This paper describes economic developments in Lao People’s Democratic Republic (PDR) during the 1990s. Economic reforms in Lao PDR that started in 1986 were supported by IMF arrangements in 1989–97. During those years, the economy grew annually at 5 percent to 8 percent and through prudent macroeconomic policies, the government managed to achieve broadly stable macroeconomic conditions. Meanwhile, structural reforms took shape, so that market processes are now at work in most segments of the economy. However, in 1997, economic conditions deteriorated and progress in structural reform slowed significantly.

Abstract

This paper describes economic developments in Lao People’s Democratic Republic (PDR) during the 1990s. Economic reforms in Lao PDR that started in 1986 were supported by IMF arrangements in 1989–97. During those years, the economy grew annually at 5 percent to 8 percent and through prudent macroeconomic policies, the government managed to achieve broadly stable macroeconomic conditions. Meanwhile, structural reforms took shape, so that market processes are now at work in most segments of the economy. However, in 1997, economic conditions deteriorated and progress in structural reform slowed significantly.

I. introduction and overview

1. Economic reforms in the Lao P.D.R. that started in 1986, were supported by Fund arrangements in the period 1989-97. During those years, the economy grew annually at 5 to 8 percent and through prudent macroeconomic policies, the government managed to achieve broadly stable macroeconomic conditions. Meanwhile, structural reforms took shape, so that market processes are now at work in most segments of the economy. However, in 1997 economic conditions deteriorated and progress in structural reform slowed significantly.

2. This report briefly discusses major developments in 1997 and updates the statistical tables included in last year’s report on recent economic developments.1

  • Chapter II gives an overview of developments in the real sector. It notes that real GDP growth in 1997 remained high, at 6½ percent, despite some negative impact of the East Asian crisis, and that inflation accelerated to 26 percent by the end of the year.

  • Chapter III discusses fiscal developments in 1996/97 and the first months of 1997/98.2 Revenue performance in 1996/97 was weaker than expected and, therefore, the contribution of government savings to national savings was not as high as expected. The 1997/98 budget is also coping with revenue shortfalls.

  • Chapter IV discusses developments in privatization and public enterprise management in 1997. With the privatization program coming to an end, the government’s attention is shifting to the commercialization of the “strategic” state-owned enterprises (SOEs).

  • Chapter V deals with developments in the monetary and financial sector. It discusses how the lack of monetary policy actions by the Bank of the Lao P.D.R. (BOL) in 1997 contributed to the depreciation of the kip against the U.S. dollar and the Thai baht. Developments in the financial sector are also dominated by emerging signs that most banks, including all the state commercial banks (SCBs), are insolvent. The chapter briefly discusses the initiatives currently taken to modernize the banking sector.

  • Chapter VI presents external sector developments in 1997. The exchange rate of the kip against the U.S. dollar depreciated substantially. The external current account deficit narrowed marginally to 16 percent of GDP, with a decline in timber exports offset by lower capital goods imports, linked to hydropower investments. International reserves dropped sharply on account of capital flight.

II. Real Sector

A. OVERVIEW

3. Output growth, at 6½ percent, remained substantial in 1997, but inflation accelerated to 26 percent (12-month rate, year-end). While the economy was affected by the turmoil in the region, in particular the slowdown in economic activity in Thailand, strong growth of the still dominant agriculture sector mitigated some effects of the crisis (Chart 2 and Tables 2 and 3). Growth in the agriculture sector was estimated at 5¾ percent, 3 percent higher than in 1996, reflecting a favorable rice crop. The growth in the industrial sector slowed to 6½ percent, down from 17¼ percent in 1996, as a result of the impact of the regional crisis. The service sector enjoyed buoyant growth of an estimated 10 percent. Inflation accelerated during the second half of 1997, reflecting the depreciation of the kip against the U.S. dollar and loose monetary conditions.

CHART 1
CHART 1

LAO P.D.R.: Revenue Collection of Major Tax Categories, First Six Months of 1997/98

(In Percent of Revised Budget)

Citation: IMF Staff Country Reports 1998, 077; 10.5089/9781451822410.002.A001

Sources: Data provided by the Lao authorities; and staff estimates.
CHART 2
CHART 2

LAO P.D.R.: REAL GDP AND MAIN ECONOMIC SECTORS, 1993-97

Citation: IMF Staff Country Reports 1998, 077; 10.5089/9781451822410.002.A001

Source: Data provided by the Lao authorities; and staff estimates.
Table 1.

