Washington D.C.
September 29, 1999

Dear Mr. Camdessus:

1. The Cambodian Government has adopted an economic program for 1999-2002 that is designed to support the reconstruction of the country and accelerate economic growth, help improve social conditions, and preserve macroeconomic stability. The details of this program are explained in the attached Memorandum of Economic and Financial Policies and Policy Framework Paper. In support of this program, we are requesting a new three-year ESAF arrangement in an amount equivalent to SDR 58.5 million (67 percent of quota).

2. The Government of Cambodia will provide the Fund with such information as the Fund may request in connection with the progress in implementing its program.

3. The Government believes that the policies and measures set forth in these memoranda are adequate to achieve the objectives of the program, but will take any other measures necessary for this purpose. During the period of the arrangement, the government will consult with the Managing Director, on its own initiative or at the request of the Managing Director, concerning the adoption of appropriate measures. In any event, Cambodia will conduct with the Fund a first review of the first annual program supported by the annual arrangement to be completed no later than end-May 2000. Moreover, while Cambodia has outstanding financial obligations to the Fund arising from loans under this arrangement, Cambodia will consult with the Fund from time to time, at the initiative of the government or whenever the Managing Director requests consultations on Cambodia's economic and financial policies.

4. To facilitate a wider distribution of the policy framework paper and the memorandum of economic and financial policies, the Government of Cambodia authorizes their publication by the Fund.

1. The objectives and strategies of the government's medium-term economic reform program for 1999–2002 are described in the accompanying Policy Framework Paper (PFP) dated October 6, 1999. Within that medium-term framework, this memorandum outlines the specific objectives and policies for 1999 and a broad framework for 2000, as a basis for the initial part of the first-annual program of the three-year arrangement under the Enhanced Structural Adjustment Facility (ESAF). Specific policies for the year 2000 will be further defined in the context of the first review under the ESAF arrangement.

2. Performance under Cambodia's first ESAF program (1994–96) was initially favorable but deteriorated through the later part of the period, owing to political instability and policy slippages. Through 1996, economic growth was robust, inflation fell to single digits, and the external position strengthened substantially. Structural reform was initiated in several areas, although the pace of implementation was slower than expected. Difficulties emerged in early 1996 in forestry management and were compounded in mid-1997 by political uncertainty, a marked deterioration in governance, and an erosion of budgetary discipline. As a result, the ESAF program lapsed mid-way through the arrangement with undrawn balances. Macroeconomic performance continued to deteriorate through the period leading up to the July 1998 elections and their aftermath also in part reflecting the adverse impact of the regional crisis. Output growth slowed substantially, inflation rose, and fiscal performance weakened. There was limited progress in implementing reforms in key structural areas such as forestry, budgetary management, and civil service and military reform.

3. The new government, formed in November 1998, is determined to break with the past. It has announced measures and taken actions against illegal logging and corruption and to strengthen fiscal management. It intends to reinforce these actions and also resume other structural reforms. Furthermore, as indicated at the 1999 Consultative Group meeting, the government is holding quarterly donors meetings in Phnom Penh to take stock of progress in implementation; the first such meeting was held on June 14, 1999, and the next is scheduled for October 27.

4. Macroeconomic prospects for 1999 have improved with the return of confidence, emerging political stability, and renewed policy reform. The budget for the year incorporates most of the revenue measures provided for under the 1997 Law on Taxation, and inflation has fallen to 2.9 percent (annual percent change) in August. Through August, the exchange rate has been broadly stable, and gross official reserves have increased to about $392 million.

5. The ESAF program will be aimed at raising economic growth and per capita income, and reducing poverty. As outlined in the PFP, these objectives will be achieved through major revenue efforts, along with civil service reform and demobilization; a substantial increase in public investment for reconstruction; a strengthening of public resource management, especially forestry; and building the framework and institutions for the private sector.

6. The program's medium-term macroeconomic framework will focus on raising economic growth to 6 percent by 2002 and lowering inflation to 4 percent, while containing the external current account deficit to sustainable levels of 12–13 percent of GDP. International reserves are targeted to reach about four months of import coverage by 2002. For 1999-2000, in particular, the objectives are to raise output growth to 4 percent and 5.5 percent, respectively, keep annual inflation under 5 percent (final quarter basis), and modestly raise reserves. To attain these objectives, the program will provide for a fundamental fiscal reform aimed at increasing revenue by 4 percentage points of GDP in the four years to 2002; redirecting spending away from defense toward social and economic sector; and a civil service reform aimed at containing the wage bill while upgrading the civil service.

