1. Our Lao authorities wish to express their appreciation to Mr. Ahuja and his team for the constructive discussions and comprehensive assessment, as well as valuable recommendations made during the recent Article IV consultation. This year’s consultation focused on the challenges of sustaining economic growth, while safeguarding macroeconomic and financial stability in the face of inflation and balance of payment pressures. The authorities broadly agree with the staff appraisal and will thoughtfully consider the policy recommendations therein.
2. Fifteen years after first sought membership, Lao PDR became the 158th member of the World Trade Organization (WTO) on February 2, 2013. Accession to the WTO will provide Lao PDR with more market opportunities by diversifying list of trading partners, help realize higher gains from trade, and enhance investor confidence. As Lao PDR enters the third year of the seventh five-year National Social and Economic Development Plan (7th NSEDP, 2011-2015), the midterm review have found that the plan has been successful in improving the people’s livelihood. Substantial progress towards the Millennium Development Goals (MDGs) has been achieved especially on poverty headcount that dropped further to 20 percent in 2012. The government remains committed to press ahead with necessary policy actions to overcome remaining obstacles to achieve the 2015 MDGs target and graduate from least developed country status by 2020 (Vision 2020).
Recent Economic Development and Outlook
3. Despite the weaker global growth and external uncertainties, the Lao economy continued to grow in line with the medium-term target of 8 percent in 2012, significantly driven by thriving investment projects in hydropower, infrastructure, and real estate construction as well as domestic consumption. Mining production has increased significantly from the operation of new gold and silver mines and the expansion of existing minerals projects. With the continued strong growth of FDI, the authorities expect to maintain the same pace of expansion in 2013, fueled by hydropower and labor-intensive sectors, including construction, manufacturing, agriculture and services.
4. Although fiscal revenue collection exceeded the target in 2012, fiscal deficit has deteriorated in fiscal year 2012/2013 due to the increase in wages and monthly allowance for civil servants and lower-than-targeted revenue collection. Nevertheless, the authorities are committed to rein in fiscal deficit at 5 percent of GDP by stepping up efforts in tax administration and collection along with expenditure measures. The authorities are more optimistic on the prospect of higher tax revenue for fiscal year 2013/2014 from new foreign investment projects and other income measures including the unification of corporate income tax rates, the introduction of a lump-sum tax for SMEs, taxes on property transfer, as well as increases in petrol and vehicle excise duties.
5. The average inflation in 2012 was moderate at 4.26 percent, but has escalated to 6.22 percent over the period of first nine months of 2013 due to prices of food and nonalcoholic beverages category, particularly meats and rice, going up by 12.3 percent caused by the shortage of livestock and the effects of flooding on agriculture. In addition, price index of restaurant-hotel category, as well as housing, water supply, electricity and fuel category also increased by 8.6 percent and 7.7 percent, respectively. Nonetheless, the authorities expect that more stable prices of fresh food and fuel in the last quarter will bring inflation to an annual average of 6.34 percent.
6. The kip’s nominal exchange rate appreciated 0.26 percent in 2012 and 0.62 percent in 09/2013 (y.o.y) against the US dollar. The authorities view that the kip appreciation is broadly in line with the movement of regional currencies and remains flexible within the target band. As noted in the staff report, they have carefully monitored and observed the phenomenon in the parallel exchange market, which has been trading at a premium over the Bank of the Lao PDR (BOL)’s reference rate since August 2013. Such irregularities were attributable to (i) temporary FX liquidity shortage of some commercial banks to fulfill customers’ request; and (ii) market’s misperception that the BOL might adjust its policy on foreign exchange transactions administration, which currently allows daily FX transaction up to kip 20 million per person. As a result, the gap between official and parallel markets was widened from less than 0.04 percent pre-August to a peak of 3.4 percent in early September. However, after the BOL continuously communicated their exchange rate policy stance to public and consistently adhered to the announced policy, the gap has narrowed down to 0.7 percent in late October. The international reserves level has declined, but gradually risen recently and is expected to increase to a more comfortable level by the end of 2013.
7. Growth of credit to the economy is expected to decelerate further to about 20.7 percent in 2013 from 26.6 percent last year. Notwithstanding a decelerating pace of credit growth and low NPL ratio, the authorities constantly strengthen its prudential regulations and banking supervision to ensure that financial system is safe and sound.
