Lao PDR Economic Monitor December 2017 1 Lao PDR Economic Monitor December 2017 CURRENCY EQUIVALENTS (Exchange Rate Effective as of December 6, 2017) Currency Unit = LAK (Lao kip) LAK 8,299 = US$1.00 ACRONYMS AND ABBREVIATIONS AEC ASEAN Economic Community MOIC Ministry of Industry and Commerce ASEAN Association of Southeast Asian Nations MW megawatt BOL Bank of Lao PDR NA National Assembly BOP Balance of Payments NEER Nominal Effective Exchange Rate CB Commercial Banks NFA Net Foreign Assets COD Commercial Operation Date NPL Nonperforming Loan CPI Consumer Price Index NSEDP National Socio-Economic EAP East Asia and Pacific Development Plan EdL Electricité du Lao PIP Public Investment Projects EDL GEN EDL Generation PPG Public and Public Guaranteed Debt FAO Food and Agriculture Organization PPP Purchasing Power Parity FDI Foreign Direct Investment PV Present Value GDP Gross Domestic Product REER Real Effective Exchange Rate GNI Gross National Income SEZ Special Economic Zones GOL Government of Lao PDR SME Small and Medium sized Enterprises IMF International Monetary Fund SOCBs State-owned Commercial Banks LAK Lao kip SOE State-owned Enterprise LNCCI Lao National Chamber of Commerce and VAT Value Added Tax Industry WBG World Bank Group MFI Microfinance Institution WEO World Economic Outlook MOF Ministry of Finance YOY year-on-year Regional Vice President: Victoria Kwakwa Country Director: Ellen A. Goldstein Practice Director: John Panzer Country Manager: Jean-Christophe Carret Practice Manager: Deepak Mishra 2 Lao PDR Economic Monitor December 2017 ACKNOWLEDGEMENTS The Lao PDR Economic Monitor December 2017 was prepared by a team comprising of Evgenij Najdov (Senior Country Economist), Somneuk Davading (Senior Economist), and Keomanivone Phimmahasay (Economist). Part II, on the t) with inputs from Franz Gerner (Lead Energy Specialist), Rome Chavapricha (Senior Energy Specialist), Takafumi Kadono (Senior Energy Specialist) and Keomanivone Phimmahasay (Economist). The team worked under the guidance of Deepak Mishra (Practice Manager, Macroeconomics and Fiscal Management Global Practice), Jean-Christophe Carret (Country Manager) and Shabih Ali Mohib (Program Leader). We gratefully acknowledge Souksavanh Sombounkhanh and Hannah Louise Mcdonald-Moniz ion and dissemination. The team would like to express its gratitude to the Government of Lao PDR, particularly the Ministry of Finance, Ministry of Planning and Investment, Ministry of Industry and Commerce, Ministry of Energy and Mines, the Bank of Lao PDR and other line ministries, and representatives from the Lao National Chamber of Commerce and a number of businesses for sharing valuable views and inputs. The findings and interpretations expressed here are those of the authors and do not necessarily reflect the views of the World Bank Group, its Executive Directors, or the countries they represent. The Lao PDR Economic Monitor provides updates on macroeconomic developments and sectoral issues in the country. It is produced bi-annually and distributed widely to the Government agencies, development partners, the private sector, think tanks, civil society organizations, and academia. For comments and questions on this publication, please contact Keomanivone Phimmahasay (kphimmahasay@worldbank.org). To be included in the email distribution list, please contact Souksavanh Sombounkhanh (ssombounkhanh@worldbank.org). 3 Lao PDR Economic Monitor December 2017 Contents Executive summary .......................................................................................................................................... 7 Recent economic developments and outlook ......................................................................................... 7 Thematic section: Lao PDR power sector: grow without sorrow ...................................................... 9 Recent economic developments in brief .................................................................................................... 11 Lao PDR Power Sector: Grow without Sorrow ......................................................................................... 12 Part I: Recent economic developments ......................................................................................................13 The Lao PDR economy continues to gradually moderate ...................................................................13 Domestic demand appears to be moderating .......................................................................................16 Exports from electricity, manufacturing, and agriculture are performing well .............................16 Inflation remains low as oil prices slowly recover and food prices fall ............................................ 17 Improvement in manufacturing and agriculture as well as low prices may have benefited the poor ................................................................................................................................................................18 Macroeconomic management has improved slightly, but risks remain high ..................................19 The fiscal space is thin. Government revenue shortfalls have been partially off-set by adjustments in spending .......................................................................................................................19 Still, public debt and risks have been increasing ............................................................................. 22 Good export performance is expected to help narrow the current account deficit. Still, the foreign reserves buffer remains low. ................................................................................................. 24 Greater flexibility in the exchange rate helped reverse some of the earlier appreciation. ..... 26 Credit growth decelerated, despite unchanged monetary conditions ....................................... 27 Expansion of the financial sector brings new challenges .............................................................. 29 Outlook..........................................................................................................................................................31 The medium-term outlook remains broadly favorable, but not without risks ..........................31 Policy Considerations ................................................................................................................................ 34 Addressing risks to macroeconomic vulnerabilities is a key priority .......................................... 34 Achieving more sustainable and stable growth will require a genuine and vibrant private sector ....................................................................................................................................................... 34 Part II: Lao PDR power sector: grow without sorrow ............................................................................. 37 Summary ..................................................................................................................................................... 37 The power sector has fueled investment and growth ........................................................................ 37 Reliable and affordable energy for people and businesses ................................................................ 39 Contribution to the budget has been growing, but remains modest ............................................... 41 Who is who in the power sector ............................................................................................................... 41 Power sector finances............................................................................................................................... 44 Growing risks .............................................................................................................................................. 45 Recommendations ..................................................................................................................................... 47 References....................................................................................................................................................... 49 4 Lao PDR Economic Monitor December 2017 FIGURES Figure 1: Growth is expected to slightly moderate ...................................................................................13 Figure 2: Still, it remains strong ...................................................................................................................13 Figure 3: GDP growth continues to be driven by the power sector ...................................................... 14 Figure 4: Tourist arrivals continue to decline ............................................................................................ 14 Figure 5: Some recovery of agricultural commodity prices.................................................................... 17 Figure 6: Headline inflation remains low ....................................................................................................18 Figure 7: Poverty is expected to continue falling......................................................................................19 Figure 8: Addressing inequality remains a challenge ...............................................................................19 Figure 9: Revenues remain short of the ambitious target ..................................................................... 20 Figure 10: Sound VAT and non-tax collection was offset by weaker performance on other taxes ........................................................................................................................................................................... 20 Figure 11: Non-wage recurrent expenditures accounted for most of the expenditure adjustment ........................................................................................................................................................................... 20 Figure 12: Fiscal deficit remains elevated .................................................................................................. 21 Figure 13: The fiscal deficit remains high compared to regional peers ................................................ 21 Figure 14: ............................... 22 Figure 15: Lao PDR increasingly resorts to bilateral and commercial loans....................................... 23 Figure 16: Lao PDR public external debt is mostly US$-denominated debt ...................................... 23 Figure 17: Financing needs are growing ..................................................................................................... 23 Figure 18: Electricity export to Thailand ................................................................................................... 24 Figure 19: Parts and components exports mostly from SEZs continue ............................................. 24 Figure 20: Lao PDR has low reserves adequacy by several metrics (data at end-2015) ................. 25 Figure 21: The kip recently depreciated against major currencies....................................................... 26 Figure 22: The trend of appreciation started to reverse ....................................................................... 26 Figure 23: The gap between official and parallel exchange rates narrows ........................................ 26 Figure 24: Broad money growth was driven by growing foreign currency deposits ........................ 27 Figure 25: The kip deposit interest rate declined since introduction of an inflation linked cap in end 2015 .................................................................................................................................................................. 27 Figure 26: Growing foreign currency deposits ......................................................................................... 27 Figure 27: Restriction on foreign currency lending contributes to lower credit growth while kip denominated lending picked up. ................................................................................................................. 28 Figure 28: Lending to commerce and industry sectors drove credit growth in the first half of 2017 ........................................................................................................................................................................... 29 Figure 29: Outlook on key commodities generally look favorable ........................................................31 Figure 30: Lao PDR lags in several areas of Doing Business ................................................................. 35 Figure 31: Starting a business in Lao PDR is still behind the regional average .................................. 35 Figure 32: Power sector at a glance ........................................................................................................... 38 Figure 33: Access to electricity has increased ......................................................................................... 39 Figure 34: Quality of electricity supply...................................................................................................... 40 Figure 35: The power sector and the business environment ................................................................ 40 5 Lao PDR Economic Monitor December 2017 Figure 36: Power sector royalties are growing slowly ............................................................................. 41 Figure 37: Financial flows in the power sector ......................................................................................... 45 Figure 38: Debt levels have been increasing, especially so in the case of EdL ................................... 46 BOXES Box 1: Tourism in Lao PDR.............................................................................................................................15 Box 2: Power sector potential ..................................................................................................................... 37 T ABLES Table 1: Energy consumption moderates ...................................................................................................16 Table 2. Key Macroeconomic Indicators and Projections ...................................................................... 