Information about Asia and the Pacific Asia y el Pacífico
Chapter

IV Monetary Policy and Financial Sector Reforms

Author(s):
Ichiro Otani, and Chi Pham
Published Date:
May 1996
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Nominal anchors, in the form of either nominal exchange rates or predetermined rates of money growth, have proved to be useful in the process of disinflation in many developing countries or transition economies. However, the authorities in the Lao P.D.R. did not adopt these anchors during the period under review. Instead, the authorities adopted a strategy of targeting the growth in net domestic assets of the banking system, taking into consideration the balance of payments objective and the expected demand for money. This strategy was adopted even though the relationship between monetary aggregates and economic activity was unstable and the degree of currency substitution extensive. At the same time, in the initial period of the disinflation process, the authorities floated the exchange rate with a view to finding a rate that reflected market forces more accurately than the fixed or managed float system, and to unifying the official exchange rates once financial imbalances were reduced. In parallel with these policy initiatives, various forms of financial sector reform were undertaken.

The approach taken by the Lao authorities proved to be effective in reducing inflation while avoiding the significant decline in output that is often experienced in transition economics. What follows describes the experience with monetary policy and financial sector reforms since 1989.

Monetary Policy

Inflation Control

The pursuit of generally prudent monetary and credit policies has been a key factor since 1989 in restoring and later sustaining macroeconomic stability. In particular, during the early years of the SAF-supported program (1990—92), these policies played a key role in substantially reducing inflationary pressures. The policy stance was gradually tightened, with interest rates sharply increasing to positive real levels in the second half of 1989, and became progressively more stringent during 1990–91. Meanwhile, in the absence of fully effective indirect policy instruments, the authorities continued to rely mainly on traditional, direct instruments, including limits on currency issue and instructions to state-owned banks to reduce credit to state enterprises. These policies, together with the Government's low level of bank borrowing, were largely successful in halting the rapid growth in credit and reducing broad money growth from almost 90 percent during 1989 to an annual average of about 12 percent during 1990–91 (Table 4). The monetary tightening, together with efforts to strengthen fiscal discipline, facilitated a dramatic decline in the inflation rate from a peak of nearly 90 percent in August 1989 to under 18 percent, on a 12-month basis, by the end of 1990 and further to about 10 percent by the end of 1991 (Chart 3).

Chart 3.Inflation and Monetary Developments

Sources: Lao authorities; and IMF staff estimates.

Table 4.Monetary Survey(End-of-period data, unless otherwise specified)
1988198919901991199219931994
(In billions of kip)
Net foreign assets1.520.121.622.736.672.958.7
Net domestic assets20.221.122.828.739.852.9107.3
Domestic credit26.526.731.144.156.174.7128.9
Net credit to Government12.8-14.3-14.6-0.90.6-9.512.6
Credit to nongovernment sector23.741.045.645.055.584.2116.2
Public enterprises222.936.639.724.117.818.317.4
Private sector20.94.45.920.937.765.998.8
Other items (net)-6.3-5.6-8.3-15.5-16.3-21.8-21.6
Broad money21.741.144.351.376.5125.8166.0
Narrow money12.125.125.128.235.152.261.3
Currency outside banks3.516.819.222.833.238.6
Demand deposits8.68.39.012.319.022.7
Quasi-money9.616.019.323.141.373.6104.6
Time and savings deposits0.10.30.94.29.730.445.6
Foreign currency deposits9.515.718.418.931.743.259.0
(Percent change)
Domestic credit47.5-3.316.342.127.133.272.5
Net credit to nongovernment sector53.673.011.2-1.323.351.7
Of which: Net credit to private sector2690.95.134.0254.180.474.938.0
Broad money37.189.37.815.749.064.631.9
Memorandum items
Velocity of money (period average)312.213.614.315.113.39.87.9
Reserve money (in billions of kip)20.422.126.336.960.774.2
Money multiplier42.02.02.02.12.12.2
Source: Lao authorities.

Includes recording in commercial bank’s balance sheets in 1994 of KN 5.3 billion worth of bonds out of KN 14 billion that were issued for recapitalization of state-owned commercial banks. Concurrently, bad loans amounting to KN 5.3 billion were removed from their portfolios.

Reflects the reclassification of credit in the monetary survey from public enterprises to the private sector following privatization.

Broad money divided by nominal GDP.

Broad money divided by reserve money.

Source: Lao authorities.

