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Lao People’s Democratic Republic

Author(s):
International Monetary Fund
Published Date:
October 2008
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I. Macroeconomic Developments

1. The Lao economy has performed well in recent years, reflecting generally stable macroeconomic conditions and a rapidly expanding natural resource sector. The fiscal position has further improved, on rising resource and more recently nonresource revenues. Despite a sharp widening in the external current account deficit, the overall external position has strengthened, given large inflows associated with resource sector development. However, these inflows are also increasingly driving monetary and exchange rate developments, presenting new challenges for policy makers.

2. Overall, the economy continued to expand at an elevated pace in 2007, with real GDP growth estimated at nearly 8 percent. Resource (investment), tourism, and trading activity led the way (Table 1 and Figure 1). Inflation began increasing in mid- 2007 and reached 5.6 percent (y/y) by year-end, mainly reflecting global food and energy price trends. The current account deficit shot up to more than 17 percent of GDP on rising oil and capital imports. However, as foreign private and official inflows also picked up, gross official reserves increased to $539 million at end-2007 (3.7 months of prospective nonresource imports) (Table 2). XZ1

Table 1.Lao P.D.R.: Selected Economic and Financial Indicators, 2004–08

Nominal GDP (2007 est.): $4,108 million

Population (2007 est.): 6.1 million

GDP per capita (2007 est.): $673

2004200520062007

Est.
2008

Proj.
GDP and prices (percent change)
GDP at constant prices6.47.18.17.97.5
CPI (end-year)8.68.84.75.613.1
Annual average10.57.26.84.510.8
Public finances (in percent of GDP) 1/
Revenue11.011.512.514.015.1
Of which: Resources 2/0.30.81.32.33.0
Grants1.11.72.01.81.3
Expenditure15.517.618.418.518.0
Overall balance (including grants)-3.3-4.5-3.8-2.7-1.7
Domestic financing-0.30.2-1.1-1.1-1.1
External financing3.64.34.93.92.7
Money and credit (annual percent change)
Reserve money12.918.037.258.831.4
Broad money22.87.730.138.738.9
Bank credit to the economy 3/9.07.6-9.121.050.5
Interest rates (end-of-period)
On three-month kip deposits 4/7.55.55.55.55.5
On short-term kip loans 4/16.017.814.011.511.5
Balance of payments
Exports f.o.b. (in millions of U.S. dollars)5366841,1431,2031,516
In percent change28.227.667.15.226.1
Imports c.i.f. (in millions of U.S. dollars)1,0561,2701,5892,1142,660
In percent change34.320.325.133.025.9
Current account balance (in millions of U.S. dollars)-423-511-368-716-936
In percent of GDP-16.9-17.8-10.5-17.4-17.8
Gross official reserves (in millions of U.S. dollars)226238335539789
In months of prospective goods and services imports 5/2.72.43.03.74.9
External public debt (in millions of U.S. dollars)2,1052,2032,3082,4462,589
In percent of GDP83.976.966.059.549.3
Exchange rate
Official exchange rate (kip per U.S. dollar; end-of-period) 6/10,35710,7679,6559,3418,662
Nominal effective exchange rate (2000=100)67.767.368.267.0
Real effective exchange rate (2000=100)95.9103.0105.5102.7
Memorandum items:
GDP at current market prices (in billions of kip)26,54930,48135,19339,28547,278
In millions of U.S. dollars2,5092,8663,4984,108
Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections

Fiscal year basis (October to September).

Royalties and taxes from mining and hydropower (resource) projects

Excludes debt write-offs.

Figure for 2008 is as of April 2008.

Excludes imports associated with large resource projects.

Figure for 2008 is as of July 3, 2008.

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections

Fiscal year basis (October to September).

Royalties and taxes from mining and hydropower (resource) projects

Excludes debt write-offs.

Figure for 2008 is as of April 2008.

Excludes imports associated with large resource projects.

Figure for 2008 is as of July 3, 2008.

Figure 1.Lao P.D.R.: Real and External Developments 1/

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

1/ From 2008, IMF staff projections.

2/ Directly related to mining and hydropower activity.

3/ In months of prospective imports of goods and nonfactor services.

Table 2.Lao P.D.R.: Balance of Payments, 2004–09
2004200520062007

20082009
Est.Proj.
(In millions of U.S. dollars, unless otherwise indicated)
Current account-423-511-368-716-936-1,214
Excluding official transfers-459-545-453-769-1,004-1,286
Merchandise trade balance-520-586-446-911-1,144-1,497
Exports, f.o.b.5366841,1431,2031,5161,699
Mining and hydropower1763296606638891,023
Other exports360355483540628677
Imports, c.i.f.1,0561,2701,5892,1142,6603,197
Mining and hydropower2853374858441,0041,325
Petroleum imports117160206311504605
Other imports6537748999591,1521,266
Services (net)132158153256314356
Of which: Tourism119147149233280308
Income (net)-97-145-218-165-238-221
Interest payments-77-86-74-93-97-91
Of which: Public-21-23-17-25-47-47
Mining and hydropower-29-32-28-36-39-33
Dividends and profit repatriation-44-88-243-228-350-354
Of which: Mining and hydropower-19-62-219-181-295-289
Other243099156209224
Transfers (net)6262144104132148
Private262859516477
Official363485536972
Capital account4425284689231,1901,472
Public sector89125130149144243
Disbursements114153162186218324
Amortization-25-28-32-36-75-81
Banking sector (net)-3922-93-135-200-258
Private sector3913814329091,2461,487
Foreign direct investment (net) 1/3152473357109721,287
Of which: Mining and hydropower projects2272022395888291,134
Other private flows and errors and omissions7613496200274200
Overall balance1917100207254258
Financing-19-17-100-207-254-258
Central bank net foreign assets-19-17-100-207-254-258
Assets (increase -)-12-11-97-204-250-253
Liabilities (reduction -)-6-6-3-3-4-6
Memorandum items:
Current account balance (in percent of GDP)-16.9-17.8-10.5-17.4-17.8-19.2
Excluding official transfers-18.3-19.0-12.9-18.7-19.1-20.3
Resource current account balance (in percent of GDP) 2/-6.3-3.6-2.3-9.9-8.7-9.8
Nonresource current account balance (in percent of GDP)-10.6-14.2-8.2-7.5-9.1-9.4
Exports (annual percent change)28.227.667.15.226.112.1
Imports (annual percent change)34.320.325.133.025.920.2
Gross official reserves (in millions of U.S. dollars)2262383355397891,042
In months of propective imports of goods and non-factor services2.01.71.82.42.93.6
(Excluding imports associated with large resource projects)2.72.43.03.74.95.8
Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

