Cambodia - From recovery to sustained development

Report No. 15593-KH Cambodia From Recovery to Sustained Development May 31, 1996 Country Operations Division Country Department I East Asia and Pacific Region ss ~ . .t4 t; ' *s f S * S 4 t @@ A ' f ' t * 't  CURRENCY EVALUATIONS Currency Unit = Cambodian Riel AVERAGE VALUE OF USS1.00 IN 1993 1994 1995 May 1996 2470 2543 2462 2600 WEIGHTS AND MEASURES Metric System GOVERNMENT'S FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ACLEDA - Association of Cambodian Local Economic Development Agencies ADB - Asian Development Bank ASEAN - Association of South-East Asian Nations APIP - Agricultural Productivity Improvement Project AusAID - Australian Agency for International Development CARD - Council for Agricultural and Rural Development CCC - Cooperation Committee for Cambodia CCRD - Credit Committee for Rural Development CIAP - Cambodia-IRRI-Australia Project CIB - Cambodian Investment Board CMEA - Council for Mutual Economic Assistance CCRD - Credit Committee for Rural Development CVAP - Cambodia Veterans Assistance Program COCMA - Central Company for Agricultural Materials DoA - Department of Agronomy DATEE - Department of Agricultural Technology, Economics and Extension EDI - Economic Development Institute ERC - Economic Recovery Credit ESAF - Enhanced Structural Adjustment Facility FAO - Food and Agriculture Organization of the United Nations FDI - Foreign Direct Investment GDP - Gross Domestic Product GSP - General System of Preferences GTZ - Gesellschaft fur Technische Zusammenarbeit (Society for Technical Cooperation) ICORC - International Committee on the Reconstruction of Cambodia ICSID - International Centre for Settlement of Investment Disputes  IDA - International Development Association IDRC - International Development Research Centre IFAD - International Fund for Agricultural Development ILO - International Labour Organization IMF - International Monetary Fund INM - Integrated Nutrient Management IPM - Integrated Pest Management IRRI - International Rice Research Institute MAFF - Ministry of Agriculture, Forestry and Fisheries MIGA - Multilateral Investment Guarantee Agency MoE - Ministry of Environment MRD - Ministry of Rural Development NGO - Non-Governmental Organization NIC - Newly Industrialized Country NPRD - National Program to Rehabilitate and Develop Cambodia PFP - Policy Framework Paper QR - Quantitative Restriction PHRD - Population and Human resource Development SIDA - Swedish International Development Authority SILIC - Severely Indebted Low-Income Country SME - Small and Medium Enterprises SSE - Secretariat of State for the Environment SOE - State-Owned Enterprise UNDP - United Nations Development Programme UNICEF - United Nations Children's Fund UJNTAC - United Nations Transitional Authority in Cambodia USAID - United States Agency for International Development VAT - Value Added Tax WHO - World Health Organization WTO - World Trade Organization   TABLE OF CONTENTS EXECUTIVE SUMMARY ................................................ 1. MARKET REFORM, STABILIZATION, AND GROWTH ...............................................1 B. FROM INFLATION TO MACROECONOMIC STABILITY ...............................................6 Fiscal Performance ...............................................6 Revenues ..............................................6 Expenditures .............................................. 10 C. MONETARY POLICY, INFLATION, AND EXCHANGE RATES .............. ................................ I I Monetary Policy .............................................. 12 Interest Rates .............................................. 12 Price Movements .............................................. 12 Exchange Rates .....................................14 . , .... 14 D. BALANCE OF PAYMENTS AND EXTERNAL DEBT ..................................... 14 External Trade and Its Financing ...................................... 14 External Debt ..................................... 15 E. NATURE AND SOURCES OF GROWTH ..................................... 16 Pace and Sector Composition of Growth ...................................... 16 F. EMPLOYMENT, INCOMES, AND LIVING STANDARDS ...................................... 18 The Employment Profile ..................................... 19 Sources of Income ............... ' 19 Employment Generation.20................ Living Standards ............... 20 2. ACHIEVING BROAD-BASED GROWTH THROUGH PRIVATE SECTOR DEVELOPMENT 22 A. IMPROVING PROSPECTS FOR NON-FARM BUSINESS ENTERPRISES ............................................................ 22 Clarifying the Legal Environment ................................................................... 23 Improving Access to Critical Inputs ................................................................... 23 B. STRUCTURE OF THE ENTERPRISE SECTOR ................................................................... 26 Privatized State Enterprises ................................................................... 26 Foreign Owned Enterprises ................................................................... 27 Informal and Small and Medium Domestic Enterprises ................................................................... 28 A Strategyfor Informal Sector and Micro-enterprise Development ......................................................... 31 C. PROMOTING AGRICULTURAL GROWTH AND IMPROVING RURAL INCOMES .............................................. 32 The Structure and Role ofAgriculture ................................................................... 32 Food Security and Rural Welfare ................................................................... 34 The Agendafor Reform in Agriculture .................................................................... 35 (i) The Role of Government in the Agriculture Sector ................................................................... 35 (v) Ensuring the Sustainability ofAgriculture Development ................................................................... 43 3. AN AGENDA FOR SUSTAINABLE DEVELOPMENT AND REQUIREMENTS FOR EXTERNAL FINANCING .................................................................... 45 A. INTRODUCTION .................................................................... 45 B. AN AGENDA FOR SUSTAINABLE GROWTH ................................................. 46 Maintaining Macroeconomic Stability ......................................................... 46 Improving the Enabling Environmentfor Private Sector Development .................................................. 49 Facilitating Rural Development ........................................................ 50 C. GROWTH PROSPECTS AND EXTERNAL CAPITAL REQUIREMENTS . ....................................... 51 The Growth Scenario ........................................................ 51 APPENDIX 1: Direction of Tax Reform ........................................................ . 57 STATISTICAL APPENDIX ........................................................ A-2   ACKNOWLEDGEMENTS This report was prepared on the basis of an economic mission that visited Cambodia in September 1995. The preparation of the report was coordinated by Guy Darlan and Kyle Peters (co-task managers) with the assistance of David Greene (consultant), based on the contributions of Su-Yong Song (macro and tax reform), Christopher Redfern (agriculture), Alison Evans (financial and informal sectors), Leila Webster (private sector development), and William Martin (international trade), under the guidance of Pamela Cox, Chief of Country Operations Division, and William McCleary, Lead Economist of the East Asia Country Department I. Contributions were also made by Yoshio Sanaka (aid flows), Mostafa El-Erian (legal framework), William Magrath (forestry issues), Gholam Azarbayejani (debt), and Ky Tran (statistics). The peer reviewers were Ritva Reinikka and Bernard Funck. The manuscript was edited by Emily Evershed and typed and formatted by Lily Tsang. The mission would like to express its gratitude to various ministries and agencies that assisted in the preparation of this report. The report was discussed with the Government of Cambodia in May 1996 and revised and updated on the basis of those discussions.  