Statement at Donor Meeting

Macroeconomic Developments, Public Financial Management and Private Sector Development Statement by Cambodia's Development Partners at the first Cambodia Development and Cooperation Forum

June 26, 2007

It is an honor for development partners to participate in the first Cambodia Development and Cooperation Forum, and to deliver some remarks on Cambodia's macroeconomic developments and policies, public financial management (PFM), and private sector development (PSD) reforms.

Overall macroeconomic developments have been impressive in the period since development partners and the Royal Government met at the Consultative Group meeting a little over one year ago. Growth has remained very high and inflation low, government revenues have grown significantly, and budgets have increasingly focused on priority development objectives in line with the National Strategic Development Plan. Public financial management reforms being put in place are increasingly lending credibility to the budget, while the business environment is improving through private sector development initiatives.

Development partners commend the Royal Government for their policy implementation efforts in these areas, and the clear successes that have resulted. Cambodia is one of the fastest growing economies in the world today, in no small measure as a result of sound and prudent implementation of macroeconomic policies and structural economic reforms, and strong financial and technical support from development partners. Moreover, as pointed out in the World Bank's Equity and Development Report, the benefits of this growth have been shared reasonably equally over the period between 1997 and 2004. This is very good news.

Macroeconomic, public financial management, and private sector development reforms have contributed to the positive outcomes both directly and indirectly. Together, they provide a stable and predictable environment necessary for growth, address governance in the management of public resources and help to channel those resources efficiently and transparently toward achieving the Cambodian Millennium Development Goals (CMDGs), and they broaden the base of economic activity and strengthen linkages between growth and poverty reduction.

In conjunction with rising economic fortunes are higher hopes and expectations for tackling some of the more difficult reforms that have not progressed as quickly as earlier planned. One must not lose sight of the fact that poverty continues to be widespread even after considering the gains made over the past decade, with deep pockets in rural areas, and significant income gaps remain between the rich and the poor. New issues have also emerged, including in particular developing the legal and policy framework to maximize the benefits of Cambodia's oil discovery while managing the risks.

Recent Macroeconomic Developments

The growth of Cambodia's economy has been impressive. Real GDP is estimated to have increased by 10¾ percent in 2006, driven by growth of around 20 percent in tourism, garment exports, and construction. Agricultural production has expanded, owing to a diversification into cash crops, improvements in yields, and favorable weather conditions. Services—in particular finance and telecommunications—increasingly contributed, and foreign direct investment was strong. These trends have generally continued in the first part of 2007.

Inflation has remained in the low single digits, and ended 2006 at a very low 2¾ percent, reflecting continued sound implementation of monetary policy. A slight pick up to around 4 percent took place in early 2007, mainly reflecting rising fish prices and a pass-through of higher international oil prices, although overall inflation pressures appear to remain muted. Strong growth in garment exports and tourist receipts led to a fall in the external current account deficit (excluding official transfers) to 7¼ percent of GDP in 2006, and helped build international reserves to over $1.2 billion in early 2007.

Prudent fiscal policy management has underpinned the strong macroeconomic performance. As a consequence of strong revenues and slow spending, the overall government deficit narrowed in 2006, expenditure arrears were reduced significantly, and government deposits in the banking system rose. Government revenue exceeded the budget due to vibrant economic activity and improved administration supported by the PFM Reform Program. Collection performance in early 2007 has accelerated, with provisional estimates indicating tax revenues increased by about one third in the year to April compared to the same period last year, and budgeted revenue targets are expected to be exceeded by large margins. Government expenditure, however, has been restrained. Much-needed domestically financed capital spending increased by only a small amount in 2006, and initial difficulties in implementing new spending procedures has slowed expenditures in priority Ministries in early 2007. A rapid resolution of these difficulties should be followed by accelerated expenditures through the remainder of the year.

The banking sector continues to expand very rapidly, with deposits and lending rising approximately 40 percent. Growth in the banking system is facilitating economic development, and reflects rising confidence.

