FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT Report No LA FOR A PROPOSED GRANT IN THE AMOUNT OF SDR 6.7 MILLION (US$ 10 MILLION EQUIVALENT) AND A PROPOSED CREDIT IN THE AMOUNT OF SDR 6.7 MILLION (US$ 10 MILLION EQUIVALENT) TO THE LAO PEOPLE'S DEMOCRATIC REPUBLIC FOR A NINTH POVERTY REDUCTION SUPPORT OPERATION (PRSO 9) August 27, 2013 Poverty Reduction and Economic Management Sector Department Southeast Asia Country Department East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS (Exchange Rates Effective as of July 31, 2013) Currency Unit = LAK LAK 7,998 = US$ 1 US$ = SDR 1 FISCAL YEAR October 1 - September 30 WEIGHTS AND MEASURES Metric System Regional Vice President : Axel van Trotsenburg Country Director : Constantine Chikosi (Acting) Sector Director : Sudhir Shetty Country Manager : Keiko Miwa Sector Manager : Mathew Verghis Task Team Leader : Genevieve Boyreau / Richard Record

3 ABBREVIATIONS AND ACRONYMS AAA Analytical and Advisory Activities MOAF Ministry of Agriculture and Forestry ADB Asian Development Bank MOES Ministry of Education and Sports ASEAN Association of Southeast Asian Nations MOF Ministry of Finance ASEM Asia-Europe Meeting MOH Ministry of Health ASYCUDA Automated System for Customs Data MOHA Ministry of Home Affairs ATIGA ASEAN Trade in Goods Agreement MOIC Ministry of Industry and Commerce AusAID Australian Agency for International MOPWT Ministry of Public Works and Transport Development BOL Bank of Lao PDR MPI Ministry of Planning and Investment CBHI Community Based Health Insurance NA National Assembly CPIA Country Policy and Institutional NERI National Economic Research Institute Assessment CPS Country Partnership Strategy NGO Non-Governmental Organization CTFP Customs and Trade Facilitation Project NHSR National Health Statistics Report DMFAS Debt Management and Financial Analysis NPL Non-Performing Loan System DSA Debt Sustainability Analysis NPSH National Policy on Sustainable Hydropower DTIS Diagnostic Trade Integration Study NSEDP National Socio Economic Development Plan EQS Education Quality Standards ODA Official Development Assistance ESDF Education Sector Development Framework PEFA Public Expenditure and Financial Accountability Assessment ESIA Environmental and Social Impact PER Public Expenditure Review Assessment EU European Union PFM Public Financial Management GATT General Agreement on Tariffs and Trade PFMSP Public Financial Management Strengthening Program GDP Gross Domestic Product PPG Public and Publicly Guaranteed Debt GFIS Government Financial Information PRSO Poverty Reduction Support Operation System GIZ Deutsche Gesellschaft fur Internationale RBO River Basin Organization Zusammenarbeit GOL Government of Lao PDR ROSC Report on the Observance of Standards and Codes HEFs Health Equity Funds RTM Round Table Mechanism HMTA Hydro Mining Technical Assistance SAO State Audit Organization Project HSIP Health Services Improvement Project SASS State Authority for Social Security ICA Investment Climate Assessment SDC Swiss Development Cooperation IDA International Development Association SDR Special Drawing Rights IDF Institutional Development Fund SME Small and Medium Sized Enterprise IFC International Finance Corporation SOCB State Owned Commercial Bank IMF International Monetary Fund SOE State Owned Enterprise IPSAS International Public Sector Accounting SSO Social Security Organization Standards JICA Japan International Cooperation Agency TA Technical Assistance JSAN Joint Staff Advisory Note TDF Trade Development Facility LDC Least Developed Country TIMS Treasury Management Information System LEnS Lao Environmental and Social Project UN United Nations M&E Monitoring and Evaluation USAID United States Agency for International Development MCH Maternal and Child Health VAT Value Added Tax MDGs Millennium Development Goals WTO World Trade Organization MDTF Multi Donor Trust Fund YOY Year on Year MEM Ministry of Energy and Mines ZBA Zero Balance Account

4 LAO PEOPLE S DEMOCRATIC REPUBLIC NINTH POVERTY REDUCTION SUPPORT OPERATION (PRSO 9) TABLE OF CONTENTS Program Summary... i I. Introduction... 1 II. Country Context... 3 III. Recent Economic Developments... 5 IV. Macroeconomic Outlook And Debt Sustainability V. Government Programs And Participatory Processes VI. Bank Support To Government Programs VII. Collaboration With The IMF And Other Donors VIII. Achievements And Lessons Learned From Past PRSOs IX. Analytical Underpinnings And Relation To Other Bank Operations X. The Proposed Ninth Poverty Reduction Support Operation XI. Operation Implementation LIST OF TABLES Table 1: PRSO macroeconomic framework: key indicators Table 2: Thresholds for external debt (percentage) Table 3: Composition of external public and publically guaranteed debt at end Table 4: Summary of changes to PRSO 9 prior actions compared to the PRSO 8 Program Document 27 Table 5: Government spending: total and in health and education, by economic category LIST OF FIGURES Figure 1: Growth and inflation (percentage change)... 6 Figure 2: Real GDP growth (at factor cost), contribution by sector (percentage points)... 6 Figure 3: Monthly inflation (yoy percentage change)... 6 Figure 4: Contributions to food price inflation... 6 Figure 5: Total government revenue (percentage of GDP)... 7 Figure 6: GOL s fiscal performance (percentage of GDP)... 7 Figure 7: Quarterly public spending: effect of wage and compensation increase policy... 8 Figure 8: Merchandise exports (US$ million)... 8 Figure 9: Merchandise imports (US$ million)... 8 Figure 10: Balance of payments, Figure 11: Foreign direct investment, (US$ million)... 9 Figure 12: Net foreign assets and international reserves... 9 Figure 13: Reserves coverage (percentage)... 9 Figure 14: Lao kip exchange rate Figure 15: Nominal and real effective Figure 16: Banking sector assets (billion kip) Figure 17: Contribution to bank credit growth... 11

5 LIST OF BOXES Box 1: Lao PDR s accession to the World Trade Organization... 4 Box 2: Key policy reforms implemented under PRSO Box 3: Good practice principles for conditionality Box 4: Prior actions for PRSO Box 5: Proposed triggers for PRSO ANNEXES Annex 1: Letter of development policy Annex 2: Policy and institutional reforms supported by PRSO Annex 3: Broader government reform program Annex 4: Country at a glance MAP.62 An International Development Association (IDA) team led by Genevieve Boyreau (Senior Country Economist) from identification to appraisal, and by Richard Record (Senior Economist) from appraisal to board, prepared the PRSO 9. The project s team members included Ratchada Anantavrasilpa (Financial Sector Specialist), Leah April (Senior Public Sector Specialist), Phetdara Chanthala (Health Specialist), Somneuk Davading (Senior Economist), Christopher Fabling (Senior Financial Management Specialist), Kate Lazarus (Senior Operations Officer, IFC), Roch Levesque (Senior Counsel), Khampao Nanthavong (Associate Operations Officer, IFC), Konesawang Nghardsaysone (Operations Analyst), Minh Van Nguyen (Senior Public Finance Specialist), Keomanivone Phimmahasay (Economist), Omporn Regel (Senior Education Specialist), Lars Sondergaard (Human Development Country Sector Coordinator), Sombath Southivong (Senior Infrastructure Specialist), Thang-Long Ton (Economist), Chau Ching Shen (Senior Finance Officer), Viengsamay Srithirath (Country Officer), Thipphaphone Vongsay (Operations Officer, IFC), Saysanith Vongviengkham (Public Sector Specialist) and Wei Aun Yap (Health Analyst). Vatthana Singharaj and Mildred Gonsalvez provided administrative assistance. Peer reviewers were Habib Rab (Senior Economist, Vietnam) and Julio Revilla (Lead Economist, Mozambique). Overall guidance was provided by Mathew Verghis (Sector Manager) and Keiko Miwa (Country Manager).

6 LAO PEOPLE'S DEMOCRATIC REPUBLIC NINTH POVERTY REDUCTION SUPPORT OPERATION (PRSO 9) PROGRAM SUMMARY Borrower Implementing Agency Financing Data Operation Type Main Policy Areas Lao People s Democratic Republic Ministry of Finance IDA Grant H8810-LA Terms: Standard IDA Grant terms Amount: SDR 6.7 million (US$ 10 million equivalent) IDA Credit LA Terms: Standard IDA Credit terms Amount: SDR 6.7 million (US$ 10 million equivalent) The proposed Ninth Poverty Reduction Support Operation (PRSO 9) is the second operation of the third programmatic series of four operations (PRSO 8-11). PRSO 9 is a single tranche operation. PRSO 9 focuses on four policy areas. Each area is equally critical for the sustainability of Lao PDR s development path, which increasingly relies on natural resource exploitation (in particular, hydropower and mining). These policy areas are consistent with the goals and strategies identified in the Government of Lao PDR s Seventh National Socio-Economic Development Plan (NSEDP7), and IDA s Country Partnership Strategy. The four policy areas are: (i) Strengthened fiscal and public financial management; (ii) Sustainable revenue management in the natural resource sectors (mining and hydropower); (iii) Sustainable public financing mechanisms for schools and health facilities; and, (iv) An improved investment climate for diversification and competitiveness. PRSO 9 is based on the adequacy of the government s macroeconomic policy framework. This framework reflects the government s commitment to macroeconomic stability. The Government and IDA jointly prepared the operation in collaboration with the European Union and the Japan International Cooperation Agency, which provide parallel budget financing. The operation was developed in consultation with other reform stakeholders, including development partners. Key Outcome Indicators Within the 7 th NSEDP framework, reforms in the policy areas noted above will improve the government s ability to sustainably manage rising earnings from the natural resource sectors; support sustainable funding mechanisms in health and education; and improve the investment climate in order to diversify sources of growth. The PRSO series will contribute to a list of outcomes and indicators, including: (i) Strengthened macroeconomic policy coordination, responsive to developments in the natural resource sectors and consistent with economic growth and stability; (ii) Improved budget credibility, orderliness and participation, as well as sector i

7 budget allocation and reporting; (iii) Coordinated and mutually reinforcing regulations that guide the fiscal and revenue management regimes for the sustainable development of the hydropower and mining sectors; (iv) In health and education, sustainable financing mechanisms at the lowest spending-level enabling improved outputs (increased number of births attended by skilled health personnel, and increased ratio of textbooks per pupil); and, (v) Streamlined and efficient trade and business processes in order to stimulate diversified private sector development. Program Development Objective(s) and Contribution to CPS The objective of the PRSO program is to support policies and institutional reforms that enable the sustainable management of increasing revenues from the natural resource sectors to deliver improved public services. This objective supports the government s priorities outlined in the NSEDP. The PRSO program contributes to the World Bank s CPS by supporting its objectives and mitigating its implementation risks. The CPS, in cooperation with the PRSO program, aims to strengthen institutions for sustainable and inclusive development by: (i) Improving public sector management; (ii) Promoting competitiveness and connectivity; (iii) Supporting sustainable natural resource management; and, (iv) Achieving inclusive development. The PRSO program is supported by complementary technical assistance from the World Bank and other development partners. Risks and Risk Mitigation Operation ID Macroeconomic risks include: (i) continued rapid credit growth in a context of low reserves and weak financial sector supervisory capacity enhance vulnerability to domestic and external shocks, including weaker commodity demand. Mitigation measures include PRSO support to improve banking disclosure, the strengthening macroeconomic framework, paying greater attention to natural resources in macroeconomic management and, at the country strategy level, to undertake further analytical work to raise awareness of the issues; and, (ii) over-borrowing with a buildup of debt and/or contingent liabilities, in the context of a fast growing economy. This PRSO series mitigates this risk by supporting the strengthening of prudential fiscal and debt policy framework, management and reporting. The fiduciary risk associated with public finance reforms is high given the weak public financial management reporting system and provincial autonomy with limited accountability mechanisms. This risk is mitigated by budget execution and revenue administration recentralization reforms. Political backsliding and reform delays are high risks for the PRSO. These risks are mitigated by enhanced engagement with the National Assembly to build internal demand for reforms. The risk of limited capacity to undertake sophisticated multi-sectoral reform in government is mitigated through technical assistance and by flexibly supporting reforms where there is momentum. P ii

8 IDA PROGRAM DOCUMENT FOR A PROPOSED NINTH POVERTY REDUCTION SUPPORT OPERATION (PRSO 9) TO THE LAO PEOPLE S DEMOCRATIC REPUBLIC I. INTRODUCTION 1. After a prolonged period of rapid economic growth and impressive poverty reduction, Lao PDR is coming under increased macroeconomic pressures that will require appropriate policy responses if the medium term outlook is to remain positive. Natural resource wealth has acted as the principal driver of economic development over recent years, stimulating increased inward investment, the expansion of exports and increased public revenues. However, to sustain the country s track record of macroeconomic stability, tightening the fast growing domestic demand will be essential in order to preserve resilience to shocks and alleviate pressures on external accounts. It will be equally important that the Lao authorities resist the temptation of undertaking too many large scale projects at once, to avoid over-borrowing risks and over-stretching the country s absorptive capacity. This PRSO series, by supporting better macroeconomic management, directly contributes to the key objective of maintaining macroeconomic stability. 2. In this context, the objective of the third Poverty Reduction Support Operation series (PRSO 8-11) is to support policies and institutional reforms for the sustainable management of revenues from the natural resource sectors. This will enable the country to more effectively translate these revenues into better development outcomes and improved public service delivery. In order to achieve these objectives, a set of primary focus areas have been identified: a. The first focus area is on fiscal and public financial management. It is aimed at (i) supporting a medium term integrated fiscal framework, to better manage large and increasing natural resource export revenues; and, (ii) strengthening public sector readiness to manage natural resource revenues, through improved planning, allocation, reporting and oversight of public revenues. b. Secondly, there are sector-specific challenges. In the hydropower and mining sectors, revenue management must be defined within a framework that maximizes revenues accruing to the government, while minimizing environmental and social risks, and maintaining competitiveness in diversified sectors. c. Third, public service delivery improvement is critical. To develop this area, effective public financial management policies, programs and mechanisms need to be in place in order to translate increased public resources into better service delivery. d. The last area is in sectors outside the natural resources, where most of the country s jobs are found. In these sectors, attracting quality investment will require an improved business and trade climate to address poor competitiveness challenged by, among other things, an appreciating real exchange rate that raises labor costs. 3. The four policy areas proposed in the new PRSO directly support the strategic objectives of the World Bank Group s recent Country Partnership Strategy (CPS) 1, namely (i) improving competitiveness and connectivity; (ii) sustainable resource management; (iii) inclusive development, and the cross-cutting theme of strategic public sector management. Additionally, the third PRSO series builds on lessons learned from the previous (second) PSRO series. To ensure 1 World Bank Group (2012) Lao People s Democratic Republic Country Partnership Strategy for the period FY12-16, Washington, DC: The World Bank. 1

9 impact and results from the previously supported reforms, the third PRSO series continues engagement in some policy areas while aiming to selectively open new fronts of support for reform to meet the country s development challenges that include diversified and inclusive growth. The preparation of the PRSO series included extensive consultations with all stakeholders, including close cooperation with the European Union (EU) and the Japan International Cooperation Agency (JICA). 4. Lao PDR s economy benefits from abundant natural resources, which, if managed well, have the potential to put the country on a sustainable and inclusive medium-term growth path. Lao PDR s forests, agricultural land, water and mineral resources and hydropower potential account for more than half of the country s total wealth. With appropriate macroeconomic and governance policies, the country s natural resource wealth can contribute significantly towards rapid, sustainable growth and poverty reduction 2. Rapid expansion of the hydropower and mining sectors has benefited the country by contributing towards general economic growth, increasing fiscal revenues, and reducing local poverty and improving infrastructure. It has also promoted change in environmental legislation. However, given the volatility of commodity prices and limited direct employment opportunities arising from growth of the resource sector, it is of critical importance to diversify the economy and develop other tradable sectors. In addition, revenues from natural resources need to be more effectively translated into poverty reduction activities to tackle increasing income gaps challenging the country s development. 5. Achieving the Millennium Development Goals (MDGs) by 2015 and graduating from Least Developed Country (LDC) status are the government s primary objectives, as detailed in the 7 th National Socio-Economic Development Plan (NSEDP7) 3. Within this framework, the Government of Lao PDR (GOL) has requested the preparation of a third PRSO series of four annual single-tranche operations (PRSO 8-11). These operations aim to support the implementation of the NSEDP7. The NSEDP7 provides a comprehensive strategy for development, with a range of medium and long-term policies aimed at achieving sustained growth and poverty reduction. To achieve its MDG social targets, the government is committed to increasing social spending up to 35 percent of total budget expenditures. Furthermore, the National Assembly has instructed the government to allocate 16 percent of public spending for education and 9 percent for health over the NSEDP7 implementation period. 6. The PRSO series builds on a strong record of previous development policy operations. Since 2004, eight annual PRSOs have contributed to the government s policies to foster economic growth, reduce poverty and address lagging human development indicators and vulnerabilities through supporting cross-sectoral and institutional reforms. The PRSOs, coupled with strong technical assistance programs, have had a significant impact on the country s performance. For example, strong technical assistance contributed to steady progress that led towards policy reforms. The commitment and ownership of the GOL have grown over the course of the previous eight operations, and its performance has improved progressively. Improved policies and institutions have led to an increase in the rating under the World Bank s Country Policy and Institutional Assessment (CPIA) for Lao PDR from 2.9 in 2004 to 3.4 in The World Bank s Lao PDR Development Report 2010 highlights the key challenges and opportunities that the Lao economy faces in order to transform wealth into lasting development results. 3 The GOL finalized and approved the NSEDP7 in June A Joint Staff Advisory Note (JSAN) was discussed by the World Bank Board in January

