Document of The World Bank FOR OFFICIAL USE ONLY Report No: P7526-LA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL MANAGEMENT ADJUSTMENT CREDIT IN THE AMOUNT OF SDR 13.5 MILLION (US$ 17.0 MILLION EQUIVALENT) TO THE LAO PEOPLE'S DEMOCRATIC REPUBLIC May 28,2002 Poverty Reduction and Economic Management Unit East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization GOVERNM[ENT FISCAL YEAR: October 1 - September 30 CURRENCY EQUIVALENTS: Currency Unit = Kip (as of May 2002) US$1 = K 9,540 ACR )NYMS AND ABBREVIATIONS ADB Asian Development Bank APB Agricultural Promotion Bank ASEAN Association of Southeast Asian Nations BCEL Banque pour le Commerce Exterieur Lao BIO Business Improvement Office BOL Blank of Lao People's Democratic Republic HPKP Bolisat Phattana Khet Phoudoi (SOE) BRC Ilank Restructuring Committee CAS Country Assistance Strategy CFAA Country Financial Accountability Assessment CPAR Country Procurement Assessment Report CPC Committee for Planning and Cooperation DAFI Development, Agriculture Forestry Industry Group (SOE) EdL Electricite du Laos EPL Enterprise of Post Lao EPTL Enterprise of Post and Telecommunications Lao ETL Enterprise of Telecommunications Lao ESAF Enhanced Structural Adjustment Facility EU luropean Union FMAC Financial Management Adjustment Credit FMCBC Financial Management Capaciy Building Credit IFC Intemational Finance Corporation IFI Intemational Financial Institution IMF Intemational Monetary Fund JBIC Japan Bank for Intemational Cooperation JICA Japan Intemational Cooperation Agency LST Lao Shinawatra Telecom Company Ltd MAF Ministry of Agrictilture and Forestry MCTPC Ministry of Construction, Transport, Post, and Communication MIH Ministry of Industry and Handicraft MOF Ministry of Finance MOJ Ministry of Justice MOUR Memorandum of Understanding for Restructuring NAO National Audit Office NBCA National Biodiversity Conservation Area NEM New Economic Mechanism NGO Non-Govemment Organization NPEP National Poverty Eradication Program NPL Non-Performing LOan NT2 Nam Theun 2 ODA Official Development Assistance PHRD Policy & Human Resources Development Fund PIP Public Investment Plan PMO Prime Minister's Office PPIAF Public Private Infrastructure Advisory Facility PPTA Project Preparation Technical Assistance PRGF Poverty Reduction and Growth Facility PrMO Procurement Monitoring Office PRSP Poverty Reduction Strategy Paper SCB State-owned Commercial Bank SIDA Swedish Intemational Development Agency SOE State-owned Enterprise UNDP United Nations Development Programme UNICEF United Nations Intemational Children's Fund WASA Water Supply Authority WHO World Health Organization Vice President: Jemal-ud-din Kassum, EAPVP Country Director: Ian C. Porter, EACTF Chief Economist and Sector Director: Homi Kharas, EASPR Task Team Leader: Ijaz Nabi, EASPR FOR OFFICIAL USE ONLY THE LAO PEOPLE'S DEMOCRATIC REPUBLIC PROPOSED FINANCIAL MANAGEMENT ADJUSTMENT CREDIT' TABLE OF CONTENTS Credit and Program Summary .................................. vi I. INTRODUCT]ION ...................................1 II. THE MACROECONOMIC FRAMEWORK ................................ . 4 A. Macroeconomic and Growth Performance ...................................4 B. Medium-Term Framework ...................................6 C. Structural Reform ...................................7 III. STRUCTURAL WEAKNESSES . . 7 A. Problems in the Public Sector .7 B. The State-Owned Enterprise Sector .11 C. The Financial Sector .14 D. Consequences of Structural Weaknesses for Growth and Poverty Reduction .16 IV. GOVERNMENT'S REFORM PROGRAM AND POVERTY REDUCTION .18 A. Public Sector Management .18 B. The State-Owned Enterprise Sector .23 C. The Financial Sector .31 V. WORLD BANK GROUP STRATEGY . .............................. 36 A. Bank Assistance Strategy .................................. 36 B. Partnerships with Other Donors and Agencies .................................. 39 VI. THE PROPOSED FINANCIAL MANAGEMENT ADJUSTMENT CREDIT .................................. 40 A. Rationale for the Proposed Program .............. .................... 40 B. The FMAC Program .. ................................ 41 C. Implementalion and Monitoring . ................................. 48 D. Credit Administration .. ................................ 48 E. Environmental Assessment .................................. 50 F. Benefits and Risks .................................. 51 VII. RECOMMENIDATION .53 The World Bank core team for this operation was led by Ijaz Nabi (EASPR) and consisted of: Magdi Amin (EASPS), Enrique Crousillat (eEASEC), Nina Eejima (LEGEA), Ron Hood (EASPR), Abha Joshi-Ghani (PFG), Olivier Lambert (E4SFS), William Magrath (EASRD), Keiko Miwa (YPP), Behdad N. H. Nowroozi (EAPCO), Sethaput Suthivart-Narueput (EASPR), Linda Schneider (EACSQ), Malarak Souk;avat (EACLF), Thang-Long Ton (RASPR), Mara T. Baranson (EACSQ), Soudalath Silaphet (EACLF), and Hedwig Abbey (EASPR). The Peer Reviewers were. Habib Fetini (MNSED), Patrick Honohan (FSP), William Mako (EASPS), Anand Rajaram (PPMPS). and Peter Winglee (IMF). This document has a restricl:ed distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. THE LAO PEOPLE'S DEMOCRATIC REPUBLIC PROPOSED FINANCIAL MANAGEMENT ADJUSTMENT CREDIT TABLE OF CONTENTS (Continued) ANNEXES Annex 1: The Lao Banking and Financial Sector Annex 2: Financial Management Capacity Building Credit Annex 3: IMF's Poverty Reduction and Growth Facility - Program Summary Annex 4: Longer-Term Reform Actions beyond the Timeframe of FMAC Annex 5: Decision Framework for Processing the Proposed NT2 Project Annex 6: Poverty Reduction Fund Project LETTER OF DEVELOPMENT POLICY REFORM POLICY MATRIX STATISTICAL APPENDIX iv BOXES IN TEXT Box 1: I-PRSP Policy Agen,ia 2001- 2003 ........................................ ................3 Box 2: Chronology of Econf;mic Developments .......................................................4 Box 3: Macroeconomic Periormance Indicators ...................................................... 46 Box 4: FMAC Program Perlormance Indicators ...................................................... 47 TABLE IN TEXT Table 1. Financing Requirements, 2001-2004 ....................................................... 40 FIGURES IN TEXT Figure 1: Lao PDR: Poverty and Gini Coefficient ...................................................2 Figure 2: Lao PDR: GDP Growth and CPI ........................................................ 5 Figure 3: Lao PDR: Composition of Investment ......................................................6 Figure 4: Lao PDR: Main Exports .................... ...................................6 Figure 5: Lao PDR: SOE E,mployment Share, Industrial Value, and NPLs . ......... 11 Figure 6: Lao PDR: The Sbuctural Problem: ....................................................... 17 Figure 7: Lao PDR: Reform Program ........................... 35 v THE LAO PEOPLE'S DEMOCRATIC REPUBLIC PROPOSED FINALNCIAL MANAGEMENT ADJUSTMENT CREDIT Credit and Program Summary Borrower: The Lao People's Democratic Republic Amount: SDR 13.5 million (US$ 17 million equivalent) Terms: Standardl IDA terms: 40-year maturity with a 1 0-year grace period Description: The proposed Credit of SDR 13.5 million (US$ 17 million equivalent), to be disbursed in two tranches, is a Financial Management Adjustment Credit (FMAC) that would build on and support the implementation of Lao PDR's current reform program. The components of the reform program lo be supported by FMAC are as follows: * The public sector reform component supports improved budget planning, streamlined budget execution and control as well as a transparent budget process, and natural resources management; * The state-owned enterprise (SOE) component focuses on strengthening overgight of financial and operational performance of SC)Es, enterprise restructuring, and rationalizing the regulatory framework. Relevant issues in the power sector are also addressed in this component; * The financial sector component seeks to stabilize the financial conditions of the banks, to strengthen them, and to launch micro/rural finance for poverty reduc:tion. Benefits: The expected result of the FMAC is strengthening of the structures of the economy such that: * Greater fiscal transparency and accountability is achieved, with better balance in budget spending; * Increased budgetary resources are available for poverty reduction; * SOEs (including Electricite du Laos [EdL] in the power sector) are more accountable within a stronger regulatory framework and manage financial risks prudently, which would prepare them for privatization down the road; * State-owned commercial banks (SCBs) meet prudential regulations and therefore do not threaten macro-stability and future economic growth; * Micro/rural finance supports poverty reduction in the rural areas where most of the population lives; and, * Incentives are in place for participatory management of forestry resources; improved monitoring and rationalization of the "cut rate" contribute to government revenues and enhance income at the village level. vi The structural improvements collectively will contribute to additional benefits, as reforms are pursued in the medium term: * Lao PDR will avoid the accumulation of contingent liabilities that result in periodic crises leading to a severe loss of investor confidence and curtailment of social services and safety nets. * Lao PDR's system of financial flows will have been streamlined and will be more transparent, giving confidence that large potential investments in the energy sector will yield economy-wide benefits in terms of income growth and poverty reduction. Risks: The key risks are: * Insufficient political will to complete reforms; * Lack of capacity and weak legal/administrative incentives to improve performance; * Possible political backlash from electricity tariff and other SOE price liberalizations; and, * Abandonment of reforms as difficulties accumulate. Efforts to mitigate the risks. - Recent government actions reflect a new commitment to reform. These include the removal of the top management of an SCB for poor performance, the agreement to hire external advisors in SCBs to prepare for restructuring, and significantly, the resale of Lao Beer back to the private sector. - Disparate SOEs are being collected under the umbrella of the Prime Minister's Office. A dynamic, reform-minded minister has been appointed to champion reform. The largest SOE, Bolisat Phattana Khet Phoudoi (BPKP), is under restructuring and will have a significant demonstration effect for restructuring other large problem SOEs. - The technical assistance operation, Financial Management Capacity Building Credit (FMCBC) that will be presented to the Board at the same time with FMAC, is expected to build capacity by aiming to change the mindset at the working level, which will generate support for reform within the system. The government's willingness to borrow for technical assistance, given extreme reluctance in the past, is a good indication of a more proactive stance on capacity building. - FMAC requires the government to implement tough legislative, regulatory and institutional measures in a number of key commanding heights of the economy. This momentum will be difficult to reverse given the PRSP process to which the authorities are committed that will ensure continued monitoring and engagement to stay the reform course. vii - Key players within the government (i.e., the Prime Minister, the Minister of Finance and others heading the key line ministries) have been engaged in a long process of dialogue and have fully endorsed the reformn program. On another level, a series of workshops and seminars have been held for mid- level civil servants to explain reform objectives and their benefits, to garner wider support. - Thc operation has been prepared in close cooperation with the IMF, the ADB, and major bilateral donors which has helped avoid conflicts that create the room for reform slippage. * Des;pite these mitigating factors, risks of poor performance are substantial andl need to be monitored. Poverty Category: Not applicable Estimated Disbursements: The credit would be disbursed in two tranches. The first tranche would amount to SDR 5.6 million (US$ 7.0 million equivalent) and the second one SDR 7.9 million (US$ 10.0 million equivalent). Project ID Number: PE-P068069 viii ]REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED F][NANCIAL MANAGEMENT ADJUSTMENT CREDIT FOR THIE LAO PEOPLE'S DEMOCRATIC REPUBLIC I. INTRODUCTION 1. I submit for your approval the following report and recommendation on a proposed Financial Management Adjustment Credit of SDR 13.5 million ($17 million equivalent) to the Lao People's Democratic Republic (Lao PDR) to provide support for the implementation of the country's current reform program. 2. The Lao PDR is one of the poorest countries in the world, with a per capita gross national income of $310 in 2001 ($290 in 2000). The percentage of the Lao population in poverty was 39.1 percent (or 1.9 million people) for 1997/98, down from 46.0 percent in 1992/93 (Figure 1).' This is an annual rate of reduction of 3.3 percent. 3. Poverty rates are uneven across regions, and across urban and rural areas. The rural poor account for more than 90 percent of all poor. In the Northern Region of the country, with the highest percentage of poor, the poverty rate was 47.3 percent in 1997/98, down from 51.6 percent in 1992/93. The Vientiane Municipality had the lowest poverty rate (13.5 percent in 1997/98; it was 33.6 percent in 1992/93). The regions and provinces in the country with the highest poverty incidence rate were also the ones with the slowest rate of poverty reduction. 4. Income inequality in Lao PDR has increased in recent years. The Gini index was 0.35 in 1997/98, up from 0.31 in 1992/93 (Figure 1). Consumption shares of the bottom four quintiles have declined. This has significantly eroded the gains from growth for those at the bottom end of the distribution. Region-wide moderation in economic growth and contraction in employment is one reason for these inequities. Another is macroeconomic difficulties of the recent past originating in structural rigidities in public sector management, the SOEs and the banking sector. 5. With its vast natural resources of forestry and hydroelectric power, the Lao PDR is well positioned to redress poverty effectively, provided there is sound macro-economic management and improved resource allocation. Macroeconomic stability is being restored with the support of a PRGF negotiated with the IMF in April 2001, but it is still fragile. To consolidate macroeconomic stability and improve the overall flow of resources in the economy, a program of structural reforms is being implemented in public sector management, state-owned enterprises, and the banking sector with technical assistance from multilateral and bilateral donors. The proposed Financial Management Adjustment Credit (FMAC) that supports the deepening of the program of structural N. Kakwani, Gaurav Datt, Bounthavy Sisouphanhthong, Phonely Souksavath, and Limin Wang, "Poverty in Lao PDR: 1992/93-1997/98," World Bank, March 30, 2002. reform has been prepared in this context of increased engagement of the Lao PDR with international financial institutions. It is designed to reduce the risk of poverty reversals as in 1997- 98 when the macro and structural reform program went off-track. Figure 1 Lao PDR: Poverty and Gini Coefficient 50 40 30 20 10 0 1992/93 1997/98 =Poor - Gini coefficient Source: Kakwani, Datt, Sisouphanhthong, Souksavath, and Wang (2002). 6. The proposed FMAC program is consistent with the government's National Socio- Economic Development Plan (NSEDP) for 2001-05 focusing on poverty reduction by promoting sustainable growth with equity. The Interim Poverty Reduction Strategy Paper 2 (I-PRSP), prepared by the authorities in March 2001 and discussed at the Boards of the IMF and the World Bank, established the official approach to poverty reduction and is the first step in developing a full Poverty Reduction Strategy Paper. The I-PRSP sets out the government's poverty reduction strategy in the context of macro-economic stability and sustainable growth. It lists sixteen areas (Box 1) where policy and institutional reform are needed to achieve broad-based, participatory economic growth. Of these 16 items, the proposed FMAC supports four items fully and another two items partially. Other areas are being covered either by other donors, or through investment operations. The areas covered by the proposed FMAC have been kept to key public financial management issues to focus the operation on where well-defined policy reforms have been identified and where government's implementation capacity is adequate. The full PRSP, currently under preparation and to be completed by March 2003, will expand on each of the policy areas and develop a comprehensive medium-term program to deepen reform. The reform of structural weaknesses discussed in Chapter III are consistent with the approach being taken in the full PRSP. A direct approach to poverty reduction by the government is discussed in the Poverty Reduction Fund Project (PRFP, Annex 6) to be presented to the Board with FMAC. 2Lao PDR, Interim Poverty Reduction Strategy Paper, IDA/SecM2001-0246), was discussed at the Board on April 24, 2001.. 2 Box 1: I-PRSP Policy Agenda 2001-2003 Policy Area Objectives MACROECONOMIC AND RE LATED Maintain macroeconomic stability, improve resource allocation, and STRUCTURAL POLICIES raise sustainable economic growth 1. Fiscal Policies Overall Budget Maintain and strengthen prudent fiscal management Decentralize budget management, while strengthening budget execution Improve fiscal transparency and budget preparation procedures Revenue Strengthen revenue collection Modernize tax system and broaden revenue base Expenditure Improve balance of current and capital expenditure and increase share of social expenditure Improve management of external debt and foreign aid 2. Enterprise Development Strengthen commercial behavior of SOEs and promote private sector development 3. Financial Sector Monetary and Exchange Rate Maintain strict monetary policy Policy Banking Reform Create sound and viable banking system and improve financial intermediation 4. Trade Policy Promote growth through increased trade and foreign direct investment SECTORAL POLICIES 5. Forestry Policy Establish a sound policy framework providing for viable and sustainable forest development and management 6. Agricultural and Rural Ensure food security and promote market-based farming. Reduce Development disparities between lowland and sloping-land farming 7. Infrastructure Maintain and develop an enabling infrastructure framework Road Infrastructure Energy HUMAN RESOURCE Strengthen Lao PDR's human capital and increase efficiency DEVELOPMENT 8. Education Improve budget for education; increase access of most vulnerable to education and reduce regional disparities; strengthen non-formal education; and, improve teacher education 9. Health Strengthen delivery of health care services at grass root level -- particularly in underserved areas -- and improve quality of services 10. Water, Sanitation, and Nutrition Increase access to safe drinking water and sanitation system and improve nutrition STRATEGIC SUPPORT POLICIES Strengthen poverty reduction actions 11. Governance and Public Establish sound governance behavior in public administration and Administration Reform consolidate the decentralization process Land Administration and Establish sound policy and legal framework for land administration, Management Policy allocation and management 12. Drug Control and HIV/AID,S Curtail opium production and minimize social and economic consequences of HIV/AIDS 13. UXO Decontamination Clear unexploded ordnance (UXO) to improve safety and reclaim land contaminated with UXOs. 14. Gender Equity Promote the role of women in socio-economic development, planning, and the public decision-making process 15. Environment Ensure environmental sustainability of development actions 16. Statistics Improve coverage, timeliness and quality of statistical databases, and expand use of international standards in compilation of data 3 II. THE MACROECONOMIC FRAMEWORK A. Macroeconomic and Growth Performance 7. In the second half of the 1980s and the first half of the 1990s, the Lao PDR implemented its "New Economic Mechanism" (NEM) to make the transition to a market economy. This reform effort was supported by the Bank through three adjustment operations that helped to stimulate economic growth as the economy moved from a centrally-planned system towards a market- oriented one (Box 2). 8. In 1997, at the height of the regional crisis, the authorities pursued an expansionary fiscal policy with ambitious investrnents in irrigation to attain rice self-sufficiency. But this was done without appropriate financing arrangements. Heavy borrowing from the Bank of Lao PDR (BOL), the central bank, caused triple-digit inflation in 1998. As a consequence, the kip depreciated to 7,600 kips per US dollar in 1999 from 2,135 in 1997. Box 2: Chronology of Economic Developments 1986 New Economic Mechanism launched 1988 New foreign investment law, with liberal regime 1989 IMF's Structural Adjustment Facility (1991-93) Bank's first Structural Adjustment Credit 1991 Announcement of privatization plan of some large state-owned enterprises Bank's second Structural Adjustment Credit 1993 IMF's Enhanced Structural Adjustment Facility (1993-96) 1994 New foreign investment law (with legal 100 percent foreign ventures) 1996 Bank's third Structural Adjustment Credit 1997 Ambitious investment plans implemented without appropriate financing 1998 Inflation soared to triple digits 1999 Collapse of the national currency New Minister of Finance and new Governor of the Central Bank, BOL. The govemment embarked on a strong stabilization program with tight fiscal and monetary policies 2001 Govemment prepared the I-PRSP IMF resumed its program to Lao PDR with a $40 million equivalent PRGF; Release of the first tranche under the program 2002 Satisfactory review of the PRGF program by the IMF Board; Release of the second tranche under the program. 9. In mid-1999, the authorities embarked on a strong stabilization program addressing fiscal, monetary and the current account imbalance, and economic conditions improved in 2001. The exchange rate stabilized and inflation fell to 7.5 percent. Despite weaker external demand, real GDP growth was recorded at 5.7 percent in 2000 and 5.2 percent in 2001 (Figure 2). 3 3 There is, however, some concem regarding reliability of GDP estimates because of poor data quality. 4 Figure 2 GDP Growth (right scale) and CPI (left scale) (percent) 50 i 2 O O 1997 1998 1999 2000 2001 2002 CPI --+ GDP Growth Rate] Source: IMF and Lao PDR authorities. 10. Improved fiscal manatgement was re-instituted with the FY2000 budget. Strong efforts were made to improve tax administration. Capital spending was reduced with the scaling down of construction projects. This allowed for more current spending. Additional external assistance supported the budget deficit and borrowing from BOL declined further. The budget deficit is projected to stay at 5 percent of GDP, of which only 0.3 percent of GDP is bank financing. Additional revenues are expected from improved tax collection. 11. Monetary policy played a key role in the stabilization program by reducing the excess kip liquidity and sharply limiting central bank financing -- especially for irrigation projects -- and the issuance of central bank securities. Inflation was brought under control following a cautionary monetary policy. 12. The current account balance was estimated at -4.9 percent of GDP in 2001 (compared with -1.4 percent of GDP in 2000, and -4 percent in 1999). In 2002, the current account deficit is projected to improve to -3.4 percent. 4 The authorities have maintained a flexible exchange rate which has been stable vis-as-vis the US$ and the Thai baht since end-1999. 13. At end-2001, gross international reserves were estimated at 2.5 months of imports, or $134 million. Exports, at $350 million, were virtually unchanged from the level attained in 2000. Electricity exports, valued at ',114 million, have overtaken timber6 as the largest foreign exchange eamer. Garments were the second largest export category at $100 million in 2001. However, due to the weaker external demand, total merchandise exports stayed at the same level as in 2000. Exports are expected to perform better in 2002, with growth projected at 6.2 percent (Figure 4). 4 Excluding the proposed Nam Theun 2 (NT2) project. The current account balance is projected to stabilize at below -3 percent of GDP subsequently and can be readily financed, even without the proposed Narn Theun 2 hydropower 5roject. Excluding the proposed Namn Themn 2 (NT2) project. The current account balance is projected to stabilize at below -3 percent of GDP subsequently and can be readily financed, even without the proposed Nam Thewi 2 hydropower project. Timber exports account for $81 million. 5 14. Imports, at US$558 million, declined slightly in 2001 (-2 percent). Consumer goods account for the largest category of imports at $280 million. Investment goods follow at $166 million (including machinery and equipment, vehicles, fuel, and construction and electrical equipment). Imports are expected to recover in 2002. Figure 3 Figure 4 Lao PDR: Composition of Investment (%) Lao PDR: Main Exports (US$ million) 35 - 140 -9 17 8 9 0 30 120- 25 100 v 20 FB80- 1 5 _ _ _ _ _ 10 -4020 5 2~~~~~~~~~~~~~~0 1998 1999 2000 Proj Proj Proj 1995 1996 1997 1998 1999 2000 2001 2002 2003 U Hydropower Invest/GDP ElPrivate (non-hydro) Invest/GDP El Timber El Electricity 0 Garments 0 Coffre El Public Invest/GDP _ Source: IMF and Lao PDR authorities. Source: IMF and Lao PDR authorities. 15. With the restoration of economic stability since 2000, and the PRGF program in place for over a year, the Lao authorities have established a track record of satisfactory macroeconomic management. The government is also committed to broad-based economic growth and poverty reduction, as outlined in the I-PRSP of 2001. This is being solidified with the on-going preparation of the full PRSP. B. Medium-Term Framework 16. In the medium term, the government will continue to maintain a macro-economic framework to attain a growth rate of about 5.5-6.5 percent, inflation of about 5-7 percent, and a stable exchange rate. This will contribute to achieving the poverty reduction objectives outlined in the I-PRSP and the NSEDP. 17. On the external side, the current account deficit is projected to improve to below 3 percent of GDP for FY04 period (excluding investment imports requirements for the proposed Nam Theun 2 Project (NT2). Exports are expected to grow at an average annual rate of about 6.7 percent for 2002-2004. Imports are projected to grow at similar export rate of about 6.7 percent per year in 2002-2004 (excluding imports related to the NT 2 Project). 18. Fiscal policies are expected to support macroeconomic stability objectives while accommodating pressures for additional social spending. The authorities envisage a fiscal deficit of about 5 percent of GDP, with a modest increase in revenue that will allow additional current spending, including expenditures in the social sectors. Domestic bank financing of the budget will be limited to l/2 percent of GDP. Improvements in administration and compliance will help to improve revenue performance with a projected modest growth of about 0.4 percent of GDP. The composition of expenditures is expected to shift toward current spending, in line with the PRGF 6 program. The increase in cturrent expenditure would accommodate the increase in government wages and additional spendin- for maintenance and arrears payments. Overall public expenditure management will be strengthened to meet fiscal targets and to support the decentralization efforts. 19. The objective of the government's monetary and exchange rate policy continues to be restraining inflation and maintaining a stable exchange rate. The BOL is expected to continue its discipline in budget financing and active sales of government securities with more attractive yields. The authorities will continue to maintain a flexible exchange rate system. C. Structural Reform 20. While a sound macroeconomic framework is central to stable economic growth and poverty reduction, it can be sustained only if the underlying structural weaknesses that impede the flow of resources in the economy to their best uses can be addressed. These weaknesses and their impact on macroeconomic stability, economic growth and poverty reduction objectives are discussed in Chapter III. 21. Structural rigidities need to be addressed also in view of the planned large investment in the energy sector associated with Nam Theun 2. The investment will generate substantial revenues that should be intermediated in the economy efficiently to ensure that the I-PRSP and NESDP objectives are achieved. 22. The government has started to implement a credible reform program to address the structural weaknesses. This program, the actions already taken, and the medium-term agenda are presented in Chapter IV. Thle program of actions supported by the proposed FMAC and the associated performance indicators are presented in Chapter VI. HI. STRUCTURAL WEAKNESSES A. Problems in the Public Sector The Budget 23. Basic Challenges. Lao PDR faces many challenges in planning and managing public resources to establish sustainable economic growth and reduce poverty. It has a relatively sparse population of just 22 persons per square kilometer as compared with 121 in Thailand and 238 in Viet Nam. The economy is overwhelmingly agricultural (53 percent of GDP) and rural (77 percent of the population). Nluch of the rural population is widely scattered. Ethnic minorities inhabit remote areas that are regularly cut off from the rest of the country by seasonal rains. Some groups move periodically as they practice slash-and-bum agriculture. 24. The cost of delivering services such as health and education is high in this demographic and geographic context. The climate and terrain make transportation services costly to build and maintain over long distances that connect relatively small numbers of people. Being land-locked, 7 the country has no coastal waterway and the Mekong river is navigable only during certain seasons. 25. Budget Execution and ControL While geography is unalterable, the I-PRSP has argued that some of Lao PDR's problems stem from weaknesses in the basic systems for budget execution and control, and these can be addressed. 26. There has been a persistent tendency towards loss of fiscal stability created by poor budget management practices. A serious bout of inflation and exchange rate depreciation in the late 1990s resulted from a series of large and unplanned investment expenditures in irrigation projects. Macroeconomic stability was eventually restored but at substantial cost due to cut-backs for health and education. While the central government ministries have since by and large managed to avoid major unplanned expenditures, the provincial governments are prone to making commitments that are not provided for in the budget. Moreover the provinces, which collect the bulk of revenues, do not consistently remit collections to the center as required, undercutting the central government's ability to redress the regional imbalances. To accommodate these items, ad hoc expenditure cuts have to be made or recourse made to central bank financing. 27. These problems arise from a lack of fiscal discipline in which the budget plan is not adhered to, and they are made more complicated by a weak system of accounting and control as well as a fragmented network of treasury accounts. While there remains a unitary budget system, the rapid pace of implementation of decentralization is placing additional strains on the government's ability to monitor and control its public resources. 28. Plannin Consistently, evidence from the various sectors shows a pattern of inadequate spending for wages, maintenance and other recurrent items, and heavy emphasis on economic sectors over social sectors that retards the achievement of poverty reduction objectives. For the last several years, capital spending in Lao PDR has accounted for 60 percent or more of the budget. This compares with 36 percent in Thailand and 29 percent in Viet Nam. These outcomes are not simply a result of local preferences. They reflect the fact that in the Lao PDR the future recurrent costs of capital projects are not estimated and are therefore not adequately taken into account when decisions are made. They also reflect the fact that revenues are persistently overestimated, and since donors cover as much as 80 percent of the capital budget, the only place where ad hoc cuts can fall is on recurrent spending, and this tends to be concentrated in the social sectors. Public sector wages have fallen by half and have remained that way for almost four years. Teachers and hospital workers are paid far less than regional averages and are leaving their jobs. These were not planned outcomes. They are the result of flawed systems. 29. The budget planning process is both bottom-up and top-down. Detailed submissions are made by lower levels of government and consolidated for presentation to the National Assembly. This is a positive feature that allows considerable scope for the incorporation of local input into the budget plan; however, the budget passed by the National Assembly is of highly aggregated form, and the details of cuts or changes made at this level are not spelled out when it is passed. Haggling over line-item interpretation of the budget drags on several months into the fiscal year. This ' One recent exception to central government adherence to the budget plan was the unplanned purchase of Thai interests in Lao Beer. 8 unusual feature of the planning part of the budget cycle results in delay of publication of the detailed budget plan and makces for an uncertain environment for budget execution. 30. Transparency and Gjovernance. The government ceased publishing the budget and expenditure outcomes after the Asian crisis, and when it did resume with FY01 data, the figures emerged with a long lag and in a highly aggregated form that did not show spending by sector. Without adequate information, judging the impact of public expenditures is hard, and the effectiveness of expenditure planning is undermined. For recent years it has not been possible to determine from the budget figures how spending lines up with the sector spending targets laid out in the government's own I-PRSP. This problem is made more complicated by the fact that the Budget Nomenclature and the Chart of Accounts are not consistent, and this separates the planning function from the accounting and control functions. At the end of the day it may be possible to determine if the government spent as much as it planned but not whether it spent this the way it planned. Moreover, there are a number of special funds, many of which are associated with donor programs, and the resources. flowing through these funds are not included in the budget. These problems have prevented reg;ular assessment of poverty-related expenditures. 