36 Table 3: Electricity generation, consumption and trade ........................................................................ 43 6 Lao PDR Economic Monitor December 2017 Executive summary Recent economic developments and outlook 1. Growth is projected to further moderate to 6.7 percent in 2017, below historical averages, but towards a more sustainable level. Continued expansion in power generation, manufacturing, and agriculture are weighed down by flat mining output, moderating construction, lower contribution from public services and weaker-than-expected tourism performance. On the expenditure side, the moderation has been driven by slowing domestic demand, which was only partially offset by good performance of exports of goods. Still, growth remains robust, close to the average for the developing East Asia and Pacific (EAP) region, one of the fastest growing regions globally. Headline inflation further declined in 2017, reflecting falling food prices and slowing aggregate demand, offsetting the effects of recovering oil prices. 2. Improved agriculture output and manufacturing activities are expected to have continued to support poverty reduction. Poverty in Lao PDR, based on the international poverty rate of US$1.90 a day in 2011 purchasing power parity (PPP), is projected to fall to 13 percent in 2017 from about 18 percent three years ago. Growth in agriculture exports, the sector that engages two-thirds of the labor force, has been due to increased participation of traditionally small-scale farming households in the production of export linked commodities, such as rice and non-rice crops. The growth in manufacturing, albeit from a low basis, is expected to have created job opportunities. However, disparity persists with the bottom 40 percent of the population benefiting less from the growth process. 3. Macroeconomic vulnerabilities remain significant despite some improvement in macroeconomic management. In the first three quarters of 2017, despite good performance of VAT and non-tax revenues, revenues slightly declined compared to the previous year reflecting lower income and trade taxes, partly due to an extraordinary high comparison base from the third quarter of the previous year. Adjustments in non-wage recurrent spending and transfers partly offset the revenue underperformance, the increase in foreign-loan-financed public investment and the increase in the wage bill. Under these trends (stronger efforts to increase revenues and prudence on expenditures), the deficit is expected to be around 4.4 percent of GDP, close to last the initial 2017 projection of 5.4 percent of GDP. Still, the deficit remains high, further adding to the already high public debt, which is projected to reach almost 60 percent in 2017, with external debt increasingly on less concessional term including bond issuance to finance the budget. 4. The current account deficit is expected to narrow slightly in 2017 on the back of strong exports of electricity, manufacturing and agriculture products while improved metal prices supported higher mining exports. This will help offset the possibly negative impact of falling tourism this year. Imports increased at a slower pace reflecting moderating domestic demand and gradually recovering oil prices. The current account deficit continues to be financed by FDI and foreign borrowing. Still, reserves adequacy is low, with the ratio of reserves to foreign 7 Lao PDR Economic Monitor December 2017 currency deposits less than 25 percent in June 2017. In response to the large current account deficit and limited reserves, the kip depreciated against the US dollar and the Thai baht since the start of 2017, helping reverse some of the strong appreciation in recent years and narrowing the gap between the official and parallel market exchange rates. 5. Credit to the economy moderated, while parts of the financial sector are still weak. Though the monetary stance remains unchanged, credit growth decelerated to 17 percent in June due to weakening in the loan portfolio, tighter fiscal space and regulation on lending in foreign currency. Similar trends appear to have continued in the rest of 2017. Risks in the financial sector persist as some banks remain undercapitalized and overall profitability remains low. 6. The overall medium-term outlook remains broadly favorable. Growth is projected to further decelerate next year as current trends continue. This could be indicative of declining potential growth in Lao PDR (The World Bank Group, forthcoming) reflecting limitations of growth driven by natural resource and public spending. Still, additional capacity that is expected to be installed in power sector as well as greater focus on improving the business environment is expected to boost the in the medium term. The installed capacity is expected to reach up to 11,000MW by 2021 while the contribution from the mining sector is expected to gradually decline as current projects mature. Outside of the resource sectors, greater regional integration opens up opportunities, especially in agriculture, tourism, and trade as well as in manufacturing, as Lao PDR becomes part of regional value chains, if supported by an improved business environment. These sectors have significant potential to create jobs and lower poverty further. Still, bold steps are needed to address the fiscal and external imbalances. The medium- term fiscal plan envisages a reduction in deficit over the medium term supported by strengthened revenue administration, improved tax-payer services and modernization as well as continued control on spending. These measures are expected to contain the deficit and public debt, which is critical in order to lower the risk of debt distress. The external deficit is likely to widen in the short term reflecting larger imports due to the construction of the Lao PDR section of the Kunming- Singapore railway project and the recovery of oil prices. It is expected to decline in the medium term as major power projects start operation and export. 7. The outlook, however, is subject to downside risks. Steeper-than-expected adjustment in China or a reversal in recent trends in Thailand could depress demand for Lao exports and put pressure on reserves and macroeconomic stability. The rapidly expanding power sector could be affected in case of lower external demand which will result in a build-up of significant liabilities which could threaten its sustainability and the Government budget. Greater global financial and exchange rate disturbances could undermine capital inflows to Lao PDR with negative implications for growth and stability. Reversal of the commodity prices recovery could also affect prospects for growth and Government revenues. Domestically, fiscal slippage, continued low reserves buffers, and failure to deal with weaknesses in the financial sector could threaten macroeconomic stability, with a disproportionate impact on the poor and on future growth prospects. The recent announcement to increase the minimum wage could affect prospects in case it is not matched with productivity improvements. 8 Lao PDR Economic Monitor December 2017 8. Addressing macroeconomic risks remains a pressing priority while improving environment for long-term growth is a continuous agenda. To create a more stable macroeconomic environment for reforms, maintaining fiscal discipline and bolder steps towards fiscal consolidation is of utmost importance at this stage. In this regard, the proposed 2018 Budget envisages, at best, only a modest adjustment. More meaningful consolidation will require stronger efforts to strengthening revenue collection through improved tax administration, including up-to-date tax payer registries, modernizing revenue collection methods as well as expanding the tax base (lowering exemptions, closing loopholes to address international taxation issues and tax avoidance etc.). The upcoming revision to the tax laws in 2018 will be a good opportunity to address a number of these issues. Any slippages in revenue should be addressed through control on public spending and improvement in spending efficiency. Recent efforts to put public employment under control and improve productivity are welcomed. Importantly, public investment, especially of loan-financed, should be carefully examined and scaled-back. The ongoing efforts to strengthen the public debt management legal framework and institutional reorganizations can improve public debt management and reduce risks. The authorities are exploring options for addressing weaker banks, including state-owned commercial banks, and are also in the process of revising the key legal framework. This provides an opportunity to take into account good practices in important areas, such as objectives and instruments of the central bank, relations with market participants, including the Government, supervision authority, and so forth. 9. However, achieving more sustainable and stable growth will require a genuine and vibrant private sector. Decelerating GDP growth in recent years in Lao PDR is indicative of the limitations of a growth pattern that relies on use of natural resources and public spending. The low and deteriorating ranking of Lao PDR on the 2018 Doing Business indicators illustrates that the country still lags on several fronts including starting a business, paying taxes and protecting minority investors as well as resolving insolvency. The constraints to business environment is further exacerbated by informality, among other top constraints identified by firms in the recent Enterprise Survey. Providing more opportunities outside the resource sector and promoting more sustainable private sector led growth will require creation of a level playing field for firms, particularly outside of the SEZs, as well as improving efficiency in the formal processes. Investing in human capital and infrastructure services will help improve productivity and competitiveness of firms. Among the potential sectors, tourism is one of the priorities. With 2018 being the Lao tourism year, improving quality and options for service infrastructure, branding and marketing of Lao PDR as a unique tourist destination can help boost the sector. Thematic section: Lao PDR power sector: grow without sorrow 10. development record over the last two decades. The power sector expanded robustly as the country exploited its ample hydro potential, and more recently thermal and other sources of energy. The expansion boosted growth and poverty reduction through investments, provision of reliable, clean, and affordable energy and higher exports. Installed capacity in the power system (from all energy sources) is estimated at around 6,800MW in 2017 and could reach 11,000MW by 2021. Still, its contribution to the Government revenue is still low due to fiscal incentives and the debt servicing schedule. 9 Lao PDR Economic Monitor December 2017 11. The power sector can have an equally dramatic influence over the future of Lao PDR. The remaining potential in the sector is significant; however, so are the risks. The expansion has saddled the public sector with significant debt and contingent liabilities. Making the power sector more sustainable will require strengthening the power system planning and the project selection process to ensure that only economically viable, fiscally sustainable and environmentally justifiable projects are selected. This may mean fewer investments, but ones with higher returns and lower risks. In addition, the commercial orientation of the public entities in the power sector needs to, including through stronger financial and corporate management. Lowering risks will critically depend on the ability to secure and connect to well-paying markets for rapidly growing electricity. Additionally, EdL should explore options to lower liabilities under PPAs and economical and non-debt creating ways of completing the infrastructure gap. 10 Lao PDR Economic Monitor December 2017 Recent economic developments in brief Growth is expected to slightly moderate Exports from electricity, manufacturing, and agriculture continue to grow (percent y/y) (percent annual average) 10 100 Electricity 8 80 Electrical machinery and equipment 6 60 40 4 GDP annual growth (annual %) 20 2 GDP growth - 10 year average 0 0 Apr-17 Aug-17 Dec-16 Nov-16 Jul-17 Feb-17 Oct-16 Jan-17 Mar-17 Sep-16 May-17 Jun-17 Sep-17 2015 2010 2011 2012 2014 2016 2017 2013 2009 2007 2008 Source: Lao Statistics Bureau and WB staff estimate Source: Thailand Ministry of Commerce But tourism has weakened Credit growth has moderated (percent y/y) (percent y/y) 40 25 20 20 15 0 10 -20 5 -40 0 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16 Feb-17 Apr-17 Feb-16 Oct-15 Oct-16 Jun-15 Jun-16 Jun-17 2012 2013 2014 2015 2016 2017H1 Grand Total Asia and Pacific Europe Source: Ministry of Information, Culture and Tourism Source: Bank of Lao PDR Greater flexibility in the exchange rate helped Fiscal revenue shortfall was offset by expenditure reverse some of the earlier appreciation adjustments, (Index Dec 2007 = 100) level (billion kip) 170 Real 0 160 Nominal 150 WB estimate -2,000 140 130 -4,000 120 110 -6,000 2017 target 100 2017 90 -8,000 2016 80 -10,000 Dec-16 Jun-09 Dec-10 Dec-13 Sep-08 Dec-07 Mar-10 Mar-13 Mar-16 Jun-15 Jun-12 Sep-14 Sep-17 Sep-11 Apr Jun Jul Aug Sep Oct May Mar Dec Feb Nov Jan Source: http://bruegel.org/ and WB staff estimates Source: Ministry of Finance 11 Lao PDR Economic Monitor December 2017 Still, public debt continues to increase Reserves buffer remains thin (percent of GDP) (percent) 90 40 75 2015 2016 2017 30 60 45 20 30 10 15 0 Jan-14 Jan-15 Jan-16 Jan-17 May-14 May-16 Sep-14 May-15 Sep-15 Sep-16 May-17 0 China Vietnam Mongolia Cambodia Malaysia Indonesia Philippines Thailand Lao PDR Reserves to foreign currency deposit (left axis) Reserves to M2 (left axis) Source: EAP Economic Update October 2017 Source: WB staff calculation based on BOL data Lao PDR Power Sector: Grow without Sorrow By mid-2000s, the power sector became a major Helping improve access to electricity source of growth* (percent of population) (Megawatt) 12,000 120 Hydro 1995 2014 change 10,000 Thermal 100 8,000 Biomass Projected 80 6,000 60 4,000 40 2,000 20 - 0 2017 2011 2021 2013 2015 