November 18, 2009

1. On behalf of the Cambodian authorities, we would like to thank the IMF staff team for the fruitful policy dialogue and thoughtful recommendations during the Article IV consultations. The exchange of views during the mission was candid. The authorities are in broad agreement with the general thrusts of staff’s assessment and policy recommendations. They will give these recommendations due consideration.

Recent Economic Developments and Outlook

2. After many years of strong economic growth, the global economic crisis has hit Cambodia hard in light of its high level of openness and highly concentrated growth base. Garments, construction and tourism, which had been main economic driving forces, have been adversely affected by the global crisis. Agriculture remains supportive of economic growth in 2009. We expect, however, that the economic contraction has bottomed out in mid 2009 and growth will bounce back in 2010. The authorities project that economic growth will be positive at around 2 percent in 2009, taking into account of growth in agriculture of 4.3 percent and growth in services of 3.2 percent. Despite contraction in tourism, services sector has maintained its growth momentum. The garment and construction industries, however, are expected to contract by 3.9 percent and 2.6 percent, respectively.

3. Inflation has declined sharply from 12.5 percent at end-2008, and is expected to stay under 5 percent per annum in 2009. Prices of food and beverage, property, water, gas and electricity, transportation, and entertainment and culture have contributed to the downward trend. The riel has depreciated slightly against the US dollar during the first eight months of 2009. However, a relatively large fluctuation occurred in August due to both seasonal and external factors. The lower demand for the riel after the harvest season and for tax payments, continued injection of the riel into the market and the slowdown of foreign inflow have contributed to the depreciation of the riel. The current account deficit has shrunk since the imports decelerated faster than exports in the first half of 2009. The level of international reserves has been somewhat stable in light of challenging external situation.

4. Going forward, economic prospects remain positive on the back of entrenched peace and stability, appropriate macroeconomic management, and the authorities’ strong commitments to reforms to shore up investments and attract international investors. For 2010, economic growth is expected to expand modestly about 4.3 percent given the positive signs of recovery in the country’s main economic drivers.

Fiscal policy

5. As also stated by staff, the authorities demonstrated strong commitment in adopting a prudent fiscal position to maintain macroeconomic stability and sustainability. Following high oil and food prices in 2008 and the global economic downturn in 2009, the loosening of the fiscal stance was appropriate and warranted to sustain economic growth and protect the most vulnerable groups to maintain social stability. The authorities expect overall fiscal deficits to increase to 6.08 percent of GDP in 2009 and about 5.3 percent in 2010. Domestic financing of the 2009’s deficits will increase to 2.88 percent of GDP (47.52 percent higher compared to 2008) and external financing will decrease to 4.18 percent (2.2 percent lower compared to last year). A modest fiscal stimulus initiated since 2008 has had some positive effects, particularly in the area of capital spending including on infrastructure. The authorities have made efforts to compress the wage bill going forward to safeguard its fiscal position so as to underpin macroeconomic stability.

6. On the revenue side, collection could meet the overall target despite the challenging external environment. Customs and excises taxes will be slightly higher than the target. Revenue mobilization remains crucial. The authorities are stepping up efforts to strengthen tax administration and collection, and broaden the tax base.

7. Expenditures have increased in 2009 due to the authorities efforts to mitigate the impact of the global economic downturn as well as of high oil and food prices. Considering fiscal stability and sustainability, the authorities are making efforts to compress and prioritize expenditures. The authorities are committed to pulling back the intervention where there is room for the private sector to operate. They are also committed to mobilize development partners’ financial assistance. The authorities have worked to strengthen public financial management. In particular, they have worked to implement the Public Finance Management Reform Program (PFMRP), as part of a step-by-step approach. Progress has been made in tax administration and mobilization as well as in budget formulation, execution and reporting.

Monetary and exchange rate policies

8. The National Bank of Cambodia (NBC) continues to pursue prudent monetary policy. The authorities concurred with the staff’s recommendation to maintain the current level of reserve requirement given the large excess of reserves in the banking system and efforts to safeguard the soundness of the banking system. In light of inflationary pressures and high credit risk in the second half of 2008, the authorities implemented policies to curb rapid credit growth. Credit growth has declined sharply in 2009 to 5.0 percent from 55.0 percent in 2008 and 76.0 percent in 2007. The authorities put in place the overdraft facility to address the risk of liquidity shortage. Broad money as of September 2009 was 30.6 percent of GDP, slightly higher than that of the same period in 2008. The authorities are keeping a close watch on liquidity situation and stand ready to mitigate liquidity risk.

