August 10, 2023
Laos has experienced a severe economic downturn in the past two years. A double shock, caused by both COVID-19 and the war in Ukraine, has exposed the country's weaknesses. Since 2021Q3, the Lao kip has depreciated by around 70% against the USD. This depreciation, combined with a substantial foreign exchange exposure in public debt, has led to nearly doubling the government debt from 60% of GDP in 2018 to 110% of GDP in 2022. The significant imbalance resulted from a combination of terms-of-trade issues and unfavourable investment decisions, providing a valuable example of how external exposure can pose significant risks for small, underdeveloped countries.
In recent years, Laos has undertaken numerous significant investment projects in the energy and transportation sectors, with a particular focus on hydropower projects and a large train line as part of the Chinese Belt and Road Initiative. The funding for these projects primarily came from Chinese authorities and Chinese banks. In general, external financing can present an opportunity to facilitate substantial investments in underdeveloped countries and has the potential to generate foreign exchange (FX) revenues through increased export capacity. These positive consequences arise when the projects prove to be profitable, and the investment deals include provisions for generating FX revenues for the home-country.
However, in the case of Laos, this profitability is questionable. Many of these projects, such as the railway line, have proven to be less profitable so far. Also, in some cases, the FX revenues flow to foreign countries instead of Laos. For instance, part of the electricity grid has been leased to a Chinese-led joint venture, effectively giving them a majority stake in the revenue. Consequently, due to the lack of revenue, Laos has been facing difficulties in repaying the substantial external debt service, which accounted for 7% of GDP in both 2021 and 2022.
The depreciation of the currency was triggered not only by unprofitable big projects with a large debt service but also exacerbated by external balance issues. Firstly, Laos heavily relies on tourism, which accounted for around 5% of GDP before COVID-19. But due to prolonged COVID-19 restrictions in China, tourism in 2022 remained approximately 60% below pre-pandemic levels. Also, FDI declined in the past years by about 3% of GDP amid lowering Chinese growth and finished energy projects. These factors, along with rising import prices, particularly on fuel, have had a negative impact on Laos' external balance. FX has started to depreciate, debt sustainability issues emerged.
The government implemented several measures to address the depreciation issue, such as introducing capital controls and closing FX bureaus. Additionally, they successfully managed to defer a substantial part of Chinese debt service, amounting to around 8% of GDP between 2020 and 2022. Thanks to these control measures and a rebound in tourism, the depreciation of the kip is expected to slow down in the short term. However, the overall long-term outlook for Laos remains pessimistic. The country foresees limited foreign exchange (FX) revenue from its major projects, while its FX reserves are at a low level, leaving little room to absorb potential shocks. Additionally, the country will need around 1.3 billion USD annually to service its FX debts. As a result, both the external and fiscal outlook of Laos appear unpromising, further depreciation of the kip is expected.