Lao PDR. Economic Monitor. MiTigATing RiSkS AnD DEEPEning REfoRMS. May UPDATE THE WORLD BANK. Public Disclosure Authorized

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1 SUSTAining RobUST growth MiTigATing RiSkS AnD DEEPEning REfoRMS Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Lao PDR Economic Monitor May UPDATE THE WORLD BANK Lao PDR

2 The world bank All rights reserved This publication is a product of the staff of the World Bank. The findings, interpretations, and conclusions expressed herein not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. Lao Economic Monitor - May 212 UPDATE is issued in Lao and English by the World Bank Office in Lao PDR. This Update reports on recent economic developments and medium-term outlook for the country (Part I) and key reform progress made in 211 and early 212 (Part II). The paper was prepared by the World Bank Office s macroeconomic policy team consisting of Somneuk Davading (Senior Economist Task Team Leader), Keomanivone Phimmahasay (Economist Co-Task Team Leader), and Genevieve Boyreau (Senior Country Economist) under the overall supervision of Mathew Verghis (Lead Economist for South-East Asia Region). We are thankful for inputs from Saysanith Vongviengkham (Public Finance Specialist), Minh Van Nguyen (Sr. Public Finance Specialist), Shabih Mohib (Senior Economist), Ratchada Anantavrasilpa (Financial Sector Specialist), Richard Record (Trade Specialist) and Konesawang Nghardsaysone (Trade Analyst). We are grateful to the Government (especially BOL, MOF, MPI/LSB, MEM, MOIC, LNTA, MAF and other ministries), LNCCI (including key business associations) and other organizations for providing inputs. We would like to also thank our World Bank colleagues: Meriem Gray, Souridahak Sakonhninhom, Alounsavath Davong, Vatthana Singharaj, Phet Udom Mainolath for inputs, dissemination and logistics. THE WORLD BANK TEAM APPRECIATES FEEDBACK ON STRUCTURE AND CONTENT OF THE MONITOR For further information please contact World Bank Lao PDR Country Office: Ms. Keomanivone Phimmahasay (kphimmahasay@worldbank.org) Mr. Somneuk Davading (sdavading@worldbank.org) The World Bank Lao PDR Country Office Patouxay Nehru Road P.O Box 345 Vientiane, Lao PDR Phone: (856-21) 45-1

3 1 L a o P D R E c o n o m i c M o n i t o r - M A Y EXECUTiVE SUMMARY with development soaring in construction, manufacturing, mining and services, Lao PDR s economic outlook in 212 is positive. As the driving force behind the domestic economy, these sectors are anticipated to drive a projected growth of 8.3 percent by year-end. To begin, higher wholesale and trading, tourism as well as transport and telecommunications will impact the service sector this year. A construction boom is also on the horizon supported by the preparation for the 9th Asia-Europe Meeting (ASEM) in Vientiane Capital. i With this said, construction will support the manufacturing sector with the additional demand for cement and construction materials. Food and beverages will also expand in response to sustained domestic demand. Additionally, Phu Bia Mining Company s upgrade of existing copper and new gold and silver projects will generate more output from the mining sector. On the other hand, the power sector will contribute less in comparison to last year, despite the operation of Nam Ngum 5 hydropower project. In the mean time, agricultural output is expected to rebound after the adverse impacts of 211 s floods. Despite this robust growth, the medium-term outlook remains subject to uncertainty in external markets. headline inflation has trended downwards since november 211, due to a decrease in food and fuel inflation. Headline inflation fell from 7.9 percent (yoy) in November 211 to 4.4 percent in April 212. Food inflation has declined from 1.7 percent to 6 percent in the same period following a decline in the rice price. Declining rice prices are explained by a high base effect in 211, a harvest season of irrigated rice in recent months, and the government s tightened control on rice exports. Energy prices continue to grow, but at a slower pace compared to last year due to a high base effect in 211 and the fuel price cap set by the government. This slowdown drove energy inflation down in April this year. Core inflation started to pick up in April 212 due to higher prices in housing and electricity tariffs as well as restaurants and hotels. This year s budget (211/12) features increased exposure to hydropower and mining revenues. However, fiscal deficit is expected to rise to 3.2 percent of GDP compared to 2.7 percent in 21/11 due to faster increase in public expenditure. Total revenue is projected to grow moderately, driven by higher grant receipts. The ratio of domestic revenues will remain at 16.9 percent the same level as the previous fiscal year due to slow down in non-resource sector revenue despite higher revenue from the resource sector. Resource sector revenues will benefit from high copper and gold prices, and the higher output from completed project expansions in the mining sector. On the other hand, non-resource sector revenue is expected to grow below GDP bringing the share of non-resource sector revenue down from 13.2 percent to 12.6 percent over the same period. This, coupled with an expected increase in expenditures, will result in non-resource and non-mining deficits deteriorating from 1.7 percent and 1 percent in 21/11 to 12.6 and 11.6 percent in 211/12. ii Total fiscal outlays are projected to rise from 23.9 percent in 21/11 to 25.2 percent in 211/12 attributable to capital spending on flood recovery iii, preparation for ASEM and poverty reduction projects. Regarding the quasi-fiscal spending that has occurred in previous years, the government remains committed to stop any offbudget spending for new public sector projects, and to re-pay past off-budget commitments on-budget, as cited in the 212/13 budget preparation instruction. In the meantime, higher recurrent expenditure is expected, targeting an increase in wages, compensations and allowances following the government policy of promoting the expansion of social public services to remote areas. i Ninth ASEM Summit to be held on November in Vientiane, Lao PDR. Projects for preparation include the construction of a convention centre, villas and the expansion and upgrading of Vientiane s Wattay International Airport. ii The non-resource fiscal deficit indicates the extent in which domestic revenue outside the mining and hydropower sectors may finance total government expenditures. This indicator also reflects revenue performance in the non-resource sector. The non-mining fiscal deficit indicates to what extent government spending is exposed to volatility associated with commodity (gold and copper) prices. Revenue from the hydropower sector is considered more stable as purchase agreements are made in advance with fixed prices. iii As a result of Haima and Nockten storms in 211.

4 2 E x e c u t i v e S u m m a r y Larger fdi and transfers outside the resource sectors are expected to help improve the overall balance of payment surplus in 212. Higher income repatriation in the mining sector is expected to outpace the expansion of direct investments and trade surplus resulting in a moderate decline in the resource sector s balance of payment surplus. Capital imports for the resource sector are likely to augment due to the growing investments in the power sector. iv Outside the resource sectors, the balance of payment is in deficit, but will improve this year following investment inflows outweighing a slight deterioration of the non-resource current account deficit. In trade, larger imports of consumption and capital goods, some of which attributable to the preparation for the 9th ASEM Summit in 212, will deteriorate the trade deficit. These imports will be partly financed by foreign investments in hotels, manufacturing and construction. Despite the reduction in the overall surplus in the resource sector, the net inflows to the non-resource sector are expected to bring slight accumulation of reserves in 212. The government continues to follow a policy of stabilized exchange rate against major currencies. From October 211 March 212, a strong demand for Lao Kip (LAK) and inflows of foreign exchange associated with investments and exports led to a.3 percent appreciation against the US Dollar. The LAK also appreciated against the Thai Baht by 1. percent during the same period, primarily due to the depreciation of the Baht against the Dollar. following a period of rapid expansion, growth in the private credit slowed down in 211 due to the combination of a base effect following last year s growth and less liquidity (long-term lending) in the banking sector. This deceleration fell from almost 34 percent in 21 to 23.4 percent (yoy) in 211. However, lending to state-owned enterprises moderately accelerated in 211 from 53.4 percent (yoy) in 21 to 6.8 percent (yoy) in 211. This was partly due to loans to Lao Airlines that financed the purchasing of 2 Airbus aircrafts. The government explicitly expressed their commitment to stop any quasi-fiscal activities in their 212/13 budget preparation instruction. Non-performing loans are reported to have declined to 2.18 percent in 211 from 3.2 percent 21. key areas of reform have undergone important developments. In 211, the National Assembly revised and approved the General Tax Law introducing public finance to a transparent, turnover based presumptive tax regime for businesses with a turnover below the VAT registration threshold. In effect, this law eliminated minimum business tax. The treasury zero-balance accounts reform also demonstrated progress after the transfer of all major large accounts at the central level and technical revenues accounts into National Treasury s control. Customs revenue management is expected to benefit from the deployment of the ASYCUDA World System currently in place at Lao PDR s largest border checkpoint, Thanaleng/Friendship Bridge. In relation to this, the National Assembly passed the revised Customs Law in December 211. In the meantime, the Ministry of Industry and Commerce is updating the Diagnostic Trade Integration Study and its Action Matrix that lays out the framework for the next phase of trade-related reforms. In addition to the progress made with these reforms, the World Trade Organization accession process achieved solid momentum in negotiations with the European Union and the United States. Finally, the implementation of the one-stop service (as stipulated on the Enterprise Law and the new Investment Promotion Law) commenced in October 211. iv For example, Hongsa Lignite project, Nam Ngum 5, Nam Ngum 3 and Nam Ngiep 1, Huay Lam Phanh Yai, Nam Khan 2, etc.

