Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No. 38315-LA

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR A PROPOSED GRANT IN THE AMOUNT OF SDR 6.7 MILLION

(US$lO.O MILLION EQUIVALENT)

TO

THE LAO PEOPLE'S DEMOCRATIC REPUBLIC

FOR A

THIRD POVERTY REDUCTION SUPPORT OPERATION

May 8,2007

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 o f their off icial duties. I t s contents may not otherwise be disclosed without Wor ld Bank authorization.

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GOVERNMENT FISCAL YEAR October 1 - September 30

CURRENCY EQUIVALENTS (Exchange Rate Effective as o f M a y 1,2007)

Currency Unit Kip 9,650 - US$1 .oo -

Weights and Measures Metr ic System

Vice President: James W. Adams Country Director: Ian C. Porter

Acting Sector Director: Indermit S. Gill Task Team Leader: Ekaterina Vostroknutova

The Lao PDR Third Poverty Reduction Support Operation i s prepared by an IDA team lead by Ekaterina Vostroknutova (EASPR) and comprising Ahsan Ali (EAPCO), Dan Biller (EASES), Somneuk Davading (EASPR), Pablo Gallego Cuervo (EASPR), Mohinder Gulati (EASEG), Boun Oum Inthaxoum (EASHD), Peter Jipp (EASRD), Morten Larsen (EASEG), Roch Levesque (LEGEA), Zhi Liu (EASTR), William B. Magrath (EASRD), Thomas R. Meadley (EWDEA), Shabih Mohib (EASPR), Apichaya Emiko Naka (EASHD), Minh Van Nguyen (EASPR), Anita Nitaya (EASFP), Toomas Palu (EASHD), Thomas Rose (EASFP), Soudalath Silaphet (EACLF), Vatthana Singharaj (EASPR), Jie Tang (EASEG), Jeffrey Waite (EASHD), Roland White (EASPR) and Lynn Gross (EASPR).

Peer reviewers for PRS03 are: Edward Mountfield (PRMED) and Martin Rama (EASPR) and the team are grateful for their guidance and support. The team i s grateful for guidance and advice from Homi Kharas (EASPR), Ian C. Porter (EACTF), Indennit S. Gill (EASPR), Kazi M. Matin (EASPR), Patchamuthu Illangovan (EACTF), Barbara Nunberg (EASPR), Luis Benveniste (EASHD), Rosa Alonso I Terme (EASPR), Alessandro Magnoli Bocchi (EASPR), Manuela Ferro, Zhanar Abdildina and Jan Walliser (OPCCE).

AAA ADB AFTA APB BCEL BOL BPBL BPKP BPO BRIC CAS CC13 CEPT CFAA CPI CPIA COA DAFI

DAI

EdL EFA EMIS EU FDI FMAC FMCBC GA GDP GFIS

GNP IAS IBA IDA IFC IL IMF IPRS JBIC JSAN LA LDB LDC LDP LECS LIC LICUS LSFC LVKK LVSVT LXP MAF MCTPC

MDGs M&E MEM MFI MOE

FOR OFFICIAL USE ONLY ABBREVIATIONS AND ACRONYMS

Analytical and Advisory Services Asian Development Bank Asian Free Trade Area Agricultural Promotion Bank Banque Commercial Exterieur du Laos Bank of Laos Bolisat Phalithaphanh Beton Lao Bolisat Pattana Khet Poudoi Business Promotion Office Bank Restructuring Implementation Committee Country Assistance Strategy Construction Company 13 Common Effective Preferential Tariff Country Financial Accountability Assessment Committee o f Planning and Investment Country Policy and Institutions Assessment Chart o f Accounts Agriculture and Forest Industry Development Group Agriculture Industry Development Import-Export State-Owned Enterprise Electricit6 du Laos Education for All Education Management Information System European Commission Foreign Direct Investment Financial Management Adjustment Credit Financial Management Capacity Building Credit Governance Agreements Gross Domestic Product Government Financial Management Information System Gross national Product International Accounting Standard' International Banking Adviser International Development Association International Finance Corporation Inclusion List International Monetary Fund Interim Poverty Reduction Strategy Japan Bank for International Cooperation Joint Staff Advisory Note Lao Airlines Lao Development Bank Least Developed Country Letter o f Development Policy Lao Expenditure & Consumption Survey Low Income Country Low Income Country under Stress Lao State Fuel Company Lat Visahakit Konchak Kasikam Lat Visahakit Sanong Vatthou Technique Lane Xang Phatthana Ministry o f Agriculture and Forestry Ministry o f Construction, Transport, Posts and Communications Millennium Development Goals Monitoring and Evaluation Ministry o f Energy and Mining Micro Finance Institutions Ministry o f Education

MOF MOFA MOH MOIC MPDF MTEF NBFIs NEM NGO NGPES

NPEP NPL NPNL NPSEs NPV NSC NSEDP NT2 PEMSP

PER PETS PFA PRGF PMO PrMO PRSO REF RMF ROC RTM SAC SAMD SBD SDT SIDA SLIE SME SMEPDO

SOE SOCB STEA SUFORD TA TFSCB TIN UN UNDAF

UNDP UNESCAP

UNESCO

USBTA VAT WTO

Ministry o f Finance Ministry o f Foreign Affairs Ministry o f Health Ministry o f Industry and Commerce Mekong Private Sector Development Facility Medium-term Expenditure Framework Non-Bank Financial Institutions New Economic Mechanism Non-Governmental Organization National Growth and Poverty Eradication Strategy National Poverty Eradication Program Non-Performing Loan Nam Papa Lao Nam Papa State Enterprises Net Present Value National Statistical Center National Socio-Economic Development Plan Nam Theun 2 (hydroelectric project) Public Expenditure Management Strengthening Program Public Expenditure Review Public Expenditure Tracking Survey Production Forest Area Poverty Reduction and Growth Facility Prime Minister Office Procurement Management Ofice Poverty Reduction Support Operation Rural Electrification Fund Road Maintenance Fund Regional Operations Committee Round Table Meeting Structural Adjustment Credit State Asset Management Department Standard Bidding Documents Special Drawing Rights Swedish International Development Agency Societe Lao Import-Export Small and Medium Enterprise Small and Medium Enterprise Promotion and Development Office State-Owned Enterprise State-Owned Commercial Bank Science and Technology Agency Sustainable Forestry for Rural Development Technical Assistance Trust Fund for Statistical Capacity Building Tax Identification Number United Nations United Nations Development Assistance Framework United Nations Development Program United Nations Economic and Social Commission for Asia and the Pacific United Nations Educational Scientific and Cultural Organization United States Bilateral Trade Agreement Value-Added Tax World Trade Organization

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties. I t s contents may not be otherwise disclosed without Wor ld Bank authorization.

Lao People’s Democratic Republic

THIRD POVERTY REDUCTION SUPPORT OPERATION

CONTENTS

OPERATION AND PROGRAM SUMMARY.. .................................................................................... 111 ...

I .

11 .

III .

Iv .

V .

V I .

VI I .

INTRODUCTION ...................................................................................................................... 1

GOVERNMENT’S REFORM STRATEGY ............................................................................. 4

ACHIEVEMENTS AND CHALLENGES ................................................................................ 6 MACROECONOMIC POLICY AND DEBT SUSTAINABILITY ..................................... 8 PROGRESS WITH POVERTY REDUCTION .................................................................. 11 TOWARDS ACHIEVING MDGs ...................................................................................... 12

KEY POLICY REFORMS UNDER PRSO 1 TO 3 ........................................................... 20 OTHER END-OF-SERIES OUTCOMES .......................................................................... 14

BANK SUPPORT TO THE GOVERNMENT’S STRATEGY ............................................... 23 LINK TO CAS .................................................................................................................... 23 RELATIONSHIP TO OTHER BANK OPERATIONS ..................................................... 23 ANALYTICAL UNDERPINNINGS .................................................................................. 24 COLLABORATION WITH THE IMF AND OTHER DONORS ..................................... 24

THE PROPOSED OPERATION ............................................................................................. 26 COMPONENT 1 : PUBLIC RESOURCE MANAGEMENT ............................................. 28

1.1 : Strengthening Public Expenditure Management ............................................................... 28 1.2: Strengthening the Banking Sector ..................................................................................... 31 1.3: Improving the Performance of State-Owned Enterprises .................................................. 33 1.4: Improving the Financial Sustainability o f Ut i l i t ies ........................................................... 36

COMPONENT 2: PUBLIC EXPENDITURE POLICIES .................................................. 38 2.1 : Aligning Spending with Pro-Poor NGPESMSEDP Priorities ............................. 2.2: Monitoring the Alignment o f Spending with Pro-Poor NGPESNSEDP Priorities .......... 43

COMPONENT 3 : STRENGTHENING PRIVATE SECTOR DEVELOPMENT ............. 44 3.1: Strengthening Private Sector Development ....................................................................... 44 3.2: Accelerating Regional and Global Integration .................................................................. 46 3.3: Improving Resource Management .................................................................................... 48

OPERATION IMPLEMENTATION ....................................................................................... 51 IMPLEMENTATION. MONITORING AND EVALUATION ......................................... 51 POVERTY AND SOCIAL ASPECTS ............................................................................... 51 FIDUCIARY ASPECTS ..................................................................................................... 53 DISBURSEMENT. REPORTING AND AUDITING ASPECTS ...................................... 53 ENVIRONMENTAL ASPECTS ........................................................................................ 54 RISKS AND RISK MITIGATION ..................................................................................... 55

TOWARDS PRSO 4 TO 7 ....................................................................................................... 57 LESSONS LEARNT FROM PRSO 1 TO 3 ....................................................................... 58

i

ANNEXES

ANNEX 1 : UPDATED PROGRAM MATRIX .................................................................................... 62 ANNEX 2: FUND RELATIONS ANNEX ........................................................................................... 74 ANNEX 3: L A O PDR AT A GLANCE ................................................................................................ 75 ANNEX 4: PROGRESS O N INDICATORS AND OUTCOMES ........................................................ 77 ANNEX 5 : LETTER OF DEVELOPMENT POLICY ......................................................................... 83

M A P IBRD 3343 1

BOXES

B o x 1: Vientiane Regional Forum o n National Plans as Poverty Reduction Strategies in EA ............. 5

B o x 3: Good Practice Principles o n Conditionality Applied in Lao PDR ................................... 50 B o x 4: Lessons Learned from Implementation o f PRS01.3 ................................................... 60

B o x 2: The New Organic Budget L a w in Lao PDR . Implications and Challenges ....................... 22

TABLES

Table 1: Summary o f Macroeconomic Framework. 2003 . 2012 ........................................................... 9 Table 2: Selected Social Indicators for Lao PDR .................................................................................. 13 Table 3: Summary o f Progress towards End-of-Series Outcomes ........................................................ 15 Table 4: Progress against HIPC Public Expenditure Management Indicators under PEMSP .............. 16 Table 5: N P L s as percent o f total loan volume. B C E L and LDB between 2001 and 2006 ................... 18 Table 6: Phase 1 SOEs profits and losses. 2003.2005. mi l l ion kip ....................................................... 19

Table 8: Number o f loss-making SOEs ................................................................................................. 34 Table 7: Summary o f Progress against Triggers for PRS03 ................................................................. 26

Table 9: Salary arrears to health workers. FY2005 and Q1 FY2006 .................................................... 40 Table 10: Salary arrears to teachers. FY2005 and Q1 FY2006 ............................................................. 41

FIGURES

Figure 1 : Per capita GNP. US$ per capita. Atlas method. 2000-2005 .................................................... 6 Figure 2: GDP growth. impact o f large projects. and inflation. 2000-2006 ............................................ 7 Figure 3 : Monthly food and non-food inflation ...................................................................................... 7 Figure 4: External Public Debt Service (Baseline and Alternative Scenarios) ..................................... 10 Figure 5 : Consumption Poverty Headcount. 1992/3 to 2002/3 (percent) ............................................. 12

Figure 7: Progress towards Selected Mi l lennium Development Goals ................................................. 14 Figure 8: Improved SOEs performance by group 2003-2005 ............................................................... 19 Figure 9: Break down o f revenues o f SOEs by group. 2004 ................................................................. 34

Figure 6: Poverty Headcount: Priority Districts versus Other Districts. 1992/3 to 2002/3 (percent) ... 12

.. 11

OPERATION AND PROGRAM SUMMARY

Lao People’s Democratic Republic

THIRD POVERTY REDUCTION SUPPORT OPERATION

Borrower

Implementing Agency

Amount

Terms

Tranching

Description

Benefits

Lao People’s Democratic Republic (Lao PDR)

Ministry o f Finance

SDR 6.7 mi l l ion (US$lO.O mi l l ion equivalent)

Standard IDA grant terms

Single tranche

Jointly prepared by the Government and IDA in collaboration with other donors, the Third Poverty Reduction Support Operation (PRS03) supports the implementation o f Lao PDR’s Poverty Reduction Strategy called National Growth and Poverty Eradication Strategy (NGPES). The financial support provided through PRS03 wil l help finance the costs o f implementing key elements o f these strategies, together with other domestic and external financing available to Government. The next proposed programmatic series o f PRS04-7 will support the Sixth National Socio-Economic Development Plan (NSEDP) which successfully incorporates the key principles o f an effective Poverty Reduction Strategy and i s being submitted as such at this time.

The last in a program o f three PRSOs, PRS03 focuses on three broad policy areas consistent with the goals and strategies identified by Government in i t s Poverty Reduction Strategy, and reflected in IDA’S Country Assistance Strategy:

(i) public resource management; (ii) public expenditure policy; and (iii) sustainable growth.

The PRSO program aims to ensure that public resources are efficiently and effectively used to support Lao PDR’s poverty reduction and growth strategies; and to ensure that, over time, more such resources become available through sustained growth and revenue mobilization.

PRSOl supported, among other actions, the establishment o f a Public Expenditure Management Strengthening Program (PEMSP); restructuring o f three major state owned enterprises (SOEs); and enactment o f revised Domestic and Foreign Investment Laws.

PRS02 supported implementation o f the PEMSP and associated capacity building; comprehensive review o f the o ld Budget L a w to

... 111

improve central-local fiscal relations; transparency in budget documents; strengthened Treasury monitoring o f budget execution; the adoption o f an action plan for the financial sustainability o f the state-owned power sector; the conducting o f independent external audits for major SOEs and state-owned commercial banks (SOCBs); and the identification and approval for restructuring o f four additional SOEs. PRS02 la id the foundations for alignment o f public expenditures with NGPES priorities, informed by a Public Expenditure Tracking Survey (PETS) and a Public Expenditure Review (PER). PRS02 supported the drafting and approval by the National Assembly o f a new Enterprise L a w and a new Customs Law.

PRS03, and the policy dialogue, pol icy matrix and performance assessment framework which underpins the program o f PRSOs, i s supporting the delivery o f further benefits in three broad categories:

(9

(ii)

(iii)

Better public resource management: continued progress with implementation o f the public expenditure management strengthening program; improved public pol icy analysis and stronger mechanisms to improve alignment o f budget allocations to NGPES priorities; the drafting o f a new revised Budget Law, Prime Ministerial Decree on Ministry o f Finance functions and draft roles and responsibilities o f the centralized National Treasury; the revision of the government chart o f accounts, realignment o f the Budget Nomenclature, and development o f a functional classification o f the budget that i s consistent with the IMF Government Finance Statistics; the development of quarterly budget execution report formats; increasing the efficiency o f public procurement; strengthened monitoring o f state owned companies including corknercial banks; and implementation o f further phases o f the power sector action plan; Public expenditure policy reforms: consolidating progress in the timeliness o f payment o f salaries to teachers and health workers; further increases in the fuel levy to fund road maintenance; and finalization o f PETS and PER that lay out the analytical background for future improvements in prioritization o f social spending and better execution o f public expenditures program consistent with Government priorities enshrined in the PRS; M o r e sustainable growth and enhanced revenue generation: malung progress with implementation o f the new Enterprise L a w based on international best practice in business regulation, and the revised Customs Law; further progress towards WTO accession and staying o n track with AFTA commitments; and preparation o f a forest industry restructuring plan to rationalize industrial capacity and resource supply.

Progress in these policy areas in turn wil l support a continuation o f the good macroeconomic situation (with growth o f 7.1 percent in 2005, average annual inflation rate at 7.6 percent in 2006, and improved

iv

Risks

Operation ID Number

revenue performance); and continued progress with poverty reduction (building on the decline in the headcount poverty ratio f rom 46 to 33 percent between 199213 and 200213). As programmatic budget support, the PRSO series i s aimed at increased predictability o f funding and the associated dialogue between Government and donors, sharper pol icy prioritization and strengthened donor coordination.

Five main risks have been identified which could affect the impact o f the proposed operation:

Weak public financial management systems indicate high fiduciary risk. This risk i s mitigated through a strong public financial management component built into the PRS03.

Severe capacity constraints in the civil service, due to the lack o f qualified personnel, and l o w pay and incentives. This risk i s partially mitigated by additional resources made available for PRS03 implementation through a WB credit (FMCBC) and a PHRD grant.

Provincial autonomy without adequate monitoring and accountability mechanisms hampers implementation o f national policies and an equitable distribution o f resources. This risk i s mitigated through a technical assistance on public financial management that focuses o n building systems for better central-local relations management and increased central control over expenditure execution and revenue collection.

Continuing fiscal risks could result in the diversion o f PRSO funds away f rom PRS priorities, and to cover losses o f State Commercial Banks and State-Owned Enterprises. This risk i s partially mitigated by program o f monitoring o f SOE and SOCB performance embedded in PRS03 program matrix.

Uneven commitment to reforms in the past has resulted in poor policy implementation performance. Recently, however, the Government has shown increasingly stronger commitment to reforms reflected in better performance on PRSO1-3, extensive dialog on NSEDPPRS, strengthening the central- local fiscal framework, and a commitment to enter international agreements such as WTO accession and AFTA.

A discussion o f these r isks along with mitigating factors i s presented in Section V I o f this Program Document. PO967 10

V

IINTERNATIONAL DEVELOPMENT ASSOCIATION PROPOSED THIRD POVERTY REDUCTION SUPPORT OPERATION

TO THE LAO PEOPLE’S DEMOCRATIC REPUBLIC

I. INTRODUCTION

1. The Government of Lao PDR has made progress in a wide-ranging structural reform agenda and improvement of outcomes in key reform areas i s noticeable. The Government o f Lao PDR has been on the path o f structural shift f rom a planned to a market-oriented economy since 1985, and reinforced this commitment in i t s 5’ and 6th National Socio-Economic Development Plans and in the Poverty Reduction Strategy called National Growth and Poverty Eradication Strategy. This Program Document proposes a Third Poverty Reduction Support Operation (PRS03) for the Lao People’s Democratic Republic (Lao PDR) and presents recent achievements o f the Government and related challenges.

2. PRS03 concludes the first programmatic series of Poverty Reduction Support Operations in Lao PDR and marks three years o f macroeconomic policy and structural reforms. Lao PDR’s First Poverty Reduction Support Operation (PRSO1)’ was approved by the Board o f the International Development Association (IDA) on March 31, 2005, together with the Wor ld Bank Group’s Country Assistance Strategy (CAS) and support to the N a m Theun 2 (NT2) hydroelectric project2 The PRSOl Program Document la id out a pol icy reform matrix and performance assessment framework for a series o f three annual Poverty Reduction Support Operations (PRSOs), including “triggers” for the preparation o f the second PRSO in the series. PRS02 was approved by the IDA Board on April 26, 2006.3 PRS02 was based o n Lao PDR’s continued maintenance o f an adequate macroeconomic framework, continued commitment to the poverty reduction strategy, and adequate (albeit modified) implementation o f the agreed reform program. The Government continued working on al l triggers and actions for PRS02 after closing o f the operation and by now al l triggers have been met.

3. The proposed PRS03 i s based on progress made and continued adequacy of the macroeconomic framework. Lao PDR continues to enjoy rapid economic growth and has made much progress with poverty reduction (see Section II). In the 1990s, real GDP growth averaged more than 6 percent a year and this performance has been sustained in the f i rs t ha l f o f the 2000s. The economy has performed particularly wel l in recent years, with growth increasing to 7.1 percent in 2005 and estimated at about 7.6 percent in 2006. Macroeconomic conditions remain relatively stable, reflecting monetary and fiscal discipline, with inflation in single digits for the last several years, public expenditures under control, and increased revenue efforts underway.

4. The IMF’s latest Article I V consultations4 and recent mission confirmed that economic outlook remains favorable and macroeconomic conditions stable. The last IMF monitoring mission took place in December 2006, and concluded that “macroeconomic outlook remained favorable”, and that “budget performance has been encouraging”. Budget revenues rose f rom 11.4 to 12.4 percent o f GDP, wel l above the original target o f 11.4 percent. The budget deficit shrunk from 3.3 percent o f GDP in

’ PRSCl provided untied financing in the credit amount o f SDR 3.0 mil l ion (US$4.5 mil l ion equivalent) and the grant amount o f SDR 3.6 mil l ion (US$5.5 mil l ion equivalent). See Report No. 3 1747-LA.

NT2 i s a $1.2 bi l l ion private sector investment project including the development, construction, and operation o f a 1,070 megawatt trans-basin diversion power plant on the Nam Theun River. Electricity generated w i l l primarily be exported to Thailand. The WBG’s support includes an IDA grant in the amount o f SDR 13.1 mil l ion (US$20 million); an IDA partial risk guarantee in the amount o f U S 4 2 million; and MIGA guarantees o f up to US$91 mi 11 ion .

PRS02 provided untied financing in the grant amount o f SDR 5.6 mil l ion (US$S.O mil l ion equivalent), see Report

The next Article IV mission i s taking place on April 25-May10, 2007. NO. 35267-LA.

1

FY2004/05 to 1.2 percent in FY2005/06 - especially due to capital expenditures below allocations. Whi le wage bill rose slightly, this was well compensated by reductions in other expenditures. The rapid extension o f credit to state-owned banks that was worrisome last year, has eased, and the strong fiscal position helped BOL to keep tight control o f i t s net domestic assets. The strengthening o f the Baht (to which the kip i s effectively pegged) has not resulted in significant loss o f competitiveness, possibly reflecting dollarization o f economy and relatively flexible wage setting conditions.

5. However, risks remain to this macroeconomic framework, especially on the fiscal side - i.e. sustaining the progress with revenue mobilization this year - and o n external debt side - i.e. continuing a prudent borrowing strategy that would not exacerbate already high debt indicators, and increased revenue effort. More discussion o f these and other r isks i s provided in paragraphs 30-35.

6. Progress with poverty reduction in Lao PDR has been remarkable over the past decade. The poverty headcount has fallen f rom almost ha l f the population in 1997/98 to one third in 2002/03. The share o f the population in poverty was reduced by 30 percent, lifting one eighth o f the total population out o f poverty. Even though the population grew by one mi l l ion people over this period, the absolute number o f poor declined from about 2.1 mi l l ion to 1.9 mill ion. The Lao PDR Poverty Assessment showed that the greatest reductions in poverty headcount happened in the areas that were selected by the Poverty Reduction Strategy (NGPES) as priority districts for poverty reduction efforts including targeted intervention^.^

7. The National Growth and Poverty Eradication Strategy (NGPEUPRS) indicates Government’s commitment to shared growth and social development. The NGPES was prepared through a participatory process and submitted to the Boards o f IDA and the IMF as i t s Poverty Reduction Strategy Paper (PRSP) in 2004. The NGPES establishes a generally appropriate framework for future reforms and makes Government development priorities more explicit and transparent. The Government continuing commitment to poverty reduction and structural reform i s reflected in i t s new 6~ five year plan (the National Socio-Economic Development Plan 2006-lo), which i s finalized and i s expected to be submitted as a PRS to the Boards o f WE3 and IMF.

8. The World Bank Group’s Country Assistance Strategy (CAS) for Lao PDR builds on the NGPESLNSEDP; and the PRSO program forms an integral part o f this strategy. The current CAS i s going to be submitted for extension til l 201 1 soon. Jointly prepared by the Government and IDA, in collaboration with the IMF and other donors, PRS03 supports the implementation o f the NGPES and NSEDP. It builds upon a strong program o f analytical and advisory (AAA) work, both completed and ongoing, and complements the Bank Group’s other activities in Lao PDR, including the so far satisfactory implementation o f the N T 2 project.6

9. Policy dialogue under PRS03 i s focused on three broad policy areas-public resource management, public expenditure policy, and sustainable growth-consistent with the Government’s Poverty Reduction Strategy and IDA’S Country Assistance Strategy, as detailed in Section V. Progress in the past 12 months suggests that Government’s commitment to reform i s deepening in the three areas supported by PRS03 strategy:

Publ ic resource management - supporting ongoing implementation o f a five year Public Expenditure Management Strengthening Program and associated capacity building measures; revising Budget L a w and the organizational structure o f the Treasury Department; revising the chart o f accounts, realigning the budget nomenclature, and developing a functional classification o f the Budget and developing a framework for introducing a system o f Budget

See Lao PDR Poverty Assessment, Report No. 38083-LA. Implementation o f the NT2 project i s assessed in six-monthly performance reviews to the Board.

2

5

Norms in the 2008/9 Budget; strengthening Treasury monitoring o f budget execution; and improving monitoring o f the state owned enterprises, including the state owned commercial banks.

Public expenditure policy - improving the timeliness o f salary payments to teachers and health workers; increasing the fuel levy to ensure that road maintenance i s more adequately financed (and increasingly by users); and staying on track with the energy sector action plan and other actions aimed at improving financial viabil ity o f the state-owned utilities.

Sustuinuble growth - making progress in implementation o f the new Enterprise Law, intended to streamline business registration; progress towards Wor ld Trade Organization accession and with implementation o f AFTA commitments; drafting a decree for the new Customs Law, and preparing a Forest Industry Restructuring Plan to rationalize industrial capacity and resource supply.

10. I n accordance with standard practice for PRSOs, progress in implementing this PRSO series i s monitored using a PRSO Program Matrix, updated annually as part o f PRSO negotiations. The Program Matr ix for PRS03 (Annex 1) records the actions completed by Government for PRSOl and PRS02; and includes 11 “triggers” and 25 actions for PRS03. The impact o f the PRSO program has been evaluated with reference to expected outcomes and indicators, also set out in the Program Matrix, and covering a l l three operations (PRSOs 1-3). The expected outcomes o f the series o f three operations were agreed between Government and IDA at the time o f PRSO 1, and progress o n these indicators to date i s presented in Annex 4.

11, The current progress in achieving triggers and action of the PRS03 operation has been faster than last year. Table 7 on page 26 l is ts the recognized prior actions (triggers) for this operation. One trigger was achieved ahead o f schedule and achieved more than was originally envisaged (Trigger 3). Due to this good performance, one o f the triggers (Trigger 5) had to be substantially modif ied fkom i t s original version. One trigger (Trigger 8) consisting o f four different sub-components, was considered achieved with only three o f those sub-components completed and the last one o n track to completion, at the advice o f the Regional Development Committee (ROC). Other triggers have been completed as planned, with slight modifications o f the language without impacting on the content and approved by the ROC. More details o n the status o f the triggers can be found in Section V.

