A. History of the Monetary System

2. The low trust in the domestic currency and in the banking system is a legacy of devastation and civil strife during the past three decades. After gaining independence in 1953, Cambodia maintained peace and economic growth for the next 17 years until the increasing strife in the region led to internal political turmoil. The period of 1970–75 was characterized by a civil war, which finally brought the Khmer Rouge to power in April 1975. The Khmer Rouge regime launched a radical experiment in communal economic and social organization: private property was outlawed, money and banks were abolished, and even barter trade was officially banned, as workers were paid in food rations.

3. A new regime came to power in 1979, and the riel was reintroduced as the domestic currency in 1980, although the political structure and security situation continued to be unsettled. Confidence in the domestic currency was further eroded by triple-digit inflation during 1988–92 as a result of substantial monetization of budget deficits. A parallel currency (the Khmer riel) was reportedly introduced by Khmer Rouge in the areas under their control in March 1993, although no information is available on the extent of its circulation. The high rates of inflation and continued political instability induced the public to shift from the riel to foreign currencies and gold.

4. The use of the dollar was further facilitated by large foreign exchange inflows associated with the United Nations operations and the return of expatriate Cambodians in early 1990s. The operation of the United Nations Transitional Authority in Cambodia (UNTAC)—one of the largest and most expensive UN operations ever mounted—cost $1.7 billion during 1991–92, most of which was spent for rent and local services by the 15,500 deployed troops and 6,000 civilians. Not surprisingly, foreign currency deposits started to be an important component of the bank deposit base in 1992.

5. Significant progress in financial stabilization had been made under the first ESAF arrangement during the period of 1994–97, leading to sharp declines in inflation and measured velocity. Economic performance, however, deteriorated after July 1997, and central bank financing of the budget was used in 1998 for the first time in 4 years. After the formation of a new coalition government in late 1998, the political environment has stabilized and macroeconomic performance has been strengthened. In 1999, GDP growth accelerated and inflation fell to low single digits.

B. Extent of Dollarization

6. Cambodia’s monetary system is characterized by a high degree of currency substitution and transactions are made mostly in cash. Prices for goods and services are routinely quoted in US dollars, and most transactions in the main cities are settled in dollars. The riel is used for small cash transactions only, and is injected into circulation primarily through government payments for goods and services (including public servants’ salaries). Although foreign currency cash holdings can not be effectively measured, they are estimated to be in the range of 85–95 percent of total currency in circulation. This suggests a stock of foreign currency cash holdings several times larger than measured broad money.

7. Asset substitution is also pervasive in Cambodia, with the share of domestic to total deposits remaining at less than 7 percent. A scant 2 percent of bank assets is denominated in riel, mostly in the form of non-interest bearing vault cash and reserves with the central bank. Bank intermediation in local currency is minimal at most banks, and a number of institutions do not accept riel deposits at all. The vast bulk of lending activities consists of dollardenominated short-term trade-related credits, and is small in relation to GDP. There are virtually no restrictions on current and capital account transactions.

8. The use of foreign currency in Cambodia is facilitated by the existence of an active foreign exchange market, with 24 money changers licensed by the National Bank of Cambodia (NBC). This market reportedly accounts for three fourths of total foreign exchange transactions, and effectively ensures access to foreign currency. Since 1994, the NBC has set the official exchange rate each morning based on surveys of the rates quoted by three major dealers in the market the day before, maintaining the spread to no more than 1 percent except for periods of market turbulence. Periodically, the NBC has conducted foreign exchange auctions in which it sells to the private sector a portion of the government’s foreign exchange receipts from nonproject foreign aid. The NBC has not auctioned foreign exchange since the second half of 1997, and with economic recovery since late 1999, has been a net purchaser of foreign exchange from the market.

9. The progress in financial stabilization since 1994 has led to significant reductions in inflation and measured velocity, but has not yet resulted in any significant reversal of dollarization, in part because of on-going political uncertainty, especially during 1997–98. Foreign currency deposits continue to be an important component of the bank deposit base, and almost fully account for changes in broad money in recent years. Increasing confidence since late 1998 has been reflected in the return of foreign currency deposits to the banking system with the share of foreign currency deposits in broad money returning to its pre-1997 level of above 60 percent.

C. Benefits and Risks of Dollarization²

10. Dollarization of financial systems in developing countries presents both advantages and risks. Following a period of very high inflation and unstable macroeconomic conditions, allowing the use of foreign currency in the domestic financial systems enhances the opportunity for reintermediation and promotes financial deepening in the economy. In addition, it can lower inflation and promote more prudent macroeconomic policies, therefore lowering the risk premium for borrowing, and inducing higher investment and economic growth. It can also promote financial and trade integration with the United States, as well as reduce the frequency and scale of external crises, in particular, if the economy is exposed to large volatile capital flows. In the case of Cambodia, the destruction of economic institutions after 1970s, economic mismanagement in the 1980s, and the large inflow of US dollars in the early 1990s, resulted in rapid dollarization, which at the same time has helped support the reconstruction of the economy.

