Public Information Notice No. 99/30

Public Information Notice: IMF Concludes Article IV Consultation with Cambodia

April 6, 1999

On March 17, 1999, the Executive Board concluded the Article IV consultation with Cambodia¹.

Background

Domestic political uncertainty and the onset of the Asian financial crisis led to a deterioration in macroeconomic performance in the second half of 1997. The downward trend continued during the period leading up to the July 1998 elections and its aftermath. Governance in the forestry sector and budgetary management deteriorated markedly. However, the formation of a new government in November 1998 had a positive impact on public confidence, and economic activity, particularly in tourism and retail trade, started to pick up in late 1998. For 1998 as a whole, no growth in output was estimated. The 12-month rate of inflation was 13 percent at the end of the year, down from 19 percent in the middle of the year, and the exchange rate against the U.S. dollar stabilized in the last few months of the year, following a 10 percent depreciation during the first half of the year.

The trade balance improved slightly in 1998, and the National Bank of Cambodia (NBC) was able to accumulate US$13 million in international reserves in addition to the US$117 million in gold holdings released by the BIS in May 1998. Exports were buoyed by a booming garment sector, while import growth was modest, reflecting weak economic activity and reductions in aid flows.

Fiscal performance continued to be characterized by weak revenue collection, overspending on the military budget and a lack of foreign budgetary support. Revenue, while benefitting from the partial implementation of the 1997 Tax Law and some improvements in tax administration, amounted to only 8½ percent of GDP as extensive ad hoc tax exemptions continued to undermine the revenue base. Current expenditure at 9 percent of GDP exceeded budget provisions owing to higher defense and security outlays as well as election-related expenses. As a result, civilian operations and maintenance outlays were squeezed for the third year in a row and development expenditure was held to only 3½ percent of GDP. The overall deficit amounted to 4 percent of GDP with significant recourse to central bank financing for the first time in four years.

Broad money grew by 16 percent in 1998, somewhat less than in 1997, reflecting a sharp increase in currency in circulation associated with bank financing of the budget deficit, partly offset by zero growth in foreign currency deposits in domestic currency terms. Credit to the private sector decreased by 6 percent in U.S. dollar terms, owing to slow economic activity. Commercial bank interest rates remained broadly unchanged at around 19 percent for dollar-based lending, 2–3 percent for dollar term deposits, and 7–8 percent for riel term deposits.

Little advance was made during 1998 in the key structural reform areas of forestry, governance in fiscal management, and civil service and military reform, as government actions were constrained both before the elections and during the formation of the new administration.

A new coalition government was formed in November 1998. In two important speeches after assuming office, Prime Minister Hun Sen promised broad fiscal reform, less spending on defense and security, and tough action against corruption, illegal logging, and crime. In early December, the government regained its seat in the United Nations and was accepted for membership in ASEAN in March 1999. During the Consultative Group Meeting in Tokyo (February 25–6, 1999), donors expressed strong support for recent initiatives to control illegal logging and to restart the reform process, but cautioned that these efforts needed to be sustained and carefully monitored.

The policy discussions with IMF staff focused on restoring macroeconomic stability and resuming structural reforms in key areas to lay the foundation for sustainable growth over the medium term.

Executive Board Assessment

Directors expressed disappointment that, in 1998, economic growth halted, the riel depreciated, inflation increased considerably, and there was little tangible progress in addressing key structural reforms. Of particular concern was the continued poor fiscal performance, characterized by extensive ad hoc tax exemptions, overspending on the military budget, and sizeable central bank financing of the government.

Against this background, Directors welcomed the authorities’ recently announced commitment to break away from the past record of poor governance and weak economic policies and performance. They urged the authorities to fully carry out this commitment. Directorsemphasized in particular that it was critical to increase transparency and accountability, adhere to the rule of law, take decisive actions against corruption and illegal logging, and improve fiscal management. Firm implementation of these reforms, together with prudent macroeconomic policies, would help lay the foundation for sustainable growth over the medium term.

Directors urged the authorities to address decisively the problem of illegal logging. The recent prohibition against illegal logging activity and exports needs to be enforced vigorously and consistently throughout the country.

Directors welcomed the 1999 budget as a step toward improving fiscal management and achieving a sustainable fiscal position over the medium term. They saw the introduction of the value-added tax as an important step in strengthening revenue performance, and encouraged the authorities to follow through on implementation of the value-added tax, and to improve budgetary governance by strictly maintaining the prohibition on ad hoc import duty and tax exemptions, and by fully collecting revenues from line ministries. Moreover, it will be crucial to revise existing contracts for forest concessions to provide increased timber royalties. Directors encouraged the authorities to shift spending away from defense and security toward health, education, and civilian operations and maintenance, in line with the recommendations made by the recent Public Expenditure Review undertaken by the World Bank. Directors stressed that vigorous pursuit of civil service reform and demobilization of defense and security forces would support the needed reorientation of government spending.

On monetary policy, Directors indicated that the authorities should maintain a freeze on central bank credit to the government in order to provide adequate credit to the private sector. They urged the authorities to pursue macroeconomic stability as the best means to promote increased acceptance of the local currency and confidence in the domestic banking system.

Directors noted that the flexible exchange rate regime has served the Cambodian economy well despite political uncertainties. They supported the authorities’ objective of reducing the spread between the official and parallel market rates. Directors also encouraged the authorities to speed up the conclusion of the remaining bilateral agreements as envisaged under the Paris Club accord, and to avoid any further accumulation of external payment arrears.

Directors emphasized the need to address the serious deficiencies in the financial sector. They urged the authorities to pursue the early adoption and implementation of the Commercial Bank Law as an important component of rationalizing the banking system, and to further strengthen supervisory capacity, while continuing on-site inspections of banks by internationally recognized firms.

Directors urged the authorities to improve the macroeconomic database and disseminate economic statistics on a regular and timely basis.

Directors considered that, with improved political stability, the current situation offers a unique opportunity to accelerate the pace at which the authorities can address the key problems in the economy and governance. They expressed the hope that the meaningful reform measures thathave already been announced will be implemented consistently, fully, and in a sustained manner, which would help form the basis for a new ESAF-supported program in the future, and which would help mobilize donor support.