Introduction

The Laotian authorities would like to convey their appreciation to the staff for the constructive discussions on issues pertaining to the Laotian economy during the Article IV consultation. The authorities are in broad agreement with staff’s analysis and policy recommendations regarding the main challenges facing the economy, and thank the staff for a comprehensive set of papers. The authorities also appreciate the excellent and timely technical assistance provided by the Fund on bank supervision and the seminar presented by the staff on the topic of central-province relations and fiscal reforms during the recent mission.

The Laotian economy achieved very robust overall growth during the fifth development plan (2001-2005), with GDP growth on average exceeding 6 percent per annum, accompanied by a stable exchange rate and comfortable levels of international reserves. These achievements have resulted from the maintenance of prudent macroeconomic policies and the implementation of structural reforms. Despite these positive outcomes, the Laotian authorities are well aware of major challenges ahead to sustain high rates of broad-based growth and eradicate poverty. As highlighted in the staff report, Lao PDR’s “poverty remains high, as over 73 percent of the population live on less than $ 2 per day.”

While recognizing the enormity of the task to reduce the poverty levels for such a wide segment of the population, the authorities note that one of the main causes of this high incidence is the legacy of heavy bombing during the Indochina war, with unexploded ordinances (UXO) still affecting half of the country’s territory, as indicated in Box 1 of the IMF Country Report No. 05/8. Since the end of the war, these leftover bombs have continuously threatened the lives of the Lao people, causing widespread injury and death, thus naturally affecting the socio-economic development of the country. The authorities would like to express appreciation to the donor community for financial support aimed at accelerating UXO clearance as this is needed to help meet MDGs.

Recent Economic Developments

Real GDP growth in 2004/05 has been quite robust as in the previous year. The estimated 7.2 percent growth was attributable mainly to industrial production, construction, tourism and agriculture. The exchange rate has remained stable since 2002 and the spread between the bank and parallel market rates has been kept below 2 percent. Inflation accelerated in October 2005 to 9.4 percent, mostly stemming from supply-side factors, particularly increasing oil and rice prices. Stable world oil supply and a new harvest of rice gradually reduced inflation to 8.8 percent by the end of 2005.

As the staff indicated, Lao PDR’s external position was stable in 2005 despite a number of adverse shocks. Rapid export growth, high world gold and copper prices and FDI inflows allowed gross official reserves to reach US$226 million by the end of 2005, equivalent to about 3 months of imports. However, strong growth in imports arising mainly from higher oil prices and capital goods associated with the construction of the NT2 dam and the mining sector kept the external current account deficit at 17 percent of GDP.

Outlook

Lao PDR’s medium-term prospects are favorable, with expected growth rates of about 7-8 percent, led by manufacturing, tourism, agriculture, and construction. This is higher than the staff’s medium-term projection of about 6-7 percent which does not take into account many pipeline projects that would have a large impact on future economic activity, revenues and exports. Since the end of 2005, an increasing number of foreign companies have shown interest in investing in the hydro-power sector in Lao PDR, in addition to the Nam Theun 2 project. In particular, the Xekaman 3 hydropower project ($273 million) is expected to export electricity to Vietnam starting 2009. This will be a joint venture with Vietnamese concerns and Electricité de Lao (EDL) with a 15 percent stake. The $800 million Nam Ngum 2 project is slated to export electricity to Thailand starting in late 2010. This project will be equally owned by the government of Laos and three Thai companies. In addition, the construction of the $600 million Nam Ngum 3 project, which will have a capacity of 460 MW, is scheduled to begin in 2008 and is expected to be able to generate power by 2013. This project will be equally owned by the Lao government, two Japanese companies and a Thai industrial utility developer.

My authorities also believe that even aside from these large projects, the underlying strength of the economy is greater than described by the staff, although there are of course many challenges. Large investment in roads and bridges and the decentralization policy have also promoted growth, albeit mainly in areas close to the fast growing neighboring countries. In the tourism sector, the National Tourism Administration is expecting more than a million visitors to Laos in 2006, generating huge revenues for the tourism sector. This will spawn the emergence and growth of small and medium scale enterprises which would support broad-based growth. The many rural development activities that were initiated in the fifth development plan should help the rural sector although this process may be slower to show results.

Fiscal Policy

On the fiscal front, the authorities agree with the staff that the main priority is to mobilize revenue through an improved tax and customs administration as well as by strengthening central government control over revenue administration and treasury operation in the provinces. This will take due regard of sequencing, especially the need to strengthen local administrative capacity and financial reporting and auditing. In this connection, as a first step, the authorities have passed the new Customs Law and established the regional customs offices under the authority of the National Customs Department.