12. The East Asia and Pacific Regional Operations Committee concluded that the progress has been adequate for provision of financial support to Lao PDR’s NGPES/NSEDP through a Third Poverty Reduction Support Operation in the amount of SDR 6.7 million (equivalent to US$lO million). This would help finance the costs o f implementing key elements o f the NGPESmSEDP, together with other domestic and external financing available to Government. The pol icy dialogue and technical support provided as part o f the PRSO program has so far helped to narrow the gap between the Government’s reform strategy and i t s ability to design and deliver necessary pol icy reform measures in the face o f governance challenges and capacity constraints; as such, i t has played an important role in the improved performance on outcomes and commitment to reform.

13. Since this i s the last o f the first series o f PRSOs, this document also contains a proposed indicative program for support through a second series o f PRSOs. The prospects for the next proposed programmatic series o f PRS04-7 are described in Section VII. An indicative set o f actions and triggers for PRS04 i s being discussed with the Government, and as advised by the ROC, the more specific triggers and actions for PRS04, and PRS05-7 wil l be discussed separately f rom PRS03.

3

11. G O V E R N M E N T ’ S REFORM S T R A T E G Y

14. The Government’s intention, articulated in i t s medium-term strategy, i s to achieve rapid economic growth in order to improve the living conditions of i t s poor, and graduate f rom the status of a least-developed country (LDC) by 2020. The Government’s strategy to achieve these goals has been articulated consistently in several national strategy documents. The most recently approved o f these i s the National Growth and Poverty Eradication Strategy (NGPES, 2004). Implementation o f the NGPES progressed with the Government completing the final draft o f the next National Socioeconomic Development Plan (NSEDP, 2006-lo), the successor to the NGPES and the proposed next Poverty Reduction Strategy.

15. Developed through an increasingly participatory process, N G P E S and NSEDP establish a framework for future reforms and make Government development priorities more explicit and transparent. These priorities are consistent with the multi-dimensional nature o f poverty alleviation. The strategy, in particular, seeks to: (1) deepen structural reforms in areas including public expenditure management, financial sector, State-Owned Enterprises (SOEs), private sector development, trade and legal development; (2) maintain macroeconomic stability by increasing revenue and ensuring appropriate monetary and fiscal policy; (3) invest in the social sectors to expand access and improve social sector outcomes; (4) invest in infrastructure such as roads, power and water supply, and expand access to these services; (5) invest in rural development and natural resource management-including support for agricultural, mining, forestry and hydropower development; and (6) strengthen national capacity and institutions. The Poverty Reduction Strategy underpins both the Country Assistance Strategy (CAS) and the PRSO program.

16. The National Socio-Economic Development Plan (6‘h NSEDP 2006-10) i s expected to be submitted as a Poverty Reduction Strategy this year. The NSEDP 2006-10 integrates the NGPES and builds on i t s participatory approach, poverty focus and to some extent results orientation. The NSEDP 2006-10 complies with the key features o f a successful Poverty Reduction Strategy (see B o x 1). In particular, i t i s poverty focused, has gone through a transparent and accountable drafting process, and contains a small but functional monitoring and evaluation framework. I t also addresses donor harmonization issues. International non-governmental organizations (NGOs) and donors active in Lao PDR endorsed the final NSEDP at the 9th Round Table Meeting (RTM) o n 28 November 2006.

17. The NSEDP envisages the achievement of poverty reduction through a combination of broad-based economic growth and focused and policy interventions. The NSEDP contains a set o f pol icy interventions aimed at achieving i t s key objectives. The four strategic intervention areas o f the plan are i) human development and private sector driven economic growth; ii) competitiveness, trade and regional integration; iii) social development and focused poverty reduction interventions; and iv) good governance. Through these key priority intervention areas, the NSEDP points to the continued evolution o f Lao PDR towards a private sector led economy with modern governance, while keeping a strong focus on human and social development. This geographical targeting o f NSEDP’s interventions reflects the empirical evidence provided by the most recent household survey and Lao PDR Poverty Assessment.

18. The NSEDP however lacks several key features that make for a feasible plan supported by resource envelope. Most importantly, i t i s the lack o f a comprehensive macroeconomic framework that includes reliable break-down o f expected and needed ODA, as wel l as fiscal envelope needed to fulfill Plan’s objectives and achieve targets. Secondly, a more comprehensive monitoring and evaluation framework than the one currently employed, would be beneficial. These concerns are reflected in the currently drafted Joint Staff Advisory Note (JSAN).

4

19. The Government has expressed interest in receiving further support for implementation of 6th NSEDP from the WB and other donors-co-financiers under next series of operations PRS04-7. Current PRS03 dialogue thus involves discussions o n future pol icy reforms which would “trigger” PRS04, as wel l as a broad strategy for the next series (PRS04-7). A more detailed description o f the proposed next series o f operations i s presented in Section VII.

Box 1: National Plans as Poverty Reduction Strategies in East Asia A Regional Forum o n National Plans as Poverty Reduction Strategies in East Asia was held in Vientiane o n April 4-6, 2006. This was the third in a series o f conferences o n poverty reduction strategies and, l ike the f i rst two, was organized jo in t ly with the IMF, ADB, and UNDP. About 125 representatives o f governments, development agencies and NGOs participated.

The main objectives o f the forum were: First, exchange experiences with formulating and implementing national plans and poverty reduction strategies among the six countries o f the region which have participated in the PRSP initiative-Lao PDR, Cambodia, Vietnam, Indonesia, Mongolia, and Timor-Leste-as we l l as the experiences in formulating national plans and poverty reduction strategies in China and Thailand. Second, agree o n core principles for continuing these efforts, and discuss next steps by governments and development agencies.

I t was agreed that the five-year experience with PRSPs has helped in identifying the core principles o f a successful poverty reduction strategy. These are:

Broad participation: consultation and transparency in formulating development strategies;

Poverty focus: a greater poverty focus in the policies and programs that comprise these development strategies.

Results orientation: better monitoring o f the results expected f r o m implementing these policies, better evaluation systems, and a tighter feedback to policymaking; and

Donor harmonization: alignment o f assistance with country priorities, and synchronization o f a id cycles and reporting mechanisms with country processes.

In accordance with the agreed next steps at the regional forum, Lao P D R i s submitting the NSEDP as i t s Poverty Reduction Strategy Paper. The JSAN for the document provides advice o n i t s implementation and assesses the NSEDP as an effective poverty reduction strategy, and provides guidance o n h o w to strengthen aspects related to participation, poverty focus and results monitoring.

Source: http://web. worldbank.orglWBSITE/EXTERNAL/COUNTRIES/EASTASIAPACIFICEXT/ O,,contentMDK:208624 16-menuPK:2098868-pagePK:64002643-piPK:640026 19-theSitePK:226301 ,OO.html

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111. ACHIEVEMENTS AND CHALLENGES

20. Lao PDR i s among the poorest countries in the world. With an estimated per capita income o f U S 4 6 0 in 2005 (see Annex 3), i t i s also below the average o f US$5 10 in developing East Asia. In 2004, 71 percent o f i t s population l ived on less than U S 2 a day, and 23 percent on less than US$1 a day.' Lao PDR has a population o f around 5.6 mi l l ion and a land area o f 236,800 square km. I t has significant natural resources l ike forestry, minerals and hydro-electric power. Despite the recent declining o f i t s share in GDP, agriculture remains the major sector o f Lao economy contributing around 45 percent o f GDP (2005) and employing nearly 80 percent o f the labor force; the industry accounts for a bit more than 29 percent and services for nearly 26 percent. Most o f the GDP i s produced by the private sector, even though Lao PDR i s a one-party state led by the Lao People's Revolutionary Party (LPRP).

21. The Government introduced the "New Economic Mechanism" (NEM) in 1986, to begin the transition from a centrally planned to a market-oriented economy. Gradually, price controls were removed, socialist cooperative farming abandoned as farmers were allowed to work on their plots and assert ownership, the exchange rate system was unified, government's monopoly o n trade removed, the number o f state-enterprises reduced, and free establishment o f private f i r m s allowed.

22. Building on these reforms, from the end o f the 1980s onwards Lao PDR has grown rapidly. In the 1990s, real GDP grew by an annual average rate o f 6.3 percent - despite the sharp fa l l -of f in growth during the regional crisis o f 1997-1999. As shown in Figure 1, Lao PDR's per capita GNP has been increasing fast since 2000. Exports grew at around 15 percent a year, but reaching 50 percent growth last year. Agriculture grew rapidly as did industry and services. A significant decline in poverty has been achieved however during the last decade: using Lao PDR national poverty l ine (of approximately US$1.5 a day) the incidence o f poverty has fallen f rom 46 percent in 1992/93 to around 33.5 percent in 2002/03. The social indicators have been improving too, but they remain among the worst in the region, and the quality o f measurements remains low.

Figure 1: Per capita GNP, US$ per capita, Atlas method, 2000-2005 OIPC.l'P"l. U..rnlW "SI

23. Lao PDR economic performance continued to improve during 2006. Real GDP grew at 7.1 percent in 2005 and growth i s estimated at 7.6 percent in 2006. This growth i s in large part due to foreign investment inflows in mining and hydro-power and growing mineral exports, but the share o f contributions f rom other sources (such as manufacturing and agriculture) has increased this year reaching 4.6 (out o f 7.6) percent. Agriculture, manufacturing and services sectors are expected to sustain growth, due to rising FDI in agriculture, manufacturing, and increasing trend in services (especially tourism).

'East Asia Update, Wor ld Bank (2005).

6

Figure 2: GDP growth, impact o f large projects, and inflation, 2000-2006 +With NT2 and key mining projects +Without NTZ and key mining projects -&- GDP (left axis) -13- Inflation (right axis)

7 5

-- 15

0 , r O 2000 2001 2002 2003 2004 2005 2006

0 -

7 -

6 -

5 -

4 -

3 7

4 2 4 2

2001 2002 2003 2004 2005 2006

24. Bank of Lao has maintained monetary and exchange rate stability since the aftermath of the Asian crisis. Average yearly inflation (of Consumer Price Index) has remained in single digits since 2005, dropping from 15.5 percent in 2003 to 6.8 percent in 2006 as shown in Figure 2. Monthly food and non-food inflation has decreased remarkably during the last 14 months, especially the core or nonfood CPI f rom just above 6 percent in January to 1.7 percent in December 2006 and just 1.0 percent in February 2007 while food CPI has picked up again during November-January (Figure 3). The kip nominal exchange rate to dollar has recently been appreciating. Reserves have increased and remain above the mark o f 3 months o f imports in 2006, pushed by surge in mining exports, tourism receipts, and FDI inflows. The Bank o f Lao PDR (BOL) continues to maintain monetary stability. However, the imports associated with large projects continue to push up the external current account deficit as percent o f GDP.

Figure 3: Monthly food and non-food inflation

Total CPI+Food CPI-Non-food CPI 1141

Source: Lao PDR Economic Monitor, April 2007.

25. Fiscal situation has been steadily improving, especially in the last fiscal year. The budget deficit has come down to 1.2 percent o f GDP in FY2006, as the wage bill increases appear to have been compensated by lower capital spending. During PRS02, the main risks were fiscal, stemming f rom poor revenues and the need for contained expenditure increases. This year, fiscal management has been good and showed progress not seen for decades. Tax collection in FY2006 has exceeded budget forecast by 2 percent, due to the new Tax law that widened the tax base and to the increased receipts f rom large projects and tourism.

26. There i s new momentum in donor support for policy reform implementation, even though Official Development Assistance (ODA) inflows as a share o f GDP have been declining for a couple o f years-mainly due to fast economic growth. Budget support i s on the rise, with JBIC and E C joining the PRSO co-financing, as are initiatives for setting up multi-donor t rus t funds (MDTFs) in two key reform areas, adding to the technical assistance support that i s already being provided. The

7

Government i s also seeking greater donor coordination and harmonization o f foreign assistance through more organized jo in t Government-donor working groups, in support o f policy reform as well as investments in health, education, infrastructure and agriculture. The Government, i t s 22 development partners and the Wor ld Bank signed the Vientiane Declaration on Donor Aid Harmonization during the Round Table Meeting (RTM) in November 2006.

MACROECONOMIC POLICY AND DEBT SUSTAINABILITY 27. Assuming that structural reforms accelerate, real GDP growth i s projected to stay above 7 percent, with underlying growth’ close to 5 percent. Sustaining underlying growth wi l l require ongoing efforts to continue trade reforms and to strengthen the investment climate. Accelerated growth in agriculture and tourism i s expected from increased regional integration, in addition to the continued growth in exports o f electricity and mining products.

28. Latest official IMF staff estimates suggest that financing requirements to support this growth scenario will be up to 3 percent of GDP in foreign financing and up to 1.5 percent of GDP in domestic financing yearly (Table 1). Lao PDR benefits f rom mostly project-related foreign assistance. Apart f rom IDA’S PRSO, ADB and Japan also provide some budget support and other donors are contemplating PRSO co-financing. It i s expected that European Commission wil l start i t s support f rom PRS03 onwards, disbursing the first tranche in FY2008. European Commission support to Lao PDR comes in form o f grants and i s expected to be around EUR3 mi l l ion (around US$4.2 mill ion) per year. JBIC has signed the financing agreement for a concessional loan o f 500 mi l l ion yen (around US$4.2 mill ion) co-financing o f PRS02 in February 2007 and i s l ikely to continue support to PRS03 and PRS04. This donor assistance in the form o f budget support comes useful to fill the financing gap as wel l as helps deal with fiscal r isks discussed below associated with sustaining current revenue performance and dealing with pressures on expenditures side.

29. Government revenues as share of GDP are projected to increase in the medium-term; however uncertainty of fiscal projections beyond FY2010 i s high. M a n y mining projects are currently expected to come on stream in FY2011 (including NT2), but prices o f gold and copper are currently projected to decline in 2011; in addition the process o f centralization o f tax, treasury, and customs i s expected to be implemented and have an impact in the years before that. The uncertainty stemming f rom exact start o f these expected events i s very high at this time, and the impact they would have on revenues i s significant. Table 1 from the Brief ing paper o f the IMF upcoming mission confirms these uncertainties in projections taking a pessimistic view.

30. A number of risks exist, however, that may potentially undermine this economic performance. First, increases in revenues reflect increased mining taxes and royalties, and o i l prices, summing up together to 0.6 percent o f GDP; however the Government lost significant part o f the revenues due to the new exemptions introduced on imports o f petroleum products, eroding the revenue base. Second, appreciation o f the Baht may be potentially harmful to Lao PDR’s economy and should be monitored closely. Third, the accumulation o f arrears to utility companies should be kept under control, and G O L should think o f using increased revenues to cover these obligations. Fourth, non-resource revenue base should be widened. Fifth, expansion o f EdL investments into the power sector and equity stakes financed by external borrowing could be harmful for the external debt position o f the Government, as wel l as to the financial sustainability o f EdL. Sixth, high risk o f debt distress. These risks are partly being addressed through the PRS03.

That is, growth excluding the large projects- such as the Sephon mine and the N T 2 hydroelectric dam.

8

Table 1: Summary of Macroeconomic Framework, 2003 - 2012 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Staff est. Staff proi.

Output and prices Real GDP

Consumer prices (end period) GDP per capita (in millions o f US dollars) Consumer prices (period average)

Savings and investment balance I/

(excluding NT2 and large mining projects)

. Gross fixed investment Private

Foreign Domestic

Government

Private Government

Gross national savings

Foreign savings (including official transfers)

Public finances 2/ Revenue Grants Expenditure

Current Capital and onlending

Domestic financing Foreign financing

Overall balance

Government debt

Balance o f payments

Trade balance Services and income (net) Transfers

Official Private

Current account balance

Capital account balance

Overall balance

Trade Exports Imports

External public debt In millions of US dollars (end period) In percent of GDP (end period) Net present value (in percent of exports)

External Public Debt service In millions o f US dollars In percent o f exports

Gross Official Reserves In millions of US dollars In months of imports 3/

Memorandum items: Nominal GDP (billions of Kip) Nominal GDP (FY; billions ofKip) Nominal GDP (millions o f US dollars)

6.1 4.2

12.6 380 15.5

28.0 17.0 2.0

15.0 11.0 19.9 14.0 5.9 8.1

10.9 2.1

18.6 7.1

11.0 -5.7 0.4 5.1

88.2

-175 -244

-17 86

197 I 1 8 79 22

1,915 93

205

40 6.7

214 3.2

22,597 21,548

2,069

6.4 6.1 8.6

433 10.5

31.9 24.6

9.7 14.9 7.3

17.1 12.3 4.7

14.8

11.0 1.1

15.5 7.4 7.3

-3.4 -0.2 3.6

82.9

-358 -478

34 85

376 118 258

19

19.9 39.0

2,086 86

199

52 7.5

226 3.0

26,539 25,553

2,418

7.1 4.3 8,8

489 7.2

27.6 21.6 12.5 9.1 6.0 7.0 2.3 4.7

20.6

11.4 1.2

16.0 8.0 6.0

-3.3 0.2 3.0

76.3

-576 -559 -102

85 593 115 478

17

22.4 41.8

2,225 80

168

67 7.6

238 2.8

30,705 29,663 2,792

foercenr chanae. unless otherwise indicated) 7.6 7.1 7.9 4.6 4.9 4.9 4.7 4.1 4.4 570 651 711 6.8 4.0 4.5

(inpercent of GDP) 25.0 36.0 35.7 19.5 30.7 30.1 9.7 20.3 19.7 9.9 10.4 10.4 5.5 5.3 5.6

11.1 12.7 14.2 6.0 8.7 10.0 5.1 4.0 4.2

13.9 23.3 21.5

(in percent of GDP) 12.4 12.7 13.3

1.9 1.3 1.1 15.5 15.6 15.1 9.2 9.5 9.2 5.5 5.1 4.9

-1.2 -1.6 -0.7 -1.5 -0.8 -1.6 2.7 2.5 2.3

71.1 63.6 59.8

(in millions of US dollars) -460 -898 -933 -387 -862 -873 -214 -148 -172 141 112 113 559 933 963 159 152 120 400 780 842

99 35 30

fin percent of GDP) 29.0 24.8 26.9 40.2 46.4 46.6

2,416 2,569 2,698 73 67 62

127 133 120

49 79 97 3.9 6.1 6.4

336 371 401 3.8 3.8 3.9

34,581 38,692 43,625 33,612 37,664 42,392 3,300 3,858 4,335

8.2 5.0 4.5 777 4.5

31.7 26.4 15.4 11.1 5.3

15.0 11.4 3.6

16.7

13.1 1 .o

14.6 9.0 4.7

-0.5 -1.4 1.9

56.1

-805 -908

-18 122 835 104 73 1 30

24.4 42.7

2,802 58

122

105 6.7

43 1 3.8

49,327 47,901

4,829

7.6 5.2 4.5 845 4.5

25.4 20.4 10.2 10.2 5.0

14.0 11.3 2.8

11.4

12.6 1 .o

14.4 8.9 4.6

-0.8 -0.8 1.6

52.3

-609 -688

-5 1 130 639

97 541 30

26.1 38.6

2,899 54

109

109 6.0

461 3.8

55,469 53,933

5,358

6.2 5.4 4.5

907 4.5

20.6 15.9 3.7

12.2 4.7

15.6 13.2 2.4 5.0

12.3 0.9

14.4 8.8 4.6

-1.1 -0.4 1.6

52.9

-294 -533 103 137 324 104 219

30

24.9 33.7

2,899 49

104

109 5.7

491 3.8

61,556 60,034

5,878

6.4 5.6 4.5

976 4.5

17.2 12.7 -0.1 12.8 4.5

16.0 11.5 4.4 1.2

12.2 0.9

14.4 8.6 4.8

-1.3 -0.3 1.6

50.3

-80 -370 145 144 110 111

-1 30

24.0 29.6

2,899 45 98

109 5.4

52 1 3.8

68,435 66,715 6,437

Exchange rate (average) 10,516 10,582 10,636 10,061 9,678 9,809 9,953 10,099 10,248 10,399

I/ Estimates for total investment are due to National Statistical Center; and other indicators are estimated using data for public finances and balance ofpayments. 2/ Fiscal year basis (October to September). 31 Excludes imports associated with NT2 and the large Oxiana and Pan Auswalian mining projects.

Source: Government of Lao PDR and IMF Article I V Briefing Paper distributed to departments in Apr i l 2007. Note: Data to be verified during IMF Article I V mission in May, 2007.

3 1. Thus, main risks stem from the vulnerable condition of the budget and the banking system. Whi le much progress has been achieved during PRSO period, in containing credit expansion and improved monitoring, the government needs to continue successful measures to increase revenues, and to

9

keep i t s spending sustainable. Further progress in monitoring banking sector credit expansion and promoting banking sector reform will also be necessary. As discussed below, the external public debt outlook also involves risks.

32. Lao PDR’s external public debt burden remains high, but the debt service burden i s manageable if prudent borrowing strategy i s maintained. According to the latest jo in t Bank-Fund staff Debt Sustainability Analysis (DSA), at end-2004 Lao PDR’s stock o f public and publicly guaranteed external debt amounted to U S D 2.1 b i l l ion in nominal terms and U S D 1.36 b i l l ion in net present value (NPV) terms. This was equivalent to 83 percent o f GDP, or 55 percent o f GDP in NPV terms (with indicative threshold o f 30). The NPV o f external debt comprised 199 percent o f exports (with indicative threshold o f 100) and 495 percent o f fiscal revenues (with indicative threshold o f 200). All three debt stock indicators exceed the indicative sustainability thresholds for countries with comparable CPIA ratings, placing Lao PDR in IDA’S “high risk o f debt distress” category.

33. The latest joint DSA shows that under the baseline scenario medium-term debt service i s manageable conditional on a prudent fiscal policy and continued reforms. The expected boost to exports and fiscal revenues from large projects could help Lao PDR meet i t s external debt service obligations in the medium-term. Nevertheless, the expected twofold increase in debt service between 2004 and 2010 presents substantial r isks to government’s liquidity position (Figure 4). Of the total projected increase in debt service between 2005 and 2010,47 percent represents increased repayments o f concessional loans from multilateral creditors (mainly ADB), about 23 percent are payments to Paris Club creditors and 30 percent i s due to the repayment o f commercial debt. It should be noted that the D S A used less optimistic revenue projections since i t was conducted before revenue effort has increased; the conclusions o n debt sustainability would thus hold and should inter alia be exceeded.

34. Under the baseline scenario, the ratio of NPV of debt to exports would fall below the HIPC threshold of 150 percent by FY2009. There are indications that Lao PDR’s exports may grow faster than indicated in baseline scenario-due to increased and stable metal prices and continuing regional integration. However, this baseline medium-term outlook i s susceptible to several risks. The priority areas that require close monitoring and strong pol icy effort include: (i) maintaining fiscal discipline; (ii) accelerating banking sector reform; (iii) ensuring that new borrowing i s only on concessional terms; and (iv) avoiding excessive reliance o n natural resources. Under an alternative scenario in which the revenue effort stays unchanged at 11 percent o f GDP, the outlook i s much less positive, with the debt service to revenue ratio continuing to r i se significantly.

Figure 4: External Public Debt Service (Baseline and Alternative Scenarios)

120 T Debt-service to revenue (alternative,

24

22

Debt-service t o reven 20 rtght scale I“ persent)

60 18

16

14

12

0 10

100

80

40

20

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Joint Bank-Fund Debt Sustainability Assessment, 2006

35. Lao PDR has so far chosen not to avail itself of debt relief under the Heavily Indebted Poor Country (HIPC) initiative or the Multilateral Debt Relief Initiative (MDRI), a decision that i s consistent with Lao PDR’s commitment to honor its debt obligations. Re-negotiations regarding

10

Russian debt restructuring are s t i l l ongoing, and getting better terms than the preliminary 2003 agreement could alleviate some o f the rise in debt service over the next few years. In addition, Lao P D R now gets al l IDA assistance on grant terns (PRS02 and PRS03 are IDA grants). Lao PDR i s now also eligible for up to 50 percent o f grants within i t s performance based allocation f rom the Asian Development Bank.

36. Given the vulnerable position of the Lao PDR with respect to external debt, it i s recommended that public investment should be financed exclusively by concessional loans or grants. Commercial borrowing, if any, should be consistent with budgetary constraints and the ultimate objective o f ensuring debt sustainability, perhaps only for few specific projects o f proven financial viability. In this context, PRSO team raised concern about the potential budget r isks posed by the Lao Airlines purchase o f two aircrafts f rom China (albeit through a loan which terms were brought down to concessional by the Government o f China) and EdL’s issue o f Thai-baht bonds on non-concessional terms to acquire equity in the N a m Ngum 2 hydropower project. The bond issue i s the only instance known to the WB team o f a borrowing on commercial terms, and does represent a potential contingent liability, since bonds were issued under the Government’s guarantee. The Wor ld Bank i s raising a more general issue o f sustainability o f acquiring stakes in al l upcoming hydro-electric projects and i s advising the Government, in a separate f rom PRSO dialog, to change this pol icy to a more efficient taxation and royalties, in order to reap revenues from natural resources without jeopardizing the financial sustainability o f the EdL.

PROGRESS WITH POVERTY REDUCTION 37. Recent progress with poverty reduction in Lao PDR has been remarkable. The poverty headcountg has fallen f rom almost ha l f the population to one third in a decade. As Figure 5 illustrates, 46 percent o f people did not consume enough to meet basic needs in 1992/3, but this number f e l l to 39 percent in 1997/8 and to 33 percent by 200213. As such, the share o f poverty was reduced by 30 percent in one decade, lifting one eighth o f the total population out o f poverty. Even though the population grew by one mi l l ion people between 1992/3 and 2002/3, the absolute number o f poor declined to less than 2 mill ion.

38. Poverty fell by 1.4 percentage points per year in the first half of this decade and by 1.2 percentage points per year in the second half. Thus, the speed o f poverty reduction remained almost unchanged during this decade, even though poverty reduction tends to become harder the lower the poverty incidence. Wor ld Bank staff projections (see Lao PDR Poverty Assessment) indicate that there i s potential for Lao PDR to continue these positive trends, with simulated poverty headcount rates o f about 25 percent in 2010.

39. Even though the pace of poverty reduction remained similar, the nature changed from the first half to the second half of the decade. Initially, poverty reduction was higher in locations with l o w poverty, which accentuated differences across areas, regions, priority districts and elevation levels. Later, poverty fe l l predominantly in high poverty locations, which in turn tended to diminish poverty differences across domains. For example, the gains in poverty reduction shifted from Vientiane in the f i rs t ha l f o f the decade to the Nor th in the second hal f o f the decade; f rom inland locations (districts not adjacent to foreign borders) to the northern Vietnamese border; f rom districts with mostly flat slopes to districts with mostly steep slopes; and from non-priority districts to priority districts. Due to these spatial shifts, the Gini index o f inequality f irst increased from 30.5 to 34.9, and then decreased from 34.9 to 32.6, and disparities across the four regions narrowed over the second ha l f o f the decade.

T h e poverty headcount gives the share o f the poor in the total population, or the share o f population whose per capita consumption i s below the national poverty line (which i s a complex estimate approximately equivalent to $1.5 per day).