Lao P.D.R.: Selected Economic and Financial Indicators, 1993–97

Nominal GDP (1996): $1,846 million

Population (1995): 4.8 million

GNP per capita (1995): $374

Fund Quota: SDR 39.1 million

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Sources: Data provided by the Lao authorities; and staff estimates and projections.

Data are on a fiscal year basis (October-September).

Lending rates were liberalized in July 1995 and deposit rates in January 1996. The rates reported here are those quoted by the BCEL, the largest commercial bank.

Excludes debt to nonconvertible area; includes debt to the Fund (SAF and ESAF).

As a ratio of exports of goods and nonfactor services.

Average of buying and selling rate.

Table 2.

Lao P.D.R.: Real GDP Growth, 1993-97

(In percent)

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Source: Data provided by the Lao authorities; and staff estimates.
Table 3.

Lao P.D.R.: GDP by Industrial Origin, 1993–97

(In billions of kip, at 1990 constant market prices)

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Sources: Data provided by the Lao authorities; and staff estimates.

B. DEVELOPMENTS BY MAJOR SECTORS

4. Agriculture. The sector represents over 50 percent of GDP, and apart from forestry is still predominantly subsistent in nature. Crop production increased 11½ percent over 1996, when floods had severely affected rice output, supported by improved irrigation, and more intensive use of plowing machines and fertilizers (Table 4). Output of cash crops, including coffee, sesame seeds, and tobacco, has continued to increase, mainly for export to neighboring countries. Looking ahead, the government aims to achieve self-reliance in rice by the year 2000 and has started a large irrigation program (Box 1).

Table 4.

Lao P.D.R.: Output of Major Commodities, 1993-97

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Sources: Data provided by the Lao authorities; and staff estimates.

5. Logging. Responding to reduced demand from Thailand, in the wake of the financial crisis, less timber was harvested in 1996/97 than planned (560,000 cubic meters, compared to the target of 626,000 cubic meters). Profitability of the industry was further adversely affected by a decline in world timber prices, accentuated in the second half of the year when Indonesia reduced its prices substantially. Consistent with the government’s medium-term strategy of keeping the annual logging quota below a sustainable pace of 500,000 cubic meters, the harvesting plan for 1997/98 aims to clear only 464,000 cubic meters, one third from the Nam Theun 2 hydropower site.

6. The management and harvesting plans for all sites are prepared by the Ministry of Agriculture, Department of Forestry. Since 1997, implementation has been brought under the control of the provincial authorities. Most of the logging is done by three state-owned enterprises under the control of the Ministry of Defense. Further innovations, however, in the government’s forestry policy include the intention to draft management plans for each individual logging site (at this time, there are only management plans for the production in each province) and to open the logging market for other companies. The government is in the preparatory stages of setting up a joint venture with a Malaysian company, to start logging in 1999.

Financial Implications of the Irrigation System

Faced with substantial rice supply problems in 1997, the government of the Lao P.D.R. started a project to increase rice production by enlarging the irrigated rice-growing areas from 22,000 ha in early 1997 to 100,000 ha by 2000. Such output would make the Lao P.D.R. self-sufficient in terms of rice production. The government financed the first phase, implemented in 1997, through the BOL. The investments for 1998/99 and 1999/2000 are to be included in the PIP and, thus, be financed directly through the budget.

The financing of the first phase was spread over fiscal years 1996/97 and 1997/98. Part of the financing was done directly in dollars (purchases of equipment from abroad), while the installation was financed in local currency. Based on the BOL accounts, the following reconstruction of the flows involved can be provided:

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Converted at the exchange rate at the time of the transactions, the total cost in local currency is estimated at KN 65 billion.

The purchase of the equipment abroad was paid directly by the BOL, in dollars, from its international reserves. The kip-part of the operation (to finance the installation and the power lines from Vientiane) took the form of loans from the BOL to the individual farmers. The BOL classified these loans partly as lending to the SOE’s, partly as lending to the private sector. It is the BOL’s intention to take these loans off its books by selling them to the commercial banks at a later stage. Agreements are being worked out whereby the farmers, directly or through a state agency, will repay the government. No part of this operation had entered the government budget.

