Multi-dimensional Review of Lao PDR

Financing Sustainable Development

Report

OECD Development Pathways

6 June 2024

3. Opportunities and challenges in Lao PDR’s sustainable development financing landscape

Abstract

Lao People’s Democratic Republic (Lao PDR) faces significant macroeconomic vulnerabilities that have been intensified by global events such as the COVID‑19 pandemic and escalating food and energy prices. Consequently, the country grapples with pronounced fiscal and liquidity pressures and is currently in debt distress. Given these circumstances, Lao PDR’s previous debt-driven infrastructure growth model is no longer viable. To effectively pursue its ambitious sustainable development agenda, the country must address its debt issues and the fragmented governance of its financing framework. Tackling these challenges is fundamental to build the type of sound environment required to harness additional and innovative resources in support of Lao PDR’s development goals. This necessitates efforts to boost tax revenues, diversify investments and develop the domestic financial sector. Given Lao PDR’s current financial constraints, sustained international support is essential to safeguard investments in key development areas, such as healthcare and education. In parallel, designing preventive strategies is crucial to ensuring long-term financial stability and avoiding future debt issues.

Lao PDR’s sustainable development finance landscape has been instrumental in supporting the country’s economic development

Lao PDR emerges from a successful decade of attracting external financing in order to advance its development objectives

The country’s consistent economic growth over the past two decades was supported by a thriving financing landscape. Between 2005 and 2016, Lao PDR achieved a notable period of economic growth, consistently surpassing 7% annually. This sustained growth was accompanied by substantial and growing inflows of financing from external sources (Figure 3.1, Panel A), in particular official development finance (ODF) and foreign direct investment (FDI). For example, there was a significant increase in official development assistance (ODA) from bilateral and multilateral development partners, growing from USD 437 million (United States dollars) in 2011 to USD 773 million in 2016. Concurrently, FDI flows into the country also showed a robust increase over this period, growing from USD 301 million to USD 953 million.

The Lao PDR government’s strong commitment to infrastructure development, as well as the People’s Republic of China (hereafter “China”)’s Belt and Road Initiative (BRI), have been two significant catalysts for this influx of financing. The surge in financing is in large part attributable to the Lao PDR government’s strategy of investing in major infrastructure projects, especially in the energy and transportation sectors. This strategy was made possible by strong government borrowing from the country’s main development partners, as well as a deliberate policy of FDI promotion. The increase in financing aligned with the availability of a large supply of external financing that coincided with the BRI’s expansionary phase. From a yearly average of only USD 459.2 million between 2007 and 2010, China’s total official financial commitments to Lao PDR reached an annual average of USD 1.8 billion between 2011 and 2017, with total financial commitments in 2016 alone reaching USD 7.1 billion (Figure 3.1, Panel B).

Figure 3.1. Lao PDR’s economic growth went hand in hand with an increase in external financing

Energy and transportation emerged as the main economic sectors for external financing and investment. During the 2010s, the Lao PDR government’s focus on energy and transport was rooted in its vision to transform the country. This transformation involved developing infrastructure that would enable the export and trade of energy, thereby generating revenue and establishing a balanced energy system for the country, as well as enhancing regional and international integration, particularly in Southeast Asia. Achieving these priorities required stepped up capital investments, which were only made possible through external financing by way of increased sovereign borrowing and foreign investment.

Following years of sustained growth, some of Lao PDR’s main sources of financing pre-COVID‑19 are starting to face bottlenecks

The dynamics of Lao PDR’s sustainable development finance landscape explain the country’s recent development achievements, but they are also a reminder of the challenges ahead. Growth in external financing flows to Lao PDR has greatly boosted the country’s recent capacity to invest in its development priorities. This led to the rapid development of Lao PDR’s electricity generation capacity thanks to the construction of new power plants, as well as improvements in connectivity through investments in railways, roads and ports. However, the country’s success in attracting large volumes of financing from various sources also accentuated its vulnerabilities, particularly by rapidly increasing its debt burden while government revenue remained stagnant.

Warnings about mounting fiscal challenges surfaced in the 2010s, but Lao PDR’s impressive strides in economic development allowed the country’s financing model to endure. The International Monetary Fund (IMF) raised concerns early on about the escalating debt situation in Lao PDR and its long-term repercussions in the absence of drastic changes to fiscal practices, including borrowing and revenue mobilisation. The overall fiscal deficit was at a record low of -5.6% of gross domestic product (GDP) in 2015, before recovering in the years leading up to the COVID‑19 pandemic (Figure 3.2, Panel A). However, the deficit was offset by high economic growth: between 2011 and 2017, Lao PDR was one of the fastest-growing economies worldwide, with GDP growth hovering around 7‑8%. Spurred by strong and steady economic growth, important development outcomes were also materialising. As discussed in Chapter 2, this included progress in poverty reduction and access to basic infrastructure, as well as increases in income per capita.

Prior to the outbreak of the COVID‑19 pandemic, Lao PDR’s fiscal challenges were already triggering a decline in its main financing sources. After a peak in sustainable development finance during the mid-2010s, financing flows to the country appeared to taper off after 2017. The rapid increase in debt, which rose from 42% of GDP in 2014 to 52% in 2017, played a key role in this decline. Notably, financing from ODF providers experienced a slowdown due to both the culmination of the BRI’s expansionary phase and Lao PDR nearing its borrowing capacity. While some financing sources (such as government revenue and FDI) held steady or even registered minor growth, this was not sufficient to offset the decline in ODF (Figure 3.2, Panel B).

In 2020, external shocks prompted a pronounced drop in sustainable development finance. The aftermath of the COVID‑19 pandemic, coupled with increasingly restrictive global financing conditions in subsequent years, negatively affected financing flows to developing countries, including Lao PDR. Most of the country’s financing flows registered a decline in 2020, except for ODA disbursements, which registered a modest increase. Nevertheless, the primary reason for the drop in financing for sustainable development in Lao PDR in 2020 was the decline in government revenue, which further strained the government’s ability to meet its debt obligations, thereby also jeopardising the country’s future financing options.

Figure 3.2. Until the COVID‑19 pandemic, Lao PDR had been experiencing persistent fiscal deficits, which contributed to rapid debt build-up

Looking ahead, Lao PDR faces a challenging financing landscape. Stagnant government revenue, combined with increasingly restrictive global financing conditions, have made it more challenging for the country to fulfil its financing needs, putting its financial stability on a precarious footing. This is reflected in the slow recovery of financing flows to the country, which remain subdued. Exacerbating this are the elevated interest rates that the country faces as a result of increasingly restrictive global financing conditions and the downgrade of its sovereign credit rating in 2022. These factors have further curtailed Lao PDR’s access to international capital markets, further limiting its financing options and ability to roll over its debt. The next section discusses the fiscal challenges facing Lao PDR following years of sustained financing growth and details their implications for the country’s ability to finance its sustainable development in the future.

Lao PDR’s debt distress is a symptom of long-term macroeconomic vulnerabilities

Lao PDR faces a challenging macro-fiscal situation

Lao PDR was already facing mounting macroeconomic vulnerabilities prior to the COVID‑19 pandemic. Despite achieving significant development progress, with one of the fastest growth rates worldwide, Lao PDR was experiencing mounting macroeconomic vulnerabilities in the years leading up to the COVID‑19 pandemic. Specifically, the country was facing a persistent fiscal deficit, with a current account balance of -7.9% of GDP in 2018 and -4.5% in 2019 due to low levels of government revenue and growing debt service from rapid debt accumulation. These vulnerabilities stemmed in part from the country’s development and growth model, which centred on large infrastructure projects that were financed through public borrowing and tax incentive-based investment promotion. Moreover, economic growth was trending downward, from approximately 8% before 2013 to 6.9% in 2017 and 5.5% in 2019.

Recent crises, such as the COVID‑19 pandemic and the global surge in food and energy prices, have intensified Lao PDR’s economic fragilities. As a result of the pandemic, the country’s economic growth plummeted to 0.5% in 2020 and only partially rebounded to 2.5% in 2021 and 2.7% in 2022. Pre-existing vulnerabilities and shallow buffers, including low levels of foreign exchange reserves, resulted in large macro-fiscal imbalances threatening Lao PDR’s economic and financial stability. Although the country reduced its external borrowing, it faced growing difficulties in meeting its debt service obligations. As commonly seen in countries facing debt issues, the financial strain caused the local currency (the Lao kip) to depreciate by more than 50% against the United States dollar in 2022 (Figure 3.3, Panel A). This, in turn, contributed to a significant surge in the inflation rate (Figure 3.3, Panel B).

Figure 3.3. Macroeconomic imbalances materialised in 2022, notably because of a depreciation of the Lao kip and rapid inflation

The country is now in debt distress. Lao PDR was already deemed to be at high risk of debt distress before the COVID‑19 crisis due to its macro-fiscal vulnerabilities. The 2019 World Bank/IMF Debt Sustainability Analysis (DSA) of Lao PDR highlighted the country’s inadequate financial buffers, rapid debt build-up and persistent primary deficit. It also pointed out specific vulnerabilities to shocks, especially risks associated with currency depreciation and contingent liabilities arising from state-owned enterprises (SOEs). Largely because of the Lao kip’s depreciation, the public and publicly guaranteed (PPG) debt stock rose from 88% of GDP in 2021 to 112% of GDP in 2022. The latest DSA, carried out in May 2023, updated the country’s status to “in debt distress” for both external and public debt under the Low-Income Countries Debt Sustainability Framework (LIC-DSF). It also deemed the country’s debt unsustainable, highlighting the very high debt-to-GDP ratio and a significant rollover risk (IMF, 2023[7]).

Lao PDR has only benefited marginally from international initiatives aimed at assisting debt distressed nations. The country benefited from the 2021 allocation of Special Drawing Rights (SDRs), which led to a modest allocation equivalent to USD 101.4 million, granted in proportion to Lao PDR’s IMF quota (IMF, 2021[8]). On the other hand, Lao PDR did not participate in the Group of 20 (G20)-led Debt Service Suspension Initiative (DSSI) or the Common Framework for Debt Treatments beyond the DSSI, largely due to its debt profile. Since China (Lao PDR’s primary lender) holds around one-half of its external debt, Lao PDR opted to engage in bilateral negotiations with China in order to secure a debt service suspension rather than pursuing consensus within broader initiatives such as the DSSI or the Common Framework, which would likely involve protracted negotiations with multiple creditors (IMF, 2023[9]).

The suspension of debt service negotiated with China prevented a default during the COVID‑19 crisis, but this merely postponed the underlying debt issue. The bilateral negotiations resulted in the suspension of principal repayments to China worth USD 220 million in 2020, and the suspension of both principal and interest payments worth about USD 450 million in 2021 and USD 610 million in 2022 (Government of Lao PDR, 2022[5]). These suspensions deferred the problem rather than providing a lasting solution and, as a consequence, the country now faces a debt service to China totalling USD 769.8 million in 2023, with similarly high amounts (approximately USD 700 million annually) expected through at least 2027. In other words, Lao PDR’s annual debt service to China has more than tripled compared with its average of USD 207 million per year in 2018‑19, before the COVID‑19 pandemic.

Lao PDR is grappling with significant financing needs and liquidity pressures that are expected to persist for years to come. Debt service was projected to surge by 186% in 2023 compared with 2022, reaching USD 1.51 billion and remaining at more than USD 1 billion through at least 2027 (Figure 3.4). The increase in debt service is largely attributable to the deferred debt payments to China and the 50% devaluation of the Lao kip against the United States dollar in 2022, which exacerbates repayment challenges by inflating the debt service cost (IMF, 2023[9]). In addition, the country’s limited foreign currency reserves are expected to come under pressure due to the obligation to repay substantial external debt.