8. The authorities reiterate their steadfast commitment to pursue structural reform and attract quality foreign investments to drive sustainable development and more diversified economy. In conjunction with this effort, the government has temporarily suspended new land concessions for gold and copper mining projects until 2015 to conduct review and evaluation of the existing projects. Such assessment will ensure compliance with regulations and maximize its benefit to meet socio-economic development objectives.
9. The authorities share staff’s views that several emerging challenges could pose downside risks to the economic outlook, and thus attach high priority to strengthening macroeconomic and financial stability. They generally agree that policy tightening may be warranted to address potential pressures on the external position and ensure inflation remains contained. To this end, the authorities will stay vigilant on any possible external shocks and stand ready to respond as appropriate.
10. The authorities recognize the importance of fiscal prudence and concur that fiscal consolidation is crucial for preserving macroeconomic stability and public debt sustainability. They are aware that steps to rebuild fiscal buffers are needed to ensure fiscal sustainability as well as cushion adverse shocks and unavoidable events in the period ahead. However, the path of consolidation proves challenging due to the committed increase in civil service wages and unexpected revenue underperformance from sharply declined commodity export prices.
11. Against this backdrop, the authorities have promptly implemented measures to enhance tax collection and curb other non-critical public spending to compensate for larger wage bill envelope. On revenue front, the authorities are mapping out effective strategies to intensify its revenue collection and widen tax base. Tax administration has been strengthened by strictly enforcing compliance with investment promotion law regarding tax and duty exemption and VAT deductibles, as well as effectively implementing the revised tax law.
12. With regard to the expenditure, the government has temporarily halted the monthly living allowance payment to civil servants, which will help to reduce expenditure more than 2 percent of GDP. The authorities will carefully reconsider the policy on future civil servant salary compensation taking into account staff’s recommendation of a more measured pace. In addition, the authorities have cut low-priority current expenditures and suspended state infrastructure development projects that are commissioned by local governments, financed by private contractor and repaid by the government upon completion of the projects. They will further carefully review procurement process and strengthen project management regulations according to the State Investment Law before lifting such suspension.
13. Over the medium-term, the authorities recognize that challenges remain in securing a more sustainable revenue stream especially from non-resource sector and enhancing the capacity on public financial management. Among others, they are in the process of imposing new valuation method for automobile and fuel imports, which would contribute to higher customs duty and tax collection. A new 5 percent tax on value of real estate transactions has also taken effect in 2013. The full implementation of the revised tax law which has been approved in 2011 will contribute to higher income tax from new foreign investment projects.
14. Despite higher pressures on fiscal accounts, the authorities are committed to keep public debt on a sustainable path and target to reduce level of external debt to be less vulnerable to external shocks. The bath bond issuance in Thailand, which is a pilot project to access the external financial market under the ASEAN+3’s Asian Bond Markets Initiative (ABMI), has been a resounding success as proved by almost three times oversubscription. The Debt Management and Financial Analysis System (DMFAS) has been rolled out which will significantly improve public debt data recording and strengthen debt management capacity.
Monetary and Exchange Rate Policies
15. On the back of heightened inflationary pressures, monetary policy has been geared towards preserving macroeconomic stability. The authorities take note of staff’s recommendation that monetary policy should be tightened by lowering M2 growth to the level consistent with a sustainable nominal GDP growth in order to anchor inflation.
16. The BOL has tightened monetary policy by continuously issuing central bank bills, hiking repurchase interest rates - from 3.5 percent to 6.55 percent for kip and from 2.65 percent to 3.93 percent for FX, strictly enforcing FX net open position regulation, as well as rationally providing FX liquidity support to commercial banks. Under current circumstances, the BOL deems raising banks’ reserve requirement ratios as a last resort. The BOL’s bills are regularly used to absorb liquidity and mobilize funds from excess liquidity in banking system and can be additionally issued as necessary.
17. The BOL remains committed to keep exchange rate flexible and in line with financial and economic conditions. In light of recent irregular movements in FX market, rules and regulations on foreign currency related operations are enforced more actively. Commercial banks must pay up the registered capital in foreign currency according to capital adequacy regulation, and may extend credit in foreign currency only for the activities that can generate revenues in foreign currency. These efforts specifically aim at containing risks of currency mismatches in bank balance sheets. On this note, the BOL is preparing to request for a technical assistance in the development of the interbank market.