10 II. COUNTRY CONTEXT 7. The GOL considers developing the country s natural resources as key to meeting the goals of the NSEDP7, achieving the MDGs and graduating from LDC status by The country s location in East Asia and the region s rising demand for electricity and natural resources makes this development path possible. In recent years, the natural resource boom coupled with large foreign direct investment inflows has fueled high growth rates and the promise of better economic opportunities for the country s youthful and growing population. A sustained effort on internal structural reforms in investment and trade, public financial management, and service delivery is being made towards attaining the GOL s goals. In recent years, the economy of Lao PDR has weathered the global financial crisis relatively well, partly due to resilient domestic demand, and because a majority of households continue to rely on subsistence farming, insulating the country from external shocks. As a result of these factors, the GOL is making broad progress towards achieving its development goals. 8. Impressive poverty reduction has been achieved over the past decade and progress toward the MDGs has been steady, although the country still lags behind the rest of the region on a number of key MDGs. According to the national poverty line, poverty fell from 39.1 percent of the population in 1998 to 33.5 percent in 2003 and 27.6 percent in It is projected to decline further to around 23 percent of the population in While the links between this decrease in poverty and government programs are complex, it is clear that substantial improvements in access to social services and infrastructure in recent years have played an important role in reducing consumption poverty and increasing welfare. Improvements in access to roads, clean water and sanitation are particularly impressive. Education opportunities have expanded, and more than eight in ten children between the ages of six and ten are enrolled in primary school. In addition, a swift expansion in ownership of assets has occurred, including motorbikes and mobile phones, even in the most remote areas. Technologies are connecting previously remote communities to markets, infrastructure and information. In contrast, a lack of access to infrastructure, services and markets is strongly correlated with lagging poverty reduction progress. Meanwhile, income disparities have begun to increase, notably affecting some population groups in remote areas. For example, school enrollment rates among ethnic minorities and those living in remote rural areas remain far below the national average. Furthermore, improvements in access to healthcare over the past five years have been slow and many households still need to travel long distances on poor roads in order to access basic services. 9. An increased reliance on natural resources is structurally shifting the economy away from agriculture. The natural resource sector has been growing very rapidly during the past decade, at an annual average of 21 percent during This growth was supported by mining projects such as foreign direct investment into the two large copper-gold mining projects (Lane Xang Minerals and Phu Bia Mining), and by large hydropower projects (such as Nam Theun 2 and Nam Ngum 2). As a result, the share of the sector in GDP almost tripled between 1998 and 2011 (from 6 percent of GDP in 1998 to 16 percent in 2011). Conversely, the contribution of agriculture dropped over the last decade, from 43 percent in 2000 to 30 percent by 2011.This fall could be due to the fact that agriculture and forestry are mainly subsistence based, with only some emerging plantation and contract farming. Agricultural exports (mainly crops) are limited, amounting to only about one-third of manufacturing exports. This transitional growth, focused on an increased reliance on natural resources, is expected to continue into the medium term, with the share of mining and hydropower projected to rise to 38 percent of GDP by While a corresponding decline in agriculture is projected, the share in services should remain stable. 4 The estimate is calculated by extrapolating past poverty trends (using the correlation between GDP growth and poverty reduction rate). Actual poverty data for 2012/13 (from LECS5) is expected to be available by end-2013 or early

11 Box 1: Lao PDR s accession to the World Trade Organization What has happened? Following the completion of accession negotiations in late 2012, Lao PDR became the 158th member of the WTO in February The accession process required a series of negotiations with members of the working party, including answering several hundred questions from WTO members. It is the completion of a fifteen year process, with application first made in However, the year 2012 saw unprecedented progress including the reaching of crucial agreements with the US and EU, and three meetings of the working party in Geneva. The WTO General Council approved the accession protocol for Lao PDR s membership in October This was the final agreement on exactly what Lao PDR has done in terms of reform, and what the country has agreed to do over the next 3-5 years. It includes a working party report and a schedule of commitments. The National Assembly ratified the accession package in December Formal membership came into force 30 days after the ratified documents were deposited with the WTO Secretariat in Geneva. What does it mean? Lao PDR is a least developed country and so was allowed to receive special and differential treatment during the accession process, generally meaning that the country did not need to make as deep commitments as other acceding countries and has been given more time to fully implement commitments. It means signing up to the WTO core principles of non-discrimination, transparency and predictability and ensuring that these principles are incorporated into Lao law. Plus a series of more specific reform measures to bring Lao legislation into line with the WTO agreements on issues such as subsidies, price controls, restrictions, and state enterprises. The average tariff has been bound at 18.8 percent. This will not have a significant impact, as Lao PDR will have to make deeper commitments to ASEAN member states by The WTO agreements cover both trade in goods and trade in services. Market access commitments have been made in 10 service sectors allowing foreign access (in for example, banking, telecoms, distribution, health, environment, tourism, construction, air transport). This means that there are limits on how the country regulates these sectors. The terms of Lao PDR's accession package, including the extent of commitments made, are broadly in line with similar recently acceding countries (such as Cambodia, Vietnam and Nepal). While a surge in foreign investment resulting from accession is not to be expected, accession to the WTO is an important externally verified signal of reform and sustained commitment to reform. However, for Laos to fully benefit, commitments will need to be fully implemented. This is a challenge as the reform pressure will be reduced once Lao PDR is a WTO member and, other country experience suggests, there will be a very real risk of backsliding. What are the World Bank and development partners doing? The World Bank and Development Partners have been supporting the Lao WTO accession process for more than four years under the Trade Development Facility Multi Donor Trust Fund financed by AusAID, EU, Japan and GIZ. The Facility has supported the direct costs of negotiations - including the last five Working Party negotiations in Geneva, drafting of legal texts in key areas (especially on sanitary and phyto-sanitary measures), bilateral negotiations, technical assistance to the negotiating team (including the first and only full time lawyer in the Ministry of Industry and Commerce), and a series of sector impact studies in professional services, distribution services, financial services, transport and telecommunications. Similarly, it includes a substantial program on trade facilitation (including the launch of the Trade Portal - which allows Lao PDR to meet WTO Trade Facilitation Agreement requirements on transparency and publication) and on customs reform, including the phase out of reference pricing and movement towards compliance with the WTO Customs Valuation Agreement. The second series of the PRSO was also instrumental in supporting a number of trade facilitation reforms required as part of Lao PDR s WTO accession process. The World Bank and Development Partners have recently approved a Second Trade Development Facility (TDF-2), a follow on operation to support the "beyond WTO" agenda over , cofinanced by AusAID, EU, GIZ and Irish Aid. This will support key aspects of the next phase trade program of GOL, including post accession work on trade in goods, trade in services and trade facilitation. 4

12 10. Even though Lao PDR has a relatively short history of large-scale natural resource development, there are increasing signs of Dutch Disease effects, such as a loss in export competitiveness 5. In recent years, Lao PDR has experienced real exchange rate appreciation, low manufacturing productivity growth, poor profitability of exporters compared to non-exporters, and rapid wage growth. As a share of GDP, manufacturing (including garments, wood and wood-based products, construction materials, light manufacturing, handicrafts, and increasingly, food, beverages and related processing) has expanded only moderately over recent years. The balance of payments, national income as well as fiscal accounts exhibit increasing exposure to development in the natural resource sectors. 11. It is therefore critical for the government to introduce policies to mitigate the negative impact that the rapid development of natural resources may have on sustainable growth and competitiveness. This includes coordinated fiscal and macroeconomic policy; diversification of the non-resource economy; trade facilitation reform, and improvements in the investment climate for nonresource sectors. Careful debt management, such as avoiding over-borrowing against future revenues from natural resources is also important, as well as prudent fiscal management with rules on spending. Efficient use of resource revenues, carefully prioritized public spending through effective public financial management, and sustainable financing mechanisms to increase spending in health and education are also crucial for realizing sustainable growth, achieving the MDGs, and graduating from LDC status. 12. The completion of Lao PDR s efforts to accede to the World Trade Organization (WTO) is an important step towards the establishment of a rules-based system of economic governance and necessary part of efforts to diversify away from the resource sectors (Box 1). Membership means that the country commits to following the WTO principles of non-discrimination, transparency and predictability. To accede, substantial reform measures were needed to bring laws in line with WTO agreements on subsidies, price controls, trade restrictions, state enterprises, and other areas. WTO membership will contribute towards efforts of the country to diversify away from natural resource dependency, attract quality investment outside the resource sectors, create jobs, and reduce poverty. The PRSO is aligned with these objectives by supporting a better business environment for investors outside the resource sectors. III. RECENT ECONOMIC DEVELOPMENTS 13. The Lao economy has experienced strong growth over recent years with annual rates of GDP growth averaging 8.0 percent, driven mainly by mining and hydropower as well as related expansion in services and construction. Large natural resource development projects support growth during the construction phase, later as projects move into the operational phase, and through spillover demand for construction materials, consumer products, food and services. While GDP growth in the mid 2000s was primarily driven by mining development, it is increasingly the development and construction of new hydropower projects that is acting as the main source of growth. Services are also growing strongly, including wholesale and retail trade, as well as tourism and transport both due to rising domestic demand and due to spillover effects from natural resource development projects. 5 This is drawn from the Lao Development Report (2010): Natural Resource Management for Sustainable Development- Hydropower and Mining, which provides an in-depth analysis of possible Dutch Disease in Lao PDR. 5

13 Figure 1: Growth and inflation (percentage change) Figure 2: Real GDP growth (at factor cost), contribution by sector (percentage points) Source: Government, LNCCI data and staff estimates Source: Government, LNCCI data and staff estimates 14. Inflation has picked up since end 2012 due to upward pressure from non-rice food prices. Headline inflation rose from 3.4 percent YOY in November 2012 to 5.8 percent in March 2013 due to higher food inflation, which rose from 3.7 percent YOY to 10.4 percent in the same period. Driving overall food prices, meat prices increased sharply from a year earlier, with, especially, beef prices surging 40 percent YOY through March 2013, as a result of a growing gap between strong internal consumption demand and limited supply associated with reported livestock exports to neighboring countries and scattered livestock rearing in the country. This trend has more than offset the fall in rice prices, which have marginally picked up month on month since January. Energy inflation has remained low, in line with international trends. Core inflation picked up noticeably from 3.6 percent in November 2012 to 4.3 percent in March 2013 due to the scheduled rise in electricity tariffs 6 and restaurants and hotels price increases. Average inflation in 2013 is expected at around 6.0 percent compared to 4.3 percent in Figure 3: Monthly inflation (YOY percentage change) Figure 4: Contributions to food price inflation Source: MPI and staff estimates Source: MPI and staff estimates 15. While the government budget exhibits an increasing reliance on revenues from mining and hydropower, fiscal policy had been adequately counter-cyclical in recent years. The GOL adopted an expansionary fiscal stance in response to the global financial crisis, with increased on and off-budget spending, a stance that it subsequently reversed over As a result, the 6 According to Electricite du Laos, electric tariffs will increase by 5 percent annually from 2012 to

14 impact of the global crisis on public finances, and by and large on the economy, was relatively muted. For FY11/12, a strong overall revenue performance and broad expenditure containment allowed a narrowing of the overall fiscal deficit to 1.3 percent of GDP, from 2.7 percent in the previous fiscal year. and the non-resource fiscal deficit declined slightly from 8.3 percent in FY10/11 to 8.1 percent in FY11/12. The ratio of total revenue to GDP rose to 19.8 percent in FY11/12, up from 18.5 percent in FY10/11, with higher grant receipts to support the hosting of big events and a good performance in domestic revenue collection stemming from a combination of higher gold and copper prices in 2011, higher revenue from hydropower projects and a strong performance in a number of non-resource revenue sources, especially turnover tax, value-added tax (VAT) and income tax. Total expenditure eased to 21.1 percent of GDP in FY11/12 from 21.3 percent the year before, as the reduction in offbudget investment spending more than offset higher recurrent expenses, including expenditure supporting preparations for the 9th Asia-Europe Meeting (ASEM). 16. With an expected decline in mining revenues coupled with scheduled public sector wage increases, the fiscal stance in FY12/13 is set to become more expansionary with a wider primary deficit. The fiscal deficit is expected to more than double to reach 2.8 percent of GDP. The nonresource fiscal deficit is expected to climb to 8.7 percent in FY12/13 while the non-mining fiscal deficit is likely to reach 7.7 percent. Total revenue as a ratio to GDP is expected to decline to 19.4 percent due to lower grants (back to pre-asem levels) and reduced mining revenue as a result of a 10 percent fall in copper prices and higher mining processing costs. The outlook for non-resource tax revenues is positive, particularly VAT and excise taxes. This reflects the increase in the number of VAT tax payers from 2,300 to 4,100 units to date and the application of a flat 10 percent rate to those tax payers who used to be subject to the 5 percent turnover tax. Figure 5: Total government revenue (percentage of GDP) Figure 6: GOL s fiscal performance (percentage of GDP) Source: MOF and staff estimates Source: MOF and staff estimates 17. The ongoing public wage policy of consecutive annual 35 percent increases for three years is already driving expenditure upwards in FY12/13 and, if it is implemented as planned, is likely to limit the scope for future adjustments in the fiscal stance as may be needed. With the wage bill increasing by 35 percent YOY this fiscal year, total spending is projected to climb to 22.2 percent of GDP. Wages and compensation are projected to account for about 61 percent of both recurrent spending and non-resource domestic revenue in FY12/13 compared to 58 and 49 percent in FY11/12 respectively. In addition, the share of non-wage recurrent expenditure, which has already been underfunded, declined to 28 percent of recurrent expenditure in Q1 FY12/13 compared to 37 percent last fiscal year. Therefore, given the recent uncertain outlook on commodity prices and the continued expansionary policy, financing this policy is likely to place increasing strains on fiscal stability. In the coming years, it will be important for the authorities to take proactive fiscal measures 7

15 to avoid further expansion in the fiscal deficit (and to remain below the government set target of a deficit that is below 5 percent of GDP). Figure 7: Quarterly public spending: effect of wage and compensation increase policy Source: MOF and staff estimates 18. The current account deficit is expected to widen due mainly to growing resource sector imports. The total current account deficit is estimated to worsen to 21.8 percent of GDP in 2013 from 15.5 percent last year resulting from a combination of factors. Firstly, capital goods imports are projected to rise by about 32 percent YOY largely driven by increased demand for inputs during the construction phase of ongoing large resource projects. Secondly, robust domestic consumption will continue to fuel demand for consumer goods imports, such as vehicles and fuel compared with slower growth in non-resource exports. However, nominal import growth will be partly offset by falling fuel and lower commodity prices for certain products. Non-resource exports grew slower in the context of economic uncertainty in some trading partners. For instance, total garment exports fell by 16 percent YOY due to a 30 percent drop in exports to the US market. Supply side constraints related to labor shortages and the real appreciation of the Kip have also played a role. Some manufacturing firms have adjusted by turning to higher value added products and by shifting to other markets such as Japan. Net income outflows (interest payments and income repatriation from mining and hydropower sectors) are expected to go above their 2012 level of US$ 620 million. Figure 8: Merchandise exports (US$ million) Figure 9: Merchandise imports (US$ million) Source: Staff estimates based on data from Lao authorities (MOIC) and partner countries Source: Staff estimates based on data from Lao authorities (MOIC) and partner countries 8

16 Figure 10: Balance of payments, (percentage of GDP) Figure 11: Foreign direct investment, (US$ million) Source: BOL and staff estimates Source: MPI and staff estimates 19. Despite a recent end-of-the-year rebound, foreign exchange reserves remain low. The balance of payments posted a surplus of 0.7 percent of GDP in 2012 helped by a slowdown in credit growth (particularly in foreign currencies) in the second half of 2012 and commercial banks recapitalization and new registration. As a result, foreign reserves and net foreign assets rebounded in Q4 by 24 percent (quarter on quarter) and 35 percent YOY after continually falling since end Reserves stood at US$ 740 million in December covering only 1.8 months of goods and services imports or about 3 months of non-resource imports, which is the lowest level over the past eight years 7. Reserve coverage of foreign currency deposits fell progressively from about 60 percent two years ago to around 40 percent at end Figure 12: Net foreign assets and international reserves Figure 13: Reserves coverage (percentage) Source: BOL and staff estimates Source: BOL and staff estimates 20. The central bank continues to pursue a managed exchange rate policy to maintain exchange rate stability. The effective exchange rate appreciated by 2.3 percent in nominal terms and by 4.3 percent in real terms from end-2011 to August This is the result of the combined kip appreciation against the US dollar (by 3 percent Q1 2013) and kip depreciation against the Thai baht in recent months (1.4 percent over the same period as the baht continues to strengthen against the US dollar as a result of strong investment inflows into Thailand). The continued real appreciation of the 7 Note that figures from the BOL show gross official reserves providing a higher import coverage than World Bank staff estimates due to differences in estimates of import requirements for goods and services. The figures for nominal reserves are consistent. 9