Near-term Outlook and Key Macroeconomic Policy Issues

The economic outlook is bright. Prudent macroeconomic policy implementation has provided stability, in turn boosting confidence and foreign direct investment, and has underpinned very strong macroeconomic performance. The broad growth trends witnessed in 2006 are projected to continue in the near term, and along with continued high levels of foreign direct investment, should result in growth of around 9 percent in 2007, and around 7½ percent over the medium term. Assuming broadly stable international oil prices, inflation should remain in the low single digits.

This positive environment provides ideal conditions to re-energize reforms in areas where progress has been less rapid, and to address some of the key risks to the outlook and constraints to broader and deeper poverty reduction and achieving the CMDGs. Key challenges include the following:

• Broadening the base of economic growth. The narrow export base in particular remains vulnerable to domestic and external developments. Although garment production appears to be holding up well, competitiveness in this area can be ephemeral. Vietnam's accession to the WTO and the lifting of safeguards measures on China are the main risks.

• Strengthening agricultural productivity. Agriculture, vital for the majority of the population, remains vulnerable to weather conditions, despite recent improvements in irrigation.

• Maintaining momentum in raising government revenues for higher and better quality spending on poverty reduction. Good progress has been made in 2007, though revenues remain low in relation to GDP and other countries. Sustained increases in revenues will continue to arise from improvements in administration and enforcement, and should be directed toward high-quality infrastructure projects, strategic civil service pay reform, and priority areas identified in the NSDP such as health and education.

• Safeguarding the soundness of the banking system. The very fast pace of growth in financial intermediation requires strong banking supervision to ensure that banks are weighing all of the lending risks properly, including those related to rapid rise in land prices.

• Improving institutions and capacity in the government, in part by addressing corruption and strengthening the civil service. There is a widening gap between the rapid pace of economic change and the naturally slower process of building institutions and capacity in the government. International studies show that a key factor in the economic growth of successful economies in the region is a stable and reliable rule of law. In that context, improving Cambodia's public sector governance, particularly through strengthening fiscal and financial sector management, and reducing corruption and increasing competition, will underpin stability, improve the investment climate, and enable further progress in poverty reduction.

In the longer term, oil production could significantly increase national income, and associated fiscal revenues would provide vital financing for development spending on NSDP priorities. Given the substantial uncertainty still surrounding the level of reserves and the timing of production, the Government should avoid undertaking large oil infrastructure projects, and be very cautious with commercial borrowing in anticipation of uncertain oil revenues.

Progress on developing policies and the legal framework for the oil sector and for managing future oil revenues would increase the probability of early commercial production and the optimal use of resources. A key building block is to strengthen the taxation regime for oil, and embedding this regime within the existing law on taxation. Development partners also encourage the Royal Government to make progress on endorsing the Extractive Industries Transparency Initiative (EITI).

The continued strong economic growth anticipated in the medium and long-term places government debt on a sustainable path and the highly concessional structure of Cambodia's lending dampens the risk of distress. Nevertheless, moderate risks do remain, particularly from the current low level of government revenues.

In this context, the recently acquired sovereign credit ratings open the door to government borrowing on international financial markets. Some limited borrowing on commercial terms for high-return infrastructure projects is consistent with debt sustainability, however such borrowing would imply large debt-servicing costs, diverting scarce government resources from other activities. A cautious approach to any commercial borrowing is therefore warranted.

Poverty, Equity and Development

Cambodia has made significant progress in reducing poverty during the past decade, with the poverty rate declining from an estimated 47 percent in 1994 to 35 percent a decade later. Over the same period, however, there was a rapid rise in inequality, a serious concern shared by development partners and the Royal Government of Cambodia.

As pointed out in the World Bank's Equity and Development Report 2007, prepared for this CDCF meeting, the rise in inequality occurred primarily in the early part of the decade (1994-97) and primarily within rural areas. During the second half of the period (1997-2004), there was no significant change in inequality. The benefits of growth over this period have been shared reasonably equally between the rich and the poor.

