Cambodia - Economic Rehabilitation Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6542-KH REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED ECONOMIC REHABILITATION CREDIT IN AN AMOUNT EQUIVALENT TO SDR 25.4 MILLION TO THE KINGDOM OF CAMBODIA MAY 26, 1995 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EOUIVALENT (May 1995, official rate) Riel 2,300 = I US dollar WEIGHTS AND MEASURES Metric system ABBREVIATIONS ADB Asian Development Bank BCM Bureau of the Council of Ministers CDC Cambodian Development Council CG Consultative Group CIB Cambodian Investment Board CMEA Council of Mutual Economic Assistance ERC Economic Rehabilitation Credit ERP Emergency Rehabilitation Project ESAF Enhanced Structural Adjustment Facility ICB International Competitive Bidding ICORC International Committee for the Reconstruction of Cambodia IDA International Development Association IDF Institutional Development Fund IMF International Monetary Fund ITC Interministerial Technical Committee on Administrative Reform MEF Ministry of Economy and Finance PMU Project Management Unit PSD Private Sector Development SDR Special Drawing Right SSCS Secretariat of State for Civil Service STF Systemic Transformation Facility UNDP United Nations Development Programme FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY TABLE OF CONTENTS Page No. Credit and Project Summary ................................ I. THE ECONOMY . A. Recent Events . B. Financing Requirements. 4 II. THE GOVERNMENT'S ECONOMIC REFORM PROGRAM 6 A. Macroeconomic Policy. 6 B. Private Sector Development. 9 C. Administrative Reform .12 III. THE ECONOMIC REHABILITATION CREDIT . .15 A. Bank Assistance Strategy ..15 B. Project Objectives .15 C. Social Cost of the Reform Program .16 D. Credit Disbursement ..16 E. Procurement .17 F. Implementation Arrangements .17 G. Cofinancing ..17 H. Benefits and Risks ..18 IV. AGREEMENTS AND RECOMMENDATION .19 A. Agreements .19 B. Recommendation .19 ANNEXES ........................................... 21 1. Government Statement of Development Policy .21 II. Government Program: Selected Reform Measures 32 II[. List of Goods Eligible Under the Credit .33 APPENDIX TABLES Table l: Key Economic Indicators .34 Table 2: Summary of Budget Operations .35 Table 3: Summary of Balance of Payments .36 Table 4: Financing Requirements .36 ATTACHMENTS ....................................... 37 1. Timetable of Key Events ......................... 37 II. Status of Bank Group Operations .................... 38 This document has a restricted distribution and may be used by recipients only in the performance of their ofricial duties. Its contents may not otherwise be disclosed without World Bank authorization.   KINGDOM OF CAMBODIA ECONOMIC REHABILITATION CREDIT Credit and Project Summary Borrower: Kingdom of Cambodia. Beneficiary: Not applicable. Poverty: Not applicable. Amount: SDR 25.4 million (US$40 million equivalent). Terms: Standard IDA terms with a 40-year maturity, including 10 years of grace. Commitment Fee: 0.50 percent on undisbursed credit balances, beginning 60 days after signing, less any waiver. Financing Plan: IDA US$40 million equivalent. Net Present Value: Not applicable. Project Identification Number: KH-PA-4035 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be disclosed without World Bank authorization.   REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE KINGDOM OF CAMBODIA FOR AN ECONOMIC REHABILITATION PROGRAM 1. I submit for your approval the following report and recommendation on a proposed development credit to the Kingdom of Cambodia for SDR 25.4 million, the equivalent of US$40 million, on standard IDA terms, with maturity of 40 years, to help finance an Economic Rehabilitation Program. I. THE ECONOMY A. Recent Events Overview 2. After nearly 20 years of war, internal strife, social upheaval, and command economy, Cambodia has embarked on a rehabilitation and reconstruction program in its transition to a market economy. Until 1992, Cambodia carried out its reforms largely on its own. International support to the country resumed only after the October 1991 Paris Peace Accords and in response to the UN Secretary-General's appeal, that same year, to support Cambodia's urgent rehabilitation efforts. Immediately preceding and during the elections of May 1993 organized by the United Nations Transitional Authority in Cambodia (UNTAC), Cambodia's situation was dire. Since then, the political situation has stabilized and improved, although it remains fragile as a result of the delicate government coalition that has emerged from the elections, and the armed conflict in the northwestern part of the country between the Khmer Rouge dissidents and the Government Armed Forces. Seasoned observers believe that the political situation will continue to improve, provided strong diplomatic, security, and financial assistance from the international community continues. For some time to come, some of this support will continue to be of an emergency nature, with all the risks associated with that type of assistance. 3. Cambodia is receiving strong international support. Under the mandate carried out by UNTAC, US$1.72 billion was spent in an effort to bring basic security, stability, and democratic rule to the country. On security, Australia, France, and the United States are continuing to assist with the reform and rebuilding of the military. Regarding economic assistance, official donor pledges for Cambodia's rehabilitation cumulatively amount to more than US$2 billion to date. 4. The political and security situation notwithstanding, the Government has been able to make good progress in addressing the most pressing economic issues. In the early 1990s the economy was experiencing high inflation in the 150 percent range. The root source of this inflation was weak public finances, in particular a large fiscal deficit for which there was not adequate financing. The Government brought inflation down to moderate levels (31 percent in 1993 and 26 percent in 1994) and has an inflation target of 10 percent for 1995. The Cambodian economy has grown fairly well throughout this stabilization period. Real annual GDP growth was about 4 percent in 1993 and 1994. As shown in the table below, the Government's medium-term program aims for 7 percent growth in 1995 and 7.5 percent growth in 1996-97. To finance Cambodia's development, both public and private savings need to rise from the current low levels; gradual improvement in savings is reflected in the  - 2 - medium-term projections. In addition, Cambodia requires strong external support. In the immediate future the country needs quick-disbursing balance of payments and budget support. The need for this emergency support will diminish and eventually disappear as the current budget deficit is gradually eliminated. It is further anticipated that disbursements from project loans will gradually build up so that the mix of ODA will shift from quick-disbursing to project support (see paras. 13 - 16). Major Macroeconomnic Indicators 1993 1994 1995 1996 1997 GDP Growth (%) 4.1 4.0 7.0 7.5 7.5 Current Revenue/GDP (%) 5.2 9.2 8.1 8.5 9.2 Current Expenditure/GDP (%) 6.7 10.5 9.8 9.4 9.4 Current Budget Deficit/GDP (%) a/ -1.5 -0.7 -1.5 -0.7 0.0 Overall Budget Deficit/GDP (%) a/ -5.9 -6.0 -7.8 -7.1 -6.6 Investment/GDP (%) 14.5 19.5 22.0 22.5 23.0 Gross National Savings/GDP (%) 8.2 5.5 7.2 7.6 9.4 Current Account Deficit/GDP (%) -6.3 -14.0 -14.8 -14.9 -13.5 a/ Cash basis. Recent Policy Changes 5. In 1979, after the defeat of the Democratic Kampuchea (Khmer Rouge) regime and a change of government, reforms began, albeit still within an overall context of central planning. It was not until 1985 that a process of market-oriented liberalization was initiated, with some private sector activities sanctioned, joint ventures allowed, and most price controls lifted. The reform process was broadened and accelerated from 1989. The key reform measure was the restoration of private property ownership in 1989, which resulted in the abandonment of collective production in non-plantation agriculture. In addition, the role of prices in the economic allocation system changed and all prices were brought closer to international prices. In 1989 the Government launched a reform program that gave state enterprises greater autonomy and strict budget constraints; allowed for the privatization of state enterprises and other state assets; and encouraged foreign and local private investment. While part of the state enterprise sector was being leased or sold, the remaining part was reduced in importance by the much more rapid growth of the emerging private sector. Foreign investors have bought or leased most of the privatized enterprises, most of which are medium-scale industrial ventures. Until recently, licenses were required for all imports and exports. In September 1993, the general licensing requirement was eliminated for most goods in which trade is undertaken by registered companies. Owing to low customs duties and weak enforcement, Cambodia became a hub of sorts for transit trade in the region. As a result of the above measures, the economic environment began to improve at the beginning of the 1990s. In both 1991 and 1992, there was a moderate strengthening of  the balance of payments reflecting some increase in exports together with, in 1992, higher private remittances, foreign direct investment, and service receipts. 