I. Macroeconomic Impact of the Resource Sector in Lao P.D.R1
1. Lao P.D.R.’s economic performance is becoming increasingly dependent on the activities of the large mining and hydropower projects (the resource sector).
The sizable foreign direct investments for the production of gold and copper and export-oriented hydropower that have taken place in recent years, are beginning to have a visible direct impact on the balance of payments, fiscal revenues, and growth. The resource sector does not have significant productive linkages to the rest of the economy (the non-resource sector), but it does have the potential to adversely affect it through its impact on inflation and exchange rate appreciation.
So far, the economic impact has been moderate. However, pressures are beginning to build up, and there are indications of an incipient slowdown in the non-resource sector.
The full impact of the resource sector is yet to be fully felt and whether it becomes a blessing or a curse will depend on the government’s policy response, namely, whether it can ensure that any adverse effects are mitigated and that the conditions for promoting a higher growth of the non-resource sector are in place.
2. This chapter provides a preliminary assessment of the macroeconomic impact of the resource sector in Lao P.D.R. It first provides an overview of Lao P.D.R.’s mineral and hydro resource potential, followed by a discussion of the sector’s short- and medium-term macroeconomic impact and challenges. In closing, this chapter analyzes the policy implications and illustrates the overall macroeconomic impact of the resource sector under alternative policy responses.
B. Mineral and Hydro Resource Potential
3. Lao P.D.R. has vast mineral and hydro resources. These sectors had long been underdeveloped, and large scale investment and operations only began in recent years.
|Name of deposits||Proven reserves||Developer||Potential|
|(Ton)||Sepon||48.8||Lang Xang Mineral (Australia)||...|
|Phu Bia||16.9||Phu Bia Mining (Australia)||...|
|Phapon||2.1||Huajing Mining (China)||...|
|(‘000 ton)||Sepon||812.0||Lang Xang Mineral (Australia)||...|
|Phu Kham||810.0||Phu Bia Mining (Australia)||...|
|Ban Houei Mo||47.0||Lao China Oriental Mining||...|
|Phu Taxan||6.7||Yuxuanglong (China)||...|
Mineral sector: Available geological data suggest that Lao P.D.R.’ mineral wealth could be comparable to resource-rich counties in the region, such as Indonesia, Papua New Guinea, and the Philippines.2 There are more than 570 mineral deposits identified, including gold, copper, zinc and lead, tin, and iron. Proven gold and copper reserves are estimated at 72 ton and 1.7 million ton, while probable reserves could be as large as 500-600 tons for gold and 8-10 million ton for copper. Large scale gold and copper mines have been developed by Australian investors—Lang Xang Minerals, Ltd. (Oxiana) starting in 2003, and Phu Bia Mining, Ltd. (Pan Australian) starting in 2005.
|MW||GWh / year|
|Existing hydropower plants||660||3,629|
|Seven large projects coming on stream by mid 2010s|
|Nam Theun 2||1,080||5,936|
|Nam Ngum 2||615||2310|
|Xe Kaman 3||250||970|
|Theun Hinboun Expansion||210||518.3|
|Nam Ngum 3||460||1,919|
|Nam Ngiep 1||252||1,274|
|Additional most likely potential||3,114||14,498|
Hydropower sector: The existing installed capacity—developed in the late 1990s to meet Thailand’s demand for electricity—will be almost quadrupled when seven additional power plants enter into operation by mid-2010. The increased capacity will be sufficient to cover the export agreements already signed with Thailand and Vietnam for the delivery of 5,000 MW over the next decade. Several additional sites have been identified for possible future development, which if fully implemented could almost double the generation capacity levels projected for 2010.
4. The economic value of the resource projects is significant, even if only proven mineral reserves and hydropower plants already in the pipeline are considered.
On current WEO projections for gold and copper prices, and using a discount rate of 4 percent, the net present value of mineral exports from large projects for the period 2007-20 would be equivalent to 110 percent of projected 2007 GDP.
