August 31, 2000

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

1. In September 1999, we wrote to inform you of the government’s Policy Framework Paper for 1999–2002 and its macroeconomic adjustment program for 1999–2000. Since that time, the government has implemented this program in a consistent manner with bold actions taken in the area of bank restructuring, forestry policy and military demobilization. Macroeconomic performance under the program has exceeded program targets with low inflation and strong real GDP growth in 1999.

2. Under the first year PRGF-supported program, all quantitative benchmarks for December 1999 and June 2000, and all quantitative performance criteria for March 2000 were met. The program of structural reform is also broadly on track except for delays in completing two structural benchmarks. A civil service reform strategy is now expected to be formulated by March 2001, and progress continues to be made in preparing commercial legislation.

3. Attached to this letter is a Memorandum on Economic and Financial Policies of the government of Cambodia for 2000 which supplements the Memorandum attached to our letter of September 29, 1999. This memorandum lays out, among other things, the main features of the government’s fiscal program for 2000 and the next steps to be taken in its bank restructuring program. In light of the fiscal program for 2000, we have revised the quantitative financial targets for September and December 2000 to take account, in particular, of revised estimates for non-project external budget support. The revised quantitative performance criteria for the next test date under the PRGF program are set out in Table 2 attached to the Memorandum.

4. The government believes that the policies and measures described in the attached memorandum are adequate to achieve the objectives of its program for 2000. The government will consult with the Managing Director, at the initiative of either party, in the event that additional measures are deemed necessary. The government will also provide information requested by the Fund to monitor the program, and will complete a second review under the arrangement by December 2000.

CAMBODIA

1. Cambodia’s PRGF-supported program, adopted in October 1999, is aimed at raising economic growth and per capita income, and reducing poverty. These objectives are to be achieved through a strengthening of fiscal revenue, a shift in expenditure away from defense, improved public sector governance, a sustainable forestry policy, trade reform, and private sector development.

2. Recent economic developments have been positive, exceeding program targets, and reflecting improved confidence in economic policies and in public sector management. Real GDP growth in 1999 is estimated to have risen sharply to about 5 percent (in excess of the program target of 4 percent), reflecting buoyant garment exports and tourism, a rebound in agriculture, and an increase in construction. Average yearly inflation fell to 4 percent—below the program target of 5 percent—reflecting declines in food prices and prudent fiscal and monetary policies. The September and December 1999 quantitative benchmarks, the March 2000 quantitative performance criteria, and the June 2000 quantitative benchmarks were all observed.

3. Budgetary performance strengthened substantially in 1999, in line with the program. Revenue rose by 2½ percentage points to 11½ percent of GDP (Table 1), while expenditure was restrained. As a result, the overall budget deficit (on a cash basis) was sharply reduced to 4½ percent of GDP, and with the help of concessional external financing, net bank credit to the government fell significantly as envisaged under the program.

4. The improvement in budget performance was centered on revenue. Direct and indirect taxes, especially the newly introduced value-added tax (VAT), performed well and partly compensated for shortfalls in trade taxes (relative to program assumptions) in the last quarter of 1999. With respect to nontax revenue, higher-than-expected timber royalties and revenue from garment quota allocations offset poor performance in other areas related to difficulties in collecting payments (including arrears) from telecommunication services, civil aviation, and the lease of state assets.

5. Government expenditure was kept in check and its composition improved. The total wage bill increased marginally in 1999 to 4.6 percent of GDP, despite a 30 percent wage increase granted in May, thanks to the elimination of "ghost“ soldiers. Moreover, expenditure for defense and security was close to budgetary appropriations, while spending committed for the social sectors (health, education, and rural development) was allowed to increase by 53 percent, mainly in the latter part of the year. Development expenditure also exceeded program projections owing to an acceleration of locally financed development projects in the last two months of the year, including for the social sectors.

6. The external current account deficit widened in 1999 to about 11½ percent of GDP, reflecting a recovery in imports and higher petroleum prices, despite the strong performance of the garment sector. Nonetheless, with the significant increase in official financing flows, gross official reserves rose in line with program projections to US$422 million, or the equivalent of 3¼ months of imports, at end-1999.

