Recent Economic Development and Outlook

2. Lao PDR performed better-than-expected during the sixth NSEDP or the first PRSP with annual average economic growth reaching 7.9 percent, as against the target of 7.5 percent. The poverty headcount was dropped from 46 percent in 1992/93 to 28 percent in 2007/08 and is expected to attain the related MDG target of 25 percent by 2015. Nevertheless, the authorities noted that there are some remaining issues and multiple challenges in meeting the MDGs, as also pointed out in the Joint Staff Advisory Note (JSAN). These remaining issues and challenges being addressed in the second PRSP. Reflecting the authorities” strong commitment to tackle poverty issues, the second PRSP places poverty eradication as one of the main strategic orientations. The Plan also focuses on macroeconomic stability and promoting inclusive and sustainable private sector led growth and regional integration, as well as sets ambitious but achievable targets and objectives. It sets the goal of attaining a GDP growth rate of at least 8 percent annually to allow a GDP per capita level of at least US$1,700 by 2015.

3. Despite the global uncertainty and domestic challenges, the economy continued to achieve a vibrant GDP growth of 8.0 percent in 2011, which is the first year of implementation of the second PRSP. The economic expansion was propelled by the industrial sector, particularly mining, electricity and manufacturing, and the services sector. Economic growth is expected to remain robust in 2012 reaching 8.3 percent on the strength of the expected recovery in agricultural and construction sector as well as appropriate policy mix. The favorable economic performance is expected to be sustained over the medium-term in line with the targets of the seventh NSEDP.

4. After peaking at 9.8 percent (y/y) in April 2011, the CPI Inflation has trended down reaching 7.6 percent in 2011 and 2.9 percent in July 2012. This favorable development was owed to abated pressures from domestic agricultural supply shocks caused by flooding brought by Nokten and Haima storms, and easing of global oil and commodities prices. At the same time, some policy tightening was put in place to address inflationary expectations. Inflation is projected to average 5.1 percent in 2012, which is in line with the Bank of the Lao PDR’s (BOL) target. The Kip exchange rate remains stable. After recording normal fluctuation against the US$ and Baht in 2011, Kip has depreciated against the US dollar by 0.07 percent, and appreciated against the Baht by 4.7 percent during the first semester 2012. Meanwhile the international reserve level has improved steadily and expected to be higher by the end of 2012.

5. The authorities continue to consider fiscal consolidation as a priority. The overall fiscal deficit moderated to 3.0 percent of GDP in FY11 from 4.6 percent of GDP in FY10, due to expenditure restraint and buoyant mining and hydropower revenues, while VAT revenue over-performed. The authorities expect the overall budget deficit to narrow to 2.5 percent of GDP in FY12 and maintain this level of deficit over the medium term. Credit growth has also slowed down markedly from 90.7 percent in 2009 to 44.5 percent in April 2012; Credit growth is expected to decelerate further to about 32 percent by the end of year. Given the rise in credit growth, albeit at a decelerating pace, the authorities continuously strengthen prudential regulation and banking supervision. Another notable progress was in the area of external debt sustainability which concluded that Lao PDR has been upgraded from a high risk to a moderate risk of debt distress country. This is due to the strong economic performance and continued improvement in public debt management by the authorities.

6. The authorities remain committed to pursue structural reforms and mobilize foreign investments. The broad-based and sustained economic growth underpinned by domestic and external macroeconomic stability is key in raising general living standards, achieving further progress in poverty reduction, and meeting the MDGs goals. This is the principal objective that guides the authorities in formulating and implementing their policies to deliver the greatest benefit for the Lao people. They noted that this year’s discussions have contributed greatly in helping the authorities evaluate the appropriateness of their strategy and have provided valuable inputs for improvement.

Fiscal Policy

7. The authorities are committed to continue fiscal consolidation through continued tax reform and improved customs administration, as well as public finance management. The authorities” performance in fiscal consolidation has been encouraging as reflected by the continued moderation in fiscal deficit and firm commitment to maintain a 2.5 percent of GDP deficit level over the medium term.

8. The authorities view that an increase in the civil service wage bill in FY12 needs to be implemented since the wage freeze had been in effect for several years. The adjustment is important not only to compensate the increased cost of living but also to contribute to public governance improvement and provide incentive for civil servants to prevent brain-drain. Noting the unintended consequences of this action, the authorities commit to carefully monitor spending so as not to overcrowd other important expenditures and coordinate with related ministries to mitigate its impact on inflation.

9. Realizing the need to build fiscal room, the authorities have established the State Accumulation Fund (SAF) this year, which will be managed under a new State Revenue Department of the MOF. The resources of SAF will be sourced from fiscal saving, either from revenue over-performance including higher share of mining revenue or from under-spending. The funds from SAF will be used for unforeseen circumstances, such as natural disasters or counter cyclical policies.

10. The authorities are of the view that public sector debt is well managed. Financing is important to deliver the PRSP goal for the economy but it has been done in prudent manner. Public debt in terms of GDP is expected to decline gradually and the country’s risk of debt distress has been reclassified from high to moderate. The authorities welcome and note that the improved debt distress rating will have important implications for Lao PDR’s borrowing capacity. In particular, it is expected that the overall envelope of external resources available to the country could potentially increase to meet the country’s increasing financial needs for socio-economic development. In terms of debt reporting system, the authorities are currently in the process of finalizing the Debt Management and Financial Analysis System (DMFAS). The DMFAS will enable the authorities to record public debt data accurately and in a timely manner, including the disbursement schedule. The system is currently in the final stage of data entries and planned to be effective by the end of this year. The UNCTAD mission is scheduled to verify and validate the system by mid-September 2012.

