COMMENTS ON THE DRAFT DECREE ON THE INTRODUCTION OF GOVERNMENT BONDS AND

GOVERNMENT GUARANTEED BONDS IN THE LAO PDR

Jean-Marc Lepain, Intergovernmental Fiscal Advisor

Date: August 22nd 2008

1. Background

In the aftermath of the Asian financial crisis, ASEAN + 3 countries have launch the Asian Bond

Markets Initiative (ABMI) to develop regional markets using common financial standards for

encouraging cross border investments. Since 2003, the Lao PDR has received the financial support of

the Japan-ASEAN Financial Technical Assistance Fund (JAFTA) in order to create a Government Bound

Market, and the ASEAN Secretariat has created the “Technical Assistance for Developing Bond

Markets in Lao PDR” programme which is now in phase 2. A roadmap and work programmes have

been developed for the creation of a bond market and the Government Joint Committee for Bond

Market Development has taken the responsibility for the roadmap implementation . Nomura, a

Japanese security firm, has been commissioned to prepare a draft decree for the regulation and

oversight of the Lao PDR Bond Market in replacement of the old Security Law.

On August 4th, the Department of Fiscal Policy of the Ministry of Finance has requested the

Intergovernmental Fiscal Adviser to review on its behalf the Draft Decree on Government Bonds and

Government Guaranteed Bonds prepared by Nomura. The Advisor has consulted with the Ministry’s

Treasury Department and other stakeholders and his conclusions, reflecting a consensus in the

Ministry of Finance, are presented in this memorandum.

2. Description of the decree

The objective of the decree is to put in place a Government bond market as part of a wider effort to

establish financial markets in Lao PDR, including a Stock Market and a Security Market for corporate

bonds. The decree on Government Bonds and Government guaranteed bonds will be completed by a

decree on Securities Markets that call for the establishment of a Market Authority and Credit Rating

Agencies

The decree covers the following topic: the products, the role of MoF in issuing bonds, the role of BoL

in organizing the sell of bonds, custodians, underwriters and investors.

2.1. Types of Government bonds

The decree covers four types of products: Treasury Bills with a maturity of less than one year,

Treasury Bonds with a maturity of one year or more, Government guarantee bonds issued by State

enterprises designated by the Prime Minister and Retail Bonds.

2.2. Currencies

Article 7 of the decree open the possibility to issue bonds not only in kips but in other currencies.

2.3. Investors

If we read correctly Article 8, the market will be open only to domestic investors which might include

“foreign organization and individuals working and living lawfully in Lao PDR”. Accepting foreign

institutional investors would require making the kip a convertible currency. However, there are good

reasons to exclude foreign investors as they are more likely to take a speculative approach and might

dramatically reinforce market fluctuations and increase volatility; as such is the case presently in

Vietnam. We advise the Ministry of Finance to review carefully the recent events in Vietnam before

making any decision.

2.4. Role of the Ministry of Finance

The role of the Ministry of Finance is to define the borrowing policy of the Government, to devise

issuing strategies and to prepare quarterly programmes for issuing treasury bills and treasury bonds.

Issuance of treasury bills is normally based on cash management requirements. A fine-tuned T-bill

policy will not be possible before the Treasury System is implemented. Issuance of bonds depends

on the financing needs for long term investments, macro-fiscal sustainability and macro-economic

stability. The MTFF and MTEF will provide the key parameters for defining and piloting the borrowing

policy.

Article 21.2 says that “The volume and interest of each of the Treasury bills shall be determined

through auction results”. The syntax of the sentence does not appear correct but might mean that

the volume of T-bill effectively sold at and auction might depend on the auction result as it is the

case in the Dutch Auction system, used for example by the US Treasury. However that might not be

compatible with MoF borrowing policy and it needs to be further discussed as it might influence the

choice of an auction method.

MoF will establish the list of “underwriting organizations”. This will require some additional

regulation and the publication of selection criteria.