I  EXECUTIVE SUMMARY 1. Cambodia has made impressive strides in re-establishing political and economic stability and re-integrating itself into the international community. The Royal Government of Cambodia has set about the difficult task of ensuring stability and security throughout the country and rebuilding the economy. It has achieved notable success, but a daunting agenda remains. 2. Recent achievements must be judged in light of the suffering that the country and its people experienced during the past quarter century. Most people lack access to health and educational facilities, potable water, electricity, and serviceable roads. The country's natural and productive capital have suffered great losses. Land mines render large portions of valuable agricultural land unusable, and pose a serious threat to people. But, perhaps the greatest loss to Cambodia was the depletion of its human capital by mass genocide and large-scale exodus of the most educated citizens during 1975-79, the years of Khmer Rouge rule. In addition to the depletion of human capital, institutions were dismantled, the legal system destroyed, and money abolished. 3. Since the late-1980s, Cambodia has embarked on a transition to a market economy. Until 1992, reforms were partial and ad-hoc. Beginning in 1993, the Government began formulating a comprehensive macroeconomic and structural reform program supported by the international community. The Government has since achieved some significant successes both in stabilizing the economy and in implementing structural reforms. The economy has expanded at an annual rate of six percent during the i990s. Inflation has been dramatically reduced, and the balance of payments is being financed without jeopardizing future creditworthiness. Progress was also made in implementing structural reforms: a two-tier banking system is being put in place and new large denominated banknotes were introduced to promote "de-dollarization"; most non- tariff barriers were eliminated; the tariff structure was streamlined; a liberal foreign investment law was adopted; and the spread between the official and parallel market exchange rates has been almost eliminated. 4 Despite recent improvements in the economy's performance, Cambodia is still one of the poorest countries in the world with a per capita income of US$260. Cambodia's economic and social indicators also compare unfavorably with neighboring transition economies and East Asian newly industrialized countries about a quarter of a century ago. Moreover, while data are scarce and often unreliable, Cambodia's per capita income and its socio-economic indicators suggest that Cambodia today is not clearly better off than in the late 1960s.  - 11 - Recent Economic Developments 5. A combination of liberalization, stabilization and structural reform with generous external assistance has led to a rapid economic recovery. GDP expanded at an annual rate of about 6 percent over 1991-95 period. Agricultural growth averaged slightly less than 3 percent; and, manufacturing grew at an average annual rate of 7 percent. Services and construction also grew rapidly, largely in response to donor-sponsored rehabilitation activities. Despite this relatively rapid growth, perhaps a quarter million persons are unemployed. Underemployment is also an important problem, with excessive, low productivity workers in state enterprises, the civil service, and the military. The proportion of people living below the poverty line has not been estimated, but it would be surprising if it were less than in neighboring transition economies. 6. The Government's policies have also successfully stabilized the economy. Inflation decelerated from an average of 140 percent in 1990-92 to 3.5 percent in 1995 largely as a result of the elimination of domestic bank financing of the budget and substantial external assistance (see Figure 1). However, domestic resource mobilization continues to be weak: tax revenue was only 6.2 percent of GDP in 1995, half the average for low income countries. In addition to low tax revenues, the revenue base is fragile, as it has been too reliant on imports for re-export and forestry. 7. With a weak and fragile revenue base, expenditure compression has borne the brunt of fiscal restraint. Current expenditures have been contained at 10 to 1 I percent of GDP since 1994. Unfortunately, this has been achieved mainly by compressing operations and maintenance, and freezing civil service employment levels and salaries. Defense and security expenditures account for almost 60 percent of all current expenditures, and have exceeded budgetary targets. Education and health expenditures are too low and most are absorbed by salaries. The share of the budget currently devoted to socially oriented, rural-based projects is also inadequate and the Government intends to allocate larger shares to these vital activities in the future. 8. A favorable external environment, improved export performance, inflows of foreign direct investment and large aid flows have all contributed to an improved balance of payments position and an increase in official reserves. While Cambodia's domestic export base is small, it has expanded rapidly, increasing about four-fold since 1991. Retained imports (net of re-exports), however, have increased six-fold. The consequent widening of the current account deficit from 1.5 percent of GDP in 1991 to 14.9 percent in 1995 was financed by an increase in external capital inflows. Part of the external financing is being provided by foreign direct investnment inflows, mostly from neighboring countries, which increased sharply, from US$10 million in 1994 to US$100 million in 1995. But, the bulk of external financing is provided by official grants and concessional loans.  - iii - Figure I Reduced monetary financing of the budget deficit resulted in lower inflation and... 120-4,2 o 40. 0~~~~~~~~~~~~~~~~~~~~~ 1992 1993 1994 1995 l |~~~-:|- Inflation -0-Monetary Financing of Budget| L ~ ~ _ __________I__ 0 ~~~allowed an expansion of credit to the private sector. 100%~~~~~~~~~~~~~~~~~~~~~~~. 80% 40%1. 20% | E a 0%~~~~~~~~~~~~~~~~~. 1991 1992 1993 1994 1995 alloe aGovemxant siState Enterprises Oprivate Sector. 9. Carnbodia received highly concessional terms on the rescheduling of its debt to the Paris Club creditors in January 1995. However, Camnbodia is still classified as a "Severely Indebted Low-Income Country" by the World Bank because of its high level of external indebtedness. The Government therefore aims to seek debt relief from bilateral donors that did not participate in the Paris Club, Russia in particular. Debt owned to Russia could amount to as much as three-quarters of Cambodia's total external debt, if it is valued at exchange rates at the time of acquisition. Cambodia's creditworthiness will remain problematic, unless this external debt overhang is resolved on favorable terms. The Future Agenda 10. Despite the recent impressive economic performance, several concerns remain (see Figure 2). Growth is not yet broad based. It is concentrated in the capital, in construction and services, and is largely aid driven. During 1991-95, almost three-  -v - quarters of growth was accounted for by services and construction. Moreover, there are fundamental disequilibria in the balance of payments and the budget. Large current account and budget deficits are filled by substantial inflows of foreign assistance. While large foreign assistance inflows can be expected for the remainder of the decade, they cannot be expected to persist indefinitely. Figure 2 Construction and services accounted for nearly three quarters of Cambodia's growth since 1991. (Percentage contribution to GDP growth during 1991-95) Agnculture Indust, S smesvices 11% 50% s ~~~~~~~~~~~~~~~~~~~Construction There are fundamental disequilibria in the balance of payments and... l 1991 1992 1993 1994 1995 0 --- Current Account Balance7 the budget. Both remain heavily dependent on external assistance. 