Report and Recommendation of the President to the Board of Directors

Report and Recommendation of the President to the Board of Directors Project Number: 44057 September 2011 Proposed Program Cluster, and Loan and Grant for Subprogram 1 Lao People s Democratic Republic: Second Private Sector and Small and Medium-Sized Enterprises Development Program

CURRENCY EQUIVALENTS (as of 24 August 2011) Currency Unit kip (KN) KN1.00 = $0.000124 $1.00 = KN8,001 ABBREVIATIONS ADB BDS Asian Development Bank business development service CIB CPS Credit Information Bureau country partnership strategy ERO enterprise registry office GDP gross domestic product Lao PDR Lao People s Democratic Republic MOIC Ministry of Industry and Commerce NSEDP7 Seventh National Socio-Economic Development Plan P3D PER RIA provincial public private dialogue Public Expenditure Review regulatory impact assessment SMEPDO Small and Medium-Sized Enterprise Promotion and Development Office SMEs small and medium-sized enterprises TA technical assistance WTO World Trade Organization NOTE In this report, $ refers to US dollars. Vice-President B.N. Lohani, Vice-President-in-Charge, Operations 2 Director General K. Senga, Southeast Asia Department (SERD) Director S. Hattori, Public Management, Financial Sector, and Trade Division, SERD Team leader Team members Peer reviewers S. Ismail, Financial Sector Specialist, SERD R. Anglingkusumo, Financial Sector Economist, SERD F. Barot, Operations Assistant, SERD K. Bird, Principal Economist, SERD P. Louangraj, Economics, Officer, Lao Resident Mission, SERD S. Zaidansyah, Counsel, Office of the General Counsel N. Khor, Economist, Economics and Research Department J. Laude, Private Sector Development Specialist, East Asia Department (EARD) Y. Qian, Lead Regional Cooperation Specialist, EARD In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS Page PROJECT AT A GLANCE I. THE PROPOSAL 1 II. THE PROGRAM 1 A. Rationale 1 B. Impact and Outcome 3 C. Outputs 4 D. Program Costs and Financing 7 E. Implementation Arrangements 8 III. DUE DILIGENCE 8 A. B. C. Governance Poverty and Social Safeguards 8 9 9 D. Risks and Mitigating Measures 9 IV. ASSURANCES 10 V. RECOMMENDATION 10 APPENDIXES 1. Design and Monitoring Framework 11 2. List of Linked Documents 14 3. Development Policy Letter 15 4. Policy Matrix 19

PROJECT AT A GLANCE 1. Project Name: Second Private Sector and SME Development Program, (Subprogram 1) 3. Country: Lao People's Democratic Republic 5. Sector Classification: 6. Thematic Classification: 2. Project Number: 44057-012 4. Department/Division: Southeast Asia Department / Public Management, Financial Sector, & Trade Division Sectors Primary Subsectors Public sector management Economic and public affairs Management Themes Primary Subthemes Economic growth Promoting economic efficiency and enabling business environment Private sector development Policy reforms Capacity development Institutional development Governance Economic and financial governance 6a. Climate Change Impact 6b. Gender Mainstreaming No Climate Change Indicator available. Gender equity theme (GEN) Effective gender mainstreaming (EGM) Some gende r benefits (SGB) No gender elements (NGE) 7. Targeting Classification: Targeted Intervention General Intervention Geographic dimensions of inclusive growth 9. Project Risk Categoriz ation: Low Millennium development goals Income poverty at household level 8. Location Impact: No Location Impact available. 10. Safeguards Categorization: Environment Involuntary resettlement Indigenous peoples C C C 11. ADB Financing: Sovereign/Nonsovereign Modality Source Amount ($ Million) Sovereign Program grant Asian Development 10.0 Fund Sovereign Program loan Asian Development 5.0 Fund Total 15.0 12. Cofinancing: 13. Counterpart Financing: 14. Aid Effectiveness: No Cofinancing available. No Counterpart Financing available. No Aid Effectiveness available.

