Dutch disease in the Lao economy: Diagnosis and treatment

Abstract

Searching for evidence of Dutch disease in the Lao economy, we do find some of its symptoms, though they are not very strong. Accordingly, we propose some policy options to mitigate its effects and ensure the sustainable development of the Lao economy: (a) invest the revenues from the booming resource-intensive exports, foreign direct investment and official development assistance in infrastructure and education; (b) reduce import barriers against capital and equipment imports; (c) establish a natural resource fund and a foreign exchange equalisation fund; (d) actively participate in regional trade agreements for advanced technologies and domestic reform; (e) establish a comprehensive bank for efficient trade and investment activities. Above all, we strongly suggest public sector reform to increase transparency in governance.

Keywords

Dutch disease resource curse sustainable development international competitiveness Lao PDR

Introduction

The Lao PDR, one of the least-developed countries in the Association of Southeast Asian Nations (ASEAN), is endowed with abundant natural resources for export. The Lao PDR economy is driven by resource-intensive exporting industries such as mining and hydropower.¹ The government finances its development plans with official development assistance (ODA) and foreign direct investment (FDI).² That is, the Lao PDR is considered dependent on the resource sector and inflow of foreign exchange for its development. More specifically, while the Lao economy grew by 7.9%, 8.1% and 8.0% in the years 2009–2010, 2010–2011 and 2012–2013, respectively, because of foreign capital inflows and the rising prices of natural resources, the Lao kip/US$ exchange rate has appreciated continuously from 8516 kip in 2009 to 8030 kip in 2011 and to 8013 kip in 2013. This kip/US$ appreciation trend reduces the competitiveness of Lao products, especially non-resource tradables. This situation seems to fit well with the condition of other resource-rich countries that are vulnerable to Dutch disease,³ which could be an impediment to the industrialisation process of the Lao PDR.

Searching for appropriate policy options for the Lao government to achieve sustainable economic development against the backdrop of Dutch disease fears, Brahmbhatt and Vostroknutova (2010) observe loss of export competitiveness and Dutch disease symptoms in the country by carefully analysing recent trends of macroeconomic indicators such as a real effective exchange rate, terms of trade, balance of payments, GDP growth rates by sector, etc. Similarly, Lord (2011) finds some evidence of a spending effect of Dutch disease in the Lao economy by investigating major macroeconomic data. In particular, Phannalangsi (2011) emphasises an even more important role of the mining and hydropower sectors on the Lao economy during the period of recent global financial crisis and proposes diversifying the industrial structure to maintain its competitiveness, which has been eroded by the possible Dutch disease problem. Phommahaxay (2013) also finds that FDI inflows into the mining sector may cause the Dutch disease problem. However, those findings are not concretely supported with a rigorous quantitative analysis.

Unlike these qualitative analyses, Kyophilavong and Toyoda (2009), by using a computable general equilibrium (CGE) model analysis with LAOMACROMODEL-2, find that foreign capital inflows into the Lao economy cause real exchange rate appreciation and lead to its loss of already weak international competitiveness. By using a CGE model analysis, Kyophilavong et al. (2013) also quantitatively measure the worrisome effect of real exchange rate appreciation assumed to be caused by the massive inflows of foreign direct investment into the mining and hydroelectricity industries. However, their findings are based on some ex ante hypothetical scenario analyses rather than facts found from historical data analysis.

Menon and Warr (2013) are an exception. They conduct an ex post regression analysis and find a negative relationship between the relative tradable to non-tradable prices in the Lao PDR and its current account deficit, which can be regarded as a symptom of Dutch disease in the country. However, their finding has only limited credibility because their estimation was based on a simple regression analysis without controlling other important determinants of the relative price. It may be premature to make a judgement based on this result.

Therefore, more precise investigation is needed to overcome limitations found in the above-mentioned empirical experiments conducted on the Lao economy. As a contribution to the existing literature, we conduct both a qualitative evaluation and a more rigorous quantitative analysis to ensure that the Lao PDR can effectively utilise its natural resources to finance development, but remain immunised from the competitiveness issues the Dutch disease may cause, while at the same time avoiding the resource curse⁴ that characterises countries rich in natural resources.

This paper surveys both Dutch disease issues in general and the Lao economy in particular to complement the existing literature. More specifically, we investigate the macroeconomic relationship between international competitiveness and Laos’ economic condition, carefully considering the possibility of Dutch disease by investigating related statistical data and conducting an econometric regression analysis. In addition, some policy lessons from other countries are examined. The analysis helps us determine whether the Lao economy might have to deal with Dutch disease in the near future and proposes some macroeconomic policy recommendations for sustainable economic development by mitigating the risk of the disease. In fact, these fears of Dutch disease lead to policy responses. The policy responses to a possible onset of Dutch disease should focus not only on traditional macroeconomic stabilisation policies in the short run, such as fiscal and monetary policy, including exchange rate intervention, but also on related industrial and commercial policies in the medium and long run.

