Executive Summary

The main elements of this research report are as follows:

• Chapter 1 presents the motivation and objectives of the study, as well as the survey and statistical methodology.
• Chapter 2 presents an economic overview of rural households in the Lao People's Democratic Republic (Lao PDR), based on a household survey conducted for the study.
• Chapters 3 and 4 present the institutional landscape of financial services in the Lao PDR. Chapter 3 presents details on the formal banking sector, while Chapter 4 presents the semiformal sources of rural and microfinance, including microfinance projects and sustainably oriented microfinance institutions (MFIs), as well as informal sources, including moneylenders, households, and houay or rotating savings and credit associations.
• Chapters 5 and 6 present results of a survey of 1,189 randomly selected rural households. These chapters represent the crux of the study and present the most salient results results. These include analyses of households' access to various means of savings, including formal and informal. They also include access to formal, semiformal, and informal sources of credit. Chapter 6 includes estimates of unsatisfied demand for credit in rural areas. Household preferences for different sources and characteristics of savings and lending products are also presented.
• Chapter 7 presents conclusions and recommendations.

Introduction – The Rural and Microfinance Survey

The Government of the Lao PDR has committed to carrying out a major rural and microfinance reform program consistent with the Policy Statement on Sustainable Rural and Microfinance that the Prime Minister's Office issued in late 2003. This program includes: (i) restructuring the Agriculture Promotion Bank (APB) to be a financially selfsustainable, market-oriented rural finance institution; (ii) adopting an appropriate regulatory framework for prudential supervision of APB; (iii) preparing an enabling legal and regulatory framework for a diversity of MFI models with minimum starting regulations, interest rate autonomy, and private and foreign investment; and (iv) promoting the creation of best-practice MFIs that are private, autonomous, professionally managed, and financially self-sustainable.

Now that the Government has committed to a major reform program in rural and microfinance, it also wishes to monitor development of the sector to assess the impact of reform and to make adjustments as necessary. For these reasons, it was timely to conduct a new survey of rural and microfinance in the Lao PDR. The survey results will hopefully inform policy decisions and the design of microfinance initiatives, as well as provide a baseline from which the Government can assess the effectiveness of its reform program.

This study is based on surveys carried out in early 2004. First, a Household Survey gathered information on the household economy, financial management, assets and liabilities, and attitudes. Second, a Rural Financial Services Survey was carried out with banks, multilateral and bilateral development agencies, international nongovernment organizations (INGOs), and MFIs to capture information about the services provided, outreach, and the terms of savings and credit offered. Third, a survey of moneylenders was undertaken to supplement this data.

The Household Survey used four geographical areas to stratify villages. Map 1 illustrates the villages selected. The strata used were:

• "Peri-urban" (areas within 25 kilometers (km) of, but outside, the country's four largest urban areas of Vientiane, Savannakhet, Luang Prabang, and Pakse);
• "Provincial Capital" (areas within 10 (km) of, but outside, the other provincial capital towns);
• "Rural Mekong" (areas with lowland rice farming systems, which do not fall within the Peri-urban or Provincial Capital strata areas); and
• "Other Rural" (areas using upland intensive and extensive systems, which do not fall within the Periurban or Provincial Capital strata).

A stratified random sample of 1,189 households was selected. The Household Survey collected information on household demographics, economic activities, assets, liabilities, and attitudes to financial services. Analysis was carried out on the sample as a whole, as well as by stratum and by wealth quartile using appropriate statistical techniques.

For the Rural Financial Services Survey, separate questionnaires were designed for (i) banks; (ii) multilateral and bilateral development agencies, INGO, and MFI projects; and (iii) informal moneylenders. The questionnaires collected information on outreach of the institution, lending activities and loan portfolios, and savings services.

An Economic Portrait of Rural Households

Characteristics of rural households' demographic structure and income-generating activities are important determinants of financial decisions such as borrowing, saving, lending, and risk management. Therefore, the study begins by presenting a brief economic portrait of rural households, based on the survey of 1,189 households.