I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on (i) a proposed program cluster for the Second Private Sector and Small and Medium-Sized Enterprises Development Program (PSME2); (ii) a proposed loan for subprogram 1; and (iii) a proposed grant for subprogram 1, all to the Lao People s Democratic Republic (Lao PDR). 1 2. The PSME2 supports the Government of the Lao PDR s strategy to develop the small and medium-sized enterprises (SMEs) sector and undertake domestic reforms with a view to promoting the SME sector as a way to achieve sustained and inclusive economic growth. The PSME2 is embedded in the Seventh National Socio-Economic Development Plan (NSEDP7) 2010 2015, which includes SME development as a key development objective. A. Rationale II. THE PROGRAM 3. The Lao PDR went through the 2009 global financial crisis relatively unscathed. The financial sector was quite insulated from the turbulence in the global financial markets because of its low level of development and limited exposure to international credit markets. The impact of the global financial crisis was on the real sector and fiscal position of the government. The slump in copper prices led to a fall in export revenues in 2009. This in turn led to a decline in resource revenues to the national budget. Despite this, gross domestic product ( GDP) growth held up well, at 7.3%, and inflation remained below the regional average. GDP growth was 7.5% in 2010, and is expected to increase to 7.7% in 2011 and 7.8% in 2012 reflecting stable growth. 2 In addition, based on the national poverty line, poverty incidence declined to an estimated 25.0% from 2003 to 2009 with poverty reduction accelerated after 2004 when per capita income surpassed $400 in 2004. 3 4. However, these relatively impressive figures do not tell the full story. Growth in the Lao PDR has been driven mainly by investments in the resource sector, making the Lao PDR vulnerable to volatile and unpredictable commodity price cycles. Spurred by higher global metal prices, mining production in the Lao PDR rose by 19.0% in 2010. Output of copper from the two main mines Phu Bia and Sepon rose by 21.0% to 147,500 tons, gold production rose by 7.0% to 173,000 ounces, and silver by 13.5% to about 500,000 ounces. 4 The export sector remains narrowly based, with the resource sector (copper, gold, electricity, and timber) accounting for 70% of total exports recorded through customs. Mining and hydropower exports reached over 60% of merchandise exports by 2008 and are projected to reach 80% by 2011. 5 Hence, GDP growth from the non-resource sector is estimated to be in the range of 5.3% 6.3%. 6 5. The resource boom is transforming the Lao PDR economy. The government anticipates significant future revenues to the budget from hydropower investments and mining in the form of taxes, royalties, and dividends. The revenue flows provide the Lao PDR, for the first time in its 1 The design and monitoring framework is in Appendix 1. 2 ADB. 2011. Asian Development Outlook 2011. Manila. International Monetary Fund (IMF). 2010. Lao People s Democratic Republic. Staff Report for the 2010 Article IV Consultation. Washington, DC stated that GDP growth rate for 2009 was 7.6%. 3 K. Bird and S. Ismail. 2010. Lao PDR ASR Trade and Industry Sector. Manila: ADB. 4 ADB. 2011. Asian Development Outlook 2011. Manila. 5 M. Brahmbhatt and E. Vostroknutova. 2010. LAO PDR Development Report 2010. Washington, DC. 6 IMF. 2011. Lao People's Democratic Republic: Staff Report and Public Information Notice. IMF Staff Country Report. No. 11/44. Washington, DC.

2 modern history, a tremendous opportunity for it to finance its development goals, raise per capita incomes, and reduce poverty. At the same time, international experience shows that, if a resource boom is not managed properly, it can lead to a decline in competitiveness in non- real exchange resource sectors such as manufacturing through excessive appreciation of the rate. The challenge for the Lao PDR, therefore, is to manage its resource boom in a way that sus tains economic growth in the non-resource sector, creates productive jobs, and continues poverty reduction. 6. There is some evidence that the resource boom is beginning to hurt the non-resource sector. An ADB study shows that the kip real exchange rate has appreciated by about 30% since 2006 much faster than regional currencies (footnote 3). Since wages are paid in kip, an excessively appreciated exchange rate would raise unit labor costs and may slow growth of the non-resource export sectors, which would affect the private sector including SMEs. 7 Thus, the challenge will be to continue reforms to create an enabling environment for SMEs to take advantage of the Lao PDR s increased international trade openness and integration, and adjust to the longer-term dynamic structural changes in the economy. The key to sustaining high eco nomic growth and poverty reduction should be based on three strategies: (i) diversify the sources of non-resource growth from its currently narrow base, (ii) undertake reforms to improve competitiveness at all levels of the supply chain, and (iii) harness trade policies that promote private sector growth and access to international trade. 7. The government recognizes the above and its development priorities are articulated in the NSEDP7. Targets include GDP growth of at least 8% annually and GDP per capita of at least $1,700 by 2015. To achieve these targets, the government recognizes that private sector growth and in particular SME which represents more than 95.0% of all enterprises will be crucial. 8 These development objectives and targets are embedded in the SME national strategy, 2006 2010 and the SME development plan, 2011 2015; therefore, the focus of the proposed PSME2. 8. ADB s country strategy and program (CSP, 2007 2011) is consistent with the NSEDP7 and the government s SME strategy and development plan. It has set expansion of formal private sector firms by 15% per annum as an outcome indicator. Since the majority of private sector firms are SMEs, broad based reforms to support SMEs will have a significant impact on the performance of the private sector. The latest country assistance program evaluation report for Lao PDR acknowledges the importance of private sector development as an important strategy. 9 The draft country partnership strategy (CPS) for 2012 2016 identifies the private sector development as a driver of change. 9. ADB has extensive experience in SME and private sector development in the Lao PDR. The first Private Sector and SME Development Program (PSME) was undertaken from 2006 to 2009. Under subprogram 1 of the PSME financed by ADB ($5 million Asian Development Fund grant), the government implemented a series of reform measures aimed at reducing the cost of doing business in the Lao PDR, including the enactment of the Law on Enterprise. 10 Subprogram 2 ($15 million Asian Development Fund grant) was approved in 2009 and focused 7 SMEs are enterprises with an annual average number of employees not exceeding 99 persons or total assets not exceeding KN 1,200,000,000 or an annual turnover not exceeding KN 1,000,000,000. 8 Lao PDR, Steering Committee on Economic Census. 2007. Report of Economic Census 2006, Volume 1. Vientiane. 9 ADB. 2010. Country Assistance Program Evaluation for the Lao People s Democratic Republic. Manila. 10 ADB. 2007. Report and Recommendation of the President to the Board of Directors: Proposed Asian Development Fund Grant and Technical Assistance Grant to the Lao People s Democratic Republic for the Private Sector and Small and Medium-Sized Enterprises Development Program Cluster (Subprogram 1). Manila.

