Laos - IMF/World Bank Update (April/May 2023)

RECENT DEVELOPMENTS

Growth in Laos has been slowing since 2013, reflecting limitations in its resource-driven economic model, and structural imbalances, which were aggravated by COVID.  Since the pandemic, growth has lagged that of its neighbours, as concerns over public debt sustainability, low FX reserves and tight liquidity limited access to markets.

IMF: Real GDP Growth with Sectoral Compositions (% YoY)

Export values increased substantially in 2021, on the back of a temporary rise in gold and paper goods exports, but these subsided in 2022, even as imports of rose, as a result of high energy prices and higher income repayment pressures.

IMF: Current Account Balance (% GDP)

The current account deficit therefore exceeded net financial flows in both 2021 and 2022, wiping out a large part of 2020’s reserve accumulation arising from a FX swap inflow from People’s Bank of China (PBoC).  Only one third of export earnings receipts have been entering the domestic banking sector, depriving the economy of foreign exchange.

IMF: Balance of Payments (% GDP)

Public and public-guaranteed debt (PPG) rose by 16% of GDP in 2021 and by 36% GDP in 2022, largely driven by currency depreciation, additional government arrears, domestic bond issuance to recapitalise banks, and SOE debts.

IMF: Public and Public-Guaranteed Debt Dynamics & Contributions (% GDP)

In 2022, the effect of the increase in global commodity prices on the terms of trade accelerated exchange rate pressures and fuelled a significant increase in inflation.  The Lao kip depreciated by around 50% against the dollar and by over 40% against the baht, the parallel exchange rate premium reaching a peak of 30% in the middle of the year, before dropping away by year end.

World Bank: Kip / US Dollar Exchange Rates

Since the beginning of 2021, the Real Effective Exchange Rate has decoupled from other countries in the region.

IMF: Real Effective Exchange Rate (Index, 2008=100)

Higher import prices, especially for fuel and fertilisers, caused inflation to surge to 41% YoY by February 2023.  According to the World Bank, inflation was 40% YoY in April 2023, with food inflation at 52% YoY.

IMF: Inflation and Main Contributors (%, YoY)

The Bank of Laos (BoL) has tightened monetary conditions.  Its extension of credit to banks and the government has been largely offset by the issuance of BoL bonds since June 2022.  BoL has increased its policy rate from 3%, at the start of 2022, to 7.5% in February 2023, and has increased reserve requirements from 5% to 5.5% (for kip) and from 5% to 8% (for FX).  The BoL has also tightened exchange controls and strengthened FX repatriation and surrendering requirements (although these are not currently enforced).

IMF: Contribution to Growth of BoL Net Domestic Assets (%, YoY)

The IMF estimates real GDP growth of 2.3% in 2022 (World Bank 2.7%), reflecting a boost in tourism after border reopening in May and the opening of the Laos-China railway, which, together with the commencement of operations at the Thanaleng Dry Port, will have facilitated trade flows.

Despite the improvement in tourism arrivals since May 2022, there is still substantial room for recovery.

IMF: Historical Arrival of International Visitors 

The World Bank reports that two-thirds of workers have experienced a decline in real incomes since the pandemic, as nominal incomes have either stagnated (41%), or declined (24%).  Inflation has been highest in essential goods, resulting in cuts to food consumption, education, and health care.   Real interest rates are significantly negative, creating disincentives to save, and putting pressure on kip deposits.  Low interest rates are putting pressure on bank solvency.

World Bank: Monthly Real Wages (Kip mn, 2015 prices)

OUTLOOK AND RISKS

Looking forward, the IMF has assumed that there are no further external shocks, that the terms of trade stabilise (after improving somewhat in H2 2022), that tourism picks up substantially, and that fiscal and monetary policies are tight, with no further lending from the Bank of Laos to the government.

On this basis, it forecasts real GDP growth of 4.0% in 2023 (World Bank 3.9%), gradually rising to a trend rate of 4.75% (World Bank 4.3%).  The lower than historic trend rate of growth reflects limited fiscal space for public capital spending.  The IMF sees average inflation of 15% in 2023 (-1.4% at year-end), stabilising at 3% by 2025.

IMF: Real GDP Growth with Sectoral Compositions (%, YoY)

On the fiscal front, revenue gains from 2021 are assumed to persist, but without further improvement, so maintaining a level a little above c.15% GDP.  Ratios of non-interest expenditure (wages, benefits etc.) are likewise predicted to be stable at c.15% GDP, but interest payments are projected to increase significantly.

