Conclusions and Recommendations

Conclusions

The most overriding conclusion of this study is that the formal sector (banks) and semiformal sector (microfinance initiatives) are failing to serve the demand for financial services of the vast majority of rural households in the Lao PDR. This is true for all geographic strata and for all wealth quartiles, but it is especially so for the poor and most remote households. The key findings of this study are:

• Only 5% of all rural households had any savings in a bank;
• Only 4% had savings in a microfinance initiative;
• Only 26.7% of rural savings is held in cash (bank deposit, cash in hand, etc.), while 73.3% is held inkind (primarily livestock but also precious metals and jewelry, and housing materials);
• Only 2% had borrowed from APB in the 12 months before the survey, and only 3% had borrowed from any bank;
• Only 4% had borrowed from a microfinance initiative;
• In contrast, 33% had borrowed from an informal source, including friends, family, moneylenders, and houay.

These results are even more striking for households in the poorest quartile:

• Only 1.5% had savings in a bank;
• Only 1.4% had savings in a microfinance initiative;
• Only 8.5% of rural savings is held in cash, while 91.5% is held in-kind;
• Only 1% borrowed from APB, and 1.9% had borrowed from any bank;
• Only 4.1% had borrowed from a microfinance initiative;
• In contrast, 40% had borrowed from an informal source.

As a result of the low outreach of the formal and semiformal sectors, rural households depend largely on informal sources. Informal loans accounted for 55% of total loan volume for rural households–KN353 billion out of KN637 billion. Moneylenders made loans to about 25,300 rural households, in an estimated amount of KN27.30 billion, a fraction of the informal lending done by households, but still more than twice as much as the semiformal sector.

There was a large reported unmet demand for credit. Unsatisfied demand for credit was almost 7 times as large as actual borrowing by all rural households: actual borrowing from all sources was KN639 billion, while unsatisfied demand was KN4,341 billion. Again, this was most striking among the poorest quartile, for whom unsatisfied demand was almost 40 times as large as actual borrowing (KN30 billion vs. KN1,161 billion). Geographically, the largest unmet demand is in the remote Other Rural households, with unsatisfied borrowing of KN2,250 billion. This accounts for 52% of all unmet demand.

While each stratum and each wealth quartile expressed unmet demand for a diversity of economic activities, unmet demand was also strongly related to the economic opportunities in the particular geographic strata. For example, in remote Other Rural areas, there was high unmet demand for livestock loans. In Provincial Capital areas, there was high unmet demand for non-rice crop production. In Peri-urban areas, there was high unmet demand for trade and other business. In all areas except Peri-urban areas, there was a high unmet demand for non-income generating activities (e.g., education, medicine and heath care, marriage and funeral ceremonies, domestic consumption), which accounts for 23% of unsatisfied demand. The conclusion is clear: outreach of financial services is low, and there is a huge unsatisfied demand for loans by rural households, covering a wide range of production opportunities and nonproduction needs.

The economic characteristics of households also point to the diversity of needs for financial services. Perhaps most importantly, there is a high degree of multifunctionality among rural households: 90% of rural households engage in multiple income-generating activities, and this is similar across strata and wealth quartiles. And although 78% of households engaged in agriculture, livestock raising, or fishing as their primary economic activity, only 38% of total reported income came from these activities. Over half of reported income came from business activities, and this was similar across strata and wealth quartiles, including the poorest quartile. The high level of multifunctionality is an important observation with implications for the rural finance system in the Lao PDR. While rural finance policies have traditionally focused on directed lending programs that target agricultural activities, the high frequency of multifunctionality suggests a need for financial services that serve a broad range of economic activities in rural households. The results highlight the importance of nonagricultural income in rural Lao PDR.

Among the formal sector financial institutions, APB has the mandate to provide financial services to rural areas and has the largest rural service network. However, APB's past practices have significantly weakened it financially. It has high NPLs and a large capital deficit, greatly limiting its ability to extend outreach. It also has limited capacity for proper credit assessment of customers despite receiving significant levels of technical assistance since 1993. However, its most significant constraint appears to be its lack of autonomy in operational decisions as it continues to carry out significant levels of directed, subsidized lending (policy lending) at the behest of the Government.

