LAO PDR: THE PROPOSED NAM THEUN 2 HYDROPOWER PROJECT UNDERSTANDING THE MACROECONOMIC EFFECTS

LAO PDR: THE PROPOSED NAM THEUN 2 HYDROPOWER PROJECT UNDERSTANDING THE MACROECONOMIC EFFECTS

Table of contents Executive Summary... 3 1. Introduction... 6 2. Macroeconomic overview of Lao PDR, 1988 to 2003... 7 2.1 Real Sector... 7 2.2 Monetary Sector... 8 2.3 External Sector... 9 2.4 Real exchange rate movements since 1988... 9 2.5 External shocks and the real exchange rate... 11 2.6 Poverty and inequality... 14 3. Macroeconomic dimensions of NT2...15 3.1 Construction Period 2004 to 2009... 16 3.2 Operational Period - 2010-2020... 17 Table B.1 Indonesia: Poverty incidence and inequality, 1976 to 2002... 18 4. Assessment of macroeconomic impacts of NT2... 19 References... 21 Boxes: Box 1 B.1 Beneficial effects of natural resource revenues - Indonesia... 18 Figures: Figure 1 Lao PDR: GDP growth (%) and CPI inflation (%)... 28 Figure 2 Lao PDR: Export and import levels (US$million)... 29 Figure 3 Lao PDR: Growth of Exports and Imports (%)... 30 Figure 4 Lao PDR: Current account balance (% of GDP)... 31 Figure 5 Lao PDR: Incoming Foreign Direct Investment (US$ m.)... 32 Figure 6 Lao PDR: Relative prices of traded and non-traded goods, 1988 to 2004... 33 Figure 7 Lao PDR: Poverty incidence and inequality, 1992 to 2002... 34 Tables: Table 1 Lao PDR: Macroeconomic indicators, 1990-2003... 22 Table 2 Lao PDR: Share of GDP by Industrial Origin at Constant Price, 1990-2002... 23 Table 3 Lao PDR: GDP growth rate by industrial origin at constant prices, 1990-2002 (per cent annum)... 24 Table 4 Lao PDR: Agricultural planted area and yields... 25 Table 5 Lao PDR: Rates of change of real exchange rates and levels of current account deficits, 1988 to 2003... 26 Table 6 Poverty incidence and inequality in Lao PDR, 1992 to 2002... 27 2

Peter Warr Australian National University December 2004 Revised Executive Summary 1. The Lao People s Democratic Republic (Lao PDR) has planned to undertake a major investment hydro-electric project on the Nam Theun River (NT2) with a consortium of international institutions, banks and private investors. The project will invest in the construction of a dam and hydroelectric generating capacity during 2005-09 period which will generate large foreign exchange earnings from the sale of electricity to neighboring Thailand from 2010 onwards. The size of the total investment package is around US$ 1.2 billion, equivalent to more than half of Lao PDR s 2004 GDP. 2. This project is likely to have significant impact on Lao PDR, in terms of the environment and social development, on growth and poverty-reduction, and on the macroeconomic situation. Various reports have examined these effects and impact. This report focuses on the macroeconomic effects of the project during construction and after its operation, and in particular on the effect it has on the real exchange rate and the implications of that effect 1. 3. A concern regarding large, foreign exchange earning projects relates to the very large inflow of foreign exchange into the domestic economy which they produce during their investment stage and subsequently during their operational phase, through export earnings. The fear is that the absorption of these large foreign exchange inflows in the domestic economy may have disruptive macroeconomic effects. Central to these effects is the potential appreciation of the real exchange rate an increase in non-traded goods prices relative to traded goods prices within the domestic economy which result from absorption of these revenues into the domestic economy through public sector spending of such revenues. Changes in relative prices of traded goods, in turn, have effects on the competitiveness of traded goods industries, both export-oriented and import-competing, relative to goods and services with are not traded internationally. These effects, known as the Dutch disease, can 1 The potential impact of hydro-power (including NT2) and mining development on GDP growth as well as on social outcomes if revenue from natural resource projects are used to improve delivery of basic services are discussed in Realizing the Development Potential of Lao PDR, CEM, World Bank 2004 3

also affect income distribution adversely, when the agricultural and light manufacturing sectors, which stand to be affected negatively, employ large numbers of poor people. 4. This report estimates the likely magnitude of these effects using data from Lao PDR. During the period 2000 to 2003, actual real appreciation occurred due largely to the inflows of foreign capital in the form of foreign assistance and foreign investment. Real appreciation occurred at the rate of about 2.8 per cent per year. It is estimated that during the construction phase of the NT2 project (2005 to 2009), spending within Lao PDR will add about 60 per cent of this amount of real appreciation, or add about 1.7 per cent per year to the rate of real appreciation that would otherwise have occurred. This effect will cease when the construction phase is completed, now scheduled for 2009. Similarly, during the operational phase, beginning in 2010, the spending of project income (mainly export receipts minus debt-service and dividend payments to foreign shareholders) within Lao PDR will add 0.75 per cent per year to the real appreciation that would otherwise have occurred. 5. The rates of real appreciation estimated above are upper bounds on the reasonable range of likely actual rates. This is for two reasons. First the estimates of the amount of spending in Lao PDR of foreign exchange inflows coming from NT2 is at the higher end of what may actually take place. Second, the past relationship between changes in current account deficit and real appreciation that is used to assess the impact of NT2-related flows ignores the impact of growth that accompanied foreign aid and foreign investment inflows in the 1990s and during 2000-2003 periods. 6. Nevertheless, these rates of real appreciation are moderate, though not negligible. It must be recognized that these rates of real appreciation imply potential problems for producers of agricultural goods as well as for producers and workers in manufacturing since the relative prices of their output will fall during the construction and operation phases of NT2. 7. However, this does not mean that poverty incidence will increase. During the decade 1992-93 to 2002-03 substantial real appreciation occurred in Lao PDR, but poverty incidence still declined significantly 2. The experience of Indonesia also shows that rates of real appreciation of the above magnitude can be managed successfully and can be consistent with growth and declines in poverty incidence in both rural and urban areas. These facts demonstrate that real 2 Incidence of poverty fell from 46 percent in 1992-93 to an estimated 33 percent in 2002-03. 4