3 on the establishment of enterprise registry offices, starting the process for regulatory reform, and advancing trade policy reforms. 11 Some tangible achievements include the establishment of the central enterprise registry office (ERO) and six piloted provincial EROs, and a reduction in the number of days to launch an enterprise from 167 days to 103 days. Subprogram 2 also included one of the first post-program partnership frameworks introduced by ADB in its policy- framework based lending programs. The accomplishments under the post-program partnership provided the basis for subprogram 1 of PSME2. Some of the lessons learned from the first PSME program include: (i) continuous policy dialogue and policy development are important for sustaining reforms, (ii) institutional development and engagement of stakeholders in the program are necessary for quality policy development, (iii) a policy-based program should be appropriately designed to reflect the capacity of the implementing agencies and policy reforms should be commensurate with the program loan or grant amount, and (iv) trade policy should include measures that increase the benefits to SMEs from trade. These lessons have been incorporated in the design of PSME2. 12 10. The proposed PSME2 is based on a program cluster approach, designed to chronologically sequence packaging of high-impact policy reforms, which allows for reforms to be phased in over an adequate period of time in a coherent yet flexible framework. The program cluster will comprise two subprograms enveloped by a medium-term results framework. Given the resource boom and its effect on the non-resource sector, it is critical to promote reforms to raise productivity in this sector, which is dominated by SMEs; hence, a program that focuses on the promotion and development of the private sector and SMEs. Based on numerous surveys and reports produced in the first PSME program, PSME2 has identified three areas critical for sustainable development of SMEs which build on the gains and continues the reforms undertaken by the government in the first PSME program: (i) SME policy development, coordination, and access to services; (ii) regulatory efficiency; and (iii) trade policy for SME development. The design of the cluster supports both the supply and demand sides of private sector development and SME growth. On the supply side, the program is addressing inefficient regulations that hinder SME growth and competitiveness. On the demand side, it focuses on improving SME access to services, including finance, and promoting trade policies to benefit SMEs in line with ADB s engagement in Aid for Trade. The design of subprogram 1 will focus on broad-based reforms to improve the business environment for the private sector and SMEs to operate effectively and efficiently, while reforms in subprogram 2 will focus on how SMEs can maximize benefit in sectors with the highest potential for SME development. The entire cluster will be in line with the focus of ADB s Strategy 2020 13 on gender empowerment and gender mainstreaming guidelines. The program cluster will be classified as effective gender mainstreaming by including gender responsive measures and activities in the policy matrix and utilizing gender-related indicators in the design and monitoring framework. B. Impact and Outcome 11. The impact of the program will be to achieve expansion of the formal SME sector. The benchmark will be expanding the number of registered SMEs by 100% based on the baseline number at the end of 2009. The outcome of the program will be to improve the business environment for SMEs. This will be measured by the percentage of newly registered enterprises 11 ADB. 2009. Report and Recommendation of the President to the Board of Directors: Proposed Asian Development Fund Grant for Subprogram 2 to the Lao People s Democratic Republic for the Private Sector and Small and Medium-Sized Enterprises Development Program. Manila. 12 ADB. 2011. Program Completion Report of PSME. Manila for details on lessons learned and accomplishments. 13 ADB. 2008. Strategy 2020: The Long-Term Strategic Framework of the Asian Development Bank, 2008 2020. Manila.

4 reporting that operating licenses to start a business were obtained in less than 15 days; the program will target to increase the percentage by 5% by 2013. The program will also aim to increase the percentage of registered SMEs owned by women to 48%. C. Outputs 12. Subprogram 1 of PSME2 supports the government s efforts in developing the private sector and SMEs through (i) implementation of SME policy, including improving SMEs access to services; (ii) improving regulatory efficiency; and (iii) strengthening trade policy that supports the development of SMEs. The government began undertaking these reforms in November 14 2009 and all 16 policy measures (including eight policy triggers) required for subprogram 1 were completed prior to circulation of the Report and Recommendation of the President to ADB s Board of Directors. 1. Output 1: Implementation of Small and Medium-Sized Enterprises Policy, including Improving Small and Medium-Sized Enterprises Access to Services 13. Subprogram 1 of PSME2 supports the government in implementing SME policy based on the government s SME national strategy and SME development plan. Key reform areas include coordination of participatory SME policy development and improving SMEs access to business services and finance. The following measures were completed before Board consideration of subprogram 1. 14. Coordination of participatory SME policy development. Formulation of SME policy across line ministries is critical to ensure there is a consistent approach to SME policy development and ownership among different constituents. Good practice policy development requires (i) a results-based strategic framework with time-bound interventions, (ii) funding of the strategy through the national budget process to ensure country ownership and sustainability, and (iii) an established monitoring and evaluation mechanism. The government s first national SME development strategy, 2006 2010 was completed in 2010. A final report on the implementation of the strategy was produced in December 2010, reported that 84% of the strategy s activities were implemented and completed; of these, 61% had fully or partially achieved expected results and impacts. 15 15. Subsequently, the government initiated the drafting of the national SME development plan for 2011 2015. This plan is an improvement on the previous strategy in several ways. First, it is fully aligned with NSEDP7. Second, for the first time it includes activities to promote empowerment of female entrepreneurs. Third, selected activities under the plan will be funded through the national budget and the National Assembly approved allocation of $4 million for this purpose under subprogram 1. 16 This proves government ownership and promotes sustainability of funding. Fourth, the new development plan includes a monitoring and evaluation framework. In developing its SME development plan, it is important for the government to receive feedback from the private sector, including at the provincial level. Under subprogram 1, the government institutionalized provincial public private dialogue forums in Champasak; they were partially institutionalized in Luang Prabang, Luang Namtha, Savanaket and Houaphan, and initiated in Xiengkhouang. Key issues that have been discussed and resolved include local taxes, levies, and land use rights. 14 Triggers are prior actions that are to be completed before submission to the Board. 15 Small and Medium Enterprise Promotion and Development Office. 2010. Monitoring Report Lao PDR SME Development Strategy 2006 2010. Vientiane. 16 This is in line with the recent review of ADB s policy based lending and international best practices.