Results indicate that the more remote Rural Mekong and Other Rural strata have larger proportions of poor households, while the Peri-urban and Provincial Capital strata tend to be wealthier. But they also indicate that all four rural strata have significant portions of poor households. Peri-urban households reported average income 1.44 times the average of Provincial Capital households, 2.14 times the average of Rural Mekong households, and 1.68 times the average of Other Rural households. The average income of the richest quartile of households was 5.08 times that of the average income of the households in the poorest quartile.

For 90.34% of rural households, the primary income source is from self-employment (including farming their own land) or ownership of a business. Only 5.38% of rural households have salaried work as the primary source of income, while wage labor provides the primary source of income for only 4.28% of rural households.

Rice production is the most common primary activity (64.65% of rural households), followed by livestock raising (10.24%), and trade (6.96%). Production of other crops is the primary activity for only 3.34% of households. The contrast between the poorest quartile, where rice production is the main activity for about 70% of households and the richest quartile where it is the main activity for only 51% of households, suggests that relative poverty is linked with the production of the subsistence crop as the primary household activity.

However, there is a high degree of multifunctionality among rural households: 90% of rural households engage in multiple income-generating activities. 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.

Overall, only 38% of reported income of rural households came from agriculture, livestock, or fishing. Over half of reported income came from business activities. Among wealth quartiles, the poorest derived only 35% of their income from agriculture, livestock, and fishing, and the richest derived 37%. The results highlight the importance of nonagricultural income in rural Lao PDR.

Rural Financial Services Supply–the Formal Sector

The supply of rural financial services in the Lao PDR can be broken down into the formal, semiformal, and informal sectors. The formal sector consists of the commercial banks; the semiformal sector comprises project-based interventions; and the informal sector comprises loans between friends and family members, informal moneylending, and lending through the traditional Lao houay.

The commercial banking industry in the Lao PDR has three principal groups:

• Three SOCBs: Banque pour le Commerce Extérieur du Laos (BCEL), Lao Development Bank (LDB), and the Agricultural Promotion Bank (APB). BCEL is focused on foreign trade, LDB on commerce, and APB on the agricultural sector.
• Three JVCBs: the Joint Development Bank (JDB), Vientiane Commercial Bank (VCB), and Lao-Viet Bank (LVB). The JVCBs mainly service customers in the country's principal cities.
• Six foreign commercial banks (FCBs), each operating a single branch office in Vientiane, and one British bank with a representative office in Vientiane. The FCBs primarily service their home country clients who have operations in the Lao PDR.

The formal sector banking industry is small and dominated by the SOCBs, which controlled a combined 64% of the KN5.4 trillion ($507 million) in total banking assets at the end of 2003. Among the SOCBs, BCEL is the largest, followed by LDB and APB. However, BCEL has the lowest number of borrowers, with an average loan size of KN1.5 billion. APB has the smallest loan portfolio and the largest number of borrowers, with an average loan size per borrower of KN3 million.

The three SOCBs accounted for 59% of total outstanding loans in the banking sector at the end of the first quarter in 2004. The SOCBs' lending mandates are evident in their portfolio compositions. APB is the principal lender to forestry and agriculture borrowers, with 66% of the total portfolio. BCEL dominates lending to industry (50%), construction and equipment (37%), and trade (41%). LDB has a more balanced loan portfolio.

The commercial banking industry has experienced considerable growth over the past few years. As a consequence of this growth, as well as continuing supervisory weaknesses, nonperforming loans (NPLs) in the industry have also grown. Moreover, as the current three SOCBs are the result of mergers between the previous seven SOCBs, the current SOCBs have inherited the financial difficulties that caused these consolidations in the first place. Hence, as of 31 December 2003, the capital of the three SOCBs was significantly negative at -35.6% of total assets and their aggregate NPL rate was 58%. Ongoing restructuring efforts at the SOCBs and the Bank of the Lao PDR (BOL) are intended to address these problems.

The commercial banks' attention toward rural areas is very limited. APB, with its mandate to promote agriculture, is the most engaged in rural areas, but in practice, the vast majority of its clients are located in urban areas–survey results indicate that only 2% of rural households borrowed from APB in the 12 months prior to the survey. The remaining commercial banks have limited distribution networks. Residents of rural areas are mostly removed from commercial banks and the services they provide.