IMF: Contribution of Interest Payments to Overall Fiscal Balance (% GDP)

Given a small positive primary balance, the overall balance is expected to improve somewhat, but public debt is expected to remain above 100% GDP for several years. (The World Bank estimated it stood at 110% GDP at the end of 2022).  The IMF sees these levels as being unsustainable on measures such as debt service to exports and debt service to revenue.  According to the World Bank, debt service payments will average $1.3bn/year between 2023 and 2026, so a little more than current FX reserves of around $1.1bn.

Gross financing rises significantly in 2023 to 16% GDP (including a swap line from PBoC) and remains at around that level for several years.  In the absence of substantial external financing, financing needs will have to be met domestically, raising risks of the crowding out of private investment.

IMF: Composition of Fiscal deficit Financing Sources (% GDP)

In addition, the IMF warns of other risks.  On is that the interest rate increases required to induce investors to finance could be very large, pressuring the central bank to monetise the deficit.  In addition, deteriorating banking asset quality could trigger liquidity shortages causing a funding crisis for the government.  There is also a risk that the government will be unable to secure foreign exchange to service external debts and pay for imports without significant FX pressure.

IMF: Public Gross Financing Needs (% GDP)

The IMF is also cautioning that risks, from contingent liabilities from PPPs and SOEs, from a possible need to recapitalise the banks, and the materialisation of expenditure arrears, could all serve to increase the debt burden.

(In February 2023, the government requested the National Assembly to approve the issuance of Kip 8trn in arrears clearance bonds.  This equates to about 3% GDP and compares to Kip 23.5trn in potential additional obligations – 11% GDP – which have been discussed with the IMF in Article IV consultations.)

Compared with IMF staff, the Lao authorities have expressed themselves more optimistic on the potential for recovery.    They have cited the positive effects from the return of tourists, goods trade following the railway and trade agreements, the future development of resources, including hydro.  They agree that stabilising the kip is key to containing inflation, but they are more optimistic on this also.  Accordingly, they are more hopeful that debt sustainability can be restored quickly.

The World Bank is less sanguine.  Despite debt service deferrals during 2020-2022, it says the ratio of debt service (principal and interest) to domestic revenue rose from 36% to 61% between 2017 and 2022, even as spending on education and health declined from 4.2% to c.2.6% GDP.   It concludes that “a successful conclusion to the ongoing debt negotiations and higher domestic mobilisation will be the key to creating fiscal space for critical growth-enhancing spending”.

POLICY DISCUSSIONS 

Fiscal Policy

At the time at which the IMF published its report, Laos’ budget plans for 2022-2025 had not been finalised.

The IMF stressed the need to develop a credible medium-term fiscal consolidation plan and a fiscal financing strategy.  After prioritising the reduction of immediate fiscal risks, it has recommended that consolidation should prioritise tax revenue mobilisation (curbing exemptions, broadening the base, improving administration), rather than, as under current plans, spending restraint.  With respect to expenditure, it believes a priority should be placed on those areas (education, training, key export-oriented infrastructure), which are clearly growth enhancing, but it believes a return to the model of driving GDP growth through public capital spending should be avoided.

IMF: Tax Revenue (% GDP)

Reversing VAT exemptions to the previous 10% rate would add about 1% to 2021 GDP.  The difference between potential and actual revenue from corporate income tax is estimated to be as high as 90%.  Investment incentives should be restructured to a cost-based system, based on depreciation and tax deductions rather than using reduced rates.  There is scope to reform land taxation, to introduce property tax and raise excise duties.

On spending, the IMF believes there is significant scope to improve the planning, allocation and implementation of budgets.  (IMF staff’s estimates of public debt for 2022 include kip 23.5trn in arrears on old investment projects.).  It highlights the need to improve debt management, fiscal statistics, transparency (to improve investor credibility and to reduce the scope for corruption), and the governance and operational performance of SOEs.

The authorities have responded by remarking that they are aiming to increase significantly the domestic surplus by increasing revenues, by closing leakages on import duties, raising excise and income tax collection, as well as spending restraint on new capex and public wages.  Negotiations with bilateral creditors are ongoing.

Monetary Policy / FX

The IMF believes the BoL should continue to tighten monetary policy – by continuing to refrain from monetisation, constraining the expansion of reserve money (in the face of the National Assembly’s decision to approve a target growth rate of 26% YoT, which would exceed nominal GDP growth), and absorbing excess liquidity by issuing bonds.  Nominal rates need to rise until real rates are positive.

Monetary policy can support exchange rate stability by facilitating market interest rates that encourage stable bank funding in domestic currency.  Higher interest rates and a stable currency will also improve FX liquidity and bank solvency.

There is scope to take further action to unify the market and official exchange rate, by keeping the exchange rate sufficiently flexible, by improving the flow of FX through commercial banks, and by better enforcing the repatriation of FX earnings in the short term.

