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p. 26 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the world II. Economic trends and prospects in developing Asia East Asia Southeast Asia Cambodia Indonesia Lao People's Democratic Republic Malaysia Myanmar Philippines Singapore Thailand Viet Nam South Asia Central Asia The Pacific III. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : Southeast Asia

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Cambodia

The ending of the Multifibre Arrangement will slash economic growth in 2005 from the estimated 2004 pace, and although growth will pick up in 2006 and 2007, it will not be by much. Against this backdrop, the Government faces the tasks of creating an environment for the private sector to play a greater role, and of raising revenues to promote development.

Macroeconomic assessment of 2004

GDP growth for 2004 is estimated to have strengthened to 6.0% from 5.2% in 2003, underpinned by a pickup in industry and a recovery in services. Industrial output is estimated to have grown by 16.9%, due mainly to a 25.0% rise in the textile, apparel, and footwear subsector as stronger world trade and a higher quota allocation by the US lifted garment exports. The services sector experienced robust 7.3% growth owing to a 30.0% increase in activity in restaurants and hotels, following a rebound in tourism from 2003 levels when the SARS outbreak and anti-Thai riots hurt visitor arrivals. In contrast, the agriculture sector is estimated to have contracted. Data for paddy production indicate a drought-induced decline of 3.7% in the dry-season crop and an 18.4% decline in the wet-season crop. In addition, agriculture was adversely affected by avian flu in the poultry industry, a smaller fish catch due to a lower Mekong river level, and the base effect of a large crop in 2003.

Although Cambodia has made important socioeconomic gains over the past decade, poverty remains widespread and intense: 35-40% of the population are below the poverty line and inequality appears to be widening. Relatively robust growth in the recent past has not led to a significant reduction in poverty, and achieving many of Cambodia’s Millennium Development Goals will be difficult. The challenge of reducing poverty has become more daunting with the expected sharp downturn in the economy caused by the ending of the Multifibre Arrangement (MFA) at the start of 2005.

During the first 11 months of 2004, government revenues and expenditures came in at 88% and 76%, respectively, of the target for the period. However, compared with the year-earlier period, revenues strengthened by 15% due mainly to a 25% rise in tax collection. This was a result of measures introduced in late 2003 to increase excise duties, and one-time factors such as revenues collected from an amnesty for the registration of cars not previously registered and taxed. However, nontax revenues fell by 5% because of collection difficulties. Total outlays during this period edged up by 0.5% from the previous year’s level. Current expenditures rose by 6%, reflecting an increase in wages, whereas outgoings on nonwage operating costs and social transfers remained subdued. Despite efforts to push up priority social spending, cash shortages again caused delays in disbursements in this area. Capital expenditures fell by 8%, as those financed from domestic sources were constrained by the need to repay arrears to domestic suppliers.

Broad money (M2) growth in 2004 virtually doubled to 30.1% from 15.3% in 2003. The main reason for the increase was a rise in net foreign assets of the banking sector, reflecting an improved overall balance on the external account and robust growth in credit to the private sector. Mindful of the shallowness of the market and that exchange rate policy has a limited impact on competitiveness, the central bank continued to intervene in the currency market to stabilize the exchange rate, which remained broadly stable at KR4,019/$1 during 2004.

On a year-on-year basis, inflation rose steadily to 5.6% in December 2004 from 0.5% 12 months earlier, giving annual average inflation of 3.9% for 2004, up from 1.2% in 2003. Higher inflation was caused by upward pressure on transportation costs from elevated world oil prices and drought-related food price increases.

Merchandise exports grew by 21.8% to $1.7 billion and imports by 22.4% to $2.2 billion in the first 9 months of 2004. Exports were boosted by robust growth in garments and in rubber as world prices of the commodity rose. The increase in imports was driven by a rise in imported inputs to the export-oriented garment industry, and the higher cost of petroleum imports. Reflecting a higher base, import growth offset that in exports and led to a widening of the trade deficit to $495.0 million in January-November 2004 from $398.8 million a year earlier.

A larger net services surplus on account of the recovery in tourism only partially cushioned a higher net income deficit due to higher profit remittances and increased interest payments on official debt. As a consequence, the current account deficit (excluding official transfers) during the first 9 months of 2004 widened to $431.7 million from $323.8 million in the same period of the previous year. The deficit was more than matched by higher inflows of official loans and grants and an increase in FDI to $90.8 million in the first 9 months from $66.1 million in the same period of 2003. The stronger FDI was attributed to investments in the garment sector as, apparently, investors hedged against the possibility of the US imposing new limits on garment exports from the PRC with the phasing out of the MFA. These developments moved the overall balance of payments into a surplus of $68.1 million during the first 9 months of 2004, from a deficit of $70.4 million in the same period of 2003. Foreign exchange reserves rose to $811.7 million at the end of 2004 from $736.7 million 12 months earlier.

Total external debt at end-2004 is estimated at 68% of GDP. Debt to the Russian Federation and the US is being renegotiated and is currently not being serviced. As a result, the debt service ratio relative to exports of goods and services at the end of the year is estimated at only 2.3%. However, relative to government revenues it was 14.8% in 2003, placing Cambodia in the category of debt-stressed countries.

Macroeconomic policy developments

Recent sources of growth have been narrowly based on garments and tourism and there is widespread recognition of the need to nurture new sources. This would require significantly higher rates of productivity and investment. However, prospects for a major increase in public investment are limited because of the very low government revenue base, while private investment is hampered by a poor business environment.