appreciation does not in itself necessarily imply increased poverty incidence, provided other things are happening that improve incentives and benefit the poor, especially the rural poor. 8. The net effects that the absorption of the NT2 revenues will have on poverty incidence depend on the manner in which these revenues are spent within Lao PDR, as well as the policy changes that take place elsewhere in the economy during the same period. If the revenues are spent in a way that benefits rural people through investments in rural infrastructure as well as in health and education -- the net effect would be quite different from those resulting from misused revenues. Experience elsewhere suggests that the net effect of large revenues from natural resource extraction depends heavily on this matter. The issue is one of governance. Measures to ensure that the revenues from NT2 are spent well are crucial. In addition, policy reforms that reduce costs of doing business, whether in agriculture or in manufacturing, as well as actions that make trade easier, are all likely to offset the disincentives that flow from the real appreciation. 5

1. Introduction 9. The Lao People s Democratic Republic (Lao PDR) has planned to undertake a major investment hydro-electric project on the Nam Theun River (NT2) with a consortium of international institutions, banks and private investors. The project will invest in the construction of a dam and hydroelectric generating capacity during 2005-09 period which will generate large foreign exchange earnings from the sale of electricity to neighboring Thailand from 2010 onwards. The size of the total investment package is around US$ 1.2 billion, equivalent to more than half of Lao PDR s 2004 GDP. 10. When very large infrastructure projects are undertaken in small economies, they can be expected to have large effects. There may be significant improvements in domestic incomes and sometimes in government revenues, but in many cases these gains are achieved at the expense of some adverse effects. These may include undesired environmental consequences, social disruption and some unintended macroeconomic effects as well. Not surprisingly, these projects are often controversial, and this is certainly the case with NT2. This report focuses on the macroeconomic effects, especially the effects on the real exchange rate and its implications. 11. The financing of the NT2 project will be overwhelmingly foreign, coming from both international institutions, and private investors and banks. There will thus be a large inflows of foreign exchange into the economy of Lao PDR during the investment stage and subsequently substantial export earnings from sale of electricity when the project becomes operational. Spending of large foreign exchange inflows in the domestic economy have macroeconomic effects that are now relatively well understood. Central to these is the appreciation of real exchange rates an increase in non-traded goods prices relative to traded goods prices within the domestic economy. These in turn have differential effects on the competitiveness of traded goods industries, both export-oriented and import-competing, relative to goods and services with are not traded internationally. A real appreciation raises the profitability of non-traded goods and services and lowers that of traded goods. These effects are often referred to as the Dutch disease, named after the effects on the Dutch economy of increased exports of gas from the North Sea, beginning in the 1960s. 12. In the context of the Lao economy, a real exchange rate appreciation may have further adverse consequences. Traded goods include the agricultural sector which is nearly half the 6

economy, as well as the manufacturing sector concentrated on garments production for export. Most of the poor people of Lao PDR are employed in the agricultural sector 3. External events which significantly harm the agricultural sector in Lao PDR may have important consequences for poverty incidence. Similarly, the garments industry employs a significant number of low-skilled people who are otherwise be poor. A sizeable contraction in these sectors, resulting from large appreciation of the real exchange rate, could have unwelcome consequences for poverty incidence. But Lao PDR has already managed successfully the absorption of the foreign exchange that comes with the large foreign aid and direct foreign investment inflows that the country has experienced in the 1990s. 13. This report is in three sections. The following section charts the recent economic history of Lao PDR, with a focus on the macroeconomic and related variables that are of interest for the focus of this study. The second section briefly describes the NT2 project in terms which are comparable with the macroeconomic dimensions of the Lao economy. The final section brings these two sets of data together to assess the likely macroeconomic consequences of NT2. 2. Macroeconomic overview of Lao PDR, 1988 to 2003 2.1 Real Sector 14. Lao PDR is a poor country, with GDP per person at around US$ 310. From 1991 to 2002 annual growth of GDP averaged 6.2 per cent per annum (annual data are in Table 1 and Figure 1), or around 3.8 per cent per person. The agricultural sector dominates in employment, with 80 per cent of the workforce and it contributes about 50 per cent of GDP. Lao PDR receives substantial external support. In 2002/3 external donors contributed 61 per cent of the government s capital budget, representing 39 per cent of total public expenditure, and 7.6 per cent of GDP. Over the decade 1992-93 to 2002-03 estimates of poverty incidence in Lao PDR declined from 46 to 31 per cent of the population. 15. Since the late 1980s, a program of market oriented economic reforms, known as the new economic mechanism (NEM), has shifted the Lao PDR economy away from the rigidly 3 Datt and Wang (2002) estimates that in 1997-98 rural people, most employed in agriculture, were twice as likely to be poor as urban people. Of all Lao people with consumption expenditures below the government s official poverty line the proportion residing in rural areas was 92 per cent, whereas rural areas contained 83 per cent of the total population. 7

