Lao Economy

Asean Economic Community Special Report – Laos: Little And Big Fish

Cut off from the ocean by the Annamite Range with rolling mountains that stretch as far as the eye can see, life has always happened at a languid pace in Laos. While stunningly beautiful, the mountainous terrain means going anywhere or moving anything takes time, but populated by a friendly, easy going people nobody really seems to be in a great rush.

The country is often viewed by outsiders as some kind of rural Shangri-la that time passed by, but as Asia becomes the engine of global growth the pace of life is quickening, even in rural Laos. China’s unquenchable demand for resources has seen the seeds of growth spread south. The road networks are rolling out as rubber and banana farms proliferate, while mobile and television signal is expanding rapidly and with it outside cultural influences are spreading north.

Looming on the horizon is the next big change, with the Asean Economic Community (AEC) coming into force at the end of 2015, in a little over two years’ time. Ostensibly the onset of AEC will bring into being a single market and production base, enabling a free flow of goods and services throughout the entire region.

Some pundits are skeptical that such a monumental change can actually take place in 2015, given the political considerations and all the vested interests at stake, but whilst it may happen a bit slower than that change will come nonetheless.

Political considerations aside, it is obvious that intra-regional trade will continue to gather a momentum of its own. The question for Laos is how to extract the maximum benefits and not let opportunities pass it by.

Connecting Asean
With increased revenues flowing from hydropower projects and the mining sector in recent years, the Lao government is determined to see the country become a land bridge between Thailand, Vietnam and China.

It is investing large sums of money to upgrade major transport routes including its sections of the Asean highway network and other strategic roads, aiming to facilitate greater regional trade and reap the flow of benefits from that.

It is also connected to the Asean power grid via Nam Thuen II- Roi Et and Thuen Hinboun-Thakek-Sakhon Nakhon. More connections are set to follow, feeding electricity into the regional grid from Hongsa, Nabong, Xe Pian, Xe Namnoy and Xayaburi.

Numerous big dam projects are in the pipeline and even more are under study. The government has given the go ahead for a Malaysian company to invest in a US$5-billion rail project to link Savannakhet with the Vietnamese border, over a distance of 220km.

It is also determined to push ahead with the US$7- billion rail link from Vientiane to the Chinese border to form the Asean-China rail link, a monumental engineering feat. For a country with a national GDP of just $10 billion, the Lao government is definitely thinking big when it comes to integration.

But the question for Laos is how to extract maximum value from the increasing trade and build the domestic industry base. This conundrum is something the Lao government is well aware of. It is moving actively to establish special economic zones at strategic locations to attract more trade, investment and industry.

The government has now approved nine special economic zones along the Mekong opposite major highways in neighbouring Thailand and one in Luang Namtha bordering China.

Numerous large companies have expressed interest in setting up operations in Laos of late. Japanese camera manufacturers Nikon recently concluded an agreement to set up an assembly factory at the Savanh-Seno industrial zone, while global giant Coca-Cola will open a bottling plant in Laos.

Given the numerous investment incentives on offer, including generous concessions, tax holidays and cheap labour costs, Laos stands poised to entice some manufacturers to relocate from Thailand, given the recent minimum wage increase and problems with low lying industrial estates.

This is of course the idea of the single market. It allows larger manufacturers to create new efficiencies by leveraging lower wage costs in less developed countries, vertically integrating region-wide supply chains which might include a factory in one of the CLMV countries, assembly or value adding in Thailand or Malaysia and customer service and marketing in the English-speaking Philippines.
The potential benefits it offers larger businesses aiming to establish regional operations are immediately evident; what it will mean for the thousands upon thousands of smaller businesses, many of them family operations, is another question altogether.

The little fish
Back in Vientiane, a Lao fish farmer gazes across the Mekong from where he farms tilapia. His is a relatively simple life and he makes a modest living feeding his fish but a growing number of illegal farms operated by immigrants on the Nam Ngum river to the north are making things more difficult.

Already facing cost pressures, fishermen are wondering what will happen if full scale competition floods in from Thailand as well. In the gulf of Thailand they also breed Asian bass or pa kapong, which is a cannibalistic species that will eat its smaller kin. Many Lao people fear that with the onset of AEC, business may become a case of “pa ngai kin ba noy pa soi kin pa xeo”, the big fish eating the smaller ones.
Large numbers of pork and chicken farms in and around Vientiane look over to neighbouring Nong Khai with similar concerns. Profit margins for livestock and poultry breeders are already tight due to oversupply and Vientiane meat markets are reportedly afflicted by distortions, with pork and chicken being shipped over the border at Savannakhet before being trucked to Vientiane for sale in the capital.

