September 12, 2003
1. The Government of the Lao People’s Democratic Republic (Lao PDR) continues to implement the reform program, aiming at raising economic growth, promoting broad-based development, and reducing poverty. The reform efforts have been supported by the International Monetary Fund’s (IMF) Poverty Reduction and Growth Facility (PRGF) and similar arrangements of the World Bank and the Asian Development Bank (AsDB). Performance under the PRGF-supported program in 2002/03 is generally satisfactory, and the government is ready to move ahead with the implementation of the economic and financial policies set forth under the third annual program through March 2004.
II. Recent Developments and Performance under the Program
2. Real GDP growth in 2002/03, like the previous year, has been quite robust, and is estimated to remain at 5.9 percent, attributed mainly to industrial production and agriculture. The IMF staff estimate is somewhat lower, 5.3 percent, to take into consideration the weaker external environment, the slowdown in tourism, lower investment and reduced credit growth.
3. Inflation rose rapidly from 7 percent (year-on-year) in early 2002, to 18 percent in May 2003, due to the lagged effect of the nominal exchange rate depreciation between May and September 2002. As the effect of the depreciation has run its course and a tight fiscal stance has been maintained since October 2002, inflation began to fall to 17 percent in June 2003, and continued to decline to less than 15 percent during July and August 2003.
4. The exchange rate has remained stable for about a year and the spread between the bank and parallel market rates has been kept below 2 percent due mainly to a tight fiscal policy on expenditures, firmer financial policy on bank credit controls and an increase in interest rates. In addition, an improved balance of payment position, evidenced by growth in gross international reserves to $207 million, or 3.7 months of imports by June 2003 helped stabilize the kip.
5. On the structural front, the reform of state commercial banks (SCBs) has begun. Since the AsDBs approval of the Banking Sector Reform Program Loan (BSRPL) in November 2002, four international banking advisors have been appointed and have commenced their assignment. As a consequence, significant change has been made in the lending behavior of SCBs as reflected by the improvement in loan recoveries and the reduction in credit growth in recent months. As for state-owned enterprise (SOE) reform, technical work on the restructuring strategies and programs has started for five large SOEs, including Electricite du Laos (EDL), the Phoudoi conglomerate, Pharmaceutical Factory No. 3, and Lao Airlines.
6. With regard to Performance under the Program, all but one of the end-September 2002 quantitative performance criteria was observed. The performance criterion for contracting and guaranteeing noncessional external public debt was exceeded because of $50 million loan for Nam Mang 3 hydropower project, which was made concessional in November 2002. Two end-March 2003 performance criteria, net domestic assets of the Bank of Lao PDR (BOL) and net credit to the government were not met by modest margins as budget revenue during the first half of 2002/03 remained weak. In response, a fiscal package was enacted at end-May 2003 to bring the fiscal program back on track. For June 2003 all benchmarks were met, with the exception of the ceiling on net bank credit to government, which was exceeded by a small amount, but is expected to be taken care of by the corrective fiscal measures implemented at end-May 2003.
III. Program for 2003/04
Fiscal policies 2002/031:
7. On the fiscal front, the package of revenue and expenditure measures introduced at end May 2003 will continue to be implemented and maintained, to attain the expected 95 percent of the budget in nominal terms, equivalent to 11½ percent of GDP. The revenue measures include mainly reapplying the tax rates on petroleum and the excise on petroleum as specified in the Tax Law. The expenditure control measures include the reduction and postponement of the wage increase (KN 30 billion) and reduced allocations for domestically financed capital expenditure by about KN 30 billion.
8. In addition, the problems of overhanging domestic arrears of KN 600 billion, which have weakened the banking system have been addressed. To date, one third of the KN 360 billion old arrears to contractors that have borrowed from the banks has been paid off through the issuance of government bonds. Furthermore, budget arrears from enterprise accounts at Treasury amounting to KN 130 billion have been cleared, through a combination of securities issues and the netting with tax liabilities. New arrears have also been limited through strict expenditure control.
