Cambodia - Progress in recovery and reform

Report No. 16591-KH Cambodia Progress in Recovery and Reform June 2, 1997 Country Operations Division Country Department I East Asia ancl Pacific Region Document of the World Bank  CUJRRENCY EVALtJATIONS Currency Unit = Cambodian Riel AVERAGE VALUE OF USS1.00 IN 1994 1995 1996 late -May 1997 2,543 2,462 2,624 2,740 WEIGHTS AND MEASURES Metric System GOVERNMENT'S FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank AFTA - ASEAN Free Trade Area ASEAN - Association of South-East Asian Nations AusAID - Australian Agency for International Development BOT - Build-Operate-Transfer CDC - Council for Development of Cambodia CEPT - Common Effective Preferential Tariff CG - Consultative Group CMAC - Cambodian Mine Action Center COCMA - Central Company for Agricultural Materials CVAP - Cambodia Veterans Assistance Program EAC - Electricity Authority of Cambodia EDC - Electricite du Cambodge ESAF - Enhanced Structural Adjustment Facility EU - European Union FAO - Food and Agriculture Organization of the United Nations FDI - Foreign Direct Investment FIAS - Foreign Investment Advisory Service FTB - Foreign Trade Bank GDP - Gross Domestic Product GSP - General System of Preferences ICRC - International Commission for the Red Cross ICSID - Intemational Convention for the Settlement of Investment Disputes IDA - International Development Association IMF - International Monetary Fund IPP - Independent Power Producers MEF - Ministry of Economy and Finance MFN - Most Favored Nation MIGA - Multilateral Investment Guarantee Agency MOH - Ministry of Health MPWT - Ministry of Public Works and Transport NBC - National Bank of Cambodia NGO - Non-Governmental Organization O & M - Operations and Maintenance PFP - Policy Framework Paper PIP - Public Investment Program PPWSA - Phnom Penh Water Supply Authority RCAF - Royal Cambodian Armed Forces SOE - State-Owned Enterprise tlNDP - United Nations Development Programme tlNTAC - United Nations Transitional Authority in Cambodia VAT - Valued Added Tax WFP - World Food Programme WTO - World Trade Organization Vice President: Jean-Michel Severino, EAP Director: Javad Khalilzadeh-Shirazi, EAI Acting Division Chief: Sanjay Dhar, EAICO Task Manager: Su-Yong Song, EAICO  TABLE OF CONTENTS EXECUTIVE SUMMARY ..................................................... i I. INTRODUCTION .1 II. RECENT ECONOMIC DEVELOPMENTS. 3 A. Overview .3 B. Real Sector Developments. 3 C. Fiscal Developments and Policies. 5 D. Monetary Policy, Inflation, Exchange Rates, and Financial Sector Reform.7 E. External Sector Developments and Policies. 9 III. CHALLENGES FOR THE TRANSITION TOWARD SUSTAINABLE DEVELOPMENT .11 A. Enhancing Public Resource Mobilization ............................................. 11 B. Improving the Efficiency of Public Expenditure .................. ................ 19 C. Strengthening Institutional Capacity ..................................................... 25 IV. MEDIUM-TERM PROSPECTS, EXTERNAL FINANCING REQUIREMENTS, AND RISKS ..................................................... 28 Appendix I: Assessment of Public Investment ......................................... 33 LIST OF TABLES. FIGURES AND BOXES Tables 1. Key Macroeconomic Indicators. 4 2. Comparison of Revenue Efforts .12 3. Cambodia's Tax Revenue Structure in 1996 Compared with Selected Country Groups .13 4. Current Expenditure by Sector .20 5. Budgetary Expenditures by Functional and Sectoral Allocations 21 6. Projection of Main Macroeconomic Indicators .29 7. External Financing Requirements .31 8. Required Commitments of Offtcial Development Assistance 32 Al. PIP 1997-1999: Programmed Level Sector Allocation ...... ....... 42 Figures 1. GDP Growth by Sector .........................................5............ ..... 5 2. Budgetary Development .........................................6........... ..... 6 3. Money, Inflation and Exchange Rate ................................ .......... 8 1. Improving Enabling Environment for Private Sector Dc 3pment ..... 30 Statistical Appendix ......................................... .................... 43  ACKNOWLEDGEMENTS This report was prepared on the basis of an economic mission that visited Cambodia in March 1997. The report was prepared by Su-Yong Song (task manager), based on the contributions of Kyle Peters (policy issues), William Magrath (forestry issues), David Steedman (administrative reform), Nat Colletta (military demobilization), Mostafa El-Erian (legal reform), Christopher Redfem (agriculture and rural development), Christopher Chamberlin (health), Peter Moock (education), Enrique Crousillat (energy), Koji Kuroda (transport), Vijay Jagannathan (water supply) and Ky Tran (statistics). Contributions were also made by Michel Cardona, Luca Papi, and R. Natarajan. The peer reviewers were Tamar Manuelyan Atinc and Luis Serven. It was prepared under the guidance of William McCleary, Lead Economist of the East Asia Country Department I and Shahid Yusuf, Acting Lead Economist. The Director was Javad Khalilzadeh-Shirazi. 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 1997 and revised on the basis of these discussions.  EXECUTIVE SUMMARY (i) Following two decades of conflict, Cambodia has made significant progress in stabilizing the economy, in restoring economic growth, and also in undertaking policy reforms to transform the economy into a market-oriented one. Progress has been especially rapid since the formation of the Royal Government in 1993. Macroeconomic developments have been impressive: GDP expanded at an average annual of about 6 percent during 1991-95; inflation which averaged about 140 percent per annum in 1990-92 was reduced to 3.5 percent in 1995; and budgetary revenue as a share of GDP doubled (albeit from a low base) during 1991-95. Fiscal discipline has been instrumental in achieving macroeconomic stability. On policy reform, prices were freed up; a major customs reform and new tax measures were introduced; a two-tier banking system has been initiated; most non-tariff barriers have been eliminated and tariffs have been reduced and streamlined; and the exchange rate has been liberalized. These recent achievements have been supported by a high level of foreign aid disbursements. Nevertheless, they are remarkable when compared with the experiences of other post-conflict countries such as Angola or Mozambique. (ii) Even with these recent improvements in the economy's performance, Cambodia remains one of the poorest countries in Asia, with a per capita income estimated at US$300 in 1996. It is also estimated that 39 percent of the total population falls below the poverty line. Cambodia's social indicators compare unfavorably with other low-income countries: population growth rate (3 percent a year) is much higher than the average of 1.7 percent, the infant mortality rate at 110 per thousand is twice as high, life expectancy at 52 years is 10 years lower, and primary enrollment rate is 50 points lower. A. Recent Economic Developments (iii) Macroeconomic performance in 1996 continued to be largely favorable. Despite the adverse impact of floods, GDP growth is estimated at 6.5 percent. However, the floods did put pressure on food prices, which raised the annual inflation rate to 9 percent. The exchange rate remained broadly stable, and foreign investment flows continued to increase. Fiscal discipline continued to be the anchor for sustaining macroeconomic stability. Nevertheless, fiscal developments in 1996 repeated the pattern of the past two years: namely, civilian operating expenditures were compressed significantly to sustain macroeconomic stability because of a revenue shortfall compared with the budget target and an overrun in defense and security outlays. During the first four months of 1997, whereas defense and security outlays were contained well within the target, the pattern of a revenue shortfall and a compression of civilian non-wage operating outlays continued. (iv) Important progress also has been made in implementing policy reforms. The Government promulgated the Central Bank Law and the Public Enterprise Law. More recently, along with an ambitious 1997 budget, the Law on Taxation, which includes new revenue-enhancing measures as well as measures to strengthen tax enforcement laws and procedures, was also legislated. (v) Delays, however, have been encountered in implementing policy reforms in other critical areas. On fiscal reform, little progress has been made in addressing the problems associated with discretionary tax exemptions and key features of the Law on Taxation have yet to be fully implemented. Regarding administrative reform, the implementation of civil service reform has been set back due to the lack of a comprehensive strategy and new hiring. There have also been delays in the enactment of several critical economic and financial laws, in particular the Financial Institutions Law and the Commercial Code.  - ii - The implementing regulations for the Investment Law, which are critical to eliminating ad hoc tax exemptions, have also been long delayed. (vi) Recent achievements have also been threatened by insufficient accountability and transparency in some areas of economic management. In particular, the lack of action in implementing a sustainable and transparent forestry management policy and in channeling forestry revenues into the budget has posed serious concern on the prospects for sustainable development. The Government recently has taken certain positive actions in forestry management and public resource mobilization, and prepared the Policy Framework Paper for 1997-99, re-affirming its commitment to policy reform. (vii) On the political front, while there was a significant positive development in that some important elements of the Khmer Rouge defected to the Royal Government, political tensions between the two main coalition partners have recently escalated. Recent political developments have, in turn, contributed to delays in implementing necessary policy reforms, and sometimes to insufficient transparency and accountability in economic management. Preparations for the two elections--local elections in May 1998 and the national elections in November 1998--are underway. B. Challenges for the Transition toward Sustainable Development (viii) Recent economic growth largely reflected a recovery from the past, and also, the benefits of macroeconomic stability and economic liberalization. Cambodia is now at the crossroads. It must make a transition toward sustainable development as these initial gains will soon be exhausted. In order to reduce poverty significantly and enhance economic and social well-being, Cambodia must sustain rapid and broad-based economic growth over the long term. Three of the main challenges confronting the country in making the transition are a weak revenue effort, inefficient expenditure allocation, and weak institutional capacity. Enhancing public resource mobilization will be of utmost importance for maintaining macroeconomic stability and increasing domestic contributions to development expenditures for economic and social infrastructure. Improving the efficiency of public expenditures will be critical to re-directing expenditures toward the social sectors and rural development, and also enhancing the effectiveness of public investment. Strengthening institutional capacity will be key to effectively implementing economic reforms and development programs. Confronting these issues will be essential especially in that, while economic development will be largely private sector driven over the longer term, the public sector must play a catalytic role in providing enabling environment for private sector development for some years to come. Whether the country will be able to make a successful transition will depend on the political will and the Government's determined efforts in implementing the necessary reforms. 1. Enhancing Public Resource Mobilization (ix) Taxation. Government revenues as a share of GDP have doubled during the past 5 years, albeit from a very low base. Nevertheless, Cambodia's budget revenue-to-GDP ratio (at 9.1 percent in 1996) remains one of the lowest in the world. The Government took an important step in introducing a modern tax system and improving revenue performance with the adoption of the new Law on Taxation in February 1997. The Law on Taxation includes some important revenue-enhancing measures: levying turnover tax on the first sale after importation; broadening the coverage of excise duties; introducing taxes on interest and dividends; extending the coverage of the tax on salaries and reducing the current exemption threshold; introducing the withholding of taxes; and introducing a value-added tax for the largest taxpayers by January 1, 1998. The Law also includes strengthened tax rules and procedures. With the passing of the Law on Taxation, the main elements of a modern taxation system are being put  - iii - in place. The Government now needs to implement decisively the provisions of the Law on Taxation. The other remaining challenges are: (i) reducing the scope for generous tax and duty exemptions granted under the Law on Investment as well as ad hoc exemptions; (ii) strengthening the capacity to collect taxes; and (iii) improving control over non-tax revenue, from forestry in particular. (x) Tax Exemptions. Tax and duty exemptions erode the tax base. The majority of these come from the liberal exemptions granted under the Law on Investment. The Council of Ministers is currently reviewing the long-delayed implementing regulations for the Law on Investment, which will help limit the scope for ad hoc exemptions. The immediate challenge for the authorities is to ensure that the implementing regulations are adopted as proposed and strictly implemented, and that no new ad hoc exemptions are granted. Over the medium term, the authorities will need to review the overall investment incentive scheme, including the possibility of revising the Law on Investment, which has generous provisions compared to other countries. Ad hoc exemptions were granted for rubber exports and luxury automobile imports during 1996, due in part to a lack of clarity in the Law on Investment. While the exemptions for rubber and luxury automobiles were discontinued in 1997, additional exemptions have been granted, such as for forestry exports. Such ad hoc exemptions not only erode the tax base, but also raise concerns regarding transparency in economic management. (xi) Tax Administration. Although improvements have been made especially in on-site tax audits of the large taxpayers, tax and customs administrative capacity is still weak. The Law on Taxation, along with the implementing regulations for the Law on Investment, should strengthen the capacity of the tax authorities to enforce compliance with the tax laws. For the medium term, strong efforts are needed in the following areas: (i) training tax officials in accounting, assessment, auditing, dispute resolution, and the VAT; (ii) strengthening the systematic exchange of taxpayer information among the Customs Department, the Tax Department, and the CDC; and (iii) establishing a computerized data base for medium-size enterprises and extending the requirement of declaration based on simplified actual accounting to medium-size enterprises. (xii) Non-tax Revenue. While improvements have been made, the budgetary coverage of non-tax revenues remains incomplete, with some line ministries and other government entities continuing to collect revenues without control and supervision by the Ministry of Economy and Finance. To bring extrabudgetary revenues under budgetary control, the Government intends, as stated in the Policy Framework Paper, to issue an Order, giving the Minister of Economy and Finance control over all negotiations involving the national patrimony and requiring the Minister of Economy and Finance's signature on all such contracts. It is critical to swiftly issue such an Order. Over the medium term, it would also be essential to: (i) engage international audit firms for valuation; (ii) apply transparent and competitive procedures in awarding concessions for natural resource exploitation; and (iii) ensure the timely transfer of associated revenue to the budget. (xiii) Forestry Resource Management. Forests are Cambodia's most developmentally significant natural resources. The implementation of economically and environmentally sound forestry policies could generate some US$100 million a year in government revenue, equivalent to over one-third of budget revenue or over 3 percent of GDP in 1996. As discussed in the World Bank/UNDP/FAO Forest Policy Assessment Report, the mismanagement of forestry resources, however, has caused concerns: uncontrolled logging has led to rapid degradation that severely threatens Cambodia's forests; large concessions have been awarded, with unsustainably high harvesting intensity and royalties that account for about one-fifth of their economic value; and only a part of revenues from logging activities have been transferred to the national budget. In 1996, US$10.5 million (or one-tenth of potential revenue under economically and environmentally sound forestry policies) was collected from forestry  - lv - exploitation. After some delays, the Government has taken initial actions to regain control over logging activities and has reconfirmed its intention to pursue medium-term measures for a' sustainable exploitation of forestry resources. Progress in implementation of the necessary policy actions to date has, however, been mixed. The immediate necessary steps are: (i) to tighten supervision of border crossing points and ports; (ii) to proceed swiftly with the four technical assistance studies recommended by the World Bank/UNDP/FAO report; (iii) to secure adequate budget resources for the recently established Secretariat of the National Committee for Forest Policy; and (iv) to cease granting new concessions, harvesting licenses, and collection agreements until a transparent and competitive process is put in place. 2. Improving the Efficiency of Public Expenditure (xiv) Quality of Expenditure Policies. The Government has made significant progress in expenditure management since the adoption of the Budget Law in 1993, and has succeeded in containing current expenditures despite revenue shortfalls and overruns in defense and security expenditures, mainly through the compression in civilian non-wage O&M expenditures. This pattern of spending has not adversely affected economic growth significantly, as the nature of the recent growth was largely a recovery from the past. Over the longer term, however, it will be detrimental to economic growth and poverty reduction. Thus, while continued fiscal discipline is essential, the composition of spending needs to be changed to support development priorities. As indicated in the Policy Framework Paper, Government expenditures need to be redirected toward priority social sectors and economic infrastructure. The composition of O&M expenditures also needs to be shifted away from salaries toward materials and supplies. To achieve these objectives, the Government needs to: (i) strengthen the capacity to monitor and control budgetary expenditures through full implementation of the recently introduced measures such as the assignment of financial controllers, direct payment systems, and competitive bidding procedures; (ii) contain the military wage bill in spite of the need for the integration of former Khmer Rouge soldiers, limit non-wage operating outlays for defense and security through strengthened audits, and implement military demobilization; (iii) re-establish control over recruitment into the civil service and implement civil service reform; and (iv) carry out a Public Expenditure Review, with a view to providing a firmer basis for sectoral allocations and the adequacy of non-wage O&M allocations in the budget. (xv) Public Investment Program. Securing an adequate level of public investment, and, equally important, enhancing the efficiency of public investment are critical to Cambodia's long-term sustained development. While public investment has contributed significantly to the rehabilitation of Cambodia's devastated physical and social infrastructure, it has too often been donor-driven and sometimes lacking adequate provision for the associated recurrent expenditure needs. The Government has made some important progress toward improving public investment management, in particular, initiating the National Public Investment Management System and preparing a three-year rolling Public Investment Program (PIP) for 1996-98 and for 1997-99, to assist in determining both the appropriate priorities for public investments and recurrent expenditure requirements. The second PIP (1997-99) has made significant improvements over the first one, but there remain a number of weaknesses. To enhance the efficiency of the PIP, the Government needs to: (i) strengthen the capacity at the Ministry of Planning and line ministries in monitoring and implementing the program, especially through more effective use of TA; (ii) formulate the next PIP on the basis of the findings of the first two PIP implementation and a Public Expenditure Review; (iii) enhance coordination among various agencies, in particular, between the Ministry of Planning and the Ministry of Economy and Finance in estimating and allocating recurrent expenditures; and (iv) strengthen coordination with donors.  