Demand for money in laos for PRD and policy implications (tt)

1 INTRODUCTION Demand for money plays a major role in macroeconomic analysis, especially in selecting appropriate monetary policy actions Consequently, a steady stream of theoretical and empirical research has been carried out worldwide over the past several decades The relationship between monetary policy and economic growth is still debated Hossain and Chowdhury (1996) argued that there is a significant correlation between money supply growth and economic growth in the long-run Other studies in this field also point out the importance of monetary policies, especially, in managing the demand side of the economy As Lao PDR is now in the process of a transition toward a market economy, there is an increasing need that the government will change the way it adopts monetary policy to achieve desirable economic growth Research is thus needed on “Demand for money in Lao PDR and policy implications” The main purpose of this dissertation is to examine the money demand function in Lao PDR from the first quarter of 1993 to the second quarter of 2010 (1993Q1-2010Q2), using available data, and to propose some policy implications This dissertation is organized into four chapters as follows: chapter 1: Overview of theoretical and empirical studies on money demand; chapter 2: Lao financial system and monetary policy; chapter 3: Demand for money in Lao PDR; and chapter 4: Policy implications 2 CHAPTER OVERVIEW OF THEORETICAL AND EMPIRICAL STUDIES ON MONEY DEMAND This chapter reviews the main theories of money demand in order to find out what factors can affect demand It also presents some empirical studies on money demand The lessons learned from the literature survey will be helpful in selecting the appropriate modeling framework and to choose suitable variables in the following chapters There is a stream of theory about the demand for money The theoretical development of money demand begins from classical economics All theories try to explain two motives for holding onto money, which are transaction motive and the asset motive 1.1 Some empirical issues in estimating money demand functions Money demand was first conducted in developed countries where the financial system developed and central banks realized the role of money demand in monetary policy There has been considerable interest in other industrial and developing countries over the past decades All empirical studies are based 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 variable (Y) and the opportunity cost of holding money (r) However, the demand for money functions estimated for different countries are not the same, because of the differences in the definitions of the dependent variables, the available of scale variables, and financial development, etc in different countries Choice of variables Definition of money Empirical studies have focused on three monetary aggregates, namely 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 Economists have shown that the studies which interchange the use of M1, M2, or M3 to estimate the demand for money will face the problem of estimating heterogeneous assets For example, cash and demand deposits may differ significantly in terms of transaction costs, risk of loss, and the ease of which illegal or tax-evading activities can be hidden A solution is to separately estimate the demand functions for cash and demand deposits This approach yields more robust empirical results, however, it does not resolve the underlying empirical difficulties Any analysis on Lao PDR will face similar issues regarding the definitions of money and should leverage the advances made by economists to deal with these empirical difficulties Scale variable Recently, scale variables were typically created by using data on a country’s GNP, permanent income or wealth, and cash measured in real terms A number of other related variables that move together with GNP such as net national product (NNP) and GDP are also utilized in creating scale variables without any significant differences Traditionally, GNP is used for transaction-oriented models, while modern-quantity theories rely on permanent income Economic aggregate proxies for scale variables to estimate demand for money function depend a lot on the development of a statistical system and available data Opportunity costs of holding money The interest rates in money demand function include two groups: the own-rate of money and the rate of return on alternative assets Tobin (1958) and Klein (1974) argued that both rates are important and should be included in any model for the for money demand This may include interest rates of government securities, commercial paper, or saving deposits In some countries where the financial sector is not highly developed and which suffers from hyperinflation, the expected rate of inflation is also a useful variable to calculate the opportunity cost of holding money Empirical estimation problems Empirical studies may face “missing money” and spurious regression The problem of spurious regression arises when a regression equation contains independent variables which are random walk or non-stationary variables 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 which contains differential terms In this case, the specification becomes:   