7. Progress has also been made in key areas of structural reform. In particular, a military census was completed in December 1999, and the discharge of 1,500 soldiers was completed as part of the pilot demobilization program. The census of the civil service was also completed in March 2000, as programmed. The Forest Crime Monitoring Unit (FCMU) has begun to issue quarterly reports on its operations, and a review of forestry concessions was completed in May 2000. New legislation and implementing regulations for the banking system have been approved and the process of re-licensing banks is underway. Finally, negotiations on a new contract for pre-shipment inspection of imports (PSI) were concluded in August 2000.

8. This section outlines the macroeconomic framework and key structural measures needed to attain the program targets for 2000, consistent with the government’s medium-term objectives. The objectives for the 2000 program are to raise GDP growth to 5½ percent, while keeping average inflation under 5 percent. The overall external position would continue to be strengthened, even after allowing for a further recovery in imports, with gross official reserves targeted to increase slightly to 3½ months of import coverage at end-2000. The key structural reforms aim at achieving a rate and a pattern of economic growth needed for a significant reduction in poverty over the medium term.

9. Strong efforts will continue to be made to improve governance, as an essential prerequisite for sustainable socio-economic development. A draft comprehensive governance action plan (GAP) was presented at the May 2000 Consultative Group meeting, and the government will start the consultation process on the draft by September. The GAP specifies concrete actions, timing and resources for governance reform under a common and systematic framework, based on findings of recent analytic work conducted on governance. It identifies a number of areas of governance reform deemed critical to Cambodia’s development over the near- and medium-term, including judicial and legal reform, public finance, civil administration reform, anti-corruption, natural resource management, and military demobilization.

10. In line with the macroeconomic objectives, the 2000 budget provided for a substantial increase in social sector spending, while allowing for a further reduction in the government’s net indebtedness with the banking system. Total revenue was budgeted to increase by 0.3 percent of GDP (1 percent of GDP after adjusting for the exceptional revenue associated with garment quota auctions in 1999). Current expenditure for the social sectors was budgeted to increase by 37 percent in nominal terms. At the same time, the wage bill was budgeted to fall to 4.2 percent of GDP, mainly on account of cutbacks in defense and security. Reflecting the increased spending in priority areas, the current surplus was budgeted to fall slightly to 1.4 percent of GDP.

11. However, revenue performance in the first four months of 2000 fell short of the underlying trend necessary to achieve the PRGF revenue target. Collection of trade taxes, in particular, was below program projections, as were key components of nontax revenue, reflecting the continued difficulties experienced in recent years.

12. Based on this trend, the revenue shortfall was estimated at CR 50 billion (0.4 percent of GDP). This shortfall is being covered by strengthened tax administration and new revenue measures. In particular, continued efforts will be made to improve customs administration, including through the reinstallation of PSI services. New measures that are being implemented include: (i) expanding the coverage of the VAT to include 500 additional firms;(ii) measures to better capture revenue from the growing tourism sector, in particular, reinforced efforts to collect visa and tourist fees—including through the revision of a contract with a major tourism service provider; and (iii) stepped-up efforts to collect arrears on telecommunication services, the leases of state assets, and tax arrears; by end-June, the government collected an additional CR 20 billion in arrears from these sources. Furthermore, to protect the integrity of the VAT system, legitimate refunds will be made on a timely basis. Any new garment quotas will continue to be auctioned, and such revenue will be transferred to the state budget. These measures taken together are expected to improve revenue collection in 2000 and cover the revenue gap indicated earlier.