2019 1991 2000 1998 2009 LAO LDC LMI MMR KHM EAP Source: EdL and Bank staff estimates Source: World Development Indicators * projection includes all forms of power But also creating debt and significant contingent been relatively modest liabilities (as percent of total fiscal revenues) (Debt / equity ratio) 2.5 3 EdL 2.0 EDL GEN 2 1.5 1.0 1 0.5 0.0 - 2012 2016 2010 2011 2015 2013 2008 2014 2005 2006 2007 2009 2013 2014 2015 2016 mid-2017 Source: Staff calculations based on data from Lao PDR Staff calculations based on 2014 and 2015 unaudited EdL Ministry of Finance Annual Reports and EdL GEN Reports 2011-2017 12 Lao PDR Economic Monitor December 2017 Part I: Recent economic developments The Lao PDR economy continues to gradually moderate 1. Growth is projected to further moderate to 6.7 percent in 2017 1, below historical averages (Figure 1), but towards a more sustainable level. Continued expansion in power generation, manufacturing, and agriculture are weighed down by flat mining output, moderating construction, lower contribution from public services and weaker-than-expected tourism performance. Still, growth remains robust, close to the average for the developing EAP region (Figure 2), one of the fastest growing regions globally. Figure 1: Growth is expected to slightly Figure 2: Still, it remains strong moderate (Percent, y/y) (Percent, y/y) 8 9 8 6 7 6 4 5 4 2 3 2 0 1 2015 2016 2017 0 Thailand Vietnam Cambodia GDP annual growth (annual %) Lao PDR GDP growth - 10 year average Developing EAP Developing EAP excl. China Source: Lao Statistics Bureau and WB staff estimate Source: EAP Economic Update October 2017 2. The power sector continues to expand. Investments in the power sector remain healthy, though somewhat lower compared to previous years as few major projects were completed. Another 500-600 MW is expected to come on stream during 2017, increasing the total capacity to almost 6,800 MW by 2017 (see Thematic Section). Its contribution is expected to be more moderate. Output in the two large mines declined in the first three quarters of 2017 as the mines start to mature and reach lower grade ore. However, higher copper price this year helped offset the volume fall and resulted in higher export earnings. 3. The performance in the non-resource sectors is mixed. Manufacturing output continues to expand, albeit from a low base and with the expansion mostly concentrated in a few special economic zones, which have been able to attract about 5-10 new entrants per year. Agriculture output benefited from relatively favorable weather conditions and more crop commercialization. 1The Lao Statistics Bureau recently released rebased GDP to 2012. The rebased GDP series are higher than the previous series by about 15 percent. The numbers presented as ratio to GDP in this report are based on the rebased GDP. 13 Lao PDR Economic Monitor December 2017 The Food and Agriculture Organization (FAO) estimates rice production in Lao PDR to grow by 2.6 percent in 2017, following a 5 percent growth last year. Some non-rice crops also increased markedly. According to Thai customs data, tubers (mostly cassava) export volume to Thailand increased by about 40 percent to about 0.6 million tons in the first ten months of 2017. Rubber output also increased in response to better prices early in the year. Commercial banana plantation has also expanded rapidly in the recent years, making bananas one of the top driver for agriculture output and export to date, mostly to China. However, concerns over misuse of chemical triggered the recent ban on new plantations and tighter control on the existing plantations. The construction sector moderated as completion of a few power projects, slowdown in credit growth and tight control on public spending offset the gradual start of the Lao section of the Kunming- Singapore railway line. On the other hand, retail trade as well as insurance continue to expand as the number of companies increased. The contribution from public services sectors remains subdued as the 7 percent increase in wages was offset by tight control on public recruitment as well as non-wage recurrent spending. Figure 3: GDP growth continues to be driven by Figure 4: Tourist arrivals continue to decline the power sector (percent y/y) (percent y/y, by source country) GDP 30 Other 2017 2016 20 Public services 10 Trade 0 Construction -10 Manufacturing -20 Mining -30 Electricity -40 Agriculture 2012 2013 2014 2015 2016 2017H1 Grand Total Asia and Pacific Europe 0 10 20 30 40 Source: LSB and WB staff estimates Source: Ministry of Information, Culture and Tourism 4. Weaker tourism is expected to weigh down on services sector. After declining by 10 percent in 2016, the total number of tourist arrivals continued to decline in 2017, falling by 10 percent in the first six months of 2017 compared to the same period in 2016 (Figure 3). The decline is driven by a drop in visitors from member countries of Association of South East Asian Nations (ASEAN). The drop in Thai and Vietnamese visitors accounts for about 56 percent of the decline. The number of Thai tourists could be affected by the promotion of domestic tourism in Thailand while the decline in number of Vietnamese arrivals could have been affected by the enforcement of measures to regulate foreign workers entering Lao PDR as tourists. Despite an increase in the number of arrivals from China, the number of arrivals from non-ASEAN countries declined, also due to a 30 percent decline in the number of arrivals from Europe. In addition, the average length of stay is slightly shorter, while the average spending increased from US$70 per day per tourist in 2013 to US$77 per day more recently. Coupled with the decline in the number of visitors, the tourism revenues and value added is likely to be affected. In response to boost the sector, the 14 Lao PDR Economic Monitor December 2017 Government recently announced 2018 as the Lao Tourism Year and plans to hold activities across 18 provinces. Box 1: Tourism in Lao PDR Tourism is an important sector for the Lao PDR economy, providing jobs and foreign exchange. Revenue from tourism almost doubled from US$ 380 million in 2010 to more than US$ 720 million in 2016 as tourist arrivals rose to 4.2 million in 2016 from 2.5 million seven years ago. With improved connectivity and affluence of Asian economies, visitors from Asia-Pacific region significantly increased. Visitors from ASEAN countries, particularly Thailand and Vietnam, rose by about 40 percent during 2010-2017, accounting for 72 percent of total arrivals. Non-ASEAN, particularly Chinese and Korean visitors, more than doubled during 2013-2016. Western visitors, who tends to spend more and stay longer (about 7 days compared to 1-3 days by regional tourists) accounted for about 7 percent in 2016. Tourism facilities and sites have expanded. Lao PDR boasts spectacular landscape, caves, waterfalls, and almost 60 percent of the nearly 2,000 government-designated tourism sites. The number of accommodation facilities increased by 38 percent from almost 1,900 places in 2010 to 2,500 in 2016. However, the occupancy rate is about half with variation across provinces in the country. Connectivity has also improved. More airlines offer more direct flights to Lao PDR such as from Korea, Malaysia, Singapore, China etc. For instance, the Korean visitors increased markedly after direct flights became available. Development and improvement of supporting infrastructure and industries can help tourism in Lao PDR realize its potential. Lao PDR currently ranks 94 globally on travel and tourism competitiveness index, better than Cambodia (rank 101), Nepal (103), but still below Vietnam (67), Malaysia (26) and Thailand (34). Investing in tourism services, including human resources, and infrastructure as well as branding Lao PDR effectively, can help distinguish Lao PDR as a unique tourist destination. Source: World Economic Forum, The Travel and Tourism Competitiveness Report 2017 and Ministry of Information, Culture and Tourism, 2016 Tourism Statistics Report. Note: Higher score (on a scale from 1-7) reflects better performance. 15 Lao PDR Economic Monitor December 2017 Domestic demand appears to be moderating 5. On the expenditure side, the moderation has been driven by slowing domestic demand, which was only partially offset by good performance of exports of goods. In the absence of high-frequency data on domestic demand, data on electricity consumption, imports and tax collection suggest cooling domestic demand. The growth rate of electricity consumption slowed across all user groups. Residential power consumption increased by only 4 percent (y/y) in the first half of 2017 compared to 12 percent in the same period last year (Table 1). Import growth has been subdued during most of 2017, with imports of vehicles declining in the first half of this year. On the investment side, completion of fewer power projects, delays on some pipeline power projects, slowdown in credit growth and tighter control on public investment projects offset the gradual start of the construction of the Lao PDR section of the Kunming Singapore railway line. Consumption also shows sign of moderation. The 7.5 percent increase in public sector wages in 2017 appears to have been offset by tight control over public sector employment and non-wage recurrent spending and temporary disruption to remittances as Lao migrants in Thailand went through the newly introduced formalization procedures. Table 1: Energy consumption moderates (Percent y/y) Period Consumer Categories Entertainment Government Commercial Residential Education- Irrigation Inter.Org Industry office Sport Total Jan-Jun 2015 10 12 11 14 16 9 (8) 39 12 July-Dec 2015 14 15 13 9 (19) 14 (9) 38 12 Jan-June 2016 12 18 21 11 (2) 13 16 32 12 July-Dec 2016 (2) 9 (5) 9 9 9 (34) 20 4 Jan-June 2017 3 4 (4) 5 (1) 3 (22) 9 4 Source: EdL Exports from electricity, manufacturing, and agriculture are performing well 6. Exports of electricity, manufacturing and agriculture continue to perform well in the first three quarters of 2017. Despite some increase in domestic consumption, most of the power generation is exported, mainly to Thailand, where electricity export increased by 15 percent (y/y) in the first nine months of 2017. Manufacturing exports, including electrical parts and components, glass lenses, garments, continued to expand but remain concentrated in the few Special Economic Zones. Encouragingly, these zones have been able to attract new companies helping generate around 500-1,000 jobs a year. The success of these companies demonstrates that, under improved conditions, Lao PDR could effectively participate in regional supply chains. A good harvest as well as recovery in key commodity prices (such as bananas, coffee) contributed 16 Lao PDR Economic Monitor December 2017 to stronger exports from the sector. Furthermore, rubber, dried cassava and coffee export increased by more than 30 percent in the first nine months of 2017 while cereal exports to China more than doubled in the same period, albeit from a low base. Figure 5: Some recovery of agricultural commodity prices (Dec 2015 = 100)* Coffee, robusta Banana, US Rice, Thai 25% Maize Tea, avg 3 auctions Rubber, right axis 140 250 130 200 120 110 150 100 100 90 80 50 2016M11 2016M10 2016M12 2017M06 2016M01 2017M01 2017M02 2017M05 2016M05 2016M06 2017M07 2017M08 2015M12 2016M02 2016M04 2016M07 2016M08 2017M03 2017M04 2017M09 2016M03 2016M09 2017M10 Source: World Bank October 2017 Note: *lines against the left axis, unless indicated otherwise Inflation remains low as oil prices slowly recover and food prices fall 7. Headline inflation further declined in 2017 reflecting falling food prices and slowing demand, amidst a very gradual recovery in oil prices. The headline inflation was 0.5 percent (y/y) in October 2017 compared to 1.9 percent in the same month last year. The decline was partly due to moderating demand related to contained public spending and slower credit growth. Food prices fell by 1 percent (y/y) in September 2017, compared to an increase of almost 4 percent (y/y) last September. This is due to well-stocked food markets and administered prices of key staples, including rice and meat. On the other hand, oil prices have been slowly recovering since the end of last year following movements in international oil prices. Fuel prices rose by 9 percent in September compared to a decline of 5.6 percent in the same month last year. Consumer prices have been edging upward for three consecutive months suggesting that the impact of the oil price decline may have dissipated. Annual average inflation is expected to be around 1 percent in 2017. Core inflation slightly picked up to 1.5 percent in October partly due to higher house renting and maintenance costs as well as clothing and footwear. 17 Lao PDR Economic Monitor December 2017 Figure 6: Headline inflation remains low (percent y/y) 6 30 5 20 4 3 10 2 0 1 -10 0 -1 -20 -2 -30 CPI (left) Core Non-core Raw food (left) Excl raw food & Petrol Oil (left) Fuel (right) Source: Lao Statistics Bureau Improvement in manufacturing and agriculture as well as low prices may have benefited the poor 8. Improved agriculture output and manufacturing activities are expected to have continued to support poverty reduction. Poverty in Lao PDR, based on the international poverty rate of US$1.9 in 2011 PPP, is projected to fall to 13 percent in 2017 from about 18 percent three years ago. Growth in agriculture exports, the sector that engages two thirds of labor force, reflects increased participation of traditionally small scale farming households in the production of export linked commodities, such as rice and non-rice crops. The growth in manufacturing, albeit from a low basis, is expected to have created job opportunities. In addition, the business confidence assessment in Lao PDR, jointly published by Lao National Chamber of Commerce and Industry (LNCCI) and the European Chamber of Commerce and Industry in 2016, reported that EU investors, mostly large firms employing more than 100 workers, indicated that they have increased their employment in late 20162. Taken together with continued expansion in the special economic zones, which currently employ about 7,600 Lao workers and create 500-1000 jobs per year, this points to better economic opportunities and some improvements in household welfare. 