Cambodia's changing distribution of income and consumption is consistent with the process of transition from a planned to an open-market economy, and with the accompanying growth of incomes. This transformation has promoted better resource allocation, expanded the range of gainful activities, and widened the distribution of earnings. Aided by robust economic growth and improved capacity for implementing public policies, Cambodia has seen many other indicators of welfare—for example, health and education—become more equal over time.

Development partners warmly welcome these findings. They suggest that Cambodia could continue to follow a path of high and equitable growth and rapid poverty reduction in the future, provided that sound policy choices are made. Indeed, a radical shift of development strategy is not needed. Improvements in public policies and public spending could lock in the gains that have been made so far and ensure that these gains are replicated in the future.

Public Financial Management

The PFM Reform Program has made substantial headway toward achievement of the Platform 1 objective of implementing a more credible budget. In addition, significant progress has been made on the necessary preparatory work for Platforms 2 (Financial Accountability) and 3 (Policy/Budget Alignment). At the aggregate level this has undoubtedly assisted the Royal Government to improve domestic revenue collection, control expenditure, and reduce domestic arrears.

Specific systemic reforms to date include:

• An improved Strategic Budget Policy Framework; including development of a macro-fiscal framework and preparation of guidelines for development of strategic budget plans by line ministries.

• A strengthened budget formulation process; including the design of a new extended budget calendar, implementation of a harmonized budget classification/chart of accounts system, early introduction of the medium term expenditure framework and the piloting of program budgeting in seven ministries. The Organic Budget Law has also been amended to accommodate these changes.

• Increased efficiency in budget execution; including continued streamlining and decentralization of commitment and payments processes and greater use of the banking system. The legal framework for procurement has also been strengthened. In addition, the first part of the design and acquisition process for an financial management information system (FMIS) is underway.

• Improvements to the control environment, including more effective internal control and the establishment of internal audit departments.

These systemic reforms have been supported with a number of institution-building measures, including a broad range of necessary training and skills development activities. A key success has been the introduction of a Merit Based Pay Initiative (MBPI) in the Ministry of Economy and Finance (MEF), which has underpinned a substantial improvement in motivation, productivity, attendance and performance.

Given this analysis, development partners are of the view that although the Joint Monitoring Indicator (JMI) target of completion of Platform one has not yet been fully achieved, substantial progress has been made towards achievement of improved budget credibility.

Next Steps in PFM Reform

At the recent PFM annual retreat, stakeholders agreed that while good progress has been achieved, work remains to be done to complete Platform 1. The five key outstanding reform issues identified include:

• Improved budget integration and comprehensiveness.

• An enhanced revenue mobilization policy.

• Rationalizing cash management including cash planning, consolidation of government bank accounts and greater use of the treasury single account.

• Further streamlining of budget execution processes.

• Further strengthening of debt management.

Development partners support the government's core strategy to focus a substantive part of the remainder of 2007 on completion of these reform actions. Development partners also support the government's intention to commence strategic and transitional planning for the next stage with the aim of commencing Platform 2 implementation in 2008. A new strategic reform area is oil revenue management, and this has been reflected in the new JMI for PFM.

There are a number of issues critical to the next phase of reform, including:

• Completion of Platform one actions related to budget integration, revenue mobilization policy, cash management, streamlining budget execution processes and strengthening debt management.

• Improving the engagement of line ministries across all PFM areas. The success of Platform 2 will depend heavily on effective coordination across both processes and institutions.

• Putting in place the policy and institutional framework to manage oil revenue. Of the hundreds of actions that constitute the PFM reform program, it is hard to think of actions more important than those that pertain to oil revenue management. In addition to endorsement of EITI, development partners look forward to the options paper on oil revenue management being drafted by MEF, expected in 2008.

• Enhancing capacity and creating an institutional development strategy in both MEF and line ministries necessary to support the more substantive changes implicit in Platform 2 activities. Experience from many countries shows that the absence of these minimum conditions undermines the probability of successful PFM implementation.