Includes repayment of private debt.

Pertains to large mining and hydropower (resource) projects.

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

Includes repayment of private debt.

Pertains to large mining and hydropower (resource) projects.

Lao P.D.R.: CPI Inflation January 2003–May 2008

(Year-on-year percent change)

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates.

1/ Percentage points contribution to headline inflation.

Lao P.D.R.: Exchange Rate Developments, 2006–08 1/

Source: Data provided by the Lao P.D.R. authorities.

1/ Through June 30, 2008.

3. Monetary conditions became more lax in 2007, due to large inflows. In response, the Bank of Lao P.D.R. (BoL) allowed the kip to strengthen gradually vis-à-vis the U.S. dollar, with the pace accelerating toward year end in line with global currency developments. Broad money increased by 39 percent (y/y) (Table 3), with credit growth reaching 21 percent (y/y). Demand for kip loans was especially strong owing to local construction activity and government’s effort to encourage kip use. Kip deposits also grew rapidly, driven by further currency substitution and a widening kip–dollar interest rate differential.

Table 3.Lao P.D.R.: Monetary Survey, 2004–08(In billions of kip, unless otherwise indicated)
20042005200620072008
Dec.Dec.Dec.Mar.Jun.Sep.Dec.Mar.Apr.Dec.

Proj.
Bank of Lao (BoL)
Net foreign assets1,9892,2502,9843,5624,1884,4614,8335,8466,0206,663
In millions of U.S. dollars190208308370437463513665689763
Net domestic assets-444-426-482-825-1,261-1,198-860-1,814-1,907-1,444
Government (net)-451-433-282-643-1,043-911-456-1,638-1,812-1,361
Economy729355247233235226161142169155
Banks131222143159166170192315349395
Other items (net)-853-571-590-573-619-683-757-633-613-633
Reserve money1,5451,8232,5022,7372,9273,2633,9744,0324,1125,219
Currency in circulation5118051,2311,3891,4231,5221,8381,8841,8032,120
Bank reserves (kip)2132174213844666449648838561,578
Bank reserves (foreign currency)8218028519641,0381,0981,1721,2651,4531,522
Monetary survey
Net foreign assets3,3223,3894,9125,8296,7487,2357,8109,0869,19610,803
In millions of U.S. dollars3173145076067047528291,0331,0531,237
Net domestic assets1,7072,0272,1342,1311,3951,6321,9642,0951,1482,769
Government (net)-210-191-89-316-653-409-275-1,311-1,543-904
Budget-456-438-535-762-1,099-1,103-969-2,005-2,237-1,748
Other246246446446446694694694694844
Credit to the economy2,6762,8802,6172,4202,5572,9253,1663,6473,6154,765
Of which:SOCBs1,0351,5261,1841,0011,1141,4401,6721,9832,062
In kip4045587097027769491,1151,3761,4452,168
In foreign currencies2,2722,3221,9081,7171,7811,9762,0522,2712,1702,597
Other items (net)-759-662-39427-509-884-927-241-925-1,092
Broad money5,0295,4167,0467,9608,1448,8679,77411,18110,34413,572
Currency outside banks5118051,2311,3891,4231,5221,8381,8841,8032,120
Kip deposits1,4351,4531,7121,8701,9652,2812,6122,8992,8604,265
Foreign currency deposits (FCDs)3,0833,1594,1034,7024,7565,0655,3246,3985,6817,188
(Annual percent change)
Reserve money12.918.037.247.151.651.658.847.346.931.4
Kip reserve money24.641.161.762.371.869.369.756.147.832.0
Broad money22.87.730.143.144.745.438.740.531.938.9
Kip broad money33.216.030.441.449.158.651.246.845.143.5
Credit to the economy9.07.6-9.1-15.6-15.5-1.321.050.748.350.5
Of which:SOCBs8.847.5-22.4-32.8-32.9-8.741.298.295.7
Kip loans8.638.327.011.016.340.957.295.9100.394.5
Memorandum items:
Money multiplier (at current exchange rates)3.33.02.82.92.82.72.52.82.52.6
Loan/deposit (in percent)43.154.840.833.334.536.737.937.740.440.3
In kip (in percent)28.138.441.437.639.541.642.747.550.550.8
Net international reserves (in millions of U.S. dollars) 1/112134220270329349389521523589
Issue of debt clearance/bank recapitalization bonds 2/246246446446446694694694694844
Exchange rate, end-of-period (kip per U.S. dollar)10,46510,8059,6969,6159,5839,6269,4238,7978,7318,730
Dollarization rate (FCDs/broad money; in percent)61.358.358.259.158.457.154.557.254.953.0
Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

Defined as gross official reserves minus BoL foreign liabilities and the foreign exchange component of reserve money.

Cumulative since end-June 2003.

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

Defined as gross official reserves minus BoL foreign liabilities and the foreign exchange component of reserve money.

Cumulative since end-June 2003.

