Report and Recommendation of the President - Asian Development Bank · 2014-09-29 · Report and Recommendation of the President to the Board of Directors Sri Lanka Project Number:

Report and Recommendation of the President to the Board of Directors

Sri Lanka Project Number: 35304-04 September 2009

Proposed Asian Development Fund Grant for Subprogram 2 Lao People’s Democratic Republic: Private Sector and Small and Medium-Sized Enterprises Development Program

CURRENCY EQUIVALENTS (as of 31 August 2009)

Currency Unit – kip (KN)

KN1.00 = $0.000117 $1.00 = KN8,520.50

ABBREVIATIONS

ADB – Asian Development Bank AFTA – ASEAN Free Trade Area ASEAN – Association of Southeast Asian Nations AusAID – Australian Agency for International Development BOL – Bank of the Lao PDR BSRP – Banking Sector Reform Program CAR – capital asset ratio CBTA – cross-border transit agreement CEPT – common effective preferential tariff CIB – Credit Information Bureau CSP – country strategy and program EA – executing agency EC – European Commission ERO – enterprise registry office ERP – effective rate of protection FDI – foreign direct investment GDP – gross domestic product GMS – Greater Mekong Subregion IA – implementing agency IFC – International Finance Corporation IMF – International Monetary Fund JICA – Japan International Cooperation Agency Lao PDR – Lao People’s Democratic Republic MDG – Millennium Development Goal MOF – Ministry of Finance MOIC – Ministry of Industry and Commerce MPI – Ministry of Planning and Investment NPL – nonperforming loan NSC – National Statistics Center P3D – provincial public–private dialogue PMO – Prime Minister’s Office PPPD – provincial public–private dialogue PSME – Private Sector and SME Development Program RFSDP – Rural Finance Sector Development Program RIA – regulatory impact assessment SEDP – Socio-Economic Development Plan SMEPDO – SME Promotion and Development Office SMEs – small and medium-sized enterprises SOCB – state-owned commercial bank SOE – state-owned enterprise SPS – sanitary and phyto-sanitary standards TA – technical assistance

TBT – technical barrier to trade UNIDO – United Nations Industrial Development Organization VAT – value-added tax WTO – World Trade Organization

NOTES

(i) The fiscal year (FY) of the Government and its agencies ends on 30 September.

(ii) In this report, "$" refers to US dollars.

Vice-President C. Lawrence Greenwood Jr., Operations 2 Director General A. Thapan, Southeast Asia Department (SERD) Country Director G. Kim, Lao PDR Resident Mission Director J. Ahmed, Financial Sector, Public Management and Trade Division,

SERD Team leader K. Bird, Senior Economist, SERD Team members E. Dizon, Administrative Assistant, SERD T. Hla, Economist, SERD S. Ismail, Young Professional (Financial Sector), SERD R. O’Sullivan, Senior Counsel, Office of the General Counsel

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS

Page GRANT AND PROGRAM SUMMARY i

I. THE PROPOSAL 1 II. THE MACROECONOMIC CONTEXT 1

A. The Global Financial Crisis 1 B. The Government's Development Strategy 1 C. The Government and its Development Partners 2

III. THE SECTOR 5 A. Recent Economic Developments and the Impacts of the Global Financial Crisis 5 B. Issues and Opportunities 9 C. Lessons 19

IV. THE PROPOSED PROGRAM 20 A. Impact and Outcome 20 B. Policy Framework and Actions 20 C. Financing Plan 26 D. Implementation Arrangements 27

V. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 30 A. Expected Impacts 30 B. Risks and Mitigating Measures 30

VI. ASSURANCES 31

VII. RECOMMENDATION 31

APPENDIXES 1. Design and Monitoring Framework 32 2. Development Policy Letter 35 3. Policy Matrix for Subprogram 2, Post-Program Monitoring Framework, and Medium-Term Direction 39 4. Development Partners' Coordination Matrix 43 5. Macroeconomic Assessment and Debt Sustainability Assessment 44 6. Private Sector Development Assessment 52 7. Poverty Impact Assessment 61 8. List of Ineligible Items 63 9. Summary Poverty Reduction and Social Strategy 64 10. Performance of Private Sector and SME Development Program Subprogram 2 Triggers 66

GRANT AND PROGRAM SUMMARY Recipient Lao People’s Democratic Republic (Lao PDR) The Proposal A grant of $15,000,000 is proposed for subprogram 2 of the Private

Sector and Small and Medium-Sized Enterprises Development Program (PSME)—the second grant of a program cluster to build on support initiated under subprogram 1, approved by the Asian Development Bank (ADB) in September 2007. Subprogram 2 is to be provided as a single tranche, based on completed prior actions demonstrating satisfactory progress.

Classification Targeting Classification: General intervention

Sector (subsector): Public sector management (economic and public affairs management Themes (subthemes): Private sector development (policy reforms), governance (economic and financial governance), economic growth (promoting macroeconomic stability) Location impact: National (low impact)

Environment Assessment

Category C

The Program Rationale

The core objective of the Government’s Sixth National Socio-Economic Development Plan (SEDP6) 2006–2010 is sustaining high rates of economic growth (about 7%–8% per annum) with poverty reduction. The SEDP6 targets a poverty incidence rate of 23% by 2015 as well as the creation of 652,000 productive jobs from 2006 to 2010. Private sector expansion is considered a key mechanism for achieving these objectives. Poverty rates have declined in the Lao PDR in the past two decades from 46% in 1992 to 33% in 2003, and estimated at 28% in 2008. This reduction has been remarkable, considering the rapid population growth during this period—with as much as 50% of the population now under the age of 20 years. It has been driven by economic expansion, opening up the economy to trade and investment, an increase in rice production, greater urbanization, and an increase in remittances from Laotian workers abroad. It is common to see a sharp reduction in poverty once a country passes a per capita income threshold, as Lao PDR has done. Achieving a further reduction in the poverty rate, of a similar magnitude as the SEDP6 target, will depend on sustaining economic growth at the current rate of 7% per annum over the medium term and mobilizing additional fiscal resources to support long-term development and social spending objectives. The Lao PDR has the potential to accomplish these goals and the private sector will be increasingly relied on to accomplish them.

The ADB country strategy and program (CSP) for 2007–2011 identifies private sector development as a key priority. It has set expansion of formal private sector firms by 15% per annum as an outcome indicator for private sector development. Small and medium-sized enterprises (SMEs) are the overwhelmingly dominant business form in the

ii

Lao PDR, and sound policy suggests that SMEs should be treated as the private sector norm and not the exception. This suggests that the reform agenda should be broad-based, focusing on reducing the transaction costs of doing business and improving predictability in the investment climate. Reforms supporting institutional development in SME policy formulation, access to finance, strengthening the investment climate, and completing the unfinished trade policy regime are crucially important for reducing transaction costs and expanding the private sector, putting economic growth on a more sustainable path, and contributing to poverty reduction.

These measures are taking place in the context of a collapse in commodity prices and severe recession in major export markets. While much of the Government’s current focus is on addressing exigencies arising from the crisis and related fiscal situation, it sees the crisis as an opportunity to build consensus among stakeholders on difficult policy reform issues and to advance its medium-term objectives related to private sector/SME development—recognizing that these reforms are fundamental to supporting higher economic growth rates, lessening reliance on the resource sector for income creation, and reducing unemployment and poverty reduction.

Under subprogram 1, the Government implemented a series of reform measures to the investment climate aimed at reducing the cost of doing business in the Lao PDR. These included the enactment of the Law on Enterprises of 2006, and commencing its implementation, as well as measures aimed at chipping away at its import and export management system. The Government is also committed to preparing for World Trade Organization (WTO) accession talks; this process is influencing the way the Lao PDR views its business climate and trade policy over the medium term. Subprogram 2 builds on reforms initiated under subprogram 1, with the core focus on implementing the enterprise law, including the establishment of the enterprise registry offices, starting a process for regulatory reform, advancing trade policy reforms, and enhancing capacity and staff training on trade policy formulation. These reforms are designed to accomplish: (i) improve institutional coordination in SME policy formulation and better access to finance,(ii) strengthen investment climate, and (iii) improve trade policy and capacity development. In response to the global economic crisis, a post-program monitoring framework is added at the subprogram 2 phase. The Government and ADB have agreed to a post-PSME framework in the next 12 months, creating the basis for continuous policy dialogue and engagement during the critical period of 2009–2010. The monitoring framework focuses on the Government’s short-term plan advancing its reforms in business climate, trade policy, and trade facilitation (a new component) supported by ADB and other development partners’ technical and program assistance. It may provide the basis for a second-generation PSME in the future.

iii

The reform program was prepared by a joint team of representatives of the Government and ADB.

Impact and Outcome

The impact of subprogram 2 of the PSME is to achieve sustainable economic growth in the non-resource sector, supported by increased contribution of the private sector and SMEs. The outcome of subprogram 2 is an improved business environment where the private sector and SMEs operate efficiently and effectively. The PSME includes a series of policy reforms that underpin the key priorities of the Lao PDR’s Sixth Socio-Economic Development Plan and its sector strategies. These reforms are designed to accomplish the following results.

(i) Improve institutional coordination for SME policy and access to finance by (a) strengthening the institutional framework for SME policy formulation; and (b) improving SME access to finance through improvements in accounting rules and guidelines and development of nonbank financial instruments.

(ii) Strengthen investment climate by (a) implementing the enterprise law, and (b) other policy reforms aimed at reducing transaction costs of doing business in the Lao PDR; and (c) more transparency in the regulatory environment affecting SMEs.

(iii) Improve trade policy and capacity development by (a) reforming the import–export management system including making measures more transparent and over the medium term, reforming the controlled list of imports; and (b) strengthening indigenous capacity to carry out trade policy analysis.

Financing Plan A grant of $15,000,000 from ADB’s Special Funds resources will be

provided for subprogram 2 of the PSME with terms and conditions set forth in the draft Grant Agreement.

Period and Tranching

The subprogram 2 period is from October 2007 to September 2009, with a single tranche grant of $15 million to be disbursed when the Government has met the conditions for grant effectiveness.

Counterpart Funds The Government will use the local currency counterpart funds

generated by the grant proceeds to meet program expenditures and associated costs of reform and to help maintain current levels of social expenditure.

Executing Agency Ministry of Industry and Commerce (MOIC). MOIC will be responsible

for coordinating the implementation and sustaining of PSME reform actions.

iv

Implementation Arrangements

The Bank of Lao PDR (BOL), Ministry of Finance (MOF) and the Ministry for Planning and Investment (MPI) are the Implementing Agencies (IAs). MOIC will establish a PSME steering committee, chaired by the minister of industry and commerce and comprising senior officials from BOL, MOF, and MPI. The committee will meet twice a year to monitor progress and oversee implementation of the PSME, and to provide guidance and direction to the Executing Agency (EA) and IAs.

Procurement The grant proceeds will be used to finance the full foreign exchange

costs (excluding local duties and taxes) of items produced and procured in ADB member countries, excluding ineligible items and imports financed by other bilateral and multilateral sources.

Program Benefits and Beneficiaries

The program cluster will provide the following benefits.

(i) Improved investor confidence through completion of implementation of the new enterprise law and a new investment law that provides for national treatment.

(ii) Lower transaction costs for business because of streamlined business start-up procedures, a reduction in red tape, and reform of remaining non-tariff barriers, which will open new opportunities, increase investment and productivity, boost the economy, and increase incomes and create jobs, and sustainable reduction in poverty.

(iii) Strengthened institutional development through raising capabilities in the EA and IAs to carry out trade, investment, and SME policy analysis with the aim of improving the quality of policy, institutional processes for policy making. Posting regulations on the SME Promotion and Development Office (SMEPDO) website will also contribute to institutional development through better regulatory transparency.

Risks and Assumptions

The Program is firmly embedded in the SEDP6, the Government’s new SME strategy, and ongoing business climate reforms. The assumptions underlying the Program include the following:

(i) Macroeconomic stability is maintained. (ii) The Government will stay on course with key business

regulatory reform measures. (iii) The Government stays on track with its preparations for

WTO accession. However, there are risks to the Program:

(i) In transitional economies, maintaining macroeconomic stability––reflected in low inflation and a stable exchange rate––is critical for investor confidence and private sector growth. The Lao PDR is particularly vulnerable to macroeconomic instability because of weak institutions. It also faces emerging fiscal stress and macroeconomic

v

challenges in the context of the fall in resource revenues, which threaten to undermine recent gains in social spending and poverty reduction. The Government recognizes these risks and is undertaking measures to raise revenue and strengthen public expenditure management, with the assistance of development partners including ADB.

(ii) The capacity of agencies to implement reforms may be constrained by resources and other emerging priorities. The PSME reduces this risk by limiting the policy triggers to a small number of high-priority, high-impact policy reforms under the jurisdiction of the EA and a limited number of IAs (BOL, MPI, and MOF), and by attaching technical assistance (TA) to each policy trigger.

(iii) There will be resistance to some of the reforms from vested interests, including the dominance of the state enterprise sector in some sectors. Reforms to the import–export management system and institutionalizing economic governance reforms––i.e., red tape review process––are likely to be a lengthy process. Resistance may also come from entrenched cultural and political economy factors that may slow market economy reforms and market competition. However, these risks are mitigated by the following factors: (a) the PSME strategic approach is to focus efforts on supporting the Government’s initiatives, and (b) reforms will focus on areas where there is political will and some measure of capacity. This has been demonstrated by the successful implementation of the enterprise law and establishment of the enterprise registry, which has resulted in substantial cuts in business compliance costs and 5,000 enterprises registering for the first time ever.

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed grant to the Lao People’s Democratic Republic (Lao PDR) for subprogram 2 of the Private Sector and Small and Medium-Sized Enterprises Development Program (PSME). The program design and monitoring framework is in Appendix 1.

II. THE MACROECONOMIC CONTEXT

A. The Global Financial Crisis

2. The proposed second subprogram of the PSME comes at a critical moment for the Lao PDR. It is designed to maintain the momentum of key development efforts at a challenging time of lower commodity prices and a recession last seen in 1998. The impact on the Lao PDR economy of the first round effects of the global financial crisis has been negligible because of the low level of development of the Lao PDR financial sector and limited exposure to international credit markets. The major impact arises from the second round effects of the collapse in commodity prices and recession in major export markets on the real sector and the Government’s fiscal situation. Copper prices, for instance, have fallen by more than half in the last 12 months, significantly affecting revenue flows to the national budget. The Government expects further stress on the fiscal situation in 2010 as tax revenue from the commodity sector is expected to drop substantially as corporate losses are carried over. In the real sector, the Lao PDR economy is also closely linked with the Thai economy, so it is vulnerable to shocks transmitted from Thailand through channels such as extensive border trade, investment, tourism, and remittances from overseas workers. Thailand began to experience recessionary conditions in the fourth quarter of 2008 and this has clearly had an impact (albeit lagged) on the Lao PDR real sector through a subsequent drop in tourist arrivals and border trade. 3. The International Monetary Fund (IMF) projects an economic slowdown in the Lao PDR from a 7.5% economic growth rate in 2008 to 4.5% in 2009. Also the international consensus is that the global economy may only experience a gradual recovery in 2010 and this will affect Lao PDR's economic growth prospects next year. Given constraints on raising budget financing, the Government has opted not to provide a fiscal stimulus—instead, it will protect and maintain public spending and therefore its poverty reduction goals. With declining resource revenues, the Government is projecting a budget deficit of about 5% of gross domestic product (GDP) in 2009, including a budget financing shortfall of about $50 million–$60 million. While much of the Government’s current focus is necessarily on addressing exigencies arising from the crisis and related fiscal situation, it also views the crisis as an opportunity (i) to build consensus among stakeholders on difficult policy reform issues, and (ii) to advance its medium-term objectives related to private sector and small and medium-sized enterprises (SMEs) development. It recognizes that these reforms are fundamental to supporting higher economic growth rates, lessening reliance on the resource sector for income creation, and reducing unemployment and poverty. B. The Government’s Development Strategy

4. In 2006, the Government announced its Sixth Five-Year National Socio-Economic Development Plan (SEDP6), 1 2006–2010, setting out the country’s development priorities,

1 Committee for Planning and Investment, Government of the Lao PDR. 2006. National Socio-Economic

Development Plan, 2006–2010. Vientiane.

2

policy agenda, programs, and projects for the current period. A key pillar of the SEDP6 is to achieve higher and more sustainable economic growth and create jobs through private sector development—with emphasis on commercial agriculture, rural development, infrastructure development, and fostering SMEs. To help implement the SEDP6 priority for private sector growth, the Government adopted a range of sector-specific strategies, most with a time-bound implementation plan and clearly defined ministerial responsibilities, some of which are supported by Asian Development Bank (ADB) sector programs and technical assistance (Figure 1). The SME strategy outlines a road map for longer term development of the sector, including regulatory reform and improved access to finance. The Law on Enterprises of 2006 reflects reform priorities under the SME strategy and its implementation, and is the responsibility of the Ministry of Industry and Commerce (MOIC). MOIC’s trade policy priorities are anchored in its World Trade Organization (WTO) accession efforts, and include reforming its import and export management system and trade facilitation (such as enhancing its sanitary and phytosanitary regulatory system). The Ministry of Finance (MOF) has a public financial management reform program with supporting technical assistance (TA) from ADB and other development partners, and includes the development of a medium-term expenditure framework, internal control systems, and accounting reforms. The Government has also drafted a financial sector development strategy (up to 2020), which has been submitted to the Prime Minister’s Office (PMO) for approval. The strategy covers development of the banking sector, nonbank financial institutions, microfinance, the capital market, and financial sector infrastructure. C. The Government and its Development Partners

5. ADB’s country strategy and program (CSP) 2007–2011 for the Lao PDR identified private sector development as a key thematic initiative.2 The CSP emphasizes that ADB will assist the Government to improve the climate for private sector development through support for policy, institutional, and regulatory reform in sectors in which ADB operates—transforming the agriculture sector from subsistence farming to a commercial orientation, improving basic transport and power infrastructure, strengthening the regulatory regime governing financial institutions, restructuring state-owned commercial banks, improving investment regulations, fostering SME growth, mobilizing resources and broadening access to financing for private sector development, and enhancing the soundness and sustainability of public finance. 6. The PSME program operationalizes the CSP by providing support for business climate and trade reforms and related capacity building at the relevant agencies. The program is structured as a cluster and aims to help the Government achieve its medium- to long-term goals of sustained economic growth of 7%–8% per annum, expansion of the private sector, and poverty reduction. The PSME focuses on three core areas directly affecting private sector development and growth: (i) institutional coordination in SME policy formulation and access to finance, (ii) investment climate, and (iii) trade policy and capacity development. Besides advancing the policy reform agenda, a core objective of the PSME program is capacity development at the relevant agencies, and staff training to undertake analytical work and strengthen policy formulation. The PSME builds on and continues ADB’s policy dialogue with the Government in this area, which has been ongoing since 2004. This engagement has contributed to a number of significant developments in recent years, including formulation of a new enterprise law, its implementing decrees such as the negative list, as well as development of the SME strategy.

2 ADB. 2006. Country Strategy and Program (2007–2011): Lao People’s Democratic Republic. Manila.

3

7. Medium-term programmatic approach. Key features of the PSME include (i) two single tranche operations, with a well-defined, medium-term framework specified at the outset and including completion of high-impact reforms prior to consideration by ADB’s Board of Directors; (ii) triggers for the subsequent subprogram to support continuity of dialogue with the Government, development partners, and other stakeholders; and (iii) a limited number of well-targeted policy actions aimed at achieving high-impact outcomes regarding improvement of the enabling environment for private sector development. In this way, the Program provides a

Government Sector Strategies

PSME Cluster Series of two single tranche grants from 2007 to 2009 Post-program monitoring framework, 2009–2010

ADB Sector Programs and TA

Core Area 1 Institutional coordination for SME policy and access to finance

SME Strategy

Draft financial sector strategy

Banking Sector Reform Program (completed March 2009)

Rural Finance Sector Development Program (ongoing)

Proposed TA on enhancing banking sector supervision

Core Area 2 Strengthening the investment climate

Implementation of the 2006 Law on Enterprises

Reform of the investment laws

Red tape reform

GMS cross-border transit agreement

Strengthening Private Sector and SME Development TA

Core Area 3 Improving trade policy and capacity development

WTO accession efforts

Reforms to the import and export management system

Reforms to customs and other trade facilitation

GMS Trade Facilitation and Investment Group

Strengthening Private Sector and SME Development TA

Figure 1: Overview of the PSME Program Cluster Strategic Framework: Lao PDR Sixth Five-Year

National Socio-Economic Development Plan, 2006–2010

Key Economic and Social Outcomes of the SEDP6: (i) Economic growth rises to 7%–8% per annum by 2015 (ii) Private sector and SME expansion (iii) Reduction in the incidence of household poverty from 33% in 2001 to 23% by 2015

ADB = Asian Development Bank, GMS = Greater Mekong Subregion, Lao PDR = Lao People’s Democratic Republic, PSME = Private Sector and SME Development Program, SEDP = Socio-Economic Development Plan, SMEs = small and medium-sized enterprises, TA = technical assistance, WTO = World Trade Organization. Source: ADB. 2007. Report and Recommendation of the President to the Board of Directors on a Proposed Asian Development Fund Grant to the Lao People's Democratic Republic for the Private Sector and Small and Medium-Sized Enterprises Development Program Cluster (Subprogram 1). Manila.