3. Strengthening Institutional Capacity (xvi) An important development priority is the need to strengthen the Government's capacity to implement its economic reforms and development programs. Without a strengthening of the Government's institutional capacity, its ability to deliver and manage the rural development and social sector programs necessary to reduce poverty and achieve broad-based growth will be limited. In addition to strengthening the human resource base, administrative and legal reform are key to building the institutional capacity necessary for achieving long-term development. This issue is closely linked to the two issues discussed above. For example, progress in civil service reform and military demobilization will have significant bearing on the allocation of government expenditures. (xvii) Administrative Reform. The Government has launched a broad and ambitious program of administrative reform. While progress has been made in certain elements of reform, the civil service renewal program has made little headway. While a number of studies and plans have been prepared, the civil service reform efforts have suffered from a lack of clear rationale, objectives, and targets and a lack of a political consensus within the Government. The Government has recently restated in the Policy Framework Paper its intention to exercise strict controls over the size of the civil service and to accelerate preparation for the reform. The Government aims to carry out the following measures, for which decisive and timely implementation will be critical to accelerating reform: (i) containing the number of civil servants at the present level or below by removing the already-identified list from the civil service rolls, by updating its data base to eliminate ghost workers and personnel with irregular status, and by strictly limiting new recruitments; (ii) presenting a prioritized program for civil service reform which reflects government objectives and implementation capacity; (iii) carrying out a civil service census to determine the experience, skill levels, and job profile of the existing civil service; and (iv) increasing political commitment to the civil service reform process and enhancing technical capacity. (xviii) Military Demobilization. The Government prepared a comprehensive military downsizing and rehabilitation program--the Cambodia Veterans Assistance Program (CVAP)--to be carried out in four phases over the medium term. A training program to build capacity for management, organization and program development, monitoring and evaluation, and financial management, and also preparation for a full registration of the RCAF are under way. The completion of the registration and the issuance of identity cards are now priority tasks as a basis for establishing the actual size of the Armed Forces and creating a transparent, monitorable system for identifying beneficiaries and accounting for benefits. In addition to finding sources of financing for the estimated cost of about US$72 million, the key constraints facing the program are political will within the Government and the creation of sustainable employment in the rural economy, to which the majority of the demobilized are likely to return. (xix) Legal Reform. Cambodia has made steady progress during the past few years in developing its legal and regulatory framework in the economic and financial areas, by adopting such laws as the Budget Law, the Law on Investment, the Central Bank Law, and the Law on Taxation. However, many critical business, economic, and financial laws, which are key elements of the enabling environment for private sector development, are still absent, and those that have been recently enacted have yet to be adequately enforced, which often creates security and governance problems. The medium-term objective of legal reform is twofold: re-establishment of the rule of law; and progressive development of a legal framework that facilitates commercial transactions, promotes private sector development, and stimulates national and foreign investment. Toward these objectives, in addition to rapidly adopting the long-delayed laws and regulations, in particular, the Financial Institutions Law, the remaining six laws of the complete Commercial Code, and the implementing regulations for the Law on Investment, the  - vi - Government will need to adopt the necessary implementing regulations, for example, for the Commercial Code. In parallel, the Government will need to develop the mechanisms, institutions, and human resources necessary to implement all manners of laws. Otherwise, the enactment of laws and regulations to support private sector development would have limited impact on Cambodia's economic development. C. Medium-term Prospects, External Financing Requirements, and Risks (xx) High Growth Scenario. The Cambodian economy will need to achieve high and sustainable economic growth if it is to significantly reduce poverty and enhance economic and social well-being, as envisaged in the Government's National Program to Rehabilitate and Develop Cambodia and Socio- Economic Development Plan. If the Government can implement a strong reform program as outlined in Section B as well as in the recent PFP, sustained high growth could be achieved. Under this scenario, there would be continued progress in consolidating macroeconomic stability, combined with an acceleration of economic reforms and the strengthening of institutional capacity. In turn, such policies would engender a high level of donor support, through official grants in the next several years and concessional loans. The continuation of economic reforms would also lead to continuing foreign investment. Under these assumptions, GDP would grow at 7-8 percent per annum, which is comparable to the growth rates achieved by several East Asian countries since the 1970s. Private sector would play a leading role in achieving this growth, with the public sector playing a supporting catalytic role by providing an improved enabling environment for private sector development. (xxi) External Financing Requirements. Under this scenario, even with an increase in private capital flows, disbursements of official assistance--grants and concessional loans--would need to be maintained at the 1996 level for 1997-99. This would require commitments of official assistance of about US$455 million per year during 1997-99, of which about US$60 million would be balance of payments/budget support. Official assistance would need to cover some recurrent expenditures (especially for civil service reform and military demobilization), domestic counterpart funds, and the foreign exchange costs of the public investment program. In the near term, there remains a need for some fast-disbursing assistance to help meet the costs of special programs and to close the balance of payments gap until the volume of project disbursements increases. (xxii) Downside Risks. Cambodia faces a number of risks and uncertainties. In the near term, the primary risk would be either a loss of fiscal discipline, due to an inadequate revenue effort, or delays in implementation of necessary economic reforms, especially in the period preceding the national elections. Over the medium term, the primary risk would stem from inadequate pace and depth of economic reforms necessary to place the economy on a sustainable growth path. Under this scenario, a loss of macroeconomic stability combined with little structural reform could lead to inflationary pressures resulting from domestic financing of the budget deficit, which would lead to price rises and balance of payments pressures. Moreover, inadequate investments in human capital because of continued weak revenue performance could pose a threat to future growth, once the gains from liberalization and relative stability have been exhausted. Such a situation could jeopardize the sustainability of development and, in turn, result in lower inflows of grants and concessional loans. Obviously, this would translate into lower growth. Another danger could be a further deterioration in the transparency of economic management. In particular, Cambodia's natural resources would be exploited in an unsustainable manner with inadequate resources accruing to the state. Should this persist for an extended period, a major source of growth for the Cambodian economy would be squandered and the economy's future prospects would be adversely affected.  I. INTRODUCTION 1. Following two decades of conflict, Cambodia has made significant progress in stabilizing the economy, in restoring economic growth, and also in undertaking policy reforms to transform the economy into a market-oriented one. Progress has been especially rapid since the formation of the Royal Government in 1993. Macroeconomic developments have been impressive: GDP expanded at an average annual of about 6 percent during 1991-95; inflation which averaged about 140 percent per annum in 1990-92 was reduced to 3.5 percent in 1995; and budgetary revenue as a share of GDP doubled (albeit from a low base) during 1991-95. Fiscal discipline has been instrumental in achieving macroeconomic stability. On policy reform, prices were freed up; a major customs reform and new tax measures were introduced; a two-tier banking system has been initiated; most non-tariff barriers have been eliminated and tariffs have been reduced and streamlined; and the exchange rate has been liberalized. These recent achievements have been supported by a high level of foreign aid disbursements. Nevertheless, they are remarkable when compared with the experiences of other post- conflict countries such as Angola or Mozambique. 2. Even with these recent improvements in the economy's performance, Cambodia remains one of the poorest countries in Asia, with a per capita income estimated at US$300 in 1996. It is also estimated that 39 percent of the total population falls below the poverty line. Cambodia's social indicators compare unfavorably with other low-income countries: population growth rate (3 percent a year) is much higher than the average of 1.7 percent, the infant mortality rate at 110 per thousand is twice as high, life expectancy at 52 years is 10 years lower, and primary enrollment rate at present is 50 points lower. 3. In 1996, macroeconomic performance continued to be largely favorable, with 6.5 percent GDP growth and 9 percent inflation (see Section 11). Progress also has been made in implementing policy reforms. The Government promulgated the Central Bank Law and the Public Enterprise Law. More recently, along with an ambitious 1997 budget, the Law on Taxation, which includes new revenue- enhancing measures as well as measures to strengthen tax enforcement laws and procedures, was also legislated. 4. Delays, however, have been encountered in implementing policy reforms in other critical areas. On fiscal reform, little progress has been made in addressing the problems associated with discretionary tax exemptions and key features of the Law on Taxation have yet to be fully implemented. Regarding administrative reform, the implementation of civil service reform has been set back due to the lack of a comprehensive strategy and new hiring. There have also been delays in the enactment of several critical economic and financial laws, in particular the Financial Institutions Law and the Commercial Code. The implementing regulations for the Investment Law, which are critical to eliminating ad hoc tax exemptions, have also been long delayed. 5. Recent achievements have also been threatened by insufficient accountability and transparency in some areas of economic management. In particular, the lack of action in implementing a sustainable and transparent forestry management policy and in channeling forestry revenues into the budget has posed serious concern on the prospects for sustainable development. After delays, the Government recently has taken initial actions to regain control over logging activities and to pursue medium-term measures for a sustainable exploitation of forestry resources.  - 2 - 6. On the political front, while there was a significant positive development in that some important elements of the Khmer Rouge defected to the Royal Government, political tensions between the two main coalition partners--the Funcinpec and the CPP--have recently escalated. Tensions started to escalate as both parties sought political allegiance from the defecting forces and they formed coalitions with smaller parties. More recently, the defection of some Funcinpec deputies has raised tensions. Recent political developments have, in turn, contributed to delays in implementing necessary policy reforms, and sometimes to insufficient transparency and accountability in economic management. Preparations for the two elections--local elections in May 1998 and the national elections in November 1998--are underway. 7. Recent economic growth largely reflected a recovery from the past, and also, the benefits of macroeconomic stability and economic liberalization. Cambodia is now at the crossroads. It must make a transition toward sustainable development as these initial gains will soon be exhausted. In order to reduce poverty significantly and enhance economic and social well-being, Cambodia must sustain rapid and broad-based economic growth over the long term. Three of the main challenges confronting the country in making the transition are a weak revenue effort, inefficient expenditure allocation, and weak institutional capacity. Enhancing public resource mobilization will be of utmost importance for maintaining maceoeconomic stability and increasing domestic contributions to development expenditures for economic and social infrastructure. Improving the efficiency of public expenditures will be critical to re-directing expenditures toward the social sectors and rural development, and also enhancing the effectiveness of public investment. Strengthening institutional capacity will be key to effectively implementing economic reforms and development programs. Meeting these challenges will be essential especially in that, while economic development will be largely private sector driven over the longer term, the public sector must play a catalytic role in providing enabling environment for private sector development for some years to come. 8. Whether the country will be able to make a successful transition will depend on the political will and the Government's determined efforts in implementing the necessary reforms. Recently, the Government has taken certain positive actions in this direction, such as the initial actions to improve forestry management and strengthen public resource mobilization. In addition, the Government has prepared a Policy Framework Paper for 1997-99, in collaboration with the IMF and the Bank, re- affirming its commitment to policy reform. But, implementing these policy commitments in a timely fashion and decisively will be critical to a successful transition. 9. The 1996 Country Economic Memorandum--From Recovery to Sustained Development-- reviewed developments in market reforms, stabilization, and growth; analyzed the situation in the enterprise and agriculture sectors; and identified an agenda for sustainable and broad-based development. The present report, which updates the 1996 report, assesses recent progress in macroeconomic and policy reform; analyzes the challenges that lie ahead to maintain macroeconomic stability and deepen the reform program; and sheds light on the prospects for the transition to sustainable development. Section II summarizes recent economic developments and discusses relevant policy issues. Section III evaluates progress made in policy reform and assesses the scope for further reform, as well as the constraints and prospects. It focuses on three of the main challenges for the transition toward sustainable development: (i) enhancing public resource mobilizatioft; (ii) improving public expenditure management; and (iii) strengthening institutional capacity. Section IV provides an macroeconomic outlook and associated external financing requirements.  - 3 - II. RECENT ECONOMIC DEVELOPMENTS A. Overview 10. Macroeconomic outcome in 1996 was broadly favorable (see Table 1). Despite the adverse impact of the floods, GDP growth for 1996 is estimated at 6.5 percent. The temporary upward pressure on food prices--as a result of the floods in September/October--raised the annual inflation rate to 9 percent. The exchange rate remained broadly stable, and foreign investment flows continued to increase. Fiscal discipline continued to be the anchor for sustaining macroeconomic stability, albeit through continued compression in civilian non-wage operating expenditures. 11. Economic developments during 1996 and early 1997 are discussed in depth below. Section B outlines developments in the real sector. Next, fiscal developments and the 1997 budget are discussed in Section C. This is followed by a discussion of monetary policy and developments in inflation and the exchange rate, as well as financial sector reform (Section D). It concludes in Section E with a discussion of external developments, external debt, and a brief review of trade policy. B. Real Sector Developments 12. GDP Growth. The weakness of the national accounts makes it difficult to assess developments in the real sector in Cambodia. Moreover, the large role of agriculture in the economy (almost a half of GDP) and the vulnerability of the sector to weather conditions also make it difficult to forecast trends. GDP expanded at an annual rate of about 6 percent over 1991-95 period. GDP growth remained high in 1996 at 6.5 percent despite the adverse impact on rice output of the floods in September/ October 1996 (see Figure 1). The benefits of growth, however, have not been spread throughout the society. Much of the growth has been driven by services and construction, concentrated in urban areas, especially in Phnom Penh. Growth in agriculture has been slower, and as a result, the gains in the living standards of rural populace--85 percent of the total population-- have been smaller. In 1996, agricultural growth was estimated at 1.8 percent, reflecting the estimated negative growth in rice output.' The slow growth in agriculture was offset by strong growth in industry (13.1 percent), especially in construction and garment manufacturing. Services also continued to expand at a robust rate of 8.8 percent, owing mainly to buoyant tourism. 13. Poverty Situation. According to a recent Bank report based on the Socio-Economic Survey, 39 percent of the total population in Cambodia live below the poverty line The main findings of the report are as follows. First, the highest incidence of poverty is found in the rural areas, with 43 percent estimated as poor, four times higher than the 11 percent poverty incidence found in Phnom Penh. Government policies and associated donor support to reduce poverty must, therefore, focus primarily on rural areas. Second, the highest poverty rate--46 percent--is found among people living in households headed by farmers. By contrast, households headed by someone working in the government are least The Ministry of Agriculture tentatively estimated that rice production in 1996 decreased by 1.7 percent. However, the FAO/WFP mission in February 1997 estimated 3.4 million tons of rice production for the 1996/97 season, 2 percent above the record harvest of the 1995/96 season and 35 percent higher than the average for the previous five years. 2 Cambodia: A Poverty Profile. 1993-94, World Bank, June 1996. It is important to note that survey limitations (about 35 percent of the population was not covered by the Socio-Economic Survey) prevent a systemic assessment of poverty on a national basis.  - 4 - Table 1: Key Macroeconomic Indicators 1991 1992 1993 1994 1995 1996 (Percentage Change) Real GDP 7.6 7.0 4.1 4.0 7.6 6.5 CPI (final quarter basis) 150.4 112.5 41.0 17.9 3.5 9.0 Domestic Liquidity 28.6 209.0 40.0 29.4 44.3 40.4 Net Credits to Government 22.9 141.8 5.6 -7.9 1.1 -3.1 Velocity of Money 21.8 16.3 19.6 15.4 13.7 10.5 (Million of US$! Export of Goods (US$, excluding re-export) 81 101 102 234 269 298 Import of Goods (US$, retained import) 113 160 305 499 673 749 Gross official reserves .. 30 71 100 182 234 (Months of import of goods and services) .. 1.0 1.8 1.4 1.5 2.1 (Percentage of GDP unless otherwise specified! Budget Revenue 4.4 6.2 5.4 9.6 8.9 9.1 Tax 2.3 4.4 4.3 5.9 6.2 6.5 Non-tax 2.1 1.8 1.0 3.7 2.7 2.6 Budget Expenditure 7.8 9.8 11.2 16.5 16.7 16.4 Current expenditure 7.4 9.5 6.9 11.0 9.6 9.9 Capital expenditure 0.4 0.3 4.3 5.5 7.1 6.5 Current budget deficit (cash basis, excl. grant) -3.0 -3.3 -1.5 -1.4 -0.6 -0.8 Overall budget deficit (cash basis, excl. grant) -3.4 -3.6 -5.9 -6.8 -7.7 -7.3 Domestic Investment 9.4 9.8 14.3 18.5 21.6 20.7 Government Investment 0.4 0.3 4.3 5.5 7.1 6.5 Non-government investment 9.0 9.5 10.0 13.0 14.5 14.2 Financing of Investment 9.4 9.8 14.3 18.5 21.6 20.7 National savings 7.9 7.3 5.9 4.4 5.4 5.1 Government savings -3.0 -3.3 -1.5 -1.4 -0.6 -0.8 Non-Government savings 10.9 10.6 7.4 5.8 6.0 5.9 Foreign savings 1.5 2.5 8.4 14.1 16.2 15.6 External Current Account Deficit (US$ millions) -25 -45 -40 -95 -131 -189 (in percent of GDP) -1.5 -2.5 -8.4 -14.1 -16.2 -15.6 Memorandum items: Nominal GDP (billions of Riels) 1,336 2,508 5,414 6,131 7,200 8,200 Official exchange rate (Riels/US$) 703 1,253 2,470 2,543 2,462 2,624 Source: Cambodian authorities.  - 5 - Figure 1: GDP Growth by Sector 168.0 o.4 10.0--- -2.0 1992 1 1994 1995 1996 -- Agriculture --Industry --- Services -Gross domestic product7 likely to be poor: in these occupations the poverty rate is only 20 percent. Clearly policies which aim at reducing poverty through enhancing income generating capacities should be targeted toward the agricultural sector. Third, Cambodians living in households with uneducated head are more likely to be poor, with a poverty rate of 47 percent. The prevalence of poverty among households in which the head had completed secondary education falls to around 30 percent. Raising educational attainment is clearly a high priority in order to improve living standards and reduce poverty. Fourth, It does not appear to be the case that female-headed households are generally more vulnerable to poverty than those headed by males: the incidence of poverty averages only 35 percent in female-headed households, compared to 40 percent in male-headed households. In this respect, gender and poverty patterns by household headship are similar to those observed in other East Asian countries such as Vietnam and Indonesia. Fifth, rural poverty in Cambodia (43 percent) is lower that its Indochina neighbors--Vietnam (47 percent) and Lao PDR (53 percent)--but considerably higher than elsewhere in East Asia, taking Indonesia as an example (24 percent). However, it must be borne in mind that rural poverty in Cambodia may have been underestimated by the exclusion of significant portions of the countryside from the survey. On the other hand, urban poverty appears to be slightly higher in Cambodia (24 percent) than its Indochina neighbors--Vietnam (20 percent) or Lao PDR (24 percent)--and much higher than Indonesia (10 percent). 14. The central goal of the Government's development program is the eventual eradication of Cambodia's widespread poverty. However, there is a lack of the necessary information to identify programs and policies to target the poor more effectively. Therefore, the Government is carrying out a multipurpose household survey designed to measure living standards at regular intervals. Information obtained from household surveys will be used to prepare poverty targeting programs. C. Fiscal Developments and Policies 15. Developments in 1996. Fiscal discipline continued to be the anchor for sustaining macroeconomic stability. The Government contained the budget deficit and prevented bank financing  - 6 - of the budget. Nevertheless, fiscal developments in 1996 repeated the pattern of the past two years: namely, civilian operating expenditures were compressed significantly to sustain macroeconomic stability because of a revenue shortfall compared with the budget target and an overrun in defense and security operating outlays. 