The net present value of electricity exports for the same period—assuming that Nam Theun 2 export prices will be applicable to the additional six hydropower projects expected to be in operation by 2010—is projected at the equivalent of an additional 110 percent of GDP.
C. Macroeconomic Impact of the Resource Sector
5. The resource sector has had limited adverse economic effects so far, but their impact is likely to increase over time, posing significant policy challenges (Figure 1).
Figure 1.Lao, P.D.R: Macroeconomic Impact of the Resource Sector, 2001–2006
Source: Lao P.D.R. authorities, and Fund staff estimates.
Balance of payment
During 2003-05, the annual resource sector external surplus3 averaged 5 percent of GDP ($120 million), of which more than 80 percent was absorbed by the non-resource sector’s net imports. The resulting small increase in net international reserves was monetized without creating inflationary pressures. In contrast, in 2006 the resource surplus exceeded 6 percent of GDP ($200 million) but only one half of it was absorbed by non-resource sector deficit. As a result, there was a sizable accumulation of international reserves. The rapid accumulation of international reserves has fueled monetary expansion, posing a risk to inflation.4 So far, however, inflation has remained subdued, reflecting the lagged impact of the exchange rate appreciation and favorable fuel and food prices.
The emergence of the resource sector has also led to an appreciation of the nominal and real effective exchange rates in recent years, but it has not had so far a significant adverse impact on export performance. The impact of the appreciation on non-resource exports has been mitigated by several factors, including (i) persistently high absorption of resource external surpluses; (ii) a high level of dollarization; (iii) preferential treatments protecting the market share of garments (the most important non-resource export), especially in the European Union; and (iv) low and flexible wages. However, all sectors still confront a high cost of doing business.
In the next five years, the resource sector annual external surplus is projected to rise further to an average of 6½-7 percent of GDP. This is likely to impose further upward pressures on international reserves, monetary expansion and the kip exchange rate. Under these conditions, the challenge will be to manage aggregate demand pressures while creating conditions for a vibrant private sector that would absorb these surpluses through higher and efficient investment.
The growing resource sector has also boosted fiscal revenues, helping to improve the overall fiscal position. About 25 percent of the increase in real revenues between 2002/035 and 2004/05 has been accounted for by resource revenues. As a result, the share of resource revenues has trebled to reach 10 percent in 2005/06. Despite the increasing dependence on resource revenues, there has not been an explicit policy on their utilization. During 2002/03-04/05, the government used almost all revenues (including resource revenues) to maintain domestic expenditures roughly constant in relation to GDP. In contrast, in 2005/06, the government net domestic financing declined by the equivalent of almost all the yearly resource revenues.
Looking ahead, annual mineral revenues could increase to 2½ percent of GDP by 2008, before starting to diminish gradually starting in 2015 until proven reserves are exhausted. In contrast, revenues from hydropower companies are expected to remain subdued (around ½ percent of GDP) over the next decade while their pre-tax profits remain low due to a heavy debt service burden. Hydropower revenues are expected to peak only after 2020. Managing these substantial resources in support of broad-based growth and poverty reduction and consistent with debt sustainability is a major challenge.
Overall growth has accelerated to an average of 7½ percent in 2005-06, compared to an average of about 6 percent in 2001-04. Over the same period, the contribution of the resource sector to growth increased from 25 percent to about 45 percent. The non-resource sector has continued to grow moderately (averaging 4¾ percent in 2001-06), but there are some indications of an incipient slowdown, as signaled by a slower non-resource import growth and declining credit to the private sector.
In the next five years, the resource sector’s annual contribution to growth is projected to remain at about 3 percentage points (reflecting a continued high level of extraction of proven mineral reserves and the construction of seven hydropower plants), before declining to about 1 percentage point. In order to sustain overall growth at the levels recently observed, it would be necessary not only to protect the non-resource sector growth from the adverse effects of the resource sector, but also to enhance the investment climate to accelerate its growth.