Figure 3.4. Lao PDR confronts a surge in debt service costs beginning in 2023

External PPG debt service (2018‑27)

Lao PDR’s fiscal situation has adversely affected its sovereign credit rating, restricting the country’s ability to secure new financing. The deterioration in the country’s fiscal position is expected to pose challenges for debt servicing in the coming years, given the limited options for Lao PDR to roll over and refinance its debt. Lao PDR already experienced a downgrade of its sovereign credit rating in 2022, with Fitch Ratings downgrading Lao PDR’s long-term foreign currency issuer default rating (IDR) to “CCC-” from “CCC” in August of that year. Ratings in the “CCC+” to “CCC-” range indicate substantial credit risk and a real possibility of default. By October 2022, Moody’s had followed suit by lowering Lao PDR’s foreign currency sovereign debt rating to “Caa3” from “Caa2”. As a result, Lao PDR has encountered increasing challenges in accessing market financing, jeopardising its ability to fulfil its debt commitments in the near future.

Lao PDR is largely indebted externally, with China as its primary creditor

Most of Lao PDR’s public debt originates from external sources. The country’s external debt stock amounted to USD 10.5 billion in 2022, representing 86% of its total external PPG debt stock (Figure 3.5, Panel A). Such a distribution can be attributed to Lao PDR’s limited access to domestic finance, which stems from its underdeveloped financial sector. In fact, until 2018, the country’s debt stock was entirely owed to external creditors.

China holds a significant portion of Lao PDR’s total debt. Approximately 43% of the nation’s total PPG debt stock is owed to China (Figure 3.5, Panel B). This surpasses the debt owed to all other bilateral and multilateral creditors combined, which amounts to a mere 26% of the total debt. While having such a concentration of debt with China enabled easier bilateral negotiations for debt service suspension, it also implies a heightened financial dependency on Lao PDR’s main creditor.

Figure 3.5. Lao PDR’s debt profile is biased towards external debt, which is largely owed to China

In the wake of the current debt crisis, Lao PDR faces constrained access to sustainable development financing. The country’s access to international capital markets has greatly diminished, with the downgrading of its sovereign credit rating, making external bond issuance more challenging. This is visible in the decreasing volume of bonds in Lao PDR’s external public debt stock that has been observed since the COVID‑19 pandemic, which declined from around USD 1.6 billion in 2018‑19 to USD 1.4 billion in 2020 and to USD 1 billion in 2021. Additionally, the debt situation has narrowed the options for Lao PDR to further borrow from its main development partners. While official loans from both multilateral and bilateral development partners increased until 2020, their volume has since plateaued. Recently, Lao PDR has primarily used bond issuances in the Thai and domestic markets, as well as loans from commercial banks, to repay non-concessional debt due in 2022. In fact, commercial bank loans, characterised by high interest rates and short maturity, were the fastest-growing debt instrument used by the country between 2018 and 2022 (Figure 3.6).

Figure 3.6. Lao PDR has compensated for constrained access to capital markets by increasing its use of official and commercial loans

Due to challenges in external borrowing, Lao PDR has pivoted towards domestic borrowing. Practically non-existent before 2017, domestic borrowing gained traction from 2018 onwards. Between 2018 and 2022, the domestic public debt stock grew from 3% to 12% of Lao PDR’s GDP (Figure 3.7). This increase in domestic borrowing was influenced in large part by the issuance of domestic bonds in order to settle public investment arrears and recapitalise the country’s state-owned banks.

Figure 3.7. External debt continues to dominate, but the government of Lao PDR is increasingly turning to domestic borrowing

Total PPG debt stock (2016‑22)

Lao PDR’s publicly guaranteed debt stock has also grown between 2019 and 2022. The publicly guaranteed debt stock has increased steadily from 9% of the country’s GDP in 2019 to 10% of its GDP in 2020, 12% in 2021 and 16% in 2022. This upward trend suggests that the government is taking a more active role in backing debts, especially from SOEs. However, risks associated with continued growth of public guarantees should be taken into account, including greater exposure to fiscal risks that could in turn lead to further downgrades of the country’s sovereign credit rating, as well as to increasing borrowing costs that could make access to capital markets unviable.

Lao PDR’s pre-COVID‑19 economic growth model has become unsustainable

Lao PDR has been among the fastest-growing economies in the world in the 2000s and 2010s, propelled by substantial public investments financed through borrowing and public-private partnerships (PPPs). The country’s economy expanded at an average rate of 8% over the period from 2011 to 2017 (Figure 3.9). This growth primarily stemmed from public and private investment in infrastructure, notably in the hydropower, transportation and mining sectors. Capitalising on its hydroelectric power potential, Lao PDR has invested heavily in hydroelectric power plants and transmission lines and has aspirations of becoming “the battery of Southeast Asia”, with the SOE Électricité du Laos incurring debt in order to take a share in numerous projects.

The government of Lao PDR borrowed extensively in order to develop the country’s transportation infrastructure. A notable instance is the USD 5.9 billion construction project for a Lao PDR‑China high-speed railway connecting Vientiane with Kunming, which is part of China’s BRI. China shouldered 70% of this cost, while Lao PDR covered the remaining 30%, partly through loans. Another example is the Thanaleng Dry Port, which was designed to boost Lao PDR’s cross-border trade with Thailand and China, and which was also partially financed through borrowing.

Many of Lao PDR’s investments in the energy and transportation sectors have been made possible through the use of PPPs. Indeed, PPPs have promoted the rapid growth of the country’s capital stock, making it an outlier in the world due to the outsized volume of its PPP capital stock in proportion to its GDP (Figure 3.8).

Figure 3.8. Lao PDR has become an outlier in terms of capital stock arising from public-private partnerships

However, in light of Lao PDR’s mounting fiscal challenges, this heavy reliance on PPPs is not sustainable in the long term in order to continue promoting investment and economic growth. In fact, PPP investments began to slow down after 2017, following a 12‑year period of consistent rapid growth. While the government’s extensive use of PPPs has been successful in attracting investment, it has also introduced fiscal challenges and risks that have contributed to the country’s debt problems. These challenges include forgone revenue from tax exemptions, fiscal commitments and contingent liabilities. The fact that Lao PDR exhibits low PPP regulatory quality is an added concern considering the fiscal significance of PPPs in the country (World Bank, 2023[11]).

The protracted post-pandemic recovery has exacerbated Lao PDR’s fiscal dilemma, making it more challenging for the country to overcome its debt problem. Following the COVID‑19 pandemic and during a period of global inflation, Lao PDR’s economic growth is only just starting to recover. The country’s growth dropped from 5% in 2019 to 0.5% in 2020 (Figure 3.9). The delayed reopening of the country’s borders in mid-2022, coupled with its economic reliance on neighbours like China (which also lifted border restrictions comparatively late, in 2023), resulted in modest economic growth in 2021 and 2022, with GDP growth rates reaching 2.5% in 2021 and 2.7% in 2022. Nonetheless, future projections indicate a swifter recovery from 2023 onwards, fuelled by increased regional growth and the reopening of borders. Specifically, these projections suggest a growth rate of 4% in both 2023 and 2024, although this remains below pre-pandemic levels (IMF, 2023[9]).

Figure 3.9. The economic downturn in Lao PDR makes debt reduction a challenging task

Evolution of GDP (in USD billion) and GDP growth (2011‑22)

SOEs are ubiquitous in Lao PDR’s economy, yet they also contribute to its debt challenges. Beyond the government of Lao PDR’s external borrowing, which accounts for 45% of the country’s PPG debt stock, the national debt stock comprises debt on-lent by the government to SOEs (30% of the total debt) and publicly guaranteed debt (14% of total), as illustrated in Figure 3.10. Consequently, although SOEs are instrumental in promoting economic growth, they are also partly accountable for the rapid debt build-up. Given Lao PDR’s difficult financial context, its continued reliance on SOE-related borrowing in order to promote growth appears untenable. A shift towards identifying alternative, sustainable avenues for broad-based economic growth is therefore necessary. As elaborated in the section on a policy and governance framework for financing sustainable development, although addressing the fiscal risks and challenges posed by SOEs is critical, achieving sustained economic growth will also require tackling other SOE governance issues, such as their overpowering presence in the economy and their anti-competitive behaviour, which stifles the development of the private sector.

Figure 3.10. SOEs contribute significantly to Lao PDR’s debt issues

Share of PPG debt stock (2022)

Local governments in Lao PDR also play a significant role in the country’s fiscal landscape. Between 2015 and 2019, local governments generated 23% of domestic revenues, were responsible for 31% of public expenditures and accounted for about one-half of the country’s fiscal deficit (World Bank Group, 2023[12]). This underscores the potential of local governments to not only influence the fiscal situation but also contribute to the nation’s broader socio-economic objectives. In particular, local authorities can play a pivotal role in enhancing fiscal discipline and ensuring a strategic alignment of public expenditure with national development priorities. In addition, as discussed in Chapter 5 on sustainable investment, local and provincial authorities are also involved in the multilevel process to approve new investments.

Steering the country towards sustainable development requires curtailing its debt burden and enhancing fiscal discipline and efficiency. Conscious of this, and with support from the Asian Development Bank (ADB), the government of Lao PDR has recently initiated a high-level dialogue on good practices for enhancing its public debt management (Asian Development Bank, 2023[13]). Looking forward, the anticipated budget constraints suggest that achieving Lao PDR’s former high growth rates will be challenging, as the financial difficulties that the country is facing could hinder the government’s ability to invest in critical sectors, potentially slowing economic development.

In this context, efforts to diversify the economy and bolster sectors beyond infrastructure, such as the tourism and agricultural sectors, can pave the way for a more balanced, diversified and resilient economic landscape in the future. In order to be successful, such efforts will need to be accompanied by an effort to establish conducive conditions for attracting and mobilising sustainable financing sources. As detailed in the following sections, this includes a clear policy and governance framework for sustainable development financing and removing bottlenecks that hinder the country’s access to sustainable development finance.

Policy and governance framework for financing sustainable development

Lao PDR has outlined its sustainable development objectives in a comprehensive and ambitious policy framework

With support from its development partners, Lao PDR has developed a wide-ranging and ambitious policy framework. The country’s sustainable development agenda is anchored in two overarching documents: Lao PDR’s Vision 2030 and 10 Year Socio-Economic Development Strategy (2016-2025), published in 2016 (Government of Lao PDR, 2016[14]), and the National Green Growth Strategy of the Lao PDR until 2030, adopted in 2019 (Government of Lao PDR, 2019[15]). This vision is backed by subsequent strategic documents, in particular the 9th National Socio-Economic Development Plan (NSEDP)2021-2025) (Government of Lao PDR, 2021[16]) (which received a mid-term review in 2023) and the associated Financing Strategy released in 2023 (Government of Lao PDR, 2023[17]). In addition, the country has also developed a Smooth Transition Strategy (STS) for its graduation from the United Nations (UN) list of least developed countries (LDCs) in 2026 (Government of Lao PDR, 2023[18]). This multipronged agenda appears particularly ambitious considering the difficult economic and financial context within Lao PDR.

While this ambition is commendable, it raises questions about Lao PDR’s capacity to implement these multiple strategies concurrently, given the prevailing challenging economic and financial circumstances. The challenge is not only in the articulation of these policies but also in their effective implementation. The complexity of managing multiple interlinked strategies could stretch Lao PDR’s administrative and financial capabilities to their limits. It will thus be critical to assess the implementation frameworks and the need to prioritise initiatives, as well as to properly sequence strategic actions in order to ensure that the country’s limited delivery capacity does not lead to inefficient allocation of scarce resources.