5 16. Improve small and medium-sized enterprises access to business services and finance. SMEs access to services is, in most cases, predicated on formal registration. Under the previous program, the new enterprise registration system was implemented with six pilot provinces completed. The new system simplified registration and cut its business compliance costs by 35%. Under the PSME2, a key reform undertaken by the government is the national rollout of a fully operational web-based enterprise registry system to the remaining 10 provincial enterprise registry offices (EROs) in June 2011. This allows SMEs to register and obtain the enterprise registry certificate at the provincial level. The registration information is then sent to the central ERO in Vientiane over the internet real time. For the national rollout, the government with ADB support through technical assistance has upgraded both hardware and software and has carried out training on implementing registration procedures. The national rollout has substantially improved SME access to registration. By May 2011, almost 70,000 enterprises had registered compared to about 35,000 in late 2008. This registration system has had a major positive impact on women entrepreneurs, as the gender bias in a high-cost system has been reduced through the simplification of registration procedures and the reduction in business compliance costs. Of newly registered enterprises in 2010, 54.8% are owned by women, up from 43.9% of newly registered enterprises in 2009. The government also increased the transparency of the system by publishing its first book on enterprise registration, which included disaggregated data by gender, region, and size. 17. One of the constraints identified in the SME national strategy has been SMEs access to finance. The GTZ Enterprise Survey of 2009 17 found that only 32% of enterprises surveyed reported had borrowed from a financial institution in 2009. SMEs face legal and capacity constraints in accessing credit. Banks primarily rely on the use of fixed assets as collateral to secure loans. Another critical constraint is limited credit information on customers that allow banks to assess credit risk. Two reforms under subprogram 1 were undertaken to address these constraints. First, the Credit Information Bureau (CIB) of The Bank of the Lao PDR completed the development of its new web-based credit information system, which was officially launched in December 2010. Credit information is uploaded into the CIB database and made available to commercial banks. With creditors information more readily available, banks will be more willing to provide financing to SMEs. The second reform relates to the government s approval of the Implementing Decree on the Secured Transactions Law. The decree will provide the basis for establishing the secured transaction registry, which will allow SMEs to obtain financing by using movable assets such as vehicles as collateral. The government is also concerned about the limited access of SMEs to business development services (BDSs). According to the GTZ enterprise survey, only 5% of BDS providers used by enterprises were commercial BDSs, 12% were publicly provided BDSs, and the remaining 80% plus were informal service providers (spouse, friend). The government recognizes that measures are necessary to develop the private sector BDS market. It took concrete steps to facilitate SMEs access to services and develop the private sector market for BDSs by making preparations to pilot test the network of SME service providers. Steps taken include establishing the Small and Medium Enterprise Promotion and Development Office (SMEPDO) BDSs unit and assigning staff to the unit. In the initial stage, the network, which consists of members from the private sector, will focus on helping and training SMEs on loan applications; their role will expand in the future. This marks a shift from the conventional view in the Lao PDR where the government provides BDSs to SMEs. 17 Lao-German Programme on Human Resources Development for a Market Economy. 2010. Enterprise Survey 2009, Summary Report. Vientiane.

