Cambodia
2010 Article IV Consultation-Staff Report; Staff Statement and Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Cambodia

Prior to the global crisis, Cambodia enjoyed a decade of high growth and relative stability. However, as a result of the global crisis, output collapsed, and longstanding structural vulnerabilities have been exposed. Discussions focused on the dual policy challenge to safeguard macroeconomic stability and policy credibility, and to lay the foundations for broader-based and inclusive growth. It is recommended that the next Article IV Consultation take place on the standard 12-month cycle. IMF staff underscored the need for better and faster data for key economic statistics.

Abstract

Prior to the global crisis, Cambodia enjoyed a decade of high growth and relative stability. However, as a result of the global crisis, output collapsed, and longstanding structural vulnerabilities have been exposed. Discussions focused on the dual policy challenge to safeguard macroeconomic stability and policy credibility, and to lay the foundations for broader-based and inclusive growth. It is recommended that the next Article IV Consultation take place on the standard 12-month cycle. IMF staff underscored the need for better and faster data for key economic statistics.

I. Introduction

1. Prior to the global crisis, Cambodia enjoyed a decade of high growth and relative stability. Real GDP growth averaged over 9 percent during 2000–07, the highest of any low-income country in Asia (and one of the best performances worldwide), enabling significant improvements in living standards and poverty reduction. Prudent fiscal policies underpinned macroeconomic stability with headline inflation well below Cambodia’s peers (Figure 1). Past surveillance has been characterized by broad agreement on the direction of policies, in particular with regard to enhancing fiscal policy credibility and financial system soundness, although progress has been slow in some critical areas such as public financial management reform. In support of government efforts, the IMF has provided significant technical assistance in fiscal, money and banking, and statistical areas.

Figure 1.
Figure 1.

Cambodia and Its Peers—Selected Indicators 1/

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

1/ PNG is the abbreviation of Papua New Guinea.

2. However, as a result of the global crisis output collapsed, exposing longstanding structural vulnerabilities. Preliminary estimates suggest that growth fell some 10 percentage points below its pre-crisis average in 2009. Cambodia was hit harder than comparator countries by the global recession, given vulnerabilities that are in part a legacy of a generation lost by civil strife. Fiscal revenues, that remain low regionally, limit the scope to fully address development priority needs, while a shallow and highly dollarized financial system undercuts broad-based growth and complicates macroeconomic management. Growth and exports have remained narrow-based, offering limited benefits to the rural poor, Cambodia’s vast majority. As a result, there are indications that poverty increased after several years of steady declines,1 setting back the momentum toward achieving the Millennium Development Goals (MDGs).

3. The authorities’ response to the crisis helped limit the hemorrhage and is supporting the recovery:

  • In an effort to provide stimulus, the government raised wages and accelerated development spending, allowing the overall fiscal deficit to increase to over 8 percent of GDP in 2009, up by more than 5 percentage points over 2008. While the deficit was mostly financed by concessional loans and grants, there was also significant recourse to domestic financing (nearly 2 percent of GDP) for the first time since 2003.

  • In addition, the National Bank of Cambodia (NBC) took an accommodative stance by reducing reserve requirements (from 16 to 12 percent) and introducing an overdraft facility. However, as a result of banking system weaknesses, the main effect was to offer a cushion against a liquidity shock in addition to banks’ own efforts, including by raising deposit rates, that contributed to a significant rise in liquidity in the banking system.

II. Outlook and Risks: Emerging from the Global Recession

4. A broadening export-led recovery has been taking hold in 2010 (Figure 2, Table 1):

Figure 2.
Figure 2.

Cambodia: Recent Developments

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Table 1.

Cambodia: Selected Economic Indicators, 2005–10

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Sources: Data provided by the Cambodian authorities; and IMF staff estimates and projections.

Contribution to broad money growth.

Ratio of nominal GDP to the average stock of broad money.

In 2006, includes transfer from the IMF of Multilateral Debt Relief Initiative proceeds as capital revenue.

In 2005, includes repayment of arrears.

Includes funds in transit and payment orders in excess of cash released.