The 9th NSEDP, which was approved in 2021, outlines Lao PDR’s sustainable development aspirations through 2025. Following on from the previous NSEDP, which spanned 2016‑20, the current plan emphasises three priorities: (i) preparing for LDC graduation; (ii) confronting development challenges, including financial constraints and emerging threats like COVID‑19 and climate change; and (iii) enhancing the country’s human capital and stimulating economic growth. The 9th NSEDP aims to serve as a blueprint for aligning the efforts of both internal and external development stakeholders. Accompanied by a thorough monitoring and evaluation framework, it was drafted through a consultative process involving government entities as well as key development partners. Considering Lao PDR’s financial difficulties, the 9th NSEDP integrates considerations regarding debt and the country’s immediate needs into its assessment of necessities and priorities.

The 9th NSEDP acknowledges the direction set by Lao PDR’s National Green Growth Strategy (NGGS) in ensuring sustainable socio-economic development. Shared objectives between the NGGS and the 9th NSEDP include stimulating economic growth, promoting the sustainable use of natural resources, minimising vulnerabilities to natural disasters and global economic dynamics, and curbing pollution and greenhouse gas (GHG) emissions.

The Financing Strategy for the 9th NSEDP has been developed to support the implementation of the country’s sustainable development goals. Published in mid-2023, the 9th NSEDP Financing Strategy benefited from strong support from the UN. The Financing Strategy was developed as part of the country’s Integrated National Financing Framework (INFF) process, which aims to integrate Lao PDR’s sustainable development goals with its national budgeting and financial planning. Through its 54 actions and policies, the 9th NSEDP Financing Strategy encompasses a holistic view of financing (in line with the Addis Ababa Action Agenda (AAAA)) by looking at public, private, domestic and external financing sources. The development of the Financing Strategy represented a significant effort requiring consultation with multiple parts of the government and positioning Lao PDR as one of the first countries in the world to publish a financing strategy based on the INFF approach. However, the timing of its release (halfway through the time frame covered by the 9th NSEDP) leaves less than two years for implementation and may require strict prioritisation.

Lao PDR has also developed an STS in anticipation of its 2026 graduation from the UN list of LDCs. In 2021, the UN General Assembly recommended Lao PDR for graduation from the list of LDCs. Acknowledging the challenging global context, the UN General Assembly granted a five-year preparatory period leading up to Lao PDR’s graduation in 2026. The STS, with its 22 actions spanning 4 pillars, appears ambitious given the country’s financial constraints. Even with the five-year buffer, there are some concerns regarding Lao PDR’s capacity to achieve its graduation with momentum in a context requiring stringent fiscal discipline.

Lao PDR’s efforts to establish a coherent and comprehensive policy framework for sustainable development constitute a positive development. The different sustainable development policy documents not only complement one another but also recognise specific areas of interconnectedness and overlap. The 9th NSEDP Financing Strategy and the STS in particular have overlapping policy objectives and actions. Specifically, 8 policy objectives from the Financing Strategy (out of a total of 54) match with 6 STS actions (out of a total of 22) (Figure 3.11). This reflects the understanding that synergies may exist across the various parts of Lao PDR’s development agenda. However, significant co‑ordination efforts will be required in order to prevent redundancies or governance challenges from arising during the implementation phase, as discussed in the next section.

Figure 3.11. Eight of the 9th NSEDP Financing Strategy’s policy objectives match with six of the STS’s actions

The governance structure underpinning Lao PDR’s sustainable development agenda appears fragmented

Although Lao PDR’s policy framework for sustainable development is robust and well-conceived, its practical implementation might face hurdles due to the fragmented governance structure. Beyond the strategic direction and vision provided by the policy framework, it is crucial to ensure collaboration among all sustainable development agenda stakeholders. Currently, the governance structures for the policy framework remain fragmented, with various parts of government spearheading the different segments of the sustainable development agenda and operating on diverse implementation time frames.

Responsibilities related to the country’s sustainable development agenda are dispersed across multiple institutions. For instance, whereas the Ministry of Foreign Affairs oversees the Sustainable Development Goals (SDGs) and the STS for LDC graduation, the Ministry of Planning and Investment is responsible for the medium- (NSEDP) and long-term (Vision 2030) development plans and for the INFF process, including the development and monitoring of the 9th NSEDP Financing Strategy (Figure 3.12). Co‑chairing arrangements – such as the National Steering Committee for Green Growth chaired by the Deputy Prime Minister and the Minister of Finance, with the Deputy Minister of Planning and Investment as Vice-Chair – have enabled some degree of intergovernmental consultation and co‑ordination. Maintaining such collaborative efforts during the implementation of the sustainable development agenda will be critical in order to prevent intergovernmental political rivalry affecting the agenda’s success.

Figure 3.12. Different parts of the government of Lao PDR lead the various aspects of the sustainable development agenda

Adding to the fragmentation, Lao PDR’s primary creditor, China, has so far shown limited involvement in the country’s strategic development co‑ordination mechanisms. China has taken a back seat in Lao PDR’s governance regarding sustainable development finance (for instance, contributing minimally to the INFF process that started in 2017 with the country’s Development Finance Assessment (United Nations, 2017[19])). As a result, the governance framework developed since the inception of the INFF process in December 2021 only reflects a portion of Lao PDR’s financing landscape, raising legitimate concerns about a lack of transparency, accountability and co‑ordination, especially due to the significance of China’s financial support of the country and its important fiscal implications. The fact that China has recently started attending the annual donor co‑ordination meetings organised by the government of Lao PDR (with support from the UN Resident Coordinator) represents a welcome development but should only be considered a first step towards China’s more active participation in Lao PDR’s co‑ordination mechanisms.

The fragmented governance framework translates into a lack of co‑ordination and policy coherence at the national level

The fragmented governance framework is apparent across many different sectors and financing sources, leading to inefficiencies. A fragmented governance framework prevents a holistic and unified understanding of the multi-dimensional impacts and trade-offs of government strategies and policies related to sustainable development. In Lao PDR, for example, this has made it difficult to comprehensively evaluate the trade-offs of prioritising economic growth sectors, such as mining or hydropower, when such decisions might negatively affect environmental or social goals (see the section on recent evolutions and the state of play of Lao PDR’s financing for a sustainable development landscape). Another issue is the highly prevalent trend of using tax incentives as the primary tool for promoting private investment, which can be effective in drawing private sector interest but often results in a significant reduction in government revenue. Balancing the positive and negative implications of such policy decisions requires the establishment of mechanisms for direct engagement and co‑ordination among all relevant institutions: for example, between the Ministry of Finance, the Ministry of Planning and Investment, relevant sector ministries, and provincial governments.

Overlapping responsibilities among government entities and a lack of proper co‑ordination mechanisms further complicate governance in key areas of sustainable development finance. For example, this is the case for investment-related policies and processes where multiple institutions and levels of government are involved in policy making and in project review and approval. Approval procedures for foreign investments thus necessitate the involvement of several ministries and levels of government, from the national government to provincial authorities. Without adequate co‑ordination mechanisms, such complexity can breed opacity and result in inefficiencies, negative externalities and delays in project implementation. Chapter 5 further discusses the need for clear inter-institutional co‑ordination mechanisms in order to ensure a whole-of-government approach to investment, as well as the alignment of investment, environmental, development and sectoral strategies.

Some development partners have also expressed concerns over the multiple government counterparts and convoluted governance within Lao PDR’s sustainable development agenda. The blurry delineation of roles and responsibilities among government institutions is perceived as complicating development partners’ engagement with the government of Lao PDR. The interlinked nature of the various strategies relevant for sustainable development financing, which are managed by different tiers or parts of the government, creates confusion regarding who to approach for specific subjects. The maze of responsibilities also results in extended government approval times for some decisions concerning development co‑operation. This includes green-lighting new development projects or granting operating permissions to new international non-governmental organisations (NGOs), which many development partners rely on for project implementation.

Recent budget constraints and increased competition for scarce resources risk further weakening co‑ordination. A unified and co‑ordinated approach to sustainable development governance is essential in order to ensure that development stakeholders’ efforts to harness financing lead to tangible development impacts. This is especially true for new and innovative financing sources (which often lack a pre-existing policy and governance framework), with clear roles and responsibilities being defined across government and other development stakeholders. The Lao PDR government’s ongoing efforts to monetise the country’s natural resources is a case in point. In the absence of a clear policy framework, which would clearly delineate the roles and responsibilities of government institutions and other development partners in designing, deploying and using the proceeds of novel financing instruments, various government entities are independently exploring the potential of innovative financing instruments such as sovereign carbon credits. Government entities are also reaching out to different development partners for help with determining viable methods for the issuance of sovereign carbon credits and the allocation of their proceeds. Such disjointed efforts may result in inefficiencies down the line, preventing the Lao PDR government from fully benefiting from these new financing opportunities. The section on innovative financing sources discusses the specific case of sovereign carbon credits, and describes different government entities’ multiple endeavours to develop them and access their resources with the support of different development partners. Box 3.1 describes the key role of development partners in supporting greater co‑ordination and preventing fragmentation in the field of sustainable development finance.

Box 3.1. Development partners are essential for cultivating sound governance and effective co‑ordination in support of Lao PDR’s sustainable development agenda

Development partners play a pivotal role in Lao PDR’s sustainable development financing landscape. In the past, Lao PDR has relied heavily on external public finance in order to support its development agenda. Current fiscal challenges limit Lao PDR’s ability to sustain its recent rate and volume of borrowing from both official and non-official sources. In this context, development co‑operation, especially in the form of concessional and technical support, remains an essential source of affordable financing and knowledge. As Lao PDR strives towards its multipronged agenda of graduating from the UN list of LDCs, as well as overcoming its debt burden, investing in human capital and encouraging inclusive growth, it is vital to ensure the effective use and co‑ordination of development partners’ support in order to make the most of this scarce but stable resource.

The impact of development co‑operation can be severely compromised by poor co‑ordination. There is a well-established and widespread consensus, supported by evidence, regarding the impact of development partners as either drivers of, or constraints to, effective development co‑operation (OECD, 2005[20]). This is demonstrated in Lao PDR, where some government departments struggle with the transaction costs associated with monitoring multiple and often uncoordinated development projects (Government of Lao PDR, 2021[21]). Beyond transaction costs, lack of co‑ordination among development partners can also result in duplicated efforts or financing gaps.

Without an established governance and co‑ordination framework, new financing sources are particularly susceptible to fragmentation and inefficiencies. If left unaddressed, such governance challenges could prevent new financing sources from fully delivering on their promise to bolster Lao PDR’s sustainable development. Due to the lack of clearly delineated roles and responsibilities, various sectors of government can be tempted to vie for control over the implementation of, and the use of proceeds from, these innovative financing sources. This risk is heightened by current fiscal constraints, which incentivise ministries to compete for access to new financing in order to protect their budgets. As discussed in the section of this chapter on innovative financing sources, the issuance of carbon credits exemplifies this challenge. Several ministries (each backed by different development partners) are engaging in carbon credit initiatives, creating confusion over their potential in terms of revenue generation and the possible use of their proceeds. This disjointed approach could also result in inefficiencies and double counting, threatening the credibility of Lao PDR’s future sovereign carbon credit issuances.

It is incumbent upon all of Lao PDR’s development partners to uphold universal principles of development effectiveness in their engagements. The Lao PDR government and its development partners have a shared responsibility to ensure the effective use of international support to promote the country’s development priorities, including by incentivising co‑ordination in order to encourage greater transparency and mutual accountability, inclusive partnerships, and a focus on results and country ownership. The Vientiane Declaration on Partnership for Effective Development Cooperation (2016‑2025) is a commendable effort at localising the effectiveness approach (Government of Lao PDR, 2015[22]). This declaration would, however, benefit from a renewed commitment to monitor the progress made by all relevant stakeholders, including development partners.