4

coherent medium-term reform strategy with two discrete but linked subprograms and a strong emphasis on performance, as the decision on whether to proceed with the next subprogram is contingent on overall satisfactory performance of the triggers. It recognizes the necessity for flexibility in the reform measures, with provisions for incorporating lessons and responding to changes in the external environment in the design of subprogram 2. 8. The Program has the following three phases:

(i) Subprogram 1. Financed by ADB ($5 million) in 2007, subprogram 1 focused on key legislative reforms to the enterprise registration regime; it began the process for SME policy and institutional strengthening, and trade policy reforms; and created the basis for continuous policy dialogue and engagement over 2007–2009 (subprogram 2).3

(ii) Subprogram 2. The current phase, to be financed by ADB ($15 million), focuses on implementing business climate reforms and SME institutional development. Subprogram 2 supports the Government’s efforts to improve trade policy capacity, especially as the Lao PDR increases its efforts preparing for WTO accession.

(iii) Post-program monitoring framework. In response to the global economic crisis, a post-program monitoring framework is a new instrument added to subprogram 2. The Government and ADB have agreed to a post-PSME program framework in the next 12 months, creating the basis for continuous policy dialogue and engagement during the critical period of 2009–2010. The monitoring framework focuses on the Government’s short-term plan advancing its reforms in business climate, trade policy, and trade facilitation (a new component) supported by ADB and other development partners' technical and program assistance. It may provide the basis for a second-generation PSME program in the future.

9. Government and development partner coordination. The PSME program works closely with other development partners—the Australian Agency for International Development (AusAID), the European Commission (EC), German development cooperation through GTZ, the International Finance Corporation (IFC), Japan International Cooperation Agency (JICA), and the World Bank—and stakeholders to provide support to private sector development in the Lao PDR (Appendix 4). In particular, the EC is providing parallel financing for TA (€3 million) designed to support implementation of the PSME program cluster and to work closely with ADB to broaden the private sector and SME reform agenda, and support the Government’s efforts to strengthen institutional capacity for policy formulation. The ADB and EC teams are joint members of the Government’s SME steering committee, chaired by the minister of industry and commerce, established under the PSME program. Program progress is reported to the steering committee every semester. ADB also participates in the Lao Business Forum and works with the Mekong Private Sector Facility of the IFC. The forum, established in 2005, comprises representatives from the Lao PDR private sector, senior government officials, stakeholders, and development partners. The primary purpose of the forum is as a vehicle to promote ongoing dialogue between the private sector, the Government, and other stakeholders on private sector development issues.

3 ADB. 2007. Report and Recommendation of the President to the Board of Directors on a Proposed Asian

Development Fund Grant and Technical Assistance Grant to the Lao People's Democratic Republic for the Private Sector and Small and Medium-Sized Enterprises Development Program Cluster (Subprogram 1). Manila.

5

III. THE SECTOR

A. Recent Economic Developments and the Impacts of the Global Financial Crisis

10. Sustained economic growth. In 2008, the Lao PDR economy continued the strong expansion that began in 2005. The economy is estimated to have grown by 7.2% in 2008, which is similar to rates achieved in 2006 and 2007 and well above the average growth rate of 6% per annum from 1990 to 2004. Table 1 presents data on key indicators over 2004–2008 to show the improved macroeconomic performance in recent years. Robust growth in 2008 has occurred across all the major economic sectors—the mining and power sectors, and to a lesser extent manufacturing, were the main engines of growth, followed by services and agriculture. In 2007, exports of goods and services increased by 17% to reach $1.3 billion and they are estimated to have grown about 24% in 2008. Tourism also performed well. More than 1.6 million tourists visited the Lao PDR in 2007, generating over $200 million. About 1.8 million visitors are estimated to have visited the Lao PDR in 2008, providing impetus for continuation of a construction boom in Vientiane and Luang Prabang, two major tourist destinations. Indicators of investment goods (such as domestic cement sales, other construction materials, and imports of capital goods) suggest investment growth was strong in 2007 and 2008. Foreign investment in the non-mining sector increased, with investments in sectors where the Lao PDR has a comparative advantage (tourism and commercial agriculture). 11. Macroeconomic conditions. The current account in the balance of payments remained in deficit at 16% of GDP in 2008, driven by investments in the resource sectors. Grants and foreign investment flows lifted gross international reserves in 2007 and the first half of 2008, but international reserves declined in the second half of 2008 as investment inflows slowed with the onset of the global financial crisis. Overall, the import coverage of gross international reserves was 3.4 months at the end of December 2008. Inflation was a problem in the first half of 2008, as the surge in international food prices transmitted into domestic inflation—reaching 11% in August 2008 on a year-on-year basis—but it has since fallen to –1.5% in July 2009. Other macroeconomic indicators (such as the public debt–GDP ratio) continue to improve. Estimates of the budget outturn for the fiscal year (FY) 2008 indicated revenues slightly surpassing the budget program target and expenditures in line with the budget program, resulting in an overall national government budget deficit of 2.1% of GDP, down from 2.8% (Appendix 5).4 12. Remarkable progress in reducing poverty. Using the national poverty line, the incidence of poverty in the Lao PDR has declined from 46% in 1992 to an estimated 28% in 2008. The reduction in the poverty rate took place as the economy began to recover from the Asian financial crisis in the late 1990s, and much of it took place in the poorest parts of the country. Factors contributing to this remarkable reduction in poverty incidence include sustained per capita income expansion, greater labor mobility between rural and urban areas and urbanization, higher rice production, private sector expansion, and improvements in market access both domestically and in neighboring countries. The Lao PDR is on track in terms of meeting the income poverty Millennium Development Goals (MDGs) by 2015. 13. Impact of global financial crisis on the Lao PDR. The direct and indirect effects of the global financial crisis on the Lao PDR banking system have been limited, as financial sector assets account for less than 15% of GDP, its exposure to international credit markets is limited, and the Government does not access international commercial credit markets to finance its budget. The major impact on the Lao PDR economy comes from the second round effects of 4 Based on the IMF definition of the overall budget balance. The IMF definition differs slightly from the Government’s

definition in that the IMF excludes amortization of debt from the calculation of the budget balance.

6

global demand destruction, the collapse in international commodity prices, and their feedback into the Government’s fiscal situation. In particular, the Lao PDR economy is linked to Thailand’s economy. ADB staff estimates indicate that a 1% decline in Thai economic growth will result in a 1%–2% decline in Lao PDR economic growth in the non-resource sector. Thailand began to experience recessionary conditions in the fourth quarter of 2008 and the economy contracted by 6% in the first quarter of 2009 on a year-on-year basis. The impact on the Lao PDR real sector has not been immediate; instead, a transmission lag is being observed through a subsequent drop in tourist arrivals of about 10% in the last 6 months, with spillovers to tourism-related sectors and sluggish border trade. Garment exports—mainly to the European markets—fell in 2008 and are expected to drop significantly from the second quarter of 2009 onward.

14. With this background, the Government has revised its macroeconomic framework and projects growth of 5.5% in 2009. The IMF projects lower economic growth of 4.5% based on faltering garment exports, a fall in resource revenues, and a slowdown in foreign investment. This translates to a negative output gap of 2.5% of GDP (i.e., actual economic growth is 2.5 percentage points below the potential economic growth rate, Figure 2e). It is the potential feedback from a slowing real sector to the banking sector that has increased vulnerabilities of the domestic banking sector. While the banking sector is in a better financial situation in 2009 than 3 years ago, the capital asset ratios of the state-owned commercial banks are still low and they remain vulnerable to relatively modest shocks. Banks will be tested through the impact of the crisis on their borrowers, with the number of nonperforming loans expected to rise if the poor economic conditions persist (Appendix 5).

15. Feedback to fiscal policy. The global financial crisis has affected fiscal policy in two ways. First, the collapse in commodity prices, especially copper (the main mineral export), from the third quarter of 2008 has reduced resource revenue flows to the national budget by about 1% of GDP below budget target. Fiscal stress is expected to increase in 2010 as profit taxes from the resource sector shrink further on the carryover of losses from FY2009. Second, because of constraints in budget financing, the Government is unable to provide for a fiscal stimulus; instead, its priority is to maintain public spending. As a result of the shortfalls in resource revenues, the Government projects that its budget deficit will rise from the initial target of 3.4% of GDP to about 5% in 2009, creating a budget shortfall of $50 million–$60 million. The deficit could be higher if non-resource tax collection falls short of its budget target in 2009. Based on the IMF definition of the overall budget balance, the deficit could be as high as 7.9% (Appendix 5). The fiscal constraint is putting at risk the recent gains in social spending, especially in education.

7

Table 1: Key Macroeconomic Indicators in the Lao People’s Democratic Republic (percentage of GDP, unless otherwise indicated)

Indicator

2005 2006 2007

2008 Real Sector Real GDP growth (%) 7.1 8.1 7.9 7.2

Agriculture 2.5 3.5 6.2 2.0 Industry 15.9 21.5 6.5 10.0 Services 6.7 5.3 12.1 9.7

Merchandise trade ($ million)a Exports 697.0 1,133.0 1,321.0 1,639.0 Imports 1,270.0 1,589.0 2,156.0 2,816.0

International visitor arrivals (’000) 1,095.0 1,215.0 1,623.0 1,767.0 Monetary Sector Annual inflation (%, average of period) 7.2 6.8 4.5 7.6 Annual inflation (%, end of year) 8.8 4.7 5.6 3.2 Broad money (% annual growth) 8.1 17.2 38.7 18.4 External public debt (end period) 81.0 63.0 59.1 53.1 External public debt service ratio (% of exports)

7.7 5.7 12.5

10.3

Current account balance (17.8) (10.3) (15.8) (16.5) Gross official reserves ($ million) 238.0 336.0 528.0 636 Public Finances National government overall budget balance (authorities definition)

(3.0) (2.9) (2.0)

(3.4)

National government overall budget balance (IMF definition)b

(3.3) (3.1) (2.8) (2.1)

Revenues and grants 14.5 15.8 15.6 15.9 Tax and nontax revenues 12.4 14.0 14.3 14.5 Of which resources 1.1 2.2 2.7 2.9 Grants 2.0 1.7 1.3 1.5 Expenditures 17.4 18.6 17.7 19.3 Current expenditures 9.1 8.9 10.3 11.3 Capital and onlending 7.2 8.1 7.0 7.1

( ) = negative, GDP = gross domestic product, IMF = International Monetary Fund, Lao PDR = Lao People’s Democratic Republic. a Estimate only. b The IMF definition of overall budget balance differs slightly from the Government’s definition in the treatment of amortization of debt and other terms. Consequently, based on the IMF definition, the overall budget balance was 2.1% in 2008 compared to the government-defined budget estimated at 3.4% of GDP.

Sources: Ministry of Finance, Ministry of Industry and Commerce, and Department of Statistics, Lao National Tourism Authority, and IMF. 2009. Article IV Consultation 2009.

8

Figure 2: Key Economic Indicators (a) Lao PDR and Thailand economic growth rates (b) Inflation rates in the Greater Mekong Region

-15

-12

-9

-6

-3

0

3

6

9

1219

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

0620

0720

08

Lao PDR Lao PDR (NR) Thailand

0

5

10

15

20

25

30

Jul-0

3

Nov-03

Mar-04Ju

l-04

Nov-04

Mar-05Ju

l-05

Nov-05

Mar-06Ju

l-06

Nov-06

Mar-07Ju

l-07

Nov-07

Mar-08Ju

l-08

Viet Nam Cambodia NE Thailand Lao PDR

(c) Monetary aggregates and credit expansion (d) Fiscal deficit % of GDP

-40

-20

0

20

40

60

80

Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

M1 M2 Credit to the economy

0

1

2

3

4

5

6

7

2001 2002 2003 2004 2005 2006 2007 2008

defic

it %

GD

P

0.0

1.0

2.0

3.0

4.0

5.0

6.0

depo

sits

% G

DP

Overall Deficit Overall Deficit (NR) Gov deposits

(d) International prices of gold and copper (e) Output gap and fiscal stance

0

2000

4000

6000

8000

10000

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

0

200

400

600

800

1000

1200

Copper Gold

-3

-2

-1

0

1

2

3

4

2004 2005 2006 2007 2008 2009

Output Gap Fiscal Stance

Positive output gap/fiscal expansion

Negative output gap/fiscal contraction

Note: NR = non-resource sector budget refers to the national government budget less resource revenue inflows; M1 (or money supply) refers to cash in circulation and demand deposits; M2 (broad money supply) equal M1 plus term deposits. GDPp = potential GDP growth and is estimated using the Hodrick-Prescott filter, which estimates a non-linear trend. The output gap is the difference between potential and actual economic growth. Fiscal stance is calculated as the percentage point change in the ratio of the overall government budget deficit to GDP. Sources: Bank of the Lao PDR, International Monetary Fund, and Asian Development Bank staff calculations.

9

B. Issues and Opportunities

16. The private sector is characterized by the dominance of micro, small, and medium-sized enterprises. The most recent data on firm numbers and size is from the 2006 industrial census carried out by the National Statistics Office (Table 2).5 The census reports 126,913 enterprises operating in the Lao PDR in 2006, of which 23% are located in Vientiane. Only 2.4% of enterprises have 10 or more employees, of which less than 0.2% (or 198) have more than 100 employees. The bulk of establishments (123,800) are micro- and small-scale enterprises with less than 10 workers. Almost two-thirds of enterprises operate in the domestic trade services sector, followed by 19% in the manufacturing sector. This pattern of size distribution in the economy is typical for small, low-income developing economies. In the initial stages of development, the private sector is dominated by small-scale enterprises, and as the economy expands, competitive SMEs may grow and add to the pool of larger firms. Findings from a recent survey of 490 registered establishments in 2007 by GTZ indicate that these growth dynamics are occurring in the economy.6 The survey found small but still significant increases in the share of large enterprises in terms of the total number of enterprises as well as employment from levels in 2005. The majority of SMEs operate informally, with only an estimated 40% holding an enterprise certificate.

17. Private sector growth and development. Measures of productivity and trade facilitation costs, as well as large recent investments in infrastructure, suggest that conditions for growth of the Lao PDR economy are improving. This improvement in efficiency of the economy, located beside the two fastest growing economies in the world (the People’s Republic of China and Viet Nam), and middle-income Thailand, as well as expected higher budget revenues from the resource sector in the longer term, provide the Lao PDR with tremendous potential for private sector growth and development over the longer term. However, attainment of this potential is held back by a range of issues that slow economic integration with neighbors, deter investment, and dampen productivity growth. These include (i) a weak institutional framework for SME policy coordination and access to finance, (ii) high transaction costs and unpredictability in the investment regime, and (iii) relatively high costs involved in importing and exporting goods (Appendix 6).

5 Lao PDR, The Steering Committee on Economic Census. 2007. Report of Economic Census, 2006 Volume 1,

National Statistics Centre, Vientiane. 6 GTZ. 2008. The Enterprise Survey of 2007. Vientiane.

10

Table 2: Number of Firms by Employment Size and Major Economic Sector (2006) Total

Economic Sector Less than 5 persons

5–9 persons

10–99 persons

100 + persons No. %

Agriculture, forestry and fishing 3,511.0 539.0 258.0 10.0 4,319.0 3.4 Manufacturing 21,925.0 1,366.0 923.0 114.0 24,331.0 19.2 Wholesale and retail trade; repair 79,728.0 1,615.0 416.0 10.0 81,780.0 64.4 Transportation and storage 3,511.0 172.0 110.0 5.0 3,799.0 3.0 Accommodation and food service 2,341.0 771.0 319.0 8.0 3,439.0 2.7 All other industries 7,576.0 805.0 809.0 51.0 9,245.0 7.3 Total 118,592.0 5,268.0 2,835.0 198.0 126,913.0 100.0 % of total 93.4 4.2 2.2 0.2

Note: Figures may not add up to totals as no detailed data were recorded for a few enterprises. Source: Lao PDR, The Steering Committee on Economic Census. 2007. Report of Economic Census, 2006 Volume 1, National Statistics Centre, Vientiane.

1. Need for Institutional Coordination on SME Policy and Access to Finance 18. Need for more coherent approach to policy formulation and implementation. For many developing economies, the problem of coordination failure between the public and private sector is a constraint on private sector and SME development. In the Lao PDR, with a large number of government agencies involved in the formulation of policies and regulations that affect the private sector, lack of a systematic, consultative process for formulation of policy and regulation has provided scope for policy unpredictability and increased the likelihood of regulations that unduly hinder private sector development. Decentralization adds a further layer of complexity to the business environment for firms, with local governments responsible for a range of regulations that have cost and operational implications. Recent reforms, however, have helped establish the framework for a more coherent approach to private sector development. A key step in this regard was the establishment of the SME Promotion and Development Office (SMEPDO) in 2004, providing a focal point for championing reforms aimed at improving the enabling environment for SMEs in particular and the private sector more generally. Under subprogram 1 of the PSME, SMEPDO formulated the national strategy for SME development (2007—2012) in 2007 and is charged with overseeing its effective implementation.7 The strategy provides a comprehensive action plan for assisting SMEs in addressing constraints to growth, including creating an enabling environment for businesses to operate. The strategy was approved by the PMO in early 2008 after extensive dialogue and consultation with stakeholders in the private sector through the Lao Business Forum, the Lao National Chamber of Commerce and Industry, other groups, and development partners. In 2008, SMEPDO established the monitoring unit in response to demand from both internal (SMEPDO) and external stakeholders of SMEPDO for transparent information, good management, and delivery of results under the strategy. The first monitoring report was produced in the first quarter of 2009 and notes that, while implementation was slow at first, it has accelerated in recent months (para 51). 19. Strengthening public–private dialogue. While an institutional mechanism exists (i.e., Lao Business Forum) to support dialogue between the business community and relevant authorities at the central government level, similar arrangements have been missing at the provincial level although local governments are responsible for the issuance, implementation, and/or enforcement of many regulations that impact the private sector. To provide an effective channel for feedback from the private sector on issues facing firms at the provincial level, the Government (with support from GTZ) has initiated provincial public–private dialogues (P3Ds) in 7 SMEPDO. 2008. The Lao Small and Medium-Sized Enterprises Strategy. Vientiane.