socialist pattern instituted immediately after the declaration of the Lao PDR in 1975. The reform process has been highly successful, but it is hardly surprising that many problems remain. The agricultural sector contracted from 61 per cent of GDP in 1990 to 50 per cent in 2002 (Table 2 ), a phenomenon typical of rapidly growing economies. Most of this contraction occurred in the crops sector (Table 2), but it is significant for later discussion that the contraction of the crops sector was concentrated in the first half of the 1990s, when the share of the crops sector in GDP contracted from 37 to 25 per cent. From then until the present, the share of the crops sector recovered to around 30 per cent of GDP. Heavy public investment in irrigation in the second half of the 1990s accounted for this change. 16. Table 4 summarizes changes in the agricultural sector at 5-year intervals. One feature of the changes in the crop sector is important. The area planted to the total rice sector remained virtually unchanged from 1990 to 2000, but within this the irrigated rice sector expanded very markedly, responding to the irrigation investments mentioned above, and the upland rice area (non-irrigated) contracted by 70 per cent. Rice became a less attractive activity for upland people. To some extent this was due to the availability of alternative crops with market outlets both within Lao PDR and in neighboring countries, made possible by the reforms in trade and private sector, and partly due to the relaxed insistence from the government that all regions of the country strive for rice self-sufficiency. It was also due in part to road improvement within Lao PDR, making production of cash crops more feasible for producers previously constrained by poor or non-existent roads to produce for subsistence. But it was also due to the declining profitability of rice itself. The reasons for this will be discussed under real exchange rates, below. 2.2 Monetary Sector 17. Inflation was moderate through the first half of the 1990s, at single digit levels for most of this period, but accelerated from 1998 to 2000, peaking at 142 per cent in 1999 (Table 1 and Figure 1). This inflationary surge was related to agricultural policy. The government of Lao PDR is committed to a goal of rice self-sufficiency. However, it was apparent through the first half of the 1990s that rice output was not growing as fast as population. A massive public investment in irrigation facilities followed, but it was financed to a considerable extent by monetary creation, producing the inflation of the late 1990s. The greatly increased public sector deficit of 1998/99 was heavily monetized. Since 2001 consumer price inflation has been contained., with an average annual rate just under 10 per cent. 8

Inflation in consumer prices in the late 1990s coincided with a collapse of the exchange rate. The kip / dollar rate collapsed from roughly 2,000 at the end of 1997 to 8,200 at the end of 2001. Although the baht also depreciated in the late 1990s, as a result of Thailand s financial crisis, the kip s depreciation was much larger. The kip / baht rate declined from 47 at the end of 1997 to about 200 at the end of 2000. This depreciation of the nominal exchange rate had implications for real exchange rates, and these were relevant for the central theme of this report. These issues are discussed below. 2.3 External Sector 18. The level of Lao PDR exports and imports since 1999 is summarized in Figure 2 and the growth of both categories since 1991 is shown in Table 1 and Figure 3. The volume of imports has exceeded exports in every year since the early 1990s. The current account deficit has averaged 12 per cent of GDP since 1991 (Figure 4). The deficit is financed by inflows on capital account. Foreign aid contributes about 7.5 per cent of Lao GDP. In 2002/3 actual incoming foreign direct investment was US$150 million, or 9.3 per cent of GDP, an increase from US$100 million (7.7 per cent of GDP) in 2001/2 (see Figure 5). 2.4 Real exchange rate movements since 1988 19. Figure 11 shows a series of relative prices corresponding approximately to the ratio of traded to non-traded goods prices, from 1988 to 2004. Because producer prices are unavailable, this figure draws on consumer price data, disaggregated by commodity category, which are collected by the National Statistical Centre, Vientiane. Because the format of the consumer price data has changed over time, the series shown in Figure 11 has three segments. (i) (ii) (iii) Food / Services I 1988 to 1997. This series shows the ratio of food to services prices, intended as proxies for traded and non-traded goods prices, respectively. Food / Energy and Construction 1997 to 2000. In 1997 the consumer price category services was discontinued and for this purpose the category Energy and Construction has been used as a proxy for non-traded goods prices. Food / Services II. The format of consumer prices was changed again in 2000 and the third series constructs a services price series as a weighted average from components of the new classification corresponding to services, using the CPI weights to aggregated these series. 9

20. These data indicate that agricultural commodity prices declined markedly relative to nonagricultural prices, especially from 1990 to 1994. An economic boom followed the more open economic environment created by the reforms introduced by the market-oriented New Economic Mechanism (NEM) in 1988, but this boom was concentrated in the services and construction sectors of the economy, concentrated in Vientiane, which drew resources from elsewhere, especially from agriculture. In addition, the inflow of foreign capital that accompanied the NEM had indirect macroeconomic effects on agricultural output, which were in some cases negative. 21. The increased domestic expenditures made possible by foreign aid and foreign investment inflows produced demand-side effects that induced contraction of agriculture. Increased demand in general produces increases in the domestic prices of those goods and services that cannot readily be imported or diverted from export. These include most services and construction. As the prices of these non-traded goods and services rise relative to those of traded goods their production becomes more profitable. The expansion of these sectors attracts resources, including labour, away from agriculture. This phenomenon - the Dutch Disease or booming sector effect - causes the prices of agricultural and other traded commodities to decline relative to other prices, with negative effects on agricultural production. To the extent that the NEM increased the exposure of agricultural commodities to international markets, this policy change indirectly increased the impact on agricultural production of these market phenomena. 22. From 1997 to 1999 this real appreciation was reversed by the massive nominal depreciation described above. The mechanism is that a nominal depreciation increases the nominal domestic prices of traded goods. Some stickiness in non-traded goods prices caused them to respond slowly to the monetary expansion that was occurring at the same time, with the result that the ratio of traded goods prices to non-traded goods increased. This effect ceased after 2000 and real appreciation resumed. 23. The two measures of 'competitiveness' are based not on domestic relative prices, but on nominal exchange rates adjusted by foreign and domestic price levels. The general form of these measures is E R = EP * / P, where E denotes the nominal exchange rate, measured in units of domestic currency per unit of foreign currency, is a measure of foreign prices, measured in foreign currency, and P is a measure of domestic prices, measured in domestic currency. The P * 10