17 exchange rate signals a loss of competitiveness of Lao PDR s exports which is consistent with the continued increases in domestic labor costs. Figure 14: Lao kip exchange rate Figure 15: Nominal and real effective exchange rate Nominal Effective Exchange Rate Real Effective Exchange Rate Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Source: BOL Source: IMF 21. The banking sector has developed rapidly in recent years but remains vulnerable to shocks due to weak regulatory enforcement and supervision. Over the past two years, 8 new commercial banks have begun operations, which brought the total number of banking institutions to 31, consisting of 4 State-Owned Commercial Banks (SOCBs) (which collectively hold two-thirds of market share), 2 joint-ventures, 11 private banks and 14 foreign bank branches. Increased competition by the recent entry of new private banks has provided an incentive for SOCBs to improve their performance, risk management, governance, products and services. Loans from commercial banks have gradually increased from 7.5 percent of GDP in 2006 to 34 percent of GDP in A small, but growing, share of households and small and medium sized enterprises (SMEs) have access to formal financial services, including expanded non-bank financial sector services. Additionally, access points have increased from a very low base during the past few years. 22. Against the backdrop of an expanding banking sector, increased efforts to strengthen bank supervision capacity are required. Along with the increasing number of banks, their total assets increased significantly by 40 percent YOY as of end-2012 while their lending rose by 35 percent (YOY) over the same period. However, not all financial institutions can comply with the mandatory requirement to timely publish audited financial statements as required by the Commercial Banking Law, making it difficult to assess the sector s financial health in a timely manner. The share of non-performing loans (NPLs) was reported to be 3.7 percent of total loans outstanding in mid-2012 but there are questions regarding the reliability of NPLs measurement, due to the central bank s weak regulations, reporting and limited supervision capacity. 23. Credit growth showed signs of a moderate slowdown by end 2012 but still continues to stimulate domestic demand. After mid-2012, the annualized rate of credit growth started to decelerate to about 27 percent (YOY) in December compared to 58 percent (YOY) in June due to the slow pace of growth of BOL s direct lending (lending to SOEs line item) and lending to the private sector. This trend may be due to a base effect and a slowdown after an already high loan to deposit ratio of almost 90 percent in mid This contributed to a recovery in net foreign assets and reserve levels by year end but uncertainty remains as to whether this will only be a temporary trend. Credit to the private sector expanded at the rate of 35 percent YOY in December 2012 and is still considered high and playing a role in stimulating domestic demand. Private sector credit growth has primarily come about as a result of increasingly buoyant growth in the construction, trade and services sectors. 10

18 For instance, lending to construction rose by 77 percent YOY contributing about 10 percentage points to aggregate credit growth to the private sector. Figure 16: Banking sector assets (billion kip) Figure 17: Contribution to bank credit growth (percent and percentage points) Source: BOL and staff estimates Source: BOL and staff estimates 11

19 3 Lao P.D.R.: Selected Economic and Financial Indicators, / Est. Proj. GDP and prices (percentage change) Real GDP growth CPI (annual average) CPI (end year) Public finances (in percent of GDP) Revenue Of which : Resources Of which : Mining Of which : Hydro power Of which : Grant Expenditure Expense Net acquisition of nonfinancial assets 2/ Net lending/borrowing Nonmining balance 3/ Money and credit (annual percent change) Reserve money Broad money Bank credit to the economy 4/ Bank credit to the private sector Balance of payments Exports (in millions of U.S. dollars) 2,196 2,529 2,738 2,898 3,097 In percent change Imports (in millions of U.S. dollars) 3,582 4,603 5,184 5,958 6,453 In percent change Current account balance (in millions of U.S. dollars) -1,256-1,773-2,008-2,472-2,686 In percent of GDP Gross official reserves (in millions of U.S. dollars) In months of prospective goods and services imports (Excluding imports associated with large resource projects) External public debt and debt service External public debt In millions of U.S. dollars 3,539 3,685 3,993 4,333 4,716 In percent of GDP External public debt service In percent of exports Exchange rate Official exchange rate (kip per U.S. dollar; end-of-period) 8,040 8,002 8,222 Real effective exchange rate (2000=100) Nominal GDP In billions of kip 56,523 66,513 74,784 86,491 97,729 In millions of U.S. dollars 6,855 8,302 9,219 10,283 11,179 Sources: Data provided by the Lao P.D.R. authorities; and IMF staff estimates and projections. 1/ Public finances are on a fiscal year (October to September) while other data are on a calendar year. 2/ Includes off-budget investment expenditures. 3/ Net lending/borrowing excluding mining revenue. 4/ Includes Bank of Lao P.D.R. lending to state-owned enterprises and subnational levels of government.

20 IV. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 24. The economic outlook for the remainder of 2013 and for the medium term remains broadly positive, although Lao PDR s ability to absorb macroeconomic shocks is limited. Taking into account uncertainties in the global economy and their continued implications for regional economic development, Lao PDR s average annual growth rate is projected at close to 8 percent per year in the medium term. This outlook assumes the successful operation of a number of key large power projects under construction or still in the pipeline. The non-resource sector is expected to maintain dynamic growth in the context of continued strong domestic consumption, sustained demand from key trading partners and continued reform efforts to improve the business environment. 25. The 7 th NSEDP target to reach an average of 8 percent economic growth is ambitious but remains achievable. A pipeline of large hydropower projects, rapidly rising demand for electricity in neighboring countries and increased production of copper and gold can be expected to support growth and help attain the NSEDP7 GDP growth targets. Nevertheless, the on-going uncertainty in the global economy and related enhanced volatility in commodity prices could negatively impact the Lao economy. 26. Inflation is projected at moderate levels in 2013, but could rise further with growing uncertainty on the global market and a buoyant economy. Inflation is expected to average 6 percent for 2013 with continued upward pressure from food inflation from non-rice food items. The effect on prices of the recently introduced temporary suspension on livestock exports remains to be seen, but in any event meat prices are not expected to continue to flare up and they may ease. Although energy inflation has remained low in recent months, fuel prices remain high and additional shocks to food and fuel prices could quickly translate into higher inflation. Overall, however, rapid domestic credit growth, increased wages and a booming real estate market are signs of risks of overheating which all call for more forceful efforts to reining in aggregate demand. 27. In the medium term, the public wage increase policy planned until FY14/15 will yield an upward trend in the fiscal deficit, albeit still within the government s target of less than 5 percent of GDP. The wage bill is expected to rise by approximately 35 percent annually until FY14/15. Going forward, with non-wage spending restraint and an unchanged revenue policy, wages and compensation are projected to account for a higher share of recurrent spending and non-resource domestic revenue. While the planned fiscal path is broadly sustainable, the growing share of wages in total recurrent spending would heighten the underfunding of the non-wage recurrent budget, and hamper efforts to improve the efficiency of public investment. For the longer term, a higher ratio of wages to non-resource revenues (which tend to be more stable than resource revenues) also implies higher fiscal vulnerability to shocks to revenue sources. 28. The authorities are broadening their sources of deficit financing, adding nonconcessional financing to their current combination of concessional foreign and domestic financing. Foreign financing will remain mostly concessional. In the FY12/13 budget, however, the authorities plan to mobilize 1,800 billion Lao kip (equivalent to about US$ 220 million, or about 2 percent of GDP) through bond issuance in foreign currency in the regional capital markets, with about half of the bond proceeds intended for repayment of off-budget spending commitments made to support local infrastructure projects. 29. Monetary policy for the rest of 2013 is expected to focus on maintaining a broadly stable exchange rate and low inflation. Containing domestic demand through a slowdown in rates of credit growth remains essential to remove pressure on external balances, in an environment of fast growth, growing demand for imported consumption goods and low and declining official reserves. The BOL also aims to pursue its policy of phasing out quasi-fiscal operations and slow down the provision of 13

21 credit, which should go some way to contribute to reducing domestic demand pressures. Allowing some depreciation of the exchange rate would reduce pressure on reserves and help to slow imports. 30. Going forward, the country s medium-term external position will continue to be heavily influenced by the hydropower and mining sectors, while the current account deficit of the nonresource sectors will remain large. The construction of large hydro projects will still drive imports higher, but the completion of several projects will ultimately slow down the buoyancy in import growth in the medium term. The non-resource current account deficit is expected to remain high partly due to robust domestic consumption and some capital imports, even after some of the needed tightening. The trend will need to be monitored and managed carefully in order to maintain macroeconomic stability and mitigate renewed pressures on the external position and on official foreign exchange reserves. Debt Sustainability 31. The 2012 Joint IMF-World Bank Debt Sustainability Analysis (DSA) concluded that Lao PDR s risk of debt distress is moderate, but the recently announced large hydropower and infrastructure projects are a source of growing concerns over debt sustainability. The level of debt distress was reclassified from high to moderate due to an improvement in policy performance from weak to moderate 8. As a result, in this analytical framework, Lao PDR is now subject to higher indicative debt distress thresholds. Under the baseline assumptions, all external debt distress indicators remain below the new policy-dependent indicative thresholds, although some breaches occur under the stress tests. This improvement has implications for possible increases in external resources available to Lao PDR. Table 2: Thresholds for external debt (percentage) Thresholds External Public Debt Indicators at end 2011 Indicator Before Present Present value of Debt to GDP Present value of Debt to exports Present value of Debt to revenue Debt service to exports Debt service to revenue 1/ Source: DSA 2012 Note: 1/ for debt service to revenue ratio, the applicable thresholds have been reduced 32. While the stock of external public and publicly guaranteed (PPG) debt has declined substantially in recent years, bilateral borrowing has been gaining a larger share of the total. The stock of external PPG debt fell to 44.4 percent of GDP in 2011 (US$ 3.7 billion), from 50.3 percent in 2010, as a result of strong economic growth and appreciation of the Lao kip against the US dollar. Multilateral creditors (mainly the Asian Development Bank and the World Bank) still account for the majority of the total external PPG debt, with 56 percent compared to the bilateral creditors share of 38 percent. The share of public borrowing from bilateral sources (mainly China, India, Japan, Korea, Russia and Thailand) has gradually increased in recent years, signifying the increasing importance of bilateral creditors. Furthermore, the share of non-concessional PPG debt has increased steadily in the past few years, although from a low base. In 2011, commercial borrowing was recorded at 6.3 percent of GDP (around US$ 200 million). As at end 2011, PPG debt servicing ratios fall comfortably under the thresholds due to the high level of concessionality of official borrowing. 8 The average CPIA rating for Lao PDR has been above 3.25 thresholds for two consecutive years, bringing Lao PDR s policy performance from weak to medium. This is based on the Joint IMF-WB Debt Sustainability Framework for Low Income Countries. 14

22 33. A US$ 50 million bond placed in the Thai market in May 2013 was Lao PDR s first issuance of non-concessional, sovereign debt. The debt was incurred to support investment needs and as part of efforts to prepare for an eventual exit from eligibility for concessional sources of finance (including IDA). The coupon is 4.5 percent in baht, swapped into US dollars, with a 3-year term. The proceeds of the bond are not earmarked for any specific investment projects, but will be utilized for investment purposes 9. The Thai government granted special approval for the GOL to proceed with the offering without a formal country credit rating in place. Further non-concessional bond issuances are planned in the coming years with longer maturity, however this will be dependent on the acquisition of a country credit rating. At just under 0.5 percent of GDP the bond issuance is small and has a negligible impact on the stability of the macroeconomic framework or Lao PDR s debt sustainability. Table 3: Composition of external public and publically guaranteed debt at end 2011 US$ billion dollars Share of total public Percent of GDP external debt Total Multilateral Bilateral Commercial # Source: IMF and WB Debt Sustainability Analysis 2012 Note: # includes direct borrowing by state-owned enterprises on non-concessional terms 34. The number of large infrastructure projects recently announced raises concerns over debt sustainability and over the country s capacity to absorb the announced new financial commitments. In this context, enhancing capacity in debt management, debt sustainability analysis and project viability appraisal is of crucial importance. The authorities are taking steps to encourage a transparent public debate over these mega-scale projects by publishing information in the media and on the National Assembly website, but these efforts are starting from a very low base. The government has also now deployed the Debt Management and Financial Analysis System (DMFAS) to improve debt monitoring and has developed a Presidential Ordinance (Decree-Law) on public debt management. All these efforts are steps in the right direction and should be sustained together with the development of a debt management strategy One key example is the proposed US$ 6.7 billion Lao-China Rail Project, which may pose significant risks to debt sustainability. If public-guaranteed borrowing to finance this project is assumed, even under concessional terms, this loan would by itself make public debt unsustainable (based on the recently acquired moderate risk thresholds in the IMF-World Bank debt sustainability framework). Assuming a 2 percent fixed rate of interest, with 20-year maturity and a 10-year grace period starting from 2013 onwards, the present value of external debt to GDP would increase from 30 percent at present to 70 percent by 2016, well above the threshold for debt sustainability of 40 percent (shown in Table 2). The thresholds for present value of debt to exports, and debt service to revenue would also be breached. A careful review of the implications for debt sustainability, in addition to careful cost-benefit analysis, is therefore critical before proceeding with this project. Similarly, the proposed US$ 5.0 billion East-West Railway, while reported to be privately financed, raises questions about the management of large infrastructure development projects. This project is claimed to be financed on a build-operate-transfer model, however it is unclear if government would be fully protected from contingent liabilities if the project were to go ahead. 9 Under the 2006 Budget Law, recurrent expenditures must be financed by domestic revenues, and thus borrowing (both domestic and foreign) can only be used for investment purposes. 10 These projects include the Satellite, Radio and Television project, Fiber Optic Project, Lao-China Railway Project, etc (KPL Newspaper 7 November 2012). 15

23 36. The recorded stock of domestic public debt rose to 8.9 percent of GDP in 2011, up from 8.5 percent of GDP in 2010, as a result of continued disbursements from the BOL to finance local government s previously committed expenditures for off-budget infrastructure projects. Lending from the BOL to local government represents about three-quarters of the recorded total domestic debt, with the remainder including government bonds related to the recapitalization SOCBs. Total PPG domestic and external debt stood at 53.2 percent of GDP in 2011, down from 58.8 percent in This improvement is also driven chiefly by the combination of GDP growth and exchange rate effects. The stock of BOL s loans to local government is projected to peak in the near future as the BOL s quasi-fiscal operations are gradually phased out. Domestic debt is expected to decline from 8.9 percent of GDP in 2011 to about 5.4 percent of GDP by An emerging trend of infrastructure projects pre-financed by the private sector may indicate a risk of contingent liabilities if there is a lack of proper accountability and careful management. An increasing number of infrastructure projects, such as roads and bridges, are being pre-financed by the private contractors citing development priorities of concerned regions against current limited budget allocations. This trend has been matched by the increasing lending to the construction sector in recent years. These projects are claimed to be aligned with provincial or national NSEDP targets and will be repaid through future budget allocations. In other words, it would mean borrowing future revenue to spend today. If not managed properly, this type of financing might generate contingent liabilities and a liquidity squeeze for the future budget, contractors and the banking sector. Therefore, it is of crucial importance that the authorities understand the current size of both on-going pre-financing arrangements and the pipeline of future projects in order to help the government to manage and closely monitor these liabilities. The GOL has indicated its commitment to phase out such off-budget expenditures and the new Presidential Ordinance on Public Debt Management, if fully implemented, will contribute to putting in place a more robust oversight mechanism for the accrual of public liabilities. 38. Notwithstanding the emerging risks, overall the current macroeconomic framework is adequate for a budget-support operation to proceed, with a broadly positive medium term economic outlook for Lao PDR. The country has established a creditable track record of macroeconomic stability in the last fifteen years. Under that track record, the authorities have pursued fiscal and monetary policies that were broadly consistent with macroeconomic stability. Going forward, the fiscal deficit remains low, despite planned wage increases, and domestic aggregate credit growth, albeit still high, has been slowing down. The authorities are aware of the need to contain excessive growth in domestic demand to sustain internal and external balance. The low coverage of official reserves signals the need for further tightening of domestic demand expansion through appropriate monetary policy to avoid pressure on external accounts. 39. Looking forward, it will be important for the authorities to take steps to more effectively address medium-term macroeconomic risks. The number of large projects which have been recently agreed or are under discussion, and infrastructure projects which are supported by private prefinancing arrangements, call for enhanced scrutiny over debt sustainability and management, in order to maintain the recently acquired moderate risk of debt distress and avoid a build-up of contingent liabilities. Moreover, the broader framework for macroeconomic policy-making and financial sector supervision needs to be upgraded to mitigate risks to macroeconomic and financial stability in the context of heightened uncertainty in the global economic environment. 16

