Country Partnership Strategy: Lao PDR, 2012–2016

 

Southeast Asia Department

Overcoming Most Critical Constraints to Inclusive Growth in Lao PDR

 

 

OVERCOMING MOST CRITICAL CONSTRAINTS TO INCLUSIVE GROWTH IN LAO PDR*

Chapter 1. Introduction and Overview

1. This study opens up an inquiry into the critical factors constraining sustained and inclusive economic growth in Lao People’s Democratic Republic (PDR), with the end in view of identifying policies and institutional reforms aimed at overcoming such constraints.1 2. To be inclusive, economic growth must yield fruits that are within reach of every citizen. But to realize this, economic opportunities must be expanded and access to them equalized. No individual should be denied the chance to improve his or her socio-economic status on account of factors that are beyond a person’s control, such as, gender, race, and family background. Inclusiveness has become an integral part of growth and development policy in view of an increasing recognition that inequality and poverty are harmful to long-run economic growth.2

3. The aggregate growth performance of Lao PDR over the past few years has been impressive, but there are concerns about the possibility of worsening inequality and persisting poverty. Close attention must thus be paid to two important tasks: poverty reduction and equitable development. In line with these twin tasks, the study will attempt to identify drivers of rapid, inclusive growth that will sustain, if not accelerate, the growth momentum triggered by Lao PDR’s transition in 1986 from a centrally planned to a market-oriented economy. 4. The major development challenge that Lao PDR faces has been to transform an economy that is to a great extent agricultural into one that can be considered industrializing. On the production side, industrialization is to be taken here as an approach in which all sectors—agriculture, industry, and services--of the economy are motivated to be efficient, and must be distinguished from the traditional notion of solely setting up heavy industries, the path that former central planning countries in Eastern Europe had taken with lamentable results. A major first step in this regard is to raise agricultural productivity. In the course, however, of increasing agricultural productivity, some agricultural workers are rendered redundant. Fewer workers are required to produce the same amount of agricultural output. 5. Public policy thus has to contend with managing the sectoral reallocation of labor and capital so that workers released from agriculture, where majority of the poor eke out a living, will find employment with higher productivity in industry and services. In other words, investment in the latter must grow at a pace rapid enough and create high-skill, high-wage jobs. In the past few years, the growth of non-agriculture relied heavily on resource-based industries, such as, hydropower and mining. Being capital intensive, and capital being subject to diminishing returns, job creation in the latter was not sufficiently strong to absorb agricultural workers rendered in surplus. Many members of the Laotian labor force had to                                                         * This report is a joint undertaking of two study teams from the Lao PDR Resident Mission (LRM) and ADB-ERD.

The two project leaders are A. Barend Frielink (LRM) and Muhammad Ehsan Khan (ERD). The team consists of: Dante B. Canlas (consultant, LRM and ERD), Yoko Niimi (ERD), Soulinthone Leuangkhamsing (LRM), Phantouleth Louangraj (LRM), Yoko Yamoto (consultant, LRM), Ma. Rowena Cham (ERD), Damaris Yarcia (consultant, ERD), Paulo Rodelio M. Halili (consultant, ERD) and Lawrence Nelson Guevara (consultant, ERD).

1 This study follows the trail set by a series of studies on Critical Development Constraints that have been undertaken for the Philippines (ADB 2007b), Nepal (ADB 2009a), Indonesia (ADB 2010b), and Papua New Guinea (ADB, forthcoming).

2 Torstein Persson and Guido Tabellini (1994), for example, have proposed a theoretical and empirical model that supports the notion of inequality causing low growth. The authors argue that when distributional conflicts are pervasive, the politically chosen tax and regulatory policies reduce the ability of private investors to capture returns, thereby dampening capital accumulation and economic growth.

cross country borders to seek employment, for instance, in plantation agriculture, construction, and personal services in Thailand. 6. In 2008, the per capita gross national product (GNP) of Lao PDR was estimated at US$ 740; this was higher than Cambodia’s US$ 600, which was the lowest among countries in Southeast Asia.3 Over the period 2004-2008, per capita GDP of Lao PDR grew at an average of about 4% each year. At that growth rate, per capita GDP could be expected to double in 17 years.4 Such growth was largely instrumental in the decline of poverty incidence, from 46% of the population in 1993 to about 27.5% in 2008, using Lao PDR’s national poverty income threshold.5 7. Both the growth of national output and decline in poverty in the recent decade were quite impressive. At this stage, however, the levels are still relatively low. A major challenge is to sustain, if not accelerate, the positive trends in aggregate socio-economic performance to usher in convergence, a situation where Lao PDR is seen graduating from a “least developed economy,” as expressed in the emerging Seventh Five-Year Plan of the Lao PDR government, and catching up with the emerging middle-income countries in Southeast Asia.

8. The Asian Development Bank (ADB) shares the goal of inclusive growth with its developing member countries (DMCs), and has made such growth the overarching goal in its partnership programs with DMCs.6 The ADB has noted that in the course of transiting to a middle-income economy, some DMCs experience rising inequality and a slowing down of the decline in poverty incidence as per capita income rises, trends that are not aligned with inclusive growth.7 To minimize the risk that Lao PDR will experience increasing income inequality accompanied by large incidence of poverty, it helps to have a good understanding of the process that yields such outcomes, and be conscious of the role that economic factors and social institutions play in the process.

1.1. Methodology 9. The study aims to identify the most critical factors constraining sustained and inclusive economic growth. The Government of Lao PDR (GOL) has long been concerned with correcting unwanted socio-economic outcomes, evidenced by its commitment to meet its targets under the Millennium Development Goals (MDGs). To heighten the likelihood of success, chosen government policy interventions must have strong factual and analytical bases. To realize this, the study is organized around the framework of inclusive growth. Meanwhile, it is widely agreed that the factors behind inclusive economic growth are many. In economies starting with low levels of human, physical, and technological capital, it may not be advisable to carry out growth-enhancing measures in several fronts at the same time. Hence, it helps to start with the most binding constraints to growth. In this connection, a growth diagnostic exercise is pursued.

                                                        3 All per capita GNP figures, unless otherwise stated, are taken from the Asian Development Outlook 2010 (ADB

2010). In 2009, GDP growth slowed down from the spill-over effects of the global financial crisis and may be viewed as a deviation from long-term trend.

4 For 2009, the World Bank estimate of Lao’s per capita income rose to about US$ 840 after adjusting for the recent appreciation of the Kip against the US dollar. If this exchange rate is preserved and the average annual growth rate of 4% continues, then in 17 years, Lao PDR may be considered a low middle-income country, the income bracket of Indonesia and the Philippines at this juncture.

5 This poverty figure is taken from Somneuk Davading (2009). 6 ADB Strategy 2020 (2008). 7 This was the theme, for example, of ADB (2007a).

1.1.1. Inclusive Growth

10. The phenomenon of economic growth accompanied by rising income inequality has been a long-standing development issue. Scholars like Simon Kuznets (1955) have noted early on a seeming empirical regularity: in the course of economic development, income inequality in some countries, individually and as a group, tends to get worse before it gets better.

11. As income inequality widens, many households in the bottom tenth of the income distribution get trapped below the poverty income threshold. A long line of researchers has been analyzing the problem, but the problem is still not considered quite solved at this point.

12. Over the past few decades, there has been a resurgence of interest, in describing the mechanisms whereby growth yields inequality and poverty, and from a normative view, how growth ought to proceed to prevent those pitfalls.

13. One mechanism rests on the relationship between the financial structure and growth. Financial deepening enhances financial intermediation, a process that increases returns to investments, thereby encouraging further capital accumulation and growth.8

14. In view of imperfect information, however, financial markets are generally incomplete. That is, not all projects applied for financing are able to raise equity financing or get loan contracts. Banks, for example, are frequently the major source of project finance, especially in developing countries like Lao PDR. Since potential borrowers differ in their probability of defaulting, banks resort to credit investigation to get information about borrower’s risk. Project risk is also assessed as a matter of course. Borrowers certified as low risk get bank loans, while those considered high risk are refused. In short, there is credit rationing. The credit market is not a spot market wherein the interest rates adjust to clear the demand and supply of loans.9 In consequence, access to credit markets, given heterogeneous borrowers, tend to be unequal.

15. For example, banks are generally better informed about rich borrowers--who invest in information to signal to the banks that they are credit-worthy--than about poor borrowers. Moreover, poor borrowers normally find the transaction cost of loan application in a bank quite large relative to the amount of the loan applied for. Such a relatively high entry cost of borrowing from banks deters poor borrowers from applying. And if the poor, nonetheless, decide to apply for a loan, banks’ limited information about their credit rating often results in rejection.

16. One missing market, for instance, is a loan market for higher education. Financing the latter is to a great extent based on family income. Absent such a credit market, students from low-income households, even if they have the aptitude and intellectual ability, find it difficult to enroll for a college degree. In contrast, students from rich households face no such liquidity problem. Earnings differentials between college and non-college graduates emerge and persist over time. Incomplete financial markets, if not rectified, perpetuate an unequal distribution of initial human capital endowments, resulting in inter-generational transmission of income inequality and poverty. The result: long-run growth gets impaired in the process.10                                                         8 Among those who have made early studies about the links between the financial structure and growth are

Raymond Goldsmith (1969), Edward Shaw (1973), and Robert Townsend (1983). 9 Incomplete financial markets can arise from asymmetric distribution of information, which includes the problems

of moral hazard and adverse selection, thereby resulting in credit rationing (see, e.g., Joseph Stiglitz and Andrew Weiss 1981).

10 See, for example, Townsend and Kenichi Ueda (2006) who have studied the nexus of financial deepening-inequality-and growth in the context of Thailand’s economic development.

17. Many analysts have thus tried to identify necessary conditions for inclusive growth. The important ones rest on (a) growth of average incomes; (b) high sensitivity of poverty to such growth; and (c) a poverty-reducing pattern from the growth of relative incomes [see, e.g., Martin Ravallion and Shaohua Shen (2003), Aart Kraay (2006]. Development policy then sets out to identify levers that are vital to reducing inequality and poverty [see, e.g., ADB (2005, 2007), World Bank (2006a), Ifzal Ali and Juzhong Zhuang (2007)]. In this study, the concept of inclusive growth that Ali and Zhuang (AZ hereinafter) have articulated from a normative standpoint is used to organize thinking about how to achieve inclusive growth (see Figure 1.1).

Figure 1.1. Inclusive Growth Concept

Source: Ali and Zhuang (2007); also in ADB (2007), Philippines: Critical Development Constraints

18. The ultimate goal of inclusive growth, as shown in Figure 1.1, is poverty reduction, which rests on three pillars. One is maximizing economic opportunities. In this regard, it is useful to note that majority of households derive their income from employment. It is income from the workplace that supports basic needs like food, schooling, health care, and shelter. The creation, hence, of productive and decent jobs is generally considered a pro-poor development task.

19. The second pillar of inclusive growth is to equalize and expand access to opportunities. It is widely observed that income generally correlates positively with the human capital that people bring to the workplace, much of which comes from investments in education, training, and health. Costs are incurred at the start, but with such human capital investments, the efficiency units of people are enhanced. Their earnings rise, which improve their command over consumption goods and afford them opportunities to save.11 Equalizing

                                                        11 See Gary Becker (1967) and Jacob Mincer (1974) about various aspects of human capital investments that

lead to higher earnings. Meanwhile, Robert Lucas, Jr. (1988) has proposed a model of endogenous growth that

Poverty Reduction

Inclusive Growth

Maximize Economic Opportunities

Ensure Minimum Economic Well-Being

Ensure Equal Access to Economic Opportunities

Governance and Institutions

and expanding access of the poor and other low-income groups to human capital inputs serve to reduce inequality in the distribution of earnings.

20. Today, Lao PDR relies largely on markets guided by a decentralized price system to coordinate interrelated activities of enterprises and households. In some cases, however, markets may not deliver the allocations commensurate to society’s needs. This happens, for instance, when individual actions inflict on third parties so-called externalities or spill-over effects, which are either positive or negative. In extreme cases, pricing is not possible, causing markets to fail, and government may be called upon to provide the corrective actions through tax-and-spending schemes. The latter are termed public goods, typical examples of which are military and police work.

21. A third pillar of inclusive growth relates to ensuring that all citizens are assured of minimum economic well-being. Markets are hardly concerned with distributive justice. That is, allocation outcomes may not conform to society’s standards of fairness. Some individuals or families may get allocations in prodigious amounts, while others end up with deprivations. To prevent inequality from degenerating into social unrest, the government sees to it that the truly disadvantaged members of society are able to gain access to growth opportunities, which improve their living standards over time.

22. In attempting to correct inequitable outcomes, the government is well advised to correct the distribution of initial endowments, including that of human capital, instead of interfering with the functioning of the price system. Moreover, since the poor are vulnerable to economic downturns, the government can consider instituting social protection schemes. But redistribution schemes of this sort must guard against tax and regulatory policies that weaken the ability to capture privately the returns from investments, to minimize the probability of dampening private investment and aggregate growth.

23. In all of the corrective actions that the government may be called upon to administer, good governance, which underpins all three pillars of inclusive growth, is a prerequisite. Good governance has several aspects, including, absence of corruption in government procurement, in particular, and sound public financial management, in the large. Furthermore, good governance is about having well-defined principles and rules of the game, along with credible institutions that oversee the play of the game. In this connection, a crucial element is the establishment of a legal and judicial system that is conducive to enforcement of contracts; and if contractual disputes emerge, this system should e able to adjudicate in a timely and fair manner. It goes without saying that good governance is essential to ushering in a favorable investment climate. 1.1.2. A Growth Diagnostic Approach

24. The standard analysis of economic growth is centered on the role of capital accumulation or investment. The time path of capital per worker dictates the time path of output per worker (see, e.g., Robert Solow 1956). If the expected marginal efficiency of investment or its internal rate of return exceeds the additional cost of finance, then the investment is undertaken. Investment, meanwhile, is impeded by factors that raise the cost of finance, along with forces that reduce the rate of return from investment. A close investigation of rate of return and cost of finance is thus the starting point of the growth diagnostic method that Ricardo Hausmann, Dani Rodrik, and Andres Velasco (2005)--HRV hereon--have proposed in identifying the most critical constraints to growth in the short run.

                                                                                                                                                                            emphasizes the ability of human capital to overcome diminishing returns to capital, and yield a long-run positive growth rate in per capita income.

25. The thinking about how investment enhances growth has been evolving over time and undergoing extensions and refinements. At the most rudimentary level, investment is a component of aggregate demand and at the same time adds to productive capacity. As firms accumulate physical capital and are able to equip each of their workers with rising amounts of physical capital, productive capacities expand, raising output per worker in the process.

26. One implication of this important role of investment is that less-developed economies will be able to catch up with the modern industrial countries in terms of per capita income, provided they can raise their savings, and accordingly, investments. This is often referred to as convergence, a situation where developing economies are able to catch up with the developed ones. Thinking about growth has thus led to thinking about development: what must the less-developed economies do to achieve the levels and growth rates in per capita incomes that developed economies have reached?

27. Since the late 1980s, may development thinkers have focused their works on accounting for levels and growth rates of per capita income in a large cross-section of countries, both developed and developing. These studies point out that capital accumulation, broadly defined, matter for growth. Human, physical, technological, public overhead capital like infrastructures, and the so-called social capital are all vital to growth.12 The main proposition emerging from these studies is that growth is a matter of choice, hence the term “endogenous growth.” Developed economies that, for instance, continue to invest in human capital, acquire advanced technologies, and build public infrastructures supportive of private production grow on a sustained basis, instead of settling in steady states with zero growth rates in per capita output and capital. In contrast, economies that fail to make the right choice of capital will languish in a state of backwardness, unable to catch up with the developed ones.

28. Capital viewed broadly through the lens of endogenous growth yields increasing, not diminishing, productivity from every unit of capital. The increasing returns can come from varying sources, including, learning-by doing or learning-by-investing (see Kenneth Arrow 1963, Romer 1986). Every time a firm invests, it creates knowledge that spills over to all the other firms in the industry. That knowledge is not diminished as it passes from one firm to another, thereby resulting in increasing returns. This same may be said of investment in human capital, which interacts with physical capital to produce long-run growth (see Lucas 1988).

29. With this evolving view in mind about investment--from the basic growth model of Robert Solow (1956) to the recent models of endogenous growth--HRV have proposed a growth diagnostic approach that seeks to uncover obstacles to growth (see Figure 1.2). The diagnosis can start with some stylized facts about the magnitude of the investment-to-GDP ratio. A low ratio may be traced to a marginal efficiency of investment or internal rate of return that falls short of the rental price of capital.

                                                        12 The importance of investment or accumulation of physical capital for growth has been emphasized in, for

instance, the basic model of Robert Solow (1956). However, to be able to explain adequately cross-country income differences, the essentiality of the other forms of capital accumulation has led to new growth models, which are referred to in the literature as endogenous growth [see, e.g., Paul Romer (I986) and Robert Lucas, Jr. (1988)].

Figure 1.2. Growth Diagnostics Framework

Source: Hausmann, Rodrik, and Velasco (2005).

30. Further diagnosis of the low internal rate of return turns on low social returns, which can stem from inadequate human capital and public infrastructure, as well as from the presence of natural obstacles associated with poor geography. There are instances when resulting market allocations fall short of society’s needs. Using tax-and-subsidy schemes, a role for the government is indicated; it can provide non-excludable public goods and services that are productive. Infrastructures, such as, roads and transport systems (which are particularly vital in overcoming unfavorable geography), are illustrative. These forms of government spending complement private production, and if found to be inadequate, reduce private returns to investment, discouraging investment and adversely affecting growth.

31. Similarly, the government has a role to play in human capital investments like education. Since there are spillover effects from education, particularly at the basic level, individuals and families may under-invest since they are likely to invest only up to the extent of the private returns, not up to the social returns for which no additional compensation to them is forthcoming. If the government budget stagnates and cannot come up with the appropriate amount of spending for education, private production suffers, given the positive marginal products of human capital, which may even entail increasing returns once combined with physical capital.

32. In addition, low rates of returns to investments may be due to government policies that hinder the ability of the investor to capture privately the returns. For instance, low appropriability may be traced to a high tax regime, uncertainty about property rights, and pervasive corruption. It is after-tax returns that matter for investment decisions. Moreover, if the government is opportunistic and nationalizes industries once shown to be profitable, private investors will be discouraged. Furthermore, if fiscal and monetary policies are discretionary and not rule-driven, the private sector will face heightened risk and uncertainty, twin factors that can be counted on to dampen investment. As regard corruption, it transfers income from productive agents to non-productive ones, which is bound to cause a decline in investments and growth.

33. Investment by a firm, in so far as it creates knowledge that spreads to all the other firms in the industry, creates additional benefits without the firm getting any additional compensation. This is case where the private returns are less than the social returns. Investment in knowledge, say R&D, will thus be less than the ideal amount. To motivate

Low Levels of Private Investment and Entrepreneurship

Low Return to Economic Activity

High Cost of Finance

Low Social Returns Low Appropriability

Poor Geography Poor

InfrastructureLow Human Capital

Government Failures

Bad International Finance

Poor Local Finance

Market Failures

Information Externalities: “Self-

Discovery”

Coordination Externalities

Low Domestic Savings

Poor Intermediation

Micro Risks: Property Rights,

Corruption, Taxes Macro Risks: Financial, Monetary,

Fiscal Instability

firms to invest in knowledge and increase growth, the government may have to subsidize R&D, but it has to find a non-distorting tax to finance the subsidies.

34. Turning now to the cost of finance, the interest rate represents the rental price of capital. If it is high, investors need to find investment projects with even higher rates of return that exceed the rental cost of capital. High interest rates are thus associated with low investments. Meanwhile, high-return projects tend to be risky, thereby raising the probability of defaults and foreclosures. And so public policy must find ways to reduce interest rates.

35. One way to reduce interest rates is to raise savings. Lending rates of financial intermediaries, mainly banks, go down if savings deposits are high and growing rapidly. In addition, promoting competition among banks also tends to keep interest rates down. Liberalizing the entry of foreign banks generally improves the competition in the domestic banking system.

36. It is widely agreed that financial deepening has salutary effects on financial intermediation. With enhanced credit creation, liquidity-constrained workers with the talent to be productive can move from employment to entrepreneurship. Likewise, availability of credit helps people make the occupational shift from less productive activities in agriculture to more productive ones in industry and services. With financial deepening, individual talents and skills, not prior wealth, determine occupational and educational choices. In the long run, this gives rise to higher wages, savings and investments, and ultimately growth.

37. The HRV growth diagnostic, in identifying critical bottlenecks to investment, productivity, and growth, leads to thinking about how to ease them. A developing country like Lao PDR that to begin with faces low levels of practically all forms of capital will find the HRV approach useful in so far as it helps in prioritizing the many policy reforms that have to be undertaken in several fronts. It must be understood, however, that HRV emphasize current constraints, not those that still have to emerge in the future.

38. The emerging Seventh Plan of Lao PDR targets a growth rate in real GDP of at least eight percent each year to enable it to graduate from being a least developed economy and join the ranks of middle-income economies in Southeast Asia. To achieve this goal, Lao PDR must sustain, if not accelerate, the growth it experienced in the past few years. Hence, Lao PDR has to pay attention to long-run sources of growth like raising investments in human and technological capital

39. At the same time, as growth proceeds, Lao PDR must significantly reduce poverty. Growth with declining poverty does not happen automatically. In fact, some countries have fallen into poverty traps, a situation whereby poverty in large numbers persists even with growth.13 It may occur, for instance, if workers leaving agriculture fail to access training or re-training that equips them with the skills and discipline that non-agriculture requires. Furthermore, if industry and services are unable to access modern production techniques, then high-skill jobs are foregone.

40. Evidently, to avoid growth with increasing inequality and poverty traps, an inclusive-growth strategy is relevant for Lao PDR.

1.1.3. Poverty and Inequality Diagnostic Framework

41. While the growth diagnostics framework was developed to identify the binding constraints to growth and associated policy priorities, the approach can also be applied to other areas of policy analysis, such as identifying critical constraints to inclusiveness of                                                         13 WB (2006a) and ADB (2007a) offer a look at the enormity of this challenge.

growth.14 Inclusive growth not only addresses the inequality issue, but it also enhances the agenda of poverty reduction (Figure 1.3).

Figure 1.3: Poverty and Inequality Diagnostic Framework

Source: Indonesia Critical Development Constraints 42. The limited reduction in poverty and persistent inequality can be caused by the lack of economic opportunities due to poor growth, unequal access to opportunities, and/or the absence of effective and adequate social safety nets.

43. Within the inclusive growth conceptual framework presented in Figure 1.1, the availability of productive employment opportunities is key to a household’s ability to improve its livelihood. However, even if the economy succeeds in creating productive and decent employment, this would not automatically lead to poverty reduction unless there is equal access to the opportunities. 44. Inequitable access to economic opportunities can be attributable to weak human capabilities and/or an uneven playing field, both of which can prevent people from participating in and contributing to the growth process on an equal basis. Certain groups of people may have weaker human capabilities than others, partly due to unequal access to education, health, and/or other social services, including clean water and sanitation systems. Inequity in accessing opportunities may also be caused by unequal access to infrastructure and productive assets, such as land and credit. For example, a in land-locked country like Lao PDR, infrastructure plays a key role in promoting inclusiveness.

45. Promoting equal access to opportunities also requires the government to provide social safety nets to mitigate the effects of external and transitory livelihood shocks as well as to meet the minimum needs of the chronically poor. The importance of social safety nets cannot be overemphasized in countries like Lao PDR which relatively has the highest poverty incidence rate in the region and a large percentage of the population is clustered around the poverty line, indicating their vulnerability to unforeseen crisis. The inadequate provision of social safety nets can thus be a constraint to reducing poverty and inequality.