11

Figure 5: Consumption Poverty Headcount, 1992/3 to Figure 6: Poverty Headcount: Priority Districts

80

50

40

30

20

10

0

2002/3 (percent) Poverty Incidence (Headcount) and Inequality (National)

versus Other Districts, 1992/3 to 2002/3 (percent)

Poverty Headcount - Priority Districts

Urban Rural National Inequality

1992193 1997/98 0 2002/03 (ani)

en

50

40

30

20

10

Flmt priority Second priority Other

Source: Lao PDR Poverty Assessment (2007), Government of Lao PDR.

Source: Lao PDR Poverty Assessment (2007), Government of Lao PDR. Note: First priority districts are the 47 priority districts identified in the NSEDP.

40. Nevertheless, poverty retains strong geographic features and thus geographical focus of the NSEDP’s poverty reduction effort i s appropriate. Poverty i s lower in cities than in villages; in areas with roads than those without; along the Thai border than along the Vietnamese border; and in the lowlands than in the uplands. The priority districts are on average much poorer than non-priority districts. Indeed, the Lao Poverty Assessment shows that largest decline in poverty happened in the priority districts (see Figure 6).

41. Increasing market integration was driven by liberalization of private sector, trade and expansion o f the road network (financed by public sector) and was a major driver of poverty reduction during 1997/98-2002/03.’0 Other major entry points for poverty reduction include road access to market, productivity o f farming, lack o f ownership o f land and livestock, l imi ted access to credit and weak marketing chains. Besides physical location, major causes o f poverty include the legacy o f physical devastation during the Vietnam war, with unexploded ordnance (UXO) s t i l l affecting ha l f o f the country’s territory; weak public service delivery, especially in the health and education sectors; inadequate communications infrastructure; and shortcomings in the management o f public resources.

TOWARDS ACHIEVING MDGs 42. Lao PDR faces challenges in meeting the Millennium Development Goals by 2015. In 2004, the Government prepared i t s first Millennium Development Goals Report, jo in t ly with the United Nations. The MDG report sets the goals to be met by 2015, in accordance with the national priorities and through the implementation o f the NGPES (see Figure 7). Lao PDR s t i l l lags behind regional averages o n almost al l key social indicators, as Table 2 illustrates. It also lags behind low-income country averages o n various indicators including l i fe expectancy, access to an improved water source, and primary completion rate. Overall, Lao PDR’s mixed record on social indicators reflects a diff icult transition process in the 1990s, a l o w tax effort at less than 11 percent o f GDP until the last year and unresolved governance challenges.

43. Progress i s being made on literacy rates. According to the draft Lao PDR Poverty Assessment 2006 (LAOPA), at about the halfway point between the 1990 benchmark and the 2015 target date, the three primary education indicators (net enrolment rate, completion rates, and the ratio o f girls to boys)

lo See Lao PDR Poverty Assessment, Report No. 38083-LA.

12

are advancing slowly. By contrast, the literacy indicators (literacy rate o f 15 to 24 year-olds and ratio of 15 to 24 year-old literate women to men) are roughly on target-although ultimately, literacy of young adults wil l hinge on achieving universal primary education, The progress gap i s widest for net enrolment rates. Literacy rates are wel l below regional averages: an adult literacy rate at 73 percent keeps on representing a considerable distance with the regional average at 91 percent. Enrolment rates data are not even, depending on the source, though using UNESCO data Lao PDR would not be too far behind Cambodia or Thailand. Primary completion rate i s also below regional average, as wel l as that of low- income countries, showing that 1 out o f 4 students i s not able to complete primary school.

East Asia & Pacific Lao PDR

Table 2: Selected Social Indicators for Lao PDR 70 55 Life expectancy at birth (years)

2004 I LOW income countries I 59 I

Infant mortality (per 1,000 live births) 2005

East Asia & Pacific (2004) 29 Lao PDR 70 Low income countries (2004) 80

Maternal mortality (per 100,000 live births) 2005

Child malnutrition, weight for age (% of under 5s) 2000

East Asia & Pacific (2004) 117 Lao PDR 405 Low income countries (2004) 684 East Asia & Pacific (2004) 15 Lao PDR 40

East Asia & Pacific 79 Low income countries (2004) 39

Access to improved water source (% of population) 2004

Access to improved sanitation facilities (% of population)

Lao PDR 51 Low income countries 75 East Asia & Pacific 51 Lao PDR 30

2004

44. Progress towards health MDGs i s more satisfactory, especially for child and maternal mortality rates. Although none o f the health targets i s yet close to being met, progress in improving health outcomes related to chi ld and maternal mortality i s remarkable given that domestic spending in this sector has been declining. Health indicators may thus be improving more as a result o f general economic advancement than government action. Chi ld health has improved significantly over the last decade. Vil lage immunization programs have been expanded since the early 1990s and now reach almost every village. As a result, access o f poor households i s almost equal to that o f non-poor households. Similarly, the coverage o f villages with anti-malaria programs increased f rom 68 percent to 75 percent over the decade. I t i s especially important in Lao PDR, where most children are dying from

Low income countries 38 East Asia & Pacific (2004) 91

13

Literacy (YO of population age 15+) 2005

Children reaching grade 5 (% of grade 1 students) 2003

Primary completion rate, total (YO of relevant age group) 2004

Lao PDR 73 Low income countries (2004) 62 East Asia & Pacific . . . Lao PDR 63 Low income countries 72 East Asia & Pacific 98 Lao PDR 74 Low income countries 78

communicable diseases, such as malaria and neo-natal tetanus. Such progress i s l ikely to have contributed to the decline in infant mortality (per thousand l ive births) f rom 104 in 1995 to 70 in 2005, and in under-five mortality f rom 170 in 1990 (WDI, 2004) to 97.6 in 2005, according to NSC's data.

40 1

30 -

Figure 7: Progress towards Selected Mil lennium Development Goals

A

e-- z

Net enrolment in primaryochool -Progress (GOUUN) -LECSlll

+Target - - Linear (Target) 120

Children under 5 mortality rate - 'Target -Progress 2005 (GWUN) - ' Linear (Target)

50

Maternal mortality rate

-Target -Pmgress 2005 (GOUUN) - Lioearrarget)

Percent of underweight chlidren under 5 - 'Target -Progress 2000 (GOLIUN) - 'Linear(Target)

50 1

Source: UN Millennium Development Goals Report for Lao PDR, 2004 (GOL/UN). Maternal mortality rate and infant mortality rate for 2005 are sourcedfrom Population and Housing Census, 2005, by NSC (data is not adjusted for under-reporting and misclass fication).Note: Lao Poverty Assessment (based on LECSIII data) and GOL/UNjgures are generally consistent, but they diverge widely for net primary enrolment rates: the MDG report refers to administrative data, which suggests large improvements, while the household survey data shows sluggish increases only. This is because survey captures attendance rates, while GOL/UN data captures beginning of the year enrollment rates.

OTHER END-OF-SERIES OUTCOMES 45. Overall, the progress towards end-of-series outcomes for the proposed operation has been satisfactory, in comparison to outcomes expected at the start of this series. The progress i s summarized in Table 3, and a more detailed analysis i s done in this section and in Annex 4. As seen in the table below, outcomes in the public financial management have not been fully realized as measured by HIPC indicators; these outcomes are expected to materialize as the pol icy reforms are implemented and have an impact on the budget. In other components o f the operation, progress has been better. There have been significant improvements in the indicators of the management o f the state-owned enterprises, including net profits increase and reaching cost recovery levels. Banking sector has performed well, and the SOCBs have not exceeded financial and operational targets set by the MOF. Progress was uneven but satisfactory overall with respect to reaching MDGs. Indicators related to business environment and regional integration have performed very well.

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Policy sub-areas

1.1.

Performance Assessment*" Indicators' targets

Strengthening Public Expenditure Management

Expenditure planning and budgeting; Budget execution and f inal reporting; Provinces

Improve management capacity; align expenditure allocations with medium-term priorities; speed up budget preparation process; enhance budget execution and procurement

S-

I I

L l L quality; , reduce 1 nf tnn accounts

I .

S+ Increase cost recovery in electricity and water utilities Ta r i f f utilities Financial sustainability o f

COM

2.1.

2.2.

COM

3.1.

- -

3.2.

3.3.

'ONENT 2: P U B L I C E X P E N D I T

Aligning spending with pro-poor NGPESNSEDP priorities

Monitoring the alignment o f spending with pro-poor NGPES

priori t ies 'ONENT 3: SUSTAINABLE GR(

Strengthening Private Sector Development

Accelerating regional and global integration

Improving Resource Management

RE POLICIES

Health; Education; Infrastructure; Pay Reform

Tracking Public Spending; Poverty Data NTH

Share o f budget allocated to health and education; uti l ization o f health centers and services; school enrolment; access to electricity and safe water; roads; c i v i l servants' salary

S

I s Completion o f PER and PETS I

S Business environment and financial sector health

Business environment; Financial sector

Trade I AFTA tariffs I s+ Revenue Improved mobil ization o f management; Forest Domestic revenue; sustainable - management I forest management

* Note: Highly satisfactory (S+), Satisfactory (S), Partially Satisfactory (S-), Unsatisfacto ry (u).

46. I n public financial management, end-of-series outcomes relate to strengthened public expenditure management capacity; improved predictability and NGPES/NSEDP alignment of expenditure allocations; a streamlined budget preparation process and timely publication o f the budget; progress towards a more centralized Treasury with consolidated functions; consolidated and more transparent financial reporting systems; enhanced predictability, efficiency and transparency o f budget execution; enhanced efficiency and transparency o f the national procurement system; and increased coherence between provincial expenditure allocations and Government priorities. These indicators are measured by H P C indicators and by the relative budget allocations for priority sectors.

Partially satisfactory rating for sub-component 1.1 i s mainly o n account o f the delay in revision o f the chart o f accounts due to which the subsequent outcomes did not materialize. Since t h i s action i s n o w completed, i t i s expected that positive outcomes will be realized by 2008-9 as the new chart o f accounts i s implemented.

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47. The indicators in Table 4 assess the targeted impact of the PEMSP program in relation to the HIPC public expenditure management indicators and benchmarks. As noted in the PRSOl Program Document f rom which this table i s reproduced and updated, if the PEMSP program i s implemented as scheduled, Lao PDR would meet a l l but two o f the benchmarks by FY2009. The f i rs t draft o f the Public Expenditure Tracking Survey (PETS) has been already prepared (indicator 10). In addition, Government has improved i t s rating in terms o f identification o f poverty related public expenditures (indicator 6) through the identification and costing o f NGPES priority sectors, and the development o f new early summaries o f budget allocations to these sectors, although further work i s needed to bring this up to “benchmark” level.

48. Thus, Lao PDR i s projected to make progress in achieving some of the HIPC outcome indicators benchmark levels in 2007. With regards to improving budget outturn close to the original budget, this year revenue collection has met (and slightly exceeded) budget estimates. This i s a very significant progress, as over-ambitious revenue estimation has been a recurrent weakness in Lao PDR. The Government has also tried to mainstream PETS as a budget monitoring tool, and the f irst report i s expected to be finalized by M a y 2007.

Table 4: Progress against HIPC Public Expenditure Management Indicators under PEMSP INDICATOR Benchmark FY2004 FY2006 FY2007 FY2009

COMPREHENSIVENESS Budget reporting follows GFS definit ion o f consolidated general govt Government activities no t funded through extra-budgetary sources Budget outtum data (levels, functional allocation) close to onginal budget Budget includes capital and current expenditure financed by donors CLASSIFICATION Budget classified on an administrative, economic and functional basis Poverty-related expenditure clearly identif ied in the budget PROJECTION Multi-year expenditure projections integrated into the budget cycle INTERNAL CONTROL Stock o f expenditure arrears, l i tt le accumulation o f new arrears over past year Internal audit i s active Tracking surveys supplement internal control RECONCILIATION Fiscal and banking reconciliation undertaken routinely REPORTING Internal budget reports f rom line ministnes/Treasury received wthin 4 weeks Functional classification i s reflected in the in-year budget reports FINAL AUDITED ACCOUNTS Closure o f the accounts occurs wthin two months after the end o f the F Y

Source World Bank assessment using HIPC PEM indicators and benchmarks Note Shading indicates when a benchmark is met

(baseline) (actual) (expected) (p roj)

49. The three key deficiencies that remain in the public financial management are: absence of functional classification of the budget, lack of effective budget monitoring system, and low capacity in the audit office. In particular, (i) the absence o f a functional classification o f the budget makes it impossible to determine programmatic spending across sectors and sub-sectors; (ii) lack o f an effective budget monitoring and execution system - GFIS i s very important f i r s t step in this regard and there i s need to further mainstream GFIS, and over time to implement an integrated government-wide financial management information system; and (iii) weak audit capacity at the State Audit Organization - there i s need to develop and implement a comprehensive capacity building program for the SA0 for improving audit capacity. These weaknesses are the main reason why the indicators in Table 4 are below their benchmark levels. These three deficiencies are being addressed gradually by the Government. Below i s a br ie f discussion o f Government plans for addressing these weaknesses:

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Developing a functional classijkation of the Budget: The Minister for Finance has approved the new GFS consistent structure o f the chart o f accounts (PRS03 trigger). This i s very significant step in improving the budget classification system. The government aims to implement the new structure o f the chart o f accounts by the FY2008/9 Budget . Once this i s done, the benchmarks on “comprehensiveness” will reach benchmark levels. This action i s critical for the N T 2 revenue management arrangements. The government has already established an inter-departmental team and engaged advisory services for getting this assignment done in time for the FY2008/09 budget.

Improving budget monitoring and execution system: Until a few years ago, budgeting was done on paper and there was n o systematic information recording framework. In this context the deployment o f GFIS across a l l ministries and provinces has been a leap in the Lao context towards improving budget monitoring and recording. GFIS i s not yet deployed across districts, where substantial transactions are carried out, however the Government i s in the process o f instituting a mechanism whereby budget execution information could be consolidated more timely at the respective provincial finance departments. Furthermore, the Government i s making plans to migrate GFIS to a fully integrated system, as GFIS would reach i t s operational capacity by 201 1. However, the problem o f t imely consolidation o f budgetary information i s not only due to lack o f systems. The provincial finance departments currently do not report to the central government, and therefore have n o incentive to report fiscal information up to MoF. This means that even if there i s a system for recording budget information, the incentive for the provinces to report, i s s t i l l lacking. The Government has taken note o f this issue and i s the one o f the main reason that the revised Budget L a w has mandated i s the centralization o f the Treasury. Effective centralization o f the Treasury i s critical in this regard.

Strengthening capacity for audit of public finances: This i s an issue which requires a comprehensive capacity building program for the State Audit Organization. The S A 0 has resolved to institute an audit-peer-review mechanism for the SA0 in order to develop such a comprehensive program. The audit-peer-review process will partner the S A 0 with another capable state audit organization f rom another country to review the current audit practices. Such a review will highlight areas that are weak and require strengthening. It i s expected that the audit peer review will commence sometime in 2007.

50. Achieving the outcome indicators for public financial management in Lao PDR requires significant and sustained capacity building. Capacity building by i t s nature i s a medium to longer term program. Over this PRSO series, the government has approved a new Budget L a w and developed a comprehensive PEMSP. Implementation o f the PEMSP to-date has put together some key building blocks needed for a robust public finance management framework. Outcomes from this work have already resulted in reduction in the stock o f arrears and more timely provision o f salaries to employees, and reduced lag in budget appropriations being received by respective ministries and provinces. Further benefits will continue to accrue over the coming years and during the next PRSO series. There wi l l be need for sustaining the momentum for effective implementation o f the Budget Law.

51. Related to the banking sector, the end-of-series outcomes targeted by the PRSO program are related to enhanced commercialization, transparency and sustainability o f SOCBs. Some steps were taken to improve transparency o f the state banks: international financial advisers are active in the state banks; independent international audits o f these banks have become regular and are giving an impartial assessment o f the situation; BRIC (that includes an MOF representative) drafts and discusses quarterly reports on the state o f SOCBs and shares them with MOF thus making the f irst step to improving the oversight. Particular indicators are related to percent o f non-performing loans (NPLs), especially f rom new risk activities, and to concentration o f top accounts on f l ow loans.

17

52. Some improvements took place in the outcomes for the Banking sector reform. If we take into account the special mention” loans, for both BCEL and LDB, NPLs o n f low loans decreased significantly. NPLs on stock loans followed the same trend, coming down after a sharp increase in 2003. If special mention loans (Cl) are not counted as NPLs, the trends are s t i l l similar, except for F low II lending, where N P L s percentage would remain the same as 2004 instead o f decreasing. The amount borrowed by top ten borrowers on “flow” loans declined in the f i r s t two quarters o f 2006 in comparison to 2005 thus showing an improvement f rom PRS02 period when it was worrisome. The data for 2005 and 2006 in Table 5 i s non-audited and would therefore need to be verified once audits come in.

(in percent) Audited

Loan Grade Classification 2001 2002 2003 2004 Stock and Flow Loans 56 56 75 68 Stock and Flow Loans including C1 80 79 83 74

Unaudited

2005 2006 48 9 52 15

Flow I + Flow I1 Flow I + Flow I1 including C1

Flow I1 1 5 Flow I1 including C1 1 10

32 31 50 69 66 67

6 5 8 6

27 9 33 15

54. For the state owned enterprise reform, the end-of-series outcomes relate to reduced SOE losses, greater transparency and commercial viability of the SOEs. In particular, indicators track percent o f loss-making SOEs; combined annual losses o f the loss-malung SOEs; combined losses o f Phase I SOEs: LA, NPNL, PH3, and BPKP. Overall, performance o f SOEs has been improving. Revenues increased between 2003 and 2004 by 20 percent in nominal terms, and aggregate net profits o f SOE sector more than doubled reaching 725.3 b i l l ion kip (approximately $70 million, see Figure 8). Total number o f loss-making companies decreased fi-om 42 to 34, accounting for 28.8 percent o f total companies in 2003 and 22.8 percent in 2004 (see Table 8). Percent o f loss-making SOEs has decreased from 28.7 percent to 22.8 percent, and combined annual loss o f loss-making SOEs has declined by 7,2 percent in nominal terms to 192 b i l l ion kip (in real terms this would be higher, given inflation o f around 8 percent). Preliminary figures for 2005 for central SOEs conf i rm this positive trend, with further increases in revenues (by 27 percent), and profits (by over 55 percent).

l2 In BOL classification, loans are C1 when they are overdue by 31-90 days. Flow I loans are those approved between January 2000 and March 3 1, 2003. Flow I1 loans are those that were approved after April 1, 2003.

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net profit

to 90.5 percent to 2006. Percent o f water utilities adjusting tariffs towards full cost recovery has also increased from 5 percent in 2003 and 11 percent in 2004 to 35 percent in 2005. Generally, the performance on the SOE sector has been satisfactory, and actually i s more than was expected at the beginning o f the series, and given the pace o f progress on pol icy reform that has been perceived as slow.

5 8. For priority sectors covered by PRSO (health, education, and infrastructure) policies alignment with the NGPESNSEDP, the end-of-series outcomes relate to improved intermediate indicators, such as proportion o f deliveries attended by trained health personnel, primary enrollment rates, or access to roads, and on public allocations to these sectors. Other indicators relate to decreasing the gap between poor and non-poor in terms o f service delivery. As sections above on MDGs and poverty progress show, progress has been good o n some o f these indicators, but uneven o n others. Infrastructure indicators have performed well: the length o f useable roads between 2004 and 2006 increased by 4 percent. Some indicators also related to the monitoring o f spending, and here PER and PETS that have been completed by the Government and the Wor ld Bank teams are a great tool for a better informed pol icy making. As discussed in details in the previous sub-section, while more and faster progress would be needed to achieve MDGs, current progress i s considered satisfactory given the monitored progress made o n social outcomes since the start o f the series in comparison to the expectations.

59. Some breakthroughs have been achieved in the private sector-related agenda. The end-of- series outcomes targeted by the PRSO program under this sub-component are related to creating enhanced competitive environment for private sector development, entrusting greater confidence amongst private sector operators, and increased diversity and competition o f non-state financial institutions. The number o f days required to start-up a business has significantly improved from 198 days in 2003 and 2004 to 163 days in 2005. W h i l e i t s t i l l takes a long time to start a business in Lao PDR, this i s a good start. With respect to provision o f financial services, share o f state banks’ credits to private sector has increased from 78 percent in 2003 to 85 percent in 2006, and non-state banks’ credits as a share o f total credits increased from 41 percent in 2003 to 48 percent in 2006.

60. Some liberalization in trade regime has also been achieved. The end-of-series indicator was measuring the level o f tariffs on imports, targeting to reduce tariffs to 0-20 percent by 2005 and to 0-5 percent by 2008. The National Assembly has recently ratif ied the new tar i f f regimes: 99.5 percent o f the Lao imported products fa l l into the required by AFTA 0-20 percent tariffs interval. The full transit to the new tar i f f schemes will be completed in 2009.

6 1. In resource management, achievements exceeded targets. The end-of-series outcomes are related to strengthening fiscal pol icy and tax collection, and to the coverage o f sustainable forests. As explained above, the revenue performance has improved with revenues rising f rom 11 percent in 200314 to 11.4 percent in 2004/5, and further to 12.1 percent in FY2005/6. This i s the f i rst time in history that revenue performance i s above the targeted level. Concerning the enhanced sustainability and participation in forest management, coverage o f sustainable forest management i s increased f rom a baseline o f 100,000 hectares in 2001 to 635,573 in 2006 and also exceeded the target o f 528,000 set for 2007.

KEY POLICY REFORMS UNDER PRSO 1 TO 3

62. The buoyant economic growth averaging at around 7 percent of GDP during the last decade has been supported by prudent macroeconomic management and ongoing progress with fiscal and structural reforms. Macroeconomic stability was maintained through monetary controls and strict cash management on the budget side; at the same time revenue policies were put in place to reduce fiscal risks. These efforts have been successful and resulted in reduction in budget deficit and meeting o f revenue targets in FY05/06. The success in maintaining macroeconomic stability would not have been possible without continuing structural reforms. Whi le detailed account o f the pol icy reforms undertaken

20

during PRSOl to 3 i s presented in Section V, this section br ief ly summarizes key elements o f these reforms.

63. Progress has been made in the public financial management reform. Budget preparation has become more transparent and predictable. Additionally, the budget approval time has been brought forward f rom October to June. The Public Expenditure Management Strengthening Program (PEMSP) has gained momentum and i s being implemented according to plan, including training and capacity building components. Coupling the PEMSP interventions with the new provisions o n centralization in the Budget Law, makes for a very robust plan for improving public finance management in Lao PDR. There are ongoing efforts in the context o f the PEMSP to improve public financial management in time for N T 2 revenues coming on stream in 20 10, and progress i s being made with identifying eligible expenditures for N T 2 resources. Government also made significant efforts to improve the monitoring and evaluation framework through the Public Expenditures Review and Public Expenditures Tracking Survey. Consultations for establishing PEFA indicators to monitor progress o f PEMSP are ongoing and i t i s expected that the PEFA indicators wil l be piloted by government in FY2007/8.

64. The new revised Budget Law that has potential to strengthen public financial management, especially in i t s currently weakest part - central-local fiscal relations - has been drafted and approved by the National Assembly significantly ahead o f schedule. In order to effectively implement the revised Budget Law, the Minister for Finance has constituted a dedicated Steering Committee and implementation o f the central-local relations package including centralization o f Treasury, customs and tax administration i s ongoing. The intention i s to establish a vertical l ine o f control in the Treasury Department and in revenue management are particularly welcome aspects o f this law. The decree on organization and operation o f MOF and draft ministerial instruction on organizational structure o f the National Treasury are further steps in implementation o f the revised Budget Law. The emphasis o f the future PRSOs will be on making this law operational (see B o x 2).

65. The new Tax Law passed last year and VAT Law that i s currently being drafted are also significant steps to improve revenue collection and broaden the revenue base. The VAT L a w has several strong points, in particular a single rate and limited exemptions, and the Government i s working on revisions to include centralized tax payer units and review o f legal framework. The VAT i s planned to be introduced in October 2008. Successful introduction o f VAT will require significant coordination and collaboration across a l l levels o f customs, tax and treasury. Other efforts o n revenue side include steady and regular increase in fuel levy, notwithstanding o i l price increases that are not subsidized in Lao PDR.

66. The Government has also strengthened oversight of the State-Owned Enterprises and made significant progress in bringing state-owned utilities to the cost recovery levels. Regular and on- schedule electricity and water tar i f f increases took place during PRSOl-3, moving state-owned utilities to cost recovery levels. The Government i s following the Power Sector Act ion Plan to ensure financial viabil ity o f the EdL, and established a Rural Electrification Fund and drafted new water supply law. I t also introduced a forestry sector monitoring system, and Forestry Industry Restructuring plan. The international audits were undertaken by GOL for the largest loss-making SOEs and for the State-Owned Banks, and the largest SOEs have been restructured. The Government has also established regular monitoring o f the progress against the restructuring plans o f SOEs and against financial targets established for the SOCBs.

67. Several steps were taken in the PRSP priority sectors (health, education, and infrastructure). During PRSO 1-3 the Government improved monitoring and timeliness o f payment o f salaries to teachers and health workers. In addition, i t launched pilots o f school grants program and equity funds pilots for hospitals. In infrastructure, i t increased financing o f the road maintenance fund to near financial sustainability through fuel levy increases; and updated road preservation fund.

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68. A shift in approach to the private sector has taken place during PRSO1-3 that marks an important step in transition from a planned to a market economy. The new Enterprise L a w approved last year i s based on international best practice, and implementing decrees are being drafted. At the Round Table Meeting in end-2006, the Government presented a comprehensive strategy for private sector development and trade focusing on improving investment climate and including reduction in cumbersome regulations and procedures at and behind the border. The Government hosted the first Lao Business Forum for private-public dialog and has made progress in answering to requests made by private sector. The Government has also committed to an SME strategy encompassing reforms in many investment climate components, such as regulation o f businesses, access to finance, enterprise taxation and accounting, and infrastructure. In financial sector, several laws and regulations have been drafted, in order to level the playing f ie ld and provide services for domestic and foreign, small and large businesses; these include Banlung Law, Secure Transactions Law, and Decrees o n precious metals and foreign exchange.

69. The government has entered regional and international agreements that require increased transparency and specific economic policies from its members. Lao PDR entered ASEAN/AFTA, and committed to access to the WTO. It became a member o f the Wor ld Customs Organization (WCO). Lao PDR undertook a Diagnostic Trade Integration Study to find main constraints to trade and i s n o w working on reduction in trade regulations. Lao PDR i s working o n WTO accession and has made progress o n i t s commitments to reduce tariffs and introduce single window and other reforms.

Box 2: New organic Budget Law in Lao PDR - Implications and Challenges

The new organic Budget Law aims to address some o f the weaknesses in the current intergovernmental fiscal relations framework that stem from decentralized management o f public finances, without adequate monitoring and control mechanisms. In essence, the new Budget Law, together wi th the Public Expenditure Management Strengthening Program, aims to put in place the fundamentals of a well functioning public finance management framework.

