Financial Sector Program Loan (Loan 1061-LAO[SF])

7/31/2019 Financial Sector Program Loan (Loan 1061-LAO[SF])

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ASIAN DEVELOPMENT BANK PPA: LAO 23335

PROGRAM PERFORMANCE AUDIT REPORT

ON THE

FINANCIAL SECTOR PROGRAM LOAN(Loan 1061-LAO[SF])

IN THE

LAO PEOPLES DEMOCRATIC REPUBLIC


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CURRENCY EQUIVALENTSCurrency Unit (KN)

At Appraisal At Project Completion At Evaluation(September 1990) (December 1993) (April 2001)

KN1.00 = $0.00143 $0.00139 $0.00012$1.00 = KN699 KN720 KN8,390

ABBREVIATIONS

ADB Asian Development BankAusAID Australian Agency for International DevelopmentBCEL Banque pour le Commerce Exterieur du LaosBOL Bank of Lao Peoples Democratic RepublicDDU Debt Disposal UnitEA Executing AgencyFDI foreign direct investmentFSN financial sector note

FSPL II

Second Financial Sector Program LoanGDP gross domestic productIMF International Monetary FundLao PDR Lao Peoples Democratic RepublicLTCF long-term credit facilityMOF Ministry of FinanceNBFI nonbank financial institutionNEM New Economic Mechanism

NPL

nonperforming loanOEM operations evaluation missionPCR program completion reportPPAR program performance audit reportRRP report and recommendation of the PresidentSDR special drawing rightsSOCB state-owned commercial bankSOE state-owned enterprise

SSO

Social Security OrganizationTA technical assistanceTPAR technical assistance performance audit reportUNDP United Nations Development ProgrammeVIS valuation information system

NOTES


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CONTENTS

Page

BASIC DATA ii

EXECUTIVE SUMMARY iv

I. BACKGROUND 1

A. Rationale 1B. Program Formulation 1C. Objectives and Scope 2D. Financing Arrangements and Actual Cost 3E. Aid Agency Coordination 3F. Program Completion Report 4G. Operations Evaluation 4

II. IMPLEMENTATION EXPERIENCE AND RESULTS 5

A. Effectiveness of Design 5B. Implementation of Policy/Institutional Reform Measures 6C. Management of the Program 7D. Assessment of Program Outputs 9

III. PROGRAM IMPACT 15

A. Socioeconomic Impact 15B. Impact on Private Sector Development 17C. Institutional Impact 18

IV. KEY ISSUES FOR THE FUTURE 19

A. An Alternate Strategy for Banking Sector Development 19B. Development of Long-Term Resources 19

C. Corporate Governance of Banks and Enterprises 20

V. CONCLUSIONS 21

A. Overall Performance 21B. Lessons Learned 24C. Follow-Up Actions 25


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BASIC DATAFinancial Sector Program Loan

(Loan 1061-LAO[SF])

A. Program Preparation and Institution Building

TA No. TA Name TypeConsultant

Person-Months

Amount($)

ApprovalDate

1433-LAO Long-Term Credit Facility Supporta

ADTA 15.5 298,000 6 Dec 1990

1434-LAO Debt Disposal Unita

ADTA 18.6 555,000 6 Dec 1990

ADTA = advisory technical assistance; TA = technical assistance.a

Accompanying TA.

B. Key Program Data

Item Currency As per ADB LoanDocuments

Actual

Total Program Cost $ million 25.00 24.71

Foreign Exchange Cost $ million 25.00 24.71

ADB Loan Amount/Utilization $ million 25.00 24.71

SDR million 17.42 17.42

ADB Loan Amount /Cancellation $ million 0.00 0.00

ADB = Asian Development Bank; SDR = special drawing rights.

C. Key Dates

Item Expected Actual

Fact-Finding 26 July-10 August 1990

Appraisal 17-28 September 1990

Loan Negotiations 29 Oct-2 Nov 1990

Board Approval 6 December 1990

Loan Agreement 19 December 1990

Loan Effectiveness 19 March 1991 26 December 1990First Disbursement March 1991 28 December 1990

Final Disbursement

March 1992 31 December 1991

Loan Closing 30 June 1993 9 September 1992

Months (effectiveness to completion) 27 20


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F. Mission Data

Type of Mission No. of Missions Person-Days

Reconnaissance 1 10

Fact-Finding 1 112

Appraisal 1 120

Program Administration:

Review 4 44

Disbursement 2 23

Program Completion 1 39

Subtotal Program Administration7 106

Operations Evaluationa 1 22

Total 11 370

aThe mission comprised A. Qureshi, Senior Evaluation Specialist (Mission Leader), K. Bagal, InternationalConsultant and S. Manodham, Domestic Consultant.


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EXECUTIVE SUMMARY

In November 1986, the Government of the Lao Peoples Democratic Republic (LaoPDR) adopted a comprehensive economic reform program, known as the New EconomicMechanism. An important component was the modernization of the countrys financial sector toadapt it to the needs of a market-based economy for efficient mobilization and allocation ofresources. The Asian Development Bank (ADB) played a lead role in initiating the financialsector reform, beginning with approval, in 1988-1989, of technical assistance (TA) for a reviewof the sector and restructuring of the monetary and banking systems. This was followed, in

December 1990, by approval of the Financial Sector Program loan (The Program) for$25 million.

In line with ADBs operational strategy for the Lao PDR, the Program aimed to supportthe Governments midterm macroeconomic stabilization and structural adjustment effortsthrough policy reforms in the financial sector. It sought to assist the Government in the designand development of a financial system capable of meeting the growing needs of the nascentprivate sector, reinforce monetary authorities capabilities and instruments, restore the solvency

of state-owned commercial banks (SOCBs), introduce market-based interest rates, encourageprivatization of state-owned enterprises (SOEs), provide a legal framework for introducingcompetition in the banking sector, develop nonbank financial institutions (NBFIs), and improvethe environment for private sector development.

A program completion report (PCR) was issued in December 1994. The PCRsconclusions implied partial achievement of program objectives. Out of 38 policy actions, 17 weredelayed by 4-7 years. Eight actions were reinforced by their inclusion in the agenda of thefollow-on intervention,1 while five actions were completed only after additional TA support.

Nonetheless, the Program was successful in some aspects. These included (i) providing theBank of Lao PDR (BOL), the central bank, with the tools to control money supply, (ii) improvingthe payments system, (iii) partially restructuring financially the SOCBs, (iv) loosening controlover interest rates, (iv) extending banking services to the northern region, (v) providing a legalframework for domestic enterprises, (vi) establishing a land registration office, and(vii) continuing progress on privatization.

Given its complex and wide-ranging agenda, the Program was overambitious. This

conclusion is supported by the fact that the country was still at an early stage of transition.ADBs own experience of rendering policy advice to transition economies was limited at thedesign stage, and the risks of implementation delays/noncompliance had been identified duringprogram processing and Board discussion. At the same time, however, implementation wasmuch slower than expected because of weak ownership by the Government.

The main objective in the banking sector was to restore the SOCBs capital adequacy


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DDU. This restructuring was, however, not based on a detailed portfolio audit of the SOCBs.Moreover, the exchange of NPLs with government bonds, though helpful in enhancing the assetquality of the SOCBs, did not improve their immediate liquidity and lending capacity. Finally, theSOCBs failed to sustain the improvement in asset quality due to continuation of unsound creditpractices and capacity constraints. As a result, they have again accumulated large amounts ofNPLs and thus require another round of restructuring.

The Program had some positive impacts in the banking sector. Banks now enjoy limitedfreedom to set deposit and lending rates within the limits prescribed by BOL, which should helpto improve the efficiency of financial intermediation. A degree of competition was introduced in

the sector by allowing some foreign and joint venture banks to operate in the domestic market.Moreover, the Program encouraged provision of banking services to geographic areas notpreviously served by banks.

In a number of other areas, impacts were delayed or limited. A number of measuresinvolved legislation or issuance of decrees, such as for providing legal frameworks for theestablishment of NBFIs, establishment and registration of domestic enterprises, bankruptcy,security enforcement and arbitration. The Government took a long time to complete theseactions, and required a number of TAs from ADB and other aid agencies to supportimplementation. The use of monetary control tools, including improved payment mechanisms,the interbank market, and the discount window introduced under the Program, has remainedlimited due to lack of depth in the monetary system. Moreover, the choice of BOL as theExecuting Agency did not prove to be appropriate, since it lacked the necessary capacity,experience, and authority. Finally, the envisaged broadening of the financial sector and thediversification of financial services have not been achieved despite passage of laws relating toleasing and insurance.

The Program is rated as partly successful. Its basic objectives were achieved in part,and with considerable delay and additional TA from ADB or other aid agencies. The view of theimplementation capacity of the Government was too optimistic. Realistic assessment andsystematic building of the capacities of executing agencies involved in implementing reforms,and their preparedness to own them, is of utmost importance for the success of any reformprogram. Another lesson relates to sequencing of reforms. One of the reasons for the failure ofthe SOCBs recapitalization was that it was pursued without parallel or prior improvement oftheir corporate governance and credit appraisal and risk management capacity, as well as thecorporate governance of the enterprise sector. Finally, experience with the Program confirmsthat in economies where the financial sector is at a nascent stage, sophisticated monetary toolsand institutions, even if introduced under legislative cover, can be operationalized only after thefinancial system has gained sufficient depth.

