Demand for money in Lao PDR and policy implications

The literature identifies other potential costs associated with dollarization: - Lower seignorage, given that only a portion of the monetary base is in local currency - Lower internation[r]

MINISTRY OF EDUCATION AND TRAINING VIET NAM NATIONAL ECONOMICS UNIVERSITY SOMPHAO PHAYSITH DEMAND FOR MONEY IN LAO PDR AND POLICY IMPLICATIONS (Finance and Banking) Code : 62.34.02.01 A dissertation submitted to the National Economics University in fulfillment of requirements for the degree of Doctor of Philosophy in Economics Supervisor: Prof Dr TRAN THO DAT Hanoi, December 2012 i DECLARATION I hereby declare that this doctoral dissertation “Demand for money in Lao PDR and policy implications” is written by me and has not been published yet I am responsible for my declaration Somphao Phaysith ii ACKNOWLEDGEMENT First of all, as the Governor of the Bank of the Lao PDR, I am very pleased and greatly honored for taking the opportunity to take part in the doctoral program organized jointly between the National University of Laos and National Economics University of Vietnam After a number of years following this program, my study is devoted to the title: “Demand for Money in Lao PDR and Policy Implications” I would like to express my heartfelt appreciation to the Lao People’s Revolutionary Party and Ministry of Education and Sport of Lao PDR for granting me this opportunity to undertake this rewarding doctoral program and achieve the result successfully as my wish comes true As one of the candidates for this program, I would like to extend my gratitude and appreciation to the leaders and management staff of these two universities for making this program possible to enhance capacity building for Lao leaders, who are well qualified from the program During the five-year program, I have got the close guidance and knowledge from the lecturers of the two universities as well as relevant authorities for their support that enable me to ease difficulties and hurdles and to complete the program successfully My achivement is also due to valuable academic support from Prof Dr Tran Tho Dat, my academic advisor and close supervisor for my research, who enable me to fulfill all requirements of the doctoral program on a timely manner My special thank also goes to Assoc Prof Lai Phi Hung, the program coordinator I would also like to extend my profound appreciation of wholehearted assistance and cooperation between our two nations, Lao PDR and Vietnam iii My research is carried out with the staff development grant from the Bank of the Lao PDR Furthermore, I shall not forget and pay tribute to kind support and sincere assistance rendered by the BOL staff, namely Ms Fongchinda Sengsourivong, Mr Soulysak Thamnuvong, and Mr Khamkeo Visisombath Lastly, my profound thanks go to my beloved family, including my wife and my two daugthers for their encouragements, care and motivation during my research They always provide me very important supports, and love during the period of hardship All of their supports provided are the power injecting to me to strive the various difficulties and to complete the program successfully as the task assigned by the Party and Lao people iv TABLE OF CONTENTS DECLARATION i ACKNOWLEDGEMENT ii TABLE OF CONTENTS iv ABBREVIATION vi LIST OF TABLES vii LIST OF FIGURES viii LIST OF VARIABLES ix INTRODUCTION CHAPTER I: OVERVIEW OF THEORETICAL AND EMPIRICAL STUDIES ON MONEY DEMAND 1.1 A brief theoretical overview 1.1.1 Quantity theory of demand for money 1.1.2 Keynesian approach (John Maynard Keynes) 10 1.1.3 Friedman’s model of the demand for money 14 1.2 Some empirical problems in estimating money demand functions 15 1.2.1 Functional forms 16 1.2.2 Choice of variables 17 1.2.3 Empirical estimation problems 20 1.3 Some Asia-specific studies on the money demand function 23 Conclusion of chapter 28 CHAPTER II: LAO FINANCIAL SYSTEM AND MONETARY POLICY 31 2.1 Economic development 31 2.2 Overview of monetary developments in Lao PDR 34 2.3 Banking system 35 2.3.1 Mono-bank system 37 2.3.2 Banking system reform 40 2.4 Monetary Policy 47 2.4.1 Monetary instruments 47 2.4.2 Target of monetary policy 51 2.5 Dollarization 54 2.6 Bond market 56 v 2.7 Stock market 58 2.8 Interbank market 59 2.9 Exchange rate policy 60 Conclusion of chapter 66 CHAPTER III: DEMAND FOR MONEY IN LAO PDR 67 3.1 The theory-based money demand function for Lao PDR 67 3.2 Data description and issues 69 3.2.1 Definition of money 69 3.2.2 Scale variable 71 3.2.3 Opportunity costs 71 3.3 Unit root and co-integrated test 73 3.3.1 Unit root test 73 3.3.2 Johansen co-integration test 74 3.4 Estimating money demand function for Lao PDR by using ECM 76 3.4.1 Engle and Granger: Error Correction Models 76 3.4.2 Estimated results and hypothesis testing 77 Conclusion of chapter 92 CHAPTER IV: POLICY IMPLICATIONS 93 4.1 Lao economic development strategy 93 4.1.1 Macro-economic targets 93 4.1.2 Targets of Economic Sectors 94 4.2 Monetary policy recommendations 98 4.2.1 Monetary instruments 99 4.2.2 Choosing intermediate target 99 4.2.3 Increasing banking supervisor 101 4.3 Some recommendations to Lao government 102 4.3.1 Dedollarization 102 4.3.2 Stimulate financial market development 104 CONCLUSION 106 REFERENCE 108 APPENDICES 114 vi ABBREVIATION Lao PDR Lao People’s Democratic Republic Laos Used under monarchy regime BOL Bank of the Lao PDR MOF Ministry of Finance BCEL Banque Pour le Commerce Exterieur or Bank for Foreign Trade Lao LDB Lao Development Bank APB Agricultural Promotion Bank SOCBs State-Owned Commercial Banks GDP Gross Domestic Product Kip Khangkhay Banknotes issuing by tri-parties of the coalition government in 1962 Kip Potpoi Liberated currency under Lao Patriotic Front NPL Non-Performing Loans RR Reserve Requirement CIB Credit Information Bureau vii LIST OF TABLES Table 1.1: Estimated income elasticity and interest rate semi-elasticity for selected Asian countries 26 Table 3.1: Unit Root Test Results 78 Table 3.2: Likelihood ratio test: lag lengths test 79 Table 3.3: Johansen test: the λmax and λtrace tests results at 5% 80 Table 3.4: Diagnostic tests for the short-run dynamic money demand model, equation (3.9) 82 Table 3.5: Short-run dynamic estimation, dependent variable is ∆ ln rmt 90 Table 3.6: Long-run relation, dependent variable is ln rmt 91 Table 4.1: Nonperforming loans ratio and number of banks in Lao PDR 102 viii LIST OF FIGURES Figure 1.1: Determinants of money demand function 30 Figure 2.1: GDP growth (1991-2011) 33 Figure 2.2: GDP by Components (billion Kip) 33 Figure 2.3: GDP growth, Inflation rate, M2 growth, M2 to GDP and FX to total deposit 35 Figure 2.4: Interest rates of deposits and loans in Kip 50 Figure 2.5: Monthly loans interest rates by currency (%) 50 Figure 2.6: Money supply- M2 (billion Kip) 52 Figure 2.7: Deposits by currency (%) 55 Figure 2.8: Relationship between M2, inflation and exchange rate (%) 63 Figure 2.9: Exchange rate (Kip/USD) movement (%) 65 Figure 2.10: Average exchange rate (Kip/USD) 65 Figure 3.1: Cumulative Sum of Squares of Recursive Residuals 82 Figure 4.1: Money and interest rate targets 100 Figure 4.2: Lao money multiplier and velocity, January, 1999 – September, 2012 101 ix LIST OF VARIABLES M Total amount money in circulation T Level of transactions Y Output V Transaction velocity of money P Prevailing price level Md Money demand MD Total demand for money M1 Sum of transaction and precautionary demands (narrow money) M2 Speculative demand (broad money) tc Transaction costs r Interest rate M/P = rm Demand for real balances πe Expected inflation rates i Nominal interest rate GNP Gross National Product NNP Net National Product GDP Gross Domestic Product ln Natural logarithm ∆ First differenced term cpi Consumer price index er Exchange rate π xt − p Error-correction factor EC t −1 Error-correction term INTRODUCTION International experiences confirm that countries with well-developed financial systems grow faster and more consistently and are better able to adjust to economic shocks A good financial market and system of institutions can channel funds from savers to the most productive investors A typical financial system in a transitional economy, especially banking system has limited capacity to assess credit risks and fund allocation according to the government plans Furthermore, governments have strong controls over the financial systems, such as setting interest rate ceilings, entry barriers, and interference in credit allocation According to McKinnon (1973) and Shaw (1973), such financial repression leads to reduction in private savings, thereby decreasing the resources available to finance capital accumulation, with a negative impact on growth The Lao PDR is in the process of transition toward a market economy, the requirement of government’s operations to change its intervention methods and scope is a fundamental process One of these fundamental changes is the way the government conducts its monetary policy as well as the development of the financial system, especially the banking system to achieve desirable economic growth The relationship between monetary growth and economic growth is still in debate Hossain and Chowdhury (1996, p.126) argued that there is a clear correlation between money supply growth and economic growth in the long-run Other studies in the field also point out the importance of monetary policy, especially, in managing the demand side of the economy In order to make the monetary policy more efficient and effective, the prerequisite for the monetary authority must be able to predict the demand for money with acceptable accuracy Theoretical views of the demand for money have usually been based on the consideration of money as a medium of exchange The Keynesian models represent money with the role of transactions and the role of the store of value Analytically, demand for money is the sum of three components: transactions, precautionary, and speculative demand Milton Friedman argued that physical goods should be regarded as a substitute for money and that higher expected rates of inflation should induce a portfolio shift from money to physical assets as well as financial assets (hard currencies) in the context of transition and underdeveloped countries The fact that money does not bring interests like other alternative assets means that money holders should receive compensation in some other forms Following the idea of Keynes, many economists attempted to model the demand for money based on the above consideration Although they are different technically, the main idea is still based on the so-called ‘liquidity services’, which money gives in compensation for the interest earning foregone The relationship between the demand for money and its key determinants is an important building block in macroeconomic theories and is a crucial component in the conduct of monetary policy (Goldfeld, 1974) Even in the era of inflation targeting, a well-specified money demand function is of utmost importance for the effective implementation of monetary policy – especially to track both, the interest rates and the stock of money – in order to access the impact of monetary policy upon the economy As a result, the issue of long-run relationship between broad money, its determinants and also the stability of the demand for money has always been in the center of research Stable money demand is particularly important for policy makers to choose a credible monetary policy instrument For instance, unstable money demand caused by the financial reforms of the late 1970s, the financial innovations and the financial integration induced many central banks in developed countries to switch from monetary targeting to the interest rate targeting as a monetary policy instrument The same view was proposed by Poole (1970) who showed that the interest rate should be targeted if the money demand function is unstable However, monetary targeting can play an important role in the formulation of an efficient monetary policy strategy, even though the monetary policy of developed countries typically uses an interest rate target as a policy instrument Monetary aggregates can be appropriate indicators for future inflation in the medium term and long-term As mentioned by Valadkhani (2006) an emerging consensus among economists is that it is not advisable to concentrate exclusively on a single policy instrument while neglecting another important information variable Both interest rates and monetary aggregates are important in selecting appropriate monetary policy actions Monetary aggregates, however, will only be related to the real economy if the money demand function is stable Thus, the stability of money demand entails whether monetary targeting is an appropriate guide to policy Due to its particular importance, the money demand function was studied extensively in many countries as can be seen from a large body of literature on theoretical as well as empirical studies of the demand for money, discussed in Chapter I However, these studies had been largely carried out in developed countries One explanation for that is the lack of good quality data in developing countries Lao PDR is not an exception in that respect Indeed, the poor quality and short time horizon of Lao economic data is well known among researchers One main reason is that Lao PDR just adopted the system of national accounts (SNA) in 1993 and the statistical system is still underdeveloped The dissertation titled “Demand for money in Lao PDR and policy implications” can be viewed as the earliest research in the case of Lao PDR This fact, while telling us about many difficulties, also can be viewed as an encouraging attempt for us since ‘learning by doing’ in many cases may be the best strategy Objectives of research The main purpose of this dissertation is to estimate the money demand function for Lao PDR during the period of the first quarter of 1993 to the second quarter of 2010 (1993Q1-2010Q2), using available data Taking into account the limitations mentioned above, the conclusion of the dissertation should be viewed as a suggestion However, by doing so it is hopefully to establish an appropriate framework for future studies in this field once the comprehensive data are available In addition, the results of this study can hopefully reveal some important issues and areas required to improve, especially data problems which will raise awareness among policy makers to improve the quality of the economic database of the country Research Questions The main research question: What is the money for demand in the Lao PDR? The specific research questions: What is the behavior of money demand patterns? How has the money demand contributed to the monetary stability in monetary policy? What are direct and indirect factors influencing the demand for money in the Lao PDR? What are the problems and obstacles confronting the Lao PDR in conducting monetary policy? Research Methodology In light of analyzing the money demand function for Lao PDR, this study uses a basic and popular theoretical framework surrounding the money demand analyzed from various empirical works After formulating the theoretical model, this dissertation adopts a framework of the Error Correction Model, which is widely used, to analyse the money demand in both developed and developing economies, to examine factors driving money demand balances in Lao PDR over a period of 1993-2011 This econometric model, an Error Correction Model is believed to be well-suited for the empirical investigation through rigorous empirical testing Contribution of the study To the best knowledge of the author, the current study represents the first attempt to examine the factors influencing money demand for Lao PDR This study will provide a quantifiable estimation of the money demand in Lao PDR for the first time by using quarterly data The outcome of the study can be useful for the purpose of conducting monetary policy for policy makers of the country’s central bank The economic variables which are used to conduct monetary policy identified in this study will be helpful to systematically consider monetary policy and facilitate policy discussions in the country The outcome will provide information needed for key decisions to formulate the future design of monetary and exchange rate policies, which will significantly impact overall macroeconomic stability The findings will be useful for central bankers to understand the factors influencing money demand in the Lao PDR, especially taking into account of dollarization problems prevailing in the economy The study also updates the database of the Lao PDR financial statistics One important contribution of this study is in constructing economic variables especially annual GDP data to quarterly GDP data This provides a good starting point to study the relationships between the money balance and other economic variables in the economic framework Further, this study can be adopted to estimate money demand in other similar developing countries as the Lao PDR Database The data used in this analysis is taken from the Bank of the Lao PDR The estimated sample uses quarterly data in the period from Q1/1993 to Q2/2010 Structure of dissertation Besides the introduction, conclusion, appendices, references, this dissertation includes chapters as follows: Chapter I: Overview of theoretical and empirical studies on money demand This chapter reviews the main theories of money demand in order to explore what factors can affect the demand for money It also presents some empirical studies on money demand The lessons learned from the literature survey will help select the appropriate modeling framework and choose suitable variables in the following chapters Chapter II: Lao financial system and monetary policy The overview of financial system development of Lao PDR will be presented in this chapter In particular, major developments of the banking sector in the last 20 years will be reviewed The monetary policy will be sketched with emphasis on the new role of the Bank of the Lao PDR The current pros and cons of BOL monetary policy raises the need to estimate the money demand function Chapter III: Demand for money in Lao PDR In this chapter, the empirical framework of money demand function for Lao PDR will be formulated and estimated, the specific problems in the case of Lao PDR will also be discussed Chapter IV: Policy implications Based on empirical estimation of chapter III, some policy implications for not only the Lao government but also for the BOL will be suggested in this chapter CHAPTER I OVERVIEW OF THEORETICAL AND EMPIRICAL STUDIES ON MONEY DEMAND 1.1 A brief theoretical overview 1.1.1 Quantity theory of demand for money The quantity theory of demand for money proposes a direct and proportional relationship between the quantity of money and the prevailing price level This relationship emerges within the classical equilibrium framework using two separate, but equivalent expressions The first expression is associated with American economist Irving Fisher and is called the “equation of exchange” The second expression is associated with Cambridge University’s Arthur C Pigou is called the “Cambridge approach” or the “cash balance approach” • Fisher’s “equation of exchange” The Fisher’s equation of exchange provides an important relation between four macroeconomic variables to determine the nominal value of aggregate income The four variables in the equation of exchange are the total amount money in circulation, M, an index of the total value of aggregate transactions, T, the price level of articles traded, P, and a proportionality factor V denoting the “transaction velocity of money” The equation is given below: MV = PT (1.1) The classical economists (including Fisher himself) built this relationship in the nineteenth and early twentieth centuries Since the classical One should note that while Fisher developed the algebraic formulation of the equation of exchange in 1911, it was John Stuart Mill who originally stated the relation, expanding on the ideas of David Hume economists believed that wages and prices were completely flexible, they posited that the level of aggregate output produced in normal economic period, Y, would remain at the full employment level, so Y is by definition is nation’s total potential level of output Fisher assumed that the ratio between the level of transactions, T, and output, Y, is reasonably stable ( Y = t × T ) and hence T can be treated as constant in the short-run Fisher believed that the velocity of money, V, is determined by the institutions in an economy, because these directly affect the way in which individuals conduct transactions For example, if consumers use charge accounts and credit cards to conduct their transactions, and consequently use money less often when making purchases, less money is required to conduct the transactions generated by nominal income (M decreases relative to PT) Hence, velocity, defined as ( PT ) / M , will increase On the other hand, if consumers find it more convenient to purchase items with cash or checks (both of them are counted as money), more money is used to conduct the transactions generated by the same levels of nominal income, hence velocity will fall Fisher theorized that institutional and technological features of the economy that affect velocity change only slowly over time, so velocity can safely be considered constant in the short-run By dividing both sides of the equation of exchange by V, we obtain the money demand function: M d = (1 / V ) / PT (1.2a) M d = kPY (1.2b) Or equivalently, Equation (1.2b) states that because k is a constant in the short-run (because V and T are constant in the short-run), PY, pins down the quantity of money that people demand, Md Fisher believed that people hold money only to conduct transactions and have no freedom of action in terms of the amount they want to hold The demand for money is determined by the level of transactions generated by the level of nominal income, PY, and by the institutions in the economy that affect the way people conduct transactions that determine velocity, V, and hence k Therefore, Fisher’s quantity theory of money suggests that the demand for money is purely a function of income Interest rates have no effect on the demand for money • Cambridge approach to money demand A group of classical economists, including Alfred Marshall and Arthur C Pigou in Cambridge, England, studied the demand for money by considering how much individuals want to hold, given a set of circumstances This approach is different from Fisher’s approach to money demand Fisher held the central assumption that individual demand for money is driven by the institutional environment, as this is the main factor that affects whether individuals use money (i.e., cash and check) to conduct transactions In the Cambridge model, the individual demand for money is not completely bound by institutional constraints such as whether one can use credit cards to make purchases Instead, individuals desire money because money is a medium of exchange and a store of wealth Cambridge economists concluded that money demand would be proportional to nominal income and expressed the demand for money function as: MD = kPY (1.3) In the short–run, k is the constant of proportionality and money demand does not depend on the interest rate However, money demand can depend on the interest rate when velocity is not constant over time From our discussion so far, the quantity theory of money emerges as the theory with a simpler approach to estimating money demand The estimating equation is 10 MV = PY (1.4) Where M denoted nominal money stock, V denotes the income velocity of circulation, P denoted the prevailing price level and Y denoted the real income Note that the elegant expression for money demand given by the quantity theory of money relies on the assumption of constant velocity In reality, however, the velocity is determined by technological and/or institutional factors, which experience large changes, especially during periods of financial liberalization In these cases, equation (1.4) cannot capture the complex relationship between the money demand and other macroeconomic variables Hence, we will turn to two other approaches to the theory of money demand: the Keynesian approach and Friedman’s modern quantity theory approach Both approaches consider the demand for money as part of the general problem of wealth allocation, but place emphasis on different aspects of the problems 1.1.2 Keynesian approach (John Maynard Keynes) In 1936, Keynes famous book, “The General Theory of Employment, Interest and Money”, abandoned the classical view of economics In its place, he offered a theory of demand for money that emphasized the importance of interest rates Keynes’ theory of money demand (referred to as liquidity preference theory), focuses on the factors that influence individual decisionmaking He postulated that there are three motives driving the demand for money: a transaction motive, a precautionary motive, and a speculative motive With this view, money demand is a function of real income (Y) and the interest rate (r) M / P = f ( r,Y ) (1.5) 11 Equation (1.5) has the key implication that velocity is not constant and is positively correlated with interest rates, which fluctuates substantially Initially, Keynes suggested a liquidity-preference schedule like the following equation, MD = M + M = M 1(Y ) + M ( r ) (1.6) where: MD is the total demand for money, M1 is the sum of transaction and precautionary demands and M2 is speculative demand In this schedule, transaction and precautionary demand depend only on the level of income, Y, where dM / dY > The speculative demand depends only on the level of interest rate, r, where dM / dr < The following sections review the work of other economists who have further developed the Keynesian theory of money demand 1.1.2.1 Transaction demand- Baumol-Tobin model The transaction motive is the demand for money rising from the use of money as regular payment for goods and services The trade-off is between the amount of interest an individual forgoes by holding money, the costs and conveniences of holding money Baumol and Tobin set up their model by analyzing a per-period model of an individual managing his wage in every time period, assuming that the person is paid in bonds an amount Y at the beginning of a period An additional assumption is that the amount Y is spent uniformly over the time period Each time the individual requires money for consumption, he