measures chosen for P * vary in different studies. The series called RER 1 uses foreign (US) consumer prices while RER 2 uses foreign (US) producer prices. Both series use Lao PDR consumer prices for P. 24. The index RER 2 is preferable to RER 1 as a proxy for traded goods prices relative to nontraded goods prices because the share of traded goods in wholesale price indices is higher than its share in consumer price indices. Thus the numerator of this index may be taken as a (very rough) proxy for domestic traded goods prices and the denominator, the domestic consumer price index, may be taken as a (very rough) index of domestic non-traded goods prices. For the reasons demonstrated in Warr (1986), both of these exchange rate based measures, but especially RER 1, may be expected to understate the magnitude of a real appreciation, compared with changes in the domestic relative prices of traded goods to non-traded goods. They will also overstate the magnitude of the real depreciation resulting from a nominal depreciation and overstate its duration. 25. The relative price series shows the largest real appreciation from 1990 to 1994. RER1 and RER2, but especially RER 1, indicate large real appreciations arising from the nominal exchange rate depreciations of the late 1990s and also suggest that the real depreciations were longer-lived than they really were. 26. To focus more clearly on the message conveyed by these data, Figure 7 summarizes the data by constructing annual averages, rather than the monthly data, with the average for 1988 indexed to 100. The message conveyed by this diagram is then itself summarized in Table 5, by calculating averages for each of three periods: 1988 to 1994; 1995 to 1999; and 2000 to 2003. These periods corresponded to real appreciations, depreciations and appreciations, respectively, by each of the three measures shown, but the magnitudes differ in the directions predicted by the theoretical discussion mentioned above. For the reasons summarized above, the relative price series is considered a more accurate indicator of traded to non-traded goods relative prices. 2.5 External shocks and the real exchange rate 27. We are interested in the relationship between external shocks, especially inflows of foreign capital, and the real exchange rate. We turn first to a discussion of the meaning of external shocks. Consider the balance of payments accounting identity R = CAB + KAB, (1) 11

where R denotes the change in the level of official reserves, CAB denotes the current account balance (positive if the current account is in surplus, negative if in deficit), and KAB denotes the balance on capital account. Alternatively, rearranging this expression, KAB = R CAB = R + CAD, (2) where CAD = CAB denotes the level of the current account deficit (positive if the current account is in deficit). 28. Now suppose there is an exogenous inflow of external resources in the form of foreign aid or foreign investment. This increases the left hand side of equation (2). This inflow may have effects on productivity and output in the medium term, but in the short term the inflow of foreign capital will be reflected in the two right hand components of equation (2): there will be some combination of an increase in foreign exchange reserves of the central bank and a current account deficit. Official reserves will increase to the extent that the inflow is sterilized by the domestic monetary authority and thereby not absorbed into domestic spending; the current deficit will increase to the extent that this does not happen and the capital inflow is absorbed into the domestic economy. It is therefore possible to interpret the magnitude of the current account deficit as that part of the surplus on capital account that is absorbed domestically, rather than saved in the form of an increase in official reserves. 29. The saved part of an exogenous capital inflow has no effect on the domestic real exchange rate, or any other domestic variable, because it does not affect domestic spending. So far as current macroeconomic effects are concerned, the relevant part of the capital inflow is the absorbed component, rather than the saved component. To see the magnitude of the absorbed component of a capital inflow, it is possible to look at the magnitude of the current account deficit. In what follows, we interpret the magnitude of the capital account surplus and decisions on official reserves as exogenous. We therefore concentrate on the current account deficit and its relationship to the real exchange rate. The objective of this discussion is to see the extent to which the absorption of capital inflows results in real exchange rate appreciations and thus, potentially, to Dutch disease effects on the domestic economy. 30. Table 5 now applies the above reasoning to the data on real exchange rates discussed above and the data on the current account deficit reviewed in Figure 9. In line with the above 12

discussion of macroeconomic events in Lao PDR the period 1988 to 2003, the period is divided into three segments: (i) (ii) (iii) 1988 to 1994: post-reform adjustment; 1995 to 1999: hyperinflation and exchange rate depreciation; and 2000 to 2003: sustained growth with capital inflow. 31. For the change in the real exchange rate it is helpful to focus on the first row of the table (Relative price tradables / non-tradables), which shows the annual average rate of relative price changes, expressed as a percentage, from Figure 7. 4 For the reasons discussed above, this series (labeled Relative price ) is considered a better approximation to the real exchange rate than either of the other two (labeled RER 1 and RER 2, as in Figure 7). We now consider the three periods outlined above. Consistent with the Dutch disease literature, the discussion will draw a connection between the level of the current account deficit an annual flow indicating the annual rate of capital inflow with changes in the level of the real exchange rate. This relationship will subsequently be used to extrapolate the future impact of current account deficits arising out of NT2 foreign exchange receipts, during construction and then during operation. 32. Period (i) - 1988 to 1994 - combined two phenomena of relevance for this study. First, there was the opening of the Lao economy through the relaxation of severe quantitative restrictions on imports and some exports a component of the New Economic Mechanism discussed above. Second, there was a substantial capital inflow, mainly through official foreign aid, which accompanied the liberalization program. Both of these phenomena will have produced real exchange rate appreciation. The liberalization did so because the removal of highly restrictive quantitative controls on imports led to reduced prices of imports and domestically produced import substitutes within Lao PDR. The capital inflow also produced a real appreciation through the absorption of these inflows, as reflected in the large current account deficits that occurred. The effects of these two contributors to the large real appreciation that occurred during this period are combined in the data and it is not possible to disentangle their respective effects. The effects of the capital inflow are relevant for this study, but the effects of the liberalization program are not. Looking at the relationship between the size of the current account deficit and the rate of real appreciation during this 4 For example, if the index changed from a value of 50 to 40 over a period of 2 years, the annual average percentage rate of change would be calculated as [(10 / 2) / 50] * 100 = - 10%. 13