The most critical issue for the future is the solution of SOCBs problems on a sustainablebasis. To that end, it is necessary, among other things, to improve the corporate governance of


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I. BACKGROUND

A. Rationale

1. The relative stagnation of the Lao economy and the discontinuation of assistance fromthe Soviet Union in 1986 triggered a gradual shift of the centrally planned economy of the LaoPeoples Democratic Republic (Lao PDR) to a market-oriented structure. The transition facedserious constraints, due to inadequate export diversification, lack of skilled human resources,deficient infrastructure, and heavy reliance on imported intermediate and basic capital goods. In1986, the Government adopted a comprehensive economic reform program, commonly knownas the New Economic Mechanism (NEM), to remove these constraints through restructuring of

various economic sectors. Major elements of these reforms included easing of restrictions onprivate sector activity and on prices (except utilities), decentralization of production decisions,adoption of a unified market-related exchange rate, trade and investment liberalization, taxreforms, and restructuring of the monetary and banking systems. Modernization of the countrysfinancial sector in tune with the needs of a market-oriented economy thus assumed particularimportance. Beginning in 1988, the Asian Development Bank (ADB) took the lead role infinancial sector reform through provision of technical assistance (TA) to restructure the countrysmonetary and banking system (para. 4). The Government and ADB thought it proper to continue

the financial sector reform process through policy dialogue and to carry out various time-boundreform measures with ADB financial assistance. The program loan modality was considered asuitable vehicle to support an agreed set of policy reform measures in the financial sector, so asto mobilize and allocate resources efficiently to enterprises in the emerging private sector and tothe economy in general.

2. Such an intervention was in conformity with ADBs operational strategy for the Lao PDR.This strategy emphasized, among other things, the need to support the Governments efforts torestructure the economy, and to assist in alleviating development constraints. The country

operational program for 1990 recognized that restructuring the rudimentary financial sector wasa major prerequisite for successful transformation of the Lao economy and for increasingdomestic resource mobilization, production, and exports. In particular, developing institutionaland regulatory framework, especially with respect to the financial sector, was consideredimportant to make it more responsive to the anticipated needs of the private sector and the neweconomy.

B. Program Formulation

3. The formulation of financial sector reforms took place at a time when the economicoutput of the Lao PDR was dominated by the agriculture sector [61 percent of gross domesticproduct (GDP)], and industrial sector output (14 percent of GDP) offered considerable potentialfor growth. Participation of the private sector in the economy was constrained, among otherthings, by lack of financing. Reforms under NEM had entailed major adjustment costs, causing asharp increase in the fiscal deficit The declining output and financial performance of state-


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adjustments in the agriculture sector.2 Increasing domestic resource mobilization and enhancingits allocative efficiency were necessary to achieve the desired outcomes of this adjustment

program.

4. Between September 1988 and September 1990, ADB approved four TAs for financialsector review and restructuring of the monetary and banking system.3 These TAs laid thefoundation for a policy dialogue on various areas of concern in the financial sector. Followingdiscussions with several ADB missions, the Government sought a program loan from ADB tosupport and sustain the momentum of ongoing reforms, and to implement additional reforms inthe financial sector. After three extensive processing missions in 1990 and policy discussionsand consultations with Government, the World Bank and IMF, a package of policy and

institutional reform measures was agreed upon (the Program) for implementation in 19911993.

The related program loan was approved on 6 December 1990 for SDR17.42 million ($25 million)together with two advisory TA grants to assist in the implementation of certain programelements.4 The Bank of Lao PDR (BOL) was selected to act as the Executing Agency (EA) forthe Program, and was expected to closely coordinate its implementation with the Ministry ofEconomy, Planning and Finance (now Ministry of Finance) and other relevant authorities. Theprogram loan was to be released in two equal tranches, the first upon loan effectiveness and thesecond by March 1992, subject to fulfillment of agreed conditions.

C. Objectives and Scope

5. The financial sector of the Lao PDR was at an early stage of development at the time ofprogram approval. A few reforms had already been initiated to separate out the commercialbanking activities of the previously monolithic central bank, establish a commercial bankingsystem, and develop a database to assist in the management of monetary conditions and thefinancial system as a whole. In this context, the Program aimed at supporting the Governmentsmidterm macroeconomic stabilization and structural adjustment efforts by bringing about further

policy reforms in the financial sector. These reforms fell into three broad categories: (i)improving the policy environment through introduction of market-based interest rates; (ii)strengthening existing institutions and financial instruments, upgrading professional bankingstandards and expertise, and strengthening the legal basis for commercial banking; and (iii)supporting private sector development. The Program attempted to provide BOL with basicmonetary control tools, such as the reserve ratio and open market operations to strengthen theinterbank market and payments mechanism; and to encourage savings and improve access tobank credit by reforming the interest rate regime through the elimination of preferential interest

rates. It also sought to strengthen the state-owned commercial banks (SOCBs) by separatingtheir nonperforming loans (NPLs); recapitalizing them in line with the accepted standards ofcapital adequacy; and helping to improve professional standards in the banking industry byintroducing a uniform accounting system, requiring annual audits by independent auditors, andproviding training facilities for banks staff. The Program also aimed to broaden the financialsector and increase the range of financial services by providing legal framework for theestablishment and operation of nonbank financial institutions (NBFIs) such as leasing and


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prompted the Government to pass supportive legislation to establish legal safeguards for thegrowth of private enterprise.

D. Financing Arrangements and Actual Cost

6. Historically, it has been difficult to estimate the cost of carrying out policy-based reformsin the service sectors, particularly the financial sector. The loan size of $25 million was justifiedon the grounds that the measures to be introduced under the Program would generateadditional demand for foreign exchange resources for investment and imports, as a result of animproved investment climate and environment for the private sector. The increase in importrequirements was estimated at $20 million-$30 million per year in 1991 and 1992, while the

costs of the SOCBs recapitalization program and introduction of a long-term credit facility(LTCF; para. 29) were estimated to be $12 million and $3 million, respectively. While the totalestimated foreign exchange and local currency costs resulting from the policy and institutionalreforms under the Program were expected to be considerably in excess of $25 million, the loanamount was considered sufficient to meet the direct costs involved and finance a part of theanticipated increase in imports. In terms of actual implementation, privatization and theevolution of the enabling environment for private sector development were slow and continuedbeyond the program period of 19911993. Actual imports increased by only about $12 million

during 1991

1993. In addition, the Government provided $4 million equivalent in cash for therecapitalization of the SOCBs. The Government also instituted a $3 million equivalent LTCFfrom the counterpart funds. Thus, the actual upfront adjustment costs financed under theProgram amounted to $19 million.5

E. Aid Agency Coordination

7. Prior to program approval, IMF had already approved a facility of $26 million for LaoPDR in September 1989. In mid-1990, the World Bank had also approved a structural

adjustment credit of $40 million. Since ADBs program loan was to cover, among others, matterssuch as central banking tools, interest rates, exchange rate policy, payments mechanisms andcheck-clearing facilities, and the issue and discounting of treasury bills, concerns were raised byManagement during program processing that ADB did not have the institutional capability todeal with macroeconomic and monetary issues and also that it was encroaching on IMFs areaof responsibility. Though the Program had been formulated in close coordination with and withthe full support of IMF, the report and recommendation of the President (RRP) did not elaborateon how such concerns would be dealt with during implementation. The structural adjustment

policy matrix of IMF6

spelled out mainly the following measures in the monetary policy area:(i) operating a formal credit window for commercial banks and setting the central bank lendingrate at a positive level in real terms (19911993); (ii) completing the first issue of central banksecurities (1991); (iii) issuing guidelines advising commercial banks to pay positive real interestrates on deposits (1991-1993); (iv) allocating adequate staff and other resources for thecompilation of banking sector accounts (1991); (v) transferring remaining central bank assetsand liabilities from Banque pour le Commerce Exterieur du Laos (BCEL) to BOL (November


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than duplication, of IMF effort. However, with hindsight, it appears that a smaller and moresharply focused intervention would have been more manageable.

F. Program Completion Report

8. A program completion report (PCR)7 on the Program was prepared in December 1994.Rather than providing a specific overall rating for the Program, the PCR reviewed the success ofindividual program measures. The PCR observed that the Program was instrumental in theevolution process of the countrys financial sector during 19911993 and that, on this basisalone, the Program had achieved the goals envisaged at appraisal. The updated policy matrixattached to the PCR, however, indicated that only half of the 38 policy measures to be

implemented during the 19911993 program period were fully complied with. Of the remaining

19 measures, 9 were considered to have been substantially complied with, and 6 partiallycomplied with, while 3 measures had made little progress. One measure, namely theestablishment of a privatization fund, was found by a subsequent ADB-funded consultant study 8to be not practicable. The PCR did not adequately explain why compliance was consideredsubstantial or partial. In the absence of such explanation, it is difficult to agree with the PCRsconclusion that the Program had achieved the goals envisaged at appraisal. On the other hand,the PCR observed correctly that unforeseen delays, insufficient understanding of the complex

nature of the reform process, and lack of data had hampered the implementation of some of thereform measures. It also noted that, since ADB had little previous experience in this type ofprogram lending activity, the implementation and monitoring of the Program had proved moreonerous than originally envisaged.