11

a number of pilot provinces.8 These are intended to provide a regular forum to bring issues facing firms to the attention of relevant local authorities for resolution at the local level. While the piloted P3Ds are in their infancy, they have highlighted common issues facing firms such as skill shortages in the workforce, the need for consistent application of taxes, and overly bureaucratic processes involved in compliance with regulations. While not all issues can be quickly or readily resolved, the ability to bring them to the attention of relevant authorities on a regular basis through a public forum is a significant new development that has the potential to spur more responsive and transparent public administration at the local level. In recognition of their value, the Government is institutionalizing the P3Ds process in the four pilot provinces and plans to replicate it in other provinces going forward. P3Ds, once effectively institutionalized, can also serve as a natural mechanism for the conduct of stakeholder consultations under key initiatives supported by the Program such as pilot testing regulatory impact assessments. 20. Access to finance. The finance sector of the Lao PDR is shallow, with the banking system constituting the main form of formal financial intermediation. Microfinance institutions are expanding to serve the needs of microenterprises but coverage remains low. Consequently, SMEs have had limited access to formal sources of financing, and generally rely on retained earnings and informal sources. The 2008 GTZ enterprise survey of 2007 found that 50% of entrepreneurs surveyed reported access to capital as a major constraint to their growth (footnote 6). The Government, with assistance from ADB through the Banking Sector Reform Program (BSRP) completed in March 2009 9 and the Rural Financial Sector Development Program (RFSDP)10 on track to be completed in 2011, have helped to restore the health of the banking sector gradually, improving the competitive environment and developing microfinance institutions. The Lao Development Bank, a state-owned commercial bank, has refocused its market segment to serving SMEs. 21. However, SMEs face legal and capacity constraints in accessing finance, and these need to be addressed if SMEs are going to benefit from recent banking sector developments. Constraints include weak protection of creditors’ rights, which means that banks largely rely on the use of fixed assets (e.g., land and buildings) as collateral to secure loans, placing SMEs generally at a disadvantage in accessing credit. The Government is addressing this through reforms such as preparation of a draft decree on secured transactions that would provide a framework for using a wider range of assets (including movable assets) as collateral for loans. Another critical constraint is limited credit information on customers that allows banks to assess credit risk. Currently, requests by banks for such information are processed by the central bank’s Credit Information Bureau (CIB) using an inefficient manual paper-based system—that can often take up to a week to generate responses. Upgrading to a system based on a centralized database that allows commercial banks to search for and update customer credit information in real time could significantly reduce the time and costs involved in credit assessment. Another constraint is the limited range of alternative financial products to bank loans available to SMEs. Under the BSRP, the Government drafted and submitted a lease financing decree to the PMO in February 2008 establishing a regulatory framework for the leasing industry, with the aim of developing the sector. The decree was approved in July 2009. A final constraint is the poor accounting and financial reporting capacity of SMEs, which also limits access to finance. According to the GTZ enterprise survey, 75% of microenterprises, 54% 8 Champasak, Louangphrabang, Louang-Nam Tha, and Savannakhet. 9 ADB. 2009. Report and Recommendation to the President to the Board of Directors on a Proposed Loan and

Technical Assistance Grant to Lao People's Democratic Republic for the Banking Sector Reform Program. Manila. 10 ADB. 2009. Report and Recommendation to the President to the Board of Directors on a Proposed Loan and

Technical Assistance Grant to Lao People's Democratic Republic for the Rural Financial Sector Development Program. Manila.

12

of small enterprises, and 25% of medium-sized enterprises do not keep proper bookkeeping records. Furthermore, the same survey found that less than 45% of small firms had ever used a business development service provider. Under subprogram 1, the Government enacted a new accounting and auditing law and is currently disseminating information and accounting standards to the business community, with assistance from the EC under its SME project.

2. Investment Climate 22. The Lao PDR has enjoyed sustained investment expansion since 2000. Reforms to the business environment since the early 1990s—with the enactment of the Business Law of 1994, foreign and domestic investment laws in 2004, the enterprise law of 2006 (replacing the business law), and other commercial legislation—contributed to this expansion. FDI is critical to development of the Lao PDR at its current level of development and with its undeveloped financial sector. Evidence shows that FDI brings important externalities to local firms, suppliers, and workers through technology and skill transfers. Successful entry of FDI breeds success and this attracts additional FDI in other sectors. It is also associated with improved employment and poverty reduction. Figure 3 shows a big jump in annual FDI approvals since 2000 across all major sectors. The composition of this growth has also changed with the increase in the share of projects going to agriculture, mining, and hotels—indicative of the Lao PDR’s comparative advantage in tourism and natural resources. While current data are not available, anecdotal evidence suggests that this investment has slowed in 2009 because of the global financial crisis and collapse in commodity prices.

Figure 3: Foreign Direct Investment Approvals (number of projects)

Source: Ministry of Planning and Investment. 23. Update on constraints on investment. The 2008 GTZ enterprise survey of 2007 reiterated the key constraints to investment attractiveness in the Lao PDR such as infrastructure (mainly roads, water, and electricity supply reliability); excessive red tape; labor skills; taxation; and access to finance. The ADB-World Bank investment climate survey carried out in 2005 found that ranking of constraints differed across major sectors.11 Manufacturing firms ranked infrastructure, regulations, and taxation as their top three constraints, while operators in tourism

11 ADB and World Bank. 2007. Reducing Investment Climate Constraints to Higher Growth. Manila and

Washington, DC.

0 10 20 30 40 50

Other

Hotel

Hydropower

Mining

Wood

Industry

Agriculture

2007 2000

13

ranked infrastructure, inadequate skills, and taxation as their major business constraints. Investors also found that some constraints have improved while others may have deteriorated since 2005. According to the GTZ survey, more investors feel that excessive red tape and finding skilled labor are bigger problems in 2007 than in 2005, while competitive pressures are less of a problem in 2007, and no change has been observed in infrastructure (Appendix 6). Some caution should be taken when comparing changes in perception over time as these are shaped from a combination of first-hand experiences as well as exposure to new knowledge about best international or regional practices (which may be particularly significant in transition economies like the Lao PDR). On a global comparison, the Lao PDR ranks relatively low. The Doing Business report 2009 ranks the Lao PDR 165th out of 181 countries, slipping three places over its ranking in 2008 (Appendix 6).12 24. Progress on business registration. Until recently, several steps were required to register an enterprise—involving several agencies, depending on the sector, and an excessive amount of documentation. Firms were required to produce 18 documents and obtain pre-approval from relevant line ministries and other authorities to qualify for registration. Under this system, it took firms 60 days on average to obtain a basic registration certificate, along with the expenditure of significant staff and other resources. Reregistration was required each year, so such costs were incurred on an annual basis. These costs provided a significant disincentive for firms to register, weakening the Government’s ability to increase the tax base or monitor private sector development effectively. Significant costs were also imposed on the Government, arising from the resources required to administer such a system (well over 300 staff were employed in this regard). A 2009 ADB study (red tape study) estimated that the enterprise registration system cost the business community more than $6 million annually to comply with the registration process.13 25. The Government has made significant progress in modernizing the business licensing process. Notably, under the new enterprise law, registration procedures have been markedly streamlined, and the period allowed for registration of enterprises not on the negative list has been limited to 10 days (compared with 60 days on average in practice under the previous regime).14 To help meet these targets, the Government is modernizing its enterprise registration system. MOIC, with ADB technical assistance has simplified enterprise registration procedures and developed a computerized system that allows for more efficient implementation of the registration process as well as monitoring of firms, through use of a centralized database in Vientiane linked via internet to client systems in provincial enterprise registry offices. 15 The new system began operation in August 2008 with four pilot provinces and is being rolled out nationwide in a phased manner—with coverage of all 17 provinces expected to be complete by late 2010 (para. 57). 26. Investment law. The Foreign Investment Law and the Domestic Investment Law were amended in 2004 and were important milestones in the Lao PDR’s transition to an open market economy, as they set out a broad framework to promote investment. However, they have major weaknesses. As foreign and domestic investors are covered under different investment laws and approval conditions, national or equal treatment is compromised. There is an element of

12 World Bank. 2009. Doing Business 2009. Washington, DC. 13 ADB. 2009. Options for a Regulatory Review Program and an Office of Best Regulatory Practice. Manila. 14 Owners can now register their enterprises directly at the enterprise registry office for any economic activity not on

the negative list. Only those wishing to register a firm for operation in sectors on the list must first seek approval from the relevant line ministry.

15 ADB. 2007. Technical Assistance to Lao People's Democratic Republic for Strengthening Private Sector and SME Development. Manila.

14

unpredictability in the administration of investment incentives, as the duration of some incentives appears to be open-ended. The list of sectors closed to foreign investment, or open under certain conditions, is not consistent with the negative list under the enterprise law of 2006. Most countries have shifted away from using a positive list for foreign investment to a negative list, as it increases transparency and predictability for investors. Ideally, the list of conditional or closed sectors under the investment law should be synchronized with those on the negative list under the enterprise law; i.e., the list of sectors on both lists should be consistent. Given the importance of FDI to Lao PDR development, these issues in the investment regime need to be addressed. 27. Excessive red tape. While the enterprise law addresses problems with registration, it does not deal with other operating business licenses issued by line agencies. There is excessive red tape affecting business operations. Under current practice, regulations are often formulated in an ad hoc manner by technical staff in line ministries subject to tight deadlines, which leaves little room for stakeholder consultation or assessment of costs to individual firms or the economy as a whole. This has helped contribute to an existing stock of business-related regulations that are unduly burdensome and costly for the private sector, serving to undermine the competitiveness of Lao PDR firms and weakening the country’s attractiveness to investment. 28. The ADB red tape study estimates that firms incur annual average expenses of KN4.1 million to comply with the three most common types of licenses (referred to as permissions in Lao PDR)—enterprise registration certificate, sector operation license, and tax certificate (footnote 13). This cost the business community an estimated KN266 billion annually in 2008, or 0.7% of GDP (Figure 4a). Firms typically have to comply with dozens of regulations, depending on their line of business, which adds to business compliance costs. A realistic estimate of total compliance costs would be 1.5%–3.0% of GDP. The major component of business compliance costs is the enterprise’s staff time and own financial resources used to prepare documentation and apply for the license. The burden of business regulatory costs falls disproportionately on small enterprises. On an employee basis, business compliance costs are much higher in small enterprises (KN258,442) than in medium-sized enterprises (KN120,000) and large firms (KN27,000). This illustrates how the regulatory burden falls most heavily on small enterprises in the formal sector, and becomes a barrier to the formalization and growth of small enterprises. 29. Need to improve quality of regulations and reduce compliance costs. The Government lacks a system whereby laws and regulations affecting licensing and inspection are reviewed to determine the impact on the private sector. As a result, the regulatory compliance costs imposed on the private sector are not appreciated. To help improve the quality of regulations and minimize compliance costs for the private sector, a more systematic approach needs to be taken in their formulation and/or review. Ideally, and following international best practice on regulatory impact assessment, this would involve use of a systematic approach to assess and make transparent the costs of particular regulations for individual firms as well as the economy as a whole (Appendix 6). This is a long-term effort. As a starting point, the Government should start with raising public awareness on the need for a regulatory reform program, and achieve broad agreement on the appropriate plan and institutional set-up for addressing red tape over the longer term.

15

Figure 4: Business Compliance Costs (a) Compliance costs by common licenses (b) Composition of compliance costs

500 800 1,100 1,400 1,700 2,000

Drug registration

Operational license

Tax certificate

Entertainment license

Import certificate

Enterprise registration

Professional certificate of pharmacy

Amount per firm (KN'000)

Enterprises' staff Time Costs

61%

Official fees32%

Facilitation fees7%

(c) Compliance costs by firm sizea (d) Compliance cost by sector

0

50

100

150

200

250

300

Micro-ennterprises

Smallenterprises

Mediumenterprises

Largeenterprises

Am

ount

per

em

ploy

ee K

N'0

00

2.0

3.0

4.0

5.0

6.0

7.0

Manufacturing Trading Pharmaceuticals Tourism

Am

ount

KN

'000

a Compliance costs per employee of the three main licenses—enterprise registration, operational license, and tax certificate.

Source: ADB. 2009. Options for a Regulatory Review Program and an Office of Best Regulatory Practice. Manila.

3. Trade Policy and Capacity Development 30. WTO accession. The Government considers WTO accession a key foreign trade policy priority and this is accelerating the momentum for finishing the trade reform agenda. The Government’s preparations for WTO accession have had an influence on the way it views trade policy and the business climate. In this regard, MOIC is considering ways to accelerate reforms to the import and export management system. It intends to continue to reduce the number of sectors on the import control list, and streamline and simplify import and export procedures and regulations. The WTO accession efforts follow on from the Lao PDR’s commitments to the Common Effective Preferential Tariff (CEPT) schedule under the Association of Southeast Asian Nations (ASEAN) Free Trade Agreement (AFTA). The Government has made progress in implementing the CEPT schedule for items in the inclusive list (0%–5%), which covers 98% of all tariff lines. As a consequence of a process of market-oriented reforms that began in the late 1980s, the average customs duty has fallen to about 10%, which is among the lowest in the region. Going forward, it is opportune to advance the reform momentum toward reducing the remaining non-tariff barriers and investment distortions—including technical barriers to trade (TBTs); reform of trade facilitation (logistics, sanitary and phyto-sanitary standards systems, or

16

sanitary and phyto-sanitary standards, and customs); consolidation of other incentives that negatively affect investment and trade decisions; and support for implementation of the Lao PDR’s WTO commitments once it accedes to the WTO (tentatively planned for 2012). Subprogram 2 deals with a subset of these reform areas. Other areas (especially trade facilitation and post-WTO implementation) are a long-term agenda requiring strong coordination among development partners. 31. Effective rates of protection. The degree of protection afforded to domestic industry through imposition of custom duties, non-tariff barriers, and domestic taxes on products can be measured by estimates of the effective rate of protection (ERP). A positive estimate of the ERP indicates the height of protection afforded to domestic industry while a negative estimate indicates the height of negative protection (or disincentive to produce) afforded to domestic industry. Variations in estimates of ERPs for different sectors of the economy reveal the extent of resource misallocation (or distortions) within the economy caused by the trade and tax policy regime, and provide a useful tool for assessing a country’s trade policy and promoting transparency. ADB and MOIC staff estimates of ERPs show that pockets of significant protection to industry remain, such as in food, beverages, and tobacco (Table 3). The trade policy and incentives regime appears to be biased against sectors that have potential to be export-oriented, as reflected in sizeable negative protection in some of these sectors (agriculture and textile and garments). Once the AFTA CEPT schedule is completed, protection in some of these sectors (auto and motorcycle assembly, and some processed foods) will disappear. Sector-specific reforms may be needed in some of the others (e.g., cement) to enhance economic efficiency (Appendix 6). The estimates do not include fiscal investment incentives, which are considered generous and vary across sectors and across firms within sectors. If these are included, the variation in ERPs could be larger. A comprehensive assessment of investment incentives is necessary. 32. Import licensing and administrative procedures. These are the major remaining non-tariff barriers, but are being phased out by the Government to be consistent with WTO rules. The Lao PDR operates an import–export management and control system, identical to the one operated in Viet Nam until recently. There are two key features of the import and export management system. The first feature is the import licensing regulation and its identification of items subject to restrictive import licensing. It categorizes imports into three categories: (i) prohibited goods,16 (ii) controlled goods, and (iii) general goods that are easily imported. Goods may be prohibited based on public safety, environmental, or moral concerns, but not to protect domestic producers. The controlled category deals with licenses for imports that are not banned but managed by MOIC. Until October 2006, these included about 25 broadly defined items such as prepared foods and all raw and semi-manufactured products used in manufacturing. MOIC is reforming the import and export management system and has made substantial reforms since 2006 to reduce trade facilitation costs. The list of items on the controlled list was revised in October 2006. Under subprogram 2, the Government has revised the import regulation to be consistent with WTO requirements, including the use of non-automatic and automatic licenses. The number of import items subject to non-automatic licenses on the controlled list has also been further reduced (para 61).

16 The list of prohibited goods and controlled goods set out in MOIC notice No. 1376 of October 2006. Previous MOIC notices of prohibited goods and controlled goods were set out in notices No. 284 and 285 of March 2004.

17

Table 3: Industry Protection—Effective Rates of Protection (%)

Sector Export or

Import Sector ERP Crops E (5.0) Livestock and poultry E (8.0) Forestry and logging E (11.8) Mining and quarrying E (11.0) Food, beverages, and tobacco I 104.8 Textiles, garments, and leather products E (6.8) Wood and paper products, printing, and publication E (0.4) Chemical products I 2.0 Non-metallic mineral products I (4.3) Metal products, machinery I 9.5 Other manufactured products I 6.1

( ) = negative, E = export-oriented sector, ERP = effective rate of protection, I = import-oriented sector. Source: Asian Development Bank and Ministry of Industry and Commerce staff estimates.

33. The second feature of the import–export management system in need of reform has been the import administrative procedures as defined under prime minister's decree 205 and its circulars. Over the last 3 years, however, these have been significantly rationalized with the removal of MOIC officials at customs posts as well as the requirement for producers to provide import plans. The Government is preparing revisions to the regulation to ensure consistency with WTO rules, especially in relation to trading rights and administration of quotas. 34. Technical barriers to trade. In preparation for WTO accession, the Government is reviewing technical barriers to trade, such as those related to sanitary and phyto-sanitary standards (SPS), with a view to making them consistent with WTO rules. This will involve establishing procedures for notifying SPSs and other TBTs to the WTO, and designating an inquiry point within government for such notifications. Early progress has been made in strengthening the SPS regulatory environment to ensure consistency with the WTO, as a series of decrees was issued related to food safety management—including principles for application of SPSs and technical measures for food safety management, plant protection, and quarantine law. As the Government considers completion of WTO commitments important for its world trade integration efforts, it must strengthen the capacity to implement the required policy reforms and to establish compliance notification procedures across relevant agencies. 35. Capacity building in trade policy. The institutional arrangements and processes for making trade policy are just as important as reforms to the trade policy regime. The Department of Foreign Trade Policy at MOIC sets the broad trade policy framework and agenda. It is taking the lead in WTO preparations and has responsibility for AFTA. With only 30 staff, it is overstretched and under-resourced to conduct adequate trade policy analysis—an area that will be critical to support further trade reform and effective participation in the WTO. 36. While the Department of Foreign Trade Policy has a key role in determining trade policy, a number of other agencies also play significant parts, including the Department of Export and Import Management that sets import and export procedures, and compiles the controlled import list. The ministries of agriculture, health, communication, transport, post, and construction—as well as MOIC—control import licensing in their respective sectors and produce TBTs, including SPSs. Ensuring consistency of trade policy across the whole Government will be a challenge, as in most countries. It is also important for the Lao PDR to continue to build its own capacity to carry out policy analysis on its merits for the Lao PDR. Under ADB technical assistance (footnote 15) training on trade policy tools has been provided to staff at MOIC and other ministries, and staff from the Department of Foreign Trade Policy worked with ADB staff to

18

develop capacity to estimate ERPs. Other activities included writing and presentation skills, media communication for senior officials, and training on trade policy tools. ADB staff also provided training on free trade agreements. It will be important to continue this longer term capacity development to support the reform momentum. 37. Trade facilitation. The performance of trade logistic services is critical to determine if the Lao PDR can trade goods and services on time and at low costs. A cross-country study conducted by the World Bank17 suggests that high logistics costs and, more importantly, low level of services are barriers to trade and hence, growth. Available indicators suggest that Lao PDR businesses bear a higher cost of logistics than other countries in the region (Figure 5). The logistics performance index ranks the Lao PDR above most countries in the region, meaning it is less efficient (costly and time-consuming). This index is developed based on a comprehensive survey of supply chain performance, including customs procedures, logistic costs, infrastructure quality, and the competence of the domestic logistics industry. 38. SPS are crucial to microeconomic infrastructure to improve the private sector’s access to the international market for agro-based products. Lao PDR exports of such products are in their infancy, and inadequate SPS management systems are an obstacle to development of such exports. The Lao PDR coffee industry has an estimated export value of $60 million only. When it accedes to the WTO, the Lao PDR will have agreed to SPS compliance within a transitional period, usually 5 years. Based on the experience of Cambodia, it is unlikely to achieve this commitment on time. It will require a comprehensive assessment of the regulatory regime and supporting institutions. There are no internationally accredited assessors in the Lao PDR and the technical capacity of laboratories to undertake SPS-related testing is very limited. Therefore, much needs to be done to strengthen the regulatory environment, including promoting competition in the sector, developing private sector providers, upgrading equipment, and testing procedures and staff training in the laboratories. The Government recognizes that much needs to be done to strengthen SPS management systems and capacity, and that this is a longer term effort. It had developed an action plan for SPS under the integrated framework diagnostic study undertaken in 2006. The action plan will need to be reviewed in light of WTO accession efforts and developments in the region, and its implementation started. ADB’s Greater Mekong Subregion (GMS) trade facilitation activities are considering ways to harmonize trade facilitation, including SPS systems, across the GMS.