7. The execution of the 1999 budget so far has been mixed. While VAT collections have performed well, there have also been substantial shortfalls in nontax revenue. The latter reflects, in particular, shortfalls in the collection of timber royalties due to the sharply lower logging volume and in spite of the new and higher timber royalties ($54 per cubic meter). Also falling well short of budget estimates are collections from post and telecommunications (including through arrears recovery), revenue from leases on state assets, and other nontax arrears. Meanwhile, there are expenditure pressures arising from the decision to increase salaries for the civil service and the military by 30 percent from May 1. Furthermore, despite intensified efforts, spending in the priority sectors has been running below budgeted levels, reflecting administrative difficulties.

8. To keep the 1999 budget on a sustainable path and to lay a foundation for the 2000 budget, the government has adopted the following measures:

• Full and timely transfer to the budget of garment quota management fees, estimated at CR 18 billion, and revenue from quota auctions of CR 80 billion.

• Strengthening customs administration, inter alia, by strictly avoiding ad hoc exemptions, unifying the duties on cigarette imports, and launching an open tender for a preshipment inspection service provider. A specific program to reinforce customs administration is outlined in paragraph 11 below.

• Stepped up efforts to recover arrears (tax and nontax), now estimated at CR 50 billion, and strict transfer to the MEF of revenue collections from line ministries and other government entities.

• Achieving savings on the wage bill for 1999 through removing redundant workers (ghosts, irregular cases, absentee workers, voluntary departures, and technical decentralization) from the civilian payroll (targeted at 3,600); and removing ghost soldiers (12,868 as of June, along with 105,234 ghost children) from the military payroll, in line with the program for demobilization (PFP paragraphs 20–21). New civilian recruitment will be kept below 920.

• Limiting (nonsalary) expenditure for defense, security, and the Council of Ministers office to the budgeted provisions.

9. Altogether, and in the context of the medium-term reform program (PFP paragraphs 8–14), these measures would achieve a current surplus of 1.3 percent of GDP in 1999, and reduce the government's net debt position to the NBC by CR 54 billion. Given the temporary nature of garment quota revenue, the government has put aside a part of this revenue for future use. For this purpose, a special account for CR 50 billion was set up at the NBC in July, to be subject to strict budgetary controls and earmarked for social priorities and counterpart funds for donor-financed projects. The balance in this account will not fall below CR 40 billion as of end-December 1999. The overall budget deficit of 3.3 percent of GDP is expected to be entirely externally financed, through budget support (0.3 percent of GDP) and project assistance (3.5 percent of GDP).

10. Within the medium-term revenue target of 13 percent of GDP by 2002, the budget for the year 2000 will incorporate, inter alia, a further broadening of the tax base and a strengthening of tax and customs administration (all designed to yield additional revenue of 0.7 percent of GDP), and any revenue arising from new garment quota auctions. With continued prudent spending policy, the current surplus is targeted at 1.3 percent of GDP, implying a further improvement in the net claims of the banking system on government in view of anticipated budget support from donors.

11. Given the particular importance of customs revenue, additional steps have been taken to reinforce administration, beyond those noted in paragraph 8. These include, notably, clarification of customs codes and legislation; simplification of customs procedures to speed up port clearance; automation of duty calculation; regular rotation of customs officers; special audit teams for selected cases; strengthening discipline and incentives for customs officials; and professional training for customs officials. Moreover, additional steps will be taken on the basis of Fund technical assistance in September 1999, and PSI is expected to be reinstated by mid-2000.

12. Efforts are being made to ensure recovery of arrears and strengthen compliance. On-site tax audits of the 300 largest enterprises will be conducted in 1999 to identify more precisely outstanding arrears. Taking full advantage of the power under the Law on Taxation, the government will collect no less than CR 2 billion in outstanding tax and nontax arrears monthly through end-1999. Steps have been taken to monitor closely compliance with the terms of lease agreements previously entered into by line ministries to ensure that enterprises are current on their obligations. Moreover, the government will ensure the direct payment of all current nontax proceeds to the budget. These measures will be reinforced by the financial controllers recently assigned to the line ministries.

13. To strengthen medium-term revenue performance, the government is implementing the amended regulations of Subdecree 88 of the Investment Law to rationalize tax exemptions for investment. The amendments include removal of incentives to resource and resource processing firms (except for oil and gas exploration); removal of the production of consumption goods from the preferred sector; removal of petroleum from the list of exempted items; and raising the investment threshold.

14. The government is bringing extrabudgetary revenues under budgetary control, the Minister of Economy and Finance will have control over negotiations and review of performance under contracts involving the sale, transfer, or use of national assets. The December 1997 Prime Ministerial Order on this subject will be reviewed and expanded to cover all forms of national assets including financial and intangible assets. Moreover, management of all financial aspects of existing contracts will be brought under the control of the MEF to ensure the timely transfer of financial resources to the national budget. In this connection, by end-September the government will ensure that the MEF has been provided with copies of all existing contracts, including all contracts operating under the Investment Law and all contracts regarding natural resource exploitation. The provisions of these contracts will be reviewed, with the assistance of internationally reputable law firms, to ascertain their validity and the performance of the contracting parties.