This paper is organised as follows. The next section theoretically reviews the relationship between Dutch disease and industrialisation. The section ‘Dutch disease and industrialisation: a case study’ examines the implications of a case study on the Lao economy by analysing resource-rich nations that experienced Dutch disease in the past. In ‘Industrialisation and Dutch disease in the Lao economy’ we analyse overall and sectoral macroeconomic relationships between international competitiveness and Laos’ economic conditions, while considering the possibility of the Dutch disease phenomenon. A multiple regression analysis is conducted to examine the possibility. Finally, in ‘Policy recommendations’ we propose some policy recommendations for the Lao PDR government to avoid a possible onset of Dutch disease and to achieve sustainable economic development.

Dutch disease and industrialisation: theoretical review

The term ‘Dutch disease’ describes ‘the adverse effects on Dutch manufacturing of the natural gas discoveries of 1960s, essentially through the subsequent appreciation of the Dutch real exchange rate’ (Corden, 1984: 1). It is:

…a phenomenon reflecting changes in the structure of production in the wake of a favorable shock such as a large natural resource discovery, a rise in the international price of an exportable commodity, or the presence of sustained aid or capital inflows. (Brahmbhatt et al., 2010: 1)

The surge in the balance of payments surplus raises the country’s currency value, deteriorates its competitiveness and leads to economic stagnation. For instance, resource-rich nations would experience an economic upturn in the short run through a boom in the resource-intensive exporting industries. However, the competitiveness of other industries, such as the non-resource tradable and non-tradable sectors, will be weakened because of the appreciation of the real exchange rate, which is defined as the relative non-tradable to tradable price. This causes nationwide recession.

To better understand and theoretically analyse the above-mentioned effects of Dutch disease, we categorise all industries into three sectors, following Corden and Neary (1982): booming exportable (resource tradable, for example the mining and hydropower electricity industry in the Lao PDR); lagging exportable (non-resource tradable, for example the textile and agro-forestry industry in the Lao PDR) and non-tradable (for example the construction industry in the Lao PDR). We then examine the cross-industry effects of Dutch disease by decomposing them into ‘spending effects’ on the demand side and ‘resource movement effects’ on the supply side of the economy.

The spending effect is caused by increased national income through extra revenues from the resource-intensive exportable industry. Corden and Neary (1982) indicate that the higher real income caused by the resource boom results in more spending on goods and services and raises the overall price of the economy. Thus, under the fixed exchange rate regime, the economic boom would bring about an appreciation in the real exchange rate, which is the relative price of non-tradable goods to tradable goods. Under the flexible exchange rate regime, the currency also appreciates as higher export earnings in a booming exportable sector would improve the balance of payments account. The final result of the resource boom is a loss of international competitiveness in the lagging non-resource tradable sector (Ruehle and Kulkarni, 2011). This may cause de-industrialisation.

The resource movement effect comes into play when the booming sector shares production factors with other sectors of the economy. The booming sector continues to attract capital and labour, resulting in an increase in factor prices. The rising cost of production would further squeeze the non-resource tradable sector. There would be a decline in the non-resource tradable sector, such as agriculture and manufacturing industries, because producers are unable to pay the higher prices for factors of production – the prices in the non-resource tradable sector are determined on the world market. The shift of factor movements away from the non-resource tradable (lagging) sector to the resource tradable (booming) and non-tradable sectors could undermine production, leading to a contraction in the lagging sector. As a result, producers reduce their output, resulting in a contraction in non-resource tradable goods. Moreover, the expectation of lower production in the non-tradable sector relative to the booming sector will lead to an increase in the real exchange rate.

Figure 1 illustrates the predicted spending and resource movement effect resulting from a boom in exports in the resource tradable sector. That is, an increase in income caused by a balance of payment surplus and the resulting increase in demand in the non-tradable sector causes the non-tradable demand curve to expand and shift from D₀ to D₁. The expansion and movement of the demand curve then causes a rise in non-tradable prices (P_NT), leading to an increase in non-tradable output (Q_NT: M→N). This change would cause labour costs to rise, and the profits of the non-resource tradable sector will eventually decline. Because of the resource movement effect, factors of production (labour and capital) will shift from non-tradable and non-resource tradable sectors to the booming exportable (resource tradable) sector, causing the non-tradable supply curve to move upward from S₀ to S₁. This makes for a rise in non-tradable prices (N→O), along with the spending effect. The increase in non-tradable prices (P_NT) will improve the country’s terms of trade on the prices of tradables (P_T) at world markets, accompanied then by a rise in real exchange rate (RER: P_NT/P_T). This appreciation damages international competitiveness, increasing the export share of the resource tradable (booming exportable) sector and decreasing that of the non-resource tradable sector. An export-oriented industrialisation strategy focusing on the manufacturing industry (non-resource sector) is not likely to be successful in a developing country such as the Lao PDR. Thus, the Lao economy would tend towards recession.