9. According to the PCR, the lesson from the Program was that the success of reformmeasures depended on policy decisiveness and institutional capability, as well as on technique.This lesson seems true but partial (paras. 5357). The PCR recommended that theGovernment display a higher degree of decisiveness, political will, extensive coordination

among its various departments and agencies, and transparency and evenhandedness amongeconomic agents in the implementation of new laws and regulations. It also concluded andrecommended that the design of future program loans should not rely on parallel ADB TAs as away to ensure the implementation of the agreed reform measures. Instead, it may be moreeffective to use TA to prepare the groundwork for program implementation, and to make thesuccessful implementation of such a TA conditional to the release of the first tranche of programloans. These conclusions are appropriate and consistent with the findings of the OperationsEvaluation Mission (OEM).

G. Operations Evaluation

10. This program performance audit report (PPAR) presents the findings of the OEM thatvisited the country from 26 March to 6 April 2001. The PPAR focuses on design andimplementation aspects of the Program, and makes an assessment of its effectiveness inachieving program objectives and in generating sustainable development The PPAR is based


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implementing agencies, financial institutions, leading aid agencies, research organizations, andthe private sector. Copies of the draft PPAR were provided to the Borrower, the EA and ADBstaff concerned for review and comments. Comments received were taken into consideration infinalizing the report. A logical framework of the Program has been prepared on an ex post factobasis to demonstrate how objectivity in evaluation has been ensured in the absence ofmonitorable indicators in the RRP (Appendix 1).

II. IMPLEMENTATION EXPERIENCE AND RESULTS

A. Effectiveness of Design

11. The Program, in general, was appropriate and responsive to the needs of a transitionaleconomy. Primarily, it aimed to reform the financial system so that it could be a facilitator for theexpected emergence of a private sector at the beginning of the 1990s. The program design,however, appears flawed when examined against the ambitious reform measures, the rathertight three-year time frame to implement these measures, and the transitional character of theeconomy. Program measures relating to monetary policy and credit control tools, and the lawsand regulations governing the environment for a market-oriented financial sector and privatesector, were new to the Government and BOL.11 As a result of this, as well as of weakgovernment ownership, implementation faced long delays, and nearly half of the second trancheconditions were subsequently waived. In addition, a part of the reform agenda was shifted to theSecond Financial Sector Program (FSPL II).12 It appears that at the stage of programformulation, neither the Government nor ADB realistically assessed the implementation capacityof the Government and EA vis--vis the program time frame, risks, and difficulties. As the entireamount of the program loan was disbursed within one year of effectiveness, ADB lost leverageand could not exercise control over the speed of implementation of reform measures.

12. The program design relied heavily on reforms that required the passage of legislation

and issuance of decrees, rules, and regulations. Legislation relating to a number of reforms inthe creation of an enabling environment for private sector growth took much longer thanoriginally expected. The implementing decrees and regulations were issued after considerabledebate and time lag. A number of reform measures required TA in their actual implementation(Appendix 2). Two TAs were already included in the original Program to establish LTCF anddeal with the NPLs of the SOCBs. During the implementation period, further TAs were providedby ADB, IMF, the World Bank, the United Nations Development Programme (UNDP), andbilateral donors to enable the Government to complete the reform measures set under theProgram.

13. Another shortcoming of the design is exemplified by the recapitalization of SOCBs. TheProgram called for the SOCBs recapitalization without providing parallel measures to enhancethe capacity of the banking institutions; expose bank managers and employees to therequirements and nuances of a market-based economy; and develop a credit culture relying onthe economic viability of projects creditworthiness of borrowers and risk analysis In the


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Accordingly, FSPL II called for reconsolidation of SOCBs by reducing their number to amaximum of four.

B. Implementation of Policy/Institutional Reform Measures

14. Program implementation is summarized in Appendix 1. The program agenda had threemain components: (i) central banking reforms and money market mechanisms, (ii) institutionalreforms in the banking sector, and (iii) private sector development. Under the first component,7 out of 10 conditions were complied with during the program period. The measures that weredelayed related to the tendering of treasury securities, the negotiability of payment and debtinstruments, and the establishment of a formal discount window at BOL. The first two measures

were delayed by five years, and the third by one year. ADBs board paper for the release of thesecond tranche stated that the condition relating to the opening of a formal discount window hadbeen technically met at the time of the release. However, though the facility was set up onpaper, its actual operation was held up, due to delayed legislation on bills of exchange andpromissory notes and their negotiability, as well as to the technicalities involved in the tenderingmechanisms. The Government could fulfill these requirements only after getting TA from theWorld Bank and UNDP. On the question of negotiability of money market paper, the primeminister issued a decree only as late as in February 1998. In the area of interbank markets,though the interbranch settlement of the former monobank carried over into the newly formedSOCBs was satisfactorily achieved, the actual establishment and operation of an interbankmarket as such did not take place during the program period. This condition was carried into theFSPL II agenda, and was met only when interbank market regulations were prepared in 1997under an ADB TA.13 Moreover, the regulations were signed by the BOL Governor and issuedonly in November 1999.

15. Under the second component, a total of 14 reform measures were required, of which 10measures were implemented during the program period. The four remaining measures related

to recapitalization of SOCBs, standardized accounting and auditing systems for banks, andlegislation on negotiable instruments. Estimation of additional capital requirements of SOCBs onthe basis of a detailed inventory (rather than an audit) of their loan portfolio was completed withthe help of an ADB TA during the program period.14 However, only in July 1994 did theGovernment issue a decree to proceed with (i) injection of KN4 billion cash equity into theSOCBs; (ii) issue of government bonds worth KN14 billion to SOCBs with maturities rangingfrom 1 to 10 years (Table 1); and (iii) transfer of NPLs totaling KN14 billion from the SOCBsto the newly created Debt Disposal Unit (DDU). The measures relating to the standardaccounting and auditing systems in the SOCBs were not met during the program period, duemainly to delays in the implementation of the supporting ADB TA. This condition was, therefore,carried forward to the FSPL II agenda.15 Similarly, the enactment of the negotiable instrumentslaw was delayed, as mentioned earlier, due to various technicalities.16


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Table 1: Recapitalization of State-Owned Commercial Banksthrough Bond Issues in 1994

(KN million)

Bank 1-Year Maturity 3-Year Maturity 5-Year Maturity 10-Year Maturity

Nakhornluang Bank 72.5 108.9 181.3 362.5Lang Xang Bank 210.5 315.8 526.3 1,052.5Phak Tay Bank 268.5 402.8 671.3 1,342.5Aroune May Bank 57.0 85.5 142.5 285.0Setthathirath Bank 330.6 495.9 826.5 1,653.0BCEL Bank 256.3 384.5 640.8 1,281.5Lao May Bank 204.6 306.9 511.5 1,023.0

Total 1,400.0 2,100.3 3,500.2 7,000.0Maturity Date 1 Aug 1995 1 Aug 1997 1 Aug 1999 1 Aug 2004Interest Rate (%) 7.0 6.0 6.0 6.0

Source: Bank of Lao PDR, Bank Operations Department.

16. The third component of the Program involved 14 measures. Of these, 7 were compliedwith during the program period, 6 were delayed substantially, and 1 measure relating toestablishment of a privatization fund was dropped (para. 8). All 6 delayed measures required

passage of laws or issuance of decrees or regulations. ADB provided a supporting TA toimplement insurance and pension fund reforms.17 A leasing decree was signed in February1999, and the decree on pension funds, with additional help under a sector project of the UNDP,was signed only in December 1999. Legislation relating to the bankruptcy law and debt recoverywas delayed because of the unfamiliarity of the Government and enterprises with theseconcepts. Thus, although the bankruptcy law was signed by the National Assembly in October1994, the prime minister signed the implementation decree only in June 2000. Similarly, thedecree to implement the law on secured transactions, which was related to debt recovery, wassigned only in September 1999. The rules and procedures for arbitration were promulgated as adecree in 1996. The establishment of a land registration office also took place after the programperiod.18

C. Management of the Program

1. Release of Loan Funds and Program Administration

17. The program loan of $25 million was released in two equal tranches. The first tranche

was made available on 26 December 1990 upon loan effectiveness. A review mission fielded inJune 1991 evaluated the progress of ADBs financial sector activities in the country, includingthe Program. In November 1991, a second review mission was fielded to ascertain the progressof implementation of the policy reforms set out in the Governments policy letter. The missionnoted the need for binding loan covenants to be realistic, enforceable, and owned by theGovernment. The mission also believed that the release of the second tranche should not bedi tl li k d t th f lfill t f diti th t i t d d d ADB TA h b


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Government took time to understand and resolve. The second tranche disbursement took placeon 31 December 1991.

