Recent Economic Developments and Outlook

2. The Lao economy has been growing robustly in recent years, supported by the strong performance of the resource sector despite a less favorable external environment. The economy is projected to grow by 6.9 percent in 2016 on account of increased investments in infrastructure, real estate development, trade and manufacturing, as well as significantly higher hydropower generation and tourism receipts. The growth is however lower than the 7.5 percent recorded in 2015 due to a decline in exports following lower commodity prices, slowdown in major trading partners and lower agricultural output as a result of poor weather conditions. Core inflation in 2016¹ stood at 1 percent, while headline inflation remained low at 1.6 percent mainly reflecting higher domestic food prices in the second half of the year which more than offset lower prices in the communication and transportation sectors. On the external front, the current account deficit declined to 8.5 percent of GDP for the first three quarters of 2016, as a result of improvements in trade

balance and transfers while FDI flows remained high. The international reserves at end-September stood at USD 998.59 million, equivalent to 6.44 months of imports.

3. The overall fiscal deficit in FY2015-16² rose to 6.9 percent reflecting a large decline in tax and non-tax revenues. The shortfall in tax revenue was mainly due to the economic slowdown and the decline in commodity prices, while lower non-tax revenue reflected the absence of the sale of state assets. Even though capital expenditure was lower in line with reduced externally financed investment, current expenditure remained high due to an increase in interest payments and transfers. Money supply grew at an appropriate pace to support productive economic activities without putting pressure on prices. The exchange rate remains stable, with the Lao Kip moving within the +/- 5 percent range against the US dollar. The banking system remains sound. Though there was a slight increase in the ratios of foreign currency deposits and credit to total deposits and credit respectively, dollarization has continued its downward path. As of end-September 2016, the NPL ratio was at 3.03 percent which was slightly higher than targeted but still manageable and lower compared to 2015.

4. The authorities expect real GDP to grow by 7 percent in 2017, underpinned by increased agriculture production, completion of hydropower projects and higher foreign investments. Inflation is expected to remain low and below 5 percent. The current account deficit is projected to narrow in the medium term, following the completion of several hydropower projects together with an increase in exports and tourism receipts. The authorities remain positive on sustained FDI inflows and strongly commit to structural reforms that will enhance the business environment and improve the efficiency of public investments, which will in turn promote greater economic diversification as well as generate comfortable levels of official reserves to cover the equivalent of 5 months of imports.

5. The authorities note staff’s assessment that downside risks to the economic outlook stem from several challenges, particularly those arising from limited fiscal space, accumulated public debt stock, undercapitalized state-owned banks and an uncertain external environment. They therefore commit to exercising vigilance and prudence in their policy implementation.

Fiscal Policy

6. The authorities recognize the importance of increasing fiscal buffers to enhance the economy’s resilience to potential shocks. In this regard, the medium-term budget plan projects a declining fiscal deficit for 2016-20, with an average of 4.06 percent of GDP, which is close to staff’s adjustment scenario. The declining deficit will support the authorities’ commitment to bring down public debt to 60 percent of GDP by 2020. In addition, the authorities are also working on the “Strategic Public Financial Management Plan toward 2025”, which is expected to be adopted by mid-2017, as well as in the process of drafting a law on public debt to strengthen public debt management and limit the off-budget payment.

7. On domestic revenue mobilization, measures are being taken to improve revenue collection and broaden the tax base in line with the recently approved five-year budget plan. Revenue collection will be strengthened by enforcing compliance of tax and duty exemptions and VAT deductibles, removing tax exemptions for vehicles and construction materials for public investment projects, and focusing on large taxpayers and taxes on vehicles, petrol and luxury goods. The authorities are also reviewing existing tax rates to ensure they remain appropriate. In addition, taxes on vehicles and luxury goods are expected to generate higher revenue as they are now based on market prices instead of baseline prices as was the previously the case. Several major steps are also being taken to improve tax administration: (i) the central tax office will now be responsible for large taxpayers while the provincial offices will focus on small and medium enterprises; (ii) the central and local authorities are closely working to reduce tax and other revenue leakages, while transfer of revenue to central budget from local authorities will also be audited and monitored closely; and (iii) the authorities will modernize its approach to tax collection from businesses, e.g. through non-cash payment, which will enable closer monitoring.

8. The authorities are also committed to pursue expenditure rationalization and enhancements to public spending efficiency. These include: (i) rationalizing investment incentives; (ii) upgrading a decree on public procurement to be a law; (iii) containing current spending by reforming the civil service to lower the public sector wage bill; and (iv) improving monitoring of contingent liabilities, particularly from public-private partnerships (PPPs). The authorities recently reformed the SOE committee and are currently drafting a decree on PPPs. In addition, the restructuring and privatization of some SOEs will be continued, namely the Enterprise of Telecommunications Lao (ETL), the Lao Airline Company and two state-owned banks. For example, the state’s share in the ETL has been reduced to 49 percent from 100 percent.

9. The authorities commit to keep public debt on a sustainable path. Although non-concessional borrowings increased in recent years, these borrowings were used to support the construction of hydropower projects which will contribute to generating foreign currency income to support repayments. Future borrowings would remain mainly on concessional terms and oriented towards necessary investments. Moreover, under the current legislation, external borrowings require government’s detailed consideration of specific amount and concessionality.