17 World Bank. 2007. Connecting to Compete: Trade Logistics in the Global Economy. Washington, DC.

19

Figure 5: Trade Facilitation—International Comparison (a) Cross-Country Export Time and Cost (b) Cross-Country Import Time and Cost

0

10

20

30

40

50

60

Eas

t Asi

a &

Pac

ificEa

ster

n E

urop

e &

Cen

tral

Asi

a

Latin

Am

eric

a &

Car

ibbe

an

Mid

dle

East

& N

orth

Afri

ca

OE

CD

Sout

h A

sia

Cam

bodi

a

Lao

PD

R

Viet

Nam

Thai

land

Sri

Lank

a

Ban

glad

esh

-2004006008001,0001,2001,4001,6001,8002,000

Time for export (days) (LHS axis)

Cost to export ($ per container)(RHS axis)

0

10

20

30

40

50

60

Eas

t Asi

a &

Pac

ific

Eas

tern

Eur

ope

& C

entra

lA

sia

Latin

Am

eric

a &

Car

ibbe

an

Mid

dle

East

& N

orth

Afri

ca

OE

CD

Sou

th A

sia

Cam

bodi

a

Lao

PD

R

Vie

t Nam

Thai

land

Sri L

anka

Bang

lade

sh

02004006008001,0001,2001,4001,6001,8002,000

Time for import (days) (LHS axis)

Cost to import ($ per container)(RHS axis)

OECD = Organisation for Economic Co-operation and Development, Lao PDR = Lao People's Democratic Republic, LHS = left hand side, RHS = right hand side. Source: World Bank. 2007. Connecting to Compete: Trade Logistics in the Global Economy. Washington, DC. C. Lessons

39. While assessing the implementation progress of triggers (Appendix 10), a number of lessons were identified and have informed the formulation of subprogram 2. These include the following:

(i) The program cluster, with a subsequent subprogram linked by triggers within a medium-term framework, has encouraged government ownership of the Program and continuous dialogue on policy.

(ii) Substantial progress on the policy triggers had been made through support from TA.

(iii) The approach of using a program cluster with triggers contains adequate flexibility to respond to lessons identified during implementation and to incorporate new developments in policy and government priorities, such as upgrading of the CIB.

(iv) In the context of the current global financial crisis and its transmission to the Lao PDR, and since subprogram 2 is the final subprogram under this program cluster, it is paramount to continue policy dialogue and engagement with the Government to maintain the reform momentum. The program cluster provides adequate flexibility though its medium-term framework to incorporate a post-program monitoring framework based on the Government’s short-term action plan (Appendix 3 policy matrix).

(v) Some of the reforms under subprogram 2 and the post-program monitoring framework are similar to reforms in other ADB programs in the GMS, and lessons from these programs are applied to subprogram 2 of the PSME. In particular, promoting reforms through interministerial taskforces or committees face significant coordination difficulties in an environment where ministries often operate within “policy silos” (i.e., in isolation). Implementing reforms is made harder when the interagency taskforce is mandated with several responsibilities

20

and functions. To overcome this, the PSME establishes a stand-alone interagency taskforce on regulatory impact assessments, chaired by Vice-Minister for Industry and Commerce.

40. As a result, subprogram 2 incorporates several new important policy accomplishments that have enhanced the Government’s agenda in the three core areas, of which some are designed to further the reform agenda. 41. Distinct features of the PSME program cluster include the consultative approach taken throughout its formulation. Under subprogram 1, a series of workshops had been organized for each component with a view to achieving the commitment of the Government and stakeholders. The design of TA was shaped in support of implementing the five policy triggers under subprogram 2, as well as broadening the reform agenda for subprogram 2 by providing detailed analytical work and active consultations with stakeholders to ensure adequate “buy-in” and government ownership of the Program. Examples include high-level policy discussion with the Government on the level of protection in the economy and the results of the red tape study.

IV. THE PROPOSED PROGRAM

A. Impact and Outcome

42. The impact of subprogram 2 is to achieve sustainable economic growth in the non-resource sector, supported by increased contribution of the private sector and SMEs. The outcome of subprogram 2 is an improved business environment where the private sector and SMEs operate efficiently and effectively. An expanding private sector will generate more and better jobs, and contribute toward sustainable poverty reduction. 43. The PSME program cluster includes a series of policy reforms that underpin the key priorities of the Lao PDR sixth Social and Economic Development Plan and its sector strategies. These reforms are designed to accomplish the following results.

(i) Improve institutional coordination for SME policy and access to finance by (a) strengthening the institutional framework for SME policy formulation and (b) improving SME access to finance through improvements in accounting rules and guidelines, and development of nonbank financial instruments.

(ii) Strengthen the investment climate by (a) implementing the enterprise law, (b) other policy reforms aimed at reducing the transaction costs of doing business in the Lao PDR, and (c) more transparency in the regulatory environment affecting SMEs.

(iii) Improve trade policy and capacity development by (a) reforming the import–export management system, including making measures more transparent, and over the medium term reforming the controlled list of imports, and (b) strengthening indigenous capacity to carry out trade policy analysis.

B. Policy Framework and Actions

44. All 14 policy measures required for subprogram 2 had been carried out by mid-August 2009. 45. The report and recommendation of the President for subprogram 1 of the PSME identified five policy triggers for subprogram 2 (footnote 3). While assessing implementation

21

progress, the Government proposed one new policy trigger to recognize recent developments in improving access to finance—the upgrading of the CIB from a manual, paper-based system to a computerized, web-based system. This will, among other things, ease access to finance by allowing borrowers to establish credit histories more readily and by allowing banks to access and make use of such information readily. This supplements the Government’s efforts to disseminate information on new accounting practices to SMEs (Appendix 10 provides an assessment of subprogram 2 triggers). 46. In total, the Government and ADB are focusing on six policy triggers, of which most are supported by eight measures that support capacity development in the Implementing Agencies (IAs) (Appendix 3, policy matrix). The Government has made substantial progress in completing these measures. It has fully or substantially accomplished the six policy triggers. All of the eight other supporting (non-triggers) measures have been completed. 47. Progress in achieving the PSME performance indicators and targets set out in the design and monitoring framework for subprogram 1 and updated for subprogram 2 (Appendix 1) has been substantial. Of the 12 performance indicators, two are assessed as exceeding medium-term program targets (increase in non-resource exports and number of days to launch a business), six are assessed as being on track to achieve medium-term targets, two have slowed (implementation of SME strategy and days it takes to prepare import and export documentation), and updated data not yet available for the remaining two indicators. 48. In the spirit of the PSME cluster, which aims to support the Government’s policy reform agenda on a continuous basis rather than through predetermined rigid conditions, the Government asked that the substantial progress be recognized. Furthermore, as individual grants under the PSME cluster are sequenced to provide continuous support in a predictable manner, and subprogram 2 is the final one of this cluster, it requested ADB and the development partners to (i) remain fully engaged as part of the ongoing dialogue, (ii) support and continuously monitor implementation and completion of the remaining policy triggers, (iii) provide longer term capacity development support for a better investment environment, and (iv) support implementation of the post-PSME program monitoring framework. ADB’s program cluster approach provides for such flexibility in reform programs that are implemented over time, by taking emerging circumstances into account.

1. Accomplishments under Subprogram 2

49. Subprogram 2 focuses on three core areas of private sector development—institutional development for SME policy and access to finance; investment climate; and trade policy, capacity development, and trade facilitation.

a. Improve institutional Coordination for SME Policy and Access to Finance

50. Subprogram 2 supports the Government’s efforts to (i) strengthen the institutional framework for promoting SME policy formulation through a consultative process with stakeholders; and (ii) improve SME access to finance through improvements in accounting rules and guidelines, and development of nonbank financial instruments. The following measures toward achieving these objectives were completed prior to Board consideration of subprogram 2. 51. SME strategy implementation. The SME strategy for 2007–2012 was formulated under subprogram 1 and approved by the PMO in early 2008. Under subprogram 2, eight defined activities of the strategy have been completed. Overall, 18.6% of planned activities have been

22

accomplished or are ongoing, and 11.4% are planned to commence in 2009.18 The monitoring unit established at SMEPDO to monitor implementation published its first quarterly report in 2009. The report produced performance indicators for many of the activities for the first time, and made recommendations based on these indicators for steps to accelerate implementation of delayed activities. 52. Public–private dialogue. To provide an effective channel for feedback from the private sector on issues facing firms at the provincial level, the Government (with support from GTZ) has initiated P3Ds in a number of pilot provinces (footnote 8). These are intended to provide a regular forum to bring issues facing firms to the attention of relevant local authorities for resolution at the local level. Issues that cannot be appropriately addressed may be forwarded for the attention of relevant authorities in the central Government. Feedback obtained through the P3Ds can also provide valuable inputs for future policy direction and reforms. In recognition of their value, the Government is institutionalizing the P3Ds process in the four pilot provinces and plans to replicate it in other provinces going forward. Once they are institutionalized effectively, it is anticipated that P3Ds will serve as a natural forum for the conduct of stakeholder consultations under key initiatives supported by the Program, such as pilot testing regulatory impact assessments. 53. Upgrading and modernization of Credit Information Bureau and system. Recognizing the importance of establishing a system that provides banks with access to timely and accurate customer credit and collateral information, the central bank is modernizing the system used by the CIB. This system had increasingly become a bottleneck on the credit assessment and approval process, in the face of rapid growth in the number of banks and demand for lending from the private sector. The CIB is moving from a paper-based, manual system based on relayed fax requests and replies to a system that makes use of a centralized database and web-based technology that will allow banks to access as well as update customer credit and collateral information in real time (compared to current response times of up to 1 week). With assistance from ADB and the EC, a prototype system has been developed in close collaboration with CIB staff and has been pilot tested with involvement from all 20 commercial banks. Capacity building is also being provided to both the CIB and commercial banks in implementation of the new system, while the system is being refined to reflect feedback from the pilot-testing phase. Following this, it will be populated with data from the commercial banks and rolled out on an operational basis by the end of 2009. 54. SME accounting practices. The Government and development partners recognize that poor accounting and financial reporting capacity of SMEs limits their access to finance. Under subprogram 1, the Government enacted a new accounting and auditing law. Under subprogram 2, MOF produced training materials on basic accounting and bookkeeping practices under the new law and disseminated these at training courses to enterprises with technical assistance and support provided under the EC SME project.

b. Strengthen the Investment Climate 55. Subprogram 2 supports the Government’s efforts to implement the enterprise law and synchronize the investment lists with the negative list under the enterprise law. The main objective is to expand the number of private enterprises (and therefore investment). Reform areas of critical significance targeted under subprogram 2 include (i) implementing the new enterprise law, such as the negative list, simplifying registration procedures, and establishing

18 SMEPDO. 2009. Monitoring Report, 1st Quarter 2009. Vientiane: SMEPDO Monitoring Unit.

23

enterprise registry offices; and (ii) other policy reforms aimed at reducing transaction costs in doing business. The following measures toward achieving these objectives were completed prior to Board consideration of subprogram 2. 56. Implementation of enterprise law. Several measures were accomplished in implementing the enterprise law, and in particular to achieve the 10-day registration deadline for investments not on the negative list (the list was approved under subprogram 1). First, after completing necessary preparations for the enterprise registry, the Government made the new registration system effective in August 2008 and started the reregistration of all firms under the new registry system and in accordance with the negative list. Its purpose is to bring enterprises under the new law and clean the enterprise registry database of firms that are no longer in business. By the end of May 2009, about 41,000 firms had registered, of which over 7,000 represented new registrants (firms that had registered for the first time). Second, the Government (MOIC) simplified enterprise registration procedures aimed at reducing compliance costs to businesses by: (i) reducing the number of documents required for registration from 18 to 2–6, depending on the type of applicant—documentary requirements not pertinent to the registration function and the enterprise law have been eliminated (e.g., the requirement for curriculum vitae, declaration of sentencing, and asset declaration); (ii) delegating approval authority from the MOIC to the registrar of the Enterprise Registry Office (ERO) under ministerial instruction No 225; (iii) issued ministerial instruction No. 0995 on enterprise registration, which standardizes enterprise registration procedures for all provincial offices (called a single window); and (iv) improved transparency in the registration process by posting on MOIC’s website all registration documents, and other legal documents, instructions, and notices; as well as posting the steps for registration in the public area of registry offices. 57. Enterprise Registry Office. A modernized ERO with a centralized database with internet-based access is crucial to allow for efficient and effective implementation of the new enterprise law and enterprise registration system. Under subprogram 1, the central ERO was established. Subprogram 2 focused on modernizing the ERO at the central level (MOIC Vientiane) and completed the upgrading of 7 provincial pilot EROs,19 which (i) established a centralized web-based database linked to the provincial pilot EROs, and provides timely updates on registrations nationally; (ii) MOIC produced and implemented a capacity development program with provincial EROs, including upgrading software and hardware, and training on implementing the new registration procedures; and (iii) ERO printed new, simplified registration certificates. It will be important to complete the national rollout of the enterprise registry system and offices although the remote offices will not be internet-based. 58. New investment law. MPI, in consultation with MOIC and stakeholders, drafted a new law on investment promotion and submitted it to the National Assembly in June 2009. The National Assembly approved the draft law in July 2009 pending refinements to it (primarily refinements to the language). This new law is a major achievement under subprogram 2. The new law merges the separate foreign and domestic investment laws, provides for national treatment between domestic and foreign investors, and streamlines the investment approval process. 59. Regulatory review program. Reforming red tape will be a long-term effort, as in most countries. Subprogram 2 supports the Government’s effort to streamline red tape by assisting with the establishment of a regulatory review process in the medium term. SMEPDO and the

19 These ERO provinces include: Bolikhamxai, Champasak, Khammouan, Louang Phrabang, Savannakhet,

Vientiane, Xiangkhouang.

24

Lao National Chamber of Commerce and Industry, with ADB technical assistance (footnote 15) undertook a review of the business costs incurred by enterprises in complying with licenses and permits. The review consisted of a survey of 156 enterprises in Vientiane, Luang Prabang, and Savannakhet. The findings and recommendations of the review were presented to senior government officials in May 2009 and again in July 2009, as a first step toward raising awareness of the need for a systematic regulatory review program. As a consequence of this dialogue, MOIC established an interministerial taskforce, chaired by the vice-minister of industry and commerce and comprising of representatives from the relevant line agencies to build a degree of consensus on an action plan for implementing a regulatory impact assessment across national agencies. SMEPDO completed the upgrade of its website and started posting major laws, business licenses, and explanatory information on steps and processes to adhere to government regulations on registration and licensing as part of improving regulatory transparency.

c. Improve Trade Policy and Capacity Development

60. Subprogram 2 supports the Government’s goals of continuing trade policy reforms to lower the costs of doing business for the private sector and facilitate integration of the economy within the GMS, AFTA, and the global economy—including participation in the WTO. The following actions toward achieving these objectives were completed before Board consideration of subprogram 2. 61. Reforms to the import–export management system. MOIC has taken a sequential approach to reforming the import–export management system, based on the experience of neighboring countries such as Viet Nam. The approach is to improve transparency, reduce the discretion of trade officials, lower administrative costs, and later reduce the number of items restricted and replace some of them with more transparent forms of protection. Measures undertaken toward this goal include the following. First, the PMO approved the revised decree on import licensing procedures consistent with WTO rules. The decree distinguishes between automatic and non-automatic licenses consistent with WTO rules. Second, based on the new PMO decree on import licensing procedures, MOIC prepared the draft notification of the import prohibited and controlled lists, which has fewer items than the 2006 notification. Prohibited imports are confined to guns and ammunition (except explosives used for industrial purposes) and illegal drugs. Items subject to non-automatic licenses (i.e., that need approval from the sector agency) on the controlled list are primarily for public health and safety, the environment, and national security rather than protecting industry. These industries include fertilizers, pesticides, and other chemicals; animal medicines; explosives; and guns for industry use. The new list also includes information on the sector regulation requiring an import license for that item and its rationale. Three sectors (cement, steel, and rice) have had import restrictions for some time, but are included on the 2009 draft list for the first time, as part of Government's efforts to improve transparency in the trade regime. Third, MOIC prepared a decree on the application of rules of origin and submitted it to the PMO for approval. 62. Technical barriers to trade. MOIC, in collaboration with relevant line ministries, commenced review and reform processes for TBT notification to the WTO. The focus has been on strengthening the legal framework for sanitary and phytosanitary standards and other TBTs, consistent with WTO rules. These accomplishments include the following: (i) updated action plans on sanitary and phytosanitary standards for the 5th working party at the WTO, that took place in July 2009; (ii) MOIC and relevant ministries issued a series of decrees related to food safety management; principles for application of SPS; and technical measures for food safety management, plant protection, and quarantine law; and (iii) the Department of Health converted the ad valorem fee for issuing import permits for food products to a specific rate, which is a

25

significant accomplishment toward cutting the costs of red tape and reducing the discretion of trade officials issuing permits. 63. Capacity development at MOIC. Building capacity and staff training at MOIC is a core objective of the PSME program. Under subprogram 2, with ADB technical assistance (footnote 16) trade policy tools were developed for computing effective rates of protection (ERPs). MOIC estimated ERPs afforded to domestic industry—the first time ERPs had been estimated for the Lao PDR. Estimated ERPs are a useful transparency tool, as they highlight areas where high protection may exist and its causes. The results of MOIC-ADB work show that ERPs are relatively low across most sectors, although pockets of high protection still exist. They also show that some key potential export sectors have negative protection, meaning that protection given elsewhere in the economy has lowered its competitiveness.

d. Impact and Outcomes and of the PSME Program

64. The reforms to the enterprise registration system will potentially have a substantial impact on business compliance costs. The ADB-SMEPDO red tape review estimates that these changes will reduce the business compliance cost of registering enterprises by over 35% through savings in staff time and costs in preparing documentation and applying for the certificate, and follow-up. Even more substantial, businesses are not required to renew registration each year. Based on the review, this will save businesses at least $6 million annually (in 2008 prices). The immediate benefits are evident, with over 5,000 enterprises registering for the first time—as of May 2009, 41,000 enterprises have registered under the new law. The new investment law will enhance predictability in the investment framework and attract additional foreign investment. The reforms to the import–export management system have opened up new trade opportunities, will increase integration with neighboring economies, and will lower domestic prices. Consequently, the Program will have indirectly contributed to an increase in imports and exports of non-resource goods since 2006.

2. Post-Program Monitoring Framework

65. The development policy letter sets out the Government’s reform agenda for the next 1–2 years, building on the reform momentum of subprograms 1 and 2. The Government and ADB have agreed to a post-PSME program monitoring framework for 12 months, focusing on 12 policy measures and capacity development efforts of the Government’s short-term plan advancing its reforms in SME policy development, investment climate, and trade policy and facilitation (Table 4 and Appendix 3). Monitoring arrangements are discussed in paras. 69 and 76.

26

Table 4: Post-Program Monitoring Framework (Short-Term Measures)

Institutional Development for SME Policy and Access to Finance

Investment Climate Trade Policy, Capacity, and Trade Facilitation

(1) Institutionalize the P3D in the four provinces

(4) Complete rollout of the enterprise registry offices to all provincial offices

(8) MOIC prepares amendments to decree 205 on the import–export management system to ensure consistency with WTO rules.

(2) Bank of Lao PDR will continue to refine the CIB and roll out its operationalization

(5) MPI to prepare and issue implementing decrees once the new investment law has been enacted by the President of Lao PDR

(9) PMO approves decree on the application of rules of origin

(3) Conduct study on ways to develop the Lao PDR accounting profession

(6) SMEPDO continues to post regulations on its website

(10) MOIC coordinates with line ministries in implementation of action plans on SPS and other TBTs consistent with WTO rules

(7) The RIA interagency taskforce carries out public awareness raising about RIA, and prepares draft action plan and time frame for implementing RIA across line ministries. As part of this effort, an RIA pilot will be carried out in MOIC.

(11) MOIC reviews SPS management systems

(12) MOIC carries out stakeholder consultations on drafting of a decree on the establishment of SPS and TBT enquiry point and notification point, and provides capacity building for the establishment of SPS and TBT enquiry points and notification authority

CIB = Credit Information Bureau, P3D = provincial public–private dialogue, Lao PDR = Lao People's Democratic Republic, MOIC = Ministry of Industry and Commerce, MPI = Ministry of Planning and Investment, RIA = regulatory impact assessment, SME = small and medium enterprise, SMEPDO = SME Promotion and Development Office, SPS = sanitary and phyto-sanitary standards, TBT = technical barrier to trade, WTO = World Trade Organization. Source: Asian Development Bank staff.