31. The procurement process is in need of improvement to ensure that it is efficient, transparent and fair. There is a general need for greater openness, but problems are particularly important with respect to contracting by state-owned enterprises. Natural Resources Managenment 32. Rural and natural resources management remains a concem for the government and its revenue contribution remains crucial to the budget. A source of structural weaknesses originates in the country's management cf its forestry sector, with impact on the budget, the SOEs related to this sector, and ultimately to the banking sector. 33. Forestry. Growth and poverty reduction prospects for the Lao PDR are heavily dependent on its natural resources. 'Yet, forestry, a substantial natural resource of the country, does not contribute adequately to national development nor to poverty reduction. Incentives facing resource users do not reflect the real scarcity of forest resources, leading to excessive demands and overexploitation. The way in which resources -- including land, investment, and revenues from timber harvests -- are mobilized in the sector are distorted and result in misallocations and, especially important, inadequate impacts on poverty and ineffective protection of biodiversity. Forestry royalties, as a share: of government revenue, have increased from 20 percent in the mid- 1990s to 6 percent of tax revenues and 5 percent of all revenues in 2001. Collection rates are low, around 50 percent, and royalty revenues have been declining since the mid-1990s. Over the last five years, the Treasury has realized only about one third of the estimated market value of the timber harvested. 34. Deforestation and forest degradation, loss of biodiversity, soil erosion, and degradation of agricultural lands are also serious environmental challenges that are directly related to the livelihood security of the predominantly poor rural population. There is an urgent priority to undertake measures to protect the fragile watershed environment associated with developed and potential hydroelectric projects. With natural resources, especially forests, as one of the few 9 sources of growth, rent-seeking and corruption are critical aspects of the management of natural resources in Lao PDR. 35. A fundamental strategic weakness in the forestry sector has been the government's attempt, in the face of overwhelming capacity constraints and limitations, to directly manage the resource through public agencies. Recent experience has shown that development approaches that actively involve local communities in decision making and resource management lead to dramatically better development outcomes. Local communities are more acutely aware of the potential and condition of the resource, are in a strong position to provide protection and control against outside threats and abuse, and will -- with technical assistance and reasonable benefit-sharing arrangements -- mobilize to plan and develop sustainable resource management. Redirecting the role and performance of the public forestry agencies from efforts at direct management to a supporting and facilitating approach will require considerable effort and discipline in controlling and managing entrenched interests and privileged elites, which benefit from the rents generated under existing policies and institutional arrangements. 36. An additional key concern in the forestry sector is the management and protection of the country's biodiversity resources. A large proportion of the forest resource has been allocated to a system of National Biodiversity Conservation Areas (NBCAs) that presently totals nearly three million hectares. The regulatory framework for NBCA management is currently weak and is inconsistent with international standards and nomenclature. This leaves the protection of NBCAs uncertain and puts at risk associated investments in infrastructure, such as the proposed Nam Theun 2 Hydropower Project. Government has tightened its approach to forest law enforcement and control, but is severely handicapped by capacity constraints, confused institutional responsibilities, and lack of local participation in all aspects of forest law enforcement. 37. Energy. Lao PDR has only a few industries in which it enjoys a comparative advantage in the region; the most important of these is the generation of electricity. The country has large and almost untapped energy reserves, principally hydropower, and a central location in a region characterized by expanding electricity demand. The Lao power sector is, however, still in a very early stage of development. Institutions are weak and the power grid serves only 18 percent of the population. Furthermore, only 450 MW of an estimated 18,000 MW of exploitable hydro potential has been hamessed. The sector has the potential to play a pivotal role in achieving the social and economic development objectives of the government of the Lao PDR by expanding the availability of low cost, reliable electricity within the country and by earning foreign exchange from export sales to the region. 38. For over a decade, a program of on-going legislative reform has been in progress, the aim of which is to create a legal enviromnent that encourages optimal, responsible and sustainable investment in the power sector. 8 These legislative changes reflect the government's wish to attract private capital to power projects. They create an environment that is sympathetic to the reasonable requirements of international investors and lenders. The Electricity Law introduced a 8 Overhaul of the legal environment includes: Contract Law (1990); Commercial Bank and Financial Institutions Law (1992); Customs Law (1994); Labor Law (1994); Business Law (1994); Law on the Promotion and Management of Foreign Investment (1994); Secured Transaction Law (1994); Water & Water Resources Law (1996); Electricity Law (1997); and, Environmental Protection Law (1999). 10 licensing system that sets out the steps and conditions to be observed by private investors seeking a mandate to develop independent power producer projects; however, regulations for key legislation have yet to be drafted to establish the conditions for issue of licenses and to define the procedures to be followed and the rights and obligations that attach to such a license. 39. Measures have been introduced to commercialize the state-owned national power utility, Electricite du Laos (EdL) and improve its financial situation; however, in recent years the government's inability to adjust tariffs at the pace of inflation has resulted in an acute financial crisis of the power sector. Specifically, EdL has been unable to meet the financial covenants agreed with IDA and ADB during the last two years. However, new tariffs, approved in April 2002, will pernit these targets to be met (Para. 107). B. The State-Owned Enterprise Sector Context and Rationale 40. The State-Owned Eniterprise (SOE) reform program must be viewed in the context of substantial progress made uander the New Economic Mechanism. Through privatization and commercialization of state enterprises, liberalization of foreign direct investment and tariff regimes, increased financial controls, and improved management practices, both the scope and role of state enterprises in the economy were dramatically reduced from 1987 to 1997. Of 640 commercial and industrial S'OBs which existed in 1989, only 93 remained as 100 percent state- owned firms in 1997, including 24 enterprises deemed strategic.9 SOEs now constitute less than 1 percent of total employment (Figure 5). Yet progress has been uneven. The 1997 regional financial crisis, policy reversals, and subsequent macroeconomic instability dramatically reduced foreign direct investment (FDI) and private job creation - both integral to SOE reform. FDI approvals declined from 17'0 percent of GDP in 1994 to 10 percent of GDP in 1998. The authorities thought it prudent to delay SOE reform in light of the harsh macroeconomic environment. Ownership diversification continued, including joint ventures being formed with Lao Telecom, Lao Beer, and Lao Tobacco. Figure 5 SOE. h-ve small .b.re of employment an... ...d asnil sha of industri lalu e ...but -ecooot for the .jonity of NPLt added (bilon kip) AgRicuturie 900 - ____r 500- 400 -rvt 300 l1 300 frl 63E SOE Public Privote 100 Ih 5% S Privete Source: Lao PDR authorities and UNIDO (1 999). 9 This figure treats SOE conglomerates, such as BPKP and DAFI (Development, Agriculture Forestry Industry Group), as single enterprises and does not include eight joint ventures or seven new SOEs. The actual number of SOEs is therefore larger. Dimensions of the Problem 41. Non-performing loans. While SOEs make a relatively small contribution to national output and employment, they contribute a disproportionately large share of non-performing loans (NPLs) [Figure 5]. As of September 2001, loans to state enterprises constituted 69 percent of the total volume of the top twenty non-performing accounts in each of the three commercial banks prior to January 1, 2000, and 29 percent of non-performing loans since January 1, 2001. Of these larger non-performing accounts, which exceeded $94 million in aggregate, SOEs comprised over $47 million.'0 The underlying causes of non-performing loans are several. Key among these is a legal framework for insolvency that does not provide sufficient incentive for banks to resolve the problem of non-performing loans due to structural defects in the code of Civil Procedure, as well as limited judicial capacity. The ADB is providing technical assistance to the Lao authorities in order to strengthen the insolvency framework and provide judicial training. The weak legal and judicial regime for addressing enterprise insolvency is combined with historically weak regulatory pressure from the BOL to enforce loan quality, effectively softening the budget constraint SOEs face. This is being addressed within FMAC, as well as by the IMF and ADB, and indicates the integrated nature of the operation. Management of most SOEs, which is assigned by line ministries, usually consists of ministry staff with little direct commercial management experience. Policy lending is still largely accepted as a means to achieve national economic objectives. 42. SOE policy and regulation. For several years, SOE policy has been fragmented among line agencies and the Ministry of Finance (MOF), with no mechanism to establish and enforce policy direction across ministries and with provincial governors, aside from the Cabinet itself. In September 2000, a new minister, under the Prime Minister's Office (PMO), was named to head the Business Improvement Office (BIO). This Minister's mandate, yet to be formally approved by the Prime Minister, includes defining the future role of the state, legal reforms, regulatory reforms, enterprise restructuring, corporate governance, social, labor and environment concerns as well as public information. This is a well-developed agenda, but will require substantial technical capacity building within BIO to enable it to both develop and guide on behalf of the government. 43. SOE governance. Under the 1994 Business Law, SOEs must report to MOF, which exercises fiduciary responsibility as caretaker of the state's investrnent capital. Despite the law, the government has an incomplete view of the operational and financial performance of SOEs. Reporting requirements are unclear, particularly at the provincial and district levels, and SOEs in the defense sector do not currently report to MOF. Mechanisms which provide direct oversight of state enterprises in order to hold them accountable to the state's performance objectives, such as SOE Executive Councils, have been ineffective. Not all SOEs have boards in place, and few of the boards that exist meet as frequently as required. Directors, frequently civil servants who have full- time functions within line ministries, have insufficient time or capacity to exercise their fiduciary responsibility. There is little clear definition of the roles and responsibility of board directors; the boards' understanding of accounting, business management or financial management is weak. While a National Audit Office (NAO) was created, few SOEs have regular annual audits. This combination of factors limits the state's ability to manage risk and execute SOE reform policy. 10 This figure includes $12 million owed by Lao Beer in relation to its buy-back of shares prior to resale to a new joint venture partner. 12 44. New SOE creation. Notwithstanding the gains made under the New Economic Mechanism, the government's official stand remains that SOEs are a major pillar of the economy. This was articulated most recently in the 7h Party Congress in March 2002: "State Economy is the most important sector in leading the transformation from a subsistence economy to commodity production ..." This policy context, combined with the policy of economic decentralization announced by the Prime Minister in March 2000 (Advisory No. 01/PM), has given provincial and district governments substantial autonomy which is being used, among other things, to create new SOEs. While the rapid creation of new SOEs to achieve political or economic objectives has largely passed, at least seven SOEs have reportedly been created recently to support provision of agricultural inputs and rice sl:orage. 45. Lack of competition. The policy and institutional environment for enterprises, both state and non-state, limits the competitiveness of enterprises and the stable development of the industrial sector. Obstacles to compelitiveness include policy, regulatory and legal framework, inadequate governance and transparency, and bureaucratic impediments to the operation and establishment of enterprises. For example, in3Frastructure enterprises such as water, energy, telecommunications and aviation are incurring operating losses due to lack of cost recovery and political interference in tariff setting. Tariff levels are kept low and this contributes to financial losses, lack of maintenance of assets, inadequate investment in new facilities, and low service levels. The playing field with the private sector is not level." In addition to unattractively low tariffs, this may partially explain why a sector like telecommunications, which was opened to competition, still remains monopolized. 46. Utility tariff reform and sector regulation Infrastructure enterprises such as water, energy, telecommunications and aviation are incurring operating losses due to lack of cost recovery. The dominance of political objectives in tariff setting has led to financial losses, a lack of maintenance of assets, inadequate investrnent in new facilities, and consequently poor service levels. While poverty is a major concern, this does not make a case for across-the-board restraint on tariffs. In general, affordability issues should be addressed by means other than general tariff interventions. SOE pricing strategy is a ccmplex mix of cross-subsidies designed to maximize revenues while limiting the price impact of commercial autonomy on the majority of the population. For example, the water tariff for Lao citizens in Vientiane is l/76h the tariff for foreign offices; however, water consumption is a poor indicator of poverty. Many poor people have no piped water connections and indeed pay a huge premium for vendor and bottled water supplies. For Lao Aviation, Nam Papa Lao, Lao Telecom and EdL, weighted-average tariffs are currently below full cost recovery for the services provided. While the objective of ensuring affordable service to lower income segments of the population is well-intentioned, directing the subsidy through the enterprise: (i) limits the ability to target the subsidy to the most needy; (ii) causes the government to subsidize enterprise losses and causes NPLs; and, (iii) limits the accountability of the enterprise for both efficiency and profitability. B3ecause the tariffs are low, the scope for new investment in the sector is limited, severely restricting potential competition which could serve to establish low prices while increasing service quality delivery. Among utility SOEs, the policy of commercial autonomy has not been supported by mechanisms, such as sector regulatory capacity and targeted and transparent subsidies, to allow competition and full price liberalization. " See Country Procurement Assessment Report, World Bank, 2002. 13 47. A coherent regulatory framework in each of the infrastructure sectors is required to attract private investment. For example, while great strides have been made in the decentralization of the water supply sector with the creation of provincial "Nam Papas", these decentralized organizations are operating in a regulatory vacuum. There is little or no clear guidance as to the long-term strategy and intentions of the government and policy is being driven by local political forces. The ambiguity is adversely affecting levels of service. C. The Financial Sector 48. The Lao banking sector is small in absolute terms, with total assets of approximately US$400 million. It is also relatively small when compared with the size of the Lao economy: the ratio of the banking system's total assets to GDP is about one fourth. State-owned commercial banks (SCBs) dominate, holding more than two thirds of the banking system's total assets. The three largest banks (Banque pour le Commerce Exterieur Lao - BCEL, Lao May, and Lane Xang) are fully owned by the government. BCEL maintains a dominant position, accounting for approximately half of total deposits and almost 40 percent of total loans in the system. (Annex I provides a detailed description of the financial sector.) Inadequate Policies 49. Directed, non-commercial credit accounts for a substantial share of total credit and appears to be responsible, to a great extent, for a high level of NPLs in the system. The analysis of SCBs' portfolios shows that about 80 percent of loans to the state sector are non-performing and it is not unreasonable to assume that SCBs' loans to the state sector are directed. This situation has also resulted in weak governance in the banks, as managers cannot be held responsible for the performance of the institutions. 50. Low repayment rates are encountered in the private sector, where NPLs stand at 60 percent of loans. Years of state-managed economy have contributed to create a culture of non-repayment, as evidenced by the low NPL recovery rate -- around 18 percent according to some unofficial estimates -- during the first recapitalization of the banking system in 1994. 12 51. Price signals are distorted, hence capital cannot flow to its best use. Commercial banks are theoretically free to set their interest rates on loans since the elimination of the guidelines on maximum lending rates in June 1995, and there is no official restriction on the maximum spread. In practice, however, SCBs behave in identical ways by not pricing loans according to risks and maturity but rather by seeking compliance with government policies. 52. Subsidized interest rates prevent the development of a sustainable microfinance industry (MFI). Currently, it is estimated that an MFI should charge an interest rate between 3-4 percent flat per month. But the Agricultural Promotion Bank (APB), which has the largest outreach, charges less than 0.5 percent flat per month. On the other hand, money lenders charge 20 percent flat per month on average. The government left the MFI pricing policies relatively free for the last 12 According to the ADB's internal evaluation department, the low recovery rate was the result of poorly designed recovery structure. 14 five years but recently have exerted pressure to lower the interest rates to unsustainable levels, discouraging new initiatives and putting at risk the few on-going microfinance projects. Weak Framework 53. The Central Bank Law does not provide the BOL with a clear mandate and a well-defined hierarchy of priorities. Thus, the BOL has pursued conflicting multiple objectives simultaneously. Even if BOL had been able to follow one course, such as price stability and low inflation, its effectiveness in monetary poliicy was limited by the following factors: * The economy is 80 percent dollarized;'3 * The BOL lacks adequate autonomy, having to consult with, and obtain approval from, the executive power for most of its activities; * Policy or directed lending accounts for a significant share of overall lending; and, * The BOL's financial resources are limited. 54. Since January 1997, a new and better chart of accounts was introduced to modernize Lao bank accounting and bring it closer to international accounting standards. However, enforcement and compliance have lagged. 55. The regulatory framework for banks departs from international best practices in some aspects. A major weakness appears to be the specific SCB governance structure that reduces SCB autonomy and limits the Managing Director's accountability. For all practical purposes, the lack of enforcement of existing prudential rules leaves SCBs unregulated. 56. There are some gaps and inconsistencies in the laws. Inportant laws such as the Bankruptcy Law or the Secured Transaction Law depart from evolving international best practices to a certain extent. More danaging, however, is the fact that laws are not always fully and systematically applied, and judgments are not always enforced. 57. With regard to microfiniance, the BOL regulation really allows only one model -- which is the savings and credit cooperalives. Restriction on institutional models, with private or diversified ownership, deters pilot projects. Weak Institutions: Lack of Skilled Human Resources 58. MOF does not have a c onsistent financing program, providing low risk and liquid assets, for the budget deficit. MOF ordy recently has unambiguously allowed adequate tax deductions for loan loss provisions. The ministry has not effectively administered accounting laws, regulations, and procedures, and has not established financial disclosure requirements adequate to ensure that financial information is reliable and available. In BOL, the bank's supervision department is staffed with relatively young people with little experience who have yet to build the necessary credibility and respect that are necessary to ensure banks' compliance to the regulatory framework. 13 The word "dollarized" used here means currencies other than the kip - i.e., U.S. dollar and the Thai baht. 15 59. Narrow and restricted dissemination by the Ministry of Justice (MOJ), of legislative acts and regulations, is responsible in part for the lack of compliance and uncertain outcomes when rights are to be protected; however, the major reason appears to be that the judiciary remains too weak to implement the laws. In addition, seeking justice through the legal and judicial system is still somewhat at odds with Lao culture. 60. The SCBs do not have sufficient skilled management and staff, resulting in SCBs providing loans in foreign currencies to borrowers without foreign exchange revenues. SCBs do not have a research and development unit to help make decisions and evaluate business opportunities. Credit officers lack the skills needed to analyze credit risk, project risk, market risk, and foreign currency risk. SCBs do not have formal lending policies or credit limits and do not use any standard credit appraisal document. Extemal legal opinions on loan contracts are not sought. SCBs do not have a policy stating when to take legal action against a particular borrower or a policy of obtaining regular financial statements from all of their borrowers. Site visit reports are not prepared. Credit files are not properly kept. Internal auditors do not carry out a regular review of banks' loans to ensure that they comply with internal and BOL's regulations. The classification of loans is not regularly carried out. These are significant deficiencies that need short and long-term remedies, and improving the "Loan Cycle" will be a long-term endeavor. D. Consequences of Structural Weaknesses for Growth and Poverty Reduction 61. A counter-factual illustrates the crisis dynamics associated with structural weaknesses and informs the design of the proposed reform program. According to IMF estimates in the PRGF, a fiscal deficit of 5 percent is sustainable even though its structure (as discussed above) is undesirable. The SOE structural problems could potentially add I to 2 percentage points of GDP to the deficit. With proper accounting, provisioning and fiscal accounting of capital injections, an additional 1 to 2 percentage points of GDP could be added to the deficit due to weaknesses in the banking sector. Thus in the absence of structural reform, a sustainable fiscal deficit of 5 percent could deteriorate to around 9 percent of GDP which would be fiscally untenable and would lead to a crisis and severe macro-economic difficulties as experienced in 1997/98. The cumulative impact of the structural weaknesses (outlined above) on macro-economic instability is presented in Figure 6. 16 Figure 6 Lao PDR: The Structural Problem: Unsustainable Public Finances that Retard Growth and Poverty Reduction Development Problem The Budget Fiscal Problem * Inadequate or no rectuTent budget -. Fiscal deficit currently about • Large donor funded investment 5 percent of GDP projects with implementation more or less sustainable problems t * Corruption and waste SOES * Equity objectives not niet / Low price due tosocialPotentially add 1-2 * Low prices due to social I >^ t_t A percentage points additional objective deficit due to directed credit * High cost due to enterprise and other contingent inefficiency liability * Corruption BA t Banki q Sector * NPLs * Corruption * Not meeting future Add 1-2 percentage growth need . points more * Not meeting the equity :9 objective * Recurrent crises as in f 4 1997/99, disrupting Total deficit could reach growth and poverty Crisis that 8-10 percent of GDP which alleviation Retards Growth would be explosive * triple digit inflation * Collapse of currency and Poverty value Reduction * Loss of confidence 17 IV. GOVERNMENT'S REFORM PROGRAM AND POVERTY REDUCTION A. Public Sector Management: 62. The govemment of the Lao PDR remains firmly committed to achieving rapid reduction in poverty. Its growth and poverty reduction strategy, as articulated in the I-PRSP and the NSEDP, highlights the importance of stable and sustainable growth to help reduce poverty. There is a recognition that the extent to which growth will result in poverty reduction depends on structural policies that improve economic efficiency and govemance while reducing the vulnerability to economic crises that adversely affect the poor. The government's reform program focuses on a set of structural problems at the stage of budget formulation and execution, inefficiencies and losses in the state-owned enterprises and the cumulative effect of these on the shallow and fragile banking sector. It is designed to increase growth by promoting stability and a clearer role of the public sector and to reduce poverty directly through improved allocation of public funds. The Budget 63. Improved public spending is an important instrument to offset the incipient trends towards increased inequality in Lao PDR and to reach marginalized groups who do not directly benefit from overall economic growth. The government is seeking to strengthen budget execution and control by improving the basic cash management, reporting, auditing and control systems that govern public expenditures. With these reforms, budgeted expenditure shares for health and education should increase in line with the PRSP and unauthorized accounts should be identified and closed. Prior Reform Measures 64. Budget planning. The government has already undertaken significant steps to improve the measurement of poverty and to enhance the poverty focus of public expenditures. The first Lao Expenditure and Consumption Survey, conducted by the National Statistical Center in 1993, was substantially improved and updated in 1998. The basic poverty measurement initiatives have enabled the government to complete the I-PRSP in April 2001 and it will complete the full PRSP in FY 2003. 65. To better achieve its development objectives, as outlined in the I-PRSP, and raise the share of recurrent spending, the government has been reducing capital expenditures which peaked at over 70 percent of total expenditures in 1998/99, and have fallen to less than 60 percent in 2001/02. Further rebalancing of public expenditures was achieved through a 25 percent increase in basic civil servant wages from the start of 2002 to compensate for past inflation. Given that a large portion of civil servants are teachers, this is helping to reach the I-PRSP target of lifting the education's share of the budget to 13 percent. 66. With the assistance of the Asian Development Bank (ADB), the Lao PDR is better able to plan and manage public investments. A Public Investment Plan (PIP) monitoring project that tracks donor-funded investment expenditures has been established and the results are published annually. This is now being extended to domestically funded public investments. Decree No. 18 58/PM, dated May 22, 2002, on Management of Public Investment and the associated guidelines provide a rationalized framework for project selection that involves streamlining by size and a two-stage process of evaluation against set qualification criteria, followed by a separate budget resource availability hurdle. This system is being applied now as the FY2002/03 investment proposals are received. 67. Budget accounting and control. Decree 20/PM of 1993 on Public Accounting is now being more fully and effectively implemented with the establishment of an information and budgetary system in four pilot Ministries (Agriculture and Forestry, Education, Finance, and Health) with assistance from the ADB. This system allows the systematic computerized recording and processing of expendittres by administrative units. It includes budgetary and accounting references, committed current and capital expenditures at the central level, and it specifies budget allocations, payment orders and the value of budget allocations available after payment orders have been deducted. 68. To tighten the control of public resource flows, a Ministerial Decision was issued in 1999 requiring MOF's Treasury Department to exercise prior commitinent controls on expenditures. To ensure that commitments are consistent with the budget, responsibility for the commitment control function now rests with the Budget Department (Ministerial Decision No. 1706/MOF, dated October 22, 2001). 69. Transparency. With assistance from the ADB, the NAO was established by Decree No. 174/PM in 1998 and began producing audits of central government ministries, provinces, and individual projects. The NAO has been reporting annually to the President, the Prime Minister and the National Assembly. The quality of its audits has been improving as the capacity of NAO staff is enhanced through continued ADB support 70. In line with the requirements of the PRGF, the Treasury Department has begun an inventory of Treasury accounts at all levels. This inventory, which is now almost complete, will allow MOF, working in conjunction with BOL, to identify and close all unauthorized Treasury accounts which facilitate the proliferation of off-budget revenues and expenditures. Reform Measures Supported by FMAC 71. With the support of the proposed FMAC, the Lao PDR is taking several additional steps to further stabilize the budgetary process and budget planning. 72. To promote transparency in fiscal management, the 2000/01 budget outcome and the 2001/02 budget plan with classification by ministry/province and service 1 were published in the Official Gazette on March 25, 2002. The detail of the presentation has been substantially expanded, including breakdow:ns by sector at both central and provincial levels. 73. Decree No. 58/PM, dated May 22, 2002, on the Management of Public Investment requires that PIP submissions for new public projects in excess of 1 billion kips in the FY 2002/03 budget 14 Classifications are by ministry/province and service, so that it is possible to identify separately the central ministry and provincial spending on health, education, etc. 19 include estimates of associated recurrent costs during the operating period. Guidelines for estimates of the recurring costs have been prepared for presentation at the provincial budget conferences in May 2002. A workshop on the subject for the Committee for Planning and Cooperation (CPC) and MOF staff, held at the CPC with the assistance of the World Bank in April this year, was very useful in disseminating information on these topics. The CPC will present the results of this work for the FY 2002/03 PIP to the donors in October 2002. A consultant has been engaged to assist CPC with recurrent cost estimates under terms of reference agreed with the Bank. As part of the second phase of the FMAC-supported program, the CPC will complete an assessment of recurrent cost estimates associated with new projects in excess of 1 billion kips. 74. Following the January 17, 2002 letter sent jointly by the World Bank and the IMF to the Minister of Finance concerning the draft Accounting Regulations and Procedures, and consistent with discussions held between the World Bank and the Accounting Department in February 2002, revisions are being prepared. This process is at an advanced stage and the government expects to adopt a Regulation of the Minister of Finance on Public Accounting and Procedures for the implementation of Decree No. 20/PM on the General Regulation of Public Accounting, dated February 18, 1993, and prepare a strategy for reform of the Department of Treasury. The Regulations and Procedures are expected to be issued by end-June 2002. These accounting reforms set the stage for the medium-term reforms for Treasury operations which will be developed in close collaboration with the International Financial Institutions (IFIs). 75. The enabling legislation for the establishment of a Procurement Monitoring Office (PrMO) is already in place. The government is moving forward with establishment of the PrMO, within MOF, headed by a qualified and experienced Director and assigned with adequate staff and resources. In addition, the Implementing Rules and Regulations will be revised in line with the recommendations of the World Bank's draft Country Procurement Assessment Review which the government received on May 3, 2002. A candidate has been identified for the position of PrMO Director. Reform Measures in the Medium Term 76. A series of medium-term reforms of Treasury operations will be launched under the guidance of a recently formed Standing Committee headed by the Vice Minister of Finance. Key reforrns will include establishment of Treasury offices in line ministries, closure of unauthorized Treasury accounts, consolidation of the network of Treasury accounts, revision of Treasury regulations including sanctions, and publication of a manual of consolidated laws, decrees and regulations for government-wide Treasury operations. Following the revision of Public Accounting regulations and refinements of the chart of accounts and budget nomenclature, the pilot computerized accounting systems will be extended to cover all central ministries and provinces. These initiatives will serve to improve both expenditure management and revenue mobilization objectives by restricting the scope for unauthorized off-budget transactions and bringing about a closer integration of treasury, accounting and budget operations. In addition, the government plans to introduce intemal audit and accounting processes, to adopt international public accounting and auditing standards and to revise accounting decrees and regulations to clarify financial control responsibilities among the central government and the provinces. 