20- 16.6 16.4 15 11.2~6. 1991 1992 1993 1994 1995 -|- Total domestic revenues -U--Total expenditures  v - 11. The task for policymakers is to move from rehabilitation and recovery to sustainable development. This will not be an easy task and it will take time. The first challenge will be to sustain the progress already made in macroeconomic stabilization. The second challenge is to maintain the pace and broaden the base of economic growth. The benefits of economic growth need to be broadly, rather than narrowly, distributed with rural, as well as urban areas, thriving. 12. To meet these challenges, there is a need to broaden the base of economic growth and to deepen structural reforms to restructure both the budget and the balance of payments. The reform agenda contains three basic elements. * The first is fiscal reform to raise domestic revenue mobilization and to restructure and rationalize expenditures. * The second is improving the enabling environment for private sector development in order to develop an economic climate that is conducive to private investment, both domestic and foreign, and to an export-oriented growth strategy. T The third is to foster accelerated rural, particularly agricultural, development to ensure that Cambodia's people -- the majority of whom live in rural areas -- benefit from economic growth and that poverty is reduced. Fiscal Reform 13. The Government is planning a fundamental reform of the tax system. Currently, the tax system yields too little revenue, is administered in many key areas on a case-by- case basis, and is too heavily dependent on trade taxes. The key objective of tax reform is, therefore, to build a modem tax system that has a higher built-in elasticity, does not distort resource allocation, relies less on trade taxes, encourages savings, and is simple and inexpensive to administer. The Government's target is to double the tax ratio from the current 6 percent of GDP to 13 percent over the next decade. This is an achievable target, but would require a careful evaluation of proposed individual tax instruments and their revenue yield. Over the. medium term, a value added tax (VAT) should be the cornerstone of a revised and modernized tax system. Therefore, the Government should move forward with its plan to enact legislation to introduce a VAT, starting with the 400- 500 large companies registered with the Large Taxpayers Unit and extending it gradually to cover smaller taxpayers. 14. The tax base should be broadened by strengthening audits and inspections of company accounts, and by extending the coverage of actual accounts-based taxation to medium-sized companies. Moreover, concessions for the exploitation of natural resources, particularly forestry, should be based on sustainable yields, and awarded competitively and transparently with royalties that are more commensurate with their economic value and that are transferred to the budget in a timely manner. Finally, the Government needs to carefully consider its policy regarding investment incentives. These incentives should be strictly limited to protect the tax base and aligned with the treatment of other ASEAN countries.  - vi - 15. To complement tax reform, the Government needs to restructure expenditures so that they promote economic growth and enhance social welfare. Currently, defense and security expenditures have had the highest priority. Other expenditures, particularly the social sectors, physical infrastructure and operations and maintenance, have had to take a lower priority. A promising first step was made with the 1996 Budget, which increased social transfers and local currency counterpart allocations. In the future, however, expenditures need to be focused more sharply on programs to strengthen human resources by expanding access to and improving the quality of primary education and basic health care and to provide and maintain the infrastructure fundamental to growth. 16. A key element of rationalizing and restructuring budgetary expenditures will be civil service reform and military demobilization. The civil service should be downsized with the size and allocation of staff more consistent with redefined, more limited government functions. Military expenditures should be reined in as the security situation improves. The Government has committed to ambitious reform programs in both areas and the timely implementation of these reforms will be important. This is also a key area for donor financial support, as these reforms will temporarily increase current expenditures in the next few years to provide for departure packages and retraining for retrenched workers. Savings from retrenchment are expected to make possible higher pay for the remaining civil servants. Improving the Enabling Environment for Private Sector Development 17. Cambodia needs to create an open, transparent and administratively simple environment for private sector development. This is especially important given Cambodia's weak human capital and institutions. Creating such an enabling environment would require re-establishing the rule of law, improving domestic governance, and bringing transparency and accountability to the actions of Government. It also requires: enacting the remaining elements of the legal framework; ensuring that laws and regulations are enforced fairly and transparently; restructuring the remaining state enterprises; undertaking further financial sector reform; and, maintaining an open trade regime. The Government is preparing and will enact a number of key pieces of legislation -- Commercial Banking, Companies, Bankruptcy and Contracts -- that are critical to establishing a well functioning market economy. This is a matter of urgency. 18. Substantial progress is being made in state enterprise reform. A large number of enterprises have been privatized or leased. With privatization regulations approved in April 1995 and the Privatization Committee established in July 1995, the legal and institutional framework is largely in place. It is important that the privatization lists are finalized, that these lists contain all state enterprises that do not serve a public purpose, and that the privatization of these enterprises is completed expeditiously. 19. As noted, enactment of the Commercial Banking Law is a priority in order to clarify the legal framework for the ownership, capital structure and management of banks. In order to complete the establishment of a two-tier banking system, the National  - vii - Bank should divest its interests in the remaining joint venture banks, its branches that engage in commercial banking activities, and privatize the Municipality Bank and the Foreign Trade Bank. The National Bank also needs to establish an effective banking supervision system, including both on-site and off-site inspections. This is especially important to deal with the large number of recently established commercial banks. 