16. On the revenue side, despite the implementation of new tax measures introduced in October 1995, as well as the initiation of pre-shipment import inspections, total budget revenue amounted to 9.1 percent of GDP compared with the budget target of 9.8 percent. It is noteworthy that the revenue-to- GDP ratio has been flat during the last two years after a significant improvement in 1994 (Figure 2). Figure 2: Budgetary Development 18T Curen deficital efci 6 42 2- 0 I--I--I--I 1991 1992 1993 1994 1995 1996 lo l-- Revenue -0-Current Expenditure -=-TtlExedtr 17. The main causes of the weak revenue effort were pervasive tax exemptions and a weak tax collection capacity. Tax exemptions granted to foreign investors under the Law on Investment, have eroded the tax base. Furthermore, additional ad hoc exemptions--granted on rubber and processed wood exports and on luxury automobile imports--exacerbated the situation. Although some progress has been made in strengthening tax collection capacity, tax collection capacity remains weak, exemplified by the fact that a recent tax audit of the largest enterprises identified substantial tax arrears, few of which have been collected to date. There were also shortfalls in collections of non-tax revenue, in part because the Ministry of Economy and Finance does not have sole responsibility for and control over contracts relating to the use of state assets. In particular, while log exports took place despite the ban imposed in April 1995, few revenues were transferred to the national budget. (For forestry revenue issues, see paras 55-60 in Section III.) 18. The Government continued to succeed in containing overall budgetary expenditures, accommodating revenue shortfalls. However, with an overrun in operating outlays for defense and security (by 0.4 percent of GDP compared with the budget allocation), budgetary expenditures have been contained almost exclusively through a compression of civilian non-wage expenditures. Outlays in priority social sectors have been hit particularly hard. Moreover, the redeployment of the budget away from civilian non-wage expenditures toward defense and security expenditures has often been non- transparent. Capital expenditures were financed almost entirely by external sources. The local currency counterpart for externally financed projects also continued to be used as a balancing item to contain the total level of expenditure.  - 7 - 19. Prospects for 1997. In the Policy Framework Paper, the Government recognizes that recent budgetary developments demonstrate the need for a significant and sustained improvement in revenue mobilization and also in the quality of fiscal adjustment. (Issues on public resource mobilization and public expenditure management are discussed in detail in Section III.) The 1997 budget represents an ambitious and bold attempt to meet these fiscal challenges. It aims to increase revenue by 0.6 percent of GDP; to reduce outlays for defense and security by 0.8 percent; to re-orient outlays toward social expenditures; and to achieve a small current budget surplus. 20. Achieving the envisaged targets will be challenging and will request decisive implementation of the new Law on Taxation, improved tax administration, and expenditure discipline. On the revenue side, while the Government adopted the Law on Taxation, which includes new revenue-enhancing measures as well as measures to strengthen tax enforcement laws and procedures, the enforcement of the Law is being delayed owing partly to the preparation of the associated regulations. Furthermore, the adoption of the long-delayed implementing regulations for the Law on Investment--which would help to eliminate the scope for ad hoc tax exemptions--is also delayed. On the expenditure side, costs related to provincial elections, relief for flood victims, the impact of further Khmer Rouge integrations into the Royal Cambodian Armed Forces (RCAF), and possible incorporation of political appointees hired in 1996 into the civil service payroll are not reflected in the budget, but they would need to be paid. (For details of administrative reform and military demobilization, see paras 74-84 in Section III.) Moreover, with the full implementation of the new accounting plan, payment orders can no longer be carried over into the next fiscal year.3 21. Budgetary developments during the first four months indicate that improving the revenue performance will be essential to maintaining macroeconomic stability and achieving budgetary priorities. While there may be some seasonality factors, total revenue collection amounted to 29 percent of yearly target (compared with the norm of 33 percent) due mainly to shortfalls in customs revenue. Whereas defense and security outlays were contained well within the target, non-wage operating outlays for civil administration have been squeezed to the bare minimum (7 percent of the budgetary allocation for the year). D. Monetary Policy, Inflation, Exchange Rates, and Financial Sector Reform 22. Monetary Policy, Inflation, and Exchange Rates. Cambodia's monetary system is characterized by a high degree of dollarization and cash transactions, limiting significantly the Government's scope for running an active and effective monetary policy. The use of the riel is confined to small transactions and wage payments by the Government. Most financial intermediation is conducted largely in foreign currency. The National Bank of Cambodia (NBC) is not using direct monetary instruments: interest rates are completely liberalized and there are no quantitative restrictions on bank lending. The development of indirect tools of monetary policy is at an early stage as reserve requirements and refinancing facilities were only recently introduced. Open market operations do not yet exist, but during 1997, the authorities are planning to issue Treasury bills in order to develop such tools, and create incentives for the market to invest in domestically denominated securities. Given the lack of instruments, the monetary authority has used foreign exchange interventions to regulate riel liquidity and to smoothen fluctuations in the exchange rate. Limitations on monetary financing of the budget deficit are used to control the creation of base money. 3 A substantial number of unpaid payment orders, amounting to CR 73 billion (or 0.9 percent of GDP) were carried over into 1997.  - 8 - 23. Broad money continued to grow at an accelerated pace in 1996, about 40 percent, only a slight drop from 44 percent in 1995.4 This rapid growth was mainly due to a continued sharp increase (57 percent) in foreign currency deposits, as a result of the establishment of new commercial banks, steady inflows of foreign direct investment, and a continued portfolio shift away from foreign currency in circulation. The growth rate in riel in circulation decelerated to 19 percent from 42 percent in 1995, indicating that the portfolio shift toward riel slowed down after the one-time shift with the introduction of larger denominations of riel notes in March 1995. The continued high growth rate in measured M2 did not, however, lead to a spur in inflation (see Figure 3). As prudent fiscal policy limited the need for the direct financing of the budget deficit, inflation was contained at 9 percent in 1996, despite the effect of the floods. Figure 3: Money, Inflation and Exchange Rate 100 80 1 60[ -t 400- 20 -2043 1994 1995 1996 -20' -0- CPI (final quarter basis) -X-Domestic Liquidity ---Exchange Rte 24. Cambodia has pursued a flexibly operated market-based exchange rate policy and has relied on tight financial policies to ensure stability in the foreign exchange market. Interventions in the foreign exchange market have been geared towards raising the level of international reserves and smoothening out fluctuations in the exchange rate. The exchange rate has been fairly stable and largely in line during 1996: the spread with parallel market rate has been maintained within 2 percent; and the depreciation against the dollar was 7.2 percent in nominal terms. 25. Financial Sector Reform. The financial sector in Cambodia essentially consists of the banking sector. In 1990, the NBC was created from the monobank and responsibility for public accounting was assumed by the Treasury. Two public banks, the Municipal Bank and the Foreign Trade Bank (FTB), took over NBC's commercial activities. Yet, the authorities have not completed the move to a two-tier banking system, e. g. the Governor of NBC is the Chief executive of the FTB. Moreover, NBC still holds minority shares in three joint-venture banks. Finally, 20 NBC branches continue to grant commercial credit. Besides the two public banks and three joint venture banks, there are seven foreign bank branches and 19 locally incorporated banks active in Cambodia. The banking sector is also characterized by a relatively high degree of concentration (at the end of December 1996, eight banks This should be interpreted with caution as foreign currency in circulation is not captured in the monetary survey.  - 9 - accounted for 86 percent of total deposits and seven banks accounted for 66 percent of outstanding loans) and a wide variation among the banks in the scale of activity (some of the smaller banks essentially extend no credit). The banks hold large amounts of foreign assets that are mostly placed with correspondent banks. The level of financial intermediation is low: total loans outstanding amounted to 4 percent of GDP in 1995. This can be compared with 19 percent in Vietnam. 26. The new Central Bank Law, promulgated in January 1996, represented an important step in establishing a modern legal framework for the financial system by giving the NBC the primary mandate of maintaining price stability and providing a number of monetary policy instruments. An immediate priority for the NBC is to strengthen its capacity, especially in the supervision of the commercial banks, as the nature of the operations of the commercial banks is not fully known. It is becoming more urgent as FDI inflows are increasing sharply. While the NBC made some progress in the strengthening of bank supervision with the reorganization of the department and the addition of new staff, the adoption of new reporting forms for commercial banks' off-site supervision and the initiation of on-site inspections, the proliferation of banks has placed a strain on scarce and generally weak bank supervision capacity. The NBC needs to ensure that its commitment to strengthening supervision capacity especially through conducting on-site inspections of eight commercial banks by end-1997 is realized. 27. In addition to the weak bank supervision, most of the prudential regulatory framework is not commensurate with the high risk environment in which banks in Cambodia operate and the accounting system is inadequate and not in line with international standards. Thus, reliable data to assess banks' solvency do not exist. While some of these deficiencies would be addressed by the long-delayed Financial Institutions Law, which will clarify the legal framework of the banking system and improve the framework for bank supervision, adequate prudential regulations need to be put in place over the medium term. 28. The Government also needs to complete the establishment of a two-tier system. The NBC has announced its intention to divest its interest in the three joint venture banks in the near term, and the Government is currently reviewing plans to separate the FTB from the NBC and to divest it. A full audit and a review of this bank which accounts for 19 percent of the banking system assets will be completed in 1997. The authorities are also considering steps to divest the remaining assets of Municipal Bank. E. External Sector Developments and Policies 29. Balance of Payments. Cambodia's balance of payments performance needs to be interpreted with caution in view of, among other factors, the estimated unrecorded (illegal) exports of log and sawn timber and rubber; the estimated imports destined for re-exports and tariff-exempt imports; and the estimated FDI based on a partial survey. 30. Domestic exports (i.e., excluding re-exports) increased by a robust rate of 11 percent in 1996, thanks to a sharp increase in General System of Preferences (GSP) exports (from U$27 million in 1995 to US$102 million in 1996), associated mostly with garments. Cambodia has obtained GSP status from 26 countries (with tariff free access to its counterparts, with markets in annual quotas) on selected  - 10- manufactured goods, particularly garments.5 While retained imports increased by 11 percent, due largely to imports under the Law on Investment, imports for re-exports declined sharply because of a sharp drop in gold imports. The current account deficit slightly narrowed to 15.6 percent of GDP. Official transfers declined by US$50 million compared with 1995, and medium and long-term loan inflows remained at the 1995 level. In contrast, FDI continued to increase rapidly, from US$80 million in 1994, to US$150 million in 1995, and further to US$240 million in 1997.6 31. Trade Regime. Cambodia's trade regime is relatively liberal. There are no quantitative restrictions on imports, and export bans apply only to unprocessed timber and sawn logs (but not processed wood products). The import tariff schedule has four dominant rates--7, 15, 35, and 50 percent--which covers some 93 percent of tariff lines. The unweighted average tariff rate was estimated at 18.5 percent (in 1995), with a rough estimate of the import weighted average of about 25.5 percent.7 Moderate export duties of 5-10 percent are applied to six products, including cut and sawn timber and rubber. 32. Cambodia is an observer in ASEAN and will become a full member in July 1997. As a member of ASEAN, Cambodia would participate in the ASEAN Free Trade Area (AFTA) and the Common Effective Preferential Tariff (CEPT). Cambodia currently holds an observer status in the World Trade Organization (WTO) and plans to apply for full membership in the near future. While the authorities are examining the possible effects of tariff changes, the potential effects of joining these two institutions--AFTA/CEPT and the Uruguay Round--have not been fully studied. In particular, the authorities urgently need to assess the implications of the CEPT in terms of budgetary, balance of payments, and structural implications. 33. External Debt. Cambodia is currently considered a "Severely Indebted Low Income Country." Some progress toward resolving Cambodia's external debt situation has been made. In 1995, Cambodia received highly concessional terms ("Naples terms") on its official convertible currency debt to Paris Club creditors. Since then, Cambodia has concluded agreements with France, Germany, and Japan, and is continuing its discussions with the remaining creditor, the United States. The Government also did not contract or guarantee any external debt on non-concessional terms during 1996. Little progress, however, has been made in finding a solution for outstanding debt in non-convertible currencies, notably that owed to Russia. Debt owed to Russia--814 million rubles--would amount to US$1.4 billion (or 44 percent of 1996 GDP) if valued at the historical exchange rate used by the Russian Federation. Accordingly, achieving external debt sustainability will depend critically on the terms on which Ruble debt is rescheduled. The arrangement with the European Union (EU), however, has been jeopardized by foreign products bearing counterfeit marks of origin from Cambodia. The United States recently granted Most Favored Nation (MFN) status to Cambodia and is currently considering extending the GSP status. 6 During 1996, 1,094 FDI projects (worth US$820 million) have been approved in the varied areas of labor- intensive relocation industries (garments, shoes), agro-processing (rubber, seafood processing), hotels, telecommunications, and electronic assembly, mainly from Malaysia, Taiwan (China), China, and Singapore. Trade and Investment Policy in Cambodia. 1995, Will Martin, World Bank, December 1995.  - 11 - III. CHALLENGES FOR THE TRANSITION TOWARD SUSTAINABLE DEVELOPMENT 34. As discussed in Section I, despite the recent progress in restoring growth and stability, Cambodia remains one of the poorest countries in Asia, with unfavorable social indicators compared with other low-income countries. Cambodia needs to achieve high, sustainable, and broad-based economic growth over the long run if it is to reduce poverty significantly and enhance economic and social welfare. Cambodia faces a number of challenges that cloud its prospects for sustainable development, among others: * A Weak Revenue Effort. Although tax revenues, as a share of GDP, tripled during 1991-1996, they remain among the lowest in the world. Moreover, the Government has yet to manage forest resources in a transparent, economically sound, and environmentally sustainable manner and to transfer associated revenues fully to the budget. The result is that the domestic contribution to financing development expenditures remains weak. * Inefficient Expenditure Allocation. Although the Govemment continues to contain current expenditures incorporating revenue shortfalls, the current fiscal situation is not sustainable over the medium term. A high level of defense and security expenditures, and a significant portion of salaries within civilian expenditures, are squeezing non-wage operations and maintenance expenditures for key economic and social sectors, as well as the local currency counterpart for externally financed investment projects, to the bare minimum. Combined with the donor-driven nature of many investment projects, this also often leads to inefficiency in the implementation of public investment. * Weak Institutional Capacity. While improving, as a legacy of years of civil conflict, institutional capacity remains weak. The Government's administrative capacity to formulate policy and implement development programs is constrained. An open, transparent, and consistent legal framework to support private sector development and a sound financial system are not yet in place. 35. Cambodia is now at the crossroads in making a transition toward sustainable development. Confronting these three challenges will be essential to sustaining the high growth rates necessary to reduce poverty and improve the livelihood of the Cambodian people, especially in that while economic development will be largely private sector driven over the longer term, the public sector must play a catalytic role in providing enabling environment for private sector development for some years to come. This chapter discusses the following three challenges in depth: (i) enhancing public resource mobilization (Section A); (ii) improving public expenditure management (Section B); and (iii) strengthening institutional capacity (Section C). A. Enhancing Public Resource Mobilization 36. Government revenues have increased significantly as a share of GDP, albeit from a very low base. Through such measures as a major customs reform, the introduction of a hotel tax and a salary tax, increases in turnover tax rates, and the application of excise taxes to a range of goods, tax revenues have risen from 2.3 percent of GDP in 1991 to 6.5 percent in 1996. Non-tax revenues have been limited to 2-3 percent of GDP owing partly to failure to collect full economic values for forestry revenues. 37. Cambodia's budget revenue-to-GDP ratio (at 9.1 percent in 1996) is very low by international standards. The current tax effort (at 6.5 percent of GDP) is roughly half of the average for low-income  - 12- countries. It compares unfavorably not only with Indochina neighbors but also with sub-Saharan African countries (see Table 2 and Table 3). Total budget revenues have not covered current expenditures. The current budget deficit and almost all capital expenditures have been financed by external grants and loans. As discussed in Section JI, the current budgetary situation is not sustainable. Unless budgetary revenues are increased significantly over the medium term, maintaining macroeconomic stability and raising the domestic contribution to the financing of the public investment program--for priority social sectors in particular--will not be possible. Table 2: Comparison of Revenue Efforts (in percent of GDP) Country Year Tax Revenue Non-tax Revenue Total Revenue Cambodia 1996 7.1 2.7 9.8 Lao PDR 1995/96 10.8 2.5 13.3 Vietnam 1996 19.6 3.4 23.0 Ethiopia 1995/96 12.2 5.4 17.6 Uganda 1995/96 9.7 0.6 10.3 Source: World Bank staffestimates. 38. The main reasons for this poor revenue performance are: (i) low incidence of taxation; (ii) generous tax and duty exemptions granted under the Law on Investment as well as ad hoc exemptions; (iii) weak administrative capacity to collect taxes; and (iv) inadequate control over non-tax revenue, from forestry in particular. 1. Taxation 39. The chief reason for the low incidence of taxation is the low level of domestic taxes on goods and services and on income (see Table 3). Accordingly, trade taxes account for more than 60 percent of total tax revenue, which will not be sustainable in view of an expected decline stemming from membership in ASEAN/AFTA and from re-exports, as tariff differentials with neighboring countries decline and their trade regimes become more open. 40. Recognizing the urgency of significantly enhancing revenue mobilization, the Government prepared a comprehensive medium-term tax reform strategy. Based on this strategy, along with the 1997 budget, the Government passed the new Law on Taxation, which includes important revenue- enhancing as well as equity-enhancing provisions. The main revenue-enhancing provisions include: * Levying turnover tax on the (previously exempt) first sale after importation; 8 Some examples of equity-enhancing provisions are: (i) income from the sale of agricultural output, by a person who is not a large taxpayer, is exempt from profits tax; (ii) dividends paid to domestic and foreign shareholders are subject to a final withholding tax; (iii) medical services, public transportation, primary financial and insurance services, and public interest non-profit activities are exempt from VAT; and (iv) luxury automobiles are taxed at the highest rate of 30 percent excise duties.  Table 3: Cambodia's Tax Revenue Structure in 1996 Compared with Selected Country Groups Income Taxes Domestic Taxes on Goods & International Trade Taxes Tax Services . Property Other Revenue Turnover, Taxes Taxes Total Individual Corporate Total Sales & Excise Total Import Export VAT (In percent of GDP) Low-income Countries 1/ Income per capita less than $350 12.90 2.64 1.14 1.50 3.51 1.87 1.64 4.87 3.82 1.05 0.24 1.64 Income per capitafrom $350 to $850 17.50 5.12 2.15 2.97 3.67 1.43 2.24 6.50 5.92 0.58 0.30 1.91 Non-OECD Asian Countries 2/ 14.10 4.90 2.30 2.60 3.70 1.70 2.00 4.00 3.50 0.50 0.30 1.20 African countries 3/ 17.70 5.70 2.20 3.20 4.80 3.00 1.90 6.10 5.10 1.00 0.30 0.80 Cambodia 6.52 0.26 0.03 0.23 1.88 1.19 0.69 4.18 4.08 0.10 0.00 0.19 (In percent of total tax revenue) Low-income Countries 1/ L Incomepercapita lessthan$350 100.00 19.44 8.71 10.73 27.84 14.98 12.86 38.51 30.14 8.37 2.05 12.16 l Income per capita from $350 to $850 100.00 27.72 12.25 15.47 24.36 8.63 15.73 37.06 32.87 4.19 1.76 9.10 Non-OECD Asian Countries 2/ 100.00 31.60 14.70 16.90 30.80 14.40 16.40 26.40 23.50 2.90 2.40 8.80 African countries 3/ 100.00 30.20 11.40 17.10 27.50 14.50 11.70 36.60 27.50 9.70 2.00 3.70 Cambodia 100.00 3.97 0.51 3.46 28.90 18.30 10.59 64.20 62.66 1.53 0.00 2.94 l/ Average during late 1970s to early 1980s (Quantitative Characteristics of the Tax Systems, V. Tanzi, 1987). 