5 3 L a o P D R E c o n o m i c M o n i t o r - M A Y ACRonYMS AnD AbbREViATionS ADB APG AML/CFT ASEAN ASEM ASYCUDA ATM BOL BOP COD CPI DT DTIS EAP EDL EU FDI FY GDP GFIS GNI GOL GSP IDA IF IFC IMF IPP LAK LDC LSB Asian Development Bank Asia Pacific Group on Money Laundering Anti-Money Laundering and Combating the Financing of Terrorism Association of Southeast Asian Nations Asia-Europe Meeting Automated System for Customs Data Automated Teller Machine Bank of Lao PDR Balance of Payment Commercial Operation Date Consumer Price Index Deposit Taking Diagnostic Trade Integration Study East Asia & Pacific Electricité du Lao European Union Foreign Direct Investment Fiscal Year Gross Domestic Product Government Financial Information System Gross National Income The Government of Lao PDR Generalized System of Preferences International Development Association Integrated Framework International Finance Corporation International Monetary Fund Independent Power Producers Lao Kip Least Developed Country Lao Statistics Bureau LSX MFIs MOF MPI NA NBFIs NDT NEER NFA NPL NPS NSEDP NT2 PER PFMSP PPG PO REER RO SAO SCUs SME SOCBs SOE TIMS VAT WB WEO WP WTO YOY Lao Securities Exchange Micro-Finance Institutions Ministry of Finance Ministry of Planning and Investment National Assembly Non-bank Financial Institutions Non-Deposit Taking Nominal Effective Exchange Rate Net Foreign Assets Non-Performing Loan National Payment System National Socio-Economic Development Plan Nam Theun 2 Project Public Expenditure Review Public Finance Management Strengthening Program Public and Public Guaranteed Public Offering Real Effective Exchange Rate Right Offering State Audit Organization Saving and Credit Unions Small and Medium Sized Enterprise State-Owned Commercial Banks State-Owned Enterprise Treasury Information Management System Value Added Tax World Bank World Economic Outlook Working Party World Trade Organization Year on year

6 4 4 T a b l e o f C o n t e n t s TAbLE of ConTEnTS EXECUTiVE SUMMARY ACRonYMS AnD AbbREViATionS PART i RECENT ECONOMIC DEVELOPMENTS GROWTH AND INFLATION GOVERNMENT S REVENUE AND EXPENDITURE PUBLIC DEBT EXTERNAL BALANCE MONETARY SECTOR PART ii STRUCTURAL AND POLICY REFORMS PUBLIC EXPENDITURE POLICY AND MANAGEMENT REFORMS FINANCIAL SECTOR DEVELOPMENT TRADE REFORM PRIVATE SECTOR DEVELOPMENT AnnEXES ANNEX 1 THE GLOBAL ECONOMIC OUTLOOK IN SUMMARY ANNEX 2 LAO PDR AT A GLANCE figures Figure 1. Growth and Inflation, (percent change) Figure 2. Real GDP Growth (at factor cost): Contribution by Sector (percentage points) Figure 3. Monthly Inflation (yoy percent change) Figure 4. Contributions to Food Inflation Figure 5. Glutinous rice prices Figure 6. Structure of Domestic revenue (% of GDP) Figure 7. Key Fiscal Expenditures (percent of GDP) Figure 8. GOL s Fiscal Performance (percent of GDP) Figure 9. Total Government Revenues (% of GDP) Figure 1. Balance of Payments (% of GDP), Figure 11. World Commodity Prices (index 25=1) Figure 12. Mining Exports (Index 25 = 1) Figure 13. Merchandise Imports (US$ million) Figure 14. FDI in Lao PDR, Figure 15 Merchandise Exports (US$ million) Figure 16 Kip Exchange Rate (Index Dec-26 =1) Figure 17. Nominal and Real Effective Exchange Rate (Index Dec-26 =1) Figure 18. NFA and international reserves have increase Figure 19. Contribution to Total Credit Growth (percentage points) Figure 2. Comparing Credits from the Banking Sector (% of GDP) Figure 21. Credit growth continues to slow in 211 Figure 22. Net foreign asset coverage (%) Figure 23. Financial deepening and de-dollarization of the economy (% of GDP) TAbLES Table 1. GOL s Priority Sectors Expenditure Note: all dollar figures are in US unless otherwise indicated

7 L a o P D R E c o n o m i c M o n i t o r - M A Y PART I RECEnT EConoMiC DEVELoPMEnTS The global economic recovery continues to be affected by the Euro area financial crisis and political fragilities in several countries. This is reflected in the global output, which is expected to expand by 3.3 percent in 212, revised down from an earlier projection of 4 percent. The European economy is projected to contract and drift into a mild recession in 212. Subsequently, emerging and developing economies are likely to experience decelerated growth due to a weakened domestic demand and a dimmed global economic situation. Nevertheless, these economies will still experience the strongest growth in comparison to other regions. The demand for commodities from Lao PDR by key trading partners in this group still helps the Lao economy. This will enable the country to maintain robust growth in 212 driven by resource sector performance and dynamics in the nonresource sector. Lao PDR s country-level projections for FDI and export demand are based on the regional and global economic outlook and commodity prices from the IMF (WEO Jan 212) and the World Bank's projections (EAP Update May 212), as presented in Annex 1. growth AnD inflation with development soaring in construction, manufacturing, mining and services, Lao PDR s economic outlook in 212 is positive. As the driving force behind the domestic economy, these sectors are anticipated to drive a projected growth of 8.3 percent by year-end (Figure 1, Figure 2). To begin, higher wholesale and trading, tourism as well as transport and telecommunications will impact the service sector this year. A construction boom is also on the horizon supported by the preparation for the 9th Asia-Europe Meeting (ASEM) in Vientiane Capital. With this said, construction will support the manufacturing sector with the additional demand for cement and construction materials. Food and beverages will also expand in response to sustained domestic demand. Additionally, Phu Bia Mining Company s upgrade of existing copper and new gold and silver projects will generate more output from the mining sector. On the other hand, the power sector will contribute less in comparison to last year, despite the operation of Nam Ngum 5 hydropower project. In the mean time, agricultural output is expected to rebound after the adverse impacts of floods in 211. Despite this robust growth, the medium-term outlook remains subject to uncertainty in external markets. given heightened uncertainty in the global economy due to price volatility, the Euro area crisis and China s economic slowdown, Lao PDR s medium term growth for the period of 213 to 215 is projected to average at 7.5 percent a year. This projection is based on the assumptions of: i) dynamic growth in non-resource sectors (manufacturing, which includes processing industries; crops plantation; construction; tourism; banking and other Figure 1 Real gdp growth (at factor cost): growth and inflation (% change) Figure 2 Contribution by Sector (percentage points) Nonresource sectors (percentage points) Resource sectors (percentage points) Real GDP growth (percent) Headline Inflation (% annual average) Services Electricity, gas, and water Construction Manufacturing Mining and quarrying Agriculture and forestry Real GDP growth (%) Source: Government, LNCCI data and staff estimates and projections. * Yearly average for Source: Government, LNCCI data and staff estimates and projections. 5

