Report No. 24443-LA Lao PDR Public Expenditure Review Country Financial Accountability Assessment Joint Report of World Bank, International, Monetary Fund and Asian Development Bank (In Two Volumes) Volume II: Detailed Reports June 28, 2002 : 1 -. Asian Development Bank International-Monetary Fund World Bank CURRENCY EQUIVALENTS (as of end March 2002) Currency unit = Lao Kip US$I = Kip 9480 FISCAL YEAR October I - September 30 WEIGHTS AND MEASURES Metric System ABBREVIATION AND ACRONYMS AAC - Annual Allowable Cut ADB - Asian Development Bank ADS - Agricultural Development Services AFTA - ASEAN Free Trade Area AIDS - Acquired Immune Deficiency Syndrome APB - Agricultural Promotion Bank BECL - Banque Pour Le Commerce Exterieur Lao BOT - Build Operate and Transfer BPKP - Bolisat Phathana Khet Phoudoi CPC - Committee on Planning and Cooperation COA - Chart of Account DAFI - Development Agricultural Forestry Industry DOF - Department of Forestry EdL - Electricite de Lao FIL - Foreign Investment Law FIMC - Conmmittee for Investment Management & Foreign Economic Cooperation FOMACOP - Forestry Management and Conservation Project FMU - Forest Management Units FY - Fiscal Year GDP - Gross Domestic Product GFM - Govemment Forest Management GOL - Government of Lao PDR HIV - Human Immunodeficiency Syndrome IDA - Intemational Development Agency IUCN - Intemational Union for the Conservation of Nature IMF - Intemational Monetary Fund IPRSP - Interim Poverty Reduction Strategy Program IPP - Independent Power Producer IRR - Implementing Rules and Regulations JFM - Joint Forest Management Lao PDR - Lao People's Democratic Republic LECS - Lao Expenditure and Consumptions Survey LSFP - Lao Sweden Forestry Project LTU - Large Taxpayer Unit MAF - Ministry of Agriculture and Forestry MCT - Ministry of Commerce and Tourism MCTPC - Ministry of Communication, Transport Post and Construction MIH - Ministry of Industry and Handicraft MOF - Ministry of Finance MOH - Ministry of Health MOUR - Memorandum of Understanding on Restructuring MTEF - Medium Term Expenditure Framework NAO - National Audit Office NBCA - National Biodiversity Conservation Area NEM - New Economic Mechanism NETG - National Electricity Transmission Grid NOFIP - National Office Forest Inventory Project NPL - Non Performing Loans NSEDP - National Socio-Economic Development Plan NTFP - Non Timber Forest Products ODA - Official Development Assistance PAFO - Provincial Agricultural and Forestry Offices PER/CFAA - Public Expenditure Review/Country Financial Accountability Assessment PHC - Primary Health Care PIP - Public Investment Program PMO - Prime Minister's Office PMO - Procurement Monitoring Office PPA - Participatory Poverty Assessment ppP - Purchasing Power Parity PRSP - Poverty Reduction Strategy Program PSP - Permanent Sample Plots RTM - Round Table Meeting SIDA - Swedish Intemational Development Agency SOCB - State Owned Commercial Bank SOE - State Owned Enterprises SPC - State Planning Committee (now CPC) STD - Sexually Transmitted Disease UXO - Unexploded Ordinance VAT - Value Added Tax VFA Village Forestry Association VFM Village Forestry Management Asian Development Bank Director General, Mekong Department Rajat M. Nag Director Operations and Coordination Division Kazu Sakai Programs Officer Gil-Hong Kim International Monetary Fund Deputy Division Chief, Asia and Pacific Department Peter J. Winglee Country economist, Asia and Pacific Department Stephen A. Cook Technical Advisor, Fiscal Affairs Department Pokar D. Khemani World Bank Regional Vice Preseident: Jemal-ud-din Kassum Country Director: Ian C. Porter Sector Director: Homi Kharas Task Team Leader: Ronald Hood ACKNOWLEDGEMENTS This report was a joint collaborative effort of the Asian Development Bank, the International Monetary Fund and the World Bank. It was written by a team including Ron Hood (team leader, World Bank), David Husband (ADB consultant) and Stephen Cook (IMF). The report includes contributions from Nihal Fernandopulle (consultant) David Howarth, Pokar Khemani (IMF), Behdad Noroowzi (World Bank), Marc Paoletti (consultant), John Richardson (consultant), Francois Vaillancourt (consultant), John Zohrab (consultant). Many valuable comments were received from Gil Hong Kim (ADB), Keiko Miwa, Allister Moon, Anand Rajaram, Klas Rasmusson (SIDA), Eric Sidgwick (IMF), Vinaya Swaroop, Paul Turner (ADB), Peter Winglee (IMF). Nancy Mensah processed the report. The report was written with guidance and consistent support from the Director of the Budget Department of the Ministry of Finance, Mr. Sunthorn Manodharm. The team would like to express its sincere thanks for the support and cooperation it received during its work in Lao PDR In particular the team would like to thank Madam Khempheng Pholsena, Mrs. Thipphakorn Chanthavongsa, Mr. Langsey Sibounheuang, and Mr. Anouphab Toulalom, In addition thanks goes to the many officials who supported us in the line ministries and provinces as well officials in the National Audit Office, State Inspection Authority, and the National Statistical Office. Sincere thanks goes to Linda Schneider who provided many insights and contacts as well as Malarak Souksavat who supported the team in the field. The report was discussed with the government during a workshop in February 2002. The Workshop was attended by Vice Minister H.E. Mr. Liane Thykeo and officials from the Ministry of Finance, the Ministry of Foreign Affairs, the Ministry of Education, the Ministry of Industry and Handicraft, and the Ministry of Communication, Transport, Post and Construction, the Ministry of Health, the Bank of Lao PDR, the National Statistical Center, the Committee for Planning and Cooperation and the Business Promotion Center in the Prime Minister's Office. During the production of the report the Sector Director was Homi Kharas and the Country Director was Ian Porter. TABLE OF CONTENTS 1. PUBLIC EXPENDITURE TRENDS ................................................................1 2. POVERTY ................................................................6 The Poverty Situation ................................................................7 Lao PDR's Poverty Reduction Strategy Framework ........................................................ 13 3. MACROECONOMIC FRAMEWORK AND RESOURCE ENVELOPE .......... ........... 20 Macroeconomic and Fiscal Background ............................................................... 20 The Medium Term Fiscal Framework and Resource Envelope ....................................... 24 Fiscal Sustainability ............................................................... 26 Conclusion ............................................................... 28 Annex 3.1: Medium Term Revenue Projections .............................................................. 29 4. IMPROVING BUDGET EXECUTION, CONTROL AND TRANSPARENCY ........... 32 Budgetary Classifications and Submission of the Budget ................................................ 32 Budget Execution ............................................................... 35 Control of Budget Execution ............................................................... 41 Fiscal Decentralization of Budget Execution ............................................................... 49 Annex 4.1: Further Measures to Improve Financial Accountability and Reduce Fiduciary Risk ........................... 54 Annex 4.2: Financial Management In Private Enterprises and SOEs ............................. 56 Annex 4.3: Financial Management of Official Development Assistance Funded Projects ...............................................................6............................; 63 Annex 4.4: Procurement and the Bid Review Process in Lao PDR .................... ............ 66 5. BUDGET PLANNING AND PREPARATION ...................................... 68 Budget Processes and Institutions ...................................... 68 Assessment of the Budget Preparation Process ...................................... 71 Annex 5.1: The Fiscal Transfer System ...................................... 83 6. SECTORS ...................................... 85 Education ...................................... 85 Health ...................................... 100 Energy Sector ...................................... 113 Forestry ...................................... 122 Boxes Box 4.1: A Brief History of Central-Provincial Fiscal Relations in Lao PDR ................ 49 Box 4.2: The Large Taxpayer Unit ........................................................ 51 Box 5.1: Measuring the Recurrent and Capital Spending ................................................ 72 Box 5.2: Limits of Cost-Benefit Analysis ........................................................ 74 Box 5.3: Funding Operations and Maintenance Costs ..................................................... 78 Box 5.4: Measuring the Costs of Achieving Plan Targets in Education ............ ............. 79 Box 6.1: Elements of the Government's Health Strategy .............................................. 105 Box 6.2: Wood Production Practices ........................................................ 132 Charts Chart 3.1: Lao PDR: Fiscal Developments 1995/96 - 2000/01 (percent of GDP) .......... 22 Chart 3.2: Projected Revenue Shares ............................................................. 29 Chart 4.1: Revenue and Expenditure for a Surplus Province .......................................... 50 Chart 6.1: Net and Gross Primary Enrolment Ratios, By Province, 1998/99 .................. 89 Chart 6.2: Evolution of the Growth and Decline of Health Centers .............................. 102 Chart 6.3: Health Expenditures and Total Expenditures (% of GDP) ............ ............... 107 Chart 6.4: Capital and Recurrent Expenditure on Health (% of GDP) .......................... 107 Chart 6.5a: Salary Expenditure, Real Terms, for Selected Provinces . .................... 109 Chart 6.5b: Administrative Expenditure, Real Terms, for Selected Provinces .............. 109 Tables Table 1.1: National Budget Expenditure, 1994/95-2001/2002 ...........................................1 Table 1.2: Lao PDR: General Government Expenditure, 1996/97, 1997/98, 1999/00, 2000/01 and 2001/02 ..............................................................2 Table 1.3: Expenditure by Sector, Central Ministry and Provinces 2000/01 Actual and 2001/02 budget ....................................................4 Table 1.4: PIP Expenditure 1995/96 to 2001/02 .....................................................:.5 Table 1.5: Revenue and Expenditure .....................................................5 Table 2.1: Per Capita Per Month Total Poverty Line, 1997/98 ..........................................7 Table 2.2: Poverty Situation in Lao PDR, 1997/98 ..................................................... 8 Table 2.3: Change in Poverty Situation: 1992/93-1997/98 ...............................................9 Table 2.4: Inequality of Per Capita Real Consumption ................................................... 10 Table 2.5: Access to Services by the Poor and Non-Poor, 1997/98 ................................. 11 Table 2.6: Regional Comparisons of Poverty .................................................... 12 Table 2.7: Growth and Inequity Effects for Poverty Reduction ....................................... 17 Table 3.1: Lao PDR: General Government Operations, 1995/96-2000/01 ..................... 21 Table 3.2: Lao PDR: General Government Operations, 1999/00-2004/05 ..................... 25 Table 4.1: Spending by Line Agencies in Khammuan Province, 1998-99 Audited Budget Figures .................................................... 41 Table 4.2: Status of Overdue Project Audit Reports .................................................... 64 Table 5.1: Expenditures, Revenues and Transfers, 1999-2000 ........................................ 83 Table 6.1: Primary School Repetition and Drop Out Rates (1999/2000) ......................... 86 Table 6.2: Indicators of Regional Disparities in Education Services ............................... 87 Table 6.3: Indicators of the Relationship Between Poverty and Access to a Primary School .................................................... 88 Table 6.4: Measures of Education Spending .................................................... 90 Table 6.5: Government Expenditure for Education and Training, 1990-2000 ................. 90 Table 6.6: Recurrent Expenditure by Subsector, 1990-2000 ............................................ 91 Table 6.7: Recurrent Expenditures by Budget Nomenclature Selected Years ................. 92 Table 6.8: Recurrent Costs of Education by Level of Schooling ..................................... 93 Table 6.9: Social Indicators, Selected Countries ...................................................... 100 Table 6.10: Access to Health Services by the Poor and Non-Poor, 1997/98 ................ 104 Table 6.11: Percentage of Population with Health Services . ............................ 104 Table 6.12: Per Capita Health Expenditures in Selected Countries, 1997/98 ................ 106 Table 6.13: EdL's Financial Position: 1990-2000 ..................................... 116 Table 6.14: Domestic Electricity Tariffs ..................................... 118 Table 6.15: Power Generation: Existing and Planned .1..................................... 9 Table 6.16: Forest Area by Potential Productivity ..................................... 122 Table 6.17: Log Production Sources, 1990 to 1999 ................................... 124 Table 6.18: Extrapolated Wood Processing Industry Capacity, January 2000 ............... 125 Table 6.19: Ownership of Wood Processing Industries, 1988-90 ................................... 125 Table 6.20: Comparison of Royalty Rates with International Reference Prices ............ 126 Table 6.21: Annual Quota and Actual Logging, 1994/95-1998/99 ................................ 128 Table 6.22: Logging Revenue Loss (average 1:994/95-1998/99) .................................... 135 Annex Tables Table 1: Key Economic Indicators ........................................................... 139 Table 2: GDP by Industrial Origin 1995-2000 ............................................................ 140 Table 3a: Lao PDR General Government Expenditure, 1996/97, 1997/98, 1999/00, & 2000/01 and 2001/02 ........................................................... 141 Table 3b: Lao PDR Lao PDR General Government Expenditure, 1996/97, 1997/98, 1999/00, and 2000/01 ........................................................... 142 Table 4: Expenditure by Sector, Central Ministry and Provisions 2000/01 Actual and 2001/02 Budget ............................................................ 143 Table 5: National Budget Expenditure, 1994/95-2001/2002 .......................................... 144 Table 6: National Budget Revenue, 1994/95-2000/01 ................................................... 145 Table 7: Magnitude of General Expenditure and Portion Administered by Each Level of Government ........................................................... 146 Table 8: Expenditure 1995/96 to 2002/03 ........................................................... 147 Table 9: PIP Expenditure, Planned and Actual - 1995/96 to 1999/00 ........................... 148 Table 10: UN Health Goals and Status in Lao PDR ................................... 149 1. PUBLIC EXPENDITURE TRENDS 1.1 This chapter provides a brief review of the recent patterns and trends in public expenditures. Table 1.1 below shows expenditures 'from 1994/95 through 2000/01. There were substantial changes in the way expenditures were reported, and from 1997/98 on budget information was made available with a significant lag and with large revisions partly due to complications arising from rapid inflation and depreciation of the kip. Table 1.1: National Budget Expenditure, 1994/95-2001/2002 1994/95 1995/96 1996/97 1997/98 1998/99 1999/2000 2000/01 2001/2002 Actual Actual Actual Actual Actual Actual Actual Budget kip billion Current Expenditure 143 166 224 305 539 1,050 1,236 1,449 Wages and Salaries 68 79 92 117 181 335 416 525 MateTials and Supplies 43 52 57 63 132 174 330 370 Interest II 10 16 39 59 103 134 145 Timber royalty finaced exp. 32 37 89 242 0 0 Other 21 25 27 49 78 196 356 409 Capital Expenditure 147 195 220 579 1,270 1,704 1,911 2,165 Total 290 361 444 884 1,809 2,754 3,147 3,614 percent Current Expenditure 49.3 46.0 50.5 34.5 29.8 38.1 39.3 40.1 Wages and Salaries 23.4 21.9 20.7 13.2 10.0 12.2 13.2 14.5 Materials and Supplies 14.8 14.4 12.8 7.1 7.3 6.3 10.5 10.2 Interest 3.8 2.8 3.6 4.4 3.3 3.7 4.3 4.0 Timber royalty finaced exp. 0.0 0.0 7.2 4.2 4.9 8.8 0.0 0.0 Other 7.2 6.9 6.1 5.5 4.3 7.1 11.3 11.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Capital Expenditure 50.7 54.0 49.5 65.5 70.2 61.9 60.7 59.9 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: IMF 1.2 Nevertheless several trends are evident. The clearest is the very sharp contraction in the share of expenditures devoted to wages which fell from almost a quarter of the budget to just 10 percent in 1998/99 and which have yet to recover. The bulk of this is accounted for by salaries of teachers and health care workers who are civil servants. It represents the combined effects of an arrears buildup and erosion of real values by inflation. As a short-term phenomenon the effects of such a contraction might be reversible and would not have a lasting impact. But it is now entering it fourth year and despite recent nominal wage increases it is having real effects on public service delivery and quality. 1.3 Capital expenditures have consistently exceeded recurrent expenditures and are quite high by intemational standards. In Thailand for instance capital spending was just 36 percent of total spending and in Viet Nam the figure is 29 percent. The figures reflect the importance of -2- donor funded programs which account for roughly 75 percent of the capital budget. This observation needs to be qualified somewhat since all donor funded items in the PIP are considered capital despite the fact they include some training and other expenses that might better be considered as recurrent. Moreover, the donors contribute in foreign exchange while the domestically financed share of the budget is in kip. During 1998/99 the sharp jump in the kip value of donor funding and in the relative size of the capital budget was strongly affected by exchange rate valuation effects. Nevertheless in relative international terms Lao PDR continues to have a very high capital/recurrent expenditure ratio. Table 1.2: Lao P.D.R: General Government Expenditure, 199o/97, 1997/98, 1999/00, 2000/01 and 2001/02 ° (percent of total) 1996/97 (1) 1997/98 (2) 1999/00 (1) 2000/01 (1) 2001/02 (2) total current capital total current capital total current capital total current capital total current caPital Total 1000 447 553 1000 446 554 1000 358 642 100.0 416 58.4 1000 43.6 564 Ministries 661 251 410 659 256 403 695 275 420 61.2 314 297 564 336 229 Agriculture and forestry 2 5 0 2 2 3 3 2 0 3 3 0 17 01 16 2 3 0 2 21 2 0 01 19 Industryandhandicraft 101 0.0 101 84 19 65 20 00 20 14 00 14 04 00 03 Conmtunicationtranpsorttand pl6 01 154 200 09 191 306 01 305 184 04 180 68 02 66 Commerce 0 0 0 0 0 0 01 01 0 0 0 0 0 0 0 0 01 0 0 01 01 00 00 Finance 03 03 00 04 03 00 142 138 04 154 15.3 02 Is0 160 20 Planning 01 01 00 01 01 00 03 00 03 01 0.0 0.1 0.2 00 02 Education 72 1 1 61 69 16 54 25 05 19 31 0.9 22 49 09 4.0 Health 2.0 10 1 1 32 08 24 04 03 02 0.7 04 03 21 03 19 Cultureandinfornmtion 18 09 0.9 1 1 04 07 17 0.1 16 07 02 0.5 1.4 02 13 Laborandsocialwelfare 45 17 28 28 1 1 16 20 01 18 23 03 21 25 02 23 Justice 01 01 00 01 01 00 00 00 00 01 01 00 01 00 01 Foreignaffairs II I I 0.1 33 30 03 17 16 01 20 20 0.0 19 IS 00 Defense 114 110 04 99 95 04 81 74 07 78 71 08 80 73 07 Interior 36 30 06 3.2 26 06 28 24 04 28 26 03 31 2.6 05 PrimeMinistce'soffice 57 46 10 33 30 03 14 08 06 39 21 17 36 25 11 Other oo 00 00 II 1.1 00 Provinces 28 0 14.5 13 6 28 7 13 3 15.4 30 5 8 4 22 2 38 8 10 2 28.6 43 6 101 33 5 Ventmane Prefecture 4 9 1 6 3 3 2 5 1 5 1 0 5.0 0 8 4 2 5 6 1 2 4 4 5 0 1 0 4 0 Phongsali 17 05 12 13 04 09 1.5 03 12 25 0.3 22 29 03 26 Louangnarntha 16 0 5 1 1 1 3 0 4 0 8 0 8 0 2 0 6 1 0 0 3 0 7 1.2 0.3 0 9 Oudornxia 1.0 05 05 12 0.5 06 18 03 15 18 04 14 22 0.4 17 Bokeo 08 04 04 13 04 09 27 02 25 16 03 14 17 03 14 LouangPrabang 20 1 1 10 21 10 1 1 1 1 05 06 31 06 2.5 27 07 21 Houaphan 12 07 05 22 06 16 24 04 20 20 06 1.3 40 08 32 Xatgnabouli 15 09 06 19 08 I I 10 04 0.5 20 05 15 29 05 23 XiangKhoang 10 06 03 12 06 06 18 04 1.4 23 05 18 20 O5 15 VienttaneProvince 14 10 04 16 08 07 17 06 1 1 24 06 17 23 06 16 Bolikharnxai 1.0 06 04 1 1 06 05 13 03 1 1 1.1 04 08 15 04 1 1 Khamnouan 13 0.9 04 17 08 09 17 05 12 19 0.6 13 28 06 21 Savannakhet 30 18 12 28 16 12 25 1.1 14 36 13 23 41 14 27 Salavan l0 06 04 12 06 0.6 14 0.3 1 1 22 04 18 1.4 0.4 10 Xekong 09 04 06 10 04 06 09 02 07 31 15 1.7 46 1 1 35 Chamnpassak 24 18 07 28 15 13 22 1.6 05 08 03 05 09 02 07 Attapu 07 03 03 0.8 04 04 0.5 02 03 1.1 03 08 09 03 07 Xtasomboun Special Region 0 7 0 3 0 3 0 7 0 3 0 5 1 9 01 0 2 0 6 01 0 4 0 7 01 0.6 Other Unaccounted 5.9 51 0 8 5 4 5 7 -0.3 0 0 0 0 0 0 0.0 0 0 0 0 0 0 0 0 0 0 Sounce Lao Authorities, staff estimates (I) Actual Data (2) Budget Data (3) Data do not cornespond exactly to Table I I due to differences in IMF and National expertditure classifications, especially debt repayment 1.4 Table 1.2 shows the pattern of expenditures by ministry and province for several years. Several important trends are evident. First, provincial expenditures are rising relative to central ministries. This partly reflects the process of decentralization. In addition, for reasons discussed in more detail in the next chapter, the central government spending is constrained by difficulties -3- in securing revenue - much of which is collected by the provinces and is supposed to be remitted to the central treasury. 1.5 Second, the fall in the share of overall recurrent expenditures is largely due to changes in provincial expenditure patterns. Unfortunately, these data do not give a complete picture of what this implies about spending by sector. Central government spending by ministry suggests that spending on education and health fell substantially. Until now there have been no comprehensive data on provincial spending by sector or function. However, in response to suggestions from the IFIs and the donors the Budget Department of the MOF did prepare a breakout of spending by sector at both the central and provincial levels for the 2000/01 outcome and the 2001/02 budget and these figures were published in the Official Gazette in April 2002. This is the first time in more than five years that such data have been available. A summary is presented in Table 1.3.' The data again indicate relatively low shares for health and education: 3.7 and 7.4 percent respectively in 2000/01. The shares allocated for these sectors have increased significantly in 2001/02 to 5.6 percent of total spending for health and 10.0 percent in education. These increases have been made possible by reductions in the budgeted shares for MAF and MCTPC. The challenge will be to ensure that the budget targets are fulfilled. 1 There are some differences in the basis of presentation used Tables 1.1, 1.2 and 1.3 arising from the fact that first uses IMF definitions and the other two use Lao PDR definitions. The main difference is that the IMF, in conformity with intemational practice, excludes debt amortization from expenditure, capturing it "below the line" instead. The rather unconventional Lao practice is to include it above the line as a recurrent expenditure. The Lao practice, which biases the recurrent spending share measure upwards, also accounts for the difference total expenditure between Table 1. 1 (3,147 billion kip in 2000/01), and Table 1.3 (3,544 billion kip). The difference of roughly 400 billion kip shows up in Table 1.3 as part of the 599 billion kip spent by MOF - the balance being interest payments which are appropriately captured as recurrent expenditures. -4- Table 1.3: Expenditure by Sector, Central Ministry and Provinces. 2000/01 actual and 2001/02 budget 2000/Olactual 2001/02 budget Growth central central central total nministry provinces total ministry provinces total ministry provinces billion kip billion kip percent Agriculture 588 79 509 418 81 337 -28.9 2.5 -33.8 Industry and Handicrafts 116 49 67 69 16 53 -40.5 -67.3 -20.9 MCTPC 809 652 157 635 276 359 -21.5 -57.7 128.7 Commerce and Tourism 8 3 5 14 4 10 75.0 33.3 100.0 Finance 599 548 51 770 727 43 28.5 32.7 -15.7 CPC 14 4 10 54 8 46 285.7 100.0 360.0 Education 261 109 152 402 198 204 54.0 81.7 34.2 Health 131 26 105 225 86 139 71.8 230.8 32.4 Information and Culture 40 26 14 102 58 44 155.0 123.1 214.3 Labor and Social Welfare 117 82 35 145 101 44 23.9 23.2 25.7 Justice 7 3 4 12 5 7 71.4 66.7 75.0 Foreign Affairs 71 71 0 75 75 0 5.6 5.6 0.0 Defense 278 278 0 324 324 0 16.5 16.5 0.0 Interior 101 101 0 125 125 0 23.8 23.8 0.0 PMO 137 137 0 146 146 0 6.6 6.6 0.0 Provincial offices in Vientiane 262 0 262 467 0 467 78.2 0.0 78.2 Other 5 0 5 53 46 7 960.0 0.0 40.0 TOTAL 3544 2168 1376 4036 2276 1760 13.9 5.0 27.9 Source: Lao P.D.R. Official Gazette March 2002 2000/Olactual 2001/02 budget Growth central central central total ministry provinces total ministry provinces total ministry provinces percent share percent share percent growth in share Agriculture 16.6 2.2 14.4 10.4 2.0 8.3 -38 -10 -42 Industry and Handicrafts 3.3 1.4 1.9 1.7 0.4 1.3 -48 -71 -31 MCTPC 22.8 18.4 4.4 15.7 6.8 8.9 -31 -63 101 Commerce and Tourism 0.2 0.1 0.1 0.3 0.1 0.2 54 17 76 Finance 16.9 15.5 1.4 19.1 18.0 1.1 13 16 -26 CPC 0.4 0.1 0.3 1.3 0.2 1.1 239 76 304 Education 7.4 3.1 4.3 10.0 4.9 5.1 35 60 18 Health 3.7 0.7 3.0 5.6 2.1 3.4 51 l90 16 Information and Culture 1.1 0.7 0.4 2.5 1.4 1.1 124 96 176 Labour and Social Welfare 3.3 2.3 1.0 3.6 2.5 1.1 9 8 10 Justice 0.2 0.1 0.1 0.3 0.1 0.2 51 46 54 Foreign Affairs 2.0 2.0 0.0 1.9 1.9 0.0 -7 -7 Defense 7.8 7.8 0.0 8.0 8.0 0.0 2 2 Interior 2.8 2.8 0.0 3.1 3.1 0.0 9 9 PMO 3.9 3.9 0.0 3.6 3.6 0.0 -6 -6 Provincial offices in Vientiane 7.4 0.0 7.4 11.6 0.0 11.6 57 57 Other 0.1 0.0 0.1 1.3 1.1 0.2 831 23 TOTAL 100.0 61.2 38.8 100.0 56.4 43.6 0 -8 12 Source: Lao P.D.R. Official Gazette March 2002 1.6 Data for the PIP are broken out by sector and cover both central and provincial spending. These figures show declines in capital spending in education and to a lesser extent in health. -5- Table 1.4: PIP Expenditure 1995/96 to 2001/02 (% share by sector) 95/96 96/97 97/98 98/99 99/00 00/01 01/02 actual actual actual actual actual plan plan Econondc Sectors 74 76 75 79 72 71 51 Agriculture forestry I I 13 22 13 12 7 16 Industry 22 17 13 4 1 4 4 Communication 40 46 40 62 56 60 30 RD - Eco. Sectors 0 0 0 0 1 0 0 Other Eco. Sectors 0 0 0 0 1 0 0 Social-Cultural 21 17 17 11 18 20 27 Education 8 8 7 5 5 6 11 Health 7 3 6 3 6 7 8 Information & Culture 1 2 1 1 3 3 4 Labor & Social Welf. 5 4 3 1 4 4 4 Office& Housing 3 4 2 6 8 * * Rural Development & other 3 4 6 4 7 10 21 TOTAL 100 100 100 100 100 100 100 Source: CPC * included with last line 1.7 The overall level of public expenditures in Lao PDR is similar to, or even a bit higher than, other countries of the region. However revenue collection effort is, substantially lower than all other countries besides Cambodia. Lao PDR enjoys a high level of donor financial support, but the weakness of the revenue engine is one of the most serious problems the country faces. It compromises the ability of the government to cover recurrent costs -of capital projects including operations and maintenance. It has contributed to counterpart funding problems. It compromises the GOL's ability to fund crucial but relatively recurrent cost intensive social expenditures and it is making it difficult to rebuild the deeply eroded real wages of civil servants including teachers and health care workers. Table 1.5: Revenue and Expenditure Revenue Expenditure Year (percent of GDP) Cambodia 8.1 11.7 1998 Indonesia 18.8 17.9 1998 Lao PDR 10.6 20.6 1999 Philippines 19.0 16.4 1998 Thailand 16.2 18.4 1998 Viet Nam 18.2 20.1 1998 Sources: Lao PDR authorities, World Development Report -6- 2. POVERTY 2.1 Understanding the extent, nature and determinants of poverty in Lao PDR is fundamental to the design of appropriate public expenditure polices. Drawing on poverty analysis to date,2 the Lao Government has outlined its development strategy and policy priorities to 2020 designed to ensure "sustainable growth with equity." However, the effectiveness and efficiency of the strategy and policy priorities in contributing to poverty reduction, and the goal of exiting the group of Least Development Countries, will depend heavily upon how well public expenditure programs are linked to the needs of the poor. 2.2 Needs are both immediate and long-term, reflecting consumption deficiencies and investment obstacles. Judging the best mix and form of public expenditure in Lao PDR is especially difficult, as the extent of poverty is so widespread and much of the population so inaccessible. Low productivity subsistence farming is still the dominant means of livelihood, with the prospect that agricultural improvements could provide a major lift to living standards in rural areas. But transformation of the agricultural sector may also lead to migration of 'surplus' labor to more productive employment in urban or township areas. Clearly, sector trends have profound implications for how education, health, transportation and other public services are provided. At issue is the degree to which the Government - with assistance from the donor community - reaches out to remote communities and households, or facilitates new opportunities in towns and emerging population centers. 2.3 Trade-offs and change are inevitable. The Government must determine where and in what form its scarce resources will most effectively and efficiently contribute to both rapid economic growth and targeted support for the poor. Focusing on the latter could mean fewer resources for broad-based national needs. On the other hand, poverty reflects wasted human resources, lack of opportunity, and substandard services; the poor must be helped to expand their prospects. Specialized commercial agriculture, forestry, tourism, light manufacturing and other off-farm employment opportunities are increasingly important complements to modernization of the agricultural sector. Urban poverty is increasingly becoming a major challenge, especially in the Southern Region. 2.4 Poverty is deeply imbedded in Lao PDR. If equitable growth can be achieved, rapid growth will be the most effective way of reducing poverty. The Lao Government's development strategy highlights decentralization, so as to enable local communities to take better charge of their destinies. While decentralization is a logical complement to a more market-based economy, the poverty of much of Lao PDR means that many communities lack the planning and management capacity to take advantage of a more flexible and responsive form of government. Also too, decentralization carries with it the danger of exacerbating regional disparities, unless care is taken to ensure each community has the fiscal resources to provide basic services. 2 Including Stenflo, Gun. Alm "Poverty Profiles for Lao PDR, Statistics Sweden, 1999; N. Kakwani, Bounthavy Sisouphanhthong, Phonesaly Souksavath, Brent Dark, "Poverty in Lao PDR", Asian Development Bank, February 2001; Gaurav Datt, Limin Wang, "Poverty in Lao PDR: 1992/93-1997/98, World Bank, March 2001; State Planning Committee and Asian Development Bank, "Poverty in the Lao PDR: Participatory Poverty Assessment", October 2000 ; N. Kakwani, Gaurav Datt, Bountavy Sisouphanhthong, Phonesaly Souksavath and Limin Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30 2002; and World Food Program, "Vulnerability Analysis", August 2000. -7- THE POVERTY SITUATION 2.5 The main features of the poverty situation in Lao PDR are presented in the Government's Report to the Seventh Round Table Meeting and the Interim Poverty Reduction Strategy Paper3. As acknowledged by the Government, the analysis of poverty in Lao PDR is still at an early stage. This caution is important, for the data are too tentative to warrant firm conclusions at this stage. Nonetheless, two expenditure and consumption surveys in 1992/93 and 1997/98, a participatory poverty assessment in 2000/01, supplemented by other information, provide considerable insight into the extent, nature and determinants of poverty in Lao PDR. 2.6 In adopting a new an official poverty line, the Government it has drawn heavily from analysis undertaken by international and national experts.4 This analysis outlines a measure of poverty reflecting both food and nonfood consumption. Based on consumption levels of people in Northeast Thailand, minimum household requirements were established incorporating gender and age factors. A household's food poverty line is the amount of money required (per person per month) to satisfy the nutritional requirements of all its members. A household's nonfood poverty line is assumed to be 20 percent of the food poverty line, equal to the food/nonfood ratio found in the 1997/98 expenditure and consumption survey. The overall poverty line is simply the sum of the food and nonfood poverty lines. Adjusting for regional and rural/urban differences in prices, the following poverty levels were determined for 1997/98: Table 2.1: Per Capita Per Month Total Poverty Line 1997/98 (In Kip) Region Urban -Rural Vientianne Mun. 22613 22613 Northern Region 19550 17253 Central Region 20751 19991 Southern Region 19476 19015 Lao PDR 20597 19718 Source: Kakwani, Dant, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30, 2002 2.7 These poverty lines were then combined with data from the 1997/98 expenditure and consumption survey, conducted by the National Statistical Center, to determine the incidence, depth and severity of poverty in Lao PDR, by province and district. 2.8 As shown in Tables 2.2 and 2.3, the Northem Region was found to be the poorest region, with a poverty incidence of 53 percent; by comparison, in the Southem and Central Regions the incidence of poverty was 38 and 35 percent, respectively. In five provinces (Phongsaly, Luangnamtha, Oudomxay, Houa Phanh, and Xaysomboom SZ), more than 50 percent of the population is below the poverty line. The first four of these provinces are in the North. 3 Government of Lao PDR, Fighting Poverty Through Human Resource Development, Rural DeveloRment and People's Participation Government Report to the Seventh Round Table Meeting, November 2000; Government of Lao PDR, Interim Poverty Reduction Strategy Paper, prepared for the Executive Boards of the International Monetary Fund and the World Bank, March 2001. 4 ADB technical assistance for poverty analysis resulted in the following report: N. Kakwani, Bounthavy Sisouphanhthong, Phonesaly Souksavath, Brent Dark, "Poverty in Lao PDR", Asian Development Bank, February 2001. This was subsequently refined in N. Kakwani, Gaurav Datt, Bountavy Sisouphanhthong, Phonesaly Souksavath and Limin Wang "Poverty in Lao PDR: 1992/93-1997-98" March 2002. The Government has drawn extensively from the analysis. -8- 2.9 The depth of poverty (as measured by the poverty-gap index5) is also most pronounced in the North. For 1997/98, the depth of poverty in the North was estimated to be 16 percent, which indicates the minimum consumption transfer needed to pull all of the poor up to the poverty line. Poverty in the Central Region is half as deep as that in the North, and it is also much less pronounced in the South. 2.10 The severity of poverty is measured taking into account inequalities among the poor.6 Again, the severity of poverty is most pronounced in the North. In particular, the provinces of Oudomxay and Hauphanh have very high rates of poverty severity, indicating the existence of extremely poor groups. Table 2.2: Poverty Situation in Lao PDR, 1997/98 Region/Province Poverty Incidence Poverty Depth Poverty Severity % growth rate % growth rate growth rate Vientiane Municipality 03.5 -18.2 2.8 -18.5 0.8 -18.3 Northern Region 47.3 -1.7 13.9 0.8 5.8 3.7 Phongsaly 57.9 -4.4 17.0 0.9 7.1 8.3 LouangNamtha 51.1 4.6 14.4 6.7 5.4 9.1 Oudamxay 66.1 7.3 24.7 18.8 12.1 29.5 Bokeo 38.9 -1.7 9.5 6.1 3.5 14.7 Louang Prabang 40.8 -7.2 9.8 -9.1 3.6 -8.8 Houa Phanh 71.3 0.0 23.4 -1.0 10.1 -2.1 Xaygnaboury 17.7 -4.6 3.1 -9.0 0.8 -12.7 Central Region 39.4 -2.7 9.7 -1.1 3.4 -0.1 Xieng Khoang 42.9 -7.7 11.9 -8.4 4.6 -7.8 Vientiane Province 27.8 -2.0 5.7 -2.5 1.8 -1.9 Borikhamxay 27.9 10.4 7.4 23.1 2.8 35.9 Khanumuane 44.5 -1.1 11.3 -0.5 3.9 -2.3 Savannakhet 41.9 -4.7 9.8 -2.6 3.2 -1.2 Xaysomboom-SZ 26.8 - 19.9 - 8.5 Southern Region 39.8 -2.8 10.0 -3.4 3.7 -4.0 Saravanh 39.2 -2.1 10.0 2.8 3.6 7.2 Xekong 49.7 -6.0 15.0 -8.9 6.5 -9.6 Champasak 37.4 -2.0 9.0 -2.5 3.3 -2.9 Attire 48.0 -4.6 12.1 -12.3 4.3 -17.3 Lao PDR 39.1 -3.3 10.3 -1.6 3.9 0.0 Source:Kakwani, Datt, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30, 2002 2.11 By all three measures of poverty, Vientiane Municipality is clearly by far the richest area in Lao PDR. It accounts for two-thirds of the urban population and has grown rapidly during the past decade. 2.12 The Government's presentation on the poverty situation in Lao PDR includes comparisons between the incidences of poverty in 1997/98 relative to 1992/93. For 1992/93, this entailed deflating the 1997/98 poverty lines by the appropriate price indices. However, the estimated poverty lines for 1992/93 are less reliable than those for 1997/98, as the price indices 5 Defined as the mean distance below the poverty line. 6 The Foster-Greer Thorbecke index used to measure the severity of poverty is sensitive to the distribution of consumption among the poor; the calculation more heavily weights those for whom consumption falls far below the poverty line. -9- reflect data from only five cities. Price data for the rural population is not available, a serious limitation in light of the segmented markets in Lao PDR due to transportation difficulties. Further, determination of the incidence, depth and severity of poverty based on these lines is problematic, as the expenditure and consumption survey for 1992/93 involved only 2937 households in 147 villages. Large standard errors surround the statistical estimates, especially at the district level. 2.13 Keeping in mind these reservations, Table 2.3 summarizes the changes in regional poverty situations during the 1992/93-1997/98 period: Table 23: Change in Poverty Situation: 1992/93-1997/98 Urban Areas Rural Areas Total Regions 1992-93 1997-98 Growth 1992-93 1997-98 Growth 1992-93 1997-98 Growth Rate Rate Rate Incidence of Poverty ( percent of Poor) Vientianne 26.9 14.9 11.8 52.9 11.1 -31.2 33.6 13.5 -18.2 North 32.7 34.8 1.2 55.5 48.6 -2.6 51.6 47.3 -1.7 Central 26.8 24.3 -1.9 48.5 41.5 -3.1 45.0 39.4 -2.7 South 13.3 22.9 10.8 51.9 41.6 -4.4 45.7 39.8 -2.8 Laos 26.5 22.1 -3.6 51.8 42.5 -4.0 46.0 39.1 -3.3 Depth of Poverty (Poverty Gap Ratio) Vientianne 5.6 3.5 -9.5 11.1 1.6 -39:0 7.0 2.8 -18.3 North 6.6 7.8 3.2 14.8 14.6 -0.3 13.4 13.9 .08 Central 5.4 5.1 -1.2 11.2 10.4 -1.5 10.3 9.7 -1.1 South 3.1 5.4 11.2 13.5 10.5 -5.1 11.9 10.0 -3.4 Laos 5.5 4.9 -2.0 12.9 11.4 -2.5 11.2 10.3 -1.6 Severity of Poverty (Foster-Greer-Thhorbeck index) Vientianne 1.6 1.1 -7.9 3.4 0.4 -43.4 2.1 0.8 -18.3 North 1.8 2.7 7.5 5.4 6.1 2.4 4.8 5.8 3.7 Central 1.5 1.7 2.0 3.8 3.6 -0.8 3.4 3.4 -0.1 South 1.0 2.0 14.6 5.2 3.9 -5.8 4.5 3.7 -4.0 Laos 1.6 1.7 1.2 4.6 4.4 -1.1 3.9 3.9 0.0 Source:Kakwani, Datt, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30,2002 2.14 The data indicate that overall the incidence of poverty declined from 46.0 percent to 39.1 percent. They also indicate that rural poverty rates are roughly two times higher than urban poverty rates; the rural poor account for 90 percent of all poor. Comparisons by region, province and district indicate large differences in the degree to which the incidence of poverty has fallen.7 The Northern Region has had the lowest rates of poverty reduction. Some provinces (Luangnamtha and Oudomxay) have apparently experienced an increase in the incidence of poverty - despite healthy rates of national growth. Also, the rural/urban poverty gap remained very wide, except in the South where urban poverty increased sharply; rural/urban migration may explain this development, at least in part. 2.15 Income inequalities are another dimension of poverty in Lao PDR. Table 2.4 shows that the bottom 20 percent of the population accounted for only 7.4 percent of total consumption in 1997/98, whereas the top 20 percent accounted for 45.3 percent. Moreover, the disparities widened between 1992/93 and 1997/98, suggesting that economic growth during the period 7 There are relatively large standard errors associated with the provincial and district level data. -10- disproportionately benefited the top income group. The bottom 20 percent of the population experienced -0.3 growth rate in real consumption, compared to a 4.2 percent for the top quintile. Table 2.4: Inequality of Per Capita Real Consumption 1992/93 1997/98 Growth Rate of (Gini Coefficients) (Gini Coefficients) Real Per Capita Consumption Lao PDR 32.6 37.5 2.5 Quintile Shares First 8.5 7.4 -0.3 Second 12.4 11.4 1.0 Third 16.0 15.2 1.7 Fourth 21.5 20.7 1.7 Fifth 41.7 45.3 4.2 Source: Kakwani, Datt, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30, 2002 2.16 Yet another dimension of poverty is vulnerability. A vulnerability index has been constructed, reflecting access indicators (rice production per capita, large animals per capita, forest area index per household, access to roads) and social indicators (education levels, crude death rate).8 Poor and very poor districts are defined as those that satisfy only 2-3 of the indicators. On this basis, it was concluded that two-fifths of the 134 assessed districts in Lao PDR are poor or very poor. 2.17 A participatory poverty assessment (PPA) conducted in 2000 by the Government and the ADB has helped identify how the poor differ from the non-poor. Notable characteristics of the poor include their ethnic minority status and dependency on swidden agriculture and forest products (e.g., wildlife). Interest in education is minimal, reflecting priority concern for securing rice and other necessities. Because of their remoteness, basic services (health, potable water, roads, electricity) are very limited or nonexistent. 2.18 The PPA study also gives insight into the causes of poverty, as perceived by the poor. Foremost among these are land problems, including the quality and amount of land. Small plots or reduced allocations for swidden agriculture has meant falling yields and very low labor productivity. Livestock disease threatens the main source of savings. Lack of roads and hence lack of access to markets blocks commercialization of slope agriculture. Workable irrigation systems, improved extension services, livestock disease prevention, basic infrastructure and financial services, and family planning are among the solutions identified by the poor. 2.19 According to another study the poor tend to live in areas where infrastructure is scarce.9 The average distance to a main road is about 13 kilometers for the very poor, compared to 9 kilometers for the non-poor. Only 17.1 percent of poor population is linked to electricity networks, compared with 40 percent for the non-poor. About 38.6 percent of the poor population has access to piped water or protected wells compared with 57.1 percent of the non-poor population. Table 2.5 summarizes the data on access to services by the poor and non-poor. 8 World Food Program, "Vulnerability Analysis", August 2000. 9 N. Kakwani, Gaurav Datt, Bounthavy Sisouphnthong,, Phonesaly Souksavath and Limin Wang, "Poverty in Lao PDR: 1992/93-1997/98", March 2002. The study develops poverty lines taking into account regional and monthly costs of living differences and is based on calorie requirement of 2100 calories per person per day. -11- Table 2.5: Access to Services by the Poor, and Non-Poor, 1997/98 (percent) Non Poor Poor Total Road in dry season 70.82 84.83 79.36 Road in wet season 38.40 61.50 52.50 Electricity 17.13 39.98 31.06 Pipe water 38.64 57.08 49.88 Public transport 38.18 57.09 49.70 Primary school 86.4 87.6 87.1 Completed primary school 43.0 55.6 50.7 Medical practitioner 46.8 57.2 53.2 Trained nurse 63.0 63.7 63.4 Immunization 87.7 92.9 90.9 Birth attendant 44.6 50.5 48.2 Pharmacy 23.8 37.5 32.1 Community health worker 41.7 45.9 44.3 Hospital 84.2 95.7 91.2 Source: Kakwani, Datt, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30, 2002 2.20 This study also undertook multivariate analysis of household living standards. Gender, household size, and literacy were found to be key determinants of poverty with female headed households, and larger households tending to be poorer. The literacy rate among the poor is only 57.1 percent as compared with 74.5 percent among the non-poor. 2.21 The study concluded that while the incidence of poverty in Lao PDR fell between 1992/93-1997/98, there was little improvement in the depth and severity of poverty. Although heavily qualified because of the small sample size of the LECS I survey, the study concluded that growth appears to have benefited mainly those close to the poverty line; growth appears to have bypassed those further below the line. This observation is of great concem to the Government, for it challenges the central development theme of sustainable growth with equity. Policymakers must design a poverty reduction strategy for Lao PDR that promotes economic growth while keeping inequality in check. 2.22 Despite the need for caution in interpreting the various poverty analyses prepared to date, a good deal has been leamed about the extent, nature and determinates of poverty in Lao PDR. More information is needed about the socio-economic characteristics of the poor, drawing on the ongoing participatory poverty assessment and information from the social sector ministries. Sensitivity analysis of key assumptions used in constructing the poverty lines would help indicate where more work is needed to improve their reflection of reality. This analysis should include issues such as the caloric threshold, food consumption patterns, and price indices. Finally, further work is needed conceming criteria for monitoring poverty and for setting targets for poverty reduction. 2.23 The Government has made some tentative suggestions concerning poverty criteria, including categorizing households as poor if they lack access to 16 kg of rice per head per month. Villages would be considered poor if more than 50 percent of the households are poor, education, health and water services are lacking, and there is no road access. Districts would be considered poor if more than 50 percent of the villages are poor, if 40 percent or more of the -12- villages lack education, health and water services, and 60 percent or more of the villages have no access to a road. Such criteria would complement official poverty lines. Also, the Government proposes regular assessment of progress concerning basic social indicators: life expectancy, literacy, immunization rates, infant and maternal mortality rates, nutrient deficiencies, and food security. Weighting these factors to derive a more inclusive assessment of poverty poses both technical and value questions. Lao's Poverty Situation in International Perspective 2.24 Lao PDR is one of the poorest countries in the world and the region. A limited international comparison of its poverty situation is shown in Table 2.6, which shows poverty estimates for Lao PDR and four other countries in the region: Indonesia, Malaysia, Philippines and Thailand. A common poverty line of $1.5 per person per day at 1993 purchasing power parity (PPP) dollars is used in estimating these poverty indices. Table 2.6: Regional Comparisons of Poverty Country Year Consumption Gini Incidence Number of $ per day (Percent) (percent) Poor (million) Lao PDR 1997-98 2.37 36.4 37.6 1.95 Indonesia 1996 2.85 36.5 25.7 50.6 Malaysia 1997 8.28 44.2 0.04 0.01 Philippines 1997 3.62 46.2 27.5 20.2 Thailand 1998 4.44 41.4 12.5 7.6 Source: Poverty in Lao PDR: 1992/93-1997-98, March 30, 2001 2.25 In PPP terms, the mean consumption level in Lao PDR is shown as $2.37 per person per day, which is about half the level for Thailand. The incidence of poverty in Lao PDR is shown as three times the level in Thailand. These comparisons, however, are subject to a variety of measurement problems and should be interpreted as no more than indicative. 2.26 Lao PDR's poverty situation relative to other countries is also revealed by reference to a variety of more standard indicators.'° Life expectancy at birth has increased to about 59 years in Lao PDR," higher than in Cambodia but much lower than for Thailand and Vietnam (about 72 and 68 years, respectively). The infant mortality rate has dropped to 82 deaths per thousand, and the number of children dying before age five years has fallen from 170 deaths per 1000 in 1995 to 107 in the year 2000. Again, these rates are better than in Cambodia but compare very poorly to those in Vietnam, Thailand and other countries in the region. Several other countries in the region (e.g., Cambodia, Vietnam, Indonesia and the Philippines) experience child malnutrition at the approximately the same rate as Lao PDR. Maternal mortality has been reduced from 656 per 100,000 live births in 1995 to 530 in the year 2000, but this rate is much above those in Thailand and Vietnam (44 and 160, respectively). Illiteracy in Lao PDR is almost three times the rate for East Asia, but again there has been substantial improvement in the literacy rate over the past decade. These improvements in social indicators reflect the Government's emphasis on the status of women in society, and on improving food production and basic services for the population. 10 See World Development Report, 2000/2001, World Bank. " As reported by the Lao Reproductive Health Survey 2000, conducted by the National Statistical Center and the State Planning Committee, with support by the United Nations Population Fund. -13- LAO PDR's POVERTY REDUCTION STRATEGY FRAMEWORK Priority Programs and the Focus for Growth 2.27 Eight priority programs guide the national planning and investment system: 1) food production; 2) commodity production; 3) stabilization of shifting cultivation; 4) rural development; 5) infrastructure development; 6) expansion of external economic relations and cooperation; 7) human resource development; and 8), services development. 2.28 The main sources of growth are expected to be specialized commercial agricultural, agro- processing, hydropower, tourism, and mining. Major benefits are also expected from Lao PDR's role as an economic corridor linking the Greater Mekong Subregion. Sector Priorities for Poverty Alleviation 2.29 Four sectors are identified as the main pillars of the Government's development strategy for poverty alleviation: agriculture/forestry; education; health; and road infrastructure. For agriculture, land and capital resources will be encouraged to diversify according to market forces, but recognizing the different support needs. of upland and lowland rural communities. Deforestation is viewed as the country's most serious environmental problem, and a forestry strategy will reestablish sustainable harvesting. For education, services, the priorities include universal primary education and increased participation in secondary and tertiary education. The quality and accessibility of education services will be improved. For health services, the goal is a comprehensive preventative and curative system, together with effective drug and HIV/AIDS/STD control programs, UXO decontamination, gender equity and a national population policy. For transportation, priorities include rehabilitation and maintenance of the main arterial roads, and development of an all-weather network of rural roads. The sector priorities for growth and poverty alleviation are defined in vision statements, including the commitment to growth with equity. 2.30 A focal site approach to rural development targets remote areas where poverty is endemic. By providing infrastructure, education, health and other services in areas with growth and development potential, people in remote areas are encouraged to resettle in more sustainable living conditions. The focal site approach is also a key element of the Government's strategy to reduce the practice of shifting cultivation. Sound management of Lao PDR's natural environment is fundamental to the overall poverty reduction strategy. However, implementation of focal site development needs to be improved through focusing on the provision of appropriate services and not enforcing involuntary resettlement. 2.31 Agriculture/forestry as one of the pillars of the Government's poverty alleviation strategy is well placed. As indicated in the analysis of poverty, 90 percent of the country's poor reside in rural and often extremely remote areas. Increased, productivity and commercialization of the sector poses daunting policy and program challenges, especially for slope agriculture in upland areas. The strategy for poverty alleviation in these areas will need to be sensitive to ethnic diversity and deeply held traditions. In this connection, the focal site approach to rural development should draw upon the experience of other countries. Resettlement of people, so as to provide basic services more efficiently, must be founded on viable employment opportunities -14- and should be voluntary. If market forces are to be encouraged, the Government will have to reexamine its agriculturalVforestry policies and programs to ensure that they fully support sub- sectors with potential comparative advantage. In particular, the strategy for poverty alleviation could feature more strongly the potential for village-based forestry; an estimated 1.5 million' people could directly benefit from village forestry. 2.32 The Government's emphasis on human development is also well placed, as experience worldwide demonstrates the strong link with poverty reduction. Primary education and illiteracy eradication are especially important. Attention to improving teachers salaries and working. conditions, and accessibility to all five grades of primary education in hard-to-reach populations, should be priorities. To realize these priorities, the share of the budget for education will have to increase considerably. An increased share will also be necessary to strengthen health care services in underserved areas, and to improve the quality of health services generally. Greater attention to preventative health care' is needed, including for the control of infectious diseases. 2.33 Road infrastructure is properly identified as another key priority for poverty reduction. Top priority must be given to maintenance of the national and provincial road systems, and construction or upgrading for rural and feeder roads. Efficient utilization of the newly established Road Maintenance Fund will demonstrate the importance of ensuring that all road projects make proper provisions for sustainable preservation. 