4. The fiscal outturn in 2006/07 was generally positive, notwithstanding some expenditure slippages. Based on staff estimates, the overall budget deficit declined by around 1 percentage point to 2¾ percent of GDP in 2006/07 owing largely to higher resource revenue (Table 4 and Figure 2). A modest reduction was also achieved in the underlying (nonresource) deficit, even though spending slightly exceeded the budget target. 2 The deficit continued to be financed through external concessional borrowing. For 2007/08, the final budget plan targeted an overall deficit equivalent to 3¾ percent of GDP—about the same as the previous year’s budget plan. Resource revenue would continue rising, but recurrent expenditure would also increase, largely due to a higher government wage bill. 3 However, capital expenditure would be lower than in recent years, in part because of the near-completion of the Nam Theun 2 project, but also given a more cautious approach by donors in line with government capacity.

Table 4.Lao P.D.R.: General Government Operations, 2003/04–2008/09
2003/042004/052005/062006/072007/082008/09
Staff EstimatesBudgetStaff

Proj.
Prel.

Budget
Staff

Proj.
(In percent of GDP)
Revenue and grants12.113.214.615.714.616.316.016.6
Revenue11.011.512.514.013.315.114.415.4
Of which:Resource revenue 1/0.30.81.32.33.03.03.2
Non-resource revenue10.811.211.311.710.312.112.2
Tax revenue9.19.510.712.311.513.312.713.5
Income and profit taxes1.61.82.03.13.23.73.9
Turnover tax2.32.32.62.72.52.93.1
Excise duties1.91.82.42.62.73.03.0
Import duties1.41.51.51.51.21.41.3
Royalties 2/0.30.50.80.80.70.90.9
Other taxes1.71.71.41.61.11.51.4
Nontax1.92.01.81.61.81.81.81.9
Grants1.11.72.01.81.31.31.51.2
Expenditure15.517.618.418.518.418.018.118.0
Current expenditure7.28.59.29.210.510.410.710.7
Wages, salaries, and benefits3.53.63.74.24.84.64.64.6
Transfers1.21.72.01.92.62.53.02.8
Interest payments0.91.10.80.50.80.80.80.7
Of which:External0.80.90.70.40.70.60.70.5
Other recurrent1.52.12.72.72.42.62.32.6
Capital expenditure and onlending6.47.77.47.56.56.36.46.4
Domestically financed2.31.61.21.41.71.92.22.3
Externally financed and on-lending 3/4.16.16.26.04.84.44.24.0
Of which:Nam Thuen 2/-2.31.10.2----
Others and contingencies 4/0.91.21.01.51.41.31.00.9
Discrepancy including unidentified expenditure0.90.30.80.30.00.00.00.0
Overall balance-3.3-4.5-3.8-2.7-3.8-1.7-2.2-1.4
Non-resource balance 5/-3.6-5.3-5.1-5.0-6.8-4.70.0-4.6
Financing3.34.53.82.73.81.72.21.4
Domestic financing (net) 6/-0.30.2-1.1-1.10.6-1.1-0.2-1.0
Bank financing-0.30.2-1.1-1.00.5-1.2-0.3-1.0
Of which:State Accumulation Fund-----0.1-0.1-0.5-0.5-0.1-0.1
Nonbank financing0.00.00.0-0.20.10.10.10.0
Foreign financing (net)4.34.93.93.12.72.42.5
Disbursements4.55.35.84.84.13.93.33.5
Amortization-0.9-1.0-0.9-0.9-0.9-1.1-0.9-1.1
Memorandum items:
GDP (in billions of kip)25,56129,49834,01538,26243,28845,28048,58353,696
Total aid (in millions of U.S. dollar)151194260263233242277279
Loan124147192193177183189209
Grant2747687057608870
Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections

Resource revenue comprises royalties, taxes, and dividends from the mining and hydropower sectors.

Includes the natural resource tax (on mining) and hydropower royalties.

On-lending includes gross repayments of funds.

Includes payments on liabilities carried over from the previous budget years and for arrears clearance.

Overall balance net of resource revenue.

Excludes bank restructuring bonds.

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections

Resource revenue comprises royalties, taxes, and dividends from the mining and hydropower sectors.

Includes the natural resource tax (on mining) and hydropower royalties.

On-lending includes gross repayments of funds.

Includes payments on liabilities carried over from the previous budget years and for arrears clearance.

Overall balance net of resource revenue.

Excludes bank restructuring bonds.

Figure 2.Lao P.D.R.: Fiscal and Monetary Developments

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

5. Performance so far in 2008 suggests the economy is facing overheating. Headline inflation reached 10.3 percent in May 2008—the highest level in nearly four years (Box 1). Core inflation also rose to 5 percent. In addition to higher food and energy costs, demand-pull elements are now exerting pressure, partly stoked by monetary easing. Credit growth reached 48 percent (y/y) at end-April, driven by the state-owned commercial banks (SOCBs), which face government pressure to lend to small- to medium-scale enterprises, including agriculture. Wage pressures may also be rising, given the recent pace of economic expansion and greater demand for skilled workers. The kip has been allowed to further strengthen against the U.S. dollar and more recently the Thai baht, given large inflows and to offset inflation pressures.

Lao P.D.R.: Credit Growth, January 2005–April 2008

(Year-on-year percent change)

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates.

1/ Percentage points contribution to overall credit growth.

Box 1.Recent Inflation in Lao P.D.R.

Inflation has been rising in Lao P.D.R. since mid-2007, but the headline rate remains considerably lower than in neighboring Cambodia and Vietnam. As elsewhere, food and energy price increases are a leading cause in Lao P.DR. However, food prices have risen less and been a smaller contributor to overall inflation than in other parts of the region. Retail petroleum prices in Lao P.D.R. have generally increased in line with world oil price movements, with diesel and gasoline up 51 and 25 percent (y/y), respectively, as of end-May.

