However, expansionary macroeconomic policies put pressure on the balance of payments. Expansionary fiscal and monetary policies alongside the rapid growth of the banking system have stimulated domestic demand and imports. In conjunction with the stabilized exchange rate regime, this has put NFA of the banking system on a downward trend since mid-2008. As a result, the liquidity buffer to absorb external and internal shocks is now substantially less comfortable than during 2000–07 and the authorities should take this into consideration when assessing the adequacy of central bank reserves.

The outlook for GDP growth in 2010 is favorable and inflation is likely to remain moderate, but pressures on the external position are likely to continue. The projected narrowing of the fiscal deficit in FY2010 would make an important initial contribution to the needed policy tightening. However, on current policies, the growth of credit is expected to remain strong, boosting domestic demand and imports, and raising risks in the financial sector.

The overall fiscal deficit, which looks set to narrow by about 2 percent of GDP in FY2010, should be kept on a consolidation path over the medium term. In this regard, staff welcomes the phasing out of the off-budget spending financed by direct lending from the central bank to provincial governments. The needed medium-term fiscal consolidation should build on recent revenue gains, including from the resources sector and the new VAT, and a prioritization of infrastructure spending.

The authorities should articulate a plan aimed at reducing the growth of credit to the private sector. The extent of the further decline in banking system NFA during 2010 will depend to a large degree on the authorities’ success in reining in private sector credit growth. In light of this, all available instruments should be considered, including raising reserve requirements, stepping up sales of central bank securities to the domestic banks, raising the policy rate, and using prudential curbs.

Staff believes that the Lao currency (kip) is overvalued, but that a stabilized exchange rate regime remains the appropriate monetary anchor for Lao P.D.R. In view of the higher risk of financial crisis and slower and more abrupt external adjustment typically associated with pegs and near-pegs, and in light of the downward trend in NFA of the banking system, this makes it all the more important to implement consistent fiscal and monetary policies.

The rapid expansion of the number of banks and the rapid growth of credit in many banks poses high credit risks and call for extra vigilance by bank supervisors. Bank lending standards should be scrutinized and a tightening of these standards should be mandated, if deemed necessary. Existing prudential regulations should be clarified and enforced, including loan classification rules and regulations which limit banks’ net open foreign currency position and prohibit bank lending in foreign currency to borrowers without foreign currency income.

Lao P.D.R.’s medium-term prospects are promising, provided that a concerted effort is made to preserve macroeconomic stability. Efforts to strengthen the soundness of the financial system should be complemented by efforts to improve the business climate and trade integration. State-owned enterprise reforms and regulatory and legal reform required for accession to WTO membership can be expected to have important long-run payoffs.

Improvements in the quality and timeliness of statistics would improve analysis and policy making. Improvements in balance of payments and national account statistics are particularly urgent.

Background

Lao P.D.R. weathered the global crisis well in 2009. Although the crisis did have an impact on exports, non-regional tourism, and capital inflows, GDP growth held up very well, at 7.6 percent, one of the highest in the region. Growth was buoyed by ongoing projects in the mining and hydropower sector, as well as the boost to construction and other sectors provided by a sizable fiscal expansion, an accommodative monetary policy, and one-off events such as the South-East Asia games that were held in Vientiane in December 2009.

Although inflation remains relatively contained at 4.9 percent, prices of real estate and land have been rising rapidly and an acceleration in the growth of domestic demand put pressure on the external position. Gross international reserves of the Bank of Lao P.D.R. (BoL) remained relatively stable at around US$630 million, thanks to the SDR allocation from the IMF (US$65 million) and sales of U.S. dollar-denominated BoL securities to domestic banks (US$43 million). However, net foreign assets (NFA) of the banking system fell by a further US$215 million in 2009.

The pressure on the balance of payments in 2009 stemmed primarily from expansionary macroeconomic policies. The overall fiscal deficit widened by 4.4 percentage points of GDP to 7.2 percent of GDP in FY09, mainly because of a sharp increase in off-budget spending (4 percent of GDP), funded mostly by loans from the BoL to provinces to finance infrastructure projects, including for the South-East Asia Games and the celebration of the 450th anniversary of Vientiane. Monetary policy was also expansionary, with the growth of credit to the private sector rising further to 88 percent in 2009. While the bulk of the new credit continued to come from the state-owned commercial banks, credit growth by the smaller private banks was also very rapid, exceeding 100 percent in some cases. While the expansionary policies did support growth, the boost to domestic demand resulted in a widening of the non-resource current account deficit from 6 to 12 percent of GDP between 2007 and 2009. With FDI inflows slowing during this period, due to delays and postponements in mining and hydropower projects in the aftermath of the global crisis, this widening in the current account deficit resulted in the decline in banking system NFA noted above.

The outlook for GDP growth in 2010 is favorable and inflation is likely to remain moderate. Growth is projected to remain close to 8 percent, supported by a continued expansion in the mining and hydropower sectors, a rebound in non-resource exports and tourism, and continued strong domestic demand. The start of commercial operations of the Nam Theun II hydropower project in March 2010 will support growth and is expected to be an impetus for further development of the country’s hydropower potential. Inflation could rise further in the next few months because of base effects but is expected to recede to 5½ percent by the end of the year.

Lao P.D.R’s medium-term prospects are promising, provided that macroeconomic stability is maintained and structural reforms continue. The recovery of copper prices and strong demand for electricity in neighboring countries are bringing forward expansion plans in the mining and hydropower sectors, which were delayed in the wake of the global crisis. Activity outside of the mining and hydropower sectors is also projected to pick up, although this will need to be supported by continued reforms to strengthen the foundation of the economy.

The rapid expansion of the number of banks in Lao P.D.R. and the rapid growth of credit in a number of banks poses risks. Reported non-performing loan (NPL) ratios remain low, but experience in other countries has shown that NPL ratios tend to rise only during the later stages of a credit boom. Capitalization of the three state-owned commercial banks remains below the prudential limits. Collectively, commercial banks are maintaining a net long position in foreign exchange of about 2 percent of GDP and some banks are exceeding the prudential limits on the net open position. And currency mismatches in the nonbank private sector may be substantial with many borrowers in foreign currency lacking foreign currency income.