Excludes unrestricted foreign currency deposits held as reserves at the National Bank of Cambodia; starting in 2009, includes the new SDR allocations made by the IMF of SDR 68.4 million.

Debt owed to the Russian Federation is valued at 0.6 rubles per U.S. dollar with the standard 70 percent discount.

  • Growth: Since the beginning of this year, signs of a recovery have emerged. Garment exports and tourist arrivals, notably by air, are bouncing back, both growing between 10 to 20 percent (y/y) in the second quarter of 2010. Construction activity, however, appears to remain sluggish with growth of most related imports still negative, while a late start of the rainy season may dent agricultural output growth.

  • Inflationandcredit: CPI inflation rose to an average 7 percent in the first quarter of 2010, from about -½ percent on average in 2009, on the back of firmer local food and global commodity prices. Credit growth has turned the corner, reaching 23 percent (y/y) in August, from 6½ percent at end 2009, amid ample liquidity in the banking system.

  • External position: After narrowing somewhat in 2009, the current account deficit is likely to widen to about 7 percent of GDP (including official transfers) in 2010 on strengthening domestic demand (Table 2). Official reserves have risen modestly (to about 3½ months of import cover), while the riel has depreciated somewhat against the U.S. dollar in recent months.

  • Exchangerate: Partly as a result of a pre-crisis surge in inflation, the riel appears to have remained somewhat overvalued in real effective terms, although standard exchange rate models are unreliable.2 Yet, the rebound of key export sectors in line with the global recovery suggests that Cambodia’s external competitiveness has remained intact.

Table 2.

Cambodia: Balance of Payments, 2008–15

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Data provided by the Cambodian authorities; and IMF staff estimates and projections.

Includes some debt-creating flows related to power sector projects.

Includes unrestricted foreign currency deposits (FCDs) held as reserves at the National Bank of Cambodia (NBC).

Excludes changes in unrestricted FCDs held as reserves at the NBC, and changes in gold holdings and valuation.

Excludes unrestricted FCDs held as reserves at the NBC; starting in 2009, includes the new SDR allocations made by the IMF of SDR 68.4 million.

5. Near-term risks are tilted to the downside. The fragility of the global recovery exposes Cambodia’s narrow export base with its heavy reliance on the U.S. and European markets—garment exports to these destinations account for 40 percent of total goods and services exports—to significant downside risks, while limited fiscal policy space and financial system weaknesses further undercut the economy’s resilience to shocks. As highlighted in the accompanying Financial System Stability Assessment (FSSA), the latter primarily arise from shortcomings in banking supervision, enforcement of regulations and uneven credit risk management and data reporting by banks, combined with a high degree of dollarization, severely constraining the central bank’s ability to act as a lender of last resort. Staff projects growth to reach 4½–5 percent in 2010. Consistent with the recovery, staff projects the headline CPI index to rise 4 percent on average this year.

6. Over the medium term, addressing longstanding structural weaknesses can improve the balance of risks (Table 3). On the one hand, potential setbacks in efforts to strengthen the business environment and enhance public sector revenues and service delivery constitute major downside risks to growth. On the other hand, a better-than-expected return on medium-term investments in the power sector and rural infrastructure could offer significant upside potential. Under the baseline scenario, growth is expected to gradually return to potential of about 6–7 percent over the medium term. The current account deficit (excluding official transfers), after rising early in the recovery (to about 13½ percent of GDP in 2010) would gradually decline (to about 8½ percent of GDP in 2015), in part reflecting increasing domestic hydropower supply, and remain fully financed through grants, official external financing, and foreign direct investment.

Table 3.

Cambodia: Medium-Term Macroeconomic Framework, 2008–15

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Sources: Data provided by the Cambodian authorities; and IMF staff estimates and projections.

Includes nonbudgetary, grant-financed investment.

Excludes re-exported goods.

Excludes imported goods for re-export.

Net official disbursements, exceptional financing, and official transfers.

Excludes unrestricted foreign currency deposits held as reserves at the National Bank of Cambodia; starting in 2009, includes the new SDR allocations made by the IMF of SDR 68.4 million.

Debt owed to the Russian Federation is valued at 0.6 rubles per U.S. dollar with the standard 70 percent discount.

