41845 Lao People's Democratic Republic Private Sector and Investment Climate Assessment REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH A Joint Document of the Asian Development Bank and the World Bank @ 2007 Asian Development Bank and The International Bank for Reconstruction and Development/The World Bank This book was prepared by the staff of the Asian Development Bank and the World Bank. The views expressed in this book do not necessarily reflect the views of the Board of Directors of the Asian Development Bank and the Executive Directors of the World Bank, or the governments they represent. The Asian Development Bank and the World Bank, including the Government of the Lao People's Democratic Republic, do not guarantee the accuracy of the data included in this publication and accept no responsibility for any consequence for their use. Use of the term "country" does not imply any judgment by the authors, the Asian Development Bank, and the World Bank as to the legal or other status of any territorial entity. Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila Philippines Tel +3 2 632 4444 www.adb.org The International Bank for Reconstruction and Development/The World Bank 1818 H Street, NW Washington, DC 20433 USA Tel +1 202 473 1000 www.worldbank.org Publication Stock No. 050606 Foreword AS THE ExTENSIvE literature on the subject points out, a good investment climate ensures conducive conditions for a firm's decision to invest, create jobs, and expand--by reducing costs of production and the risks of doing business, and by creating incentives to increase productivity. It is therefore important to assess the quality of the investment climate in an economy to inform policy reform. To this end, this Investment Climate Assessment is a snapshot of the business environment and investment climate in the Lao People's Democratic Republic (Lao PDR) in 2005 that is based on perceptions and reports by firms of types, sizes, or ownership, and that identifies constraints for these firms to invest, create jobs, and expand. The knowledge and policy recommendations that the study provides would be useful to policy makers and other stakeholders who may potentially benefit from an improved investment climate in the Lao PDR, including private sector operators and poor people who are shown to benefit from opportunities that private sector entrepreneurship and employment offer. Moreover, the comparison to the neighboring countries that an Investment Climate Assessment is able to provide is useful in terms of determining of comparative advantages and binding constraints that have been overcome by the Lao PDR's neighbors. This feature of the Investment Climate Assessment will help the Lao PDR in its regional activities, including the Regional Cooperation Strategy Program of the Greater Mekong Subregion activities, as well as its ASEAN membership. The National Socio-Economic Development Plan (NSEDP) of the Government of the Lao PDR for the period of 2006­2010 has proposed an ambitious agenda to strengthen the role of the private sector to increase productivity, investment, and cross-border trade in the medium term. The Plan's strategic thinking in terms of private sector development proposes to continue strengthening the protection of property rights and the overall regulatory framework to provide a supportive environment for the growth of the private sector. Through the round table process, this study has informed the dialogue between the Government and its development partners. The dialogue between the Government and the private sector in the Lao PDR has also been developing in recent years, and this study informed this development--through a series of presentations and consultation workshops, including a feature presentation at the First Lao PDR Business Forum in May 2006. v This Investment Climate Assessment was conducted jointly by the World Bank and the Asian Development Bank. We hope that this fruitful collaboration between our institutions will continue. Ifzal Ali Ian Porter Chief Economist Country Director Asian Development Bank for South-East Asia, World Bank v Acknowledgment THIS INvESTMENT CLIMATE ASSESSMENT has been prepared by a joint team from the World Bank and the Asian Development Bank, and in close collaboration with the Committee for Planning and Investment and other government agencies. The report benefited from inputs and comments from various agencies of the Government of the Lao PDR, from the donor community, and from the country teams of the World Bank and Asian Development Bank (ADB).While preparation of this report has been through participation of all these partners, the core team that coordinated and put together the final report was led by Ajay Tandon on ADB side and Ekaterina vostroknutova on the World Bank side. The joint team included George Clarke (Senior Economist, World Bank), Gemma Estrada (ADB), Eric Suan (ADB), and Charles C. Udomsaph (World Bank).MaincontributorstospecificchapterswereMortenLarsen(Electricityand Mining), David Peters (Tourism), Francisco Quintana (Informality, Regulation, and Taxation), and Gemma Estrada (Informality). The report was peer reviewed by Albert Zeufack (Senior Economist, WB), Mary Hallward-Driemeier (Senior Economist, World Bank), and Warrick Smith (Senior Manager, International Finance Corporation [IFC]). The team has enjoyed guidance and support from (in alphabetical order) Ifzal Ali (Chief Economist, ADB), Abuzar Asra (Senior Statistician, ADB), Indermit S. Gill (Sector Manager, EASPR), Rana Hasan (Senior Economist, ADB), Patchamuthu Illangovan (Country Manager, World Bank), Homi Kharas (Sector Director, EASPR), Kazi M. Matin (Lead Economist, EASPR), James Nugent (Country Director, ADB), Bishnu D. Pant (Assistant Chief Economist, ADB), and Ian C. Porter (Country Director), and help from Amanda Carlier (World Bank), Somneuk Davading (World Bank), Mona Haddad (World Bank), Rattanatay Launglatbandith (LRM-ADB), Manfred Matzdorf (GTZ), Sengxay Phousingoa (IFC),TanatatPutthasuwan(WorldBank),andCharlesSchneider(IFC).Theteam has benefited from excellent assistance by Araceli Patricio (ADB), Chanthalath Pongmala (ADB), vatthana Singharaj (World Bank), and Rowena vicente (ADB). Special thanks are due to Indochina Research Limited in conducting the investment climate survey under the supervision of Tim Smith and Chansada Souvanlasy. The design, layout, and typesetting were carried out by Mercedita Cabañeros and Rhommell Rico. Editing was done by Deborah Davis. v The team would like to express gratitude to the Government of the Lao PDR and in particular to the Committee for Planning and Investment, Ministry of Energy and Mines, Ministry of Industry and Trade, National Statistics Center, and other government agencies for support, help, and extensive comments. vii Contents Foreword iii Acknowledgment v SummaryofFindings xvii I. BACKGROUND 1 1. Stateoftheeconomy 1 2. Structuralchange 5 3. Relatedchallenges 9 II. INVESTMENTCLIMATEANDFIRMPERFORMANCE INMANUFACTURING 12 4. Manufacturingsurvey 12 5. Investmentclimateconstraints 14 6. Infrastructure 20 7. Regulationandregulatoryuncertainty 35 8. Taxation 52 9. Macroeconomicuncertainty 59 10. Finance 60 11. Governance 68 12. Land 74 13. Firmperformanceinmanufacturing 76 III. INVESTMENTCLIMATEANDFIRMPERFORMANCE INSERVICES 79 14. Thetourismindustry 80 15. Supplyconstraints 82 16. Privatesectorconstraintsinthetourismindustry 84 17.Productivityinthetourismsector 96 IV. INFORMALECONOMY 100 18. Profileoftheinformalsector 101 19. Linksbetweentheinformalandformalsectors 105 viii 20. Keyconstraintstogrowthofmicro-firms 108 21. Poverty,investmentclimate,andtheinformaleconomy 114 V. CONCLUSIONSANDRECOMMENDATIONS 118 22. Manufacturing 118 23. Tourism 121 APPENDICES 125 Appendix1Reviewofrecentprivatesectorstudieson theLaoPeople'sDemocraticRepublic 126 Appendix2Manufacturing 131 Appendix3Governance 140 Appendix4Regulation 142 Appendix5Statisticalappendixonaccesstofinance 147 Appendix6Electricity 151 Appendix7Tourism/services 152 Appendix8Informalitysection 153 Appendix9Householdbusinesses 155 REFERENCES 159 LISTOFTABLESANDFIGURES Table2.1 Sectoraldistributionwithinmanufacturing(%ofGDP) 7 Table6.1 ElectricitytariffschargedbyEdLandprojectionsasof April2006 29 Table7.1Numberofproceduresrequiredtostartabusiness 40 Table11.1Bribetaxinpublicservicesamongcomparatorcountries 71 Table12.1Percentageoffirmswithnewinvestment 76 Table18.1Geographicaldistributionofhouseholdbusinesses 103 Table21.1Household-basedenterprisesbyexpenditurequintiles 114 SummaryFigure1 Manufacturinggrowthininternationalperspective xviii SummaryFigure2Numberoftouristarrivalsandrevenue xix SummaryFigure3 Percentoffirmsidentifyingeachinvestment climatecomponentasmajororsevereconstraints xxi SummaryFigure4 Lossesduetoinfrastructurequalityforfirms thatcomplained(%ofsales) xxii SummaryFigure5 Timetoobtainconnection,days xxii SummaryFigure6 Regulatorypolicyuncertainty xxiv x Summary Figure 7 Regulatory burden on exporters versus nonexporters xxv Summary Figure 8 Sources of financing for new investment xxvii Summary Figure 9 Median labor productivity in garment industry xxix Summary Figure 10 Median labor productivity in wood processing xxix Figure 1.1 Real GDP and sectoral growth 2 Figure 1.2 Growth with and without large projects and trade and current account balance 2 Figure 1.3 Exchange rate movements--the Lao PDR versus other Mekong countries 3 Figure 1.4 Lending rates 4 Figure 1.5 Net FDI and gross investment, (% of GDP) 5 Figure 2.1 Shares of agriculture, industry, and services in GDP 5 Figure 2.2 Lao PDR's manufacturing growth in international perspective 6 Figure 2.3 Exports composition by sector ($ million) 7 Figure 2.4 Growth rates of the value added in services 8 Figure 2.5 Number of tourist arrivals and revenue from tourism 9 Figure 4.1 Distribution of manufacturing firms in the investment climate survey, 2005 13 Figure 5.1 Main policy areas that constrain business -- Asian and transition countries comparison 15 Figure 5.2 Investment climate constraints -- Mekong and South Asia countries comparison 16 Figure 5.3 Main groups of constraints perceived by the Lao PDR firms as major or severe 17 Figure 5.4 Investment climate constraints by sector 18 Figure 5.5 Investment climate constraints by province 19 Figure 5.6 Firms that recognize constraint as major or severe, by size 20 Figure 6.1 Infrastructure as a constraint to doing business 21 Figure 6.2 Quality and efficiency of infrastructure services 22 Figure 6.3 Regional comparison of electricity as a constraint and cost 25 Figure 6.4 Causes of investors' dissatisfaction with electricity supply 26 Figure 6.5 Perception of electricity tariffs being "expensive/very expensive," by sector 26 Figure 6.6 Average electricity tariffs for industrial consumers, by consumption size 27 Figure 6.7 Average electricity tariffs for commercial consumers, by consumption size 27 x Figure 6.8 Reported dissatisfaction with quality of electricity supply 30 Figure 6.9 Reasons of dissatisfaction with quality of electricity supply 30 Figure 6.10 Regional comparisons of power interruptions per year 31 Figure 6.11 Reasons of dissatisfaction with EdL services 32 Figure 7.1 Regulatory policy uncertainty as a constraint to doing business, by province and type of firm 36 Figure 7.2 Unpredictability of regulation, by province, sector, and type of firms 36 Figure 7.3 Regulatory burden as a constraint ­ international comparisons 37 Figure 7.4 Lao PDR ranks 147th out of 155 on the ease of doing business in 2005 38 Figure 7.5 Time spent dealing with government regulations 41 Figure 7.6 The number of inspections is higher in the Lao PDR than in other countries in Southeast Asia, but lower in the People's Republic of China 41 Figure 7.7 Uncertainties in payments for firm sales 42 Figure 7.8 Approximate lead time elapsed from fabric order to destination port 43 Figure 7.9 A generic business registration procedure 45 Figure 7.10 District and provincial registration 45 Figure 7.11 Firms are most concerned with regulatory uncertainty, taxation and customs, and trade regulation--fewer firms were concerned about other specific areas of regulation 47 Figure 7.12 Most inspections were from forest, customs, and tax departments 48 Figure 7.13 ...and the same agencies, plus industry, caused the longest time spent dealing with regulators 48 Figure 7.14 The burden of regulation is greater for exporters and they are less confident about its predictability 50 Figure 7.15 The burden of regulation is greater for firms in the textile and wood processing sector than in other sectors 51 Figure 8.1 The official tax rates and taxation burden are at par with comparator countries 52 Figure 8.2 Tax revenues fell in 2003­2005 53 Figure 8.3 Tax and tax administrator by sector 54 Figure 8.4 Main tax-related obstacles 55 Figure 8.5 Tax and tax administration, exporters, and FDIs 56 Figure 8.6 Tax and tax administration, by province 56 Figure 8.7 Taxation as a constraint for SMEs and large firms 57 x Figure 10.1 Firms in the Lao PDR use internal funds to finance their short and long-term assets 62 Figure 10.2 Firm use informal sources of finance and banks to finance more of their short-term capital needs than their long-term investment needs 63 Figure 10.3 Few firms in the Lao PDR report having loans with terms of greater than 3 years 64 Figure 10.4 Nominal interest rates are relatively high in the Lao PDR-- but inflation is also high meaning that real interest rates are relatively low 64 Figure 10.5 All types of firms rely heavily upon retained earnings to finance new investment 65 Figure 10.6 Reasons for not having loans, by type of firm 67 Figure 10.7 Use of financing by province 68 Figure 11.1 Transparency international corruption perception index and perceptions of firms in investment climate surveys 69 Figure 11.2 Firms did not view corruption as an important constraint to business, but it was costly for some firms 70 Figure 11.3 Bribes are expected at an average rate among comparator countries 71 Figure 11.4 Agencies that inspect most often were also the ones most likely expect bribes or gifts during inspections 72 Figure 11.5 Inspections and gifts expected, by sector 73 Figure 11.6 Inspections and gifts expected, by province 73 Figure 12.1 Access to land as a constraint 75 Figure 14.1 Average stay ­ subregional tourism, 2004 81 Figure 14.2 Average tourist's expenditure in GMS subregion 81 Figure 15.1 Room occupancy rates by province, 2003­2004 82 Figure 16.1 Top constraints perceived by tourism firms 85 Figure 16.2 Main constraints in the tourism sector, by type 85 Figure 16.3 Electricity disruption by province 86 Figure 16.4 Electricity disruption versus occupancy rate ­ hotels/guesthouses 87 Figure 16.5 Education of top managers and value-added per worker in the tourism sector 90 Figure 16.6 Business registration and approval flow chart 93 Figure 16.7 Mean inspections per year in the tourism sector 94 Figure 16.8 Financing in the tourism sector 96 Figure 17.1 Annual value-added per worker in the tourism sector 97 Figure 17.2 Constraints and productivity in the tourism sector 97 x Figure 18.1 Distribution of household businesses by sector 102 Figure 18.2 Urban and rural household businesses 103 Figure 19.1 Subcontracting companies ­ garments 106 Figure 19.2 From informal to formal 108 Figure 20.1 Electricity tariffs, 2005 113 Figure 20.2 From residential to nonresidential tariff 113 Figure 21.1 Poverty versus household businesses, by province 115 Figure 21.2 Household business versus infrastructure, by province 116 Figure 21.3 Impact of investment climate on employment 117 LIST OF BOxES Box 3.1 Government strategies focusing on private sector development 10 Box 6.1 Strong performance in electrification 23 Box 6.2 GMS transport sector strategy 34 Box 7.1 Methodology of the doing business rankings for starting a business 38 Box 8.1 A negotiation under the contract system 58 Box 13.1 Productivity between exporters and nonexporters in the garment industry differs significantly 77 Box 16.1 Open-skies policy 88 Box 17.1 The GMS tourism sector strategy 99 Box 20.1 An experience with money lenders 110 LIST OF APPENDIx FIGURES AND TABLES Figure A.1.1 Major problems of companies, from Human Resource Development for Market Economy Survey conducted by German Development Cooperation through GTZ 128 FigureA.1.2 Percentage of firms in the Enterprise Baseline Survey rating issue as "very serious" or "big" 129 Figure A.1.3 Problems with "fees and regulations" 129 Figure A.3.1 The size of bribes ­ measurement differences due to response type 141 TableA.2.1 Profile of manufacturing firms 135 Table A.2.2 Production function estimation 136 Table A.2.3 Statistical annex to productivity in manufacturing 138 Table A.2.4 Investment incidence and propensity by type, region, and sector 139 x Table A.4.1 Impact of inspections on time spent dealing with government regulations 145 Table A.4.2 Regression results 146 TableA.5.1 Effect of firm characteristics on access to credit 150 Table A.6.1 ICS results ­ electricity 151 Table A.7.1 Tourist arrivals in the Lao PDR by region of origin, 1998­2004 152 Table A.7.2 Revenue from tourism by origin, 2004 152 Table A.8.1 Selected characteristics of nonfarm household-based enterprises 153 Table A.9.1 Impact of investment climate on proportion of household businesses at the village level 157 Table A.9.2 Simulations on impact of investment climate 158 xv Currency Equivalents (as of 20 January 2006) US$1 = 10,800 Lao Kip (KN) Note: In this report, "$" refers to US dollars. Abbreviations and Acronyms ACMECS Ayeyawaddy-Chao Phraya Mekong Economic Cooperation Strategy ADB Asian Development Bank ADF Asian Development Fund AFTA ASEAN of Free Trade Area APB Agricultural Promotion Bank ASEAN Association of Southeast Asian Nations BAO BangkokArea Office BCEL Banque pour le Commerce Extérieur Lao BOL Bank of Lao PDR CEM Country Economic Memorandum CMT cut, make, and trim DMC developing member country DTIS Diagnostic Trade Integration Study DTO District Tax Office EACTF EastAsia Countries Thailand Field Office EASMAT East Asia Multidisciplinary Advisory Team EASPR EastAsia and Pacific Region EBS Enterprise Baseline Survey EdL Electricité du Laos FDI foreign direct investment FOB free-on-board FOF foreign-owned firms GDP gross domestic product GDS Global Development Solutions GMS Greater Mekong Subregion GOL Government of Lao People's Democratic Republic GSP general system of preferences GTZ German Agency for Technical Cooperation xv HBE household-based enterprise HRDME Human Resource Development for Market Economy ICA Investment Climate Assessment ICS Investment Climate Survey IFC International Finance Corporation IFS International Financial Statistics ILO International Labour Organization IMF International Monetary Fund IQR interquartile range LAOPA Lao PDR Poverty Assessment LATA Lao Association of Travel Agents LECS Lao Expenditure and Consumption Survey LDB Lao Development Bank LDC least developed country LECS Lao Expenditure and Consumption Survey LHRA Lao Hotel and Restaurant Association LIC low-income country LICUS low-income country under stress LNTA Lao National Tourism Administration MIH Ministry of Industry and Handicraft MOIC Ministry of Information and Commerce MOIC Ministry of Industry and Commerce MPSDF Mekong Private Sector Development Facility MTCPC Ministry of Communication, Transportation, Post, and Construction MW megawatt NEM New Economic Mechanism NSEDP National Socio-Economic Development Plan NGPES National Growth and Poverty Eradication Strategy NLMA National Land Management Agency NSC National Statistical Center NTDS National Tourism Development Strategy NTO National Tax Office PDR People's Democratic Republic PSD Private Sector Development SFA­TFI Strategic Framework for Action on Trade Facilitation and Investment SIDA Swedish International Development Association SMEs Small and Medium Enterprises SMEPDO Small and Medium Enterprise Promotion and Development Office xv SNv Stichting Nederlandse vrijwilligers (Netherlands Development Organization) SOE State-Owned Enterprise PRSO2 Second Poverty Reduction Support Operation TEPCO Tokyo Electric Power Company UNESCO United Nations Educational, Scientific, and Cultural Organisation UNIDO United Nations International Development Organization vIS value information system SUMMARY OF FINDINGS xv Summary of Findings A good inveStment climate ensures conducive conditions for a firm's decision to invest, create jobs, and expand--by reducing costs of production and the risks of doing business, and by creating incentives to increase productivity. A country's investment climate thus covers a number of key elements such as: the degree of macroeconomic (un)certainty; the quality and accessibility of infrastructure; the extent of government regulation; the nature of taxation; the access to and cost of financing for firms; access to, cost, and quality of the factors of production; the degree to which the government creates a level playing field for firms; governance and corruption; and security. theWorldBankandAsiandevelopmentBank(AdB),incollaborationwith thegovernmentoftheLaoPeople'sdemocraticRepublic(LaoPdR),undertook jointlyaninvestmentClimateAssessment(iCA)basedonaninvestmentClimate Survey(iCS)carriedoutin2005. The survey covered 303 firms in six sectors and seven provinces (vientiane City, Oudomxay, Luang Prabang, Luangnamtha, Xayaboury, Savannakhet, and Champassack). The survey included 246 firms in manufacturing covering wood processing, construction materials, garments, textiles/handicraft, and food and beverage sectors and 57 firms in tourism covering hotels, tour operators, and travel agencies. With the exception of the garment and wood processing sectors, which traditionally have larger firms and more foreign investment, most firms in the sample were domestic small and medium enterprises (SMEs). thesurveyprovidedthreetypesofinformationusefulfortheinvestment ClimateAssessment:perceptions of firms operating in the Lao PDR regarding the relative importance of investment climate constraints to their businesses; quantitativedataonfirms'performanceandproductivity;andcomparatorcountry information from their ICAs, for benchmarking the Lao PDR's investment climate against regional standards. This ICA report provides a detailed discussion of the investment climate issues, and this Summary provides an overview of the main findings and lessons.1 1All figures in the executive summary are from the main Investment Climate Assessment (ICA) report. xv REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH The Lao PDR has already shown impressive growth, but more attention is needed to harness the full potential of the private sector in sustaining strong growth and reducing poverty theadoptionoftheneweconomicmechanismbytheLaoPdRgovernment in1986pavedthewayforeconomicreformsandhigherpublicinvestment.The reforms included the removal of price controls, withdrawal of the Government's monopolyontrade,andreductioninthenumberofstate-ownedenterprises(SOEs), and increased private participation, as well as the expansion of infrastructure and schools. As a result of these reforms and public investment, the country achieved an impressive record of high economic growth, averaging more than 6% per year since the 1990s, with the incidence of poverty falling from 47% in 1992/1993 to 33% in 2002/2003. In addition, the country witnessed rising foreign direct investment (FDI), which in 2004­2005 was estimated at more than 10% of gross domestic product (GDP), with the private sector becoming more important than SOEs in the strong growth of both exports and total investment. inthelastfewyears,industryandserviceshavegrownrapidly,crowding out agriculture's share of gdP. Manufacturing has grown significantly since 1989: its share in GDP rose from below 10% to almost 20% by 2004 (see Summary Figure 1). value-added in the services sector expanded at an average rate of 6% since 2000, and by 2004 the sector's contribution was about 15% of Summary Figure 1 Manufacturing growth in international perspective 40 PRC 35 THA sector 30 MAL 25 INO 2003 20 CAMVIE PHI LAO 1989­2003 15 manufacturing GDP in of 10 KGZ share 5 MON % 0 6.0 7.0 8.0 9.0 10.0 11.0 Natural logarithm of real GDP per capita, 2003 Notes: Calculations based on the data from the World Development Indicators, World Bank. CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam SUMMARY OF FINDINGS xx GDP. Most of the growth in services has come from transportation and trade, including tourism (see Summary Figure 2). Summary Figure 2 Number of tourist arrivals and revenue (right axis) 1,000,000 160 900,000 140 800,000 120 700,000 600,000 100 500,000 80 400,000 60 300,000 40 200,000 100,000 20 0 0 1993 94 95 96 97 98 99 2000 01 02 03 04 05 (Est.) Number of tourist arrivals Revenue from tourim ($ mn) Source: National Tourism Authority. theLaoPdR'smanufacturingsectorandtourismexpandedrapidlyinthe 1990s,andcollectivelyemploysaround122,000workers.The small and micro enterprisesdominatethemanufacturingsector,with23,000firmseachemploying lessthan10employees,andthreequartersofthem,employingonly1­2employees. Another 542 firms employ anywhere between 10 and 99 people, and 116 firms employ more than 100 people each, most of them being foreign-owned garment firms. This predominance of small enterprises in the manufacturing sector2 is good for employment, but not so good for capital accumulation and productivity growth. Food and beverage, garments, wood processing, and construction materials are the three largest manufacturing subsectors in the Lao PDR, with garments and wood processing representing the largest manufacturing exports. thetourismsectorintheLaoPdRhasgrownatanannualrateof24% since 1993. It employs around 22,000 workers to look after 800,000 foreign tourists a year (2005), with 70% of them from neighboring countries, i.e., Thailand, People's Republic of China, viet Nam, and Japan. theLaoPdRiscommittedtocontinuingintegrationwiththeregionand theworldasalsotoprivatesectordevelopmentandexportgrowth.Its existing commitments under the Association of Southeast Asian Nations (ASEAN) and the Greater Mekong Subregion (GMS) will make the country increasingly open 2 See World Bank, 2004a. xx REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH regionally and its planned accession to the WTO will do so globally. This means that production of goods and services for the domestic market will have to be just as competitive as that for the export markets. The recent Sixth National Socio- Economic Development Plan (NSEDP 2006­2010) commits it to promoting the private sector and exports as a means of achieving the objectives of the Plan. Thus expanding private sector investment and productivity has an urgency in the Government's agenda. maintaining robust growth in manufacturing and tourism will be the keytoensuringsustainedstronggrowthandrapidreductioninpovertyover themediumterm.This growth can be achieved by increasing productivity and enhancing the ability of private firms to compete effectively in an increasingly more open domestic and regional market. Exploiting the full potential of the private sector to invest, expand, create jobs, and increase productivity will be key to achieving and maintaining growth in manufacturing and services in the Lao PDR. Agriculture and agro-processing will remain important not only for meeting domestic demand but also for exports to a rapidly growing region. This will require a better understanding of the barriers to the growth and productivity of firms in these sectors, including policies to address the constraints identified by the surveyed firms, in order to improve the investment climate. The ICS enterprises shows that manufacturing and tourism firms continue to face significant constraints to investment, productivity, and growth, and these havetobeaddressed. Thethreedominantconstraintsidentifiedbymanufacturing firms are infrastructure, regulations, and taxation (Summary Figure 3); next in importance are macroeconomic uncertainty and financing. Governance and skills/land come after that. However, the survey indicated that firms in tourism-- unlike in other sectors--highlight inadequate skills and education of workers to be the most important impediment to doing business in their sector. Skills/ education was ranked among the top three constraints by tourism firms, along with infrastructure and taxation. Macroeconomic uncertainty and regulatory burden came after those constraints. infrastructureandregulationsaretwoofthetopthreeconstraintsforall manufacturing subsectors that were surveyed, as for all provinces surveyed, exceptLuangprabang. On regulatory burden, the survey also shows that large firms,exportingfirms,andforeign-ownedonesthatalsohavehigherproductivity, are being affected disproportionately more than others; this may be because they have to compete with more efficient firms and thus feel the burden of uncertainty about regulations more acutely. It also means that alleviating regulatory uncertainty will generate greater increases in investment and productivity. SUMMARY OF FINDINGS xx Summary Figure 3 Percent of firms identifying each investment climate component as major or severe constraints 60 50 40 30 establishments 20 all %10 0 Infra- Regulation Tax Macro- Finance Skills/ Governance Others structure economic land uncertainty Source: Lao PDR ICS, 2005. Notwithstanding recent growth, firms in all manufacturing sectors identified poor infrastructure, cumbersome regulations, and discretionary taxation as three most important constraints to investment and productivity growth, macroeconomic uncertainty, and lack of affordable finance came next Quality of and access to infrastructure services are inadequate, imposing high fixed costs, which are especially harmful to small and informal firms More than 50% of firms found the quality of infrastructure services to be a major or severe constraint. Indeed, the quality of infrastructure such as electricityiswellbelowtheregionalaverage.An average firm that used each of the services was estimated to lose up to 5.5% of sales due to poor transport infrastructure, 3.9% due to poor transport services, 4.3% due to poor electricity, 1.6% due to water supply problems, and 1.8% due to poor telephone services (see Summary Figure 4). More than 30 days were required to obtain an electricity connection or a mainline telephone connection, and almost 20 days were needed on average to obtain a water connection. This was longer than in any comparator country, including Cambodia, Thailand, viet Nam, and other Asian countries (see Summary Figure 5). Fixed costs of switching to an industrial/commercial distribution network nearly tripled the electricity bill for informal small firms (small consumers), while it "only" doubled for larger ones. xx REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Summary Figure 4 Losses due to infrastructure quality for firms that complained (% of sales) 6 5 4 3 2 1 0 Water Mainline Transport Power Transport supply telephone services infrastructure service Source: Lao PDR ICS, 2005. Summary Figure 5 Time to obtain connection, days 40 35 30 25 20 15 10 5 0 LAO THA VIE MAL INO MON KGZ CAM PHI PRC Time to obtain electricity connection (days) Time to obtain water connection (days) Time to obtain mainline telephone Note: CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Source: Lao PDR ICS, 2005. Firms cited high tariffs for electricity--combined with a low quality of supply--as an important constraint. Most firms surveyed found tariffs to be "expensive" or "very expensive." This is surprising, since the Lao PDR has one of the lowest tariffs for industrial and commercial consumers in the region. The dissatisfaction appears to be rooted in exceptionally low traditional tariff rates, the absence of cost incentives for energy management and efficiency, and poor SUMMARY OF FINDINGS xx consumer information. In addition, power interruptions were more frequent in the Lao PDR than in any other comparator country except viet Nam and the Kyrgyz Republic. Losses due to these interruptions were second only to losses experienced by firms in the Philippines. This will require special attention to the generation and transmission of power for domestic use, in particular to ensure that the Government's current strategy of exporting hydropower does not detract from meeting the country's domestic needs efficiently. Firms that cited transportation as a major or severe constraint had lower value added and experienced higher lead times Firmsthatcitedtransportationasamajororsevereconstrainthadlower valueaddedandexperiencedhigherleadtimes.Firms that complained about transportation had lower value added (by 6.3%) due to transportation problems and poor access to markets, which was almost double of costs incurred by firms that did not complain. Firms that cited transport as a severe problem also had longer lead times (27 against 22 days) and higher transportation expenditures (36% higher) than those that did not complain. Firms in Champassak, Oudomxay, and Luangprabang are most affected by inadequate road conditions. This suggests that more investments in roads and in transport services are needed, notwithstanding the very significant public investments in roads that took place between 1995 and 2004. Restrictive and cumbersome regulations hamper enterprises and introduce yet other unnecessary fixed costs to starting and doing business. These resources are not collected by the Government but wasted thedoingBusinessdatabasefoundthattheLaoPdRhadahighnumber of procedures required to start a business and, more importantly, a significantly longtimetocompletethem. Since registration of business is required before connection to infrastructure networks (such as electricity) can be obtained, lengthy and cumbersome start-up procedures create even tighter bottlenecks for business development. Discretion given to officials of the regulatory bodies, and especially tax authorities, adds to the unnecessary fixed costs of doing business and forces firms to stay informal Firms place regulatory uncertainty--i.e., inconsistent interpretations of lawsandregulations--highonthelistofmajororsevereconstraintstotheir businesses (see Summary Figure 6). Almost 30% of firms, and nearly half of firms in Champassack, complained about regulatory policy uncertainty being a xxv REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH severe constraint to their business. In addition, on average, firms spent about 5% of their time dealing with officials, with firms in textiles spending more than 6% of their time. Summary Figure 6 Regulatory policy uncertainty % of firms identifying regulatory policy uncertainty as "major" or "severe" obstacle 60 50 40 firms 30 of % 20 10 0 INO MON CAM PRC KGZ PHI LAO THA MAL VIE Country Note: CAM=Cambodia, INO=Indonesia, KGZ=Kygryz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Source: Investment climate surveys. Garment industry firms and exporters in general reported the highest burden of regulations, especially customs regulations, while firms located in Champassackfeltespeciallyburdenedbyunpredictableregulations.Textilefirms reported higher "time tax," i.e., time spent with regulators. Wood-processing firms have more inspections (averaging 26 times a year) due to inspections by the Forestry Department in addition to several other agencies. Firms that exported felt more burdened by regulations than other firms (Summary Figure 7). This has important policy implications for the Lao PDR since its Sixth NSEDPemphasizes rapid export growth as a key driver of overall growth, and reducing regulations maybe a least-cost way of promoting that objective. the doing Business database, using a different methodology, also reconfirms that the Lao PDR has a high number of procedures to start a business and, more importantly, takes a significantly long time to complete them. Since registration of business is required before connection to infrastructure networks (such as electricity) can be obtained, lengthy and cumbersome start-up procedures create even tighter bottlenecks for business development. This may account for the relatively low number of private firms that operate in the country. SUMMARY OF FINDINGS xxv Summary Figure 7 Regulatory burden on exporters versus nonexporters Time spent 3.6 with regulators 4.9 Customs 3.8 inspections 5.6 Total 13.0 inspections 29.1 0 10 20 30 Number of inspections/percent of time with regulators Exporter Nonexporter Source: Lao PDR ICS, 2005. More than 20% of firms cited tax or tax administration as a major or severe obstacle--higher than the proportion of firms in Cambodia and Viet Nam. Tax rates in the Lao PDR are not excessively high by international standards, and yet the most important issue on taxation for Lao firms is the perception of high rates and discretionary application of existing rates by tax authorities. Smes were particularly burdened by the prevalent tax rates and their discretionary application compared to larger firms. While small and large firms agree on the ranking of constraints, they assess taxation and perceive tax administration differently. This suggests the existence of an informal economy that consists mainly of microfirms and firms that pretend to be small. The main concern of firms appears to stem from the "contract" system of taxation which generally involves an arbitrary negotiation between the tax officers and entrepreneurs. Most firms engage in negotiation with tax officers, leading to the unequal application of the tax rates and rent-seeking behavior by tax officers, in part because of inadequate transparency of tax rules and regulations and in part because of inadequate training of tax officials. Owing to the nature of the contract taxation system, the inadequacy of the accountingsystem,andcumbersomeregulations,businessesstayinformalor partlyinformal. Evidence suggests that firms are inclined to register themselves as small at the district level where regulations are less restrictive. For example, theTax Office has reported a sharp decrease in the number of registered medium- xxv REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH sized firms in the past 3 years, which suggests intended misclassifications. This and other related inefficiencies have contributed to losses in tax collections: tax revenues have stagnated as percent of GDP in recent years. Yet, enforcement of the existing system without reform may not lead to an increase in tax collection but to more informality. inspectionsaremorecommonintheLaoPdRthaninmostcomparator countries.Firms that were inspected more often spent a longer time dealing with government authorities and were also more likely to pay bribes. Most inspections came from the Forest, Customs, and Tax departments, and these agencies--plus the economic police--were among those most frequently expecting informal payments. For example, 56% of firms said that a bribe was expected for getting an import or export license, and more than 30% of firms said that a payment was expected by a tax official. Yet only 9% of firms cited corruption as a major or severe constraint, notwithstanding high regulatory uncertainty, considerable officials' discretion and frequent inspections. This share of firms is also significantly less than what was found in the PRC, though Transparency International assessed levels of corruption to be similar in the PRC and the Lao PDR in 2005.3 The estimated "bribe-tax" is also similar in both countries. More work is clearly necessary to understand these apparent inconsistencies among different sources. Once a business is operating, other factors constrain its growth and potential productivity and performance Financial services are scarce and inaccessible, especially for small and informal firms The financial sector is underdeveloped in the Lao PDR, and 25% of firms rank access to or cost of finance as a major constraint to their business. Thirty- three percent of firms in the garment sector think that finance is the single most important constraint to their business. Firmsofallsizes,locations,andindustriesrelyoverwhelminglyoninternal funds for financing, as informal funds are prohibitively expensive. Only 10% of firmshaveoverdraftfacilitiesfrombanks,comparedto71%offirmsinMalaysia, 44% of firms in Viet Nam, and 19% of firms in Indonesia. Lao firms, therefore, rely heavily on retained earnings or own funds to finance their new investments 3 PRC's ranking in the Corruption Perception Index in 2005 was 78 and Lao PDR's, 77, with scores of 3.2 and 3.3 correspondingly (higher index indicates lower perceptions of corruption). SUMMARY OF FINDINGS xxv Summary Figure 8 Sources of financing for new investment KYR NEP PHI MON MAL INO VIE CAM PRC LAO 0 25 50 75 100 % of financing for new agency internal funds Banks informal sources Nonbank formal Note: CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, NEP=Nepal, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Source: Investment climate surveys. (see Summary Figure 8). Few firms have long-term loans, and only 9% of the loans have maturities of more than 3 years. Access to finance is significantly better for larger firms vis-a-vis SMEs. Larger firms in the Lao PDR are more likely: to have a loan, to have an overdraft facility, to finance more new investment, to have working capital through bank financing, and to have longer-term loans than smaller enterprises. Due to these investment climate drawbacks, firms bear additional fixed costs and their performance is lower than in comparator countries investmentclimateconstraintshavedirectlyreducedtheperformanceand productivityoffirms.4Forexample,infrastructurefailureshavebeencostly:every 10 hours of power outages was associated with a 3% and a 7% lower value-added for the food and beverages sector as well as for the construction materials sector, respectively. Overall, firms incurred substantial costs, up to 5% of sales, due to infrastructure bottlenecks (see Summary Figure 4). Some investment climate constraints may impact firms of various types and locations differently. There were significant differences in productivity among different types of firms. Small firms were less productive and more 4 Productivity here being defined as value added per worker. xxv REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH capital intensive, even though they had the least access to capital. Exporters were more productive than non-exporters. Firms in Luangprabang and Savannakhet had higher productivity than those in Oudomxay. Firms in garments and wood processing were the most productive in the Lao PDR, in part due to greater foreign investment and thus access to better technology and management. Their productivity was, however, also more adversely affected by the unpredictability of regulations. Lack of backward linkages, burdensome regulations, limited access to finance, and a passive marketing approach were the main impediments to competitiveness of firms in the garment industry. In the manufacturing sector, more productive firms complained the most about the following key investment climate constraints: finance, infrastructure, regulation,andmacroeconomicuncertainty.Among these, finance was the most significant constraint for high-productivity firms. Firms that complained more about less important constraints, such as labor and land, had lower productivity than others. Firms that complained about taxation and governance had the same levels of productivity, suggesting that these constraints impact efficient and inefficient firms in the same way, or impose only fixed costs. LaborproductivityislowintheLaoPdRbyinternationalandregional standards. This is true even in garments and wood processing, which generally has higher labor productivity than other sectors in the Lao PDR. As measured by value-added per worker, labor productivity in garments is only just above that of Cambodia (see Summary Figure 9); and in wood processing, it is only marginally above that of viet Nam (see Summary Figure 10). Productivity in other sectors is at the bottom among comparator countries In services, tourism firms'productivity is reduced by the same constraints as in manufacturing, except that the tourism sector also is much more affected by inadequate numbers of skilled workers inthetourismsector,thecriticalconstraintstodoingbusinessareskills andeducationofworkers,andtransportation. These constraints are in addition to the constraints that firms in the manufacturing sector identified; i.e. electricity, regulation, and taxation, followed by macroeconomic uncertainty and finance. Tourism firms in the Lao PDR performed worse than those in Thailand. Significant differences exist between the impact of investment climate on the productivity of firms in manufacturing and in tourism. Foreign and domestic firmsinthemanufacturingsectordonotsignificantlydifferinproductivitylevels, suggesting similar investment climate constraints for both groups. Foreign firms SUMMARY OF FINDINGS xxx in tourism, on the contrary, have much higher productivity than domestic firms, possibly due to better access to skilled labor and better external networks. The services sector as a whole has a large informal component... In a small separate survey, informal and microfirms complained mostly about the lack of affordable finance, and said that they stayed informal due to discretionary taxation, regulations, and fixed costs imposed by inadequate infrastructure Summary Figure 9 Median labor productivity in garment industry MAL THA TAP INO PHI VIE LAO CAM $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 $9,000 Note: CAM=Cambodia; INO=Indonesia; LAO=Lao People's Democratic Republic; MAL=Malaysia; PHI=Philippines; THA=Thailand; TAP=Taipei,China; VIE=Viet Nam Source: Investment climate surveys. Summary Figure 10 Median labor productivity in wood processing THA INO LAO VIE $0 $500 $1,500 $2,000 $2,500 $3,000 $3,500 $4,000 $4,5000 Note: INO=Indonesia, LAO=Lao People's Democratic Republic, THA=Thailand, VIE=Viet Nam Source: Investment climate surveys. xxx REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH informalityisagrowingandlargelyunexploredphenomenonintheLao PdR.Broadly defined as household businesses and microfirms that may or may not be registered, the informal sector in the Lao PDR is large. More than 60% of urban firms are microenterprises.5 In 2002/2003, nonagricultural income- generating activities of households accounted for 16% of total employment, up from 12% in 1996. The number of households engaged in non-farm activities has also grown from 40% to 60% in the last 5 years; during the same period, the number of households that hired labor grew from 7% to 21%.6 the majority of household and microbusinesses are in service sectors (wholesale/retailtrade,community,socialandpersonalservices,andtourism services),andonly16%areinmanufacturing.Informal household enterprises are more likely to be located in urban areas, to have been in operation for less than 5 years, and to be operated from home. The informal sector serves as a backward linkage in the formal sector's supply chain, providing materials and unskilled labor. The supply chains of the formal sector are seriously constrained by the lack of capacity in informal suppliers. Microfirms often fail to meet the quality standards set by bigger formal sector firms, resulting in a number of unsuccessful experiences reported by firms. The surveyed microfirms mentioned access to financing as the most important constraint. Almost none of the surveyed entrepreneurs had ever considered borrowing from a commercial bank, and relied on retained earnings and relatives for finance. Indeed, richer households operated more household- based enterprises (82% of the highest quintile) than poor households (only 2%). Other important constraints to informal firms were cumbersome regulations and complicated,discretionarytaxation.Most surveyed microfirms reported that they remained small to avoid taxation. Businesses were far more likely to thrive in areas with a good investment climate. Simulations indicate that addressing the constraints in areas with poor investment climate--those lacking access to infrastructure, financing facilities, and markets--could lead to a significant increase in the number of microenterprises, generating widespread employment opportunities. Since areas with a poor investment climate also tend to have higher poverty rates, improvements in the investment climate are likely to have important implications for poverty reduction. 