6. Although the initial results of the market-oriented reforms had been globally positive, these reforms had yet to yield their full benefits on the internal and external balance when the Royal Government was established. The main reasons for this were military strife, political and financial instability, and numerous bottlenecks. Also, the transition from a command economy to an open market system had not been well coordinated. A clear government policy had been missing, as well as a trained civil service with a recognized tradition of public service and an established code of conduct. Equally essential to the transition, but clearly missing, was a fully functioning and effective legal framework attuned to the needs of a private enterprise system. Cambodia's macroeconomic situation was still characterized by major imbalances (fiscal deficit, high inflation, trade and current account deficits) as the aggregate demand for resources exceeded the resources available internally or obtainable from abroad. In the various production and infrastructure sectors, most of the difficulties were a combination of structural deficiencies and the effects of budgetary difficulties. Following 20 years of war and dislocation, Cambodia's human resources had been severely depleted; in all sectors, the limited number of qualified and trained personnel was a critical constraint to rehabilitation. Security concerns and the widespread presence of mines also hampered the recovery process considerably in key sectors, especially in agriculture. 7. In September 1993, following the free elections of May 1993 and three months of an interim government, the Royal Government of Cambodia was established. The Government called on the Bank and the IMF to help strengthen and develop the reform program. With respect to capacity building and emergency assistance, the Bank responded by providing technical assistance through an IDF grant and by extending a US$62.7 million credit to finance an Emergency Rehabilitation Project (ERP). The ERP's main objectives have been to: (i) allow for essential repairs and rehabilitation in infrastructure, agriculture, and social sectors; and (ii) provide budget support through the counterpart funds generated by the Credit. The IMF provided assistance through a Systemic Transformation Facility (STF). In this context, together with the IMF, the Bank negotiated a Policy Framework Paper (PFP) with the Government on the basis of which the IMF approved a three-year Enhanced Structural Adjustment Facility (ESAF) arrangement of SDR 84 million in May 1994 in support of the Government's stabilization program for the period 1994-96.' Recent Performance 8. Overall macroeconomic performance during 1994 was good despite adverse events, including severe flooding followed by drought when the monsoon rains ended prematurely (see Table 1 in the Appendix). As a result, output growth in 1994 is estimated at 4 percent because of slower increases in agricultural production (rice in particular: as much as 300,000 tons may have been lost due to the combined effect of flooding and drought). 9. With regard to budgetary policy, the Government is implementing all of the key measures discussed during PFP negotiations, albeit some partially (the summary of the budget is presented in Appendix Table 2). During the first part of 1994, budget revenue performance exceeded the initial target as a result of strong customs performance and unexpected receipts from the export of forestry products. While total expenditure was kept at a manageable level during the first part of the year, the situation changed significantly in the second part of the year. Expenditure picked up sharply, especially in defense and security. As regards external financing, the inflow of budget support was The ESAF arrangement replaced the STF arrangement.  lower than expected: during the first three quarters, only half of the US$63 million envisaged in the budget had been received at the Treasury; this reflected slower than anticipated disbursements by bilateral donors together with difficulties in realizing the cash equivalent of commodity aid. However, as a result of the adjustments taken in response to these budgetary developments, the Government was able to meet its targets under the ESAF program. The current deficit was limited to 0.7 percent of GDP (compared with 1.9 percent envisaged in the original budget). Similarly, the overall deficit was limited to 6.0 percent of GDP (compared with the original target of 6.7 percent). 10. With regard to monetary policy, the Government is maintaining tight limits on bank financing of the budget and the public enterprise sector, a key objective agreed during PFP negotiations. Minimum reserve requirements for commercial bank deposits were introduced in December 1993, along with a system of penalties to ensure compliance with the obligatory bank reserves. As a result, the Government was able to contain inflationary pressures while ensuring sufficient availability of credit for the private sector.2 In addition, efforts to transform Cambodia's banking system into a modern two-tier banking system have continued. At the same time, the National Bank moved closer to the use of indirect policy instruments. As a step in this direction, interest rates were freed, except for deposit rates which cannot be set below a rate specified by the National Bank. HI. With regard to trade and exchange rate policy, the Government continued to follow a market-oriented exchange rate policy with a view to unifying the official and parallel exchange rates. To help carry out this policy, the Government instituted a foreign exchange auction system managed by the National Bank. The first auction took place in September 1993. Since early 1994, the spread between the official and free market exchange rates has been kept to no more than 2 percent (less than 1 percent since July 1994). With regard to trade policy, as a result of measures taken before or in the course of 1994, the following situation applies: (i) the import license system has been abolished, with the exception of fire arms and pharmaceutical products; (ii) quantitative import restrictions have now all been eliminated; (iii) export licenses are no longer required, except for rice, logs, sawn timber, precious metals and stones, and antiquities3; and (iv) the following items are exempt from import duties: school materials and equipment, pharmaceutical products, sporting goods, and agricultural equipment and inputs. 12. As part of its foreign investment policy, the Government passed a new, liberal investment law in 1994. The main goal of this law is to streamline the foreign investment regime and provide fiscal incentives to potential investors. However, the Government has yet to prepare the law's implementing regulations. B. Financing Requirements 13. Cambodia requires donor financing for two main activities: to support the investment program and to meet the budgetary deficit. Table 4 shows external financing requirements for 1995 and 1996 based on balance of payments projections (Table 3). The balance of payments outlook assumes a reasonably stable political environment and continued implementation of a strategy aimed at macroeconomic stability, rehabilitation, and reintegration into the world economy. Export growth is projected to reach 11 percent in 1997 (after a likely decline in 1995-96 associated with a re-imposition 2 Inflation was being contained until the second part of the year when it rose as a result of higher food prices caused by the floods. 3 The Government has announced that it will end the ban on rice exports in November 1995.  of the ban on log exports). This growth would reflect increases in non-traditional exports, spurred by foreign investment. Export growth would be complemented by increases in receipts from tourism and private transfers. After their sharp rise in 1994, partly because of improved statistical coverage, imports would increase in dollar terms by about 6 percent annually to accommodate the requirements of the public investment program. The external current account deficit is expected to widen to 15 percent in 1995 and 1996 (from 14 percent in 1994) and then to narrow thereafter. 