As highlighted in the staff report, the preliminary fiscal outturn for 2004/05 indicates that the budget deficit declined to 3½ percent of GDP, the same level as in 2003/04, whilst revenue collections increased from 11 to 11.4 percent of GDP. For the 2005/06 budget, the authorities will implement the fiscal package approved by the National Assembly in October 2005, which targets revenue at 11.9 percent of GDP and expenditure at 20.1 percent of GDP.

The staff highlighted that the revenue target is overambitious and warned that the new revenue bonus scheme will erode revenue collection. Our authorities disagree and believe that the new revenue bonus scheme, at one percent of total taxes collected (0.5 percent for customs duties and 1.5 percent for other taxes) will be an important element to strengthen revenue performance. These funds go to the Tax and Customs Departments to pay for the cost of collecting revenue. In particular, this will give the local revenue offices a stronger incentive to administer the revenue system according to the law. Nevertheless, the authorities are keeping an open mind on this and if the actual outturn shows that the new revenue bonus scheme does not produce the expected positive results, the authorities are committed to strengthening other revenue reforms for the next fiscal year.

On the expenditure front, the authorities’ focus will be on the health and education sectors along with road construction and institutional capacity building. In particular, the authorities have given priority to improved social services, particularly in terms of health and education for the rural areas, which lack teachers and nurses. In this connection, the authorities will be recruiting 8,000 employees to be deployed in the rural areas, with the commitment to cut back spending should the revenue outturn fall below target. The staff have pointed to the need to contain increases in the wage bill and the authorities agree with them. However, the authorities wish to clarify that the increase in the wage bill reflects the extra cost of the eight thousand to be deployed to the rural areas and not the basic salaries of civil servants.

Monetary and Exchange Rate Policy

The Bank of Lao PDR (BOL) has been successful in implementing its monetary policy framework to cap inflation at a single digit. In order to further reduce inflation, the monetary stance of the BOL will continue to remain firm. Tight control over the BOL’s net domestic assets will continue to be the main anchor of monetary policy. Credit extended by the State commercial banks (SCBs) will continue to be restrained and limited to 12 percent in the year ending September 2006, compared to 14 percent growth for total commercial bank credit. The actual credit growth of SCBs will be based on a careful risk assessment under new appraisal procedures, especially for foreign currency loans. Under this cautious stance, broad money is expected to grow by 18 percent in the year ending September 2006. This will allow gross international reserves to further increase to $240 million (3 months of imports) by September 2006.

On exchange rate policy, a managed floating exchange rate system has served Lao PDR well. The exchange rate has remained stable since 2002 and the spread between the bank and parallel market rates has been kept below 2 percent. The stable exchange rate has allowed the BOL to continue a prudent easing of the monetary policy stance while maintaining reserves at a comfortable level. In this respect, the authorities’ intervention in the foreign exchange market is aimed at smoothing transitory fluctuations in the exchange rate, and maintaining an adequate level of reserves.

Structural Reforms

On the structural front, the authorities recognize that strengthening structural reform efforts in all sectors, particularly in the state commercial banks, state owned enterprises (SOEs) and the trade sector, and undertaking reforms to improve the investment climate for the promotion of private sector driven growth will be key to promoting economic efficiency and competitiveness. And these are crucial for sustainable economic growth and poverty eradication. Toward this end, the authorities will focus their efforts on increasing tax collection, strengthening public expenditure management and fiscal transparency, implementation of an agricultural and rural development strategy, reduction in transaction costs for initiating business activity, a strengthened financial system and reform of the judicial sector.

The authorities broadly agree with the staff’s overall assessment of Lao PDR’s financial system. In this context, the government will continue to implement the banking sector reform program supported by the AsDB, the World Bank, and the European Union. The authorities will maintain the two international bank advisors and four assistant bank advisors in the SCBs. As the SCBs become stronger under the reform process, the government will seek a strategic investor for one of the two reformed SCBs by 2006. The authorities agree with the staff that on-site and off-site inspections and overall credit limits for the SCBs will be maintained and critical operational benchmarks will continue to be provided for these institutions. In this context, the authorities intend to proceed with the recapitalization of the SCBs in four tranches from 2006 to 2008, based on the performance of each bank with respect to its respective governance agreement.

With regard to the cement project, the authorities consider it to be essential to the economy’s future. Based on their assessment, the project is a viable and bankable project and the authorities are exploring ways to increase equity in this project and to diversify its sources of financing. Recently, the authorities have received investment bids from countries eager to participate in the project, namely Canada, France and Switzerland, and the authorities are now engaged in the process of selecting the most appropriate investor.