                                                        14 ADB. 2010. Indonesia Critical Development Constraints

 

 

Lack of productive employment opportunities

due to low economic growth

Low levels of private investment and entrepreneurship (follow the Growth Diagnostic Framework)

Weak human capabilities• unequal access to education• unequal access to health• unequal access to other social services

Uneven playing field

• unequal access to infrastructure and productive assets (credit, land)

Inadequate public service delivery• Limited resources• Poor targeting• Poor governance

Exclusion • Geographical exclusion• Economic exclusion• Social exclusion

Market failures

Slow Rate of Poverty Reductionand High Inequality

Unequal access toopportunities

Inadequate socialsafety nets

46. The Poverty and Inequality Diagnostic framework also suggests that each of the above issues (weak human capabilities, uneven playing field, and inadequate social safety nets) can, in turn, be due to a number of factors, including market failures, government failures to deliver adequate public services, and/or social exclusion. The key role of the government in promoting inclusiveness is to address these market, institutional, and policy failures.

1.2. Organization of the Study

47. The study is organized as follows: After the introduction and overview in Chapter 1, Chapter 2 reviews some facts bearing on economic and social trends in the Lao PDR. The recent aggregate and sector outcomes and performances of the economy are documented, along with the extent of poverty incidence and degree of inequality of the country’s income distribution. These observed socio-economic outcomes are indicative of whether or not inclusive growth is being served. These outcomes have emerged largely in an economy that is transiting from central planning to a market-oriented economy; the extent to which the economic policy reform process has contributed to these outcomes is looked into. The chapter first reviews the policy adjustments and related reforms pursuant to the decision to adopt market-oriented reforms. In addition, the economic and social outcomes are placed in a comparative setting, using some low to high middle-income countries in Southeast Asia as benchmarks; this can help assess which targets geared to inclusive growth are feasible, and whether the envisioned transformation is taking place or not.

48. Chapter 3 elaborates on the growth diagnostics and discusses the constraints to growth following the HRV framework: social returns to investment, private appropriability, and the cost of finance.

49. The HRV is an approach that is appropriate for the short run. However, since Lao PDR is committed to the goal of inclusive growth, which has long-run dimensions, the HRV approach is extended using the AZ inclusive-growth framework. Following the HRV approach, Chapter 4 focuses on the most important factors constraining inclusive growth in Lao PDR. It is focused on access to economic opportunities, such as, education and training which are vital to achieving full, productive and decent employment.15 Meanwhile, in view of unavoidable labor-market imperfections and unwanted business fluctuations, the government seeks the establishment of a social protection system that permits people who are temporarily displaced by economic vicissitudes to bounce back. In the workplace, inclusive growth is concerned not with mere counting of jobs generated, but with the creation of high-wage and high-skill jobs.

50. Chapter 5, the concluding section, summarizes the findings on most critical constraints to growth in Lao PDR and analyzes potential drivers of growth in Lao PDR, which would bring the analysis from an aggregate to sector and subsector levels. The need to accelerate investments in industry and services to facilitate the absorption of workers released from agriculture in the course of rising productivity therein underscores the importance of identifying potential drivers of growth. Growth drivers must be able to enhance economic integration, with strong inter-industry linkages.

                                                        15 This theme is emphasized in Key Indicators of Developing Asian and Pacific Countries (ADB 2009).

Chapter 2. Socio-Economic Performance 51. This section discusses Lao PDR’s aggregate economic performance and some aspects of social development in recent years. The point of departure is a brief review of the policy reforms associated with the shift towards market orientation and away from central planning that got underway in 1986. 2.1. Towards a Market-Oriented Economy 52. Following the end of the “Thirty Years’ Struggle” that started in 1945 and culminated in the establishment of the Lao PDR in 1975, the urge for economic and social development emerged and was pursued in earnest by the government under a socialist framework anchored on central planning. Under the latter, however, the socio-economic outcomes had proved inadequate relative to society’s needs. Actual GDP growth generally fell below the government’s target and high inflation rates buffeted the economy.

53. And so in 1986, in the aftermath of the Fourth Party Congress, the government introduced a variety of economic policy reforms based on reliance on the ability of markets guided by decentralized prices to coordinate a host of interrelated business and economic activities. This has been popularly referred to as the New Economic Mechanism or NEM.16 54. The market-oriented framework recognized private property rights, although land ownership stayed with the State and special provisions covered land use. Privatization of state enterprises was started. Collectivization in agriculture was abandoned in favor of small farms. Foreign investments began to be liberalized, paving the way for greater private participation. 55. A wide-ranging policy reform program sought to get prices right in a number of markets. For example, in the commodity market, many of the price controls in place were lifted except for eight “strategic” commodities. In the credit market, ceilings on borrowing and lending rates were removed. The exchange rate regime also shifted gradually from fixed to flexible. In addition, in the late 1980s, the government adopted a macroeconomic stabilization program under the auspices of the International Monetary Fund (IMF) and the World Bank mainly to combat inflation and strengthen the fiscal position of the government. 56. The reforms and the incentives they embodied created opportunities conducive to private sector-led growth. Since the Second Five-Year Plan (SFYP), the succeeding development plans of the government, have hewed to a market-oriented framework. The government at this juncture is preparing the Seventh National Socio Economic Development Plan (NSEDP).

57. In the current draft of the Plan, the government targets real GDP to grow eight percent each year, which policymakers see as vital to Lao PDR graduating from a low-income country. Assessing the feasibility of this growth target is one of the objectives of this study. On the face of it, based on recent growth performance of the economy, the target does not look far-fetched; but a closer look suggests the imperative of overcoming critical constraints that hindered past growth.

                                                        16 For a historical account of Lao’s transition to a market-oriented economy see Richard Vokes and Armand

Fabella (1996), from which this section draws a great deal.

2.2. Growth Performance 2.2.1. Overview 58. Prior to 1988, production data used the Materials Product System under the socialist system; after 1998, the government started to use the United Nations System of National Accounts. In 1987-1988, real GDP declined on account of a drought that caused agricultural output to shrink. The recovery started in 1989, which then stabilized, and has been sustained since then. Over the period 1990-2008, real GDP grew at an average of 6.5 percent each year. It showed its resilience when in 2009, in the aftermath of the global financial crisis, the economy grew at about 7 percent (see Figure 2.1). ADB (2010h) forecasts that Lao PDR is expected to grow by about 7.4% in 2010 and 7.5% in 2011.

Figure 2.1. Lao PDR Annual GDP Growth (%)

Source: World Development Indicators, Accessed October 2010.  59. To gain insights about living standards of the population, it is useful to look at per capita income. Column 1 of Table 2.1 shows Lao PDR’s per capita GNP obtained from various issues of the Asian Development Outlook published by the ADB over the period 1990-2008. Column 2 shows per capita GDP adjusted using purchasing power parity (PPP) of the Kip to the US dollar over the same period; these are obtained from the World Development Indicators of the World Bank (WB).

-3

0

3

6

9

12

15

Table 2.1. Lao PDR Per Capita GNP and GDP (in US$) Year Per Capita GNP*

(1) Per Capita GDP (PPP)**

(2) 1990 170 664.74 1991 230 697.90 1992 250 733.40 1993 290 773.631994 320 832.26 1995 350 885.84 1996 400 941.11 1997 400 997.58 1998 330 1,024.06 1999 280 1,090.21 2000 290 1,154.552001 310 1,227.51 2002 310 1,300.54 2003 320 1,386.93 2004 390 1,517.12 2005 440 1,651.30 2006 500 1,818.16 2007 580 1,976.76 2008 740 2,125.66

Sources: * ADB, Asian Development Outlook (various years) **WB, World Development Indicators, accessed November 2010

60. Between 1990 and 2008, the per capita GNP of Lao PDR more than quadrupled from US$ 170 to US$ 740, for an average growth of slightly more than 18 percent each year. Meanwhile, the PPP-adjusted per capita GDP increased from US$ 664.74 in 1990 to US$ 2,125.66 in 2008, for an average annual growth rate of 12 percent. 61. At growth rates between 12 and 18 percent each year, per capita output can be expected to double in 4 to 6 years. If such growth rates can be sustained, then Lao PDR can move up to a low middle-income country, the bracket that Indonesia and the Philippines find themselves in at this stage of their development. 62. However, much of the growth in output over the period 1990-2008 can be traced to an increase in the factors of production. As each Lao PDR worker got equipped with capital, growth in per capita output accelerated. Given diminishing marginal productivity in each of the inputs, the growth may slow down, unless there is a marked increase in total factor productivity (TFP), which generally stems from improvements in knowledge or technological progress. 17

                                                        17 The importance of TFP to long-run growth, long recognized in sources-of-growth accounting, has been

emphasized recently in ADB (2010). The latter points out that to accelerate output growth in many DMCs, gains in TFP are crucial.

2.2.2. Accounting for Sources of Growth 63. Growth from the Production Sectors. Due to the mountainous terrain and the large tracts of land that remain contaminated by unexploded ordnance, only 4% of the land area is considered arable. Moreover, agricultural production is vulnerable to natural calamities, and Lao PDR is no exception to periodic droughts and floods.

64. Despite this, viewed from the production sectors, a good portion of the GDP growth rate in the late 1980s stemmed from agriculture, with an output that still accounted for 61.2 percent of GDP in 1990 (see Table 2.2, column 1).

Table 2.2. Lao PDR Sector Shares to GDP (in %)

Year Agriculture (1)

Industry (2)

Services (3)

1990 61.23 14.51 24.26 1991 58.23 16.82 24.95 1992 61.81 17.76 20.43 1993 57.54 17.74 24.72 1994 57.58 18.14 24.28 1995 55.68 19.24 25.08 1996 53.35 21.15 25.60 1997 52.80 21.05 26.15 1998 53.30 22.50 24.20 1999 53.71 22.63 23.65 2000 52.55 22.90 24.57 2001 51.25 23.70 25.06 2002 50.35 24.65 24.99 2003 48.24 26.44 25.32 2004 46.71 27.55 25.74 2005 36.32 24.28 39.40 2006 34.71 28.20 37.09 2007 35.52 27.16 37.33 2008 34.73 28.16 37.11

Source: WB, World Development Indicators, accessed October 2010.

65. A decade later, agriculture’s share to GDP fell to 52.5 percent as agriculture modernized and started shifting away from subsistence. By 2008, this share had reclined further to 34.7 percent. This type of industrial transformation in the course of development is an empirical regularity. In many economies, rising agricultural productivity increases incomes and savings of households in rural agricultural areas. At the same time, fewer workers are needed to produce the output from agriculture. Investments in non-agriculture then grow at a rapid pace to absorb the surplus workers from agriculture. By 2005, the share of services had taken the lead (see Figure 2.2).

Figure 2.2. Sector Shares in GDP (%)

Source: World Development Indicators, Accessed October 2010

66. Early on, the growth in agriculture stemmed from expansion of land and labor; this was followed by increasing use of fertilizer and irrigation in the Mekong Corridor, which helped raise yield per hectare. Rice, maize and cassava have been the main crops, but in recent years, cash crops like rubber have been gaining importance. 67. The ongoing decline in the share of agriculture, evident over the period 1990-2008, is to be expected. It must be noted that the geographic nature of Lao PDR does not leave much space for expanding hectarage devoted to agriculture. Lao PDR is land locked and has a mountainous terrain that renders only an estimated eight percent or about 1.8 million hectares of its total land area arable (see Vokes and Fabella 1996). Thus rapid capital accumulation in industry and services must continue to spearhead the creation of high-wage jobs.

68. At this point, the share of agriculture to total output is still large in absolute terms. According to the Socio-Economic Atlas of the Lao PDR, which is based on the 2005 Census of Population and Housing, about 67 percent of households still operate agricultural lands. Meanwhile, approximately 78 percent of the employed are in agriculture. These figures, a relatively low share of agricultural output to GDP and a large share of agricultural employment, suggest that labor productivity in agriculture still has plenty of room for improvement. The relatively low state of productivity in agriculture at this point has likewise been noted in (ADB, 2010c). 69. Columns 2 and 3 of Table 2.2 above show the changes in the sector shares of industry and services. The share of industry output to GDP in 1990 was 14.5 percent. By 2008, this share had grown to 28.2, led by manufacturing, and electricity, gas and water. The share of the manufacturing sub-sector in GDP likewise grew moderately from no more than 10% of GDP in 1989 to 20% of GDP in 2004, dominated by small enterprises. However, in 2005, the contribution of the manufacturing sub-sector to GDP reverted to its 1989 levels and has remained relatively stable below 10% of GDP up to 2008 (Figure 2.3).18

                                                        18 World Bank. World Development Indicators. Accessed November 2010.

0

10

20

30

40

50

60

70

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Agriculture, value added (% of GDP)Industry, value added (% of GDP)Services, etc., value added (% of GDP)

Figure 2.3. Lao PDR Manufacturing Value Added (% of GDP)

Source: World Development Indicators, accessed November 2010.

70. Meanwhile, the share of the service trades increased from 24.26 percent in 1990 to 37.1 percent in 2008. Trade, transport and communications led the service sector. A reallocation of resources from low-productivity pursuits in agriculture to high-productivity activities in non-agriculture is bound to boost output growth. 71. Following the liberalization of foreign direct investment, industry grew fast, led by hydropower and mining. Meanwhile, as domestic production and trade with the neighboring countries of Thailand, Vietnam, and China increased, catch-up investments in infrastructure, particularly in roads and transport, propelled the growth of construction. At the same time, the service trades like retail and wholesale trade, along with transport and communications, also witnessed an increase in their growth rates. 72. Aggregate-Demand Sources of Growth. The shares to GDP of the various components of aggregate demand are shown in Table 2.3. Consumption has been the most dominant component of GDP with its share ranging from 88 to 94 percent during the period 1984-1988. In 2008, consumption accounts for 63.2 percent of GDP; investment, 36.9 percent; government spending, 7.6 percent, and net exports, -12.03 percent. 73. Investments here include both domestic and foreign, broken down as follows: more than half is foreign and 45 percent is domestic. To finance domestic investment, domestic savings contribute 40 percent, while 60 percent come from official development assistance. Investment is the component of aggregate demand that matters most for growth in Lao PDR, given its state of development. Since 2001, the share of aggregate investment has picked up; the share of domestic investment must do likewise. Net exports have been perennially in deficit, ranging from about minus 18 percent to minus 3 percent. Given its small domestic market, Lao PDR must tap market foreign markets as new growth areas. In this connection, Lao PDR must invest in roads and transport system, whether land or air, to be able to expand trade with neighboring countries and others in the rest of the world. It must tap specialized intermediate products that emanate from R&D to increase the variety and quality of its manufactured exports. This may mean hosting foreign investors engaged in the manufacture of specialized components and parts for export to outsourcing firms in the developed economies.

0

5

10

15

20

25

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Table 2.3. Share of Expenditure Components in GDP (%) Consumption Government Investment Net exports

1980 90.24 8.03 7.43 -5.70 1981 89.95 8.13 7.35 -5.43 1982 89.87 8.16 7.82 -5.85 1983 90.54 8.61 8.77 -7.92 1984 90.89 6.50 6.18 -3.58 1985 89.95 8.73 7.04 -5.73 1986 88.51 8.65 6.93 -4.09 1987 89.44 8.30 10.19 -7.93 1988 93.91 10.86 13.50 -18.27 1989 98.80 10.07 10.99 -19.87 1990 92.32 9.54 11.33 -13.19 1991 91.08 9.74 11.45 -12.27 1992 89.94 9.36 10.78 -10.08 1993 89.37 9.37 10.97 -9.71 1994 93.51 9.85 11.48 -14.84 1995 93.04 9.74 11.33 -14.11 1996 96.43 10.12 11.81 -18.36 1997 95.63 10.04 11.70 -17.37 1998 90.75 9.52 11.09 -11.36 1999 88.25 9.26 10.80 -8.31 2000 75.52 7.92 20.88 -4.32 2001 70.39 7.39 27.14 -4.92 2002 71.48 7.50 26.52 -5.49 2003 70.18 7.36 28.03 -5.58 2004 68.68 7.21 31.87 -7.75 2005 64.41 6.76 32.58 -3.74 2006 66.80 7.01 32.50 -6.31 2007 62.22 6.71 39.65 -12.07 2008 63.23 7.57 36.85 -12.03

Source: UN Data, Accessed November 2010. 74. A Comparative View of Lao PDR’s Growth. Table 2.4 shows the per capita income of Lao PDR in comparison with neighbor countries in the Greater Mekong Subregion (GMS).

Table 2.4. Comparative Per Capita GNP and GDP (in US$) Year Lao PDR Cambodia Viet Nam Myanmar Thailand

GNP per

Capita

GDP Per

Capita

GNP per

Capita

GDP Per

Capita

GNP per

Capita

GDP Per

Capita

GNP per

Capita

GDP Per

Capita

GNP per

Capita

GDP Per

Capita

1990 170 664.74 - - 200 651.60 200 - 1,420 2,860.30 1991 230 697.90 200 - 220 700.04 500 - 1,580 3,172.55 1992 250 733.40 - - 220 763.01 893 - 1,840 3,465.06 1993 290 773.63 - 568.98 170 826.43 220 - 2,040 3,786.46 1994 320 832.26 - 614.48 215 901.25 235 2,210 4,166.58 1995 350 885.84 - 648.76 240 989.75 - - 2,740 4,601.35 1996 400 941.11 300 678.72 290 1,083.30 - - 2,960 4,926.70 1997 400 997.58 300 711.90 320 1,174.05 - 2,800 4,912.72 1998 330 1,024.06 280 739.05 330 1,238.38 - - 2,200 4,418.86 1999 280 1,090.21 260 821.70 370 1,299.61 - - 1,960 4,650.86 2000 290 1,154.55 260 895.33 390 1,415.65 - - 2,010 4,935.44 2001 310 1,227.51 270 971.38 410 1,526.91 - - 1,970 5,103.97 2002 310 1,300.54 280 1,035.45 430 1,639.87 - - 1,980 5,399.01 2003 320 1,386.93 310 1,129.35 480 1,772.08 - - 2,190 5,836.96 2004 390 1,517.12 320 1,261.29 550 1,937.22 - - 2,540 6,309.31 2005 440 1,651.30 380 1,452.71 620 2,142.74 - - 2,750 6,750.94 2006 500 1,818.16 480 1,634.90 690 2,365.16 - - 2,990 7,267.40 2008 740 2,125.66 600 1,966.18 890 2,812.81 - - 2,840 8,150.13

Source: GNP Per Capita data from ADB, Asian Development Outlook (various years). GDP per capita data in current US$ PPP from WB, World Development Indicators, November 2010. 75. Using 2008 figures, Lao PDR is ahead of Cambodia in terms of the level of the unadjusted per capita GDP. It, however, trails Vietnam. Lao PDR seeks to graduate from its status as least developed economy. It terms of what’s possible, Thailand may serve as a possible model, which in 2008 had a per capita GDP of US$ 2,840. Since the 1970s, Thailand has endeavored to transform its largely agricultural economy into a newly industrializing one. In this regard, it has been making steady progress. In the long run, Lao PDR may look to Taiwan and South Korea as models of successful industrialization; both were also predominantly agrarian economies when they embarked on an industrialization drive in the 1960s. By the 1980s, these two economies, along with Hong Kong and Singapore, had become exporters of manufactured goods on a global scale.19 76. It must, however, be understood that several factors underpin cross-country per capita income differences. Aside from increasing the factors of production, government and private spending to raise human, infrastructure, and technological capital is vital. Success in catching up with middle-income economies in the region hinges on how effective Lao PDR is in raising productivity. 2.3. Indicators of Social Development 77. This section looks at poverty and income inequality in Lao PDR to gain further insights into the living standards of Laotian citizens, and start thinking about how to help the poor out of their predicament. The poverty figures are a reminder that quite a number of Laotians are still mired in misery, unable to catch up and partake of the benefits from growth. Some are employed at low wages: they work but are poor. It must be noted that pro-poor policies are also pro-growth policies. Within, for instance, the basic Solow growth model, the

                                                        19 Lawrence Lau (1990) gives a rigorous account of the sources of growth of Taiwan and South Korea. Hong

Kong and Singapore, at the beginning of their industrialization drive, had no agricultural sector and were engaged mostly in re-export trade.

poor can potentially add to growth if they can be equipped with employable skills that raise their productivity, real earnings, and savings. Furthermore, rising real income increases the opportunity cost of time, prompting couples to engage in job search and opt for fewer children, which are intensive in parent’s time.20 A smaller family size enables parents to invest children with more human capital, thereby contributing to growth. 2.3.1. Recent Trends in Poverty and Inequality

2.3.1.1. Poverty

78. The proportion of people with consumption below the national poverty line and the international $1.25 per day threshold has gone down over the period 1992-2008. Table 2.5. shows that based on Lao PDR’s national poverty line, the income threshold that will support a recommended food basket with a raising factor for basic non-food items, poverty incidence declined from 46 percent in 1992-1993 to 27.6 percent in 2007-2008, representing a 40-percent decrease. And based on the poverty criterion of US$ 1.25 per day, poverty incidence dropped from 55.7 percent in 1992-1993 to 44 percent in 2002-2003, a 21-percent decline. This is a significant response to economic growth, a trend that going forward must be sustained.

Table 2.5. Poverty Incidence by Population (in %) 1992/93 1997/98 2002/03 2007/08 National Poverty Line 46.0 39.1 33.5 27.6 $1.25/day 55.7 49.3 44.0 ---

---Not available Note: The national poverty line is calculated on a nutritional basis. An adult must be able to consume an equivalent of 2,100 kilocalories a day to be above the poverty line. S/he should have access to some non-food necessities. The monetary equivalent of 2,100 kilocalories is first calculated, and then an allowance of 30% added to this cash amount for non-food items. The sum of these two is the poverty line. Source: Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th National Human Development Report; and World Bank (2010), PovcalNet Database. Accessed on 12-14 October 2010. 79. Listed below, based on various reports from the GOL and the UN (2008), are some of the key factors behind the poverty reduction in Lao PDR:

a. Government programs: During the period 1992-1993 to 2002-2003, poverty incidence, poverty gap, and poverty severity all decreased steadily in the Northern Highlands and Northern Lowlands. The strong and continuous performance in poverty reduction appears closely related to the focus of the GOL on remote upland areas and a shift in public rural investment programs toward rural infrastructure construction, particularly, roads and irrigation infrastructure. It is estimated that during the late 1990s, more than three quarters of expenditures on irrigation were for capital investments. The GOL’s district targeting for priority investments appears to have been effective: Poverty incidence and number of poor in first-priority districts, of which most are located in the Northern Lowlands and Highlands, decreased markedly. Moreover, poverty gap and severity decreased even faster than poverty incidence, indicating that the government programs have also been effective in reaching the poorest segments of the poor.

                                                        20 Gary Becker (1965) has underscored the importance of rising opportunity cost of time in explaining the

demographic transition, a shift from high fertility rates to low.

b. Shared border with China: Poverty reduction has been strong in Lao PDR along the China/Myanmar border, an indication of a good response to economic growth in southern China, especially, demand for agricultural products and growing tourism. The toughest challenge persists in areas bordering Viet Nam, home to a still-large and increasing number of rural poor. Remoteness and inaccessibility on both sides of the border are preventing dynamic movements similar to those observed along the China border.

c. Improved food security: Food poverty declined faster than overall poverty between 1992-1993 and 2002-2003, and the average number of months without sufficient rice in villages dropped between 1997-1998 and 2002-03. The number of poor people in 2005 was lower by about 870,000 due to rising income since 1992-1993. The number of people with food consumption below the food poverty line in 2002-2003 was lower by about 850,000 due to improved food security since 1992-1993 [see also WB (2006); UN (2008)].

80. However, while poverty has declined significantly, the challenge remains. Lao PDR still has the highest incidence of poverty in the Southeast Asian region, with almost half of the population living below $1.35/day and more than three quarters of the population living below $2/day (Table 2.6.)