24 V. GOVERNMENT PROGRAMS AND PARTICIPATORY PROCESSES 40. The main objective of the government s strategy is to achieve the MDGs by 2015 and to graduate from LDC status by In June 2011, the National Assembly adopted the most recent five-year plan, the 7 th National Socio Economic Development Plan. In October of that year, the NSEDP7 became operational. The plan was developed after extensive consultations with key stakeholders and development partners. On January 12, 2012 the World Bank Board discussed a JSAN informing the Board of Executive Directors on priority areas to best implement the Lao PDR NSEDP7 for The NSEDP7 provides a comprehensive strategy for development, with a range of medium and long-term policies aimed at achieving sustainable economic growth and poverty reduction. It establishes the following overarching goals: i) ensure the continuation of national economic growth with security, peace and stability, and ensure a GDP growth rate of at least 8 percent annually. In addition, GDP per capita should reach a minimum of US$ 1,700 by 2015; ii) achieve the MDGs by 2015, and adopt appropriate technology, skills and create favorable conditions for the country to graduate from LDC status by 2020; iii) ensure sustainable development by emphasizing economic development parallel to cultural and social progress, preserving natural resources and protecting the environment; and iv) safeguard political stability, peace and an orderly society. 42. To achieve these goals, the NSEDP7 proposes a number of measures, including i) build a strong base for sustained economic growth for the country to move out of LDC status in order to reduce poverty; support an economic and labor structural shift from agriculture to industry; share the benefits of development with all; promote SMEs; and promote people s participation; ii) focus on rural development and poverty eradication, to reduce income disparities; iii) improve education standards by continuing education reforms and supporting human resource development; upgrade and expand educational opportunities; and strengthen labor skills; promote good health and sanitation; strengthen staff management and high-skilled workers capacity; iv) strengthen the effectiveness of public administration, rule of law and the fight against corruption; v) optimize the use of natural resources; increase cooperation and integration at regional and global levels; increase competitiveness; develop socio-economic infrastructure; and vi) implement industrialization strategies, with a focus on both large mega projects as well as ensuring that small and medium sized firms are able to integrate into the regional economy. 43. The NSEDP7 addresses some of the priority areas previously identified as lacking in the JSAN for the Sixth NSEDP The NSEDP7 focuses on macroeconomic stability, promotes inclusive and sustainable private sector-led growth and regional integration, and is poverty and resultsfocused. Sector priorities, principles and mechanisms to achieve objectives are consistently presented throughout. A greater role is envisaged in the NSEDP7 for further strengthening public financial management and human development, in particular the need to build skills. 44. The NSEDP7 consultation process included a wide-range of players including the donor community, the private sector, civil society and non-governmental organizations (NGOs). The Ministry of Planning and Investment (MPI), alongside other line ministries, led consultations during its development with local communities, focusing on the country s poorest districts. Through the Round Table Implementation Mechanism (RTM), the private sector, donor community and civil societies were also consulted. Other participants included National Assembly members and massorganizations such as the Lao Women s Union (LWU). Cooperation across the government was strong, as the MPI led frequent technical meetings with the Ministry of Finance (MOF) and other line ministries. 17

25 45. The NSEDP7 goals are ambitious, but achievable. High commodity prices coupled with numerous hydropower and mining projects in the pipeline bring the 8 percent growth target within reach. This is, however, dependent to some degree on the global economic outlook. The government has outlined clear and specific objectives for increased international and regional integration as a means of achieving economic and social development targets. The focus on the sustainability of natural resource development is welcome in a resource-rich country such as Lao PDR. The NSEDP7 identifies a number of measurable targets related to natural resource management. Social sector goals (achieving the MDGs by 2015) are appropriate, although the national targets do not reflect the significant geographic variations within the country. 46. Significant intervention will be required to achieve all of the MDGs, given current trajectories. In particular, the MDGs on malnutrition, maternal health, child health, access to water and sanitation in rural areas, and loss of environmental resources are unlikely to be realized without increased government focus and expenditure. The NSEDP7 appropriately proposes to increase allocations to social sectors, but proper sequencing and prioritization of expenditures, along with the monitoring of their impact, will be critical for their success. Links to the Country Partnership Strategy VI. BANK SUPPORT TO GOVERNMENT PROGRAMS 47. The World Bank Group s Country Partnership Strategy for Lao PDR can be summarized as, Strengthening Institutions for Sustainable and Inclusive Development in full support of the NSEDP7 11. Building on the government s impressive growth and poverty reduction record, the World Bank CPS proposes to work in partnership with Lao PDR as it lays the foundations to become a middle income economy. Consistent with the directions articulated in the NSEDP7, the CPS supports efforts to bolster Lao PDR s competitiveness and connectivity with its neighbors to better integrate the country regionally and internationally. It also supports the country s efforts to sustainably and equitably develop natural resource wealth, with consideration to social and environmental welfare. To translate the expected benefits from increased competitiveness and sustainable natural resource management into inclusive development, the CPS supports GOL s efforts in poverty reduction as well as improvement of the quality of education and health services, especially for the poor. To achieve these three strategic objectives, building institutions and strengthening public sector management are seen as a cross-cutting challenge. 48. The PRSO program goes hand-in-hand with the World Bank s CPS and contributes to reaching its objectives and to mitigating its implementation risks by supporting a selection of policy and institutional reform elements. The proposed five pillars of this PRSO series are consistent and mutually reinforcing with the cross-cutting theme and three objectives of the CPS. The cross-cutting theme - Strong Public Sector Management recognizes that institutional capacity in the public sector limits the government s ability to design and implement its programs. Therefore, the achievement of each strategic objective will require some strengthening of public sector management, which makes this the core and unifying CPS theme. Objective 1 - Competitiveness and Connectivity - focuses on using investment and analytical services to support diversification of trade and private sector development and the establishment of a competitive and efficient regulatory framework for the private sector. 11 The CPS is a joint strategy paper between the World Bank s International Development Association (IDA) and the International Finance Corporation (IFC). 18

26 Objective 2 - Sustainable Natural Resource Management - proposes to strengthen governance and management of the hydropower and mining sectors. Objective 3 - Inclusive Development - supports increased utilization and quality of essential maternal and child health services. VII. COLLABORATION WITH THE IMF AND OTHER DONORS 49. The PRSO series is characterized by an evolving partnership framework between government and development partners, and has become an established aid coordination tool. The EU jointly designed the PRSO 8-11 operations, provides parallel budget financing and supports a complementary program of technical assistance. Japan previously provided parallel financing to the first and second series and has rejoined to provide parallel financing to the third series from PRSO 9. Australia is an important PRSO partner through the provision of technical assistance for PRSO implementation. PRSO development partners inform the donor community on its progress and encourage participation in the joint PRSO dialogue. 50. The EU s participation in the joint PRSO 8-11 focuses on dialogue in the following sectors: social sectors (with an emphasis on education) and in public finance management, including support to the State Audit Organization (SAO) and the Budget and Finance Committee of the NA. It is tentatively planned that the EU provides parallel budget financing to PRSO 8-11 in the amount of EUR 14 million and also provide complementary technical assistance valued at EUR 4 million. Specific service contracts are envisaged for technical assistance in the social sectors. Support to Public Financial Management (PFM), including the SAO and the Budget and Finance Committee of the NA is envisaged as continued support through a World Bank administered Multi-Donor Trust Fund (MTDF). 51. Japan s decision to join PRSO 9 is welcomed and will renew a long-term partnership of policy dialogue through the PRSOs. Japan has a particular interest in health and education policy dialogue. It takes an active role in education to promote the adoption and implementation of Education Quality Standards Assessments. In health, Japan s support focuses on the coordination of dialogue through the support of the health sector-wide coordination mechanism, as well as technical assistance to develop and implement a human resource strategy. 52. The International Monetary Fund (IMF) conducts annual Article IV consultations with the authorities. The Bank and the IMF staff collaborate closely during these annual consultations in the context of the PRSO program, and conduct a joint and annual Debt Sustainability Analysis (DSA). The IMF s last Article IV consultation was completed in June The next consultation and DSA is scheduled for August Additionally, close coordination with the IMF is ensured on technical assistance in public sector management. 53. Other development partners providing technical assistance in areas related to PRSO include the United Nations agencies, the Asian Development Bank (ADB) and bilateral donors such as Australia (AusAID), Germany (GIZ) and the United States (USAID). The PRSO coordinates missions focusing on the development of shared technical assistance, joint projects, and promotes dialogue through development partner coordination mechanisms, such as the Round Table Technical Working Groups. Australia, represented by AusAID, supports the implementation of PRSOs by providing complementary support via World Bank-managed multi-donor trust funds: i) the Public Finance Management Strengthening Program; ii) the Trade Development Facility; and iii) the Hydromining Technical Assistance Project. 19

27 VIII. ACHIEVEMENTS AND LESSONS LEARNED FROM PAST PRSOS 54. The first operation of the third PRSO series, PRSO 8, was discussed and approved by the World Bank Board of Executive Directors in August 2012 alongside a medium-term PRSO program (PRSO 8-11) of four single-tranche operations (Annex 2). Since then, the program framework has remained broadly consistent with the dialogue with the authorities and circumstances of Lao PDR. PRSO 8 supported (i) a new format of reporting by revenue-collecting agencies separating hydropower and mining revenues from other type of revenues for better fiscal planning, (ii) the implementation of the Zero Balance Account (ZBA) in all three state-owned commercial banks; (iii) the adoption of legislation applying international accounting standards for the private sector and for commercially oriented entities in the public sector; (iv) the first time distribution of the school block grant by the Ministry of Education and Sports (MOES) to public primary schools based on a per student formula; (v) the adoption of the National Free Maternal and Child Health Policy; (vi) a transparent access to information on trade-related processes and procedures; and (vii) simplified enterprise registration procedures and the abolition of investment licenses for general investments under the Investment Law. 55. One of the lessons learned in the course of PRSO 8 implementation is the need to make mid-course adjustments for PRSO 9 and the rest of the series on the PRSO PFM engagement relative to what was envisaged at the time of PRSO 8. In particular, during the preparation of PRSO 9, the government indicated its preference to work on upgrading its home-grown Government Financial Information System (GFIS) instead of adopting an off-the-shelve Treasury Information Management System (TIMS), as previously discussed with the World Bank team. Subsequently, that decision was reversed and government s current plan is to commence the implementation of an Integrated Financial Management Information System to replace the GFIS using internal resources. Past Achievements 56. Policy dialogue under the second series, PRSO 4-7, focused on two broad areas: i) sustaining growth through improvement of the investment climate, facilitating trade and enhancing management of natural resources; ii) improving social outcomes through better public financial management systems and service delivery, in alignment with the government s own development strategies as articulated in its National Growth and Poverty Reduction Strategy and the 5-year NSEDP. The first component focused on the development of an improved legal framework for investment and private business activity. It aimed to put in place more open trade and investment policies so that the country could benefit from efficient integration with economies, regionally and internationally. This component also placed an increased emphasis on natural resource management, as a key element of the regulatory environment for a majority of the current investments occurring throughout the country. The second component focused on building a functional public finance management system with: effective controls over revenues and expenditures; a clearer delineation of powers, responsibilities and resourcing of central and local levels of the administration; budgetary processes that enable spending plans to be aligned with strategies, and control systems to ensure that resources are used in accordance with those plans; and external oversight mechanisms to ensure greater accountability to the people. The component also focused on ways to improve spending in health and education. 20

28 Box 2: Key policy reforms implemented under PRSO 4-7 Component 1: Sustaining growth through improvement of the investment climate, facilitating trade, and enhancing management of natural resources Simplification and codification of legal regime for domestic and foreign investment: A unified Investment Law was passed, which abolished lengthy licensing approval procedures for general investment activities. This created a level playing field for domestic and foreign investors, promoting greater investments. Laws on Commercial Banks, Secure Transactions Laws and Microfinance Decrees were created to ensure a fair operating environment for both state owned and private banks, and between domestic and foreign-owned banks. Progress on financial sector policy framework: A financial sector strategy was approved, laying out sequenced priorities to develop the sector. Prudential rules for banking sector supervision were strengthened. Elements of legal framework for regulation and taxing natural resource exploitation approved: Minerals Law and implementing decree. Decree on Environmental Impact Assessment. Trade reforms implemented: Requirement for annual import-export plan abolished, Trade Facilitation Strategy and Action Plan prepared and approved, new WTO-consistent decrees on Rules of Origin and the Import and Export of Goods, introducing the principles of national treatment into Lao law. Border processes simplified with removal of all but Customs, Immigration and Quarantine agencies from checkpoints. ASEAN compliant Single Administrative Document introduced. Progress on SOE reform: Government arrears to the electricity utility settled, and a mechanism to avoid future arrears introduced. Component 2: Improving social outcomes through better public financial management systems and service delivery Progress on fundamental reforms to financial management and centre-province fiscal relations: New Budget Law passed and implemented: centralisation of Treasury, Customs and Tax Departments brought revenues and spending under central government control, and a single treasury account system implemented. Implementation of new Chart of Accounts, new revenue sharing formula and aggregate budget allocation norms agreed, minimum provincial spending on health and education mandated. Publication of budget outcomes. State Audit Organisation published first audit of a budget execution report. Costed annual education sector work plans prepared, exposing variation in sector spending across provinces. Health financing strategy prepared, Education yearbook including Assessment of Student Learning Outcomes and health statistics report completed. 57. PRSO 4-7 supported policy reform results included the following: Support for public financial management reform has helped develop stronger policy control over the use of budgetary resources: both in terms of making sure that revenues are spent according to policies and plans, and that plans and policies better determine how revenues are allocated to priority areas. Improvements in budget processes and oversight functions have enhanced the transparency and accountability of the public finance system, which are prerequisites for better use of government resources. These efforts will make it possible to improve the allocation (level and composition) of social sector spending, needed to deliver key MDGs. At the moment, sectoral ministries lack the tools to ensure that education and health spending is well targeted, or is at levels consistent with sector development plans. 21

29 Reforms have improved the environment for investment, trade and doing business. However, changes in laws and regulations take time to translate into on-the-ground results, and implementation is only starting in many of the supported areas of the trade and investment climate. Reforms in the natural resource management area will, if implemented thoroughly, improve social and environmental sustainability of projects. Similarly, improvements in the regulation and governance of the financial sector will eventually contribute to the soundness of the financial sector and reduce fiscal risks, such as the need for further recapitalizations of stateowned commercial banks. 58. Improvements are evident in a number of the program s results indicators, although results are mixed in some key areas: Indicators for the enabling business environment, reduction of trade barriers, performance of stateowned enterprises (SOEs) and commercialisation of SOCBs show improvements; Indicators for a number of measures of the quality of public financial management demonstrate improvements. However, some show no change, but none show deterioration; but, Key indicators for improving service delivery have not shown improvements. In particular, in health and education, non-wage-recurrent spending as a share of total spending has not improved by as much as expected over this period. Lessons Learned 59. A number of lessons have been learned from the past two PRSO series, and are described as follows: Acknowledging the value of the PRSO as an effective and mature policy instrument and the value of aid coordination providing higher visibility to sector reforms and greater coherence of the cross-sectoral reform agenda. Effectiveness was strengthened during the second PRSO series by achieving greater focus, and through the initiation of a series of supportive analytical and advisory activities. Selecting focused sector engagement where PRSO works better. One of the lessons learned during the past series of PRSO dialogue in the social sectors was that in spite of significant challenges, policy dialogue did lead to the intended result of increased spending in those sectors. It is important that further support strategically selects areas of focused engagement in the social sectors, in particular leveraging PRSO s comparative advantage of strengthening dialogue between the MOF and line ministries on social spending. Need for a following up on implementation. The PRSOs have focused a great deal on establishing the legal, regulatory and strategic pillars of reforms, as a prerequisite for sustainable and lasting change. Implementation has sometimes not materialized as initially envisaged for a number of reasons, the main one being that it takes time for legal change to translate in on-theground changes and results. This has been in particular the case for investment climate and business environment engagement, where the legal and strategic frameworks have been strengthened, and where implementation needs to be supported to reflect expected outcomes. Sequencing reforms and PRSO intervention. The second series set ambitious targets on a number of parallel fronts. This was especially true for PFM reforms, where the most remarkable progress took place in the first generation reforms, which concentrated on securing control over resources and budget execution. Reforms on resource allocation linked with policy priorities and service delivery improvement have been slower. Thus, policy dialogue needs to be carefully sequenced over the life of the PRSO series to ensure the buildup of reform momentum. Coordination with sector working groups and other development partner support. In areas where sector working groups are active, it is important that the PRSO dialogue is embedded into established mechanisms for government-development partner dialogue. It is equally important that 22