ln rmt  a1 ln Yt  a2 rt  a3 ln rmt 1 1.2 Some Asian studies on the money demand function A lot of data is available to estimate money demand function The initial work in this area was primarily confined to industrial countries, especially the U.S and the U.K However, there have been good studies also in developing countries in Asia and South East Asia Many central bank officials realize that understanding the money demand function is the cornerstone of monetary policy The followings studies were chosen on the basis of the potential associated with the Lao PDR context A number of Asian studies, e.g Fan and Liu (1970); Aghevli et.al (1979); Khan (1980); Tseng and Corker (1991); Watanabe S and Pham T B 5 (2005); Nguyen, D H., and W D Pfau (2010) showed that demand for money is a proportion of income level and constrained by a measure of wealth which can be represented by income or permanent income The demand for money fluctuates with changes in the opportunity cost of holding money This opportunity cost depends on the relative return on non-money assets, such as other financial investments Expectations are also 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 case of dollarization, the interest rate of dollar and the exchange rate are also interesting explanations for money balance demand In developed countries, the nominal interest rate is considered as an appropriate proxy for the opportunity cost of holding money, whereas the weak financial markets and the administrative interest rates are the overriding feature in most of the developing countries In these countries, the nominal interest rate is institutionally determined and does not fully capture the opportunity cost of holding money Furthermore, the administrative nominal interest rates are not often adjusted to change in inflation and consequently the real interest rate in many periods becomes negative Therefore, to overcome on this problem, researchers often use the consumer price index as the representation for the interest rate In fact, 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 than the nominal interest rate can be regarded as a better proxy for opportunity costs of holding money in developing countries 6 CHAPTER LAO FINANCIAL SYSTEM AND MONETARY POLICY Lao PDR is a small and land-locked country in Southeast Asia, bordering China, Vietnam, Cambodia, Thailand and Myanmar The total area covers 236,800 square kilometers with a total population of 6.2 million 80 percent of the population engages in subsistence agriculture, utilizing traditional tools to plow and cultivate rice production for economic survival The industrial sector is restricted to hydropower, and mining The social indicators reflect a low level of socio-economic development as demonstrated by high degree of poverty, high illiteracy rate, low life expectancy and high risk for the public health sector 2.1 Overview monetary development in the Lao PDR In the Lao PDR, the overriding objective of monetary policy is to stabilize price and sustaining economic growth The monetary authority’s strategy for inflation management is based on the view that inflation is essentially a currency stability and monetary phenomenon Because targeting the exchange rate level and money supply growth are considered as appropriate methods of targeting inflation in Lao economy, the central bank of Lao PDR (BOL) chose 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 measure of money (M2) as the intermediate target, and the exchange rate and monetary base as the operating target, the BOL utilized a mix of indirect (market-determined) instruments to achieve monetary objectives These instruments include reference exchange rates, reserve requirements, open market operations on Treasury bill, liquid asset ratios and the discount window 7 2.2 Banking system 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 was similar to a centrally-planned economy The role of monetary policy was confined to accommodating the large credit demands of state enterprises Credit plans established at the beginning of the year were of little operational significance, as they were exceeded by wide margins Interest rates did not play any role in the allocation of credit, because of their low levels The banking system before 1988 had some weaknesses: the main sources for providing credit came from banknote printing; high level of nonperforming loans; the interest rate did not reflect the variation of the marketoriented conditions; restrictions of the bank capacity in mobilizing deposits for financial resources; payment and settlement systems had problems of liquidity and the banking system itself did not clearly define its roles between the central bank and commercial bank Banking system reform The Council of Ministers approved the resolution No 11/PM, dated 11th March 1988 on the transformation of the banking sector into a commerciallyoriented system which was aimed at restructuring the State Bank from a mono-bank system and it replaced by a two-tier banking system, consisting of Bank of the Lao PDR, and commercial banks This law gave the Bank of the Lao PDR power and obligations similar to the central bank of developed countries The Bank of the Lao PDR became a Central Bank of the Lao PDR, and one organization of the Council of Ministers, with the main function