Issue # 16 Lao PDR Economic Monitor SEPTEMBER UPDATE 68708 in Lao PDR Macroeconomic Balances to Sustain High Economic Growth The World Bank, Vientiane — SEPTEMBER 2010 LAO PDR RECENT ECONOMIC DEVELOPMENTS S P E C I A L P O I N T S O F I N T E R E S T:  STRONG ECONOMIC PERFORMANCE IN 2010.  RISING FOOD PRICES PUTTING PRESSURES ON INFLATION.  DECLINE IN NET FOREIGN ASSETS AND INTERNATIONAL RESERVES POSING MACROECONOMIC RISKS. Lao PDR Economic Monitor - SEPTEMBER 2010 UPDATE is issued in Lao and English by the World Bank Office in Lao PDR. This update reports mainly on recent economic developments and medium-term outlook for the country. The paper was prepared by Somneuk Davading (Country Economist) and Keomanivone Phimmahasay (Research Analyst) under the overall supervision of Genevieve Boyreau (Senior Country Economist) and Mathew Verghis (Lead Economist). We are grateful to the Government for providing inputs. We would like to thank our World Bank colleagues: Vattana Singharaj, Boualamphan Phouthavisouk, Thalavanh Vongsonephet and other staff for designs, printing and dissemination of the Monitor. “THE WORLD BANK TEAM APPRECIATES FEEDBACK ON STRUCTURE AND CONTENT OF THE MONITOR” Email contacts:  Mr. Somneuk Davading on structure and content (sdavading@worldbank.org)  Ms. Keomanivone Phimmahasay on data issues (kphimmahasay@worldbank.org) LAO PDR ECONOMIC UPDATE — SEPTEMBER 2010 PAGE 2 GROWTH AND INFLATION Lao PDR economic growth continues to be strong in 2010, against the backdrop of a Figure 1. Real GDP growth (percent) fragile global recovery yet dynamic regional demand. Growth is projected at 8.5 percent in Nonresource sectors (percentage points) Resource sectors (percentage points) 2010, from 7.5 percent in 2009 — see Figure 1. Real GDP growth (percent) The resources sector is projected to contribute 8.5 about 4 percentage points of economic growth, of 9 8.5 7.5 7.5 7.8 7.3 8 which electricity, water and gas about 3.2 7 6 4.5 percentage points. This increment is largely due to 5 6.1 5.0 4.8 5.6 the start of NT2 operations (about 8 months of 4 7.6 3 production this year), contributing 3 percentage 2 4.0 2.5 2.5 3.0 points or $160 million, mining - mostly copper 1 ‐0.3 2.0 0 and gold – contributes about 0.8 percentage ‐1 2006 2007 2008 2009 2010 2011‐15 points, with a higher than anticipated extraction (especially copper: around 16 percent increase for Phubia (or to about 63,000 tons this year from 54,000 tons in 2009) and 4 percent for Sepon (or to 70,000 tons in 2010 from 67,000 tons in 2009; Figure 2. Sectoral contribution to growth but with recent expansion Sepon’s copper output (percentage points) will rise by 14 percent in 2011(or to about 80,000 Agriculture and forestry Mining and quarrying Electricity, gas, and water Manufacturing tons). Construction Services 9 The non-resource sector is performing well in 8 0.8 2010, although agriculture may under-perform 0.8 0.9 7 0.9 following weather shocks. In the non resource 2.6 1.3 0.7 sectors, manufacturing (agro-processing, food and 6 2.0 2.5 3.2 beverages, cement and metal) and construction 5 2.3 1.3 (continued booms in infrastructure construction – 4 0.8 0.2 0.8 0.6 0.9 0.8 roads and bridges, housing and other trade and 3 0.4 0.6 entertainment/tourism related facilities) have 2 3.1 3.2 3.0 performed well this year while garments started to 1 2.5 2.5 rebound. However, growth in agriculture 0 ‐0.4 (especially rice production) is expected to slow in ‐1 2007 2008 2009 2010 2011‐15 2010 due to early draught and recent flood in Source: MPI/DOS and staff estimates and projections. some remote provinces, although the net impact Note: Annualized average growth rate for 2011-2015 on total production this year will depend on the yield of upcoming harvest in October/November. Services (mostly trade, banking and transport services) contribute 2.5 percentage points — see Figure 2. Tourism is likely to recover this year - the total number of tourist arrivals to the country increased by 26 percent during the first half of 2010 compared to the same period of last year (most importantly the number of visitors from Europe and America together rebounded by 64 percent while from Asia and Pacific region