I am writing this while I am vacationing with the family in Thailand. However, in a couple of weeks we will be heading to Laos where my wife has worked for a number of years.

So I thought it would be interesting to write a small post on the economic situation in Laos and “luckily” for me – or at least for the relevance of what I am going to write – we are at the moment at challenging times for the Lao economy. I am of course no implying this in anyway is good – it is bad – but just saying that it is easier to write a blog post if there is some interesting to write about and for some reason crisis is more interesting than no-crisis.

This story is a couple of days old:

Debt-ridden Laos has been told by the International Monetary Fund to tighten its policies to avoid a major economic crisis.

An IMF mission held annual consultations recently with the government in the country’s capital Vientiane, raising concerns about its rising inflation, the banking system, public spending, deteriorating current account deficit and falling international reserves, according to the Washington-based Fund’s officials.

“A tightening of macroeconomic policies is urgently needed to reduce vulnerabilities, replenish international reserves and engineer a soft landing,” Ashvin Ahuja, who led the IMF mission from Aug. 28 to Sept. 12, said on his return to the U.S. capital.

The IMF warning came amid a persistent shortfall in revenue, which led Prime Minister Thongsing Thammavong to order ministries and government agencies last month to closely control expenditures for Laos to pay its debts and avoid a financial crisis.

“In general, Laos is running a high level of debt and is at risk of a financial crisis,” Thongsing said, according to the state-controlled Vientiane Times newspaper. “This means we should closely control all aspects of investment and sharpen our focus during the upcoming 2013-14 fiscal year.”

Finance Minister Phouphet Khamphounvong told the national Assembly, the country’s parliament, in July that the government debt is 29.8 percent of Gross Domestic Product (GDP), or the country national output. The debt to GDP ratio is one of the indicators of the health of an economy.

This sounds like the most classic of classic Emerging Markets crises – a balance-of-payment crisis caused by excessive easy monetary and fiscal policy under a pegged or quasi-pegged exchange rate regime.

This story is really simple and very much a textbook crisis. The fiscal situation is unsustainable – the debt to GDP ratio continues to increase. As a result sooner or later the government will have to monetize the budget deficit (this is the old story of some unpleasant monetarist arithmetics). Obviously the central bank will not be able to maintain a pegged or a quasi-pegged exchange rate if it also have to fund an ever larger government budget deficit. Therefore, devaluation fears will be escalating leading to currency outflow. This is what we are seeing in Laos – the currency reserve continues to drop.

Furthermore, if fiscal policy is eased via the banking system – as it is partly the case in Laos (and other quasi-reformed communist countries like China and Vietnam) then you are also going to get a banking problem sooner or later. Furthermore, there are some clear reminders of earlier Emerging Markets crises where government controlled, sponsored or government owned banks are subject to special interests – such as the business ventures of top government or ruling party officials. This obviously is the ultimate form of moral hazard. I don’t know the Lao story well-enough, but my suspicion would clearly be that we could be facing this kind of problems with crony-government-banking in Laos as well.

Hence, in the stylized textbook balance-of-payment crisis you have a situation where the currency is facing a major correction due to a cocktail of overly easing fiscal, monetary and credit policies (add some cronyism). This also seems to be the case of Laos today.

Ensure nominal stability through fiscal consolidation and banking reform 

The policy prescription in such a scenario is quite clear. If you want to maintain a pegged or quasi-pegged exchange rate you will have to significantly reduce the devaluation expectations and the only way to do that is to reduce the public budget deficit so nobody will fear that the public debt will be monetized. The cost of this of course would be a major slump in domestic demand or said in another way you cannot both ensure currency stability and economic stability.

A more prudent alternative to a sharp drop in domestic demand would be to allow the currency to weaken significantly – in the case of Laos a sharp devaluation of the kip. Obviously that would not solve the fundamental fiscal and banking problems. You would still need massive fiscal consolidation and banking reform (a total de-politicization and privatization of the Lao banking sector). However, a devaluation (and a shift to some kind of rule based monetary policy regime) could significantly reduce the possible negative economic and financial implications of the needed fiscal and financial adjustments.

I am no expert on the Laotian economy, but it certainly looks like we are here dealing with a very classic balance-of-payment crisis. This is something we rarely see these days and most countries are not really maintaining pegged exchange rates (the euro countries is a horrible outlier here). It will be very interesting to see how this plays out in the coming quarters. It could unfortunately end very badly if the situation is mis-managed, but I also think that crisis can be avoided if the right step are taking by Laotian policy makers – devaluation and the introduction of a new monetary policy regime with a more freely floating kip, fiscal consolidation and banking reform.  This obviously is much easier said than done in a only partly reformed communist country.

One thing I hope that the IMF is not recommending to the policy makers in Laos is to “fight to the end” to defend an unsustainable level for the kip. That could potentially lead to an extreme tightening of monetary policy which would send the economy into a free fall and a banking crisis would be nearly impossible to avoid. This is the kind of mistakes countries like Thailand and South Korea made in 1997. I hope Laos will not repeat these mistakes.

PS I did not mention China here, but it is obviously important. About one third of Laos’ exports goes to China so it is very easing to argue that Laos is hugely affected by Chinese monetary tightening. This is the China as a monetary superpower story. That said the recent slowdown in the Thai is likely somewhat more important.