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Country Economic Review: Lao People’s Democratic Republic : I. Recent Economic Developments
C. Monetary Development and Prices1. Monetary Developments31. From a peak of 113.3 percent growth in 1997, broad money growth dropped to 78.3 percent in 1999 and to 45.8 percent in 2000 (Table 8). Traced from the liabilities side, the slowdown in broad money growth during the previous years was due to the deceleration in growth of foreign currency deposits. Year-on-year growth of foreign currency deposits decreased from 131.6 percent in 1997 to 111.3 percent in 1999, and down to 39.6 percent in 2000; cash and deposits reflected mixed trends during the same period. These trends reflect the relatively high dollarization rate6 of the Lao PDR, reflecting in part the effects of various measures undertaken to liberalize the economy in the late 1980s. By 2000, the amount of foreign currency deposits accounted for more than three fourths of the total stock of broad money.  32. The ratio of broad money to GDP (a measure of the country’s financial deepening) dropped to 16.7 percent in 2000 from 18.5 percent in 1997. Excluding foreign currency deposits, broad money as a percentage of GDP dropped to 4 percent in 2000 from 8 percent in 1999. When compared with Viet Nam (40.3 percent), this ratio appears to be extremely low, suggesting weak mobilization of domestic funds in the Lao PDR. 33. Traced from the asset side, the growth in broad money was mainly driven by the rise in credit extended by the monetary system to the public and private sectors. However, since 1998, growth of domestic credit has been slowing. Year-on-year growth of domestic credit dropped from 94.5 percent in 1998 to 48.3 percent in 1999, and down to 37.8 percent in 2000. BOL stopped financing the Government’s deficit. This measure was complemented by the increased use of BOL bills and treasury bills (T-bills) to siphon off excess liquidity in the system. 34. In 2000, domestic credit rose by 37.8 percent, following the increase in credit to the public sector (at 54.4 percent) and private sector (at 43.7 percent). In particular, commercial banks’ total credit grew by 44 percent in 2000 from 1999, about 63 percent of which was in foreign currency. In terms of relative share to total credit of commercial banks, the private sector continued to be the primary borrower, availing KN1.1 trillion or 78 percent of total credit. Meanwhile, broad money growth was accompanied by the improvement in the monetary system’s net foreign assets, one of the components of net domestic assets, as increased foreign capital inflows strengthened the monetary system’s foreign exchange reserves. 35. The domestic use of foreign currency, known as “dollarization” (regardless of the currency used) is an important issue in the Lao PDR. Currently foreign currency deposits account for between 70 and 80 percent of total deposits. Estimates suggest that as much as 80 percent of value of cash circulated is held in foreign currency, predominantly the Thai baht, but also the US dollar and the Vietnamese dong. in addition to serving as a means of exchange, foreign currency is an important store of value and increasingly as a unit of accounting. In addition, many Lao citizens store their wealth in “hard” assets such as cattle and gold. 2. Interest Rates36. Historically interest rates have been set administratively and been inflexible, which has serious consequences in a traditionally inflationary economy such as the Lao PDR’s. From 1996 to 2000, inflation ranged from a low of 13 percent to a high of 134 percent, yet interest rates for saving accounts have been fixed in the range of 6 to 22 percent and were in fact lower in 2000 than in 1996, despite the fact that the inflation was twice as high in 2000. 37. In addition to bank saving accounts, the Government sells T-bills. Starting in March 1994, T-bills were auctioned twice a month and secondary trading was allowed (although it was quite rare). In October 1997, the Treasury set a ceiling rate of 20 percent of T-bills and not surprisingly, the auctions were suspended in April 1998 as inflation far exceeded the ceiling rate and demand dried up. In 1999, the Treasury issued T-bills with a fixed rate of 30 percent. 3. Prices38. The Lao PDR has had several bouts with inflation in the past decade. In 1989, inflation rose to 59.7 percent only to drop to 13.4 percent in 1991. From 1991 until 1997, inflation as measured by the consumer price index (CPI) was below 20 percent. Although the level of inflation was high compared with rates reported in other Southeast Asian countries and probably has some harmful effect on economic growth, inflation was not a serious problem in the Lao PDR until 1998 (Table 9). 39. Inflation rates, as measured by the CPI, increased dramatically in 1998 and 1999. In 1998, inflation increased to 87.4 percent, a more than four-fold increase from the previous year. In 1999, inflation peaked at a record 134.0 percent. In 2000, the inflation rate dropped significantly to 27.0 percent. For the first quarter of 2001, inflation has significantly moderated to 9.2 percent (on an annualized basis). Lao authorities expect the annual inflation rate to remain below 10 percent.  