Cambodia--Concluding Statement for the 2004 IMF Article IV Consultation Discussions

July 15, 2004

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

July 15, 2004

The mission thanks the Cambodian authorities for the excellent cooperation and support that was provided to facilitate the discussions for the 2004 Article IV consultation, and those surrounding the IMF staff's Ex-Post Assessment report.

I. Recent Economic Developments and Prospects for 2004

Economic performance in the last few years was generally favorable, especially on the macroeconomic front. Annual real GDP growth averaged 6-7 percent, reflecting both favorable external developments relating to bilateral trade agreement with the US and large aid inflows, as well as prudent macroeconomic policies. Under political stability, private sector activities, including in the informal sector, are reported to have flourished in urban areas.

· Exports soared following a 1996 bilateral trade agreement with the United States that effectively reduced the average US tariff rate for garments produced in Cambodia from 50-70 percent to 10-20 percent. As a result, garment exports to the U.S. rose rapidly from $1 million in 1996 to $1,120 million in 2003. The benefit to the domestic economy was less dramatic as almost all non-labor inputs were imported and the bulk of profits were remitted.

· Large aid inflows, which averaged 12 percent of GDP, helped finance a large part of domestic investment and fueled construction activities. About half of the inflows were grants in the form of donor-financed projects outside the budget. Aid inflows were largely used for improving health and education, rebuilding physical infrastructure, and strengthening economic and social institutions. However, only a limited amount was spent on agricultural development.

· Prudent fiscal policy has been key to ensuring price stability in Cambodia's highly dollarized economy. As much as 95 percent of total liquidity, including estimated U.S. dollars in circulation, is in dollars. With few monetary policy instruments, the task of ensuring that aggregate demand does not become a source of inflation necessarily fell to fiscal policy. This task has been made easier in recent years because of low inflation in trading partners.

More recently, real GDP growth of 5.2 percent in 2003 reflected a strong rebound in agricultural production, which more than offset weaker non-agricultural growth due to SARS-related drop in tourism and election related uncertainties in the business environment.

Unfortunately, the pace of structural reforms slowed in the run-up to and aftermath of the July 2003 election. Since 1999, some progress was made in building institutions, including the passage of a Financial Institutions Law that provided the legal basis for successful bank relicensing. In addition, various laws ranging from commercial contracts to accounting were adopted to pave the way for WTO accession. Since 2001, governance issues have been partly addressed in the context of the Governance Action Plan. However, improvements in revenue administration slowed in 2003, and with parliament yet to formally convene, the 2004 budget and a range of legislation needed to complete WTO accession are on hold.

More importantly, the reconstruction efforts have not yet been able to establish a strong foundation for future sustainable growth. In particular, structural weaknesses remain in the following three inter-related areas.

· Favorable external developments have masked an underlying deterioration of competitiveness. Poor public administration and weak governance have exacerbated uncertainty in the business environment, while embryonic and yet poorly maintained infrastructure keeps operation costs high. Increasingly, labor disputes are adding to the already high costs in the formal sector, deterring foreign investment.

· Poverty remains pervasive as recent growth was narrowly based, and economic opportunities for the poor have remained limited. Although 80 percent of the poor live in the rural areas and depend on agriculture, growth in that sector has been slow as access to arable land and markets remains limited. Not only has the slow growth in agriculture pushed Cambodia further away from meeting the MDGs, but the growing income disparity could lead to social unrest as increasing numbers of people are expected to enter the labor market in the medium term.

· Government capacity remains severely constrained by lack of human capital and entrenched governance problems. Progress has been particularly slow in legal and judicial reform, forcing the private sector to operate under uncertain market rules. Even though close to half of all aid flows since the early 1990s have been spent on technical assistance, government capacity remains low in part due to delays in public administration reform and insufficient transfer of knowledge. Fiscal revenue, currently at 10-11 percent of GDP, is hardly enough to even meet the basic priority spending needs.

The outlook for growth in 2004 is tinted by weaker prospects for agricultural production. The Avian flu earlier in the year, the smaller fish catch due to the lower Mekong river level, and crop production that is unlikely to exceed the bumper harvest in 2003 argue for weaker output growth. While non-agricultural growth is expected to rebound strongly due to a recovery in tourism, the overall GDP would most likely grow by 4-4½ percent.