15. Although the government has in recent years succeeded in containing total expenditures, the pattern of current spending needs to be improved. Reflecting strong pressures for defense and security spending, priority social spending had been severely compressed. The 1999 budget targets a shift (of 0.3 percent of GDP) from defense and security outlays to social expenditures. Operational outlays by the civil administration, which include the bulk of social spending, are targeted to increase by 1 percent of GDP and provisions for locally financed investment have been raised. In the light of the slow spending in the priority sector through the first half of 1999, steps are being taken to speed up disbursement for these sectors, notably through doubling advance payments to local health authorities.

16. The government intends to limit spending on security and defense in 1999 to CR 470 billion, through containing the wage bill and strengthened control procedures, including on procurement. For 1999, the civil service wage bill will not exceed CR 199 billion. No further general wage increase will be granted in this year. Meanwhile, recurrent spending on health, education, agriculture, and rural development will be accelerated with a view to meeting the budgetary provision of CR 257 billion. The budget for the year 2000 will target a further significant shift (0.4 percent of GDP) from defense and security spending toward the priority sectors, and a further reduction in the wage bill through downsizing the overall payroll. Decisions on future general wage increases will be taken only after adoption of a concrete plan to downsize the civil service, following completion of the civil service census.

17. To facilitate the close monitoring of revenue and expenditure performance, the government has agreed with the Fund staff monthly revenue and expenditure targets for 1999 consistent with paragraphs 8 through 16 above.

18. The government's strategy and policy is to strengthen forestry management and governance for sustainable logging (PFP paragraphs 15–19). Efforts in 1999 have focused on establishing a credible and effective unit for monitoring forest crime, beginning to reinforce the concession management system, and strengthening forestry revenue for the budget. As regards monitoring, reports of the monitoring unit, including independent outside experts, are being made available to the public on a quarterly basis beginning in mid-October 1999. In addition, to pave the way for an overhaul of the concession system, a subdecree on concession management will be submitted for approval by the Council of Ministers by mid-October 1999. This subdecree will provide the guidelines for corrective actions (including cancellation of concessions), following a review of concessions which is underway and is expected to be completed by early 2000. In the future, existing royalty provisions will be kept under review and new concessions will be awarded on the basis of competitive and transparent procedures. Progress in implementing forestry policy will be a particular focus of all reviews under the ESAF arrangement.

19. The monetary program for 1999 targets broad money growth at 17 percent, consistent with projected nominal GDP growth and a significant decline in velocity, in line with the recent increase in the growth of dollar deposits. The program for 2000 has targeted an increase in broad money of 16 percent reflecting a more gradual decline in velocity. Ceilings have been placed on net domestic assets of the banking system, with subceilings on net bank credit to the government and on total domestic financing for the government. Gross official reserves of the National Bank are targeted to increase by $36 million to $426 million by end-1999.

20. The government recognizes the importance of strengthening banking supervision capacity to deal effectively with weak banks. On-site inspections by international audit firms have been underway and will be completed for all commercial banks by end-1999. The NBC will continue to avoid liquidity support for insolvent banks. The Financial Institutions Law will be approved by the National Assembly by mid-October 1999 to strengthen the legal basis for regulation and supervision, and all banks will be subject to the provisions of this law.

21. In order to complete the transition to a two-tier banking system, the NBC will facilitate the privatization of the Foreign Trade Bank (FTB) in which it is still a major shareholder, by implementing a restructuring plan drawn up following the recently completed full audit of the FTB. The FTB will be privatized by end-2001, and in the interim, the FTB will grant new loans only on strictly commercial criteria.

22. The NBC will continue to pursue a market-based exchange rate policy and set the official rate in line with the market rate with a view to full unification of the rates. The spread between the average official and market rates will be limited to no more than 1 percent. The NBC will use the opportunity offered by any increased demand for money to bolster its international reserve position, but will not intervene to resist downward pressure on the exchange rate except in circumstances of disorderly market movements. The government intends to accept the obligations of the Fund's Article VIII Sections 2, 3, and 4, during the program period as a clear commitment to an open exchange system.

23. Further trade reform is envisaged in the context of Cambodia's prospective participation in the ASEAN Free Trade Area (AFTA) and accession to the WTO. Cambodia has an average import tariff rate of 17 percent. While the five primary tariff bands (0, 7, 15, 35, and 50 percent) cover over 98 percent of the tariff lines, there are a few tariff peaks. The government intends to rationalize the tariff structure and reduce the maximum rate to 30 percent and the number of tariff bands to four by 2002. In view of Cambodia's extreme reliance on customs revenue, technical assistance from the Fund has been requested to help develop alternative revenue sources. On this basis, a comprehensive tariff reform proposal aimed at reducing the statutory average tariff rate to 13-14 percent by 2002 will be adopted by March 2000 as a condition for the first review. Finally, Cambodia has obtained GSP and MFN status on selected manufactured goods, particularly garments. All necessary steps will be taken to safeguard these preferences through appropriate property rights protection, transparency in the treatment of garment quota revenue, and compliance with ILO labor standards.