2.34 The energy sector is expected to contribute significantly to poverty alleviation, but linkage needs to be better developed. Rural electrification is not highlighted in the poverty reduction strategy, even though electricity is vital to improved living conditions and productivity gains. Also, export earnings from hydropower, including from Nam Theun 2, will grow dramatically during the decade and plans should be made as to how best to ensure benefit for the poor. 2.35 While the role of women in development in Lao PDR is strong, reflecting the importance of the Lao Women's Union and other institutional and cultural factors, a more comprehensive gender-sensitive strategy to poverty reduction would be desirable. The participation of girls in all levels of education must be improved. Health and family planning concerns of women must also be addressed. Governance and Public Administration Reforms 2.36 The development strategy for poverty alleviation recognizes that the transition to a more market-based economic system requires ongoing governance and public administration reforms. Administrative accountability, transparency, and mechanisms for policy development and coordination must be improved. Most importantly, the quality of the public services must be upgraded. The Government will strengthen performance management and gradually reduce the size of the public service. The rule of law will be strengthened though improvements of the legal framework and enforcement. "Red tape" will be reduced, assisting small and labor-intensive businesses. 2.37 The core governance reform is decentralization, focusing on the delegation of specified authorities and responsibilities from the central to the local levels. Provinces as strategic units -15- mean that they are now responsible for formulating and implementing their development and budget plans. While consistency with national goals is required, considerable flexibility has been delegated to the provincial Governors and district Chiefs, and to key offices at the local level - notably to the provincial and district offices of Finance and the Committee for Planning and Cooperation. Delegated responsibility for collection of selected taxes (e.g., land taxes) reinforces the decentralization initiative. Governance reform initiatives have also been launched in Vientiane and four secondary towns (Pakse, Savannakhet, Luang Praban and Thakhek). Capacity building programs of local administrations must accompany empowerment of local communities and active participation of all citizens, requiring improved levels of education. Macro-Economic Stability 2.38 Very significantly, the strategy acknowledges that macro-economic stability is a fundamental precondition for successful poverty alleviation. The Asian financial crisis and excessive deficit-financed public investment in 1997/98 triggered severe inflation, necessitating subsequent fiscal restraint - including in services vital to poverty alleviation (e.g., education and health). By early 2001 the Government had largely reestablished macro-economic stability but it will take time to fully reestablish and expand upon budgetary support for the social sectors. Targets and Goals 2.39 The Five-Year Plan for 2001-2005, the Medium-Term Expenditure Framework and the Public Investment Plan set out a number of targets and goals, including the following: * graduation from the least developed country status by 2020, and a sharp reduction in the incidence, depth and severity of poverty by 2005; * GDP growth of 7 percent or better by 2003, reflecting a strong build-up in private investment, especially in hydropower; * a sharp decline in the fiscal deficit, reflecting increased revenues (to 15 percent of GDP) and a better balance between current and capital expenditures; * a sharp increase in the PIP allocation for the social sectors, to 25 percent (compared to 11 percent in 1998/99); also, doubling in the investment share for rural development, to 10 percent; * further progression towards a market-based economic system, including trade liberalization and promotion of the private sector. 2.40 Sector targets and goals, together with the relevant programs, are discussed in subsequent chapters. In the context of the medium-term expenditure framework, an overarching concern is whether resources are available for reaching these targets and goals. As discussed in the Education Chapter, attainment of quality universal primary education and other goals would require allocating approximately 15 percent of the overall budget to the sector. In 2000/01 only 7.4 percent of public expenditure was for the education sector, although the planned budget allocation of the current fiscal year has increased to 10 percent. It was noted earlier that for Lao PDR to exit the group of Least Development Countries by 2020 will depend importantly upon how well public expenditure programs are linked to the needs of the poor. Some guides are needed for this purpose. -16- Linking Public Expenditure to Poverty Reduction 2.41 To have a significant impact on poverty, public expenditure must be budgeted and disbursed for activities that help the poor improve their welfare and income-earning potential. Appropriate policy and institutional frameworks must complement further, public expenditure. In their absence, investments in infrastructure, education and health to help the poor will be less effective. Particularly critical for the rural poor is the issue of land distribution and security of property rights. Access to financial services and capital is related to property rights; hence it is apparent that efficiency in public expenditure is heavily interdependent with the policy and institutional framework. Aside from the need to consider the context for efficient expenditure use, measures for linking sector programs to poverty reduction include the following:"2 * consistency of commitment; if the budget document is not "hard" and governed by a sustainable medium-term expenditure framework, ad hoc reallocations of fiscal resources may result in reducing financing for pro-poor programs (as occurred in Lao PDR for education and health programs during 1998-99); * sector planning, requiring ministries and line agencies to develop strategic plans as inputs to the overall poverty reduction strategy; the Government's series of sector "vision statements" prepared for the Round Table Consultative Process contribute to this process; * standards of public finance management; this includes improved accounting and implementation procedures, and performance indicators against which expected budget "outputs" can be measured; decentralization in Lao PDR underscores the need for performance indicators, both so as to ensure better realization of national priorities (e.g., universal primary education) and minimization of regional disparities in basic services; road participation; opening up budget systems to public scrutiny - by publishing information on budget formation, budget execution, and public accounts - can have a significant impact on the quality of public debate and the accountability of public institutions; the Government has published budget information, but greater detail for all levels is needed. 2.42 A series of steps should be followed in linking public expenditure to poverty reduction: * an overall review of past and current spending, including sectoral disaggregation, budgeted and actual spending, and a functional distribution of expenditures; * a listing of the main development programs, with a summary account of the objectives, intended and actual beneficiaries, the relationship to potential target populations and program cost information; * an income profile of the population, detailing information on the demographics, skills, location and economic activity; the analysis should include the non-poor, so as to evaluate income inequality and the extent to which the non-poor are benefiting from pro-poor programs by design or accident; * an initial analysis of the relationship between government programs and the population profile, including: (i) listing of the main programs against target groups; 12 See A. Fozzard, M. Holmes, J. Klugman, and K. Withers, Public Spendin2 for Poverty Reduction, World Bank, November 2000. -17- (ii) an overall coverage and cost analysis, designed to show which population groups (poor and non-poor) are being covered by different programs, and how much is being spent; (iii) identifying a set of key questions concerning both the impact of different programs and potential areas for reform and reallocations; (iv) overall evaluation of the impact of government programs on the income (or other dimension of well-being) of the population groups, in comparison with other interventions. 2.43 As noted in Chapter 5 of the PER there has been a serious deterioration in the quality of data on public expenditure. As new budget coding systems are adopted, better information on the composition of spending will become available. This should be used in conjunction with LECS mI to construct a poverty-expenditure mapping that will more effectively reveal the impact that public expenditures have on poverty reduction by region and expenditure program. Balancing the Goals of Equity and Growth 2.44 Lao PDR's transition to a more market-based economic system, involving a relatively small population thinly spread over a large, difficult terrain, poses special challenges for public expenditure management and poverty reduction. The Government's development strategy for poverty reduction is centered on helping the rural poor help themselves through more productive farming practices and other natural resource-based activities. It has meant gradually pushing out the frontiers of basic health, education and other services, as improvements in the road network make remote areas more accessible. Having accomplished a great deal in national integration, the Government is endeavoring to accelerate the provision of services to all districts and villages. While strong economic growth is expected to be the main means for reducing poverty, equitable growth will be better assured through an intensified emphasis on pro-poor expenditure programs such as improved access to primary education. 2.45 The goal of equitable growth is significant, for inequities in growth to date have detracted from poverty reduction. Decomposing growth during the 1992/93-1997/98 to measure separately the impacts of growth and inequity on the change in poverty yields the results shown in Table 7: Table 2.7: Growth and Inequity Effects for Poverty Reduction Changed Explained By: Annual Poverty Indicators Growth Inequity Total Change Incidence (%ofpoor) -14.8 11.8 -3.1 Depth (poverty gap) -19.5 17.6 -1.8 Severity -13.5 12:5 -0.9 Source: Kakwani et al., "Poverty in Lao PDR", Govemment of Lao/ADB, March, 2000. 2.46 The table indicates that, but for increased inequity, the incidence of poverty would have fallen by almost 15 percent a year, rather than by only 3 percent. Progress in reducing the depth and severity of poverty was also slowed by increased inequity during the 1992/93-1997/98 period. Nonetheless, despite the fact that progress in reducing poverty would have been much -18- greater if growth had been more pro-poor, economic growth in Lao PDR was still mildly pro- poor."' 2.47 Reinforcing pro-poor growth means inclusive growth - enabling the poor to actively participate in and significantly benefit from economic activity. This entails the removal of institutional and policy biases against the poor, as well as the adoption of direct pro-poor policies. The ethnic diversity of Lao PDR, and the very different socio-economic conditions of the Mekong lowlands compared to the uplands, calls for a high degree of sensitivity to local needs. Direct pro-poor policies include adequate education, health, family planning, transport, electricity, water and other services. Also, access to credit is important. 2.48 .While the removal of institutional and policy biases against the poor may be relatively costless, provision of the above cited public services to a widely scattered and frequently inaccessible population is very costly. The equity/efficiency tradeoff question must be addressed. 2.49 Two considerations bear importantly upon the question. First, from a welfare perspective, lower income groups than must give greater weight to income improvements for those at the top. This suggests focusing on equity considerations when evaluating public expenditure programs. Efficiency is also critical and - as much as possible - programs should strive to satisfy both equity and efficiency criteria. Education and health services for the poor will enhance their productivity and living standards, meeting both criteria. 2.50 Second, long-term sectoral and rural/urban trends must be taken into account. To support market-based decisions of investors and workers, the Government must keep pace with the changes of modernization and industrialization. Drawing on the experience of other countries whose economies have grown rapidly from a traditional agricultural base, Lao PDR could expect to see the relative importance of agriculture shrink from just over 50 percent of GDP currently to less than 30 percent by 2020. While much of the growth of industry will be agriculture and natural resource based, industry's share of GDP could almost double and the service sector will likely continue to grow in importance. Reflecting these trends, the urban population growth rate is more than double the rural rate; whereas approximately 1 million live in urban areas currently, by 2020 more than 2 million can be expected to live in urban areas."4 2.51 The provision of public services should be demand rather than supply driven. But immediate demands must be tempered by longer-term considerations. Even though poverty is overwhelmingly a rural problem, a balance must be struck to ensure that public expenditures for rural services don't absorb so much that urban services deteriorate. The Government's development strategy for poverty reduction is premised on 5 percent annual growth for agriculture, but more than double this rate for the industry and service sectors. Netting out 13 Nanak Kakwani and Emesto Pernia, "What is Pro-Poor Growth?" Asian Development Review. Vol. 18, 2000. The authors outline an index for measuring the degree to which growth is pro-poor. The index is derived by dividing the overall change in the poverty situation by the pure growth effect (i.e., subtracting out the equity effect). They concluded that, for Lao PDR, the pro-poor growth index for the period 1992/93-1997/98 was .21; that is, for a 1 percent increase in growth there was a .21 percent decline in the incidence of poverty. Growth is viewed as weakly pro-poor if greater than zero but less than .33, moderately pro-poor if between .33 and .66, and strongly pro-poor if greater than .66. Because of population momentum and falling child mortality rates, the population growth increased from 2.5 percent per year in 1995 to 2.8 percent currently: Lao Reproductive Health Survey 2000. -19- population growth, this suggests - unless other employment opportunities materialize on a considerable scale - that per capita incomes in rural areas will advance by only about 2.5 percent per year. Rural/urban income disparities could be expected to widen, encouraging an acceleration of rural/urban migration. This is the typical pattern for developing countries; exceptions include the Republic of Korea and Taiwan, China which managed balanced and equitable growth. In the case of Lao PDR, much will depend on how the forestry is developed and how revenues from hydropower projects (notably the Nam Theun 2 project) are shared to the benefit of the rural poor and on how the country's potential in commercial agriculture and tourism is realized and better urban-rural and market linkages are established. Summary and Concluding Remarks 2.52 A good start has been made by the Government, assisted by international experts, in defining the extent, nature and determinants of poverty. The analysis shows that poverty is most severe in the North, but also that there are districts throughout the country where poverty is deeply imbedded. A healthy rate of economic growth between 199/93-1997/98 contributed strongly to reducing the incidence of poverty in Lao PDR. Howeyer, increased inequity resulted in much less progress than could have transpired. Indeed, the benefits of growth largely bypassed those far below the poverty line. Consequently, economic growth has been only mildly pro-poor. 2.53 The Government must continue to emphasis broad-based sustainable growth, but with particular emphasis on bolstering rural growth where poverty is most concentrated. In this context, public expenditures must be evaluated from both an equity and efficiency perspective. -20- 3. MACROECONOMIC FRAMEWORK AND RESOURCE ENVELOPE 3.1 Fiscal policy in Lao PDR is crucial for both macroeconomic stability and implementing the Government's key policy objectives through the national budget. Demands for spending to meet these policy objectives are high. However, the Government is constrained by its ability to raise domestic revenues, the level of donor inflows and the scope to finance the budget deficit through borrowing from the banking system. 3.2 Central bank financing of the deficit risks creating significant inflationary pressures due to the high degree of dollarization in the country. Previous experience has demonstrated that a rapid expansion of credit to finance budgetary operations prompts individuals to switch excess holdings of domestic currency into foreign exchange. This swiftly results in deprecation of the local currency putting upward pressure on prices. The scope for bank-financed deficit spending is therefore very limited. 3.3 Monetary conditions, and macroeconomic stability, have also been affected by quasi- fiscal activities in the form of public investments undertaken through the banking system. In the absence of sufficient domestic revenues the Government has encouraged state-owned commercial banks to. extend loans to both state-owned and private enterprises to implement public policy programs (e.g. infrastructure projects). This directed lending is in effect credit to the government and poses macroeconomic risks similar to those of direct budget financing through the banking system. In addition, directed lending has frequently failed to generate sufficiently high rates of return with the result that projects have been unable to service their debts leading to an accumulation of bad loans in the SOCBs. The government has to bear these costs through public restructuring of the SOCBs and SOEs. 3.4 This highlights the crucial role of fiscal discipline in preserving macroeconomic stability. Therefore, the following discussion emphasizes the need for a the medium term fiscal framework and resource envelope to that can provide a stable medium term macroeconomic foundation for sustained future growth. MACROECONOMIC AND FISCAL BACKGROUND 3.5 In the first half of the 1990's Lao PDR averaged 7-8 percent economic growth with inflation at around 11 percent through implementing its New Economic Mechanism (NEM). Growth and macroeconomic stability were underpinned by prudent fiscal policy. Prior to the domestic economic crisis domestic revenue collections were increased to 13 percent of GDP in 1995/96 following the implementation of the 1995 tax law. At the same time significant receipts of foreign grants and loans enabled deficits of 6 to 7 percent of GDP (including grants) to be run while the government accumulated deposits in the banking system (Table 3.1). -21- Table 3.1: Lao P.D.R. General Government Operations, 1995/96 - 2000/01 1995/96 1996/97 1997/98 1998/99 1999/00 2000/01 June 12, 2001 Est. Est. (In percent of GDP) Revenue 13.0 11.3 9.8 10.6 13.2 13.6 Tax 10.8 9.3 7.8 8.5 10.6 11.1 Nontax 2.2 1.9 2.0 2.1 2.5 2.5 Grants 3.5 3.4 5.3 6.0 3.7 3.2 Expenditure 22.1 21.9 23.6 20.6 21.5 21.4 Current 10.2 11.1 8.1 6.1 8.2 8.4 Capital and onlending 11.9 10.8 15.5 14.4 13.3 13.0 Primary balance -4.9 -6.4 -7.4 -3.3 -3.8 -4.1 Current balance, excluding grants 2.8 0.2 1.7 4.4 5.0 4.6 Overall balance -5.6 -7.2, -8.5 -4.0 -4.6 -4.6 excluding grants -9.1 -10.6 -13.8 -10.0 -8.3 7.8 Financing 5.6 7.2 8.5 4.0 4.6 4.6 Domestic financing (net) -1.1 1.6 2.5 -0.6 -1.2 1.3 of which; Bank financing -0.9 -1.6 0.8 -0.4 -0.8 1.7 Foreign financing (net) 6.7 5.6 6.0 4.6 5.7 3.2 External loans 7.1 6.0 6.6 5.4 7.2 5.8 Amortization -0.4 -0.4 -0.7 -0.9 -1.5 -1.4 Memorandum items: Nominal GDP, fiscal year (in billions of kip) 1631 2029 3745 8,788 12,688 14,454 Sources: Lao P.D.R. authorities and IMF. 3.6 However, a loss of fiscal discipline resulted from the Government's need to finance ambitious growth and investment objectives. In particular, to meet the Government's commitment to achieve rice self-sufficiency targets, the construction of large-scale irrigation projects was undertaken in 1997/98. This raised capital-spending to 15.5 percent of GDP just as domestic revenues declined. This forced the government to compress current spending and borrow from the central bank to finance the deficit. Given the high level of dollarization, this precipitated a steep inflation/depreciation spiral. In 1998/99, despite improved revenue collections and cuts in capital spending, further compression of recurrent spending was required to avoid further bank financing. This resulted an accumulation of arrears, in particular for salary payments for social sector workers. Although the government actions supported economic growth the resulting macroeconomic instability was severe. Inflation peaked at 167 percent (12 month basis) in early 1999 and by mid 1999 the domestic currency, the kip, had lost 90 percent of its value over the previous two-year period. -22- Chart 3.1: Lao PDR: Fiscal Developments 1995/96 - 2000/01 (percent of GDP) 30 2s 20 Is 10 0 * Grants t Revenue -10 MExpenditure UDeficit -15 ..... ........._...__.._....-.. _ ... _ . . 195/96 1996/97 1997/90 199V9 199/00 2000/01 Est 3.7 Recognizing the costs of high inflation the authorities embarked on a strong stabilization program through monetary and fiscal tightening that reduced inflation to single digit levels over the subsequent 18 months. Revenue collections improved sharply, through determined efforts to improve tax administration and higher timber royalties, and increases in recurrent expenditures were offset by further cuts in capital spending. As a result, the overall deficit declined to some 4 percent of GDP and the government accumulated deposits with the banking system. However, recurrent spending remained significantly lower than in pre-crisis years and was insufficient to fund key social sector programs, provide sufficient counterpart funds for donor-financed capital spending, and adequately compensate civil servants for their erosion in real wages. 3.8 The experience of Lao PDR in recent years demonstrates how easily macroeconomic stability can be lost and how difficult it is to restore. The maintenance of future stability is therefore crucial for durable economic growth and the implementation of poverty alleviation programs. 3.9 A major weakness with the annual budget process is the bias towards optimistic macroeconomic projections. This bias reflects, in part, the fact that the five year National Economic and Social Development Plan sets targets rather than projecting the most likely outcome. Under the planning framework, an optimistic revenue target can appear to supply the funds needed to meet the many demands for expenditures. While this might be rationalized as a way of inducing the revenue departments to make greater efforts, the bias toward optimistic projections gives rise to several macroeconomic problems: a. The optimistic revenue targets result in excessive short-term focus on achieving nominal targets compromising the implementation of systematic improvements aimed at raising revenues in the medium term. They can also create a dependence -23- on tax negotiations that is detrimental to building a more transparent business environment based on the strict provisions of the tax law. b. When revenue targets are not met, difficult choices have to be made. If expenditure is not restrained, excessive bank financing will create macroeconomic problems. c. Since typically the revenue shortfall is only acknowledged late in the fiscal year, it is too late to implement systematic expenditure cuts, especially under the current system with no controls over expenditure commitments, after the executing officer certifies they are in the budget. Thus, if bank financing is to be avoided, payments have to be withheld, creating the potential for payment arrears. 3.10 It is possible to deliberately overestimate some expenditure to form a contingency element. However, this would only be a temporary device as the hidden nature'of the contingency element would be swiftly exploited, and expenditure demands increased to ensure that it was used. 3.11 To strengthen budget preparation the immediate focus should be to improve the realism of macroeconomic projections, and in particular revenue projections. This would require a more flexible approach in assessing economic conditions prevailing at the time of the budget and for the forthcoming fiscal year that is less closely tied to targets in the 5-year plan. A further step would be adoption of a simple, medium term macroeconomic framework linking growth, inflation, and the fiscal, monetary and external sectors to provide a more formal underpinning to budgetary projections and to help guide policy discussions. The first year of the framework would provide the foundation for the current budget and the outer years would provide indicative projections of potential resource availability. 3.12 Recommendation. Adopt realistic revenue forecasts so that estimates reflect most likely outcomes rather than targets. Adoption of a simple, medium-term macroeconomic framework linking growth, inflation, and the fiscal, monetary and external sectors 'would provide a more formal underpinning to budgetary projections and help guide policy discussions. 3.13 Recommendation. Implement a mid-year budget adjustment. The present system in principle allows the authorities the flexibility to adjust the budget to take into account the inevitable variations in revenue collections over the course of the year. However, lags of as much as six months in finalization of the line item budget detail, as well as the absence of reliable quarterly data on the economy make judgments on the need for revisions more difficult to implement. Reducing the political costs of a mid-year budget adjustment would allow expenditures changes to be made to accommodate revenue fluctuations in a more coordinated and systematic manner. 3.14 Recommendation. Improve the reconciliation between revenue and expenditure and budget financing. Currently the "above-the-line" items are not reconciled with the financing, especially as measured by the bank accounts of the treasury. Requiring this reconciliation at all levels of government would provide the incentive to be more conscious of the number of banks accounts used, be more accurate in the recording of revenue and expenditure, and to better monitor the macroeconomic impact of budgetary policies. -24- THE MEDIUM TERM FISCAL FRAMEWORK AND RESOURCE ENVELOPE Projected Framework 3.15 The medium term fiscal framework presented below is based on underlying medium term macroeconomic policies designed to sustain the economic stability of the past two.years. However, it should not be interpreted as providing point estimates for key aggregates, but more as illustrating potential resource availability to guide sectoral expenditure allocations. 3.16 The medium term fiscal framework assumes that the government successfully pursues its macroeconomic and structural reform policy resulting in an increase in real growth of 5.8 percent in 2000 rising to 7 percent by 2005.'5 In general, growth and investment could be expected to be supported by greater private sector activity, as investor confidence improves with the continuation of macroeconomic stability, although the quality of the legal and enabling environment will also affect investor confidence. Construction of the Nam Theun II hydroelectric power project would provide a further boost to the economy as will investments mining, commercial agriculture and agro-processing. Pursuit of prudent monetary and fiscal policies over this period, in particular modest non bank financing of the fiscal deficit and restrained credit expansion, would be expected to reduce end period inflation from 11 percent at end 2000 to under 5 percent in the medium term. 3.17 The medium term fiscal framework and resource envelope accompanying these projections is detailed in Table 3.2. The fiscal deficit in the medium term is projected to decline gradually towards 4 percent of GDP (including grants) and be largely financed through continued donor resources. Consistent with the low inflation objective there would be no bank financing of the deficit and only a limited amount of non-bank financing over the period, comprising asset sales and treasury bill issues. '5 However, given a sharp deterioration in the global and regional external environment currently facing Lao PDR a period of lower near term growth, of around 5 percent per annum, appears likely. -25- Table 3.2: Lao P.D.R. General Government Operations, 1999/00 - 2004/05 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 June 12, 2001 Est. Est. Est. Proj. Proj. Proj. (in percent of GDP) Revenueand grants 16.9 16.8 16.4 17.2 17.2 17.7 Revenue 13.2 13.6 13.1 14.1 14.4 14.9 Tax 10.6 11.1 10.7 11.5 12.0 12.5 Nontax 2.5 2.5 2.5 2.5 2.4 2.3 Grants 3.7 3.2 3.3 3.1 2.8 2.8 Expenditure 21.5 21.4 21 22.2 22.2 22.5 Current 8.2 8.4 8.6 9.5 9.7 10.0 Capitalandonlending 13.3 13.0 12.4 12.7 12.5 12.5 Primary balance -3.8 -4.1 4.0 -3.8 -3.8 -3.7 Overall balance -4.6 4.6 4.6 -5.0 -5.0 4.8 excluding grants -8.3 -7.8 -7.9 -8.1 -7.8 -7.6 Financing 4.6 4.6 4.6 5.0 5.0 4.8 Domestic financing (net) -1.2 1.3 0.6 0.3 0.5 0.4 of which; Bank financing -0.8 1.7 0.5 0.2 0.2 0.2 Foreign financing (net) 5.7 3.2 4.0 4.7 4.5 4.4 Extemal loans 7.2 5.8 6.0 6.2 6.0 5.8 Amortization -1.5 -1.4 -2.0 -1.4 -1.5 -1.4 Memorandum items: Nomninal GDP, fiscal year (in billions of kip) 12,848 14,671 16,614 18,422 20,934 23,492 Sources: Lao P.D.R. authorities and IMF 3.18 Successful efforts to increase revenue mobilization lie at the heart of the fiscal framework, both to support continued macroeconomic stability and to provide additional resources for key expenditure priorities. To achieve medium term improvements in revenue collections progress will be needed in three key areas: the introduction of a VAT, continued reforms in tax and customs administration and a reduction of exemptions (see Box 3.1 and Annex 3.1). With committed and sustained implementation of these measures revenues could be raised from an estimated 13.2 percent of GDP in 1999/00 to near 15 percent of GDP over the 5 year horizon. A 1.5 percent of GDP increase in revenues over the period is a conservative estimate in light of known current policies, but it aims to avoid the macroeconomic risks in setting overly ambitious targets. 3.19 This framework projects total external donor support (grants and loans) to continue at close to 9 percent of GDP over the medium term. Such a level is in line with donor inflows in the last fiscal year and assumes continued assistance in support of the government's poverty alleviation strategy. The majority of these resources are project finance for public investments included in the PIP. With a more stable macroeconomic environment and in support of structural reforms, a conservative estimate for additional program loans for general budgetary support by the World Bank and the ADB have been included in the fiscal framework. The continued support of donors will of course be critically dependent on improved transparency, accountability and reforms in governance. -26- 3.20 Mobilizing domestic revenues and external resources of this order over the period would allow total expenditures to rise by 0.8 percent of GDP, to 22.5 percent of GDP, from the projected 2000/01 outcome. However, the Government intention to reduce the share of the capital budget toward 12 percent of GDP would allow recurrent spending to rise to 10 percent of GDP to accommodate critical poverty alleviation programs, increased operations and maintenance spending and improved civil service wages and salaries. This would restore the more balanced structure of spending close to that prevailing before the crisis A further rebalancing to perhaps a 50-50 ratio of recurrent to capital spending should be considered and would be in line with sectoral spending recommendations. 3.21 The main risk to this framework would be the failure to achieve the revenue targets. Any significant problems or delays in implementing the VAT, and in achieving sustained improvements in revenue administration could lead to revenue shortfalls. As has been stressed this would pose risks either to macroeconomic stability or threaten important government programs if expenditures had to be cut. 3.22 Recommendation. Continue with revenue enhancement measures including implementation of the VAT in 2004 and introduction of improvements to tax and customs administration including at the Large Taxpayer Unit. FISCAL SUSTAINABILITY 3.23 The projected medium fiscal framework appears sustainable for Lao PDR. Although there are risks from revenue and expenditure sources, the pressures from both appear manageable at present and suggest that projected fiscal policies will not lead to a build up of excessive debt levels. The need for continued reforms to raise revenues and the suggested policies to achieve higher collections have previously been noted and are discussed in greater detail in Annex 1. 3.24 Pressures for higher expenditures may arise from a variety of sources; to meet the cost of SOCB restructuring, for potential government contingent liabilities, for funding key social sector priorities for poverty alleviation, and for civil service reforms, especially reversing the erosion of civil service real wages. 3.25 The costs of SOCB restructuring appear manageable within the current fiscal framework. Three SOCBs, accounting for 70 percent of banking system deposits and equivalent to only 12 percent of GDP, are to be restructured. The preliminary estimate of banks' capital deficiency is currently 4 percent of GDP, however this could prove to be higher. The government is in the process of preparing bank restructuring plans that will include targets for debt workouts and operational management improvements. A phased capitalization buildup program of the banks will be undertaken conditional upon these improvements. This could occur over a period of roughly four years. The fiscal framework could accommodate the interest costs of government restructuring bonds (issued at an illustrative 10 percent interest rate) as annual interest payments would rise from 0.1 to 0.4 percent of GDP over the four year period. To stay on track the GOL needs to move forward with the signing of Memoranda of Understanding on Restructuring (MOUR) with SOCBs covering capital build up, restructuring and NPL recovery plans. Contracts for implementing business plans based on the MOLJRs then need to be signed with international consultants. The GOL also needs immediately to stop directed lending through the -27- SOCBs. A clear mechanism for policy lending needs to be formulated incorporating the principle that, in the limited circumstances where targeted subsidies may be warranted, they should be funded explicitly through the budget. 3.26 A significant uncertainty in the fiscal framework is the level of the govemment's contingent liabilities. A full accounting of these liabilities to identify the size and likelihood of any potential future claims on fiscal resources government would be required to assess the risks to fiscal sustainability and the robustness of the fiscal framework. The costs of SOCB recapitalization already capture those loans provided by SOCBs to SOEs that have gone into default. However, an analysis of all extrabudgetary funds should be made to assess the potential impact on the fiscal position. This applies in particular to the known extrabudgetary Road Maintenance Fund, the Poverty Reduction Fund and the planned Environmental Fund, but comprehensive financial information on all such accounts is necessary. With assistance from AusAID audits are being conducted on the SOCBs. While the contingent liabilities of the Agricultural Promotion Bank (APB) are likely smaller than those of the other banks, they may still be significant and APB lending practices may distort factor markets in the agriculture sector. An audit of the APB is to be conducted with the assistance of the ADB. 3.27 The roughly 34 fully state owned SOEs as well as 8 joint ventures and 59 provincial SOEs are responsible for a large portion of the NPLs of the SOCBs. For example, they account for about 80 percent of the ten largest NPLs of BECL and have a face value of US$ 35.4 million. Ongoing losses at SOEs that have given rise to these NPLs must be stopped or the bank restructuring and capital build up efforts will unravel. Key steps towards this end include the following. 3.28 Recommendation. Tighten the financial and management oversight of SOEs including unified financial reporting to MOF's Office of State Assets and PMO's Business Improvement Office, and establishment of early warning and contingent liability monitoring systems. 3.29 Recommendation. Launch a phased program of enterprise financial and operational restructuring starting with establishment of restructuring principles followed by pilot restructuring cases to demonstrate the viability of the restructuring process. Have draft recovery plans prepared by ten largest non-performing debtors and submitted to creditors. Complete workouts with creditors and implement recovery plans. 3.30 Recommendation. Bring tariffs in the power, aviation, water, transport and telecommunication sector to cost recovery levels. Give autonomy to adjust prices to ensure full cost recovery and debt service capability. 3.31 A further source of expenditure pressures could arise from civil service reforms. The government has announced targets for a reduction in aggregate civil service employment of 5 percent by 2003. However, work on civil service reform is at a preliminary stage and sufficiently detailed information to estimate the likely costs of wage reforms and an associated retrenchment exercise is not yet available. When the work is more advanced these costs will need to be reflected in a revised the medium term fiscal framework. -28- 3.32 The debt sustainability of the medium term framework aimed at macroeconomic stability appears manageable. Fiscal policies in the framework could be expected to result in the primary deficit (including grants) declining to a stable level 4 percent of GDP in the medium term, compared to 7.5 percent in 1997/98. 3.33 In terms of government debt levels, current domestic debt is low and interest payments are budgeted at only 4 percent of recurrent spending in the 2001/02 budget. With continued fiscal restraint only limited additional treasury bill issues would be needed to finance the deficit. This would limit the growth of future interest payments. As noted earlier the capital cost of SOCB restructuring is expected to amount to approximately 4 percent of GDP and the additional treasury bill issues required would cause domestic debt to rise from less than 1 percent of GDP in 1999/00 to some 5 percent by 2004/05. 3.34 Extemal sector debt developments do not appear to pose a threat to fiscal sustainability at present. The stock of public external sector debt is estimated at US$ 2.6bn in 2000, with the main bilateral creditor being the Russian Federation (US$ 1.3bn). This debt is currently under negotiation. Over the medium term, the continued access to donor funds on concessional terms assumed in the fiscal framework and avoidance of nonconcessional borrowing by the government could lower the ratio of debt to GDP (excluding the Russian Federation debt) from 90 percent in 1999 to 60 percent in 2005. Over the medium term debt sustainability needs to be monitored especially as the grace period for a significant portion existing concessional expires. 3.35 However, fiscal sustainability is not a static concept. Although the above discussion indicates that at present the risks appear manageable fiscal sustainability has be regularly reassessed taking into account actual revenue and expenditure developments, the provision of greater detail on medium term expenditure programs as they are formulated, and information on contingent liabilities. CONCLUSION 3.36 Fiscal policy is crucial to the government's commitment to achieve sustained growth with poverty alleviation. Fiscal policy must contribute to overall macroeconomic stability, essential for setting the foundations for sustained growth, while at the same time generating the resources for key public spending for poverty alleviation programs. The center of any medium term fiscal framework therefore will have to be sustained efforts to raise domestic revenue collections through key policy initiatives, by introducing a VAT, and ongoing efforts to improve tax administration. 3.37 If successful these efforts would appear to suggest a modest expansion of total government expenditure could be achieved without threatening macroeconomic stability or being fiscally unsustainable. If, as the government has planned, capital spending is restrained to a level consistent with priority sectors and implementation capacity, recurrent spending could rise at a somewhat faster rate than overall spending for crucial poverty alleviation programs. -29- ANNEX 3.1: MEDIUM TERM REVENUE PROJECTIONS Chart 3.2: Projected Revenue Shares 100% Other nontax revenues 90% Overflight revenues 80% Other tax revenues 70% Timber royalties Trade taxes 60% 50% 40% Indirect taxes 30% 20% 10% 0% Direct taxes 1995/96 1999/00 2004/05 3.38 Increased revenue (as a percentage of GDP) is essential to provide for growth in recurrent spending targeted at key social sector programs while restraining the deficit to maintain macroeconomic stability. The inability to generate sufficient domestic revenues to fund priority government programs was the root cause of macroeconomic instability between 1997 and 1999 when the government resorted to the alternative of inflationary bank financing. 3.39 Since 1995/96 revenue sources have been diversified away from trade taxes and anticipated hydropower royalties, toward consumption taxes and direct taxes (Chart 3.2). Trade taxes have declined largely due to tariff reductions that became fully effective in 1998/99.'f While this negatively affected turnover tax on imports, overall excise taxes increased with the introduction of higher turnover tax rates in 1997 and the extension of products subject to duty in 1998. Increases in direct tax collections resulted from the creation of a Large Taxpayer Unit, which introduced simplified taxpayer registration and identification systems (including self- assessment procedures), simplified tax forms and more effective audit procedures, and computerized key administrative tax functions. 3.40 This diversification will continue. The medium term fiscal frarnework incorporates a conservative estimate of revenue potential to avoid inflating the resource envelope and expanding expenditure commitments beyond levels of what can realistically be financed. The framework is based on an assessment of known policy intentions, in particular the conversion of the turnover tax to a VAT, to help offset declines in future AFTA related import duties, and a cautious estimate of what can be achieved through purely administrative improvements focusing on large taxpayers and limiting exemptions. In light of the expectation that the future growth of the economy will be increasingly driven by private sector activity tax reforms will rely on continuous improvements in the taxation of the nonstate sector. 16 Erosion of the real value of collections because of the effects of inflation on fixed nominal charges was also a factor. -30- 3.41 The government intends to introduce a VAT in 2004 through converting the current turnover tax that has many features of a VAT; an input tax credit mechanism, zero-rating of exports, limited exemptions and a turnover threshold that only captures the larger taxpayers. However, the turnover tax still has weaknesses. The tax base remains too narrow, being limited to the first sale of imported and domestically produced goods and services, and the two rates, though simplified from four, complicate compliance and administration. In addition, turnover tax exemptions are excessive and the only partially effective input tax credit system has cascading effects in later stages of production. 3.42 The government has therefore established a technical VAT committee in MOF to examine VAT issues and prepare an implementation plan. The details of this policy have yet to be fully elaborated, including how implementation will be affected by decentralization, but a full VAT with a single positive rate, a wider goods and services base and restricted exemptions would require only a limited number of administrative and legislative preparations to amend the current turnover tax system. Nevertheless careful preparation is needed to introduce the VAT in a timely manner. 3.43 Tax administration reforms have focused on collecting revenue from the largest taxpayers. Until recently the institutional arrangements for the largest taxpayers had been subject to revision and a degree of uncertainty. The periodic transfer of large enterprises to provincial revenue offices that was unfamiliar with large taxpayer assessment techniques, a shortage of full time staff and uncertainty over the LTU's formal position in Ministry of Finance all complicated the implementation and weakened the impact reforms. 3.44 However, the GOL has now made clear its commitment to decentralization and the aim of raising revenues from large taxpayers through establishing large taxpayer units in the major provincial centers. For this system to succeed it is important that the regional LTUs have sufficient staff, fully trained in the specific techniques for large taxpayer assessment and that the LTUs co-ordinate activities to prevent enterprises "shopping around" for preferential treatment. This will require an effective monitoring and enforcement role from a central MOF based unit. 3.45 The reduction of exemptions is a key area that would contribute to increased medium term revenues. Although a start in addressing this issue was made with the announced restriction on Foreign Investment Law (FIL) exemptions in the 2000/01 budget, customs data indicate that more than 60 percent of import value is exempt from import duties. This results from FIL provisions under which virtually all imports are either fully exempt or pay no more than 1 percent duty, as well as an absence of clear policy guidelines and customs procedures for restricting exemptions, and excessive exemptions from turnover tax in conflict with established tax law. 3.46 Until recently the absence of more detailed data has precluded an estimate of the potential effects of these reforms. However, the introduction of new data collection and reporting procedures in the customs department have now started to produce preliminary data. This system should be made fully operational to identify the revenue loss from exempt imports. Following this consideration should be given to designing and developing an administrative system in the MoF to administer the granting and monitor of exemptions to reduce exemption leakages. -31- Box 3.1: Medium Term Revenue Projections Revenue collections are forecast to increase from 13.2 percent of GDP in 1999/00 to near 15 percent of GDP by 2004/05. Tax revenues are projected to increase by 2 percent of GDP but nontax revenue decline by 0.2 percent of GDP over the period. In detail; Profit, income and excise taxes could be expected to rise slightly in excess of nominal income growth (with a buoyancy of 1.1) driven by continued, but conservatively estimated, improvements in tax administration focusing on collections from large taxpayers. These measures would result in direct and indirect taxes rising as a proportion of total revenue collections from 18 percent and 30 percent respectively in 1999/00 to 21 percent and 44 percent in 2004/05. The conversion of the current turnover tax to a full VAT is the single most important source of additional revenue in the medium term and it is estimated that a single rate of around 10 percent with few exemptions could raise an additional 1.5% of GDP. With implementation in 2004 these benefits are projected to accrue equally over a 3 year period. The introduction of the VAT would help offset an anticipated reduction in customs duties arising from the implementation of AFTA commitments between 2001 and 2008. It is estimated that import duties could fall by at least 25 percent over the period with losses peaking in 2005 (the date of the last transfer list) and continuing thereafter with further tariff reductions. This could result in trade taxes declining to only 8 percent of total revenue collections by 2004/05. In line with Government plans to respond to unsustainable levels of logging in previous years and environmental concerns, timber royalties are conservatively estimated to rernain constant in absolute terms over the medium term resulting in natural resource taxes declining from 16 percent of total revenues in 1999/00 to only 5 percent by' 2004/05. Other tax and non-tax revenue bases show no great potential for buoyant growth and hence are projected to remain broadly constant as a percentage of GDP. -32- 4. IMPROVING BUDGET EXECUTION, CONTROL AND TRANSPARENCY'7 4.1 Budget execution and the reporting, accounting, and auditing systems that support it are an area of particular weakness in Lao PDR Improvements at a fundamental operating level for expenditure management, control and reporting will have to be made before more far reaching changes to budget preparation and strategic planning can be effectively implemented. At this stage the authorities have neither the basic information about budget outcomes nor the tools of cash management to allow for more effective budgeting and planning systems. There are some solid technical assistance projects in these areas but they are only a start and need to be placed in the context of an overall public expenditure management strategy. The focus of this chapter is therefore on the immediate goal of improving these basic systems. The following chapter deals with the improvements to the planning and budget preparation process, but it should be clear that those are longer term goals that can only be achieved once there has been clear progress on the issues identified in the current chapter. BUDGETARY CLASSIFICATIONS AND SUBMISSION OF THE BUDGET 4.2 Decision No. 1239/MOF of the Ministry of Finance dated November 21, 1995 established a new budget classification grouping receipts by broad revenue categories (PIT, VAT, excises etc.) and expenditures by economic type of spending (salaries, current spending, subsidies, grants, other social transfers, capital expenditures, interest payments). 4.3 The current classification of revenues, by line item, requires only minor changes, to reflect the new division of revenue responsibilities among the central government, provinces, and districts under the decentralization process. 4.4 However, the current classification for expenditures is inadequate. The economic classification is not related to administrative (subdivisions of ministries, provinces, districts) or program (defense, environment, housing, culture, education, health) classifications. Because it only incorporates a line-item classification it is not possible to show how planned expenditures will implement government policies or that budget execution is in line with these policies. In addition, the classification is not consistent with article 18 of the 1994 Budget Law (which requires budget expenditures to be classified vertically by administrative unit) nor does it incorporate the recommendations of a 1994 International Monetary Fund mission for a simplified administrative classification. '' This chapter includes the World Bank Country Financial Accountability Assessment. In addition, it includes a section on decentralization as well as the key findings of the Country Procurement Accountability Review which was presented to the Government separately. -33- 4.5 The poverty reduction strategy, the devolution of financial responsibilities to provinces under the decentralization process, and steps toward computerizing part of the expenditure chain, all require a revised budget classification that identifies, on a regular and timely basis, the administrative entity to which the expenditure relates, and/or the priority.sector concerned. During the next few years, this would serve as the proxy for identifying expenditure by programs. It should be noted that with the support of the ADB the GOL has undertaken efforts to computerize a part of the expenditure process (see below). Links Between the Budget Classification and the Chart of Accounts 4.6 Double-entry bookkeeping is provided for in the Chart of Accounts (COA) of the State which are divided among different classes, balance accounts (loans, fixed assets), liaison accounts with the provinces, third party accounts (creditors, suppliers), financial accounts (banking, cash), budgetary charge accounts and budgetary proceeds. The COA is based on a classification by type of expenditures (salaries, other operational expenditures, transfers, and capital expenditures), in addition to some functional accounts (education, health) which appear to be an ad hoc response to the absence of an administrative and program classification. Although both the budget nomenclature and the COA are based on an economic classification (line-item by type of spending), the budget and COA codes are not the same. This rules out any automatic link between the accounts of the authorizing officers and those of the treasury department. .4.7 The COA, in accordance with intemational practice, is controlled by the accounting services. Some parts of the COA are currently used for the provinces and districts. The provinces, whose operations are in tum consolidated by the Treasury Department, consolidate accounting entries for the districts. Implementation of the accounting plan ends with submission of (i) financial statements and monthly account balances for the government's information and year-end reports; and (ii) annual budget execution documents submitted for approval by the National Assembly. 4.8 The budget nomenclature and the COA should be harmonized to create a single coding system. Since both classifications would be linked and the budget classification would contain functional and administrative categories, the functional categories currently found in the COA would then become redundant and should be removed. 4.9 Recommendation. Construct a comprehensive budget classification by incorporating the administrative and functional classifications, adopting an alpha-numeric coding structure, which would allow: i. Identification of Ministry, or agency or province; ii. Identification of service (provincial or district counterpart of the Ministry); iii. Identification of program, identified by the main function of the basic administrative unit; iv. Identification of the economic type of spending (pickingup the current chart of accounts line item classification, class 6 accounts). 4.10 Recommendation. Establish a COA in line with the revised budget classification with uniform budget and accounts codes for processing transactions. Prepare a simplified budget nomenclature and COA for provinces and districts, which should be consistent with the revised -34- budget and accounting classification at the central level, and establish clear reporting procedures between provinces and central government to enable the tracking of expenditures. 