9. However, household consumption growth is still low compared to regional peers, with some evidence that the better off are benefiting more than the poor. Annual growth of consumption per capita for total population was around 2.2 percent in Lao PDR compared to 3.5 percent in Thailand, 3.4 percent in Indonesia, and 8.2 percent in China. Domestic disparity also persists with the population group at the bottom 40 percent face even slower growth in consumption at 1.5 percent, compared to almost 3 percent in the Philippines and almost 5 percent in Vietnam and Thailand. This is in part due to the nature of a resource based economy where few 2 2016 Business Confidence Assessment in Lao PDR jointly published by Lao National Chamber of Commerce and Industry (LNCCI) and the European Chamber of Commerce and Industry in 2016. https://eccil.org/news/eccil- news/business-confidence-assessment-july-december-2016-2/ 18 Lao PDR Economic Monitor December 2017 jobs are created, though recent developments in the labor market are more encouraging. Therefore, opportunities in labor intensive industries such as agriculture, manufacturing and services coupled with redistribution of benefits from resources will be key to improving consumption and making the growth process more inclusive. Figure 7: Poverty is expected to continue Figure 8: Addressing inequality remains a falling challenge (percent of population) (percent) 10 8.9 60 8 8 50 6 4.8 4.5 40 3.8 4 30 2.4 1.5 2 20 0 10 0 2014 2015 2016 2017 2018 2019 (US$, 3.2$ PPP) - Proj Annualized growth in per capita real survey mean consumption or income, bottom 40% (%) (US$, 3.2$ PPP) (US$, 1.9$ PPP) - Proj Annualized growth in per capita real survey mean consumption or income, total population (%) (US$, 1.9$ PPP) Source: EAP Economic Update October 2017 Source: World Bank, http://povertydata.worldbank.org/poverty/region/EAS Macroeconomic management has improved slightly, but risks remain high The fiscal space is thin. Government revenue shortfalls have been partially off-set by adjustments in spending 10. Revenues declined in the first nine months of 2017 and are likely to remain considerably below the ambitious target.3 Total revenue reached LAK16.1 trillion (approximately US$2 billion) in the first three quarters of the year, about 6 percent decline compared to the same period last year. Improving collection of value added tax (VAT), mining royalties and non-tax revenues, was offset by weak performance of income and trade taxes, including due to an exceptionally high comparison base from the third quarter of 2016. The improvement in VAT collection was due to strengthened administration, expanded tax base for VAT as well as some recovery in commodity prices. Royalties from natural resources also benefited from the higher commodity prices. Non-tax revenue collection increased due to higher dividends and over-flight revenues. Total revenues reached around 68 percent of the plan, reflecting the moderation of economic activity and falling profit tax but also weaknesses in the planning process resulting in 3 ment of loans on-lent to state-owned enterprises) category as net lending in capital spending. 19 Lao PDR Economic Monitor December 2017 ambitious targets.4 Grants also declined reflecting slow implementation of the donor-supported projects compared to plan. In October 2017, road tax payment was rolled out following the enforcement of the new Presidential Decree on Road Tax. There has been stronger emphasis on revenue collection recently; still, revenues for the year are expected to decline to around 16 percent of GDP, and underperform by at least 5 percent compared to the initial 2017 Budget. Figure 9: Revenues remain short of the Figure 10: Sound VAT and non-tax collection ambitious target was offset by weaker performance on other (billion LAK) taxes (billion LAK) 25,000 5,000 3Q 2016 3Q 2017 4,000 20,000 2017 target 3,000 2017 15,000 2016 2,000 1,000 10,000 0 5,000 0 Apr Oct Jun Jul Aug Sep May Dec Feb Jan Mar Nov Source: Ministry of Finance Source: Ministry of Finance 11. Importantly, the underperformance on revenues was matched by adjustments in spending. The adjustments to the non-wage recurrent spending and domestically financed investment spending compensated for the Figure 11: Non-wage recurrent expenditures higher capital spending supported by accounted for most of the expenditure adjustment foreign finance. The wage bill increased (billion kip) reflecting a 7.5 percent hike in wage index 10,000 3Q 2016 3Q 2017 at the start of the year. Civil servant intake was kept at 5,000 positions in 8,000 2017, most of which as replacement for 6,000 retirees. Non-wage recurrent spending and transfers were cut. Capital spending 4,000 increased as the fall in domestically financed public investment constrained by 2,000 limited domestic revenues and control on construction of new buildings was more 0 than offset by public projects financed by Wages Other recurrent Capital external loans. The spending is expected Source: Ministry of Finance and WB staff calculations to accelerated slightly in the last quarter of the year reflecting also the improved liquidity following 4 The formal planning process is underpinned by a 5-year fiscal plan approved by the National Assembly (NA). There is reluctance to revisit plans to take account of new developments, which locks MOF in preparing budgets in line with ambitious assumptions with the bias in estimates increasing over time. 20 Lao PDR Economic Monitor December 2017 the issuance of government bonds in October 2017. Total spending is expected to decline to around 20 percent of GDP in 2017 compared to around 21 percent last year. 12. Under these trends, the deficit for the year is expected to slightly narrow to 4.4 percent of GDP from 4.5 percent of GDP in 2016 and compared to the initial 2017 projection of 5.4 percent of GDP. The deficit in the first nine months of 2017, was around LAK4 trillion, or around a half of the deficit planned for the year. Under current trends, the deficit could be slightly lower compared to the Budgeted. Despite the improvement, the fiscal deficit is still relative high compared to regional peers (Figure 12). The deficit in the first half was mostly financed by the foreign loans and borrowing from the banking sector. In the latter half of the year, the authorities resorted to bonds issuance in the Thai capital market issuing bonds worth around US$420 million in October 2017. Figure 12: Fiscal deficit remains elevated (billion kip) (Percent of GDP) 0 Revenue and grants Expenditure -2,000 Overall balance (incl grants) 25 -4,000 15 -6,000 2017 target 2017 -8,000 5 2016 -10,000 -5 Apr Jun Jul Aug Sep Oct Dec May Jan Feb Mar Nov 2015 2016 2017 Proj Source: Ministry of Finance Source: Ministry of Finance Figure 13: The fiscal deficit remains high compared to regional peers (percent of GDP) Source: EAP Economic Update October 2017 0 IDN Note: Cambodia (KHM) figures refer to deficit before PHL MYS grants. FJI CH -5 SLB VNM MMR Average 2017 19 LAO KHM THA MNG -10 -15 -15 -10 -5 0 Average 2014 16 21 Lao PDR Economic Monitor December 2017 Still, public debt and risks have been increasing 13. The high fiscal deficit resulted in further increase in the already high public debt level, keeping the risk of debt distress elevated. Total public and publicly guaranteed debt (PPG) was estimated to reach around US$9 billion in 2016 or 59 percent of GDP and reached about 60 percent in 2017. The increase was driven by foreign-financed public investment, budget-financing bond issuance in the Thai capital market as well as growing domestic debt issuance. Overall, Lao Figure 14: on the high side compared to compared to less than 40 regional economies percent in Cambodia, less than (percent of GDP) 50 percent in Thailand and 90 Philippines (Figure 13) with the 75 2015 2016 2017 2016 joint IMF-World Bank Debt 60 Sustainability Analysis (DSA) 45 moving Lao PDR from moderate 30 to high risk of debt distress due 15 to breaches on 3 indicative debt thresholds.5 The increase in the 0 China Vietnam Malaysia Mongolia Cambodia Indonesia Philippines Thailand Lao PDR debt level and increasing portion of less concessional loans are likely to put pressure on debt services going forward. Source: EAP Economic Update October 2017 14. External debt accounts for about 80 percent of the total public debt. External debt is increasingly being contracted on market terms, mostly through the issuance of bond at the Thai capital market. More than a half of the borrowing is in US dollar, followed by special drawing rights (SDR), Chinese yuan and Thai baht respectively. This makes sudden kip depreciation one of the key risks to public debt sustainability. The domestic debt includes Treasury-bonds and Treasury- bills, capitalization bonds and direct loans from BOL to local authorities to finance infrastructure projects. An estimated one third of public external debt is financing public investment in the power sector, including for equity in selected self-financing power projects, which are expected to help lower risk on debt. However, this will depend on the ability to secure markets and set prices above cost-recovery level for the rapidly growing generation (see Thematic Section). Alternatively, the sector could create significant liabilities for the Budget. 5Lao PDR breached the thresholds for: i) the net present value (PV) of public and public guaranteed external debt (PPG) as a percent of GDP; ii) PV of debt to revenue ratio and iii) debt services to revenue ratio. Lao PDR was expected to breach the thresholds until around the mid-2020s under the baseline scenario. 22 Lao PDR Economic Monitor December 2017 Figure 15: Lao PDR increasingly resorts to Figure 16: Lao PDR public external debt is bilateral and commercial loans mostly US$-denominated debt (percent of total external debt) (percent of total external debt) Others, Other, 5 ADB, 11 12 Thai World baht, 7 Bank, 7 Bonds, 15 Chinese yuan, 12 Thailand, 8 SDR, 15 China, 46 Japan, 2 US$, 60 Source: WB calculations based on MOF data Source: WB calculations based on MOF data 15. The Government has resorted to bond issuance in the Thai capital market to finance the budget. Ministry of Finance placed the seventh issue of government bonds in October 2017 worth TBH14 billion or about US$420 million, the largest tranche so far and also with longest maturity6. The issue comprises of 3, 5, 7, 10, 12 and, for the first time, 15 years maturity bonds with interest rates ranging from 3.65 percent to 6.05 percent receiving a BBB+ rating (reported as the first BBB+ rated bonds with 15 year maturity issued at the Thai capital market). With this the stock of outstanding bonds is expected to have reached around US$1.3 billion. 16. The increasing financing needs and debt service costs reduces the space for spending on national priorities. The financing Figure 17: Financing needs are growing needs, defined as the fiscal deficit (percent) and the amortization on public 10 borrowing, rose from almost 6 8 percent of GDP in 2015 to an 6 estimated 8 percent in 2017. At the same time, interest payments as a 4 share of domestic revenue increased 2 from 6 percent in 2015 to 9.3 percent in 2017. This amount exceeds 0 2015 2016 2017 Proj planned public spending on health and is equal to about 60 percent of Total financing needs (% of GDP) planned education spending. This Interest payment as % of domestic revenue underscores the importance of Source: WB staff calculation based on MOF data. lowering the debt burden and fiscal Note: Financing needs are the sum of the fiscal deficit and consolidation through improving amortization of principals on public borrowing revenue collection and improved efficiency in spending. 6 http://www.nationmultimedia.com/detail/Corporate/30328464 23 Lao PDR Economic Monitor December 2017 Good export performance is expected to help narrow the current account deficit. Still, the foreign reserves buffer remains low. 17. The current account deficit is expected to slightly narrow on the back of strong exports of electricity, manufacturing and agriculture products as well as improved metal prices. This will help offset the possibly negative impact of falling tourism this year. The current account deficit continues to be financed by FDI and foreign borrowing. 18. Exports to the three largest export markets (China, Vietnam and Thailand) increased by about 15 percent in the first nine months this year. Power exports to Thailand in the first three quarters reached US$825 million compared to US$ 715 million in the same period last year. Manufacturing of parts and components (electrical machinery, parts and components including digital camera parts and glass lenses, etc.) continued to grow by more than 20 percent in 3 quarters, reaching about US$300 million. The expansion continues to mainly come from two special economic zones (Vita Park in Vientiane Capital and Savanh-Seno SEZs in Savannakhet province) which continued to attract new entrants recently. Figure 18: Electricity export to Thailand Figure 19: Parts and components exports (million US$, cumulative) mostly from SEZs continue (million US$, cumulative) 1,200 400 1,000 300 800 600 200 400 100 200 0 0 Apr Jul Oct Jun Aug Sep Dec Feb Mar May Nov Jan Apr Oct Jun Jul Aug Sep Dec Feb Mar May Jan Nov 2015 2016 2017 2015 2016 2017 Source: Thailand Ministry of Commerce Source: Thailand Ministry of Commerce (http://www2.ops3.moc.go.th/) (http://www2.ops3.moc.go.th/) 19. Recovery in commodity prices has given a boost to agriculture and mining export earnings. Rubber prices increased by about 30 percent (y/y) on average, almost doubling rubber export to China to US$71 million in the first three quarters of 2017. In addition, other non-rice crops exports such as coffee, dried cassava, cereal also increased. The recovery of copper and ore prices boosted export earning of ores and copper, especially to China and Thailand, despite relatively flat output. 20. Imports increased at a slower pace. The fuel import bill increased gradually in line with slowly increasing oil prices. At the same time, imports related to the railway project construction picked-up in the second half of the year. The latter was off-set by completion of the construction 24 Lao PDR Economic Monitor December 2017 of some power projects, import substitution with domestic production (for example, cement) as well as the deceleration of domestic demand. 