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p. 6 of 21 BACK | NEXT Executive Summary I. Background II. Overview of Development Issues A. Poverty Profile B. Postconflict Issues C. Economic Growth III. External Development Assistance IV. Priority Sectors for ADB's Future Operations V. ADB Strategy in Operation

Country Operational Strategy - Cambodia : II. Overview of Development Issues

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C. Economic Growth

1. Overview

37. From the discussion thus far, boosting rural labor productivity emerges as an important element of a growth strategy for poverty reduction. Almost 85 percent of the population live in rural areas where agriculture is the chief means of livelihood. The dominant agriculture sector is characterized by the lowest rice yield in the region, partly as a result of poor irrigation systems, frequent flooding, and drought. Industrial development is still nascent, depending primarily on aid-funded reconstruction and preferential access to western markets for textile exports. The urban service sector is also weak, with larger scale operations catering to tourists and other foreign visitors while small-scale family operated businesses serve local consumers. Weak institutions, a lack of skilled civil servants, and an almost total dependence on foreign funds for public investment plague the public sector. Private sector development is constrained by inadequate physical infrastructure and weak governance.

38. The average rate of growth of real GDP from 1994 to 1998 was 4.0 percent in Cambodia, with agriculture expanding at 2.14 percent, industry at 15.43 percent, and services at 0.79 percent.¹⁶ Figure 1 shows sector shares of GDP. Agriculture, dropping from 42.0 percent of real GDP in 1993 to 38.3 percent in 1998, failed to grow as fast as the population, despite a 4 percent average increase in crops, which accounted for 18 percent of GDP in 1998. Livestock growth was an anemic 0.86 percent over the same period. The engine of industrial growth was manufacturing, particularly textiles, which grew an average of 56 percent over five years, increasing from 1.2 percent of GDP in 1993 to 6.4 percent in 1998. Most of this explosive growth occurred after the country gained preferential access to European Union and US markets. The disappointing service sector performance, despite 8.7 percent growth in hotels and restaurants, included a steady contraction of wholesale and retail trade after the United Nations Transitional Authority in Cambodia (UNTAC) period.

Figure 1: GDP at Constant Prices, by Major Sector 1993-1998 Note: Adjustment to GDP includes taxes on products, subsidies, and imputed bank service charges. Source: National Institute of Statistics.

39. As discussed in Chapter I, the internal and external crises of 1997-1998, combined with severe weather, adversely affected economic growth. Nevertheless, it is clear that the US garment trade agreement, which may have a much smaller impact on the economy in the future, was the main countervailing event in 1997-1998. Investment in this sector is slowing and the main source of service sector dynamism, tourism, is slow to recover from the effects of the internal and external crises. Moreover, the influence of forestry on the economy is bound to decline over the next several years as either reform or deforestation slows the pace of exploitation. Thus, it becomes even more critical to redirect investment toward the rural economy, which has been somewhat neglected as industrial growth centered on Phnom Penh.

40. That economic growth over the last several years has not been adequate is apparent when labor force productivity is analyzed. Sophal et al. 1999 (footnote 8) compared productivity in 1993-1994 and 1996 and found that (i) labor productivity declined by 5.0 percent between the two periods, and (ii) labor productivity in agriculture declined by 16.0 percent because agricultural output grew slower than the agricultural labor force. Agriculture's share of the labor force increased from 75.0 percent to 78.2 percent at the same time that its share of output was shrinking. When the effects of the 1997/98 shocks on the rural and urban poor (falling wages and rising rice prices) are incorporated, the conclusion is that the vast majority of the population did not enjoy a substantial increase in living standards in the last five years.

2. Constraints

41. There are four basic constraints to sustained poverty-reducing economic growth: inadequate human resources, insufficient investment, weak institutions to provide public services to support private sector development of the economy, and mismanagement of the country's natural resources. Removing these constraints will enable accelerated growth in the long run.

a. Human Resource Development

42. A principal long-term constraint on economic development in Cambodia is the poor quality of human resources. Low productivity and low wages characterize the labor force. Moreover, the military and civil service are overstaffed with low-skill, low-wage personnel that must now be integrated into the private sector labor force. The quality of the labor force is affected by high rates of morbidity and mortality. Furthermore, the proportion of the population with disabilities is high. About 40 percent of the Cambodian population have never attended school, 32 percent are illiterate, and less than 1 percent have had any training beyond high school, an alarming legacy of the Khmer Rouge years. Thus, Cambodia lacks even the skilled personnel to effectively improve its administrative, legal, educational, and medical institutions. Furthermore, public expenditures on education are very low, 10 percent of total expenditure in 1998, not quite 1 percent of GDP. The government share of total educational expenditures is as low as 25 percent, with informal private payments contributing significantly to user costs.