20. Finally, the Government needs to maintain its open trade regime. The reform of Cambodia's trade regime from a centrally controlled system into the relatively open system that prevails today is impressive. Any pressures for adopting inward-looking policies or trade protection geared to individual sectors or firms should be resisted. High priority should be given to integrating Cambodia's trade regime rapidly and transparently with its East Asian neighbors, and putting WTO membership on a fast track. Accelerating Rural Development 21. With 85 percent of Cambodia's population living in rural areas, accelerated rural and agricultural development is critical to raising incomes and reducing poverty. Agriculture is the backbone of the Cambodian economy. It accounts for 50 percent of GDP and 75 percent of employment. Rubber and timber have recently accounted for three quarters of total recorded domestic exports. Agriculture has grown by slightly less than three percent during the past several years. This is respectable given the adverse weather conditions in the past several years, existing infrastructural bottlenecks and the fact that large areas of good agricultural land cannot be cultivated because of the security situation and the presence of land mines. Demining is a key priority for external assistance. However, on land that is cultivated, agricultural productivity is still low compared to other Southeast Asian countries. 22. Systemic reforms over the past several years have dissolved the agricultural collectives, allowed the privatization of land, largely freed agricultural input and output prices, and eliminated virtually all non-tariff trade restrictions. The Government is committed to further reform, in order to improve productivity. The main elements of the agenda are: to strengthen the capacity of the Ministry of Agriculture to provide technical support and extension; to financially restructure, modernize and where feasible privatize Cambodia's rubber plantations so that they can once again become an important source of employment and foreign exchange; to privatize other state enterprises in the sector, the most important of which are the input supply company, the fishing company, and some import-export companies; to develop and implement a water resource management strategy and to develop appropriate irrigation facilities; and to review and rationalize laws governing the use and ownership of land and natural resources. In addition, upgrading rural infrastructure will be critical to accelerated rural development. Rural transport, in particular, is a priority. 23. The key issue in ensuring the sustainability of Cambodia's development is the management of forestry resources. Deforestation and degradation has affected over four million hectares over the last thirty years. Current Government policies have sought to  - viii - promote a capital-intensive wood processing sector through a log export ban, have allocated nearly all of the country's viable timberlands to a small number of concessionaires and have generated inadequate royalties. The Government urgently needs to adopt a more transparent and market-oriented forestry development strategy. In the near term, five initiatives are recommended: a legal review of existing concession contracts; developing guidelines for concession management plan proposals; reformulating the forest inventory project; developing monitoring systems for concessions; and, preparing a national forest policy. This would allow the Government to move towards a longer term strategy of awarding concessions in a transparent and competitive manner which yields larger fiscal revenues, of improving the ability to monitor and enforce the provisions of concessions (including cutting limits consistent with sustainable yields) and of de-regulating gradually log allocations and trade. Growth Prospects 24. Under the illustrative macroeconomic scenario presented in this Report, Cambodia's growth prospects are good, assuming a favorable external environment, the continuing support of the international community and a reasonably stable political/security situation. It also assumes that the Government continues to make progress in consolidating macroeconomic stability through tight fiscal and monetary policies and in improving the enabling environment for the private sector and rural development. Under these conditions, GDP growth averaging about 7 percent per year should be attainable over the next five years. This rate of growth would require, however, that national saving increase from the present very low level of about 4 percent of GDP to about 9 percent by the year 2000. Government saving would increase to almost two percent of GDP by 2000, as a result of tax reform and effective control of current expenditures. Private saving would increase as disposable incomes increase and financial institutions are developed. Private investment would rise, reflecting both domestic saving and expanded foreign direct investment inflows. Government investment would grow in line with GDP, with an increasing proportion financed by government saving. 25. The current account deficit can be expected to fall as a percentage of GDP gradually over the medium term. This decline will be largely driven by an increase of exports (net of re-exports) from US$265 million in 1995 to US$495 million in 2000. The main source of export growth would be nontraditional, labor-intensive, light manufacturing products, garments in particular. Rubber, rice, and other agricultural products would also contribute to export growth, especially in the later years. Log and wood product exports are assumed to be limited to levels permitted by sustainable forest practices. Retained imports might be expected to grow by slightly less than GDP, as the need for extraordinary imports for reconstruction diminish.  - ix - External Financing Requirements and External Assistance 26. Total external financing requirements, including reserve accumulation and debt amortization, would increase from US$520 million in 1995 to US$551 million in 2000. An increasing proportion of Cambodia's external financing requirements will be met by foreign direct investment inflows, which are expected to grow from about US$100 million to US$200 million by the end of the decade. Even with this increase in private capital flows, there remains a substantial need for disbursements of official assistance. Disbursements of official assistance-grants and concessional loans-for 1996-98 would, therefore, need to be maintained at levels not lower than the amounts disbursed in 1995. 27. During 1992-95, the international community pledged significant amounts of official assistance -- about US$2 billion--for the recovery and rehabilitation of Cambodia. By the end of 1996, these "pledges" will have been largely disbursed. Therefore, maintaining the level of official disbursements during 1996-1998 would require commitments of official assistance of roughly US$500 million per year -- of which about US$65 million would need to be for cash/commodity aid and US$435 million for project aid. In the near term, the proportion of official assistance provided in the form of grants would need to be maintained at their 1995 level. 28. The Government's priorities for official assistance are outlined in its Public Investment Program. There are several key priorities. First, civil service reform and military demobilization are important to streamline and rationalize civil administration and contain defense expenditure. Budget support for these programs, totaling disbursements of about US$65 million per year during 1996-98, is an important priority for external assistance. Second, the de-mining activities of the Cambodia Mine Action Center are another important priority for official grant assistance. Finally, there are investment needs in infrastructure, particularly in rural areas, where the private sector is unlikely to invest and in human resource development in order to rebuild Cambodia's human capital base.   1. MARKET REFORM, STABILIZATION, AND GROWTH 1.1 At the end of the of the 1980s Cambodia, devastated by internal warfare and misrule, most of its of physical infrastructure had been destroyed and its human capital base decimated. The economy was subject to broad state ownership, intervention, and controls, which resulted in inefficient allocation and use of resources. Yet the coming of peace, the transition to democracy, and the liberalization of the economy released the energies of the Cambodian people and led to economic recovery. 