21. The improvement in merchandise exports is expected to compensate for the decline in net services balance as a result of slower tourism activities. Tourism revenues in 2016 remained stable at around US$724 million despite the declining number of arrivals. With continued fall in tourist arrivals, revenue is expected to fall this year. Furthermore, western arrivals, who usually stay longer and spend more, fell by more than 30 percent in the first half. At the same time, more outbound tourism will contribute to higher service imports over the year. Remittances are expected to have remained stable, with stronger growth in Thailand offset by a temporary disruption due to the requirement to register informal migrants. 22. As a result, the current account deficit is expected to marginally fall, from 13.2 percent of GDP in 2016 to 13 percent in 2017. The deficit is financed by foreign direct investment and increased foreign borrowing, the latter on less concessional terms. Reserves increased to US$ 960 million in June 2017 with the recent bond issuance likely to have pushed reserves to above US$1.1 billion. Nevertheless, despite this temporary increase, reserves buffer is still considered thin by most indicators. Reserves cover less than 2 months of imports, less than 25 percent of foreign currency deposits and 11 percent of broad money, all significantly below regional peers (Figure 20). Figure 20: Lao PDR has low reserves adequacy by several metrics (data at end-2015) Source: IMF Article IV, 2017 Note: In percent of GDP is against the right axis 25 Lao PDR Economic Monitor December 2017 Greater flexibility in the exchange rate helped reverse some of the earlier appreciation. 23. On the back of large current account deficit and limited reserves, the kip depreciated against both the US dollar and Thai Baht. The authorities allowed greater flexibility in the exchange rate during 2017. As a result, by September 2017, the Kip depreciated by 2.1 and 7.6 percent y/y against the US dollar and the Thai baht, respectively. Such movements helped reverse part of the strong appreciation in recent years. The real effective exchange rate of the kip against and similar trends are expected to have continued in the rest of 2017. This helped to bridge the gap between the official and the parallel rate in the foreign exchange market, which narrowed below 1.5 percent in November 2017 from above 3 percent at the start of the year. Figure 21: The kip recently depreciated Figure 22: The trend of appreciation started to against major currencies reverse (Index Dec 2007=100) 8,300 Kip/$ (Left axis) 255 170 Real 250 160 Nominal 8,250 Kip/Baht (Right axis) 245 150 WB estimate 8,200 240 140 235 130 8,150 120 230 110 8,100 225 100 220 8,050 90 215 80 8,000 210 Dec-13 Dec-10 Dec-16 Jun-09 Sep-08 Mar-10 Mar-13 Mar-16 Dec-07 Jun-15 Jun-12 Sep-14 Sep-11 Sep-17 Jul-16 Nov-16 Jul-17 Jan-16 Jan-17 Mar-16 Mar-17 May-16 Sep-16 May-17 Sep-17 Source: Bank of Lao PDR Source: http://bruegel.org and WB staff estimate Note: an increase in the index indicates appreciation of the home currency against the basket of currencies of trading partners Figure 23: The gap between official and parallel exchange rates narrows Parallel Markaet Rate 260 Parallel Markaet Rate 8,600 Commercail Banks Rate Commercail Banks Rate 255 8,500 250 Kip/Baht 8,400 245 240 Kip/US$ 8,300 235 8,200 230 225 8,100 5/3/2017 1/3/2017 6/3/2017 4/3/2017 2/3/2017 3/3/2017 9/3/2017 8/3/2017 7/3/2017 9/3/2017 6/3/2017 4/3/2017 2/3/2017 1/3/2017 5/3/2017 8/3/2017 3/3/2017 7/3/2017 Source: Bank of Lao PDR 26 Lao PDR Economic Monitor December 2017 Credit growth decelerated, despite unchanged monetary conditions 24. Broad money growth accelerated on the back of growing foreign currency deposits . Broad money expanded at 16.4 percent in the first half of 2017 compared to 11 percent last year due to a 25 percent (y/y) increase in foreign currency deposits (Error! Reference source not f ound.). On the other hand, kip deposits rose more slowly at 9.4 percent in June (y/y) compared to 11.3 percent last year. This could be related to the lowering of policy rate Figure 24: Broad money growth was driven by growing and introduction of inflation linked foreign currency deposits (percentage points) deposit rate for the kip since end 2015 25 as well as some currency substitution following the weakening of the kip 20 against the US dollar and the Thai 15 baht. As a result, foreign currency 10 deposits account for 53 percent of 5 total deposit in June compared to 49 0 Dec-15 Dec-16 Mar-15 Mar-16 Mar-17 Jun-15 Sep-15 Jun-16 Sep-16 Jun-17 percent last year. Deposit data from financial statement of commercial banks suggest that the growth rate Foreign currency deposit Time and saving deposit may have moderated in the third Currency outside Bank Demand deposits quarter. Source: Bank of Lao PDR Figure 25: The kip deposit interest rate Figure 26: Growing foreign currency deposits declined since introduction of an inflation (percent) linked cap in end 2015 (percent) Total deposits at CBs 35 1-yr dep KIP Deposits in Kip 10 1-yr dep TBH 30 Deposits in Foreign currency 1-yr dep USD 8 25 20 6 15 4 10 2 5 0 0 Aug-15 Apr-16 Aug-16 Dec-15 Dec-16 Feb-17 Apr-17 Feb-16 Oct-15 Oct-16 Jun-17 Jun-15 Jun-16 Apr-17 Apr-15 Jul-15 Apr-16 Jul-16 Jul-17 Jan-15 Oct-15 Jan-16 Oct-16 Jan-17 Source: Bank of Lao PDR Source: Bank of Lao PDR Note: CB refers to commercial banks 27 Lao PDR Economic Monitor December 2017 25. While monetary conditions remain unchanged in 2017, credit growth decelerated in the first half due to tighter fiscal space, stronger enforcement of regulation on lending in foreign currencies and weakening of the loan portfolios. There were no major changes in the monetary policy stance since 2015 when the BOL lowered its policy rate and introduced a cap on interest rates. However, the growth of credit to the economy moderated at 17 percent (y/y) in June compared to 23 percent (y/y) a year ago. In real terms, credit growth moderation was slower, from 21 percent (y/y) in mid-2016, to 17 percent (y/y) in mid-2017. Financial statement from reporting banks suggest continued moderation in the third quarter of 2017. The slowdown is partly due to slower economic activities, tighter Figure 27: Restriction on foreign currency fiscal conditions and pending arrears to the lending contributes to lower credit growth while banking sector as well as more due diligence kip denominated lending picked up. effort by banks to screen customers in an (percent y/y) effort to improve loan quality. In addition, 35 the BOL issued a decision in late 2016 30 allowing foreign currency lending only to 25 borrowers who have foreign currency 20 15 earnings or importers of certain products7, 10 which is reported to have constrained 5 lending by some banks. As a result, the pace 0 of foreign currency lending reduced to 14 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16 Feb-17 Apr-17 Oct-15 Feb-16 Oct-16 Jun-15 Jun-16 Jun-17 percent (y/y) in June 2017 from 33 percent a year ago while Kip denominated loans Credit to economy of which in kip continued to grow from 19 percent last year of which in US$ to 24 percent (y/y) in June (Figure 27). Source: Bank of Lao PDR 26. Credit growth was driven by lending to industry and commerce sectors, followed by agriculture. Lending to the commerce sector expanded by 33 percent in the year to June 2017 while agricultural credit increased by 34 percent (y/y), albeit from a low base. Despite some moderation, credit to the industry sector, including to some power projects, grew by 17 percent (y/y) in June 2017. Lending to the construction sector remains flat partly due to the pending issue on public sector arrears and control on new public investment projects. 7 The BOL issued a decision on foreign currency credit from commercial banks on November 17, 2016. The decision limits lending in foreign currency to borrowers who have sufficient foreign currency income and importers of products such as such as agriculture inputs, materials and equipment for industry sectors, medicine and medical equipment and fuel. Proper documentation on the needs to settle in foreign currency needs to be presented to the BOL. Commercial banks will settle directly with suppliers, discouraging cash disbursement. Commercial banks can issue letter of credits and bank guarantees in foreign currency importers, but they have to put in place risk management mechanism to ensure sufficient repayment. 28 Lao PDR Economic Monitor December 2017 Figure 28: Lending to commerce and industry sectors drove credit growth in the first half of 2017 (percent and percentage points) 30 25 20 15 10 5 0 -5 2016Q1 2016Q2 2016Q3 2016Q4 2015Q2 2015Q3 2015Q4 2017Q2 2017Q1 Industry and Handicraft Construction Assembly Agriculture Commerce Transport and post Services Others Credit growth from CBs Source: Bank of Lao PDR Expansion of the financial sector brings new challenges 27. The banking sector continued to expand. Banking sector assets almost tripled in 2017 compared to five years ago, with the recent expansion driven by entry of foreign branches. Despite some moderation, the banking sector assets still grew at 17 percent in June 2017, reaching LAK118.2 trillion (approximately US$14.3 billion) . The aggregate capital to assets ratio in the banking sector (excluding state-owned banks) is above the mandated minimum of 8 percent and the aggregate loan-to-deposit ratio is around 1. 28. Microfinance institutions (MFIs) continued to expand rapidly, albeit from a low base. Total assets of MFIs reached about US$450 million in July 2017, up by 11 percent y/y and reaching almost 3 percent of GDP. According to the UNCDF, the proportion of adults using at least one regulated financial service in Lao PDR was 47 percent in 2014, higher than Myanmar at 30 percent, but still lower than Nepal at 61 percent in the same year. Despite the expansion of the bank and non-bank financial institutions, informal financial services also exist, but often with higher interest rates with fewer procedural requirements. Reported proportion of adults using unregulated financial services was as high as 60 percent compared to 33 percent in Myanmar and 21 percent in Nepal in 2014.8 29. However, the financial sector still faces challenges. Part of the banking sector, including some state-owned commercial banks (SOCBs) and some private banks, have capital to asset ratio lower than the minimum regulatory level of 8 percent. In response, the authorities recently announced plans to restructure two SOCBs. Also, the largest commercial bank, BCEL was recently 8 UNCDF Making Access Possible Program. http://map.uncdf.org/lao-peoples-democratic-republic 29 Lao PDR Economic Monitor December 2017 recapitalized; though, additional resources may be required. Nonperforming loans (NPLs) have been edging upward, with some concerns that the official figure of around 3.3 percent understates the actual NPLs, including due to a recent regulation that loans related to public investment projects should not be treated as NPLs. While the extent of NPLs due to arrears on government projects is unclear, the authorities recently authorized issuance of LAK3,250 billion in 10-year bonds to settle these liabilities.9 In general, the profitability indicators for the sector are low. Data from commercial bank financial reports show that half a dozen of banks made losses in the year up to the third quarter of 2017 with only 5 banks having return on assets of around 2 percent and above. 30. In response, the BOL is in the process of improving the regulatory and supervisory framework. There is a commitment to move to risk-based supervision. The Laws on the Bank of Lao PDR and Commercial Banks are being revised which is a good opportunity to take into account good international practices, including on management of BOL, relations with market participants including the Government, ability to regulate banks etc. There has been progress on the developing a payment system with the Automated Clearing House, a cost-efficient payment system, expected to be introduced during 2018. Reflecting anti-money laundering effort during 2017, Lao PDR was delisted from the grey list and in the process of preparing a national risks assessment. 9To qualify, the projects should be on-budget, approved by the National Assembly; certified to be fully completed; and pre-financed by loans from commercial banks certified by the commercial banks and BOL. 30 Lao PDR Economic Monitor December 2017 Outlook The medium-term outlook remains broadly favorable, but not without risks 31. Growth in 2018 is projected to further ease at 6.6 percent before picking slightly in 2019-2020. Growth is projected to further decelerate next year as current trends continue. This could be indicative of declining potential growth in Lao PDR (The World Bank Group, forthcoming) reflecting limitations of growth driven by natural resource and public spending. Still, additional capacity that is expected to be installed in power sector as well as greater focus on improving the business environment is expected to boost the in the medium term. Growth will continue to be driven by the power sector, while greater ASEAN integration opens opportunities, especially in agriculture, tourism, retail trade as well as some manufacturing as part of regional value chain. These sectors have significant potential to create jobs and lower poverty further. The power sector will continue to expand with the installed capacity expected to reach about 11,000MW by 2021. A few large projects are expected to come on stream, including Xepian- Xenamnoi (410 MW, commissioning date (COD): 2019), Nam Ngiep 1 (270 MW, COD in 2019), Don Sahong (260MW, COD: 2019) and Xayabury power project (1,287MW, COD in 2019). The contribution from mining is expected to gradually decline as the current investments mature while the moratorium currently in place limits investments in new deposits. The slowdown also reflects potential impact of recent decisions to limit the land allocations for agriculture plantations, which appear to have had an important impact in commercializing production and increasing exports. 