13. A reform strategy and targets for rationalizing the civil service will be formulated and agreed with the World Bank by March 2001. No wage increase will be granted until the reform strategy is agreed. The reform strategy will take into account efforts to date, including: (i) the removal of 6,091 irregular cases identified so far by the census, plus other irregular cases as they are identified; (ii) the completion of finger-printing and computerization of the census data base; (iii) sufficient results from a functional analysis of government operations; (iv) the initial experience in the formulation of Priority Mission Groups (in consultation with the World Bank and relevant donors); and (v) World Bank simulations on possible reform scenarios using the initial census results. For the remainder of 2000, government hiring is expected to amount to 4,500, consisting of 4,100 qualified teachers, 300 medical graduates, and 100 other civil servants. In the future, the size of the civil service will be monitored through the use of a central computerized payroll. The wage bill in the 2001 budget will be prepared on the basis of the status quo. Reserve funds (to be agreed in the context of budget formulation) will be included in the budget to reflect potential costs associated with the implementation of the Priority Mission Groups; after the announcement of the reform strategy, the budget will be revised accordingly. Monthly information, in a standardized format, on the implementation of the ongoing reform actions will be available to the IMF and the World Bank starting in September 2000.

14. Priority is being given to launching the demobilization program, beginning in 2000. The pilot program for discharging 1,500 soldiers—out of a total defense force at end-March 2000 of 133,817, including 3,275 spouses of dead soldiers—was completed in July. A plan of action for implementing the next stage is being prepared, taking into account the experience under the pilot as it becomes available, so as to ensure that by end-2000 a further 10,000 soldiers will be demobilized, followed by 10,000 annually in 2001 and 2002. As a result of these efforts, the defense wage bill will be limited to 1.6 percent of GDP in 2000 and will be further reduced to 1.1 percent of GDP by 2002, when the total defense force will have been lowered to less than 100,000. In this regard, to support the demobilization program, preliminary financing indications were secured from donors at the May Consultative Group meeting in Paris.

15. Attention will be given to ensuring the targeted increase in, and efficiency of, social sector spending in 2000. The aim of the government will be to achieve a more even pattern of expenditure during the course of the year, especially for health and education, and to ensure more competitive and transparent procurement procedures. Institutional measures will be strengthened to support social sector spending, as part of the ongoing and anticipated World Bank assistance to improve expenditure management. For economic reconstruction, capital expenditure is expected to increase considerably to 7 percent of GDP, mainly from foreign-financed projects. In addition, locally financed development expenditure will be implemented cautiously and in line with revenue developments, to ensure that program financing targets are met. Such an increase in overall capital expenditure will be accompanied by close scrutiny of procurement standards and practices.

16. As a result of these measures, the budget framework targeted under the program remains achievable. In particular, the overall budget deficit will be limited to 5.3 percent of GDP and will be fully financed by concessional foreign assistance. Taking into account such assistance, further net repayments of 0.4 percent of GDP will be made to the banking system, as targeted. Consistent with this, the monetary program for 2000 is based on an increase in broad money of 35 percent, reflecting further increases in net foreign assets and improved confidence, and overall private credit growth of 23 percent. The budget framework for 2001 will be formulated in consultation with the Fund staff and will be based, inter alia, on increasing revenue to 12.1 percent of GDP and achieving a current budget surplus of 1.4 percent of GDP.

17. Cambodia’s flexible exchange rate policy will be continued. The riel has been relatively stable in both nominal and real effective terms over the past 16 months, and the official exchange rate has been set on a daily basis to limit the spread with the parallel market rate to no more than 1 percent. The National Bank of Cambodia (NBC) will continue its policy of using any increased demand for local currency to bolster international reserves, but will not intervene to resist downward pressure on the exchange rate, except in circumstances of disorderly market movements.

18. The government is committed to further trade reform in the context of Cambodia’s participation in the ASEAN free-trade area (AFTA) and accession to the WTO. By 2002, the tariff structure will be rationalized, and the maximum tariff rate reduced to 30 percent and the number of tariff bands to four (including a zero tariff band). On the basis of technical assistance from the Fund, alternative revenue sources, in particular increases in excise duty rates, will be incorporated in the 2001 budget in tandem with further reductions in tariff rates.

19. Given Cambodia’s limited debt-servicing capacity, the government will avoid contracting or guaranteeing any foreign currency loans on nonconcessional terms. The Ministry of Economy and Finance, as the sole authority for managing all public external borrowing, will continue to closely monitor all such borrowing. Furthermore, with a view to normalizing relations with creditors, technical discussions will be continued with the two remaining bilateral creditors on rescheduling agreements under the Paris Club framework and efforts will be made toward concluding these discussions.

