## Lao P.D.R.: Assessment Letter for the Asian Development Bank and World Bank

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### Recent developments
- Kip traded in a relatively narrow band in the first half of 2005.
- Inflation declined to 5½ percent in June, despite a sharp increase in fuel prices.
- External reserves remained comfortable at around three months of imports.
- Economic activity is robust, with growth projected to rise to 7¼ percent in 2005, driven by an expansion in mining activity and the construction of the Nam Theun 2 (NT2) hydroelectric dam.
- Preliminary data suggest budget performance weakened in the third quarter of the fiscal year.
  - Revenue collections through May were running below target.
  - Budget deficit through April was in line with the annual target of 4 percent of GDP, but more recent data suggest the deficit has started to rise and domestic arrears are reported to be accumulating.
  - National Assembly approved a package of tax measures in May; implementation likely delayed until late August or early September.
  - The revenue target for the 2004/05 budget has been reduced to 11.6 percent of GDP but remains overambitious.
  - Proposed increase in the wage bill to 4.9 percent of GDP (from 4.3 percent in 2003/04) could put the budget under pressure.
- Monetary policy more expansionary than expected:
  - Net domestic assets of the Bank of Lao P.D.R. (BoL) are running above target, mainly because of a drawdown in government deposits.
  - Growth in Kip reserve money rose to 40 percent in April (year-on-year).
  - Domestic liquidity, especially currency in circulation, continued to grow more rapidly than programmed.
  - Little evidence yet that higher-than-expected liquidity expansion is putting pressure on the Kip or on inflation.
- Pace of structural reform remains slow:
  - Improved customs law enacted, but limited progress on fundamental tax and customs reforms due to lack of consensus on establishing central control over provincial tax and customs offices.
  - Progress in restructuring state banks is slow; concerns that relaxation of the restrictive lending regime and reduction in international banking advisers could deteriorate state banks’ financial positions.

### Economic outlook
- Overall outlook favorable, conditional on progress in structural reform.
- Growth prospects:
  - Economic growth should remain strong during the next few years, with NT2 and large mining projects more than offsetting weak garment exports following expiry of the MFA quota system.
  - Regional integration likely to stimulate agriculture and tourism sectors.
- External sector:
  - Current account deficit projected to increase due to large projects, but increased capital inflows—mainly foreign direct investment—should more-than-offset this and keep external reserves comfortable at around three months of imports.
- Vulnerabilities:
  - Fiscal position fragile: weak revenue collections and rising spending pressures, notably on wages.
  - Public external debt remains high at 75 percent of GDP.
  - Budget will have to absorb significant contingent liabilities, notably large capital deficiencies of the state banks.
- Top priorities: accelerate structural reforms, increase revenue effort, strengthen expenditure management, and reinvigorate state bank reform program.