LDB also has a significant branch network and therefore the potential to increase its provision of rural financial services. Like APB, it also has experience in group lending techniques, which are well suited to lending to groups of rural households without collateral or credit history. LDB is particularly well suited, however, to lend to rural small and medium enterprises, including agriculture processing operations. Also like APB, however, it has high NPLs and a large capital deficit, limiting its ability to extend outreach. It also has limited capacity, but again its lack of autonomy appears to be the most important constraint. No other banks have a significant branch network in rural areas, or an interest in increasing provision of rural financial services.

While funding for semiformal microfinance initiatives has significantly increased in recent years (roughly doubling each year from 1999 to 2003), overall funding remains low, at less than $1 million cumulatively over 5 years. Funding of capacity building has also grown but remains low, at less that $100,000 cumulatively over 5 years. As a result, outreach of these initiatives remains low, as does their capacity.

However, three MFIs have begun to demonstrate the potential of sustainably oriented microfinance in the Lao PDR. Loan products offered by the three MFIs that are striving for sustainability have a median effective interest rate of 48% per year, while loan products offered by INGO and multilateral/bilateral microfinance components have median interest rates from 12% to 22% per year. Only the MFIs charge interest rates at sustainable levels, thus creating the potential to provide permanent access to financial services. Moreover, these three MFIs also had the lowest percentage of borrowers in arrears at 7.8% (lower than other microfinance initiatives, and much lower than the SOCBs, including APB). However, most microfinance initiatives demonstrated weaknesses in financial reporting.

Households' expressed preferences for financial services are also telling. In assessing the importance of various characteristics of loan products, households most frequently cited "confidence that a loan would be made" (59%), whereas the interest rate was cited less frequently (38%). Households in the poorest quartile named "confidence that a loan would be made" almost twice as frequently as the interest rate (52.89–27.64%). These results for the Lao PDR are consistent with results in other countries: the poor are more concerned with sustained access to financial services than they are with low interest rates rates.

It is also clear that, as in many other developing countries, rural households have substantial savings, including the poor. However, due to the low outreach of formal and semiformal financial institutions, the vast majority (73.3%) of savings is held in-kind. And even among cash savings, almost 50% is held outside formal financial institutions.

Recommendations

Embedded in the critical assessment and conclusions above lie the seeds of opportunity and optimism for developing the rural finance sector in the Lao PDR.

When it comes to preferences for savings vehicles, almost 30% of rural households said their first preference was to save in APB or another bank (despite the fact that only 5% had savings in a bank). Similarly, regarding preferences for loan sources, 25% expressed a first preference for APB or another bank, despite the fact that less than 3% of households had borrowed from a bank in the previous 12 months. There are clear opportunities for APB and perhaps other banks (e.g., LDB) to expand their outreach.

At the same time, the results also offer hope for the potential of sustainable microfinance. Although few rural households expressed a preference for borrowing or saving in an MFI, this is probably the result of their lack of familiarity with using MFIs. Moreover, unfortunately, with so few microfinance initiatives operating sustainably, many such initiatives have had short lives, thus discouraging households' reliance on them for sustainable access. At the same time, however, rural households expressed large unmet demand for loans of the kind that MFIs can often deliver more effectively and efficiently than formal banks–small, short-term loans that do not require traveling long distances to obtain. Also, importantly, rural households (especially the poor) more frequently noted the importance of sustained access to loans than they did the interest rate. Hence, the evidence indicates that they are willing to pay sustainable MFI interest rates in the 30–50% range. Indeed, when rural households (again, especially the poor) are unable to borrow interest-free from friends and family, they typically have to borrow in informal markets at interest rates over 100% or even 200%.

The key issue then is how to expand formal and semiformal financial services in rural areas. The Government has already taken important and helpful steps in recent years. The Policy Statement on Sustainable Rural and Microfinance, issued by the Prime Minister's Office in late 2003, establishes a new and improved framework for developing the sector. Much of this policy has also been incorporated in the National Growth and Poverty Eradication Strategy (NGPES) approved by the National Assembly in 2004. These high-level documents call for phasing out directed, subsidized lending by APB and transforming it into a self-sustaining, market-oriented rural financial institution with genuine management autonomy in operational decisions. This is indeed a key and necessary reform. APB, with its branch and service network, has the greatest potential to rapidly expand access to rural finance on a sustainable basis. When such transformations from agricultural policy bank to market-oriented rural bank occurred in Indonesia and Mongolia, both outreach and bank profits grew rapidly.