Table 2.6. Headcount Indexes Based on Four Poverty Lines (in %)

Country Survey Year

Headcount Index $1/day $1.25/day $1.35/day $2/day

Cambodia 2004 25.5 40.2 44.2 67.5Indonesia 2005 9.6 21.3 25.2 52.5Lao PDR 2002 26.8 44.0 48.8 76.1Malaysia 2004 0.1 0.5 0.9 7.4Philippines 2006 13.0 22.6 25.4 44.4Thailand 2004 0 0.4 0.9 11.0Viet Nam 2006 11.5 21.4 24.7 47.6

Source: World Bank (2010), PovcalNet Database. Accessed on October 12-14, 2010.

81. About half of the total employed is mired in poverty measured by those consuming less than US$1.25 each day, suggesting a preponderance of employment at low wages in Lao PDR (see Table 2.7). Over a ten year period 1992-2002, the share of the working poor declined, but only from 57 percent to about 46 percent when the poverty income criterion is $1.25 a day. The corresponding figures when the income criterion increases to $2 a day are 86 percent and 81 percent.

Table 2.7. Poverty and Working Poverty (in %)

Year

Share of Population Below

$1.25/day

Share of Population

Below $2/day

Share of Working Poor at $1.25/day in Total Employment

Share of Working Poor at $2/day in Total Employment

1992 55.7 84.3 57.0 86.0 1997 49.3 79.3 51.2 83.4 2002 44.0 76.1 45.7 80.9 Sources: For poverty incidences, World Bank, PovcalNet database; and for the share of the working poor, ILO (2009), Key Indicators of the Labour Market, 6th edition.

82. Measured by the UN’s Human Development Index, Lao PDR has one of the lowest score in the region (Figure 2.4).

Figure 2.4. Human Development Index (2010)

Source: UNDP (2010), Human Development Report 2010: The Real Wealth of Nations - Pathways to

Human Development. 83. At the regional level, rural areas have significantly higher incidence of poverty than urban areas. The Northern region consistently has the highest ratio of the poor followed by the Central region. The Southern region has reduced significantly its poverty incidence over the past decade (Table 2.8.).

Table 2.8. Poverty Incidence by Place of Residence and Region (in %) 1992/93 1997/98 2002/03 2007/08 Lao PDR 46.0 39.1 33.5 27.6 Urban 27.0 22.0 19.7 17.4 Rural 52.0 43.0 37.6 31.7 North 51.6 47.3 37.9 32.5 Center 45.0 39.4 35.4 29.8 South 45.7 39.8 32.6 22.8

Note: See note in Table 2.5. Source: Ministry of Planning and Investment and UNDP (2009) Employment and Livelihoods: The 4th National Human Development Report. 84. According to the UN MDG report, from 1992-93 to 2002-03, agricultural growth averaged nearly 5% per year and was the most important driver of reducing rural poverty.

85. Rural areas consistently have higher poverty incidence than urban areas in all regions, particularly in the North and Central regions. With the exception of urban areas in the Central region, the rest of the country experienced a decline in poverty incidence between 2002-03 and 2007-08 (Figure 2.5.).

0 0.2 0.4 0.6 0.8 1

Cambodia

Lao PDR

Viet Nam

Indonesia

Philippines

Thailand

Malaysia

Singapore

Figure 2.5. Poverty Incidence by Place of Residence and Region (in %)

Source: Department of Statistics, Ministry of Planning and Investment.

86. There are provinces with poverty incidence greater than the national average in 2002-03 and 2007-08, namely, Phongsaly, Oudomxay, and Huaphanh in the Northern region; Xiengkhuang, Khammuane, and Savannakhet in the Central region; and Saravane and Sekong in the Southern region. There are also provinces that experienced a rise in poverty incidence, namely, Luangnamtha, Bokeo, Xiengkhuang, Vientiane, and Sekong during the same period (Figure 2.6.).

Figure 2.6. Poverty Incidence by Province (in %)

Source: Department of Statistics, Ministry of Planning and Investment. 87. As for ethnicity, non-Tai-Kadai ethic groups are significantly worse off, same as those living in the Midlands and Highlands. South-Central Highlands have average per capita expenditure, which is only half the national average and three out of four persons in this region live in poverty (Table 2.9.).

0

10

20

30

40

urban rural urban rural urban rural urban rural

Lao PDR North Center South

2002/03 2007/08

0

10

20

30

40

50

60

Lao

PD

R

Phon

gsal

y

Luan

gnam

tha

Oud

omxa

y

Bok

eo

Luan

gpra

bang

Hua

phan

h

Xay

abur

y

Vie

ntia

ne C

apita

l

Xie

ngkh

uang

Vie

ntia

ne

Bor

ikha

mxa

y

Kha

mm

uane

Sav

anna

khet

Sar

avan

e

Sek

ong

Cha

mpa

sack

Atta

peu

North Center South

2002/03 2007/08

Table 2.9. Poverty Incidence and Average Per Capita Expenditure (2002/03)

Poverty Incidence

Share in Total Population

(%)

Ave. per capita expenditure (Kip/month)

Lao PDR 0.34 100.00 140,721

Place of Residence

Urban 0.20 26.14 208,641 Rural 0.38 73.86 116,581

Ethnicity

Tai-Kadai 0.26 61.06 160,924 Mon-Khmer 0.51 23.31 101,797 Tibeto-Burman & Hmong-Mien 0.44 11.41 114,833 Others 0.40 4.22 132,177

Agro-ecological region

Vientiane Plain 0.16 15.17 211,983 Mekong Corridor 0.33 34.07 132,691 Northern Lowlands 0.28 20.45 135,333 Northern Midlands 0.46 12.57 120,295 Northern Highlands 0.42 9.79 121,274 South-Central Lowlands 0.60 4.69 90,830 South-Central Midlands 0.65 0.52 78,277 South-Central Highlands 0.75 0.43 70,296 Boloven Plateau 0.15 2.30 158,339

Note: In 2003 one US$ corresponded in average to about 7900 Kip. See note in Table 2.5 on how the national poverty line is calculated on a nutritional basis. Source: Epprecht et al. (2008), The Geography of Poverty and Inequality in the Lao PDR.

2.3.1.2. Inequality

88. Income distribution in Lao PDR is one of the most equitable ones in the Southeast Asian region, whether measured by the Gini Coefficient or the ratio of the income of the richest quintile to the poorest quintile (see Figures 2.7. and 2.8.). However, the likelihood that income distribution would worsen is always present as hypothesized by Kuznets (1955). In line with the findings of Persson and Tabellini (2006), inequality harms growth through the choice of public policies (e.g., taxation and government regulation) that prevent workers and investors from being able to appropriate a good deal of the returns from their efforts. In this connection, Lao PDR should pay close attention to the principles of inclusive growth.

Figure 2.7. Gini Coefficient (%)

Note: Data for Cambodia are for 1994 and 2007; Indonesia for 1993 and 2007; Lao PDR for 1997 and 2002; Malaysia for 1995 and 2004; the Philippines for 1994 and 2006; Singapore for 1998; Thailand for 1996 and 2004; and Viet Nam for 1993 and 2006. Source: ADB (2010), Key Indicators for Asia and the Pacific 2010.

Figure 2.8. Income Ratio of Highest 20% to Lowest 20%

Note: Data for Cambodia are for 1994 and 2007; Indonesia for 1993 and 2007; Lao PDR for 1997 and 2002; Malaysia for 1995 and 2004; the Philippines for 1994 and 2006; Singapore for 1998; Thailand for 1996 and 2004; and Viet Nam for 1993 and 2006. Source: ADB (2010), Key Indicators for Asia and the Pacific 2010.

89. While income distribution at the national level is not as much of a concern yet as in other countries, an examination of income distribution at the sub-national level by different categories shows more pronounced income disparity within groups, such as, urban dwellers, ethnic minorities, and residents of the Northern Highlands (see Figure 2.9.).

0

5

10

15

20

25

30

35

40

45

50

Cambodia Philippines Singapore Thailand Malaysia Viet Nam Indonesia Lao PDR

1990s 2000s

0

2

4

6

8

10

12

14

Cambodia Malaysia Viet Nam Indonesia Lao PDR

1990s 2000s

Figure 2.9. Gini Coefficient by Difference Categories (2002/03)

Source: Epprecht M., Minot N., Dewina R., Messerli P., and Heinimann A. (2008), The Geography of Poverty and Inequality in the Lao PDR.

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

Lao

PDR

Urb

an

Rur

al

Tai-K

adai

Mon

-Khm

er

Tibe

to-B

urm

an &

Hm

ong-

Mie

n

Oth

ers

Vie

ntia

nce

Plai

n

Mek

ong

Cor

ridor

Nor

ther

n Lo

wla

nds

Nor

ther

n M

idla

nds

Nor

ther

n H

ighl

ands

Sou

th-C

entra

l Low

land

s

Sou

th-C

entra

l Mid

land

s

Sou

th-C

entra

l Hig

hlan

ds

Bolo

ven

Pla

teau

Residence Ethnicity Agro-ecological region

Chapter 3. Critical Constraints to Growth 90. This section starts with applying the growth diagnostic approach proposed by HRV to determine the most critical constraints to economic growth in the short run. The aim is to identify current constraints the easing of which can trigger immediately additional economic growth. The number of short-run critical constraints is not that many. However, in line with the vision of the GOL to graduate from being a least developed economy, which is enunciated in the emerging Seventh Five–Year Plan, together with GOL’s commitment to inclusive growth, sustaining a high growth rate in the long run is an imperative.

91. In HRV (2006), the proponents assert their approach is better than the wide-ranging reform process embodied in what they refer to as the “Washington Consensus.” According to HRV, “countries need to figure out the one or two most binding constraints on their economies and then focus on lifting those.” It is, however, important to note HRV’s cautionary remarks that “we are concerned mainly with short-run constraints.” Furthermore, HRV emphasize that “our focus is on igniting growth and identifying constraints that inevitably emerge as an economy expands, not on anticipating tomorrow’s constraints on growth.” Given, however, the economic challenges confronting the Lao PDR at this point, the need to extend the HRV method along the principles of inclusive growth is indicated. 92. In the context of the Lao PDR growth experience, the main issue is not to trigger growth, since Lao PDR, as noted in Chapter 2, has been experiencing strong economic growth over the past decade, including in the aftermath of the global financial crisis of 2008. The challenge is to sustain, if not to accelerate, growth and ensuring the inclusiveness of that growth. The HRV method, which calls for concentrating attention on one or two most critical constraints in the short run, is extended using the AZ framework to be able to account for the long-run nature of some constraints to inclusive growth; but just like the HRV approach, only the most critical constraints are examined. 93. Starting from a very low initial level of capital per worker in Lao PDR, increases in capital per worker have since the 1990s permitted vigorous per capita output growth in that economy. As more Laotian workers got equipped with physical capital, made possible by inflows of foreign direct investments and official development assistance (ODA) under market-oriented policies, growth was triggered. The rapid growth, however, may not be sustained; it is at risk of slowing down unless diminishing marginal productivity of capital can be overcome. One proven way to do this is to make sure that investments embodying new knowledge and technologies grow at a sufficiently rapid pace.

94. Consistent with the HRV method, the level and growth of investment is a good starting point. First of all, investment raises productive capacity. In addition, as Arrow (1962) and Romer (1986) have stressed, whenever firms invest, they raise the level of knowledge and technology, not only in their own firms. Insofar as such knowledge spills over to other firms at nearly no cost, the index of technology rises in the entire economy, thereby overcoming diminishing rates of return.

95. At the most rudimentary level, the decision to invest hinges on whether the internal rate of return from a particular investment exceeds the rental price of capital, which is the additional cost of every unit of additional financing. A good proxy for the latter is banks’ lending rate. If the lending rate is high, investment is dampened. Somneuk Davading (2009) reported that the annual lending rate adjusted for inflation in Lao PDR averaged 16.4 percent in 2008, based on financial statistics from the IMF (2008). Prior growth was accompanied by a high aggregate investment-GDP ratio, but domestic private investment was low. Many local micro, small and medium enterprises were not able to access bank

credit. Workers who wanted to shift from low-productivity employment to, say, entrepreneurship with high expected returns could not do so, resulting in low productivity.

96. In the growth diagnostic done for the Lao PDR economy, Davading points out that low level of physical capital accumulation has effectively constrained growth therein. World Bank estimates (reported in Table 1 of Davading) show that over the period 2000-2008, gross capital formation (or investment inclusive of depreciation) averaged 22.9 percent of GDP each year. A positive note in this regard is that except for a slight decline in 2006, Lao PDR’s aggregate investment rate as a percentage of GDP has been increasing during the period 2002-2008. In 2008, the level of investment for Lao PDR was reported at 37.13%, which is one of the highest in the region, next to Viet Nam’s with 41.12% of GDP (Figure 3.1). A cautionary note, though, is that a sizable part of aggregate investment is foreign and has gone to heavy, resource-based industries like mining and hydropower.

Figure 3.1. Investment Rate/Gross Capital Formation (% of GDP)

Source: WB, World Development Indicators, Accessed January 2011.

97. It is reasonable to ask why against the backdrop of a relatively high ratio of investment to GDP, the growth rate of GDP has not grown faster than actual. One possible reason is the low growth rate of investments (Figure 3.2). Investment levels may be historically high, but incremental investments show unevenness and volatility. Although Lao PDR’s total investment grew by more than 38.7% in 2007, the growth dropped to only 4.77% the following year. This may be traced to the concentration of investment in heavy resource-based industries, which tend to be lumpy and with high installation and adjustment costs; subsequent investments then come in relatively small quantities. To trigger new growth areas, domestic investments need to accelerate.

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Cambodia Indonesia Lao PDR Malaysia Myanmar

Philippines Singapore Thailand Vietnam

Figure 3.2. Growth Rate of Total Investments (%)

Source: WB, World Development Indicators, Accessed January 2011.

98. Following the problem-tree analysis of HRV, we start by dissecting the cost of finance in Lao PDR. 3.1. Cost of Finance 99. Lao PDR’s level of aggregate domestic savings is low relative to investment demand compared with the more developed countries in the region and higher than the rest of its regional peers, propping up high lending rates. A low level of domestic savings, in the presence of high investment demand, could push up the interest rate, depending on the magnitude of the savings-investment gap. Lao PDR’s gross domestic savings (as a percentage of GDP) was one of the lowest in the region during the period 1984-1988. Since it adopted the NEM, however, Lao PDR’s gross domestic savings has increased (2000-2008), except for a slight decline in 2004 (Figure 3.3). As of 2008, Lao PDR’s gross domestic savings was reported at 25.47%. This is slightly higher than that of Viet Nam (24.5%), and the Philippines (13.9%).

Figure 3.3. Gross Domestic Savings (% of GDP)

Source: WB, World Development Indicators, Accessed January 2011.

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100. Low domestic savings may constrain growth only if they fall sufficiently short of investment requirements in the economy. In Lao PDR, investment rates have been historically higher than domestic savings (Figure 3.4). In 2008, Lao PDR’s gross domestic capital formation was reported at 37.13% of GDP while gross domestic savings was at 25.48 %. This can mean that the low savings rate impeded Lao PDR investment and economic growth.

Figure 3.4. Domestic Savings and Investment Rate (% of GDP)

Source: WB, World Development Indicators, Accessed January 2011.

101. The domestic savings rate above does not capture the remittance inflows from abroad. Lao PDR’s remittance inflows amounted to as much as US$ 40-50 million in 1996-1998. This level of remittances however went down abruptly at less than US$ 1 million after the 2008 global financial crisis and has not yet recovered since then (Figure 3.5).

Figure 3.5. Remittance flows (US$ million)

Source: WB, World Bank Remittance Data. Accessed January 201121

                                                        21 Available online at http://go.worldbank.org/QOWEWD6TA0

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102. The savings-investment gap was closed through foreign direct investment, which as a ratio to GDP accounted for an annual average of 9 percent, and official development assistance of 14.2 percent each year.

103. In 2000-2008, based on official sources in the Lao PDR government, annual gross domestic investment was just 13.9 percent of GDP, on the average. Public investment constituted 70.8 percent of GDP each year, while annual private domestic investment accounted for an average of 29.2 percent of GDP. About 80.6 percent of bank credit was the source of financing for domestic investment, with credits to the private sector amounting to 54.4 percent of GDP each year, and credits to state-owned enterprises absorbing 26.2 percent of GDP.

104. It is clear that the domestic investment-GDP ratio is low at this point. Given the uncertainty and volatility of foreign direct investment, a high aggregate investment-to-GDP ratio will not be sustained, unless private domestic investment steps up. It is thus important to understand the role that local financial factors and institutions play in keeping interest rates high, a situation that results in low domestic investment and low productivity. If a high interest-rate regime persists, then disincentives to domestic investment will be maintained. This has adverse consequences in the long run, especially if investment creates knowledge that spills over to all firms in several industries; technological progress is bound to stagnate with a slowing down of investment. Financial-market reforms that permit savings to be transformed into economically efficient investments are thus essential.

105. Financial-market constraints. Lao PDR’s prior growth history is associated with a limited domestic financial market. Commercial banks at the national level, private and state-owned, dominate this market. State-owned commercial banks hold more than 70 percent of total deposits of the banking system. Financial intermediation tends to be narrow and largely state-directed. Big firms and state-owned enterprises obtain a large proportion of bank credit, while the small firms are rationed out.

106. There are village-level lending institutions, including production credit groups and informal lenders, including pawnshops. There are also non-deposit taking non-bank institutions

107. Many workers, particularly those engaged in subsistence agriculture, may want to shift to entrepreneurship. In the absence of credit to finance this occupational shift, workers have to accumulate wealth first before they can do so. Similarly, those who have businesses already and want to expand need to accumulate wealth, too, in the absence of credit to realize their business plans. The poor that have no access to wealth are at a disadvantage, thereby raising the likelihood of an inter-generational transmission of poverty and inequality.

108. The importance of paying attention to the financing called for by expected occupational shifts and labor mobility may be gleaned by looking at some of the facts below taken from the Socio-Economic Atlas of Lao PDR, which are based on the 2005 Population and Housing Census:

109. About 67 percent of the population aged 10 years and over is considered economically active, which is either employed (98.6 percent) or unemployed (1.4 percent). The employed include self-employed or own-account workers, as well as unpaid family workers. Only about 11.5 percent of the economically active population is formally employed in the government, state-owned enterprises, and private sector. The self-employed generally need financing to expand existing businesses, or to shift from one activity to another, particularly in agriculture.

110. Some 67 percent of all households operate agricultural lands as if they own the land. The government, however, has not given out titles to the land. The farm households are landless and have to pay rent, either in cash or in kind. Without land titles, they have no asset to use as collateral for a bank credit. Absence of property rights means uncertainty, which may induce some farm households to migrate to the city to improve income and employment. Vientiane is a favored destination, being the center of better-paying jobs, and quality education, training, and health-care facilities. Migration and household occupational decisions are not costless. Without credit, only the wealthy are able to finance and carry out these decisions, thereby perpetuating poverty and inequality.

111. If high interest rates persist, even those who have managed to shift occupations or expand existing businesses may have to take on high-risk business activities. To overcome high interest rates, they have to look for high-risk and high-return projects. In the absence of an equity market, an institution for allocating risk bearing, they have to take on more risk than warranted, with commensurate increase in the probability of a business failure. A stock market was inaugurated on January 2011 with a few listed firms, which is definitely a step in the right direction. It diversifies risk by making dividend income contingent on the firm’s bottom-line performance. 112. The efficiency of Lao PDR’s domestic financial intermediation is the lowest in the region and may be a critical constraint. Inefficient financial intermediation can increase the cost of financing for investors. As noted earlier, a good starting point for assessing the competitiveness and efficiency of the banking sector is to measure the size of the spread between the lending and deposit rates. A competitive and efficient banking sector generally shows lower interest rate spreads than that of an inefficient one. 113. A comparison with other Asian countries indicates that the spread between lending and deposit rates in Lao PDR is the highest in the region (Figure 3.6). In 2007, Lao PDR’s spread was reported at 23.5% while other countries in the region have spreads that are lower than 10%. Considering that Lao PDR’s domestic financial intermediation is the most inefficient in the region, this may be a critical constraint to growth.

Figure 3.6. Spreads between Deposit and Lending Rates

Source: WB, World Development Indicators, Accessed January 2011.

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30 Lao PDR Indonesia Malaysia Philippines Thailand Vietnam Myanmar

114. High spreads between lending and deposit rates, however, make borrowing from the banks less attractive. Despite reforms in the financial sector, Lao PDR’s domestic credit has remained almost stable over the past two decades. Consequently, Lao PDR’s credit-to-GDP ratio has remained the lowest in the region since 2002. In 2008, Lao PDR’s credit-to-GDP ratio was 10.48% while the other countries in the region range from 36.75% (Indonesia) to as much as 145.64% (Thailand) in the same year (Figure 3.7).

Figure 3.7. Ratio of Domestic Credit to GDP

Source: WB, World Development Indicators, Accessed January 2011. 115. The stagnation in real domestic credit growth may be due to lack of investors’ appetite for domestic bank credit, as the investors, especially foreign, have access to better and more attractive financing sources for their investments. 116. The formal domestic financial sector has long been dominated by state-owned commercial banks. There are signs though of receptivity to liberalization and competition. Bank branching, along with joint-venture arrangements, is encouraged. A regulatory framework, contained in the Commercial Bank Law of 2009, is geared towards enhanced competition. Clearly, these moves are encouraging and expected to have positive effects on reducing interest rates. 117. The high loan rate may also be due to expected depreciation of the Kip. Foreign investors will hold a Kip-denominated security if they get a rate of return that protects them against the local currency’s depreciation. More recently, however, an appreciation of the Kip against the US dollar materialized instead of depreciation. To convince foreign investors that the appreciation stems from sound, rule-based monetary, financial and international-trade policies, the Bank of Lao, its central bank, must cement its reputation as a credible inflation fighter. 118. Access to financial markets of enterprises is limited and can be regarded as a critical constraint. Recent surveys support the view that access of investors, especially domestic ones, to finance and its cost is a major constraint to doing business in Lao PDR. 119. In its most recent enterprise survey, the IFC22 noted that 18.9% of the firms surveyed (more than 300 firms) in Lao PDR identified access to finance as a major constraint vis-à-vis other constraints, lower than the 19.4% for the region (Table 3.1). But the other survey

                                                        22 IFC. 2011. Enterprise Survey. Accessed January 2011.

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results suggest limited financial access. For example, only about 18.5% have credit lines with financial institutions, which is below the 40.4% for the region. Collateral requirements for a bank loan are high at 307.6 percent of loan value, much higher than the 170.6% for the region. It’s no surprise then why no firm uses bank loans to finance investments and only about 10.7 percent of firms use banks to finance expenses, compared to 31.4% for the region.

Table 3.1. Summary of IFC’s Enterprise Survey for Finance Finance Lao PDR Region All countries

% of Firms with Line of Credit or Loans from Financial Institutions 18.53 40.4 34.41 % of Firms Using Banks to Finance Investments 0 27.6 23.46

% of Firms Using Banks to Finance Expenses 10.73 31.45 27.56

Value of Collateral Needed for a Loan (% of the Loan Amount) 307.56 170.59 144.28 % of Firms Identifying Access to Finance as a Major Constraint 18.97 19.42 31.04

Source: IFC. 2011. Enterprise Survey. Accessed January 2011 120. The limitations on financing is also supported by findings of the WB’s Doing Business 2011,23 which noted that Lao PDR ranks 152 (out of 183 economies) overall in terms of getting credit. This is one of the lowest ranks among Asian countries (Figure 3.8).

Figure 3.8. Getting Credit in Selected Asian Countries

Source: WB Doing Business 2011

121. Developed financial markets provide payment services, mobilize deposits, and ease investment financing. The resulting financial intermediation done by banks and equity exchanges reduces reliance on internal funds and on money from informal sources, such as, family and friends, as firms get connected to a broad range of lenders and fund investors through the formal financial intermediaries. 122. In the case of Lao PDR, the IFC24 noted that majority (more than 95%) of the firms included in its Enterprise Survey rely on internal financing for its investments while the remainder is dependent on equity and sale of stocks for investment. Firms of all sizes,

                                                        23 World Bank. 2010. Doing Business 2011. Lao PDR. Making a Difference for Entrepreneurs. 24 IFC (2011), Enterprise Survey, Accessed January 2011.