it grew by about 22 percent). PAGE 3 LAO PDR ECONOMIC MONITOR RISING FOOD PRICES FUELED INFLATION IN RECENT MONTHS After a period of deflation in 2009, the Figure 3. Recent inflation (y-o-y percent change) headline inflation (y-o-y) has risen notably in Energy (percentage points) Food  (percentage points) the past months and was at nearly 8 percent in 10 Core  inflation  (percentage  points) Headline inflation (y‐o‐y % change) 8.0 August 2010 due to rapid increase in food 8 6.8 prices. Food prices grew by 14 percent y-o-y in 6 4.2 4.7 4.9 4.8 4.9 3.9 4.8 August (or contributed about 5.7 percentage 4 1.7 2.0 2.0 1.6 4.5 5.7 1.6 1.9 1.5 2.8 points to the total inflation) and core inflation 2 1.1 1.2 1.7 1.8 1.6 1.9 1.2 1.3 1.3 1.5 1.6 1.7 (excluding food and energy) climbed slightly by 0 1.2 1.2 1.1 1.2 3.4 percent (or contributed around 1.7 percentage ‐2 ‐0.1 ‐ 1.8 points) caused by sustained demand for ‐4 ‐ 2.3 consumption goods while fuel prices increase has Aug ‐09 Oct‐ 09 Dec‐ 09 Feb‐10 Apr‐10 Jun‐ 10 Aug‐ 10 slowed to 6.8 percent in August from 20.3 Source: MPI/DOS and staff calculation. percent in May (or contributed only 0.5 percentage points). Among key food items, rice Figure 4. Contribution to food prices (percentage points) price (mainly sticky rice) contributed 8.8 Rice Poultry 14.1 16 13.9 percentage points (or increased most by 49.2 Meat Fish 12.9 12.4 14.0 14 Vegetables The rest percent y-o-y), vegetables about 1.3 percentage 11.1 Total food  CPI 10.0 12 9.9 9.6 points (or grew by 11 percent y-o-y) and the rest 8.6 10 8.8 8 6.8 about 3.9 percentage points to food prices in 6.0 7.3 5.0 4.7 6 4.3 4.3 4.0 August. Imported inflation, through the 3.4 3.9 2.9 2.7 4 1.3 depreciation of the kip vis a vis the Thai Baht of 2 4.6 percent over the last 12 months and Thai 0 ‐2 inflation (3.3 percent in August), also contributes ‐2.0 ‐2.7 ‐4 to higher prices. It is nevertheless expected that rice prices are likely to drop during the harvest season from October onward (See box 1). Source: MPI (DOS) and staff calculations. Box 1: Factors driving the increase of the price of glutinous rice Local rice price in Lao PDR is more influenced less harvest of glutinous rice. According to the by seasonal changes than global trends. Unlike department of meteorology and hydrology report, Thailand and Vietnam, Lao PDR produces mainly late rain resulted in 14.4% less of rainfall this year glutinous (sticky) rice (around 85-90% of total compared with normal rainfalls. rice outputs in the rainy season) which is mostly Market coordination failures, with reported produced for domestic consumption. The recent withholding of stock of paddy by traders, anticipating surge in the price of glutinous rise may be higher prices; attributed to a combination of the following factors: Official and unofficial rice exportations to Vietnam, and reportedly China, contributing to a lower Reduced “dry-season” harvest (April) and domestic supply; unfavorable prospects for the 2010 main “wet- season” crop about to be harvested. The flood Sharp increase of the benchmark Thailand export (2009) and drought (2010) in Champasack and price for the same type of rice (White Glutinous rice Attapeu provinces have contributed to the much 10%). Volumes of glutinous rice exported by SEPTEMBER 2010 UPDATE PAGE 4 It should be emphasized that food price dynamics and impact in Lao PDR differ from other countries in 2 main ways: First, consumption is largely based on subsistence agriculture and self- sufficiency in production in most provinces. The impact of rising food prices on households will vary considerably. Some households (net producers of food) may conceivably benefit from rising prices. Households involved in small-scale subsistence farming (who buy and sell only small amounts of food) are unlikely to experience a significant impact of rising prices. Clearly, the most vulnerable groups are landless rural households (a relatively small group) and poor or near-poor urban households that depend extensively on purchased food. About 40-60 percent of food consumed by rural households are self-produced whereas in cities just about 9 Thailand in the first eight months of 2010 are much