Public Information Notice No. 05/2

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with the Lao People's Democratic Republic

January 12, 2005

On November 29, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Lao People's Democratic Republic.¹

Background

Since the last Article IV, Lao P.D.R.'s macroeconomic performance has been relatively encouraging. After a brief hiatus in 2002, macroeconomic stability has been restored and growth has been relatively robust. The latest data also show that poverty has continued to decline. However, while progress has been made in strengthening macroeconomic policies, advancing the agenda of structural reform has proved more challenging, especially with regard to mobilizing revenues and strengthening expenditure management, two key reform priorities under the PRGF arrangement.

The economy has performed relatively well in 2004, rebounding well from a number of shocks, including a drought and the regional impact of the Severe Acute Respiratory Syndrome (SARS) the previous year. Although economic growth dipped in 2003 to 5¼ percent, half a percentage point lower than in 2002, activity has rebounded in 2004, and growth is projected to rise to 6 percent, supported by a recovery in agriculture and hydroelectricity output, and a rebound in tourism. Inflation, which had surged into double digits in 2002, has been on a downward trend since mid-2003. With the kip remaining stable over the last 18 months, inflation has fallen to 7½ percent in September. The external position has also improved, with brisk export growth and continued donor assistance, leading to a further rise in external reserves. However, public external debt remains high.

The improvement in macroeconomic performance has been underpinned by steady implementation of macroeconomic policies for much of the past year. Monetary policy has been restrained over the past year, with the Bank of the Lao P.D.R. keeping its net domestic assets broadly stable. Preliminary data suggest that the budget performance also improved in 2003/04. Revenues rose from 11.1 to 11.3 percent of GDP, partly reversing the significant decline in revenues in 2002/03, and expenditures fell due to lower donor-financed capital expenditures. With the government keeping tight control over domestic spending, the overall deficit declined to 3.9 percent of GDP.

The priority over the past year has been to advance key structural reforms, especially with regard to strengthening the revenue base. To this end, the authorities have announced their intention to introduce a VAT in January 2007 and have started to reform the turnover tax-reducing the number of its rates from three to two—a key preparatory step. However progress in addressing the key administrative reforms, related to centralizing control over the tax and customs administration, has proved difficult as they touch directly on the issue of center-provincial relations. The authorities have also continued to make headway in reforming the state banks and state-owned enterprises, although much remains to be done in both areas to limit contingent liabilities to the budget.

Provided that sound macroeconomic policy implementation is sustained, macroeconomic performance is expected to remain favorable in 2005. Growth is projected to rise to 7 percent, driven by an expansion in mining exports, inflation should remain in single digits, and strong export growth would help Lao P.D.R. improve its external reserve position. However, two potential risks have emerged to this positive outlook: (i) the 2004/05 budget plan, approved by the National Assembly in October, proposes a large increase in the wage bill which may prove unsustainable, unless phased over a longer-time period; and (ii) state bank credit has expanded rapidly over the last quarter, potentially undermining a key element of recent monetary discipline.

The government's National Growth and Poverty Eradication Strategy sets out a medium-term strategy to achieve rapid growth in order to improve the living conditions of the poor. If strong progress is made in structural reform, Lao P.D.R. has the potential to achieve the government's medium-term objectives of raising growth to 6-6½ percent—and sharply reducing poverty—as a number of major projects, such as the Nam Theun 2 hydroelectric dam, are in the pipeline. Achievement of this outlook is predicated on further reform with regard to revenue mobilization, and banking and state-owned enterprise reforms, needed to address potential risks to fiscal sustainability, stemming from Lao P.D.R.'s high debt burden. Strengthening expenditure management will also be critical to maintaining progress in ensuring sustained improvements in social indicators consistent with the Millennium Development Goals.

The present PRGF arrangement for SDR 31.7 million, was approved in April 2001, and was extended by an additional year, through April 24, 2005, in September 2003. The third review was completed on September 12, 2003. Discussions of the fourth review, which have been ongoing since December 2003 will resume after the conclusion of the 2004 Article IV consultation.