To enhance transparency, the staff has brought these extrabudgetary expenses into the fiscal accounts and shown them in the monetary accounts as claims on the government, as indicated in the table below. Thus, both the 1996/97 and 1997/98 capital expenditure outturns were revised. The impact for 1996/97 is an increase in the capital budget (and the overall deficit) of about 1 percent of GDP and for 1997/98 an increase of 1½ percent of GDP. In the monetary survey, the reduction in credit to the nongovernment sector is offset by an increase in credit to the government.

Fiscal accounts before and after inclusion of irrigation financing

(in percent of GDP)

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Monetary accounts at end-1997 before and after reclassification of irrigation financing

(KN billions)

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7. Industry. The share of industry (mining, manufacturing, construction and electricity) in GDP was about 20 percent. Industrial output grew by only 6½ percent in 1997, affected by the Thai crisis and difficulties in negotiating preferential trading terms with the United States and the European Union. Manufacturing, accounting for 75 percent of the total, grew more slowly than in 1996 (7 percent compared with 18 percent). Growth of output of garments and wooden products was sluggish, offsetting a major expansion of beer production. Garment exports rebounded only marginally and one garment factory was closed, following the closing down of 10 enterprises the year before when the Generalized System of Preference (GSP) status was withdrawn. Though there had been high hopes of the United States according the Lao P.D.R. Most Favored Nation status, negotiations were not concluded and GSP status was restored by the European Union only in October 1997 (under the new arrangement, the Lao P.D.R. received a one-year derogation from the local content regulation, to allow all ASEAN inputs to count as local value-added). Two new factories are planned to open in 1998.

8. Long periods of drought resulted in a general shortage of water during most of 1997 and lower electricity production. In April 1998, a new hydropower dam (Theun Hinboun) came into operation, more than doubling the country’s electricity capacity and contributing to an expected increase in production of 1582 GWH in 1998. Activity in the construction sector slowed down in the second half of the year, when several Asian investors decided to delay projects.

9. Services. Representing 25 percent of GDP, growth in the services sector in 1997 continued to be strong with both wholesale and retail trade and transportation and communication recording growth rates of about 10 percent. New roads to the suburbs of the capital contributed to higher levels of transportation. Tourism also was a strong performer during 1997, with hotel and restaurant turnover increasing by 23 percent. However, the number of tourists dropped in early 1998, reflecting a decrease in visitors from Asian countries and recent problems encountered by Lao Aviation. The largest airplane in its fleet has been grounded at Bangkok airport because of lease payment arrears, disturbing the daily flight schedule to and from Bangkok.

C. PRICES, EMPLOYMENT AND WAGES

10. Inflation increased from about 13 percent in December 1996 to over 25 percent one year later and to 45 percent by March 1998 (Table 5). Sharp increases in food prices, especially rice as a result of shortages in the wake of the 1996 floods, began to push up inflation during the second quarter in the southern provinces, spreading to other cities during the second half of the year. Shortages were also accentuated because Thai traders started buying rice paddy in Lao cities, preventing prices from falling after the new crop became available. Starting in July, a sharper rise in consumer prices also reflected higher import prices following the depreciation of kip against the dollar—nonfood prices rose by 23 percent between August 1997 and January 1998. The pressure on prices continued in early 1998, affected by the depreciation of the kip against Thai baht.

Table 5.

Lao P.D.R.: Consumer Price Indices, 1993–98

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Source: Data provided by the Lao authorities.

11. Wages increased significantly in 1997. The average monthly wage for civil servants was KN 45,000 at the end of the year, following a salary increase of 8 percent on average (KN 3,300 per month was awarded across the board), given at the beginning of the 1997/98 fiscal year (Table 10). Average wages in the private sector were unofficially reported to have increased by about 35 percent in 1997. Moreover, the minimum wage for civil servants and workers in production, business and service sectors was increased by 40 percent in October 1997 (from 26,000 kip to 36,400 kip per month). There are no official statistics on unemployment and private sector wages in the Lao P.D.R—according to a census carried out by the National Statistical Center, in 1995 the unemployment rate was 2.4 percent and no further information has been made available.

III. Public Finance

A. Overview

12. Whereas the 1995/96 budget outcome was generally better than expected (the current surplus reached 2¾ percent of GDP, ½ percent more than planned and the overall deficit was, at 9 percent, marginally lower than budgeted), the fiscal position worsened in 1996/97, and the outcome of the first six months of 1997/98 again indicates that it will be problematic to achieve the budget targets (Tables 7, 8 and 9). Thus, fiscal consolidation has not made substantial progress in the last and current fiscal year.