Includes recording in commercial bank’s balance sheets in 1994 of KN 5.3 billion worth of bonds out of KN 14 billion that were issued for recapitalization of state-owned commercial banks. Concurrently, bad loans amounting to KN 5.3 billion were removed from their portfolios.

Reflects the reclassification of credit in the monetary survey from public enterprises to the private sector following privatization.

Broad money divided by nominal GDP.

Broad money divided by reserve money.

The authorities continued to pursue generally cautious monetary and credit policies during 1992–94, notwithstanding some acceleration in the growth of broad money in 1993 related to structural changes in the banking system (discussed below). These developments contributed to a substantial reduction in the velocity of money, which helped avoid any significant adverse effects of the rapid monetary growth on financial stability. Owing to these policies, as well as to continued efforts at fiscal tightening, the inflation rate declined to single-digit levels in 1992 and settled at about 6½ percent in 1993–94.

Progressive Strengthening of Monetary Control (1988–94)

In the years leading up to the adoption of the SAF-supported program in mid-1989, various factors contributed to the authorities' weak control over monetary policy. First, before 1989, the principal aim of monetary policy was to help fulfill the development plan. Thus, although policy was guided by a credit and currency plan, this plan was implemented flexibly, as additional credit requests by state enterprises to meet production targets and implement new projects were liberally approved. Second, even if the authorities intended to achieve a given monetary growth target, they lacked the effective tools to do so. In these circumstances, the central bank experimented with direct instruments of control, such as credit-deposit ratios. Third, interest rates played only a small role in mobilizing and allocating resources and remained unchanged throughout 1979–85, despite sharp increases in inflation. Finally, the structure of the banking system was rudimentary. Prior to 1988, the banking system consisted of a single financial institution—the State Bank—and its provincial and district branches, which conducted both central and commercial banking activities. Administrative deficiencies also impeded the implementation of monetary policy, while statistical weaknesses complicated the analysis of related developments. These deficiencies in the institutional and policy framework contributed to the generally rapid expansion in monetary and credit aggregates in the second half of the 1980s.

Monetary Developments (1988–91)

Following a sharp wage adjustment in the public sector in late 1988 and the resultant heavy budget deficit financing in 1989, broad money rose by nearly 90 percent during 1989. Facing this situation, the authorities initiated several actions to tighten monetary control and reform the financial system. To slow monetary growth, they eliminated preferential access to credit by public enterprises and established an overall credit ceiling. Moral suasion was also used extensively to contain the growth of credit to enterprises. Interest rates were raised substantially in July 1989 on bank deposits and loans—to real positive levels by the end of the year—and punitive rates were imposed on overdrafts. The authority to determine interest rates was transferred from the Council of Ministers to the central bank. Most important, the rate on the central bank's advances to the commercial banks was increased from 6 percent to 28 percent; the rate on one-year time deposits was increased from 14 percent to 36 percent; and a daily rate of 1 percent was imposed on overdrafts at the commercial banks (see Table 5 and the discussion below). Also, in November 1989, the central bank issued guidelines to banks and branches of the State Bank to observe a credit-deposit ratio of 70 percent. In the area of financial sector reform, the process of separating the central and commercial banking functions of the State Bank was initiated. Efforts were also intensified to improve the classification, coverage, and timeliness of monetary data.

Table 5.Interest Rates(In percent a year)
1989 August11991 July21991 November31993 July41994 September
Deposit rates
Demand1.20.0–1.21.2
Savings24.016.0–20.012.012.0 (minimum)12.0 (minimum)
Time
3 months30.018.0–24.015.0
6 months33.620.0–26.016.0
1 year36.024.0–30.018.0
Lending rates524.0 (maximum)24.0 (maximum)
Agriculture and forestry28.0, 27.0, 27.015.0, 9.0, 7.014.0, 12.0, 10.0
Industry and handicrafts28.0, 27.0, 27.022.0, 12.0, 10.023.0, 18.0, 18.0
Construction and transportation29.0, 28.0, 28.025.0, 15.0, 12.025.0, 19.0, 18.0
Commerce and services29.0, 28.0, 28.030.0, 12.0, 10.026.0, 20.0, 18.0
Agricultural Promotion Bank10.0, 8.0, 7.0–15.010.0, 8.0, 7.0–15.02
Overdraft28.028.0
Bank of the Lao P.D.R. advances (credit window)28.024.024.026.026.06
Preferential projects72.0–12.02.0–12.02.0–12.0
Rate paid on required reserves of banks held at the central bank1.21.51.51.28
Settlement account1.21.51.51.21.28
Treasury bills (6 months)15.19
Source: Lao authorities.

