IMF Executive Board Concludes 2007 Article IV Consultation with the Lao People's Democratic RepublicPublic Information Notice (PIN) No. 07/106
August 23, 2007
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On August 3, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Lao People's Democratic Republic.1
Macroeconomic performance remains strong. Real GDP growth increased to 7½ percent in 2006, driven by the resource sector such as a sizable expansion of mineral production and the construction of the Nam Theun 2 (NT2) hydro-electric dam. The non-resource sector continued to grow moderately. Inflation has fallen below 4 percent in recent months, due to favorable oil and food prices and the lagged impact of the exchange rate appreciation. The current account deficit narrowed, reflecting buoyant resource exports and rising tourism receipts, and together with higher foreign direct investment and official development assistance inflows, resulted in an increase in the balance of payments. By end-June 2007, gross international reserves increased to about US$460 million, 4.6 months of non-resource imports. The rapid accumulation of international reserves led to an acceleration in the growth of monetary aggregates. By end-May 2007, reserve and broad money growth accelerated to 45 and 39 percent, respectively.
Fiscal policy in 2005/062 and the first eight months of 2006/07 contributed to lower demand pressures. Higher-than-anticipated resource revenues, coupled with non-resource revenues gains from the full implementation of tax changes in 2005 helped to reduce the deficit and lower net domestic borrowing. Bank credit to the private sector has also fallen in recent months.
Progress in economic reform has been mixed and the cost of doing business remains high. Restructuring of state-owned banks (SOCBs) and enterprises (SOEs) is proceeding, but SOCBs are far from being solvent and some SOEs are still making losses or are heavily indebted. Several laws for reforming the budget system (such as tax and customs administration and intergovernmental relations), introducing a VAT, and improving the investment climate (including the 2005 Enterprise Law and 2006 Commercial Bank Law) have been approved, but there is considerable delay in finalizing the respective implementing regulations. ASEAN Free Trade Area (AFTA) agreement is being pursued, and work to gain World Trade Organization (WTO) accession is ongoing.
The economic outlook is promising, but much depends on the way in which the government handles the natural resource bonanza. Were the government to adopt sound policies and accelerate reforms in anticipation of an adverse impact of the resource sector, growth would remain strong at around 6½ percent in the medium term, and inflation would stay below 5 percent. On the contrary, the outlook would be less benign if the government does not take timely policy actions, with lower growth and higher inflation. There are several risks to the outlook. Upside risks include additional proven mineral reserves, new investment in the mining sector, and construction of more hydropower plants. Downside risks comprise adverse commodity price shocks, delays in construction of hydropower plants, and slow process in important economic reform.
Executive Board Assessment
Executive Directors welcomed Lao P.D.R.'s recent record of robust growth, low inflation, and strengthened external position, which reflects a rapidly growing mining and hydropower resource sector as well as a favorable external environment. Poverty has been reduced significantly. Directors were encouraged by Lao P.D.R.'s strong fiscal performance, by the progress achieved in banking and state-owned enterprise (SOE) reform, and by the steps taken to improve the investment climate.
Directors concurred that the economic outlook for Lao P.D.R. is promising. They considered that the implementation of policies to sustain macroeconomic stability and accelerate the pace of reform will be key to realizing the full benefits of the resource sector, by supporting a strong supply response in the non-resource sector. This will be needed to help Lao P.D.R. mitigate the risks associated with the increased reliance on the natural resource sector and to help reduce exposure to debt distress.
Directors welcomed the authorities' commitment to fiscal consolidation and debt sustainability over the medium term, but expressed concern that full implementation of the recently approved 2007/08 budget will be a move away from the realization of the government's medium-term fiscal objectives. Accordingly, they encouraged the authorities to identify additional measures that would maintain fiscal prudence. Directors underscored the importance of a timely introduction of a VAT and a review of the tax system, coupled with stepped-up efforts to improve revenue and expenditure administration, and reform intergovernmental fiscal relations. In order to support the alignment of expenditures with national priorities, Directors called on the authorities to put in place an integrated medium-term fiscal framework that takes into account the uncertainties of resource revenues. Future external financing should continue to rely on grants and concessional loans.
Directors stressed that the development of a sound and transparent resource management framework, with appropriate expert assistance, will be key to ensuring a level playing field and attracting investor interest. In this regard, the net benefits of taking an equity stake in future resource projects should be closely evaluated, given the associated financial risks and the potential conflict of interest with government's dual role as regulator and shareholder. Directors also encouraged the authorities to participate in the Extractive Industries Transparency Initiative.
Directors underscored the need for maintaining a tight control of Bank of Lao P.D.R.'s (BoL) net domestic assets and bank credit to the private sector. They agreed the BoL's liquidity management instruments should be upgraded, and supported the introduction of a standing deposit facility until instruments using treasury bills are in place. Steps should also be taken to develop the interbank money market and mechanisms to avoid the quasi-fiscal costs of managing liquidity.
Directors considered that the Lao P.D.R.'s exchange rate policy is appropriate, and that the exchange rate appears to be in line with macroeconomic fundamentals. They shared the authorities' concern about the risk of large exchange rate fluctuations. To help manage such risk, Directors encouraged the authorities to strengthen international reserves further, to build up the BoL's capacity to smooth fluctuations, and to take steps to develop a well-functioning foreign exchange market.
Directors urged the authorities to accelerate banking and SOE reform, including by fully implementing the banking law, strictly enforcing prudential regulations, and strengthening bank supervision. Directors encouraged the authorities to expedite the recapitalization of the state-owned commercial banks, including by involving strategic investors. They noted that deepening SOE restructuring would help strengthen the banking sector. With the reduced reliance of SOEs on the budget, the extension of public guarantees on SOEs' borrowing should henceforth be conditioned on the viability of business plans.
Directors welcomed the authorities' plans to enhance trade integration and improve the investment climate. The authorities' efforts to gain WTO accession should be sustained. Directors considered that more decisive steps to reduce the high cost of doing business will help Lao P.D.R. to reap the full benefits of trade integration.
Directors observed that improving the Lao P.D.R.'s macroeconomic and financial data will support more effective surveillance and enhance decision-making, and encouraged the authorities to focus, in particular, on data on the balance of payments, government finances, and external debt, and on bank soundness indicators.