20 77. Further steps to improve the transparency of budget processes will include continued publication of the budget plan and budget outcome and steps to reduce the publication lag. In the medium term, the government intends to adopt legislation to provide greater autonomy for the NAO and to establish an effective parliamentary oversight over public finances, and to make the audited annual accounts and audit reports of the NAO fully accessible to the public. A review will be undertaken to assess the scope for rationalizing the roles and responsibilities of the oversight agencies including the NAC), the State Inspection Agency, MOF's Inspection Department, the Permanent Economic Committee of the National Assembly, and the BIO within the PMO. The government also intends to introduce by appropriate legal instrument the principle that all subsidies and other quasi-fiscal expenditures be reflected explicitly in the national budget. This will be reinforced by the program to enhance Treasury operations and closure of unauthorized accounts, thereby enabling the Lao authorities to progressively eliminate all off-budget revenues and expenditures. 78. Financial reporting in the private sector will benefit from the introduction of measures to improve the institutional framework for setting its accounting and auditing standards. These include efforts to streamline various laws and regulations related to accounting and auditing practices in the private seclor, as well as adoption of international accounting and auditing standards for this sector. 79. To enhance budget planning, the government will improve revenue estimation methods and begin to reverse the persistent pattern of revenue shortfalls and subsequent ad hoc expenditure cuts. It will develop better unit cost measures for major expenditure programs, including health and education, to support mole realistic bottom-up estimation of the costs of achieving plan goals. The classification used by the CPC in the PIP monitoring system will be aligned with the budget classification system, and the latter will be extended to allow identification of expenditures by program. These steps will zdlow the government to reflect the results of poverty monitoring, expenditure tracking and PRS"? work in public expenditure plans and expenditure outcomes. Forestry 80. The performance of the forestry sector has not been as satisfactory as expected. The government believes that the contribution of forest resources to the incomes and livelihoods of rural people would be increased under a better forest management system. This includes addressing, among others, the iissue of unplanned and uncontrolled logging. Prior Reform Measures 81. A number of steps has been taken toward reforming the policy and institutional constraints challenging forestry and the government is working with a number of partners to build the capacity needed to improve management of the resource. These steps include reducing excess capacity in wood processing sector, mandating that timber production be restricted to areas targeted for infrastructure development or covered by sustainable forest management plans, introducing market-oriented timber sales methods, achieving successful trials of participatory forestry management, and successfully controlling illegal and unauthorized logging in targeted areas. 21 82. The government recognizes the full range of environmental, economic and social benefits that a well managed forestry sector will provide. The Lao PDR is well endowed with forest biodiversity and is recognized as the host of unique and globally endangered species of plants and animals. A system of NBCAs has been established and the government is introducing management and protection of these areas. In the future, the authorities expect to improve the quality of management of these areas by, among other things, employing participatory approaches that combine conservation with tangible contributions to the livelihoods of local people. Reform Measures Supported by FA4C 83. The Ministry of Agriculture and Forestry (MAF) has formally approved the key Principles for Village Participation in Sustainable Management of Production Forests and the PMO has issued a Decree on Sustainable Management of Production Forest Area that supercedes relevant articles of existing orders. 84. Under the FMAC program, the government will strengthen the regulatory framework for protected areas management and will issue, through MAF, Regulations amending the Implementing Regulations on National Biodiversity Conservation Areas, Regulation No. 0524/AF.2001, dated June 7, 2001, inter alia, to clarify the definitions and procedures governing zoning and land use within said Conservation Areas, and eliminate inconsistencies in respect of protected species listings. Furthermore, Implementing Regulations on Sustainable Forestry Management will be adopted which include specific provisions to enable the involvement of local communities in production forest management. 85. The government's top priorities under the period of the FMAC program focus on bringing order and discipline to the exploitation of the country's production forest resources. Until now, these areas have not been adequately mapped, inventoried, or their harvest properly planned and organized. Harvesting is considered by international norms to be of lower efficiency than expected. If proper forest management is not undertaken, pressures from mismanagement of the production resources would increase and the result would negatively affect the goals for sustained revenue mobilization and biodiversity conservation, and would require urgent attention and correction. 86. Recognizing that the capacity of government forestry agencies at all levels is limited, the official strategy is to involve local communities in forest management by providing a framework for the rapid expansion of the area under sustainable scientific forest management conducted in cooperation with Village Forestry Organizations. Decree No. 59/PM, dated May 22, 2002, and Implementing Regulations on Sustainable Forestry Management which include specific provisions to enable the involvement of local communities in production forest management, will provide guidance to the national, provincial and local agencies responsible for working with communities and Village Forestry Organizations on the basis of voluntary Village Forestry Agreements and written management plans. This regulatory framnework will implement the "Principles for village participation and other key principles in sustainable management of production forests." 87. implementation of this program, expected to be supported by international partners, is aimed at rapidly bringing a large portion of the production forest resource under sustainable 22 management. This will involve mapping, demarcation and registration of a network of production forest areas and the preparai[ion, approval and implementation of management plans. 88. The government will initiate a forestry sector monitoring program to routinely assemble and analyze information on policy implementation and development results. A comprehensive sectoral monitoring program, which will enable the government to monitor and report on the implementation of this program, will be initiated with the FMAC program. Reform Measures in the Medium Term 89. Looking beyond the FMAC program, the government intends for the forestry sector to continue to develop as a sustainable source of growth and public revenue and a means for poverty reduction. To support this, the Lao PDR will continue its efforts to introduce more market- oriented timber sales methods, will develop policies to reduce excess capacity in the wood processing sector, and will complete the regulatory framework for forestry envisioned under the Forestry Law with well firmulated Implementing Regulations covering all forest types and management systems under the law. 90. Investments are expected to continue in reforestation, plantation development and watershed management. These efforts are vital to the development of alternative sources of raw material, and to the protection of existing and planned downstream infrastructure. As with the management of natural production forests and conservation areas, the government intends to employ participatory methods and will consult with a range of stakeholders to ensure broad-based support for sustainable development. B. State-Owned Enterjprise Sector 91. The government recognizes that a well-functioning, financially-sustainable enterprise sector is important to improving the delivery of services to the poor, creating meaningful productive employment, as well as supporting the transformation of the economy from an agrarian to an industrial and service-based economy. Many of the enterprises have, in the past, supported a mix of social, political and economic objectives. With social and political stability in place, the government's focus is now on enhancing the economic contribution of state-owned enterprises. The Lao PDR's objectives are to improve the oversight and management of those SOEs which shall remain under state jurisdiction, in order to make them more commercially oriented, efficient and able to compete with other enterprises. For several non-perforrning enterprises, this will require deep internal reform to strengthen management and eliminate non-productive activities. For infrastructure SOEs, this will require regulatory and tariff reform. 92. Reform of SOEs should contribute to poverty reduction by permitting a better allocation of public funds. WNhile there iis some danger that the poor could be adversely affected by higher tariffs, this risk has been rnitigated by careful design of the tariff structures to permit more effective poverty targeting while meeting efficiency of reduced internal costs, and closer alignment of prices and marginal costs. 23 Prior Reform Measures 93. Commercialization The Lao PDR's SOE reform policy must be viewed in light of gains made in implementing the NEM, which dramatically reduced the number of SOEs through liquidation and privatization, hardened budget constraints, and removed the monopoly status which many SOEs previously enjoyed. Under the 1994 Enterprise Law and implementing regulations, the framework for commercial autonomy and self-sufficiency of SOEs was introduced. All SOEs have introduced Executive Councils which govern SOEs, replacing the previous direct municipal or central government control and ownership mechanism. The Office of State Assets within MOF was assigned to execute the fiduciary responsibility of the state as shareholder. 94. Privatization. From 1988 to 1997, the government undertook a substantial program of privatization. Of over 600 central and provincial SOEs which existed in 1988, only 91 remained as 100 percent state-owned enterprises by 1995. In 1996, plans were developed to privatize an additional 58 enterprises. Unfortunately, the disruptions of the economic crisis delayed the SOE reform process, as it was difficult to force further adjustments in the midst of a harsh macroeconomic climate. By impacting macroeconomic stability -- which is a prerequisite to foreign investor interest in transformed assets -- as well as domestic purchasing power, the crisis made further progress on privatization very difficult. However, several enterprises, including Lao Tobacco and Lao Telecom, continued to be privatized during this period. 95. Restructuring A number of larger SOEs, including those in infrastructure sectors, have been unable to achieve financial sustainability, which in turn contributed substantially to both the non-performing loans problem in the banking system and a fiscal drain on the budget. The performance of enterprises which remained in state control during the crisis and through 2001 revealed weaknesses in the management and oversight of SOEs. Policy Decision No 368/PMO in October 2000, provided the context for intervention to restructure non-performing SOEs. In December 2001, Bolisat Phattana Khet Phoudoi (BPKP), the enterprise responsible for the largest non-performing loans in the banking system, was transferred to MOF, and the process of restructuring was initiated. Audits of Lao Aviation and BPKP further strengthened the government's commitment to finding a comprehensive solution. 96. SOE reform policy. In this broad context, the government began to engage with the Bank in September 2001, through the FMAC program, to improve the financial performance of state- owned enterprises and consolidate the gains previously made in transforming SOE management. A new Minister was named to head the BIO in order to lead enterprise reform policy, particularly with respect to SOEs. A target list of enterprises has been identified for restructuring by this office. 97. With respect to infrastructure SOEs, financial sustainability is a particularly difficult challenge in light of the need to undertake substantial investment programs to provide essential services to the poor. Integral to the financial sustainability of several of these enterprises is a combination of internal restructuring to reduce costs with tariff reforms and introduction of appropriate regulatory frameworks. 98. Water sector. The Water Supply Authority (WASA) was established as the central regulatory authority for the water and sanitation sector of the country in the Ministry of 24 Communication, Transport, Post and Construction. This was followed by the water sector policy statement in 1999. The new policy changed the role of the central government from service provider to facilitator and coordinator in the development process for water supply and wastewater management systems in urban and rural areas throughout the country, including sector investment support. Work is underway with donor support (ADB's Project Preparation Technical Assistance, PPTA) to develop a legal and regulatory framework for the water supply and sanitation sector under the auspices of WASA. The national water policy is described in the Prime Ministerial Decision No 37/PM of 1999 on Management and Development of the Water Supply Sector. This document establishes the principles for a tariff policy and for the Provincial Nam Papa operations on commercial principles in lirLe with the national policy on working toward full cost recovery for urban water supply and centralized wastewater systems, with progressive block rate tariff structures. 99. In accordance with the Decision 37/PM, the tariffs shall be set within the constraints of affordability and willingness to pay, adopting a uniform province-wide tariff system with possibilities for cross subsidizing. Average tariff has increased from 195 Kip/m3 in 2000 to 550 Kip/m3 in September 2001. WVASA has authorized an increase to 650 Kip/m3 from July 2002. Nam Papa Vientiane has proposed a tariff of 750 Kip/m3. However, further reforms are envisaged as tariffs still remain well below cost recovery and do not take into consideration new capital investment costs. 100. In a context of developing regulatory instruments for the sector, WASA has agreed to review the water tariff principles and elaborate a comprehensive water and sanitation tariff policy in consultation with key stakeholders of the sector. The review is expected to be done in light of possible future private sector participation in the water supply and sanitation sector. 101. Telecommunications. T he government has made a number of changes to the structure of the telecommunication sector over the last decade. These include introducing private investment through a joint venture (1994') as well as separating post from telecommunication (1995). A telecommunication law was passed in April 2001 and lays the framework for telecom regulations and entry into the sector. The sector has been open to competition since the beginning of November 2001. The government issued a mobile license in early 2001 for Millicom Intemational Cellular SA, a Luxembourg-headquartered international mobile investor. 102. Until 1993, the Enterprise of Post and Telecommunications Lao (EPTL) was the 100 percent government-owned organization responsible for operating telecommunications in the country. In 1994; a joint venture was established between the government and a Thai company, Shinawatra International Public Company Limited -- Lao Shinawatra Telecom Company Ltd. (LST) -- to operate telecom services (Telecom Project Phase III). This was not the first example of private investment in the telecorn sector. In 1995, ETPL was divided into Enterprise of Post Lao -- responsible for postal services - and Enterprise of Telecommunication Lao (ETL) -- responsible for telecommunications. In 1996, ETL and LST were merged to form Lao Telecommunications Company Limited (LaoTel) with the government owning 51 per cent and Shinawatra owning 49 per cent. LaoTel was granted a concession of 25 years with five-year exclusivity (through October 2001). ETL was resurrected in August 2000 to hold grant-financed government assets. As a result, LaoTel ended up leasing certain network elements needed for its service provision such as 25 the international gateway. With the expiration of LaoTel's exclusivity in October 2001, the way is now open for ETL to enter the sector as a telecom service provider. ETL plans to provide fixed telephone lines, mobile Global System for Mobile Communications, and Voice Over Internet Protocol services in 2002. 103. While a tariff structure exists in this sector, the government recognizes that domestic tariffs are highly subsidized and the need to develop a firmer policy for tariff determination. The Telecom Department, as the regulatory body, is putting in place a tariff policy study and has requested assistance for the development of a regulatory framework including tariff rebalancing and interconnection charges as well as a framework for private sector participation and licensing arrangements. 104. Transport. Three tariff increases for Lao Aviation were approved over the last year. While the government recognizes that tariffs are not yet at cost recovery levels, it is considering a recent request from Lao Aviation to increase tariffs from 8 cents/seat/km to 20 cents/seat/km for domestic flights - bringing tariffs to cost recovery levels (at 65 percent capacity utilization) in the first quarter of 2003. 105. Electricity. Since 1997, there have been several activities for restructuring tariffs and regulation in this sector, upon the preparation of parallel projects of the World Bank and ADB. The Ministry of Industry and Handicraft (MIH) issued in March 2001 a Power Sector Policy Statement (with World Bank support) that established the following two main objectives for the Power sector: (i) to maintain and expand an affordable, reliable and sustainable electricity supply within the country to promote economic and social development; and (ii) to promote power generation for export to provide revenues to meet the government's development objectives. It was agreed that the achievement of these twin goals depends on continuing progress in the following two areas: * Development and enhancement of the legal and regulatory framework to effectively direct and facilitate power sector development; and * Reform of institutions and institutional structures to clarify responsibilities and streamline administration. 106. Prior to the Policy Statement, the Lao PDR's National Assembly enacted the Electricity Law (1977), an important advance in the development of a legal framework to attract, direct and control optimal investment in power projects. Currently, consideration is being made for the separation of Electricite du Laos (EdL) from its off-grid and independent power producer responsibilities, and to establish an independent regulator. Resources are being mobilized in support of an open debate on sector reform. The government has also approved a proposal for a Public-Private Infrastructure Advisory Facility (PPIAF) supported workshop on sector reform (scheduled to be held around November 2002) which would be followed by the formulation of an action plan. 107. The government's efforts to commercialize EdL started in the mid-1990s under technical assistance support of the World Bank and ADB. Since then, EdL has been established as a separate juridical entity with a functioning Board of Directors. Also, EdL has strengthened its 26 financial management capability (with World Bank support), has been reorganized on the basis of cost centers that facilitate accountability of each operation, and the utility has divested from some non-core activities (e.g. concrete pole plants). This process was supported by the enactment of the Electricity Law which supports the commercialization of the sector. Following the 1997 regional financial crisis, EdL's financial situation was seriously affected by exchange losses. In response to this situation, in December 2000 a Financial Recovery Plan, satisfactory to the Bank, was proposed for EdL. This plan called for: (i) conversion of some debt to equity; (ii) temporary relaxation of onlending conditions to EdL, particularly for debt associated to social-oriented investments; (iii) undertaking a tariffs study and the subsequent implementation of a new tariff policy; (iv) revaluation of fixed assets; (v) signing of a performance agreement between EdL and the government; and, (vi) review of EdL's investment plan. In spite of the slow implementation of this Plan at the onset, almost all of the measures have been implemented at this stage. New tariffs approved in early April 2002 will allow EdL to comply with financial covenants for the first time in more than three years. Reform Measures Supported by FMAC 108. The SOE reform program in FMAC, paralleling the objectives of the PRGF, is expected to contribute to a strengthened financial management of existing SOEs, enterprise restructuring, and tariff reforms. 109. In recognition that the monitoring of the operational and financial performance of SOEs, particularly at the Provincial and District levels and among some ministries, is insufficient to support management of financial risks and execution of SOE reform policy, the government has issued a Decree: (i) requiring that financial and operational performance of all SOEs at the ministerial, provincial and district levels be reported to MOF; (ii) specifying regular reporting requirements; and, (iii) stating that new SOEs to be established are those which are specifically approved by the Prime Minister, and which will provide essential services which cannot be currently provided by the private sector or by budgetary means; (iv) requiring MOF to publish in the Official Gazette the financial performance of SOEs on a quarterly basis; and (v) requiring the privatization or liquidation of those SOEs which have produced the greatest operating losses, or which otherwise fail to comply with this Decree. To contain the growth of non-performing loans contributed by SOEs, the government prohibits non-commercial policy lending to SOEs, and all lending to SOEs with outstanding non-performing loans. 110. Recognizing that a limSited number of SOEs have contributed disproportionately to non- performing loans in the banking system, the government has signed Memoranda of Understanding to initiate the restructuring process for BPKP, Lao Aviation, Nam Papa Lao and Pharmaceutical Factory No. 3. These Memoranda define the contribution of the enterprise, the PMO, and the Office of State Assets of MOF with respect to the preparation of time-bound restructuring plans for each enterprise and the first stages of their implementation. 111. To better manage the utilities with a view toward cost recovery, reforms have been initiated in the tariff policy for electricity, water, transport, and telecommunications. For electricity, the government has implemented a new electricity tariff policy, to be applied from May I for a period of 36 months. It consists of an average monthly increase of 2.3 percent which will take the 27 average tariff to Kip 665/Kwh by the end of the period (US cents 7 at the current exchange rate, between US cents 5 to 6 under the government's set of assumptions). Following the proposal of the tariff study, the schedule will move towards a marginal cost structure while keeping a lifeline tariff to protect low-income consuners. 112. For water, a draft tariff policy outline was prepared for the water sector and was submitted to the Bank for review. Policy objectives and principles have been laid out. These will be developed and firmed up after consultation with the stakeholders (consumers and operators, national and local Treasury and international development agencies). Gradual increase of water tariffs is being implemented. The most recent set of tariff increases was authorized by WASA on April 23, 2002. 113. The Ministry of Construction, Transport, Post and Communication (MCTPC) and Lao Aviation have requested a tariff study to support the achievement of full cost recovery tariffs by the second tranche. An increase has been agreed between the MCTPC and Lao Aviation for domestic tariffs. It is agreed that the domestic tariffs for Lao Aviation would be the higher of $0.20/seat/kilometer or the tariff required to achieve full recovery of all operating maintenance and depreciation costs. 114. A study on tariff structure and tariff policy for telecommunications has been launched with grant assistance from JICA. A JICA-financed consultant is attached to the Telecommunications Department at MCTPC. The telecommunications departrnent is preparing a telecom policy statement, and Kreditanstalt ftr Wiederaufbau of Germany has agreed to provide assistance. 115. In order to clarify the policy on management of SOEs, the government will issue, through MOF, Implementing Regulations to Decree No. 54/PM, dated May 9, 2002, on Management of State-Invested Enterprises. 116. By end-March 2003, the government expects to begin to realize some results of the Decree strengthening the performance monitoring of SOEs. An assessment of the financial performance of SOEs will be prepared and, under criteria consistent with technical audit standards, will identify non-performing SOEs that require: (i) performance improvement; (ii) strengthening of financial reporting; or, (iii) bringing them to the point of sale or liquidation, as the case may be. Gradually, this will be expanded to all state-owned enterprises. 'The government will adopt a time-bound restructuring plan for BPKP, Nam Papa Lao, Pharmaceutical Factory No. 3, and Lao Aviation, and implement all of the actions under said restructuring plan, which in accordance with such time- bound restructuring plan. Substantial progress is being made by each enterprise in defining its restructuring plan. 117. In SOE restructuring, MOF will execute memoranda of understanding for the development and execution of time-bound restructuring plans with DAFI and four loss-making SOEs which have outstanding, non-performing loans in excess of one billion kip. 118. The government expects to complete the financial restructuring of EdL, including revaluation of assets, amendment of selected subsidiary loan agreements, and debt-to-equity conversions. 28 119. Tariff reforms will be continued. For water, transport and telecommunications, the government will adopt and publish tariff policies and structures incorporating: (i) cost recovery principles; and (ii) directed and transparent subsidies, if any, for the potable water supply and telecommunications sector, Lao Aviation, and telecommunications sector; and will adopt a time- bound action plan for the implementation of said tariff policies. The implementation of tariff policy will be through appropriate legal instruments such as Ministerial Regulations. The government has commissioned studies to formulate tariff policy and tariff structure to include cost recovery. These are expected to be ready by November 2002. Appropriate stakeholder discussions will be held and social impact studies will be carried out on the tariff policy for each sector. The Terms of Reference for Social Impact Assessment Studies for the water sector have been drafted. Similar work for electricity and telecommunications will be addressed. 120. Going forward, the government will clarify the role and strengthen the functions of regulatory bodies/departments. This will be accomplished through providing and developing adequate resources and capacilty in water, telecommunication, energy and transport sectors. 121. In the water sector, the Water Supply Authority -- the water sector central regulatory authority for the water and sanitation sector of the country -- is being assisted by ADB in developing its mandate, including a better definition of its role, functions and jurisdiction. 122. In telecommunications., the government will seek to define and strengthen the capacity of the Department of Telecommumications in MCTPC as the designated regulator for this sector. In addition, the government will work to identify resource requirements for this agency under the grant from PPIAF. The regulatory framework will also be developed under the PPIAF Grant. 123. Transport. The government's pian is to develop a regulatory framework for this sector. 124. Energy. The govermnent will continue to implement the commercialization of EdL that was started in the mid-1990s, with strengthened management capacity and a firmer financial footing through the Financial Recovery Plan. Reform Measures in the Medium-Term 125. While the policies proposed for support under the FMAC represent a substantial effort by the government to address some of the most urgent deficiencies in the enterprise sector, the reform program will clearly require a mnedium-term effort. The Office of State Assets will require further strengthening in order to take a proactive stance through early detection and intervention of enterprises which may cause financial damage to the state budget or to the banking system. The capacity of the NAO will also require strengthening in order to execute more regular audits of key enterprises. The Boards of Directors of state enterprises will need to become more effective in financial control and strategic management, both through training and through expansion of the use of independent, experienced directors from outside the civil service. 126. Through the enterprise restructuring process, the government hopes to identify and address many of the key obstacles to financial sustainability of state-owned enterprises, including removal 29 of non-commercial mandates on pricing and service delivery, strengthening of the social safety net to alleviate the impact of SOE reform on workers, reducing the cost and improving the function of organizational structures, and institutionalization of effective management controls. To strengthen the incentives for all enterprises to achieve financial sustainability, the government expects to have made substantial progress, with ADB support, on strengthening the legal framework for insolvency, secured lending and civil procedures. 127. Beyond FMAC, the government's medium-term vision for the enterprise sector is one in which all enterprises, irrespective of the nature of ownership, are able to contribute substantially to increased employment generation and poverty reduction, improved service delivery, and macroeconomic stability. Realization of this vision rests on five pillars: * establishment of a sound and stable investment environment for the development of all enterprises leading to the resumption of foreign and domestic direct investment flows; * creation of a market-oriented regulatory framework and tariff regime for key infrastructure sectors which enables the private sector to contribute to essential service delivery on a competitive basis; * leveling of the playing field between SOEs and the private sector, including in the areas of taxation and public procurement, to introduce greater competition between SOEs and the private sector and to facilitate the flow of resources to areas of greatest demand; * creation of a judicial system which is able to provide strong incentives to improve financial performance and facilitate commercial transactions, including credit; and, * achieving a simple, manageable trade regime that promotes integration of Lao PDR first within Asian Free Trade Agreement and then within the global economy. 128. This will require a substantial and cross-ministerial reform agenda, developed in consultation with the private sector, SOE managers, and the foreign investment community. To build ownership and commitment to the reforms among all concerned stakeholders, the government will establish a public-private consultative mechanism led by the CPC, with the support of the World Bank, IMF, ADB, and the Mekong Project Development Facility. The government's immediate priorities are to increase the attractiveness of Lao PDR as a destination for foreign direct investment, to simplify business registration procedures for foreign and domestic entrepreneurs, and to continue to reform the trade regime. Longer-term reform priorities of the enterprise sector are expected to emerge from the consultations with domestic and foreign businesses. 129. With more progress on governance of state enterprises, improvement of the domestic business and regulatory environment, and a resumption of foreign investor interest in Lao PDR, the conditions will be in place for a resumption of the previous policy of ownership transformation on a more sound footing. Meanwhile, the government will continue to take a pragmatic approach to the question of ownership transfortnation, including the potential use of joint ventures to improve the performance of SOEs. 130. In the medium term, the issue of transparency and financial accountability in the SOE sector will be addressed though implementation of the following measures designed to improve its financial reporting and corporate governance: (i) requiring large SOEs to prepare financial 30 statements in accordance wilh adopted standards and be annually audited by independent auditors; and, (ii) publishing their audited financial statements and making them accessible to the public. 131. The government shall consider additional measures to achieve a more effective level of financial management. These include: (i) introducing an internal audit function in large SOEs; (ii) establishing audit committees of the board; and (iii) strengthening the accounting professional organizations to become fully professional bodies. C. The Financial Sector 132. Financial sector reform is critical to reducing the risk of a financial crisis which could have a devastating impact on the poor. The government is finalizing a comprehensive reform program in the financial sector, with the support of the three key international financial institutions (IMF, ADB and the Bank) wrorking in close partnership. The financial sector components helps reduce poverty in three main ways: (i) macroeconomic stability in banking reforms; (ii) broad- based growth via a financial sector oriented towards credit to the private sector; and, (iii) direct poverty reduction though support for micro and rural finance. Progress on the financial sector reform agenda is expected to take several years. In the medium term, the flow of resources to better uses and the development of direct access by the poor to financial services will be important ingredients of the overall poverty reduction effort. 