Regions and Countries

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p. 8 of 12 BACK | NEXT Executive Summary I. Recent Economic Developments II. Short-and Medium-Term Economic Prospects and Policy Issues A. Policy Issues B. Short- and Medium-Term Prospects III. Poverty Reduction

Country Economic Review: Lao People’s Democratic Republic : II. Short-and Medium-Term Economic Prospects and Policy Issues

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A. Policy Issues

63. The Lao PDR is well on the way to recovery after the economic instability caused by heavy government borrowing from BOL and the slowdown in investment and economic activity associated with the regional financial crisis. In early 2001, the Government entered into a poverty reduction and growth facility agreement with IMF, reflecting the country’s renewed economic stability. The Lao PDR is highly integrated in the Greater Mekong Subregion, especially with Thailand, and is vulnerable to economic slowdowns in the subregion. The economy is highly dollarized and shocks in foreign currencies (especially the Thai baht) can have serious effects on the Lao economy.

64. The Lao PDR plans to graduate from its classification as one of the least developed countries by 2020. This will require substantial effort by the Government and significant economic growth and reform. This paper discusses several recurrent themes that need to be addressed for the country to have sustainable economic growth and to reduce poverty significantly. These include

1. maintaining macroeconomic stability, with low and predictable inflation and exchange rates;

2. ensuring that government spending is balanced between capital and recurrent expenditures;

3. strengthening government revenue mobilization to ensure that sufficient resources are available for counterpart funding of concessionary loans, and to maintain and staff existing investments; and

4. reforming and deepening the financial sector to ensure an adequate flow of funds for investment to the private sector and to microfinance operations.

65. These themes are all interlinked and center on providing a stable environment for growth and better defining the role of the state and the private sector.

1. Financial Sector Reform

66. The financial sector currently consists of four state-owned banks accounting for approximately 70 percent of total assets in the banking system and a variety of foreign and joint venture banks, accounting for the remaining 30 percent. Deposits are about evenly split between individuals and firms. Foreign banks are restricted to Vientiane; local banks have a strong regional focus.

67. Currently the depth of the financial sector is quite low. The ratio of broad money (M2) as a percentage of GDP, a common indicator of financial sector depth, is around 18 percent, which is one of the lowest in the world. In addition, approximately 80 percent of broad money is in the form of foreign currency deposits. Based on regression estimates, the Lao PDR will need to increase the proportion of broad money to approximately 50 percent to reach its stated target of graduating from the category of least developed country.⁸ A larger and more robust financial sector will be able to better mobilize domestic savings and permit the economy to grow. It will also strengthen the ability of BOL to maintain macroeconomic stability by strengthening its monetary tools.

68. The financial sector needs to reform its lending practices. Currently most credit is directed towards SOEs. The ratio of nonperforming loans (NPL) is thought to be quite high, although it varies considerably. BOL estimated NPLs in 2000 to be 20 to 25 percent of total loans, while a review of the financial sector estimated the range at 50 to 70 percent of total loans.⁹ Banks do not have adequate provisions to cover this risk. Credit will have to be targeted to firms on the basis of their ability to repay the loan (which depends on the lender making economically sound investments) and lending interest rates will have to become more flexible to allow adjustments for risk. A formal system of sharing information on bad credit risk is also an important prerequisite in strengthening the financial sector.

2. Public Expenditure, Governance, and Decentralization

69. The Lao PDR is gradually introducing decentralization as a tool to reduce poverty. Provinces will be increasing responsible for the design of local strategies and setting the framework for development in their jurisdiction, while districts will have greater responsibility for planning and budgeting. Although decentralization creates new opportunities for provinces and districts to respond to develop their own solution to local issues, it can also lead to new risks.

70. Decentralization should involve the transfer of responsibility along with the transfer of resources necessary to ensure that these responsibilities can be met. The central Government also needs to clarify local governments’ right to control certain tax revenues that are collected locally. At the same time, local governments need to provide the central Government with information to ensure that they are meeting their obligations. Without an understanding of government responsibilities at all levels, decentralization can seriously affect public finances and reduce the possibility of good governance.

71. Currently the Government does not have data on spending by sector (i.e., health, education, roads, etc.). This is largely because spending has largely been decentralized and the central Government does not receive systematic information from local authorities on spending by sector. This complicates the Government’s ability to set priorities and meet its long-term economic and social goals.

72. As mentioned, the Government will have to take steps to increase the amount of money received and to improve the quality of the tax system. This is necessary to ensure that the Government is able to implement the pro-poor policies that it has committed itself to. Additionally, however, raising revenue is essential to ensure that the Lao PDR can provide necessary counterpart financing for future concessionary debt.

3. State-Owned Enterprises

73. Related to problems in the financial sector, is the need to reform SOEs. SOEs are by far the largest borrowers from the banking system and are largely responsible for the high level of NPLs. A myriad of SOEs are operating in the country, at both the national and local levels. Some like Electricité du Lao, the electricity producer, and Lao Aviation are major companies with substantial operations all over the countries, while others are small companies with a very local focus.

74. SOEs can also create other distortions in the economy. Some are able to pay reduced taxes by taking advantage of their political connections. SOEs often serve as informal licensing agencies by restricting trade and charging fees to private sector firms that attempt to enter the market.

75. Increasing transparency is key to reforming the SOEs. This requires the codification of their rights and limitations of SOEs in the markets where they operate. Establishing and using sound accounting and auditing practices also play an important role in guaranteeing transparency.

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