6. The future impact of the resource sector is subject to considerable uncertainty. There are both up and downside risks.
Mining revenues can change significantly in response to commodity price shocks and revisions in the expected life of the mining sites. Although mineral prices have been favorable in recent years, their volatility has increased considerably.6 On current mining trends, gold and copper proven reserves are expected to last 10-15 years, with production starting to decline significantly from 2015 onwards. The upside risks in mining resides in the vast amount of probable reserves, which as indicated above, can be somewhere between 6-8 times the current level of proven reserves.
The main downside risk to hydropower estimates stems from delays in completing construction and closing the projects’ financing arrangements and to changes in hydrological conditions due to climate changes, although experts believe that the latter risk is low. On the upside, however, if the neighboring countries’ reported expressions of interest for additional Lao hydropower exports firm up, it could attract new investments for the sites already identified.
D. Policy Implications
7. The challenges posed by the resource sector call for a comprehensive and timely policy response. Specifically, policies need to be geared toward: (i) mitigating the adverse effects of the resource bonanza on price stability by appropriately managing aggregate demand; (ii) optimizing the generation and use of resource revenues consistent with medium term debt sustainability; and (iii) enhancing the investment climate to promote fast and sustained growth of the non-resource sector. Discussions on the most desirable policy response are presented in the Staff Report, hence the rest of this section focuses on those areas of the policy and institutional framework that need to be strengthened to improve policy effectiveness.
Monetary and exchange rate policy framework
8. The Bank of Lao P.D.R. (BoL) needs to strengthen its capacity to manage liquidity and enhance the transmission mechanisms of monetary policy. Key areas where action is required include:
Developing market-based instruments to manage liquidity. The BoL currently relies on reserve requirements, limits on state-owned banks’ credit, and moral suasion. It will be important that the BoL develops its capacity to conduct open market operations using treasury bills and avoid incurring the high costs of past experiences.7 To this end, the BoL will need to strengthen its monetary programming framework and agree with the Ministry of Finance on a formula to share the net cost of conducting open market operations.
Developing the interbank money market. The BoL’s lending rate to banks should be set at a level higher than the market rate to discourage banks to borrow directly from BoL. It would be equally important to require banks to disclose data on their financial situation to build up business trust on each other. The BoL should also prepare and made publicly available on a regular basis a standard set of financial soundness indicators of the banking system.
9. BOL also needs to build up its capacity to help manage potentially disruptive changes in the exchange rate, particularly stemming from a higher exposure to the volatility of resource revenues. This will require developing the foreign exchange market further, strictly enforcing limits on banks’ open foreign exchange positions, and by enhancing its reserve management practices.
Fiscal policy framework
10. The firm pursuit of fiscal consolidation will continue to be essential for maintaining macroeconomic stability and ensuring debt sustainability over time. The rapidly rising resource revenues certainly provide some budgetary relief to attend to important, but previously unfunded recurrent and capital development needs. However, the pace at which they are spent has to be consistent with achieving fiscal consolidation and debt sustainability over the medium term. In particular, the expenditure plans will need to take into account the uncertain nature of resource revenues to avoid sudden expenditure adjustments or unanticipated borrowing in case of adverse shocks. Moreover, given that some of the resource revenues are finite, their utilization should be framed in a multiyear context to take into account intergenerational equity issues. In this context, there are a number of areas where the current fiscal policy framework needs strengthening, including:
Developing a fully-fledged medium-term fiscal framework (MTF) that explicitly takes into account the level and nature of resource revenues and use it to frame the annual budgets. The MTF should include a specific quantitative path of fiscal consolidation at the level of both the overall and non-resource balances, and make adequate provisions for contingencies. Until the BoL develops further its set of monetary management tools, the MTF should continue to envisage an annual reduction in the domestic financing requirements to help control demand pressures.