18. ADB fielded two other review missions in October 1992 and July 1993 to review theimplementation of the Program and four TAs in the financial and SOE sectors. The missionsobserved slow progress on various program measures, particularly on adoption of anaccounting system for BOL, independent audit of the SOCBs and legislative actions, as well aslack of government commitment and counterpart support for TA consultants. The October 1992mission noted the lack of required human resources in BOL to implement the policy conditions,and the need for further TA on legal, accounting, and privatization aspects. The July 1993mission anticipated considerable delay in program implementation.

2. Procurement and Disbursements

19. Loan proceeds were withdrawn according to ADBs standard disbursement procedures.Goods procured with the loan proceeds conformed to eligible imports based on the negativeimport list agreed upon during appraisal. The bulk of imports originated in Thailand; Japan;Singapore; Taipei,China; and Australia, in that order. Two disbursement missions fielded inSeptember and November 1991 briefed the EA on disbursement matters and verifieddocuments supporting expenditures financed/reimbursed by the program loan.

3. Effectiveness of Technical Assistance

20. ADB approved two TAs together with the Program. One of these TAs was to assist in theimplementation of LTCF that was to be funded in the amount of $3 million equivalent from thecounterpart funds generated by the Program, and was to be made available by the Governmentto BOL for onlending through the SOCBs to nonagricultural borrowers.

21. The TA scope comprised design and implementation of LTCF; provision of advice to theSOCBs on the screening of proposals, appraisal and the recovery process; and training in creditsupervision and debt recovery. This TA, however, failed to achieve sustainable output, namelydevelopment of a viable long-term lending mechanism within the SOCBs. The second TAcovered the establishment of DDU, enhancement of BOLs prudential supervision capability,review of the SOCBs loan portfolios and identification of NPLs, training and assistance in debtrecovery including preparation of debt recovery guidelines, and development of therecapitalization plan for the SOCBs. Subsequent development showed that the portfolio reviewscarried out under this TA may not have fully identified all the NPLs. Moreover, the TA did notachieve the key objectives of debt recovery and strengthening of BOLs prudential supervisioncapacity. A technical assistance performance audit report (TPAR) prepared by ADB inDecember 1999 rated both these TAs as unsuccessful.19

4. Effectiveness of the Executing Agency/Government


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Program was not appropriate. An independent program implementation unit, withrepresentatives from BOL, MOF, the Ministry of Justice, and possibly the Prime Ministers Officemight have been more effective in pushing ahead with the reform program.

23. Program implementation took inordinately long. This may in part be due to havingpacked a large agenda in a tight time frame, but it also reflected insufficient commitment andownership by the Government. The legal process in the country involves extensiveand timeconsumingdiscussions between various branches of the Government. The process wasfurther slowed by lack of understanding of the necessity of passing certain laws under theProgram, for example, the law on bankruptcy and secured transactions; as well as theperceived need to study the experience of neighboring countries. The Government took a long

time to complete the measures required to pass laws and implement decrees, rules, andregulations. Moreover, though laws relating to NBFIs were eventually passed, not much effortwas made to promote the breakthrough or derive benefits from the enabling environment thatwas created for the development of new financial intermediaries. In this regard, rejection of alarge number of applications for bank licenses may also have dampened the enthusiasm offoreign investors otherwise interested in setting up financial institutions in Lao PDR.20 TheGovernment also did not ensure that key personnel associated with the implementation of theProgram in various agencies stayed in relevant positions for a sufficient length of time to

maintain continuity.

D. Assessment of Program Outputs

1. Reforms in the Central Bank Area

24. The Program helped in providing, through policy measures, a basic framework for BOLto carry out its central banking functions (Box 1). However, although these reforms have createdthe enabling environment for monetary management through the use of indirect monetary

control instruments, BOL has yet to use these instruments aggressively. It has adjusted thereserve ratio only twice since its introduction. Initially, it was set at 5 percent, then increased to10 percent; at present it stands at 12 percent. Though BOL has issued bills and bonds and MOFhas issued treasury bills during 19901998, the open market operations and discounting of suchbills at the discount window have not had any perceptible impact. Thus, during 19951998, thevolume of treasury bills discounted by BOL remained modest, with a minimum of KN290 millionin 1996 and a maximum of KN5 billion in 1998. The discount window has been dormant since1998 because there are no outstanding treasury bills with banks at all.

25. ADB provided a TA in September 1996 to develop an interbank market and helpformulate its regulation and a clearinghouse agreement (footnote 13). The interbank market wasinitially used only to settle the interbranch balances of the former monobank branches, whichhad later become independent SOCBs. In terms of overnight accommodation or short-termaccommodation for banks, the market has remained small, and since 1998 has been inactive.Even when the market was active the volume of interbank transactions was modest at KN10


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Box 1: Central Banking Reforms

Separation of central banking functions from commercial banking activities. Increased competition in the banking sector and increased provision of banking services. The number

of commercial banks, both state-owned and private (foreign and joint venture), has increased to 15. The banksnow serve the entire geographical area of Lao PDR. Three joint venture banks and seven foreign bankbranches compete with five state-owned commercial banks, to the benefit of the users of banking services.

Introduction of indirect monetary control tools. The Program provided the Bank of Lao PDR (BOL) with thetools to control the money supply by instituting a reserve ratio for all financial institutions, opening a formalmechanism for open market operations through the sale and repurchase of government paper, andestablishing a discount window to provide liquidity on the investment instruments held by banks.

Improved financial intermediation. The Program also encouraged savings, discouraged directed lending,

and improved access to bank credit through substantial elimination of the preferential interest rate structure(limited now only to the agriculture sector). However, the lending rates are not completely risk-adjusted andthus distort resource allocation.

Foreign exchange reserves management. The management of foreign exchange reserves has beenentrusted to BOL and that of foreign debt to the Ministry of Finance.

Table 2: Interest Rates on Deposits and Loans(percent per year)

Item Dec 1996 Dec 1997 Dec 1998 Dec 1999 Dec 2000

Deposit rates

Savings 16.0-16.5 16.0-16.5 22.0-22.0 6.0-12.0 6.0-12.0Time

3 months 16.0-16.5 16.0-17.0 19.0-23.0 12.0-15.0 12.0-15.06 months 16.0-17.0 16.0-18.0 19.0-24.0 14.0-20.0 14.0-20.01 year 16.0-19.0 16.0-20.0 19.0-25.0 16.0-24.0 16.0-24.02 years 24.0-24.0 24.0-27.0 18.0-27.0

Rate Paid on Required

Reserves of Banks Held atBOL

12 12 12 12 12

Lending Ratesa

Agriculture and Forestry 18, 16, 20 18, 17, 16 25, 28, 19 25, 25, 28 17, 16, 16Industry and Handicrafts 24, 23, 22 22, 23, 25 30, 32, 33 29, 31, 32 22, 24, 25Construction and Transport 25, 24, 23 23, 24, 26 30, 31, 33 30, 31, 33 26, 27, 28Commerce and Services 27, 26, 25 25, 26, 27 32, 34, 35 32, 34, 35 28, 29, 30Agriculture Promotion Bank 10, 8, 7 10, 8, 7 10, 8, 7 10, 8, 7 10, 8, 7

Bank of Lao PDRAdvances/Overdrafts 35 35 35 35 35

a The three rates refer to short-term, medium-term, and long-term loans, respectively.Source: Bank of Lao PDR.

26. In the area of interest rates, BOLs regulations are unclear. There is evidence that BOLexercises direct and indirect influence over interest rates by prescribing minimum and maximumdeposit interest rates, as well as maximum lending interest rates for various sectors. The banks

t ll d t l di t b d i k fil f b ithi th t


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pursued an inflationary policy (or at the very least, did not try to control inflation). However, thegap between the inflation rate and the nominal interest rate is narrowing (Table 3). ThePrograms attempt to increase the use of the kip has not been effective, since the dollar andbaht continue to be used freely in routine market transactions.

Table 3: Nominal and Real Interest Rates of Commercial Banksa(percent per year)

Item Nov 91 Dec 92 Dec 93 Dec 94 Dec 95 Dec 96 Dec 97 Dec 98 Dec 99 Dec 00

Nominal DepositRate

b

15.0 15.0 13.6 12.7 16.2 16.3 16.5 21.0 13.5 13.5

Real Deposit Ratec

2.8 9.0 7.5 5.9 -3.1 2.5 -70.9 -66.4 -120.5 -13.5

Nominal LendingRate

d

18.4 18.4 19.3 15.1 22.4 22.8 29.1 29.1 30.2 23.9

Real Lending Ratec

6.2 12.4 13.2 8.3 3.1 9.0 -58.3 -58.3 -103.9 -3.1Spread 3.4 3.4 5.7 2.5 6.2 6.5 8.1 8.1 16.7 10.4Expected Inflation

e12.2 6.0 6.1 6.8 19.3 13.8 87.4 87.4 134.0 27.0

aFor kip transactions, excluding preferential projects program.

bAverage rates on three-month deposits.

cNominal deposit rate minus expected inflation.

dAverage lending rate by sector as of December.

eRate calculated using a moving average of annualized inflation as a proxy for expected inflation.

Source: Bank of Lao PDR.