C. Financing Plan 66. The Government has requested an Asian Development Fund grant of $15 million to finance subprogram 2 of the program cluster, with such terms and conditions as are substantially in accordance with those set forth in the draft Grant Agreement presented to the Board. 67. The ADB funds are to support the reforms outlined in the development policy letter (Appendix 2) and policy matrix (Appendix 3). The grant size was increased from $5 million, as initially planned when the program cluster was approved by the Board in October 2007, to $15 million. At the time of designing the program cluster in 2007, it was felt that the $5 million grant for subprogram 2 was relatively small when measured against the expected prior actions of subprogram 2. However, at that time limited Asian Development Fund funds to the Lao PDR did not permit more realistic funding of the Program. The increase grant from $5 million to $15 million is also justified on the basis that policy accomplishments under subprogram 2 have surpassed program expectations, its positive development impact on private sector growth and its links to job creation and sustainable poverty reduction (Appendixes 7 and 9). Direct adjustment costs include (i) foregone budget revenues from reform of the import–export management mechanism; and (ii) the costs of carrying out improvements to the business registration system and establishment of business registry information systems and offices in

27

the provinces, as well as establishing systems for posting regulations, licenses, and permits required to start and operate a business on the SMEPDO website. Therefore the total program cluster financing has increased from $10 million to $20 million. 68. The program grant also reflects the development financing needs of the Government. The collapse in copper and other commodity prices has resulted in a reduction in program budget revenues by up to 1% of GDP. As a result, the budget shortfall is $50 million–$60 million for FY2009. To address the shortfall, the Government will raise excise taxes on alcohol and petroleum and the Government has requested additional grant support from development partners. The proposed grant amount of $15 million for subprogram 2 will help close the financing gap for FY2009 (Table 5).

Table 5: Projected Financing Sources for 2009 ($ million)

Programmed external borrowings and grants in 2009 Proposed Amounts in 2009

ADB’s planned disbursementsa 88.7 of which:

BSRP third tranche 5.0 PSME subprogram 2 15.0

Other donor 73.5 a ADB = Asian Development Bank, BSRP = Banking Sector Reform Program, PSME = Private Sector and SME Development Program.

Note: An exchange rate of KN8,500 = $1 was used for calculations. a Planned disbursements for 2009.

Source: Ministry of Finance and ADB. D. Implementation Arrangements

1. Program Management 69. The implementation arrangements established under subprogram 1 will remain under subprogram 2. MOIC will be the Executing Agency (EA). It will be responsible for the overall implementation of subprogram 2, including carrying out all policy actions, program administration, and maintenance of all program records. The PSME steering committee, chaired by the minister of industry and commerce and comprising senior officials from BOL, MOF, and MPI, is responsible for coordinating the implementation and sustaining of the PSME policy actions with MOIC and relevant line agencies involved in supporting the PSME Program (BOL, MOF and MPI) and the post-program monitoring framework. The committee will meet twice a year to monitor progress and oversee implementation of the PSME Program and the post-program monitoring framework. ADB will participate in the meetings. English translations of the minutes of these meetings will be forwarded to ADB within 2 weeks of each meeting. MOIC will be responsible for day-to-day program implementation activities, and will report on implementation progress. The BOL and MPI will be acting as implementing agencies. MOF will be responsible for subprogram 2 disbursements and accounts maintenance.

28

2. Implementation Period 70. Subprogram 2 of PSME program period is from October 2007 to September 2009. All actions included in the policy matrix for subprogram 2 were implemented by mid-August 2009.

3. Procurement and Disbursement Arrangements 71. The program grant of $15 million will be released in a single tranche upon effectiveness. The grant proceeds will be used to finance the full foreign exchange costs (excluding local duties and taxes) of items produced and procured in ADB member countries and incurred no more than 180 days before the effectiveness date of the grant, excluding the items specified in the negative list of ineligible items (Appendix 8) and imports financed by other bilateral and multilateral sources. In accordance with the provisions of ADB’s Simplification of Disbursement Procedures and Related Requirements for Program Loans,20 the proceeds of the program grant will be disbursed to the Lao PDR as the recipient. No supporting import documentation will be required, if during each year that grant proceeds are expected to be disbursed the value of Lao PDR total imports minus imports from nonmember countries, ineligible imports, and imports financed under other official development assistance is equal to or greater than the amount of the grant expected to be disbursed during such year. The Government will certify its compliance with this formula prior to the withdrawal request. Otherwise, import documentation under existing procedures will be required. Disbursements will be made under the simplified procedures for program loans. In accordance with the simplified disbursement procedures and related requirements for program grants, all goods and services produced and originating in ADB member countries will be procured, with due consideration to economy and efficiency, in accordance with the Government’s standard public procedures and normal private sector commercial practices acceptable to ADB. Goods commonly traded on the international commodity market will be procured in accordance with procedures appropriate to the trade and acceptable to ADB. 72. The reform needs supported under the PSME will be met through local currency counterpart funds generated from the proceeds of the PSME grant.

4. Anticorruption and Fiduciary Assessment 73. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Government. Consistent with its commitment to good governance, accountability, and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to the Program. To support these efforts, relevant provisions of ADB’s Anticorruption Policy are included in the grant regulations and the bidding documents for the Program. In particular, all contracts financed by ADB in connection with the Program shall include provisions specifying the right of ADB to audit and examine the records and accounts of the EA and all contractors, suppliers, consultants, and other service providers as they relate to the Program. 74. An assessment of the country’s financial management systems has been carried out to understand fiduciary risks better and determine appropriate fiduciary arrangements for the purpose of this Program. This assessment was based on the Lao PDR Public Expenditure Review and Integrated Fiduciary Assessment Report (PER) led by the World Bank and

20 ADB. 1998. Simplification of Disbursement Procedures and Related Requirements for Program Loans. Manila.

29

participated in by ADB, the IMF, and the EC in 2006.21 The assessment carried out under the PER identified core areas to address with support from development partners. Based on this assessment, the PER determined that the fiduciary risk in the use and management of public funds is high. The Government is aware of the need to increase the amount of public resources allocated to planning and management to overcome significant weaknesses in the basic systems and processes for budget preparation, execution and control, reporting, and oversight. The PER acknowledges that since 2002, the Government has taken significant actions to address these weaknesses through its Public Expenditure Management Strengthening Program (PEMSP), and implement the last PER recommendations including strengthening the public accounting framework by issuing implementation regulations and by implementing a unified budget nomenclature and chart of accounts throughout the Government; progressively implementing a computerized government financial information system that has introduced an automated system for accounting, budget execution control, and reporting that will improve the capture and timely reporting of data and increase budget control; and issuing a new procurement decree and supporting implementation regulations and creating a Procurement Monitoring Office. ADB, the World Bank, and other development partners are working closely with the Government to implement improved public sector financial management systems. ADB has been supporting MOF with fiscal planning and budget preparation 22 and the second component of the Government’s Public Expenditure Management Strengthening Program on budget executing, accounting, and reporting.

5. Accounting, Auditing, and Reporting 75. ADB retains the right to audit the use of grant proceeds and to verify the accuracy of the Government’s certification for the withdrawal applications. Before withdrawal, the Government will open a deposit account at the Bank of the Lao PDR to receive all grant proceeds. The account will be managed, operated, and liquidated in accordance with terms satisfactory to ADB. MOIC will be required to submit quarterly progress reports as well as a final report on the progress of subprogram 2 implementation.

6. Performance Monitoring, Evaluation and Program Review 76. In cooperation with the PSME committee (para. 69), ADB will carry out periodic reviews of program implementation, and assess the impact of the PSME and the post-program monitoring framework. The Government will keep ADB informed of the outcome of policy discussions with other multilateral and bilateral agencies that have implications for PSME implementation, and provide ADB with the opportunity to comment on any resulting policy proposals. ADB, in collaboration with the committee, will undertake a review of program performance 8 months after grant effectiveness to review the outcome of subprogram 2. In addition to the review report, the committee will submit to ADB within 8 months of grant effectiveness of subprogram 2, a review report that assesses compliance with, and the impact of, agreed actions under subprogram 2. In addition, participants in the Lao Business Forum (partner agencies, business groups, and other stakeholders) will be encouraged to support private sector monitoring of the reforms under the PSME.

21 World Bank, IMF, ADB, and European Commission. 2007. LAO PDR: Public Expenditure Review and Integrated

Fiduciary Assessment, Vientiane, LAO PDR. 22 ADB. Lao PDR - Public Expenditure Planning for the National Growth and Poverty Eradication Strategy, TA 4627.

Manila.

30

77. The Government and ADB have agreed on a range of outcome and output indicators to monitor the PSME implementation and evaluate its impact, within the overall PSME framework (Appendix 1).

V. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS

A. Expected Impacts 78. The key benefits expected from the PSME program cluster are as follows:

(i) Improved investor confidence through completion of implementation of the new enterprise law and a new investment law that provides for national treatment between foreign and domestic investors.

(ii) Lower transaction costs for business because of streamlined business start-up procedures, a reduction in red tape, and reform of remaining non-tariff barriers which will open new opportunities, increase investment and productivity, boost the economy, and increase incomes and create jobs.

(iii) Strengthened institutional development through raising capabilities in the EA and IAs to carry out trade, investment, and SME policy analysis with the aim of improving the quality of policy, institutional processes for policy making. Posting regulations on the SMEPDO website will also contribute to institutional development through better regulatory transparency.

B. Risks and Mitigating Measures 79. The PSME program cluster is subject to the following risks:

(i) In transitional economies, maintaining macroeconomic stability––reflected in low inflation and a stable exchange rate––is critical for investor confidence and private sector growth. The Lao PDR is particularly vulnerable to macroeconomic instability because of weak institutions. It also faces emerging fiscal stress and macroeconomic challenges in the context of the fall in resource revenues that threaten to undermine recent gains in social spending and poverty reduction. The Government recognizes these risks and, with development partner assistance including ADB, is undertaking measures to raise revenue and strengthen public expenditure management.

(ii) The capacity of agencies to implement reforms may be constrained by resources and other emerging priorities. The PSME program cluster reduces this risk by limiting the policy triggers to a small number of high-priority, high-impact policy reforms under the jurisdiction of the EA and a limited number of IAs (MPI and MOF), and by attaching TA to each policy trigger.

(iii) There will be resistance to some reforms from vested interests. Reforms to the import–export management system and institutionalizing economic governance reforms––i.e., red tape review process––are likely to be a lengthy process. Resistance may also come from entrenched cultural and political economy factors that may slow market economy reforms and market competition, including the dominance of the state sector in some sectors (cement, steel, pharmaceuticals, food processing and beverages, and utilities). However, several factors mitigate these risks: (a) the PSME strategic approach is to focus efforts on supporting the Government’s initiatives, and (b) reforms have focused on areas where there is political will and some measure of capacity. This has been demonstrated by successful implementation of the enterprise law and

31

establishment of the enterprise registry, which has resulted in substantial cuts in business compliance costs and 7,000 enterprises registering for the first time in 2008 and 2009.

VI. ASSURANCES

80. In addition to the standard assurances, the Government has given the following assurances, which are incorporated in the legal documents.

(i) The Counterpart Funds will be used to finance the local currency costs relating to the implementation of subprogram 2 and other activities consistent with the objectives of subprogram 2 and shall provide the necessary budget appropriations to finance the structural adjustment costs relating to the implementation of reforms under subprogram 2.

(ii) The policies and actions taken prior to the date of the PSME grant agreement, as described in the development policy letter (including the policy matrix), will continue to be in effect for the duration of the PSME program cluster and subsequently.

VII. RECOMMENDATION

81. I am satisfied that the proposed grant would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve the grant not exceeding $15,000,000 to the Lao People’s Democratic Republic from ADB's Special Funds resources for subprogram 2 of the Private Sector and Small and Medium-Sized Enterprises Development Program, on the terms and conditions that are substantially in accordance with those set forth in the draft Grant Agreement presented to the Board. Haruhiko Kuroda President 9 September 2009

Appendix 1

32

DESIGN AND MONITORING FRAMEWORK

Design Summary

Performance Targets/Indicators

Update to Subprogram 2

Data Sources/ Reporting

Mechanisms

Assumptions and Risks

Impact Sustainable economic growth supported by increased contribution of the private sector and SMEs

By 2011, SEDP6 goals attained: Real GDP growth at 7%–8% per annum

GDP growth of 7%–8% in 2007 and 2008, expected to slow to 4%–5% in 2009 because of global recession (on track)

NSC data Poverty incidence data from NSC

Assumption Macroeconomic stability maintained Risks Prolonged and severe global recession will lead to greater economic slowdown in Lao PDR than anticipated

The collapse in commodity prices does not recover in the short term, leading to increased fiscal stress

Outcome Improved business environment where the private sector and SMEs operate efficiently and effectively

By end of 2011: Increase number of private enterprises and SMEs formally registered by as much as 15% (2006 baseline was 77,000 registered firms) Increase number of enterprises (formal and informal) and number of female entrepreneurs by 5% per year (2006 baseline was 126,913 enterprises) Increase employment in the private sector (baseline 102,000 workers in industry in 2004) Increase non-resource trade by 5%–10% per annum (2004 baseline was $980 million)

ERO began reregistration process under new law in August 2008. By end of May 2009, almost 30,000 enterprises registered—of which 5,000 (or 17%) registered for the first time (on track) Data not yet available Employment data not yet available Non-resource trade increased from $980 million in 2004 to $1.7 billion in 2008, or about 17% per annum (exceeded expectations)

NSC enterprise survey

NSC published trade data

GTZ enterprise baseline survey

NSC published consumer price index

Next industrial census

Assumption Government stays on course with key fiscal policy reform measures and business regulatory reform Risk Lack of commitment and willingness of government agencies and stakeholders to participate in implementing reforms

Appendix 1

33

Design Summary

Performance Targets/Indicators

Update to Subprogram 2

Data Sources/ Reporting

Mechanisms

Assumptions and Risks

Outputs 1. Institutional coordination for SME policy and access to credit improved

By end of 2010 (with baseline 2005 or 2006 indicators in brackets):

Implement the SME strategy, which aims for better interministerial coordination on SME policies Increase the number of SMEs included in MOF accounting training programs (2005 baseline was none) Increase the number of SMEs served by the banking and finance sectors (baseline 2005)

SME strategy is being implemented. Based on GTZ report, about 18% of program activities implemented or ongoing after 1 year (slow progress) MOF undertook provincial workshops in 17 provinces covering 994 participants, of which 80% from the private sector, predominantly SMEs, and 35% were female participants (on track) Proportion of population with a loan increased from 5% in 2000 to 14% by 2008 (on track)

ADB review missions Department of Accounting, MOF ADB review missions

Assumption Government stays on track with its preparations for WTO accession Risks Weak interagency coordination

Capacity of agencies to implement reforms may be constrained by resources and other emerging priorities

Reforming import–export management system may face strong resistance from vested interests

2. Investment climate strengthened

Reduce the average number of days to launch an enterprise by 20%–30% (baseline in 2006 was 167 days IFC) Increase the number of FDI projects approved (baseline in 2004 was 161 approved projects)

IFC Doing Business 2009 reports 103 days to launch a business—a reduction of 38% in days (exceeded expectations) FDI approved projects increased from 161 in 2004 to 191 in 2007. In dollar equivalents, FDI increased from $533 million in 2004 to $1,136 million in 2007 (on track)

ADB-World Bank Investment Climate survey, IFC Doing Business reports, GTZ benchmark enterprise survey (2007 and 2009) MPI

3. Trade policy and capacity development improved

On track to reduce the number of items on the controlled import list (baseline in 2006 was 42 items at 8 digit HS; 3 items at 6 digit HS; 9 items at 4 digit HS)

The new notification streamlines the criteria, introduces automatic and non-automatic licensing, and reduces the number of sectors to 21 (on track)

MOIC (Department of Export and Import) notification of items included in the controlled list (2008)

Appendix 1

34

Design Summary

Performance Targets/Indicators

Update to Subprogram 2

Data Sources/ Reporting

Mechanisms

Assumptions and Risks

Reduce the time it takes to prepare documents for importing and exporting goods by 20%–30% (baseline in 2006 was 54 days IFC) Reduce prices of imported goods removed from the controlled import list

50 days in 2008 or 9% reduction over baseline (slow progress) Not yet available (in process)

IFC Doing Business reports ADB TA and review missions NSC published consumer price index

Activities with Milestones (during subprogram 2) 1.1 MOIC to produce annual report on SME development and issues (Dec 2009) 1.2 MOIC completes rollout of the EROs in all provinces (Dec 2009) 1.3 Bank of Lao PDR continues to refine and operationalize the CIB (Dec 2009) 1.4 Conduct study on ways to develop Lao PDR accounting profession (June 2010) 2.1 MPI prepares implementing decrees once the new investment law is enacted by the National Assembly (June 2010) 2.2 SMEPDO continues to post regulations on its website (June 2010) 2.3 Interagency committee carries out public awareness raising about RIA, and prepares draft action plan and time frame for pilot testing RIA in selected line ministries and institutionalizing it across government (June 2010) 3.1 MOIC prepares amendments to decree 205 on the import–export management system to ensure consistency with WTO rules (Dec 2009) 3.2 MOIC reviews SPS management systems (June 2010)

Inputs ADB subprogram program 2 grant ($15 million).

ADB = Asian Development Bank, CIB = Credit Information Bureau, ERO = enterprise registry office, GDP = gross domestic product, FDI = foreign direct investment, IFC = International Finance Corporation, Lao PDR = Lao People’s Democratic Republic, MOF = Ministry of Finance, MOIC = Ministry of Industry and Commerce, MPI = Ministry of Planning and Investment, NSC = National Statistics Center, SEDP6 = Socio-Economic Development Plan, RIA = regulatory impact assessment, SMEs = small and medium-sized enterprises, SMEPDO = SME Promotion and Development Office, SPS = sanitary and phyto-sanitary standards, TA = technical assistance, WTO = World Trade Organization. Note: HS = harmonized codes used for classifying imports and exports of goods. Source: Asian Development Bank.

Appendix 2

35

DEVELOPMENT POLICY LETTER

Appendix 2

36

Appendix 2

37

Appendix 2

38

Policy Matrix for Subprogram 2, Post-Program Monitoring Framework, and Medium-Term Direction

Policy Actions

Accomplishments under Subprogram 2 Triggers (in bold) and Other Policy Measures (non bold)

Post-Program Monitoring Framework

(Short-Term Action Plan 2009–2010)

Medium-Term Program Direction

and Goals (2007–2012)

1. Institution Coordination and SME Access to Credit 1.1 Coordination of SME development across line ministries

(1) Provincial public–private dialogues (P3Ds) undertaken in 2008 in four provinces to identify investment climate issues for resolution (done) (2) SMEPDO made progress in implementing its SME strategy (done; ongoing process)

(1) Institutionalize P3Ds in the four provinces

(1) SMEPDO rolls out P3D to other provinces (2) SMEPDO institutionalizes SME strategy, including producing annual report on the SME sector

1.2 Improve enterprises’ access to finance by increasing capacity for financial reporting

(3) BOL has undertaken upgrading the CIB from a manual system to a secure computerized system for commercial banks and BOL. The piloted CIB was completed in January 2009, with the participation of all commercial banks. The new system will allow real-time search and uploading of borrowers’ credit information, reducing commercial banks’ search time from 1 week to less than 10 minutes (substantially done. Design and pilot completed) (4) MOF produced training materials on basic accounting and bookkeeping practices and disseminated them at training workshops to enterprises (done)

(2) BOL continues to refine the CIB and roll out its operationalization (3) Conduct study on ways to develop Lao PDR accounting profession

(3) Functioning CIB (4) More robust accounting training

2. Strengthening the Investment Climate 2.1 Implement the enterprise law

(5) MOIC simplified the enterprise registration process by: (i) reducing the number of documents required from 18 to 2–6, depending on the type of applicant (e.g., eliminated the requirement for curriculum vitae, declaration of sentencing,

(4) Complete rollout of the EROs to all provincial offices

(5) Complete implementation of the enterprise law

Appendix 3 39

40 A

ppendix 3

Policy Actions

Accomplishments under Subprogram 2 Triggers (in bold) and Other Policy Measures (non bold)

Post-Program Monitoring Framework

(Short-Term Action Plan 2009–2010)

Medium-Term Program Direction

and Goals (2007–2012)

and asset declaration); (ii) delegated the approval authority from MOIC to ERO under MOIC ministerial instruction 225; (iii) standardized enterprise registration procedures for all provincial offices (called single window) under MOIC instruction no 0995 ; and (iv) improved transparency in the registration process by posting on MOIC’s website all registration documents, forms, samples, and other legal documents, instructions, and notices and posting the steps for registration in the public area of the registry offices (done) (6) Began implementing the new enterprise registration system in August 2008 (MOIC instruction 1238). Firms operating in sectors not on the negative list no longer require to seek approval first from the relevant line ministry (done) (7) MOIC modernized the enterprise registry system at the central level (Vientiane) and completed 7 provincial ERO pilots, which (i) established a centralized web-based database linked to pilot provinces, and provides timely updates on registrations nationally; and (ii) MOIC produced and implemented a capacity development program with provincial EROs from August 2008, including upgrading software and hardware, and training on implementing the new registration procedures (done)

(6) Functioning EROs in all 17 provinces

2.2 Draft new investment law

(8) MPI drafted new Law on Promotion of Investment and submitted to the National Assembly in June 2009. The National Assembly approved the draft law pending refinements to it. This new law merged the foreign and domestic investment laws, provided for national treatment, and streamlined the investment approval process. (done).