4.11 Recommendation. Introduce COA and budget nomenclature changes starting with consolidation of COA classifications, introduction of standardized codirig for budget surplus/deficit, assets, liabilities, expenditure, income and internal treasury accounts, as well as separate cost center codes for identifying expenditure by sector to provide better tracking of priority poverty reduction spending. Begin longer-term phased process of introducing codes for expenditure by program based on administrative units. 4.12 Recommendation. Streamline reporting requirements and budget monitoring system in MOF and in all the ministries, including the following measures: i. clearly define the format, frequency and distribution of financial reports both internally within the ministry and with MOF; ii. develop a formal system for ex-post monitoring of budget implementation, including a periodic reconciliation of accounting records at the line ministries and at the national treasury and reports produced by line ministries in addition to those produced by the national treasury for use by the Budget Department; iii. ensure that Treasury accounts track all budgetary operations of the State and government administrative units, in the areas of tax and non tax revenue collections, external resources (foreign loans and grants) and expenditures. 4.13 Publication of the budget is an important part of transparency and accountability. In Lao PDR the budget passed by the National Assembly in October contains only aggregate spending levels. Detailed spending plans are worked out in a process of negotiation between MOF and the ministries, provinces and districts taking the National Assembly aggregates as spending ceilings. The final detailed spending plans are not settled until up to six months into the fiscal year. There are a few other countries that follow a similar process but it is not common and is not best practice. Best practice is to pass a detailed budget and publish it prior to the beginning of the fiscal year. This ensures that there is no ambiguity about allocations for the various spending units and the framework for accountability is clear from the outset. The principles of financial disclosure require that the key assumptions underlying budget allocations (economic assumptions and policy decisions) also be disclosed. This is not done in a comprehensive manner in Lao PDR In addition, the current presentational format of the budget does not fully reconcile revenue and expenditure activities with budget financing, complicating economic analysis of fiscal policy. 4.14 There is also a lag in the preparation of the previous year budget outcome figures. In recent years, budgets (and previous year outcomes) have been published long after the National Assembly passes the budget, if at all.'8 Clearly, detailed outcome figures cannot be finalized immediately after the year-end. But the cycle needs to be shortened and consideration should be given to providing estimates that can be tabled with the budget and then revised subsequently. '8 In this regard the publication of the 2000/01 budget in the Official Government gazette (April 2001) is a welcome first step towards greater fiscal transparency. -35- 4.15 Government public policy is also funded and conducted through individual funds that are not currently recorded as part of the general budget (e.g. the Road Fund and Poverty Reduction Fund). As these extra-budgetary funds make a claim on the resources of the state and are part of overall government expenditures in the economy they should ideally be incorporated into the general budgetary accounts. If there are especially compelling reasons for them to remain separate funds however, they should be subject to the same principles of transparency and accountability as the general budget with regular compilation and publication of their accounts. 4.16 Recommendation. Publish the itemized budget, including explanatory notes and accounts of all extra-budgetary funds, presented on an internationally recognized standard (e.g. Government Financial Statistics). Tighten the lag in publication of previous year outcomes and move towards a best practice system where expenditure detail is resolved much earlier in the budget cycle, if necessary by including it in the budget passed by the National Assembly. BUDGET EXECUTION 4.17 The procedures for budget execution are based on the principle of a separation between authorizing officers, from the line ministries who order the execution of receipts and expenditures, and government accountants, who as Treasury Department officers of the MIinistry of Finance collect receipts and pay expenditures after checking for consistency with budget appropriations. The Expenditure Chain 4.18 Authorizing officers exercise their financial responsibilities for a government expenditure by committing the expenditure and issuing a payment order to the government accountant. At the central government level, the ministers are the authorizing officers for the different sectoral ministries. At the provincial and district levels, the governors and the district chiefs (by delegation from the governors) are the respective authorizing officers.'9 4.19 To assist ministries to manage their budgets more effectively the Government Accounting Department, in conjunction with the Asian Development Bank (ADB), has recently installed an information and budgetary tracking system in four central pilot Ministries (Education, Health, Agriculture and Finance) and one of the Provinces (Savannnakhet). At present, this system (i) records and processes expenditures according to their administrative units. Thus, it allows the tracking of expenditures according to those units (e.g. large individual hospitals in Vientiane operating under the central Ministry of Health)20, (ii) computerizes existing manual practices for the "administrative accounts" from the stage of the payment orders the order to final payment. These accounts summarize separately, with both a budgetary and an accounting reference, committed current and capital expenditures at the central level, specifying in particular (i) the value of budget allocations authorized for use in the current quarter; (ii) the value of payment orders issued by the authorizing officer; (iii) the value of payment orders 19 The village, the lowest administrative level in the decentralized system, may assume responsibility for collecting certain taxes, but does not comprise an autonomous administrative unit. 20 However, these subdivisions are presently only used for intemal purposes and not used by the MOF in the budget preparation or execution. -36- processed by the treasury; and (iv) the value of budget allocations available after the payment orders have been deducted. 4.20 The current phase of the computerization project in the four pilot ministries is close to completion with the extension of the system to Savannakhet province. It is understood that the ADB will support extending the project to other ministries, central government agencies and provinces. 4.21 However, at this stage and under its current specifications, the computerization of existing practices will not be fully effective in managing the overall budget, when it is extended to all ministries for the following reasons: (i) the continuity of the expenditure chain with general State accounting is not effective, because information on orders effectively paid, by the Treasury, is not reintegrated in the system, and; (ii) the system, which is essentially based on a classification by type and administrative unit, does not identify expenditures by service or sector. It is understood that the design of the system is sufficiently flexible to incorporate any necessary changes to the budget classification in a relatively straightforward manner. 4.22 In the medium term Lao PDR would benefit from development of a more comprehensive strategy for implementing an integrated financial management system for the whole government that avoids the pitfalls of a piecemeal approach. Consideration should be given to assigning responsibility to a new or existing agency for development of government-wide IT strategy including a review of the feasibility of implementing an integrated financial management system. Government Accounts The Government Accounting Department 4.23 The Government Accounting Department is responsible for developing and modifying accounting standards and monitoring their implementation. It plays a technical advisory role through preparing accounting procedures manuals for the Treasury services and supervising the implementation of computerization projects involving not only the expenditure chain but the general State accounts as well. The department has recently been strengthened through ADB technical assistance. The Treasury Department 4.24 Government accountant functions are provided by the Treasury Department, which was established under Decree No. 18 of February 17, 1993.2' Its principal role as a centralizing accountant is to maintain the general State accounts, both for budgetary operations and associated funding operations, in line with current regulations. It is responsible for paying expenditures and collecting revenues, on behalf of the ministries and other central agencies, and the provinces and districts. The Treasury is responsible for recording accounting entries for operations, maintaining accounting journals, periodically establishing government balances, and reporting on the execution of the national budget. This requires that the Treasury coordinate its activities with the revenue departments and the Budget Department. 21 Previously the Central Bank was in charge of Treasury operations. -37- Government Banking Arrangements 4.25 At present the unified management of government finances is complicated by the large number of bank accounts opened by local governments in the state-owned commercial banks (SOCBs) reflecting an under-developed financial sector. In addition to this, poor reporting prevents the preparation of a consolidated position of the government financial position at both the central and provincial level and thus the treasury's position can only be determined on an approximate basis and after some delay. Treasury Management 4.26 By law, the Treasury is responsible for collecting all State revenues and disbursing all State expenditures, either in cash, or through bank transactions. Most of these transactions are effected through the intermediary of accounting offices, provincial and district treasuries put under the authority of the Treasury. 4.27 Bank accounts opened by the Treasury in the SOCBs are used primarily for revenue collection. For expenditures, the provincial and district treasuries primarily use payment in cash. Salary expenses are customarily paid starting on the fifteenth day of each month. The chiefs of provincial services receive the total amount of salaries to be paid, so they can make the payments for which they are responsible. Other operating expenses are paid following acceptance of a payment order. However, there are payment delays, which the Treasury reports to the Budget Department for information purposes. Certain suppliers have special' accounts with the treasuries which are used by the treasuries to pay for purchases of supplies, and by the suppliers to pay their financial obligations to the State. 4.28 The weaknesses in expenditure reporting and information systems has made it difficult to precisely identify the position regarding expenditure arrears. Outstanding payments arise on both GOL financed investment expenditures and from payment orders not completed before the close of the fiscal year (September 30) which on October 15 are carried over into the following fiscal year. It is accepted, however, that previous revenue shortfalls have resulted in payments being delayed (for example on teachers salaries) to avoid recourse to bank financing and that inefficient cash management (see following section) has also prevented the timely transfer of cash balances to deficit provinces. The lack of effective expenditure controls means it is difficult to ascertain whether arrears are resulting from unbudgeted commitments or nonbudget _xpenditures. Therefore, in addition to instituting expenditure control procedures, the development of systematic procedures to accurately monitor and report arrears is required for both budget preparation and execution. 4.29 The treasury management system should be extended to effectively record information on orders paid by the treasury. This would assist in the identification of treasury arrears, arising from late or non-payment of authorized payment orders. However, data reporting of commitments made but payment orders not authorized would also need to be developed to capture additional sources of arrears accumulation. 4.30 Expenditure payments for investments financed by donor agencies are carried out by the central Treasury. The provincial Treasuries, depending on the size of the projects, effect either -38- by the central Treasury or payments for GOL financed investments but this responsibility has not yet been entrusted to the district Treasuries. Accounting Law and Regulations 4.31 Budget Law No. 05/94 dated 18th July 1994 and Public Accounting Decree No. 20/PM dated 18th February 1993 are the main statutes governing the accounting requirements in ministries that are funded by the national budget. The Decree itself has several strong features and is sufficiently broad to develop an appropriate framework for implementing an effective accounting function within the government. It is however, ambiguous in terms of reporting and accountability, particularly in light of the government's decentralization program. The regulations need to be revised to clarify financial control and oversight responsibility, including reporting responsibility to the MOF at the line ministries and delineation of financial management responsibilities among the central agencies and the provinces. 4.32 Several of the shortcomings in the government accounting system are being addressed in the current technical assistance financed by ADB's technical assistance project. This project has the following components: * Preparation of accounting regulations for implementing the Public Accounting Decree 20/PM * Design of the form and content of government financial statements * Development of comprehensive accounting policies and procedure manuals * Development of an in-depth training program for counterpart staff in MOF and the National Audit Office 4.33 Substantial progress has been made to date in developing the accounting regulations and procedures and in installing the new accounting systems. New accounting systems have been installed in the four pilots (MOH, MOE, MOF and MOA), and in the Savanhakhet provincial govemment. The draft accounting regulations and an accounting procedures manual have been developed, which, in essence, will establish the basic intemal control framework within the ministries. The new regulations cover expenditure, revenues, retained revenues, fixed assets, management of cash, inventory management, salaries, accountable forms, losses and deficiencies, safe custody of public monies, intemal control systems and intemal auditing. The current draft regulations need to be refined in the following respects: * The accounts forms and registers should fully support and facilitate the preparation of the year-end Financial Statements. * The Notes to Financial Statements should be sufficiently detailed and show a breakdown of types of expenditures. * The Manual should have flowcharts for each accounting process, to illustrate the documentary flow and intemal controls. 4.34 Looking forward the government needs to initiate work on drafting of new Treasury Regulations and Procedures. These should include the following features: * Detailed procedures for commitment controls on expenditures. If the position of certifying officer is to be decentralized, the new regulation on delegation of authority should cover this aspect. -39- * Banking arrangements for deposit of government funds should be clearly formulated. Strict internal controls for use of the retained revenue and expenditure procedure should be devised. 4.35 Revision of the Public Accounting legislation itself is a more complex and longer-term task, which will eventually need to be tackled. The law currently requires that the public sector follow the enterprise accounting plan, which is aimed at the private sector and SOEs. The law needs to be revised to introduce stronger financial management accountability in public sector so that, in addition to compliance with fiduciary and regulatory record-keeping responsibilities, economy and efficiency in use of public resources and the achievement of objectives are also covered. Additionally, the accounting legislation need to be revised to: (i) empower financial departments in the line ministries with sufficient authority for financial control; and (ii) clearly delineate the accounting responsibilities among the central government agencies and the provinces, districts, and villages, including application of regulations and procedures, transfer of revenues, inspections and audit, internal controls and internal auditing requirements. The Banking System 4.36 While the Treasury manages public funds, the Bank of Lao PDR does not play a role in centralizing information on banking operations relating to budget execution, including determining the net position of the Treasury. This is partly due to the BOL not having local branches. Thus the State commercial banks function as bankers for the provinces and districts. 4.37 At lower government levels multiple bank accounts can be opened by the province and by the district. For example, in Savannakhet province 19 bank accounts are open in three different banks, the BCEL, the Lao May Bank, and the Agricultural Promotion Bank22. Three accounts were opened by the Treasury for the province itself, eight banks accounts for four districts, and eight bank accounts for eight districts. No bank accounts have been opened for three districts that use banking agencies in neighboring districts. Due to the cost of electronic communication, transfers among bank accounts are limited and do not help the Treasury to adjust its position. 4.38 The existence of multiple accounts in different local banks is designed to facilitate the management of receipts from different levies and taxes due from taxpayers, and reflects the undeveloped nature of the banking system and the lack of a local clearing house. The receipt of different checks issued is more rapid and thus makes funds paid to the Treasury more readily available. On the other hand, the provincial Treasury cannot accurately calculate its consolidated position at any time, because it does not have information on its position in the different accounts on a timely basis, and no banking agency at the provincial level provides the centralization and consolidation of banking data for provinces or districts. 4.39 Therefore, there does not seem to be a unified and consistent cash forecasting and management system at either the provincial or central level. As a result, there are, throughout the year, substantial positive balances in different Treasury bank accounts throughout the country, 22 This bank specializes in agricultural development projects, particularly irrigation, and actually has limited participation in the treasury network. -40- and substantial amounts of notes in safes in different Treasury offices, at the same time as there are delays in expenditure approvals and payments in other parts of the country and substantial interest is being paid on outstanding Treasury bills. 4.40 Thus, expenditure arrears and delays arise because Treasury bill issuance is not used to cover seasonal shortages of cash, and because cash is not transferred systematically from one area to another. Contributing to this passive approach to cash management and short-term debt may be the relatively high level of budgetary risk: uncertainty as to whether revenues will materialize in the future to meet planned expenditures creates an incentive to hoard cash. 4.41 The undeveloped banking system presents a challenge to efficient cash management but certain improvements can be made. In particular, the network of government accounts can be streamlined to the minimum required to conduct government operations given the banking situation in any given province or district. In addition, more regular and timely reporting of provincial government account balances would facilitate the reconciliation of the overall government financial position. 4.42 Recommendation. Simplify banking system management at the local level, by reducing the number of bank accounts used by public entities (e.g. utilizing a single bank account for each autonomous administrative unit), registering all permitted bank accounts, and prohibiting the use of unregulated accounts. 4.43 Recommendation. Issue new treasury regulations that should include, inter-alia, detailed procedures for commitment control on expenditures, banking arrangements for deposit of government funds, and internal control for retained revenues and expenditures. 4.44 Recommendation. Prepare an action plan for the phased establishment of a single network of Treasury Accounts. 4.45 Recommendation. Prepare a model agreement for financial relations between banks and autonomous administrative units, defining the rights and obligations of each party and the methods to be used by the bank to hold government funds. 4.46 One of the main risks in the management of revenues and expenditures is loss of cash due to fraud, misappropriation or conversion of assets for personal gain. To minimize this risk, a sound internal control framework needs to be established and maintained. In Lao PDR, at present, some basic aspects of this internal control framework features exist, such as segregation of duties, checks and balances, accounting reconciliations, delegation of authority, and accounting procedures and reporting. However, these controls are not necessarily effective or efficient. Moreover some ministries and provinces are permitted to retain some of their revenue collections to meet expenses. The intermingling of cash receipts and cash payments is a fundamental control weakness that reduces accountability and makes independent reconciliation difficult. In addition, each department within a ministry is involved in the buying and receiving activity. From a control perspective, the fact that the purchasing and receiving functions are not segregated can lead to abuse. 4.47 Recommendation. Introduce a formal system for daily banking of collections and for independent and regular reconciliation of bank statements with accounting records in order to -41- avoid intermingling of cash receipts and payments. The more frequent use of checks for settling creditors should also be considered. 4.48 Recommendation. Consider establishing a purchasing function and a separate receiving activity in large ministries for items over a certain monetary value. Small value purchases could be made through a petty cash float within each ministry. As an alternative, the same person or persons engaged in purchasing the goods or services should be prohibited from certifying the receipt of the goods and services. CONTROL OF BUDGET EXECUTION Commitment Controls 4.49 Although Budget Law No. 5/94 specifically requires financial control of expenditure commitments at the authorizing officer level, the financial controls exercised by the Budget Department at the commitment stage were abandoned in 1998. The government accountants before payment of expenditures only carried out internal controls. As a result, in 2000/01, the head of the spending agency had full control of spending within the budget allocation, subject to ad hoc inspections, and the potential for an audit by the relatively small National Audit Office. While the paper work and checking associated with this system was cumbersome and time consuming, it did little to ensure that expenditures were in conformity with the budget. 4.50 Macroeconomic stability is also placed at risk, as in the event of revenue shortfalls effective controls are needed to restrain expenditures to a level consistent with available revenues. A lack of commitment controls can lead to excessive commitments that would either have to be met through inflationary bank financing or through accumulating arrears by stopping unfunded payments. Table 4.1: Spending by Line Agencies in Khammuan Province, 1998-99 Audited Budget Figures (million Kips) Expenditure Total in 1998/99 of which category Health Education Labor Other line agencies Imp. plan Accounts Imp. plan Accounts Imp. plan Accounts Imp. plan Accounts Imp. plan Accounts I Payroll & allowances 5,950 5,734 886 937 2,790 2,848 51 45 2,223 1,904 11 Current expenditures 1,511 1,498 155 158 298 180 15 10 1,043 1,150 IV Adjustment 3,438 2,339 369 194 956 896 1,509 534 604 715 VI Investment & construction 8,333 28,843 0 209 0 98 0 11 8,333 28,525 Total exp 19,231 38,413 1,409 1,498 4,044 4,022 1,575 599 12,203 32,294 Source: State Audit Agency, Khammuan Province Finance Department Audit Memorandum, 1998 - 1999 4.51 The results of the 1998-99 audit of Khamnmuan Province shown in Table 4.1 above illustrate that budget control problems between the MOF and' the provinces are not confined to the revenue side but also affect expenditure outcomes. In particular: Total spending greatly exceeds plan - by 100% (possibly due to underpayments of revenue to center or over collection of revenues) -42- * Spending on health, education and labor is broadly in line with plan; however spending in non-social sectors is 260% of plan. * The over-run in total spending is in investment and construction (overrun is 180% of plan) rather than recurrent spending (which falls slightly short of plan) * The over-run in investment is mainly outside the social sector agencies (occurring mainly finance, administration, agriculture and communication agencies) * These data are consistent with anecdotal evidence that provinces do not fully remit surpluses to the center, and that there is a preference at province level for investment spending. 4.52 Some steps have been taken to reestablish effective controls that would allow removal of excessive paperwork and redundant systems. In order to better control expenditures, Budget Department review of expenditures was introduced in 2001/02 on quarterly wage and provincial level recurrent expenditures and individual investment projects to help to ensure that, ex ante, spending authorizations are only for budgeted programs, and that there are sufficient funds for this spending, in case of revenue shortfalls. Effectiveness of these new controls will become evident as fiscal outcomes are evaluated against budgeted amounts. The system in place for disbursements involves many checks and balances by several different individuals and units. It is an elaborate system, which provides for a degree of control in that there are excessive pre- approval and verification processes leading to payment of an invoice. These steps constitute ex- ante controls performed by the Budget Department and the National Treasury department of MOF on payments requested by line ministries. Recurrent expenditures and counterpart funds for ODA projects are filtered through these two departments before final payment. For ODA projects the External Finance Relations Department of the MOF scrutinizes and approves the payments made to suppliers before passing payment requests on to the National Treasury for settlement. These measures were designed to help ensure that ex-ante spending authorizations are only for budgeted programs, and that there are sufficient funds for this spending. Ex-ante controls carried out by units outside the line ministry incurring the expenditure can result in delays. Over time, ex-post monitoring by Budget Departments may be a more suitable practice than ex-ante controls, but only once a formal system for effective budget monitoring has been established and effective, intemal control policies and procedures and intemal audit are proven to be in place. 4.53 Some countries' budgetary control systems rely on post audit procedures to provide an altemative to strict a priori controls. However, in Lao PDR the system of post audit is not yet effective and will take time to develop. It cannot be relied upon to identify and correct the weaknesses arising from a lack of a priori expenditure control system. Recommendation. Continue with the application of the prior financial control system established for investment projects and recurrent expenditures. Evaluate the effectiveness of these controls as fiscal outcomes become available, refine, and extend the system accordingly. Over time, move toward more reliance on ex-post control, in parallel with the strengthening of the intemal and external audit functions. -43- Overall Fiduciary Risk 4.54 The overall fiduciary risk in Lao PDR is considered to be high. There is insufficient transparency related to public finances and the general attitude towards fiscal discipline is not strong.23 The general permissive environment and lack of incentives in complying with the rules and regulations are compounded by an inadequate awareness of modern practices of internal control in the public sector. The government has introduced a decentralization initiative without putting in place a sufficiently robust institutional framework that clearly defines the new responsibilities at lower levels. Staff at these levels lacks an adequate technical capacity to effectively implement these responsibilities. The oversight functions are weak: the National Audit Office's independence is not assured; the parliamentary oversight function is not effective; the audit of provinces is carried out only in very few instances; and there is an overlap of functions between the various oversight agencies. 4.55 The government is aware of the need to strengthen and modernize the internal control environment as well as the necessity to rationalize the work that each of the oversight units is performing. Responsibility for internal controls will need to be clearly assigned to the line ministries with a shift to ex-post audit. In addition, more focus needs to be directed to evaluation of the adequacy of the intemal control systems. Modern internal control policies and internal audit regulations need to be introduced. The concepts that controls are designed for achieving organizational objectives and that accounting information is necessary for decision-making will need to be introduced into the management culture of the public sector. 4.56 Recommendation. To reduce fiduciary risk while reducing the current duplication and overlap that are costly, ineffective, and disruptive, it is recommended that the Government take the following steps: * Review the functions and responsibilities of the different oversight agencies with the goal of rationalizing their roles and responsibilities; * Develop a policy on internal control that embodies the principles and objectives of modern internal control, namely achievement of objectives in effectiveness and efficiency of operations, reliability of financial data and report, and compliance with laws and regulations. Issue relevant regulations to introduce this internal control framework at all levels of the govemment. * Issue regulations to introduce intemal audit function in the ministries. One option is to strengthen the capacity and increase the skills of the inspection group located within each ministry so that this group could eventually function as a professional intemal audit group. * Build capacity and train oversight agencies in modem internal control, auditing and inspection methodologies and techniques. 23 The IMF Code of Good Practices on Fiscal Transparency, March 2001, was used as a set of standards for assessment of transparency as a component of public financial accountability. -44- The Oversight Function 4.57 Audit and inspection play an important role in assisting the government to ensure accountability. In Lao PDR, the main institutions involved in the public oversight process, with overlapping functions, are the National Audit Office, the State Inspection Authority, and MOF's Inspection Department. 4.58 The National Audit Office was established in 1998 with assistance from the ADB. This agency establishes a posteriori control of the State, State agencies, the* provinces, State companies, as well as foreign financed investment projects. An annual audit plan is prepared and submitted to the government. An annual report on its activities is submitted to the Prime Minister and the President of the National Assembly. To assist in its operations an auditing guide describing control tasks and procedures, as well as a method for evaluating computerized systems, has been developed. 4.59 The creation of the National Audit Office is a fundamental element in establishing an ex- post financial control system for the State. As the agency develops its expertise and experience with additional resources, it is intended not only to improve the quality and reliability of financial operations carried out by the State and public services, but also to play an advisory role in improving management. The 1999/00 program of activities for the Department in charge of State agencies was overly ambitious in light of available human resources and only half of the planned audits were completed. 4.60 The NAO, in the context of its limited financial budget and staffing resources, is nevertheless delivering an effective compliance auditing service. But it needs to improve in several respects. To strengthen its oversight function the NAO intends to develop auditing regulations. The regulations have been drafted but have not as yet been submitted for discussion. The regulations cover such matters as the independence of the AG, confidentiality of information, duties and responsibilities of the office, reporting standards and the adoption of international auditing standards. 4.61 At present, the NAO audit reports are not published. Publication of these reports involves two main issues that need to be considered: the target audience and the information to be disseminated. The accountability of a government to its citizens is to report on the use of public resources. This cannot be achieved unless reports with an adequate level of detail are made accessible to the public. These reports will be more meaningful if they reflect the independent opinion of institutions responsible for ensuring accountability (i.e. NAO). However, the external audit will not be meaningful if other components of control environment are weak or remain weak. Other elements are awareness and commitment, ethics, performance measurement, internal audit. A report on the independence of Supreme Audit Institutions (SAIs) published by INTOSAI24 found that the majority of SAIs in Asia, Latin America and Anglophone Africa are currently free to make their reports available to the media and the public. Although a number of published annual reports are activity reports and not audit reports, these SAIs expect significant improvements over the short and medium terms on this issue. The reports need not be published in their integral form. The SAI should have the freedom to decide what to publish. When 24 Task Force Report on Independence of SAIs Project, INTOSAI, March 31, 2001 -45- interests protected by law are involved, the SAI should weigh such interests against the benefits of disclosure. Similarly, reports on SOEs disseminated to the public should observe the restrictions required for the protection of confidential trade information. The freedom of SAIs to define their own communication policy toward the media and the public within existing regulatory framework is an essential component of their independence and effectiveness.25 4.62 Making the office independent of the executive branch of the government can also strengthen the independence of the Auditor General. The relationship of the office with the National Assembly also needs to be strengthened. 4.63 Recommendation. In the longer term define the role of the external audit function in legislation, which provides for the responsible entity to report to the National Assembly, thus guaranteeing its independence from the executive branch of the government. As the capacities of the NAO are developed and its autonomy deepened, the audited annual accounts, audit reports of the NAO and results of parliamentary discussion on audit reports should be published and made fully accessible to the public. 4.64 Recommendation. Adopt internationally accepted public sector auditing standards; establish effective parliamentary oversight over public finances; and determine the manner in which the provinces and districts should be audited. 4.65 The State Inspection Authority was established by Decree No. 98/PM dated 30 May 2001 with extensive responsibilities and wide powers, including the ability to propose suspension and sanctions towards state employees. SIA's role, its organizational structure and the scope of its work. A President who is appointed and removed according to Articles 53.4 and 60 of the Constitution heads the SIA. SIA is defined in Decree 98/PM as a department of the Prime Minister's Office under the Prime Minister's direct guidance, with the following functions: (i) control and inspect the administration of ministries and other government agencies, including SOEs and provincial and district governments; (ii) examine and resolve requests and petitions pertaining to state organizations and state employees involved with violations of the law; (iii) control the behavior and acts of state employees in performing assigned tasks in the case of breach of the law, and report the audit results to the organization concerned for timely solution; and (iv) take necessary measures to fight all negative appearances, including corruption in all forms. It is noteworthy that Article 3.10 of Decree 98/PM requires SIA to "publicize the results of its audit to the public in a uniform manner as a measure of ideological education for the whole society, and as measure to combat corruption." SIA has an important role to play in ensuring that citizen's rights are respected, abuse of powers is dealt with appropriately, and corruption is curbed or prevented. Considering that the SIA has only recently been formed, its role should be clearly delineated as soon as possible to prevent overlap and duplication, particularly with the functions of the National Audit Office. 4.66 Recommendation. Issue ministerial instructions to interpret Decree 98/PM in order to clearly delineate SIA's functions and establish a systematic communication of objectives, annual programs, and the sharing of inspection results between SIA and the other oversight agencies. 25 Limna Declaration of Guidelines on Auditing Precepts, INTOSAI, 1977/1998 -46- 4.67 Recommendation. Arrange for provision of technical assistance to strengthen SIA and, over time, make it more independent of the executive branch of the government. 4.68 Recommendation. Coordinate more closely the inspection and review activities of the SIA the NAO, the State Property and Inspection Departments of MOF and the various tax authorities. Review the functions and responsibilities of these different agencies with a goal of rationalizing their tasks and activities. Proposed Stratery and Action Plan: A Timetable 6bj e _ _Flre To make financial data a. Revise the accounting decrees and regulations to clarify financial control and Short-term more timely, relevant and delineation of financial management and reporting responsibilities between the reliable for effective central govemment and the provinces. management of public b. Unify and streamline the existing Chart of Accounts into a logical order of resources assets, liabilities, revenues and expenses that would also take into account the Short-term counterpart funds in ODA-funded projects. c. Improve the cash control and bank account reconciliation processes. d. Streamline reporting requirements and budget monitoring system in MOF and Short-term in all the ministries. e. Issue revised manuals and provide training. Short-term f. Conduct a review on the feasibility of implementing an integrated financial management system and develop an IT strategy for the govemment as a whole. Short-term Medium-term To strengthen the a. Require that the audited annual accounts, audit reports of the National Audit Medium term govemment's Office and results of parliamentary discussion on audit reports be fully accountability in its use of accessible to the public. public resources b. Streamline existing control processes, and adopt a modem intemal control Medium-term framework for the govemment as a whole. c. Clarify and improve roles and responsibilities of the oversight bodies to Medium-term increase their effectiveness. d. Adopt intemationally accepted public sector auditing standards and establish Medium-term an intemal audit function in line ministries. e. Further define the role of the extemal audit function in legislation to strengthen the independence and role of the National Audit Office as well as establish an Long-term effective parliamentary oversight over public finances. f. Adopt intemational public sector accounting standards and conduct a Medium-term comprehensive training program on application of new standards. To improve institutional a. Streamline various laws, regulations, and decrees related to accounting and Short-term framework for setting auditing practices in the private sector. accounting and auditing b. Strengthen LICPA to become a professional body. Medium-term standards and regulating c. Adopt international accounting and auditing standards. Medium-term the profession in the private d. d. Conduct a comprehensive training program on application of adopted Medium-term sector standards. To improve financial a. Require large SOEs to prepare financial statements in accordance with adopted Medium-Term reporting in SOEs standards and be annually audited by independent auditors. Publish audited financial statements of those SOEs and make them accessible to the public. To strengthen the intemal a. Consider introducing an intemal audit function in large private enterprises and Medium-Term control and improve the SOEs to strengthen their intemal control and monitoring system. corporate govemance of b. Consider requiring appointment of outside directors on the boards of large SOEs private enterprises and establish audit committees of the boards of large private Medium-Term enterprises and SOEs. -47- Procurement 4.69 The Government has had established procurement procedures since 1994. The enabling instrument is a prime ministerial decree of December 1995, with implementing rules and regulations (IRR) introduced in September 1996, updated in December 1998 and currently undergoing a second update due for promulgation by mid-2002. Donor procedures are permitted to take precedence on donor-funded projects, which represent about 80% of public sector procurement. 4.70 Although the procedures generally provide for procurement to be conducted in accordance with best international practice, there are some aspects of concern. The first is the delay related to high level officials of the Government being involved in the approval of small value of both donor funded and government contracts. Second, Government-funded procurement involves (1) relatively loose provisions that permit direct negotiations in certain circumstances, and (2) use of a highly subjective scoring system to evaluate non-monetary items. While no change to the basic legislation is considered necessary, these potential areas of non-transparency could be dealt with in the amended IRR now being drafted. 4.71 In 1993, the Government proposed to establish a central Procurement Monitoring Office (PMO) to monitor procurement. After ADB Technical Assistance (TA) in 1996, the PMO was formed in 1997 and received further TA from ADB in 1998 for institution building and training. However the PMO office is not currently functioning and there are an urgent need to establish of a focal point for procurement monitoring and training, and provision of assistance to individual project staff. 4.72 Among Government staff responsible for procurement, there is inadequate knowledge of the Government's and donor procurement procedures, procurement sections of credit agreements and Standard Bid Documents (SBDs). This is due to lack of training, language difficulties, especially relating to commercial and legal terms, and frequent rotation of project staff and their replacement often by inexperienced new staff. Many national contractors also lack full understanding of the procedures, reflected in poor quality bids and delays during evaluation while bid deficiencies are resolved. 4.73 The time taken to recruit consultants and contractors can be improved but the majority of project delays occur during contract administration. Skills in project management including procurement and disbursement scheduling, progress tracking and record-keeping, need enhancing. Regular and comprehensive procurement training programs need to be developed and implemented for all Government staff involved with procurement activities. 4.74 Some State-Owned Enterprises (SOE) have been winning contracts on World Bank- financed projects, particularly in the construction sector. It is questionable whether some SOEs that have won Government contracts are legally and financially autonomous and there have been complaints from the private sector that Government subsidies in various forms distort the competitive bidding process. The Government, is undertaking reforms of SOEs to put them onto a more commercial footing but this will take time. Meanwhile, bid documents should include a requirement that bidders submit proof of autonomy and bids from any SOE that cannot demonstrate its legal and financial autonomy should be rejected. -48- 4.75 To simplify procurement, the Government is keen to harmonize procurement guidelines among donor agencies, particularly for NCB and small works procurement that characterize poverty alleviation and rural self-help projects, and particularly between the World Bank and ADB. The World Bank is currently part of a global working group among all major multi-lateral development banks tackling this issue. In Lao PDR, donors have already agreed and adopted common procedures for small-scale procurement in the transport sector and this should be extended to other sectors as soon as possible. 4.76 The private sector in Lao PDR is still small but evolving quickly - foreign investment applications have doubled annually since 2000. There are no regulations relating to procurement by the private sector, which, by and large, is free to pursue procurement in the way, it deems most suitable to its needs. However, the Government occasionally encourages private sector companies and individuals to procure locally. 4.77 Recommendation. The PMO should become a functional entity as soon as possible, located within an appropriate department of the Ministry of Finance (MOF). It should assume the pivotal role in procurement reform, providing monitoring of country-wide procurement activities and take an important role in delivering training programs. It should not be another layer in the Government's procurement approval processes, nor place controls on approved budgets of line ministries and project executing agencies. 4.78 Recommendation. The Government, together with the World Bank and other donor agencies, should jointly design and implement a structured procurement training program, geared to the needs of all Government officials and project staff involved with procurement at both central and provincial level. Budgets for all new projects should include provision for training of PIU staff. A specific component of training should address micro-procurement on small-scale poverty reduction programs that are increasingly the focus of donor assistance. A small element of the program should be addressed at local contractors to assist them in improving the quality of their bids. To improve the whole "climate" in which procurement is carried out, a project management-training component should be included in each major project, funded by specific allocation in the project budget, whether Government-funded or donor-funded. Selected staff should be sent for intensive project management courses. 4.79 Recommendation. To improve the transparency of procurement throughout Government, the ongoing revision of the Government's IRR should incorporate a few critical changes that reflect best international practice. These are examined in more detail in Annex 4.4 4.80 In addition the Government should review its staff rotation policy and provide a minimum incumbency for key project staff to ensure reasonable continuity and reduce disruption. The complex issue of conflicts of interest and delay on official work caused by staff absenteeism and parallel employment should be addressed through the introduction of a transparent system of Government-financed supplementary remuneration on donor-financed projects. 4.81 To ensure a "level playing field" for bidding, only SOEs that are fully autonomous should be awarded contracts. To ensure this, standard clauses should be included in all bid -49- documents that detail how the evaluation of a bidder's autonomy will be carried our and which supporting documents need to be submitted evidencing autonomy. 4.82 The Government as well as the donors need to work together to develop harmonized procurement guidelines, particularly for small-scale procurement in rural areas. 4.83 The Government should review the present SOE monopoly for freight forwarding and consider allowing private sector competition to promote increased efficiency and lower costs. FISCAL DECENTRALIZATION OF BUDGET EXECUTION 4.84 The current decentralization initiative is a priority government policy. However, the manner and speed of its implementation, in the absence of sufficient preparation, has given rise to significant difficulties in the area of fiscal management, exacerbating the many existing weaknesses in the system. At issue are not only fiscal matters such as the ability to raise revenue and channel resources equitably. There are also fundamental questions about the ability of the various levels of government to exercise effective control over the resources, and to implement the policies, that legally are within their respective jurisdictions. These issues have not been satisfactorily resolved. Box 4.1: A Brief History of Central-Provincial Fiscal Relations in Lao PDR Lao PDR has experienced several swings policies governing in intergovernmental fiscal relations over the last 30 years. A centrally planned economy was established in 1975, although difficulties of transportation and communication allowed provinces to enjoy a substantial degree of autonomy. The New Economic Mechanism of 1986 saw an important liberalization of both internal and international trade, the privatization of state-owned enterprises and a formal devolution of powers to the provinces. From then until 1991, expenditures were under the control of Provincial Governor. Taxes were collected by the provincial branches of the Ministry of Finance and were not regarded as national revenues. Few resources were transferred to the central government by the provinces. Government employees were managed provincially rather than centrally. Local branches of the state bank acted independently and even set exchange rates independently in each province. This devolution resulted in large disparities between provinces in standards of service provision due to differences in the tax base between provinces. Lack of fnancial management skills at the regional level was also a problem. In an effort to achieve greater uniformity of service provision a law was passed in 1991 requiring all revenues to be passed to the MOF as part of a unified national budget - the first since 1975. This lasted until 1997 when the provincial govemors were given responsibility for a wide range of governnent services and since 1997 budget allocations for those services have been made directly to the provinces and are no longer through the line ministries. This devolution was reinforced in 2001 by Prime Ministerial Decree 01 and Instruction Note 128 from the SPC which had the general objective of "making the province the strategic unit, the district the budget planning unit and the village the implementing unit". 4.85 As Box 4.1 indicates, Lao PDR has wrestled with the problem of how best to divide powers between the provinces and the central government for over a quarter century. The current decentralization policy introduced new administrative and financial arrangements in 2000/01, which extended financial management responsibilities to provinces, and districts in the formulation and execution of budgets. This autonomy has resulted in the submission of separate budgets for the central services, for each province and for each district (within the provincial budget for the time being), in principle, based on objectives set by government directives. -50- 4.86 Under the decentralization policy districts will become budgeting centers. 6 This involves increased responsibility for CPC and MOF in provinces and districts. District officers of the MOF will gain increased responsibility for revenue collection and districts will establish a budget office. Districts receiving blocks of funds will no longer have to accept the decisions of the provincial governor in regard to detailed budget lines. Districts will oversee the implementation of plans for their constituent villages, with a particular focus on revenue collection. Revenue Mobilization 4.87 A key reason for the decentralization changes was to relieve fiscal stress experienced at the central level created by the centralization of 1991, which reduced the incentives for subnational governments to collect revenue on behalf of the central government. Specifically, the changes aimed at making provinces, districts and villages self-sufficient in terms of raising locally the funds required to fund the expenditures they are responsible for according to the national budget. However, the weaknesses in budget control mean that decentralization is actually making the problem of central government finances worse. Chart 4.1: Revenue and Expenditure for a Surplus Province. Expenditure 450 D planned A E target Revenue 4.88 If a province's targeted revenues exceed its budgeted expenditures it is classified as surplus. The relationship between the actual revenues and expenditures for surplus provinces is shown in Chart 4.1 as ABDC. Provinces that exceed their target revenues can keep 50% of these excess revenues and must transfer the remainder to the center.2" (This is segment CD) In principle, surplus provinces that do not meet their revenue target are supposed reduce their spending and maintain their transfers to the center (segment CE). However, in practice they do 26 District budgets (which are built up from the village level) will be approved by the National Assembly as lines in the provincial budget. Currently district budgets are not included in the national budget, but are prepared by the provinces from their own lines in the national budget. There is a separate process for large urban areas (there are four Urban Development Administration Authorities which levy special taxes and charges related to electricity and water). Around eight or ten percent of revenues collected by villages will be kept in a 'village fund'. As village funds accumulate this will be used (inter alia) for education and health related activities. 