Rural Financial Services Supply–the Semiformal and Informal Sectors

The semiformal sector in the Lao PDR primarily comprises project-based interventions. They are "formal" in the sense that they either fall under the government-approved activities sponsored by multilateral and bilateral development agencies and INGOs, or they operate under BOL regulations. They are "informal" in that the savings and credit activities carried out are not supervised by BOL and their financial sector operations are not subject to official financial reporting requirements.

The survey had 23 respondents, who supported a total of 50 microfinance initiatives. The respondents comprised three groups. The first consisted of six multilateral and bilateral development agencies supporting microfinance components in larger projects. The second group consisted of 14 INGOs supporting microfinance components in larger projects. The third group consisted of three specialized MFIs set up specifically to provide sustainable microfinance services.

Multilateral, bilateral, and INGO projects are typically implemented through local partners. The Lao Women's' Union (LWU) was the most frequent local partner, followed by the Ministry of Agriculture and Forestry (MAF). One of the sustainably oriented initiatives, established originally with UNDP support, works with the Ministry of Finance (MOF).

Three main types of microfinance organizational forms predominate in the Lao PDR. These are:

• Savings and Credit Unions (SCUs) and Credit Cooperatives operating under BOL regulations.
• Village Savings and Credit Groups (VSCGs) not operating under BOL regulations;
• Village Revolving Funds (VRFs) not operating under BOL regulations.

In the semiformal sector, there are no product offerings other than savings and loans.

Data show that funding for microfinance activities 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.

The total number of villages reached by microfinance initiatives as of 31 December 2003 was reported as 930. The multilateral and bilateral microfinance components reached 211 villages; the INGO components reached 406 villages; and the MFIs reached 313 villages. Overall outreach of 33,392 savers remains low. Conservatively assuming each saver corresponds to one rural household, this implies outreach to only 3.7% of rural households.

As of 31 December 2003, the semiformal sector reported 12,365 outstanding borrowers with loans outstanding of KN12 billion. (The difference in the number of borrowers and savers was due to the fact that one INGO, FIAM, reported having 20,880 savers but was unable to report on its borrowers.)

Loans products offered by MFIs have a median effective interest rate of 48% per year, while loans products offered by INGO microfinance components have a median interest rate of 22% per year, and those of multilateral and bilateral development agency microfinance components have a median rate of 12% per year. Only the MFIs regularly charge interest rates at sustainable levels, thus creating the potential to provide permanent access to financial services.

MFIs also had the lowest percentage of borrowers in arrears, at 7.68%. Multilateral and bilateral development agency projects reported 13.71% of borrowers in arrears, while INGOs reported 14.84%. The data also indicate that groups are less likely to default than individuals, and that women are less likely to default than men.

In the Lao PDR, the informal sector comprises loans between households, informal moneylending, and lending through the traditional houay. Results indicate that rural households made an estimated 353,574 loans to friends, family, and other households valued at KN660.69 billion ($62.2 million) in the 12 months preceding the survey, dwarfing the amount loaned in the semiformal sector.

The vast majority of lending (76%) was done by households in the wealthiest quartile. Households in the Other Rural stratum account for the vast majority of loans by number: they account for 60% of all loans (and 44% of loan volume), almost certainly the result of the lack of outreach by more formal and semiformal institutions in the remote Other Rural areas, and therefore the need to rely on informal inter-household loans.

In the 12 months before the survey, moneylenders made loans to about 25,300 rural households in an estimated amount of KN27.30 billion ($2.57 million), a fraction of the informal lending done by households, but still more than twice as much as the semiformal sector. Moreover, about 3,100 rural households participated in houay which lent their members about KN18.53 billion ($1.74 million), about 50% more than the semiformal sector.

Household Savings

It is commonly believed that many rural households in less developed countries, including the Lao PDR, are too poor to save. However, a considerable amount of research disproves this view. In fact, the poor do save but do not have ready access to savings facilities in formal financial institutions. Instead, they use alternative, informal vehicles for their savings such as livestock, gold and other precious metals, jewelry, and housing materials or other stocks of physical goods. Many of these informal savings mechanisms involve high risk and high transaction costs and result in savings that are not easily turned into ready cash. Experience has shown that households often value the availability of appropriate deposit services as much as, and sometimes more than, access to credit.