Lao PDR’s development partners must avoid contributing to fragmentation. This involves ensuring that their contributions are complementary and do not lead to the duplication of effort or to fragmented approaches within the government that could undermine country ownership. Concurrently, the government of Lao PDR should ensure that all relevant development partners (including China and Lao PDR’s South-South partners) actively participate in the country’s aid co‑ordination mechanisms. Revitalising the sector and subsector working groups under Lao PDR’s national Round Table Process could further support this endeavour.

Examples of aid co‑ordination mechanisms from other Asian countries can provide insights or models for enhancing governance and effectiveness in managing international support

The Philippines

Sulong Pilipinas: Hakbang Tungo sa Kaunlaran (Onward Philippines: Leap Towards Progress), formerly known as the Philippine Development Forum, serves as the Philippines’ primary platform for facilitating policy dialogue among stakeholders regarding the country’s development agenda. This annual event gathers various stakeholders from across the nation, including representatives from the government, development partners, businesses, civil society, academia and youth organisations. In addition, regional forums, such as the Mindanao Development Forum, have been launched as nationwide initiatives to stimulate dialogue with regional line agencies, donors, local government units and local businesses, with the goal of revitalising job creation and hastening poverty reduction. This model could inspire Lao PDR to enhance its Round Table Process by incorporating more diverse stakeholder perspectives, including from local actors, in order to ensure that development initiatives promote inclusive economic growth.

Cambodia

In order to support the implementation of its Development Cooperation and Partnership Strategy 2024‑2028, the Royal Government of Cambodia has developed flexible partnership mechanisms at the national, sectoral and subnational levels. These mechanisms include national multi-stakeholder consultations, bilateral consultations with development partners, government and NGO consultation meetings, and subnational partnership dialogues. Furthermore, the implementation of Joint Monitoring Indicators (JMIs) provides a standardised framework for tracking progress on key development goals, promoting accountability and aligning stakeholders’ efforts in order to enhance the effectiveness of development co‑operation.

Bangladesh

In Bangladesh, the Aid Effectiveness Unit within the Economic Relations Division of the Ministry of Finance provides policy advisory, networking and donor co‑ordination functions, facilitating high-level donor co‑ordination and development dialogues through initiatives like the Local Consultative Group (LCG) and the Bangladesh Development Forum (BDF). It also works on the formulation of a national policy for effective development co‑operation and the establishment of an Aid Information Management System (AIMS) in order to increase aid transparency and accountability. In parallel, the Development Partners Group (DPG) brings together key stakeholders to co‑ordinate on development priorities, while sector working groups focus on specific sectors such as healthcare and education.

By considering these examples from peer countries, Lao PDR can identify practical measures to strengthen its own aid co‑ordination frameworks. Each example provides a road map for how Lao PDR might adapt its existing mechanisms or introduce new strategies in order to ensure that development efforts are well-co‑ordinated, aligned with national and local priorities, and capable of delivering tangible results towards sustainable development. Adopting a similar approach to regional forums could help Lao PDR address localised development challenges more effectively by cultivating dialogue with regional stakeholders and tailoring development efforts to the specific needs of different regions within the country.

Recent evolutions and the state of play of Lao PDR’s financing for a sustainable development landscape

Lao PDR’s sustainable development landscape has expanded significantly, but still exhibits notable imbalances. As in other developing countries, government revenue in Lao PDR accounts for a sizeable share of the country’s financing for sustainable development, although it remains low relative to the levels observed in peer countries. FDI represents another significant financing source for the country’s sustainable development goals and has often been used as part of PPPs in the energy and, more recently, transportation sectors. However, the potential of domestic private finance has been stymied by the limitations of the local financial sector. Remittances, despite their critical role in individual livelihoods, remain a minor source of financing. In the challenging financial context currently confronting Lao PDR, the government has started turning its attention towards innovative sources of financing, such as carbon finance. The following section delves deeper into these financing dynamics, shedding light on their implications and potential.

Lao PDR presents vast scope for improving the mobilisation and use of government revenue

The strong and sustained economic growth experienced by Lao PDR has not translated into an increasing tax-to-GDP ratio. While most countries enhance their revenue mobilisation capacity as their economies mature, Lao PDR’s tax revenue shows little responsiveness to the country’s economic growth – a concept known as tax buoyancy that is further explored in Chapter 4 (Figure 3.13, Panel A). As a result, the country stands out for its low capacity to raise taxes, having the lowest tax-to-GDP ratio out of all Association of Southeast Asian Nations (ASEAN) Member States. Lao PDR’s tax-to-GDP ratio in 2021 was less than 10%, in contrast to Thailand’s 16%, Viet Nam’s 17% and the OECD average of almost 35% (Figure 3.13, Panel B). As explained in Chapter 4, Lao PDR’s challenges in mobilising tax revenue are primarily linked to its low tax rates and narrow tax base, resulting in part from the aggressive use of tax incentives in order to attract private investment. The government’s tax revenue is further undermined by issues related to tax compliance.

Figure 3.13. The tax-to-GDP ratio in Lao PDR has decreased between 2011 and 2021 in a context of sustained economic growth

The low capacity to raise sufficient levels of tax revenues affects the Lao PDR government’s capacity to finance key development sectors. Domestic resources, in particular tax revenue, are essential in order to finance progress in key development areas. This includes social sectors, which receive comparatively low financing from government sources in Lao PDR compared to what is observed in other countries that are at similar development levels. In 2020, Lao PDR’s total spending on education amounted to 2.3% of its GDP, compared with 3% on average in low-income countries (LICs) and 3.9% in lower middle-income countries (LMICs). A similar trend can be observed for healthcare expenditure, which amounted to 2.7% of Lao PDR’s GDP compared with 5.1% in LICs and 3.9% in LMICs in 2020. As further discussed in the section on recent evolutions and the state of play of Lao PDR’s financing for a sustainable development landscape, the country is currently unable to provide adequate social funding, which results in the majority of the population lacking basic social protection coverage and access to basic healthcare, and in Lao PDR exhibiting relatively poor educational outcomes.

In tandem with low government revenue, public expenditure efficiency is suboptimal, hindering the utilisation of already scarce resources. The Public Expenditure and Financial Accountability (PEFA) Assessment 2018 revealed that Lao PDR has considerable room for improvement across most indicators of public financial management (PFM) (World Bank, 2019[24]). Key issues include low budget reliability, lack of transparency in fiscal information, and insufficient information about budget allocations, particularly concerning provincial budgets. While the foundational elements of a robust PFM system exist, they require enhancement and full implementation. Existing PFM legislation is not fully implemented, often contradicting other legislation or having become outdated since it was initially passed. The budgeting process currently lacks a strong medium-term perspective and connection to policy objectives. Although efforts are under way to transition towards a Treasury Single Account (TSA) and enhance cash management, past attempts to do this have not been successful, leading to challenges such as payment delays and reliance on costly short-term borrowing. Notably, however, strides are being made to upgrade the Ministry of Finance’s core systems and processes, with the anticipated nationwide rollout of a new financial management information system in 2024.

Recent efforts to restore fiscal balance have relied on public expenditure cuts rather than additional revenue generation. The government of Lao PDR is making a conscious effort to improve the management of its public budget and mitigate its public debt by reducing the long-standing fiscal deficit. However, the sustainability of these fiscal reforms throughout the 9th NSEDP hinges on transitioning from a model of fiscal consolidation based on expenditure reduction to one that emphasises enhancing the mobilisation of domestic revenue and the efficiency of public spending. Furthermore, there is scope to improve the budget’s credibility and better align budget allocations with NSEDP priorities.

International support for domestic resource mobilisation (DRM) and PFM in Lao PDR is slightly above the average among ASEAN Member States but is promoted by a few large projects. Between 2017 and 2021, Lao PDR received on average USD 0.72 per capita of ODF for DRM and USD 1.77 per capita for PFM. In comparison, the average among ASEAN Member States stood at USD 0.30 per capita for DRM and USD 1.59 per capita for PFM. Two other LMICs that received comparatively little international support between 2017 and 2021 were Ghana (which received only USD 0.56 per capita for DRM and USD 1.16 per capita for PFM) and Bolivia (which received only USD 0.01 per capita for DRM and USD 0.31 per capita for PFM) (Figure 3.14, Panel B). All official development finance for DRM that is provided to Lao PDR is provided in the form of ODA. In the case of DRM, a single ODA loan from Korea, disbursed in 2018‑19 in order to establish a tax revenue information system, accounted for 77% of the ODA that Lao PDR received for DRM between 2017 and 2021. The situation is similar for PFM, where an ODA loan from the ADB that was disbursed in 2019 as part of a programme to strengthen Lao PDR’s PFM also represented 77% of total ODA that the country received for PFM between 2017 and 2021 (Figure 3.14, Panel A).

Figure 3.14. Official development finance for domestic revenue mobilisation and public finance management in Lao PDR is slightly above the ASEAN average

Given the fiscal challenges currently affecting Lao PDR, there may be significant benefits to increasing development partner support in order to enhance budget planning, improve the mobilisation of domestic resources and ensure the efficiency of public spending. It is crucial for Lao PDR to adapt its tax policies, broaden its tax base and enhance tax compliance in order to effectively mobilise domestic revenue. At the same time, streamlining public expenditures, eliminating inefficiencies and aligning budgetary processes with clear policy objectives are essential to improving the delivery of key public services, as well as enhancing the credibility and durability of the fiscal adjustment undertaken by the government. Collaborative efforts involving international donors and key government stakeholders should be intensified in order to build robust financial systems and practices that can sustain Lao PDR’s development aspirations in the long term.

Private investment in Lao PDR is dominated by resource-seeking FDI in the mining and energy sectors

Lao PDR has implemented a proactive policy in order to attract FDI. In order to strengthen Lao PDR’s position as an attractive destination for investment, the government has pursued a proactive policy aimed at encouraging FDI, notably by making extensive use of tax incentives. This strategy, also evident in the establishment of Special Economic Zones, is reminiscent of models championed by neighbouring countries, notably China and several ASEAN Member States.

The government of Lao PDR has gradually introduced measures to support investors and facilitate the conduct of business in the country. Laws and regulations related to investment are routinely publicised, and an official website offers access to pertinent information. Newly introduced laws and regulations aim to streamline administrative processes (such as the acquisition of licences) while also enhancing investor support. Nevertheless, in a 2022 ASEAN survey, Lao PDR scored poorly on the perceived quality of investment facilitation services, with fewer than 20% of respondents rating services as satisfactory or exceeding expectations (ASEAN, 2022[25]). In contrast, Cambodia scored 60% and Viet Nam nearly 80%, suggesting that Lao PDR could benefit from an exchange of experiences with its regional counterparts. Moreover, Lao PDR was the ASEAN Member State with the highest proportion of investors who saw room for investment facilitation improvement, a view shared by nearly 90% of survey respondents.