27 The funds retained by the province are to be used for investment projects submitted in the annual planning exercise the province to the Committee for Planning and Cooperation (CPC) but not selected for inclusion in the annual budget due to lack of funds. -51- not do so. Instead, they reduce their transfers to the center in line with revenues and maintain their planned expenditures (segment BC). In this range provinces have no incentive to collect additional revenue. However, if their revenues fall short of even planned expenditure, their transfers are exhausted and they are forced to reduce expenditures below planned amounts (segment AB). Given this incentive structure, it is interesting to note that of the 18 provincial level entities, three of the four that did not meet their target for revenues were surplus provinces (Vientiane, Savannakhet and Champasak). 4.89 As a result the fiscal transfer system weakens provincial revenue mobilization effort and contributes to overall revenue shortfalls. Five provinces are surplus provinces with the bulk of the transfers coming from Vientiane municipality, Savannakhet and Champasak. The last two provinces are alleged to transfer fewer resources than they should. Vientiane Municipality, which is closely supervised by the central government, does transfer the planned resources. Some of the surplus provinces are alleged to collect taxes and customs duties without fully complying with the regulations. For example, some Customs offices use adjustments in valuation and classification to reduce effective duty rates. This tax competition may boost local trade and economic activity in a given province, at least in the short run, but it creates overall revenue shortfalls when surplus provinces to fail reach their revenue targets. There is an additional dynamic effect that weakens provincial revenue collection effort since the fulfillment (or over fulfillment) of a revenue target in a given year may simply result in an increase in the target for the following year. Because of uncertainty provinces also have an incentive to under report revenue early in the year and delay making transfers to the center to make sure they have enough to cover their planned expenditures. 4.90 There is another problem that complicates the allocation of tax revenues between levels of government, which stems from the practice of assigning taxes between central and provincial governments according to the nature of the taxpayer rather than the nature of the tax base. For instance, the turnover tax is assigned according to-size thresholds. In general this is a poor practice that is conducive to taxation by negotiation rather than taxation by rules. Further consideration will have to be given to this matter as the transition from the turnover tax to the VAT is pursued. Box 4.2: The Large Taxpayer Unit Recently the Large Taxpayer Unit located in the central office of the Taxation Department has seen the number of fnrms it is responsible for shrink from 723 to 50. Most of these were transferred to the tax office of Vientiane municipality. Although some tax staff were transferred to the municipality along with the responsibility for revenue collection, the central Large Taxpayer Unit was a more specialized organization. Moreover, the large firns involved, while headquartered in Vientiane are mostly national in scope, and the additional revenue collected by the municipality will (or should) revert to the central government anyway, since Vientiane municipality is a surplus province. 4.91 The key weaknesses under the decentralization initiative thus appear to be: * A lack of incentives to achieve budget targets. * A chart of accounts and budget nomenclature that do not currently reflect the devolution of financial management responsibilities. -52- The weak technical capacity of local staff in budgetary and accounting procedures to implement new responsibilities under decentralization. 4.92 Recommendation. With due regard for administrative efficiency align responsibility for tax administration more closely with revenue assignments sources and, where necessary, adopt revenue sharing arrangements in preference to splitting collection administration. In particular the responsibility for collection of Customs duties should be shifted back to the center. Strengthen the revenue collection capacities of local authorities. 4.93 Recommendation. Move a significant portion of larger taxpayers back to the central LTU during fiscal year 2001/02. Institutional Structures and Capacity 4.94 Problems of budget execution and control are also exacerbated by civil service hiring and payment practices and weak human resource capacity. A recent ADB publication identified several problems of the public service as a whole. Erosion of civil service wages has severely cut the motivation to perform jobs effectively. Recruitment and promotion processes vary widely by ministry but are generally are based on factors other than merit.28 Job descriptions are absent and skills are lacking in English language, management and planning. Moreover the top-down management environment stifles initiative. There are no grievance mechanisms and risk averse officials tend to defer decisions to superiors and are unlikely to identify and communicate problems upwards. 4.95 The Ministry of Finance has a small number of staff in Headquarters in Vientiane. But the majority of the central ministry staff, including those in the Treasury, Tax and Customs Departments, are located in the provinces. While this staffs are officially central ministry employees, the province pays their salaries and benefits. The central ministry but the actual recruitment set hiring standards and the province does hiring. Locally based treasury officials find it difficult to follow centrally mandated expenditure control and financial management practices in the face of conflicting local pressures from the provincial Governor. Difficulties arising from this arrangement prompted the issuance of a Presidential Decree #127, which states that all Treasury, Tax and Customs staff are to be under the direct supervision of the respective headquarters directors of the Minister of Finance. But despite the decree a subsequent Prime Ministerial Implementation Order, hiring and payment practices are unchanged and the problem persists 4.96 In addition, local financial management would be improved through strengthening physical and human resources, particularly in terms of a financial training program for local government officials. A training program could be directed first to district financial officials, where the need to improve management is greatest. It could include two parts (i) Basic training in the area of budgets and accounting in a three-month phase, to be conducted in the country's three finance schools and provided to about 280 district financial services agents from all districts, and, (ii) technical assistance to support the training and assist its implementation in the field. 28 Asian Development Bank, Key Governance Issues in Cambodia, Lao PDR and Viet Nam April 2001 -53- 4.97 The first part could be nationwide while the initial phase of the second part could be based on a local development and institutional strengthening project, and subsequently be expanded to government groups and provincial level agencies. 4.98 Recommendation. Introduce a series of human resource strengthening measures: (i) implement the provisions of Presidential Decree #127 putting provincially located MOF staff under the direct supervision of directors at headquarters; (ii) allow direct hiring and payment practices of these staff by headquarters; (iii) improve public expenditure management at the local level through strengthening physical and human resources, particularly in terms of a personnel training program. -54- ANNEX 4.1: FURTHER MEASURES TO IMPROVE FINANCIAL ACCOUNTABILITY AND REDUCE FIDUCIARY RISK 4.99 The risk that public financial accountability is not fulfilled is a fiduciary risk, defined as the possibility that funds might not be spent for authorized purposes. This involves budgets that are not implemented as passed, government funds diverted to off-budget activities, insufficient or unreliable information on budget execution, diversion or waste of funds through corrupt practices, systems of control that are not functioning adequately, and reporting systems that do not provide accurate or timely information.29 In a sound public financial accountability management system, these risks are managed. to an acceptable level. At present in Lao PDR, there is clearly a high degree of fiduciary risk in the use of public resources, given that many of these risks are still present. 4.100 The ADB has provided assistance for the introduction of new government accounting regulations and issuance of an accounting manual in the public sector. These constitute the tools for providing basic accounting records and periodic financial statements. They serve as a basis for budgetary and intemal control and form a solid foundation for a minimum accountability requirement. Lao PDR needs, however, to build upon this base to achieve a more effective and efficient level of financial management. Proposed Financial Management Strategy and Human Resource Challenges 4.101 A major challenge in implementation of such in-depth reform will involve the human dimension. Accounting is but a set of tools to provide information to users and success depends on having the know-how. In Lao PDR, as in many small and developing countries, users of financial information constitute a heterogeneous group: Members of the executive, legislative, judicial and administrative branches of government; those involved in managing central, local and district governments; enterprises involved in business relationships with the govermnent; and representatives of the media and academia, and through them, the public at large. The characteristics of the financial management system (for instance, the basis of accounting and the nature of financial statements) have to suit the needs and capacity of users. A financial management system could meet international standards but be of limited value to the country concerned if there were few or no people acquainted with these standards. Financial management reform should be based on a realistic understanding of the country concerned, and its needs and capacity to implement reforms. 4.102 To optimize the chance of success, Lao PDR should consider adopting a strategy that promotes a phased approach as follows: * Proceed cautiously but make certain first that govenment entities carry out their transactions in accordance with applicable legislation and regulations; that 29 The Operations Evaluation Departmnent of the World Bank has identified seven elements critical to sound public financial accountability. These are as follow: i) quality and openness of the budget process; ii) adequacy of internal control within the government; iii) quality of public accountants of the nation; iv) effectiveness of the public audit function; v) adequacy of legislative scrutiny over the performance of the executive; vi) right and access of the public to information and vii) adequacy of corporate accounting, auditing, and oversight functions. -55- spending limits are observed; that transactions are authorized; and that timely, relevant and reliable financial information is available. * Assist decision-makers in valuing accounting data as a tool for effective monitoring of the financial resources entrusted to it. * Promote an organizational climate that fosters the achievement of financial management objectives, a climate that includes commitment from senior management, shared values and ethics, communication and organizational leaming. * Provide managers with the information and knowledge they need to support operational decisions and to understand the financial implications of their decisions before they are made. This will enable them to monitor their decisions for lessons to be learned from experience, and to adapt or react as needed. 4.103 Efforts to improve financial accountability in the public sector need to focus on upgrading the government financial management system, streamlining processes and procedures, and rationalizing and strengthening institutions responsible for ensuring accountability. There is also an urgent need to improve financial reporting and auditing as well as corporate govemance of SOEs. While in other developing countries the human factor--skills and know how--is important, in Lao PDR it is critical. The country's primary effort to improve financial accountability should focus on addressing the following basic constraints: lack of skills in producing and understanding financial statements; lack of resources available for financial management and lack of motivation and commitment in complying with the rules and regulations. Only after the above basic shortcomings are satisfactorily resolved and the system is stabilized should one proceed to the adoption of international standards and establishment of a modem internal control framework 4.104 In the implementation of the proposed program, the role of the Accounting Department in MOF as a champion of reform should be emphasized and formalized. It is preferable to establish a permanent unit in this Department to coordinate, pilot and follow up on the proposed programn implementation. 4.105 Sustainability of the program should be emphasized, with focus on adequate resources, training the trainers and creating a core group of officials who would continue to be responsible for the dissemination and education. -56- ANNEX 4.2: FINANCIAL MANAGEMENT IN PRIVATE ENTERPRISES AND SOEs Institutional and Regulatory Framework for Accounting and Auditing Standards and Practices 4.106 The Lao PDR accounting legislation includes the Law on Enterprise Accounting No.12/90, the Decree on the Implementation of the Law on Enterprise Accounting 05/PM dated January 24,1992 and the General Accounting Plan. Accounts must be maintained in the Lao language and in the national currency. The accounting legislation applies to all resident enterprises owned by foreigners or Lao PDR persons, including state enterprises, the co- operatives, mixed state/private enterprises, partnerships, private enterprises, sole proprietorships, and joint ventures. For foreign enterprises, accounts are required to be filed annually with the taxation office and the Foreign Investment Management Committee (FIMC). 4.107 Financial reporting is driven by taxation concems and does not address the need of the users of the financial statements. SOEs are required to prepare annual financial statements and to submit these statements to their supervisory ministries, but such statements are not required to be audited. The tax department requires enterprises to file annual tax returns for the purpose of income tax payment but the financial statements accompanying these returns need not be audited. The decree and the accounting system manual have a rigid chart of accounts, and the manual is mainly a bookkeeping guide. 4.108 Other laws and regulations relevant to accounting and auditing in the private sector include (i) Law on the Promotion and Management of Foreign Investment in Lao PDR. (LFIL) dated 13 March 1994, (ii) Business Law No.5 dated 18 July 1994, (iii) Tax Law of Lao PDR No.04/NA dated 14 October 1995 and its Decree on the Organization and Practice of the Tax Law No.72/PM dated 22 March 1996, (iv) Decree on Auditing No. 159/PM dated 26 August 1996, (v) Decree on National Financial Control No.160/PM dated 26 August 1996, (vi) Decree on the Establishment of the Accounting Council and the Accounting Profession Organization No. 161/PM dated 26 August 1996, and (vii) Regulations on Foreign Loan and Grant Management and Disbursement No. 1369/MOF dated 20 December 1995. 4.109 The LFIL requires foreign businesses to obtain a foreign investment license before commencing any activity in Lao PDR. To obtain a license, foreign investors must submit their application to the Foreign Investment Management Committee. The FIMC is a one-stop entity responsible for the promotion and management of foreign investments, including licensing, in consultation with the relevant ministries. Licenses have a fixed duration, usually 15 years. Under this law, accounts are required to be filed annually with the taxation office and FIMC. 4.110 The Business Law contains provisions for establishment of companies, registration of enterprises, and conditions for business operations, as well as audit requirements for certain types of enterprises to protect shareholders' interest. This Business Law applies to businesses with a registered capital over Kips 1.0 million. There are four types of enterprises in Lao PDR: (1) private enterprises, (2) state-owned enterprises, (3) collective enterprises and (4) joint enterprises. Private enterprises formed as sole-trader enterprises and partnerships are not required to appoint an auditor. The auditor appointed under the law should be a public accountant registered with LICPA, with a term of three years. -57- 4.111 The Tax. Law provides the basis for recording income and expenses for the purpose of computing taxable income. There is no requirement that an independent auditor audit the financial statements being submitted with tax returns. Audits are to be conducted by tax inspectors as and when irregularities are suspected. Foreign enterprises are required to submit tax returns with their annual financial statements, while state enterprises are required to submit them on a quarterly basis. 4.112 The Decree on Auditing details the provision relating to auditing and auditors for both private and public audits. The code of conduct and audit standards are provided in general terms. The audits must be conducted only by appointed persons. Independent auditors must be licensed audit firms or individual auditors. 4.113 The legal framework appears to be adequate but there is a lack of capacity to implement the laws and monitor compliance. Grants from several donors, including the ADB's assistance for training on accounting, have been provided but the efforts have not been coordinated and the institutions to support the enforcement of the laws are weak. The only incentive for enterprises to prepare financial statements and have them audited as required by the laws are bidding requirements for large projects, which usually require three years of audit reports as part of pre- qualification. The financial statements of an entity are required to be prepared according to the accounting laws but there is a considerable lack of monitoring mechanisms and oversight agencies to ensure full compliance. 4.114 The financial statements of enterprises could be un-audited and used for submission with the tax returns, while separate reports are prepared for internal management, dividend payment and other purposes. The company financial statements are not required to be filed elsewhere to be made accessible to the public. The shareholders, investors or financiers need to request these statements from the enterprises themselves, as there is no agency responsible for collecting them in one place. 4.115 Recommendation. The government should review the laws on taxation and on domestic and foreign investments with the objective of amending them to make them consistent. It should also introduce an effective and efficient framework for standard setting and for regulating and overseeing the accounting and auditing profession. Detailed recommendations in this respect are formulated in subsequent sections. Accountancy Profession 4.116 There are 3 organizations involved in the regulation and oversight of the accountancy profession. These are the Accounting Council, the Lao Institute of CPAs and the Association of Accountants, created legally under the Decree on the establishment of the Accounting Council and the Accounting Professional Organizations No.161/PM dated 26th August 1996. The Accounting Professional Organizations (APOs) are established to regulate the accounting profession, license accounting firms, grant CPA titles, and improve the accountancy profession. 4.117 The Accounting Council, established in 1998 within MOF, is responsible for setting accounting standards The Association of Accountants is an APO responsible for gathering individuals who perform the profession as an employee. The Association's main mandate is to -58- ensure adequate training for accountants, a minimum remuneration level for the accountant as professionals and to protect the integrity of the accounting profession. A Lao Institute of CPAs (LICPA) was also established under the Accounting Department of MOF in the year 1998 at the same time as the Accounting Council was set up. Its responsibilities are (i) develop a qualified accounting and auditing profession; (ii) improve accounting and auditing standards; (iii) develop a system of professional ethics with a code of conduct applicable to all qualified accountants; and (iv) maintain a registry of CPAs and audit firms. However, due to human and financial resource constraints, this Institute has still not been able to take off. (The World Bank will be considering an IDF grant to strengthen LICPA). 4.118 The registration of accountants is performed by the Accounting Department in the MOF. Graduates from the universities in Lao PDR and from two other vocational-type educational institutes are required to follow a six-month course of study organized by the Accounting Department. Upon satisfactorily passing the examinations set by the Accounting Department, successful candidates are eligible to practice as public accountants. To take the CPA examination, relevant practical experience is required--at least 5 years for graduates with diplomas and 6 months for graduates with university degrees. The examination contains 9 subjects that cover mainly general and business laws, revenues code, managerial, cost and financial accounting, and other accounting- related subjects. The exam does not, however, cover information technology and auditing standards and procedures. 4.119 The highest degree in accounting education in Lao PDR is a diploma from the two vocational schools; (i) Pakpasak Technical School, a private school and (ii) Dongkhamsang Technical School, a MOF-supported school. No major accounting degree is offered in Lao universities. In universities, the accounting subjects are taught as part of university degrees in business, economics, and agriculture. The graduates from both vocational school and universities need 6 months more of training courses conducted by the Ministry of Finance before being certified as an accountant. The accounting and auditing profession tend to remain undeveloped. Graduates have a basic level of knowledge as bookkeepers and producers of statistical information. There are Lao national staffs working in international accounting firms, but those are usually university graduates from abroad, e.g. Thailand and Australia. More work needs to be done in developing the curriculum and course content of degrees that will lead to further accreditation as a professional accountant and auditor. There is a need to upgrade professional standards and education to meet international requirements. The number of professional accountants also needs to be increased to meet the audit requirements for state enterprises and government joint ventures. Audit Firms in Lao PDR 4.120 The auditing practice in the private sector faces several challenges. These include unfamiliarity with International Accounting and Auditing Standards; most of the staff at enterprises and government agencies are still not quite conversant with international standards. This is a very young market and the need to educate clients is increasingly acute. To open an auditing firm in Lao PDR as a foreigner, one has to apply under the Foreign Investment Law and comply with its requirements as well as with professional requirements such as the need for a minimum number of staff with CPA qualifications. Time is needed for the local firms to grow and be able to compete. There are a total of 13 audit firms operating in the country, including the -59- two international firms of PWC and KPMG. Their clients are mainly international business enterprises operating in Lao PDR. They follow the requirements of the Enterprise Accounting Law but also submit audited accounts to the parent company based on international auditing and accounting standards. The local accounting firms provide accounting and auditing services to local companies and ODA-funded loan projects. Domestic consultants for loan projects are often recruited from these local accounting firms. There are about 100 individual CPAs and 13 audit firns operating in Lao PDR. 4.121 Recommendation. To build capacity for accounting and auditing, the government should consider taking the following steps * Upgrade professional standards and accounting education in Lao PDR up to the level of a University Degree Program. * Strengthen LICPA, the Accountancy Council and the Association of Accountants to be a primary source of guidance in accounting and auditing and to develop professional qualifications and quality control mechanisms consistent with international standards. * Prepare a plan for the establishment of a continued professional education program for all qualified accountants. * Develop practical guidance in accounting and auditing through development of reference manual and self-study training materials. * Design and implement a training program on prudent financial management and best practices for accountants in public and private sectors. Accounting Standards Used in Private Enterprises 4.122 Accounting Council was established in 1998; in accordance with Decree 161/PM dated 26t August 1996, to be responsible for setting accounting standards. It is placed within the MOF with representatives from several economic and professional sectors. However, as it does not have a supporting financial budget or a secretariat, it has not been able to function properly. Some of the International Accounting Standards (IASs) have been translated and are subjected to MOF approval but none has been officially issued. 4.123 The only available accounting standards in Lao PDR are an integral part of the Enterprise Accounting Law and its decree. It provides broadly basic principles of financial presentation and accounting practices, which are outlined in detailed accounting recording methods for Assets, Liabilities and etc. There is no set of standards and practical guidelines and accounting treatment for particular financial transactions. The presentation of financial reporting is limited to the basic financial statements, without any explanatory notes or disclosures. 4.124 The Law on Enterprise Accounting No. 12/90 and Decree No.05/PM on implementing this law are the main statutes governing the accounting requirements and setting standards for accounting in the private sector. The law requires observance of the principles of double entry and the adoption of accrual accounting. It also requires the enterprises to prepare a balance sheet, a profit and loss statement, and a sources and application of funds statement, together with a statistical and taxation statement. Overall, the basic financial information that is required to operate a business is being captured, recorded and reported. However, the requirements of the -60- legislation do not fully comply with international accounting standards as the system still has several shortcomings as follows: The accounting policies and systems of financial control and financial analysis could be improved. There must be greater emphasis placed on management accounting to include costing systems, product profitability, divisional accounting and budget management systems. There are no financial disclosures or notes for significant accounting policies or other additional information which may be deemed to be necessary for financial interpretation and analysis. * The executive boards meet only twice a year to examine the company's financial statements. More regular meetings of the executive boards are desirable. * When an enterprise has subsidiaries, financial statements are not consolidated with those of the parent company. 4.125 Recommendation. In order for financial reporting to be more credible, the Government should consider taking the following steps: * Adopt international accounting standards for all large enterprises in the private sector * Develop practical guidelines to implement these standards. Audit of Private Enterprises 4.126 The Decree on Auditing No. 159/PM provides general rules for auditing and fundamental auditing standards on professional ethics, audit principles, and reporting. The audit decree is more on code of conduct and lacks an enforcement mechanism. The legislation on audit of private enterprises needs to be strengthened in the following respects: * Enterprises are not subject to independent external audits, although other government oversight institutions perform several inspection-type reviews periodically. Under Article 3 of the decree, persons entitled to conduct the audit could be one of the five following parties: State Inspection Authority, National Audit Office, MOF, Tax Authority and Independent External Auditor. However, companies are getting little value added from these inspections, as they do not focus sufficiently on commercial activities. * The internal audit function does not exist in all enterprises. Where there is such a function, its quality is not up to international standards and needs to be improved, with more emphasis on the evaluation of systems of intemal control that focus on economy, efficiency and effectiveness. 4.127 Recommendations. To strengthen financial accountability in private enterprises, the government should consider introducing the following enhancements to the legislation on audit in the private sector: * Adopt international auditing standards for the private sector, including requiring large enterprises to be annually audited by independent auditors. * Develop practical guidelines to help implement these standards. -61- Financial Reporting of SOEs 4.128 The Law on Enterprise Accounting No. 12/90 and Decree No.05/PM on implementing this law are the main statutes governing the accounting requirements and setting standards for accounting in the private sector. State-owned enterprises are also required to comply with the provisions of this law.30 The law, however, suffers from several shortcomings as follows: * Financial statements of the SOEs are not published. * There are no financial disclosures or notes for any significant accounting policies or other additional information which may be deemed to be necessary for financial interpretation and analysis. * Performance indicators for monitoring the government's financial interest are not clearly identified for reporting purposes. * The current accounting system does not track the profitability of the various products that are being sold. There is a need to improve the quality of management accounting. * The financial statements of subsidiary companies are not consolidated with those of the parent company. Audit of SOEs 4.129 The Decree on Auditing No. 159/PM that governs audit in the private sector also applies to SOEs. SOEs are not subject to independent external audits, although other government oversight institutions perform several inspection-type reviews periodically. The audit under the decree could be carried out by organizations such as (1) National Audit Office, (2) Anti- corruption Committee (ACC), (3) State Control Committee (SCC), (4) Financial inspectors from MOF, (5) Auditors from the State Inspection Authority, (6) State property management officers, (7) Bank inspectors with the Bank of the Lao PDR, (8) Independent auditors registered with APO, and (9) Internal auditors of each department. 4.130 The internal audit function does not exist in all SOEs. Where there is such a function, its quality is not up to international standards and needs to be improved with more emphasis on evaluation of the systems of internal control that focus on economy, efficiency and effectiveness. 4.131 In some SOEs, the Internal Audit Unit reports directly to the Director of Administration, who is also in charge of the finance function. This raises the issues of conflict of interest and independence of the audit function. There are no outside directors on the board of SOEs and there is no audit committee of the board. 4.132 Recommendations. To strengthen corporate governance of private enterprises and SOEs, it is recommended that the government take the following steps: * Require large SOEs to prepare financial statements in accordance with adopted standards, be annually audited by independent auditors. * Consider introducing the internal audit function to SOEs to strengthen their internal control and internal monitoring systems. 30 The new international public sector accounting standard requires SOEs to adopt and follow international accounting standards applicable to private enterprises. -62- * Consider appointment of outside directors on the boards of large private enterprises and establish audit committees of the boards of directors in large private enterprises and SOEs. -63- ANNEX 4.3: FINANCIAL MANAGEMENT OF OFFICIAL DEVELOPMENT ASSISTANCE FUNDED PROJECTS Cui'rent Regulations 4.133 The regulations relevant to accounting and financial management of externally financed projects include (i) Regulation on Foreign Loan and Grant Management and Disbursement No. 1369/MoF dated 20 December 1995, (ii) Regulation No. 866/MoF dated 31 January 1995 (iii) Provision on Calculation of Administrative Spending No. 989/MoF dated 7 April 1997 (iv) Decree on Procurement of Goods, Civil Works, and Services with Government's Fund and (V) Regulation on Implementation of the Decree on Procurement No. 2642/MoF dated 21 September 1996. 4.134 The External Finance Relations Department (EFRD) in the Ministry of Finance, previously named the Foreign Currency Affairs Department (FCAD), is responsible for managing financial transactions of foreign-funded projects. The day-to-day management of individual projects is delegated to the concerned line ministries or government-owned entities. EFRD, however, controls the operation of most project Special Accounts into which donor agencies deposit foreign funds and from which contractors and suppliers are paid. 4.135 The government allocates budgetary funds to foreign loan projects as agreed percentages through the normal budgeting system. Once a loan or grant is approved, the responsible Project Implementing Unit (PIU) is required to prepare a work plan, an estimate of funding arrangements and the counterpart fund portion, a breakdown of the total annual project fund. The PIJ then requests the budgetary contribution by incorporating it into the Ministry or concerned province's annual budget. Budget expenditures are recorded at the time of payment through a double-entry bookkeeping system. Contributions in-kind to the project are required to be valued and included in the annual budget plan and recorded in project accounts in monetary terms. Disbursement of counterpart funds to the project is controlled and monitored by the provincial budget division and provincial treasury. Each disbursement is supported by a budget expenditure and payment order. 4.136 Project accounting systems follow the general accounting regulations under Decree No.20/PM. There is no specific rule that governs external fund transactions and reporting procedures. The systems for budgeting, accounting, reporting of project funds, and auditing are developed separately in accordance with each donor's requirements. -64- Financial Management and Audit Compliance 4.137 At a CPPR'focus workshop attended by World Bank staff and project representatives from Lao PDR in May 2000, project financial management was highlighted as the most important area in need of improvement. The participants identified a number of key issues and weaknesses in the financial management system operated by project implementation agencies, detailed below. These issues remain unresolved.3' * Inconsistent and inadequate' financial management standards, procedures and software in each PIU; * Delays to project implementation resulting from management of Special Accounts by MOF; * Delayed audit and'lack of consistent external audit standards and procedures; * PIU accounting departments that have been poorly staffed and equipped at start-up; * Poor internal control procedures and absence of internal audit in line agencies; and * Lack of financial management capacity at provincial and district levels. 4.138 As more projects are approved with a focus on social sectors and poverty reduction, project implementation will likely become more complex. Complexity will also be driven by the fact sub-national level agencies are increasingly involved in project implementation across a wider geographical area. Implementation responsibility for these projects will thus shift away from larger national agencies to much smaller local government units with weaker financial management capability. This trend will likely result in a more difficult and risky accountability environment and it is clear that the central government must act quickly to ensure that the local level government structures have the capacity to meet future project implementation needs. 4.139 The following statistics on audit compliance in Lao PDR projects financed by the World Bank provide an illustration of the problem at hand. One key element in an efficient and useful financial management system is timely project audits by independent auditors approved by the World Bank. Table 4.2 below shows the status of project audits as of January 31 2002, with comparative data as of June 1999 and March 2000. Table 4.2: Status of Overdue Project Audit Reports32 As of June 1999 As of March 2000 As of January 2002 Number of reports required 22 22 19 Audit reports received on or before due date 10 7 0 Number of overdue reports, of which: 12 15 19 Overdue between 0-4 months 2 12 11 Overdue between 4-9 months 8 3 1 Overdue over 9 months 2 0 733 4.140 It is apparent that there is considerable delay in receiving project audit reports and the situation has recently worsened for reports overdue over six months. The number of trust fund " Lao P. D. R. Country Portfolio Performance Review, May 12, 2000 32 Laos PDR Country Portfolio Performance Review, May 2000, Table 6 and EAP Region Monthly Management Report, February 2002, Table 6.1 33 Five of these reports were due under the SAC II Project that was closed in December 1993. -65- overdue audit reports stands at 32, as of January 31, 2002. The country team has taken action and should continue its effort to rectify the problem of overdue audit reports for projects as well as trust funds. Much of the problem is explained by delay in the process of receipt, review, and entry of audit reports into the ARCS, as well as weak capacity for audit in Lao PDR. There is also a perception among implementing agencies that audit of World Bank-financed projects is only the concern of the World Bank. 4.141 Recommendations. The Government should consider taking the following measures to strengthen financial management at ODA-funded project levels: * Establish a system to consolidate ODA-funded project accounting and adopt an accounting system for external debt management. * Develop and implement 'a comprehensive training program for national and local institutions, which should incorporate project management, accounting, reporting and monitoring standards. * Devote more resources to the National Audit Office for auditing the provincial and district levels, so that NAO will over time take the full responsibility for financial audit of ODA-funded projects. * Find ways with the donor community to harmonize the latter's requirements, and deal with systemic and cross-sectoral issues common to all donors. * Rectify the problem of overdue audit reports implemented by implementing agencies responsible for implementation of World Bank-financed project. -66- ANNEX 4.4: PROCUREMENT AND THE BID REVIEW PROCESS IN LAO PDR 4.142 Where there are specific procurement procedures prescribed by multilateral and foreign donors in their loan or grant agreements with the Government, they take precedence over national procedures. Approximately 80% of Government procurement is currently assisted by multilateral credits, mainly from the World Bank and ADB, or grants from donors such as JICA. Direct application of the Government's regulations therefore applies to only about 20 per cent of official procurement. 4.143. However, all procurement decisions made under donor procedures are still subject to final approval by a procurement committee, which must be established for all donor- and non- donor procurement. In the case of public (open or pre-qualified) international procurement, the committee must comprise 3-5 persons, 1-3 from the procuring entity, one from MOF, one from the Central Bank and one from CPC. For donor-funded procurement, the requirement for Central Bank representation on the committee is dropped. For central Government contracts worth over 50 million kip (approximately $5,200), the committee's decision is further subjected to approval at a meeting among Ministers and Vice-Ministers who were represented on the committee. For provincial government contracts worth over 30 million kip (approximately $3,040), the committee's decision is further subjected to approval at a meeting of officials who were represented in the joint committee. For all contracts worth over 1,000 million kip (approximately $104,000), award shall be approved by the Government, although precisely who in Government is not stated. 4.144 These provisions effectively place the final decisions on procurement on all Government projects, whether self-funded or donor-funded, in the hands of high-level officials regardless of whether prior procedures have been correctly followed. While no evidence has been found of procurement decisions being changed by these arrangements, there are documented delays in some cases as a result of time taken to address queries raised by the committee and higher authorities. For major contracts, the Government may wish to retain the right to review the related evaluation but there are two issues that need to be addressed related to the present system. They are: (i) the value of a contract that is subject to such a review needs to be substantially increased and (ii) any such reviewers should not be perrnitted to make a recommendation for award. 4.145 Government procedures provide initially for the establishment of responsiveness of bids, after which the contract award shall be based on the lowest evaluated bid. However, there is a further provision that non-price factors may be taken into account (time, overheads, efficiency of plant being offered, after-sales service, provision of warranty), through evaluation in monetary terms or by a scoring system. Although bidding documents must state the evaluation criteria, the use of a scoring system can still be subjective and open to abuse, and is no longer used in best practice procurement. Provision of matters like time, warranty and after-sales service can be mandated in the bid documents and evaluated as a pass/fail condition of responsiveness. Overheads should be included in the bid price and efficiency of plant can be evaluated in monetary terms as provided in the- World Bank's procedures, through calculating and capitalizing recurrent operating costs. -67- 4.146 Decree 95/PM states that in certain circumstances, direct contracting through price negotiation is allowed. The circumstances are defined in the IRR as (1) no responsive or suitable bid is received after announcement of public bidding; (2) for technical reasons or protection of industrial property rights, only one contractor or supplier is capable of executing the contract; (3) additions to ongoing contracts are valued at not more than 20 per cent of the original contract price; (4) cases of extreme urgency are brought about by unforeseen events and minimum time limits for public bidding would be unacceptable; and, (5) consultant contracts are valued at not more than 20 million kip (approximately $2,000). While inclusion of these five exceptions provides flexibility for exceptional situations, they could be liable to misuse in circumventing competitive bidding. It is noteworthy that MOF reports that only 60% of Government-funded contracts are procured in accordance with Governmnent procedures. Revised, and more precise drafting of the IRR, should reduce this risk and increase the percentage substantially. 4.147 The Government's legislation permits that, when there are less than three bidders or when all bids received are substantially higher than the budget provided, direct negotiation with the lowest bidder is perrnitted. The World Bank's procedures are that all bids may be rejected where there is lack of competition, in which case the contract shall be re-bid, but that the number of bidders alone does not determine lack of competition. As part of updating of the IRR this aspect needs tightening to avoid abuse. 4.148 Other aspects of the Government's procedures that are weak compared with international best practice are: * Record keeping. There is little in the Government's procedures requiring comprehensive records to be kept of all stages of the procurement process. * Gratuities and inducements. There is nothing specific in the Government's procedures to outlaw the offering of inducements during decision-making stages. * Single source procurement by price negotiation. The Government's procedures do not contain a provision that this -method of procurement is permissible only when the reasons for urgency were not foreseeable and not contributed to by the procuring entity. * Examination, evaluation and comparison. It is sound practice to require that a successful bidder re-establishes its qualifications before being awarded a contract but this is not covered in the Government's regulations. * Review. No mechanism is provided in the Government's procedures for a bidder or potential bidder to complain regarding procedural non-compliance by the procuring entity, or to seek administrative or judicial review. * Signing contracts. The authority for signing contracts is not clearly defined in Government procedures. -68- 5. BUDGET PLANNING AND PREPARATION BUDGET PROCESSES AND INSTITUTIONS The Planning Process 5.1 In common with other transition economies, annual budget spending in Laos PDR is undertaken in the context of a comprehensive planning framework. This framework includes a twenty year plan, five year National Socio-Economic Development Plan, and five and one year Public Investment Plans. These plans are intended to link government decisions about development with the annual budget process and they are supplemented by strategic documents such as the National Poverty Reduction Program and the I-PRSP However, priorities in these plans are expressed qualitatively rather than quantitatively in the form of financial allocations and this weakens the link to financial allocations specified in the annual budget. 5.2 The 20 Year Plan provides the Government's strategy for exiting from the status of least developed country by 2020. The 2020 development goal is being pursued through eight national socio-economic priority programs. These are in the areas of food production, commodity production, reducing shifting cultivation, rural development, infrastructure development, external economic relations, human resource development and services development. The Government's goals are to eliminate poverty by 2010, increase economic growth to a minimum of 6.6 percent per year, and to improve food security and education. Sector ministries have their own complementary strategic plans. 5.3 Attainment of the 2020 development goal involves three stages - 1) transition from a command to a market economy (already largely achieved under the NEM), 2) establishment of 35 In this regard the publication of the 2000/01 budget in the Official Government gazette (April 2001) is a welcome first step towards greater fiscal transparency. 36 The village, the lowest administrative level in the decentralized system, may assume responsibility for collecting certain taxes, but does not comprise an autonomous administrative unit. 37 However, these subdivisions are presently only used for internal purposes and not used by the MOF in the budget preparation or execution. I Previously the Central Bank was in charge of Treasury operations. 39 This bank specializes in agricultural development projects, particularly irrigation, and actually has limited participation in the treasury network. 4 District budgets (which are built up from the village level) will be approved by the National Assembly as lines in the provincial budget. Currently district budgets are not included in the national budget, but are prepared by the provinces from their own lines in the national budget. There is a separate process for large urban areas (there are four Urban Development Administration Authorities which levy special taxes and charges related to electricity and water). Around eight or ten percent of revenues collected by villages will be kept in a 'village fund'. As village funds accumulate this will be used (inter alia) for education and health related activities. 41 The funds retained by the province are to be used for investment projects submitted in the annual planning exercise the province to the Committee for Planning and Cooperation (CPC) but not selected for inclusion in the annual budget due to lack of funds. -69- physical and human infrastructure, and 3) people-centered development aimed at improving the well being of the populace.42 5.4 The Five-Year National Socio-Economic Development Plan (NSEDP) is the cornerstone of Lao planning. It translates the policies of the Party Congress into targets and objectives for sectors and regions. The targets reflect the eight priority national programs, with the program of food self-sufficiency having a high priority. 5.5 The PIP, which is a component of the NSEDP, lists the investment projects contained in the various sector programs. It therefore has a sector structure.43 In common with other developing countries, the PIP is also a 'bid' document for donor funding." 5.6 The NSEDP guides the selection of projects in the annual budget process, including by sector and region. Investment projects in the PIP have given heavy emphasis to the Communication and Transport sector partly in reflection of donor funding priorities. However the rolling three-year PIP of 2000 - 2003 gives greater importance to rural infrastructure and health and education. 5.7 The Annual National Socio-Economic Development Plan sets annual budget in the context of the five-year plan. It includes the priorities for the fiscal year and the project breakdown by sector and region. Provinces prepare their own budgets. Each province is assigned a spending ceiling for total provincial spending. These ceilings are not broken down by sector. Instead, the provincial governments determine their sectors allocations. However the way in which the provinces make these allocations must reflect central level guidelines for the provinces, issued in a decree early in the year and based on the NSEDP. 5.8 Sector and Regional Plans are linked to the above three levels of planning but are more detailed. Typically the sector plans are prepared by the responsible ministry and the regional plans by the relevant level of government (provincial or district). For example, for education there is a 20 year perspective plan (2001 - 2020) and its first phase comprises a five year educational plan (2001 - 2005). Both present lists of targets and priorities, list programs and enunciate concerns about program effectiveness. 5.9 The Medium-Term Expenditure Framework (MTEF) Planning targets in the 20- and 5- year plans are not developed within formal resource envelopes. The planning process is therefore a prioritizing exercise rather than a programming exercise. Public sector resource envelopes are introduced, instead, through the preparation of a three-year MTEF, which grows out of the annual budget process rather than the multi-year planning process. Projections for the major economic aggregates are included in the MTEF as are sources of revenue and estimates of official grants over the projection period. The expenditure side of the MTEF includes target 42 The third stage includes basic food security and decentralization of participation in development responsibilities. Government of Lao PDR, Discussion Paper on Macro-economic Policy and Reform Framework for the Roundtable Process 2000 - 2002, page 5. 43 PIP projects are also cross classified according to the eight National Priority Programs. 44 Projects fully financed by donor grants tend to be excluded as are projects involving the provision of loan funds to joint venture partners with the private sector. Maintenance outlays in excess of lOm kip are included in the PIP. 45 Plans set out priorities rather than actual resource allocations in response to these priorities. -70- levels for wages, recurrent and capital expenditures. Taken together, these revenue and expenditure figures provide projections for the fiscal deficit. The Annual Budget Cycle 5.10 The financial year runs from October 1 to September 30. Budget preparation begins in January of the preceding year. At the beginning of each financial year, the Minister of Finance and the President of the CPC report to the National Assembly on actions taken in the preceding year and on the budget for the upcoming year. The report consists of summary revenue and expenditure data and expenditure data by line item for general government operations and by individual ministry and province both for the current fiscal year and for the budget. 5.11 It is important to recognize that budget preparation proceeds in two streams. At the national level the Planning Department of (for example) the MOH sends a request to the CPC for funding for national level health projects. At the same time the provincial governor formulates a budget based on project requests from all provincial sector offices (including the district components) and forwards them to the CPC. 5.12 The proposals are then considered by the CPC for inclusion in the annual PIP. This involves a second round of inter-sector prioritization and review based on regional meetings.' The proposed annual PIP is completed by CPC around August of each year and then goes to cabinet. When approved it is submitted to MOF to ensure that the required funding is made available. This forms the capital component of the annual budget (allocated by line ministry and province). 5.13 The annual plan and PIP are approved by the National Assembly in parallel with the recurrent budget in September. This is in conjunction with a report by the Government on the results of the previous year's budget.47 5.14 In summary then, the budget preparation is based on a 'top-down/bottom-up/top-down system'. Regional ceilings are determined early in the budget process in line with planning priorities (top-down), district and provincial agencies and national ministries then identify spending bids within their ceilings (bottom-up) and these are renegotiated between the central and regional agencies (top down). Since the splitting of the Ministry of Economy, Planning and Finance into a financing and a planning agency in 1993 the capital and recurrent budgets have been prepared in separate (albeit overlapping) budget processes.48 46 The CPC and MOF are responsible for submitting a draft budget which conforms to the Prime Minister's guidelines to the Prime Minister's Office. The expenditure budget is divided into salaries, operating and maintenance expenditure and investment and construction expenditure. 