24. Given Cambodia's very limited medium-term debt-servicing capacity, the government will not contract or guarantee any foreign currency loans on nonconcessional terms. To secure external debt sustainability, contacts have already been initiated with major creditors with a view to resolving outstanding issues on bilateral rescheduling agreements under the Paris Club framework and best efforts will be made to conclude these discussions, while seeking to obtain at least comparable treatment with all other bilateral creditors. The MEF will continue to have the sole authority over the contracting or guaranteeing of all public external borrowing, and such debt will be closely monitored.

25. Further efforts are needed to improve the quality and timeliness of statistics. Progress has been made in establishing a statistical base with technical assistance from the Fund and other multilateral institutions. In the coming year, the government will intensify its efforts to improve the economic data base, with particular attention devoted to implementing the recommendations made under past technical assistance. The government will also build on ongoing efforts to publish economic and financial data to enhance public understanding of, and confidence in, its policies.

26. The first annual program of the three-year ESAF arrangement provides quantitative and structural performance criteria and benchmarks (Table 2). The quantitative benchmarks for end-September, end-December 1999, end-March 2000, and end-June 2000 include: (i) a ceiling on the net domestic assets of the banking system; (ii) a ceiling on net credit to the government from the banking system; (iii) a ceiling on net domestic financing of the budget; (iv) a zero ceiling on publicly contracted or guaranteed nonconcessional foreign currency loans up to one-year maturity; (v) a ceiling on medium- and long-term debts of 1-5 years maturity; and (vi) a floor on net official international reserves of the National Bank of Cambodia. All quantitative benchmarks for end-March 2000 will be performance criteria. As a continuous performance criterion, neither the government nor the public sector will accumulate any new external payments arrears during the program period.

27. Prior actions to be taken prior to the Executive Board approval of the program, and structural performance criteria and benchmarks have been provided to monitor policy implementation in key areas. The first annual program will provide for two reviews with the Fund, to be completed by end-May 2000 and end-November 2000. Particular focus for the first review will be on forestry policy and implementation of the year 2000 budget, and for the second review on forestry, budgetary management, civil service reform, and demobilization. The completion of the first review, together with the observance of end- March 2000 and continuous performance criteria, will be a condition for the availability of the second disbursement.

This memorandum sets out the understanding between the Cambodian authorities and the Fund staff regarding the definitions of quantitative performance criteria and benchmarks, for the first annual program of the three-year arrangement under the Enhanced Structural Adjustment Facility (ESAF), and the related reporting to the Asia and Pacific Department with the indicated timing. The data will be based on the existing reporting system of monetary and financial data.

Quantitative performance criteria

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. NIR data will be transmitted weekly within one week.

2. Net Domestic Assets of the Banking System (NDA) is defined as broad money minus net foreign assets of the banking system adjusted for the valuation of changes arising from the difference between the program and the actual exchange rate. NDA data will be transmitted monthly within five 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. NCG data will be transmitted monthly within three weeks of the reporting period.

4. Net domestic financing of the budget (NDF) is defined as the sum of net credit from the banking system to the budget and any nonbank financing for the budget.

5. Adjustment clauses. The floor on NIR will be adjusted downward (upward) for any shortfall (excess) in external nonproject budget support from the program estimates (Table 2). The quantitative performance criteria and benchmarks will be adjusted downward (upward) by and shortfall (excess) in the September 1999 outcome relative to the program estimate.

The ceilings on NDA, NCG, and NDF will be adjusted upward (downward) by any shortfall (excess) in external budget support from the program estimates. All adjustments for shortfalls in budget support will not exceed US$10 million.

6. Publicly contracted or guaranteed nonconcessional foreign currency loans are defined as loans with a grant element (NPV 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). A loan-by-loan accounting of all new concessional and nonconcessional loans contracted or guaranteed by the public sector, with terms, will be transmitted on a monthly basis within four weeks. For these purposes, 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.

7. 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 a stock-of-debt operation. An accounting of nonreschedulable external arrears by creditor countries (if any), with relevant details will be transmitted on a monthly basis within four weeks.

Data reporting

1. CPI data will be transmitted monthly within five weeks.

2. Consolidated report of government operations (TOFE) will be transmitted monthly within four weeks.

3. Monetary survey of the NBC and the commercial banks will be transmitted monthly within five weeks.

4. Daily exchange rate data (official and market exchange rates) will be transmitted daily. Trade data will be transmitted monthly within ten weeks of the reporting period.