2. Reforms in the Banking Sector

27. The Program launched major banking sector reforms with varying degrees of success(Box 2). By far, the most important reform related to the recapitalization of the SOCBs. This wasimplemented by an exchange of NPLs totaling KN14 billion for government bonds (Table 1), anda KN4 billion cash injection into the SOCBs equity. The SOCBs could not fully benefit from this

restructuring, since their lending capacity was enhanced only to the extent of direct injection ofcash equity. Had the SOCBs carried provisions of KN14 billion against NPLs, their capital wouldhave been restored by reversal of those provisions following the replacement of NPLs withgovernment bonds. Nevertheless, the exchange of NPLs for risk-free government bondsconsiderably improved the quality of the SOCBs assets.

Box 2: Banking Sector Reforms

Debt Disposal Unit (DDU) and recapitalization of state-owned commercial banks (SOCBs). The Programinitiated steps to restore the soundness of SOCBs by analyzing their nonperforming loans (NPLs), transferringNPLs to a DDU, providing a basis for launching an orderly effort for recovery of those NPLs (though actualrecovery has been modest), and recapitalizing SOCBs (though continuation of SOCBs unsound lendingpractices has again caused serious capital deficiency).

Long-term lending by commercial banks. The Program made an attempt to extend the maturity structure ofcommercial banks assets by introducing the long-term credit facility

Interbank settlements by netting out previous backlog of interbank assets and liabilities


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28. The NPLs exchanged for government bonds were transferred to DDU with theexpectation that most of them would be recovered. However, due to lack of personnel, andbecause a number of the defaulting units have been privatized, DDU is still saddled with a baddebt portfolio of about KN11.5 billion (Table 4). On the other hand, continuation of unsoundlending practices in the SOCBs has completely wiped out the benefits of the recapitalizationexercise. The dramatic depreciation of the kip and the weak performance of the Lao economy inthe wake of the Asian financial crisis have magnified the SOCBs insolvency problems that werebrought to light by independent audits for 1996-1997 funded by the World Bank and theAustralian Agency for International Development (AusAID). As a result, the cost of a secondrecapitalization is being variously estimated in the range of $50 million$70 million (Table 5).

Table 4: Summary of Bad Debts with Debt Disposal Unit(as of 31 March 2001)

Bank Number of Borrowers Unrecovered Amount(KN million)

Borrowers with Business and RevenueLang Xang Bank 49 712.9BCEL 1 364.9Lao May Bank 77 1,011.5

Subtotal 127 2,089.3

Borrowers with No Business and No RevenueLang Xang Bank 275 1,687.8BCEL 36 1,030.9Lao May Bank 251 2,043.5

Subtotal 562 4,762.2

Bankrupt, Dead or UntraceableLang Xang Bank 354 2,550.6BCEL 24 763.0Lao May Bank 476 1,377.0

Subtotal 854 4,690.6Total 1,543 11,542.1

BCEL = Banque pour le Commerce Exterieur du Laos.Source: Bank of Lao PDR, Bank Operations Department.

29. The LTCF of $3 million equivalent in kip funded from the Programs counterpart fundswas utilized with the help of a credit advisor provided under the ADB TA. However, the facilitydid not result in lengthening of credit maturities by the SOCBs on a sustainable basis due to theshortage of capital and long-term deposits, the absence of long-term funding from institutional

savers, an inadequate legal basis for secured lending,21

and the lack of trained bank staff toappraise projects and manage term lending risks. A subsequent ADB TA,22 which is presentlyunder implementation, has focused on these aspects. This TA should also help to promote acommercial credit culture and risk-adjusted pricing of loans.


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Table 5: Financial Highlights of State-Owned Commercial Banks($ million, as of end-December)

BCEL LMB LXBItem

2000 2001 2005 2000 2001 2005 2000 2001 2005

Balance SheetCash and Short-Term Assets 137.8 149.3 241.0 26.6 29.0 46.1 27.1 29.1 48.2Net Loans Receivable (full provision) 35.6 40.2 70.0 14.9 16.4 23.2 8.1 9.2 13.8Total Assets 198.8 216.0 339.0 45.7 49.5 71.7 43.9 47.4 75.3Deposits 175.9 192.2 303.0 43.6 53.6 73.9 40.4 44.7 74.4Capital (deficit) (36.9) (36.4) (30.1) (3.9) (5.1) (11.7) (0.4) (1.2) (5.3)

Capital Adequacy Requirement at8% 42.0 42.0 36.0 5.5 6.8 14.3 1.3 2.2 7.712% 44.0 44.0 40.0 6.2 7.6 17.4 1.8 2.7 8.3

Income StatementNet Interest Income (loss) 0.2 1.4 (0.8) (1.9) 0.3 0.3Foreign Exchange and Fee Income 2.6 4.8 1.1 1.2 0.1 0.2Net Operating Income (expenses) (1.0) (1.4) (0.7) (0.9) 1.1 1.5Net Income (losses) after Tax 0.5 2.0 (1.2) (2.6) (0.8) (1.1)

= not available; BCEL= Banque pour le Commerce Exterieur du Laos; LMB = Lao May Bank; LXB = Lang Xang Bank.Note: The figures indicated above are based on (a) estimating year-end 2000 balances using 31 August 2000 data, and (b)preliminary financial projections without the benefits of close interaction with the management of the SOCBs. These figurescould substantially change after close consultations with management.

Source: ADB consultants.

30. The use of kip checks as a payment medium is growing (Table 6). BOL data indicatethat the volume of kip checks passing through the clearing system increased from 6,893 checks(KN30.5 billion) in 1990 to 30,468 checks (KN221.9 billion) in 1995. After undergoing a steepdecline in number of checks to 21,170 (KN229.7 billion) in 1996, the volume steadily rose to33,605 checks (KN1.78 trillion) in 2000. The reasons for the drop in 1996 are not clear, though

one of them could be the issuance in 1996 of higher-denomination quip notes, which reducedthe inconvenience of large cash settlements. There is as yet no mechanism in place to issueand clear checks denominated in foreign exchange, which was one of the measures to beintroduced under the Program.

Table 6: Clearing of Checks by theLao Bankers Clearing House

Year No. of Checks Amount(KN billion)

1990 6,893 30.51991 15,685 99.41992 19,377 99.51993 23,749 140.7


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31. The bank accounting and audit reforms contemplated under the Program wereformalized by the Government through the Enterprise Accounting Law in December 1990 andits implementing decree, which was approved in January 1992. This was followed, in November

1993, by a BOL instruction that required banks to undertake audits meeting internationalstandards commencing in 1995.23 Audits for the years 1996 and 1997 had been completed bythe time of fielding of the OEM, while the audit for 1998 was reported to be ready forcommencement under AusAID funding. This backlog in bank audits has added to theuncertainty about the SOCBs true financial condition. Hence, the cost of their furtherrecapitalization cannot be assessed accurately.

3. Reforms for Private Sector Development and Privatization

32. The Program attempted to establish an enabling environment for the private sector totake root and grow (Box 3). It also sought to help the Government to reactivate its stalledprivatization program. Implementation of program conditionalities relating to private sectordevelopment has been gradual and slow. The laws on property and contracts were approved inJune 1990. The National Constitution of August 1991 guarantees the right to private propertyand operations. An enterprise decree approved in March 1993 and upgraded to a law in July1994 created a system of registration for enterprises. The Lao PDR has thus provided the basicframework for the existence and growth of private enterprise. Lending by banks to private sectorenterprises has been growing considerably in nominal terms (Table 7).24 However, therecontinue to exist some disincentives that have moderated the pace of private sector growth. Forexample, private enterprises find onerous the requirement to renew their professional licensefrom the line ministry each year as well as to register their business. Furthermore, enterprisesare required to pay a minimum amount of tax even if they suffer losses in a tax year. Legalreforms relating to bankruptcy and secured transactions were delayed, incorporated intoFSPL II, and implemented only in 1999 and 2000.

Box 3: Private Sector Development

Legal framework for private sector development. The Program prompted the Government to passlegislation to establish legal safeguards for the establishment and operation of private enterprises of varioustypes, provide a debt recovery and bankruptcy framework, and make institutional arrangements for registrationof domestic enterprises and land entitlements

Privatization. The Government undertook a major review of state-owned enterprises (SOEs) to identifycandidates for privatization. In 1993, a permanent office of the Privatization Committee was approved. In all, 69

SOEs were privatized during 1992

1996, as against a minimum 10 envisaged under the Program.

Broadening the range of financial services. The Program also helped initiate enactment of laws relating tononbank financial institutions to encourage long-term savings and make a broader range of financial servicesand alternate financing sources available to the private sector.


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Table 7: Credit to Private Enterprises by Sector

(outstanding as of year-end, KN million)

Item 1995 1996 1997 1998 1999 2000

Industry 14,884 19,359 58,544 108,698 226,125 370,410Construction 10,997 13,197 35,702 73,753 147,482 176,410

Transport & Communications 2,518 2,549 2,316 2,503 2,909 10,410

Agriculture 21,486 24,134 34,732 43,968 85,404 181,220

Material Supply 91 185 261 259 574 270

Commerce 14,823 15,775 52,292 108,496 127,505 241,720

Others 54,614 49,223 5,160 15,714 54,517 61,080

Total 119,413 124,422 189,007 353,391 644,516 1,041,520Growth over previous year (%) 4.2 51.9 87.0 82.4 61.6Inflation Rate (%)

a13.0 15.5 90.0 128.4 23.2

aChange in consumer prices (annual average).