has to convert bonds to money and incur two costs in the process: • Transaction costs, (tc), which represent the direct cost of converting bonds into money • Interest opportunity costs, which are forgone interest earned by converting bonds into money 12 Solving to find the optimal number of transactions yields the minimum sum of transaction costs and interest opportunity costs This solution can be used to derive a function of individual-level money demand that can be aggregated across individuals The aggregate money demand function can then be expressed as: M / P = rm = ( 2tcY / r ) 1/2 (1.7) Where M and P are the same as in equation (1.4), and, r represents the interest rate 1.1.2.2 Precautionary demand Precautionary demand is the demand for money held to meet unforeseen contingencies In a world of uncertainty, an individual faces risks with respect to income and expenditures Hence the individual’s problem is that it is costly for him to hold excess money in participation of uncertain expenditures because he will forego interest income for the money held In this case, the money demand equation is based on the trade-off between the expected losses from illiquidity (lack of money) and forgone interest It turns out that the optimal amount of monetary holdings is determined when the marginal cost of foregone interest is exactly equal to the marginal benefit from not being illiquid Miller and Orr analyzed the situation of uncertainty of cash flow, m, within a given time interval (e.g., 1/t), where t is the number of transactions within a period of time (e.g., one week) Assuming that money balances are bounded below by zero and bounded above by h, Miller and Orr solve for the optimal return level z Note that the bounds imply that if the balances are below zero, then z dollars of bonds are converted to money On the other hand, if the balances are above h, then z dollars of bonds are converted to a bond Note that there are the same determinants of money demand as in the transaction model 13 Miller and Orr formulate the problem such that the optimal level of z minimizes the expected sum of transaction costs and opportunity costs Using the same framework, they also solve for the optimal size of average cash balances M*: M * = / 3z* = / ( 3tc / 4r ) m 2t  1/3 (1.8) where z* is the optimal level of return and the other variables are the same as in equation (1.7) In equation (1.8), the level of balances demanded has a negative relationship with the interest rate, r The level of balances has a positive relationship with income, where income is expressed as the variances of changes in cash balances, m2t 1.1.2.3 Speculative demand Speculative demand for money arises from uncertainties about the money value of alternative assets that an individual can hold The portfolio balance model, developed by Tobin, has provided the most convincing theory of speculative demand for money Based on an assumption that the return on bonds is risky while the return on money is certain, Tobin’s model analyzes an individual’s optimal portfolio allocation between bonds and money The three most important components of this model are: − The probability distribution of capital gain from bonds, where the risk is measured by the standard deviations from the mean, − The budget constraint, which represents the individual’s feasible portfolio allocation, and − The utility map of the individual; (represented by indifference curves), which show the individual’s preferences over different portfolio allocations Tobin’s model implies that for a given level of wealth W, the amount of wealth to be help in the form of money is inversely related to the prevailing 14 interest rate Note that the distinguishing feature between different portfolios allocated is the balance between profitability and risk Although the Keynesian approach to analyzing the demand for money focuses on the three motives for holding money, the models not allow us to uniquely identify an individual’s particular motive for holding money However, this is not an important weakness of these models because all three motives together influence an individual’s optimal level of money holding Next we will review Friedman’s work (1956) as he developed a theory on the demand for money based on another approach: producer and consumer behavior 1.1.3 Friedman’s model of the demand for money In 1956, Milton Friedman developed the modern quantity theory of demand in a famous article, “The quantity theory of money: A restatement” He simply stated that the demand for money must be influenced by the same factors that influence the demand for any other asset An individual’s demand for money should be a function of his wealth and his expected relative (to money) return on alternative investments Friedman developed his theory on the demand for money within the context of the traditional microeconomics theories of consumer behavior and of the producer demand for input Consumers hold money because it yields a direct utility stemming from the convenience of holding an immediate form of payment Producers hold money because it is a productive asset which smooths the payment and expenditure streams over time Therefore, the sum of demand for money by both consumers and producers is the demand for real balances Intuitively, this demand should depend on the level of real income (or real output) as well as on the returns of alternative assets such as bonds or durable goods (for consumers) Therefore, the equation below gives us the demand function for real balances: 15 rm = M / P = f (Y , r1 , r2 , , rn ) (1.9) Where rm is the demand for real balances and sequence r1, r2,…, rn represent the real rates of return on alternative (i.e., non-money) assets In particular, Friedman considers durable goods as an important category of alternative assets to money for consumers With this view, the demand for consumers’ durable goods depends on expected inflation rates, πe, then, the demand function for real balances also depends on the expected rate of inflation rm = f ( y, r , π e ) (1.10) where drm / dy > , drm / dr < and drm / d π e < In conclusion, all money demand models can be broadly lumped into three separate frameworks namely transactions, asset and consumer demand theories of money The optimal stock of real money balances is inversely related to the rate of return on earnings of alternative assets and positively related to real income This is the starting point of all empirical studies 1.2 Some empirical problems in estimating money demand functions Money demand functions were first conducted in developed countries where financial systems developed and central banks realized the role of money demand in conducting monetary policy However, lately there has been considerable interest among several other industrial and developing countries All empirical studies base on a conventional textbook formulation of a simple theoretical demand for money function, rm = f ( r , Y ) , relating demand for real money balances (rm) to a measure of transactions or scale variables (Y) and the opportunity costs of holding money (r) However, the demand for money functions estimated for difference countries are not the same Because of the differences in definitions of dependent variables, available of scale variables, financial development,… 16 This section will discuss some issues related to estimating money demand function 1.2.1 Functional forms The money demand function commonly shown in macroeconomic textbooks is: rm = f (Y , r ) (1.11) However, this function is very general and does not suggest an immediate estimate equation for empirical analysis Hence, equation (1.11) is usually taken to express the contemporaneous relationship between economic variables combined with the assumption of log linearity The equation is generally modified as below: ln rmt = b1 ln Yt + b2 rt (1.12) If the coefficients of a regression equation such as (1.12) were estimated using time series data, there would be no dynamic dependence in the model due to the lack of lagged explanatory variables However, time series data are typically dependent on their previous values, i.e , the data observed during the period t − and earlier Therefore, lagged explanatory variables are necessary to obtain the correct model specification using time series data Generally, errors in model specification are often reflected in specific tests such as those for residual autocorrelation and heteroscedasticity For example, a naive application of a static regression such as (1.12) to time series data will likely exhibit a strong autocorrelation in the residuals This autocorrelation occurs because information concerning dynamic relations through the data is not reflected in any way by the static regression, so all this information is captured in the “unmodeled” part of the model, i.e., the residual From a purely statistical perspective, it is hence appropriate for models with time series data to include relevant lagged variables 17 To sum up, the standard demand for money function should include lagged dependent variables as one of the explanatory variables The lagged variable lnmt-1 has also been justified on the basis of dynamic models that incorporate partial adjustment or adaptive expectations 1.2.2 Choice of variables Definition of money Empirical studies have focused on three monetary aggregates M1, M2, and M3 The components of monetary aggregates differ from country to country and depend on many factors, e.g., a country’s level of financial market development Thus, we must be careful to conduct cross-country comparisons, as the dependent variables not have any uniform definitions In studies of Asian countries (reviewed in the next section), the definition of narrow money, M1, included only cash and demand deposits while in the American studies, M1 includes cash, travelers’ checks, demand deposits and other checkable deposits (Goldfeld and Sichel, 1990) Economists have shown that studies that interchange the use of M1, M2, or M3 to estimate the demand for money face the problem of estimating heterogeneous assets For example, cash and demand deposits may differ significantly in terms of transaction costs, financial risks, and the ease of concealing illegal or tax-evading activities One solution is to separately estimate the demand functions for cash and demand deposits This approach has yielded more robust empirical results, but it does not resolve the underlying empirical difficulties Any analysis on Lao PDR will face similar issues regarding the definition of money and should leverage the advances made by economists to deal with these empirical difficulties Scale variables Recently, scale variables were typically created by using data on a 18 country’s GNP, permanent income or wealth, measured in real terms A number of other related variables that move together with Gross National Product (GNP) such as net national product (NNP) and GDP have also been heavily utilized in creating scale variables without any significant differences induced by their substitution Traditionally, GNP has been used for transaction-oriented models, while the modern-quantity theories relied on permanent income Permanent income is most frequently measured as an exponentially weighted average of current and past values of GNP Since permanent income is often viewed as a proxy for wealth, the direct measures of wealth have also been used Given that financial transactions can generate a demand for money, the use of wealth is also consistent with a transaction view of the demand for money Empirical studies show that the choice of the scale variable must be tied to the sample period, the definition of money, and the specific country context When transactions-oriented models began to “misbehave”, it is natural to examine whether permanent income or wealth might improve the model’s results In more recent years, research on how to obtain scale variables has focused on two measures of transactions: the need to construct more comprehensive transaction measures, and the disaggregation of transactions into its various components, reflecting the observation that not all transactions are equally “money intensive” The construction of more comprehensive measures is motivated by the fact that even GNP is less inclusive than a more general measure of transactions In particular, the GNP excludes all scales of intermediate goods transfer, purchases of existing goods, and financial transactions, all of which may contribute to the demand for money The GNP may also overstate IMF Working paper, “Survey of literature on demand for money”, 1999, P.21 19 transactions because it includes impute items While these shortcomings of using GNP have been recognized for a long time, data limitations have prevented the construction of a more general measure of transactions Some researchers such as Judd and Scadding (1982a) substitute debits to GNP, but the effect of this substitution is small Whichever measure of transactions is ultimately chosen, the question of whether it can be disaggregated into several scale variables remains an open question For example, if real GNP is the basic scale variable, one might separately enter some different components of GNP as each category is likely to generate a different payment need For example, one might posit that consumption is the most money-intensive component of GNP However, while there are some promising indications, there is no clear evidence that disaggregated measures of GNP yield worthwhile improvements to understand the aggregate demand for money Economic aggregate proxies for scale variables in estimating demand for money function depend much on the development of statistical systems and available data Opportunity costs of holding money Interest rates in money demand includes two groups: the own-rate of money and the rate of return on alternative assets Tobin (1958) and Klein (1974) argue that both of these rates are important and should be included in any model for money demand However, perhaps for ease of empirical analysis, several economists in the U.S treat the explicit own-rate as zero in the period before 1980 Regarding the return on alternative assets, the researcher has several choices Those with a transactions view of demand for money use more shortterm rates like the yields on government securities, commercial paper, or saving deposits The argument for using these alternatives is that they are 20 closer substitutes for money and hence their yields are especially relevant when deciding how much cash to hold Those considering a less narrow view of the demand for money can use a boarder set of alternatives that includes the return on equities, yields on long-term government or returns on corporate bonds Previous work has also incorporated foreign interest rates and the expected rate of depreciation for domestic currency In countries where the financial sector is not highly developed and also suffers from hyperinflation, the expected rate of inflation is also a useful variable to calculate the opportunity cost of holding money The reasons for using this variable are four-fold4: first, there is a limited substitution between money and alternative assets due to the underdeveloped financial markets outside the banking system; second, interest rates may show insufficient variations for a long period of time because they may be regulated by the government; third, payment of interest is legally prohibited in some countries; and finally, time series data on the interest rates may simply not be available 1.2.3 Empirical estimation problems The ‘missing money” The number of empirical studies on the demand for money function exploded between the 1960s and the 1970s with American economists leading the movement, according to Tomoo Yoshida (1990), these studies stayed with the frame of a particular adjustment mechanism to estimate the “standard” money demand function according to traditional macroeconomic theory It is interesting to note that in the U.S., the interest rate generated a significant effect on the amount of money demanded Equation (1.13) is a simplified specification of a model from this time period: ln rmt = a1 ln Yt + a2 rt + a3 ln rmt −1 IMF Working paper, “Survey of literature on demand for money”,1999, P.25 (1.13) 21 where rm (equal to M/P) is the real demand money, Y is real income and r is the interest rate Note that rm and Y are transformed to the natural logarithmic scale in equation (1.13) Goldfel (1973) is particularly representative of the studies during this period In fact, Goldfel’s work is often regarded as the culmination of the farranging research that took place during this period Equation (1.13) includes a one-period lag in the real money balance as an explanatory variable in addition to income (Y) and interest rate (r) The basic form of this model has survived time and many researchers still use this specification In the mid-1970s, the consensus on the stability of the money demand function began to break down In 1976, Enzler, Johnson and Paulus pointed out that the poor performance of the 1973 models on the out-of-sample, post-1974 period The problem was that the 1973 models consistently overestimated money demand in the post-1974 period Goldfel (1976) coined the term “missing money” to explain this phenomenon He argued that the overestimates were at least partly attributable to a shift in the money demand function resulting from financial innovation such as the introduction of NOW accounts and MMMFs In the U.S., tracing the “missing money” renewed interest on studying the stability of the money demand function These studies can be divided into three broad categories: • Attempts to improve the explanatory power of the money demand function by including explanatory variables such as wealth and bank debits, • Attempts to incorporate the explicit effect of financial deregulation into the money demand function by introducing the racket effect of high interest rate, and • Attempts to better incorporate effects of financial deregulation on money supply by adopting artificial money supply aggregates as additional model components, i.e., as additional dependent variables 22 Spurious regression The problem of spurious regression arises when a regression equation contains independent variables that are random walk or non-stationary variables Nelson and Plosser (1982) conducted ADF tests using annual data on key macroeconomic variables in the U.S., such as nominal and real GNP, industrial production index The number of people employed, the unemployment rate, the GNP deflator, the consumer price index, the nominal and real wage indices, the money supply, the interest rate and the price of publicly traded stocks To their own surprise, Nelson and Plosser could not reject the null hypothesis that each of these variables followed a random walk pattern, with only one exception: the unemployment rate In time series analysis, the properties of each series of data must be clearly known since estimation methods such as ordinary least squares only work when data series is stationary If the regression equation includes one or more nonstationary variables, familiar statistics such as the coefficient of determination and t-values no longer have conventional distributions Consequently, these types of regression equation are likely to lead us into incorrect inferences To address this issue, Phillips (1986) investigated the case of regression between two mutually independent random walk variables The highlights of his findings are summarized below: • Since the conventional t-values not have a limiting distribution, it does not have an asymptotically correct set of critical values If the set of critical values for a normally distribution variables is used, the probability of finding a significant relationship between the two variables will increase with the sample size • The coefficient of determination (R2) has a non-degenerate limiting distribution, hence we expect moderate values of R2 23 • As the sample size approaches infinity, the Durbin-Watson (DW) ratio approaches zero To avoid the problems with spurious regression as demonstrated by Granger and Newbold (1974) and Plosser and Schwert (1978), Hafer and Hein (1980) and Gordon (1984b) showed that it is preferable to estimate a money demand function such as (1.14) that contains a first differenced term In this case, the specification becomes: ∆ ln rmt = a1∆ ln Yt + a2 ∆rt + a3∆ ln rmt −1 (1.14) On this topic, Hendry, Pagan and Sargan (1984) and Engle and Granger (1987) pointed out that regression using the first difference form of economic variables, equation (1.14), is different from equation (1.13) in an important way In particular, equation (1.13) does not address the concern that such a regression equation may not be reliable when the information on variables levels is important, i.e., when a group of variables is “co-integrated” 1.3 Some Asia-specific studies on the money demand function A large body of literature is available to estimate money demand functions Initial work in this area was confined primarily to industrial countries, especially the U.S and the U.K However there has also been considerable attention paid to studying the money demand function in developing countries in Asia and South East Asia Various central bank officials realized that understanding the money demand function is a cornerstone of monetary policy In this section, the set studies are carefully chosen on the basis of potential relevance to the Lao PDR context • Fan and Liu (1970)5 This paper uses annual data from 1953-68 for nine Asian countries The most robust finding is that real income is positively correlated with the This study is summarized in Hossian and Chowdhury (1996, P.16) 24 demand for real money balances The authors use actual income (not permanent income) in their analyses and justify this by arguing that the concept of permanent income is meaningless in developing country economies that are not stable Fan and Liu find that the opportunity cost of holding money is given by the call money interest rate in Japan, Korea, Philippines, Thailand, and Myanmar For countries like Taiwan, India, Pakistan and Sri Lanka, the opportunity cost of holding money is given by the government bond yield Fan and Liu found that the effects of interest rate on the demand for money are significant and have mixed signs In some countries, it has positive effects, but in the others, negative effects In the case of Lao PDR, the interest rate has an effect on the behavior of the money market For context, the government has liberalized the economy, including money market If the difference between the interest rate and the return one can obtain via the black market is very high, then many commercial banks face difficulties in collecting money via savings from consumers However, the number of private commercial banks is increasing in Lao PDR This market entry partly reflects the observation that the country’s interest rates are responsive to the market’s signal Thus, the higher the interest rate, the lower the demand for money In the Lao PDR, individuals face the negative opportunity costs of holding money • Aghevli et al (1979) Hossian and Chowdhury (1996, p 165) also highlight the study of Aghevli et al (1979), which covers six Asian countries: Indonesia, Malaysia, Philippines, Singapore, Sri Lanka and Thailand The study treats the demand for money as a function of actual income, expected rate of inflation and lagged real money balances In their model, the opportunity cost of holding 25 money is given by the expected inflation rate and not the interest rate The period of data analyzed is 1975 to 1978, as these are three years during which all of the countries in the study had been following a policy of financial repression by controlling interest rates In these countries, the monetary authorities typically kept the interest rate below the market-clearing rate The estimated result from using a partial adjustment mechanism framework shows that the demand for real money balance has a significant relationship with real income, the rate of inflation and the lagged real money balance The only exception to this is Singapore, where the coefficients are not significant at the 95% confidence level Estimating the money as demand function by including the expected inflation rate as an explanatory variable has been used to study hyperinflation as well For example, Kate Phylaktic and Mark P Taylor use this type of model to study the monetary policies in Argentina, Bolivia, Brazil, Chile and Peru during the 1970s and 1980s These studies find that inflation is a statistically significant and useful predictor of the demand for money Thus, studies that are undertaken to understand hyperinflation during the 1980s and 1990s in Lao PDR would likely benefit by incorporating inflation as an explanatory variable in the model • Khan (1980) Khan studied the demand for money in 11 countries: seven Latin American countries and India, Malaysia, Philippines and Thailand The study is worth noting because of the amount of data used in the empirical analyses, as Khan studied these countries from 1962 to 1976 (Hossian and Chowdhury 1996, p 165) The study confirms the results documented by Aghevli et al (1970): there are significant relationships between real money balances, actual income, and expected rate of inflation 26 • Tseng and Corker (1991) Tseng and Corker specified an error-correlation model for their study Their study uses the data from the period of financial liberalization (19701989) and shows that interest rates had moved in line with the actual economic situation The implication is that the opportunity cost of holding money is given by the interest rates and not the expected rate of inflation Table 2.1 shows that income and interest rates have a significant relationship with the demand for money The sign of income is positive and interest rate is negative Therefore, in order to preclude spurious results, we must test for unit roots before choosing an estimating equation Another observation for table 1.1 is that in the hyperinflation countries, inflation is a better predictor of money demand than the interest rate It is useful to note that in financially liberalized countries, income and interest rates are fitted explanatory variables Table 1.1: Estimated income elasticity and interest rate semi-elasticity for selected Asian countries Period of study Interest rate Country Income elasticity (year and quarter) Semi-elasticity 1974II – 89IV Indonesia 1.16(28.1) -0.66(3.0) 1970I – 89IV Korea 