Table 6a.

Lao P.D.R.: Wages by Economic Sector, 1992, 1994

(In kips per month)

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Source: Data provided by Ministry of Labor.
Table 6b.

Lao P.D.R.: Wages by Occupation, 1994

(In kips per month)

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Source: Data provided by Ministry of Labor.
Table 7.

Lao P.D.R.: General Government Operations, 1993/94-1997/98

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Sources: Data provided by the Lao authorities; and staff estimates.

Includes revisions made in March 1998.

Excludes KN 14 billion of government bonds issued to recapitalize the state-owned commercial banks in August-September 1994.

Including grants.

Excluding grants.

Comprising bank and nonbank financing, and receipts from government asset sales.

Table 8.

Lao P.D.R.: General Government Revenue, 1993/94-1997/98

(In billions of kip)

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Sources: Data provided by the Lao authorities; and staff estimates.

Includes the revisions made in March 1998.

Table 9.

Lao P.D.R.: General Government Expenditure, 1996/97 and 1997/98

(In billions of kip)

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Original budget.

B. 1996/97 BUDGET

13. Targets. The 1996/97 budget, presented in September 1996, aimed to raise the current surplus to 3½ percent of GDP and reduce the overall deficit (before grants) to below 8 percent of GDP, to enhance fiscal sustainability. Revenue at that time was targeted to increase by ½ percent of GDP on account of the full-year effects of tax measures taken in 1995/96 and the introduction of excise duties on electrical goods. Current expenditure would remain broadly unchanged at 10 percent of GDP. The wage bill would remain below 5 percent of GDP, notwithstanding a 12 percent increase in base salaries. The capital budget targeted a further increase in spending on social sectors, in line with the Public Expenditure Review (PER) recommendations. An increase in government deposits with the banking system was foreseen because foreign financing of the budget was expected to exceed the planned deficit and because of the planned sale of Lao Telecom.

14. Revenue fell 1½ percent of GDP short of its target for a number of reasons. The tax administration encountered staffing and equipment problems while implementing the more sophisticated rules under the new tax law, leading to a shortfall of profit and income tax receipts. Excise duties were lower than planned because of the delayed implementation of the measure to replace exceptional import tariffs (those above 40 percent) by an equivalent rise in excise duties.3 Import duties, although as expected in the GDP terms, could have been higher if appropriate valuation techniques had been applied.4 Timber royalties fell short of their target because sales to Thailand stalled in the last quarter of the fiscal year in the wake of the Thai crisis. In the nontax categories, shortfalls in leasing, overflight and interest receipts were largely offset by higher dividend payments. Given that several of these revenues are collected in U.S. dollars, this was still a disappointing result in light of the depreciation of the kip during the fiscal year. Leasing income was lower because several leases were not renewed and some companies facing financial difficulties obtained an exemption from lease payments. The shortfall in overflight receipts was related to the outdated and inaccurate equipment used to record overflying aircraft.

15. Current expenditure was slightly lower than budgeted in GDP terms, reflecting firm government control over spending in light of the unfavorable revenue developments. External interest payments remained low, because of the concessional nature of government debt. Domestic interest payments rose after the government agreed, in the course of the year, to bear the interest cost of securities issued by the BOL to absorb excess liquidity. The wage bill was marginally higher than originally planned because 900 new staff were hired during the second half of the year. These new staff were employed by the Ministries of the Interior, Justice and Foreign Affairs, respectively to strengthen the courts and the police force and to fill newly created ASEAN-related jobs (including for diplomatic representations in other ASEAN capital cities). Following the transfer of the personnel department to the party headquarters in December 1996, civil service reform slowed down markedly. No progress was made in standardizing hiring procedures. In addition, coordination problems emerged between hiring and departures as these issues were handled by different departments. At the end of 1996/97 there were 69,610 civil servants (Table 10).5

Table 10.

Lao P.D.R.: Personnel and Salaries of Civil Servants, 1993/94-1997/98

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Sources: Data provided by the Lao authorities.

Data relate to beginning of fiscal year (October). Military personnel is excluded. Number for 1997/98 is target for the year. Actual number at the beginning of the year was 69,610.

Excludes bonuses and other compensations.