6 2. Output 2: Promoting Regulatory Efficiency 18. Subprogram 1 of the PSME2 supports the government in addressing the high cost of regulation through institutionalizing a regulatory impact assessment (RIA) in the government and reforms to the investment climate. ADB s Options for a Regulatory Review Program and Office of Best Regulatory Practice 18 (red tape study) estimates that firms on average incur $483 annually to comply with the three most common licenses: (i) the enterprise registration certificate, (ii) the sector operational license, and (iii) the tax certificate. Overall, it costs the business community (those complying) $36 million to comply with the three licenses. Depending on the sector, firms will require additional licenses A realistic estimate of the business compliance costs was between 1.5% and 3.0% of GDP in 2008. 19. The government s commitment to the RIA process is reflected in the accomplishment of two important measures under subprogram 1. First, the RIA interagency taskforce headed by the vice minister of industry and commerce that was established by the government in 2009, developed a draft action plan to implement RIA in selected line ministries. The action plan included advocacy and communication activities and capacity development activities. Second, the government established a RIA unit at the Ministry of Industry and Commerce (MOIC), within the legal division under the Permanent Secretary Office. The unit produced a set of RIA guidelines and the MOIC RIA work plan of proposed legislation that will go through the RIA process in the next 12 months, which have been endorsed by the vice minister of Industry and Commerce and the deputy permanent secretary. The government also approved the Prime Minister s Decree on Implementing the Investment Promotion Law in 2011. This decree harmonized the enterprise registration system at ERO with the Investment Promotion Law, 2009 and the law on special economic zones, so an investment license is no longer necessary for general businesses. Enterprises can begin operating as soon as they obtain the enterprise registration certificate from ERO. This reduced red tape and cut the number of days taken to start a business. The decree also provides the basis for the establishment of a one-stop service center that acts as the focal point for enterprises to obtain information and submit applications. 3. Output 3: Strengthening Trade Policies to Support Small and Enterprises Growth Medium-Sized 20. Subprogram 1 of PSME2 supports the government in strengthening trade policies to support SME growth. A joint publication of ADB and the ADB Institute on enterprise utilization of preferences under the ASEAN Free Trade Area and other preferential trade agreements found 19 that SMEs utilization rates were low compared to larger firms. Two factors identified in the study included a cumbersome application process for obtaining certificates of rules of origin, and SMEs lack of critical information on ways to benefit from preferential trade agreements. Output 3 is the first step in reorienting ADB s support from general trade measures to trade policies, which focuses on SMEs development and growth. Two key areas of reform under this output are (i) implementing measures to enhance SME growth from trade, and (ii) enhancing transparency in trade policy. The following measures were completed before Board consideration of subprogram 1. 21. Implementing measures to enhance SME growth from trade. The government s preparations for World Trade Organization (WTO) accession have provided momentum for reforming the import and export management system consistent with WTO rules. Under subprogram 1, the Government s Office approved two important decrees aimed at reducing 18 ADB. 2009. Options for a Regulatory Review Program and Office of Best Regulatory Practice. Manila. 19 M. Kawai and G. Wignaraja. 2011. Asia s Free Trade Agreements. Cheltenham, UK: ADB.

7 trade facilitation costs: (i) the Decree on Import and Export of Goods, which clarified trading rights of importers and distributors; and (ii) the Decree on Rules of Origin, which implemented a transparent process for obtaining rules of origin certificates. Another important measure undertaken by the government to assist enterprises is related to geographical indication, which is a process to protect trademarks based on regional origins. The government considers geographical indication as an important initiative to support value-added creation in its niche markets, thereby benefiting SMEs. Under subprogram 1, and with ADB technical assistance, 20 the Ministry of Science and Technology developed a strategy and action plan for implementing geographical indication. The government has identified two products for possible local registration: Bolaven Coffee and Small Chicken Sticky Rice. 22. Enhance transparency in trade policy. Under subprogram 1, the government undertook several reform measures to enhance transparency in trade policy. First, the Prime Minister s Decree on the Notification and Enquiry of Trade Related Information was approved in August 2010. This decree established the notification framework and delineated the roles and functions of relevant ministries. MOIC was tasked to establish the Sanitary and Phytosanitary and Technical Barriers to Trade Notification Unit and the minister of MOIC issued a decision to establish the unit. Second, to address SMEs low utilization of trade preference agreements, the government disseminated information to SMEs on how they could benefit from WTO accession, regional trade agreements, and bilateral trade agreements through workshops and the MOIC website launched in 2011. 23. Triggers for subprogram 2 and medium-term framework. The PSME2 has specified eight triggers that need to be satisfactorily accomplished by mid-2013. The triggers advance accomplishments under subprogram 1 (Appendix 2). These include endorsement of the national SME development plan, including gender mainstreaming activities; launching the network of SME expert service providers; endorsement and implementation of the national RIA action plan and MOIC RIA work plan; implementation of the geographical indication action plan and local registration of products; and SMEPDO s collaboration with departments at MOIC to coordinate web-based information systems to assist SMEs to obtain trade-related information. 24. Medium-term framework. The PSME2 is enveloped by a medium-term framework drawn from the NSEDP7 and sector strategies. The framework is results-based with specified medium-term accomplishments and expected results. D. Program Costs and Financing 25. To support reform initiatives, the government requested a loan of $5 million equivalent and a grant not exceeding $10 million from ADB s Special Funds resources to help finance subprogram 1 of PSME2. The $5 million loan equivalent will have a 24-year term, including a grace period of 8 years, an interest rate of 1.0% per annum during the grace period and 1.5% per annum thereafter, and such other terms and conditions set forth in the draft financing agreement. The program loan and grant will be disbursed in accordance with the financing agreement and the provisions of ADB s Simplification of Disbursement Procedures and Related Requirements for Program Loans. 21 Subprogram 1 of PSME2 will provide for retroactive financing for eligible expenditures incurred up to 180 days prior to loan and grant effectiveness. ADB will retain the right to audit the use of the loan and grant proceeds and to verify the accuracy of the withdrawal application certification. 20 ADB. 2010. Technical Assistance to Lao People s Democratic Republic Support for Post-Private Sector and Small and Medium-Sized Enterprises Development Program Partnership Framework. Manila. (Project Number 44114). 21 ADB. 1998. Simplification of Disbursement Procedures and Related Requirements for Program Loans. Manila.