Officially fixed rates.

Guidelines for minimum and maximum interest rates.

Guidelines for minimum interest rates.

Revised guideline of July 5, 1993.

The three rates refer to short-term, medium-term, and long-term loans, respectively.

The credit window was replaced by a discount window in May 1994.

On-lending of concessional borrowing by the Government.

Effective December 1993.

Weighted average of successful bids in the three auctions held in September 1994.

Source: Lao authorities.

Officially fixed rates.

Guidelines for minimum and maximum interest rates.

Guidelines for minimum interest rates.

Revised guideline of July 5, 1993.

The three rates refer to short-term, medium-term, and long-term loans, respectively.

The credit window was replaced by a discount window in May 1994.

On-lending of concessional borrowing by the Government.

Effective December 1993.

Weighted average of successful bids in the three auctions held in September 1994.

Together, the above measures served to improve monetary control. The concurrent privatization of state enterprises also contributed to a drop in credit demand by this sector. These tightening efforts were sustained and brought favorable results in 1990–91. The growth rate of credit to the state-owned enterprise sector was cut dramatically, reducing sharply the growth of broad money to some 8 percent in 1990 and 16 percent in 1991.

Three points should be highlighted with regard to monetary policy in 1990–91. First, tight monetary policies did not impose an undue constraint on emerging private sector activity, largely because the credit squeeze was concentrated on the public sector. Second, the authorities did not revert to the use of quantitative credit ceilings but sought to enforce the targeted credit-deposit ratio through moral suasion alone. Third, while the authorities regarded guidelines for minimum interest rates and informal limits on credit to public enterprises as policy tools to be used during the transitional period, they recognized that indirect monetary instruments would better serve the needs of a market-oriented economy. Thus, as discussed further below, they initiated the development of such instruments, including bank reserve requirements in 1990–91.

Monetary Developments (1992–94)

Monetary developments in 1992—94 were affected by three main features: the impact of ongoing financial sector reforms, in particular the emergence of foreign banks; substantial declines in the velocity of money; and the development of, and greater recourse to, indirect tools of monetary management.

Monetary growth gathered momentum over this period, largely reflecting buoyant private sector activity and the related surge in credit demand. After accelerating to nearly 50 percent during 1992, monetary growth rose further to about 65 percent during 1993. This sharp increase was attributable to a combination of factors. First, rising real deposit rates on kip-denominated savings deposits sparked a sharp growth in time and savings deposits. Second, six foreign banks commenced operations in Vientiane, thereby boosting confidence in the banking system and encouraging the conversion into bank deposits of foreign currencies (Thai baht and U.S. dollars) that had been previously in circulation but not recorded as broad money. Finally, the rapid monetary growth also reflected to a lesser extent a onetime balance-sheet effect of the new banks” opening positions on their assets and deposit liabilities. In 1994, broad money expansion slowed markedly in line with the waning impact of some of these special factors, especially the entry of foreign banks.

The faster rates of monetary growth posted in 1992–94 should be viewed in conjunction with the sharp decline in velocity witnessed during this period. The steady decline in velocity from 15 in 1991 to 8 in 1994 helped to check the re-emergence of inflationary pressures.

During 1993–94, monetary control was exercised increasingly through indirect instruments. As discussed further below, the central bank made frequent discretionary adjustments in the cost of credit provided to commercial banks through its credit window, and, in mid-1994, it replaced the window with a discount facility to tighten the scope of such lending. In late 1994, to reduce the potential for further rapid credit creation arising from excess liquidity in the banking system, the central bank doubled the reserve requirement ratio and sought to discourage recourse to its overdraft facility by tightening the terms of such borrowing.

Monetary Instruments

The central bank has taken a number of steps to develop indirect instruments of monetary management. First, in October 1990, a minimum reserve requirement of 5 percent of specified liabilities was introduced. In November 1994, as noted above, this requirement was doubled to 10 percent in order to absorb excess liquidity in the banking system. Second, in January 1992, a formal credit window was opened at the central bank. Under this facility, commercial banks could borrow to meet their short-term liquidity needs. However, to strengthen monetary control and tighten the provision of central bank credit, the credit window was replaced by a discount facility at the Central Bank in May 1994. Third, in March 1994, treasury bill auctions were commenced on a regular basis. These last two measures, together with the further progress made in allowing market forces to determine interest rates, are expected to lay the foundation for liquidity management through open market operations and to contribute to the development of an interbank money market.