A notable share of FDI in Lao PDR has been facilitated through PPPs. Historically, Lao PDR has leveraged PPPs as a tool to attract FDI, especially in sectors like energy, with a focus on hydropower projects. More recently, their use has been expanded to include investments in the transportation sector, as demonstrated by the USD 5.9 billion railway project connecting Lao PDR with China, which is part of the Lao PDR government’s strategy to evolve from a “landlocked” to a “land-linked” country. While there are undeniable advantages to employing PPPs in certain situations, the fact that the country’s growing use of PPPs has coincided with its growing fiscal challenges prompts concerns regarding the sustainability of this investment model. Specifically, it raises questions about whether the decision to adopt the PPP model primarily stems from a desire to bypass the government’s narrowing fiscal space. These partnerships also carry inherent – and sometimes hidden – risks and costs, including potentially forgone revenue from tax incentives and contingent liabilities. As detailed in Chapter 5 on stimulating sustainable investment, building country capacity on PPPs would be key to mitigating these risks and preventing such investments from aggravating the country’s debt issues.

During the 2010s, FDI inflows into Lao PDR have presented a pattern of rapid expansion that reached its apex in 2017 before experiencing a significant contraction. Between 2011 and 2017, Lao PDR attracted a growing volume of FDI, although it experienced a high level of volatility compared with peer countries (Figure 3.15, Panel A). The volume of FDI in Lao PDR rose by 75% from USD 5.7 billion in 2016 to USD 10 billion in 2019 before experiencing a drop. This distinctive trend can be partly attributed to the extensive use of PPPs, which, while encouraging investment, also placed considerable strain on the government’s fiscal position. It is reasonable to conclude that the progressive materialisation of Lao PDR’s fiscal challenges contributed to the ebb in FDI inflows after 2017.

Foreign investment plays a pivotal role in Lao PDR’s capital formation. Data analysis reveals a relatively steady rise in FDI flows as a percentage of gross fixed capital formation (GFCF) between 2011 and 2017 (Figure 3.15, Panel B). Lao PDR also presents a high ratio of FDI inflows as a percentage of GFCF (19% on average between 2011 and 2021) compared with other developing countries in Asia (for which the average stood at 5% over the same period). This suggests that a significant portion of the country’s capital investments – infrastructure, machinery, buildings and other forms of fixed assets – is financed by foreign capital rather than domestic sources. It also underscores the need for policy makers to consider adopting strategies that diversify capital formation sources, thereby mitigating risks associated with an over-reliance on FDI in the future.

Figure 3.15. FDI inflows to Lao PDR have been substantial but volatile over the past decade

Delving into the composition of Lao PDR’s FDI reveals a concentration in sectors such as mining and energy. Indeed, mining and hydropower together accounted for 79% of the country’s FDI between 2017 and 2021. Recent years have seen continued investment in energy and increasing investment in transport, which has been promoted by large infrastructure projects, notably with China. For instance, the USD 5.9 billion railway project linking Lao PDR with China opened in December 2021. Numerous hydropower projects have also commenced or continued construction. One such example is the USD 2.4 billion Phou Ngoy hydropower project, which involves a consortium of Korean companies and is scheduled to be completed around 2029.

The focus on resource-seeking FDI raises concerns regarding its impact on Lao PDR’s long-term sustainable development. While sectors such as energy and mining bring in considerable investments, these projects also come with significant social and environmental impacts. Furthermore, research suggests that some of these investments might not significantly contribute to value addition or job creation (Columbia Center on Sustainable Investment, 2016[27]). This underscores the need for Lao PDR to diversify its FDI, ensuring that investments are in line with the country’s long-term and sustainable development goals. Interviews from the fact-finding mission for this report revealed that the government of Lao PDR is already looking at sectors like tourism and manufacturing to try to diversify the country’s FDI. Nevertheless, FDI in these sectors remains in its infancy and will require some of the country’s remaining challenges related to the business environment to be addressed. For example, an enabling environment for private sector development plays a more pivotal role in attracting foreign investors in manufacturing than in mining. Chapter 5 on stimulating sustainable investment explores the enabling environment for private investment in Lao PDR in greater detail and presents specific policy options to make the country’s market more attractive to FDI.

The domestic financial sector has limited depth and can only make a marginal contribution to financing Lao PDR’s sustainable development

A robust and well-developed domestic financial sector is vital to providing financing for sustainable development. A thriving financial sector fuels economic growth, supports business ventures, helps attract private investment and facilitates capital allocation for diverse development projects, including by facilitating sovereign borrowing in the local currency.

Lao PDR’s financial and banking landscape is relatively shallow, lagging behind countries with similar economic structures and development trajectories. The financial development index for Lao PDR is one of the lowest in Asia, registering a score of less than 20% (IMF, 2023[28]). For context, neighbouring Cambodia scores marginally better, hovering around 20%. Bolivia and Viet Nam, which are also categorised as LMICs, exhibit a far more advanced local financial sector, with their scores nearing the 40% mark (Figure 3.16).

Figure 3.16. Lao PDR exhibits low financial development

Financial development index and GDP per capita (2021)

Lao PDR’s domestic financial sector is dominated by large, government-owned banks. The country’s financial ecosystem consists of 38 commercial banks divided into 6 categories: 1 state-owned bank, 5 joint venture state banks, 7 private banks, 8 subsidiary banks, 16 foreign commercial bank branches and 1 specialised bank (Bank of Lao PDR, 2023[29]). In addition, five enterprises offer life insurance and three engage in securities trading. Other financial institutions encompass providers of money and value transfer services, foreign exchange bureaus, and microfinance institutions.

Despite a gradual improvement in capital and asset quality of the major banks, Lao PDR’s domestic financial sector still exhibits vulnerabilities. The issue of non-performing loans remains a primary concern, although gauging its scale is challenging due to limited data availability (IMF, 2023[9]). Alarmingly, many banks fail to meet the capital adequacy ratios mandated by the Basel Committee on Banking Supervision, with a significant number also grappling with insufficient cash reserves. In response, the government of Lao PDR has recapitalised two of its banks in 2021 and 2022. Recognising these shortcomings, the IMF has recently emphasised the need for Lao PDR to enhance banking regulations, bolster oversight and establish robust capital reserves (IMF, 2023[9]).

The limited depth of the financial sector inevitably curtails access to domestic credit for both the public and private sector. As a result of the underdeveloped local financial market, both the government and enterprises in Lao PDR, especially small and medium-sized enterprises, struggle to access long-term credit domestically. In the case of the government, this results in a significant reliance on external borrowing. For local enterprises, this often translates into reduced capacity to invest in their own development. For instance, despite some visible improvement since 2011, with 3.1 commercial bank branches per 100 000 adults in 2021 (up from 2.5 commercial bank branches per 100 000 adults in 2011), Lao PDR still lags behind the ASEAN average of 9.2 commercial bank branches per 100 000 adults (Figure 3.17, Panel A). In addition, the proportion of enterprises using banks to finance investment is notably lower in Lao PDR than in other countries. Fewer than 9% of enterprises in Lao PDR rely on bank financing for their investments. This percentage is higher than in neighbouring countries like Cambodia (3%) and Myanmar (7%), but significantly lower than the average for LMICs (23%) or other regional peers like Viet Nam (29%) (Figure 3.17, Panel B). Considering the modest size of Lao PDR’s financial sector, there is also a risk that increased sovereign domestic borrowing – stemming from limited access to international capital markets – might inadvertently crowd out credit availability for the local private sector.

Figure 3.17. Lao PDR needs to increase its capacity to finance businesses

Another significant challenge facing Lao PDR is the limited access its population has to basic banking and financial services. A large segment of the country’s population remains unbanked and effectively excluded from the formal financial system. Such restricted access stifles the improvement of individual livelihoods and hampers the mobilisation of domestic savings for investments. The absence of a developed banking sector, particularly in remote areas, further exacerbates this divide, causing many to depend on informal lending sources such as family and friends. From 2011 to 2021, the proportion of Lao PDR’s population with an account at a financial institution or with a mobile money service provider increased from 27% to 37%. Although this is a commendable increase, it pales in comparison to regional peers like Viet Nam (56%) and Thailand (96%), or the average for other LMICs (62%). However, it is slightly above Cambodia’s 33% (Figure 3.18, Panel A).

Lao PDR stands out positively in terms of gender equality in financial inclusion, although there is room for improvement concerning access to finance for its poorest citizens. Unlike its peer countries, Lao PDR exhibits a slightly higher percentage of account ownership among women than men. Specifically, 34% of women aged 15 years and over have an account at a financial institution or with a mobile money service provider, compared with 33% of men (Figure 3.18, Panel A). In contrast, many other countries show a more pronounced gender gap that generally favours men, with the average account ownership for LMICs being 59% for women and 65% for men. On the other hand, Lao PDR could better address the financial inclusion of its most economically disadvantaged groups (Figure 3.18, Panel B). While nearly one-half (47%) of the wealthiest 60% of the population holds an account at a financial institution, only 23% of the poorest 40% of the population owns an account. This gap, which is considerably more pronounced than the average among LMICs, can be partly explained by the fact that the poorest segments of society in Lao PDR live in rural and often remote areas. This underscores the importance of expanding access to banking and financial services. Digitalisation offers promising solutions in this area, as discussed in this section and further elaborated on in the section concerning remittances.

Figure 3.18. Financial inclusion in Lao PDR is low compared with peer countries

Village banks have emerged as a local solution to fill the financial void in the rural areas of Lao PDR. In Lao PDR, where two-thirds of the population live in rural areas, village banks emerged in the late 1990s as a solution to partly bridge the financial access gap at the grassroots level. Present in approximately 4 000 villages thanks to support from development partners and promotion by the government, village banks operate as community-based savings groups, providing loans and savings options to villagers. Lao PDR’s experience shows that these banks can play an important role in facilitating small-scale investments, addressing immediate financial needs and promoting local entrepreneurship. As such, the funds they provide offer an avenue for integrating unbanked rural populations into a financial ecosystem that recognises and respects local customs and traditions.

However, community-based village banks present their own set of challenges and risks. As semi-formal entities, they operate outside the purview of the national financial regulatory framework, eluding the supervision of the Bank of the Lao PDR. Their management, operation and activities are essentially governed by internal by-laws (UNCDF, 2021[30]). In addition, most village banks are not able to intermediate savings beyond the village level, leaving their loan portfolios vulnerable to specific localised risks. The absence of professional management exacerbates these concerns.

The development of financial technology provides a possible way forward to bolster financial inclusion and strengthen rural finance. In 2019, GIZ supported the development of a microfinance platform to help Lao PDR’s multitude of village banks maintain and keep track of their transaction records, and hence mitigate risk and fraud. Since then, this platform (named Lan Xang Banker) has been successfully rolled out across hundreds of village banks in the country. Among other things, the platform aims to help facilitate the intermediation of savings beyond the village level, potentially solving a critical issue in the traditional model of village banks.

Mobile banking and mobile payments technology are another significant opportunity to advance financial inclusion in Lao PDR. By integrating digital platforms and mobile banking and payment solutions, local financial institutions can enhance their reach, offer diverse financial products, and instil greater transparency and efficiency in their operations. Mobile banking platforms allow users to conduct basic financial transactions – from checking their account balances to transferring funds – without the need to go to an automated teller machine (ATM) or bank branch. Meanwhile, mobile payments enable peer-to-peer transfers, bill payments and commercial transactions, thus integrating a larger segment of the population into the formal financial ecosystem. The data generated from these digital transactions can ultimately assist financial institutions in crafting tailored financial products and services to meet the unique needs of previously excluded individuals, including those living in remote areas.

Remittance flows to Lao PDR are low but showed an upward trend until the COVID‑19 pandemic

For Lao PDR, remittance inflows have traditionally been on the lower side compared with some of its neighbours. Remittances play a crucial and growing role in the economies of many developing countries, offering a lifeline to families and sometimes surpassing foreign aid in volume. In Lao PDR, remittances are relatively low, at 1.3% of GDP, as compared with 4.6% of GDP in LMICs on average (Figure 3.19). In Southeast Asia, Thailand’s remittances (1.8%) are closest to those of Lao PDR, but Lao PDR trails far behind other regional neighbours like Viet Nam (3.2%) and Cambodia (8.7%), which have longer experience of economic migration. It should, however, be noted that remittance statistics might not capture the full extent of transfers from migrants, as many use informal channels.