133. Working closely withl the World Bank, IMF and ADB, the government has started to implement a comprehensive reform program in the financial sector. The program includes three main themes: ensuring macroeconomic stability via banking reform, promoting broad-based growth via a strengthened fulancial sector, and unleashing the power of micro-finance to reduce poverty. Prior Reform Measures 134. The government has taken a number of actions recently to stabilize the balance sheets of SCBs that include credit ceilings, adherence to stricter classification of loans and provisioning, prohibition of lending to deftiulting borrowers, suspension of accrual of interest on all NPLs and restrictions of the distribution of dividends by the SCBs. Tax Law has been clarified to allow loan-loss provisions as a normal deduction against taxable income. Last year, disciplinary measure was taken to remove top execuitives of Lao May Bank to send a signal that mismanagement will no longer be tolerated. 135. With the assistance of international financial institutions and bilateral donors, the government has taken a number of steps to improve the overall climate for the financial sector. The government has establisihed a technical committee, the Working Committee for Financial Sector Development (whose miembership includes MOF, BOL, MOJ, and CPC) with the mandate to oversee the preparation of policy reforms in-the financial sector. A vision of the Lao Financial Sector was formulated after discussions among senior policy makers to build understanding, consensus, and ownership. A Bank Restructuring Committee (BRC) was established for restructuring of SCBs. The BRC prepared draft Memoranda of Understanding with the IFIs stating the restructuring principles and strategy. To address the NPL problem and its resolution, an 31 analysis was launched to identify how to strengthen the legal and judicial underpinnings of the involuntary process. A Steering Committee and External Committee for NPLs resolutions was established. The government is also developing a voluntary process for NPLs resolution and has agreed to initial outcome targets by setting specific numbers on NPLs to be resolved and in the process of resolution within the specific timeframe of FMAC. 136. In order to assess accurately the financial situation of the SCBs, the government has commissioned audits of SCBs accounts for three years (1998, 1999 and 2000) with assistance from AusAid. To bring the SCBs up to date in terms of banking technology in the future, the government has initiated a World Bank-supported study to analyze the information technology requirements for SCBs. Similarly, with World Bank support, the government has launched the study of the social impact of SCB restructuring in order to design an adequate social safety net for redundant workers. 137. Rural and micro-finance are important for a country such as the Lao PDR where the majority of the population and the poor live in the countryside. The needs for micro-finance, as effective means for poverty alleviation, are most acute in these areas. In 1997, the government undertook a survey of the sector with UNDP support. Based on the results evidencing a large unmet demand for micro-financial services, the government piloted an ambitious project to improve awareness, sensitization, and access of the people for micro-finance. With donor support, the government has built this capacity through exposure visits to various rural and micro finance initiatives in the region. The activities in this area have been given a new momentum with the establishment of the Rural and Microfinance Committee to oversee government activities in this area and to prepare policy recommendations. With ADB support, the government has agreed to launch an operational diagnostic and a financial audit of the APB with a view to gamer experience and infornation on rural banking services and to restructure APB. Reform Measures Supported by FMAC 138. As part of FMAC preparation, the government is continuing to deepen reforms in the financial sector. By the end of March 2003, measures undertaken will be assessed to (i) avoid the deterioration of the SCBs' risk portfolio; (ii) implement its risk diversification rules; and (iii) effectuate the autonomy of SCBs. This regime shall remain in place until banks are actively engaged in their restructuring program. Furthermore, the BOL has issued (i) a set of Instructions to centralize credit decisions in SCBs' headquarters and limit individual and group exposures; and (ii) a time-bound action plan. BOL will ensure compliance with these measures. 139. The government is committed to establishing SCB autonomy. To this end, MOF has issued a Notice to SCBs that all future lending (including policy lending) be subject to commercial criteria. The Minister of Finance delegated to the SCBs' Boards of Directors to appoint Deputy Managing Directors and Branch Managers upon proposal of the Managing Directors and to allow SCBs to freely set interest rates on loans and deposits. The BOL is to prepare a time-bound action plan for implementation, monitor and ensure full implementation of this measure. * In addition, the BOL is considering an amendment to the Decree Law on Commercial Banks. This alleviates the concerns related to the permanence of Notice 0566/MOF, 32 dated March 31, 2002, on commitment to the autonomy of SCBs, as one area to be amended will precisely be on governance of SCBs to ensure consistency with the Business Law. Concerning SC]3's institutional restructuring, the government has signed a Memorandum of Understanding of Restructuring (MOUR) for each SCB which includes (i) phased capital build-up based on improved operational performance; (ii) temporary management support to SCBs in the form of international advisors; and (iii) an action plan in case SCBs do not reach performnance indicators. 140. The government is pledging to undertake several additional measures by end-March 2003 under FMAC as follow-up to the steps noted above to consolidate the reform effort. The government intends to audit the calendar year 2001 accounts of SCBs, and for the Agricultural Promotion Bank the calendar years 2000 balance sheet and 2001 accounts. 141. The government is committed to have the SCB's institutional restructuring programs launched and by March 2003 will procure the professional services of at least two banking advisors, to provide advisory services for the management of SCBs, with qualifications and experience adequate to carry out their services according to detailed terms of reference agreed. 142. Regarding non-performing loan resolution, the government requires that by end-March 2003, SCBs resolve an aggregate amount of Kip 100 billion equivalent of SCBs non-performing loans of at least ten accounts through: (i) the liquidation of non-viable companies; (ii) the restructuring of viable companies such that their debts can be fuilly serviced by their cashflows; (iii) the seizure and sale of assets to recover cash; or (iv) the exchange of the loan for cash or marketable assets. The government will also prepare an assessment that identifies ten non- performing loan accounts undergoing resolution. 143. The Lao PDR strategy is to increase access to financial services for the poor people. In consultation with MOF, BOL, and the relevant provincial authorities, and microfinance entities including Cooperative de Credit de Soutien aux Producteurs, Microfinance Project and Project de Developpement Decentralise de Phongsaly, will prepare a policy statement, an assessment and a time-bound action plan to address the implementation of a rural and microfinance reform program. Reform Measures in the Medium Term 144. Financial sector reform will continue to be pursued well beyond the current phase supported by FMAC and ADB's planned Financial Sector Program Loan III (FSPL III) to ensure that the financial services needs of a growing economy are met and also adequate attention is paid to the less well-off segments of the society. 145. The government objective is a Lao banking system with modern, sound, robust, efficient, and sustainable institutions meeting prudential standards. Banks will be cost-efficient and customer-oriented. The government envisages a competitive environment in which banks unable to comply with the law and regulations are removed, and the better banks -- whether private or state-owned -- will be allowed to thrive. 33 146. To improve further the framework for sound commercial banking and the banking environment in general, The govermnent is conunitted to implementing several measures. It will continue to build and strengthen the capacity in the supervision department of the BOL. This includes providing, in the next two years, training in accounting, regulations, on-site inspection techniques and off-site analysis with support from the IMF and the EU. To support off-site analysis, the government intends to establish adequate MIS for the supervision department to enable BOL staff to monitor the process. 147. Legal reforms for the financial sector are also on the anvil. The government plans to conduct a review of the Banking Law (Decree) in order to: (i) make it consistent with the Business Law (on corporate governance) for SCBs, (ii) increase competition outside the Vientiane area, and (iii) review capital requirements of banks. The government intends to review banking regulations with a view to bringing them into conformity with international banking standards. The government is also committed to enhancing transparency in the banking system. To this end, the government will modify Lao accounting standards to better conform with international accounting standards and will implement a program of dissemination of banking laws. The govermnent will also improve enforcement of laws governing (i) secured lending ; (ii) bankruptcy; (iii) dispute resolution; and (iv) debt recovery by enhancing the capacity of judges. 148. The planned measures for improving legal capacity of judges outlined above, in conjunction with appropriate modification of the judicial procedures, including the setting up of specialized courts for commercial dispute, will help in the recovery of NPLs. A voluntary debt resolution process will also be put in place to promote NPL resolution. To that end, a fully functional Credit Bureau will be established to improve access to creditor and debtor records. 149. In the area of rural and microfinance, the specific policy measures to create an enabling environment will be articulated under FMAC and the planned FSPL III and the government intends to implement those according to the action plan to be defined. However, the authorities have already decided that APB should become a viable market-oriented rural financial institution. 150. To ensure smooth implementation of the credit, the government intends to establish a Project Implementation Unit at MOF for the implementation of FMAC by May 2002, under the proposed Financial Management Capacity Building Credit (FMCBC). 151. To conclude, the government's impressive reform agenda and its prior actions and measures attack the triad of inefficiency (e.g., budget, SOEs, and banking sector; Figure 7) that has retarded Lao PDR's efforts at stable growth and steady poverty reduction. It addresses key structural weaknesses and thereby reduces macroeconomic vulnerability, strengthens the enabling environment for growth, and reduces poverty. 34 Figure 7 Lao PDR Reform Program: Attacking the Triad of Inefficiency Reform Objective The Budget Reform Measure * Planning * Balance recurrent and capital * Accounting & control - spending • Transparency - * Approve regulations to the Public Accounting Law *Publish the budget, off-budget SOEs expenditures * Strengthening * Prohibit new SOE's non- oversight | -. commercial lending, consolidate * Enterprise reporting, strengthen boards restructuring * Transfer ownership to MOF and * Tariff reform restructure (including EdL) * Prepare and implement tariff policies with cost recovery and transparent subsidy; rationalize regulatory bodies Banking Sector * Check risky lending * Stabilize banks * Strengthen management, * Restructure banks t~o encourage commercial credit suppor futur g h policies and improve accounting support future grovmth - sE * / L-- \ practices *Promote micro/rural practice Promote mic a -. * Achieve NPL recovery targets finance . - , .'-> . *^ . Prepare sector vision after dialogue and announce a time bound action plan to realize that vision 35 V. WORLD BANK GROUP STRATEGY A. Bank Assistance Strategy 152. The FMAC comes to the Board at the tail end of the implementation period of the current CAS (FY2000-02). As such, the FMAC involves actions that will take place during the next CAS period. The participatory phase of preparing the next CAS covering FY2003-05 is about to start. The CAS is expected to be presented to the Board, which will also discuss the government's full PRSP and the Bank-Fund Joint Staff Assessment, towards the end of FY2003. The full PRSP is an important input to the FY2003-05 CAS, and therefore the timing of the latter has been driven by the timetable for the full PRSP. 153. Summary of the FY2000-02 CAS. The last CAS (Report No.19098-LA, March 30, 1999) was prepared at a time of deteriorating macroeconomic conditions triggered by the regional economic crisis and exacerbated by mishandling of macroeconomic policy by the government. It was designed to serve as a critical instrurnent of dialogue with the government by articulating issues and outlining measures needed to restore balance and resume sustainable growth. The fundamental objective of the CAS was poverty reduction with the goal of helping the country to return to a path of sustained 6-7 percent GDP growth, improving social indicators, and graduating from the ranks of the Least Developed Countries by 2020. 154. The CAS focused on helping Lao PDR in: * Stabilizing the economy (in close collaboration with the IMF); * Deepening structural reforms in the financial sector and SOEs, improving the regulatory environment for the private sector and other sectors such as agriculture and forestry, and supporting capacity building; * Investing in the social sector, health and education; * Investing in rural development and natural resource management - including support for rural and national infrastructure and hydropower development; and, * Strengthening portfolio management. 155. To achieve the FY2000-02 CAS objectives, a program of assistance, including investment and sector adjustment operations, technical assistance credits and grants, learning and innovation loans, and adaptable program loans, and policy advice and dialogue, was proposed. Supporting analytical work and capacity building were also identified. The strengthening of portfolio management and project supervision was envisaged. 156. CAS FY2000-02 triggers. The CAS provided for three (Low-, Base-, and High-Case) lending scenarios. In 1999, Lao PDR was in the Low Case (US$50-$75 million for the three-year IDA lending). It was, however, agreed that restoration and maintenance of macroeconomic stability -- evidenced by agreement on an ESAF program (later replaced by the PRGF), for example -- along with progress on financial and legal sector reforms as well as increased per capita expenditures (in real terms) in the social sectors, would trigger a Base Case Scenario (US$125-150 million of three-year IDA lending). A High Case (with three-year IDA lending of $150-200 million) would be triggered by a deeper and more rapid pace of reforms compared to the Base 36 Case, inter alia characterized by offering some SCBs to strategic investors, privatizing SOEs, and reforrning logging arrangements. 157. Progress since the CAS FY2000-02. The government highlighted the progress made and its strategy going forward in the I-PRSP which was discussed at the Bank and Fund Boards in April 2001. The full PRSP (also known as the National Poverty Eradication Program or NPEP) is under preparation. In April 2001, the IMF approved a three-year arrangement under the PRGF. A strong stabilization program was launched to address fiscal, monetary and current account imbalances, and economic conditions have steadily improved (including the lowering of inflation from the triple-digit levels reached earlier and the stabilization of the domestic currency) over the CAS period. In February 200:2, the first performance review under the PRGF was presented to the IMF Board and release of a second tranche was approved. The economy is now growing at over 5 percent, and inflation has been contained at around 6-7 percent. Furthertnore, financial management reforms will be supported through the FMAC and required strengthening of capacity is being developed under the iFMCBC. Also, public expenditure allocations for the social sectors have been raised, signifying greater comnmitment to human development. Overall, significant progress has been made since the CAS was approved by the Board, and Lao PDR has met the triggers identified in the CAS for movement from the Low Case to the Base Case scenario. During the three year period FY2000-02, IDA lending operations are expected to total $85 million, reflecting this transition from ihe Low Case to the Base Case. 158. However, the macroeconomic stability attained remains somewhat fragile and many of the underlying causes of previous imbalances still need to be further addressed. The pace of reforrn has also often faltered. The proposed FMAC, FMCBC, and the PRFP operations, along with the IMF's PRGF program, will support the government's continuing effort and also strengthen the capacity for economic management and policy-making. The government is moving forward at a stepped-up pace with more comprehensive policy and institutional reforms supported by more intensive dialogue, analytical work, and support for preparation of a range of projects by the Bank, in addition to intensive supervision of its portfolio. The measures included in the FMAC relating to budgetary and public expenditure reforms, SCBs, SOEs, and the willingness of the government for the first time to accept an IDA credit for technical assistance, are demonstrations of political will on the one hand and, on the other, a recognition of the importance of strengthening capacity to design and implement reforms speedily. 159. The government has expressed its eagerness to create the conditions in which the proposed Nam Theun 2 (NT2) hydropower project could be successfully implemented. Preparation of this one billion dollar, thousand megawatt, private sector hydroelectric project, regained momentum in August 2000 with the signing of a tariff MOU between the developers and Thailand's Electricity Generating Authority of Thailand (EGAT). This momentum has been reinforced by the recent initialing of the key Concession and Power Purchase Agreements and the prospects of signing of formal agreements in July 2002, leading to delivery of power to Thailand in 2008. A framework for possible Bank Assistance for the Planned NT2 Project is found in Annex 5. Bank management has indicated that the Lao PDR needs to further articulate an overall development framework for poverty reduction along with clear and monitorable performance benchmark, establish a track record of performance against such benchmarks, and improve its communications with the international community, in addition to undertaking due diligence on safeguard and project quality 37 issues, before it could be in a position to consider proposing to the Board possible Bank support to the project . The government has responded positively to this challenge. 160. In addition to working on enhancing the design and implementation of its poverty reduction strategy, the government is strengthening its relationships with other partners in the international donor community, other countries in the sub-region (stemming from positive ASEAN developments), and with the international private sector (evidenced in the working relationship established between the government and Nam Theun 2 Electricity Consortium (NTEC), the developer for NT2, and with the Sepon Mining Project supported by the IFC). The government is also adopting new approaches supporting empowerment, participation and decentralization. A good example is the government's support for and ownership of the proposed IDA-financed Poverty Reduction Fund Project, which would provide a mechanism for targeting revenues to poverty-reduction activities with many decisions being made directly at the village level. 161. Progress is also being registered in the challenging area of environmentally sustainable natural resource management. The recent Bank logging survey mission in the NT2 project area found that there has been progress in more effectively controlling logging; the government is adopting measures needed to further village forestry reforms, and concrete steps (such as the establishment of the Nam Theun Watershed Management and Protection Authority) are being taken to promote conservation and sustainable environmental management. 162. Finally, the governmentfs greater attention to implementation issues is also reflected in the improved performance of the IDA portfolio. The disbursement ratio improved from 12 percent in FY2000 to 25 percent in FY2001 and is currently running at close to the same rate for FY2002. Of the nine active projects currently in the portfolio, only one still remains in problem status and the number of "at risk flags" have also diminished. The number of overdue audits have also declined. Portfolio issues are regularly reviewed and discussed with the government in the field with other donors often participating as observers and generic issues are addressed and procedures streamlined as early as possible. 163. Preview of the proposed FY2003-05 CAS. While the next CAS is being formulated in a more positive environment than the last CAS, it would be a mistake to underestimate the challenges ahead. Lao PDR is governed by a single political party with tight control over political and economic activities. The political consensus supporting the direction and pace of reforms, though strengthening, is still fragile. Capacity, both in the public and the private sector, is extremely weak. Civil society organizations of the type seen elsewhere (such as multiple political parties, local NGOs, nongovernmental media) are conspicuous by their absence or have little voice. Beginnings have been made on issues such as empowerment and participation, but these policy objectives have yet to develop deep roots. The risks of weak economic management, reluctance to address structural problems frontally, inadequate capacity at both the policy and implementation levels, and shortcomings in governance, are significant risks that need to be addressed. 164. In the context described above, it is important that the government articulates a medium- term development vision, designs and implements a comprehensive reform program that underpins such a vision, and establishes clear and monitorable performance indicators that enable 38 measurement of progress. The government proposes to use the NPEP, now under preparation, to serve this purpose. The NPEP, which would be reviewed by the National Assembly, would also serve as the basis for dialogue and communication with the international community. This would also be the program with which the Bank would align its own assistance strategy in the CAS in coordination with other donors. As done previously, the next CAS will couch the Bank's assistance program within various scenarios. Details, including explicit triggers and lending levels, will be formulated at that time after a participatory and consultative process. B. Partnerships with Other Donors and Agencies 165. International Monetary Fund. After a hiatus of almost five years, the Lao authorities requested IMF assistance. On April 23, 2001, the IMF approved in principle a three-year arrangement for Lao PDR under the PRGF for about US$40.2 million equivalent to support the government's strategy to strerLgthen macroeconomic stability and reduce poverty through growth with equity (Annex 3). The IMF also approved and released the first tranche of $5.7 million equivalent under the PRGF at the same time. Also in April 2001, the IMF and the Bank issued the Joint Staff Assessment of the government's I-PRSP. 166. The first review of the performance of the Lao economy under the PRGF was presented to the IMF Board in February 2002 following some delay. The IMF Board approved the release of a second tranche of $5.6 million equivalent, signaling its continuing support for the government's steady effort in strengthening macroeconomic stability and laying the basis for further structural reforms. IDA will continue 1o collaborate closely and coordinate activities with the IMF staff. Staff of the two institutions prepared joint assessments of the PRSP. IDA has been coordinating with the IMF on the content of the FMAC and PRGF to ensure that these instruments complement one another. The proposed FNMAC has to be seen in this conducive setting. 167. Asian Development Bank. The ADB has formulated its new Country Strategy and Program with considerable consultations with stakeholders in 2001. This CSP will provide guidance for ADB activities in Lao PDR for the next five years. Continuing its theme of a shift in assistance toward poverty reduction, ADB will support the Lao PDR's efforts to address poverty and to undertake poverty reduction measures with broadened community participation and opportunities. ADB focus in ]Lao PDR will be on four priorities: rural development and market linkages, human resource development, sustainable environmental management, and private sector development and regional integration. 168. Current and future ADB lending and technical assistance programs will focus on efforts to reduce poverty, including direct poverty intervention projects and pro-poor growth projects. In 2001, ADB commitments for Lao PDR amounted to $65 million in 2001 ($60.5 million in 2000), and $39.8 million ($51 million in 2000) was disbursed from 18 on-going projects. 169. The Bank is coordinat:ing with the ADB in activities to support the financial sector, education, health, rural development strategy, forestry, energy and transport sectors. Specifically, in the financial sector, ADB and the Bank are coordinating to ensure complementarity of instruments between the proposed FMAC and ADB's up-coming Financial Sector Program Loan. Technical assistance and capaciity building instruments currently include ADB's PPTA grants. 39 170. Japan Bank for International Cooperation (JBIC) has been supporting Lao PDR in the power sector. JBIC has provided ODA loans to tap hydroelectric power projects that could help utilize the abundant hydroelectric power resources of the country. Total accumulated commitments from three ODA loans amounted to 9.1 billion yen. The Bank is coordinating efforts on project financing in the energy sector. Japan also provides the largest support through JICA. Currently, JICA is finalizing a macro-economic intellectual support project and the IFIs are coordinating with JICA in this project. 171. Bilateral donors and other international organizations. The Bank is maintaining close working relationships with bilateral donors: Australia (Land Titling, Audit of the SCBs), Norway and Switzerland (education); Belgium (health), and Finland and Sweden (forestry). The Bank also coordinates with other international organizations: UNICEF, UJNDP, and WHO, as well as EU. VI. THE PROPOSED FINANCIAL MANAGEMENT ADJUSTMENT CREDIT A. Rationale for the Proposed Program Financing Needs 172. The Lao PDR's financing requirements for 2002-04 are currently estimated to be $75 million. It is expected that this financing gap will be met by disbursements under the IMF's PRGF and support from the Bank with the proposed operation and commitments from other donors (Table 1). Table 1. Financing Requirements, 2001-2004 (US$ million) Prel. Projected 2001 2002 2003 2004 Financing needs 200 222 268 368 - Current account deficit 108 115 123 233 - Medium and long terrn amortization 39 43 50 52 - Others 48 34 48 43 - Reserve requirements 5 30 47 40 Financing resources 200 222 268 368 - Grants 23 54 70 82 - Long-term borrowing 104 106 125 118 - Direct foreign investment 33 41 60 168 - Other inflows 40 1 -22 -20 - Additionalfinancing needs 20 35 20 Source: Derived from IMF data, May 2002. A Robust Reform Agenda Consistent with I-PRSP 173. The government has sought the advice of the Bank, the ADB, and the IMF for designing a comprehensive reform program to address the various dimensions of the structural imbalance. This strategy was spelled out in the I-PRSP discussed at the Boards of the Bank and the IMF in April 2001. The government intends to undertake a comprehensive restructuring of the economy 40 to address sources of financial imbalances, in the budget, in the SOE sector and in the banking system. Such restructuring will give confidence to investors that Lao PDR will be able to utilize the substantial financial flows associated with the planned NT2 investments and the expected increase in revenues following implementation of a rational forestry policy. Capacity Building/Technicai' Assistance Support 174. With critical needs in economic and financial sector management and a relatively underdeveloped human capital base and weak institutions, the Lao PDR priority is to build capacity and to support instiitutional capacity building for the successful implementation of the government's reform program. The required technical assistance project is being provided to support the government in implementing reforms (Annex 2). Consistency with the CAS 175. Until early 2001, the CAS for the Lao PDR was in the Low Case scenario (out of three which were envisaged for FY2000-02). These three scenarios were based on the pace of macroeconomic stabilization measures; pace, depth, and coverage of structural reforms and institutional development; progress on project implementation and improving the quality of the portfolio; and, the absorptive: capacity of the economy. The Base Case scenario has been triggered by the restoration and maintenance of macroeconomic stability. Now that macroeconomic stability has been restored and a PRGF with the IMF is in place, the Bank program, as stipulated in the CAS, can move to the Base Case scenario. B. The FMAC Prograinn 176. The proposed FMAC is a two-tranche operation supporting the following policy actions by the government. 177. Actions Taken by the Lao PDR Public Sector Reform Budget planning: * Issued a Decree on Public Investment Management requiring that PIP' submissions for new public projects in excess of 1 billion kip in the FY2002/03 budget include estimates of associated recurrent costs during operating period; Budget transparency * Published in the Official Gazette the FY2000/01 outcome and the FY2001/02 budget with classification by ministry/province and service with a separate identification of the distinct central ministry and provincial expenditures by sector and expenditure category; 41 Natural resources management * MAF approved the key Principles of Village Participation in Sustainable Management of Production Forests: PMO issued a Decree on Sustainable Management of Production Forest Area and superceding relevant articles of existing orders; SOE Reform Strengthen oversight of financial and operational performance of SOEs * Issued a Decree: (i) requiring that financial and operational performance of all SOEs at the ministerial, provincial and district levels be reported to MOF; (ii) specifying regular reporting requirements; (iii) stating that new SOEs to be established are those which are specifically approved by the Prime Minister, and which will provide essential services which cannot currently be provided by the private sector or by budgetary means; (iv) requiring MOF to publish in the Official Gazette the financial performance of SOEs on a quarterly basis; and (v) requiring the privatization or liquidation of those SOEs which have produced the greatest operating losses, or which otherwise fail to comply with this Decree; * The MOF and BOL prohibited non-commercial policy lending to SOEs, and all lending to SOEs with outstanding non-performing loans; Enterprise Restructuring * Transferred ownership of the largest loss-making SOE, BPKP, to the Ministry of Finance for corporate restructuring in cooperation with the Office of the Prime Minister; Tariff Reform * Electricity: implemented a new electricity tariff policy; * Water: prepared a white paper on tariff policy for the water sector; * Transport and Telecommunication: launched studies on tariff structure and started the preparation of tariff policies for Lao Aviation and Lao Telecommunication; Financial Sector Reform Financial sector reform to promote macroeconomic stability * BOL issued (i) an Instruction to stop the growth of SCBs' risk portfolio if the ratio of NPLs to credit risk portfolio (net of provisions) exceeds 15 percent of loans made after December 31, 1999 and (ii) a time-bound action plan for implementation; 42 * BOL issued (i) an Instruction to centralize credit decisions in SCBs headquarters and limit individual and group exposures and (ii) a time-bound action plan for implementation; Banking reforms to su)port broad-based economic growth Framework for Sound Banking * Borrower committed to the autonomy of SCBs: Minister of Finance issued a Notice to SCBs requiring that all future lending (including policy lending) be subject to commercial criteria; Minister of Finance issued a delegation of his powers to appoint deputy Managing I)irectors and Branch Managers, to the SCBs Board of Directors, so that those managers are appointed by the Boards upon proposal of the Managing Directors; * Minister of Finance issued a Notice to SCBs to allow them to set freely interest rates on loans and deposits and BOL prepared a time-bound action plan for implementation; Institutional restructuring * MOF/BOL/SCBs sSigned MOUR for each SCB which includes (i) phased capital build- up based on improved operational performance; (ii) temporary management support to SCBs in the form of international advisors; and, (iii) an action plan in case SCBs do not reach performance indicators; 178. BOARD CONDITIOTN (met) Project Implementation Unit Proiect management * Establishment of a Project Implementation Unit at the Ministry of Finance, satisfactory to the Association, :for implementation of the FMAC and the FMCBC in May 2002; 179. EFFECTIVENESS CONDITION Public Sector Reform Budzet accounting and control * Adopt a Regulatiorn of the Minister of Finance on Public Accounting and Procedures for the implementation of Decree No. 20/PM on the General Regulation of Public Accounting, dated February 18, 1993, satisfactory to the Association. 