32. In the near-term, commodity prices outlook provides mixed implications for Lao PDR. Oil prices are projected to gradually recover to US$60/barrel in 2019-2020 from around US$43/barrel in 2016. While the increase can lift the import bills and domestic fuel inflation, it will also boost Government revenues. Prices for agriculture products including rice, maize, rubber are expected to grow slowly which can provide favorable prospect for the agriculture sector. However, reversal of this trend, natural disasters and weather shocks could be one of the key downside risks. Figure 29: Outlook on key commodities generally look favorable (Index 2016=100) Crude oil, avg Maize 160 Coffee, Robusta 160 Rice, Thailand, 5% Bananas, US Sugar, World Rubber, Malaysian Copper Gold 140 140 120 120 100 100 80 80 2020 2021 2023 2025 2022 2024 2016 2019 2017 2018 2022 2024 2018 2016 2019 2021 2023 2025 2020 2017 Source: World Bank Commodity Markets Outlook, http://www.worldbank.org/en/research/commodity-markets 31 Lao PDR Economic Monitor December 2017 33. The medium term fiscal plan envisages a gradual reduction of the fiscal deficit helping to stabilize and eventually put public debt on a sustainable path by 2020. The revenue improvement is expected to come from planned increase in excise tax rates, strengthened revenue administration, improved tax-payer services and the launch of modern revenue management information system. The authorities, with support from development partners, recently completed a tax policy review and are finalizing a plan for tax administration improvement. Building on these efforts, during 2018, the authorities plan to revise the Law on VAT and the Tax Law, and adopt new law on Income Taxation and on Excises. At the same time, spending growth will be controlled through continued strong control over the wage bill and public recruitment (intake of new staff is further reduced to 3,000 in 2018), cancelation of some public investment projects as well as cuts on non-essential spending. 34. However, the fiscal plan for 2018 appears to propose, at best, a slower pace of deficit reduction. The revenues, while revised downward compared to estimates from the October 2016 revision of the 5-year plan, remain optimistic. This was only partially offset through cuts in spending, resulting in a significantly slower reduction of the deficit than initially planned with the 5-year medium term fiscal plan. Downside risks to this outlook include weaker oil and metal prices that will also affect revenue collection. Public debt level is expected to remain high in coming years, continuing to pose a high risk to fiscal sustainability. 35. The external deficit is expected to widen in 2018 reflecting the large import content of the infrastructure projects, including the railway, and higher oil prices. The current account deficit is projected to enter a declining trend after 2018, as the power generation capacity comes on stream and increases exports, while manufacturing exports continue to grow. Gradual recovery of agriculture commodity and metal prices will support export earnings. The current account will continue to be financed by FDI and external borrowing, the latter increasingly on less concessional terms. 36. Major changes in monetary and exchange rate policies are unlikely. The authorities will continue to manage the exchange rate within the +/- 5 percent band; using the full band should provide the authorities with greater flexibility and lower pressures to intervene in the market to stabilize kip. The authorities project credit growth of up to 20 percent, also in response to planned policies to increase lending to small and medium size enterprises (SMEs) as well as further adjustments in the interest rates that would stimulate credit demand. Given recent trends in lending and weakening loan-portfolio, credit growth could be lower. 37. Inflation is expected to pick up but remain in low single digit area. Further fiscal consolidation, low pressure over income, moderate credit growth and gradual recovery in commodity prices are target of less than 5 percent. 38. Risks to this outlook are mainly tilted towards the downside. Steeper than expected adjustment in China or a reversal in recent trends in Thailand could depress demand for Lao 32 Lao PDR Economic Monitor December 2017 exports and put pressure on reserves and macroeconomic stability. Similarly, greater global financial and exchange rate disturbances could undermine capital inflows to Lao (bonds for public and private sector financing, loans etc.) with negative implications for growth and stability. The rapid expansion of power sector in Lao PDR resulted in buildup of significant liabilities which could threaten its sustainability. The thematic section discusses the opportunities and risks in the power sector development. On the other hand, the authorities have recently shown greater commitment to improving the business environment and facilitating private sector development. Genuine efforts in this direction could unlock opportunities for Lao PDR and boost growth. The recently proposed increase in minimum wages if not coupled with productivity improvement can hurt the competitiveness of the nascent manufacturing sector. 33 Lao PDR Economic Monitor December 2017 Policy Considerations Addressing risks to macroeconomic vulnerabilities is a key priority 39. Staying the course on the fiscal consolidation plan and fiscal discipline remains a priority. The preliminary 2018 Budget appears to indicate a slower pace of fiscal consolidation. In addition, given the relatively ambitious revenue target and not-fully clear treatment of arrears settlement, the Budget deficit could easily increase in 2018. Careful monitoring and adjustment is required, It would be important that any slippages in revenue collection are addressed through controlling public spending and improving spending efficiency in order to keep the deficit and public debt contained. Controlling spending growth should continue to focus on curbing non- essential spending, foreign loan financed public investment as well as strengthening the project selection processes. 40. On debt management, given the elevated debt and growing reliance on market-based financing, continued efforts on strengthening public debt management is equally important . As the adoption of the draft Public Debt Management Law has been delayed to 2018, it is essential to take this opportunity to prepare the necessary secondary regulations and institutional setup to properly support its implementation. The Law aims to strengthen public debt management through a stronger and more accountable Ministry of Finance and provides a legal basis for the formulation of the medium-term debt management strategy, on which discussion has just started. Institutional reorganization within the Ministry of Finance (domestic and external debt management are to be integrated into one department), which is now taking place will also support such reform. 41. Advancing reforms in the financial sector can reduce risks. It is important to ensure that the planned restructuring of the weaker SOCBs is done in line with good practices and that measures are taken to deal with identified weaknesses in the sector. As the authorities are revising the legal framework, such as the Laws on the Bank of Lao PDR and Commercial Banks, it is a good opportunity to consider good practices, including on the management of the BOL, relations with market participants including the Government, supervision authority, etc. Achieving more sustainable and stable growth will require a genuine and vibrant private sector 42. Boosting growth outside of the resource sector will need improvement in business environment. Tourism is a sector with significant potential for Lao PDR. After the downturn in tourism sector for the past two years, the Government announced the Lao tourism year in 2018 with promotional plans for cultural, historical and natural tourism activities across the 18 province needed to support its long-term development. Importantly, in addition to sector-specific interventions, at the broader level, promoting broad-base economic activities will require improvements in the general business environment. The ranking for Lao PDR in 2018 Doing Business report dropped to 141 in 2018 ranking from 139 in 2017. The most lagging indicators are 34 Lao PDR Economic Monitor December 2017 starting a business (from rank 160 in 2017 to 164 in 2018 report), getting electricity (from 155 last year to 149), protecting minority investors (from 165 to 172), paying taxes (from 146 to 156), trading across border (120 to 124) and resolving insolvency (from 169 to 168) (Figure 29, 30). 43. In addition, the recent Enterprise Survey showed that informality is one of the top constraints for businesses. Informality involves unevenly enforced regulations and inadequate business registration to avoid costs and complexity of the formal system, tax evasion, and a culture of non-compliance10 or bypassing the regulations. Therefore, reforms to provide level playing fields to businesses, simplifying processes for starting and doing a business in Lao PDR as well as investing in human capital can better stimulate private sector growth, which is also important for improving the fiscal performance and provides an opportunity to accelerate fiscal consolidation plan. Figure 30: Lao PDR lags in several areas of Doing Business Source: Doing Business 2018, http://www.doingbusiness.org/data/exploreeconomies/lao-pdr Figure 31: Starting a business in Lao PDR is still behind the regional average Source: Doing Business 2018, http://www.doingbusiness.org/data/exploreeconomies/lao-pdr 10 . 35 Lao PDR Economic Monitor December 2017 Table 2. Key Macroeconomic Indicators and Projections 2016 2017 2018 2019 2015 Est. Proj. Proj. Proj. Real Economy Annual percentage change, unless otherwise indicated Real GDP 7.4 7.0 6.7 6.6 6.9 GNI per capita, US$ (nominal) 2,000 2,150 .. .. .. GDP deflator 2.3 3.0 1.4 2.8 2.8 CPI (average) 1.3 1.6 1.0 3.0 3.0 Fiscal Accounts Percent of GDP Revenues 19.8 16.4 15.9 16.6 17.2 Expenditures 24.2 20.9 20.3 20.7 20.7 General Government Balance -4.4 -4.5 -4.4 -4.3 -3.5 General Government Total Debt 59.2 58.7 59.5 59.0 58.3 Selected Monetary Indicators Percent of GDP, unless otherwise indicated M2 ( % of GDP) 51.2 51.5 54.7 57.4 60.0 Domestic Credit to the economy 46.7 51.2 55.5 60.5 65.5 ( % of GDP) Domestic Credit to the economy (% y/y) 16.8 20.9 17.2 19.6 19.0 Balance of Payments Percent of GDP, unless otherwise indicated Current Account Balance -16.2 -13.2 -13.0 -15.8 -15.4 Merchandise exports 29 27 27 27 28 Merchandise imports 46 41 39 42 41 Services, net 3.4 3.1 1.9 1.5 1.0 Gross Reserves (in US$ million, eop) 987 815 986 1,134 1,299 In months of imports 2.2 1.6 1.8 1.8 1.9 Exchange Rate, USD (average) 8,117 8,198 8,280 Other memo items GDP (nominal, billion Kip) 117 129 140 153 169 GDP nominal in US$ billion 14.5 15.9 16.9 18.3 20.0 Note: The ratios to GDP are based on the rebased GDP to 2012 which was recently released by the Lao Statistics Bureau. The fiscal deficit for 2018 approved by the National Assembly is 4.9 percent of GDP. 36 Lao PDR Economic Monitor December 2017 Part II: Lao PDR power sector: grow without sorrow Summary Lao decades; its influence over the future can be equally dramatic. The sector expanded robustly as investors exploited the ample hydro potential, and more recently thermal while also exploring other sources of energy. The expansion boosted growth and poverty reduction through investments, provision of reliable, clean, and affordable energy, higher exports, and government revenues. The remaining potential in the sector is significant; however, so are the risks. This note focuses on the achievements as well as the financial risks. The expansion has saddled the public sector with significant debt and contingent liabilities. Strengthening the sustainability prospects of the sector will require strengthened project selection and scaling back planned investments, securing well-paying markets for rapidly growing electricity generation as well as improving the commercial operations, organizational and ownership structure of the public utilities. The power sector has fueled investment and growth 1. milestone in Lao PDR development. A decade after it was introduced, the planned socialist economy model came under strain in the mid-1980s. Growth averaged a respectable 5 percent during 1975 1986, but it was accompanied with high current account and fiscal deficits and inflation rates prompting the launch of early market-oriented reforms. The supply response was robust and a limited structural transformation was initiated. Output expanded on average by 6.3 percent per year during the 1990s. Importantly, the second half of the 1990s also saw the launch Box 2: Power sector potential Hydro The annual water discharge is around 270 333 billion m3, representing a hydropower potential of up to 25,000 MW. Of the total capacity, about 18,000MW is technically exploitable, with 12,500MW found in the major Mekong sub-basins (Source: Ministry of Energy and Mines). The 1,700 km of the Mekong River flowing through Lao PDR is also the second-most-diverse watershed in the world in fish biodiversity. Thermal Hongsa Lignite (1,878MW installed capacity) commenced operation in 2016 and is the biggest thermal power plant; few smaller ones operate mostly connected to local industries. There are plans to develop additional thermal capacity utilizing domestic and imported coal. These plants will provide additional baseload power and generate export revenues; however, there are concerns on new coal fired plants which use inefficient sub-critical technology burning low calorific value coal with serious environment impacts. Bioenergy Traditionally, wood and charcoal are being used for cooking and heating in rural areas. Commercial use of biomass for electricity generation is limited to couple of facilities using sugarcane and corn with a total installed capacity of around 40MW. Given substantial amount of waste from agriculture and forestry and the potential to cultivate energy crops, there are opportunities to scale up bioenergy generation. 