of maintaining the stability of the value of domestic currency associated with price management and foreign currency management to ensure the flexibility and efficiency of the performance of the banking system The function of the Bank of the Lao PDR (BOL) is to serve as lender of last resort to commercial banks, responsible for issuing or revoking the banking license to commercial banks, and the BOL also has the degree of autonomy in macroeconomic management relating to monetary management In 1992, the government issued the decree No.3 to commercial banks which has become the legal document or basis to transform the branches of the State Bank into commercial banks, performing its operations with autonomy and opening up the banking industry to several types of banking by having other economic sectors invest in the banking sector 2.3 Monetary Policy Monetary instruments To implement monetary policy consistent with market forces, the BOL began to develop monetary instruments, starting from October 1990 by introducing the reserve requirement ratio of commercial banks, providing a short-term loan to cope with liquidity problems of banks, the government or BOL began to issue bills and the BOL began to introduce the interest rate policy Nowadays, monetary tools of the BOL include reserve requirement (RR), interest rate policies, discount window lending, open market operation, and exchange rate Target of monetary policy Since 1988, the BOL implemented the monetary policy with the objective to maintain price stability by setting the monetary aggregates to maintain the value of currency using direct instruments Since 1995, the BOL used indirect instruments to control money supply following the BOL set reserve requirement ratio to provide a short-term loan and serve as a lender of last resort, and the government also issued T-bills to finance fiscal deficits During the global financial crisis in 2007-2008, the BOL pursued monetary policy and exchange rate policy to maintain monetary stability In particular, the BOL used exchange rate policy as a main instrument or nominal anchor to maintain price stability and to control the fluctuation of exchange rates, along with the foreign currency management policy by sufficiently supplying foreign exchanges to the public 2.4 Dollarization The Lao economy is partially dollarized Foreign currency deposits to total deposits remains high, accounting for 53.7 percent and the degree of dollarization is becoming a chronic problem in Lao PDR In Lao PDR, the broad money to GDP ratio is relatively low, approximately 39.3 percent in 2010 The high level of dollarization causes the real demand for domestic currency to decline 2.5 Bond market The government began to issue securities in June 1990 amounting to 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 The first auction for Treasury Bills occurred in March 10th, 1994 Since then biweekly auctions were held between state owned and private banks In January 9th, 1995 the T-bill auction was amended, particularly taking into account the inclusion or participation of the non-banking sector in the bidding 2.6 Stock market After the Lao securities exchange was officially launched on 11th January, 2011, the institutional investor accounts covered a small proportion of total accounts but they played a substantial role in the trading of stocks In 10 2011, overall trading stocks on the Lao securities exchange amounted to 301.49 billion Kip and total trading stock amounted to 40.01 million On 27 th December, 2011 the securities exchange index closed at 899.46 points, a drop of 10.05 percent compared to the base index and the total value of market capitalization equivalent to 0.1% of GDP 2.7 Interbank market An inter-bank market has played an important role recently in the development of the financial market, compared to the previous 10 years when trading was only between commercial banks and the BOL The BOL occasionally provides liquidity for commercial banks that hold T-bills through: repurchase agreements (repo), discount, and collateralised lending 2.8 Exchange rate policy After the declaration of full independence in 1975, economic development in Lao PDR followed in the footsteps of the Soviet style centrally planned economy During this period, the government implemented a fixed exchange rate policy and had multiple exchange rates for different purposes In September 1995, the fixed exchange rate was abolished and the government adopted a floating exchange In 2006, the BOL set exchange rates by determining the range between selling and buying rates within +/0.25 percent Since then, the implementation of this policy exchange rate has been relatively stable for some time 11 CHAPTER 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    1 y   r (3.1) d where M is the demand for money balances, P is the price level, M d / P is the demand for the real money, y is the real income that represents the scale variable, and r is the interest rate on the alternative assets which represent the opportunity cost variable 3.2 Data description and issues The data used in this study is taken from the Bank of Lao PDR The estimated sample uses quarterly data in the period from Q1/1993 to Q2/2010 Definition of money The study applies both narrow money M1 and broad money M2 as the dependent