Several factors may explain lower inflation in Lao P.D.R. than other parts of the region.

  • Domestic agricultural conditions have been conducive to relatively low food price inflation. Agricultural output expanded by 2.9 percent in 2007 (and rice production by 3.9 percent)—up from 2.1 percent the previous year. Rice production is also primarily glutinous rice, which has a limited export market (rice exports were US$14 million in 2006/07 (October–September)—only around 3 percent of the annual crop). The government encourages producers to sell in local markets, although no export duties or controls exist on rice. Food imports also tend to be low, reflecting the government’s policy of food selfsufficiency. The recent rise in food prices appears more likely driven by higher input costs, including fertilizer and transport.

  • Greater exchange rate flexibility in Lao P.D.R may also provide a better cushion against inflation, as the kip has strengthened more recently than have other currencies in the region vis-à-vis the U.S. dollar and in nominal effective terms. Furthermore, around 70 percent of Lao imports also come from Thailand, where inflation has been comparatively lower. 1

  • Finally, bank credit has expanded at a slower pace in Lao P.D.R. than in either Cambodia or Vietnam, although there has been considerable catching up the past year.

Regional Inflation Indicators
200620072008
(Latest)
Headline inflation (y/y, in percent) 1/
Lao P.D.R.6.84.510.3
Cambodia4.710.618.7
Thailand4.62.27.6
Vietnam7.48.425.3
Headline inflation (share attributable to food) 1/
Lao P.D.R.56.872.956.1
Cambodia63.384.075.0
Thailand38.170.059.7
Vietnam50.957.871.8
Core inflation (y/y, in percent) 1/
Lao P.D.R.4.42.25.0
Thailand2.31.02.8
Vietnam6.66.214.4
Credit growth (y/y, in percent) 2/
Lao P.D.R.-1.523.048.3
Cambodia51.676.0102.7
Vietnam25.453.964.0
Sources: National agencies; and IMF staff estimates.

For 2008, as of May except Cambodia (January 2008).

As of April 2008.

Sources: National agencies; and IMF staff estimates.

For 2008, as of May except Cambodia (January 2008).

As of April 2008.

Lao P.D.R.: Petroleum Price Index, January 2005–May 2008

(January 2005=100)

Sources: Data provided by the Lao P.D.R. authorities; IMF WEO database; and IMF staff estimates.

1/ From Lao P.D.R. consumer price index.

Lao P.D.R.: Rice Prices, January 2004–May 2008

(December 2005=100)

Sources: Data provided by the Lao P.D.R. authorities; IMF, Commodity Price System database; and IMF staff estimates.

1 Based on the IMF’s Direction of Trade Statistics for 2006. Some of these imports may be re-exports from other countries and/or settled in currencies other than the Thai baht.

II. Outlook and Risks

6. Growth is projected by staff at 7½ percent in 2008, but downside risks have emerged with the recent acceleration in inflation. 4 Driving growth are similar factors as last year, as well as higher mining output. However, measures may be needed to reduce overheating, mainly by curbing credit growth. Staff still expect inflation will stay in the low double digits this year—but well above the government’s target of 6 percent, with recent global trends pointing to further upside pressure. Notwithstanding high mineral prices, the external current account deficit is expected to widen to around 18 percent of GDP in 2008 on continued large oil and capital imports. However, the overall external position should improve on strong inflows, in particular those for hydropower development.

7. The medium-term outlook for Lao P.D.R. remains favorable, but rests on sound development of the resource sector and steps elsewhere to strengthen competitiveness. Staff’s growth projections are in line with the government’s target at 7.5–8.0 percent per year (Table 5), led by resource activity (Box 2). Underlying (nonresource) growth is also expected rise to 6 percent over the medium term, but this requires a more dynamic financial sector, better investment climate, and further trade integration in the region and beyond, as well as human capital and infrastructure development. The current account deficit should begin to decline significantly starting in 2012, assuming resource project-related imports moderate, world oil prices stabilize, and new hydropower projects come on stream as planned, including the large Nam Theun 2 project from end-2009. Under this scenario, external vulnerability is reduced, with the reserve cover reaching nearly six months of nonresource imports over the medium term.