The key elements of the new Budget Law are: (i) the centralization o f the Treasury Department; (ii) the centralization o f the customs and tax departments; and (iii) development o f a robust revenue sharing framework that would allow aligning policies with budget allocations. If successful, these new measures w i l l significantly improve the intergovernmental fiscal relations framework and help the government in establishing greater control on public finance resources, and align policies to the budget more clearly.

Effective implementation o f the Budget Law w i l l require significant capacity, continued political commitment, technical assistance, and a well developed and sequenced 3-5 year Budget Law Implementation Plan for centralization o f the three departments, as wel l as developing the revenue sharing framework. In this regard it will be particularly important to ensure that inter-linkages between these elements o f the plan are carefully calibrated. Another important issue is the implementation o f the Value Added Tax - currently planned for October 2008. In order for this measure to be successful, close coordination will be required between the tax department, customs department and the Treasury. Particular attention w i l l be needed to ensure that the VAT refund system i s properly instituted and tested prior to the introduction o f the VAT. O f particular importance i s the effective centralization o f the Treasury. Without an effective Treasury, all other reform elements may not succeed.

Implementation o f the Budget Law has started with the restructuring o f the Ministry o f Finance via the Prime Ministerial Decree Number 80. T h e Minister for Finance has also constituted a dedicated committee to formulate the related implementing decrees and regulations. The government i s also working on developing a detailed 3-5 years Budget Law implementation plan that looks at each o f the main elements o f the Budget Law, along with their inter-linkages. There will be need for significant and untied financial support to government for developing information systems, human resource management skills, and related technical assistance. for which meater harmonization o f donor suuuort w i l l be crucial.

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IV. BANK SUPPORT TO THE GOVERNMENT’S STRATEGY

LINK TO CAS

70. The present CAS was designed to support the Government’s National Growth and Poverty Eradication Strategy (NGPES). Specifically, the f i rs t two objectives o f the CAS a im to support the implementation o f NGPES priorities by: (i) sustaining growth through improving management o f key drivers - regional integration and private sector development, rural development, and natural resource management; and (ii) improving social outcomes and reducing vulnerability through strengthened public financial management and service delivery capacities and targeted poverty reduction programs. In achieving these first two objectives, the CAS will also focus on i t s third and fourth complementary objectives, namely: (iii) adopting a strategic approach to capacity development and partnerships to y ie ld better NGPES results; and (iv) supporting the implementation o f N T 2 as an example o f an area-based, sustainable natural resource development program that contributes to growth, social outcomes, capacity development and stronger partnerships.

71. The PRSO program i s an integral component of the CAS, supporting the key policy and institutional reforms targeted in both the NGPES and the CAS. The CAS includes a mixture o f programmatic policy-based lending (through PRSOs), investment lending and analytical and advisory (AAA) services. The CAS was presented to the IDA Board at the same time as PRSO1, and included a grant provision o f U S $8 mi l l ion for the current PRS03, plus a further U S $8 mi l l ion for a possible PRS04 (which would be the f irst in a second series o f PRSOs). The actual amounts were US $10 mi l l ion for PRSC1, U S $8 mi l l ion for PRS02, and a proposed U S $10 mi l l ion for PRS03. The proposed CAS update includes a provision o f $10 mi l l ion for each o f the PRSOs 4-7.

RELATIONSHIP TO OTHER BANK OPERATIONS

72. The PRSO program plays a key role in supporting other Bank operations, both ongoing and as envisaged in the CAS; and in turn i s supported by other Bank operations. PRSOs are a complement rather than an alternative to sectoral investment operations: over time, a satisfactory policy- based operation may provide IDA evidence that country policies and institutions are improving and al low more resources to be made available for both sectoral investment operations and budget support. In particular, the Wor ld Bank’s financed Financial Management Capacity Building Credit (FMCBC) ‘ i s assisting the government in implementation o f the PEMSP implementation to N T 2 revenue management arrangements.

73. PRSOs are a critical complement to the Bank’s support for NT2. The Wor ld Bank decision to support the N T 2 project was based on a decision framework with three key elements: (i) Lao PDR establishing and implementing viable development policies, characterized by concrete performance, and national programs for poverty reduction and social and environmental protection; (ii) the technical, financial, economic and implementation aspects o f the proposed project, as wel l as the design and implementation o f safeguards policies, being sound; and (iii) wider understanding and broader support f rom the international donor community and global and local c iv i l society for Lao PDR’s development framework and the proposed project. The PRSOs support the implementation o f development policies, and national programs for poverty reduction and social and environmental protection, as referenced in the f i rst element o f the N T 2 decision framework. The links to N T 2 entail a high degree o f scrutiny o f the reform program, including the PRSO program, through annual consultations with N T 2 partners, the International Advisory Group and ultimately through dissemination o f information to the donor community and the wider public.

23

74. A key component of the first series o f PRSOs supports the Government’s program for improvements in the transparency and effectiveness in public expenditure management, as laid out in its Public Expenditure Management Strengthening Program (PEMSP). The PEMSP inter alia supports implementation of the N T 2 revenues management arrangements which are aimed at resources in support for poverty reduction and environmental protection programs, to be selected according to an agreed eligibil i ty criteria.

75. The FMCBC was designed to finance technical assistance and capacity building needs to support the implementation of the Government’s structural reform programs in public expenditure management, State Commercial Bank reform, SOE reform and enterprise development. F M C B C has already been used to support the financing o f various PRSO-related activities, including independent audits o f SOEs and SOCBs under PRSOs 1 to 3; provision o f technical assistance for revising the chart o f accounts and realigning the budget nomenclature, training o f staff, procurement o f hardware to improve management o f state assets, and the recruitment o f technical assistance under the PEMSP. F M C B C i s now being restructured, to provide additional financing o n grant terms, to assist the government in scaling up the capacity building needs for the PEMSP, implementation o f the revised Budget Law, and reforms envisaged under the PRSOs.

ANALYTICAL UNDERPINNINGS

76. The proposed operation and program are underpinned by analytical work carried out and ongoing in Lao PDR to date, including a Country Procurement Assessment Review (ZOOZ), a Poverty Study (2002), a Country Financial Accountability Assessment (2002), a Public Expenditure Review (2002), a Poverty-Environment Nexus Study (2002), and more recently by the Country Economic Memorandum (2004), Lao Poverty Assessment (see paragraph 199 for description), Public Expenditure Review (see paragraph 200 for description), Poverty and Social Impact Analysis (see paragraph 202 for description), the f i r s t Public Expenditure Tracking Survey (see paragraph 20 1 for description); the Diagnostic Trade Integration Study (DTIS-leading to an integrated strategy and action plan to enhance the global integration o f Lao PDR); and an Investment Climate Assessment (ICA, in collaboration with the ADB). These studies have been prepared by Bank staff in collaboration with Government. Several o f the studies have been completed in collaboration with other donors including the IMF, ADB and EU. As part o f the N T 2 revenue management arrangements, the Government has undertaken to conduct a PER and a PETS every two years, building on those currently under way.

77. The explicit strategy of the PRSO series and accompanying analytical work has been to identify and fill key knowledge-gaps with an emphasis on jo in t work with other development agencies so that there i s buy-in on the diagnosis. The results o f this AAA process were used for building a consensus on pol icy reform, sector investments, and harmonization o f donor assistance in key areas and are reflected in the NGPES and NSEDP as wel l as their implementation.

COLLABORATION WITH THE IMF AND OTHER DONORS

78. The International Monetary Fund’s (IMF’s) Poverty Reduction and Growth Facility (PRGF) was approved by the Fund’s Board in April 2001, and completed three reviews before expiring in April 2005. Subsequent reviews were not completed because safeguard actions for the Bank o f Lao PDR and key structural measures could not be accomplished within the timeframe o f the PRGF cycle. Since April 2005, Lao PDR has been under the Fund’s surveillance-including annual Article IV consultation as wel l as half-yearly macroeconomic assessment letters. The IMF’s last Article IV consultation was discussed by on March 8, 2006. The next Article IV mission i s taking place on April 25- M a y 10, 2007, with Assessment Letter to be provided to the WB on M a y 12, 2007; the macroeconomic framework presented in this document i s consistent with the Article IV Brief ing Paper distributed to departments on April 13,2007.

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79. Overall, the IMP’S staff appraisal in the Article I V and subsequent missions in 2006 highlighted adequacy of macroeconomic policy, but also noted potential risks to its continued success. Particular features o f the macroeconomic performance were (i) the continued encouraging performance o f the economy in 2006; (ii) the favorable economic outlook, provided that progress i s made on structural reforms; (iii) o n the fiscal side, the challenge in 2005 was that o f avoiding an unsustainable expansion o f spending, especially on the wage bill - and 2006 analysis indicated, i t has been dealt with, resulting in sharp decline in budget deficit; (iv) the medium-term pr ior i ty o f mobil izing revenues to meet development needs within a sustainable fiscal framework; (v) the importance o f further progress under the PEMSP to strengthen fiscal management and improve the allocation o f public resources; (vi) the need for prudent debt management to mitigate the r isks f rom high debt burden, and special attention needed to the debts acquired to finance stakes in private hydropower and mining projects; (vii) the appropriate nature o f the current fi-amework o f monetary and exchange rate policy, but with a need to strengthen oversight o f state commercial banks; (viii) the intention to explore more actively the possibility o f jo in t venture partners for the banks; (ix) the steps taken to improve the investment climate; and (x) the need to strengthen statistics. The PRSO program plays an important role in addressing the concerns discussed during Article IV consultations, and the Bank and the Fund will continue close collaboration.

80. PRSOs in Lao PDR reflect an evolving partnership between Government and donors, with the potential to become an important new aid modality and a vehicle for donor harmonization and policy coordination. During preparation o f PRSC1, PRS02, and PRS03, the PRSO program was discussed with major development partners including the IMF, European Commission (EC), Japan International Cooperation Agency (JICA), Japan Bank for International Cooperation (JBIC) and the Asian Development Bank (ADB). For PRS03, the matrix was appraised jo in t ly by the three donors co- financing the program. It i s expected that European Commission wil l start i t s support f rom PRS03 onwards, disbursing the f i rst tranche in FY08-justified by progress made in PRS03 and the fulfillment o f the three European Commission eligibil i ty criteria for Budget Support: i) the existence o f a well- defined national development strategy, ii) a stability oriented macroeconomic pol icy i s in place and iii) that a sound Public Financial Management reform i s on going. European Commission support to Lao PDR comes in form o f grants (approximately in the amount o f EUR3 mi l l ion a year under PRSOs). JBIC has signed a financing agreement for a concessional loan o f 500 m i l l i on yen (around US$4.2 mill ion) as co-financing o f PRS02 in February 2007 and i s currently discussing support to PRS03 and PRS04 in similar amounts.

8 1. For donors not ready or able to co-finance the PRSOs, could provide grants for technical assistance in support of policy reforms and capacity building. The PRSO i s an ambitious agenda, and grant-based technical assistance plays an important role. Several donors are already providing this. JBIC financed consulting to the Business Promotion Office (BPO) in the Prime Minister’s Office (PMO) to support the development o f SOE restructuring plans under the PRS02. The Government o f Japan i s providing a PHRD grant for technical assistance to Government under PRS03. The EC, ADB and Swedish International Development Agency (SIDA) financed technical assistance to support the PRSO- l inked 200516 Public Expenditure Review (PER) and are supporting the Public Expenditure Management Strengthening Program (PEMSP). The PRSO process has involved close collaboration with many other donor-supported initiates-notably, the ADB’s work on banking reform, SIDA’s work o n tax reform and the United Nations Development Program’s work on governance and public administration.

82. With EC and World Bank support, the Government has developed and recently discussed with wide audience of development partners a proposal for a multi-donor trust fund to provide grant-based TA for the Public Expenditure Management Strengthening Program (with E C and Swedish SIDA jo in ing forces). A similar initiative i s being set up for trade-related assistance, with EC, AusAID, and Swiss SECO joining forces under a proposed Wor ld Bank-managed Trade Development Fund (a multi-donor facility).

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V. THE PROPOSED OPERATION

83. Jointly prepared by the Government and IDA and in collaboration with other donors, the Third Poverty Reduction Support Operation (PRS03) supports the implementation o f Lao PDR’s Poverty Reduction Strategy, as reflected in the National Growth and Poverty Eradication Strategy (NGPESPRSP) and the Sixth National Socio-Economic Development Plan (NSEDP). The financial support provided through PRS03 will narrow the gap between the costs o f implementing key elements o f these strategies and the resources available f rom the Government’s own revenues and other donor support.

84. The PRSO program aims to ensure that public resources are efficiently and effectively used to support Lao PDR’s poverty reduction and growth strategies; and to ensure that more such resources become available through sustained growth and revenue mobilization in the future. The last in an in i t ia l series o f three PRSOs, PRS03 i s focused o n three broad pol icy areas consistent with the goals and strategies identified by Government in i t s NGPES, and reflected in the CAS: (1) Public resource management; (2) Public expenditure management; and (3) Sustainable growth.

85. Progress in these policy areas i s supporting a continuation of the good macroeconomic situation; and continued progress with poverty reduction. As programmatic budget support, the PRSO program will contribute to predictability o f funding, and the associated dialogue between Government and donors to strengthened pol icy prioritization and donor coordination. Eleven triggers were negotiated for PRS03. The wording o f these triggers i s set out in Table 7 below along with pr ior actions recognized and negotiated with the Government.

Table 7: Summary o f Progress against Triggers for PRS03

Prior action recognized: MOF approved an updated PEMSP and implementation plan based on 2005/6 PER analysis and demonstrated ongoing progress with its implementation and capacity building

ACHIEVED. Prior action recognized: MOF prepared FY2006-07 budget with: (i) administrative classification; (ii) priority expenditure sectors; and (iii) summary data on statutory funds, and published it within first half o f the fiscal year

Prior action recognized: MOF submitted to the National Assembly an appropriately revised Budget Law, adopted decree on organization and operation of MOF and drafted ministerial instruction on organizational structure o f the National Treasury

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ACHIEVED. Prior action recognized: MOF approved revised GFS compatible chart of accounts structure, budget nomenclature and implementation strategy, following consultations with key stakeholders

ACHIEVED (modified at ROC due to relevance to adjust for over-completion o f Trigger 3). Prior action recognized: MoF approved the reporting formats for quarterly budget execution reports consistent with the revised Budget Law

ACHIEVED. Prior action recognized: BRIC submitted to MOF quarterly evaluation of BCEL and LDB performance against operational and financial targets, including recommendations to banks for targets off track

ACHIEVED. Prior action recognized: BPO carried out monitoring and evaluation and submitted to PMO a semi- annual evaluation of progress against approved restructuring plans for SOEs, including recommendations on corrective actions for SOEs

ACHIEVED (modified at ROC). Prior action recognized: Government and Electricite' du Laos implemented succeeding phases of the power sector action plan, including tariff adjustments, operational efficiency improvement measures, and arrangements for arrears settlement

ACHIEVED. Prior action recognized: Government improved the timeliness of payment of salaries to teachers and health workers

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86. The following sections review in detail progress made in the key pol icy areas covered by the PRSO program. Each section discusses the key issues and government’s reform strategy and actions that the Government plans to carry out under PRS03; and the targeted outcomes and indicators o f the series o f three PRSOs.

COMPONENT 1: PUBLIC RESOURCE MANAGEMENT

1.1: Strengthening Public Expenditure Management

Key issues and Government reform strategy

87. Achieving socially inclusive development in Lao PDR will require sustained efforts to improve the public expenditure management framework. Existing capacity and institutions for public expenditure management remain extremely weak, frustrating efforts to achieve higher growth and poverty reduction. The Government has made key decisions on how the new public finance management framework will function, especially with regards to central-local relations. The revised Budget L a w envisages significant centralization o f treasury and revenue administrations (tax and customs). The challenges to effective implementation wil l be continued polit ical support for centralization o f these departments as wel l as having adequate implementation capacity.

88. Established practices in expenditure planning and budgeting do not provide a sound and predictable basis for aligning resources with NGPESLNSEDP priorities, either at national or provincial level. One o f the key deficiencies has been the absence o f a functional classification o f the budget, meaning that the Government i s not able to allocate resources at the sub-sector level. In addition, the budget preparation process i s based on unrealistic fiscal forecasts - especially revenue estimation; FY2005/06 has been the f i rs t year in recent history that revenue collection has been o n target. The budget preparation cycle i s overly compressed with insufficient time allowed for dialog between MOF, sector ministries and provinces. Project preparation and procurement planning i s often weak. Budgets are often published late, and the structure and coverage o f both the budget and end-year accounts i s deficient. For capital expenditures, a parallel process i s run by the Committee o f Planning and Investment (CPI) and the capital and recurrent sides o f the budget are not wel l coordinated.

89. Although central Government has identified national strategies and national priority programs, the bulk of public expenditures are managed at subnational levels. Furthermore, established intergovernmental fiscal arrangements and budget processes give MOF, CPI and sector ministries litt le influence over how provincial administrations allocate their resources as wel l as providing few incentives for these administrations to budget in line with local needs. The absence o f an effective fiscal reporting and control system means that i t i s not possible to consolidate information f rom provinces in order to determine how the budget was executed. Additionally provincial finance

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departments have litt le incentive to report vertically, as they are managed by local governments. Provincial finance department capacity i s weak, hampering the abil ity to deliver upon national priorities. This i s one o f the central reasons for the current move towards centralizing Treasury and revenue administrations.

90. These issues are addressed by the current work on functional classification and work related to the NT2 revenue management arrangements. In addition to CoA, i t i s useful to identify functions and sub-functions related to poverty spending programs/projects identified in the pro-poor NGPES/NSEDP priorities in the priority sectors. In addition, a sound tracking system for pro-poor NGPESNSEDP priorities would need a comprehensive monthly cash-flow plan, a treasury single account system, and developed internal and external audit procedures. More discussions and dialog wil l be needed to shape such additional interventions.

91. Budget execution i s distorted by the ability of provincial treasuries and other sub- treasuries to retain revenues which may not appear in the formal budget system and, in the case o f surplus provinces, to ho ld on to revenue intended for central government. This significantly reduces the abil ity o f the central government to provide funds to deficit provinces. Budget execution has been further weakened by the lack o f consolidated and transparent financial reporting systems and o f a functionally efficient and transparent national procurement system.

Progress under PRS03

92. A revised PEMSP program document was prepared after national consultations and benefiting from the PER work, and the first and second PEMSP newsletters were published. The PEMSP secretariat engaged a capacity building advisor and a MOF wide English language training program was starting. This program has now entered into i t s second stage, including staff f rom the National Audit Organization. The Government and development partners are n o w in the process o f establishing a multi-donor t rus t fund to support the PEMSP and there i s ongoing progress with implementation and capacity building.

93. PEMSP implementation has remained satisfactory and broadly on track. During the last year o f PEMSP implementation, the following has been achieved: (i) implementation arrangements were strengthened with four dedicated taskforces established to implement component elements of the PEMSP; (ii) a long term capacity building advisor has been engaged; (iii) work on improving the IT infrastructure for the government financial information has commenced; (iv) a new revised Budget L a w was prepared and approved by the National Assembly in January 2007; (v) preparations for a Med ium Term Expenditure Framework in Health and Education sectors continued; (vi) a suitably qualified chart o f accounts advisor was engaged to make sure this critical aspect o f PEMSP i s executed effectively; (vii) a comprehensive I C T strategy has been drafted; and (vi) English language training courses have started for staff o f the Ministry o f Finance; (vii) needs assessment completed for improving debt management; (viii) on-going comprehensive capacity building needs assessment for M o F completed; and (iv) development o f plans for provide comprehensive support to improving quality o f learning at the M o F training centers.

94. As part of PRS03, MOF, MOH, MOE and provinces have resolved to develop and issue a guideline on minimum per capita budget allocations for education and health programs in every province. This was supposed to be a f i r s t step towards establishing a mechanism, consistent with the principle o f decentralization, by which government can ensure minimum service standards and expenditure allocations to NGPESNSEDP priority programs in each province. This action was based o n the expectation that the revised Budget L a w would be promulgated in late 2007. However, based on the good progress that G o L has made with preparation o f the revised Budget Law, and i t s expected promulgation, this action was modified by consensus. The Wor ld Bank team and the Government are o f

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the v iew that i t i s preferable to develop Budget Norms for a wider set o f social/priority sectors in 2007, for implementation in the FY2008-09 budget. These Budget Norms would be based on the revised Budget L a w and would benefit f rom the developed functional classification o f the budget. Given the short time remaining for the old Budget L a w to be in operation, and limited capacity, i t may not be advisable to develop budget norms based on the o ld Budget Law, only to change them in six months time, as the revised Budget L a w gets promulgated.

95. The government has made significant progress with decompressing the budget preparation and approval cycle. In previous years, the National Assembly used to approve an aggregate budget envelope in September, without any aggregate approval by ministry or provinces. However, starting this year, the National Assembly has approved not just the aggregate budget, but has also approved the overall budget ceilings for ministries and provinces in June. This change in budget approval cycle allows M o F to work with other ministries and departments to disaggregate the overall ceilings into l ine item allocations in a more timely manner.

96. MOF submitted to the National Assembly an appropriately revised Budget Law, which was approved by the National Assembly in November 2006, and signed by the President in February 2007. MOF also approved a P M Order on the organizational structure o f the Ministry o f Finance and drafted ministerial instruction on structure and organization o f the National Treasury. This new legislative and regulatory framework addresses key issues including: (i) various aspects o f central-local fiscal relations (including clarifying expenditure and revenue assignments and central-local transfers); (ii) the restructuring o f the Treasury and consolidation o f budget execution functions; and (iii) paving the way for centralization o f the revenue departments. The revised Budget L a w envisages significant changes to the Central-Local relations framework and there will be need for significant technical assistance, staffing capacity, and financial resources for effective implementation o f the revised Budget Law. The Bank team recommended that the Government engage development partners at the soonest in order to secure funding for implementation o f this critical l a w once i t goes into effect. See B o x 2 o n page 22 for a more detailed discussion o f the Budget Law.

97. MOF also formulated and approved a revised GFS-compatible COA and budget nomenclature, together with an implementation strategy that builds on consultations with key stakeholders. In addition to the revision o f the C O A the functional classification o f the Budget was developed in order to facilitate sectoral budget information generation. T o ensure that GFIS can generate timely, accurate and appropriate budget execution reports, MOF also revised reporting format for quarterly budget execution reports. This trigger has been changed from i t s original formulation due to the faster than expected promulgation o f the Budget Law, since there was n o time to do a l l the pieces required under the original trigger, i f we wanted them to be consistent with the new approved Budget law. The CoA i s an important step towards more timely and informative reporting o f in-year budget execution and will support the achievement o f the N T 2 revenue management arrangements.

98. During PRS03, PrMO agreed to take steps to ensure standardized application of procurement rules, including systematic publication o f procurement information and monitoring of outcomes. In addition to standardized application o f procurement rules, the original procurement actions in the PRS03 matrix had also stipulated systematic publication o f procurement information and monitoring o f outcomes. The Procurement Monitor ing Office (PrMO) has finalized the Standard Bidding Documents for Goods and for Works under local Public Bidding, including incorporating the Bank's comments thereon. T w o other important SBDs, the standard Request for Quotation document for Goods and for Works are also nearing finalization. PrMO plans to ho ld a stakeholder workshop and then issue these four most important SBDs together through an official notification by MOF in M a y 2007. Many agencies have already started to use the SBDs, even though they wil l be formally required to be used by al l procuring agencies upon issuance o f MOF's notification.

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99. Much of the information to be published will be derived largely from the data to be reported by procuring agencies and collected through the procurement monitoring system. Collection o f procurement data i s a pre-requisite for publication o f comprehensive i n f ~ r m a t i o n . ' ~ P rMO completed the development o f the Performance Measurement Tool, with Agency Performance Indicators, and applied the tool to four agencies, MOH, MCTPC, EdL and Vientiane capital. The report has been drafted and reviewed by PrMO. The application o f the performance measurement tool to four key government agencies marks the in i t ia l establishment o f the procurement monitoring system. The tool may be refined further based on stakeholder feedback and then rolled-out to al l agencies at the national level.

1.2: Strengthening the Banking Sector

Key issues and Government reform strategy

100. Strengthening of the banking sector i s important to ensure access as well as adequate financing for the desired private sector-led growth in Lao PDR. More immediately, the strengthening i s necessary in order to ensure that fiscal and monetary pressures caused by the weak performance o f the State Commercial Banks (SOCBs) do not distort public resource management and jeopardize macroeconomic stability.

101, The Lao banking sector remains rudimentary and predominantly state-owned. The sector remains small, with assets o f less than US$630 mi l l ion and loans o f US$250 mi l l ion in 2004. The three SOCBs-Banque Commercial ExtCrieur du Laos (BCEL), Lao Development Bank (LDB) and Agricultural Promotion Bank ( A P B t a c c o u n t e d in 2006 for about 52 percent o f the loan market. Three private domestic banks (two jo in t ventures and one with fully private ownership) and six foreign bank branches accounted for the remaining 48 percent. The Government has split APB into two banks by separating i t s functions and portfolio. One bank i s now a commercial bank that extends customer credits, and the second i s a pol icy bank that assumes al l o f the past policy lending on i t s balance sheet. This split should position the commercial APB bank as a viable institution. The Government must be careful however, not to revert to using the bank for non-commercial purposes and should closely monitor i t s performance.

102. The three SOCBs remain essentially insolvent, even though the level of insolvency i s dropping given recent improved performance and some recapitalization by the Government. The current insolvency rests primarily o n the impact associated with the large outstanding Non-Performing Loan (NPLs) portfolios which have yet to be resolved, with the possible exception o f APB (once the banks are fully split). SOCBs continue to be susceptible to pressure to extend non-commercial lending, although this appears to be improving; their capacity to evaluate credits, while being gradually improved, remains weak and proper governance structures, with checks and balances such as external board members, i s only now being addressed with the MOF appointments, but the impact o f the appointments i s yet to be seen. The performance o f the banking sector i s further challenged by the capacity constraints at that the Bank o f Lao PDR (BoL) to conduct effective supervision and enforce prudential regulations.

103. The risk of further deterioration in the loan portfolios of the largest banks i s still of concern. Pressure for non-commercial lending continues. NPL resolution remains slow and often ineffective, although recent write-offs have improved some indicators. The enforcement o f newly

l4 This data will be based o n the indicators in the procurement performance measurement too l o f the proposed monitoring system (such as contract award summaries, number o f procurement through competitive procedures, number o f procurement using SBDs, etc, etc.). Whi le there i s some information (such as bidding advertisements) that does not have to be collected through the monitoring system and can be published in the bulletin, such information would be limited.

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approved operational policies and procedures, especially in the credit underwriting process has not been fully implemented and may require further enhancement. Further efforts are needed to establish effective governance structures with necessary checks and balances and the Board o f Directors need capacity building so they better understand their role and can begin to play a stronger and more responsible role in the performance o f the banks. The performance o f the banks has not been closely monitored in the past by either the supervisor or the owner’s representative, MOF. This shows s igns o f change with the recent review o f the performance reports o f the two large SOCBs and MOF’s appointment o f a representative to the Board o f Directors o f LDB (and coming appointment o f another to B C E L in June 2007). These actions represent positive steps, but will need to be closely monitored to ensure they fulfill their potential.