variables In addition, given the fact that there are multi-currencies used in the Lao PDR, the 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, while M2 is broad money consisting of M1, saving and time deposits Scale variable According to data availability, the scale variable used in this study is the gross domestic product (GDP) as an income measurement 12 Opportunity costs Expected rates of inflation, exchange rates and interest rates are used as proxies of the opportunity cost of holding money in the Lao PDR Past value of actual inflation is used as a proxy of expected inflation rates The quarterly series of saving USD interest rate are used as a proxy for foreign currency interest rates due to USD deposits taking the highest proportion Average exchange rates Kip/Dollar and Kip/Baht are used as proxies of exchange rates 3.3 Unit root and co-integrated test Unit root test The prerequisite for a co-integration test is to examine the properties of the time series variables, in order to have a reliable regression test, the dissertation first needs to make sure that the model could not be subjected to “spurious regression” Johansen co-integration test Since the variables are considered to be I(1), the co-integration method is appropriate to estimate the long-run demand for money If the unit roots test suggests that there are non-stationary series with indifferences in integrating orders, the Johansen test approach is conducted to identify the long-run equilibrium of the variables in the structural forms 3.4 Estimating money demand function for Lao PDR by using ECM 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 results obtained from unit root tests and the co- 13 integration 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: n n  ln rmt  0   1i  ln rmt i    ji t i   ECt 1   t i 1 (3.8) i 0 ECt 1  ln rmt 1    1  t 1 Assumptions: (1) The error term is white-noise process E ( t )  0; E ( t t)   for all t, where   { ij2 , i, j  1,2, .m} is m  m positive definite matrix; E ( t  t )  for all t ≠ t ’ and E ( t / xt )  ' (2)  ti ’s are not perfectly correlation or no multi-correlation Estimated results and hypothesis testing Unit root test results Unit root test showed that it could not apply all variables directly in estimating the demand for money function in the case of Lao PDR 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 Johansen co-integration test results 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) The result from  max and trace statistic 14 suggests that the similar co-integration vectors for money demand functions have 95 per cent critical value The error correction model results On the basis of the diagnostic tests, the short-run dynamic model of money demand provides the validity of outcomes, except the broad money M2 model with misspecification Therefore, M2 demand function is not estimated  Short-run money demand functions The short-run dynamic models including narrow money demand, broad money demand functions both in Kip and foreign currencies have a sensible statistic test Estimated short-run money demand functions are as follows : 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  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  ln rm2 f ,t  0.044  0.36  ln rm1,t 1  0.46  ln rgdpt   0.77  ln cpit   0.28 riusd t 1  0.25 EC t 1 (3.11) (3.12) (3.13) All coefficients are significant and reasonable in explaining the model by approximately 45-60 percent The Durbin-Watson statistic shows the overall model serially uncorrelated 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 for narrow money aggregate, 4.3 quarters for broad money in Kip and quarters for broad money in foreign currencies 15 Even the coefficient sign of the real income is negative which is different from expectations, but it significantly affects the demand for real money Thus, this explanatory variable is included in order to ensure the model validity In the estimated narrow money demand function, the coefficient of real exchange rate Kip against 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 for M1 will decrease If the Kip loses value by percent in the last two quarters, then real money demand M1 will decline by 0.26 percent, given other factors are constant The first difference of the real exchange rate Kip/USD in the previous quarter with a positive coefficient is included in this model in order to maintain model validity In equation 3.12, 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 higher opportunity costs of holding money, so the real broad 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 the Kip will decline by 0.27 percent, if other factors remain constant The second difference of real saving in the USD interest rate in the previous quarter with a positive coefficient is included in this model in order to maintain model validity In equation 3.13, the coefficient of expected inflation is -0.77 after two quarters The negative coefficient shows the substitution effect of holding money by physical goods including gold, land, and housing 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, 16 real money demand M2 in foreign currencies will decline by 0.77 percent, if other factors are 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 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 Long-run 