Phouvong Phongphansay heads the Lao Chicken Farmers’ Group. He is very concerned that when the borders are fully opened, many local egg producers and broiler farms may go bankrupt, unable to compete with Thai operators who have more business experience, greater cost efficiencies and economies of scale.

Banks in Thailand and Vietnam charge about 3-5 per cent interest annually on loans issued to farmers, Phouvong explained, but banks in Laos impose a rate of 13-15 percent per annum, meaning Lao farmers cannot afford to borrow or expand.

Meanwhile Thai chicken and pork conglomerate CP has already established a presence in Laos, operating under a model where farmers build only the pigsties and chicken sheds and the company provides brood stock and guaranteed markets for the pigs, broiler chickens and eggs produced. The contracted farmers will make less money than an independent operation would but their lack of access to finance makes it an attractive option for some.

Lack of access to finance is reported to be one of the main market barriers faced by local SMEs which now make up a very significant proportion of the Lao economy, experiencing considerable growth since the early 1990s when reforms commenced under the New Economic Mechanism started to take effect.

However detailed data for this sector of the economy is lacking. A 1995 study found that the number of SMEs was expanding at around 10 per cent per annum, while the latest comprehensive economic census was undertaken back in 2006.

It found that about 127,000 enterprises were in operation, of which 93 per cent were micro-enterprises with fewer than five employees. Numbers are likely to be higher now, but nevertheless, the study illustrates the fact that the vast majority of SMEs in Laos remain largely family operations and that the country still lacks a real manufacturing base.

Family business
Only a small proportion of business-operating households engage paid employees, at around 15 per cent, with the majority either self employed or relying on unpaid family labour. Despite the fact that Laos has a number of large garment factories, average employment in the manufacturing sector was still only 4.3 persons per enterprise at the time of the study.

President of the Lao Young Entrepreneurs Association Valy Vetsaphong admits that most small businesses in Laos are likely to face more challenges than opportunities when AEC comes into force. She says the country’s production base is simply too small while poor infrastructure and lack of education remains significant impediments to growth.

Majority of business operators have no formal training and learn pretty much everything from their families. Most operators are concerned largely with day-to-day operations rather than long term planning, and rely on methods passed down from previous generations.

“We do business whilst learning from our mistakes,” Valy says, admitting that most people aren’t ready for competition. Many Lao businesses will cease trading immediately if their ventures are not profitable, while “Chinese and Vietnamese traders will spare no efforts to stay in business despite not turning a profit”.

Culturally speaking, many immigrant traders appear to have a more hardnosed attitude to business than most Lao people do. Commercial roads in Vientiane such as Rue Dong Palane are covered with confetti and dancing dragons during Chinese and Vietnamese New Year celebrations, giving some indication of the extent to which foreign businesses already dominate commercial trade in the capital.
With the advent of AEC though, Thais are likely to be among the first to take increasing advantage of emerging business opportunities, with cultural and language similarities likely to give them advantages over other prospective operators.

It begs the question as to how local businesses will fare when the doors are flung fully open, but the extent to which small traders will lose out no one really knows for sure. Associate professor Phouphet Kyophilavong from the National University of Laos’ Faculty of Economics and Business Management admitted recently that it will probably take 10 years before Laos sees concrete benefits from trade liberalisation and WTO membership as it gradually becomes more attractive to foreign investment.

The-long-term view
Lao government policymakers though, are adamant that integration is the best and perhaps only option for the country over the longer term. They point to previous growth under the new policy of renovation as proof poverty can be alleviated.

The Ministry of Industry and Commerce statistics show that foreign investment in Laos stood at barely $51 million in the early 2000s, but the figure had ballooned to $2.9 billion in 2012, with more revenues starting to flow from big mining and hydropower projects.

In the early 2000s, trade volume was only about $865 million including exports of $324 million, but the figure more than quadrupled to $4 billion in 2012 including exports of $1.6 billion. Meanwhile tourist arrivals blossomed from a mere 100,000 arrivals in 2000 to more than 3 million visitors last year.

Over the same period, average income per capita grew from a little over $300 in 2000, to almost $1,400 in 2013 as the Lao population hit 6.5 million people. They are considerable numbers. “This growth was made possible because of integration,” stresses Deputy Director General of the MIC’s Foreign Trade Policy Department Saysana Sayakone.

The Ministry of Industry and Commerce is also heading the efforts to mitigate the negative effects of integration on SMEs, providing management training and facilitating access to markets and finance. As part of its three-pronged strategy, the ministry has established a dedicated fund for SMEs which will provide low interest loans to eligible businesses.