Table 5.Lao P.D.R.: Medium-Term Macroeconomic Framework, 2006–13
20062007200820092010201120122013
Est.Proj.
Output and prices (percent change, unless otherwise indicated
GDP at constant prices8.17.97.57.57.58.08.07.1
Excluding resource projects5.46.54.65.55.85.96.16.1
Consumer prices (end-year)4.75.613.17.65.54.54.54.5
Annual average6.84.510.89.97.05.54.54.5
GDP per capita (in millions of U.S. dollars)5816698409931,0901,1911,2891,383
Saving and investment balance (in percent of GDP) 1/
Gross national saving20.121.618.317.920.519.219.819.6
Foreign saving (including official transfers)11.018.118.820.018.316.113.98.6
Gross fixed investment31.139.737.137.938.835.333.828.3
Private24.432.431.332.832.829.728.222.8
Government 2/6.77.45.85.26.05.65.55.5
Public finances (in percent of GDP) 3/
Revenue12.514.015.115.416.015.615.815.9
Grants2.01.81.31.21.21.21.21.2
Expenditure18.418.518.018.018.218.118.218.2
Current9.29.210.410.711.011.311.511.7
Capital and onlending7.47.56.36.46.36.16.26.2
Overall balance-3.8-2.7-1.7-1.4-1.0-1.4-1.2-1.1
Nonresource balance-5.1-5.0-4.7-4.6-4.4-4.1-4.1-3.8
Domestic financing-1.1-1.1-1.1-1.0-1.1-0.5-0.6-0.6
Foreign financing4.93.92.72.52.11.91.81.7
Balance of payments (in millions of U.S. dollars; unless
otherwise indicated)
Current account balance-368-716-936-1,214-1,265-1,237-1,182-804
In percent of GDP-10.5-17.4-17.8-19.2-17.9-15.7-13.6-8.5
Exports1,1431,2031,5161,6991,8221,9992,3032,463
Of which:Resources6606638891,0231,0841,1931,4221,499
Imports1,5892,1142,6603,1973,3903,5443,7923,576
Services and income (net)-66917613513212010286
Transfers144104132148171188205223
Exports of goods and services1,3841,4781,9082,1422,3122,5392,8903,101
Imports of goods and services1,6592,1922,7383,2833,4863,6503,9113,708
Capital account balance4689231,1901,4721,3581,3391,284867
External public debt and debt service
External public debt (in millions of U.S. dollars)2,3082,4462,5892,8323,0463,3913,7304,018
In percent of GDP66.059.549.344.743.043.042.942.3
External public debt service (in percent of exports)3.55.16.46.06.06.06.06.4
Gross official reserves
In millions of U.S. dollars3355397891,0421,1291,2271,3251,384
In months of imports of goods and non-factor services1.82.42.93.63.73.84.34.4
In months of imports (excluding resource projects)3.03.74.95.85.85.75.75.5
Memorandum items:
GDP at current market prices (in billions of kip)35,19339,28547,27855,83564,20973,17482,56992,420
In millions of U.S. dollars3,4984,1085,2576,3347,0827,8868,6949,506
Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

Estimated using data for public finances and balance of payments.

Excludes investment financed by on-lending from the government.

Fiscal year basis (October to September).

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections.

Estimated using data for public finances and balance of payments.

Excludes investment financed by on-lending from the government.

Fiscal year basis (October to September).

8. Despite this positive outlook, substantial risks remain going forward. The most immediate threat would be a further rise in oil and food prices. A higher oil import bill could also offset rising mining export receipts. Over the medium term, large inflows could result in “Dutch disease” absent reforms noted above needed to ensure more balanced and sustained growth. On the other hand, a persistence in tight global credit conditions could raise borrowing costs and cause start-up delays in resource sector projects, with negative fiscal and growth consequences. Demand for raw materials, fueled by emerging markets, could also come down sharply if global prospects further soared.

Box 2.Resource Sector: Medium-Term Outlook

Under the current baseline, hydropower is expected expand rapidly, with installed generation capacity projected to increase nine-fold by 2014, provided current plans are fully implemented. Investment in this sector alone could reach US$5.2 billion over the next five years (averaging the equivalent of around 14 percent of GDP a year).

Mining capacity should also increase, but at a more measured pace, based on current investment plans. The government has recently shortened the concession period for new mining licenses to encourage faster exploration and development. Mining (gold and copper) and electricity exports are expected to account for around 60 percent of total exports over the next decade.

Resource revenue is expected to level off at around 3 percent of GDP over the medium term. This projection may appear conservative based on recent trends and does not account the spillover effects to other activities. In addition, it could change significantly depending on the extent of the government’s equity stake in resource projects above current expected levels. Resource revenues also remain subject to volatile commodity prices and an uncertain external environment.

The public sector’s planned stake in large resource projects poses a potential fiscal risk. Based on current plans, equity participation in the hydropower sector by public entities (including state enterprises) could total nearly US$600 million between now and 2014, most of which is expected to be financed through external borrowing. Other possible financing mechanisms include deferred dividends from or tax waivers for project operators, which could limit available resources for other budget priorities. 1

Lao P.D.R.: Electricity Exports and Installed Generation Capacity, 2005–15

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates.

Lao P.D.R.: Resource Revenue Projection, 2003/04–2012/13

(In percent of GDP)

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates.

Lao P.D.R.: Sensitivity of the Fiscal Balance to Resource Prices and Output, 2007/08–2012/13 1/

(In percent of GDP)

Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates

1/ Direct price effect only.

Lao P.D.R.: Financing of Power Generation Projects 1/

(December 2005=100)

Sources: Ministry of Energy and Mines; Electricité du Laos; and IMF staff estimates.

1/ For hydropower projects (including planned) and Hongsa Lignite Plant to 2014.

2/ Financing modalities may involve debt financing.

1 So far, the government has funded its 25 percent equity stake in the Nam Theun 2 dam project largely through donor concessional loans and grants. It also has equity stakes in several large mining projects, with financing through deferred dividends.

III. Policy Discussions

9. Policy discussions focused on three key issues: (i) improving monetary management, including as a complement to banking reform; (ii) pursuing a sound fiscal stance, supported by strengthened public financial and resource revenue management; and (iii) managing resource-related investment effectively.

A. Monetary and Exchange Rate Policy and Near-Term Stability

10. Under current conditions, staff indicated more decisive action was needed to contain excess liquidity arising from external inflows. Monetary tightening was advised, including allowing for further exchange rate appreciation. In particular, stricter control was recommended over growth in net domestic assets (NDA) of the BoL. This would likely need to come through higher reserve requirements (kip and foreign currency), given the lack of available instruments. 5 Open market operations could also be employed, possibly through the issuance of monetary stabilization bonds, as the BoL is now better able to bear the financial costs associated with indirect instruments. To increase policy effectiveness, staff again emphasized the need to develop an interbank money market. As a first step, a more efficient payments and settlement system is required, so that banks can avoid holding excess reserves at the BoL and manage their liquid balances more effectively, including through interbank activity.

11. The authorities recognized the challenges posed by current conditions, but were reluctant to tighten monetary policy to stem the recent credit growth. At the same time, the BoL would consider ways over time to improve capacity in monetary control, including foreign reserves management, and continue pursuing a flexible exchange rate policy. The authorities noted that bank credit in Lao P.D.R. was small by most measures (8 percent of GDP at end-2007) and needed to increase rapidly to sustain growth. Staff indicated these factors should be weighed against the risk of undermining macroeconomic and financial stability.