2/ Average during late 1980s to early 1990s (Tax Policy Handbook, 1995). 3/ Unweighted average during 1986 to 1992.  -14- * Broadening the coverage of excise duties to automobiles, international air travel, and international telecommunications service; * Introducing taxes on interest and dividends; * Strengthening the application of the (already existing) minimum tax to the enterprises, including those granted tax holidays under the Law on Investment; applying a 30 percent profit tax rate for oil and gas production-sharing contracts, and for exploiting natural resources including timber, ore, gas, and precious stones; * Extending coverage of the tax on salaries to government employees, elected officials, and employees of NGOs; reducing the current exemption threshold; introducing taxation of fringe benefits; * Introducing the withholding of taxes; and * Replacing taxes on turnover and consumption with a value-added tax (VAT) for the 600 largest taxpayers, by January 1, 1998, and extending it gradually. 41. Among the above measures, eliminating the exemption of turnover tax on the first sale after the importation would have the biggest revenue-boosting effect, estimated roughly at 30 billion riels on an annual basis (or 0.3 percent of GDP). While it introduces cascading, this provision would eliminate the current implicit subsidy to imports at the expense of domestic or potential domestic production. It would also remove the current incentive to vertical integration. Effective tax rates paid by the consumers are approximately 3.5 percent (importers and retailers) for imports and between 7.5 percent (producer to retailer) and 11.5 percent (producer to wholesaler to retailer) for similar domestically produced goods. Imposition of the turnover tax on the first sale after importation would level the effective rates between 7.5 percent and 11.5 percent which would help prepare for the introduction of a IO percent VAT. 42. The introduction of a VAT at a single rate of 10 percent would be, in principle, revenue enhancing, as a significant amount of the current turnover tax is collected at the border in the form of a consumption tax (currently at a standard rate of 4 percent). The introduction of a VAT initially for the large taxpayers (legal person, import/export firms, and investment enterprises) registered at the Large Taxpayer Unit (BGGE) is considered feasible as the BGGE is the most efficient office in the Tax Department, all these firms are covered by one office, and these firms would account for 80-90 percent of the VAT take. This approach is also consistent with best practice which suggests that it is better to exclude firms from coverage on the basis of their size (as in Malawi) rather than on the basis of their place in the production and distribution chain.9 The cascading effect on the small firms outside the VAT system would be minimized by reducing the turnover tax rate to 2 percent from the current 4 percent. 43. While foreign experts have been working to design an appropriate VAT and to ensure that it can be properly administered, international experience shows that preparation for the proper implementation of a VAT would require 12-18 months and implementation could further strain the Lessons of Tax Reforn, World Bank, 1991.  - 15 - weak administration capacity. Therefore, the extent of such enhancement would critically depend on progress made in strengthening the tax administration capacity. 44. Over the medium term, the Government's objective is to increase the revenue ratio from the current 9 percent of GDP to 13-14 percent by the year 2000. Tax revenue is envisaged to reach 9-10 percent, of which 60 percent would be from domestic taxes compared with the current contribution of 40 percent. In the near term, strengthened tax administration and strictly limited tax exemptions would play the major role in enhancing revenue. In the later years, the contribution of the new tax measures would become more significant as tax administration is strengthened. 45. With the passing of the Law on Taxation, the main elements of a modern taxation system are being put in place. The challenge for the Government will be its implementation in view of the weak tax administration. Over the medium term, the Government will need to add the remaining elements--in particular land and property taxation and a proper duty drawback system to replace the current ad hoc re-export scheme, and do away with some of the tax measures--such as the minimum tax and prepayment of tax on profits--which should be considered as transitional measures. 2. Tax Exemptions 46. Generous tax and duty exemptions seriously erode the tax base. The majority of these come from the liberal exemptions granted under the Law on Investment. Customs revenue losses resulting from exemptions under this Law were estimated at about US$30 million (or 1 percent of GDP) in 1996. Furthermore, ad hoc exemptions granted for rubber exports and luxury automobile imports during 1996- -due in part to a lack of clarity in the Law on Investment--have exacerbated the situation. While the exemptions for rubber and luxury automobiles were discontinued in 1997, additional exemptions have been granted, such as for forestry exports. Such ad hoc exemptions not only erode the tax base, but also raise concerns regarding transparency in economic management. Customs revenue losses in 1996 from ad hoc duty exemptions were estimated at US$23 million (or 0.7 percent of GDP). In total, customs revenue losses were estimated at 1.7 percent of GDP in 1996, nearly one-quarter of tax revenue. 47. In the Policy Framework Paper, the Government has committed to issue the implementing regulations for the Law on Investment to eliminate significantly the scope for these exemptions. The Council of Ministers is currently reviewing these long-delayed implementing regulations. To be effective in eliminating unnecessary and ad-hoc tax exemptions, the Government needs to adopt the implementing regulations (as proposed) which include the following main provisions: (i) clarifying that exemptions apply to profit tax and customs duties, and not to other taxes such as the tax on salary, the turnover tax, or the VAT, which have been major areas of contention between investors and the Tax Department; (ii) strictly limiting the scope of the investment activities eligible for the generous tax incentives under the Law, in particular low-value added activities such as natural resource extraction; (iii) requiring that prepayment of the tax on profits applies to all enterprises granted a 9 percent tax rate as an investment incentive; (iv) requiring that the minimum tax applies to all enterprises, including 10 It is well documented that the administrative costs of VATs are much higher, as high as 5 percent of revenue collected, than those for trade and excise taxes, ranging from I to 3 percent. (World Development Report, World Bank,1988) These transitional measures would not be necessary under a well administered tax system. The minimum tax could be viewed as a proxy for a wealth tax usually in the form of an assets tax which is applied regardless of the level of taxable income. Prepayment of tax on profits is necessary in view of low tax compliance.  - 16 - enterprises granted an exemption from the profit tax; (v) requiring that enterprises are granted investment incentives to pay import duties on all imports, which will be rebated once the appropriate use of the goods has been established; and (vi) requiring all enterprises that are granted investment incentives to submit monthly and annual tax declarations for all taxes, and explicitly stating that non- compliance will result in a revocation of all tax and duty exemptions. The immediate challenge for the authorities is to ensure that: the implementing regulations contain these provisions; they are strictly implemented; and no new ad hoc exemptions are granted. 12 48. Even with the adoption of the implementing regulations, the tax incentives offered by the Law on Investment would still be generous by international standards. The experience of other countries indicates that tax incentives rank low as determinants of investment flows. Moreover, tax policy affecting multilateral corporations in the majority of countries allows for some credit for tax paid abroad, so that tax holidays in Cambodia only serve to shift tax revenue to foreign governments. Over the medium term, the authorities should review the overall investment incentive scheme--including the possibility of revising of the Law on Investment--based on an in-depth analysis. A recent FIAS study will provide an input into this review.13 3. Tax Administration 49. The Government has also committed to strengthen tax administration, which will be essential for broadening the tax base and achieving the envisaged revenue enhancement. Although improvements have been made, the current tax and customs administrative capacity is still weak. On domestic taxation, the most significant achievement is the establishment of the Large Taxpayer Unit (BGGE). The BGGE tracks the activities of the largest enterprises (1,600 enterprises currently being tracked) and conducts follow-up audits to verify compliance. The Tax Department has conducted on- site tax audits of the 136 large enterprises for which there was evidence of underpayment of taxes and identified CR 23.6 billion in unpaid taxes, of which only CR 600 million have been collected. The Tax Department aims to conduct on-site tax audits of additional 225 enterprises by end- 1997. On customs administration, the Government has instituted a system of pre-shipment inspections in order to reduce revenue leakage from under-reporting of import values. Efforts to improve tax compliance, however, have encountered resistance and tax collections have been hampered by ad hoc tax exemptions, due mainly to the lack of clear legal provisions. 50. The legal framework for tax administration is being improved. The Law on Taxation strengthens the tax rules and procedures, in particular the power of the tax administration authorities to enforce the tax code, including provisions for confiscation, the freezing of bank accounts, the stopping of export-import operations, and the nullifying of permits and licenses. The Law on Taxation, along with the implementing regulations for the Law on Investment, should strengthen the capacity of the tax authorities to enforce compliance with the tax laws. 51. For the medium term, strong efforts will be needed in the following areas: (i) training tax officials in accounting, assessment, auditing, dispute resolution, and the VAT; (ii) strengthening the systematic exchange of taxpayer information among the Customs Department, the Tax Department, and In early 1997, while the exemptions for rubber exports and luxury automobile imports were removed, additional ad hoc tax exemptions were granted on processed wood exports for eight concessionaires. 13 Cambodia: Monitoring Direct Investment, World Bank, April 1997.  - 17- the CDC; (iii) establishing a computerized data base for medium-size enterprises and extending the requirement of declaration based on simplified actual accounting to medium-size enterprises. 4. Non-tax Revenue 52. Non-tax revenues contribute about 30 percent of total revenue. The principal sources are royalty payments from forestry, fees and commissions paid in connection with government joint ventures and the granting of monopoly rights, and operating surpluses from posts and communications. Over the medium term, the Government envisages a bigger contribution to total revenue, especially from forestry. 53. The budgetary coverage of non-tax revenues remains incomplete, with some line ministries and other government entities continuing to collect revenues without control and supervision by the Ministry of Economy and Finance. Extrabudgetary revenues need to be brought under budgetary control. The Government aims to issue an Order, giving the Minister of Economy and Finance control over all negotiations involving the sale, transfer, or use of the national patrimony and requiring the Minister of Economy and Finance's signature on all such contracts. The Order would bring the management of all financial aspects of existing contracts under the control of the Ministry of Economy and Finance. With the enactment of the Order, the commercial activities of the line ministries would effectively end. It is, therefore, critical to swiftly issue such an Order, as intended. 54. Over the medium term, it would also be critical to: (i) engage international audit firms for valuation; (ii) apply transparent and competitive procedures in awarding concessions for natural resource exploitation such as forestry, oil and gas, land, and gem extraction; and (iii) ensure the timely transfer of associated revenue to the budget. The same procedures should be applied to any revenue resulting from the privatization of SOEs, rubber plantations in particular. 55. Forestry Resource Management. Raising revenue from forestry is one major element of the Government's reform efforts to establish an export-oriented, market-based system for the sustainable exploitation of resources. Forests are Cambodia's most developmentally significant natural resources. The implementation of economically and environmentally sound forestry policies could generate some US$100 million a year in government revenue, equivalent to over one-third of budget revenue or over 3 percent of GDP in 1996.14 The mismanagement of forestry resources, however, has caused concerns: uncontrolled logging has led to rapid degradation that severely threatens Cambodia's forests; large concessions have been awarded, with unsustainably high harvesting intensity and royalties that account for about one- fifth of their economic value (US$14 per cubic meter compared with an average stumpage value of US$70); and only a part of revenues from logging activities have been transferred to the national budget. In 1996, US$10.5 million (or one-tenth of potential revenue under economically and environmentally sound forestry policies) was collected from forestry exploitation. 56. Actions taken by the Government during 1996 raised questions about its commitment to sustainable forestry management. Most significant was the decision to allow the export of up to one million cubic meters of logs, supposedly felled before the imposition of the export ban in April 1995 ("old" logs). These proposed sales of uninventoried stockpiles were based on secret negotiations rather than open auctions, and the sales procedures, which were developed well after the initiation of negotiations, did not provide assurance that revenues would accrue to the national budget. The 14 Cambodia: Forest Policy Assessment, World Bank, UNDP, and FAO, June 1996.  - 18 - authorized amount of exports was finally reduced to 125,000 cubic meters, based on the verification that the logs in question were indeed felled before April 1995. 57. After some delays, the Government has taken initial actions to regain control over logging activities and has reconfirmed its intention to pursue medium-term measures for a sustainable exploitation of forestry resources. The Government issued a Declaration that includes: reimposing a complete ban on all exports of logs and sawn timber effective January 1, 1997; allowing only forest concession companies to export processed wood; using military force to control illegal activities; seeking the cooperation of neighboring countries to enforce the export ban; and pursuing the studies proposed in the Bank/UNDP/FAO report (i.e., forestry concession management, forestry policy reform, logging control and log verification, and legal review of concession contracts). 58. Progress in implementation of the necessary policy actions to date has, however, been mixed. On the positive side, among the main accomplishments of the Government has been introduction of controls on illegal logging and of a credible log export ban. While not entirely successful, the Government's efforts, which include improved cooperation among government agencies including the military (a regiment of 1,900 soldiers has been assigned to the enforcement of the log export ban and the control of illegal logging), seizures of illegally felled logs and logging equipment, and diplomatic initiatives with neighboring countries, have led to a decline in illegal logging. In some border provinces, however, illegal log exports with the help of foreign traders continued. Second, some progress has been made on the technical assistance studies and, with a concerted effort, the four studies recommended by the World Bank/UNDP/FAO report could commence by July 1997. These studies should provide a specific and monitorable agenda for further actions in forestry, as well as interim recommendation some of which can be put into place as early as 1997/98 logging dry season. Third, the National Committee for Forest Policy under the co-chairmanship of the two Prime Ministers and consisting of representatives of nine agencies most directly involved in forest development has been established as has the Committee's Secretariat. 59. On the other hand, three recent developments call into question the Government's commitment to sustainable forestry management. First, forestry revenue collection has not been satisfactory as the Government has granted export tax exemptions to 8 forestry companies. Second, the Government has not yet allocated sufficient budgetary resources to the Secretariat of the National Committee for Forest Policy. Third and perhaps most troubling has been continued granting of forest concessions, annual harvesting licenses and authorizations for collection of logs outside of concession area that are not market-based, transparent, nor based on satisfactory environmental assessments. The recent granting of a large concession of about 459,000 hectares and other award of land and harvesting permits are inconsistent with the commitment of the Government to the fundamental need for forestry policy reform. In addition, the Government has issued annual harvesting licenses, albeit at higher royalty rates, without adequate planning, supervision, or local consultation. Other ad hoc arrangements providing private firms access to public resources, such as permission to one firm for the collection of 80,000 cubic meters outside of its designated area have been also of concern. 60. The immediate necessary steps are: (i) to tighten supervision of border crossing points and ports; (ii) to proceed swiftly with the four technical assistance studies recommended by the World 15 While the Government restricted the official crossing points for export of wood products to just two border points (Phnom Penh and Sihanoukville), illegal exports through the port at Koh Kong continued and also there have been reports of smuggling to Vietnam.  - 19- Bank/UNDP/FAO report; (iii) to secure adequate budget resources for the recently established Secretariat of the National Committee for Forest Policy; and (iv) to cease granting new concessions, harvesting licenses, and collection agreements until a transparent and competitive process is put in place. Over the medium term, based on best practice of other countries, three principles should guide forestry policy: effective rent capture; environmental sustainability; and transparent and accountable governance. In particular, the experience of many other countries shows that the use of low cost stumpage to promote rapid development is unlikely to be sustainable or economically viable. Methods to improve rent capture include revised royalty schedules, controlled deregulation of restrictions on log exports, and competitive bidding for the allocation of concessions and cutting rights. Guaranteeing sustainable timber extraction is likely to require a cautious approach to the use of natural forests and the continuation and expansion of forest inventory work (now under way with the assistance of FAO and UNDP). Improved transparency and governance await pending legislation which will ensure concession and cutting awards on a more open and competitive basis. B. Improving the Efficiency of Public Expenditure 61. The Government has made significant progress in expenditure management since the adoption of the Budget Law in 1993. The Law established the authority of the central Treasury over all revenue of government institutions, and ensures ex ante as well as ex post review of expenditures by the Treasury. Progress has since been made in establishing audit and inspection, Treasury cash management, and accounting. More recent progress includes: assigning financial controllers to each ministry, establishing a system of direct payments by the Treasury for procurement over a specified amount, establishing competitive bidding procedures through the Public Procurement Department, and adopting a public accounting sub-decree to avoid having unpaid pay orders carry over into the next fiscal year. 62. Quality of Expenditure Policies. The Government, through these steps and measures and a strong policy commitment to macroeconomic stability, has succeeded in containing current expenditures at around 10 percent of GDP. However, the very high level of defense and security expenditures (while declining to 50 percent of total current expenditure in 1996) has resulted in a very limited scope for civilian expenditures (see Table 4). Furthermore, as salaries are the predominant item of current expenditures for civil administration (accounting for about one-third of the total), expenditures for non-wage operations and maintenance have been squeezed to the bare minimum, especially in priority sectors such as education and roads (see Table 5). 63. While the Government has targeted lower defense and security expenditures and thereby higher development-oriented expenditures in the initial budget allocations during 1994-95, actual defense and security outturns have significantly overrun the budgetary targets, often through ad hoc non-transparent processes. This, combined with lower revenue outturns compared with budgetary targets, has meant that the allocations for social sectors and local currency counterparts have often been reduced to minimum levels from the budgetary targets. In 1996, however, the Government succeeded in containing defense and security expenditures largely within the initial budget allocations, but a revenue shortfall still constrained non-defense expenditures.  - 20 - Table 4: Current Expenditure by Sector 1/ 1994 1 1995 1996 r 1997 Budget Outcome Budget IOutcome Budget I Outcome Budget (in billion of riels) Defense and Security 283.2 391.5 299.0 421.2 392.3 400.7 383.5 Education 63.8 61.0 73.4 72.4 83.8 80.5 87.9 Health 42.4 30.0 36.2 26.1 60.4 44.0 60.7 Agriculture & rural development 14.9 12.4 17.2 15.3 20.8 18.7 24.4 Total Current Expenditure 585.6 662.3 652.7 731.7 751.0 793.9 870.0 (in % of total current expenditure) Defense and Security 48.4 59.1 45.8 57.6 52.2 50.5 44.1 Education 10.9 9.2 11.3 9.9 11.2 10.1 10.1 Health 7.2 4.5 5.5 3.6 8.0 5.5 7.0 Agriculture & rural development 2.5 1.9 2.6 2.1 2.8 2.4 2.8 I/ Payment-order basis. Source: Cambodian authorities. 64. Cambodia spends about 2 percent of GDP on health and education, compared with an average of 5 percent of GDP for low-income countries. In contrast, Cambodia's level of expenditures for defense and security is two to three times higher. This pattern of spending has not adversely affected economic growth significantly, as the nature of the recent growth was largely a recovery from the past. Over the longer term, however, it will be detrimental to economic growth and poverty reduction. Thus, while continued fiscal discipline is essential, the composition of spending needs to be changed to support development priorities: government expenditures need to be significantly redirected toward priority social sectors and economic infrastructure, and the composition of 0 & M expenditures needs to be shifted away from salaries toward materials and supplies. 65. The Government is fully aware of the need for such expenditure re-orientation and it has committed to achieve this re-orientation in the PFP. The objective is to increase expenditures for health and education to 5 percent of GDP from the current 2 percent by the year 2000, and reduce defense and security spending to 3.5 percent of GDP from the current 5 percent. To achieve these objectives, building on the progress made so far, the Government will first need to strengthen the capacity to monitor and control budgetary expenditures through full implementation of the recently introduced measures such as the assignment of financial controllers, direct payment systems, and competitive bidding procedures. Second, the Government should make strong efforts to contain the military wage bill in spite of the need for the integration of former Khmer Rouge soldiers. Non-wage operating outlays for defense and security will also need to be contained through strengthened control procedures, especially through ex post audits. Effective implementation of military demobilization will also be critical (see paras 80-84 in Section III). Third, the Government will need to re-establish control over recruitment into the civil service and to implement civil service reform (which has been delayed) (see paras 74-79 in Section III). Finally, the Government will need to carry out a Public Expenditure  Table 5: Budgetary Expenditures by Functional and Sectoral Allocations, 1994-1997 1/ 1994 (Outcome) 1995 (Outcome) 1997 (Budget) Current Capital Total Current Capita Total Current Capitap Total Wage & Non- } I Wage & Non- tal Wage & Non-j Salary wage Other Salge wage Other Salary wage Other O&M j- O&M - O&MI - .'.''.'''. ..,.. ,.......... . .. .. . ... ... Agriculture & rural development 6.4 5.9 1.2 34.0 47.5 6.5 7.4 1.5 31.2 46.5 7.8 15.0 1.6 88.6 113.0 Public works 3.4 2.5 1.6 127.3 134.9 3.6 1.6 2.8 209.6 217.6 4.1 2.1 2.2 78.2 86.6 Industry 1.2 1.0 2.6 71.1 75.9 1.2 0.7 2.8 94.8 99.5 1.5 2.1 2.7 84.7 91.0 Health 8.4 21.5 0.2 11.3 41.3 8.6 16.7 0.8 21.7 47.8 11.1 47.0 2.7 92.7 153.5 Education 53.0 7.0 1.0 4.8 65.8 58.8 12.5 1.1 25.0 97.5 64.8 20.8 2.3 29.8 117.8 Total 288.5 318.8 55.0 335.5 997.7 346.2 302.1 83.4 511.1 1242.8 364.7 360.2 145.1 610.8 1480.8 ,,,.E ,, , , ,,,.,. ., ., S. ........ .. ............ , ,,, .,,,,. .S~~~~~~~~~. . .... . .......... Agriculture & rural development 13.5 12.5 2.5 71.6 100.0 14.0 15.8 3.2 67.0 100.0 6.9 13.3 14 78.4 100.0 Public works 2.6 1.9 1.2 94.4 100.0 1.7 0.7 1.3 96.3 100.0 4.7 2.4 2.5 90.4 100.0 Industry 1.5 1.4 3.4 93.7 100.0 1.2 0.7 2.8 95.3 100.0 1.6 2.3 2.9 93.1 100.0 Health 20.3 51.9 0.4 27.4 100.0 18.1 34.9 1.6 45.4 100.0 7.2 30.6 1.7 60.4 100.0 Education 80.5 10.7 1.5 7.3 100.0 60.3 12.8 1.2 25.7 100.0 55.0 17.7 2.0 25.3 100.0 Total 28.9 32.0 5.5 33.6 100.0 27.9 24.3 6.7 41.1 100.0 24.6 24.3 9.8 41.2 100.0 1/ Payment-order basis; for 1996 data are not currently available. Source: Cambodian authorities.  - 22 - Review, with a view to providing a firmer basis for the sectoral allocations and the adequacy of non- wage O&M allocations in the budget. 66. Assessment of Public Investment. Securing an adequate level of public investment, and, equally important, enhancing the efficiency of public investment are critical to Cambodia's long-term sustained development. Since 1993, public investment has been almost entirely financed by external sources. A substantial part of the foreign-funded projects, especially from NGOs, has been operated outside of Government agencies. The Government's provision of a local currency counterpart for foreign-funded projects has been grossly inadequate. Implementation capacity of Government agencies, while improving, is still weak. 67. While public investment has contributed significantly to the rehabilitation of Cambodia's devastated physical and social infrastructure, it has often been donor-driven, concentrating on the building of new infrastructure--roads, hospitals, and schools--and sometimes lacking adequate provision for the associated recurrent expenditure needs. The lack of adequate O&M expenditures has often undermined the effectiveness of public investment, often resulting in ineffective delivery of services (e.g., schools without teaching materials, health clinics without drugs, rehabilitated roads once again becoming impassable because of inadequate maintenance). Reflecting needs that are of an emergency rehabilitation nature, public investment has concentrated on area/rural development (21 percent of total) and transport (21 percent), followed by agriculture (14 percent), education (13 percent), health (11 percent), and social development (9 percent). 68. The Government has made some important progress toward improving public investment management, in particular, initiating the National Public Investment Management System and preparing the Public Investment Program (PIP). The Government has prepared a three-year rolling PIP for 1996- 98 and for 1997-99, to assist in determining both the appropriate priorities for public investments and the recurrent expenditure requirements. The second PIP (1997-99) made significant improvements over the first one: (i) the coverage was improved, as the first PIP failed to capture some ongoing projects; (ii) the second PIP was more consistent with the prospects for externally financed resources; (iii) it is better linked to macroeconomic and sectoral strategies and policies; and (iv) coordination among various agencies, the Ministry of Planning, the CDC, the Ministry of Economy and Finance, and line ministries was improved. 69. Notwithstanding these significant improvements, there remain a number of weaknesses in the second PIP. First, some projects are still omitted as a large number of projects funded by bilateral and multilateral donors as well as most NGO projects continue to operate outside the national budget despite attempts over the last two years to coordinate activities and integrate them into PIP projects. The coverage varies by sector depending on monitoring capacity. For sectors with strong coordination with donors (especially with NGOs), the coverage is better (e.g., health). The coverage appears to be weak for sectors such as education and agriculture. Second, the second PIP has not yet fully connected proposed allocations to past progress in implementation, as the monitoring mechanism is currently lacking--owing partly to the fact that a significant part of the donor-financed projects is outside of the authority of ministries. Third, while this is inevitable to some extent, a number of projects continue to be supply driven. As a result, inter-sector and intra-sector allocations do not fully reflect the appropriate  - 23 - priorities.'6 Fourth, the PIP do not fully consider the recurrent expenditure needs associated with projects. In preparing the 1997 budget, considerations for recurrent expenditure allocations for investment projects in the PIP were not completely incorporated as the PIP was only completed and approved in late October 1996, at about the same time when the draft 1997 budget was finalized. 70. The PIP for 1997-99 calls for US$1.2 billion. In addition, it requires US$200 million for special programs such as administrative reform and military demobilization. For the US$1.2 billion, the allocation across the sectors is broadly consistent with the Socio-Economic Development Plan for 1996- 2000, with larger allocations given to health (19.5 percent), transport (17.5 percent), education (13.5 percent), energy (12.7 percent), agriculture (12.5 percent.), and water supply and sanitation (9.5 percent) (Table A.1 in the Appendix I). The proposed allocation shows greater investment than currently in health and non-transport economic infrastructure and less investment in transport infrastructure. This reflects appropriately a gradual transition from emergency rehabilitation and recovery toward more long-term development. 71. To enhance the efficiency of the public investment program, the Government needs to undertake the following. First, capacity at the Ministry of Planning and line ministries in monitoring and implementing the program needs to be developed. Second, the Government needs to formulate the next PIP on the basis of the findings of the first two PIP implementation as well as a Public Expenditure Review. Third, coordination among various agencies needs to be strengthened. In particular, closer collaboration is needed between the Ministry of Planning and the Ministry of Economy and Finance in estimating and allocating the appropriate amounts for recurrent expenditures. Fourth, coordination with donors needs to be strengthened to ensure that the available financing is in fact allocated to the Government's priority program and to improving the coordination of the various technical assistance programs. This could be achieved through donor coordination meetings on selected sectors, such as the one held on civil service reform, military demobilization, and forestry management in January 1997. 72. A brief assessment of public investment by sector is given in Appendix I. The sectors covered are agriculture and rural development, health, education, energy, transport, and water supply and sanitation. For each sector, there is an assessment of the current situation and an assessment of the PIP for 1997-99. The summary of the main findings are as follows. First, government involvement in the public investment projects is generally justified, with the exception of agriculture, e.g., agricultural inputs distribution, rice trading, and rubber marketing. Greater private participation should be actively sought out, as only in the power sector are there important private initiatives. Second, while it is difficult to judge the appropriateness of the investment level, as a significant part of donor-financed projects operate outside of Government agencies, the level of donor-financed investment could be considered reasonable with respect to absorptive capacity. The budgetary contribution, however, is inadequate in providing non-wage O&M expenditures--most severely in education, transport, and agriculture and rural development Third, the policy environment has improved toward a more market- oriented strategy, but much still needs to be done, especially in the area of cost recovery. Fourth, implementation capacity and the effectiveness of expenditure, although improving, are weak in all ministries (with the possible exception of health). While continued technical assistance is required, more effective use will be critical to improving implementation capacity. Fifth, while the sectoral description in the PIP document is adequate, the linkage between the stated strategy and the proposed 16 The core PIP included projects with ranks 1-3. Rank I was assigned to ongoing projects, and rank 2 to committed projects. Rank 3 was assigned to pipeline-high priority projects that are at an advanced stage of receiving funding commitment or are of high national priority.  - 24 - PIP could be strengthened. The supply-driven nature of some projects is a problem in this regard. In particular, in contrast to the emphasis given to rural development in view of its importance for promoting broad-based economic development and poverty reduction, not enough projects that specifically target rural development are programmed. C. Strengthening Institutional Capacity 73. As can be seen from the foregoing discussion, an important development issue is the need to strengthen the Government's capacity to implement its economic reforms and development programs. Without a strengthening of the Government's institutional capacity, its ability to deliver and manage the rural development and social sector programs necessary to reduce poverty and achieve broad-based growth will be limited. This is especially important as the Government needs to provide enabling environment for private sector development. In addition to strengthening the human resource base, administrative and legal reform are key to building the institutional capacity necessary for achieving long-term development. This issue is closely linked to the two issues discussed above. For example, progress in civil service reform and military demobilization will have significant bearing on the allocation of government expenditures. 1. Administrative Reform 74. As a legacy of years of civil strife, while improving, the Government's capacity to formulate policy and implement development programs is still severely constrained. The current Government inherited a civil service that was poorly remunerated, lacking in the skills and knowledge necessary to manage a technical bureaucracy in a market economy, and suffering from a distorted demographic profile. There are relatively few staff in the 30 to 40 age group and younger staff are poorly equipped to perform. Older staff, while better trained, are poorly motivated and their skills are unsuited to a market economy. Absenteeism is rampant because wages are well below the poverty line. The bulk of the work is done by expatriate Khmers and other foreign experts paid by donors or by local staff who receive salary supplements to work on donor-aided projects. This approach has yielded fairly good results in a number of ministries: local staff working with expatriates have been able to set up systems, gather data, and implement program in finance, health, education, and agriculture. However, what was intended as an interim solution threatens to become of longer duration because of slow progress in administrative reform. 75. Given the seriousness of the deterioration in public sector capabilities and performance, institutional development needs to proceed by stages in Cambodia. Nevertheless, a long-term strategy for institutional strengthening should be an integral part of the development effort. The first stage should consist of putting the essential building blocks in place: (i) a reorganized public sector reflecting privatization of public enterprises and a smaller, professional military; and (ii) a reconstituted civil service management system and the initial phase of civil service reform. Once this initial stage has been achieved and stability established within the civil service, the prerequisites will be in place for a major capacity-building effort whereby retrained civil servants and new recruits could gradually take over the duties of expatriates, and ad hoc administrative arrangements funded by donors could be replaced by fully functioning line ministries. This transition would take 5 to 10 years to be fully implemented. 76. Recognizing the importance of administrative reform, in the fall of 1994 the Government launched a broad and ambitious program of administrative reform in five main areas: (i) re-establishing  - 25 - the institutional and legal basis; (ii) strengthening the management capacity of sectoral ministries; (iii) reforming the civil service; (iv) developing human resources; and (v) strengthening the provincial administration. With substantial technical assistance from UNDP, the European Union, France, and the Bank, the Government has produced studies and plans on: reducing the size and renewing the skills profile and composition of the civil service; creating the management tools and systems necessary for sustaining performance; installing a data base and a personnel and payroll management system; devising a new remuneration policy; reforming recruitment and personnel management; and reorganizing the ministries. This work has been complemented by the analysis and modeling of various options for the reduction and renewal of the civil service. 77. While progress has been made in certain aspects of public sector reform, the civil service renewal program has made little headway. Despite significant background work, civil service reform efforts have suffered from a lack of clear rationale, objectives, and targets and a lack of a political consensus within the Government. Of particular concern is the failure to control the size of the civil service, which crowds out useful government expenditures and makes impossible the improvement in remuneration that is necessary to attract better qualified and skilled persons. Whereas the target for the size of the civil service at end-1996 was set at 130,000, the year began with 145,000 and about 18,000 political recruitments were added, bringing the number of individuals with the right to claim civil service status to 163,000. The political appointees have been integrated based on the Paris Peace Accord, but most of them are not yet on the payroll. 78. In the PFP, the Government has restated its intention to exercise strict controls over the size of the civil service and to accelerate preparation for the reform. The Government aims to carry out the following measures, for which decisive and timely implementation will be critical to accelerating reform: (i) taking measures to hold the number at the present level or below by removing the already- identified list from the civil service roll, by updating its data base to eliminate ghost workers and personnel with irregular status, and by strictly limiting new recruitments through consistent application of new circular governing recruitment; (ii) presenting a prioritized program for civil service reform which reflects government objectives and implementation capacity to the CG meeting in July 1997 with a view to implementation after the elections; (iii) initiating a civil service census by September 1997-- with assistance from the UNDP--to determine the experience, skill levels, and job profile of the civil service, and completing the census by April 1998; and (iv) creating a Superior Council for the Reform of the State Apparatus to be chaired by the two Co-Prime Ministers, and a Steering Committee for Administrative Reform to implement the reform process, under the guidance of the Superior Council, to increase political commitment to the civil service reform process and enhance technical capacity. 79. Best practice of other countries--for example, Malaysia or Uganda--demonstrates the importance of defining goals, ensuring sustained commitment from the highest levels over the long haul, and devising a strategic plan and setting up appropriate institutional arrangements. Prospects for successful implementation will, therefore, critically depend on the Government's political will as well as the strengthening of the implementation capacity with continued technical assistance from various donors. 2. Military Demobilization 80. The high levels of expenditures on defense are crowding out essential government expenditures in the productive and social sectors. The Government recognizes this problem and intends to carry out military downsizing, or the demobilization and reintegration of combatants into a productive civilian  - 26 - life, as an integral part of its overall development strategy. RCAF is estimated at 127,000 including several thousand recently registered Khmer Rouge defectors, which could increase to 130,000 with further defections. Given the likelihood of ghost soldiers, part-time irregular soldiers, and payments to widows of deceased soldiers, there is a serious need to conduct a full census on the registration of the RCAF to determine the actual universe from which a demobilization program would draw candidates for dowAisizing. 81. To guide the downsizing, the Government has established a National Commission for Demobilization and Reintegration, chaired by the two Co-Prime Ministers with cross-ministerial representation, an Executive Secretariat to handle the day-to-day implementation, and prepared a comprehensive military downsizing and reintegration program--the Cambodia Veterans Assistance Program (CVAP). The program design has benefited from the best practice established in similar downsizing exercises in countries like Uganda and Mozambique. 82. The Government is currently targeting 43,000, although the total could rise as high as 50,000 depending on the number of defections. I The demobilization is expected to take place in four phases, beginning with a pilot phase to start by August 1, 1997 in one or two select provinces for about 1,500 soldiers involving those close to retirement and most vulnerable. A second phase targeting the most vulnerable and involving 10,000 soldiers would take place in mid-1998 depending on the results of the pilot and on the security conditions in the country. The third and fourth phases, involving groups of about 1 1,000 and 17,000 regular soldiers, would take place at intervals of three to six months depending on the implementation capacity and performance of the previous phases. The total cost of the program is estimated at about US$72 million (of which about 60 percent for departure allowances) over three to four years. 