Adopting a sound and transparent resource management system that maximizes the resource revenues accruing to the government and sets clear ex-ante rules for their utilization (and saving) in the context of the MTF. The key ingredients of such a system are developed in Chapter II.
Strengthening further fiscal planning and budgeting, and making budget execution more transparent and accountable.
11. Whether Lao P.D.R. benefits from the resource bonanza would ultimately depend on the sustainable development of the non-resource sector. Given the flexibility in the labor market, it is possible that an expansionary fiscal policy could actually induce a much faster growth of the non-resource sector than a prudent fiscal policy stance. However, the likelihood that such a supply response will be short lived increases if the expansion in aggregate demand is led by consumption and starts putting pressure on the price of non-tradeables, with adverse consequences for investment and growth. By contrast, a moderate expansion of aggregate demand driven by a cautious use of resource revenues together with a renewed impetus to economic reform should create the right climate for higher and long term investment in the non-resource sector. In this context, several areas require decisive action, including:
Accelerating the reform of the banking system, particularly the state-owned banks, and strengthening the bank prudential and regulatory framework. A sound and competitive system is key to sustain long-term growth.
Addressing the main impediments to investment as identified in various surveys.8 This includes, in addition to maintaining macroeconomic stability, improving the infrastructure, reducing and making regulations more predictable, and simplifying and shortening procedures to facilitate trade and secure property rights.
Pursuing further trade integration to expand non-resource export market opportunities.
E. Overall Macroeconomic Impact Under Alternative Policy Responses
12. The overall macroeconomic impact of the resource sector over the medium term, will depend on the quality and timeliness of the policies adopted to raise and sustain the growth of the non-resource sector. To illustrate this point, staff has simulated the evolution of key macroeconomic parameters under two policy response scenarios: one in which the government adopts sounds policies and accelerates reforms to shelter the non-resource sector in anticipation of a potentially adverse impact of the resource sector (a proactive policy response), and the other where the government waits to take policy action until the resource curse has set in (a reactive policy scenario). The key policies underlying each scenario are presented in Box 1, whereas the main results are summarized below (see also Figure 2).
Figure 2.Lao, P.D.R: Macroeconomic Impact of The Resource Sector Under Alternative Policy Responses, 2006–2012
Source: Lao P.D.R. authorities, and Fund staff estimates.
Proactive policy response. The pursuit of prudent fiscal and monetary policies keeps inflation subdued while the real exchange rate continues to appreciate, albeit at very moderate pace. The prevailing macroeconomic stability, coupled with improvements in the investment climate, encourages private investment. As a result, non-resource exports and output growth accelerate, offsetting an expected decline in mining output due to the depletion of proven reserves. The external sector position continues to strengthen, with the ratio of international reserves to non-resource imports gradually rising to about five months.
Reactive policy response. The pursuit of more expansionary fiscal policy initially raises GDP growth at a faster pace than in the proactive policy response scenario. However, a faster growth in aggregate demand soon causes the price of nontradeables to rise. Inflation starts accelerating and the real exchange rate appreciates more rapidly affecting adversely non-resource export performance. Without tangible improvements in monetary management and continued high costs of doing business, investment slows down and the initial stimulus to growth starts dwindling, particularly that of the non-resource sector.
F. Concluding Remarks
13. Lao P.D.R. has the opportunity to benefit from revenues to be generated from its vast mineral and hydro resource endowment. However, future revenues are subject to considerable up and downside risks. A prudent approach would be to hope for the best and prepare for the worst. Accordingly, and given the nature of these resources, a policy response that does not wait until the well-known “resource curse” sets in (i.e., a proactive policy response) stands a better chance to maximize the net benefits of the emerging resource bonanza.