Interest Rate Policy

Since the second half of 1989, commercial banks have been given progressively greater autonomy in setting their own interest rates on deposits and loans within bands established by the central bank. The main objective of these guidelines has been to ensure that rates remain positive in real terms. Subsequently, the development of market-based instruments of monetary management, the easing of inflationary pressures, and the strengthening of the banking system have ail combined to allow a gradual reduction in nominal interest rates and the removal of most interest rate guidelines. Interest rates have been decontrolled at a gradual pace in order to (i) allow banks to adapt to the more competitive environment and develop the skills and expertise needed to operate in the new market-oriented financial system; (ii) give banks the opportunity to increase their profitability and improve their financial positions; and (iii) allow the central bank time to improve its capacity for banking supervision and regulation.

In 1991, all interest rate ceilings were removed, but the minimum rale guidelines were retained for a period to ensure the maintenance of real positive interest rates (Table 5). In July 1993, in light of their continuing success in reducing inflation—which had fallen to single-digit levels in 1992–93—the authorities eliminated most of the minimum rale guidelines on deposit and lending rates. However, guidelines for minimum and maximum lending rates to the agricultural sector and a minimum rate on savings deposits were retained, while a maximum rate for loans was introduced.

Reform of the Banking System

Beginning in 1988, the Government implemented a series of measures to reform the banking system, with a view to making it more market oriented and improving the mobilization and allocation of resources. Several of these reforms were part of the SAF- and ESAF-supported adjustment programs.

Early Development of the Banking System

Prior to 1988, the financial sector had many of the characteristics of financial sectors in centrally planned economies. A single financial institution—the State Bank—conducted both central and commercial banking activities. The State Bank's principal operations were to accept deposits from state-owned enterprises and provide credit to them under the Central Government's economic plan; to act as the Government's treasury; and to manage the supply of currency.

Beginning in 1988, the financial sector underwent a major restructuring in the context of the NEM, as central bank activities were separated from the commercial banking activities of the Stale Bank. This separation began with the transformation of branches of the old State Bank into two autonomous commercial banks (Nakhoneluang Bank and Sethathirath Bank). In October 1989, the Joint Development Bank was established, constituting the first private sector participation in the banking industry, with 70 percent equity capital provided by Thai investors and 30 percent by the Lao central bank. In November 1989, the central bank's largest branch, the Banque pour le Commerce Extérieur Lao (BCEL), was granted autonomy, followed by the constitution of three more independent state-owned banks in 1990 (Pak Tai Bank, Lao May Bank, and Lane Xang Bank) from previous branches of the central bank.

The proper central banking activities of the State Bank were formally separated with the enactment of the Central Bank Law in June 1990, which established the Bank of the Lao P.D.R. as a centra) bank, established its role and functions, granted it the necessary powers, and assigned it primary responsibility to exercise control over monetary and financial developments. In September 1991, the two-tier banking system was further strengthened. First, the Aroun May Bank, the last remaining of the original four branches of the old State Bank, was turned into a commercial bank. Second, a centralized system of international reserve management was put in place by transferring assets from the BCEL—which had held most of the official international reserves—to the Bank of the Lao P.D.R.

The Bank of the Lao P.D.R. is now responsible for issuing currency; acting as the Government's banker and fiscal agent; acting as an agent for auctioning treasury bills; managing official international reserves; licensing and regulating financial institutions; and exercising prudential supervision of the financial sector.9 It has the autonomy to conduct monetary and credit policy; act as a lender of last resort by extending short-term credit to commercial banks; set guidelines for interest rates; and formulate exchange rate policy.

In the past few years, the Lao banking system experienced further growth and a concomitant increase in competition with the entry of foreign banks. The first branch of a foreign bank (Siam Commercial Bank) commenced operations in December 1992, followed by four new branches of foreign banks (Thai Military Bank, Thai Farmers Bank, Krungthai Bank, and Bangkok Bank) in 1993, and one (Ay-oudya Bank) in 1994. A joint venture (Vientiane Commercial Bank) was also established in 1993, with 25 percent of the capital provided by Lao private investors and 75 percent provided by foreign investors. Finally, a new, entirely state-owned bank (Agricultural Promotion Bank) opened in July 1993, undertaking the role of servicing the agricultural sector. As of the end of 1994, there were eight slate-owned commercial banks, two joint-venture banks, and six branches of Thai banks in the Lao P.D.R.

