1.  Cambodia is an integrated territory under one government for the first time in three decades. In this more stable political environment, the government--formed in November 1998--is now in a position to renew its economic and structural reform program. With substantial support from the international community, progress was made in the first half of the 1990s in restoring financial stability and beginning economic reconstruction. However, much remains to be done to build basic economic and social institutions and attain sustainable development. As a legacy of the past, administrative and institutional capacities are weak, and Cambodia's need for external support remains considerable.

2.  The goals of the government's reform program are poverty alleviation and the achievement of sustainable economic growth. This program is premised on strengthening the rule of law and governance, and tackling corruption. The overall agenda and strategy were endorsed by the National Assembly on November 30, 1998. The objectives of this agenda are: (i) safeguarding social stability and security; (ii) building human capacity; (iii) strengthening infrastructure and fostering an environment for private investment; (iv) fully protecting and preserving the natural environment; (v) enhancing national revenues in the context of a fully accountable and transparent fiscal policy; and (vi) encouraging the private sector as the engine of growth, investment, and employment creation. Within this agenda, this paper sets out the government's economic policy strategy and structural reforms for the period 1999-2002.

Contents

3.  Macroeconomic performance deteriorated in the period leading up to the July 1998 elections and their aftermath, reflecting political instability and the impact of the regional crisis. In this difficult environment, the government made strong attempts to contain the economic deterioration. Economic growth slowed, but remained positive, and inflation increased moderately. Fiscal performance reflected shortfalls in revenue and external financing, as well as overspending on the military. As a result, development expenditure was compressed, urgent increases in social spending were not achieved, and substantial bank financing of the budget was needed for the first time in four years. Moreover, there was limited progress in key structural areas such as forestry, budgetary management, and civil service and military reforms.

4.  With emerging political stability and returning confidence, economic prospects for 1999 and beyond have improved significantly. The government is determined to break from the past, and has already initiated reform measures, announced in late 1998 and early 1999, against illegal logging and corruption, and to strengthen fiscal management. Moreover, the 1999 budget provides for important tax reform measures, increased social sector spending, and envisages no domestic financing. With these policies, and based on early indicators, economic growth in 1999 is expected to rise to 4 percent (on the strength of a rebound in agriculture and a recovery in tourism), and inflation is projected to decline to 5 percent. The external current account deficit is expected to widen to 12 percent of GDP reflecting a recovery in imports and a sharp curtailment of illegal logging activity.

5.  Building on recent initiatives, the government's medium-term strategy will focus on achieving lasting improvements in the structure of the public finances and in public resource management, in particular forestry, all in close collaboration with international financial institutions, bilateral donors, and civil society. The program will also aim at rebuilding basic institutions, and undertaking related structural reforms, to create a secure environment for the private sector. The government has recently taken additional measures to reinforce its commitment to the reform program in the areas of tax administration, civil service and military reform, and forestry policy. However, the government fully recognizes that further actions will be needed to deepen these reforms (as indicated in the attached policy matrix).

Contents

6.  The objectives of macroeconomic and structural policies are to raise economic growth and per capita income, and reduce poverty. The key elements of the strategy are:

• Major efforts to strengthen revenue collections and enhance the transparency of fiscal operations, combined with reforms of the civil service and military;

• A substantial increase in public investment aimed at rehabilitating the country's poor social and physical infrastructure, and increased spending for health, education, and rural development;

• A strengthening of the legal framework and economic institutions.

7.  The medium-term macroeconomic framework for 1999-2002 will aim at: raising economic growth to 6 percent; lowering annual inflation to 4 percent; containing the external current account deficit to 12-13 percent of GDP; and increasing gross official reserves to about four months of import coverage. The projected increases in output growth are premised on rising investment and savings. These will require a fiscal reform that increases revenues by 4 percentage points of GDP over the period, and redirects spending priorities away from defense toward social and economic reconstruction.

8.  The fiscal agenda aims at strengthening the role of the budget for economic management, and generating the resources needed to fund increased spending in priority areas. The main goals are to raise government saving to finance the public investment program and to avoid bank financing.