43. Inadequate health care and nutrition is literally debilitating the population. Stunting is common among children and adults frequently lose days of work because of illnesses for which treatment by a health provider is expensive. Leading causes of death include malaria, acute respiratory infections, tuberculosis, road accidents, and mines. An impending crisis is the HIV/AIDS epidemic, the worst in Asia and the worst outside Africa. Public expenditures on health are also very low, leading to poor-quality health care and low access, which in turn leads to one of the lowest rates of health services utilization in the world. In 1998, only an estimated 37 percent of the urban population and 5 percent of the rural population had access to clean water.

b. Investment

44. A critical constraint to economic growth in Cambodia is the low investment rate. Gross capital formation peaked at 15.2 percent in 1996 before falling to 13.4 percent in 1998. This compares with the average of about 28.5 percent for Viet Nam, 33.7 for Thailand, and 27.8 for the Lao PDR for the same period. Two sources of the low investment rate are low national savings and a relatively poor ability to attract foreign investment. Cambodian gross national savings averaged 3.1 percent in 1996-1998, compared with 10.4 percent for the Lao PDR, 21.3 percent for Viet Nam, and 34.2 percent for Thailand.

45. The low savings rate in Cambodia is partly a result of low government resource mobilization, partly a result of widespread poverty, and partly a result of a preference for informal savings because of low confidence in the banking system. The Government's 1998 revenues were 9.2 percent of GDP, up from 4.8 percent in 1993, but still the lowest of all reporting DMCs of ADB. The Government's goal is to achieve revenues of 13 percent of GDP by 2002. In the meantime, public investment declined from 7.6 percent of GDP in 1996 to an estimated 5.6 percent in 1999. Moreover, the bulk of this is financed by foreign assistance-99 percent in 1997 if budget support and project aid are taken together. In 1998 the percentage was only about 75 percent, but the Government resorted to bank financing of the gap.

46. Mobilizing private domestic savings for domestic investment is a long-term process of building confidence in the domestic banking and improving the private sector investment climate. The extent to which Cambodia can attract FDI in the interim will depend on regional economic recovery and the external assessment of the political climate and pace of reforms in the country designed to build market-friendly institutions. FDI declined from $294 million (9.3 percent of GDP) in 1996 to $168 million (5.5 percent of GDP) in 1997 to $120 million (4.4 percent of GDP) in 1998. The regional crisis and the period of political instability affected FDI levels in 1997 and 1998.

c. Market Institutions

47. In the 1990s, the types of private investment, domestic and foreign, that predominated in Cambodia were short-term investments that either do not depend on strong governance or perhaps even rely on weak governance. Legal noncompliance and rent seeking by government and military officials, for example, plagued the timber industry. Indications of labor law violations in the garment sector brought quotas on exports to the US. Although improvements in the labor force, financial markets, and public infrastructure (e.g., transportation, electricity) are important, it is corruption that is cited by businesses as the most important current constraint to private sector activities in Cambodia. The related lack of transparent laws and institutions to define and enforce private property rights is also a critical deterrent to the ability of the private sector to assume the lead role envisioned by the Government in poverty-reducing economic growth.

48. The long-term effort to improve urban infrastructure and labor force skills suitable for the development of labor-intensive industry and services will be ineffective without also focusing on improvements in the public institutions to support private sector development. Moreover, substantial investments in urban infrastructure are incompatible with the desire to redirect investments to rural development and social services. Thus, improved governance, including reducing corruption, increasing public administration efficiency, and improving legal and judicial institutions, is an important first step. It will foster private sector development in both urban and rural areas.

d. Natural Resource Management

49. One legacy of the 1990s transition period was accelerated environmental degradation. Declining Khmer Rouge influence resulted in increased access to previously little used forest resources even as the population steadily increased. The central Government also was unable to control logging in remote areas of the country for a variety of reasons. Recent studies indicate the severity of the situation. About 70,000 ha/year (yr) were deforested in 1973-1993, increasing to 180,000 ha/yr in 1993-1997. If harvesting is not curbed soon, commercially valuable timber will be exhausted in a few years, robbing the Government of a valuable source of revenue as well as creating problems in biodiversity and watershed control. Community pressures on forests, in the form of fuelwood collection, shifting agriculture, and permanent land conversion, are also an important cause of deforestation and forest degradation.