Fiscal policies 2003/04:
9. As regards the fiscal stance in 2003/04, efforts will be made to reverse the sharp slide in the revenue to GDP ratio and to limit bank financing. The 2003/04 budget to be proposed at the end of September includes revenue at KN 2,900 billion (12.2 percent of GDP) excluding capital return. In view of attaining the set revenue target, a range of measures will be implemented. These include maintaining the statutory duty, excise and turnover tax rates on petroleum and the mobile phone excise tax; increasing the excise on luxury goods including alcohol and tobacco; and ensuring that the implementation regulations for Presidential Decree 01 on tax incentives to be issued will adequately safeguard budget revenue.
10. Capital expenditure will be significantly reduced mainly due to the cuts in new domestically financed expenditure to offset the rise in both domestic and foreign debt service resulting from debt clearance bonds and Russian debt. However, current expenditure will increase by 0.9 percent of GDP, due mainly to the wage increase of 30 percent for civil servants to offset the significant increases in utility prices, tariffs and recent petroleum tax increases, in order to restore the real wage level to that of the mid-1990s. This policy is purely motivated by increasing living costs and will be a one-off adjustment. My authorities do not intend to repeat this policy as they are mindful of the fiscal implications and as it could cause inflationary pressures.
11. My authorities are aware of the staff s concerns on the decree on tax incentives for investment and the revenue losses this could incur, however, they are undertaking these measures to emphasize and promote the private sector. Whilst my authorities realize the need to protect the tax base, they also realize the need to develop the private sector for the long-term growth of the economy, as well as to reduce poverty; incentives are a necessary enticement for private sector development. As highlighted in the staff paper, “the PRSP-based process of the NPEP is building a consensus that, while many obstacles remain, poverty reduction can only be achieved through market-based growth from the private sector”. The authorities are fully aware of, and will not allow this new initiative to undermine, the fiscal position, and are willing to work with staff to formulate implementing regulations to safeguard budget revenues, which they are confident can be done together with the Decree, and are even willing to revise the Decree if deemed necessary.
12. With regard to reversal of the turnover tax reduction enacted in 2002/03, as proposed by staff, my authorities are of the view that it would be inappropriate to include such a measure in this budget, as such a quick about-turn, so soon after its implementation, would damage their credibility and only involves a modest direct revenue loss. However my authorities have agreed to review this in the next budget. Also, the introduction of the VAT has been put back to 2006, in order to have sufficient time to be adequately prepared for such a venture.
13. In view of addressing the deficiencies in public expenditure management, the government is implementing the reform plan which focuses on commitment controls, treasury operations, fiscal reporting, budget planning and execution and auditing. The reforms undertaken will both tighten expenditure controls and improve information systems through the development of a national treasury, the rationalization of government bank accounts, and the introduction of a classification of expenditure by administrative unit at the central government level. Efforts will also be intensified to clear budget arrears identified in the recent survey of arrears and the bank restructuring process, through issuing of debt clearance bonds to settle budget obligation to contractors for capital projects with NPLs at the SCBs mainly incurred before 2001.
Monetary and exchange rate policies:
14. In order to reduce inflation, the monetary stance of the BOL will continue to remain firm. With an expected increase in foreign financing, net credit to the government by the BOL is expected to decline slightly. This will allow gross international reserves to further increase to $228 million (3.8 months of imports) by September 2004. As a result, the growth in reserve money is expected to be limited to 15 percent in 2003/04.
15. The SCBs credit will continue to be restrained and limited to 16 percent in the year to September 2004, compared with 18 percent growth for total commercial bank credit. The SCBs credit extension will be based on a careful risk assessment under new appraisal procedures, especially for foreign exchange credits. Under this cautious stance, broad money is expected to grow by 19 percent in the year September 2004.
16. To avoid pressure on the exchange rate, BOL will phase the redemption of securities or issue new securities to reduce excess liquidity as warranted. In this connection, the government will continue to maintain a flexible exchange rate regime and keep the spread between the bank and parallel market rates under 2 percent. The implementation regulations for the Foreign Exchange Decree Law are in the drafting process, and are expected to be issued by June 2004.
