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Country Economic Review: Lao People’s Democratic Republic

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Executive Summary

The gross domestic product (GDP) has continued to grow after a slowdown in 1998. The real GDP growth rate was 7.3 percent in 1999 and 5.9 percent in 2000. Growth in the agriculture sector has been healthy at 8.2 percent in 1999 and 5.1 percent in 2000, and growth is balanced among the sectors. Agriculture led the recovery in 1999, and industry and energy production (largely for export) were major contributors to growth in 1999 and especially in 2000.

During the regional financial crisis, Government spending was overly expansionary and too heavily focused on capital spending. Capital spending increased from around 50 percent of total Government expenditures to around 75 percent, as inflation eroded the value of recurrent expenditure, particularly government salaries. The Government is taking steps to restore the balance between capital and recurrent spending; capital spending now accounts for about 65 percent of total Government expenditures. The Government is implementing an ambitious decentralization that will give local governments (provinces and districts) more authority in spending and collecting revenues.

Development agencies make a major contribution to the Government’s revenues in the form of concessionary loans and grants. The Government is increasing both tax and nontax revenues in response to the significant decrease during the regional financial crisis. The Government is planning to introduce a value-added tax in 2003 as part of comprehensive tax reform. Currently taxes fall mostly on imports and the tax system is not very transparent or efficient.

After several years of moderately high inflation (in the 10 to 20 percent range), prices increased sharply in 1998 and 1999. Inflation was estimated to be 87 percent in 1998 and 134 percent in 1999. This increase in prices has several causes. First, the devaluation of the Thai baht put downward pressure on the Lao kip. The Bank of Lao (BOL) made no attempt to sterilize aid assistance, which led an increase in the domestic money supply. In addition, BOL started monetarizing the budget deficit, in particular Government investments in irrigation. This effectively led to a real decline in recurrent expenditures and salaries. In 2000, inflation moderated to 27 percent and will likely be below 10 percent in 2001. BOL has committed to not financing the Government deficit in the future. The International Monetary Fund recently approved a poverty reduction and growth facility for the country; this is a testament to the country’s efforts at economic reform.

The sharp increase in inflation led to a corresponding rapid devaluation of the kip against the US dollar and the Thai baht. Stability has since returned to the exchange rate, and the kip has appreciated from the lows reached against the dollar in August 1999. As a result of the instability, dollarization (the holding of foreign currency for domestic transactions) has increased. Both the dollar and the baht circulate widely, and dominate in commercial transactions and bank deposits.

Exports have grown steadily since 1998 and the balance of payments, although in deficit, is improving. Key exports include timber and forestry products, electricity, and textiles. The amount of unregistered exports of timber and rice is significant. External financing has been the major source of funding for the balance of payment deficit, although foreign direct investment (especially in the hydroelectric sector) has played an important role as well. This trend is expected to continue as new hydroelectric investments enter the country. Tourism is also playing an important role in the balance of payments. In 2000, more than 720,000 tourists entered the country compared with 375,000 in 1996. Foreign reserves have increased to an estimated $140 million in 2000, enough to provide 2.4 months of import coverage.

The financial sector is in need of reform. The proportion of nonperforming loans is quite high. Interest rates are capped and do not respond to market conditions. This severely limits the financial sector’s ability to serve as a financial intermediary and provide investment funds for development.

External conditions permitting, the country should be able to grow by 6 to 7 percent in the next two years. Although this will have a positive effect on poverty, this effect is likely to be dampened by an increase in income inequality. Growth is expected to be balanced among the principal sectors.

The Government is committed to increasing

1. targeting of public expenditures to the poor and
2. social spending

Further investment in infrastructure should also increase the access of the poor to markets. Revenue, as a percentage of GDP, is expected to increase as the Government strengthens the tax system. Saving rates are expected to increase as faith is restored in the domestic economy and the financial sector is strengthened. Foreign domestic investment will also enter the country to support the hydroelectric sector.

Inflation is expected to be moderate as the Government seeks to increase its revenue from taxes and other fiscal sources. BOL has committed to not finance future budget deficits by printing money. The high level of dollarization and the weak financial sector limit the options available to BOL in terms of monetary policy. Government expenditures are expected to increase as the balance between recurrent and capital spending is restored; tax revenues are also expected to increase.

A large part of the country’s population lives outside of the market economy and, as a result, the positive effects of growth were largely felt in urban areas and in lowlands. Poverty decreased from 45 percent in 1992/93 to 39 percent in 1997/98; income inequality increased.

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