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What is causing the monetary crisis in Laos? – The Diplomat

Over the past few weeks, the economic situation in Laos has started to deteriorate. Fuel shortages have been widely reported as the falling currency drives up the cost of imports. The Lao kip traded at around 9,400 to the dollar in September 2021, but fell to 13,450 last week. The central bank announced measures to combat the pressure, seemingly blaming currency manipulators and speculators. There’s probably some of that going on, but there are also deeper structural issues at play here.

The first is that the US Federal Reserve raises interest rates, which increases the value of the dollar against most currencies. This happens whenever the Fed raises interest rates, and it often causes capital to flow out of emerging markets, especially those with large fiscal or current account deficits. To hedge against this, central banks in emerging markets typically store large foreign exchange reserves that can be used to support the currency in times of high volatility. This sends a message to global creditors that the country in question can cover its debts.

It has been doubted for some time that Laos is able to cover its debts. The country imported $6.36 billion worth of goods in 2021 and also accumulated significant liabilities on its balance of payments, which increases vulnerability to capital flight. Investors seem to believe that the central bank’s foreign exchange reserves, which stood at $1.26 billion in December 2021, are insufficient.

Added to this is the double shock of high commodity prices, which have caused the price of fuel imports to skyrocket. This is not unique to Laos. Every country in the world is grappling with the same problem and for short-term liquidity crises like these, there are tools available to smooth things out until fuel prices stabilize. This obviously creates short-term economic difficulties, but the price of fuel will eventually come down.

The biggest long-term problem is whether Laos has incurred too many balance of payments liabilities relative to the increase in productive capacity that these liabilities are likely to generate. Investment inflows into Laos have accelerated considerably in recent years. Net foreign direct investment increased from $635 million in 2012 to $1.7 billion in 2017. The rate of investment has slowed in recent years, but in 2021 net inflows were still above $1 billion .

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Foreign investment is a bit of a double-edged sword, as these inflows must be repaid over time to the owners of the capital through dividends and interest. Therefore, as FDI inflows have increased, capital outflows in the primary income account have increased, as investors are repaid. These gross outflows totaled $1.23 billion in 2021.

The million (billion?) dollar question is: what are investment flows for? If they increase productive capacity beyond the cost of capital, they constitute a net gain for the economy. If the cost of capital exceeds the economic benefit, they drag down the economy and will eventually dig a hole in the country’s balance of payments.

Capital markets seem to think that the latter scenario is the most likely and as a result the kip has seen a significant loss in value in recent months. High commodity prices and interest rate hikes in the United States accelerated this process, but it was likely to happen anyway given investor sentiment and low levels of foreign exchange reserves.

Laos, a nation with a population of just 7 million, has a limited domestic market, much of that foreign investment has gone into infrastructure that can boost exports like power generation and transportation. Laos has significantly increased its electricity exports, almost all of which are absorbed by Thailand. According to OEC data, in 2010 Laos exported $272 million worth of electricity to Thailand. In 2020, these exports soared to $1.9 billion, or 31% of all exports. Almost all of this was bought by Thailand. But is it enough?

For this model to work, Laos needs to convert foreign investment into exports. It needs to sell electricity from foreign-owned power plants to Thailand, and it needs its expensive new high-speed rail line to increase the volume of goods and services it exports to China. It is difficult to say what will happen in the long term; In 10 years, exports could be booming, and these investments will prove to be worth the risk.

But for now, that makes the economy heavily dependent on just two of its neighbours, Thailand and China, to absorb exports. And during this time, the accumulated liabilities of all these foreign investments and the lack of significant foreign exchange reserves made Laos particularly susceptible to shocks from the global financial system, which is why it was one of the first countries in the region to really struggle with capital. flight.