Emerging Role of the Commercial Banking System

The banking system has become more important in recent years because of a number of factors. First, the extension of banking services, together with the maintenance of substantially positive real interest rates, served to attract savings. Second, the entry of foreign banks and the actions to improve the management capabilities of commercial banks helped enhance confidence in the banking system. Confidence was further strengthened by the establishment in 1995 of nonbank foreign exchange bureaus and the resulting ability of residents to maintain bank accounts in foreign currencies.10

The financial sector traditionally was characterized by the absence of nonbank financial institutions—with the exception of the General Insurance Company, a subsidiary of a French company—and the lack of an established securities market. The latter deficiency was corrected in March 1994, when the primary market for treasury bills was instituted with the commencement of regular auctions of those instruments. Until recently, a large informal credit market, comprising mainly credit cooperatives, served to channel household savings to borrowers who did not qualify for loans from the formal banking system. The rapid growth of the commercial banking network has led to a shift of funds from credit cooperatives to banks; consequently, many cooperatives encountered serious financial difficulties and recently ceased to operate.

The range of banking services offered has expanded considerably in recent years. Since 1988, banks have begun to offer a range of deposit and credit instruments on a competitive basis and to provide basic services to their customers. Nonetheless, while the increased monetization in the Lao economy has fostered a rapidly expanding market for banking services, the banking system remains small in relation to the size of the economy.11

A prominent feature of the commercial banking system is its large degree of concentration. The three largest banks (the BCEL, the Nakhoneluang Bank, and the Sethathirath Bank) control about half of the system's assets and deposit liabilities. By and large, the BCEL maintains a dominant position, accounting for about 31 percent of the total assets and about 38 percent of the total deposit liabilities of the commercial banking system. The system is also characterized by a marked geographical concentration of banking services. State-owned banks operate on a regional basis, but, despite the gradual expansion of branches in rural areas, banking activities are concentrated in the Vientiane area. Each foreign bank is allowed to establish only one branch in the country and is restricted to operating in the Vientiane area.

Bank Recapitalization and Restructuring

The state-owned commercial banks have been burdened since their creation by a large number of bad loans to public enterprises and cooperatives that they inherited from the old State Bank. Nonperforming loans dominated their loan portfolios and seriously undermined their financial soundness. Thus, as a precursor to bank recapitalization, a survey of these banks' asset portfolios was initiated in 1990 to estimate the amount of bad loans and assess the amount of capital needed to bring the banks' capital base in line with the capital adequacy requirement of 8 percent of risk-adjusted assets specified by the Basle Committee on Banking Regulation and Supervisory Practices. This survey, completed in 1994, determined that approximately KN 18 billion (1.6 percent of GDP in 1994) would be needed to recapitalize the state-owned banks. With financial and technical support from the Asian Development Bank, the financial viability of state-owned banks was strengthened with the cash injection of KN 4 billion in March 1994 and the issuance of KN 14 billion in government bonds in late 1994, and the subsequent removal of bad loans from the banks' assets. Relieved of the burden of bad debts and having established an adequate capital base, banks can now make the transition to competitive commercial operations and improve their bank management skills.

The problem of bad loans, on the one hand, and the granting of autonomy to commercial banks, on the other, have highlighted the importance of developing a prudential system. Recently, the Bank of the Lao P.D.R. initialed a number of measures to improve its capacity to exercise prudential regulation and supervision over financial institutions, with technical assistance provided by multilateral organizations and bilateral donors.

Future Monetary and Banking Sector Reforms

Notwithstanding the good progress made in financial sector reform, a number of challenges remain. First, the authorities will endeavor to ensure that the problem of bad loans does not recur by implementing a variety of measures, including a strengthening of bank management. Second, the monetary authorities need to develop expertise in indirect monetary management and in promptly adapting monetary policy to changing circumstances. Third, the complete liberalization of interest rates is on their agenda. Other tasks will include steps to develop an interbank market and a secondary market for securities and to introduce one comprehensive accounting system for the central bank and another for the commercial banks.

The Bank of the Lao P.D.R. is no longer involved in direct lending to the private sector, except to on-lend funds from multilateral organizations to the commercial banks.

Effective mid-l995, the Bank of the Lao P.D.R. required that all foreign exchange bureaus be representatives of the commercial banks.

This is illustrated by the very low ratio of the stock of broad money to nominal GDP, which, as of the end of 1994, was estimated at 1:8.

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