0.79 (35.6) -0.84 (3.6) 1970I – 89IV Malaysia 1.11 (74.0) (No data) 1970I – 89IV Myanmar 1.27 (37.9) (No data) 19970I – 89IV Nepal 1.75 (48.2) (No data) 1973I – 89IV Philippines 0.67 (9.0) -1.16 (4.4) 1975I – 89IV Singapore 0.86 (55.4) -1.17 (5.65) 1978I – 89IV Sri Lanka 0.92 (12.8) -1.60 (5.6) 1977I – 89IV Thailand 0.85 (40.8) -1.53 (6.1) Note: Parentheses indicate t-statistics Source: Tseng and Corker (1991) 27 • Watanabe S and Pham T B (2005)6 Watanabe and Pham tried to find the relationship between broad money and inflation by decomposing the demand for money into the demand for domestic currency and the demand for foreign currency in view of the fact that Vietnam is highly dollarized The empirical analysis employs cointegration, error correction model, impulse response and variance decomposition and uses quarterly data over the period 1993-2004 This paper found that the long run demand for real broad money of domestic currency is determined by real income, domestic interest rate, inflation rate and rate of return of USD deposits, which satisfies the standard properties of the demand for money The long run demand for real foreign currency deposit is determined by real income and the difference between rates of returns of foreign and domestic currency deposits, that represents asset substitution Demand for real foreign currency deposits is found to be very sensitive to the difference between rates of returns of foreign and domestic currency deposits, especially exchange rate depreciation A positive difference between rates of returns of foreign and domestic currency deposits triggers a shift from domestic financial assets and real assets to foreign financial assets, resulting in a lower inflation rate and a strong increase in demand for foreign money When this effect is very strong, then even an increase in broad money, including foreign currency deposits, may negatively correlate with inflation • Nguyen, D H., and W D Pfau, (2010)7 This paper investigated the money demand function in Vietnam by using Watanabe, S and Pham, T.B (2005) “Demand for Money in Dollarized, Transitional Economy: The Case of Vietnam” Paper presented at the 1st VDF-Tokyo Conference on the Development of Vietnam Nguyen, D H., and W D Pfau, (2010) "The Determinants and Stability of Real Money Demand in Vietnam, 1999-2009." GRIPS Discussion Paper 10-14 Tokyo: GRIPS 28 co-integration analysis and a reduced-form short-run error correction model over the period of 1999-2009 It found evidence for a co-integrating relationship between the real money demand, income, the foreign interest rate, and the real stock price More importantly, statistical tests show that real money demand in Vietnam is stable in this period Although Watanabe and Pham found a statistical significance for domestic interest rates in 1993-2004 for the long-run analysis of real money demand, the estimation in this study provides no evidence that domestic interest rates influenced long-run real money demand in the period from 1999-2009 This implies that a rigid interest rate policy might become ineffective when the economy is opening, following milestones such as the establishment of the Vietnam-US Trade Agreement in December 2001 and accession to the WTO in November 2006 In the context of Vietnam's increasing integration into the world economy, interest rate policies need to be reformed towards market principles in order to improve the effectiveness of monetary policy Conclusion of chapter The demand for money is a proportion of income level In addition, most of the models assume a relationship between money demand and transactions The specific relationship is context-specific with regard to the industrial structure, financial development, and institutional arrangements of a particular country in a given time period For example, two countries with the same income level may have very different aggregate demands for money if one country has an agro-based economy while the other has a service-based economy We might expect the country with an agro-based economy to have 29 a higher aggregate demand for money, perhaps because the transaction velocity in agriculture is lower than that in services Another example of how two countries with the same income level can have a developed credit system, as this can reduce the demand for narrow money, M1 A demand for money is constrained by a measure of wealth that can be proxied by either income or permanent income The demand for money fluctuates with changes in the opportunity costs of holding money This opportunity cost depends on the relative return on non-money assets such as other financial investments and real goods Expectations are important The demand for money depends not only on the prevailing level of factors such as the interest rate and inflation, but also on the future expected values of each of these factors In the case of dollarization, interest rates of dollar and exchange rates are also an interesting explanation for demand for money balances In the developed countries, the nominal interest rate considers an appropriate proxy for the opportunity cost of holding money, whereas the weak financial markets and administrative interest rates are the overriding feature in most of the developing countries In most developing countries the nominal interest rate is institutionally determined; it does not fully capture the opportunity cost of holding money Furthermore, administrative nominal interest rates are not often adjusted for changes in inflation and consequently the real interest rate becomes negative To overcome this problem, , researchers often use the consumer price index as the proxy for the interest rate variable In fact, the asset substitution in developing countries usually occurs between money and real assets as inflation hedges and not between money and other financial assets Thus the expected rate of inflation rather 30 than the nominal interest rate can be regarded as a better proxy for the opportunity cost of holding money in developing countries In the next chapter, an overview of the financial system and current monetary policy will be presented With this, the researcher can choose suitable variables for estimating demand for money function for Lao PDR Scale variable Gross Domestic Products Measure of Economic Activity The Determinants of Money Demand function Nominal Interest rate Vector of Opportunity Cost Variable Inflation rate Assets Substitution Exchange rate Currency Substitution Foreign Interest rate Foreign Factors Figure 1.1: Determinants of money demand function 31 CHAPTER II LAO FINANCIAL SYSTEM AND MONETARY POLICY 2.1 Economic development Lao PDR is a small and land-locked country in Southeast Asia, bordering China, Vietnam, Cambodia, Thailand and Myanmar The total areas cover 236,800 square kilometers with total population of 6.2 million From 1893 to 1975 during its colonization and under the monarchy regime, Laos was at the very early stage of development with a self-reliant economy system The degree of monetization in the economy was limited, and there was a lack of infrastructure However, the country has abundant natural resources, such as fertile land, dense forests, water resources and mining 80 percent of population engaged in subsistence agricultural farming, utilizing traditional tools to plow and cultivate rice production for economic survival The Industrial sector was restricted to hydropower sector, and the mining industry was mainly zinc production in Khammouane province Transport and communication was difficult, creating barriers for the distribution of goods and people domestically and internationally Social indicators depicted a very low level of socio-economic development as demonstrated by the high degree of poverty, high illiteracy rate, low life expectancy and very high risks in the public health sector Since 1975 Lao PDR followed a centrally planned economy After the transformation from a centrally planned economy into a market-oriented economy in 1988, Lao PDR continued to expand with an annual average growth at percent per annum as depicted in Figure 2.1 After the promulgation of Law on foreign investment promotion came into effect in 1988, foreign direct investment increased rapidly, which became a major 32 factor driving economic growth According to IMF report (2006), direct foreign investment contributed to Lao GDP growth by percent annually In the Asian Financial Crisis (1997 to 2001, foreign investments slowed, pushing down economic growth In 1998 the Lao economy grew by only percent per annum However, when macroeconomic stability regained, the economic growth expanded with an average growth of 7.5% - 8% per annum During the last two decades, which began in 1990 to 2010, Lao PDR began to address some important economic problems, such as: • Completely solve the problem of foodstuff shortages since 1998 and also maintain for reserves for emergency purposes like the natural disaster which occurred in 2008, Lao PDR did not need to import rice Exports rose to a total of 100,000 tons per year; • Completely eliminated the opium plantation in 2005; • Completely eliminated slash and burnt practice at the basic level by 2010; • Basically diversified economic the structure to be consistent with industrialization and modernization: In 1990 the agriculture sector dropped from 62.9% to 30.6% in 2010; the Industrial rose from 15% to 29.8%; Service sector rose from 26.8% to 39.6% respectively, as shown in figure 2.2 • Resist the Asian financial crisis and prevent the spilled over effect from the global financial crisis 2007-2008; • Address the poverty of the people to the level of 24% in 2010; • Set a strategy to take the country off the list of least developing countries by 2020 by maintaining economic growth threefold compared to 2006 and income per capita to US$ 1,700 dollar 33 Figure 2.1: GDP growth (1991-2011) Source: BOL Figure 2.2: GDP by Components (billion Kip) Source: BOL 34 2.2 Overview of monetary developments in Lao PDR In Lao PDR, the overriding objective of monetary policy conducted by the Bank of the Lao PDR (BOL) is to achieve price stability and sustained economic growth The monetary authority’s strategy for inflation management is based on the view that inflation is essentially linked to currency stability and monetary growth Because targeting exchange rate level and money supply growth are considered as an appropriate method of targeting inflation, the BOL chooses an exchange rate anchor and monetary targeting policy framework to achieve its objective of price stability and economic growth With the exchange rate and broad money (M2) as the intermediate target, and the exchange rate and monetary base as the operating target, the BOL utilized combined monetary tools of direct and indirect (market-determined) instruments to achieve its monetary objectives These instruments included reference exchange rates, reserve requirements, open market operations on Treasury bill, liquid asset ratios and the discount window Following the monetary framework as mentioned above, the monetary sector has gradually played a significant role in economic development since the financial crisis in 1997 Noticeably, since 2007 the ratio of M2 to GDP has increased sharply without creating high inflation; and GDP growth continues high The Kip ratio has been gradually increased during the period of macroeconomic stability with stable currency and low inflation rates However, a degree of multicurrency’s use was still high as can be seen in the ratio of foreign currencies to total deposits which has been more than 50 percent over the last two decades (Figure 2.3) This can be explained public confidence needs time to develop because Lao people had been living with high inflation and a declining Kip for a long time 35 Factors which explain the persistence of this multicurrency use are the underdevelopment of the money market, the limited scope of interbank transactions, inactive OMOs and nonexistence of a bond market In addition, there was a history macroeconomic instability such as high inflation and exchange rate volatility As a result, assets and currency substitutions were an alternative method of hedging This can be seen in the ratio of foreign currency to total deposits which rose to the peak in 1997-99 when the inflation rate also peaked Figure 2.3: GDP growth, Inflation rate, M2 growth, M2 to GDP and FX to total deposit Source: BOL 2.3 Banking system During 1893 to 1951, France delegated the absolute power or monopolistic power/right to the Indochina bank, a French private bank, to have exclusive rights to print banknote called “Piastre” was circulated and was used in three Indochina countries In December 1950, France transferred the exclusive rights to print banknotes from the Indochina bank to banknote 36 printing house (Institut d’Emission des Etats du Cambodge, du Laos et du Vietnam or Issuing Authority of the (Associated) States of Cambodia, Laos and Vietnam) annexed to Indochina Bank, located in Cambodia, to print system banknotes (Piastre) Each country also had its own banknote printing house to print Piastre to be used These banknotes, however, were legal tender and were used in Indochina countries until 1955 It was not until 25th December 1954, that the Lao central bank was called National Bank of Laos established by Laos after the National banknote printing house was dissolved The Central Bank of Laos started to print the banknotes called “Kip” for the first time on 5th May, 1955 to substitute the Piastre Since then, Kip banknotes had officially been issued and introduced by the central bank of Laos and became a legal tender banknote in the Lao territory So banknotes issued by the National Bank of Laos during the era of the monarchy in 1955 were also terminated in 1976 after the abolition of the monarchy and the establishment of Lao PDR A "tri-coalition" government which was formed for second time in 1962 also issued its banknotes, which was called Kip Khangkhay This banknote was used for the administration of the government In 1968, KhangKhay banknotes were abolished Since 7th October 1968, the Lao Patriotic Front declared the official establishment of a bank named Pathet Lao Bank (Bank of Laos) at the economic and financial cave in Nakai Village, Viengxay District, Houaphanh province and the Bank used its own currency, which was called Kip PotPoi (liberated currency Kip) circulating in the liberated zone In March 1976, the banking sector was formed as a unified system by transforming the National Bank of Laos and some commercial banks in Vientiane under the monarchy regime by consolidating with the Pathet Lao 37 Bank of the Lao Patriotic Front in Viengxay district to establish a unified or a single bank called the National Bank, with headquarters in Vientiane municipality On 13th June 1976 the Central Party Committee and the government of Lao PDR reached an agreement to replace the Kip issued by the Vientiane-led front by the Kip Potpoi at the rate 20 Kip Vientiane versus Kip Potpoi After that, to further improve the monetary regime in line with the new regime, on 10th December 1979 the Central party Committee and the government of Lao PDR agreed to reform the Kip Potpoi that had been circulated in the country for over 10 years, which started from 1968 and change to the Bank’s currency called “Kip” The change of 100 Kip Potpoi was equal to Kip of the new currency banknote Afterwards, the Supreme People’s Assembly issued a Law on the monopolistic rights of the banking sector No:001/81/SPC, dated 21st August 1981, the National Bank changed its name to the State Bank, which practiced a mono-bank system with its main functions as follows: printing banknotes for circulation, managing the money supply in the economy, responsibility for domestic payments and settlements, serving as the agent of the government for the budget revenue and expenditure treasury, financing the state enterprises according to the Economic Plan of the central government and mobilizing the savings from the general public as additional funds in addition to banknote printing for lending to individuals, state enterprises and different cooperatives through Bank branches located in Vientiane and the provinces 2.3.1 Mono-bank system After the proclamation of independence of the Lao PDR in 1975 until October 1988, the structure of banking system during this period was similar to the Soviet-style banking system The nature of banking sector in Lao PDR 38 had been similar to the centrally-planned economy The banking system consisted of mono-bank system with state bank’s head office located in the central level, and its branches located in the provinces and sub-branches in districts and performed their functions both as the central bank and commercial banks The main function of the State Bank was a deposit taking from the state enterprises and provided loans to the state enterprises; a function similar to the national treasury and controlled the money supply under the centralized economic planning of the government In this period the government supervised the banking sector The banking system implemented only the functions as the management of the state and, financial services provided expenditure disbursement for the state budget The monetary policy and the credit of the State Bank were performed according to cash and credit plans established Monetary objectives were based on the credit plan which identified the financial needs for fiscal purposes and enterprises rather than monetary objectives This kind of setting demonstrated that cash in circulation plans and credit plans were designed and formulated based on demands at a micro-level without taking into account the needs at the macro level For example, credit was provided on the basis of principles: (1) credit shall be provided on the basis of the plan set; (2) credit shall be provided for specific targets; (3) credit shall be provided based on the availability of goods; (4) credit shall be provided on the basis of repayment ability; and (5) credit shall have a definite period of maturity Therefore, the Lao banking system had to provide funding directly to the budget by providing loans to finance the budget deficit and indirectly by providing cash and credit to the state enterprises according to the plan set by state enterprises The role of monetary policy accommodated the large credit demands of state enterprises Credit plans established at the beginning of the year had a little 39 operational significance, as they were exceeded by wide margins Interest rates have played virtually no role in the allocation of credit, because of their low levels This induced credit growth in 1986-1987 The factors which contributed to the acceleration in credit growth were as follows: First, an increasing number of state enterprises were given greater financial autonomy under the application of the New Economic Mechanism and, as a result, the budget reduced the supply of liquid funds to these enterprises, giving rise to the need for larger bank credit Second, commercial credit rose sharply following the trade liberalization, which led to a surge in the volume of domestic trade across provincial and district boundaries This was reinforced by the drought, which caused an increase in rice shipments from surplus to deficit areas And, third the large depreciation of the official exchange rate for some transactions led to larger credit requirements to finance imports In summary, the banking system before 1988 had performed its role based on the principle of a centrally-planned system which was considered as an inefficient way since the banking operation and management was carried out in line with a centrally planned system This had some weaknesses: (1) the main sources for providing credit was from the banknote printing, the cost of funds were very cheap (low interest rest) which resulted in high demand for borrowing by state enterprises and numerous collective cooperatives to be used in their business operations and forced the central bank to provide more loans, causing bank credit to deal with many non-performing loans Furthermore, the interest rate did reflecting the variation market-oriented conditions, restricting the bank’s capacity to mobilize deposits for financial resources for lending into the production sector The payment and settlement system had the problem of liquidity; the banking system itself had not clearly defined its roles between the central bank and the commercial banks as was the case in developed countries 40 In order to ensure the success of the new market-oriented economy process and prepare for global challenges, the Lao banking system needed to be transformed into a two-tier banking system which performed better than the mono-bank system the country had since 1988 2.3.2 Banking system reform Since 1988 the government of the Lao PDR implemented several measures to implement banking system reform towards the era of economic openness and a market-oriented economy, and transformed the banking sector to improve fund mobilization and financial intermediary functions to maximize the allocation of financial resources effectively To achieve, the Council of ministers approved the resolution No 11/PM, dated 12th March 1988 on the transformation of the banking sector into a commercially-oriented system which aimed at restructuring the State Bank from a mono-bank system to be replaced by a two-tier banking system consisting of: the Bank of the Lao PDR and commercial banks The main objective was to strengthen the functions and mandates of the Bank of the Lao PDR, at the same time phasing out its function of commercial banking at the provincial level to commercial banks The function between the central bank and commercial banks was clearly and formally divided in June 1990 when the law on the establishment of the Bank of the Lao PDR began This law created the Bank of the Lao PDR and gave power and obligations similar to the central bank of developed countries The Bank of the Lao PDR has become a Central Bank of the Lao PDR as one organization of the Council of Ministers, with main the function being maintaining the stability and value of the domestic currency associated with price management and foreign currency management to ensure flexibility and 41 efficiency of the performance of the banking system The function of the Bank of the Lao PDR is to serve as lender of last resort to commercial bank, responsible for issuing or revoking the banking license to commercial banks, and the BOL also has a degree of autonomy in macroeconomic management relating to monetary management The government issued the decree on commercial banks No.3 in 1992 which has become the legal or basis to transform the branches of the State Bank into commercial banks performing operations with autonomy and opening up the banking industry to several types of banking by having other economic sectors to invest in the banking sector Lao banking reform has gone through different stages of development depending on the growth and the needs of banking expansion and government policy from time to time 2.3.2.1 The first period: transformation from a mono-bank system into a two-tier banking system Under New economic mechanisms implemented in 1986, the banking sector was transformed from a mono-bank system into a two-tier banking system, which began in October 1988 First, the first and the second branches of the State Bank in Vientiane were transformed into two commercial banks, namely Nakhonlouang Bank and Sethathirath Bank Second, BCEL (Banque pour le Commerce Exterieur Lao) was transformed into a commercial bank in November, 1989 These three state-owned commercial banks (SOCBs) were based in Vientiane After that, other branches of the State Bank around the country merged into three state-owned commercial banks in 1990 namely PhakTai Bank, Lao May Bank and LaneXang Bank with head offices based in such as Champasack province, Savannakhet province and Louangprabang province respectively The transformation of branches of the State Bank was 42 completed in September 1991 after the Alounmay Bank was founded with the head office in Xiengkhouang province as the result of merging branches of the State Bank in Houaphanh province and Xiengkhouang province In 1988, Law on foreign investment promotion was promulgated This Law defines investment policy to attract foreign investment in Lao PDR In the banking sector, foreign banks also began to expand their branches in Lao PDR In October 1989, the Joint Development Bank was founded It is the first time that the private sector set up a joint venture bank with 70 percent of shares belonging to Thai private businessman and 30 percent of shares owned by the State Bank However, the separation of functions between the central bank and commercial banks and the transformation of a mono-bank into a two-tier banking system was not completed until September 1992, when foreign currency management, previously supervised by the BCEL, was transferred to the Bank of the Lao PDR to further supervise according to the functions of macro management foreign currency Starting from 1992, the Lao banking sector started to expand and face competition The Law on foreign investment was enacted in 1988 The first foreign bank branch to operate in Lao PDR was the Siam commercial bank, which began operations in December 1992, followed by branches of foreign banks, namely, Thai Military Bank, Kasikone Thai Bank, KrungThai Bank and Bangkok Bank, these banks were opened at the same period in Lao PDR in 1993, then Krungsi Ayuthaya Bank was established in 1994 In addition to branches of foreign banks opened, in 1993, Vientiane commercial bank, a private joint venture bank between the Lao private sector (25percent share) and foreign investors from Australia, Taiwan and Thailand (75 percent share), was established After that, the Agriculture Promotion Bank (APB), a stateowned commercial bank was set up in 1993 APB was set up to perform the 43 role of providing financial service for rural development by receiving financial resources from the government and by implementing a subsidized interest rate policy determined by the government In the meantime, other commercial banks, which had not lent to rural development or agriculture sector, contributed 10 percent of saving mobilization to APB to enable APB to provide lending to promote rural development Banking reform was centered on the building capacity of the banking sector to mobilize deposits, attract foreign investments in the banking industry and improve the