104. The second tranche of recapitalization of the two SOCBs was conditional on the good performance under the BRIC evaluation of performance against the financial and operational targets by the Banks, and was approved by MOF in March 2007. The report in November 2006 concluded that the Banks met these targets and thus can be recapitalized with the second tranche. Further tranches would also be conditional on quarterly performance evaluation by BRIC.

105. On August 11,2006, the government entered into revised Governance Agreements (GA) for BCEL and LDB, as part o f i t s commitment to the ADB. A similar GA i s n o w being negotiated for APB. These revised agreements seek to streamline the management structure o f the banks, to make managers more accountable, set performance measures and reporting and are expected to put greater emphasis o n concrete improvements in financial performance. The International Banking Advisers (IBAs) have been given expanded responsibility for monitoring performance against the operational and financial benchmarks. Recently i t appears that management o f the banks has begun to use the IBAs more effectively which i s a positive s i g n in the capacity building within the institutions.

106. The fiscal and monetary risks associated with the SOCBs continue during the PRS03 period, as i s elaborated in the section below. However, i t appears that they have moderated slightly in 2005 and 2006 with the improved performance o f the banks, better monitoring of their performance and more active bank supervision.

Progress under PRS03

107. Given the previous experience and weaknesses identified under PRS02, a renewed emphasis was placed on regular and transparent monitoring of the SOCBs under PRS03. The focus i s more on oversight o f the SOCBs by the Bank Restructuring Implementation Committee (BRIC), M O F and BOL. Under PRS03, BRIC submitted to M O F a quarterly quantitative evaluation o f B C E L and LDB performance against operational and financial targets, and suggested to the Banks to take specific corrective actions for the targets o f f track.

108. BRIC monitored the quarterly performance of each SOCB in the following areas: (i) credits by classification (including off-balance sheet items); (ii) new credits originated post April 1, 2003 by classification; (iii) the amount o f NPL resolution and i t s breakdown; (iv) the reduction in concentration risk (exposure to any individual borrower); (v) the percentage o f credits subject to the IBA’s certification which were approved by SOCBs without IBA certification and concurrence; and (vi) the percentage o f growth in SOCB credits. The quarterly reports have been completed (but were delayed given that the revised GAS were only signed in August 2006). The actions taken since the performance reports were submitted by the banks do indicate significantly improved compliance and a deepening understanding within the Government o f i t s role and the need to more closely monitor the performance o f the SOCBs (see Table 5 o n page 18).

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109. Overall BRIC reports showed that the SOCBs have met the majority of its financial performance targets, but have implemented about half of their operational performance plans. For example, B R I C report for B C E L covering the f i rs t nine months o f 2006 - 15 financial indicators in compliance with target, two partially complied; 2 1 operational indicators fully implemented, 12 partially implemented, and one not implemented. The feedback f rom BRIC to the banks i s communicated through the BRIC meetings (as well as reports) which includes two MDs o f the SOCBs. Going forward and starting f rom the last available report, BRIC i s also sending a cover letter to inform the SOCBs o f their targets o f f track upfront and to recommend corrective actions.

110. The Banks also took corrective actions for the targets off track. There are two types o f recommendations in BRIC report concerning the corrective actions - either o n indicators off-track or o n overall criteria (financial, credit policies, operational policies, and reporting criteria). A number o f corrective actions have been taken on off-track as seen in examples below:

o n credit policies criteria for both B C E L and LDB, to perform daily monitoring o f exchange rates to reduce net l iabil i ty and negative positions. BCEL adopted systematic monitoring and set up currency management pol icy and LDB reported daily monitoring in 4th quarter, fully implementing the recommendation;

o n internal audit policies and reporting for LDB, to specify audit work program and reporting in areas such as cash and liquid asset management and portfolio management. LDB has assigned detailed tasked and reporting format for the work areas required thus fully implementing the recommendations.

1 1 1. Independent IFRS 2005 audit reports for BCEL, LDB and APB have been finalized, and the dialog i s ongoing o n their completion between the banks and auditors at this time. The 2004 and 2005 audits o f APB have been completed, though they are s t i l l to be published. The 2004 audits o f LDB and BCEL were completed in spring 2006. They each held internal meetings to discuss the findings and to establish a plan o f action. They have monitored performance under the plan. The 2005 audits o f BCEL and LDB have been finalized, and the 2006 ones will be ready by mid-year. The Government has also placed the burden o f paying for the 2005 and 2006 audits o f BCEL and LDB o n each o f the banks themselves. Once these audits have been completed, the Government should fo l low up to ensure that plans o f action have been prepared and are followed in addressing the weaknesses. In the future, these reports will serve as a good benchmark for improvement in the banks as audit exceptions are eliminated.

112. Under PRSO 3, the MOF had set up an internal team to exercise its ownership role more effectively and committed to appointing qualified representatives to the Boards of BCEL and LDB. Historically, MOF did not take an active role in protecting the Government’s investment and allowed the SOCBs to perform without being adequately monitored. The appointments can have a positive role if the new Board members understand their role and are active on the Board. A representative for LDB has already been appointed, and the one for B C E L has been already identified and will be appointed in June, 2007.

1.3: Improving the Performance of State-Owned Enterprises

Key issues and Government reform strategy

113. Lao PDR’s SOE sector i s relatively small, and thus the potential risk it creates in comparison to an average transition economy. Lao PDR has 149 SOEs (Table S), one third o f which belong to central ministries and the rest belong to provincial authorities. SOEs reporting to the central ministries represent

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the largest companies in terms o f revenue, turn-over, and losses (see Figure 8 o n page 19).15 However, monitoring o f SOEs i s s t i l l important since it may s t i l l present potential risk from the budget perspective.

Table 8: Number of loss-making SOEs 2003 2004 2005

Loss-making SOEs 42 34 -- Central I O 7 6

Provincial 32 27 _ _ Total number of SOEs 146 149 143

Central 48 50 44 Provincial 98 99 99

Source: State Assets Management Department, MoF. Note: Data for 2005 is prelimina y.

114. Concentration in SOEs sector i s high: in 2004, the revenue o f the 11 largest SOEs accounted for more than 70 percent of all SOE revenues. These SOEs include jo in t ventures and exclude banks and are reporting to central l ine ministries. Among these, revenues o f f ive SOEs fully owned by GovernmentI6 accounted for about 42 percent, revenues o f six jo in t venture SOEs” for around 31 percent, revenues o f others (more than 130 SOEs) comprised less than 30 percent (see Figure 9). Preliminary figures for 2005 confirm this trend.

Figure 9: Break down of revenues of SOEs by group, 2004

5 largest S O B The rest

6 largest joint ventures

31%

Source: State Assets Management Department, MoF.

115. Reforms implemented in the early 1990s reduced Lao PDR’s State-Owned Enterprise (SOE) sector substantially. The SOEs today are fewer in number and play a significantly reduced role in the Lao economy in terms o f share o f GDP and employment.I8 Nevertheless, many o f the remaining

l5 These figures are calculated according to the local accounting standards. International audits o f the 4 SOEs o f Phase-I show different figures by company; however these audits do not allow for analysis o f the SOEs sectors as a whole. l6 These include: Electricite Du Laos (EdL), Enterprise o f Telecommunications Lao (ETL), Lao Airlines, Lao State Fuel Company and Capital Water Supply State Enterprise. l7 These include: Lao Telecommunication Enterprise, L a o Brewery Co. Ltd, Lao Soft. Drink Co. Ltd, Lao Insurance Co. Ltd, Lao Tobacco Co. Ltd and Lane Xang Hote l Enterprise.

For example, Lao Airlines obtained a credit from the Government o f Lao PDR, which it on-lent f r o m the credit o f the Import-Export Bank o f China. The credit t o Government o f Lao P D R i s o n commercial terms but subsidized by the Government o f China to bring it down to concessional terms. This credit, in the amount o f U S 3 5 m i l l i on was used to buy two Chinese aircraft. LA reports that the on-lent credit i s with 20 years maturity, 7 years grace period, and 2 percent yearly interest, in dollar terms. Whi le L a o Airl ines has made efforts to improve i t s management and financial accounts, without a jo in t venture and consequently better management practices, it is unl ikely that Lao Airl ines will be able to repay th is credit unassisted. Act ion i s required to harden the budget constraint faced by remaining SOEs, and thereby to sharpen their incentives for reform.

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SOEs continue to generate losses; continue to receive loans guaranteed by the state budget; and continue to account for a significant share o f the stock o f non-performing loans (NPLs) in the banking sector. Efforts to strengthen State-Owned Enterprises (SOEs) are necessary to ensure that the remaining loss- making SOEs do not create further fiscal burdens on the budget or further solvency problems for the banking sector. For the longer term, such efforts will help ensure that the remaining state-owned enterprises become more transparent and commercially viable. Due to these reforms, performance of Lao PDR SOEs has been improving (see paragraph 54).

116. In 2001, Government revived the SOE reform program, with a view to improve enterprise transparency and governance, restructuring those enterprises which have caused losses to the state and banks and rationalizing the regulatory and pricing environment for infrastructure SOEs through tariff reform. The restructuring program that was init ially supported under the FMAC addressed mainly the financial weaknesses o f the most indebted SOEs. The focus was o n operational restructuring o f nine large enterprises in two phases, including sale o f non-core assets, and the gradual move to cost-recovery tariffs.

117. Gradual progress was made in late 2003 and early 2004 in monitoring the performance of remaining SOEs and preparing SOEs restructuring plans to return Phase 1 loss-makers to commercial viability. Indeed, Government carried out restructuring o f two Phase 1 enterprises-Lao Airlines (LA) and Bolisat Pattana Khet Poudoi (BPKP). The SOE reform program has been ongoing, but many challenges remain. Many SOEs do not yet have functioning Boards in place or competent directors; and few SOEs have regular annual audits.

118. The capacity and authority of the Business Promotion Office (BPO) in the PMO also remains insufficient, and its influence on SOEs and ministries that are responsible for their restructuring i s weak. Government recognizes that this combination o f factors limits the state's abil ity to manage risk and execute SOE reform policy. I t i s taking steps to bolster the capacity and authority of BPO and to accelerate implementation o f plans. The NSEDP for 2006-10 indicates that the Government will, over the next five years, complete the restructuring and reform o f SOEs from the center to the provinces and the districts and that only a small number o f key SOEs that are important for the national economy will be kept. The new NSEDP and the new Enterprise l aw lay out a new framework for the SOEs sector, that aims to reform the sector in the long-run, while the short-terms issues are tackled by the BPO. This long-term reform wil l include transforming the SOEs to l imi ted l iabi l i ty companies, and limiting the State's financial l iabi l i ty for their financial actions; a more broad strategy will be aimed at making the current and future SOEs sector sustainable and financially viable, while keeping it small and limiting i t s budget impact.

119. Given the higher priority that i s given to SOE reform in this NSEDP, the new Government that took office in June has started an upgrade of the BPO aimed at strengthening the role o f the BPO and PMO in SOE restructuring process, consolidate power and raise prof i le o f SOE reform. Due to this ongoing restructuring, staff in the BPO has been replaced and increased. This process, however, slowed down progress in SOE reform that has been planned for this year. I t i s hoped that after this restructuring i s completed next year, the progress o f SOE reform will resume and accelerate.

Progress under PRS03

120. The Government i s continuing reforms started under PRSCl and PRS02, to improve situation of the largest loss-making SOEs, in three phases. Phase 1 SOEs include: Lao Airlines (LA), N a m Papa Lao (NPNL), Pharmaceutical Factory #3 (PH3), and Bolisat Pattana Khet Poudoi (BPKP). Phase 2 SOEs include: DAI, LSFC, CC13, and SLIE. Phase 3 SOEs include: DAFI (this moved f rom Phase 2 recently) and Lane Xang Phatthana (LXP), Lat Visahakit Sanong Vatthou Technique (LVSVT), Lat Visahakit Konchak Kasikam (LVKK) and Borisath Phalithaphanh Beton Lao (BPBL). Initially, there

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were five Phase 2 SOEs. However, DAFI Group was moved to Phase 3. DAFI group non-core businesses are currently leased to the private sector (to pay o f f their debts and increase performance) and a more general decision need to be taken about future ownership o f this company; i t makes l itt le sense to audit this company at this time.

121. Under PRS03, Government will start independent external audits of financial accounts for 2005 and 2006 for four Phase 2 SOEs and for three Phase 1 SOEs: Agriculture Industry Development Import-Export State Owned Enterprise (DAI), Lao State Fuel Company (LSFC), SocietC Lao Import-Export (SLIE), and Road Construction Company (CC13), as wel l as o f BPKP, NPNL, and PF3 from Phase 1. The start o f audits has been delayed because the new Government that took office in June required approval f rom Prime Minister’s office before starting these audits; the PM approved the audits start only o n February 9, 2007, and the bidding for contracts has already started. Notwithstanding the delay, more companies and for more years will be audited, which will help build better monitoring basis and database, as wel l as save cost.

122. The Government also followed up on the recommendations of audits completed for Phase 1 SOEs: Lao Airlines (LA), N a m Papa Lao (NPNL), Pharmaceutical Factory 3 (PH3) and Bolisat Pattana Khet Poudoi (BPKP). The auditor made presentation o f the findings o f the audits and BPO has followed up with SOEs on their future plans regarding the audit recommendations. A two-day workshop was held twice over the period under review and brought together SOEs, central and line ministries - owners o f SOEs, aiming at creating consensus among al l the stakeholders involved in SOE reform, as well as initiate specific discussions to fo l low up on the reports.

123. The Government finished the first draft of the restructuring plans for Phase 2 SOEs and will issue these for consultations shortly. V i a support f rom the Japan Bank for International Cooperation (JBIC), the Prime Minister’s Office (PMO) has already completed a report o n the situation o f DAI, LSFC, SLIE, DAFI and CC13. Based o n this report, as wel l as on the workshops outcomes, the Government draft recommendations for these SOEs and updated accordingly the semi-annual report on restructuring progress.

124. Most importantly, BPO continued its quarterly monitoring and evaluation and submitted to the Prime Minister’s Office a semi-annual evaluation of progress against approved restructuring plans for SOEs. The report signed in June, 2006 contains up-to-date information o n the progress o f restructuring and other events on a l l phases o f SOE reform and lays out further actions to be taken. The report finalized by BPO in March 2007 and contains information o n the audits o f Phase 1 SOEs, and recommendations for Phase 2 SOEs. As a result o f this process, awareness has been raised among SOEs’ management on the usefulness o f audits and a closer oversight o f SOEs was beneficial to the outcomes in the sector.

125. Finally, Government completed the SAMD performance monitoring and assessment report for all SOEs for FY05. This survey once again consolidates and summarizes annual financial data o f a l l central and provincial SOEs and identifies loss making and non-performing SOEs. It provides Government with updated information on SOE-related fiscal r isks and further institutionalizes the established monitoring and reporting systems.

1.4: Improving the Financial Sustainability of Utilities

Key issues and Government reform strategy

126. Electricity and water utilities in Lao PDR remain largely under state ownership. There are many challenges to the financial sustainability o f these utilities. In the past, tariffs have lagged inflation and remained significantly below cost-recovery levels. L o w tariffs and complex tar i f f structures have

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resulted in inefficient energy and water usage, and have reduced the resources available for further investment in these sectors. Major arrears have built up to the utilities, including arrears fkom the government budget. Against this, the utilities themselves have fallen behind o n servicing o f their debts to Government.

127. The Government’s strategy i s steadily to adjust utility tariffs to cost-recovery levels and minimize cross-subsidy among consumer categories; to reduce budgetary subsidies to the utilities; and to generate increasing private investment. Progress has been made with implementation o f this strategy in recent years, including not only formulation o f more appropriate tar i f f policies and schedules, but actual revisions o f tar i f f levels and structures. Util i t ies have been given increased commercial autonomy and regulatory capacity i s being steadily developed.

128. As part o f this agenda, MEM, MOF and EdL signed the Action Plan for Financial Sustainability o f Power Sector (Financial Action Plan). This plan i s intended to address the major issues impeding EdL’s financial sustainability, namely the need to increase tariffs to cost-recovery levels; and the need to eliminate the stock and avoid future additions to Government’s payment arrears to EdL. After tar i f f increases last year, the plan’s next components included:

0 tar i f f adjustment, with tariffs being restructured and increased by an average o f 1 percent per year in real terms until 201 1 when cross-subsidy among customer categories should be minimized and full cost recovery achieved (based o n the EdL tar i f f study - Electrowatt, 2004);

settlement o f accumulated arrears f rom Government to EdL, with agreement on a final arrears figure (as o f October 3 1, 2005) by January 3 1, 2006, along with agreement on a settlement schedule over approximately two years. This may be financed, if needed, through EdL’s debt service payments to Government which should go up effective January 2006 upon the expiry o f a one time concession extended through a previous financial restructuring plan o f EdL; and avoidance o f future arrears by Government to EdL; and

0 operational efficiency improvement by EdL, with overall system losses reduced f rom about 20 percent in 2004 to around 13 percent in 20 1 1.

Progress expected under PRS03

129. Under PRS03, Government and EdL had agreed to implement succeeding phases of the Power Sector Action Plan, as described above. In particular, the Government was going to verify, agree and settle the past and new Government arrears on a regular basis up to September 30, 2006. EdL was also going to invest to reduce system losses and i s expected to implement the tar i f f adjustment as per the Act ion Plan.

130. Progress on implementing the Action Plan has been adequate with regard to increasing tariffs and reducing system losses, but slow with regard to dealing with arrears. The MOF and EDL have agreed to settle 113 b i l l ion (out o f in i t ia l ly claimed 125 b i l l ion kip) o f arrears accumulated before September 2005. The settlement o f these arrears i s ongoing in scheduled and agreed upon amounts f rom retained interest payments. Concerning arrears accumulated between October 1, 2005 and October 3 1, 2006, n o formal agreement has been reached yet on the amount o f arrears accumulated during that year, and the Government has committed to agree on this number in July 2007. Preliminary numbers however, show that arrears repayment increased in FY06 as compared to FY05 (the amount o f arrears settled doubled). If no arrears are accumulated in FY07, given the fact that there i s s t i l l room to increase usage o f retained interest payments, a l l existing arrears can be settled by 2010.

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13 1. The Government has also designed a plan for reducing accumulation of new arrears that consists of three main parts: introduction o f energy savings, estimation o f the current consumption by each Government agency, and enforcement o f payments form the Budget. MOF plans to gradually increase the annual budget allocation for electricity consumption in government offices, to reflect verified needs for electricity usage, and will provide incentives for individual offices to pursue efficiency gains. At the same time, EdL will be expected to implement necessary measures (including disconnection, if required) in order to maintain a bill collection time o f not more than 60 days, as per the Contract Plan between EdL and Ministry o f Finance, and in l ine with the Act ion Plan for Financial Sustainability. Unfortunately, these plans have not sufficiently advanced, as they require broad consultations between different agencies o f the Government and may require introduction o f special budget lines. The Government will continue working o n this problem.

132. In addition, Government implemented succeeding phases of the water tariff revisions on schedule, with provincial government authorities adjusting urban water supply tariffs further towards full cost recovery in line with the National Water Supply Tar i f f Policy. Sector responsibilities have been clearly defined. The Water Supply Div is ion o f the Department o f Housing and Urban Planning (DHUP) i s responsible for the urban water sector policy, planning and development; W A S A i s responsible for sector regulation; and the N a m Papa State Enterprises (NPSEs) and other operators are responsible for the delivery o f safe water supply services to customers. The tariffs were fully adjusted in 6 utilities (35%) o f 17 utilities by 2006, however only 2 o f 17 utilities generated a small positive return to capital.

COMPONENT 2: PUBLIC EXPENDITURE POLICIES

2.1 : Aligning Spending with Pro-Poor NGPES/NSEDP Priorities

133. Aligning Lao PDR’s public expenditure policies with pro-poor NGPES/NSEDP priorities i s central to delivery of these national strategies. However, i t i s important to understand the interactions between public expenditure management processes and public expenditure policies. The priority sectors identified in the NGPESmSEDP-health, education, agriculture and forestry, and infrastructure- provide services principally assigned to local levels o f government. Although Government has identified national strategies and national pr ior i ty programs, under current arrangements the bulk o f public expenditures are currently managed at sub-national level and established budget processes give MOF, CPI and sector ministries l itt le i f any influence over how provincial Governors allocate their resources. As such, significant progress with Component 1 o f the PRSO program i s necessary to lay the foundations for longer-term progress with Component 2.

HEALTH: Key issues and Government strategy

134. Access to basic health i s a vital part of Lao PDR’s NGPES and NSEDP. While chi ld mortality indicators are improving, they remain among the highest in East Asia. Although village immunization programs have been expanded and now reach almost every village, full immunization rates (children under 2 years o f age who have received the immunization package) are s t i l l unacceptably low. The coverage o f villages with anti-malaria programs increased f rom 68 percent to 75 percent over the decade. But there are significant differences in health outcomes and health services performance among provinces within Lao PDR. For example, infant mortality rates ranged f rom 125 per 1,000 births in Luang Prabang province to 18 in Vientiane, with a national weighted average o f 82 in 2000; and the proportion o f pregnant women receiving antenatal care ranged f rom 6.5 percent in Phongsaly to 79 percent in Vientiane with a national weighted average o f 24 percent (NCS 2003).

135. Health care utilization remains very low, though scarce available data only covers central hospitals and thus may not be representative nation-wide. Less than 30 percent o f people in need o f medical care turn to Government health services for help. Uti l ization o f urban central health services was about 0.1 visits per capita per year before the start o f PRSO and there i s n o data o n improvements so far.

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Geographical distance, financial cost, and the quality o f services provided are the top three reasons for not accessing health services. LECS data shows that the average distance o f households to health centers has worsened slightly for the poor between 1992/3 and 2002/3. For example, infant mortality rates ranged from 122 per 1,000 births in Sekong province to 18 in Vientiane Capital, with a national weighted average o f 70 in 2005 (according to NSC); and the proportion o f pregnant women receiving antenatal care ranged from 6.5 percent in Phongsaly to 79 percent in Vientiane with a national weighted average o f 24 percent (NSC 2003).

136. Given poor coverage of rural population by health centers, the Government prioritized village drug kits, volunteer doctor residence in remote areas, and community-based basic services. The number o f village drug k i t s has increased significantly in the last few years. Vil lage drug k i t s and outreach activities f rom health centers and district hospitals i s the most effective way to reach the population in a country o f dispersed rural population and mountainous terrain such as Lao PDR. The government also maintains immunization high on i t s priority l ist, and immunization rates have been increasing.

137. Shortage of public funding i s a key constraint for improving the performance of health services. Compared with other IDA countries, Lao PDR invests a very small proportion o f public expenditure in health. W h i l e this i s partly due to donor spending crowding out domestic spending, the domestically financed share o f health expenditures i s the main source for recurrent expenditures o f public health services, and thus increasing domestic recurrent spending i s key to improving outcomes. The Government has permitted the introduction o f cost recovery for drugs, medical consumables, diagnostic tests and treatment in public facilities. These charges increasingly constitute a financial barrier to access by the poor. The Government has acknowledged the need to introduce fee exemptions for the poor, and a number o f schemes are now being piloted. These need to feed into development o f more comprehensive Government policy. Issues o f central-local relations and the fact that in the current system health spending in Lao PDR i s predominantly the responsibility o f provinces, reduce the abil ity o f the central authorities to implement national programs.

138. There have recently been reductions in capital spending in the health sector that may or may not have changed the overall trend in public health financing. The Off ic ia l Gazette data shows that health financing has increased as percent o f total budget, f rom 4.3 percent in FY2004 to 6 percent in FY2005, while capital spending has decreased.

HEALTH: Progress under PRS03

139. Developing a set o f budget norms for health and education will be a first step towards establishing a mechanism, consistent with the principle o f decentralization, by which government can ensure minimum service standards and expenditure allocations to NGPESNSEDP priority programs in each province. MOF, MOH, MOE and provinces had agreed to develop and issue a guideline on minimum per capita budget allocations for expenditures in health and education in a l l provinces, for introduction as part o f the FY 2007/08 Budget. Whi le continuing to have substantial discretion over the use o f their budgets, provinces will be assisted to ensure that an appropriate minimum i s allocated for basic education and basic health programs. However, due to the faster than expected progress with drafting the revised Budget Law, these guidelines need to be drafted in accordance with the new law and i t s implementing regulations. I t has therefore been advised by the WB team that these regulations are issued for introduction as part o f the FY 2008/09 Budget instead. Education will be f i rst sector for which guidelines and norms wil l be issued, followed by health and other priority sectors. The corresponding action has been redrafted accordingly (see Annex 1).

140. The Government improved the timeliness of payment of salaries to health workers from the PRSOZ benchmark. The report for the last quarter o f FY05/06 (July-September, 2006) showed a

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significant reduction in arrears f rom this benchmark (of a stock o f salaries outstanding more than 1 month o f 22 percent), as Table 9 shows.

200512006 Q21Jan-Mar I Q3IAprJune I Q41J u ly-Se pt

1.5% 0.0% 1.3%

Table 9: Salary arrears to health workers, FY2005 and 01 FY2006 200612007

Ql1Oct-Dec 3.9%

The salary payment reported by the MOH i s consistent with the preliminary findings o f the PETS that found that about 60 percent o f health staff received their salary late and the average delay was about 1.4 months: a l l parties admit that salaries are often paid to remote health facility staff once in two-months or once in a quarter, due to the costs o f travel f rom their posting to the nearest financial office for payments.

141. Some issues with capacity of MOH to monitor the salary payments have been faced during implementation of the PRS03. W h i l e reporting time has shortened in just one year, these issues should be tackled using TA available. An improvement in this system will require ongoing quarterly monitoring o f provinces by MOH and dialogue with provinces delaying the data to identify issues and find solutions.

142. Other health sector intentions under PRS03 include the issuing of implementation instructions for equity fund operations based on the new Curative Health Law and Decree 381, including updating the exemption policy, guidelines for identification o f the poor and setting rates o f user fees. The MOH team has met with the key officials in the Ministry o f Health and Ministry o f Labor and conducted f ie ld visits to the currently operating three Equity Funds in the northern, central and southern region. On April 2, the MOH held a workshop o n the health equity funds implementation guidelines which concluded on the following: (i) emphasized the three-fold objective for the guidelines - contribute to poverty reduction, contribute to the long term pol icy goal o f universal health protection, support development o f health services; (ii) suggested to pi lot different forms o f local equity fund operators in addition to the proposed NGO third-party model; (iii) for selecting pi lot districts to consider also districts with existing experience with poverty identification or Community Based Health Insurance; (iv) instructed the team to finalize the guidelines by taking into account the comments f rom the workshop and submit to the MOH Steering Committee for approval.

EDUCATION: Key issues and Government strategy

143. Access to basic education i s a vital part o f NGPES and NSEDP. Net primary school enrollment rates increased and literacy and months o f education have also increased gradually. Nevertheless, there are widespread disparities in access and outcomes. Children from l o w income, minority ethnic groups (especially minority women) and rural areas remain less l ike ly to be in school than other children.