In the case of Government guaranteed bonds the role of MoF is strictly limited to issuing the

guarantee legal documents. However, guaranteed bond will impact the government solvability and

should be recorded as off-balance commitments. There is a risk for MoF to loose the control of its

fiscal policy if the Prime Minister Office can authorized SOEs to issue guaranteed bond without

referring to MoF. Within the framework of it borrowing policy, MoF might set limits for guaranteed

borrowing.

2.5. Role of the Bank of Lao PDR

Usual practices are that MoF give to the central bank a mandate for organising the issuance of T-bills

and T-bonds either through auctions, direct sales or underwriting. The central bank, as the

Government banker, will also collect interest and capital repayments. Often this mandate is

formalized by a Memorandum of Understanding signed between the MoF and the central bank.

The Central Bank is also responsible for creating a Central Security Depository (CSD) which normally

is not dedicated only to Government bonds but is open to all types of securities. The central bank is

then responsible for maintaining the CSD infrastructure and issuing all the related regulation. A

dedicated decree will need to be published by BoL. Additionally, MoF will need to establish the

principles of CSD accounting. Those principles might be integrated in the BoL Decree.

BoL will need to publish another decree on the eligibility criteria of candidate custodians and the

principles of their selection.

Eventually the Central Security Depository is linked to the payment system (Real Time Gross

Settlement) through a Delivery versus Payment System (DvP) that ensures that the payment is

absolutely simultaneous with the security transfer and that all systemic risks are eliminated.

2.6. Custodians and underwriters

The decree does not make a clear distinction between custodians and underwriters as custodians are

also expected to act as underwriters. A custodian is a financial institution that has received the

agreement of the central bank to hold and manage bonds recorded in the Central Security

Depository on behalf of its customers. This suggests that custodians might become active in

organizing a secondary market, either in organizing bond transactions between their customers or

selling bonds to each others.

3. Assessment of the decree

The technical content of the decree is excellent and reflect the expertise of Nomura. However, the

decree in the present stage remains high level and does not provide the sort of details required for a

bond market to become operational. The decree calls for (a) secondary regulation that will define

processes and procedures, (b) a clarification of the Government borrowing policy, (c) a feasibility

study.

As such the decree is not complete enough to allow a market to start operating. Not only it requires

as expected additional regulation, but a better definition of instruments and of participant

responsibilities must be introduced in the law. The scheduled feasibility study is expected to solve

these problems.

Secondary legislation could take the form of a circular issued by MoF or the Prime Minister Office

and a circular issued by BoL. Those circulars will give more information on the financial instruments

such as maturities, calculation of interest, secondary markets, method of auction, role of the

underwriters, conditions under which an investor can activate the Government guarantee,

accounting rules, custodian risk management rules and internal control, custodian insurance, etc.

In the absence of a State Borrowing Policy Paper, it is difficult to assess the decree. A Borrowing

Policy does not reflect only fiscal policy considerations but also monetary policy considerations that

must be discussed with BoL. The Government must first define the objectives of its borrowing policy

and then devise a strategy to meet those objectives. When such a strategy will be ready, it will

become possible to see if the decree and the secondary regulation allow meeting the objectives

through the approved strategy. In practice, drafting of the regulation will be impossible in the

absence of such a policy paper.

The decree does not say anything on market makers and by what mechanism the transaction price of

a bond will be established on the secondary market.

4. Borrowing Policy

It will not be possible to prepare the regulation required by the decree unless a Borrowing Policy is

put in place. The Borrowing Policy is currently under preparation by the External Finance

Department, but we have not had access to its preliminary findings and therefore are not in position

to make any recommendation.

The debt sustainability analysis conducted in 2007 indicates that the Lao DPR continues to face a high

risk of debt distress although all indicators at that time were positively oriented and debt service

ratio remaining relatively low. While nominal debt stocks have increase, strong growth has led the

nominal debt-to-GDP ratio to steadily decline since 2002. Since 2006 all debt service indicators have

reversed their upward trends, reflecting continued strong GDP and export growth. However the size

of the domestic public debt is negligible. This situation opens the possibility to substitute domestic

debt to international borrowing, although 75% of the country external public debt are highly

concessional loans.