It will not be available for everyone though and the size of the funding pool is not clear. “Not all SME operators will have access to the loans, only those whose business proposals are poised to be profitable and convince the fund’s executive board,” Saysana said.

The bigger fish
Sectors traditionally dominated by state-owned enterprises like telecommunications, aviation, cement, and oil and gas should fare better under integration than SMEs due to their prominent position in the market and well-established connections. However, they too will be subject to greater competition from outside interests looking to expand their operations to Laos.

Thailand’s oil and gas conglomerate PTT Plc recently announced plans to spend 2.45 billion baht ($76 million) to expand its retail oil business before AEC takes effect. Laos is among the countries where it has expansion plans, attractive due to its proximity to existing depots in Issaan and its rapidly growing vehicle fleet. Fuel consumption in Laos is increasing faster than GDP, at 8-9 per-cent per year.

Almost 1 billion litres of fuel is imported to Laos annually, of which around 250 million litres is imported by the Lao State Fuel Enterprise. Deputy Director Phayboun Phomphaphi admits they will have to partner with other regional companies to enhance financial capacity and remain competitive.

Thailand’s PTT envisions 60 sites in Laos, up from the current 20. It also plans 45 petrol stations in Cambodia, up from 15 at present, 60 pumps in Myanmar, up from one, and 135 in the Philippines, up from 50.

In contrast to PTT, Lao State Fuel doesn’t have any regional expansion plans and will concentrate on shoring up its share of the domestic market first. “Of course, we will improve our services and study how we can deal with market liberalisation,” Phayboun said.

The cement industry is another that will face increased competition and given the myriad of road construction and hydropower projects being planned it is a very attractive market indeed, one which domestic interests would be keen to protect.

Lao Cement Company has traditionally enjoyed a monopoly with import restrictions in place but will now have to face competition from Siam Cement among others, which also has regional expansion plans.
“If we can keep our costs competitive we are confident that we can continue to dominate the Lao market,” asserts company director Thongpon Kingkhamphet, who doesn’t fear market liberalisation.
Domestic demand still exceeds current supply in Laos, which can produce only 1.5-1.6 million tonnes per annum while the demand stands at 1.8-2 million tonnes per year and is growing between 10 and 20 per cent annually.

Vangvieng Cement Plants I and II currently produce 240,000 tonnes and 80,000 tonnes per annum respectively. A much larger third plant is scheduled to commence operations next year, with a capacity of around 1 million tonnes per annum.

One of the main challenges for Lao Cement is fluctuations of the price of coal imported from neighbouring countries. Soon this will no longer be the case as the enterprise is planning coal mining operations in nearby Hinheup and Feuang districts, which are currently undergoing feasibility studies.

Meanwhile under the Asean open skies policy, Lao Airlines will face increased competition on international routes, with Bangkok Airways, Air Asia and other airlines having already opened flights to Laos. However the surge in business travel is opening up more opportunities as well. Lao Airlines plans to open more direct flights not only to Asean countries but also to China, Korea and Japan as part of preparations for AEC.

It just commenced daily flights between Vientiane and Incheon, South Korea at the end of last month, up from three times a week due to rising demand. The airline also announced recently that it will reopen direct flights from Vientiane to Phnom Penh after previously cancelling the route back in 2008. In 2015, Lao Airlines plans to buy two more Airbus A321s to grow its aircraft fleet.

Of all the larger enterprises in Laos, perhaps it is the producer of the national lager which is best poised to benefit from regional integration and the new markets it will offer. Known throughout the world to be one of the best beers in Asia, Beerlao will sell very well in neighbouring countries if prohibitive taxes are removed.

In anticipation of AEC, Lao Brewery Company has already opened agencies in Thailand, Singapore, Myanmar, Cambodia and Vietnam. They are yet to open in Brunei, Indonesia and Malaysia, those being Muslim countries.

Beerlao aside though, most state enterprises and many domestically focused SMEs will be primarily concerned with preserving their Lao market interests as AEC looms large on the horizon.

Shoring up revenues
In addition to pressure on local enterprises, government regulators will also have to deal with a significant hit to revenues when tariffs are reduced or abolished.

This will be a particular problem for Laos and the other newer members of Asean, those being Cambodia, Myanmar and Vietnam. Large sections of their populations remain impoverished and exist largely outside the cash economy, meaning they have much smaller tax bases from which to draw and yet greater need for infrastructure.
This has been recognised by Asean and CLMV countries will be granted special dispensation, with some tariffs allowed to remain in place until 2018, allowing regulators and businesses more time to adjust.

For its part, Laos has already reduced tariff rates to zero for 79 per cent of all products listed under the region-wide Common Effective Preferential Tariff (CEPT). By 2015, some 8,879 listed products will have zero tariffs, but an extension until 2018 has been granted for 326 products for which it is considered necessary.