(5) MPI to prepare and issue implementing decrees once the new investment law has been enacted by the President of the Lao PDR

(7) Unified enterprise registration and investment licensing procedures

2.3 Regulatory reform aimed at reducing the transaction costs

(9) SMEPDO completed red tape review, including reviewing at least five key licenses for reform (done) (10) In implementing the SME strategy, the Government (MOIC)

(6) SMEPDO continues to post regulations and guidelines on SMEPDO website

Appendix 3 41

Policy Actions

Accomplishments under Subprogram 2 Triggers (in bold) and Other Policy Measures (non bold)

Post-Program Monitoring Framework

(Short-Term Action Plan 2009–2010)

Medium-Term Program Direction

and Goals (2007–2012)

of doing business established an interagency taskforce (RIA taskforce) chaired by the Vice Minister for Industry and Commerce and comprising senior officials from the relevant ministries to raise awareness and help facilitate the design and development of an action plan for implementing a regulatory impact assessment (RIA) across national line ministries. (done) (11) SMEPDO completed the upgrade of its website and started posting major laws, business licenses, and explanatory information on steps and processes to adhere to government regulations on registration and licensing as part of improving regulatory transparency (done)

(7) RIA taskforce carries out public awareness raising about RIA and helps facilitate developing a draft action plan to implement RIA in selected line ministries; starts with pilot RIA program in MOIC

3. Trade Policy and Capacity Development

3.1 Continue reforms to trade policies to reduce trade costs to private sector

(12) MOIC continued to reform the import control and management system by the following: (i) issued new import licensing procedures decree, which distinguishes between automatic and non-automatic import licensing consistent with WTO rules; (ii) prepared a revised import controlled list based on the new import licensing procedures decree and (iii) MOIC prepared decree on application of rules of origin to be submitted to the PMO for approval (done). (13) MOIC, in collaboration with relevant line ministries, started strengthening the legal framework for SPSs and other TBTs consistent with WTO rules. These accomplishments included (i) updated action plans on SPSs and other TBTs for the 5th working party meeting that took place in July 2009; (ii) MOIC and relevant ministries issued a series of decrees related to food safety management; principles for application of SPS and technical measures for food safety management; plant protection and quarantine law; and (iii) DOH converted a fee for issuing import permits for food products from an ad valorem fee to a specific rate (done)

(8) MOIC prepares amendments to decree 205 on import–export management system to ensure consistency with WTO rules (9) PMO approves decree on the application of rules of origin. (10) MOIC coordinates with line ministries in implementation of action plans on SPS and other TBTs consistent with WTO rules, and provides capacity building to relevant line ministry

(8) Improved analytical support to assess trade policy for effective participation in WTO (9) Continue reform of the import–export management system

42 A

ppendix 3

Policy Actions

Accomplishments under Subprogram 2 Triggers (in bold) and Other Policy Measures (non bold)

Post-Program Monitoring Framework

(Short-Term Action Plan 2009–2010)

Medium-Term Program Direction

and Goals (2007–2012)

(11) Review SPS management systems

3.2 Improve transparency in trade policy

(14) MOIC developed trade policy tools for computing effective rates of protection and produced estimates for 2008 (done)

(12) MOIC carries out stakeholder consultations on drafting of a decree on the establishment of SPS and TBT enquiry point and notification point (finalized by 2010), and provides capacity building for the establishment of SPS and TBT enquiry points and notification authority

(10) Improved analytical capacity to support trade policy for effective participation in WTO

BOL = Bank of the Lao PDR, CIB = Credit Information Bureau, ERO = Enterprise Registry Office, MOIC = Ministry of Industry and Commerce, MOF = Ministry of Finance, MPI = Ministry of Planning and Investment, PMO = Prime Minister’s Office, RIA = regulatory impact assessment, SMEs = small and medium-sized enterprises, SMEPDO = SME Promotion and Development Office, SPS = sanitary and phytosanitary standards, TBT = technical barrier to trade, WTO = World Trade Organization. Source: Asian Development Bank.

Appendix 4

43

DEVELOPMENT PARTNERS COORDINATION MATRIX

ADB Support for Private Sector and SMEs

Major Support from Other Development Partners

Banking Sector Reform Program (completed on 31 March 2009)

Japan (JICA) – SME promotion in the local districts, export promotion

Rural Finance Sector Development Program

European Commission – SME TA project in partnership with ADB’s PSME program, WTO accession

Trade facilitation and cross-border transport agreement

World Bank – financial management, SOE reform, Integrated Framework for Trade, Poverty Reduction Grant Support Program

Irrigation IFC – Mekong Private Sector Facility

Commercial agriculture support, agriculture production improvement

UNDP – ASEAN Support Project, Integration into International Trading System Project

GMS Trade Facilitation TA UNIDO – PSD and SME promotion, manufacturing productivity

Australia (AusAID) – regional trade areas

Canada (CIDA) – APEC economic integration, trade policy capacity

Germany (GTZ) – Human resource development for SMEs

Sweden (SIDA) – Strengthening fiscal management

ADB = Asian Development Bank, APEC = Asia-Pacific Economic Cooperation, ASEAN = Association of Southeast Asian Nations, AusAID = Australian Agency for International Development, CIDA = Canadian International Development Agency, GMS = Greater Mekong Subregion, IFC = International Finance Corporation, JICA = Japan International Cooperation Agency, SIDA = Swedish International Development Agency, SMEs = small and medium-sized enterprises, SOE = state-owned enterprise, TA = technical assistance, UNDP = United Nations Development Programme, UNIDO = United Nations Industrial Development Organization, WTO = World Trade Organization. Source: Asian Development Bank.

44 Appendix 5

MACROECONOMIC ASSESSMENT AND DEBT SUSTAINABILITY ASSESSMENT

1. This assessment provides a summary of developments in macroeconomic policy. It also presents a summary assessment of debt sustainability. A. Macroeconomic Stability 2. This section assesses macroeconomic performance to date and summarizes the discussion of the key medium-term macroeconomic policy issues. While much has been done to put fiscal policy on a sound path, the collapse in commodity prices heightens four critical issues for the Government in ensuring fiscal sustainability over the medium term: (i) increasing efforts to mobilize domestic revenues, (ii) better management of natural resource revenues, (iii) improving efficiency in public expenditure management, and (iv) improving debt sustainability. We conclude that, with the collapse in commodity prices, sustainable adjustment will require more efforts to raise domestic revenues resources over the medium term.

1. Fiscal Policy 3. Fiscal crisis: 1998–2001. After improving in the first half of the 1990s, the macroeconomic fortunes of the Lao People’s Democratic Republic (Lao PDR) quickly reversed following the Asian crisis. In the mid-1990s, budget revenues were improving and inflation was on a downward trend. Then came the fall in demand for Lao PDR products arising from the Asian financial crisis and, exacerbated by expansion in domestic money supply to finance public investments in irrigation, led to a severe economic crisis. The kip exchange rate against the US dollar depreciated, leading to hyperinflation during 1998 and 1999, tax revenues plunged, and the national government deficit increased sharply and public debt began to climb. The overall budget deficit reached 5.6% of gross domestic product (GDP) in 2003. 4. A major factor contributing to deterioration of the fiscal balance was that revenues were undermined because (i) tax collection was deconcentrated with decentralization, and provincial governments had little incentive to collect and pass on additional taxes to the central Government; (ii) several sectors were outside the tax base; and (iii) tax administration weaknesses persisted and were not addressed. 5. Emerging from crisis. In 2001, the Lao PDR emerged from the economic and fiscal crisis. The Government has restored macroeconomic stability and has maintained it through fiscal discipline and better management of monetary policy. This has been at the expense of suppressed expenditure in the social sectors (education and health) and a substantial decline in public sector real wages. In the FY 2008 budget revenues exceeded the budget plan—primarily as a result of increased collections from the booming mining sector, with resource revenues amounting to 3.2% of GDP, up from 2.6% in 2007 and 1.9% in 2006. Overall, budget revenue collections rose by 1.9 percentage points of GDP in 2008 over 2006 levels. As a result, the overall budget deficit as a share of GDP fell from 4.5% in 2005 to 2.9% in 2007 and 2.0% in 2008, surpassing fiscal targets (Table A5.1).

Appendix 5

45

Table A5.1: Fiscal Policy Indicators, 2001–2008 (%, unless otherwise stated)

Item 2003 2004

2005 2006

2007 2008a Revenues and grants 13.0 12.1 12.7 14.6 15.8 15.6 Revenues 10.9 11.0 11.4 12.7 14.0 14.3 Tax 8.9 9.1 9.4 10.8 12.1 12.5 Resources 1.3 1.1 1.3 1.7 2.2 2.7 Non-resource 7.6 8.0 8.1 9.2 10.0 9.8 Non-tax 1.9 1.9 2.0 1.9 1.9 1.8 Grants 2.1 1.1 1.2 1.9 1.7 1.3 Expenditures 18.6 15.5 16.0 17.7 18.6 17.7 Current 7.1 7.4 8.0 9.0 8.9 10.3 Capital expenditure 11.0 7.3 6.0 7.3 8.1 7.0 Other 0.5 0.8 2.0 1.0 1.6 0.4 Overall balance (5.7) (3.4) (3.3) (3.1) (2.8) (2.1) Foreign Financing (net) 5.1 3.6 3.0 4.6 2.9 2.0

( ) = negative, Lao PDR = Lao People’s Democratic Republic. a Estimated. Source: Ministry of Finance, Lao PDR; International Monetary Fund. 2008. Lao PDR: Selected Issues and Statistical Appendix, Washington, DC. 6. Collapse in commodity prices and emerging fiscal stress in 2009. Booming commodity prices from 2006 to 2008 raised central government budget revenues by 1.9 percentage points over 2005 levels and expectations were that the elevated commodity prices would continue for some years to come. This perception influenced the Government’s management of resource revenues and spending priorities. The 2009 budget formulated in early 2008 assumed commodity prices would remain at elevated levels and resource revenues would contribute to 30% of the increase in budget revenues in 2009. Overall, budget revenues were projected to rise by 14% over the 2008 budget outturn. Paralleling revenues, planned current expenditures were projected to rise by 24% and a projected overall budget deficit of 3.4% of GDP, which was considered manageable given that the Government had consistently exceeded revenues projections in the previous two budgets. However, the underlying weakness of the overall budget can be ascertained by stripping away resource revenues from the central government budget. The non-resource budget balance is much higher, at 5.3% of GDP in 2008, suggesting the budget is vulnerable to deterioration in Lao PDR terms of trade (Figure A5.1). The collapse in copper prices and other key minerals, except for gold, has feedback into a projected decline in resource revenues by 21% below the 2009 budget plan and as a share of GDP. As a result, the overall budget deficit is expected to rise to 4%–5% of GDP in 2009 and create a budget financing shortfall of $50 million–$60 million in FY2009. The Government is addressing this through increased excise taxes on alcohol and retail gasoline sales, and increased grants from development partners. The stress in the fiscal situation may persist in 2010 as corporate profit tax from the resource sector declines as losses are carried over.

46 Appendix 5

Figure A5.1: Resource Revenues and the National Government Budget

(a) Overall Budget and Non-Resource Budget (b) Impact of Commodity Prices on Deficits (% of GDP) Resource Revenues to the NG Budget

0

1

2

3

4

5

6

2005 2006 2007 2008 2009

% o

f GD

P

Overall budget balance Non-resource budget balance

0

1

2

3

4

2005 2006 2007 2008 2009

% G

DP

50

100

150

200

250

300

350

Pric

e in

dex

Resource revenues to the budget

Commodity price index

GDP = gross domestic product, NG = non government. Note: The commodity price index refers to the composite price index of metals and minerals (copper, gold, nickel, silver, etc.). Sources: Budget data from the Ministry of Finance, Vientiane; Commodity price data from the Development Economics Prospects Group, World Bank; and International Monetary Fund projection for 2009.

2. Banking Sector

7. Impact of global financial crisis. Direct impacts of the global financial crisis on the domestic financial system so far have remained negligible. The banking system has not been affected by the direct effect of the global crisis because of its low level of financial sector development (banking assets account for 15% of GDP) and almost nonexistent exposure to troubled US assets. There is no corporate bond market, government treasury bills are not traded on the market, and the Government does not access international credit markets. However, the banking system is vulnerable to the potential feedback loop from the global crisis transmitting to the real sector, and the slowdown in the real sector transmitting to increased nonperforming loans (NPLs) and erosion of banking sector capital. The increased vulnerability arises for two reasons. First, the three state-owned commercial banks (which account for about 60% of banking sector assets) have a combined capital to asset ratio of 1.77%, indicating essentially no capital to buffer a modest deterioration in asset quality, such as a doubling of NPLs from the current 4% level. Lao Development Bank (LDB) and Agriculture Promotion Bank (APB) have negative capital and Banque pour le Commerce Exterieur Lao (BCEL) capital turned positive in 2007 although it is still below the Bank of the Lao PDR (BOL) required 8% capital–asset ratio (CAR). Private banks reportedly have a CAR of 16%. Second, bank lending had accelerated to unprecedented levels in 2008, rising by more than 50% in BCEL and LDB. The loan to deposit ratios are relatively low (around 50%) and gross NPLs are low at 4% (on BOL’s definition). However, the rate of increase in credit over a relatively short period and the slowing economy slowing are likely to increase NPLs over the next 12 months, especially if the economic slowdown persists into 2010. BOL recognizes the need to remain vigilant in monitoring banks and NPLs, and in this context has requested Asian Development Bank (ADB)

Appendix 5

47

technical assistance (TA) for enhancing capacity and staff training in bank supervision—both on-site and off-site monitoring. ADB has proposed the Enhancing Financial Sector Supervision TA grant project covering (i) capacity development for effective supervision of microfinance institutions under the Banks and Financial Institutions Supervision Department at BOL, (ii) capacity development for effective supervision of commercial banks under the supervision department, and (iii) capacity development for strengthening the anti-money-laundering intelligence unit.

Figure A5.2: Banking Sector Indicators (a) Combined capital–asset ratio of SOCBs (b) SOCB LDR and NPLs

-10

-8

-6

-4

-2

0

2

4

2006 2007 2008

0

10

20

30

40

50

60

2006 2007 2008

% L

DR

0

2

4

6

8

10

12

14

% N

PLs

LDR NPLs

(c) Total outstanding loans (adjusted to inflation) (d) 2008 Financial indicators of three SOCBsa

0

1000

2000

3000

4000

5000

6000

2006 2007 2008

Kip

bill

ion

-6

-4

-2

0

2

4

6

BCEL LDB APB

%

CAR NPL

APB = Agriculture Promotion Bank, BCEL = Banque pour le Commerce Exterieur Lao, CAR = capital asset ratio, Lao PDR = Lao People’s Democratic Republic, LDB = Lao Development Bank; LDR = loan–deposit ratio; NPL = nonperforming loan, SOCB = state-owned commercial bank. a Unaudited 2008 financial accounts of the three SOCBs. Source: Bank of the Lao PDR.

3. External Sector

8. Balance of payments. The balance of payments surplus is expected to decline amid pressure from the global financial crisis. The Lao PDR recorded a balance of payments surplus of $113 million or 2.0% of GDP in 2008. Consequently, gross international reserves rose from

48 Appendix 5

$528 million in 2007 to $636 million in 2008, equivalent to about 3.4 months of imports. Conventionally, at least 3 months of import coverage is considered a sufficient buffer against a modest external shock. However, the global financial crisis has put increased pressure on the balance of payments. Exports year-on-year started to decline in the fourth quarter of 2008 because of falling commodity prices and the slowdown in demand for garments from developed countries. Imports also started to decline in the first quarter of 2009. It is projected that exports (mainly commodities) will decline by about 21% and imports by 14% in 2009. As a result, the current account is expected to remain in deficit in the range of 14% of GDP. On the capital account side, foreign direct investment flows are expected to slow, although partially compensated by increased inflows of official assistance.

3. Medium-Term Macroeconomic Issues 9. Considerable fiscal gains have been achieved since 2001, and fiscal space has been provided by taxes from commodities, but the global financial crisis and collapse in commodity prices highlight the importance of locking in these gains and building on them. 10. Issue 1: Fiscal consolidation. Over the medium term, sustainable fiscal consolidation will require further non-resource revenue effort. The Lao PDR has one of the lowest non-resource tax revenue to GDP ratios (about 10%) among low-income countries, partly because of the dominance of the subsistence agriculture sector. Substantial gains in non-resource tax collection were made in 2006 and 2007, with revenues rising by two percentage points of GDP because of improvements in tax administration. However, these gains appear to have leveled out in 2008. Most of the recent gains in revenues come from royalties and profit taxes from the natural resource sector. Revenue management is challenged by (i) the erosion of the income tax base caused by the proliferation of tax incentives in growth sectors of the economy––about 1,600 and large firms have significant fiscal incentives under the investment laws; and (ii) persistently weak tax administration. The Government is addressing these issues in a systematic and sustainable way, and this will be a longer term effort. Importantly, the National Assembly enacted the budget law in 2006, which re-concentrates tax collection. The law, modeled on Viet Nam’s budget law, defines revenues belonging to the central Government, provincial governments, and those revenues to be shared between central and provincial governments. The budget law also places the Treasury and Customs Department under central government authority, ensuring that revenues are passed to the central Government. The Government has designed a value-added tax and intended to implement it in January 2009. This has been delayed because much work still needs to be done to clean up the taxpayer registration, expand it, and develop a refund mechanism, and undertake taxpayer education. 11. Fiscal outlook for 2009 and 2010. An outlook for fiscal policy over the next 2 years is presented in Table A5.2, which presents a baseline scenario based on assumptions of low commodity prices and economic growth in the range of 4%–5% in 2009 with recovery in 2010. The low-case scenario of a continued expenditure program with lower revenues would be a fiscal deficit projected up to 7.5% of GDP while a high case scenario of additional measures to raise revenue and lower expenditure would be a projected deficit of 3.5% of GDP. While the low and high scenarios are indicative, they demonstrate the need for continuing increasing revenue effort and expenditure management.

Appendix 5

49

Table A5.2: Lao PDR Medium-Term Outlook, 2009–2010 (% of GDP, unless otherwise stated)

Indicator 2008 2009 2010 Revenues and grants 15.6 14.9 15.3 Revenues 14.3 12.9 13.2 Tax 12.5 11.4 11.6 Resourcesa 2.7 2.3 1.7 Non-resource 9.8 9.1 9.9 Non-tax 1.8 1.5 1.6 Grants 1.3 2.1 2.1 Expenditures 17.7 22.8 21.1 Domestic expenditure 12.8 18.3 16.2 Wagesb 4.6 5.8 5.6 Interest 0.8 0.8 0.9 Otherc 7.4 11.2 9.7 Development partner financed expenditure

4.8 4.5 4.9

Overall balance (excluding additional measures) d

(2.1) (7.9) (5.8)

Overall balance (including additional measures)

(3.5) (3.5)

Foreign financing (net) 3.0 2.4 2.6 Memorandum items: External public sector debt 71.5 69.1 66.7

Nominal GDP (fiscal year, KN billion)

44,993.0

48,391.0 52,106.0 ( ) = negative, GDP = gross domestic product, Lao PDR = Lao People’s Democratic Republic. a Includes taxes and royalties from timber, hydro, and mining sectors. b Includes salaries and benefits, compensation, and extra work allowances. c Includes onlending, debt repayment, and contingencies. d Additional measures refer to tax increases and reduced expenditures to bring the overall budget deficit to

3.5% of GDP. Scenarios in progress of been updated, as additional evidence emerges on the impact of the crisis on the Lao PDR economy and fiscal situation.

Source: IMF. 2008. International Monetary Fund projections. Washington, DC.