40. Given the high level of dollarization, the price level is very sensitive to the money supply. The devaluation of the Thai baht in 1997 led to almost automatic devaluation of the Lao kip, which increased the value of dollars circulating in the economy and the value of dollars received by the country as concessionary loans and grants. Instead of taking action to reduce the inflationary effect of the devaluation, BOL started monetarizing capital spending by the Government. This spending was primarily for investment in lowland irrigation schemes. The extensive use of foreign currency, the already built-in inflation expectations, and the lack of depth of the financial system guaranteed that the increase in the monetary stock was rapidly transmitted into an increase in prices and a depreciation of the exchange rate. These two facts led to a vicious circle of ever-increasing inflation leading to devaluation of the kip to further increase the monetary supply from the inflow of foreign capital. 41. BOL probably only has a limited ability to fight inflation given the small size of the financial sector and the lack of bonds that are held by the public. Adjusting the reserve requirement in commercial banks is one option open to BOL, and there is some room for open market operations. While reducing inflation can be painful, it is clear from the Lao PDR’s experience that having high levels of inflation can be extremely costly as well in terms of a loss of faith in the domestic currency and economy. 42. Inflation is essentially a tax on the population that holds currency. As such, it can have serious distributional consequences. The burden of inflation usually fall most heavily on the poor, as wealthier households are able to protect themselves through financial instruments and foreign exchange. Due to the lack of household surveys, little quantitative evidence is available on the winners and losers of the recent bout of inflation. However, qualitative studies have been completed on the effect of inflation. In the case of Lao PDR, the biggest losers were formal sector workers with fixed salaries. This group largely consisted of government workers, including civil servants, teachers, and health workers. Essentially, inflation led to a direct cut of the salary of public sector workers. Private sector workers were largely compensated by increases in salary. Lowland agricultural producers largely subsist in the baht-based economy. Highland farmers, who are overwhelming poor are generally not well-integrated into the market economy, and hence were probably not affected directly by inflation.  43. The fact that inflation seemed to have little direct effect on the poor does not mean that it had no effect on their welfare. Figure 3 presents an example of the effects of inflation on one vulnerable group: school teachers. In 1998, teachers’ salaries dropped precipitously to less than half of their original value. In 1999, salaries were increased in nominal terms, but in real terms salaries remained well below their initial levels.7 The significant decline in real income of social sector workers has a particularly severe effect on these providers in rural areas, who are not able to fall back on household contributions or a second job, like as their urban counterparts. Anecdotal evidence suggests that many teachers did in fact stop working in rural areas.Likewise, the cost of many essential imported goods, such as medication, increased with potentially negative effects on the well-being of the population. 44. The measurement of inflation in the Lao PDR is still being developed. Until 1997, BOL calculated the CPI based on prices in Vientiane municipality. In 1996, the National Statistical Centre introduced a CPI covering five provinces and 130 items. In 1999, the National Statistical Centre updated the CPI and adopted a new consumer basket. The number of items covered increased to 197, and the index was expanded to cover price movements in three more provinces. 4. Exchange Rates45. The slowdown in broad money growth and the consequent deceleration of inflation contributed partly to the slowdown in the rate of depreciation of the kip relative to the dollar. The Banque pour le Commerce Exterieur Lao (midpoint) rate shows that the average annual depreciation rate of the kip to the dollar slowed from 161.7 percent in 1998 to 115.6 percent in 1999, and down to 10.4 percent in 2000. 46. The initiative to keep the margin between the parallel and bank rates to less than 2 percent was evident in 2000. On average, the gap between the parallel and bank rate of the kip relative to the dollar narrowed from 8.5 percent in 1999 to 2.2 percent in 2000. The impact of the initiative was even more pronounced in the case of the kip relative to the baht. On average, the gap between the parallel and bank rates of kip relative to baht was trimmed from 8.5 percent in 1999 to 1.0 percent in 2000. _____________________________________________
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