8 R e c e n t E c o n o m i c D e v e l o p m e n t s services); ii) the successful implementation of large hydropower projects under construction and in the pipeline (such as the construction of the Hongsa Lignite Power Plant, Nam Ngum 5, Nam Ngum 3, Nam Ngiep 1, and other planned medium sized projects); and iii) a sustained demand for the country s main export products from key trading partners in Developing Asia, whose growth is projected to be most rapid from , in comparison to other regions (Annex 2). v Figure 4 Contributions to food inflation headline inflation has trended downwards since november 211, due to a decrease in food and fuel inflation. Headline inflation fell from 7.9 percent (yoy) in November 211 to 4.4 percent in April 212. Food inflation has declined from 1.7 percent to 6 percent in the same period following a decline in the rice price although meat prices remained high (Figure 4). Declining rice prices are explained by a high base effect in 211, a harvest season of irrigated rice in recent months, and the government s tightened control on rice exports. Energy prices continue to grow, but at a slower pace compared to last year due to a high base effect in 211 vi and the fuel price cap set by the government. Consequently, energy inflation declined to 3.7 percent (yoy) in April from 25 percent in November. Core inflation started to pick up in April 212 due to higher prices in housing and electricity tariffs as well as restaurants and hotels. Source: MPI (LSB) and staff calculations. Figure 3 Monthly inflation (yoy percent change) Figure 5 glutinous rice prices Food inflation (percentage points) Energy inflation (percentage points) Core inflation (percentage points) Headline inflation (percent change) Dec-8 Mar-9 Jun-9 Sep-9 Dec-9 Mar-1 Jun-1 Sep-1 Dec-1 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Source: MPI (LSB) and staff calculations Index Dec 25=1 Thai White Glutious Broken A.1 Special Thai glutinous rice 1% (export price, fob) Lao Rice price Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Apr-1 Jul-1 Oct-1 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Source: Thai Rice Exporters Association and Lao Statistics Bureau 6

9 7 L a o P D R E c o n o m i c M o n i t o r - M A Y government S REVEnUE AnD EXPEnDiTURE The 211/12 budget features increased exposure to hydropower and mining revenues. This year s fiscal deficit is expected to rise to 3.2 percent of GDP compared to a previous 2.7 percent due to a faster increase in public expenditure (Figure 8). With this said, the deficit is still within the target of less than 5 percent. viii ASEM preparation grants have supported moderate revenue growth from 21.2 percent to 22 percent this year. Domestic revenues will remain at 16.9 percent due to slow down in non-resource sector revenue despite higher revenue from the resource sector (Figure 6). Resource sector revenues will benefit from high copper and gold prices, and the higher output from completed project expansions in the mining sector. On the other hand, non-resource sector revenue is expected to grow below GDP bringing the share of non-resource sector revenue down from 13.2 percent to 12.6 percent over the same period. The slower revenue growth, coupled with an expected expenditure increase, have resulted in the non-resource and non-mining sectors deficit deteriorating from 1.7 percent and 1 percent in 21/11 to 12.6 and 11.6 percent in 211/12 respectively. Figure 6 Structure of Domestic revenue (% of gdp) Figure 7 key fiscal Expenditures (% of gdp) Nonresource revenue Mining Hydropower Domestic revenue FY8 FY9 FY1 FY11 FY12 FY Current expenditure Capital expenditure(off-budget) Capital expenditure (on-budget) Others/contingencies Total expenditurte FY8 FY9 FY1 FY11 FY12 FY13 Source: MOF and staff estimate and projection Source: MOF and staff estimate and projection Figure 8 gol s fiscal Performance (% of gdp) Figure 9 Total government Revenues (% of gdp) Revenue and grants Total expenditurte Nonresource deficit (domestic) Nonmining deficit (domestic) Fiscal deficit (Total) Capital expenditure(off-budget) FY8 FY9 FY1 FY11 FY12 FY13 Source: MOF and staff estimate and projection Revenue and grants Domestic revenue Tax Resource revenue Nontax FY8 FY9 FY1 FY11 FY12 FY13 Source: MOF and staff estimate and projection v World Economic Outlook Update, January 212 projected that Developing Asia s economies will grow at an average of 7.5 percent during This projection was revised downward from the 211 projection, but still remained higher than other regions. vi The government regulates fuel prices through the adjustment of tariffs and setting a reference import price. Ministry of Finance and Ministry of Industry and Commerce adjust tariffs on imported fuel (2 percent on special petrol, 15 percent on regular petrol, 5 percent for diesel). Despite such adjustment measures, fuel prices still rose following trends in the international market and high demand for fuel. According to the Fuel Association, demand for fuel has risen by 1 percent per year on average since 27. viii Budget Preparation Instruction for fiscal 211/12, No. 154/MOF, May 211.

10 8 R e c e n t E c o n o m i c D e v e l o p m e n t s Total fiscal outlays are projected to climb in this fiscal year. Total fiscal expenditure is projected to rise from 23.9 percent in 21/11 to 25.2 percent in 211/12, due to flood recovery efforts, preparation for ASEM, poverty reduction projects and higher recurrent spending (Figure 6). Damage from Haima and Nock Ten storms crippled the lives and local economies of thousands in Lao PDR. In response to the disaster, the government reportedly allocated 4 billion LAK (US$ 5 million equivalent) for flood recovery efforts. The government has allocated reserves into the State Accumulation Fund to support emergency responses. Parallel to this, the preparation for ASEM has augmented public capital expenditures through several projects, such as: the construction of the International Conference Centre through grants from China; Wattay International Airport expansion through grants from Japan; and the Wattay International Airport upgrade, supported by a loan from China. Higher spending on poverty reduction projects also contributes to the expanded public outlays. On recurrent expenditures, wages are expected to rise following the planned wage index increase and planned staff quota of more than 15,. ix Higher compensations and allowances are also projected as the government continues to promote the expansion of social public services to remote areas. x The government is committed to a budget deficit below 5 percent of gdp. According to the recently approved 212/13 Budget preparation instruction (No. 999/mof dated April 212), the implementation of the public expenditure must adhere to the approved budget plan from the National Assembly (NA) signifying the stop of spending outside the NA s approval. Following the 211 Tax Law amendment growth in tax revenue collection, particularly in the nonresource sector, is expected to slow due to lower tax rates. xi Revenue collection from the mining sector is projected to still depend on commodity price movements, despite the expected output expansion. The GOL is taking the following measures to meet its revenue targets: i) strengthening revenue centralization and administration; ii) developing capacity for technical revenue administration xii ; iii) closely monitoring gaps associated with imports of vehicles and fuels for investment projects; and iv) assessing other potential sources of revenue. On the expenditure side, the government remains committed to stopping any off-budget spending while past off-budget commitments should re-paid on-budget for 212/13. PUbLiC DEbT Multilateral credits still hold most of Lao PDR s external public and public guaranteed (PPg) debt. Despite this, bilateral creditors have emerged. Multilateral creditors hold approximately 6 percent of Lao PDR s external PPG debt. This primarily includes the Asian Development Bank (ADB) at 33 percent and the World Bank (IDA) at 21percent. Bilateral creditors, in which China, Russia and Thailand are the key creditors, hold about 36 percent of total external PPG debt. Aside from these primary lenders, India and Korea also increased their lending over the past three years. The remaining percent of external PPG debt comprises of external debt incurred by public entities on non-concessional terms and guaranteed by the government, mainly for hydropower development and electricity generation. This debt also includes the financing of equity stakes. The increasing presence of emerging market creditors, particularly China, underscores the need to strengthen debt management capacity, particularly to ensure that debt sustainability considerations are taken into account. A mitigating factor for Lao PDR s external debt burden lies in the prospective returns on the hydropower and mining projects that have been financed in part by external PPg debt. While the projects face construction and implementation challenges, the long-term power purchase agreements that are signed for these projects and projected government revenues in the form of royalties, dividends and profit tax payments, arguably reduce the risk of debt distress. Domestic public debt has accumulated in the past few years in order to finance local government s off-budget infrastructure projects. Lending from the Bank of Lao PDR (BOL) represents 82 percent of the recorded total domestic debt, with the remainder comprising of government bonds, in particular those related to the recapitalization of stateowned commercial banks. In 212/13, the government plans to issue bonds worth of 1.6 trillion LAK (US$2 million equivalent) to finance the planned increased expenditure. This is expected to add to public debt stock. ix Staff quota for 211/12 was reported at 15,34, while 17, were approved for 21/11. In 21/11, more than 9,6 of the quota were teachers, reflecting the government's effort to address teacher shortages in rural and remote areas. x PM Decree on Incentive Provision to Civil Servants Working in Rural and Inaccessible Area, Nov 21 xi xii That includes a lower excise tax, income tax, tax on rents and the removal of minimum business tax. In accordance with the Presidential Decree No. 3 and MOF Instruction No. 727/MOF dated 2 April 21. Technical revenue is considered a non-regular revenue base. Accumulated amount was 442 billion LAK in 29/1. However, the amount has declined to 22 billion LAK in 211/12.