20. The government is firmly committed to proceeding with the re-licensing of commercial banks and the process of liquidating nonviable banks. In line with the provisions of the Law on Banking and Financial Institutions, the NBC has suspended the license of 3 banks that did not submit re-licensing applications by the deadline of May 31. In the first week of August, the NBC began to close banks which did not meet the provisions of the Law on Banking and Financial Institutions and subsequent implementing Prakas (announcements), starting with the suspension of the licenses of three nonviable and insolvent banks. Steps toward closing additional insolvent banks are expected in the period ahead. Final decisions on all remaining banks will be made by November 2000 on the basis of evaluations of re-licensing applications, and appropriate actions will be taken. As first steps toward the eventual privatization of the Foreign Trade Bank (FTB) by end-2001, a regulation establishing this bank as a separate legal entity was issued in August, and an external auditor has been engaged to conduct a financial review to determine its net worth. An initial recapitalization and licensing of the FTB, as a state-owned bank operating on a commercial basis, under the procedures of the financial institutions law will be completed by end-November 2000. Assistance from the Fund, the IFC, and the AsDB is being sought to help with the reform process.

21. Strong efforts will continue to be made in forestry reform. The second quarterly report of the FCMU was released in May. It will help the government to continue to take actions to combat illegal logging, in line with the recent trend of a substantial reduction in such activities. Taking into account the recommendations of a recently completed AsDB-financed concession review, and in consultation with the AsDB and the World Bank, the government has started taking corrective actions to reform the forestry concession system to put it on a more sustainable basis. As immediate first steps, three concessions whose forest resources are too depleted for commercial operations were canceled. For the other concessions, no cutting permits will be released until required inventory information has been provided. Furthermore, the annual allowable cut for these concessions will be reduced by 50–70 percent until they have submitted proper management plans and signed new concession contracts. These concessions are also required to submit environmental and social impact assessments prepared by credible professional foresters and based on a detailed inventory. In the interim, efforts to monitor forestry management of concessionaires will be strengthened. National consultations on the new Forestry Law were initiated in June 2000, and the draft law will be submitted to the National Assembly by end-2000. Finally, with respect to forestry revenue, a review of the revenue system is under way in consultation with the Bank and Fund staffs, and is expected to be completed by end-December, taking into account input from an industry-funded study.

22. In other structural areas, the main components of new commercial legislation have been submitted to the Council of Ministers and are expected to be submitted to the National Assembly by end-2000 as envisaged. All state-owned rubber plantations have been corporatized, and steps will be taken to prepare the first plantation for privatization by end-2001.

23. Actions to be taken prior to Executive Board consideration of the first review, and structural performance criteria and benchmarks, are contained in the attached Table 1. Quantitative benchmarks through March 2001 are in Table 2, with quantitative benchmarks for end-September 2000 serving as performance criteria. The second review under the PRGF program is expected to be completed by December 2000, focusing particularly on the 2001 budget and budgetary management, and further progress in demobilization, forestry policy, and bank restructuring. The completion of the second review, together with the observance of the September 2000 and continuous performance criteria, will be conditions for the availability of the third disbursement.

24. With the joint assistance of World Bank and Fund staff, the government launched the process for developing a Poverty Reduction Strategy Paper (PRSP) in May, aimed at deriving an interim PRSP (I-PRSP) by October 2000. An initial draft of the I-PRSP has been prepared and discussed with relevant government ministries, donors, and NGOs. The I-PRSP includes, among other things, a timeline and consultative process by which a full PRSP will be developed in 2001.

This memorandum sets out the understandings between the Cambodian authorities and the Fund staff regarding the definitions of the quantitative performance criteria and benchmarks for the program supported by the Poverty Reduction and Growth Facility (PRGF), and the related reporting system of monetary and financial data.