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) Long-run broad money demand function in Kip ln rm2 k ,t  3.22  0.51ln rgdpt  1.96ln rerkbt  0.4riusd t (3.15) Long-run 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) The long-run relationship for real M1, M2 in Kip, and M2 in foreign currency have a rational economic explanation All signs are intuitive and plausible Demand for money in the Lao PDR has a positive relation with income If real GDP increases by 1%, demands for real M1, M2 in Kip, and M2 in foreign currency will rise by 0.81%, 0.51% and 0.33%, respectively Thus, demand for narrow money is most affected by changes in output The local currency, the Kip, is used mostly for transaction purposes 17 The Lao demand for real M1, M2 in Kip money functions shows the situation of a multi-currency economy Exchange rates, the Kip against the USD and against Baht, have a negative influence on money demand It shows the effect of currency substitution Therefore, people tend to hold more foreign currencies such as USD or Baht when the local currency loses value Exchange rate elasticity of real narrow money balance is -0.57 to Kip depreciation against the USD, and -0.42 to Kip depreciation against the Baht In the case of broad money demand function in foreign currencies, the exchange rate coefficients of the Kip against the USD and against the Baht are -0.77 and -2.33, respectively This means that when the Kip depreciates against the USD or the Baht by 1%, people reduce foreign currencies from their portfolio by 0.77% and 2.33%, respectively It can be explained by behavior of the Lao people, when the value of the Kip decreases a lot, the citizens expect inflation will be high Hence, they hedge themselves by investing in real estate and gold As a result, M2 in foreign currencies declines Capital mobility is sensible for real M1, M2 in Kip money demand models The real saving in the USD interest rate elasticity has a negative sign, -0.1 in M1 function and -0.4 in M2 in Kip function If the real saving in the USD interest rate (the opportunity cost of holding Kip) increases, people tend to hold less Kip In the case of M2 in foreign currency, the USD interest rate elasticity is 2.6 and the Kip interest rate elasticity is -2.95 The Lao people will have more incentive to hold foreign currencies if the USD interest rate increases and the Kip interest rate decreases Expected inflation shows an important implication to money demand in the Lao PDR The Lao people usually reduce their money balance holding when they expect high inflation They hedge the risk of high inflation by investing in physical assets such as gold, houses and land 18 Interpretation of estimated results The overall results indicate that the single money demand models are plausible to interpret the demand for money phenomenon in the Lao PDR Both the short-run and long-run relationships are meaningful to cite the intuitive explanations for changes in money demand On the basis of the results and the situation in Lao PDR, four important points are worth discussing First, due to the multi-currency use phenomenon in the Lao PDR, the currency substitution plays an important role in determining money balances 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 is hurt more from the exchange rate uncertainty than that of narrow money Hence, in order to maintain prosperity or increase wealth, Lao citizens will be more sensitive to adjust broad money balance, especially foreign assets Second, capital mobility also shows the significant role in real money balances, especially saving interest rates in USD This influence is more elastic in the demand for foreign currency because by law, people can save in foreign currency at domestic banks This result can be a tool of monetary policy and the local currency uses promotion by reducing the incentives of holding foreign currency Third, as Lao PDR experienced a long period of inflation phenomenon, people still preferred an accumulated physical asset to substitute when they expect inflation will increase This situation can be seen from the behavior of people who hold foreign currency instead of local currency People go away from financial assets to physical assets due to the poor financial market development in the Lao PDR; hence physical assets such as land, houses, and gold are the alternative assets to invest in order to hedge exchange rate volatility and interest differential 19 Fourth, people tend to hold the local currency just for transaction purposes as it can be seen that elasticity of real narrow money demand and real broad money demand in the Kip with respect to real GDP is higher than that of real broad money demand in foreign currency Demand for narrow money, broad money in Kip and board money in foreign currencies were estimated The estimated results suggested that all demand functions are stable They can be intermediate targets of the BOL Coefficient signs are comparable with theory 20 CHAPTER POLICY IMPLICATIONS 4.1 Lao economic development strategy Macro-economic targets The economic plan aims to ensure a GDP growth rate of at least at 8% per year 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 maximum level of 5% per annum 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 does 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 