8 26. The size of the loan and grant is based on consideration of a number of factors required to support implementation of program reforms. The main considerations include (i) the relative importance of the sector to the economy and the weight and benefits of the reform program, (ii) the policy adjustment costs incurred by the government and stakeholders in implementing and complying with reforms, and (iii) the need to conform to the overall financing requirement from the CSP 2007 2011. ADB estimates that the direct benefits of the reform program over the program period (2009 2013) will be about 1.1% of GDP or a discounted present value lump sum of $64.9 million (in 2011 prices). These economic benefits include the gains to the economy from a reduction in business costs of compliance with licensing, efficiency gains in enterprise registration from the rollout of the registration system, improved access to finance, and potential value added in selected agriculture products from geographical indication registration. The policy adjustment costs to the government and private sector are conservatively estimated at a discounted present value lump sum of $21.4 million. These adjustment costs include the administrative, investment, and budgetary costs to the government in implementing the reforms, including activities under the SME development plan. Overall, the program s benefit cost ratio is about 3.0. 22 27. The reforms to the business licensing system will have distributive effects in favor of women entrepreneurs. The main channel will be through lower business compliance costs that will encourage more women entrepreneurs to register formally and, thereby, improve access to finance and business development services. Evidence of this gender impact is reflected in the share of newly registered enterprises owned by women in the first year of the program period of 2010 over 2009 and 2008. This has increased from about 40% of new registrations in 2008 to 43.9% of new registrations in 2009 and 54.8% of new registrations in 2010. Overall, womenowned enterprises account for about 46.0% of the total 70,000 registered firms in 2011. E. Implementation Arrangements 28. The executing agency for the program will be MOIC. MOIC will be responsible for overall implementation of the program cluster. A steering committee chaired by the minister of MOIC has been established. The role of the steering committee is to provide guidance and direction on the government s national SME agenda. Implementation is the task of the program coordination team, which is chaired by the director general of the SME Promotion Development Office (SMEPDO), and includes representatives from the Foreign Trade Policy Department and Domestic Affairs at MOIC, the Ministry of Planning and Investment, the Ministry of Justice, the Government s Office, and the RIA interministerial taskforce, which are implementing agencies for the program. The Ministry of Finance will be responsible for disbursement. The implementation period for subprogram 1 is from November 2009 to October 2011 and the loan and grant closing date is 30 April 2012. The implementation period for subprogram 2 will be from November 2011 to September 2013. The indicative financing amount for subprogram 2 is a $12 million loan equivalent from ADB s Special Funds resources. A. Governance III. DUE DILIGENCE 29. An assessment of the country s financial management systems has been carried out to better understand fiduciary risks and determine appropriate fiduciary arrangements for the program. This assessment was based on the Lao PDR s Public Expenditure Review (PER) and Integrated Fiduciary Assessment Report led by the World Bank, in which ADB, the International 22 Summary Program Cluster Impact Assessment (accessible from the list of linked documents in Appendix 2).

9 Monetary Fund, and the European Commission participated in. 23 The PER determined that the fiduciary risk in the use and management of public funds is high. The main reasons identified are weaknesses in the budget processes and budget execution, accounting and control, and reporting. Weak internal and external auditing institutional arrangements and capacity and insufficient legislative oversight of budget execution contribute to high fiduciary risk. The PER acknowledges that, since 2002, the government has taken significant actions to address these weaknesses through its Public Expenditure Management Strengthening Program, and implement the last PER recommendations including implementing a unified budget nomenclature and chart of accounts throughout the government, progressively implementing a computerized government financial information system, and creating a procurement monitoring office. ADB, the World Bank, and other development partners are working with the government to implement improved public sector financial management systems. ADB has been supporting the Ministry of Finance with fiscal planning and budget preparation. A public financial management project is included in the pipeline of the CPS (2012 2016). ADB s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the government. B. Poverty and Social 30. Reforms under the PSME2 are expected to lower the incidence of poverty. PSME2 will contribute to a sustainable reduction in poverty through three channels. The first channel is through higher, broad-based, and sustainable economic growth. Reducing business compliance costs and lowering trade facilitation costs will increase the number of SMEs, thereby supporting inclusive economic growth. Measures to increase the benefits to SMEs from greater trade openness will enhance the income of entrepreneurs and workers in these sectors. The second channel is through the labor market, with increased real wages and hiring activity from higher investment by SMEs. The third channel is through lower prices of goods and services. By improving transparency in trade policy, supporting integration within the region and the rest of the world through trade policy and regulatory reforms, domestic prices will fall through greater economic efficiency. PSME2 will have a positive impact on achieving the goal of gender equality through effective gender mainstreaming in the SME development plan (2011 2015), the proposed SME Law under subprogram 2, and the regulatory review process. C. Safeguards 31. PSME2 does not trigger the safeguard policies and is category C for the environment, involuntary resettlement, and indigenous peoples. The following are agreed, and has been incorporated into the financing agreement. Consistent with its commitment to good governance, accountability, and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to the program. The government agreed to cooperate, and shall cause any and all government offices, organizations, and entities involved in implementing the program to cooperate fully with any such investigation and to extend all necessary assistance, including providing access to all relevant books and records, as necessary, for the satisfactory completion of such investigation. D. Risks and Mitigating Measures 32. Assumptions underlying PSME2 include the following: (i) macroeconomic stability is maintained; and (ii) the government stays on course to implement key regulatory and traderelated reforms (outcome level). However, there are four main risks to PSME2 that are low and expected to be outweighed by the benefits of the Program (Table). 23 Lao PDR. 2007. Public Expenditure Review, Integrated Fiduciary Assessment. Vientiane.