14. Prospects for foreign assistance are broadly favorable. A significant pipeline of multilateral and bilateral project assistance already exists. As a result of the mid-year floods and the subsequent rice crop losses, the Government is receiving additional food aid to compensate for the losses. Over time, private capital inflows are expected to make up an increasing share of Cambodia's external financing, as foreign direct investment grows in response to the maintenance of stability and implementation of reforms. Gross foreign reserves of the National Bank would increase to 2.9 months of imports by 1996 (2.4 months in 1995) from 1.7 months of imports in 1994, which would provide an adequate cushion against external shocks. In 1995, as reflected in Table 4, Cambodia is expected to benefit from a major rescheduling of its outstanding external debt from the pre-1991 period. Thereafter, external debt relative to GDP is projected to stabilize at just below 25 percent. Since virtually all of this debt would be contracted on concessional terms, the debt service ratio (on accrual basis) would be within a manageable level of about 18 percent. Current payments falling due on pre-1975 debt are assumed to be covered by debt relief or additional financing flows. 15. With regard to commoditv/budget aid, it is estimated that about US$75 million will be required for 1995. Of this, a prospective US$20 million will come from past commitments of Japan, the United Kingdom, France, the ADB, Germany, and the World Bank. The rest, about US$55 million, is expected to be financed by additional commitments made by donors at the March 1995 International Committee for the Reconstruction of Cambodia (ICORC) meeting. The proposed IDA credit would be part of this financing. For 1996, the requirements are expected to be lower (about US$64 million); they are to be financed, in part, by past commitments to which new commitments will have to be added (see para. 17). 16. With regard to public investments the Bank has examined the Government's 1994-96 Priority Investment Program and determined the amount of project aid flow necessary to support public investment in each of the three years (see Table 4). These estimates show that disbursements from pledges made at past donor conferences (including the Bank's own indications) would be sufficient to cover public investment requirements provided donors were willing to make some shifts in allocations toward higher priority projects and emerging needs. 17. For these reallocations to take place the coordination of aid must be improved. The three ICORC meetings have been successful at bringing Cambodia's problems and needs to the attention of the international community. The meetings, however, have not substituted for normal aid coordination sessions that would focus primarily on economic and technical, rather than political, aspects of development. The participants of the March 1995 ICORC meeting recognized this shortcoming and have agreed that a Consultative Group for Cambodia should be organized and should meet on a regular basis. The first CG meeting is likely to be held in 1996, in time to review the financing of Cambodia's budget and investment requirements for the second half of 1996 and beyond.  - 6 - II. THE GOVERNMENT'S ECONOMIC REFORM PROGRAM 18. The Government's reform program is described in its Policy Framework Paper. During the preparation of this operation, the Government has provided additional details of its intentions during 1995 and 1996. These are indicated in the Government's Statement of Development Policy, which lays out the broad policy direction (see Annex I, and Annex II for a summary matrix of key measures). The TA Project under implementation is aimed at strengthening capacity to carry out these structural measures. The Government's intended reforms fall into three broad areas of macroeconomic policy, private sector development, and administrative reform. A. Macroeconomic Policy 19. The Government's strategy for 1995-97 is to maintain macroeconomic stability, to push forward the process of reconstruction, and to continue putting in place the building blocks for a liberal market economy. The key elements are (i) continued fiscal restraint, backed by transparent budget procedures; (ii) an expanding public investment program aimed at reconstruction, supported by aid financing; (iii) a conservative monetary policy; (iv) structural reforms in the financial sector, trade and exchange systems, and civil service and public enterprises; and (v) normalization of relations with the international financial community. 20. In line with the PFP objectives, the Government's macroeconomic objectives for 1995 are to achieve output growth of 7 percent, inflation of 10 percent, and an increase in the gross reserves of the National Bank to 2.4 months of imports of goods and services by the end of 1995. As a result of fiscal restraint, national saving would amount to a projected 7.2 percent of GDP in 1995. With investment projected to increase to 22 percent of GDP, the external current account deficit would rise to 14.8 percent of GDP. The bulk of the current account deficit would be financed on concessional terms. Budgetary Policy 21. In 1995, the budget situation will remain very tight. The Government has adopted a budget fraVlework that rests on a considerable revenue effort and continuing restraint on spending, while it strictly limits bank financing of the budget. The maintenance of budgetary balance will depend on: (i) a subs antial increase in customs duties on petrol by adjusting both the dutiable value and the custoI<s duty to a more realistic level; (ii) the maintenance of tariff customs rates at the same 1994 levels; (iii) the strengthening of the domestic and customs collection administrations; (iv) no net increase in the number of civil servants and no increase in civil service salaries; and (v) the containment of defense spending. 22; Q For 1995 a current deficit of 1.5 percent of GDP is forecast (as compared withW0.7 percent in 1994). The overall deficit is projected to be 7.8 percent of GDP (compared with 6 percent in 1994). Net domestic bank financing is to be limited to 0.2 percent of GDP. To realize this objective, the Government requires US$75 million of external budget support and commodity aid, and US$242 million of project aid (see paras. 15 - 17 and Appendix Table 4). 23. While achieving the targets envisaged in the 1995 budget is feasible, it will require, above all, strong political will and discipline in addition to the continued firm implementation of fiscal reform. As regards resource mobilization, domestic taxation administration will be further  - 7 - strengthened, especially in facilitating collection procedures, customs administration, and anti- smuggling efforts. The new revenue measures to be implemented with the 1995 budget would raise the equivalent of 0.4 percent of GDP, mostly from customs revenue. The main new revenue measure will be an increase in the tariff rate on gasoline from 45 percent to 50 percent and an increase in the official dutiable value (from US$200 per metric ton to US$275). On the non tax revenue side, no revenue from log exports is assumed as a result of the reimposition of the ban. Also, strong efforts in the area of tax reform are urgently needed: without tax reform the shift from external budget support to domestic public savings in meeting budgetary requirements would not be possible. Hence, in 1995, the Government intends to adopt a revised agenda and timetable for tax reform. 24. While current expenditure in 1994 was kept under control, defense expenditure could not be contained at the level envisaged in the revised budget. The Government realizes that strong, concrete measures will be required to control defense expenditure in the future. In this regard, the Government has started implementing the military reform announced in August 1994. The plan is intended to reduce the size of the armed forces from the current 132,000 to 80,000 during 1995-97. In line with measures adopted in the context of the 1995 Budget Law, the MEF will assign financial controllers to the Ministry of Defense. The MEF will help the Ministry of Defense prepare procurement expenses and will pay expenses directly to the suppliers. The Ministry of Defense is one of four pilot ministries' in which such procedures will be enforced in 1995. These procedures are expected to be extended to all ministries in 1996. Once this operation has been tested, and once it is shown that the expenditure control measures can be enforced, the Government could commit itself to specific expenditure reduction targets. The Government also intends to reduce the size of the civil service by 20 percent by 1997 (see para. 53). 