Extrapolating from the survey sample to the population, in early 2004 rural households in the Lao PDR held an estimated KN2,290.28 billion ($215.62 million) in cash savings. Almost 90% of rural households reported holding some cash savings–89% reported cash in-hand but only 5% reported any bank deposits, suggesting a low level of outreach by the Lao banking sector (including APB) in rural areas. However, bank deposits represented 55% of cash savings reported, while cash in hand represented 39.75%. Just over 4% of rural households reported savings in the semiformal sector, and this represented only 0.5% of cash savings.

The richest quartile of households accounts for 81.30% (KN1,862 billion) of the cash savings held in banks, while the poorest quartile of households accounts for only 2.10% (KN48.4 billion) of such savings. However, only 13.8% of households in the richest quartile and 1.5% of households in the poorest quartile maintain any savings in the banking system.

In rural areas of the Lao PDR, savings are mostly held in-kind. Non-cash savings amount to KN6,291.7 billion and account for 73.3% of total savings in rural areas. Non-cash savings exceed cash savings for each wealth quartile, and for three of four rural strata (the exception being Peri-urban households). Livestock is the most common means of noncash savings in Lao rural households, used by 98.2% of rural households and accounting for KN4,268 billion. Livestock as a means of savings is especially important for households in the poorest quartile where it accounts for 77.09% of non-cash savings. Precious metals, jewelry, and housing materials are also commonly used as savings vehicles.

Although household preferences are revealed to some extent by actual practices, underlying preferences may differ from practice depending on the availability of options. Almost 30% of households said their first preference was to save in APB or another bank (12.43% in APB and 17.29% in another bank). Some 27.63% expressed some preference (first, second, or third) for APB, while 35.6% expressed some preference for other banks. As less than 5% of households actually have savings in any bank, this suggests a large unmet demand for formal savings services in rural Lao PDR.

Among non-cash alternatives, livestock is the most preferred vehicle for savings, with preferences on the same order as that for banks. More than a quarter of all households (27.97%) stated that livestock was their first preference for saving, and 56.6% expressed some preference for this savings method. Examined by stratum and wealth quartile, results show a more frequent preference for non-cash instruments (especially livestock) as savings vehicles amongst the poorer and more remote households, and a greater preference for APB and other commercial banks amongst richer and less remote households.

Household Borrowing

One cause of poverty observed in less developed countries is the lack of access to credit, especially among rural households. The poor often find themselves in a vicious circle: producing at a subsistence level makes it difficult to accumulate assets, thus making it difficult either to invest any surplus or to gain access to credit in formal financial markets, which leads to low productivity and continued poverty.

Recognizing this, many government policy makers have promoted initiatives to deliver formal credit to rural areas. These have often included setting up special agricultural banks to lend to rural borrowers, and this has also been the case in the Lao PDR.

Overall, 40% of rural households borrowed in the 12 months before the survey. The formal sector made loans to less than 3% of rural households, while the semiformal sector reached 4% of rural households. In contrast, informal sources made loans to 33% of rural households. The poorest two quartiles relied on informal sources significantly more than the richest two quartiles while the richest two quartiles had greater access to formal sources.

Extrapolating from the survey sample to the population, rural households borrowed an estimated KN636.82 billion ($59.95 million) in the 12 months preceding the survey. Borrowing from family and friends was the most common: 25% of households borrowed from friends or family, in an amount equal to KN307 billion (48% of loan volume). The average loan size was KN1.38 million ($130). Supplier credit was the next common means of financing, with loans taken by 6.14% of households, with estimated overall borrowing of KN134.81 billion (21% of loans by value). The average original loan size from suppliers was KN3.76 million ($354). The third most common loan source, in terms of the number of households borrowing, was VRFs. An estimated 2.18% of rural households borrowed from VRFs. The average original loan size was KN612,000 ($58).

APB was the fourth most common means of financing, reaching an estimated 18,267 rural households, or 2.01% of all rural households in the 12 months preceding the survey. It is noteworthy that APB reports about 87,000 total borrowers in the Lao PDR. The survey findings indicate that only 21% of APB borrowers are located in rural areas. This is also consistent with APB's lending records, which indicate that the large urban areas of Vientiane, Savannakhet, Pakse, and Luang Prabang absorb the vast majority of its lending. Average loan size for APB's rural borrowers was KN2.65 million ($249).

