1. The authorities would like to express their appreciation to the IMF mission team for the constructive policy discussions and comprehensive assessment during the 2017 Article IV consultation. They broadly agree with the staff appraisal and will thoughtfully consider staff’s recommendations in steering policy measures to preserve macroeconomic stability.
2. The Lao economy continues to expand at a sustained and high annual average growth rate above 7 percent over the past decade, which has translated into commendable progress in poverty reduction, increased employment and favorable investment climate. Notwithstanding these encouraging developments, the authorities note that external and domestic challenges to the economic outlook remain, requiring continued commitment to fiscal consolidation, prudent monetary policy, financial stability and structural reforms. The implementation of such policy measures will ensure strong and sustainable growth and graduation from the least developed country status as set out in the National Socio-Economic Development Plan for 2016–2020.
Recent Economic Development and Outlook
3. In 2017, growth registered at 6.8 percent underpinned by continued hydropower generation, construction and the ongoing Lao-China railway project. This was marginally below the growth target of 7 percent due to lower commodity exports, tourist receipts and government measures towards sustainability such as the suspension of log export and expenditure restraint. Inflation in 2017 was 0.8 percent reflecting the decline in food prices and moderation of domestic demand. Higher electricity and manufacturing exports helped narrow current account deficit to 13 percent of GDP while FDI remained healthy in natural resource sector and special economic zones. Reserves at the end of 2017 stood around USD 1 billion and covered 4.5 months of imports, representing an adequate buffer to external shocks.
4. Looking at 2018, the authorities have set the minimum growth target of 7 percent, supported by expected electricity output from new capacity coming on stream and tourism activities stemming from “Visit Lao” initiative. Inflation is projected to be manageable at below 5 percent. Continued efforts will be made in mobilizing revenue, improving the legal framework, enhancing tax compliance and strengthening fiscal discipline. In this connection, the authorities target the fiscal deficit to be less than 5 percent of GDP. The current account deficit is projected to narrow further with the increase in exports and tourism receipts. The authorities also remain positive about FDI inflows and are determined to enhance the business environment which will support economic diversification and strengthen reserves. The medium-term outlook will remain broadly positive on the back of gradual improvements in the macroeconomic framework but the authorities note that uncertainties in the regional and global contexts could affect external demand and investments.
5. Tax administration has been strengthened with technical support from the Fund and development partners. Precisely, the authorities have completed an organizational restructure by putting the local tax authorities under the Tax Department in headquarter. The enterprise survey is also underway to explore the scope for broadening the tax base. Point of Sale (POS) technology has also been rolled out into strategic retail stores to improve intelligence and tax compliance. Building on the recent success in requiring road tax payment via the banking system, a similar modernization approach will be further expanded. On customs revenue, rigorous measures have been put in place to counter smuggling and stem revenue leakage. At the same time, the authorities have also been working with custom authorities in neighboring countries to closely monitor import activities. Exemptions will also continue to be strictly implemented according to items listed under the Law on Investment Promotion.
6. Besides ongoing measures to discontinue off-budget expenditure, the authorities will strictly enforce the Prime Minister’s Order on economizing and eliminating non-essential outlays. They will also continue to prioritize investment projects with credible and highest rates of return while improving the existing management framework. At the same time, current expenditure will be controlled through civil service reform to lower recruitment quota. In the medium term, the authorities target a reduction in the wage bill from 55 percent to 40 percent of total spending.
7. Public debt level remains high but most of the debt is long-term and concessional and therefore manageable. To ensure the sustainability and appropriate management of public debt, the Law on Public Debt Management will be tabled at the National Assembly (NA) in 2018. Its core elements are the statutory public debt ceiling of 65 percent of GDP and a requirement for NA approval of investment projects with value above USD 50 million. While commercial loans remain restricted to financing hydropower projects with FX income, the authorities emphasized that further borrowings will be pursued on concessional terms to support necessary investments.
8. The authorities agree with staff on the importance of establishing a public debt anchor but have reservations about the target level of 50 percent of GDP and deficit requirement of 2.6 percent of GDP in medium term. They recognize that adequate time is required for fiscal adjustments to yield desirable results as significant needs remain in financing poverty reduction. The authorities therefore consider that a medium-term debt target of 55 percent to GDP to be more realistic in reducing the risk of debt distress and strengthening the external position.
Monetary and Exchange Rate Policy
9. The stable exchange rate has served as an effective anchor for inflation and has restored confidence in the local currency. The authorities see merit in staff’s recommendation of allowing gradual depreciation of the exchange rate in the near term but are concerned that the depreciation could raise inflationary pressures and currency substitution may arise, as experienced in the past. Nevertheless, the currently low inflation environment has allowed the authorities to relax the exchange rate movement in line with market forces and within the target band. While believing that the current managed-float regime remains appropriate and supportive to a stable macroeconomic environment, the authorities also agree with staff that a more flexible regime is desirable when preconditions are in place to support the transition.