25. Although the Government has made considerable headway in establishing a more modern and appropriate budget and accounting system under the Budget Law, there is much to be done with respect to consolidating system changes, especially in the line ministries and in provinces, since the reforms to date have been largely limited to the Ministry of Economy and Finance (MEF), namely: (i) strengthening the budget preparation capacity of the MEF, the technical ministries, and the provinces; (ii) strengthening public investment budgeting and management, including budget monitoring and control mechanisms; (iii) strengthening Treasury cash management functions; and (iv) training administrators of the technical ministries and provinces to understand and apply the new procedures and training treasurers to understand the new expenditure and accounting system. The Government intends to carry out this program during 1995-96 with substantial donor-financed technical assistance. 26. Achieving the targets envisaged in the 1995 budget will require technical assistance from the World Bank, the IMF, and other donors. The Bank TA Project will provide support aiming at: (i) strengthening the budget preparation capacity of MEF, technical ministries, and provinces; (ii) strengthening budget monitoring and control mechanisms; (iii) strengthening procurement procedures, including at the Ministry of Defense; (iv) strengthening Treasury cash management functions; and (v) training administrators of the technical ministries and provinces to understand and apply the budget procedures adopted for the first time in the context of the 1994 budget. Priorities for Public Investment 27. The degree of success of the Government's reconstruction program and the rate at which it is implemented depend heavily on improving investment programming at the national level. To 4 The Ministry of Education, the Ministry of Health, and the Ministry of Foreign Affairs are the other three.  - 8 - properly mobilize the resources needed to sustain the recovery process, it is necessary that the various government agencies work together to establish investment priorities for the relevant sectors and identify investment and budget requirements. In this context, the Government is taking the necessary steps to build up its capacity for policy formulation, macroeconomic analysis, and aid coordination. Through the Technical Assistance Project, the Bank is assisting the Government in these areas. Also, the Government has proposed a Priority Investment Program (1994-96) which the Bank has reviewed in connection with donor aid coordination meetings in 1994 and 1995. The six priority areas of the Investment Program are: agriculture and rural development; transport; energy; water supply; health; and education.5 Monetary Policy and Financial Sector Reform 28. Over the period 1995-96, the Government envisages the development of financial programming, a more active use of interest rate policy, the development of new instruments of monetary policy, and the introduction of broader financial sector reforms. Monetary policy in 1995 will aim at curbing the acceleration of inflation that occurred during the second half of 1994. A significant decline in liquidity growth to 20 percent will be targeted during 1995 from the 33 percent estimated during 1994. The growth of the net domestic assets of the banking system would be consistent with this rate of monetary growth and projected balance of payments developments. The increase in net credit to the Government from the banking system during 1995 will be limited to 0.2 percent of GDP, while, on an aggregate basis, bank lending to nonfinancial public enterprises will also be limited. This tight fiscal position should permit a significant increase to take place in commercial bank credit to the private sector. 29. The key element of monetary control remains the maintenance of a tight fiscal position to check bank financing of the budget. However, the transition toward a more market-oriented monetary policy -- through the use of reserve requirements, purchases and sales of foreign currency, and interest rate flexibility -- is under way. Efforts to develop other instruments of monetary policy will continue. Banks will be allowed to set interest rates freely. 30. The central bank also intends to put in place a system of bank supervision that would address the recent proliferation of commercial banks in Cambodia. As a step toward this goal, a Bank Supervision Commission was created in October 1993. The National Bank has already revamped the licensing procedures for commercial banks in order to ensure that the new licenses will be issued only to banks with an adequate capital base and a sound managerial record. Licenses granted to banks that have not yet commenced operations have been withdrawn. The National Bank's banking supervision function will be strengthened with the introduction of prudential ratios, loan classification and provisioning guidelines, and adequate procedures for the review and examination of banks' returns and for on-site inspection of their operations. In this context - and to complement the central banking law which is expected to take effect from July 1995 -- a new financial institutions law has been prepared. It includes provisions for bank licensing, supervision and liquidation of financial institutions, conduct of 5 The 1994-96 Priority Investment Program, together with appropriate sectoral policy measures and the macroeconomic framework adopted by the government in the course of negotiating the PFP and preparing the ESAF arrangement, are described in the World Bank 1994 economic report to the International Committee on the Reconstruction of Cambodia, ICORC (Report No. 12667, February 1994). In its 1995 Report to ICORC (Report No. 13965, February 1995), the Bank focussed on the main issues and bottlenecks that affected the implementation of Cambodia's rehabilitation program in 1994 and considered the prospects for 1995 and 1996.  - 9 - securities activities, and documentation of credit activities. This second law will be presented to the National Assembly by September 1995. 31. The Government is planning to carry out a currency reform in 1995-96. The reform, launched in March 1995, consists of issuing new banknotes in larger denominations than currently available and minting coins in the same denominations as the banknotes currently in circulation. This currency reform is expected to encourage a shift from the use of foreign currency to riels, thereby enhancing the effectiveness of monetary policy. 32. As in other macroeconomic sub-sectors, these reforms are being undertaken in the context of a substantial technical assistance effort. For example, in the area of banking, technical assistance provided under a UNDP/IMF project focuses on further consolidating the financial sector by: (i) completing the division of responsibilities between the central and commercial banking layers; (ii) promoting competition among commercial banks to improve efficiency in financial intermediation; (iii) developing the National Bank into an independent central bank with strong policy and supervisory capabilities; and (iv) developing the tools for a more market-oriented approach to monetary policy. International Trade Policy 33. Today virtually all quantitative import restrictions have been eliminated and very few export restrictions remain; some are to be lifted in 1995 (namely, rice). This has paved the way for the Government to develop a policy for industrial development and to mobilize resources for it. The development of Cambodia's industrial policy will have to be carried out in line with the liberal trade policy that has apparently now been firmly established. Issues such as export promotion will have to be considered in this context. The Government will require specialized technical assistance to help in developing these policies. Foreign Debt Policy 34. As part of the normalization of its relations with the international financial community, the Government has been seeking a regularization of its outstanding external debt from the pre-1991 period. The Government has requested the Paris Club to proceed with the rescheduling of the pre-1975 external debt to OECD countries. In January 1995, Cambodia was offered new, improved debt relief terms which would allow up to a two-thirds writeoff of the debt stock. This accord is expected to be confirmed during 1995; the Government is expecting US$239 million to be rescheduled in 1995 (see Table 4). Regarding ruble claims by former Council for Mutual Economic Assistance (CMEA) countries, the Government has initiated discussions with those countries in order to resolve these claims. The Bank TA Project will assist in: (i) developing the institutional and legal framework for the management of Cambodia's public external debt, and (ii) establishing the new debt office in the MEF. This program will include assisting the Government in preparing for debt rescheduling negotiations