144. Almost one-quarter o f primary teachers are untrained, however, absenteeism i s not the primary problem in education. PETS data shows that 35 out o f 244 primary schools (14 percent) had at least one teacher absent on the survey date. Shortage o f school buildings i s a more acute problem and the number o f primary schools has fallen since 2000. Despite improvements in internal efficiency, it i s proving diff icult to keep children in school long enough to complete the cycle, and Lao PDR has a very l o w proportion o f students who complete the full cycle o f primary and secondary school.

145. Although management problems play an important role, it i s clear that the slow improvement of educational attainment also reflects the collapse in education spending in the late 1990s. Despite the recovery over the last five years (with the education budget growing in real terms by 12 percent a year), public educational expenditure has s t i l l not reached the levels o f a decade ago, either in relation to GDP or as a proportion o f total public spending. The dominant features o f recent education

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public expenditures are the high proportion o f capital spending and the high percentage o f that spending financed by foreign aid. Even though the share o f the recurrent budget allocated to salaries has improved, the situation with teachers’ pay remains a critical constraint, with the result that teaching has become a financially unattractive career option.

20 0 512 0 0 6 Q2IJan-Mar I Q3IAprJune I QIIJuly-Sept

8.0% 3.0% 0.0%

146. A critical requirement i s for Lao PDR to increase the proportion o f national resources allocated to education. The projections made as part o f the planning for “Education for All” (EFA) emphasize the magnitude o f the required expenditure increase, with, salary increases for teachers a high priority. The NGPES indicated a target o f 15 percent o f the national budget. L i ke basic health care spending, however, basic education spending in Lao PDR i s predominantly the responsibility o f provinces and sustained progress in increasing education spending in l ine with national strategies will depend in part o n prior progress under the PEMSP. The budget allocated 13.9 percent o f total state budget (including external financing) to the education sector for FY 2005-06. This i s a significant increase as a share o f total spending, up f rom 11 percent o f the state budget (including external financing) in FY 2003-04. It i s a major step towards the NGPES target o f 15 percent o f the state budget (including external financing) for education.

200612007 QlIOct-Dec

2.9%

EDUCATION: Progress under PRS03

147. Under PRS03 MOF, MOE, M O H and provinces initially agreed to develop and issue a guideline on minimum per capita budget allocations for education and health programs in al l provinces, for introduction as part o f the FY 2007/08 Budget. It however will be introduced one year later due to the progress made with drafting the revised Budget Law. Education wil l be f i rst sector for which guidelines and n o m s will be issued, followed by health and other priority sectors.

148. Government has improved the timeliness of payment of salaries to teachers and health workers from the new benchmarks established in PRS02 (in the case o f teachers, a stock o f salaries outstanding more than 1 month o f 6 percent o f one month’s payroll). Government will continue quarterly monitoring o f these data, sharing reports with the Wor ld Bank. As noted above, together with the Wor ld Bank, the Government has also launched the Public Expenditure Tracking Survey which will provide further insights into the extent to which and timeliness with which salaries are reaching the pockets of teachers and health workers. The last report (44 o f FYOY06) showed n o deviation f rom the trend o f improving timelines o f payments in comparison to the benchmark. The report for Q1 o f FY06/07 shows that the salary payment timelines have improved, as presented in Table 10.

149. Other education commitments under PRS03 include adopting an integrated framework and plan for an Education Management Information System (EMIS); and evaluating the pilot community grant program with a view to scale-up. A robust EMIS wil l be critical to linking national pro-poor priorities for education to the allocation o f resources at the provincial, district and school levels, and then monitoring the resulting outcomes. The community grant program i s a step towards more participatory local decision-making in resource allocation in primary education. Copy o f the E M I S Stocktaking and Diagnostics Study has been finalized. It includes a proposal for an integrated framework and development plan, and involves much capacity building at central and provincial levels. A dissemination workshop for the study was held on April 4. MOE thus has made considerable progress towards adoption o f this framework.

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INFRASTRUCTURE: Key issues and Government strategy

150. The development o f road access for agriculture and international trade i s especially important, but also challenging. Lao PDR i s mostly mountainous and has a l o w population density (24 people per square kilometer in 2005). Due to years o f good effort, national and provincial roads are now in better condition. However, the 6,675 km o f national roads (of which 55 percent are paved) are not rehabilitated or improved regularly enough, and only 3 percent o f the non-national road network (28,586 km) i s paved. More than 10 percent o f a l l district centers and over 40 percent o f a l l villages do not have year-round road access. Lack o f road access to market i s a major constraint for agricultural development, although there i s an increasing effort in this field and total kilometers o f rural roads has increased by 10 percent f rom 2005 to 2006, and represent now 40 percent o f total road system’s length in Lao PDR.

151. NSC data on road kilometers suggests that while between 1990 and 1995 the length o f tarred roads declined by almost one quarter, the length recovered after 1995 and was in 2004 80 per cent higher than in 1990. However, Wor ld Bank analysis o f LECS data suggests that rainy season access to roads o f households with expenditures around the poverty l ine dropped from almost 45 percent in 1992/3 to just over 25 percent in 1997/8, and had recovered only partially to j us t under 40 percent by 200213.

152. Following a period o f stagnation in the early 1990s, rural electrification has increased significantly from about 16 percent o f the national households in 1995 to approximately 48 percent by the end of 2005, according to administrative statistics. This achievement, however, masks an uneven development pattern in which Vientiane and other urban areas enjoy almost 100 percent coverage, whilst only 25 percent o f villages in rural areas have access to electricity. Vil lage access to piped water and protected wells increased by about 2 percent between 1997/8 and 2002/3 and progress was even for poor and non-poor subgroups (Figure 5 and Figure 6). However, access to such safe water for the poor and for people living in priority districts lags non-poor and other districts. Simulations conducted in the Wor ld Bank’s Country Economic Memorandum (CEM) indicate that providing piped water and electricity to al l villages would lower poverty among the newly covered families by 8 percent.

153. The NGPES and NSEDP clearly indicate the Government’s commitment to strengthening basic infrastructure. The Government has established a well-run Road Maintenance Fund (RMF), to ensure a steady and adequate domestic funding source for road maintenance based o n substantial recovery o f costs f rom road users. Plans are being elaborated to provide small towns with water and sanitation services and the Ministry o f Industry (MEM) i s committed to expanding access to rural electrification through the Rural Electrification Fund, for which a Government Decree was promulgated in August, 2005.

INFRASTRUCTURE: Progress under PRS03

154. Under PRS03, the MEM opened the Rural Electrification Fund to other donors and private investors. The Rural Electrification Fund has a mandate to implement electrification plans directed by MEM. However, i t i s recognized that there i s scope for attracting additional funding (apart f rom IDA and consumer contributions) for rural electrification f rom non-traditional sources, if mechanisms are devised to meld concessionary funding with private funding at moderate commercial rates. After endorsement o f the REF Decree by Prime Minister in March 2006, community groups and private service companies can contribute to MEM’s own electrification efforts if such groups and companies are allowed access to the Rural Electrification Fund.

155. Regarding water supply and sanitation, M C T P C i s planning to submit the Water Supply and Sanitation Law to the National Assembly in i t s upcoming session. This will allow consolidation o f water supply related legislation; clarify the regulatory environment for water; enable greater private

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sector and community participation in and management o f water supply; clarify responsibility and establish the right o f access to basic water supply, sanitation and wastewater services; and strengthen the legal basis for the provision o f sanitation services. The inclusion o f sanitation within the Water Supply L a w will facilitate future implementation decrees assigning responsibility for sanitation nationally to a single government agency.

156. In the transport sector, MCTPC has increased the fuel levy that contributes to the Road Maintenance Fund (RMF) to 200 kipdliter. As RMF expenditures increase gradually, effort i s required to raise the RMF revenues to cost recovery and more sustainable levels. To ensure that these funds are wel l spent, MCTPC once again updated the Road Preservation Plan, covering national and provincial roads. Finally, MCTPC has also prepared a draft Ministerial Directive o n Rural Transport Services, building o n the pol icy statement on rural transport services prepared during PRS02.

PAY REFORM: Key issues and Government strategy and Progress under PRS03

157. Public sector pay remains extremely low in Lao PDR, both by historical standards and in comparison with neighboring countries. For central government c i v i l servants, non-wage benefits and other sources o f income may make government employment s t i l l attractive. However, teachers and health workers are paid significantly less than regional averages and with continuing delays in payment in some parts o f the country. Many skilled public sector workers are leaving their jobs for more lucrative employment, with vacancies remaining in key posts. Formal c iv i l service recruitment requires P M O authority, but the widespread use o f contractual employment means that i t i s diff icult for Government to control staffing increases through this channel.

158. Government recognizes the need to balance pay increases and new recruitment with revenue enhancement. T o this end, they have deferred any further increases in base salaries in 2005/06. Under PRS03, and with support f rom UNDP, the Government has conducted a c i v i l service census as the baseline for a new c iv i l service database. Building on this data and o n the PER, the PMO and MOF are currently working on a c iv i l service pay reform pol icy consistent with the medium-term fiscal framework.

2.2: Monitoring the Alignment of Spending with Pro-Poor NGPESLNSEDP Priorities

Key issues and Government reform strategy

159. Strengthening public expenditure policy in Lao PDR requires a concerted effort to strengthen systems for monitoring the alignment of spending with pro-poor NGPESLNSEDP priorities. This includes efforts to strengthen tracking and analysis o f public expenditure; and efforts to improve the quality o f poverty data and broader statistical reporting systems.

160. The administrative systems for public expenditure tracking remain under development and the data produced by them i s o f uncertain quality and accuracy. Although progress i s being made in implementing the new Government Financial Information System (GFIS) at provincial level, there are currently limits to the accessibility, manipulability and accuracy o f this data. As part o f i t s commitments under the N a m Theun 2 project, the Government has undertaken to conduct a Public Expenditure Tracking Survey (PETS) every two years, to obtain more accurate and informative data on public expenditure policy and management practices in provinces and districts o n a periodic basis. Government has also undertaken to conduct regularly a Public Expenditure Review (PER), to examine public expenditure trends and support the Government to achieve i t s key development objectives by strengthening public financial management practices.

161. The PETS i s focused on health and education, and aims at (a) understanding and analyzing current public expenditure management practices and (b) serving as an independent monitoring tool to

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assist government in improving accountability in service delivery. The 2005/6 PER aims (a) to review macro-fiscal performance and sustainability as wel l as the intra- and inter-sectoral allocation o f public spending at the central and local levels; (b) review the institutional framework for public expenditure management; and (c) conduct intra-sectoral analysis o f public resources for NGPESNSEDP priority sectors, including assessing the quality o f core public services and the efficiency o f their delivery.

162. Effective implementation of the NGPESiNSEDP, as well as progress towards MDGs, wil l require careful collection and monitoring of socio-demographic statistics (population, health, education, poverty and labor market statistics). In Lao PDR, statistics are the responsibility o f the National Statistical Center (NSC). Lao PDR follows international conventions in conducting a population census every ten years; and an Expenditure and Consumption Survey every five years. These surveys are o f good quality. However, NSC i s s t i l l in the process o f putting in place the procedures required to institutionalize a modem, more thorough-going and timely statistical reporting system. Current data dissemination practices do not yet provide for the timely availability o f data or i t s access to the broader public.

Progress expected under P R S 0 3

163. Under PRS03, MOF, MOH and N S C finalized the Public Expenditure Review report and the Public Expenditure Tracking Survey, and wil l finalize P E T S report by M a y 2007. The Wor ld Bank has agreed to provide technical support for the in i t ia l PETS and PER exercises, and for fo l low on exercises every two years.

164. Under PRS03, the National Statistical Center remains on track with implementing the Statistical Strategy. The government has accepted Wor ld Bank support o f this strategy by a TFSCB (Trust Fund for Statistical Capacity Building) grant, with coordination between the Bank, SIDA and the IMF to contribute to different parts o f the statistics strategy.

COMPONENT 3: S T R E N G T H E N I N G PRIVATE S E C T O R DEVELOPMENT

3.1 : Strengthening Private Sector Development

Key issues and Government reform strategy

165. Stronger private sector development in L a o PDR wil l require concerted efforts to improve the environment for business and investment. The comparative cost o f doing business in Lao PDR i s high. Whi le Lao PDR has cheaper labor costs, i t has higher average transport, telecommunication and rental costs than other East Asian countries. Whi le electricity i s relatively cheap, the quality o f service i s l o w and installation costs are high. Medium and large scale enterprises find it diff icult to operate due to the fol lowing constraints: poor infkastructure, cumbersome and time-consuming regulatory procedures and taxation; l imited provincial government capacity and over-bearing inspections regime; poor access to finance; l imi ted domestic markets; l imi ted market information; and l o w levels o f entrepreneur capacity.

166. As reflected in the NGPES and the N S E D P 2006-10, the Government recognizes the key role of the private sector in growth and poverty reduction. For this reason, in the medium-term, the Government plans to: (a) give private sector equal rights and reduce entry restrictions for private f i r m s to most o f the sectors; (b) facilitate private sector development through a more favorable pol icy environment and level playing field and by streamlining registration and licensing procedures for new firms; (c) remove remaining biases in administrative procedures and regulations that favor SOEs over domestic or foreign private f irms; (d) strengthen market institutions, including dispute resolution and contract enforcement; (e) facilitate the registration and licensing process for investors, and to equalize domestic and foreign investors; (f) improve land rights and the use o f land as a collateral; and (g) to promote and increase exports and facilitate trade and regional integration.

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167. The National Assembly recently approved a new Enterprise Law, replacing the old Business law. I t creates a level playing f ie ld for private businesses, significantly simplifies regulations and procedures to start up a business, moves from licensing to registration as the main principle, envisages a transparent “negative l is t ” o f the sectors where entry o f private business i s conditional, and envisages a one-stop-shop for business registration.

168. Lao PDR needs the development of a larger, healthier and more diverse financial sector. Currently, the financial sector i s comprised o f banks (predominately SOCBs), one state-owned insurance company, some foreign exchange bureaus, and a social security fund. Non-Bank Financial Institutions (NBFIs), such as leasing companies, do not yet exist and the size and reach o f financial markets i s very limited. There i s essentially n o capital market and n o money market. Intermediation i s low, with loans to GDP o f approximately 8.5 percent (end 2005), but it i s reported that the bulk o f the lending i s to the private sector (albeit wel l connected to the Government in many cases).

169. Today business development relies on many sources of financing, but for the most part the funds do not come from the formal financial sector. The financial sector today plays a nominal ro le in the overall economy o f Lao PDR, but as seen from experience in other countries; it will become more critical in the future. In order for Lao P D R to develop a stronger private sector, entrepreneurs will need financing. Financing will depend greatly on the abil ity o f the financial sector to mobil ize funds. Access to finance i s limited; physical penetration o f the formal banking sector i s very l imi ted with only 0.8 branches per 100,000 people. It i s estimated that about 2 percent o f total population have access to credit f rom formal to semi-formal financial sector. Firms heavily rely on retained earnings to finance working capital and new investment. Smaller f i r m s rely even more heavily o n retained earnings and family funds.

170. The current legal and regulatory framework does not provide the banking sector with level playing field competition. Restrictions on the activities o f non-state banks and market segmentation remain in force. Foreign banks are s t i l l restricted from expanding their branch network. Presidential Decree L a w 01 governing the management o f foreign exchange and precious metals requires businesses dealing with mining and exporting o f natural resources to open deposit accounts only with SOCBs. The SOCBs are, accordingly, s t i l l protected f rom the competitive pressures that would motivate the SOCBs to improve their efficiency. Therefore it i s important to promote competition in the financial sector and to encourage privately-owned financial institutions in addition to restructuring the SOCBs and improving bank regulation and supervision. The NSEDP 2006-10 generally supports level competition in the banking sector through removal o f remaining legal and regulatory impediments to entry and expansion by non-state banks.

Progress under PRS03

171. Under the PRS03, the Government has made progress towards implementation of the Enterprise Law. In particular, the Government issued a P M Order for EL implementation which i s essentially a time-bound action plan and division o f responsibilities for implementation o f the EL. Implementation i s a complex and challenging process, given the vested interests and polit ical system in place. The Government i s conducting consultations to develop a short “negative l i s t ” o f industries that need line ministry approval to start operations; the l i s t i s planned to be finalized by May, 2007. The Government i s also working on a review o f existing laws and regulations with a v iew to harmonize them with the new Enterprise Law.

172. The MOF drafted a new Accounting Law and i s planning to submit it to the National Assembly in June 2007 session. This i s intended to ensure that enterprise accounting moves in the direction o f international accounting standards. An inter-ministerial committee (comprising MoJ, MoF, L N C C I and the Foreign Investment Committee o f the CPI) has recently been set up and a number o f consultations on the draft L a w have been conducted. The revised draft was resubmitted to GOL in

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February 2007. Further reviews and consultations o f the draft with the Legal Committee o f NA are expected to happen in coming months and the final draft will be submitted to the NA for endorsement in i t s upcoming session.

173. Government continues to conduct the semi-annual business forums, building on the participatory process ongoing now, enabling a direct dialog between the Government and the private sector. This dialog i s especially important in Lao PDR and wil l support the Government’s efforts to give more prominence to the private sector and i t s ro le in growth and poverty reduction. The First Forum took place in M a y 2006, and the Second Forum took place in March 2007.

174. New Law on Commercial Banks has been promulgated in March 2007, and BOL has drafted amendments to the Presidential Decree Law Governing the Management of Foreign Exchange and Precious Metals. The law creates conditions for level playing f ie ld competition in the banking sector. The draft amendments to the Presidential Decree L a w No.Ol/OP remove current restrictions that require that businesses dealing with mining and exporting o f natural resources open deposit accounts with state banks only, as wel l as additional restrictions on foreign exchange. The amendments thus create a more leveled playing f ie ld in the banlung sector.

175. The BOL i s also drafting a Financial Sector Strategy, which outlines the principles and steps for further financial sector reform. The strategy includes measures for making state-owned banks more financially viable, encourages jo in t ventures and outlines restructuring principles. It also outlines main principles for opening up the banking and financial sectors.

3.2: Accelerating Regional and Global Integration

Key issues and Government reform strategy

176. Maintaining the momentum o f trade reform will play a crucial role in growth and poverty reduction in Lao PDR, particularly given the country’s strategic location between Thailand, China and Vietnam. The Government recognizes the importance o f both regional and global integration. At the regional level, Lao PDR i s a member o f the A S E A N Free Trade Area (AFTA). At the global level, Lao PDR i s committed to achieving Wor ld Trade Organization (WTO) accession as early as possible and has started formal negotiations.

177. AFTA membership includes obligations to liberalize trade with other members on set schedules and according to potential imports classified on four l is ts, including (i) an Inclusion L i s t (IL) o f goods immediately eligible for preferential treatment under certain conditions; and (ii) a Temporary Exclusion L i s t (TEL) o f goods which must be moved to the IL according to a set schedule. Each member specifies a Common Effective Preferential Tar i f f (CEPT) for each IL and TEL item, and IL items can be imported at this rate-exempt f rom a l l non-tariff barriers-under specified conditions.

178. The four new ASEAN members are committed to moving all TEL items to the IL and setting all IL rates to 0-5 percent by 2008. Lao PDR has been integrating gradually into the wor ld economy since 1989. The reform process accelerated after Lao PDR’s accession to A S E A N and the jo in ing o f AFTA in July 1997. The country started to implement the AFTA Common Effective Preferential Tar i f f (CEPT) scheme in January 1998, and has completed the moving o f the TEL to the IL ahead o f schedule. Lao PDR will complete the liberalization schedule by 2008, reducing i t s tar i f f o n imports f rom A S E A N countries to 0-5 percent.

179. At the same time, Lao PDR i s making progress with global trade integration. Lao PDR signed a Bilateral Trade Agreement with the United States (USBTA) in 2003, which required the Government to open up i t s services sector over time. At the same time, Lao PDR was granted Normal

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Trade Relations by the US Congress in November 2004. The Government has prepared a legislative action plan for WTO accession, and i s n o w working on a roadmap for WTO accession. Government notes that import licenses are now limited to only four products: fuel, cement, steel and vehicles. However, i t recognizes that more needs to be done to address additional regulatory requirements imposed by provinces.

Progress under PRS03

180. Under PRS03, Government made further progress towards WTO accession. This includes application, drafting o f the legislative action plan, finalizing the checklist o f documents (including offer o f goods and services), and starting implementing the legislative action plan. The Government organized second Working Party Meeting on WTO accession in November 2006. The process o f W T O accession will, however, run beyond the timelines o f this f i r s t PRSO series. In addition, Government stayed o n track with implementation o f AFTA commitments, including preparing i t s justification for those products to be kept on the General Exclusion l i s t and discussions with the A S E A N Secretariat.

181. The Government made decision to move forward the agenda of WTO accession and planned to complete it as soon as possible. Under PRS03, the fo l lowing actions have been taken: (1) After a process o f consultations with key government agencies and other stakeholders concerned, P M O approved the revised Legislative Act ion Plan (LAP)” and Ini t ia l Offer (for goods);” M o I C submitted the plan to WTO in October 2006 and conducted the second working party meeting in Geneva in November 2006, where multilateral and bilateral negotiations on goods took place. M o I C has also completed the f i rst draft o f the In i t ia l Offer for Services and i s currently consulting with key ministries involved, with a v iew to submit i t to WTO in the next few months. In addition, M O I C i s preparing response to the third round questions and reviewing requests received from multilateral and bilateral negotiating partners after the second working party meeting.

182. As part of implementation of AFTA CEPT Scheme Lao PDR completed the transfer of all tariff lines from the Temporary Exclusion List (about 3,402 tar i f f lines or about 96 percent o f the total existing tar i f f l ines) to the Inclusion List through five-installment phases. The IL was submitted to the A S E A N Secretariat on schedule, and the fourth and fifth installments have been now ratif ied by the National Assembly.’l

183. As part of reduction of tariff lines in the General Exception List (GEL), and in order to open up trade with ASEAN member countries at an optimal level, in September 2006 the Lao government approved the removal o f 28 tar i f f lines (mainly on alcohol and beverage, soft drinks, tobacco and other related products) f rom GEL and will transfer i t into the Inclusion List by 20 13 through various installments, starting f rom 2008.

184. GOL i s working closely with other ASEAN member countries (AMC) on implementing the work program for reducing the non-tariff barriers (NTBs) within the AFTA framework. The work program for the assessment o f NTMs and elimination o f identified NTBs was discussed among AMCs and then endorsed by 38th AEM in August 2006. A M C s compiled official legal documents and submitted to A S E A N Secretariat in September 2006. Further discussions and consultations o n

The legislative action plan preliminarily includes a list o f laws and regulations subject to revision for WTO compliance, especially those relate to customs valuation, rules o f origin, VAT, foreign exchange control, SPS and TBT.

’O The GOL has submitted the init ial offer for goods as the first step, which proposed more than ten thousands tariff lines (all tariff lines based on HS 2002) for bilateral and multilateral negotiations.

” T h e first three installments have been effective since 2003. T h e last two installments have just become effective after N A ratification. Since it was submitted to ASEAN earlier, GOL committed to reimburse the difference in tax (between MFN rates and normal tariffs currently applied) to the tax-payers after the ratification; the method o f this reimbursement has not been identified yet.

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classification o f NTBs continued among A M C s in October 2006. In early 2007, and in parallel with other A S E A N member countries, G O L conducted local consultations to validate the A S E A N Secretariat’s classification o f verified NTBs and identified NTB constraints that hamper Lao exports.

3.3: Improving Resource Management

K e y issues and Government reform strategy

185. Lao PDR’s revenue to GDP ratio i s among the lowest in the region. A major challenge i s to mobilize revenues to enable Lao PDR to meet i t s poverty reduction and growth objectives within a sustainable fiscal fi-amework, consistent with the need to reduce Lao PDR’s high public debt.

186. The Government recognizes the need for a revenue effort. While a small addition to Government revenues (around an additional ha l f percent o f GDP) will be made by the N a m Theun 2 hydroelectric project, starting in FY2009/10. Other mining and hydro projects are also expected to come on stream. However, Government recognizes the needed to increase non-resource related revenue effort: there i s broad consensus o n the need to centralize the collection o f major taxes such as customs and turnover tax. The latter in any case i s a pre-requisite for the planned implementation o f a Value-Added Tax (VAT) in 2008/09. The in i t ia l focus should be on improving oversight o f large and medium taxpayers; and o n establishing an effective, centralized tax identification number (TIN) system, in i t ia l ly in the national Large Tax Payer Unit and the three largest provincial tax offices. For the longer-term, better management o f natural resources and better administration o f associated taxes and royalties, could make an important contribution to Lao PDR’s revenues as wel l as supporting environmental and social goals.

187. The new Customs L a w establishes the transaction value principle (which i s required for WTO accession) but also facilitates customs modernization more generally including clarifying the roles and responsibilities o f the center and the provinces. However, customs administration remains decentralized. This seriously impedes the effectiveness o f revenue mobilization and remittance from this source. IMF i s currently providing technical assistance to the government to finalize the implementing regulations for the revised Customs Law. The Wor ld Bank has started assistance for customs and tax centralization under the new Budget Law.

188. Forests are a significant and vital resource for Lao PDR. Communities depend upon them for land, employment and income. Deforestation, forest degradation, loss o f biodiversity and soil erosion are serious environmental challenges with important implications for the livelihoods o f rural populations. In addition, forests are a significant revenue source for Lao PDR-and one with significant growth potential. Royalty revenues have been declining since the mid-1990s. I t i s estimated that, over the last f ive years, the Government has realized only about one third o f the estimated market value o f the timber harvested.

189. Policy toward forestry has been shifting over time and seems headed toward a more market-oriented and pro-poor approach. Since the 1990s’ approximately 3.2 m i l l i on hectares o f largely forested land have been designated as National Conservation Areas, covering 20 different sites. However, management planning for these areas has advanced slowly and few areas are managed under long term, approved plans with adequate resources. This leaves these areas subject to encroachment and erosion from a number o f threats, including i l legal logging, hunting and agricultural conversion.

190. In 2002, the Government established legal provisions for the establishment of a system of National Production Forest Area (PFA). Eight sites (totaling around 636,000 hectares) have been identified for designation as PFA and management planning has begun, although to date none have been formally established under the required procedures. Despite some reforms, timber sales practices remain

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controlled and ineffective. An annual national log production quota system remains in place, administered by the Prime Minister’s Office that allocates harvests to provinces. However, the quota system i s subject to manipulation, does not build from forest management plans based on appropriate surveys, inventory and harvest prescriptions, and does not provide incentives for preparation and implementation o f sustainable management programs.

191. Timber produced under the quota i s to be processed domestically to achieve increased value added transactions. The conduct o f timber sales auctions, sales contracts and payment procedures need to be improved and brought into l ine with commercial practices in other sectors. The Forest Sector Monitoring System aims at enhancing forest resources sustainability and community participation in forest management and consists o f several elements: (a) forest cover monitoring; (b) internal forest control and compliance; (c) chain o f custody timber identification and tracking; and (d) and forest l aw enforcement reporting. MAF and the Science and Technology Agency (STEA) have agreed on the respective roles o f the two agencies in implementing the forest monitoring system and specific tasks o f the two agencies have been detailed in the annual work plan.

