University of Michigan
Ben Thornley
Carson Christiano
International Financial Policy
April 20th, 2009
Cambodia: Macroeconomic Challenges
I. Macroeconomic Overview
Cambodia’s economy has grown rapidly over the past few decades. On average, real GDP grew 8.6 percent per year between 1994 and 2006, while per capita growth averaged 6.1 percent per year. Per capita earnings doubled from US$285 in 1997 to US$593 in 2007. This expansion can be attributed to high yields for agriculture, success in the garment and tourism industries, and high flows of foreign direct investment (FDI).[1] A stable exchange rate and slow, steady inflation (averaging 4.7 percent over the past decade) have also aided growth.
[pic]
Figure 1. Real GDP Growth, 1994-2007
Stable macroeconomic management has been achieved with very few policy instruments. Cambodia’s economy is highly dollarized, leaving fiscal policy as the main instrument.[2] With a narrow base for economic growth and low domestic savings and investment, Cambodia is particularly vulnerable to weakened global trade and investment flows.
Due to the war, rebellion, famine and genocide that took place during the 1970s in Cambodia, today’s population is very young. In 2004, half of the population of 13.3 million was under the age of 20, and youth aged 15-24 made up over 30 percent of the workforce.[3] The formal sector is unable to support this many workers, resulting in high unemployment and a large informal economy. Self-employed workers and non-registered enterprises account for 85 percent of the workforce and 75 percent of GDP.[4] Many don’t pay taxes, creating challenges for revenue collection, to be discussed later.
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Figure 2. Total Population, 1950-2006[5]
Exports have expanded steadily in Cambodia, jumping from 30 percent of GDP in 1998 to nearly 70 percent in 2006. This number has declined in the past two years as world demand for Cambodia’s garments, which make up 88 percent of total exports, has shrunk. While exports have grown sharply, imports have increased by an even greater margin, reaching nearly 75 percent of GDP in 2006. This trade imbalance explains Cambodia’s large and growing current account deficit.
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Figure 6. Current Account as a Percentage of GDP, 1993-2007
Government expenditures are extremely low, hovering around 5 percent of GDP. As a result, infrastructure lags far behind Cambodia’s regional neighbors. In the past few months, donor countries have pledged large aid packages to Cambodia, which may substantially increase government spending. However, it is unclear whether this additional spending will make up for the decline in aggregate demand caused by the global financial crisis.
Private consumption is high, hovering around 80 percent of GDP. This is a decline from nearly 100 percent in 1993. Private domestic investment has increased steadily, but remains a modest 20 percent of GDP. While Cambodia borrows a lot from foreigners, investment and savings are extremely low. Consequently, infrastructure is sorely lacking. Most investment goes into construction projects, for which there is low demand presently.
Figure 3. Composition of GDP – Expenditure (% of total)
| |2005 |2006 |2007 |
|Private Consumption |84.3 |80.9 |78.2 |
|Government Consumption |4.1 |3.5 |5.7 |
|Investment |18.9 |19.3 |19.2 |
|Exports |64.1 |68.6 |65.4 |
|Imports |72.7 |76 |73 |
Source: IFS
II. High Priority Issues
Domestic Macroeconomic Imbalances
Despite rapid growth, the Cambodian economy is susceptible to long-term instability.
GDP is heavily dependent on the garment industry, which accounts for 95 percent of Cambodia’s exports. Garments accounted for 16 percent of 2007 GDP.[6] Demand, coming primarily from the United States, began to slow in late 2007 and will continue to do so as the recession unfolds. The removal of safeguards on China’s clothing and textile exports to the US at the end of 2008 compounded this problem by increasing international competition.
In the last few years, Cambodia’s exports have become less competitive because of the appreciation of the real exchange rate, which reduces investment in those industries. Cambodia’s comparative advantage (low cost labor) is being undermined by the appreciation of the riel. Because foreign goods have become more inexpensive relative to domestic goods, import growth has exceeded export growth, leading to a widening current account deficit and reducing aggregate demand.
[pic]
Figure 4. Nominal vs. Real Exchange Rate, 2004-2008
After decades of relative stability, inflation increased sharply in 2007, as it did for other countries in the region. According to the National Institute of Statistics (NIS), the year-on-year inflation rate in Cambodia reached 18.7 percent in January 2008. This trend is likely the result of rising commodity prices (fuel and food), and the depreciation of the dollar.
[pic]
Figure 5. CPI Inflation Rate, 1995-2008
Cambodia’s options for addressing the appreciation of the riel are limited because its high level of dollarization. The government could increase savings relative to investment or reduce inflation through fiscal policy. It could depreciate the nominal rate by increasing the money supply, depreciate the currency and increase aggregate demand.