30 PRSO coordinates with other external development partner activities that are relevant to the PRSO dialogue. IX. ANALYTICAL UNDERPINNINGS AND RELATION TO OTHER BANK OPERATIONS Analytical Underpinnings 60. Two critical principles of PRSO engagement are solid analytical underpinnings and provision of on-the-ground, effective technical assistance. The third PRSO series is underpinned by a number of Analytical and Advisory Activities (AAA), including the 2010 Lao Development Report on Natural Resource Management for Sustainable Development (focused on hydropower and mining), a 2011 Public Expenditure Review (PER), a 2010 Public Expenditure and Financial Accountability (PEFA) Assessment, a 2011 Investment Climate Assessment, a 2012 DTIS update, a 2010 Poverty Report and associated policy notes, a 2011 Health Expenditure Review, a 2011 Budget Brief, and biannual Lao Economic Monitors, a 2010 Pay and Compensation Review and associated Civil Service Reform Policy Note, a Report on the Observance of Standards and Codes (ROSC), which was finalized in 2007 and an IDF supported follow-up action plan to implement key recommendations. 61. The strategy underpinning the Bank s AAA program identifies and fills key knowledgegaps with an emphasis on joint work with the government and other development partners. The results of this AAA process were used to build consensus on policy reform, sector investments, and harmonization of donor assistance in key areas. These are reflected in the NSEDP as well as its implementation. Several of these studies have been prepared in collaboration with other development partners including the IMF, AusAID, ADB, EU and UN. 62. This PRSO series draws its key policy reforms from the 2010 Lao PDR Development Report: Natural Resource Management for Sustainable Development. The report clearly identifies strengthening the management of revenues from the natural resource sectors as a critical priority for the sustainability of the country s development path. Recommendations include; i) the proactive management of volatile mining revenues, strengthening rules for public debt and non-resource deficits; ii) adjusting the fiscal regime in the mining and hydropower sectors to minimize risks, and maximize government revenues while maintaining international competitiveness of the sectors; iii) improving the investment climate in the non-resource sectors to reduce the high transactions costs facing traders (also drawing from the investment climate assessment and trade-related analytical work); and iv) strengthening revenue distribution and management as a part of an essential element of the natural resource management value chain. 63. In addition, other analytical foundations inform the PRSO series engagement in public financial management, health and education sectors. The 2010 PEFA Assessment and the 2011 PER underscore the need to address the fragmented budgeting mechanism, to continue treasury centralization reforms, and to strengthen budget accountability to enable the public sector to deliver efficient public services. The recommendations made in the ROSC underpin the PRSO dialogue on international accounting standards. The PER, together with the Health Spending Review, points out that low non-wage recurrent spending is a significant constraint for the efficient delivery of basic health and education services. Other Bank Operations 64. The PRSO program complements other World Bank operations, both ongoing and as envisaged in the CPS. The PRSO framework provides a platform for policy and institutional reforms which are then implemented with support from other World Bank operations. 23

31 65. A key component of the series supports the government s program for improving effectiveness in public expenditure management, the Public Financial Management Strengthening Program (PFMSP). AusAID, the EU - and initially the Swedish International Development Agency and Swiss Development Corporation - have established a Multi-Donor Trust Fund (MDTF) managed by the World Bank to support the implementation of the PFMSP. This MDTF is an important vehicle for providing untied additional resources to the government for implementation of the PFMSP, including support for implementation of the new Budget Law. The MDTF also improves donor coordination and harmonization. A successor to the PFMSP multi-donor trust fund is under discussion. 66. The Second Trade Development Facility (TDF) Multi Donor Trust Fund Program and the Lao Customs and Trade Facilitation Project (CTFP) both contribute to improving trade competitiveness. CTFP aims to facilitate trade by improving the efficiency and effectiveness of customs administration, with the ultimate objective of reducing the transaction costs and time to clear goods. This is being achieved through investments in customs automation and by simplifying customs procedures, and by eliminating duplication and redundancy. The project is built upon the results of AAA work, including the Diagnostic Trade Integration Study (DTIS) and Investment Climate Assessment (ICA) and supports the reform agenda to facilitate improved regional connectivity and competitiveness. The TDF, administered by the World Bank, and with financing from IDA, Australia, the EU, Germany and Ireland, forms the core of a program-based approach to trade in Lao PDR and provides the framework for aid-for-trade delivery in Lao PDR. The project provides technical assistance to improve transparency of trade, streamline non-tariff measures, implement WTO and ASEAN commitments on goods and services, and improve competitiveness outside the natural resources sectors. Technical assistance provided via the two projects is closely integrated with PRSO policy dialogue. Major reforms in trade facilitation and other trade-related areas are supported through the PRSO program. 67. The Technical Assistance for Capacity Development in Hydropower and Mining Sector Project provides a platform, complementary to PRSO policy dialogue, to increase human capacity and improve the performance of government oversight institutions for the two sectors. It aims to build critically needed capacity and generate public awareness across the hydropower and mining sectors. The provision of adequate skills and training of government staff, as well as the next generation of leaders, would eliminate bottlenecks critical to the development of both sectors. The hydropower component focuses on capacity building in support of sustainable hydropower development in Lao PDR. Activities cover the entire value chain, from planning, concession bidding, construction, and operation to revenue management, including facilitating the implementation of the National Policy on Sustainable Hydropower (NPSH). The mining component supports: (i) the completion and dissemination of the new mining legislation; (ii) the development of a national mining development policy; (iii) the preparation of a standard mineral development agreement; and (iv) the promotion of models for corporate social responsibility, risk mitigation and community benefitsharing approaches. X. THE PROPOSED NINTH POVERTY REDUCTION SUPPORT OPERATION 68. Building on the lessons learned from the first and second PRSO series, several principles of selectivity were discussed and agreed up with the government and development partners. These principles, which have helped determine the design of the third PRSO series and areas of engagement, may be described as follows: Criticality - The area of engagement should be critical to government development goals and the World Bank CPS. 24

32 Alignment with knowledge and technical assistance - Appropriate resources (analytics, technical assistance, staff for dialogue) should be made available to the government and World Bank/PRSO development partners to support sustainable medium-term policy and institutional change. To begin with, having analytical underpinning is a prerequisite for engagement. Comparative advantage - PRSO should have a comparative advantage as an instrument to support the identified medium-term policy and institutional changes through either supporting inter-agency coordination or providing greater visibility to reforms. Box 3: Good practice principles for conditionality Ownership: ensure country proprietorship of the program PRSO ownership is high and benefits from strong institutional implementation mechanisms namely, the government PRSO Steering Committee, chaired by the MOF, the PRSO Secretariat and joint identification of priorities and regular joint reviews to assess progress. PRSO provides the government with a solid platform for coordination between line agencies and between the GOL and development partners to align behind government reform objectives. Harmonization: agree on a coordinated framework to evaluate performance under the program, but ensure flexibility in implementation Under the PRSO series, there is an agreed mutual accountability framework including a well-defined policy matrix and detailed aide-memoire for measuring progress under the program and to foster mutual understanding of steps towards the achievement of reforms. PRSO is supported by technical assistance, which strengthens mutual accountability. Customization: adjust content and design to suit country circumstances PRSO content is fully aligned with the government s expressed policy intentions and with the NSEDP7. PRSO remains flexible to changed circumstances of reforms, and remains open to modifications if warranted by the pace of reforms or other country-specific factors. Criticality: choose only government actions critical for achieving results as conditions for disbursements; avoid process conditions Country circumstances (and advancement of structural reforms) dictate approaches to achieve the objectives of the program. Corresponding technical assistance is identified from the beginning, and development partners commit to providing assistance to implement the reforms, while joint reviews of progress reinforce the principle of mutual accountability. Transparency and predictability: agree on a transparent review cycle; in IDA countries, develop a process conducive to predictable, but also performance-based financial support The PRSO support is aligned with the budget cycle and is disbursed on an annual basis. Regular reviews are done through frequent assessment missions and annual plan processes are incorporated into the routine monitoring of progress on actions and prior actions. Aide-memoires are jointly reviewed, which include both a description of the joint understanding of reform content and rationale, and time-bound plan for the timely completion of prior-actions and milestones. 69. Other principles - derived from the lessons learned during the previous series include: Strategic selection of modality of engagement in the social sectors to ensure that PRSO value-added as a policy dialogue instrument is maximized for results. For example, areas of reforms such as strategic resource allocation through budget planning, which call for strong coordination between MOF and social ministries, is a good candidate for PRSO engagement. Follow up of reforms to ensure implementation of the legal and regulatory reforms established during the previous PRSO operations. This includes trade policy reforms, a trade 25

33 facilitation master plan, the enterprise and investment law, the mining law, a national policy on sustainable hydropower, a financial sector strategy and action plan, the budget law, a civil service strategy, an education sector development framework and a health financing strategy. Sequencing reforms and PRSO engagement in concordance with capacity and the implementation of a medium term reform program. Operation Description 70. This PRSO series focuses on the sustainable management of revenues of the natural resource sector (hydropower and mining) and the use of these revenues to improve public service delivery, with a focus on funneling increased resources towards health and education, per government s own objectives. This focus is justified because it implies a significant component of inter-agency coordination, in particular between other agencies and the MOF, and proposes focused and selective sector engagement. Also, it coincides with areas of reform where the World Bank has aligned technical assistance and analytical knowledge, and has built upon previous PRSO dialogue. 71. To this end, four areas of priority, or policy areas, have been identified. First, better fiscal and financial management will enable policymakers to maximize benefits accruing from increased revenues from natural resources. Second, the revenue management framework in the hydropower and mining sectors themselves should also be clearly defined to maximize revenues accruing over time to the government for development purposes while attracting good quality investment in the sector. Third, diversification of economic growth sources through a competitive private sector outside the resource sector is critical to ensure the sustainability of growth. As the natural resource sector is capital intensive, it does not provide abundant job opportunities, as opposed to manufacturing, agribusiness or services. Diversified sources of growth are also important to reduce vulnerability to developments and exogenous shocks in narrow set of sectors. Finally, the fourth and fifth priorities for translating these increased revenues from the natural sectors into improved public service delivery are a strong public sector capable of managing these revenues effectively coupled with the establishment of sustainable financing mechanisms for schools and health facilities. 72. Per government s request, the third series of PRSOs builds on the implementation of reforms undertaken in the second series while exploring new policy areas consistent with the country s emerging development challenges to achieve sustainable, diversified and inclusive growth. Consultations started early among development partners, who identified and discussed broad reform areas to be supported under the current series. The proposed series builds on the past by i) continuing dialogue and achievements in the public financial management areas; ii) developing trade and business climate areas to implement the legal and regulatory frameworks, as supported by the past PRSO series; iii) scaling up PRSO engagement in the natural resource sectors by improving revenue mobilization; iv) engaging in dialogue to strengthen the macroeconomic policy framework; and v) focusing PRSO in the social sectors to establish new financing mechanisms that support the government in introducing output (as opposed to input) based financing (e.g. a per student formula for a school grant for nonwage recurrent spending is introduced). Policy Areas 73. While PRSO program clusters identified in the PRSO 8 Program Document remain broadly consistent with the overall country policy dialogue, a number of changes have been introduced to flexibly adapt to new policy reform developments, as indicated by the authorities (see Table 4). First, the program now reflects the government s preference to start the implementation of an Integrated Financial Management Information System to replace the GFIS using internal resources. The PRSO 8 trigger proposing the adoption of TIMS has been replaced by a PRSO 9 prior 26

34 action focusing on expanding the GFIS coding down to tier-2 budget entities. Second, four PRSO 8 triggers have been strengthened as policy reform intentions have become clearer. Table 4: Summary of changes to PRSO 9 prior actions compared to the PRSO 8 Program Document Indicative PRSO 9 triggers Revised PRSO 9 prior actions Comments MOF submits a draft Presidential Decree on public debt management to the government office MOF approves the TIMS design with modernized fullfunction treasury processes and system functional/technical requirements MOF appoints a Mining Revenue Task Force which reports to the Minister on projected FY13/14 revenues and FY/12/13 revenues from the mining sector MOH and MOF adopt a coverage, financial, and monitoring plan for scaling up free MCH and HEFs over the next three government fiscal years, encompassing domestic and external financing MOHA submits to Government Office the draft revised Law on Local Administration Government approves the draft Presidential Ordinance on public debt management MOF, with MOES and MOH, adopts organization codes for Tier-2 budget entities under the current budget coding system and allocate FY 2012/13 budget to these levels for education and health sectors at the central level Replaced MOF appoints a Mining Revenue Committee and reports to the Minister on mining fiscal regime issues and options MOES collects and makes available for dissemination a full number of school based expenditure reports (full meaning 95 percent or more of schools) in at least 30 percent of districts MOH submits to the MOF and MPI, a coverage, financial, and monitoring plan for scaling up free MCH and HEFs, including a roadmap for human resource development developed through the sector-wide coordination mechanism, over the next three government fiscal years (FY 13/14, FY 14/15, and FY 15/16), encompassing domestic and external financing Dropped The new prior action represents greater than expected actual progress made in government s efforts to put in place a strengthened legal framework for overseeing public debt. This new prior action reflects the policy intention of the government to implement a more decentralized public finance management framework to reach the service delivery level through the current upgrading of the home-grown GFIS. MOF has now decided to start implementation of an Integrated Financial Management Information System to replace the GFIS using internal resources. The prior action is revised to reflect the government terminology ( committee replaces task force ) and to reflect the strengthening of the action through the reporting of options for reform. This new prior action reflects the commitment of government and MOES in particular in implementing school block grants and reporting. The prior action is revised to reflect the development of a human resource roadmap as part of the free MCH policy, supported by JICA. The draft law was initially planned to be submitted to the Government Office for consideration and approval in March/April 2013; MOHA has however been advised by the NA to postpone the submission of the draft law for NA consideration and approval at the end-year session, with the draft law to be submitted for consideration and approval in August or September. 74. Similarly, the PRSO 8 public debt management trigger has been strengthened to reflect the actual legal instrument used and to reflect progress made, including the approval of the ordinance by the cabinet. The PRSO 8 mining trigger has been refined to reflect the actual reporting to the minister of issues and recommendations regarding the mining fiscal regime. A new prior action on school block grant implementation and reporting has been introduced, to reflect government commitment to swiftly implement the policy. The health trigger has been strengthened to account for the development of a human resource development plan supporting and complementing the 27

35 implementation of the Free Maternal and Child Health policy coverage plan. Lastly, the PRSO 8 trigger supporting local administration reform has been dropped to better separate PRSO primary reform areas from the government broader reform objectives (Annex 2) and more time needed to for the authorities to shape this important reform agenda. Cluster 1: Strengthened fiscal and public financial management 75. The strengthening of the macroeconomic fiscal framework will help formulating a multiyear fiscal policy to better inform policy trade-offs within a given fiscal envelope. The absence of macroeconomic fiscal analysis and forecasts which include developments in the natural resource sectors constrain the credibility of budget formulation. Budget planning mostly focuses on the annual budget preparation on an incremental basis. The budget plan discussed by the National Assembly contains limited analytical discussions of important trends and policies, including debt sustainability and borrowing strategies. Finally, limited information is available on developments in the financial sector and associated risks. Reliable information is generally unavailable, making external scrutiny and analysis difficult. 76. On the public financial management side, the government has been undertaking a comprehensive set of public sector management reforms since 2005 under the auspices of the PFMSP. The PFMSP is led by the MOF and supported by development partners through a combination of technical assistance, analytical work, support to policy implementation, and investment in human resources and information systems. The PFMSP has helped the government achieve many successes, notably the revamping of the legislative framework governing public finances the Budget Law and the Audit Law; establishment of the centralized National Treasury, Customs Department and the Tax Department; establishment of the consolidated treasury account, treasury control over spending units technical revenue accounts, alignment of the chart of accounts with the GFIS, and operationalization of a significantly upgraded GFIS real-time across the country; greater fiscal transparency through the publication of external audit reports, the budget, and budget execution reports with enhanced coverage to include statutory funds; improved revenue policy and administration (through the introduction of VAT) helped improve revenue collection and reduce ad hoc cash rationing. Looking forward and building on past reforms, it is proposed to support core public budget policies and institutions to manage increasing public revenues (in particular from natural resources) by enabling: i) budget planning processes at the central and local levels that show more clearly the linkage between national government policy and budget allocations; ii) financial management systems to deliver and report on public finances in a timely and accurate manner; and iii) Lao PDR to be on par with good international practices on fiscal disclosure and transparency. In addition, the government, through the newly upgraded Ministry of Home Affairs (MOHA), has begun reviewing the law on the local administration aimed at clarifying definition of the central and local level assignments based on the key principles of the Party-State "Three Formulations" strategy issued in March To respond to the above challenges, on the macro-fiscal side the PRSO supports a budget formulation process informed by macro-fiscal developments in the resource and nonresource sectors (PRSO 8) and a clear fiscal envelope (PRSO 10), a more robust debt management framework (PRSO 9), and a medium-term macro-fiscal analysis (PRSO 11). PRSO 9 supports the establishment of a unified debt management legal framework, which will clarify debt management mandates across the government, and provide the legal basis for strengthened debt reporting and transparency. Debt management legislative pieces are so far fragmented into various government legal documents. The new Presidential Ordinance (Decree-Law) on public debt management will clarify the authority to borrow and to issue new debt, invest and undertake transactions on the government s behalf, debt management objectives and include requirements to 28