Includes wages, salaries, and other compensations of military and nonmilitary personnel.

16. Capital expenditure was about 1 percent of GDP higher than projected, mainly on account of the extrabudgetary expenditures related to the building of irrigation systems. During the last quarter of the fiscal year, the BOL spent KN 18 billion on this operation on behalf of the government; these expenditures were included in the budget presentation to enhance fiscal transparency. In line with the World Bank recommendations in the PER, spending on education was increased to 3 percent of GDP and health to 1.8 percent of GDP. Spending on the economic sectors (infrastructure, transportation, agriculture) was slightly reduced to 9 percent of GDP.

17. The disappointing revenue outcome caused the current surplus to be only 1¾ percent of GDP, a deterioration compared with the previous year. The overall deficit (before grants) was 9¼ percent, more than 1½ percent worse than planned. This deficit was totally foreign-financed (grants and concessional loans). Thus, the receipt of KN 48 billion from the partial sale of Lao Telecom, although partly offset by the financing of irrigation equipment, allowed the government to increase its deposits with the banking system by KN 14 billion. Lao Telecom was the last large company on the government’s privatization list. The government also reduced its debt towards the nonbank sector by reimbursing a stock of older securities.

C. 1997/98 BUDGET

18. Targets. The government presented to the National Assembly, as part of the 1997/98 budget, a package of revenue enhancing measures to regain the grounds lost in 1996/97 and to increase reliance on domestic taxes, away from trade taxes. The budget was presented in the new budget nomenclature, a condition under the World Bank Structural Adjustment Credit (SAC III). This new nomenclature, specifying expenditure by ministry and for headquarters and provinces separately, will allow the government to monitor current and capital expenditure more closely. The budget targeted revenue at 13¾ percent of GDP, more than 2 percentage points higher than the 1996/97 outcome. This increase was to come from:

  • rationalizing income tax rates;

  • reducing turnover tax rates from four (3, 5, 10 and 15 percent) to two (7 and 10 percent);

  • imposing excise duties on those items that would go from the 15 to the 10 percent turnover tax rate, to make this part of the operation revenue-neutral;

  • increasing excise duties on petroleum products;

  • introducing a stamp duty; and

  • increasing land tax on commercial and residential land in urban areas.

Total expenditure was set to increase slightly to 21 percent of GDP. Current expenditure (10½ percent of GDP) would be affected by the inclusion, for the first time, of funds to finance the restructuring of the state-owned electricity and water companies, explicit interest subsidies for agricultural lending,6 the cost of ASEAN membership and a contingency for state commercial bank (SCB) restructuring. The budget also incorporated a 13 percent increase in the wage bill with the first 8 percent to be given at the beginning of the fiscal year and the remainder at the time of the introduction of new salary scales. Planned spending on defense and security was reduced as a share of total spending (by 2 percentage points). The capital budget was set at 10¾ percent of GDP, with a further increase in outlays for health and education. A larger proportion of the capital budget was allocated to the provinces as part of a policy of decentralization (4 percent more than in 1996/97). The overall deficit would be more than financed through grants and concessional loans, allowing a further build-up of government deposits at the banking system (2.3 percent of GDP). Part of these foreign inflows would be a disbursement by the World Bank under SAC III of $19.2 million.

19. Fiscal performance during the first six months has been disappointing, in particular on the revenue side, mainly because the package of revenue enhancing measures, proposed by the government to the National Assembly, was not approved. In addition, import duties suffered from lower-than-expected imports and from the use of outdated exchange rates, while low timber exports led to reduced timber royalties. Moreover, timber royalty rates were lowered in January 1998 in an attempt to improve the Lao P.D.R.’s competitive position. As a result, tax revenue, at 40 percent of the amended full-year target, was much lower than expected, despite the gains that should have been realized from the exchange rate depreciation and inflation. Nontax revenue, however, did benefit from the depreciation—at 61 percent of the full-year target, receipts were better than planned.

20. Concerned by the poor revenue performance, the government presented a new package of revenue measures to the National Assembly in March 1998, consisting of the original measures plus some additional actions to offset some of the losses due to the delays incurred. However, the package was still under consideration in late May and it is expected that there will be a revenue shortfall of about 1 percent of GDP in 1997/98.