12. In line with greater exchange rate flexibility, more efforts are needed to deepen the foreign exchange market. Formal intervention by the BoL appears limited mostly to smoothing short-term volatility and so as to keep the official market rate (i.e., the exchange rate band around the BoL’s daily reference rate) in line with the parallel market rate. 6 However, the lack of trading in the interbank markets requires the BoL to step in on occasion to help banks manage their foreign liquidity needs. Staff noted that greater interbank trading could be facilitated by better information sharing between banks, including through more automated transactions. Related to this, consideration should be given to widening the daily trading band.

B. Fiscal Policy and Resource Management

13. Initial indicators point to further fiscal consolidation in 2007/08 on continued revenue gains. The overall budget deficit is projected to fall to 1.7 percent of GDP—significantly outperforming the official target. Revenue is expected to be boosted by still buoyant mining taxes and royalties and improved tax administration. However, overall performance will be tempered by fiscal measures taken to mitigate the impact of high energy price. Starting in May 2008, caps were placed on the dutiable price of petroleum imports, effectively providing tax relief on gasoline, diesel, and kerosene in the event of further price rises. 7 The authorities generally agreed that any further measures, including on food, would be well targeted and minimally distorting, with a limited impact on the overall fiscal position, including in next year’s budget.

14. Based on preliminary budget preparations, the government is expected to continue pursuing a moderately low fiscal deficit in 2008/09. Staff supported this move, given the size of public debt and to help contain aggregate demand pressures. However, it needs to be complemented by further efforts to broaden the tax base, improve revenue administration, and strengthen expenditure management, in line with the government’s public finance management strengthening program (PFMSP). Despite long delays, staff also urged caution in proceeding with a value-added tax (VAT) planned for January 2009 and recommended postponement, if necessary, given work to be done on taxpayer registration, refunds, and education. To meet the targeted date, the authorities noted a limited rollout might be considered by raising the compulsory VAT threshold, but staff noted this could present further administrative challenges by restricting the number of taxpayers. 8 On expenditure, staff recommended caution on any further large wage bill increases, including to avoid crowding out critical spending on operations and maintenance and in key social sectors. Plans to expand the civil service would also be weighed carefully against the existing budget envelope. 9 The authorities also concurred with staff on the need to show spending and financing for the 2009 SEA Games transparently.

15. Discussion also focused on progress made in strengthening budget execution and performance. Under the PFMSP, focus remains on recentralizing fiscal authority and improving overall accountability in line with the revised Budget Law (2006), with support from the World Bank’s Poverty Reduction Support Operations (PRSO) and other donors.

  • On recentralizing tax and customs administration, government instructions have been issued guiding the process, with initial pilots establishing central authority through regional customs offices and provincial tax offices now under way in several larger provinces. More resources are also being devoted to developing and staffing a large taxpayers unit.

  • To strengthen inter-governmental fiscal relations, an implementation decree was issued in early 2008 guiding the framework on revenue and expenditure assignment. However, considerable work remains in setting budget norms to ensure adequate spending in priority areas with shared revenues.

  • New budget nomenclature has been approved consistent with GSFM 2001, and a revised chart of accounts is expected to be introduced for fiscal year 2008/09. Regulations are also being devised for introducing a Treasury Single Account framework over the next few years to strengthen cash management and control.

16. The staff encouraged the government to develop a comprehensive strategy for resource management. The need was reiterated for a medium-term fiscal framework that accounts for potential volatility in resource revenues and ensures expenditure priorities are properly funded. Underpinning this would be a transparent fiscal regime, which a revised Mining Law is expected to contain for that sector when finalized later this year. With a State Accumulation Fund (SAF) for resource revenues now operating, staff also urged the accounting for and use of the SAF remain on-budget, consistent with the IMF’s Guide on Resource Revenue Transparency. Staff also noted that any strategy should lay out the conditions for government equity ownership in the resource sector, to ensure they are consistent with maximizing revenue and limiting risk exposure. Closer monitoring was also urged of new debt-creating obligations for public entities in the hydropower sector, including on-lent funds to and direct loan guarantees for Lao Holding State Enterprise and Electricité du Laos (EDL).

C. External Viability and Competitiveness and Debt Sustainability

17. The authorities agreed with the staff assessment that the value of the kip is broadly in line with fundamentals. CGER-type estimates indicate scope for a further modest appreciation, although these results should be interpreted cautiously. 10 Recognizing this, more should be done to strengthen external competitiveness. A major component of the World Bank’s current PRSO is aimed at improving the investment climate and lowering business costs, including streamlining licensing for business startups and harmonizing the investment regime for domestic and foreign investors—all consistent with the Enterprise Law (2005). 11 The government has also committed to revising customs laws and procedures to simplify and automate the import-export license regime and customs clearance process, with World Bank and IMF technical support. Staff also encouraged continued progress on trade integration. The authorities indicated they remain committed to WTO accession by 2010, but this will require timely interventions by the government through forthcoming working party meetings and additional work on amending regulations to be WTO compliant.

Real Effective Exchange Rates: Lao P.D.R. and Selected Economies, 2002–08

(January 2000=100)

Source: IMF Information Notice System database.

18. The debt sustainability analysis for Lao P.D.R. continues to show the debt stock well above policy-based indicative thresholds, suggesting a high risk of debt distress. Nonetheless, debt indictors have become more favorable in recent years, supported by strong economic growth, a more stable macroeconomic environment, and favorable external conditions. The total stock of external public and publicly-guaranteed debt was US$2.4 billion at end-2007, or 60 percent of GDP. Debt sustainability continues to depend on sustained high growth, as well as on improved external competitiveness and largely concessional borrowing. Strong control over quasi-fiscal risks arising from the state sector will also be necessary, including borrowing and guarantees for resource sector projects, as noted above.