and building capacity for debt reporting to the World Bank. B. Private Sector Development 35. The Cambodian Govermnent fully realizes that the complex task of reconstruction and development cannot be achieved through an exclusive reliance on public enterprises or other public entities and that the potential of the private sector should be harnessed more fully to meet the development needs of Cambodian society and to reduce poverty. New investments are required in all productive sectors of the economy. Reliable data on the private sector are not available, owing to the lack of systematic enterprise registration, reporting, and surveys. Yet in Phnom Penh and other urban  - 10 - centers, the mushrooming of dynamic private businesses is evident, in particular in construction, commerce, cottage industries, and miscellaneous services. Privatization 36. In 1989 the administration launched a broad reform program which gave state owned enterprises (SOEs) greater autonomy and strict budget constraints; allowed for the privatization of SOEs and other state assets; and encouraged foreign and local private investment. Privatization made gains in speed and scope that were unprecedented in the region, but this was largely "spontaneous," with limited transparency; and private business began to develop speculatively in commerce, construction, and tourism. To date, leasing accounts for more than half of the privatization operations under the main ministries. 37. The Government realizes that privatization (that is, the sale of state assets to the private sector) is potentially one of the ways of augmenting the role of the private sector. However, the limited capacity and resources of the private sector in Cambodia, the weakness of the banking sector, the absence of capital markets, political sensitivity to the sale of public enterprises to foreign private interests, opposition to divestiture by the bureaucracy, and the limited governmental capacity to negotiate privatization deals effectively are among the major factors accounting for the limited results of the first privatization program. 38. To remedy this situation, the Government has recently adopted a position paper on privatization providing broad guidelines on the basis of which the divestiture program will be carried out. - This paper, and the policy documents and the accompanying legal dispositions that will follow, will provide the policy and legal frameworks that were missing in the first privatization program. In addition, the Government will conduct a diagnosis of enterprises slated to remain in the public sector, with a view to implementing individual rehabilitation programs in line with the following guidelines: (i) the elimination of budgetary transfers; (ii) no credit by the National Bank; and (iii) quantitative limits on the availability of credit from the commercial banks. Other measures to rehabilitate the public enterprise sector include the establishment of a new legal framework for SOEs. Such a framework would clarify relations between SOEs and the state with a view to identifying the responsibilities and obligations of both sides. Under this framework, ministries would no longer undertake commercial activities, either directly or indirectly, and the autonomy of SOEs would be ensured. 39. The first piece of legislation of this framework is now being prepared with a view to having it adopted by the Council of Ministers by July 1995 and passed by the National Assembly before the end of the year. Also, in 1995 the Government will offer KAMPEXIM (trading company) and CKC (petroleum company) for sale. The list of companies to be privatized will be prepared in 1995. The Bank TA Project is financing the services of an international expert to help the Government carry out its PE reform and privatization program and will provide resources to finance audits of major PEs as a guide for further action. The Legal Environment 40. Given the recent history of Cambodia, the country's existing legal and regulatory framework in general, and its capacity to enforce existing laws and regulations in particular, is exceedingly weak. Although today there does exist a body of law, however imprecise, and much on-going preparation of new laws and regulations aimed at completing and improving the existing legal framework, the evolution of the State to one in which the rule of law prevails is severely hampered by at least three significant obstacles. Firstly, the crises which Cambodia has experienced since 1970 have resulted in the destruction of much of what was the prevailing legal system, including underlying  - 11 - institutions. The Khmer Rouge regime of the late 1970s simply abolished all recourse to law. Secondly, there exists a very significant lack of resources, whether in financial, physical, or human terms. For example, the salaries of magistrates are below basic subsistence levels and courtrooms, especially those in provincial centers, typically lack basic security, filing cabinets and desks, telephones and typewriters, and even writing paper. In addition, there is a gross shortage of qualified personnel with the capacity to make any legal system operate properly. Thirdly, the present imperfections in the political system often impact adversely on the program of legislative reforms. The sharing of executive power by opposing political parties, which is reflected in each Ministry, naturally generates obstacles and a politicized senior bureaucracy and thus results in a lack of coordinated legislative programs. 41. The legal environment specifically for business and investments is deficient. Only a few relevant laws have been passed, including the investment law passed by the National Assembly in August 1994. Many other critical areas of commercial and business laws (for example, property, companies, associations, contracts, dispute settlement, bankruptcy, mortgages, insurance, labor, accounting, and mining) are absent. These gaps in the legal framework have adverse motivational effects on entrepreneurs and potential investors; they also affect the implementation of donor-financed programs. For existing laws, transparent implementation regulations are scarce and are not easily accessible. Most regulations (including those on taxes, land, and foreign investment) are thus negotiable on the enterprise level, and private business is not, on the whole, governed by the rule of law. The secure establishment of private companies, which would require the provision of limited liability, the recognition of the private ownership of property, the transfer of assets and other forms of collateral, and a reasonably free access to land, is not adequately provided for. This state of affairs fosters non-transparency and insecurity. 42. The Government's medium-term program to develop a suitable enabling environment for the development of private sector activities includes, among others: enactment of economic and financial laws, including provisions for bankruptcy; enactment of implementing regulations to the investment law which was enacted in August 1994; streamlining the foreign investment regime and ensuring that the twin objectives of fiscal revenue and external competitiveness are served; adoption of legislation to implement the provisions of the MIGA and ICSID conventions, with a view to providing security for foreign investors; organization of the CDC's Cambodian Investment Board (CIB) as a "one-stop" service agency to provide information, assistance and administrative services to prospective investors, whether domestic or foreign. The Institutional Environment 43. Public Sector Organizations. An important component of a supportive institutional framework is the capacity of the country's public agencies, both economic and financial, to plan and implement the policies, laws, and regulations affecting the private sector. An exclusive focus on policy reforms as a means of achieving private sector development (PSD) is an inadequate approach, given the Cambodian realities. For example, where market power is a problem, the Government may need to play a regulatory role. Public agencies will be required in some cases to monitor and assist the process of PSD. Regulatory agencies (monopoly commissions, departments of company law, industrial licensing agencies, etc.) and developmental and promotional agencies (CDC as a one-stop investment promotion center, commercial banks, trade development agencies, industrial extension bureaus, etc.) are examples of such public organizations. 