12. Issue 2: Public expenditure management. Medium-term fiscal sustainability requires improving efficiency in the public expenditure management by ensuring a balanced public expenditure program between capital spending and recurrent expenditures, as well as between discretionary and nondiscretionary spending items (interest payments and wages).1 This will require reorienting spending toward priority sectors identified in the Government’s poverty reduction strategy. In recent years, there have been large increases in public servant wages to compensate for hyperinflation in 1998 and 1999. While this is understandable, the expansion in the wage bill and other nondiscretionary items should be more prudent going forward. Implementing improved systems for public expenditure management—including the medium-term expenditure framework, which aligns the budget planning process with strategic objectives and priorities—is integral to improving efficiency in public expenditure management. Progress is been made. The Government has developed a public expenditure framework and is implementing improved budget processes. It has shifted to a public financial management framework that includes the revenue side of the budget. The 2007 public expenditure review

1 The share of discretionary spending in the national government budget has declined in the last 4 years from 62%

in the FY2004 budget to 58% in the FY2006 budget and 56% in the FY2008 budget. In contrast, nondiscretionary spending on wages and salaries and transfers has increased from 32% in the FY2005 budget to 39% in the FY2008 budget.

50 Appendix 5

carried out by the World Bank, International Monetary Fund (IMF), ADB, and the European Commission noted that public expenditure in education and roads is reasonably efficient and equitable, but less so in other sectors such as agriculture and health.2 13. Issue 3: Managing resource revenues. The collapse in commodity prices and feedback to the fiscal situation reminds authorities and development partners of the realities of a resource sector that is characterized by a volatile commodity price cycle. The resource sector provides the Lao PDR with a unique opportunity to fund its development goals and reduce its aid dependence over the longer term. At the same time, it provides the Lao PDR with important challenges as to how these revenues should be managed since such resource revenues are volatile and unpredictable. There are good lessons from other similar small countries that have experienced similar resource booms. Perhaps the most successful example is Botswana, another small, resource-rich landlocked economy. Through cautious macroeconomic policy, public investments, and economic reforms, Botswana has been among the fastest growing economies in the last three decades and has a per capita income of $3,600 in 2003. It was ranked among the 25 poorest countries in the world in the mid-1960s. Key features of Botswana’s macroeconomic policy included (i) smoothing out spending resource revenues rather than spending all as it comes; (ii) aligning expenditures with conservative, long-term forecasts of resource revenues; (iii) saving some portion of revenues for leaner years by establishing a stabilization fund and a public debt service fund to ensure it can meet debt obligations in case the resource boom busts; (iv) a balanced expenditure program between recurrent and capital expenditures; and (v) investing in infrastructure, especially in rural areas where the majority of the population lives. Given the current global environment, it has become pertinent for the Government to develop a resource revenue management strategy. 14. Issue 4: Maintaining debt sustainability. Public debt as a share of GDP has been declining but remains high. At the end of 2007, the stock of external public and publicly guaranteed debt was estimated at 60% of GDP. Concessional borrowing from ADB and the World Bank accounts for the bulk of the increase in public debt since 2001. The stock of domestic public debt is small at 1.5% of GDP. Recent IMF–World Bank debt sustainability analysis continues to show the debt stock well above policy-based indicative thresholds, suggesting a high risk of debt distress.3 Debt sustainability depends on sustained economic growth, as well as improved external competitiveness and largely concessional borrowing and grants. Strong control over quasi-fiscal risks arising from the state sector will also be necessary, including guarantees for resource sector projects. 15. The Government has outlined a strategy to support a sustainable adjustment in fiscal policy over the next few years with technical assistance supported by development partners:

(i) Continue to implement reforms to enhance the revenue system by broadening the tax base through the introduction of value-added tax, replacing the turnover tax. In 2005, the Government passed a new tax law that widened the tax base and increased receipts from large projects and tourism.

(ii) Addressing problems associated with fragmented tax administration. The Government has made progress in returning tax collection functions (Treasury and Customs) under the jurisdiction of the central Government and clarifying the tax revenue sharing between the central and provincial governments. The World Bank, the European Commission, and the Swedish International Development

2 World Bank, IMF, ADB, and European Commission. 2007. Lao PDR: Public Expenditure Review and Integrated

Fiduciary Assessment. Vientiane. 3 IMF. 2008. Lao PDR 2008 Article IV Consultation – Staff Report. IMF Country Report No. 08/350. Washington, DC.

Appendix 5

51

Cooperation Agency are working closely with the Government to address problems associated with tax administration.

(iii) Implementing the medium-term expenditure framework, internal control systems supported by government financial management information systems development. ADB and the World Bank, among other development partners, are working closely with the Government to implement systems to improve public expenditure management, including the medium-term expenditure framework.

52 Appendix 6

PRIVATE SECTOR DEVELOPMENT ASSESSMENT 1. The sector analysis updates the performance of the private sector and provides the background to identification of issues, constraints, and threats and the Government’s priority reforms in support of development and growth of the private sector and small and medium-sized enterprises (SMEs).1 A. Background 2. The Lao People’s Democratic Republic (Lao PDR) has experienced robust growth and development in the last 5 years. From 2003 to 2008, economic growth has averaged around 7.1%, and gross domestic product (GDP) per capita increased by over 40% to $669 in 2007. Based on the national poverty line, poverty incidence declined to an estimated 28% during the same period, and poverty reduction accelerated after 2004 when per capita income surpassed $400 in 2004. The economic growth has been supported mainly by the industrial sector, with investments in hydropower and the mining sector driving industrial expansion in recent years—making the Lao PDR vulnerable to volatile and unpredictable commodity price cycles (Figure A6.1). The manufacturing sector has enjoyed robust growth rates, although the garments sector—the major manufacturing export sector—has experienced a decline in exports in recent years. The service sector has also enjoyed growth. Within services, tourism and related services have enjoyed rapid expansion in recent years—international visitors to the Lao PDR continue to increase, with over 1.6 million people traveling in 2007, generating over $200 million in revenues. Most of the recorded tourist arrivals are for short-term stays (1–3 days) from neighboring economies. More recently, there has been an increased number of foreign investments in the agriculture sector, especially large-scale commercial plantations. 3. The Lao PDR economy has undergone significant structural transformation since 1990, but the export sector remains narrowly based—with the resource sector (copper, gold, electricity, and timber) accounting for 70% of the total exports recorded through customs (Figure A6.1). The economic transformation is reflected in the expansion of the industrial sector relative to the agriculture and services sectors. Industry as a share of GDP has increased from about 16% of GDP in 1990 to 23% in 2000 and 33% in 2008, with investments in hydropower and the mining sector the engine of growth. Agriculture’s share of GDP is declining, while services have remained relatively stable at about 26% of GDP. This pattern of structural change is expected as an economy grows and develops; resources move from low productivity activities in subsistence agriculture and traditional services to higher productivity activities in industry and modern services. This process, and the associated rural–urban migration that occurs with this transformation, has contributed to the reduction in poverty in the Lao PDR.

1 The sector analysis benefited from several reports on the private sector in the Lao People’s Democratic Republic

(Lao PDR). These include ADB. 2009. Options for a Regulatory Reform Program and an Office of Best Regulatory Practice. Manila; ADB. 2009 (forthcoming). Lao PDR's Trade and Investment Incentives Framework, Manila; GTZ. 2007. Enterprise Survey of 2007, Vientiane; ADB. 2007. Survey of Issues in Trade Policy and Institutions Affecting SME Competitiveness in Lao PDR, Consultation Mission Report, April 2007. Manila; ADB and the World Bank. 2007. Reducing Investment Climate Constraints to Higher Growth. Manila and Washington, DC; ADB. 2006. Technical Assistance to the Lao People's Democratic Republic for Preparing for Private Sector and SME Development Program. Manila; and ADB. 2006. Lao PDR: Private Sector Assessment. Manila.

Appendix 6

53

Figure A6.1: Key Economic Growth Indicators of the Lao PDR Economy (a) Economic transformation of Lao PDR economy (b) Changes in composition of exports (% of GDP by major sector) (% of total exports)

0%

20%

40%

60%

80%

100%

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

Agriculture Industry Services

0%

20%

40%

60%

80%

100%

2003 2004 2005 2006 2007

Gold Copper Electricity Timber Garments Other

(d) International prices of gold and copper (e) Garment exports ($ million) revenues from tourism ($ million on RHS)

0

2000

4000

6000

8000

10000

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

0

200

400

600

800

1000

1200

Copper Gold

020406080

100120140160180

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

(f) Tourist arrivals (’000) and revenues ($ million) (g) Number of FDI projects by sector

0200400600800

10001200140016001800

199019911992199319941995199619971998199920002001200220032004200520062007

0

50

100

150

200

250

Visitors Revenues

0 10 20 30 40 50

Other

Hotel

Hydropower

Mining

Wood

Industry

Agriculture

20072000

Sources: Asian Development Bank staff estimates from National Income Accounts, National Statistics Center, Vientiane, Lao PDR. Tourism data from the Department of Tourism. Garment exports from the Lao PDR Garment Producer Association. FDI projects from the Ministry of Planning and Investment, Vientiane, Lao PDR. 4. The SME sector dominates economic activity in the Lao PDR and accounts for substantial employment. According to the latest available data from the 2006 industrial census,

54 Appendix 6

there are 126,913 enterprises, of which 124,000 (97.6%) are small enterprises employing less than 10 workers (Table 6A.1). Another 2,835 firms employ 10–99 workers and 198 firms employ 100 or more workers. Sixty-four percent are operating in services, 19% in manufacturing and 3.4% in agriculture. More than half the enterprises are concentrated around the capital Vientiane and the north, with 32% enterprises residing in central Lao PDR; 15% reside in the south. About 40% of firms have a registration certificate and 70% reported having a tax certificate. The majority of SMEs are unregistered, primarily because of the high cost, cumbersome procedures, and lack of transparency in the registration process. An ADB red tape study reported that it costs about $112 per firm to comply with registration procedures alone, and firms had to reregister every year. Business compliance costs more than quadruple when the operation license from the sector ministry and the tax certificate from the Ministry of Finance are added. These licenses are more burdensome on SMEs than larger firms when benchmarked against compliance costs per worker.

Table A6.1: Lao PDR Economic Census 2006: Enterprise Size and Location of Primary Economic Units

Enterprise Size Economic Units Location Economic Units No. % Provinces No. %

Less than 5 employees 118,592 93.4 Vientiane Capital City 28,784 22.75–9 employees 5,268 4.2 North 38,017 30.010–99 employees 2,835 2.2 Central 40,551 32.0100+ employees 198 0.2 South 19,561 15.4

Total 126,913 100.0 Total 126,913 100.0Lao PDR = Lao People’s Democratic Republic. Note: Items may not add up to total as no detailed data were recorded for a few enterprises. Source: Lao PDR, The Steering Committee on Economic Census 2007, Report of Economic Census, 2006 Volume 1, National Statistics Centre, Vientiane Capital. 5. In the short term, the Lao PDR economy is affected by the collapse in commodity prices and the global recession. The International Monetary Fund (IMF) projects that economic growth will slow from 7.2% in 2008 to 4.5% in 2009 because of faltering garment exports, a fall in resource revenues, and a slowdown in foreign investments. In the longer term, the Lao PDR economy will be challenged by the impact of the resource sector on the competitiveness and growth of the non-resource sector. Notwithstanding the current slump in commodity prices, the Government anticipates significant future revenues to the budget from hydropower investments and mining in the form of taxes, royalties, and dividends over the next decade. The revenue flows provide the Lao PDR with a significant opportunity to finance its development goals, raise per capita incomes, and reduce poverty (as the diamond boom did in Botswana, another landlocked economy). At the same time, there are important lessons from international experience for the Lao PDR in supporting private sector growth when there is a large commodity resource sector. A resource boom—like the one experienced from 2006 to 2008—can affect the growth conditions of the non-resource sector if it leads to an “excessive” appreciation of the real exchange rate. An excessive appreciation of the exchange rate may slow growth of the non-resource tradable goods sector (manufacturing and agriculture). The manufacturing sector (especially garments) is particularly vulnerable to an excessive real appreciation. Unit labor costs in the Lao PDR garment sector are on a par with Cambodia and other neighbors.2 However, the sector operates on relatively lower profit margins, and since wages are paid in kip, an excessively appreciated exchange rate would raise unit labor costs in

2 ADB. 2007. Survey of Issues in Trade Policy and institutions Affecting SME Competitiveness in Lao PDR. Manila.

Appendix 6

55

US dollar terms—squeezing profit margins. Updated estimates of the real kip exchange rate indicate that it has appreciated faster than its neighbors from 2006 to 2009, although there is no definitive evidence that this has hurt the competitiveness of the non-resource sector to date. 6. The experiences of Indonesia and Botswana show that modest appreciation can be successfully managed and can be consistent with growth of the non-resource sector. The critical lessons from these two countries include the following: (i) fiscal discipline (guarding against inflationary pressures from excessive spending of resource revenues in the domestic economy), (ii) promoting a balanced public expenditure program, (iii) maintaining a conservative debt strategy, and (iv) promoting business climate reforms and investments to raise productivity in the tradable sector. The Government of the Lao PDR has followed some of these good practices—it invested in irrigation projects in 1998 and 1999, which has boosted agriculture productivity, and it reduced transaction costs in doing business. ADB and other donors are providing assistance to raise productivity in the agriculture sector. However, the Government does not have a strategy for managing resource revenues and much more needs to be done to enhance efficiency in trade facilitation. Recent external developments also highlight that sustainable high growth will require diversification of the sources of growth beyond the resource sector, garments, and tourism. This will also reduce the Lao PDR’s vulnerability to external economic shocks. 7. Investment surveys and several recent value-chain studies have identified impediments to the Lao PDR realizing its medium-term growth potential and economic diversification. Surveys on business climate perceptions suggest that the following, among other factors, are major obstacles to private sector growth and development: regulatory uncertainty and excessive red tape, remaining distortions in the trade regime, and inadequate skills of the labor force. Value-chain studies identify poor product quality, an inadequate sanitary and phyto-sanitary standards (SPS) policy framework, underdeveloped links between the rural and modern sectors of the economy, and relatively costly logistics as constraints to export diversification. A common thread in many of these investment and value-chain studies is the Lao PDR’s weak competition policy framework—broadly defined to include remaining distortions at the border (non-tariff barriers) and behind the border (technical barriers to trade and industry regulation, and investment incentives). State-owned enterprises (SOEs) remain dominant in several key sectors of the economy, and this tends to undermine competition and economic efficiency. The Government’s approach to SOE reform was first to privatize enterprises in the 1980s and early 1990s. It is considering a new round of privatizations through partial listings of state enterprises on the stock market once it is established after 2010. B. Medium-Term Growth Issues 8. This section summarizes the key business climate impediments to private sector growth and economic diversification. While much progress has been made in creating an enabling environment for the private sector to grow in the Lao PDR, much more needs to be done to lower transaction costs by addressing excessive red tape, improving the investment climate, completing the unfinished trade policy agenda, improving trade facilitation, and strengthening the institutional framework for SME policy making. 9. Transaction costs for doing business in the Lao PDR are high, but much lower than they were in the 1990s. The Lao PDR continues to rank low in several international surveys of competitiveness because of high transaction costs in the regulatory environment, trade facilitation, and an undeveloped logistics sector. The 2007 World Bank report on trade logistics shows that trade facilitation costs in the Lao PDR are high on a regional and international

56 Appendix 6

comparison. The ADB-World Bank Investment Climate Survey of enterprises carried out in 2005 reported several major constraints in the Lao PDR: infrastructure, regulation, taxation, macroeconomic stability, and access to finance. The German Agency for Technical Cooperation (GTZ) enterprise survey of 2007 (footnote 1), which is a follow-on to its 2005 benchmark survey, provides information about changes in perceptions or wareness about business constraints. It finds that business reported increased problems in 2007 with access to capital; finding skilled technical labor, accountants, and management; access to technology and business development service providers; and increased fees and regulations.

Figure A6.2: Enterprises Identifying Problem as “Major” Constraint to Growth

(a) % of enterprises reporting as major constraint (b) Change in % of enterprises reporting factor as major constraint from 2007 to 2005

0

10

20

30

40

50

60

Access tocapital

Fees andregulations

Com

petitionenvironm

ent

Skilled labor

Accountants

Market

information

Access to

technology

Infrastructure

Managem

ent

-5

0

5

10

15

20

25

Access tocapital

Skilled labor

Accountants

Managem

ent

Access totechnology

Fees andregulations

Market info

Infrastructure

Com

petition

Source: GTZ. 2007. Enterprise Survey of 2007, Vientiane. 10. Fees and licenses. The 2009 ADB red tape study estimates that firms on average incur $483 annually to comply with the three most common licenses—the enterprise registration certificate, sector operational license, and the tax certificate. Overall, it costs the business community $36 million to comply with the three licenses. Depending on the sector, firms will require additional licenses and a realistic estimate of the business compliance costs was 1.5%–3.0% of GDP in 2008. The report also showed that red tape costs vary across sectors, with the pharmaceutical (production and retail) and tourism sectors having relatively high cost regulatory systems. Foreign and domestic investors requesting fiscal incentives must also obtain an investment license from the Ministry of Planning and Investment (MPI) under the investment laws. The process is unpredictable, as sector ministries are able to attach additional conditions before the investment license is approved. The cost of red tape has deterred entrepreneurs from formalizing their businesses, with only 40% of total enterprises reportedly having an enterprise registration certificate. To address the red tape, international practice takes a two-step approach: (i) review the existing stock of regulations, estimate its compliance costs to businesses and the economy, and produce a reform strategy; and (ii) later institutionalize a regulatory impact assessment (or review) mechanism designed to screen and monitor future red tape issuances. Posting regulations and impact assessments on the relevant ministry's website helps improve transparency in the regulatory regime. In August 2008, the Government implemented the new registration system, which reduced compliance costs by 35% and saved the business community at least $6 million in compliance costs from not having to renew the registration certificate every year.

Appendix 6

57

11. Competition policy. The ADB red tape study focused on the business compliance costs of obtaining licenses and permits. Other important costs of the regulatory regime are the adjustment costs firms have to undertake to comply with regulations and the economy-wide impact of regulations. A common thread of many of the investment climate and value chain studies is the Lao PDR’s weak competition policy framework (para. 7). Three factors affect the nature and level of competition in several sectors. First, the presence of SOEs in the economy is widespread, and they are dominant in several sectors in manufacturing and utilities. Many of these SOEs have loosely defined public service obligations that can affect their commercial operations and efficiency levels in the sector. Second, the investment incentives regime is very generous on an international comparison, and lacks transparency. Incentives vary across sectors, regions, and in some instances even among firms in the same sector as the incentives package appears to be custom-made for some investors. This incentives regime has created price distortions and provides an un-level playing field for firms. Third, while most industry regulations restricting competition have been eliminated, pockets of industry are provided with protection or supported by anticompetitive regulations (such as in cement). 12. Trade policy. Compared to other countries, the Lao PDR’s most favored nation import duty rate is relatively low—at a simple average of 10%—although dispersion is relatively high, with duties ranging from 0% to 40%. The effective tariff rate is lower if various duty exemptions are included, and when implementation of the Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA) tariff schedule commitments is achieved. The import–export management system and import controlled list imposes time-consuming administrative costs on importers and producers, as well as providing some protection to domestic industries. The estimates of effective rates of protection (ERPs)—which measure the extent to which trade policy has raised prices above international ones—are relatively low although pockets of significant protection to industry still exist in food and beverages, metal products, and some chemicals. The ERP estimates also indicate that the trade policy regime is biased against sectors with potential for export of goods (agriculture, textiles, and garments) as reflected in substantial negative protection to these sectors. The Government is making significant progress in improving trade policy, such as the recent revisions to the import licensing decree (and distinguishing between automatic and non-automatic licensing), the reduced controlled list, and ongoing revisions to the import–export management decree. 13. Trade facilitation. Trade facilitation is still relatively costly, but it is improving. With large investments in road networks and infrastructure, and the cross-border transit agreement (CBTA) with Thailand, the cost of trucking goods in terms of delivery time and cost per unit has falling in the last several years. According to a recent TNT report,3 it now takes 4 hours to truck goods from the Viet Nam border to the Thai border via the East–West Economic Corridor. However, problems remain with transportation and trade facilitation. The local truck industry does not appear to be competitive, and is characterized by poor vehicle standards and breakdowns. The high cost of the local truck industry is partly offset by the Lao PDR authorities permitting trucks from neighboring countries to enter the Lao PDR, also cutting costs. There is lack of access of Lao PDR vehicles of good quality to neighboring countries. The time involved in trade facilitation, especially through customs, remains costly. Pre-clearance is required at Savannaket, and original copies must be sent to customs at the border at Dansawan, involving a 2-day processing time. According to the TNT report, the new bridge has only saved 45 minutes because of hassle with customs. Another problem identified by the study is the lack of distribution consolidation points along the border, which would be particularly helpful for SME exporters to store their products while in transit. Problems of trade facilitation particularly hurt 3 ACMECS. 2007. Cross Border Transport and Trucking, ACMECS.