5 See Ministry of Industry and Handicraft­German Agency for Technical Cooperation (MIH-GTZ, 1996). SMEs in the Lao PDR: The Results of a National Survey. Lao-German Small Enterprise Development Project. 6 These results are based on the Lao PDR Expenditure and Consumption Survey III database (2002/2003). SUMMARY OF FINDINGS xxx The actions that would help firms move from the informal to the formal sector, and to increase productivity, stem from the observations above Improve infrastructure that is important for business: · Improve the quality of service and reliability of electricity provision, the latter especially during the rainy season and in the North. Review Electricité du Laos' (EdL's) tariff structure with respect to micro and household businesses to minimize the large tariff distortion between residential and commercial consumers. Use an information campaign to inform users about tariff changes. · Improve road transportation and cross-border transportation, to broaden access to local and neighboring country markets. Encourage private investment in trucking services and inland dry ports to facilitate cross- border trade and transportation. · To promote tourism, pursue an "open skies policy" so that direct air links with countries outside the region--particularly Europe, Japan, and the United States (US)--can be started easily. Establishing joint-venture activities for Lao Airlines would increase the airline's resources, help upgrade its fleet, and enhance management. Reduce unnecessary government regulation: · Move from a licensing to a registration principle with regard to starting a business. Hasten approval of the implementing decrees for the new Enterprise Law approved in 2005. Investment laws and incentives should be made public and easily available. · The number of obligatory procedures for starting a business should be reduced, especially line ministry licenses in most sectors; and company seal requirements should be simplified or removed. Re-registration procedures could also be simplified. · Rationalize inspections, eliminate those that are unnecessary, and carry out others no more than twice a year. Make the aims of inspectors transparent, and pre-identify criteria for inspections to reduce opportunities for rent- seeking. · Reduce the large number of approvals and signatures required for exports. Streamline customs procedures. · Support ongoing efforts to harmonize cross-border regulations through subregional cooperation in the GMS to facilitate trade and investment. xxx · Introduce GMS visas. Streamline the process for obtaining tourist visas, with opportunities of renewal outside vientiane. · Promote foreign and regional cross-border investments into manufacturing (including agro-processing) and services as they can transfer technology and good management practices and contribute to higher productivity in the relevant subsector. Reduce discretion in the taxation system and improve administration: · Amend the policy on annual registration for tax purposes, extending the validity of registration for medium and large firms. · Simplify tax procedures. The current contract system should be replaced with a nondiscretionary system. Increasing the number and capacity of tax officers is also important, while eliminating their discretion to determine tax payments. · Simplifycustomsregulationsandmakethemmoretransparent.Unnecessary discretion in import and export licensing procedures should be removed. Maintain macroeconomic stability and reduce uncertainty: · Promote a productive public­private dialogue and provide capacity building to industry associations, to enable them to play a more active role in shaping public policy. Widen opportunities to access formal sources of financing: · Continue efforts to reform, restructure, and recapitalize the banking system, together with substantial improvements in corporate governance and technical training. Encouraging the entry of foreign banks can provide expertise and much-needed financing: for example, by leveling the playing field between state-owned commercial banks and private banks, and by encouraging strategic investors to partner with state banks. · Review the banks' lending procedures to simplify the application process and foster the creation of commercial-based lending criteria, to ease financing for private companies with viable investment projects. · To support the expansion of micro and small household businesses and firms, and encourage the growth of microfinance institutions. xxx Undertake steps to improve the skills and education of workers to ensure a steady supply of well-qualified staff in the tourism industry: · Strengthen vocational training for tourism workers. Develop a training institute for the tourism industry, drawing on regional or international examples such as the Dusit Thani School in Thailand. For example, encourage a joint-venture hotel school with initial support of the National Tourism Authority. BACKGROUND I. BACKGROUND 1. Stateoftheeconomy The Lao People's Democratic Republic (Lao PDR) is a small transition economy in which the private sector plays an unusually important role in the gross domestic product (GDP). The Lao PDR is landlocked in the middle of the Greater Mekong Subregion (GMS). It is a one-party state led by the Lao People's Revolutionary Party. With an estimated per capita income of $390 in 2004, the Lao PDR is one of the poorest countries in Asia. From 1975 to the late 1980s, the Lao PDR had a centrally planned economy. In 1986, however, the Government introduced the New Economic Mechanism, ushering in a transition from a centrally planned to a more market-oriented economy. This entailed a gradual removal of price controls; abandonment of socialist cooperative farming; unification of the exchange rate system; removal of the Government's monopoly on trade; reduction in the number of state enterprises; and free establishment of private firms. Currently, the private sector accounts for more than 80% of GDP. Since the end of the 1980s and building on these reforms, the Lao PDR has established an impressive track record in sustaining high economic growth. In the 1990s, despite the challenges of transition and the sharp reduction in growth during the regional crisis of 1997 to 1999, real GDP grew at an annual average rate of 6.3%. Exports8 grew an average of 15% per year over the same period. All sectors grew rapidly--with industry growing the fastest albeit from a low base (Figure 1.1). The share of agriculture in GDP has fallen from more than 60% in 1987 to below 50% in 2002. However, this impressive growth has been in major part due to the large mining and hydropower projects (see Figure 1.2), and thus attention to nonmining sectors of economy is considered one of the main priorities of the Government at this time. 7 The World Bank classifies the Lao PDR as a low-income country (LIC) and as a low- income country under stress (LICUS). For the Asian Development Bank (ADB), Lao PDR is classified as a developing member country (DMC) with very low per capita gross national product (GNP) and limited debt repayment capacity, fully eligible for concessional Asian Development Fund assistance. Under United Nations classification, the Lao PDR is considered a least developed country (LDC). 8 In US dollar terms. REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 1.1 Real GDP and sectoral growth 35 30 25 20 15 10 5 0 1988 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 -5 Agriculture Industry Services GDP Source: World Development Indicators online. Figure 1.2 Growth with and without large projects and current account balance 9 40.0 -6 -7 8 35.0 7.0 7.1 30.0 -8 7 -9 6.1 6.4 25.0 -10 6 5.8 5.8 20.0 -11 6.1 -12 5 5.8 5.8 15.0 10.0 -13 4 4.8 -14 4.2 4.2 5.0 -15 3 0.0 -16 2001 02 03 04 05 06 2001 02 03 04 05 With NT2 and key mining projects Exports, % GDP Without NT2 and key mining projects Imports, % GDP Current account balance, including transfers, % GDP, right axis Sources: International Monetary Fund (IMF) and World Bank (WB) staff estimates, See Lao PDR Economic Monitor (WB), various issues. Economic growth, improved infrastructure, and the structural change have been the main drivers in reducing poverty in the Lao PDR. The Lao PDR PovertyAssessment (LAOPA) showed that improvements in the investment climatehavehadasignificantpositiveimpactonhouseholdbusinesses.According to the LAOPA, a significant decline in poverty has been achieved during the last decade; using the Lao PDR's national poverty line,9 the incidence of poverty fell from 46% in 1992/1993 to around 33.5% in 2002/2003. 9 While derived in a complex way, it is approximately equal to $1.5 a day in 2003 prices. See Lao Poverty Assessment, 2006. BACKGROUND Recent growth has been supported by broadly stable macroeconomic conditions, especially since the country's recovery from the aftermath of the Asian financial crisis. Inflation has been brought back to single digits, with the period average of the consumer price index falling from 15.5% in 2003 to 7.2% in 2005.The kip exchange rate has stayed in a very narrow band, and the Bank of Lao PDR (BOL) has maintained monetary stability. In line with the experience of other countries in the region, the kip gradually depreciated until 2005. It should be recalled that the value of the kip deteriorated sharply during the Asian financial crisis (Figure 1.3). While a high dollarization10 of the economy helps maintain some degree of financial stability, currency mismatches at the firm level render firms vulnerable to exchange rate shocks. This fact, and the psychological aftermath of theAsian financial crisis, may be the reasons behind the perception of firms regarding macroeconomic uncertainty. The same risks are likely to be present in the financial system. Figure 1.3 Exchange rate movements--the Lao PDR versus other Mekong countries 100 LAO rate 80 60 exchange in 40 THA 20 CAM change VIE % 0 1996 97 98 99 2000 01 02 03 04 Note: CAM=Cambodia, LAO=Lao People's Democratic Republic, THA=Thailand, VIE=Viet Nam Source: IMF, 2005. The cost of borrowing in the Lao PDR is high. Lending rates are significantly higher than those in Thailand (Figure 1.4). The ratio of M2 to GDP is only 18%. The entire banking system has only about $500 million in assets (which amounts to 23% of GDP) and $250 million of loans (11% of GDP). Efforts are underway to reform the banking sector to reduce entry barriers and promote the expansion of private banks. The draft amendment to the Presidential Decree on Commercial Banks submitted to the National Assembly is aimed at 10The share of foreign currency deposits in M2 exceeds 70%, up from 35% in 1995 (IMF 2004). Anecdotal evidence also suggests that barter may be used for up to 80% of all economic transactions. REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH partially removing the restrictions for foreign banks to set up branches outside Vientiane. Encouraging the entry of private banks is expected to foster greater competition in the banking system and help widen access to financing. Figure 1.4 Lending rates (%) 35 Lao PDR Thailand 30 LAO 25 20 15 10 THA 5 0 1995 96 97 98 99 2000 01 02 03 04 Note: Rates are the highest rates charged by commercial banks to loans to private customers. LAO=Lao People's Democratic Republic, THA=Thailand Source: International Financial Statistics, Dec 2005. Foreign direct investment (FDI) has grown rapidly, but this has mainly been due to large mining projects. Mining-related FDI is expected to continue to grow rapidly in the coming years. Increasing both private domestic and foreign investments has been a key issue in the Lao PDR. While gross capital formation as a share of GDP in the late 1990s was higher in the Lao PDR than in other Mekong countries, in recent years the position of the Lao PDR has deteriorated (Figure 1.5). In 2003­2004, among the largest recipients of both domestic and foreign investment projects in the Lao PDR were the power, tourism, construction, and mining sectors. Some estimates suggest that private investments, in large projects constitute 35% of total investments; other private investments, about 40%; and Government investments, about 25%. Due to investments in large projects, some estimates of FDI are as optimistic as 10­18% of GDP in 2004 and 2005.11 11See Lao Economic Monitor, various issues. BACKGROUND Figure 1.5 Net FDI and gross investment (% of GDP) Net FDI, % of GDP Gross capital formation, % of GDP 10 45 40 8 35 6 30 4 25 20 2 15 0 10 1995 96 97 98 99 2000 01 02 03 1995 96 97 98 99 2000 01 02 03 04 LAO CAM LAO CAM THA VIE THA VIE Note: CAM=Cambodia, FDI=foreign direct investment, GDP=gross domestic product, LAO=Lao People's Democratic Republic, THA=Thailand, VIE=Viet Nam Source: World Development Indicators (WDI) online. 2. Structuralchange Apart from being a transition economy, the Lao PDR is undergoing a process of rapid industrialization. Production has moved from agriculture to industry, especially in recent years. The share of services with respect to other economic activities has increased substantially, due largely to tourism (Figure 2.1). Figure 2.1 Shares of agriculture, industry, and services in GDP 100 90 80 70 60 share 50 % 40 30 20 10 0 1989 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05 Agriculture Industry Services, etc. Source: World Bank. REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH The manufacturing sector in the Lao PDR has grown very rapidly, raising its share in GDP to levels higher than that of many countries at similar income levels. The Lao PDR's manufacturing sector expanded its share ofGDPfrom9%in1989to19%in2003(Figure2.2).Smallenterprisesdominate the manufacturing sector. Around 23,000 firms employ less than 10 employees, and three quarters of these employ only 1­2 employees. Another 542 firms employ 10­99 people, and 116 firms employ more than 100 people each. Most firms employing more than 100 people are foreign-owned garment firms. This distribution of enterprises, and the fact that the manufacturing sector employs only about 100,000 people, indicates the predominance of small enterprises in the manufacturing sector.12 Figure 2.2 Lao PDR's manufacturing growth in international perspective 40 PRC 35 THA MAL sector 30 25 INO CAM 2003, 20 VIE PHI LAO 1989-2003 15 manufacturing GDP in of 10 KGZ share 5 MON % 0 6.0 7.0 8.0 9.0 10.0 11.0 Natural logarithm of real GDP per capita, 2003 Notes: The line corresponds to the predicted share of manufacturing in GDP from a regression on the natural logarithm of real GDP per capita and a constant, with slope equal to 3.415 (standard error equal to 0.691). CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand VIE=Viet Nam Source: Calculations based on the data from World Development Indicators. Food and beverage, garments, wood processing, and construction materials are the largest manufacturing subsectors in the Lao PDR. Within the manufacturing sector, faster growth has occurred in sectors that supply retail trade and construction. Garment sector output also grew from 0.7% to 1.1% of GDP (Table 2.1). Garments and wood processing products also represent the largest manufacturing exports: at present, garment exports are second only to electricity and mining (Figure 2.3). 12See World Bank, 2004a. BACKGROUND Table 2.1 Sectoral distribution within manufacturing (% of GDP) 1991­1995 1996­2000 2001­2002 Food and beverage 10.1 12.8 14.6 Construction 3.1 3.0 2.3 Garments 0.7 1.0 1.1 Wood processing 0.8 0.6 0.6 Construction materials 0.2 0.4 0.6 Tobacco products 0.7 0.6 0.5 Fabric metal products 0.2 0.3 0.3 Water 0.1 0.1 0.1 Chemicals 0.1 0.1 0.0 Source: Country Economic Memorandum (CEM), World Bank, 2004. Figure 2.3 Exports composition by sector ($ million) 350 300 250 200 150 100 50 0 1995 96 97 98 99 2000 01 02 03 04 05 Electricity and Mining Garments Agricultural products Other manufacturing Wood and wood products (excluding garments) Source: Lao PDR Economic Monitor, 2006. Value added in services grew at a higher rate, at par with real GDP growth. Hotelsandrestaurantsgrewatanunevenpacebutataratereaching15% in 2004 (Figure 2.4). The potential of the tourism sector is yet to be unlocked and this can be achieved by improving the investment climate, education of workers, and basic infrastructure. REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 2.4 Growth rates of the value added in services 17.5 15.0 12.5 10.0 7.5 5.0 2.5 0 2000 01 02 03 04 05 06 -2.5 Services Wholesale and retail trade Others Transportation, storage, Hotels and restaurants and communications Source: Government of Lao PDR, IMF, World Bank. The tourism sector in the Lao PDR has strong potential to accelerate development and generate additional employment. In 2003, tourism contributedaround8%ofGDP(hotelsandrestaurantscontributedapproximately 2%)13 and provided direct and indirect employment to about 22,000 workers.14 While tourism's contribution to total output is comparable to that of Thailand and higher than that of Viet Nam, total tourism arrivals in the Lao PDR accounted for only about one-fourth those of Viet Nam and 6% those of Thailand in 2003. More than 800,000 foreign tourists visited the Lao PDR in 2005, as compared with around 700,000 in 2000. The average annual growth of tourist arrivals has been 24% since 1993 (Figure 2.5). More than 70% of tourists came from neighboringAsian countries (primarilyThailand, and, to a lesser extent, People's Republic of China [PRC]), Japan, and Viet Nam). Tourism arrivals are expected to further increase with the abolition of visa restrictions in ASEAN countries; the Government'sintensifiedpromotionoftheLaoPDRasatourismdestination;and greater cooperation among countries in the GMS in developing and implementing tourism strategy. For the tourism sector to develop further and take advantage of these opportunities, there needs to be an appropriate set of policies and support mechanisms to address current investment climate constraints. 13See World Bank, 2004a. 14Asian Development Bank, 2005. BACKGROUND Figure 2.5 Number of tourist arrivals and revenue from tourism (right axis) 1,000 160 900 140 800 120 700 600 100 500 80 `000 400 60 300 40 200 100 20 0 0 1993 94 95 96 97 98 99 2000 01 02 03 04 05 (Est.) Number of tourist arrivals Revenue from tourism ($ mn) Source: National Tourism Authority. 3. Relatedchallenges The Lao PDR remains a transition economy, with a large private sector that is undergoing structural change. This has two consequences for economic policy. First, the Government will not be able to exercise strict state control over the private sector, and therefore needs to move the emphasis from control to monitoring. Attempts to impose old-fashioned controls would only lead to the expansion of informal activities and a reduction in compliance. Second, the transformation from a planned to a market economy entails not only economic structural change, but also a change in ways of doing business. In particular, enterprises still have limited capacity to function in the new economy, and learning by doing will need to take place before the transition is complete. Although recent growth has been pro poor and broad based,15 production is largely confined to very small, informal, and household businesses. The growth of both nonfarm work opportunities for households (including nonfarm businesses), and improvements in infrastructure (roads access and electricity supply) contributed to poverty reduction. The main drivers of poverty reduction are growth and improvements in agricultural productivity. The informal economy is estimated at around 30% of GDP.16 The growth of the informal economy has been due mainly to cumbersome regulations and discretion in taxation laws and regulations. In addition, low levels of development (thus 15Between1998­2003.SeeLaoPDRPovertyAssessment(2006)andADB'sCountryStrategy and Program Update for the Lao PDR (2005). 16See Schneider, 2004. 0 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH low capital intensity), subsistence agriculture, and a small state-owned enterprise (SOE) sector have made the Lao PDR predisposed to microfirms: about 63% of urban households and 17% rural households run a household business. The lack of capacity for doing business in a market-oriented economy and continuing structural change have created a gap between perceptions of the private sector and the direction of government policies. This gap partly explains the disconnect between government regulations and firms'compliance, resulting in the expansion of the informal economy. It also sheds light on the disconnect between perception and quantitative data in the Investment Climate Survey. Sustaining growth is one of the key objectives and revenue mobilization is one of the first priorities of the Government of the Lao PDR, in light of the current budget and trade deficits. The Government of the Lao PDR has explicitly committed to promote private sector development (PSD) and to open up trade, as articulated in its National Growth and Poverty Eradication Strategy (NGPES; 2005) and most recently in its Sixth National Socio Economic Development Plan (NSEDP 2006­2010). These have emphasized private sector development as one of the drivers of export-led growth.The Government is working in several directions, gradually involving more government agencies and expanding the scope of policy reform. Box 3.1 outlines the development goals of the private sector, as stated in the Sixth NSEDP and the NGPES. Box 3.1 Government strategies focusing on private sector development Both the Sixth Five-Year Socio-Economic Development Plan (2006­2010) and the national poverty reduction strategy focus on development of the private sector via the following priorities for the medium term: · Mobilize investment from the private sector in the economy to reach 22% of GDP, while the total investment would be about 32% of GDP to achieve the GDP growth of 7.5% per annum. · Promote small and medium enterprises, focus on household output to progress to become a group or a cooperative, and increase the variety of products and improve their quality; · Promote the production of goods for exports, and attract foreign investment and technology; · Expand domestic private sector from 10.5% in 2005 to 12.5% in 2010; and · Expand the labor force from 2.7 million in 2005 to 3.4 million in 2010. Source: Sixth National Socio Economic Development Plan (draft), January 2006. BACKGROUND The main challenges are to sustain current growth in manufacturing and services, to ensure that the private sector can produce goods and provide services that meet regional export demand, and to expand the domestic market. To meet these challenges, the Lao PDR needs to respond to private sector concerns by managing the changing perceptions during the transition period and taking into account international best practices in business regulation from the GMS region. The main objective of the Investment ClimateAssessment is to support the Government strategy for promoting sustainable growth and industrial and business development. The report will also contribute to support the Lao PDR's attempts to strengthen regional and international competitiveness of its economy, given increasing competition with ASEAN and GMS countries. Implementation of the PSD program would increase employment and speed up poverty reduction by generating higher growth and by empowering the poor.17 17Most poor people in the world indicated employment and business opportunities as the most effective tools that would bring them out of poverty (World Development Report, World Bank, 2005). 12 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH II. INVESTMENTCLIMATE ANDFIRMPERFORMANCE INMANUFACTURING 4. Manufacturingsurvey The Investment Climate Survey (ICS) was undertaken jointly by the Government of the Lao PDR, the Asian Development Bank (ADB), and the World Bank. In all, 303 firms were sampled. Of these, 246 were manufacturing firms,and57firmswerefromthetourismsector.Throughface-to-faceinterviews with managers and owners, the ICS gathered qualitative and quantitative information regarding the investment climate and the performance of firms in sampled provinces and industries. Topics included infrastructure, finance, labor, regulatory burden and administrative delays, governance, innovation and technology,andfirmproductivity.Takentogether,thequalitativeandquantitative data help connect the characteristics of the investment climate in the Lao PDR with the firms' performance. The data and results from the ICS are intended to help develop policy reforms that would further promote growth and productivity of firms in the Lao PDR. The manufacturing part of the survey was carried out in six provinces, namely, Vientiane, Oudomxay, Luangprabang, Xayaboury, Savannakhet, and Champassak. It covered five industries: wood processing (35%), construction materials (27%), garments, textiles/handicraft (25%), and food and beverage (14%). Forty-seven percent of surveyed firms were small (less than 20 workers), 31% were medium (20-99 workers), and 22% were large (more than 99 workers)18 (Figure 4.1). 18FollowingthenewdefinitionusedbytheGovernment,smallfirmsarethosewith19 workers, medium firms with 20­99 workers, and large firms with 100 or more workers. This new definition is used in the national small and medium enterprise (SME) strategy currently being formulated by Small and Medium Enterprise Promotion and Development Office (SMEPDO) at the Ministry of Industry and Commerce (MOIC). Turnover Assets Workers Small < 400 m kip < 250 m kip < 19 Medium < 1,000 m kip < 1,200 m kip < 99 Large > 1,000 m kip > 1,200 m kip > 100 However, the ICS sampling was carried out before this definition was officially adopted, and therefore it was impossible to use this definition throughout the report. Notes are made in all figures and tables concerning the definition used. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 13 Figure 4.1 Distribution of manufacturing firms in the investment climate survey, 2005 Distribution of firms by sector and employment size Distribution of firms by sector and employment size Construction materials Construction materials Large (>50) 8 Large (>99) 2 Medium (11­50) 29 Medium (20­99) 21 Small (<=10) 30 Small (<20 44 Food and beverages Food and beverages Large (>50) 4 Large (>99) 3 Medium (11­50) 16 Medium (20­99) 8 Small (<=10) 14 Small (<20) 23 Garments Garments Large (>50) 33 Large (>99) 29 Medium (11­50) 6 Medium (20­99) 10 Small (<=10) 0 Small (<20) 0 Textile and handicrafts Textile and handicrafts Large (>50) 6 Large (>99) 2 Medium (11­50) 11 Medium (20­99) 9 Small (<=10) 3 Small (<20) 9 Wood processing Wood processing Large (>50) 32 Large (>99) 19 Medium (11­50) 24 Medium (20­99) 28 Small (<=10) 30 Small (<20) 39 0 10 20 30 40 0 10 20 30 40 50 Number of firms Number of firms Distribution of firms by sector and exporter/nonexporter Distribution of firms by sector and FDI/Non-FDI Construction materials Construction materials Exporter 0 FDI 6 Nonexporter 67 Non-FDI 61 Food and beverages Food and beverages Exporter 2 FDI 7 Nonexporter 32 Non-FDI 27 Garments Exporter 30 Garments FDI 21 Nonexporter 9 Non-FDI 18 Textile and handicrafts Textile and handicrafts Exporter 8 FDI 6 Nonexporter 12 Non-FDI 14 Wood processing Wood processing Exporter 43 FDI 7 Nonexporter 43 Non-FDI 79 0 20 40 60 80 0 20 40 60 80 Number of firms Number of firms Note: FDI means having at least 10% foreign equity Distribution of firms by province and employment size Distribution of firms by province and employment size Champassack Champassack Large (>50) 6 Large (>90) 5 Medium (11­50) Medium (20­50) Small (<=10) 5 8 Small (<=20) 68 Luangprabang Luangprabang Large (>50) 0 Large (>90) 0 Medium (11­50) Medium (20­50) 2 Small (<=10) 45 Small (<=20) 7 OudomxayLarge (>50) 0 OudomxayLarge (>90) 0 Medium (11­50) 4 Medium (20­50) 1 Small (<=10) 10 Small (<=20) 13 Savannakhet Savannakhet Large (>50) 20 Large (>90) 14 Medium (11­50) 11 Medium (20­50) 13 Small (<=10) 30 (<=20) 34 Vientiane Capital VientianeSmall Capital Large (>50) 55 Large (>90) 35 Medium (11­50) 53 Medium (20­50) 48 Small (<=10) 18 Small (<=20) XayabuoryLarge (>50) 2 XayabuoryLarge 43 (>90) 1 Medium (11­50) 6 Medium (20­50) 4 Small (<=10) 9 Small (<=20) 12 0 20 40 60 0 10 20 30 40 50 Number of firms Number of firms Source: Lao PDR ICS, 2005. 14 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Private domestic firms comprise most of the surveyed firms. While 11% of the surveyed firms were previously owned by the Government, now only 2% can be considered government firms, based on ownership shares. Forty- seven firms have at least 10% foreign equity, roughly half of them in the garment sector. The remaining firms are equally distributed across sectors. The firms are relatively young, averaging 9 years in existence. Eighty-three firms (34%) are from the export sectors, mainly comprising of wood processing and garments (see Table 4.1). In most of the cross-country comparisons, this report uses nine comparator countries. It benchmarks the Lao PDR's investment climate to neighboring countries that have generally similar GDP per capita and/or geographical endowment: Cambodia, People's Republic of China, Indonesia, Kyrgyz Republic, Malaysia, Mongolia, Philippines, Thailand, and Viet Nam. SomecomparisonsmaybelimitedbytheavailabilityoftheICSinthecomparator countries, and others by the unmatched questionnaires. A gap exists between the perceptions of firms and quantitative data, which is not usually present in other countries. The presence of such a gap can be explained by the transition period and ongoing structural change in the economy, which precludes the ability to conduct a productivity analysis using the Lao PDR's ICS data. This is due to the fact that more productive firms complain more about investment climate constraints, therefore reducing the significance of the regression results. Usually, the assumption underlying the productivity analysis is that a poor investment climate leads to lower firm productivity (see section on firm performance andAppendix Table 3). 5. Investmentclimateconstraints The investment climate is the set of location-specific factors that shapes opportunities and incentives for firms to invest productively, create jobs, and expand their businesses.19 While firms see opportunities to do these things, they assess the costs and risks that are inherent in this process. These costs and risks are shaped by Government policies in various areas, which determine whether there is a level playing field and influence competition among firms. The quality of interaction between governments and firms could help determine the pace of economic growth, investment expansion, and poverty reduction. 19World Bank, 2004b. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 15 In ranking its top constraints, the Lao PDR is quite dissimilar to both Cambodia andViet Nam, as well as to otherGMS countries. Itisalsodifferent from that of other transition countries in the region (Figure 5.1, Figure 5.2). It stands out in the region for having the highest proportion of firms that rate electricityasamajororsevereobstacle.Interestingly,thetopconstraintsreported byfirmsintheLao PDRaremoresimilartothosereportedby firms inSouthAsia (Figure 5.2). There is also wide dissatisfaction over the provision of electricity and regulatory policy uncertainty among firms in Bangladesh, Sri Lanka, and Nepal--a country that is landlocked like the Lao PDR.20 Concerns of the Lao PDR firms about the quality of infrastructure are higher than the average among the comparator countries. Perceived quality of infrastructure seems to be the largest problem in the Lao PDR compared with other countries. Regulation and taxation, as well as macroeconomic policy uncertainty and finance constraints, seem to be at comparator country average. Resources (labor, skills, and land) and governance concerns are at the comparator country minimum (Figure 5.1, Figure 5.2). Figure 5.1 Main policy areas that constrain business -- Asian and transition countries comparison Infrastructure Infrastructure 60 60 50 50 40 Governance 40 Skills/land Skills/land Governance 30 30 20 20 10 10 0 0 Macro Macro uncertainty Tax uncertainty Tax Finance Regulation Finance Regulation LAO MAL LAO MON INO PHI KGZ Note: INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia Source: Regional Investment climate surveys. 20The Nepalese Investment Climate Assessment included fewer constraints in the ICS questionnaire and thus is not presented in the graphs. 16 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 5.2 Investment climate constraints -- Mekong and South Asia countries comparison Infrastructure Infrastructure 60 80 50 70 Governance 40 Skills/land Governance 60 Skills/land 30 50 20 40 30 10 20 0 10 Macro Macro 0 Tax uncertainty uncertainty Tax Finance Regulation Finance Regulation LAO THA LAO CAM VIE SRI PRC BAN Note: BAN=Bangladesh, CAM=Cambodia, LAO=Lao People's Democratic Republic, PRC=People's Republic of China, SRI=Sri Lanka, THA=Thailand, VIE=Viet Nam Source: Regional Investment climate surveys. In the Lao PDR, firms perceive the three main constraints to growth and operations are infrastructure, regulation, and taxation, followed by macroeconomic uncertainty and finance (Figure 5.3). Within these constraints, around40%offirmsconsiderelectricitytobeamajororsevereobstacle,citingthe price­quality relationship as being problematic. Regulatory policy uncertainty is a major issue for 29% of firms, and uncertainty arising from the macroeconomic environment is a major constraint for 27%.21 Surveyed firms do not consider skills, access to land, and corruption to be binding constraints to their operations. There was relatively low concern about other components of the investment climate, such as the skills and health of workers, access to land, corruption, crime, theft and disorder, anticompetitive practices, and the legal system and conflict resolution.This indicates that these constraints are not binding at this stage. 21Other organizations have commissioned other studies of the constraints to private sector development in the Lao PDR. In some of them, the list or prioritization of constraints differs fromthisstudy.Thesedifferencesaremostlyduetodifferentdatacollectionmethods(survey versus interviews) or from different sampling frames. The results in this study should be analyzed with care, as they can only be generalized for the sectors and firm types included in the sample of ICS. The results of these various studies are discussed inAppendix 1, while sample constraints for this study are discussed in the beginning of Chapter 2 and in the appendices on Manufacturing and Tourism. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 17 Figure 5.3 Main groups of constraints perceived by the Lao PDR firms as major or severe 60 50 40 30 % 20 10 0 Infra- Regulation Tax Macro- Finance Skills/ Governance Others structure economic land uncertainty Note: Infrastructure includes electricity, transportation, and water. Regulation includes regulatory policy uncertainty, labor regulations, customs and trade regulations, and business licensing. Tax includes rates and administration. Finance includes cost and access. Skills/land includes skills, education, and health of workers and access to land. Governance includes corruption, crime, theft and disorder, anti-competitive practices, legal system, and conflict resolution. Source: Lao PDR ICS, 2005. Firms in all sectors perceive infrastructure, particularly electricity, to be the top investment climate constraint (Figure 5.4). Section 6.1 deals with electricityandexplainsthatthemainreasonforsuchnegativeperceptionsappears to have been the price quality relationship, probably triggered by the recent tariff increases. Note, however, that the ranking of constraints here was limited to 19 preselected factors, which are roughly common among ICS questionnaires used across countries. A common set of constraints is used in the questionnaires to allow for cross-country comparisons.22 For most sectors, regulatory policy uncertainty is the second most important constraint. Taxation is also an issue that runs across all sectors, but is more pronounced among garments and textiles/handicrafts. Access to finance is also a significant constraint in the garments and textiles sector. For firms in wood processing and construction materials, a common important issue is transportation. Bad or inaccessible roads and high transport costs can hamper their access to their main (resource-based) inputs. 22Theinvestmentclimatefactorsaretelecommunications;electricity;transportation;regulatory uncertainty; tax administration; customs and trade regulations; skills and education of workers; health of workers; access to financing; cost of financing; corruption, crime, theft, and disorder; anti-competitive or informal practices; legal system; access to land; tax rates; labor regulations; business licensing/operating permits; and macroeconomic uncertainty. The questionnaire also allowed firms to identify other constraints that were not listed. 18 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 5.4 Investment climate constraints by sector Garments Textile/handicrafts Infrastructure Infrastructure Regulations Tax Tax Regulations Finance Macroeconomic uncertainty Skills/land Finance Macroeconomic uncertainty Skills/land Government Government Others Others 0 10 20 30 40 50 60 0 10 20 30 40 50 60 Food and beverage Construction materials Infrastructure Infrastructure Regulations Macroeconomic uncertainty Macroeconomic uncertainty Regulations Tax Tax Skills/land Finance Others Skills/land Governance Others Finance Governance 0 10 20 30 40 50 60 0 10 20 30 40 50 60 Wood processing Infrastructure Regulations Tax Macroeconomic uncertainty Finance Governance Others Skills/land 0 10 20 30 40 50 60 Note: Horizontal axis refers to percent of establishments identifying problem as "major" or "severe" obstacle. Source: Lao PDR ICS, 2005. In different provinces, regulation, infrastructure, and taxation feature as the most severe constraints, in different provinces. Infrastructure is the top constraintinVientiane,Luangprabang,andOudomxay.InXayaboury,taxationis the biggest impediment (Figure 5.5). In the South, regulations are considered to be the most important constraint. Customs and trade regulations are also among the top constraints in Oudomxay and Savannakhet. This could be due to the nature of cross-border transactions in these provinces. Transportation is among the top constraints in Champassak, Oudomxay, and Luangprabang--reflecting the poor road conditions, especially in the rainy season, when only 26­52% of the villages in these provinces have passable roads. Information about the most important constraints as perceived by firms in each province can be useful in designing investment strategies for each locality. Large firms are more critical of investment climate constraints. While the survey reveals that a similar set of factors is severely constraining both large INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 19 Figure 5.5 Investment climate constraints by province Vientiane Capital Oudomxay Infrastructure Infrastructure Regulations Tax Finance Regulations Macroeconomic uncertainty Skills/land Tax Macroeconomic uncertainty Skills/land Others Government Governance Others Finance 0 10 20 30 40 50 60 0 20 40 60 80 Luangprabang Xayaboury Infrastructure Tax Others Regulations Finance Infrastructure Tax Finance Governance Macroeconomic uncertainty Resources Others Macroeconomic uncertainty Governance Regulations Resources 0 20 40 60 80 0 10 20 30 40 50 60 Savannakhet Champassack Regulations Regulations Infrastructure Infrastructure Tax Macroeconomic uncertainty Macroeconomic uncertainty Tax Government Government Finance Others Others Resources Resources Finance 0 10 20 30 40 50 60 0 10 20 30 40 50 60 Note: Horizontal axis refers to percent of establishments identifying problem as "major" or "severe" obstacle. Source: Lao PDR ICS, 2005. firms and small and medium enterprises (SMEs), large enterprises have more often raised concerns. Such attitudes (Figure 5.6) appear to hold true in other Asian countries that have conducted investment climate surveys, e.g., Cambodia, Philippines, and Indonesia.23 Larger firms seem to be more weighed down by business obstacles. This may be because they suffer more significant losses from apoorinvestmentclimate,suchasinfrastructurefailures,regulatoryredtape,and macroeconomic instability. The most striking difference is in access to finance: large firms consider it a greater constraint than taxation and macroeconomic uncertainty, while small firms do not. Linkage of large firms to international markets, through import/export activities or foreign equity, also makes them more predisposed toward higher and more competitive standards, which are often lacking in developing countries such as the Lao PDR. 23A striking difference, however, between the Lao PDR and Cambodia is that in the latter, a greater proportion of small firms compared to large firms consider regulatory policy uncertainty and macroeconomic instability as serious obstacles. 