9.  Revenue mobilization will be the key element in this strategy. To achieve the targeted increase in the revenue ratio from 9 percent of GDP in 1998--one of the lowest in the world--to 13 percent by 2002, the government will act on three fronts: full implementation of the remaining provisions in the 1997 Law on Taxation, strengthening the administrative capacity to collect taxes, and further broadening of the revenue base.

10.  The main focus will be on a strengthening of tax and customs administration, and on ensuring full collection of nontax revenues, including arrears. Administration and enforcement of tax compliance will be enhanced through the exchange of taxpayer information between government departments; intensified on-site tax audits; and through further technical assistance from the Fund. The current practice of disqualifying investors from tax exemptions unless they are current on their tax obligations will be reinforced and extended to other taxpayers.

11.  In addition, the revenue base will be broadened through:

• Tightening and strictly monitoring tax and duty exemptions provided under the Law on Investment (by revising the Law and its implementing regulations where necessary).

  Strictly avoiding ad hoc tax or duty exemptions, subjecting imports to preshipment inspection, and reinforcing customs administration.

• Extending VAT coverage in terms of the number of taxpayers and the sectoral coverage.

• Strengthening financial controls by bringing all extrabudgetary revenues under the control of the Treasury, including those collected through line ministries, through strict implementation of the December 1997 Prime Ministerial Order for the transfer of revenue collected by line ministries to the Treasury, and the recent cabinet decision that empowers the Ministry of Economy and Finance (MEF) to directly collect proceeds from the sale and lease of state assets.

• Incorporating into the budget all revenue arising from garment quota auctions and management fees, and, in accordance with the Prime Ministerial Order of May 3, subjecting all new quotas to auction.

12.  The government attaches importance to achieving a substantial shift in public expenditure toward priority social areas and economic infrastructure. With recent improvements in the security situation, the government will aim at a significant and durable reduction in defense and security spending from 4.2 percent of GDP in 1998 to 2.5 percent of GDP in 2002. This will require sustained reductions in operational expenditures and in the military wage bill in line with the planned removal of ghost soldiers and the demobilization program. The civilian wage bill (1.7 percent of GDP in 1999) will be contained and any further increases in wages will be tied to progress in implementing civil service reform.

13.  Adequate funding for priority sectors will be ensured, in line with the government's Socio-Economic Development Plan, and the World Bank's Public Expenditure Review (PER). Annual reviews of the three-year rolling Public Investment Program (PIP) will be strengthened to ensure that capital spending is supportive of development needs. Moreover, the government will mobilize the required local-currency counterpart of externally financed capital spending to facilitate timely disbursements of project assistance.

14.  To improve budgetary performance and transparency, the government will ensure that all issues relating to taxation are prepared in a transparent manner, with the MEF given the responsibility for drafting, implementing, and administering tax legislation. Ad hoc spending decisions outside the budget framework will be minimized, ministries' technical and financial management capabilities will be strengthened, and responsibility for performance at the level of spending units will be promoted. A National Audit Authority will also be established by mid-2000.

15.  The government's objective in forestry is the development of an environmentally sustainable, socially responsible and economically viable sector. Initial measures have been taken to curtail illegal activity, strengthen governance, and improve overall monitoring. These measures will be reinforced by overhauling concession management, formulating a legal framework for forestry, establishing a permanent forest estate, and strengthening intersectoral oversight and accountability.

16.  The government is committed to fighting forest crime, through all elements of society including the military, police, provincial authorities and local communities. Above all, effective forest management, as outlined below, will serve to prevent forest crime. In addition, to better detect forest crime, monitoring capacity is being strengthened in the key agencies, and a forest crime monitoring unit has been established with the participation of outside independent experts. The government will publish the reports of this unit on a quarterly basis.

17.  The government is reforming the concession system to ensure appropriate revenue for the budget, consistent with sustainable logging. Performance of concessionaires is being reviewed against their contracts and action will be taken to terminate those concessions in serious breach. In the first half of 1999, out of a total of 31, 11 concession contracts covering 2.2 million hectares have been cancelled and the remaining concessions are under review. The review of all concession contracts will be completed by early 2000. The government also intends to improve the practices and procedures for the management and control of any new concessions. Retendering of forest areas for concessions will be based on rational criteria, and will be supported by prior public notice and disclosure of contract terms and conditions. Concessionaires will be required to operate in accordance with standards for forest practice, as defined by the draft Sub-Decree on Forest Concession Management to be submitted to the Council of Ministers by mid-October 1999.