II. Challenges and Prospects

The immediate concern is to find ways to dampen the expected slowdown in GDP growth in 2005. The current situation calls for a much more forceful approach to improve competitiveness by addressing impediments to private sector activities. The elimination of the quota system in January 2005 will expose Cambodian exporters to direct competition from neighboring countries. It will take some time before Cambodia's exports could recover, even if all identified reforms are undertaken. Cambodia could earn some time if the U.S. takes recourse in either the so-called "product specific" safeguard against Chinese imports, available until 2013, or the special textiles safeguard, which expires in 2008. However, it would be highly risky for the government to formulate its economic strategy on the uncertain assumption that the U.S. will adopt either of these two options. Furthermore, additional tariff reduction by the U.S. or relaxation of rule of origin requirements by the EU and Canada would have only a marginal favorable impact.

To achieve the NPRS objective of reducing poverty through durable private sector-led growth, reform in the agricultural sector is essential. Promoting agriculture will reduce income disparity between the urban and the rural sectors, and secure a key source of growth that could help absorb a part of the expected increase in the labor force. At the core of the problem is the poor use of land. The increasing underemployment in agriculture, which is constrained by limited availability of usable land, is an urgent policy agenda that will need to be addressed in tandem with a strengthening of property rights, and formulation of pro-poor commune policies on land, fishery, and forestry. A refocusing of government policy, backed by clear time bound actions, could be complemented by greater investment in agriculture through a redirection of aid flows.

Even under the best case scenario, growth could reach the annual NPRS target of 6-6½ percent only by 2009. This achievement presumes that various challenges, including those noted in this statement, are properly met. A strong agricultural sector growth will also provide a rapid expansion of the domestic market for manufacturing products. Otherwise, a recovery from the negative shock of the quota elimination may not be possible, and growth could be limited to 2-4 percent annually in the medium term.

III. Policy Recommendations

A. Fiscal policy

Attaining the government's fiscal objectives within a medium-term framework hinges critically on the success of additional revenue mobilization. To meet the fiscal revenue target of 2004, tax policy measures (inclusive of those measures announced last December) to yield an additional 0.4 percent of GDP in the remainder of the year are required The mission sees large scope for enhancing revenue collection from strengthened efforts against smuggling and tax evasion, although some progress was made during the first quarter of 2004 regarding duties collected on vehicles. Together with revenue loss from the existing tax exemptions and government concessions and contracts, total potential revenue foregone could be significant.

To achieve fiscal sustainability, cumulative revenue measures equivalent to about 2½ percent of GDP will be needed during 2004-2008. Otherwise it will not be possible to attain the NPRS targets of higher social spending and rural infrastructure development, even if foreign financing were to continue at the current level in US dollar terms. Recourse to domestic financing would threaten exchange rate stability as the market is very shallow. The mission suggests introducing a 2 percent minimum uniform tariff in 2005, one of the August 2003 FAD mission proposals, as the tariff increase will be broadly cost-neutral to garment exporters with the elimination of the auction fee starting in 2005.

The mission considers computerization of the information system, in both the tax and customs departments, to be key to building capacity. On tax administration, continued efforts should be made to collect arrears to help institute a tax-paying culture, including through enforcement measures and strengthening the audit system, and for organizational restructuring of the department aimed at supporting a modern tax system based on taxpayer services, education, and self-assessment. In the customs department, passage of the Law on Customs is crucial to strengthen enforcement capabilities. To help the customs department clamp down on smuggling, a concerted effort is required by other law enforcement agencies, not only at the border, but also in large urban centers.

Serious problems in the process of awarding government contracts need to be urgently addressed to contain the drain of revenue. Most of the Build-Operate-Transfer contracts in recent years were awarded through direct negotiations that resulted in actual payments to the treasury, through either profit sharing or taxes, that were well below expectations. The mission recommends that the National Audit Authority audit the operations of existing contract holders with significant fiscal implications to verify compliance with the terms of the contracts. For new contracts, the World Bank's proposed overhaul of the procurement and concession legislation, which stresses competitive bidding, is expected to help address part of the problem in the medium term.

