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Asian Development Outlook 2001 : II. Economic Trends and Prospects in Developing Asia : Southeast Asia

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Lao People’s Democratic Republic

Sharp reductions in the rates of inflation and monetary expansion accompanied moderate economic growth in 2000. The outlook is for this improvement to continue, provided that the Government sustains its commitment to macroeconomic stability and refocuses on structural reform, particularly in the banking system.

Recent Trends and Prospects

Supported by improvements in macroeconomic management, real GDP rose by an estimated 5.5 percent in 2000. This was accompanied by an increase in trade as both imports and exports expanded rapidly. As macroeconomic conditions improved, larger foreign direct investment and official loan disbursements enhanced capital inflows, improving gross official reserves to cover about 2.4 months of imports in 2000 from 2.1 months in 1999.

Agriculture, accounting for over 50 percent of GDP, continued to show a solid expansion because of extensive public irrigation investments made during 1997–1999. In services, accounting for about 26 percent of GDP, the robust trend of growth in real value added, which averaged over 6 percent in 1996–1999, persisted as tourism earnings continued to strengthen. The industry sector averaged about 8 percent growth over 1997–2000, continuing to lag average performance of 13 percent growth during 1993–1996 for two main reasons. First, Thailand’s 1997 financial crisis delayed the start of several hydropower investment projects in the Lao People’s Democratic Republic (Lao PDR) intended to produce electricity for export to Thailand. This reduced large-scale construction activity, although anecdotal evidence suggests that greater small-scale construction activity occurred in 2000 than in 1998 and 1999. Second, the EU withdrew preferential access for Lao PDR garment exports in late 1995 and reinstated it in late 1997. The garment sector is only now gradually recovering.

Macroeconomic management improved markedly in 2000. Revenues (excluding grants) grew strongly from 10.6 percent of GDP in fiscal year 1999 (1 October 1998–30 September 1999) to 12.7 percent in fiscal year 2000. However, a steep fall in grants contributed to the increase in the fiscal deficit relative to GDP. The growth rate of the money supply fell from 72.4 percent in 1999 to 45.7 percent in 2000. This was the primary factor both in reducing the rate of inflation from 128.4 percent in 1999 to 23.2 percent in 2000, and in slowing the annual average rate of depreciation of the kip against the dollar from 53.6 percent to less than 13.5 percent over the same period.

The outlook for 2001 and 2002 is for some improvement in economic growth despite the adverse impact of flooding on agriculture in late 2000. Industrial growth should accelerate as garment exports to the EU continue expanding, and gold and copper mining operations commence in Savannakhet Province. If the large Nam Theun II hydropower project proceeds as planned, investment, construction activity, and the current account deficit will increase significantly, beginning in 2002. As economic growth gradually accelerates, inflation is likely to fall, along with the rate of growth of the money supply. The fiscal improvement is likely to be sustained as the Government continues to enhance revenues, while containing expenditures in conjunction with a possible new International Monetary Fund program currently under negotiation.

Policy and Development Issues

Since mid-1999, the Government has taken decisive steps to reduce its fiscal deficit and contain monetary expansion so as to restore macroeconomic stability after the volatility of 1998 and 1999 when fiscal deficits and monetary expansion led to soaring inflation and rapid exchange rate depreciation. However, to ensure continued macroeconomic stability and to accelerate economic development, the Government needs to undertake the structural reforms necessary to restore investor confidence and strengthen the economy’s ability to withstand external shocks. Perhaps the most pressing problem is the weakness of the banking system, which was aggravated by the extremely high inflation rates of 1998 and 1999.

A decade earlier, in 1988, as part of its moves toward a market-based economic system, the Government established a two-tier banking system. By 1991, seven state-owned commercial banks (SOCBs) managed by the Bank of the Lao PDR (BOL), which also acted as the monetary authority, dominated banking. Because of weak supervision and regulation, about 35 percent of SOCB loans were nonperforming loans (NPLs) in 1994, and the Government recapitalized the banks. Despite several new laws designed to improve supervision and regulation, audits of SOCB accounts in 1996 and 1997 revealed still-high levels of NPLs. Then, in the midst of the Asian financial crisis, with fiscal revenues and foreign financing falling, the Government turned to the banks to finance its rising fiscal deficit, delaying reform and accelerating the deterioration of SOCB balance sheets.

The Government prepared a Financial Sector Note with the Asian Development Bank and the World Bank in 2000, as part of its moves to strengthen the banking system. The SOCBs dominate the banking system with 80 percent of total bank deposits, of which about 85 percent are in foreign currencies (reflecting the lack of confidence in the kip). Deposits account for about 60 percent of bank resources, with debt to BOL constituting as much as 10 percent of bank liabilities and invested capital for only about 15 percent. Loans account for about 30 percent of bank assets; about 75 percent are in foreign currencies and about 50 percent are to the public sector. With an NPL ratio perhaps as high as 60 percent, adequate provisioning and subsequent recapitalization of SOCBs to achieve an adequate capital adequacy ratio would cost about $50 million, or 4 percent of GDP.

However, as the 1994 recapitalization demonstrated, it would be advisable for the Government to ensure that appropriate banking regulatory measures and institutions are in place prior to investing such a substantial amount. The high level of NPLs is partly the result of insufficient human resources at BOL and the SOCBs, preventing these institutions from setting up the necessary systems to assess general lending conditions, evaluate risks, and establish guidelines for lending practices. Many NPLs, for example, originated because borrowers with no foreign exchange earning potential were permitted to take out loans in foreign currency. When the kip depreciated rapidly, many of them defaulted.

Another problem is the Government’s frequent recourse to the banking system to finance public sector activities. Thus, even if the banks had the capacity to adopt prudential practices, they would find it difficult to do so. BOL’’s mandate does not focus only on the maintenance of a healthy financial sector, but also requires it to ensure financing for the Government’s development priorities. When inflation began to accelerate in 1998, the Government capped the interest rate on treasury bills at 20 percent to limit interest expense. The negative real interest rate made the treasury bills unmarketable and the Government began to rely more heavily on bank credit to finance budget deficits as well as off-budget spending priorities. However, in 2000, it ceased borrowing from BOL.

The banks have also been frequently called on to give credit to state-owned enterprises (SOEs), even to those defaulting on existing loans (though recent government policy statements suggest that this practice is ending). Despite progress in the early 1990s in privatizing SOEs, several key enterprises remain under government control. Some of these SOEs account for many of the NPLs at SOCBs. Commercializing SOE operations can reduce their reliance on easy credit from SOCBs.

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