20 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 5.6 Firms that recognize constraint as major or severe, by size (percent) 65 55 45 35 25 15 5 Large (>99) Medium (20­29) Small (<20) Others Skills/land Macroeconomic uncertainty Infrastructure Governance Tax Finance Regulations Source: Lao PDR ICS, 2005. A large gap exists between concerns on taxation of small and large firms. Small firms are more concerned about tax rates than are larger firms, and they are less concerned than larger firms about tax administration and regulatory policy uncertainty. This seems to suggest that many small firms may remain informal for tax reasons, escaping, at the same time, regulatory changes and tax administration ramifications. Manyfirmsprefertoremainsmall.Thesurveyrevealedthatabout70%of small firms that started operating about 5­10 years ago remained small.This may signal some difficulty in moving into a bigger scale of operations, unless most of them have opted to remain small. The choice to remain small can be shaped by the business environment that offers few incentives to expand.Apart from tax rates, the decision to stay small or informal may be due to regulatory red tape, uncertainty, and other investment climate constraints such as inaccessibility or prohibitive costs of finance or unreliable infrastructure. The ranking of business constraints indicates that small firms are more concerned about regulatory and macroeconomic policy uncertainty and taxation than they are about financing issues. 6. Infrastructure Efficientinfrastructurefacilitiesenhance the competitiveness of an economy and improve the quality of life. Good infrastructure connects firms to their customers and suppliers, and enables the use of modern production technologies. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 21 Figure 6.1 Infrastructure as a constraint to doing business Electricity Telecommunications 45 45 that problem 40 that tions problem 40 35 35 firms 30 firms 30 of 25 25 electricity "severe" of "severe" or 20 or 20 15 telecommunica 15 identify 10 10 ercentageP "major"a 5 ercentageP 5 0 identify "major"a as LAO PHI PRC THA MON INO VIE MAL CAM KGZ 0 as PRC THA PHI INO LAO MON MAL VIE CAM KGZ Loss of value added due to Transportation infrastructure inefficiency 45 6.0 40 that problem 5.0 35 30 4.0 firms 25 of "severe" 3.0 20 transportation or 15 2.0 10 ercentageP 1.0 identify "major"a 5 0 0.0 as MON LAO VIE PRC PHI INO THA MAL CAM KGZ Water Mainline Transport Power Transport supply telephone services infra- services structure Notes:In the value added loss, the number of observations is different for each investment climate component and thus these are not generally additive. This is for an average firm that used and rated all of the services. CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Source: Lao PDR ICS, 2005; investment climate surveys of selected countries. Conversely, deficiencies in infrastructure create barriers to opportunities, increase costs, disrupt production, and result in lower revenue for all firms-- from microenterprises to multinational corporations. The ICS captures the dual challenges of providing strong infrastructure: the physical construction of power lines, water systems, and telephone connections; and the development of institutions that can effectively provide and maintain public services. The ICS provides three sets of indicators to assess infrastructure in the Lao PDR. The first set shows how firms perceive three components of infrastructure as constraints: electricity, telecommunications, and transportation. The second set measures the quality of infrastructure--the number of days when interruptions in electricity, water, and mainline telephone services occurred; and the value of lost sales due to these interruptions. The third set of indicators evaluates the efficiency of infrastructure services by quantifying the delays in obtaining connections to electricity, water, and telephone. 22 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH More than half of firms in the Lao PDR cite infrastructure as the main obstacle to doing business. Around 40% of the surveyed firms cited electricity as the main concern. In contrast, only 9% and 22% of firms identified telecommunications and transportation, respectively, as a major or severe investment climate constraint (Figure 6.1). Frequent power outages increase the actual and opportunity costs to firms in the Lao PDR, and put them at a disadvantage when competing with firms from neighboring countries. The quality of electricity in the Lao PDR is much poorer than in Cambodia, Indonesia, Mongolia, and Thailand. Although power outages occur more often in Viet Nam, production lost due to service interruptions is much lower. In terms of water and mainline telephone service, the Lao PDR performs adequately and on par with other countries (Figure 6.2). Figure 6.2 Quality and efficiency of infrastructure services Electricity Water 12 7 12 7 10 6 year)10 6 changes sales) sales) 5 lectricitye supply water of per 5 of year) 8 8 to 4 to (% 4 (% power per 6 water (days 6 due of 3 due of 3 4 4 (days 2 2 value 2 value 1 2 interruption 1 Lost interruption requencyF 0 0 Lost requencyF interruptions 0 0 VIE KGZ LAO CAM PHI INO MON THA PHI CAM KGZ LAO INO VIE MON Frequency of power outages (days per year) Frequency of power outages (days per year) Lost value due to interruptions (% of sales) Lost value due to interruptions (% of sales) Mainline telephone Time to obtain connection, days 12 7 sales) 40 10 6 of 35 telephone 5 (% 30 year) 8 mainline 4 25 to per 6 20 mainline 3 to 15 of 4 (days 2 value interruptions 10 2 1 5 Lost requencyF 0 CAM LAO KGZ INO 0 0 LAO THA VIE MAL INO MONKGZ CAM PHI PRC Frequency of interruptions (days per year) telephone Time to obtain electricity connection (days) Lost value due to interruptions (% of sales) Time to obtain water connection (days) Time to obtain mainline telephone Note: CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Source: Lao PDR ICS, 2005; investment climate surveys of selected countries. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 23 As measured by the number of days required to obtain electricity, water, and mainline telephone connections, the efficiency of public services provision in the Lao PDR is the poorest among comparator countries. Figure 6.2 shows that34and32daysareneededtoobtain electricityand mainlinetelephone connection, respectively, which is by far the longest among the comparator countries. Nineteen days are needed for a water connection, which is also much longerthanthetimeneededinallothercountriesexceptThailand.Facedwithlong delays in the provision of electricity, water, and mainline telephone connections, firms find expansion difficult and, as a consequence, overall investment will fail to grow. 6.1. Electricity More than 40% of respondents identified electricity services as a problem for the operation and growth of their business. In light of the perceived strong sector performance of the Lao PDR's electricity sector, it is surprising to see that it is being singled out as the primary constraint to investment (Box 6.1). In response to the somewhat surprising conclusion of the survey, a more detailed study of the perceived quality of the electricity supply was carried out.24 Box 6.1 Strong performance in electrification The Lao PDR is renowned for its hydrological resources, which have enabled the country not only to meet domestic demands but also to export power to Thailand. Power exports have ranked among the top three export commodities for more than 2 decades. Another impressive sector achievement is the rapid electrification of the country increasing from around 15% of all households in 1995 to almost 50% in 2006. This rate is still in the low end in a regional comparison but places the Lao PDR above Cambodia (17% electrification rate in 2003) and almost on par with Indonesia (55% in 2003). From 2006 to 2010, the Government plans to construct six new hydroelectricity schemes with a capacity of 2,100 megawatt (MW). In addition, an output of 600­800 MW is projected from six to eight smaller hydroelectricity schemes. Dissatisfaction with electricity services is universal across all sectors although the construction materials sector reports a slightly more positive position("only"a30%negativeresponserate).Thisdeviationmightbeexplained 24See Tokyo Electric Power Company (TEPCO 2006). Structured interviews were conducted with 34 enterprises in Champassak, Savannakhet, and Vientiane, covering all five sectors. The companies were drawn from the ICS survey; however, the principle of anonymity prevented the interviewers from selecting their new sample from among the 40% of the companies that had originally said that electricity is a constraint. Instead, the sample was designed randomly. 24 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH by a higher reliance of the sector on automotive and captive power compared with other sectors, which consume more electric power. The comparatively high production value lost due to power interruptions in wood processing and garments/textiles industries confirms that these industries have the highest reliance on uninterrupted electric power supply for production. The lower part of Appendix TableA.6.1 shows that the electricity constraints are most strongly felt bylargerenterprises--thosehavingmorethan51workers.Thisistobeexpected, as the number of workers and the degree of mechanization of the factories are correlated. The geographical differences in electricity service are significant, and the Northern provinces report much stronger dissatisfaction than the Southern provinces. Sixty-seven percent of surveyed firms in Luang Prabang, and 57.1% in Oudomxay were dissatisfied with electricity services, while 24.6% in Savannakhet and 36.8% in Champassak showed dissatisfaction. The higher dissatisfaction in the two northern provinces (Luang Prabang and Oudomxay) appears justified, given the number of days of power interruptions. These provinces suffer significantly more interruptions than do other parts of the country. Two factors can explain this difference. First, the national power system is less developed in the north, with lower electrification rates and a weaker power network, which is more prone to blackouts. On the other hand, Savannakhet and Champassak provinces are both directly linked to the Thai electricity network and receive part of their power from imports. Second, the mountainous northern regions have a higher frequency of thunderstorms, which are the main reason for power interruptions. While dissatisfaction with electricity as a constraint to business is the highest among GMS countries, losses due to outages are modest by regional standards. Figure 6.3 shows that while the perceived constraints related to the Lao PDR's electricity sector are by far the highest in the region, at 41%, the reported loss of production value caused by electricity sector constraints does not entirely justify the criticism.At 4.3%, the Lao PDR is only one percentage point higher than the average for the EastAsian and Pacific region, and lower than the Philippines. This pattern indicates that the perceived dissatisfaction is driven by reasons other than pure economic concerns. Incidence of generator use in the Lao PDR is low. Three factors could explain the low incidence of self-generation. First, the disproportionate costs of importing generator equipment or fuel could restrain investors in the Lao PDR compared with investors in other countries. However, fuel costs in the Lao PDR are comparable to neighboring countries, and the import duty on mechanical INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 25 Figure 6.3 Regional comparison of electricity as a contraint and cost 45 7 41.1 constraint firms) 40 39.0 39.1 5.9 36.6 6 of 35 33.4 5 majora (% 30 4.3 29.7 interruptions 25.6 4.1 4 value) as 25.625.3 firms) 25 22.33.3 22.6 of 20 power 16.2 16.0 3.0 3 to sales (% 14.8 15.3 generators 15 12.6 2.2 of 2.0 2.0 2 due electricity 10 (% own 7.7 1.4 5 n.a. 1 value Have 0 0.0 0 LAO CAM PRC INO MAL PHI THA EAP KGZ Lost Identifying Firms identifying electricity as major constraint (% of firms) Have own generator (% of firms) Lost value due to power interruptions (% sales value) Note: CAM=Cambodia, EAP=East Asian and Pacific region, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand Source: Regional Investment climate surveys. equipment is only 5% or less. Second, the structure of the industry might not require the same level of system reliability as in other countries, which have more sophisticated processing industries. This assumption is refuted by investor responses, which indicate that power interruptions do indeed carry a risk of damaging either the production line or the machinery. Third, lack of skilled labor intheLao PDRformaintenanceandoperationofpowergeneratorsmightdissuade investors from procuring generator sets. The average skills and education level of Electricite du Laos (EdL) workers are limited. Nonetheless, these factors do not seem to provide sufficient explanations with regard to the significantly lower numbers of firm-owned generators in the Lao the PDR. 6.1.1. Tariff considerations Seventy-six percent of respondents find tariffs "expensive" or "very expensive" (Figure 6.4).25 Of almost equal importance is the quality of electric supply. Other causes rank lower but are far from negligible. The dissatisfaction with tariff rates is unequivocal, with more than 80% in all sectors reporting that electricity tariffs are "expensive" or "very expensive" (Figure 6.5). Only in construction materials sector that less than 80% (53%) of firms report that rates are high. 25This finding and the subsequent detailed responses were obtained in the follow-up survey conducted by TEPCO in January 2006, in which 34 companies among the original sample were interviewed. 26 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 6.4 Causes of investors' dissatisfaction with electricity supply (%) Quality of supply 100 8071% 60 40 Others 20 Tariff 0 76% 0% 38% 53% In-house installations Service level of education Note: The respondents could choose among the following five answers to characterize the electricity tariffs: "very expensive", "expensive" "reasonable", "cheap", or "very cheap". Source: TEPCO, 2006. Figure 6.5 Perception of electricity tariffs being "expensive/very expensive" by sector 100 100 90 86 82 80 80 70 60 56 % 50 40 30 20 10 0 Garments Textile/ Food and Construction Food handicrafts beverages materials processing Note: The respondents could choose among the following five answers to characterize the electricity tariffs: "very expensive", "expensive" "reasonable", "cheap", or "very cheap". Source: TEPCO, 2006. However, the Lao PDR enjoys the lowest tariffs for industrial consumers in the region for small-scale enterprises and larger operations (Figure 6.6).26The situation is slightly different for commercial consumers, since the Lao PDR's commercial tariffs rank third in the region, after Viet Nam and Cambodia (Figure 6.7). 26A direct comparison is distorted by the various types of efficiency incentives which are offered in some countries but are not available in the Lao PDR. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 27 Figure 6.6 Average electricity tariffs for industrial consumers, by consumption size 16.00 14.90 14.00 13.66 12.00 11.92 10.00 8.00 cent/kWh 6.23 6.80 7.02 6.95 7.30 6.22 6.54 6.21 5.96 US 6.00 6.35 5.29 5.60 4.00 2.00 0.00 Small Medium Large LAO VIE MAL CAM THA Note: CAM=Cambodia, LAO=Lao People's Democratic Republic, THA=Thailand, VIE=Viet Nam Source: TEPCO, 2006. Figure 6.7 Average electricity tariffs for commercial consumers, by consumption size 18.00 16.14 16.00 14.90 14.00 12.00 11.92 10.67 10.21 10.00 9.59 cent/kWh 8.20 8.19 8.00 7.80 7.21 6.96 6.62 US 6.00 7.30 6.35 5.60 4.00 2.00 0.00 Small Medium Large LAO VIE MAL CAM THA Note: CAM=Cambodia, LAO=Lao People's Democratic Republic, THA=Thailand, VIE=Viet Nam Source: TEPCO, 2006. The perceived dissatisfaction with tariff levels therefore appears to be rooted in traditionally low tariff rates that have been recently growing at a relatively fast pace. As will be discussed below, power supplies in the Lao PDR are of roughly similar quality to those in neighboring countries, at least in terms of power interruptions. Traditionally, EdL has been hampered by tariff ceilings, which were fixed well below the actual cost of production. This policy has been gradually revised during the past 7 years. Monthly tariff increases were 28 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH implemented from 1999 to 2001 at an aggregate annual rate of almost 50%. The tariffs, still below cost recovery, were subsequently subjected to annual increases of some 20­30% in 2002­2004. Tariff adjustments in 2005 and 2006 hover between 5% and 6%. Despite recent relief in tariff adjustments, some consumer groups are still feeling the increases imposed in the past years. Additional dissatisfaction comes from the fact that commercial consumers are cross-subsidizing residential consumers. As a consequence of the rigorous adjustment program, tariffs for industrial consumers have now reached the point of cost recovery, while commercial consumers are paying tariffs that are significantly higher than the cost recovery level.27 The system seems to punish the potentially most productive sectors and small enterprises by making their fixed costs very high. The discontent is also due to the fact that consumers are not aware of the prices in other countries. Enterprises with constant or flexible electric capacity requirement are particularly disadvantaged in terms of electricity costs.28 EdL provides no cost incentives to consumers for energy management and efficiency, except for a 10% reduction to consumers who choose to invest in own transformers and receive electricity at medium voltage. This puts highly mechanized the Lao PDR enterprises at a comparative disadvantage to producers in Thailand and the Philippines, where various schemes are available, including rebates at off-peak hours and two-part tariffs with separate charges for peak capacity and total volume. Such initiatives are estimated to yield substantial cost savings. It can therefore be recommended that such energy efficiency (demand-side management activities) be implemented for strategic consumers. This would be advantageous for both EdL and its customers. 27Electrowatt, 2004. 28Tariffreformsareongoing,withtheobjectiveofreducingcross-subsidiesbetweenresidential and corporate consumers. Tariffs for residential consumers will gradually increase until 2011, while industrial consumers will enjoy a reduction of 8% (2005 values). INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 29 Table 6.1 Electricity tariffs charged by EdL and projections as of April 2006 (kip) 2003 2004 2005 2006 Residential consumers 0­25 kWh/month 99 113 115 133 26­150 kWh/month 231 265 265 276 >150 kWh/month 667 765 765 773 Nonresidential consumers Agriculture 257 295 295 313 Government 616 706 706 703 Industry 555 636 636 634 Commercial 721 826 826 835 International organizations 1040 1,066 1,066 1,077 Entertainment 955 1,095 1,095 1,106 Total average 430 514 543 552 Average tariff increase (%) 19.40 5.54 1.76 2007 2008 2009 2010 2011 Residential consumers 0­25 kWh/month 155 178 204 234 269 26­150 kWh/month 287 296 304 313 322 >150 kWh/month 781 781 781 781 781 Nonresidential consumers Agriculture 332 348 366 384 402 Government 701 692 682 673 664 Industry 631 623 614 606 597 Commercial 843 843 843 843 843 International organizations 1,088 1,088 1,088 1,088 1,088 Entertainment 1,118 1,118 1,118 1,118 1,118 Total average 555 558 562 566 571 Average tariff increase (%) Note: Rates for 2007­11 are expressed in 2006 values. Source: EdL. 30 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH 6.1.2. Quality of supply considerations Four of the five sectors reported dissatisfaction with the quality of supply (Figures 6.8 and 6.9).29The dissatisfaction is predominantly with frequent power interruptions (67%). This is not surprising since a complete outage is often more directly felt than periodic drops in voltage level, frequency instability, etc. The average number of power interruptions is estimated to be slightly less than nine times per year, and the total duration of interruptions is about 60 hours annually (Figure 6.10). Figure 6.8 Reported dissatisfaction with quality of electricity supply 100 80 78 82 60 60 57 % 50 40 20 0 Garments Textile/ Food and Construction Wood handicrafts beverage materials processing Source: TEPCO, 2006. Figure 6.9 Reasons of dissatisfaction with quality of electricity supply 100 80 67 60 % 50 40 21 20 17 0 0 High Low outage Voltage Unstable Others frequency recovery fluctuation frequency of outage Source: TEPCO, 2006. 29The quality of supply is distinguished from the quality of service. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 31 Figure 6.10 Regional comparisons of power interruptions per year 120.0 12.0 100.0 10.0 80.0 8.0 annum 60.0 6.0 interruptions per of 40.0 4.0 Hours 20.0 2.0 requencyF 0.0 0.0 LAO CAM PRC INO KGZ MAL MON PHI THA VIE AVERAGE Total power outages Frequency of power outages Note: CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the) LAO=Lao People's Democratic Republic MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand VIE=Viet Nam Source: Investment climate surveys. The quality of electricity supply in the Lao PDR is close to the regional average, but large differences persist among regions, sectors, and firms of different size. While there have been service improvements in the capital, Vientiane, installation and supply of electricity to the provinces still face some difficulties and supply disruptions. The average annual duration power interruption, which is 60 hours, is above the commonly used benchmark of 24 hours. Huge differences exist across provinces and sectors. Outage durations were reported as low as 15 hours in Vientiane (averaging around 30 hours), whereas the Northern provinces suffer more than 100 hours of interruptions per year. Reliability of supply is also dependent on customer size; small enterprises experience around 50% longer interruptions per year than larger enterprises. This pattern is not surprising, since large consumers have the option to receive medium voltage (22 kV) supplies, while small consumers normally receive the stepped down 0.4 kV supply, which is more prone to interruptions, given the additional transformation. The duration of outages has been increasing. Despite the fairly good performanceoftheEdLnetworkintermsofannualpowerinterruptions,statistics fromtheutilityrevealthatthetotalnumberofinterruptionsinVientianeProvince increased by more than 30% from 2001 to 2003. Besides the frequency of power interruptions, the duration of interruptions also received a fairly high response rate, at 17%. Although EdL reportedly recovers from outages faster than the regional average (the majority of interruptions are recovered within 2 hours), a 32 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH number of power interruptions have been known to last for 5 hours or more. Such long durations are very disruptive to businesses. 6.1.3. Service level of EdL The dissatisfaction with the service level of EdL's operations is high among thesurveyedfirms,witharesponserateof67%.Thepatternisfairlyconsistent across sectors and provinces, thus indicating that the problem is general rather than sector specific. Figure 6.11 provides a breakdown of the main causes of dissatisfaction. Sixty-seven percent of respondents cite the billing process/meter reading; the need to strengthen billing procedures was confirmed in a previous Loss Reduction Study (TEPCO, 2004). Estimates show as much as 5% of EdL's operating losses ($3 million a year) could be attributed to nontechnical reasons. Figure 6.11 Reasons of dissatisfaction with EdL services 100 80 67 60 % 44 40 20 11 6 0 0 Unreliable Corruptive Bureaucratic Low Others billing behavior red tape monitoring process equipment Source: TEPCO, 2006. quality EdL's billing process relies on manual meter reading, with few controls in place to monitor the readings. The TEPCO study recommended switching to computerized meter reading with handheld devices, increasing inspection frequency, and introducing incentive schemes for meter readers to reduce the large number of incorrect readings. EdL has reported significant success in the Vientiane branch after extensive training and introduction of incentives for meter readers. Similar activities will now spread to other provincial branches. Likewise, the fairly modest reporting of "corruptive behavior" of EdL's officials is a result of targeted campaigns within EdL, which is expected to further reduce reported incidents. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 33 Bureaucratic constraints and red tape, such as long response time and delayed provision of requested services, are also significant causes of customer discontent. Almost half of the respondents (14 companies) reported a lead time of 30 days or more from their application to actual connection. It should be noted, however, that private electric companies and not EdLundertake almost all of the connection works. The delay is therefore as much a problem of insufficient capacity at the level of private electricians and service companies. The average time to establish connection was reported as high as 34.2 days. Such delays contribute to the poor investment climate. 6.2. Transportation Raising the productivity of firms in the Lao PDR requires significant improvements in the transport infrastructure. Between 1990 and 2000, the Lao PDR was able to expand its road network by 71%, higher than the 63% increase in the PRC. However, only 15% of all roads in the Lao PDR were paved, compared to Viet Nam's 25%, and the PRC's 79%.30 The draft Sixth National Socio­Economic Development Plan (NSEDP, 2006­2010) provides for the implementation of priority infrastructure projects in the transport sector to open opportunities for developing all regions. These include easing transport within the country through highway projects betweenVientiane capital and other cities and provinces, and through new railway transport connecting key areas. The NSEDP has also laid down plans to better connect the Lao PDR to other countries through inland roads and bridges, including the upgrade of existing national roads linking the Lao PDR to neighboring countries. An important issue forfirms in the Lao PDR and its neighbors is cross- bordertransport in the subregion. In1996,anADBtechnicalassistanceproject found that several nonphysical trade barriers prevented the free movement of vehicles,people,goods,acrossborderswithinthesubregion.Suchfactorsinclude restrictions on entry of motor vehicles, different vehicle standards, inconsistent and difficult formalities related to customs procedures and guidelines, and restrictive visa requirements.31 To reduce these barriers, a GMS Cross-Border Transport Agreement was formulated, with the Lao PDR being one of the signatory countries, along with Cambodia, PRC, Myanmar, Thailand, and Viet Nam.32Theagreementcoversseveralaspectsofcross-bordertransportfacilitation, 30See Asian Development Bank/Japan Bank for International Cooperation/World Bank, 2005. 31Asian Development Bank, 2005c. 32The Cross-Border Agreement was originally signed by the Lao PDR, Thailand, and Viet Nam on 26 November 1999 in Vientiane. 34 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH including single stop/window customs inspection, cross-border movement of persons, transit traffic regimes, requirements for vehicles going across borders, exchange of commercial traffic rights, and infrastructure (road and bridge design standards, road signs and signals). In addition, the Lao PDR stands to benefit from the proposed GMS Transport Sector Strategy, since it would be part of both theNorth­SouthEconomicCorridorandtheEast­WestEconomicCorridor(Box 6.2). Other measures that will be taken to increase efficiency, reduce costs, and maximize the economic benefits of the economic corridors include improving the warehouses; building two new distribution centers; building infrastructure for trucks carrying containers across the border; providing information and communication technology on transportation; and increasing capacity building for the staff at the Lao PDR international checkpoints and at the Ministry of Communication, Transportation, Post, and Construction (MTCPC). Box 6.2 GMS transport sector strategy A strategy to develop a comprehensive Greater Mekong Subregion (GMS) transport network is being formulated to link the GMS countries in an efficient and sustainable manner. The network will be established mainly through a GMS-wide multimodal transport systems covering all possible current and future modes; i.e., road, rail, inland, water, sea, and air. The expected outcomes include lower costs to consumers and producers arising from reduced import costs; more competitive exports from lower costs of transporting to local and regional markets and to global market transfer locations; reduced travel times for GMS residents and tourists; and a more attractive environment for inbound investment through high-quality transport links. Three corridors have been identified to facilitate trade, reduce transport costs, make movement of goods and people more efficient, provide employment opportunities, and reduce poverty. These are the North­South Economic Corridor, East-West Economic Corridor, and the Southern Economic Corridor. Source: Asian Development Bank, 2005f. A quarter of the surveyed firms cited transportation as a severe obstacle to their operations. Transportation is an important component of the production value chain. The quality and accessibility of transportation affect the time it takes to obtain input goods for production and to gain access to local and international markets. Quality of infrastructure may also impact the loss of value in transportation. About 3.9% of value added is lost due to poor transport services, and 5.3%isduetotransportinfrastructure.Moreover,firmsthatcitedinfrastructure asamajororsevereconstraintlost6.3%oftheirvalueaddedduetoinfrastructure and access to markets, which is almost double the losses incurred by firms that did not complain. Firms that cited transport as a severe problem also had longer INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 35 lead times (27 against 22 days) and higher transportation expenditures (36% higher than those that did not complain). Transportation appears to be a binding constraint to expansion and higherproductivity formore productive firms. Firms with higher productivity cited poor transportation as a major or severe problem more often than other firms. These firms also tended to use land transportation more often than air or river routes, and to incur higher transportation costs (12%, on the average). 7. Regulationandregulatoryuncertainty The Government's regulatory policy plays a significant role in shaping investment decisions and the conduct of business. Effective regulations address market failures that inhibit productive investment and reconcile private and public interests. Poorly designed and inefficiently implemented regulations, however, present major administrative and financial burdens. Often, these burdens are in the form of bribes--"unofficial" payments to public officials to get things done. Weak regulatory quality, poor policy framework, inconsistent regulations, and complex rules and procedures all contribute to an unhealthy business environment and undermine the credibility of the Government. In turn, risk increases, expectations are lowered, and investment is discouraged. ICS provides three sets of qualitative and quantitative indicators of regulatory burden and corruption. The first set of indicators focuses on the perceptionsoffirmsregardingregulatorypolicyuncertaintyandthepredictability of regulations at the national and provincial government levels. The second set presents the perceptions of firms regarding red tape, and measures the amount of unofficial payments; i.e., the "bribe tax" and the extent to which specific administrative and regulatory functions require gifts or informal payments. The third set of indicators captures the "time tax" imposed by regulation. Nearlyonethirdofsurveyedfirmsrateregulatorypolicyuncertaintyas a major or severe problem. TheproblemisevenmorepervasiveinChampassak and among large firms, exporters, and foreign-owned firms. Twenty-nine percent of total firms surveyed rate regulatory policy uncertainty as a major or severe problem, while regulatory policy uncertainty was cited as a major or severe by 42% of firms in Champassak (44% of large firms; 45% of exporters, and 38% of foreign-owned firms, see Figure 7.1). The uneven and discretionary application of laws has also generated confusion and uncertainty, discouraging investors. There are indications that a number of laws and legal instruments, including 36 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 7.1 Regulatory policy uncertainty as a constraint to doing business, by province and type of firm By province By firm characteristics 45 45 40 40 35 35 30 30 25 25 %20 % 20 15 15 10 10 5 5 0 0 LAO VientianeOudomxayLuangbrabang Xayaboury Savannakhet Champassack LAO Small Medium Large SME Exporter Nonexporter Foreign Domestic Notes:Percentage of firms citing Regulatory policy uncertainty as a "major" or "severe" problem. LAO=Lao People's Democratic Republic, SME=Small and medium enterprise Source: Lao PDR ICS, 2005. those related to business and investment incentives, lack a clear set of guidelines, or are done on a case-to-case basis, leading to unfair implementation.33 Many firms in the Lao PDR believe that the interpretation of regulations by government officials at the provincial levels is unpredictable. Unpredictability in Champassak province was particularly noted by local businesses.Withregardtolocalgovernmentadministration,26%offirmsthought that interpretation of regulations was unpredictable (Figure 7.2). Furthermore, firms located in Champassak were especially affected by the unpredictability of local regulations--42% of firms believe that the interpretation of regulations by local government officials is unpredictable (Figure 7.2). Figure 7.2 Unpredictability of regulation, by province, sector, and type of firms 50 50 45 45 40 40 35 30 35 % 25 %30 20 25 15 20 10 15 5 10 0 5 LAO VientianeOudomxayLuangbrabang Xayabuory Savannakhet Champassack LAO Small MediumLarge SME Exporter Nonexporter Foreign Domestic Notes:Percentage of firms that believe provincial/local government official's interpretation of regulations is unpredictable. LAO=Lao People's Democratic Republic, SME=Small and medium enterprise Source: Lao PDR ICS, 2005. 33See Sung, 2005. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 37 TheextentofregulatoryuncertaintythatfirmsintheLao PDRperceive is similar to the level found in neighboring countries and other landlocked economies. Figure 7.3 shows that the PRC, Kyrgyz Republic, Philippines, and Thailand have similar percentages of firms that identify regulatory burden as a problem. Viet Nam has the lowest percentage, with 14% of its firms identifying regulatory policy uncertainty as a constraint. Indonesia recorded the highest at 48%. At the same time, the firms in the Lao PDR place both regulation and regulatory uncertainty combined as the second-most important constraint to their business (see Figure 5.1). Figure 7.3 Regulatory burden as a constraint­international comparisons Regulatory policy uncertainty 60 uncertianty 50 problem policy 40 "severe" 30 egulatoryr or 20 citing "major"a 10 firms as 0 of INO MON CAM PRC KGZ PHI LAO THA MAL VIE % Note: CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Sources: Lao PDR ICS, 2005; investment climate surveys of selected countries. Regulation in the Lao PDR appears to be very restrictive by international standards. In the Doing Business Report, the Lao PDR ranked 147th out of 155 countries with respect to ease of doing business in 2005 (Figure 7.4).34 In looking at the Doing Business rankings for a particular country, it is important to understand the specific methodology used to calculate these numbers. The main purpose of the Doing Business methodology is to allow for international comparisons among many countries with different regulation systems in place. Such methodology is bound to miss the specificity of each particular country's regulation system (Box 7.1). It is, therefore, necessary to supplement it with a country-specific review of regulation that is attempted below. 34These comparisons are based on regulations and laws in place at the beginning of 2005. 38 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 7.4 Lao PDR ranks 147th out of 155 on the ease of doing business in 2005 160 restrictive) 120 more 80 means 40 (higher 0 Ranking Overall Paying Hiring Starting a Dealing Pro- Regis- Trading Enforcing Closing a Getting taxes and business with tecting tering across contracts business credit firing licences Investors Property borders Source: World Bank, 2006. Box 7.1 Methodology of the doing business rankings for starting a business The Doing Business Survey records all generic procedures that are officially required for an entrepreneur to start up and operate an industrial or commercial business. These include obtaining all necessary licenses and permits and completing any required notifications, verifications, or inscriptions with relevant authorities. After a study of laws, regulations, and publicly available information on business entry, a detailed list of procedures, time, cost, and paid-in minimum capital requirements is developed. Subsequently, local incorporation lawyers and government officials complete and verify the data on applicable procedures, the time and cost of complying with each procedure under normal circumstances, and the paid-in minimum capital. On average, four law firms participate in each country. Information is also collected on the sequence in which procedures are to be completed and whether procedures may be carried out simultaneously. Any required information is assumed to be readily available and that all government and nongovernment agencies involved in the start- up process function efficiently and without corruption. If answers by local experts differ, inquiries continue until the data are reconciled. To make the data comparable across countries, several assumptions about the types of businesses are made. The Doing Business report assumes that the firm: (i) is a limited liability company operating in the country's most populous city; (ii) is 100% domestically owned and has five owners, none of whom is a legal entity; (iii) has start-up capital of 10 times income per capita at the end of 2004, paid in cash; (iv) performs general industrial or commercial activities, such as the production or sale of products or services to the public; (v) does not perform foreign trade activities and does not handle products subject to a special tax regime; (vi) does not use heavily polluting production processes; (vii) leases the commercial plant and offices and is not a proprietor of real estate; (viii) does not qualify for investment incentives or any special benefits; (ix) has up to 50 employees 1 month after the commencement of (continued) INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 39 Box 7.1 (continued) operations, all of them nationals; (x) has a turnover at least 100 times income per capita; and has a company deed that is 10 pages long. Several assumptions about procedures are also used. In particular: · A procedure is defined as any interaction of the company founder with external parties (government agencies, lawyers, auditors, notaries). · The founders complete all procedures themselves, without middlemen, facilitators, accountants, or lawyers, unless the law mandates the use of a third party. · Procedures that are not required by law for starting a business are ignored unless they are necessary to conduct everyday transactions of the company. · Shortcuts are counted only if they fulfill three criteria: they are legal, available to the general public, and avoiding those causes substantial delays. · Only procedures required of all businesses are covered. Industry-specific procedures are excluded. · Procedures that the company undergoes to connect to electricity, water, gas, and waste disposal services are not included unless they entail inspections required before starting operations. Time is recorded in calendar days. The minimum time required for each procedure is assumed to be 1 day. Time captures the median duration that incorporation lawyers indicate is necessary to complete a procedure. If a procedure can be accelerated for an additional cost, the fastest procedure is chosen. It is assumed that the entrepreneur does not waste time and commits to completing each remaining procedure without delay. The time that the entrepreneur spends on gathering information is ignored. It is assumed that the entrepreneur is aware of all entry regulations and their sequence from the beginning. Source: World Bank, 2005b. For more detail, see www.doingbusiness.org/Methodology/StartingBusiness.aspx. While the Lao PDR does not have the largest monetary cost of starting a business, the number of regulatory procedures and the number of days required to start operation are very high (Table 7.1). The Doing Business survey shows that the Lao PDR has the most restrictive procedures for starting a business among the comparator countries and the second most restrictive in the world. The actual number of days to start a business ranges between 25 days and 180 days, as some provinces have simplified regulations. Although the legal framework for registering a business is uniform across provinces, the provinces implement these procedures differently.35 For example, in all six provinces, each ministerial department requires a separate business license application. However, in Savannakhet, investors can submit the applications to any one of the required departments, which will then act as a one-stop shop 35See Lao PDR Provincial Business PolicyAssessment. World Bank, Washington DC. 2006. 40 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH and distribute the applications to other departments. Some provinces also require additional procedures. For example, departments in Vientiane often require in- person interviews. In Oudomxay, an inspection of the proposed business location is required. Because of these and other differences, the average number of days required to complete the first five procedures to register a business varies from less than 25 days in Savannakhet to 90­180 days in Oudomxay.36 Table 7.1 Number of procedures required to start a business Cost Min. capital Procedures Time (% of income (% of income (number) (days) per capita) per capita) Lao PDR 9 198 15.1 23.4 Cambodia 10 86 276.1 80.7 China, People's Rep. of 13 48 13.6 946.7 Kyrgyz Republic 8 21 10.4 0.6 Malaysia 9 30 20.9 0.0 Philippines 11 48 20.3 2.0 Thailand 8 33 6.1 0.0 Viet Nam 11 50 50.6 0.0 AVERAGE 9.9 64.3 51.6 131.7 Source: World Bank, 2005b. Despite this restrictive regulatory regime, firms in the Lao PDR do not report spending an excessive amount of time dealing with government regulatory requirements. The average firm reports that senior management spends less than 5% of its time dealing with government regulations (Figure 7.5). This is higher than in Indonesia, but lower than in any of the other comparator country. The Lao PDR is also working to improve the regulatory environment by creating a one-stop shop for firm and investment registration, and has recently approved the new Enterprise Law, which will substantially reduce unnecessary regulatory burden.37 36Data are according to provincial authorities and are reported. See Lao PDR Provincial Business PolicyAssessment, World Bank, Washington DC. 37The new Enterprise Law, approved by the National Assembly in 2005 to replace the old BusinessLaw,isbasedoninternationalbestpracticesinbusinessregulation.Implementation of the Law is estimated to reduce the number of days required to start a business from 198 to less than 20 days, though this is a preliminary estimation since the implementing decree has not yet been drafted. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 41 Figure 7.5 Time spent dealing with government regulations 25 20 time regulation 15 with 10 management of dealing 5 % 0 LAO INO VIE KGZ PHI MAL CAM PRC Notes:Outliers more than three standard deviations above or below the mean are dropped when calculating averages. CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Source: Lao PDR ICS, 2005; investment climate assessments. Inspections are, however, more common in Lao PDR than in most of the comparator countries. Someoftheseinspectionsaremoreburdensomethan others. On average, firms in Lao PDR are inspected close to 19 times per year-- higher than in any of the comparator countries except the PRC (Figure 7.6). Figure 7.6 The number of inspections is higher in the Lao PDR than in other countries in Southeast Asia, but lower in the People's Republic of China Tax Labor Total PRC PRC PRC MAL MAL MAL PHI PHI PHI VIE VIE VIE INO INO INO LAO LAO LAO 0 10 20 0 10 20 0 10 20 Number of inspections Number of inspections Number of inspections Notes: Outliers more than three standard deviations are dropped. INO=Indonesia, LAO=Lao People's Democratic Republic, MAL=Malaysia, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Sources: Lao PDR ICS, 2005; investment climate surveys. 