11 9 L a o P D R E c o n o m i c M o n i t o r - M A Y EXTERnAL balance The overall balance of payment is projected to slightly improve in 212, as a result of augmented fdi and transfers outside the resource sectors (figure 1). The resource sector s balance of payment surplus is expected to moderately decline from 12.6 percent to about 11 percent in 212 following higher income repatriation in the mining sector, which offsets the expansion of direct investments and trade surplus in the resource sector. Projected net income repatriation is about US$95 million in 212 compared to approximately US$68 million last year due to higher output from mining project expansion and commodity prices (Figure 11, 12). It is projected that investment in the mining sector will considerably decelerate in 212 following the completion of the expansion and new projects by Phu Bia Mining Company (Figure 14). Capital imports are likely to augment by 28 percent (yoy) due to strong investments of large power projects such as Hongsa Lignite project, Nam Ngum 5, Nam Ngum 3, Nam Ngiep 1, Huay Lam Phanh Yai and Nam Khan 2. Figure Mining CAB Non-resource CAB Overall balance balance of Payments (% of gdp), Power CAB CAB Capital account balance Source: BOL and staff estimates and projections Nonresource overall balance (% of GDP) Overall balance Resource overall balance (% of GDP) Source: BOL and staff estimates and projections. Figure 11 world Commodity Prices (index 25=1) Figure 12 Mining Exports (index 25 = 1) Crude oil Copper price Rice Rubber Gold price Coffee Maize Gold output Gold price Copper output Copper price Source: WB DECDG s recent estim ates and projections Source: Lane Xang Minerals Limited and Phu Bia Mining Companies, 211

12 1 R e c e n t E c o n o m i c D e v e l o p m e n t s The non-resource sector s external balance is still in deficit, but demonstrates improvement this year. In short, investment inflows and transfers will outweigh deterioration in non-resource trade deficit. The non-resource external balance deficit is projected to moderately lower from 12.3 percent in 211 to 1.2 percent in 212. In trade, manufacturing export earnings are projected to climb by 15 percent compared to last year, reaching approximately US$8 million in 212. In contrast, agriculture exports might slowdown due to the tightened control on rice exports and lower price assumptions of some agricultural products. However, non-resource exports will remain outpaced by larger imports of consumption and capital goods, some used for the preparation for ASEM. This will deteriorate the non-resource sector s trade deficit, which will be partly financed by higher foreign investments in hotels, manufacturing and construction, grant receipts to support ASEM organization as well as expected higher inflows through the Lao Stock Exchange as a result of planned capital increase in EDL GEN xiii. MonETARY SECToR Exchange Rate The government continues to follow a policy of stabilized exchange rate against major currencies. From Oct 211 Mar 212, inflows of foreign exchange associated with investments and exports resulted in the LAK appreciating by.3 percent against the US Dollar. The LAK also appreciated against the Thai Baht by 1 percent during the same period mostly because of the depreciation of the Baht against the Dollar. The effective exchange rate of Kip has continued to appreciate by 1.5 percent in nominal term (NEER) in 211 and appreciated by 4.22 in real terms (REER) in the same period (Figure 16, 17). foreign exchange reserves and net foreign assets declined at the end of 211. Foreign reserves declined by US$51 million reaching US$679 million in December 211. This reserve level could cover approximately 2.8 months of non-resource imports. Similarly, net foreign assets (NFA) fell by US$6 million reaching US$718 million by December. The expansion of foreign exchange lending, partly to finance imports expansion was the primary cause of this Figure Merchandise imports (US$ million) Consumer goods Capital goods Raw materials Total imports Source: Staff estimates and projections based on data from MOIC, LNCCI and partner countries. Figure Agriculture Services Power fdi in Lao PDR, (US$ million) 848 Manufacturing, etc. Mining Gross FDI inflows Source: MPI and staff estimates and projections. Figure Merchandise Exports (US$ million) 28 Non-resources Electricity Mining Source: Staff estimates and projections based on data from MOIC, LNCCI and partner countries xiii Net portfolio investment is expected to rise this year with Right Offering (RO) and Public Offerings (PO) by EDL-Gen following the expected purchase of EDL s shares in four operational Independent Power Producers (IPP) projects in 212 (Theun Hinboun power plant including expansion, Houay Ho power plant, Nam Ngum 2 power plant, Nam Lik 1-2 power plant) and the commercial operation date (COD) of 6 MW Nam Song in Q3 212

13 L a o P D R E c o n o m i c M o n i t o r - M A Y fall (Figure 18). In particular, two Airbus aircrafts totalling over US$91 million, purchased towards the end of 211 with a loan from Banque Pour le Commerce Exterieur Lao (BCEL) and the BOL contribute to explaining a decline in net foreign assets. As a result, NFA coverage indicators, which illustrate the financial sector s ability to meet demand for foreign currencies, have continually declined (Figure 18, 22). Official reserves in 212 are projected to remain at a similar level as 211 due to the need for imports and income repatriation, despite the expected inflows of investments and export earnings. Monetary Developments After a period of rapid expansion, credit growth slowed down in 211. This deceleration in 211 was caused by the combination of a base effect following last year s high growth and limited long-term liquidities (long-term deposits) in the banking sector (Figure 19, 21). Total credit growth has decelerated to 38 percent (yoy) in December 211 compared to 46 percent in 211 due to an approximate 1 percent drop in private credits, from almost 34 percent in 21 to 23.4 percent (yoy) in 211. Additionally, liquidities are becoming more limited. This is explained by a higher loan to deposit ratio of 81.4 percent in 211 compared to 74.5 percent in 21 as deposits declined towards the end of 211 (Figure 21). The slow growth in long-term deposits is one factor constraining long-term lending to the private sector. However, recent loans to Lao Airlines to finance the purchase of 2 Airbus aircrafts contributed to acceleration of lending to SOEs from 53.4 percent (yoy) in 21 to 6.8 percent (yoy) in 211. The government s commitment to stop any quasi-fiscal activities continued to be explicitly expressed in their Budget preparation instruction for 212/13. Non-performing loans are reported to have declined to 2.18 percent in 211 from 3.2 percent in 21. Overall, credits from the banking sector in Lao PDR is still lower than the average of the lower middle income country group and lower than the regional average (Figure 2). Figure 16 kip Exchange Rate (index Dec-26 =1) Figure 17 nominal and Real Effective Exchange Rate (index Dec-26 =1) (Index Dec26 = 1) Kip/USD Kip/Baht USD/Baht Dec-6 Apr-7 Aug-7 Dec-7 Apr-8 Aug-8 Dec-8 Apr-9 Aug-9 Dec-9 Apr-1 Aug-1 Dec-1 Apr-11 Aug-11 Dec-11 Source: BOL and Bank of Thailand and staff calculations Neer Reer 26M12 27M4 27M8 27M12 28M4 28M8 28M12 29M4 29M8 29M12 21M4 21M8 21M12 211M4 211M8 211M12 Source: IMF Figure 18 nfa and international reserves have increased Broad money (M2) Credit to the whole economy Net foreign assets (y-o-y percent change) Gross international reserves ($m) Dec-7 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Jun-9 Sep-9 Dec-9 Mar-1 Jun-1 Sep-1 Dec-1 Mar-11 Jun-11 Sep-11 Dec-11 Source: BOL (yoy percent change) Net foreign assets Gross official reserves Dec-6 Mar-7 Jun-7 Sep-7 Dec-7 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Jun-9 Sep-9 Dec-9 Mar-1 Jun-1 Sep-1 Dec-1 Mar-11 Jun-11 Sep-11 Dec-11 Source: BOL 11