period would overstate the degree to which larger current account deficits alone would increase the rate of real appreciation. 33. Period (ii) - 1995 to 1999 - was a period of macroeconomic turmoil, both in Lao PDR and elsewhere in the region. In Lao PDR, this was a period of monetary instability and resulting hyperinflation and nominal exchange rate chaos. To a lesser extent this was also the case in neighboring Thailand, Lao PDR s major trading partner. The effects of this instability on the real exchange rate presumably dominated any effect of capital inflows. The real depreciation that occurred during this period was a consequence of the nominal depreciations increasing the domestic prices of traded goods relative to the (temporarily stickier) prices of non-traded goods and services. This period may be disregarded as an indicator of the underlying macroeconomic relationship of interest in this study because a period of nominal exchange rate stability is required for this purpose. 34. Period (iii) - 2000 to 2003 - seems more suitable for revealing the relationships of interest. Current account deficits of 6.5 per cent of GDP coincided with rates of real appreciation of 2.8 per cent per annum, 36 per cent of the rate of appreciation that occurred during period (i) - 1988 to 1994. Using this relationship estimated from period (ii) to extrapolate to period (i), the somewhat higher rate of capital inflow during period (i) relative to GDP apparently produced about half of the real appreciation that occurred during that period. Economic reform was responsible for the other half. 2.6 Poverty and inequality 35. Studies of poverty incidence in Lao PDR are constrained by the availability of household survey data sets which can support this form of analysis. The only such data sets available are assembled by the government s National Statistical Center and are known as the Lao Expenditure and Consumption Survey (LECS). Three such surveys have been conducted to date: LECS 1, covering 1992-93; LECS 2 covering 1997-98; and LECS 3, covering 2002-03. 36. Statistical changes in LECS 2 limited the scope for comparison with LECS 1, but LECS 2 and 3 are closely comparable. The data from LECS 3 were released in late 2004. 14

Available data on poverty incidence and inequality in Lao PDR are shown in Table 6. Because official poverty estimates based on the 2002-03 (LECS 3) data are not yet available, preliminary estimates from the World Bank office in Vientiane are reported here. According to these estimates, over this 10 year period poverty incidence in Lao PDR declined from 46 per cent to 33 per cent of the population, that is, by 1.3 per cent of the population per year. This compares favorably with Cambodia (0.5 per cent decline per year over the five years ending in 2001) 5 and Thailand (1.6 per cent per year over the 33 years ending in 2002) 6, but is less than Vietnam s reported rate of decline (roughly 3 per cent of the population per year over the 5 years ending in 2001) 7. The Lao PDR rate of poverty reduction is clearly encouraging. Sustaining it over an extended period will reduce poverty incidence to very low levels. 37. One observation regarding these data is especially important for the present discussion. The real appreciations noted above, and the resulting decline in the profitability of agricultural production, did not prevent very large reductions in poverty incidence from occurring. Moreover, these reductions occurred in both rural and urban areas. Over the two intervals 1992-93 to 1997-98 and then 1997-98 to 2002-03, the annual rate of poverty reduction in rural areas was approximately the same (1.9 per cent of the rural population per year in each case), despite the fact that the rate of real appreciation was much larger in the former case. Of course, other things were happening at the same time and these also contributed to the poverty outcomes which were observed, but these data show that real appreciation does not, in itself, guarantee that rural (or urban) poverty incidence will increase. 3. Macroeconomic dimensions of NT2 38. The project occurs over two distinct periods: (i) construction period - 2005-2009; and (ii) operational period - 2010-2020 and beyond. 5 Source: World Bank, 2002. East Asia Rebounds, But How Far? Washington, April (Appendix Table 8). 6 Source: Warr (2005) based on data from National Economic and Social Development Board, Bangkok. These estimates for Thailand are based on household income data, rather than expenditures as is the case with Lao PDR, Cambodia and Vietnam. 7 Source: World Bank, 2002. East Asia Rebounds, But How Far? Washington, April (Appendix Table 8). 15

3.1 Construction Period 2004 to 2009 39. The estimated Gross Fixed Capital Formation (GFKF) in Lao PDR, excluding hydropower investment over the construction period of the project is around US$ 740 million per year. The total capital investment of the project is therefore equivalent to 1.6 years of total GFKF in Lao PDR. But comparing the total capital cost of the project with Lao PDR annual GFKF is potentially misleading in the sense that if the NT2 project was not undertaken, this capital would not be available for investment in Lao PDR. 40. Of the total base cost of US$ 1.2 billion, investments through imported goods and services will have roughly no impact on the Lao PDR economy, except for the residual value at the end of the project. The services will have an effect only to the extent that some of the payment for these services is spent within Lao PDR. It should be expected that there will be effects of this nature. But domestic civil works contracts is likely to be worth about US$ 300 million spread over the five years of construction. This, plus the spending of service providers within Lao PDR, constitutes the capital inflow during the construction period whose macroeconomic effects require consideration. 41. Considering US$ 300 over five years as an average annual flow of US$ 60 million per year, this amount represents 3 per cent of Lao PDR GDP in 2003. This is also equivalent to 61 per cent of the annual absorption of capital inflows into Lao PDR (i.e. current account deficit) that occurred over the period 2000 to 2003. Thus the capital inflow can be projected to contribute to an increase in the rate of real appreciation in Lao PDR of about 60 per cent of the amount which occurred over that period, or 1.7 per cent per year. 42. This calculation excludes the fact that some of the imported services used in the project will result in spending in Lao PDR. However, it also ignores the fact that a substantial proportion of the domestic civil works contracts analyzed will themselves require imported capital goods. It seems probable that the second omission is more significant than the first. Thus the rate of real appreciation projected above is probably an upper bound on the actual rate. The calculation also ignores the fact that during the five-year period of the project the Lao PDR economy will be larger than it was in 2003 and its relative magnitude will thus be somewhat smaller in the relevant years, than the calculations above assume. 16