42 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Although the total number of inspections is quite high, the types of inspections are quite different when compared with most other countries. Firms in the Lao PDR were more likely to report that bribes are expected than firms in Indonesia and the Philippines, and less likely than firms in Viet Nam and Cambodia. Section 11 on governance deals with this and related issues. Uncertainties regarding regulations are also reflected in the difficulties faced by firms in their transactions with clients. In particular, this concerns the enforcement of contracts. On average, about 23% of firm sales were sold on credit (as opposed to prepaid and paid at delivery). However, in some of the transactions, customers did not pay within the agreed time period or never paid at all. On average, about 24­26% of sales of firms, which are sold on credit in the garments, textiles, and construction materials sectors were not repaid on time (Figure 7.7). In the food sector, about 8% of sales on credit were never repaid. This may reflect not only the extent of legal uncertainties facing firms, but also the difficulty of private customers (some of which could be firms themselves) in accessing financing to enable them to better organize their cash flow and meet financial obligations. Figure 7.7 Uncertainties in payments for firm sales 35 30 25 20 sales of 15 % 10 5 0 Garments Textile Food Construction Wood All materials processing firms Percentage of sales sold on credit Percentage of sales not paid within agreed time Percentage not actually paid Source: Lao PDR ICS, 2005. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 43 Twenty percent of firms in the Lao PDR consider customs and trade regulations a major or severe obstacle. Compared with other landlocked countries, the percentage of firms that identified trade regulation as a major or severe obstacle is lower than in Nepal (45%), but higher than the Kyrgyz Republic (13%) and Bhutan (10%). Among landlocked countries, customs and trade regulations are expected to be critical issues in cross-border transactions. Reports38 that show that customs clearance procedures and cargo processing for import and exports, and an inefficient licensing system, pose barriers to trade barriers in the Lao PDR).39 The supply chain study of the firms in the garment industry shows that cross-border transactions add significantly to the lead times (Figure 7.8). Figure 7.8 Approximate lead time elapsed from fabric order to destination port Place order for fabric purchase Cut, sew, finish, pack Europe: 40 days 90 days Load to truck and take to USA: port 93 days 3 days Offload to ship and set sail 27 days 30 days Buyer port Buyer port EU, USA, Le Havre East coast Notes:This process can take on average up to 105 days in the Lao PDR, compared to 60 in India, and 80 in Sri Lanka and Bangladesh; it takes 135 in Nepal which is a country as far as the Lao PDR from destination ports. EU=European Union, USA=United States of America Source: GDS, 2006. 38See Martin 2001; Diagnostic Trade Integration Study (DTIS) 2006. 39The Prime Minister's Export­ImportsAgreement No.36/PM9.7.2001 establishes a one-stop service for customs clearances. However, many sectors face difficulties in implementing this type of service. 44 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Easing difficulties in cross-border trade is essential for the Lao PDR businesses, and especially for exporters. Efforts are under way to facilitate cross-bordertradebetweentheLao PDRandothercountriesintheregionthrough the GMS program and other initiatives. The Second GMS Summit endorsed a Strategic Framework for Action on Trade Facilitation and Investment (SFA- TFI), which provides a comprehensive set of measures to facilitate trade through four priority areas: customs procedures, inspection and quarantine measures, trade logistics, and mobility of business people. Among the important measures identified are simplifying, harmonizing, and making transparent customs procedures; aligning quarantines and inspections; having laws and regulations with commonly agreed international standards; developing greater inter-agency cooperation in the individual countries and at the GMS level regarding inspection and approval procedures, harmonizing cross-border transport regulations and procedures, and pursuing a GMS-wide business visa. A regional cooperation strategy and program takes the GMS program to the next stage through enabling investmentandtechnicalassistance,withacomprehensivedevelopmentmatrixto guide the planning of subregional programs.40 Complementing this strategy is the Ayeyawaddy­ChaoPhrayaMekongEconomicCooperationStrategy(ACMECS), initiated by Thailand to promote greater economic cooperation among four GMS members: Cambodia, the Lao PDR, Myanmar, and Thailand.41 7.1. Practice of regulations in the Lao PDR To obtain a business license and start business operations, nine procedures and often up to a hundred documents are required by central and provincial authoritiesandlineministries.Toregisterabusiness,anaveragefirminatypical sector and province needs to get investment licenses from several departments of the central Government, from the line ministries, plus registration licenses from tax departments, the Ministry of Finance, bank, and business seal (Figure 7.9). Small businesses are allowed to register at the district level, while large businesses need to register at the provincial level. The registration of a business at the district level involves the departments of trade and finance and the line ministry. Capitalization will decide the administrative level of registration of a company. Firms with a turnover of below Kip (KN) 25 million (US$2,350) are allowed to register at the district level.42 Figure 7.10 compares the registration processes at the district and provincial levels. 40Asian Development Bank 2004. 41Effort is ongoing to develop a single visa concept forACMECS members. 42Businesses with less than 1 million kip ($93) of capital investment follow a separate procedure. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 45 Figure 7.9 A generic business registration procedure Procedure Department of Department Department Department 1 Commerce of Industry and of Agriculture of CTPC Handicraft Provincial File with CPI for the Investment License CPI Procedure Investment (threshold on amount applied: <$1mn or >$1mn) 2 License Vientiane Capital Department of Commerce issue Enterprise Registration CPI Certificate after Procedures 1 and 2 approved Enterprise Registration Procedure Certificate from 3 Department of Commerce (prov) Register with Deposit Capital Procedure Register Assets with Department Procedure Procedures into Bank 4 Department of Finance of Finance for Tax 5 6 & 7 and make sign Day 1 of Business Seal Procedure Proce- Business by Department of dure 8 Security 8 Notes: Implementation may differ by province, sector, and type of operation. CPI=Committee for Planning and Investment, CTPC=Communication, Transportation, Port, and Construction Source: See Study of Provincial Regulations (World Bank, 2005). Figure 7.10 District and provincial registration District level Step By whom Contents 1 Applicant Start-up license 5 (to Trade + Sector) District finance 2 District Trade Request sector license 6 3 District Issues sector license 1 4 4 District Trade Issues trade license 2 5 Applicant Request tax Relevant 6 District Finance Registers district offices District trade 3 Step By whom Contents 1 Applicant Request start-up license Provincial level (to line ministry) 2 Line ministry Issues start-up license 3 Applicant Request company New business registration certificate to MoC 4 3 1 2 7 8 5 6 4 Ministry of Issues company registration certificate Ministry Relevant Tax department 5 Applicant Request tax code to Tax of commerce line ministries (Ministry of Finance) 6 Tax Department Issues tax code 7 Applicant Request operational license 8 Line ministry Issues operational license 46 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Registration procedures at the district level are less cumbersome than those at the provincial level. It may require 160 fewer days and 42 fewer required documents to register at the district level. Registration requirements depend on the sector of operation, but large variations persist. Twenty days are enough to complete the registration of a firm in the district office, but the same operation may take 189 days if the provincial administration is involved.While a district-operating entrepreneur has to prepare and attach 24 documents to register a noodle shop, the provincial registration of a food manufacturing company would entail 66 attachments, not including tax registration.43 Large differences in registration procedures were also observed for different sectors. These differences are due mainly to line ministry licenses, possible overlaps in coverage, and the resulting confusion. Trading companies havetheeasiestregistrationprocedures.Forexample,ittakes222daystoregister a guest house with a total of 59 documents; it takes 189 days to register a food company with 66 documents; and it takes 36 days and 22 documents to reregister a furniture company.44 7.2. Perceptions about the burden of regulation Firms are most concerned about regulatory uncertainty, taxation, and customs and trade regulations. Fewer firms are concerned about other specific areas of regulation. More than one quarter of firms in the sample said that regulatory uncertainty was a serious problem (Figure 7.11). When asked whether officials' interpretations of laws were predictable, 55% of firms agreed that national officials' interpretations were predictable, and only 33% said the same thing about local officials. Thus, the firms' biggest concerns related to regulation appear to be the predictability of enforcement rather than the content of individual laws and regulations. Permits and requirements related to the construction of operational facilities and company registration were the biggest problems among the operating licenses. The Lao PDR ranks better on this measure of regulation than it does in most areas, as fewer than 10% of firms ranked business licensing as a serious obstacle. However, this may be due to selection bias--existing firms are generally less concerned about the cost of starting a business than are potential entrepreneurs. Although some licensing procedures affect firms' 43Data from the Survey of Informality in the Lao PDR as background study for the Lao PDR Investment ClimateAssessment (2005). 44Mekong Private Sector Development Facility (MPDF) study of registration procedures (2006), presentation at Lao Business Forum, May 2006. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 47 Figure 7.11 Firms are most concerned with regulatory uncertainty, taxation and customs, and trade regulation--fewer firms were concerned about other specific areas of regulation 40 firms 20 of % 0 Labor Legal Business Corruption Tax Trade Tax Regulatory regulation system licensing adminis- regulation rates uncertainty tration Source: Lao PDR ICS, 2005. ongoing operations, they are often most burdensome on new firms that have yet to complete them. Existing firms have already completed many required start-up procedures; hence they are less likely to be concerned about them. Firms that rated business licensing as a serious problem were also asked what aspects of business regulation were most troublesome. The total number of inspections in the Lao PDR is higher than in any comparator country other than the PRC, although the Lao PDR performs better than some of the comparator countries with respect to the time spent dealing with government regulations. As discussed earlier, this does not appear to be due simply to a high number of inspections by the agencies that typically perform the most inspections (e.g., the tax authorities and labor and social security departments, Figure 7.6). The Forest Department is responsible for most inspections. The average firm reports having 4.3 inspections45 from the Forest Department in a year (Figures 7.12 and 7.13). Inspections by this agency are heavily concentrated in a few firms--mostly in the wood-processing sector. In fact, the median firm reports no inspections from the Forest Department. 45This includes firms from sectors other than wood processing. 48 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 7.12 Most inspections were from forest, customs, and tax departments Forest 4.3 Customs 4.1 Tax 2.5 Industry 1.6 Trade 1.3 Economic Police 0.6 Labor 0.4 Municipal Police 0.3 Food and Drug 0.3 Total 18.7 0 5 10 15 20 Average number of inspections Mean Median Note:Outliers more than three standard deviations are dropped when calculating averages. Because of this procedure individual averages do not exactly sum to the total average. Source: Lao PDR ICS, 2005. Figure 7.13 ...and the same agencies, plus industry, caused the longest time spent dealing with regulators Industry 2.0 Customs 2.0 Forest 1.7 Tax 1.7 Economic police 1.6 Labor 1.6 Trade 1.4 Municipal police 1.3 Food and drug 1.2 0 1 2 3 Average length (in hours) Note:Outliers more than three standard deviations above or below the mean are dropped when calculating averages. Source: Lao PDR ICS, 2005. TheCustomsDepartmentisresponsibleforthesecondgreatestnumber of inspections--4.1onaverage,and3.0forthemedianfirm.TheTaxDepartment and the Industry Department have the next highest numbers, with 2.5 and 1.6 for the average firm and 1.0 for the median firm. Other agencies inspect fewer than half the firms in the sample (i.e., the median firm is not inspected) and, except for trade, inspect the average firm less than once a year. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 49 Nearly all inspections last less than 8 hours, and most inspections take less than 1 hour.46 For all the agencies, the median firm reported that the inspections lasted 1 hour. After discarding the outliers, there is relatively little variation in average length. The longest average length was 2 hours for the industry and customs departments,47 and the shortest was 1.2 hours for the Food and Drug Department.48 Firms that are inspected more also have a higher "time tax" of dealing with regulators. Whenweregressthetimethatmanagementspendsdealingwith regulations on the total number of inspections, the coefficient on total inspections is positive and statistically significant (Appendix Table 5). Labor, tax, and industry department inspections appear to be the most time consuming. When we regress management time spent dealing with each type of regulation, the size and statistical significance of the coefficients are different for different types of regulation--although the coefficients are positive in all cases (see column 2 in Appendix Table 5). An additional tax inspectionincreasestotalmanagementtimespentdealingwithregulationby0.31 percentage points, while an additional Industry Department inspection increases the total time spent dealing with regulation by 0.35 percentage points. Although the coefficients on Labor Department and Forest Department inspections are statistically insignificant at conventional significance levels, the point estimates of the parameters suggest that an additional inspection increases the total time by 0.88 and 0.07 percentage points, respectively. 7.3. Differences among firms By most measures, exporters face a higher regulatory burden than non- exporters (Figure 7.14). Senior management of exporting firms spent a greater portionoftheirtimedealingwithgovernmentregulationthannonexporters(4.9% of exporters' time, compared to 3.6% of nonexporter's time). Exporters also reported a higher number of inspections (29.1 per year for exporters compared to 13.0 per year for nonexporters).Although the average exporter reported more 46Outliers were dropped. One firm reported a customs inspection that took 48 hours (fewer than 1% of the firms reported customs inspections), and three firms reported inspections by the Industry Department that took between 20 and 30 hours (fewer than 1.5% of the firms reporting industry inspections). 47While the Customs Law established the right of authorities to inspect imports and exports, risk management techniques are shown to reduce the time spent and number of inspections, with similar results in terms of discouraging illegal imports and exports. 48As noted previously, we consistently discard outliers that are more than three standard deviations above or below the mean when reporting means. 50 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 7.14 The burden of regulation is greater for exporters and they are less confident about its predictability Time spent 3.6 with regulators 4.9 Local regulators Customs 3.8 inspections 5.6 National Total 13.0 regulators inspections 29.1 0 10 20 30 0 25 50 75 Number of inspections/percent of time % of firms saying regulations with regulators predictable Exporter Nonexporter Exporter Nonexporter Note: Outliers more than three standard deviations above or below the mean are dropped when calculating averages. Source: Lao PDR ICS, 2005. customs inspections than did nonexporters (5.6 per year compared to 3.8 per year for nonexporters), this is too few to account for the entire difference in the total number of inspections. This suggests that a greater burden is imposed on exporters due to their status. It should not be discounted, however, that some firms, including exporters and foreign direct investors, might tend to spend more time dealing with government regulations for their own vested interests, or to obtain special privileges. Exporters perceive regulations to be more unpredictable than nonexporters. Fifty-four percent of exporters said that national regulations were predictable, while 57% of nonexporters said the same. Exporters were even more concerned about local regulation--only 26% of exporters said local regulations were predictable, compared to 37% of nonexporters. Overall, the results of the ICS suggest that the regulatory burden is slightly greater for exporters than for nonexporters. For example, the average exporter is about 10 times the size of the average nonexporter. If large enterprises faceagreaterregulatoryburdenthannonexporters,thenthismightaccountforthe difference between exporters and nonexporters. To control for other differences between exporters and nonexporters, we ran several regressions with time spent dealing with regulations, total number of inspections, and how predictable the firm claimed regulations are (seeAppendix 2 on manufacturing). INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 51 Textilefirmsreportthegreatest"timetax"spentdealingwithregulators. Overall, firms in the textiles sector report that their senior management spends an average of 6.3% of their time dealing with government regulations. The burden is also high for wood processing firms, which spend more than 5% of senior management time dealing with government regulations. Senior management spends less of their time in the three other industries--from 3.5­4.0%. Wood processing firms report more inspections than other firms. Most of these inspections are from the Forest Department. The average wood processing firm reports being inspected 26 times per year. These inspections account for a significant share of total inspections--the average wood processing firm is inspected 12 times per year. Garment firms report that they face a relatively high number of inspections--25 per year, on average (Figure 7.15). Despite the high number of inspections, garment firms report, on average, that their senior management spends only 3.6% of their time dealing with regulations, which is lower than in any other sector. There are several reasons why the number of inspections and time spent with regulators is not perfectly correlated. Inspections are only one part of regulation and different inspections impose a different burden on enterprise managers. At the enterprise level, some types of regulation, i.e., tax inspections and inspections by the industry department, are more highly correlated with Figure 7.15 The burden of regulation is greater for firms in the textile and wood processing sectors than in other sectors Time spent with regulators Tax inspections Total inspections Garments Garments Garments Construction Construction Construction materials materials materials Food Food Food Wood Wood Wood processing processing processing Textile Textile Textile 0 5 10 0 3 6 0 20 40 % of time spent Number of inspections Number of inspections with regulators Note: Outliers more than three standard deviations above or below the mean are dropped when calculating averages. Sources: Lao PDR ICS, 2005. 52 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH the overall burden of regulation than others. This also appears true at the sector level. Tax inspections, for example, are more highly correlated--although not perfectly correlated--with management time spent with dealing with regulatory requirements. Bribes may also reduce the time spent dealing with regulators (see Section 11 on governance). 8. Taxation Tax rates in the Lao PDR are not excessively high by international standards. As Figure 8.1 shows, taxes as percent of profits, number of payments required, and the amount of time it takes in the Lao PDR are below average among the comparator countries.According to the Doing Business Report, firms in the Lao PDR pay fewer taxes than firms in the most comparator countries. Nevertheless, more than 30% of firms said that both taxes and tax administration are severe obstacles to their businesses. Figure 8.1 The official tax rates and taxation burden are at par with comparator countries KGZ KGZ VIE PRC PHI PRC PHI INO INO INO VIE KGZ VIE PRC CAM MAL CAM MAL CAM PHI LAO LAO LAO 0 20 40 60 0 25 50 75 100 0 400 800 1,200 Taxes (as % of profits) Number of payments Time in hours Notes: Outliers more than three standard deviations above or below the mean are dropped when calculating averages. CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Sources: Lao PDR ICS, 2005; Investment climate surveys. Although tax rates in the Lao PDR are not high by international standards, some evidence suggest that tax collection is inefficient and that too many exemptions have been granted. In comparison with similar countries, the Lao PDR does not lag too far behind in terms of percentage of non-resource taxes collected as percentage of nonagricultural GDP.49 However, between 2001 and 2005, tax revenues stagnated and fell as a percentage of GDP 49IMFArticle IV, 2004. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 53 Figure 8.2 Tax revenues fell in 2003­2005 14 8 12 7 research 10 6 5 which 8 GDP of 4 real % 6 3 of and 4 % 2 2 1 Revenue 0 0 2001 02 03 04 05pr 06pr Revenue (% GDP) Real GDP growth % of which resource (percentage change) Note: pr=preliminary Sources: Government of Lao PDR, IMF, and World Bank. (Figure 8.2). Under-collection of customs revenues was wide ranging and often not justified. Losses of revenue due to exemptions50 and other legal reasons have been estimated at about 50% of the total revenue. While revenue losses in the rest of the tax system are hard to pin down, some evidence suggests that they are of similar order of magnitude. For example, one analysis by the MOF estimated a tax gap51 of around 70% under the given rates. Although the statutory taxes on small and medium businesses are 25­35%, calculations using data from the Enterprise Baseline Survey (EBS) suggests that mean value of the effective tax rate for the Lao PDR firms is around 8.6% with a median of 5%, consistent with the results of the tax gap analysis.52 8.1. Perceptions of firms More than 30% of firms cited tax or tax administration as major or severe obstacles. In some sectors, even a higher number of firms found taxation to be a serve constraint. While this is lower than the average for the Asia and 50Customs exemptions in Customs Law are guided by clauses 43 (general), 44 (investment promotions), and 45 (diplomatic and international organizations). Importantly, there are temporary exemptions on raw materials and materials for construction projects. Literature suggests that tax exemptions granted in the past have reduced tax collection in comparison to potential. Poor skills of the tax collectors and low capacity of the tax bodies have also been mentioned among the main reasons for low revenues. 51Tax gap is equal to loss of revenues due to poor enforcement of the current tax system. 52See Lord (2006), this tax study has been supported by the European Commission. 54 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Pacific region, this is higher than the proportion of firms in Viet Nam (14%) and Cambodia (18%). There are also significant differences by sector and types of firms. Thirty-five percent of surveyed firms in the textiles sector perceive tax rates as a serious issue. More than 30% of firms in garments perceive that tax administration is a serious problem (Figure 8.3).The textiles and garments sector are in a worse position as nearly all firms surveyed in these sectors complained gravely over taxes and are bothered by high rates. Figure 8.3 Tax and tax administrator by sector (%) Textile/handicrafts Garments Garments Textile/handicrafts Word processing Food and beverage Construction materials Word processing Food and beverage Construction materials 0 10 20 30 40 50 0 10 20 30 40 50 % of firms naming tax rates % of firms naming tax administration as "major" or "severe" obstacles as "major" or "severe" obstacles Source: Lao PDR ICS, 2005. Among the surveyed firms that saw tax rates as a serious constraint, 84% were most concerned about high rates (Figure 8.4).53 In the ICS, about 40%saidthatamultiplicityoflocaltaxeswas a serious obstacle;37% said equity wasaproblem,and22%saidunderstandingapplicabilitywas aconstraint.Fewer firms were concerned about predictability or enforcement. Foreign-owned firms and exporters are more concerned about tax administrationthandomesticfirms.Inparticular,exportersweremorelikelyto be concerned about tax administration than nonexporters (29% and 15% of firms respectively), but not about tax rates (23% and 20% respectively). Thirty-six and thirty-four percent of foreign-owned firms respectively said that tax rates and tax 53It is common for firms to complain about taxation--especially about tax rates. In over half the countries where investment climate surveys have been completed, tax rates are among the top three obstacles and in over four fifths they are among the top five obstacles (World Bank 2004). This result is also consistent with a GTZ study on SMEs in which 43% of the firms interviewed indicated "too high taxes" as one of their major problems. See also Schultze (2003). INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 55 Figure 8.4 Main tax-related obstacles High rates Multiplicity Equity Confusion in applicability Predictability Enforcement 0 20 40 60 80 100 % of firms reporting tax rates as "major" or "severe" obstacle. Source: Lao PDR ICS, 2005. administration were a problem. However, only 19% and 17% of domestic firms said tax rates and tax administration was a problem respectively (Figure 8.5). While both foreign and domestic firms care about high tax rates, foreign-owned firms were more concerned about confusion related to applicability (48% of foreign firms compared to 27% of domestic firms) and were less concerned about equity (18% compared with 45%). A greater proportion of firms in Oudomxay (43%) and Xayaboury (41%)appearburdenedbytaxratesthanfirmsintheotherprovinces(Figure 8.6).Acloser look at firms in these provinces reveals that their foremost issue is high tax rates, more so than other issues (e.g., multiplicity of taxes, predictability, confusion in applicability, etc.). Tax administration is also an important concern, with 20% of firms saying it is a serious problem, but significant differences among firms are present. In the garments sector, 36% of firms find tax administration to be a big obstacle. The issue of tax administration is particularly strong in Champassak. Twenty-six percent of firms in this province viewed tax administration as a major or severe obstacle. Data show that Champassak, Luangprabang, and Savannakhet have the highest frequency of tax inspections, averaging five to six times a year. While inspections may be necessary to monitor compliance and validate tax declaration of firms, a review of such policy to ensure consistency and transparency is needed (see Section 11 on governance). 56 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 8.5 Tax and tax administration, exporters, and FDIs (%) Exporter Exporter Nonexporter Nonexporter 0 10 20 30 40 50 0 10 20 30 40 50 FDI FDI Non-FDI Non-FDI 0 10 20 30 40 50 0 10 20 30 40 50 % of firms naming tax rates % of firms naming tax administration as a "major" or "severe" obstacles as a "major" or "severe" obstacles Note: FDI=foreign direct investment Source: Lao PDR ICS, 2005. Figure 8.6. Tax and tax administration, by province (%) Oudomxay Champassack Xayaboury Xayaboury Vientiane Vientiane Champassack Oudomxay Savannakhet Savannakhet Luangprabang Luangprabang 0 10 20 30 40 50 0 10 20 30 40 50 % of firms naming tax rates % of firms naming tax administration as a "major" or "severe" obstacles as a "major" or "severe" obstacles Source: Lao PDR ICS, 2005. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 57 For large firms, tax administration is perceived to be a more serious issue than tax rates, while for SMEs tax rates appear to be more critical (Figure 8.7). For small firms, the issues of tax rates and administration are interrelated, due to the current system in place (see next section). The difficulties faced by SMEs thus arise from the application of tax rates: determining the amount of tax to be paid opens discretionary opportunities for tax collectors, and thus it is understandable that small firms complain about rates. Figure 8.7 Taxation as a constraint for SMEs and large firms SME (1­99) SME (1­99) Large (>99) Large (>99) 0 10 20 30 40 50 0 10 20 30 40 50 % of firms naming tax rates % of firms naming tax administration as a "major" or "severe" obstacles as a "major" or "severe" obstacles Source: Lao PDR ICS, 2005. 8.2. Practice in tax and tax administration Firms register for tax purposes when they register the business. They pay a registration fee based on turnover estimation. The Tax Department also requires enterprises to reregister with their local tax office at the beginning of each year. There have been complaints from firms that encounter delays in the issuance of renewals of tax license. These were due not so much to arrears in tax payments, but to the inability of tax offices to handle renewals of registration. A discretionary contract system for tax rates estimation is employed in the Lao PDR. This system is based on negotiation between tax officers and entrepreneurs.Itestablishesaflatmonthlyratebasedontheassessmentofannual turnover.The turnover is based on sales, expenses, location, and others. For large andmediumfirms,theestimationisdonebythefirmitself.Forsmallfirmsorthose earning less than KN100 million (about $9,500), taxes are estimated during the negotiation between the tax officer and taxpayer. Poorly maintained accounting system makes it difficult for tax officers to determine a firm's annual revenues and gives room for discretion (Box 8.1). Such system creates opportunity for firms to underreport earnings and for taxpayers to extract informal payments 58 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH (see Chapter 4 and Sung, 2005). The law provides directives to estimate wealth of an entrepreneur, but does not specify the method.54 In addition, tax payments are done through cash transactions with the provincial and district tax offices, increasing incentives for informal practices. Box 8.1 A Negotiation under the contract system A service provider is helping a restaurant in the negotiation with the District Tax Office. First they agree on bringing the estimation of the annual turnover below the KN200 million threshold (less than $19,000). Because of this, the owner will no longer have to keep accounting books. The real turnover of the firm is actually estimated to be at least twice the threshold figure. The tax inspector makes a first estimation of $100 monthly fee, or $1,200 per annum. The final fee is set at $25 per month, plus a single payment of $100 to the tax inspector. The total annual payment will then be $400 (with only $300 actually being collected by the Finance Office). In the next fiscal year, the Tax Office will try to renegotiate a higher tax fee. Source: Interviews during the survey of informal firms. The new tax law expands the coverage of small enterprises eligible for thecontractregime.ThenewlawenactedinOctober2005includesallenterprises having an annual turnover of less than, KN200 million. The previous law only coveredthosewithannualturnoverofKN100million.Smallbusinessespaytaxes following basic elementary accounting system, but micro businesses that do not apply standard accounting practices are subject to arbitrary assessments. In the EBS survey, about 60% of small businesses and 96% of all microenterprises do not maintain bookkeeping accounts. For those who do, there may be some doubts on the quality of records they keep.55 The contract system and the two-tier accounting system stimulate businesses to register the company as small business at the district level. Going above the legal turnover ceiling of KN200 million (less than $19,000 per annum) involves a much tighter set of accounting requirements.The potential tax reduction derived from the negotiation in the contract system and the complexity of the accounting system create incentives to register at the district level. Some estimates suggest that as many as 40% of companies are unregistered for tax purposes, see Chapter 4. 54Examples of misuse of the vagueness of the laws on both sides abound. For instance, tax officials would use visible items, such as cars, houses, and bank deposits in possession of an entrepreneur to estimate the turnover, while these may not be necessarily acquired from operation of the firm.The resulting disagreement is resolved during negotiations between the parties. 55See Lord, 2006. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 59 On the Government's side, the misclassification of firms produces significant revenue losses. Over the last 3 years, the Tax Office has reported a decreaseinthenumberoffirmsregisteredasmediumsizedfortaxpurposes(from 5,500 firms to 2,700 firms). This rapid reduction must be, at least in part, caused by the mere reclassification of companies from medium to small size. Small enterprises now account for 90% of total registered businesses. Of this figure, about 54% pays taxes under the contract system. The remaining 46% pay taxes through cards or tickets (Lord 2006; Quintana 2006).Anecdotal evidence shows that the tax unit operating at Vientiane's Morning Market is probably collecting less than 20% of its potential revenues, due mostly to such misclassification. A survey on tax registration56 showed the existence of a parallel collection system under which 20% of the businesses in the sample were paying taxes under a scheme of unofficial tickets/cards. The percentage of unofficially collected taxes that actually reaches the Tax Office remains unclear.57 The weak tax administration system creates possibilities and incentives for tax evasion and corrupt practices. Weak tax administration, low capacity of officials, and vague laws and regulations all contribute to informal practices and reduced revenues. The contract system thus leaves opportunities for abuse, which are exacerbated by the current system of tax administration. Low salaries of tax collectors are likely to drive them to accept irregular payments from firms negotiating for lower than the mandated tax payments. 9. Macroeconomicuncertainty As ICS indicates, macroeconomic uncertainty is regarded as one of the top four constraints. Among the firms that rated macroeconomic uncertainty as a major or severe obstacle, about 80% considers exchange rates as a big constraint. This is despite the stable exchange rate in the last 2 years. In the past, a major issue discouraging the flow of investments into the Lao PDR has been the weak macroeconomic management and the impact of the Asian financial crisis. The incidence of double-digit inflation and sharp exchange rate depreciation were at its worse in the late 1990s, when the Bank of Lao PDR resorted to monetizing the budget deficit. The past events may be the reasons for the current concerns of firms, which point out the importance of continuing the successful efforts in maintaining a stable macroeconomic environment in the future. 56SIDA Tax Team at the National Tax Office, Ministry of Finance--February 2005, 105 businesses in Chantabouly district, Vientiane capital. 57Other forms of tax evasion undoubtedly have an impact as well. For example, textile- exporting firms are known to avoid taxes by under-declaring their export prices. 60 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH As in the experience of other countries in the region, the Lao PDR's kip has only gradually depreciated in recent years. After the financial crisis, FDI inflows in the Lao PDR deteriorated; this was largely due to its heavy regional dependence for FDIs and as a potential market for electricity exports (the energy sector has been the largest recipient of FDI), foreign savings, and trade tax receipts.58In1997­1998,EastandSoutheastAsiaaccountedforabout80%ofthe Lao PDR's exports and imports. Given poor economic conditions in the region in the aftermath of the Asian financial crisis, exports of the Lao PDR fell by about 11% in 1999. It may still take some time before a number of firms take some comfort on the business environment and pursue more aggressive investment decisions. This also highlights the importance of maintaining macroeconomic stability in the long and medium term. The Lao PDR Business Forum is a good beginning for improving the credibility of the Government's policy toward the private sector. As shown by Business Forum processes in other transition countries, the Lao PDR Business Forum will foster dialogue between private sector and government and is expected to instill greater confidence among private sector businesses. The Government of the Lao PDR prepared for the first semi-annual business forum by conducting central and provincial private sector focus groups. With support from the Mekong Private Sector Development Facility working group meetings have been conducted with the representatives of the private sector in three of the four sectors (tourism, manufacturing, service and trading), and discussions on energy and mining will be held starting from the next Forum. 10. Finance The financial sector in the Lao PDR remains underdeveloped, with banks accounting for more than 97% of total assets.59 On one common macroeconomic measure of financial sector, development (namely, the ratio of money and quasi-money [M2] to GDP) the financial sector is smaller than in any of the comparator countries (with a value of 18%). It is almost equal to 20% in Cambodia, 42% in Mongolia, 96% in Malaysia, and 175% in PRC.The economy is widely dollarized and about 70% of monetary payments are made in foreign cash. The entire banking system has only about $500 million (23% of GDP) of assets and $250 million (11% of GDP) of loans. Two state-owned banks, Banque pour le Commerce Extérieur Lao (BCEL) and Lao Development Bank (LDB) holdhalfofthefinancialsystemassets.Athirdstate-ownedbank,theAgricultural 58See Okonjo-Iweala et al., 1999. 59This section draws heavily upon Fratzscher, Rose, and Vongviriyatham, 2005. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 61 Promotion Bank (APB), is a policy bank that focuses on rural and agricultural development, but which also engages in some commercial banking activities. Credit at state-owned banks is highly concentrated, even though about 70% of all loans outstanding are to the private sector. BCEL, the largest bank by assets and loans, carries only a small number of loans on its books. However, 10 of its customers account for almost three quarters of its loan flow, with one client accounting for more than 30%. LDB seems to have a lower credit concentration and a more even spread of loan value across various loan sizes. BCEL has traditionally been more deeply involved in lending to the state sector, with 40% of its total portfolio devoted to that sector, while LDB's state-sector loans have always been low. Non-state commercial banks hold over 40% of the system's assets. Microfinance and all non-bank intermediaries hold just over 2.5% of total assets. Among the non-state banks, three private domestic banks account for about 31% of loans and six small foreign banks account for the remaining 14%. The Lao PDR currently has no framework to allow companies to raise capital through public offerings of either equity or debt. Private banks are also weak and rely upon fee-based activities, rather than lending, for most of their income. The private banks that have adopted the most aggressive stances toward lending have nonperforming loan portfolios similar to those of the state-owned banks. The microfinance industry is also underdeveloped. It is constrained by public interventions, lack of a regulatory framework and the prevalence of short-term, subsidized development projects. There is also a general lack of awareness of microfinance principles, international best practice, and a lack of understanding and practice of sustainable interest rates, methodologies and controls and systems. Effective exclusion from the formal and semiformal financial systems drives up the cost of financing for small enterprises. Informal moneylenders provide an additional source of capital. Because of the high risk involved and the lack of legal recourse in this sector, interest rates tend to be very high, ranging from 5­10% per month to as much as 50% per day. The high cost of borrowing from the informal sector makes it very difficult for small firms in the Lao PDR to invest. 10.1. International comparison Firms in the Lao PDR do not rely heavily on bank financing for their short-term, long-term, or new investments. This is not surprising, given the 62 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH underdeveloped banking sector in the Lao PDR; the near insolvency of the state- ownedbanks;andtheimportanceofthestate-ownedbanksrelativetothebanking sector. Only about 10% of firms in the Lao PDR have overdraft facilities (Figure 10.1). Only firms in Mongolia and Cambodia are less likely to have overdraft facilities. On the average, firms reported financing only about 4% of their new investment through bank financing. In comparison, firms in Viet Nam reported financing about 26%. Firms in the Lao PDR rely heavily on retained earnings and internal funds to finance both new investment and working capital (Figure 10.2). Given the relatively modest amounts of new investment financed through the formal banking sector, this is not surprising. Firms also reported that they financed about 11% of their new investment and working capital through non- bank formal financial sector. Based on ICS results, the most important way of finance is through equity financing and sales of shares. Given that no active market allows firms to raise capital through public offerings either of equity or debt in the Lao PDR, these sales are presumably private offerings.60 Figure 10.1 Firms in the Lao PDR use internal funds to finance their short and long-term assets (%) (%) MAL KGZ VIE NEP MON PHI PHI PRC MAL INO INO CAM VIE MON CAM PRC LAO LAO 0 20 40 60 80 0 25 50 75 100 % of firms with overdraft % of firms registered with any agency Internal funds Banks Informal sources Nonbank formal Note: CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, NEP=Nepal, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Source: Investment climate surveys. 60Research Committee on Developing Bond Market in the Lao PDR. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 63 Figure 10.2 Firm use informal sources of finance and banks to finance more of their short-term capital needs than their long-term investment needs Working capital New investment Nonbank Nonbank formal (11%) formal (11%) Informal Informal sources (6%) sources (3%) Banks (5%) Banks (4%) Internal Internal funds (78%) funds (82%) Source: Lao PDR ICS, 2005. Financing of short-term assets is done via informal sources. Firms only report financing about 3% of new investment and 6% of working capital through informal sources such as moneylenders and family and friends. This suggests that informal financing is more commonly used to finance short-term assets. In part, the difference reflects that firms were more likely to use moneylenders to finance short-term rather than long-term assets--something that might not be surprising given that loans from informal moneylenders are often relatively expensive. However, during informal interviews with firms in the country, many indicated that informal moneylenders were an important source of financing. To an extent, firms might be unwilling to mention informal borrowing in formal interviews due to concerns about the legality of the activity (see Chapter 4). Few firms reported having long-term loans. Firms were more likely to use banks to finance their short-term working capital needs than they were to finance new investment (Figure 10.2). Only about 9% of loans had maturities of more than 3 years and 68% reported maturities of less than 1 year (Figure 10.3). The few firms with bank loans--about one quarter of the sample-- report paying high nominal interest rates, which are, however, low in real terms (Figure 10.4). The median firm reported an annual interest rate of about 12% in the Lao PDR, compared to about 6% in PRC, 10% in Viet Nam and Cambodia, and 11% in the Philippines. Real rates, however, appear to be quite modest and even negative. Between 2000 and 2004, inflation averaged about 13% in the Lao PDR. This indicates that those who saved in local currency were 64 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH being penalized with losses in real purchasing power, which may have then made it quite difficult for banks to pool more savings to finance their lending operations. Figure 10.3 Few Firms in the Lao PDR report having loans with terms of greater than 3 years 100 75 investment 50 new of 25 % 0 LAO PRC PHI VIE INO Less than 1 year Between 25 months and 3 years Between 13 months and 2 years Over 3 years Note: INO=Indonesia, LAO=Lao People's Democratic Republic, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Source: Investment climate surveys. Figure 10.4 Nominal interest rates are relatively high in the Lao PDR-- but inflation is also high meaning that real interest rates are relatively low 25 20 15 investment 10 new of % 5 0 LAO PRC VIE CAM PHI NEP INO KGZ Median interest rate Average inflation rate (2000­2004) Note: CAM=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), Lao=Lao People's Democratic Republic, NEP=Nepal, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Source: Investment climate surveys. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 65 10.2. Differences between large and small firms Access to finance is significantly better for larger firms. Larger firms in the Lao PDR are more likely to have a loan, an overdraft facility, finance more new investment and working capital through bank financing, and have longer-term loans than other enterprises. For the average firm in the sample, expanding the firm size by 10 workers increases the likelihood that the firm has a bank loan by about 5 percentage points, the likelihood of having an overdraft facility by 2 percentagepoints,theshareofworkingcapitalfinancedthroughbankfinancing by 1.2 percentage points, the share of new investment financed through bank financing by 1.1 percentage points, and an average loan duration of 2 months. Small firms appear to use internal funds more than medium or large firms, even though such funds were the most important source of financing for all types of firms. For financing of working capital and new investment through internal funds, the coefficients on the number of workers is negative and statistically significant in both regressions (see alsoAppendix Table 7). Small firms do not appear to rely heavily upon informal sources of finance either--presumably, due to their high cost. All groups use informal sourcesoffinancingforabout2­3%oftheirinvestmentneeds(Figure10.5).Most of this was money from family and friends. None of small enterprises and only Figure 10.5 All types of firms rely heavily upon retained earnings to finance new investment 100 75 investment 50 new % 25 0 Small Medium Large Foreign Domestic State- Exporter Non- owned exporter Internal funds Informal sources Banks Nonbank formal Source: Investment climate surveys. 66 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH three mid-sized and one large enterprise used informal moneylenders to finance either new investment or working capital. During field interviews, managers often said that informal financing was available; however, a few appear to use it. Thehigh cost of borrowing from moneylenders discourages firms from using this source of financing very heavily. Firms of all sizes rely on nonbank formal sources of financing such as equity to finance new investment. About 10% of small, 15% of mid-sized, and 12% of large enterprises reported using equity financing. Other sources of formal financing were less common. Only one mid-sized firm and one large firm reported using credit from suppliers or customers. Exporters rely less heavily on the banking sector than non-exporters. After controlling for other factors (e.g., size, ownership, sector of operations, and location), exporters are 31 percentage points less likely to have a loan, 18 percentagepointslesslikelytohaveanoverdraftfacility,finance11 percentage points less of their working capital, and fund 10% less of their new investment through bank loans. The average duration of exporters'loans is about 19 months shorter than similar nonexporters (Figure 10.6). Many studies in both developed and developing countries have shown that exporters tend to be more efficient than other firms--something that would presumably make them relatively better candidates for loans.61 There is also little evidence that exporters have less demand for loans than non-exporters--exporters were less likely to say that they did not want a loan. Exporters were more likely to have had loans rejected than non-exporters, and were less likely to say that interest rates were too high. SOEs do not enjoy preferential treatment with respect to bank loans. This does not appear to be due to low demand.Among firms without loans, SOEs were less likely to say that they did not want a loan than other firms and were more likely to have had a loan rejected. Partially state-owned firms are unable to rely upon informal sources of credit to finance new investment and rely only marginally on financing from other formal sources.As a result, state-owned firms are especially reliant upon retained earnings to finance both new investment and working capital (Figure 10.5). Foreign-owned firms are less likely to have loans or overdraft facilities than other firms and finance less of their working capital and new investment needs through the banking sector than other firms. One issue seems to be the 61The large literature on the relative efficiency of exporters and non-exporters is summarized in Tybout, 2003. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 67 Figure 10.6 Reasons for not having loans, by type of firm (%) (%) (%) Do not want Do not want Do not want loan loan loan Interest rates Interest rates Interest rates too high too high too high Application Application Application too difficult too difficult too difficult Loan Loan Loan rejected rejected rejected 0 20 40 60 0 10 20 30 40 0 10 20 30 40 % of firms % of firms % of firms Domestic State Exporter University Secondary Foreign Nonexporter Vocational Note: Firms were able to give multiple reasons and no reason other than "have not applied" for loan. "Does not want" implies that firm responded with reason such have enough funds, small market, received funds from parent company, do not want to have debt, no plan, borrow from relative or other reasons that suggested they did not want a loan at the current time. Source: Lao PDR ICS, 2005. difficulty of foreign-owned enterprises in getting loans from local banks. However, foreign-owned firms (FOFs) are less likely to need loans because they can get financing from other sources such as international banks or from their parent companies. Consistent with this, FOFs were less likely to say that the loan application was rejected; were less likely to say they did not have a loan because the loan process was too difficult; were less likely to say interest rates were too high; and were more likely to say that they did not want a loan. Having an educated manager does not seem to help when getting loans. Given that one of the major complaints of firms without loans was that the loan process was too complicated, it seems plausible that firms with better-educated managers might be able to negotiate the loan process more easily. This does not seem to be the case. Managers with vocational education appear to get slightly longer-term loans--about 9 months longer than managers with only a secondary education.Managerswithuniversityeducationwerelesslikelytosaythattheloan application process was too difficult. However, university-educated managers were also more likely to have their loan applications rejected and were more likely to need a loan. Although better-educated managers were less concerned about complicated application procedures, there is little evidence that they found access to finance easier. 68 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Despite Vientiane's favorable location, only modest differences in access to credit are detected across regions. Firms located in the North were more likely to use retained earnings and firms located in the South were more likely to use family or equity sale to finance their investment (Figure 10.7). The regression analysis of the coefficients on a Vientiane dummy variable are howeverstatisticallyinsignificant(AppendixTable7).Infact,thepointestimates were negative in all cases, suggesting that firms in Vientiane were less likely to have a loan or overdraft facility, used less bank financing, and had shorter-term loans than firms in the North of the country. Overall, this suggests only modest differences in access to credit across regions. Figure 10.7 Use of financing, by province 100 80 60 % 40 20 0 LAO VIE Oudomxay Luangprabang Xayaboury Savannakhet Champassak Internal funds or retained Equity, sale of stock Informal sources earnings Family, friends (money lender) Domestic commercial banks Others (loans, overdraft) Note: Lao=Lao People's Democratic Republic, VIE=Viet Nam Source: Lao PDR ICS, 2005. 11. Governance Onlyaround10%offirmsnamedanyissuerelatedtogovernanceasamajor or severe constraint to their business. The combined governance indicators in Figure 5.2 include corruption, crime, theft and disorder, anti-competitive practices,legalsystem,andconflictresolution.Theresponsetoeachissueamong these was even lower than 10%. While Transparency International ranked the Lao PDR to be as corrupt as the PRC in its corruption perception index, the perceptions of firms in the Lao PDR differ from perceptions of the respondents to Transparency International's survey, as well as from the perceptions of firms in the PRC (Figure 11.1). INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 69 Figure 11.1 Transparency international corruption perception index and perceptions of firms in investment climate surveys (%) 80 problem 60 corruption CAM MON severe identify or 40 INO PHI KAZ that PRC majora 20 THA Firms as VIE MAL LAO 0 1 (corrupt) 2 3 4 5 6 (clean) Transparency International's corruption perceptions index 2005 Notes: The line corresponds to the predicted investment climate survey corruption score (i.e., percentage of firms that identify corruption as a major or severe problem) from a regression on Transparency International's Corruption Perception Index 2005 and a constant for a sample of 61 countries, where the slope is equal to -8.0 with standard error equal to 2.3. CAM=Cambodia, INO=Indonesia, KAZ=Kazakhstan, LAO=Lao People's Democratic Republic, MAL=Malaysia, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Sources: Investment climate surveys, various years; Transparency International, Corruption Perception Index 2005. Corruption is not considered a binding constraint by the firms at this stage. It is less important than infrastructure, regulation, or taxation issues. Perceptions of corruption in the Lao PDR compares very favorably with neighboring countries and firms do not perceive corruption as a problem (Figure 11.2). Only 9% of firms in the Lao PDR identify corruption as a constraint. Some indicators, however, point to the possibility of corruption becoming a problem once the other constraints are eliminated or cease to be binding. For example, while 50% of firms said that bribes were never expected, the other 50% said that bribes were always (24%) or sometimes expected (26%). ICSprovidessomewhatcontradictingevidenceonthesizeofanaverage bribe paid to officials. Depending on the question and units of measurement, the averagebribetoagovernmentofficialaspercentageofsalesvariedbetween0.2% and 4% of sales (see Appendix 3 on Governance for more detailed calculations, and Figure 11.2). These contradictions may be a direct consequence of measurement problems or an indication of corruption being created by cumbersome regulations and legalized discretion. For example, bribes "to get things done" 70 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Figure 11.2 Firms did not view corruption as an important constraint to business, but it was costly for some firms. Estimates of average bribe size range from 0.2­4% of sales as 60 to 100 8 90 7 problem 50 gifts 80 6 sales) corruption 40 expected 70 informal is 60 5 or of 30 report payments 50 4 (% "severe" 40 gifts identify or 20 that 3 officials 30 of 20 2 that 10 informal Firms or 10 1 alueV payments "major" 0 public 0 0 Firms CAM MON INO PHI KGZ PRC THA MAL VIE LAO VIE PRC CAM KGZ LAO PHI INO Informal payments Max/min Average value expected, % interval of informal payments Notes: The results on bribes as percentage of sales need to be considered with care, see Appendix on Governance. Cam=Cambodia, INO=Indonesia, KGZ=Kyrgyz Republic (the), LAO=Lao Peole's Democratic Republic, PHI=Philippines, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Sources: Lao PDR ICS, 2005; Investment climate surveys. may help firms navigate though the unnecessarily cumbersome regulations or to deal with discretionary taxation. Their incidence and size would then go down with simplification of regulation, increased predictability of regulations, and elimination of discretion in tax administration. However if this is not the case, corruption may become a problem after other constraints have been eliminated or mitigated. More research is, therefore, needed to conclude on the relative importance of corruption as a constraint to investment climate. The results that ICS gives are presented as follows. Firms in the Lao PDR were less likely to report that bribes were expected during inspections of different agencies than firms in Viet Nam or Cambodia, but more likely than firms in Indonesia or the Philippines. Firms were asked whether bribes or gifts were expected during inspections by different agencies. Figure 11.3 shows the percentage of firms that said bribes were at least sometimes expected during inspections by three agencies: the tax authorities, Labor Department, and municipal police. Import and export licenses are especially burdensome when informal paymentsareexpected"togetthingsdone."Supplychainstudyinthegarment industry indicates that informal payments are also expected at about 3% of value added, from both cut-make-trim (CMT) and free-on-board (FOB) producers (see GDS 2006 and Box 13.1). Champassak and Savannakhet also have the highest proportions of firms that experience making informal payments to tax inspectors based on the responses of around 50% of the surveyed firms. Even beyond INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 71 inspections, firms are expected to pay for infrastructure connections (electricity, water, and mainline telephone), construction-related permits, import licenses and main operating licenses, as shown in Table 11.1. These additional hidden and unpredictable costs may impose comparatively high fixed costs on small firms. Figure 11.3 Bribes are expected at an average rate among comparator countries Tax Labor Municipal police VIE VIE VIE CAM CAM CAM PHI PHI PHI PRC PRC INO INO PRC LAO LAO LAO 0 20 40 60 0 20 40 60 0 20 40 60 % of firms that say % of firms that say % of firms that say bribes expected bribes expected bribes expected Notes: Firms are classified as saying that bribes or gifts were expected during inspections if they said that they were expected or requested "sometimes" or "always". CAM=Cambodia, INO=Indonesia, LAO=Lao People's Democratic Republic, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam Source: Investment climate surveys. Table 11.1 Bribe tax in public services among comparator countries Percentage of firms that report gifts or informal payment are expected LAO CAM PRC INO MON PHI VIE Always/Yes Electrical connection 14.8 7.4 5.6 4.0 ­ 4.0 17.9 Water connection 23.1 5.4 ­ 2.7 ­ ­ 12.3 Mainline telephone connection 11.8 3.2 5.5 4.3 ­ 2.4 8.3 Construction-related permit 19.2 ­ ­ 6.9 31.6 16.0 38.1 Import license 56.5 91.8 16.9 4.7 40.0 19.9 24.3 Main operating license 24.4 ­ 1.7 8.4 ­ 15.0 23.7 Tax department 34.5 42.0 38.7 11.2 ­ 27.6 48.4 Labor and social security 19.2 28.0 28.0 4.6 ­ 12.9 20.0 Municipal police 31.0 44.5 44.5 ­ ­ 19.2 43.4 Notes: CAM=Cambodia, INO=Indonesia, LAO=Lao People's Democratic Republic, MON=Mongolia, PHI=Philippines, PRC=People's Republic of China, VIE=Viet Nam ­ not available. Sources: Lao PDR ICS, 2005; Investment climate surveys. 72 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Informal payments or gifts are either expected or requested during many of the non-tax inspections as well. The agency that was most likely to expectinformalpaymentsorgiftswastheeconomicpolice--closetotwothirdsof firms reported that bribes of gifts are expected during inspections by this agency (Figure 11.4). Other than the economic police, the agencies that were most likely to expect informal payments or gifts are the agencies responsible for most of the inspections--thetaxauthorities,CustomsDepartment,andForestryDepartment. About one quarter of the surveyed firms reported that gifts are sometimes or always expected during industry department inspections. The simple correlation between the average number of inspections and the percentage of firms reporting that bribes are expected is 0.19. Figure 11.4 Agencies that inspect most often were also the ones most likely to expect bribes or gifts during inspections Industry 2.0 Economic police Customs 2.0 Forest Forest 1.7 Customs Tax 1.7 Tax Economic police 1.6 Municipal police Labor 1.6 Food and drug Trade 1.4 Industry Municipal police 1.3 Trade Food and drug 1.2 Labor 0 1 2 3 0 25 50 75 Average length % of firms saying bribes or gifts expected Note: Outliers more than three standard deviations above or below the mean are dropped when calculating averages. Firms are classified as saying that bribes or gifts were expected during inspections if they said that they were expected or requested "sometimes" or "always". Source: Lao PDR ICS, 2005. Informal payments come along with tax inspections. About 34% of firms, which have been inspected by the tax department, say that informal payments are always or sometimes expected during inspections. Six out of nine large firms and 26% of SMEs, which have undergone inspections, reported making some informal payments. Within each sector, the gap on frequency of inspections between firms saying tax inspectors "always/sometimes" expected and those saying that gifts were "never" expected was most pronounced in the garments and food and beverages sectors (Figures 11.5 and 11.6). INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 73 Figure 11.5 Inspections and gifts expected, by sector Frequency of inspections and if gifts are asked by tax office inspectors by sector Garments Wood processing Food and beverages Textile/handicraft Construction materials 0 5 10 15 20 Mean number of inspections Firms saying tax inspectors "always/sometimes" expect gifts Firms saying tax inspectors "never" expect gifts Source: Lao PDR ICS, 2005. Figure 11.6 Inspections and gifts expected, by province Frequency of tax office inspections and if gifts are "always/sometimes" asked, by province Champassack Champassack Luangprabang Luangprabang Oudomxay Oudomxay Savannakhet Savannakhet Vientiane Vientiane Xayaboury Xayaboury 0 1 2 3 4 5 6 0 10 20 30 40 50 60 Number of inspections Percent of firms saying gifts expected "always/sometimes" Source: Lao PDR ICS, 2005. More frequently inspected firms are likelier to pay bribes and have higher "time tax" when dealing with regulators. For example, with respect to tax inspections, firms reporting that gifts are "always" expected were inspected an average of 10 times in the previous year, compared to only 5 times for firms that reported that gifts were "never" expected. Together, these results suggest a 74 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH correlation between the burden of regulation and the prevalence of bribes. The pointestimateofthecoefficientsuggeststhatincreasingthenumberofinspections by one would increase the percentage of time that senior management spends dealing with regulations by 0.1 percentage point (see column 1 in Appendix TableA.4.1). 12. Land Only about 6.9% of firms in ICS mentioned land as a major or severe constrainttotheirbusiness.Amongthese,themainconcernwasthecostofland, followed by difficulties in the procurement process (see Figure 12.1). Nearly half of firms that identified access to land as an issue considered land cost as a major or severe obstacle. In 2004, only 11­21% of firms acquired new lands, although around 70% of firms had new investments of some kind (see Table 12.1). About 40% of firm with issues on land found the procurement process to be a major or severe constraint. Provincial governments provide land rights, and anecdotal evidence suggests that the process takes several months, but the duration may vary at the discretion of authorities. This process is faster in districts where the Land Titling Project62 is operational. The Land Law and related ministerial decrees specify a method for issuing of a land title--that is, a formal document recognizing land use rights.63 Obtaining a land title by a Lao national is either for a long term or perpetually;landcanalsobeleasedforatermupto90years.Therearerestriction on foreigners in acquiring land but long-term leases and concessions64 are available to them. Land titles and leases can be used as collateral; in case of lease, registering a mortgage on the lease may be done. 65 62The Land Titling Project is a joint project by the World Bank and AusAID, with GTZ participation in one component. The project is working in nine provinces, issuing titles village by village applying systematic adjudication processes. To date, 720 villages have been titled and the project will work in over 300 villages in the next year. About 400,000 land titles have been issued of a projected 1.6­2 million land parcels. 63The 2003 Land Law provided for the creation of a National Land Management Agency (NLMA), bringing together in one organization the Department of Lands, the Department of National Land Use Planning and urban Development, parts of the Department of State Assets. The transition to NLMAis underway. 64Concessions are used for plantations, mining exploration, etc. and are usually concerned with large tracts of land. 65The issue of leases and concessions is overseen by the Department of State Assets and other government agencies at the central and provincial level. There are shortcomings in the investment/concession process, and the Government is working to overcome them. For example,astatecompanyonlanddevelopmentandserviceswasestablishedasatypeofone- stop shop for major investors, charged with reducing red tape and simplifying processes. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 75 Figure 12.1 Access to land as a constraint % Cost of land Procurement process Disputed ownership Availability of infrastructure Other sources Small size of land ownership 0 10 20 30 40 50 Firms which rated access to land as a "major" or "severe" obstacle Source: Lao PDR ICS, 2005. To provide land ownership records, land titles are provided in the areas under the Land Titling Project and survey certificates are provided in other areas. The LandTitling Project issues a land title which is readily accepted by the public as an authoritative statement of the ownership. It is also accepted by banks and lenders as collateral for loans. Land titles are the strongest form of security of tenure. The titling process generally takes 3­4 months from first inspection of the land.The adjudication process includes an administrative rather than judicial process for resolving land disputes. In areas where the project is not yet operational, land offices at the province and district level issue survey certificates.Surveycertificatesarelesserformsoftitlewithlesscertainlegislative basis, but they are readily accepted as a temporary form of title. Because the lending market is expanding, lenders are encouraging borrowers to apply for survey certificates and are accepting these as a form of collateral as well. When the project moves to an area where survey certificates already exist, the land will be included in a new cadastral map of the area and the survey certificate will be upgraded to a land title. To support the effective operation of the land market, the Government is working on strengthening the provincial land offices in their role of registering transfers, mortgages, and subdivisions of registered land. For example, lenders can readily search registered land to check current ownership and can register a mortgage over registered land taken as a security. This process is underway in the nine provinces. Villagers are still reluctant in some cases to register transfers, but where finance is required, banks and other lenders encourage registration so that the mortgage can also be recorded on the title. 76 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH The project includes setting up a valuation information system (VIS) to provide a simple valuation methodology for calculating registration fees on transfers and mortgagesinatransparentway.VISisprogressivelybeingexpandedintodistricts where land titling has been completed. Recent field activity to upgrade rate tables indeed indicates that increases in the value of land have indeed recently taken place. Table 12.1 Percentage of firms with new investment Firms in % With new investments 69.5 Land 11.0 Land/building 21.1 Machinery 58.1 Vehicle 22.8 Source: Lao PDR ICS, 2005. 13. Firmperformanceinmanufacturing To promote rapid growth, it is important to understand how the investment climate impacts on productivity and which aspects of the investment climate matter most for different types of firms. Managers who must deal with unpredictable regulations from local governments face difficulties in planning the operation and growth of their business. Poor roads lead to the breakage or spoilage of goods in transit or block access to markets. Frequent power outages lead to costly interruptions in production. This section will investigate the relationship between firm characteristics, productivity, and the investment climate in the Lao PDR using econometric analysis based on data from ICS (AppendixA.2) and on other evidence. There are significant labor productivity (defined as value added per worker) differences across provinces, sectors, sizes of firms, and exporting status. Large firms are more productive than SMEs. Exporters have significantly higher value added than nonexporters. Foreign and domestic firms have roughly the same productivity, which suggests that investment climate constraints are similarly constraining for both types. Firms with the highest value added are located in Luangprabang, Xayaboury, and Savannakhet (by different measures), while the lowest productivity is observed in Oudomxay. Firms in Oudomxay and Champassak are also the least capital intensive. Value added per worker is INVESTMENT CLIMATE AND FIRM PERFORMANCE IN MANUFACTURING 77 highest in garments and wood processing firms, while total sales per worker are highest in construction materials and wood processing (Appendix TableA.3). Even within industries, productivity of firms may differ significantly. For example, in garments, productivity between CMT producers and producers that export directly differs by a factor of 10. The agent cost is the main reason for this difference, and therefore indicates the huge impact of exports infrastructure on productivity (Box 13.1). Box 13.1 Productivity between exporters and nonexporters in the garment industry differs significantly Over 90% of garment exporters are involved in either cut and make or cut, make, and trim (CMT) production, which has a low value added and has no backward or forward linkages. The Lao PDR garment industry is comprised of 110 companies, 58 of which are exporting. Only about six companies are free-on-board (FOB) producers--which produce a specialty--or niche market product that is not subject to fashion trends, can enjoy long production runs, and have higher in-country value added. Value added per trouser is 54% higher for the FOB manufacturer than CMT producer, even after deducting material and port charges. In addition to lower value added, CMT manufacturers are required to pay agent fees equal to about 10% of the total value added, while no such burden is incurred by the FOB manufacturer. Agent fees are very high for CMT producers, and erode the margins significantly--that is, ranging from 7.5­30% of the export factory price. As a consequence, profit margins between the two types of producers differ by a factor of 10. While profits are higher for FOB manufacturer, this must be tempered against the fact that such manufacturing enterprises must have the financial means and willingness to take the upfront financial risk to purchase material, which can be as much as $27,632/ container load. But as evident from the following table, these risks are rewarded with higher returns. Profit margin between FOB and CMT manufacturers differs by a factor of 10. CMT versus FOB value chain costs CMT FOB Costs Total cost Costs Total cost Ex-works $1.00 $1.00 $4.68 $4.68 Less material and port charges $0.00 $1.00 $3.14 $1.54 Less agent fees $0.09 $0.92 $0.00 $1.54 Less profits $0.07 $0.85 $0.78 $0.76 Source: Global Development Solutions, 2006. 78 REDUCING INVESTMENT CLIMATE CONSTRAINTS TO HIGHER GROWTH Approximately 60­75% of sampled firms invest. The incidence of investment (percentage of firms with positive investment) also varies depending on firms' location, type, and sector of operation. Large firms invest more often than do small firms. Exporters invest more often than non-exporters. FOFs invest more often than domestic firms. However, the investment rate (ratio of investment to current capital) is higher in small, non-exporting, and domestic firms. Domestic firms indicate low levels of current capital's high propensity to make new investment and desire to expand (Appendix Table 4). Power outages are costly for production, especially in construction materials and food and beverages. In food and beverages, every 10 hours of power outages is associated with an average 3% lower value added, and every percentage of shipment loss due to breakage or spoilage in transit is associated with an average 8% lower value added. In construction materials, every 10 hours of power outages is associated with an average 7% lower value added. In addition, estimating the value added lost due to various investments climate constraints shows that infrastructure might cut significant chunks of the value added, especially for a small firm. Firms that complained about governance or taxation issues had no significant differences in value added, suggesting that these constraints impact on all firms equally, or do not have an impact on labor productivity, or impose only fixed costs. Firms that complained about infrastructure, regulation, regulatory or macro uncertainty, and electricity have higher productivity than those which did not complain. This suggests that these constraints become binding as the firms approach the production frontier. Firms that cited finance as a major or severe obstacle have significantly higher productivity than those that did not complain. This suggests that access to finance becomes a binding constraint at higher levels of value added. Similar conclusions are reached by the supply chain analysis.Firms'productivityingarmentsandtextileswasstronglycorrelatedwith the unpredictability of local government officials'interpretation of regulation. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 79 III. INVESTMENTCLIMATEANDFIRM PERFORMANCEINSERVICES The services sector has grown at par with real GDP and now contributes about 25% of GDP, 8% of which is from tourism. The growth was faster in hotel and restaurant businesses than in an average service firm. Undoubtedly, a high potential for increasing growth is still uncovered in the Lao PDR's tourism sector due to the country's location and natural beauty. Tourism is a critical part of the services sector that can contribute to the economic development of the Lao PDR. According to the Lao PDR National Tourism Administration (LNTA), tourism generated revenue of almost $120 million in 2004. Endowed with a rich culture and interesting scenic spots, the country has benefited from an increasing number of tourists in recent years. MorethanhalfofthetouristarrivalseachyearareThaicitizens,whousuallycome on day trips across the Mekong River, return without taking accommodation, and spend only a small amount of money while in the country. If the Lao PDR can attract more international tourists who will stay longer and infuse more money into the local economy, the sector has considerable scope for growth. The tourism industry faces critical supply-side challenges in its efforts to take advantage of regional tourism opportunities. Outsideofthemainurban areas, the country's physical infrastructure--electricity, telecommunications, and road networks--is insufficient to meet the needs of both the local and large projected influx of mid- and high-end tourists. Low education and training levels of tourism personnel make it difficult for tourism companies to find and retain qualified employees. Further complicating the operations of tourism firms are uncertainties regarding the macroeconomic and regulatory environment. This chapter explores those constraints, and identifies the key challenges the country faces in its efforts to develop the tourism sector. 80 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH 14. Thetourismindustry The Greater Mekong Subregion (GMS)66, has enjoyed significant benefits from the growth in tourism. Approximately 18.7 million tourists visited the subregion in 2004. According to ADB estimates, the industry accounted for roughly$22.2billioninoutput,$18.6billioninincome,$2.3billioningovernment revenue, and sustained 3.8 million jobs. However, the majority of this activity is in one country--Thailand--and substantial development of the other markets is required to spread the benefits more evenly among these six countries. A number of factors can make the Lao PDR a promising tourist destination. The country has great natural beauty, including a system of Natural Protected Areas and two properties designated as World Heritage Sites by the United Nations Educational, Scientific and Cultural Organisation (UNESCO).67 It is a multi-ethnic society, with many of the cultures maintaining traditional dress and customs. Lao PDR's attractions remain relatively unexplored, fostering an aura of novelty that is of particular value to international tourists seeking unique experiences. Because of these attractions, tourist arrivals have shown a generally positive growth trend. In accordance with the Law on Investment Promotion and Tourism, the Government of the Lao PDR has promoted investment in tourism by catering to both local and foreign investors. Because of this and other reform actions, the tourism sector is estimated to contribute about 8% to GDP and provide direct and indirect employment of about 22,000 jobs. Starting from a baseof38,000visitorsin1991,shortlyafterthecountry'sborderswereopenedto tourists, the Lao PDR surpassed the one-million-visitor mark in 2005. Between 1998 and 2004, arrivals increased by almost 80% (Appendix TableA.7.1). Despite this overall growth trend, the majority of tourist activity is concentrated in a small number of locations. On the average, tourists stay in the Lao PDR for less than 3 days, and spend a relatively small amount per day during their visits. Only four destinations attracted more than 5% of the country's tourist arrivals in 2004: Vientiane municipality, Luangprabang, Vientiane Province (Vang Vieng), and Champassak.68 More than 73% of arrivals 66GMS encompasses Cambodia, the Chinese provinces of Yunnan and Guangxi, Lao PDR, Myanmar, Thailand, and Viet Nam. 67ThetwoWorld Heritage Sites are the ancient town of Luangprabang and theVat Phou temple complex in Champassak province. The Government of Lao PDR has proposed a third site-- the Plain of Jars--added to the list, and hopes to have it inscribed in 2006. 68Lao National TourismAdministration Planning and Cooperation Department, 2005. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 81 in 2004 came from the neighboring countries of Thailand, Viet Nam, and PRC, often on day trips or border passes; and spent an average of less than $27 per day (Appendix TableA.7.2). The remaining 27%, coming from all other countries stayed in the Lao PDR for 6.5 days on the average, and spent about $59 per day. The average stay in the Lao PDR for international tourists is shorter than in most other countries in the region, and the average daily expenditure is lower (Figures 14.1 and 14.2). Figure 14.1 Average stay ­ subregional tourism, 2004 10 8 (days) 6 stay 4 Average 2 0 THA VIE MYA LAO CAM PRC Note: CAM=Cambodia, LAO=Lao People's Democratic Republic, MYA=Myanmar, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Source: ADB, 2005. Figure 14.2 Average tourist's expenditure in GMS subregion 200 180 160 ($/day) 140 120 100 80 expenditure 60 40 Average 20 0 PRC THA CAM MYA VIE LAO Note: CAM=Cambodia, LAO=Lao People's Democratic Republic, MYA=Myanmar, PRC=People's Republic of China, THA=Thailand, VIE=Viet Nam Source: ADB, 2005. 82 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH Aquick overview of the tourism sector indicates that while the industry shows considerable promise, there remains room for growth. The tourism sector can further grow not just by attracting more tourists but also by improving the quality of tourists' experience to promote longer stays and higher spending. For instance, using the 2004 arrival figures and assuming no change in the travel and spending patterns of visitors from neighboring countries, the Lao PDR could double its tourism revenue (with just a 1% across-the-board increase in the total number of arrivals), if international tourists stay in the Lao PDR for as long as they do in Viet Nam (8 days), and spent as much as they do there ($80/day). 15. Supplyconstraints The hotel sector in the Lao PDR operates at moderate occupancy rates. The national average room occupancy rates were 45% and 44% in 2003 and 2004, respectively. Despite a 41% increase in tourist arrivals between 2003 and 2004, occupancy rates increased in just six provinces, and no province had an occupancy rate of more than 65% in 2004 (Figure 15.1). There is no evidence now that the tourism sector has been unable to generate sufficient supply of hotel and guesthouse rooms to meet current demand. The total number of hotel and guesthouse rooms almost doubled Figure 15.1 Room occupancy rates by province, 2003­2004 Average Attapeu Bokeo Bolikhamxay Champassak Houaphanh Kammouane Luangnamtha Luangprabang Oudomxay Phongsaly Saravanh Savannakhet Sayabouli Sekong Vientiane Municipality Vientiane Province Xieng Khouang 0 0.2 0.4 0.6 0.8 2003 2004 Source: Lao National Tourism Administration Planning and Cooperation Department, 2005. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 83 between 2000 and 2004,69 reaching a total of 13,666 rooms and 20,480 beds in 2004. Even with the unrealistically conservative assumption of only one guest per room, this means that each hotel and guesthouse room in the country was occupied for an average of 190 days out of the year. The quality of rooms is more important than the number of available rooms. To accommodate strong growth in the tourism sector, many rooms will have to be replaced or upgraded. Either way, substantial investment will be required. Many industry analysts feel that much of the newly established hotels are poorly designed, lack amenities, and are therefore ill suited for mid-and high-end tourists. The Government of the Lao PDR projects that tourist arrivals will continue to grow between 1.5 million and 5 million by 2014. Under this aggressive growth scenario, tourism would be a billion-dollar industry by 2014. Lao PDR even projected that tourist arrivals could reach 1.7 million in 2010. Underthecurrentgrowthprojection,coupledwithimprovementsininfrastructure and tourism climate, the industry is expected to bring in more than $500 million per annum. To achieve those arrival numbers and visitor receipts, however, the industry should ensure that infrastructure exists to support the growth. The sector also has to ensure that the ensuing social and environmental effects of increased exposure to international tourism do not undermine the country's essential advantages as a tourist destination. To address these, the Lao PDR has developed a National Tourism Development Strategy (NTDS). It has also been an active participant in the GMS Tourism Sector Strategy, which brings together the Governments of Cambodia, PRC, the Lao PDR, Myanmar, Thailand, and Viet Nam to develop and promote Mekong as a single tourism destination and help distribute the benefits of tourism more widely. To realize large increases in the number of international tourism arrivals, the tourism strategy of the Lao PDR must pay careful attention to the country's growing reputation as a destination for backpackers. Growth of the tourism industry will require an expansion of focus to promising new market segments. In general, the Lao PDR lacks the infrastructure and facilities that will be needed to accommodate substantially higher tourist arrival levels and to diversify the market away from the backpacker segment. The strategy of evolving into higher-end tourism will have to deal with these capacity constraints. The Government and a variety of industry analysts agree that the Lao PDR entrepreneurs lack the exposure and expertise to understand what kind of tourism products are attractive to the international market. 69Lao National TourismAdministration Planning and Cooperation Department, 2005. 84 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH To attract greater numbers of international tourists, the Lao PDR will also have to distill its strategy into a tourism brand to promote the sector overseas. The firms interviewed suggest that to compete more effectively with neighboring countries, the Lao PDR needs to develop a strong tourism brand, along the lines of Thailand's "Land of Smiles" campaign or Malaysia's "Truly Asia" campaign. If the Lao PDR cannot establish its own tourism brand, it may benefit from the promotion of a single brand image for the Mekong subregion, as proposed in the GMS tourism strategy. 