18.  New concessions will be awarded on the basis of competitive and transparent procedures. To ensure appropriate forestry revenue, royalty provisions will be kept under review. Furthermore, to promote efficient processing and marketing of timber, the current log export ban policy will be reviewed commensurate with improvements in the enforcement of forest law.

19.  Recognizing the national and global significance of Cambodia's natural heritage, the government is committed to the preservation of a representative range of the country's natural ecosystems and biodiversity. In addition to requiring concessionaires, and park and protected area managers to adhere to strict standards, the government supports community forestry as part of an approach to rural development and forest resource management. Mechanisms will be initiated for the award of long-term tenure rights to forest resources to local communities, indigenous peoples, and other targeted groups including demobilized soldiers and their families.

20.  Following increases in the size of the civil service in recent years, the government's objective is to rationalize and downsize the civil service. The precise number and status of civil servants needs to be ascertained and for this purpose, the government will fully implement the computerized payroll and management system. This system is now operational in eight ministries, and will be extended to all ministries by March 2000. On this basis, the government will strictly limit the number of new hires and reduce the number of civil servants in 1999 through elimination of all redundant workers and through normal attrition. Further reductions will be made in 2000-2002 following a functional review of all ministries and adoption of a comprehensive civil service reform program, all aimed at containing the wage bill to within 1.7 percent of GDP while upgrading the civil service.

21.  Demobilization will be vital. Under the recently updated program for demobilization--the Cambodian Veteran's Assistance Program (CVAP)--the overall objective is to reallocate funds from defense to social and economic sectors, through reducing, over a five-year period, the size of the Royal Cambodian Armed Forces (RCAF) from 142,308 as of June 1999 to about 80,000-100,000. Total defense spending (excluding security) would be reduced from 2.9 percent of GDP in 1998 to no more than 2 percent of GDP by 2002. As the first phase of the CVAP, the identification and registration process will be completed by late 1999 and the pilot implementation will begin early in the year 2000. Full-scale implementation of the CVAP will start thereafter, following an evaluation of the pilot implementation. In the interim, the government will make full use of all possibilities for reducing the military wage bill through elimination of ghost soldiers and their dependents. In addition, other personnel with irregular status, including those identified in the registration process, will also be eliminated.

22.  For transparency and a level playing field, the government is reforming the legal and institutional frameworks for the private sector. Cambodia has made steady progress in developing the legal and regulatory framework, but substantial gaps and inconsistencies need to be rectified. For this purpose, a comprehensive Commercial Code is being prepared to strengthen the regulatory framework for business organization, contracts, intellectual property rights, and product liability. Two commercial laws will be submitted to the National Assembly by December 1999, and the remainder by end-2000. Measures will also be taken to strengthen the rule of law and transparency, including modernizing the judiciary.

23.  Building on the progress in defining a strategy and a regulatory framework for public enterprise reform, further steps will be taken to establish a more efficient and streamlined public enterprise sector. The government intends to corporatize the eleven (mainly infrastructure) SOEs to remain in the public sector in accordance with the Law Regulating the Public Enterprises. Furthermore, restructuring plans for seven rubber plantations and a privatization schedule will be prepared, aimed at privatizing at least one selected plantation by December 2001.

24.  The banking system must be strengthened to better meet the development needs of the economy. The new Financial Institutions Law will be adopted by October 1999, under which banks will be subject to relicensing and the provisions of the law. The Foreign Trade Bank, in which the National Bank of Cambodia (NBC) is still a major shareholder, is being restructured and will be privatized by end-2001. On-site inspections of banks through internationally recognized audit firms will be continued and their frequency increased. Further improvements in banking supervision capacity will also be made by increasing and training NBC staff. Credit policy will be geared to reducing inflation through avoiding recourse to bank financing of the budget. Issuance of treasury bills at market determined interest rates will be initiated to promote intermediation and provide the NBC with a monetary policy instrument, thereby contributing to dedollarization.

25.  The government will maintain its market-based exchange rate policy and a liberal exchange system. The official exchange rate will continue to be adjusted flexibly. To signal its commitment to a liberal exchange and payments system, the government intends to accept the obligations under the Fund's Article VIII, Sections 2, 3, and 4, during the program period.