Monetary and Exchange Rate Policy

10. The managed float exchange rate regime is an effective policy in anchoring inflation given the limited effectiveness of monetary policy implementation due to dollarization and cash-based economy. In a long history of dollarization, expectations of rapid depreciation could lead to macroeconomic instability. Therefore, the authorities see the need to minimize volatility and maintain exchange rate stability, while taking steps to improve market monitoring and building up reserves. While agreeing with staff that greater exchange rate flexibility would help in building-up reserves, the authorities consider the current level of reserves to be adequate. To improve the exchange rate policy framework, the central bank has since the end of 2016 started carrying out foreign exchange rate auctions with commercial banks and big exchange rate bureaus. In addition, the central bank will continue efforts to spur the development of the domestic forex derivative market by taking a lead role in operating forward, future and swap arrangements.

11. The authorities will continue to manage the growth of broad money in line with supporting growth and price stability. In order to enhance the effectiveness of monetary policy and to promote the use of Lao Kip, efforts will be directed at strengthening the transmission mechanism, developing payment systems and the inter-bank money market, and introducing a liquidity management framework. At the end of 2015, the authorities introduced the ad-hoc interest rate policy to provide commercial banks with guidance to lower the cost of lending in Lao Kip to more appropriate levels in order to promote greater access to credit by SMEs. This temporary arrangement is expected to have positive effects on productive sectors of the economy. In addition, the authorities are strictly enforcing the Foreign Currency Management Law to limit the use of foreign currencies and promote the use of Lao Kip, such as issuing a guidance at the end of 2016 to support transaction for vehicle retail sales to be made via bank transactions and in Lao Kip only for cash payments.

12. The authorities recognize the importance of capacity building in supporting their efforts to improve the policy frameworks and therefore, are appreciative of ongoing Fund TA. In addition, the authorities have devoted resources to developing economic models to support policy evaluation and formulation as well as improving the quality of statistics towards meeting international standards.

Financial Stability

13. To maintain a stable and sound banking system, the authorities are implementing policies consistent with the “Lao Strategic Financial System Development Plan 2016-2020 and Vision toward 2030”. These policies include improving the central bank’s legal framework to strengthen risk-based supervision and transition towards adoption of most Basel-core principles and the Basel II standard; restructuring state-owned banks and enhancing transparency of their operations; upgrading accounting standards in line with the International Financial Reporting Standards; revising guidelines for bank licensing in line with AML/CFT standards; and developing the crisis management framework. In this regard, the authorities are in the process of drafting a master plan and action plan for BASEL II implementation. In addition, they are considering additional macroprudential measures to curtail potential risks from a rise in funding from non-core foreign sources. At the end of 2016, the authorities introduced amendments to regulations related to overseas funding of commercial banks in order to support their domestic lending as well as improve tracking records of funding flows and ensure the repayment ability of the banks.

14. In addition, as part of continued efforts to strengthen financial stability, the authorities appreciate Fund TA on on-site and off-site supervision manuals, as well as the World Bank’s TA to improve banking supervision tools and relevant regulation frameworks. The authorities are also in the process of improving the compilation of financial soundness indicators which have benefitted from Fund/Bank TA.

Structural Reforms

15. Structural reforms continue to be the policy priority of the government, together with efforts to continue improving the quality of life, enhancing the business environment to attract more FDI, and diversifying the economy for sustainable development. To improve living conditions, the authorities will remain actively engaged in the improvement and prioritization of education and health care. On health care, the authorities will continue to focus on improving maternal health, early childcare, and nutrition in line with improving the quality of public health services. On education development, efforts will continue to be directed at enhancing the quality of primary education in the rural areas and promoting technical and vocational training to address skill mismatches and promote specialization. The authorities are working with the World Bank to improve the efficiency of public investments in education and health care.

16. The authorities are prioritizing public infrastructure projects in roads, railways, bridges, and transmission lines, which are essential in improving the rural areas and diversifying the economy. The completion of key hydropower projects in the near term will help to meet the energy needs of a growing economy and thus, enhance the business climate and competitiveness. To attract more investment inflows, the authorities have continued to improve the regulatory framework, such as by amending the investment law in early 2016, to allow for targeted and time-bound tax exemptions for businesses that invest in the rural areas and allowing a lower tax rate for investments made in the special economic zone while preparing to upgrade a decree on special economic zone to be a law in 2017. To promote sustainable development, the authorities are introducing measures to safeguard the sustainability of natural resources, such as suspending licenses for new mining projects and export of unprocessed wood. To increase financial inclusion, the authorities have introduced “BCEL Community Money Express” in 2015, which allows microfinance institutions to utilize commercial banks’ branches to expand their outreach to the rural areas. The authorities are also close to completing a draft national financial inclusion strategic plan for 2016-20.

Conclusion

17. The Lao authorities are in the process of implementing the new NSEDP to address the remaining bottlenecks to graduate from the least developing country list by 2020 as well as to meet the Sustainable Development Goals. The authorities note that economic expansion needs to bring a durable reduction in poverty and substantial improvements in socioeconomic conditions. The authorities are committed to maintain macroeconomic and financial stability, promote sustainable and inclusive growth, and stand ready to implement any measures deemed appropriate. Mindful of the challenges ahead, efforts will be intensified to improve efficiency of public service delivery, reform public financial management, strengthen the banking regulatory and supervisory framework, and enhance the business environment.