Some 30.3% of households in the richest quartile had borrowed during the previous 12 months, compared to 43.1% of the households in the poorest quartile. The poorest quartile was more dependent on friends and family: 28.4% of the poorest households borrowed from this source but only 15.2% of richest households did so. Higher percentages of households in the poorest quartile also borrowed from suppliers, moneylenders, and VSCGs. A higher percentage of the households in the richest quartile borrowed from APB and other banks: 5.5% of households in the richest quartile borrowed from a bank while only 1.9% of households in the poorest quartile did so. And despite APB's mandate to provide subsidized loans to the poor, its richest-quartile clients outnumbered its poorest-quartile clients by more than 3 to 1. However, outreach of APB and other banks was extremely low to all strata and all quartiles.

The average household in the richest quartile borrowed 17 times as much as the average household in the poorest quartile. Moreover, households in the richest quartile borrowed 33.6 times as much as households in the poorest quartile from banks. This included 12.6 times as much from APB. Overall, 77.7% of the borrowing from APB by value was by households in the richest quartile. The vast majority of borrowing by the poor comes from family and friends.

Similar to savings, household preferences are revealed to some extent by practices, but preferences may differ from practice depending on the availability of options. Overall, 57% of households said borrowing from family and friends was their first preference; 75% expressed some preference for this (i.e., either first, second, or third preference). Next was APB, with 19% of households expressing this as their first preference, and 36% expressing some preference for this. This compared to only 6% that expressed a first preference for borrowing from another bank and smaller percentages for other sources. As only 2% of rural households actually borrowed from APB in the 12 months before the survey, there is clearly a significant untapped market for APB.

Rural households were also asked to state what the important characteristics were for them when choosing where to apply for a loan. Consistently across all wealth quartiles, "confidence that a loan will be made" was the most frequently cited important characteristic–households want to be sure of being able to access the loan. Almost 60% of households regarded this as an important factor in choosing where to apply for a loan. In all wealth groups, this was more frequently cited than the interest rate. Households in the poorest quartile named this characteristic almost twice as frequently as the interest rate (52.89% to 27.64%), indicating that confidence about receiving a loan (i.e., access to the loan) is significantly more important than price for them. 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.

For the poorest quartile of rural households, convenience in terms of a short journey to the source of the loan was almost as important as price (24.35% of the poorest quartile citing this as an important factor). For the richest quartile, 50% of households cited interest rates as being an important factor compared to only 26.68% who cited a short journey to the loan provider as being important.

The availability of long-term loans, low collateral requirements, and simple loan procedures were the next most important factors across all households. While longterm loan availability was the fourth most frequently cited important characteristic when determining where to apply for a loan, it is noteworthy that only 22.32% cited this; hence, 77.68% did not consider this to be important. A considerable amount of policy lending by the Government, as well as donor credit lines, has been justified by the perception that demand for long-term loans is high. The evidence of this survey indicates that such policies may be misguided.

In terms of loan purpose, borrowing is concentrated in the transport, services, and trade businesses, as well as livestock, rice production, and medicine and health care. Virtually all borrowing for service businesses takes place in Peri-urban areas (99.3%); and virtually all is borrowed by households in the richest quartile (99.5%). While borrowing for trade is more equally distributed across strata, it is also concentrated in the richest quartile, who borrow 90.6% of such lending. Similarly, borrowing for transport businesses is concentrated in Peri-urban households (67.3%) and households in the richest quartile (91.7%).

Borrowing for rice production is predominant in Provincial Capital and Rural Mekong households, which together comprise 81% of such borrowing. Again, however, such borrowing is concentrated in the richest quartile, which borrowed 63% of total lending for rice production. Borrowing for livestock production is concentrated in Other Rural households, which borrowed 96.7% of such lending; again, the richest quartile account for most, borrowing 95% of total lending for livestock.

Results also point to the importance of loans for health and medical purposes in the three poorer quartiles, which together borrowed 95% of such lending. Households in the poorest quartile borrowed over five times as much as households in the richest quartile for health and medicines, and this accounted for 34.9% of all borrowing by households in the poorest quartile, compared to 0.4% for the richest quartile.