percent. These groups, estimated to be around 300- smaller than last year (121 k tons, compared to 206 400,000 people, face significant risks. Second, k tons in Jan-Aug 2009) following a reduced crop although rising food prices comprise a risk to in northeast and central provinces of the country nutritional outcomes, a shortage of food is where much of the glutinous rice is produced. probably not going to further exacerbate malnutrition in Laos. Malnutrition is a significant The rise of domestic fuel prices affects the rice concern in Laos. Recent surveys have found that price only to a limited extent. The average diesel between 40 and 50 percent of children under 5 are price of this year is 8,200 kip per liter, compared to stunted--i.e. they are significantly shorted than they 6,500 kip per liter in 2009, ie. a rise of 20%. This would have been if they had consumed adequate cost push inflation is likely to be marginal, and and appropriate food, in particular during the first does not affect overall rice production. In upland two years of their lives. While food shortage and areas, rice production is largely for subsistence and food insecurity are clearly contributing factors to with very minimal use of fertilizers and other malnutrition, evidence from Laos and inputs. In low land areas, there is little use of internationally suggest that other factors, including fertilizer and other inputs for the rainy season crop. breast-feeding practices, complementary feeding Rice prices are expected to drop during the harvest practices, and high incidence of diarrhea disease season from mid-October onward. Anecdotal are more important. evidence based on rapid interviews of several rice millers in Vientiane in the end of September showed that un-milled sticky rice price offered by rice traders or middlemen has decreased very recently to 3,500 kip per kg from 4,000 kip in past months (Jul-Sep) and this declining trend is expected to continue in coming months. Nonetheless, improvement of rice sector coordination and management (with regard to reserve fund, rice production, stocking and distribution management, improving value chain to raise quality and value added) is critical for the GOL in order to ensure food security and maintain food price stability in the country. PAGE 5 LAO PDR ECONOMIC MONITOR GOL’S REVENUE AND EXPENDITURE IMPLEMENTATION The Government is taking steps to rein in the Figure 4. GOL’s revenue and expenditure (% of GDP) expansionary macroeconomic policy in place Grants Resource Revenue during the global crisis. First, it is expected that Non‐resource Revenue Expenditure Total Revenue Overall budget balance the fiscal deficit will reduce from 6.6 percent in 25 23.7 F2009 to 4.8 percent of GDP in FY2010 (about 22.4 18.9 22.1 20 18.1 18.0 19.1 2.7 percent of GDP from off-budget spending. 17.5 15.2 15.1 15.8 4.3 4.0 15 14.6 Quasi-fiscal off-budget operations have 2.1 1.1 1.7 2.6 1.3 3.1 2.1 2.7 2.0 3.2 10 continued into 2010, on the basis of 2009 12.5 5 11.3 11.3 10.7 11.0 11.9 commitments, while government has committed 0 to stop any new lending). The GoL’s revenue ‐5 collection for the first three quarters of this fiscal ‐2.9 ‐2.7 ‐2.6 ‐4.8 ‐3.0 ‐10 ‐6.6 year has performed well, reaching 85 percent of FY06 FY07 FY08 FY09 FY10 FY11 the annual target (largely due to higher tax and customs revenue) and overall domestic revenue GOL’s wage bill (percent change) to GDP ratio is expected to increase to 14.6 60 Wages, salaries and  percent this year from 13.7 percent in FY2009. benefits (%  of GDP) 50 Overall public spending will increase moderately Wages, salaries and  to 23.6 percent of GDP in FY2010 from 22.4 40 benefits (%  of total  percent in FY2009 mainly due to the new 30 exp) Wages, salaries and  inclusion of non-project grants (about 2.5 percent benefits (%  of  20 of GDP) into the budget from this fiscal year. recurrent exp) Wages, salaries and  Wage spending share in GDP is expected to 10 benefits (%  of non‐ resource  revenue) decline to 4.6 percent in FY2010 from 5.4 0 percent in FY2009. This relative decline is due to an only moderate increase in the nominal wage bill (with no change in the multiplier). While still Quarterly  revenue collection (bil. kip) appropriate by international standards, the level Nontax  revenue Indirect taxes of the wage bill has generally increased over the Direct taxes Domestic  revenue recent years (due to adjustment of real wage, 3000 increase in allowances and the number of civil 2500 2000 servants)1. Similarly, domestically financed 1500 capital expenditure is expected to decline to 5.7 1000 percent of GDP in FY2010 from 6.6 percent in 500 FY2009 as a result of prudent spending policy. 