3.2 Operational Period - 2010-2020 43. Over the operating life of the project, expected to be 25 years, rather than the 10 years conservatively stated above, the Lao PDR government will receive a stream of royalty, tax and dividend payments from the project. This income stream is an injection into the Lao PDR economy, with macroeconomic effects analogous to those considered above. The amount of this income stream is equivalent to an annuity of roughly US$ 25 million per year. Following the calculations above, this will have a real appreciation effect which would add about 26 per cent to the rate of real appreciation that would otherwise have occurred. That is, it would result in an addition to the rate of real appreciation of 0.75 percentage points per year. Again this calculation ignores the fact that real GDP in Lao PDR will be considerably higher in the operational phase of the project than it was in 2003, so it too must be considered an upper bound on the likely true rate. 44. Caveats. Furthermore, the estimated relationship between the level of the current account deficit and the rate of real appreciation which is used in these calculations makes no allowance for the fact that some real appreciation can be expected as a consequence of the rate of growth that was also occurring. It is well known that economic growth increases the demand for non-tradables, raising their prices relative to those of tradables, whose prices are determined internationally. That is, increases in real incomes cause some real appreciation. In so far as the discussion above attributes all of the real appreciation that occurred between 2000 and 2003 to the level of the current account deficits that occurred during that period, ignoring the effect of the growth that was also occurring, it potentially overstates the effects that capital inflow have on the real exchange rate. Again, the resulting estimates must be considered an upper bound on the likely true rates. 17

Box 1 B.1 Beneficial effects of natural resource revenues - Indonesia Indonesia from the mid-1970s to the mid-1990s is an example of a country which derived large public sector revenues from natural resource extraction, in this case petroleum. A large real appreciation resulted (Warr 1986 and 2003). Using methods of measurement comparable with those used here, Warr (2003) demonstrates rates of real appreciation for Indonesia even more rapid than those estimated in this report for Lao PDR. In the Indonesian case, some of the revenue derived was clearly misappropriated. But enough of it was used for the benefit of rural people to produce substantial net gains to them. This occurred through investments in rural infrastructure, including roads and irrigation facilities, and improvements in educational and health facilities (Booth 1992). Poverty incidence in Indonesia declined markedly as a result, in both rural and urban areas, as Table B.1 shows. Table B.1 Indonesia: Poverty incidence and inequality, 1976 to 2002 (Units: per cent, except Gini coefficient) National Poverty (P) Rural Poverty (P R ) Urban Poverty (P U ) Gini Coefficient 1976 63.3 65.4 54.4 0.34 1978 53.6 54.0 43.2 0.38 1980 44.2 45.9 40.7 0.34 1984 33.9 34.3 32.4 0.33 1987 26.7 26.0 28.2 0.32 1990 23.3 23.1 23.6 0.32 1993 21.4 22.3 18.8 0.34 1996 17.7 19.9 13.6 0.36 1999 23.4 26.0 19.4 0.31 2002 18.2 21.1 14.5 0.33 Sources: Poverty estimates from Statistical Yearbook of Indonesia, various issues, Central Bureau of Statistics, Jakarta, based on household expenditure data collected in the SUSENAS survey; inequality estimates from Islam (2004). 18

4. Assessment of macroeconomic impacts of NT2 45. The NT2 project will undoubtedly contribute to incomes in Lao PDR. These gains will be achieved at the expense of some economic adjustment costs within Lao PDR. These are a result of increased spending within Lao PDR during both the construction and operational phases of the project. 46. Real appreciation during the period 2000 to 2003 occurred already, at the rate of about 2.8 per cent per year. It is estimated that during the construction phase of the project (2005 to 2009), spending within Lao PDR will add about 60 per cent of this amount, or about 1.7 per cent per year, to the rate of real appreciation that would otherwise have occurred. This effect will cease when the construction phase is completed, scheduled for 2009. During the operational phase, beginning in 2010, the spending of project income within Lao PDR will add around 0.75 per cent per year to the real appreciation that would otherwise have occurred. 47. The rates of real appreciation estimated above are considered upper bounds on the reasonable range of likely actual rates. These rates of real appreciation are moderate. They are manageable, but they are not zero. It must be recognized that these rates of real appreciation potentially imply problems for some Lao PDR people, including agricultural producers selling to the local or export market or aspiring to do so, and for some workers in the manufacturing sector. But this does not mean that poverty incidence will increase. During the decade 1992-93 to 2002-03 substantial real appreciation occurred in Lao PDR, but poverty incidence still declined significantly. These facts demonstrate that real appreciation does not in itself necessarily imply increased poverty incidence, provided other things are happening which benefit the poor, especially the rural poor. 48. The net effects that the absorption of the NT2 revenues will have on poverty incidence depend on the manner in which these revenues are spent within Lao PDR, as well as the policy changes that take place elsewhere in the economy during the same period. If the revenues are spent in a way that benefits rural people through investments in rural infrastructure as well as in health and education -- the net effect would be quite different from those resulting from misused revenues. Experience elsewhere suggests that the net effect of large revenues from natural resource extraction depends heavily on this matter. The issue is one of governance. Measures to ensure that the revenues from NT2 are spent well are crucial. 19

In addition, policy reforms that reduce costs of doing business, whether in agriculture or in manufacturing, as well as actions that make trade easier, are all likely to offset the disincentives that flow from the real appreciation. 20