In short, Cambodia has very low public revenue raising abilities, high debt, high rates of poverty, and poor governance. Inadequate private investment and poor revenue collection leave Cambodia heavily dependent on foreign donor funding for debt repayment, capital expenditure and social services.
Vulnerability to the Global Economic Crisis
Cambodia is particularly vulnerable to the immediate detrimental impacts of the global financial crisis. With its heavy dependence on export income and foreign direct investment, the global recession will undoubtedly reduce Cambodia’s aggregate demand and output. The IMF cut its forecast 2009 GDP growth for Cambodia by over 5% in March, from 4.75% to -0.5%, as illustrated in chart X. Coupled with a downward revision of 1.25% in 2008 GDP growth, this represents a 2009 output shortfall of KHR2.4 trillion, or 6.5% of Cambodian GDP -- a stunning reversal of fortune from an average annual growth rate of 11% from 2005-2007.
The susceptibility of Cambodia’s export industry to foreign shocks, and the country’s heavy reliance on foreign direct investment in its critical construction industry, are particularly worrisome. According to the World Bank, foreign direct investment in 2007 accounted for about 10 percent of Cambodia’s GDP, or US$867 million, with a heavy focus on tourism-related construction and real estate projects. The International Labor Organization estimates that FDI finances 75% of the construction industry and 50% of the real estate sector.
Cambodia’s Ministry of Land Management, Urban Planning and Construction reports that new investment in construction was down 12.5 percent in the first 11 months of 2008, compared with the same period last year, falling from US$3.2 billion to US$2.8 billion. Unions say that more than 30 percent of construction jobs in Cambodia have been lost as projects have been cancelled or scaled back. (Chun Sophal and Hor Hab, Phnom Penh Post, Tuesday, 23 December 2008).
Figure 7 shows the steep increase in total net foreign assets (foreign assets less foreign liabilities) in Cambodian depositary corporations from 2001 to the second quarter of 2008. Since the third quarter of 2008, net foreign assets have declined by 10%.
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Figure 7. Net Foreign Assets, 2001-2008 (quarterly)
Reduced output due to the downturn in sectors makes Cambodia especially vulnerable to foreign shocks. Foreign capital outflows will likely lead to significant job and household income losses in Cambodia.
III. Recommendations
1. Implement a significant financial stimulus.
In the short run, concerns about growth trump concerns about inflation. To address the immediate impacts of the global economic slowdown, Cambodia needs to implement a significant fiscal stimulus to compensate for reduced output. In addition to boosting aggregate demand, a stimulus could help support a more diverse economy through well-targeted investments in infrastructure projects, education, the development of new markets and the strengthening of existing markets.
There are limitations to this approach. In order to support a stimulus, Cambodia would have to raise tax revenue or borrow from other countries. As Cambodia’s debt is already quite large, further borrowing may be difficult if not impossible. Raising revenue from taxes is challenging without government infrastructure to collect taxes and the narrow tax base. There is also a risk of higher inflation and further appreciation of the real exchange rate.
2. Diversify the economic base.
Cambodia must diversify its economy if it is to maintain steady growth in the face of the global economic crisis. This may be accomplished by building on existing core competencies, developing new markets and encouraging the development of human capital through education.
This strategy faces a number of limitations, not least of all the sheer size of the informal economy in Cambodia (upwards of 75% of GDP and 85% of the workforce). Entrepreneurs face serious challenges in terms of accessing markets and growing their businesses. These challenges include entry costs, time costs of regulatory compliance, incomplete property rights, crime, transparency, and corruption. Diversification also requires coordination between the public and private sector, which is notoriously weak in Cambodia.
3. Continue to strengthen regional integration.
Cambodia should continue to strengthen its regional integration to reduce financial sector risk and to increase inter-regional trade. Inter-regional trade, according to the World Bank, comprises only 13 percent of Cambodia’s trade against a regional average of 49 percent (WB). Cambodia should leverage the expertise of ASEAN partners to improve the quality of exports in compliance with regional and international standards.
Cambodia’s ability to integrate regionally is limited due to poor infrastructure development. For example, it continuously fails to meet sanitation standards necessary to increase trade with China. (National Single Windows could generate positive synergies in terms of information sharing, transparency and lower transaction costs).
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[1] World Bank, East Asia Update, April 2008.
[2] According to the World Bank, 71 percent of transfers made within the country, mainly by wage earners, and even in rural areas, are made in dollars (WB report).
[3] Cambodia National Institute of Statistics, 2004.
[4] International Labor Organization, 2006.
[5] International Financial Statistics (IFS) data, 2009. Vertical lines denote the Khmer Rouge’s ascension to power and takeover by the Vietnamese in 1979.
[6] World Bank. “Sustaining Rapid Growth in a Challenging Economy,” 2009.
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