Box 1.Proactive and Reactive Policy Response
|Proactive case||Reactive case|
|Fiscal policy||• Smoothed spending over the medium term by prudently spending resource revenues during rising resource revenue periods.||•Volatile spending in tandem with resource revenue movements.|
|•Continued fiscal consolidation with targets on non – resource fiscal balance (in addition to overall fiscal balance). Develop a medium-term fiscal framework.||•Fiscal policy solely dependent on annual budget without developing a medium-term plan.|
|• Continued efforts to mobilize non-resource revenues. Optimize the generation of resource revenues.||• Weaker revenue collections from the non-resource sector. No additional efforts to optimize the generation of resource revenues.|
|• Resource revenues used for developing human and physical capital (as well as associated maintenance costs) to enhance productivity. Set up a framework to enhance transparency.||• Spending of resource revenues for recurrent items (such as wages and salaries) in non-transparent manner.|
|• Continued efforts to strengthen a public expenditure management system; and an appropriate transparency framework in resource revenue management.||• No particular action.|
|Monetary policy||Tight control on NDA, coordinating closely with the MoF.||• Weaker control on NDA.|
|• Development of market-based instruments for managing liquidity.||• No particular action.|
|• Build-up of BoL capacity to intervene in the foreign exchange markets.||• No particular action.|
|MOF and BoL relation||• Remuneration of government deposits at BoL so that budget can benefit from accumulation of financial assets. Set up an appropriate mechanism of BoL profit and loss sharing with the budget. MoF capitalizes BoL with treasury bills for use in open market operations.||• No particular action.|
|Banking||• Appropriate capitalization and profitability; enhanced competition||• Slow SOCBs capitalization and profitability; no strategic investors.|
|SOEs||• Commercial principles prevail; dividends on rise.||• Delayed restructuring; and continued dependence on budget support.|
|Cost of doing business||• Lower regulatory burden; streamlined licensing requirements; and better infrastructure.||• Slow resolution of registration problems; and red tape.|
|Trade and exchange system||• Timely accession to WTO; and advanced liberalization of trade and no restrictions.||• Delays in joining WTO; delayed reduction of non-tariff barriers and elimination of exchange restrictions.|
Inflation, broad money, and the exchange rate
1. A vector autoregressive (VAR) model is applied to better understand the dynamic relationship between inflation, broad money, and the exchange rate in Lao PDR.9 The model is estimated using monthly data from 1995-2006. The dynamics of the variables is explored with the following VAR model:
Where, E = ln(Kip per US$1 exchange rate), M = ln(broad money), P = ln(consumer price index), and ln represents the natural log.
2. All the variables are first differences as they contain unit roots. Granger causality tests show that all the variables granger cause each other, indicating that the variables are highly correlated with each other, however causality cannot be determined. The VAR model is specified with six lags based on the likelihood ratio test. Alternative lag specifications provided similar results. The structural shocks are recovered from the VAR residuals using the Cholesky decomposition of the variance-covariance matrix.10 The structure of the shocks the VAR model described above can be defined as follows:
3. The reaction of inflation to independent shocks to broad money or exchange rates, such as resource inflows, is the relationship of interest in this paper. Accordingly, the ordering of variables in the Cholesky decomposition places inflation last so that it is affected by the contemporaneous structural shocks of both broad money growth and inflation.11
4. Figures A.1 and A.2 show the accumulated impulse response of inflation to an increase in broad money growth and in the change in exchange rate, with the corresponding 95 percent confidence intervals.12 Standardizing the magnitude of the shocks presented in the charts would lead to the conclusion that (i) one percent increase in broad money growth would lead to a 0.64 percent increase in inflation after 12 months, and (ii) one percent depreciation of the nominal exchange rate (positive increase in the change in Kip per USD rate) would lead to an increase in inflation of 0.96 percent after 12 months.
Accumulated Impulse Response of Inflation to Shocks in
Source: Fund staff estimates.
1/ The shocks used in this chart correspond to one Cholesky standard deviation. The vertical axis units are Cholesky standard deviations for the variables specified in each chart, expressed in logarithm form, presented with a two standard deviations interval.