Cash basis, excluding the accumulation of arrears on debt owed to the Russian Federation and the United States.

III. Policy Discussions: Returning to Sustainable Growth

7. Discussions focused on the dual policy challenge to safeguard macroeconomic stability and policy credibility, and lay the foundations for broader-based and inclusive growth. Key policies include: (i) expanding room for fiscal policy maneuver and effectiveness; (ii) strengthening monetary policy implementation and effectiveness in the context of a nascent and highly dollarized financial system; (iii) preserving financial system stability and mitigating systemic risks; and (iv) promoting private sector led economic diversification in the context of Asia rebalancing.

A. Fiscal Management: Providing Credibility and Change

8. Following the significant easing in 2009, the fiscal outturn through August suggests that the 2010 budget target of a gradual fiscal consolidation is on track (Figure 3, Table 4):

Figure 3.
Figure 3.

Cambodia: Fiscal Indicators

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Table 4.

Cambodia: General Government Operations, 2007–11

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Sources: Data provided by the Cambodian authorities; and IMF staff estimates and projections.

Capital revenue includes privatization proceeds.

The full amount of Multilateral Debt Relief Initiative (MDRI) proceeds (CR 341 billion) was recorded as capital revenue in 2006. In subsequent years, spending under the MDRI has been recorded as capital expenditure.

Capital expenditure (externally financed) includes a statistical discrepancy, reflecting the difference between actual and recorded disbursements.

Current spending by the ministries of public health; education, youth, and sport; agriculture, forestry, and fishery; rural development; women’s affairs; justice; and urbanization and construction.

  • Revenues: The rebound in tax revenue is broadening, with both direct and indirect cumulative tax collection through the first eight months rising by 11 and 13 percent (y/y), respectively. In particular, profit tax collection has gained momentum and, since May has been consistently better than in 2009, supported by the ongoing economic recovery. In addition, continued efforts to strengthen revenue administration and reduced incentives for smuggling due to diminishing regional disparities in gasoline and diesel prices have helped contain tax evasion. As a result, staff estimates that revenue could exceed the budget target by about ½–1 percent of GDP.

  • Spending: If current spending remains under control and planned cuts in defense and security spending continue to be implemented, the current balance could turn positive (and reach about ¾ percent of GDP) and provide almost half of the funding for the budgeted locally financed capital spending.

  • Financing: Higher-than-budgeted disbursements of concessional loans and grants imply that externally-financed capital spending could exceed the budget by about 1 percent of GDP. While this would result in a higher overall fiscal deficit (including grants) of 3¼ percent of GDP (compared with about 2¾ percent of GDP in budget), recourse to domestic financing would be kept well below the budget target (about 1 percent of GDP), and be significantly lower than in 2009.

9. Staff emphasized the need for fiscal adjustment beyond 2010. Cambodia’s macroeconomic stability continues to critically depend on prudent fiscal policies.

  • Staff indicated that as the economic recovery gains traction, the recourse to domestic financing, and thus the injection of significant additional riel liquidity, should be eliminated to avoid undue external and inflationary pressures.

  • Staff’s illustrative medium-term scenario envisages a deficit reduction (excluding grants) by about 2½ percent of GDP between 2010 and 2015. Under this path, a debt sustainability analysis indicates that Cambodia would retain its moderate risk-of-debt distress rating and regain an ability to absorb future shocks similar to pre-crisis levels (Supplement 1: Joint IMF/World Bank Debt Sustainability Analysis 2010). The public and external debt-to-GDP ratios would decline to about 26 percent of GDP in 2016, in line with the levels before the global financial crisis. At the same time, the government would fully replenish its deposits in the banking system, which serve both as an important reserve to finance fiscal stimulus in the absence of a market for government debt and as a backstop to financial system fragilities.

  • Contingent liabilities, in particular those related to the growing number of build-operate-transfer (BOT) hydropower schemes or banking system weaknesses, constitute major, but difficult to quantify, risks to the debt outlook. Moreover, a sooner-than-anticipated shift of aid financing from grants to loans would also add to the debt burden.