The Government, BOL, and APB therefore need to carry out the concrete actions to realize the policy embodied in the Policy Statement and NGPES. This includes adopting a concrete plan to phase out policy lending in a short period of time and placing remaining policy lending, if any, in a non-bank, non-deposit-taking policy lending mechanism, preferably on the Government budget where it can be transparently monitored. APB must make loans on a strictly commercial basis, but within the framework of the Government's poverty reduction objectives. As illustrated by this study, market orientation and poverty reduction can be mutually reinforcing objectives. However, to do this, the Government must grant APB genuine management autonomy. While the Government can (and should) set the overall objectives of APB, APB management must then have full independence in operational decisions (including credit allocation) to meet those objectives.

APB must also be brought under the full prudential, regulatory, and supervisory regime for state-owned commercial banks to ensure sound operations, rather than being treated as a special "policy bank" that is not supervised. APB also needs to enhance its human resources management and develop a comprehensive staff training program to ensure capacity. External assistance may be necessary. APB's information and communications systems also need to be upgraded for it to operate as a modern bank, providing quality services and lowering costs. Finally, APB has inherited a precarious financial position as a result of its past operations–capital is highly negative and NPLs are high. APB must be authorized to write-off its loss-graded loans and be recapitalized by the Government, but conditional on a proven track record of improved performance. By operating in a sustainable, market-oriented manner, APB can generate profits, build its capital, finance its expansion, and generate tax revenues for the Government.

At the same time, the Government should continue to support the microfinance sector through improvements in the policy, legal, and regulatory environment, as well as supporting pilot projects focused on the creation and development of sustainable MFIs. The Prime Minister's Policy Statement notes that donors and private businesses, both local and foreign, would invest in microfinance if the environment were conducive, and that MFIs need to have access to national and international public and private investors to expand. Moreover, the Policy Statement calls for a sector comprised of several new, autonomous MFIs with a diversity of legal ownership, including private and public ownership, and practicing a variety of methodologies to meet demand.

The Policy Statement marks a sea change in Government policy to support microfinance. Again, the key is to operationalize these policies through concrete actions. A major improvement was achieved in June 2005, with BOL's issuance of new regulations for MFIs. These regulations permit a variety of ownership–including public, private, domestic, and international–and a variety of MFI models They also distinguish between deposit-taking and non-deposit-taking MFIs, wisely requiring that non-deposittaking MFIs only need to register, while deposit-taking MFIs must be licensed. At the same time, the regulations allow BOL to authorize registered MFIs to accept some deposits if no other deposit services are available from a licensed financial institution in a given location. These regulations are in fact a model that many other countries would benefit from following.

The Government should also continue to take concrete steps to attract foreign investment in the microfinance sector. The authors of this study are unaware of any country in the world where microfinance has been able to develop without significant funding and technical assistance from international donors and development partners. As microfinance has evolved over the past 20 years, shifting from a "social" to a more "commercial" orientation, donors have become more and more concerned about the sustainability and professional, transparent management of MFIs that they support. Moreover, several international investment funds have developed in recent years in response to the recognition that MFIs often need equity investments more than they need credit lines for onlending. In this new environment, both donors and investors are requiring, as a condition of their support, a formal ownership share and seat on the board to allow them to oversee the proper use of their funds. The Government has recognized the need for foreign investment in many sectors of the economy to contribute to technology transfer and management expertise. This applies to microfinance also. Such investments will also complement the currently limited capacity and resources of BOL to supervise MFIs.

For their part, microfinance donors, sponsors, and practitioners must ensure that their microfinance initiatives follow good practices and focus on sustainability from the outset. Directed credit, interest rate subsidies, and other unsustainable practices should be avoided. "Smart subsidies" such as grants for training and capacity building, piloting of new and innovative services, accounting and management information systems, and start-up capital should be encouraged. Donors, sponsors, and practitioners should also actively participate in discussions with the Government to give feedback on the policy environment and suggest revisions when necessary to encourage sector development. They should also consider developing a "code of conduct" to reflect their commitments to supporting sustainable microfinance.

Finally, the Government should regularly monitor the development of the sector. Under the new microfinance regulations issued by BOL, all microfinance initiatives will need to either register or be licensed by BOL. BOL should create a central database of such initiatives, thus allowing it to monitor the number and outreach of institutions of various types. In addition to this direct monitoring, the Government's Rural and Microfinance Committee should meet regularly with microfinance stakeholders to review progress in developing the sector, to receive feedback, to identify implementation and policy issues, and to propose new solutions to further develop the sector.

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