quality of financial services Banking reforms achieved during this period were that the performance of the banking system gradually improved, and this contributed to the stability of the financial system and better and efficient resource allocation Factors which contributed to improve the banking sector were: (i) allowing the public to make deposits in foreign currencies, which led to increased public confidence in the banking sector, (ii) maintaining positive interest rates on deposits to enable more deposits; (iii) more foreign banks entered in the banking industry improve efficiency; (iv) giving licenses to the private sector to open money changers, and (v) BOL introduced a banking supervision policy for commercial banks which gave public confidence in the banking sector Nevertheless, informal lending markets widely emerged during this period These included credit cooperatives which offered interest rates on deposits and lending higher than commercial banks The operations of credit cooperatives which offered attractive interest rates, eventually went into bankruptcy later on After public confidence was restored in the banking sector, the public withdrew money from the cooperatives and redeposited it in banking sector Consequently, the cooperatives had financial difficulty and ceased their operations 44 2.3.2.2 The second stage: state-owned commercial bank (SOCB) reform As banking reform has progressed in recent years, recapitalization of banks is needed to improve the financial operations The diagnostic analysis of non-performing loans (NPL) and doubtful loans of SOCBs were implemented during 1991-1992 Following the audit of state-owned commercial banks, recapitalization of seven SOCBs was made in the amount of 14 billion Kip, which comprised a cash injection of billion Kip in March 1994 and the issuance of 10 billion Kip in government bonds in August and September 1994 However, the performance of banks in general remains weak and lack motivation even after recapitalization In 1997, an external audit on banks was carried out for operations of seven SOCBs Reports of the external audit suggested that credit officials lacked tools to implement their tasks effectively by not giving close attention to some standard indicators on credit quality Internal control was weak The regulations of BOL, internal rules and regulations were not strongly enforced Many loans lacked of sufficient collateral and there was a lack of provisions for bad loans and inadequate supervision Moreover, the Asian financial crisis in 1997 caused the rapid depreciation of Kip against US Dollar and consequently caused a negative impact on financial positions of banks, making the rate of debt collection deteriorate in 1997 Therefore, restructuring of SOCBs was the top priority of banking reform: (i) by merging small banks at provincial levels from seven banks into three state-owned commercial banks with head offices based in Vientiane namely BCEL, Lao May bank and LaneXang bank; (ii) along with restructuring SOCBs, the Bank of the Lao PDR also issued new regulations on loan management, regulations on capital adequacy, regulations on lending 45 to large borrowers, regulations on foreign exchange exposure and etc.; (iii) Bank Supervision Department was also set up by BOL to supervise the commercial banks with the implementation of existing regulations In particular, in connection with its on-site examination and off-site examination; (iv) Depositor Protection Fund, established in 2000 to protect the interest of depositors of commercial banks; (v) BOL also issued regulations on credit information bureaus (CIB), compilation and exchanges of information among borrowers and records of loan payment Due to the weakness of management and the weak financial performance of banks, which resulted in an unstable macroeconomic environment and put pressures on state enterprises, the severe depreciation of domestic currency during 1997-1998, contributed to a negative impact on the balance sheets of banks and created many NPLs, which was about 70 percent As the level of NPLs and bad debts SOCBs increasingly expanded, this had a negative impact on the financial performance of SOCBs In order to further restructure SOCBs and comply with international standards, the government of Lao PDR sought technical assistance from the Asian Development Bank to strengthen SOCBs by having another round of restructuring 2.3.2.3 The third stage: restructuring SOCBs Another round of restructuring took place in November 2003 During this period, there was a governance agreement signed between three parties, namely the Ministry of Finance (MOF), the Bank of the Lao PDR and SOCBs (BCEL and Lao Development Bank: merging LaneXang Bank and Lao May Bank) Both SOCBs had to implement conditions set in the governance agreement by adopting new management styles with the help of international banking advisers dispatched to these two banks to advice and monitor the implementation of necessary standards such as implementing 46 programs: (i) business plans, (ii) plans for dealing with NPLs, (iii) plans for an efficient and effective organizational reform, (iv) plans for human resource development (HRD), (v) fixed assets, (vi) technology development and (vii) fund accumulation and increased capital Recapitalization plans for these two banks to comply with the standard practices of banks were prepared, so recapitalization of the banks depended on SOCBs compliance with the standard indicators set annually with certified performance by banking advisors and committees set up by BOL who monitor the progress of the program and set the criteria To implement these targets, the committee had to prepare a progress report submitted to Ministry of Finance and then the Ministry of Finance decided to recapitalize banks by issuing bonds to BCEL in three installments with a total amount of 325 billion Kip So the recapitalization was completed in 2008 LDB recapitalization was made in four installments with total amount of 225.8 billion Kip by November 2010 Restructuring of SOCBs enabled banks to perform better, generating some profits and improved financial performance Therefore, the restructuring of SOCBs ended in 2010 Following the restructuring of SOCBs, the government decided to restructure APB in 2007 by transforming it into a commercially orientedbank The restructuring of the APB started with clear separation of lending between policy and lending and sources of fund to transfer to government (In practice, policy lending was transferred to Nayoby Bank), while lending from deposit mobilization by APB shall be kept with APB The Restructuring of the APB was carried out in line with criteria and programs similar to what had been implemented with two SOCBs as discussed above Recapitalization of APB also depended on criteria and indicators set in the governance agreement The Restructuring of the APB was completed in 2011 As of 2010 total amount of recapitalization for APB by MOF 47 amounted to 139.8 billion Kip of which 15 billion Kip was in cash and 124.8 billion Kip in bonds To further strengthen SOCBs to comply with international standards, some SOCBs were transformed into public companies, with the intention to be listed in the stock market as the government established on 10th October, 2010 BCEL began to prepare a necessary condition as set by securities commission, especially as to conditions on minimum registered capital BCEL was approved to be a public company based on the decision of the Prime Minister No.181/PM dated 14 December 2010 The major shareholders were the government, who owned 70 percent, strategic partners owned 10 percent, domestic investor owned 15 percent and foreign investors owned percent Until 1st January 2011, BCEL public was listed in the stock market and started to issue shares to the public for 20 percent BCEL is now a public company 2.4 Monetary Policy 2.4.1 Monetary instruments To implement monetary policy consistent with market forces, BOL began to develop monetary instruments, starting from October 1990 by introducing reserve requirement ratios of commercial banks, providing a short-term loan to cope with the liquidity problem of banks, the government or BOL began to issue bills and BOL began to introduce policy interest rates The details of each instrument are discussed below Reserve requirement (RR) BOL used RR as one of instruments to control and achieve monetary targets The employment of this instrument depends on the necessary conditions In the case of commercial banks showed rapid credit expansion, BOL would increase RR as was needed for the conduct of monetary policy BOL even increased further as long as BOL observed that banks continued to 48 lend more, vice versa, BOL also lowered RR if the situation would be under control Generally speaking, the rate of RR was in the range of 5-8 percent for Kip and 5-15 percent for foreign currencies In October 1990, BOL set RR at percent for Kip and foreign currencies for short-term deposits In November, 1994 credit was expanded rapidly by banks, which was put pressure on the exchange rate and money supply, BOL increased RR to 10 percent, then to 12 percent when the credit expanded by banks continued to rise further in June 1995 In November 2001, BOL lowered RR in Kip from 10 percent to percent but RR in foreign currency remain unchanged Then, BOL increased again RR in Kip from percent to percent when commercial banks continued to lend substantially, and RR in foreign currency increased from 12 percent to 15 percent After inflation was under a single digit, BOL lowered RR in Kip from percent to percent 15 percent to 10 percent for foreign currency in September 2009 until today Interest rate policy By using RR, BOL could control the growth of monetary base effectively BOL further made an effort to introduce a market-oriented instrument like interest rate policy to mobilize deposits and to allocate for lending effectively and to be used as a tool to control money supply The implementation of interest rate policy was done in various steps, ranging from direct-oriented interest rates to fixed interest rates and to market-oriented determinations During 1986-1988, the objective of monetary policy was centrally to control credit growth, while interest rates during this period was determined by the BOL with fixed interest rates In October 1988 interest rates moved upward trend for the first time since 1985 with the objective to mobilize deposits In January 1989, commercial banks issued a certificate of deposits with interest rate percent per month and loan interest 49 rates was percent To implement interest rate policy based on marketoriented force, in August 1990, the government delegated BOL to determine interest rate During the initial stage, prior to July 1991, BOL set a fixed interest rate for commercial banks to follow To allow interest rates to move along with market force, BOL began to set interest rate policy by setting a positive interest rate, implying that interest rate on deposits should be higher than inflation rate, interest rates on loan should be higher than deposit rate, and interest rates on long-term lending should be higher than short-term lending To move forward to implement interest rate policy in this direction, BOL set a ceiling rate for loan and deposits and informed commercial banks to comply with its instruction In July 1993, BOL set a maximum interest rate for loans and minimum rates for deposits Then BOL abolished a maximum lending rate in July 1995 and kept minimum interest rates on deposit unchanged, except interest rates on lending for the agricultural sector Until 1996 BOL abolished all kinds of setting ceiling rates and allowed commercial banks to set the interest rates based on market forces as shown in Figure 2.4 and 2.5 The improvement of mechanisms for setting an interest rate as mentioned above was to: (i) allow banks to adapt to the changing environment of competition and also to intensify the capacity to implement its policy based on market forces; (ii) enable commercial banks to have an opportunity to generate some profits and improve their financial position; and (iii) allow BOL to have more time to enhance its capacity in bank examinations and the supervision of commercial banks 50 Figure 2.4: Interest rates of deposits and loans in Kip Source: BOL Figure 2.5: Monthly loans interest rates by currency (%) Source: BOL Discount window lending BOL provided a short-term loan to cope with the liquidity problem of banks by using securities/bills as collaterals and introduced discount windows to address liquidity problems of banks as well as for the sake of monetary policy By implementing this policy, BOL also set policy rates differently from time to time In the wake of high inflation rates, policy rate set by BOL was 51 36 percent per year and then lowered to 30 percent per annum, however, this policy rate continued until 2009 and is now lowered to percent per annum 2.4.2 Target of monetary policy From international experiences, from country to country, the implementation of monetary policy differed from time to time, these include exchange rate targets, monetary aggregate targets and inflation targets or some countries also employed targets “just it” based on certain economic conditions Following a renovation policy, especially the New Economic Mechanism initiated in 1986, the Bank of the Lao PDR has implemented its monetary policy to be in consistent with the expansion of the financial system and the degree of financial integration Since 1988, BOL had implemented monetary policy with the objective to maintain price stability This objective was stipulated in article of the Law on the Bank of the Lao PDR promulgated in 1995 In order to achieve this objective, BOL set monetary aggregates to maintain the value of currency From 1988 to 1995, BOL used direct instruments to control money supply by allowing commercial banks to maintain cash ratios to ensure certain amount of money when clients withdraw BOL set loan-deposit ratio between 60-80 percent of deposits Since 1995, BOL used indirect instruments to control the money supply following the BOL set reserve requirement ratio and provided short-term loans and serve as a lender of last resort, and the government also issued T-bills to finance the fiscal deficit The BOL used reserve money programming to control money supply In using reserve money programming the BOL closely monitors the transactions of the deposits account held by the Ministry of Finance, monitors the movement of deposits accounts of commercial banks, such as clearing accounts and controls the credit growth of the central bank It was implemented successfully in the 52 1990s Since 1996, this kind of operational target to control money supply appeared to be ineffective due to advances from the central bank to finance fiscal deficit, BOL shifted targets to net domestic assets with the objective of controlling the credit growth of the banking system, especially the credit expansion to state enterprises and the Ministry of Finance Therefore, using monetary aggregate as targets remains unachievable In particular during the Asian financial crisis 1997-1998, monetary policy seemed to be less effective because of the rapid increase in money supply (Figure 2.6), which was beyond the capacity of BOL to control as a result of the rapid depreciation of the Kip As a result, the inflation rate jumped to triple digits in mid-1998 To combat with high inflation, BOL issued its bills with high interest rate of 60 percent per annum, increased RR in Kip to 12 percent and RR in foreign currencies to 15 percent, along with direct lending restriction to the Ministry of Finance After these policy measures, inflation was brought down to one digit at the beginning in 2001, while in the meantime, credit restrictions of banks also reduced economic growth to 4% in 1998 and 5.8% in 2000 Figure 2.6: Money supply- M2 (billion Kip) Source: BOL 53 During the global financial crisis in 2007-2008, BOL pursued monetary policy and exchange rate policy to maintain monetary stability Of which BOL, used an exchange rate policy as the main instrument or nominal anchor to maintain price stability and to control the fluctuation of exchange rates, along with foreign currency management policy by sufficiently supplying foreign exchange to the public By implementing exchange rate policy, BOL implemented a floating exchange rate regime, which BOL set an annual broad target to move within the range of 5% of appreciation/depreciation and also set reference rate for commercial banks to be within +/- 0.25 percent With improved macroeconomic environment and confidence, monetary policy was set to ease the gradual pressure in inflation and the central bank recognizes that the high level of dollarization in the economy highly limits the scope for central bank financing and will thus continue its policy of tightly controlling its net domestic assets The government considers that exchange rate stability played a crucial role in reducing inflation, both directly on prices and indirectly by restoring confidence in economic policymaking For this reason while the exchange rate will be managed flexibly, the central bank would be prepared to tighten monetary policy if there was a sustained depreciation not attributable to real shocks, and to ensure that banks adjust their exchange rate to keep the margin with the parallel market rate under 2%, while the central bank accepted the policy toward avoiding restrictions on current payments and transfers The government reiterated that monetary policy would remain geared towards containing inflation and did not envisage any major changes in the monetary framework The broad aim would continue to keep the central bank’s net domestic assets, the main anchor of monetary policy, relatively 54 stable This would be underpinned by a government commitment to avoid bank financing of the budget, and the current policy framework of the government by keeping the Kip relatively stable has served Lao PDR well in the past couple of years, with the government being able to smooth out most fluctuations in the exchange rate, without highly jeopardizing their reserve position The government recognizes the capacity to smooth out transitory fluctuations, and that exchange rate stability could ultimately only be preserved through prudent fiscal management and effective control over the commercial banks, both of which are central to monetary control Since then, the inflation rate has been under control; in 2006-2007 broad money grew at a rate 26.1% and 35.4% resulting from the foreign inflows due to the foreign direct investments After the world financial crisis in 2007-2008, the government has continued using exchange rate policy to keep the exchange rate stability As a result of implementing this policy, inflation rates during 2008-2010 was single digit number with an average annual rate of 6-7% 2.5 Dollarization In conducting monetary policy in Lao PDR there are some constraints associated with the implementation as follows: the banking sector is at the early stage of development, the scope and activities of financial market are limited compared to GDP, money supply accounts for 39.3 percent of GDP, credit of banking sector represents 30.1 percent of GDP in 2010, capital markets remained immature and recently emerged in 2011 Foreign currency deposits to total deposits remained high, accounting for 53.7 percent as shown in Figure 2.7 and the persistence of dollarization has been a chronic problem 55 Figure 2.7: Deposits by currency (%) Source: BOL Lao economy is partially dollarized Lao people widely use foreign currencies for three main reasons, such as medium of exchange, store of value and unit of account The scope of holding foreign currencies is commonly measured based on foreign currency deposits in proportion to broad money in the banking system In 1992, the total amount of foreign currency deposits to broad money was equal to 59.3 percent and was 55 percent at the end 2011 Main reasons of holding foreign currency deposits in Lao PDR are: (i) lack of confidence in the domestic currency as a medium of exchange, store of value and unit of account, and (ii) geographical reasons and the trade and investment with Thailand The consequence of dollarization is apparently the loss of effective monetary policy by the central bank Dollarization also causes the volatility of economy and inflation and the likelihood of fluctuation of exchange rate 56 (Calvo, and Veges 1996 Balino et al 1999, Berg and Boresztien 2000) because the demand for domestic currency will have some impact on costs In the meantime, changes in interest rates also affect the demand for money Demand for domestic currency affects on the cost structure of foreign currencies Thus, the elasticity of interest rate to demand for domestic currency will be higher than the level of dollarization Key consequences of elasticity of interest rates in a floating exchange regime is that the exchange rate shall react to projected changes in money supply and other factors affecting the equilibrium of the financial market Money supply shall be an internal factor which central bank can control only domestic currency The change in the structure of money demand is transitory to unstable prices and production as unexpected (Chang and Velasco, 2000) 2.6 Bond market The government began to issue securities in June 1990 with a total amount of billion Kip, with months maturity, priced at 4% per month for the subscription by the non-bank public to control the rising inflation and to absorb excess liquidity in the economy After the implementation of the tight monetary policy in November inflation gradually decreased Henceforth the government reduced the rate from November 1990 to October 1991 to 42% per annum In addition to pave the way for the eventual introduction of another important tool of monetary management, open market operations, the BOL commenced the issuance of six-month bonds in January 1992 These bonds issued at intervals of about two months can be held by commercial banks and public enterprises 57 The first auction for Treasury Bills took place on March 10th, 1994 Since then biweekly auctions were held amongst state owned and private banks In January, 1995 the T-bills auction was amended, particularly include of the Non-banking sector in the bidding During 1995, the BOL was able to issue Treasury Bills to absorb excess liquidity and restrain inflation in the economy The tight monetary policy worked toward the end of the year with relatively lower inflation and more stable exchange rates The 1997 Asian Financial Crisis affected the Lao economy, where Lao inflation rates rose to three digits and the Kip drastically depreciated particularly against the US Dollar and the Baht by 29% and 13%, respectively With the continuous augmentation of inflation in the country, the BOL issued its owned bills which amounted to 180 billion kip at 36% to 60% per annum with the one year maturity and implemented direct instruments such as credit/deposit ratios and imposed a credit ceiling for each commercial bank These measures were called “belt-and-braces” Another form of government securities were issued in 2003, in the form of Triangle Bonds Triangle Bonds were issued by the Ministry of Finance (MOF), with the intention of eliminating the non-performing loans of commercial banks, which came from the government’s deferment in paying for their projects In reality the amount of triangle bonds with maturity from to years outstanding as of August 2005: was 296.6 billion Kip and 10.2 million USD Except for the Triangle bonds denominated in US Dollars issued to BCEL, all of the outstanding triangle bonds were denominated in Kip Since 2005, the Ministry of Finance (MOF) started issuing Treasury Bills as an avenue to finance Lao fiscal deficits T-bills are issued in accordance to the annual budgetary plan as approved by the National 58 Assembly with maturities ranging from months to year and the ceiling of coupon rates, depending on the market scenario By end of 2005 MOF issued of 200 billion Kip of recapitalization bonds to two commercial banks, Banque Pour Le Commerce Exterieur Lao (BCEL) and Lao Development Bank (LDB) The government bonds had a maturity of five years at a fixed per annum rate of, inflation (approximately to 10%) plus 1% The issuance of recapitalized bonds did not only aim to restructure and recapitalize the mentioned state owned commercial banks, but this activity also stabilized the money supply in the economy In addition, as of early September 2005 Agriculture Promotion Bank’s capital restructuring via recapitalized bonds was under evaluation and further discussion between MOF and APB’s management Agriculture Promotion Bank (APB) issued 5-year savings bonds with a lottery to the public from 1998 to 2000 up to billion in total 1998 issue was sold by BOL while 1999 and 2000 issues were sold through branch a network of APB Coupon rate was 5% All the coupons are going to be paid at maturity without compounding A Lottery is drawn every quarter, and the winners can get the prize of 7% extra coupon only if they maintain the bond until the maturity When a bondholder needs immediate cash, early redemption is possible Also endorsement to a third person is possible 2.7 Stock market After Lao securities exchange was officially launched on 11th January 2011, with the first two companies registered were: Banque Pour Le Commerce Exterieur Lao Public (BCEL) and Electricite du Laos (EDL) public company and their total registered stock were 1,005.17 million stocks Trading proceeded smoothly in the primary market and total mobilization by 59 two companies amounted to 1,237.40 billion Kip or 0.02 percent of GDP In parallel, to facilitate the initial public offering (IPO) and trading, the Securities exchange commission authorized two securities exchange companies to be established: BCEL-KT Company and Lane Xang Public Company Securities exchange commission also approved two external audit companies such as: PWC Company and Ernst & Young Company to conduct an external audit for securities Since the official launch, the Lao stock exchange has increasingly drawn a lot of interest from both domestic and foreign investors As of the end of 31 December 2011, there were 8,187 securities trading accounts, of which domestic investor accounts accounted for 6,910 accounts (with 6,877 individual accounts and 33 institutional accounts) and represents 84.40 percent of total investment and 1,277 foreign investor accounts (with 1,253 individual accounts and 24 institutional accounts) covering 15.60 percent Although, institutional investor accounts cover a small proportion of total accounts they play a substantial role in trading In 2011, the overall trading stocks in Lao securities exchange amounted to 301.49 billion Kip (average trading 1.24 billion Kip/day) and total trading stock was amounted to 40.01 million stocks (average 165,357 stocks/day) On 27 December 2011, the securities exchange index closed at 899.46 points, a drop of 10.05 percent compared to base index and the total value of market capitalization equivalent to 0.1% of GDP 2.8 Interbank market An inter-bank market has played an important role recently in the development of the financial market, compared with the last 10 years when trading was only between commercial banks and the BOL BOL occasionally provides liquidity for commercial banks that hold T-bills through: repurchase 60 agreement (repo), discount, and collateralised lending BOL started such operations by practicing There is no written notice or announcement that notifies BOL’s T-bill operations to the banks Repurchase Agreement BOL and a commercial bank sign an agreement that BOL purchases Tbills from the commercial bank, and the commercial bank repurchases the Tbills from BOL after 14 days The agreement follows the same format for any commercial bank Discount Discount is an operation wherein BOL purchases T-bills from a commercial bank without a repurchase agreement BOL may hold the T-bills until its maturity or re-sell them to another commercial bank Collateralised Lending BOL may grant loans to account holders against the security of valuable documents (as defined in Art 36 of the Law on the Bank of the Lao PDR), with repayment periods not exceeding 183 days, and on terms and conditions determined by the BOL As there are very limited secondary transfers of Tbills with transactions only between BOL and commercial banks, physical delivery of the certificates is still a common practice for settlement 2.9 Exchange rate policy After declaration of full independence in 1975 economic development in Lao PDR followed in the footsteps of Soviet style’s centrally planned economy Exchange rates were also aligned with the economic system as the government decided During the period of implementing a centrally planned economy, the government implemented a fixed exchange rate policy and with multiple exchange rates for different purposes The bank had implemented the 61 official exchange rate policy between the Kip currency and foreign currencies three times: (1) 25th January 1980 the rate was set for 10 Kip to dollar serving as the reference rate for the business transaction of public agencies and for the foreign payment and settlement; (2) 2nd June 1981 the exchange rate was set for 30 Kip to dollar with variation range from 25 Kip to 35 Kip per dollar to be consistent with the real market situation in that period, while the exchange rate between Kip currency versus other currencies had been calculated through dollar cross rate; and (3) 3rd October 1985 the exchange rate of Kip versus dollar currency consisted of five exchange rates such as 35 Kip per US$ up to 95 Kip per US Dollar Since January 1988 the government abolished a multiple exchange rate and set a unified rate for different purpose, which was relatively close to the market rate of 390.5 Kip per US$ During this period BOL also had a policy to introduce a unified exchange rate throughout the country The Exchange rate policy during 1987-1990s was quite successful, and official and parallel exchange rates became close during 1990-1991 The reasons were due to tight monetary policy and large foreign capital inflows, enabling the banking system to have foreign exchange increases sufficient to maintain a stable exchange rate Nevertheless, to implement unified exchange rate policy in the country, there was a gap between the official rate and the parallel rate as stated in article VIII of IMF, if two exchange rates of official market and parallel markets differed more than percent, it is considered Lao PDR remain multiple exchange rates This remains based on article VIII of IMF Eventually in September 1995 the fixed exchange rate was abolished and the government adopted a floating exchange regime Since September 1995, Lao PDR experienced difficulty with exchange rates crisis during 1995 and 1997-98 this was due to domestic and external factors, which will be discussed as follows 62 The exchange rate crisis in 1995 arose from loose monetary policy in during the previous three years, especially 1994 Monetary policy was not consistent related to several issues: • Large capital inflows which the banking sector utilized for credit expansion due to large increases in deposits In addition, increases in deposits in the banking sector were due to the government received loans from the Asian Development Bank in mid-1994 to recapitalize SOCBs amounted to 25 million USD (four million was in the form of cash and the rest was in the form of government bonds with redemption periods of year to 10 years) • The level of fiscal deficit was high, mostly from borrowing from the central bank Consequences of these problems affected the money supply increased 72.9 percent in 1993 In early 1995 excessive amounts of money in Kip created pressure for large demands of foreign exchange • The government set a fixed exchange rate, resulting in the holding of Kip by the public who wanted to hold foreign currency to hedge the value of currency The more gaps of exchange rate of the parallel market and commercial bank rate, the greater the public wanted to hold foreign currency During the exchange rate crisis in 1997-1998 which came from the Asian financial crisis, the Baht depreciated sharply in July 1997, adding pressure on foreign exchange markets To response to the depreciation of Baht: • Government took administrative measures in foreign exchange market by closing private foreign exchange bureaus and restricting transactions in foreign exchange • Changes in foreign exchange policy created concern in the foreign exchange markets and widespread black markets and also money transfers to Thailand 63 • By the end of 1997 and 1998, monetary policy was not effective because the government withdrew money from the central bank to finance fiscal deficits In 1996, the government adopted a five-year plan which centered on self-sufficiency in rice production until 2020 To meet this objective, the government identified a massive investment program for irrigation projects during 1997/98 and 1998/99 To support the project, the government borrowed directly from banks for state-enterprises and provinces Thus, money supply rose dramatically at 116.3 percent in 1998 (roughly 60 percent exclude depreciation effect, see Figure 2.8) Figure 2.8: Relationship between M2, inflation and exchange rate (%) Source: BOL 64 External factors mainly stemmed from the Baht crisis which caused the Kip depreciation and prompted domestic price to increase suddenly Initially, the Kip was depreciated in line with the Baht depreciation and the Kip against Dollar lost its value by about 215 percent by end-1997 However excessive liquidity from credit policy and fiscal financing further added pressure on the Kip to depreciate in June 1998 and the nature of rapid depreciation was similar in January 1999 and June 1999 Depreciation of the Kip caused the inflation rate to increase rapidly to a peak of 167.06 percent in March 1999 During this period, authorities did not pay attention to absorb the excessive liquidity by conducting a tight monetary policy because of tight conditions and the high cost of open market operation (interest rate on BOL bills shall be high to attract people to buy securities) After the exchange rate of the Baht against the dollar became stable and the dollar slightly appreciated and Baht appreciated some: exchange rates, which set based on market forces, pushed the Kip up during the Baht appreciated against US Dollar In this situation, the BOL made an effort to keep the exchange rate stable but practically impossible because the BOL was short of foreign exchange to intervene in the market when necessary This coupled with seeking an appropriate exchange rate mechanism that make the exchange rate in Lao PDR in the wake of financial integration a floating exchange rate regime when necessary This policy, BOL set exchange rate by determining the range between selling and buying rate within +/- 0.25 percent Since the implementation of this policy in 2006 exchange rate has been relatively stable for some time (See Figure 2.9 & 2.10) 65 Figure 2.9: Exchange rate (Kip/USD) movement (%) Source: BOL Figure 2.10: Average exchange rate (Kip/USD) Source: BOL 66 Conclusion of chapter Lao economy has high fluctuations of inflation Monetary growth rates have not been calculated by considering the demand-side The administration of financial sector policies has been slow to solve several issues The monetary policy framework is limited and incomplete It is mainly based on the obligation and issuance of bonds of the Bank of the Lao PDR while credit and marketing officers may not yet use them It is for such reasons that the sources of money and credit are restricted The exchange rate management mechanism is not yet fully consistent with the actual conditions, thereby limiting the efficiency of its implementation The use of foreign currencies in transactions by enterprises and the general population is still widespread The central bank has not yet been able to set indicative interest rates to guide the market The administration and the setting of guidelines for market rates still have severe difficulties During the last two years of the Fifth Plan, interest rates on loans extended economic entities remained substantially high although the rate of inflation declined significantly, thereby adversely affecting economic growth The main tools of BOL are interest rate, reserve requirement, discount window lending The BOL has used open market operations One of the reasons to explain this is that the stock market has been opened for less than two years The financial market is developing within a limited scope Credit is limited and meets only 15 percent of the requirements The loan amortization periods are short and there is pressure on the operations of enterprises and the capacity of the commercial banks to recover loans The volume of repayments overdue in the banking system is substantial and is concentrated mainly in the domestic commercial banks, which suffer from poor financial capacity and quality of transactions High non-performing loans (NPL) are a drag on credit flow and high interest rates remain 67 CHAPTER III DEMAND FOR MONEY IN LAO PDR 3.1 The theory-based money demand function for Lao PDR The theory money demand function for Lao PDR is assumed to take the following practical form: M d / P = α + α1 y + α r (3.1) Where M d is the demand for money balances, P is the price level, M d / P is the demand for real money, y is real income that represents the scale variable and r is the interest rate on the alternative assets which represent the opportunity cost variable The selection of the scale variable and the opportunity cost of holding money depend on the theoretical background of money demand function and vary among empirical studies Following the empirical literature on money demand in developing countries (Goldfeld and Sichel, 1990), the long-run money demand can be specified in the following (natural) logarithmic form: ln rmtd = β + β1 ln yt + β ln it + β ln π te + ε t (3.2) In most empirical studies, the interest rate term is used in nonlogarithmic form, which leads to the following: ln rmtd = β + β1 ln yt + β ln it + β 3π te + ε t β1 ( Income Elasticity ) = d ln rmt >0 d ln yt β ( Semi - Interest Elasticity ) = d ln rmt <0 d ln it (3.3) 68 β ( Semi - Inflation Elasticity ) = d ln rmt <0 dπ te Where rmtd is the desired demand for real money balances, defined as the demand for money deflated by the price level p, yt is a scale variable (for example, real measured income), it is the nominal interest rate on financial assets which represents alternatives to holding money, π te is expected inflation which measures the rate of expected return on physical assets, and ε t is an error term The function rmtd is increasing in yt and decreasing in both it and π te (Hossain, 2007) When physical assets represent the major alternative to holding money in high or hyperinflationary countries, the money demand may be specified as a function of expected inflation alone M d / P = f (π e ) (Peter Bofinger, 2001) In the developed countries, the nominal interest rate considers an appropriate proxy for the opportunity cost of holding money, whereas the weak financial markets and administrative interest rates are the overriding feature in most of the developing countries (Dornbusch and Fisher, 1990) In most developing countries the nominal interest rate is institutionally determined; it doesn’t fully capture the opportunity cost of holding money (Hossain and Chowdhury, 2001) Furthermore, the administrative nominal interest rates are not often adjusted for changes in inflation and consequently the real interest rate becomes negative Therefore to overcome this problem researchers often use the percentage change in consumer price index as the proxy for the interest rate variable (Bahmani-Oskooee and Tanku, 2006) ln rmtd = β + β1 ln yt + β ln cpit + ε t (3.4) 69 In fact, assets substitution in developing countries usually takes place between money and real assets as inflation hedges and not between money and other financial assets Thus the expected rate of inflation rather than the nominal interest rate can be regarded as a better proxy for the opportunity cost of holding money in developing countries Furthermore, given the fact of currency substitution in some developing countries, many studies included nominal exchange rate as an explanatory variable in the estimated equation (Samreth and Sovannroeun, 2008) ln rmtd = β + β1 ln yt + β ln cpit + β ln ert + ε t (3.5) To capture the effects of foreign factors many studies on the demand for money in developing countries have included the impact of foreign interest rate and the expected rate depreciation of the domestic currency (Oluwole and Olugbenga, 2007) ln rmtd = β + β1 ln yt + β ln cpit + β ln ert + β 4ii* + ε t (3.6) The inclusion of foreign interest rate in the money demand function is to capture the effect of capital mobility and the expected exchange rate captures the substitution between domestic and foreign currencies Its impact on the demand for money can be either positive or negative 3.2 Data description and issues The data used in this analysis is taken from the Bank of the Lao PDR The estimated sample uses quarterly data in the period from Q1/1993 to Q2/2010 3.2.1 Definition of money The first issue in estimating the money demand function is the selection of the monetary aggregate as the dependent variable The economic literature provides two major approaches in estimating the money demand: 1) the transaction approach, and 2) the assets approach (Harb, 2003) According to 70 the transaction approach, households choose between holding liquid money or interest bearing assets as a store of value Thus, the decision on allocating their portfolio depends on the return of each choice The assets approach, on the other hand, based on the consumer demand theory, assumes that the consumer drives utility by holding real and financial assets including money The choice of monetary aggregate as the dependent variable depends on the approach used in estimating the money demand function The transaction approach emphasizes the liquid asset of money suggesting using narrow money (M1) as the monetary aggregate While the asset approach (portfolio) emphasizes the role of financial assets employs the broader money aggregate (M2) as the monetary aggregates Many believe that the use of broad definition of money and lower interest-elasticity are correlated In response Friedman (1968) suggested that the appropriate definition of money should be empirical matter (Apostolos Serletis, 2001) and if the broad money is empirically found to have a more stable relationship with the economic variable than the narrow money, then broad money should be used in empirical analysis Hence, this study will apply both narrow money (M1) and broad money (M2) as dependent variables In addition, given the fact that there is the multicurrencies use phenomenon in Lao PDR, hence, monetary aggregate will be classified by currency as local currency (Kip) and foreign currencies M1 is narrow money including cash in circulation and current account M2 is broad money consisting of M1, saving and time deposits In the next part, m1 is denoted as narrow money demand; m2 is broad money demand; m2k is broad Kip money demand which equals m1 plus saving and time deposits in Kip; m2f is broad foreign currencies money demand which equals m1 plus foreign currency deposits 71 3.2.2 Scale variable The scale variable in the money demand function represents the transactions related to economic activity The selection of the scale variable depends on the role of money as a transaction approach or asset approach The transactions approach emphasized the role of money as a means of transactions, thus the level of GNP, GDP and NNP are the most commonly used as scale variables The permanent income, which is constructed from the present and expected future incomes, can be used as a scale variable The asset approach, however, puts more emphasis on wealth, but is difficult to measure According to the data availability, the scale variable used in this study is gross domestic product (GDP) as an income measurement Currently, Lao PDR has only annual GDP data Therefore, in order to estimate the money demand function with quarterly data, this study uses Thailand quarterly GDP trends to derive quarterly figures of Lao GDP from the annual data The nominal gross domestic product (ngdp) is divided by the consumer price index (cpi) to obtain the real terms of this variable – rgdp 3.2.3 Opportunity costs The theoretical foundation of the inclusion of the expected inflation rate in the money demand function goes back to the pioneering work of Friedman (1956, 1969) The idea for the inclusion of the expected rate of inflation is based on the fall of the purchasing power of the real value of money The strong inflationary expectations would give people the incentive to switch out of money to real assets (Resina, 2001) In the case of developing countries, where they suffer from underdeveloped monetary and financial systems and non-market determined interest rate and physical assets represent one of the major hedges against inflation and an alternative asset in the portfolio of the non-bank-public, the expected rate of inflation is the proper variable used as 72 the opportunity cost of holding money In other words, in developing countries where interest rate ceilings and capital controls prevail, the assets substitution is likely to be between money and physical assets rather than between money and financial assets (Nachega, 2001) The expected inflation rate is expected to have a significant and positive impact but is not always statistically significant The results suggest that depositors run away from a domestic currency whenever they expect losses associated with their domestic currency However, in many cases there has been an increase in dollarization despite the fact that the country is following a successful macroeconomic stabilization program This is because it is costly to return to domestic currency after domestic inflation decreases Clements et al (1992) argued that it is very difficult for domestic residents to forget the episode of high inflation and these memories will stay for long periods Moreover, they will assign more weight in comparison to episodes of low inflation rates It is assumed that the past value (one year) of actual inflation ( Pt −1 ) is a good proxy for expected inflation ( P e ) (Hadad, 1985) In an open economy model, additional opportunity costs have been included in the money demand function, the expected exchange rate of national currency Expected exchange rate is usually included in the money demand equation in an open-economy to capture the degree of currency substitution in the economy It has an undetermined effect on money demand, which depends on how the public anticipate the future currency depreciation If the public anticipate future depreciation, therefore, the effect of currency depreciation on money demand is negative, where the agent prefers to substitute their local currency for a foreign and stable currency An increase in expected exchange rates would lead to the substitution of domestic currency for foreign currency under the implication that the expected return 73 from holding foreign currency will increase (Resina, 2001) Exchange rate plays a noticeable role in the degree of dollarization This role is influenced by the expected volatility of the inflation rate Dollarization occurred when the expected rate of inflation is high in relation to that of exchange rate depreciation According to the Lao regulation, the banking system is allowed to accept three currencies in deposit Kip, USD and Baht Therefore, to capture the impact of capital mobility, foreign currency interest rates are also used in this study as a proxy of the opportunity cost Hence, expected rate of inflations, exchange rates and interest rates are used as proxies of opportunity cost of holding money in Lao PDR The past value of the actual inflation is used as a proxy of the expected inflation rate The quarterly series of saving USD interest rate (denoted as iusd) are used as a proxy of foreign currency interest rates due to USD deposits taking the highest proportion Average exchange rates Kip/Dollar (denoted as erks) and Kip/Baht (denoted as erkb) are used as proxies of exchange rates 3.3 Unit root and co-integrated test 3.3.1 Unit root test The prerequisite for co-integration test is to examine the properties of the time series variables, in order to have reliable regression tests, we first need to make sure that our model could not be subjected to “Spurious Regression” The problem of spurious regression arises because time series data usually exhibits non-stationary tendencies and as a result, they could have nonconstant means, variance and autocorrelation as time passes This could lead to non-consistent regression results with misleading coefficients of determination (R2) and other statistical tests Therefore, we need to establish 74 the stationary properties of the variables used in the model using Augmented Dickey-Fuller “ADF” (1979, 1981) to determine the degree of integration of the variables; how many times should a variable be differenced to attain stationary Examining the integrating order of series, Augmented Dickey-Fuller (ADF) test is conducted with the auto-regressions The test is chosen on the basis of following considerations: (i) Even though the sequences of price index and exchange rate jumped rapidly during the period 1997-1999 and then came back to the same usual trend by the early 2000, there are no priori reason to expect a structural change; (ii) According to Said and Dickey (1984), if data is finite it can infer that autoregressive integrated moving average, ARIMA (p,1,q) is equivalent to ARIMA(p,1,0) Hence, AR (p) is applied for ADF test; and (iii) Lag lengths are determined by Schwarz Bayesian Criterion (SBC) test 3.3.2 Johansen co-integration test The heart of the use of co-integration analysis is the error term deviation in the money demand function must be temporary for the economic theory to make sense If ε t has stochastic trend, the error term will be a cumulative so that the deviation from money market equilibrium will not be determined Therefore, the error term must be stationary As the variables tend to be nonstationary I(1), there will be no tendency to return to long-run levels However, the theory asserts that there is a linear combination of their nonstationary variables that is stationary Equilibrium theories involving nonstationary variables require the existence of a combination of the variables to be stationary Since the variables are considered to be I(1), the co-integration method is appropriate to estimate the long-run demand for money The cointegration technique helps to clarify the long-run relationship between 75 integrated variables” (Resina, 2001) That is when co-integration holds and there is any disequilibrium in the money market due to shocks, there is a short-run dynamic adjustment process such as error-correction mechanism that pushes the system back toward the long-run equilibrium (Jason, 2005) If the unit root test suggests non-stationary series with indifference in integrating orders, the Johansen test approach is conducted to identify the long run equilibrium of variables in the structural forms This test can avoid the problems which occur from a single regression (Enders 1995, p.385) such as: (i) There is no systematic procedure in the single regression method because of separating estimation of the multiple co-integrating vectors; and (ii) Two-step of Engle-Granger procedure creates problems because the estimated residual may not appropriate to be a proxy for co-integration test due to the OLS properties The Johansen test procedures also consider deterministic specification and number of lag lengths Setting a different deterministic will make the asymptotic distribution of likelihood ratio (LR) test various Unit root statistic test will provide this reference Sufficient lag lengths are determined on the basis of the LR statistic tests recommended by Sims in 1980 with the traditional VARs approach9 (Enders 1995:396-397) So, the estimated form of the model to test co-integrating relations in the first differencing is p −1 ∆xt = A0 + ∑π i ∆xt −i + πxt − p + ε t (3.7) i =1 LR test statistic: LR = (T − c)(log Σ r − log Σ u ) ; Where, T is number of observations; c is number of parameters in the unrestricted system: c = pn+1, n is number of equations in the system (n=6), p is number of lags; log Σ i is natural logarithm of the determinant of Σ i , i = r, u r is number of lag restrictions and u is number of lag un-restrictions The null hypothesis of restricted VARs model is under χ 0.05,df (df = rn2) Traditional VARs approach use stationary variables in the VAR model So, VARs system is estimated by level form as suggested