should be environmentally sustainable and adhere to set standards, and where possible, create jobs The distribution of gains would be equitable regionally and among everyone Targets for the Economic Sectors Production The target is to produce million tons per paddy within 1.04 million hectares, the expected productivity reaching about tons per hectare Accordingly, the per capita production would 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 domestic animal breeding by 4-5% per year, in which 2-3% will be cows and buffaloes, and 4% pigs and 6% poultry, to develop irrigation for agricultural development using machines and electricity on 60- 21 70% of the cultivable area in flat lands or to cover about 50% of rice and livestock lands and industrial plantation areas In next years, it is aimed to construct hydropower plants with a combined installed capacity of about 2,862 MW during the plan period; to develop maps of minerals in the earth on a 1:200,000 scale on at least 75% of the total land area; to attract tourists on average of 2.8 million tourists per year; to construct/expand road networks to 100% of the road plan to link subregions and construct urban and rural roads to link focus areas and some groups of villages (Kumbans); to expand the telecommunications service network to cover 90% of the villages nationwide 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 a fast developing economy, including its increasing international integration The dynamism of the commercial banks will be improved by reducing the operations of relevant authorities 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 4.2 Monetary policy recommendations Based on estimated results and the economic development strategy of Lao PDR, the following are recommendations to the BOL and the Lao government Monetary instruments The BOL should use open market operations frequently to conduct monetary policy since it has 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; and they can be implemented quickly 22 Choosing intermediate targets The study finds that the three real money demand functions in Lao PDR (rm 1, rm 2k and rm2f) are stable, which is an important foundation for effective implementation of monetary policy The BOL can use these money aggregates as the intermediate targets of monetary policy Increasing banking supervisor The stronger the development of banking sector, the more developed the financial system develops The entry of new banks and the rapid development of the bank sector require a strengthening of banking supervision Table 4.1: Non-performing 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 Dedollarization The most important challenge associated with dollarization is the loss of effective control over monetary policy According to Jayant Menon (2007), the multiple currency phenomenon in the Lao PDR has more costs than 23 benefits Thus, the government should develop the financial system and dedollarize by the following ways: improving the usability of the local currency and adjusting the denomination of the local currency adapted to local business needs Stimulate financial market development In order to develop the financial markets, the Lao government should minimize the intervention of bureaucratic hierarchy in the provision of loans by the commercial banks; improve the mechanisms for the provision of loans and ensure that the pledging of collateral is in accordance with the direction enhance self-reliance; establish strong regulations to control the monetary-financial markets in order to facilitate foreign exchange operations and the transfer (trading) of money in the market; terminate the sale of government bonds to commercial banks to solve the problems of triangle debts (of SOEs), etc 24 CONCLUSION This dissertation aims to explore 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 test for stability of the money demand function in the Lao PDR during the period 1993:Q1-2010:Q2 This study employs the Johansen maximum likelihood co-integration procedure to show that there is a long-term relationship between the mentioned variables and applies the error correction model of Engle-Granger Demand for narrow money, broad money in Kip and board money in foreign currencies were estimated The estimated results suggest that all demand functions are stable They can be intermediate targets of the BOL The coefficient signs are comparable with theory In the future, the BOL should use open market operations frequently to control money supply The BOL has also to strengthen banking supervision to make the banking sector operate more efficiently The Lao government should stimulate the development of the financial system and step by step dedollarize  ... broad money demand in foreign currency Demand for narrow money, broad money in Kip and board money in foreign currencies were estimated The estimated results suggested that all demand functions... themselves by investing in real estate and gold As a result, M2 in foreign currencies declines Capital mobility is sensible for real M1, M2 in Kip money demand models The real saving in the USD interest... issues in estimating money demand functions Money demand was first conducted in developed countries where the financial system developed and central banks realized the role of money demand in monetary