1.2 Under the process set in train by the Peace Accords, Cambodia has established itself as a democracy. These Accords established the United Nations Transitional Authority for Cambodia (UNTAC) to maintain peace and develop a neutral political environment in which free and fair elections could be held. The elections took place in May 1993 and, following three months of an interim provisional government, a national government was established in late September 1993 within a framework of parliamentary democracy, under a new constitution, with a constitutional monarch as head of state. International ties were renewed, then strengthened, and the donor community pledged its support for Cambodia's rehabilitation. UNTAC's mandate ended in November 1993. 1.3 Under UNTAC's guidance, Cambodia continued its transition to a market economy. Until 1992, Cambodia carried out its reforms largely on its own, in a partial and an ad hoc fashion. With the establishment of a democratic coalition government in 1993, stabilization and structural reform continued to have high priority. The resumption of official assistance though the International Committee on the Reconstruction of Cambodia (ICORC)) contributed greatly to the process of rehabilitation and recovery. 1.4 Despite the recent improvements in the economy's performance, Cambodia is one of the poorest countries in the world, with a per capita income of US$260. As demonstrated in Table 1.1, Cambodia's economic and social indicators also compare unfavorably with neighboring transition countries and sub-Saharan African countries, and East Asian newly industrialized countries (NICs) about a quarter of a century ago. Moreover, while Cambodians' economic well-being has improved since 1989 when the Government started implementing market-oriented economic reforms, Cambodia today is not clearly better off than in the late 1960s, i.e., before the traumatic events of the past  -2- two decades; while some social indicators are better now, per capita income still has not fully recoveredI (see Tablel.2). 1.5 Cambodia has made a rapid transition. The country is now in a crucial transitional phase between recovery and sustained development. The economy has responded well to liberalization and stabilization measures, and recent growth, especially in the capital area, has been remarkably robust (see Table 1.3 for key economic indicators). Economic events in Cambodia are moving rapidly: some of the recent developments have been encouraging, especially the rapid growth of investment and exports. 1.6 The key step in the process of transition from a command to a market economy and in the reversal of economic decline was the restoration of private property rights in 1989. At about the same time, the regime gave state enterprises greater autonomy, began the process of privatization of state enterprises, under close supervision, and increased incentives for local and foreign private investment. This set the stage for the remarkable growth of the private sector. While some state enterprises were being leased or sold, the remaining were being reduced in importance by the much more rapid growth of the private sector. In 1994 a new, liberal Investment Law was passed, setting off a rapid increase in foreign direct investment in Cambodia. 1.7 Resource allocation is improving as a result of being increasingly determined by market forces. The role of prices in the economic system started changing in 1989, when the state order system under which farmers were compelled to sell a portion of their output to the state at below-market prices was abolished. State intervention in commodity markets has now virtually disappeared. Prices are market determined and are open to the influence of international trade. Commodity price subsidies and subventions to state- owned enterprise have been virtually eliminated. 1.8 External trade has also been greatly liberalized. Until 1987, the state monopolized external trade and most transactions were governed by annual protocols with Council to Mutual Economic Assistance (CMEA) countries. By 1989, the private sector was permitted to establish trading companies, although licenses were still required for all imports and exports. In 1993, the general licensing requirement was eliminated for most goods in which trade is undertaken by registered companies. Furthermore, owing to its low customs duties and weak enforcement, Cambodia became a hub of sorts for transit trade in the region, especially with Vietnam. Also in 1993, the import tariff system was significantly streamlined through the creation of a four-band system with rates of 7, 15, Because economic and social data in Cambodia is scarce and often unreliable, these comparisons should be viewed as rough approximations.  -3- Table 1.1: Economic and Sodal Ind lcat: Iatatlonal Compazris w Cinhedla La FDt viSuma Avae of Sub- iulhn Kor So1waro Afriea (1970) (1965) GDP per Cqita b USS 260 320 250 500 620 500 AricultureiGPRio % 45 51 33 20 26 3S GlkvDmisicSgvia"'PRmio % 7.5 3.2 20.2 15.0 18.8 7.4 TaKODP Rado % 6.2 10.4 22.0 17.2 13.2 15.0 AidGDPRato % 14.2 14.9 2.9 11.5 3.0 9.3 Aid perCiita USS 40.6 43.2 8.0 35.7 5.5 21.8 Pdubic Expniture on Health od EductinlOOP % 1.S 2.7 7.9 NA 4.6 7.0 IlUitacyRas %pop.eS 15+ 35 43 6 50 21 15 lUeh EVCpOcy Yaws 52 52 68 52 60 57 hs&tMrtrlaty per dlo. live bih 110 92 42 92 65 63 Ndil ou Cwnbodi rmoody for 1995; odre countrie mogdy Sr 1994; Korm (1965); and lbiad (1970). VCPI in the Uiited Stxs wa usd in conveting per crsia owme of Kora mid Thailand into 1995 US dollm Tranb in Devqing Economies, 1990 and 1995, World IiS Soia 1n&gar of DeveIopnit 1990 and 1995, Waiid Bank. Unified Survey dst*e of the Waid Bsnk. Tax Polcvy H1do, Puhasrhi Sh9m, IMF, 1995. GeceqIhicad Dinsibutic of Financial Flows, OECD, vwious ym Word Bank staf esiimge Table 1.2: Economic and Social Indicators: Comparison with the Past Circa 1969 Circa 1989 1995 Per Capita GDP (USS) In Current Prices 110 170 260 In 1995 Prices a/ 455 208 260 Agriculture/GDP (%) 38 52 45 Rice Production (million tons) 3.2 bi 2.6 2.7 Social Indicators Life Expectancy (years) 42 c/ 46 di 52 Population per Physician (persons) 16250 16500 d/ 7730 Infant Mortality (per thou. of live births) 181 160 d/ 110 Illiteracy (% of population age 15+) 36 cl 71 e/ 35 Notes: a/ CPI in the United States was used in converting per capita income of 1969 and 1989 into 1995 US dollars. b/ Average of 1967-69. c/ 1960. d/Around 1930-85. c/ Around 1980, i.e., immediately after the fall of the Khmer Rouge regime. Sources: World Development Report, 1978, World Bank. Social Indicators of Development, 1996, World Bank. Cambodia: A Country Profile, Swedish International Development Authority, 1989.  -4- Table 1.3: Key Economic Indicators 1991 1992 1993 1994 1995 (Percentage Change) Real GDP 7.6 7.0 4.1 4.0 7.6 CPI (final quarter basis) 150.4 112.5 41.0 17.9 3.5 Domestic Liquidity 28.6 209.0 40.0 29.4 45.0 Net Credits to Government 22.9 141.8 5.6 -7.9 0.6 Velocity of Money 21.8 16.3 19.6 15.4 13.6 (Million of Us$ Export of Goods (US$, excluding re-export) 81 101 168 293 375 Import of Goods (US$, retained import) 113 160 361 644 830 Gross official reserves .. 30 71 100 182 (Months of import of goods and services) .. 