Public Information Notice No. 98/48

Press Information Notice: IMF Concludes Article IV Consultation with Lao People’s Democratic Republic

July 7, 1998

On June 15, 1998, the Executive Board concluded the Article IV consultation with Lao People’s Democratic Republic ¹.

Background

During the 1990s, the Lao economy expanded substantially, benefitting from opening up and the initiation of structural reforms in major areas. Annual real GDP growth has been in the range of 5–8 percent and consumer price inflation, after being brought down from the high levels of the late 1980s, remained mostly in the single-digit range until 1997. Expenditure moderation resulted in current fiscal surpluses (excluding grants) and reductions in the overall deficit since 1992. Fiscal consolidation was also reflected in an improvement in the external current account.

Output performance remained strong in 1997 despite the adverse impact of the Asian crisis. However, macroeconomic stability deteriorated significantly. In the 12 months through June 1998, the kip depreciated by almost 70 percent against the U.S. dollar. The depreciation, combined with high food prices in 1997 resulting from earlier floods, led to a sharp rise in inflation (to over 60 percent at end-May 1998). The external current account deficit (before grants) narrowed marginally in 1997 to 16 percent of GDP, reflecting reduced consumer imports and lower capital goods imports for hydropower investment. Substantial aid inflows and foreign direct investment helped in financing the deficit. Net official reserves fell by over $30 million during 1997 and the gross official reserve position declined to two and a half months of imports.

In recent months, the government has been preparing a set of measures to address the macroeconomic situation. Interest rates have been raised and open market operations are being conducted to stem the growth in liquidity. The National Assembly has approved a package of revenue increasing measures. Their full impact will be felt mainly during next fiscal year, starting in October. The government is determined to take additional measures, if needed, to arrest the current deterioration. Meanwhile, output growth for 1998 is expected to be around 6 percent, benefitting from higher production in the hydropower and agriculture sectors.

Progress with structural reform since 1989 has been significant, if slower than anticipated at the outset. The Lao P.D.R. now has the basic ingredients of a market-oriented economy, but further deepening is necessary. One of the most successful parts has been the privatization program whereby all but 33 "strategic" state-owned enterprises (SOEs)—employing 9,200 staff, less than one percent of the labor force—will have been sold or liquidated by the end of 1998. In addition, the government has started to commercialize the remaining SOEs. The financial system, on the other hand, remains underdeveloped and weak and the banking supervision framework has not been able to correct major bank weaknesses in a timely manner. Audits of the 1996 accounts of the state commercial banks indicated that the sector has severe solvency problems. The government, with the assistance of the multilateral organizations is preparing a reform plan which includes mergers, the establishment of independent bank management and, in a next phase, recapitalization. In addition, the government will also address problems in the private banks and open up the sector to more foreign participation. Finally, the government is also planning to introduce a foreign exchange interbank market to arrive at a market-determined exchange rate.

Executive Board Assessment

Executive Directors expressed deep concern about the deteriorating macroeconomic performance in 1997 and early 1998. While recognizing the impact of the Asian crisis, and events in Thailand in particular, they noted that the lack of tangible measures to tighten macroeconomic policies had contributed to a sharp depreciation of the exchange rate, a surge in inflation, and severe problems in the banking system. In light of the most recent developments in the exchange market, Directors noted the urgent case for strong, well-balanced, and front-loaded measures to tighten monetary and fiscal conditions, and address the banking system weaknesses and the inefficiency of the foreign exchange system.

On the fiscal side, Directors regretted the failure to implement tax measures presented in last September’s budget to improve the structure of the tax base and accelerate fiscal consolidation. They welcomed the recent adoption of these measures, but noted that the contribution to the current year's fiscal performance would now be very limited. They urged the authorities to tighten their fiscal stance in the coming years, and to improve the transparency of fiscal operations. They encouraged the authorities to prioritize expenditure in the publicinvestment program, and to put more emphasis on increasing budgetary allocation for education, health, and poverty reduction programs.

Directors noted that monetary policy actions in 1997 had failed to stem rapid credit growth, contributing to the sharp and continuing depreciation of the kip and to the rise in inflation. They urged the authorities to act quickly to raise interest rates to positive real levels, and to contain credit expansion.

Directors underlined the need to accelerate structural reforms following the near standstill in 1997, especially with respect to the banking sector and the foreign exchange system. They emphasized the crucial importance of a well-functioning banking system to support medium-term growth. Directors encouraged the introduction of foreign participation to deepen domestic banking expertise. Directors also saw an urgent need to review the operations of the private banks and to improve banking supervision, and called for closer coordination and cooperation between the authorities and multilateral organizations in the provision of financial and technical assistance.

On the foreign exchange system, Directors observed that recent developments have demonstrated the fragility of the current arrangements. They urged the authorities to address the weaknesses by laying the foundations for a broad-based foreign exchange market in which the exchange rate reflects market conditions.

Directors welcomed the commercialization of the strategic state-owned enterprises and encouraged the authorities to promote transparency in the operations of the state companies, in particular those controlling logging and wood processing.

Most Directors observed that the Lao People’s Democratic Republic’s medium-term outlook is favorable, provided macroeconomic stability can be restored in the near term and domestic savings increased through fiscal consolidation. They encouraged the authorities to work closely with the staff to establish a strong program that could be supported by a new ESAF arrangement.

With respect to statistical issues, Directors regretted the continuing shortcomings in accuracy and coverage of key economic data.