Figure 3.19. Remittances are surprisingly low in Lao PDR compared with peer countries

Personal remittances received (% of GDP), 2020-22 average

During the years leading up to the COVID‑19 pandemic, there was a noticeable upswing in remittance inflows to Lao PDR, hinting at a changing dynamic in the country’s financial landscape. Several factors contributed to this upward trend. A growing number of Laotians sought employment opportunities abroad, particularly in neighbouring countries like Thailand and Viet Nam. These migrant workers sent money back to their families, contributing to the increasing volume of remittances (Figure 3.20, Panel A). Additionally, improvements in banking infrastructure and the proliferation of mobile money services observed from the end of 2018 onwards made cross-border transactions more accessible. On the other hand, progress on the affordability of remittance fees has been inconsistent. The cost of sending remittances to Lao PDR rose from 13% in 2015 to 16% in 2017, before decreasing in 2018 and 2019, and stabilising thereafter (Figure 3.20, Panel B).

Figure 3.20. The COVID‑19 pandemic halted the rise of remittance inflows to Lao PDR

The onset of the COVID‑19 pandemic disrupted the trend of increasing remittances to Lao PDR. Due to lockdowns, travel bans and job losses, Laotian citizens working abroad faced hardships during the COVID‑19 pandemic, with many returning home. Consequently, remittances fell from 1.6% of GDP in 2019 to approximately 1.2% in 2020 (Figure 3.20, Panel A). The decline in remittances during the pandemic underscored the vulnerability of relying heavily on such inflows for economic resilience. While Lao PDR is not overly dependent on this financing source, the reduction in remittances primarily affected household incomes, leading to potential setbacks in areas like education, healthcare and general well-being.

Looking forward, remittances to Lao PDR present a substantial opportunity for growth, particularly as global economies rebound post-pandemic. As the economies of Southeast Asia recover post-pandemic and barriers to international employment recede, a rebound in remittance inflows to Lao PDR is plausible. In order to maximise the potential development impact of remittances, the government of Lao PDR, in collaboration with development partners, could focus on facilitating cross-border financial transactions and promoting financial literacy. Encouraging the formalisation of these inflows can cultivate a more transparent and efficient financial system. Moreover, there is a compelling case for introducing policies and financial products that nudge remittance recipients towards savings and investments, facilitating capital accumulation. By transforming remittances from mere consumption support to a catalyst for sustainable growth, Lao PDR could harness a valuable resource for its socio-economic advancement in the coming years.

Nonetheless, increased migration among Lao PDR’s youth will come with challenges. Given the relatively slow economic recovery, Lao kip devaluation and high level of inflation experienced by the country, a significant portion of the Lao PDR workforce, especially youth, could be tempted to seek employment opportunities in neighbouring countries. While this movement might lead to an increase in remittance inflows to Lao PDR, it could also strip the country of a crucial engine of economic growth: its young workforce and human capital. Such a shift could ultimately pose challenges to achieving sustainable long-term growth. Policies should thus be crafted to ensure that migration leads to upskilling for these workers and offers incentives or prospects for their return to Lao PDR, enabling local industries to benefit from the demographic dividend (Asian Development Bank, 2023[32]).

Development co‑operation is expected to continue playing an important role for years to come in key development sectors in Lao PDR

ODF has taken on an increasingly important role in Lao PDR during the 2010s. This type of financing, encompassing both grants and loans from bilateral and multilateral development partners, supported Lao PDR’s strategy of capital-intensive investment in energy and transportation infrastructure. Notably, loans from China played a significant part in these infrastructural ventures. Furthermore, ODF has been instrumental in the social sectors, an area where government allocations have been constrained due to limited fiscal capacity. ODF flows (excluding those from China) surged by 67% between 2011 and 2019, rising from USD 369.4 million to an impressive USD 746.6 million (Figure 3.21, Panel A).

Loans, previously Lao PDR’s fastest-growing source of ODF, experienced a sharp decline after 2019 as a result of the country’s fiscal challenges. After a notable increase from USD 27.2 million in 2012 to USD 349.7 million in 2019, the amount of ODF loans dropped to USD 200.3 million in 2020 (Figure 3.21, Panel B). These changing dynamics underscore the significance of a country’s fiscal situation in terms of influencing development finance patterns.

Figure 3.21. After experiencing sustained growth between 2011 and 2019, ODF flows in Lao PDR started to decline in 2020 as a result of reduced access to official loans

Financing from China and the multilateral development banks, which dominated official finance to Lao PDR during the 2010s, are on the decline. China, the ADB and the International Development Association (IDA) were the largest sources of ODF flows to Lao PDR between 2017 and 2021. Excluding China, the ADB accounted for 17% of ODF flows, followed by the IDA (11%) and Japan (11%) (Figure 3.22, Panel A). A salient characteristic shared among these major financiers is their inclination to extend loans. Lao PDR’s debt issues make it challenging for these partners to maintain their previous levels of lending to the country. This trend is evident in the decrease of multilateral development finance to Lao PDR after 2019, as shown in Figure 3.22, Panel B. In the current era of escalating global debt, this raises the question of how development partners can continue supporting countries grappling with significant fiscal challenges, especially those in or at high risk of debt distress.

Figure 3.22. Bilateral development partners are playing a growing role in Lao PDR’s financing for a sustainable development landscape

Maximising the impact of development co‑operation hinges on ensuring its fitness for purpose, quality and effectiveness. The experience of Lao PDR demonstrates the importance of developing countries carefully analysing and selecting their financing sources and instruments, including the appropriate mix of concessional and market-term finance required in order to achieve their objectives. ODA, which represents the concessional facet of ODF, accounts for a smaller share of the external financing mix in Lao PDR relative to peer countries (Figure 3.23). Specifically, ODA accounts for just over 25% of Lao PDR’s external financing, in stark contrast to the nearly 40% typical for the average developing country at a comparable development stage. This comparatively lower share of ODA in Lao PDR can be attributed to the prominence of China’s lending – which does not fall under ODA and is in large part non-concessional – and the significant influence of FDI. Beyond the level of concessionality, other factors are also crucial to maximising the impact of development co‑operation. For example, the importance of transparency and co‑ordination cannot be overstated. Key development partners’ active engagement and participation in the country’s aid co‑ordination mechanisms and strategic dialogues is paramount to curbing some challenges in aid management and governance, such as the risk of fragmentation and duplication discussed in Box 3.1.

Figure 3.23. Concessional finance, such as ODA, accounts for a relatively small share of Lao PDR’s external financing mix compared with countries at a similar development stage

Average ODA as a share of total external financing flows, 2017‑21

Innovative financing sources are in their infancy in Lao PDR but have the potential to reconcile its twin agenda of resource mobilisation and natural capital preservation

The government of Lao PDR, like the governments of many developing countries, is exploring innovative financing mechanisms as potential tools to boost its revenue and enhance its access to financing. These mechanisms, which include carbon credits as well as green, social, sustainable and sustainability-linked (GSSS) bonds, have the potential to help countries monetise their natural assets while promoting environmentally conscious behaviours domestically. However, the fiscal situation of a country dictates what timing is feasible and requires differentiating and prioritising among the different options considered.

Carbon credits offer an attractive and credible option to generate additional revenue by monetising Lao PDR’s natural capital. Carbon credits have become a topic of increasing interest in recent years, especially as part of discussions around the Conference of the Parties (COP) on climate change. Enterprises have historically been the main purchasers of carbon credits: in Lao PDR, for example, the Lao–Swedish enterprise Burapha Agro-Forestry Co., Ltd., a plantation and wood products manufacturing company successfully issued carbon credits tied to its agroforestry activities for the first time in 2022 for a value of approximately USD 1 million. While this example confirms the potential for carbon credits to be a source of additional revenue, it is essential to note that carbon credits have faced global criticism about their actual environmental benefit.

Recent international discussions open opportunities for Lao PDR to issue sovereign carbon credits. International discussions have recently explored new mechanisms for sovereign nations to purchase and sell carbon rights, including those tied to forest conservation projects. Specifically, the involvement of governments and the creation of internationally transferred mitigation outcomes (ITMOs) under Article 6.2 of the Paris Agreement offers a new opportunity for governments to participate in more credible international carbon credit markets. Countries can use these new types of credits in order to meet their nationally determined contributions (NDCs) under the Paris Agreement (Box 3.2). This opens significant opportunities for countries like Lao PDR to explore converting their carbon sinks into natural capital that yields a return on investment against a commitment to preserve it. This is particularly suitable for Lao PDR since the country has included the goal of increasing its forest cover to 70% of its land area in its NDC, at an estimated cost of USD 1.7 billion (Government of Lao PDR, 2021[33]).

Box 3.2. The early experiences of pioneer countries with sovereign carbon credits present valuable learning opportunities for Lao PDR

The concept of sovereign carbon credits, although still in its early stages, has been gaining traction globally. Sovereign carbon credits quantify a nation’s efforts to reduce GHG emissions as tradable units. This system not only incentivises sustainable practices but also opens new avenues for economic growth and environmental conservation. Lao PDR stands to gain valuable insights and learn lessons from early adopters such as Ghana, Costa Rica and Colombia, which, despite their differing geographical and economic contexts, offer instructive examples of how sovereign carbon credits can be effectively implemented.

Ghana’s approach is noteworthy for its focus on establishing a comprehensive institutional framework. In 2022, Ghana became the first country to adopt a comprehensive institutional and regulatory framework for issuing ITMOs under Article 6 of the Paris Agreement. During the COP 27 climate conference that same year, Ghana, Switzerland and Vanuatu announced the first voluntary co‑operation to trade ITMOs. This arrangement allows Switzerland to purchase ITMOs in return for its support of climate change mitigation projects. The initiative in Ghana will support thousands of rice farmers to reduce methane emissions by converting to more sustainable forms of agriculture. These farmers, who account for approximately 80% of Ghana’s rice production, stand to increase their income through revenues generated from ITMO sales. This model promotes environmental stewardship while simultaneously bolstering the local economy, offering Lao PDR a valuable example of the potential of sovereign carbon finance to align economic incentives with environmental conservation.

Costa Rica, currently the only nation to have successfully reversed deforestation, capitalises on its environmental achievements to engage in carbon credit issuance. The country’s success in forest and biodiversity preservation builds upon a track record of strong government policies over several decades. During the 1970s and 1980s, Costa Rica experienced one of the world’s fastest deforestation rates, which was caused by the clearance of forest areas for cattle ranching and road construction. Since the 1980s, Costa Rica has implemented strong government policies that tackled deforestation and allowed its forest cover to grow back to 60% from a low point of 40% in the 1980s. In 1997, the government introduced the Payments for Environmental Services (PES) programme, through which landowners receive payments for adopting sustainable forestry practices such as forest protection and reforestation. PES payments compensate landowners for the loss of revenue that they could have earned from agriculture by converting tropical forest to field or other land uses. Originally funded by a fuel tax and water usage fees, the PES revenue base could be expanded to include a significant share from carbon credits. Costa Rica’s experience demonstrates the possibility of Lao PDR reversing deforestation and adopting sustainable forest management practices, and demonstrates how carbon credits could be leveraged in support of this goal.