21. Current and budgetary capital expenditure were broadly on track after six months, having been managed conservatively in light of the slow revenue developments. The first wage increase was given in the form of a “cost of living” adjustment, involving an across-the-board salary increase of KN 3,300 and an increase in transfers to spouses, children and retirees, bringing the total increase to KN 12 billion, on an annual basis (a 13 percent increase in the wage bill). Allocation of an additional KN 5 billion to the base salary bill (including cost of living adjustment) and KN 12 billion to function benefits has been held up pending the introduction of a more competitive wage structure. The new structure has yet to be approved by the government and some savings are expected this fiscal year.7 Adjustments in other current expenditure items were made to reflect the effect of the exchange rate depreciation (materials and supplies, restructuring of SOEs, and interest payments).

22. In light of the disappointing revenue developments, the government decided to cut non-priority capital expenditure. However, these cuts were more than offset by the inclusion of the spending on irrigation systems (with an impact of 1½ percent of GDP in 1997/98), leading to an estimated capital budget of over 14 percent of GDP (compared with the original target of 10¾ percent of GDP).

23. As a result of these developments, the current surplus will be smaller than budgeted (3 percent of GDP) and the overall deficit much wider (over 11 percent of GDP). Mainly as the outcome of the financing of the irrigation systems, there will be no room for further building up government deposits with the banks.

IV. Privatization and commercialization of State-owned enterprises

A. Privatization

24. Following the sale of Lao Telecom in late 1996 and the decision to retain Lao Tobacco in the government portfolio for the time being, the privatization momentum has dissipated. The remaining nonstrategic SOEs to be divested were all small in size and did not employ a sizable number of staff. During 1997, the government divested 13 enterprises, for a total value of $3 million (Annex II), through management buyouts, divestment to provincial authorities and a few liquidations. Lao Tobacco was retained in government hands because no acceptable price and terms could be obtained.

25. The government recognizes that the remaining 32 nonstrategic enterprises, for a total value of about $3 million, and employing about 1,100 workers, will be hard to sell since their assets are limited and several of the companies are not viable. All enterprises have been advertized for sale, but the government will soon start liquidating several of them, with the aim to divest them all by the end of 1998. This will be the end of one of the most successful parts of the Lao P.D.R.’s structural reforms thus far. In the early 1990s, the Lao government controlled more than 800 enterprises. The remaining 33 “strategic companies” are in the process of being commercialized so that they can compete with the private sector on equal terms and give impetus to private sector development.

B. Commercialization

26. In 1997, the government’s attention shifted from the privatization program to the commercialization of the 33 strategic enterprises (32 original ones and Lao Tobacco) that will remain in government hands. The value of these enterprises is estimated at KN 245 billion and they employ about 11,000 staff. Of these enterprises, eight are commercial banks and the remainder are utility companies and the three holding companies primarily engaged in logging. In 1996, the government started a pilot project under which five SOEs would be commercialized (Electricité du Laos (EDL), Nam Papa (water), Postes du Laos, Industrie Pharmaceutique No. 2, and Imprimérie Nationale (printing)). The commercialization program consists of (i) converting and registering them into public joint-stock companies; (ii) appointing Boards of Directors; and (iii) agreeing on performance plans setting out technical, commercial and financial objectives and specifying performance improvement criteria.

27. Despite some delays, significant progress has been made. For EDL, all three parts of the restructuring operation were finished in early January 1998. Meanwhile, the government has started a financial restructuring of the company (as envisaged in the 1997/98 budget). EDL is not paying dividends toward this year’s budget and will undergo a debt rescheduling operation. Boards have also been appointed for Nam Papa, the Post company and Lao Tobacco. The two other parts of the program (legal transformation and performance contract) are expected to be in place for these companies by mid-year. A similar timetable is envisaged for the printing and the pharmaceutical company. The government aims to finish similar operations for most of the other nonbank enterprises before the end of the year.8 Simplification of the performance contracts, compared to the ones prepared for the pilot companies would expedite the operation. The largest stumbling block seems to have been the appointment of boards of directors because of shortage of qualified people. Financial restructuring will be necessary for several of these SOEs. In this regard, the government has undertaken audits of the three holding companies engaged in logging, contemplating a reorganization of these enterprises because they are involved in too wide a variety of social and economic activities.

V. monetary policy and financial system

A. Developments in Money and Credit

28. Monetary developments in 1997 took place against a backdrop of the unfolding crisis in Thailand, Lao P.D.R.’s major trading partner. Though the importance of the depreciation of the baht against the U.S. dollar should not be understated, monetary policy inaction contributed to the disappointing outcome. Particularly during the second half of the year, monetary policy was subordinated to other policy considerations.