• Strengthening the role of the oversight authorities (the National Audit Authority and the Parliament). Key to this is to develop the capacity, resource base and independence of the Auditor General and to facilitate the capacity of the parliamentary secretariat to support important oversight committees.

There appears to be considerable political and managerial commitment and stakeholder consensus on the way forward. Challenges exist but these appear to be generally recognized, with agreement on a broad vision of the future path and identification of the steps needed to progress. There also appears to be willingness, in both MEF and line ministries, to build the technical capacity necessary to follow the reform path. Development partners have committed to provide substantial funding in support of these critical reforms.

A major barrier to PFM reform remains the challenges in the underlying administrative and human resource framework. For a modern PFM system to be efficient and effective, it requires a complementary institutional and human resource management framework that supports strategic and operational resource management, and a human resource management system that effective promotes human resource planning, management and utilization. This will encompass improved civil service pay, rationalization of civil service employment, restructuring, performance appraisal and capacity building within an approved budget framework. Achievement of such a framework takes time, and requires continuous active leadership and substantial support from the responsible government institution, the Council for Administrative Reform.

A number of efforts to encourage such reforms have been made through the PFM Reform Program, including support for rationalization of salary supplementation schemes, functional reviews, the introduction of the MBPI, and more comprehensive coverage of salary and related payments through the payroll. With the exception of the MBPI in MEF, however, other reform initiatives have not proceeded as envisaged earlier, and dialogue has unfortunately stalled.. Development partners are willing to assist the Government on the design and implementation of a comprehensive public service and human resource reform agenda, and look forward to finding ways to resume progress on this key issue.

Private Sector Development Reforms

Since the launch of the Small- and Medium-sized Enterprise (SME) development framework in early 2006, progress has been made in promoting the development of, and enabling environment for SMEs. SMEs account for almost 99 percent of all enterprises in Cambodia, most of them in the informal sector. Enhancing an enabling environment for smaller enterprises so that they will grow, invest, generate income and employment and move into the formal economy will be essential in our joint efforts to alleviate poverty by supporting a more diversified economy and direct growth in rural areas.

Streamlining and simplifying all licences is ongoing. A plan for licensing review mechanisms has been adopted. Implementation of the reform of those licenses having the most impact on SMEs is a priority. Progress has also been made in the company registration process of businesses at provincial levels. Pilots are being established in selected provinces. Implementation of single window offices in the provinces will significantly reduce the costs of doing business.

While more favourable conditions for SMEs are being created and implemented at all levels, the implementation of the law on commercial enterprises especially at provincial levels remains a challenge. To further the promotion of SMEs the burden of informal fees and smuggling needs to be addressed, as this impedes the growth of legitimate businesses.

As the SME development framework points out, the road map also provides for actions that will improve access to finance. Much progress has been made, for example with the adoption of a simplified financial reporting template. Access to credit has improved and increased. However, more financial instruments appropriate for SME lending should be developed and further progress in issuing land titles are of the utmost importance, as they will provide SMEs, especially in the rural areas, with much needed secure collateral.

Trade

Over the past year, Cambodian exports continued to grow, with sustained expansion in the important garments and tourism sectors. It is indeed encouraging that Cambodia has managed to continue growth in spite of the end of the MFA garment quota system. However, as noted above, Vietnam's accession to the WTO will present Cambodia's garment manufacturers with stiffer competition, and their success depends to an important extent on the cost and time it takes to do business in Cambodia. Building on past achievements, there are still gains to be had in this area. The identified risk also highlights again the need for diversification of Cambodia's exports, for which development of entrepreneurs' supply capacity is as important as ensuring facilitation of trade.

With regard to trade facilitation, progress has been made in the past year in the establishment of a risk management unit in the Customs and Excise Department, and the approval of the single administrative document that will be piloted in the second half of this year. The test of these documents and structures will be in their implementation through, for instance, the administrative agreements among all the relevant agencies on procedures and guidelines for the inspection and clearance of imported and exported goods.