37 Lao PDR Economic Monitor December 2017 Wind and Solar have been undertaken of the wind potential and a more comprehensive measurement campaign is under way for both wind and solar. The prospects for solar appear more favorable given good solar power given the seasonality in water flows. Still, a more robust legal or regulatory framework is needed to promote development non-hydropower renewable energy. 1. By mid-2000s, the power sector became a major source of growth as investors began to tap into the ample potential to meet the demand from the fast-growing region. The construction of the Nam Theun 2 (NT2) power plant (project cost of US$1.2 billion, or around 25 percent of annual GDP in the construction period, and installed capacity of 1,070MW) signaled the start of rapid development of the sector. Investment in the sector surged from US$183 million in 2005 to above US$2 billion by 2015 with the sector accounting for 36 percent of all approved investments between 2010 and 2015. Installed capacity increased from less than 700MW in 2005 to around 6,400MW in 2016 and this could reach 11,000MW by 2021. Electricity exports account for a growing share of Lao P with Lao PDR recently entering the list of top ten per capita exporters of electricity. Figure 32: Power sector at a glance Installed capacity Power sector value added, (in MW) (percent of GDP) 12,000 10 Hydro 10,000 Thermal 8 8,000 Biomass Projected 6 6,000 4 4,000 2 2,000 - - 2012 2011 2013 2014 2010 2015 2016 2008 2005 2006 2009 2007 2021 2011 2015 2017 2013 2019 1998 1991 2000 2009 Source: 2016 Electricity Statistics and WB staff Source: Lao PDR Statistics Bureau estimates; Note: Projections include all energy sources Electricity exports to Thailand, Approved investments in power sector, (percent of total exports to three main partners) (percent of total approved investment) 25 40 35 20 30 25 Public 15 20 15 Private - domestic 10 10 5 Private - foreign 5 0 2010-15 2005-10 - 2010 2012 2011 2013 2014 2015 2016 2006 2007 2009 2008 2005 Source: Staff calculations based on data from Customs Source: Lao PDR Ministry of Planning and Investment departments of Thailand, Vietnam and China 38 Lao PDR Economic Monitor December 2017 2. The contribution to employment has been more modest. Given the capital-intensive nature of the sector, the sector generated few jobs directly (around 20,000 jobs in 2013 together with mining). Still, the construction of power plants contributed to the significant growth in the employment in the construction sector (almost 50 percent increase between 2003 and 2013 to 113,000 jobs), though anecdotal evidence suggests that a considerable share of the labor needs during construction has been met with foreign labor, mostly from neighboring countries. Reliable and affordable energy for people and businesses 3. The expansion of the power sector also supported an impressive electrification effort, improving livelihoods and supporting businesses. By end 2016, around 92 percent of the households were electrified (94 percent by mid-2017)11, up from 78.5 percent in 2011 and only 15 percent in 1995 and significantly above levels observed in Myanmar and Cambodia. In general, Lao PDR businesses rate the quality of electricity supply more favorably compared to neighboring countries as well as more advanced developing countries. Around half of companies experienced electrical outages in Lao PDR in 2016, down from almost 90 percent in 2012 and similar to the EAP region average. Furthermore, companies reported less than 1 outage per month, performing considerably better compared to the EAP region average of around 5 outages in a typical month. Both the average duration of the outages and the associated losses were lower in Lao PDR compared to the EAP average also reflected in a smaller share of firms that own generators. Lao PDR ranks 149 (out of 190 economies) on the 2018 Doing Business Getting Electricity indicator as relatively good performance on frequency and duration of outages as well as affordability of electricity is offset by burdensome and costly procedures required to obtain a permanent electricity connection. Figure 33: Access to electricity has increased (percent of population) Notes: 100 LDC: Least-developed countries, 1995 2014 change LMI: lower middle income, 80 MMR: Myanmar; KHM: Cambodia; 60 EAP: East Asia and Pacific (excluding high income) 40 Source: World Development Indicators 20 0 LAO LDC LMI MMR KHM EAP 11This translates into a smaller share of the total population as the remaining households without access to electricity tend to be in remote areas where household size is bigger. 39 Lao PDR Economic Monitor December 2017 Figure 34: Quality of electricity supply Notes: 5 Score on a scale from 1 to 7 with higher value denoting better performance. 4 KHM: Cambodia; 3 VNM: Vietnam KAZ: Kazakhstan PHL: Phillipines 2 BTS: Botswana 1 Source: World Economic Forum, Global Competitiveness Report 2017-18 0 LAO KHM VNM KAZ PHL BTS Figure 35: The power sector and the business environment Firms experiencing power outages Frequency of outages (percent of all firms) (Number of outages in a typical month) 100 12 80 10 8 60 6 40 4 20 2 0 0 2012 2016 2016 2015 2016 2012 2016 2016 2015 2016 LAO KHM VNM MMR EAP LAO KHM VNM MMR EAP Losses due to outages Firms owning generators (percent of annual sales) (percent of all firms) 4 60 50 3 40 2 30 20 1 10 0 0 2012 2016 2016 2015 2016 2012 2016 2016 2015 2016 LAO KHM VNM MMR EAP LAO KHM VNM MMR EAP Notes: KHM: Cambodia, VNM: Vietnam; MMR: Myanmar; EAP: East Asia and Pacific Source: World Bank Enterprises Surveys; available at www.enterprisesurveys.org 40 Lao PDR Economic Monitor December 2017 Contribution to the budget has been growing, but remains modest 4. While the financial flows in the power sector have been growing rapidly, its contribution to the Government Budget has been less commensurate contribution to fiscal revenues has been relatively small. Royalties reached around US$45 million in the last three completed fiscal years (FY2013/14 to FY2015/16), up Figure 36: Power sector royalties are growing slowly from around US$20 million in the (as percent of total fiscal revenues) earlier period. Information on the 2.5 collection of other revenues (taxes, 2.0 dividends, dividend tax, in-kind payments) is not easily available, but 1.5 rough estimates put total revenues at around US$100 million, or 0.6 1.0 percent of GDP and 4 percent of 0.5 government revenues, in 2016. Power sector projects usually 0.0 2012 2010 2011 2015 2013 2016 2014 2005 2006 2007 2008 2009 benefit from extended profit tax exemptions, low royalty rate and other incentives in the early years of Source: Staff calculations based on data from Lao PDR Ministry of their operations which is keeping the Finance effective tax rate relatively low. 5. Still, Government revenues from the power sector are expected to gradually increase going forward. Revenues are expected to double to around US$200 million by 2020 and reach around US$300 million by 2025. Revenues may grow faster afterwards as tax exemptions and incentives expire, and assets are transferred to Lao PDR ownership following the end of the build- operate-transfer (BOT) arrangements. Who is who in the power sector 6. Ministry of Energy and Mines (MEM) is the Government entity in charge of setting the strategy and developing policies for the power sector. It also engages with public and private sector companies in processing investment proposals, including technical designs, financial analysis, environmental assessment, negotiations etc. MEM oversees the work of all public enterprises in the power sector (see below) and monitors the performance of the private enterprises operating in the sector. 7. Electricite du Laos (EdL) is a public electric utility, 100 percent owned by the Government of Lao PDR. After having divested most of its generation capacity to EDL-GEN, it currently operates the transmission and distribution grids. By end 2016, it owned 8 plants with an installed capacity of just 3MW and owns the transmission network (except for dedicated transmission lines built by investors operating power plants that export directly to neighboring countries) as well as the distribution network. However, EdL still invests in new generation projects and takes on project debt on behalf of EDL-GEN. 41 Lao PDR Economic Monitor December 2017 8. EDL Generation Public Company (EDL-GEN) was established in late 2010 as spin off (subsidiary) of EdL. EDL-GEN was publicly listed in the Lao Stock Exchange in early 2011. EdL has a 75 percent equity stake, with the remaining 25 percent held by domestic and foreign private entities12. It is increasingly taking over the generation capacities from EdL through agreements for transfer of assets and liabilities agreements with EdL, financed through issuance of bonds (as of mid-2017 around $500 million) as well as loans (around US$580 million as of mid-2017). By end- 2016, it owned 10 power plants with installed capacity of 619MW. It also has equity stakes of 20 percent 60 percent in power plants developed by private investors (around 10 plants with total installed capacity of 2,300MW with EDL-GEN accounting for around 635MW). 9. The Lao Holding State Enterprise (LHSE) is a 100 percent government owned entity which manages government investment in power projects dedicated for exports. So far, Nam Theun 2 (1,070MW with LHSE holding 25 percent stake) and Hongsa (1,878MW with LHSE holding 20 percent stake) are in operation with LHSE accounting for 644MW. Two large projects are expected to come on stream within the next 3-4 years: Xe Pian Xe Nam Noy (410MW with LHSE holding a 24 percent share) and Nam Ngiep 1 (290MW with LHSE holding 25 percent stake). 10. A wide range of investors are involved in the Lao PDR power sector. With limited public financing, Lao PDR encouraged foreign participation in the sector, largely through build-operate- transfer (BOT) arrangements with concession periods of around 30 years. While most of the development costs are borne by private investor, public enterprises (EDL, EDL-GEN or LHSE) do own equity stakes in a number of these projects (see above). Thai investors account for around energy mix, and difficulties to build new electricity infrastructure domestically. Chinese companies, supported by near- Bank, are rapidly gaining share and account for around 13 percent of the installed capacity, up from 7 percent in 2014. European investors, who accounted for 22 percent of installed capacity in 2014, have seen their share drop to 9 percent -8 percent of installed capacity) with few plants that appear to have faced some delays. The producers can be classified in three broad groups: • Independent Power Producer (IPP) dedicated for export. These are typically large power plants where most of the generated power is exported, in most cases with the Electricity Generation Authority of Thailand (EGAT) as the main off-taker. Long-term Power Purchase Agreements (PPA) with EGAT, a financially creditworthy electric utility, have allowed developers access to long-term affordable financing. Five entities (installed capacity 4,200MW) produced an estimated 19,000GWh in 2016, out of which 18,300GWh were exported via dedicated transmission lines to Thailand generating revenues of US$960 million. One more producer has a connection to Vietnam. Around 5 10 percent of generated electricity from these IPPs is delivered to the Lao national power grid. Going 12The second largest entity is a Thai company holding 5.65% of shares, followed by a Singapore-based entity with 4.49% of shares. BCEL, a Lao state-owned commercial bank holds 2.28% of shares and Krung Thai Bank has 1.54% of shares. The other investors have less than 1% each. According to company reports available at www.edlgen.com.la. 42 Lao PDR Economic Monitor December 2017 forward, by 2020 it is expected that an additional 2,500MW will come on stream in IPPs dedicated to export. • IPPs supplying the domestic market. This segment accounts for a growing share of o better manage the power sector and position EdL in negotiations with foreign electricity markets. Also, smaller power plants are not conducive for direct export arrangements making it more efficient to connect these to the national grid where EdL is the off-taker. In 2016, these producers delivered an estimated 3,300GWh to EdL, up from around 900GWh in 2013. Generation from these the years ahead. • Small Power Producer (SPPs) refer to power plants with installed capacity of up to 15MW. SPPs sold 181GWh to EdL in 2016, more than a fourfold increase compared to 2013 (47GWh). With almost two dozen of new SPPs expected to come on stream until 2020, electricity generation from these producers is expected to exceed 1,000GWh by 2020. 11. Imports have been declining as the country has been able to meet an increasing share of its consumption. While around two-thirds of the installed capacity is exported, the fragmentation of the transmission system, the seasonality of hydropower production as well as rapid demand growth keeps Lao PDR reliant on power imports; though these are expected to decline going forward. Imports accounted for 17 percent of domestic consumption in 2016 compared to around 30-40 percent during most of the previous decade. Table 3: Electricity generation, consumption and trade (In GWh) Generation 25,066 Domestic Consumption 4,660 EdL 13 Exports 19,869 EDLGEN 2,629 EdL 1,538 IPP EGAT off-take 18,331 IPP EGAT off-take 18,331 IPP EdL off-take 3,912 Other 1,330 SPP 181 Imports 793 Supply 25,859 Use 25,859 Note: Other includes losses. Source: Staff estimates based on Lao Statistic Bureau (total generation) and EdL 2016 Electricity Statistics 12. The transmission and distribution grid has expanded. The length of the transmission grid (35kV voltage and above) more than doubled over a period of just five years between 2011 and 2015. Similar improvements were made to the distribution network which facilitated the strong improvement in electrification rate and the relatively favorable assessment of the quality of electricity supply. 