26.  Under an outward-oriented growth strategy, the government is committed to intensifying Cambodia's integration into the regional and world economy. Cambodia joined ASEAN in April 1999 and preparation is well advanced for Cambodia's participation in the ASEAN Free Trade Area (AFTA) and for accession to the World Trade Organization (WTO). Membership in the Multilateral Investment Guarantee Agency (MIGA) has been ratified in the National Assembly, and efforts are continuing to conclude bilateral investment agreements with partner countries.

27.  In the context of AFTA and WTO, a credible trade reform over the period 2000-2002 will be an important start to liberalization. Currently, Cambodia's tariff structure consists of a maximum rate of 50 percent with a few exceptions, five bands including the zero rate, and an average tariff rate of 17 percent. The government aims to further rationalize and reduce import tariffs, by progressively lowering the maximum tariff rate to 30 percent by January 2002 and the number of tariff bands to four. On this basis, and taking into account technical assistance from the Fund to help define alternative revenue sources, it is envisaged that the average tariff rate could be reduced to a range of 13-14 percent by 2002.

28.  Given Cambodia's limited debt servicing capacity, the government will not contract or guarantee foreign currency debt on nonconcessional terms over the period 1999-2002. In addition, concessional external debt will be closely monitored, and will be contracted only after the economic viability and prospective returns have been assured. The Minister of Economy and Finance will continue to have the sole authority over the contracting and guaranteeing of all public external borrowing. The MEF's external debt management unit will be strengthened further with technical assistance from the World Bank and the Asian Development Bank (AsDB). The government will also make its best effort to conclude the one remaining bilateral agreement under the 1995 Paris Club agreement, and the agreement with Russia within the framework of the Paris Club, as well as seeking comparable treatment by other bilateral creditors.

29.  The government will continue to improve the coverage, quality, and timeliness of economic data. To enhance public confidence, the trend of greater openness through regular and timely publication of data will be continued. Particular attention will be paid to improving the coverage of fiscal data to include donor-financed expenditures, and to more frequent publication of comprehensive fiscal data over the three-year ESAF period. The government will also seek to participate in the IMF's General Data Dissemination System.

30.  The government accords high priority to agricultural and rural development, as agriculture contributes half of Cambodia's GDP and employs 80 percent of the labor force. Moreover, poverty remains predominantly rural, demanding accelerated public investment and social services to the rural areas. The main objectives in the agricultural sector are: to improve food security through expanding rice production and diversifying crops; increase income-earning opportunities for farm households by facilitating production of cash crops and non-farm rural enterprises; and enhance the contribution of agriculture and agro-processing to economic growth and exports.

31.  To achieve these objectives, the following key policy actions will be taken:

• Increase public investment in rural infrastructure, including upgrading and maintenance of secondary and tertiary roads, and rehabilitation of irrigation and water supply systems based on cost sharing of operating and maintenance costs;

• Increase agricultural productivity (especially rice) through production and marketing of improved seed varieties, appropriate pest management and water control, and strengthening of technical services, conservation, and management;

• Promote agricultural export earnings through research, surveys and pilot projects for the development of commercial agriculture and agro-processing;

• Develop sound rural finance institutions, and create a transparent and secure land market by adopting, after appropriate national consultations, a revised land law and its implementing regulations, with adequate protection for the rights of small-scale producers.

32.  Despite recent improvements, access to good quality health care remains a priority, as government spending in health is still inadequate. The policy actions in this sector are:

• Expand the network of health centers and referral hospitals, increase the package of services to focus on maternal and child health and national disease control, and extend these services to the rural areas;

• Increase government health spending to 2 percent of GDP and establish a program of cost recovery (including user charges and community based pre-paid insurance schemes);

• Phase in a sector-wide approach, by addressing reform issues such as decentralization, financial management, local capacity, and monitoring.

33.  The goals of education reform are to improve quality and to achieve equity in opportunity, through the following actions:

• Allocate a minimum of 15 percent of government revenue to education, mainly to improve the provision of books and materials, training, and teacher incentives, and focus spending on basic and lower secondary education, while encouraging private sector involvement in upper secondary and tertiary education.