14 R e c e n t E c o n o m i c D e v e l o p m e n t s The economy continues its financial deepening and monetization while maintaining a policy of stable exchange rate against the US dollar and the Thai baht. The de-dollarization rate xiv slightly declined to 45 percent in December 211 compared to 46.2 percent at end 21 due to increased foreign currency deposits following the inflows of investment and exports (Figure 23). Driven by strong overall deposit growth and solid economic performance, broad money (M2) expanded by 25 percent (yoy) in December 211. However, in order to manage inflationary pressure, the BOL more than doubled its security issuance from US$124 million equivalent to US$266 million at the end of 211. Figure Contribution to Total Credit growth (percentage points) Jun-7 Sep-7 Dec-7 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Jun-9 Sep-9 Dec-9 Mar-1 Jun-1 Sep-1 Dec-1 Mar-11 Jun-11 Sep-11 Dec-11 Credit to SOEs (percentage points) Credit to private sector (percentage points) Credit to Economy Figure 2 Comparing Credits from the banking Sector (% of gdp) Figure 21 Credit growth continues to slow in Lower middle income Cambodia Lao PDR Source: World Development Indicators, 21 Pakistan Vietnam East Asia & Pacific (developing only) CBs' Loan to economy (yoy % change) CBs' Deposits (yoy % change) CBs' Loan to deposit ratio (%) (left axis) Dec-1 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec Source: BOL Figure net foreign asset coverage (%) Figure 23 4 financial deepening and dedollarization of the economy (% of gdp) end June 28 end June 29 end June 21 end Dec 21 end June 211 Ratio of NFA to foreign currency deposits Ratio of BoL NFA to money base Ratio of NFA to broad money Ratio of commercial bank NFA and reserves to foreign currency deposits end Dec Currency outside banks and demand deposits Time and saving deposits Foreign currency deposits Broad money Source: BOL and staff calculations Source: BOL and staff calculations xiv In the context of Lao PDR, de-dollarization rate is the ratio of LAK deposit to the total deposit (This simple formula is used by BOL as a proxy for estimating the de-dollarization rate in the country due to data limitation on the composition of LAK and foreign currencies outside the bank). 12

15 13 L a o P D R E c o n o m i c M o n i t o r - M A Y PART II STRUCTURAL AnD PoLiCY REfoRMS PUbLiC EXPEnDiTURE PoLiCY AnD MAnAgEMEnT REfoRMS Public finance management reforms continue to be implemented within the overall umbrella of the Public Finance Management Strengthening Program (PFMSP). Since 28, PFMSP has covered reforms on both the revenue and expenditure sides as mandated by the 27 Budget Law. Reportedly, the development of a new fiscal transfer system, establishment of greater control of public finance resources, alignment of policies to the budget, and strengthening of external oversight and audit functions have progressed. To meet the new budget management requirements and to mitigate the risks associated with the nation-wide Government Financial Information System (GFIS), the Ministry of Finance aims to design a full-functioning Treasury Information Management System (TIMS). The system conceptual design is being completed and existing treasury (business) process review is underway. Efforts have been made to improve the budget coverage, through bringing off-budget funds and service delivery agencies technical revenue on budget. A treasury single account framework has been developed with a phased implementation approach. On the revenue side, deployment of the fully automated ASYCUDA system is now operating at the Thanaleng/Friendship Bridge 1 checkpoint. Deployment in Lao PDR s other major checkpoints is scheduled to be automated by the end of 212 and is on track. After 5 years of implementation, it was realized that the State Budget Law required amending to cope with emerging developments. The first minor revision was done to Article 54 in December 211. The revision allows the state budget to be revised anytime during the fiscal year in case of a shortfall in revenue collections. A major revision to the Budget Law is expected to take place in December 212. To improve oversight capacity, the State Audit Organization (SAO) has a 1-year action plan for capacity development. Recently, the implementation plan has been updated, including its recent progress. Additionally, further needs for the plan were identified and incorporated into the updated version. SAO aims to comply with international standards on auditing, and incrementally develop performance audit capacity. The 7th NSEDP continues to focus on strengthening the governance of public finances for improved service delivery. The PFMSP will implement this governance process. In order to fully implement the PFMSP, the government will require significant capacity enhancement, continued political commitment. Implementation is expected to start from January 213. Key Reform Progress The operationalization of the budget Law continues to progress, through the implementation of the PfMSP medium-term plan. As part of this process, the revenue sharing and distribution framework has been designed and finalized, while budgetary allocation norms have been prepared and implemented in the education and health sectors for 21/11. However, the application of the budgetary allocation norms has encountered some challenges. Implementation of new revenue assignments between central and local levels (based on the implementing decree of the Budget Law) was drafted in 21/11, but awaits government approval. To improve public debt management under the PFMSP implementation, the Ministry of Finance has drafted a Public Debt Management Decree and is at the stage of holding consultations on the draft. A PFM multi-donor trust fund launched in February 29 continues to provide financial support for the implementation of critical reforms under the PFMSP. The general Tax Law has been revised while the implementation Decree and other related regulations are still works in progress. In 211, the National Assembly approved the revised General Tax Law, introducing a transparent, turnover based presumptive tax regime for businesses with a turnover below the VAT registration threshold. This revision eliminates minimum business tax. It is expected that the Implementation Decree and other regulations will be finalized and approved in the foreseeable future. A Public Expenditure Review (PER) conducted in 21 was completed the following year. The review will be disseminated in 212. Key PER recommendations include the need to plan and budget based on total resources available and coordinate sector allocations based on clearly defined resource availabilities and objectives. It also suggests to balance capital and recurrent spending in sectors, and to move to medium-term perspectives to the budget.

16 14 S t r u c t u r a l a n d P o l i c y R e f o r m s Treasury reform progress in efficient budget execution, improved accounting and timely reporting continues. The National Treasury, the BOL in collaboration with the commercial banks, line ministries and provinces are developing a program to consolidate spending unit s technical revenue into Treasury-managed accounts. The program also aims to establish Treasury zero-balance accounts in BOL and its branches. This will ensure more efficient cash management and utilization, broaden the budget coverage and enhance fiscal transparency. Additionally, this will assist the BOL with conducting its monetary policy. An inventory survey identified 2,5 accounts to be closed and transferred to the National Treasury. Reportedly, 1,174 accounts were closed as of January 212. Of these, 128 were at the central level and 1,46 at the provincial level. It has also been reported that all major large accounts at the central level such as that of the Road Maintenance Fund have been placed under the National Treasury s control. Technical revenue accounts that were not moved to the National Treasury are not significant in terms of their balances. The National Treasury plans to hold meetings with individual ministries and agencies to review the progress of account transfer. Their aim is to complete the transfer of all accounts at the central level by the end of this fiscal year. At the provincial level, the Minister of Finance will issue the instructions to enforce this policy. Progress with the provincial closure of accounts will be monitored through 212. The operation of the locally developed government financial information system (gfis) has been stabilized following its roll out to all provinces and line ministries. The nation-wide GFIS is now able to generate the preliminary quarterly budget execution report 4 weeks after the quarter. To meet the new budget management requirements and to mitigate the risks associated with the GFIS, the MOF has recruited an international consulting firm to help design the Treasury Information Management System (TIMS). The consultant team is completing the system conceptual design and conducting existing treasury (business) process review. The consultant will define functional requirements, which will lead to an international open procurement process to identify and select a preferred product to be implemented as TIMS. Lao PDR s Customs Department is moving forward with the implementation of the ASYCUDA world system. Live operations of ASYCUDA now take place at Thanaleng/Friendship Bridge 1, Lao PDR s largest border checkpoint. ASYCUDA provides a platform for the introduction of modern risk-managed techniques for customs, streamlining trade facilitation procedures and improving the efficiency of revenue collection. A fully functioning prototype of ASYCUDA World, configured to Lao PDR s requirements, has now been developed. Pilots of live parallel customs transactions using the new system commenced at Thanaleng in October 211. Following a period of successful testing, the legacy customs system (C-2) was switched off in January 212 and 1 percent of import and export transactions processed through ASYCUDA at Thanaleng/Friendship Bridge 1 checkpoint. This checkpoint accounts for more than half of Lao PDR s imports. During the remainder of 212, the system will continue to be configured with increased functionality added progressively, including direct trader entry. The national roll-out of ASYCUDA is expected to commence in April 212 and progress throughout the remainder of 212. Parallel reforms to the legal framework governing import and export transactions are also in-progress, aiming to simplify the customs processing path and modernize operations that take into account risk management, electronic transactions, advance rulings and postclearance audit. To support these developments, the National Assembly passed a revised Customs Law in the December 211 session. Work is now underway on subsidiary regulations. Risk management approaches are also being progressively rolled-out as part of the ASYCUDA deployment. As of February 212, the share of import transactions processed at Thanaleng and subject to physical inspection (red channeled) has been reduced to approximately 55 percent (with the remainder channeled green, yellow or blue), down from 1 percent under the previous manual system. Similarly, reference or minimum prices have been abolished for all imports expect fuel or vehicles as part of efforts to come into compliance with WTO requirements. Full compliance with the WTO Customs Valuation Agreement, is expected to be achieved by the end of 212. SAo continues with the implementation of its 3-year plan for capacity development and is making important impacts on strengthening government accountability. In 211, SAO reported to the NA on the findings of the budget execution for 29/1; however, SAO was advised by the NA to further improve the report. It is expected that the NA will approve the report in the coming plenary session. SAO financial and human resources have been further strengthened with its budget and staff allocation. For example, staff allocations have been increased by 5 additional positions. The introduction of budgetary allocation norms for the education and health sectors made some progress. Momentarily, its impact is still unknown. The introduction demonstrates efforts to evolve the 28 budget allocation norms into more rule-based budgeting. To further progress on this, formulae for the social sectors budget allocation norms were discussed and agreed upon by MOF and concerned line ministries. Initially the implementation encountered some difficulties due to inadequate explanations and insufficient understanding of the provincial and sectoral authorities on this initiative. Recently, MOF and concerned line ministries made a collective effort to work out the details of the unit costs, which would be used in the budget allocation norm formulae, so that the budget norms could be applied from 211/12. The Minister for Finance defined the application of the budget allocation norms for the education and health sectors as stated in the Budget Preparation Instruction, starting from 211/12. Subsequently, the school block grant was introduced at the primary school level. However, the impact of these reform initiatives will become evident once the outturned budget data for 211/12 are published.