Source: Bank of Lao PDR.

33. During 19911993, the Government issued several decrees relating to privatization. Aprivatization coordination committee was established in 1991 and was operative until 1996,when the Government discontinued privatization. Fifteen SOEs were privatized in 19891991,and 69 in 19921996. At the time of the OEM, the state assets department had plans toundertake initial assessment of another 10 SOEs. A privatization committee established in theprime ministers office is preparing master plans for various sectors, with a view to determiningwhich SOEs the Government may retain. Privatization has, thus, made a considerable thoughslow progress.

34. The Program also improved the legal environment for financial sector development. Anumber of laws, decrees, and regulations were issued relating to approval, licensingarrangements, and regulation of commercial banks and negotiable instruments. However, inpractice, no new bank was provided with a license during 19942000. The Program also helpedto provide the legal framework for establishing pension funds, leasing companies, andinsurance companies to develop the NBFI sector for mobilizing long-term savings and providingadditional financing avenues. The decrees on leasing and pension funds, however, were issuedonly in 1999. The countrys first pension scheme for the entire enterprise sectorthe Social

Security Organization (SSO)

was just about to be launched in 2001, and it is too early topredict how it will develop as a source of long-term funds for enterprises. What appears certain,however, is that, in the absence of capital and bond markets, bank deposits may remain theonly investment avenue for the SSO in the foreseeable future. The progress of the leasingindustry has also been modest. While a few equipment rental companies have been licensedand have commenced operations, none of them has yet entered into financial lease

i hi h i i f l l f di di


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However, the Program set in motion a process of important policy reforms which are helping thetransition of the countrys economy, even if the pace of transition is slower than expected. TheProgram contributed to economic stability and to maintaining a healthy growth rate of 67percent per year until the onset of the Asian financial crisis (Appendix 3). By improving theenvironment for private enterprise, the Program also encouraged foreign direct investment(FDI) and helped to diversify exports. The number of FDI projects increased from less than 50 in1990 to more than 130 in 1995, though it stabilized at lower levels of 60-70 in subsequent years.The labor-intensive garments industry benefited significantly from FDI, thereby expanding jobopportunities for the unemployed. In 19921993, garments overtook hydropower as thecountrys largest foreign exchange earner. Recapitalization of the SOCBs, privatization, andimprovement of the environment for private business allowed banks to direct increasing

amounts of credit to the private sector, which helped to further increase employmentopportunities and encourage indigenous entrepreneurs. The reforms implemented under theProgram enhanced BOLs capacity in monetary management and banking supervision. This,coupled with loosening of controls over interest rates, helped to improve the volume andefficiency of financial intermediation. This is evidenced by the growth of banking system assets(Table 8), at rates considerably in excess of the inflation rates for 19911995 (Appendix 3). It isnotable that the interest rates offered by banks on deposits remained positive until the onset ofthe regional financial crisis in 1997. The Program also extended the reach of banking servicesto regions not previously served by banks.

Table 8: Structure and Growth of Financial Sector Assets(KN million, as of 31 December)

Bank 1989 1990 1991 1992 1993 1994 1995

Bank of Lao PDR 97,084 99,011 120,938 149,062 170,684 184,577 247,104

Commercial Banks 50,174 95,058 107,207 143,528 233,738 280,707 359,452

of which:SOCBs 48,424 91,891 102,069 130,151 176,456 201,803 249,036PCBs 1,750 3,167 5,138 13,377 57,282 78,904 110,416of which:

Joint Venture 1,750 3,167 5,138 13,377 23,150 27,327 34,689Foreign 34,132 51,577 75,727

Total Assets 147,258 194,069 228,145 292,590 404,422 465,284 605,556

Growth of Assets (% per annum)All Banks 31.8 17.6 28.2 38.2 15.0 30.1

BOL 2.0 22.1 23.3 14.5 8.1 33.9

Commercial Banks

89.5 12.8 33.9 62.9 20.1 28.1SOCBs 89.8 11.1 27.5 35.6 14.4 23.4PCBs 81.0 62.2 160.4 328.2 37.7 39.9

BOL = Bank of Lao PDR; PCBs = private commercial banks; SOCBs = state-owned commercial banks.Source: Data from Lao PDR authorities and ADB documents.


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resulted in money supply growth of about 100 percent and triggered depreciation of the kip and asharp increase in the inflation rate.

Table 9: M2 Money Plus Quasi-Money(ratio to GDP at current prices)

Year Lao PDR PRC Mongolia Thailand Viet Nam

1989 0.10 0.69 0.64

1990 0.07 0.80 0.69

1991 0.07 0.87 0.52 0.73

1992 0.09 0.94 0.28 0.75

1993 0.13 1.01 0.26 0.79

1994 0.15 1.00 0.27 0.78

1995 0.14 1.04 0.19 0.79 0.20

1996 0.14 1.11 0.18 0.81 0.21

1997 0.18 1.23 0.20 0.92 0.23

1998 0.20 1.32 0.20 1.03 0.24

1999 0.15 1.48 0.25 1.09 0.36

2000 0.17 1.06 0.44

Lao PDR = Lao Peoples Democratic Republic; PRC = Peoples Republic of China.

Source: IMF, International Financial Statistics.

B. Impact on Private Sector Development

37. The OEM has not attempted to quantify the impact of the Program on private sectordevelopment in Lao PDR due to data constraints. In general, however, this impact appears tohave been positive, since the sectors where the private sector is more active, such asmanufacturing, construction, hotels and restaurants, and wholesale and retail trade, haveregistered higher GDP growth rates (Table 10). An important objective of the Program was tobring about an enabling environment for private sector growth and provide a push to theGovernments privatization efforts through enactment of various laws and regulations. By theyear 2000, though the Government had moved slowly in creating the legal infrastructure for theprivate sector to take root in the Lao economy, most of the requirements set under the Programwere in place. The Government also provided the legal framework for broadening anddiversifying financial services through NBFIs. Finally, the Program also helped in looseningBOLs control over interest rates, redefining its role as the countrys central bank, and settingthe banking system on a reform path to better serve the private sector.

38. The private sector in the Lao PDR is a combination of informal and formal firms withdiverse ownership structures and linkages to the Government. The formal private sector isestimated to be relatively small in terms of number of manufacturing firms, and SOEs operatealongside the private sector. Under the Programs agenda, the Government undertook aninventory of nearly 650 SOEs and identified 177 units for privatization. Between 1989 and 1996,


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retained in the state sector and those to be privatized. On the whole, the Program had anappreciable impact on privatization and private sector development in the Lao PDR.

Table 10: Real GDP Growth Rates by Sectors(percent)

Average

Sector 1994 1995 1996 1997 1998 1999 2000 Annual Growth

Agriculture 8.3 3.1 2.2 7.5 3.1 8.2 5.0 4.8Crops 12.7 -2.5 0.9 16.2 6.4 13.5 12.9 7.7

Livestock and Fishery 4.3 3.7 4.0 1.2 2.5 2.3 2.9 2.8

Forestry 4.0 28.2 1.7 -5.2 -9.7 2.3 -33.6 -4.5

Industry 10.7 13.1 17.3 8.1 9.2 8.0 7.6 10.4Mining and Quarrying 30.4 -3.7 41.2 50.0 12.7 33.5 17.1 20.1

Manufacturing 7.0 17.7 19.0 8.5 9.6 7.1 7.8 11.5

Construction 17.2 6.8 8.7 8.3 -13.9 -0.6 -10.5 -0.7

Electricity, Gas, and Water 29.0 -8.8 15.2 -2.3 62.8 21.6 24.3 17.1

.

Services 5.5 10.2 8.7 7.3 5.5 6.7 6.0 7.4

Transportation, Storage and

Communication 4.3 18.2 15.1 5.4 6.6 5.8 6.2 9.3

Wholesale and Retail Trade 7.9 9.3 10.0 12.1 9.7 7.2 5.3 9.1Banking, Insurance, and 8.2 42.0 -0.8 7.6 1.6 3.0 3.0 9.8

Real Estate

Ownership of Dwellings 8.6 3.4 4.2 4.4 2.5 2.5 2.5 2.8

Public Wage Bill -6.6 -4.5 0.0 1.4 4.3 6.7 0.7 1.1

Nonprofit Institutions -3.0 2.4 11.1 -4.5 -20.0 -4.8 8.0 -1.7

Hotels and Restaurants 53.6 35.0 14.5 16.2 8.2 21.6 19.8 19.3

Others 3.0 15.4 23.1 -6.3 5.0 19.6 31.0 12.2

GDP at Market Prices 8.1 7.1 6.8 7.0 4.0 7.3 5.7 6.3

Source: IMF reports.