44. There is considerable risk that, although policies may be well conceived, there will be poor implementation by public agencies. The concern is that the weakness of the public sector will make required compliance burdensome and will render the many services to be provided to businesses by the Government inadequate. Although the new investment law frees Cambodia of most of the  - 12 - unnecessary bureaucratic requirements that usually hamper the private sector, government agencies will need to be strengthened, particularly the CDC which has primary responsibility for implementing the new law. In the absence of the investment law's implementing regulations, the CDC is being entrusted with considerable discretionary powers. Furthermore, the information and advice required by private entrepreneurs to respond to opportunities and constraints in the economy are not yet readily available. 45. These are reasons why the Government intends to pay attention to the adequacy of the policy and regulatory framework and the capacity and incentives of the public institutions relevant to PSD. With regard to strengthening the CDC, UNDP, the World Bank, and the ADB will provide some of the support needed by the Government. 46. Private Sector Organizations. In Cambodia, apart from NGOs, the private sector is not organized, which makes it difficult for its members to have any positive influence on government policies and the institutional environment relevant to them. The Cambodian Government welcomes a well-organized private sector and encourages collective endeavors that may take several forms, including: (i) representative organizations such as chambers of commerce and small industry associations; (ii) professional associations that uphold standards and educate their members (for example, associations of accountants, auditors, lawyers, engineers, and managers); and (iii) resource mobilizing and allocating bodies, such as stock exchanges and private financial institutions. TA Support 47. The TA Project will focus on assisting Cambodia to develop certain fundamental elements of a suitable enabling legal environment for the development of private sector activities. The principal objectives will be to: (i) assist in the re-establishment and strengthening of certain key legal institutional capacities and procedures which are required for developing the economic and financial legal framework necessary for private sector development in Cambodia; and (ii) provide the Government with the assistance of qualified legal advisers. The PSD component of the Project will provide legal advisory services, training and related equipment for implementing the following principal activities: (i) preparing a diagnostic study to determine the progress and status of development to date of Cambodia's economic and financial laws, and Cambodia's medium-term economic and financial legal reform priority agenda; (ii) carrying out a comprehensive legal training needs assessment; (iii) formulating, on the basis of the findings and recommendations of the legal diagnostic study and the training needs assessment, a time-based master plan which clearly sets out the specific economic and financial legal priority drafting and training measures to be implemented under the Project; and (iv) re-enforcing the Government's official procedures for publishing, on a regular basis, Cambodia's Official Journal in the Khmer, French and English languages. C. Administrative Reform Background 48. Cambodia's public administration suffers from a severe shortage of skills owing to the elimination and emigration of the educated during the 1970s and the subsequent isolation from external aid, as well as the inadequacy of middle management skills resulting from a total lack of formal education during the 1970s. In addition, the administration retains a number of organizational features inherited from a command economy's concept of the state role. These features are not consistent with the country's current requirements, which are aimed at producing the maximum results possible with the limited means available. The size of the administration (close to 150,000 civil servants, or about 1.7 percent of the population -- or 3.5 percent when security forces are added) is much larger than public management norms recommend, which leads to duplication and conflict of assignments within  - 13 - the administration and is the root cause of current overstaffing. If the actual required number of civil servants is kept at 1 percent of the population (a ratio more in line with world standards), the civil service would need to be downsized by about 50,000 employees. 49. The burden of government service on the country's budget is high. The combined civilian and military wage bill accounts for close to 50 percent of the recurrent budget and crowds out other operational expenditures. However, the average pay received by the civil servants (US$20 to US$30 per month) is quite low compared with the wage levels in the private sector labor market and the monthly income (US$150) needed for decent living. This situation is at the root of the extremely low professional commitment and motivation today. 50. At present, the organization of the civil service subsumes all categories of state personnel within a single system: the various branches of the administration, the state-owned enterprises, the political parties, the mass organizations, and the trade unions. In addition, the civil service suffers from a number of organizational deficiencies which account for its inefficiency. There is no real personnel management system nor is there a coherent body of rules or statutory regulations establishing the rights and responsibilities of civil servants or laying down guidelines in areas such as recruitment, training, career development, performance appraisal and promotion, and service discipline. The existing systems of classification and career development, as well as the salary structure, do not provide motivation for better performance among civil servants; neither do the latter help maintain the high levels of professionalism, morale, and integrity needed for efficiency, and effectiveness. The recruitment system is not based on merit but is highly politicized. There is no system of establishment control for the creation of government posts, nor is there a procedure under which recruitment could take place only for budgeted positions. The result is that appointments can be made at any time and on considerations not related to merit or requirements of the job. The size of the administration also increases coordination requirements, slows decision-making, and dilutes the authority of the state when it is confronted with endemic implementation problems. Government Program 51. The Government is committed to reform the public service and to take the drastic measures that will accompany this reform in order to increase its capacity and thereby improve its effectiveness and efficiency. Publicly, and at the highest levels, the Government has announced its determination to reduce the number of civil servants. Since 1993, the Government has been preparing a wide-ranging administrative reform program with the technical support of UNDP. In 1994, the Government officially approved the program in a policy document. To give it the required political support, the program has been placed under the authority of the Council of Ministers. It has been organized around the following five general thrusts. Restructuring the Public Sector. Rationalization of the organization of the Government; redefinition of the mandates and responsibilities of the various ministries and agencies; legal reforms to provide an appropriate legal framework for public sector activities; codification of texts and re-establishment of the Official Journal; judicial reforms. Strengthening the Management of Line Ministries. Administrative simplification, rationalization and standardization of procedures; creation of information systems; intensive training of senior managers; improvement of responsiveness to public needs and enhanced service delivery. The program will be started in pilot ministries and then will be adapted as needed for the rest of the Government.  - 14 - Reforming Civil Service Management. Establishment of control over the civil service by controlling recruitment and other personnel movements, carrying out a census, eliminating irregularities, establishing a reliable data base and a payroll system; development of a strategy for reducing the size of the civil service through departure programs and the provision of packages; preparation of detailed ministerial staffing plans and matching of posts and individuals; provision of a functioning personnel management system for the Government; reforming of key systems and functions: career management, remuneration, evaluation, training, and the pension plan. Developing Human Resources for the Public Sector. Identification of training needs and development of a training policy; setting up of an administrative training center; implementation of the program. Strengthening Provincial Administration. Establishment of the legal framework, including the definition of the rights and responsibilities of the different jurisdictions and the legal status of provincial personnel; capacity building in the Ministry of the Interior and in three pilot provinces. 