Progress under PRS03

192. Regarding revenue management, under PRS03 the Government prepared implementing decrees and regulations for the new Customs Law. In particular, within the process o f implementation o f the new Budget Law, the Government i s working on the centralization plan for customs and tax departments, to complement ongoing reforms at central level. The Government has submitted the implementing decree for the Customs law to PMO. Other implementing regulations are being drafted in the meantime. For example, the valuation agreement guidelines have already been drafted under support f rom Japan.

193. The Government prepared a Forest Industry Restructuring Plan to rationalize industrial capacity and resource supply. This plan strengthens efforts to reduce the number and wood processing capacity o f mills dependent on wood supply from natural forests. The Government has issued a Prime Minister order (PMO number 31) for the controlled management o f forestry and the timber industry aiming to promote the wood processing industry and sustainable development. The order recognizes that in the past government’s legislative efforts to manage and maintain forests were insufficient and that forests were often over exploited and degraded as a result. The new order constitutes a plan for the f i rs t steps o f the needed restructuring o f the forest-based industry. I t clarifies institutional jurisdiction, directs that wood-based enterprise licensing requirements be enforced (covering such things as requirements to locate mills outside o f forest areas), and sets the basis for a triage approach to wood industry that ranges from mill closure to upgrading. The Department o f Forestry within MAF also began field testing the forest management information system. Field testing was conducted in the southern provinces as part o f an approved annual work plan for the Sustainable Forestry for Rural Development (SWORD) Project and the system will continue to be rolled out in the current dry season.

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Box 3: Good Practice Principles on Conditionality Applied in Lao PDR

Principle 1: Reinforce Ownership Ownership o f the PRSO series i s reinforced through program design and participatory and transparent PRS process. Recent track record o f Lao P D R indicates increased commitment and ownership o f the program supported by PRSOs. The analytical work i s being undertaken by the GOL in close collaboration with development partners and i s used in policy and decision making process. In order to adjust to a more realistic assessment o f the polit ical commitment to SOE and banking sector agenda, during PRS02 the focus o f PRS03 was r ightly shifted in direction o f monitoring these sectors while st i l l trying to push forward reforms.

Principle 2: Agree up front with the government and other financial partners on a coordinated accountability framework

Under PRSO series, there i s an agreed accountability framework including a well-defined pol icy matrix for measuring progress under the program. This framework however i s not yet harmonized across the donor community, but significant steps are being taken to improve aid coordination and harmonization across the board, reflected in signing the Vientiane declaration o n a id effectiveness (by GOL and 22 development partners). Importantly, cooperation o f the donor community behind the current PRSO1-3 series has intensified during PRS03, including j o in t missions, monitoring and evaluation, and strategic planning for PRS04-7.

Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances

The modalities o f the operation are meeting country needs and encourage public financial management reform. However, some adjustments need to be made in the future o n the timing o f reforms, particularly in sectors related to structural adjustment to a market economy, such as SOEs and banking sector. Ownership o f some sensitive po l icy reforms has been strong (hke on trade liberalization and utilities reform), however i t was weaker on other issues (such as SOE reform and state-owned banks reform). The evidence amounts that policies supported under PRSOs reflect Government’s expressed pol icy intentions and are aligned with PRS.

Principle 4: Choose only actions critical for achieving results as conditions for disbursement

Prior actions and conditions chosen from the agreed accountability framework are focused o n crit ical actions for achieving the objectives o f the program. Country circumstances and advancement o f structural reforms however dictate specific approach t o achieving the objectives o f the program.

Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support

The PRSOs support i s aligned with the budget cycle and i s disbursed just o n time for the fiscal year close in September. Regular reviews are done through frequent assessment missions and RTM and annual p lan processes are incorporated into the routine monitoring o f progress o n actions and triggers. Result focus o f these reviews should however be strengthened in the future. For the proposed PRS04-7, i t i s currently planned to reduce the size and coverage o f the pol icy matrix according to best practice and to keep benchmarks to a minimum necessary for maintaining pol icy dialog. I t is hoped that for PRS04-7, analytic work wil l be fed more upstream into the pol icy dialogue, bui lding o n the achievements o f the analytical work during recent years that has been participatory and increasingly owned by the Government.

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VI. OPERATION IMPLEMENTATION

IMPLEMENTATION, MONITORING AND EVALUATION

194. The implementation of the PRSO program i s led by the PRSO Steering Committee, which i s chaired by the Minister o f Finance. The Steering Committee i s supported by a PRSO Technical Secretariat, which i s chaired by the Director General o f the External Finance Relations Department of the Ministry o f Finance and includes representation f rom various ministries. In particular, Ministry of Foreign Affairs, Committee for Planning and Investment and i t s National Statistics Center, Ministries o f Education and Health, Ministry o f Energy and Mining, Ministry o f Industry and Commerce, Ministry of Agriculture and Forestry, MTCPC, Bank o f Lao PDR, Prime Minister Office and i t s Business Promotion Office, PACSA, and other agencies.

195. Progress with the PRSO program implementation i s monitored with reference to the PRSO Program Matrix, updated annually as part o f PRSO negotiations. Accordingly, this Program Document in the series o f three PRSOs includes a revised pol icy reform matrix, building on that developed for PRSO1-2 but updated jo in t ly by Government, IDA and other donors, to reflect evolving policies and the pace o f implementation o f the NGPES and NSEDP and the current status o f progress (Table 7). In addition to monitoring o f progress against pol icy actions, there i s close monitoring o f macroeconomic developments, as wel l as poverty and social indicators. Sub-component 2.2 o f the PRSO Program Matr ix includes measures to strengthen such monitoring indicators.

196. As i s standard practice for PRSOs, the impact of this PRSO series i s evaluated in accordance with a Monitoring and Evaluation (M&E) framework covering a l l three operations in the series and established by the Government and IDA at the time o f PRSO1. The end-of-series outcomes expected under each sub-component o f the PRSO program are recorded in the revised PRSO matrix (Annex 1) and summarized in Table 3 on page 15. Although some adjustments have been made to the pol icy actions in the Program Matrix, these actions remain consistent with the end-of-series outcomes which were agreed and fixed in the f i rs t Program Document o f the series and which remain unaltered. The progress on the end-of-series outcomes and indicators i s evaluated in Section III and in particular in sub-section on “Other end-of-series outcomes”, and details are presented in Annex 4 “Indicators and Outcomes”.

197. M&E activities are coordinated by the PRSO Steering Committee and Technical Secretariat, supported by the National Statistical Center (NSC), with participation of other development partners. However, the Wor ld Bank and other donors monitor progress through continuous dialogue throughout the year, including periodic supervision missions. The IMF continues to conduct enhanced supervision, supplementing annual Article IV missions with mid-year assessments. Regular discussions also take place with the donor community within the Macroeconomic, Private Sector Development and Trade Working Group as part o f the RTM process, as wel l as separate and more detailed discussions o n each part o f the PRSO in other RTM working groups. Donors, especially co- financing donors, participate in missions, and retreats. The WB drive for j o in t AAA work has also contributed to consensus building among the donor community and led to more efficient use o f resources.

POVERTY AND SOCIAL ASPECTS

198. Several beneficiary-related outcomes o f the undertaken reforms stand out based on the results of recent AAA work done by the country team. Overall, economic growth and improvements in infrastructure and social sphere have benefited poor the most. Poverty was reduced the most within the poorest districts. Impact incidence shows that minorities, while s t i l l remained disadvantaged, have

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benefited on average more than other groups. Infrastructure and moved into poorer districts through increased public and ODA spending. The ongoing studies will nuance this picture.

199. The Lao Poverty Assessment (LAOPA) was completed in 2006. It finds strong evidence o f a relationship between poverty and certain characteristics in Lao PDR. LAOPA finds a strong correlation between poverty and rural infrastructure: in 2002/3, the poor were o n average 6.7 kilometers away f rom a road, compared with only 2.9 percent for the non-poor. In addition, the poor are more likely to l ive in a village without electricity (45 percent) or a primary school (7 percent). I t also finds that the education o f the household head and spouse are strongly correlated with poverty. For example, the share o f heads o f household without any schooling i s 75 percent larger in 2002/3 than among the non-poor. This compares with only about 50 percent in 1992/3, suggesting that some schooling has become more important for escaping poverty. LAOPA thus tends to confirm the poverty reduction benefits o f priorit izing sectors such as basic education, rural transport and rural electrification, as i s done in the PRSP.

200. The 2005/6 Public Expenditure Review i s completed and has conducted analysis o f poverty impact o f social sector spending. The integrated PER examines public expenditure trends between 2002 and 2005, and supports the GOL to achieve i t s key development objectives by establishing sound, accountable and transparent financial management practices. This PER also outlines the key requirements o f the N a m Theun 2 (NT2) revenue management arrangements and applies them to priority sectors.

201. The 2006 Public Expenditure Tracking Survey, the f i rs t PETS in Lao PDR, was initiated in September 2004 and completed in 2006. The PETS report i s currently being prepared and i s focusing on education and health sector expenditures and provides information o n education and health outcomes, describes budget process and flows o f funds between different administrative levels (provincial, district, and facility), identifies public financial management issues that constrained service delivery in social sectors (such as l o w level and frequent delay o f salary payment that may lead to absenteeism). In practical terms, PETS i s also providing pol icy suggestions, allows to track salary payments f rom district to facility levels, and helps document human resources at the facil i ty level. PETS examines education and health service delivery at provincial and district levels, for poor and non-poor, in priority and non- priority districts, and by ethnicity breakdowns.

202. Poverty and Social Impact Analysis (PSIA) was initiated to understand- more about how Government’s poverty reduction strategies are translated into implementation at community level, and the degree to which they are effective in closing poverty gaps between ethnic groups, and between men and women. The study looks at the government’s strategy to focus poverty reduction efforts at the 47 poorest districts which are the areas where these gaps are also the greatest, at how public expenditure allocations have been reformed in response to this strategy and at how i t translates into inclusive actions at the community level. I t was anticipated that a better understanding o f how this strategy manifested itself in activities on the ground would contribute to information on the potential social impacts o f pol icy based lending, and provide recommendations for management o f N a m Theun 2 revenues, as wel l as providing information on the nexus o f sectoral strategies and investment projects, with geographic targeting. The PSIA provides an overview o f the districts and villages, discusses the l ivelihood situation in each district, human development situation in the districts, and how government and donors are working to improve the situation; how communities or local governments are contributing to their o w n development, and how district or village grants contribute to this; the planning and management o f public expenditures and donor funds and the extent to which they are used to meet the needs o f the communities; and discusses the decision-making processes, including people’s participation. Draf t report concludes that reforms are needed to allow for greater f lexibi l i ty at local level to respond to communities’ needs, and other community-focused reforms in land, concessions, or environmental protection, t o mitigate the negative impacts o f the rapid economic development taking place in vulnerable areas.

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FIDUCIARY ASPECTS

203. The 2005/6 PER incorporates an Integrated Fiduciary Assessment (IFA). The F A found that the overall fiduciary risk i s considered to be high due to weakness in the basic financial management systems o f government. Despite the fact that there are some built in controls within the government’s financial management system, there i s insufficient transparency related to public finances. The Government’s decentralization initiative needs to be supported with a sufficiently robust institutional framework that clearly defines the new responsibilities at lower levels. The oversight functions and the State Audit Organization need to be strengthened. The accounting and auditing profession and related institutions need to be developed. T o address these deficiencies, the government has agreed to implement a program o f reforms under i t s Public Expenditure Management Strengthening Program (PEMSP) which was approved in 2005, updated under this operation, and being implemented now. Progress in implementing recommended actions under PRS03 i s contributing to reducing the fiduciary risk, but this s t i l l remains high. Major recommendations aimed at improving the public financial management systems, including the efficiency and transparency o f use o f public resources, are reflected in the PEMSP supported by the PRSO program. The challenge wil l be in effectively implementing the PEMSP, and active monitoring o f the strengthening program initiatives by the Government i s critical. Strengthening external audit function and public financial management systems i s a medium to long term process which will extend beyond the period o f the envisaged PRSO.

204. The last IMF Safeguard Assessment of the Central Bank (Bank o f Lao PDR), which was conducted in 2003, classified the risk as being medium-high in a l l f ive categories o n which the assessment was based (external audit mechanism, legal structure and independence, financial reporting framework, internal audit mechanism and internal control system). Progress o n the safeguard recommendations has been slow, and the agreed jo in t audit o f the Bank o f Lao PDR’s 2003 and 2004 accounts by the State Auditor and an international audit firm has not been done. The authorities have indicated that they are not in a position to implement this agreement o n the audits.

205. In view of the high fiduciary risks, as detailed in the minutes of negotiation, the Recipient will maintain a dedicated deposit account for the proceeds o f the Grant, and will report on the funds f l ow o f the dedicated deposit account. The Government will, if considered necessary by IDA, allow an independent external audit o f the dedicated foreign currency deposit account.

DISBURSEMENT, REPORTING AND AUDITING ASPECTS

206. The recipient i s the Lao People’s Democratic Republic. A single tranche grant o f SDR 6.7 mi l l ion (US$lO mi l l ion equivalent) wil l be made available upon grant effectiveness, anticipated for July 2007. The closing date o f the operation will be February 2008.

207. The Grant proceeds will be disbursed against satisfactory implementation of the development policy program and the stipulated release conditions o f PRS03. The grant proceeds will not be tied to any specific purchases. However, such proceeds wil l not be used for ineligible expenditures. As detailed in the minutes o f negotiation, the Recipient will maintain a dedicated Deposit Account in U S dollars at the Bank o f Laos (which i s the Central Bank o f the Government), as part o f the general foreign currency reserves o f the government, and the Grant proceeds will be deposited by IDA into that Deposit Account. An equivalent amount wi l l be converted into local currency and credited to a Central Treasury account that i s used to finance budget expenditures.

208. Through the Ministry of Finance, the Government will report to IDA the amount received into the U S Dollar Deposit Account at the Bank of Laos, and the amounts withdrawn f rom the Deposit Account and the equivalent amounts credited in local currency to the Central Treasury Account available to finance budgeted expenditures. The report on the amounts withdrawn will include the date and namehumber o f the government’s bank account into which the local currency amounts have been

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deposited. The report on receipts and disbursements f rom the Deposit accounts i s to be submitted to I D A within 45 days o f the final disbursement o f the grant proceeds f rom the Deposit Account.

209. The Government will ensure that the grant proceeds are used for budgeted public expenditures except for purposes o r items on IDA’S “negative list” as agreed during negotiations and specified in the Financing Agreement. If the proceeds o f the Grant or any part o f the Grant proceeds are used for ineligible purposes, as defined in the Financing Agreement, the Bank will require the Government, upon notification f rom IDA, to refund the amount directly to IDA. Amounts refunded to IDA upon such requests shall be cancelled. Upon request by IDA, the dedicated account and related fund flows to and from this account will be audited by independent auditors acceptable to IDA and in accordance with terms o f reference acceptable to IDA, and the audit report wi l l be provided to IDA within four months after IDA’S request for such an audit. The processes and controls described above reflect the findings o f the IMF’s safeguard assessment as regards the central bank control environment in making use o f a dedicated deposit account for the foreign exchange proceeds o f the Bank‘s disbursement.

ENVIRONMENTAL ASPECTS

210. Overall, the environmental impacts of this operation are not expected to be significant. Nevertheless, certain environmental impacts are likely-positive in some areas and potentially negative in others, and PRS03 supports a wide range o f pol icy areas and interventions. Whi le some PRSO supported actions may have environmental implications (such as SOE restructuring and trade liberalization), given that SOE sector i s small and that trade agenda i s not featured prominently in this series o f operations, impacts will be low.

2 1 1. PRS03 continues to support major policy and institutional reform in natural resources management especially forest management. Regarding infrastructure, the PRSO program provides support to EdL to implement the Act ion Plan for the Financial Sustainability o f the Power Sector. Since the major source o f power comes from hydropower with potentially high environment and social impacts, the government i s working toward ensuring compliance with environmental and social safeguards. Support f rom international partners i s available through the N a m Theun 2 Hydroelectric Project, N a m Theun Social and Environment Project, and the Lao Environment and Social Project.

212. With support from the PRSO program, Government has made progress towards sustainable development in several areas. The Ministry o f Agriculture and Forestry (MAF) completed requirements for independent certification o f sustainable forest management in pi lot villages. A forest sector monitoring system was developed and piloted. The Act ion Plan for the Financial Sustainability o f the Power Sector was adopted by the MEM, MOF, and EdL. At the same time, in the context o f NT2, the Government has enacted the National Policy on Environmental and Social Sustainability o f the Hydropower Sector to ensure that future development o f the hydropower projects complies with environment and social safeguards.

213. The PRSO program i s supported by AAA work. In particular, Poverty and Environment Nexus (PEN) study; the Lao Environmental and Social (LEnS) project; N T 2 environmental, economic and social work; the Poverty and Environment Nexus study series; the Lao Environment Monitor that came out recently, and the 2005/6 Public Expenditure Review. With respect to the relationship between budgeting and environmental impacts, the 2005/6 Public Expenditure Review has a chapter devoted to environmental issues.

214. The Poverty and Environment Nexus (PEN) study pointed out the importance o f Non-Timber Forest Products (NTFPs) to rural communities, and recommended production and market monitoring, and development o f the legal framework and practical tools to allow greater community participation in resource management. The PEN study also suggested the importance o f trade for rural economies in demonstrating links between rural poverty and road access. However, there were also indications that

54

forest NTFPs were decreasing in abundance where market access was greatest. Despite the efforts of the government to properly manage the recently established system o f National Production Forest Area (NPFA), ongoing attention i s needed to lower the risk of illegal logging, encroachment, and agricultural land conversion. The revenue sharing scheme must be transparent and equitable to benefit the local communities whose livelihood primarily depends on the forest resources. T o further support forest management, resources are available f rom the Sustainable Forestry and Rural Development Project.

215. The Lao Environmental and Social project i s supporting the development o f the regulatory framework for the hydropower sector, and in relation to other large development projects. Sub-grants to support implementation o f the National Policy o n the Environmental and Social Sustainability o f the Hydropower Sector and the Resettlement Policy are due to get underway in the coming weeks. A further sub-grant wil l help to develop a river basin organization to manage water resources in the N a m Theun / N a m Kading basin, contributing to the development o f a national river basin management model, alongside ABD/AFD efforts in the N a m Ngum basin.

216. The Nam Theun 2 project remains the primary vehicle for on-the-ground implementation o f social and environmental safeguards related to hydropower development, and i s providing considerable practical experience and potential for capacity building in relation to a broad range o f social and environmental activities, including detailed and long-term village consultations, protected area management, community forestry, community fisheries, development o f market-based agriculture, and development o f links between micro-credit schemes and the formal financial sector.

217. Several studies and activities are currently under way, and will contribute to the work under PRS04-7 series. A piece o f regional AAA on the Social and Economic Drivers o f Wi ld l i fe Trade in East Asia currently underway wil l also contribute to the understanding o f trade issues in relation to conservation. This work will be o f relevance to environmental impacts o f the next PRS04-7 series, where trade component would be significantly larger than in the current series. LEnS funds could be used to examine or address environmental issues related to the PRSO activities. Future Environment Monitors could also be addressed towards relevant topics. In mining, a study i s currently being undertaken that wil l bring technical assistance into the mining industry to help the government deal with impacts o f the growing mining operations, including environmental impacts.

R I S K S AND R I S K MITIGATION

218. Overall, the Lao PDR PRSO series remains a high risk program. The potential payoff-Lao PDR remaining on i t s current growth and poverty reduction trajectory and making rapid progress towards Mi l lennium Development Goals-is substantial enough to justify this risk. However, risk mitigation will be necessary. Five main risks have been identified which could affect the impact o f the proposed operation and PRSO program. These are set out below together with mitigating factors.

2 19. Weak public financial management systems indicate high fiduciary risk. These systems are characterized by poor coordination between planning and budgeting, lack o f transparency and weak central control during budget preparation and execution, a l l o f which undermine efforts to enforce fiscal discipline and the pol icy alignment o f spending. This risk is mitigated by: (i) progress being made in strengthening public financial management processes and systems through the Government-prepared Public Expenditure Management Strengthening Program (detailed further under component 1.1 in Section V above); (ii) the recruitment o f a PEMSP Technical and Capacity Building Advisers; (iii) commitment to a clear and transparent framework to ensure that revenues from the N a m Theun 2 (NT2) hydroelectric project are allocated to poverty reduction, growth and environmental programs in a transparent fashion; and (iv) the commitment shown by the authorities in conducting f ie ld work for the PETS and PER during the PRS02-3 period.

55

220. Severe capacity constraints in the civil service, due to the lack of qualified personnel and low pay and incentives. This risk is mitigated by: (i) recognition o n the part o f the Government o f these weaknesses in the NGPES and NSEDP; (ii) the TA and capacity building activities financed through IDA’S Financial Management Capacity Building Credit (FMCBC), by PHRD grant provided by the Government o f Japan, and by other donors.

22 1. Provincial autonomy coupled with inadequate accountability and monitoring framework hinders implementation of national policies and an equitable distribution of resources. Provinces retain authority over revenue collection and budget execution, and s t i l l report sporadically to the central Government. Further, provincial treasuries often retain revenues intended for the central administration, resulting in central Treasury cash constraints and wide variations between provinces in per capita expenditures on priority sectors. This risk is mitigated by; (i) the commitment in both the PEMSP and the NSEDP 2006-10 to address these issues; (ii) the ongoing dialogue o n fiscal decentralization as part o f the revised Budget L a w process under the PEMSP; and (iii) the Government’s progress under PRS03 with implementing a new Government Financial Information System (GFIS).

222. Continuing fiscal risks could result in the diversion of PRSO funds away from NGPES/NSEDP priorities and to cover losses o f SOCBs and SOEs. In particular, SOCBs are s t i l l vulnerable to pressures to extend credits on a non-commercial basis. This risk is mitigated by; (i) the Government’s repeated and explicit commitment to maintain budgetary discipline; (ii) commitment to the PEMSP, including measures to strengthen fiscal planning, budget execution, monitoring and transparency; and (iii) PRSO-supported actions to reform SOCBs, public utilities and other SOEs, and to ensure international standard external audits for the largest SOCBs and SOEs.

223. Uneven commitment to reforms in earlier years has resulted in poor policy implementation performance. This risk is mitigated by: (i) the apparent commitment to and growing momentum o f a broad-based program o f reforms in the past few years, under both the Financial Management Adjustment Credit (FMAC) and PRSO1-2; (ii) the broad participation and pol icy dialogue through which the NGPES and NSEDP have been formulated and fostered by the PRSO series; and (iii) the reform momentum l ikely to be generated by trade integration, including ASEAN Free Trade Area (AFTA) commitments and the application for Wor ld Trade Organization (WTO) accession.

224. W h i l e the negotiations for PRS03 were successfully completed and the GOL has endorsed the negotiated financial agreement and confirmed the outcome o f negotiations, concerns were expressed by the GOL regarding the new Supplemental Letter o n Financial and Economic Data which provides for external debt reporting requirements described under OP14.10. The Bank and GOL are holding discussions to come to a mutually agreeable resolution o f this matter. Since the issue i s not specifically related to this operation it was decided to proceed with Board presentation; the signing o f the financing agreement for the operation will be pending until such an agreement i s reached

56

VII. T O W A R D S P R S O 4 TO 7

225. The 6th National Socio-Economic Development Plan (NSEDP) for the Lao People’s Democratic Republic was approved b y the National Assembly on June 17, 2006. I t predecessor, the National Growth and Poverty Eradication Strategy (NGPES), was finalized in February 2004 as a PRSP. The NSEDP incorporates key elements o f the NGPES, especially i t s geographical targeting and overall poverty focus. International non-governmental organizations (NGOs) and donors active in Lao PDR endorsed the final NSEDP at the 9th Round Table Meeting (RTM) o n 28 November 2006.

226. Over the past plan period (2001-2005), GDP growth averaged 6.2 percent per year and the headcount poverty rate was reduced almost b y half. Social indicators also improved, with enrolment rates in primary school rising from 77.3 to 84.2 percent and in health with infant mortality declining from 82 to 70 per 1000 l ive births. Government policies supported this broad-based growth and poverty reduction in the poorest areas o f the country where the Government focuses i t s interventions through (mostly donor-funded) targeted poverty alleviation programs. The Plan states that the main shortcomings o f the past plan period were a decline in the revenue to GDP ratio f rom 13.2 to 10.9 percent, a misalignment o f domestic expenditures to plan priorities and insufficiency coherence between national and local level planning and budgeting. The NSEDP appropriately aims to address these shortcomings over 2006-10, which will be critical for the successful implementation o f the national plan.

227. The N S E D P 2006-2010 i s the first Government-owned poverty reduction strategy of the Lao PDR. L ike previous national plans, the NSEDP establishes a vision and a broad direction for government pol icy for the period i t covers. However, i t also incorporates lessons learned from the elaboration o f i t s PRSP/NGPES. In particular, the elaboration o f the NSEDP was accompanied by a more comprehensive consultation process than pervious planning exercises, involving for the f i rst time, the donor community and the private sector. The NSEDP i s also more poverty-focused and results-oriented than previous national plans and applies a number o f regionally identified good practices for poverty reduction strategies.

228. The NSEDP aims at poverty reduction through a combination of broad-based economic growth and focused and policy interventions. The NSEDP contains a sound set o f pol icy interventions in the fol lowing areas: (1) human development and private sector driven economic growth; (2) competitiveness, trade and regional integration; (3) social development and focused poverty reduction interventions; and (4) good governance. These priorities and the strategic pol icy directions the plan sets in each o f them are well-suited to deliver on plan objectives. Through these priority intervention areas, the NSEDP points to the continued evolution o f Lao PDR towards a private sector led economy and modem governance whi le keeping a strong focus on human and social development and equity considerations.

229. The Plan represents a credible Poverty Reduction Strategy and i t s strength i s in the twin focus on poverty reduction and private sector led economic growth. The Plan addresses the three main principles o f Poverty Reduction Strategies: poverty reduction focus, transparency and participation, and monitoring and evaluation. The Plan sets a realistic poverty reduction target, clearly recognizes that the private sector i s an increasingly important driving force for accelerating growth and reducing poverty, and articulates strategies for infrastructure, rural, social and human development, and environmental protection for sustainable export-driven growth.

230. The N S E D P however, lacks several key features that make for a feasible plan supported b y resource envelope. Most importantly, i t i s the lack o f a comprehensive macroeconomic framework that includes reliable break-down o f expected and needed ODA, as wel l as fiscal envelope needed to fulfill

57

Plan’s objectives and achieve targets. Secondly, a more comprehensive monitoring and evaluation framework than the one currently employed, would be beneficial. The Government should work on developing these in the preparation o f the Act ion Plan and Annual Plans under NSEDP, and has already requested Wor ld Bank’s assistance in developing an M&E framework.

231. The new PRS04-7 series should be structured along the four pillars of the NSEDP; it however cannot cover all of them, given the scarce resources available and lessons learned from the past. Within the four pillars o f NSEDP, the PRSO would focus on the areas which are a) monitorable; b) most critical to the achievement o f outcomes; and c) have lasting effect in improving incentive systems.22 The content o f each subject area will be determined by sector experts and the task team leaders.