1.0 1.8 1.5 1.9 (Percentage of GDP unless otherwise specified) Budget Revenue 4.4 6.2 5.4 9.6 8.9 Tax 2.3 4.4 4.3 5.9 6.2 Non-tax 2.1 1.8 1.0 3.7 2.7 Budget Expenditure 7.8 9.8 11.2 16.6 17.0 Current expenditure 7.4 9.5 6.9 11.2 10.2 Capital expenditure 0.4 0.3 4.3 5.5 6.8 Current budget deficit (accrual basis) -3.0 -3.3 -1.5 -1.5 -1.3 Current budget deficit (cash basis) -1.2 -4.3 -1.4 -1.5 -0.6 Overall budget deficit (accrual basis) -3.4 -3.6 -5.9 -7.0 -8.0 Domestic Investment 9.4 9.8 14.3 19.5 22.4 Govemment Investment 0.4 0.3 4.3 5.5 6.8 Non-govemment investment 9.0 9.5 10.0 14.0 15.6 Financing of Investment 9.4 9.8 14.3 19.5 22.4 National savings 7.9 7.3 5.6 5.8 7.5 Govermnent savings -1.2 -4.3 -1.4 -1.5 -0.6 Non-Govemment savings 9.1 11.6 7.0 7.3 8.1 Foreign savings 1.5 2.5 8.7 13.7 14.9 External Current Account Deficit (US$ millions) -28 -50 -190 -330 -434 (in percent of GDP) -1.5 -2.5 -8.7 -13.7 -14.9 Memorandum items: Nominal GDP (billions of Riels) 1,336 2,508 5,414 6,131 7,200 Official exchange rate (Riels/US$) 703 1,253 2,470 2,543 2,462 Source: Cambodia authorities. 35 and 50 percent applying to over 93 percent of tariff items.2 Quantitative restrictions were all eliminated; export restrictions now apply only to logs, sawn timber, antiquities 2 A maximum rate of 120 percent is applied to automobiles. A zero rate applies to medical and educational materials.  -5- and rice. (While a ban on rice exports, imposed in reaction to a drop in output due to drought, was lifted on December 1, 1995, a quantitative ceiling is in place with a view to preserving food security.) 1.9 The four tariff rates were assigned on the basis of a broad classification of imports. The highest rate (50 percent) was applied to consumer goods; the 35 percent rate was for goods for which some infant-industry protection considered desirable; the 15 percent was for capital goods; and the 7 percent rate was applied to inputs needed for domestic production. Although simple, such a system can provide high rates of protection for import-substituting production. Where the customs duty is collected as a de facto excise tax (e.g., for cigarettes and alcohol), this protection is eliminated by the imposition of excise taxes at the same rate as the customs duty. 1.10 Although the foreign exchange law includes restrictions on the provision of foreign exchange for certain current transactions, these restrictions are not enforced. A new foreign exchange law has already been drafted and will be submitted to the National Assembly in the near future. Cambodia plans to become a member of ASEAN by 1997, and later the WTO, in order to further reintegrate the country into the regional and world economies. Cambodia has followed a market-oriented exchange rate policy since 1993, with the official exchange rate adjusting to movements in the parallel market rate. With the establishment of a weekly auction system, the official rate has now narrowed to within 1 percent of the market rate. 1.11 Progress has been made toward establishing market-oriented financial and monetary systems. In 1980 the domestic currency was reintroduced, with the value of one riel fixed as the price of one kilogram of rice. That same year saw the re- establishment of the National Bank. In 1993 the establishment of a two-tier banking system was initiated as most of the central and commercial banking responsibilities of the National Bank were separated. The National Bank has since ceased most commercial banking activities. Interest ceilings were completely eliminated. Minimum reserve requirements for commercial bank deposits were introduced. New, larger denominations of banknotes were issued in March 1995 to encourage the use of the domestic currency. Riel-denominated Treasury bills are now being prepared for issue.. The Central Bank Law, which strengthens the autonomy of the National Bank and gives it a clear mandate to maintain price stability, was enacted on January 2, 1996. 1.12 Despite these changes, meant to encourage use of the domestic currency and lay the groundwork for effective monetary policy, the economy remains heavily "dollarized" and still relies on cash transactions. Monetary policy is still in the very early stages, and for the time being, at least, fiscal policy will have to be the main instrument for maintaining macroeconomic stability. Creating a fully functioning system of financial intermediation will need to be managed carefully to foster and maintain confidence in the riel.  -6- B. FROM INFLATION TO MACROECONOMIC STABILITY Fiscal Performance 1.13 Fiscal restraint has been the anchor for macroeconomic stability. The introduction of new tax measures and the strengthening of tax administration have increased revenues. The introduction of a new budget nomenclature and new budget procedures have strengthened expenditure control. As a result of reduced fiscal deficits and strict limits on domestic financing of the budget, inflation has been reduced from triple digits to single digits. Nevertheless, the fiscal situation, and with it macroeconomic stability, remainsfragile. Increased domestic revenue generation is absolutely necessary if budgetary balance and internal and external economic stability are to be maintained. 1.14 High levels of financial support from the international community have contributed to recovery and stabilization by reducing the need for expansionary financing of the budget and allowing a rapid increase in imports. However, external financing masks some fundamental budgetary and balance of payments problems. Domestic resource mobilization continues to be weak, and, over the longer term, macroeconomic stability will not be sustainable unless domestic resource mobilization is increased. In addition, transparency and accountability in economic management is insufficient -- in particular, in awarding concessions of natural resources and transferring associated royalties to the budget -- and delays in implementation of structural reforms raise concerns about medium term sustainability. The Government now faces the challenge of making the transition from operating within a short-term emergency management mode to establishing a solid foundation for the maintenance of macroeconomic stability and sustainable economic growth. 1.15 Cambodia's fiscal situation remains precarious because of the low level of domestic resource mobilization and the heavy dependence on foreign aid for budget support. Tax and non-tax revenues together amounted to only 8.9 percent of GDP in 1995 (of which tax revenue was only 6.2 percent of GDP). Total budgetary revenues in that year covered only 89 percent of current expenditures. In other words, part of current expenditures and almost aLl capital outlays were financed by foreign aid flows. Budget/commodity aid and project aid provided by foreign assistance rose from 0.5 percent in 1991 to 7.4 percent of GDP in 1995. The high level of foreign assistance has allowed inflationary domestic financing of the budget deficit to all but disappear since 1994, contributing to a sharp reduction in inflation and to exchange rate stability. Revenues 1.16 Some effort has been made to mobilize budgetary revenue. A major customs reform was implemented in 1992-93, and pre-shipment import inspection was introduced  -7- Figure 1.1: Budget Deficit, Domestic Liquidity and Inflation Current Budget Deficit and Inflation 120 -5 1002 < -4.5 , 100 -3.5 i - 20 -1 p -0.5 t 0 0 1992 1993 1994 1995 -X- Cufrent Budget Deficit -0-- Inflation Domestic liquidity and Inflation (annual percentage change) 250 200 150 100 50 - 0 1992 ~~~~~~1993 1994 1995 -X- Inflation (final quarter basis) -0-- Domestic Liquidity Monetary Financing of Budget Deflcit and Inflation 120 4.5 4.0 ; 100- ~~~~~~~~~3.5 80 ~~~~~~~~~~~~~~3.0 - C 2.5 o 60 2.0 jZ 40 1.0 ac 20 0.5 '0' 0 -0.5 0' 1992 1993 1994 1995 -X- Inflation -0-- Monetary Financing of Budg7et  -8- Table 1.4: Summary of Budget Operations, 1991-96 1991 1992 1993 1994 1995 1996 Rev. Budget Estimate Budget Billion Rich Revenue 58.8 156.1 290.1 590.4 694.4 642.9 797.5 Tax 31.1 109.7 234.1 364.6 466.3 445.4 577.3 O/w Customs Duties 22.0 79.3 172.4 280.9 347.6 320.8 373.9 Non-tax 27.8 46.3 56.0 225.8 228.0 197.5 220.2 O/w SOE Transfer 25.8 42.3 53.6 .. Otw Forestry Exploitation .. .. 