Figure 1.

Dutch disease effect on non-tradable sector.

Dutch disease and industrialisation: a case study

In this section, we examine the implications of a case study on the Lao economy by analysing resource-rich nations that experienced Dutch disease in the past. From these case studies, we attempt to draw lessons for policy options that can then be implemented effectively.

Table 1 summarises five different cases: Senegal, Mongolia, Myanmar, Chile and South Africa. The first two illustrate the relatively unsuccessful policy results, and the other three the relatively successful policy outcomes.⁵ The table summarises the causes and symptoms of Dutch disease in the five countries and subsequent policies implemented to deal with the problems.

Table 1.

The Dutch disease phenomenon: case studies.

	Senegal	Mongolia	Myanmar	Chile	South Africa
Causes	Sharp increase in foreign aid inflows from 1980–1992	The third biggest copper and gold mine in the world	Abundant natural resources (oil, natural gas, lead, zinc)	Largest producer of copper	Abundant natural resources (gold, coal, iron, diamonds)
Economic characteristics as of 2011	Low income: GDP per capita: US$1075 GDP growth rate: 2.6% Unemployment rate: 48% Inflation rate (CPI): 3.4% Current account: –US$1681m Fixed exchange rate	Lower-middle income: GDP per capita: US$3042 GDP growth rate: 16.4% Unemployment rate: 9.9% Inflation rate (CPI): 12.6% Current account: –US$931.5m (2010 est.) Flexible exchange rate	Low income: GDP per capita: US$832 GDP growth rate: 5.5% Unemployment rate: 4.0% Inflation rate (CPI): 4.2% Current account: –US$1366m FDI inflow: US$910m (2010) Foreign reserves: US$3931m Multiple exchange rate (public vs. private)	Upper-middle income: GDP per capita: US$14,410 GDP growth rate: 6.0% Unemployment rate: 6.6% Inflation rate (CPI): 3.3% Current account: –US$3231m FDI inflow: US$8500m Foreign reserves: US$41,944m Flexible exchange rate	Upper-middle income: GDP per capita: US$8066 GDP growth rate: 3.1% Unemployment rate: 24.5% Inflation rate (CPI): 5.0% Current account: –US$13,342m FDI inflow: US$48,867m Foreign reserves: US$48,867m Flexible exchange rate
Symptoms	Increased aid inflows from 1980 to 1986 (96.3% rise from 1983–1986) High level of wages in the formal sector (50% of total current expenditure from 1980–1984) The real effective exchange rate of the CFA franc appreciated by 17% from 2010 to 2011 Heavy trade deficit throughout the 1980s	Minerals account for more than 90% of total exports FDI rose from US$131.5m (6.2% of GDP) to US$3202m (17% of GDP) from 2004 to 2011 The real exchange rate of the tug appreciated by 37% from 2006 to 2011. A rise in the production of non-tradable goods and a decline in manufacturing production	Resource export boom since 2006 The kyat appreciated by 11.7% on average from 2008 to 2011 Loss of international competitiveness of tradable commodities (agriculture, garments, furniture)	Copper export boom since 2003 The peso appreciated by 2.3% on average from 2008 to 2011 Loss of international competitiveness of tradable commodities (agriculture, manufacture)	Huge short-term capital inflows since the late 1990s The rand appreciated by 2.8% from 2008 to 2011 Loss of international competitiveness of tradable commodities (manufactures)
Policy response	Liberalising the labour market and restructuring the public sector Decrease in government consumption and wages Privatisation	Imposing a credible fiscal discipline: fiscal responsibility law and medium-term fiscal framework in 2010 Raise interest rates	Central bank intervention to alleviate exchange rate appreciation Abolishing the export-first and import-later policy	Chilean macroeconomic policies implemented through prudent fiscal and monetary policies Increasing imports Paying off the debt Investing overseas	• Mix of fiscal and monetary policy for a more competitive rand

Sources: Adenauer and Vagassky (1998); Erdene (2010); Ruehle and Kulkarni (2011); World Bank (2011); Asian Development Bank (2012); Export-Import Bank of Korea (2012); Fielding and Gibson (2012); Hodge (2012); Kubo (2012); Tserendorj and Purevjav (2012).

CPI: consumer price index; FDI: foreign direct investment.

We present the cases of Senegal in Africa and Mongolia in East Asia to emphasise the unsuccessful handling of the problem. For Senegal, the decline in competitiveness was due to an abrupt inflow of foreign aid. For Mongolia, it was mainly because of the resource boom and foreign direct investment inflow. These cases highlight the harmful effects of Dutch disease experienced in these economies in 2011. In fact, the negative outcomes in Senegal and Mongolia were not so much due to the policies implemented as the lack of transparent governance – that is, corruption and rent-seeking activities in the public sector. For example, Senegal channelled a considerable proportion of its budget into the sizeable public sector, which is included in the non-traded goods sector, for its wage payments. Budget allocations should be based on performance so that the negative effects of excessive spending on public consumption can be avoided (Adenauer and Vagassky, 1998). Despite several policy responses, Senegal still receives large amounts of aid. If the Senegalese government continues to receive aid regardless of whether it has implemented prudent macroeconomic reforms, ensuring aid effectiveness will be difficult.