0 An important element of the Government exit strategy out of the fiscal stimulus is to allocate part of capital spending to on-budget repayment GOL's quarterly  expenditure  (bil. kip) of local projects financed out of off-budget BoL Capital Expenditure loans. Current Expenditure Total Expenditure 3000 2000 1000 0 Source: MoF and staff estimates and projections (FY11). 1/ For an analysis of the wage bill, please see the World Bank 2010 report “Civil Service Pay and Compensation Study”. SEPTEMBER 2010 UPDATE PAGE 6 EXTERNAL BALANCE The current account deficit is expected to manufactured goods, have started to rebound and improve to 9.6 percent of GDP in 2010 from are projected to grow by 11 percent in 2010, 13.8 percent in 2009, supported by strong driven by demand from China, Thailand and export performance in the resource sector. Vietnam. The total export value is expected to The positive impact on the current account of increase to about US$2 billion in 2010. Imports high export earnings in 2010 is somewhat muted are expected to grow by 9 percent this year driven by (i) increased profit repatriation from mining by the non-resource sector (consumer and to some this year projected at $336 million, as mining extent by investment related goods). Overall, the exports have performed well, and higher imports non-resource current account balance is expected in the non-resource sector. Lao exports to deteriorate in 2010 to 20.8 percent of GDP. Lao performed well in 2010 supported by increased PDR exports not only metals and hydro- regional demand, the operational start of new electricity, but also other products, such as projects, and favorable commodity prices. garments, wood and wood products, and -- most Exports are projected to surge by about 38 recently -- agricultural products and imports percent this year with resource exports growing investment goods (machinery and equipment, at 54 percent (electricity –NT2 by 150 percent construction materials, etc.), fuel, raw materials and mining 40 percent). Non-resource exports, for garment industries, agriculture and processing consisting mainly of agriculture, wood products, industries, and various consumer goods. to a lesser extent garments and other Figure 6. Exports by Sector ($ million) Figure 7. Commodity Prices (index 2000 = 100) Mining Electricity Copper Gold Cof f ee Wood & Wood  Products Garments Maize Rubber Rice 2500 Agriculture Other 600 2000 500 400 1500 300 1000 200 500 100 0 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2006 2007 2008 2009 2010 2015 Source: GOL, trading partners and staff estimates and projections. Figure 8. Balance of Payments, 2006-10 (percent of GDP) Overall balance Cap ital account balance Curren t account balance No n-resource CAB 30 25 23.7 20.1 20 17.1 15 12.5 10 8.5 4.7 5 2.8 1.9 0 -5 -1.3 -1.1 -10 -9.6 -15 -14.3 -13.8 -20 -18.8 -18.6 -18.2 -18.6 -18.3 -19.0 -20.8 -25 2006 2007 2008 2009 2010 Source: Lao PDR authorities (BOL) and staff estimates/projections PAGE 7 LAO PDR ECONOMIC MONITOR Meanwhile, net capital inflows are projected Meanwhile, net capital inflows are expected to to decline to 8.5 percent in 2010 from 12.5 fall to $631 million in 2010 from $771 million in percent of GDP in 2009, following a temporary 2009, on the account of (i) lower gross inflows drop in investments in the hydropower sector, and increased net debt repayments. mostly on the account of the completion of NT2 construction in 2009, and delays in Hongsa Figure 9. Disbursement of FDI in Lao PDR, lignite coal-fired power project construction. FDI 2006-2010 (US$ millions) in hydropower will rebound in 2011, with projects starting construction. By contrast, FDI in Agriculture