11. On the negative side, full dollarization implies that the central bank completely relinquishes monetary and exchange rate policy tools, loses its lender-of-last-resort function when facing a bank run, and foregoes seigniorage revenue. In addition, in the event of a negative real shock, limitations on bank financing of the budget will constrain the use of fiscal policy to cushion the contractionary effects on the economy, and thus contribute to deflationary pressures. Even though Cambodia’s high degree of dollarization has already severely limited the NBC’s scope for conducting monetary and exchange rate policies, full dollarization implies a permanent elimination of an exchange rate adjustment in response to shocks. Experiences with major devaluations of rigid pegs, such as departures from the gold standard and the devaluation of the CFA franc, suggest that an “exit” option has some real value in the presence of extreme shocks.

12. The policy choice of exchange rate regime also inevitably has its political dimension. There is a question whether full dollarization by Cambodia would be compatible with deepening economic integration of ASEAN as most other partners of ASEAN maintain floating exchange rates with the US dollar. The disparity of exchange rate systems will lead to volatility in the bilateral real exchange rates of member countries, which may be problematic both on political and economic grounds. Another rarely mentioned aspect of countries’ experience with full dollarization is the severe banking crisis that Panama confronted in the late 1980s when the interbank credits lines to Panama were frozen.

13. Even under the existing high degree of dollarization, seigniorage revenue in Cambodia has been nontrivial. Seigniorage revenue represents the profits accruing to the monetary authority from its right to issue legal tender. The annual flow of seigniorage is generally defined as the increase in reserve money net of any interest payment on bank reserves, since this is the amount of resources the government can obtain without creating any future obligations to pay interest. Alternatively, as a result of issuing noninterest bearing debt (currency) and holding-interest earning assets (such as foreign currency reserves), the central bank earns a profit. These two measures, however, are equivalent in a present value sense, except for the initial stock of money.

14. Estimates of seigniorage in Cambodia using both measures are shown in Table 1. The annual increase in reserve money has been around 1–2½ percent of GDP in the last four years, whereas central bank profits are estimated to be of the order of 0.2–0,4 percent of GDP. The size of seigniorage in Cambodia in recent years does not seem to be high compared with most developing countries, although it surged in 1998 when there was a large expansion in domestic currency to finance the fiscal deficit.

Table IV.1

Cambodia: Estimates of Seigniorage

^1/Calculated as the interest rate on U.S. T-bills multiplied by the average of the beginning- and end-of-period stocks of banks’ reserve money. Ignores the costs of currency production. The NBC does not pay any interest on bank required reserve holdings.

Source: IMF, International Financial statistics, and staff estimates.

Table IV.1

Cambodia: Estimates of Seigniorage

			1994	1995	1996	1997	1998	1999
Reserve Money Approach
Change in reserve money (CR bn)			57.8	28.6	135.3	95.5	257.3	127.3
		(In percent of GDP)	0.9	0.4	1.6	1.1	2.5	1.1
	(In percent of Govt. rev.)		19.9	4.8	21.0	12.7	29.2	13.5
Central Bank Profit Approach
Interest Income (CR bn) 1/			11.0	16.5	19.2	25.2	32.5	40.4
		(In percent of GDP)	0.2	0.2	0.2	0.3	0.3	0.4
	(In percent of Govt. rev.)		3.8	2.8	3.0	3.4	3.7	4.3
Memorandum items
CPI Inflation (final quarter basis, %)			17.9	3.5	9.0	9.1	12.6	0.0
Change of Reserve Money (as percent of GDP)
	Laos		1.2	0.7	1.2	2.1	3.1	2.0
	Vietnam		3.1	1.3	2.0	1.1	0.8	4.9

^1/Calculated as the interest rate on U.S. T-bills multiplied by the average of the beginning- and end-of-period stocks of banks’ reserve money. Ignores the costs of currency production. The NBC does not pay any interest on bank required reserve holdings.

Source: IMF, International Financial statistics, and staff estimates.

View Table

Table IV.1

Cambodia: Estimates of Seigniorage

			1994	1995	1996	1997	1998	1999
Reserve Money Approach
Change in reserve money (CR bn)			57.8	28.6	135.3	95.5	257.3	127.3
		(In percent of GDP)	0.9	0.4	1.6	1.1	2.5	1.1
	(In percent of Govt. rev.)		19.9	4.8	21.0	12.7	29.2	13.5
Central Bank Profit Approach
Interest Income (CR bn) 1/			11.0	16.5	19.2	25.2	32.5	40.4
		(In percent of GDP)	0.2	0.2	0.2	0.3	0.3	0.4
	(In percent of Govt. rev.)		3.8	2.8	3.0	3.4	3.7	4.3
Memorandum items
CPI Inflation (final quarter basis, %)			17.9	3.5	9.0	9.1	12.6	0.0
Change of Reserve Money (as percent of GDP)
	Laos		1.2	0.7	1.2	2.1	3.1	2.0
	Vietnam		3.1	1.3	2.0	1.1	0.8	4.9

^1/Calculated as the interest rate on U.S. T-bills multiplied by the average of the beginning- and end-of-period stocks of banks’ reserve money. Ignores the costs of currency production. The NBC does not pay any interest on bank required reserve holdings.