58 Appendix 6

SMEs as they export small quantities of products, so the fixed costs of trade facilitation account for a higher proportion of FOB export prices than for larger firms. Governments of member states in the GMS are addressing some of these trade facilitation problems4 by implementing the CBTA, as well as reforming customs. 14. Trade logistics. The performance of trade logistic services is critical to determine whether the Lao PDR can trade goods and services on time and at low costs. A cross-country study conducted by the World Bank5 suggests that high logistics costs and, more importantly, a low level of services are barriers to trade and hence, growth. Available indicators suggest that Lao PDR businesses bear a higher cost of logistics than other countries in the region. The logistics performance index ranks the Lao PDR 117 out of 150 countries in the survey, meaning it is less efficient. This index is developed based on a comprehensive survey of supply chain performance, including customs procedures, logistic costs, infrastructure quality, timeliness of reaching destination, and the competence of the domestic logistics industry. The Lao PDR was ranked 146 in domestic logistic costs, 139 in tracking and tracing, 121 in customs efficiency, and 121 in infrastructure cost. In comparison, Thailand is ranked 31, Indonesia 43, Viet Nam 53, the Philippines 65, and Cambodia 81. 15. Sanitary and phyto-sanitary standards. SPSs are key to microeconomic infrastructure, improving the private sector’s access to the international market for agro-based products. The Lao PDR SPS management system is in its infancy. Lack of resources and technical expertise mean that development of minimum standards for food and beverages is weak, especially among SMEs. The Government has a broad SPS action plan, although it needs to be reviewed in light of the Government’s progress in preparing for World Trade Organization (WTO) accession. The Government recognizes that much needs to be done to improve SPSs, including (i) strengthening the SPS framework for effective SPS management; (ii) improving SPS regulations related to food, water, and agro-processed products; (iii) establishing coordination processes and procedures for notifying WTO on SPS regulations and other TBTs, and establishing inquiry points within the Government; (iv) ensuring competition within the domestic market SPS providers, auditors, and assessors; and (v) capacity development for effective management systems, such as upgrading of laboratories, assisting with the laboratories’ International Organization for Standardization accreditation so that tests are internationally recognized, procuring equipment and rapid diagnostic tools, and training staff. An ADB GMS trade facilitation project is considering ways to assist GMS member states with SPS capacity building to enable cross-border trade while adequately protecting the health of crops, livestock, and consumers. It is intended to develop an action plan with investment projects based around four areas: (i) developing a risk-based system of border handling; (ii) strengthening regional and national capacities for diagnostic and testing facilities; (iii) promoting private sector capacities for food safety compliance; and (iv) promoting academic training needed for managing SPSs. 16. Contract enforcement and judicial capacity. Weaknesses in the legal and regulatory framework as well as judicial capacity clearly have an impact on private sector development, as reflected in the country’s rankings on key investment climate indicators in the World Bank’s 2009 Doing Business survey—the Lao PDR is ranked 181 out of 181 for ease of closing business, 180 out of 181 for investor protection, and 111 out of 181 for enforcing contracts.

4 Also see technical reports on customs and logistics development presented at the 5th Meeting of the Trade

Facilitation Working Group, 16–17 May 2007, Bangkok. 5 World Bank. 2007. Connecting to Compete: Trade Logistics in the Global Economy. Washington, DC.

Appendix 6

59

17. The rankings reflect a range of factors, including outdated laws and regulations (e.g., bankruptcy law), weak capacity and independence of the courts, frequent staff rotations, and lack of case precedence, as well as cultural and institutional factors inhibiting recourse to legal means to enforce contracts in a closely knit, consensus-based society (reflected by the low number of foreclosure cases filed in relation to nonperforming loans, and the time and tedious processes involved in resolving such cases). 18. ADB has provided support for capacity building in the judiciary and the development of alternative dispute resolution mechanisms (e.g., the Banking Sector Reform Program). However, the impact of these measures has been limited, partly because of the ad hoc and stand-alone approach adopted. Based on experience and lessons learned from these as well as ADB interventions in other countries, legal and judicial reform often require deep-seated institutional changes, including public financial management reforms and increased resources to the judicial sector, if they are to lead to meaningful and lasting results. This means that systematic and sustained engagement as well as political will are required over the longer term. 19. The Government has outlined a strategy to reduce transaction costs in doing business, supported by the PSME program cluster and the post-program monitoring framework:

(i) Under Subprogram 1 of the PSME, the Government enacted the Law on Enterprises of 2006 which promised to streamline registration procedures and introduce a negative list of sectors restricted to enterprise registration. Under subprogram 2, the Government implemented the enterprise law—including making effective the new, simplified enterprise registration process with a negative list; and establishment of enterprise registration offices with internet links between the central office and pilot provinces. The Government intends to complete the rollout of the enterprise registry offices by the end of 2009.

(ii) The Government has drafted a new law on investment that provides national treatment for foreign and domestic investors, and synchronizes the investment lists with the negative list under the enterprise law.

(iii) Under subprogram 1, the Government—with ADB assistance—drafted the SME strategy and it was approved in early 2008. The Government is making progress toward implementing its SME strategy, including regulatory reform and transparency, capacity development of the SME sector, etc.

(iv) The Government is chipping away at the import–export management system. In 2006, to improve transparency, it reclassified goods on the import controlled list according to harmonized codes. In 2007, the Ministry of Industry and Commerce (MOIC) issued a notice removing trade officials from the customs border posts, and abolished the requirement that producers/importers must have an import plan for the year. Most recently, it revised the import licensing decree and distinguishes between automatic and non-automatic licenses consistent with WTO rules, reduced the number of items on the controlled list, and is drafting revisions to the import–export management decree, including trading rights, consistent with WTO rules.

(v) The Government (MOIC) has started a regulatory reform process, including establishing an interagency taskforce to advocate the introduction of regulatory impact assessments and pilot test a regulatory impact assessment at MOIC. To improve transparency in regulations and procedures, the SME Promotion and Development Office (SMEPDO) upgraded its website and started posting business regulations on its website, as well as elaborating on registration procedures.

60 Appendix 6

20. Going forward, a second generation of reforms should focus on completing implementation of the SME strategy; implementing a regulatory review process within national Government that promotes better quality regulations and promotes competition; enhancing trade facilitation measures in customs, logistics and SPS; and preparing for implementing WTO commitments once Lao PDR accedes to the WTO, planned for 2012.

Appendix 7 61

POVERTY IMPACT ASSESSMENT

The PSME will contribute to sustainable reduction in poverty in the short and medium term through (i) an increase in investment and the number of enterprises; (ii) the labor market, with increased hiring activity across most sectors; and (iii) lower prices of tradable goods through increased integration within the region and rest of the world through trade policy reforms. Channel of Effect Effects on the Poor General Specific Direct Short Term Indirect Short Term Medium Term Mitigation or Enhancement Measures Investment Foreign and

domestic investment (non-resource sector)

Increase in investment will support economic growth Increase in the number of enterprises, including SMEs, will create additional employment

Foreign investment will create linkages with local suppliers and further employment opportunities

Foreign investment will create technology spillovers through labor turnover and demonstration effect

Implementation of the enterprise law reduces the costs of enterprise registration and opens up new opportunities for entrepreneurs. This is reflected in the increased number of enterprises registering for the first time—since August 2008, at least 15% of enterprise registrations under the new law are new enterprises. New investment law promotes national treatment, between foreign and domestic investors and streamlines the investment approval process. Start regulatory reform program to reduce further the cost of doing business and therefore support sustained enterprise growth

Labor market

Formal and informal sector

The increase in the number of enterprises has created new formal employment

Sustained economic growth through private sector development rate will expand formal employment and reduce unemployment

Lower prices

Trade policy reforms and WTO accession

Continued reduction in non-tariff barriers through reform of the import management system will lower prices of goods to households, thereby enhancing household welfare

Increased integration with regional economies and the rest of the world will increase opportunities for trade and investment and lead to increased incomes generated from the non-resource sector

Strengthen trade facilitation measures (such as in customs, transport, and SPSs)

Introduce capacity development in trade facilitation, especially in SPS management systems

Channel of Effect Effects on the Poor General Specific Direct Short Term Indirect Short Term Medium Term Mitigation or Enhancement Measures Net Impact Channels of effect. The PSME program aims to reduce the transaction costs in doing business through regulatory and trade policy reforms and by strengthening relevant institutions/agencies such as the enterprise registry offices. This will increase the number of formal enterprises and jobs. Foreign investment will promote technology diffusion. Trade reforms will lower prices of goods. Time dimensions. The immediate impact of investment and the increase in the number of enterprises will be economic growth and jobs. Trade reforms will lower prices. Over the medium term, foreign investment will promote technology spillovers and lift longer term economic growth rates. Crucial Assumptions Adjustment costs of trade reforms are not high, as the Lao PDR does not have a large and inefficient industrial base built around high protection. Lao PDR = Lao People’s Democratic Republic, SMEs = small and medium-sized enterprises, WTO = World Trade Organization. Source: Asian Development Bank.

62 A

ppendix 7

Appendix 8

63

LIST OF INELIGIBLE ITEMS 1. Loan proceeds will finance the foreign currency expenditures for the reasonable cost of imported goods required during subprogram 2 of the Private Sector and Small and Medium-Sized Enterprises Development Program. 2. No withdrawals will be made for the following:

(i) expenditures for goods included in the following groups or subgroups of the United Nations Standard International Trade Classification, Revision 3 (SITC, Rev. 3) or any successor groups or subgroups under future revisions to the SITC, as designated by the Asian Development Bank (ADB) by notice to the Borrower:

Table A8: Ineligible Items

Chapter Heading Description of Items

112 Alcoholic beverages 121 Tobacco, unmanufactured; tobacco refuse 122 Tobacco, manufactured (whether or not containing tobacco

substitute) 525 Radioactive and associated materials 667 Pearls, precious and semiprecious stones, unworked or worked 718 718.7 Nuclear reactors, and parts thereof, fuel elements (cartridges),

nonirradiated for nuclear reactors 728 728.43 Tobacco processing machinery 897 897.3 Jewelry of gold, silver, or platinum-group metals (except watches

and watch cases) and goldsmiths’ or silversmiths’ wares (including set gems)

971 Gold, nonmonetary (excluding gold ore and concentrates) Source: United Nations. (ii) expenditures in the currency of the Borrower or of goods supplied from the

territory of the Borrower; (iii) expenditures for goods supplied under a contract that any national or

international financing institution or agency will have financed or has agreed to finance, including any contract financed under any loan or grant from ADB;

(iv) expenditures for goods intended for a military or paramilitary purpose or for luxury consumption;

(v) expenditures for narcotics; and (vi) expenditures for environmentally hazardous goods, the manufacture, use, or

import of which is prohibited under the laws of the Borrower or international agreements to which the Borrower is a party; and

(vii) expenditures on account of any payment prohibited by the Borrower in compliance with a decision of the United Nations Security Council taken under Chapter VII of the Charter of the United Nations.

64 Appendix 9

SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY

A. Linkages to the Country Poverty Analysis Is the sector identified as a national priority in country poverty analysis?

Yes

No

Is the sector identified as a national priority in country poverty partnership agreement?

Yes

No

Contribution of the sector or subsector to reduce poverty in the Lao People’s Democratic Republic (Lao PDR): The Private Sector and Small and Medium-Sized Enterprises Development Program Cluster (PSME) focuses on three policy areas: (i) institutional development of small and medium-sized enterprises (SMEs) policy and access to finance, (ii) a strengthened investment climate, and (iii) trade policy and capacity building. The PSME policy areas correspond with those of the Government as spelled out in the Sixth Five-Year National Socio-Economic Development Plan, 2006–2010, which focuses on five core areas: (i) economic growth, including fostering SMEs; (ii) providing basic social services; (iii) stronger human security; (iv) enhanced participation by the poor; and (v) developing the poorest regions. The SEDP6 has several crosscutting issues relevant to the PSME, including (i) private sector development through a stable macro-economy, creating an enabling environment for businesses, and promoting foreign direct investment; and (ii) regional integration, including reducing trade barriers, promoting cross-border investments and economic corridors, membership of the Greater Mekong Subregion (GMS), Association of Southeast Asian Nations (ASEAN), and the World Trade Organization (WTO). The SEDP6 mission is to reduce the poverty rate from 33% in 2003 to 23% by 2015. Private sector development and growth is crucial for sustained poverty reduction, as it will be the major generator of jobs and incomes in the future. This is vital as almost 50% of the population is under the age of 20 years, and over 80% of employment is in informal activities (mainly subsistence agriculture). Removing regulatory constraints to the private sector to invest and create new businesses is crucially important. The regulatory transaction costs are more burdensome on SMEs, and they constrained dynamic growth of SMEs by keeping most of them informal. Indicative of the burden on SMEs, the Asian Development Bank (ADB) red tape study shows that the annual average cost of compliance with licenses and permits amounts to about $25 per employee in micro and small enterprises compared with $3 per employee in large firms (100 or more employees). The Government has modernized the business law through the enactment of the enterprise law in 2006, which makes it easier to register a business and open sectors up for new enterprises to invest in by issuing the negative list (people can invest in any sector except for those included on the negative list). Other reforms include drafting a new investment law that provides for national treatment for all investors, and reducing the nontransparent forms of non-tariff measures to improve productivity and allow SMEs to access inputs at lower prices. B. Poverty Analysis Targeting Classification: General intervention The poverty incidence dropped from 46% in 1992 to 33% in 2003, as the economy expanded 6%–8% per annum for most of this period, and it is estimated at 28% in 2008. Improved rice production and rising overseas remittances have also helped reduce poverty. The Government targets a poverty rate of 23% by 2015, assuming economic growth continues in the current range of 7%. An assessment of poverty implications of the PSME indicates that on balance, the PSME program will contribute to a reduction in the incidence of poverty by lowering the transaction costs of doing business. A reduction in red tape and other regulatory compliance costs would induce additional SME start-ups and therefore additional investment and employment. The recent reforms to enterprise registration show that 5,000 small firms have registered for the first time. Obtaining the registration certificate formalizes them and helps open access to formal sector funding. Reform of the non-tariff measures will lower the prices of several industrial commodities, which in turn will support industrial expansion and jobs. Lower prices will ultimately be passed to households/consumers. C. Participation Process Is there a stakeholder analysis? Yes No Is there a participation strategy? Yes No However, as part of the PSME process, consultations were held with a wide range of stakeholders, including the private sector, civil society groups, and development partners.

Appendix 9

65

D. Gender Development Strategy to maximize impacts on women: The PSME has had indirect gender impacts through its emphasis on reducing the transaction costs of doing business. The improved investment climate will steadily increase the number of SMEs. According to the German Agency for Technical Cooperation (GTZ) enterprise survey of 2005 and 2007, the share of female entrepreneurs has increased from 36.2% in 2005 to 43.3% in 2007. Female entrepreneurs account for 51.1% of entrepreneurs in microenterprises, 47.5% in small enterprises, and 21% in medium and large enterprises. Has an output been prepared? Yes No E. Social Safeguards and Other Social Risks Item

Significant/

Not Significant/ None

Strategy to Address Issues

Plan Required

Resettlement

Significant

Not significant

None

Implementation of the PSME will not require involuntary resettlement.

Full

Short

None Affordability

Significant

Not significant

None

The poor and vulnerable are expected to benefit from lower prices arising from lower transaction costs in doing business.

Yes

No

Labor

Significant

Not significant

None

It is expected that sustained economic growth will result in more jobs. The PSME does not envisage any changes to labor market policies.

Yes

No

Indigenous Peoples

Significant

Not significant

None

The PSME will not have any impact on indigenous people. Yes

No

Other Risks and/or Vulnerabilities

Significant

Not significant

None

The livelihood of the poor and vulnerable is expected to be positively affected.

Yes

No

66 Appendix 10

PERFORMANCE OF PRIVATE SECTOR AND SME DEVELOPMENT PROGRAM SUBPROGRAM 2 TRIGGERS

Original Triggers as Specified in Subprogram 1 Document, Table A2.2 of Appendix 2

Performance

1. MOF to issue a set of guidelines (including a booklet on basic accounting and bookkeeping) for SME accounting practices based on the Lao PDR Accounting Standards

1. Substantially accomplished. MOF, with assistance from the EC SME TA project, produced training materials for dissemination of accounting practices to SMEs at workshops in 15 of the 17 provinces in 2008. At the same time, MOF is revising and updating the basic accounting software for SMEs that the EC helped produce in 2005 under EU Banking Training. The purpose of the workshops is to assist SMEs to improve accounting practices for better access to finance.

2. MOIC to issue legal notification to streamline registration procedures, which (i) removes requirements for curriculum vitae, declaration of sentencing, asset declaration, and certification; (ii) consolidates business seal application; and (iii) eliminates the pre-inspection requirements before registration

2. Accomplished: MOIC simplified enterprise registration process by (i) reducing the number of documents required from 18 to 2–6, depending on the type of applicant (e.g., eliminated the requirement for curriculum vitae, declaration of sentencing, and asset declaration); (ii) delegating the approval authority to the enterprise registry office under MOIC decree 225; (iii) the ERO central office issuing a ministerial instruction on enterprise registration (instruction no. 0995) that standardized enterprise registration procedures for all provincial offices (called single window); and (iv) improving transparency in registration process by posting on its website all registration documents, forms, samples, and other legal documents, instructions, and notices; as well as posting the registration requirements and procedures in the public area of the registry offices.

3. MOIC to establish business registry at central level and 4 pilot provinces, which (i) establishes the database at MOIC; (ii) provides plan for capacity building at registry offices in provinces; and (iii) sets up the network connection for central database and local stations.

3. Accomplished. MOIC modernized the enterprise registry offices at the central level (Vientiane) and completed modernization of seven pilot provinces, which (i) established a centralized web-based database linked to pilot provinces, which provides timely updates on registrations nationally; and (ii) MOIC produced and implemented a capacity development program with provincial the enterprise registry offices, including upgrading software and hardware, and training on implementing the new registration procedures and operationalization of the new system.

4. MOIC and MPI to synchronize the positive investment list under the Foreign Investment Law with the negative list under the Enterprise Law of 2006

4. Accomplished MPI drafted a new Law on Promotion of Investment, which was approved by the National Assembly in July 2009. This merged the foreign and domestic investment laws, provided for national treatment between domestic and foreign investors, and streamlined the investment approval process.

5. MOIC to (i) reduce the number of items on the controlled import list, and (ii) produce a strategy for reforming the import–export management system consistent with WTO rules

5. Substantially accomplished (reform program ongoing). MOIC continued to reform the import control and management system by the following: (i) the PMO approved the new import licensing procedures decree in July 2009, which distinguished between automatic and non-automatic import licensing consistent with WTO rules; (ii) as a follow-on to the approved import licensing procedures decree, MOIC has prepared the draft MOIC ministerial notification of items on the prohibited and controlled import and export list—the draft notification has reduced the number of items on the controlled import list based on the new import licensing decree (expected to be issued in 2009); and (iii) MOIC prepared a draft decree on the application of rules of origin to be submitted it

Appendix 10

67

to the PMO for approval. MOIC, with assistance from ADB, is also preparing amendments to the decree on the import and export management system (decree 205) to make it consistent with WTO rules (expected to be completed by the end of 2009).

New Policy Trigger 6. BOL to upgrade credit information system, starting with designing and pilot testing a web-based CIB system new policy trigger.

6. Accomplished. As part of the Government’s efforts to improve SME access to finance, BOL, with ADB TA, has undertaken upgrading of the CIB from a manual to a secure computerized system for commercial banks and BOL. Pilot testing of the CIB was completed in January 2009, with the participation of all commercial banks. Refinements to the CIB are under way and the CIB is expected to be operationalized by the end of 2009. The new system will allow real-time search and uploading of borrowers’ credit information, reducing commercial banks’ search time from 1 week to less than 10 minutes (design and upgrade completed).

ADB = Asian Development Bank, BOL = Bank of the Lao PDR, CIB = credit information bureau, CPI = Committee for Planning and Investment; EC = European Commission, EU = European Union, Lao PDR = Lao People’s DemocraticRepublic, MOF = Ministry of Finance, MOIC = Ministry of Industry and Commerce, MPI = Ministry of Planning andInvestment, PMO = Prime Minister’s Office, SMEs = small and medium-sized enterprises, TA = technical assistance, WTO = World Trade Organization. Note: The CPI was upgraded to a ministry to become MPI in 2008. Source: Asian Development Bank.