Executive Board Assessment

Executive Directors commended Lao P.D.R.'s progress toward macroeconomic stability, with inflation declining and the external position strengthening, and welcomed the robust economic growth and reduction in poverty. While improved economic management has been central to this performance, Directors stressed that significant challenges remain. In particular, faster progress is needed in strengthening domestic revenue mobilization and public expenditure management, completing the restructuring of state-owned banks and enterprises, and promoting private sector activity and investment. In this context, Directors welcomed the completion of the National Growth and Poverty Eradication Strategy (NGPES), and called on the authorities to translate its objectives into concrete actions embedded in a robust policy framework. Given the country's limited capacity, these efforts will require continued support from the international community.

While Lao P.D.R's near-term outlook remains favorable, Directors expressed concern about the 2004/05 budget plan, approved by the National Assembly in October. They noted, in particular, that the revenue targets may not be achievable in the absence of additional revenue measures, and that the large increase in the wage bill will likely need to be phased in over a longer period of time. Directors also encouraged the authorities to ensure that increases in world oil prices are passed on to consumers, as the budget cannot afford a loss of revenue from reductions in petroleum taxes at this juncture.

Directors welcomed the authorities' intention to continue to gear monetary policy toward reducing inflation. Tight control over the Bank of the Lao P.D.R.'s net domestic assets, underpinned by a government commitment to avoid bank financing of the budget, should continue to be the principal anchor of monetary policy. This will need to be complemented by firm restraint of credit by the state banks, and, in this regard, Directors expressed concern about the recent expansion of credit to finance a government-sponsored project. Directors considered Lao P.D.R's flexible exchange rate system, with interventions limited to smoothing operations, to be appropriate. They welcomed the ongoing review of the exchange system, and encouraged the authorities to expedite the process of accepting the obligations under Article VIII.

Directors underscored that improving revenue mobilization will be critical to ensuring fiscal sustainability, given Lao P.D.R.'s substantial expenditure needs and high public debt. Key priorities in the period ahead are the strengthening of revenue administration, which will importantly depend on reforms to re-centralize authority over tax and customs administration, and the introduction of a value added tax in early 2007. Directors also encouraged the authorities to ensure that tax incentives provided under the new investment laws do not undermine efforts to broaden the tax base, and to reduce tax incentives over time.

Directors stressed the need to accelerate reforms of public expenditure management in order to strengthen the accountability and monitoring of public spending. They urged the authorities to develop a comprehensive treasury reform strategy that will bring treasury operations in the provinces under central government control. These reforms will require pressing ahead with the ongoing review of the decentralization framework, to clarify the assignment of revenue and expenditure responsibilities between the center and provinces, and develop a robust mechanism for intergovernmental transfers.

Directors urged the authorities to pursue vigorously the restructuring of state banks, whose financial position remain precarious, and to maintain close oversight over the banks' operations until the restructuring process is complete. Some Directors considered that private investor participation would facilitate the reform of state banks and improve their management and financial operations. Directors also encouraged the authorities to move ahead with measures to improve the overall banking environment, notably through legislation to strengthen competition in the banking sector.

Directors welcomed the recent progress on state-owned enterprise reforms and the ongoing utility price adjustments. They urged the authorities to proceed with the sale of noncore assets of the large and most indebted enterprises, and to finalize a comprehensive strategy to address the losses of Lao Airlines. To complement the reforms to the state sector, the overall climate for private sector activity and investment should also be improved, including by reforming the legal system.

Directors stressed that lowering Lao P.D.R.'s high external debt to a more sustainable level will require strong action on several fronts. In addition to efforts to mobilize domestic revenue and reduce borrowing relative to GDP, the authorities will need to maximize grant financing and maintain a high level of concessionality on new borrowing. Some Directors also called for limits on concessional borrowing. Directors also urged the authorities to improve the monitoring and reporting of public external debt, and to centralize control over the contracting of new debt. Directors noted that, despite Lao P.D.R.'s eligibility, the authorities have indicated that they do not intend to avail themselves of debt relief under the enhanced HIPC Initiative.

Directors regretted that the joint audit of the central bank's 2003 accounts by the state auditor and an international audit firm has not yet been undertaken. They urged the authorities to fully implement this key recommendation of the safeguards assessment as soon as possible. Most Directors supported the view that, in the interim, the authorities should ensure that, at minimum, adequate safeguards are put in place with respect to the reporting of the central bank's net international reserves and net domestic assets.

While efforts have been made to improve Lao P.D.R's statistics, Directors urged the authorities to continue to work, with IMF technical assistance, to address remaining weaknesses and to improve data dissemination.