Source: IMF, International Financial statistics, and staff estimates.

15. While the central bank may earn some profits from non-remuneration of banks’ required reserves in foreign currency, it can not avoid foregone seigniorage that result from foreign currency in circulation. The seigniorage cost of becoming fully dollarized would be an initial purchase cost to redeem domestic currency in circulation³ plus annual loss of foregone seigniorage due to any increases in currency demand. One easy way of estimating the potential increase of seigniorage if all dollar notes in circulation were exchanged for riels is to first estimate the ratio of U.S. dollar currency to GDP. For example, if this ratio is 40 percent in 1999,⁴ and assuming monetary aggregates grow at an average of 15 percent a year, potential seigniorage gains could increase to 6 percent of GDP a year if only riel notes were used in circulation. Both the national budget and the NBC would benefit from substitution of riel notes for U.S. dollars in circulation. Table IV.2 illustrates the benefits of de-dollarization using the central bank profit approach based on the stock of riel currency in circulation as of the end of 1999.

Table IV.2.

Estimated Impact of Increase in Riel Circulation ^1/

^1/Assuming riel in circulation is 10% of total currency in circulation, and a 5 percent return on foreign assets.

Table IV.2.

Estimated Impact of Increase in Riel Circulation ^1/

Riel notes as % total currency in circulation		Riel in circulation	Increase in Revenue from Foreign assets		Allocation of NBC Profit to (US$ million)
		(US$ million)	(US$ million)	as percent of GDP	Capital and Reserves (25%)	Budget (75%)
Scenario I:	30%	387	12.9	0.4	3.2	9.7
Scenario II:	50%	645	25.8	0.9	6.5	19.3
Scenario III:	100%	1289	58.0	2.0	14.5	43.
						5

^1/Assuming riel in circulation is 10% of total currency in circulation, and a 5 percent return on foreign assets.

View Table

Table IV.2.

Estimated Impact of Increase in Riel Circulation ^1/

Riel notes as % total currency in circulation		Riel in circulation	Increase in Revenue from Foreign assets		Allocation of NBC Profit to (US$ million)
		(US$ million)	(US$ million)	as percent of GDP	Capital and Reserves (25%)	Budget (75%)
Scenario I:	30%	387	12.9	0.4	3.2	9.7
Scenario II:	50%	645	25.8	0.9	6.5	19.3
Scenario III:	100%	1289	58.0	2.0	14.5	43.
						5

^1/Assuming riel in circulation is 10% of total currency in circulation, and a 5 percent return on foreign assets.

D. Implications for Policy

16. While the analysis of costs and benefits of dollarization sheds some light on which country characteristics would likely make dollarization an appropriate choice, the balance of this analysis is difficult to draw, since important considerations in the analysis are hard to quantify. There is also only limited historical experience to draw from, as most economies that have adopted a foreign currency are small and politically-dependent, with the recent case of Ecuador being a main exception. In addition, given the near irreversibility of dollarization, considerations must be given to events that may be rare but cannot be ruled out from a longterm perspective, such as extreme terms of trade shocks.

17. There are essentially two monetary and exchange rate options for Cambodia: move to full dollarization, or proceed with policies expected to promote de-dollarization. A currency board arrangement is an obvious option consistent with the government’s stated policy of dedollarization while maintaining much of the benefits of stability and confidence associated with dollarization. However, any potential choice of monetary and exchange rate regime requires the maintenance of sound fiscal and monetary policies (and political stability) to be effective. At present, neither the fiscal position nor the soundness of the banking system in Cambodia would appear to be sufficiently strong to support a move to full dollarization or a currency board. Therefore, it is crucial for Cambodia to continue to strengthen its fiscal position and the banking system before making any changes in the monetary regime. In view of these circumstances, the authorities’ current policy is to support non-administrative and gradual de-dollarization through continued strengthening of macroeconomic performance.

18. Experiences in other countries have shown that once dollarization has occurred, it usually takes a long time for market perceptions to change. In fact, a return of confidence in the initial stages of reform often leads to an inflow of foreign currency deposits, therefore an increased degree of dollarization, as experienced by several Latin America countries and Cambodia in the 1990s. This points to some form of “hysteresis”, as changing the uses and practices regarding the settlement of transactions is a slow process that involves institutional changes. Therefore, direct administrative measures to reverse dollarization, such as regulatory limits on foreign currency usage, will simply drive dollars offshore, further reducing financial intermediation, and are ultimately counterproductive. On the other hand, introducing high quality riel-denominated assets and paying a premium on domestic currency denominated reserves may play a catalytic role in financial deepening in the domestic currency. In addition, increasing economic integration of the rural area may also promote the use of national currency, as the riel is more widely used in the countryside. These steps, together with the maintenance of low inflation, would be expected to lead to a gradual increase in the underlying level of seigniorage over time as confidence in the local currency is further strengthened.