1. Net official international reserves of the National Bank of Cambodia (NIR) is defined as the gross official reserves of the National Bank of Cambodia (NBC) less foreign liabilities of NBC. Under the program, the floor for NIR will be: (i) decreased (increased) by the amount of a shortfall (excess) in external nonproject support from program estimates—any downward adjustment would not exceed US$10 million; and (ii) decreased by any foreign currency costs associated with bank restructuring. For purposes of monitoring performance against the program target for NIR, valuation effects on the stock of gold holdings will be excluded, and gold holdings will be evaluated at the end-December 1999 gold price. Similarly, the level of foreign assets and liabilities will be evaluated at the end-December 1999 U.S. dollar/SDR exchange rate. NIR data will be transmitted to the Fund weekly with a lag of no more than one week.

2. Net Domestic Assets of the Banking System (NDA) are defined as broad money minus net foreign assets of the banking system adjusted for valuation changes arising from the difference between the program and the actual exchange rate. The program ceilings for NDA will be adjusted upward (downward) for any shortfall (excess) in nonproject external budgetary support from program assumptions—upward adjustments will not exceed US$10 million. NDA data will be transmitted monthly within four weeks of the reporting period.

3. Net credit to the government from the banking system (NCG) is defined as claims on the government by the banking system less deposits of the government with the banking system. The program ceilings for NCG will be adjusted upward (downward) for any shortfall (excess) in nonproject external budgetary support from program assumptions—any upward adjustment would not exceed US$10 million. NCG data (as reflected in the monetary survey) will be transmitted monthly within four weeks of the reporting period.

4. Net domestic financing of the budget (NDF) is defined as the sum of NCG and any nonbank financing of the government. The program ceilings for NDF will be adjusted upward (downward) for any shortfall (excess) in nonproject external budgetary support from program assumptions—any upward adjustment would not exceed US$10 million. For purposes of program monitoring, actual levels of NDF will not include any flows associated with “outstanding operations” (committed spending that has not yet been executed) or from “exchange rate adjustment” (valuation effects on government deposits from exchange rate fluctuations). Details on all transactions associated with outstanding operations and the exchange rate adjustment will be reported at all test dates. NDF data (as reflected in the TOFE table) will be transmitted monthly within four weeks of the reporting period.

5. Public or publicly guaranteed nonconcessional foreign currency borrowing is defined as loans contracted or guaranteed by the public sector in Cambodia with a grant element (NPV discount relative to face value) of less than 35 percent, based on the currency- and maturity-specific discount rates reported by the OECD (commercial interest reference rates). Public sector is defined to include the Government of Cambodia, the National Bank of Cambodia, publicly owned enterprises, or any other agency acting on behalf of the government. The program has ceilings for all borrowing below five years maturity and all nonconcessional borrowing for maturities beyond five years (both set at zero). The coverage of debt includes financial leases and other instruments giving rise to external liabilities on nonconcessional terms. Details on any such borrowing should be reported within three weeks of their occurrence.

6. External payments arrears are defined as the stock of external arrears on loans contracted or guaranteed by the public sector (as defined above) except on debts subject to rescheduling or debt forgiveness.

Summary of data reporting requirements

1. Exchange rate data (official and market rates) to be transmitted daily.

2. NIR to be transmitted weekly with a lag of one week.

3. Monetary survey of the NBC and commercial banks to be transmitted monthly within four weeks.

4. Consolidated report of government operations (TOFE) to be transmitted monthly within four weeks.

5. CPI data to be transmitted monthly within five weeks.

6. Flash report of NBC accounts to be transmitted weekly within one week.

7. Trade data to be transmitted monthly within ten weeks.

8. Any publicly contracted or guaranteed nonconcessional borrowing to be reported within three weeks.

9. Any external payments arrears to be transmitted monthly within three weeks.

10. Information on the status of civil service reforms (e.g. fingerprinting and computerization, functional analysis, and removal of irregular cases from the payroll) to be reported monthly within two weeks.

11. The outstanding stock of tax and nontax arrears, and any expenditure arrears, to be reported quarterly within four weeks.