9. The authorities concurred with staff that improvement in liquidity management is crucial in preparing the ground for a well functioning inter-bank and money market. Efforts have been taken to implement an operational liquidity monitoring framework aimed at mitigating the risks associated with a reversal of the currently large liquidity overhang. The authorities are working on securitization of fixed deposits. A draft of Repo Master Agreement has been finalized and communicated with the public for consultation. These are steps of diversifying arrays of financial products that could also be used as collateral in the banking sector in particular for the money market operations. Fund technical assistance on liquidity monitoring has been essential for the NBC in terms of operational assistance and capacity building.

10. While committing to maintaining exchange rate stability which serves Cambodia well as a nominal anchor, the authority agreeably noted staff’s view that “allowing greater exchange rate flexibility would help facilitate adjustment and protect international reserves, especially in view of the accommodative fiscal stance”. Gross international reserves, as of October 2009, have remained somewhat stable at around USD 2.2 billion. The authorities are committed to safeguarding adequacy of international reserves given the high level of dollarization in the economy.

Financial and banking issues

11. The authorities thank the staff for the banking sector vulnerabilities analysis in Box 3 of the staff report. The authorities would like to stress, however, that the results of the sensitivity analyses are not forecasts of the likely outcome. In fact, the results are based on staff’s assumptions to give the authorities a picture of possible scenarios. Notably, the stress tests did not give any consideration to collateral value and do not consider the impact of retained earnings as of August 2009. We wish to highlight that the authorities have taken steps to ensure that the outcomes of the analyses will be precluded. The authorities welcome the FSAP scheduled for early 2010 which will examine the soundness of the banking sector in greater depth.

12. Financial and banking sectors have seen unprecedented expansion in the country. Bright prospects of the Cambodian economy have attracted foreign investors to enter the banking system. While welcoming the expansion of the banking sector, the authorities maintain a close watch on financial stability. The authorities have strengthened their regulatory and supervisory framework and enforcement. They have implemented the following measures to strengthen the banking system; first, maintaining the current level of reserve requirement ratio of 12 percent; second, continuing to play its role as lender of last resort to provide overdraft facilities to banks; third, classifying banks’ assets and loans into different sectors and maintaining appropriate provisions; fourth, continuing to encourage banks to increase their minimum capital and to comply with prudential measures; fifth, strengthening bank supervision capacity; and sixth, monitoring liquidity condition of the banking system.

13. The authorities concurred with staff of the need to move swiftly to strengthen regulatory enforcement, particularly in the areas of corrective actions and banks’ compliance with the new capital requirements. As part of its onsite inspections, the NBC is focusing on prompt corrective actions, for many cases, on appropriate provisioning, loan appraisal and disbursement, and good governance. The NBC is encouraging banks to adhere strictly to the regulation on new loan classification and provisioning. Progress has been made on the draft of MOU between NBC and the Ministry of Economy and Finance as part of bank resolution plan.

14. Maintaining financial stability remains a key objective of the NBC. In light of growth and diversification of the financial sector, NBC is strengthening its supervision and oversight capacity, and working on improving operating standards and reducing risk concentration in the banking system. The NBC and Securities and Exchange Commission of Cambodia (SECC) are closely collaborating to prepare appropriate legal and regulatory frameworks for a new stock exchange to avoid opportunities for regulatory arbitrage.

Structural Reforms

15. The authorities are of the view that the economy’s resiliency to exogenous shocks needs to be addressed. The authorities continue to develop agricultural sector and they are well aware of the need to diversify production, especially in increasing agricultural productivity and value added, promoting agro-industry and SME development, strengthening microfinance activities, and developing rural physical infrastructure. The authorities have made continued progress to improve private sector led businesses and to shore up investors’ confidence. Improving the business climate and private sector development remains a priority for the authorities. They are improving and finalizing regulatory and institutional frameworks related to the WTO’s requirements in order to promote further integration into the regional and the world economy.

Conclusion

16. Although significant progress has been made following decades of political instability, institutional and infrastructural frameworks remain challenging for the authorities to implement effectively. As such, peace and political stability remain essential for the country to strive toward more in-depth reforms. High food and fuel prices and unfolding global economic downturn have required adjustments to the pace of reform. Having said that, the authorities would like to underscore their commitment to reforms supported by technical assistance from all development partners.