16. Privatesectorconstraintsinthetourismindustry Successful development of the Lao PDR's tourism industry will depend on the private sector's ability to take advantage of opportunities arising from the Government's strategic focus on the industry. Tourism has been targeted as a key sector for the country's economic development. However, to realize the sector's full potential, there is a need to examine and address the various constraints to the operation and growth of tourism firms. ICS intends to determine the key constraints faced by private firms in the tourism sector. For tourism, the survey collected data from 57 firms in two sectors--hotels and guesthouses (42), and tour operators and travel agencies (15)--includinginformationabouttheirperceptionsoftheseverityofthevarious constraints they face. The sample included firms located in three provinces of the Lao PDR--Vientiane, Luangprabang, and Luangnamtha--and represented a cross-section of firm sizes. Based on the perceptions of the firms surveyed, the most important constraints in the tourism sector are infrastructure and resources70 (Figure 16.1). The serious concern over infrastructure is primarily due to electricity, while the main issue related to resources is the skills and education of workers. By a two-to-one margin, infrastructure is the most commonly cited constraint in the hotel sector, while resources enjoy an even larger margin as the most important constraint in the tour operator and travel agent sector (Figure 16.2). Taxation, maintaining macroeconomic stability, and addressing 70Considering the limitations of drawing statistical inferences from a relatively small sample size, key informant interviews were conducted to flesh out the relevant issues qualitatively, and to characterize the nature of the key constraints facing tourism firms. In general, the respondents appeared to have been hesitant to discuss the constraints they faced frankly during the survey, perhaps because of cultural factors, or perhaps because of concerns about their anonymity, particularly with regard to constraints related to their interaction with government officials. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 85 regulatory impediments are also important among tourism firms. This section will examine how these and other important factors are constraining the tourism sector, based on the survey, additional interviews , and a review of information generated by the Mekong Private Sector Development Facility Lao Business Forum's Tourism Working Group (BFTWG). 16.1. Infrastructure Electricity was cited as a major or severe obstacle by more than half of the hotel firms surveyed. Tour operators and travel agencies placed a lower importance on electricity, considering that a greater part of their interaction Figure 16.1 Top constraints perceived by tourism firms All tourism firms (%) Infrastructure Skills/land Tax Macroeconomic uncertainty Regulations Others Finance Governance 0 10 20 30 40 50 Establishments identifying problem as a "major" or "severe" obstacle. Source: Lao PDR ICS, 2005. Figure 16.2 Main constraints in the tourism sector, by type Hotels/guesthouses (%) Tour operators/ travel agencies (%) Infrastructure Skills/land Tax Macroeconomic uncertainty Macroeconomic uncertainty Skills/land Regulations Finance Infrastructure Regulations Others Others Governance Tax 0 10 20 30 40 50 60 0 10 20 30 40 50 60 % of firms identifying problem as a % of firms identifying problem as a "major" or "severe" obstacle "major" or "severe" obstacle Source: Lao PDR ICS, 2005. 86 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH with customers is independent of their electricity supply. For instance, a guided walking tour through the temples of Luangprabang will not be impacted by a power outage in the tour operator's office, whereas hotel guests are aware of the availability of fans, airconditioning unit, television, and light whenever they are in their rooms. Nonetheless, electricity was, overall, the most frequently cited constraint on business during the survey. Access to electricity is particularly difficult outside Vientiane and Luangprabang. Hotel firms surveyed in Luangnamtha reported an average of 13.8powerdisruptionsperyear(withonefirmreportingasmanyas40),compared to 6.5 in Luangprabang and 5 in Vientiane (Figure 16.3). The power disruptions in Luangnamtha also lasted longer--5.5 hours on the average, compared to 3.1 hours in Luangprabang and 2.6 hours in Vientiane. Among hotels, lower occupancy rates are more likely seen among those with more power disruptions (Figure 16.4). Some of the travel agencies interviewed said that inconsistent electricity supply outside the main centers increases the difficulty of their jobs, as they have to be particularly sensitive about their clients' needs. They also do not want to send tourists to areas where they will be uncomfortable and unhappy with their visit. The current focus on building ecotourism packages to remote rural locations exacerbates this problem. Figure 16.3 Electricity disruption by province 15 10 5 0 Luangnamtha Luangprabang Vientiane Hours disruption/day Days of disruption Source: Lao PDR ICS, 2005. The key informants interviewed in Vientiane repeatedly mentioned electricity as a constraint, but expressed greater concern about cost than about access. Electricité du Laos (EdL) has a multi-tiered tariff system that allows residential customers to be cross-subsidized by certain businesses paying higher rates. Hotels are classified as entertainment establishments, the highest INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 87 rate-paying category. As a result, tariffs paid by firms in the hotel sector are almost 10 times as high as those paid by small residential users, and about 72% higher than those paid by industrial and agricultural users. Hotel owners feel they are being asked to pay an unfairly high rate for electricity. Since their rate has been rising sharply in recent years, hotel owners also believe electricity is becoming an increasingly important cost driver for their businesses. Figure 16.4 Electricity disruption versus occupancy rate ­ hotels/guesthouses 10 8 6 4 2 0 Days Hours of Losses as percent of disruption disruption/day of sales Above median occupancy rates Below median occupancy rates Source: Lao PDR ICS, 2005. The companies participating in the Lao PDR Business Forum's Tourism Working Group list transportation policy as the most important high-priority issue facing the tourism industry. Their argument is simple: tourism cannot succeed if tourists cannot get to their destinations. No flights currentlylinktheLaoPDRtoEurope,Japan,ortheUnitedStates(US).Therefore, all inbound and outbound air traffic is routed through neighboring countries (mostly Thailand and Viet Nam), reinforcing the Lao PDR's status as a side-trip destination. According to one local tourism expert, routing a group tour to the Lao PDR through Thailand can add as much as 30­40% to the costs compared with a similar group tour to Thailand. Many international travel agencies have therefore dropped the country from their list of pre-packaged tour destinations, andwillonlyarrangetoursonacustomizedbasiswhenthereisaspecialdemand. Direct international flights, even if it were only one or two, would improve this dynamic. To that end, the tourism working group has called for the Government of the Lao PDR to adopt an "open-skies policy" (Box 16.1). 88 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH Box 16.1 Open-skies policy An open-skies policy has been adopted by a number of countries for passenger traffic and/or cargo carriers through bilateral or multilateral aviation agreements. This liberal aviation policy allows the airlines of participating countries to determine routes, capacity, and pricing. For example, the "Multilateral Agreement on the Liberalization of International Air Transportation," signed by Brunei, Darussalam, Chile, New Zealand, Singapore, and the US in May 2001, grants airlines of each party the right to fly across other countries' territories, to operate flights and establish sales and promotion offices in other countries, and to independently set prices. Regardless of the form of the open-skies policy, there is a need for support infrastructure such as sufficient runways and airports to accommodate more traffic with the expected entry of other airlines. At the First Lao Business Forum in April 2006, the Private Sector Working Group for Tourism proposed that the Government of the Lao PDR adopt an open-skies policy to help boost tourism in the country. The policy is expected to promote competition in the aviation industry which, in turn, can raise the level of efficiency and satisfaction of air travelers by enabling better quality and lower-priced services. It can expand opportunities not only for tourism but also for other industries, through facilitating trade and transportation. To appreciate the merits of this policy, the Government of the Lao PDR may undertake an assessment of its costs and benefits. Source: Author's summary from Private Sector Utility Group tourism report. Domestic airtransportation is also considered a high-priority issue. Lao Airlines, a state-owned enterprise (SOE), holds a 100% monopoly on domestic air travel. The airline operates a small fleet made up of mid-sized European aircraftforitsinternationalroutesandthewell-traveleddomesticroutes(between Vientiane and Luangprabang, and between Vientiane and Pakse), and small Chinese aircraft for more remote destinations. The age and condition of the fleet, and the relatively low level of airport security--by international standards-- give rise to safety concerns. The airline has also earned a bad reputation for unreliable schedules and frequent mechanical failures. Moreover, the route map is organized according to a hub and spokes model.This means tourists wishing to travel by air--for instance from Luangprabang to Oudomxay--both of which are in northern part of the Lao PDR have to transit through Vientiane en route. On land transportation, the Lao PDR has no railroad and has a poorly developed highway system. Although a number of road-building projects are underway, with ADB spearheading the process in line with the GMS Tourism Sector Strategy, many potential tourist destinations can only be reached via one-lane, unpaved roads. Long travel times, combined with restrictions on the length of visas upon arrival, often mean that tourists can visit only a limited number of areas. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 89 The tourism sector faces similar infrastructure challenges in telecommunications. Outsideofthemajorcenters,landlinesarescarceandmany tourist destinations in remote areas are serviced only by cell phones or satellite phones. One tour operator commented that the scarcity and lack of reliability of telephone and fax contacts with some of these destinations make it difficult to confirm reservations or to arrange last-minute itinerary changes. It is sometimes impossible to contact a property where the operator has customers, which creates anxiety about their safety and security. 16.2. Skills and education After electricity, skills and education are the next most frequently cited obstaclesamongcompaniessurveyed.Concernsaboutskillsandeducationwere far more apparent among tourism firms than among firms in the manufacturing sector.Among tour operators and travel agencies, the incidence was particularly high, with 53% identifying this as a major or severe obstacle. The depth and scope of this challenge were reinforced in the findings of the Lao PDR BFTWG, as well as in a number of key informant interviews. The skills constraint in the Lao PDR cuts across all strata of workers, from the least skilled positions to senior management. At the highest level, the key informants interviewed admitted their firms lacked the essential entrepreneurial and management skills required to operate professional businesses. Many new entrants into the tourism sector, especially outside of the main centers, do not have the international exposure and expertise required to develop tourism products that appeal to an international market. Among the firms surveyed, the education level of the top managers seem to be related to the firm's success. Almost 80% of those firms with value added per worker above the median value have a top manager who attended at least some university, while only 10% have top managers who have not completed upper secondary school. By comparison, only 64% of those firms with value added per worker below the median value have a top manager who attended at least some university, while 18% have top managers who have not completed upper secondary school (Figure 16.5). Employees in the tourism sector have high educational levels relative to the general population, but employee education does not seem to be related to a firm's success. On the average, 64% of employees in the firms surveyed have completed secondary school or received vocational training. This reflects a high level of education by the Lao PDR's standards, given that only 68% of 90 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH Lao PDR children between the ages of 6 and 14 are enrolled in school, and only halfofthosewhobeginreachtheGrade5level(WorldBank2004c).Theaverage percentage of workers with at least secondary or vocational education is similar among firms with below median value added per worker and among those with above median value added per worker (nearly 70%). The principal concern is the quality of education, especially since it pertains to the various skills required in the tourism sector. Figure 16.5 Education of top managers and value-added per worker in the tourism sector Did not complete upper secondary Upper secondary Vocational training Some university training Graduate degree Postgraduate degree 0 10 20 30 40 50 % of top managers Above median value added/worker Below median value added/worker Source: Lao PDR ICS, 2005. Language skills are also frequently cited as a concern among firms in the tourism industry. Many firms interviewed with more than about 10 employees have sent some of their staff for supplementary language training to help them interact with clients. One tour operator described the difficulty of finding specialized tour guides to handle groups from European countries such as Germany, Italy, and Spain. However, most firms interviewed said that the largest skills challenge they face is with regard to vocational skills for their nonmanagerial employees. The key informants did not consider the vocational schools to be helpful in producing qualified employees, and pointed to the need for a tourism school. In September 2003, the Stichting Nederlandse Vrijwilligers (SNV) proposed a tourism training institute as part of a study it undertook for the LNTA on training needs in the industry (Eshoo et al. 2003). According to the key informants interviewed in January 2006, little has changed since SNV's INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 91 assessment in 2003. Although training programs have recently been initiated by various stakeholder groups in the industry, these programs are all small scale and have not provided a comprehensive framework for meeting industry-wide training needs. Like the Lao PDR, other countries within GMS also experience problems with weak training systems, insufficient private sector participation in vocational and management training, and insufficient investment in training by the tourism industry. In addition, insufficient training of public sector officials in sustainable tourism planning, development, and management are further barriers to tourism development within the region. 16.3. Tax One of the key constraints identified by tourism firms is the tax rates. More than 20% of all companies surveyed listed this as a major or severe obstacle, including almost 30% of the companies with fewer than 10 employees. Only 1 of 57 firms surveyed listed tax administration as a major or severe obstacle. Key informants, however, revealed that firms' specific concerns with tax rates focus on the structure of the system and the non-transparent way in which rates are determined for individual firms. Like many other aspects of firms'interactions with the Government of the Lao PDR, tax rates are essentially negotiable for most companies. Below a predetermined amount of tax liability, the tax authorities arrive at a fixed- sum tax payment for the company, based on the information provided by the investor in the application to establish the company. Though no specific criteria are published, the authorities take into account a variety of factors, such as the company's projected assets and the scope of its business. For a hotel, this could be the number of beds and the size of any related food and beverage business. For a tour operator, this could be the number of vehicles, distinct tour offerings, or the number of destinations covered. Since the fixed-sum tax system is not based on actual business results, a company's effective tax rate increases in periods when business is slow. The size-based criterion for application of this system helps explain the greater perception among small companies that tax rates are an obstacle. In addition, this system places the company's tax situation at the discretion of the district tax inspector, which opens room for the firm to negotiate its tax rate with the inspector. In general, this system of negotiated tax rates creates significant opportunities for rent seeking and reduces the predictability of future earnings, thus discouraging medium- and long-term planning. 92 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH 16.4. Macroeconomic uncertainty PrivatefirmsintheLaoPDRareconcernedaboutthefutureoftheeconomy. These concerns take two forms. First, they are concerned about risks arising directly out of macroeconomic events. Second, tourism firms are concerned about the Lao PDR's policy response to external economic events. Firms are sensitive to exchange rate fluctuations and other macro- economic volatility. Firms in the tourism sector are likely to receive at least part of their revenue in foreign currency, and their expenses can also be in a variety of currencies.As a result, they are particularly sensitive to changes in the exchange rates.The Lao PDR kip had generally been stable against the US dollar since 2000. In April 2005, however, it was devalued by about 20%. The kip's devaluation was good for firms that received income in dollars, but was bad for firms that received a substantial amount of their income in kip, thus increasing inflationary pressures in some sectors. The only means these companies have to hedge against currency risk is to keep their operations denominated in foreign currency. Until recently, however, this was not permitted. Firms are concerned about the Government's policy response to external shocks. When the Government of the Lao PDR decides on important matters,suchasthedevaluationofthekip,hotelfirmsoftenfeeltheyarecaughtby surprise. In addition, the Government's policy toward businesses'use of foreign currency has changed over time. In 2005, the Government liberalized firms' ability to receive revenue in foreign currency. Given the Government's historical track record of decision making, the firms interviewed were not confident that this measure represented a commitment to liberalization. They feel that this program is just a temporary measure that could be reversed when warranted by external circumstances. This feeds into a broader concern that despite its public commitment to development of the tourism sector, Government policymaking remains opaque and unpredictable. 16.5. Regulation Regulatory uncertainty is commonly cited as a constraint to doing business in the Lao PDR. This is shown in the results of the survey, the Lao BFTWG, and key informant interviews. Within the survey, only about 10% of respondents listed this as a major or severe obstacle, but almost all firms surveyed mentioned it as an obstacle of some kind. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 93 Opening a business in the Lao PDR remains a difficult and time- consuming process, involving a variety of government authorities and veto points. Although none of the survey participants cited this as a major or severe obstacle, the key informants interviewed unanimously mentioned their frustration with this process. A simple, indicative flow chart (Figure 16.6) demonstrates the complexity of this process. The chart should be considered illustrative, rather than definitive. In practice, it is rarely clear to the applicant at the time of submission what specific approvals will be required and which government agency will approve the registration. One official at the LNTA's Hotel and Tourism Management Department, which is responsible for business registration, estimates that the approval process, from beginning to end, should take about 3 months.71According to investors who have recently opened tourism businesses, however, the process can take up to a year. Their frustration with this process centers on its unpredictability.72 Figure 16.6 Business registration and approval flow chart Commission for Planning Provincial and Culture Environment Tax Investment Authorities Lao National Investor Tourism Ministry of Business Administration Commerce Registration Provincial District Tourism Health Police Tax Office Authorities Source: Peters, 2005. Firms cite a number of areas in which they believe the Government's policy toward the tourism industry hinders growth. Among these is the visa 71The official explains though that this is not a guaranteed time frame, and that much depends on the nature of the application and on the applicant's ability to fulfill the administration's requirements. 72Lack of information on the registration process is also part of the problem. For example, investments in hotels and plantations are not covered by the Industry Department, though they are often believed to be under the jurisdiction of this department, thus resulting in more delays. 94 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH policy regarding fees, durations, and extensions.All international tourists require avisatoentertheLaoPDR.Inthepastfewyears,theGovernmenthasintroduced a $30, 15-day visa on arrival, and has continued to increase the number of entry points where these visas can be issued. On the other hand, Lao PDR embassies abroad issue 1-month tourist visas for the same price. Given the fact that visits to the Lao PDR tend to be side trips on larger Southeast Asian itineraries, and the importance of encouraging international tourists to stay for longer periods in the country, many firms believe that visas on arrival should either cost less than $30 or carry longer durations. Extensions of tourist visas can be obtained only in Vientiane. Thus, to get a visa extension, tourists in the provinces must either travel back to the capital or surrender their passports to a third party--such as a travel agent--for several days, which many tourists refuse to do. A large number of government agencies involve themselves in every aspect of a firm's business through frequent official inspections.73 Given the largenumberofinspectingbodies,itisnotsurprisingthattourismfirmsareforced to devote a large amount of time and resources to handling ongoing inspections. In all three provinces where the survey was conducted, hotel and guesthouse firms have an average of more than 10 inspections per year, and there is a large variation in the number of inspections across provinces (Figure 16.7). Figure 16.7 Mean inspections per year in the tourism sector 10 8 6 4 2 0 Luangnamtha Luangprabang Vientiane Hotels/guesthouses Tour operations/travel agencies Source: Lao PDR ICS, 2005. 73TouroperatorsandtravelagenciesareinspectedbytheTaxDepartment,CustomsDepartment, Labor and Social Security, Economic Police, Municipal Police, Tourist Police, and Trade Department. Hotels and guesthouses receive inspections from the Tax Department, Labor and Social Security, Fire and Building Safety, Municipal Office, Environmental, Sanitation and Epidemiology, Food and Drug Department, and Tourist Police. INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 95 Atthesametime,severalfirmsinterviewedbelievethattheGovernment is not doing enough to protect and maintain the standards and image of the tourism industry overseas. Two aspects of this task are of particular concern to the interviewees. First, almost every hotel owner interviewed expressed support for an independent system of hotel classification.Any property now can describe itself as four or five-star, regardless of the actual condition of the hotels and the amenities provided. The second area is in international promotion. All firms interviewed welcome the advent of a Tourism Promotion and Marketing Board under the new Tourism Law. Despite assurances that substantial representation from the private sector will be included, however, the level of public­private dialogue is generally so low that most firms are doubtful that they will have any real input to the marketing process. The limited private sector participation in tourism development and marketing appears to be a common problem in the GMS area, and thus, measures have been proposed to address this issue through subregional cooperation. 16.6. Finance The companies surveyed in the tourism industry seem to have little access to finance. For instance, not a single tour operator or travel agency surveyed had a bank loan or short-term credit, such as an overdraft facility. Among the hotels surveyed, only 20% had bank loans and just one reported having an overdraft facility. Despite the presence of some bank financing in the hotel sector, the firms reported that they financed an average of almost 95% of their new investments fromretainedearnings.Thebanksthatreportedhavingloansusedthemtofinance an average of about 16% of their new investments. More than 85% of the tour operators and travel agents and almost 30% of hotels had not applied for a loan. Almost 50% of hotels reported that the process of applying for a loan was too complicated and difficult (Figure 16.8). OtheraspectsoftheLaoPDR'sfinancialsystemalsoserveasconstraints on firms' operations. Several interviewees cited their inability to clear credit card payments through the Internet or other means without the physical presence of the card. Some tour operators and travel agencies attempt to receive payments in advance through electronic fund transfers; however, these transactions are slow and costly. For hotels, the situation is more serious. They take reservations over the Internet, but cannot take guarantees. Thus, hotel owners report that their level of no-shows has been growing since the development of the MPDF-LHRA joint marketing website for Lao PDR hotels. 96 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH Figure 16.8 Financing in the tourism sector 100 80 60 40 20 0 Hotel/guesthouses Tour operators/travel agencies Without loan Did not apply Difficult to apply Source: Lao PDR ICS, 2005. 17. Productivityinthetourismsector The structural and operating constraints have impacted productivity in the tourism sector, especially among locally owned firms. Among the firms surveyed, the overall value added per worker was kip (KN) 32.5 million (about $3,070), with hotels and travel agencies reporting more than KN60 million per worker, and guesthouses and tour operators just over KN20 million (Figure 17.1). These overall figures, however, are distorted by a small number of large, foreign-owned firms (FOFs) (four hotels and one travel agency--that reported substantially above-average value added per worker (almost KN95 million). In particular, value added per worker seems substantially higher in Luangprabang thanintheotherprovincessurveyedbecauseofoneestablishment,whichreported a very high value added kip per worker. The median result in Luangprabang was KN26 million per worker, in line with the other provinces.Among firms with no foreign ownership, the average value added per worker was just KN27 million, and the median was KN21 million. Value added per worker among the firms surveyed was substantially lower than the figure for neighboring Thailand--the regional competitive benchmark for tourism. Becauseofthesmallsamplesizeandthelargevariation between firms, the median survey result is a more representative descriptive statistic to describe productivity in the tourism sector than the mean figure. The median productivity of the Lao PDR's tourism firms was KN21 million or $2,003, less than 60% of the baht (B) 140,000 per worker (around $3,900) INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 97 reported in Thailand.74 Using purchasing power parity conversion factors, the ratio of the Lao PDR price levels to Thai price levels is about 67%,75 giving Thailand's tourism sector a 10% competitive advantage over its counterpart in the Lao PDR. Lao firms trying to attract tourists for longer stays in the country are, therefore, hindered by poor productivity (Figure 17.2). Figure 17.1 Annual value-added per worker in the tourism sector 100 90 80 70 kips 60 50 40 Million 30 20 10 0 Hotel Guest- Tour Travel Vientiane Luang- Luang- Small Medium/ FDI Non-FDI house/ operator agency namtha prabang large inn Source: Lao PDR ICS, 2005. Figure 17.2 Constraints and productivity in the tourism sector 50 40 kips 30 20 Million 10 0 Electricity Macroeconomic Skills uncertainty and education No obstacle­moderate Major/severe Source: Lao PDR ICS, 2005. 74The productivity figure for Thailand was computed using tourism gross value-added estimates by the Bank of Thailand (2005) and employment data from Thailand's National Statistics Office. 75World Development Indicators Online, 11 January 2006. 98 REDuCINg INVESTMENT CLIMATE CONSTRAINTS TO HIgHER gROwTH The survey also reveals substantial productivity differences between firmsthatperceivedelectricityormacroeconomicuncertaintyasconstraints and those that did not. The average value added per worker of firms that cited electricity as a major or severe obstacle was just KN19 million, compared to 41 million for firms that said it was a moderate obstacle or no obstacle (see Appendix onTourism). Similarly, value added per worker among firms that cited macroeconomic uncertainty as a major or severe obstacle was KN26 million, compared to KN34 million for firms that said it was a moderate obstacle or not an obstacle at all.The median figures were substantially lower than the mean figures forallcategoriesmeasured.Nonetheless,itappearsthatfortheseconstraints,firms' perception of the severity of the obstacle corresponds to lower productivity. Interestingly, firms' perception of skills and education as an obstacle has no significant impact on productivity. The average value added per worker of firms that cited skills and education as a major or severe obstacle was KN32 million kip, compared to KN35 million for firms that said it was a moderate obstacle or not an obstacle. Given the size and variance of the sample, this difference is not statistically significant. The skills and education of Lao workers, therefore, appear to affect the productivity of companies equally across the entire spectrum of companies surveyed, whereas other constraints--such as electricity and macroeconomic uncertainty--seem to affect certain companies more than others. This suggests that while improvements in skills and education will positively impact all Lao tourism firms, addressing the electricity constraint will have a much stronger positive impact on the group of companies most affected by it. Anumber of the issues affecting tourism firms in the Lao PDR are the same issues confronting other GMS countries. GMS countries have agreed to adopt a joint strategy of addressing these constraints to promote tourism development within the region. It is advantageous for the Lao PDR to continue participating and even taking a more active role in the GMS tourism strategy to better address the issues affecting its tourism industry and reap more benefits from the program (Box 17.1). INVESTMENT CLIMATE AND FIRM PERFORMANCE IN SERVICES 99 Box 17.1 The GMS tourism sector strategy The objectives for the tourism sector in the subregion are to (i) develop and promote the Mekong as a single destination, offering a diversity of good quality and high- yielding subregional products that help distribute the benefits of tourism more widely; (ii) add to the tourism development of each GMS country; and (iii) contribute primarily to poverty reduction, gender equity, and sustainable development, while minimizing any adverse social impacts. To achieve its objectives, the strategy will be implemented through seven program areas: · Marketing and product development: foster the development of multi-country tourism in GMS by stimulating demand from appropriate high-yield markets through joint promotional activities; · Human resource development: upgrade the skills of tourism leaders and tourism trainers of GMS; · Heritage conservation and social impact management: promote higher standards in the management of natural and cultural resources for conservation and tourism purposes; · Pro-poor tourism development: help reduce the incidence of poverty and increase rural incomes; · Privatesectorparticipation:encourageprivatesectorparticipationandpartnerships in planning, investment, and marketing of GMS' tourism sector; · Facilitating the movement of tourists: identify and address impediments to travel to and within GMS; and · Tourism-relatedinfrastructuredevelopment: jointlyplananddeveloptourisminfra- structure in GMS with a view to ensuring a wider distribution of tourism benefits and supporting pro-poor tourism development in designated priority zones. Source: Asian Development Bank, 2005e. 100 Reducing investment climate constRaints to HigHeR gRowtH IV. INFORMALECONOMY This chapter explores the barriers to growth of microfirms and household- based enterprises (HBEs) and to their move from informality to formality.76 A separate section attempts to establish the link between the investment climate and the rise of household businesses, as well as studies their impact on poverty. Two types of surveys were employed to study the informal sectorin the Lao PDR, which was not covered by investment climate surveys (ICS). First were the Lao Expenditure and Consumptions Surveys (LECS) 2 and 3 (1998 and 2002), which have data on household businesses. Second was a mini-survey of informal firms conducted alongside the ICS. The samples and methodology of these surveys are presented hereafter and in Appendices 8 and 9. Due to a very limited coverage and representativeness of the mini-informal survey, the report also relies on the German Agency for Technical Cooperation (GTZ) report on small and medium enterprises (SMEs) (HRDME Survey 2005). Informal firms have been growing alongside the formal economy. Informal firms are those engaged in nonfarm activities employing two or fewer, and microenterprises employing mostly family labor. They are either registered or unregistered. ICS only covered firms that employ five or more workers, which left a large part of the economy unexamined. Estimates show that as many as 70% of all firms in manufacturing employ fewer than two workers and provide employment to approximately 2% of the labor force (more than 30,000 people). However, the majority of informal firms are in the services sector. Household businesseshaverapidlygrownduringthelastyearsandareprovidingemployment to 16% of the labor force (460,000 people), mostly in the services sector. The number of HBEs increased by almost 50% between 1998 and 2002/2003, as indicated in LECs 2 and 3. Informal economy provides significant employment opportunities, mostly self-employment, for the poor. While a number of microfirms and HBEs have grown and become part of the formal sector, a number of factors continue to deter the remaining enterprises, as well as new microfirms, from becoming formal. 76While a number of countries use a combination of criteria in their official definition of informality, an official definition of informality has not yet been established in the Lao PDR. investment climate and FiRm PeRFoRmance in seRvices 101 The growth of the informal sector has been made possible by improvements in the investment climate over the last decade. Significant improvements in rural infrastructure, opening up to cross-border trade, and the rise in domestic and regional demand for the Lao PDR products have contributed tothegrowth.Asthisreportshows,thenumberofhouseholdbusinessispositively correlated with improvements in investment climate where the households are located. While household firms grew in numbers, they have also hired more labor, and some of them eventually moved to the formal economy. In the past years, the number of household businesses had grown by half, but the majority have been operating for less than 5 years, indicating high entry and turnover rates. Some of these firms went to the formal sector while others did not. It is important to understand why. Evidencesuggeststhatlackoffinancialresourcesandarbitrarytaxation are important constraints to the growth of informal firms.77 Registration procedures have been perceived as particularly burdensome; and the benefits of registering do not seem to offset the costs of moving to the formal sector, as suggested by some surveyed firms. Following the general pattern found in the Lao PDR, the lack of skills hampers the opportunities of these firms to form production linkages with the formal sector. Where such linkages exist, these are mostly in the form of raw materials and unskilled labor. 18. Profileoftheinformalsector 18.1. Nonfarm household businesses Between 1998 and 2002, households have been increasingly involved in nonfarm business activities, and have increasingly hired non- family labor. Some significant changes have occurred between LECS 2 and 3. First, the share of households in urban areas that engages in nonfarming activities rose from 40­60%. Nationwide, this increase was from 21­28% of the households. Households also seem to be hiring more paid employees. About 20% of these businesses had at least one employee in 2002, up from 7% in 1998. However, the geographical dispersion has not changed, 60% of the activity is still located in the central part of the country. 77These conclusions are based on a very small sample of surveyed informal firms (28 firms) conducted alongside ICS and described in Quintana (2005). More research and surveys on the informal economy are needed; the results presented here should be interpreted with care. 102 Reducing investment climate constRaints to HigHeR gRowtH The majority of the household businesses are in the service sector. About 55% of household businesses are in wholesale or retail trade; 14% are in community, social, and personal services; and 11% are in tourism and other services (Figure 18.1). While HBEs in developing countries are often associated withbusinessesconductedbysmalltradersandpeddlers,theLaoPDRisdifferent: a good proportion of household businesses are in manufacturing (16%). Figure 18.1 Distribution of household businesses by sector Sectors (%) Manufacturing (%) Trading Food and beverages Manufacturing Textile Commercial, social, Garments and personal services Wood processing Tourism and other services* Furniture Others** Others*** 0 10 20 30 40 50 60 70 0 10 20 30 40 50 60 70 Household businesses Manufacturing businesses Note: *Includes hotels, restaurants, travel agencies, ***Includes coal and petroleum, nonmetallic transport finance, and real estate mineral products, metal products, electrical **Covers businesses related to agriculture, mining, electricity, gas, water, and construction, machinery, transport equipment, and and unclassified business. recycling. Source: Estimates based on LECS 3. Although the average HBE is 7 years old, 60% of all these enterprises have been operating for fewer than 5 years. Among the sectors, tourism businesses are generally the youngest, with a mean age of 5 years. This suggests some turnover and the recent emergence of new businesses. Geographicalconcentrationofformalandinformalbusinessessuggests that many formal firms have sprung from informal household enterprises. Close to 60% of household businesses are located in the Central Region (mostly Vientiane capital), and only 17% operate in the South (Appendix 8). Overall, 80% of all household businesses are concentrated in just six provinces, namely, Vientiane Capital, Luangprabang, Xayaboury, Vientiane Province, Savannakhet, and Champassack (Table 18.1), despite these provinces accounting for only 60% of the total household population. These provinces also accounted for 72% of all firms with 5 or more employees in the National Statistical Centre's (NSC) list of establishments in 2003. HBEs therefore appear to have thrived in areas with more formal sector firms. This indicates that formal or registered firms may have been mainly an offshoot of small HBEs that had grown and eventually became part of the formal sector. investment climate and FiRm PeRFoRmance in seRvices 103 Table 18.1 Geographical distribution of household businesses Provinces Total businesses, in % Vientiane Capital 28.1 Luangprabang 10.9 Xayaboury 7.9 Vientiane Province 8.3 Savannakhet 11.5 Champassack 13.0 Other provinces 20.3 Total 100.0 Source: Estimates based on LECS 3. Urban households are more likely to start a business compared to their rural counterparts. Sixty percent of all household businesses are in urban areas. In almost all provinces, more than 30% of the urban household population has a nonfarm enterprise, with Luangprabang having the biggest percentage, at 70% (Figure 18.2). In Luangprabang, Vientiane Capital, Vientiane Province, and Xayaboury, more than 20% of the rural household population have a household business. Figure 18.2. Urban and rural household businesses Percent of rural and urban households Location of household businesses having a business, by province in rural and urban are, by province Attapeu Attapeu Bokeo Bokeo Borikhamxay Borikhamxay Champassack Champassack Huaphanh Huaphanh Khammuane Khammuane Luangnamtha Luangnamtha Luangprabang Luangprabang Oudomxay Oudomxay Phongsaly Phongsaly Saravane Saravane Savannakhet Savannakhet Sekong Sekong Vientiane Capital Vientiane Capital Vientiane Province Vientiane Province Xayaboury Xayaboury Xaysombone Xaysombone Xiengkhuang Xiengkhuang 0 10 20 30 40 50 60 70 80 -100 -60 -20 0 20 60 100 Urban Rural Rural Urban Source: LECS 3, Lao PDR National Statistical Centre, 2002/2003. 104 Reducing investment climate constRaints to HigHeR gRowtH Slightly more than half of households conduct business at home. More of the female-headed households engage in business activities than male-headed households. Only 18% of household businesses are located in industrial sites or markets, while the majority are mobile (along roadsides and similar places). While female-headed households account for only 5% of households, nonfarm enterprises appear to be an important source of their livelihood. About 38% of female-headed households are engaged in business, compared to only 24% of male-headed households. Only 20% of household businesses hire paid labor, but only 10% have hired more than two employees. Rather than hiring labor, most HBEs-- including manufacturing household businesses--are operated by household members. Thus, these businesses mainly generate self-employment. However, they have a significant collective impact; total employment generated by all HBEs is estimated at 460,000 or equal to 16% of the labor force.78 Households operate small-scale labor-intensive businesses, which are significantly more productive than their farming activities. Although the average turnover of a business is less than KN3 million per month,79 the productivity of a nonfarm household business is still considerably higher than agricultural activities. An average household business generates KN13,700 per hourofwork,ascomparedtoKN1,390/hourinitsagriculturalactivities.80Intotal, householdbusinessesgeneratealmostthreetimesmorerevenuesthanhouseholds engaged solely in agriculture, while investing only a fourth as much time. 18.2. Survey of microfirms A small survey of microfirms was carried out alongside ICS to complement the findings of the survey of manufacturing firms. Twenty-four firms were interviewed in Vientiane capital. Because the manufacturing survey covers firms with five or more workers, the mini-survey of microfirms was limited only to establishments with fewer than five workers, including family members. The sample was very diverse in terms of sectors of activity. Manufacturing firms 78This is close to the estimates of Leidholm and Mead (1999) on the proportion of working age population employed by microenterprises in other developing countries, including Botswana, Dominican Republic, Kenya, and Lesotho. 79With an important difference between urban (over KN5 million) and rural areas (KN1 million). 