48 In 1993 the Ministry of Economy, Planning and Finance was split into the Ministry of Finance (including the Treasury) and the Committee for Planning and Cooperation (CPC) adding Cooperation to Planning and Public Investment under the Office of the Prime Minister. In 1996 the CPC was separated and became the State Planning Committee (SPC) and the Cooperation component was shifted to the Prime Minister's Office. Coordination of foreign aid was within FIMC (Foreign Investment Management Committee) then CIC (Committee for Investment and Cooperation). Finally in July foreign aid coordination was reintegrated into the SPC and the SPC was renamed the Committee for Planning and Cooperation (CPC). -71- ASSESSMENT OF THE BUDGET PREPARATION PROCESS 5.15 Despite recent progress, a number of key problems remain. Problem 1: There has been a persistent tendency for the ratio of capital to recurrent spending to be too high. 5.16 Re-balancing capital and recurrent spending at the aggregate level. The capital and recurrent budgets are prepared separately. The balance of recurrent and investment in spending in each budget is effectively determined by planning targets relating to the share of investment spending in GDP rather than by trading off the benefits from additional capital spending versus additional recurrent spending at the margin. 5.17 As noted in Chapter 1, this investment ceiling is relatively high by international standards, and forces a lower level of recurrent spending than would otherwise be the case. It is possible that recurrent spending crowded out by the ceiling may have higher social returns than less cost-effective investment projects, which are sheltered from the pressure to compete for a share of budget resources. 5.18 Re-balancing capital and recurrent spending at the sector level. In any annual budget there is an ideal balance of capital and recurrent spending for each sector. For example, in the education sector there is an ideal balance of spending on new school buildings (capital) and school textbooks (current). In the transport sector there is an appropriate balance between construction of new roads and maintenance of existing roads. 5.19 A good balance can only be achieved when the budget preparation process considers capital and recurrent spending proposals for the sector simultaneously rather than under separate budgeting processes. Future funding can then be divided between capital and recurrent to achieve the best return from public spending in the sector. This is an issue, which can be addressed only by the integration of the capital and recurrent budgeting processes. 5.20 However investment priorities are set across sectors in the light of the Government's eight priority programs, and agencies propose investments in the light of these priorities. This approach has the advantage of ensuring that the composition of public investment reflects the priorities in the Medium Term Economic Development Plan. However it has a major drawback of failing to ensure that the level of recurrent spending in each sector is appropriately coordinated with past and present levels of capital spending. 5.21 An alternative used in some developing economies is for the traditional role of the PIP to move away from being a project list (with the annual budget providing funds as a matter of course), and toward its role as a strategic planning document. Instead the PIP has become a strategic document with the selection of individual projects more closely linked with priority setting in the preparation of the annual budget. This means that proposed project commencements, and levels of ongoing funding, are obliged to compete with agency bids for recurrent spending. This results in better integration of the recurrent and capital budgets in the light of the overall resource envelope available to the government. -72- 5.22 The central role of donors. Donors have an important impact on the capital recurrent balance since they fund roughly 75 percent of the capital budget but almost none of recurrent spending. Moreover, new capital projects create ongoing recurrent expenditure demands that must be provided for in future budgets. Donor funds are often made as grants or low cost loans which the government is reluctant to turn away. This distorts the decision making environment in a way that results in inappropriate overall use of funds. Two steps could be undertaken to address this issue. 5.23 Recommendation. Starting in FY 2002/03 larger project proposals submitted to the PIP, including those supported by donors, should include estimates of the future recurrent costs associated with the projects. The estimates associated with the projects in the approved PIP should be made available to the donors collectively as soon as the budget is passed. 5.24 Recommendation. By December of 2002 the government should meet collectively with the donors, perhaps in the context of one of the Round Table Meetings, to evaluate the consistency of the recurrent cost demands of the new PIP projects with the likely availability of government's own revenues and the other main recurrent funding needs including the recurrent costs of existing projects. The purpose would be to inform the process of subsequent year's PIP formulation. 5.25 Recommendation. In the longer term, develop mechanisms for judging individual investment proposals on their merits in the budget preparation process (including competing against recurrent spending proposals) rather than investment being pre-determined by the priority approach. Box 5.1: Measuring the Recurrent and Capital Spending The recurrent/capital expenditure ratio is affected by the manner in which the Central Planning Committee compiles the Public Investment Program. Donor-financed projects are included in the PIP as capital investment, even though substantial components of donor projects may address activities that are more properly classified as recurrent (e.g., training, medical supplies, monitoring, promotion). The recurrent/capital expenditure ratio has also been influenced by the sharp devaluation of the kip since 1997. For instance donor assistance for the health sector has jumped substantially when expressed in kip. However, in US dollar terms the amount of donor assistance for the sector has increased only modestly. 5.26 The balance between recurrent and capital spending should be the result of choosing the best use for limited resources rather than being imposed a priori. This might result in some variation from year to year. For instance, it may be desirable in one year to include a large capital project with a high economic return and relatively low recurrent costs and this would lead to a temporary spike in the capital budget share. However, for illustrative purposes the projected 2000/01 37 percent share of recurrent expenditure is in all likelihood to low and, as better allocative decisions are made, it might be expected to rise to perhaps 45 percent by 2004/05 and be accompanied by a better alignment of budgeted and actual spending. -73- Problem 2: Need to improve budget processes to achieve better expenditure balance between sectors 5.27 The Government, with substantial donor assistance, has invested heavily in transport and communications infrastructure in an effort to integrate the economy and help make it more market-oriented. This high level of investment in public infrastructure favors the economic sectors over the social sectors, and the relatively high capital/recurrent spending ratio reflects the more capital intensive nature of the economic sector projects. 5.28 But even within the capital budget, social sector spending has been compressed. From 1995/96 to 1997/98, expenditure on the social sectors accounted for about 18 percent of the PIP, while the economic sectors accounted for 75 percent. In 1998/99, the social share slipped to 11 percent while the share for the economic sectors rose to 79 percent. Most recently, the social share has recovered somewhat. While the draft Five-Year Socio-Economic Development Plan for 2001-2005 sets targets for reaching universal primary education, lower infant mortality rates and other social goals, it also sets targets for the economic sectors. In many senses, the draft Plan leaves little aside. The only clear shift to the social sectors is with regards to capital expenditures. The PIP for 2000/01 indicates an approximate 70/30 split between the economic and social sectors, and the longer-term PIP for 2001-05 indicates an approximate 65/35 split as time progresses. Again, though, while capital expenditure is needed for the social sectors, it is the current side that is so seriously in deficit. 5.29 It is tempting to recommend target levels of spending in social and economic sectors at the aggregate level and to and gauge the overall success of budgetary reform in terms of progress towards the targets. But slight variations in the way expenditures are classified can strongly affect the measured ratio and give a false sense of change. Moreover, what most important is to reform the process by which budget allocation decisions are made and to ensure that these are sound. Then appropriate allocative outcomes should emerge. For this reason the focus here is on budget processes rather than the allocation of broad aggregates. 5.30 Project identification. New project proposals should be identified on the basis of comprehensive needs assessment. The system in Laos has some strengths in this area. Preparation of each provincial budget involves a comprehensive bottom up process for identifying and screening investment proposals, beginning at the municipal level. Project proposals are then further screened at the provincial and national levels. 5.31 The hierarchy of screening processes at district, provincial and national levels ensures that there is community input into the identification and design of public policy proposals. It has the potential for a greatly improved identification process for new projects, which is systematically based on multi-level regional development strategies. 5.32 However this decentralized process of project identification is a two-edged sword. With the current emphasis on 'bottom up' regional project selection there will be strong pressures for each region to 'have its share of the investment cake', regardless of the overall economic return on the projects it proposes.49 A further requirement is therefore that the investment screening 49 This problem is similar in nature to each sector receiving its share of investment proposals under pre-determined sector investment ceilings rather than on the merits of the projects actually proposed for the sector. -74- takes into account regional and national benefits of proposed projects to avoid approving regionally promoted proposals, which displace projects in other areas with higher economic returns. 5.33 The ADB's Institutional Strengthening of PIP Management Project is directed in part a this issue. It includes a component for preparation of a PIP operations manual, which is expected to recommend a fornal separation of project approval from PIP approval, and to establish approval authority levels for various project types and improve the project selection process. PIP Decree 58PM supporting this process has just been signed and will be applied to the 2002/03 budget cycle. It provides that the PIP is to cover all public investments including those financed by foreign loans and grants as well as domestically financed public projects and that estimates of ongoing recurrent costs associated with large and medium PIP projects are to be prepared and' included with PIP submissions. 5.34 Project appraisal. Currently there is little use of project appraisal in formulating the capital budget. There are no prescribed standards for project justification and limited capacity for investment appraisal, either in the proposing agencies or the central coordinating agencies responsible for advising the Government on short-listed projects. Box 5.2: Limits of Cost-Benefit Analysis The 'science' of cost benefit analysis provides rigorous principles for estimating the economic benefit of a project proposal. This has the enormous advantage of allowing proposals in widely differing sectors - whether health, transport or resource extraction - to be prioritized in a common framework based on their net economic benefit. However too much credence should not be given to estimates of project net present value. In the last resort, the benefit of cost benefit analysis is in ensuring that the difficult questions about projects are routinely and objectively asked rather than put in the 'too hard (or too embarrassing) basket'. Where quantitative estimates of project net benefits can be made, however, they are valuable for defuiing best and worst outcomes. In order to weed out 'white elephants', project proposals should only be funded where the net present value is unambiguously positive. 5.35 Instead, top down sector priorities derived from the planning system and its eight priority programs drive the selection process. Investment projects tend to be accepted or rejected on the basis of these planning priorities, without formal investment appraisal.50 5.36 The best way to build up the PIP is to compare economic rates of return on individual projects, not simply to fill up the priority sectors according to the plan. The fact that a project is proposed for a high priority sector is no guarantee that the project has a higher economic return than competing proposals for lower priority sectors. In fact, giving priority status to a particular sector may encourage poorly conceived project proposals for that sector since interested parties correctly perceive there is a greater chance of winning funds. The situation is exacerbated where projects not only deliver low economic returns but also require ongoing subsidies from the 50 The bulk of public investment in each annual budget comprises projects that were begun in a previous year. These projects have a priority claim on funds, due to contractual conmmitments and the desirability of generating a benefit stream from funds already sunk in the project. This means that the funds available for new project commencements in any particular budget year are strictly limited. This underlines the need to choose new project conmmencement carefully, i.e., to ensure that 'green field' projects in the PIP and regional investment database 'migrate' to the successive annual budgets in the best possible sequence. -75- budget. The solution to this problem is to allow the sector composition of investment to be determined by the merits of the investment proposals from each agency rather than by a priori sector priorities. However this is impossible without effective appraisal of the investment proposals. 5.37 Currently project proposal submissions are supposed to include information on project inputs and outputs, local and external funding (grant or loan for the latter) together with project rationale. There are norms for estimating costs. Instructions for calculating project rate of return were issued in 1998, but 'are only calculated for big projects'.5" 5.38 Again the role of donors is important. In the transportation and education sectors there have been recent donor-supported efforts to evaluate the costs and to some degree the benefits of ongoing programs and projects. Efforts should be made to extend this work to other sectors in support development project appraisal capacity. 5.39 Recommendation. Larger donor supported projects submitted to the PIP should include basic cost benefit analysis and estimates of the economic rate of return to support project selection decisions of CPC and MOF. This would be consistent with the requirement that ongoing recurrent costs of large and medium size projects be included with all PIP submissions. 5.40 Recommendation. Over time the systematic use of investment appraisal needs to be actively promoted by the Government. This will require the promulgation of common standards for investment appraisal and the requirement that these standards are met by proposing agencies before projects can be admitted to the PIP. This implies a broad-based need for capability building for public investment appraisal in program agencies. In view of the importance of donor funding to the capital budget and the differences in donor procedures, it would be useful if one of the one of the Round Table Meetings were devoted to the issue of investment appraisal and to discuss the various donor practices with a view to adopting a more uniform approach to project proposal preparation in support of better investment appraisal. 5.41 Recommendation. In the medium term the following steps should be taken to provide a more performance focused platform for investment budgeting than exists at present: * establish common guidelines and standards for the appraisal of investment project proposals. * exclude projects from listing in the PIP unless these standards are met 5.42 A program of capacity building in investment appraisal should be established in both central and line agencies. Problem 3: Weak information base for budget preparation 5.43 No data on public spending by sector. Increased spending on the social sectors is a national priority. However Lao PDR is unusual among the countries of the region in not having data on the total level of government spending on the social sectors. Nor does it have 51 One view was that even if CPC requests additional information from proposing ministries or provinces this infornation is not always supplied. Appraisal is better for Bank financed projects. -76- comprehensive data on subsectors, programs and functions. Improved reporting is essential in assessing the adequacy of resource flows. 5.44 Budget allocations are not necessarily an accurate guide to actual budget spending. Government spending by ministry have been was published for certain years (see Table 3.2). and outturn for the previous year has sometimes been included. However, this information has not be consistently collected. Moreover, it appears that some provinces and sectors have not fully reflected actual spending in local budget records.52 It is also suggested that there is wide variation between provinces in approved and implemented budgets. This is attributed in part to the decentralization of the Treasury to district level in 1998-1999, with District Finance Bureaus facing cash shortages.53 5.45 This lack of essential information compromises the planning and budgeting process. It stems from deficiencies in the coding, classification and accounting systems for public expenditures as outlined in Chapter 3. 5.46 Recommendation. Resume preparation and publication of budget and expenditure outcome data on a comprehensive basis reflecting sectors, levels of government and items of expenditure. 5.47 Limited project monitoring data. Some weaknesses in investment planning stem from deficiencies in monitoring and feedback in regard to existing projects. In principle project progress is monitored every three months, with information provided to the provincial CPC, then to the center. In the past this information is not always forthcoming. However, with the support of donors, the Government is taking steps to improve feedback information in the management of future investment program. The ADB has recently launched a project on Institutional Strengthening of Public Investment Management that will focus on revising PIP submission formats and procedures for provinces and line ministries and will establish a PIP monitoring system. This builds on the work of a previous ADB Project on Strengthening the Capacity of Aid Coordination and Monitoring launched in 1999. It should unify systems for monitoring domestic and extemal funding flows and will include substantial training and computer hardware components. This work will be complemented by the ADB project on Capacity Building in Project Financial Management which will focus on the budget preparation and approval cycle for the ODA-fuinided projects, streamlining the fund flow mechanisms and procedures and providing training in financial management. SIDA has been providing similar support to MCTPC for project financial management in the transport sector. 5.48 Limited information on program performance. Lao budget allocations tend to be based on last year's level of funding, or the use of norms, rather than the results generated by the program. Ultimately there is a need for monitoring the performance of programs against appropriate performance indicators in order to provide feedback for improving budget allocations. 52 Government of Lao PDR, Discussion Paper on Macro-economic Policy and Reform Framework for the Roundtable Process 2000 - 2002, page 28. 53 Bouapao, L, Sengchandavong, 0, and Sihavong, S, Educational Financing and Budgeting in Lao PDR, International Institute for Educational Planning, Dec 2000, page 46. With primary and secondary schools gaining only limited access to recurrent budget the schools are required to rely on commnunity and parent associations. -77- 5.49 Budget agencies in transition economies are typically uncomfortable in focusing on program results. Their historical role has been essentially a financing role. Assessing the outputs and outcomes of their financing activity does not come easily. However this is less true of some program ministries. Typically the health and education ministries have developed at least rudimentary indicators of program effectiveness, such as re-infection rates in hospitals or repeat rates in the education system. 5.50 A common problem is that performance information is collected but is not used to improve internal, resource allocation decisions. This can reflect poor communication between different parts of the program ministry or between the ministry and the budget agency. Thus an ADB Report on education in Laos suggests that while information systems in the education Ministry need further development, ". ..information available is not currently being analyzed and used in planning decisions, partly because MOE does not have a tradition of inter-department sharing of information."54 5.51 It is desirable that the development of performance indicators in CPC and line agencies be encouraged and utilized as a feedback into budget funding. However this does not mean that Lao PDR should contemplate a shift to performance based budgeting at this time. The development of performance indicators adequate for this is costly and time consuming. Moreover full performance based budgeting is generally undertaken in the context of a post audit system in which spending agencies are not subject to expenditure controls but rather are held accountable via systems that measure performance results against expenditures already made, without any system of prior expenditure authorization. Lao does not yet have the reporting systems, let alone the audit capabilities, for this to be prudent at this time. Nevertheless some initial work on performance indicators could enhance the existing budget process. 5.52 Recommendation. A capability should be steadily developed in the area of identifying performance indicators and program outputs and these should be used to assist program agencies to develop a performance focus. 54 Asian Development Bank, Lao People's Democratic Republic, Education Sector Development Plan Report, July 2000, page 15. -78- Box 5.3: Funding Operations and Maintenance Costs In principle Laos' budget processes provide some links between capital projects and future recurrent funding for their operation and maintenance. For example, when a school is finished the MOE applies norms to determine additional teacher requirements in the province. Based on the norms it proposes an increase in teaching staff for the province to the Department of Public Administration. The increased quota of teachers for the province leads MOE to propose an increase in budget allocation to the province (or lower payment from the province where it is a surplus province). In reality, however, the consultation of MOE by the MOF seems to be patchy (a matter of complaint by the ministry). It appears that this year's budget allocation to a province is driven by last year's allocation rather than the norms developed by the line ministry. For example, in regard to the MOE "...when a new, perhaps expensive, primary school is built, the required complementary recurrent budget is unavailable: the new school is staffed by an underpaid teacher, (insufficient funds to pay adequate teacher salaries) who has only those day to day teaching supplies that can be paid for by families or others in the community (no funds at all from Government to buy teaching supplies or to pay for annual school maintenance)."' Thus many teachers only work part of the day, and children receive a reduced quality of education. ' Government of Lao PDR, Discussion Paper on Macro-economic Policy and Reform Frameworkfor the Roundtable Process 2000- 2002. 5.53 Recommendation. A capability should be steadily developed in the area of identifying performance indicators and program outputs and these should be used to assist program agencies to develop a performance focus. Problem 4: Poor integration of the NSEDP/PIP with the annual budget process. 5.54 While the various planning instruments are useful for prioritization they are not prepared against resource envelopes, either in the form of future budget allocations or proposed reallocation of funds within the sector (from activities which are to be reduced or eliminated)." The absence of a resourcing framework means that these priorities are not anchored in feasible budget allocations. Instead it is the annual budget preparation, which finally reconciles planning targets with available resources. This means that there is a risk that, at the time annual budgets are prepared, funds will not be available to realize the planning targets. 5.55 In order to be effective, the prioritization in the plan should take account of resource constraints. This would require that the costs of achieving planning targets be estimated and then the investments sequenced in a way, which is consistent with each future year's resource envelope. The annual budget process has drawbacks as a device for programming investment projects involving multi-year commitments of funds (both for project execution and subsequent operation and maintenance). This is essentially the role of a medium term expenditure framework. 55 Hence the plans are called 'perspective plans' in ADB, Lao PDR Education Sector Development Plan Report, July 2000, page 13. -79- Box 5.4: Measuring the Costs of Achieving Plan Targets in Education An education-financing project is being conducted with the support of SIDA and the World Bank to provide analysis of the feasibility of reaching the universal basic education (UBE) goal by 2015. It provides a tool for projecting the cost factors and resource requirements of reaching the plan targets. Projections are constructed in a comprehensive, bottom-up manner using the following basic building blocks: 1. Demographic projections and enrollment ratios. 2. Unit cost measures incorporating learning hours per student week, teaching hours per teacher per week, teacher utilization rates, teacher salaries, class size, and annual per student costs of administration, scholarships, non-teaching staff, and operations and rmaintenance. 3. Economic assumptions including the rate of GDP growth, the share of budget revenue in GDP and a balanced budget. 4. Education budget assumnptions including the share of education in the total budget, a declining share of the education investment budget funded from foreign sources and full domestic financing of the recurrent budget. 5. The financing gap to be funded from external sources is calculated as a residual. The projections provide for efficient phasing of projects and programs so that initially the emnphasis is on primary school, and as the larger primary cohorts move up through the system greater resources are devoted to higher levels. The projections also, allow for modest improvements in efficiency stemming from reduced repetition rates. Work is ongoing and results have not been finalized but it appears that substantial budgetary resources will be needed to reach UBE by 2015. It is also clear, even from the preliminary projections, that this will require a massive effort in teacher training to provide the necessary number of teachers. A sustained increase in teacher salaries has been factored into the analysis in line with the view that salaries are currently inadequate to attract people into the profession. It is also clear that investment expenditures should remain flat and that recurrent spending must initially grow very rapidly before slowing in the outer years. 5.56 The Lao Government does currently prepare each annual budget within a multi-year macroeconomic framework. However, this is a simple set of macroeconomic aggregates established in a consistent top down manner that defines a rough global resource envelope. A MTEF by contrast would be built up from accurately costed forward estimates, which would become the starting point for preparing each annual budget. Recurrent spending in problem areas such as road maintenance should also be programmed into the MTEF, alleviating the need to adopt the second best solution of funding road maintenance from an extra budgetary fund in order to guarantee it a slice of the resource envelope. 5.57 The use of a MTEF for the multi-year programming of capital and recurrent spending is a way of maintaining the current strong planning framework but subordinating it to the realities of Laos' limited resource envelope. It is also a framework for managing the transition from current high levels of public investment to a greater resourcing of the social sectors. 5.58 However there is some way to go before Lao PDR is ready for a MTEF based process for integrating planning with annual budgeting. The annual budget processes have to be operating effectively. In particular budget officials need to have a high level of competence in costing government programs. This in turn is dependent on improving the budget data and reporting systems as recommended above. This suggests a phased approach to improving this aspect of budget planning. -80- 5.59 Some recent work in the education sector is suggestive of a more robust budgeting framework that would provide a basis for multi-year planning and better integrated capital and recurrent budgeting, as well as assisting greatly with donor coordination and resource mobilization (see Box 5.4). Extension to other sectors could be accomplished through development of unit costs measures for each sector and adoption of a common set demographic and economic assumptions and a consistent set of assumptions regarding sector shares of the overall budget. 5.60 Recommendation. With the introduction of accounting, coding and reporting changes in line with the recommendations, more useful information on actual spending by will be generated over the budget cycle. These data should be used to build up basic sets of unit cost information for core programs/projects weaving in data from existing norms where appropriate. 5.61 Recommendation. The medium term expenditure framework should be built up over time to integrate three key aspects of budgeting - the macro fiscal constraints, the Public Investment Plan (PIP) and annual budget preparation. The MTEF should be formally linked with the core components of the PIP by including existing projects. These steps combined with improved cost information will allow the MTEF to develop more of a 'bottom up' focus than at present. Eventually it would contain all future budget costs associated with each of the Government's spending programs. Problem 6: Poor inter-agency coordination 5.62 There appear to be major coordination problems between the central line ministries and CPC/MOF, and between the line ministries and the provinces.56 The central line ministries' role in budget preparation is declining as decentralization progresses. This is creating problems of coherence in expenditure planning and monitoring which are exemplified by developments in the education sector. The Provincial and Disirict Education Services are departments of the MOE. They are supposed to report both to the MOE and to the provincial Governors. Through the Governors, they also report to the MOF and CPC concerning budgetary and investment matters. Likewise, the MOE reports to the MOF and CPC on budgetary and investment matters. With Ministerial-equivalent rank and membership in the Party Central Committee, Governors have extensive authority. On budgetary matters, the Provincial and District Education Services refer directly to the Governor. The Governor is not obliged to consult the Ministry of Education on education matters. Provincial and District Education Services no longer inform the Ministry of Education of their expenditures, or not on a systematic basis. There are meetings twice a year between the Ministry of Education with provincial and district education officials in order to facilitate exchange of information and planning. But in the absence of provincial data on a functional basis, it is very difficult to judge whether or not education priorities outlined in the Five-Year Plan are priorities in practice. In short, there is an information disconnect between central and provincial education authorities. The problem is made worse by the increased 56 Typically, in transition economies the planning ministry is responsible for the preparation of the multi-year PIP and the finance ministry for the annual budget. This requires a high level of coordination between the two agencies, particularly in regard to the migration of projects from the PIP to the annual budget. In many instances the authority and capability of the planning ministry is in decline. This does not appear to be the case in Laos PDR. The CPC takes a lead role in the budget preparation process while the MOF assembles the finance. -81- responsibilities assigned to the district level when district authorities lack the resources to maintain the type and quality of information earlier provided by the provincial authorities. 5.63 In some cases the declining role of the line ministries means that ministry norms and have less influence on budget formulation. Recurrent -budget allocations in particular appear to be largely based on last year's level rather than an assessment of outputs and associated unit costs. 5.64 A major component of the recurrent budget is wages and salaries. In this area ministries do seem to play a key role in determining standards at the provincial level. For example, MOE determines the number of teachers and other staff in the education sector in the provinces and districts. A budget plan for salaries is therefore determined by the MOE and approved by the MOF. In other areas, such as curriculum standards, it appears that standards are not clearly enforced. This opens the way to increasing inequity of service provision across provinces and districts. These difficulties are echoed in other sector ministries. 5.65 Following approval of the budget the MOF prepares detailed implementation instructions and budget allocations for each line ministry and province. The Provincial Finance Services and Provincial Planning Services then inform the various sector agencies of their recurrent and capital budgets. However this information does not appear to be transmitted to the respective ministries at the national level and in practice the provincial governor has authority for the allocation, authorization and revision of both recurrent and capital budgets. 5.66 The Government has recently instructed that only projects included in the PIP approved by the National Assembly will be funded from the budget. This appears to be a response to the promotion by provincial governors of projects (particularly irrigation projects) which are not in the PIP or approved by the National Assembly. 5.67 A full assessment of the quality of coordination would benefit from a case study of the handling of some specific programs and projects proposals in the budget preparation cycle. This would throw light on such issues as the consultation practices within MOF, between MOF and key line ministries and between MOF and the CPC. It would also indicate how far agencies proposing an investment project are required to seek coordination comments from all other affected agencies ministries. 5.68 Recommendation. The Government should ensure that all provincial and district level budget submissions and expenditure outcomes for both recurrent and capital budgets are made to the respective sector ministries as well as to the CPC and MOF. 5.69 Human resource constraints. The decentralization program assigns a central role to the districts as the main budgeting and planning units. The government has taken certain steps to prepare the districts for these major new responsibilities. A survey is being conducted to determine the need for transfers of staff from central ministries to provinces and from provinces to districts. A new salary structure is being designed and may incorporate performance evaluations and merit increases. Training programs for civil servants and high school graduates through the National Institute for Politics and Administration (NOSPA) and through the Finance School of the MOF have been started. -82- 5.70 Despite these initiatives, it will be a long time before any significant proportion the of districts are in a position to perform these new functions adequately and efforts to rush the pace of devolving responsibilities beyond the provincial level are likely to encounter significant implementation problems. The staffing needs assessment is not yet completed, let alone provision made for relocating people. Financial incentives will be needed to get civil servants to move, but the work on salary structure reform is at an early stage. While a 20 percent increase in basic salaries is expected this is fiscal year, will not compensate for the accumulated effects of inflation, and total compensation will remain extremely low. A retrenchment program of perhaps 5 percent is being discussed but it is yet to be decided whether to spread this over three years or five. This is too small to create the room for significant salary increases. In any event the number of civil servants is not large in relation to total population, and downsizing is basically at odds with the decentralization policy. The training programs are a step in the right direction but they are underfunded and lack text books, libraries and computer facilities. 5.71 Recommendation. The GOL needs to provide adequate support for decentralization. In order to ensure that mechanisms for accounting, budget management and financial control are in place, the devolution of responsibilities to districts needs to be accompanied by enhanced training, especially where new district level budget line items are created. 5.72 Recommendation. In the medium term the government needs to undertake a comprehensive civil service reform. This would likely entail significant increases in real wages and perhaps changes in the classification and pay scales, which separate social service workers in health and education from workers in ministries and government administration, as well as some retrenchement. However, budgetary constraints are such that it would not be prudent to implement in the short term. In addition the authorities need to come to a firmer view about the practical limits to the decentralization policy before committing to deeper civil service reforms. -83- ANNEX 5.1: THE FISCAL TRANSFER SYSTEM57 5.73 In the majority countries around the world the central government collects more revenue than it spends directly, and the lower levels of government have greater expenditure responsibilities than revenues. Accordingly there is a system of transfers that shifts resources from the center to the lower levels. In Lao PDR the net transfer is from lower levels up. The reason is not that the central government is assigned a small portion of the taxes. In fact, the central government is assigned the bulk of the turnover tax, which is the largest single tax, as well as customs revenues, and several other important taxes. Rather, the transfers result from the fact that the provinces on behalf of the central government collect these taxes. For instance, in 1999-2000 the provinces collected 99 percent of the customs duties although these are assigned to the central government. Table 5.1 Expenditures, Revenues and Transfers, 1999-2000 (million of )ips) Population Poverty Revenues Expenditures Rev-Exp Transfers to (+), from (-) Center Province * 1995 1997-1998 total 1,f00 kip/cap 1 2 3 4 (5)=(3)-(4) 6 7 All Govemment 4,581,258 39 1,779,593 2,777,766 -998,173 Central Govenment 1.014,558 1,929,228 -914,670 523,775 114 All Provinces 765,034 848,534 -83,500 -69,854 -15 Houaphan D 246,414 75 2.898 65,535 -62,637 -11,480 47 Oudonmay D 210,820 73 6,348 49,582 -43,234 -6,614 -31 Phongsaly D 158,820 64 5,018 40,446 -35,428 -7,738 49 Luang NamTha B 114,519 58 18,151 23,546 -5,395 1,002 9 Saysomboun Special Zone D 54,112 55 3,890 10,428 -6,538 .7,438 -137 Luang Phrabang D 365.333 49 15,835 31,930 -16,095 -7,760 -21 Sekong D 63,836 46 5,312 23,751 -18,439 -7,530 -118 Attapeu D 87,182 45 9,289 13,004 -3,715 -6,559 -75 Bolikhamxay B 163,847 42 28,840 37,453 -8,163 11,275 69 Khamnuamne S 273,779 42 60,604 46,377 14,277 18,596 68 Sarvane D 256,550 40 16,548 39,183 -22,635 -3,138 -12 Bokeo D 113,847 37 13.040 75,434 -62,394 -1,316 -12 Savannakhet S 671,581 37 187,730 70,586 117,144 157,211 234 Chantpassak S 500,994 36 70,389 59,727 10,662 66,943 134 Xteng Khouang D 200,075 35 9,262 49,100 -39,838 4,411 -22 Vientiane Provtnce B 286,089 24 18,157 46,515 -28,358 -5,869 -21 Sayabourn B 291,705 21 23,920 26,407 -2,487 890 3 Vientiane Municipality S 528,109 12 269,804 139,521 130,283 269,750 511 Memo items. Central transfers to deficit provinces as share of total central government expenditures 3 6% Central transfer to deficit province as share of tmnsfers to center 13 3% Provincial transfers to Center as share of total governmtent expenditure 18 9% Sources Column (I) UJNDP document "Facts about the Country; Column (2) Poverty Analysis and the Govenrnent's Development Strategy Table 2,tnimeo,2001 Columns (3) and (4) Budget 2O0002001 ,Official Gazette, April 20 a ,2001. Column (6)Trtesury department data. July 2001 * S-Surplus, D-Defich, B-Balanced 5.74 However, it is only the surplus provinces that make actual remittances to the center. The deficit provinces retain their collections of centrally assigned government taxes for expenditures in the agreed budget.58 But as discussed in detail in Chapter 3 there are serious accounting and control problems at the provincial level. As a result the provinces accumulate central government revenue collections in a variety of separate bank accounts or even in cash and spend them without effective reference to the budget. Neither the amount nor the use of these funds is adequately monitored or controlled. 57 This annex draws from work done for the PER by Francois Vaillancourt with financial support from SIDA. 58 In virtually every other country in the world, 100 percent of Customs revenues are collected and retained by the central government. In Lao P.D.R they are collected by the provinces and are retained by all but the three surplus provinces. -84- 5.75 The key point here is that regardless of which way the centralization-decentralization pendulum has been swinging, the central government has consistently experienced fiscal problems related the fact that too much revenue collection is administered by provincial and lower levels and that this collection has not be effectively monitored and controlled by the central government. Even the notional tagging of all revenues as "central" after 1991 did not effectively solve this problem. 5.76 The redistributive effects of the transfer system line up roughly with the incidence of poverty as shown in Table 5. 1, which ranks provinces in descending order of poverty. Vientiane municipality, which is the richest, is at the very bottom of the list and it transfers the most revenue per capita to the center. But Xieng Khouang and Vientianne Province which are relatively well off receive funds from the center, and Sekong and Saysomboun Special Zone which receive the most per capita are well down the poverty ranking. 5.77 However, fiscal transfers alone give a very partial picture of the overall redistributive effect of the fiscal system for several reasons: * Less than 5 percent of central government spending is represented by transfers to deficit provinces. The rest is spent through central ministries. Although the capital budget is broken out by province, the recurrent budget currently is not, so the provincial distribution of the largest portion of total government spending is unknown. * The definition of surplus or deficit hinges on the level of budget expenditures which is arrived at through annual budget negotiations. A rich province that successfully negotiates a large expenditure program may be classed as deficit and receive funds from the transfer system rather than contributing to it. * Extra budgetary funds are not included in the transfer formula. 5.78 The redistributive effects of the current transfer system operate largely through the revenue side with the richer surplus provinces contributing revenues the equivalent of 19 percent of total government spending. The expenditure side of the transfer system is relatively undeveloped: transfers to the deficit provinces are small. Ideally the fiscal transfer system should be based on needs and means. A variety of formulas are used in other countries including transfers based on per capita differences in provincial (or district): * tax bases * GDP * poverty indices. 5.79 These types of transfer formulas generally achieve a significant portion of the net redistribution through the expenditure side via transfers from the center to lower levels of government. This would be desirable in Lao PDR as well. However, data on provincial GDP do not exist in Lao PDR, and the poverty indices are at an early stage of development. Implementing such formulas in Lao PDR must await further improvement of these statistical capabilities as well as a more accurate assessment of the geographic distribution of expenditures by central ministries. -85- 6. SECTORS EDUCATION Key Development Challenges 6.1 Despite some improvement over the last decade, education sector outcomes remain poor. At the primary level, some 20 percent of school age children are effectively out of the system. Dropout and repetition rates are high, especially for ethnic minorities, and a significant gender disparity continues. Growth in primary school enrolment during the past five years has been little more than the growth of the primary student age group. Progression rates through secondary education remain low, and participation in tertiary education is the lowest in the region. Shortages of qualified teachers are acute in many districts. Almost 70 percent of the labor force have either no education or never completed primary education. Some 30 percent of the population, and more than 50 percent of women over 35, are illiterate. Quality 6.2 Only about 5 percent of students who enter secondary school complete the full six years. Deficiencies in the quality of instruction as well as poor alignment of the school schedule with the agricultural cycle are key factors. Quality problems reflect the inadequate preparation of teachers and the lack of textbooks and teaching materials. Approximately 80 percent of secondary teachers have only completed lower secondary school plus three years of teachers' training (8+3); the new standard requires completion of upper secondary education (11+3). School supervision and quality control are weak. 6.3 Teachers' salaries were eroded by more than a third in the three years prior to 1999/0059. This and the emergence of persistent arrears in payment caused large numbers of teachers to quit the profession or take second jobs, and a growing number of graduates from teacher training schools have chosen other careers. Enrolment in teaching training programs has dropped sharply since 1997 although it rose sharply in 2000-02. The shortage of qualified teachers is serious, especially at the secondary level.i' 6.4 In-service training has proven effective in upgrading teachers. However, two years of experience are required for each incremental salary step, and the increase in salary is very small 59 World Bank, Basic Education (Girls) Project: Costs and Financing of Education in Lao PDR, November 2000. Teachers' salaries average 2.8 times per capita GDP in Asia, but in Lao PDR the multiple is little more than one. 60 Success in increasing the percentage of children in school results in pressures to expand the next tier. By one estimate, there is current shortage of secondary teachers of about 2,000. ADB, Lao PDR: Education Sector Development Plan Report, July 2000, pp. 116. -86- (from 1,000 to 10,000 kip per month). It takes 30 years to progress through the full salary range. Promotions appear to be unpredictable and subject to factors other than competence.6" 6.5 In October 2000, the Government granted a 40 percent pay increase that goes some distance in reestablishing former salary levels. But substantial further increases in incentives for teachers will be needed to improve education quality. Access 6.6 While 85 percent of all villages are reported to have a primary school, only 43 percent have a complete primary school (i.e., all five grades). Many villages in remote and mountainous areas do not have schools. Secondary schools tend to be located in larger towns, requiring rural children to travel long distances or having to board at the school location. In the case of Sekong province, there are only four lower secondary and two combined lower and upper secondary schools to serve the whole province. Efficiency Table 6.1: Primary School Repetition and Drop Out Rates, 1999/2000 (percent) Grade I Grade 2 Grade 3 Grade 4 Grade 5 Repetition Rate 39.3 19.7 11.9 8.0 6.0 Drop Out Rate 16.2 8.6 8.5 9.5 10.1 Source: MOE Annual Statistics Bulletin 6.7 Reducing dropout and repetition rates could sharply increase efficiency by cutting the countrywide average time to graduate from primary school from more than 9.3 years to something closer to the standard 5 years. Increasing the number of complete primary schools would contribute significantly to this objective.Q Improved access and quality can lead to increases in attendance and student progression rates. Strengthening the primary system would contribute to better progression rates in secondary education, and could lead ultimately to lessening the need for two-years of "foundation studies" before commencing university degrees. 6.8 The overall student/teacher ratio of 30:1 is adequate but the distribution of primary teachers is very uneven. Urban and semi-urban areas often have surpluses of teachers while rural areas may lack a teacher altogether; classes of over 70 students are relatively common. Incentive payments for teachers who work in remote areas are irregular. The poor quality of schooling, compounded by a widespread lack of teaching materials and textbooks, and the lack of access to schooling beyond the first two years, has meant continued high dropout rates. Children of ethnic minorities have particularly low attendance records; most do not speak the national Lao language - the language of instruction. Expanded reliance on multi-grade teaching is expected to be a strong cost-saving measure. Economies are possible through amalgamation of very small schools in areas where continued access for students would still be assured. Significant cost savings could be realized through cuts or redeployment of Central Ministry staff. 61 ADB, Project Feasibility Report. Second Education Oualitv Improvement Project, February 2001, pp. 20. 62 ADB, Lao PDR: Education Sector DeveloRment Plan Report. July 2000. -87- 6.9 Increasing student/teacher ratios in post-secondary education to 15:1 and the student/non- teacher ratio to 45:1 would alone generate savings of almost 4 percent of total education costs. Additionally, reducing student fellowships (by some combination of cost recovery or targeting fellowships only to the neediest students) could generate savings of up to 3 percent.63 Greater control of the expansion of upper secondary and higher forms of education would also conserve scarce public resources, contributing thereby to the goals of universal access to primary education and improved quality and relevance. Equity Table 6.2: Indicators of Regional Disparities in Education Services (percent) Province Poverty Pre-Primary Dropout Rates Repetition % Enrolled % New Prim. Incidence NERs (Grades 1-5) Rates in Complete Teachers (Grades 1-5) School Unqualified Phongsaly 64.2 4.0 27 24 22.3 41.7 Luang Namtha 57.5 5.5 22 20 34.6 39.3 Oudamxay 73.2 3.0 24 25 - Bokeo 37.4 3.0 16 24 47.5 40.3 Louang Prabang 49.4 7.0 18 27 44.2 34.4 Houa Phanh 74.6 7.0 20 26 41.4 30.4 Xaygnaboury 21.2 - 16 22 - 1.0 Xieng Khoang 34.9 4.0 17 25 45.0 14.1 VientianeProvince 24.3 11.0 17 25 71.6 2.9 Vientiane Municipality 12.2 14.9 16 21 85.7 11.4 Borikhamxay 25.8 5.5 18 24 49.7 7.1 Khammuane 41.6 7.5 20 24 47.6 1.8 Savannakhet 37.1 13.5 22 25 59.5 8.5 Xaysomboom - SR 55.0 - 18 33 58.6 3.7 Saravanh 39.6 1.0 19 31 35.7 15.2 Xekong 45.7 3.0 2t1 27 33.8 27.0 Champasak 35.6 6.5 17 29 59.8 1.3 Attapeu 45.3 2.5 23 25 39.6 0.0 Lao PDR 45.0 8.0 19 25 Sources: ADB, Education Sector Development Plan Report July 2000; Kakwane et al., "Poverty in Lao PDR, Govemment of Lao PDR, March 2001 6.10 Regional disparities in education services pervade every level. For example, four relatively advantaged provinces (Vientiane Municipality, Vientiane Province, Sayaboury, and Charnpasak) have the highest enrolment rates at the pre-school level. Enrolment rates are lowest in the poorest provinces (Oudomaxay, Hauphanh, Phongsaly, Louang Namtha, and Xaysomboom Special Zone). The net enrolment rate for girls 6-10 years of age is on average 7 percentage points lower than for boys. Children in urban areas are almost eight times more likely to attend early learning activities than children in nmral areas.65 Dropout rates for grades 1-5 also correlate strongly with the degree of poverty; Phongsaly, Oudomxay, Attapeu, Savannakhet and Luangnamtha have the highest dropout rates (25 percent or more), while Vientiane Province, Vientiane Municipality, and Sayaboury have the lowest rates (about 15 percent). Repetition rates show a less clear pattern, but the number of years taken to graduate from primary school is related to the incidence of poverty. Primary schools in Vientiane Municipality have many more Lao language and mathematics books per school than Sekong. Oudomxay, Sekong and Saravan 63 World Bank, Lao PDR: Financing and Management of Education, December 1997. 64 Lao PDR, Multiple Indicator Cluster Survey. MICS II, 2000, State Planning Committee, National Statistical Center, Ministry of Health, and the National Institute of Public Health. 65 Lao PDR, Multiple Indicator Cluster SurveY MICS II, 2000, State Planning Committee, National Statistical Center, Ministry of Health, and the National Institute of Public Health. -88- have the lowest ratio of primary school classrooms per 1,000 habitants; some districts in Saysomboune and Xiang Khouang have ratios 2-3 times those in the least-developed school areas. 