by Sims in 1980 76 The basic idea of this test is that if coefficient matrix ( π ) is of rank n, the vector process is stationary However, if rank ( π ) is equal to 1, there is a single co-integrating vector and the expression π xt − p is the error-correction factor For other cases in which 1< rank ( π ) <n, there are multiple cointegrating vectors The number of distinct co-integrating vectors can be obtained by checking the significance of the characteristic roots ( λ ) of π Two-test statistics can be conducted to test for the numbers of characteristic roots that are λmax and λtrace statistic tests It can calculate λmax and λtrace 10 statistic from the characteristic roots of π 3.4 Estimating money demand function for Lao PDR by using ECM 3.4.1 Engle and Granger: Error Correction Models Error correction model (ECM) is used in order to determine money demand and explain their dynamics of the economic model equation (3.8) if observed variables are non-stationary and they are co-integrated (Engle and Granger 1987) If the obtained results from unit root tests and the cointegration test of the Johansen approach are provided as in the Engle and Granger representation theorem, then the short run dynamics of money demand can be described by ECM The model in general form presents as: 10 Trace statistic for the null hypothesis of r co-integrating relations, while maximum eigenvalue statistic tests the null hypothesis of r co-integrating relations against the alternative r+1 co-integrating relations They are computed as: λtrace (r ) = −T n ∑ ln(1 − λˆ ) ; i λmax (r , r + 1) = −T ln(1 − λˆr +1 ) i = r +1 Where, λ̂i is the estimated value of characteristic roots obtained from the estimated π matrix T is the number of usable observations And r is the number of co-integrating equations 77 n n i=1 i=0 ∆ln rmt = β0 + ∑β1i ∆ln rmt−i + ∑β ji∆χt−i +γ1ECt−1 +εt (3.8) ECt −1 = ln rmt −1 − β − β1 χ t −1 Where EC t −1 is error-correction term that is derived from the long-run relationship and γ is a speed of adjustment to long-run equilibrium χ t is set of explanatory variables Equation (3.8) will be estimated by OLS estimation Assumptions: (1) The error term is white-noise process E (ε t ) = 0; E (ε t ε t′ ) = Σ for all t, where Σ = {σ ij2 , i, j = 1,2, .m} is m × m positive definite matrix; E (ε t ε t ) = for all t ≠ t ’ and E (ε t / xt ) = ' (2) χ t −i ’s are not perfectly correlation or no multi-correlation The ECM has proved to be one of the most successful tools in applied money demand research This type of formulation is a dynamic errorcorrection representation in which the long-run equilibrium relationship between money and its determinants is embedded in an equation that captures short-run variation and dynamics The ECM is shown to contain information on both the short- and long-run properties of the model with disequilibrium as a process of adjustment to the long-run model In addition, the long-run equilibrium is specified by economic theory while short-run dynamics is defined from the data When co-integrated holds and if there is any shock that causes disequilibrium, there exists a well-defined short-run dynamics adjustment process such as error-correction mechanism that will put back the system toward the long-run equilibrium 3.4.2 Estimated results and hypothesis testing 3.4.2.1 Unit root test results Series are expected to have a time-variant mean due to trend movement in each series In addition, investigating autocorrelation from correlogram, all 78 variables have slowly decayed and Q-statistics provide significant of autocorrelation in each series The ADF test is used and it suggests the results that the unit root test can be rejected for all variables at the first difference, which ADF test statistics of each variable is beyond the percent critical value in absolute terms (Table 3.1) It means that all variables have meanreverting properties in the first differencing; I(1) process with intercept Qstatistic from Box and Jenkins also shows correlation coefficients decreasing of these non-stationary variables in the first differencing Table 3.1: Unit Root Test Results ADF test statistics Critical value at 5% Main variables Level First difference (I1) Level First difference (I1) Lnrm1 0.16 -5.3 -2.9 -2.9 Lnrm2 -0.63 -6.81 -2.9 -2.9 Lnrm2k -1.55 -6.43 -2.9 -2.9 Lnrm2f -1.17 -3.38 -2.9 -2.9 Lncpi -1.52 -3.71 -2.9 -2.9 Lnrgdp -1.29 -11.25 -2.9 -2.9 Lnrerkb 0.08 -4.22 -2.9 -2.9 Lnrerks -0.06 -3.52 -2.9 -2.9 Ikip -1.39 -6.3 -2.9 -2.9 Iusd -1.99 -7.38 -2.9 -2.9 Hence, this study it could not apply all variables directly in estimating the demand for money function in the case of Lao PDR According to the Granger representation theorem, if money demand and explanatory variables are co-integrated then short-run dynamics can be described by an appropriate 79 ECM and vice versa Therefore, in this case, the two-step procedure can be used to estimate the corresponding ECM: testing the errors that are residuals from a co-integration regression with the ordinary least square (OLS) method for stability and then estimating a short-run error correction mechanism 3.4.2.2 Johansen co-integration test Results Even Johansen test can detect differing orders of integration; it is good not to mix variables with multiple integrating orders Then, to ensure the white-noise process of residuals, LR statistic test is conducted As shown in the Table 3.2, under null hypothesis of unrestricted VARs model, the LR test results at χ 02.05,df show that there are at least up to lag lengths in each money demand function Table 3.2: Likelihood ratio test: lag lengths test LR Module of real money demand (rm1) 56.77 Module of real money demand (rm2) 51.16 Df 25 25 16 25 0.0002 0.0015 0.0011 0.02 7 Modules P-value Lag length at 5% Module of Module of real Real Kip foreign currencies money money demand demand (rm2k) (rm2f) 38.8 41 The Johansen co-integration test includes the intercept (Ao), but no deterministic trend that is determined by the unit roots test The LR test indicates setting lags (p = 6) The test consists of money demand models with non-stationary variables I(1) shown in Table 3.1 So, equation (3.6) is estimated Then, the result from λmax and λtrace statistic suggests that the similar co-integration vectors for four money demand functions have 95 per cent critical value (Table 3.3) 80 Table 3.3: Johansen test: the λmax and λtrace tests results at 5% Model and number of co-integration λ max tests results λtrace tests results Module of real money demand M1 (rm1) 3 Module of real money demand M2 (rm2) 5 Module of Real Kip money demand 1 2 vectors (rm2k) Module of real foreign currencies money demand (rm2f) 3.4.2.3 The error correction model results As a result of non-stationary I(1) process in each series and cointegrating relations, the error correction model is estimated in order to capture the long-run relationship of money demand On account of VARs method and Johansen test, it considers effects of all series in the whole systems and verifies the co-integration of multivariate non-stationary which helps to avoid misspecification As a result, the error correction model is estimated in the first differencing form with up to six lags • Short-run money demand functions The short-run dynamics presents in the specific form as: 6 i =1 i =1 ∆ ln rmt = β0 + ∑ β1i ∆ ln rmt −i + ∑ (β2i ∆ ln rgdpt −i +1 + β3i ∆ ln cpit −i +1 + β4i ln rert −i +1 + β5i ln riusdt −i +1 + β6i rikipt −i +1 ) + γ 1ECt −1 + ε t Error-correction term can be derived from the long-run equation as: (3.9) 81 ECt −1 = ln rmt − β0 − β1 ln rgdpt −1 − β2 ln cpit −1 − β3 ln rert −1 − β4riusdt −1 − β5rikipt −1 (3.10) The OLS estimation is applied for this two-step error correction model, equation (3.6) and equation (3.9) in order to draw the relationship between money demand and its factors The short-run dynamic models including narrow money demand, broad money demand functions both in Kip and foreign currency have a sensible statistic test All coefficients are significant and reasonable explaining the model by approximately 45-60 percent The Durbin-Watson statistic shows the overall model serially uncorrelated However, not all signs are an intuitive and plausible (Table 3.5) Therefore, the model will be examined for its adequacy It also looks for remedies such as omitting an important variable or having used the wrong function form To determine whether model inadequacy results from one or more of these problems, various methods to test residual performance will be used The results of the diagnostic test (Table 3.4) suggest that the error term fulfill the classical assumptions, except model for M2 In specific, Cramervon Mises (W2) and Anderson-Darling (A2) test cannot reject the null of normal distributed error at per cent significant level In addition, the LM test for serial correlation and auto-regression conditional heteroskedasticity (ARCH) also depicts the satisfied residuals that cannot reject the null of no serial correlation and no ARCH only up to order In addition, the diagnostic test for model specification of RESET cannot reject the null of homoskedasticity, independence of regressors and the correct of model specification up to one and three fitted values for M1, M2FX and M2kip model respectively; except broad money M2 dynamics can reject the null of homoskedasticity even up to six fitted values CUSUM test for the stability of error square also shows stable (Figure 3.3) 82 Table 3.4: Diagnostic tests for the short-run dynamic money demand model, equation (3.9) rm1 Tests rm2k rm2f rm2 Methods Statistic Statistic test Prob Statistic test Prob Statistic test Prob 0.053 0.44 0.079 0.208 0.074 0.239 0.068 0.284 0.034 0.47 0.491 0.211 0.442 0.279 0.440 0.282 F-stat F(3,57)=2.13 0.105 F(1,61)=1.130 0.291 F(3,58)=1.849 0.148 LM test Obs*R-squared 6.76 0.079 1.219 0.269 5.849 0.119 ARCH F-stat 0.774 F(1,64)=0.322 0.572 F(1,64)=0.002 0.962 0.770 0.331 0.565 0.002 0.962 0.487 F(3,59)=1.94 0.132 F(1,60)=0.937 0.336 0.456 6.304 0.097 1.038 0.308 Cramer-von Normality test Mises (W2) AndersonDarling (A2) Serial Correlation F (1,64)=0.082 test F(1,61)= 0.032 0.034 F(1,63)= 2.155 Prob 0.858 0.852 0.147 Test Obs*R-squared F-stat Ramsey 0.085 F (1,59)=0.489 2.150 F(6,56)= 2.704 0.142 0.022 RESET Test Log likelihood 0.553 ratio (LR) 16.796 0.001 Source: Estimated results rm2k short-run mode rm1 short-run model rm2f short-run model rm2 short-run model 1.4 1.4 1.4 1.4 1.2 1.2 1.2 1.2 1.0 1.0 1.0 1.0 0.8 0.8 0.8 0.8 0.6 0.6 0.6 0.6 0.4 0.4 0.4 0.4 0.2 0.2 0.2 0.2 0.0 0.0 0.0 0.0 -0.2 -0.2 -0.2 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 CUSUM of Squares 5% Significance 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 CUSUM of Squares 5% Significance -0.2 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 CUSUM of Squares 5% Significance 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 CUSUM of Squares 5% Significance Figure 3.1: Cumulative Sum of Squares of Recursive Residuals On the basis of the diagnostic tests, the short-run dynamic model of money demand provides the validity of outcomes, except the broad money 83 M2 model with misspecification Therefore, in the following discussion in this study, it does not estimate M2 demand function Narrow money demand function ∆ ln rm1,t = 0.03 + 0.36∆ln rm1,t −1 − 0.5∆ ln rgdpt −1 − 0.41∆ ln rgdpt −2 + 0.29∆ ln rerkst −1 − 0.26∆ln rerkst −2 − 0.45ECt −1 (3.11) Based on the short-run estimated results, the adjustment coefficient of error correction for long-run equilibrium shows the intuitive sign with adjustment speed for 2.2 quarters This result reflects the inertia in holding money that 100 percent change in real narrow money demand in 2.2 quarters ago still influences the current change by around 45 percent, regarding the effects of other explanatory variables The coefficient of ∆ ln rm1,t −1 is positive, 0.36 It means that the growth rate of demand for real narrow money will increase by 36 percent if the previous growth rate of differencing in real money M1 increases by 100 percent, given other factors unchanged Even the coefficient sign of the real income is negative which is different from expectations, but it significantly affects the real money M1 after two quarters This explanatory variable is included to ensure the model validity The coefficient of real exchange rate Kip against the USD is 0.29 after one quarter and -0.26 after two quarters If the negative coefficient in the second quarter reflects the higher opportunity cost of holding money, then the real money demand M1 will decrease If the Kip loses value by percent in the last two quarters, the real money demand M1 will decline by 0.26 percent, if other factors are constant The first difference of real exchange rate Kip/USD in the previous quarter with a positive coefficient is included in this model in order to maintain model validity 84 Broad money demand function in Kip ∆ ln rm k ,t = 0.042 − 0.42 ∆ ln rgdp t − − 0.27 ∆ riusd t −1 + 0.37 ∆ riusd t − − 0.23 EC t −1 (3.12) Refer to the short-run estimated results, the adjustment coefficient of error correction for long-run equilibrium shows the intuitive sign with adjustment speed 4.3 quarters This result reflects the inertia in holding money that 100 percent change in real broad money demand 4.3 quarters ago still influences the current change by around 23 percent, regarding the effects of other explanatory variables Even the coefficient sign of the real income is negative which is different from expectations, but it significantly affects the real money M2 in Kip after two quarters This explanatory variable is included in order to ensure the model validity The coefficient of real saving in the USD interest rate is -0.27 after one quarter and 0.37 after two quarters The negative coefficient after one quarter reflects the higher opportunity costs of holding money, and so the money demand M2 in Kip will decrease If the real saving in the USD interest rate increases by percent after one quarter, real money demand M2 in Kip will decline by 27 percent, if other factors remain constant The second difference of real saving USD interest rate in the previous quarter with a positive coefficient is included in this model in order to maintain model availability Broad money demand function in foreign currencies ∆ ln rm2 f ,t = 0.044 − 0.36∆ ln rm1,t −1 − 0.46∆ ln rgdpt −2 − 0.77∆ ln cpit −2 − 0.28∆riusdt −1 − 0.25ECt −1 (3.13) Based on the short-run estimated results, the adjustment coefficient of error correction for long-run equilibrium shows the intuitive sign with 85 adjustment speed for quarters This result reflects the inertia in holding money that 100 percent change in real broad money demand in quarters ago still influences the current change by around 25 percent, regarding to the effects of other explanatory variables Even the coefficient sign of the real income is negative which is different from expectations, but it significantly affects the real money M2 in foreign currencies after two quarters These explanatory variables are maintained in order to ensure the model validity The coefficient of expected inflation is -0.77 for two quarters The negative coefficient shows the substitution effect of holding money by physical goods including gold, land, and house Consequently, the money demand M2 in foreign currencies will decrease Specifically, if people expect that inflation will increase by percent in the last two quarters, real money demand M2 in foreign currencies will decline by 0.77 percent, if the other factors unchanged The coefficient of the real saving in the USD interest rate is 0.28 after one quarter The positive coefficient after one quarter reflects the incentive for holding foreign currencies Consequently, the money demand M2 in foreign currencies will increase If the real saving in the USD interest rate increases by percent in after one quarter, real money demand M2 in foreign currencies will increase by 0.28 percent, if other factors remain constant • Long-run money demand functions Narrow money demand function ln rm1,t = 2.34 + 0.81ln rgdpt − 0.42 ln rerkbt − 0.57 ln rerkst − 0.10 riusd t (3.14) This real M1 long-run relationship is consistent with the rational economic explanation All signs are intuitive and plausible Specifically, the 86 factors from income effect such as real GDP explore significant in terms of economic intuition and magnitudes For instance, considering the other effects, an increase in real GDP by per cent raises demand for real M1 by 0.81 per cent Beside that currency substitution affects such things as the exchange rate of the Kip against USD and Baht it has a negative influence that infers that when the Kip losses its value, people tend to hold the USD or the Baht Specifically, the elasticity of real narrow money balance is -0.57 and -0.42 respected to the Kip depreciation against the USD and against the Baht respectively In addition, capital mobility is sensible for M1 model which the real saving in the USD interest rates has negative sign, -0.1 It means that there is an opportunity cost of holding Kip when higher real USD interest rate, then people tends to reduce real money balances M1 In summary, demand for M1 model depends on the income factor and the opportunity costs including the real exchange rate Kip/USD, Kip/Baht and the foreign interest rates which reflect currency substitution effect and capital mobility Broad money demand function in Kip ln rm2 k ,t = 3.22 + 0.51ln rgdpt − 1.96ln rerkbt − 0.4riusdt (3.15) This rm2k long-run relationship is rational economic explanation All signs are intuitive and plausible Specifically, the factors from income effect such as real GDP explore significant in terms of economic intuition and magnitudes For instance, with considering the other effects, an increase in real GDP by per cent raises demand for money by 0.51 per cent Currency substitution exists in this relation, exchange rate Kip against the Baht has a negative influence that infers that when the local currency Kip 87 loses its value people tend to hold other currencies more such as the Baht Specifically, when the Kip depreciates against Baht by percent, people will reduce the Kip balance in their portfolio by 1.96 percent, if other factors constant The capital mobility effect is also presented in the M2Kip model The real saving in the USD interest rate has negative effect, -0.4 If the real saving in the USD interest rate increases by percent, people tend to hold Kip balance less by 0.4 percent, if others are unchanged In sum, the demand for M2 in Kip function in Lao PDR is empirically determined by real GDP, real exchange rate Kip/Baht and real saving USD interest rate Broad money demand function in foreign currencies ln rm2 f ,t = 8.81 + 0.33ln rgdpt − 0.97 ln cpit −1 − 2.33ln rerkbt − 0.77 ln rerkst − 2.95rikipt + 2.6 riusd t (3.16) This rm2f long-run relationship is rational economic explanation Almost signs are intuitive and plausible Specifically, the factors from income effect such as real GDP explore significant in terms of economic intuition and magnitudes For instance, considering the other effects, an increase in real GDP by percent raises demand for money by 0.33 per cent The currency substitution affect are different The coefficients of the exchange rate Kip against USD and against the Baht have, -0.77 and -2.33 respectively This means that when the Kip depreciates against USD or Baht by percent, people reduce foreign currencies from their portfolio by 0.77 percent and 2.33 percent respectively This result can be explained by the idea that people expect high inflation when the Kip loses a lot of value Hence, they would hedge themselves by investing in other assets especially real estate and goods (Gold) Then, M2 in foreign currencies would decline 88 The capital mobility effects interest rate movement The coefficient of interest rate is -2.95 for Kip interest rate and 2.6 for USD interest rate If the saving interest rate of Kip increases by percent, it will reduce the incentives of people holding foreign currencies by 2.95 percent In contrast, if the real saving in the USD interest rate increases by percent, it will put more incentives to hold foreign currencies by 2.6 percent, if other factors constant The expected inflation (lncpit-1) shows the important implication of money demand in Lao PDR especially foreign currencies that people tend to reduce its real money balance when they expect high inflation and hedging the risk by investing in physical assets such as gold, house and land This creates demand for foreign currencies because the prices of these physical assets are mainly called in foreign currencies In summary, demand for M2 in foreign currencies model has been affected by all plausible explanatory variables in the model consisting of real GDP, expected inflation, exchange rate Kip/USD, Kip/Baht, domestic and foreign interest rates Outstanding results from three money demand functions According to the results discussed above, results can be drawn among money demand functions as follows: • Speed of adjustment from the short-run dynamics to the long-run equilibrium: the M1 model adjusts its long-run equilibrium relatively faster than other models by using only 2.5 quarters while others is 4.3 and quarters for M2 in Kip and M2 in foreign currencies respectively This result reflects that the portfolio of the M1 model is highly liquid with cash-based component which has relatively lower opportunity costs to reallocate its portfolio • As an expectation, income is significant having contemporaneous effects on the money demand adjustment Precisely, the elasticity of current 89 money demand differencing with respect to that of GDP is at least 0.4 per cent for all types of demand for money In long-run relations, considering the other effects, an increase in real GDP by 100 per cent raises demand for money by 81 per cent, 51 per cent and 33.7 per cent for model M1, M2 in Kip and M2 in foreign currencies, respectively • Other important results from the short-run ECM dynamics is that all proxies of opportunities cost have effect on the real money demand in respect to exchange rate depreciation especially Kip against USD affects the real narrow money demand negatively after two quarters Interest rates both in local and foreign currencies have significantly influenced real broad money demand in local currency and foreign currencies The expected inflation rate has negative effect on real broad money demand in foreign currencies after two quarters These negative influences indicate a short-run substitution effect of foreign currencies or real goods for real money demand Specifically, money holders persuade various ways of hedging according to the level of liquidity Money holders for M1 applied currency substitution to handle with currency risk, while that of for money in the longer terms (rm2k and rm2f) adjusts itself by using capital mobility to deal with interest rate risks In addition, broad money demand in foreign currency (rm2f) is adjusted by asset substitution such as land and gold to avoid the effect of inflation and maintain purchasing power • Opportunity cost proxies in long-run relation; rm2f model includes all plausible explanatory variables This reflects Lao situation appropriately with the phenomenon of multi-currency uses which lead to currency substitution and capital mobility effect The expected inflation also has a negative impact from the long period of high inflation, hence it requires sometimes for people to adjust their rational attitude by enhancing macroeconomic stability for period of time until they are confident and feel comparable with 90 Table 3.5: Short-run dynamic estimation, dependent variable is ∆ ln rmt Variables Narrow money Broad money demand demand function function in Kip Broad money demand function in foreign currency ∆ ln rm1t Prob ∆ ln rm2 k t Prob ∆ ln rm2 f t Prob C 0.03 0.00 0.04 0.00 0.044 0.002 ∆ ln rmt −1 0.36 0.00 ∆ ln rgdpt −1 -0.503 0.00 -0.369 0.000 ∆ ln rgdpt − -0.415 0.00 -0.466 0.000 ∆ ln rerkst −1 0.29 0.031 ∆ ln rerkst − -0.26 0.062 -2.252 0.004 0.284 0.003 -0.779 0.000 -0.257 0.000 -0.423 0.00 ∆rikipt − ∆riusd t −1 -0.279 0.00 ∆riusdt − 0.372 0.00 ∆ ln cpit − ∆ ln cpit −3 ECt −1 -0.452 0.00 -0.232 0.00 Adj R-Squared 0.634 0.607 0.442 DW 1.527 1.721 1.462 F 20.10 26.536 11.491 Prob 0.00 0.00 0.000 91 Table 3.6: Long-run relation, dependent variable is ln rmt Variables Narrow money demand function ln rgdpt log rm1t 2.342 0.818 Prob 0.006 0.00 ln rerkst -0.577 0.00 ln rerkbt -0.429 0.010 C Broad money demand function in Kip log rm2 k ,t 3.22 0.51 -1.967 Prob 0.000 0.005 0.00 rikipt riusd t ln cpit −1 Adj R-Squared DW F Prob -0.105 0.927 1.084 222.433 0.000 0.037 -0.406 0.924 0.76 282.18 0.000 0.00 Broad money demand function in foreign currency log rm2 f ,t Prob 8.812 0.000 0.337 0.072 -0.778 0.000 -2.337 0.000 -2.950 0.002 2.609 0.006 -0.974 0.000 0.938 1.014 174.195 0.000 3.4.2.4 Interpretation of estimated results The overall results indicate that the single money demand models are plausible to interpret the demand for money phenomenon in Lao PDR Both the short-run and long-run relationships are meaningful to provide intuitive explanations for changes in money demand On the basis of the results and Lao PDR situations, four important points are worth discussing First, due to the multi-currency use in Lao PDR, currency substitution plays an important role in explaining the determinants of money balance in Lao PDR Specifically, the effects of exchange rates are more elastic in the demand for broad money than that of narrow money This means that the real broad money demand has a more destructive effect from the exchange rate uncertainty than that of narrow money Hence, in order to maintain their prosperity or increase its wealth, they will be more sensitive to adjust its broad money balance especially foreign asset Second, the capital mobility also shows the significant role in real money balance especially the saving interest rate in USD This influence is more elastic in the demand for foreign currency because by the Law, people can 92 save in foreign currency at domestic banks This result can be a tool of monetary policy and the local currency use promotion by reducing the incentive of holding foreign currency Third, as Lao PDR has a long period of inflation phenomenon, people still preferred to accumulate physical assets to substitute when they expect inflation will increase, even though we have macroeconomic stability for a decade This situation can be seen from the behavior of people who hold the foreign currency instead