External Debt

Although Lao PDR’s level of external debt is high, our authorities are committed to bringing the debt to GDP ratio on a downward trend. The authorities have reaffirmed that they do not intend to seek debt relief under the enhanced HIPC Initiative. In particular, our authorities believe that the analysis in the staff report overstates the risks for servicing the debt accumulated since 1999. A substantial part of this debt was incurred to support the government’s investment in the electricity sector as well as in other utilities and roads and bridges. Our authorities believe that this debt will directly add to the economy’s capacity to service this debt. Although much of this debt was channeled through the government, it was onlent to enterprises, especially EDL, who will be responsible for servicing this debt from export earnings and user charges, and will contribute royalties and dividends to the government.

The Lao PDR authorities reiterate their continued commitment to sound macroeconomic management and the reform agenda, consistent with the sixth five-year plan (2006-2010) and the National Growth and Poverty Eradication Strategy (NGPES). The reform program seeks to raise Lao PDR from the rank of least-developed country by 2020 while the key policy goals for the sixth five-year plan (2006-2010) are robust growth, rural development, poverty reduction, low inflation, and improvement in fiscal and monetary management. Despite our authorities’ view on the HIPC Initiative, they acknowledge the large challenge in attaining these objectives. For this reason, our authorities would welcome a shift to grant financing by the international financial institutions, especially for social sector, rural development, poverty reduction, environmental, and technical assistance projects.

Data Issue

Despite the recent improvements in statistical data, our authorities recognize that there is room for further improvement in many areas to ensure quality data is used for policy formulation and dissemination to the public. Therefore, they would welcome receiving assistance from the donor community to provide capacity enhancement in this area, including suitable training for local personnel and the development of necessary processes.

Ex Post Assessment

The authorities appreciate staff’s efforts and broadly agree with the ex post assessment (EPA) provided by staff. The EPA confirms that the Fund-supported programs that Lao PDR engaged in over the last decade have been beneficial. Under the Fund-supported programs, balance of payments stability was restored, the government’s GDP targets were met, and poverty was reduced. On the structural front, prices were liberalized, the trade and payments systems have gradually opened up, and the privatization of non-strategic state-owned enterprises (SOEs) has been largely completed. In particular, macroeconomic stability regained momentum under the PRGF arrangement during April 2001-April 2005. However, the EPA also highlighted that the implementation of fiscal and banking reforms has been slower than originally planned. Persevering with these reforms will be the focus of our authorities’ efforts in the period ahead.

The findings of the EPA raised concerns about the authorities’ ownership of the reforms under the PRGF. Our authorities are strongly committed to the reforms agreed under the PRGF and other IFI-supported programs. However, they believe that capacity constraints both at the provincial and local government levels, coupled with a desire to move ahead with reforms on many fronts, contributed significantly to the difficulties in the timely implementation of the many conditions agreed under the IFI-supported programs. In particular, during the period 2002-2005, the authorities were simultaneously implementing the PRGF, a Financial Management Adjustment Credit (FMAC) and Poverty Reduction Support Credit (PRSC) - which later became the Poverty Reduction Support Operation (PRSO) - financed by the World Bank, and a Banking Sector Restructuring Program Loan (BSRPL), financed by the AsDB. Also, as more experience and input on the reforms were obtained, some modifications to the substance, sequencing, and timing were needed. Nevertheless, as evident in the progress reported on the revenue, public expenditure management, and banking reforms, our authorities are fully committed to achieving the objectives of these economic reforms. Looking forward, they agree that engagement with the Fund is currently best served through surveillance and technical assistance. Our authorities look forward to the support and understanding from the international community to assist in the continuation of the reform efforts in Lao PDR.

Conclusion

Our authorities highly value continued support from the international community, including the Fund. Despite the numerous difficulties of the past, our authorities have achieved significant economic success, not least of which is stabilizing the economy. They recognize that much remains to be done before the country can achieve its medium term poverty reduction goals. They are studying best practice approaches to adopting a VAT that is appropriate for the Laotian economy in order to improve revenue mobilization. Our authorities are encouraging the private sector to utilize the opportunity of the NTR with the US to foster trade and are taking some primary steps toward WTO accession. The authorities are firm in their intention to continue with prudent macroeconomic policies, liberalization of the economy and improvements in the business climate.

We are pleased to inform the Board that the Laotian authorities consent to the publication of the staff report for the 2005 Article IV consultation, and the accompanying documents, with necessary deletion of market sensitive information.