Monetary and Exchange Rate Policies

11. Monetary policy has been geared to achieve and maintain price stability. The authorities believe that the current monetary policy settings are generally appropriate. While authorities recognize that there are still room to improve the efficiency of open market operations and liquidity forecasting, they stressed that in the conduct of monetary management they always take into account liquidity condition and the Kip exchange rate movement. They note the staff’s advice to contain the expansion of the central bank net domestic assets (NDA) by accelerating the exit from quasi-fiscal lending. In fact, since the beginning of last year the BOL has restrained its quasi-fiscal lending by providing loans only for a few necessary and productive projects to improve the domestic supply of goods, with decreasing amount in the period ahead. Likewise, BOL’s loan to local governments is expected to be gradually phased out.

12. In the current framework setting, the BOL securities are considered as the most efficient instrument in conducting monetary policy. It also plays an important role to promote interbank operations and help liquidity management in the banking system in the Lao context. The BOL takes note of staff’s recommendation on issuing additional BOL securities but will consider carefully on implementation. Taking into account the current condition, the BOL views that an increase in the reserve requirement ratio is the last resort to be considered. Over the medium-term, the authorities indicated that an implicit inflation target range will be considered once the monetary policy framework is sufficiently strengthened.

13. The authorities continue pursuing a managed floating exchange rate regime as the main instrument to maintain monetary stability. In this regard, the authorities appreciate staff’s assessment on exchange rate policy that a stabilized exchange rate regime remains the appropriate monetary anchor since this regime has contributed greatly to overall macroeconomic and financial stability as well as promoting the greater use of Kip. The BOL continues to promote active FX interbank market operations and further liberalize foreign exchange policy. This liberalization aims at reinforcing public confidence and eliminating the FX parallel market eventually.

14. The authorities shared the importance of building the reserve level to improve the policy room. However, the authorities believe that recent international reserves coverage remains sufficient based on their measurement of imports. They have a fruitful discussion with staff on the appropriate measurement of imports and found scope for further improvement in this regard. With the strong prospect of FDI and ODA, including the plan to sell land titles valued in foreign exchange by the end of 2012, it is expected that the international reserves coverage level will further improve.

Financial and Banking Issues

15. With the current rapid expansion of financial sector, the authorities remain committed to strengthening supervision to support financial soundness. Currently, the banking condition remains sound with adequate capital, low NPL and regular banking supervision/examination. The BOL is well aware of keeping the pace of strengthening prudential regulations and supervisions in line with the financial development. They have taken steps to safeguard financial sector soundness by increasing the minimum capital adequacy ratio from 8 to 12 percent and issuing a new regulation on loan classification and provision requirement. The authorities are more optimistic on credit growth as it is reflective of a welcome financial deepening process (credit over GDP ratio has increased from 23 percent in 2009 to 39 percent in 2012) and accompanied by proper prudential regulation and continued improvement on banking supervision. They see the important role of FSAP in guiding a sound and rigorous financial sector development but would like to concentrate on improving data and other necessary condition before launching to that stage.

16. To address the shortcomings in the AML/CFT indentified in the 2011 evaluation by APG, an AML/CFT law is currently being drafted. In this regard, the authorities have requested and expect valuable inputs from the Fund before submitting the draft law to the National Assembly (NA) by the end of year.

Structural Reforms

17. The authorities have accelerated structural reforms to help improve business climate and build broad-based and inclusive growth. Commitments under the AFTA and the prospect of WTO accession had led to significant revisions of laws and the regulatory regime. Progress has been made in streamlining business registration procedures and preparing the investment promotion law; trade-related legislation is expected to be approved by the NA in September; the WTO accession would be finalized by end-2012. These could help enhance competitiveness and diversify the economic growth engine.

18. In conjunction with these efforts, the authorities continue working on modernizing and upgrading the quality and availability of economic and financial data. The statistics law and the statistics strategy for 2010–2020 are now in place, while the implementing decree passed in the Government meeting. This decree has been further amended and will be submitted to the Ministry of Justice for consideration and approval. Currently, the National Statistics Bureau is in a process of forming its team to work with the World Bank to launch a Lao statistics project, which will include 4 main components: (i) improvement of regulatory framework and other related regulations, (ii) enhancement of basic infrastructure of the statistics, (iii) development of data collection and analysis, and (iv) ICT system upgrade.

19. In addition, the BOL has recently accepted to participate in the project on the improvement of external sector statistics in the Asia Pacific region, which is the first project that will be held at the newly established TA office for Lao PDR and Myanmar in Bangkok.

Conclusion

20. The authorities continue to show their strong commitment to pursue the macroeconomic and financial stability while delivering a more inclusive growth for the economy guided by the seventh national socio-economic plan 2011–2015. That said, they understand that there would be an arduous road to achieve the goals stated in the Plan. Moreover, some goals will need longer-term to yield the benefits. They acknowledge that these goals are important to accelerate economic development and deliver a better and inclusive welfare for the Lao people. Thus, the authorities appreciate the Fund’s continuous engagement, timely advice and policy recommendations. They also call for appropriate technical assistance from the Fund in various areas. They look forward to enhancing the already productive and warm relationship with the Fund and the international community in the near future.