D. Banking Sector and State Enterprise Reforms

19. Banking reform should continue to be pursued vigorously, given the financial recovery of SOCBs is still at an early stage. Nonperforming loans (NPLs) have been reduced noticeably at the larger SOCBs, but weak capital positions still leave these banks vulnerable (Box 3). Interest rate spreads also remain large, suggesting the need for improved operating efficiency and greater competition. To bring the banks up to the minimum stipulated capital-adequacy ratio of 8 percent in the next few years, staff encouraged the authorities to continue carefully recapitalizing the SOCBs, improving their profitability, and seeking possible strategic investors. The SOCBs viewed rapid credit expansion as key to increased profitability. However, staff cautioned that given the current pace and with risk controls not yet fully tested, these banks continued to warrant close monitoring to avoid new NPLs. Efforts are also needed to develop a credit information system and strengthen the payment culture. As a complementary move, staff urged stricter enforcement of the existing prudential and regulatory framework, including through more off-site monitoring. In support, the authorities indicated plans to issue soon a full set of implementation regulations for the commercial bank law. Staff also noted that better disclosure of banks’ financial condition, including through development of financial soundness indicators, was essential to safeguarding the banking system. 12

20. Further progress has been made on state-owned enterprise reform. Under the World Bank’s first series of PRSO, the larger SOEs began undergoing external audits in

Box 3.Banking Sector Reform

Lao P.D.R. has pursued a reform program since 2003 aimed at strengthening banking oversight and restructuring the state-owned commercial bank (SOCB) sector. It also seeks to level the playing field for private and foreign banks and encourage their entry, given the small size of the banking system and dominance by the SOCBs (which accounted for 63 percent of total system assets at end-2002, compared to 54 percent as of April 2008). Reforms were necessitated by a sharp deterioration in the quality of SOCBs’ balance sheets as a result of poor risk management and large directed lending (particular to state-owned enterprises). Conditions were exacerbated by weak monetary discipline and lapse bank supervision.

Following initial delays, some progress has been made, with donor technical and financial support mainly from the Asian Development Bank (AsDB), as well as the World Bank.

Lao P.D.R.: Financial Soundness Indicators, 2004–07 1

Sources: Data provided by the Bank of Lao P.D.R.; and IMF staff estimates.

1 Indicators for 2005–07 are for Banque pour le Commerce Exterieur Lao (BCEL), Lao Development Bank (LDB), and Agricultural Promotion Bank (APB), while those for 2004 are for BCEL and LDB.

2/ Asset–weighted average of capital adequacy ratios for BCEL, LDB, and APB.

Lao P.D.R.: Loan-to-Deposit Ratio, January 2001–April 2008

Sources: Data provided by the Bank of Lao P.D.R.; and IMF staff estimates.

  • The Law on Commercial Banks approved in 2006 aimed at strengthening bank governance, with prudential regulations in line with Basel Core Principles. The law also allows majority foreign ownership of banks.

  • Non-performing loans (NPLs) have declined significantly at the SOCBs. Progress has been achieved through loan work-outs and write-offs, but some NPLs are off-balance sheet awaiting final resolution. Banks have increased loan-loss provisioning, but their loan-to-deposit ratios has also fallen sharply, limiting profits.

  • Improvements in SOCBs’ capital positions have lagged. By official estimates, each SOCB remains insolvent but this, too, is changing. Since June 2006, the government has issued kip 350 billion of a planned kip 600 billion in recapitalization bonds. The rest is expected by late 2008, which should further strengthen SOCBs’ capital base.

  • Oversight of all banks has also been strengthened. The BoL has increased its on-site supervision and off-site monitoring, although capacity remains weak. Branch lending caps and lending limits on related parties and single borrowers have been imposed, but the recent increase in the latter limit from 10 to 25 percent of Tier 1 capital merits close watch by the BoL. The two large SOCBs now undergo external audits consistent with governance agreements between them and the BoL. However, the BoL continues as both SOCB regulator and owner, which creates potential conflicts.

  • A small policy bank was created in early 2007 as a spin-off from an SOCB. However, the government continues to pressure SOCBs to lend to certain sectors, which could compromise their financial recovery.

The government has indicated interest in attracting strategic investors for SOCBs, including foreign banks. Consideration is also being given to transforming the two large SOCBs into publicly-held companies at the targeted launch of a stock market in 2010. Competition from private and foreign banks is also increasing. Since 2003, 4 new deposit-taking institutions (2 local and 2 foreign banks) have been licensed, bringing the total to 15, with 3 more foreign bank expected this year. Nonbank activity remains limited, although three insurance companies were licensed over the last year and a private leasing company is being formed.

early 2008. EDL’s financial performance has also improved through further clearance of government arrears (with plans now in place to settle those through fiscal year 2005/06) and more frequent adjustments in electricity tariffs. In furtherance of the commercialization of SOEs, staff supported efforts to create an operational body to monitor their financial performance, including debt management, as well as to transform or liquidate non-strategic or loss-making enterprises.

E. Other Issues

21. A government decree is being prepared authorizing the removal of exchange restriction on tax payment certificates, as a possible precursor to accepting the obligations under Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement. No firm timetable was given, but the authorities noted the decision to remove the restriction was in conjunction with plans to ratify the World Customs Organization’s revised Kyoto Convention on simplifying and harmonizing customs procedures.