In addition, tariffs of up to 5 per cent will be allowed to remain in place for 266 products listed in the sensitive category, those being mostly agricultural commodities. Under the CEPT, there is also a general exemption category for products considered of national strategic or cultural value. Laos has nominated 87 product categories for exemption, with tariffs of between 5 and 40 per cent to apply as per usual.

The Lao government is also in the process of implementing a value added tax in order to compensate for the lost tariff revenues, VAT being the most widely used consumption tax both in OECD countries and other Asean nations as well.

This will pose problems in terms of collection as rather than being levied at the border as a single fee it applies to every product transaction. Naturally this will be very difficult to implement in a country where many businesses exist in the informal economy, not even having bank accounts let alone accurate bookkeeping records.
However, there are revenue leakage problems at the borders and the structure of the VAT may entice more businesses to declare their business transactions. Unlike a sales tax, VAT is only levied on the value-added component in the supply chain, with businesses eligible for a refund on the component they paid at purchase once they sell the goods.

Depending on their sales volumes and the level at which the VAT is set, it should entice more businesses to join the formal economy. In Vietnam, for instance, when turnover tax was replaced by VAT, tax revenue grew from around 11 per cent of GDP to more than 17 per cent in the matter of a couple of years, but it has a larger manufacturing base.

Drawing more small businesses into the formal economy has other advantages. It will drive them to keep modern accounting systems which will allow for better business planning and greater competitiveness over time.

Barriers to broadening
However the country must still do more to broaden its industry base for the smaller businesses to supply. Among the most common complaints have been the long delays at customs processing, up to 10 days reportedly, and also the rising cost of electricity.

Laos has made significant progress towards the implementation of its national single window, scheduled to commence operations in 2014, forming part of the Asean Single Window which alongside tariff reductions, is the central plank of reforms to facilitate the free flow of goods and create the common market.

Meanwhile, with Laos aiming to become the ‘battery of Asean’, local manufacturers are frustrated about the high cost of domestic electricity. This is largely because, to date, most hydropower projects are foreign-funded and power purchase agreements concluded with outside investors dictating the price of electricity, which is something the country needs to address.

However, Laos cannot afford to rely solely on trying to attract more manufacturing. According to the World Bank’s Investment Climate Assessment 2011, labour productivity is lower than most comparator countries. Meanwhile some estimates suggest the country could face a labour shortage of up to 500,000 workers by 2015, mostly in the agriculture and garment sectors.

Director General of the National Economic Research Institute, Dr Leeber Leebouapao warns that while the country has a shortage of labourers, most of the management level positions may go to more highly qualified graduates from other countries if the education system is not rapidly improved.

Concerted efforts are being made in this regard. Private institutes have been prohibited from opening new tertiary courses until standards are improved while young people are being encouraged to undertake vocational training to fill the skills shortage instead.

According to the World Bank, relying on labour intensive export industries may constrain the diversification required to ensure more equitable growth. Last year, the ADB warned that whilst developing Asia has reduced poverty faster than any other region in the world, it has come with rising inequality.

This is in contrast to the ‘growth with equity’ story that marked the transformation of the newly industrialised economies in the 1960s and 70s and more recent trends in Latin America. If left unchecked it could undermine the momentum for economic growth and the quality of life for all Asians, according to the bank.

A question of time
Many observers believe that AEC is a very ambitious project that will take longer to implement than the time frame set out, even with political will from all member countries. Reducing tariffs is only the first step and addressing pervasive non-tariff barriers will be much more difficult, while assessing progress is hard due to bureaucratic opacity and the vagaries of the scorecard system.

Charged with overseeing the transition to a $1.8 trillion common market, the Asean Secretariat had a paltry budget of around $15 million in 2011, and a professional staff of just 200 or so. The fact that it is equally funded by the 10 member states limits the Secretariat budget to the financial capacity of the weakest members like Laos.
Despite repeated urging to reform the funding structure, national leaders have been reticent to do so. Add to this the fact that AEC has already been put back by a year due to complications with visas and concerns over issues like drug trafficking, it appears that it may take some time to fully implement and the changes to really come into effect.

With its small economy, relative isolation and the enduring reality that things happen a little slower in Laos, the country should be sheltered from the most dramatic changes that will come with the inception of AEC, at least at first anyway.

The question for Laos, like the other newer members, will be whether it can learn from the regional experience and ready itself in time; whether it can use its abundant natural assets wisely, diversify its economy and spread the benefits of rapid growth among the wider population or whether the money will flow to the big fish alone while small farmers are left watching the trucks rumble past and local businesses floundering.