43 180. Actions for the Release of the Second Tranche 181. By the release date of the second tranche of the FMAC, the Lao PDR will need to have accomplished the following: Public Sector Reform Budget planning 1. completed, through CPC, an assessment, in a manner and substance satisfactory to the Association, recurrent cost estimates associated with new projects in excess of 1 billion kip; Budget accounting and control 2. prepared, through the Ministry of Finance, in a manner and substance satisfactory to the Association, a strategy for the reform of the Department of Treasury; Budget transparency 3. established a Procurement Monitoring Office within the Ministry of Finance, headed by a qualified and experienced Director and assigned with adequate staff and resources in a manner and substance satisfactory to the Association; Natural resources management 4. issued, through the Ministry of Agriculture and Forestry, in a manner and substance satisfactory to the Association, Regulations amending the Implementing Regulations on National Biodiversity Conservation Areas, Regulation No. 0524/AF.2001, (June 7, 2001), inter alia, to clarify the definitions and procedures governing zoning and land use within said Conservation Areas, and eliminate inconsistencies in respect of protected species listings; 5. adopted, through the Ministry of Agriculture and Forestry, Implementing Regulations on Sustainable Forestry Management, satisfactory to the Association, which includes specific provisions to enable the involvement of local communities in production forest management; SOE Reform Strengthen oversight of financial and operational performance of SOEs 6. issued, through MOF, Implementing Regulations to the Decree on Management of State-Invested Enterprises, Decree No.54/PM, dated May 9, 2002, satisfactory to the Association. 7. prepared and furnished to the Association in a manner and substance satisfactory to the Association, through the Ministry of Finance, an assessment of the financial performance of SOEs, and under criteria consistent with technical audit standards satisfactory to the Association, identified non-performing SOEs requiring: (i) performance improvement; (ii) strengthening of financial reporting; or (iii) bringing them to the point of sale or liquidation, as the case may be; 44 Enterprise restructurilig 8. adopted a timebound restructuring plan, satisfactory to the Association, for BPKP, Nam Papa Lao, Pharmaceuitical Factory No. 3, and Lao Aviation, and implemented all of the actions under said restructuring plan, which in accordance with such time-bound restructuring plan are due within seven (7) calendar days prior to the exchange of views under Section 2.02(d) of the Development Credit Agreement; 9. executed, through MOF, memoranda of understanding for the development and execution of time-bound restructuring plans with DAFI and four loss-making SOEs which have outstanding, non-performing loans in excess of one billion, in a manner and substance satisfactory to the Association; 10. completed the financial restructuring of EdL, in a manner and substance satisfactory to the Association, including the revaluation of assets, amendment of selected subsidiary loan agreements, and debt 1:o equity conversions; Tariff reform 11. adopted and published tariff policies and structures incorporating: (i) cost recovery principles; and (ii) directed and transparent subsidies, if any, for the potable water supply, telecommunications sector and Lao Aviation; and adopted a timebound action plan for the implementation of sai.d tariff policies, all in a manner and substance satisfactory to the Association; Financial Sector Reform Stabilization of financial institutions to support macroeconomic stability 12. prepared an assessment, in a manner and substance satisfactory to the Association, that assesses the measures undertaken by the Borrower to: (i) avoid the deterioration of the SCBs' risk portfolio; (ii) implement its risk diversification rules; and (iii) effectuate the autonomy of SCBs; 13. audited, in a manner and substance satisfactory to the Association, the calendar year 2001 accounts of SCBs, and for the Agricultural Promotion Bank the calendar year 2000 balance sheet and 2001 accounts; Strengthening financial institutions to support economic growth SCBs Institutional Restructuring 14. procured the professional services of at least two banking advisors, to provide advisory services for the management of SCBs, with qualifications and experience adequate to carry out their services detailed in terms of reference satisfactory to the Association; Non Performing Loan Resolution 15. resolved an aggregate amount of Kip 100 billion equivalent of SCBs non-performing loans of at least ten accounts, in a manner and substance satisfactory to the Association, through: (i) the liquidation of non-viable companies; (ii) the restructuring of viable companies such that their debts can be fully serviced by their cashflows; (iii) the seizure and sale of assets to recover cash; or (iv) the exchange of the loan for cash or marketable assets; 45 16. prepared an assessment, in a manner and substance satisfactory to the Association, that identifies ten non-performing loan accounts undergoing resolution; and, Increasing access to financial services by the poor 17. prepared, in consultation with MOF, BOL, and the relevant provincial authorities and microfmance entities including Cooperative de Credit de Soutien aux Producteurs, Microfinance Project and Project de Developpement Decentralise de Phongsaly, a policy statement, an assessment, and a timebound action plan to address the implementation of a rural and microfinance reform program, all in a manner and substance satisfactory to the Association. 182. Performance Indicators. The macroeconomic and FMAC program performance indicators are presented in Box 3 and Box 4, respectively. Box 3: Macroeconomic Performance Indicators 1. Inflation has been in single digit levels for twelve months prior to exchange of views. 2. A stable foreign exchange rate has been maintained. 3. The fiscal deficit for 2001/02 was less than five percent of GDP and the fiscal deficit for 2002/03 has been programmed at about five percent of GDP. 4. Domestic bank financing of the fiscal deficit has been less than 0.5 percent of GDP in the twelve months prior to the exchange of views. 5. Education expenditure for 2001/02 was at least 10 percent of the total budget and education expenditure programmed for 2002/03 was at least 12 percent of the total budget. 6. Extemal financing program for the balance of payments for 2002/03 has been put in place. 7. The budgeted expenditures on power projects in 2002/03 were in line with the medium- term Power Development Plan. 46 Box 4: FMAC Program Performance Indicators Public Sector Perfor ance Indicators A. Expenditure shares for health and education meet or exceeded in FY 2001/02 budget outturn, and shares in budget plan for FY 2002/03 are increased in line with the PRSP. B. Unauthorized treasury accounts are identified and closed. C. The FY 2002/03 budget plan and the FY 2001/02 outcome are published with full sector detail. II. SOE Reform Indicators A. At least 60 percent of all SOEs have provided quarterly reports to MOF, consistent with guidelines issued by MOF, for quarters ending December 31, 2002 and March 30, 2003. B. As of March 30, 2003 ihe total number of state-owned enterprises is no greater than the total number as of March 30, 2002. C. The number of business units in the BPKP has been reduced no greater than 9 through liquidation, merger and/or consolidation by March 30, 2003. D. Domestic tariffs for Lao Aviation are the higher of $0.20/seat/kilometer or the tariff required to achieve full recovery of all operating, maintenance and depreciation costs. HI. Financial Sector Performance Indicators A. The level of non-performing loans (NPLs) in state-owned commercial banks must be kep below the level as of December 31, 2001: 1. BCEL - below 23 percent; 2. Lane Xang Bank - lbelow 30 percent; and 3. Lao May Bank - below 73 percent. (Loans signed after January 1, 2000. NPL classified as per Regulation BOL No. 8.) B. No new non-commercial loans. Non-commercial loans are defined as loans made (i) without ensuring that the borrower's cashflow is sufficient to repay; (ii) pricing at below market interest rate; or (iii) by-passing recently improved credit procedures. C. Kip 100 billion equivalent of SCBs' NPLs will be resolved. 47 183. Medium-Term Follow-up Actions. The proposed FMAC helps launch the reform program in the right direction to meet the objectives listed under the program actions above. These objectives are consistent with the I-PRSP. However, government commitment and donor support beyond the time frame of FMAC will be critical to consolidate and deepen reform in the medium term. Such medium term reform program will be reflected in the full PRSP expected to be completed by March 2003. The CAS (under-preparation) will spell out the continuity of Bank's engagement in the medium term reform program via both technical assistance as well as possible Poverty Reduction Credits to support further deepening of the reform program. The medium term actions in each of the FMAC supported areas are listed in Annex 4. C. Implementation and Monitoring 184. The government is planning to establish a high level inter-ministerial coordination committee to monitor progress and implementation of reforms to ensure that there is adequate participation from all relevant quarters. 185. Monitoring arrangements. The government, with the assistance of the Bank's country office, will strengthen management information systems for SOEs and for all public spending, and for the banking system to ensure adequate monitoring of the activities supported by the project. 186. Monitoring and supervision of this proposed operation will take place in close collaboration with the IMF. In order to facilitate this task, the government is to provide formal periodic reports to the Bank on the progress made in each component of the program. In addition, joint periodic review meetings are proposed to assess progress more frequently and take special actions where necessary. D. Credit Administration Borrower and Credit Amount 187. The Borrower is the Lao People's Democratic Republic. This operation is a two-tranche Credit of US$ 17 million equivalent. The first tranche of SDR 5.6 million (US$ 7.0 million equivalent) would be made available upon credit effectiveness. The second tranche of SDR 7.9 million (US $ 10.0 million equivalent) would be available for disbursement upon fulfillment of the Milestones end-March 2003 conditions. The closing date of the Credit is May 31, 2003. 188. The project will be managed by the MOF under the direct supervision of the Minister of Finance. To assist the Minister, a day-by-day project implementation unit has been set up under the proposed FMCBC and included officials from MOF's specific units, the Budget Department, the Department of Treasury, and the State Asset Department, as well as representatives from the Ministry of Agriculture and Forestry. The project will be under the overall guidance of the Prime Minister's Office, the Committee for Planning and Cooperation, and the Bank of Lao PDR. 48 Disbursement, Reporting and Auditing Arrangements 189. The Credit will folllow IDA's simplified disbursement procedures for adjustment operations, '5 and the Credit proceeds will be disbursed in compliance with the stipulated release conditions. Various measures have been taken to ensure that the overall fiduciary policies and institutions are adequate to proceed with support from IDA and other development partners. Disbursement will not be linked to any specific purchases and no procurement requirements will have to be satisfied. Deposit Account 190. The Borrower will open and maintain a dedicated Deposit Account in US dollars in the BOL into which the proceeds of the Credit will be disbursed for the Borrower's use once the Credit is approved by the Board. Disbursements from the Deposit Account will follow normal government policies and procedures. If after deposit in the Deposit Account the proceeds of the Credit or any part thereof are used for ineligible purposes, as defined in the Development Credit Agreement, the Bank will requtire the Borrower to either return that amount to the Deposit Account to be used for eligible purposes, or refund the amount directly to IDA. The BOL, on behalf of the government, will maintain an appropriate accounting system in accordance with generally acceptable accounting principles. The Deposit Account of BOL will be independently audited each year on terms of reference already agreed with IDA. 191. All US dollar disbursemnents out of the Deposit Account will be executed by the Lao PDR in accordance with its existing rules and should be monitorable by the World Bank. Since BOL does not import directly, it will: sell this foreign currency to commercial banks that will execute the imports. These banks in turn, would open separate deposit accounts from which they will finance the eligible imports and maintain those accounts for review by the BOL. 192. Through the BOL the Borrower will: (i) report the exact sum received illto the Deposit Account; (ii) ensure that all withdrawals are for "eligible" expenditures; (iii) indicate to IDA details of the account of the M/[OF which is part of the consolidated fund of the treasury to which the kip equivalent of the Crediit proceeds will be credited; and, (iv) submit a report on receipts and disbursements for the Deposit Account. 193. The processes and controls described above are intended to provide assurance that IDA funds have arrived at their intended destination and are being used for their intended purposes, and are subject to the Borrowers' rules and regulations. Country Financial Accountability Assessment (CFAA) 194. The CFAA has been prepared by the Bank and the draft was shared with the authorities in early 2002. Its findings also serve as input into the draft Public Expenditure Review which was discussed with the government in February-March 2002. 15 Operational Memorandum: Simpliifying Disbursements under Structural and Sectoral Adjustment Loans, February 8, 1996. 49 195. The overall fiduciary risk in Lao PDR is considered to be high despite the fact that there are elaborate built-in controls within the government financial management system. There is insufficient transparency related to public finances and the general attitude towards fiscal discipline is not strong. 16 These weaknesses are compounded by an inadequate awareness of modem practices of internal control in the public sector. While an elaborate control system is in place, involving many pre-approval and checking processes, it needs to be made more effective. The government's decentralization initiative needs to be supported with a sufficiently robust institutional framework that clearly defines the new responsibilities at lower levels. Technical capacity of staff at these levels needs to be strengthened. The oversight functions and the National Auditor's Office need improvement. To address these deficiencies, the government has agreed to implement several recommendations of the Public Expenditure Review and CFAA. The proposed FMCBC as well as the government initiative supported by ADB are expected to bring the fiduciary risk to an acceptable level. Procurement 196. The draft Country Procurement Assessment Report (CPAR), prepared in March 2002, reviews the overall efficiency of procurement processes in the Lao PDR and specifically the efficiency of procurement on Bank-assisted projects. It also develops an action plan to address areas that need to be strengthened. The draft CPAR made a series of recommendations for the country's procurement system, the most critical of which are highlighted as follows. The government's PrMO needs to be made functional as soon as possible to play the pivotal role in procurement reforms, providing monitoring of country-wide procurement activities and playing an important role in delivering training programs. The PrMO, once functional, will serve as a procurement resource center to promote an improved dialogue between the government and private project developers to assist in removing bureaucratic bottlenecks to promoting the continued development of the private sector. To improve the transparency of procurement, the government will need to reflect best international practice in its procurement policies. E. Environmental Assessment 197. The proposed FMAC is a structural adjustment credit in support of a collection of reform and policy support activities. In accordance with Bank's environment policies (OP/BP 4.01), this operation is classified as Category C. With its low level of economic development and one of the lowest population densities in the East Asia region, environment concerns in the Lao PDR center mainly on rural and natural resources management issues. 198. The government is developing a regulatory framework for environmental assessment, and standards and compliance monitoring, but additional work will still be needed to improve this framework and to strengthen implementation capacity. The government of the Lao PDR is committed to undertaking a broad program of environmental capacity building, institutional strengthening, environmental and land use planning as well as physical investment projects addressing environmental issues. Progress in these matters is also coming through preparation for 16 Based on the set of standards for assessment of transparency as a component of public financial accountability in the IMF Code of Good Practices on Fiscal Transparency (March 2001). 50 the proposed Sustainable Forestry, Nam Theun 2 and Nam Theun Social and Environment operations. 199. A high national priority has been reduction of shifting cultivation practices as part of efforts to reduce deforestation and forest degradation. The government's priority has been the development of irrigated alteniatives to slash-and-bum practices, but there may be greater promise in developing sustainable rainfed upland fanming practice, more in line with traditional practices and technology. The government is working with both the Bank and other donors on alternative agricultural development projects and strategies aimed at reducing environmental degradation related to agricultural production. F. Benefits and Risks Benefits 200. The expected result of the FMAC is the strengthening of the structures of the economy such that: * Greater fiscal transparency and accountability is achieved, with better balance in budget spending; * Increased budgetary resources are available for poverty reduction; * SOEs (including EdL in the power sector) are more accountable within a stronger regulatory framework and manage financial risks prudently, which would prepare them for privatization down the road; * SCBs meet prudential regulations and therefore do not threaten to macro-stability and future economic growth; * Rural and microfinance support poverty reduction in the rural areas where most of the population lives; and, * Incentives are in place for participatory management of forestry resources, improved monitoring, and rationalization of the "cut" rate contribute to government revenues and enhance income at the village level. 201. The structural improvements collectively will contribute to additional benefits as reforms are pursued in the mediuim term: - Lao PDR will avoid the accumulation of contingent liabilities that result in periodic crises leading to a severe loss of investor confidence and curtailment of social services and safety nets. - Lao PDR's system of financial flows will have been streamlined and will be more transparent, giving confidence that large potential investments in the energy sector will yield economy-wide benefits in terms of income growth and poverty reduction. 51 Risks 202. The key risks are: * Insufficient political will to complete reforms; * Lack of capacity and weak legal/administrative incentives to improve performance; * Possible political backlash from electricity tariff and other SOE price liberalization; and * Abandonment of reforms as difficulties accumulate. 203. Efforts to mitigate the risks: - Recent government actions reflect a new commitment to reform. These include the removal of top management of an SCB for poor performance, the agreement to hire external advisors in SCBs to prepare for restructuring, and significantly, the resale of Lao Beer back to the private sector. - Disparate SOEs are being collected under the umbrella of the Prime Minister's Office. A dynamic, reform-minded minister has been appointed to champion reform. The largest SOE, BPKP, is under restructuring and will have a significant demonstration effect for restructuring other large problem SOEs. - The technical assistance operation, Financial Management Capacity Building Credit (FMCBC) that will be presented to the Board at the same time with FMAC, is expected to build capacity by aiming to change the mindset at the working level, which will generate support for reform within the system. Government's willingness to borrow for technical assistance, given extreme reluctance in the past, is a good indication of a more proactive stance on capacity building. - FMAC requires the government to implement tough legislative, regulatory and institutional measures in a number of key commanding heights of the economy. This momentum will be difficult to reverse given the PRSP process to which the authorities are committed that will ensure continued monitoring and engagement to stay the reform course. - Key players within the government, (i.e., the Prime Minister, the Minister of Finance and others heading the key line ministries), have been engaged in a long process of dialogue and they have fully endorsed the reform program. On another level, a series of workshops and seminars have been held for mid-level civil servants to explain reform objectives and their benefits, to gamer wider support. - The operation has been prepared in close cooperation with the IMF, the ADB, and major bilateral donors, which has helped avoid conflicts that create the room for reform slippage. * Despite these mitigating factors, risks of poor performance are substantial and need to be monitored. 52 VII. RECOMMENDATION 204. I am satisfied that the proposed credit would comply with the Articles of Agreements of the Association and I recommend that the Executive Directors approve it. James D. Wolfensohn President by Shengman Zhang Washington, D.C. May 28, 2002 Attachments 53 ANNEX 1 - LAO PDR -- FMAC The Lao Banking and Financial Sector The Lao banking sector is small in absolute terms, with total assets of approximately US$400 million. It is also relatively small when compared with the size of the Lao economy: the ratio of the banking system's total assets to GDP is about one-fourth. 'This ratio is particularly low for an economy with a non-diversified financial system and is evidence of a system in an early stage of development. State-owned commercial banks (SCBs) dominate the market, holding more than two- thirds of the banking system's total assets. The three largest banks (Banque pour le Commerce Exterieur Lao- BCEL, Lao May, and Lane Xang) are fully owned by the government. BCEL maintains a dominant position, accounting for approximately half of total deposits and almost 40 percent of total loans in the system. The main characteristics of deposits (Kip 1.5 trillion or US$193 million equivalent2) are the following: overwhelmingly (a) from urban areas, (b) in foreign currencies and (c) in State-Owned Banks. Deposits represented 14 percent of GDP. As of September 1999, loans constituted the main item in the consolidated balance sheet but only accounting for only 33 percent of total banks' assets. The consolidated SCBs loan-to-deposit ratio stood at a low 20 percent at year end 1999. The share of private sector was about 53 percent of total loans while the public sector3 was 47 percent. At year-end 1999, 75 percent of bank loans were denominated in foreign currencies. The Agricultural Promotion Bank (APB) is the only formal institution providing financial services of any significance to the rural households4. APB channels subsidies through reduced interest rates. But APB is also an agriculture promoting agency and serves as a "super-coop" for agricultural inputs and equipment by importing and providing fertilizers, hand tractors and equipment to borrowers through lending in kind. The Lao banking system enjoys a certain degree of openness. There are three joint- venture banks (one private, one mixed and one jointly owned by Lao PDR and Vietnam), seven branches of foreign banks (six Thai and one Malaysian), and a foreign private bank representative office. Major clients of foreign banks are foreign companies or subsidiaries and affiliates of foreign companies. Given the current economic environment, foreign branch activities have essentially been funding the working capital of Thai and Malaysian manufacturing and trading firms operating in the Lao PDR. l This summary is based on the paper, "The Banking and Financial Sector of Lao PDR: Financial Sector Note," by Bank of Lao PDR, World Bank, and ADB, May 2002. 2 End of December 1999 at Kip/US$ rate of 7,600. 3Public sector comprises of Government entities at the national, provincial and municipal levels, companies that are state-owned, joint ventures with the Govemment and state-connected enterprises (including those closely identified with the Govemment and undertaking projects for the Government). There appears to be some inconsistencies between the banking accounting procedures and the above definition of public sector enterprises as the monetary survey indicates that only 1/3 of credit goes to public enterprises. 4 APB remains a very little known institution which claims to hold about 100,000 accounts. ANNEX 1 Page 2 of 2 There are only a few formal non-bank financial institutions in Lao PDR. There is one full fledged insurance company and recently a second one entered the market in selected segments; the social security system is still in its infancy, with no accumulated financial surpluses. The microfinance system comprises five types of suppliers. The APB is the largest supplier of micro-loans and charges low (highly subsidized) interest rates. There are an estimated 1,600 donor fuinded Village Revolving Funds (VRFs) providing microfinance services, mostly on a subsidized basis; institutional sustainability is almost never an objective. The Lane Xang Bank, one of the three SCBs, also started to provide micro- loans (under 30 million kips). Only three emerging MFIs (still projects), which target the poor, seek financial sustainability. Money lenders lend at rates averaging 20% per month. Assessment of The Current State of the Lao Financial System The formal banking and financial sector has a limited outreach. The Lao banking system is characterized by a marked geographical concentration in banking services in Vientiane (capital city) and in the five "larger" cities. It is estimated that less than 10 percent of the population has access to ihe banking system. Banking services provided are poor; for example, statements of individual accounts are not provided readily and regularly. The microfinance industry's outreach is also limited as it only started to develop in the last four years. Estimates show that only 25 percent of potential micro-borrowers and potential micro-depositors have access to micro-financial services. The formal system is insolvent to a large extent. Four major banks holding two-thirds of the system's assets are inm,olvent (but generally liquid) since 60 percent of loans, on average, are nonperforming. These institutions hold almost 80 percent of total deposits. The SCBs capital requirements stood at approximately Kip 700 Billion5 (US$80 million) to strictly meet the Lao regulation (8 percent Capital Adequacy Ratio). In a small and concentrated economy such as the Lao PDR, the capital adequacy ratio should be higher than 8 percent to ensure that the banking system would not be wiped out after the first economic downturn. 5Source: KPMG Audit Report datcd November 2001. Figures as June 30, 2001 and I US$ = 8,750 Kip. ANNEX 2 - LAO PDR -- FMAC Financial Management Capacity Building Credit The proposed credit will focus on strengthening the government capacity in undertaking the reform program under the Bank's proposed FMAC. Capacity building activities would draw on recommendations from donors including ADB and IMF. Output will be a detailed capacity building partnership program between the government and donors. The proposed credit would support the reform objectives and long-term development of institutional capacity, through technical assistance, training programs and system development in selected government agencies., aiming for a comprehensive framework for consolidating, and providing a strategic focus in, capacity building activities in the Lao PDR. Objective The central objective of the project is to provide technical assistance and training programs to support the development of institutional capacity to assist in the successful implementation of the governments reform program. The project also aims to provide a medium-term framework for Bank's assistance. The time frame of the proposed Credit would provide continuity to the reform program particularly in institutional strengthening. At the same time, the proposed Credit is envisaged to provide timely and flexible support to facilitate the implementation of the reform program. Components The credit will focus on capacity building activities in the following areas: * Financial Sector Reform: (i) stabilize the financial condition of the state-owned commercial banks (SOCBs); (ii) strengthen the SOCBs to support broad-based economic growth; and (iii) enhance micro/rural finance for poverty alleviation; * Public Expenditure Reform: (i) improve budget planning, (ii) streamline budget execution and control, and (iii) make the budget process more transparent; increase awareness in public sector of internal control measures both at federal and provincial levels through adoption of international public sector accounting and auditing standards and establishing internal audit functions in line ministries; Strengthen oversight function of National Audit Office to mitigate fiduciary risk in government through conducting comprehensive review of oversight bodies. * State-owned Enterprises Development: (i) strengthen oversight of financial and operational performance of SOEs, (ii) restructure selected enterprises, and (iii) establish tariff policies reflecting cost recovery; establish regulatory framework in infrastructure sectors. Implementation The project design calls for a centrally located implementation unit which would have a broad overview and mandate. The implementation responsibility will be located within the MOF in the form of a Project Implementation Unit (PIU). The monitoring and evaluation will be carried out jointly with the government and the participating donors. ANNEX 3 - LAO PDR -- FMAC IMF's Poverty Reduction and Growth Facility - Program Summary. In April 2001, the IMF approved in principle a three-year arrangement for Lao PDR under the PRGF for about US$40.2 million equivalent to support the government to strengthen macroeconomic stability and reducing poverty. The IMF released the first tranche under the PRGF of $5.7 million equivalent in April 2001. The second tranche of $5.6 million equivalent was approved by the IMF Board in February 2002, following a satisfactory review of performance in the first year o0f the PRGF arrangement. The PRGF is helping the Lao E'DR to build on recent gains in macroeconomic stabilization. Sustained macroeconomic stability and higher growth with equity are to be the basis for poverty reduction program. GDP growth in 2002 is projected at 5 percent (5.2 percent in 2001). Credit restraints by the central bank a%nd state-owned commercial banks (SOCBs) and a prudent fiscal stance are being pursued by the authorities so as to maintain the downward pressure on inflation. Credit growth of the SOCBs will be sharply reduced to 18 percent in 2002, concurrently supporting better loan quality. The authorities will manage a flexible exchange rate regime with the margin between the banks and the parallel markets rates to be kept under 2 percent. Exchange system controls would continue to be eased. On thefiscal side, the overall budget deficit will be kept at about 5 percent of GDP for the period 2000/01-2002/03. External concessional financing will be relied upon to finance this deficit while avoiding domestic bank 1inancing. To increase revenue, reforms of the tax administration included focusing on large tax lpayers in preparation for the VAT to be introduced in 2003. Additional revenues would be lfor social spending, including rural development. Improvement of the treasury system, fiscal reporting, and accountability would be expected to render public expenditure management more efficient. For the banking sector, PRGF provide for reforms in recapitalizing the weak SOCBs conditioned upon improved performance. Other features include enhanced governance, implementation of a standard accounting framework, loan classification, and provisioning requirements. SOCB- directed lending is to be phased out. In the enterprise sector, the authorities will initially focus on avoiding losses in key large SOEs through price adjustments and develop more comprehensive reforms during the first year of the program. Measures to promote private sector development will also be formulated. Trade reforms will focus on the implementation of AFTA commitments, including removal of quantitative restrictions and lowering of tariffs for AFTA members. The IMF review rated the performance of the Lao economy during the first year of the PRGF as satisfactory. There was some rmoderate slowing of the GDP growth to about 5 percent but inflation remained at about 7 percent in 2001. The authorities have undertaken actions to improve revenue administration. ANNEX 4 - LAO PDR -- FMAC Longer Term Reform Actions beyond the Timeframe of FMAC Public Sector Component Budget Planning * Improve the systems for revenue estimation and establish track record that reverses the currently persistent pattern of revenue shortfalls and subsequent ad hoc expenditure cuts. * Develop better unit cost measures for major expenditure programs including health and education to support more realistic bottom-up estimation of the costs of achieving plan goals. * Develop mechanisms for judging individual investment proposals on their merits in the budget preparation process (including competing against recurrent spending proposals). * Improve the systems for monitoring PIP expenditures and align the PIP expenditure classification systems at CPC with those of MOF. Budget Accounting and Control * Revise the budget classification to allow identification of expenditures by ministry/province, service, program and item. * Refine COA through eliminating redundant spending items, and adopt a simplified COA for provinces/districts. * Harmonize and unify coding for budget classification and COA. * Extend MOF/ADB pilot computer system to all line ministries and major provinces following revision of budget classification. * Improve the systems of monitoring of PIP expenditures and align the system of classification of PIP expenditures with that of MOF for better expenditure monitoring. * Extend budget classification to