The mission welcomes progress made in speeding up disbursements under the PAP. Nevertheless, reflecting chronic cash shortages, the government's spending commitments are still bunched late in the year, resulting in delays in disbursements and earmarking of next year's tax receipts. To address this issue, future budgets should explicitly provision amounts for reducing arrears (payable). The establishment of the MEF Reform Committee under the chairmanship of the Secretary General promises a new opportunity to promote ownership and internalization of technical assistance. In this regard, the mission welcomes progress being made under the PFM SWAp, and considers it to be essential that the reformulation build on the improvements, reform efforts, and technical assistance provided to-date. The mission is also encouraged by the government's commitment to improve the effectiveness of public spending by sharpening expenditure tracking.

The mission urges early completion of the ongoing studies needed to make an informed decision in overhauling the structure of the civil service and wages. The government would need to pay attention to the potential social and economic impact of any civil service reform. Therefore, it considers early completion of ongoing analytical studies, which have been substantially delayed, to be critical in preparing a comprehensive civil service reform strategy in consultation with the World Bank. The key studies include functional reviews to determine the appropriate institutional arrangements, organization, processes, and staffing of government functions; and labor market analyses to identify adequate remuneration.

B. Monetary and exchange rate policy

The mission supports the central bank's intervention policy in the foreign exchange market to stabilize excessive fluctuation of the exchange rate. Domestic currency cash injected by government spending is normally retained in circulation as the transaction demand for riel continues to rise with economic growth. Exchange rate instability usually arises when the government's net spending accelerates or the central bank is slow to absorb the excess supply. To the extent that most prices are denominated in U.S. dollars, a fall in the value of the riel will lead to an equivalent increase in prices in riel. Mindful that the riel is predominantly used by the poor in rural areas, it is important to stabilize "riel" inflation at a low level by maintaining a broadly stable exchange rate. At the same time, the authorities should not prevent the exchange rate to adjust to fundamental changes in underlying market conditions.

The mission agrees with the NBC that Cambodia would benefit from de-dollarizing the economy in the long run. In addition to the loss of seigniorage, the lack of monetary policy independence and the central bank's inability to act as a lender of last resort could eventually threaten financial stability. Moreover, although the United States now accounts for 25 percent of Cambodia's gross external trade, this is expected to decline after the elimination of the quota system. Hence, the potential benefits of lower transactions costs from certainty about the value of the riel vis-à-vis the U.S. dollar will be more limited. De-dollarization initiatives, such as requiring that all government transactions be conducted in domestic currency, could also be considered. But forceful administrative measures or political uncertainty could immediately translate into capital flight.

Banks have played only a limited role in facilitating investment finance. While successful bank restructuring during 2000-02 helped financial deepening, lending remains well below those in other countries in the region. At the same time, a too rapid credit expansion without strengthened credit risk assessment capacity of banks and other legal infrastructure that supports the enforceability of financial contracts and reliable borrower information should be avoided. In this regard, the mission welcomes the recently issued prakas on Prepaid Payments on Rentals and Leases, Requirement in Compliance with Fact and Substance, and Payments of Dividends in Advance to contain any potential access to banks' assets. Also, the mission looks forward to an early passage of the Negotiable Instruments and Payment Transactions Law, the Secured Transaction Law, the Insolvency Law, and the Securities and Exchange Law, all of which are needed to reduce payment system risks and to ensure a legal basis for collateral-based lending. Early completion of the implementation of the new chart of accounts and the accounting law will provide banks better information on potential borrowers. The mission also endorses NBC's strategy to reduce lending rates in rural areas through increased competition among lending institutions, and not through administrative measures.

C. Structural policies

Legal and judicial reform has been on the government's agenda for the last 10 years. However, only in recent years has work accelerated on drafting new legislation in conjunction with preparation for WTO accession. Once the accession package is adopted by parliament, Cambodia will become, along with Nepal, one of the first low-income countries to join the WTO. Benefits are expected to be wide-ranging as accession requires adoption of 46 pieces of legislation over the next several years, ranging from judicial reform to trade related property rights. But equally strong effort needs to be placed on proper implementation of these legislations.

The mission welcomes the recent increase of salaries of judges and the establishment of the Royal School of Judges and Prosecutors. Progress has also been made by the Council for Legal and Judicial Reform with the adoption of an action plan to implement the Strategy for Legal and Judicial Reform in June 2003. Since then, reform priorities via a consultative process has been established. While Cambodia will require significant donor assistance, some measures can and should be implemented in the next 1-3 years that require little or no such assistance. Those include:

· Adopting the law on the status of judges and prosecutors that would establish an appointment process and the terms and conditions of service, including a code of conduct.