### Key policy issues and recommendations
- Strengthen fiscal position (remainder of 2004/05):
  - Promptly implement new revenue measures approved in May.
  - Strengthen oversight over major customs posts.
  - Intensify compliance efforts for large taxpayers.
  - Staff project 2004/05 revenue will be at 11.2 percent of GDP, or 0.4 percentage points less than the government’s current projection.
  - Expenditure restraint necessary, especially on wages; staff encouraged authorities to limit the wage bill as close as possible to the original proposal of 4.5 percent of GDP.
  - Authorities plan spot checks of civil servants in the provinces to ensure provincial wage claims are not overstated.
- 2005/06 budget framework parameters suggested by staff:
  - A revenue target of 11.9 percent of GDP. This requires new tax measures of around 0.3 percent of GDP in addition to reforms to strengthen revenue administration.
    - Remainder of revenue increase would come from full-year effects of new tax measures approved in May and additional mining royalties and taxes.
    - Potential measures include further reform of the turnover tax and increases in selected excises (e.g., diesel and tobacco).
  - A ceiling on expenditure of 17 percent of GDP.
    - Main priority: contain the wage bill to 4.7 percent GDP, to keep its growth in line with that of domestic revenues.
    - Non-wage recurrent spending should be raised for priority social spending.
    - Capital budget should cover government counterpart funding commitments and funding of ongoing projects.
    - Spending on education and health—$10 per capita (combined)—is well below the level needed to make progress toward the Millennium Development Goals.
  - A budget deficit of about 3½-4 percent of GDP, consistent with projected donor financing and the need to gradually reduce the debt burden.
    - Staff stressed importance of maximizing grant financing and borrowing only on highly concessional terms.
    - Jointly with the World Bank, staff will update the Debt Sustainability Analysis for Lao P.D.R. at the time of the 2005 Article IV Consultation.
- Monetary policy:
  - Should be geared to maintaining recent progress in reducing inflation.
  - Staff prepared an updated framework for 2005 under which the increase in the BoL’s net domestic assets would be progressively reversed over the remainder of the year.
  - Continued monetary stability hinges on maintaining tight control over credit growth at the state banks.
    - Authorities should continue to set ceilings on state banks’ net domestic assets to contain their credit growth to around 10 percent.
    - Expedite progress in strengthening bank regulations, particularly for single borrower exposures.
- Structural reforms in fiscal area:
  - Revenue administration:
    - Centralize authority over tax and customs administrations with three components:
      - Secure political consensus on national revenue administration.
      - Integrate provincial tax and customs offices into national organizations.
      - Launch capacity building to strengthen tax and customs departments.
    - Creating a national revenue administration remains highly sensitive.
  - Customs Department:
    - Finalize regulations for the new Customs law, especially regarding the role and responsibilities of the national Customs Department.
    - Strengthen customs operations via post clearance audits and computerization of customs procedures.
    - Finalize and approve new organizational structure, including a third deputy director-general to oversee field operations.
  - Tax Department:
    - Consider integrating administration of large taxpayers into a single unit under control and responsibility of the Tax Department.
    - Technical assistance program supported by SIDA (Sweden) will be critical.
  - VAT:
    - VAT will need to be delayed until 2008 to ensure adequate preparatory time.
    - National Assembly will start discussion of VAT key parameters in September; main obstacle is need to establish national tax and customs administrations.
  - Public Expenditure Management Strengthening Program (2005/06 emphasis):
    - Strengthen control over provincial treasuries to ensure timely transfer of national revenues to the center.
    - Strengthen budget planning and execution by updating budget nomenclature and developing supporting accounting systems.
    - Improve cash management through development of a quarterly cash management plan.
    - Public Expenditure Review with the World Bank expected to clarify medium-term fiscal strategy; work started and expected completion by mid-2006.
- Bank reform and supervision:
  - Reinvigorate bank reform process; greater priority on finding joint venture partners for two state banks.
  - AsDB assisting to strengthen governance agreements for state banks.
  - Proposed reforms: streamline management structures, strengthen performance indicators, re-establish prudential lending framework.
  - Issue first tranche of bank recapitalization bonds to address capital deficiency of state banks.
    - Accompanied by more active involvement of Ministry of Finance, as shareholder, to avoid repeat of failed recapitalization experience in the 1990s.
  - Oversight of banking system needs further development:
    - Strengthen regulatory framework and BoL supervisory capacity.
    - Broaden scope of bank supervision beyond two major state banks to assess soundness of private banks.
    - Develop standard financial soundness indicators for the banking system to identify potential problem areas.
  - The 2003 audit for the BoL, long overdue, should be finalized.
    - Authorities plan to combine the 2003 and 2004 audits this year to shorten delay.
    - IMF technical assistance mission advised State Audit Organization (SAO) on conducting a central bank audit to international audit standards (ISA); follow-up visit expected in September after field work for BoL audit is completed.

### Fund relations and technical assistance
- Staff expect to remain engaged in close policy dialogue with the authorities, working in collaboration with the World Bank and AsDB.
- Next mission will be in the fall for the 2005 Article IV Consultation, for discussion by the Board in early 2006.
- Staff offered to continue—and expand, if requested—technical assistance in the Fund’s core areas of expertise, such as revenue administration, expenditure management, and bank supervision.
- Recent PRGF arrangement expired on April 24, 2005.