LESSONS LEARNT FROM PRSO 1 TO 3 232. The track record of adjustment lending in Lao PDR between 1989 and 2001 was uneven. The Wor ld Bank Operations Evaluation Department (OED) rated as unsatisfactory the outcome o f the f irst three Wor ld Bank Structural Adjustment Credits-SAC I (approved in 1989), SAC I1 (approved in 1991) and SAC III (approved in 1996). The first SACs supported the N e w Economic Mechanism aimed at liberalizing trade and foreign investment, strengthening the private sector, and improving macroeconomic management. According to OED’s evaluation, the SACs did not perform well-mainly due to weak Government commitment to the reform program and weak implementation capacity. OED recommended that future policy-based operations in Lao PDR should take o n board key lessons.

233. The lessons from these adjustment lending operations were taken on board in the design of the PRSO1-3 program. The Bank’s increased confidence in the Government’s commitment to the reform program i s based on the full implementation o f the FMAC, approved in June 2002, to which can now be added successful implementation o f PRSCl and PRS02, approved in March 2005 and April 2006. Moreover, the PRSO program i s based on the Government’s own poverty reduction strategy rather than on an externally imposed framework.

Fostering greater inter-ministerial coordination. The Government made a specific effort to ensure inter-ministerial coordination through the NGPESmSEDP process and through the PRSO Steering Committee and Technical Secretariat, with representation f rom across Government. As part o f the PRSO review process, Government has organized frequent inter- ministerial PRSO meetings, to align implementation strategies and discuss cross-cutting issues.

Supporting the operation with adequate and appropriate technical assistance (TA). The Government continues to use F M C B C and other resources to support technical assistance, capacity enhancement and institutional development efforts. I t i s also making use o f the PHRD grant TA attached to the PRS03. Furthermore, the proposed MDTF for PEMSP will provide significant additional grant resources for technical assistance to effectively implement policies.

Taking full account of capacity limitations. T o take account o f capacity constraints, the PRSO program was designed as a programmatic series, recognizing the need to manage reform in a series o f steps, but focused on medium-term outcomes and monitorable impacts.

234. Efforts to mitigate the above shortcomings of the previous budget support operations have been successful during implementation of the PRSOs 1 to 3, especially o n greater coordination

22 Some o f the measures included in the NSEDP in the areas of transparency and participation have t h i s characteristic, as they lay the basis for improved and sustained accountability.

58

and provision o f TA. First, the inter-ministerial agency coordination has been improved through the PRSO process and related dialog; this resulted in a process that was comparatively more owned and efficient under PRS03 than under PRS02. Second, the impact o f provision o f technical assistance in selected areas o f PRS02 and 3 has been clear in public financial management component: progress on this component has been faster and more profound in comparison to other areas that enjoyed less o f such support (for example, banking reform).

235. However, the design of the PRSO1-3 series has not fully taken into account the existing capacity limitations. While the programmatic series has been more beneficial than a self-standing operation might have been, the Government’s capacity to implement reforms may have been over- estimated during the design o f the f i rst programmatic series. Structural reforms during transition from planned to a market economy, such as SOE reform and Banking sector reform, need to be accompanied by several parallel processes before they can be successful. Such processes require building understanding o f the meaning o f these reforms, and building support within different parts o f the Government. This suggests a sequence that needs to be followed: improved monitoring, setting targets and monitoring achievement o f such targets, building incentives system to achieve targets within the public sector, and finally action (restructuring if it comes to SOE reform). Building capacity to perform in such complex reforms during this sequence i s key to success o f these reforms.

236. Several other concerns about the coverage of PRSO have emerged from implementation of the first PRSO programmatic series. The Wor ld Bank and Government PRSO1-3 teams have taken stock o f the lessons learned from implementation o f the first programmatic series o f operations in Lao PDR, PRSO1-3. The discussions o f lessons learned took place during the dialog o n PRSO1-3, as wel l as during retreat that took place in Houayxay o f Bokeo province (see B o x 4), the administrative capital o f Bokeo province in the Lao PDR. Some o f the lessons learned are:

Recognizing the benefits o f greater focus. The next PRSO series need to be focused in only two or three pol icy areas, and have less triggers and actions. The PRSO1-3 teams perception i s that the coverage o f the PRSOs was too ambitious for a government in a L o w Income Country Under Stress (LICUS) county, with small public sector, severe capacity constraints and l o w level o f inter-agency coordination;

Identifying and addressing the critical capacity constraints. Take into account the small size o f the Lao PDR program and opportunity costs o f the WB team in pursuing an overambitious budget support operation. In addition, every action or trigger should be accompanied with TA or other WB program in order to achieve outcomes.

Fostering ownership by aligning with national development objectives. The reform areas to which the Government has not fully committed or that do not have enough capacity or champions in the Government that are able to lead reforms should not be included for now, whi le the dialog in these areas should continue through other instruments, such as A A A s and capacity building activities;

Shifting the focus to outcomes. The emphasis should be shifted f rom actions and triggers to outcomes and indicators, leading to a more streamlined pol icy matrix o f maximum 6 triggers and 12 actions. Relying on outcomes will also al low to focus on achieving outcomes through a coherent and well-timed program, rather than focus on having an action in each sub-sector every year;

Maintaining flexibility in order to achieve these outcomes. Triggers and actions should be worded more flexibly and indicatively, to allow for adjustments along the way that would lead to better outcomes rather than fulfilling the matrix to the letter. The

59

Government should also get credit for reforms that lead to the outcomes, even if these were not init ially envisioned in the matrix;

(0 Aligning AAA work with PRSO objectives will help achieve actions and triggers and lead to a more meaningful dialog on many issues.

Box 4: Lessons learned from implementation of PRSO1-3: Government team comments at the retreat in Bokeo province

The Bokeo retreat had two main objectives: (1) Ensure PRS03 i s finalized o n schedule and taking stock o f the progress made to date and urgent needs during the coming month; (2) collect lessons learned f rom the implementation o f the three year program and take stock o f the programmatic support and the ways for WB-GOL cooperation in going forward.

During the retreat, the GOL team took an active part in discussions and had well-thought views o n the f i s t programmatic series successes and failures, as wel l as some suggestions o n the way forward. M a i n concerns with the implementation o f the current PRSO series were related to the feasibility and opportunity costs for the Government to perform o n a wide-ranged reform agenda as opposed to concentrating o n several priori ty areas. The fol lowing have been mentioned:

Sector coverage was too wide. The step forward would be to focus o n priori ty sectors f rom PRSNSEDP, and priorit ize within sectors based o n analytical work (recent PER) would be desirable;

Number o f triggers and actions was too high (42 under PRS02, reduced to 38 in PRS03 - as per PRS02 f inal document). The way forward would be to reduce the number o f actions, make each o f them more flexible in drafting, and deepen current reforms in pr ior i ty areas rather than trying to do too many things in too short a time;

Actions and triggers should be driving towards main goals o f the PRSNSEDP: growth, poverty reduction, and macroeconomic stability, and should not include actions that are already core business o f the government - instead, PRSO program should help GOL build country systems needed for the market economy, that would enhance macroeconomic stability and increase growth and poverty reduction in the long- and medium-term, as wel l as help advance structural reforms;

Technical assistance provided for Public Financial Management component by the WB has had an enormous impact o n the quality and depth o f reforms; in other areas, o n the contrary, the lack o f such assistance combined with severe capacity constraints hampered progress. Going forward, TA f rom the Wor ld Bank o r other donors should accompany each action and a principle o f mutual accountability between donors and GOL should be taken as basis for continued relationship. The principle o f mutual accountability should al low the WB to take responsibility for providing TA to the Government and if such TA i s not provided to take it into account in evaluating the country’s performance o n PRSO.

These comments, combined with the PRSO team (including EC) thoughts have la id the basis for criteria to be used for the next series o f operations, in deciding which triggers and areas o f intervention to include.

237. Given these lessons learned, the following criteria for triggers and actions to be included into the next operation have been put forward. In order to be accepted, the triggers should qualify o n the following criteria that are consistent with good practice on conditionality (see B o x 3).

(a) B e consistent with NSEDPPRS and cover four years (PRS04-7);

(b) Do not attempt to fully cover al l NSEDP agenda - o n the contrary, they should help GOL prioritize the reform agenda la id out in NSEDP;

60

(c) B e flexibly formulated and be leading to achievement o f monitorable outcomes based on programmatic approach. Focus should be more on a four-year program deliverables rather than on particular year-by-year actions;

(d) B e critical to the achievement o f the series outcomes (growth, poverty reduction, and macro stability);

(e) Have lasting effect in improving mechanisms and incentive systems;

( f ) B e accompanied by TA on a principle o f mutual accountability.

238. The proposed process leading to the design of the next programmatic series of PRS04-7 i s aimed at maintaining momentum in structural reform. The PRS03 Program Document outlines main principles o f the PRS04-7 operations and summarizes key lessons learned from PRSO1-3, as wel l as rationale for continuation o f the programmatic series in Lao PDR. The Document also summarizes main discussions with the Government o f Lao PDR with respect to the next series. The preparatory work on the indicative matrix for PRS04-7 has already started and will continue after PRS03 becomes effective. PRS04-7 will be prepared during 2007-2008 and made ready for the Board approval by M a y 2008. Given Board approval, PRS04 disburses by acknowledging triggers and actions achieved by March 2008, and agreed upon in June 2007, at a jo in t GOL/WB/EC/JBIC retreat. PRS04 program document will, in turn, specify the matrix o f reform for PRS0.5-7. In this way, the programmatic series will not skip a year and thus the momentum o f structural reforms gathered during PRSO1-3 will be maintained. Such design i s also beneficial for attracting more donors into the budget support process.

61

c

U a

.. 3

I .

111 W

n

I

I

I

c

0 Y

U

i

3 b

N

v) w

ANNEX 2: FUND RELATIONS ANNEX

This wil l be distributed as an addendum.

74

Lao PDR at a dance

9.8 37.3 32.6 30.9

ANNEX 3

4/18/07

or^ -om

POVERTY and SOCIAL

2005 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNi (Atlas method, US$ billions)

Average annual growth, 1999-05

Population (%) Labor force (%)

Most recent estimate (latest year available, lSSS-05)

Poverty (% of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 1,OOOlive births) Child malnutrition (% of children under5) Access to an improved water source (% ofpopulation) Literacy (% ofpopulation age 15+) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1985

GDP (US$ billions) Gross capital formation/GDP Exports of goods and services/GDP Gross domestic savingdGDP Gross national savings/GDP

Current account balance/GDP Interest payments/GDP Total debVGDP Total debt servicelexports Present value of debtlGDP Present value of debtlexports

2.4 7.0 4.0 1.3 1.3

-4 1 0.0

26.1 12.0

lS85-95 1995-05

GDP 5.6 6.1 GDP per capita 2.9 4.1

(average annual growth)

Exports of goods and services .. 9.8

Lao PDR

5.7 460 2.6

1.6 1.6

34 27 61 70 40 51 47

116 124 109

IS95

1 .a

23.2 11.9 15.2

-10.8 0.4

38.3 6.2

2004

6.4 4.7 6.2

East Asia 8 Pacific

1,885 1,627 3,067

0.9 1.3

42 70 29 15 79 91

115 116 114

2004

2.5 31.9 24.0 17.6 17.1

-14.3 1.6

100.9 17.1 54.5

195.4

2005

7.1 5.4

17.0

Low- Income

2,353 580

1,364

1.9 2.3

31 59 80 39 75 62

104 110 99

2005

2.9 27.6 27.1 13.4 7.0

-19.9 3.1

100.8 20.4 50.8

164.5

2005-09

7.6 5.8

10.0

Deve lopmen t

Li fe

-

Gross primary

capita enrol iment /

1

Access to imDroved water

Lao PDR Low- incme group

-

E c o n o m i c ra t ios -

Trade

T Domestic I+++ formation Capital savings

Indebtedness

-Lao PDR ~ Low-income group

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Household final consumption expenditure General gov't final consumption expenditure Imports-of goods and services

Manufacturing

1985 1995 2004 2005 I G r o w t h of c a p i t a l a n d G D P (%)

1s85-95 1995-05 2004 2005 I G r o w t h of e x p o r t s a n d i m p o r t s (%) I (average annual growth) Agriculture 4.0 4.2 Industry 11.3 10.4

Services 4.9 6.4 Manufacturing 13.1 9.9

Household final consumption expenditure .. 2.7 General govY final consumption expenditure .. 6.7 Gross capital formation .. 18.0 31.4 Imports of goods and services .. 16.1 29.0 16.6

Note: 2005 data are preliminary estimates. Group data are to 2004.

*The diamonds show tour key indicators In the country (in bold) compared with its income-group average It data are missing, the diamond will be incomplete.

75

Lao PDR

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeflcit

TRADE

(US$ millionsj Total exports (fob)

Electricity Mining Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (2000=100) Import price index (2000=100) Terms of trade (2000=100)

BALANCE of PAYMENTS

(US$ miliionsj Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, ioca//US$j

EXTERNAL DEBT and RESOURCE FLOWS

(US$ miilionsj Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Composition of net resource flows ORicial grants ORicial creditors Private creditors Foreign direct investment (net inflows) Portfolio equity (net inflows)

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

1985

64.8

-6.9

1985

41

135

1985

58 138 -80

-18 0

-98

118 -21

45

1985

619 0

27

7 0

15 36 0

-2 0

0 0 0 0 0 0

1995

19.6 19.7

16.5 6.5

-3.9

1995

313 24

15 589 49 43

218

99 99

101

1995

410 858

-249

-7 64

-191

206 -15

805

1995

675 0

267

26 0 3

130 75 0

95 0

19 28

1 27 2

25

2004

10.5 10.4

11.7 4.6

-3.3

2004

500 91 58 27

977 90

108 468

108 120 90

2004

687 1,032 -346

-98 65

-358

346 12

226 10,582

2004

2,530 0

618

120 0

13

113 54 0

234 0

28 37 8

29 5

24

2005

7.2 6.0

12.2 4.5

-3.2

2005

646 107 203

9 1,206

102 160 620

128 100 128

2005

875 1,267 -392

-269 85

-576

564 11

238 10,636

2005

2,910 0

649

182 0

14

117 79 0

349 0

35 9

26 5

21

-GDP deflator -0- CPI

I Export and Import levels (US$ mlll.)

1,400

1.200

1.000

800

600

400

200

0

I Cur ren t a c c o u n t b a l a n c e t o G D P ( O h )

0

-5

.M

-15

-20

! C o m p o s i t i o n of 2004 debt (US$ m i l l . )

c 38

D: 860

A - IBRD E- Bilateral B - IDA D - Other F - Private C - IMF multilateral G - Short-

*_-

Development Economics 4/18/07

76

v) d, v) v) d,

8

c!

- 0 0

b

8

c! 8 IC

8

c! 0 0

03

8

c! 0 0

b

8

c! m

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ANNEX 5

LAO PEOPLE'S DEMOCRATIC REPUBLIC Peace Independence Democracy Unity Prosperity

4"'! e-- MINISTRY OF FINANCE N D 9 ' /MOF Vientiane, 0 2 HA

1107

LElTER OF DEVELOPMENT POLICY

Mr. Paul D. Wolfowitz President The World Bank Washington, D.C.

Dear Mr. Wolfowitz,

On behalf o f the Government o f Lao PDR, I am writing to request the International Development Association's continued financial and technical support for the implementation o f our National Growth and Poverty Eradication Strategy through a Third Poverty Reduction Support Operation (PRSO 3).

Povertv Reduction Stratew

Our intention i s to achieve rapid economic growth in order to improve the living conditions of the poor population. We are committed to halving poverty by 2015 and graduating from the status o f least-developed country by 2020. Our commibnent to reforms and the development strategy to achieve these goals has been articulated in the five-year National Socio-Economic Development Plan for 2006-2010 (NSEDP 2006-10 ), which was approved by the National Assembly last year, and that i s a successor of the National Growth and Poverty Eradication Strategy (NGPES, currently the Lao Poverty Reduction Strategy Paper),

The government has made strides in recent years towards more participatory and transparent development planning. The NGPESPRSP and NSEDP 2006-10 were also developed through extensive consultations at central as well as local levels, With financial support fiom the UNDP, the World Bank, ADB and other donors. The consultative process was broadened to increase participation by civil society and the private sector. In addition to consultations with mass organizations, such as the Lao Women's Union, discussions were held with the private sector, academics, and the provinces, as well as at the viHage level. Consultations with donor pamen were carried out in the context o f the 9* Roundtable Meeting in November 2006.

The NGPES establishes a framework for future development (all incorporated into the NSEDP 2006-10) and makes our development priorities more explicit and transparent. These priorities

.take into account the multi-dimensional nature of poverty alleviation, and are detailed in the concrete actions detailed in these hvo documents:

83

Maintain macroeconomic stability by increasing revenue and ensuring appropriate fiscal and monetary policy; Deepen structural reforms in the following areas: public expenditure management, financial sector, SOEs, private sector, trade, public administration, and development of the legal system; Invest in the social sectors to expand access to basic education and health services and improve Lao’s social sector outcomes; Invest in inftastructure such as roads, power, and water supply, and expand access to these services; Invest in rural development and natural resource management-including support for agricultural. mining, forestry and hydropower development; and Strengthen capacity.

I

Third Povertv Reduction S U P O O ~ ~ Ooeration

A third PRSO wil l provide selective support to the implementation of NGPES and NSEDP 2006-10, building on the valuable support provided under PRSC 1 and PRSO 2. The ongoing series o f PRSOs is assisting us to make monitorable progress in realizing the objectives laid out in the NGPESRRSP, and to enhance the sustainability o f our development efforts through the promotion o f economic growth. T h e policy improvement program articulated in the PRSOs focuses in a selective fashion on key areas o f the NGPES, by drawing on the conclusions and recommendations o f analytical work realized in recent years by the Bank in cooperation with us and other donors.

PRS03 underpins our objective to maintain a sound macroeconomic environment and accelerate growth, while providing external resources for the execution o f our FY 2007 budget. The PRSOs aim at increasing available resources by enhancing the environment for resource generation, and promoting sustainable growth via a stronger private sector, greater trade volume, and greater capacity to manage natural resources. The PRSO program i s structured in three components and nine sub-components, each with agreed policy actions and defined outcomes and indicators (please refer to the revised PRSO Program Matrix).

CornDonents and PRS03 Prior Actions

Component 1 o f the PRSO Program Matrix focuses on strengthening public resource management (including subcomponents on strengthening public expenditure managernen6 strengthening the banking sector, improving the performance o f state- owned enterprises and financial sustainability o f utilities). Component 1 prior actions for PRS03 include:

I. Ministry o f Finance approved an updated Public Expenditure Management Strengthening Program and implementation plan based on 2005/06 PER analysis, and demonstrated ongoing progress with its implementation and capacity building;

84

11. Ministry o f Finance prepared FY 2006-2007 budget with (i) administrative classification; (ii) priority expenditure sectors; and (iii) summary data on statutory funds, publishing this summary within first half o f the fiscal year;

111. Ministry o f Finance submitted to the National Assembly an appropriately revised Budget Law and adopted decree on organization amd operation o f MOF and drafted ministerial instruction on organizational structure o f the National Treasury;

IV. Ministry o f Finance approved revised GFS compatible Chart o f Accounts structure, budget nomenclature and implementation strategy, following consultations with key stakeholders;

V. Ministry o f Finance approved reporting formats for quarterly budget execution reports consistent with the Budget Law.

VI. Bank Restructuring Implementation Committee (BRIC) submitted to Ministry o f Finance a quarterly evaluation o f BCEL and LDB performance against operational and financial targets, including recommendations to banks for targets off track;

VII. BPO carried out monitoring and evaluation and submitted to Prime Minister's Office a semi-annual evaluation o f progress against approved restructuring plans for SOEs, including instructions on corrective actions for SOEs; and

VII. Government and Elecrrici!e' du Laos implemented succeeding phases o f the power sector action plan, including tariff adjustment, EDL's operational efficiency improvement measures, and arrangements for settlement.

Component 2 o f the PRSO Program Matrix focuses on strengthening public expenditure policy (including subcomponents on aligning spending with pro-poor NGPESMSEDP priorities and monitoring this alignment). Component 2 prior actions for PRSO 3 include:

IX. Government improved the timeliness o f payment o f salaries to teachers and health workers.

Component 3 o f the PRSO Program Matrix focuses on sustainable growth (including subcomponents on strengthening private sector development, accelerating regional and global integration and improving resource management). The component 3 prior action for PRSO 2 was:

X. Government made progress with new Enterprise Law implementation; XI. Government prepared a Forest Industry Restructuring Plan to rationalize

industrial capacity and resource supply.

PRSO 4-7

We agree to work with the World Bank team on designing the triggers and actions o f the PRS04 and PRS05-7 operations, and will commit to the triggers for PRS04 operation during the month o f June, 2007. These actions will be from the following areas, consistent with the aims of NSEDP 2006-10: public financial management (implementation o f the PEMSP and measures to increase revenues), monitoring and corrective actions to reduce losses o f stateswned enterprises and banks; improvements in the expenditure allocations to the priority sectors; improvements o f

85

the investment and business clime through reforms in financial sector, enterprise law implementation, regional integration and improvements in business regulations according to the GOL plan announced at the RTh4 meeting, and prudent natural resource management.

We are committed to providing to the World Bank information and comfort on our progress in implementing the triggers that are currently being drafted for PRS04-7, as well as other actions that wil l be detailed in the PRS04 Policy Matrix.

Fiscal Sustainabilitv and Macroeconomic Stability

We remain firmly committed to maintaining fiscal sustainability and macroeconomic stability over the medium-term and wil l implement the 2006/2007 budget prudently towards that end. Also, the civil service wage and allowance increases wil l be implemented in a manner that ensures fiscal sustainability in 2007/2008 as well. We are determined to maintain prudent lending policy o f the state-owned banks and to implementation o f the PEMSP.

We are committed to providing to the World Bank information and comfort on our macroeconomic performance, and to permit monitoring o f quarterly progress in respect o f the various component o f the PRSO program. In particular, to enable a thorough macroeconomic assessment, we wil l provide the Bank quarterly information on fiscal, external accounts, and monetary accounts o f the Lao PDR.

Conclusion

We request the World Bank's assistance to facilitate the realization o f this program. Once again I would like to assure you that we wil l continue to implement the 2006/2007 budget and to plan the following budgets in away that ensures and maintains medium-term fiscal sustainability and macroeconomic stability.

Yours sincerely,

I . ' ' . ? Q S I K H A ~ Minister o f Finance Lao People's Democratic Republic

86

MAP SECTION

Phou BiaPhou Bia(2,817 m) (2,817 m)

X iangkhoang PlateauXiangkhoang Plateau

Plain of JarsP lain of Jars

Cammon PlateauCammon Plateau

BolovensBolovensPlateauPlateau

SASAYYABOURABOURYY

OUDOMSAIOUDOMSAI HOUAPHANHOUAPHAN

BOKEOBOKEO

PHONGSALPHONGSALYY

SEKONGSEKONG

AATTTTAPEUAPEU

XIANGXIANG

LUANG LUANG PHRABANGPHRABANG

LUANGLUANGNAMTHANAMTHA

VIENTIANEVIENTIANE

SASAVVANNAKHETANNAKHET

CHAMPCHAMPASSAKASSAK

KHAMMOUANEKHAMMOUANE

BOLIKHAMSAIBOLIKHAMSAI

SARASARAVVANEANE

KHOANG KHOANG

MM

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nngg

SSee BBaanngghhiioonngg

DDoonn

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OOuu

BBeenngg

TTaa

XXeeBBaannggffaaii

OOuu

KKaaddiinngg

Gnot-OuGnot-Ou

MuangMuangKhoaKhoa

PakbengPakbeng

Boun-NuaBoun-Nua

ViangxaiViangxai

MeungMeung

KhamKham

PhokhounPhokhoun

NambakNambak

XaisombounXaisomboun

PaklayPaklay

XanakhamXanakham

KhamkeutKhamkeut

XeponXepon

PhinPhin

KhongxedonKhongxedon

PakxongPakxong

KhongKhong

SanamxaiSanamxai

XebangfaiXebangfai

SamouaySamouay

Ban Na PhanBan Na Phan

XXéénono

XiangkhoXiangkho

Ban NalBan Naléé

KasiKasi

VangviangVangviang

NanNan

PhongsalyPhongsaly

LuangLuangNamthaNamtha

BanBanHuaisaiHuaisai

LuangLuangPhrabangPhrabang

XiangXiangKhoangKhoang

PaksanePaksane

ThakhekThakhek

SaravaneSaravane

ChampassakChampassak AttapeuAttapeu

SekongSekong

SavannakhetSavannakhet

Sam-NevaSam-Neva

MuangMuangXaiXai

SayabourySayaboury

PonePoneHongHong

VIENTIANEVIENTIANE

VIETNAM

C H I N A

THAILAND

MYANMAR

CAMBODIA

PREFECTURE OFVIENTIANE MUN.

SAYABOURY

OUDOMSAI HOUAPHAN

BOKEO

PHONGSALY

SEKONG

ATTAPEU

XIANG

LUANG PHRABANG

LUANGNAMTHA

VIENTIANE

PREFECTURE OFVIENTIANE MUN.

SAVANNAKHET

CHAMPASSAK

KHAMMOUANE

BOLIKHAMSAI

SARAVANE

KHOANG

Gnot-Ou

MuangKhoa

Pakbeng

Boun-Nua

Viangxai

Meung

Kham

Phokhoun

Nambak

Xaisomboun

Paklay

Xanakham

Khamkeut

Xepon

Phin

Khongxedon

Pakxong

Khong

Sanamxai

Xebangfai

Samouay

Ban Na Phan

Xéno

Xiangkho

Ban Nalé

Kasi

Vangviang

Nan

Phongsaly

LuangNamtha

BanHuaisai

LuangPhrabang

XiangKhoang

Paksane

Thakhek

Saravane

Champassak Attapeu

Sekong

Savannakhet

Sam-Neva

MuangXai

Sayaboury

PoneHong

VIENTIANE

VIETNAM

C H I N A

THAILAND

MYANMAR

CAMBODIA

Mekong

Mek

ong

M

e ko

ng

Se Banghiong

Don

Noy

Ou

Beng

Ta

XeBangfai

Ou

Kading

Gulf ofTonkin

Nam NgumReservoir

To Gejiu

To Daluo

To Khon Kaen

To Ubon

Ratchathani

To Qui Nhon

To Vinh

To Khon Kaen

To Hanoi

To C

hian

g Ra

i

To Lincang

Xiangkhoang Plateau

Plain of Jars

Cammon Plateau

BolovensPlateau

Phou Bia(2,817 m)

22°N

18°N

22°N

20°N

18°N

16°N

14°N

16°N

14°N

104°E 106°E

104°E102°E100°E 106°E 108°E

LAO P.D.R.

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

0 50

0 25 50 75 100 Miles

100 Kilometers

IBRD 33431

NOVEMBER 2004

LAO PEOPLE'SDEMOCRATIC

REPUBLICSELECTED CITIES AND TOWNS

PROVINCE CAPITALS

NATIONAL CAPITAL

RIVERS

MAIN ROADS

RAILROADS

PROVINCE BOUNDARIES

INTERNATIONAL BOUNDARIES