3.9 86.0 85.9 52.9 22.5 Expenditures 104.1 245.6 608.4 1019.2 1230.8 1221.5 1395.1 Current Expenditure 98.9 238.6 373.2 683.9 792.3 732.9 853.8 Defense& Security 46.8 118.6 219.4 431.8 413.0 425.7 400.0 O/w Salaries .. .. 102.9 188.8 234.0 229.6 247.4 Civilian 52.2 119.9 153.8 237.5 310.1 290.3 384.8 O/w Salaries .. .. 67.4 99.6 125.1 111.6 128.7 Capital Expenditure 5.2 7.1 235.2 335.5 438.5 488.6 541.3 0/w Domestically Financed .. .. 23.2 78.7 66.4 56.9 81.0 Local Projects .. .. 23.2 .. Local Cost of Extemal Financed .. .. .. .. Cunrent Deficit (accrual basis) -40.1 -82.5 -83.1 -93.5 -97.8 -90.0 -56.4 Overall Deficit (accrual basis) -45.3 -89.6 -318.3 -428.8 -536.3 -578.6 -597.7 Financing 45.3 89.6 318.3 428.8 536.3 578.6 597.7 Foreign Financifig 6.1 1.5 239.1 432.1 524.3 536.8 593.1 Project Aid na na 208.2 256.8 372.1 428.3 460.3 Budget Support/Commodity Aid na na 30.9 110.5 152.2 81.8 182.5 Domestic Financing 39.2 88.1 79.2 -3.2 -0.4 -1.6 4.5 O/wBankFinancing 14.5 112.1 30.7 -14.3 12.0 5.5 12.0 Percent of GDP Revenue 4.4 6.2 5.4 9.6 9.6 8.9 9.8 Tax 2.3 4.4 4.3 5.9 6.5 6.2 7.1 Ohw Customs Duties 1.6 3.2 3.2 4.6 4.8 4.5 4.6 Non-tax 2.1 1.8 1.0 3.7 3.2 2.7 2.7 Expenditures 7.8 9.8 11.2 16.6 17.1 17.0 17.2 Current Expenditure 7.4 9.5 6.9 11.2 11.0 10.2 10.5 Defensed& Security 3.5 4.7 4.1 7.0 5.7 5.9 4.9 Civilian 3.9 4.8 2.8 3.9 4.3 4.0 4.7 Capital Expenditure 0.4 0.3 4.3 5.5 6.1 6.8 6.7 CurTent Deficit (accrual basis) -3.0 -3.3 -1.5 -1.5 -1.4 -1.3 -0.7 Overall Deficit (accrual basis) -3.4 -3.6 -5.9 -7.0 -7.5 -8.0 -7.4 Financing 3.4 3.6 5.9 7.0 7.5 8.0 7.4 Foreign Financing 0.5 0.1 4.4 7.0 7.3 7.5 7.3 Domestic Financing 2.9 3.5 1.5 -0.1 0.0 0.0 0.1 O/w Bank Financing 1.1 4.5 0.6 -0.2 0.2 0.1 0.1 Source: Cambodian authorities.  -9- in September 1995. New domestic taxes were also implemented. A hotel tax was introduced in October 1992, and a salary tax and a tax on unutilized land were put in place January 1995. More significantly, effective October 1995, the turnover tax rate was increased from 2 percent to 4 percent, and 10 percent excise tax was imposed on selected domestically produced and imported goods. Customs and tax administration have been strengthened: an anti-smuggling task force was created, a master file of large taxpayers was established, and three tax departments were merged into two units. 1.17 As a result of these measures, tax revenue increased from 2.3 percent of GDP in 1991 to 6.2 percent in 1995.3 The 1996 budget is based on tax revenue collections of 7.1 percent of GDP, reflecting the full-year effect of the tax measures adopted in October 1995 and improvements in tax administration. Non-tax revenue has been important, yielding 2.7 percent of GDP in 1995 (up from 2.1 percent in 1991).4 Fees on logging accounted for just under 40 percent of this; other major sources were posts and telecommunications (about a quarter) and royalties (a little more than 10 percent). Revenues from log exports will be reduced in 1996 because of a log export ban imposed on May 1, 1995. 1.18 While further consolidating the efforts recently made, more fundamental revenue reform is needed. Cambodia's tax ratio is only half of the 12 to 13 percent average for all low-income countries.5 Low levels of collection reflect a narrowly based and inelastic tax system and low tax rates on income and expenditures. Revenues from consumption and income taxes amounted to only 1.6 percent of GDP in 1995 compared with an average of about 7 percent for all low-income countries. The heavy reliance on trade taxes -- especially taxation of re-exports -- makes the tax system inelastic and vulnerable to external shocks. Import duties represent about 70 percent of total tax revenue, of which about one-third comes from the taxation of re-exports to neighboring countries. 1.19 Over the medium term, the Government aims to achieve macroeconomic stability and growth, with 7 percent GDP growth, 5 percent inflation, and a significant reduction in poverty. This will require a substantial increase in domestic savings -- public savings in particular -- to avoid inflationary financing of the budget and to finance the required increase in domestic investment. Toward this end, the Government needs to implement a comprehensive tax reform with a view to broadening this tax base and enhancing the efficiency of taxation. (For the recommended direction of tax reform, see paras 3.7 - 3.12 in Chap. 3 and also Appendix I). Tax administration also needs to be strengthened. Recognizing the importance and urgency of tax reform, the Government is now preparing 3 Tax revenue increased substantially in 1994 due mainly to strong customs performance resulting from improvements in customs administration and a vigorous anti-smuggling campaign. However, tax revenue increased only slightly in 1995 due in part to a temporary delay of shipments by importers associated with the introduction of pre-shipment inspections in September. 4 Non-tax revenue in 1994 was boosted by a temporary lift of log export ban. 5 See Table I in Appendix 1.  -10- a comprehensive strategy for tax reform, including a phased implementation of future steps to begin in 1997.6 1.20 Protecting the revenue base from unwarranted exemptions is also important. In particular, tax incentives under the Investment Law, which was introduced in August 1994, are too generous by international standards and could result in a serious erosion of the future tax base for the following reasons: (i) the corporation tax rate is only 9 percent compared with 20 percent for domestic corporations; (ii) exemptions from the corporation tax last up to eight years, with a five-year loss carry-forward, and an exemption for profits reinvested; (iii) dividends, profits, or proceeds of investments are exempt from taxes; and (iv) there are selective import duty exemptions on capital goods and spare parts, intermediate goods, and raw materials. 1.21 Concessions for the exploitation of natural resources such as forestry, rubber, and oil and gas should be eva!uated in terms of their effect on environmental and resource sustainability and their longer-term implications for budget revenues. Concessions should be awarded competitively and the proceeds from the contracts should be transferred to the budget in a transparent and timely manner. Expenditures 1.22 The adoption of the Budget Law in 1993 has allowed an improvement in expenditure management. It ensures ex ante as well as ex post review of expenditure by the Treasury, and provides a new nomenclature consistent with modern accounting and budgetary standards. Progress has since been made in establishing audit and inspection, Treasury cash management, accounting, and competitive bidding procedures. Further efforts will be made to improve internal monitoring and control during 1996. Financial controllers will be assigned to each ministry, and a system of direct payments by the Treasury for procurement over a specified amount by ministries will be established 1.23 Current expenditure has been stabilized at 10 to 11 percent of GDP since 1994. Unfortunately, this has been achieved mainly by compressing civil administration -- operating expenses in particular -- while defense and security expenditures have not been brought under effective control. Defense expenditures remain extremely large, accounting for almost 60 percent of all current expenditures in 1994-95. 