The need to broaden the growth base, and for the private sector to raise its competitiveness in light of the country’s 2003 accession to WTO, has led to renewed attempts to promote private sector development. The new Government, formed in July 2004, a year after elections, launched a private sector development program focusing on trade facilitation, SME development, and private participation in infrastructure. Progress has been made in several areas, including reducing the cost and time associated with import and export procedures and company registration, and further reforms are proposed for 2005. In trade facilitation, this includes the establishment of a single entry point, or window, that will allow parties involved in trade to fulfill all documentary requirements for import or export in a single transaction. For infrastructure, the Government has committed itself to implementing a new Concession Law, which defines a clear process for private participation. It is also committed to enforcing amendments to the Law on Investment that create a transparent 28-day process of investment approval. In the area of SME development, the Government is to approve an SME development framework to be used among all official agencies.

Despite progress, the outstanding reform agenda for private sector development remains large, particularly in the legal, judicial, and civil service systems, which forces the private sector to operate under uncertain rules. These and other constraints to the private sector such as a lack of access to, and high cost of, transportation and energy; a limited skills base; and limited access to land need to be addressed if the private sector is to promote growth and generate employment on a sustainable basis.

Although Cambodia’s revenue-to-GDP ratio has increased in recent years (from 8.1% in 1998 to 10.4% in 2003), it remains among the lowest in the world. Weak revenues have constrained public spending and led to accumulated payment arrears to domestic suppliers. These repayments are expected to weigh heavily on future budgets. Given the need to substantially increase revenues and the difficulties in doing so as growth slows in the near term, improving revenue mobilization will depend on strengthened tax administration and improved tax policy. Toward this end, the Government, with the support of its development partners, has launched a comprehensive public financial management reform program that aims to (i) improve budget formulation by strengthening the links between policies and budgets, and by introducing a medium-term expenditure framework; and (ii) enhance budget execution by strengthening cash management and overhauling treasury operations.

Given the extremely low domestic revenue base, external assistance will continue to be the dominant source of finance for the public investment program. In this context, the Government has prioritized strengthening its aid management capacity and effectiveness and improving donor aid coordination. Existing government-donor technical working groups are being restructured to enhance government commitment and to provide the basis for more effective management of official development assistance.

To implement the development vision set out in the new administration’s Rectangular Strategy for Growth Employment and Equity, the Government and its development partners have agreed to prepare a single planning document, the National Strategic Development Plan (NSDP) 2006-2010, to replace the existing Second Socio-Economic Development Plan 2001-2005 and the National Poverty Reduction Strategy 2003-2005. Working groups are developing relevant action plans and monitoring indicators for the NSDP.

Outlook for 2005-2007 and medium-term trends

The economy has entered a new phase with the ending of the MFA. Notwithstanding investments in the garment industry in 2004, the sector is likely to be hurt by increased competition in world markets, especially from the PRC where production costs are up to 30% lower. The slowdown in garment exports will be partly counterbalanced by expected strong growth in tourism. Agriculture (especially field crops) is expected to show some recovery from its drought-induced level in 2004. GDP growth in 2005 is forecast to drop to 2.3%, before picking up gradually to 4.1% in 2006 and 4.7% in 2007, reflecting both efforts to promote diversification and increased commercialization in agriculture that begin to raise productivity in that sector, and progress in implementing structural reforms.

Despite attempts to increase revenues in 2005, the projected budget deficit (excluding grants) for the year, at 6.3% of GDP, will remain at around the prior-year level of 6.4% due to difficulties in raising revenues in an environment of slower economic growth. The budget deficit is likely to narrow to 6.0% in 2006 and 5.4% in 2007 as compliance with tax laws and customs procedures improves, and as antismuggling actions are reinforced. Spending will increase on health, education, rural development, and agriculture. The ability of domestic-financed capital expenditures to influence development activity during the forecast period will, however, be limited by the need to repay arrears.

Inflation is likely to moderate to 3.5% in 2005 and slow further to 3.0% in 2006 as a gradual upswing in agricultural output reduces food price inflation, while somewhat lower world prices for oil reduce imported inflation. Helping contain inflation is a commitment by the authorities to avoid recourse to domestic bank financing of the budget deficit. A significant depreciation of the riel is also unlikely during the forecast period as this would have only a limited impact on competitiveness, since most costs in Cambodia, including wages, are denominated in US dollars.

Exports will decline in 2005 because of the phaseout of the MFA. Imports are also set to decline, owing to a reduction in imports of garment-related inputs, but at a more moderate pace than exports, given the import-dependent nature of the economy. As a result, the trade deficit is predicted to widen further. This will be offset to some extent by buoyant growth in tourism showing through on the services account. The current account deficit is, however, likely to deteriorate from an anticipated 9.8% of GDP in 2004 to 11.7% in 2005 and will be only partially covered by official grants and loans, and FDI (Figure 2.6). As a result, the overall balance of payments will switch to a deficit.

In 2006, exports are likely to climb modestly before recovering more strongly in 2007 due to an increase in agricultural exports and a gradual recovery in garment exports as measures taken to improve competitiveness in the sector begin to yield results. Import growth will once again outpace export growth in 2006-2007, leading to a further widening of the trade deficit. The current account deficit, however, could narrow to 11.3% in 2006 and 10.5% in 2007 as receipts from tourism, which are expected to grow by some 15% a year, outpace interest payments on external debt. Continued inflows of official loans and grants, coupled with a pickup in FDI resulting from an improved environment for private sector development, are seen as leading to an overall surplus on the balance of payments. Gross international reserves during the forecast period are likely to remain at around 3 months of imports.

Public external debt is expected to be sustainable over the forecast period as the terms are highly concessional. Assuming that the Government reaches a debt-rescheduling agreement with the Russian Federation and the US in 2005 on terms comparable with the 1995 Paris Club agreement, total external debt is projected to decline to 47% of GDP by end-2005. However, the net present value of public external debt would still represent around 230% of total revenues.

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