Services Manufacturing, etc. Mining mining and non-resource sectors started to Power Gross FDI inflows 1200 Net FDI flows rebound this year, in line with regional trends in 976 investment inflows. The start of NT2 operations 1000 838 769 in 2010 without new operations starting this year 800 724 implies a fall of FDI in the sector by $112 512 600 million. By contrast, net FDI in mining is rebounding this year, with planned expansion of 400 operations, and will further increase in 2011 as 200 Phubia mine is finishing repaying its debt. FDI 0 in the non-resource sector is expected to follow 2006 2007 2008 2009 2010 the same trend, as a response to the strong regional demand and high commodity prices2. Source: Lao PDR authorities (MOIC) and staff estimates MONETARY SECTOR The Government is pursuing an exchange rate Figure 10. Nominal and Real Effective Exchange Rates policy of stabilized exchange rate regime (with an objective of ± 5 percent of fluctuations vis a 140 NEER REER vis major currencies per annum) to maintain 130 price stability. The authorities have been 120 promoting a stable kip to contribute to low 110 inflation, to build people’s confidence in the national currency and lower the dollarization rate 100 of the economy. The Lao kip exchange rate has 90 appreciated against the US dollar but depreciated 80 notably against Thai baht in recent months. The Lao kip appreciated by 4.5 percent against the US dollar and depreciated by 4.6 percent against (Index Dec2006 = 100) the Thai baht during the past 12 months, 110 Kip/USD Kip/Baht reflecting the GoL’s attempt to balance kip 105 exchange rate fluctuations against these two 100 major foreign currencies. Pursuing the policy 95 will become increasingly challenging in the 90 context of a weakening US dollar against other major currencies and further depreciation of the 85 kip against the baht fueling inflation in the near 80 Apr-07 Apr-08 Apr-09 Apr-10 Dec-06 Aug-07 Dec-07 Aug-08 Dec-08 Aug-09 Dec-09 Aug-10 future. Source: IMF, BOL and staff calculation. 2/ FDI inflows from China and Vietnam have been rising rapidly in recent years, rivaling Thailand’s position as Lao’s largest source of FDI. Investments from China and Vietnam have been primarily in natural resources, such as hydropower and mining. The remainder of the investment flows to projects in agriculture, manufacturing, tourism/entertainment related businesses and construction infrastructure. There are indications that FDI from China and Vietnam will surge in the coming years as the two countries vie for influence and to secure raw materials (in mining and hydro power projects) SEPTEMBER 2010 UPDATE PAGE 8 Net foreign assets and international reserves Figure 11. Reserves and Net Foreign Assets are have declined, as a result of (i) high net declining imports growth in the non-resource sector, (ii) Net foreign  assets  (bil.  Kip) lower net capital inflows, and (ii) government International reserves  ($  million  ‐ right axis) efforts to support a stabilized exchange rate 10000 700   policy. Reserve levels dropped Q-to-Q by 12.3 percent and y-o-y by 7.3 percent by June 2010 8000 600   (or about US$558 million in June from US$636 m in March 2010) while net foreign assets in the 6000 500   banking system declined by 11.4 percent and y-o -y by 27.2 percent. It is expected that the fall in 4000 400   reserves and net foreign assets levels will, as a response to credit growth slowdown, tightened public spending, and sustained inflows of exports stabilize by the end of 2010, with the continued (M-to-M percent change) slowdown of domestic credit expansion. 15 International reserves Net f oreign assets 10 To GDP ratios: 5 160 140 Ratio of NFA  to foreign  currency deposits 0 120 Ratio of BoL  NFA   to  -5 100 money base 80 -10 Ratio of NFA  to broad  Aug-09 Sep-09 Nov-09 Dec-09 Oct-09 Apr-10 Jul-09 Feb-10 Mar-10 May-10 Jun-09 Jan-10 Jun-10 60 money 40 Ratio of comm  bank  NFA   20 and reserves to  forex  (Q-to-Q percent change) 0 deposits International reserves Net foreign assets end June  2008 end June  2009 end June  2010 30 20 Source: Lao PDR authorities (BOL) and staff calculation. 