29. During the first half of 1997, growth in the money supply was moderate (Tables 11 and 12). Reserve money grew by only 2 percent, which served to hold the growth in broad money to 13 percent, despite the valuation effects of a 12 percent depreciation of the kip in this period. However, the moderation was achieved partly through a $10 million drawdown of international reserves (partly the result of capital flight spurred by the crackdown in the parallel exchange market in May). Direct credit from the BOL, which represented about 13 percent of the stock of credit to the nonbank public at the beginning of the year, grew only slightly in the six months to June 1997. However, net domestic credit grew by 24 percent in the same period. While this increase included valuation effects, it also reflected the effects of the BOL’s decision to discontinue bank-by-bank credit ceilings at the beginning of the year.

Table 11.

Lao P.D.R.: Monetary Survey, 1994-97

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Sources: Data provided by the Lao authorities; and staff estimates.

Net credit to Government in 1994 included KN 14 billion of government bonds issued for recapitalization of state-owned commercial banks. Bad loans amounting to KN 14 billion were written off from the bank’s portfolios. Includes liabilities from borrowing under the structural adjustment facility and the enhanced structural adjustment facility.

Excluding bad loan write-off.

Broad money divided by reserve money.

Table 12.

Lao P.D.R.: Sources of Broad Money Growth, 1996-97

(Increase as percent of previous period broad money)

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Sources: Data provided by the Lao authorities; and staff estimates.

30. During the second half of the year, and into 1998, the situation deteriorated markedly, with expansionary policies being pursued in an environment where confidence in the currency had already been shaken. In the aftermath of the crackdown in the parallel market and the uncertainty brought about by the plummeting baht, there was a substantial expansion of direct credit from the BOL to finance the building of the irrigation system (KN 86 billion, about half of all the new credit extended between June 1997 and January 1998). The equivalent of $25 million of this credit was used directly for imports, and contributed to the $45 million decline in net foreign exchange reserves of the banking system registered during the year. The rest of these credits, around KN 26 billion, represented a direct infusion of cash into the economy. Between end-August 1997 and end-January 1998, currency in the hands of the public increased by 22 percent.

31. The resulting growth rate for broad money for 1997 was 64 percent. Abstracting from valuation effects, money grew by 23 percent during the year. Foreign currency deposits (expressed in U.S. dollars) dropped in the wake of the May crackdown and started to recover only during the last quarter of the year, to end near the level of 12 months earlier. Reserve money, less affected by the exchange rate, grew by 44 percent. Total credit, both from commercial banks and from the BOL, rose more rapidly than had been originally envisaged (Tables 15 and 16). Credit to the economy increased by approximately KN 130 billion (excluding the effects of devaluation on foreign currency loans) during the second half of the year alone.

B. Monetary Policy

32. Efforts to use monetary policy to maintain macroeconomic stability during 1997 were sporadic and generally ineffectual. At the beginning of the year, the BOL announced its intention to abandon the use of bank-by-bank credit ceilings because they were deemed inefficient. However, resort to moral suasion did not prove very effective. The use of indirect instruments—issuance of treasury and BOL bills—was discontinued around mid-year. The use of the reserve money programming framework was stopped early in the year, depriving the BOL of a basic framework to decide on the size of intervention needed to control liquidity. Inaction was fed by growing reluctance of the government to bear the cost of monetary interventions through either BOL or treasury bills and reluctance to increase the interest rates on either securities necessitated by the acceleration in inflation.

33. As a result of the government’s indecisiveness and easing of monetary conditions, interest rates on treasury bills went slightly down during the year and the stocks of outstanding treasury bills and BOL bills decreased. Maturing treasury bills that had been issued earlier added to the liquidity of the banking system during the second half of the year. Commercial bank interest rates remained broadly unchanged throughout the year, leading to real interest rates becoming significantly negative. This rigidity in interest rates was in part a result of high levels of kip liquidity in the system (Tables 13 and 14).

Table 13.

Lao P.D.R.: Interest Rates, 1993-97

(In percent; end of period)

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Source: Data provided by the Lao authorities.

In June 1995, the maximum lending rate was abolished. The guidelines on minimum deposit rate were abolished in January 1996.