The IMF estimates gross FX reserves to have been $1.1bn at end 2022, corresponding to 1.6 months of imports.  In May 2020, BoL entered into a three-year swap with PBoC, for the amount of c.$900mn, $300mn of which was included in stated reserves at the end of 2020.  However, details on the arrangements are not available and, according to IMF methodology, reserves that include a clause restricting the use of resources (eg. facilitating transactions on trade and investment with China) should be excluded.  The IMF estimates that, for a country at Laos’ stage of developments, reserves are optimal at between 3 months and 5.5 months of imports.

IMF: Lao PDR Reserve Adequacy Assessment (Months of Imports)

The authorities have agreed that monetary policy needs to be tightened, but gradually, as the banks have maturity mismatches.

Financial Sector

The IMF has noted that some of the improvement in financial sector ratios in 2022 is because of interventions at two state-owned banks.  It believes cash balances and liquidity are low, profitability is low, and that capital adequacy, for many banks, is below minimum requirements.  (One bank, 60% state-owned, reported a capital ratio of 5.7%, below the regulatory minimum of 8%, in September 2022.).

The IMF believes these weaknesses are reflected in the banking sector’s sluggish risk appetite, in a largely dollarised environment.

IMF: Commercial Banks’ Loan-to-Deposit Ratios (%)

The IMF believes that banks’ credit (in kip) to the government has been facilitated by BoL liquidity, and also was likely fuelled by the recapitalisation of two ailing public banks.

IMF: Banks’ Exposure to the Government (Kip bn)

Meanwhile, high inflation, low nominal kip deposit rates, kip depreciation and BoL high yield bonds have discouraged kip deposits, but supported loan demand.

IMF: Kip Credit and Deposit Growth (%, YoY)

The forbearance regime remains in place.  These are concealing profitability and solvency strains, and the process of recognising losses appears not to have started.

IMF: Non-Performing Loans (%)

Exchange rate depreciation has inflated the kip value of balance sheets, as about 70% of loan books are FX-denominated.  In addition, in several cases, domestic depositors have shifted to FX deposits, exacerbating FX mismatches.   Kip-denominated capital resources have shrunk by comparison.

The IMF has recommended (i) raising interest rates, to preserve depositor confidence and support bank profitability in the face of rising costs,  (ii) requiring banks to retain profits to support solvency, (iii) requiring banks to report detailed information on restructured loans still subject to forbearance and to prepare the necessary provisions, (iv) communicating a clear plan (with dates) for exiting from forbearance policies  and (v) instructing banks to raise capital and set aside higher provisions.

In addition, it sees a need to improve the corrective action framework / supervision / regulatory environment / bank restructuring framework, to ensure the authorities are ready to respond effectively in situations of banking distress.

The authorities appear to be more sanguine than the IMF in this area, arguing that the banking system is profitable, with a system-wide CAR of 18%.  FX pressure should ease with recent measures.  Data on outstanding restructured loans is being prepared.

Structural Policies / Governance / Data

The IMF has noted that past high levels of investment in resources have produced very little growth in employment and productivity.  In future, the need to maintain a tight fiscal stance will preclude high levels of public investment.  More will be needed from private sector growth.  Improving productivity will be a key input to sustaining a stable exchange rate in the long term.

Challenges faced by the private sector include (i) skills shortages in high-growth firms outside construction, manufacturing and hospitality (ii) firms reacting to competition from informal firms by downsizing and becoming informal themselves (iii) access to finance (iv) administrative burdens.  Reforms are required to improve education, skills and training, to reduce regulatory burdens, to improve consistency and transparency in their implementation, and to increase registration and labour formality. (70% of businesses pay informal charges for licences, which may account for c.6% of revenues, and up to 90% do not have businesses registrations or tax licences.)

In addition, the IMF has highlighted significant weaknesses in the management of public institutions, in the enforcement of the regulatory framework, in the planning, allocation and implementation of budgets, and in the governance of SOEs.  Effectiveness in the implementation of the Anti-Corruption Law (2012) is unclear.

The IMF sees a need for increased transparency in these areas, as well as in investor protection and the resolution of disputes.  Improving the quality, coverage and timeliness of economic data is seen as critical.

One area highlighted in the Article IV report relates to significant discrepancies in the balance of payments data, where “errors and omissions” reflecting the under-reporting of imports, capital flight etc., have averaged 3.8% GDP in 2012-2021.

IMF: Balance of Payments, Errors and Omissions (% GDP)

In its report, the World Bank included the following table, summarising the reforms that it believes are vital to restoring macroeconomic stability in Lao:

 

The following is a table of the IMF’s estimates and projections for the Lao economy in 2019-2028:

 

To read the full Article IV report by the IMF, please use the following link to its website:

https://www.imf.org/en/Countries/LAO

 

For the World Bank’s report, please use the following link:

https://www.worldbank.org/en/country/lao