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locations, and industries in Lao PDR rely overwhelmingly on internal funds for financing, as informal funds are prohibitively expensive. 3.2. Social Returns to Investments 123. Low economic growth can also be explained in terms of low returns to economic activity which in turn can be due to low social returns to investment and/or low private appropriability of returns.25 124. Returns to society is deemed affected by the level of investment public goods like human capital and infrastructure such that inadequate investment can dampen the productivity of factors of production and increase the cost of doing business, and ultimately lowering the returns to investment. A low level of social returns could be a symptom of deficiencies in human capital and/or infrastructure.

125. A comparison of social returns across the major Southeast Asian economies shows that Lao PDR’s annual social return to investments has been relatively stable since 2000 and at par with other Southeast Asian countries although higher social returns to investments were observed in Cambodia, Myanmar and Singapore (Figure 3.9).

Figure 3.9. Social Returns to Investment in Southeast Asia.

Source: World Development Indicators, 2010.

3.2.1. Human Capital 126. Unemployment rates are low but underemployment rates are high. While the Lao PDR economy has been growing in recent years, due largely to massive foreign investment in hydro-power and mining, the demand for the level of professional employees needed to maintain this economic growth surpasses the supply. Lao PDR is facing a skilled labor shortage, making human capital a constraint to entry of private sector investments.                                                         25 ADB. 2010. Indonesia Critical Development Constraints

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127. Labor force participation. Labor force participation rates are almost the same as those of other countries in the region, with a sharp drop between 2001 and 2005 (see Figure 3.10). The drop is significant, from 85 percent in 2001 to 66 percent in 2005. This may be attributed to lack of employment opportunities due to a generally low level of education among the labor force depriving them of necessary skills to be employable. Members of the labor force opting out may have been discouraged by the lack of good employment and wage offers. For example, workers rendered redundant in agriculture, lacking industrial discipline, may find it difficult generating job offers in non-agriculture. Discouraged, they quit job search and choose to stay out of the labor force. This may be an offshoot of the low educational attainment of the labor force, and correspondingly, the lack of employable skills.

Figure 3.10. Labor Force Participation Rate (in %)

Note: Figures for Cambodia in 2005 refer to 2004.

Source: ADB (2010), Key Indicators for Asia and the Pacific 2010. 128. Unemployment Rate. The unemployment rate declined significantly in 2005, giving Lao PDR the lowest unemployment rate in the Southeast Asian region at 1.4 percent in 2005 (see Figure 3.11). However, in view of the fall in the labor force participation rate, this drop in unemployment could be largely due to people moving out of the labor market, and not because employment creation has increased considerably. From a growth standpoint, a look at the employed and the opportunities for productivity enhancement in the workplace is insightful.

Figure 3.11. Unemployment Rate (in %)

Source: ADB, Key Indicators for Asia and the Pacific 2010.

0 10 20 30 40 50 60 70 80 90

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1995 2000 2005

129. On the other hand, if low unemployment rate reflects engagement of the labor force in economic activities (i.e., people who can be employed are employed), human capital, in this regard, may pose a constraint to the entry of further investments from the private sector, unless new investments would offer better packages in terms of remuneration and benefits, which the private sector may be more willing to offer only to those with relatively high educational attainment and/or employable skills (depending on the employment needs of the investment), such that those who have moved out of the labor force, if any, will still be unemployed. 130. Based on data from the International Labor Organization (ILO) on employment-to-population ratio, Lao PDR has one of the highest employment rates in Southeast Asia (77.2 per cent in 2009), even though this slightly declined during the period between 1991 and 2008 (see Figure 3.12). This may imply that population is growing faster than increase in employment opportunities, and increasing lack of employable skills.

Figure 3.12. Employment to Population Ratio (Age 15+, in %)

Source: International Labor Organization (ILO), Key Indicators of the Labor Market, 6th ed.

131. According to the UNDP (2009), “irrespective of the growth in national income, poverty fell by a near constant rate, implying that the relationship between the two variables is not very obvious. This argument is further supported by the fact that increased labor use outside agriculture has not accompanied growth: more than three-quarters of the workforce still works in largely traditional agriculture.”

132. For every one-percentage increase in production, employment increases by 0.4 percent. Only the growth in the hotels and restaurants service sub-sector has a multiplier effect on employment with a one percentage growth in value added resulting in a more than proportionate increase in employment of 1.3 percent (see Table 3.2).

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Table 3.2. Employment Elasticity by Sector (1995-2006) Industry/Activity Employment-production elasticity Aggregate 0.40 Agriculture 0.37 Non-agriculture 0.79 Industry 0.57

Mining 0.29 Manufacturing* 0.63 Electricity, gas and water 0.38

Services 0.94 Wholesale and retail trade 0.73 Hotels and restaurants 1.32

*Includes construction Source: Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th National Human Development Report. 133. While unemployment is at a relatively low level, the quality of employment opportunities leaves much to be desired. About 90 percent of the population is employed either as an unpaid family worker or an own account worker (see Figure 3.13). There are some gender differences: unpaid family workers represent the largest share (65 percent) among women, while own- account workers have the largest share among men (57 percent). The next common employment category is government employees, occupying about 10 percent and 4 percent of the male and female population, respectively. The large proportion of unpaid family and own-account workers are reflective of the low level of educational attainment. Formal employment generally requires qualifying standards based on high educational attainment. Figure 3.13. Distribution of Employment Categories by Employee Type and Gender

(2005)

Source: Messerli et al. (2008), Socio-Economic Atlas of the Lao PDR.

134. Underemployment. The predominance of unpaid and own-account workers leads to a high underemployment rate in Lao PDR with more than one out of four workers reported being underemployed (see Figure 3.14). Underemployment is again indicative of low schooling years. The employed that are reported as underemployed express wanting

0%

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additional work, from which one can infer that earnings are low on account of limited schooling. 135. Based on the 4th National Human Development report, more than a quarter (26.4%) of the employed work force in Lao PDR consider themselves underemployed26, wanting extra or supplementary work, pointing out the extent of workers’ dissatisfaction and/or the quest for upward mobility. Nonetheless, a high underemployment rate does not necessarily make human capital a constraint to private investments especially if investments would require not much skilled labor.

Figure 3.14. Underemployment Rate by Different Categories (2007/08)

Source: Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th

National Human Development Report. 136. Productivity. Labor productivity in the industry sector substantially rose between 1995 and 2005, but barely improved for the rest of the economy over the same period (see Figure 3.15). Moreover, overall productivity is low, comparatively speaking.

Figure 3.15. Labor Productivity by Sector (million Kip in 1990 prices)

Source: Ministry of Planning and Investment and UNDP( 2009). Employment and Livelihoods: The 4th National Human Development Report.

                                                        26 In the 4th NHDR, to determine the rate of underemployment, respondents were asked whether they needed

more or extra work, or wanted extra or supplementary work.

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137. Total factor productivity (TFP) in agriculture increased in the 1980s through the 1990s, and it is, on average, high relative to other countries in the Southeast Asian region (see Table 3.3). However, since Lao PDR is aiming for an average annual real GDP growth rate of eight percent in the Seventh Plan, TFP growth must increase significantly. For instance, assuming capital-labor ratio grows at four percent each year, TFP must grow at four percent, too, to support long-run growth.

Table 3.3. Total Factor Productivity Growth in Agriculture (in %) 1961/1980 1981/2001 Average

Cambodia -5.75 1.96 -1.89 Indonesia 4.43 -0.39 2.02 Lao PDR 1.2 2.52 1.86 Malaysia 3.62 1.39 2.51 Philippines 1.89 -0.3 0.79 Thailand 1.18 1.08 1.13 Viet Nam -0.37 3.26 1.45

Source: Avila and Robert Evenson (2010), “Total Factor Productivity Growth in Agriculture: The Role of Technological Capital,” in Pingali, P. and Robert Evenson, eds., (2010). Handbook of Agricultural Economics, Vol. 4. Elsevier BV.

138. Wages. Assuming that wage earners work eight hours a day and with a conversion rate of 0.000125 Kip/US dollar, workers generally earn between $2 and $4 per day (Figure 3.16). This is just slightly above the international poverty income threshold of $1.25/day. At these wages, living standards are woefully low. Again, this is an offshoot of low and inferior investments in education.

Figure 3.16. Hourly Earning of Wage Workers (2007/08, Kip/hour)

Source: Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th National Human Development Report. 139. Self-employment provides better compensation based on gross income per month, with earnings of the self-employed more than twice that of wage earners (see Figure 3.17). In addition, the service sector provides higher income than the manufacturing sector. It should be noted, however, that, on average, income of the self-employed translates to about $200/month or about $7/day, way below the average per capita income of the neighboring countries in the region. Table 3.4 shows the wage differential for workers based on skills for a particular occupation, namely, wood processing workers. The monthly wage of the skilled is twice that of the unskilled, but still low.

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Figure 3.17. Monthly Gross Income (2007/08, Kip)

Source: Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th National Human Development Report.

Table 3.4. Average Monthly Wage Rate for Wood Processing Workers in Vientiane Unskilled Labor $25-$35 Semi-skilled $35-$40 Skilled $50-$70 Skilled machine operators US$100

Source: Ministry of Planning and Investment and UNDP (2009). Employment and Livelihoods: The 4th National Human Development Report. 140. Geographic Employment and Wage Differentials. Geographic differentials in wages and employment largely follow the distribution of human capital. Localities with more educated and skilled workers show better employment and wages. Figure 3.18 shows employment by province. Employment rate is generally higher for the Northern and Southern regions compared to that for the Central region. However, the latter has a higher share of employment in wage and non-farm activity.

Figure 3.18. Employment Rate by Province (2007, % of Population 10+)

Source: Ministry of Planning and Investment, Department of Statistics (2009), The Household of Lao PDR Social and Economic Indicators: Survey Results on Expenditure and Consumption of Household 2007/08 LECS 4.

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141. Figures 3.19-3.21 show similar geographic distribution of employment by type of worker and gender. Female wages pale in comparison to male wage. The disparities get pronounced by province differing in level of economic development.

Figure 3.19. Employment Rate by geographical categories (2007, % of Population 10+)

Source: Ministry of Planning and Investment, Department of Statistics (2009), The Household of Lao PDR Social and Economic Indicators: Survey Results on Expenditure and Consumption of Household 2007/08 LECS 4.

Figure 3.20. Type of Employment (2007, Share of Total)

Source: Ministry of Planning and Investment, Department of Statistics (2009), The Household of Lao PDR Social and Economic Indicators: Survey Results on Expenditure and Consumption of Household 2007/08 LECS 4.

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Own Operated Farm Non-farm Activity Paid Employee

Figure 3.21. Type of Employment by Province (2007, Share of Total)

Source: Ministry of Planning and Investment, Department of Statistics (2009), The Household of Lao PDR Social and Economic Indicators: Survey Results on Expenditure and Consumption of Household 2007/08 LECS 4. 142. Returns to Education. A study by Phanhpakit Onphanhdala and Terukazu Suruga (2007, using 2002/2003 LECS data27) shows that, workers in the private sector received two times more than their counterparts in the public sector (Table 3.5). The gap between two sectors is larger especially for tertiary educated workers and in other provinces. A private worker with a university education level received four times higher than his or her counterpart in the public sector in other provinces.

Table 3.5. Monthly earnings (1,000 Kip) by education Education Vientiane Capital Other Provinces Lao PDR

Private Public Ratio Private Public Ratio Private Public Ratio No education 649 297 2.19 509 312 1.63 534 308 1.73Primary 859 291 2.95 725 458 1.58 755 418 1.81Secondary 1,211 462 2.62 850 416 2.04 971 432 2.25Vocational-Technical28 1,106 473 2.34 1,260 409 3.08 1,189 434 2.74University 1,485 673 2.21 1,370 345 3.97 1,450 576 2.52All Levels 1,070 499 2.14 774 409 1.89 860 444 1.94

Source: Lao Expenditure and Consumption Survey 2002/2003, as quoted in Phanhpakit Onphanhdala and Terukazu Suruga. Education and Earnings in Transition: The Case of Lao. Asian Economic Journal. 2007 143. Similarly, across levels of education, a university educated private worker earns almost three times more than a private worker with no education, and two times more than a

                                                        27 The 2007/2008 Lao Expenditure and Consumption Survey Report does not carry data on monthly earnings by

education. Given that Onphanhdala and Suruga used 2002/2003 data, annual changes in these variables may render the findings of the study inconclusive or not applicable to the present situation.

28 The Technical and Vocational Education Department formal institutions currently require grade 9 (formerly grade 8) as the minimum academic qualification for acceptance. The only access to formal TVET skills training for those without this academic qualification remains in the generally limited offerings of non-formal skills training through the Ministry of Labor and Social Welfare skills training centers or, at least in the past, through similar programs under MOE non-formal education centers.

0%

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Phon

gsal

y

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tha

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omxa

y

Boke

o

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gpra

bang

Hua

phan

h

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bury

Vien

tiane

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ital

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gkhu

ang

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xay

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vane

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ng

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peu

North Central South

Own Operated Farm Non-farm Activity Paid Employee

primary educated private worker, while a public worker with university education earns only almost two times more than a public worker with no education. The importance of primary education manifests in the graduated ratio below (Table 3.6).

Table 3.6. Ratios across levels of education Vientiane

Capital Other

Provinces Lao PDR Private Public Private Public Private Public Ratios: University/No education 2.29 2.27 2.69 1.11 2.72 1.87 University/Primary 1.73 2.31 1.89 0.75 1.92 1.38 University/Secondary 1.23 1.46 1.61 0.83 1.49 1.33 University/Voc-Tech 1.34 1.42 1.09 0.84 1.22 1.33 Primary/No education 1.32 0.98 1.42 1.47 1.41 1.36 Secondary/Primary 1.41 1.59 1.17 0.91 1.29 1.03 Voc-Tech/Secondary29 0.91 1.02 1.48 0.98 1.23 1.01

Source of raw data: Lao Expenditure and Consumption Survey 2002/2003, as quoted in Phanhpakit Onphanhdala and Terukazu Suruga. Education and Earnings in Transition: The Case of Lao. Asian Economic Journal. 2007 144. The study confirmed that the private rates of returns to education have risen significantly with economic transition. In particular, returns for young workers are considerably higher than for older workers. Although large earnings premiums are generally received by workers with high levels of education, the most profitable investment in education for a large number of paid employees is still the primary level. Moreover, there are the significant public-private sector wage differentials. The research findings have important implications for public sector salaries (especially in other provinces where public sector salaries seem to be distorted giving no premium at all to higher levels of education) and the financing of education in Lao PDR. 145. The study indicated that the return to primary education is statistically significant and the highest at 35 percent. This rate is even higher than the rate of 27% for the international standards. On the other hand, the rates of returns to secondary and tertiary education levels are also low at about 7 percent for both levels. The authors indicated that while large earnings premiums translate into workers with a high level of education in the private sector, the best investment (most profitable) for a large number of the employed population, is still the primary level. In this regard, Lao PDR’s policy makers may need to improve the supply of primary education services, and consider a more direct subsidy of primary school education for the poor. 146. The study also found out that, overall, women have a higher return to their schooling investment, and to additional work experience than men (particularly in the provinces). 147. Productivity and education. There is a positive relationship between an economy’s competitiveness and productivity levels (two important outcome indicators) and its school-life expectancy and adult literacy rates (two proxy indicators for workforce quality). As expected, competitive economies with higher productivity tend to have education systems that provide more average years of schooling and develop more literate adults. The evidence also reveals the disparities between the education systems in ASEAN. On one end, the more competitive economies, including Malaysia and Thailand, have average school-life expectancies of more than 12 years. Indonesia, the Philippines and Vietnam have rates that average between 10 and 12 years of schooling. And at the other end, the number of years of

                                                        29 Voc-Tech/Secondary ratios appear inconclusive as Voc-Tech students should normally have finished grade 9

at least. It could be that vocational training used to be available to students competing grade 5.

education that a child can expect to achieve in Cambodia, the Lao PDR, and Myanmar is less than 10 years. 148. Based on Table 3.7 below, certain trends in literacy appear, particularly among the lower-income Southeast Asian economies characterized by weaker productivity and competitiveness. In Cambodia and Lao PDR, for instance, adults have a literacy rate of 76.3 per cent and 73.2 percent, respectively, placing Lao PDR at the bottom among its Southeast Asian neighbors.

Table 3.7. Competitiveness rankings, output per worker, school life expectancy and adult literacy rates in ASEAN, most recent year

Global competitiveness ranking

Output per worker, constant 1990 US$

School life expectancy, primary to tertiary education (years)

National literacy rate for adults, ages 15+ (%)

2007-2008 2007p 2006* 2007** Singapore 7 46,494 -- 94.4 Brunei Darussalam -- -- 14.0 94.9 Malaysia 21 25,045 12.7 91.9 Thailand 28 14,999 13.5 94.1 Indonesia 54 10,309 11.5 91.4 Philippines 71 8,075 11.7 93.4 Vietnam 68 5,453 10.3 -- Myanmar -- 5,082 8.3 89.9 Cambodia 110 3,772 9.8 76.3 Lao PDR -- -- 9.2 73.2 Notes: "p" demotes projections; "--" denotes data not available or ranking not given; "*" data for school life expectancy are from 2006, except Malaysia (2005), Myanmar (2002), and Vietnam (2000); "**" date for adult literacy rates are from 2007, except Myanmar (2000). Sources: School-life expectancy and adult literacy rates: UNESCO Institute for Statistics, accessed July 2008; Global competitiveness ranking: World Economic Forum, Global Competitiveness Report 2007-2008; Output per worker: The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2008.

Source: ILO. Labor and Social Trends in ASEAN, 2008. 149. Shifts in employment. Figure 3.22 shows the evolution of employment in some Southeast Asian countries. While the agricultural sector remains the largest in terms of employment for the ASEAN region, the share of employment in agriculture is on the decline in every Southeast Asian country, led by sharp decreases in Cambodia and Vietnam. Even with these shifts, the agricultural sector is still home to almost 80 per cent of workers in Lao PDR, more than half of workers in Cambodia and Vietnam, and more than 40 percent of workers in Indonesia.

Figure 3.22. Shifts in Employment Pattern

Sources: ADB Key Indicators for Asia and the Pacific 2010, World Development Indicators, accessed February 2011 (see Annexed Table for data) 150. Table 3.8 shows actual employment growth by sector since 2000, along with the annual rates of growth in each sector. These two pieces of information provide a very good picture of the dynamics of employment shifts across sectors. Overall, the agricultural sector in ASEAN (excluding Myanmar) has grown by 324,000 workers, representing annual growth of approximately 0.1 per cent. The agricultural sector has contributed less than 2 per cent of all new employment growth in the region since 2000. More than 8.4 million new jobs have been created in the rapidly expanding industrial sector, representing annual growth of more than 3.6 per cent. The services sector grew by 13.3 million, or by 2.8 per cent annually. In aggregate, the services sector accounted for approximately 60 percent of all new employment while the industrial sector accounted for more than 38 per cent of new employment in the region. While the share of employment in agriculture is declining in all ASEAN Member Countries, the sector(s) in which new employment is being generated differs across the region. In Cambodia, Thailand and Viet Nam, employment is growing rapidly in both industry and services. In Malaysia, Philippines and Singapore, employment is growing much faster in the services sector, even as Malaysia and Singapore experience low growth due to declining industrial employment. In Indonesia, Lao PDR, and the Philippines, agriculture is still generating a large share of total employment, which likely reflects persistent surplus labor in rural areas in those countries where the sector plays the role of “employer of last resort” for many unskilled or low-skilled rural workers (ILO, 2008).

Table 3.8. Growth in employment by sector, 2000–2006 Total change in employment ('000s) Annual growth rate (%) Agriculture Industry Services Agriculture Industry ServicesASEAN* 324 8,445 13,314 0.1 3.6 2.8Cambodia 310 540 1,110 1.4 15.3 15.5Indonesia -544 2,078 4,086 -0.2 2.1 1.9Lao PDR 236 159 -22 1.5 -1.2 -1.2Malaysia -208 109 1,051 -2.1 3.5 3.5Philippines 1,765 454 3,198 2.6 3.8 3.8Singapore 0 18 307 1.1 2.9 2.9Thailand -780 1,223 2,847 -0.8 4.0 4.0Vietnam -670 3,388 3,463 -0.5 5.8 5.8Note: *ASEAN regional figures exclude Myanmar. The starting and ending years for the calculations are 2000 and 2006, respectively, except for the following countries: Cambodia (2000, 2005); Lao PDR (1995, 2003); Singapore - agricultural sector only (1997, 2004) Source: ILO, Global Employment Trends Model, 2008; official data from national statistical offices.

Source: As quoted in ILO. Labor and Social Trends in ASEAN, 2008.

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151. In terms of labor productivity, Table 3.9 shows that the agricultural sector has the lowest level of labor productivity while the industrial sector is the most productive (except in Lao PDR where it is essentially at the same level as the services sector). The ratio of average productivity in industry to agriculture is greatest in Thailand – nearly 12 to 1, which means that it would take the average industrial worker only one month to produce the same value as the average agricultural worker would produce in one full year. In Indonesia, the ratio is 7.7 to 1. In Vietnam, it is 6.4 to 1, in the Lao PDR, it is nearly 5 to 1, and in Cambodia it is 4 to 1. The ratio is lower (approximately 3 to 1) in Malaysia and Singapore. While high ratios indicate high probabilities of significant inequalities in earnings and quality of employment between workers in different sectors, they also indicate the high potential returns to employment shifts out of agriculture (ILO, 2008).

Table 3.9. Labor productivity by sector (constant 2000 US$ and average annual growth) and contribution from sector employment shift, 2000–2006

Labor productivity, most recent year

Annual labor productivity growth

Contribution from employment shift

Ag. Ind. Serv. Ag. Ind. Serv. Total Total % ASEAN* 806 7,429 4,209 3.2 1.3 2.1 3.1 0.6 18.3 Cambodia 361 1,445 1,149 3.6 -1.2 -4.7 3.2 1.5 46.9 Indonesia 773 5,408 2,456 3.4 1.9 4.4 3.8 0.3 7.6 Lao PDR 477 2,318 2,329 2.9 6.6 4.9 4.2 1.0 23.8 Malaysia 6,442 18,838 8,816 5.6 3.6 1.8 2.9 -0.2 -5.4 Philippines 1,226 6,015 3,493 1.1 1.5 2.3 1.8 0.1 3.7 Singapore 16,202 50,309 43,744 -2.2 3.6 1.7 2.3 0.0 -2.0 Thailand 838 9,873 5,788 3.4 3.1 0.4 3.4 1.0 30.6 Vietnam 392 2,523 1,523 4.2 0.8 1.3 5.0 1.8 36.7 Notes: *ASEAN regional figures exclude Myanmar. The starting and ending years for the calculations are 2000 and 2006, respectively, except for the following countries: Cambodia (2000, 2005); Lao PDR (1995, 2003); Singapore - agricultural sector only (1997, 2004)

Source: ILO calculations based on official employment data from national statistical offices and value added data from World Bank, World Development Indicators online database.

Source: As quoted in ILO. Labor and Social Trends in ASEAN, 2008. 152. Nearly a quarter of the productivity growth in the Lao PDR was due to the country’s structural employment shift. However, productivity growth was robust in each of the individual sectors. 153. Lao PDR has high potential in benefiting from structural shifts in employment. Similar with Cambodia, Thailand and Vietnam, Lao PDR is already reaping significant benefits from structural change. Indonesia, Myanmar and the Philippines have considerable potential, given their large shares of agricultural workers. But widespread benefits from structural change have not yet been realized. In this group and especially in the lower-income/agriculture-oriented countries, a primary focus should be on the continued facilitation of labor mobility across sectors. Promoting productivity growth within sectors is also an important objective for long-term sustainable growth (ILO, 2008). 154. High-quality labor market information is essential for facilitating employment shifts and promoting employment growth across and within sectors. For instance, in order for employment services to be effective in helping to reduce gaps between labor supply and demand, good-quality labor market information is needed to identify the emerging employment opportunities for workers and the skills that are in demand so that training programs can be designed accordingly (ILO, 2008).