· Taking concrete steps to ensure the independence and the transparency of the operation of the Supreme Council of the Magistracy, to enable it to fulfill its functions set forth in the Constitution.

· Establishing a commercial court that will specialize in commercial dispute resolution. A law on the commercial court is currently being prepared and is expected to be passed in 2005.

· Passing an anti-corruption law that establishes an effective framework for investigation and prosecution of corruption offences and provides for declaration of income and assets by senior government officials; and preparing the implementing regulations.

· Publishing all court decisions and creating a repository of all laws in English/Khmer.

Private sector activities are deterred by the high costs of inputs, cumbersome administrative impediments and informal fees, as clearly identified in recent World Bank analysis. The high input cost is associated with poor infrastructure and human capital that can only be addressed in the long run. Establishing an independent and well functioning judiciary within a transparent legal system is also a project for the longer term. Accordingly, cumbersome red tape and informal fees, which can only be scaled back through strong political resolve, appears to be the only obvious short- to medium-term solution to the challenge. In addition, the provisions for overtime, nightshift, and holiday pay--while upholding the core labor standards--will need to be revisited. Moreover, greater wage flexibility will need to be assured to avoid creation of an arbitrary dual labor market.

There are several impediments to agricultural growth. At the core of the problem is the limited size of arable land and lack of property rights. About 36 percent of the Cambodian territory (6.5 million hectares) is estimated to be agricultural, grass and shrub land, of which only 2.4 million hectares is cultivated while only 0.3 million hectares are irrigated. Although it is unclear to what extent the remaining land is arable, the size of crop land has not increased since 1996 even though deforestation, though abated now, and demining have continued. In some cases, land concessions for economic use, and lack of clear enforcement of property rights that favored those with power to influence the judiciary in land disputes, have prevented farmers' access to these lands. Moreover, the absence of a clear land registration system has weakened incentives to improve land productivity through irrigation and improved seeds.

While some progress has been made, the mission sees an urgent need for the government to focus more on the land situation, including auditing the process by which recent economic concessions were awarded, reviewing the transfers of ownership of de-mined and de-forested land, and identifying impediments to land cultivation by farmers. Limited access to market due to poor and insufficient roads and lack of information on prices subject small scale farmers to unfair competition. In addition, lack of warehouses contributes to huge price swings between post- and pre-harvest seasons (close to 100 percent sometimes), exposing poor farmers to very volatile income. Perhaps establishing agricultural associations and cooperatives could strengthen the bargaining position of small farmers and improve their access to financial resources.

The mission considers that it is important that the government review, together with donors, the current allocation of foreign aid flows. Although weak administrative capacity may have required that about 40-50 percent of all aid flows be used for technical cooperation (of which a large part was spent for payments of salaries of expatriates) until now, such allocation may not be appropriate in the period ahead as Cambodia enters a new phase of reconstruction. Moreover, the enormous investment needs of the agricultural sector argue for sharper focus on building simple infrastructure rather than for more studies and reviews, except where there is clearly a need.

Unsustainable logging has destroyed a valuable source of income and contributed to soil erosion. Although the ban on logging remains in place, monitoring of illegal log transportation and other forest crimes could be strengthened. The mission recommends retaining the ban on logging until a sustainable forest concession management plan is put in place, as well as a plan for community based forestry to safeguard the livelihood of local communities. In particular, more forceful action is required by the government in response to incidents reported by the Société Générale de Surveillance, the new independent forestry monitoring firm.

Other issues: The mission welcomes continued dialogue with the U.S. and the Russian Federation to seek ways to complete the debt rescheduling negotiation. The mission welcomes progress made toward preparing the annual PRSP progress report, now expected to be completed by end June. The mission notes that the matrix, which is still under preparation, needs to prioritize spending needs and specify monitorable targets and actions for the coming year. Cambodia's statistical framework is being upgraded but substantial weaknesses remain. In the coming years, there is a need to rely more on domestic resources and training to strengthen technical capacities. The mission welcomes progress made in the preparation of a new comprehensive anti-money laundering law, on which the authorities received TA from a joint LEG-MFD mission in December 2003, and look forward to adoption once a new government is formed.

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