36 publish on a timely basis information on the public debt. This is an important step toward a unified and strengthened framework for debt management, which becomes critical as the country has greater financing needs through its fast economic growth and development and simultaneously greater access to financial resources which will need to be carefully assessed and proactively managed under a clear and consolidated legal framework. PRSO 10 will focus on defining fiscal spending ceilings for spending ministries and provinces, in order to strengthen the policy content of budget formulation and fiscal responsibility. 78. PRSO supports as number of public financial management reforms aimed at: i) institutionalizing the budget as a key tool of government policy; ii) strengthening of controls in budget execution and fostering transparency in financial reporting; and, iii) enhancing the timeliness and quality of financial audits. This support builds on the achievements of the previous PRSO series, and is expected to positively impact on budget allocation transparency, recording and management of cash through further consolidation of government funds. PRSO 8 has focused on the consolidation of all treasury-managed government accounts at the BOL headquarters and its branches into the Treasury account through zero balance accounting mechanisms and the adoption of International Accounting Standards in the private sector while PRSO 9 and PRSO 10 support (i) the revision of the chart of account down to the service delivery level (tier 2); and, (ii) the implementation of the TSA framework. The adoption and subsequent implementation of International Public Sector Accounting Standards (IPSAS) on a cash basis will ensure that whole of government financial statements will be available for the first time. 79. This support will result in a consistent macro-fiscal framework more responsive to developments in the mining and hydropower sectors and enabling better fiscal and budgetary formulation. It will be complemented on the PFM side, by better budgeting at the service delivery level, stronger cash management through treasury accounts centralization and more transparent accountability of the budget through the use of International Accounting Standards. Analytics: Lao Economic Monitor, Lao Development Report, PEFA, PER, Lao Fiscal Strategy, Debt Sustainability Assessment, and IMF Article IV. TA: PFMSP MDTF1 (and upcoming 2) and Lao Statistical Capacity Building Project. Other development partner support and coordination mechanisms: On the macro-side, current development partners include Japan (support to NERI), UNDP (support to MPI for NSEDP design and monitoring) and past ADB TA for a fiscal modeling tool. Donor coordination is implemented through the Macroeconomic Working Group. AusAID and EU are supporting the MDTF for PFMSP managed by the Bank and are aligned behind the policy reform agenda. Japan is consulted, as there are significant synergies with the public investment planning TA they provide. The IMF provides TA on audit and accounting standards. There is a need to ensure appropriate coordination with France and ADB through sectoral working groups or through bilateral meetings. Cluster 2: Sustainable revenue management of the natural resource sectors (mining and hydropower) 80. Hydropower and mining projects are a key element of the government s 5-year NSEDP. The sectors are considered to be a key driver of foreign investment and growth, a major source of government revenue, as well as a potential trigger for local development. While such projects have many benefits, they also present many risks. The government s challenge is therefore to maximize the benefits while mitigating and minimizing the risks. Currently, there are approximately 140 mining projects at various stages of exploration and development, and 85 hydropower projects in the pipeline. Collectively, these projects will significantly stretch the capacity of national and local government to effectively mitigate risks and oversee project implementation. 29

37 81. The PRSO supports the sustainability of public revenues in the resource sectors by adopting fiscal regimes and administration which balance government and private sector interests. This support builds on discussions initiated during the previous PRSO series on strengthening the strategic and legal framework in natural resource management. Expected results focus on putting in place core elements of a standard fiscal regime in mining and hydropower for the sustainable development of the sectors. 82. In the mining sector, current priorities include developing a standardized mineral fiscal regime. The regime will be localized to the Lao context while drawing on international experience. To date, mineral tax and royalty regimes have been negotiated on a project-by-project basis. It is important for the government to move towards a more transparent and predictable system that ensures a strong return for mining, encourages quality investors, and is robust to the volatility of mineral prices. For the mineral royalty regime to be successfully managed and implemented, it needs to be accompanied by the development of specialized capacity within the MOF. Due to the magnitude of mining revenues, in addition to the complexity of mining accounting and taxation, specialized mineral capacity should be developed over the medium term. 83. PRSO 9 supports the establishment of a mining revenue committee and its reporting on fiscal regime policy issues and options in the sector. Mineral royalties and tax income are the biggest source of government revenues. However, the current approach has been customized on a project-by-project basis, and it is not clear that the balance between generating revenue and incentives for quality investment is optimal. There is a need to develop a long-term and standardized approach to the overall tax and royalty regime for the mineral sector, as well as to build capacity in mineral revenues planning and administration. The prior action is a step toward building greater capacity within government on the mining fiscal regime and administration. 84. PRSO 10 will support the discussion by government of a policy reform proposal on the mining and hydropower fiscal regimes. The expected result is that the core framework of standard fiscal regime will be implemented in at least one instance by the end of the program. Analytics: Lao Development Report. TA: Hydro mining TA, partnership with IFC. Other development partner support and coordination mechanisms: Development partners involved in natural resource management (particularly related to mining, hydropower, and water resources) are the ADB, AusAID, Germany, Japan, Switzerland, and the UN. Donor coordination is implemented through project level partnerships and financing for the energy and mining sectors, and through broader cooperative frameworks for the water sector. The Extractive Industries Transparency Initiative Secretariat and the Multi-Donor Trust Fund have also started dialogue with the government on procedures for enhanced transparency in extractive industries revenue collection. Cluster 3: Sustainable public financing mechanisms of schools and health facilities 85. The establishment of sustainable financing mechanisms for public service delivery is an important part of efforts to improve education and health outcomes in Lao PDR. This will enable increased resource allocation and execution in the health and education sectors, particularly for nonwage recurrent expenditures at the service delivery level. It will also strengthen linkages between financial transfers and service outputs. In the social sectors, government s commitment stated in the NSEDP7 - to increase the fiscal outlays up to 35 percent of total budget expenditures is key to achieving the MDGs social targets. The National Assembly has instructed the government to allocate 30

38 over the NSEDP period a share of total public spending of 16 percent for education, and 9 percent for health. Table 3 below reports the respective shares of spending in these two sectors, according to various spending categories. When ODA is included, targets appear more within reach, but mask the reality of very low non-wage recurrent spending in both sectors, which are currently significantly below targets in both health (1.3 percent) and education (3.4 percent). Table 5: Government spending: total and in health and education, by economic category USD million 2006/07 % 2007/08 % 2008/09 % 2009/10* % 2010/11* % Total Government Spending 858 1,109 1,236 1,745 1,897 recurrent ,036 o.w. non-wage recurrent capital o.w. ODA health % % % % % recurrent % % % % % o.w. non-wage recurrent 2 1.3% 3 1.5% 5 1.9% 7 1.5% 7 1.3% capital % % % % % o.w. ODA % % % % % education % % % % % recurrent % % % % % o.w. non-wage recurrent 4 2.6% 5 2.2% % % % capital % % % % % o.w. ODA % % % % % % means as a share of the corresponding economic category; * budgeted allocation Source: MOF 86. Despite significant improvements in maternal and child health (MCH) indicators, maternal mortality is still high considering Lao PDR s economic progress and status 12. Only onefifth of deliveries are attended by skilled birthing attendants, who are able to provide basic emergency obstetric and neonatal care. Recognizing the significant national socio-economic benefits that improved MCH brings, the government made this a national priority in the NSEDP7. In addition, specific targets based on the MDGs, and accompanying a broad action plan, have been developed. These targets include the provision of free MCH services, which exempt user fees for antenatal and postnatal care visits, deliveries, and some services for children under five. These services address the demand-side financial barriers for health care services. 87. Under the education sector development plan, and in accordance with the policies and strategies of the education sector development framework (ESDF), one of the main targets is to set up new financing mechanisms based on outputs, rather than inputs to help funnel more central government resources to schools. The mechanisms will consider the capacity of the government and of community, to ensure that sufficient learning and teaching materials are provided to raise the quality of education. To achieve this target, MOES, with the support of the MOF, has initiated a block grant scheme for primary schools based on a per student financing formula. If designed and implemented well, such scheme has the potential to help achieve a number of objectives, including: i) providing for a more transparent distribution mechanism (i.e. formula based); ii) empower schools and local communities to make decisions regarding the best use of their non-wage recurrent expenditure budget; and, iii) ensure (from the central government s perspective) that all schools irrespective of their geographical location receive a minimum amount of non-wage recurrent resources. 12 The maternal mortality rate was 470 per 100,000 live births in 2011, much higher that the lower-middle income average of 213 and the East-Asian average of 138 for the same year. 31

39 88. The current financing system provides inadequate resources for schools, and excludes incentives that focus on improving educational quality and the efficiency of spending, and eradicating inequities. Lao PDR lags behind its neighbors on both enrollment rates and on literacy rates. In addition, assessments of student learning outcomes are a relatively recent phenomenon and so far, only two 5 th grade assessments have been carried out (while an assessment of 3 rd graders will be carried out in 2012). The problem is partly that Lao PDR has allocated relatively few resources to education around 2.5 percent of GDP since 2005 and has a weak education financing system in place. In this system, the central government has been responsible for wage and capital expenditures (although donors finance the bulk of capital expenditures) while there has been less clarity on who should mobilize the resources for non-wage recurrent expenditure. According to some accounts, provinces have been asked to mobilize the resources for non-wage recurrent expenditure but this division of responsibility does not seem to have worked: provinces have not had the resources (or willingness) to allocate non-wage recurrent resources. Since 2004/05, non-wage recurrent expenditure has only grown marginally and, as a result, shrunk from 17 percent of the total education budget in 2001/02 to less than 4 percent 2006/07, after which it has recovered somewhat (reaching 8 percent of total spending in 2008/09). As a result, schools have only minimum equipment: blackboards, chalk, desks and a teacher s guide. Other basic essentials, such as teaching aids, textbooks and reference materials, are largely confined to a select group of schools that can benefit from a richer classroom environment. 89. In the health sector, the free MCH policy seeks to address several constraints related to improving access and utilization of quality health services. First, fee-free services and reimbursing costs of transport will improve access and financial protection for mothers and their children, and increase utilization of essential maternal and child health services. Second, the policy will increase the flow of budgetary resources to health facilities. Currently, the health sector is allocated only 7 percent of the national budget, and health facilities receive very little funding for nonwage recurrent expenditures. The new policy, supported under PRSO 9, therefore establishes an output-based financing mechanism to increase the service delivery budget, which will in turn contribute to service quality while improving financial access for patients. National scale up of the free delivery policy alone will not be sufficient to address the larger problem of inadequate non-wage recurrent cost transfers to front-line health, however, since deliveries represent only a portion of health services. A multiple-track strategy is necessary, including: i) strengthening monitoring of government expenditures reaching front line service delivery, and using these data to encourage national and provincial governments to move toward nationally adopted expenditure targets in health and education; ii) gradual expansion of output-based payments for health services, through scaling up of free maternal and child health services; iii) further expansion and consolidation of other social health protection mechanisms, including health equity funds, which pay user fees on behalf of the poor; and iv) an increase in the skills of primary service providers, especially nurses and midwives, in order to ensure increased access to quality services. 90. The free MCH policy creates an entry point to address other pressing issues in the health sector. It will establish a policy framework to harmonize and develop a national scale-up strategy for the various donor-financed free MCH schemes that have been piloted in recent years. This includes schemes financed by the World Bank s Health Services Improvement Project (HSIP), which piloted a free maternal health scheme in two districts. Second, it will provide a basis for coordination and harmonization with other social health protection schemes, including Health Equity Funds (HEFs), Community-based Health Insurance (CBHI), and health insurance schemes for civil servants (SASS) and private sector workers (SSO). Third, it will require clarification of fund flows, monitoring, and verification arrangements for these transfers at the national, province, district, health facility and community levels, the funds will also aim to strengthen accounting systems and financial management capacities at all levels of the health system. Improvements will also need to be made in health human 32

40 resource management and planning. Finally, guidelines will need to evolve to clarify accounting procedures and policies on technical revenues in the health sector, in conjunction with MOF. 91. PRSO will support the design and implementation of social sector policies prioritized by the government, namely the MCH policy and school grants, that will be implemented with domestic budget resources. The policies propose to increase public resources available at the lowest spending unit level schools and health facilities in addition to the overall budget envelope available to those sectors. This support builds on the previous PRSO series, which supported establishing a financing strategy in the health sector, costing a sector plan in the education sector, as well as increasing non-wage recurrent expenditure in education. 92. These health and education policies are expected to positively impact the quality of service delivery, with in health an increase provision of free maternal and child health services (number of births attended by skilled health personnel) and in education an increase in learning materials available at the facility level (textbook to pupil ratio), which are directly correlated with social outcomes in those sectors. 93. Specifically, in education, PRSO 9 supports making available for dissemination school based expenditure reports, so to be available to monitor spending in general and the school block grant scheme in particular. The school block grant represents a major investment of government resources (and by implication a proportion of development partner resources). It is important for fiduciary and impact reasons that the GOL understands how those resources are being used at the outset of the scheme. It will also provide a comparison with how resources may be used over time when schools have moved on from using SBG to meet basic resource needs (furniture, utility costs) to using resources in areas that will directly influence the quality of education (teacher training, remedial classes, teaching and learning materials, school libraries). Second developing detailed disaggregated financial information is a key objective of PFM reform and collecting it, even on a memorandum basis, will support the introduction of policy-related budgeting. The absence of good financial information is proving a real handicap to introducing annual costed sector plans in education for example. Success in the education sector will provide encouragement for introducing similar reporting from lower level health institutions. It will also provide incentives to speed up the capture of financial information at the institutional level through the GFIS. 94. In addition, Education Quality Standards (EQS) training modules are being developed along with guidelines at the province and district level to improve school planning and management of block grants, and as part of broader objectives under the ESDF. Preparation of EQS training modules incorporating school block grant management and the delivery of school level training is a key prerequisite for the effective roll-out of the school block grants, and to ensure that increased resources results in improved outcomes and the achievement of education quality standards. Similarly, coherent guidance is required from the central to local levels, including at the school level, to facilitate more effective educational planning and budgeting in the education sector. 95. In health, PRSO 9 supports the MOH, which will submit to the MOF and MPI, a coverage, financial, and monitoring plan for scaling up free MCH and HEFs, including a roadmap for human resource development developed through the sector-wide coordination mechanism, over the next three government fiscal years (FY 13/14, FY 14/15, and FY 15/16), encompassing domestic and external financing. This prior action will support the institutionalization of the free MCH policy and enhance the sustainability of key interventions likely to improve the maternal mortality rate (MDG 5) in anticipation of the 2015 MDGs. Addressing issues related to supply-side capacity building training, supply of key commodities, technical supervision, facility and equipment upgrades are implicitly required in the scale-up plan. 33

41 96. In education, PRSO 10 will support the comprehensive dissemination of school based expenditure reports initiated under PRSO 9. In health, PRSO 10 will support the implementation of the plan prepared under PRSO 9 of the free MCH integrated policy. Analytics: PEFA, PER, Civil Service Pay and Compensation Review and Health, Education Financial Management Assessments. TA: PFMSP MTDF, IDA Education Development Project, Education for All-Fast Track Initiative, Health Services Improvement Project and Additional Financing, AusAID and EU TA in social sectors. Other development partner support and coordination mechanisms: Other development partners in the health sector include ADB (eight northern provinces), JICA (four southern provinces), Lux-Development (focusing on Vientiane Province, Bolikhamxay and Khammouane), World Health Organization (TA on MCH and piloting free maternal and child health in two districts of Khongsedone in Salavan Province and Khoun district of Xiengkhouang Province, UNFPA and UNICEF. The World Bank Health Service Improvement project (HSIP) supports increased utilization and quality of health services for poor women and children, focusing on the five southern provinces. Donor coordination falls under the health and education Sector Development Working Group, which was recently upgraded from a sub-group to a full working group. Box 4: Prior actions for PRSO 9 1) Government approves a draft presidential ordinance on public debt management 2) MOF, with MOES and MOH, adopts organization codes for Tier-2 budget entities under the current budget coding system and allocate FY12/13 budget to these levels for education and health sectors at the central level 3) MOF submits to the Government Office a decree on public sector accounting 4) MOF appoints a Mining Revenue Committee and reports to the Minister on mining fiscal regime issues and options 5) MOES collects and makes available for dissemination a full number of school-based expenditure reports (full meaning 95 percent or more of schools) in at least 30 percent of districts. 6) MOH submits to the MOF and MPI, a coverage, financial, and monitoring plan for scaling up free MCH and HEFs, including a roadmap for human resource development developed through the sector-wide coordination mechanism, over the next three government fiscal years (FY13/14, FY14/15, and FY15/16), encompassing domestic and external financing. 7) MOF implements a customs risk management approach to imports where the automated customs system is deployed Cluster 4: An improved investment climate for diversification and competitiveness 97. Lao PDR is actively integrating into regional and multilateral trading systems. The economy is being liberalized with an emphasis on facilitating increased inward investment. Regulatory reform is being driven, to large extent, by commitments at the ASEAN level, and as a result of the efforts to accede to the WTO (successfully concluded in October 2012, with Lao PDR becoming the 158th member of the WTO in February 2013). 34