IV. Key Structural Reforms
Banking sector reform:
17. The government will continue to implement the banking sector reform program supported by the AsDB, the World Bank, the European Union and the IMF. With the four international bank advisors in the field, operational improvements in the SCBs are expected to be realized over the 3-4 year period through monitoring performance targets. As the SCBs strengthen under the reform process, the government will seek a strategic investor for one of the two reformed SCBs by 2005.
18. At the same time, The BOLs supervisory and regulatory role over the banking and financial institutions will be upgraded through the development of on-site inspections and off-site supervision. Existing prudential regulations of BOL need to be strengthened and revised, in particular Regulation 98 pertaining to the reporting and monitoring of open foreign exchange positions of banks. In this connection, the requirement will be made for matured letters of credit to be recorded as credit and provisioned accordingly. In addition, the BOL undertakes to submit the amendments to the Decree Law on Commercial Banks to the Standing Committee of the National Assembly by January 2004. The said amendments will provide for enhanced competition in the banking system by equalizing minimum capital requirements for banks with domestic and foreign shareholders, and allowing foreign bank branches to operate on a nationwide basis.
19. The process of restructuring the five large SOEs is at the stage of preparing restructuring plans. The government, in collaboration with international experts working under the World Bank’s Capacity Building Credit, will review the plans and assist in the development and implementation of enterprise-specific restructuring plans. Furthermore, in view of reaching cost recovery levels set within the time frames under the World Bank’s Financial Management Adjustment Credit (FMAC), the price of key utilities will continue to be adjusted. This includes Lao Airlines, which is expected to be able to cover the costs of its recent three-year lease of an Airbus.
20. The government has recently reached agreement in principle on the external debt to Russia. As a result of rescheduling on the basis of a 70 percent upfront discount, the resulting stock of debt of $387 million will be paid over 33 years. Specific repayment terms are expected to be agreed upon by the end of this year.
21. The government will refrain from contracting and guaranteeing noncessional public external debt. To avoid future deficiencies, remedial measures have been implemented to strengthen the monitoring and reporting of all public sector external debt. This includes (i) the revision of the Ministry of Finance Instruction 912 to include both external debt contracted by SOEs with government guarantee and external debt without government guarantee; and (ii) the provision of a comprehensive report of all public sector external debt, including on all SOEs external debt.
22. The Round Table Meeting (RTM) on the National Poverty Eradication Program (NPEP) has recently been held in Vientiane. The final NPEP document, which will incorporate comments made during the RTM, is expected to be completed by October 2003, for submission to the Boards of the IMF and the World Bank for consideration and acceptance of NPEP to serve as a basis for the Poverty Reduction Strategy Paper.
23. The Government intends to take part in the IMFs General Data Dissemination System (GDDS). To this end, a GDDS coordinator will soon be nominated and the process of finalizing the metadata will be pursued. In the meantime, the recommendations and action plan prepared by the multi-sector statistics mission are being reviewed and verified.
24. The audit of BOLs 2001 accounts was completed at end-August, on schedule, with the assistance of an international audit firm, and the financial statements were reformulated to be more aligned with international accounting standards and published. The BOL has also agreed to implement all the high priority recommendations of the on-site assessment, particularly to maintain close and interactive cooperation with an international audit firm to help the State Audit Authority (SAA) conduct the audit of the BOLs 2002 accounts at international standard of auditing (ISA). Furthermore, BOL has also agreed that the audit of the 2003 accounts be conducted jointly with an international audit company.
25. The government intends to authorize publication of the Staff Report, EBS/03/127; Progress Report on the NPEP; and the Joint-Staff Assessment of the progress report on the NPEP.
26. As stated in the letter of intent, the government of the LAO PDR believes that policies and measures set forth in the attached Memorandum of Economic and Financial Policies (MEFP) are adequate to achieve the objectives of the reform program supported by the PRGF arrangement, and therefore remains committed to implementing them in order to achieve the set objectives thereof. In conclusion, my authorities reiterate their profound gratitude and appreciation to the Board, Management and staff of the IMF for the continued support granted to the Lao PDR in relation to the country’s poverty reduction and growth process.