155. Thus, in ASEAN Member Countries with a high share of workers still engaged in agriculture, like Cambodia, Indonesia, Lao PDR (Table 3.10), Myanmar, Philippines and Thailand, investments aimed at boosting agricultural productivity are likely to both improve the livelihoods of the poorest workers and help to address the problem of rising food prices30. They also are likely to promote structural change, which would likely raise average productivity levels and increase overall economic growth and development prospects.

Table 3.10. Activity of workers by main sectors in Lao PDR (%, 2005) Percent of population in farm activity Non-farm activity Male Female Male Female Lao PDR 75.7 81.3 24.3 18.7 Vientiane Capital 34.0 36.9 66.0 63.1

Source: Ministry of Planning and Investment – National Statistics Centre (2005) “Population and Housing Census 2005”, quoted in Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th National Human Development Report. 156. ASEAN’s Economic Ministers have recognized the importance of increasing productivity in agriculture through the transfer of technology, research and development, the increase of agricultural land and the substantial increase of public and private investment. 157. In addition to the importance of increasing mobility across economic sectors to boost labor productivity, it is critical for Southeast Asian economies to increase productivity within sectors. Small and medium-sized enterprises (SMEs) hugely outnumber large enterprises in Southeast Asian countries in both the quantity of establishments and the share of the labor force they employ. Thus, improving productivity in those enterprises will be an essential factor to increasing productivity of the overall economy and strengthening the backbone of the ASEAN Community (ILO, 2008). 158. Skills shortage. The Lao Labor Market Assessment conducted by ADB in 2010, in conjunction with the Ministry of Education (MOE) and the Ministry of Labor and Social Welfare (MOLSW), identified skills shortages across several sectors, including construction, furniture-making, and automobile and machinery repair. 159. The Labor Market Assessment focused on labor market demand in order to clarify current and potential labor market needs in the different economic sectors. 817 companies, located in eight provinces of Lao PDR, took part in the study, and were divided into the following categories: 136 companies with more than 100 employees (17 per cent), 297 companies with 10 to 100 employees (36 per cent) and 384 companies with fewer than 10 employees (47 per cent). 160. The study indicated that the hardest hit industry was the furniture sector which was short of 3,000 workers. There is an international demand for high quality Lao PDR furniture, and official restrictions have recently been placed on Lao PDR timber exports to encourage domestic added value. However, meeting this demand is currently hindered by low quality skills and a mismatch between what the furniture sector is able to produce and what buyers demand. The labor market survey indicated that 42% of the workers working within the furniture sector were female, and that the sector is almost entirely comprised of small and medium enterprises. 161. Inasmuch as the construction industry is cross-cutting, as it incorporates a number of trades in the construction of buildings, including road and bridge construction, mining and

                                                        30 “Joint ministerial statement on food security”, ASEAN Economic Ministers’ Retreat, May 3,2008, available at:

http://www.aseansec.org/21498.htm

hydropower, the construction sector has to match the increase in demand for skilled workers in these related trades. There is a considerable growth in all these economic sectors, and there is especially need for construction/technical civil engineering skills, with the Ministry of Public Works and Transport’s (MPWT) 2010–2020 Master Plan containing a list of 808 projects on the National, Provincial and Rural Roads network (including bridges), reaching some 13,700 km of construction and rehabilitation, and the Ministry of Mining and Energy’s (MOME) approval of 168 mining projects in different stages of development. Similarly, there are at present some 75 approved hydropower projects at different stages of development, eventually requiring a large number of skilled workers. 162. The assessment found similar findings for tourism and hospitality, and the mechanical maintenance sectors, which indicated lack of skilled local workforce.In general, the lack of skilled labor in Lao PDR is being met by large scale employment of foreign workers. 163. The study likewise noted that a critical weakness in the Lao PDR, in connection to industrial expansion was the absence of up-to-date labor market information, so that it acted as a constraint to economic planning and to the effective operation of the Technical Vocational Education and Training (TVET) system. Vocational Training has a significant impact on both productivity and poverty reduction. Thus, technical and vocational education and training (TVET) is a key focus of the Lao PDR government’s Education Sector Development Framework, and the government has developed a TVET strategy and master plan. 164. Results of Investment Climate Surveys. Taking on the perspective of the investors, results of recent enterprises surveys and investment climate surveys confirm the findings of the Lao Labor Market Assessment. 165. Based on the IFC-World Bank Enterprises Surveys (2009), inadequately educated workforce has been identified by surveyed firms as the third top business environment obstacle (with tax rates and access to finance being voted as the top two obstacles facing the firms in Lao PDR). For medium firms (with 20 to 99 employees) and large firms (with 100 or more employees), inadequately educated workforce emerged as the top constraint in their business operations. More than 40 percent of these firms indicated inadequately educated workforce as a major problem (please see Figure 3.23. below).

Figure 3.23. Snapshot of Business Environment in Lao PDR

 Source: IFC/World Bank. Enterprises Surveys: Lao PDR Country Profile 2009.

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electricity

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166. The GTZ-sponsored Enterprise Survey conducted in 2009 under the Lao-German Programme on Human Resource Development for a Market Economy (published in 2010) likewise yielded similar results in terms of labor/workforce as a determinant of investment decisions from the private sector. In terms of staff education, the level of trained technical and administrative staff is higher the bigger the enterprise size. Comparing trained staff across 2005, 2007 & 2009, the data shows that the greatest progress is being achieved in the small size group. The survey indicated that the investment and speed of innovation by enterprises to counter competitive pressures on liberalized markets is constrained particularly by ‘inadequate management skills’ by owners/managers and ‘access to finance’, and also by ‘skill deficits’ of the technical staff. As one of policy interventions, the survey proposed the enhancement of labor market-orientation of the TVET system in Lao PDR. 167. On the other hand, in Oraboune Syviengxay’s “Investment Climate in Lao PDR” (2010)31, the respondents in Vientiane gave an average of 3.2 rating for macro-economy, governance, regulatory framework, infrastructure, labor issues, land, and finance using a 5-point scale (1 very poor; 2 poor; 3 fair; 4 good; 5 excellent). Labor issues include quality of workers. In the most populated province of Savannakhet, which has 50 percent labor force, labor supply becomes a problem as labor force tends to be divided between Vientiane and Savannakhet. 168. The 2009 ADB survey of 140 investors in Lao PDR32 also shows that the majority of investors surveyed considered Lao PDR at or below average performance on access to land and property, cost of raw materials, environment and quality of life, cost of credit, cost of labor and adequate supply of skilled labor, lack of transparency in government. 169. Based on the aforementioned surveys, human capital in Lao PDR poses a constraint for the private sector to invest in the country. 3.2.2. Infrastructure 170. Inadequacies in Infrastructure are critical constraints to Lao PDR’s investment and growth. Inadequate infrastructure is a constraint to growth and private investment as poor availability and quality of infrastructure can reduce the economic returns to investment. Although there has been significant infrastructure development over the past two decades, Lao PDR’s infrastructure sector remains largely underdeveloped. This underdeveloped state of Lao PDR’s infrastructure sector however, presents both a challenge and an opportunity. 171. Available data for private participation in Lao PDR indicate a modest investment from the private sector during the period 1997-2004, most of which were in the telecommunications sector. Then came a resurgence of private sector investments, in 2005-2008, the bulk of which coming from the energy sector, with more than US$ 1.2 billion worth of private investments in 2006 (Figure 3.24). This pattern of investment however, contributes to volatility of incremental investments.

                                                        31 In “Investment Climate in Major Cities in CLMV Countries”, edited by Masami Ishida, BRC Research Report

No. 4, Bangkok Research Center, IDE-JETRO, Bangkok, Thailand, 2010. 32 ADB. 2011. Sector Assessment, Strategy and Road Map: Lao PDR - Trade and Industry (Small and Medium-

Sized Enterprises) 2011-2014. Forthcoming.

Figure 3.24. Investments in Infrastructure with private participation (current US$)

Source: WB, World Development Indicators, Accessed January 2011.

172. Private sector investments in Lao PDR telecoms reached as much as US$ 92 million in 1996. Since then, however, private investments have not increased significantly, amounting to only a total of US$ 106 million during the period 1997-2008 (Figure 3.25), one of the lowest in the region.

Figure 3.25. Investment in telecoms with private participation (current million US$)

Source: WB (2010), World Development Indicators, Accessed November, 2010.

173. Historically private sector investments in the energy sector had been isolated and inconsistent. Recently, however, there has been a renewed interest from the private sector in Lao PDR’s energy sector amounting to as much as US$ 1.2 billion in 2005 (Figure 3.26).

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Lao PDR  Cambodia  Indonesia  Thailand  Vietnam 

Figure 3.26. Investment in energy with private participation (current US$ Millions)

Source: WB (2010), World Development Indicators, Accessed November, 2010.

174. Investment Climate. The reliability and availability of infrastructures and the provision of water, electric, and other utility services generate an investment climate conducive to growth, given that infrastructures of high quality raise the marginal productivity of private capital. Physical integration through, for instance, roads, transport systems, and telecommunication; replacement of manual labor by electrical machines: all this illustrates efficiency gains from good infrastructures. Some of these infrastructures are not constraining growth in the short run, but bottlenecks are expected in the long run as Lao PDR makes a push for middle-income economy status.

175. Based on the GTZ’s Enterprise Survey33, Lao PDR’s physical infrastructure, (lack of: roads, water, electricity and telephone), was not perceived as a major constraint It should be noted however, that majority of the firms covered by the survey (66%) were situated in the urban areas where infrastructure is relatively more developed.

176. The IFC Enterprise survey34 shares the same view that infrastructure, measured in terms of the duration to obtain selected utility services (power, water and telecommunication) was not considered a severe constraint vis-à-vis other critical factors, e.g. tax rates, access to finance, education, etc. In fact, the number of power outages in Lao PDR, is one of the lowest in the region (Figure 3.27), after Thailand, Philippines and Malaysia.

Figure 3.27. Number of Power Outages in a Typical Month

 Source: IFC. Enterprise Surveys. Accessed January 2011.

                                                        33 GTZ. 2010. Enterprise Survey 2009 Main Report Lao PDR 34 GTZ. 2010. Enterprise Surveys. Available online at: http://www.enterprisesurveys.org/ExploreTopics/?topicid=8

Accessed in January 2011.

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177. In terms of water insufficiency and delay in obtaining water connections, although relatively lower than its neighboring countries in Southeast Asia, Lao PDR ranks slightly higher than other economies in the Southeast Asian region (Figure 3.28).

Figure 3.28. Average Number of Incidents of Water Insufficiency in a Typical Month

 Source: IFC (2011), Enterprise Surveys, Accessed January 2011.

178. On the other hand, ADB and WB (2007)35 noted that majority of the firms surveyed (more than 300) in both the manufacturing and tourism sectors, identified poor infrastructure as the most severe constraint to investment and productivity growth (Figure 3.29). In particular, quality of and access to infrastructure services are inadequate, imposing high fixed costs, which are especially harmful to small and informal firms.

Figure 3.29. Key investment climate constrains identified.

Source: ADB and World Bank. Reducing Investment Climate Constraints to Higher Growth.

179. An average firm that used each of the services was estimated to lose up to 5.5 percent of sales due to poor transport infrastructure; 3.9 percent due to poor transport services; 4.3 percent due to poor electricity; 1.6 percent due to water supply problems; and 1.8 percent due to poor telephone services. Although Lao PDR has one of the lowest tariffs

                                                        35 ADB and WB (2007), Reducing Investment Climate Constraints to Higher Growth.

0 1 2 3 4 5 6

Indonesia (2009)

Lao PDR (2009)

Vietnam (2009)

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Tourism

Manufacturing

for industrial and commercial consumers in the region, most of the firms surveyed found electricity tariffs to be expensive due to exceptionally low traditional tariff rates, the absence of cost incentives for energy management and efficiency, and poor consumer information. 3.2.2.1. Transportation 180. Lao PDR is landlocked by five countries and does not have direct access to the sea. World Bank36 noted that the road network carries approximately 98% of passenger traffic and 86 % of freight traffic (ton-km) while the remainder is substantially carried via the Mekong River and its tributaries. The contribution of Air transport is not significant due to the relative cost, although it remains an important mode of transport especially in the inaccessible areas. 181. Roads. Due to its landlocked nature and the absence of an alternative railway system, road transport has become the dominant mode of transportation in the country. Although Lao PDR has a rudimentary, but improving, road system, Lao PDR lags behind other neighboring countries in terms of provision of transportation.37 Lao PDR’s total road network has more than doubled since 1990 with the bulk of new roads established during the period 1995-2002.38 As of 2007, Lao PDR’s total road network was about 36,831 kilometers (Figure 3.30).

Figure 3.30. Lao PDR’s Road Network 1990-2007

Source: 1990-2005 data from WB (2010),World Development Indicators, 2007 data from CIA Factbook Accessed November 2010.

182. But while the total road network has increased over the past few years, there is very little improvement in terms of the quality of roads. In 1990, there were about 14,000 kilometers of road, 24% (or 3,353 km) of which is paved while in 2007, only 4,811 kilometers or 13.06% has been paved39 most of which are national roads and more than 80 percent are unpaved (Figure 3.31). Compared to other countries in the region, Lao PDR has a higher proportion of paved roads vis-à-vis the Philippines and Cambodia.

                                                        36 World Bank. Transport in Lao PDR. Available online http://go.worldbank.org/U719S4CTE0] 37 A rigorous assessment may be seen in ADB (2010f). 38 WB, World Development Indicators, Accessed November 2010. 39 CIA (2010), The World Factbook-Laos. Accessed November 2010. Available online at

https://www.cia.gov/library/publications/the-world-factbook/geos/la.html

0.00

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40,000.00

1990 1991 1992 1993 1994 1995 1999 2002 2005 2007

Paved Unpaved

Figure 3.31. Paved Roads (% of total roads)

Note: Latest figure for Cambodia is 2004, Philippines 2003, Thailand 2000, & Viet Nam 2007

Source: WB, World Development Indicators. Accessed on 20 October 2010 183. Notwithstanding this development in road network, Lao PDR’s road density (kilometers of road per 100 sq. kilometers of land area) stood at 12.59 in 2007 (Figure 3.32). This was the lowest in the region next to Myanmar.40

Figure 3.32. Road Density Selected countries

Source: World Development Indicators, Accessed November 2010.

184. Due to lack of adequate funding and appropriate maintenance however, the development of the road transport network will remain a key issue for the Lao PDR’s growth and regional economic integration.

185. Railway Network. Lao PDR does not have any major railway link to any of its neighboring countries even though all neighboring countries share the same gauge. A short and narrow portage railway with a gauge of 600 mm and a length of about 7 km. once existed on the Mekong River over the islands of Don Det and Don Khone during the former French colonial administration but this is no longer operational.41 The only working railway is in the country is a short rail link connecting Vientiane and Thailand over the Thai-Lao Friendship Bridge.                                                         40 WB (2010), World Development Indicators. Accessed November 2010. 41 Hufnagel, Hans, (2003), “The only railway (ever) in Laos,” In The International Steam Pages. Available online

at: http://internationalsteam.co.uk/trains/laos01.htm

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Cambodia (2004)

Indonesia (2005)

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186. Given the high capital cost of rail infrastructure, the viability of establishing a railway network will be a great challenge for Lao PDR given its very limited resources. The absence of an integrated railway network in Lao PDR deprives the country of: (1) a complementary and alternative means of road transport for both passenger and commodities and (2) the potential benefits of increased trade and tourism as a result of integrating with the rail networks of neighboring countries, particularly, PRC, Thailand, Viet Nam, Cambodia and Myanmar. Hence, this is a great opportunity for Lao PDR to establish a railway system by connecting with the already established systems of its more developed neighboring countries.

187. Water transport. Being a landlocked country, Lao PDR possesses no ports or harbors on the sea. Nevertheless, Lao PDR maintains 1 cargo ship for shipment of goods. Inland waters, however, make-up for water transport in the country with the Mekong River and its tributaries (the Nam Ou and Se Kong rivers) providing about 4,600 km of navigable water routes. An additional 2,900 kilometers are also seasonally navigable by craft drawing less than 0.5 m.42 There are also some 21 river port facilities on the Lao PDR side of the river all of which are under the responsibility of the provincial government (except Kaolia which is privately owned and operated). 188. The WB noted that waterway transport doubled its share of the market from 4% in 1990 to 8% in 2002. However, this increase is partly due to the failure of the road system as well as the growth of the economic activities along the Mekong River.43 Inland waterways in Lao PDR, if adequately and properly maintained can provide a more efficient and cheaper alternative and complementary transport to the existing road network. Lao PDR’s strategic location on the Mekong River makes it a natural transit corridor for neighboring countries, hence there is merit in developing Lao PDR’s waterways section. 189. Airports. As of 2010, Lao PDR has 41 airports, but only 9 of which have paved runways.44 There is only one airline operating domestic flights in Lao PDR (Lao Airlines) that remains government-owned and is subject to price and government control. Consequently, it is financially unsustainable. The volume of airfreight in 2008 was only 2.6 million-ton-km and was one of the lowest in the region next to Cambodia (Figure 3.33).

Figure 3.33. Air transport, freight (million ton-km) of Selected Asian Countries

Source: WB (2011), World Development Indicators, Accessed, January 2011.

                                                        42 CIA (2010), The World Factbook-Laos. Accessed November 2010. Available online at

https://www.cia.gov/library/publications/the-world-factbook/geos/la.html 43 Nogales, Alberto, (2004), Lao PDR: Transport Sector Brief. World Bank. 44 CIA (2010), The World Factbook-Laos. Accessed November 2010. Available online at

https://www.cia.gov/library/publications/the-world-factbook/geos/la.html

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190. With regard to passengers carried, although the number has been increasing over the years (from 13,000 in 1980, 115,000 in 1990, 210,000 in 2000 and 323,000 in 2008), Lao PDR’s air transport is still one of the lowest in the region next to Cambodia (Figure 3.34). Nevertheless, domestic-passenger air transport plays a crucial role in linking urban areas and otherwise remote parts of the country, particularly in the mountainous areas.

Figure 3.34. Passengers Carried (‘000) by Air, Selected Southeast Asian Countries

Source: WB (2010), World Development Indicators, Accessed, November 2010.

191. The transport of passengers and goods in Lao PDR is constrained by an already inadequate transport network and further limited by its deteriorating physical condition. The development of an efficient transport system that would provide adequate transport domestically, as well as “land-link” the country to its more developed neighbors would therefore be crucial to Lao PDR’s socio-economic development and regional integration. 3.3.2. Telecommunication 192. Due to Lao PDR’s geographical attributes and limited resources, the telephone line service to the general public remains poor, although improving. As early as 1980, Lao PDR had about 5,500 telephone lines. This has increased over the past two decades albeit at a much slower pace than other countries in the region. In 2008, there were about 127,800 existing telephone lines that were relatively higher than Brunei and Cambodia (Figure 3.35).45

                                                        45 World Bank. World Development Indicators. Accessed November 2010.

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Source: World Development Indicators. Accessed November 2010.

193. Similar to other developing Asian countries, cellular phone technology came in much later, but its usage has grown at a relatively rapid pace. From only a handful of 290 mobile subscribers in 1992, these had increased to about 2.02 million cellular phone subscribers in Lao PDR as of 2008 (Figure 3.36). This is greater than the number of mobile phone subscribers in Myanmar (367,000) and Brunei (376,000) in the same year.

Figure 3.36. Mobile phone subscribers of Selected Asian Countries (‘000)

Source: WB (2010), World Development Indicators, Accessed November, 2010.

194. As the demand for telecommunication services is expected to increase, however, further development of the telecommunication sector would depend on increasing investments from both the public and the private sectors. 3.3.3. Energy

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195. In terms of supply, Lao PDR does not have any proven reserves for oil and natural gas.46 Nevertheless, Lao PDR is endowed with significant indigenous energy resources, mainly hydropower despite its landlocked attributes. As of 2008, Lao PDR has a total generation capacity of 723 MW, almost 94% of which are generated by hydropower.47 196. Lao PDR is also a producer of coal. Total proven coal reserves are estimated at around 900 million tons (810 million tons of lignite and 100 million tons of anthracite).48 Lignite reserves of low sulfur content in the northwestern part of the country can sustain about 2,000MW installed capacity.49 Lao PDR exports some of the lignite to Thailand.50 197. Given these resources, power generation in Lao PDR has historically been more sufficient than consumption. As of 2008, generation amounted to almost 4 billion kWh while domestic consumption was only 1.1 billion kWh (Figure 3.37). Lao PDR’s energy consumption per capita is considered one of the lowest in the world. ADB estimates that generation will pick up to as much as 14.2 percent in 2015 and 47.8 percent in 2030 as the demand (both for domestic and exports) increases. 51

Figure 3.37. Lao PDR Power Generation and Consumption (Million kWh).

Source: International Energy Statistics database, EIA. Accessed November 2010.

198. This excess generation has allowed Lao PDR to export its surplus energy to neighboring countries. Surplus electricity (partly seasonal) from Lao PDR’s hydroelectric power plants was exported to Thailand even before the 1980s, peaking to as much as 3,600 million kWh in 2000. Exports however, have gradually declined after 2001 as domestic power demand also grew (Figure 3.38). Meanwhile, having no oil-refining facility, Lao PDR imports all of its petroleum product requirements. Demand for imported petroleum products

                                                        46 EIA (2009), World Proved Reserves of Oil and Natural Gas, Most Recent Estimates. Accessed on November

2010 at: http://www.eia.doe.gov/emeu/international/reserves.html 47 EIA (2009), International Energy Statistics Database. Accessed November 2010. 48 ADB (2009), Energy Outlook for Asia and the Pacific. Page 241. 49 “Promotion of Renewable Energy, Energy Efficiency and Greenhouse Gas Abatement (PREGA),” Draft Final

Country and Policy Report. 2006. Available online at: http://www.greengrowth.org/download/green-business-pub/Greening_of_the_Business/Governments/Lao_People_s_Democratic_Country_Report.pdf?bcsi_scan_7823DFCE46415F3E=0&bcsi_scan_filename=Lao_People_s_Democratic_Country_Report.pdf

50 ADB, (2009), Energy Outlook for Asia and the Pacific. Page 241. 51 ADB (2009), Energy Outlook for Asia and the Pacific. Page 343.

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however, has been kept to a minimum (as much as 280 million kWh in 2008) vis-à-vis exports.

Figure 3.38. Lao PDR Electricity Imports and Exports

Source: EIA (2010), International Energy Statistics database, EIA. Accessed November 2010. 199. Despite the abundance of hydropower, most of Lao PDR’s energy consumption (80% of the people in the rural areas) is in the form of noncommercial energy, particularly firewood and charcoal primarily for cooking.52 However the government recognizes that this is a non-sustainable resource and that significant logging can have negative impacts on the environment in the long run.53 200. In terms of electrification, less than half of the population or around 45% of Lao PDR had access to electricity as of 2005 (Figure 3.39), one of the lowest in the Asian region.54

Figure 3.39. 2005 Asian Electrification Rates

Source: ADB. 2009. Energy Outlook for Asia and the Pacific

201. One of the possible reason for the low electrification rate is that getting electricity in Lao PDR, according to the WB, takes about 134 days on average and costs about US$ 2,734.30, one of the most expensive in Asia (Table 3.11).55

                                                        52 Energy Status in Lao PDR. 53 Ministry of Energy and Mines' Department of Energy Promotion and Development (2010), “Energy Sector in

Lao PDR,” From the Powering Progress website. Accessed in November 2010 at http://poweringprogress.org/index.php?option=com_content&view=article&id=55&Itemid=27

54 ADB (2009), Energy Outlook for Asia and the Pacific.

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Table 3.11. Getting Electricity in Asia, 2010.