5. A VAR estimation directly on 12-month broad money growth, 12-month inflation, and 12-month change in exchange rate provides similar results.
Monetary policy and inflation
6. A similar approach is applied to understand the effectiveness of monetary policy, conducted through changes in NDA relative to broad money13, on inflation. A vector autoregressive (VAR) model is applied to 12-month inflation, 12-month change in NDA relative to broad money, and 12-month change in the exchange rate in Lao PDR.14 The model is estimated using monthly data from 1995-2006.
7. The model is specified with 4 lags based on likelihood ratio tests. Alternative lag specifications provide similar results.15 The Cholesky decomposition of the variance-covariance matrix orders the variables follows: 12-month change in the exchange rate, 12-month change in BoL’s NDA relative to reserve money,12-month inflation.16
8. Figure A.3 shows the accumulated impulse response of inflation growth to growth in NDA changes relative to broad money with the corresponding 95 percent confidence intervals.17 Standardizing the magnitude of the shocks presented in the chart would lead to the conclusion that one percent increase in the growth of NDA changes relative to broad money results in a 0.31 percent increase in inflation over 12 months. Thus, an acceleration of net domestic assets results in an acceleration of inflation, where the bulk of the confidence interval lies above zero.18
Figure A.3.Accumulated Impulse Response to a Shock in NDA Changes Relative to Broad Money 1/
Source: Fund staff estimates.
1/ The shocks in this chart correspond to one Cholesky standard deviation. The vertical axis units are in Chelosky standard deviation, for the value of logarithm of NDA with two standard deviation intervals.
Asian Development Bank and the World Bank2007“Lao P.D.R : Reducing Investment Climate Constraints to Higher Growth.”
LeeperEricM.C.A.SimsT. ZhaR.E.HallB.S.Bernanke1996“What Does Monetary Policy Do?”Brookings Papers on Economic ActivityVol. 2pp.1–78.
World Bank(2000)“Botswana: An Example of Prudent Economic Policy and Growth,”Africa Region Findings No.161.
World Bank2004“Lao P.D.R. Country Economic Memorandum: Realizing the Development Potential of Lao P.D.R”
World Bank2006aWorld Bank Economic Geology DFR2“Sector Plan for Sustainable Development of the Mining Sector in Lao PDR.”
The main contributor to this chapter is Pritha Mitra.
Defined as the difference between the resource sector’s export and FDI inflows minus imports, repatriated dividends and debt service.
For an analysis of the dynamics of inflation in Lao P.D.R. see Annex I.
The fiscal year ends in September.
For further reference see Chapter II.
BoL introduced open market-type operations in the late 1990s, a time of high inflation. Both treasury and central bank securities were auctioned to the public to absorb excess liquidity, but the operations were short lived because of their high cost (interest rates were as high as 60 percent).
For an application of the VAR approach to studying relationships across monetary variables see Leeper, Sims, et. al (1996).
The Cholesky decomposition imposes the correct number of restrictions for just identification and imposes a recursive structure on the system; so that the most endogenous variable is ordered last. i.e., it is affected by all contemporaneous ‘structural’ shocks. The results of the VAR thus could be highly susceptible to the ordering chosen.
The results are similar regardless of whether broad money growth or the change in exchange rate is ordered first.
The charts are constructed applying one standard deviation shocks to broad money growth and to the change in exchange rate.
Where broad money is the beginning of period broad money.
Inflation and changes in exchange rate are used rather than the price level and exchange rate itself in order to maintain compatibility with changes in NDA relative to broad money.
The data are first differenced as they contain unit roots.
Similar results are found when the ordering of 12-month change in BoL’s NDA relative to reserve money and 12-month change in the exchange rate are reversed.
A one standard deviation shock is applied to change in NDA relative to broad money.
For simplicity only 12-month change results are presented here. More rigorous analysis, including log levels and 1-month changes, yield qualitatively similar results.