As mentioned in Tserendorj and Purevjav (2012), resource-rich nations commonly encounter rising rents and the concomitant problems from corruption. As evidenced, Mongolia has consistently ranked high in worldwide surveys of corruption. Most of its revenues are obtained from the booming resource sector and FDI, and are largely allocated towards government demand for non-tradable goods. Public spending crowds out private investment, resulting in inflation and real exchange rate appreciation.

The Myanmar (Southeast Asia), Chile (South America) and South Africa (Africa) cases illustrate desirable policy responses to the problem.⁶ These three nations have a common feature: they are resource-rich countries. However, their economic status, the exchange rate regime, the causes of Dutch disease, and the government’s policy responses are different. The competitiveness of the economy weakened from the soaring prices of resources in the case of Myanmar (a low-income country) and Chile (an upper middle-income country) and from an abrupt inflow of foreign capital in the case of South Africa (an upper middle-income country). Moreover, Myanmar and Chile were concerned about the Dutch disease threat because of their relatively low employment rates, but South Africa had a high unemployment rate and was therefore not heading towards economic recession from the resource movement effect. Myanmar has multiple exchange rates that do not coincide with the market-determined rate because the country is characterised by heavy government intervention. Unlike Myanmar, Chile and South Africa have implemented a flexible exchange rate regime.

In contrast to Senegal and Mongolia, the three other countries have been successful in dealing with Dutch disease as indicated by their lower currency appreciation rate (see Table 1). Examining each government’s policy response, we note that Myanmar implemented a central bank intervention policy to depreciate the domestic currency under a multiple exchange rate system and an expansionary import policy of easing import regulations. The government of Chile implemented more diversified policy options: a tight fiscal policy to adjust spending effects as well as monetary and balance of payment adjustment policies to ease appreciation pressures through import volume expansion, repayment of foreign loans and foreign investment promotion. Considering South Africa’s high unemployment rate, the likely resource movement effect was not high. Thus, the government did not actively respond to the Dutch disease threat.

In sum, these case studies provide several policy options for the Lao PDR government. We also found that the effectiveness of policies implemented to deal with the Dutch disease phenomenon heavily depends on not only internal and external market conditions but also for example an effective institutional framework for public sector governance and market operating systems.

Industrialisation and Dutch disease in the Lao economy

The Lao PDR government has identified five strategic and prioritised industries, namely: electricity, agro-forestry, tourism, mining and construction material, for its industrialisation strategy. To enhance and implement the strategy, the government has emphasised the importance of infrastructure development and resource mobilisation to finance the development of these strategic sectors. A number of tax exemptions and incentives have been introduced and the foreign investment law amended to attract FDI to the prioritised industries. The government has set up a number of special economic zones to promote infrastructure development as part of its efforts to establish an industrial base and improve the business environment in prioritised locations. All these efforts have led to a significant increase in investment, both from domestic private and foreign investors.

As a result, the inflow of FDI, currently directed towards the resource sector, particularly mining and hydropower, has resulted in a boom in the sector since 2003 and an increase in mining and electricity exports. These FDI inflows and export earnings have contributed to a high growth rate in the Lao economy in recent years. Although there are no significant productive linkages between the resource sector and the rest of the economy (non-resource sector), the former does have the potential to adversely affect the latter through its impact on the inflation rate and exchange rate appreciation (World Bank, 2004). The real appreciation of the exchange rate as a result of the inflow of foreign exchange and a boom in the non-tradable sector, as compared to the non-resource tradable sector, would retard the development of the latter – a symptom of the so-called Dutch disease. The anxiety that this effect places on the economy is also linked to the wariness of the resource curse.

Based on external evidence, the internal facts, to be described later, cause concerns about Dutch disease and raise the spectre of the resource curse in the Lao economy. These fears, if warranted, would impede government efforts to pursue an industrialisation policy and promote the development of the non-resource manufacturing sector, particularly small- and medium-sized enterprises.

Industrialisation oriented to the resource-abundant sector

The mining sector in the Lao PDR has changed dramatically since 2003, when production started in large gold and copper mines that were developed by the Australian investors Lang Xang Minerals, Ltd. (Oxiana) and Phu Bia Mining, Ltd. (Pan Australian), which began operations in 2003 and 2005, respectively. Although a number of companies participated in the mining sector and engaged in mine production long before the entry of large operators, 2003 marks the beginning of what we have classified in this section as the boom period (see Table 2), in which the GDP share of the mining industry increased significantly.