80Indicative data: net revenues in the agriculture sector are compared with high gross revenue in household businesses. investment climate and FiRm PeRFoRmance in seRvices 105 represent 37% of the total (garments, 20%; food processing 13%, others 4%). A quarter of the surveyed firms were in the hotel/restaurant sector. Retail (food and motor) accounted for 16% of the sample. Services and construction represented 13% and 8%, respectively. The survey was undertaken in December 2005. The profile of surveyed microfirms is similar to the standard urban firm in LECS 3. These firms have been operating for an average of 6.8 years. Eighty-seven percent of them operate 12 months a year and are the sole income- generating activity of the owner. The other 13% are also the main income source for entrepreneurs, but do not run all year due to lack of customers. Apart from the owner, the surveyed firms employ an average of 1.6 workers, half of whom were full-time workers. More than 50% of the firms'workforce are family members. Surveyed microfirms were only half as productive as small firms in the ICS sample. Only 60% of the businesses were able or willing to estimate their daily sales turnover, or to provide data. Businesses that responded employed the equivalent of 1.8 workers per firm, and their average daily turnover per worker was around KN50,000 ($1,900 per annum in sales per worker). More than 90% of the sales of these microfirms were to individual customers, while the rest were sales to small and medium firms. 19. Linksbetweentheinformalandformalsectors There are two main types of linkages between the informal and formal sectors--backward­forward linkages (informal sector firms supply factor inputs to the formal sector, and serve as retail and distribution networks for formal sector firms); and the transition of microfirms from the informal to the formal sector. 19.1. Backward­forward linkages Informal firms mostly provide unskilled laborand input materials to formal firms. Backward linkages from the informal to the formal sector are common. In the case of raw materials, medium and large firms try to maximize their national sourcingofinputstoavoidtransportationcosts,wheninputsareavailablelocally. It seems, however, that inputs provided by the informal sector cannot satisfy the demand for more complex products. In these cases, the sourcing is sought abroad.Along the same lines, the informal sector provides the formal sector with a supply of cheap unskilled labor. 106 Reducing investment climate constRaints to HigHeR gRowtH Private formal sector firms feel that the Lao PDR labor market cannot meet their demand for semi-skilled and skilled workers. Furniture factories employlocallaborforloading,painting,varnishing,anddistributionofmaterials, but seek foreign workers to do semi-skilled tasks such as woodcutting. Big garment companies employ and train local workers for most production tasks (cutting, sewing, etc.), but have difficulty finding a pool of local staff for middle management positions.81 Those positions are often filled with workers from the region that provide a blend of sufficient skills and low salaries. Informal firms play a role as retailers and distributors of formal firms. The distribution channels for formal companies are often based on small-scale transportation businesses, especially in the rural areas. More sophisticated linkages are rare. For example, subcontracting is a growing practice in furniture and garment industries (Figure 19.1); however, these operations are limited to members of professional associations that are usually large formal firms. The Lao Garments Association bans its members from providing inputs or outsourcing any part of their production processes to nonmembers.82 Similarly, subcontracting of specific orders in the furniture industry is carried out among registered members. Figure 19.1 Subcontracting companies ­ Garments 70 60 50 40 companies of 30 20 Number 10 0 2003 04 05 Exporting companies Subcontracting companies Source: Lao Garments Association. 81Venture Garments--the second biggest factory in Vientiane--launched a program of recruitment among management students in Lao universities, but the program was dropped after a few years due to unsatisfactory results. 82Members of the asssociation are required to be fully registered at the provincial level. In 2007, they will also be required to register their workers for social security. investment climate and FiRm PeRFoRmance in seRvices 107 Outsourcing operations are also hampered by the lack of capacity of microfirms and by unfavorable regulatory arrangements. Key informants reported a number of unsuccessful subcontracting experiences. Smaller firms commissioned for large orders often failed to meet the quality requirements due to lack of equipment and skilled labor. They also experienced difficulties meeting delivery deadlines. On the regulatory side, movement of goods between companies for outsourcing purposes are often taxed as final output, adding extra cost to the process. Asaresult,thetransferofskillsandknow-howbetweenthetwosectors is minimal. The analysis of furniture and garment value chains83 confirms the limited capacity of microfirms to play a relevant role in their production processes. They remain outside the value added processes, and no significant transfer of technology or skills occurs.Ahost of other factors prevent microfirms from joining the ranks of the formal sector firms. 19.2. From informal to formal Both the agriculture sector and the formal economy have limited capacity to absorb surplus labor. Self-employment seems to be the only alternative for a growing number of job seekers. The World Bank's Country Economic Memorandum (2004) finds that 94% of households in the agriculture sector produce only for self-consumption. Although there is potential to expand employment and output in the sector, deep structural reforms are needed to realize such potential. Records of the Tax Office show contraction by around 20% in the number of formal medium-sized firms in the last 4 years. Medium and large firms now account for 5% of the total number of enterprises, and 95% of the revenue collection by the tax administration. Figure 19.2 shows the step-by-step process of becoming formal and obstacles along the way. In the first stage of informality, microfirms do not have to deal with registration procedures or the taxation system. Operations of very small firms can easily escape the control of local authorities, especially in rural areas. The second step involves registration at the district level, which exposes them to regulation and taxes.At this stage, operating outside the system becomes costlier. Registration and taxation at this level are not very cumbersome, and a number of informal practices ease the procedures. For most businesses, however, going into this first degree of formality does not imply improved access to the formal financial sector. 83See Global Development Solutions, 2006. 108 Reducing investment climate constRaints to HigHeR gRowtH Figure 19.2 From informal to formal ADMINISTRATIVE LEVEL LEVEL OF FORMALITY­EFFICIENCY BUSINESS CONSTRAINTS Medium FORMAL enterprises SECTOR Provincial Registration registration procedures Lack corruption High INFORMAL--EFFICIENT of taxes Lack access Micro­small of enterprises skills to financing INFORMAL--SUBSISTENCE District Registration registration procedures UNREGISTERED MICRO­ SMALL SUBSISTENCE New labor force and surplus Formal labor from agriculture sector sector Source: Quintana 2006. 20. Keyconstraintstogrowthofmicro-firms Findings of several small surveys suggest that access to financing, fear of registration procedures, and taxation are the fundamental constraints to micro and small firms. In addition, microfirms have identified electricity and governance as secondary constraints imposing fixed costs. 20.1. Access to financing The microfirms surveyed for ICS consider lack of access to sources of financing the most important constraint to operating their business. About 30% of the firms emphasized that the lack of affordable credit supply prevents them from expanding or simply running their business properly. The HRDME Survey found that 68% of microfirms would like to apply for loans. Only 11% of the rural population have access to the formal financial sectorandonly1%ofthepopulationhavesavingdeposits.84Inurbanareas,the 84Fukui and Llanto, 2003. investment climate and FiRm PeRFoRmance in seRvices 109 access rate might be higher but no data is available. The Agricultural Promotion Bank (APB) has been running microfinance schemes for the last 10 years. Despite the cost of formality--APB's procedures to obtain loans remain long and cumbersome when compared to informal sources--it has reached around 40,000 households in rural areas with subsidized interest rates. Surveys show that there is demand for microfinance services. In the microfirms' survey, more than 50% of entrepreneurs mentioned that a village credit fund for business development would improve their capacity to sustain and expandtheirbusiness.In2002,theBankofLaoestimatedthesizeofthepotential microfinancemarketataround270,000borrowersand560,000depositors.Italso states that only 25% of this market is being served by microfinance providers including moneylenders. The majority of microfirms in the Lao PDR have access only to very basic financial systems. Major reasons to explain the problem of access are lack of information on financial possibilities and lack of experience in dealing with the formal financial sector. Other surveys dealing with medium enterprises found other major constraints such as failure to meet the requirements of commercial banks in terms of collateral (mostly land certificates) and cumbersome and time- consuming procedures and paperwork. As a result, the only available sources of financing for the vast majority of the Lao entrepreneurs are suppliers, members of their community, and informal moneylenders. Unlike in the formal sector, suppliers constitute a major source of credit for operating microfirms, mostly in the form of factor inputs. Based on the estimates of national surveys, a quarter of microfirms have outstanding debts with their suppliers.85 Traders and equipment suppliers often supply their goods on credit.The supplier would then have strong interest in ensuring that the purchaser succeeds financially so they can repay loans. To ensure success, some equipment suppliers provide a package of equipment, training, and follow-up services to support purchasers. Retained earnings and family and friends are the main sources of financing to start up a business. HRDME survey by GTZ (2006) found that 15% of the microfirms have outstanding loans with friends or relatives, with zero interestratesandnocollateralrequired.Normally,nospecificamortizationperiod is fixed. The repayment of the principal stretches over an undetermined period, depending on the success of the activity, until the loan is paid off. The amount 85HRDME Enterprise Baseline Survey 2005, GTZ 2006. 110 Reducing investment climate constRaints to HigHeR gRowtH of resources available from these sources is small, and very often alternative financial sources are required. Box 20.1 An experience with money lenders At 5:30 am, a woman borrows KN40,000 from a private moneylender known to her family at Vientiane's Morning Market. She will use the money to buy oranges and limes from a neighbor on the outskirts of Vientiane, keeping KN2,000 aside to pay the market tax daily fee. Two hours later she starts selling. Before 5 pm, the moneylender will arrive to have the money repaid with 20% interest for the day: KN48,000. If she fails to reimburse the money, she will have to pay 40% on the outstanding debt the day after. If sales are appropriate, in a couple of weeks she should be able to do without borrowing. She would again request the services of the moneylender if she needs to expand her business or if she considers paying for a license to rent one of the market stalls. Source: Interviews during the survey of informal firms, 2006. 20.2. Taxes High taxes are perceived by microenterprises as an important constraint to business.86Inthesurveyofmicrofirmscarriedoutforthisreport,thesecondmost important constraint identified by firms is the high taxes. Taxation has also been identified by microfirms as a major issue in the HRDME Enterprise Baseline Survey (GTZ 2006).87 Despitetheperceivedhightaxes,about75%ofthemicrofirmssurveyed are actually paying taxes. While half of them considered the level of taxes appropriate, about half of them found taxes too high for their income. Sixteen percent acknowledged that they should and could be paying more taxes. Most Lao PDR microfirms operate under district jurisdiction. The District Tax Office (DTO) is in charge of calculating and collecting taxes for businesses operating at the district level. Given that microfirms usually operate with a small amount of turnover or below KN200 million, their annual tax fee is fixed through the contract system by DTO. Most entrepreneurs operating at the district level engage in negotiation with tax officers, where no actual turnover estimation is made and the tax payment is settled at officers' discretion. Very often, the tax payment is negotiated at a very low level, following an unofficial payment from the owner to the inspector. 86Informality survey (Investment Climate Assessment, World Bank 2006); HRDME Survey on Microfirms (GTZ 2005). 87This is based on a sample of 83 establishments with fewer than three employees. investment climate and FiRm PeRFoRmance in seRvices 111 The level of compliance with accounting requirements is very low. Even in the case of the simplified system, most small firms do not keep records of their transactions. Transparency in the accounting records at this level is rare. In Vientiane, firms are said to keep three sets of books: one for the tax office; one for the tax office when it says it wants to see the real set of books; and the real set of books.88 Thus, firms seek to operate at the district level where regulation avoidance is easier. Businesses seeking to comply with the accounting and taxation regulations find themselves at a disadvantageous position to compete with firms that negotiate their taxes. Businesses that remain small (or at least "officially" small) have a number of means to avoid tax regulations. Under the actual system, entrepreneurs at the district level seem to be the biggest beneficiaries in monetary terms of irregularities in the system. The results of small surveys carried out by the National Tax Office (NTO) suggest that most micro and small firms are paying taxes below theoretical level and many are also paying below their real capacity.89 The determination of the level of taxes that microenterprises could afford to pay and how close it is to the current legal and real levels is difficult to estimate, and no comparable studies have been carried out in neighboring countries. Tax officers also take a share of the gains, at the expense of the national Treasury. 20.3. Registration procedures Estimatesbasedonregisteredfirms'recordsfromtheNTOsuggestthatabig majority of registered firms are micro or small businesses that are required to register only at the district level. Indeed, 96% of registered firms in the Tax Office are classified as a small business according to their annual turnovers. It is beneficial to register as a small firm since registration procedures at the district level are simpler than those at the provincial level. Virtually all microfirms at the district level start operating without formalregistration,and30%continuetooperateunregistered.Aconsiderable percentage of them manage to operate unregistered over the long term. Practices inidentifyingsuchfirmsandencouragingthemtoregistervaryacrossregionsand at the discretion of tax officials.Asurvey conducted by the Swedish International Development Association (SIDA) project in the Tax Department found that approximately 30% of businesses in Chantabouly District were unregistered 88Stuart-Fox, 2006. 89SIDATax Team at the National Tax Office, Ministry of Finance. 112 Reducing investment climate constRaints to HigHeR gRowtH with the tax administration90 (25% of the companies surveyed for the microfirms survey were in the same situation). Registration procedures are not perceived by the firms as particularly burdensome. However, the benefits from registering do not appear to offset the costs of moving to the formal sector, as suggested by some surveyed firms. Thirty-eight percent of firms were not registered, although some of them have been registered before. Taxes were collected monthly by the Finance Office, suggesting a lack of coordination between finance and trade district offices. Businesses providing domestic services (small construction work, cleaning services), operating at home or in premises not visible from the street (mostly household-basedtailors),wereunregistered. Onlyonefirmacknowledgedpaying not to be registered, but two more implicitly recognized that their businesses were incorrectly registered as district-level firms. According to these firms, the conditions to access financing did not improve and no access to a broader market was gained by registering. Only 16% of the registered firms perceived the registration process as cumbersome. Reasons given by unregistered firms not to register were lack of money to pay taxes and the small size of their activity. 20.4. Electricity Microfirmsperceiveelectricitypricesasa secondary constraint forbusiness. However, the cost of electricity may be one reason for staying unregistered. The tariff system is structured as residential and nonresidential sets of tariffs, as shown in Figure 20.1. EdL inspectors are responsible for ensuring that businesses are paying the nonresidential rate instead of the residential one. A small household business could be at the second level of consumption (<150 kWh/month), whereas a larger business will almost certainly be on the third consumption block. However, if these two firms are properly registered, both will be paying the rate for "commercial nonresidential consumers." Registration has a greater effect in the smallest businesses, in terms of fixed costs for electricity bills. All types of small businesses with low consumption suffer important increases in their electricity bill after registration. Once registered, a small commercial business triples its electricity expenses, while bigger businesses double their expenses, compared with a nonregistered business with similar consumption. Figure 20.2 compares the effect of changing from residential to nonresidential commercial tariffs in businesses with low 90February 2005, 105 businesses in Chantabouly District, Vientiane Capital. investment climate and FiRm PeRFoRmance in seRvices 113 Figure 20.1 Electricity tariffs, 2005 (kip/kWh) Entertainment International organizations Commercial Industry consumers Nonresidential Government Agriculture Third block (>150 Second block (26­150) Residential consumers First block (0>25) 0 200 400 600 800 1,000 1,200 kip Source: Ministry of Industry, 2005. (second block) and high electricity consumption. In the case of low consumption businesses, the increase in expenditure is relatively higher. The constraints described above act as barriers to the growth of informal sector firms and their move to the formal sector. Breaking these barriers will enable informal sector firms to grow and have important implications for reducing poverty. Figure 20.2 From residential to nonresidential tariff 180 160 140 120 Kip 100 `000 80 60 40 20 0 Business 1 Business 2 (130 kWh/month) (200 kWh/month) Residential Nonresidential Source: Quintana, 2005. 114 Reducing investment climate constRaints to HigHeR gRowtH 21. Poverty,investmentclimate,and theinformaleconomy In the Lao PDR, households with relatively higher income are more likely to own a household business. Thus, while informality in developing countries has often been associated with deeper poverty, informality in the Lao PDR-- defined in terms of HBEs--seems more apparent among relatively higher- income groups. LECS data indicate that business ownership by households is strongly associated with living standards. While only 2% of the poorest group own a household business, 82% of the richest group own household businesses (Table 21.1). Thus, business start-ups are more likely conducted by more well- off groups. In 2002­2003, the two poorest expenditure groups accounted for only 8% of the households that started a business in the 2 years prior to the LECS 3 survey, compared to more than 50% for the richest quintile. Table 21.1 Household-based enterprises by expenditure quintiles Quintiles (poorest to richest) 1 2 3 4 5 Percent with household-based enterprises 2.4 6.1 15.5 36.5 82.4 Percent to total households that started businesses over past 2 years 2.0 5.5 10.4 26.3 55.9 Source: Estimates based on the LECS, 2002/2003. A number of factors may explain why the poor are less likely to start their own business. These include low level of skills, lack of training, and limited capital. Lacking in assets, the poor are also less likely to obtain credit-- especially from formal sources--to finance their working capital. ThepoorestgroupsintheLaoPDRarelesslikelytoengageinnonfarm businesses, like in Viet Nam (see Vijenberg and Haughton 2002). However, a much higher proportion of the poor in Viet Nam operate nonfarm enterprises compared to the proportion of the poor in the Lao PDR. About 35% of the households in the bottom two quintiles in Viet Nam owned a nonfarm enterprise in the 1990s, compared with only 4% of the households in the two poorest expenditure groups in the Lao PDR in 2002­2003. Opportunities to engage in entrepreneurial activities appear to have been mostly captured by more well-off groups in the Lao PDR. This does not, however, indicate that the poor have not benefited from the policy reforms and accompanying high economic growth. Agrowing economy means more businesses created, offering alternative income investment climate and FiRm PeRFoRmance in seRvices 115 and employment opportunities for the poor. LECS data show that poverty rates are lower among provinces with a greater proportion of household businesses (Figure 21.1). Figure 21.1 Poverty versus household businesses, by province 40 Phongsaly Sekong Saravane 30 Oudomxay HuaphanhAttapeu incidence Xiengkhuang Luangprabang (%) 20 Savannakhet overtyP Bokeo 10 BorikhamxayXaysombone Khammuane Champassack Luangnamtha Xayaboury Vientiane Province Vientiane Capital 0 0 10 20 30 40 50 60 70 % of households with business Note: Poverty incidence is based on a $1-a-day. Source: LECS 3, 2002/2003. For growth to be broadly based, it requires an environment that facilitates the entry and growth of firms. Much of this growth in the Lao PDR may come from the dynamism of micro and small enterprises. An important set of factors that can strongly influence the growth and operation of enterprises is the investment climate. Good infrastructure means better access to markets, which provides opportunities for the poor to gain from their labor endowment and from selling their products. A good investment climate lowers risks associated with operating a business, encouraging the entry of new enterprises. Thus, provinces with better access to electricity and roads have higher proportions of households that operate nonfarm enterprises (Figure 21.2). Earlier studies found that rural poverty incidence can be reduced by 7.2% by providing all-weather roads. This is equivalent to 5.6% of the total population in the Lao PDR (ADB 2005g). Astudy by Warr (2005) also shows that providing dry season road access can lower rural poverty incidence in the Lao PDR from 33 to 29.7%, based on the national poverty line. 116 Reducing investment climate constRaints to HigHeR gRowtH Villages with better investment climate had much higher number of household businesses. Simulations based on a village-level regression analysis have been undertaken for an average village with a poor investment climate-- village with no access to electricity, roads, financing, and daily or periodical markets (Appendix 9). Out of the 540 villages in the LECS 3, there are 165 of suchkind.Anaveragevillagehadabout20%ofthehouseholdsrunningnon-farm enterprises. However, for an average village with a poor investment climate, the proportion of household-based enterprises was only about 7%. Addressing the investment climate constraints could double self- employment levels in villages with poor investment climates (Figure 21.3). This has important implications for poverty reduction since poverty was also found to be higher in areas with an inferior investment climate. Figure 21.2 Household business versus infrastructure, by province Access to electricity Access to all-season roads Vientiane Capital Vientiane Capital 50 50 40 40 business Luangprabang business Luangprabang Champassack Xayaboury with 30 Xayaboury Vientiane Province with 30 Champassack Vientiane Province Attapeu Khammuane Khammuane Attapeu 20 Xiengkhuang Savannakhet 20 Xiengkhuang Savannakhet households Bokeo LuangnamthaBorikhamxay households Luangnamtha Bokeo Sekong Borikhamxay of 10 Xaysombone Sekong Xaysombone Saravane Huaphanh of 10 Huaphanh Saravane % Oudomxay % Oudomxay Phongsaly Phongsaly 0 0 0 20 40 60 80 100 0 20 40 60 80 100 % of households with electricity % of households with access to all season roads Note: Access to all-season roads means with passable roads during wet and dry seasons. Source: LECS 3, 2002/2003. investment climate and FiRm PeRFoRmance in seRvices 117 Figure 21.3 Impact of investment climate on employment Total employment in villages with no access No infra, financing, and markets Provide access to electricity Electricity + roads Electricity + roads + financing Electricity roads + financing + markets 0 10 20 30 40 50 60 70 in thousands Note: Access to all season roads means with passable roads during wet and dry seasons. Source: LECS 3, 2002/2003. 118 Reducing investment climate constRaints to HigHeR gRowtH V. CONCLUSIONS ANDRECOMMENDATIONS The issue of quality of data has severely undermined the ability to rank investment climate constraints and determine the binding constraints. To identify binding constraints, perception data need to be compared with available quantitative data, and be supported by background information and evidence. The investment climate survey (ICS) of the Lao PDR has shown some disconnections between these sources of information. Most likely, the current rapid structural change and the move to a market economy have produced this disconnection. Such phenomenon has been observed in many transition countries, especially least-developed countries (LDCs), and it is hoped that this problem will be diminished as transition progresses. To improve the diagnostics, several directions for new studies need to be deepened. These may include the reasons for informality; the size and productivity of microfirms and specific constraints that they face in comparison to formal firms; the extent and impact of governance on firm performance; the taxation of SMEs; and the policy going forward. To improve the investment climate, the Government of the Lao PDR needs to eliminate the binding constraints on the ability of businesses to increase productivity, expand, and create jobs. 22. Manufacturing 1. Improve infrastructure that is important for business · Improve quality of service. Improve reliability of electricity provision, especially during the rainy season and in the north. Review with respect to microbusinesses, the tariff structure of Electricité du Laos (EdL) to minimize the large tariff distortion between residential and commercial consumers. Use an information campaign to inform users about tariff changes. Encourage greater private sector involvement in utility operations to enhance the efficiency of operations. conclusions and Recommendations 119 · Good roads are critical for development. Adequate funding should be provided for building new roads and maintaining existing road networks. This will strengthen linkages between product and input markets, as well as reduce firm losses arising from transportation failures. Improve road transportation, as well as cross-border transportation, to improve access to local markets. Encourage private investment in trucking services and inland dry ports to facilitate cross-border transportation. · Private investment in infrastructure should be encouraged through trans- parent and consistent regulations and more competitive markets. In deciding whether to invest, private firms are particularly concerned about the extent of regulatory uncertainties. 2. Reduce unnecessary government regulations · Move from licensing to registration in regulations on starting a business. Hasten the review and approval of the implementing decrees for the new Enterprise Law 2005. Investment laws and incentives should be made public and easily available. · The number of obligatory procedures prior to starting a business should be reduced, and line ministry licenses for business operating licenses in most sectors should be eliminated or changed so that registration can also take place after the start of business. For example, this can be achieved by designating one department to accept and process applications, and to coordinate with other government units in the issuance of business license. Operational licenses should be maintained only for strategic businesses that require closer overseeing. Company seal and sign requirements should also be reduced. Re-registration procedures should be significantly simplified. Regulations regarding issuance of licenses/permits and re-registration should be made uniform across the country. · Improve government efficiency in business monitoring. Reduce the frequency of inspections to a maximum twice a year. Make the aims of inspectors transparent, and pre-identify criteria for inspections to reduce opportunities for rent seeking. Using teams of inspectors may also help decrease inspection time or opportunities for informal practices. · Reduce the number of procedures and signatures required for exports. Streamline customs procedures. Consistent with the Greater Mekong Subregion (GMS) program, efforts should be made to simplify and make 120 Reducing investment climate constRaints to HigHeR gRowtH customs procedures transparent; and continue to harmonize customs procedures, inspections, quarantines, and other cross-border regulations along with other countries in the subregion. · The country should continue to support ongoing efforts to harmonize cross- border regulations through subregional cooperation in GMS to facilitate trade and investment. Easing cross-border regulations through faster processing and simpler rules will reduce travel time and transactions costs, accelerate investment, and ease the process of tapping into new markets. · Promote foreign and regional cross-border investments into manufacturing (including agro-processing) and services as they can transfer technology and good management practices and contribute to higher productivity in the relevant subsector as has happened in garments and wood sectors. The government's move toward the privatization of state-owned enterprises (SOEs), and the eventual tariff reductions under the ASEAN of Free Trade Area (AFTA) agreement, could create apprehensions over decreases in both tax and nontax revenues. Such concerns may be unwarranted if the Government can implement measures to improve tax collection and broaden the tax base. In additiontosimplifyingtaxstructuresandreducinginefficienciesintaxcollection, the challenge for the Government is how to promote private sector growth to raise incomes. It is critical to facilitate an environment that stimulates current private businesses and encourages entry of new firms. 3. Reduce discretion in the taxation system and improve administration · Amend the policy on annual registration by extending the validity of registration for medium and large firms for 3­5 years. Multiplicity of taxes and confusion in tax implementation can be addressed by implementing greater transparency and simplifying tax procedures, taking lessons from other countries that have restructured their tax systems. · A nondiscretionary system should replace the current contract tax system. While, in theory, the contract system should be adequate for a country where private firms traditionally maintain poor accounting records, it has proven inefficient in collecting revenues and has become a source of extortion in practice. conclusions and Recommendations 121 · Amend the policy on annual registration for tax purposes, extending the validity of registration for medium and large firms. · Encourage the use of noncash payments system (banking or postal) for tax collection. · Simplify customs regulations and make them more transparent. Unnecessary discretion in import and export licensing procedures should be removed. · Make laws and investment incentives publicly and easily available. 4. Maintain macroeconomic stability and reduce uncertainty · Continue to maintain macroeconomic stability. · Promote a productive public­private dialogue and provide capacity building to industry associations to enable them to play a more active role in shaping public policy. This will also improve private sector compliance with official rules and regulations. 5. Widenopportunitiestoaccessformalsourcesoffinancing · Continue efforts to reform, restructure, and recapitalize the banking system, together with substantial improvements in corporate governance and technical training. Encouraging the entry of foreign banks can provide theadditionalmuchneededfinancing--forexample,bylevelingtheplaying field between the state and private banks, and by encouraging strategic investors to partner with state banks. · Review lending procedures of banks to simplify the application process and foster the creation of commercial-based lending criteria, to ease financing for private companies with viable investment projects. · To support the expansion of small firms, encourage the growth of microfinance institutions. 23. Tourism The study suggests that infrastructure, skills and education, government regulation, access to finance, and macroeconomic uncertainty are the leading constraints on private sector businesses in the tourism industry. 122 Reducing investment climate constRaints to HigHeR gRowtH 1. Infrastructure The two critical problems are electricity and transportation. At the Lao Business Forum's Tourism Working Group, the most often-cited, highest-priority issue was air transportation. · Review EdL's tariff structure to ensure fair assessment of utility costs and support the move to cost recovery across economic sectors and consumer categories. · Continue infrastructure development in the rural areas of the Lao PDR to facilitate international tourism. · Pursue an open-skies policy and direct air links with countries outside the region, particularly Europe, Janpan, and the US. · Seek a joint-venture partner for LaoAirlines that will increase the airline's resources, help upgrade its fleet, and enhance management. 2. Skills and education The tourism sector faces a skills shortage across the complete range of seniority levels and job functions. A variety of tourism-specific training initiatives have sprung up, but there remains no comprehensive training institute or program to ensure a steady supply of well-qualified employees. · Strengthen vocational training for tourism workers. Develop a training institute for the tourism industry, drawing on regional or international examples, such as the Dusit Thani School in Thailand. For example, encourage a joint-venture hotel school with initial support from the Lao PDR National TourismAuthority. · Review the resource requirements of the tourism management program at National University of Laos to ensure that it can play a valuable role in educating the next generation of industry leaders. 3. Government regulation (including tax rates and business registration procedures) · Streamline the business registration process to create a true one-stop approval process--preferably with guaranteed decision times--and conclusions and Recommendations 123 rationalize inspections, covering only the most critical areas while ensuring transparency. · Restructure the visa system to allow one-month visas upon arrival for no more than the cost of attaining a tourist visa at a Lao embassy overseas, and to allow tourists to obtain visa extensions outside of Vientiane. Introduce GMS visas. · Establish a hotel classification system for the Lao market. · Promote private-sector participation in the new Tourism Promotion and Marketing Board to enhance coordination between the country's tourism providers and the image being presented to the international market. 4. Accesstofinance · Continue efforts to reform, restructure, and recapitalize the banking system, together with substantial improvements in corporate governance and technical training, to transform the Lao banking sector into a viable system for mobilizing savings to finance private sector investment. · Review lending procedures of banks to simplify the application process and foster the creation of commercial-based lending criteria that ease financing for private companies with viable investment projects. 5. Macroeconomic uncertainty Firms expressed great concern about the unpredictability of the government's response to external events, and the potential difficulties it could present to their operations. In general, these firms expressed frustration with the poor quality of the public­private dialogue in the Lao PDR, and the perception that the industry has little real input into the government policy-making process. Initiatives such as the Lao Business Forum have helped the industry express an agenda, but the key informants interviewed did not feel the Government's policy-making process was responsive to that agenda. · Provide technical assistance to the two relevant industry associations-- Lao Hotel and Restaurant Association (LHRA) and Lao Association of Travel Agents (LATA)--to develop their advocacy and policy development capabilities. 124 Reducing investment climate constRaints to HigHeR gRowtH · Work with LNTA, LHRA, and LATA to promote a productive public­ private dialogue in the tourism industry, recognizing the importance to tourism firms of involvement in shaping the future of their sector. APPENDICES 125 APPENDICES Surveys and stand-alone studies conducted under the Investment Climate Assessment 1. Investmentclimatesurvey(seeQuintana,2006) 2. Informalfirmssurveyandstudy(seeQuintana,2006) 3. Electricitydemandsurveyandstudy(seeTEPCO,2006) 4. Supplychainanalysisofthegarmentindustry (seeGlobalDevelopmentSolutions,2006) 5. Tourismsectorstudy(seePeters,2005) 126 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Appendix 1 Review of Recent Private Sector Studies on the Lao People's Democratic Republic Overthepastseveralyears,anumberofstudieshavebeenconductedtoexamine privatesectorconstraintsintheLaoPDR.Liketheinvestmentclimateassessment (ICA),thesestudiesalsoraiseanumberofimportantissuesthatneedtobe addressedtopromoteprivatesectorgrowth.ICAcomplementsthesestudiesby providingquantitativeevidenceofhowfirmsviewthebusinessconstraintsand howtheconstraintsimpactfirmoperationssincemostofthestudiesdidnotbase theresultsonanenterprisesurvey.Inthecaseofstudiesthatalsoconducteda surveyoffirms,theirfindingsappeartoreinforcetheresultsofICA. In2002,astudyconductedunderanAsianDevelopmentBank(ADB) technicalassistanceprojectaimedtoanalyzeissuesaffectingmarketentryand operationsintheLaoPDRandformulaterecommendationstostrengthenthe businessenvironment.Amongthekeyrecommendationsofthestudywereto streamline registration and licensing; conduct stronger government­private sectordialogue;improvethetaxstructure;formulateamechanismforbetter disseminationofregulations;ensuregreatertransparencyintheawardingof investmentincentives;developasmallandmediumenterprise(SME)financing strategy;andimplementanactionplanforprivatesectordevelopment.Manyof theseissueswerereinforcedinaprivatesectorassessmentconductedbySung (2005)forADB.Inadditiontoanalyzingtheoverallconstraintstoprivatesector development,Sungalsoexploredspecificissuesaffectingthecompetitivenessof keysectors,andlaidoutpolicyactionsfortheprivatesectoringeneral,aswell asmeasureswhichweresector-specific. Another study commissioned by the United Nations Development Programme,NationalEconomicResearchInstitute,andUnitedNationsIndustrial DevelopmentOrganizationalsofocusedonexaminingthebottleneckstoprivate sectordevelopmentintheLaoPDR.ThisstudybyMallon(2005)highlighted thedifficultiesregardingbusinessentry,taxationandcustomsadministration, andtheoveralladministrativeandregulatoryenvironment.Weaknessesinpublic administrationandcontractenforcementwerenotedtoposespecificbarriersto businessdevelopment. In2006,inthetradeintegrationstudyontheLaoPDR,theWorldBank anddonorsoftheintegratedframeworkpressedtheneedtopromotetheprivate sectortoenablethecountrytotakeadvantageoftradeopportunities.Amongthe keychallengesfacingthebusinesssectorarecostlyandunreliableinfrastructure APPENDICES 127 services,cumbersomeregulatoryenvironment,andlowlevelofentrepreneurial skills.Inthestudy,businessandregulatoryenvironmentismentionedasthe numberonebindingconstraintforexportsandtradepromotion.Thehighdegree ofpolicyuncertaintyisconsideredaresultofpoorpublic­privatedialogue, uncleargovernmentpolicies,andthelackoftransparency. Otherprivatesectorstudiesbasedtheiranalysisoninterviewsorsurveysof firms.AstudyconductedbyShultze(2003)--onbehalfofGermandevelopment cooperatonthroughGTZ--wasbasedonaninterviewoffirms,butfocusing onlyonSMEsinVientianecapitalandworkingwithfewerfirmscomparedto ICA.1Intheinterviewsconductedunderthestudy,firmswereaskedabouttheir assessmentoftheoveralleconomicpolicyandsituation,theimpactofthese onthem,theirratingofspecificproblemsaffectingfirms,andtheirfinancing experience.Onthegeneralperceptionabouteconomicpolicy,abouthalfofthe respondentsvieweditas"good."Forsomefirmsthatviewedotherwise,their negativeassessmentwasbasedontheperceptionsoflackofsupportfromthe government,lackofmechanismforbusinesspromotion,inconsistencyinrules andregulations,andthehighcostofinfrastructureservices.Firmswerealso askedabouttheirratingofalistofmainproblemsaffectingcompanies.Atthe topintherankingofconstraintsis"toohightaxes,"followedbycompetition, lackofmarketing,andlackofcapital(FigureA1.1).WhilebothICSandGTZ consideredtaxationacrucialissue,theydifferedintermsoftheimportance placedoncompetition.InICS,only5%consideredanti-competitivepractices asaseriousobstaclecomparedto33%offirmsintheGTZstudy.Itshouldbe noted,however,thatsincetheGTZsurveywasconductedinVientianewhere morefirmsoperaterelativetootherprovinces,thencompetitioncouldindeedbe morepronounced. A recent survey of firms was commissioned by German development cooperationthroughGTZandundertakenin2005,almostinparallelwithICA: theHumanResourceDevelopmentforMarketEconomy(HRDME)Enterprise Baseline Survey (EBS). Like ICA, EBS was concerned about identifying constraintstofirmgrowthandproductivityandusedacombinationofperceptions andquantitativedata.However,EBShadasmallergeographicalcoverageand appliedadifferentsamplingframebasedonthe2004taxregistrationofcovered districts.AcomparisonofEBSandICAsurveysindicatessomesimilaritiesand differencesintheimportanceplacedontheconstraints.2Incomparingthetwo, oneshouldnotethatthelistofpre-identifiedconstraintsinawaydifferbetween 1 The study of Shultze utilized information mainly from a survey of 40 firms from VientianeCapital. 2 See"ExtractsofHRDMEEBS2005Survey"(HRDME2006). 128 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH them. For example, macroeconomic uncertainty and transportation were not amongtheconstraintsstatedinEBS,butwereidentifiedinICA. Figure A.1.1 Major problems of companies, from Human Resource Development for Market Economy Survey conducted by German Development Cooperation through GTZ (%) Too high taxes Competition with local companies Lack of marketing Competition with foreign companies Lack of capital Lack of security (corruption) Lack of management staff Lack of skilled labor Lack of innovation Lack of management skills State influence (interference) Too high labor costs 0 10 20 30 40 50 Firms which view problem as "big" or "very big" Source: Shultze, 2003. Asimilaritybetweenthetwosurveysistheperceptiononregulations. RegulatoryuncertaintyrankedsecondinthelistofICSconstraints.InEBS,fees andregulationswerealsoconsideredamongthetopthreeconstraints,with28% offirmsratingtheseas"big"or"veryserious"problems(FigureA1.2).Taxation alsofiguredamongthetopthreeconstraintsinICS.InEBS,"toohightaxes" wastheforemostconcernamongallissuesrelatedto"feesandregulations," with51%offirmssayingsuchissuewas"veryserious"or"big"(FigureA1.3). Anothersimilarresultisoncustomsandtraderegulations.InEBS,about23% viewedtheseasseriousissues.Thisiscomparabletothe20%offirmsinICS, whichconsideredthemasmajororsevereobstacles. Thereisadifference,however,betweenthetwosurveysintermsofthe importanceplacedonfinancing.InICA,financingwasconsideredaserious issueamong22%offirmssurveyed,makingitthefifthmostimportant.InEBS, however,"lackofcapital"wasthetopconstraintandconsideredmoreserious thaninfrastructureorregulations.Infrastructurewasthehighestconstraintin ICS,withabout50%offirmssurveyedfindingitasmajororsevereobstacle, and the main issue being electricity tariffs. In EBS, only 13% considered APPENDICES 129 infrastructurea"veryserious"or"bigproblem,"However,inEBS,about33% offirmsconsidered"highutilitycosts"amajorissue,whichindicatesthatcostof electricitycouldbetheproblem--moresothanaccess--justlikeinICS.Although therearedifferencesintheweighingofissuesbetweenICAandEBS,stillboth havebroughtoutquitesimilarissuesthatimpedeprivatesectordevelopment. Figure A.1.2 Percentage of firms in the Enterprise Baseline Survey rating issue as "very serious" or "big" (%) Lack of capital Competition problem Fees and regulations Lack of market information Physical infrastructure Low level of technology Lack of technically skilled labor Lack of management skills Lack of management staff High labor costs 0 10 20 30 40 Firms rating issue as "very serious" or "big" Source: EBS, 2006. Figure A.1.3 Problems with "fees and regulations" (%) Too high taxes and duties High utility cost Other fees and unofficial Customs/foreign trade Foreign currency Others Labor and safety 0 10 20 30 40 50 60 Firms rating issue as "very serious" or "big" Source: EBS, 2006. 