C. Institutional Impact

39. The Program significantly altered the institutional structure of the financial sector. BOLemerged as the apex institution entrusted to oversee the banking sector and exercise control

over monetary variables to bring about monetary stability in the Lao economy. It now has thetools of monetary control, such as a reserve ratio, open market operations, and the discountwindow, to manage the liquidity in the banking system. The reforms also established aninterbank market and a check clearing system covering all provinces. In short, the Programhelped refocus the role of BOL on the traditional responsibilities of a central bank. However,BOL suffers from inexperience in effectively performing that role. It also lacks autonomy, and its


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joint venture banks and seven foreign bank branches provide diversity and limited competitionwithin the banking sector, based on service quality and interest rates, subject to the limitsspecified by BOL. However, though ADB TA helped improve the staff skills of the SOCBs, their

lending practices have not significantly improved. Previous subjugation to directed lending and amindset to depend on the guidance of BOL and MOF have not yet fully given way to soundcredit and risk management practices. Restructuring and reforms in the banking system havegenerated demand for professional skills in banking and finance, and have exerted pressure onthe training and educational institutions to meet this enhanced demand for trained professionals.The Banking and Finance Training Centre (established under ADB TA) has been helpful in thisarea (para. 43). However, the training facilities at this Centre need upgrading. Overall, theinstitutional structure created under the Program has remained weak and has operated below

its full potential, both on account of the controlled economy mindset and the transitionaleconomy context.

IV. KEY ISSUES FOR THE FUTURE

A. An Alternate Strategy for the Banking Sector

41. The Programs approach to developing the banking sector in the Lao PDR was not fullyeffective. While the recapitalization of the SOCBs improved their financial position, the

continuation of unsound lending policies in subsequent years has practically wiped out theircapital base and brought them to the brink of technical insolvency. Efforts to improve theSOCBs portfolios should continue through ADB TAs, such as those under implementation atpresent,25 which are attempting to improve the credit culture and corporate governance of theSOCBs. However, it appears that the overall effort is thinly spread over the SOCBs, losing inthe process the required thrust to change their mindset and culture. An alternate strategymay be to focus ADBs attention and resources on reforming a single SOCB, which could thenbecome a model for others, and could even become attractive for privatization or reorganized as

a joint venture with a sound foreign bank. It may well be desirable for ADBs Private SectorGroup to make an equity investment in the selected SOCB at an appropriate time, in associationwith a reputable foreign bank, thereby demonstrating ADBs willingness to help reform theSOCB and influence its governance from within.

B. Development of Long-Term Resources

42. Commercial banks in the Lao PDR depend heavily on deposit resources, whichconstitute nearly 60 percent of their total liabilities. The SOCBs account for about 80 percent of

total deposits in the banking sector, thus dominating the deposits market. However, time andsavings deposits represent less than 10 percent of total bank deposits, which indicates thatsavers are reluctant to entrust their savings to banks for longer terms, mainly on account of pastexchange rate volatility and fear of inflation and depreciation of the kip. For the same reason,banks are also reluctant to lend for extended maturities, due to the fear of exchange ratedepreciation which would impair the ability of clients to repay such loans Thus it is difficult for


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term funds. A more effective way to solve these problems might be to develop contractualsavings institutions, such as insurance and pension funds. Though the Program provided thelegal framework for establishment of such institutions, the development of NBFIs has been slow.

Government and ADB need to continue efforts in that direction.

C. Corporate Governance of Banks and Enterprises

43. The transparency and reliability of financial information is not just an essential element ofgood governance, it is also a critical input to sound credit decisions, and thus to the health of thewhole financial sector. Strong and well-functioning accounting and auditing professions are, inturn, necessary to ensure that the financial information submitted to financial institutions is of

high quality. Besides, for auditing to be effective, there must be a well-defined basis foraccounting, used with uniform standards by all entities within a particular group, such asbanking, and consistently applied from year to year. In the Lao PDR, despite the existence ofprofessional bodies and institutions such as the Accountants Association, Accounting Institute,Internal Auditors Institute, Accounting Board, Lao Institute of Certified Public Accounts, Schoolof Accountancy, and School of Finance, there appears to be a critical shortage of accountantsand auditors well versed in modern accounting and auditing practices. The recently establishedAccounting Board and the professional accountants bodies are positive steps. However, thesebodies are functioning without a full-time staff or budget, and have yet to play an effective role in

the development of the accounting and auditing professions. Likewise, the Banking and FinanceTraining Centre set up with ADB assistance under the umbrella of BOL is functional but needsfurther capacity building to be able to meet the increasing requirements of the SOCBs and otherbanking institutions, particularly in areas such as risk management, credit appraisal on the basisof the commercial and economic viability of projects, risk-adjusted loan pricing, and effectivedebt recovery.

44. Good corporate governance relies on a sound legal framework, including appropriate

regulations, implemented by capable institutions and trained officials, and on the waycompanies manage themselves internally. Thus, corporate governance at the enterprise levelrequires a proactive management with transparent policies, accountability for its actions vis--vis the set corporate goals, and a consciousness of its responsibilities toward stakeholders,including employees. In the Lao PDR, corporate governance structures are weak at all levels,i.e., government, SOCBs, and SOEs, as well as private enterprises. Shortcomings exist in thequality of financial information, enforcement of the legal framework, knowledge of rules andregulations and the capacity to implement them at operating levels within banks andenterprises, and internal audit capacity and practice within enterprises. Corporate governance

assumes particular importance in a transitional economy, where banks and enterprises aregradually moving to a system that follows market signals. ADB is trying through TA to help theSOCBs with institution building by strengthening their governance and exposing them to soundbanking concepts and practices (footnote 25).However, strengthening corporate governance oftheir clients, the borrowing enterprises, is of equal importance. Introducing sound corporategovernance principles in SOEs and private enterprises will help to promote a credit culture


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IV. CONCLUSIONS

A. Overall Performance

1. Appropriateness and Relevance

45. The Program was relevant to the needs of an economy in transition, where the privatesector was expected to play an increasing role in economic activity. Its design addressed twokey objectives: increased domestic resource mobilization and enhanced allocative efficiency ofthe financial system, and an improved environment for private sector development. However,the design appears to have been flawed on three counts. First, given the three-year time frame,

the reform agenda was too ambitious. In particular, the one-year period provided for compliancewith second tranche conditions proved grossly insufficient. A part of the agenda relating tomonetary policy instruments and actions merely reinforced the reforms already covered by theIMF program and could well have been left out. Second, the design did not fully take intoaccount the constraints on the implementation capacity of the Government and EA. Accordingly,the Government was unable to implement a number of the program measures, particularlythose involving legislation, without provision of additional TA by ADB and other aid agencies.With hindsight, it appears that advisory and capacity-building TA relevant to program conditionsshould have preceded rather than followed program approval. This design flaw is also

recognized by the PCR. Third and finally, the choice of BOL as the EA did not turn out to be themost appropriate. Since program measures involved actions by a number of governmentministries and agencies, and BOL had no previous experience of coordinating policy reformsaiming at transition from a command economy, a more empowered EA with interdepartmentalrepresentation would have proven more effective.

2. Program Impact and Efficacy

46. The Program made a positive impact in a number of areas, though progress wasachieved over a much longer period than envisaged. The commercial banks now enjoy limitedfreedom to set interest rates from time to time, within the limits specified by BOL, which shouldhelp to improve the efficiency of financial intermediation. The issuance of government securitiesand the opening of the BOL discount window will contribute to enhancing the liquidity of thebanks assets and lending capacity. A degree of competition has also been introduced in thebanking sector by allowing some foreign and joint venture banks to operate. Moreover, theProgram encouraged the extension of banking services to cover the entire geographical area ofthe country. The Program also improved payment mechanisms and helped to promote the

check culture. The Government made sustained and successful efforts to privatize SOEsduring 19881996. However, the existing SOEs and newly privatized enterprises have lackedgood governance practices.

47. The Program was not successful in putting the SOCBs on a sound footing, since theSOCBs have not been able to benefit from recapitalization on a sustainable basis In other


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regulations were issued only after considerable debate and time lag. The laws and regulationsissued under the Program are not widely disseminated and are not always easy to interpret sothat further rules may be needed for their clarification.

3. Sustainability

48. The Program has set in motion important financial sector reforms to support thetransition of the Lao PDR to a market-oriented economy. Since the Lao PDR is a member of theAssociation of Southeast Asian Nations, and is also seeking to join the World TradeOrganization, it is in a way committed to complete its transition to a market-based economy, soas to be an eligible and competitive member of these organizations. However, if benefits are to

be derived from reform measures on a sustainable basis, the Government will need todiscontinue policy lending through the SOCBs, prepare financial sector institutions to faceincreasing competition, and allow them to operate in an open and deregulated economicenvironment. The attempt made under the Program to recapitalize the SOCBs and put them ona sound footing has practically failed in the face of lack of development of a commercial creditculture, continued SOCB mindset of working under the rules of a command economy, and thelack of clarity in the rules and regulations governing the banking sector. Despite ADBs efforts toimprove the credit culture in the SOCBs through TA, the ratio of NPLs was still estimated to beabout 60 percent of their assets portfolio in 1999 (Table 11). A second and bigger

recapitalization is thus inevitable to restore the SOCBs capital adequacy before subjecting themto rigorous prudential supervision.