Table 2.

Share of the mining sector in GDP (%).

	1999–2000	2004–2005	2005–2006	2006–2007	2007–2008	2008–2009	2009–2010	2010–2011	2011–2012	2012–2013
Mining & quarrying	0.2	4.9	11.2	11.0	10.1	7.7	8.6	8.8	8.4	7.2
Electricity and water supply	4.3	3.7	3.1	2.7	2.5	2.7	3.5	4.1	4.9	4.5
Non-resource sectors	95.5	91.3	85.7	86.3	87.4	89.7	87.9	87.1	86.8	88.3

Source: Lao Statistics Bureau, Ministry of Planning and Investment, Government of Laos, 2014.

About 17% of Laos’ economic growth from 2003 to 2013 can be attributed to the rapid development of the mining sector, as shown in Figure 2. The average growth rates of mining and electricity production during the period from 2006 to 2013 were 18% and 13%, respectively. The sector has also become an important source of revenue for the government. Since the period 2005–2006, the revenue from the natural resource sector has accounted for about 17% of total revenue and 2.2% of GDP, as illustrated in Figure 3.

Figure 2.

Contribution of the natural resource sector to GDP growth (%).

Figure 3.

Tax revenue as % of GDP.

The resource sector is expected to continue its important role over the next decade, thanks to the hydroelectric power development projects which are expected to continue until 2020, and are expected to contribute not less than 20% per year, on average, to the electricity production growth rate. In addition, the untapped potential in the mining sector, if explored, seems likely to remain high. It is estimated that the potential reserves of gold and copper could be five to eight times the size of the currently proven reserves⁷ (Brahmbhatt and Vostroknutova, 2010).

External-finance-dependent industrialisation and inflow of foreign exchange

During the last five years, mining and energy have become the fastest growing sectors and account for the largest share of total exports, driven by volume expansion and a surge in commodity prices from 2005 to 2008. Exports of natural resources increased from an average of 32% of total exports from 2000 to 2004 to 58% during the 2006–2013 period (Figure 4). This reflects a dramatic increase in the value of mining and electricity exports (Figure 5).

Figure 4.

Share of the resource sector in approved foreign direct investment and exports (%).

Figure 5.

Resource and non-resource exports (million US$).

The effort to industrialise the economy calls for sizeable levels of finance, which cannot possibly be sufficient if it is to come from domestic sources alone. Therefore, external resource mobilisation is considered a necessary and important task which the Lao government must undertake to improve its economic fundamentals for self-financed development in the future. Although foreign investment in the resource sector has fluctuated over time, it covers more than 51% of total approved investment from 2005 to 2013, compared to about 29% from 2001 to 2004. This indicates that a boom in the natural resource sector has attracted more foreign investment inflow into the Lao economy. In addition to this inflow, ODA increased remarkably during the boom period (Figure 6).

Figure 6.

Official development assistance (ODA) (Million US$).

Although the inflow of foreign exchange in the form of export earnings, FDI and ODA have contributed to economic growth and industrial development, this form of income could also contribute to an appreciation of the national currency and, consequently, a loss of competitiveness in the non-resource tradable sector. This raises concerns, and even suspicion, about the existence of Dutch disease in the Lao economy.

The possibility of Dutch disease in the Lao economy

On the surface, the Dutch disease phenomenon could be detected by observing the movement of the real exchange rate, the growth of the non-resource tradable sector, the development of the non-tradable sector (service sector) driven by rising demand or increasing purchasing power, private and government spending trends, labour productivity and movement, etc. These will prove the existence of Dutch disease through spending and labour movement effect channels, which lead to real appreciation of the exchange rate and a loss of competiveness in the non-resource tradable sector. The following highlights some issues that are integral to the early assessment of Dutch disease in the Lao economy.

Real appreciation in exchange rate

In general, an appreciating trend in the real exchange rate can be observed, particularly after a natural resource sector boom, such as the one in 2003 (Figure 7). However, this picture must be interpreted with care. The resource boom and inflow of foreign exchange could theoretically contribute to the appreciation of the real exchange rate. However, this is difficult to detect in the sense that during the same period, especially since 2000, the government has focused on macroeconomic stabilisation. This is partly because of a de-dollarised effort – an attempt to improve trust and confidence in the national currency. The policy is said to have been effective as the depreciation trend was halted and eventually reversed. However, identifying the causal link, especially attributing the success of the policy to the appreciation trend (caused by the inflow of capital), is still unwarranted, as is the argument that the appreciation is partly because of the policy rather than the Dutch disease syndrome. We investigate the causal link by using some multiple regression equations with the ordinary least squares (OLS) estimation method covering 19 years from 1993 to 2011 in the Lao economy. The regressors in the equations are separated into two groups, one strictly for the Dutch disease effect of capital inflow on real exchange rate and another to control causal linkages between real exchange rate and macroeconomic indicators.