Country Procedures

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per capita) Brunei Darussalam 5 86 46.7 Cambodia 4 183 3,581.50 Indonesia 7 108 1,350.00 Lao PDR 5 134 2,734.30 Malaysia 6 51 55.8 Philippines 5 63 479.2 Singapore 4 36 33.9 Thailand 4 35 86.3 Vietnam 5 142 1,536.00

Source: World Bank. Doing Business 2011. 202. The need for further electrification therefore remains high and the government targets to increase access to electricity to 90% by 2020 through financing from multilateral and private sources. 3.4. Appropriability of Returns to Investments 203. Private entities invest willingly if they can capture adequate returns from their investments. Accordingly, anything that weakens or lowers such returns discourages investment and, ultimately, slows down economic growth. Risks to such appropriability can emanate from either government failures or market imperfections, if not downright failures. Some risks have macroeconomic roots, such as, unanticipated inflation, currency crises, and shifting tax rates. Microeconomic risks, meanwhile, include, unpredictable government regulation, labor strikes, and other “hold-up” concerns, say, from some subcontractors and input suppliers. Furthermore there are institutional and implementation risks, such as, corruption and weak rule of law that result in non-enforcement of contracts, which may be viewed as forms of “hold-ups,” too. On the other hand, market imperfections and failures affecting appropriability normally emanate from information asymmetry, learning externalities, and coordination failures. We review some possible macroeconomic and microeconomic risks to see if some can be ruled out as contributing to appropriability, thus posing constraints to inclusive growth. 3.4.1. Macroeconomic risks 204. Lao PDR’s conduct of macroeconomic policy has been sound and may not be a source of appropriability risk. Fiscal and current-account deficits have been made manageable by reining in government spending, given modest tax revenues. Meanwhile, prudent monetary policy has kept inflation at single-digit levels. In 2008, inflation increased from sudden spikes in rice and fuel prices, but that proved temporary, though. 205. Fiscal Account Balance. Lao PDR’s fiscal position has been in deficit since 1990, but Lao PDR was able to bring its fiscal deficit down from about 12.5% of GDP in 1995 to only 2.2% in 2008 (Figure 3.40). Fiscal deficit in 2009, however, rose again slightly to 3.3% of GDP, in view of the global financial crisis. The ADB (2010)56 noted that the current crisis could continue to widen the fiscal deficit because governments in general could not easily reduce expenditures in line with their lower receipts and because many of them deliberately

                                                                                                                                                                            55 WB (2010), “Getting Electricity in Lao PDR,” In Doing Business 2011. Data accessed on November 2010 and

available in http://www.doingbusiness.org/data/exploretopics/getting-electricity 56 ADB (2010), Key Indicators.

allowed deficits to rise to counter the crisis. By maintaining, or increasing their expenditures, governments, Lao PDR including, have been compensating for the shortfall in consumer expenditure and business investment. 206. Current Account Balance. After posting a weak current account position from 2003-2005, Lao PDR’s current account balance shifted to surplus levels during the period 2006-2008. The balance, however, shifted to a deficit in 2009 (2.4% of GDP), probably due to exports declining faster than imports57. ADB projects that the current account deficit is likely to persist at 9.0% and 8.0% of GDP for 2010 and 2011, respectively.

Figure 3.40. Lao PDR Fiscal and Current Account Position (% of GDP)

Source: ADB (2010), Key Indicators 2010. 207. Government Revenues. On the revenue side, similar to its regional peers, Lao PDR has maintained total government revenues above 10% of GDP for the past two decades. But while Lao PDR’s government revenues (as a % of GDP) has been increasing for the past five years it remains as one of the lowest in the region, recording only 14.8% of GDP in 2009. (Figure 3.41).

Figure 3.41. Total Government Revenue (% of GDP)

Source: (ADB 2010), Key Indicator 2010. 208. Tax Revenues. The tax effort, too, has been improving. In 2009, Lao PDR’s tax revenues were at 13.1% of GDP overtaking both the Philippines (12.8%) and Indonesia

                                                        57 ADB (2010), Asian Development Outlook.

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(11.6%), although still lower than the more developed economies of Thailand, Viet Nam, and Malaysia (Figure 3.42). Though relatively high, this tax effort has been able to support GDP growth. It signals to the private sector a fiscal discipline that in the long run ushers in a manageable interest-rate regime that is conducive to investment.

Figure 3.42. Tax Revenues (% of GDP)

Source: ADB (2010), Key Indicator 2010. 209. Inflation. The financial crisis in 1998 pushed Lao PDR’s inflation (based on consumer price index) to as high as 91% and 128% in 1998 and 1999, respectively (Figure 3.43). Inflation declined to 25% in 2000. Since 2005, inflation has been kept below 10%, although there was a slight increase from 2007 (4.5%) to 2008 (7.6%). The main factors, according to ADB (2010),58 were higher food and fuel prices, with the drought setting back food production and prices. Inflation is seen to average 5%–6% in 2010 and 2011, owing to upward pressure from higher global oil and food prices, a rapid growth in credit, the depreciation of the Kip against the baht, and, for 2010, the value-added tax.59

Figure 3.43. Inflation (%)

Source: WB (2011), World Development Indicators, Accessed January 2011.

                                                        58 ADB (2010), Key Indicators 2010. 59 ADB (2010), ADB Outlook Update

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3.4.2. Microeconomic Risks 210. Governance and Delivery of Public Goods and Services. Ineffective governance and weak institutional arrangements pose risks to appropriability of investment returns. Lao PDR has consistently ranked low in all dimensions of governance over the past decade or so, based on the World Governance Indicators (WGI) by the World Bank (Table 3.12). Not only has its rank been low in terms of governance indicators, but it likewise deteriorated further over the years, particularly in the aspects of Control of Corruption - from 39.8 in 1998 to 9.5 in 2009; Voice and Accountability - from 17.2 in 1996 to 4.7 in 2009; Government Effectiveness - from 24.8 in 1998 to 14.8 in 2009; and Political Stability - from 81.7 in 1996 to 43.9 in 2009 (Figure 3.44). While its rank in terms of Regulatory Quality and Rule of Law indicators improved, it remains at a level that leaves much to be desired (14.3 and 18.4, respectively, in 2009).

Table 3.12: Governance Indicators of Lao PDR, Percentile Rank60 Indicator 1996 1998 2000 2002 2003 2004 2005 2006 2007 2008 2009 Voice and Accountability 17.2 17.3 13.9 2.9 2.9 5.8 4.8 6.7 5.8 4.8 4.7

Political Stability 81.7 31.7 23.1 38.9 15.4 28.8 38.9 45.7 39.9 47.8 43.9 Government Effectiveness N/A 24.8 20.9 14.1 11.7 10.7 11.2 17.0 17.9 16.9 14.8

Regulatory Quality 3.9 14.6 7.3 7.3 5.9 9.3 10.2 9.3 13.1 14.5 14.3

Rule of Law 1.4 21.9 22.4 15.7 14.3 18.6 15.7 20.5 21.0 23.0 18.4 Control of Corruption N/A 39.8 25.7 13.1 11.7 8.7 10.2 8.7 7.2 7.2 9.5

Source: World Governance Indicators

Figure 3.44. Governance Indicators of Lao PDR, Percentile Rank

Source: WB, World Governance Indicators.

                                                        60 The percentile rank indicates the percentage of countries in the world that score below a given country. Thus, a

higher number indicates a higher rank or better performance by that given country.

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3.4.3 Control of Corruption 211. Corruption may not be viewed as a constraint by local firms operating in Lao PDR, but external investors note its importance in improving delivery of public services. It was only in late 1990s to early 2000 when the concern grew within the Lao PDR society that corruption was becoming widespread. Among the main causes are the new rent-seeking opportunities created by the new economic policies, increased foreign investment and donor aid, weak legal enforcement and low domestic salaries (UNDP, 2002). Decisions were made behind closed doors. Budget preparation and execution were not made transparent and not available to the public. 212. Comparison with its Southeast Asian neighbors suggests that Lao PDR, in controlling corruption, only fared better than Cambodia and Myanmar in 2009, and ranked much lower than the rest of ASEAN member countries (Figure 3.45).

Figure 3.45. Control of Corruption Indicators of South East Asian Countries

213. Transparency International’s Corruption Perception Index indicates similar picture. Lao PDR ranks 154 (together with Cambodia), higher only than Myanmar (ranked 176) out of 178 surveyed economies. Table 3.13 shows deterioration of Lao PDR’s performance as it used to be ranked 77 (out of 158 countries) in 2005.

Table 3.13. Transparency International’s Corruption Perception Index,

ASEAN Countries Country

2005 2006 2007 2008 2009 2010 R S R S R S R S R S R S

Brunei -- -- -- -- -- -- -- -- 39 5.5 38 5.5 Cambodia 130 2.3 151 2.1 162 2.0 166 1.8 158 2.0 154 2.1 Indonesia 137 2.2 130 2.4 143 2.3 126 2.6 111 2.8 110 2.8 Lao PDR 77 3.3 111 2.6 168 1.9 151 2.0 158 2.0 154 2.1 Malaysia 39 5.1 44 5.0 43 5.1 47 5.1 56 4.5 56 4.4 Myanmar 155 1.8 160 1.9 179 1.4 178 1.3 178 1.4 176 1.4 Philippines 117 2.5 121 2.5 131 2.5 141 2.3 139 2.4 134 2.4 Singapore 5 9.4 5 9.4 4 9.3 4 9.2 3 9.2 1 9.3 Thailand 59 3.8 63 3.6 84 3.3 80 3.5 84 3.4 78 3.5 Vietnam 107 2.6 111 2.6 123 2.6 121 2.7 120 2.7 116 2.7

No. of Countries 158 163 179 180 180 178

Note: R – Country Rank (with 1 as the highest rank), S – Score (with 10 as the highest) Source: Transparency International’s Corruption Perception Index

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214. The Lao PDR was among the first countries to sign the United Nations Convention against Corruption (UNCAC) in 2003. Following the National Assembly's resolution to ratify UNCAC on 22 September 2009, the Government of the Lao PDR deposited the instrument of ratification with the Secretary General of the United Nations in New York on 25 September 2009. Ratification of UNCAC has made 2009 a landmark year for the fight against corruption in the Lao PDR (United Nations). In December 2010, Lao PDR began the process of assessing its implementation of the UN Convention against Corruption. Lao PDR will then be reviewed under the UNCAC Mechanism for the Review of Implementation in 2011-2012 and has decided to commence work in advance of this review to conduct an open and participatory UNCAC Self-Assessment61. 215. It is interesting to note, however, that in the Lao PDR Investment Climate Survey (ICS) 2005 by ADB and World Bank, firms perceive that the three main constraints to growth and operations are infrastructure, regulation, and taxation, followed by macroeconomic uncertainty and finance. Surveyed firms do not consider skills, access to land, and corruption to be binding constraints to their operations. Only around 10% of firms named any issue related to governance as a major or severe constraint to their business. The governance indicators under the ICS 2005 include corruption, crime, theft and disorder, anti-competitive practices, legal system, and conflict resolution. The response to each issue among these was even lower than 10%. Nonetheless, governance issues such as control of corruption still need attention by the government given its low rank in the World Bank’s governance indicators. 216. Political Stability. Lao PDR started with a high of 81.7 percentile rank in terms of political stability in 1996, the year when the Sixth Congress of the Lao People’s Revolutionary Party (LPRP) approved changes that tipped the balance of power in favor of the party faction that opposed comprehensive and rapid reforms. Nonetheless, the Sixth Congress reaffirmed its commitment to Lao PDR’s reform policy, the New Economic Mechanism (Bourdet, 1997). Inasmuch as the political system was not liberalized, lack of transparency and accountability exacerbated Lao PDR’s difficulties in rebounding from economic problems that began with the Asian financial crisis in 1997 (Lintner, 2000). 217. The spate of bombings that targeted buses and bus stations in Vientiane and southern Lao PDR in years 2000 and 2003 caused the decline in its political stability performance that dipped to 23.1 in 2000 and to its lowest 15.4 in 2003. These suggested that opposition to the ruling party may be growing. Any public dissent, however, is dealt with harshly by the government. 218. Lao PDR regained political stability in recent years. Compared to its Southeast Asian neighbors, Lao PDR’s political stability in 2009 stood at 43.9 percentile rank, which is higher than Cambodia, Indonesia, Thailand, Philippines, and Myanmar (Figure 3.46).

                                                        61 The UNCAC Self-Assessment initiation workshop was held in conjunction with the celebrations for

International Anti-Corruption Day and took place on 14 and 15 December 2010. There were approximately 60 participants from all the main ministries and agencies in the Lao PDR government, including: the Government Inspection Authority, Ministry of Foreign Affairs, Ministry of Public Security (Police), Ministry of Justice, State Prosecution, Federal Court, Ministry of Information (Media) and Ministry of Planning and Investment. Representatives from the UNDP Asia-Pacific Regional Centre in Bangkok and the Basel Institute of Governance (BIG), Switzerland presented on the UNCAC and the UNCAC Self-Assessment process with support from UNDP Lao PDR and the International Law Project Office in Lao PDR.

Figure 3.46. Political Stability Indicators of South East Asian Countries

Source: World Governance Indicators, Accessed February 2011 219. Government Effectiveness. Based on 2010 WGI, Lao PDR’s performance in terms of government effectiveness was not impressive either. It started at a low of 24.8-percentile rank in 1998, plummeted to 10.7 in 2004, and improved slightly to 14.8 in 2009 but still lower than the 1998 level (Figure 3.47).

Figure 3.47. Government Effectiveness Indicators of South East Asian Countries

Source: World Governance Indicators, Accessed February 2011 220. Lao PDR is currently undergoing transition from a centrally planned to a market economy, from a subsistence-oriented and largely self-contained economy to a commercially oriented and regionally integrated economy, and from an agrarian to more urbanized society. These transitions pose challenges in terms of public finance, delineation of powers and responsibilities among different levels of government, and development

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financing. There is need to shift the focus of government activity toward delivering infrastructure, education, and health services (ADB, 2010). 221. Comparison with other ASEAN countries paints a bleaker picture. Lao PDR’s performance in terms of government effectiveness has consistently been at the bottom two. Its score of 14.8-percentile rank in 2009 is above only than that of Cambodia at 1.0 percentile rank. 222. While significant efforts were made to address problems of access to basic social services, education and health still required major improvements. Based on the Lao PDR’s status of Millennium Development Goals (MDG) progress (appendix to ADB, 2010), only 61.5% of pupils starting grade 1 reached last grade of primary (2006); literacy rate for 15-24 age bracket stands at 82.5% (2007); only 20.3% of births have been attended by skilled health personnel (2006); only 40% of 1-year old children have been immunized against measles (2007); and only 35.1 percent of women aged 15-49 was given antenatal care (2006). Poor road connection made access to services even more difficult (ADB, 2010). 223. Voice and Accountability. While the 115 members of the National Assembly, the single chamber parliament, are elected by popular vote, the candidates are selected by the only legal political party, the LPRP. The National Assembly elects the President, who heads the state, for a five-year term. The Prime Minister, who heads the government, is nominated by the President and elected by the National Assembly for a five-year term. This system somehow limits the people’s participation in selecting their government. 224. Through the years, the ruling party has always maintained strict control over the media. The government owns all newspapers and broadcast media. Newspaper circulation is very low. Slandering the state, distorting party policies, and spreading false rumors are all considered criminal offenses (http://news.bbc.co.uk/2/hi/asia-pacific/country_profiles/1154621.stm). Media rights group, Reporters Without Borders (RSF) noted in 2010 that “the activities of the President and top party leaders are always the lead stories in the state media, which are the only media permitted.” 225. All these conditions work against Lao PDR such that among all the governance indicators, Lao PDR scores the lowest in voice and accountability indicator -- only 4.7 percentile rank in 2009, from an even lower score of 2.9 in 2002 and 2003, which may be explained by the arrest of foreign journalists reporting on a little-known anti-government rebellion by members of the ethnic Hmong minority. The government has long denied the existence of the anti-communist rebel movement, which has been around for decades, and has suppressed information about the military's efforts to crush the insurgency. 226. Compared to other ASEAN countries, Lao PDR likewise consistently ranked lower than other South East Asian countries in voice and accountability (Figure 3.48).

Figure 3.48. Voice and Accountability Indicators of South East Asian Countries

Source: World Governance Indicators, Accessed February 2011 227. Rule of Law. While Lao PDR improved its rank in Rule of Law indicator from a low of 1.4 in 1996 to 18.4 in 2009, it still fared worse compared to other ASEAN countries, scoring higher only than Cambodia (16.0) and Myanmar (3.8) in 2009 (Figure 3.49).

Figure 3.49. Rule of Law Indicators of South East Asian Countries

Source: World Governance Indicators, Accessed February 2011 228. Human trafficking is a serious crime and has become a matter of high concern in the Lao PDR. Approximately 60,000 young people try to enter the labor force each year, but employment opportunities are very limited making migration an attractive alternative for many young people in search of work. The lack of public awareness of laws and legislation makes potential migrants vulnerable to exploitation and human trafficking.

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Malaysia

Brunei

Cambodia

Vietnam

Laos

Myanmar

Percentile Rank

2009

2004

1998

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Brunei

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Thailand

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Vietnam

Indonesia

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Cambodia

Myanmar

Percentile Rank

2009

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1998

229. Since the mid 1990s, drugs trafficking have become an increasingly serious problem. The Lao PDR lacks both human and financial resources to effectively police its 5,083-kilometer long border with Myanmar (235 km), Cambodia (541 km), China (423 km), Thailand (1,754 km), and Viet Nam (2,130 km). Most drug smuggling takes place in the Northern region and across the Mekong River in transit from Myanmar on its way to other countries 230. The Government has expressed its concerns on the increase in related corruption and money laundering. Because of its geographical location and its vulnerability, the country is attracting the attention of trans-national criminal organizations and is at risk of becoming a hub for storage, illicit transit trafficking, and drug consumption in the region. Although there are no indication that large scale production of synthetic drugs currently occurs in the Lao PDR, strategic analysis indicate that it is only a matter of time before synthetic drugs are secretly produced in the country. 231. The Lao PDR has a civil law system that is closely modeled on the Soviet/Chinese legal systems. For now, the fundamental rights declared in the Constitution do not include any rights relating to criminal justice. Presumption of innocence and the right to be represented are among the rights declared by the Criminal Procedure Law but there is no right to silence. The criminal justice system is inquisitorial and trials are sometimes conducted with reliance on confessions without witnesses being present. There is no requirement that the prosecution should prove the admissibility of a confession and the accused do not get an opportunity to show that a confession has been extracted. 232. The legal profession is also fragile. With less than 100 lawyers in the whole country, the required expertise about laws, legal concepts and judicial processes is very limited and legal drafting skills remain weak. A majority of the members of the National Assembly and legal sector officials do not have a sufficient legal background. There are not enough judges and serving judges with competent legislative and judicial expertise. Lack of funding often prevents the implementation of general basic legal training (United Nations). 233. Regulatory Quality. The 2010 WGI shows that while Lao PDR improved its rank in Regulatory Quality indicator from a low of 3.9 in 1996 to 14.3 in 2009, it still fared worse compared to other ASEAN countries (Figure 3.50). Lao PDR scored higher only than Myanmar (1.0) in 2009.

Figure 3.50. Regulatory Quality Indicators of South East Asian Countries

Source: World Governance Indicators, Accessed February 2011

0 20 40 60 80 100

Singapore

Brunei

Malaysia

Thailand

Philippines

Indonesia

Cambodia

Vietnam

Laos

Myanmar

Percentile rank

2009

2004

1998

234. Lao PDR’s comparatively liberal investment law is significantly undermined by inconsistency in implementation. The decline in foreign direct investment after 1996, while partly due to the regional economic crisis, was rooted in other factors as well, such as bureaucratic impediments to the application process; a lack of transparency in the regulatory framework; a lack of skilled workers; and an uncertain domestic economic environment (US Embassy, Vientiane, Lao PDR. 2007). 235. The principal laws, regulations, decrees and guidelines governing international trade and investment, as well as the protection of intellectual property, are available to the public, although not all have been officially translated into English. Laws and their schedules for implementation are customarily published in the Lao PDR daily newspapers, and relevant line ministries are beginning to put laws and regulations on websites. While Lao PDR’s body of enterprise law is slowly taking off, the interpretation and application of existing laws is one of the greatest impediments to investment. A lack of transparency in a centralized decision-making process, as well as the difficulty encountered in obtaining information, augment the perception of the regulatory framework as arbitrary and unfathomable (US Embassy, 2007). 236. Results of the Lao PDR Investment Climate Survey 2005 by ADB and World Bank confirm the same findings. Firms place regulatory uncertainty—i.e., inconsistent interpretations of laws and regulations—high on the list of major or severe constraints to their businesses (see Figure 3.51). Almost 30% of firms, and nearly half of firms complained about regulatory policy uncertainty being a severe constraint to their business. In addition, on average, firms spent about 5% of their time dealing with officials, with firms in textiles spending more than 6% of their time.

Figure 3.51. % of firms identifying regulatory policy uncertainty as “major” or “severe” obstacle

237. Garment industry firms and exporters in general reported the highest burden of regulations, especially customs regulations, while firms located in Champassack felt especially burdened by unpredictable regulations. Textile firms reported higher “time tax,” i.e., time spent with regulators. Wood-processing firms have more inspections (averaging 26 times a year) due to inspections by the Forestry Department in addition to several other agencies. Firms that exported felt more burdened by regulations than other firms (see Figure 3.52). Overall, the results of the ICS suggest that the regulatory burden is slightly greater for exporters than for non-exporters. This has important policy implications for the Lao PDR since its Sixth NSEDP emphasizes rapid export growth as a key driver of overall growth, and reducing regulations maybe a least-cost way of promoting that objective.

Figure 3.52. Regulatory burden on exporters versus non-Exporter

238. Inspections are more common in the Lao PDR than in most comparator countries. Firms that were inspected more often spent a longer time dealing with government authorities and were also more likely to pay bribes. Most inspections came from the Forest, Customs, and Tax departments, and these agencies—plus the economic police—were among those most frequently expecting informal payments. For example, 56% of firms said that a bribe was expected for getting an import or export license, and more than 30% of firms said that a payment was expected by a tax official. Yet only 9% of firms cited corruption as a major or severe constraint, notwithstanding high regulatory uncertainty, considerable officials’ discretion and frequent inspections.

239. Taxation. Tax rates in Lao PDR are generally comparable to those of other ASEAN countries but paying taxes may be considered a cumbersome process. While Lao PDR has the highest corporate income tax in the Southeast Asian region at 35% followed by the Philippines and Thailand at 30%, it enjoys a relatively low value added tax (VAT) at 5% and 10%, lower than the Philippines’ 12% VAT, and comparable to Vietnam, Cambodia, Indonesia and Malaysia which likewise impose 10% VAT (Table 3.14). Thus, the tax rates alone may not make investing in Lao PDR less attractive than in the region’s other economies.

Table 3.14. Tax Rates in Southeast Asia (%) Country Corporate Income Tax VAT

Lao PDR 35 5, 10 Thailand 30 7 Philippines 30 12 Indonesia 28 10 Vietnam 25 10 Malaysia 20 (on first RM500,000) 25 (on the balance) 10 (Sales) Brunei Darussalam 23.5 -- Cambodia 20 (or 1% on turnover, whichever is higher) 10 Singapore 17 7 (GST)

Source: Doing Business Survey 2011 240. The total tax rate62 (as a percentage of profit) in Lao PDR, at 33.7%, is relatively comparable to other ASEAN countries (Figure 3.53).