10 Risks Weak interagency coordination Capacity of agencies to implement reforms may be constrained by resources and other priorities Legislative process may be slow and overshoot time line, and trade reforms may be opposed by vested interests A further slow down in the economic growth rates of the advanced economies may impact on lower commodity prices with feedbacks to the Lao PDR national government budget. Source: Asian Development Bank. Summary of Risks and Mitigating Measures Mitigating Measures The Ministry of Industry and Commerce has established a program coordination team which includes all implementing agencies. A steering committee chaired by the minister has been established. The program reduces risk by focusing on policy triggers that constitute high priority, high-impact policy reforms supported by substantial capacity development assistance in the core areas of the program. The program focuses on efforts to support the government s own initiatives and reforms in areas where there is strong political will and commitment. Where needed, support is provided through technical assistance resources. Engagement with key officers in the National Assembly is done continuously. The Government recognizes these risks and has undertaken measures to raise revenue and strengthen public expenditure management, with the assistance of development partners including ADB. IV. ASSURANCES 33. The government has assured ADB that implementation of subprogram 1 of the PSME2 shall conform to all applicable ADB policies including those concerning anticorruption measures, safeguards, gender, procurement, consulting services, and disbursement as described in detail in the financing agreement. V. RECOMMENDATION 34. I am satisfied that the proposed program cluster, and loan and grant would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve (i) the program cluster to the Lao People s Democratic Republic for the Second Private Sector and Small and Medium-Sized Enterprises Development Program; (ii) the loan of SDR3,122,000 equivalent to the Lao People s Democratic Republic for subprogram 1 of the Second Private Sector and Small and Medium-Sized Enterprises Development Program, from ADB s Special Funds resources, with an interest charge at the rate of 1.0% per annum during the grace period and 1.5% per annum thereafter; for a term of 24 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft financing agreement presented to the Board; and (iii) the grant not exceeding $10,000,000 to the Lao People s Democratic Republic, from ADB s Special Funds resources, for subprogram 1 of the Second Private Sector and Small and Medium-Sized Enterprises Development Program, on terms and conditions that are substantially in accordance with those set forth in the draft financing agreement presented to the Board. 8 September 2011 Haruhiko Kuroda President

Appendix 1 11 DESIGN AN D MONITORING FRAMEWORK Design Summary Impact Expansion of the formal SME sector Outcome Performance Targets and Indicator s with Data Sources and Baselines Reporting Mechanisms By end of 2015 Number of SMEs registered in the enterprise registry system increased by 100% (2009 baseline: 45,000 registered enterprises) By end of 2013 Improved business (i) Number of newly environment for SMEs registered enterprises reporting that operating licenses to start a business were obtained under 15 days, increased by 5% per year Outputs 1. SME policy implemented, including improvement in SMEs access to services (2009 baseline: 55%) (ii) Percentage of registered SMEs owned by women increased to 48% of total registered enterprises (2009 baseline: 43%) By end of 2013 (i) At least 90% of measures in the SME development plan implemented by 2015, with at least 80% of activities fully or partially achieving expected results and impacts, including measures and activities related to empowerment of women entrepreneurs (2009 baseline: Nil) a Statistics from ERO GIZ enterprise survey Statistics from ERO ADB TA, review missions, and GIZ monitoring unit report Assumptions and Risks Assumption Macroeconomic stability maintained Risks A further slow down in the economic growth rates of advanced economies may result in lower commodity prices, at last in the short term, with feedbacks to lower resource revenues in the Lao PDR national government budget. Assumption The government stays on course to implement key regulatory and trade- related reforms. Risk Legislative process to improve business environment may be slow and overshoot time line Assumption The CIB is managed efficiently so that there is free flow of information between the CIB and commercial banks. Risk The capacity of agencies to implement reforms may be constrained by resources and other emerging priorities.

12 Appendix 1 Design Summary Performance Targets and Indicator s with Baselines (ii) The government institutionalizes P3D in six provinces (2009 baseline: P3D institutionalized in one province) Data Sources and Reporting Mechanisms ADB TA, review missions, and GIZ monitoring unit report Assumptions and Risks Weak interagency coordination may result in implementation delays. (iii) 350 bank enquiries made to CIB per day CIB report (2009 baseline: Nil) a (iv) Number of banks using CIB credit report for loan approvals is 100% CIB report (2009 baseline: Nil) a (v) 500 SMEs use services provided by expert network of SME service providers SMEPDO report and GIZ SME monitoring unit report (2009 baseline: Nil) a 2. Regulatory efficiency improved By end of 2013 (i) The cost of business compliance with regulations (the three most common requirements) reduced by 15% ADB TA and review missions Assumption Momentum on RIA is sustainable through expansion of pilot program (2009 baseline: $483 per firm annually) (ii) 35% of consultations on measures related to RIA are with women stakeholder groups RIA reports of RIA interministerial task force (2009 baseline: Nil) a (iii) 20 preliminary impact assessment completed and published by three line ministries Reports by line ministries undertaking RIA (2009 baseline: Nil) a 3. Trade policy supporting SMEs development strengthened By end of 2013 (i) Two products locally registered for geographical indication Geographical indication report published by the Intellectual Property Division of Ministry of Assumption The government remains committed to reforms as part of the World Trade