Figure 7.

Real exchange rate.

We conduct five regressions based on the following three equations.⁸

Equation 1:

R E E R_{t} = a + b \cdot C A P I_{t} + c \cdot I N F L_{t} + d \cdot P G D P_{t} + e \cdot G E X P_{t} + u_{t}

t: time,

REER: real effective exchange rate,⁹

CAPI: capital inflow [(export of both electricity and mining sector + ODA grants)/total export],

INFL: inflation rate [consumer price index (CPI)],

PGDP: per capita GDP in US$,

GEXP: share of government expenditure in GDP,

u: error term

We include INFL, PGDP and GEXP as independent control variables. We expect positive estimates for all the coefficients (b, c, d and e) in Equation 1. From the estimation with the level series in Equation 1, we found that most variables have unit root problems. Thus, we run the regression in growth form (indicated with D) to overcome the unit root problems as follows:

Equation 2:

D l o g (R E E R_{t}) = a + b \cdot D (C A P I_{t}) + c \cdot D (I N F L_{t}) + d \cdot D (P G D P_{t}) + e \cdot D (G E X P_{t}) + u_{t}

We run Equation 2 with two different periods, one covering all samples from 1993 to 2011 and another covering samples from 1997 to 2011 to exclude the period when the exchange rate system in the Lao economy was closed due to a fixed exchange rate system (Models 1 and 2).

In order to check the Dutch disease problem in its strict definition, we run an alternative regression (Equation 3) with the export value of resource sector (EXPV, which is the export value of electricity and the mining sector) instead of CAPI. Similarly, we run Equation 3 with the above-mentioned two different sample periods (Models 3 and 4).

Equation 3:

D l o g (R E E R_{t}) = a + b \cdot D l o g (E X P V_{t}) + c \cdot D (I N F L_{t}) + d \cdot D (P G D P_{t}) + e \cdot D (G E X P_{t}) + u_{t}

Table 3 reports the estimation results.

Table 3.

Estimation results.

Dependent variable: Dlog(REER_t)	Model 1 (1993–2011)	Model 2 (1997–2011)	Model 3 (1993–2011)	Model 4 (1997–2011)
Constant	−0.051 (0.016)***	−0.056 (0.014)***	−0.045 (0.017)**	−0.050 (0.014)***
D(CAPI_t)	−0.145 (0.096)	−0.129 (0.083)
Dlog(EXPV_t)			−0.040 (0.040)	−0.053 (0.032)
D(INFL_t)	0.110 (0.037)***	0.119 (0.030)***	0.102 (0.038)**	0.117 (0.030)***
D(PGDP_t)	0.524 (0.080)***	0.576 (0.068)***	0.523 (0.087)***	0.597 (0.071)***
D(GEXP_t)	0.679 (0.387)**	0.996 (0.357)**	0.634 (0.414)	1.078 (0.366)**
R ²	0.77	0.88	0.75	0.88
F-Statistics	10.905	18.293	9.705	18.735
Durbin–Watson stat	2.737	2.366	2.733	2.468

Note: Standard errors are reported in parentheses, and *, ** and *** denote significance at the 10%, 5% and 1% levels, respectively.

REER: real effective exchange rate; CAPI: capital inflow; EXPV: export value; INFL: inflation rate; PGDP: per capita GDP; GEXP: share of government expenditure in GDP.

From these regression results, we find that the rapid increase in the inflow of capital in the form of resource export and ODA had not made any significant impact on the trended appreciation of the Lao currency. This means that there is no statistically significant evidence of the Dutch disease phenomenon. On the other hand, all the control variables have had significant effect on the real exchange rate appreciation. The inflationary growth performance and expanded government spending have been initiated by the resource sector boom as we mentioned earlier. It implies that there exists a possible symptom of Dutch disease through an indirect channel, which should be carefully considered.¹⁰

Increasing role of the non-tradable sector

As for the role of the non-tradable sector, quite clearly the service sector has increasingly become an important part of the Lao economy. The service sector’s share of value added to GDP increased gradually by almost 0.9 percentage points per year from 2000 to 2013 (Table 4). The growth rate of the service sector’s value added ranged from 8% to 10% on average during the period from 2000–2013. This might partly, but not conclusively, be explained by the spending effect of Dutch disease. Interestingly, the construction subsector has increasingly contributed to GDP growth, ranking ninth during the period 2000–2005 and second during 2011–2013 (Figure 8). This subsector, though a part of the industrial sector, can shed light on the increasing role of the non-tradable sector. In addition, other service subsectors also ranked high for their contributions to GDP growth.

Table 4.

Industrial structure (%).

	1999–2000	2004–2005	2009–2010	2012–2013
Agriculture	46.18	34.90	28.88	25.20
Industry	17.85	21.42	26.89	28.04
Services	30.43	37.43	37.20	38.86

Source: Lao Statistics Bureau, Ministry of Planning and Investment, Government of Laos, 2014.