• Ensure more efficient deployment of teachers and staff, and develop transparent and equitable means for nongovernment financing (e.g., school community partnerships, private education).

• Monitor results in terms of the increases in the net enrollment of children in basic education and in terms of the closing of the gender gap.

34.  The focus for transport infrastructure will remain rehabilitation of high-priority trunk and feeder roads and bridges, in order to realize the potential of agriculture, tourism and trade in the rural areas. There is also the need to develop a comprehensive transport policy framework, addressing issues such as development of a balanced construction and maintenance program; increased involvement of the private sector over time; and financing of road maintenance and cost recovery mechanisms. With regard to institutional strengthening, the Ministry of Public Works and Transport will formulate strategies to improve its capacity to plan, manage, and implement road operations.

35.  To improve water supply and sanitation services, steps have been initiated towards formulating a sectoral strategy. The government plans to finalize, over the next few years, sectoral policies on tariffs, financing, and institutional arrangements. Based on this strategy, the government will develop institutions to provide services based on consumer demand; develop financing policies that leverage private and community investments; encourage outsourcing of utility operations to the private sector; and promote investment in sanitation.

36.  To commercialize and strengthen the power sector, and attract private sector investment, the government aims to: re-establish an adequate supply of electricity nationwide, through direct support of donors and private participation; enact an Electricity Act and establish a regulatory body (Electricity Authority of Cambodia); commercialize EDC through a performance- based contract; strengthen sector managerial and implementing capability; formulate procedures for the selection and contracting of private generators; and formulate strategy for rural electrification and initiate the first project.

37.  The strategy for the environment is outlined in the National Environmental Action Plan (NEAP) approved by the Council of Ministers in 1998. The NEAP provides action plans to deal with issues related to forest policy, fisheries and floodplain agriculture in the Tonle Sap, coastal fisheries, biodiversity and protected areas, energy development and the environment, and urban waste management. Immediate priority is being given to the strengthening of forest policy, biodiversity, and the protected areas management. The Ministry of Environment, with technical assistance from the World Bank, is preparing a pilot project at the Virachey National Park to demonstrate a model approach to protected areas management that can be applied to the other 22 protected areas in the country.

38.  Implementation of the reform program described above will contribute to a strengthening of the external position. Over the program period, export growth in dollar terms is projected to accelerate to an average annual rate of 10 percent, while import growth is projected to rise to about 9½ percent annually, reflecting increases in project aid and FDI as confidence returns. Accordingly, the current account deficit (excluding official transfers) would be contained to a sustainable level of 12-13 percent of GDP, and official reserves would rise moderately to about four months of import coverage.

39.  On this basis, the total external financing requirement for the period 1999-2002 is projected at $3.5 billion (Table 3). Total disbursements from official grants and loans are projected at $1.3 billion and foreign direct investment at $0.5 billion. The residual financing gap, estimated at $0.2 billion, could be covered by prospective disbursements of the Bank's Structural Adjustment Credit (SAC), possible co-financing and other bilateral loans, and prospective drawing under the IMF's ESAF. Since new debt would be contracted on highly concessional terms, the debt service ratio is projected by the Fund staff at 5½ percent in 2002.

40.  Successful implementation of the reform program requires substantial technical assistance in the period ahead, including more attention on capacity building and training. As noted in the PFP matrix:

• The Fund will provide further technical assistance in broadening the revenue base and strengthening revenue administration, in central bank operations and banking supervision, and in the external debt area.

• The Bank will provide assistance in VAT implementation; expenditure management; civil service census, and a functional review of all ministries; governance, commercial law, and the rule of law; the power and water sectors; and in implementing the national environment action plan; and along with other donors, in the forestry area, public investment program, demobilization, and on poverty monitoring.

• Bilateral and multilateral donors are providing assistance in the key structural areas such as forestry, infrastructure, and social sectors.

41.  Further technical assistance will be needed, inter alia, to develop a transparent and market-based mechanism for timber royalties; to implement an action plan for civil service reform (including social safety nets for retrenchment); to restructure and modernize the rubber sector; to develop a comprehensive transport sector policy; to implement and review pilot programs for cost recovery in the health sector; and to regularize the current informal cost recovery program in the education sector.