Cambodia and the IMF Other Titles in the Occasional Paper Series

O C C A S I O N A L   P A P E R       219       Economic Policy in a Highly Dollarized Economy The Case of Cambodia Mario de Zamaróczy and Sopanha Sa ©2003 International Monetary Fund September, 23, 2003 Order Information Acknowlegements I   Overview II   Economic and Financial Developments III   Dollarization in Cambodia A Synopsis of the Concepts of Dollarization and of Currency Substitution Measuring Dollarization in Cambodia IV   Costs and Benefits of High Dollarization in Cambodia Drawbacks of High Dollarization Benefits of High Dollarization V   Implications of High Dollarization for Macroeconomic Policy Design Dollarization and the Banking System Execution of Budget Consideration of a Possible Currency Board Arrangement VI   Conclusion Appendix Cambodia—A Simple Model to Estimate Dollars in Circulation Outside Banks Bibliography Boxes 1.   Key Dates in Cambodian Political and Financial History 2.   Empirical Models of Dollarization 3.   Theoretical Models of Dollarization 4.   Causality Analysis Between Inflation and Dollarization in Cambodia, Lao P.D.R., and Vietnam 5.   Measuring Seigniorage 6.   Banking Reform in Cambodia 7.   Currency Board Arrangement Versus National Bank of Cambodia Policies Tables 1.   Ratio of Dollars Circulating in the Economy 2.   Estimates of Seigniorage 3.   Interest Rates on Deposits and Loans, February 2002 4.   Budget Execution in Foreign Currency 5.   Velocity of Broad Money 6.   Maximum Likelihood Estimates for the State-Space Representation 7.   Velocity of Broad Money 8.   Value of the Proportionality Coefficient Figures 1.   Foreign Currency Deposits 2.   Real GDP and Inflation 3.   Assets and Liabilities of the Banking System in Foreign Currency 4.   Dollarization Ratios 5.   Ratio of Foreign Currency Deposits to Broad Money 6.   Foreign Currency Deposits in Cambodia, Lao P.D.R., and Vietnam 7.   Dollars in Circulation Outside 8.   Estimated Currency Substitution 9.   Ratio of Dollars in Circulation to Foreign Currency Deposits 10.   Estimated Dollarization 11.   Official International Reserves 12.   Spread Between Official and Market Exchange Rates 13.   Riels per U.S. Dollar 14.   Riels per Thai Bhat and 100 Vietnamese Dong 15.   Effective Exchange Rates 16.   Co-Currency Circulation

I. Overview In recent years a number of countries have adopted the U.S. dollar as their official currency. In some other countries the dollar has become a semi-official currency. This "dollarization" occurs in a variety of ways. Some countries allow several currencies to circulate side by side and over time the dollar dominates (so-called "de facto dollarization"). Others make a conscious choice, opting for the dollar because of its traditional stability. In Cambodia, this process has been particularly rapid and extensive. The signing of the Paris Peace Agreements on October 23, 1991 heralded the political and economic rebirth of the Kingdom of Cambodia after more than 20 years of continuous civil and international wars. The United Nations Transitory Authority in Cambodia (UNTAC) oversaw the country's political and economic management from 1991 until 1993, when free elections brought a civilian government to power. Since then the country has achieved an economic rebound, albeit from a very low base. Although the country achieved good economic progress during 1994­95—among other things, in the framework of an International Monetary Fund (IMF)-supported program—factional fighting broke out briefly in July 1997, resulting in a temporary setback in development and foreign investment. Elections in 1998 brought a coalition government to the helm and, through the surrender of the last Khmer Rouge, the country returned to peace and stability at the end of 1998. The coalition government has been able to focus on economic and structural reforms, and embarked upon a new IMF-supported program in October 1999. A notable feature of the Cambodian economy is its high level of dollarization, which presents a challenge for decision makers to devise the best policy mix for sustainable growth, coupled with steadfast poverty reduction. Dollarization was neither sought nor encouraged by the monetary authorities. Rather, it came from the "supply side" in the form of sudden and massive inflows of foreign currency—continuing to date—stemming from sizable international assistance, private transfers, and export earnings. Such large inflows of dollars from overseas, coupled, on the "demand side," with a lack of confidence in the domestic currency and political uncertainties, provided the impetus for speedy dollarization, which is a unique feature of Cambodia's economic experience. Since the authorities have adopted an open economy and a liberal exchange system, the U.S. dollar has become a de facto second legal tender along with the national currency, the riel. As a result, Cambodia has been confronted with multiple currencies circulating freely throughout its territory, to the point that the dollar has become the dominant currency, with the riel playing a relatively minor role. Cambodia achieved almost complete de facto dollarization during 1991­95 and this condition has continued to prevail since then. The country is largely a cash-based economy, with a large amount of cash dollars circulating outside the banking system. The originality of recent Cambodian economic policy is that it has been akin to an "orthodox" currency board arrangement, yet it has been implemented in a virtually fully dollarized environment. This policy has served Cambodia well since 1999, but a number of risks associated with the growing economy call for close monitoring of economic developments. This paper is organized as follows. Section II presents a short description of economic, financial, and structural developments in Cambodia since independence, but focuses on the decade ending in 2001, which serves as a backdrop for the discussion on the emergence of dollarization. Section III reviews recent developments in the literature on dollarization and discusses the degree of dollarization in Cambodia. Owing to the unique way in which dollarization was introduced in Cambodia and to the specific characteristics of Cambodia's economy, an attempt is made to provide an econometric estimation of cash foreign currency circulation. Section IV examines costs and benefits of dollarization in Cambodia, and Section V discusses the ensuing macroeconomic policy implications.