Figure 8.

Contribution to growth – Top-10-ranked sectors.

More spending in the economy (spending effect)

The resource sector boom, along with FDI and ODA, has contributed to export earnings and government revenue. This might potentially increase the purchasing power of the government and the private sector in general. According to the second, third and fourth rounds of the Lao Expenditure and Consumption Survey, average household consumption growth during the five-year period increased by almost 100%, from 8.4% during the period from 1998–2003 to 19% during the period from 2003–2008. Consumption growth has been observed in both urban and rural areas (Table 5).

Table 5.

Index of monthly household consumption.

	1997–1998	2002–2003	2007–2008
Lao PDR	100	150	354
Urban	100	150	309
Rural	100	133	338

Source: Authors’ estimation, based on Lao Household Expenditure and Consumption Survey, National Statistic Centre, Government of Laos, 2014.

For the government sector, total expenditure has also seen an increasing trend. Expenditures increased from an average of 6.19% during the financial year (FY) 2001–2003 to 17.96% during the period FY 2004–2006, to 19.78% during FY 2007–2010 and to 23.08% during FY 2011–2013. The increase in government expenditures is mostly from current spending, particularly wages and salaries, and other current expenditures such as the purchase of office materials and supplies (Figure 9).

Figure 9.

Government spending (million kip).

Insignificant labour movement effect (resource movement effect)

The expansion of the resource sector has not contributed to a significant movement as a factor of production, particularly in labour, from the non-resource to resource sector. This might be due to the capital-intensive characteristic of the resource sector itself. Based on the Economic Census of 2006, the mining sector employs only 1.3% of labour in the non-agricultural sector or 0.28% of the total labour force, and the hydropower sector employs 1.05% of non-agricultural labour or 0.24% of the total labour force.

As for the changing structure of labour over the years, a decrease in the proportion of agricultural labour from 78.5% in 2005 to 70% in 2010 (a reduction of 8.5 percentage points) has resulted in an increase in the proportion of industrial labour by only 2.2 percentage points, from 4.8% to 7%, with the rest going to the service sector. This shows that the service sector absorbs labour flow from the agricultural sector more than it does from the industrial sector. As was pointed out earlier, the main driving force of the industrial sector is the resource subsector, which is not labour-intensive or skilled-labour oriented. On the assumption that the Dutch disease leads to a spending effect, a boom in the service sector would attract more labour. Therefore, judging from a theoretical perspective, the labour movement effect of Dutch disease could be said to be insignificant.

Unclear performance of the tradable non-resource sector (manufacturing)

After the boom in 2003, the mining sector has grown remarkably, with an eightfold increase in its value added in 2003 (compared to 2002), and grew at an average rate of 23% from 2004 to 2013 (Figure 10). Meanwhile, the manufacturing sector has also grown continuously at the average rate of 9.7%, faster than the overall national growth and its own previous 2003 growth (6.7% on average from 1998 to 2002).

Figure 10.

Growth of GDP and its components (%).

The resource and non-resource sector exports have experienced the same growth trend since 2003. During the period 2004 to 2013, the export growth of the resource sector, at 32%, was faster than that of the non-resource sector (20%; Figure 11). Despite some negative cyclical growth in manufacturing exports, its overall growth seems to be strong, so far. This indicates that the manufacturing sector is in general performing well, even though one observes an appreciation in the real exchange rate. The Lao garment factories’ claims of losing competitiveness seem justified to some extent, considering that the number of factories has reduced from 55 in 2007 to 50 in 2011. However, one witnesses both newcomers and closures every year, the latter mostly wholly Lao owned private factories, while some newcomers remain open for only two years before closing their business. Therefore, we cannot conclude that the manufacturing sector has been affected by a real appreciation of the exchange rate. More research and time are needed to demonstrate this effect.

Figure 11.

Export growth of the resource and non-resource sectors (%).

Strong interdependence between industries

The estimated correlation between the sectoral GDP of mining, manufacturing, agriculture and services is shown in Table 6. The analysis of correlation coefficients shows a positive correlation among sectors; in effect, it supports the conclusion that the Lao PDR’s booming exports (mining) have a large and positive impact, driving growth in other sectors. The correlations as of 2003, amidst the economic boom in the Lao PDR and after the persistent rise in mining product prices in the world markets, have been slightly weaker than before the economic boom.

Table 6.

Correlation coefficient matrix of GDP among the sectors of the Lao economy.

For the period 1994–2012.

Constant GDP	Mining sector	Manufacturing sector	Agricultural sector	Service sector
Mining sector	1.000
Manufacturing sector	0.9636	1.000
Agricultural sector	0.9461	0.9899	1.000
Service sector	0.9689	0.9935	0.9886	1.000

For the period 1994–2002.

