Laos: Downgrade from 6/7 to 7/7 for MLT political risk

Event

Unsustainable external debt ratios and challenging future debt service repayments amid poor liquidity and tightened global monetary conditions have brought Laos closer to a sovereign debt default. Therefore, Credendo decided to downgrade Laos’ MLT political risk rating from category 6/7 to the highest category, 7/7.

Impact

Laos’ public finances sharply worsened because of the double shock of Covid-19 and fallout of the war in Ukraine. Public debt skyrocketed from 69% of GDP pre-Covid to 128.5% in 2022, and from 500% to 966% of government revenues over the same period. As a result, interest payment charges are above 25% of revenues, whereas they were under 10% in 2019. The size of the public debt deterioration is largely explained by the collapse of the kip, which lost 90% of its value against the US dollar between September 2021 and May 2023. Indeed, 85% of Laos’ public debt is external, which greatly exposes the public sector to exchange rate risks. Moreover, public revenues remain by far too low as they amounted to an average 12.5% of GDP in 2020-2022.

The negative impact of the war in Ukraine is visible through other macroeconomic indicators. GDP growth stabilised at 2.3% in 2022 (and thus barely reached an average 1.3% in 2020-2022), whereas inflation soared and amounted to 38.8% in May 2023 because of costlier imports, especially of oil,  making it the second-highest inflation in Asia behind Sri Lanka. The only positive development of the past years came from the significant narrowing of the current account deficit amid stronger exports of main goods, namely minerals and hydropower electricity. The deficit is nevertheless expected to increase in the coming years with the ratio-to-GDP nearing its 2019 level (-9%) by 2025. Still, China’s reopening could contribute to a rebound in Chinese investments, Laos’ exports and the country’s tourism sector – which accounted for 13% of current account revenues before coming to a halt as a result of the pandemic. The tourism sector has slowly been recovering since Laos’ full reopening in June 2022 and this could gradually help and slightly alleviate liquidity pressures and the economic crisis.

Costlier commodity imports have raised the cost of living and led to shortages of basic goods since last year, provoking rare protests in the stable one-party state. In this context, the country has been facing a gradual decrease in foreign exchange reserves, which are chronically low with under two months of imports since 2011. Based on the latest official data from December 2022, the country had an import cover of less than six weeks. As in Sri Lanka and Pakistan, the shortage of foreign currency has led the central bank to prioritise the use of foreign currencies for essential goods. The liquidity stress is happening in a context of a too expensive market access to refinance commercial bonds (on the Thai market) amid tighter global financing conditions. The problem is exacerbated by a very challenging debt service, which is forecasted to amount to at least twice the level of foreign exchange reserves in the next few years. Given the government’s unwillingness to seek support from multilaterals, it will fully rely on its most important creditor China – owning half of Laos’ external public debt – to service its debt. Laos is one of the countries in the world that depends the most on Chinese loans.

Among the several possible options, a combination of an extended debt moratorium (as in 2020-2022), new loans (including a currency swap) and a debt-for-equity deal looks to have potential until an inevitable debt restructuring is decided to restore MLT debt sustainability. Indeed, external debt is very worrying around 120% of GDP in 2021 and expected to remain critical with expensive market access, and a kip at a historic low and under continuing depreciating pressures. Moreover, public external debt could be underestimated due to hidden Chinese debt and contingent liabilities from state-owned enterprises (SOEs) debt. Looking ahead, China is likely to remain Laos’ lender of last resort. The country is a strategic ally for which China cannot let the external debt (vis-à-vis China) go into default, particularly given the latest sovereign debt difficulties encountered by two other Belt and Road Initiative recipients, Sri Lanka and Pakistan. Hence, an external debt default risk looks more elevated for commercial and non-Chinese official creditors. Meanwhile, the authorities are advised to implement structural reforms to put Laos’ economy on a firmer foot, from raising taxation levels to addressing the chronically poor foreign exchange reserves, deep corruption perception within the single communist party and mismanagement of the many loss-making SOEs. However, there is high scepticism those steps will ever be taken, let alone soon. The authorities’ hope that hydropower will solve Laos’ debt sustainability risks and ensure long-term stability is also questionable given huge debt accumulation, low government revenues and insufficient current account receipts. Moreover, electricity production proves to be volatile, particularly given the rising effects of climate change in the Mekong region.

Analyst: Raphaël Cecchi – r.cecchi@credendo.com