83. A training program is under way to build capacity for management, organization and program development, monitoring and evaluation, and financial management. Preparation for a full registration of the RCAF is also under way. This is currently being financed with funds from IDA's Technical Assistance Credit and the Australian Trust Funds. The German Government has pledged funding to assist in registration and pilot development. Registration is expected to begin by August 1, 1997. The completion of the registration and the issuance of identity cards are now priority tasks as a basis for establishing the actual size of the Army and creating a transparent, monitorable system for identifying beneficiaries and accounting for benefits. The further public education or promotion of the program awareness within and outside government, the strengthening of capacity, particularly in the key implementing agencies, and the pilot testing of the program in one or two selected provinces are the contingent next steps. 84. In addition to finding sources of financing, the key constraints or problems facing the program are political will within the Government and the creation of sustainable employment in the rural economy, to which the majority of the demobilized are likely to return. By moving step-by-step and transparently on program implementation, first by confirming the beneficiary group through a transparent registration process, and second by piloting the program in one or two provinces, the Government can build a consensus and the political will to move forward quickly with full implementation after the election. The creation of employment will depend largely on the Government's ability to encourage private investment that is job-creating or labor-intensive in nature, 17 Hypothetical reduction of 43,000 soldiers in 1996 would have saved about 0.9 percent of GDP from salaries alone.  - 27 - and to ensure property rights and access to arable land in the rural areas for those soldiers who choose to return to the agricultural economy. 3. Legal Reform 85. During Cambodia's years of civil conflict, judicial institutions were destroyed. Most notably, many critical business, economic, and financial laws, which are key elements of the enabling environment for private sector development, are still absent, and those that have been recently enacted have yet to be adequately enforced, which often creates security and governance problems. The Government has been reforming the legal framework with a view to establishing greater certainty and clarity in law, regulations, and procedures. The legal and regulatory framework is being re-established from those systems that existed under previous regimes. Consequently, there are number of gaps and inconsistencies and in areas where the law is not clear or where implementing regulations do not yet exist (e.g., land) procedures are negotiated on a case-by-case basis. Moreover, capacity to implement the law is not solidly established. 86. Cambodia has made steady progress during the past few years in developing its legal and regulatory framework in the economic and financial areas. Since the 1993 elections, fundamental pieces ol .z,gislation, such as the Budget Law, the Law on Investment, and the Central Bank Law, have been prepared. More recently, several important pieces of legislation have been adopted--Public Enterprise Law, Law on Commercial Regulations and Registration, Law on the Chambers of Commerce, and the new Law on Taxation. However, other key laws and regulations have been delayed, in particular the Financial Institutions Law, implementing regulations for the Law on Investment, and the remaining six laws of the complete Commercial Code--business organizations, contracts, bankruptcy, arbitration, trademarks, and product liability. 87. The primary medium-term objective of legal reform is twofold: (i) re-establishment of the rule of law; and (ii) progressive development of a legal framework that facilitates commercial transactions, promotes private sector development, and stimulates national and foreign investment. This would be achieved through adoption of additional basic commercial laws and implementing regulations, strengthening key judicial institutions, promoting transparent and consistent enforcement of laws, and enhancing independent economic and financial sector regulatory and supervisory authorities. Moreover, an enabling legal climate for private investors must include an effectively functioning legal bar and the proper training of law officials and practitioners, as well as adequate institutional mechanisms to assure the constitutionality of laws and the smooth functioning of constitutional processes. This twofold objective would be accomplished also through the creation of procedural structures that are likely to produce the most effective legal reform in the medium term. Toward these objectives, in addition to rapidly adopting the laws and regulations mentioned above, to enhance the effectiveness of implementation the Government will need to adopt the necessary implementing regulations--for example, for the Commercial Code. In parallel, the Government will need to develop the mechanisms, institutions, and human resources necessary to implement all manners of laws. Otherwise, the enactment of laws and regulations to support private sector development would have limited impact on Cambodia's economic development.  - 28 - IV. MEDIUM-TERM PROSPECTS, EXTERNAL FINANCING REQUIREMENTS, AND RISKS 88. The improvement in Cambodia's performance over the last few years reflects an encouraging response to the Government's initial program of liberalization, stabilization, and market reforms. However, recent delays in implementing policy reforms as well as insufficient accountability and transparency in economic management pose concerns for the medium term. The successful transition toward sustainable development will hinge critically on the Government's political will and its efforts to implement the necessary economic reforms--the three areas discussed in Section III in particular--as well as on improvements in governance. The Government recently prepared a Policy Framework Paper (PFP) for 1997-1999, re-affirming its commitment to implementing necessary reforms. 89. High Growth Scenario. The Cambodian economy will need to achieve high and sustainable economic growth if it is to significantly reduce poverty and enhance economic and social well-being, as envisaged in the Government's National Program to Rehabilitate and Develop Cambodia and Socio- Economic Development Plan. If the Government can implement a strong reform program, as outlined in Section III as well as in the recent PFP, sustained high growth could be achieved. Under this scenario, there would be continued progress in consolidating macroeconomic stability, combined with an acceleration of economic reforms and the strengthening of institutional capacity. In turn, such policies would engender a high level of donor support, through official grants in the next several years and concessional loans. The continuation of economic reforms would also lead to continuing foreign investment. Under these assumptions, GDP would grow at 7-8 percent per annum (see Table 6). This growth rate is comparable to the growth rates achieved by several East Asian countries since the 1970s. Private sector would play a leading role in achieving this growth, with the public sector playing a supporting catalytic role by providing an improved enabling environment for private sector development (see Box 1). 90. Agriculture would grow by 4.5 percent per year over the next five years (assuming normal weather conditions), and by 5 percent per year over the following five years. While this is high growth for agriculture, it should be noted that much of this represents a recovery that would be made possible by higher public outlays on rural and agricultural development and improvement in the security situation. Strong supply response would be expected in rice production as a result of enhanced productivity. In the later years, robust growth would be expected for rubber, with more private sector participation, and also for forestry, with the establishment of an export-oriented, market-based system for the sustainable exploitation of forestry. Industry would grow by 9-10 percent a year. Reforms in the enabling environment would translate into higher industrial growth, albeit from a small base, led by labor-intensive manufacturing and stimulated by foreign investment. Garment production would be the leading sector, but basic consumer goods for the domestic market can also be expected to expand rapidly in response to rising incomes. Services would also grow rapidly, 8-9 percent a year, spurred by tourism, for which Cambodia has great potential. 91. Attaining economic growth in the range of 7-8 percent a year would entail a substantial increase in domestic savings and investment. National saving would more than double from the present low level of 5 percent of GDP to 12 percent by the year 2001. Government savings would improve significantly as a result of enhanced tax efforts (13 percent of GDP by the year 2006) and increased non-tax revenue, especially from forestry, as sustainable management practices take hold. The extent of improvement in government savings, however, would be limited up to the year 2001, as the implementation of civil service and military reform would require additional expenditures.  - 29 - Government savings would increase from -0.8 percent of GDP in 1996 to 2 percent by the year 2001, and further to 4 percent by the year 2006--a high rate which is comparable to that achieved in Korea in the period of its rapid economic growth in the 1970s and the 1980s. Private savings would increase steadily as macroeconomic stability is maintained, as disposable incomes increase, and as financial institutions are developed. Private investment would also increase steadily, reflecting both higher domestic savings and expanded foreign direct investment. While the government investment would remain at around 7 percent of GDP, the part coming from government savings would expand relative to the part that is externally financed. Table 6: Projection of Main Macroeconomic Indicators I/ (In Percent) 1995 1996 1997 1998 Average Average 1999-2001 2002-2006 Actual Prel. Projection GDP Growth 7.6 6.5 6.5 6.5 7.1 7.6 Inflation 3.5 9.0 5.0 5.0 5.0 5.0 Revenue/GDP 8.9 9.1 9.7 11.1 13.7 16.9 Current Expenditure/GDP 2/ 9.6 9.9 9.4 10.5 12.2 13.1 Govemment Savings/GDP -0.6 -0.8 0.3 0.6 1.5 3.7 Government Investment/GDP 7.1 6.5 6.6 6.9 6.9 7.0 Private Investment/GDP 14.5 14.2 15.8 16.0 16.6 18.2 Private Savings/GDP 6.0 5.9 6.1 7.0 9.2 12.7 Current Account Balance/GDP 3/ -16.2 -15.6 -16.0 -15.2 -12.9 -8.8 Debt/GDP 3/ 71.3 68.8 67.8 64.3 57.0 47.1 1/ For 1997-99, the projection is based on the PFP framework for 1997-99. 2/ Expenditure needs for civil service and military reforms are incorporated for 1998-2001. 3/ Excludes non-convertible currency debt payments. Source: World Bank staff estimates and projections. 92. Domestic exports (i.e., net of re-exports) would grow at a robust rate of about 10 percent per year over the long term, led by strong growth in non traditional, labor-intensive light manufacturing products--garments, in particular. The increase in these exports (at about 13 percent per annum) would be spurred by foreign direct investment inflows. Rubber, rice, and other agricultural products would also contribute to export growth, especially in later years. Log exports would gradually increase after sustainable forestry management mechanisms have been put in place. Retained imports (i.e., excluding imports for re-exports) would grow by slightly less than GDP. 93. External Financing Requirements. Although the current account deficit would narrow as a percentage of GDP to about 13 percent by the year 2000, it would rise in dollar terms from US$488 million in 1996 to US$580 million (Table 7). An increasing proportion of Cambodia's external financing requirements, which also reflect reserve accumulation and debt amortization, would be met by foreign direct investment inflows. FDI would steadily increase to US$300 million by the year 2000.  - 30 - Even with this increase in private capital flows, a substantial need for the disbursement of official assistance would remain. Disbursements of official assistance--grants and concessional loans--would need to be maintained for 1997-99 at about the 1996 level. In the later years, it would decline steadily. Box 1: Improving Enabling Environment for Private Sector Development In order to significantly reduce the incidence of poverty over the next two decades, Cambodia must reach and sustain a growth rate in the 7-8 percent range comparable to what several other East Asian countries have achieved since the 1970s. Aside from attention to the macroeconomic fundamentals and investment in human resources, such performance will depend upon the initiative and dynamism of the private sector. As with the other East Asian economies, Cambodia's ability to realize its full economic potential will be a function of private sector led development, with the public sector playing a supporting, catalytic role. Improved macromanagement and the government's liberalization policies have begun to stimulate private investment mainly in the urban areas. Construction, light manufacturing and service activities are on the rise and its is these that have been largely responsible for Cambodia's respectable growth rate during the first half of the 1 990s. A substantial flow of FDI has usefully augmented private capital formation and fueled the expansion of commercial real estate, trading and the communications industry. Maintaining these rapid trend rates of growth will require action by the Government in five areas: (i) Trade and Tax Changes. A strong start has been made with trade and tax reforms, as described earlier in the Report. The response from the private sector and foreign investors has been encouraging. But in order to continue the momentum, it will be necessary to satisfy the expectations that have been generated and move to the next stage. This will help to sharpen incentives and market competition still further. (ii) Governance. To strengthen private investors' belief in the govemment's commitment to reform and the irreversibility of the liberalization measures already taken, improvements in governance are highly desirable. These should be designed so as to increase accountability of public agencies, minimize political interference in policy enforcement, reduce red tape, promote transparency and build trust between the government and the business community. Better governance will lessen the perceived risk and transaction costs for local as well as foreign investors. (iii) Legal System and Legislation. Both the strengthening of markets and improvements in governance call for an effort to build an autonomous, impartial and effective legal system that is able not just to pass laws but to enforce them as well. Such institution building is a lengthy process, which is all the more reason to give it early attention. It will require the accumulation of specialized skills, putting in place a substantial infrastructure of courts and enforcement mechanisms and embedding a number of substantive and procedural rules. Development of the legal system will buttress the progress made in adopting fundamental pieces of legislation, such as the Law on Investment and the Law on Commercial Regulations and Registration. However, other legislation has been delayed because of insufficient technical capacity or sometimes insufficient political commitment. In some cases, such as the Financial Institutions Law, the Government needs to act with speed so as to clarify the legal framework for the ownership, capital structure, management and prudential supervision of banks. Furthermore, implementing regulations for the Law on Investment will clarify the scope of investment incentives. (iv) Public Utilities. A serious bottleneck to private sector development is the inadequate supply and poor quality of basic services. This has been repeatedly singled out as one of the principal factors that sharply increases the costs of doing business in Cambodia. As an initial step, the Government should undertake the organizational changes and the investment needed to augment the supplies of power, water and communication services. But the medium run strategy should be to divest public utilities, where this is feasible, and to encourage the entry of the private sector into these activities. To ensure competition and efficient services delivery by private suppliers, the Government will also have to build its regulatory capacity, drawing where possible on the experience of other countries that have taken the privatization route. (v) Administration. An enabling environment in which transaction costs for private participants are low requires an efficient administration. Currently, Cambodia's administrative capabilities are inadequate even though the level of civil service employment has been rising. There are three main problems: first is the acute shortage of skilled and experienced personnel; second civil service pay scales are low and provide few incentives; third the organization of ministries and the information systems at their disposal are still weak. All of these deserve urgent attention because delay will only worsen the situation and administrative shortcomings will slow progress in other areas needed to create the desired enabling environment.  - 31 - 94. During 1992-95, the international community pledged significant official assistance (about US$2 billion) which has been fully disbursed. At the Consultative Group (CG) meeting in July 1996, US$500 million was pledged, of which a substantial part has been disbursed to date. Therefore, maintaining the level of official disbursements would require commitments of official assistance of about US$455 million per year during 1997-99, of which about US$60 million would be balance of payments/budget support (see Table 8). Until the Government significantly increases domestic revenues, official assistance would need to cover some recurrent expenditures (especially for civil service reform and military demobilization), domestic counterpart funds, and the foreign exchange costs of the public investment program. Therefore, in the near term there would remain a need for some fast- disbursing assistance. The Government's priorities for official assistance are outlined in its Public Investment Program for 1997-99 are discussed in paras 66-72. Table 7: External Financing Requirements 1/ (in million of US dollars) 1996 1997 1998 1999 2000 Prel. Projection Financing Needs Current Account Deficit 488 536 561 570 580 Reserve Accumulation of NBC 52 56 20 33 41 Medium & Long-term Debt Amortization 16 7 15 17 17 Total 557 599 597 620 639 Financing Resources Official Grants 299 274 257 246 200 Medium & Long-term Borrowing 75 85 117 125 149 IMF (net) 0 40 -1 -4 -10 Foreign Direct Investment 241 252 269 288 300 Other Short-term -58 -52 -45 -34 0 Total 557 599 597 620 639 1/ For 1997-99, the projection is based on the PFP framework for 1997-99. Source: World Bank staff estimates and projections.  - 32 - Table 8: Required Commitments of Official Development Assistance (US$ millions) Existing Comistment Projected Commitment Commitment CG 1996 1997 1998 1999 BOP/Budget Support 97 65 65 55 Project Assitance 1/ 404 390 390 400 Total 501 455 455 455 1/ Including special program, such as CMAC. Source: World Bank staff estimates and projections. 95. Downside Risks. Cambodia faces a number of risks and uncertainties. In the near term, the primary risk would be either a loss of fiscal discipline, due to an inadequate revenue effort, or delays in implementation of necessary economic reforms, especially in the period preceding the national elections. Over the medium term, the primary risk would stem from inadequate pace and depth of economic reforms necessary to place the economy on a sustainable growth path. Under this scenario, a loss of macroeconomic stability combined with little structural reform could lead to inflationary pressures resulting from domestic financing of the budget deficit, which would lead to price rises and balance of payments pressures. Moreover, inadequate investments in human capital because of continued weak revenue performance could pose a threat to future growth, once the gains from liberalization and relative stability have been exhausted. Such a situation could jeopardize the sustainability of development and, in turn, result in lower inflows of grants and concessional loans. Obviously, this would translate into lower growth. Another danger could be a further deterioration in the transparency of economic management. In particular, Cambodia's natural resources would be exploited in an unsustainable manner with inadequate resources accruing to the state. Should this persist for an extended period, a major source of growth for the Cambodian economy would be squandered and the economy's future prospects would be adversely affected.  - 33 - Appendix I Page 1 of 10 Appendix I: Assessment of Public Investment 1. A brief assessment of public investment by sector is given below. The sectors covered are agriculture and rural development, health, education, energy, transport, and water supply and sanitation. Each sectoral discussion is in two parts. The first of these is an assessment of the current situation, focusing on the following issues: * The appropriateness of the current investment level: whether it is adequate relative to the needs of the country and whether there is an appropriate division of labor between the public and private sectors; also discussed is whether the balance is appropriate between current and capital expenditures, and between wage and non-wage O&M expenditures; * The current policy environment (pricing policy, cost recovery, autonomy of SOEs, etc.) and implementation capacity, and what needs to be done to make expenditures more effective; and - The adequacy of the current private-public mix (for example, does the Government have a legitimate role or should more activities be left to the private sector?). 2. The second part of each sectoral discussion is an assessment of the PIP for 1997-99, focusing on the following issues: * Is the PIP consistent with the Government's stated overall development strategy as well as its sectoral strategy? * What major projects should be avoided or delayed? What projects need to be added or advanced? * Does the PIP fully take into consideration the associated recurrent expenditure requirements? * Is the PIP consistent with the desired private/public mix? A. Summary of Main Findings 3. The main findings are summarized below: * Government involvement in the public investment projects is generally justified. One notable exception is the agriculture sector, e.g., agricultural inputs distribution, rice trading, and rubber marketing. The Government has committed to privatize these activities in the PFP. Greater private participation should be actively sought out, as only in the power sector are there important private initiatives to address power supply in provincial towns. In health, spontaneous private investment has only focused on the sale of drugs or disease treatment and on private medical consultations. In education, private sector involvement is restricted to vocational education and higher education. In transport, proposed BOT operations have yet to attract private investors. In water supply, private participation has been only in the form of outsourcing goods and services.  - 34 - Appendix I Page 2 of 10 * While it is difficult to judge the appropriateness of the investment level, as a significant part of donor-financed projects operate outside of Government agencies (in agriculture and rural development, for example), the level of donor-financed investment could be considered reasonable with respect to absorptive capacity. The budgetary contribution, however, is inadequate in providing non-wage O&M expenditures-- most severely in education, transport, and agriculture and rural development (see Table 5 in the main text). * The policy environment has improved toward a more market-oriented strategy, but much still needs to be done, especially in the area of cost recovery. In power, the current tariff levels do not permit cost recovery because of EDC's poor collection records. In water supply, the Government has recently agreed to a revamped water tariff structure for Phnom Penh city, but it is not clear whether the autonomous PPWSA has authority to raise tariff rates. In health, there exists a de facto policy of cost recovery, with practitioners and specialists charging patients informally for services in public facilities. In education, despite non-existent cost recovery policies, even for higher education, household spending is perhaps three to eight times that of government expenditures at the different levels of education. In transport, despite increased traffic volumes and heavier axle loads, there are no adequate road user charges. * Implementation capacity and the effectiveness of expenditure, although improving, are weak in all ministries (with the possible exception of health). In education, weak implementation capacity is due primarily to the absence of managerial capacity among the sector's 74,000 employees. The cost-effectiveness of expenditure is hampered by excessive numbers of non-teaching staff. In agriculture, capacity is limited also, especially in research and extension. While continued technical assistance is required, more effective use will be critical to improving implementation capacity. * While the sectoral description in the PIP document is adequate, the linkage between the stated strategy and the proposed PIP could be strengthened. The supply-driven nature of some projects is a problem in this regard. In particular, in contrast to the emphasis given to rural development in view of its importance for promoting broad-based economic development and poverty reduction, not enough projects that specifically target rural development are programmed. * While a number of the "high priority" projects require feasibility study before actual implementation, some projects in particular would require a rigorous feasibility and sustainability study. Examples are: in agriculture, small irrigation systems; in health, national hospital rehabilitation and mental development programs; and in power, the Kirirom electricity station rehabilitation project. The viability of some other projects also would need to be re-examined based on more details of those projects or the completion of the sector master plan. Examples are: in agriculture, canal rehabilitation and an animal production center; in health, pharmaceutical reform; in power, the KamChay hydropower project and the Sambor hydropower study; and in water supply, Chinese-assisted rural water supply. * Some issues require fuller treatment in the PIP. In rural development, projects specifically aimed at this area--such as rural roads, rural water supply, and rural electrification--are scant. In agriculture, projects for rehabilitating and upgrading agricultural training institutions, and developing rural credit services, are missing. In health, the continuation of the blood transfusion program is in doubt as ICRC begins to withdraw from its large program of support and no other donors are lined up to fill the gap. In education, secondary education, which will become increasingly important to provide further opportunities for those who complete primary education and as the base for  - 35 - Appendix I Page 3 of 10 strengthening the quality of tertiary education, is largely neglected. In transport, although a sustainable maintenance system has to be developed to ensure that investments will continue to deliver the expected benefits after rehabilitation road works, little funding is provided for the maintenance of recently rehabilitated roads. B. Agriculture and Rural Development 4. Assessment of the Current Situation. Public investment expenditures through the Ministries of Agriculture and Rural Development were US$11.8 million in 1995, and US$32.1 million (budget) in 1997, rising from 5.6 percent to 14.2 percent of the total. How much additional public investment in the sector takes place through wholly foreign-funded projects not reflected in the national budget is not known, but it is possible that part of the increase in budgeted expenditure for investment in agriculture simply represents a shift from direct foreign assistance (outside the budget) to budgeted investment. The analysis of the 1994-96 priority PIP, including NGO and donor programs, carried out for the 1994 World Bank Economic Report, indicated that an annual amount of expenditure on agriculture and rural development of about US$90 million should be maintained, with a decreasing proportion going to food aid, food for work, and other short-term relief measures, and an increasing proportion going to long- term productive investment, including capacity building. At least half of this amount in 1993 was spent by NGOs, and most of the rest was provided and managed by international organizations and other donors. A progressive shift to Government execution, and recording in the national budget, was expected. The data provided on the 1995 and 1997 capital budget expenditures suggest that this shift is taking place, but without a more detailed study, it is not possible to tell what is happening to donor and IO/NGO financing trends. While there are no estimates, the rate of change in private investment in agricultural sector could be considerably higher than public investment growth as rural households and entrepreneurs attempt to recapitalize and exploit the opportunities afforded by an expanding economy. 5. While major changes toward a more market-oriented strategy have been introduced since the late 1980s, there still remain areas to be further liberalized. The Government should have a major role in organizing the provision and maintenance of public infrastructure for agriculture, including the provision of roads, water, research and extension, animal health and crop protection services, and the management of common property resources such as public lands, forests, and water and fisheries. The Government's policy should be to avoid direct intervention in the economy and to promote the development of competitive markets for agricultural inputs and products, intervening only for the regulation of standards, the protection of public health and the environment, and the management of emergency situations such as floods and epidemics. In accordance with this strategy, the Government needs to wind up its involvement in agricultural inputs distribution (through COCMA), rice trading, and rubber marketing (through KAMPEXIM or other SOEs). The implementation capacity of the Ministry of Agriculture, Forestry and Fisheries, especially in research and extension, is weak. 6. Assessment of the PIP. It is difficult to judge the appropriateness of the level of investment. Such an assessment should take into consideration rural investments in other sectors and also the implementation capacity of the ministries. Within the sector, the PIP allocates about half of the total to crop production, followed by de-mining, research and extension, and livestock. This sector allocation within the sector is broadly consistent with the Government's sectoral strategy and the Bank's policy dialogue with the Government. A notable exception is the lack of projects that specifically target rural development, such as rural roads and rural water supply.  - 36 - Appendix Page 4 of 10 7. The feasibility of the some of the larger items included in the "high-priority" list would need to be carefully reviewed before actual implementation. Some examples are canal rehabilitation, "small irrigation systems", and the animal production center. In contrast, the omission of other important projects whose priority has been urged in numerous donor reports would need to be addressed--such as investment in rural roads (which would probably require at least US$10 million per year added to ongoing programs), investment in the rehabilitation and upgrading of agricultural training institutions (which would require up to US$25 million), the development of rural credit services, or support for any of the programs under the Ministry of Rural Development. 8. The Ministries of Agriculture and Rural Development approved capital expenditure budgets for 1997, exceeding their current budgets by a factor of about 4:1 in each case. Given the pervading lack of funds for salaries and non-wage operating expenses, and the low level of motivation and output resulting from this, it would be difficult--without an increase in its current budget for 0 & M, assured counterpart budgets, and increased technical assistance for capacity building--to satisfactorily accomplish all of those development projects for which funding is either committed or proposed. In particular, care needs to be given to ensuring feasibility of any large investments for water control projects before firm funding commitments are made. C. Health 9. Assessment of the Current Situation. The Government's health budget expenditure has grown rapidly but is still well below that of other poor countries and well below the minimum expenditure required for the delivery of basic health services. The Ministry of Health (MOH), with its very low budgets of recent years has spent most of its budget on salaries, running costs, and drugs. The Ministry of Health's budgets for non-wage O&M have been substantial compared to salaries, but the ability to expend those resources has lagged behind salary expenditures. Donor direct financed programs have funded the construction and equipping of many facilities in Cambodia, but not through the budget of the MOH. With the recent funding from the Bank and the ADB directly flowing through the Government system, the MOH will build the basic service delivery capacity that the many disparate donor and NGO programs have long needed as a framework for their own more targeted and local health projects. 10. Some indications from a pharmaceutical assessment of the MOH's drug logistics system, the coverage and cure rate of the tuberculosis program, and the proportion of doctors working outside Phnom Penh show improving cost effectiveness. The MOH is one of the more capable and efficient ministries. At the policy and strategy level, the MOH has made impressive strides, but the capacity for more detailed implementation activities in the area of expenditure planning, accounting and disbursement, and procurement is needed. 11. The priorities of the MOH are to control communicable and preventable diseases and to rehabilitate and extend access to basic health services. The private sector is not constrained from entering these areas of health services and in fact will be contracted to provide special services in HIV control and malaria prevention. On an experimental basis, the MOH will contract out some basic service facilities to the private sector in order to compare costs, quality, and impact with publicly managed services. Spontaneous private investment has focused where private returns are more lucrative, namely on the sale of drugs for disease treatment and private medical consultations. No substantial investments in private hospitals have yet emerged. The network of public health facilities in Cambodia has long pursued a de facto policy of cost recovery, with practitioners and specialists  - 37 - Appendix I Page 5 of 10 charging patients informally for services in public facilities. In 1996 the MOH produced a statement of principle and policy on the question of fee schedules and formal cost recovery in public facilities, committing the ministry to implement over time a more rational system, through which fees collected would support service improvement. 12. Assessment of the PIP. The PIP summarizes well the policy priorities of the MOH. The investment program targets public goods and basic services, all of which are disproportionately consumed by the poor. The Blood Transfusion Program is entering a period of uncertainty as the ICRC begins to withdraw from its large program of support for the Cambodia blood supply system. There are, as yet, no donors ready to fill the gap. The Blood Transfusion Service is considered a high quality program for a country of Cambodia's level of development, and its continuation is now in doubt. 13. Central hospital capital budgets are a key issue in the PIP, as this historically has been a heavy budgetary burden on the MOH and a regressive feature of the MOH 's spending pattern. In the Core PIP Tables, a funding gap of US$3 million is identified for national hospital rehabilitation. This issue would require a detailed analysis of the cost-effectiveness and poverty targeting of such investments and more attention to issues of donor coordination. The "Mental Development Program" would also need to be scrutinized before the large funding gap is met with donor or Government of Cambodia resources; a mental health program would meet real needs in war-traumatized Cambodia, but its cost- effectiveness may not reach competitive thresholds. Pharmaceutical reform is another area that would need to be scrutinized. If the funding gap of US$4.2 million for 1997 includes the additional cost of rehabilitating the drug factory, this actively would need to be given lower priority. 14. The World Bank funded investments in rural facilities have been analyzed and judged acceptable in terms of their recurrent cost burden. Many of the other programs listed are counting recurrent-type costs as part of the PIP (for example, the tuberculosis and malaria programs and training). Most of the programs listed therefore do not involve heavy recurrent cost implications. The PIP includes a program of financial pilot projects to assess the fiscal and health impacts of different mixes of private and public sector production of health services. Over the next few years, these pilots will be useful for long-term planning for the sector and, in particular, for deciding how to release or reduce the Government's responsibility for hospital recurrent costs. D. Education 15. Assessment of the Current Situation. Total education investment requirements for the next five years is estimated at approximately US$300 million. Despite significant support from the international community, the Education Ministry continues to face significant investment shortfalls. One major gap in the current investment program is a massive program of school building rehabilitation and construction, including the provision of adequate water and sanitation, furniture, and equipment. The combined effects of a constrained recurrent budget and high numbers and costs of trained teachers provide little budget for non-wage O&M, especially in the areas of quality improvement, (for example, classroom materials and building maintenance). Salaries constitute between 85 and 95 percent of recurrent spending on education by the provinces, which are responsible for basic education and most secondary education, and the present trends indicate that this share is rising. There is currently very little private sector investment in education other than in vocational training (for example, language and commercial courses) and in a few higher education programs.  - 38 - Appendix I Page 6 of 10 16. The education sector's implementation capacity is weak, owing primarily to the lack of managerial capacity among the sector's 74,000 employees. The Ministry lacks qualified trained planners and managers throughout the system, and especially in the area of financial management. The cost-effectiveness of expenditure on education is hampered by excessive numbers of non-teaching staff. Of the 38,200 employees in primary education, 7,800 are estimated to be out-of-classroom administrative staff, and approximately 4,000 of this number are qualified teachers. The Education Ministry planned to redeploy 1,000 qualified staff from support positions to active teaching positions for the beginning of the 1996-97 school year, and it proposes to extend this redeployment on the same scale annually over the next few years. Additional measures taken by the Ministry to increase the cost- effectiveness of expenditures include the establishment of a cluster school model to lower administrative costs, and share resources among several small-scale schools, thereby increasing efficiency. 17. Although education in Cambodia is, in principle, free of charge to all students, unofficial fees are charged at most levels of the education system. Despite the lack of a transparent pricing policy and cost recovery system for the education sector, household spending on education is perhaps three to eight times that of government expenditures at different levels of education. Cost recovery policies are currently non-existent, even at the higher education level, but the forthcoming Higher Education National Action Plan identifies the need for cost recovery in higher education and calls for a feasibility study. Private sector involvement in education is restricted primarily to vocational education and training and to higher education. 18. Assessment of the PIP. Priority in investment is being given to basic education, followed by higher education, and then technical and vocational education. However, the secondary education sub- sector is being relatively neglected, although it will become increasingly important to provide further opportunities for those completing primary education and as the base for strengthening the quality of tertiary education. The PIP would need to be adjusted to increase the relative level of investment in both lower secondary and upper secondary education. Another critical investment area is the financial management and administrative procedures necessary for running the education system at both primary and secondary levels. 19. The PIP does not, in and of itself, impose unsustainable additional recurrent costs in education on the budget. However, the PIP does not adequately address the ongoing problems of current expenditures in education--namely, the high salary costs relative to non-salary expenditures, which undermine quality, and also the low level of individual salaries, which undermines motivation, and ensures a short school day and a short school year, which undermines quality even further. 20. The Government needs to take a gradual approach to full privatization of the elements of the education and training system. The first step would be to increase levels of cost recovery within existing management and financial arrangements, and the second to encourage a more commercial approach, especially in technical and vocational education and higher education initially, with institutions being allowed to raise and keep additional incomes. E. Energy 21. Assessment of the Current Situation. The Government's priority program focuses mainly on the power sub-sector, since the highly deregulated hydrocarbon sector is driven by market forces. The  - 39 - Appendix I Page 7 of 10 power supply constraint in Phnom Penh is about to be resolved as multilateral and bilateral support in generation and distribution is being complemented by private independent power producers. In addition, there are important private initiatives to address power supply in provincial towns. In this respect, the level of investment in recent years has been adequate both in absolute terms and in its private-public mix. Although Cambodia's energy needs largely exceed the current supply, a larger level of investment would have been constrained by limited implementing capability. The Government's strategy addresses short-term investment needs as well as medium- to long-term issues associated with institutional strengthening and sector reform, including the commercialization of the state-owned power utility, Electricite du Cambodge (EDC). 22. The government's efforts to re-establish an adequate power supply and to reform the sector are constrained by: the overall weakness in the management and implementation capacity of institutions; the financial weakness of EDC; the slow pace in implementing sector reform measures, in particular in the appointment of EDC's board, the enactment of the Electricity Act, and the establishment of EAC; and inadequate transparency and competition in the current process for private sector entry, resulting in the high price of Independent Power Producers (IPP). 23. The current tariff levels do not permit cost recovery because of EDC's poor collections record (around 60 percent--a problem caused mostly by Government customers). Therefore, there is an urgent need to agree with the Ministry of Economy and Finance on the implementation of an action plan to address EDC's accounts receivables. It is also urgent to secure funding for EDC's Institutional Support. EDC's financial situation is weak and its short-term commercial performance will rely heavily on the availability of technical assistance in consumer services (collections) and marketing. 24. Assessment of the PIP. The Government's stated strategy in the PIP document is sound and addresses Cambodia's most important energy sector needs. However, the proposed PIP is somewhat unbalanced and appears to be supply driven (i.e., only those projects supported by multilateral or bilateral donors are included). This could introduce a bias toward projects of specific commercial interest (e.g., donor country suppliers), regardless of their economic merits; because of grant financing, the economic viability of projects could be ignored. Another apparent problem is insufficient coordination among donors. 