By Jonathan McGrain

Dawn in Vang Vieng, Laos. Laos’s ability to sustain economic growth will depend heavily on attracting foreign investment and increasing the human capital of its citizens. Source: Kelsey Hannah’s flickr photostream, used under a creative commons license.

The accession of Laos to the World Trade Organization last year was the latest in a series of milestones in the country’s global economic integration, stretching back to the launching of economic reforms by the ruling Lao People’s Revolutionary Party in 1986.

Since then, the Lao government has pursued a steady, albeit slow and conservative, path toward opening its economy, resulting in one of the highest rates of gross domestic product (GDP) growth in the world, averaging 7.6 percent over the past five years.

While the Lao economy remains the smallest in Southeast Asia, it has been drawing the attention of foreign investors for a number of reasons, including its abundant natural resources, low-cost labor force, and proximity to China and the fast-growing markets of ASEAN.

Laos’s neighbors – China, Thailand, and Vietnam – continue to dominate the investment landscape, accounting for more than half of all foreign investment. China surpassed Vietnam last year, with licensed projects valued at more than $5 billion. But Laos is broadening its appeal to other investors as well. Japanese investment increased by nearly 15 percent in 2013, to more than $400 million, attracted by improvements in the country’s infrastructure and the prospect of an alternative production base to Thailand.

Mining and hydropower remain the leading foreign investment sectors, together accounting for about half of licensed projects and more than 60 percent of exports last year. Tourism has grown at an annual rate of 18 percent since 2008, and is one of the nation’s leading sources of foreign exchange, generating about half the revenue of mining exports.

But the story of Laos’s impressive growth is accompanied by a long list of challenges.

The prominence of extractive industries highlights that rapid GDP growth does not necessarily translate into broad economic advancement and infrastructure improvement.

The mining sector has been hit by falling global commodity prices. Despite achieving record production last year, the Sepon mine in southern Laos, one of the nation’s largest, saw earnings fall 19 percent as a result of lower copper prices.

Although hydropower exports, primarily to Thailand, generate tremendous revenue, they remain a source of tension between Laos and its neighbors, and a lightning rod for criticism from environmental and other non-governmental organizations.

While investors are attracted by low labor costs, businesses find it difficult to hire and retain qualified employees. Poorly funded schools have failed to produce enough skilled workers to fill manufacturing and other technology-driven jobs, and those with qualifications frequently pursue higher paying work in Thailand.

Like other developing countries, Laos is handicapped by an immature judiciary and legal system, and was ranked 159 out of 189 economies in the 2014 World Bank Ease of Doing Business survey, which measures the effect of business regulations and their enforcement.

However, some challenges facing Laos may represent investment opportunities. While agriculture contributes about one quarter of GDP, it is the slowest growing sector of the economy, hobbled by low productivity and outdated farming methods. Infrastructure and information technology remain significant impediments to development, particularly in remote, mountainous regions outside Vientiane and other population centers. Health care and education suffer from chronic underfunding.

The most immediate and significant challenge facing Laos is an expanding fiscal crisis. The country has a ballooning budget deficit, fueled by unchecked spending by state organizations and provincial governments and an outsized increase in public sector wages last year. The Asian Development Bank in April warned that Laos must address its deficit in order to maintain economic stability and future growth, even if it means accepting slower near term growth .

A proposed $7.2 billion high-speed railway between Vientiane and China’s Yunnan province further complicates fiscal matters. The project cost is about 70 percent of Laos’s GDP and while the source of financing remains unresolved, a strong possibility exists that Laos will end up shouldering most of the burden through loans from China.

At its highest levels, the Lao government appears to take the situation seriously, working to control wayward spending in the state sector and the provinces. State media attributed a recent cabinet shake-up, including the appointment of a new finance minister, to “economic difficulties driven by budget tensions.” More than 250 state investment projects have been suspended, and efforts are underway to improve revenue collection.

The next milestone in Laos’s economic integration path is the launching of the ASEAN Economic Community (AEC), set for the end of 2015, which will liberalize flows of capital and labor among the 10 ASEAN nations. While the AEC presents new opportunities for investment in Laos, concerns exist about whether Lao industries will be overwhelmed by foreign competitors with superior resources and experience, and whether the arrival of skilled workers from other countries will hurt local employment.

Over the past 30 years, Laos has achieved a respectable track record of economic liberalization and integration. The nation’s ability to navigate its present challenges and maintain growth by continuing to attract foreign capital will depend largely on the government’s stewardship of the economy and investment environment.

Mr. Jonathan McGrain is publisher of Laos Investment Review. Readers can learn more here.