  • The authorities welcomed the staff’s analysis and reiterated their commitment to fiscal sustainability. They inquired about the implications of raising their ceiling on contracting external debt from SDR 200 million to SDR 400 million (financing by about an additional 2 percent of GDP). Staff cautioned that this would delay the pace of consolidation, and constrain the government’s ability to respond effectively to further shocks without losing its current moderate risk-of-debt distress rating.

10. The government is committed to further improving revenue administration. The team and the authorities concurred that gains in tax collection offer the best hope for Cambodia to meet the dual objective of securing fiscal sustainability and mobilizing resources for its vast development needs. Specifically:

  • There was agreement that the scope to improve the productivity of the tax system is significant (Box 1). Staff estimates based on experience in other low-income countries and controlling for country-specific fundamentals such as economic size and structure, level of development, and foreign direct investment suggest that Cambodia’s tax revenue to GDP ratio is about 5–7 percent below its potential. Bringing the productivity of the VAT alone to a level comparable with other Asian low-income countries would yield an additional 1½ percent of GDP.

  • The team supported the government’s target of improving the tax revenue to GDP ratio through better administration by 0.5 percentage points per year, which means that about one-third to one-half of the revenue enhancing potential would be realized over the medium term.

  • There was agreement that much will depend on following through with detailed action plans of the revenue collecting agencies, including: (i) to enhance taxpayer compliance through auditing; (ii) information sharing among revenue-collecting and law-enforcement agencies; (iii) taxpayer education; and (iv) improved governance within the agencies (notably through better protection of enforcement officers and disclosure requirements under the recently adopted Anti-Corruption Law). Staff recommended that a comprehensive strategy to enable a more aggressive collection of tax arrears, which rose 20 percent in the year ending July 2010, be put in place.

uA01fig01

Asian LICs: VAT Productivity 1/2/

(In percent)

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.1/ Proportion of effective to nominal tax rate; effective tax rates are caculated as proportions of annual collection to consumption and GDP.2/ Lines are Asian LICs averages, solid line is relative to GDP, while dotted is to consumption.

11. Reducing the scope for evasion will also critically enhance the effectiveness of tax policy changes that are currently considered with a view to raise revenue. For example, staff estimate that replacing the reference price for taxes on petroleum imports to the current transactions price level would yield about 1 percent of GDP, and higher “sin” taxes on alcohol and tobacco could generate an additional 0.2 percent of GDP. However, these calculations assume that the resulting increase in domestic retail prices over those in neighboring countries does not erode the tax base. This requires that greater incentives for smuggling are effectively curbed by the envisaged improvements to customs control. From a strategic perspective, staff and authorities agreed that better information sharing and transfer of know-how in the fight against tax evasion from the General Customs and Excise Department to the General Tax Department will also be needed in light of trade liberalization commitments and the growing reliance on domestic taxes relative to trade taxes. The IMF stands ready to provide further technical assistance in customs and tax administration.

Assessing the Scope for Revenue Enhancement

Cambodia’s revenue mobilization is still among the weakest in the region, despite progress over the last decade. Since the mid-1990s, the tax revenue to GDP ratio has doubled, but at 12 percent, it is still the second lowest among Asian LICs (average 17 percent). The revenue base has also remained narrow, making it particularly vulnerable to external shocks. About one-half of the total revenues are collected from imported goods, with fuel and vehicle imports alone accounting for a combined 60 percent of total customs revenue. Smuggling continues to erode the base, given a stretched porous border. As for domestic taxes, revenue collection falls particularly short of that of peer countries—at 3½ percent of GDP it is at only 17 percent of Vietnam’s level.

uA01fig02

Revenue Strength

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.

Weak revenue administration is the main factor for Cambodia’s low fiscal revenue. Staff’s estimates, based on a sample of 49 developing countries and controlling for economic fundamentals (such as level of development, economic structure, and FDI), show that Cambodia’s revenue-to-GDP ratio is about 5–7 percent below its potential.1 Estimates, controlling for country-specific differences in tax policies,2 suggest that administrative improvements could make up at least one-half to three-quarters of Cambodia’s underperformance. The bulk of this shortfall is attributable to weak administration, including risk-based tax audits to ensure taxpayer compliance.