25. There is no project addressing rural electrification needs, inconsistent with the Government's overall strategy and the extremely low level of electrification in rural areas. The PIP includes the Kirirom power station rehabilitation project: the economic merit of this investment would need to be fully examined given its high capital cost and relatively small capacity. Its status would need to be reviewed once the ongoing Master Plan for Transmission and Rural Electrification (AusAid- funded/World Bank-executed) is completed. KamChay hydropower is misclassified as an ongoing project, as it is still at an early stage of study, and its priority would need to be re-examined upon completion of the Master Plan. The high-priority character of the Sambor hydropower study would also need to be re-examined upon completion of the Master Plan. F. Transport 26. Assessment of the Current Situation. The 1994 Economic Report estimated the priority investment program for 1994-96 at US$217 million, mainly aiming at emergency repairs of transport facilities, especially roads. A sizable amount of donor financing has been mobilized, but the envisaged  - 40 - AppendixI Page 8 of 10 budgetary contribution for complementing listed projects such as rural roads projects, as well as recurrent maintenance activities, has not materialized. While capital investment funded by external sources largely achieved the initial objective of emergency repairs to transport infrastructure it was not sufficient to keep up with the continued deterioration of the road network. The Ministry of Public Works and Transport (MPWT) is suffering from budget shortage and has no financing instruments for routine maintenance activities for transport infrastructure. Thus, maintenance has been deferred even for the recently rehabilitated facilities. A sustainable maintenance system has to be developed in order to ensure that investments will continue to deliver the expected benefits after rehabilitation works. 27. At present, despite increased traffic volumes and heavier axle loads, there are no adequate road user charges. Port charges and tariff setting are in their infancy. The Government has been processing the Road Act; the Act clarifies the responsibility of MPWT regarding road operations and management. MPWT is considering the possible introduction of Road Funds, an earmarked tax on gasoline to be used for road maintenance. Although there is discussion of a BOT operation for toll road operations between the international airport and downtown Phnom Penh, the MPWT has yet to attract private investors. Prospects for BOT operations for ports and railways are not promising at this stage, as private investors are requesting Government support for fixed infrastructure costs. 28. Studies are needed to develop a resource mobilization strategy for transport investments. This strategy would need to cover such issues as road pricing, user charges, duties, and taxation. On the other hand, a strategy would also need to be established for improving the operations of transport public enterprises, privatizing transport services, and facilitating private sector participation in the financing of the transport sector. In the process of establishing strategies, in the short term, the operations of Government institutions including state-owned transport enterprises would need to be improved by obtaining technical assistance focusing on management in operations and equipment maintenance. 29. Assessment of the PIP. While sector strategy in the PIP document properly addresses the needs, constraints, and challenges, the PIP only lists possible donor-financed projects and consequently the linkage with the stated strategy is not strong enough. 30. The PIP does not include the rehabilitation of the section between Pursat and Sisophon on Route 5, which the ADB has been discussing with MPWT under the next road project. This rehabilitation is of high priority as, once it is completed, it would reduce the transportation operation costs for the commodity flow between Thailand and Cambodia and would contribute to reducing the gap in the commodity prices between the two countries. Within Route 6, which is included in the PIP, the section between Siem Reap and Kampong Thum would need to be given priority, as it would provide another transport mode in addition to air transport between Phnom Penh and Siem Reap, the tourism area. It would also provide direct access between the richest farmland (the Tonle Sap area) and Phnom Penh. G. Water Supply and Sanitation 31. Assessment of the Current Situation. While public investment in the sector is highly inadequate in terms of needs, it has been reasonable with respect to the resource absorption capacity. A substantial part of external assistance has been directed at the repair and rehabilitation of existing facilities, making the distinction between current and capital expenditure unclear. Adequate data are lacking on the wage/non-wage mix in public expenditure in water utilities, but the Phnom Penh Water  - 41 - Appendix I Page 9 of 10 Supply Authority (PPWSA) has a fairly good record in this respect, with wages expected to account for under 20 percent of total operational expenditure. 32. The Government is committed to the principle of cost recovery for water and sanitation services and has agreed recently to a revamped water tariff structure for Phnom Penh city. The Government's recent legislation conferring a degree of autonomy on PPWSA under the new Public Enterprise Law has increased managerial autonomy and is expected to generate incentives for improving operational efficiency. It is not clear, however, whether this autonomy extends to empowering PPWSA to raise tariff rates. The Government's long-term objective for provincial towns is to develop autonomous utilities on the model of PPWSA, although this is unlikely to be achieved in the PIP period for 1997-99 except in the port town of Sihanoukville. 33. The sector suffers from weak regulatory structures, along with inadequate institutional and implementation capacity. Skilled manpower in engineering, accountancy, administration and procurement, and even semi-skilled manpower for tasks such as meter-reading, and leak repairing, is in short supply, especially outside of PPWSA. A crucial weakness in the existing sectoral environment is in the policymaking process itself. Responsibility for water and sanitation is fragmented among at least seven different institutions in the Government, and inter-agency coordination has been weak. Recently, the Government set up an Inter-ministerial Coordination Committee to address this problem. The Government has encouraged the private sector to participate in both rural and urban water and sanitation provision. In the absence of adequate regulatory and institutional framework, private sector participation has been mainly in the form of outsourcing goods and services. 34. Assessment of the PIP. The PIP in the sector appears largely consistent with the Government's stated development strategy. Investments in expanding water supply in Phnom Penh make good sense as a growth promotion strategy as well as a strategy to improve public health. The former would be accomplished by the creation of a facilitative industrial and commercial environment, and the latter by the mitigation of the existing adverse health impacts of the unsatisfactory water supply and sanitation services in Phnom Penh. 35. The PIP's sole public investment in a free-standing rural water supply is the on-going Chinese- assisted project. Given the importance of the sector, the PIP should perhaps have identified a pipeline for rural water or sanitation. A feasible option, once initial improvements in Phnom Penh are completed, is for an increased share of public investment to be directed to secondary cities and rural areas of the country. 36. The data in the PIP do not enable an assessment to be made of whether recurrent costs have been provided for. However, in respect of the Phnom Penh water supply investments, this is not a significant issue, as the PPWSA appears to be capable of managing the incremental recurrent costs without recourse to the budget. The PIP is generally consistent with the appropriate public-private mix in the country's present conditions.  - 42 - Appendix I Page 10 of 10 Table A.1: PIP 1997 - 1999: Programmed Level Allocation by Sector Sector Name Programmed Level Us, 000 % of total % of sector Agriculture 149668 12.5 100.0 Crop production 72234 48.3 De-mining 24275 16.2 Fisheries 2280 1.5 Forestry 11210 7.5 Livestock 18652 12.5 Research and extension 21017 14.0 Transport 210125 17.5 100.0 Aviation 18067 8.6 Ports and Waterways 2579 1.2 Rail 3000 1.4 Roads 186479 88.7 Communications 56400 4.7 100.0 Information 21600 38.3 Telecommunications 34800 61.7 Trade and Industry 12856 1.1 100.0 Manufacturing 9856 76.7 Mining 3000 23.3 Education 162400 13.5 100.0 Basic Education 95800 59.0 Higher Education 29700 18.3 Technical & Vocational 20000 12.3 Upper Secondary Education 10400 6.4 Youth and Sports 6500 4.0 Energy (Electricity) 152342 12.7 Religion and Culture 30731 2.6 Administration 11781 1.0 Water Supply & Sanitation 113988 9.5 Health 233811 19.5 Environment & Conservation 23365 1.9 Social & Community Services 39824 3.3 Tourism 2709 0.2 Total for Sectors: 1200000 100.0 Special Programs: 200000 Grand Total 1400000 Source: Public Investment Programme, 199 7-99, Ministry of Planning.  - 43 - Statistical Appendix List of Tables Table No. 1 Population by Age Group and Sex, 1993 2 Income and Social Indicators 3. Gross Domestic Product by Industrial Origin at 1989 Constant Prices 4. Growth Rates of GDP By Industrial Origin at 1989 Constant Prices 5. Shares of GDP by Industrial Origin, at 1989 Constant Prices 6. Major Export Products, 1991-1996 7. Customs Imports, 1993-1995 8 Balance of Payments, 1991-1996 9. Summary of Budget Operations, 1991-1997 10. Structure of Revenue, 1994-1997 11 Budgetary Expenditure by Economic Classification, 1994-1997 12. External Debt, 1991-1995 13. Consumer Price Index and Exchange Rates 14. Monetary Survey, 1991-1996 15. Agriculture, Livestock, Fishery, and Forestry Production, 1985-1996  - 44 - Table 1: Population by Age Group and Sex, 1993 Of which: Of which: Age Group Share (%) Male (%) Female (%/6) 0-9 28.5 49.8 50.2 10-19 24.1 50.2 49.8 20-29 16.1 46.9 53.1 30-39 12.3 44.7 55.3 40-49 7.5 42.7 57.3 50-59 5.5 43.6 56.4 60 and over 6.0 41.7 58.3 Total 100.0 47.4 52.6 Source: National Institute of Statistics.  - 45 - Table 2: Income and Social Indicators Unit of Latest Single Year Indicators Measure 1970-75 1980-85 1990-96 Population Population (mnid-year) millions 7.1 7.6 10.0 Population growth rate annual % 0.5 3.4 3.0 Total fertility rate births per woman 5.5 5.1 5.1 Poverty National poverty line Total Riels per day Phnom Penh .. .. 1578 Other urban " . .. 1264 Rural .. .. 1117 National Headcount Index Total % of population .. .. 39.0 Phnom Penh .. .. 11.4 Other urban .. .. 36.6 Rural .. .. 43.1 Income GNP per capita US$ 280 Consumer price index Dec. 1989 = 100 .. .. 1817 Social Indicators Public expenditure on basic social services % share of GDP .. 1.8 Gross primary enrollment rate Total % of school age 42 .. 47 Male " 48 .. 48 Female 35 .. 46 Access to safe water Total % of population 45 Urban 97 .. 20 Rural 38 .. 12 Immunization rate Measles % under 12 months .. .. 38 DPT .. .. 38 Under-five malnutrition rate % age group .. 20 Life expectancy at birth years 40 46 52 Infant mortality rate per 1,000 livebirths 181 160 110 Under-five mortality rate per 1,000 live births .. .. 177 Maternal mortality ratio per 100,000 live births .. 500 900 Sources: Social Indicators of Development, 1996; Cambodia-Poverty Profile, 1993/94; and Bank staff estimates.  - 46 - Table 3: Gross Domestic Product By Industrial Origin at 1989 Constant Prices (in billions of riels) 1991 1992 1993 1994 1995 1996 Agriculture 135.9 138.5 137.1 137.1 145.9 148.5 Crop & Rubber 79.3 79.0 77.2 70.9 82.2 82.9 Rice 47.6 46.7 48.2 38.6 47.9 47.3 Other Crop & Rubber 31.7 32.3 29.0 32.4 34.3 35.7 Livestock 34.5 36.9 38.0 39.5 41.1 43.8 Fishery 13.5 12.7 12.0 11.8 12.2 12.1 Forestry 8.6 9.9 9.9 14.9 10.4 9.7 Industry 39.5 45.7 51.7 55.6 61.1 69.2 Mining and Quanrying 3.0 3.2 3.4 3.7 4.0 4.6 Manufacturing 18.4 19.0 20.5 22.1 24.3 27.5 Electricity and Water 0.5 0.6 0.7 0.7 0.8 0.9 Construction 17.6 22.9 27.1 29.1 32.0 36.2 Services 86.8 96.5 103.3 111.0 119.7 130.2 Transport and Comnmunication 7.0 8.1 8.9 9.7 10.7 12.2 Wholesale and Retail Trade 34.4 39.9 42.3 44.8 48.8 54.6 Hotels and Restaurants 1.0 1.3 1.4 1.7 1.8 2.2 Govt. Admin., Education & Health 11.0 11.0 11.5 12.5 12.9 12.7 Home Ownership 16.3 17.4 18.8 20.3 21.8 23.0 Other Services 17.1 18.8 20.4 22.1 23.7 25.5 Gross Domestic Product 262.2 280.7 292.1 303.7 326.8 347.9 Memorandum Items Nominal GDP 1336 2509 5414 6131 7200 8200 Nomial GDP in million US$ 1900 2002 2245 2340 2923 3125 Sources: Cambodian authorities and World Bank/lMF estimates.  - 47 - Table 4: Growth Rates of GDP By Industrial Origin at 1989 Constant Prices (in percent) 1991 1992 1993 1994 1995 1996 Agriculture 6.7 1.9 -1.0 0.0 6.4 1.8 Crop & Rubber 7.2 -0.4 -2.3 -8.2 15.9 0.9 Rice -4.0 -1.9 3.2 -19.9 24.1 -1.3 Other Crop & Rubber 29.9 1.9 -10.2 11.7 5.9 4.1 Livestock 1.2 7.0 3.0 3.9 4.1 6.6 Fishery 8.9 -5.9 -5.5 -1.7 3.4 -0.8 Forestry 24.6 15.1 0.0 50.5 -30.2 -6.7 Industry 8.8 15.7 13.1 7.5 9.9 13.3 Mining and Quarrying 7.1 6.7 6.3 8.8 8.1 15.0 Manufacturing 7.0 3.3 7.9 7.8 10.0 13.2 Electricity and Water 0.0 20.0 16.7 0.0 14.3 12.5 Construction 11.4 30.1 18.3 7.4 10.0 13.1 Services 8.5 11.2 7.0 7.5 7.8 8.8 Transport and Conunwnication 9.4 15.7 9.9 9.0 10.3 14.0 Wholesale and Retail Trade 12.8 16.0 6.0 5.8 9.1 11.9 Hotels and Restaurants 42.9 30.0 7.7 21.4 5.9 22.2 Govt. Admin., Education & Health 0.0 0.0 4.5 8.3 3.6 -1.6 Home Ownership 2.5 6.7 8.0 8.0 7.4 5.5 Other Services 10.3 9.9 8.5 8.3 7.2 7.6 Gross Domestic Product 7.6 7.1 4.1 4.0 7.6 6.5 Sources: Cambodian authorities and World Bank/IMF estimates.  - 48 - Table 5: Shares of GDP By Industrial Origin, at 1989 Constant Prices (in percent) 1991 1992 1993 1994 1995 1996 Agriculture 51.8 49.3 46.9 45.1 44.6 42.7 Crop & Rubber 30.2 28.1 26.4 23.3 25.2 23.8 Rice 18.2 16.6 16.5 12.7 14.7 13.6 Other Crop & Rubber 12.1 11.5 9.9 10.7 10.5 10.3 Livestock 13.2 13.1 13.0 13.0 12.6 12.6 Fishery 5.1 4.5 4.1 3.9 3.7 3.5 Forestry 3.3 3.5 3.4 4.9 3.2 2.8 Industry 15.1 16.3 17.7 18.3 18.7 19.9 Mining and Quarrying 1.1 1.1 1.2 1.2 1.2 1.3 Manufacturing 7.0 6.8 7.0 7.3 7.4 7.9 Electricity and Water 0.2 0.2 0.2 0.2 0.2 0.3 Construction 6.7 8.2 9.3 9.6 9.8 10.4 Services 33.1 34.4 35.4 36.5 36.6 37.4 Transport and Communication 2.7 2.9 3.0 3.2 3.3 3.5 Wholesale and Retail Trade 13.1 14.2 14.5 14.7 14.9 15.7 Hotels and Restaurants 0.4 0.5 0.5 0.6 0.6 0.6 Govt. Admin., Education & Health 4.2 3.9 3.9 4.1 3.9 3.7 Home Ownership 6.2 6.2 6.4 6.7 6.7 6.6 Other Services 6.5 6.7 7.0 7.3 7.3 7.3 Gross Domestic Product 100.0 100.0 100.0 100.0 100.0 100.0 Sources: Cambodian authorities and World Bank/IME estimates.  - 49 - Table 6: Major Export Products, 1991-1996 (in millions US$) 1992 1993 1994 1995 1996 Total Exports 51 219 462 809 659 Rubber 12 11 30 41 32 Logs 25 50 124 112 53 Sawn timber 34 73 73 96 Soybeans 2 Maize 1 Fishery products 1 4 Sesame 2 Kapok fiber 0 Other traditional exports 7 6 7 1 Non-traditional exports 43 113 Re-exports 117 228 540 361 Source: Data provided by the Cambodian authorities.  - 50 - Table 7: Customs Imports, 1993-1995 (in millions of US dollars) 1993 1994 1995 Gold 28.0 78.4 305.0 Cigarettes 60.0 95.9 192.5 Petrol 17.7 29.0 58.3 Motorcycles 13.3 29.0 36.0 Diesel oil 18.4 30.4 51.0 Vehicles 18.5 12.0 22.0 Construction material 24.2 20.8 19.2 Clothing 20.7 11.9 17.2 Food Products 2.7 11.6 17.8 Beer 10.0 14.7 14.7 VCRs 15.8 23.1 14.9 TVs 10.3 21.2 17.3 Fabric 69.5 36.2 12.6 Cement 0.0 12.3 12.3 Radio cassettes 4.7 4.3 4.0 Vehicle parts 4.3 3.2 6.8 Fuel oil 2.7 3.2 6.4 Nonalcoholic drinks 3.8 5.9 4.3 Alcohol 0.7 7.7 6.9 Refrigerators 1.1 1.3 1.8 Generators 4.1 2.6 2.5 Sugar 0.0 13.8 6.4 Lubricants 0.0 3.0 4.5 Monosodium 0.0 6.1 9.6 Steel 0.0 7.8 4.3 Cooking oil 0.0 0.5 1.7 Silver 0.0 0.8 1.1 Other 30.8 66.4 78.8 Total 361.3 553.1 929.9 Source: Data provided by Cambodian authorities.  - 51 - Table 8: Balance of Payments, 1991-1996 (in millions US$) 1993 1994 1995 1996 Trade Balance -203.0 -275.4 405.0 -451.0 Total Exports 219.0 461.7 809.0 659.0 Domestic Exports 102.0 233.7 269.0 298.0 Re- Exports 117.0 228.0 540.0 361.0 Total Imports 422.0 737.1 1213.0 1110.0 O.w. Retained Imports 1/ 305.0 499.0 673.0 749.0 Services Balance 10.0 -74.6 -92.0 -60.0 Receipts 66.0 59.7 121.0 172.0 Payments 2/ 56.0 134.2 213.0 231.0 Private transfers 4.0 20.0 20.0 23.0 Current Account Balance -189.0 -330.0 -477.0 488.0 (excluding official transfers) Official Transfers 149.0 235.0 346.0 299.0 Current Account Balance 40.0 -95.0 -131.0 -189.0 (including official transfers) Capital Account 75.0 136.0 171.0 241.0 Official medium-and long-term loans(net) 5.0 54.0 71.0 59.0 Disbursements 5.0 61.0 75.0 75.0 Amortization 2/ 0.0 7.0 4.0 16.0 Foreign Direct Investment 0.0 80.0 151.0 240.0 Short-term flows and errors & omissions 70.0 2.0 -51.0 -58.0 Overall Balance 35.0 41.0 40.0 52.0 Financing -35.0 -41.0 40.0 -52.0 Change in gross official reserves 41.0 -72.0 -82.0 -52.0 Debt rescheduling 0.0 0.0 239.0 0.0 Arrears reduction 0.0 10.0 -239.0 0.0 I1 6.0 21.0 42.0 0.0 Purchase/disbursement 6.0 21.0 42.0 0.0 Repurchase/repayment 0.0 0.0 0.0 0.0 Memorandum Items: Current Account Balance/GDP (excluding official transfers) -8.4 -14.1 -16.2 -15.6 Current Account Balance/GDP (including official transfers) -1.8 -4.1 -4.5 -6.0 Gross Official Reserves 3/ In Millions Of US Dollars 71 100 182 234 In Months Of Imports of Goods and Services 1.8 1.4 1.5 2.1 1/ Total imports (including project aid imports and estimate of unrecorded imports) less re-exports. 2/ Accrued interest on external debt and scheduled amortization on the existing stock of debt vis-a-vis official creditors are excluded. 3/ For 1992-1993, gross official reserves are the gross foreign assets of the National Bank of Cambodia and the Foreign Trade Bank. From 1994 onward, gross official reserves are of National Bank only. Source: IMP' estimates based on data provided by Cambodian authorities.  - 52 - Table 9: Summary of Budget Operations, 1991-1997 I/ 1991 1992 1993 1994 1995 1996 1997 Budget (In Billions of Riels) Revenue 58.8 156.1 290.1 590.4 642.9 749.1 896.4 Tax 31.1 109.7 234.1 364.6 445.4 534.3 673.3 O/w Customs Duties 22.0 79.3 159.5 280.9 320.8 344.1 437.8 Non-tax 27.8 46.3 56.0 225.8 197.5 214.8 223.1 O/w SOE Transfer 25.8 42.3 53.6 42.7 26.7 39.2 55.3 O/w Forestry Exploitation .. 1.4 3.9 86.0 52.8 27.5 25.8 Expenditures 104.1 245.6 608.4 1009.1 1200.6 1342.8 1480.8 Current Expenditure 98.9 238.6 373.2 673.8 689.6 812.9 870.0 Defense & Security 46.8 118.6 219.4 398.2 398.2 399.9 390.8 O/w Salaries 22.5 56.9 105.3 192.1 214.8 220.6 232.5 Civilian 52.2 119.9 153.8 275.6 291.4 413.0 479.2 O/w Salaries 25.1 57.6 73.8 101.4 110.9 130.2 132.2 Capital Expenditure 5.2 7.1 235.2 335.3 511.1 529.9 610.8 O/w Domestically Financed 5.2 7.1 5.0 78.5 56.9 61.6 122.8 Current Deficit -40.1 -82.5 -83.1 -83.4 -46.5 -63.8 26.4 Overall Deficit -45.3 -89.6 -318.3 -418.7 -557.7 -593.7 -584.4 Financing 45.3 89.6 318.3 418.7 557.7 593.7 584.4 Foreign Financing 6.1 1.5 239.1 432.1 559.3 575.6 597.5 Project Aid 6.1 1.5 230.2 256.8 454.2 467.1 488.0 Budget Support 0.0 0.0 8.9 132.2 107.2 149.9 111.4 Domestic Financing 39.2 88.1 79.2 -13.4 -1.6 18.1 -13.1 (/w Bank Financing 14.5 112.1 30.7 -26.6 5.5 -17.0 0.7 (In Percent of GDP) Revenue 4.4 6.2 5A4 9.6 8.9 9.1 9.7 Tax 2.3 4.4 4.3 5.9 6.2 6.5 7.3 O/w Customs Duties 1.6 3.2 2.9 4.6 4.5 4.2 4.7 Non-tax 2.1 1.8 1.0 3.7 2.7 2.6 2.4 Expenditures 7.8 9.8 11.2 16.5 16.7 16.4 16.0 Current Expenditure 7.4 9.5 6.9 11.0 9.6 9.9 9.4 Defense & Security 3.5 4.7 4.1 6.5 5.5 4.9 4.2 Civilian 3.9 4.8 2.8 4.5 4.0 5.0 5.2 Capital Expenditure 0.4 0.3 4.3 5.5 7.1 6.5 6.6 Current Deficit -3.0 -3.3 -1.5 -1.4 -0.6 -0.8 0.3 Overall Deficit -3.4 -3.6 -5.9 -6.8 -7.7 -7.2 -6.3 Financing 3.4 3.6 5.9 6.8 7.7 7.2 6.3 Foreign Financing 0.5 0.1 4.4 7.0 7.8 7.0 6.5 Domestic Financing 2.9 3.5 1.5 -0.2 0.0 0.2 -0.1 O/w Bank Financing 1.1 4.5 0.6 -0.4 0.1 -0.2 0.0 1/ Cash basis Source:i Cambodian authorities.  - 53 - Table 10: Cambodia: Structure of Revenue, 1994-1997 (In billions of riels) 1994 1995 1996 1997 Prov. Budget Total revenue 590.4 642.9 749.1 896.4 Tax receipts 364.6 445.5 534.3 673.3 Direct taxes 8.6 20.9 26.5 40.3 Wage tax 0.0 1.1 2.7 3.5 Profit tax 6.3 17.8 18.5 32.8 Property tax 0.9 1.2 2.1 3.0 Others 1.5 0.8 3.1 1.0 Indirect taxes 75.0 103.8 163.7 195.2 Turnover tax 8.2 17.1 27.4 35.0 Consumption tax 46.9 60.0 70.4 79.3 Excise taxes 2.9 9.0 56.6 65.0 Tax on illegally imported cars 11.0 8.3 0.4 0.2 Others 6.0 9.2 8.9 15.7 Taxes on international trade 280.9 320.8 344.1 437.8 Taxes and duties on imports, of which 257.6 300.8 334.8 417,1 Import tariffs on petroleum 46.1 80.3 99.7 120.3 Taxes on exports 18.2 17.3 8.2 16.9 Others 5.1 2.7 1.2 3.8 Nontax receipts 225.8 197.5 214.8 223.1 Receipts on publicproperty 148.6 128.2 131.9 121.3 Fisheries 4.8 9.1 7.1 10.0 Forests 86.0 52.8 27.5 25.8 Receipts from public enterprises, of which 42.7 26.7 34.8 55.3 Factory leases 4.8 5.9 10.1 22.0 Civil aviation 8.2 10.8 17.1 16.5 Royalties and concessions 4.2 17.0 6.2 6.5 Privatization proceeds 0.0 0.0 21.6 0.0 Others 10.9 22.4 29.6 23.7 Othernontaxreceipts, of which 77.2 69.3 98.5 101.8 Posts and telecommunication 61.0 54.4 80.0 81.2 Source: Data provided by the Cambodian authorities.  - 54 - Table 11: Budgetary Expenditure by Economic Classification, 1994-1997 1/ 1994 1995 1996 1997 Budget (In billions of riels) Salaries 293.4 325.7 350.8 364.7 Operating costs 324.3 284.4 344.9 362.2 Social transfers 41.3 44.8 63.9 80.7 Economic transfers 4.7 14.5 16.1 10.2 Capital 335.3 511.1 529.9 610.8 Other 2/ 10.1 20.2 37.2 52.2 Total 1009.1 1200.7 1342.8 1480.8 (in percent of total expenditure) Salaries 29.1 27.1 26.1 24.6 Operating costs 32.1 23.7 25.7 24.5 Social transfers 4.1 3.7 4.8 5.4 Economic transfers 0.5 1.2 1.2 0.7 Capital 33.2 42.6 39.5 41.2 Other 2/ 1.0 1.7 2.8 3.5 Total 100.0 100.0 100.0 100.0 (In percent of GDP) Salaries 4.8 4.5 4.3 3.9 Operating costs 5.3 4.0 4.2 3.9 Social transfers 0.7 0.6 0.8 0.9 Economic transfers 0.1 0.2 0.2 0.1 Capital 5.5 7.1 6.5 6.6 Other 2/ 0.2 0.3 0.5 0.6 Total 16.5 16.7 16.4 16.0 1/ Cash basis. 2/ Includes interest payments and subsidies to provinces. Source: Data provided by the Cambodian authorities.  - 55 - Table 12: External Debt, 1991-1995 (in millions of US$) 1991 1992 1993 1994 1995 Total Debt Stocks 1/ 1894.6 1872.6 1862.1 1943.4 2094.1 Long-term debt 1721.4 1712.6 1718.3 1773.8 1882.1 Public and publicly guaranteed 1721.4 1712.6 1718.3 1773.8 1882.1 Private nonguaranteed 0.0 0.0 0.0 0.0 0.0 Memo: of which interest arrears 114.4 113.1 103.6 110.1 110.2 Official creditors 114.1 112.9 103.4 109.9 110.0 Private creditors 0.3 0.2 0.2 0.2 0.2 of which principal arrears 696.6 976.1 1269.3 1574.5 1574.5 Official creditors 696.0 975.7 1268.9 1574.1 1574.1 Private creditors 0.5 0.4 0.4 0.4 0.4 Use of IMF credit 26.8 14.9 8.6 29.6 72.0 Short-term debt 146.4 145.1 135.3 140.1 140.0 Principal Payments 0.0 0.0 0.0 0.0 17.2 Interest Payments 15.1 0.7 0.0 0.3 8.0 Debt Indicators Debt/Exports (