Presently all domestic debt is made of short term T-bills. It pertains to the Borrowing Strategy to

decide if there is an opportunity to substitute long term bonds to short term T-bills, knowing that

such a policy can become effective only when the Cash Management System is implemented. The

Budget Law does not allow borrowing for financing recurring expenditures. However, from a cash

management viewpoint, when a treasury gap occurs, it is impossible to separate recurring

expenditures from investments. The usual policy is to use T-bills for short term gap resulting from

delay in revenue collection, and long term bonds for structural needs. If the analysis shows that there

is a minimum revolving stock of T-bills that represent a structural long term deficit, it is possible to

consider substituting long term bonds.

The question of substituting bonds to T-bills must be decided by an analysis of the opportunity cost.

Long term bonds represent for the Treasury a steady source of financing that reduces the interest

risk, especially within the context of raising inflation and interest rates. On the other hand, the cost

of borrowing long term is usually higher than the cost of borrowing short term. However, in Lao PDR

the market of interest rate instruments is not developed enough to make prediction on the yield

curve.

Another risk to be taken in consideration is the risk of depreciation of the Government bonds if

interest rates rise sharply (see Vietnam in section 6) and the risk that investors loose confidence in

the market, forcing the Government to borrow at higher rates. Many techniques exist for mitigating

this risk. Accounting rules play an important role. If insurance companies are obliged to mark to

market the value of their portfolio even if they intend to keep the bond until their maturation they

might be reluctant to buy the bonds or will ask for a risk premium. Central Bank policy plays also an

important role for the bank. Open market policy, pension and repurchase agreements might help in

creating some market liquidity.

The development of a Government bond market is far less risky than in international currencies. The

Decree opens the possibility of issuing bonds in foreign currency and this question should be decided

by the Borrowing Policy paper as it involves certain risks.

The borrowing policy should be formalized in a borrowing policy paper to be integrated in a Fiscal

Policy Declaration which is usually one of the preliminary budget formulation document presented to

the Cabinet and the Parliament.

5. Potential impact on the macro-economic and fiscal outlook

According to the IMF, “Public domestic debt in low-income country and emerging markets remains a

controversial issue…” (IMF Working Paper 07/127). An analysis of pros and cons leaves a very mix

image. Issuing domestic debt, whether to finance the fiscal deficit or to mop up liquidity, involves a

complex evaluation of the costs and benefits to the economy.

Traditional public finance literature highlights the risk of encouraging the issuing of domestic public

debt and its potential negative impact on private investment, fiscal sustainability, growth and

poverty reduction:

The most prominent concern is the crowding out effect on private investment. Bank might

find investing in Government bonds an attractive low risk substitute to financing the

economy through commercial loans. This attitude might have in the long term a negative

impact on growth.

Domestic borrowing is more expensive than concessionary borrowing. ADB and World Bank

Treasury Loans can be excellent substitute to domestic borrowing for financing structural

needs if the loan conditionality is accepted. With domestic borrowing, the final cost of

borrowing is unknown and might rise sharply due to rising interest rate and time

inconsistency when Government credibility is low.

Stimulation of financial markets can contribute to economic growth in a way that

beneficiates only the affluent part of society but create a type of economy with more

exclusion for the poor.

However, in the recent years more voices have increasingly echo the positive view of many market

participants regarding the importance of domestic debt instruments for monetary, financial and fiscal

systems. The proponents of domestic debt stress its positive impact on growth, inflation and savings

as well as the contribution that more sophisticated financial markets can make to economic

development.

Here are some of the main advantages that they identify:

The development of a Government bond market is an important stimulant to the

development of a security markets in the absence of potential private borrower. It will help

the Central Bank to set interest rates for different maturities and be used by commercial

banks as a pricing benchmark.

Government bonds are an important instrument for the conduct of indirect monetary policy

operation and collateralized lending in inter-bank markets, reducing the need for frequent

central bank intervention.

Domestic debt markets might stimulate population saving, having a positive effect on

inflation and on macro-economic stability. The example of China and India are often given,

but they are very large economies.