Roll out of the ASYCUDA system is also making steady progress, and a positive impact would result in an increase in customs revenues, availability of reliable trade statistics, and a reduction in average clearance time. The in-depth reforms of the customs system that the implementation of ASYCUDA requires will themselves account for an important part of the expected gains.

As part of the Royal Government's legal agenda, the draft Law on Concessions and the draft Law on Customs have been submitted to the National Assembly, and development partners look forward to their consideration in plenary session as soon as possible.

The Special Economic Zone in Bavet was the first to establish a one-stop service window, with five government agencies represented in a single room. Such windows will be established whenever a new SEZ becomes operational.

Early this year, the first draft of the Diagnostic Trade Integration Study (DTIS) 2007 was prepared by a group of donors, coordinated by UNDP, under the leadership of the Ministry of Commerce. This document updates the DTIS that came out in 2002 and it should provide a rallying point for policy dialogue and priority setting among donors with an involvement with trade-related assistance. It will be vital that the final DTIS 2007 is of the highest quality, to ensure sufficient buy-in from all stakeholders in this effort to increase aid effectiveness.

The Ministry of Commerce has also progressed in its preparations for a more sectoral approach to trade-related assistance, while it has initiated an internal reform process and reinvigorated the Trade Development Sub-Steering Committee. The Customs and Excise Department has recently updated its Customs Reform and Modernisation Plan, taking stock of achievements and setting out a course for further progress, providing the Department itself, as well as donors interested in supporting it, with a way ahead for this crucial organisation.

Close coordination of all trade-related agencies will continue to be central to the Government's role in promoting private sector development. This is evident in Cambodia's remaining agenda for legislative work related to its WTO accession. Areas like SPS and TBT, for instance, could become very important for a more diversified and rural-based exports sector, and require a great deal of cooperation between line ministries.

Conclusions and Issues for Discussion

Cambodia has achieved a remarkable degree of macroeconomic stability, accompanied by strong rates of economic growth and poverty reduction, and deserves to be commended for these results. They reflect the combined effect of prudent implementation of macroeconomic policies and structural reforms to public financial management systems and efforts to facilitate private sector development, strong financial and technical support from development partners.

The challenge now is to take advantage of the very positive environment to make progress on some of the key development issues facing Cambodia, so that deeper inroads can be made in reducing poverty and achieving the CMDGs. In this light, development partners would like to raise the following issues in the spirit of constructive dialogue, on which the views of the Royal Government would be most welcome:

• The discovery of oil has major policy implications, even if the amounts ultimately recoverable were to be less than early estimates. Progress in preparing the legal, regulatory and taxation regimes should be made in advance of actual oil production, to ensure that the kitchen is ready when the fish is finally pulled from the water. There are similar issues that arise for other industries, such as mining. What are the government's priorities for these sectors, and how can development partners assist?

• Recently acquired sovereign credit ratings open the door to government borrowing from international financial markets. While some limited borrowing on commercial terms for high-return infrastructure projects is consistent with debt sustainability, such borrowing would imply large debt-servicing costs and divert scarce government resources from other activities. What are the government's views on these considerations?

• A comprehensive reform of the civil service is needed to underpin implementation of the NSDP as well as improvements in governance. How can different views over the broad direction to be taken be reconciled, so that Government can develop a high performing civil service capable of meeting the challenges of the 21^st century?

• Public financial management reforms are progressing very well, and the focus over the coming year is to complete Platform 1 activities, and begin laying the foundation for Platform 2. Reforms will increasingly rely on active participation of the line ministries. How does the government see that process evolving?

• Private sector development reforms are critical for broadening the base of economic growth and strengthening linkages between growth and poverty reduction. Progress has been made in improving the business environment, and in implementing trade facilitation reforms. However, the high cost of informal fees and the lack of a complete framework of commercial laws, including the anti-corruption law, are hindering this progress. What does the government see as the most important steps for addressing these problems over the coming year?

Development partners congratulate the Royal Government for the success achieved, and we remain committed to working closely with the government in pursuit of its development reform agenda. We look forward to a fruitful and constructive dialogue at this first CDCF meeting.