program level. * Rationalize treasury accounts in banking system; reduce number and establish single account for each autonomous administrative unit. * Complete the closure of all unauthorized treasury accounts continue with a sustained effort to eliminate all off-budget revenues and expenditures. * Undertake a sustained program of training under Budget Department of MOF to support extension of expenditure control system to district levels as the decentralization program is unfolded though 2004. * Reform the system of tax assignments and intergovernmental transfers to address incentive and equity considerations. ANNEX 4 Page 2 of 4 Budget Transparence * Continue the publication of the budget plan and budget outcome with full sector detail, eventually including program level expenditures. Include greater detail in the budget passed by the National Assembly to eliminate post-budget line item negotiations and reduce the lag in publication. * Issue a decree to make audited annual accounts, audit reports of the National Audit Office and results of parliamentary discussion on audit reports fully accessible to the public. * Adopt a modem internal control framework for the government as a whole. * Conduct a comprehensive review to rationalize the roles and responsibilities of the oversight agencies including the National Audit Office, The State Inspection Agency, MOF's Inspection Department, the Permanent Economic Committee of the National Assembly, and the Business Improvement Group within the Prime Minister's Office. * Adopt international public accounting standards and internationally accepted auditing standards and establish an internal audit function in line ministries. * Conduct a comprehensive training program on application of new standards. * Define the role of the external audit function in the Constitution to strengthen the independence and role of the National Audit Office as well as establish an effective parliamentary oversight over public finances. SOE Reform Component Oversight of Financial and Operational Performance of SOEs * Strengthen capacity of MOF's Office of State Assets to evaluate financial performance and manage contingent liabilities arising from guarantees of SOE debt. * Build capacity and awareness of corporate governance principles. * Build audit capacity both at National Audit Office and at board level in larger enterprises. * Strengthen SOE autonomy by replacing majority of ministry-appointed board officials and managers with board members and managers selected on basis of business competence. ANNEX 4 Page 3 of 4 Enterprise Restructuring * Full separation of commercial and policy roles of SOEs, with removal of all non- commercial mandates (pricing, labor, service delivery). * Strengthening legal framework for insolvency including both bankruptcy, secured lending and civil procedures with respect to appeals. * Removal of barriers to competition with private sector, including, inter alia, development of competition policy framework, reform of public procurement, and liberalization of import licensing. * Improving investment regime including FDI approval, business licensing and registration. * Strengthening and funding of social safety net. * Full commercialization with targeted privatisation and private sector provision of infrastructure. Tariff Reform * Regulatory capacity building and training. * Capacity building on targeted subsidies. Financial Sector Stabilization of Financial Institutions to Support Macroeconomic Stability * Strengthening of BOL Supervision Department to implement adequate prudential regulations * Implementation of institutional restructuring of SCBs Strengthening Financial Institutions to Support Economic Growth Framework for Sound Banking * Phasing out of directed and policy lending * Similar governance structure in private banks and in SCBs to hold management accountable for results * Market determined interest rates on loans and deposits * Adequate accounting and auditing frameworks * Adequate disclosure requirements * Functional Credit Bureau. SCBs Institutional Restructuring * Operational restructuring (adequate policies and procedures, rightsizing with Social Safety Net; adequate investments in information technology...) * Financial restructuring ANNEX 4 Page 4 of 4 Non Performing Loan Resolution The creditors have a credible threat against defaulting debtors. * Adequate legal instruments: bankruptcy law, secured transaction law * Adequate judicial system which is able to implement laws and enforce decisions in a timely and efficient manner. * Adequate dissemination of laws including official translations. Increasing Access to Financial Services by the Poor * Implementation of the Action Plan * Institutional restructuring of the Agricultural Promotion Bank * Establishment of transparent subsidy mechanisms Forestry Reform Componenat Production Forestry Poliicy * Reduce wood industry over capacity * Removal of quota harvest system with management plan based harvests * Royalty calculation rationalization Forest Biodiversity Conservation * Clarification and stanldardization of regulatory framework Plantation Forestry * Eliminate policies that restrict private sector plantation investment (land access, transport) ANNEX 5 - LAO PDR -- FMAC Decision Framework for Processing the Proposed NT2 Project Proposed NT2 Project 1. The proposed private sector investment project includes the development, construction, and operation of a thousand Megawatt trans-basin diversion power plant on the Nam Theun river, a tributary of the Mekong, in the central region of the country, about 250 kilometers east of Vientiane. The main features of the project are a 48-meter high gravity dam on the Nam Theun river, a 450 sq. km. reservoir, the powerhouse, and a 130 km long double-circuit 500 kV transmission line to deliver the electricity produced to the Thai grid. A 70 km. long single- circuit 115 kV transmission line will also be included to carry the small portion of total electrical output that will be dedicated to domestic uses. 2. The project is structured as a BOOT (Build-Own-Operate-Transfer) arrangement. The Government asked a foreign consortium, Nam Theun 2 Electricity Consortium (NTEC), comprised of EdF (France) in a head-contractor partnership with Montgomery Watson Harza of USA (35 percent), EGCO of Thailand (25 percent) and Ital-Thai Development also of Thailand (15 percent), to assist in constructing and operating the project. NTEC, currently representing the private sector interests, will shortly be incorporated with the Lao Government's investment entity (Electricite du Laos, with 25 percent of equity) to formn the operating company, Nam Theun 2 Electricity Company (NTECO), for a concession period of 25 years. The developer has informed the Bank that it expects to sign, in July 2002, a Power Purchase Agreement (PPA) with EGAT (the Thai public-sector power entity) for export of over 90 percent of the energy generated by NT2 and also sign a Concession Agreement (CA) with the Government of Lao PDR in the same month. 3. Estimated project cost is US$1.075 billion (about 65 percent of GDP in Lao PDR) and is expected to be funded using loan facilities of $752 million and shareholders' equity of $323 million. Export credits to the tune of $270 million, commercial loans from Thai banks amounting to $375 million and commercial loans from developed countries' banks to the extent of $107 million, make up the loan financing ($752 million) for the project. Decision Framework for Processing the NT2 Project 4. A broad decision framework was shared with the Government of the Lao PDR during a Management mission led by the Country Director in August 2001. Project processing would be linked to progress shown by the Government on: (a) implementation of a development framework characterized by concrete performance that aims at poverty reduction and environmental protection; (b) ensuring that the technical, financial and economic aspects of the project and the design and implementation of safeguard policies were of a standard acceptable to the Bank; and, (c) obtaining broad support from international donors and civil society for the country's development strategy and the NT2 project itself. The three elements of the decision framework are elaborated upon below. ANNEX 5 Page 2 of 5 5. Policy and Institutional Reforms. Less than ten percent of the power produced by NT2 will be used in Lao PDR; the rest is to be sold to Thailand. Therefore, the major benefit from the NT2 project would be sizable incremental revenues (through royalties, taxes and return on equity) flowing to the Government of the Lao PDR for several decades starting from 2008 -- not the direct benefits of power pioduction. Global experience has clearly shown that such additional revenues can be pul: to the most productive uses when governance improvements and human capital development go hand in hand with project initiatives. Currently, the policy and governance framework in Lao PDR is flawed and capacity in the public sector is woefully weak. Substantial sustainable improvements to these policy and institutional areas are needed to achieve macro-economic stability and pave the way for sustainable broad-based growth. While it is appreciated that such reforms take time to complete, a serious start and demonstrated progress is necessary before sufficient confidence can be gained that these reforms will indeed be accomplished. Such demonsbtation is all the more important to assuage lingering doubts in the community of international financial institutions and donors, dating back to the macroeconomic missteps taken in 1997-1999 tlhat exacerbated the effects of the regional crisis. 6. The IMF-backed Poverty Reduction and Growth Facility (PRGF) and the government- driven Interim Poverty Reduclion Strategy Paper (I-PRSP) lay the foundations of such policy and institutional reforms. An overall poverty reduction framework (PRSP) is needed to lay out the strategy for the sustainable and environmentally responsible use of revenues derived from natural resources such as hydropower, forestry, and mining. The full PRSP, that will be discussed at the Bank Board in FY 2003, is expected to set the agenda for further Bank support through a series of Poverty Reduction Support Credits (PRSCs) to strengthen governance and promote human development in Lao PDR. Furthermore, expected annual budgetary revenues from NT2 would be, in part, channeled directly to initiatives aimed at poverty reduction and a portion of the proceeds would also partially fund long-term conservation efforts (for several decades) in designated consenration areas. 7. Meanwhile, building on the efforts of the past SACs and the recently-completed Public Expenditure Review (PER), the FMAC and its companion Financial Management C'apacity Building Credit (FMCBC) seekc to strengthen GOL's capabilities through financial and public sector reforms. Key areas being addressed include: i)financial sector -- stabilize financial condition of the banks (SCBs), strengthen banks to support broad-based economic growth, and launch micro/rural finance for poverty reduction; ii) public sector -- improve budget planning, streamline budget execution and control, make the budget process more transparent and launch participatory forestry framework which has significant budgetary implications; and, iii) SOEs -- strengthen oversight of financial and operational performance of SOEs, restructure enterprises, rationalize the regulatory framework (power sector SOEs are addressed here as well -- especially EdL, the entity that would carry GOL's equity share in the NT2 project). A Poverty Reduction Fund (PRF) Project would corrmplement these efforts through direct targeting of funds for poverty-reducing investments at the village level. A separate forestry operation will also address improvements in forestry management at the regional level. Improvements in public expenditure management would lead to betler poverty targeting. ANNEX 5 Page 3 of 5 8. The health of the overall IDA portfolio in Lao PDR must also be addressed. There are nine active IDA projects in the portfolio at this time. In recent years, performance of the portfolio has been mixed, but with an improving trend. 9. Success on the policy and institutional reform front will be measured through progress on the development and implementation of a comprehensive government-driven reform program, articulated in the PRSP and other policy statements and supported by the Bank, IMF and other donors through instruments such as the PRGF, FMAC, PRSCs and various investment operations as well as maintenance of good standing on the overall project portfolio. Therefore, a sine qua non for Bank support to the project is an agreement upfront on a set of policy and institutional reforms and demonstrated progress on the implementation of these reforms. Progress on all these operations will be guided and measured by a set of performance benchmarks. This pre- requisite for Bank support for NT2 has been accepted by the Lao PDR Government. 10. Project Standards and Safeguards. The NT2 project is being designed and will be implemented by NTEC (or NTECO). The head contractor -- EDF/Montgomery Watson Harza -- is strong and each is highly rated as a leader in the field. Therefore, unlike public sector energy projects, cost overruns or completion delays are not serious risks. The project sponsors have amassed substantial analysis affirming that NT2 is technically sound in terms of hydrology and dam design and also economically and financially viable. The Bank is in the process of re- confirming these findings through ongoing due diligence. The project is well-managed to date and the Developer is capable and responsive to Bank suggestions. NT2 is a priority for the Government while also being financially attractive to the Developer. This provides incentive for all parties to find workable solutions when problems arise. With this said, the Bank must still, inter alia, perforn due diligence on the PPA and other legal agreements covering the project, the case for additional power purchase by Thailand, the design of the dam and associated construction (a Bank supported Dam Safety Panel is operating) and the detailed implementation arrangements. The satisfactory completion of due diligence -- and any remedial actions that the Bank may propose -- is an integral component of the Bank's decision-making framework for processing the project and this has been recognized by the Lao PDR Government. 11. The NT2 project involves application of all ten Bank safeguard policies. The project demands effective conservation and management of the watershed areas due to possible negative environmental and social impacts. These relate to the construction of the dam and flooding of land to fill the reservoir. Other impacts include resettlement of nearly 5000 persons, flooding of dry season cultivation zones on the Xe Bang Fei river, ecological impacts relating to changes in water quality and flow on the Xe Bang Fei and Nam Theun rivers, possible endangerment of certain rare fish and animal species, changes in the stock and migration of fish, and loss of habitat in the reservoir area from inundation. Unless these negative impacts are carefully mitigated, the net benefits flowing from the project may not be attractive enough to justify it. 12. Project preparation has focused on mitigating these negative impacts by ensuring that the design and implementation of plans pertaining to all of the Bank's safeguard policies are carried out so as to meet or exceed Bank standards. Furthermore, the proposed Nam Theun Environmental and Social Project (NTSEP) supports, inter alia, resettlement and community development, environmental capacity-strengthening, watershed area management and ANNEX 5 Page 4 of 5 environmental mitigation, and poverty reduction in the project area. Through these efforts, the Government seeks to ensure that the livelihoods of all who live in the project area are enhanced and that the environment -- in the project area and possibly beyond -- is conserved for the long- term. Potential conservation bienefits warrant special mention, as NT2 would help to preserve one of the few remaining pristine rainforest regions in the world. Without NT2, it is not clear if or how such conservation cou] d be ensured. An independent International Advisory Group and a Panel of Environmental and Social experts advise the Bank and Government, respectively, on these critical issues. 13. The design of risk mitigation measures is contained in three document packages (which are governed by the Bank's disclosure policy): the Environmental Assessment and Management Plan (EAMP), the Resettlement Action Plan (RAP) including an Indigenous Peoples Development Plan (IPDP), and the Watershed Conservation and Management Plan -- also including an IPDP. The preparation of these plans has been carried out by experts working for the Government and the Developer, with substantial input from Bank staff (including the provision of detailed comments and discussions on application of Bank safeguards policies). Implementation arrangements are included in these documents and completion of this work, to the satisfaction of the Bank, would be a pre-requisite for Bank consideration of the NT2 project. 14. A strong dialogue is in p:rogress with both the Developer and the Government on project quality and safeguard issues and there is a clear understanding by all parties on the what must be done to comply with the Bank's guidelines and standards in this regard. 15. Broad-based Supportfor the Government's DevelopmentStrategy and the NT2 Project. Burden-sharing with other international donors is a critical element of the Bank's decision- making framework because of two factors. First, it is critical to the success of the project that sustained progress on reforms be maintained over the long-run. The Government would receive revenues for several decades and most of the policy and institutional reforms would also take several years to complete. Thc: reforms are more likely to be fully carried out if major donors are also deeply committed to the policy and institutional reform package while also supporting the implementation of NT2-relatecl conditionality. Second, the NT2 project requires substantial external support, through granis (to finance the Government's contribution to equity in the project), export credits, financial transfers, and technical assistance from donors other than the Bank. 16. These requirements put the international donor community in a crucial role going forward. The Government will need to dtevelop a detailed program (building on ad hoc measures taken so far) for systematic consultations with key international stakeholders to keep them informed. For bilateral donors and the multilaterals, this will need to include briefing missions to important donor capitals as well as infonnal meetings in Vientiane. The UNDP supported round table mechanism would also be used to keep donors informed and engaged. 17. International civil society has a legitimate and strong interest in the project as well -- particularly since local civil society is not developed and there are no local NGOs. Local consultations have been remarkable in the Lao context, but fall short of the expectations of the international community. Broad support from responsible international NGOs, particularly those ANNEX 5 Page 5 of 5 involved with environmental and social issues, provides much-needed comfort that the environmental and social issues relating to the project will be successfully managed in the event. It is, however, highly unlikely that anti-dam NGOs would cease to attack this project. They likely will continue to launch focused campaigns against NT2 -- including website appeals reaching large audiences. 18. A series of seminars on NT2 led by the Lao PDR Government would be proposed to engage international NGOs on the project. The tone of these seminars is likely to be set by the on-going debate on the World Commission on Dams report. The expertise of the International Advisory Group of the Bank and the Panel of Environmental and Social experts, engaged by the Government, would be made available at these seminars. 19. The importance of broad-based international support is well understood by the Government but their capacity to network is severely limited. The Government is seeking Bank advice on its communications plan. 20. Project preparation continues within the framework described above. Emphasis going forward will be on further development by the Government of specifics relating to safeguards, fiduciary elements, use of revenues, a strong communications plan, and monitorable benchmarks for determining Lao PDR's policy and institutional readiness for the NT2 project. ANNEX 6-LAO PDR - FMAC The Poverty Reduction Fund Project Objective In support of the governmenl.'s Five-Year Plan and Poverty Reduction Strategy, the project would: * Assist villagers to develop community public infrastructure and gain improved access to services; * Build capacity and empower villages in poor districts to manage their own public investment planning and subproject implementation in a decentralized and transparent manner; and * Strengthen local institutions to support participatory decision-making and conflict resolution processes at the village, khet (grouping of villages), and district levels, involving a broad range of villagers, including women and the poor. Project Design Features * Sub project menu limited to a list of eligible small scale public infrastructure and services sub projects all within the implementation capacity of beneficiary communities; * Utilizes a dual strategy of social control and technical oversight to attain sustainable outcomes; * Broad-based community participation and decision making; * Local contributions and ownership; * Transparency and accountability. Project Components * Sub-project grants to a v illage or group of villages; * Local capacity building; * National project management. LAO PEOPLE'S DEMOCRATIC REPUBLIC Peace Independence Democracy Unity Prosperity 1 o1 3 MINISTRY OF FINANCE No ........_. JMOF Vientiane, date 2.4 M .W ,20 Mr. James D. Wolfensohn President The World Bank Washington, D.C. Dear Mr. Wolfensohn Letter of Development Policy Our National Socio-Economic Development Plan for 2001-2005 of Lao PDR has focused on poverty reduction through the promotion of stable and equitable growth. In conformity with the objectives of the aforiementioned Plan, wf prepared, in March 2001, an Interim Poverty Reduction Strategy Paper (I-PRSP) and presented it to the Boards of the IMF and the World Bank. Our economic reform program supported by the Financial Management Adjustment Credit (FMAC) and outlined below is an hored in both the I-PRSP and the National Socio- Economic Development Plan (NSEDP). The reform program will be given a forward-looking thrust, beyond the life of the two-tranche JFMAC, in the full PRSP that we are currently preparing. We expect t7 present the full PRSP to the World Bank Board in FY 2003. Macroeconomic 'ramework Since the year 2000, we have pursued sound macroeconomic management and have restored economic stability and low inflation. This past first year under the Poverty Reduction and Growth Facility (PRGF), the economy has grown at a rate of 5.2 percent in 2001 and inflation remained under control at about 7 percent. A modest fiscal slippag. through September 2001 was due to the decentralization initiative, but we pursued strong corrective measures in the new budget in the last quarter of the year, bringing the fiscal performance back on track. For the medium term, we expect to contiiwue our macroeconomic policies to sustain an acceptable growth rate of about 5.5 to 6.1 percent, an inflation of about 5-7 percent, and a stable exchange rate to realize the objectives outlined in the I-PRSP and the NSEDP. That Luang Road, P.O.Box: 46 Vientiane, Lao PDR Tel: 412406,412417 Fax: (856-21) 412415,412405 Tlx: 4369 MOF LS Our fiscal policies will strengthen macroeconomic stability and at the same time will meet pressures for additional social spending. We envisage a fiscal deficit of about 5 percent of GDP. With improvements in administration and compliance, we project an improved revenue performance that will allow additional current spending, including expenditures in the social sectors. We aim to limit domestic bank financing of the budget to 1/2 percent of GDP. We intend to shift expenditures composition toward current spending, in line with the PRGF program, enabling us to accommodate the increase in government wages and additional spending for maintenance and arrears payments. Our strategy is to strengthen overall public expenditure management to meet fiscal targets and to support the decentralization efforts. Our objectives in monetary and exchange rate policy continue with keeping inflation under control and maintaining a stable and flexible exchange rate system. The Bank of Lao People's Democratic Republic (BOL) will continue its discipline in budget financing. We recognize that a sound macroeconomic framework is a pre-requisite to stable growth and poverty reduction. But if this is going to be sustained, we need to address effectively and directly the underlying structural weaknesses that impede the flow of resources in the economy to their best uses. Our recent experience is that severe macro-economic instability undermines not only economic growth but also poverty reduction objectives. We are resolved, therefore, to address the systemic weaknesses in the economy that are the root causes of macroeconomic uncertainty. The systemic weaknesses that our reform program addresses encompass the budget making process and public sector reform, the state owned enterprises, and the financial system. Together these weaknesses result in a number of development. problems. In public sector management, there are problems in the budget process as well as in natural resource management. At the budget stage the problems are inadequate attention to recurrent budget, excessive reliance on donor funded investment projects that cause implementation problems, issues of non-transparency and inefficient use of resources. In natural resource management, we are focusing on forestry practices that result in excessive depletion , yield inadequate revenues for the budget and do not result in sufficient income earning opportunities at the local level. The state owned enterprises suffer from problems of high costs due to managerial inefficiencies and low prices that undermine their commercial viability. Weaknesses in the banking sector have resulted in substantial non-performing loans and capital inadequacy that have impeded the banks' capacity to support future growth and provide financial services to the poor. Our government is resolved to address these weaknesses. Public Sector Management: The Budget Our long-term vision for the public sector is to efficiently and effectively use public resources for poverty reduction and the promotion of sustainable growth. The key building blocks in the realization of this vision include progressive adoption of best practices for: (i) budget planning; (ii) budget execution and control; and (iii) transparency. Letter of Development Policy Page 2 of 19 Actions Recently Taken Budget planning. We have already undertaken significant steps to improve the measurement of poverty and to enhance the poverty focus of public expenditures. The first Lao Expenditure and Consumption Survey (LECS), conducted by the National Statistical Center (NSC) in 1993, was substantially improved and updated in 1998. The basic poverty measurement initiatives have enabled us to complete our I-PRSP in April 2001 and we will complete the full PRSP in FY 2003. To better achieve our development objectives, as outlined in the I-PRSP, and raise the share of recurrent spending, we have been reducing capital expenditures which peaked at over 70 percent of total expenditures in 1998/99, and have fallen to less than 60 percent in 2001/02. Further rebalancing of public expenditures was achieved through a 25 percent increase in basic civil servant wages from the start of 2002 to compensate for past inflation. Given that a large portion of civil servants are teachers, this is helping to reach the I-PRSP target of lifting the education's share of the budget to 13 percent. With the assistance of the Asian Development Bank (ADB), we are better able to plan and manage public investments. A Public Investment Plan (PIP) monitoring project that tracks donor-funded investment expenditures has been established and results are published annually. This is now being extended to domestically funded public investments. Decree No. 58/PM on Management of Public Investment has been signed on May 22, 2002. This and the associated guidelines provide a rationalized framework for project selection that involves streamlining by size and a two-stage process of evaluation against set qualification criteria, followed by a separate budget resource availability hurdle. This system is being applied now as the FY2002/03 investment proposals are received. Budget accounting and control. Decree 20/PM of 1993 on Public Accounting is now being more fully and effectively implemented with the establishment of an information and budgetary system in four pilot Ministries (Education, Health, Agriculture and Finance) with assistance from the ADB. This system allows the systematic computerized recording and processing of expenditures by administrative units. It includes budgetary and accounting references, committed current and capital expenditures at the central level, and it specifies budget allocations, payment orders and the value of budget allocations available after payment orders have been deducted. To tighten the control of public resource flows, a Ministerial Decision was issued in 1999 requiring the Ministry of Finance's Treasury Department to exercise prior commitment controls on expenditures. To ensure that commitments are consistent with the budget, responsibility for the commitment control function now rests with the Budget Department (Ministerial Decision No. 1706/MOF, dated October 22, 2001). Transparency. With assistance from the ADB, a National Audit Office (NAO) was established by Decree No. 174/PM in 1998 and began producing audits of central government ministries, provinces, and individual projects. The NAO has been reporting annually to the President, the Prime Minister and the National Assembly. The quality of its audits has been improving as the capacity of NAO staff is enhanced through continued ADB support. Letter of Development Policy Page 3 of 19 In line with the requirements of the PRGF, the Treasury Department has begun an inventory of Treasury accounts at all levels. This inventory, which is now almost complete, will allow MOF, working in conjunction with BOL, to identify and close all unauthorized Treasury accounts which facilitate the proliferation of off-budget revenues and expenditures. Actions under FMAC With the support of the proposed F MAC, we are taking several additional steps to further stabilize the budgetary process and budget planning. To promote transparency in our fiscal management, the 2000/01 budget outcome and the 2001/02 budget plan with classification by ministry/province and services were published in the Official Gazette on March 25, 2002. The detail of the presentation has been substantially expanded, including breakdowns by sector at both central and provincial levels. Decree No. 58/PM on the Managemnent of Public Investment has been issued, requiring that PIP submissions for new public projects in excess of 1 billion kips in the FY 2002/03 budget include estimates of associated recurrent costs during the operating period. Guidelines for estimates of the recurring costs have been prepared for presentation at the provincial budget conferences in May 2002. A workshop on the subject for the Committee for Planning and Cooperation (CPC) and MOF staff held at the CPC with the assistance of the World Bank in April this year was very useful in disseminating information on these topics. The CPC will present the results of this work for the FY 2002/03 PIP to the donors in October 2002. A consultant has been engaged to assist CPC with recurrent cost estimates under terms of reference agreed with the Bank. As part of the second phase of the FMAC-supported program, the CPC will complete an assessment of recurrent cost estimates associated with new projects in excess of 1 billion kips. Following the January 17, 2002 letter sent jointly by the World Bank and the IME to the Minister of Finance concerning the draft Accounting Regulations and Procedures, and consistent with discussions held between the World Bank and the Accounting Departmnent in February 2002, revisions are being prepared. This process is at an advanced stage and we expect to adopt by a Regulation of the Minister of Finance on Public Accounting and Procedures for the implementation of Decree No. 20/PM on the General Regulation of Public Accounting, dated February 18, 1993, and prepare a strategy for reform of the Department of Treasury. We expect that the Regulations and Procedures will be issued by end-June 2002. These accounting reforms set the stage for the medium-term reforms for Treasury operations which will be developed in close collaboration with the International Financial Institutions (IFIs). The enabling legislation for the establishment of a Procurement Monitoring Office (PrMO) is already in place. We are moving forward with the establishment of the PrMO within the Ministry of Finance headed by a qualified and experienced Director and assigned with adequate staff and resources. In addition, we will continue to revise the Implementing Rules and Regulations in line with the recommendations of the 1 Classifications are by ministry/province and service, so that it is possible to identify separately the central ministry and provincial spending on health, education, etc. Letter of Development Policy Page 4 of 19 World Bank's draft Country Procurement Assessment Review which we received on May 3, 2002. A candidate has been identified for the position of PrMO Director. Medium-Term Actions A series of medium-term reforms of Treasury operations will be launched under the guidance of a recently formed Standing Committee headed by the Vice Minister of Finance. Key reforms will include establishment of Treasury offices in line ministries, closure of unauthorized Treasury accounts, consolidation of the network of Treasury accounts, revision of Treasury regulations including sanctions, and publication of a manual of consolidated laws, decrees and regulations for government-wide Treasury operations. Following the revision of Public Accounting regulations and refinements of the chart of accounts and budget nomenclature, the pilot computerized accounting systems will be extended to cover all central ministries and provinces. These initiatives will serve to improve both expenditure management and revenue mobilization objectives by restricting the scope for unauthorized off-budget transactions and bringing about a closer integration of treasury, accounting and budget operations. In addition in the medium term we plan to introduce internal audit and accounting processes, to adopt international public accounting and auditing standards and to revise accounting decrees and