Public Information Notice No. 09/115

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with the Lao People's Democratic Republic

September 11, 2009

On July 10, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Lao People’s Democratic Republic.¹

Background

Macroeconomic performance of the Lao P.D.R. economy was broadly positive in 2008, in spite of external and weather-related shocks. GDP growth moderated only slightly despite severe flooding which negatively impacted agricultural production, with construction and mining picking up the slack. Activity was further supported by a surge in credit growth. Inflation came off its mid-year peak as food and fuel prices abated, aided by continued currency appreciation. The nonresource current account deficit widened, despite robust exports and tourism receipts, due to the impact of soaring commodity prices on the import bill in the first half of the year, but this was more than offset by strong foreign direct investment (FDI) inflows.

More recently, the impact of the deteriorating external environment, which began to show in the second half of 2008, has become increasingly evident. The largest impact has been through the mining sector, but other sectors such as tourism, remittances and agriculture have also been affected. Previously strong foreign currency inflows (into both the current and capital accounts) have slowed. The decline in copper prices together with tighter global financing conditions has lowered export revenue, depressed financial performance, and delayed mining expansion plans. New hydropower investments have also been delayed. Lower-than-budgeted profit tax collection from the mining sector has placed fiscal revenues under strain.

The external position has weakened in the face of slowing foreign currency inflows and loose policies. International reserves have fallen from their June-2008 highs, as FDI flows and exports weakened, in the context of a strong and stable exchange rate.

Growth will likely hold up much better than in some other countries in the region, assuming no further negative shocks. Economic activity is projected to grow at around 4½ percent in 2009 supported by projects already in train, rapid past credit expansion, and strong public investment, with modest drag from somewhat weaker tourism and declining rural incomes. Inflation would remain low and stable, predicated on currency stability and flat commodity prices. With new large-scale investment projects taking off at the earliest in late-2010, growth is expected to only tick up in 2010 as Nam Theun II comes on stream, with continued softness in other sectors. The external position would continue to weaken, as expansionary policies, export softness, and lower FDI drive international reserves lower.

Risks to the near-term outlook are both external and domestic. On the external front, a weaker global economic recovery could further depress demand for tourism, garments, and other exports. Foreign direct investment in the mining and hydropower sectors could also be adversely affected. On the domestic side, the main risk is that excessively expansionary economic policies may jeopardize macroeconomic stability. The next 18 months appear particularly challenging.

However, provided macroeconomic stability is maintained and structural reforms are accelerated, the medium-term outlook is positive. As the global crisis works itself out, investments in the mining and hydropower sectors would resume, and activity in the broader economy would pick up, as reforms to strengthen the foundations of the economy push forward. Although the external current account deficit is expected to widen again as investment-related imports rise, this would be more than offset by increased FDI and other capital inflows—the external position would strengthen, with international reserve coverage gradually returning to current levels. External debt is projected to remain high, but concessionality should keep public debt service manageable. That said, improvements in the global economy, while key to improving external demand conditions, may not be sufficient to ensure sustainable growth. For this, strong policies and structural reforms are required.

Executive Board Assessment

Executive Directors commended the authorities for their economic management and structural reforms, which contributed to the recent robust economic growth, notwithstanding the severe flood and a deteriorating external environment. Directors noted that, while Lao P.D.R. has weathered the global crisis well relative to neighboring countries, expansionary policies have placed the external position under strain. An immediate priority is to safeguard macroeconomic stability, while supporting growth.

Directors supported the exchange rate as a nominal anchor, until market-based monetary policy instruments can be put in place. They stressed that prompt and determined tightening of fiscal and monetary policies would be necessary to support exchange rate stability. They noted the staff’s assessment that the real effective exchange rate is broadly in line with its medium-term equilibrium.

Directors emphasized the need to reduce the fiscal deficit, to curtail quasi-fiscal operations, and to bring all fiscal operations on budget. They welcomed steps to boost revenue and the plan to bring forward revenue measures. Directors noted however that expenditure restraint, including postponement of non-priority spending, would need to bear most of the consolidation burden in order to create fiscal space to protect spending for social programs. Directors welcomed efforts to improve public financial management and to recentralize tax, customs, and treasury operations. They encouraged efforts to reduce vulnerability to resource revenues by broadening the tax base, and to strengthen budget planning by introducing a medium-term expenditure framework. Directors stressed the importance of prudent debt management, given the country’s high risk of debt distress.

Directors encouraged the Bank of Lao P.D.R. to rein in bank credit growth, and to limit its lending to temporary liquidity support for banks. They recommended that steps be taken to improve the effectiveness of monetary policy, focusing on developing indirect instruments, fostering an interbank market, and strengthening domestic liquidity management.

Directors encouraged further efforts to deepen financial intermediation and address weaknesses in the banking sector, particularly the financial positions of state-owned commercial banks. This would require sound risk management and banking practices, improved supervisory oversight capacity, and full implementation of the banking law.

Directors noted that bold structural reforms are key to achieving sustained growth. Priorities in this area include improving the investment climate, reducing regulatory uncertainty, and advancing trade integration. These reforms will help expand private sector participation and diversify the sources of growth. Directors looked forward to furthering World Trade Organization compliance.

Noting shortcomings in data provision for surveillance, Directors called on the authorities to improve the quality and timeliness of various statistics, drawing upon technical assistance from the Fund. Enhanced coordination among statistical agencies would help ensure data consistency.

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.