Overall, an estimated 308,884 loans or just over 72% of all loans (by number) were for nonproductive purposes (house construction, domestic consumption goods, health and medicines, education, marriage, funeral, or other purposes) at an average size of KN990,000 ($93), evidencing the substantial demand for the type of lending that can often be delivered through MFIs more effectively than through formal banks.

About half of all loans taken by rural households (50.71%) had zero interest–the vast majority of these came from family and friends. At the same time, 23.75% of loans had effective interest rates of more than 100% per year, and 13.50% had effective rates in excess of 200% per year. In other words, the vast majority of loans were either at zero interest or at extremely high interest–only a small minority fell in the mid-range.

The poorest quartile of households benefit from higher access to interest-free loans (53.7% of their loans compared to 26% of loans borrowed by the richest quartile and 50.7% of loans borrowed by the population as a whole), but they are also less able to access interest-bearing loans at the rates prevailing in the commercial banking sector. Only 8.9% of the interest-bearing loans received by the poorest quartile of households were at less than 60% interest per year, while 42.6% of the interest-bearing loans received by the richest quartile were at less than 60% per year. It is estimated that, nationwide, the poorest rural households borrowed 22,485 loans at interest rates over 100%, while the richest rural households borrowed 10,698 loans at these interest rates. Clearly, delivering sustainable, market-oriented credit at (unsubsidized) market interest rates to the poor through MFIs and APB could make a significant contribution to the wellbeing of the poor.

The results show considerable unsatisfied demand for credit among rural households. Overall, unsatisfied demand equals KN4,341 billion for all rural households, which is 6.7 times the amount actually borrowed over the previous 12 months. This difference between actual borrowing and unsatisfied demand is most pronounced among households in the poorest quartile–unsatisfied demand is 39 times as large as actual borrowing. In contrast, for households in the richest quartile, unsatisfied demand is only 3.93 times as large as actual borrowing. The Lao rural finance system is clearly failing to satisfy the demand for credit from the poorest households.

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 in the country and is likely a result of the low level of outreach by financial institutions in the more remote areas. Relative to actual borrowing, Provincial Capital households and Other Rural households are the most underserved–with unmet demand exceeding actual borrowing by factors of 15.76 and 11.43, respectively. This contrasts with Provincial Capital households, whose unmet demand is only 2.28 times their actual borrowing. The conclusion is clear: there is a huge unsatisfied demand for loans by rural households, covering a wide range of production opportunities and nonproduction needs.

Conclusions and Recommendations

The most overriding conclusion of this study is that the formal sector and semiformal sector 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. 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, while 73.3% is held in-kind;
• 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 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.

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. 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.

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.

Three MFIs have begun to demonstrate the potential of sustainably oriented microfinance in the Lao PDR. 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.

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.

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, 25% expressed a first preference to borrow from 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. 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, the evidence indicates that rural households (especially the poor) are willing to pay sustainable MFI interest rates in the 30–50% range. Indeed, when rural households (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 is how to expand formal and semiformal financial services in rural areas. The Government, BOL, and APB need to carry out the concrete actions to realize the policy embodied in the Prime Minister's Policy Statement on Sustainable Rural and Microfinance and the National Growth and Poverty Eradication Strategy. This includes phasing out policy lending in a short period of time and placing remaining policy lending, if any, in a non-bank, nondeposit- taking policy lending mechanism. APB must make loans on a strictly commercial basis. 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.

APB also needs to enhance its human resources management and upgrade its information and communications systems. Finally, 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.

A major improvement in the microfinance operating enviroment was achieved in June 2005, with BOL's issuance of new regulations for MFIs. These regulations permit a variety of ownership and a variety of MFI models. They also distinguish between deposit-taking and non-deposit-taking MFIs, wisely requiring that non-deposit-taking MFIs only need to register, while deposit-taking MFIs must be licensed.

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. Donors have recently 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 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.

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.

Finally, the Government should regularly monitor the development of the sector. BOL should create a central database of microfinance 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.

The views expressed in this paper are the views of the author/s and do not necessarily reflect the views or policies of the Asian Development Bank Institute nor the Asian Development Bank. Names of countries or economies mentioned are chosen by the author/s, in the exercise of his/her/their academic freedom, and the Institute is in no way responsible for such usage.

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