Table 11: Nonperforming Loans in the Lao Banking System(as of September 1999)

Share of NPLs inin Outstanding Loans (%)Name of Institution

OutstandingLoans

(KN billion)

Market Share(%)

BOL Estimate 1999 Portfolio Review

BCEL Bank 392 40 30 88Lao May Bank 110 11 29 84Lang Xang Bank 70 7 7 47Joint Development Bank 84 8 83 Other Banks 331 34 16

Total 987 100 60a

= Not available, BCEL = Banque pour le Commerce Exterieur du Laos, BOL = Bank of Lao PDR.a

Weighted average.Source: Joint ADB-WB-BOL Financial Sector Note (Second Draft) dated 7 December 2000.

49. Moreover, the full benefits of financial sector reforms will be realized only if similarreforms are pursued in other sectors of the economy that the financial sector is supposed to


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financial discipline of a competitive market environment. Moreover, in order for the banks tomake informed lending decisions, the quality of financial information on enterprises needs to beimproved and made reliable. This, in turn, calls for improved accounting and internal and

external auditing practices.

4. Role and Performance of the Asian Development Bank

50. ADB has played a lead role in the reform of the financial sector in the Lao PDR. Inkeeping with this, the Program was followed in September 1996 by FSPL II, which carriedforward some of the unfinished agenda and made an attempt to consolidate the bankingsystem. Program implementation suffered from long delays. It appears that because of its

inexperience in policy-based assistance to transitional economies, ADB was unable to make arealistic assessment of the capacity of the implementing agencies in the Lao PDR. Thus, during19882000, ADB provided 22 TAs, totaling $8.4 million, to support various sets of policy reformsin the Lao financial sector (Appendix 2). Yet there are still a number of areas whereimprovements are needed to fully benefit from the reforms implemented so far. Based on thelessons of experience under the two programs and the various TAs, ADB is charting its futureagenda for the Lao financial and private sectors in active coordination with other aid agenciesparticularly the World Bank and IMF.

5. Management of the Program by the Government

51. Program implementation took a long time and its completion was partial. Though, to alarge extent, packing a large reform agenda into a short span of time was responsible for thisoverflow, it also reflects vacillation in the Governments commitment and ownership of theProgram. While agreeing to complete the reform agenda within the agreed schedule, the reduceGovernment did not fully take into account its capacity constraints. This is evident from thenumber of TAs it has needed over the years from ADB, the World Bank, the IMF, UNDP, and

other agencies to complete its obligations under various agreed reform measures.Implementation experience also reveals that the choice of BOL as the EA was not appropriate.First, BOL had no track record of managing the financial sector. Second, it did not enjoy thetype of autonomy that was needed to push forward the reform agenda and depended heavily onMOF as well as the Ministry of Justice to implement the Program. Third, as the newly createdSOCBs were in fact former branches of BOL, it could not dispassionately persuade the SOCBsto adhere to sound banking practices. The Government also did not give sufficient attention toensuring that key personnel associated with the implementation of reforms stayed in relevantpositions for a sufficient time to maintain continuity and familiarize operating-level staff with the

significance of reforms.

6. Program Rating

52. The Program is rated partly successful because a significant proportion of the reformmeasures could not be completed during the given period and not all the expected benefits

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privatizing a significant number of SOEs during and after the program period, the enterprisesprivatized lack sound corporate governance and market orientation.

B. Lessons Learned

53. Experience with the Program provides a number of lessons relevant to design,formulation, and implementation of such financial sector interventions, which to some extentalso apply to program loans in general. Three design flaws are discernible with respect toprogram scope, implementation capacity of the Government, and sequencing of reforms. Interms of its scope and coverage, the Program was overly ambitious, particularly because theLao PDR was a transition economy, and ADB was inexperienced in policy-based lending to

transition economies. Apprehensions to that effect had been expressed by Management duringprogram processing. It is likely that government readiness to accept the Program wasmistakenly believed to match its ability to implement the reform agenda in a timely manner. Amore careful and thorough assessment of implementation capacity would have resulted in abetter-focused reform agenda, and upfront consideration of a realistic capacity building planwould have expedited effective implementation of that agenda. As it became clear later, theGovernment was unable to proceed with most of the reforms without further TA from various aidagencies.

54. Second, and related to this, is the lesson that measures preparatory to actualimplementation of reforms should be completed before program approval or effectiveness, aswas also concluded by the PCR. This is particularly important where reform programs involveissuance of laws, decrees, or regulations. If there is a felt need for TA to formulate and draft therequired legislation and regulations, then TA should precede program approval.

55. The third important lesson relates to the ownership of reform agenda. Long delays wereexperienced in implementing reforms under the Program, mainly because intragovernment

consensus building and consultation processes were initiated only after program approval. Toensure smooth and efficient implementation of the Program, these processes should have beeninitiated during its formulation and completed before its approval.

56. The importance of properly sequencing reform actions cannot be overemphasized. Therecapitalization of the SOCBs failed because it was implemented without sufficient attention toremoving institutional weaknesses underlying their portfolio problems. Resolving internalgovernance issues in the SOCBs, and strengthening their credit appraisal and risk managementskills in parallel with or prior to recapitalization, would have helped instill sound lending practices

within them and thus would have sustained their financial health. Second, the requirement ofadditional capital was estimated without detailed portfolio audits, thus making the estimatesunreliable. Third, the Program did not include any specific measures to address the weaknessesin the corporate governance of the SOCBs clients, i.e., SOEs and private enterprises. So longas these weaknesses persist, the quality and reliability of financial information provided to creditinstitutions will remain suspect leading to poor or ill-informed credit decisions

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C. Follow-Up Actions

58. In the Governments official document discussed during the Seventh Roundtable

Meeting held in November 2000, a series of financial reforms was outlined over a period of fiveyears. The document recognized the unsustainable nature of the SOCBs in the wake ofcontinuing NPLs. A financial sector note (FSN),26 prepared jointly by ADB, the World Bank, andBOL, lays the road map of future financial sector reforms. A high-level policy workshop, held inVientiane in March 2001 and attended by the Government, ADB, and other stakeholders,extensively debated further reforms required in the financial sector. These initiatives areappropriate to build ownership by stakeholders of future reforms, so as to avoid the pitfallsexperienced during the implementation of the Program. Because of its rich knowledge of, and

long-standing involvement in, the Lao financial sector, it is appropriate that ADB continue to leadin charting its future course, while maintaining active coordination with other aid agencies.

59. Against this backdrop, the OEM recommends the actions outlined below.

1. Scope, Modality, and Implementation Arrangements of Future ReformPrograms

60. ADBs continued engagement in the Lao financial sector is necessary to consolidate the

gains of the Program, FSPL II, and the various TAs. However, lessons from the Programsuggest that future interventions should have a manageable and sharply focused reformagenda. Moreover, instead of the traditional two-tranche modality, future program loans in LaoPDR should be made on a cash on delivery basis, using the single tranche or program clustermodalities. Finally, considering the capacity constraints in BOL and MOF in carrying out reformsin the financial sector, as well as the likely conflict of interest involved in carrying out reformsthat may affect their respective jurisdictions, the Government may set up an autonomousimplementation unit for financial sector reforms. Alternatively, it may convert the existing

Working Committee for Financial Sector Development into such a unit. This unit should beassigned responsibility to implement further policy reforms in the sector following the adoption ofthe FSN by the Government. It should draw on capable high level staff from BOL and MOF, aswell as other government agencies concerned, and be assisted by technical advisers asnecessary.

2. An Alternate Strategy for State-Owned Commercial Bank Restructuring

61. As explained in para. 41, instead of making efforts to bring about wholesale changes in

the entire banking sector, the Government and ADB might focus on comprehensively reforminga single SOCB, in anticipation of a demonstration impact on other banks. ADB equityinvestment in such an SOCB at an appropriate time, in association with a reputable foreignbank, could prepare this SOCB for privatization in due course.

3. Strengthening Accounting and Auditing Institutions and Professions

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particular, in order to improve the transparency and reliability of financial information onenterprises, assistance should be directed to strengthening the existing accounting and auditinginstitutions, and to upgrading professional expertise in this important area. A large number of

educated and well-trained accountants and auditors (including internal auditors) are needed tobring the accounting/auditing knowledge and practice in the SOCBs and enterprises up tointernational standards. The teaching institutions and professional bodies responsible for theaccreditation of accountants and auditors should be helped to upgrade their capacities on anurgent basis.

4. Removing Constraints on Availability of Long-Term Funds

63. The present macroeconomic environment and the lack of expertise in the bankingsystem do not encourage intermediation of long-term funds in the economy. Under the Program,an effort was made to provide an enabling legal infrastructure for NBFIs that would mobilizelong-term savings and make available medium- and long-term funds for capital investments.However, since the NBFI sector has not developed, there is a need for ADBs continuedengagement in this area. To begin with, ADB might conduct a diagnostic study to identifyconstraints on the development of NBFIs and the measures needed to overcome theseconstraints.


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APPENDIXES

Number Title Page Cited On

(page, para.)

1 Logical Framework at Evaluation 28 5, 10

2 Technical Assistance to the Lao Financial Sector 42 5, 12

3 Economic and Financial Indicators 43 16, 35