13. However, remaining weaknesses in transmission and distribution make Lao PDR reliant on imports and prevent the country from fully exploiting its export potential. Further effective integration of the national transmission grid is needed to connect parts of the country with surplus power to areas where supply is insufficient. Also, the capacity to move electricity to 43 Lao PDR Economic Monitor December 2017 external markets is constrained by the limited availability of higher-voltage transmission lines. There is one 500kV transmission line to Thailand, two 230kV lines and six 115kV lines, most of which are owned and operated by the IPPs dedicated for exports where EGAT is the off-taker and a 230KV line dedicated to Vietnam. There is one 110kV line to China and additional smaller voltage (10-35kV) connections to Thailand, Vietnam and China which are insufficient to accommodate significant electricity flows. On the distribution side, the electrification rate increased from 15 percent of households in 1995 to 92 percent of households in 2016; though the remaining unserved areas are remote and difficult to reach. Power sector finances 14. EdL made payments of US$340 million in 2015 for purchases of electricity from EDL - GEN, IPPs, SPPs as well as from imports. Preliminary estimates suggest that purchases may have reached to above US$420 million in 2016. This translates into average cost of supply of around 5.7 US$ cents/kWh. The price has been edging upward slightly over the last few years due to growing purchases from IPPs and SPPs with higher negotiated tariffs. • Staff calculations based on EDL-GEN financial statements suggest that EdL paid around 5 US$ cents/kWh for its purchases of electricity from EDL-GEN until 2015 and increasing to around 5.6-5.7 US$ cents/kWh per the Government approved tariffs for 2012 2017. • The average prices for purchases from IPPs (where EdL is the off-taker) was around 5.3 US$ cents/kWh in 2016, up from below 5 US$ cents/kWh in the years before. Importantly, several newer projects appear to have power purchase agreements with prices closer to 6 US$ cents/kWh suggesting that the average price is likely to increase slightly going forward. • The average price for electricity purchased from SPPs was 6.7 US$ cents/kWh reflecting efforts by the authorities to stimulate the SPPs. SPPs account for a relatively small share number of SPPs come on stream. • The average prices of imported electricity was around 5.5 US$ cents/kWh in 2016, up from 5 US$ cents/kWh a year earlier, but varies from around 4 US$ cents/kWh to above 10 US$ cents/kWh depending on the supplier as well as the terms (scheduled vs unscheduled). 15. In 2015, EdL collected US$455 million from selling electricity domestically and for exports. The average selling price (from both exports and domestic sales) was around 7.6 US$ cents/kWh; additional revenues are collected from meter maintenance charges. • The average price for domestic sales was 8.8 US$ cents/kWh. Following relatively rapid upwards adjustments until 2013, domestic electricity prices have been trending upwards only very gradually in more recent years. A relatively complex tariff schedule provides for significant cross-subsidies among various consumption segments. Prices are lower for residential consumption with relatively low consumption levels (a household consuming 150kWh per month is paying 422 kips/kWh or 5.1 US$ cents/kWh), as well as for irrigation and industry. On the other hand, entertainment venues as well as international 44 Lao PDR Economic Monitor December 2017 organization pay significantly higher rates (more than 1,400 kips/kWh or 16.9 US$ cents/kWh). Also, as a general principle, prices are lower as voltage increases. • Average price for EdL exports was around 3.8 US$ cents/kWh in 2016. The relatively low export price is because most EdL export are treated as non-firm13 wholesale exports without guarantee of availability. 16. EDL-GEN had revenues of around US$150 million in 2016, largely from selling electricity to EdL. The revenues have been increasing reflecting higher volumes as well as adjustment in prices. The costs of sales were close to US$60 million, translating into average costs of around 2.3 US$ cents/kWh. Figure 37: Financial flows in the power sector (Approximate values, in US$ million) US$960mln Foreign off- IPPs takers (Off-take EGAT) US$25mln US$44mln US$60mln IPPs US$180mln (Off-take EdL) SPPs Lao consumers EdL US$12mln (Off-take EdL) US$400mln EDLGEN US$150mln (Off-take EdL) Source: Staff calculations based on EdL 2016 Electricity Statistics, EdL Annual Report, EDL GEN Financial statements and Thailand Customs Department data 17. Prices at which IPPs with dedicated exports to EGAT are selling the electricity are somewhat higher. These tariffs are, in general, not disclosed; however, information derived from foreign trade statistics suggests an average price of around 5.2 US$ cents/kWh. Growing risks 18. While bringing enormous benefits; the expansion of the power sector resulted in high debt and significant contingent liabilities which could undermine gains and EDL- levels have weakened the financial position of EdL which poses significant risks to the sustainable development of the sector, but also to the Budget and the overall macroeconomic stability. In fact, 13 45 Lao PDR Economic Monitor December 2017 borrowing to fund the expansion of EdL and EDL-GEN has been a significant contributor to public debt and the reclassification of Lao PDR to high risk of debt distress. 19. At the end of 2015, EdL debt liabilities were close to US$3 billion, most of which in the form of government debt on-lent to EdL. Debt accumulation has been very rapid with debt more than doubling over a period of only two years between 2013 and 2015. The debt/equity ratio14 at the end of 2015 reached 2.8, up from 1.6 in 2013. A generally accepted debt/equity ratio for utilities in the gas and electricity sector is around 1-1.5. Consequently, debt servicing costs (interest expenses and principal amortization) are rising rapidly reaching 30% of revenues in 2015 (compared to 20% in 2013). Despite this, significant amounts of new loans were signed during 2016 while an equally ambitious expansion plan is being proposed for the years ahead. 20. EDL- Figure 38: Debt levels have been increasing, better, though debt levels are increasing especially so in the case of EdL fast. At the end of June 2017, EDL-GEN debt Debt / equity ratio 3 liabilities were close to US$1.1 billion, largely EdL raised at market terms through bonds EDL GEN 2 issuance and loans (domestically and abroad).15 This puts EDL- 1 ratio at almost 1 in mid-2017, compared to 0.16 in 2013. While not part of public debt, - 2013 2014 2015 2016 mid-2017 EDL-GEN exposes the Budget to risks. Source: Staff calculations based on 2014 and 2015 audited EdL Annual Reports and EDL GEN Reports 2011-2017 21. Significant additional risks come from contingent liabilities from Power Purchase Agreements with domestic IPPs and SPPs. Power generation may be growing faster than the - or- tracts without seasonal or peak/off-peak differentiation which will contractually bind EdL to purchase the generated electricity even if it does not need the power. It is estimated that electric energy available/contractually required to be purchased by EdL would almost double from around 11,000GWh (2017) to over 21,000GWh by 2020, and approach 30,000GWh by 2025. Most of the incremental energy is expected from domestic private power producers. Unless EdL can secure markets for this energy, and importantly at above cost prices, the impact over EdL finances is likely to be severe. 14 Staff estimates based on unaudited statements from 2015 EdL Annual Report. Debt includes long-term borrowing, current portion of long-term borrowing and debentures. 15 Some of EDL-GEN debt is also recorded as EdL debt. Part of the government strategy is to transfer generation assets from EdL to EDL-GEN. Together with the assets, the responsibility to service the associated liabilities is also transferred to EDL-GEN. 46 Lao PDR Economic Monitor December 2017 22. Finally, the commercial orientation of the power sector utilities can be improved . In general, indicators of profitability (Returns on Equity, Return on Assets) are low for both public percent of revenues in 2015 (up from 27 percent in 2013). For example, employment in the sector increased to above 6,000 at the end of 2016, almost doubling over a period of only five years (3,239 in 2011) and faster than the growth of revenues resulting in a continuous decline in revenues per worker. In addition, significant accounts receivable and payable reflects limited financial liquidity and suggests a need to improve financial management in the sector. Accounts receivable at EdL increased from 16.8 percent of sales in 2013 to 21.1 perncet of sales in 2015, indicative of weak payment discipline, though anecdotal evidence suggests that this appears to be concentrated among certain groups. Accounts receivable in EDL-GEN rose rapidly during 2016 and 2017; with EdL being the single buyer of EDL-GEN, this could be indicative of liquidity crunch. Recommendations 23. Prompt action is needed to ensure that the power sector remains a driver for economic development for Lao PDR. Under current trends, the financial performance of the public sector entities will continue to deteriorate and risks undermining the investment and growth prospects for the sector as well as creating a significant liability for the Government Budget. The following recommendations could help: • Strengthen the project selection process to ensure that only economically viable, fiscally sustainable and environmentally justifiable projects are selected . This should be undertaken as part of a robust integrated power sector planning exercise. In general, non-critical investments should be postponed. The proposed stronger selectivity of projects will lead to fewer investments but with higher economic and social returns, will better match the growth in installed capacity with infrastructure improvements and demand and with a noticeably smaller footprint over land and water use. This will slow down the expansion of the balance sheet of EdL and EDL-GEN, reduce debt financing and lower their investment costs. • Improve the commercial orientation of the power sector, including stronger financi al management arrangements and adopting cost-reflective tariffs. Measures to control costs, such as stronger procurement, better payment discipline and limiting intake of new staff can help the power sector utilities. Importantly, the new domestic electricity tariffs, scheduled to become effective in 2018, will be an important opportunity to minimize untargeted subsidies to customers and reflect the full cost of supply, including generation, transmission and distribution. Any subsidies should be identified and budgeted for. • Re-designing the PPAs with IPPs where EdL is the off-taker. EdL should explore options with IPPs for mutually acceptable revisions to the PPAs to lower the costs and liabilities of EdL. More generally, direct project negotiation for new projects can be replaced by a more systematic and competitive process where potential developers bid on key aspects of the PPA (tariff, partial revenue assurance). 47 Lao PDR Economic Monitor December 2017 • Secure markets for rapidly growing power generation capacity. The slower-than- expected domestic growth and demand from Thailand as well as the gaps in the institutional and physical infrastructure to facilitate efficient cross-border power exchanges will make this more challenging. Furthermore, the prolonged period of low oil and gas prices enviro countries in the region are potential markets for Lao PDR. A recently signed agreement will see 100MW of power exported to Malaysia in 2018, potentially 1 GW to Vietnam by 2020 and discussion are ongoing to open up Myanmar market. Export to China is technically feasible but unclear if economically viable due to the large capacity surpluses in the Southern China grid. • Explore economical and non-debt creating ways of completing the infrastructure gap. To optimize benefits in an environment of growing number of smaller- and medium-size hydropower plants and growing surplus electricity, Lao PDR needs a new strategy for system-to-system transactions and efficient integration of the domestic power grid. However, the proposed plans for expansion of the transmission and distribution grids the public sector. Several transmission projects appear viable and could attract private sector investment on Build-Operate-Transfer (BOT) basis. • Attract additional resources in the sector. The overall fiscal position is likely to remain challenging going forward and may prevent the Government from providing additional equity to the sector. Still, new external equity (such as through a capital increase of EDL- GEN) can be attracted while still preserving a majority share for the Government. Also, EDL-GEN may consider spinning off some generation projects. And, it is worthwhile to review the option of separating the electricity transmission function, to create financial flexibility outside of EDL Group and attract private investment in transmission network. 48 Lao PDR Economic Monitor December 2017 References Electricite du Laos (EDL) annual statistics report and the annual reports. http://edl.com.la/ EDL Generation Public Company Annual reports, https://www.edlgen.com.la/index.php?lang=en IMF-WB. 2017. Debt Sustainability Analysis Lao Statistics Bureau, www.lsb.gov.la Ministry of Information, Culture and Tourism. 2016. UNCDF. 2017. http://map.uncdf.org/lao-peoples-democratic-republic World Bank Enterprise Surveys, http://www.enterprisesurveys.org/ World Bank Group. 2016. EAP Economic Update: Reducing Vulnerabilities. World Bank. Washington DC. World Bank Group. 2017. EAP Economic Update: Balancing Act. Washington DC. World Bank. World Development Indicator Database. available at: http://data.worldbank.org/data-catalog/world-development-indicators and http://data.worldbank.org/country/lao-pdr. World Bank Group. 2017. Formal informality: informal practices of formal firms as a key business constraint. http://documents.worldbank.org/curated/en/979281509632059588/Formal- informality-informal-practices-of-formal-firms-as-a-key-business-constraint World Economic Forum. 2017. https://www.weforum.org/reports/the- travel-tourism-competitiveness-report-2017 The World Bank Group. (forthcoming). January 2018, Global Economic Prospects; Broad-based upturn: Will it last? Washington, D.C.: The World Bank Group. 49