                                                        62 In 2011 Doing Business Survey, the total tax rate, expressed as a percentage of profit, aggregates corporate

income tax; mandatory social contributions and labor taxes paid by the employer; property and property transfer

Figure 3.53. Total tax rate (% of profit)

Source: 2011 Doing Business Survey

241. However, the cumbersome process of paying taxes in Lao PDR may deter some investment. 2011 Doing Business Survey reports that, on average, a business in Lao PDR has to make 34 tax payments a year (Figure 3.54), requiring about 362 hours of work (Figure 3.55).

Figure 3.54. No. of tax payments per year

Source: 2011 Doing Business Survey

Figure 3.55. No. of hours per year to pay taxes

Source: 2011 Doing Business Survey

                                                                                                                                                                            taxes; dividends, capital gains, and financial transaction taxes; and waste collection, vehicle, road and other taxes.

0 5 10 15 20 25 30 35 40 45 50

Philippines

Thailand

Indonesia

Malaysia

Lao PDR

Vietnam

Brunei Darussalam

Singapore

Cambodia

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Cambodia

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Vietnam

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Singapore

242. Doing. Business. In the 2011 Doing Business Survey, Lao PDR ranked 93rd, in terms of ease of starting a business, behind only Singapore ranked high at 4th, but the rest of the ASEAN countries are close to one another. It indicated that an investor needed to go through seven (7) procedures (Figure 3.56), requiring up to 100 days to start a business (Figure 3.57), although at a relatively lower cost of 11.3% of income per capita (Figure 3.58). This may account for the relatively low number of private firms that operate in Lao PDR (ICS Lao PDR, 2005).

Figure 3.56. No. of procedures to start a business

Source: 2011 Doing Business Survey

Figure 3.57. No. of days to start a business

Source: 2011 Doing Business Survey

Figure 3.58. Cost of starting a business (% of income per capita)

Source: 2011 Doing Business Survey

0 2 4 6 8 10 12 14 16

Philippines

Brunei Darussalam

Vietnam

Malaysia

Indonesia

Cambodia

Thailand

Lao PDR

Singapore

0 20 40 60 80 100 120

Brunei Darussalam

Lao PDR

Cambodia

Indonesia

Vietnam

Philippines

Thailand

Malaysia

Singapore

0 20 40 60 80 100 120 140

Cambodia

Philippines

Indonesia

Malaysia

Brunei Darussalam

Vietnam

Lao PDR

Thailand

Singapore

243. Investors’ perception of Lao PDR’s competitiveness and ease of doing business has generally been poor. The 2011 Doing Business Survey ranked Lao PDR 171st out of 183 countries based on ease of doing business, placing it at the bottom among ASEAN countries63 (Table 3.15). The latest ranking of Lao PDR in terms of doing business could lead to a further deterioration of the investment climate unless government takes firm action to create an enabling and market-friendly environment.

Table 3.15. Doing Business (DB) Survey Results Topic Rankings DB 2011 Rank DB 2010 Rank Change in Rank

Starting a Business 93 87 -6 Dealing with Construction Permits 115 114 -1 Registering Property 163 162 -1 Getting Credit 152 150 -2 Protecting Investors 182 182 No Change Paying Taxes 116 109 -7 Trading Across Borders 170 170 No Change Enforcing Contracts 110 110 No Change Closing a Business 183 183 No Change Overall Ranking 171 169 -2

Source: World Bank, http://www.doingbusiness.org/

244. Making trade between countries easier is increasingly important for business in today’s globalized world. Excessive document requirements, burdensome customs procedures, inefficient port operations, and inadequate infrastructure all lead to extra costs and delays for exporters and importers, stifling trade potential. 245. In terms of trading across borders, Lao PDR exhibited poor performance ranking 170th and landing at the bottom among ASEAN countries. Cambodia follows at 118th, Vietnam at 63rd, and the Philippines at 61st. An entrepreneur in Lao PDR has to deal with a lot of requirements and tedious processes, and will have to shell out a large sum of money, before it can export. 2011 Doing Business Survey shows that Lao PDR has 9 required documents (highest next to Cambodia, Figure 3.59), which will take the longest time (48 days) to process in the region (only 22 days in Cambodia, Figure 3.60), before it is allowed to export, at a staggering cost of US$1,860 per container (Figure 3.61) which is accordingly the most expensive in the region.

Figure 3.59. No. of documents to export

Source: 2011 Doing Business Survey

                                                        63 Myanmar was not part of the 2011 Doing Business Survey.

0 2 4 6 8 10

Cambodia

Lao PDR

Philippines

Malaysia

Vietnam

Brunei Darussalam

Indonesia

Thailand

Singapore

Figure 3.60. No. of days to export

Source: 2011 Doing Business Survey

Figure 3.61. Cost to export (US$ per container)

Source: 2011 Doing Business Survey

246. Likewise, based on 2011 Doing Business Survey, an entrepreneur in Lao PDR has 10 required documents (Figure 3.62), which will take 50 days to process (Figure 3.63), before it is allowed to import, at a staggering cost of US$2,040 per container (Figure 3.64).

Figure 3.62. No. of documents to import

Source: 2011 Doing Business Survey

0 10 20 30 40 50

Lao PDR

Brunei Darussalam

Vietnam

Cambodia

Indonesia

Malaysia

Philippines

Thailand

Singapore

0 200 400 600 800 1000 1200 1400 1600 1800 2000

Lao PDR

Cambodia

Indonesia

Philippines

Brunei Darussalam

Thailand

Vietnam

Singapore

Malaysia

0 2 4 6 8 10

Lao PDR

Cambodia

Vietnam

Philippines

Malaysia

Indonesia

Brunei Darussalam

Singapore

Thailand

Figure 3.63. No. of days to import

Source: 2011 Doing Business Survey

Figure 3.64. Cost to import (US$ per container)

Source: 2011 Doing Business Survey

247. The 2011 Doing Business Survey used three (3) indices of investor protection, namely, extent of disclosure index, extent of director liability index, and ease of shareholder suits index. Stronger investor protection matters for the ability of companies to raise the capital needed to grow, innovate, diversify, and compete. In terms of protecting investors, Lao PDR scored the lowest (1.7, Rank 182) among Southeast Asian countries followed by Vietnam, the Philippines and Brunei Darussalam (Figure 3.65).

Figure 3.65. Strength of investor protection index (0 - 10)

Source: 2011 Doing Business Survey

0 10 20 30 40 50

Lao PDR

Indonesia

Cambodia

Vietnam

Brunei Darussalam

Philippines

Malaysia

Thailand

Singapore

0 500 1000 1500 2000 2500

Lao PDR

Cambodia

Thailand

Philippines

Brunei Darussalam

Indonesia

Vietnam

Malaysia

Singapore

0 1 2 3 4 5 6 7 8 9 10

Lao PDR

Vietnam

Philippines

Brunei darussalam

Cambodia

Indonesia

Thailand

Malaysia

Singapore

Chapter 4. Critical Constraints to Reducing Poverty and Inequality

248. In line with the HRV growth diagnostic approach, this study has identified cost of finance as one of the most critical constraint to growth; easing this constraint provides an impulse that can carry the momentum of growth in Lao PDR seen in the past few years into the Seventh Plan period. The vision for this Plan, however, calls for inclusive growth; to realize this, the GOL need to address some major constraints to long-run sources of growth.

249. While recent aggregate economic growth has been remarkable, concerns linger about the inclusiveness of this growth. These concerns stem, for instance, from the observation that many agricultural workers are still engaged in subsistence agriculture. In addition, a number of urban non-agricultural workers are doing informal low-wage work, trapped in poverty. Moreover, the incidence of malnutrition among children between age 0 and 5 is high, while the decline in the maternal mortality rate is waning. All this indicates that at this stage, many individuals and households continue to be excluded, lagging behind and experiencing severe difficulties. Efforts must be exerted to help them escape economic deprivation, and in the process, provide potential sources of new growth.

250. Many of the interventions needed to overcome these critical constraints to inclusive growth must emanate from the government, although some corrective actions can be done in partnership with the private sector. The reason is that these interventions may be viewed as investments wherein the social rates of returns exceed the private rates. Benefits spill over to third parties for whom the individual or family investing is not compensated, and so under-investments are likely to take place. The government thus intervenes to come close to society’s total needs. 4.1 Access to Opportunities 4.1.1. Human Capabilities

251. Understanding the barriers to inclusive growth typically starts with the human capital that people have. Human capital is about the efficiency units, for example, that labor brings to the workplace. It accumulates through the years with investments in, for instance, education, training, and health and nutrition. People with more human capital tend to be more productive than their counterparts that have less, evident from the positive correlation between schooling and earnings that is observed with regularity in a variety of country settings.

252. In a growth context, expanding physical capital is subject to diminishing marginal productivity, but if human capital also increases, then this diminishing marginal productivity is thwarted. The skills acquired from human-capital investments raise the overall index of knowledge in the economy with salutary effects on growth. Lucas (1988), for instance, has emphasized this point.

253. Empirical sources-of-growth studies confirm that growth does not come from mere addition to labor and capital. After accounting for the contributions of these two factors of production to overall output growth, a large residual remains. One major factor behind this large residual is human capital and the efficiency gains it makes possible [Solow (1957) and Denison (1962)].

254. Human capital has at least two avenues to growth. People with higher schooling years have higher labor force participation rates. This is observed, for example, in the case of women in many countries, whose labor force participation rate has gone up as a result of

higher educational attainment. In addition, once employed, people endowed with human capital can easily master any new production technique that emerges, which translates into higher productivity on the job. As they settle into permanent employment, experience on the job then leads to further accumulation of efficiency units, while earnings rise accordingly.

255. In contrast, if educational attainment is limited, wage offers tend to be low, which do not encourage members of the labor force to engage in job search. Labor force participation rates by age groups and gender are, in consequence, dampened.

256. Statistics on educational attainment in Lao PDR are not encouraging, particularly, when compared to the other countries in the GMS. Access to primary schools in Lao PDR may be high, but completion rates are low. As a result, few children of school age have access to even the lower secondary schools, much less to higher secondary schools. School children in rural areas are the most disadvantaged in this regard [see Luis Benveniste, Jeffrey Marshall, and Lucrecia Santibanez (undated)].

257. Individuals with limited educational attainment tend to have inferior job opportunities than their more educated counterparts. The unskilled, if hired, have low wages. If economic conditions take a downturn, they‘re the first to be fired. They have high turnover rates, and go through long spells of unemployment, forgoing skills that are acquired on the job. A look at some labor market indicators---labor force participation rates, employment, underemployment, and unemployment, productivity and wages---is instructive.

258. Financial constraints to human capital accumulation. Workers thinking of shifting occupations may need to invest in skill acquisition through education and training. In the absence of loans for education and training, they have to save and accumulate wealth first to be able to invest in human capital. Meanwhile, the wealthy are able to invest at once and capture the returns accordingly. The poor get behind in socio-economic status as growth proceeds. 259. Human capital investment plays an important role in long-run growth. We investigate this role more closely in the context of inclusive growth, and the extent to which human capital constrains Lao PDR’s growth, not in the short run, but as Lao PDR pursues its goal to move up to a higher development status.

4.1.1.1 Education 260. In view of the important role education plays in determining labor-market status of people, and the labor market being the major source of economic opportunities, we look at some indicators of the status of education in Lao PDR. In relation to the other countries in Southeast Asia, a catch-up in education is indicated. Within the Lao PDR, the disparities among individuals and groups suggest some affirmative actions to produce equitable education outcomes in the long run.64 261. Quality basic education is the stage in which essential skills of literacy and numeracy (reading, writing, and numbers) are first acquired. These vital work skills provide a foundation of human capital needed for higher productivity employment and competitiveness in global markets, particularly for countries in which the economy is still predominantly reliant on agriculture and low-skilled manufacturing. Although examining input indicators such as attainment of basic education does not provide an accurate gauge of the quality of basic education, it can offer insights into the extent to which children participate in education as preparation for the labor force and a decent work life.

                                                        64 This has also been observed, for example, in Benveniste et. al. (no date). For the GOL plan for the education

sector, see Ministry of Education (2009).

262. Millions of children in ASEAN cannot access or complete basic education because of the costs of schooling and the need to support family income or care for siblings. Unfriendly school environments and poorly equipped schools with inadequately trained teachers are additional factors that often deter parents from enrolling or keeping their children in education. Early school drop-out often results in child labor as well as unemployed or underemployed youth who lack the skills to form a high-quality workforce (ILO, 2008). 263. By neglecting universal basic education for all children now, countries are risking a future labor force that could lack the essential skills needed for increasing national competitiveness in rapidly changing regional and global markets. Thus, for Southeast Asian countries at lower levels of per-capita income, such as Lao PDR, strengthening the quality of basic education and improving access to and completion of primary and lower secondary education should be the priority focus in their education and training policies, while targeting vulnerable children and youth who have been left out of the school system (ILO, 2008). 264. Primary Education completion rate. Throughout ASEAN, tremendous efforts have been made to enhance access to primary education (Table 4.1). Primary net enrolment rates have exceeded 90 per cent for all countries, with the exception of Cambodia (89.9 per cent) and the Lao PDR (83.7 per cent). Unfortunately, many children in the ASEAN region do not remain long enough in the school system to acquire even basic literacy and numeracy skills. The survival rates to grade 5 in 2005 were only 62 percent in the Lao PDR, 62.2 percent in Cambodia, and 71.5 percent in Myanmar. In addition, of the children who do complete primary education in those three countries, only 81.2 percent in Cambodia, 77 percent in Lao PDR and 73.8 percent in Myanmar make the transition to lower secondary school. In contrast, transition rates in Malaysia and the Philippines exceed 99 per cent and are nearly 93 per cent in Vietnam.

Table 4.1. Key education indicators, selected ASEAN Member Countries, most recent year (%)

Net enrolment rate, Primary

Survival rate to grade 5

Transition from primary to lower secondary

Net enrolment rate, Secondary

Tech, & vocational enrolment as share of secondary enrolment

2006 2005 2005 2006 2006 Lao PDR 83.7 62.0 77.0 34.9 1.2 Cambodia 89.9 62.2 81.2 30.8 3.2 Myanmar 99.6 71.5 73.8 45.7 -- Vietnam 94.5 92.1 92.7 61.0 5.0 Indonesia 95.5 84.4 88.5 59.0 13.6 Philippines 91.4 74.0 99.1 60.4 -- Thailand 94.2 -- -- 71.0 15.5 Malaysia 99.9 99.3 99.6 68.7 5.9

Notes: '--' denotes data not available; enrolment data are from 2006 except Malaysia (2005); survival and transition are from 2005 except Malaysia (2004). Source: UNESCO Institute for Statistics, accessed July 2008.

Source: As quoted in ILO, Labor and Social Trends in ASEAN 2008 265. High rates of primary school enrollment have been achieved in many economies; however, too many children still leave before completing the last grade. Between 2000 and 2008, Lao PDR improved in terms of primary education completion rate from 69.3 percent in 2000 to 74.7 percent in 2008 unlike some economies in the region (Table 4.2).

Table 4.2. Primary education completion rate (percent) Both Sexes Female Male 2000 2008 2000 2008 2000 2008

Southeast Asia

Brunei Darussalam 121.7 105.7 121.3 106.9 122.0 104.6

Cambodia 47.2 79.5 41.2 79.0 53.1 79.9 Indonesia 98.2 108.1 98.7 106.9 97.8 109.3 Lao PDR 69.3 74.7 63.3 71.0 75.1 78.3 Malaysia 94.0 96.4 93.4 96.2 94.6 96.5 Myanmar 79.9 96.9 77.8 99.7 82.0 94.1 Philippines 101.5 92.3 106.3 95.1 96.8 89.6 Singapore … … … … … … Thailand 87.0 87.5 86.7 88.5 87.3 86.6 Viet Nam 96.4 … 94.2 … 98.5 …

Source: ADB, Key Indicators for Asia and the Pacific 2010

266. Educational Attainment Educational attainment improved with 27.3 percent of the population gaining education beyond primary schooling in 2005, compared to only 15.7 percent in 1995 (Figure 4.1). The population with no education fell from 42.5 percent to 26.4 percent during this period.

Figure 4.1. Highest Level of Education Completed among Population Aged 6 and Above, 1995 and 2005

Source: http://www.nsc.gov.la/Products/Populationcensus2005/PopulationCensus2005_chapter4.htm, downloaded on 18 October 2010. 267. Based on the Lao Expenditure and Consumption Survey (LECS) 2007/08, the share of population aged six and above with no education fell to 18.3 percent in 2007-08 (See Figures 4.2 and 4.3). While disparity in educational attainment is significant between male and female population, disparity is more pronounced among different ethnic groups. One-fourth of the female population has not attended any schooling whereas only 11 percent of the male population has not. In terms of ethnicity, the difference is starker with one in every three persons with non Lao-Tai ethnicity having no education compared to just one in every 10 persons of Lao-Tai origin having received no education. Residents of urban areas and of the Central region perform better in educational attainment compared to the rest of the

0%

10%

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60%

70%

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1995 2005

>primary

primary completed

primary not completed

none

population. The availability of roads makes a significant difference in educational attainment of the population in rural areas.

Figure 4.2. Highest Level of Education Completed (Age 6+, 2007)

Source: Authors’ estimate based on Lao Expenditure and Consumption Survey 2007/08

Figure 4.3. Highest Level of Education Completed (Age 6+, 2007) by Province

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Phon

gsaly

Luan

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tha

Oud

omxa

y

Boke

o

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gpra

bang

Huap

hanh

Xaya

bury

Vien

tiane

Cap

ital

Xien

gkhu

ang

Vien

tiane

Borik

ham

xay

Kham

mua

ne

Sava

nnak

het

Xays

ombo

on S

R

Sara

vane

Seko

ng

Cham

pasa

ck

Atta

peu

North Central South

None Primary Secondary University/Vocational

Source: Authors’ estimate based on Lao Expenditure and Consumption Survey 2007/08 268. Literacy rates in Lao PDR also show improvement in the past decade, but the country still lags behind its regional neighbors, and gender disparity is pronounced (See Figures 4.4-4.6). Literacy correlates with cognitive ability, a trait that affects productivity on the job.

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Lao

Urban

Rural without road

North

South

female

None Primary Secondary University/Vocational

Figure 4.4. Adult Literacy Rate among 15 Years and Above (%)

Note: Figures for Cambodia in 2000 refer to 1998 and Indonesia to 2004. In 2008, figures for Indonesia refer to 2006, Lao PDR to 2005, and Thailand to 2005.

Source: ADB (2010), Key Indicators for Asia and the Pacific 2010.

Figure 4.5. Adult Literacy Rate among 15 Years and Above by Geographical Category and Gender (%)

Source: Ministry of Planning and Investment, Department of Statistics (2009). The Household of Lao PDR Social and Economic Indicators: Survey Results on Expenditure and Consumption of Household 2007/08 LECS 4.

0

20

40

60

80

100

Cam

bodi

a

Indo

nesi

a

Lao

PD

R

Mal

aysi

a

Phi

lippi

nes

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gapo

re

Thai

land

Viet

Nam

Cam

bodi

a

Indo

nesi

a

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R

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Nam

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a

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a

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PD

R

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a

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nes

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gapo

re

Thai

land

Viet

Nam

Both Sexes Female Male

2000 2008

-

20

40

60

80

100

Lao PDR Urban Rural North Center South

Female Male

Figure 4.6. Adult Literacy Rate among 15 Years and Above by Province and Gender (%)

Source: Ministry of Planning and Investment, Department of Statistics (2009), The Household of Lao PDR Social and Economic Indicators: Survey Results on Expenditure and Consumption of Household 2007/08 LECS 4. 269. Gender-bias favors the male population in terms of employment in non-farm economic enterprises (see Figure 4.7). Given the same level of vocational, technical, college or university education, the male population is more likely to be employed than their female counterparts.

Figure 4.7. Distribution of Male and Female Workers by Education Attainment in

Non-Farm Economic Enterprises (2006)

Source: Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th National Human Development Report.

-

20

40

60

80

100

Pho

ngsa

ly

Luan

gnam

tha

Oud

omxa

y

Bok

eo

Luan

gpra

bang

Hua

phan

h

Xay

abur

y

Vie

ntia

ne C

apita

l

Xie

ngkh

uang

Vie

ntia

ne

Bor

ikha

mxa

y

Kha

mm

uane

Sav

anna

khet

Sar

avan

e

Sek

ong

Cha

mpa

sack

Atta

peu

North Central South

Female Male

0% 20% 40% 60% 80% 100%

University

College

Technical

Vocational

General

Unspecified

Male Female

270. A little over one-third of all female workers have no education, which makes them vulnerable to getting low-wage employment (Figure 4.8). Geographic disparities in educational attainment also show major disparities (Figure 4.9).

Figure 4.8. Distribution of Education Attainment by in Non-Farm Economic Enterprises (2006)

Source: Ministry of Planning and Investment and UNDP. 2009, Employment and Livelihoods: The 4th National Human Development Report.

Figure 4.9. Distribution of Education Attainment by Geographical and Demographic Categories (2007/08)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Lao

Urb

an

Rur

al w

ith

road

Rur

al

with

out r

oad

Nor

th

Cen

tral

Sout

h

fem

ale

mal

e

Non

Lao

-Tai

Lao-

Tai

None Primary Secondary University/Vocational

Source: Authors’ estimate based on Lao Expenditure and Consumption Survey 2007/08

271. Enrolment rates. Across all levels, despite improvement over the past decade, enrolment rates are low compared to other countries in the region (See Figure 4.10).

0%

20%

40%

60%

80%

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Note: Net primary school enrolment figures for Malaysia in 2008 refer to 2007 and the Philippines in 2000 refer to 1999; Net secondary school enrolment figures for Cambodia, Lao PDR, and Malaysia in 2008 refer to 2007 and for the Philippines in 2000 to 1999; and Gross tertiary enrolment for Indonesia in 2000 refer to 2001, Malaysia in 2008 to 2007, and the Philippines in 2000 to 1999. No data for Singapore. Source: WB (2010), World Development Indicator. Accessed on 20 October 2010.

272. School enrolment for 6-10 year olds are fairly equal for both girls and boys, but the imbalance occurs for those aged 11-15, particularly in the Northern region and rural areas with no access to roads (see Table 4.3, Figure 4.11). This could also be reflecting the higher opportunity cost of sending older children to school, especially in more depressed areas. This is even more pronounced at the provincial level.

Table 4.3. Net School Enrolment (%) among children Age 6-10 Age 11-15 Girls Boys Girls Boys Lao PDR 78 80 90 95 Urban 94 93 98 99 Rural with Road 76 80 90 95 Rural without Road 69 67 77 91 North 74 78 85 95 Center 84 85 94 96 South 76 75 90 94

Source: Ministry of Planning and Investment, Department of Statistics (2009), The Household of Lao PDR Social and Economic Indicators: survey results on expenditure and consumption of household 2007/08 LECS 4.

Figure 4.11. Net School Enrolment Among Children Aged 11-15 by Province (2007, %)

Source: Ministry of Planning and Investment, Department of Statistics (2009), The Household of Lao PDR Social and Economic Indicators: survey results on expenditure and consumption of household 2007/08 LECS 4. 273. Male enrolment rates exceed those of females (see Table 4.4). While other countries in the region show greater gender parity in terms of opportunities to education, Lao PDR lags behind, particularly at the secondary and tertiary levels. For all school levels, the ratio falls below the regional average.

Table 4.4. Female-Male Ratio for Gross/Net Enrollment Ratios by Gender (2007)

Primary (net) Secondary (net) Tertiary (gross) Cambodia 0.96 0.88 0.56 Indonesia 0.96 1.01 1.00 Lao PDR 0.95 0.87 0.72 Malaysia 1.00 1.10 1.22 Philippines 1.02 1.20 1.24 Thailand 1.12 1.23

Southeast Asia, average 0.99 1.04 1.11

Note: For Malaysia, primary figures refer to 2006, secondary to 2005, and tertiary to 2006. For the Philippines, tertiary figures refer to 2006. Source: Economic and Social Commission for Asia Pacific (ESCAP), Statistical Yearbook 2009.