Appendix 1 13 Design Summary Performance Targets and Indicator s with Baselines (2009 baseline: Nil) a (ii) Number of days needed for import and export reduced b y 20% Data Sources and Reporting Mechanisms Science and Technology International Finance Corporation Doing Business Report 2011 Assumptions and Risks Organization accession process while focusing on trade reforms that help develop SMEs. (2009 baseline: 50 days) (iii) 500 SMEs consulted annually for negotiation of trade agreements and formulation of trade policies, 50% of which are SMEs owned by women (2009 baseline: Nil) a Foreign Trade Policy Department reports Risk The legislative process may be slow and overshoot the time line, and trade reforms may be opposed by vested interests. (iv) 30 sanitary and phytosanitary and technical barriers to trade notifications made Foreign Trade Policy Department reports (2009 baseline: Nil) Activities with Milestones 1.1 Publish seven policy areas for SME development plan, 2011 2015 1.2 Set up expert network for SME service providers to provide training and services to SMEs, including for loan application 1. 3 Launch credit information bureau with circulars from the Bank of the Lao PDR 2.1 Activate RIA interagency taskforce and develop draft action plan to implement RIA in selected line ministries 2.2 Carry out public awareness programs about RIA, including workshops and ministerial circular to establish an RIA unit in the Ministry of Industry and Commerce 2.3 Review and consolidate investment incentives 3.1 Approve decree on the application of rules of origin 3.2 Prepare framework to protect Lao PDR s geographical indication a Inputs ADB subprogram 1: Loan ADB: $5 million Item Amount ($ million) ADF 5 Grant: $10 million Item Amount ($ million) ADF 10 ADB = Asian Development Bank, ADF = Asian Development Fund, CIB = Credit Information Bureau, ERO = enterprise registry office, Lao PDR = Lao People s Democratic Republic, P3D = provincial public private dialogue, RIA = regulatory impact assessment, SMEs = small and medium-sized enterprises, SMEPDO = Small and Medium-Sized Enterprise Promotion and Development Office, TA = technical assistance. a Nil baseline refers to actions that are being implemented for the first time, so there are no prior figures to be reflected as baseline. Achievements in subprogram 1 may be used as baseline for subprogram 2. Source: Asian Development Bank.

14 Appendix 2 LIST OF LINKED DOCUMENTS http://www.adb.org/documents/rrps/?id=44057-012-2 1. Financing Agreement 2. Sector Assessment (Summary): Trade and Industry (SME) Sector 3. Contribution to the ADB Results Framework 4. Development Coordination 5. Country Economic Indicators 6. International Monetary Fund Assessment Letter 7. Summary Poverty Reduction and Social Strategy 8. Risk Assessment and Risk Management Plan 9. List of Ineligible Items Supplementary Documents 10. Supplementary Document: Program Impact Assessment 11. Supplementary Document: Macroeconomic Developments 12. Supplementary Document: Knowledge Audit and Source

Appendix 3 15

16 Appendix 3

Appendix 3 17

18 Appendix 3

Draft Policy Matrix for Private Sector and SME Development Second Generation Program Triggers (in bold) and Policy Milestones Policy Actions Subprogram 1 Accomplishments (2009 2011) Triggers in bold 1. Implementation of SME Policy and Access to Services 1.1 1) The Government through the Ministry of Planning Coordination and Investment (MPI) has (i) institutionalized the of Provincial Public-Private Dialogue Forum ( P3D) in participatory the province of Champasak; (ii) partially SME policy institutionalized P3D in four other pilot provinces development (Luang Prabang, Luang Namtha, Savanaket and Houaphan), and (iii) initiated the institutionalization of P3D in the province of Xiengkhouang. 23 investment climate issues, primarily dealing with local taxes, levies and land usage rights were discussed and 14 resolved at the P3D. Subprogram 2 (2011 2013) Triggers in bold 1) Government (MPI) continues to institutionalize P3D in other provinces Medium Term Direction and expected results (2013 2015) 2) The Government through the Small and Medium- Office, has completed implementation of the national SME Development Strategy (2006-2010).The national strategy monitoring unit reported that 84% of initiatives included in the strategy had sized Enterprise Promotion and Development either been fully or at least partially completed and 61% of expected results had been (at least partially) achieved. 3) The Government through SMEPDO has initiated the drafting of the national SME Development Plan (2011-2015) by publishing on its website the 7 areas of intervention under the 2) Government endorses the National SME Development Plan ( 2011-2015) and makes substantial progress on implementation. Key fe atures of the Plan include: (i) Gender responsive activities specified for promoting female entrepreneurs, and ( ii) Regulatory Impact Assessment (RIA) action plan incorporated in the Plan. 3) SME monitoring unit continues to publish quarterly progress reports on implementation of the SME development plan (2011-2015). 1) SME Development Plan at least 90% implemented by 2015 with at least 80% activities (at least partially) achieved 2) SME law enacted by the National Assembly and begin implementation Appendix 4 19