Lao Economic Monitor, May 2023: Addressing Economic Uncertainty - Key Findings

Economic activity in the Lao PDR has been weighed down by structural challenges, macroeconomic instability, and a deteriorating external environment. GDP growth was estimated at 2.7 percent for 2022, supported by a gradual recovery in tourism and other services. While the Laos-China railway and new dry port have facilitated travel and trade flows, with industrial activity supported by natural resource exports, recovery has been undermined by macroeconomic instability and external factors. The need to service large external debts, together with high import prices and limited foreign exchange, contributed to a sharp fall in the value of the kip. This caused high inflation, in turn weakening income, consumption, and investment. For many households, real income is falling and spending on health and education is declining.

·         Driven by persistent external imbalances, the kip depreciated sharply in 2022 and fell by 32 and 43 percent against the Thai baht and US dollar respectively in the year to April 2023. The exchange rate has recently stabilized, supported by tighter monetary policy. However, limited exchange liquidity and low reserves have resulted in foreign exchange rationing by commercial banks, driving the parallel exchange market.

·         The depreciation of the kip and rising global prices have resulted in high inflation, which stood at 40 percent in the year to April 2023. Increased global commodity prices, particularly for fuel and fertilizer, have led to rising costs for raw materials and locally produced goods. Food price inflation reached 52 percent year-on-year, severely affecting urban poor households.

·         Real household incomes have suffered from rampant inflation. While the share of households reporting income losses fell from May to December 2022, nearly two-thirds of workers saw their income stagnate or decline amid rising living costs. By the end of 2022, 64 percent of Lao families were living on the same or a lower budget than a year earlier.

·         Fiscal consolidation was driven by tighter expenditure and marginally higher domestic revenues. The fiscal deficit dropped slightly and the primary balance, excluding interest payments, showed a small surplus. However, revenue was still lower than before the pandemic and gross financing needs remain considerable, owing to high debt-service obligations. The lack of fiscal space is limiting the government’s ability to support poor households or to invest in health and education.

·         Public and publicly guaranteed debt has reached critical levels, undermining macroeconomic stability and development prospects. Laos faces both solvency and liquidity challenges, with debt estimated at over 110 percent of GDP in 2022. The energy sector accounted for about 37 percent of debt stock in 2021. China holds about half of the external public debt stock and the repayments scheduled for 2023–26. As the ratio of debt service payments to domestic revenue increased from 35 to 61 percent between 2017 and 2022, public spending on education and health declined from 4.2 percent of GDP to an estimated 2.6 percent in the same period.

·         External imbalances remain high amid foreign currency demand for imports and debt service. As a ratio to GDP, the current account balance slightly worsened in 2022 due to a lower trade surplus and increased net income payments. Export growth was partly offset by higher import prices, particularly for fuel. Capital inflows remained limited as foreign investment declined. With only a third of export receipts entering the domestic banking sector, foreign exchange levels are inadequate.

·         The economy is projected to grow at 3.9 percent in 2023 and accelerate to an average of 4.3 percent in the medium term, led by continued recovery in services and exports. External demand is expected to help sustain manufacturing and agriculture exports, while industry will benefit from investment in the power sector and special economic zones. However, growth is expected to remain below pre-COVID levels, weighed down by structural weaknesses. Inflation will remain elevated in 2023, partly due to high commodity prices and kip depreciation. If structural imbalances are addressed, the economy could recover faster.

·         Household nominal incomes are expected to gradually improve, albeit undermined by high living costs. Inflation has eroded purchasing power, increased consumption costs, and depleted household savings and human capital spending, placing many households at risk of falling into poverty. Assuming Laos remains on this path of vulnerable recovery, per capita income growth will stay below pre-pandemic and regional peer levels in the medium term.

·         The economic outlook is subject to significant downside risks. External risks include low growth and demand in regional economies. On the other hand, inflation in advanced economies could cause further interest rate increases and renew pressure on the kip. Domestic risks include problems in refinancing external debt, slow progress on structural reforms, and deteriorating bank balance sheets. Labor shortages due to out-migration for better wages could also undermine recovery prospects in agriculture, manufacturing, and services.

To restore macroeconomic stability, reforms are needed in five crucial policy areas:

1. raising public revenues to protect spending on education, health, and social protection;
2. improving expenditure allocation and efficiency;
3. expediting debt negotiations;
4. strengthening financial sector stability; and
5. improving the business environment to promote investment and exports.

In addition, improving data availability, timeliness, and quality is key to effective evidence-based policymaking.

Thematic Section: Impacts of Macroeconomic Instability on Lao Households

Lao households are suffering the impacts of continued macroeconomic instability. Low-income households tend to be more vulnerable to inflation than better-off households due to their limited coping ability and lack of financial buffers to deal with higher living costs. Poorer households are also more likely to be affected by a decline in social spending, as benefits from public health and education services represent a greater share of their income.

Inflation has affected almost 90 percent of Lao families, forcing them to adopt coping strategies. Between May and December 2022, urban and high-income families saw their living costs rise by an estimated 24.5 percent and 22.5 percent respectively, owing to sharp increases in food and transport prices. While rural and low-income households are less exposed to inflation, the impact was still widely felt as farm input prices rose. Meanwhile, minimum wages and public sector wages lost 27 percent and 24 percent of their real value over 2020–22. In response to inflation, more than three-quarters of affected households reduced food consumption or switched to cheaper, self-produced, or wild foods. This could lead to poor food and nutrition security.

Constrained government and household budgets have led to a decline in human capital spending, especially among low-income households. Inflation and currency depreciation resulted in higher costs for public health and education, while the rising debt burden, stagnant public revenues, and increases in other expenditure categories have crowded out social spending. Adverse effects are expected to be most keenly felt by low-income households as the better-off are more likely to be able to access private health and education services. Among families affected by inflation, more than half reduced their spending on education and health care. It was reported that about 7 percent of children from low-income households dropped out of school in 2022, mainly for financial reasons.

Key policies to alleviate the adverse impacts of macroeconomic instability:

• Reallocate public spending into priority areas, including health and education.
• Redesign fiscal policy to enable targeted support to the poor and vulnerable. Moving away from tax cuts and exemptions to more progressive fiscal interventions like targeted cash transfers will allow the government to protect household livelihoods from ongoing price shocks at a smaller fiscal cost.