References Athukorala, Prema-chandra and Peter Warr, 2002. 'Vulnerability to a Currency Crisis: Lessons from the Asian Experience', The World Economy, vol. 25 (1), (January), 23-57. Booth, Anne E. (ed.) 1992. The Oil Boom and After: Indonesian Economic Policy and Performance in the Soeharto Era, Oxford University Press, Singapore. Datt, Guarav and Limin Wang 2001. Poverty in Lao PDR: 1992/93 1997/98, World Bank, Washington DC, mimeo. Islam, Iyanatul, 2004. "Why Inequality Matters: A Contribution to the Indonesian Development Agenda", United Nations Support Facility for Indonesian Recovery", Discussion Paper Series No. 04/08, August. Kakwani Nanak, Guarav Datt, Bounthavy Sisouphanthong, Phonesaly Souksavath and Limin Wang 2002. Poverty in Lao PDR during the 1990s, Asian Development Bank, Manila, mimeo. Srinivasan, T.N. 1986. The Costs and Benefits of Being a Small, Remote, Island, Landlocked or Ministate Economy World Bank Research Observer 1 (2) July, 205-218. Warr, Peter, 1986. 'Indonesia's Other Dutch Disease: Economic Effects of the Petroleum Boom', in J.P. Neary and S. van Wijnbergen (eds.), Natural Resources and the Macroeconomy, Basil Blackwell, Oxford, 288-320. Warr, Peter, 2003. What Caused the Asian Crisis, in Dilip K. Das (ed.), An International Finance Reader, Routledge, London, 381-400. Warr, Peter, 2005. Boom, Bust and Beyond in Peter Warr (ed.), Thailand Beyond the Crisis, Routledge, London, 3-65. World Bank, 2002. East Asia Rebounds, But How Far? Washington, April. World Bank, 2004. Country Economic Memorandum, Realizing the Development Potential of Lao PDR, Washington DC, December. 21

Table 1 Lao PDR: Macroeconomic indicators, 1990-2003 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 (growth rates, percentage changes) Real GDP growth 6.6 4.0 7.0 6.5 8.1 7.1 6.8 6.5 4.0 5.2 5.7 5.7 5.5 Consumer prices 19.6 10.4 8.0 7.0 6.8 25.7 7.3 26.4 141.9 86.7 7.8 10.6 11.4 Growth in credit 11.2 15.7 23.6 51.7 50.0 34.8 20.8 79.2 86.6 74.3 74.0 72.1 73.2 Interest rate (1 year) 36.0 18.0 18.2 12.0 12.0 16.0 16.5 19.0 23.0 26.0 23.0 24.0 26.0 Export (value $US) 18.2 22.9 37.3 24.9 4.2 3.1-1.4 6.3 9.4-3.2-2.8 21.0 Import (value $US) -9.5 14.3 7.3 16.8 30.6 4.4 17.1-6.0 14.7 3.6-5.2 2.9 10.5 (per cent of GDP) Government revenue 9.9 10.3 10.7 12.0 12.3 12.2 13.0 11.3 11.2 11.3 12.9 13.4 11.9 Government expend. 23.4 20.9 20.6 18.2 23.8 21.9 22.1 20.6 32.5 22.3 20.3 18.2 21.6 Current 11.4 11.3 10.9 11.2 11.3 10.6 10.2 9.5 8.1 9.1 6.5 7.6 na Capital 12.0 9.6 9.7 7.0 10.4 11.1 11.9 11.8 18.8 12.6 9.4 13.0 na Overall fiscal balance With grants -10.7-6.8-5.2-4.4-5.2-4.2-5.6-6.5-15.5-4.5-3.2-4.7 na Without grants -14.4-11.3-9.9-7.8-11.5-9.7-9.1-10.0-21.3-10.9-4.9-7.7 na Current account With transfers -6.9-4.3-3.5-0.9-6.3-6.9-12.1-10.6-4.0-1.4-3.9-1.9-2.1 Without transfers -9.6-11.0-8.8-8.4-14.4-13.0-16.5-16.2-8.8-8.1-7.5-5.2-5.0 Debt service ratio 10.3 11.2 6.5 4.7 3.3 5.7 5.8 7.3 8.4 7.7 7.2 8.0 na Gross external reserves ($US millions) 64.8 57.2 85.5 150.9 61.0 93.0 167.0 136.0 110.0 109.0 107.0 116.8 na Source: National Statistical Centre, Vientiane; and National Economic Research Institute, Vientiane, NERI Economic Monitor, various issues. Note: na means not available. 22

Table 2 Lao PDR: Share of GDP by Industrial Origin at Constant Price, 1990-2002 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Agriculture 60.7 57.3 58.0 56.3 56.6 54.3 52.2 52.2 51.8 52.2 50.8 50.8 49.9 Crops 36.7 30.7 32.4 27.3 28.5 25.9 24.9 26.5 27.2 28.7 30.3 30.3 29.6 Livestock & Fishery 20.8 22.9 23.3 22.9 22.2 21.4 20.6 19.7 19.4 18.5 17.4 17.4 17.2 Forestry 3.2 3.8 2.3 6.1 5.9 7.0 6.7 6.0 5.2 4.9 3.2 3.2 3.1 Industry 14.4 16.6 16.7 17.4 17.8 18.8 20.6 20.8 21.9 22.0 23.5 23.5 24.5 Mining & Quarrying 0.1 0.1 0.1 0.2 0.2 0.2 0.3 0.4 0.4 0.5 0.5 0.5 0.5 Manufacturing 9.9 12.3 12.6 12.8 12.7 13.9 15.4 15.7 16.6 16.5 17.8 17.8 18.9 Construction 2.9 2.8 2.8 3.1 3.3 3.3 3.5 3.4 2.8 2.6 2.4 2.4 2.1 Electricity 1.4 1.4 1.1 1.3 1.6 1.3 1.4 1.3 2.1 2.3 2.9 2.9 2.9 Services 24.1 24.6 23.9 24.3 23.5 24.5 24.8 25.0 25.3 25.2 25.0 25.0 24.9 Transport & Communications 5.2 5.0 5.0 4.9 4.7 5.2 5.4 5.5 5.7 5.8 5.9 5.9 6.1 Wholesale & retail trade 6.8 7.2 7.2 8.1 8.1 8.3 8.6 8.9 9.4 9.4 9.6 9.6 9.7 Banking 1.1 1.0 1.0 1.1 1.1 1.4 1.3 1.3 1.3 1.3 0.8 0.8 0.4 Ownership of dwellings 4.0 4.4 3.4 3.5 3.5 3.4 3.4 3.2 3.2 3.0 2.9 2.9 2.8 Public administration 5.8 5.0 4.6 4.3 3.7 3.3 3.1 2.9 2.9 2.9 2.8 2.8 3.1 Nonprofit institution 0.9 1.5 1.7 1.5 0.9 1.2 1.2 1.1 0.8 0.7 0.6 0.6 0.6 Hotel & restaurants 0.2 0.4 0.8 0.8 1.2 1.5 1.7 1.7 1.8 1.9 2.1 2.1 2.0 Other services 0.1 0.1 0.2 0.2 0.1 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 Import duties 0.9 1.4 1.4 2.0 2.1 2.5 2.4 2.0 1.1 0.6 0.8 0.8 0.8 GDP at market price 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Data from National Statistical Centre, Vientiane 23