6.11 These data indicate the challenges in improving education services, especially for poor villages. Remoteness and lack of access to roads greatly increase the cost of providing education services. While schools are needed, capital costs can and should be minimized by use of local materials. The greater need is for qualified teachers, with skills aligned to the interests and language capabilities of their students. The availability of teaching and school materials must also be improved. For those villages with electricity, use of long-distance education techniques could be both a source of learning and opening to the outside world. By concentrating on strengthening current expenditures in support of education, and exercising strict economies on capital investment, greater gains will be possible in improving access to education services in rural areas. Table 63: Indicators of the Relationship Between Poverty and Access to a Primary School Province Access to a Primary School Access to a Cornplete Primary School Percent Rank Percent Rank Vientiane Mun. 85.00 7 73.9 18 Phongsaly 65.7 3 14.6 2 Luangnamtha 71.5 4 23.7 4 Oudomxay 62.1 1 13.1 1 Bokeo 64.0 2 18.5 3 Luangphrabang 94.6 14 42.1 6 Huaphanh 100.0 18 51.3 9 Xayaboury 98.1 17 65.8 16 Northern Region 84.9 8.4 38.6 5.9 Xiengkhhang- 92.9 13 48.3 8 Vientiane Province 90.1 10 58.5 14 Borikhamxay 90.7 11 54.4 11 Khammuane 87.9 8 43.0 7 Savannakhet 80.6 6 52.0 10 Xaysomboom-SR 95.8 15 67.0 17 Central Region 86.5 10.5 51.8 11.2 Saravane 91.7 12 54.5 12 Sekong 79.6 5 32.9 5 Champasack 96.2 16 56.0 13 Attapeu 88.6 9 64.0 15 Southern Rezion 93.0 10.5 54.7 11.3 Lao PDR 87.1 9.5 50.7 9.5 Correlation with percent of Poor 0.503 0.591 Source: N. Kakwani, ADB Participatory Poverty Assessment, June 2001 6.12 Private schools account for less than 2.5 percent of the total student population and are concentrated in Vientiane Municipality; the Municipality. Six provinces have no private schools. The quality and efficiency of private schools is considerably better, as reflected in much lower dropout and repetition rates. Private school students place well in national examinations. These outcomes also reflect family income status. -89- Chart 6.1: Net and Gross Primary Enrolment Ratios, By Province, 1998/99 160 140 __ _ _ _ 120 100 t!~~~~~~~~~~ v 40 | ,- ' . , ^ * _ _ w v v 20 S ' 20 '1 e/ / // / / / p $/ ' Gross EnroOlment Ratio Net Enrollment Ratio - - Net'Ner Enrollment Ratio | Source: Asian Development Bank, Lao PDR: Education Sector Development Plan Report, July 2000. 6.13 Enrolment data at the district level indicate much wider variations than indicated in the above chart. For example, net enrolment ratios for 6-10 year olds in several districts are less than 15 percent (Xaybuathong/Khammouane, Long/Luang Namtha, Viengphoukha/Luang Namtha, Samuoi/Saravan, TaOi/Saravan, Toumlan/ Saravan, Nong/Savannakhet, Kaleum/Sekong). In the last case listed, the net enrolment ratio is only 3 percent. While the proportion of incomplete schools in these districts explains part of the variation, poverty, ethnicity and other variables are also important. Government Goals for Education 6.14 The Government's recognizes the need for increased support to education and has the following goals for the year 2020:' * universal primary education and continued increased participation in lower secondary education; * universal literacy; * improved quality of education; * improved relevancy of education, including capability of the labor force to utilize modem science and technology; * expansion of vocational, technical and higher education. 6.15 Specific targets for education and training to the year 2005 include the following: * increase number of children age 3-5 in pre-school by 5 percent per annum; * increase the net enrolment rate for primary education to 86.0 percent; 66 The Education Strategic Vision Up to the Year 2020, Ministry of Education, October 2000 and Lao PDR, Fighting Poverty Through Human Resource Development, Rural Development and People's Participation, Government Report to the Seventh Round Table Meeting, November 2000. -90- * reduce repetition and drop-out rates by at least 2-3 percent per annum; * reach gross enrolment rates of 52 and 24 percent, respectively, for lower and upper secondary education; * increase the adult literacy rate to 80 percent; * upgrade untrained teachers to achieve basic qualifications; * increase the share of the budget for education to 15 by 2005 percent. Education Finance and Planning Government Expenditure Trends 6.16 The overall education "effort" improved considerably during the first half of the 1990s; the share of the total budget for education doubled, from 7.2 percent to 13.9 percent resulting in significant improvements including higher net enrolment rates for primary school age children, a higher percentage of primary school teachers certified, lower repetition rates at the primary level and higher adult literacy. 6.17 After 1996/97, however, overall expenditure for education fell sharply to a low in 1998/99 of 5.8 percent of the budget and 1.2 percent of GDP, which is less than half of the Asian norm. Moreover the ratio between recurrent and capital expenditures became progressively misaligned. Table 6.4: Measures of Education Spending Measures of Ed. Spending Typical Lao PDR Lao PDR Asian 1996/97 1999/00 Practice Ed. Budget as share of Total Govern. Budget 15 15.2 7.2 Ed. Recurrent Expenditure as share of Ed. Budget 80 56 52 Ed. Capital Expenditure as share of Ed. Budget 20 44 48 Education Expenditure as share of GDP 3.5 2.9 1.4 Ed. Recurrent Expenditure as share of GDP 2.8 1.6 0.7 Primary Ed. Per Capita Expend. As share of Per Capita GDP 8 5.4 1.9 Source: ADB, Basic Education (Girls) Project. Costs and Financing of Education in Lao PDR, November 2000. Table 6.5: Government Expenditure for Education and Training, 1990-2000 90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 Education Budget: Bil. Kip 13.5 14.9 18.9 24.4 49.0 46.6 64.4 72.1 101.7 198.5 Recurrent 11.7 11.2 14.0 15.4 26.2 27.7 35.5 40.2 53.9 103.7 Capital 1.8 3.7 4.8 8.9 22.8 18.8 28.8 31.9 47.9 94.8 EdBudget:percentofGDP 1.9 1.8 2.0 2.2 3.6 2.8 3.1 1.9 1.2 1.4 Recurrent 1.6 1.3 1.5 1.4 1.9 1.7 1.7 1.1 0.6 0.8 Capital 0.3 0.5 0.5 0.8 1.7 1.1 1.4 0.7 0.6 0.6 Ed Budget percent Total 7.2 10.1 9.4 9.7 13.9 13.7 13.0 10.1 5.8 7.2 Budget 6.2 7.6 6.9 6.1 7.4 8.2 7.2 5.6 3.1 3.7 Recurrent 1.0 2.5 2.5 3.6 6.5 5.5 5.8 4.5 2.7 3.5 Capital Source: Finance Department, Ministry of Education. -91- 6.18 Clearly, trends since the mid-1990s are inconsistent with strengthening of the education sector. In real terms the budget for education in 1998/99 was only a third of what it was in 1994/95. On a per student basis, the deterioration was even worse. The Government has recently strengthened its support for education and training, from 5.8 percent of the total budget in 1998/99 to 7.2 percent in 1999/00. For 2000/01, thei'Government has allocated 8.8 percent of the total budget to education or about 1.9 percent of GDP. It has a target of 12 percent by 2002/03. This is still 25 percent below the regional norm and will make it difficult, if not impossible, to reach the govermment's long term goals. 6.19 Of particular concern has been the sharp drop in recurrent expenditure, from 5.6 percent of the total budget in 1997/98 to only 3.1 percent in 1998/99 reflecting the erosion of teachers' salaries. Recurrent expenditures for education are about 21,000 kip or about US$2.50 per capita (i.e. per person in the total population). Table 6.6: Recurrent Expenditure By Subsector, 1990-2000 (percent of total recurrent expenditures) Subsector 1990 1994/95 1999/00 Pre-school 4.1 3.3 3.6 Prirary 43.7 46.0 48.7 Lower secondary 18.5 16.9 16.7 Upper secondary 9.1 7.1 8.3 Technical and Vocational 4.4 6.5 2.6 Teacher Training 7.1 4.8 2.7 Higher Education 5.8 8.4 6.8 Adminristration 7.3 7.2 11.1 Source: MOE, January 2001 6.20 The increasing share of recurrent spending 'going to primary education reflects rising primary student numbers and enrolment rates. The shares for teacher and technical/vocation training have fallen sharply while the share for administration has risen by 50 percent. The decline for teacher training reflects falling enrolments in teachers' colleges and unattractive salaries for graduates. The decline in the share for technical and vocational training is of less concern, as private sector provision is serving as an alternative to the public system. Rising administration costs relate to decentralization; more staff are needed at the provincial and district level, and the central government has not been successful in reassigning, or declaring redundant, surplus staff in the Ministry of Education. -92- Table 6.7: Recurrent Expenditures by Budget Nomenclature Selected Years 1990 1995196 1998/99 1999/00 A. Central (% of C) 20.1 45.9 33.3 36.7 Recurrent(%ofA) 81.0 22.8 35.9 21.1 Salaries (40.0) (34.3) (24.8) (44.1) Operation (11.0) (10.1) (7.1) (6.3) Maintenance (18.0) (12.4) (7.1) (6.3) Fellowships (30.0) (43.2) (61.0) (43.2) Investment (% of A) 19.0 77.2 64.1 78.9 GOL (19.0) (14.4) (20.6) (18.6) Foreign 0.0 (85.6) (79.4) (81.4) B. Provincial/Local (% of C) 79.9 54.1 66.7 63.3 Recurrent (% of B) 98.9 90.7 61.5 70.3 Salaries (91.4) (92.4) (75.9) (71.4) Operation (4.0) (3.3) (4.9) (4.6) Maintenance (2.0) (0.8) (1.6) (1.5) Fellowships (2.0) (3.6) (17.4) (22.4) Investment (% of B) 1.1 9.3 38.5 29.7 GOL 0.0 (9.3) (33.7) (36.1) Foreign 0.0 0.0 (66.3) (63.9) C. Consolidated 100.0 100.0 100.0 100.0 Recurrent 95.4 59.6 52.9 52.3 Salaries (83.6) (82.2) (64.4) (67.4) Operation (5.0) (4.5) (5.4) (4.9) Maintenance (5.0) (2.8) (2.9) (2.2) Fellowships, (7.0) (10.5) (27.3) (25.5) Investment 5.0 40.4 47.1 47.7 GOL (5.0) (25.1) (27.8) (25.5) Foreign 0.0 (74.9) (72.2) (74.5) Source: MOE, Dept. of Accounting and Finance Control, December 2000. 6.21 From the table, the following trends respecting recurrent expenditures are evident: * the declining share of the education budget for recurrent expenditures; in 1999/2000, recurrent expenditures accounted for 52 percent of the education budget, while investment accounted for 48 percent; * the declining share of recurrent expenditures at the provincial level accounted for by salaries; this development reflects falling real wages for teachers; * in contrast, the increasing share of total recurrent expenditures accounted for by salaries at the central level; * the growth in the importance of fellowships for higher education and vocation/technical training; they now account for more than 25 percent of total recurrent costs; * the small and declining share of recurrent expenditures for maintenance. 6.22 Capital expenditures accounted for almost 50 percent of the education budget in 1999/00. The regional norm is more in the order of 20-30 percent. Donor assistance accounts for three-quarters of total capital expenditures for education. 6.23 International research suggests returns from primary education on the order of 25 percent or more than twice the level from tertiary and vocational training. The share of recurrent expenditures for primary education remained steady over the 1990s, at just below 50 percent. The share for lower and upper secondary education fell during the first half of the 1990s, but -93- began rising in recent years. The share for tertiary education increased marginally during the 1 990s while the share for vocation/technical training fell sharply. However, a high proportion of investment (40 percent in the case of donor assistance) was for tertiary facilities; less than 30 percent was for primary school facilities. This reflected the cost of establishing the National University of Laos. However, this trend is being reversed and donor assistance is now highly focused on support for primary education. 6.24 Fellowships for secondary and tertiary/vocational education account for 25 percent of total recurrent expenditures for education. The beneficiaries are predominately from above average income families. This is even more so the case for students attending tertiary and vocational training institutes. The cost of these institutes is fully borne by the Government, as there are no tuition fees. As shown in Table 6.8 below, the unit cost of technical and vocational training is approximately 10 times the cost for primary education. Table 6.8: Recurrent Costs of Education by Level of Schooling Sub-sector Unit Cost in Kip Unit Cost Per Capita GDP 1994/95 1996/97 1994/95 1996/97 Pre-primary 39,627 44,800 0.15 0.10 Primary 19,839 24,524 0.08 0.06 Lower secondary 43,601 46,129 0.17 0.11 Upper secondary 48,403 55,282 0.18 0.13 Technical/vocational 251,767 252,528 0.96 0.58 Teacher training 313,899 237,192 1.20 0.54 Higher education 247,116 182,508 0.94 0.42 Source: Mingat, A, Curriculum for General Primary Education, National Research Institute for Educational Science, Lao PDR, 1998. 6.25 As a result of these factors, and the fact that better quality primary schools are generally located in above average income areas, public expenditures for education in Lao PDR strongly favor the upper income quintiles." Rebalancing of the subsector allocation is needed, both to gain greater returns for society as a whole and so as to improve equity. Universal primary education must be the top priority, with assurance that reasonable quality extends to all students. The Government has indicated it will allocate 55 percent of recurrent expenditures for education to primary education. It should also ensure an equitable allocation of this expenditure among the provinces and districts. Tertiary education and vocational/technical training are important for Lao PDR's evolution to a more industrialized and service-based economy. However, user fees should be an important source of financing, in acknowledgement that the beneficiaries of higher education or training have much improved earnings prospects. The Resource Challenge 6.26 Raising teachers' real salaries is critical if the Government's goals for the sector are to be achieved. However teachers' salaries are the biggest single component of recurrent expenditures for education and because of the unified salary structure for all public servants, raising teachers' salaries means raising all public service wages as was the case with the 40 percent salary increase awarded teachers in October 2000. Even then, average teachers' salaries rose to only 70 67 World Bank, Lao PDR: Financing and Management of Education, December 1997. -94- percent of per capita GDP compared with 130 percent in 1996/97. The regional norm for teachers' salaries is 280 percent. To reestablish the 1996/97 ratio for the almost 40,000 teachers in the system would cost an estimated $7.6 million boosting education's share of the total budget from 8.8 percent to 10.5 percent. If extended to all public servants, the cost would be about $16 million, adding some 4 percent to total expenditures. To reach the regional norm of 280 percent would require roughly tripling these dollar amounts and percentages and would be out-of-step with the Medium-Term Expenditure Framework. .6.27 Another major resource challenge is the rapidly increasing importance of secondary education. Higher numbers of students are completing primary school and progressing though secondary school. In addition to the demands for more teachers, classrooms and teaching material, budgetary resources for fellowships have increased dramatically, reflecting the lack for most rural students of a secondary school within commuting distance. However, continuance of the policy of encouraging higher participation rates in secondary education collides with the expansion of primary education.68 Population growth alone means having to accommodate large increases in student numbers. Currently, 45 percent of the population is under the age of 15. With a population growth rate of 2.5 percent, it is projected that by 2005 an additional 158,000 children will be of school age.69 Just to accommodate this population increase will require some 5,000 additional classrooms and teachers. However, the scale of the challenge is much greater than this, as achieving universal primary education by 2015 requires vigorous action over the next five years in raising net enrolment ratios, especially if quality improvements are addressed at the same time. 6.28 Informal calculations by the Ministry of Education indicate a cost of $31 million over the next three years for education facilities, which would include approximately 3,200 additional classrooms; 1,300 for primary education, and 1,200 and 700 for lower and upper secondary education, respectively. Additions of this scale would appear largely geared to population growth. Providing access to five grades of primary school for all primary age children will require much greater investment than planned. At least 55 percent of the education budget will need to be directed to providing primary school classrooms, teachers and learning materials. It is simply not possible to provide for rapid increases in both the numbers of primary and secondary school students, even if 15 percent of the total budget is allocated to education.70 6.29 Recurrent expenditures are normally met from domestic resources, with donor assistance focused primarily on support for capital expenditures. Simultaneously effecting a substantial increase in the budget share for education and decreasing the capital portion in favor of recurrent expenditures is only possible if some combination of the following measures is taken: * the major portion of the gains in resource mobilization projected over the medium-term is directed to the education sector; * the budget allocation for other sectors (e.g., transportation) is considerably reduced; 68 At present there are 261,000 secondary school students and 12,000 teachers. The Ministry of Education has set a goal of 335,000 students and 15,000 teachers by 2004/05, and for 415,000 students and 19,000 teachers by 2009/10. 9 Govermment of Lao PDR/ADB, Medium-Term Expenditure Framework and the Public Investment Program. April 2000. 70 ADB, Basic Education (Girls) Project: Costs and Financing of Education in Lao PDR November 2000; Sida/World Bank, Education fmancing in Lao PDR, R. Noonan, June 2001. -95- * donor assistance is substantially reformulated to support recurrent expenditure in the education sector. 6.30 Using the budget for 2000/01 as a reference, increasing the share for education to 12 percent would mean increasing the resource allocation for the sector from approximately $35 million to $50 million. More ambitiously, raising the share to 15 percent would mean increasing the resource allocation to $60 million. In short, the more achievable target of 12 percent means finding additional funds of $15 million, while the more elusive target means finding additional funds of $25 million. These amounts would need to increase in real terms by about 8 percent annually, reflecting the growth in the budget over the medium term. However, additional investment in education should be within the absorptive capacity of the country and the executing agencies. Care needs to be exercised that donors do not crowd each other's activities compromising the efficiency of education expenditure. 6.31 The donor community has registered a strong interest in supporting the education sector in Lao PDR and it can be expected that the donor, community will continue to fund some 75 percent or more of capital expenditure for the education sector. Given that the Public Investment Program for 2001-05 provides a 10 percent share for education, and this is expected to be equal to about 1.3 percent of GDP, capital expenditure for the sector of about $25 million annually is anticipated over the medium-term. Donor funding of $20 million annually for capital expenditure would approximate recent levels of support. 6.32 The larger question is how much support can be expected for recurrent expenditure. Projects in the "pipeline" in support of teacher training, capacity building, and the supply of textbooks and teaching materials will help boost recurrent expenditures. However to raise teachers' salaries and accommodate the rising student numbers and ambitious enrolment targets, much more donor assistance for this dimension will be required. One possibility would be a series of policy-based loans, which would supplement the Government's general revenues conditional on meeting agreed upon policy and other reforms. While borrowing to strengthen recurrent expenditures in the education sector would normally be discouraged, it could be viewed as a form of bridge financing until expected new revenue sources materialize." Decentralization 6.33 The Government's motives for decentralization include the search for lower costs and improved financing, and complements greater community involvement in the development process. Decentralization of education began in 1998/99 and provinces, districts and villages are continuing to establish the implementing procedures and necessary institutional capacity, including training of district treasury officials by provincial officials so as to transfer spending authority. 6.34 Decentralization of education services has drawn attention to the urgent need for capacity building at the local level. Not all provinces and districts are capable of fulfilling effectively or efficiently their designated roles. In particular, substantial differences exist between rural and urban districts, and between those located in the lowlands (with better communication and 71 Such as from introduction of a VAT and comrnissioning of the NT2 hydropower project. -96- transportation services) those in remote mountainous areas and small districts. Capacity building is also required at the village level, as they are the "implementing units" for school construction and the assignment of teachers. 6.35 Local authorities exercise considerable discretion in drafting their budgets for education, and increasing degrees of discretion through the budget year in realigning line items. Provincial and District Education Services no longer inform the Ministry of Education of their expenditures, or not on a systematic basis. In short, there is an information disconnect between central and provincial education authorities, weakening the utility of the Five-Year Plan. The problem stems from the increased responsibilities assigned to the district level; district authorities, lack the resources to maintain the type and quality of information earlier provided by the provincial authorities. 6.36 Decentralization may exacerbate regional disparities in the provision of education services; It is questionable whether the current transfer system effectively addresses these disparities. The poor quality of data and the pervasiveness of off-budget expenditures cloud the issue. Moreover, because existing regional disparities in education services are so serious, "extra" transfers to poor provinces and districts will be required to enable them to catch up to minimum national standards. Despite the intergovernmental transfer system, marked regional disparities in educational services persist. Alternative intergovernnental fiscal arrangements need to be considered.72 The Budget Process 6.37 The Ministry of Education and the provincial and district authorities are responsible for drafting their respective education budgets and all budgets must respect national priorities and fiscal limitations. A national budget conference of Ministers and Governors, held in May or June each year and overseen by the Prime Minister, provides a forum for determining sectoral and provincial allocations. Follow-up negotiations "one-on-one" set the budget, both revenues and expenditures. The national budget, which combines all levels of the Government, must be approved by the National Assembly. 6.38 Recurrent expenditures are budgeted on the basis of the current fiscal year, with provisions in the new budget for increased numbers of teachers and other operating expenses to acconmmodate expected increases in the number of students. While the budget estimates are "demand driven", demographic and other relevant information is limited. There appears to be no medium or long-term indicative planning concerning budgetary resources necessary or likely for achievement of the Government's educational goals. Nor are recurrent expenditures associated with capital expenditures reflected in budgetary planning. 6.39 Off-budget expenditures for education are significant. Communities cover about 4 percent of recurrent expenditures. In some -cases - especially in remote and mountainous areas - they account for virtually all school maintenance and other non-salary expenses. Also, families incur expenses for sending their children to school. These expenses include fees, uniforms, books, supplies and transportation. The 1997/98 Lao Expenditure and Consumption Survey 72According to the Ministry of Finance, the fault was not so much in the design of the fiscal arrangements as in the limited capacity of the Government to make the transfers. -97- reported that these costs varied considerably,'3 from a high of 53,700 kip annually per household in Vientiane Municipality to less than 5,000 kip in the case of four provinces. The average for the country was estimated to be 15,200 kip. In current values, this would be equivalent to about 85,000 kip or $10 per household annually. Off-budget capital expenditures for schools and facilities are also considerable. Communities on average account for 20-30 percent of capital expenditures. Some donor assistance is off budget, notably 100 percent grant assistance for small-scale projects. 6.40 Since teachers' salary grades and levels are set by the Central Government, the numbers of teachers and their qualifications are the main budgetary variables. The Department of Public Administration, Prime Minister's Office, must approve additions to the public service for education purposes, including teachers. Salaries as a percentage of total expenditures for education vary widely among the provinces.74 6.41 Fellowships facilitate access for students distant from secondary or higher education institutes. Approximately half the student places are supported by the fellowship system, which covers room and board and incidental expenses. Fellowships are exam based, but allocated among districts according to a quota system. The Central Government sets the level of support for fellowships." 6.42 Investment proposals are generally descriptive, citing cost estimates but with little if any evaluation of expected rates of return. Only the largest projects are subject to more careful scrutiny. There is heavy reliance on external evaluations, especially regarding donor assisted projects which are the overwhelming majority. Provision for counterpart funds is usually in the 10-20 percent range, although much of the provision is "in kind"; actual cash implications are usually much lower. Contrary to forward budgeting, recurrent expenditures associated with investment proposals are not systematically reported. 6.43 The Department of Investment, CPC, reviews the investment proposals and narrows the list - after consultations with the Ministry and provincial authorities - so as to stay within the budget guidelines. Past allocations heavily influence budget allocations assigned to each spendihg authority, while leaving room for new priorities of the Government (e.g., schools in remote areas). Ongoing projects are normally included in the Public Investment Program. The PIP, together with the overall budget, is submitted to the National Assembly for approval. 6.44 Until recently, the Ministry of Education had no post-budget monitoring system. With donor assistance, the Ministry (together with two other Ministries) now has a computerized accounting system fully integrated with the Treasury. However, the system is limited to the central level. Further, reporting by budget nomenclature rather than on a functional and economic basis undermines the usefulness of post-budget monitoring. 6.45 CPC regularly visits the Ministry of Education and the provinces to monitor and evaluate implementation of capital investments. Quarterly reports are made to the National Assembly. 73 Lao PDR, The Households of Lao PDR. State Planning Committee and National Statistical Center, December 1999. 74 World Bank, Education Finance in the Lao PDR: Data Report, submitted by George Brown, January 11, 2001. 75 There are no "on-budget" fees; the National University of Lao PDR has yet to introduce tuition fees. -98- The Minister of Education attends the presentations, and is answerable for all questions raised concerning the education sector. This aspect appears to be a weak link in accountability, since provincial and district authorities are increasingly independent of the Ministry. As discussed later, actual investment expenditures differ widely from planned allocations. Recommendations: * Improved education services and enhanced enrolment should be core elements of the long-term development strategy for poverty reduction. * Restore the budget share for education to at least 3 percent of GDP corresponding to 13 percent of the budget projected for 2003. Strive by 2005 and beyond to increase the budget share for education to 15 percent. * Increase the share of current expenditures for education from 50 percent to 70 percent. This target cannot be expected to be achieved through donor assistance; domestic revenue mobilization is essential. * Insulate the education budget from fiscal shocks. * Improve use of donor assistance through a) early stakeholder involvement in project design b) greater attention to capacity building at all levels of project management and implementation, c) consistent provision for recurrent expenditures associated with capital, d) assignment of a more active role to the MOE - together with provincial and district education agencies - in coordinating donor assistance to limit the tendency of the donor driven approach towards recurrent budget-starved and inequitably distributed development projects and e) enhancement of the Ministerial responsibility for the proper allocation and use of funds. * Increase the share of primary education in the education budget from 50 percent to 55 percent. Increase resources for non-formal education particularly for to women and to ethnic minorities. * Review intergovernmental transfer system with a view to reducing the marked regional disparities in education service. * Review options for improving teachers wages including delinking from civil service wage scale, enhancing training and performance increments, and allowing salary supplements in budget submissions. * Eliminate salary arrears. * Give priority to increasing the proportion of primary schools offering all grades through consolidation, emphasis on recurrent funding over capital spending for new projects, and increased use of multi-grade classrooms. * Enhance enrollments through stronger community involvement, variations in the school year to suit local agricultural labor requirements, and fuller use of 20 percent local content in the curriculum. * Improve access to non-formal education. * Strengthen both in-service and institutional training and introduce competency- based certification. * Rationalize placement of staff among districts with low and high student/teacher ratios, especially benefiting villages where there are no qualified teachers. -99- Learning and teaching materials must be made more available. The Govemment's goal of a 1/1 ratio for textbooks to students should be strongly supported by the donor community. Adopt measures for greater efficiency and resource conservation including: a. provision of future recurrent costs estimates associated with capital investments with PEP submissions. b. more accurate estimation by MOE of the costs of achieving plan targets based on demographic trends, unit costs, projected enrollments, transition rates, etc. c. expansion of private sector participation in the education system, especially in urban areas. d. cutting back on fellowships to students from above average incomes, and introducing tuition fees for both vocation/technical training and tertiary education; e. integrating access, quality and relevance measures, leading to significant decreases in dropout and repetition rates; f. improvement in the allocation of teachers, and reducing non-teacher staff levels; g. greater use of multi-grade teaching; h. consolidation of schools in selective areas, while protecting access; i. continued expansion of the cluster-school concept; j. utilization of local materials and other steps to minimize the cost of schools and education facilities generally; k. staff cutbacks at the Central Ministry, or relocation to provincial/district offices in support of decentralization; 1. ensuring that donor assistance is properly coordinated and addresses key priorities, including non-capital expenditures such as teacher training and text books. -100- HEALTH Key Development Challenges 6.46 Health, like education, is an essential element of human development and critical to poverty reduction. This is especially the case in Lao PDR, as its health indicators - as shown in Table 6.9 - are among the worst in Asia. Table 6.9: Social Indicators, Selected Countries INDICATOR YEAR LAO CAMBODIA VIETNAM LAND MALAYSIA PDR LAND Human Development Index 1999 140 137 110 67 56 Population Growth (percent) 1993-00 2.4 2.7 1.8 1.2 2.1 Total Fertility Rate 1996 4.5 4.6 2.6 1.7 3.2 Life Expectancy at Birth (years) 2000 59 53.4 67.4 68.8 72 Maternal Mortality Rate (per 100,000 1993-00 530* 900 160 200 80 live births) 1997-00 82* 106 32 31' 10 Infant Mortality Rate (per 1,000 live 1997-00 106* 167 43 26 1 1 births) 1995 40 -- 40 26 25 Under-Five Mortality Rate (per 1,000 1995-00 52 36 36 86 78 live births) 38 33 32 87 66 Underweight Under-Fives (percent) 75 65 53 98 96 Access to Safe Water (percent) 1995-00 37 14 22 74 94 Rural 19 8 16 72 -- Urban 67 81 47 80 -- Sources: Government of Lao PDR, Ministry of Health, Health Strategy to the Year 2020 and CPCINational Statistical Center/UNFPA, CPC, Lao Reproductive Health Survey 2000. Also, United Nations, Lao PDR: Common Country Assessment, January 2001; World Bank, World Development Report 2000/2001. *MOH, National Health Survey. Lao PDR, January 2001. 6.47 Particularly distressing are Lao PDR's high infant and matemal mortality rates. Causal factors include high fertility rates, incomplete immunization, malnutrition, limited knowledge about proper health practices and a weak primary health care system. More generally, high morbidity rates prevail among the rural population. Malaria cases are reported to exceed one million annually and the disease is the most common cause of death. Almost 40 percent of all hospital patients are malaria cases. Diarrhea is another major cause of mortality and morbidity, reflecting poor sanitary practices (lack of a latrine and use of impure water). Acute respiratory infections (notably pneumonia) are the third major health problem. 6.48 All these causes of mortality and morbidity can be addressed through the health and education systems. Indeed, considerable progress has been made over the past decade or more in improving the health and quality of life of the Lao people. According to the national health survey conducted in 2000, the chances of survival until the age of five have doubled and life expectancy at birth is now 59 years of age (compared to 48 in the late 1980s). Infant and matemal mortality rates are reported to have dropped significantly in recent years. 6.49 However, the degree of progress in improving the health status of the Lao people must be viewed with caution. There are large inconsistencies between the Government's data and those -101- from multilateral agencies.' Moreover, there are large differences between rural and urban areas, and even more pronounced differences for ethnic minorities living in remote areas. Infant and maternal mortality rates in these remote areas may be 3-4 times the national norm. Quality 6.50 For'most of the past decade public health policies have focused on building or upgrading hospitals, particularly the central, regional and provincial hospitals. In short, the focus was on curative rather than preventive health services. Yet the quality of curative care is poor. The population/bed ratio is about 760, nearly double the ratio in 1990. District hospitals are generally small, with 5-30 beds, and they can only provide basic treatment. Of the 125 district hospitals, most suffer from a lack of supplies, public services (electricity, water, etc.) and trained personnel. Alarmingly, the rate of misdiagnosis and 'wrong treatment appears to be high.77 The referral system is weak and utilization rates are extremely low.78 6.51 There are 2 central, 5 regional, and 13 provincial hospitals, with each hospital averaging about 100 beds. Despite insufficiently controlled expansion,- these hospitals also suffer deficiencies. Equipment is often outdated or broken, or the staff unfamiliar with its use. 6.52 The human resource complement is weak; reflecting limited pre-service and in-service training and retraining. Low salaries and difficult working conditions discourage the recruitment of personnel. There are less than 100 doctors per 1,00,000 people, which is among the lowest ratio in Asia. The number of nurses is far below what is needed and both doctors and nurses are poorly deployed; more than half of fully qualified doctors are located in Vientiane. Lao PDR has 0.9 personnel per bed, compared to the regional average of 1.5 6.53 A series of vertical programs was intfoduced during the 1990s to help overcome weaknesses in high priority basic services, including for malaria and tuberculosis control, mother and child health, eye care, immunization, iodine supplementation, potable water and sanitation, and reproductive health. Despite their benefits, the vertical program approach to basic health services has proven fragmentary and inefficient. Now the Government, with the support of the donor community, is concentrating on strengthening the primary health care system (PHC). Numerous projects' and programs have been introduced, each individually beneficial but collectively lacking in coherence' and standards. The many ministries and agencies in Lao PDR with roles in health services, and the move to decentralization compound the problem of coherence. 6.54 In view of the poor quality of public health services, their financial cost, and the distance required in most instances to access them, it is not surprising that utilization rates for public health services remain very low. Less than 30 percent of people in need of medical services turn 76 For example, the Lao Reproductive Health Survey 2000 indicated that the under-five mortality rate had declined to 106 per 1000 live births, while the World Health Report for 2000 indicates a rate of 150 per 1000 live births. 77 ADB, Lao Primary Health Care Project Quarterly Report #13 September 1998. In one district the rate of misdiagnosis was reported to be about 40 percent. 78 According to WHO, many district hospitals have-only 2-3 inpatient and 10-15 outpatient visits per day, despite having a staff of 50-60 health personnel. WHO, Proposal for Integrated Community Health/Safe Motherhood Proiect, March 1999. 79The number of staff per bed may simply reflect the overall low utilization rate of health care facilities. -102- to the public health system for help and there is a heavy reliance on private remedies. Unfortunately, over use of drugs is a widespread, making person more vulnerable to infection and the recurrence of diseases.80 The number of private pharmacies has multiplied from less than 100 in 1990 to more than 2000 currently. Located for the most part in provincial and district prefectures, they are inadequately regulated and the quality of the drugs sold is often compromised. Unlicensed drug sellers are numerous. Prescription drugs are regularly sold regardless of treatment guidelines. Access 6.55 Under the cooperative farning system a nation-wide network health of care centers was established in the 1970s and 80s, each staffed with 2-4 auxiliary nurses that provided both preventive and curative services. Once the cooperative system was abandoned, community support to health workers and centers dropped - leading to a sharp contraction in the number of centers in the 1990s (Chart 6.2). Chart 6.2: Evolution of the Growth and Decline of Health Centers 1400 * Number of health centers 1200 - - _ _ ..- _ __ _ _ 1000 - ,-_ --.- 600 - . 400 - - _ * 200 - 5 -- -- -- 0 1976 1980 1985 1989 1993 1997 2000 Year Source: ADB, Feasibility Study: Primary Health Care Plan, November 1999. 6.56 Closure of local health centers meant having to travel to more distant district hospitals, causing a de facto contraction in coverage of basic health services. Since the mid 1990s, the Ministry of Health has been trying to rebuild the network of health centers. Currently, there about 550 such centers, with 2-3 beds each. However, staffing has been inadequate, especially for centers in remote areas, and supplies, equipment, and the facilities are substandard, with the result that the quality of services is poor. The introduction in 1995 of cost-recovery fees has meant that households must judge whether the expense of visiting a heath care center is worth it. Extremely low utilization rates8' indicate that most have concluded otherwise. 80 United Nations, Common Country Assessment: Lao PDR, January 2001 sI According to some estimates, the utilization rate is generally below 10 percent. WHO, Proposal for Integrated Community Health/Safe Motherhood Project, Lao PDR, March 1999. -103- 6.57 Geographic accessibility to health services is a major barrier for many villages. According to a recent national health survey 62 percent of villages are located within 4 kilometers from the nearest health center; 24 percent are between 4-16 km from a center, and 14 percent are more than 16 km distant.82 There are significant regional differences in access, with the north having the worst access. The average distance to the nearest hospital in the north is approximately 26 km, compared with 12 km and 8 km for the central and southern regions. Urban areas, in contrast, have virtually complete coverage. 6.58 According to a household survey conducted in 11 provinces in 1999,83 less than 30 percent of people in need of medical services turn to the public health system for help. About 35 percent of sick people seek care from non-government sources such as private pharmacies, drug sellers, traditional and religious healers, village health workers, birth attendants, , and. A roughly equal percentage seek either no care or treat themselves at home with traditional medicines. The Lao Expenditure and Consumption Survey conducted in 1997/98 revealed that more than 90 percent of household expenditure for health care was for medicines (which may include the cost of advisory services on their use). Efficiency 6.59 One measure of efficiency in resource allocation for health services is the degree to which low-cost, high-impact interventions such as health education, immunization, and prenatal care and family planning are favored. Unfortunately, too much emphasis has been placed on physical facilities (hospitals) and equipment - that is, on high-cost, low impact interventions. Observations made in the 1997/98 public expenditure review have yet to be corrected: medical personnel are over-concentrated at the central level, especially in Vientiane. Further, the referral system is highly inefficient, both because of high rates of misdiagnosis and "passing-up-the-line" to higher cost services when proper treatment at lower levels would be possible. Equity 6.60 Basic health services are more deficient in areas where the poor are concentrated. As shown in Table 6.10, the non-poor have better access to all forms of health service including pharmacies, medical practitioners, community health workers and immunization programs. 82 National Institute of Public Health, MOH, Lao PDR, National Health Survey in Lao PDR, January 2001. 83 ADB, Laos Primary Health Care Expansion Project: Household Survey in 11 Provinces of Lao PDR, July 1999. -104- Table 6.10: Access to Health Services by the Poor and Non-Poor, 1997/98 (percent) Health Service Indicator Very Poor Mod. Poor Non-Poor Total Has pharmacy in the village 26.1 38.2 48.9 43.0 Has licensed pharmacy 16.7 26.6 37.9 32.1 Has a medical practitioner 41.0 50.4 57.2 53.2 Has a trained nurse 60.0 63.5 64.2 63.4 Has community health workers 36.4 46.3 45.7 44.3 Has a traditional healer 47.3 54.6 55.2 53.8 Has a traditional birth attendant 36.7 52.0 50.0 48.2 Hours to reach the nearest hospital 21 8 3 7 Has immunization program 84.4 90.4 92.7 90.8 Source: Govemment of Lao PDR, CPC/NSC, Lao Expenditure and Consumption Survey. 1997/98. 6.61 In light of much lower access to health services by the very and moderately poor, it would be advisable to review the heavy reliance on user fees. There must be greater assurance that user fees result in improvements in the quality of service, and not at the expense of access by the poor. There may be a better mix of private/public finding, resulting in both better health services and more efficient use of medical personnel and facilities. However, decisions about user fees need to take into consideration that access by the poor may also be limited by factors other than user fees, and that user fees in some areas such as the provision of drugs may be necessary for sustainable service delivery. Table 6.11: Percentage of Population with Health Services Province Poverty Incid. Medical Trained Nurse Community Licensed Immunization Practitioner Health Worker Pharmacy Vientianne Mun 3.5 66.6 57.5 17.6 62.2 97.3 Northern Reg. 47.3 45.3 59.6 41.4 35.3 87.5 Phongsaly 57.9 46.0 44.6 37.2 44.4 82.2 Louang Namtha 51.1 16.2 17.5 18.0 11.0 88.9 Oudomxay 66.1 53.1 79.7 7.7 31.5 88.7 Bokeo 38.9 38.4 34.0 24.8 28.4 85.2 Louang Prabang 40.8 50.7 50.7 33.5 25.3 83.3 Houa Phanh 71.3 44.5 74.0 55.0 36.4 81.4 Xaygnaboury 17.7 47.5 81.3 80.3 57.0 100.0 Central Region 39.4 53.5 64.3 44.4 44.8 91.1 Xieng Khoang 42.9 33.8 57.0 35.8 38.8 88.9 Vientianne Prov. 27.8 65.0 74.9 43.2 65.8 91.6 Borikhamxay 27.9 51.2 56.9 30.3 37.8 86.7 Khammuane 44.5 46.8 44.5 43.6 53.3 88.5 Savannakhet 41.9 58.1 73.1 54.5 34.5 94.3 Xaysomboom 26.8 51.9 54.0 3.9 55.6 84.5 Southern Reg. 39.8 57.4 71.1 63.6 41.2 92.0 Saravanh 39.2 49.5 54.5 47.3 44.8 95.0 Xekong 49.7 36.5 49.0 42.9 29.0 54.7 Champasak 37.4 62.5 85.8 79.8 41.7 100.0 Attire 48.0 66.9 53.2 36.1 37.1 66.3 Lao PDR 39.1 53.2 63.4 44.3 43.0 90.9 Sources: Kakwani, ADB Poverty Assessment TA, June 2001. Kakwani, Datt, Bountavy, Phonesaly and Wang "Poverty in Lao PDR: 1992/93-1997-98", March 30, 2002 -105- 6.62 The northern region has the highest infant, child and maternal mortality and the lowest life expectancy; it also has the highest incidence of poverty and the poorest level of medical services. Variations in medical services are much more marked on a district and village basis. A further consideration is that many ethnic minority communities do not value social services; providers often have little understanding of their needs or values and the quality of services in isolated areas with large ethnic populations is very low.8' 6.63 Variations in medical services reflect variations in provincial health expenditures per capita. For example, between 1997-2000, per capita health expenditures in Louang Namtha were about twice the level in Phongsaly.85 While investment expenditure accounts for a large part of the variation, even excluding this component the difference between the two provinces was about 50 percent. Clearly, national norms and the intergovernmental transfer system should be improved to ensure equality in health expenditure and services. Government Goals for Health 6.64 The general goal of the Government with respect to the health sector is "to free the healthcare services in the Lao PDR from the state of underdevelopment, ensure full healthcare services coverage, justice and equity in order to increase the quality of life of all Lao ethnic groups."86 All people should have equitable access to health care services by 2020. This will require complete and comprehensive health services, including the development of referral systems and an effective balance between preventive and curative approaches. 6.65 The MOH's strategic focus will be preventive health care through a strengthened PHC system. Elements of the health strategy are shown in Box 6.1. Box 6.1: Elements of the Government's Health Strategy * Strengthen the ability of health care providers; * Improve community-based health promotion and conmmunicable disease prevention; * Improve and expand hospitals at all levels and in remote areas; * Reduce non-communicable diseases related to food consumption, smoking, alcohol, and drug abuse; * Encourage use of traditional medicine and integrate with modem care; * Promote operational health research; * Ensure effective health administration and management; * Establish a health insurance fund. 6.66 To realize these goals, the Government has identified five priorities: human resource development; renovation and improvement of existing healthcare facilities; strengthening of the financing system; improvement of the legal and regulatory framework; and clean water for all. 84 ADB, Health and Education Needs of Ethnic Minorities in the Greater Mekona Subregion. Lao PDR Country Report. August 2000. 85 Provincial Health Service Annual Financial Reports. 86 Government of Lao PDR, Fighting Poverty through Human Resource Development. Rural Development and People's Participatio4 Government Report to the Seventh Round Table Meeting, November 2000. Also, MOH, Health Strategv up to the Year 2020, May 2000. -106- 6.67 In addition, the Government is endeavoring to extend and strengthen pre-payment schemes at the community level, so as to build the foundations for an eventual universal social security system - including health insurance. 6.68 Achievement of the above goals and priorities presents a major challenge. In Statistical Appendix Table 9 they are compared, together with selected health indicators, to the series of UN resolutions on health care, starting with the Alma-Ata Declaration on Primary Health Care in 1978 and the 16 declarations since then. The comparison underscores the gulf between the current health status of Lao PDR and UN goals for developing countries. As in the education sector, the authorities needs to come to grips with the question of the financial feasibility of fulfilling stated objectives for improving the quality, accessibility and equity of health services. Health Finance and Planning 6.69 The health sector is critically under-funded. Health care financing from all sources in Lao PDR, including govermment subsidies, donor assistance, social security and household payments, was estimated to be US$ 11.50 per capita in 1997/98. This is low by comparison to other countries in the region, as shown in Table 6.12 below, and it has likely worsened since then. A recent analysis for five provinces in Lao PDR found that their total planned health expenditures for 1999-00 was one-third the level for 97/98.87 6.70 Household expenditures are the largest gross contributor to the sector, at about 60 percent of total health expenditures, followed by foreign aid at about 25 percent and government expenditures at about 15 percent.88 These shares are significantly different from the time of the previous public expenditure review; at that time, it was estimated that households accounted for 52 percent of total health expenditures, followed by the govermment at 32 percent and foreign aid at 16 percent.89 Table 6.12: Per Capita Health Expenditures in Selected Countries, 1997/98 Country Per Capita Health Expenditures ($) India 8.0 Bangladesh 10.5 Sri Lanka 11.0 Lao PDR 11.5 China 19.0 Philippines 42.0 Malaysia 67.0 Thailand 103.0 Hong Kong 944.0 Japan 2,947.0 Source: ADB, Laos Primary Health Care Expansion Project. Volume 2 November 1999. 87 ADB, Provincial Health Budgets and Expenditures, Laos Prirnary Health Care Expansion Project, August 2000. 88 ADB, Lao PDR: Public and Private Health Expenditures, prepared by Brad Schwartz, May 1999. 89 World Bank, Lao PDR Public Expenditure Review, 1997. -107- Government Expenditure Trends Chart 6.3: Health Expenditures and Total Expenditures (% of GDP) 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 1 9 1 9 1 9 1 9 1 9 1 9 1 9 19 1 9 91 92 92/ 93/ 94/ 95/ 96/ 97/ 98/ 93 94 95 96 97 98 99 | + % of GDP ---- % of total govt. exp. I Source: ADB, Medium-Term Expenditure Framework and Public Investment Program: Lao PDR, April 2000. 6.71 Chart 6.3 indicates that between 1992/93 and 1995/96 the share of the budget for the health sector increased considerably, from 2.5 percent to almost 7 percent. However, as in the education sector, following the Asian financial crisis and macroeconomic instability in Lao PDR, the budget allocation for health contracted sharply - to just 4.7 percent in 1998/99. This was equivalent to little more than one percent of GDP,,which was among the lowest level in Asia. Since 1995, the population has increased by more than 15 percent yet government expenditures for the health sector have fallen in real terms by 20 percent. 6.72 Of particular concern has been the contraction in recurrent expenditures for the health sector. Chart 6.4 indicates that the focus of public health expenditures since the early 1990s has been on investment in capital facilities, notably central and provincial hospitals. This focus reflects donor assistance and the Government's own preference for tangible accomplishments from grant and loan fumds. Chart 6.4: Capital and Recurrent Expenditure on Health (% of GDP) 2.0% 1.5%/o - go Capital * Current 1.0% - 0.5% 0.0% - - - - 1991 1992 1992/93 1993/94 1 994/95 11995/96 1 996/97 1 997/98 11998/99 | Current 0.4% 0.3% 0.4% 0.7% 0.8% 0.6% 0.7% 0.5% 0.5% |Capital 0.3% 0.3% _0.1% 0.4% 0.5% 0.9% 0.4% 1.0% 0.7% Source: ADB, Lao PDR: Medium-Term Expenditure Framework and the Public Investment Program, April 2000. -108- 6.73 Whereas recurrent expenditure has normally accounted for about 60 percent of total government expenditure for the health sector, in recent years it's share has fallen to about 40 percent or even less. Salaries account for approximately half of total recurrent expenditure, and administration expenses for about 20 percent. The remainder of recurrent expenditure is mostly divided between social welfare (12 percent) and support/promotion of core health programs (12 percent). Social security accounts for only a small amount (less than 4 percent). 6.74 As in the case of education, hyperinflation in 1998 and 1999 cut real wages in the health sector by more than half. Whereas average monthly salaries were about $35 monthly in 1997/98, by 1999/00 they had fallen to about $16. The Government provided a 40 percent boost in salaries for public servants in late 2000, including for all personnel in the health sector. In real terms, however, salaries are still substantially below the pre-1997 level. This leads to the need for a second source of income, affecting service delivery, postings to remote places, fees, and under- the-counter charges. Low salaries are adversely affecting quality and accessibility. 6.75 Unfortunately, health expenditure accounting is not conducted on a functional or target basis, hence it is not possible to determine the division between preventive and curative health care. The MOH, Planning and Finance Division has estimated that on average about one-third of the Ministry's annual budget is concentrated in development and administration of the central hospitals; the remainder is used for the development of health centers in the 18 provinces. 6.76 About two-thirds of recurrent expenditures for health are at the provincial and district level. As for the past 2-3 years the provinces have not been reporting their expenditures except on a line item basis, according to the budget nomenclature, it is not possible to track trends in levels of support. However, fiscal austerity following the 1997/98 budget bore very severely on the provinces; the salary component shrank. Salaries suspensions for health personnel of several months were common and this remains a continuing problem. 