of the local currency People prefer physical assets because of a lack of confidence in the financial market development in Lao PDR; hence physical assets such as land, houses, and gold metal are the alternative assets to invest in order to hedge exchange rate volatility and interest differential Fourth, people tend to hold local currency just for transaction purpose as it can be seen that higher elasticity of real narrow money demand and real broad money demand in Kip respect to real GDP than that of real broad money demand in foreign currency Conclusion of chapter This chapter, a core part of the dissertation, conducts an empirical analysis of money demand for Lao PDR using available quarterly data from the period of Q1/1993-Q2/2010 The purpose is to examine the behavior of money demand in Lao PDR during recent periods of economic and financial reform A simple theoretical model based on the money demand function is developed to explain the relationship between the money demand and its determinants for the case of Lao PDR The theoretical model is tested using the co-integration technique, the error correction modeling of Engle-Granger to estimate the demand for narrow money, broad money and broad money in foreign currencies The estimated results confirm the main factors of the model that all demand functions are stable They can be intermediate targets of BOL The coefficient signs are consistent with theory 93 CHAPTER IV POLICY IMPLICATIONS 4.1 Lao economic development strategy 4.1.1 Macro-economic targets The plan aims to ensure a GDP growth rate of at least at 8% per year The agriculture and forestry sector is slated to grow at 3.5% annually, to form 23% of GDP by 2015; the industrial sector to grow at 15% annually, to form 39% of the GDP; and the services sector to grow at 6.5% annually, to form 38% of the GDP It is estimated that in by 2015, the GDP per capita will be about US$ 1,700 at current prices (exchange rate at 8,500 Kip/ USD) The inflation rate will be maintained lower than the growth rate and the exchange rate will be kept stable, the fluctuation of Kip value against major currencies will be at a maximum level of 5% per annum, average export value increases by 18% and import increases by 5% per annum; manufacturing industry and handicraft sectors have growth rates at maximum 13% per annum and account for 15% of GDP respectively; establishing household economic cooperation units to cover 50% of total groups of villages (kumbans); and strive to increase the foreign currency reserves to meet import requirements for at least months It is estimated that private consumption expenditure will be about 75% of the GDP, public expenditure (consumption) 8%, investment (state and private, combined) about 32%, import about 50% and export about 35% by 2015 The plan aims to ensure a balance of payments (BOP) and current account balance; control inflation to keep it at less than the economic growth rate; and maintain an exchange rate (currency) stability 94 By 2015, the budget revenue target (including grants) is estimated to be at least 19-21% of the GDP, the domestic revenue about 16-18%, and the budget deficit will not exceed 3-5% of the GDP per annum The target is to increase the money deposit by 25.6% annually, or 39.5% of the GDP The growth process is environmentally sustainable and adheres to set standards, and where possible, job-creating The distribution of gains would be equitable regionally and among the people 4.1.2 Targets of Economic Sectors Production The target is to produce million tons paddy within 1.04 million hectares, the expected productivity to reach about tons per hectare Accordingly, the per capita production is to be 450-500 kgs per year on average, to ensure a daily requirement for energy between 2,400-2,500 kcal/person; The aim is to raise the domestic animal breed by 4-5% per year, where 23% are cows and buffaloes, and 4% are pigs and 6% are poultry develop irrigation for agricultural development using machines and electricity on 6070% of the cultivating area in flat lands or to cover about 50% of rice and livestock lands and industrial plantation areas; For the next years, the aim to construct hydropower plants with a combined installed capacity of about 2,862 MW during the plan period The next target is to expand medium voltage power transmission lines of 22 KV, provide off-grid electricity in rural and remote areas, and make electricity accessible to 80% of the total households in the country by 2015 Lao PDR has set rural electrification as an important factor for achieving Millennium Development Goal (MDG) target 95 The aim is to develop the maps of minerals in the earth on a 1:200,000 scale on at least 75% of the total land area, discover and excavate/process important materials; for example, flat copper at 86,000 tons annually, copper dust 298,000 tons annually, gold bars at tons annually, coal at 728,000 tons annually, and granite 600,000 tons annually and others The aim is to attract tourists, on average to about 2.8 million tourists per year, increase hotels to 350 and restaurants to 850, discover and expand historical sites, and attempt to make at least more World Heritage Sites in the country The aim is to construct/expand the road networks to 100% of the road plan to link sub regions and construct urban and rural roads to link focus areas and some groups of villages (Kumbans), so that these areas are accessible for at least one season by the year by 2015; aim to make air transport grow by 810% per annum (this should certainly be possible if tourism grows); and expand the supply of piped water to the urban population, to reach 67% of the total urban population The aim is to expand the telecommunications service network to cover 90% of the villages nationwide, construct the optical fiber networks of length 17,192 km, and expand the telephone connectivity through both cell phones and fixed phones to reach 80% of the total population Banking sector One of the important objectives in the financial sector is to continue to refine the legal framework for the banking sector to better meet the needs of the fast developing economy including its increasing international integration Laws on Banking and credit organizations would be modified and supplemented to serve as the basis for the development of the capital markets The financial capability of commercial banks would continue to be 96 strengthened, with a move toward the full implementation of internationally accepted rules and standards on banking activities The operations of the commercial banks will be guided toward the provision of improved credit services to the economy based on the principles of safety, efficiency and selfsustainability Priority would be given to supporting the production, processing and marketing of key products/goods in the agriculture sector and in rural areas The commercial banks will be encouraged to expand the provision of credit to profitable and effective projects The dynamism of the commercial banks will be improved by reducing the interventions by relevant authorities in their operations The improvements will be achieved in the procedures and practices of commercial banks for the provision of loans Monitoring and adjusting mechanisms in providing loans by commercial banks will be based on asset ownership (collateral) They will be encouraged to diversify monetary and banking services The development of capital markets and foreign exchange trading among commercial banks will enhance the capacity of the state-owned commercial banks (SOCBs) including in lending The staff skills will be improved to support the activities of commercial banks and ensure the strict monitoring and the evaluation of the commercial bank system The Government will monitor SOCBs and enforce adherence to government agreements There will be an examination of the accounting system to bring it up to international standards There will be some changes in the classification of debts of the SOCBs based on international standards Regulations will be enforced widely and these include shark loans, exchanges, guarantees and other conditions in order to allow creditors to collect their debts, including through confiscation and sale of the debtors’ properties There will be an improved assessment of the creditworthiness of borrowers 97 and increased monitoring of the loans by the banks to reduce loan losses Transparency will be taken seriously in evaluating debt amounts accurately The Government is committed to recapitalize the state-owned commercial banks (SOCBs) through the provision of about 700 billion Kip in 2006 and 2007 The restructuring and strengthening of the SOCBs will continue, especially the three major ones (Banque Pour Le Commerce Exterieur Lao, the Lao Development Bank and the Agriculture Promotion Bank) building upon the results of the diagnostic financial audits of the institutions The Government is also exploring the feasibility of partial privatization/joint ownership of the Lao Development Bank The Agriculture Promotion Bank (APB) will be transformed into a self-sustaining, market-oriented rural financial institution A variety of micro-finance institutions will be encouraged The Policy Statement, the Industry Assessment and Action Plan developed by the Rural Microfinance Committee were endorsed in early 2004 by the Prime Minister’s Office The Policy and action plan aim to promote a sustainable development of microfinance industry by encouraging microfinance institutions to have diverse forms and ownership and discourage subsidized credits The judicial foundations and regulations to support the implementation of lending by SOCBs will be strengthened based on common policies, in order to eliminate the free loans and the investments that not comply with commercial practices The BOL will continue improving and creating the regulations related to, among others, the monitoring of the operations of the commercial banks and their loans based on their capital, assets, management, earnings and liquidity (CAMELs) ratios There will be a study on the feasibility of initially putting in place an advance warning system, based on the Basel Principles, especially on forecasting the interest and profit 98 trends, prices of services and the growth of loans Monitoring of the SOCBs will utilize modern technology It is planned to assess BOL’s capacity to pay interest on the mandatory reserves of commercial banks (and other financial intermediaries) deposited with BOL The assessment will be based on the revenue resources of BOL, derived through the management of foreign currency funds, and the effectiveness of the tools in the open-market operations and repayment operations The Government plans to gradually eliminate the preferences for Stateowned banks At the same time, State-owned banks would be required to stop their direct involvement in the business activities of commercial banks The banking services such as savings and loans will be developed further and the operations will be modernized adopting the e-transaction systems The investments in inter-bank settlements, credit payment mechanisms and the deployment of a number of new services will be increased The financial services will be diversified and their quality and quantity improved, thereby increasing their contribution to the value added in the services sector The communications modalities in the financial and banking systems will be modernised to make the services courteous and expeditious The Government plans to develop and increase the quality of the people’s credit system Regulations on peoples’ credit funds (including Village Development Funds) will be announced to suit the special needs of the social economy and the population Loans will continue to be provided for people to help build independent associations on the basis of volunteerism, self-reliance and self-motivation 4.2 Monetary policy recommendations Based on the estimated results and the economic development strategy of Lao PDR, the following part shows some recommendations to BOL and Lao government 99 4.2.1 Monetary instruments It has been widely agreed that an open market operation is the most effective tool in controlling money aggregate In the case of Lao PDR, BOL has just used open market operation In theory, monetary policy can be implemented by changing the size of the monetary base Central banks use open market operations to change the monetary base The central bank buys or sells reserve assets (usually financial instruments such as bonds) in exchange for money on deposit at the central bank Those deposits are convertible to currency Together such currency and deposits constitute the monetary base which is the general liabilities of the central bank in its own monetary unit Usually other banks can use the base money as a fractional reserve and expand the circulating money supply by a larger amount Hence, BOL should use open market operations frequently to conduct monetary policy since they have a number of advantages: - They are under the direct and complete control of the central bank - They can be large or small - They can be easily reversed - They can be implemented quickly 4.2.2 Choosing intermediate target The study finds that the three real money demand functions in Lao PDR (rm1, rm2k and rm2f) are stable, which is an important foundation for effective implementation of monetary policy Once the central bank can accurately predict the level of the intermediate target either money supply or interest rate and commit to not deviate from the target, monetary policy will not generate inflationary pressure and also will promote economic growth It can be used IS-LM model to analysis (Figure 4.1) 100 IS2 LM(M) i i* LM(i) IS1 Y1’ Y1 Y* Y2 Y2’ Y Figure 4.1: Money and interest rate targets In this figure, the LM curve labeled LM(M) is LM curve that exists when the BOL fixes the money stock The LM curve labeled LM(i) describes money market equilibrium when the BOL fixes the interest rate It is horizontal at the chosen level of interest rate, i* In the short-run, the money demand function is stable as estimated results in the previous part LM curve thus stays unchanged If there is a shift in IS from IS1 to IS2 and BOL keeps the interest rate constant, output will deviate more from its equilibrium than if the BOL keeps the monetary constant In this case the BOL should have monetary targets However, according to Rudebusch and Svensson (2002), monetary targeting is not necessarily an optimal choice to conduct monetary policy for countries even if the demand for money is stable In the case of Lao PDR, the situation is exasperated by the fact that the money multiplier has also been volatile and the velocity of money is not constant (Figure 4.2) In addition, the financial market is not well-developed; and the channels of monetary transmission not work properly These hindering factors will lead to an ineffectiveness of monetary policy implementation by applying money supply as an intermediate target 101 Figure 4.2: Lao money multiplier and velocity, January, 1999 – September, 2012 There are also limitations on other policy regimes For instance, an interest rate targeting is not a viable option as the financial markets are shallow An exchange rate target may not be possible due to uncertainty in foreign exchange flows And, a full-fledged inflation target is not feasible due to lack of well-developed analytical framework and data limitations Given the uncertainty in conducting monetary policy and data and analytical limitations, the authorities could follow an eclectic approach Since the primary objective of the monetary policy is to preserve price stability with the constraint of Lao PDR as multi-currencies use phenomenon and imported counties, the Bank of Lao PDR could use the monetary target flexibly and nominal exchange rates would anchor to achieve its inflation objective as a transitional regime aimed at buying time for the implementation of the structural reforms needed for a single credible nominal anchor 4.2.3 Increasing banking supervisor The stronger the development of banking sector, the more developed the financial system The entry of new banks and the rapid development of the 102 banking sector requires a strengthening of banking supervision Reported nonperforming loans ratios remain low (Table 4.1) and compliance-based onsite and offsite inspections of banks take place regularly However, given the untested risk management capacities, the strong growth of credit to the private sector raises concerns about a possible recurrence of nonperforming loan problems, especially given the backdrop of the continued undercapitalization at two major SOCBs This fact leads authorities to strengthen prudential regulations and supervision, building on recommendations of recent ADB-provided technical assistance Table 4.1: Nonperforming loans ratio and number of banks in Lao PDR 2007 2008 2009 5.9 5.4 3.8 State-owned commercial banks 4.2 1.7 1.3 Joint-venture banks 12.7 4.5 1.3 Foreign bank branches 0.6 13.9 10.5 Private banks … 1.4 1.9 Number of banks 13 20 23 25 State-owned commercial banks 4 4 Joint-venture banks 2 2 Foreign bank branches 10 11 Private banks NPL ratio 2011 Source: BOL 4.3 Some recommendations to Lao government 4.3.1 Dedollarization The most important challenge associated with dollarization is the loss of effective control over monetary policy The small domestic currency 103 component of the monetary base makes it difficult to control monetary growth, which reduces the effectiveness of monetary policy as a tool to stabilize the economy The literature identifies other potential costs associated with dollarization: - Lower seignorage, given that only a portion of the monetary base is in local currency - Lower international reserves, because when transactions are conducted in the foreign currency, the central bank accumulates less of that currency as reserves - Loss of an effective exchange rate policy, the authorities cannot manage the exchange rate in response to exogenous shocks, so that adjustment through the real economy will be necessary - Loss of the lender of last resort role to a financial sector that holds large amounts of foreign currency deposits - Public and private sector balance sheet vulnerabilities due to excessive dollarization of liabilities - Larger output fluctuations since adjustments to external or domestic shocks would require nominal price and wage flexibility According to Jayant Menon (2007), the multiple currency phenomenon in Lao PDR has more costs than benefits If this is the case, then how should Lao PDR go about reversing the multiple currency phenomenon, or increasing the use of Kip in the economy? The only sustainable move away from the multiple currency use towards the increased usage of kip must come from increased confidence in the Kip In this sense, multiple currency phenomenon in Lao PDR is not the problem, but is a symptom The problem, or the cause, is a lack of confidence in the Kip, whilst the symptom, of the effect, is the use of another currency such as the US Dollar 104 The causes of the problem emanate from an underdeveloped monetary system, macroeconomic instability, and weak legal and institutional systems Furthermore, the lack of monetary instruments in the form of Kipdenominated interest-bearing assets further limits the use of Kip as a store of value Most of these problems are long-term in nature, and are characteristic of an economy in transition When these problems are addressed, then the symptom in the form of multiple currency use will also disappear To a certain degree, this is exactly what has happened in neighbouring Viet Nam, where the use of the US Dollar as a medium of exchange has diminished as the monetary and institutional systems have developed and matured, and as macroeconomic stability has been restored In order to improve the role of BOL in conducting monetary policy, the government should: - Develop the financial system: when the financial sector develops, the citizens will have an abundance of assets beside the dollar - Dedollarize by improving the usability of the local currency, adjusting the denomination of the local currency adapted to local business needs 4.3.2 Stimulate financial market development It is necessary to start work on the development of the financial markets at the initial stage of the Sixth Five-Year Plan, in compliance with the strategic content of the Plan This includes the development of the stock market, money market, capital market and immovable property (including land or real estate) market in a comprehensive manner, guaranteeing their regular and safe operation to ensure the growth of the markets step-by-step - Enhance the self-reliance of the business operations of the state-owned commercial banks - Minimize the intervention of bureaucratic hierarchy in the provision of loans by the commercial banks 105 - Improve the mechanisms for the provision of loans and ensure that the pledging of collateral (procurement of secured properties) is in accordance with the direction of enhancing self-reliance - Establish strong regulations to control monetary-financial markets in order to facilitate foreign exchange operations and the transfer (trading) of money in the market to be simple and transparent, while monitoring the movement of the volume of currencies in the market to be consistent with sound monetary management - Study the development of the bond market, setting forth the interest rate to be consistent with the changing situation and the trading within the bond market - Terminate the sale of government bonds to commercial banks to solve the problems of triangle debts (of SOEs) The sale of government bonds should be through open bidding through the banks, with the bond buyers providing clear certificates on their financial status The Government should have an active role in selling bonds and have detailed plans on expenses by period (year) and should publicly declare the plans to enable the commercial banks to balance their capital sources and buy the bonds - Consider developing the state-owned banks in order to enable the Government to supervise and monitor the performances of the monetaryfinancial system to be more transparent in solving doubtful debts through auditing of the accounts and the categorization of debts in accordance with international standards 106 CONCLUSION This dissertation is aimed at exploring the dynamic relationship between the money balance and four other macroeconomic variables: real GDP, expected inflation, exchange rate, domestic and foreign interest rate by modeling and tests for stability of money demand function in Lao PDR during the first quarter of 1993 to the second quarter of 2010 This study employs the Johansen maximum likelihood co-integration procedure to show that there is a long-run relationship of the mentioned variables and applies the error correction model of Engle-Granger Demand for narrow money, broad money and board money in foreign currencies were estimated The estimated results suggested that all demand functions are stable They can be intermediate targets of BOL The coefficient signs are suitable with theory The substantial consequences present as: (i) there is an evidence of the ample influence of exchange rates and interest rates on money balance dynamics in Lao PDR This outcome is associated with a high degree of multi-currency use; (ii) the expected inflation shows the effect of high inflation episodes on money balances especially in terms of foreign currency; the country has improved its macroeconomic stability; and (iii) local currency, Kip, is used mostly for transaction purpose compared to that of foreign currency There is an issue of heteroskedasticity of error term from broad money balance; the short-run dynamic money demand model remains valid and consistent due to its lags and the differencing in lag variables as the components of explanatory variables with percent significant level However, seeking for instrument variables or changing methods of estimation to deal with the issue of heteroskedasticity should be considered in further study 107 In the coming years, the BOL should use open market operations frequently to control the money supply The BOL also has to strengthen the banking supervision to make the banking sector operate efficiently Lao government should stimulate the development of the financial system and step by step dedollarizing This dissertation also considers the limitations in the research and should be interpreted with caution Firstly, according to the unknown form of the data-generating process whether AR(P) or MA(q) or ARIMA(P,I,q), the ADF test may mislead Secondly, if some series sequences have structural changes, the ADF test will be biased and tends to accept the null of unit roots Thirdly, it may be true that our series may have a trend stationary process So this could lead to the misspecification of money demand dynamic models Fourthly, the short-run model may face the problem of third factor argument because the evidence of dropping either one or another variable will make the remaining variables have low power of test The suggestion for future further studies on money demand for Lao PDR may include: (i) Lao quarterly GDP should be used rather than taking Thai quarterly GDP as a proxy in the model, (ii) the forward-looking factor will be considered to avoid the possible model inconsistency 108 REFERENCE Aghevli, B.B and Khan, M.S., (1978) “Government deficit and the inflation process in developing countries”, IMF Staff Papers, Vol 25, pp 383-416 Aghevli, B.B., Khan M.S., et.al., (1979), “Monetary Policy in Selected Asian Countries”, IMF Staff Papers, Vol 26, pp 775-824 Akhand Akhtar Hossain., (2007) “The narrow money demand behavior in Indonesia”, 1970-2005, ASEAN Economic Bulletin Annamaria Kokenyne, Jeremy Ley, and Romain Veyrune., (2010), “Dedollarization”, IMF working paper, WP/10/188, August Asian Development Bank (ADB) Team., (2012), “Lao PDR Bond Market Guide”, February Dwivedi, D N., (2008) Macroeconomics, McGraw-Hill 2008, p 236 Dickey, D & Fuller, W., (1979) “Distribution of the Estimators for Autoregressive Time Series with a Unit Root”, Journal of the American statistical Association, Vol (74), pp 427-431 Jayant Menon., (2007), “Dollarization and the Multiple Currency Phenomenon in Lao PDR: Costs, Benefits and Policy Options”, ADB Institute Discussion Paper No 58 Enders, W., (1995), “Applied Econometric Time Series”, Wiley, New York 10 Engle, Robert E and Granger, C., (1987), “Cointegration and ErrorCorrection: Representation, Estimation, and Testing”, Econometrica 55:251-76 11 Fan, L.S., and Liu, Z.R., (1970), "Demand for Money in Asian Countries: Empirical Evidence", Indian Economic Journal, pp 475-481 12 Friedman, M., (1968), “The Role of Monetary Policy”, American Economic Review 109 13 Goldfeld, S M & Daniel E Sichel, (1990), "The Demand for Money" in the Handbook of Monetary Economics, 1, B 14 Goldfeld, S.M., (1974), “Demand for Money: Empirical Studies” in the New Palgrave Dictionary of Money & Finance by P Newman, M Milgrate and J Eatwell Eds., London: Macmillan Press 15 Goldfeld, Stephen M., (1973), “The Demand for Money Revisited” Brookings Papers on Economic Activity 1973:3, 577-638 16 Goldfeld, Stephen M., (1976), “The Case of the Missing Money,” Brookings Papers on Economic Activity 1976:3, 683-730 17 Granger, C.W.J., and P Newbold, (1974), “Spurious regressions in econometrics”, Journal of Econometrics, 2, 111-120, 18 Hadad, Adeeb, (1985), “Model of Demand for Money in Jordan” Central Bank of Jordan, Unpublished paper 19 Harb, Nasri., (2003), “Money Demand Function: Heterogeneous Panel Application”, Unpublished Paper, UAE University 20 Hendry, D., Pagan, A.R & Sargan, J (1984), “Dynamic specification” in Z Griliches, M.D Intriligator (eds), Handbook of Econometrics, NorthHolland, Amsterdam, pp 1023-1100 21 Hoa Hà Quỳnh, (2008), “Cầu tiền và hệ ñối với ñối với chính sách tiền tệ Việt Nam”, Luận án Tiến sỹ kinh tế, Trường ðại học Kinh tế Quốc dân, Hà nội 22 Hossain, A., & Chowdhury, A., (1996), “Monetary and Financial Policies in Developing Countries Growth and Stabilization” Routledge Studies in Development Economics, London and New York 23 Jason, F Vaccavo., (2005), “Cross-country Evidence on the Demand for Money”, Unpublished Thesis, Calgary, Alberta, Canada 24 Jean- Claude Nachegcz., (2001), “A Cointegration Analysis of Broad 110 Money Demand in Cameroon”, IMF Working Paper, WP/O1/26 25 Jean-Claude Nachega., (2001), “A Cointegration Analysis of Broad Money Demand in Cameroon”, International Monetary Fund, (WP/01/26) 26 Johansen, S and Katarina, J., (1990), “Maximum likelihood estimation and inference on cointegration-With applications to the demand for money”, Oxford Bulletin of Economics and Statistics, Vol 52, pp 169210 27 Johansen, S., (1988), “Statistical analysis of cointegration vectors”, Journal of Economic Dynamics and Control, Vol 12, pp 231-254 28 Judd, J.P Scadding., J.L (1982), "The Search for a Stable Money Demand Function: a Survey of the Post-1973 Literature", Journal of Economic Literature, Set.1982, pp 993-1023 29 Keith M Carlson & Scott E Hein, (1980), "Monetary aggregates as monetary indicators," Review of Federal Reserve Bank of St Louis, issue Nov, pages 12-21 30 Keynes, J M., (1936), “The General Theory on Employment, Interest and Money” 31 Khan, M.S., (1980), “Monetary shocks and the dynamics of inflation”, IMF Staff Papers, Vol 27, pp 250-284 32 Klein, Benjamin., (1974), "Competitive Interest Payments on Bank Deposits and the Long-Run Demand for Money" American Economic Review, American Economic Association, vol 64(6), pages 931-49, December 33 Lodewyk Erasmus; Jules Leichter; Jeta Menkulasi., (2009), “Dedollarization in Liberia—Lessons from Cross-country Experience” IMF working paper, WP/09/37, March 111 34 Mankiw, N Gregory, (2000) “Macroeconomics”, Macmillan 35 McKinnon, Ronald I., (1973), “Money and Capital in Economic Development”, Washington 36 Milton Friedman., (1956), “The Quantity Theory of Money: A Restatement” in Studies in the Quantity Theory of Money, edited by M Friedman Reprinted in M Friedman The Optimum Quantity of Money (2005), pp 51-67 37 Nelson, C.R and Plosser, C.I., (1982), ‘Trends and random walks in macroeconomic time series’, Journal of Monetary Economics 10, 139-162 38 Nguyen, D H., and W D Pfau., (2010), "The Determinants and Stability of Real Money Demand in Vietnam, 1999-2009." GRIPS Discussion Paper 10-14 Tokyo: GRIPS 39 Oluwole Owoye and Olugbenga A Onafwora., (2007) “M2 targeting, money demand and real GDP growth in Nigeria”, Journal of business and public affairs; volume1, issue 40 Oskooee and Tanku., (2006), “Black market exchange rate, currency substitution and the demand for money in LCDs”, SSRN 41 Peter Bofinger., (2001), “Monetary Policy, Goals, Institutions, Strategies, and instruments”, Oxford University 42 Peter Bofinger., (2001), “Monetary Policy, Goals, Institutions, Strategies, and instruments”, Oxford University 43 Phillips, P.C.B., (1986), “Understanding spurious regressions in econometrics”, Journal of Econometrics, 33, 311-340 44 Plosser, Charles I & Schwert, G William., (1978), "Money, income, and sunspots: Measuring economic relationships and the effects of differencing", Journal of Monetary Economics, Elsevier, vol 4(4), pages 637-660, November 112 45 Poole, W., (1970) “Optimal choice of monetary policy instruments in a simple stochastic macro model”, Quarterly Journal of Economics, 84(2), 197-216 46 R W Hafer & Scott E Hein., (1980), "The dynamics and estimation of short-run money demand," Review, Federal Reserve Bank of St Louis, issue Mar, pages 26-35 47 Resina, Katafono., (2001), “A Re-Examination of the Demand for Money in Fiji”, Working Paper (2001/03), Reserve Bank of Fiji 48 Robert J Barro & David B Gordon., 1984, "Rules, Discretion and Reputation in a Model of Monetary Policy", NBER Working Papers 1079, National Bureau of Economic Research, Inc 49 Samreth, Sovannroeun., (2008) “Estimation money demand function in Cambodia: ARDL approach”, Munich Personal RePEe Archive 50 Scott E Hein., (1980), "Dynamic forecasting and the demand for money," Review, Federal Reserve Bank of St Louis, issue Jun, pages 13-23 51 Serletis, Apostolos., (2001), “The demand for money: theoretical and Empirical Approaches”, 1st ed., Kluwer Academic Publishers, London 52 Shaw, Edward., (1973), “Financial Deepening in Economic Development”, New York: Oxford University Press 53 Trần Thọ ðạt, Hà Quỳnh Hoa., (2011), “Cầu tiền và chính sách tiền tệ Việt nam”, Nhà xuất ðại học Kinh tế Quốc dân, Hà nội 54 The Seventh Five-year National Socio-Economic Development Plan (2011-2015), Ministry of Planning and Investment, Vientiane, October 7, 2011 55 Tobin, J (1956), "The Interest Elasticity of the Transactions Demand for Cash", Review of Economic Studies, Vol 23 (3), p.241-7 113 56 Tobin, J., (1958), "Liquidity Preference as Behavior Towards Risk", Review of Economic Studies, Vol 25 (1), p.15-29 57 Tseng, W, and R Corker., (1991), “Financial liberalization, money demand, and monetary policy in Asian countries”, IMF Occasional Paper 84, IMF 58 Valadhani, A., (2006), “What determines the demand for money in the Asian-Pacific countries? An empirical panel investigation”, Faculty of Commerce, Economics, Working Paper 06-11, University of Wollongong 59 Watanabe, S and Pham, T.B., (2005), “Demand for Money in Dollarized, Transitional Economy: The Case of Vietnam”, Paper presented at the 1st VDF-Tokyo Conference on the Development of Vietnam 114 APPENDICES Appendix 1: Estimated results Narrow money demand Long run-relation Dependent Variable: LNRM1 Method: Least Squares Sample: 1993Q1 2010Q2 Included observations: 70 Variable Coefficient Std Error t-Statistic Prob C 2.342115 0.828897 2.825579 0.0063 LNRGDP 0.818950 0.135599 6.039485 0.0000 LNRERKB -0.429020 0.161900 -2.649908 0.0101 LNRERKS -0.577310 0.088470 -6.525472 0.0000 RINUSD -0.105292 0.049539 -2.125437 0.0374 R-squared 0.931918 Mean dependent var 2.594890 Adjusted R-squared 0.927729 S.D dependent var 0.441551 S.E of regression 0.118704 Akaike info criterion -1.355627 Sum squared resid 0.915884 Schwarz criterion -1.195020 Log likelihood 52.44693 Hannan-Quinn criter -1.291832 F-statistic 222.4337 Durbin-Watson stat 1.084246 Prob(F-statistic) 0.000000 115 Short-run Dependent Variable: D(LNRM1) Method: Least Squares Sample (adjusted): 1993Q4 2010Q2 Included observations: 67 after adjustments Variable Coefficient Std Error t-Statistic Prob C 0.030534 0.007601 4.017070 0.0002 D(LNRM1(-1)) 0.369044 0.098959 3.729249 0.0004 D(LNRGDP(-1)) -0.503196 0.071385 -7.049046 0.0000 D(LNRGDP(-2)) -0.415876 0.061560 -6.755643 0.0000 D(LNRERKS(-1)) 0.290540 0.131525 2.209007 0.0310 D(LNRERKS(-2)) -0.260976 0.137117 -1.903315 0.0618 ECMM1(-1) -0.452716 0.085601 -5.288663 0.0000 R-squared 0.667802 Mean dependent var 0.024156 Adjusted R-squared 0.634582 S.D dependent var 0.096013 S.E of regression 0.058040 Akaike info criterion -2.756772 Sum squared resid 0.202116 Schwarz criterion -2.526431 Log likelihood 99.35185 Hannan-Quinn criter -2.665625 F-statistic 20.10255 Durbin-Watson stat 1.527717 Prob(F-statistic) 0.000000 116 Broad money demand in FX Long run-relation Dependent Variable: LNRM2FX Method: Least Squares Sample (adjusted): 1993Q2 2010Q2 Included observations: 69 after adjustments Variable Coefficient Std Error t-Statistic Prob C 8.812256 1.127752 7.814002 0.0000 LNRGDP 0.337019 0.184686 1.824824 0.0728 LNCPI(-1) -0.974416 0.071222 -13.68133 0.0000 LNRERKB -2.337946 0.435255 -5.371444 0.0000 LNRERKS -0.778521 0.192741 -4.039212 0.0002 RINKIP -2.950436 0.951811 -3.099813 0.0029 RINUSD 2.609335 0.928153 2.811320 0.0066 R-squared 0.944002 Mean dependent var 0.632970 Adjusted R-squared 0.938582 S.D dependent var 0.649480 S.E of regression 0.160958 Akaike info criterion -0.719419 Sum squared resid 1.606265 Schwarz criterion -0.492771 Log likelihood 31.81997 Hannan-Quinn criter -0.629500 F-statistic 174.1954 Durbin-Watson stat 1.014820 Prob(F-statistic) 0.000000 117 Short-run Dependent Variable: D(LNRM2FX) Method: Least Squares Sample (adjusted): 1993Q4 2010Q2 Included observations: 67 after adjustments Variable Coefficient Std Error t-Statistic Prob C 0.044788 0.013992 3.200956 0.0022 D(LNRGDP(-1)) -0.369410 0.095476 -3.869145 0.0003 D(LNRGDP(-2)) -0.466658 0.093454 -4.993467 0.0000 D(LNCPI(-2)) -0.779046 0.183050 -4.255930 0.0001 D(RINUSD(-1)) 0.284400 0.094187 3.019510 0.0037 ECM2FX(-1) -0.257166 0.069583 -3.695795 0.0005 R-squared 0.485052 Mean dependent var -0.000616 Adjusted R-squared 0.442843 S.D dependent var 0.112157 S.E of regression 0.083718 Akaike info criterion -2.037447 Sum squared resid 0.427528 Schwarz criterion -1.840012 Log likelihood 74.25449 Hannan-Quinn criter -1.959322 F-statistic 11.49170 Durbin-Watson stat Prob(F-statistic) 0.000000 1.462995 118 Broad money demand in Kip Long-run Dependent Variable: LNRM2KIP Method: Least Squares Sample: 1993Q1 2010Q2 Included observations: 70 Variable Coefficient Std Error t-Statistic Prob C 3.223165 0.883442 3.648418 0.0005 LNRGDP 0.512815 0.180171 2.846268 0.0059 LNRERKB -1.967358 0.223316 -8.809760 0.0000 RINUSD -0.406787 0.061429 -6.622071 0.0000 R-squared 0.927677 Mean dependent var 3.531628 Adjusted R-squared 0.924389 S.D dependent var 0.595540 S.E of regression 0.163758 Akaike info criterion -0.725407 Sum squared resid 1.769905 Schwarz criterion -0.596921 Log likelihood 29.38924 Hannan-Quinn criter -0.674371 F-statistic 282.1891 Durbin-Watson stat 0.765008 Prob(F-statistic) 0.000000 119 Short-run Dependent Variable: D(LNRM2KIP) Method: Least Squares Sample(adjusted): 1993:4 2010:2 Included observations: 67 after adjusting endpoints Variable Coefficient Std Error t-Statistic Prob C 0.042854 0.006975 6.144036 0.0000 D(LNRGDP(-2)) -0.423753 0.055171 -7.680667 0.0000 D(RINUSD(-1)) -0.279312 0.102358 -2.728780 0.0083 D(RINUSD(-2)) 0.372521 0.102159 3.646495 0.0005 ECRM2KIP(-1) -0.232416 0.047263 -4.917512 0.0000 R-squared 0.631270 Mean dependent var 0.034850 Adjusted R-squared 0.607481 S.D dependent var 0.090464 S.E of regression 0.056677 Akaike info criterion -2.831197 Sum squared resid 0.199162 Schwarz criterion -2.666668 Log likelihood 99.84510 F-statistic 26.53613 Durbin-Watson stat 1.721781 Prob(F-statistic) 0.000000 120 Broad money demand Long-run Dependent Variable: LNRM2 Method: Least Squares Sample(adjusted): 1993:2 2010:2 Included observations: 69 after adjusting endpoints Variable Coefficient Std Error t-Statistic Prob C 1.661321 0.772709 2.149995 0.0353 LNRGDP 0.684178 0.137271 4.984126 0.0000 LNCPI(-1) 0.062399 0.031250 1.996729 0.0501 RINUSD -0.189045 0.053584 -3.527977 0.0008 LNRERKB -1.083798 0.246852 -4.390476 0.0000 R-squared 0.945063 Mean dependent var 3.637831 Adjusted R-squared 0.941629 S.D dependent var 0.498756 S.E of regression 0.120500 Akaike info criterion -1.324637 Sum squared resid 0.929289 Schwarz criterion -1.162745 Log likelihood 50.69999 F-statistic 275.2423 Durbin-Watson stat 1.105083 Prob(F-statistic) 0.000000 121 Short-run Dependent Variable: D(LNRM2) Method: Least Squares Sample (adjusted): 1994Q1 2010Q2 Included observations: 66 after adjustments Variable Coefficient Std Error t-Statistic Prob C 0.050269 0.008342 6.025704 0.0000 D(LNRGDP(-2)) -0.489667 0.056522 -8.663302 0.0000 D(LNCPI(-3)) -0.325578 0.104014 -3.130141 0.0027 ECM2(-1) -0.248531 0.060134 -4.132958 0.0001 R-squared 0.609123 Mean dependent var 0.027660 Adjusted R-squared 0.590210 S.D dependent var 0.083790 S.E of regression 0.053638 Akaike info criterion -2.954415 Sum squared resid 0.178378 Schwarz criterion -2.821709 Log likelihood 101.4957 Hannan-Quinn criter -2.901977 F-statistic 32.20589 Durbin-Watson stat 2.038844 Prob(F-statistic) 0.000000 122 Appendix 2: Expansion of commercial banks in Lao PDR As discussed above, private banks were permitted to operate in Laos in 1965 with total number of five banks during the era of monachy regime During 1968-1975, banking system was emerged in the liberated zone ruled by Lao People’s Party After declaration of a full independence in 1975, in March 1976 banking system was merged between two parts and established the National Bank as a mono-bank system with branches in every province and district After renovation policy of the Party and the implementation of market-oriented economy in 1986, a mono-bank was replaced by a two-tier banking system consisting of central bank and commercial banks By enforcing the resolution No.11/SPC dated 11th March 1988 regarding the transformation of banking sector into commercilization, Government completed the transformation of all branhes of the State Bank into stateowned commercial banks located based on geographical locations in 1991 After the enactment of law on investment promotion in 1988, foreign private investor and foreign banks were allowed to open banks in Lao PDR + Until 1991 there were state-owned commercial banks namely : Nakhonlouang Bank, Sethethirath Bank, BCEL (Foreign Trade Bank of Laos), PhakTai Bank , Lao May Bank, LaneXang Bank and AlounMay Bank, Joint Development Bank was established in 1989 All commercial banks were operated under decree of commercial banks + Foreign Banks opened their branches in Lao PDR during 1992-1995 namely: Thai Military Bank (1992); BangKok Bank, Krung Thai Bank and Siam Commercial Bank (1993); Krungsi Aduthaya Bank (1994); Public Bank (1995) Vientiane Commercial bank-joint venture bank between local private 123 sector and foreign partner (1993) In addition, the government also set up Agriculture Promotion Bank as a specilized Bank (1993) Up to 1995 there were 16 commercial banks: state-owned commercial banks, specilized bank, public and private foreign joint venture bank, private joint venture bank, branches of foreign banks and branch from Bank of Malaysia + In 1999 there were state-owned commercial banks merging into banks which later were renamed Lane Xang Bank and Lao May Bank, while BCEL was kept its structure In 1999 BCEL formed a joint venture bank with Investment bank of Vietnam to establish Lao-Viet Bank Kasikone Thai Bank was ceased its operations during Asian Financial Crisis Until 1999 there were 12 commercial banks namely: state-owned commercial banks, specialized bank, branches of foreign banks and joint venture banks + By end of 2003, the government decided to consolidate state-owned commercial banks and renamed as Lao Development Bank, while BCEL remained unchanged Other Banks continued to operate as normal By end of 2003 there were 11 commercial banks, namely: state-owned commercial banks, specialized bank, branches of foreign banks, joint venture banks During this period, commercial banks, joint venture banks and other were operating on a level of playing field, except branches of foreign banks were only permitted to operate within Vientiane Capital + Since the promulgation of Law on Commercial banks in 2006, commercial banks were expanded rapidly Under this Law foreign banks are allowed to open their branches without restricted locations Banks with head 124 office in Laos are permitted to open their branches Bank with head office shall have a minimum registered capital of 300 billion Kip, while branches of foreign banks planned to open shall have a minimum registered capital of 100 billion Kip Until 2011, there were 25 commercial banks operating in Lao PDR, namely: state-owned commercial banks, of which APB-previously specilized bank was transformed into a commercially-oriented banks, specilized bank named Nayoby Bank (founded in 2007); joint venture banks, private banks, affiliated banks, branches of foreign banks, representative offices 125 Appendix 3: Lao Banking System Bank of the Lao PDR State Owned Commercial Banks Joint Venture Bank Private Banks Banque pour le Commerce Extrieur Lao Lao-Viet Bank Joint Development ANZN Bank Bangkok Bank Barque Franco-Lao Phongsavanh Bank Acleda Bank Krung Thai Bank International Commercial Bank Siam Commercial Bank Affiliated Bank Foreign Branch Standard Chartered Bank Lao Development Bank BIDV Bank ST Bank Agricultural Promotion Bank Indochina Bank Thai Military Bank Booyong Lao Bank Public Bank Nayoby Bank
Nayoby Bank is a specialized bank, established in 2007 , with its main role to implement the government policy in providing credit to the poorest districts determined by government Representative Office Ayudhya Bank Sacom Bank Military Commercial Joint Stock Bank Industrial and Commercial Bank of China 126 Table 1: GDP Growth 1991-2010 GDP Components 1991 1992 1993 1994 1995 1996 1997 Agriculture, Forestry and Fishing -2.0 8.6 -1.7 7.1 2.6 3.3 1.7 Industries 9.4 7.8 8.3 12.4 9.0 16.2 12.8 Secondary Industries 9.7 5.1 16.6 7.9 6.8 8.4 14.3 63.7 -6.6 42.0 7.1 57.9 3.6 -3.8 4.0 7.0 5.9 8.1 7.1 6.8 6.9 1998 1999 2000 2001 2002 2003 2004 Agriculture, Forestry and Fishing 7.1 12.6 0.5 -2.2 -0.3 2.5 3.4 Industries 4.8 2.7 8.8 -0.1 13.4 19.4 3.7 Secondary Industries 3.1 8.3 7.0 16.4 11.2 3.8 12.0 -20.9 -41.3 84.5 45.0 15.3 5.0 13.4 4.0 7.3 5.8 5.8 6.9 6.2 7.0 2005 2006 2007 2008 2009 2010 Agriculture, Forestry and Fishing 0.7 2.5 8.6 3.7 2.8 3.2 Industries 10.6 14.1 4.4 10.4 18.5 17.5 Secondary Industries 9.9 9.7 9.1 9.7 6.0 7.0 13.1 19.3 8.1 9.0 3.5 4.5 6.8 8.7 7.8 7.8 7.5 8.1 Taxes on Products and Import Duties (net) GDP Growth Continued Taxes on Products and Import Duties (net) GDP Growth Continued Taxes on Products and Import Duties (net) GDP Growth Source: Department of Statistics, Ministry of Planning and Investment 127 Table 2: Inflation Rate 1991-2010 Month January February March April May June July August September October November December Annual Average Inflation 1991 14.96 13.04 14.00 13.69 15.81 15.23 13.57 13.25 13.38 12.38 12.19 10.36 1992 12.55 12.76 10.36 8.45 7.03 7.09 10.93 13.28 12.46 10.47 7.25 5.98 1993 6.44 6.39 6.06 7.57 5.17 5.21 4.33 5.18 6.53 6.68 7.00 8.96 1994 7.46 7.34 9.34 7.99 7.28 6.95 5.13 5.02 5.89 5.27 7.09 6.77 1996 26.71 29.08 24.97 19.72 13.76 13.23 11.42 4.56 2.95 5.65 6.99 7.28 1997 11.44 11.97 12.44 12.28 16.23 15.93 19.57 25.69 27.64 26.85 25.12 26.56 13.49 9.88 6.29 6.79 19.38 13.86 19.31 Continued January February March April May June July August September October November December Annual Average Inflation 2001 10.11 9.03 8.41 7.80 7.93 6.69 6.93 8.08 6.25 7.11 8.24 7.54 2002 7.18 7.22 7.17 7.44 6.67 9.07 11.23 12.63 14.71 14.25 14.00 15.19 2003 15.36 15.62 17.88 17.83 18.21 16.69 14.98 14.87 14.49 14.45 13.69 12.62 2005 8.06 7.05 6.48 6.42 5.97 5.45 5.35 6.55 7.66 9.44 8.75 8.78 2006 8.09 8.57 8.18 8.31 7.99 8.08 7.74 6.92 5.47 3.70 4.52 4.72 2007 5.51 4.91 4.64 3.56 3.43 3.49 3.53 3.58 4.25 5.59 6.13 5.57 2008 6.09 6.43 7.73 8.68 10.32 10.20 9.96 9.57 8.49 6.53 4.55 3.17 2009 2.43 1.64 0.67 -0.19 -1.59 -1.84 -1.51 -2.26 -1.76 -0.11 1.50 3.92 2010 4.20 4.71 4.89 4.84 4.77 4.94 6.82 7.98 8.13 7.87 6.70 5.76 7.84 10.56 15.56 10.55 7.16 6.86 4.52 7.64 0.08 5.97 2004 12.57 12.90 11.95 11.94 12.39 12.61 12.13 9.21 7.38 6.77 8.13 8.66 1995 7.92 8.53 10.55 14.73 21.11 19.00 19.55 24.66 27.04 26.99 26.84 25.66 1998 31.30 44.65 45.55 62.49 62.77 101.57 103.83 99.54 106.33 112.55 136.28 142.01 1999 150.80 150.42 167.06 159.21 155.44 124.66 135.71 140.17 122.62 121.10 94.33 86.46 2000 75.75 58.74 45.39 34.87 31.01 21.40 10.57 6.63 9.61 8.33 11.02 10.54 87.41 134.00 26.99 Source: Department of Statistics, Ministry of Planning and Investment 128 Table 3: Money Supply 1993-2010 (Kip billions) Year Currency Demand Outside Deposits Bank (1) (2) Dec-93 51.7 19.0 Dec-94 77.6 22.7 Dec-95 108.2 24.2 Dec-96 112.2 32.6 Dec-97 150.3 26.6 Dec-98 285.0 105.8 Dec-99 430.6 139.1 Dec-00 556.9 276.1 Dec-01 714.7 262.9 Dec-02 905.5 358.2 Dec-03 1066.6 436.7 Dec-04 1344.7 540.9 Dec-05 1637.9 610.4 Dec-06 2063.6 767.7 Dec-07 2671.3 1225.8 Dec-08 3052.2 1492.1 Dec-09 3919.2 1704.7 Dec-10 4624.3 2556.0 Source: Bank of the Lao PDR Narrow Saving & Foreign Time Currency Money Deposits Deposits (M1) (4) (5) (3)=(1)+(2) 70.8 30.9 43.7 100.4 45.6 59.0 132.5 44.4 75.7 144.8 70.2 99.2 176.9 96.3 229.7 390.8 116.2 580.8 569.7 96.8 1231.7 833.0 199.7 1712.3 977.6 307.7 2028.8 1263.7 452.3 2490.1 1503.3 761.8 2634.0 1885.6 897.2 3050.4 2248.3 842.9 3158.5 2831.3 944.7 4103.1 3897.1 1382.7 5391.9 4544.3 2025.0 5823.5 5623.9 3395.5 6992.1 7180.3 5452.3 9281.3 QuasiMoney (6) = (4)+(5) 74.6 104.6 120.1 169.4 326.1 697.0 1328.5 1912.0 2336.5 2942.4 3395.8 3947.6 4001.4 5047.8 6774.6 7848.5 10387.6 14733.6 Money Supply (M2) = (3)+(6) 145.3 205.0 252.6 314.1 503.0 1087.7 1898.2 2745.0 3314.2 4206.1 4899.1 5833.2 6249.7 7879.1 10671.7 12392.8 16011.5 21913.9 129 Table 4: Average Exchange Rate 1993-2010 Dec-93 Kip/USD Market Commercial bank Market 733.50 717.00 28.80 Dec-94 729.50 719.00 29.25 28.82 Dec-95 939.50 925.12 37.55 37.10 Dec-96 980.67 939.00 38.61 37.49 Dec-97 2,082.50 2,019.00 47.11 45.54 Dec-98 4,586.00 4,217.00 127.15 116.10 Dec-99 7,686.10 7,674.00 201.70 199.39 Dec-00 8,356.00 8,237.50 194.99 194.50 Dec-01 9,541.50 9,467.00 218.46 216.94 Dec-02 10,790.50 10,714.00 250.80 249.01 Dec-03 10,488.50 10,479.50 264.85 264.17 Dec-04 10,426.00 10,413.50 266.56 266.20 Dec-05 10,850.00 10,810.00 265.60 264.67 Dec-06 9,708.65 9,696.48 272.63 271.83 Dec-07 9,445.16 9,396.73 281.63 281.32 Dec-08 8,525.27 8,518.10 243.84 243.90 Dec-09 8,487.57 8,486.32 256.06 255.86 Dec-10 8,057.28 8,056.14 268.33 268.03 Year Source: Bank of the Lao PDR Kip/Baht Commercial bank 28.18 130 Table 5: Deposits of Banking System 1993-2010 (Kip billions) Current Savings & Foreign Total Year Account Time Currency Deposits = 1+2+3 Deposits (1) Deposits (2) Deposits (3) Dec-93 19.0 30.9 43.7 93.6 Dec-94 22.7 45.6 59.0 127.4 Dec-95 24.2 44.4 75.7 144.4 Dec-96 32.6 70.2 99.2 202.0 Dec-97 26.6 96.3 229.7 352.7 Dec-98 105.8 116.2 580.8 802.8 Dec-99 139.1 96.8 1231.7 1467.6 Dec-00 276.1 199.7 1712.3 2188.1 Dec-01 262.9 307.7 2028.8 2599.4 Dec-02 358.2 452.3 2490.1 3300.6 Dec-03 436.7 761.8 2634.0 3832.5 Dec-04 540.9 897.2 3050.4 4488.4 Dec-05 610.4 842.9 3158.5 4611.8 Dec-06 767.7 944.7 4103.1 5815.5 Dec-07 1225.8 1382.7 5391.9 8000.4 Dec-08 1492.1 2025.0 5823.5 9340.6 Dec-09 1704.7 3395.5 6992.1 12092.3 Dec-10 2556.0 5452.3 9281.3 17289.6 Source: Bank of the Lao PDR 131 Table 6: Loans of Banking System 1993-2010 (Kip billions) Year Claims on Credit to Total Government (net) economy Credit Dec-93 14.2 87.2 101.4 Dec-94 73.4 129.5 202.8 Dec-95 95.7 191.5 287.2 Dec-96 63.8 209.9 273.7 Dec-97 230.3 398.7 629.0 Dec-98 569.5 760.4 1329.9 Dec-99 621.7 1318.3 1940.0 Dec-00 476.2 1858.9 2335.1 Dec-01 1029.3 2474.4 3503.7 Dec-02 934.9 2563.8 3498.7 Dec-03 1165.6 2377.7 3543.3 Dec-04 1159.4 2603.2 3762.5 Dec-05 1071.4 2829.3 3900.7 Dec-06 1122.6 2616.8 3739.4 Dec-07 -247.4 3162.5 2915.2 Dec-08 448.5 5846.8 6295.3 Dec-09 516.0 11143.1 11659.1 Dec-10 674.4 16118.3 16792.7 Source: Bank of the Lao PDR 132 Table 7: Deposits Interest Rates 1993-2000 (% per annum) Saving Deposit 12-month Deposit Year Kip Baht Dollar Kip Baht Dollar Dec-93 12.00 5.00 2.50 15.00 8.50 4.25 Dec-94 12.75 5.00 2.50 14.50 8.00 4.65 Dec-95 16.00 4.75 2.50 17.50 8.00 4.63 Dec-96 16.25 3.75 2.38 17.50 6.25 4.25 Dec-97 16.25 4.00 2.50 18.00 6.50 5.00 Dec-98 22.00 5.50 5.00 22.00 7.50 6.38 Dec-99 9.00 2.75 2.00 20.00 4.75 4.00 Dec-00 9.00 1.75 1.75 20.00 3.75 4.00 Dec-01 9.00 1.75 1.75 20.00 3.75 4.00 Dec-02 9.00 1.75 1.75 20.00 3.75 4.00 Dec-03 7.17 0.50 0.43 14.75 1.40 1.20 Dec-04 8.50 0.31 0.28 12.67 0.89 0.78 Dec-05 4.50 0.48 0.44 10.50 1.13 1.06 Dec-06 4.13 0.69 0.81 11.00 1.98 2.50 Dec-07 3.65 0.75 0.88 10.54 2.04 2.59 Dec-08 3.62 0.82 0.97 9.88 2.17 2.59 Dec-09 3.54 0.99 1.19 10.90 3.41 3.24 Dec-10 3.28 1.00 1.21 8.98 3.28 3.17 Source: Bank of the Lao PDR 133 Table 8: Loans Interest Rates 1993-2000 (% per annum) Year Kip Baht Dollar Dec-93 19.38 15.75 9.00 Dec-94 17.50 14.00 9.00 Dec-95 22.88 14.56 9.50 Dec-96 23.38 14.34 9.69 Dec-97 21.63 14.59 11.25 Dec-98 29.13 14.63 11.63 Dec-99 28.88 13.50 10.75 Dec-00 23.25 10.47 9.13 Dec-01 23.25 10.47 9.13 Dec-02 23.25 10.47 9.13 Dec-03 22.50 11.63 9.67 Dec-04 20.56 11.01 9.64 Dec-05 19.75 11.50 10.79 Dec-06 19.00 11.10 10.55 Dec-07 18.10 11.52 10.17 Dec-08 17.64 11.52 9.83 Dec-09 14.36 8.77 8.54 Dec-10 14.12 9.76 9.28 Source: Bank of the Lao PDR 134 PUBLICATIONS Somphao Phaysith (2012), “Lao banking sector and monetary policy of Lao PDR”, in Proceedings of International Conference: “Lao–Vietnam economic cooperation on development of some key industries up to the year 2020”, Volume III, pp: 136 -167, Vientiane, October, 2012 Somphao Phaysith (2011), “ðầu tư trực tiếp nước ngoài (FDI) với việc phát triển thủ ñô Viêng Chăn”, Kỷ yếu Hội thảo Quốc tế: “Phát triển kinh tế - xã hội Việt nam – Lào giai ñoạn 2011 – 2020”, tập III, pp:153-160, Vientiane, July, 2011 Somphao Phaysith (2011), “The Bank of the Lao PDR’s Mandate on Balancing Growth, Inflation and Exchange Rate”, paper presented at the “International Symposium on Investment Opportunities in Lao PDR”, Vientiane, 15-16th September, 2011 Somphao Phaysith, Tran Tho Dat and Ha Quynh Hoa (2012), “An Analysis of Demand for Money in the Lao People’s Democratic Republic”, Journal of Economics and Development, Volume 14, Number 3, December, National Economics University, Hanoi