Colombia is another pioneer country exploring the potential presented by carbon credits. Since 2023, Colombia has participated in the Supporting Preparedness for Article 6 Cooperation (SPAR6C) programme, funded by the German Ministry for Economic Affairs and Climate Action and led by the Global Green Growth Institute (GGGI). The SPAR6C initiative focuses on developing robust frameworks for international carbon markets and helping develop mitigation activities eligible for market participation. Colombia’s example illustrates how Lao PDR could leverage its rich biodiversity and forest resources for mitigation, positioning itself as an active participant in global carbon markets and securing a new stream of financing in order to incentivise green investments and practices.

The experiences of early carbon credit adopters like Ghana, Costa Rica and Colombia offer key insights and practices that can be beneficial to other countries, including Lao PDR. These three nations have employed unique approaches in their efforts to develop market-based mechanisms for mitigating GHG emissions, and their examples illuminate different paths towards leveraging carbon credits in order to integrate environmental sustainability and economic progress. By understanding the variety of approaches and paths towards harnessing sovereign carbon credits, Lao PDR can effectively navigate its own carbon finance journey and progress towards achieving its climate goals while encouraging sustainable development. The experience of Ghana, which was shared and discussed during a meeting of the OECD Mutual Learning Group, shows that integrating carbon finance as part of a sustainable finance package requires a multifaceted approach:

Alignment with local policies and regulations: Adhering to Lao PDR’s policy and regulatory framework is essential for the success of carbon finance initiatives. The fiscal regime, along with environmental regulation and the financial framework, play interconnected roles in unlocking carbon finance.
Establishment of credible institutional structures: Building robust institutional structures is crucial for the effective implementation and monitoring of carbon finance projects. This includes setting up entities responsible for oversight, verification and enforcement in order to maintain credibility and transparency in the carbon market.
Mobilisation of actors: Achieving success in carbon finance requires collaboration across all sectors of society, including the public and private sectors. This entails engaging stakeholders in order to cultivate awareness of, participation in and a commitment to sustainable practices.
Youth involvement: Engaging youth in carbon finance initiatives is critical for long-term sustainability.

Source: Authors’ elaboration based on the OECD Mutual Learning Group meeting held on 29 February 2024.

In order to fully capitalise on the carbon finance opportunity, Lao PDR must satisfy specific conditions. These include improving governance and co‑ordination among key stakeholders, keeping a detailed record of land use across the country, and producing accurate, harmonised and regularly updated environmental statistics (a topic expanded upon in Chapter 6). Fulfilling these preconditions will ensure that carbon credits and forest preservation efforts are effective, sustainable and adequately monitored. Lao PDR could also benefit from creating bilateral agreements with countries willing to offer technical support for both the monitoring of forest preservation activities and the purchase of carbon credits. This approach would mirror the model used by the agroforestry enterprise Burapha Agro-Forestry Co., Ltd., which collaborates with a private entity for technical support on carbon credit issuance and, in return, pledges to sell the credits to that private entity.

An uncoordinated approach to carbon credits could endanger the credibility and success of the entire initiative. Carbon credits, by their nature, demand a high degree of trust among stakeholders, usually upheld by stringent assurance processes. Among other things, they require a multistep process of measurement, reporting and verification (MRV) in order to certify that an activity has actually prevented or removed GHG emissions. Also, as shown in Chapter 6, co‑ordination is crucial in making data available for measuring, reporting and verifying carbon credits. While the concept of sovereign carbon credits is relatively new, past experiences highlight the necessity of a solid governance framework. Conversely, a fragmented approach risks introducing complexity, which could severely undermine trust in Lao PDR’s sovereign carbon credits. In order to avoid this, strategic co‑ordination is paramount, both within the government and among development partners.

Currently, key responsibilities are scattered across various parts of the Lao PDR government, which are working alongside different development partners in order to operationalise carbon credits. For instance, the Ministry of Agriculture and Forestry is responsible for the National REDD+Strategy (reducing emissions from deforestation and forest degradation in developing countries) , which includes clear emissions reduction and removal targets (Ministry of Agriculture and Forestry, 2021[34]). Since 2020, the Ministry of Agriculture and Forestry has been collaborating with the World Bank under the Forest Carbon Partnership Facility to issue carbon credits. As part of this Emission Reductions Payment Agreement (ERPA), the World Bank committed to making payments to Lao PDR for verified reductions of up to 8.4 million tonnes of carbon dioxide emissions in northern Lao PDR, valued at approximately USD 42 million (World Bank, 2021[35]). Since 2023, the Ministry of Natural Resources and Environment (MONRE), backed by the GGGI and Australia, is seeking to establish a co‑ordinated policy structure and MRV system. Other institutions, such as the Ministry of Public Works and Transport, have responsibility for the emissions of specific sectors or activities. Looking forward, harmonisation is required across these multiple and overlapping initiatives in order to ensure the coherence and complementarity of efforts at the national level and avoid institutional or sectoral compartmentalisation.

The issuance of GSSS bonds, often touted as a promising financing avenue for developing countries, is not a viable option for Lao PDR in the short to medium term. These instruments, despite emerging as innovative financing tools globally, require a stable economic environment, reliable access to capital markets and a certain level of borrowing capacity. For developing countries like Lao PDR, diving into such complex financial instruments amid fiscal challenges might exacerbate their economic vulnerabilities. Moreover, the issuing, management and servicing of these bonds often involve significant costs and require robust legal and regulatory frameworks. Until Lao PDR can achieve a more fortified fiscal position and establish the necessary infrastructures, the risks associated with GSSS bonds are likely to outweigh their potential benefits.

While the immediate feasibility of GSSS bonds may be in question for Lao PDR, it is important to recognise that the foundation for such instruments can be cultivated progressively. The establishment of a conducive environment for these bonds is intrinsically linked to the restoration of macroeconomic stability, the development of the domestic financial sector and the availability of harmonised data and statistical systems in order to ensure that different ministries and government departments responsible for the projects financed with the bonds can report on the use of the proceeds, the impact of projects, or the achievement of sustainability targets. As Lao PDR works towards strengthening its economic base and building a more diversified financial sector, it can simultaneously lay the groundwork for GSSS bonds (OECD, 2022[36]). This would involve regulatory enhancements, statistics capacity building, and cultivating partnerships with international financial institutions and relevant development partner initiatives, such as the European Union’s Sustainable Finance Hub. Over time, as macroeconomic conditions stabilise and the local financial sector matures, Lao PDR will be better positioned to harness the benefits of these sustainable financial instruments. Furthermore, in the long term, a robust GSSS framework could act as a catalyst, channelling the necessary funds and investments into sectors relevant to developing sustainable tourism, forestry and renewable energy, thereby promoting a green and sustainable economic growth trajectory for the country.

Mounting challenges in financing key development sectors put Lao PDR’s development objectives at risk

The debt situation threatens the financing of essential development sectors

The 9th NSEDP and its Financing Strategy point to healthcare, education and the environment as priority sectors. This strategic focus, reflecting the government’s commitment to sustainable development and inclusive growth, is designed to address the interlinked challenges of reducing poverty, improving the quality of life for Lao PDR’s citizens and safeguarding natural resources. Under the NSEDP, the government aims to enhance access to quality healthcare and education services and reduce disparities in access to such services, especially for girls, women and ethnic minorities. Meanwhile, the NSEDP sets environmental goals that emphasise the protection of biodiversity, the promotion of sustainable agricultural practices and the management of the effects of climate change. By allocating resources and mobilising international support for these objectives, the government could ensure a transformative impact on Lao PDR’s socio-economic landscape, laying the groundwork for long-term resilience and prosperity.

The 9th NSEDP Financing Strategy acknowledges the current gap between these priorities and actual allocations of public resources. Despite the NSEDP’s clear emphasis on social sectors and environmental protection, some of the sectors with negative social and environmental externalities (such as energy, mining and public works) together made up more than 20% of all public expenditure in 2020. Public expenditure on energy and mining, for example, accounted for 1.6% of GDP (Figure 3.24). In contrast, public expenditure dedicated to environmental protection and water resources represented only 1% of total expenditure as a share of GDP (Government of Lao PDR, 2021[16]). The government’s revenue is also highly dependent on activities that are potentially harmful for the environment and for social outcomes. For example, between 5% and 10% of the government’s total revenue comes from royalties related to the exploitation of Lao PDR’s natural resources.

Figure 3.24. There is a significant misalignment between the Lao PDR government’s priorities for sustainable development and actual allocations of public resources

Public expenditure in key environmentally relevant sectors as a percentage of GDP (2020)

Compared with other countries, Lao PDR has historically demonstrated very low spending in social sectors. These include healthcare and education, where its government spending is among the lowest in the world. Government expenditure on education in Lao PDR stands at around 1.4% of GDP, compared with 3.2% of GDP for the average LMIC (Figure 3.25, Panel A). Even Cambodia, which has a lower income per capita, exhibits a slightly higher volume of education spending relative to its GDP. This also holds true for healthcare expenditure, which represents a mere 2.7% of GDP in Lao PDR (Figure 3.25, Panel B). In contrast, the average healthcare expenditure for LMICs is nearly 4% of GDP, and all of Lao PDR’s neighbouring countries demonstrate a higher ratio of healthcare expenditure to GDP, including 4.4% for Thailand, 4.7% for Viet Nam and 7.5% for Cambodia. Lao PDR’s low spending in social sectors is likely due to the low levels of government revenue that also characterise the country, as discussed in Chapter 4 on generating sustainable fiscal revenue.

Figure 3.25. Government expenditure in social sectors in Lao PDR ranks among the lowest in the world

The healthcare sector financing landscape in Lao PDR reveals a high degree of reliance on sources other than government expenditure. Compared with other LMICs, a significant portion of Lao PDR’s healthcare sector financing comes from ODA and out-of-pocket contributions from the country’s citizens. In contrast, government expenditure in the healthcare sector is lower than that in countries at a similar income level. This financing trend has detrimental implications for the country’s most vulnerable populations, as the poorest citizens are disproportionately burdened by out-of-pocket expenses, especially during times of high inflation. For example, a recent survey showed that more than one-half of Laotian families affected by high inflation had to decrease their education and healthcare spending. Spending reductions were more prevalent among low-income families, with 65.6% reducing healthcare spending and 68.2% reducing education spending, compared with only 54.6% of more affluent households reducing healthcare spending and 50.7% reducing education spending (World Bank, 2023[37]). Without an increase in government expenditure, the current financing situation in social sectors is thus likely to exacerbate poverty and inequality.

Debt service already surpasses, and could increasingly crowd out, government spending in both the healthcare and education sectors. While Lao PDR’s social sector spending remains worryingly below the global average, the country’s debt service burden continues to escalate, taking precedence over investment in vital areas, such as healthcare or education. In fact, despite the debt service deferrals that the government negotiated with Lao PDR’s main bilateral creditor between 2020 and 2022, the ratio of debt service to GDP exceeds that of the government’s expenditure in healthcare and education (Figure 3.26). An alarming statistic illustrates this challenge: in 2022, while the combined expenditure on healthcare and education was estimated to represent 2.6% of the country’s GDP, debt service represented nearly 7% of its GDP.

The recent need for fiscal consolidation in order to address debt distress has resulted in spending cuts in healthcare and education. Lao PDR displays a worrying trend where essential development sectors, notably healthcare and education, have faced expenditure reductions (Figure 3.26). This fiscal consolidation, prompted by growing concerns over the debt situation, has primarily been achieved through these spending cuts. In stark terms, the commitment to address debt risks is curtailing essential spending on healthcare and education, which is vital for human development. This is particularly concerning given the sharp increase in inflation in 2022, which remained elevated in 2023.