1.24 Defense and security expenditures substantially exceeded the targets in the initial budgets in both 1994 and 1995, absorbing 7 percent of GDP in 1994 and 6 percent in 1995. Defense outlays in these years reflected, in part, extrabudgetary expenditures financed through a supplier's credit contracted in 1994 for the purchase and repair of 6 The Government does not intend to introduce additional tax measures in 1996, in view of the political opposition to the introduction of two new tax measures effective October 1, 1995 and the imposition of a 1 percent service fee for the recently introduced pre-shipment inspection of imports.  -11- military equipment. The 1996 budget calls for a reduction of defense and security spending to 5 percent of GDP. 1.25 Salaries are the predominant item of current expenditure for civil administration, accounting for about a third of the total. The high share of salaries results in a squeezing of expenditure for operations and maintenance. Although the average salary level is only about US$20 per month (or below the subsistence level), the civil service wage bill is quite large. In an effort to contain the wage bill, the number of civil servants and civil service wages were not increased in 1995. The 1996 budget will keep the nominal wage bill at the same level as in 1995. Wage increases for the remaining employees will depend on the reduction in numbers during 1996. 1.26 The Government plans to cut the number of defense personnel from the current 125,000 to 85,000 by end-1997. The Government has also committed itself to reduce the number of civil servants by 10 percent in both 1996 and 1997. However, the Government recently indicated that it would not cut employees of "priority" sectors (i.e., education and health), representing a combined total of 92,000 workers, at least in 1996. This will make the reduction exercise extremely difficult, since it means that one-quarter of employees of non-priority sectors will have to be cut to meet the overall target of 10 percent in 1996. 1.27 Funding for operating expenditures and economic and social transfers is inadequate. This results in inefficient use of infrastructure investments and ineffective service delivery in social sectors such as health and education. Education and health accounted for only 6.6 percent and 4.1 percent, respectively of total budgetary expenditure. The issue is not only the low shares, but the composition as well. For example, in 1994 only 7 percent of total expenditure for education went for capital outlays, such as construction of schools, and only 11 percent for operations and materials, such as textbooks, while 80 percent was absorbed by teachers' salaries. 1.28 Almost the entire capital expenditure is financed by external aid. Externally- financed investment has been concentrated on transport (22 percent of total) and area/rural development (21 percent) followed by education (13 percent), agriculture (12 percent), health (10 percent), social development (10 percent), and energy (8 percent). Funding for local currency counterpart for externally-financed investment is liadequate, often resulting in delays in implementation. Funding for small-scale, socially-oriented, rural-based projects is also inadequate. C. MONETARY POLICY, INFLATION, AND EXCHANGE RATES 1.29 Financing of the budget by domestic money creation, which had been the cause of inflation, was virtually eliminated in 1994 and 1995, resulting in a sharp deceleration in inflation. The National Bank aims to continue strictly limiting monetary financing of the budget in 1996: in fact, the Central Bank Law clearly defines a legal limit to central bank financing of the budget excluding grants and proceeds from the sale of assets). The  -12- National Bank aims to limit the growth of liquidity to 20 percent in 1996, which would require continuing prudent limits on credit to the Government and public enterprises. 1.30 Banking system credit to the Government and public enterprises has been tightly controlled and this has permitted a substantial increase in net credit to the private sector. While credit to the Government and public enterprises doubled during 1991-95, credit to the private sector sharply increased by 30 times (see Table 1.5 and Figure 1.2). Accordingly, the share of credit to the private sector increased from 12 percent to 66 percent during 1991-95. Commercial bank credit is largely absorbed by trade financing -- the simplest and lowest risk form of bank lending. Lending to the commodity producing sectors, such as agriculture and industry, is much smaller. Monetary Policy 1.31 The high degree of dollarization, as well as the lack of effective instruments of monetary control, continues to hamper monetary policy. Because of this, fiscal policy is, and will be for some time, the key to macroeconomic stability. The introduction of larger denominations of bank notes should promote the use of domestic currency, and, with continued macroeconomic stability, riel holdings and riel deposits can be expected to increase over the medium term. Developing indirect instruments of monetary control is critical, if distortion-inducing credit controls are to be avoided. In this regard the National Bank intends to issue riel-denominated Treasury bills in an effort to assist in the management of riel liquidity and the maintenance of a market-determined interest rate. It plans to sell short-term bills to the commercial banks starting from mid-1996 and to issue Treasury bills to nonbank private sector savers at a later stage. While indirect monetary control instruments are further to be developed mechanisms for direct credit control, including bank by bank credit ceilings, will be needed in the transition period. Interest Rates 1.32 Until early 1994, the National Bank fixed minimum rates for commercial banks' riel deposits. However, in March 1995 lending and deposit rates were completely liberalized. Interest rates have been maintained positive in real terms, thanks in part to the deceleration in inflation. Although commercial banks will continue to set their rates freely, the National Bank will use Treasury bill operations to influence these rates in order to ensure that rates remain positive in real terms. It should be noted, however, that interest rates on riel instruments are not very significant, given the low use of riels. Price Movements 1.33 The rate of inflation decelerated from 112 percent in 1992 to 18 percent in 1994 and to 3.5 percent in 1995 as monetary financing of the budget deficit all but disappeared during the last two years. Recent stable exchange rates also contributed to the deceleration in inflation. Although price developments have been largely dictated by  -13- Table 1.5: Summary of Monetary Survey, 1991-95 1991 1992 1993 1994 1995 (Billions of Riels) Net Foreign Assets -1.7 24.2 101.9 390.8 537.6 Net Domestic Assets 80.7 223.9 225 59.2 114.7 Domestic Credit 87.6 267.3 355.4 386.3 444.2 Net Claims on Government 55.6 156.8 187.6 143.2 145.6 State Enterprises 22.1 11.7 6.2 6 4.8 Private Sector 9.9 98.8 161.6 237.1 293.7 Total Liquidity 79 248.1 326.9 450 652.3 O/w Foreign Currency Deposits 0.7 65.3 114.6 232.6 347.3 (Percentage Share of GDP) Net Foreign Assets -0.1 1.0 1.9 6.4 7.5 Net Domestic Assets 6.0 8.9 4.2 1.0 1.6 Domestic Credit 6.6 10.7 6.6 6.3 6.2 Net Claims on Govemment 4.2 6.3 3.5 2.3 2.0 State Enterprises 1.7 0.5 0.1 0.1 0.1 Private Sector 0.7 3.9 3.0 3.9 4.1 Total Liquidity 5.9 9.9 6.0 7.3 9.1 Source: National Bank of Cambodia. Figure 1.2: Domestic Credits Development Credit to the Govemrment and Liquidity Growth Boo T 500 . 20 1 400 e200 1991 1992 1993 1994 1995 -|- Net Claims on Government -0- Total LUquidity Composition of Domestic Credits 90% . 80% - -1-1 --- : 70% 80%