Public Information Notice No. 02/114

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Lao People's Democratic Republic

October 4, 2002

On August 26, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Lao People's Democratic Republic.¹

Background

Economic performance has improved considerably since late 1999. Starting in mid 1999, the authorities tightened macroeconomic policies after inflation rose to triple digits in 1998-99. The firm implementation of these policies quickly brought down inflation and stabilized the exchange rate. Since then, economic conditions have generally been favorable. A rekindling of business confidence and continued aid inflows helped to offset the negative impact of weaker regional growth in 2001, with real GDP growth weakening only slightly to 5¼ percent. Recent evidence suggests that the pick-up in regional activity, new small-scale construction, and foreign investment should sustain real GDP growth in 2002 at about 5½ percent. In particular, ongoing reforms to the foreign investment framework, including streamlined approval procedures, have attracted relatively large investments in telecommunications, manufacturing, mining, and aviation.

Reflecting the success of stabilization policies, inflation has generally been subdued. Problems in policy implementation in 2000/01 arising from the decentralization initiative led to missed program targets and significant exchange rate depreciation through September 2001.² However, quick remedial actions stabilized the exchange rate and limited the impact on inflation, which in April-May 2002 fell to 7 percent. However, with renewed pressure, mainly from implementation problems, the kip depreciated significantly by about 9 percent in May-July, but has stabilized since then. As a result of this and food price increases, inflation jumped to 11 percent in July.

Fiscal policy has generally remained firm, despite the weakness of revenue. Revenue for the first half year, only 37 percent of the annual program target, compared to 42 percent last year, put the budget under pressure, but expenditure restraint limited the recourse to bank financing. Remedial measures are now being implemented, particularly refocusing attention on the largest taxpayers. Although revenue collections improved somewhat in the June quarter, they were not sufficient to offset the seasonal pick-up in expenditure. With further efforts to mobilize revenue, it is expected that net banking system credit to the government will be limited to about ½ percent of GDP and the 2001/02 budget deficit target of 4.6 percent of GDP including grants will be achieved.

For most of the past year, the modest fiscal deficit has limited the increase in the net domestic assets of the Bank of Lao P.D.R. (BOL), thus contributing to the general slow-down in inflation. However, recent fiscal weaknesses and an increase in BOL deposits at banks boosted reserve money growth to 25 percent (year-on-year) in June 2002. Higher foreign exchange inflows enabled gross international reserves to reach $141 million, 2.4 months of imports in June. Although credit by state commercial banks increased sharply through March 2002 despite credit controls, possibly due to irregular lending, it has stabilized in recent months.

On the structural side, the phased banking and enterprise reforms are underway: (i) Banking reform has been initiated with measures to stop the deterioration in performance and reduce the level of new nonperforming loans. Restructuring plans have also been developed to improve management procedures, engage external advisors, merge the small banks, and rationalize branches. Competition will also be enhanced by expanding the role of foreign banks. (ii) SOE reform, which covers the largest and most indebted enterprises, has also begun. Management contracts, joint ventures, asset sales, and price adjustments are being used to improve SOE operations. (iii) For the private sector, the program will continue with implementing the measures to improve the environment for foreign and domestic investment. To make their inputs more accessible, the authorities have made significant progress in simplifying import controls.

Executive Board Assessment

Directors welcomed Lao P.D.R.'s robust GDP growth, and the progress made under the PRGF-supported program in strengthening macroeconomic stability and initiating broad-based structural reforms to improve the environment for sustained high growth and private investment over the medium term. At the same time, however, a substantial reform agenda remains to be tackled. In particular, continued strong efforts will be needed to consolidate macroeconomic stability, put state-owned enterprises (SOEs) on a viable commercial basis and reduce the state's involvement in commercial sectors, as well as make resources available for social services that are essential for poverty reduction.

Directors noted that the recent pick-up in inflation underscores the fragility of macroeconomic stabilization. The corrective fiscal and monetary policies being implemented by the authorities are welcome, but this effort will need to be sustained and further strengthened over time to improve prospects for ensuring fiscal sustainability. In particular, Directors urged the authorities to press ahead with effective implementation of structural fiscal measures, in order to overcome the chronically weak revenue performance. More focus is required on collections from large taxpayers, and on strengthening the operation of the central tax department and developing a national customs service. A stronger tax administration will also support the timely implementation of the VAT. Directors regretted the delay in developing a public expenditure management plan, given the urgent need to significantly improve expenditure tracking and increase fiscal transparency and accountability. They recommended the authorities to make full use of the available technical assistance to address weaknesses in this area expeditiously. Continued restraint of non-priority expenditure will also be needed to protect investment and social spending.

Directors urged continued vigilance to restrain credit growth by both the central bank and the state commercial banks (SCBs). While welcoming recent efforts in this regard, they noted that further reductions in central bank credit to the government and banks will be necessary. Close monitoring to control lending by state banks in the run-up to restructuring and recapitalization will also remain important, while full credit review mechanisms are still being put in place.

Most Directors considered the phased approach to bank restructuring to be appropriate, given the significant capacity and institutional constraints that the authorities are facing. It will nevertheless be important to ensure that the reform process remains firmly on track. Priority should be given to improving loan quality and strictly applying commercial lending criteria, which will require the elimination of political interference, stronger bank supervision with Fund technical assistance, and the full use of foreign management expertise. Directors welcomed the plan for the upfront restructuring of one of the distressed banks, while urging close monitoring to ensure that the plan is fully implemented. They emphasized that the removal of restrictions on nationwide operation of foreign banks would significantly add to competition and result in higher quality services. A few Directors expressed concern about the dominant role of the SCBs in the banking sector and recommended more emphasis on privatizing them.

Directors stressed the crucial role of restructuring the largest and most indebted SOEs to promote economic efficiency and reduce the burden on the banking system. Effective implementation of the restructuring programs, especially asset sales and price adjustments, will be essential, to put the ongoing reforms on a sustainable path and pave the way for greater private sector involvement. In particular, Directors urged the sale of the commercial operations of enterprises slated for restructuring to recover nonperforming loans of the SCBs.

Directors supported ongoing trade reforms, as well as the continuation of the flexible exchange rate system, which, along with continued efforts to reduce structural impediments, will be key to preserving external competitiveness. They encouraged the Lao authorities to accept the obligations under Article VIII as soon as possible. Some Directors recommended that the implications of the high dollarization of Lao P.D.R.'s economy be kept under close review.

Directors welcomed the integration of the Poverty Reduction Strategy Paper (PRSP) approach into the government's own poverty reduction program. However, significant additional work remains to be done, including the development of systems to ensure that budget expenditures are appropriately prioritized for pro-poor programs, and upgrading the statistical base to monitor poverty reduction and other intermediate social targets.

While noting that data provision to the Fund is satisfactory for surveillance purposes, Directors saw scope for significant further progress in both policy and statistical transparency. The quality of data should be improved, and the more general dissemination of data would support the informed discussion and ownership of economic policies.

Directors welcomed recent improvements in Lao P.D.R.'s external debt management, while emphasizing the crucial importance of applying an effective centralized debt management policy to all public external debt, and avoiding nonconcessional borrowing. They supported recent efforts to resolve debt issues with Russia, and encouraged both sides to work toward an early agreement on mutually satisfactory terms.