### Key statistics and projections (selected)
- Nominal GDP (2004): $2,451 million
- Population (2003): 5.66 million
- Real GDP growth (percentage change)
  - 2001: 5.8
  - 2002: 5.8
  - 2003: 5.8
  - 2004: 6.4
  - 2005 Est./Proj Latest 1/Proj: 7.3
- Inflation (annual percent change)
  - Period average 2001–2005: 7.8, 10.6, 15.5, 10.5, 7.6, 5.9 (latest)
  - End of period 2001–2005: 7.5, 15.2, 12.6, 8.7, 5.4, 5.4 (latest)
- Government budget (in percent of GDP) 2/ 3/
  - Revenue: 13.2, 13.1, 11.0, 11.3, 5.6   4/11.2 (Fiscal data for Oct 2004-April 2005)
  - Grants: 3.1, 2.0, 2.1, 1.1, 1.0   4/1.6
  - Expenditure: 20.7, 18.4, 18.9, 15.8, 8.1   4/16.8
  - Overall balance (including grants): -4.4, -3.3, -5.8, -3.4, -1.4   4/-4.0
  - Government debt: 69.9, 73.5, 82.7, 82.8, 75.7   4/75.6
  - Bank restructuring bonds (excluding debt clearance bonds): 0.0, 0.0, 0.0, 0.0, 0.0   4/0.7
- Money and Credit (annual percent change) 2/ 5/
  - Reserve money: -19.3, 19.4, 23.7, 30.9, 14.3   6/16.5 (As of April, 2005)
  - Broad money: 7.8, 12.9, 24.1, 21.0, 10.6   6/15.0
  - Bank credit to the economy: 27.6, -5.2, 5.4, 10.1, 13.6   6/10.7
- Interest rates (end of period) 2/
  - On three-month deposits: 16, 17, 10, -15, 9, -11, 6, -8...
  - On short term loans: 4, 12, -18, 12, -20, 22, -25, 16, 13...
- Balance of payments (in millions of U.S. dollars)
  - Exports: 362, 370, 462, 521...652
  - Imports: 650, 633, 723, 972...1050
  - Current account balance (including official transfers): -146, -131, -159, -322...-465
    - (in percent of GDP): -8.3, -7.2, -7.6, -13.2...-16.5
  - Gross official reserves (in millions of U.S. dollars): 134, 196, 216, 227, 221   7/245 (As of June 24, 2005)
    - (in months of prospective goods and services imports) 8/: 2.4, 3.2, 3.2, 3.1, 2.7   7/3.0
    - (in percent of short-term debt): 35, 24, 19, 33, 62, 32, 32, 91   7/324
- External public debt 9/ (in millions of U.S. dollar): 1,213, 1,330, 1,915, 2,014...2,128
  - Net present value (in percent of exports): ...220, 200, 185...161
  - External public debt service (in millions of U.S. dollars): 36, 36, 40, 69...77
    - (in percent of exports): 6.8, 6.7, 6.6, 9.7...8.9
    - (in percent of revenue, excluding grants): 18.2, 16.8, 13.5, 14.9...17.4
- Exchange rate
  - Commercial bank rate (kip per dollar; end of period): 9,490, 10,680, 10,467, 10,377, 10,977 10/... (As of July 19, 2005)
  - Nominal effective exchange rate (Base Year 2000=100): 95.7, 83.3, 73.1, 71.2, 71.4   6/
  - Real effective exchange rate (Base Year 2000=100): 102.2, 97.3, 97.6, 103.2, 104.2   6/...
- Memorandum item:
  - Nominal GDP (in billions of Kip): 15,705, 18,390, 22,189, 26,018...29,836

*Source: Lao P.D.R.: Assessment Letter for the Asian Development Bank and World Bank, August 15, 2005 (IMF staff report).*

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