50. The resulting reduction in crop yields because of soil erosion and increased flooding may dramatically increase poverty in a rural population that is heavily dependent on agriculture. A related problem is that fish catches, a vital source of protein in the diet, are plummeting because of the combined effects of habitat loss in the inundation zone of Tonle Sap, overexploitation, destructive fishing practices, and agrochemical pollution. An additional area of concern is the environmental impact of industrial and infrastructure investments, which has only recently come under government purview through the 1997 law on environment and natural resources. Finally, inadequate investment in aging sanitation systems combined with strong population growth presents an increasing threat to the health of both the environment and the population. The Environmental Sector Strategy Note on Cambodia elaborates the key environmental issues in more detail.¹⁷ Improved natural resource management, including the cessation of quasi-legal and destructive logging by elements of the armed forces, is a critical litmus test of the Government's resolve to reform and desire to improve the lives of average citizens.

3. Development Potential

51. Growing at 2.5 percent annually, the population will reach about 13.5 million by the end of 2005, increasing by about 18.0 percent. If the incidence of poverty is not improved, the number of people living below the poverty line will increase by 750,000, approaching 5 million. This will exacerbate a growing problem of land shortage and urban migration, as well as increase the demand for social services and jobs. Despite these daunting facts, the economic setbacks of the last two years, and the disappointing impact on poverty of economic growth in the last five years, Cambodia has the potential to achieve sustained economic growth in the Government's target range of 6.0-7.0 percent by 2001. This would improve per capita GDP by about 3.5-4.5 percent per year. With a well-balanced development agenda that increases rural investments, particularly in agriculture and social services, the potential for poverty reduction is great. If governance is strengthened and political stability is maintained, the private sector investment to develop the country's potential in industry and services should also materialize.

52. Harnessing the country's agricultural potential is a vital element of sustainable poverty-reducing development. Food security, the Government's first agricultural priority, is achievable with a well-rounded development plan that relies, to the extent possible, on markets to channel goods and provide distributive and productive signals to maximize efficiency. Eliminating the constraints to the efficient functioning of private sector operations should be the Government's focus. If property rights are strengthened, management of water and other natural resources is improved, the primary and rural road networks are expanded, the supply of rural credit is increased, and research/extension services are broadened, then agricultural productivity (rice yields, commercial crop production, and livestock production) should climb significantly.

53. Recorded output in fisheries and forestry together accounted for 13 percent of real GDP in 1998, down from 17 percent in 1994. It is likely that there was significant unrecorded activity, especially in forestry. Furthermore, current exploitation of these natural resources is widely regarded as unsustainable. Thus, to achieve the tremendous development potential in both forestry and fisheries, immediate action by the Government to halt overexploitation is essential. In reality, because of past abuses, the Government must race against time to avoid the collapse of those industries. It is unlikely, therefore, that in the next five years output in these two sectors will grow significantly; at worst, it could decline precipitously.

54. The SEDPI identifies a number of constraints to industrial development in Cambodia. First, Southeast Asia is a region that is highly competitive in labor-intensive manufacturing and many countries there recently went through a currency depreciation that increased competitiveness relative to Cambodia. Second, the skills-base of Cambodia's labor force, including entrepreneurial skills, is exceptionally low as indicated by educational achievement and health indicators. Third, power, communications, water supply, access to industrial land, and transportation are inferior in Cambodia. Fourth, physical and economic security is inadequate. Fifth, administrative red tape is excessive. Finally, the markets for financial and information services are underdeveloped.

55. Given these constraints, it is clear that significant expansion of the industrial base is a long-term goal. The SEDPI outlines a strategy of promoting key "growth centers" at Phnom Penh, Sihanoukville, Siem Reap, Battambang, and Kompong Cham. Phnom Penh is the center of government and located at the confluence of the Mekong and Tonle Sap rivers. Sihanoukville is a coastal town with harbor facilities and good transportation to Phnom Penh. Siem Reap is close to the northern shore of the Tonle Sap with Angkor Wat nearby (see Box 2 for a discussion of Cambodia's tourism potential). Battambang is close to significant natural resources as well as the Thai border. Kompong Cham is in the most populous province and holds a strategic location on the transportation network. Each of these areas has a natural location advantage and would be developed through infrastructure provision and industrial zoning. In general, an outward-oriented industrial policy that alleviates key constraints and relies on market forces to identify areas of comparative advantage is ideal.

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