Revenue Performance: Actual vs. Norm (Est.) 1/

(Revenue excluding grant, percent of GDP)

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Estimation based on a cross country panel of 49 middle and low-income countries. A pooled OLS was estimated using combination of (i) real GDP per capita, (ii) nominal GDP, (iii) oil export in percent of GDP, and (iv) FDI in percent of GDP.

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.
uA01fig03

Decomposotion of Revenue Shortfall to Norm 1/

(In percent)

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

1/ Estimation based on a cross country panel of 43 middle and low income countries. A pooled OLS was estimated using combination of (i) real GDP per capita, (ii) nominal GDP, (iii) oil export in percent of GDP, (iv) FDI in percent of GDP, and (v) VAT rate; Model 2 omits (iv) and Model 3 (iii).Sources: Data provided by the Cambodian authorities; and IMF staff estimates.

Against this background, the authorities have made improvements to revenue administration a high priority. The government’s target of increasing the ratio of tax revenue to GDP by 0.5 percentage points every year (anchored in the PFMRP) is supported by comprehensive action plans that focus on enhancing compliance through tax payer audits and education, and better governance in the revenue collecting agencies.

1For similar approaches in the literature see Abhijit S. Gupta (2007), “Determinants of Tax Revenue Efforts in Developing Countries,” Staff Papers, IMF, Vol. 50, No. 1, pp. 245–295; or Dhaneshwar Ghura (1998); “Tax Revenues in Sub-Saharan Countries,” IMF Working Paper 98/135.2Based on proxies for indirect taxes (VAT rate) and direct taxes (corporate tax rate). However, the latter proved to be statistically insignificant, perhaps reflecting wide-spread exemptions and weak enforcement.

12. Stepping up efforts under the public financial management reform program (PFMRP) will be critical to secure gains from enhanced revenue administration and improve the effectiveness of social priority spending. Staff welcomed progress in cash management and budget formulation that has resulted in greater fiscal control through midyear reviews and curbed supplementary expenditure credits, and eliminated expenditure arrears since 2007. However, budget execution and recording continue to be fragmented, especially with regard to donor-financed capital spending, hampering an assessment of fiscal and quasi-fiscal activities and effective budget planning. Moreover, payroll and procurement controls remain weak with over 60 percent of contracts above the competitive bidding threshold escaping competitive bidding through regulatory loopholes. Against this background, staff recommended a focus on those measures under Phase II of the PFMRP that are both achievable in the near term and of strategic importance. Specifically, the authorities should: (i) further deepen budget classification at the line ministry level as a precursor to the introduction of a financial management information system and the planned de-concentration of budget authority;3 (ii) expedite the consolidation of all government deposit accounts; (iii) expedite the enactment of the procurement law and strengthen post procurement audit through increased staffing, funding, and training; and (iv) strengthen internal audit departments, another important precursor for de-concentration.

13. Staff welcomed the recent disclosure of revenue information related to oil exploration. In line with commitments under the PMFRP, staff encouraged the authorities to consider subscribing to the Extractive Industries Transparency Initiative (EITI) as a means to signal Cambodia’s strong commitment to improve governance and strengthen fiscal management. The authorities intend to further strengthen the content and procedure of dissemination in line with international norms, such as EITI, but cautioned it would be premature to formally subscribe to the initiative at this stage.

B. Monetary and Exchange Rate Policy: Enhancing Policy Scope and Effectiveness

14. The policies of the NBC have contributed to macroeconomic stability, but, from a longer-term perspective, this stability has not delivered the desired greater monetary independence. In the absence of a formal monetary framework, the exchange rate vis-à-vis the U.S. dollar has been the effective nominal anchor for three decades, but low inflation has not been able to halt or reverse the trend increase in dollarization (Box 2).4 Moreover, a relatively fixed exchange rate conflicts with the need to facilitate adjustment to external shocks as well as to protect official reserves (given the NBC’s already limited lender-of-last resort capability under dollarization). During the recent crisis, the NBC responded by reducing the reserve requirement, but interest rates remained virtually unchanged while the main effect was a liquidity overhang as banks sought self-protection against a possibly severe liquidity shock (Table 5). At the same time the foreign currency deposits coverage ratio (in terms of gross official reserves) has steadily declined.