regulations to clarify financial control responsibilities among the central government and the provinces. Further steps to improve the transparency of budget processes will include continued publication of the budget plan and budget outcome and steps to reduce the publication lag. In the medium term, we intend to adopt legislation to provide greater autonomy for the National Audit Office (NAO) and to establish an effective parliamentary oversight over public finances, and to make the audited annual accounts and audit reports of the NAO fully accessible to the public. We will also undertake a review to assess the scope for rationalizing the roles and responsibilities of the oversight agencies including the NAO, the State Inspection Agency, MOF's Inspection Department, the Permanent Economic Committee of the National Assembly, and the Business Improvement Office (BIO) within the Prime Minister's Office. We also intend to introduce by appropriate legal instrument the principle that all subsidies and other quasi-fiscal expenditures be reflected explicitly in the national budget. This will be reinforced by our program to enhance Treasury operations and closure of unauthorized accounts, thereby enabling us to progressively eliminate all off-budget revenues and expenditures. Financial reporting in the private sector will benefit from the introduction of measures to improve the institutional framework for setting its accounting and auditing standards. These include efforts to streamline various laws and regulations related to accounting and auditing practices in the private sector, as well as adoption of international accounting and auditing standards for this sector. To enhance budget planning, we will improve revenue estimation methods and begin to reverse the persistent pattern of revenue shortfalls and subsequent ad hoc expenditure cuts. We will develop better unit cost measures for major expenditure programs, including health and education, to support more realistic bottom-up estimation of the costs of achieving plan goals. The classification used by the CPC in the PIP monitoring system will be aligned with the budget classification system, and the latter will be extended to allow identification of expenditures by program. These steps will allow us more directly to reflect the results of our poverty monitoring, expenditure tracking and PRSP work in public expenditure plans and expenditure outcomes. Letter of Development Policy Page 5 of 19 Public Sector Management: Forestry The performance of the forestry sector, a key component of public ector management in Lao PDR, has not been as satisfactory as expec;ted. We believe that the contribution of forest resources to the incomes and livelihoods of rural people would be increased under better forest management system. This includes addressing, among others, the issue of unplanned and uncontrolled logging. We are resolved to face these challenges in public sector management. Actions Already Taken We have taken a number of steps toward reforming the policy and institutional constraints challenging forestry and are working with a number of partners to build the capacity needed to improve management of the resource. These steps incl ude reducing excess capacity in wood processing sector, mandating that timber production be restricted to areas targeted for infrastructure development or covered by sustainable forest management plans, introduction of market-oriented timber sales methods, successful trials of participatory forestry management and successful efforts to control illegal and unauthorized logging in targeted areas. We recognize the full range of environmental, economic and social benefits that a well managed forestry sector will provide. The Lao PDR is well endowed with forest biodiversity and is recognized as the host of unique and globally endangered species of plants and animals. Aware of the responsibilities that these unique resources convey, we have established a system of National Biodiversity Conservation Areas and are introducing management and protection of these areas. In the future, we expect to improve the quality of management of these areas by, among other things, employing participatory approaches that combine conservation with tangible contriibutions to the livelihoods of local people. Actions under FMAC The Ministry of Agriculture and Forestry (MAF) has formally approved the key Principles for Village Participation in Sustainable Management of Production Forests and the Office of the Prime Minister has issued a Decree on Sustainable Management of Production Forest Area and superceding relevant articles of existing orders. Under the FMAC program, by end-March 2003, we will revise and strengthen the regulatory framework for protected areas management ;md will issue, through the Ministry of Agriculture and Forestry, Regulations amending the Implementing Regulations on National Biodiversity Conservation Areas, Regulation No. 0524/AF.200 1, (.June 7, 2001), inter alia, to clarify the definitions and procedures governing zoning and land use within said Conservation Areas, and eliminate inconsistencies in respect of protected species listings. Furthejrmore we will adopt, through the Ministry of Agriculture and Forestry, Implementing Regulations on Sustainable Forestry Management which include specific provisions to enable the involvement of local communities in production forest management. Letter of Development Policy Page 6 of 19 Our top priorities under the period of the FMAC program focus on bringing order and discipline to the exploitation of the country's production forest resources. Until now, these areas have not been adequately mapped, inventoried, or their harvest properly planned and organized. Harvesting is considered by international norms to be of lower efficiency than expected. If proper forest management is not undertaken, pressures from mismanagement of the production resources would increase and result in negatively affecting our goals for sustained revenue mobilization and biodiversity conservation and require urgent attention and correction. Recognizing that the capacity of government forestry agencies at all levels is limited, our strategy is to involve local communities in forest management by providing a framework for the rapid expansion of the area under sustainable scientific forest management conducted in cooperation with Village Forestry Organizations. A Decree and Implementing Regulations on Sustainable Forestry Management which includes specific provisions to enable the involvement of local communities in production forest management will be adopted to provide guidance to the national, provincial and local agencies responsible for working with communities and Village Forestry Organizations on the basis of voluntary Village Forestry Agreements and written management plans. This regulatory framework will implement the "Principles for village participation and other key principles in sustainable management of production forests." Implementation of this program, which we expect will be supported by international partners, is aimed at rapidly bringing a large portion of the production forest resource under sustainable management. This will involve mapping, demarcation and registration of a network of production forest areas and the preparation, approval and implementation of management plans. We will initiate a forestry sector monitoring program to routinely assemble and analyze informnation on policy implementation and development results. A comprehensive sectoral monitoring program will enable the government to monitor and report on the implementation of this program and will be initiated with in the FMAC program. Medium-Terms Actions for Forestry Sector Looking beyond the FMAC program, we intend for the forestry sector to continue to develop as a sustainable source of growth and public revenue and a means for poverty reduction. To support this, we will continue our efforts to introduce more market-oriented timber sales methods, will develop policies to reduce excess capacity in the wood processing sector, and will complete the regulatory framework for forestry envisioned under the Forestry Law with well formulated Implementing Regulations covering all forest types and management systems under the law. We also expect to continue investments in reforestation, plantation development and watershed management. These efforts are vital to the development of alternative sources of raw material, and to the protection of existing and planned downstream infrastructure. As with the management of natural production forests and conservation areas, we intend to employ participatory methods and will consult with a range of stakeholders to ensure broad-based support for sustainable development. Letter of Development Policy Page 7 of 19 State-Owned Enterprise Sector We recognize that a well-functioning, financially-sustainable enterprise sector is important to improving the delivery of services to the poor, creating meaningful productive employment, as well as supporting the transformation of the econom,y from an agrarian to an industrial and service-based economy. Many of our enterprises have, in the past, supported a mix of social, political and economic objectives. With social and political stability in place, ouir focus is now on enhancing the economic contribution of state-owned enterprises. Our objectives are to improve the oversight and management of those SOEs which shall remain under state jurisdiction, in order to make them more commercially oriented, efficient and able to compete with other enterprises. For several non-performing enterprises, this will require deep internal reform to strengthen management and eliminate non-productive activities. For infrastructure SOEs, this will require regulatory and tariff reform. Actions Recently Taken Commercialization. Our SOE reform policy must be viewed in light of gains made in implementing the New Economic Mechanism, which dramatically reduced the number of SOEs through liquidation and privatization, hardened budget constraints, and removed the monopoly status which many SOEs previously enjoyed. Under the 1)94 Enterprise Law and implementing regulations, we introduced the framework for commercial autonomy and self-sufficiency of SOEs. All SOEs have introduced Executive Councils which govern SOEs, replacing the previous direct municipal or central government control and ownership mechanism. The Office of State Assets within MOF was assigned to execute the fiduciary responsibility of the state as shareholder. Privatization. From 1988 to 1997, we undertook a substantial program of privatization. Of over 600 central and provincial SOEs which existed in 1988, only 91 remained as 100 percent state-owned enterprises by 1995. In 1996, plans were developed to privatize an additional 58 enterprises. Unfortunately, the disruptions of the economic crisis delayed the SOE reform process, as it was difficult to force further adjustments in the midst of a harsh macroeconomic climate. By impacting macroeconomic stability -- which is a prerequisite to foreign investor interest in transformed assets -- as well as domestic purchasing power, the crisis made further progress on privatization very difficult. However, several enterprises, incl uding Lao Tobacco and Lao Telecom, continued to be privatized during this period. Restructuring. A number of larger SOEs, including those in infrastructure sectors, have been unable to achieve financial sustainability, which in turn contributed substantially to both the non-performing loans problem in the banking system and a fiscal drain on the budget. The performance of enterprises which remain in state control during the crisis and through 2001 revealed weaknesses in the management and oversight of SOEs. In October 2000, we announced Policy Decision No 368/PMO, which provided the context for intervention to restruclture non-performing SOEs. In December 2001, Bolisat Phattana Khet Phoudoi (BPKP or Phoudoi), the enterprise responsible for the largest non-performing loans in the banking system, was transferred to MOF, and the process of restructuring was initiated. Audits of Lao Aviation and BPKP further strengthened the govermnent's commitment to finding a comprehensive solution. Letter of Development Policy Page 8 of 19 SOE reform policy. In this broad context, we began to engage with the Bank in September 2001 through the FMAC program to improve the financial performance of state-owned enterprises and consolidate the gains previously made in transforming SOE management. We named a new Minister to head the Business Improvement Office (BIO) in order to lead enterprise reform policy, particularly with respect to SOEs. A target list of enterprises has been identified for restructuring by this office. With respect to infrastructure SOEs, financial sustainability is a particularly difficult challenge in light of the need to undertake substantial investment programs to provide essential services to the poor. Integral to the financial sustainability of several of these enterprises is a combination of internal restructuring to reduce costs, combined with tariff reforms, and introduction of appropriate regulatory frameworks. Water sector. We have established the Water Supply Authority (WASA) as the central regulatory authority for the water and sanitation sector of the country. The establishment of WASA in the Ministry of Communication, Transport, Post and Construction followed our water sector policy statement in 1999. The new policy changed the role of the central government from service provider to facilitator and coordinator in the development process for water supply and wastewater management systems in urban and rural areas throughout the country, including sector investment support. Work is underway with donor support (ADB's Project Preparatory Technical Assistance, PPTA) to develop a legal and regulatory framework for the water supply and sanitation sector under the auspices of WASA. Our national water policy is described in the Prime Ministerial Decision No 37/PM in 1999 on Management and Development of the Water Supply Sector. This document establishes the principles for a tariff policy and for the Provincial Nam Papa (PNP) operations on commercial principles in line with our national policy on working toward full cost recovery for urban water supply and centralized wastewater systems, with progressive block rate tariff structures. In accordance with the Decision 37/PM, the tariffs shall be set within the constraints of affordability and willingness to pay, adopting a uniform province-wide tariff system with possibilities for cross subsidizing. Average tariff has increased from 195 Kip/m3 in 2000 to 550 Kip/m3 in September 2001. WASA has authorized an increase to 650 Kip/m3 from July 2002. Nam Papa Vientiane has proposed a tariff of 750 Kip/m3. However, further reforms are envisaged as tariffs still remain well below cost recovery and do not take into consideration new capital investment costs. In a context of developing regulatory instruments for the sector, WASA has agreed, on our behalf, to review the water tariff principles and elaborate a comprehensive water and sanitation tariff policy in consultation with key stakeholders of the sector. The review is expected to be done in light of possible future private sector participation in the water supply and sanitation sector. Telecommunications. We have made a number of changes to the structure of the telecommunication sector over the last decade. This includes introducing private investment through a joint venture (1994) as well as separating post from telecommunication (1995). A new telecommunication law was passed in April 2001 and lays the framework for telecom regulations and entry into the sector. The sector has been open to competition since the beginning of November 2001. We issued a mobile license in early 2001 for Millicom International Cellular SA, a Luxembourg-headquartered international mobile investor. Letter of Development Policy Page 9 of 19 Until 1993, the Enterprise of Post and Telecommunications Lao (EPTL) was the 100 percent government- owned organization responsible ,For operating telecommunications in the country. In 1994, a joint venture was established between the government and a Thai company, Shinawatra International Public Company Limited -- Lao Shinawatra Telecom Company Ltd. (LST) -- to operate telecom services (Telecom Project Phase III). We would like to note that this was not the first example of private investment in the telecom sector. In 1995, ETPL was divided into Enterprise of Post Lao (EPL) -- responsible for postal services -- and Enterprise of Telecommunication Lao (ETL) -- responsible for telecommunications. In 1996, ETL and LST were merged to form Lao Telecommunications Company Limited (LTC) with the government owning 51 per cent and Shinawalra owning 49 per cent. LaoTel was granted a concession of 25 years with five-year exclusivity (through October 2001). ETL was resurrected in August 2000 to hold grant-financed government assets. As a result, LaoTel ended up leasing certain network elements needed for its service provision such as the international gateway. With the expiration of LaoTel's exclusivity in October 2001, the way is now open for ETL to enter the sector as a telecom service provider. ETL plans to provide fixed telephone lines, mobile GSM and VOIP services in 2002. While a tariff structure exists in tlnis sector, we recognize that domestic tariffs are highly subsidized and we need to develop a firmer policy for tariff determination. The Telecom Department, as the regulatory body, is putting in place a tariff policy study and has requested assistance for the development of a regulatory framework including tariff rebalancing and interconnection charges as well as a framework for private sector participation and licensing arrangements. Transport. We have approved three tariff increases for Lao Aviation over the last year. While we recognize that tariffs are not yet at cost recovery levels, we are considering a recent request from Lao Aviation to increase tariffs from E; cents/seat/km to 20 cents/seat/km for domestic flights - bringing tariffs to cost recovery levels (at 65 percent capacity utilization) in the first quarter of 2003 . Electricity. Since 1997, we have embarked on several activities for restructuring tariffs and regulation in this sector, upon the preparation of parallel projects of the World Bank and ADB. The Ministry of Industry and Handicraft (MIH) issued in March 2001 a Power Sector Policy Statement (with World Bank support) that established the following two main objectives for the Power sector: (i) to maintain and expand an affordable, reliable and sustainable electricity supply within the country to promote economic and social development; and (ii) to promote power generation for export to provide revenues to meet GOL development objectives. It was agreed that the achievement of these twin goals depends on continuing progress in the following two areas: Letter of Development Policy Page 10 of 19 * Development and enhancement of the legal and regulatory framework to effectively direct and facilitate power sector development; and * Reform of institutions and institutional structures to clarify responsibilities and streamline administration. Prior to the Policy Statement, our National Assembly enacted the Electricity Law (1977), an important advance in the development of a legal framework to attract, direct and control optimal investment in power projects. Currently we are considering the separation of Electricite du Laos (EdL) from its off-grid and IPP responsibilities, and to establish an independent regulator. We are taking actions to mobilize resources in support of an open debate on sector reform. We have also approved a proposal for a PPIAF supported workshop on sector reform (scheduled to be held around November 2002) which would be followed by the formulation of an action plan. Our government's efforts to commercialize EdL started in the mid-i 990s under technical assistance support of the World Bank and ADB. Since then, EdL has been established as a separate juridical entity with a functioning Board of Directors. Also, EdL has strengthened its financial management capability (with World Bank support), has been reorganized on the basis of cost centers that facilitate accountability of each operation and the utility has divested from some non-core activities (e.g. concrete pole plants). This process was supported by the enactment of the Electricity Law which supports the commercialization of the sector. Following the 1997 regional financial crisis, EdL's financial situation was seriously affected by exchange losses. In response to this situation, we proposed in December 2000 a Financial Recovery Plan (FRP) for EdL that the Bank found satisfactory. This plan called for: (i) conversion of some debt to equity; (ii) temporary relaxation of onlending conditions to EdL, particularly for debt associated to social-oriented investments; (iii) undertaking a tariffs study and the subsequent implementation of a new tariff policy; (iv) revaluation of fixed assets; (v) signing of a performance agreement between EdL and our government; and (vi) review of EdL's investment plan. In spite of the slow implementation of the FRP at the onset, almost all the measures have been implemented at this stage. New tariffs approved in early April 2002 will allow EdL to comply with financial covenants for the first time in more than three years. Actions under FMAC The SOE reform program in FMAC, paralleling the objectives of the PRGF, is expected to contribute to a strengthened financial management of existing SOEs, enterprise restructuring, and tariff reforms. In recognition that the monitoring of the operational and financial performance of SOEs, particularly at the Provincial and District levels and among some ministries, is insufficient to support management of financial risks and execution of SOE reform policy, our government has issued a Decree (i) requiring that financial and operational performance of all SOEs at the ministerial, provincial and district levels be reported to the Ministry of Finance, (ii) specifying regular reporting requirements and (iii) stating that new SOEs to be established are those which are specifically approved by the Prime Minister, and which will provide essential services which cannot be currently provided by the private sector or by budgetary means; (iv) requiring the Ministry of Finance to publish in the Official Gazette the financial performance Letter of Development Policy Page 11 of 19 of SOEs on a quarterly basis; and (v) requiring the privatization or liquidation of those SOEs which have produced the greatest operating losses, or which otherwise fail to comply with this Decree. To contain the growth of non-performing loans contributed by SOEs, we have prohibited non-commercial policy lending to SOEs, and all lending to SOEs with outstanding non-performing loans. Recognizing that a limited number of SOEs have contributed disproportionately to non-performing loans in the banking system, the goverrnent has signed Memoranda of Understanding to initiate the restructuring process for BPKP, Lao Aviation, Nam Papa Lao and Pharmaceutical Factory No. 3. These Memoranda define the contribution of the enterprise, the Office of the Prime Minister and the Office of State Assets of MOF with respect ito the preparation of time-bound restructuring plans for each enterprise and the first stages of their implementation. To better manage our utilities with a view toward cost recovery, we have initiated reforms in the tariff policy for electricity, water, transport, and telecommunications. For electricity, our government has implemented new electricity tariff policy, to be applied from May I for a period of 36 months. It consists of an average monthly increase of :2.3 percent which will take the average tariff to Kip 665/K.wh by the end of the period (US cents 7 at the current exchange rate, between US cents 5 to 6 under our set of assumptions). Following the proposal of the tariff study, the schedule will move towards a niarginal cost structure while keeping a lifeline tariffto protect low-income consumers. For water, we have prepared a draft tariff policy outline for the water sector and submitted it to the Bank for review. Policy objectives and principles have been laid out. These will be developed and firmed up after consultation with the stakeholders (consumers and operators, national and local Treasury and international development agencies). Gradual increase of water tariffs is being implemented. The most recent set of tariff increases was auithorized by WASA on April 23, 2002. The Ministry of Construction, Transport, Post and Communication (MCTPC) and Lao Aviation have requested a tariff study to support the achievement of full cost recovery tariffs by the second tranche milestone. An increase has been agreed between the MCPTC and Lao Aviation for domestic tariffs. It is agreed that the domestic tariffs for Lao Aviation would be the higher of $0.20/seat/kilometer or the tariff required to achieve full recovery of all operating maintenance and depreciation costs. A study on tariff structure and tariff policy for telecommunications has been launched with grant assistance from JICA. We also have a JICA-financed consultant attached to the Telecommunications Department at MCTPC. The telecommunications department is preparing a telecom policy statement - and KfW of Germany has agreed to provide assistance. In order to clarify the policy on management of SOEs we will issue, through MOF, Implementing Regulations to the Decree on Management of State-Invested Enterprises, Decree No.54/PM dated May 9, 2002. Letter of Development Policy Page 12 of 19 By end-March 2003, we expect to begin to realize some results of the Decree strengthening the performance monitoring of SOEs. We will prepare, through the Ministry of Finance, an assessment of the financial performance of SOEs and, under criteria consistent with technical audit standards, and identify non-performing SOEs that require (i) performance improvement; (ii) strengthening of financial reporting; or (iii) bringing them to the point of sale or liquidation, as the case may be. Gradually, this will be expanded to all state-owned enterprises. We will adopt a time-bound restructuring plan for BPKP, Nam Papa Lao, Pharmaceutical Factory No. 3, and Lao Aviation, and implement all of the actions under said restructuring plan, which in accordance with such time-bound restructuring plan. Substantial progress is being made by each enterprise in defining its restructuring plan. In SOE restructuring, we will execute, through MOF, memoranda of understanding for the development and execution of time-bound restructuring plans with DAFI and four loss-making SOEs which have outstanding, non-performing loans in excess of one billion kip. We expect to complete ongoing financial restructuring of EdL, including revaluation of assets, amendment of selected subsidiary loan agreements, and debt to equity conversions. We will also continue to pursue tariff reforms. For water, transport and telecommunications, we will adopt and publish tariff policies and structures incorporating: (i) cost recovery principles; and (ii) directed and transparent subsidies, if any, for the potable water supply and telecommunications sector, Lao Aviation, and telecommunications sector; and will adopt a time-bound action plan for the implementation of said tariff policies. The implementation of tariff policy will be through appropriate legal instruments such as Ministerial Regulations. We have commissioned studies to formulate tariff policy and tariff structure to include cost recovery. These are expected to be ready by November 2002. Appropriate stakeholder discussions will be held and social impact studies will be carried out on the tariff policy for each sector. The Terms of Reference for Social Impact Assessment Studies for the water sector have been drafted. Similar work for electricity and telecommunications will be addressed. Going forward, we will clarify the role and strengthen the functions of regulatory bodies/departments. This will be accomplished through providing and developing adequate resources and capacity in water, telecommunication, energy and transport sectors. In the water sector, the Water Supply Authority -- the water sector central regulatory authority for the water and sanitation sector of the country is being assisted by ADB in developing its mandate, including a better definition of its role, functions and jurisdiction. In telecommunications, we will seek to define and strengthen the capacity of the Department of Telecommunications in MCTPC as our designated regulator for this sector. In addition, we will work to identify resource requirements for this agency under the grant from PPIAF. The regulatory framework will also be developed under the PPIAF Grant. Letter of Development Policy Page 13 of 19 Transport. Our plan is to develop, a regulatory framework for this sector. Energy. We will continue to implement the commercialization of EdL that was started in the mid-1990s, with strengthened management capacity and a firmer financial footing through the Financial Recovery Plan (FRP). Medium-Terms Actions While the policies proposed for support under the FMAC represent a substantial effort by our government to address some of the most urgeni: deficiencies in the enterprise sector, the reform program will clearly require a medium-term effort. The Office of State Assets will require further strengthening in order to take a proactive stance through early detection and intervention of enterprises which may cause financial damage to the state budget or to the banking system. The capacity of the National Audit Office will also require strengthening in order to execute more regular audits of key enterprises. The Boards of Directors of state enterprises will need to become more effective in financial control and strategic management, both through training and through expansion of the use of independent, experienced directors from outside the civil service. Through the enterprise restructuring process, we hope to identify and address many of the key obstacles to financial sustainability of state-owned enterprises, including removal of non-commercial mandates on pricing and service delivery, strengthening of the social safety net to alleviate the impact of SOE reform on workers, reducing the cost and ijmproving the function of organizational structures, and institutionalization of effective management controls. To strengthen the incentives for all enterprises to achieve financial sustainability, we expect to have made substantial progress, with ADB support, on strengthening the legal framework for insolvency, secured lending and civil procedures. Beyond the FMAC, our medium-term vision for the enterprise sector is one in which all enterprises, irrespective of the nature of ownersihip, are able to contribute substantially to increased employment generation and poverty reduction, irnproved service delivery, and macroeconomic stability. Realization of this vision rests on five pillars: establishment of a sound and stable investment environment for the development of all enterprises leading to the resumption of foreign and domestic direct investment flows; * creation of a market-oriented regulatory framework and tariff regime for key infrastructure sectors which enables the private sector to contribute to essential service delivery on a competitive basis; * leveling of the playing field between SOEs and the private sector, including in the areas of taxation and public procurement, to introduce greater competition between SOEs and the private sector and to facilitate the flow of resources to areas of greatest demand; * creation of a judicial system which is able to provide strong incentives to improve financial performance and facilitate commercial transactions, including credit; and * achieving a simple, manageable trade regime that promotes integration of Lao PDR first within Asian Free Trade Agreement: and then within the global economy. Letter of Development Policy Page 14 of 19 This will require a substantial and cross-ministerial reform agenda, developed in consultation with the private sector, SOE managers, and the foreign investment community. To build ownership and commitment to the reforms among all concerned stakeholders, we will establish a public-private consultative mechanism led by the CPC, with the support of the World Bank, IMF, ADB, and the Mekong Project Development Facility. Our immediate priorities are to increase the attractiveness of Lao PDR as a destination for foreign direct investment, to simplify business registration procedures for foreign and domestic entrepreneurs, and to continue to reform the trade regime. Longer-term reform priorities of the enterprise sector are expected to emerge from the consultations with domestic and foreign businesses. With more progress on governance of state enterprises, improvement of the domestic business and regulatory environment, and a resumption of foreign investor interest in Lao PDR, the conditions will be in place for a resumption of the previous policy of ownership transformation on a more sound footing. Meanwhile, the government will continue to take a pragmatic approach to the question of ownership transformation, including the potential use of joint ventures to improve the performance of SOEs. In the medium term, the issue of transparency and financial accountability in the SOE sector will be addressed though implementation of the following measures designed to improve its financial reporting and corporate governance: (i) requiring large SOEs to prepare financial statements in accordance with adopted standards and be annually audited by independent auditors; and (ii) publishing their audited financial statements and making them accessible to the public. We shall consider additional measures to achieve a more effective level of financial management. These include: (i) introducing an internal audit function in large SOEs; (ii) establishing audit committees of the board; and (iii) strengthening the accounting professional organizations to become fully professional bodies. Financial Sector Working closely with the World Bank, IMF and ADB, we have started to implement a comprehensive reform program in the financial sector. The program includes three main themes: ensuring macroeconomic stability via banking reform, promoting broad-based growth via a strengthened financial sector, and unleashing the power of micro-finance to reduce poverty. Actions Already Taken We have taken a number of actions recently to stabilize the balance sheets of SCBs that include credit ceilings, adherence to stricter classification of loans and provisioning, prohibition of lending to defaulting borrowers, suspension of accrual of interest on all NPLs and restrictions of the distribution of dividends by the SCBs. We have also clarified the Tax Law to allow loan-loss provisions as a normal deduction against taxable income. Last year we took the disciplinary measure of removing top executives of Lao May Bank to send a signal that mismanagement will no longer be tolerated. Letter of Development Policy Page 15 of 19 With the assistance of international financial institutions and