Figure 3.26. The gap between Lao PDR’s debt service and government spending on social sectors is expected to widen

Debt service and total government spending on healthcare and education in Lao PDR as a percentage of GDP (2018‑22)

Unless specific measures to increase government revenue are adopted, it is probable that a widening financial chasm will emerge, with rising debt service costs overshadowing government spending on social sectors. Prioritising debt payments in order to avoid default could detract from government investments in social sectors. The steep increase in debt service that has been projected from 2023 onwards is likely to further widen the gap between debt service and social spending. In this context, the already insufficient social spending is unlikely to increase in the coming years without the government securing new financing sources. Therefore, it is critical for the government to take steps to increase its revenue, which could include the adoption and implementation of “sin taxes” (e.g. on tobacco), an option examined in detail in Chapter 4. Another option could be to explore mechanisms to sustainably manage future revenues from hydropower, forestry and mining, learning from peer experiences, such as the Bhutan Economic Stabilization Fund or similar sovereign wealth funds (SWFs). Recent research suggests that stabilising SWFs help reduce fiscal policy volatility (Al-Sadiq and Gutiérrez, 2023[39]).

Underfunding of essential development sectors jeopardises Lao PDR’s sustainable development trajectory

Lao PDR’s consistent shortfalls in investment in social sectors raises critical concerns about its sustainable future. If this pattern persists, it could pose significant challenges to the country’s long-term development goals. Social sectors, including healthcare and education, are foundational to the prosperity and progress of any country. A sustained underinvestment in these areas not only affects immediate well-being but can also hinder human capital formation, which is crucial for Lao PDR’s overall growth trajectory and competitiveness on the global stage. This is acknowledged by the 9th NSEDP Financing Strategy, which considers healthcare and education as priority sectors for financing due to the importance of human capital in helping to realise Lao PDR’s objectives of achieving irreversible LDC graduation and attaining the SDGs, all in a post-COVID‑19 context.

Similarly, insufficient financial support for environmental protection and climate action poses a threat to the implementation of the NGGS. The Lao PDR government’s shift to environmentally protective policies is a step in the right direction. Recent research suggests that in recent decades, forest loss and degradation has cost Lao PDR nearly 3% of its GDP per year, and that the health effects caused by pollution have an estimated cost equivalent to 15% of the country’s GDP (World Bank, 2023[40]). This is compared with biodiversity protection costs amounting to 0.3% of global GDP per year, which, if applied to Lao PDR, would have represented investments totalling USD 60 million per year in 2020 (Government of Lao PDR, 2023[17]). In addition, Lao PDR showcases ambitious climate mitigation objectives, as shown by its NDC, with investment needs estimated at USD 4.8 billion (representing around USD 500 million annually until 2030). In practice, this is far more than the total amount of climate-related development finance currently being accessed by the country, including for both mitigation and adaptation measures (Figure 3.27).

Figure 3.27. Despite an increasing trend, Lao PDR still has room for improvement in terms of access to climate finance

Lao PDR’s climate-related development finance and financing requirements (2011‑21)

The current trajectory of government investment in education and healthcare is not in alignment with achieving Lao PDR’s set or suggested targets in these areas. Despite growing recognition of the critical importance of education and healthcare for sustainable development, the allocation of funds remains inadequate when measured against domestic policy goals and international benchmarks. Government spending on education has been on a downward trend since 2015, from representing nearly 16% of total public expenditure in 2015‑16 to barely 13% in 2020 (Figure 3.28, Panel A). In the case of healthcare financing, government expenditure has increased from 0.4% of GDP in 2011 to 1.2% in 2020, but that is still far from the 4% of GDP recommended by the World Health Organization (WHO) (Figure 3.28, Panel B) (ADB, 2023[42]).

Figure 3.28. Government expenditure on education and healthcare in Lao PDR is far below target or recommended levels

Without significant adjustments to the financing trends for its priority sectors, Lao PDR risks falling short of its developmental aspirations in these vital areas. This underinvestment could stifle the country’s human capital and sustainable development, two cornerstones of economic growth and poverty alleviation. In order to reverse this trend, it will be essential for the government to prioritise environmental and social sectors within the national budget in an effort to close the gap between current expenditure levels and the strategic investments required to develop a healthy, educated and productive society.

Bolstering the government’s revenue is key to addressing the shortfall in social sector financing. A robust revenue system provides a steady stream of resources that can be channelled into crucial public services and infrastructure. It also reduces the dependency on external finance and ensures that domestic priorities can be met in a consistent manner. This is particularly true for investments in social sectors and in climate adaptation, both of which tend to be financed in large part through public finance because their returns, which require a long-term horizon, are typically less appealing to private investors.

Box 3.3. Key recommendations

Given its challenging economic and financial situation, Lao PDR requires a carefully phased approach aimed at addressing both its immediate and future financing challenges and opportunities. Addressing the escalating debt is a prerequisite for the country to return to a path towards sustainable development. In the short term, priority should be given to reducing the debt burden. This will involve seeking debt relief or restructuring where possible in order to alleviate the immediate financial pressures, as well as securing ways to ensure a sustained fiscal consolidation. Looking towards the medium term, it is important for Lao PDR to cultivate new economic drivers that can diversify its economy beyond traditional sectors, such as resource extraction and agriculture, which often carry negative environmental and social consequences. Striving to better harness current and new financing sources is also essential in order to facilitate adequate investment in key development sectors. Long-term stability hinges on institutional reforms that prioritise sustainable debt levels, including the implementation of prudent financial management that steers the economy towards increased resilience.

In the short term, Lao PDR should deleverage in order to reduce the debt burden and re-establish macroeconomic stability.

Address the country’s fiscal challenges in order to break the vicious cycle of escalating debt, currency depreciation and high inflation:
- Seek debt relief from the country’s primary lender (i.e. China) in order to free up fiscal space and alleviate short-term payment pressures.
- Co‑ordinate and communicate transparently with development partners in order to avoid moral hazard concerns, ensuring that any new concessional financing results in additional investment in development rather than merely serving to free up government resources to repay other creditors.
- Gradually shift the emphasis of fiscal consolidation efforts from expenditure reduction to increased revenue generation and spending efficiency in order to ensure the sustainability and credibility of the fiscal adjustment (building on the recommendations detailed in Chapter 4 on on generating sustainable fiscal revenue).
Mitigate mounting fiscal risks arising from contingent liabilities associated with PPPs and SOEs:
- Audit existing SOEs and PPPs in order to evaluate their fiscal risk profiles and identify urgent threats to macroeconomic stability.
- Define and enforce strict criteria for government guarantees in order to minimise fiscal exposure, ensuring that such guarantees are only issued when absolutely necessary.
- Identify and enact quick-win reforms (such as cost-cutting and operational efficiency improvements) in those SOEs that present the riskiest profiles in order to stabilise SOE finances.
- Communicate clearly with development partners and the public about the short-term fiscal risks identified in SOEs and PPPs, and about the measures being taken to address them.

In the medium term, Lao PDR should establish a sound framework in order to secure financing for the country’s development goals.

Address the current fragmentation and lack of co‑ordination in the country’s sustainable development financing landscape:
- Establish a shared and well-co‑ordinated governance of the sustainable development financing agenda among the multiple government stakeholders involved, including the co‑chairing of key committees.
- Ensure adequate resourcing of, and institutional engagement in, the sector and subsector working groups of Lao PDR’s Round Table Process.
- Secure the active participation of, and garner contributions from, all relevant development partners in strategic development and aid co‑ordination mechanisms.
- Develop a clear and coherent governance framework for sovereign carbon finance in order to promote a co‑ordinated approach across the government, avoiding inefficiencies and reputational risks that could jeopardise this new financing source.
Take steps to safeguard the impact and effectiveness of development co‑operation:
- Reinvigorate the multi-stakeholder dialogue around the Vientiane Declaration on Partnership for Effective Development Cooperation (2016-2025), as well as efforts to monitor the implementation of the Country Action Plan for the Implementation of the Vientiane Declaration on Partnership for Effective Development Cooperation (2016-2025).
- With a view to maximising international support for sustainable development, use existing aid co‑ordination platforms in order to consult partners on key governance and institutional issues constraining development co‑operation flows to Lao PDR.
Enhance spending efficiency and build greater capacity for revenue collection:
- Explore opportunities with key development partners for enhanced support on public financial management and domestic resource mobilisation, appropriate to Lao PDR’s fiscal context and challenges.
- Develop and implement a comprehensive action plan to increase government revenue, with clear and credible revenue targets (building on the recommendations detailed in Chapter 4 on on generating sustainable fiscal revenue).
- Review the current investment promotion framework in order to assess its costs and benefits, factoring in the effect of tax incentives on government revenue (building on the recommendations detailed in Chapter 5 on stimulating sustainable investment).
Create and strengthen a centralised public debt management function with authority over public debt issuance:
- The legal framework should clarify which body has the authority to borrow and to issue new debt, to invest, and to undertake transactions on the government’s behalf.
- Credit risk assessment and validation should be centralised for all public debt issuance, including by SOEs.

In the long term, Lao PDR should lay the foundations more broad-based growth and take preventive measures in order to avoid debt issues in the future.

Strengthen the business environment in order to encourage greater private sector development, reducing the strong reliance on public investment:
- Carry out an in-depth review of the role, governance and performance of the country’s SOEs, which can help inform an action plan to tackle the negative implications of their dominant position in the development of Lao PDR’s private sector.
- Strengthen the local banking sector in order to reduce financial sector vulnerabilities and fiscal liabilities while promoting enhanced credit provision to the private sector.
- Identify new drivers for foreign private investment, and seek development partner support in order to design an integrated and cross-cutting investment promotion strategy that considers the impacts on various sectors of the economy and aligns with Lao PDR’s sustainable development objectives (building on the recommendations detailed in Chapter 5 on stimulating sustainable investment).
- Engage with South-South partners and regional platforms in order to exchange knowledge and experiences with regard to maximising the development impact of remittances, including through policies supporting increased human capital and productive investments.
- Explore additional support from development partners on key areas in order to increase the channelling of remittances to savings through the formal or semi-formal (e.g. village banks) financial system, with a focus on expanding access to digital services and improving financial education.
Promote sustainable borrowing policies and practices, and design formal mechanisms for contingency planning:
- Continue the policy dialogue on debt management initiated with the main international financial institutions and identify key functions of government that require additional technical support.
- Seek technical support and capacity building from development partners in key areas of sustainable development finance, specifically in order to better harness finance opportunities and to design sound frameworks allowing Lao PDR to tap into innovative or nascent financing instruments in the future, including carbon and biodiversity finance. Explore possible financial or technical support from the INFF Facility initiative in order to cover part, or all, of the costs of the technical assistance.
- With support from development partners and regional platforms, explore and assess the benefits for Lao PDR of mechanisms to stabilise and sustainably manage future revenues from commodity exports such as hydropower and mining. Use regional platforms to discuss good practices and peer experiences, such as the Bhutan Economic Stabilization Fund or other types of SWFs.
Develop a knowledge base and robust country systems in order to harness innovative financing sources:
- Strengthen the country’s statistical systems and data collection processes – especially with regard to environmental protection, climate adaptation and mitigation – in order to support Lao PDR’s efforts to harness innovative financing, such as carbon credits. As detailed in Chapter 6, access to carbon markets is likely to require technical support and capacity building from development partners in order to help Lao PDR produce harmonised and regularly updated data and statistics on its GHG emissions and the carbon absorption capacity of its forests.
- Keep abreast of developments and the experiences of regional peers with regard to GSSS bonds as possible instruments to consider in the future, once Lao PDR is back to sustainable debt levels. In parallel, efforts to strengthen the local financial sector and the country’s PFM and statistical systems will provide solid foundations to make sustainable finance instruments a viable option in the future.

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