17 15 L a o P D R E c o n o m i c M o n i t o r - M A Y Key Priority Sector Spending Table 1 gol s Priority Sectors Expenditure xv Priority Sectors Recurrent Spending 28/9 29/1 21/11 Act Act Plan (percent of total recurrent spending)* Total four sectors Agriculture Infrastructure Education Health (percent of total expenditure) Total four sectors Agriculture Infrastructure Education Health Total Priority Sectors Spending (percent of total expenditure) Total four sectors Recurrent Capital Agriculture Infrastructure** Education Health (percent of GDP) Total four sectors Recurrent Capital Agriculture Infrastructure Education Health The 21/11 budget plan, if implemented accordingly, exhibits lower shares of the four priority sectors spending to the total spending. A key driver was a marked reduction in off-budget and on-budget outlays on infrastructures. Off-budget spending in 21/11 was estimated to halve to 1.5 percent of GDP from about 3 percent in 29/1 (Figure 8) as lending is strongly discouraged for new infrastructure projects outside the approval from the NA. The share of the education sector s spending slightly fell to 11.5 percent in 21/11 due to slower capital spending growth and faster recurrent spending increase in the sector. On the other hand, the share of the health sector s expenditure augmented to 7.2 percent mostly through donor-financed capital spending in the sector. Recurrent expenditure for the four sectors as shares of the total recurrent expenditure remained stable at 19.6 percent in 21/11. Within this, the education sector s recurrent spending rose partly due to higher staff quota in this fiscal year. The health sector s share of recurrent spending remained at 1.6 percent, the same as the previous fiscal year. However, slow growth in recurrent spending for agriculture and infrastructure led to slight falls of their shares compared to the total recurrent expenditures. This implies a lack of efficiency in public investment in the context of fast growing investment spending. Source: Ministry of Finance and staff calculations Note: * Total recurrent expenditure includes salaries and benefits, transfers, administrative expenses and other recurrent spending. ** Includes off-budget spending on local infrastructure projects. xv Ratios are based on IMF s fiscal definitions.

18 16 S t r u c t u r a l a n d P o l i c y R e f o r m s financial SECToR DEVELoPMEnT The Lao financial system is small with low intermediation and is at an early stage of development; especially when compared to countries with similar level of GDP per capita. Medium-term stability in the financial system is subject the progress made in regulatory reforms and capacity building to support the implementation and supervision of these reforms. The central Bank of Lao PDR has initiated some positive improvements. The country s financial system is relatively small with low intermediation and is at an early stage of development. Currently, the financial sector comprises of banking, insurance and capital markets. The official interbank market within the money and foreign exchange markets has not been established, but there is, however, informal cooperation between some of the individual institutions. The banking system remains dominant in Lao PDR s financial system, while other financial markets still have limited impact on the country s economy. The credit for privte sector accounted for 24 percent of GDP in 211. This contribution increased from 7.5 percent in 26. The insurance market represents a fairly small proportion of all financial services, while the LSX s market capitalization is approximately 7 percent of GDP. As a result, access to finance is one of the top three obstacles to economic growth in Lao PDR, according to the investment climate assessment in 211. Almost all surveyed enterprises have financial relationships, but the share of firms with outstanding loans is the lowest among comparators, partly due to the high value of collateral requirements. The banking sector has grown over the past few years. The commercial banking industry grew rapidly after the Commercial Bank Law was passed and implemented in 27. Currently, 25 commercial banks operate in Lao PDR, a country of 6 million. This consists of 4 state-owned commercial banks (SOCBs), 2 joint venture banks (JV Banks), 8 private banks and 11 foreign bank branches. Additionally, the BOL recently granted three new licenses, which will soon bring the total number to 28 institutions. In 211, the banking sector had in total 8 branches and 236 service units around the country; however, bank access is more developed in urban areas, especially in the capital city of Vientiane. This brings the ratio of branches per 1, of the population to 1.33, which is relatively low when compared with other comparable countries. Alternatively, ATMs have become a popular option for urban people after the significant proliferation of ATMs services in recent years, increasing from 44 ATMs in 27 to 414 ATMs in 211. With this said, the inter-bank ATM network remains a challenge for the industry. The banking sector is currently dominated by four SoCbs with a market share of 6 percent in terms of total assets as of 211, while the rest shares the balance. Competition intensified after new private banks were established over the past few years, which forced banks to improve and develop a variety of products and services in response to a changing market demand. In 211, the asset size of private banks significantly increased by 57 percent (yoy), in comparison to a total industry growth of 3 percent. Strengthening supervisory framework and effective enforcement is the needed key factor to promote banking stability in Lao PDR, especially in the existing volatile global market environment. To increase stability, it is crucial that the BOL strengthens its supervisory function and monitoring systems, updates prudential regulations, and enforces the rule of law. The capital adequacy requirements are in line with or below Basel I standards, but enforcement is still weak. The overall banking sector as a whole shows positive cumulative capital at percent, as of December 211. However, SOCBs continue to operate under relative regulatory and supervisory forbearance, especially with regard to capital requirements. In terms of asset quality, non-performing loans has been reportedly low in recent years at an average of about 3 percent of total loans. One factor enabling low NPL level is the fast growing credits in recent years. Additionally, it statistically takes 3 to 5 years for bad loans to be classified as NPLs. In this context, strengthening risk management and bank supervision is a prerequisite for banking stability. According to the Asia Pacific Group on Money Laundering (APG), there is an urgent need to strengthen and enforce regulations in the anti-money laundering and combating the financing of terrorism (AML/CFT) area. financial disclosure has improved. Limited data and information in Lao PDR s banking sector is one of the major obstacles for banking supervisors in monitoring banking development. In the medium-term, this may lead to associated risks. Presently, commercial banks have not fully complied with financial disclosure rules as stipulated in the Commercial Bank Act, making it difficult to assess the sector s financial stability. It is recommended that authorities should strengthen the financial disclosure practice in order to improve the sector s monitoring process. The BOL issued three notifications to strengthen compliance: No.35/BOL dated January 21, 211, No.5/BOL dated January 31, 211 and No.141/BOL dated February 28, 212. These notifications have indicated the qualifications of external auditors, the presentation format of annual financial reports and the timing of sharing financial statements with the public. non-bank financial institutions (nbfis) are at an early stage of development, but improving. NBFIs in Lao PDR consist of 34 micro-finance institutions (MFIs) including pawnshops and leasing and money transfer companies. With technical support from development partners, stakeholders in the microfinance industry have grouped together and initiated