10. While remaining supportive of market-based interest rates, the Bank of Lao PDR (BoL) noted with concern on 2015 surge in lending rates into the double-digits, stemming from competition amongst banks to mobilize deposits. Interim measures were introduced to guide commercial banks in lowering interest rates to more appropriate levels with the objective of reducing borrowing costs and promoting access to finance for SMEs. Going forward, the authorities will closely monitor credit developments and with an eye to reversing the measure when market conditions permit.
11. Recognizing that a high degree of dollarization limits the ability to implement effective monetary policy, the authorities have constantly endeavored to promote greater use of the local currency (kip). In addition to inflation and exchange rate stabilization, the authorities have employed a multipronged strategy ranging from a kip promotional campaign, the introduction of deposit insurance, raising FX reserve requirements as well as legal enforcement on domestic transactions to be based in kip. As a result, dollarization, as measured by foreign currency deposit to broad money, has gradually declined from its peak of 80 percent in late 1990s to 42.4 percent in 2016. To move forward in de-dollarization, the authorities will promote the ease of mobile banking services and payments to play a greater role in kip transactions as well as reducing cash in the economy.
12. Overall, the banking sector remains sound and stable as the system-wide capital adequacy ratio is maintained above 15 percent and NPLs are around 3 percent. The undercapitalized state-owned commercial banks are now undergoing internal restructuring while the BoL is carefully considering options for privatization. Beginning from 2017, the authorities have tightened due diligence and prudential requirements, leading to the recent decline in credit dollarization, however FX loan remains available to entities with FX earnings and strategic imports.
13. The Regulatory framework is regularly reviewed and updated to better align with current developments and international best practices. This includes the Laws on Commercial Banks and the Central Bank, which are being revised in consultation with the World Bank. The Regulation on Loan Classification and Provisions issued in 2011 remains an effective tool to accurately capture the problematic loans. Banks’ stress testing will be conducted with a key focus on liquidity and credit risk while an early warning exercise will be devised as part of the development of crisis management framework. To this end, the authorities are also implementing Fund and World Bank advice in improving Financial Soundness Indicators to effectively monitor the health of the banking system.
14. Significant progress has been made in transforming the supervisory framework towards risk-based supervision and Basel II compliance. The authorities have been appreciative of MCM technical assistance in migrating from compliance-based to risk-based supervision as well as developing manuals for onsite examination and offsite supervision. On Basel II, a Master Plan has been recently adopted to guide institutional set up during the transition period. A key task in 2018 will be requiring all banks to complete their internal gap analysis to comply with the new minimum capital requirement. The target for full-fledged Basel II compliance will hinge upon the progress in addressing the identified gaps.
15. The authorities are aware of the country’s narrow domestic production and export base and note that structural reform is necessary to move towards more broad-based growth. Despite the gradual expansion in the services sector and commercialization of agricultural products, crucial tasks remain in creating a sound business environment and promoting the role of the SME sector to enhance its capacity to manufacture and export. Given this background, the authorities are determined to streamline business and property registration, enhance legal enforcement and create a level playing field. In a similar vein, any administrative bottlenecks that create additional cost for starting and doing business will be addressed. To press ahead with these reforms, the Prime Minister, earlier this month issued an executive order, calling on line ministries to address deficiencies identified in the World Bank’s Ease of Doing Business indicators. The Law on Investment Promotion has also been amended to create more favorable incentives for projects invested in strategic zones.
16. As approved by the government, the authorities are currently drafting the Strategic Plan on Restructuring SOEs. Key reform areas will include equitization, employing professional management, and improving accounting standards, which aim at enhancing profitability, transparency and minimizing the burden to the government’s balance sheet. The plan will also identify targeted SOEs with a clear strategy for restructuring process while aiming at lowering the number of SOEs and government’s shares to a more appropriate level in medium term.
17. The authorities will continue to focus on the improvement of the health and education sectors and social protection to enhance progress in poverty reduction and strengthen productivity and capacity. Greater attention will be directed to people in rural areas to make growth more inclusive. In this regard, the authorities have announced a plan to gradually increase budget allocation in coming years to develop necessary infrastructure and capacity in the health and education sectors. Building on the progress made in achieving the Millennium Development Goals (MDGs), the authorities are committed to achieving Sustainable Development Goals (SDGs) especially with regards to the social and environmental aspects of the country’s development.
18. The authorities are mindful of the considerable challenges to achieving targeted growth and sustainable development. While acknowledging the likelihood of lower growth prospects, the authorities emphasize the need to address structural weaknesses and create a solid foundation to support development goals going forward. It is also equally important for the authorities to improve people’s living standard and to graduate from least-developed country status by 2020. In the near term, growth will be supported by continued fiscal consolidation, well-grounded monetary and exchange rate management and financial stability as well as greater competitiveness for SOEs. In this regard, the authorities extend their appreciation to Fund staff for continuous engagement through various technical assistance projects and invaluable policy advice. All recommendations will be carefully considered and appropriately implemented and sequenced to achieve desired policy outcomes.