42 98. Nevertheless, the economy is increasingly dominated by investment and trade in natural resource based sectors (principally in hydropower and mining). Dominant investments in one primary sector results in increased risks associated with export concentration and challenges in sustaining growth in others. In addition, Lao PDR s transition to market-based systems remains incomplete due to an over emphasis in centralized planning. Thus, there remains an increasingly large gap between the de jure enabling environment for trade and private sector development, and the de facto regulatory processes and procedures enterprises face. 99. PRSO enables investment in the non-resource sectors for diversified growth and competitiveness by supporting the establishment of a transparent, rules-based and predictable business environment. Two main areas of action are being support under this cluster: i) reforms associated with initiating rules-based and transparent border procedures that enable imports and exports, building on previous achievements such as a WTO consistent legal framework; and, ii) reforms supporting the establishment of a more predictable and transparent investment environment outside the resource sectors through the implementation of enterprise and investment promotion laws, which contain the legal foundations for a streamlined, simplified business environment. This support builds on a number of legal foundations supported by the previous PRSO series to simplify the regulatory framework for trade and investment and is expected to positively impact the time and cost it takes to import and to start a business PRSO 9 supports the implementation of a customs risk management approach for imports. Under the current manual customs declaration processing procedures, 100 percent of inbound cargo is subject to physical inspection. This results in inefficient use of customs resources and unnecessary delays at the border. The deployment of the new automated customs system (ASYCUDA) and allied risk management approach will allow the Customs Department to physically inspect fewer imports, while maintaining the integrity of revenue collection. This is an important part of broader efforts to establish rules-based and transparent border procedures than enable import and export trade PRSO 10 proposes to support the establishment of a pilot regulatory national single window for trade facilitation. The establishment of a national single window is an important part of efforts to make trade faster, simpler and lower cost for the private sector. Successful implementation of a regulatory national single window will allow for the simultaneous submission and processing of all import/export related regulatory requirements across customs and non-customs agencies PRSO 10 will also support, through a partnership with IFC, a Doing Business regulatory reform action plan and the streamlining of business environment in at least one prioritized area Both support areas are expected to result in simplified trade and business regulatory requirements, reduced transaction costs, improved data integrity, reduced opportunities for rent seeking, increased transparency and predictability and the adoption of modern risk based approaches across government agencies. Practically, success will be measures by a reduced time and cost in import and export processes as well as in starting a business. Analytics: Lao Development Report, Investment Climate Assessment 2011 (and 2013 Update), Trade and Transport Facilitation Assessment and related corridor analysis, government's new DTIS. TA: TDF-1 and 2 (including MDTF contributions from AusAID, EU, Germany and Ireland), Customs and Trade Facilitation Project and additional financing, National Single Window Preparation Grant, Partnership with IFC. Other development partner support and coordination mechanisms: Development partners involved in trade and competitiveness issues include IMF technical assistance, the ADB 35

43 SME/PSD Program Loan, GIZ technical assistance, and the USAID Luna project. Donor coordination falls under the Trade and Private Sector Working Group. Box 5: Proposed triggers for PRSO 10 1) MOF and MPI in collaboration with relevant government agencies define the spending ceilings for all spending ministries and provinces in the (Prime Minister s) Budget Preparation Instruction for FY14/15 consistent with aggregate fiscal spending envelope 2) MOF, with MOAF and MOPWT, adopts organization codes for Tier-2 budget entities under the current budget coding system and allocate FY13/14 budget to these levels for agriculture and public works sectors at the central level and input in GFIS. 3) MOF (i) completes transferring technical revenues accounts into National Treasury of all provincial revenue accounts, (ii) reflects them in the budget, (iii) disburses their funded expenditures through the National Treasury network. 4) A policy reform proposal of the mining fiscal regime is discussed by government 5) A policy reform proposal of the hydropower fiscal regime is discussed by government 6) MOES collects and makes available for dissemination a full number of school based expenditure reports (full meaning 95 percent or more of schools) in 95 percent of districts 7) MOH implements the adopted plan for scaling up free MCH and HEFs, including a roadmap for human resource development, and monitors indicators in the NHSR in the current government fiscal year ( ) 8) Government approves the legal framework for the establishment of a pilot regulatory national single window for trade facilitation, incorporating customs and non-customs agencies. 9) Government approves a Doing Business regulatory reform action plan and streamlines business environment in at least one prioritized area Poverty and Social Impact XI. OPERATION IMPLEMENTATION 104. The PRSO series supports and is fully consistent with the government s Poverty Reduction Strategy. The NSEDP7 names poverty eradication as one of its seven main strategic orientations. It proposes to tackle poverty issues through several thematic and cross-cutting issues, aiming to further its reduction through sector and regional development. These include reducing the rural-urban income divide through education, capacity building, private sector development, and better health, infrastructure and regional development policies. The plan outlines the sustainability of development by emphasizing economic development alongside a strengthening of the country s cultural and social fabric as a critical goal While the country in general has made good progress on advancing gender equality, in particular in urban areas, gender disparities still prevail and are more pronounced in rural areas and among some smaller ethnic groups. For example, the years of schooling completed for Lao-Thai boys (the majority group) are 6.2 compared to 3.6 and 1 year for Hmong-Lu-Mien boys and girls respectively. Health care for pregnant and new mothers, and maternal and child malnutrition are areas of particular concern. The maternal mortality rate (estimated at 357 per 100,000 live births) remains one of the highest in Asia, and most women (58 percent) still deliver without the assistance of 36

44 a skilled birth attendant. Female farmers continue to face obstacles to improved production and market returns. The Country Gender Assessment for Lao PDR 13 also highlights women s limited participation in local decision making bodies. Economic growth by itself will not be enough to bring about improved gender equality, in particular for vulnerable groups. Concerted public actions in infrastructure development and improved outreach of services are needed to close persistent gender gaps. PRSO support to the health and education sectors is expected to positively contribute to reduced gender disparities. PRSO support to the implementation of the free MCH policy in particular addresses one of the areas of gender disparity where Lao PDR falls furthest behind regional peers Policy actions supported under PRSO 9 are expected to have positive poverty and social impacts. No significant negative impacts are envisaged. A strengthened macroeconomic policy framework responsive to developments in the natural resource sectors and volatility in mining revenues will have, a positive impact on growth and indirect incomes, by providing a stable and predictable macroeconomic and fiscal environment, enabling medium-term planning for budget policies. A rules-based investment and trade environment, by contributing to a more predictable and level playing field, will attract more investment outside the resource sectors thereby contributing to poverty reduction, having a positive impact on employment and incomes Households in Lao PDR are highly dependent on natural resources (e.g. forest products) for food and livelihoods. This reliance is highest among the poor and other vulnerable groups. Places where the most potential exists for new mining and hydro projects are remote areas that are inhabited by ethnically diverse and vulnerable populations. Taken together, there is a relatively high risk of deterioration in poverty and social indicators if the impact of mining and hydro projects on these populations is not effectively managed. Benefit sharing and other mitigation strategies that can reduce these risks and are appropriate for Lao PDR s context. PRSO, by supporting the establishment of financial mechanisms for the sustainable management of natural resources, contributes to addressing and mitigating these risks As a whole, the PRSO support for improvement of revenue management in the hydropower and mining sectors will have positive social and poverty impacts. The hydropower and mining sectors are already the biggest contributors to national revenues, and therefore to service delivery. Ensuring similarly broad environmental benefits will take additional efforts, including through the institutional and policy reforms mentioned here. Each mining and hydropower project represents both considerable benefits and risks, which makes the overarching priority of boosting capacity to manage these sectors and projects properly all the more important. The PRSO also encourages an approach to public finances in natural resources that reinforces the overall sustainability of the sectors in the long-run Public financial management reforms aim to improve fiduciary controls and enhance the quality of service delivery 14. Poverty and social impacts are expected to be positive, as they improve the ability of the government to provide more effective, timely and accountable services to citizens Better access to education and health, particularly through sustainable financing mechanisms utilized at the spending-unit level are expected to have a positive impact on poverty reduction. One systematic way to improve resource flows towards the education and health sector in an efficient and equitable way is for schools and health facilities to manage resources themselves. The increased community oversight from such a scheme is known to have enhanced accountability in education and health systems, which have adopted the approach. The PRSO support to the school 13 World Bank/ADB (2013) Country Gender Assessment for Lao PDR: Reducing Vulnerability and Increasing Opportunity, Washington, DC: The World Bank / Manila: The Asian Development Bank. 14 PFM reforms are category C and do not trigger any safeguards. 37

45 block grant policy and the Free Maternal and Child Care Policy is expected to have a positive impact on social spending levels and effectiveness, thereby positively impacting poverty reduction. Environmental Aspects 111. By supporting the sustainable management of resources coming from the natural resource sectors and promoting diversified growth, the environmental impact of the operation will be either positive or neutral. The PRSO series supports a more sustainable policy and institutional management framework in the hydropower and mining resources value chain, to maximize the development of the sector, while minimizing potential adverse social and environmental impacts. Supported under the previous PRSO series, the government has developed regulations on environmental and social safeguards, including Environmental and Social Impact Assessments, and is working toward ensuring compliance. Support from international partners is available through the Nam Theun 2 Hydroelectric Project, Nam Theun Social and Environment Project, the Lao Environment and Social Project (LEnS), the Hydropower and Mining TA project and the Environmental and Social Standards in the Hydropower Sector of Lao PDR project: The Lao Environmental and Social Project (LEnS) supports the development of the regulatory framework for the hydropower sector, in relation to other large development projects. Sub-grants to support implementation of the National Policy on the Environmental and Social Sustainability of the Hydropower Sector and the Resettlement Policy have been implemented and their Phase I reports are complete. Based on the findings and on dialogue with stakeholders, the Environment and Social Impact Assessment (ESIA) Practice and New ESIA regulation in Lao PDR have been revised and approved. A sub-grant to develop a River Basin Organization (RBO) to manage water resources in the Nam Theun/Nam Kading Basin, has contributed to the development of a national river basin management model, alongside ADB and French Government efforts in the Nam Ngum Basin. The Hydropower and Mining Technical Assistance Project supports the upgrading of curricula and professional skills in sectors relevant to hydropower and mining, and strengthening the planning, management and monitoring systems within the Ministry of Energy and Mines (MEM), including with the Departments of Mining, Geology, Electricity, and Energy Promotion and Development. Support also extends to the Provincial Departments of MEM, to strengthening monitoring systems, including for environment and social safeguard issues. Community-level support is also provided in mine-affected areas where procedures for community development funds (financed from mining sector revenues) will be promoted. The Nam Theun 2 Project remains the primary vehicle for on-the-ground institutional development of social and environmental safeguards related to hydropower development, and is providing considerable practical experience and potential for capacity building in relation to a broad range of social and environmental activities, including participatory approaches for communities, protected area management, post-resettlement livelihood development (such as community forestry, fisheries, development of market-based agriculture, and development of links between micro-credit schemes and the formal financial sector), as well as strengthened grievance, disclosure, and oversight and monitoring regimes. The Environmental and Social Standards in the Hydropower Sector of Lao PDR Project aims to help the country foster sustainable hydropower, while ensuring that the environment is protected and that local people have access to the water resources they depend upon. The project aims to increase the share of new hydropower projects that follow international best 38

46 practice environmental and social standards by working with the Government of Lao PDR to improve policies and regulations and better anticipate, evaluate and manage the cumulative impacts of hydropower development. The project also works with financial institutions and hydropower companies investing/developing in Lao PDR by providing them the tools to share knowledge and improve their own environmental and social guidelines for improved decisionmaking. Implementation, Monitoring and Evaluation 112. The proposed series is the 3rd programmatic PRSO series, with four annual singletranche operations (PRSO 8, PRSO 9, PRSO 10 and PRSO 11). The series includes estimated expenditure and dates in a medium-term framework, prior actions and defined triggers (key actions signifying progress in program implementation) for moving into the next operation. It focuses on stepby-step policy and institutional reforms and capacity building. PRSO 9, the second operation in the series, will be considered under streamlined Board procedures. The four-year programmatic policy matrix framework was designed during the preparation of PRSO NSEDP7 implementation progress is monitored annually by the government. Each year, line agencies report to MPI on implementation progress through a bottom-up process, which follows administrative hierarchies (from districts, to provinces, to central administrations). Regular discussions also take place with the donor community within the Macroeconomics Working Group, and in the Trade and Private Sector Working Group as part of the Round Table Implementation Mechanism meetings process, as well as separate and more detailed discussions on each part of the PRSO in other RTM working groups. The IMF conducts supervision through annual Article IV missions. PRSO development partners participate in missions and retreats, and PRSO remains an open-operation welcoming new partnerships. The Bank supports progress in strengthening the M&E framework for the NSEDP7, by providing capacity building to the MPI, key line ministries, pilot provinces, and to the National Assembly staff. An essential part of these capacity-building activities includes support for the sector monitoring plans under the NSEDP The PRSO Steering Committee leads the implementation of the PRSO program. By order of the Prime Minister, the Steering Committee was established, and is chaired by the Minister of Finance. The Committee is supported by a PRSO Secretariat which is in turn chaired by the Vice Minister of Finance. Both bodies include senior level representation from relevant ministries. In particular, the Ministries for Planning and Investment, Education and Health, Energy and Mines, Industry and Commerce, Agriculture and Forestry, Natural Resources and Environment, Bank of Lao PDR, Prime Minister s Office, and other agencies are represented. The PRSO Secretariat oversees the program implementation and coordinates with all relevant ministries and agencies Stakeholder consultations on reforms take place regularly, are government-led and mainstreamed into PRSO policy actions. Consultations are an integral part of the consensus building efforts towards reform in Lao PDR and are a key element of success. It is a standard practice for the government to set up working groups, task forces, steering committees and organize workshops with key agencies and stakeholders to discuss strategic orientations, including design of sectoral strategies, legislative and regulatory framework, and implementation modalities of policies. Development partners support consultation initiatives through financial and technical assistance In addition to monitoring progress against policy actions, a monitoring and evaluation (M&E) framework was designed for the whole PRSO series, and is presented in Annex 3.The M&E framework covers all four operations in the series and will reflect progress towards the end of the series. The progress will be reported in the Implementation Completion and Results Report in The end-of-series outcomes expected under each sub-component of the PRSO program are 39

47 recorded in the PRSO matrix (Annex 3). In addition, macroeconomic developments and poverty and social indicators will be closely monitored. Fiduciary Aspects 117. The government has improved fiduciary arrangements around budget execution; however, weaknesses remain. The overall fiduciary risk is considered to be significant due to weakness in the financial management systems and slow implementation of the improved public procurement framework. The government has started publishing quarterly budget execution reports to increase transparency in budget execution but because the government s current automated GFIS has no commitment controls (no requisition, procurement and goods receipt management), the reliability and accuracy of these reports represents a significant and ongoing fiduciary risk. In addition, no applications currently exist to allow the system to generate revenue reports which severely hampers the government's ability to produce adequate or consolidated reports for management, accounting, reconciliation, auditing or accountability purposes The consolidated treasury account framework has helped the National Treasury take direct control over revenue accounts across the country. This has allowed the National Treasury to conduct daily reconciliation of bank accounts. From 2008/09 the SAO submitted findings from the 2008/09 annual budget audit report from the June session to the National Assembly. The publication of an audit report summary was a PRSO7 prior action. The audit report summary for the 2008/09 was prepared and published in the local press in April The accounting and auditing profession and related institutions still need to be developed and PRSO8-11 intends to provide support PRSO has supported significant progress in improving the PFM system and reforms, despite significant fiduciary weaknesses, which warrant continued support via a budget support operation. Actions planned under PRSOs 8-11 contribute to the reduction of fiduciary risks. Major recommendations aimed at further improving public financial management systems, including the efficiency and transparency of public resource use are reflected in the PFMSP and supported by the PRSO program, as well as other instruments in place such as the MDTF. Strengthening the external audit function and public financial management systems is a medium to long-term process. The challenge is to effectively implement the government s PFMSP, and monitor the strengthening of program initiatives by the government Budget transparency has improved and this agenda is on-going. The budget is published and accessible to the public. The government started publishing in 2007/08 the summary of the budget in the print media and details in the National Gazette four months after the NA approval. According to the PEFA assessment, 65 percent of the budget is being disclosed by administrative and economic breakdown. Budget execution reports are published on average four months after NA approval and four months of end of the fiscal year. Since 2008/09 the audit finding debate is broadcasted on radio and television, and the summary of the audit report published in the print media. The National Gazette is accessible in print to the general public from the National Treasury offices and the NA. Looking ahead, the government could do more to publish more accurate in-year budget execution reports and end-of year financial statements PRSO has supported the strengthening of the legislative framework for public procurement through the passage of a new procurement decree, implementing rules and regulations, a standard procurement manual and standard bidding documents. However, implementation has lagged behind. To better understand procurement reform in Lao PDR, and to build on legal foundations which PRSO has helped set in place, a Lao PDR Procurement Binding Constraints Diagnostic Assessment has been prepared. 40