6.77 The situation following 1997/98 has been well documented in the case of six provinces (Luang Prabang, Bokeo, Luang Namtha, Sayabouri, Oudomxay, Phongsali). As shown in Charts 6.a and 6.b, in real terms salary and administrative expenditures for the health sector contracted sharply.' 90 ADB, Provincial Health Budgets and Expenditures August 2000. The dollar values of these amounts are strongly affected by currency movements. -109- Chart 6.5a: Salary Expenditure, Real Terms, for Chart 6.5b: Administrative Expenditure, Real Selected Provinces Terms, for Selected Provinces 1200 400 . 97-98K 98-993 99-00 _ E97-98 M98-99 099-00 - 1000. ... 300-.. - 800 - .. 3250 - z2 LO, ....3 ... 00 - ------- -------------- ...... 20 400 - .. . .... ----- ----- ----- ----- ----- ---- 6 - - - - - - - 200 - --- - ---------------------- - - ~~~~ 4QQ-~~~~~~~~~~~~~~~150 - ------------------ 200 - but-the-trend-is50 -s Provinces Provinces 6.78 Capital expenditures, in contrast, have increased steadily and considerably. Year-to-year fluctuations reflect the start-up or completion of major projects (e.g., construction of New Sethathirath hospital by Japan at $14.7 million) or programns (e.g., primary health care expansion by ADB at $20 million), but the trend is strongly up. 6.79 The Govermment has indicated that it will increase recurrent spending on social sectors and ensure adequate counterpart funding for PIP projects.9 More specifically, it has indicated that the share of the budget for health will be increased between 2001 and 2003. However, it has not provided an overall target level. 6.80 The draft PIP for 2001-05 indicates that, for the five-year period, public investment in the health sector will amount to 885 billion kip, or 6.1 percent of total public investment. An additional 257 billion kip will be invested in the health sector under the auspices of the Rural Development Program, bringing the combined amount to 1,142 billion kip or almost 8 percent of total public investment. These projections suggest a level of investment in the sector of between US$ 25-30 million annually for the next five years. Decentralization 6.81 Approximately 70 percent of all public health expenditures are now by provincial and district authorities. MOH's policy for primary health care is based on a high degree of decentralization.92 On paper, each delivery unit has clearly defined responsibilities and the necessary logistics for supervision, referral, and counter-referral. 6.82 Although at an early stage, the Government's decentralization policy has enhanced the role of Provincial Governors and their administrations in the formation and implementation of 91 The ADB's Primary Health Care Project should help to boost recurrent spending. 92 Government of Lao PDR, MOH, Policy on Primary Health Care, January 2000. -110- health care services. All Governors are now members of the Central Committee and their senior status challenges - at least to some extent - the authority of portfolio ministers, including the Health Minister. 6.83 As a result of decentralization, reporting to the MOH has been disrupted. District Offices lack the resources and capacity to maintain spending records in the same detail formerly provided by the Provincial Offices, with the result that functional data for the health sector is no longer provided to either the MOH or the MOF. As such, there is no way of determining overall expenditures on health, and hence little way of determining whether or not the Government's strategy of "health for all" is being followed. 6.84 Decentralization is intended to help build community participation and ensure that services are responsive to the needs of the people. While in theory decentralization should enhance the efficiency and effectiveness of health services, lack of budgeting and administrative capacity at the district level is a major impediment. Poor and remote districts are finding the transition especially difficult. The result could well be widening of already marked disparities in health services. 6.85 Some features of health care services, such as the importance of a high degree of training and the need for integrated referral services, make decentralization more difficult than for-other sectors. Without proper planning and a good appreciation of lessons learned from other countries, decentralization can be disappointing and potentially detrimental. 6.86 Because health care is such a technical and complex responsibility, it does not fit well into the various decrees that have so far been issued regarding decentralization. The general distinction between policy (Central Government) and service provision (Provincial and District Authorities) is not sufficient. The impact of health decentralization will depend on which services are decentralized, the institutional environment, the intergovernmental fiscal arrangements, and the cost-recovery methods. 6.87 It would appear that in the health sector Lao PDR has decentralized too far, too fast. To maintain a commnon vision about health goals, decentralization should include coordination mechanisms. While Ministry, provincial and district officials meet on a regularly to discuss health matters, the data basis for effective coordination has been fractured. Further, wholesale decentralization of programs like family planning and immunization may result in under- investment in these vital services, since the national benefits are unlikely to be fully recognized by provincial and district authorities. 6.88 There is need to clarify how the 'vertical programs' of MOH should combine with the enhanced responsibilities at the provincial and district level for 'horizontal programs'. An extensive capacity building program is also needed to help districts become 'budget centers'. Budget Planning 6.89 Recurrent expenditures should be assessed against performance indicators and areas favored that yield high returns in terms of improved health care. Currently, there appears to be little attention to determining how recurrent expenditures should be allocated so as to best -111- contribute to the goal of 'health for all". Rather, the primary determinant appears to be the previous year's allocation. 6.90 Nor does there appear to be forward planning for recurrent expenditures. Demographic variables should play a major role in planning future recurrent expenditures; especially fertility and morbidity rates begin to change. Forward planning and budgeting should also provide for recurrent expenditures associated with capital expenditures.93 6.91 Since capital investment is so overwhelmingly determined by donor assistance, the MOH and provincial and district counterparts rely heavily on project feasibility studies undertake by foreign experts. 6.92 The process of compiling an investment list seems to be strong on form but weak on substance. Investment proposals reflect consensus views drawing from the Five Year Plan and a series of meetings at the provincial and district level. They also reflect norms and other guidelines issued by CPC, MOF and the Prime Minister's Office. 6.93 Investment proposals lack strategic focus, for they are not evaluated against how best to contribute to health goals and targets. Indeed, the goals and targets themselves lack grounding in firn statistical data and program analysis. Five-year investment projections are presented in global terms, without any basis for their calculation. Even in the case of vertical programs, there appears to be no estimates of the resources needed to reach program targets. Instead, budget estimates for public investment in the health sector are largely based on actual and expected donor commitments.95 6.94 The Government's medium-term expenditure framework indicates that its revenues will strengthen to 15 percent of GDP by 2003. Government expenditures are expected to increase to about 22.8 percent of GDP, with current expenditures equal to 10.3 percent and capital expenditures equal to 12.5 percent.' The draft PIP indicates that the health sector will account for 6.1 percent of total public investment, which would imply investment in the health sector, will of about 0.76 percent of GDP. This is about equal to the level that has prevailed in recent years. 6.95 What is needed is clarity regarding commitment to recurrent expenditure. Given the current status of the health sector in Lao PDR, a recurrent/capital expenditure ratio on the order of 60/40 may be reasonable. On this basis, recurrent expenditure should be about 1.15 percent of GDP. In total, then, public expenditure for the health sector should equal about 1.9 percent of GDP. In terms of the medium-term fiscal framework, this would suggest that the share of the budget for the health sector should increase to about 8.3 percent by 2003. Cur-rently it is only 5 percent and it has never been above 7 percent. 93 ADB's PHC Expansion Project includes efforts to increase provision for recurrent costs. The provinces are being asked to take (in principle) responsibility for recurrent cost financing (based on certain standards), while central flnds should mainly be used for investrnent and public priority programs. Detailed forward health budget requirements are being prepared for each province, as a basis for the financing dialogue. 94 Government of Lao PDR, Draft Decree of the Prime Minister on the AdoMtion of the Regulation of Public Investment Management; July 2001. 95 ADB, Feasibility Study: Primary Health Care Plan, November 1999. 96 Government of Lao PDR, Interim Povertv Reduction Strategv Paper March 2001. -112- 6.96 Some $25-30 million a year in donor support will be needed for the health sector to approximate the funding levels outlined above - or 40-60 percent more than current disbursements. A growing portion of this assistance should be directed to strengthening recurrent expenditures. Recommendations 6.97 Three themes stand out: the need to ensure that the poor are included in the health system; the need to improve the incentives to provide quality services; and the need to improve the management of public health resources. The following recommendations address these themes: 6.98 Strengthen incentives for improvement in quality of health services. The Government should provide for: * proper salarnes and benefits to attract qualified medical personnel; * supplementary benefits for medical personnel serving in rural areas; * retention of treatment fees in support of improving salaries for medical personnel; * removal of the 20 percent tax on cost-recovery revenue; * a central/local government cost-sharing provisions in support improvements in health services; * strengthening local capacity to manage health resources. 6.99 Respond to market failure. Government resources should be directed to areas where market failure is most pronounced and positive externalities the strongest, notably preventive care. Accordingly, the Government should provide for: * free or highly subsidized immunization and advisory services (e.g., family planning), and medical supplies (e.g., impregnated bed nets, nutrition supplements) related to population and major disease control; * education and information programs to heighten awareness of good health practices (e.g., hygiene, nutrition, birth spacing, HIV/AIDS); * partial subsidization of water supply and sanitation, together with implementation of a price system to encourage private sector participation in the supply of such services; * maintenance of high quality, affordable essential drugs in public health facilities; * proper regulation of private sector provision of medical supplies and drugs and appropriate enforcement mechanisms. 6.100 Rationalize resource use. Devolution of responsibility for health services offers the opportunity to rationalize resource use. Accordingly, the Government should provide for: * reassessment of health targets and associated resource needs, consistent with the government's medium-term expenditure framework; * reassessment of central/provincial responsibilities respecting health care, ensuring that essential national interests (e.g., standards f6r medicines) are respected while maximizing flexibility in response to local needs; * realignment of health resources in favor of preventive health care, particularly for programs and measures important to the health status of the poor; -113- * integrated health services at the provincial level, leading to comprehensive preventive care systems incorporating the vertical programs of the central government and funds expended under the Rural Development Program; * a much strengthened referral system, ensuring that curative care is provided where it is most effective and efficient; * improved quality of services, so ensure better utilization rates of health facilities; * a better spatial and professional distribution of medical personnel; * an integrated approach to health services, incorporating education, transportation and other factors; * effective coordination of donor assistance, resulting in a coherent health system. 6.101 The above recommendations will not be easy to implement, especially since the resource constraints are so tight. The key to improving public health services is strengthening the budget for recurrent expenditures, which in turn depends on strengthening domestic revenues. ENERGY SECTOR Key Development Challenges 6.102 Electricity exports are already an important source of foreign exchange eamings, amounting to $45 million in 2000 and accounting for 13 % of total exports. Further, they are important source of Government revenues. Yet only 3;5 % of a total 18,000 MW of Lao PDR's exploitable hydropower potential has so far been developed. 6.103 The challenge is to harness this power potential in a manner that best serves the interests of the people, with particular emphasis on poverty reduction through sustainable economic growth. Large-scale projects can and should be supported if community groups displaced by such projects are fully compensated, if the environmental effects are carefully assessed and addressed, and if the net benefits are shared equitably between investors and the Lao people as owners of the resources. The revenues generated from increased export earnings will be vital to improving basic government services, including education, health, and infrastructure services in poor areas of the country. 6.104 In addition to export and revenue earnings, power development must serve rural electrification. Less than 20 percent of the rural population in Lao PDR has access to electricity. Some of the electricity needs of the rural poor can be met by drawing from projects serving export markets but in many areas smaller projects serving local communities are more economic. 6.105 The development strategy. should also distinguish between the appropriate roles for the public and private sectors, taking account of Lao PDR's continuing transition to a more market- based economy. It should be possible to encourage greater participation by the private sector in the generation and distribution of electricity, leaving the government to focus on the appropriate regulatory framework and overall transmission system. 6.106 Other management issues also demand public attenLIll v uau i;uii.tion. Electricity use in Lao PDR is highly subsidized and, despite monthly increases in domestic tariffs since early 1999, full cost recovery is still distant. Consequently, Electricite du Laos (EdL), the state agency -114- principally involved in the generation and distribution of electricity, has a serious debt burden. The problem also reflects EdL's legacy of borrowing unprotected for exchange rate risk. Sharp devaluation of the Lao currency following the Asian financial crisis has greatly deepened EdL's problems. EdL must be put on a firmer financial footing and its efficiency strengthened. 6.107 The Government is both an investor in power development and the regulator of the sector. The two roles lead to conflicting interests. Its objective of encouraging social and economic development through electrification at highly subsidized tariffs is counter to sound power management and the commercial viability of EdL. If the Government wishes to be both a regulator and an investor, then it needs to establish an institutional framework that ensures the two roles are not in conflict. 6.108 International best practices should assist in determining the right course of action. The Government has initiated actions drawing from these practices, notably adjusting the pricing system to accord better with cost recovery principles. Also, the Government is restructuring EdL's debt obligations and initiating other institutional and regulatory matters central to sound management of the power sector. The Government, through EdL, has successfully engaged the private sector as a partner in power development. However, it may be appropriate for the Government to consider consolidation of this experience, drawing benefits from power projects through concession fees, royalties and taxation. Seeking a large share of dividends though equity participation is highly risky, and may not accord with EdL's or the Government's financial interests. 6.109 Nam Theun 2 is under active consideration as the next major hydro power project. The economics of the project are expected to be strong; unit costs of generation from the 1088 MW NT2 project are expected to be almost 20 percent less than for the Theun Hinboun project. The financial benefits of NT2 to the GoL in the first year of operations would average about $22 million per year over the first five full years of operation and would rise steadily to 150 million in 25 years, the expected life of the project. This represents an approximate 5-8 percent boost in overall revenues for the Government. Together with increasing benefits from the Theun Hinboun project and other possible additional facilities, the power sector could very significantly strengthen the fiscal position of the GoL. As noted earlier, this is essential if basic services such as education, health, water and roads are to be extended to the rural poor. Indeed, one of the conclusions of the public expenditure review is that improvement in these services is conditional on significant strengthening of Government revenues. 6.110 Hydropower is central to Lao PDR's development prospects. However, NT2 and other future hydro projects involve important social and environmental issues that must be addressed in a satisfactory manner if they are to receive donor support. Further, there are key policy and institutional issues that must be resolved. Most importantly, the Government and the international community must come to an accord on how to help a resource-rich but income poor country improve the welfare of its people. Government Goals for Power Sector Development 6.111 The Government has two broad objectives for power sector development: to promote economic and social development in the country by providing an affordable, reliable and -115- sustainable electricity supply; and to promote power generation for export as an additional revenue base for meeting development objectives. Growth in domestic demand of roughly 10-15 % per year over the medium term will be met by a combination of small to medium sized hydropower projects, off-takes from IPP projects, and imports from neighboring countries. The Government hopes to supply 90 percent of the population with electricity by 2020. The main elements of the development program include the following: * Extension of the Main Grid with, priority to poor areas and possible interconnection of the Northern, Central and Southern grids * Increase of Off Grid supplies to reach isolated rural communities. * Use of grants and concessional loans in support of Main Grid and Off Grid projects. * Large export power projects undertaken in partnership with IPPs. * Development of power exchange arrangements with neighboring countries * Establishment of a High Voltage (HV) National Electricity Transmission Grid (NETG) to facilitate large IPP projects and regional power exchanges. * Reforn of the legal and regulatory framework to ensure greater clarity and certainty including: the Foreign Investment Law (1994); Water & Water Resource Law (1996), Electricity Law (1997) and Environmental Protection Law (1999). The Electricity Law will be modified to allow site-by-site variations in tariffs, so as to facilitate cost recovery. and possible tax concessions. * Institutional reforms including enhanced efficiency, transparency and accountability of the Department of Electricity (DoE), EdL, Lao National Grid Company and the Committee for Investment Management & Foreign Economic Cooperation (FIMC). Further, the Government will create a suitable agency to assume responsibility for GoL's equity investments in IPP projects. * Putting EdL on a sound commercial footing through adoption of full cost tariffs combined with capital subsidies for services in remote areas. The Role of EDL EdL 's Financial Performance 6.112 Comparison of Table 6.13 with a similar one that appeared in the 1997 Public Expenditure Review for Lao PDR shows that expectations for operating revenues and surplus were far from realized.97 Operating revenue was $44 million in 2000, compared to the forecast of almost $100 million largely because domestic tariff rates were 2.6 cents per kWh versus the expected 4.7 cents. 97 World Bank, Public Expenditure Review: Background Papers, 1997. -116- Table 6.13: EdL's Financial Position: 1990-2000 ($US million except where noted otherwise). 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 TotalPowerSo-d(GWh) 797 16 705 860 1135 1013 1172 1144 918 1164 1503 Average revenue (US$/KWh) 0.027 0.029 0.035 0.034 0.033 0.034 0.034 0.034 0.026 0.027 0.026 Operating Revenue 21.9 24 25 30.1 28.6 36.7 45.6 47.8 34 39.5 43.8 of which Income from Electricity Sales 21.6 23.4 24.6 28.6 37.2 34.8 39.9 38.8 23.6 31.5 39.8 Income from Investment Theun Hinboun 5.7 16.6 18.5 Houay Ho Operating Expenses 13.6 14.4 11 13.5 17.8 25.7 25.2 29.5 23.9 32.2 26.7 Operating Surplus 8.3 9.6 14 16.6 10.8 11 20.4 18.3 10.2 7.3 17.1 Total Remittances to Govemment 4.9 5 6 11.7 11.8 10.2 10.1 8.3 4.2 5.7 8.2 Total Remittances incl. Interest 31.4 19.7 8.5 13.6 29.4 7.7 9.4 14 12.7 14.6 10.7 Self- - Financing Ratio 0.3 0.7 0.3 0.4 0.2 Source: 1990-94, ADB; 1995-2000, EdL 6.113 Interest charges and foreign exchange losses are cutting heavily into the operating surplus. EdL has borrowed extensively for its power projects and equity positions with IPPs. This borrowing included loans from the Government, on lent by it to EdL as conditions of concessional loans from ADB, the World Bank and other donors.98 EdL assumed the foreign exchange risk of these loans. The steep devaluation of the kip since 1997 has resulted in a very serious situation for EdL. Interest charges have increased almost seven-fold, to $10 million in 2000.9 Foreign exchange losses over the 1998-2000 period totaled 176 billion kip, or about $20 million. '° 6.114 Because EdL's losses have been accumulating over many years, its equity position has been reduced to 2 percent of its total assets while the debt position is almost 100 percent. The main asset of EdL is an account receivable from the Government, representing pledged capital. If this is discounted, EdL's net assets are negative to the amount of approximately $165 million. 6.115 The two main measures adopted to strengthen EdL's financial position are higher electricity tariffs and debt restructuring. Tariffs were first doubled early in 1999, and since then tariffs have been increased 3 percent monthly. As of 2001, the rates were as shown in Table 2. The two largest groups of users (residential users consuming more than 200 kWh and industry users) will have tariff's averaging 5 cents a kWh. This represents a major improvement but it will still be much below the level necessary for full recovery of generation and distribution costs, estimated at 9.5 cents per kWh.'"' Recognizing this the authorities have announced that as tariffs 98 At the end of 2000, EdL's outstanding loans amountea to UJS $286 million. Of this amount, $161 million originated as ADB loans, $56 miUion as IDA loans and $69 million as various bilateral loans, including a $29 million OECF loan. The power sector accounts for about 25 percent of total external debt (excluding CMEA debt). 99 Source: income statements for EdL. Note that the audited figures shown in EdL's income statements for 1999 are very different from those shown in the ADB report, Power Sector Strategv Study: Mid-Term Report December 2000. The latter shows much.higher foreign exchange losses and interest charges. '°° EdL, Income Statements, May 2000. '01 ADB. Corporate and Financial Development of Electricte du Laos 2000. -117- will be raised 2.3 percent per month for 36 consecutive monthly which should bring EdL to full cost recovery in three years. Table 6.14: Domestic Electricity Tariffs Category of User % Share of Tariff: Tariff: Total Consumption Kip kWh s/kcWh102 Residential: From 0-50 kWh 10.0% 56 .0067 From5l- 100 7.4% 133 .0158 From 101-200 10.5% 200 .0238 From 200 up 22.0% 433 .0515 Embassies ($/kWh) 1.2% .0981 .0988 Commercial 10.6% 450 .0536 Entertainment 1.9% 563 .0670 Government 9.4% 400 .0476 Irrigation 5.2% 167 .0199 Industry 21.1% 400 .0476 Weighted average 251 .0299 Source: EdL, May 2001 6.116 Consistent with the Government's strategy and goals for the power sector, debt restructuring for EdL includes the following features: * conversion of debts to equity, including for the Theun Hinboun power project; * allowing EdL to retain dividends on the Theun Hinboun project to meet financial loan covenants.;'03 * reduced interest rates on World Bank/ADB loans on-lent to EdL by the Government;'04 * extension of maturity of 5 years for all ,subsidiary loans. EdL, the Budget and Poverty Goals 6.117 EdL is a state agency and its operations are therefore off budget. But poor commercial performance inevitably spills over into the state budget.'05 There remains concern that despite tariff adjustments and debt restructuring efforts these problems will compromise the government's ability to support poverty reduction strategies. These concerns include the following: * Tariffs still cover only half of the cost of EdL's generation and transmission activities. * Power export earnings are used to cross-subsidize domestic power consumption. This absorbs revenues that would otherwise be available for poverty reducing 102 The exchange rate used was 8398 (first quarter period average), but had depreciated to 9467 by end 2001. '03 This provision will apply until EdL is on a stronger financial footing. 104 In the case of loans for projects generating profits, the interest rates will be reduced by 50 percent. In the case of loans for projects not making a profit, including transmission lines, interest rates will be reduced to 2 percent for 5 years. 105 For example EdL had to be exempted from paying the 29 percent dividend tax during 1997-99 because of week performance. -118- expenditures and the subsidies themselves largely benefit consumers in better-off urban centers. * Continued equity participation in hydro power projects exposes EdL to financial risk. * EDL will continue to be over-leveraged, relying on unsourced/uncommitted debt to finance future expansion. 6.118 Rural electrification is very costly but is necessary for poverty reduction. Off grid power must play a dominant role given that the majority of the poor live further from a road than would permit them access to on-grid power. The cost of rural electrification, at about US $500 per household, makes the target of 90 percent electrification by 2020 questionable. It would require providing service to 425,000 rural households, which lack access to roads, plus an additional 71,300 rural households with road access. The cost of rural electrification is estimated at US $276 million for the equipment and installation alone, or about $15 million annually. Significant economies could be gained through a full-scale program of off-grid electrification, perhaps cutting the cost by as much as 25 percent."0 6.119 The Government has indicated that Rural Electricity Service Companies will be formed to handle rural electrification, leaving EdL to concentrate on its core utility business - hydropower generation and transmission. The Rural Electricity Service Companies are to be supported by a strengthened Rural Electrification Division of the Department of Electricity, MIH. In light of MIH's very small budget and skill shortages concerning off-grid techniques, further donor assistance for capacity building will be needed. The Electricity Law recognizes that off-grid electricity services have a different cost structure than grid power. It permits tariff variations to reflect the cost of production and distribution. However, a "straight jacket" still encumbers local initiative. As much as possible, the sector should be deregulated and private provision encouraged. While the transmission system for on-grid power is a natural monopoly and, therefore, a logical responsibility of the Government, micro-production of electricity is an appropriate area for private sector participation. Encouragement of private initiative for electricity provision is important. The Electricity Law needs to be revised to ensure a conducive investment framework. 6.120 It would be more transparent, efficient and equitable for the profits from exports of electricity to accrue to the Government, providing thereby a very significant source of revenues (up to 25 percent of total revenues by 2010). On-grid domestic electricity sales, which now account for 50 percent of EdL's total sales, should be on a full-cost recovery basis.'"' This principle is key to EdL operating on a commercial basis. Provincial variations in domestic tariffs should be considered, to reflect cost differences in generation and transmission/distribution. Then, if rural electrification is to be subsidized, it should be done on an explicit, on-budget basis and on a scale that is compatible with macroeconomic stability and in a fashion that minimizes disincentives for private participation. 106 ADB, Power Sector Strategv Study. Draft Final Report, Volume 2, February 2001. 107 Tariff reforms would also induce more economnical use of electricity and would provide better incentives for EdL to improve collection rates and its distribution losses which are currently 15%. -119- EdL 's Equity Stakes 6.121 As shown in Table 6.15 seven hydropower facilities in Lao PDR have generating capacity of 623 MW. Another 11 power projects are in,the planning or advanced planning stage. They are designed to add 4,000 MW of generating capacity during this decade. Eight of the 11 projects will be built on an IPP/BOT basis, while EdL is planning to finance the three smallest projects. The latter would involve financing of about $115 million. EdL's equity requirements for the IPP/BOT projects could range from $375 million (assuming a 70/30 debt/equity ratio and an average equity position of 25 percent) to $750 million (on a 50 percent equity basis). Partial risk guarantees would likely be necessary to mobilize commercial debt. An examination of EdL's financial situation shows that even a low equity position is difficult. Table 6.15: Power Generation: Existing and Planned No. Power Plants Province Year Completed. Project Inst. Cap. Annual Energy Types MW GWh EXISTING PLANTS 623 3688 1 NamNgum Vientiane 1917,78,84 EdL 150 998 2 Xeset Saravan Nov-91 EdL 45 180 3 Selabam Champasack 1970/1993 EdL 5 34 4 Nam Dong Louang Prabang 1970 EdL 1 5 5 Theun Hinboune Bolikhamsai Apr-98 BOT 210 1620 6 Houay Ho Attapeu 3/9/99 BOT 152 617 7 Nam Leuk Special Zone Apr-00 EdL 60 234 PLANNED PROJECTS 4036 19277 8 Nam Mang 3 Vientiane 2004 EdL 30 140 9 Xeset 2 Saravan 2005 BOT 76 309 10 Nam Mo Xiengkhuang 2006 BOT 105 581 11 Nam Theun 2 Khammouane 2006 BOT 1088 5500 12 NamNgum2 Special Zone 2006. BOT 615 2233 13 Nam Ngum 3 Special Zone 2006 BOT 460 2035 14 Tha Kho Champasack 2007 EdL 30 190 15 Hongsa Lignite Xaiyabouli 2008 BOT 720 4265 16 Xepian-Xenamnoy Sekong 2008 BOT 390 1864 17 Xekaman I Attapeu 2008 BOT 468 1924 18 Nam Ngum Xiengkhuang 2008 EdL 54 236 Source: EdL, Ministry of Industry and Handicrafts, May 2001. 6.122 Progress has been made towards a more market-based economic system with the opening of the power sector to private sector participation. The Theun Hinboun Hydropower Project has well illustrated the benefits to the Government of a well-structured public/private sector partnership. However, the conditions nurturing this partnership were highly. favorable, including strong demand by Thailand for electricity, a profitable export tariff, and a buoyant investment climate (prior to the Asian financial crisis). Also, ADB played a major role, both as a neutral third party to reconcile public and private interests, and in providing financial and technical support for the Government. 6.123 The Nam Theun Electricity Consortium (EdL, Electricite de France, Transfield Holdings Ltd., Ital-Thai Development plc, Jasmine International, and Phatra Thanakit plc) is hoping to -120- conclude an equally successful public/private partnership. EdL's equity position is expected to be 25 percent versus 60 percent for the Theun Hinboun project. However, a minority public sector position partnered with a majority private, sector position raises questions about the Government's vulnerability, as illustrated by the Houay Ho project. The reliability of concession fees, royalties and taxes needs to be weighed against the risky nature of profits/dividends and the real risk of losses. Concession agreements to date have exposed the Government to a wide variety of risks, including hydrological, geological, indemnity, force majeure, default and performance risks.'08 There are fundamental risks for Lao PDR in the unsolicited negotiated approach to awarding concessions. Planned commencement of a power market pool by Thailand in 2003 may eventually nudge out long-term purchase power agreements, compounding the degree of risk associated with hydropower projects. EdL's equity holdings in IPP projects are now detracting from the core business of domestic grid supply. There is considerable scope for scaling back Government involvement in favor of private ownership and management. 6.124 Financing is the biggest obstacle and private sector participation is essential. Neither the Government nor EdL is in a position to raise the funds necessary for majority stakeholder positions - especially in the case of large-scale projects such as NT2. Concessional loans can be justified for limited positions, but their use for power development would be at the expense of support for other sectors, including the health and education. Moreover, the Government's borrowing capacity will be tested further as large scale projects will likely require - given the very altered investment climate in Southeast Asia - guarantees on unsecured debt. Waiving the equity requirement in IPP projects could reduce the Government's financial requirements by some $100 million annually. It should also be possible for public/private co-financing of significant portions of domestic power supply (generation and distribution). In short, greater reliance on private sector investment could cut the Government's financing requirements for power development by half or more. The Need for Institutional and Regulatory Changes 6.125 Effective exploitation of hydro resources will require fundamental changes in the institutional and regulatory framework. The government's efforts to commercialize Elecricite de Lao (EdL) started in the mid-1990s under technical assistance support of the World Bank and ADB. Since then, EdL has been established as a separate juridical entity with a functioning Board of Directors. Also, EdL has strengthened its financial management capability, has been reorganized on the basis of cost centers that facilitate accountability of each operation, and the utility has divested from some non-core activities. This process was supported by the enactment of the Electricity Law which supports the commercialization of the sector. Following the 1997 regional financial crisis, EdL's financial situation was seriously affected by exchange losses. In response to this situation, in December 2000 a Financial Recovery Plan was proposed for EdL calling for: (i) conversion of some debt to equity; (ii) temporary relaxation of onlending conditions to EdL, particularly for debt associated to social-oriented investments; (iii) undertaking a tariffs study and the subsequent implementation of a new tariff policy; (iv) revaluation of fixed assets; (v) signing of a performance agreement between EdL and the government; and, (vi) review of EdL's investment plan. In spite of the slow implementation of this Plan at the onset, almost all of the measures have been implemented at this stage. New tariffs 108 World Bank, Hydropower Development Strategy for Lao PDR. Final Report, September 2000, Section 6.4.2. -121- approved in early April 2002 will allow EdL to comply with financial covenants for the first time in more than three years. 6.126 The Electricity Law, passed by the National Assembly in 1997, established a basic legal framework to attract, direct and control optimal investment in power projects. In March 2001, MIH issued a Power Sector Policy Statement setting out the conditions for the beginning of a power sector reform, providing possibilities for a greater private sector participation and competition and establishing the following four goals: (a) maintain and expand an affordable, reliable and sustainable electricity supply within the country to promote economic and social development; (b) promote power generation for export to provide revenues to meet GOL development objectives; (c) develop and enhance the legal and regulatory framework to effectively direct and facilitate power sector development; and (d) reform of institutions and institutional structures to clarify responsibilities and streamline administration. These polices are necessary and appropriate for the development of the sector but neither the Power Sector Policy Statement nor the specific actions needed to support the goals have been formally adopted by the government. In discussions with the World Bank and the ADB, the government has undertaken to hold a workshop to open debate on power sector reform strategy. During this process the authorities need: i) to reconsider the requirement that EdL take an equity position in all IPPs and instead allowing benefits to flow through fees, royaities and taxes rather than dividends; ii) to consider the separation of EdL from its off-grid and IPP responsibilities, and iii) to establish an independent regulator for the power sector. The workshop process should underpin formulation of a specific action plan which would then be formally adopted by the government. Policy Recommendations: * Reevaluate the role of Government in the power sector, focusing on the policy/legal/and regulatory framework, and the transmission/hydropower development strategy; * Facilitate piloting of private sector participation in the generation and distribution of electricity, either on a contract or standalone basis; * Complete implementation of tariff increases to achieve full cost recovery (generation and distribution); * Modify the requirement that EdL take an equity position in all IPPs; consider divestment of some portion of current holdings; * Secure benefits from power projects through concession fees, royalties and taxes rather than dividends, so as to minimize risk; * Encourage pilot projects for Rural Electricity Service Companies to take the lead in providing services at the district level; decentralize on a spatial rather than a functional basis; * Encourage small-scale power producers, and allow competitive inputs to the power grid; * Tighten the environmental and social provisions governing hydropower development; * Enforce full compensation for resettlement or other costs associated with power projects; * Minimize use of concessional loans for the power sector; * Scale back the electrification target for 2020, from 90 percent to 75 percent; -122- * Adopt a comprehensive hydropower development strategy for the power sector, and evaluate and prioritize projects in the context of this strategy; * Seek a neutral third party to help negotiate project agreements, and to reconcile public and private interests; * Strengthen systems efficiency through capacity building, cut distribution losses to 10 percent or less, and improve collection rates - especially from Government agencies. FORESTRY 6.127 Several factors set Lao PDR apart from other countries in the way in which the forestry sector is linked to public expenditures. The economic value and the size of the forest sector relative to other economic sectors means that forest policy is unusually important in helping to shape overall levels of economic activity. In addition, the ways in which forest resources, including forest land, timber and non-timber forest products, enter into the economic life of poor rural communities means that forest policy does a great deal to shape the demands placed on the public expenditure system for poverty alleviation and rural services. 6.128 Two key issues emerge with respect to forestry and public expenditures polices. First, forest resources constitute a large and poorly utilized source of resources to support public expenditures. Forest based revenues, which on current trends are likely to decline to around 6 percent of total revenues, could through a suite of reforms be sustainably maintained at 15 percent or more. Second, the Government has the opportunity to use forests directly for public purposes through innovative, directly participatory institutional arrangements such as village forestry that support the poor. Overview of Lao PDR Forestry Resources 6.129 Eighty percent of Lao PDR is forested, with more than half covered by extremely degraded forest. Two and one-half million hectares are designated as production forests, but these are not mapped, criteria for their designation are not published, and logging is not confined there. Deforestation is occurring at 0.6-0.8 percent per year. Log production has grown at an increasing rate since the 1980s. Only 57,000 hectares of plantations have been established, of which less than half is available for production. Table 6.16. Forest Area by Potential Productivity Potential Forest Productivity Nil Very Low Low Medium High Total Total (1) (2) (3) (4) (5) 3-5 Total Land Area 4,716 10,044 2,762 3,914 1,543 8,219 22,979 Percent Total Area % 21 44 12 17 7 36 --- Percent of Potential Forest Area % --- 55 15 21 8 45 - Steep Slopes 298 1,130 185 350 146 681 2,110 NBCA (net of steeply sloped area) 293 751 341 905 603 1,849 2,893 Physically/Legal Accessible. 4,125 8,163 2,235 2,659 794 5,688 17,976 Percent of Potential Forest Area % --- 45 12 15 4% 31 --- Source: Based on MRC/GTZ -123- 6.130 Forestry contributes 7-10 percent of Lao GDP and 15-20 percent of non-agricultural GDP. In rural areas forest exploitation is one of the few available economic activities, and non- timber products provide more than half of family income. The sector contributes 34 percent of total export value, and even more of net foreign exchange. Forestry royalties as a share of GOL revenues have decreased from 20 percent in the mid-1990s to 6 percent of tax revenues and 5 percent of all revenues last year. Collection rates are low, around 50 percent, and royalty revenues have been declining since mid-1990s. Over the last five years Treasury has realized only about one-third of the estimated market value of the timber harvested. 6.131 Total extraction (recorded commercial logging and estimated household use) from production forests is in the order of 1.3 million cubic meters. The interim AAC for commercial species has been estimated at 0.6-0.7 million cubic meters. The resource base for household use is generally estimated as greater than that for commercial use due to the wider range of species used. Despite the inadequate data, it appears that the current utilization pattern is unsustainable particularly in the areas of most intensive forest utilization in Central Laos. Logging is carried out without proper management plans. Loggers harvest the most valuable species, leaving behind a forest whose economic worth has been severely depleted. Since logging quotas are granted annually, and each firm has to re-apply every year, there is a very strong incentive to harvest as much as feasible because there is no assurance that a new quota will be obtained the next year. Since the quota is measured not in the forest but at second landing, there is a strong incentive to leave in the forest valuable though not perfect logs. This also evidently leads to recorded logging being well below the volume cut. High intensity logging systems degrade the forest and cause environmental damage. Seed-trees are not left and post harvest forest management and care is not practiced, compromising the recovery of logged stands. 6.132 Almost two-thirds of timber production over the last five years has come from infrastructure or development conversion projects. Moreover, logging in the Nam Leuk reservoir, Nam Ngum, and Huay Ho are completed, and the Nam Theun II reservoir will be completed within the next 1-2 years. Feasibility studies indicate that, the GOL needs to substantially improve sustainable forestry management particularly with respect to infrastructure investment. Thus, the contribution of major infrastructure projects to timber production would reduce rapidly in the next 1-2 years. Wood Production 6.133 Log production has been growing at an increasing rate since the 1980s, particularly from the mid-1990s onwards. There has been increasing reliance on production from infrastructure and land development projects. Of nearly 2 million cubic meters harvested between 1990-1994, less than half (48.2 percent) were from conversion for development projects, while of 3.3 million cubic meters harvested between 1995-99, almost two-thirds (63.1 percent) came from conversion. ' 6.134 The amounts of timber harvested from production forests average 224,300 cubic meters per year over the decade. At least 620,000 cubic meters per year are harvested or collected for traditional wood use, and some 1.5 million cubic meters for fuelwood and charcoal. These other 09 Worley International Consultants, Feasibility Studies on Potential Hydro Electricity Dam Projects, Dec 1999 -124- wood products, however, do not come entirely from forests; the species and dimensions are different, and non-forest trees and very degraded forests and shrublands may play an important role as their source. If half of these traditional forest products were to come from production forests, they might amount to more than one million cubic meters per year. Total extraction from production forests would thus be some 1.3 million cubic meters per year. Unfortunately, there is no official estimate of the AAC to be used as a comparison; an interim AAC of 600-700,000 cubic meters of commercial species per year was recently suggested. "° Table 6.17: Log . u.. on Sources, 1990 to 1999 Production Forests Development Conversion Total Log Production Year Forests 000 m3 Percent ooo m3 percent 000 cubic meters 1990 220 73.8 78 26.2 298 1991 200 51.2 190 48.8 390 1992 120 61.5 75 38.4 195 1993 340 66.7 170 33.3 510 1994 150 25.3 444 74.7 594 Sub-Total 1990-94 1,030 51.8 957 48.2 1,987 1995 204 23.3 670 76.7 874 1996 263 39.9 396 60.1 659 1997 170 30.4 389 69.6 559 1998 257 55.3 208 44.7 465 1999 319 43.5 415 56.5 734 Sub-Total 1995-99 1,213 36.9 2,078 63.1 3,291 Total 1990-99 2,243 42.5 3,035 57.5 5,278 Source: 1990-1994, FORTECH/ADB, January 1999; 1995-99, DOF, November1998 The Wood Processing Industry 6.135 Lao PDR has the potential for competitive value-added wood processing. Despite heavy investment, however, the industry has suffered from intermittent raw material supply, inconsistent policy decisions, and GOL interventions in marketing. The large scale wood industry being attracted to Lao PDR is highly capital intensive and generates relatively little employment in the production of semi-processed goods (veneer, rough sawnwood). 6.136 Current wood industry operating capacity is estimated at 1,165,700 cubic meters/year. The installed capacity of the wood industries sector in year 2000 is in the range of 2-3 million cubic meters, far in excess of the AAC. The large processing capacity leads investors to pressure the GOL and provincial authorities to secure raw material supplies to operate their mills profitably, at the expense of sustainable management of the production forest resource. There is no evidence that unsustainable wood production has had a positive impact on rural poverty; rather it has had a negative one by destroying the environment on which the poor depend. 6.137 Three SOEs dominate the forestry sector, and logging in particular: the Agricultural Development Services Group (ADS); the Bolisat Phathana Khet Phoudoi Group (BPKP or Phoudoi), and the Development, Agriculture Forestry Industry Group (DAFI). The SOEs are 110 Castren and Southavilay, 1999. Other estimates range from 282,600 cubic meters per year (TFAP) to 1.0 million cubic meters per year (Director General, pers. comm.). 11' Conversion from existing forestry to non-forest land uses (infrastructure development, agriculture, rural development). -125- under the jurisdiction of the Ministry of Defense, an assignment which raises concerns about a possible undue role of the military in forestry. SOE operations in the forestry sector are disruptive as they are very large within the sector and receive preferential treatment in the allocation of logging, processing, export quotas and logging contracts as well as de facto exemptions from paying royalties. 6.138 Over time the three SOEs have grown increasingly independent and secretive, and are not monitored in any significant or transparent manner. There have been neither financial nor operational audits of SOEs. Internal financial control is supposed to be based on guidelines issued by MOF, but adherence to such guidelines has never been assessed. MAF, DOF and PAFOs are reluctant to carry out field audits, monitor or enforce regulations in harvesting, utilization or marketing operations of the SOEs. 6.139 The most recent data available on the ownership structure of wood industry is more than one decade old. At that time, SOEs owned some 28 to 38 percent of processing plants and 39 to 49 percent of operating capacity, between 1988-90 (Table 6.19). There was a corresponding increase in private and joint venture investments during the period. Table 6.18: Extrapolated Wood Processing Industry Capacity, January 2000 Operating Capacity Operating Efficiency/Installed Capacity Scenarios Region (cubic meters log input) 31 percent 59 percent 80 percent (1990 Survey) (1996 MGP) (1996 Mill) Northem Region 34,100 110,000 57,800 42,600 Central Region 1,055,100 3,403,500 1,788,300 1,318,900 Southem Region 76,500 246,800 129,700 95,600 TOTAL 1,165,700 3,760,300 1,975,800 1,457,100 Table 6.19: Ownership of Wood Processing Industries, 1988-90 Ownership 1990 Data 1988 Data Number % Capacity % Number of % Capacity % of Mills cubic meters Mills cubic meters SOE 7 8 42,000 9 5 10 32,000 11 Province SOE 29 33 130,000 30 21 40 110,000 38 Military SOE 2 2 2,000 - 2 4 2,000 - Private 26 30 163,000 35 11 21 81,000 28 Joint Venture 22 25 113,000 25 12 23 64,000 22 SOE/Private 88 100 455,000 100 52 100 291,000 100 Forest Policies Log Trade Policy 6.140 The GOL has sought to increase domestic processing of plywood and furniture by imposing restrictions on exports of roundwood and rough sawnwood. PMO 10/2000, bans log exports. The benefits of such a policy to the Lao economy may be questioned. On average the benefit to the Lao economy per one cubic meter of logs was US$ 41 higher if the logs were exported unprocessed (with all royalties and taxes duly recovered) than if they had been processed locally and then exported. -126- Log Prices and Royalties 6.141 Wood prices are one of the most important incentives in any forestry sector indicating scarcity of forest resources and giving users important signals on the value of conservation, efficiency and investment. Data on two indicator species groups show that Lao royalty rates have generally been lower than intemational prices although there have been instances when the system has led to royalties above their world market equivalents. The failure of royalties to track their international comparators suggests serious weakness in the royalty system. Table 6.20: Comparison of Royalty Rates with International Reference Prices (December 1999) Species Group International($/ m ) Lao PDR Lao/Int. Price (%) Rosewood (Pterocarpus 400 285-365 71-91% macrocarpus) Keruing (Dipterocarpus spp) 140 93-102 67-73% Source: (i) IT1O International Market Reports: Rosewood: Myanmar auction prices; Keruing: Sarawak export price (FOB); (ii) Ministry of Commerce and Tourism, Lao PDR: Laos: Royalty (higher: log export rate, lower: processed log rate) + average harvesting and transport cost (US$ 50/m3). 6.142 Price lists for logs per species, issued by the Ministry of Commerce and Tourism (MCT), are frequently, but not systematically, updated. Officials responsible for price setting do not have adequate independent market information or access to regular trade publications, sales bulletins, or web sites. 6.143 Payments for logs include royalties, a reforestation fee, and provincial/local development taxes and fees. Wood buyers may be exempted from the reforestation fee by replanting, but the scale of planting is not commensurate with harvesting. There are separate rates for logs for a) export, b) sawnwood production, and c) finished product/secondary processing (including veneer). The highest rates are applied for logs exported unprocessed; the lowest for logs for secondary processing. The system creates serious distortions. Lower royalties for plywood and other secondary processing industries also inappropriately subsidize integrated processing mills against specialist sawmills and secondary processing chains. The current system requires a single mill to handle the whole production chain from wood procurement to secondary processing but more specialized enterprises would benefit from both technical and commercial efficiency. 6.144 Recent changes in the regulatory framework for log sales have introduced more flexibility to the system. Recently introduced Prime Minister's Order no. 10 (PMO 10/2000, October 2000) allows provincial authorities and their departments of commerce and tourism to establish contract prices in negotiations with the buyer. MCT only establishes minimum royalty levels. If the contract price is above the floor price, part of the margin may be allocated as bonuses to the province. This is, however, at the discretion of GOL. Logging Quotas 6.145 In the absence of effective market signals, quantitative restrictions heavily relied upon to control resource use. Allocation of quotas is not systematic, competitive, or transparent, nor is it -127- related to the AAC. Allocations are based on ad hoc short-term administrative criteria rather than on long-term sustainable forest management principles. 6.146 A major drawback to the quota system is the strong incentive it creates to utilize only premium logs. Imperfect logs abandoned in the forest are not measured at log landings and do not count towards the quota. Even medium-quality, fully-utilizable logs are left in the forest. Excess waste has been estimated at 20-40 percent of commercially utilizable volume. 