bilateral donors, we have taken a number of steps to improve the overall climrrate for the financial sector. We have established a technical committee, the Working Committee for Financial Sector Development (whose membership includes MOF, BOL, Ministry of Justice, and CPC) wiith the mandate to oversee the preparation of policy reforms in the financial sector. We have formulated a vision of the Lao Financial Sector after discussions among senior policy makers to build understanding, consensus, and ownership. We have established a Bank Restructuring Committee (BRC) for restructuring of SCBs. The BRC prepared draft Memoranda of Understanding with the IFIs stating the restructuring principles and strategy. To address the NPL problem and its resolution we have launched an analysis to identify how to strengthen the legal and judicial underpinnings of the involuntary process. We established a Steering Committee and External Committee for NPLs resolutions. We are also developing a voluntary process for NPLs resolution. We have agreed to initial outcome targets by setting specific numbers on NPLs to be resolved and in the process of resolution within the specific timeframe of FMAC. In order to assess accurately the financial situation of the SCBs, we have commissioned audits of SCBs accounts for three years (1998, 1999 and 2000) with assistance from AusAid. To bring the SCBs up to date in terms of banking technology in the future, we have initiated a World Bank-supported study to analyze the information technology requirements for SCBs. Similarly, with World Bank support, we have launched the study of the soc-ial impact of SCB restructuring in order to design an adequate social safety net for redundant workers. Rural and micro-finance are important for a country such as the Lao PDR where the majority of the population and the poor live in the country side. The needs for micro-finance, as effective means for poverty alleviation, are most acute in these areas. In 1997, we undertook a survey of the sector with UNDP support. Based on the results evidencing a large unmet demand for micro-financial services, we piloted an ambitious project to improve awareness, sensitization, and access of the people for micro- finance. With donor support, we built our capacity through exposure visits to various rural and micro finance initiatives in the region. The activities in this area have been given a new momentum with the establishment of the Rural and Microfinance Committee to oversee government activities in this area and to prepare policy recommendations. With ADB support, we have agreed to launch an operational diagnostic and a financial audit of the Agricultural Promotion Bank (APB) with a view to gamer experience and information on rural banking services and to restructure APB. Letter of Development Policy Page 16 of 19 Actions under FMAC As part of FMAC preparation, we are continuing to deepen reforms in the financial sector. By the end of March 2003, we will assess the measures undertaken to (i) avoid the deterioration of the SCBs' risk portfolio; (ii) implement its risk diversification rules; and (iii) effectuate the autonomy of SCBs. This regime shall remain in place until banks are actively engaged in their restructuring program. Furthermore, the BOL has issued (i) a set of Instructions to centralize credit decisions in SCBs' headquarters and limit individual and group exposures; and (ii) a time-bound action plan. We shall retain this regime in place until SCBs have acceptable credit policies and procedures. BOL will ensure compliance with these measures. We are committed to establishing SCB autonomy. To this end, the MOF has issued a Notice to SCBs including all future lending (including policy lending) be subject to commercial criteria. I delegated to the SCBs' Boards of Directors to appoint Deputy Managing Directors and Branch Managers upon proposal of the Managing Directors and to allow SCBs to freely set interest rates on loans and deposits. The BOL is to prepare a time-bound action plan for implementation, monitor and ensure full implementation of this measure. In addition, the BOL is considering an amendment to the Decree Law on Commercial Banks. This alleviates the concerns related to the permanence of Notice 0566/MOF on commitment to the autonomy of SCBs, dated March 31, 2002, as one area to be amended will precisely be on governance of SCBs to ensure consistency with the Business Law. Concerning SCB's institutional restructuring, we have signed a Memorandum of Understanding of Restructuring (MOUR) for each SCB which includes (i) phased capital build-up based on improved operational performance; (ii) temporary management support to SCBs in the form of international advisors; and (iii) an action plan in case SCBs do not reach performance indicators. We are pledging to undertake several additional measures by end-March 2003 under the FMAC as follow-up to the steps noted above to consolidate our reform effort. We intend to audit the calendar year 2001 accounts of SCBs, and for the Agricultural Promotion Bank the calendar years 2000 balance sheet and 2001 accounts. We are committed to have the SCB's institutional restructuring programs launched and by March 2003 will procure the professional services of at least two banking advisors, to provide advisory services for the management of SCBs, with qualifications and experience adequate to carry out their services according to detailed terms of reference agreed. Regarding non-performing loan resolution, we are requiring that by end-March 2003, SCBs resolve an aggregate amount of Kip 100 billion equivalent of SCBs non-performing loans of at least ten accounts through: (i) the liquidation of non-viable companies; (ii) the restructuring of viable companies such that Letter of Development Policy Page 17 of 19 their debts can be fully serviced by their cashflows; (iii) the seizure and sale of assets to recover cash; or (iv) the exchange of the loan for cash or marketable assets. We will also prepare an assessment that identifies ten non-perforning loan accounts undergoing resolution. Our strategy is to increase access to financial services for the poor people. In consultation with MOF, BOL, and the relevant provincial authorities, and microfinance entities including Cooperative de Credit de Soutien aux Producteurs, Miicrofinance Project and Project de Developpement Decentralise de Phongsaly, will prepare a policy statement, an assessment and a time-bound action plan to address the implementation of a rural and microfinance reform program. Medium-Term Actions for the Financial Sector Financial sector reform will continue to be pursued well beyond the current phase supporled by the FMAC and ADB's planned Financial Sector Program Loan III (FSPL III) to ensure that the financial services needs of a growing economy are met and also adequate attention is paid to the less well-off segments of the society. Our objective is a Lao banking system with modem, sound, robust, efficient, and sustainable institutions meeting prudential standards. Banks will be cost-efficient and customer-oriented. We envisage a competitive environment in which banks unable to comply with the law and regulations are removed, and the better banks -- whether private or state-owned -- will be allowed to thrive. To improve further the framework for sound commercial banking and the banking environment in general, we are committed to implementing several measures. We will continue to build and strengthen the capacity in the supervision department of the BOL. This includes providing, in the next two years, training in accounting, regulations, on-site inspection techniques and off-site analysis with support from the IMF and the EU. To support off-site analysis, we intend to establish adequate MIS for the supervision department to enable BOL staff to monitor the process. Legal reforms for the financial sector are also on the anvil. We plan to conduct a review of the Banking Law (Decree) in order to: (i) make it consistent with the Business Law (on corporate governance) for SCBs, (ii) increase competition outside the Vientiane area, and (iii) review capital requirements of banks. We intend to review our banking regulations with a view to bringing them into conformity with international banking standards. WVe are also committed to enhancing transparency in the banking system. To this end, we will modify Lao accounting standards to better conform with international accounting standards and will implement a program of dissemination of banking laws. We will also improve enforcement of laws governing (i)i secured lending; (ii) bankruptcy; (iii) dispute resolution; and (iv) debt recovery by enhancing the capacily ofjudges. Letter of Development Policy Page 18 of 19 The planned measures for improving legal capacity of judges outlined above, in conjunction with appropriate modification of the judicial;procedures, including the setting up of specialized courts for commercial dispute, will help in thet recovery of NPLs. A voluntary debt resolution process will also be put in place to promote NPL resolution. To that end, a fully functional Credit Bureau will be established to improve access to creditor and debtor records. In the area of rural and microfinance, the specific policy measures to create an enabling environment will be articulated under FvIAC and the planned FSPL III and we intend to implement those as per the action plan to be defined. However, we have already decided that APB should become a viable market-ornented rural financial institution. To ensure smooth implementation of the credit, our government intend to establish a Project Implementation Unit (PIU) at the Ministry of Finance for the implementation of the FMAC by May 2002. Conclusion My government has already implemented a number of policy measures and initiatives in the past two years to first stabilize our economy and then to strengthen the gains so far achieved. We consider that the program as outlined in this letter will further enhance the economic and social objectives of the Lao People's Democraiic Republic and will enable us to better implement our strategy as set out in the I-PRSP and the draft NESDP. My government requests the World Bank's assistance to facilitate the realization of this program. ISincerely yours. A- Souih MAHALATH Minist of Finance Lao People's Democratic Republic Letter of Development Policy Page 19 of 19 LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 1 of 8 REFORM PROGRAM MATRIX Issues/Objectives Actions Taken by Lao PDR { Actions to be Taken by Lao PDR to Satisfy Second f | ~~~~~~~~~~~~~~~~~Tranche Release Conditionsl I. PUBLIC SECTOR REFORM A. Planning Recurrent and capital spending Issued a Decree on Public Investment Management 1. Completion, through CPC, of an assessment, are poorly balanced. requiring that PIP submissions for new public projects in in a manner and substance satisfactory to the excess of 1 billion kip in the FY2002/03 budget include Association, of recurrent cost estimates estimates of associated recurrent cos't du.ring opera'iug associated with new projects in excess of 1 billion | period. | kip. B. Budget Accounting and Control The Public Accounting Law of EFFECTIVENESS CONDITION TO BE MET: 2. Preparation, through the Ministry of Finance, 1994 does not provide an Adopt a Regulation of the Minister of Finance on Public in a manner and substance satisfactory to the adequate framework for public Accounting and Procedures for the implementation of Association, of a strategy for the reform of the financial management. Decree No. 20/PM on the General Regulation of Public Department of Treasury. Accounting, dated February 18, 1993, satisfactory to the Association. C. Budget Transparency D. The budget and expenditure Published in the Official Gazette the FY2000/01 outcome outcomes are not and the FY2001/02 budget with classification by comprehensive, published in ministry/province and service with a separate identification a timely way nor presented of the distinct central ministry and provincial expenditures by sector in a manner that facilitates and expenditure category. public understanding or reconciliation with stated budget priorities. Financial Management Adjustment Credit LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 2 of 8 REFORM PROGRAM MATRIX Issues/Objectives Actions Taken by Lao PDR Actions to be Taken by Lao PDR to Satisfy Second Tranche Release Conditions Absence of government agency 3. Establishment of a Procurement Monitoring to oversee country-wide Office within the Ministry of Finance, headed by procurement and implement a qualified and experienced Director and effective procurement training. assigned with adequate staff and resources in a manner and substance satisfactory to the Association. D. Natural Resources Management Better management of forestry MAF approved the key Principles of Village Participation 4. Issuance, through the Ministry of Agriculture to increase government in Sustainable Management of Production Forests: PMO and Forestry, in a manner and substance revenue, expand rural income issued a Decree on Sustainable Management of satisfactory to the Association, of Regulations generation, and promote Production Forest Area and superceding relevant articles amending the Implementing Regulations on sustainability. of existing orders. National Biodiversity Conservation Areas, Regulation No. 0524/AF.2001, (June 7,2001), inter alia, to clarify the definitions and procedures governing zoning and land use within said Conservation Areas, and eliminate inconsistencies in respect of protected species listings 5. Adoption, through the Ministry of Agriculture and Forestry, of Implementing Regulations on Sustainable Forestry Management, satisfactory to the Association, which includes specific provisions to enable the involvement of local communities in production forest management. Financial Management Adjustment Credit LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 3 of 8 REFORM PROGRAM MATRIX Issues/Objectives Actions Taken by Lao PDR Actions to be Taken by Lao PDR to Satisfy Second Tranche Release Conditions II. SOE REFORM A. Strengthen Oversight of Financial and Operational Performance of SOEs Monitoring of the operational Issued a Decree: (i) requiring that financial and 6. Issuance, through MOF, of Implementing and financial performance of operational performance of all SOEs at the ministerial, Regulations to the Decree on Management of SOEs, particularly at the provincial and district levels be reported to the Ministry of State-Invested Enterprises, Decree No.54/PM Provincial and District levels Finan.e; vil) speciv.y4g reguiar reporting requirements; dated May 9, 2002 satisfactory to the Association. and among some Ministries, is (iii) stating that new SOEs to be established are those insufficient to support which are specifically approved by the Prime Minister, management of financial risks and which will provide essential services which cannot 7. Preparation of and furnishing to the policy. Strengthened oversight currently be provided by the private sector or by Association in a manner and substance and control must be developed budgetary means; (iv) requiring the Ministry of Finance to satisfactory to the Association, through the through mandatory reporting publish in the Official Gazette the financial performance Ministry of Finance, an assessment of the and strengthening SOE of SOEs on a quarterly basis; and (v) requiring the financial performance of SOEs and, under Executive Councils (boards). privatization or liquidation of those SOEs which have criteria consistent with technical audit standards, produced the greatest operating losses, or which otherwise and identify non-performing SOEs that require fail to comply with this Decree. (i) performance improvement; (ii) strengthening of financial reporting; or (iii) bringing them to The MOF and BOL prohibited non-commercial policy the point of sale or liquidation, as the case may lending to SOEs, and all lending to SOEs with outstanding be. non-performing loans. B. Enterprise Restructuring SOE losses have created I Transferred ownership of the largest loss-making SOE, 8. Adoption of a timebound restructuring plan, significant non-performning BPKP. to the Ministry of Finance for corporate satisfactory to the Association, for BPKP, Nam loans in the banking system. restructuring in cooperation with the Office of the Prime Papa Lao, Pharmaceutical Factory No. 3, and The debt is limiting the Minister. Lao Aviation, and implemented all of the actions to finance future growth. ounder sad restructuracg plan, whrch sn capacity of thebankingsystemunaccordance with such time-bound restructuring Operational and financilal . . ._.I._._._ Financial Management Adjustment Credit LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 4 of 8 REFORM PROGRAM MATRIX Issues/Objectives Actions Taken by Lao PDR Actions to be Taken by Lao PDR to Satisfy Second Tranche Release Conditions restructuring of SOEs is plan are due within seven (7) calendar days prior needed. to the exchange of views under Section 2.02(d) of this Agreement. 9. Execution, through MOF, of memoranda of understanding for the development and execution of time-bound restructuring plans with DAFI and four loss-making SOEs which have outstanding, non-performing loans in excess of one billion, in a manner and substance satisfactory to the Association 10. Completion of the financial restructuring of EDL, in a manner and substance satisfactory to the Association, including the revaluation of assets, amendment of selected subsidiary loan agreements, and debt to equity conversions. Financial Management Adjustment Credit LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 5 of 8 REFORM PROGRAM MATRIX. Issues/Objectives Actions Taken by Lao PDR Actions to be Taken by Lao PDR to Satisfy Second Tranche Release Conditions C. Tariff Reforms Tariffs in the water, transport, Electricity: implemented new electricity tariff policy. 11. Adoption and publishing of tariff policies power and telecommunication and structures incorporating: (i) cost recovery sectors are below cost recovery Water: prepared a white paper on tariff policy for the principles; and (ii) directed and transparent levels, and enterprises lack water sector. subsidies, if any, for the potable water supply, autonomy to adjust prices. telecommunications sector and Lao Aviation; Insufficient separation of social Transport and Telecommunication: launched studies on and adoption of a time-bound action plan for the and commercial functions of tariff structure and start the preparation of tariff policies implementation of said tariff policies, all in a SOEs prevent sustainability of for Lao Aviation and Lao Telecommunication. manner and substance satisfactory to the the enterprises and cause Association. macroeconomic risks. A comprehensive approach to tariff adjustmnent needs to be implemented, including efficiency improvements and targeted subsidies for low income groups executed through the budget. III. FINANCIAL SECTOR REFORM A. Financial Sector Reform to Promote Macro-economic Stability Measures to avoid deterioration BOL issued (i) an Instruction to stop the growth of SCBs' of SCBs portfolio, risk portfolio if the ratio of NPLs to credit risk portfolio (net of provisions) exceeds 15 percent of loans made after December 31 1999 and (ii) a time-bound action plan for The quality of risk managementimlenao. at branch level is weak. implementation. Procedures for risk Financial Management Adjustment Credit LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 6 of 8 REFORM PROGRAM MATRIX Issues/Objectives Actions Taken by Lao PDR 1 Actions to be Taken by Lao PDR to Satisfy Second Tranche Release Conditions diversification are not BOL issued (i) an Instruction to centralize credit decisions 12. Preparation of an assessment, in a manner implemented. in SCBs headquarters and limit individual and group and substance satisfactory to the Association, exposures and (ii) a time-bound action plan for that assesses the measures undertaken by the implementation. Borrower to: (i) avoid the deterioration of the SCBs' risk portfolio; (ii) implement its risk diversification rules; and (iii) effectuate the autonomy of SCBs. B. Banking Reforms to Support Broad-based Economic Growth 1. Framework for Sound Borrower committed to the autonomy of SCBs: Banking Minister of Finance issued a Notice to SCBs requiring that all future lending (including policy lending) be subject to Structural measures to ensure commercial criteria; Minister of Finance issued a that the financial sector delegation of his powers to appoint deputy Managing Directors and Branch Managers, to the SCBs Board of Directors, so that those managers are appointed by the Boards upon proposal of the Managing Directors. Minister of Finance issued a Notice to SCBs to allow them 13. Audit, in a manner and substance to set freely interest rates on loans and deposits; BOL satisfactory to the Association, the calendar year prepared a time-bound action plan for implementation. 2001 accounts of SCBs, and for the Agricultural Promotion Bank the calendar years 2000 balance Accounting and Auditing sheet and 2001 accounts. 2. Institutional Restructuring MOFtBOL/SCBs signed MOUR for each SCB which 14. Procurement of the professional services of Addressing SCBs financial and includes (i) phased capital build-up based on improved at least two banking advisors, to provide operational weaknesses. operational performance; (ii) temporary management advisory services for the management of SCBs, Financiai Management Adjustment Credit LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 7 of 8 REFORM PROGRAM MATRIX Issues/Objectives Actions Taken by Lao PDR Actions to be Taken by Lao PDR to Satisfy Second Tranche Release Conditions support to SCBs in the form of international advisors and with qualifications and experience adequate to (iii) an action plan in case SCBs do not reach performance carry out their services detailed in terms of indicators. reference satisfactory to the Association. 15. Resolution of an aggregate amount of Kip 100 billion equivalent of SCBs non-performing loans of at '. .nt accout, ,i a uianner and substance satisfactory to the Association, through: (i) the liquidation of non-viable companies; (ii) the restructuring of viable companies such that their debts can be fully serviced by their cash-flows; (iii) the seizure and sale of assets to recover cash; or (iv) the exchange of the loan for cash or marketable assets. 16. Preparation of an assessment, in a manner and substance satisfactory to the Association, that identifies ten non-performing loan accounts undergoing resolution. Financial Management Adjustment Credit LAO PDR - FINANCIAL MANAGEMENT ADJUSTMENT CREDIT Page 8 of 8 REFORM PROGRAM MATRIX Issues/Objectives Actions Taken by Lao PDR Actions to be Taken by Lao PDR to Satisfy Second Tranche Release Conditions C. Micro/Rural Finance for Poverty Alleviation Measures for the development 17. Preparation of, in consultation with MOF, of sustainable rural and micro- BOL, and the relevant provincial authorities finance. and microfinance entities including Cooprative PreparinQy a supportive de Credit de Soutien aux Producteurs, enviromnt Microfinance Project and Projet de Developpement Dcentralise de Phongsaly, a policy statement, an assessment, and a time- bound action plan to address the implementation of a rural and microfinance reform program, all in a manner and substance satisfactory to the Association. IV. PROJECT IMPLEMENTATION UNIT BOARD CONDITION (MET) Project Management Establishment of a Project Implementation Unit (PIM) at the Ministry of Finance, satisfactory to the Association, for implementation of the FMAC and the FMCBC by May 2002, before Board presentation. Financial Management Adjustment Credit FMAC - Statistical Annex Page I of 8 L,ao PDR at a glance 9/21/01 East POVERTY and SOCIAL Lao Asia & Low- PDR Pacfic Income Development dtamond 2000 Populatlon, mid-year (rntHons) 5.2 1,853 2,459 ULe expectancy GNI per capita (Ailas metho USS) 290 1.060 420 GNI (Abas method, US$ blil.ns) 1.5 1,964 1T030 Average annual growth, 199440 Population (%) 2.5 1.1 1.9 9rs Labororc () 2.2 1 4 2.4 GNI per " primary Most recent estimate (latest year available, 199400) capita enrollment Povarty (% ofpopulabion below nabonal poverty line) Urban population (' of toal populaton) 24 35 32 Life expectancy at bbth (yearq) 54 69 59 Infant mortallty (per 1 O0 live bths) 93 35 77 Child malnutrition (% of chdren under 5) 40 13 .. Aocess to improved water source Access to an Impmved water source (X utpopulabon) 90 75 76 Illteracy (% of populaton age 1*+) 51 14 38 L POR Gross prlmaryenrollment (9 otschool-agepopulston) 112 119 96 ao Male 123 121 102 Low-ncome group Female 101 121 86 KEY ECONOMIC RATIOS and LONG-TIRM TRENDS 1980 1990 1999 2000 Economic ratios GDP (USS bIllons) 0.86 1.8 2.1 Gross domestic investment/GDP .. .. 22.7 20.4 Exports of goods and servkceslGDP .. 11.3 24.7 22.9 Trade Gross domestic saavngsaGDP .. Gross natlonal savings/GDP .. .. 16.4 14.6 Curent account balance/GDP .. -11.8 -5.2 -4.6 DomestIc Interest payments/GDP 0.3 0.5 0.5 savInInvestment Total debVGDP 204.5 143.8 116.4 s s/ngj Total debt service/exports 8.7 7.1 7.5 Present vatue of debVGDP 78.9 Present value of debt/exports .. .. 267.2 Indebtedness 19510-90 1990-00 1999 2000 2000-04 (average annual growth) GDP .. 6.5 7.3 5.7 6.6 -Lao POR GDP per capita .. 3.8 4.7 3.3 4.0 - Low-4ncome group Exports of goods and services .. .. STRUCTURE of the ECONOMY 1980 1990 1999 2000 Grwth of Investmnt and GDP (%) (% of GDP) io Agricultura .. 61.2 53.5 52.9 Industry .. 14.5 22.5 22.8 Manufacuring .. 10.0 16.9 17.2 Servces .. 24.3 24.0 24.3 0 Private consumption 9. .. .. . 9 99 General govemment consumption . .. .. .. GD1 - GDP Imports of goods and services .. 24.5 1980-90 199040 1999 2000 (average annual growth) Agriculture 3.5 4.9 8.2 5.0 Industry 6.1 11.0 8.0 7.6 Manufacturing 8.9 11.7 7.1 7.8 Services 3.3 8.6 6.7 6.0 Private consumption .. General govemment consumption .. Gross domesUc Investment Imports of goods and services .. Note: 2000 data are preliminary estimates. The diamonds show four key indicators In the country (in bold) compared with is hcome-group average. If data are missing, the dlmond wil be incomplete. FMAC - Statistical Annex Page 2 of 8 Lao PDR PRICES and GOVERNMENT FINANCE Domestic pdces 1980 1990 1999 2000 Inflation (%) (% change) .so Consumer prices .. .. 134.0 27 1 loo.. Implicit GDP deflator .. 38 0 126.5 23.8 Government flnance 50 (% of GDP, Indudes cunmnt grants) c < Current revenue .. 10.0 19.6 19.4 95 96 97 99 99 00 Current budget balance .. . 9.6 8.9 - GDP deflator O CPI Overall surplus/defcit . .. -6.2 -5.7 TRADE (US$ millions) 1980 1990 1999 2000 Export and Import levels (USS mill.) Total exporis (fob) .. 363 393 80 Wood products .. . 106 120 Agriculture .. .. 8 13 Manufactures . .. 100 88 Total imports (cif) . 554 591 400 J 99 * Food .w Fuel and energy Capital goods 147 74 c _ _ _ _ _ Export prce index (1995=100) 94 . .. Import price index (1995=100) . .. .. . Exports Imports Terms of trade (1995=100) BALANCE of PAYMENTS (USS millions) 1980 1990 1999 2000 Current account balance to GDP (%) Exports of goods and services .. 102 509 544 o Imports of goods and services 214 601 636 Resource balance . -111 -93 -93 - . I . Net income .. -1 -28 -37 * f- I I Net curren transfers .. 11 30 30 -10 Current account balance .. -102 -91 -99 Financing items (net) . 135 94 143 Changes in net reserves 3 -34 -3 -44 -20 Memo: Reserves induding gold (US$ millions) . 0 106 140 Conversion rate (DEC, local/US$) 10.2 708 6 5,864.4 6,280.8 EXTERNAL DEBT and RESOURCE FLOWS 1980 1990 1999 2000 (US$ millions) Compositlon of 2000 debt (USS mill.) Total debt outstanding and disbursed 350 1,768 2,527 2,499 IBRD 0 0 0 0 IDA 6 131 405 403 B 403 Total debt service 3 9 37 42 IBRD 0 0 0 0 C42 IDA 0 1 5 7 Composition of net resource flows Official grants 16 47 56 65 E: 1,392 Official creditors 54 146 61 55 Private credrtors 0 0 0 0 D Foreign direct investment 0 6 79 30 Portfolio equrty 0 0 0 0 World Bank program Commitments 13 48 2 0 A-IBRD E -Bilateral Disbursements 5 32 21 20 8- IDA D - Other mulblateral F - Pnvate Principal repayments 0 0 2 4 C - IMF G - Shrort-tenr Net flows 5 32 19 17 Interest payments 0 1 3 3 Nettransfers 5 31 16 14 Development Economics/EASPR 9/21101 FMAC - Statistical Annex Page 3 of 8 LAO PDR: KEY ECONOMIC INDICATORS, 1997-2004 Actual Prel. Est. Projected 1997 1998 1999 2000 2001 2002 2003 2004 Growth Rates (%) Real GDP 6.9 4.0 7.3 5.8 5.2 5 5 6.0 6.5 Consumer price index (annual avg.) 193 85.3 127.1 25.1 8.5 7.2 5.0 5 0 Debt Service Debt service (US$ million) 37.0 38.0 64.0 73.0 74.0 81.0 89.0 96.0 Debt service/XGS (%) 11.7 11.3 18.7 20.8 21 1 218 22.0 22.6 Extemal debt /GDP (%/) 55.9 84.5 80.0 70.1 89.6 86.4 79.1 71 2 Ratios to GDP (current prices) (%) Investment 22.8 22.8 22.5 21.0 22.1 22.5 309 333 National savings 12.2 12.7 14.8 12.7 14 6 15.1 15.2 16 0 Public investment 15.3 15.5 13.3 13.0 12.6 12.7 12.7 12.7 Private investment 7.5 7.3 9 2 8.0 9.5 9.8 18 2 20.6 Ratio of public/private investment 2.0 2.1 1.4 1.6 1.3 1.3 0.7 06 Other Items Export growth rates (nominal) (%) -1.4 6.4 1.5 2.6 -0.3 6.2 8 7 5 4 Import growth rates (nominal) (%) -6.0 -14.7 0.3 2.7 -2.0 4.5 8.1 7.3 Current account balance (US$ million) -before official transfers -282.0 -130.0 -129.0 -143 0 -108.0 -115.0 -123.0 -233.0 * percent of GDP (%) -16.3 -10 1 -8.8 -8.3 -6.2 -6.5 *6.5 -11 3 -aHter official transfers -185.0 -56.0 -60.0 -24.0 -85.0 -61.0 -53.0 -151.0 * percent of GDP (%) -10.6 4.4 -4.0 -1.4 4.9 -3.1 -2.8 -2.4 Gross reserves in weeks of imports 2 5 2 2 2.1 2 5 2.5 2.8 3.4 3.9 Note Figures are rounded Source: Actual data: Lao authorities and Bank and Fund staff estimates. Estimates and projections: World Bank and [MW. FMAC - Statistical Annex Page 4 of 8 LAO PDR: BALANCE OF PAYMENTS, 1997-2004 (USS Million) Actual Prel. Elst. Projected 1997 1998 1999 2000 2001 2002 2003 2004 Exports (fob) 317 337.0 342.0 351.0 350.0 371.0 404.0 425.0 Imports (cif) 648 553.0 554.0 569.0 558.0 583.0 631.0 752.0 Trade Balance -331 -212.0 -212.0 -218.0 -208.0 -212.0 -227.0 -326.0 Services (Net) 28 71.0 98.0 126.0 146.0 146.0 159.0 147.0 Factor income (net) -21 -34.0 -45.0 -73.0 -68.0 -73.0 -79.0 -80.0 of which: Interest -19 -26.0 -35.0 -37.0 -35.0 -38.0 -39.0 -44.0 Transfers (Net) 140 123.0 99.0 142.0 44.0 78.0 94.0 108.0 of which: - Official Transfers 97 74.0 70.0 121.0 23.0 55.0 70.0 82.0 - Private Transfers (net) 43 49.0 30.0 21.0 22.0 23.0 24.0 26.0 Current Account Balance -185 -56.0 -60.0 -24.0 -85.0 -61.0 -53.0 -151.0 (excluding official transfers) -282 -130.0 -129.0 -145.0 -108.0 -115.0 -123.0 -233.0 Capital Account 154 38.0 63.0 68.0 84.0 65.0 64.0 179.0 Medium and Long-Term 161 86.0 65.0 81.0 65.0 63.0 75.0 74.0 -Disbursements 179 98.0 94.0 117.0 104.0 106.0 125.0 126.0 - Amortizations/Principals -18 -12.0 -29.0 -36.0 -39.0 -43.0 -50.0 -52.0 Other capital flows 14 -17.0 -47.0 25.0 34.0 -39.0 -70.0 -63.0 DirectInvestment 104 56.0 82.0 31.0 33.0 41.0 60.0 168.0 of which: hydropower 18.0 27.0 30.0 0.0 0.0 0.0 99.0 Errors and Omissions -125 -86.0 -37.0 -69.0 -48.0 - - - Overall Balance -30 -18.0 3.0 44.0 -2.0 5.0 11.0 27.0 Financing 30 18.0 -3.0 -44.0 2.0 -5.0 -11.0 -27.0 Change in Foreign Reserves 30 18.0 -3.0 -44.0 2.0 -25.0 -46.0 -47.0 IMF (Net) Additional financing needs 0 0.0 0.0 0.0 0.0 20.0 35.0 20.0 Note: Figures are rounded. Source: Actual data: Lao authorities and Bank and Fund staff estimates. Estimates and projections: World Bank and IMF. FMAC - Statistical Annex Page 5 of 8 LAO PDR1 KEY EXPOSURE INDICATORS (USS rnillion) Prel Projected 1997 1998 1999 2000 2001 2002 2003 2004 Total debt outstanding anddisbursed(TDOD) 955 1,087 1,178 1,220 1,571 1,540 1,507 1,475 Public Multilateral 889 971 1,039 1,042 1,089 1,068 1,045 1,021 Bilateral 67 115 125 129 433 429 426 424 Others 14.4 48.5 48.9 42.5 36.0 29.6 Key Debt Service Indicators (%/.) Total debtVGDP 55.9 84.5 80.0 70.1 89.6 86.4 79.1 71.2 DebtservicetXGNFS 11.7 11.3 18.7 20.8 21.1 21.8 22.0 226 Note: Figures are rounded. Source: Actual data: Lao authorities and Bank and Fund staffestirmtes. Estirmtes and projections World Bank and IMF. FMAC - Statistical Annex Page 6 of 8 Financial Management Adjustment Credit Selected Indicators of Bank Portfolio Performance and Management (As of May 15. 2002) Indicator 1999 2000 2001 2002 Portfolio Assessment Number of project under implementation a/ 10 10 10 9 Average Implementation Period (years) b/ 3.4 4.4 3.9 4.5 Percent of problem projects by number a/ c/ 20 30 10 11.1 Percent of problem projects by amount a! c/ 37.6 28.5 14.8 17.0 Percent of projects at risk by number a/ d/ 20 40 30 33.3 Percent of projects at risk by amount a/ d/ 37.6 37.9 43.6 41.6 Disbursement ratio (5) e/ 18.8 12.3 25.1 20.8 Portfolio Management CPR during the year (yes/no) yes yes yes Memorandum Item Since FY 80 Last Five FYs Project evaluated by OED by number 19 6 Project evaluated by OED by amount (US$ million) 355.3 122.0 Percent of OED projects rated U or HU by number 36.8 33.3 Percent of OED projects rated U or HU by amount 19.7 19.1 Note: a. as shown in the Annual Report on Portfolio Performance (except for current FY). b. Average age of projects in the Bank's country portfolio. c. Percent of projects rated U or HU on development objectives (DO) and/or implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the beginning of the year: investment project only. * All indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio, which includes all active projects as well as projects which exited during the fiscal yea FMAC - Statistical Annex Page 7 of 8 Lao People's Democratic Republic Status of Bank Group Operations As of Date 05/15/2002 Closed Projects: 20 IBRD/IDA * Total Disbursed (Active) 91.56 of which has been repaid 0.00 Total Disbursed (Closed) 384.85 of which has been repaid 18.00 Total Disbursed (Active + Closed) 476.41 of which has been repaid 18.00 Total Undisbursed (Active) 97.89 Total Undisbursed (Closed) 1.09 Total Undisbursed (Active + Closed) 98.98 Active Projects Board Last PSR Original Amount in US$ Millions Difference between Date Supervision Rating Expected and Actual Fiscal Disbursements Year Active Projects Development Implementation IBRD IDA Cancel. Undisb. Orig. Revised Objectives Progress 1999 P059305 Distribution Upland Dev. S S 2.0 0.6 0.7 2001 P065973 Agricultural Development S S 16.7 16.2 -0.3 1995 P004200 Health System Reform S S 19.2 6.9 9.0 0.3 1997 P004210 Highway Improvement III S S 48.0 8.4 10.5 1996 P004208 Land Titling S S 20.7 11.2 8.7 3.3 1994 P004207 Luang Namtha S S 9.7 0.2 0.2 1999 P042237 Provincial Infrastructure. S S 27.8 16.6 5.1 2001 P064821 Road Maintenance S S 25.0 21.3 1.6 Southern Province 1998 P044973 Rehabilitation U S 34.7 16.5 6.1 Overall Result result 203.8 97.9 41.7 3.6 FMAC - Statistical Annex Page 8 of 8 Lao People's Democratic Republic Statement of IFC's Held and Disbursed Portfolio As of 5/01/2002 (In US Dollars Millions) Held Disbursed Fiscal Company Loan Equity Quasi Participation Loan Equity Quasi- Participation Year Equity. Equity Approval SEF 1998 BAFCO 0.77 0 0 0 0.77 0 0 0 SEF 1998 Endeavor 0.15 0 0 0 0.15 0 0 0 1998/00 SEF Settha 0.18 0 0 0 0.18 0 0 0 SEF Villa 2001 Santi 1.15 0 0 0 1.15 0 0 0 Total Portfolio: 2.25 0 0 0 2.25 0 0 0 IMAGING Report No.: P 7526 LA Type: PR