1 52. The Government administrative reform is ambitious, broad in scope, and is scheduled to last several years. The Government is preparing to implement the program. It is identifying priority requirements with the help of the skills and resources currently available. The following agencies will play a leading role in preparing and implementing the administrative reform: the Council of Ministers, the Bureau of the Council of Ministers (BCM), and the Council's Interministerial Technical Commission for Administrative Reform (ITC); and the State Secretariat for the Civil Service (SSCS). The BCM is the key body for administrative monitoring and coordination. The SSCS has only a staff of 68 and currently shares personnel management responsibilities with the Ministry of Planning and the operational ministries. The ITC's day-today operations are run by its Executive Secretariat, which is composed of 8 high-level staff; the Secretariat has overall responsibility for the design, implementation, and evaluation of the public administration reform program. 53. As part of the program, the Government intends to reduce the size of the civil service by 20 percent by 1997 (down from the present number of 144,000). As a first step, there will be no net increase in the number of civil servants during 1995. In order to ensure control over hiring, the Government will establish a system requiring that the Ministry of Economy and Finance and the Secretariat of State for Civil Service countersign documents (called visas) before ministries or agencies hire new staff. Furthermore, no increase in civil service salaries will take place. As a second step, the Government conducted a head count of all civil servants on February 7, 1995, which enabled the Government to identify some of the so-called "ghosts" and other anomalies in the payroll files. This step will be followed later in 1995 by an actual census of the civil service. 54. The Government is enlisting the support of donors for the detailed preparation and subsequent urgent implementation of administrative reform program components. UNDP, the Bank, the European Union, France, Australia, and New Zealand have indicated their intention of support. Under the TA Project, the Bank's contribution will be to help the Government prepare a strategy to reduce the number of staff in the civil service. The preparation of personnel departure schemes will be carried out in parallel with the strengthening of the government capacity to implement the civil service reform program once the study phase is over. Following the study phase under the TA Project, the Government would implement the departure schemes, possibly to be supported under a follow-up adjustment operation.  - 15 - III. THE ECONOMIC REHABILITATION CREDIT A. Bank Assistance Strategy 55. The Bank's assistance strategy has been fully articulated in the Country Assistance Strategy (CAS) for Cambodia (Report No. 14465-KH, May 10, 1995). The strategy is directed at restoring growth, reducing poverty, and supporting the country's transition to a market economy. Key elements in the Bank's program to implement this strategy are support for: (a) augmenting government capacity for policy formulation, public investment programming, and institutional reforms; (b) restoring economic and social infrastructure; and (c) strengthening aid coordination to help guide the international aid effort to the most effective areas. 56. The Economic Rehabilitation Credit (ERC) is a key component of the Bank's strategy for Cambodia. In addition to this operation, the Bank will address: capacity building through the Technical Assistance Project (FY95); social services needs through a Social Fund Project (FY95); needs in infrastructure through the Phnom Penh Power Rehabilitation Project (FY96) and the Infrastructure Rehabilitation Project (FY97); and needs in agriculture through the Agriculture Productivity and Rural Development Project (FY97). 57. During the preparation of this operation, the Government has issued a Statement of Development Policy (see Annex I) which outlines the reform program ("the Program") that the Government intends to implement during 1995 and 1996. This Statement is in line with the PFP; it focusses on macroeconomic policy, private sector development, and administrative reform, as detailed in the previous section. 58. Given (i) the important reform measures already taken or being pursued under the Government's program, (ii) the continuing need for balance of payments support, (iii) the steps taken by the Government and donors to facilitate faster disbursements; and (iv) the fact that funds from the ERP are expected to be fully disbursed or committed by June 30, 1995, continued Bank involvement in supporting Cambodia's rehabilitation efforts is needed, hence the ERC. The ERC will provide continued balance of payments support as a follow-up to the ERP and help the Government through 1995 and the first part of 1996. This will allow time for the efforts of other donors to improve disbursements to bear fruit and assure a balanced contribution among donors over the 1994-96 period. The Bank's financing will help avoid an economic relapse and prevent the financial effort made so far by the international community from going to waste. The ERC is a single tranche operation with the release of funds not tied to specific tranche release conditions. However, the Bank will monitor the Program set forth in the Statement of Development Policy during 1995-96. This rehabilitation credit is an intermediate step between the emergency credit and structural adjustment lending. B. Project Objectives 59. The overall objective of this operation is to assist Cambodia's recovery and its continued transition to a market economy. The Credit of SDR 25.4 million (US$40 million equivalent) will finance general imports of goods to meet part of Cambodia's short-term external financing requirements. Both private and public sector imports will be eligible for financing, subject to a positive  - 16 - list. Eligible goods are listed in Annex 111; they include raw materials, manufactured goods, equipments, spare parts, and building materials. Counterpart funds generated by the Credit will be utilized in budgets agreed with the Government in the context of the PFP negotiations and directed toward priority investments that have been evaluated by the Bank in preparation for donor coordination meetings in 1994 and 1995. These funds will make it possible for the Government to: (i) increase public expenditures on health, education, and other social programs; (ii) fully finance the Government's counterpart contribution to development projects; and (iii) finance priority investments carried out by the Government, without donor assistance, in the provinces. C. Social Cost of the Reform Program 60. The ERC will make it possible for the Governrment to increase public expenditure on health, education, and other social programs. A viable poverty reduction strategy in Cambodia should first focus on promoting wide-ranging economic development by providing greater employment and income generating opportunities. This strategy should aim at stimulating informal socio-economic networks, including small enterprise development, and not replacing them with expensive and ultimately unsustainable transfer programs that place a heavy burden on the official budget. Nonetheless, identifying appropriate actions to protect and support essential expenditures during the interim transitional phase of fiscal stabilization and economic transformation is critical. It can go some way to containing social and political tensions. This is the objective that the Social Fund Project (Report No. P-6620-KH, May 11, 1995) will help accomplish; the project will provide poor rural families with short-term employment opportunities in local construction activities (health and education facilities, water supply, small bridges, etc.) and restore local services and economic activities dependent on such infrastructure. Also, a Poverty Assessment will commence in FY96; it will provide important insights for the health and education sectors, as well as for rural development strategies. D. Credit Disbursement 61. Credit disbursement will be made on the basis of 100 percent of foreign expenditures for imported goods to be provided under the project. Retroactive financing up to SDR 5.1 million (US$8 million equivalent) will be provided to reimburse expenditures for eligible imports incurred after March 1, 1995. Disbursements will be administered by the Ministry of Economy and Finance. For goods valued at less than US$3 million equivalent, the simplified document procedures for adjustment operations will be followed. For such contracts, each valued at less than US$3 million, IDA will reimburse the Borrower on the basis of Statements of Expenditures (SOEs) prepared from the customs certificates showing that eligible goods at least equal in value to the amount requested from IDA had been imported into the country during the period under consideration. The customs certificates will be retained by the MEF for review by supervision missions and for subsequent audit by the external auditors. For contracts each valued at US$3 million equivalent or more, IDA will reimburse the Borrower against full documentation: contracts, supplier invoices, date of importation. Withdrawal applications will be consolidated in amounts of at least US$1 million. Goods already financed by another IDA Credit or grant, or by other development assistance funds will not be eligible for financing under the Credit. The Credit is expected to be disbursed over a period of one year. The closing date will be June 30, 1997.  - 17 - E. Procurement 62. All procurement of goods under the project will be in conformity with the new World Bank Procurement Guidelines (January 1995). The basic principles for procurement of goods under the Credit are outlined below. (a) The imported goods will have to be in one of the categories in the positive list (Annex 111). (b) For large contracts valued at US$3 million equivalent or more each, ICB procedures will be followed; such contracts will be subject to prior review. (c) For contracts valued at less than US$3 million equivalent: (i) public sector entities will be required to follow the Borrower's public procurement procedures, provided that such procedures shall have been found acceptable to IDA; and (ii) private sector firms will be required to follow shopping procedures in accordance with the Guidelines, and for procurement for proprietary items, direct contracting may be used. Such contracts will be subject to post review. (d) No financing will be available under the Credit for contracts valued at less than US$50,000 equivalent. F. Implementation Arrangements 63. To ensure an efficient and timely implementation of the project, the Project Management Unit (PMU) established under the TA Project will serve as the implementation unit for the ERC. Accordingly, its mandate has been extended by ministerial decision. The experience gained by the local staff under the TA and Emergency Rehabilitation projects will benefit the management of the ERC. The main responsibilities of the PMU will be as follows: (a) to collect the documents necessary for Credit disbursement and ensure that the invoices are eligible for financing under the Credit; (b) to ensure that procurement is carried out in accordance with the provisions of the Development Credit Agreement and IDA's Procurement Guidelines; (c) to maintain project records and accounts; and (d) to prepare and submit quarterly progress reports to IDA. G. Cofinancing 64. Sweden (SIDA) has expressed an interest in providing grant financing in parallel with this Credit. The grant would also be disbursed against a positive list and would not be tied to exports of a specific country.  - 18 - H. Beneflts and Risks 65. Benefits. The ERC will help the Government maintain its rehabilitation and reform efforts in these difficult times of nation rebuilding. Specifically, the operation will help maintain the momentum gained with the ERP and contribute to an international aid effort directed at restoring essential economic and social services to speed economic recovery and increase social welfare. The Bank's evaluation of the Government's Priority Investment Program has found that program to be a well-focussed effort directed at key areas in agriculture/rural development, transportation, energy, water, health, and education. In addition, this operation, together with the TA Credit, provides support to the Government's efforts to strengthen capacity and to improve performance in macroeconomic management, private sector development, and administrative reform. 66. Risks. The main risk involves the fragile political and security situation in Cambodia. All Cambodian political factions participated in the May 1993 elections except the PDK (Khmer Rouge). Following the elections and three months of an interim government, a national government was established in September 1993 within a framework of parliamentary democracy, under a new constitution, with a constitutional monarch as head of state. The government comprises a coalition between the royalist party (FUNCINPEC), the former communist governing party (CPP), and a smaller religious party (BLDP). The Government has two Prime Ministers -- First Prime Minister Prince Norodom Ranariddh from FUNCINPEC and Second Prime Minister Hun Sen from CPP -- and each ministry is led by a minister from one major party with a vice minister from the other. This arrangement is undoubtedly a source of tension, but even the most critical observers admit that, in spite of the periodic complications, cooperation between the coalition partners remains workable, owing partly to the apparently good relationship between the two prime ministers and partly to the unifying influence of King Sihanouk. 67. The Khmer Rouge insurgents are expected to continue to stage operations with a view toward getting publicity and, ultimately, being asked to join the Government. Foreign diplomats discount the prospect of the Khmer Rouge returning to power by military means, but they also see no prospect for the Government decisively defeating the guerrillas in the present state of readiness of the Royal Army. The Government, with the assistance of a number of bilateral donors, is preparing a reorganization program for the military, with the aim of creating a leaner and more efficient organization. Nevertheless, in the unlikely event that a situation would arise in which it would be improbable that the agreed program could be carried out, the Association would have the right to suspend disbursements.  - 19 - IV. AGREEMENTS REACHED AND RECOMMENDATION A. Agreements 68. The Government's Statement of Development Policy which the authorities have prepared is annexed to this report in order to affirm the type of economic reform program that the Government is implementing. The Statement reflects the ongoing dialogue with the Bank on economic and institutional reform. The Government will exchange views with the Bank on the progress achieved in carrying out the program; this exchange of views will take place on the basis of progress reports prepared by the Government. The PMU will be established and maintained with satisfactory staff and terms of reference. Furthermore, for all expenditures with respect to which withdrawals from the Credit Account will be made on the basis of SOEs, the Government will: (i) maintain records and separate accounts at the PMU reflecting such expenditures, and (ii) have these records and accounts audited by an independent auditor acceptable to the Bank within 6 months after the end of each fiscal year. B. Recommendation 69. I am satisfied that the proposed development credit would comply with the Articles of Agreement of IDA, and I recommend that the Executive Directors approve it. Richard H. Frank President ad interim Attachments Washington D.C. May 26, 1995   - 21 - Attachment 1 Cover Letter A[N[STRY OF ECONO'',kAND F[NANCE r7 FAX /PHONE ( 8552 .3779g KINGDOM. OF CAMD9OJA Naiion - Re!!gioa . Ki,.q Mr. Richard H. Frank May, 19, 1995 Acting President International Development Association 1818 H Street, N. W. Washington, D.C., 20433, U.S.A. Dear Mr. Frank, The attached Statement of Development Policy describes the Kingdom of Cambodia's economic reform program. We request the Intemational Development Association to assist in supporting this program with a Rehabilitation Credit in the amount of USD 40 million equivalent. It is our intention to implement the program described in the attached Statement in order to achieve economic recovery within a sustainable macroeconomic framework. We will osely monitor the progress the program and, where appropriate, we will review ary adjustments with the Association. ~ '~'~wnc ~ yours, Chhon Sr. Minister in charge of Rehabilitation and Development, Minister of Economy and Finance D 4S  - 22 - ANNEX I Page 1 of 10 STATEMENT OF DEVELOPMENT POLICY About Selected Areas of Economic reforms to be SuDported by an Economic Recoverv Credit Development Obiectives and Strate2ies: The Royal Government of Cambodia is commnitted to achieving a fair, equitable, just and peaceful society and, through accelerating the rate of economic growth, to raise the living standards of all Cambodians. The main elements of the Government's strategy are: achieving a full-fledged market economy; working with the private sector as a full partner in the rehabilitation and developm