Table 5.

Cambodia: Monetary Survey, 2007–10

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Sources: Data provided by the Cambodian authorities; and IMF staff estimates and projections.

Foreign currency loans and deposits only.

The ratio of nominal GDP to the year-to-date average stock of broad money.

uA01fig04

Cambodia: Net U.S. Dollar Purchases, Exchange Rates, and Riel Circulation, 2006–10

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.1/ Official mid-rate.
uA01fig05

Cambodia: Credit to the Economy and Excess Reserves, 2008–10

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.
uA01fig06

Cambodia: Official Reserves and Foreign Currency Deposits, 2006–10

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.

15. The authorities and staff agreed that enhancing the monetary policy framework would need to be sequenced carefully. Staff cautioned that basic steps are still required, such as implementing a comprehensive liquidity monitoring framework (in both U.S. dollar and riel, using daily data) and putting in place coordination and information-sharing mechanisms with the National Treasury and other agencies under the Ministry of Finance. Staff recommended that an independent in-house research unit for macroeconomic analysis and forecasts be established to help inform the recently established Monetary Policy Committee (MPC). The NBC should also strive to disseminate more frequent and up-to-date data and analysis on monetary and credit developments, including on its website, which would provide valuable experience for moving to more comprehensive communications with market participants, including on MPC decisions. Staff and the authorities agreed that the development of an interbank money market (in both U.S. dollar and riel) is important for reducing the vulnerabilities induced by a dollarized financial system, and for a more effective implementation of monetary policy. Staff emphasized that progress along these lines would, over time, create space for moving away from exchange rate-based stabilization.

Dollarization in Cambodia: Extent, Causes, and Strategies

Over the past decade, Cambodia has become Asia’s most dollarized economy. Measured as the ratio of foreign currency deposits to broad money, dollarization in Cambodia has risen steadily from about 60 percent in the late 1990s to about 80 percent in 2010. This compares with 50 percent in Lao P.D.R., 30 percent in Mongolia, and 20 percent in Vietnam. Moreover, in these economies, dollarization has been on a declining trend or broadly stable.

uA01fig07

Cambodia: Ratio of Foreign Currency Deposits to Broad Money, 2000-10

(In percent)

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.

Dollarization has costs and risks: (i) the NBC loses the lender of last resort ability; (ii) seigniorage revenue is also lost. Based on a reserve money growth method, Cambodia is losing an estimated 5 percent of GDP in recent years. Based on estimates of currency in circulation in comparator low-income countries in Asia, seigniorage loss for Cambodia could range from about 5–19 percent of GDP; (iii) the banking system becomes more exposed to liquidity risk (as shown in the accompanying 2010 FSSA for Cambodia) where any sudden changes in investor and depositor perceptions about the health of the banking system can result in a deposit run. In fact, the ratio of official reserves to foreign currency deposits has declined to 70½ percent at end-September 2010 from 84 percent a year earlier.

uA01fig08

Cambodia: Riel Deposits, 2005-10

Citation: IMF Staff Country Reports 2011, 045; 10.5089/9781455216659.002.A001

Sources: Data provided by the Cambodian authorities; and IMF staff estimates

Somewhat paradoxically, growing dollarization in Cambodia has occurred against the backdrop of greater macroeconomic and political stability. The usual motive, currency substitution, does not appear to have been a factor. As the use of dollars increased over the years, the use of the riel, in volume, has also risen. Banking system riel deposits have grown fourfold since the mid 2000s. Dollarization resulted from a strong inward flow of dollars. Growth in Cambodia’s dollar economy, that is largely urban, has far surpassed growth in the riel economy, which remains largely agricultural and rural. The dollar economy has benefited from the buoyant garments sector, tourism, foreign direct investment, and aid, contributing to robust growth in related sectors and a wider use of the dollar. The rural economy, however, has lagged behind. For example, during 2000–08 real annual GDP growth in the manufacturing and hotel and tourism sectors averaged 10½ percent, more than double the rate of growth for agriculture.