6.147 Annual logging volumes are reportedly set through logging quotas issued by the Prime Minister's Office on the basis of proposals from Ministry of Agriculture and Forestry (MAF), Ministry of Commerce and Tourism (MCT) and the industry and input from provincial and district authorities. However, procedures for quota setting and granting are not clear, criteria not made public, and guidelines not available. The 1999/2000 regulation on forest management (PMO 11/99) only stated that there are separate quotas for local use and export processing. Usually, company proposals are submitted through PAFO or Province Govemor to DOF and/or MAF for review. Logging quotas may be divided according to source (production forests, infrastructure development areas, conversion for agriculture or rural development) and target (domestic industries, exports). There is no assurance, however, that quotas granted with respect to development projects (including dams) are genuine; in some cases, logging may be carried out in anticipation of developments that are unlikely to be realized. 6.148 Until recently, much of the annual logging quota was issued on an ad hoc basis to finance barter trade and local development projects. Quotas were either decided at the national level or based on province-to-province agreements with Vietnam and China. From late 1999 (PMO 11/99) these are officially banned, but there is still a strong pressure to continue these practices. 6.149 Further, additional quotas are issued during the logging season. If a wood industry has need for raw material beyond its initial allocation, it may obtain it by applying either to provincial authorities or directly to higher levels of GOL. In 1998/99, the quota was increased by 60 percent, from 450,000 m3 (reported in October 1998) to 714,000 m (reported in October 1999). This leads to over-allocation of annual cuts and inequitable access to forest resources. For logging season 1999/2000, the initial quota set was 500,000 m3. 6.150 In some years actual recorded logging has exceeded the quota by more than one third, all of which has been authorized by the authorities. In 1998/99, the final reported harvest was 735,000 m3, above even the increased quota. (Table 6.21). -128- Table 6.21: Annual Quota and Actual Logging, 1994195-1998/99 Year 94/95 95/96 96/97 97/98 98/99* Quota/Production 000 m3 Quota 610 712 680 540 714 Shareofdamsites% 71 66 72 54 -31 Production 874 659 559 465 735 Share of dam sites % 77 60 70 45 26 Quota utilization % 143 93 82 86 103 * As reported in October 1999, i.e., post logging season Source: MAF/DOF, annual statistics 112 6.151 Log allocation of annual quotas to mills is not based on competitive bidding or auctioning, but is done through non-transparent administrative processes. A mill must be registered to buy logs and export contracts are usually required for an exporter to buy logs. Registration is based on the recommendation of the provincial authorities (PAFO, MCT, MOF, and Governor). Quotas seem to reflect: a) capacity of the mill; b) financial performance; and c) subjective assessment of relations of the mill with local authorities and the community. The process does not reflect market conditions and is exposed to arbitrary, subjective and potentially corrupt decision-making. 6.152 For 1999/2000, mills applied for a total quota of 1,130,000 m3 but were allocated only 392,000 m3, i.e., 35 percent I13. As for individual companies, allocations ranged from 10 percent to 100 percent (only one mill) of the volume for which they applied. SOEs appear to have had a lowest rate of log allocation, receiving 26% of the volume requested. This may be due to a) grossly inflated applications; b) arrears in royalty payments from previous years; and c) knowledge that supplementary quotas are available. Foreign and joint venture companies were more successful, as they were allocated almost 50 percent of their requests. 6.153 In October 2000, GOL introduced new policies leading to gradual phasing out of logging quotas. The new regulation (PMO 10/2000) prohibits logging in areas other than a) infrastructure development sites, and b) production forests with proper management plans. The latter allows production forest logging only in The Forestry Management and Conservation Project (FOMACOP) and Lao Sweden Forestry Project (LSFP) areas. In addition, there is to be some logging in other areas during a transition period while the management plans are being prepared. Once the system is fully operational, logging will be based on management plans and annual operational plans based on the market situation. 6.154 The system is still in its infancy and the first management plans are being prepared in three pilot areas. There are, however, not any guidelines or terms of reference issued for the planning teams. Whether the new approaches are going to improve the level of management would depend to a great extent on the technical quality of the plans and if they are followed. 6.155 Log allocation to individual mills does not appear to have been changed by the new regulations. Only operating processing mills may apply for logs and log exports are banned. Also rough sawnwood exports are to be gradually reduced. The new regulations do not indicate more competitive mechanisms to be applied in log allocation (e.g. bidding). How this basically 112 There is often inconsistency among various DOF statistics, both on logging and quota data. 113 Total quota was 500 000 rn3; thus, 108 000 m3 is either unallocated or some allocations have not been reported -129- administrative resource allocation can be implemented together with freely negotiated prices remains to be seen. 6.156 GOL has indicated that it aims at reducing excess wood processing capacity in the country. The means applied are still unknown but will include mainly administrative rather than market based interventions. Such forced mill closures, if properly implemented, may cut the capacity much faster than a market based approach. It may also lessen the risk of the mills trying to obtain raw material through informal channels. There are other risks, however, Government should establish explicit and transparent criteria for selection of mills to be closed. Forest Management Regulations 6.157 Forest logging rights are granted to firms under terms and conditions not conducive to sustainable forest management and without formats or guidelines for contracts or permits. Instead, short-term agreements for felling, roading and landings are applied. Since companies must apply each year for an annual harvesting quota, companies seek to extract as much as possible while they can. Post-harvest natural forest management is not practiced. 6.158 Harvesting waste in the forest is excessive as the result of poorly located and constructed roads and access tracks, uncontrolled felling techniques, bucking of bottom and top logs, loss of logs, and excessive extraction damage. Waste may exceed 60 percent of potential extraction volume although some of the waste may be utilized by villagers. There is no incentive for companies to reduce in-forest waste as volumes and grades of logs are not assessed or recorded until delivery to the second landing. Management and monitoring is lax, and under-grading, mis- scaling and incorrect recording of species at the second landing are common. All these lead to major losses of revenue and excessive pressures on the resource base. Legislative Arrangements 6.159 Legislation and regulations governing forestry are complex, incomplete, inconsistent, and difficult to interpret and to apply. This lack of transparency and predictability severely compromises the performance of the sector. The Forestry Law covers forest management and classification, timber and forest produce harvesting, forest industry, tree planting and forest regeneration, wildlife and forest protection and conservation, and the rights and obligations of forest users. But it does not clearly address village forestry, forest plantations, sustainable natural forest management practices, wood industry investment, and the administrative functions of GOL and its relevant Ministries and Departments. 6.160 Other laws complement, overlap, conflict with, or contradict the Forestry Law. The Agriculture Law and Land Law regulate crop and livestock lands, but these overlap with forests and forest lands (such as conversion for agricultural and rural development projects, shifting cultivation, and plantations). There seems to have been no systematic effort to make laws and, for example, the Instructions on Land-Forest Allocation, compatible. Other laws give the Prime Minister's Office and Ministry of Commerce and Tourism duties and responsibilities on forest- related subjects. Importantly, the Land-Forest Allocation Program's main legal basis, Instruction 03/PM, recognizes legal rights of Lao citizens on land and forests including right of possession, -130- right to use, usufruct right, right to transfer, right of inheritance, and right to receive compensation at requisition by the state. 6.161 Since a complete set of Implementing Regulations to implement the Forestry Law have not been issued, the Prime Minister's Office (PMO) has issued interim instructions and procedures for such implementation. 6.162 PMO 10/2000 is more complete than Order ll/PM/99, which it repeals. It reiterates requirements in the Forestry Law concerning prohibition of logging in the absence of forest management plans, changes procedures for setting and collecting timber revenues, introducing the possibility of having some kinds of bidding at the provincial level, and revises the timber quota system. But it continues with administrative controls on timber allocation and does not fully allow the role of market forces on resource allocation and utilization. 6.163 Among the key provisions of Order 10/PM/2000 are the following: * logging is to proceed only in infrastructure sites and in production forests with approved management plans; * several specific forest areas (including those surrounding the Nam Theun 2 project and resettlement areas) are closed to logging; * it bans the felling of standing trees of four valuable species; * it bans the export of logs; * it retains the rules and institutional responsibilities set up in Order 1 I/PM/99 for timber sales, with the important change that now MCT does not set timber prices but let the provinces negotiate these; GOL may let the provinces retain part or all of the surplus they manage to negotiate above the MCT-set minimum royalty rate. Local authorities are given full authority to sign wood sale contracts, a right previously restricted to MCT; * it forbids local authorities from issuing logging permits without Government approval, as well as logging in exchange for projects outside the Government plans; * it orders that logging shall be carried out only by state wood logging enterprises (an unfortunate step back towards the State Forest Enterprises abolished four years ago); if these are not available, provinces can create them or sub-contract logging to private companies; * it forbids the private sector to control and enter forests for logging by itself; and * it declares "local participation" promoted, but is explicitly restricted to the supply of labor. 6.164 There are positive developments here such as the introduction of the possibility of negotiating timber prices and the enforcement of the Forestry Law ban on logging without management plans. However, there is still heavy reliance on quantitative restrictions and increased control from the center. Probably the most important consideration is that, rather than pursuing permanent regulatory reform through issuance of implementing regulations, GOL continues to rely on ad hoc provisions subject to modification and confusion. Decentralization 6.165 Extension of the GOL planning decentralization policy to the forestry sector could lead to substantial improvements in forest management. It is necessary, however, to retain some national -131- level of control and authority where there are divergences between local and national priorities, when there are no instruments to reconcile them or when technical capacities are limited. In particular, arrangements for specific areas need to be linked to the mandate and accountabilities of the agencies and levels of government expected to exert regulatory control. 6.166 Application of Order 01/PM/2000 to forestry is still unclear. Apparently district authorities would have to prepare forest management plans and handle forest management budgets. Most likely, the lack the technical skills would make that a practical impossibility. Order 01/PM/2000, if strictly interpreted, would also, seem to give district governments authority over timber sales, and over the funds thus generated from all local forests. This would completely preempt the expansion of the successful village forest management experiences to new areas and jeopardize, if not destroy, existing VFM arrangements. Administrative Weaknesses 6.167 DOF and the PAFOs lack the personnel, skills, equipment, transport facilities, and funding to carry out the effective monitoring of activities in the production forest areas and the enforcement of laws, regulations and contract conditions. They do not have the capacity to effectively use the modem tools such as satellite imagery, forest inventories, GIS and GPS technology, some of which are available under the auspices of foreign-assisted projects. They also lack competence in forest economics, and in natural resource economics, management and conservation. For all practical purposes, the DOF does not perform any real role in forestry policy or forest management. MAF, and DOF in particular, as well as the PAFOs, need a long- term institution-building program to achieve the minimal standards to perform the required monitoring and enforcement functions. This, however, will only be meaningful and effective if there is a genuine intent to utilize these agencies under clear and public terms of reference. Illegal Logging and Forest Law Enforcement 6.168 Recent World Bank missions have assessed the extent of unauthorized, illegal, unplanned and illicit logging in selected National Biodiversity Conservation Areas (NBCA) and in the Nam Theun 2 watershed area where logging is prohibited. Serious logging infractions in the Nakai Nam Theun NBCA, and other areas which the GOL had designated as off-limits to logging. Similarly, even though logging quotas refer to the specific final use or destination of the timber, there are clear signs of unreported or underreported log exports to Thailand and Vietnam."' Four main factors contribute to these problems: * Complex, incomplete, inconsistent, regulatory framework which is not geared to effective forest management * Unauthorized issuing of logging permits simply do not have the authority * Inadequate field demarcation, and even definition, of protected areas * Corruption that the confusing legal and administrative arrangements permit. 6.169 GOL's forest management and utilization policy will not be credible until current procedures are made transparent and predictable. All agencies should be accountable for their 124 Review mission night sights of log trucks on Route No. 8; Deutsche Presse-Agentur, "Vietnam importing huge amount of timber from Laos", Hanoi, June 6, 2000. -132- activities and decisions, in terms of both performance and financial management; accounts should be regularly and independently audited; and checks for corruption put in place and actively enforced. This, needs strong technically competent oversight over the agencies involved, and independent control over performance, budget utilization, and to check for non-compliance and corruption. Poverty Focused Forestry Management 6.170 In the context of a population that is largely rural and poor, the overriding objective for the use of forest resources in Lao PDR should be sustainably reducing poverty. Two policy initiatives could be directed at this objective: Introduction of village forest management schemes that use forest resources more efficiently; and revenue enhancement through fuller capture of the rents on the forestry resource. Box 6.2: Wood Production Practices No sustainable strategies to manage a region's, province's, or district's forest on an annual allowable cut basis have been prepared. The significance of this is demonstrated by contrasting the two ways in which wood is harvested from natural forests in Lao PDR and by recognizing that Government policy implicitly sanctions only what is described below as the High Intensity Harvesting Model. High Intensity Harvesting Model Historically, logging in Lao PDR is based on harvest of 25 cubic meters/hectare or more, on a 50-year cycle. Few post-harvest management measures ensure that the residual growing stock is nurtured and protected between cycles. High intensity logging has not proven environmentally, economically, or socially sustainable. DOF and PAFOs are responsible for overseeing and controlling forest production management, but neither has the required capacity or capability. NOFIP, PAFO, DAFO, and the SOEs and other companies jointly inventory the areas identified by the latter for harvesting, and assist in preparing operational plans. PAFO and MCT measure log volumes at landings and monitor stocks at processing plants and trade at borders. Logging companies undertake harvesting operations, often through sub-contractors, without reference to codes for harvesting practice, standards, or guidelines for roading, landing locations, and reduced-impact felling or extraction. Roading, landings, and harvesting operations are conducted with minimal investment and specifications. The resulting poor harvesting and roading practices degrade the forests and cause environmental damage. Low Intensity Harvesting Model In addition to village-based participatory models, FOMACOP has introduced forest management using low intensity harvesting systems. Based upon forest resource data and Permanent Sample Plots (PSPs), village decision-making determines rates and densities of harvesting, and management and marketing strategies. Villagers then conduct pre- harvest inventory, obtain up-to-date market intelligence information, undertake sales negotiations, manage, and implement low impact harvesting, and conduct joint grading, scaling and sales documentation on landings. The over-riding principle has been sustainability of forest resources through low-intensity reduced impact logging as a silvicultural tool to simulate natural mortality of trees. Coupled with this, low-impact logging is practiced with directional felling, self-loading 6x6 truck forwarders, and operations restrictions to dry season months only. A strong factor for sustainability is the role of forests as a source of food, wood, and other non-wood products. Villagers have a substantial stake in maintaining a healthy forest environment as their livelihood depends upon it because, unlike outside commercial operators, they cannot simply move to other forest areas. The Scope for Village Forestry 6.171 In many countries, and as piloted in Lao PDR, village forestry involves written agreements between the state and members of a specific community who have an established -133- traditional or other association with a specific forest area. While terms vary, the user group typically agrees to undertake management activities, to supply wood and non-wood forest products, and to protect the forest from encroachment and other hazards. Similarly, the state enforces the claim of users against third parties, such as commercial loggers, recognizes the rights of the user group especially their commercial autonomy, and provides technical and other management assistance. Experience under the World Bank-financed FOMACOP clearly demonstrated that village forestry can introduce effective sustainable management over well- stocked forests and, if allowed to function, can yield benefits to both the participating community and the public treasury. Based on forest types, rural population, access to roads, topographic considerations and other factors, some 54 percent of the production forest area outside of the NBCA system has a combination of attributes similar to those sites with potential for successful village forest management. Approximately 1.54 million people live in the areas suitable for village management, making village forestry one of the most promising rural poverty reduction approaches available to the GOL. Results from the LSFP Joint Forest Management pilot programs (JFM), and the World Bank-supported FOMACOP project demonstrate the potential for both the villagers and the Government. In 1999/99, the first 15 villages harvested almost 4,000 m3, sold for almost US$ 400,000. Of these, 69%, or US$ 275,000, was paid to Government as royalties and taxes, US$ 75,000 (19%) was spent in felling and transport costs, and US$ 25,000 (6%) in village forest management costs. The remaining US$ 25,000 (6%), or US$ 1,700 per village, was kept by the villages (some US$ 0.30 per person per year, assuming about 5,500 people live there). In the JFM areas, profits were utilized for village development works (such as access roads, wells and water pumps, schools, health centers and water reservoir/fish pond). The main costs of introducing village forest management are the technical assistance to introduce the system, and transport, estimated at US$ 2.5/ha. In addition, village management is some US$ 2.5/ha more expensive than the current forest management system. The financial rate of return of such investment and additional costs has been estimated, under different scenarios, at over 40% for the program at large, and at 13-17% for the Government-funded investments."15 In addition village forestry assures a higher payment of forest royalties both at any given time and over the long term and increases the likelihood that management practices incorporate consideration of the importance of nontimber forest products. This provides only an indicative scope of the potential for village forest management. The analysis also highlights that village forest management (VFM) and government forest management (GFM) are complementary rather than competitive, and that 46 percent of the accessible forest area urgently needs to be put under effective government management. 115 Production Forestry Review fimded by World Bank SIDA and Finland -134- Box 6.3: Non Timber Forest Products For rural Lao NTFPs are the most important products from the forest. Key NTFPs include food (game, fish, bamboo shoots, fruits, greens, and honey); fiber (khem grass, used to produce brooms, and paper mulberry); condiments and medicinal products (cardamom and malva nuts); inputs for chemical and perfume industries (benzoin, peuak meuak, resins and oleoresins, 'kisi' resin, and larnxay); bamboo poles, rattan, and fuelwood.' In Saravan province, for example, the IUCN-NTFP project found that virtually all food except for rice is derived from the forest. A rural family consumes some US$280 equivalent per year in NTFPs (including fuelwood). Thus the 800,000 rural families (4 million people) may consume the equivalent of US$ 224 million per year in NTFPs, which may provide some 40 percent of total rural family income (equivalent to 20 percent of Lao GNP. Simplified income model of an average Lao rural household of five persons Income category US$ Percent Remarks Source of data/estimate Forest foods $200 28 % Bamboo-shoots/fish/greens K. Clendon, IUCN-NTFP, 1999 Firewood $40 6 % Firewood & local use wood Southavilay T. & T. Castren, 1999 Other NTFPs $40 6 % Medicines/rattan/bamboo etc. Sounthone Ketphanh, pers. comm. Total NTFPs $280 40 % Equivalent to 80 % of rice Rice $350 50 % 350 kg paddy/person/year Various IUCN-NTFP field reports Total non-cash $630 90 % Very little cash income Cash income $70 10% NTFPs 55 %, livestock 30 % Various IUCN-NTFP field reports $700 100% NTFPs provide 44 % of non-cash and 55 % of cash income Total income Source: Foppes & Ketphanh, Forest Extraction or Cultivation, Local Solutions from Lao PDR, forthcoming Scopefor Forestry Plantations 6.172 The ADB has supported the use of degraded and unstocked forestland for plantation on a commercial basis. The ongoing Industrial Tree Plantation project has (i) catalyzed the adoption of plantation forestry in the Lao PDR, and (ii) demonstrated the potential to provide income generation opportunities to rural poor villagers and contribute to economic growth in the country. It has helped improve the technical capability within the Department of Forestry to support plantation forestry, raise the profile of plantations among the private sector and individual farmers, and establish workable processes for participatory planning of plantation forestry. It has demonstrated the willingness and capability of individual farmers and private enterprises to engage in production forestry through tree plantations. There are potential economic, social, and environmental benefits from further development of the commercial plantation sector in the Lao PDR, which is still at an early stage of development. The sector needs continued assistance to (i) build links between larger scale plantation investors and small-scale farmers to have greater impacts on poverty reduction, and (ii) ensure that private sector involvement and interest in plantations is maintained and grows over time. -135- Forest Revenue Performance 6.173 Forestry and forest-based industries have been one of the backbones of the Lao economy. Remarkably little of this wealth, however, has found its way to supporting development through public spending. Royalties have been providing some 10-20% of the government revenues through most the 1990s, but even this limited share has been decreasing. For fiscal year 1999/2000, a notable increase was forecast (to US$ 35 million, or 15% of total GOL revenue, almost a twofold increase over the previous year). Collections of arrears ultimately accounted for 50% of 1999/2000 revenues. 6.174 The main reasons for the limited contribution are low royalties, in-forest harvesting and extraction waste, irregularities in grading and measurement, low collection rates, misreported species and underestimated volumes. Only about half of the royalties assessed were actually collected. SOEs are the major contributors to the shortfall. Through the fiscal years 1994/95 to 1998/99, GOL received US$ 114 million in royalty payments, the average being US$ 22.8 million per year. However, the market value of standing timber may be estimated at US$ 340 million for the whole period or US$ 68 million annually' 16. Therefore, only one third of the value of the resource used actually reaches the Treasury to finance ordinary budget items, such as social development and schools. Table 6.22: Logging Revenue Loss (average 1994/95-1998/99) Revenue Loss (%) Stumpage Value (US$ 000) - of remaining - cumulative value * Market (stumpage) value of the 67 901 standing timber Minus: 1) excess logging waste 20 20 -13 580 2) under pricing 30 44 -16 296 3) arrears 40 66 -15 210 Net revenue actually collected 22 815 * not cumulative Source: World Bank estimate 6.175 One fifth of the value of the cut trees is lost due to excessive in-forest waste. Some of it may be used by local communities for household use. Underpricing and arrears/non-payment account for almost half of the estimated market value of the trees cut. Inefficient royalty collection benefits companies and individuals trading in roundwood. This leads both to loss of fiscal revenues and arbitrary resource allocation. 6.176 There is strong evidence that community based forest management actually has more efficient incentives and tools for improved revenue collection than, often under-resourced, state forest management. The main factors are: * villagers have better access which enables superior monitoring of the forests and their utilization * villagers have direct interest in the revenues 116 This is the value that an efficient private woodlot owner would charge as stunipage fees. The final market value of the logs or sawn timber would be higher and would cover cutting costs, transportation and normal profit. -136- * social capital and coherence ensures that officials are likely to protect the interests of the society, the large number of villagers involved hinders corruption * moving towards sustainable resource utilization ensures constant or increasing revenue flow both for the communities and GOL. 6.177 Due to the currently unsatisfactory level of revenue collection, village forestry would not only redistribute royalty revenues but also increase total revenue. Assuming that improved forest management and utilization practices would cut the decline in forest structure and gradually increase average logging, increase royalty levels and, most importantly, increase collection rate from current 50% to 80%, village forestry would be a profitable investment also from GOL's fiscal perspective. 6.178 A preliminary projection of GOL revenue illustrates the potential impact of implementation of improved revenue procedures along with expanded village forestry. Under conservative assumptions, revenues and incremental forest management costs are projected to 2020. Without reform, annual royalty revenue is projected to fall sharply over the next five years to less than $10 million and ultimately to less than $6 million. With substantial reductions in harvests and incomes over the next few years (equivalent to an investment of over $44 million), revenues under a reform scenario are projected to rise from a low of around $13 million to over $22 million by 2010 and to a sustained level in excess of $33 million by 2020. 6.179 On this basis, investment in village forestry would, in pure fiscal terms, provide an internal rate of return of 17% making it a profitable investment for GOL. Even allowing a 25% share of production forest revenues to be retained by the VFAs and assuming a 50/50 sharing of incremental management costs the IRR would remain 13%. It needs to be noted that this estimated VFA revenue share is well above that to which VFAs in FOMACOP areas are entitled. The strong anticipated revenue increase allows investments in improved forest management. 6.180 NTFPs have been found to provide, on average, 55 percent of family cash income of villages near forests. Income from NTFP sales is difficult to estimate, but might amount up to some $31 million per year, of which roughly US$ 6-7 million (or 2 percent of Lao exports) are exported. In times of shortage, poor families go into debt to borrow rice, but debt repayment often forces people to harvest and sell forest products in a destructive manner. Trade is poorly documented, but exports of several products have risen considerably over the last few years. Cardamom and malva nuts, both used in medicines, are the most important together representing 60-70 percent of total NTFP export value."7 Recommendations Improve Forest Management and Utilization 6.181 GOL needs to bring the production forest under long-term, scientific forest management: * Define Forest Management Units and Prepare Management Plans. A first task is to define specific forest management units (FMUs) and prepare management "7 Foopes, J. and S. Ketphanh, The Use of Non-Tirnber Forest Products in Lao PDR, Paper presented at the International Workshop on Sustainable Management of Non-Wood Forest Products, UPM, Serdang, Selangor, Malaysia, 14-17 October 1997. -137- plans for them, which in turn requires a clearly defined and mapped national forest estate and the establishment of management entities. * Strengthen the Regulatory Apparatus. GOL needs to complete, clarify, and simplify the legal and regulatory framework and establish an effective regulatory body to oversee forestry operations; * Increase Reliance on Market Approaches and Mechanisms. GOL should move away from intervening in commercial decision-making in the wood market and in the wood industries sector; * Restructure State-owned Enterprises. SOE reform should begin with disclosure of financial audits, non-performing loans, and data on logging activities, and then extend to discontinuation of preferential logging contracts, harvesting quota allocations, access to domestic and foreign markets, and clearing for land conversion. Community Participation in Forestry. 6.182 To provide credible endorsement to a village forestry policy, GOL needs to: * Clarify the legislative and regulatory framework. GOL should establish clear predictable procedures for the rapid expansion of the area under village management; * Ensure commercial autonomy for VFAs. GOL needs to provide assurance that Village Forestry Association can conduct the full range of commercial and marketing activities needed to maintain themselves as viable commercial forest management entities; and * Improve village land allocation. GOL should more substantively integrate the lessons learned from community forestry pilots into its village land allocation process to make it more equitably sustainable and productive. Controlling Illegal Logging 6.183 It will be difficult for GOL to immediately launch a fully effective suppression program, but activities could be initiated that could quickly lead to a meaningful law enforcement effort. A program to control illegal logging needs to address prevention, detection, and suppression activities. GOL can help in preventing illegal logging by curbing sources of pressure on the resource, such as stopping promotion of excess wood processing capacity, allowing inefficient mills to go out of business, and improving monitoring of log exports crossings. As an immediate step, GOL can implement the prohibition of licensing of new wood processing plants, as stipulated in the Prime Minister's Order No. lO/PM/2000. A forest crime monitoring program to systematically collect data on illegal logging and to prioritize needs for suppression and prevention efforts could be established quickly and at low cost. -138- Statistical Appendix List Tables Table 1: Key Economic Indicators Table 2: GDP by Industrial Origin 1995-2000 Table 3a: Lao PDR General Government Expenditure, 1996/97, 1997/98, 1999/00, and 2000/01 (billions of kip) Table 3b: Lao PDR Lao PDR General Government Expenditure, 1996/97, 1997/98, 1999/00, and 2000/01 (percent of total) Table 4: Expenditure by Sector, Central Ministry and Provisions 2000/01 Actual and 2001/02 Budget Table 5: National Budget Expenditure, 1994/95-1999/00 Table 6: National Budget Revenue, 1994/95-2000/01 Table 7: Magnitude of General Expenditure and Portion Administered by Each Level of Government PIP Expenditure Table 8: 1995/96 to 2002/03 (shares by sector) Table 9: PIP Expenditure, Planned and Actual - 1995/96 to 1999/00 Table 10: UN Health Goals and Status in Lao PDR -139- Table 1: Key Econonnic Indicators 1995 1996 1997 1998 1999 2000 2001 Nominal GDP (billion kips) 1419 1725 2201 4240 10329 13671 15599 Real GDP growth 7.0 6.8 7.0 4.0 7.3 5.8 5 2 Prices CPI (% growth) 19.4 7.3 26.6 141.9 86.7 10.6 7.5 Government budget (% GDP) (1) Revenue 12.2 13.0 11.3 9.8 10.6 13.2 13.6 Grants 5.5 3.5 3.4 5.3 6.0 3.7 3.2 Expenditure 21.9 22.1 21.9 23.6 20.6 21.5 21.4 Overall balance including grants 4.2 -5.6 -7.2 -8.5 -4.0 4.6 -4.6 Domestic financing -0.4 -1.1 1.6 2.5 -0.6 -1.2 1.3 Foreign financing 4.6 6.7 5.6 6.0 4.6 5.7 3.2 Balance of Payments Imports 627 643 601 506 527 Exports 310 323 318 342 338 Trade balance -317 -320 -283 -164 -189 Exchange rate 925 954 2135 4274 7600 8218 9490 Source: International Financial Statistics, IMF -140- Table 2: GDP by Industrial Origin 1995-2000 1995 1996 1997 1998 1999 2000 billions of 1990 kips Agriculture 454 464 499 514 556 584 Crops 216 218 253 271 306 346 Livestock and Fishery 179 186 188 193 197 203 Forestry 59 60 57 51 53 35 Industry 157 184 199 217 234 252 Mining and quarrying 2 2 4 4 5 6 Manufacturing 116 138 150 164 176 190 Construction 28 30 33 28 28 25 Electricity, gas and water 11 13 13 21 25 31 Services 204 222 238 252 268 284 Transportation, storage and communication 44 50 53 56 60 63 Wholesale and retail trade 69 76 85 93 100 106 Banking, insurance and real estate 12 12 13 13 13 14 Ownership of dwellings 28 30 31 32 32 33 Public wage bill 28 28 28 29 31 31 Nonprofit institutions 10 11 11 8 8 9 Hotels and restaurants 12 14 17 18 22 26 Other 1 2 2 2 2 2 Import duties 21 23 19 11 6 6 GDP at market prices 836 893 955 994 1064 1126 percent Agriculture 54.3 52.0 52.3 51.7 52.3 51.9 Crops 25.8 24.4 26.5 27.3 28.8 30.7 Livestock and Fishery 21.4 20.8 19.7 19.4 18.5 18.0 Forestry 7.1 6.7 6.0 5.1 5.0 3.1 0.0 0.0 0.0 0.0 0.0 0.0 Industry 18.8 20.6 20.8 21.8 22.0 22.4 Mining and quarrying 0.2 0.2 0.4 0.4 0.5 0.5 Manufacturing 13.9 15.5 15.7 16.5 16.5 16.9 Construction 3.3 3.4 3.5 2.8 2.6 2.2 Electricity, gas and water 1.3 1.5 1.4 2.1 2.3 2.8 Services 24.4 24.9 24.9 25.4 25.2 25.2 Transportation, storage and communication 5.3 5.6 5.5 5.6 5.6 5.6 Wholesale and retail trade 8.3 8.5 8.9 9.4 9.4 9.4 Banking, insurance and real estate 1.4 1.3 1.4 1.3 1.2 1.2 Ownership of dwellings 3.3 3.4 3.2 3.2 3.0 2.9 Public wage bill 3.3 3.1 2.9 2.9 2.9 2.8 Nonprofit institutions 1.2 1.2 1.2 0.8 0.8 0.8 Hotels and restaurants 1.4 1.6 1.8 1.8 2.1 2.3 Other 0.1 0.2 0.2 0.2 0.2 0.2 Import duties 2.5 2.6 2.0 1.1 0.6 0.5 GDP and market prices 100.0 100.0 100.0 100.0 100.0 100.0 Source: National Statistical Office -141- Table 3a: Lao P.D.R: General Government Expenditure, 1996/97, 1997/98, 1999/00, 2000/01 and 2001/02 (billions of Kips) (3) 1996/97 (1) 1997/98 (2\ 1999/00 (t) 2000/01 (1) 2001/02 (2) total current capital total current capital total current capital total current capital total cumnt capital Total 430 192 238 541 242 300 2778 995 1783 3547 1477 2071 4035 1761 2274 Ministries 284 108 176 357 139 218 1929 763 1166 2169 1114 1055 2276 1354 922 Agricultureandforestry II I 10 18 I 16 48 3 45 80 6 74 82 6 76 Industryand handicraft 44 0 43 45 10 35 55 1 55 49 1 48 16 2 14 Comm transport and post 67 1 66 109 5 104 850 3 847 652 13 639 276 10 266 Commerce 0 0 0 0 0 0 1 1 0 3 1 2 4 2 2 Fiancc I I 0 2 2 0 394 385 10 548 541 7 727 645 82 Planning 0 0 0 0 0 0 9 1 8 4 1 3 8 1 7 Education 31 5 26 37 8 29 68 15 53 109 31 78 199 37 162 Health 9 4 5 17 4 13 12 7 5 26 15 11 86 11 75 Cultureandinformiation 8 4 4 6 2 4 48 4 44 26 7 19 58 7 51 Lahorandsocialwelfare 19 7 12 15 6 9 54 4 50 82 9 73 101 10 91 Justice 0 0 0 1 1 0 1 1 0 3 2 1 5 2 3 Foreign affairs 5 5 0 18 16 2 47 45 2 71 70 1 75 73 2 Defense 49 47 2 54 51 2 224 204 20 278 251 27 324 296 28 Interior 15 13 3 17 14 3 78 68 10 101 91 10 125 105 20 PrimeMinistets office 25 20 5 18 16 2 39 21 18 137 75 62 145 102 43 Other 45 45 Provinces 121 62 58 155 72 83 849 232 616 1377 363 1014 1759 407 1352 VientianePrefecture 21 7 14 14 8 6 140 22 117 200 43 157 200 40 160 Phongsali 7 2 5 7 2 5 40 8 33 88 10 78 119 13 106 Loaangnamtha 7 2 5 7 2 4 24 7 17 37 11 26 48 13 35 Oudomxia 4 2 2 6 3 3 50 7 42 65 14 51 87 17 70 Bokeo 4 2 2 7 2 5 75 6 70 57 9 48 69 14 55 Louang Prahang 9 5 4 12 5 6 32 14 18 109 21 88 110 27 83 Houaphan 5 3 2 12 3 9 66 10 55 70 23 47 161 32 129 Xaignabouli 6 4 3 11 4 6 26 11 15 71 18 53 115 22 93 XiangKhoang 4 3 2 7 4 3 49 11 38 82 19 63 82 21 61 Vientiane Province 6 4 2 9 5 4 47 16 30 85 23 62 91 26 65 Bolikhamxai 4 3 2 6 3 3 37 8 30 40 13 27 59 15 44 Khammoaun 6 4 2 9 4 5 46 14 32 69 23 46 Ill 25 86 Savannakhet 13 8 5 15 9 6 71 31 39 128 46 82 164 55 109 Salavan 5 3 2 6 3 3 39 8 31 79 14 65 55 16 39 Xekong 4 2 2 5 2 3 24 5 19 III 52 59 184 44 140 Charmpassak 10 8 3 15 8 7 60 45 15 28 9 19 37 10 27 Attapu 3 1 1 4 2 2 13 5 8 38 10 28 38 11 27 XtasombounSpecialRegion 3 1 2 4 2 3 10 4 7 20 5 15 29 6 23 Other Unaccounted 25 22 4 29 31 -I Source Lao Authorities (1) Actual Data (2) Budget Data (3) Data do not correspond exactly to Table I I due to differences in IMF and National expenditure classifications, especially debt repayment -142- Table 3b: Lao P.D.R: General Government Expenditure, 1996/97, 1997/98, 1999/00, 2000/01 and 2001/02 (3) (_eent of total) 1996197 (1) 1997/98 (2) 1999/00 (1) 2000/01 (1) 2001/02 (2) total current capital total current capital total current capital total current capital total current capital Total 1000 44.7 553 1000 446 554 100.0 35.8 642 1000 416 584 1000 436 564 Ministrics 661 251 410 65 9 25 6 40.3 69 5 27 5 42 0 612 314 29 7 56.4 33 6 22 9 Agriculture and forestry 2 5 02 2 3 3 2 0 3 3 0 1 7 0 1 16 2 3 0 2 2 1 2 0 0 1 1 9 Industryand hndicraft 101 00 101 84 19 65 20 00 20 14 00 14 04 00 03 Comnmunication trnpson and pi 6 0 1 15 4 20 0 0 9 19 1 30 6 0 1 30 5 18 4 0 4 18 0 6 8 0 2 6 6 Commece 00 00 00 01 01 00 00 00 00 01 00 01 01 00 00 Finance 03 03 00 04 03 00 142 138 04 154 153 02 180 160 20 Planning 01 01 00 01 01 00 03 0.0 03 01 00 01 02 00 02 Education 72 11 61 69 16 5.4 25 05 19 31 09 22 49 09 40 Htalth 20 10 1 1 32 08 24 04 03 02 07 04 03 21 03 19 Culture and information 1 8 0 9 0 9 1 1 0 4 0 7 1 7 01 1 6 0 7 0 2 0 5 1 4 0 2 1 3 Laborandsocialwelfare 45 17 28 28 I I 16 20 01 18 23 03 21 25 02 23 Justice 01 01 00 01 01 00 00 00 00 01 01 00 01 00 01 Foreignaffairs I I 1.1 01 33 30 03 17 16 01 20 20 00 19 1.8 00 Defense 114 110 04 99 95 04 81 74 07 78 7.1 08 80 73 07 Interior 36 30 06 3.2 26 06 28 24 04 28 26 03 31 26 05 Prime Minister's office 5 7 4 6 10 3 3 3 0 0 3 14 0 8 0 6 3 9 21 17 3 6 2 5 1 1 Other 00 00 00 I II 00 Provinces 280 145 136 287 133 154 305 84 222 388 102 286 436 101 335 Vientiane Prefecture 4 9 16 3 3 2 5 15 10 5 0 0 8 4 2 5 6 12 4 4 5.0 10 4 0 Phongsali 17 05 12 13 04 09 15 03 12 25 03 22 29 03 26 Louangnanmha 16 05 1 1 13 04 08 08 02 06 10 03 07 12 0.3 09 Oudornxia 10 05 05 12 05 06 18 03 15 18 04 14 22 04 17 Bokeo 08 04 04 1 3 04 09 2.7 02 25 1 6 03 1 4 1 7 03 1 4 LouangPrabang 20 1 1 10 21 10 1 1 1 1 05 06 31 06 25 27 07 21 Houaphan 12 07 05 22 06 16 24 04 20 20 06 13 40 0.8 32 Xaignabouti 15 09 06 19 08 I I 10 04 05 20 05 15 29 05 23 XiangKhoang 10 06 0.3 12 06 06 18 04 14 23 05 18 20 05 15 VientianeProvince 14 10 04 16 08 07 17 06 1 1 24 06 17 23 06 16 Bolikhamxai 10 06 04 1 1 06 05 13 03 1 1 1 1 04 08 1 5 04 1 1 Klhammouan 13 09 04 17 08 09 17 05 12 19 06 13 28 06 21 Savannakhat 30 18 12 28 16 12 25 1 1 14 36 13 23 41 1.4 27 Salavan 10 06 04 12 06 06 14 03 1.1 22 04 18 14 04 10 Xekong 0.9 04 06 10 04 06 09 02 07 31 15 17 46 1 1 35 Chaotpassak 24 18 07 28 1.5 13 22 16 05 08 03 05 09 02 07 Attapu 07 03 03 0.8 0.4 04 05 02 03 1 1 03 08 09 03 07 Xiasomboun Special Region 0 7 0 3 0.3 0 7 0 3 0 5 19 01 0.2 0 6 01 0 4 0 7 01 0 6 Other Unaccounted 5 9 5 1 0 8 5 4 5.7 -0.3 0 0 0 0 0.0 0 0 0 0 0 0 0 0 0.0 0.0 Source Lao Authorities, staff estimates (I) Actual Data (2) Budget Data (3) Data do not correspond exatly to Table I I due to differences in IMF and National expenditurc classifications, especially debt repayment -143- Table 4: Expenditure by Sector, Central Ministry and Provinces. 2000/01 actual and 2001/02 budget 2000/Olactual 2001/02 budget Growth central central central total ministry provinces total ministry provinces total -ministry . provinces billion kip billion kip percent Agriculture 588 79 509 418 81 337 -28.9 2.5 -33.8 Industry and Handicrafts 116 49 67 69 16 53 -40.5 -67.3 -20.9 MCTPC 809 652 157 635 276 359 -21.5 -57.7 128.7 Commerce and Tourism 8 3 5 14 4 10 75.0 33.3 100.0 Finance 599 548 51 770 727 43 28.5 32.7 -15.7 CPC 14 4 10 54 8 46 285.7 100.0 360.0 Education 261 109 152 402 198 204 54.0 81.7 34.2 Health 131 26 105 225 86 139 71.8 230.8 32.4 Information and Culture 40 26 14 102 58 44 155.0 123.1 214.3 Labor and Social Welfare 117 82 35 145 101 44 23.9 23.2 25.7 Justice 7 3 4 12 5 7 71.4 66.7 75.0 Foreign Affairs 71 71 0 75 75 0 5.6 5.6 0.0 Defense 278 278 0 324 324 0 16.5 16.5 0.0 Interior 101 101 0 125 125 0 23.8 23.8 0.0 PMO 137 137 0 146 146 0 6.6 6.6 0.0 Provincial offices in Vientiane 262 0 262 467 0 467 78.2 0.0 78.2 Other 5 0 5 53 46 7 960.0 0.0 40.0 TOTAL 3544 2168 1376 4036 2276 1760 13.9 5.0 27.9 Source: Lao P.D.R. Official Gazette March 2002 2000/Olactual 2001/02 budget Growth central central central total ministry provinces total ministry provinces total ministry provinces percent share percent share percent growth in share Agriculture 16.6 2.2 14.4 10.4 2.0 8.3 -38 -10 -42 Industry and Handicrafts 3.3 1.4 1.9 1.7 0.4 1.3 -48 -71 -31 MCTPC 22.8 18.4 4.4 15.7 6.8 8.9 -31 -63 101 Commerce and Tourism 0.2 0.1 0.1 0.3 0.1 0.2 54 17 76 Finance 16.9 15.5 1.4 19.1 18.0 1.1 13 16 -26 CPC 0.4 0.1 0.3 1.3 0.2 1.1 239 76 304 Education 7.4 3.1 4.3 10.0 4.9 5.1 35 60 18 Health 3.7 0.7 3.0 5.6 2.1 3.4 51 190 16 Information and Culture 1.1 0.7 0.4 2.5 1.4 1.1 124 96 176 Labour and Social Welfare 3.3 2.3 1.0 3.6 2.5 1.1 9 8 10 Justice 0.2 0.1 0.1 0.3 0.1 0.2 51 46 54 Foreign Affairs 2.0 2.0 0.0 1.9 1.9 0.0 -7 -7 Defense 7.8 7.8 0.0 8.0 8.0 0.0 2 2 Interior 2.8 2.8 0.0 3.1 3.1 0.0 9 9 PMO 3.9 3.9 0.0 3.6 3.6 0.0 -6 -6 Provincial offices in Vientiane 7.4 0.0 7.4 11.6 0.0 11.6 57 57 Other 0.1 0.0 0.1 1.3 1.1 0.2 831 23 TOTAL 100.0 61.2 38.8 100.0 56.4 43.6 0 -8 12 Source: Lao P.D.R. Official Gazette March 2002 -144- Table 5: National Budget Expenditure, 1994/95-2001/2002 1994195 1995/96 1996/97 1997/98 1998/99 1999/2000 2000/01 2001/2002 Actual Actual Actual Actual Actual Actual Actual Budget kip billion Current Expenditure 143 166 224 305 539 1,050 1,236 1,449 Wages and Salaries 68 79 92 117 181 335 416 525 MateialsandSupplies 43 52 57 63 132 174 330 370 Intenest 11 10 16 39 59 103 134 145 Timber royalty finaced exp. 32 37 89 242 0 0 Other 21 25 27 49 78 196 356 409 Capital Expenditure 147 195 220 579 1,270 1,704 1,911 2,165 Total 290 361 444 884 1,809 2,754 3,147 3,614 percent CurentExpenditure 49.3 46.0 50.5 34.5 29.8 38.1 39.3 40.1 Wages and Salaries 23.4 21.9 20.7 13.2 10.0 12.2 13.2 14.5 Materials and Supplies 14.8 14.4 12.8 7.1 7.3 6.3 10.5 10.2 Interest 3.8 2.8 3.6 4.4 3.3 3.7 4.3 4.0 Timber royalty finaced exp. 0.0 0.0 7.2 4.2 4.9 8.8 0 0 0.0 Other 72 6.9 6.1 5.5 4.3 7.1 11.3 11.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Capital Expenditure 50.7 54 0 49.5 65.5 70.2 61.9 60.7 59.9 Total 100.0 100.0 1000 100.0 100.0 100.0 100.0 100.0 Soure: IMF -145- Table 6: National Budget Revenue, 1994/95-2000/01 1994/95 1995/96 1996/97 1997/98 1998/99 1999/2000 2000/01 Actual Actual Actual Actual Actual Actual Actual Total Revenue 164,583 220,311 228,300 360,800 950,855 1,779,593 2,279,001 A. Tax Revenue 128,280 173,670 189,600 287,400 745,453 1,344,746 1,718,899 1. Income and Profit Taxes 25,760 35,730 34,900 50,900 149,943 303,646 497,354 ProfitTax 17,156 24,350 23,400 34,000 80,353 186,521 315,800 Income Tax 8,604 11,380 11,500 16,900 69,590 117,125 181,554 2. Agriculture Land Tax 1,888 3,100 2,500 5,300 4,809 7,303 12,228 3. Domestic Goods&ServicesTax 30,209 41,770 57,900 90,000 317,103 516,275 715,199 Turnover Tax 23,255 32,300 40,000 61,000 159,759 290,043 378,724 Excise Duties 6,954 9,470 17,900 29,000 157,344 226,232 336,475 4. International Trade Taxes 38,875 51,150 53,300 81,200 122,933 175,815 250,847 Import Duties 33,400 45,000 47,000 68,000 98,515 41,184 106,855 Export Duties 5,475 6,150 6,300 13,200 24,418 134,631 143,992 5. Natural Resources Taxes 25,814 34,600 31,700 42,000 94,750 286,675 125,901 Timber Royalties 24,664 33,000 31,700 42,000 89,461 272,538 115,000 Taxes on OtherResources 1.150 1,600 5,289 14,137 10,901 6. Other Revenue 5,734 7,320 9,300 18,000 55,915 55,032 117,370 Business Licenses 184 180 200 600 277 1,253 - 2,666 Registration Fees 1,600 1,740 4,939 7,185 8,628 Other 3,950 5,400 9,100 17,400 50,699 46,594 106,076 B. Non-tax Revenue 36,303 46,641 38,700 73,400 205,402 434,847 560,102 1. State-owned Enterprises 8,486 5,160 14,200 ,22,000 33,447 56,910 226,524 Depreciation and Dividends 3,287 3,250 9,400 14,000 22,011 41,717 207,000 Leasing Fees 5,199 1,910 4,800 8,000 11,436 15,193 19,524 2. On-lendingofForeignFunds 13,820 12,330 8,300 20,800 113,007 79,108 36,003 interest and Capital Return 13,820 12,330 8,300 20,800 113,007 79,108 36,003 3. State Assets 13,997 29,151 16,200 30,600 58,948 298,829 297,575 Concessions 234 320 200 400 993 1,716 3,594 Overflight Rights 7,657 9,500 10,000 24,200 40,300 46,594 106,076 Other 6,106 19,331 6,000 6,000 17,655 250,519 187,905 Total Revenue 100.0 100.0 100.0 100.0 100.0 100.0 1000 A. Tax Revenue 77.9 78.8 83.0 79.7 78.4 75.6 75.4 1. Income and Profit Taxes 15.7 16.2 15.3 14.1 15.8 17.1 21.8 ProfitTax 10.4 11.1 10.2 9.4 8.5 10.5 13.9 Income Tax 5.2 5.2 5.0 4.7 7.3 6.6 8.0 2.AgricultureLandTax 1.1 1.4 1.1 1.5 0.5 0.4 0.5 3. Domestic Goods & Services Tax 18.4 19.0 25.4 24.9 33.3 29.0 31.4 Turnover Tax 14.1 14.7 17.5 16.9 16.8 16.3 16.6 Excise Duties 4.2 4.3 7.8 8.0 16.5 12 7 14.8 4. International Trade Taxes 23.6 23.2 23.3 22.5 12.9 9.9 11.0 Import Duties 20.3 20.4 20.6 18.8 10.4 2.3 4.7 Export Duties 3 3 2.8 2.8 3.7 2.6 7.6 6.3 5.NituralResourcesTaxes 15.7 15.7 ,13.9 11.6 10.0 16.1 5.5 Timber Royalties 15.0 15.0 13.9 11.6 9.4 15.3 5.0 Taxes on Other Resources 0.7 0.7 0.0 0.0 0.6 0.8 0.5 6. Other Revenue 3.5 3.3 4.1 5.0 5.9 3.1 5.2 Busincss Licenses 0.1 0.1 0.1 0.2 0.0 0.1 0.1 Registration Fees 1.0 0.8 0.0 0.0 0.5 0.4 0.4 Other 2.4 2.5 4.0 4.8 5.3 2.6 4.7 B. Non-tax Revenue 22.1 21.2 17.0 20.3 21.6 24.4 24.6 1. State-owned Enterprises 5.2 2.3 6.2 6.1 3.5 3.2 9.9 Depreciation and Dividends 2.0 1.5 4.1 3.9 2.3 2.3 9.1 Leasing Fees 3.2 0.9 2.1 2.2 1.2 0.9 0.9 2. On-lendingofForeign Funds 8.4 5.6 3.6 5.8 11.9 4.4 1.6 interest and Capital Return 8.4 5.6 3.6 5.8 11.9 4.4 1.6 3. State Assets 8.5 13.2 7.1 8.5 6.2 16.8 13.1 Concessions 0.1 0.1 0.1 0.1 0.1 0.1 0.2 Overflight Rights 4.7 4.3 4.4 6.7 4.2 2.6 4.7 Other 3.7 8.8 2.6 1.7 1.9 14.1 8 2 Source: Government authorities and World Bank staffestimates. 8' ~ ~ ~ z Z~ w - ,vwc A8"=>OW>>~>Ooa9i~ts @>W99>t^° 2b 2 W v . > o - ~ w.o o. E< _ n<__>_ o_oo 2 bowoe g n R # ¢ C b~~~ C s ovPO_"W9O-9 _3 i 9 o - W o o o w- >ON_O _ S W.S .40 O VSC-Cx OCS o' 5 oveo<- 0 ~ N- So, C ONL., -JO 0 CC N CC C C C NJC -O -C ' 080b OOo 93S o' o ooNoio-o~9s -_ooo-vr c o C0 O C_CC > .4o_oCs °~oS° °9 >tDO_OO^O.4 W >C O N 3n i a ooNO1 = oo oeoeOCWo s OS NNO o J^ o 4i , o - CC S OC O Cf JCNo . O ~ O i I' s Noe aow-DOO<-sO. D O< O _ ._C ft -147- Table 8: Public Expenditure Plan 1995/96 to 2002/03 (shares by sector) 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 actual actual actual actual actual plan plan plan % % % % % % % % Economic Sectors 74 76 75 79 72 66 58 57 Agriculture forestry I1 13 22 13 12 23 19 18 Industry 22 17 13 4 1 5 6 7 Comminucation 40 46 40 62 56 38 33 32 RD- Eco. Sectors 0 0 0 0 1 0 0 0 Other Eco. Sectos 0 0 0 0 1 0 0 0 Social-Cultural 21 17 17 11 18 17 26 27 Education 8 8 7 5 5 7 10 10 Health 7 3 6 3 6 3 6 7 Information & Culture 1 2 1 1 3 3 4 4 Labor & Social Welf. 5 4 3 1 4 4 6 6 Offlce & Housing 3 4 2 6 8 13 6 5 Rural Development & other 3 4 6 4 7 5 10 10 TOTAL 100 100 100 100 100 100 100 100 Source: State Planning Committee -148- Table 9: PIP Expenditures, Planned and Actual - 1995/96 to 1999/00 1995/1996 1996/1997 1997/1998 1998/1999 1999/2000 Domsti 484823 7 6 7 30116 9415426 9 8025 3 0 20563 2 Forci 154 58 7 101 8 18 70 94273 7414 40 7037 10 13419 0 0 EconirdcSectrs 16 5 7412 17. 0 610 225.440 7 06 5 717 79 11.120 72.02 TOAgrcltueoety 202 205 10 1009 249 264 100 100 6 32190 100 100 64090 10010 1 57410 2170 100 100 FATeipu28r_ 2 2 21 99 4 34 1 2 135 65 1 1 08 19 1 13 27 13 2 1 9 Domeatio 73 72 30 0 289 8224 6 1 48 121 292710 102 7764 762 1 29 1574 177 1061 Domestic 30 13 99 24 24 21 8 9 27 0 72 3 816 2147 0 16 30 023 Foreign 2154221577151 1580 40392272436614 4140 1803 27108 4304 19 70 01 Foreign 73 63 31 85 66 98 37 140 104 210 36 110 272 511 56 132 882 803 47 84 Socl-Cultural 44 42 21 96 71 34 17 58 66 103 17 84 110 100 I1 64 308 314 18 94 Educafion 19 16 8894 3 121 8 62 32 42 7 71 50 46 5 66 87 89 5 95 Domestic 5 5 2 99 6 6 2 85 7 5 1 41 4 163 1 65 20 22 1 102 Foreign 14 11 57 9 25 1 5 656 25 37 6 80 36 34 4666 67 67 4 93 Health 1414 799 23 9 3 39 1934 6993 1 30 3 69 109 109 6 93 Domestic 2 3 1 128 4 4 194 4 4 154 1 8 1 69 13 13 1 93 Foreign 1 411 5299 19 6 23 28 1 9 31 5109 22 22 269 96 96 6 93 Cnfomnuation & Culture 4 3 1 868 4 5 2 8100 5 6 170 1 11 62 169 49 53 3 99 Domestic 2 2 199 3 3 1103 3 3 149 6 6 168 10 14 1 125 Foreign 2 0 023 1 1 194 1 3 0 112 5 5 1370 62 62 4 93 Labor&Social Welf 7 10 5 135 13 9 4 67 11 20 3 102 19 13 1 47 62 62 4 93 Domestic I I 088 2 2 1994 2 2 0257 3 3 0 72 5 6 0 94 Foreign 6 9 4 144 I2 8 3 63 9 15 3 110 16 10 1 43 57 57 3 93 Office&Housing 7 6 3 93 23 494 1 19 2 61 3950 69 1109 1 2 26 Domestic 6 6 399 1 0 4 94 9 9 2 57 2132 4 107 40 17 1 39 Foreign 0 0 0 0 1 0 94 1 2 0 109 1 818 271 70 19 4 11 RuralDevelopient and 6 6 3 99 10 10 4 94 20 36 6 99 40 4 1 4 73 44 126 7 266 Domestic 2 2 1 99 4 4 2 94 4 5 1 60 8 7 1 60 16 63 4 365 Foreign 4 4 2 23 5 5 2 94 15 31 5 110 32 34 4 76 28 62 4 208 Investment reserves 100 100 SouTce: CPC -149- Table 10: UN Health Goals and Status in Lao PDR UN Goals Lao PDR Status Allocate an average of 20% of ODA and 20% of the In 2000, 16% of ODA was allocated to social sectors (5% national budget to basic social programs. education, 8% public health, 4% social welfare). In 1998/99, social sectors accounted for 13% of total Govem. expenditure (education 8.4% and health 4.7%). Reduce the number of undemourished people to half their In 2000, 40 % of children were stunted and underweight, and 15% present level by 2015. were wasted. Achieve by 2005 a life expectancy at birth greater than In 2000, life expectancy at birth was 59 years (61 for females and 65, and by 2015 greater than 70. 57 for males). By 2015 achieve an infant mortality rate below 35 deaths In 2000, the infant mortality rate was 82 per 1000 live births. per 1000 live births. By 2015, achieve an under five mortality rate below 45 In 2000, the under five mortality rate was 106 per 1000 live births. deaths per 1000 births. Countries with high matemal mortality rates should In 2000, the matemal mortality rate was 530 per 100,000 live achieve rates below 125 and 75 per 100,000 live births by births. 2005 and 2015. Universal access to safe drinking water In 2000, 52% of the population had access to safe drinking water. Universal access to sanitary disposal means. In 2000, 37% of households had latrines (67% urban and 19% rural) Universal access to primary health care. In 2000, 61.5% of villages were located less than 4 km from the nearest health center; 24% were between 4-16 km, and 14% were more than 16 km. The average distance to a hospital was 26 km in the north and between 8-12 km in the south and central regions. By 2000, 90% immunization coverage for children under In 2000, only 32% of children 12-23 months had received all types one year of age and against tetanus for women of of immunization. 42% of women giving birth had received two or childbearing age. more doses of tetanus toxoid. By 2000, eradicate, eliminate or control major diseases of More than 30% of women in Lao PDR have never heard of global significance. HIV/AIDS. By 1995, reduction of 95% in measles deaths and Measles is no longer among the top 10 causes of morbidity. reduction of 90% in measles cases. By 2000, 25% reduction in diarrhea incidence rate. In 2000, 6.2% of children had diarrhea in the two weeks prior to the National Health Survey. By 2000, reduce mortality from acute respiratory In 2000, one percent of children under five had ARI two week infection in children by one-third. period prior to Health Survey. By 2000, institute anti-malaria program. In 2000, there were 1.4 million cases of malaria, resulting in 14,000 deaths. 22% of population sleep under impregnated nets. To contain the resurgence of tuberculosis. In 1999, there were 2,420 reported cases, a three-fold increase from 1995. Reproductive health care fully accessible by 2015 and In 2000, less than 30% received antenatal care from skilled "children by choice" through family planning. medical personnel. Only 20% assisted at the time of birth. Only 32% of married women used contraceptives. Virtual elimination of Vitamin A deficiency. In 2000, less than 55% of children had ever received Vitamin A. Widespread Vitamin A deficiency exacerbates susceptibility to measles and causes poor eyesight/ blindness. Reduction of iodine deficiency disorders. Two-thirds of households now use iodine salt however 65% of population still severely deficient in iodine.