Monetary and Exchange Rate Policy

The authorities will continue to gear monetary policy toward reducing inflation and creating a stable financial environment that are deemed essential to facilitate growth, private investment, and promote international trade. Monetary policy has generally been restrained over the past year. As illustrated in Table 4 in the staff report, growth of credit to the economy was slower than the target, largely contributed to by relatively tight credit controls under the state bank restructuring program during 2003/04. However, due to a one-off investment in a domestic strategic industry (cement), net domestic assets of the SCBs showed a temporary jump in 2004. The authorities are exploring ways to increase equity in this project and to diversify its sources of financing. Credit growth is expected to return to a moderate rate, in line with nominal GDP, over the medium-term.

On exchange rate policy, a managed floating exchange rate system has served Lao’s authorities well. In this respect, the authorities’ intervention in the foreign exchange market is aimed at smoothing transitory fluctuations in the exchange rate.

Structural Reforms

The authorities recognize that strengthening structural reform efforts in all sectors, particularly in the state commercial banks (SCBs), state owned enterprises (SOEs), and the trade sector, will be a key to promoting economic efficiency and competitiveness. This is crucial to sustaining economic growth which is required for poverty reduction.

On SCBs, the authorities are committed to continuing the banking sector reform program supported by the World Bank, the IMF, and the AsDB. The Lao authorities recognize that the reform is not only crucial to the proper functioning of the financial sector, but also to fiscal and macro stability. In this respect, the process of finalizing the external audit of the banks’ 2003 accounts, which will be used to establish appropriate performance targets for BCEL (Banque pour le Commerce Exterieur du Laos) and LDB (Lao Development Bank) in 2004/05, is underway. The authorities agree with staff that on-site inspections and overall credit limits for the SCBs will remain and continue to provide critical operational benchmarks for these institutions. However, the time table for bringing the SCBs into compliance with these prudential regulations need to be set appropriately with due consideration to institutional capabilities. In this context, the authorities intend to proceed with the recapitalization of the SCBs during 2005. In addition the Bank of the Lao PDR will also issue regulation on loan concentration and foreign currency exposure.

For the non-financial state-owned enterprises, the authorities have made progress in restructuring the five large-indebted SOEs, namely the electricity utility (EDL), the Ministry of Defense conglomerate Phoudoi, the water utility (Nam Pa Pa), the national airline (Lao Airlines), and a pharmaceutical factory. Steps have also been taken to resolve and streamline operations of a number of key corporations, including to address the ongoing losses of Lao Airlines. With assistance from the World Bank, restructuring for the EDL is almost complete, and the programs for three other enterprises have also been initiated and are expected to be completed by end-2005. To promote private sector activity and improve the investment climate, the authorities intend to ensure that the new investment laws, as approved by the National Assembly in October 2004, are consistent with the earlier structure and levels of incentive provided under the presidential decree.

The authorities have also initiated several legal reform projects with assistance from the donor community. To foster the development of a more favorable environment conducive to private activities and investments, a number of reforms have been implemented to enhance competition and provide a more level playing field. In particular, quota restrictions on imports have been abolished and import licensing menu has been narrowed down to only four products, namely fuel, cement, steel, and vehicle. Furthermore, a decree on competition was also issued in February 2004, lifting barriers to trade and laying out a framework for dealing with uncompetitive practices, followed by another decree issued in June 2004, abolishing barriers to movements of goods within the country. The authorities are also committed to continuing the process of tariff reform in line with AFTA schedule, moving ahead with WTO application, and seeking to normalize trade relations (NTR) with the USA.

The authorities have made progress in improving the quality of macroeconomic statistics, with Fund technical assistance. Preparations are being undertaken to improve data coordination between the government agencies. On the safeguards issue, the authorities are reviewing staff’s proposal for the commissioning of a targeted external review of the Bank of Lao’s external reserves and reserve money positions by an international audit firm. Further discussion on this issue with the staff is expected to take place during the fourth PRGF review period, after this Article IV Consultation.

External Debt Management

The authorities recognize that the external debt level is high, but is nevertheless manageable. Accordingly, they are committed not to seek debt relief under enhanced HIPC Initiative. In this context, they will pursue policies aimed at raising economic growth in a sustainable manner and increasing gradually the government revenue ratio to GDP. In addition, the authorities plan to reduce the fiscal deficit over time and will make sure that new debts contracted carry a sufficiently high degree of concessionality, and will focus on strict enforcement of the Instruction on Centralization of the Management and Monitoring of External Debt at the Ministry of Finance.

Outlook

In the medium-term, the economy is expected to remain reasonably favorable, fostered by macroeconomic stability and continued progress in the structural reform program. The authorities agree with staff that FDI inflows, particularly in mining, and in the hydroelectric power sector are expected to be the main engine of growth. The current account deficit is expected to be fully financed by FDI and concessional borrowings. The authorities acknowledge that prudent fiscal and monetary policy is essential to sustaining the economic growth momentum. In addition, further acceleration of the structural reform program being undertaken by the authorities will gradually lessen the government’s debt burden to a more sustainable level. The authorities are also aware that such an ambitious target to reduce the debt burden can only be achieved through a combination of revenue enhancing, expenditure streamlining, as well as private sector development measures. Strong and sustained economic growth will, in turn, provide a firm basis for continued poverty reduction over the period.

Conclusions

Considering the relatively dire conditions that the Lao’s authorities had to start with, we believe that from the beginning of the PRGF program in 2001, Lao’s economic and social development has come a long way. The authorities highly value the continued support from the international community, including the Fund. Despite considerable progress being achieved thus far, there are challenges ahead. The Lao’s authorities look forward to the continuation of the close and effective cooperation, as in the past, with the Fund through further discussion on the fourth PRGF review. The authorities would like to thank staff, once again for their hard work and dedication, in seeking alternative ways to fulfill the requirements of the program, giving due consideration to the formidable constraints facing Lao PDR. On their part, the authorities will employ their utmost efforts in pursuit of development in order to fulfill both national targets, as well as international community’ expectations.

With regards to AML-CFT, Lao PDR maintains restrictions on financial transactions and accounts are frozen if they involve individuals or organizations included in the list of terrorists maintained pursuant to (a) UN Secretary Council Resolution 1373 (September 28, 2001); and (b) the list of current terrorist organizations designated by the US Secretary of State.

The Authorities intend to authorize publication of the Staff Report for the 2004 Article IV consultation, Poverty Reduction Strategy Paper-Joint-Staff Advisory Note (EBS/03/127), Selected Issues and Statistical Appendix on the Fund’s web site.