130 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Asdiscussedinthemaintext,thesedifferencesbetweensurveysaremostly due to different data collection methods (survey versus interviews) or from differentsamplingframes.Theresultsinthisstudyshouldbeanalyzedwithcare, astheycanonlybegeneralizedforthesectorsandfirmtypesincludedinthe ICSsample. APPENDICES 131 Appendix 2 Manufacturing Regression analysis takes into account many firm-specific characteristics and provides a systematic method of measuring the effect of investment climate constraints on productivity. In the analysis below, productivity refers to the effects of any variable different from the inputs--capital and labor--affecting the production process. In general, productivity is expected to be correlated with labor and capital, and therefore, these factors of production must be treated as endogenous regressors when estimating production functions. To address the endogeneity problem of the inputs, the analysis adopts the approach described in Escribano and Guasch (2005). Specifically, an extended Cobb-Douglas production function is estimated, where a vector of firm-specific observed variables in the Lao PDR Investment Climate Survey (ICS) dataset proxies for fixed aspects in the investment climate. Given that the technical rates of substitution between the factors of production are very different for different goods, the estimation methodology consists of splitting the sample of firms into industry groups: garments/textile, food and beverages, construction materials, and wood processing. Econometric methodology As a starting point, technology is described by a Cobb-Douglas production function with Hicks-neutral technical change (in natural logarithmic form) for firm i in industry j at time t: vi , j t= lli, j t+ kki, j t+ui,j t (1) where value-added v is produced combining labor l and capital k. u is residual firm productivity and can be decomposed as follows: uit = it + it j j j (2) where is a component of firm productivity that is known to the firm manager and possibly affects input choices but is unknown to the econometrician and is a random shock to productivity that is realized after input choices are made (therefore, it is not correlated with input choices). Since more productive firms will hire more labor and use more capital to produce greater quantities, estimates of the corresponding production function parameters, l and k, obtained by ordinary least squares (OLS) techniques that do not account for such endogeneity are biased. More specifically, the conditional expected values verify the following equalities: E[it / lit]=0 and E[it / kit]=0. 132 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH To mitigate the endogeneity problem of the inputs, the Cobb-Douglas productionfunctionisaugmentedbyobservedfirmcharacteristicsandproxies forusuallyunobservedfirm-specificfixedeffectsavailableinICSdata: qZ qIC vi, = l li, + kki, + Zn, + ICn ICn, + ui, j j j t t t j i j j i t n =1 n =1 () whereZisavectoroffirmcharacteristicsandICisavectoroffirm-specific investmentclimateconstraints.Zincludesdummyvariablesforexportstatus,size, province,andyear.ICincludestotalhoursofpoweroutagesin2004;adummy variableequalto1iffirmibelieveslocalgovernmentofficials'interpretationof regulationsisunpredictable;andtheaveragepercentageofshipmentlossdueto breakageorspoilageintransit. Equation3isestimatedbyOLSusingdatacollectedinICSforyears2002, 2003,and2004,withclusteringonestablishment.Note,however,forvariables invectorsZandIC,dataareavailableonlyfor2004.WhilevariablesinZare generallyfixedoverthe3-yearperiod,investmentclimateconstraintsmaybe quitedifferentyear-to-year.Intheregressionanalysis,anassumptionismade thatICvariablesarefixedover2002,2003,and2004.Thelimitednumberof observationsinthedatacollectedbytheLaoPDRICS--asdescribedbelow-- necessitatessuchaheroicassumption. Thus,severalstandardmethodsforestimationofproductionfunctionsand forestimatingthedemandforexportsanddeterminantsofinvestmentshavebeen attemptedinthisstudy.However,noneoftheseproducedsignificantorplausible results.Thiswasmainlyduetothesmallsamplesizebysector,andtotheskewed distributionofthefirmstypeswithinindustries(forexample,toomanyexporters inoneindustryandtoolittleinothers).Thepooledregressionsdidnotworkdue tothetoorestrictiveassumptionsregardingconstantconditionsinthepastand lowpoweroftests.Thus,productivityanalysisislimited,butresultsarepresented belowforfurtherreference.Attemptswithinvestmentandexportdecisionand demandequationsaredescribedattheendofthisappendix. Definition of variables Theregressionanalysisofproductivityisbasedonasubsampleofmanufacturing firmsfromICSforwhichthevaluesofvariablesarenotconsideredoutliers andforwhichdataonallproductionvariablesareavailable.Theoriginaltotal numberoffirmsinthesurveybeforeselectionis246:53ingarments/textiles;34 infoodandbeverages;67inconstructionmaterials;and92inwoodprocessing. APPENDICES 133 Identifyinganddroppingoutliers,thesamplesizeisreducedto160firms:40in garments/textile;23infoodandbeverages;42inconstructionmaterials;and55 inwoodprocessing.Consequently,poolingall3yearsofdataisnecessarygiven thesmallsamplesizesforeachindustry. Anobservation(i.e.,firm)isdefinedanoutlierforvariableX ifitsvalue isgreaterthanthe75thpercentileofXinindustryibymorethan3timesthe interquartilerange(IQR--whichisthe75thpercentileminus25thpercentile--) forindustryiorifitsvalueislessthanthe25thpercentileofXinindustryiby morethan3timesIQRforindustryi.Thevariablesforwhichthisoutlierrule isappliedaretheoutput­laborratio,capital­laborratio,materials­laborratio, laborshareinrevenue,andmaterialsshareinrevenue.Forinputrevenueshares, allfirmswithlaborormaterialsrevenueshareslargerthan1areadditionally classifiedasoutliers.Outliersareidentifiedfortheratiosandsharesineachof thethreesampleyears. Productionfunctionvariablesaredefinedasfollows: · Valueaddedfor2002,2003,and2004,respectively,aregivenby"total sales" (q66_1_02, q66_1_03, and q66_1_04) minus total purchase of "rawmaterialandintermediategoods(whetherusedinproductionornot), includingfinishedgoodsforresale"(q66_2_02, q66_2_03,andq66_2_04) inquestion66. · Laborfor2002,2003,and2004,respectively,aregivenbythetotalnumber of"permanentemployees"(q57_1, q57_2,andq57_3_1)inquestion57a. · Capitalfor2002,2003,and2004,respectively,aregivenbynet­bookvalue of"machineryandequipment(includingtransport)"(q70_1_02,q70_1_03, andq70_1_04)inquestion70. Inputrevenuesharesusedintheidentificationofoutliersaredefinedasfollows: · Laborrevenuesharefor2002,2003,and2004,respectively,arecalculated asthe"totalcostoflabor,includingwages,salaries,andbonuses"(q66_3_ 02, q66_3_03,andq66_3_04)dividedby"totalsales"(q66_1_02, q66_1_ 03, andq66_1_04)inquestion66. · Materials revenue share for 2002, 2003, and 2004, respectively, are calculated as total purchase of "raw material and intermediate goods (whetherusedinproductionornot),includingfinishedgoodsforresale" (q66_2_02, q66_2_03,andq66_2_04)dividedby"totalsales"(q66_1_02, q66_1_03,andq66_1_04)inquestion66. 134 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Firmcharacteristicsaredefinedasfollows: · Exportersaredefinedasfirmsthat"exporteddirectly"atleast10%oftotal salesin2004asgivenbyquestion9a(q9b_3). · Sizeisgivenbysumofpermanentworkers(q57_3_1)inquestion57a andthepermanent­equivalentoftemporaryworkers,whichisdefinedas thetotalnumberof"temporaryemployees"(q58a_1_1)timesthefactor of"averagelengthofemploymentforeachtemporaryworkerindays" (q58a_4)dividedby365.Sizecategoriesaredefinedasfollows:small (lessthan20employees),medium(20­99employees),andlarge(100or moreemployees). Theinvestmentclimatevariablesaredefinedasfollows: · Hoursofpoweroutageisgivenby"numberofdays"ofpoweroutages (q28_2_1) times "average duration per day (hours)" of power outages (q28_3_1)inquestion28. · Thedummyvariable"believelocalgovernmentofficials"interpretationof regulationsinunpredictableisgivenbyresponseoffirmitoquestion48 thatasks:"Towhatextentdoyouagreeordisagreewiththisstatement?: In general, (provincial/local) government officials' interpretations of regulationsaffectingmyestablishmentarepredictable."Firmsareclassified asbelongingtotwogroups:(1)thosethatanswered"fullyagree,""agree inmostcases,"or"tendtoagree";and(2)thosethatanswered"fully disagree,""disagreeinmostcases,"or"tendtodisagree"(q48_2). · "Percentageofshipmentlossduetobreakageorspoilageintransit"is givenbyquestion31athatasks"Forshipmentsinthedomesticmarket, whatpercentageofthevalueofyourshipmentwaslostwhileintransitdue tobreakageorspoilage?"(q31a_1). APPENDICES 135 Table A.2.1 Profile of manufacturing firms Item All Construction Food and Garments Textile/ Wood materials beverages handicraft processing Number of firms 246 67 34 39 20 86 Median number of workers 21.0 11.0 13.5 250.0 20.5 25.0 Average share of female workers (%) 33.0 14.7 33.1 82.5 65.3 14.7 Average age (years) 9.1 7.5 9.4 9.5 10.9 9.6 Share of firms by age group ( %) >=5 30.9 35.8 29.4 25.6 15.0 33.7 6­10 31.7 44.8 26.5 25.6 40.0 24.4 >10 37.4 19.4 44.1 48.7 45.0 41.9 Share of firms with one or more branches 18.7 17.9 14.7 25.6 20.0 17.4 Share of firms by majority ownership (%) Private domestic 78.9 88.1 79.4 43.6 65.0 90.7 Foreign 18.7 7.5 20.6 53.9 30.0 8.1 Government/ others 2.4 4.5 0.0 2.6 5.0 1.2 Share of firms previously owned by government (%) 11.0 4.5 14.7 5.1 10.0 17.4 Share of exporting firms (%) 33.7 0.0 5.9 76.9 40.0 50.0 Average share of exports to sales (%) 28.8 0.0 3.6 72.1 19.5 43.7 Source: Lao PDR ICS, 2005. 136 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH ** * 8 _ _ 0.254 [0.096] 0.539 [0.285] (0.001) [0.002] 0.306 [0.353] 0.787 [0.535] 0.146 [0.584] (0.118) [0.897] 0.435 page). [0.415] processing next ** *** ood W 7 _ _ _ _ _ _ _ _ _ _ 0.265 [0.109] 0.688 [0.150] 0.002 [0.002] 0.199 [0.417] (continued *** *** *** 6 _ _ * ) _ _ materials 0.378 [0.059] 0.864 [0.254] (0.007) [0.003] 0.431 [0.419] (0.164) [0.099] (0.923) [0.538] (0.915 [0.806] *** *** ** 5 _ _ _ _ _ _ _ _ Construction 0.351 {0.048 0.531 [0.119] (0.007) [0.003] 0.363 [0.378] (0.125) [0.091] * * 4 _ _ estimation 0.082 [0.160] 0.760 [0.420] beverages (0.002) [0.002] (0.145) [0.400] (0.077) [0.044] (0.350) [0.636] 0.319 [0.757] 0.308 [1.358] function and *** * 3 _ _ _ _ _ _ _ _ oodF 0.040 [0.129] 0.790 [0.124] (0.003) [0.002] 0.034 [0.290] (0.070) [0.046] Production *** * 2 _ _ _ _ _ _ .2.2A 0.133 [0.084] 0.977 [0.181] 0.002 [0.003] (0.553) [0.299] 0.651 [0.391] 0.540 [0.416] ableT *** * Garments/textile 1 _ _ _ _ _ _ _ _ _ _ 0.126 [0.089] 0.971 [0.103] (0.001) [0.002] (0.523) [0.275] added) officials' breakage to ln(value regulations due employees) of (hours) loss transit employees) variable: government in more or outage local [20­99 unpredictable shipment spoilage (100 (Capital) (Labor) Dependent ln ln owerP interpretation is of or Believe % Exporter Medium Large Oudomxay APPENDICES 137 * ** *** 8 155 1.322 [0.676] 0.777 [0.512] 0.702 [0.332] 0.376 [0.422] (0.062) [0.081] (0.072) [0.109] 2.372 [0.858] 0.717 Processing ) *** ood W 7 ­ ­ ­ ­ ­ ­ ­ ­ 155 (0.073) [0.088] (0.076 [0.120] 2.589 [0.378] 0.659 6 ­ ­ ­ ­ * *** materials 114 Materials (0.246) [0.320] (0.071) [0.419] (0.174) [0.092] (0.146) [0.131] 2.451 [0.539] 0.694 2002­ year construction 5 ­ ­ ­ ­ ­ ­ ­ ­ ) *** (15); 114 Construction (0.132 [0.085] (0.047) [0.112] 2.931 [0.403] 0.677 Vientiane;­ beverages province 4 ­ ­ and 62 (0.619) [0.447] 0.551 [0.444] 0.437 [0.521] 0.273 [0.190] 0.281 [0.225] 2.881 [1.737] 0.610 food Beverages 19); employees); & 18, 20 oodF 3 ­ ­ ­ ­ ­ ­ ­ ­ *** 62 (17, than 0.247 [0.184] 0.266 [0.208] 3.338 [0.917] 0.589 (less 2 ­ ­ ** ­ ­ * small­ extile 110 Garments/textile size 0.282 [0.597] (0.560) [0.265] 0.195 [0.110] 0.155 [0.122] 1.359 [0.961] 0.762 code: 1% at ISIC variables: *** Garments/T 1 ­ ­ ­ ­ ­ ­ ­ ­ 101 2-digit 0.166 [0.109] 0.138 significant [0.115] 2.081 [0.501] 0.739 by dummy of *** set 5%, at Industries calculations. added) (20) respective brackets. significant Author's in group ** 2005; ln(value errors processing 10%, S,IC at wood comparison PDR (continued). variable: observations standard 27); Lao .2.2A of R2 (26, Omitted significant* 2003 2004 Robust Sources: ableT Dependent Luangprabang Xayaboury Savannakhet Champassack earY earY Constant Number Adjusted Notes: 138 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Table A.2.3 Statistical annex to productivity in manufacturing (Unit: $) Total Total Value Capital per Value Total sales in sales per added per worker in added per compen- 2004 worker worker 2004 capital sation per worker All Firms 323,769 5,357 2,520 1,898 374 668 Size Small 57,473 4,647 2,345 1,969 366 657 Medium 355,911 6,197 2,458 2,123 220 668 Large 924,736 5,731 2,971 1,405 613 691 Industry Garments 628,182 4,244 2,800 792 748 646 Textile/handicrafts 113,352 3,493 1,758 1,602 253 728 Food and beverages 94,033 4,045 2,267 2,383 320 501 Construction materials 203,806 5,692 2,220 2,171 322 651 Wood processing 442,306 6,582 2,917 2,058 310 746 Province Vientiane 371,756 5,164 2,469 1,761 377 676 Oudomxay 16,313 2,451 1,776 1,117 242 637 Luangprabang 168,095 6,900 2,986 1,939 305 538 Xayaboury 183,286 5,988 3,701 1,460 411 762 Savannakhet 349,296 6,200 2,388 2,118 455 684 Champassak 364,902 4,888 2,601 3,111 189 556 Export status Nonexporters 131,245 4,828 2,241 2,056 300 664 Exporters 737,053 6,443 3,090 1,578 526 675 Ownership Domestic 280,592 5,333 2,535 1,992 336 659 Foreign 529,120 5,463 2,457 1,460 547 705 Source: LAO PDR ICS, 2005. Severalattemptshavealsobeenmadetoestimateinvestmentandexport demand/decision equations. Export demand equations lacked right-hand-side variablesandnumberofobservations.Ontheinvestmentdecisionequations,a probitmodelwasused.TheTobitmodelcouldbeusedifthedependentvariable tookonthevaluezerowithpositiveprobabilitybutwasroughlycontinuously APPENDICES 139 Table A.2.4 Investment incidence and propensity by type, region, and sector Investment>0 Investment rate (%) Investment rate (%) for investing all firms (percentage firms (zeros included) of firms) (new investment/ (new investment/ last year capital) last year capital) All firms 66.3 44.9 28.9 Size Small 64.9 53.4 33.60 Medium 60.8 49.4 29.23 Large 76.9 24.1 18.22 Industry Garments 77.8 28.2 21.5 Textile/handicrafts 65.0 50.1 31.6 Food and beverages 60.6 57.7 35.0 Construction materials 63.6 38.7 22.9 Wood processing 65.9 51.0 33.2 Province Vientiane 62.0 34.1 20.7 Oudomxay 78.6 74.9 56.2 Luangprabang 77.8 45.1 35.1 Xayaboury 68.8 66.8 45.9 Savannakhet 70.5 41.2 27.9 Champassak 63.2 80.5 49.2 Export status Non-exporters 62.7 49.0 29.6 Exporters 73.4 38.0 27.5 Ownership Domestic 66.0 47.5 30.5 Foreign 67.4 33.2 21.8 Source: LAO PDR ICS, 2005. distributedoverstrictlypositivevalues.Therefore,theTobitmodelisappropriate ifthedependentvariableistheinvestmentrateandnon-investorsareincluded. Ifthequalityofdataispoorandtheidentificationofzerosandmissingvaluesis inaccurate,oneusuallygetsaroundthisproblembyestimatingtheinvestmentrate equationononlythesampleofinvestors(i.e.,firmswithinvestment>0)only.In thiscase,probitisappropriatesincethesampleisnotcensoredatzero.However, suchmodeldidnotgivepositiveestimatesandresultsarenotreportedhere. 140 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Appendix 3 Governance IntheInvestmentClimateSurvey(ICS),firmswereaskedwhetherestablishments aresometimesrequiredtogivegiftsorinformalpaymentstopublicofficialsto "getthingsdone"withregardtocustoms,taxes,licenses,regulations,services, etc. Over 50% of firms answered affirmatively: 58 firms (24%) responded "always"and66firms(27%)responded"sometimes."Forfirmsthatanswered "always"or"sometimes,"asubsequentquestionwasasked:"Ontheaverage, overayear,whatpercentageofannualsalesvaluewouldsuchexpensescosta typicalestablishmentinyourareaofactivity?"Ifthefirmcouldnotanswerin percentageterms,thetotalvaluewasalternativelygiveninkips(anddividedby theannualsalesnumberprovidedbythefirm).Ofthe124firmsthatanswered affirmativelytothefirstquestion,68and56firmsprovidedestimatesofthebribe valueinpercentagesandkips,respectively. AsseeninthehistogramspresentedinFigureA.3.1,thedistributionsofthe twogroupsaresignificantlydifferent.Fromtheanswersprovidedbythe68firms thatansweredinpercentageterms,thevalueofgiftsandinformalpaymentsis estimatedtobeontheaverage4.2%ofannualsales(when4outliersaredropped). Ontheotherhand,fromtheanswersprovidedbythe56firmsthatansweredin kips,thevalueisestimatedtobeontheaverage0.2%ofannualsales(when 2outliersaredropped).Becausethequestionisansweredsolelyinpercentagesin theICSofcomparatorcountries,thetwotypesofanswersintheLaoPDRcannot becombinedandcomparedtotheaveragesofothercountries.(Inthecomparison ofthebribelevelintheLaoPDRagainsttheaveragesofcomparatorcountries presentedintheICAreport,onlytheaverageoffirmsthatansweredthequestion inpercentagetermsisused.)Therefore,furthersurveyworkisnecessarybefore strongconclusionscanbemadeaboutcorruptionintheLaoPDR. APPENDICES 141 Figure A.3.1 The size of bribes ­ measurement differences due to response type Firms that answered in percentages (%) Firms that answered in kips (%) 1.0 0.5 ractionF 0 0 5 10 15 20 0 5 10 15 20 Annual sales Annual sales Gifts or informal payments to public officials Source: Lao PDR ICS, 2005. 142 Reducing investment climate constRaints to HigHeR gRowtH Appendix 4 Regulation To examine the question of how different factors--including ownership--affect the burden of regulation for enterprises in the Lao PDR, we estimate several versions of the equation below: Regulatory Burdeni = ß1+ ß2 Firm Characteristicsi + i The dependent variables are two measures of the burden of regulation--the number of inspections that the firm faced in the previous year and the percentage of time that the senior management of the firm spends dealing with regulations (Table A.4.1). Although these two variables are positively correlated at the enterprise level ( = 0.36, p-value = 0.00), they are not perfectly correlated. As discussed in the main text, this is not surprising. Dealing with inspections is not the only burden associated with regulation. For example, firms also have to deal with preparing for required meetings, filling out forms, preparing tax statements, and ensuring that their physical premises meet regulatory standards. Both dependent variables are limited dependent variables. The first variable--the percentage of time that senior management spends dealing with regulatory requirements--is bounded between 0 and 100%. To take account of this in the estimation, we allow this variable to be bounded between 0 and 100. In practice, no firms reported that their senior management spent all their time dealing with regulatory requirements. The other variable--the number of inspections--is a count variable (i.e., it only takes scalar values). We estimate this model using a negative binomial count data model. We use this more general model because hypothesis tests strongly reject the null hypothesis that the count data follows a simpler Poisson distribution. Previousstudieshaveshownthatsmallfirms--especiallymicroenterprises-- manage to avoid much of the burden of regulation in low- and middle-income countries.4 For example, in a sample of low and middle-income countries, microenterprise managers spent about 10% of their time dealing with government regulations and faced about 3 inspections, compared to 12% and 12 inspections for very large enterprises. We therefore control for this in the number of employees that the firm has in the model. 4 See World Bank, 200a. Data from World Bank (2004b) for Bangladesh, Brazil, Cambodia, Guatemala, India, Indonesia, Kenya, Pakistan, Tanzania, and Uganda. APPENDICES 143 Otherfactorsmightalsoaffecttheburdenofregulation.Tocontrolforthis, weincludeadummyvariablerepresentingwhethertheenterprisesexportsmore than10%ofitssales.Itseemsplausiblethattheburdenofregulationwillbe greaterforexporters.Forexample,exportersarelikelytofaceinspectionsrelated toexporting(e.g.,customsandtradedepartmentinspections).Giventhatfirms appeartobeconcernedabouttraderegulation,thismightbeaespeciallybig problemintheLaoPDR. Theregressionsincludetwovariablesindicatingfirmownership.Ifthe governmentownsmorethan10%oftheenterprises,theenterpriseisclassified as(partly)state-owned.Stateownershipmightaffecttheburdenofregulationif state-ownedfirmsaremorevisibletothegovernment.Ontheotherhand,previous studiesinothercountrieshaveoftenfoundthatstate-ownedenterprisesmanage tousetheirpoliticalinfluencetoavoidmanyburdensomeregulations.6Ifforeign enterprisesorindividualsownmorethat10%,itisclassifiedas(partly)foreign- owned.Foreign-ownedenterprisesmightbeabletoavoidsomeoftheburden ofregulationeitherbybargainingwithgovernmentsforreducedregulationor bylocatinginspecialeconomiczonesorexportprocessingzones.Ontheother hand,foreignenterprisesarelikelytobeespeciallyvisibletotheauthoritiesand mightbeeasiertoregulateforpoliticalreasons. Inadditiontothesevariables,theregressionsalsoincludeaseriesofsector andlocationdummies.Theregionaldummiesaredummyvariablesindicating thatthefirmislocatedinthecapital,Vientiane,andadummyvariableindicating thatitislocatedinthesouth(Champassak/Savannakhet).Theomittedregionis thenorth(Oudomxay/Luangprabang/Xayaboury).Previousstudieshaveshown thatregulationvariesbetweenregionintheLaoPDR.7 Finally,theregressionsincludeaseriesofdummiesindicatethesubsection oftheeconomythatthefirmoperatesin.Thedummiesareforgarment,textile, foodandbeverage,andwoodprocessingfirms.Theomittedsectorisconstruction materials.Giventhelargenumberofinspectionsbytheforestrydepartment,it seemsplausiblethatwoodprocessingfirmsmightfacemoreinspectionseven aftercontrollingforotherfactorsthataffectthenumberofinspections. When we regress management time spent dealing with regulation on eachtypeofregulation,thesizeandstatisticalsignificanceofthecoefficients are different for different types of regulation--although the coefficients are 6 See,forexample,thediscussionoftheeffectofstateownershiponpollutioninAsiain Hettigeandothers(1995). 7 SeetheWorldBank,2005a. 144 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH positiveinallcases(TableA.4.2).Combiningthetypesofinspectionsthathave thelowestlevelsofstatisticalsignificanceandrerunningtheregressionstendto increasethesignificanceoftheremainingvariables.Thenullhypothesisthatthe coefficientsoninspectionsbycustoms,theeconomicpolice,municipalpolice, tradedepartment,andfoodanddrugdepartmentareallequalcannotberejected at conventional significance levels (p-value=0.97).When we reestimate the equationallowingthecoefficientsontheseinspectionstobeequalbutallowing thecoefficientsonthosetypesofinspectionsthataremorehighlysignificant tobedifferent,werejectthenullhypothesisthatcoefficientsontheremaining variables(taxinspections,forestdepartmentinspections,industrydepartment inspections,andlaborinspections)arethesameastheothercombinedcategory ata5%significancelevel(p-value=0.02).Baseduponthecoefficientestimates incolumn3,anadditionaltaxinspectionincreasestotalmanagementtimespent dealingwithregulationby0.31percentagepoints,whileanadditionalindustry departmentinspectionincreasesthetotaltimespentdealingwithregulationby 0.35percentagepoints.Althoughthecoefficientsonlaborinspectionsandforest departmentinspectionsarestatisticallyinsignificantatconventionalsignificance levels,thepointestimatesoftheparameterssuggestthatanadditionalinspection increases the total time by 0.88 and 0.07 percentage points, respectively. Althoughinspectionsincreasethetimespentdealingwithregulations,labor,tax, andindustrydepartmentinspectionsappearthemosttimeconsuming. APPENDICES 145 Table A.4.1 Impact of inspections on time spent dealing with government regulations Model Tobit Dependent variable Time spent dealing with government regulations Observations Total inspections 0.09*** 0.02 [4.44] [0.59] Forest department 0.08 0.06 0.08 [1.20] [0.76] [1.48] Tax department 0.38** 0.35** 0.39*** [2.33] [2.49] [3.08] Industry department 0.37 0.40* 0.42** [1.54] [1.84] [2.02] Labor department 0.92 1.05 1.20* [1.16] [1.53] [1.87] Customs department 0.03 [0.19] Economic police 0.06 [0.30] Municipal police 0.38 [0.78] Trade department 0.10 [0.43] Food and drug department (0.01) [(0.03)] *** Significant at 1% significance level. ** 5% level. * 10% level. Source: LAO PDR ICS, 2005. 146 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Table A.4.2 Regression results Tobit Poisson Tobit Poisson Percent of Number of Percent of Number of time spent inspections time spent inspections dealing with dealing with regulations regulations Observations 238 240 237 239 Firm characteristics Number of workers 0.3285 0.2472*** (natural log) [0.59] [13.96] Firm is an exporter 3.2878** 0.5829*** 2.7737* 0.1092** (dummy) [2.45] [14.59] [1.73] [2.03] Ownership State-owned 1.7885 0.2950*** 1.5967 0.2151** (dummy) [0.67] [3.45] [0.60] [2.50] Foreign-owned 0.0314 (0.1718)*** (0.1503) (0.2860)*** (dummy) [0.02] [4.02] [0.11] [6.55] Sector of operations (construction materials is omitted) Garment (2.9466) 0.7412*** (3.2244) 0.6232*** (dummy) [1.47] [11.18] [1.57] [9.19] Textile 2.1049 0.0828 2.1759 0.1843** (dummy) [1.03] [1.04] [1.06] [2.32] Food and beverages 0.4873 0.4228*** 0.5168 0.4735*** (dummy) [0.31] [6.95] [0.33] [7.77] Wood 0.3590 0.6891*** 0.3687 0.7341*** (dummy) [0.26] [13.23] [0.26] [13.91] Region Vientiane 0.0 309 (0.3163)*** (0.2132) (0.4956)*** (dummy) [0.02] [6.53] [0.14] [9.84] South (Champassak/ Savannakhet) (0.0208) 0.0652 (0.2063) (0.0654) (dummy) [0.01] [1.40] [0.14] [1.37] *** Sig. at 1% level. ** Sig. at 5% level. * Sig. at 10% level. Note: Outliers for the dependent variables with more than three standard deviations above or below the mean are dropped from the regressions. Source: LAO PDR ICS, 2005. APPENDICES 147 Appendix 5 Statistical Appendix on Access to Finance We examine the question of how different factors, including ownership, affect access to credit in the Lao PDR, estimating different versions of the equationbelow: Financei= ß1 + ß2 For,Characteristicsi+i Thedependentvariablesarevariousmeasuresofaccesstofinanceforfirm i.Themeasuresincludethefirm'sperceptionsaboutaccesstofinancingandthe costoffinancing,whetherthefirmhasaloanfromabankoranoverdraftfacility, thepercentofshort-termassets(e.g.,inventoriesofshort-termassetsthatare usedinproductionsuchasrawmaterialsandintermediategoodsandaccounts receivable)thatthefirmusesbankloanstoacquireorfinance,thepercentage ofnewinvestmentthatthefirmfinanceswithbankloans,andloandurationfor firmswithloans. The dependent variables are limited dependent variables. The two perceptionvariablesarebaseduponquestionsthataskedthemanagertorankon a5-pointscalehowgreatanobstacleaccesstofinancingandthecostoffinancing weretoenterpriseoperationsandgrowth.8Sincetheresponsesareordered,with highernumbersmeaningagreaterobstacle,butnotcountdata,themodelis estimatedasanorderedProbitmodel.Twoofthevariables--whetherthefirm hasabankloanandwhetherithasanoverdraftfacility--aredummyvariables. These models are estimated as simple Probit models.Two of the variables, percentageofnewinvestmentandshort-termassetsfinancedthroughthebanking sector,arerestrictedtobebetween0and100%--althoughinpractice,fewfirms financed100%ofshort-termassetsthroughthebankingsector.9Thesemodels areestimatedasatwo-limitTobitmodel.Thefinalvariableisloandurationin months.Thisvariableistruncatedbelowat0and,therefore,weestimateitusing aone-limitTobitmodel. Alargeliteraturehasshownthatfinancingtendstobeagreaterproblem forsmall-andmedium-sizedenterprises.10Theregressionsthereforecontaina variabletocontrolforenterprisesize--thenumberofworkersintheenterprise. Wealsoincludedavariablerepresentingfirmageinsomemodelspecifications. 8 Responseswere0=noobstacle,1=minorobstacle,2=moderateobstacle,3=majorobstacle, and4=verysevereobstacle. 9 NoneofthefirmsintheLaoPDRobtainalltheirfinancingfrombanks,makingthisrestriction nonbindinginthiscase. 10SeeSchiantarelli(1996)forareviewoftheliteratureonfirmsizeandfinancialconstraints. 148 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Sincethisvariablewasconsistentlystatisticallyinsignificantweomititfromthe mainspecification. Firm'sfinancingneedsarealsolikelytodependuponitscustomers.In particular,weincludeadummyvariablerepresentingwhethertheenterprises exportmorethan10%ofitssales.Apriori,itisdifficulttoassesswhetherthe coefficientonthisvariableshouldbepositiveofnegative.Ontheonehand, exportersarelikelytobemoreefficientthanotherenterprises,suggestingthat theymightfinditeasiertogetfinancing.Ontheother,iftheirgreaterefficiency translatesintohigherprofits--notnecessarilythecasesinceinternationalmarkets arelikelytobemorecompetitivethatdomesticmarkets,theymighthaveless demandforbankloans. Theregressionsincludetwovariablesindicatingfirmownership.Ifthe Governmentownsmorethan10%oftheenterprises,theenterpriseisclassified as(partly)state-owned.State-ownershipmightaffecttheavailabilityofcredit-- especiallyintheLaoPDR,wherethebankingsectorisprimarilystate-owned.If foreignenterprisesorindividualsownmorethat10%,itisclassifiedas(partly) foreign-owned.Foreign-ownedenterprisesmightbeabletogetfinancingeither intheirhomecountryorfromtheirparentcompanyand,therefore,belesslikely todependuponlocalbanksforfinancing. Ifbettereducatedmanagersaremorelikelytohavecontactsthatallow themtogetloansorfinditeasiertodealwithbureaucraticrequirementsand paperwork,thentheymightfindaccesstofinancealessseriousconstraintthan otherfirms.Consistentwiththisidea,firmswithuniversityeducatedmanagers aremorelikelytohaveauditedaccountsthanotherfirms--47%offirmswith universityeducatedmanagersreportedhavingauditedaccountscomparedto 22%ofotherfirms.Thisremainstrueaftercontrollingforadditionalvariables (i.e.,theonesincludedinthemainregressions),althoughthecoefficientbecomes marginallystatisticallyinsignificant(13%significancelevel).Inasimpleprobit regressionofadummyvariableindicatingthatthefirmhasauditedaccountsona dummyvariableindicatingthatthemanagerhasauniversityeducationandother controlvariables(e.g.,size,ownership,location,andsector),thecoefficienton thedummyindicatingeducationremainspositive. Inadditiontothesevariables,theregressionsalsoincludeaseriesofsector andlocationdummies.Theregionaldummiesaredummyvariablesindicating thatthefirmislocatedinthecapital,Vientiane,andadummyvariableindicating thatitislocatedintheSouth(Champassak/Savannakhet.Theomittedregionis thenorth(Oudomxay/Luangprabang/Xayaboury). APPENDICES 149 Finally,theregressionsincludeaseriesofdummiesindicatethesub-section oftheeconomythatthefirmoperatesin.Thedummiesareforgarmentfirms, textilefirms,foodandbeveragefirms,andwoodprocessingfirms.Theomitted sectorisconstructionmaterials. 150 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Table A.5.1 Effect of firm characteristics on access to credit 1 2 3 4 5 Estimation method Probit Probit Probit Tobit Tobit Dependent variable Firm Firm has Percent of Percent of Duration of has loan overdraft working investment most recent (dummy) (dummy) capital financed loan financed through bank through bank loans loans Observations 244 224 244 239 56 Firm characteristics Number of workers 0.1631*** 0.0675*** 22.4751*** 26.5017*** 7.3258*** (natural log) [4.84] [3.26] [3.66] [3.57] [3.11] Firm is an exporter (0.3107)*** (0.1713)*** (62.0860)*** (69.0377)*** (19.3525)** (dummy) [3.82] [2.69] [3.35] [3.15] [2.47] Ownership State-owned (0.0896) (0.0025) (13.9545) (9.8368) (3.7293) (dummy) [0.85] [0.03] [0.58] [0.38] [0.33] Foreign-owned (0.2322)*** (0.0860)** (43.6509)*** (41.0386)** 14.8410)* (dummy) [3.52] [2.20] [2.67] [2.20] [1.93] Manager education (secondary or less is omitted) University education 0.0347 0.0343 16.4976 16.7109 6.0966 (dummy) [0.51] [0.74] [1.44] [1.25] [1.16] Vocational education 0.0696 (0.0149 6.2090 9.8522 9.5420* (dummy) [0.89] [0.33] [0.50] [0.70] [1.70] Sector of operations (construction materials is omitted) Garments 0.0639 0.1524 1.3435 (12.2648 (3.4873 (dummy) [0.54] [1.52] [0.07] [0.55] [0.39] Textiles 0.2164* (6.6741) 2.9828 17.0937** (dummy) [1.68] [0.34] [0.14] [2.14] Food and beverages 0.0002 (0.0682) (11.9745) (21.5350) 11.6150 (dummy) [0.00] [1.32] [0.76] [1.10] [1.54] Wood 0.0865 0.0085 7.8001 13.2738 5.1858 (dummy) [1.11] [0.19] [0.62] [0.94] [0.89] Region Vientiane (0.0519) (0.0524) (10.4360) (9.3957) (6.0432) (dummy) [0.62] [0.92] [0.74] [0.57] [0.88] South (Champassak/ Savannakhet) (0.0388) 0.0006 (24.2003) (19.1321) (6.5271) (dummy) [0.48] [0.01] [1.64] [1.13] [1.00] *** Sig. at 1% level. ** Sig. at 5% level. * Sig. at 10% level. Source: LAO PDR ICS, 2005. APPENDICES 151 Appendix 6 Electricity PertinentconclusionsoftheoriginalICASurveyaresummarizedinthe followingtable: Table A.6.1 ICS results ­ electricity Firms No. of days Average Lost value Days to Own identifying of power duration due to obtain generator electricity inter- of power power electrical (%) as major ruptions inter- inter- connection constraint (2005) ruptions ruptions (%) (hours) (% sales value) Sector Garments 53.8 8.2 4.0 5.2 9.7 2.6 Textile/ 40 4.7 5 3.7 22.5 5 handicrafts Food and 44.1 8.1 2.8 2.1 7.0 8.8 beverages Construction 29.9 7.3 5.9 3.9 43.7 9.0 materials Wood 43.0 11.3 4.9 4.9 38.1 9.3 processing Province Vientiane 47.6 7.2 4.2 4.1 42.3 3.2 Oudomxay 57.1 19.0 7.8 8.0 7.0 35.7 Luangprabang 66.7 14.8 7.0 1.3 ­ ­ Xayaboury 29.4 5.1 5.6 6.3 9.2 35.3 Savannakhet 24.6 9.3 4.7 4.6 42.0 3.3 Champassak 36.8 12.5 5.3 3.2 ­ 10.5 Size Small (< 11) 37.7 8.5 5.2 4.7 13.8 6.5 Medium (10 < 36.0 9.0 4.7 3.4 50.4 11.6 workers <51) Large (51+ 49.4 8.7 4.4 4.9 34.4 4.8 workers) Total 41.1 8.7 4.7 4.3 34.2 7.7 Source: LAO PDR ICS, 2005. 152 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Appendix 7 Tourism/Services Table A.7.1 Tourist arrivals in the Lao PDR by region of origin, 1998­2004 Region of 1998 1999 2000 2001 2002 2003 2004 origin Asia-Pacific 421,196 510,703 604,254 553,249 579,031 498,185 730,107 of which, Thailand 273,095 356,105 442,564 376,685 422,766 377,748 489,677 Viet Nam 78,216 71,748 68,751 82,411 71,001 41,594 130,816 Europe 52,076 68,564 86,462 80,736 101,924 93,960 112,092 Americas 25,326 31,780 42,111 34,370 46,704 39,453 47,153 Others 1,602 3,231 4,381 5,468 8,003 4,763 5,454 Total 500,200 614,278 737,208 673,823 735,662 636,361 894,806 Source: Lao National Tourism Administration Planning and Cooperation Department, 2005. Table A.7.2 Revenue from tourism by origin, 2004 Origin Number of Average Average Tourism arrivals stay expenditure revenue (people) (days) ($/day) ($) Thai (passport) 75,702 3 40 9,084,240 Thai (border pass) 413,975 1 20 8,279,500 Viet Nam (passport) 72,412 3 30 6,517,080 Viet Nam (day tripper) 58,404 1 12 700,848 PRC (passport) 18,379 3 30 1,654,110 PRC (day tripper) 14,640 1 12 175,680 Subtotal 653,512 1.5 26.8 26,411,458 International tourists 241,294 6.5 59 92,536,249 Total 894,806 2.9 46.6 118,947,707 Source: Lao National Tourism Administration Planning and Cooperation Department, 2005. APPENDICES 153 Appendix 8 Informality Section Table A.8.1 Selected characteristics of nonfarm household-based enterprises (%, unless otherwise specified) All Manu- Trading Tourism Commu- Others** facturing and other nity and services* personal services Region As a proportion to total establishments for each sector North 24.5 32.7 20.9 25.1 30.3 21.3 Central 58.0 60.3 57.7 59.3 52.4 66.8 South 17.5 7.0 21.3 15.7 17.3 11.9 As a proportion of total establishments in the region North 100.0 20.8 46.6 11.6 19.2 3.8 Central 100.0 16.3 54.5 11.6 12.6 5.0 South 100.0 6.3 66.8 10.1 13.8 3.0 Urban/Rural Urban 60.3 57.7 61.0 70.9 52.9 56.2 Rural 39.7 42.3 39.0 29.1 47.1 43.8 Areas of operation Home 54.1 83.7 52.2 20.2 62.4 33.2 Industrial site/market 17.6 5.3 26.4 8.9 8.6 3.4 Roadside/other fixed 10.2 7.7 10.0 8.6 15.9 8.8 place Mobile 15.8 1.4 8.8 60.6 12.0 51.7 n.a. 2.2 1.9 2.7 1.8 1.1 2.8 Age Mean (in years) 7.0 7.2 7.3 5.1 7.0 7.0 2 or less 34.0 28.8 34.2 36.9 35.4 37.4 3­5 25.4 30.8 25.0 26.5 19.9 26.7 6­10 13.1 13.2 12.4 14.3 15.0 12.7 Over 10 22.4 24.2 22.9 16.7 24.3 17.3 n.a. 5.1 3.0 5.5 5.5 5.4 6.0 (continued next page). 154 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Table A.8.1 (continued). All Manu- Trading Tourism Commu- Others** facturing and other nity and services* personal services Number of months in operation in the past year Mean 9.5 9.6 9.7 9.6 9.4 7.4 1­3 10.1 7.3 9.5 9.6 11.1 25.1 4­6 12.9 16.3 11.0 12.8 13.1 23.9 7­11 17.9 20.1 16.3 18.8 19.1 24.4 12 57.9 55.0 61.8 58.0 55.4 26.6 n.a. 1.2 1.2 1.3 0.7 1.2 0.0 Labor Household head is male 94.6 92.1 91.1 94.8 94.9 95.1 Number of workers who are not household members 0 60.9 55.8 63.7 58.7 61.4 47.6 1­2 13.5 13.4 12.5 14.5 15.3 16.3 3­4 2.2 1.7 1.6 1.3 2.7 12.3 >=5 1.7 3.3 0.3 0.6 1.8 15.7 n.a. 21.8 25.8 21.9 24.9 18.8 8.1 Number of household members working in the household business 0 4.8 2.5 4.9 3.9 6.1 9.3 1­2 81.3 72.3 83.8 80.3 84.8 73.8 3­4 7.8 8.6 8.0 5.2 6.3 14.6 >=5 1.1 3.8 0.6 0.6 0.6 0.9 n.a. 5.0 12.8 2.7 10.0 2.2 1.4 Mean workers employed (household members + non- household members) 1.8 2.0 1.7 1.4 1.7 3.5 Estimated employment 462,808 80,050 238,447 42,331 61,750 40,229 Note: *includes hotels, restaurants, travel agencies, transport, finance, and real estate. **covers businesses related to agriculture, mining, electricity, gas, water, construction, and unclassified business. Source: Estimates using LECS 3, 2002/2003. APPENDICES 155 Appendix 9 Household Businesses Anexaminationoftheinvestmentclimatefactorsisimportantinunlocking themostimportantbarrierstostartingabusiness.Toexaminetheimpactof investmentclimateonhouseholdbusinesses,thissectionappliesaregression analysisusingvillage-leveldataculledfromtheLECS3survey.Themodelis givenbelow: Y=o+ß1(HHchar) +ß2(IC)+ where: Y­theproportionofhouseholdswithnon-farmenterprisesinthevillage Hhchar­averagehouseholdcharacteristicsofthevillage IC­investmentclimatefactors Thefollowingareusedasindicatorsofinvestmentclimate:roads,electricity, dailymarket,andfinancing.Thesevariablesaremeasuresofaccessatthevillage level,makingthemmorelikelyexogenous,whichmaynothavebeenthecaseif theyweremeasuresofaccessatthehouseholdlevel. Theinvestmentclimatefactorsarerepresentedbydummyvariables,which takeonavalueof"1"todenoteavailabilityofthefactor,and0,forlackofaccess. Thus,avillageisassignedavalueof1for"roadaccess"ifatransportation(i.e., truckorcar)canreachthevillageinbothdryandwetseasons.Avillagealso takesonavalueof1forelectricityaccessifconnectedtoanelectricnetwork, anda"1"for"dailymarket"ifthereisapermanentdailymarketinthevillage. ThesethreemeasuresarefoundunderPartD-InfrastructureoftheLECSvillage questionnaire.Accesstofinancingreferstoavailabilityofapublicfinancial institutioninthevillageunderPartA-Organization/ServicesoftheLECS. In addition to the investment climate factors, household attributes averagedatthedistrictlevelarealsoincludedintheregression.Theseinclude ageofhouseholdhead,landownershippercapita,valueofdurables,number ofhouseholdmembersatages15­64,maximumeducationofanyhousehold member,andproportionofmale-headedhouseholdsinthevillageisalsousedas anadditionalregressor. To derive the regression parameters, the maximum-likelihood probit regressionforgroupeddataorprobitisused.Twovariantsofthemodelarealso employed,onewithhouseholdattributesandanotherwithout.Inbothmodels, 156 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH allinvestmentvariablesarefoundtobesignificantpredictorsoftheproportion ofhouseholdbusinessesinthevillage.Theregressionutilizesinformationfrom 537villages. TheregressionresultsinTableA.9.1indicatethat,ontheaverage,avillage withaccesstoall-seasonroadshasagreaterproportionofhouseholdbusinesses comparedtoonethathasnoaccess.Controllingforhouseholdattributes,the shareofhouseholdswithbusinessesisalsohigherby4percentagepointsfora villagewithelectricitycomparedtothathavingnoelectricity.Accesstofinancing alsomakesagooddifference--villageswithaformalfinancialinstitutionhave agreaterproportionofhouseholdbusinesses,at3percentagepointsmorethan thosewithout.Arelativelymorepronouncedimpactisprovidedbypresenceof markets.Thisissosincevillageswithaccesstomarketshaveabout8percentage pointsmorebusinessescomparedtothosewithoutmarkets. Itisinterestingtoquantifyhowanimprovementinaccesstoinvestment climatefactorscanenhancebusinessactivitiesatthevillagelevel.Theregression coefficientsareusedtosimulatetheimpactofchangesoninvestmentclimate ontheproportionofhouseholdbusinessesandemployment.Thesimulationis doneforanaveragevillagewithapoorinvestmentclimate,havingnoaccessto infrastructure,financing,andmarkets.Outofthe537villagesintheLECSdata, thereare165ofsuchkind.Simulationsontheimpactofanimprovementinthe investmentclimateforavillagewithaveragecharacteristicsarealsoundertaken forcomparison. Basedontheregressionmodel,theexpectedproportionofhouseholds havingnon-farmenterprisesisabout20%(TableA.9.2).However,foranaverage villagewithapoorinvestmentclimate,theexpectedproportionofhousehold- basedenterprisesisonlyabout7%.Providingelectricityinthevillagetendsto raisetheproportionofhouseholdswithnon-farmenterprisestoaround10%. Anincreaseintheproportionofbusinessesisalsoseenwiththeadditionof roads.Movingfurther,settingupfinancingfacilitiesmakesa2percentage-point improvementintheproportionofhouseholdbusinessesfromthepreviousstate whenonlyroadsandelectricitywereavailable.Finally,establishmentofmarkets atthevillagelevelcouldraisetheproportionofhouseholdbusinessesby6.5 percentagepoints.Overall,theshareofthehouseholdpopulationwithbusinesses atthevillagelevelrisesfromabaseof7%tonearly20%withanimprovement intheinvestmentclimatefactors.Foranaveragevillage,however,theincrease intheproportionofhouseholdbusinessesisfrom20­33%. APPENDICES 157 Anotherimportantanalysisistheimpactonemployment,whichisestimated bymultiplyingtheaveragenumberofworkersemployedbyhouseholdbusinesses totheincreaseinthenumberofhouseholdbusinessforeveryimprovementinthe investmentclimate.Foranaveragevillage,themeannumberofworkersis1.8 whilethemeanisjustoneworkerforeachhouseholdbusinessinvillageswith poorinvestmentclimate.Overall,newhouseholdbusinesseshavethepotential ofincreasingemploymentofnon-farmenterprisesbyabout50%.Butabigger impactcanbeseenontheemploymentlevelsofvillageswithpoorinvestment climate,orthosewithnoaccesstoinfrastructure,financing,andmarkets.The increaseinthenumberofhouseholdbusinessesinvillageswithpoorinvestment climateisestimatedtobeslightlymorethandouble. Table A.9.1 Impact of investment climate on proportion of household businesses at the village level (bprobit) 1 Without household 2 With household attributes attributes Coefficient Pr(outcome) Coefficient Pr(outcome) Road access (wet and dry seasons) 0.363*** 0.095*** 0.061*** 0.015*** [89.26] [96.02] [13.24] [13.34] Electricity 0.656*** 0.185*** 0.165*** 0.041*** [189.90] [191.81] [39.41] [39.15] Finance 0.083*** 0.023*** 0.100*** 0.026*** [13.53] [13.13] [16.92] [16.28] Daily market 0.510*** 0.162*** 0.289*** 0.079*** [113.49] [100.56] [60.04] [54.15] Average age 0.168*** 0.041*** [55.70] [56.57] Average age- squared (0.002)*** (0.000)*** [57.73] [58.60] Average land ownership per capita (4.204)*** (1.032)*** [7.53] [7.55] Average durables (log) (0.382)*** (0.094)*** [45.59] [45.83] (continued next page). 158 REDuCINg INvEStmENt ClImAtE CoNStRAINtS to HIgHER gRowtH Table A.9.1 (continued). (1) Without household (2) With household attributes attributes Coefficient Pr(outcome) Coefficient Pr(outcome) Average durables- squared (log) 0.027*** 0.001*** [47.39] [47.61] Average no. of household members within ages 15­64 (0.163)*** (0.040)*** [47.25] [47.54] Share of male-headed households (1.332)*** (0.327)*** [61.60] [61.75] Average maximum education of any household member 0.131*** 0.032*** [179.93] [182.04] Constant (1.431)*** (3.762)*** [392.91] [57.66] Observations 861,578 861,578 Wald chi2(4) 93,174.75 143,145.47 Prob > chi2 0.0000 0.0000 Log pseudo- likelihood (427,002.21) (392,216.59) Pseudo R2 0.1101 0.1826 Notes: (i) Robust z statistics in brackets. (ii) * significant at 10%; ** significant at 5%; *** significant at 1%. Source: Estimate using LECS 3, 2002/2003. 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