Public Information Notice No. 01/40

Public Information Notice: IMF Concludes Article IV Consultation with the Lao People's Democratic Republic

April 26, 2001

On April 23, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Lao People's Democratic Republic.¹

Background

Lao P.D.R. made important progress at economic reform through implementing its "New Economic Mechanism" in the first half of the 1990s, supported by a program under the Enhanced Structural Adjustment Facility. Then, in 1997, an expansionary response to the Asian crisis was adopted. Ambitious investment plans, particularly irrigation projects to achieve rice self-sufficiency, were pushed through despite the regional crisis and without appropriate resource allocations. Recourse to central bank financing, given the high level of dollarization, caused inflation to skyrocket to triple digits and the kip to depreciate sharply.

Recognizing the severe cost of high inflation, the authorities embarked on a strong stabilization and sustained program from mid-1999. With restrained policies, economic conditions improved considerably. Under relative exchange rate stability, inflation fell sharply, from 87 percent at end-1999 to 9 percent in February 2001. Real GDP growth is estimated to have been about 5.7 percent in 2000, as stronger domestic demand from higher credit growth appears to have offset the drop-off in Foreign Direct Investment, but there is considerable uncertainty with GDP estimates because of the poor quality of the data.

Monetary policy played a key part of the stabilization effort. Sharp limits on central bank financing, especially on irrigation projects, and the issue of central bank securities, were critical in reducing the excess kip liquidity. Thus, Bank of Lao P.D.R. (BOL) credit to the government and economy, which rose sharply in 1998 and early 1999, has since been flat, except for onlending of external project loans. Supplementing BOL credit restraint were efforts to make commercial banks operations more prudent. As a result of this caution, in 1999 commercial bank credit remained flat in U.S. dollar terms. However, in 2000, state-owned commercial banks (SOCBs), seeing a return to stability, SOCBs increased their lending rapidly, by 40 percent (in U.S. dollar terms), putting pressure on the underlying quality of their portfolios.

The 1999/2000 budget marked a return to more orderly fiscal management. Although there were attempts to restrain expenditures in 1998/99, the burden fell on social expenditures, and significant domestic arrears were incurred, including as unpaid wages to social sector workers. In the 1999/2000 budget, strong efforts were made to improve tax administration, and as a result, the ambitious target of raising revenue by nearly 2 percentage points to 13 percent of GDP was achieved. At the same time, scaling back the construction projects sharply reduced capital spending in relation to GDP, and made more room for unwinding the very tight constraints on current spending which increased to 8 percent of GDP. Additional external assistance enabled the budget deficit to be increased from 4 percent of GDP to 5 percent in 1999/2000, but with a reduction in net banking system credit to the government of about ½ percent of GDP, and credit from the central bank was reduced by more than twice this amount.

On the foreign exchange side, while maintaining a flexible exchange rate system, the strong policy actions have stabilized the rate since late-1999. Although the rate subsequently depreciated by 9 percent against the U.S. dollar, it has remained stable against the baht, and the margin with the parallel market has generally remained under 2 percent, and gross international reserves increased from 2 months of prospective imports at end-1999 to 2.4 months at end-2000.

Executive Board Assessment

Executive Directors commended the Lao authorities for their strong actions to stabilize the economy by tightening central bank credit and fiscal policy. These determined efforts succeeded in sharply reducing inflation from triple digits in 1999 to the current single digit range. Directors stressed the importance of building on this record to strengthen macroeconomic performance and more effectively meet the government's objectives of sustaining higher growth with equity. Extensive structural and appropriately sequenced reforms will also be essential, and should aim at promoting efficiency and private sector activity, while spreading the benefits of development more broadly, especially to rural areas.

Directors considered that further credit restraint by the central bank and the state-owned commercial banks is needed to sustain macroeconomic stability. This restrained credit policy is key for avoiding renewed inflationary pressures while maintaining a flexible and market-based exchange rate, which Directors consider to be appropriate.

Directors welcomed the framework for prudent fiscal policy. Central to this framework are strong revenue efforts, especially through more effective tax administration for large taxpayers, which will also pave the way for introduction of a value-added tax in 2003. A combination of revenue efforts and spending restraint will be needed to achieve the fiscal targets for the 2000/01 budget and, in this regard, Directors encouraged the authorities to adhere to their commitment of adjusting spending in line with available revenue. To enhance the poverty focus of the budget while maintaining fiscal discipline, they stressed that major improvements in public expenditure management will be needed, aimed at enhancing transparency and at directing expenditures more effectively for poverty reduction, especially in the context of ongoing decentralization. These efforts will require considerable technical assistance from the Fund and other multilateral institutions. Directors also observed that, in view of Lao P.D.R.'s limited debt-servicing capacity, external borrowing will need to be closely monitored in the period ahead. Several Directors encouraged the authorities to make further progress in their debt negotiations with key bilateral creditors.

Directors emphasized the need to move ahead decisively with reform of the state-owned commercial banks. They attached particular importance to developing and implementing bank specific restructuring plans based on phased recapitalization, which should be strictly conditional on improvements in bank performance and governance, as well as the resolution of nonperforming loans. Sustainable rehabilitation of the banking sector will equally depend on supporting measures to improve lending discipline, especially measures to phase out policy lending and develop banking supervision.

Directors agreed that reforms of the enterprise sector are essential to complement banking reforms. They welcomed the recent price adjustments that strengthened the financial performance of state-owned enterprises, but noted that additional adjustments will be needed to achieve cost recovery and will need to be followed by more comprehensive reforms. Regarding nonstate enterprises, the recent issuing of the implementation regulation for the Foreign Investment Law is an important start, but further progress will be required to create a transparent and fair business environment.

Directors supported the government's commitment to economic integration in order to boost its growth prospects. They recognized that, given the structure of Lao P.D.R.'s trade, liberalization under the ASEAN Free Trade Area will present both major benefits and challenges, and will need to be supported by measures to strengthen competitiveness.

While welcoming recent steps to strengthen the database, Directors expressed concern at the quality and availability of economic statistics for surveillance and for monitoring poverty reduction. They stressed, in particular, the importance of improving the quality of fiscal data as well as broadening its availability, within the government and to the public, to improve transparency.