22. On macroeconomic and financial data, shortcomings remain that hamper surveillance. Priority should be placed on strengthening balance of payments (BOP) statistics and national income accounts, as well as external public debt (including guarantees) and subnational fiscal accounts. Better measurement of BOP-related activity, in particular, would enhance policy formulation in managing inflows and containing vulnerabilities. Automation of customs procedures is expected to improve trade statistics over the next few years, but more coordination among statistical agencies, greater use of banking data, and a direct survey of foreign-invested activity are also needed.

IV. Staff Appraisal

23. The Lao economy has entered a critical stage of development, as it opens to large-scale inflows and creates conditions for sustaining high growth. A combination of favorable commodity price trends and growing electricity demand in the region are expected to help sustain growth and strengthen external position over the medium term. While much more remains to be done to improve competitiveness, the government’s reform agenda appears supportive of these objectives. Maintenance of a stable macroeconomic environment will also be important to lowering business costs and attracting foreign investment, including outside the resource sector.

24. The economy remains resilient to global economic slowdown and financial turbulence, but inflation pressures present a growing challenge to the authorities. More decisive action is needed to counter these pressures, given their current sources and potential costs, in particular to the large number of impoverished households in Lao P.D.R. Exchange rate appreciation has helped mitigate some of the impact, and a further strengthening of the kip could ease pressures. However, rapid expansion of credit growth is fueling demand pressures, which risks reversing recent stability gains.

25. Under these circumstances, monetary tightening is warranted, but the effectiveness of the BoL will depend on how quickly it moves to improve its capacity for managing domestic liquidity. Over the near term, consideration should be given to using available indirect instruments as recommended in this staff report and earlier ones. Absent effective monetary operations, tighter prudential regulations may be necessary to contain credit growth, in particular by still-fragile SOCBs. The government should also resist pressuring these banks to lend to certain sectors. Staff views the move to greater exchange rate flexibility as appropriate, in facilitating a tightening of monetary policy and enhancing the economy’s resiliency to external shocks. Given the REER appears somewhat undervalued, a more flexible exchange rate should also allow quicker adjustment to the equilibrium level and reduce spreads between official and parallel rates.

26. The fiscal stance is broadly appropriate, with maintenance of a low deficit consistent with reducing external vulnerability and containing demand pressures. To this end, the authorities will need to remain vigilant in recentralizing its fiscal authority, to ensure it can avoid past problems with weak revenue collections and spending oversight. Full implementation of the VAT should proceed carefully, including formulation of a reasonable timetable and with sound technical advice. The government should also carefully consider the size of its wage bill to ensure it is consistent with the available budget envelope and does not crowd out more critical spending priorities. The new SAF could potentially be used to address longer-term expenditure needs, but this should be guided by a sound strategy for managing and using funds and anchored by a medium-term fiscal framework.

27. External viability and sustained growth will depend on sound development and management of the resource sector. The potential rewards are large, but so are the risks if poor sector governance comes with reduced external competitiveness, excessive government indebtedness, or increased vulnerability to shocks. The authorities recognize these challenges, but will also need to develop sound fiscal, legal, and regulatory regimes, as well as environmental standards, to maximize gains from sector development.

28. Important steps have been taken on banking reform, but the challenge remains in ensuring banks further improve their financial soundness. Avoidance of a costly recurrence of NPLs and disintermediation by the banking system necessitates a commitment on the part of SOCBs to ensuring lending decisions are guided by proper risk management and controls. On its part, the BoL will need to ensure its regulatory and supervisory framework and capacity are supportive of developing a sound financial system. To this end, adherence to the banking reform strategy developed with donor partners and implementation of the new commercial bank law are key.

29. It is recommended that Lao P.D.R. remain on the 12-month consultation cycle.

Nonresource imports exclude those imports associated with major mining (gold and copper) and hydropower projects.

For spending on early preparations for the Southeast Asia (SEA) Games, which Lao P.D.R. will host in 2009.

Government wages were increased by an average of 25 percent in October 2007, on top of an increase of 11 percent in October 2006. However, civil servant wages remain compressed compared to the private sector.

The official projection for is 7.9 percent, with the authorities expecting a greater contribution from services.

Staff also noted an earlier recommendation to develop a standing deposits facility (i.e., through remunerated excess reserves).

Currently, commercial banks must limit the bid-ask spread on their daily foreign exchange transactions to ±0.25 percent of the BoL’s daily reference rate (reduced from ±0.30 in August 2007). The BoL typically uses this daily trading band as well as regional currency trends to set the next day’s reference rate, although on occasion the reference rate is set outside the band to account for broader (i.e., parallel) market conditions. Spreads between official and parallel market rates fluctuate, but generally remain less than 1 percent.

At the time, staff estimated the cost of this measure was about 0.3 percent of GDP in foregone revenue in 2007/08. However, given most petroleum taxes are collected on an ad valorem basis, total collections for the year should more than exceed the budget target owing to much higher-than-anticipated petroleum import prices.

The VAT replaces the turnover tax for large taxpayers and introduces a standard 10 percent rate. Under current plans, compulsory registration will be required for those enterprises with annual turnover of more than kip 400 million (US$;45,000)—around 1,800. Based on staff’s estimate, postponement of the VAT in 2008/09 would result in lower revenue by 0.2 percent of GDP.

The government indicated it plans to increase the number of civil servants between now and 2010 by around 4–5 percent a year, mainly to hire new education and health workers, but also to establish a new agency to cover water and environment issues.

Based on total trade and nonresource balances for the period 1991–2007, the estimated results suggest the real effective exchange rate (REER) is undervalued by 7½ percent and 1 percent, respectively, relative to the mediumterm level of its fundamental determinants. However, their robustness may be limited given major structural changes to the Lao economy, weak and incomplete macroeconomic data, and a limited number of observations.

A Prime Minister’s decree was issued in April 2008 approving a “negative list,” which is expected to streamline business approvals.

The BoL will require banks to publish annual reports starting in 2009.

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