10 0 -10 -20 Credit growth is slowing down, mostly on the Central Bank grew by 84.4 percent (a moderate account of private credit deceleration, while decrease from 98.3 percent Q1). Direct credit to BoL credit is expanding at a fast pace on the local projects amounted almost half of the total basis of previous 2009 commitments. The credit disbursement during the second quarter of Government’s commitment to rein in credit 2010. Credit growth is expected to slow further growth seems to pay off, with credit growth by the end of this year as a combination of (i) the decelerating y-o-y to about 60 percent in June phasing out of committed quasi-fiscal activities, 2010 from 90 percent in March. Credits to private (ii) a policy response to the decline in net foreign sector grew by 52.6 percent in Q2 of 2010 (a assets of the banking system and rising inflation; notable decline from 86.5 percent in Q1). and (iii) tightened liquidity with banking sector’s Nevertheless, lending to local projects (by the loan to deposit ratio climbed to 76 percent by Q2 PAGE 9 LAO PDR ECONOMIC UPDATE — SEPTEMBER 2010 of 2010. Monetary growth slowed during the first six months of 2010. Broad money (M2) growth slowed y-o-y to 26 percent by Q2 of 2010 from 28 percent in Q1 and 31 percent in end-2009. At the Figure 12. Credit growth (y-o-y percent change) same time, total deposits grew y-o-y by 25.9 Credit to PS To SOEs percent in Q2 of 2010 (compared to 29.7 percent Deposits Credit to economy in Q1). Demand for kip saving and time deposit 200 175 doubled to LAK4,013 billion (USD487 million) 150 yoy in June 2010 reflecting the increased 125 confidence in the public in kip monetary holdings. 100 Foreign currency deposits increased by a more 75 50 moderate rate of 17 percent y-o-y over the same 25 period (up to USD921 million). The dollarization 0 rate (defined as the ratio of foreign currency Jun‐08 Jun‐09 Jun‐10 Dec‐08 Mar‐09 Dec‐09 Mar‐10 Sep‐08 Sep‐09 deposits in banks over broad money) was 46 percent in June 2010 and has been on a decline trend over the last few years. The credit deceleration is welcome, against the Figure 13. Deposits and broad money backdrop of relatively weak banking (y-o-y percent change) supervision. Total lending as percent of GDP amounted 21 percent of GDP in December 2009 40 Broad money (M2) Deposits while reported non-performing loans (NPL) dropped from approximately 10 percent at the end 30 2006, to approximately 3.7 percent in June 2010. In the context of rapid credit growth, it is not clear 20 however whether these NPL reductions are coming from an improvement in the loan portfolios of banks or from a mechanic impact 10 from new loans expansion. There are also concerns over the accuracy of NPLs measurement and the use of internationals standards. These risks are highlighted by a history of a lack of Source: Lao authorities (BOL) and staff calculation. appropriate capacity for screening of borrowers. It will be important in the future to strengthen banking supervision and improve credit screening capacity in banks to prevent potential risks of defaulting in the banking sector. Another encouraging development is the continuous decline in interest rate spreads. The spread in Kip reduced from 7.82 percent in 2008 to 5.14 percent in 2009 and 5 percent by mid-2010 compared to USD which declined from 7.56 percent to 5.33 percent in the last quarter of 2009. Lending rates in kip for the tenor of 1 year is 14.36 percent which is significantly higher than in US dollar of 8.54 percent, while 1 year deposit rates are 9.22 percent and 3.21 percent respectively. THE WORLD BANK, VIENTIANE P.O Box UN 345, Patou Xay Nheru Road Vientiane, Lao PDR Lao PDR Economic Monitor — SEPTEMBER UPDATE Tel: (856-21) 450010-11, 414209 Fax: (856-21) 414210 www.worldbank.org/lao THE WORLD BANK, WASHINGTON, D.C. 1818 H Street, N.W. Washington, D.C. 20433 Tel: (202) 472-1653 Fax: (202) 522-1560/1557 www.worldbank.org “THE WORLD BANK TEAM APPRECIATES FEEDBACK ON STRUCTURE AND CONTENT OF THE MONITOR” Email contacts:  Mr. Somneuk Davading on structure and content (sdavading@worldbank.org)  Ms. Keomanivone Phimmahasay on data issues (kphimmahasay@worldbank.org) LAO PDR ECONOMIC MONITOR — SEPTEMBER 2010 FREE COPY (NOT FOR SALE)