48 122. The last IMF Safeguard Assessment of the BOL, conducted in 2003, classified risks as medium to high in the five categories. These medium to high risk categories are external audit mechanisms, legal structures and independence, financial reporting framework, internal audit mechanism and internal control systems. Progress on the safeguard recommendations has been mixed, and the agreed joint audit of the BOL 2003 and 2004 accounts by the State Auditor and an international audit firm have not been pursued. However, the SAO has conducted compliance and financial audits on BOL annually since 2007/08, but capacity remains limited. These audit reports have been submitted to the NA, but are not available to the public It is recommended that the recipient maintain a dedicated deposit account for the proceeds of the Grant/Credit, and will report on the funds flow of the dedicated deposit account. The government will, if considered necessary by IDA, allow an independent external audit of the dedicated foreign currency deposit account. Disbursement and Auditing 124. A single tranche IDA Grant of SDR 6.7 million (US$ 10 million equivalent) and IDA Credit of SDR 6.7 million (US$ 10 million equivalent) for a total amount of US$ 20 million equivalent will be available upon effectiveness, anticipated for October The recipient of the single tranche is the Lao PDR. The closing date of the operation will be March 31, The proceeds of PRSO 9 will be disbursed against satisfactory implementation of the policy program, and the stipulated release conditions of PRSO 9. The proceeds will not be tied to any specific purchases. However, such proceeds will not be used for ineligible expenditures. As was practice under PRSO 1-8, the recipient will maintain a dedicated deposit account in US dollars at the BOL, as part of the general foreign currency reserves of the government, and the proceeds will be deposited by IDA into that deposit account. An equivalent amount will be converted into local currency and credited to a central treasury account that is used to finance budget expenditures within two days Through the MOF, the government will report the amount received in the US dollar deposit account at the BOL to IDA. The government will report the amounts withdrawn from the deposit account and the equivalent amounts credited in local currency to the central treasury account available to finance budgeted expenditures. The report on the amounts withdrawn will include the date and name/number of the government s bank account into which the local currency amount has been deposited. The report on receipts and disbursements from the deposit account is to be submitted to IDA within 45 days of the final disbursement of the proceeds from the deposit account The government will ensure that the proceeds are used for budgeted public expenditures except for purposes or items on IDA s negative list, as agreed during negotiations and specified in the Financing Agreement. If the proceeds are used for ineligible purposes, as defined in the Financing Agreement, the Bank will require the government, upon notification from IDA, to refund the amount directly to IDA. Amounts refunded to IDA upon such requests shall be cancelled. Upon request by IDA, the dedicated account and related fund flows to and from this account will be audited by independent auditors and in accordance with terms of reference acceptable to IDA. The audit report will be provided to IDA within four months after IDA s audit request. The processes and controls described above reflect the findings of the IMF's safeguard assessment as regards the central bank control environment in making use of a dedicated deposit account for the foreign exchange proceeds of the Bank's disbursement. 41

49 Risks and Mitigation 128. Two sets of macroeconomic risks are identified: first, continued rapid credit growth in a context of low reserves and weak financial sector supervisory capacity enhance vulnerability to domestic and external shocks, including weaker commodity demand. Rapid credit growth accommodates the expansion of domestic demand fueled by large investments inflows and expectations of continued strong economic growth. This demand puts pressure on external accounts, leading - with a stabilized exchange rate regime - to downward pressures on external reserves. This risk is heightened by weak supervision in the financial sector. Mitigation measures include PRSO support to improve banking disclosure, the strengthening of the macroeconomic framework, paying greater attention to natural resources in macroeconomic management and, at the country strategy level, to undertake further analytical work to raise awareness of these issues The second source of risk is over-borrowing with a buildup of unsustainable levels of debt and/or contingent liabilities. In a fast growing environment with a growing number of interested financiers, the temptation to finance a too large amount of infrastructure projects either at the national or local level should be measured and within the limits of fiscal affordability and debt sustainability. This PRSO series mitigates this risk by supporting the strengthening of the fiscal and debt policy framework, management and reporting Public finance and revenue management reforms go to the heart of the political economy, so political backsliding and reform delays are high risks in the context of a limited capacity environment. The public financial management system does not allow for timely reconciliation. Additionally, reporting of public finances indicates a high fiduciary risk of possible leakages of funds. This risk is heightened by provincial autonomy without adequate monitoring and accountability mechanisms. This has been mitigated to some extent by the recentralization of budget execution at the National Treasury and revenue administration functions (Customs and Tax Departments) supported by the PRSO. The PRSO team has engaged in consultations and outreach activities with policy-makers and other key stakeholders to build consensus around reform priorities. The PRSO also has built an enhanced engagement with the National Assembly to strengthen the demand for reform from within, and aims to support reforms already endorsed by the Party Congress and contained in the NSEDP Another risk is limited human capacity to undertake sophisticated cross-sector reforms. This is true in the PFM reform program and in the social sectors, where decentralization at the spending unit level is capacity-demanding. This also applies in the natural resource sectors, where capacity constraints may lead to an increasing gap between the level of governance and sophistication of reforms needed and the capacity to respond to those needs. Finally, this is true also outside the resource sectors where that might cause an increasing gap between de facto and de jure reforms. This risk is mitigated through significant investments in technical assistance, and through a sustained medium term reform program. Opportunities include supporting reforms with good support and momentum on the one hand, while on the other hand continuing to push reforms in the making, which may proceed at a slower pace. 42

50 Annex 1: Letter of development policy LAO PEOPLE'S D MOCRA TTC REPUBLIC Peace Independence Democracy Unny Prosperity MINISTRY OF FINANCE No. J 6 -!Mdf- Vientiane, 23.AU Mr. Jim Vong Kim President The World Bank Washington, D.C. LETTER OF DEVELOPMENT POLICY Dear Mr Kim~ I. On behalf o f the Government of l..ao PDR. I run writing to request Ute International Development Association's continued financial ond technical suppon for the implementalion of our lhc yc:ar Natioml Socio Econonuc Developmem Plan for (NSEDP ) through a Ninth Po erty Reduction Suppon Operation (J'RS09), the second of a third I'RSO progrrunmutic series iprs08 to PRSO II). Poverty Reduction Strategy 2. Our iutcntloo is to achieve rapid and lndusive economic growth in order to Improve the Uvlug conditioou of tbe poor population. We arc committed to balving po cny by 2015 and gradualing from the status of least-developed oounuy by Our commitment to rcfonns and the development stra1egy to nehievc U1ese goals m c articuloted in the five-year National Socio Economic Development Plan for (NSEDP ) approved by the Notional Assembly in June 20 II. 3. A comprehensive und inclusive planning process was followed for the 7th NSEDP. The Ministry of l'lnnning nnd lnv~tment (lv!pi) and line ministries led consultntions with local commuuili., fwu ing on the pooi1:si dlstncts. lnrough the Round Table Mce1ings (RTM), the private sector, donor communi!)', and Civil Society wore also consulted. Other participants included National Assembly members and moss-organiu1tions like the Lao P.D.R. Women's Union. Cooperation.teross government was strong, with tbe MPI leading mquent technical meetlf1i$ \\ith the Minisuy of Finance and line ministries. A series of consuhalions within eight Sector Working Orou;:>s (SWGs) has taken place in the lead-up to the RTIM 20 12, complemented by the Provincial Coasultation in Xieng Khouang in May At U1cse forums, discussions and eonsolidntion of inputs on the nnnual progress, achicvemenis and challenges in Implementing the 7th NSI:iDP and MDGs have occurred. 4. The 7th NSEDP lays out a framework fllr dev~lopment and makes our development priorltits plicil and transparent. These priorities take imo account the multi-dimensional nature of poveny alleviation, and ate detailed in the concrete actions de1ailed in this document: I... 43

51 Tbe seventh NSEOJ' provides n comprehcnsi ve strategy fur development, with o range of me-dium- and long-ll:nn policies aimed at sustained growth nnd poverty reduction. It establishes the following overorehing goals: (i) Ensure continuation cf national economic srowth with security, peace and >lability, and ensure GDP JII'Owth rate of at least 8 pe=nt annually and GOP per capita to be at leust USD 1,700 by 2015; (ii) Achieve the Millennium Development Goals (MDGs) by 2015, and adopt appropriate technology, skills Qlld create favorable conditions for grnduating the country from Least Developed Countty (LDC) Status by 2020; (iii) Ensure the sustainabitity of dc"clopment b) emphasizing economic de.,lopment with. cultural and social progress, preservina natural resources and protecting the environment; (iv) Ensure political stability, peace and an orderly society. 5. To aehjeve these goals, the NSEDP proposes to: (il build a strong base for sustained economic gro\\1b so to dnve the nation out of the status of a least-<leveloped countty, reduce poverty, support an economic and labor structural shift from agriculture to induslty, sbare the benefi!s of development with nil ; promote small and medium enterprises; and promote people's pat ticipution; (ii) focus on ntrol development and poverty eradication and reducing income disparities; (ill) continue education reforms and support hurroo resourec development, upgrade and ex pension of educational opportunities and labor skills, ~>Od health and sanilation, building bener management staff and high skilled workers; (iv) strengthen tbe effectiveness of public administ, ation, rule of law, fight against corruption, (v) optimize the usc of naturnl re.o;ources, increase cooperation and integration at regional and global levels, raise competitiveness, develop soci~economic infrastructure; (vi) implement industrializatioa strategies, with a focus on lmge projects and small and medium enterprises willing to integrate regionally and globally. 6. The 7th NSP.l>P is now at the mid-term review point of implementation ( ). The m in achievements in implementing the first Annual NSEDP (20 I 0-20 II) were reported to the National A.s.sembly in June 2011 anri r~on'ted in various Seetor Worldng Groups' progre.s reports. Tbe 6th and 7th NSEDP implementation have entailed important achievements in refonns in economic areas, sncial sectors management lls well as in P Jblic Finance Management (PFM) with key reforms being supported by the PRSO. Policy dialogue under PRS04-7 focused on two broad ureas: (i) susuining growth through improvement of the investment climate, facilitating llade nnd enhancing management or natural resources: and (ii) inproving social outcomes through beller public financial management S)'Slems and service delivery. 7. The PRSO dialogue contributed in vnrlous ways to the Government reform effort: Suppo11 for public finance management refonn has helped develop stronger policy control over the use of budgetary resourees: both in terms of making sure that revenues are spent according to policies and plans, md that pims and polictes better dctennine how revenues arc allocated to priority areas. lmprcvements ut budget processes and oversight functions have enhanced tl1e transparency rutd accountability of the public finance systc1n, wblch arc prerequisites for better use of Government resources. These eitoris will 1nnke it possible to improve the allocation (level and compo>ition) of ocx;i.u -w. >j~<udiug,.-jed to deuver ke) M:Ovs. We look lorward to the continued PRSO support in these areas so to enable J)Ublic financial management system to allocil!e higher spendmg at bealtlt and education, per govemme111 objectives. 8. PRSO bus olso been Instrumental during the past to s upport improventent in the eo,ironmtot for Investment, trade and doing busincu. Ho\\-ever, changes in laws and regulations take time to translate into on-the-around results, and implementation is only stunting in

52 many of me suppornd areas of trode and investment climate. Some refonns in the natural resource management llre8 wjl, if imple~nented thoroughly, slow down and increase COStS of investment, in the interesls of improving social and environmental sustainubility. Si1nilarly, improvements in lhe regulation and governance of the financial sector eventually contribute to the soundness of lhc financial sector anc roduce fiscal risks, such as with further recapimlizations of slllte-owncd commercial banks. We look forward to PRSO suppon in U1ese imponnm areas, building oru p~t dinlogue nod moving on to implemenration of laws and regulation for on improved and competitive busin= climate. P<>verty Reduction Support Opcmtion Third Scde (PkS08-11) 9. The PRSO third series (PRS08, PRSOO, PRSOIO, PRSOil) aims to assist the implementation or the NationAl Social and Economic Development Plan by focusing on tho sustainable management of revenues from natural, esources so these increasing revenues trnnslate into development outcomes and improvement in service delivery. through in particular increased domestic spending in the health and education S«tors. To this end, the four policy or~ns wilich have been identified in partnership with PRSO development partners are as follows: (i) Fiscal ood publ c financial management for service deli\ery; (ii) Sustainable revenue management in the natural resom-cc sectors (mining and hydropower); (ti i) Sustainable putlic financing mechanisms of schools and health facilities; (iv) An investment climate for diver.>ification and competiti encss. I 0. Within the ~eve nth NSEDP fnomework, reforms in the bove-rderred areas will improve the Covennneot' ability for macroeconomic policy coordination, with framework responsive to developments in the natunl resource sectors, consistent with economic growth and st<lbility. Thai dialog11c includes n strengthened debt management, and more transparent nnancial sector. U will improve U1e sustainable maoutgemcnt of increasing financial Oows from the natuml resource sectors. Refonns will design 6scal regimes in hydropower and mining that maximize revenues for Oovenuneno while minimize the eoviroiullental and so<ial costs, nnd mainwin U>e sector attractiveness for private investors. Reforms will continue strenglhening public fmandal management systems to plan and execute public budget in the most efficient, equitable, and transparent ways. We will support the establishment of suslbinable funding mechanisms in health and education (namely the school bla<;k arant and the Free Matenml and Child Health Policies), and will implement reforms to ensure o competitive trode and business climate to nurture diversified sources of growth. It is expected that the PRSO third series will significantly contribute to these objecti ves. II. Expetted results are: (i) a macroecooomte fnunework established that guides decision making ofu1c next NSEDP, with a focus on natural resource developments; (ii) Improved budget credibility. orderliness nnd pnnicipation, improved sector budget allocation nnd reponing; (ill) Coordinated and mutually reinforcing regulations that guide the fiscal regimes for the sustainable development of the h)'dropowcr and mining sectors to mll.<ionize Government revenues while mi11imizing U>c fioancinl, econom ic, social and environmental and maintaining the attractiveness of the sectors to priv1tc investors; (iv) In health and education, increased non-wage recunent spending at the aggregate, provincial and school and health faetlity le\'cls; and (v) a streamlined and efficient u ade and business processes through efficient customs, a trauspurent trade reginte and implementation of the investment and enterprise laws. 45

53 12. The ninth PRSO is the second oft he third PRSO series. h undelpins our objoctive of mainwining a sound macroeconomic environment and accelerating growth. This operation by IDA wiu provide externcl resources for the execution of our FY2012/13 budget, including supporting our effons to maintain a broad-based economic growth and meet the important needs in <ocial sector spending, and in particular meet our objective of increasing non-wage recurrent spending in bealth and educatioil During the last year, the Government has started implementing through the successful completicn of PRSOS the PRS08 11 medium-term rcfom1 program. 13. The implemeot11tion of 11U prior actionj aad policy actions is doscribcd in the Progmm Document for the PRS09. The prior actions implemented by differen1 agencies arc presented below to demonstrate the multi-sector nature of the operation tb<~t brings together diflerent agencies ar.d development panners to implement a consistent policy reform liumework. In addition to those prior actions, a number of policy actions have also been carried out that contribute to the 0\'e:-all reform momentum. These are described in the broader governmelll reform matrix. I. the Cabinet has appr<y~'cd a draft Pr<Sidential Ordinance on Public Debt Management; 2. tire MOF. MOES and MOH have adopted organization codes for lier-2 budget enlilits under the current budget coding system and has allocated FY 2012/IJ budger to these levels for cducwlon cmd luwlth sectors at the centr allevel; 3. tire MOF has submi11ed 10 the Govunment Office for review and approval by the Cabbw a decree on public seer or accouming; 4. the MOF has appointed " mining revenue commillee and the sold commillu has report~d to the Mmisler of Flnanu on mining fiscal regtme issuu and options; 5. the MO.ES has collected and made availttble for dissemina/jon school-based apendlturr refj(jrh for nlnety.j"n:e percent (95%) '" more of schools In at leasj thirl)l f"'tunl {JQn) of districts; 6. the,\1()/1 has supmilted to the MOF and MPI a coverage, financial, and monitoring plan for scaling up.free maternal and child heal1h servicts and health equil)l fimds, including a roadmap for human resource development prepored throug!t a sector-wide coordination mechanism. over rita ne.tlthree (3) government fiscal _;e(i)'s (FY /3114, FY 14115, and FY 151/6), encompa.sslng domestic and external financillg. and 7. tlte MOF has implomentecl a customs risk m<magemell/ 11iJproaclt 10 imports where an autamated system for Cl/.stoms data is deployed. Macroeconomic and.fiscal nollry framewnrk Sutctainabilitv and Stnhilitv 14. Lao I'OR's mol GDP growth will.-.,main robust In 2013 u-ith projected growth of not less than 8 pcn:em con1pared to 8.3 percent in Natural "'sources 1111d manufacturing sectors are expected to drive growth, together wi ~1 garment exports rebound, growth improvement in the service sector, partic-jiorly tbe trlln!."pon nnd tourism sectors and retail trading. Agriculture (fishery, li=tock and crops) is expected to benefit from the recent increase in regional demand and higher food prices. 4 _... 46