Constant GDP	Mining sector	Manufacturing sector	Agricultural sector	Service sector
Mining sector	1.000
Manufacturing sector	0.9679	1.000
Agricultural sector	0.8959	0.9316	1.000
Service sector	0.9412	0.9181	0.9081	1.000

For the period 2003–2012.

Constant GDP	Mining sector	Manufacturing sector	Agricultural sector	Service sector
Mining sector	1.000
Manufacturing sector	0.9621	1.000
Agricultural sector	0.9556	0.9875	1.000
Service sector	0.9717	0.9967	0.9892	1.000

Policy recommendations

From both qualitative and quantitative analysis of the overall and sectoral macroeconomic relationship between international competitiveness and Lao’s economic conditions and considering the possibility of Dutch disease, some observations need to be made on the spending effect of the disease, but not the resource movement effect in the Lao economy. In other words, we find some symptoms of Dutch disease in the Lao economy at present, though they are not very strong. Until now, however, Lao government policy has focused on traditional stabilisation policy measures. For sustainable industrialisation of the Lao economy, the government should consider some policy options to mitigate the disease effects when they start manifesting.

The Lao government will need to pay due diligence in scrutinising the economy. Particular attention must be paid to the manufacturing sector to improve export competitiveness in pursuit of an outward-looking industrialisation strategy. Maintaining a competitive exchange rate and stable inflation in a period with large capital inflow is very important. Based on the case studies in a previous section, we propose the following preventive measures for the successful achievement of the Lao PDR’s national socio-economic development plan (NSEDP):

First, the government should use the surging capital inflows from the booming resource tradable sector, FDI and ODA to enhance overall productivity through selected strategic industries. In addition, the abundant foreign reserves should be distributed with more emphasis on education to offset the deterioration in competitiveness. That is, the government should introduce an aggressive supply-side policy.

Second, barriers against capital and equipment imports from abroad should be reduced or eliminated. This will enhance capital investment and boost the supply side of the economy as well as reduce the balance of payments surplus, enhancing international competitiveness in the long run.

Third, the government could consider establishing various special funds. The spending effect of the Dutch disease would diminish with the allocation of a fixed percentage of the export earnings to a natural resource fund as a means of inventory control. In effect, this fund would be a flexible tool to cope with volatile resource prices and an effective instrument to reduce economic volatility. Establishing a sovereign wealth fund only for foreign investment would help in avoiding a large balance of payment surplus. Serious concerns about exchange rate appreciation could also be addressed by a savings fund, which would deposit a fixed proportion of the balance of payment surplus into an overseas savings account. Using the special funds, the government should launch an exchange stabilisation fund to stabilise the domestic currency and the foreign exchange market.¹¹

Fourth, the Lao PDR should consider actively participating in regional trade agreements (RTAs), especially by undertaking deeper trade liberalisation with developed countries. It will strengthen the competitiveness of import-substitution industries, mainly in the non-resource tradable manufacturing sector, and will also help diversify exporting industries in the manufacturing sector. In this regard, we recommend that the Lao government establish financial institutions to enhance the effective resource allocation to improve the import-substitution and export industries. For instance, the Lao PDR could consider establishing a specialised financial institution such as the Export–Import Bank of Korea.¹²

The following policy options could be considered as complementary measures to be implemented as and when necessary to ensure macroeconomic stability in the short run and prevent the adverse effects of Dutch disease when the phenomenon becomes more apparent.

Tightening monetary policy, such as imposing loan limits for the real estate market and adopting differential interest rates for lending to industry, would directly control inflationary pressures in specific subsectors within the non-tradable sector.

Tightening fiscal policy, including increases in the corporate tax rate in a booming industry and cutting general spending, would effectively control the spending effect.

More importantly, we should pay attention to politico-economic factors. No desirable policy option can be effective without transparent governance. If there are serious rent-seeking activities in the public sector, these proposed policy responses may not work properly, as was learnt from the unsuccessful cases of Senegal and Mongolia. Therefore, public sector reform, both in the fiscal and financial sectors, is a prerequisite for sustainable development of the Lao economy free from the threat of Dutch disease.

Footnotes

Acknowledgements

The authors would like to thank Leebeer Leebouapao and Bounleua Sinxayvoravong, as well as the participants of the final reporting workshop held at Vientiane in the Lao PDR on February 4, 2013, and three anonymous reviewers for their helpful comments and suggestions. The authors also thank Yujin Choi, Ran Kim and Amphaphone Sayasenh for their excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily reflect the views of National Economic Research Institute (NERI), the Lao PDR. The authors are solely responsible for any errors.

Funding

An earlier version of this paper was contributed to a policy consultation report, ‘Resource Mobilization and Dutch Disease Phenomena in the Lao PDR’ for the 2012 Knowledge Sharing Program with the Lao PDR. The programme was financially supported by the Korean Ministry of Strategy and Finance and Korea Development Institute.

Notes

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