Public Information Notice No. 06/31

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Lao People's Democratic Republic

March 21, 2006

On March 8, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Lao People's Democratic Republic.¹

Background

The economy performed well during 2005. Economic growth increased to 7 percent, driven mainly by an expansion in activity at the Oxiana gold and copper mine and the construction of the Nam Theun 2 (NT2) hydro-electric dam. Higher rice and fuel prices put upward pressure on inflation in mid 2005, but core inflation remained at around 5-6 percent. With food prices easing, headline inflation fell back to 8.8 percent in December. The external position held up well, despite a number of adverse shocks. A surge in mining exports helped to offset the impact of higher oil prices and lower garment exports. Consequently, external reserves remained broadly unchanged, at around $230 million or 3 months of imports.

Macroeconomic policies remained on track, but the underlying situation continues to be fragile, especially in view of Lao P.D.R.'s high external public debt (80 percent of GDP). The government kept a tight control over the cash budget deficit (3.5 percent of GDP) despite shortfalls in revenue. However, with debt service and the wage bill continuing to rise, non-wage spending has come under increasing pressure. The Bank of the Lao P.D.R. maintained monetary stability, through tight control over its net domestic assets, but large directed credits at the state-owned commercial banks pose a risk to macroeconomic stability.

The economic outlook is favorable, provided progress is made on structural reforms. Growth should remain strong during the next few years (in the range of 6-7 percent), driven by the continuing stimulus from NT2 and the large mining projects. The external outlook is also reasonably buoyant as these projects should generate sizeable net inflows. However the prospects for sustaining a rapid pace of growth and development depend on actions to address key structural weaknesses—especially with regard to revenue mobilization, which is critical for progress towards debt sustainability, and reform of the state-owned commercial banks. Progress on both fronts continued to be slow in 2005. Further efforts will also be needed to advance trade reforms and improve the investment climate.

Lao P.D.R.'s PRGF arrangement, approved in April 2001, lapsed in April 2005, with only three of six reviews completed. Although macroeconomic performance remained broadly on track, lack of progress on structural reforms and safeguards policies prevented completion of further reviews. An Ex Post Assessment (EPA) of performance under Lao P.D.R.'s PRGF and ESAF programs has been completed. The EPA concluded that the design of the programs had been broadly appropriate, but that slippages with regard to key structural reform objectives suggested that, in addition to capacity constraints, there had been insufficient government ownership of the reforms.

Executive Board Assessment

Executive Directors commended the Lao P.D.R. authorities for maintaining stable macroeconomic conditions and welcomed the robust economic growth and the progress in reducing poverty. While disciplined economic management has underpinned the improved performance of the economy in recent years, Directors noted that many challenges remain. The underlying macroeconomic situation remains fragile, reflecting weaknesses in the fiscal position and the banking system, as well as the large external debt burden. There is also a need to improve the trade and investment regime to enhance the competitiveness of the economy, and expenditure management needs to be strengthened to ensure a more effective use of public resources for poverty reduction. Directors encouraged the authorities to use the opportunity provided by the sixth national development plan to move forward in these critical areas.

Lao P.D.R.'s economic outlook is favorable given the sizeable stimulus from major projects in the mining and hydropower sectors, but Directors stressed that this is not without risk. The immediate priority is to ensure a sound budget framework for 2005/06, based on realistic revenue targets and a sustainable expansion in the wage bill. In this context, Directors welcomed the authorities' commitment to make the expansion in civil service employment conditional on strengthened revenue mobilization. This would allow for alleviation of the compression in nonwage spending in priority sectors, while containing the overall deficit to a level consistent with available concessional donor financing.

Directors welcomed the authorities' intention to continue to gear monetary policy toward reducing inflation. They agreed that the Bank of the Lao P.D.R.'s net domestic assets should remain the main anchor of monetary policy, and that firm control of net domestic assets should be underpinned by prudent fiscal management. Directors noted that rapid credit expansion by state-owned commercial banks, reflecting large credits to a government-sponsored project, posed a risk to monetary stability. They welcomed the initial steps to rein in the exposure of these banks, but emphasized the need to strengthen the regulations on single borrower exposure and to limit the scope of regulatory forbearance in this area. The authorities should also move swiftly to find a strategic investor to place the project on a financially viable footing. Directors considered Lao P.D.R.'s exchange rate system, with intervention focused on smoothing transitory fluctuations, to be appropriate.

Directors stressed the importance of mobilizing revenue to enable Lao P.D.R. to meet its substantial expenditure needs within a sustainable fiscal framework. The main priority is to establish a strong tax and customs administration to raise revenues and support major tax policy reforms, including the introduction of a VAT. Progress on this front would depend importantly on reforms to strengthen central control over revenue operations in the provinces.

Directors urged the authorities to advance the Public Expenditure Management Strengthening Program. While the immediate focus on improving budget monitoring is appropriate, the main priority is to establish a strong national treasury with effective control over public finances. Given its decentralized structure, strengthening fiscal management will require a broader review of center-province relations to clarify the assignment of revenue and expenditure responsibilities and establish a clear and credible revenue-sharing framework.

Directors noted the government's decision not to avail itself of debt relief under the enhanced HIPC and Multilateral Debt Relief Initiatives. To lower the country's high external debt, they encouraged the authorities to maximize grant financing and maintain a high level of concessionality on new borrowing, in addition to strengthened domestic revenue mobilization.

Directors urged the authorities to expedite the restructuring of the financially weak state-owned commercial banks. They encouraged the government to seek private participation in the banks to facilitate their reform and enhance the banking system. In the interim, it will be important to maintain close oversight of the banks until their restructuring is complete. Directors also emphasized the importance of improving bank supervision, and urged the authorities to provide a more level playing field for private banks.

Directors encouraged the authorities to strengthen the trade and investment climate to improve the economy's competitiveness. They welcomed the authorities' plans to move ahead with the ASEAN Free Trade Agreement and their initiation of formal negotiations for WTO accession, and considered these as important steps towards integrating the economy into the regional and global markets. Directors were encouraged by the approval of a new Enterprise Law, but noted that more needs to be done to create a transparent and predictable regulatory environment for investors, and develop an effective legal and judicial system.

Directors welcomed the opportunity to review Lao P.D.R.'s performance under Fund arrangements since the early 1990s. They agreed that Lao P.D.R. had made significant progress in reducing poverty and moving towards a market based economy under the ESAF and PRGF-supported programs, but noted that many challenges remain. Looking ahead, Directors considered that, in addition to building capacity, a strong consensus within government on needed structural reforms, especially in the fiscal and banking areas, will be important. Evidence of progress on this front should be a precondition for any future Fund-supported program. In the meantime, Directors were of the view that surveillance, combined with well-targeted technical assistance, would be the most appropriate form of engagement.

Directors expressed concern that the poor quality of economic statistics is hampering effective surveillance and urged the authorities to strengthen the balance of payments, the national accounts, and government financial statistics, especially at the provincial level. They also encouraged the authorities to address weaknesses in the accounting systems at the Bank of the Lao P.D.R., which are hindering the effective monitoring of monetary and foreign exchange developments.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.