19 17 L a o P D R E c o n o m i c M o n i t o r - M A Y national networks focusing on three core areas: capacity building, developing research knowledge, representation and advocacy. With support from these networks, the central bank has revised three MFI regulations in 211 and elevated these to a Prime Minister Decree. Currently, the MFIs, comprising of 8 deposit taking MFIs (DT MFIs), 13 saving and credit unions (SCUs), 1 non-deposit taking MFIs (NDT MFIs), 1 post bank, and 2 co-ops, have served a total of 82, customers (1.3 percent of the total population). The MFIs comprise of approximately 46, deposits and 36, borrowers. Even though the MFIs have doubled their asset size over the past two years, their share remains less than 1 percent of overall banking assets, as of June 211. The insurance industry is undergoing reform. As part of its WTO accession process, the GOL is making an effort to introduce reforms to the insurance industry. This reform aims to improve the service sector. The Ministry of Finance has set up a steering committee led by the Fiscal Policy Department to revise the new Insurance Law. The committee is finalizing the Insurance Law and is expected to submit it to the National Assembly for approval in the near future. The Insurance Law reform will pave the foundation for insurance sector development and enhance the level of insurance services to regional and international standards. Following a decade of monopoly, as of May 21 there are six registered insurance companies operating in Lao PDR. The insurance market is narrow, and most insurance coverage applies to non-life insurance products. More than 9 percent of insurance policies are related to the commercial and industrial sectors, since demand for personal coverage is low throughout the country. Statistically, Lao PDR s insurance density and insurance premium per capita is ranked among the lowest in the region. Similarly, insurance penetration is less than 1 percent of the country s GDP. The security market is relatively young and has low trading volume. The Lao Security Exchange (LSX) was inaugurated in January 211, and began with trading on two state-owned enterprises (EDL-Generation and BCEL). At present, thin and volatile, the LSX has two listed companies and a market capitalization of LAK 5,113 billion (equivalent to US$ 61 million). After one year of operation, the LSX has remained in an early stage of development. Similarly, the regulatory framework requires strengthening, while market infrastructure, including payment, settlement systems and auditing practices are on the plan for improvement. According to an LSX plan to broaden the stock market, 6 potential companies exist (1 SOCB, 1 SOE in telecom, 1 SOE in the airline industry and 3 private companies) in the pipeline to be listed. Currently, less than.1 percent of the total population is trading in the LSX through two security companies. More than 97 percent of investors are individuals. Retail investors are relatively new to this trading and need to be equipped with good risk management practices. LSX daily trading volume peaked on February 2, 211 when 2.9 million shares changed hands at the value of LAK 27 billion (equivalent to US$ 3 million), but they fell significantly to 1,3 shares with a value of LAK 8 million (equivalent to US$ 941) on April 2, 212. LSX management decided to increase trading activities by increasing the Call Auction Sessions from 2 to 6 morning sessions, but the attempt did not seem to meet its objective. Efforts have been made to improve financial infrastructure. The check clearing system has remained the only effective settlement system in Lao PDR, even though authorities have devoted efforts to developing an alternative payment and settlement system. In the first half of 211, the BOL installed a new IT system worth US$ 1 million with the objective to improve the infrastructure of Lao PDR s financial sector. The new system should allow interbank transfer, money transfer for stock trading, support the National Payment System (NPS), and facilitate ATM pools. However, market participation is strongly required for the success of this new infrastructure development. Concurrently, the International Finance Corporation (IFC) provided assistance to the BOL to improve the legal framework of the NPS. As an outcome of this program, an improved NPS with a sound legal basis will help commercial banks offer modern banking services to customers, in particular SMEs and individuals. In terms of accounting and auditing infrastructure, institutional capacity should be strengthened in line with international practices. TRADE REfoRM Key Reform Progress Lao PDR continues to progressively integrate into the regional and international economy, through the adoption and implementation of commitments within ASEAN and as part of efforts to accede to the World Trade Organization (WTO). The country initially applied to join the WTO in 1997, and after key breakthroughs in bilateral negotiations with the European Union and United States, it is now close to accession. The GOL is implementing a sector-wide approach to trade-related reforms based on the 26 DTIS/IF Action Matrix xvi to help address the supply-side constraints that inhibit export competitiveness. Since late 211, the Ministry of Industry and Commerce has been preparing a DTIS Update that presents the framework for the next phase of trade-related reforms and required donor assistance, with completion of the DTIS Update and its Action Matrix expected by mid-212. New institutional structures are being implemented and new investments are being made in customs and border administration. In broader terms, the government continues to make solid progress in efforts to have a more predictable and rulesbased legal framework for trade and private sector development. However, continued gaps in implementation between the de jure regulatory framework and de facto practices pose an increasing risk that the private sector will see less than anticipated benefits from improved laws, regulations and procedures.

20 18 S t r u c t u r a l a n d P o l i c y R e f o r m s Progress towards wto accession unexpectedly accelerated in late-211, and after major bilateral negotiating breakthroughs with the EU and US accession is now within sight. The seventh meeting of the Lao WTO Working Party (WP) took place in June 211. Accession takes place when the Working Party submits the WP Report to the WTO Ministerial Council or General Assembly recommending accession by the applying country. At this meeting the Lao delegation reported continued progress on legislative reforms and was granted permission by WP members to move from the elements of the WP report to a full WP report. Bilateral agreements were signed in mid-211 with Australia and Chinese Taipei. In late- 211, negotiations were concluded with the European Union and substantially concluded with the United States. Conclusion of negotiations with these two key trading partners represented the passing of a highly significant milestone in Lao PDR s WTO accession efforts. Ukraine remains the last on the list of bilateral negotiations to complete the negotiation process. The country is now close to completing its 15-year application process. The eighth meeting of the Lao WTO WP took place in March 212 with an estimated two more Working Parties expected as the accession process comes to a conclusion. Continued progress has been made with key legislations, bringing Lao PDR in line with international and wto requirements. These legislations include the new Customs Law, a new Intellectual Property Law, new regulations on the Import and Export of Goods, the establishment of sanitary, phytosanitary (SPS) and TBT Enquiry Points and a number of a key implementing regulations relating to sanitary, phytosanitary and technical standards. However, a key challenge will be to ensure the implementation of newly enacted legislation to guarantee that the private sector experiences its benefits, including increased predictability, transparency and measurable improvements in service standards. in 211, efforts to improve trade facilitation progressed. After the establishment of an inter-agency coordinating body namely the National Trade Facilitation Secretariat for trade facilitation in October 21, the government approved a National Trade Facilitation Strategy and Action Plan in July 211. The strategy and action plan identifies an agenda for improving trade facilitation and cooperation among border agencies with a proposed implementation structure and clear responsibilities for lead agencies, as well as pre-defined performance indicators. Similarly, work to reform and modernize customs procedures continues to progress with the completion of the ASYCUDA prototype in mid-211, the start of parallel pilot operations in October 211, and the live deployment of ASYCUDA at the Thanaleng in January 212. Supported by the Customs Law approved by the National Assembly in December 211, new customs procedures are being progressively implemented alongside the automated system, including the adoption of risk-based approaches at the border, WTO consistent valuation, advance rulings, administrative appeals and electronic approvals. Similarly, work to prepare a Lao Trade Portal/Repository that will put information on all import/export laws, regulations, procedures, measures and tariffs into the public domain via an electronic interface has been substantially completed with a live launch planned for May 212. This will be an additional key step for Lao PDR to meet compliance with the WTO and ASEAN commitments. Efforts to update the 26 Diagnostic Trade integration Study are now at an advanced stage. The Ministry of Industry and Commerce, which leads the task, is now close to completion with a full 212 DTIS Update scheduled for validation by mid-212. The DTIS Update, including its Action Matrix, presents the government s core trade and integration policy reform and investment priorities over the course of the 7th NSEDP. During this planning period, Lao PDR is expected to experience increased stresses from the growing natural resources development boom, and the move from a pre to post-wto reform environment. The DTIS Update will serve as the underlying framework in which future trade-related assistance to Lao PDR will be managed. Greater efforts will be made to improve coordination and efficiency of aid-for-trade, and to reduce overlaps and gaps, through the increased use of multi-donor trust funds and pooled approaches implemented by the government. xvi The action matrix was formulated based on the recommendations of the Diagnostic Trade Integration Study (DTIS) and is implemented under the National Integrated Framework (IF) Governance Structure.