Table 3 Lao PDR: GDP growth rate by industrial origin at constant prices, 1990-2002 (per cent annum) 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Agriculture -1.7 8.3 2.7 8.3 3.1 2.8 7.0 3.1 8.2 4.4 4.3 4.0 Crops -13.0 13.1-11.0 12.7-2.5 2.9 14.0 6.4 13.5 8.9 8.2 3.5 Livestock & Fishery 14.4 9.0 4.2 4.3 3.7 2.8 2.4 2.5 2.3 2.4 2.4 4.6 Forestry 23.2-35.4 183.7 4.0 28.2 2.0-4.9-9.8 2.3-14.1-16.4 5.1 Industry 19.9 7.5 10.3 10.7 13.1 17.3 8.1 9.2 7.9 9.8 8.9 10.3 Mining & Quarrying -7.9 12.9 36.5 30.4 3.7 61.2 28.5 13.7 33.5 1.3 1.3 10.1 Manufacturing 29.7 9.4 7.7 7.0 17.7 18.1 9.3 9.6 7.1 10.1 9.2 13.0 Construction -1.0 7.4 16.1 17.2 6.8 12.3 5.0-14.1-1.2 1.7 1.6-6.5 Electricity -1.9-9.8 21.4 29.0-8.8 15.0-1.9 62.7 21.6 18.6 15.6 7.6 Services 6.5 3.9 7.7 3.9 12.0 8.5 7.5 5.5 6.9 5.4 5.1 5.7 Transport & Commun. 1.4 6.9 3.1 4.3 18.2 10.1 10.3 6.5 9.7 7.1 6.6 8.4 Wholesale & retail trade 10.0 7.0 18.5 7.9 9.3 11.2 10.8 9.8 7.2 7.1 6.7 7.5 Banking -10.6 11.4 13.2 8.2 42.0-2.7 9.0 2.0 3.0-13.8-16.0-46.3 Ownership of dwellings 14.6-16.2 8.0 8.6 3.4 6.2 2.5 2.5 2.5 2.5 2.5 2.5 Public administration -10.5-2.7-0.2-6.6-4.5 0.4 1.1 4.2 6.7 4.4 4.2 15.0 Nonprofit institution 76.8 20.8-9.8-31.7 37.6 7.9-1.2-20.3-10.0-0.2-0.2 4.2 Hotel & restaurants 151.8 125.3 14.8 53.6 35.0 21.3 9.6 8.0 15.0 10.9 9.8 2.7 Other services 80.7 51.8 3.5 3.0 19.4 11.8 3.2 2.0 12.4 16.8 14.4 2.7 Import duties 71.3 4.9 52.8 13.2 25.0 2.9-10.5-45.2-37.5 18.3 15.5 6.0 GDP at market price 4.0 7.0 5.9 7.7 7.5 6.9 6.9 4.0 7.3 5.9 5.6 5.9 Source: Data from National Statistical Centre, Vientiane 24

Table 4 Lao PDR: Agricultural planted area and yields 1990 1995 2000 % change 1990-2000 Planted area (thousand ha.) Rice 664 560 690 4 Season rice 392 367 500 27 Irrigated rice 11 14 110 900 Upland rice 260 179 80-69 Starchy roots 20 14 8-60 Maize 48 28 10-79 Vegetables and beans 8 9 40 406 Raw materials for manufacturing 58 58 72 24 Total 797 669 820 3 Yields (tons / ha.) Rice Season rice 2.77 2.92 3.27 18 Irrigated rice 3.55 3.71 4.23 19 Upland rice 1.46 1.65 1.63 11 Starchy roots 8.22 7.09 6.49-21 Maize 1.70 1.71 2.36 38 Vegetables and beans 7.68 6.48 6.38-17 Raw materials for manufacturing 3.41 2.10 3.45 1 Source: Data from Ministry of Agriculture and Forests and National Statistcal Centre, Vientiane. 25

Table 5 Lao PDR: Rates of change of real exchange rates and levels of current account deficits, 1988 to 2003 1988-1994 1995-1999 2000-2003 Relative price tradables / non-tradables -7.7 +0.8-2.8 (average change, per cent per year) Real exchange rate I -4.5 +10.1-0.4 (average change, per cent per year) Real exchange rate II -5.7 +7.2-0.5 (average change, per cent per year) Current account deficits 9.5 13.8 6.5 (annual average, per cent of GDP) Source: Author s calculations using data from National Statistical Center, Vientiane, and International Monetary Fund. Note: A negative change in the real exchange rate (e.g. the relative price variable from 1988 to 1994) means a decline in the ratio of traded goods prices to non-traded goods prices; a positive change (e.g. the same variable from 1995 to 1998) means an increase in this price ratio. 26