18. The authorities welcome staff’s assessment that the current exchange rate policy is a generally appropriate anchor, which has contributed to increased confidence in the kip. The authorities are committed to maintain a stabilized exchange rate scheme while pursuing de-dollarization objective and promoting greater use of the kip. In addition, the authorities are taking steps to enhance the mechanism for regulating foreign exchange transactions to be able to monitor daily trading activities in a more real-time basis.
19. Realizing the importance of safeguards against external uncertainties, the BOL has stepped up their efforts to augment international reserve. Measures that have been implemented include an abortion of foreign currency lending to local governments and state-owned enterprises since last year, collecting outstanding loans, and intensifying enforcement of foreign currency related regulations. In spite of the widening current account deficit, the authorities are more optimistic that current international reserve level remains adequate at 2.9 months of officially reported imports data in June 2013. More importantly, the level of foreign reserves has gradually increased recently and is expected to reach a more comfortable level at the end of the year. The authorities are of the view that 2013 import figures would slow down from 2012, which witnessed high import volume related to the ASEM meeting preparation. They also urge staff to be cautious in using trading partners’ export data as proxy for Laos’ import, as a significant part of the unrecorded import content is re-exported to other countries. That said, the authorities are in agreement that there could be scope for exploring the discrepancy in the measurement of imports and enhancing the authorities’ data collection system.
20. The BOL considers sound and robust financial system crucial for efficient allocation of financial resources for long-term economic development. The overall banking sector remains sound with strong capital adequacy, ample liquidity, and low NPL. The authorities view credit growth as a positive move toward financial deepening, which is a driver of economic growth and poverty alleviation. Nonetheless, the BOL is aware of potential risks from extended period of rapid credit growth, thus has tightened prudential regulation for banks to closely monitor credit quality and supervisory interventions to ensure good quality underwriting standard, especially for banks with NPL ratio of more than 3%. Regulations to control single lending limit to mitigate concentration risk and prohibit connected lending to shareholders, directors and subsidiaries have recently been issued.
21. More importantly, plans are underway to adopt Basel II capital standard with technical support from the WB and the Bank of Thailand. In tandem, supervisory capacity and regulatory framework are being strengthened to preserve a safe and sound banking system. These efforts along with ongoing enhancement of the regulatory framework under the ASEAN Banking Integration Framework will help to improve banking capacity and enhance financial stability.
22. To address the deficiency of AML/CFT regime, the authorities have drafted AML/CFT Law, and are in the process of several consultations and reviews by the Ministry of Justice. The World Bank will subsequently help review the draft law to ensure its compliance with international standards and, tentatively, the BOL will propose draft AML/CFT Law to the National Assembly by 2014.
23. Lao PDR has become the 158th member of WTO in February 2013 and Lao PDR has granted foreign access to domestic in several sectors. Significant progress was achieved on structural reforms where more than 90 laws and regulations were enacted, including those related to import licensing, custom valuation, investment, sanitary and phytosanitary measure, technical barriers to trade, as well as intellectual property right in order to better align with international norms. The authorities also continue their efforts in simplifying business start-up procedures, notably with the establishment of a one-stop shop to coordinate the application for foreign investment in the country through various levels and spheres of approval. Electronic data interchange system has been modernized to better facilitate cross-border trades. Additionally, Lao trade portal (www.laotradeportal.gov.la) has been introduced to facilitate trade and enhance transparency. The authorities believe that these initiatives will create a favorable business climate conducive to more broad-based and inclusive growth.
24. The authorities realize the importance of high-quality and comprehensive set of macroeconomic and financial sector statistics for conducting economic surveillance and formulating appropriate and timely policy responses. In view of the need for producing and disseminating these statistics in line with the international guidelines, efforts are made toward improving official statistics and the reporting system. The authorities welcome the Fund’s technical assistance to enhance statistical capacity.
25. The government envisages the Lao PDR to achieve LDC graduation by 2020. With such ambitious undertaking, the authorities reaffirmed their commitment to carry out the 7th national socio-economic plan in a manner that would sustain the investment and growth momentum, while simultaneously preserving macroeconomic and financial stability. They are aware of many challenges ahead and intend to gear the efforts towards enhancing business environment, improving efficiency of public services, reforming public financial management, building up necessary fiscal and monetary policy space as well as strengthening banking regulation. Our authorities welcome productive policy dialogue with the mission team and wish to express their appreciation to the continued support of the Fund, especially in the area of technical assistance.