Therefore, de-dollarization will likely take time and needs to be managed carefully. International experience from successful cases of de-dollarization (e.g., Israel, Poland, Chile, and Egypt) shows that market-based policies toward de-dollarization work best. From these studies, several measures will be needed in Cambodia, including: (i) maintaining macroeconomic stability; (ii) promoting intermediation in the riel and building a liquidity line of defense, specifically by having a higher reserve requirement on foreign currency liabilities to make such liabilities more costly, and accumulating international reserves for liquidity support and help reduce the perception of a weak domestic currency; (iii) building monetary policy tools and establishing an interbank market; (iv) promoting the use of the riel as a unit of account possibly through regulation that requires all prices in the market to be denominated in riel, and that the riel be used for all accounting and financial reporting and official purposes; and (v) promoting the use of the Cambodia riel for payments by offering more convenient and lower-cost services for the riel than for foreign currency. For example, Peru introduced a 2 percent tax on checks denominated in foreign currency to discourage the use of foreign currency for payments.

16. Staff cautioned the authorities to monitor closely the current liquidity overhang. To avoid undue pressures on inflation and the exchange rate from resurgent credit growth as the recovery strengthens, the NBC should be prepared to increase the reserve requirement on foreign currency deposits. Gradually returning reserve requirements on U.S. dollar deposits to their pre-crisis level (of 16 percent) and beyond, if necessary, will serve as an important signaling device for banks while minimizing the risk of disrupting their operations. In order to do so, the authorities intend to step up daily liquidity monitoring of banks and, with IMF technical assistance, assess the impact of changes in the reserve requirement on banks’ liquidity positions.

17. The authorities recognized that greater monetary independence will also critically depend on a national strategy of de-dollarization. To a large extent, dollarization reflects Cambodia’s unbalanced and narrow growth over recent decades that was driven by the dollarized urban export and tourism centers (Box 2). Therefore, staff underscored the need for diversified development with greater emphasis on agriculture and rural areas, where the riel is commonly accepted, to help contribute toward a decline of dollarization. Staff further argued that based on international experience of countries with a successful de-dollarization strategy, the incentives for greater use of riel could be increased by: (i) a greater differential in reserve requirements in favor of riel deposits, which would make bank intermediation in riel more attractive and also mitigate bank’s liquidity risks arising from a run on dollar deposits in the absence of a lender of last resort; (ii) a requirement for all retailers to list prices in riel; (iii) promoting the use of riel for payments by circulating bills of larger denomination and introducing a clearance tax for checks denominated in foreign currency. However, many cases of failed de-dollarization attempts show that going beyond incentives and taking administrative measures, such as prohibiting foreign currency deposits, is often counterproductive and undermines confidence in the local currency.

C. Financial Supervision: Mitigating Systemic Risks and Preserving Stability

18. In addition to being highly dollarized, Cambodia’s financial system is relatively shallow. The legacy of civil strife and demonetization under the Khmer Rouge (1975–79) still casts a long shadow on public confidence. Bank credit to the private sector is low at about 26 percent of GDP. Over 95 percent of banking system deposits are denominated in U.S. dollar. While many new banks have been licensed in recent years, the system is dominated by five large banks (two of which are foreign owned) accounting for nearly 80 percent of credit. Rural areas are primarily served by micro-finance institutions, representing less than 10 percent of financial system assets.

19. While the banking system emerged seemingly intact from the financial crisis, significant risks to stability remain. The sharply slowing economy and collapse of the real estate market in 2009 likely weakened banks’ balance sheets severely. The findings of onsite examinations of several banks by supervisors suggest that the reported aggregate NPL ratio for 2009 of around 4 percent may be substantially understated, largely due to uneven implementation and enforcement of the strengthened regulation on asset classification. Furthermore, the general lack of effective risk management by banks remains of concern (Table 6). Having said that, the ongoing recovery provides an opportunity to clean up bank balance sheets and reduce financial system vulnerabilities while maintaining confidence.

Table 6.

Cambodia: Core Financial Soundness Indicators, 2009

(In billion of riels, unless otherwise indicated)

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Sources: Data provided by the Cambodian authorities; and IMF staff estimates.

Foreign currency deposits in percent of broad money.