International borrowing, even at concessionary rates, exposes the country to exchange rate

risk (although with a weak dollar the risk seams mitigated). Domestic debt reduces the

vulnerability to international market shocks.

Budgets finance sectors such as agriculture, sanitation, public work which are unattractive to

the banks. Government bonds mobilize bank deposits and redirect national saving to the

financing of those sectors.

Coming to a clear cut conclusion in this debate is difficult. A complete review of these factors is not

possible in the framework of such a short note. Those questions need to de debated and clarified in

an in depth discussion of borrowing policy.

6. The example of Vietnam

Vietnam offers a good example of the damage that a poor borrowing policy can make. It is estimated

that by July 2008 Vietnam has issued more than US$ 15 billions of Government bonds, of which US$

3 billions are hold by foreign investors. With raising inflation, the Bank of Vietnam has been obliged

to raise significantly its rates. As a result Government bonds have lost 30% of their value and the

market confidence in Government has been greatly damaged. The depreciation has been aggravated

by foreign investors who have closed their positions and left the market. As a consequence if the

Government wants to mobilise capital at this moment, it has to pay a risk premium that put the bond

yield above inter-bank rates.

7. Feasibility Study

The implementation of a Government bond market will take many years and should be seen with the

context of the Government priorities. Although it is always possible to develop a legislative

framework to leave all options open, a bond market will also require a heavy investment in IT

infrastructure. For MoF, the priority should be the implementation of the Treasury System including

the cash management module, the implementation of a debt management system and the

implementation of the Treasury Single account. For BoL the priorities should be the implementation

of its General Ledger, the implementation of the account management system and the

implementation of its payment systems. Only when whose systems are in place, will it be possible to

consider a Central Security Depository and a Delivery versus Payment system. Therefore we are

considering a time horizon which is 4-5 years minimum. This gives already an indication that there is

no reason to speed up the development of security markets.

The delayed in BOL for implementing an information system covering banking operations, account

management and general ledger on one hand, and a real time gross settlement system on the other

hand, might become a serious bottleneck of the development of bond markets. It is important that

on this issue MOF and BOL coordinate their policy.

A feasibility study should take into consideration all those aspects. It is understood that the ASEAN

Secretariat is already preparing the Terms of Reference (ToR) of the next phase projects. Those ToR

include a feasibility study for issuing long-term bonds. This feasibility study will focus on three points:

Whether the economy is stable enough to issue long-term government bonds, including

estimation of the possible size of the issuance;

Identification of potential investors for long term government bonds;

Suitable terms and conditions (i-e terms, interest rate, form, etc.) of Government long-term

bonds.

It should be noticed that the ToR do not include a feasibility study for the infrastructure and does not

seem to consider the prioritization of reforms within the Government.

8. Conclusions

A good borrowing policy should be neutral in terms of size of the budget and budget deficit.

The introduction of a Government bond market may have a significant impact on the

monetary and fiscal policy of the country and affect its macro-economic stability.

The issuance of domestic debt has a combination of positive and negative effect on the

economy. There is no evident conclusion in the case of Lao PDR. The same causes produces

different effects in different countries, depending on the size of the economy, the culture of

people, their saving habits, attitude toward financial risks, experience with inflation, etc.

The development of a long term bond market implies some serious risks that must be

carefully analysed.

The Draft decree on Government Bonds and Government Guaranteed Bonds raise a number

of issues that can only be clarified within the framework of a borrowing policy study including

a debt sustainability analysis and a modelling of different scenarios.

The Draft decree remains incomplete and will require for its implementation extensive

regulation that might require several decrees or circulars from the Prime Minister Office, the

Ministry of Finance and the Bank of Lao PDR. Without an approved Borrowing Policy Paper it

will be impossible to start drafting the regulation.

The Feasibility Study scheduled by the ASEAN Secretariat will also be dependant for progress

on the Borrowing Policy Paper. In addition to the three points mentioned, the study should

also address the issue of the technical infrastructures required. It should include a tentative

date for starting the implementation of the Central Security Depository and an overall cost

estimate of the whole projects. It also needs to address the issue of the prioritization of the

different infrastructure projects inside MoF and BoL.