274. Education Spending. Although Lao PDR’s public spending on education, as a per cent of GDP, is relatively not far from that of the Philippines and Singapore, it is one of the lowest in the region. Lao PDR is only ahead of Cambodia based on most recent data (Figure 4.12).

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Source: World Bank (2010), World Development Indicator. Accessed on October 2010

4.1.1.2. Health 275. Health is another important source of human capital. People with good health and nutritional status are likely to be productive in the workplace. The malnourished and the undernourished among children are likely to be sick more often, and are vulnerable to high absenteeism rates in school. This may persist even when they assume their adult role as workers. It is thus important to pay equal attention to health as a source of human capital.

Health Outcomes. Life expectancy at birth has improved over the past two decades. However, Lao PDR still lags behind its neighbors in this dimension of health (Figure 4.13).65

Figure 4.13. Life Expectancy at Birth (Years)

Source: ADB (2010), Key Indicators for Asia and the Pacific 2010.

276. Rate of malnutrition is the highest in the region with almost one in every four persons suffering from undernourishment (Figure 4.14).

                                                        65 For an elaborate assessment, see ADB (2010e).

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energy requirements continuously. Source: WB (2010), World Development Indicators. Accessed on 22 October 2010. 277. Infant and under-five mortality rates have dropped significantly over the past two decades (Figure 4.15 and 4.16). However, Lao PDR continues to trail its neighbors by a large margin.

Figure 4.15. Infant Mortality Rate (per 1,000 live births)

Source: ADB (2010), Key Indicators for Asia and the Pacific 2010.

Figure 4.16. Under-Five Mortality Rate (per 1,000 live births)

Source: ADB (2010), Key Indicators for Asia and the Pacific 2010.

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278. While there is a general improvement in the Infant Mortality Rate (IMR) between 1995 and 2005, the IMR rose in five provinces, namely, Oudomxay, Khammuane, Saravane, Sekong, and Attapeu (Figure 4.17). According to the Ministry of Planning and Investment and UNDP (2009), the regional variation in IMR more than doubled during the period from 1995 to 2005, indicative of an increase in regional disparity in health outcomes. The study also underscores the deterioration of IMR in Khammuane and Saravane, which are not even located in the hinterland.

Figure 4.17. Infant Mortality Rate by Province (per 1,000 live births)

Source: Ministry of Planning and Investment and UNDP (2009), Employment and Livelihoods: The 4th

National Human Development Report. 279. While significant progress has been made in other indicators of health outcomes, maternal mortality rate (MMR) did not change between 1990 and 2000 and even worsened between 2000 and 2005 (Figure 4.18). It is almost fifty times worse compared to Singapore’s level in 2005.

280. Uncertainty about lifetime has significant negative economic effects. Saving is dampened, with parents showing a high degree of preference for consuming in the current period. With meager savings, couples are not able to invest in the human capital of their children, resulting in an inter-generational transmission of poor human capital endowments.

Figure 4.18. Maternal Mortality Rate (per 100,000 live births)

Source: ADB (2010), Statistical Database System. Accessed on November 2010.

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281. Access to Health Services. The poor performance in maternal mortality rates mirrors the performance in terms of proportion of births attended by skilled health personnel and antenatal care coverage (See Figures 4.19 and 4.20). The former worsened between 1995 and 2007 and the latter is almost half the low-income country average. Both indicators are dismally low compared to other Southeast Asian countries.

Figure 4.19. Proportion of Births Attended by Skilled Health Personnel (%)

Note: In 1995, figures for Cambodia, the Philippines, and Singapore refer to 1998, for Lao PDR to 2001, for Thailand to 2000, and Viet Nam to 1997. In 2007, figures for Cambodia and Malaysia refer to 2005, for Lao PDR, Thailand, and Viet Nam to 2006 and for the Philippines to 2008. Source: ADB (2010), Key Indicators for Asia and the Pacific 2010.

Figure 4.20. Antenatal Care Coverage (2000-2008%)

Source: World Health Organization (WHO, 2009), World Health Statistics 2009.

282. Furthermore, there is a substantial disparity in access of pregnant women to healthcare by rural-urban areas, income status, and educational attainment (Figure 4.21).

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Figure 4.21. Birth Attended by Skilled Health Personnel by Different Categories (2006, %)

Source: WHO (2009), World Health Statistics 2009

283. Delivery of Healthcare. Total health expenditure per capita was the lowest in Southeast Asia in 2007 (Figure 4.22).

Figure 4.22. Health Expenditure Per Capita (2007, current US$)

Source: WB (2010), World Development Indicators. Accessed on 29 October 2010.

284. The government allocation to health must rise from the current level of less than 1% of GDP to at least 2-3%, which is the prevailing rate in countries that have made rapid progress in this front (Figure 4.23). This is according to the Ministry of Planning and Investment UNDP (2009).

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Source: WB (2010), World Development Indicators. Accessed on 12 October 2010

285. The low level of public expenditure on health transfers a large proportion of total spending to private financing (Table 4.5). Such financing leads to an unequal distribution of health outcomes skewed in favor of high-income groups.

Table 4.5. Private Expenditure on Health (% of Total Health Expenditure) 1995 2000 2006 Cambodia 81 78 74 Indonesia 60 62 50 Lao PDR 55 67 79 Malaysia 54 48 55 Philippines 61 52 60 Singapore 58 63 66 Thailand 53 44 36 Viet Nam 68 70 68

Source: ESCAP (2009), Statistical Yearbook 2009. 4.2 Uneven Playing Fields 4.2.1 Infrastructure: Social Overhead Capital Constraining Growth

286. To realize the full potentials for growth of both human and physical capital, a complementary production factor is critical, and that is social overhead capital. Infrastructure facilities constitute a large portion of the latter. If the services from infrastructures are non-excludable, that is, once provided to one person they have to be provided to all, then government usually steps in to provide the infrastructures through a tax-and-spending scheme. More recently, schemes have been worked out so that some infrastructures can be provided using public-private partnerships (PPP).

287. Accumulation of several forms of capital inputs is a proper undertaking of the private sector, which means policies conducive to enhancing private-sector participation are vital. Meanwhile, some other forms of capital accumulation must be led by the public sector, such as, major infrastructure projects. Moving forward, it is crucial to establish the appropriate

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division of labor between the public and private sectors in jumpstarting and sustaining the momentum of capital accumulation, broadly defined.

288. Inadequate infrastructures, especially the non-excludable kind financed by government, constrain growth to the extent private investment is not expanding in its absence. Although there has been significant infrastructure development over the past two decades, Lao PDR’s infrastructure sector remains largely underdeveloped.

289. If private physical capital expands and government spending for infrastructures increase accordingly, then diminishing marginal productivity of capital may not set in, allowing sustained growth in the long run.66 Goods get distributed in an efficient manner, while individuals and families are able to improve their access to social facilities like schools and health clinics. In consequence, human capital accumulation takes place smoothly, leading to a synergy in the accumulation of the various forms of capital that matter for growth.

290. It is useful to note that at this stage of Lao PDR’s development, it is starting with low levels of virtually all forms of capital: physical, human, social overhead, and technological. Modern analysis of economic growth has established that these various forms of capital matter significantly.67 291. This is particularly useful in an environment where investments in several fronts are indicated. In other words, which of several investment possibilities, whether public or private, should take priority? In line with the thrust of this study, focus on the most critical constraints to growth is underscored. 292. Furthermore, there are provinces where about one-third of the household population does not have access to roads (Figure 4.24). ADB (2011) added that remote areas still have low traffic density due to the low level of their economic activities.68

Figure 4.24. Road Accessibility among Rural Population (2007/08, %)

Source: Department of Statistics, Ministry of Planning and Investment.

                                                        66 Barro (1990) has emphasized this point in the context of pure public goods financed by government. 67 This point is emphasized in studies based on endogenous growth theory about what explains cross-country

differences in levels and growth rates of per capita income. The same point was recently articulated in Update: Asian Development Outlook 2010 (ADB, 2010).

68 ADB (2011), “Transport Sector in Lao People’s Democratic Republic”, In Learning Curves, February 2011.

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4.2.2 Access to Social facilities. 293. Table 15 shows that majority of the population have easy access to social facilities. Surprisingly, however, only about one-third of the population can access provincial capitals within 0 to 0.5 hour (Table 4.6).

Table 4.6. Access to Facilities (2005, %)

Schools Health Centers

District Capitals

Provincial Capitals

0 to 0.5 h 86.5 74.6 60.4 29.8 0.5 to 1 h 4.0 9.2 15.4 17.2 1 to 1.5 h

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Source: Messerli et al, eds., (2008), Socio-Economic Atlas of the Lao PDR.

4.2.3 Access to Finance 294. Access to credit remains limited at the village level, particularly in rural areas without road access. Noteworthy, however, is that villages in the Northern region have greater access to credit compared to the Central and Southern regions (Figure 4.25).

Figure 4.25. Access to Credit at the Village Level (2007)

Source: Authors’ estimate based on Lao Expenditure and Consumption Survey 2007/08

4.2.4 Asset Protection 295. The importance of tenure—or the lack of it— cannot be undermined. As many poor people, do not own the land or fishing grounds that they rely on for income, their lack of

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secure tenure makes them vulnerable to being dispossessed of their homes as well as their livelihoods.

296. Secure tenure can be defined as the certainty that a person’s rights to continuous use of land or resources will be recognized and protected against challenges from individuals or the state.69 This kind of certainty provides an incentive to make long-term investments in maintaining or enhancing the productivity of that property. Accordingly, when insecurity of tenure acts as a disincentive to long-term investments for example in soil conservation, irrigation, etc., land quality can deteriorate and agricultural productivity can suffer. According to Deininger (2003),70 increase in tenure security can have significant benefits in terms of equity, investment, credit supply and reduced expenditure of resources on defensive activities.

297. In Lao PDR, most of the rural population especially the indigenous peoples and local farmers often have de facto access to forests, but their tenurial control over the resources (trees, timber, etc.) and the right to manage such resources is often limited in scope and unrecognized in law.71 This, among other reasons, has resulted in land conflicts over the past few years (See Box 1). Viravong (1999)72 noted that encroachment of non-owned land increased as residents and farmers sold houses and fields for short-term profits, and moved on to cultivate new areas of non-owned urban land and began to clear forest land for cultivation. 298. Land conflicts in Lao PDR can be viewed from an economic standpoint. On the demand side, migration and resettlement after the war propagated claims against other families and against the State. Moreover, many concessions have been given to national and international companies to increase agricultural and mining production in recent years.73 On the supply side, however, there is a growing scarcity of the land because of population growth, soil degradation, and land conversion.74

299. Against these opposing forces, is a relatively new, and not yet generally accepted legal framework that is constituted by pieces of land legislation, some of which run counter to customary institutions and traditional land-tenure systems. Consequently, this is compounded by poor enforcement and corruption. Nevertheless, as the implementation of new resource laws has the effect of somewhat redefining and redistributing existing property rights, conflicts between local users (especially in the rural areas) and the State are generally unavoidable.

300. Mohaphonh (2007)75 noted that as the economic development era progressed, the land tenure systems (e.g. inheritance systems) became ineffective as rural land became more valuable and attitudes towards land as a commercial asset increased. The continued land conflicts however, if not properly addressed, will continue to have a negative impact on

                                                        69 World Resources Institute (WRI), UNDP, UNEP and World Bank. 2005. World Resources 2005: The wealth of

the Poor - Managing Ecosystems to Fight Poverty. Washington, DC. 70 Deininger, K. (2003). Land Policies for Growth and Poverty Reduction. Washington DC: World Bank Policy

Research Report. 71 Lynch, O., and K. Talbot. 1995. Balancing Acts: Community Based Forest Management and National Law in

Asia and the Pacific. Washington DC: World Resources Institute. 72 Viravong, M., 1999, Reforming Property Rights in Laos, in ‘Women’s Rights to House and Land: China, Laos,

Vietnam’, edited by Tinker, I and Gale Summerfield, Lynne Rienner Publishers, London. cited by Burns. Anthony. 2002. Comparative Study of Land Administration Systems – Lao PDR Case Study - Contextual Information Laos.

73 GTZ. 2009. Foreign Direct Investment (FDI) in Land in the Lao PDR. 74 Kirk, Michael. 1996. Land Conflicts and Conflict resolution. In “Land Tenure Development and Divestiture in

Lao P.D.R.” available online at: http://www.mekonginfo.org/mrc/html/kirk/kil_frm.htm 75 Mohaphonh, Nouphanh, et al. 2007. Study on Land Conflicts and Conflict Resolution.

food security and poverty, unequal distribution of land and environmental degradation in the long run and may ultimately be a binding constraint to Lao PDR’s growth.

301. World Bank Land Titling Projects (LTP) I and II. The largest land administration project carried out in Lao PDR is the Laos Land Titling Project co-financed by the World Bank and AusAID. LTP was a long term land titling program aimed at developing Lao PDR’s land administration capacity in support of its economic development and poverty reduction goals. The project aimed to: (i) improve the security of land tenure; (ii) develop transparent and efficient land administration institutions at the national and provincial levels; and (iii) improve the government's capacity to provide social and economic services through broader revenue base from property related fees and taxes. In general, the project facilitated the formulation and approval of land policy and regulatory changes, strengthened the institutional capacity and project management, accelerated land titling activities in areas of high demand, developed and implemented an efficient and transparent land registration system, and strengthened land valuation systems.76

302. The first phase had been successful in the development of the regulatory framework and the implementation of the property valuation component and facilitated the enactment of a Land Law was in 1997 and the preparation and approval of several decrees on land administration and property valuation. However, the project was less successful in the issuance of land titles as the number of titles issued was much lower than initially planned, due to lack of government counterpart funds, weak staff capacity and bottlenecks in the technical processes. Phase 2 continued to establish a viable land registration mechanism that officially recognizes private land rights, facilitates the buying and selling of land rights and generates government revenue. Overall, the project was very successful in issuing titles, identifying and addressing land disputes and setting up the land administration system to manage the land registration activities. However it did not address many of the limiting factors such as customary land and forest land and did not target the issue of landless families.

303. Although the land disputes have been minimized as a result of legislation and the management reforms as a result of the various assistance from development partners, recent studies show that there were some land conflict cases still persist. During the period 2006-2007, Mohaphonh et al, observed some 370 land conflict cases over a total of 3,800 cases in the same period (or 9.74%).77 304. Land tenure security can also constrain growth. Delays in the resolution of disputes are reflective of the limited scope of government legislation and of the capability of the government to resolve such land issues expeditiously. Moreover, such delays can also translate to opportunity costs in terms of the income foregone vis-a-vis the income derived from an otherwise secured land.

305. IFC’s Enterprise survey has earlier noted that access to land is considered as a consideration by firms albeit not as much as other factors like tax rates and access to finance.

306. The 2011 property rights index78 however, shows that Lao PDR (tied with Viet Nam) ranked 2nd to the lowest in the Southeast Asian region after Myanmar (Figure 4.26). This                                                         76 World Bank. 2003. Project Appraisal Document for Lao PDR Second Land Titling Project. 77 Mohaphonh, Nouphanh, et al. 2007. Study on Land Conflicts and Conflict Resolution. 78 A subcomponent of the Index of Economic Freedom, the property rights index measures the degree to which

a country’s laws protect private property rights, and the degree to which its government enforces those laws. Higher scores are more desirable, i.e. property rights are better protected. Scores are from 0 to 100. Available online at: http://www.globalpropertyguide.com/Asia/Laos/property-rights-index#Property%20Rights%20Index_notes

index also assesses the likelihood that private property will be expropriated and analyzes the independence of the judiciary, the existence of corruption within the judiciary, and the ability of individuals and businesses to enforce contracts. Hence Lao PDR is considered high risk in terms of property rights vis-à-vis other Southeast Asian countries.

Figure 4.26. Property Rights Index - Asia

Source: The 2011 Index of Economic Freedom. 307. World Bank79 noted that the land titling program in Lao PDR has more or less improved tenure security and in the process, increased access to formal credit, reduced the cost of borrowing, increased the size of loans, investment in agriculture land and agriculture productivity, land values, and property tax collection. Other indications suggest that land titling has facilitated land use planning and development control. There is no evidence however, that land titling alone has increased land markets activities as other factors, such as the state of the economy, policy distortions, and access to credit, also affect land markets. 308. Notwithstanding the success of the land titling program, however, Lao PDR still ranks one of the lowest in the region (after Brunei) in terms of registering property. In its most recent report, Doing Business 2010, ranks Lao PDR as 163rd (out of 183 economies) in terms of Registering Property (Figure 4.27).

Figure 4.27. Registering property rankings in Southeast Asia.

Source: Doing Business 2010.

                                                        79 World Bank. 2004. Regional Study on Land Administration, Land markets and Collateralized Lending.

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309. The above ranking however, assumes a standardized case of an entrepreneur who wants to purchase land and a building that is already registered and free of title dispute hence, registration will take longer in case of an existing land dispute.

Chapter 5. Concluding Remarks: Summary and Recommendation 310. This study seeks to identify the most binding constraints to inclusive growth in Lao PDR, an economy in transition from central planning to a market-oriented economy. At the outset, it is recognized that this study is fraught with difficulties considering the many factors that influence economic growth and social development, more so in an economy trying to overcome institutional constraints and other rigidities that operated under the former socialist form of government. 311. To approach the issues at hand, the study adopts the HRV method for diagnosing the most binding constraints to growth, and extending it with the use of the AZ framework to take into consideration critical long-run factors constraining inclusive growth. Professional thinking on the issues has also been solicited by interviewing key resource persons and holding workshops with selected experts, practitioners, and government policymakers in Lao PDR. Based on the above, herewith are the most critical constraints to inclusive growth n Lao PDR: 5.1. Summary of Most Critical Growth Constraints 312. High cost of finance is the most critical constraint to inclusive growth. Among domestic commercial banks, most of which are state-owned, lending rates are high, with steep collateral requirements. Borrowers are hard pressed to find projects with internal rates of return that exceed lending rates. The situation is not conducive to growth in the long run. High lending rates induce adverse selection, that is, borrowers with high-risk, high-return projects are the ones that apply for loans, thereby raising the likelihood of loan defaults. As it is, domestic microenterprises, as well as small and medium enterprises, are either credit-deprived or rationed, while foreign firms are able to tap loans from foreign banks allowed to operate in Lao PDR. And so if differential access to bank loans persists, income inequality is expected to worsen. 313. Lack of skilled educated workers hinders inclusive growth. To support growth in the long run, Lao PDR needs educated and skilled manpower that is productive and capable of mastering new production techniques that constantly emerge in an economy increasingly being integrated with the world economy. The trend in education characterized by high dropout rates in the lower grades, which prevent many pupils from moving up to higher education levels, has to be reversed immediately by investing in quality basic education. In view of the importance of having a critical mass of technical and scientific manpower to raise the level of knowledge in vital industries and in the overall economy, education policy at the tertiary level must support research and development (R&D) in institutions of advanced learning. To expand and equalize access to education at various levels, education subsidies must be rationalized, but students must be made to shoulder part of their schooling costs, especially at the tertiary level, since they can capture most of the returns from their education investments. 314. Health and nutritional status of children impedes growth and its inclusiveness in the long run. Malnourished and undernourished children forego a good deal of human capital when they get sick and are forced by recurrent ailments to absent themselves from school. And when they assume their adult roles as workers, the residual effects on their health of illnesses they contracted while young lead to morbidity, reduced work effort, and prolonged absence from work. They lose precious human capital accumulated on the job. The life-

cycle effects of health investments on productivity are well established. Public policy for health must likewise aim to expand and equalize access to medical and health-care inputs. 315. Inadequate roads and other transport systems that limit access of households and enterprises in rural agricultural areas to the main transport corridor is an obstacle to inclusive growth. The present road and transport system limits access of families and firms living in the periphery to the center of business, economic, social and cultural activities. The situation creates several imbalances. Growth, for example, of microenterprises and SMEs is stunted. The envisioned transformation of the main road corridors into economic corridors is thus slow to materialize. Income inequality between small and big firms is thus perpetuated. To clip this, public policy has to accelerate the physical integration of the periphery with the center through meaningful public investments in secondary and local roads. 316. Good governance is a prerequisite to overcoming the critical constraints to inclusive growth and in boosting development of the growth drivers discussed below. While the political leadership of Lao PDR has been responsive to calls for ensuring political stability and maintaining peace and order, there are many other important aspects of good governance that must be instituted to generate long-run growth. For instance, the fight against corruption must be invigorated, particularly, in the area of government procurement. Moreover, public financial management has to meet international standards. These measures are key to raising investment, both domestic and foreign, and growth that rests on rising total factor productivity. . 5.2. Recommendation: Identifying Growth Drivers 317. Two major development goals of Lao PDR are (1) sustained growth of income and employment; and (2) elimination of poverty and improvement in the distribution of income and wealth. To realize these goals, the main strategy is to transform a predominantly agricultural economy into one considered industrializing. 318. To succeed in this endeavor, investments designed to raise agricultural productivity are necessary, but such investments are not sufficient for inclusive growth. Generating gainful employment on an economy-wide basis is vital. In the course of rising agricultural productivity, some workers are released from agriculture. And so investments in industry and services must grow fast enough to generate jobs that would absorb rural agricultural workers rendered in surplus. Export enhancement is vital since exporting means producing for outside markets, an activity that requires global competitiveness. Moreover, exporting of manufactured products is a good avenue for broadening the industrial base of the Laotian economy. 319. In this connection, it may be helpful to have an industrial policy supportive of income and employment growth, similar to the one that transformed East Asian economies [see Joseph Stiglitz and Shahid Yusuf (2001) and Indermit Gill and Homi Kharas (2007)]. 320. This is not an easy task but lessons from the past growth experience of Lao PDR are instructive. Over the past few years, some sources-of-growth studies have estimated that mining and hydropower account for at least two percentage points of GDP growth rates [see, e.g., Davading (2009)]. However, these industries are capital intensive and given diminishing marginal productivity of capital, cannot be relied on over the long term to generate high-wage, high-skill jobs called for by inclusive growth. This suggests the need to explore potential drivers of growth other than the resource-based industries. Here are some sectors worth considering:

321. Agribusiness has strong inter-industry linkages with huge potentials for employment generation. The growth in the traditional crops like rice and corn and in plantation crops,

such as, rubber makes investment in agro-based processing appealing. The activities are labor intensive. The possibilities for income and employment growth from exports are enormous. As Lao PDR gets integrated with countries in the Greater Mekong Subregion, market access expands, allowing microenterprises and SMEs engaged in this type of manufacturing to emerge and to grow.

322. Tourism is a driver for growth with many subsectors that have high degree of employment response to output growth. Lao PDR is strategically located as a tourism destination. Physically, it is linked with China, Thailand, Vietnam, Cambodia, and Myanmar, which offer a cluster of tourism destinations. At the same time, many of the service trades involved in tourism, such as hotels and restaurants, have employment elasticities derived from a percentage change in output growth that are greater than one.

323. Urban- and city-led development creates scale economies geared to rapid growth of income and employment. As the economic transformation of Lao PDR proceeds, the demand for sophisticated services in telecommunications, information technology, transport, and financial and insurance services is heightened. In meeting such demand, it is efficient to cluster the development in cities and other major urban centers to capture the usual scale and agglomeration economies. The manpower requirements of these industries in various rungs of the skill ladder are immense.80

324. Finally, this two-pronged approach of addressing critical constraints to inclusive growth and pursuing the development of new growth drivers is geared to the expanded use of advanced production technologies accompanied by rising real income and consumption. The various time paths of production and consumption interact in virtuous ways to create opportunities and bring the rewards of growth to all Laotian citizens.

                                                        80 Urban- and city-led development has many requirements, including, water supply and sewerage system. For

an expanded treatment of the issues, see ADB (2010g)

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