21 19 L a o P D R E c o n o m i c M o n i t o r - M A Y PRiVATE SECToR DEVELoPMEnT Lao PDR imposes few restrictions on private sector activity. In fact, the 1991 Constitution protects state, collective and private forms of ownership. The 26 Enterprise Law and the 21 Investment Promotion Law have laid the foundations for developing market-based rules and institutions to support private sector development. While domestic investment has witnessed growth such as in construction and services, foreign investment inflows have increased rapidly, in both resource and non-resource sectors (mainly hydropower, mining, agriculture, processing industries and tourism). Between 25 and 211, foreign investments are estimated to increase 4 folds from about US$3 million to more than US$15 million, with hydropower and mining now accounting for some 8 percent of inflows. The main foreign investors are from China, Thailand and Vietnam. Other countries such as Australia, France and South Korea have also registered with significant investments. Lao PDR has an increasingly strong higher-level regulatory business environment and has made promising progress in reducing the costs of business entry. However, significant gaps remain with inconsistent and partial implementation of key laws, and gaps remaining in the subsidiary legislation. Licensing requirements remain costly and burdensome for businesses, and the framework for regulating key sectors remains very underdeveloped. Key Reform Progress Lao PDR imposes few restrictions on investment activities and efforts have been made to streamline licensing requirements for most activities, although a number of issues remain. The country is progressively reforming the environment for business entry; however, cumbersome and lengthy licensing procedures in some sectors and inconsistent implementation of legislation are a concern. As part of the implementation of the 211 Enterprise Law and the new Investment Promotion Law, new businesses can now apply for a unified business registration that includes business registration, tax registration and approval for company seal from one location within the Ministry of Industry and Commerce. Currently, registration under the Enterprise Law is relatively quick and efficient. Making a company seal accounts for the majority of time needed to start a business. Procedures for obtaining an operating license for general manufacturing activities have been significantly reduced after the abolition of the factory establishment license. However, obtaining additional sector specific licenses from appropriate line ministries or departments for some services activities can be slow and cumbersome. During operations, businesses in most sectors are required to annually renew their tax registration certificate. Most operating licenses are required to be renewed every two to three years, depending on the sector. Minimum capital requirements for enterprises were abolished under the Enterprise Law, although some requirements remain for sectors such as banking, insurance and leasing. business entry has few hurdles and start-up costs are reasonable, due to recent regulatory changes. Lao PDR has made important steps forward in easing business entry procedures. One of these steps was the final abolition of investment licenses for general (open) activities in October 211 under the unified Investment Law. This step leveled the playing field between foreign and domestic enterprises, and eased business entry costs. The approval of the revised general Tax Law in June 211 introduces simplifying presumptive tax regime reforms through business segmentation (micro, small and medium) and turnover-based approaches. The new presumptive regime, which applies to SMEs with turnover of less than US$ 5, equivalent, aligns the upper threshold of the presumptive regime with the VAT threshold for compulsory VAT registration. Secondly, abolition of the minimum tax on turnover and revisions to corporate tax rates by introducing a uniform rate (26 percent) is in line with regional practice and levels the playing field for foreign and domestic businesses (under the old law, there were two different rates used for foreign businesses (2 percent) and local businesses (35 percent). However, continued uncertainty over actual implementation of the new Tax Law has created frustrations in the private sector. The minimum wage was increased to LAk 626,4 (approximately US$78) in January 212. This represents an increase from LAK 348,, or LAK 569, including mandatory allowances. The new minimum wage is a single cash-based rate, replacing previous separate minimum wage and allowances. The labor market in Lao PDR is considered to be relatively flexible and the minimum wage is only effectively enforced among larger manufacturers, principally in the garments and manufacturing sectors. Salaries diverge across the private and public sectors with private sector wages now enjoying a significant premium reflecting a growing demand for labor. The government is rolling out a social security scheme among large private sector employers financed through payroll deductions.

22 2 A n n e x AnnEX 1 ThE global EConoMiC outlook in SUMMARY (Percentage change from previous year, unless otherwise specified) global conditions World Output 1/ World trade volume Consumer prices Advanced Economies Emerging and Developing Economies 2/ 28 29e 21e 211f 212f 213f Commodity prices (percentage change of USD terms) Non-oil commodities 3/ Oil price 4/ London Interbank Offered Rate (%) 5/ on USD Deposits on Euro Deposits On Japanese Yen Deposits Real gdp growth World Advanced Economies United States Euro Area Japan United Kingdom Emerging and Developing Asian Economies Developing Asia China India ASEAN-5-6/ Latin America and the Carribean n/a n/a n/a n/a Source: IMF (WEO, Jan 212) Note: 1/ The quarterly estimate and projections account for 9 percent of the world purchasing power parity weights 2/ The quarterly estimates and projections account for approximately 8 percent of the emerging and developing economies. 3/ Average based on commodity export weight 4/ Simple average of prices of UK Brent, Dubai, and West Texas Intermediate crude oil. The average oil price was US$ a barrel in 211 the assumed price based on futures markets is US$99.9 in 212 and US$95.55 in / Six-month rate for the US and Japan. Three month rate for the Euro Area 6/ Indonesia, Malaysia, Phillippines, Thailand and Vietnam.

23 L a o P D R E c o n o m i c M o n i t o r - M A Y AnnEX 2 LAo PDR AT A glance Lao PDR: key indicators key Development indicators Lao PDR East Asia & Pacific Lower middle income 211 Population, mid-year (millions) 6.6 1,962 2,519 GNI (Atlas method, US$ billions) 7.4 7,249 4,78 GNI per capita (Atlas method, US$) 1,13 3,696 1,619 GNI per capita (PPP, international $) 2,46 6,657 3,632 GDP growth (%) GDP per capita growth (%) e 212f 213f output and Prices (% change yoy) Real GDP * Consumer price index Structure of the Economy GDP (millions US$) 5,722 6,967 8,8 9,427 1,395 Agriculture (% of GDP) Industry (% of GDP) Services (% of GDP) Public Sector (% of gdp) 1 Total revenues incl. grants Government expenditures Government balance Non-resource fiscal balance Non-mining fiscal balance foreign Trade, bop and External Debt Trade balance (millions US$) ,38-1,426 Exports of goods (millions US$) 1,489 2,149 2,644 3,77 3,211 (% change y-y) Imports of goods (millions US$) 2,215 2,573 3,472 4,115 4,637 (% change y-y) Current account balance (millions US$) ,29-1,658 (% GDP) Foreign direct investment (millions US$) ,157 1,58 1,962 Total external debt (millions US$) 6,5 6,574 7,42 8,612 9,958 (% GDP) Debt service ratio (% exports of g&s) Foreign exchange reserves, gross (millions US$) (in months of imports of goods and services) financial Markets Domestic credit (% change y-y) 4/ Short-term interest rate (% p.a.) 5/ Exchange rate (Kip/US$, ave) 8,516 8,259 8,52 7,932 7,9 Real effective exchange rate (2=1) (% change y-y) Stock market index (end-period, Jan 12, 211=1) 899 Source: National data sources * average e = estimate f = forecast 1/ Fiscal year basis 2/ After grants 3/ Excluding gold 4/ domestic credit, excl. Govt lending funds 5/ Treasury bill rate Source: World Development Indicators and staff estimates based on data provided by Lao authorities mentioned under above figures. 21

24 THE WORLD BANK OFFICE, VIENTIANE P.O. Box UN 345, Patou Xay Nehru Road Vientiane, Lao PDR Tel: (856-21) , Fax: (856-21) THE WORLD BANK OFFICE 1818 H Street, N.W. Washington, D.C Tel: (22) Fax: (22) / LAO PDR ECONOMIC MONITOR May 212 FREE COPY (NOT FOR SALE)