Report No. 16591-KH

CambodiaProgress in Recovery and ReformJune 2, 1997

Country Operations DivisionCountry Department IEast Asia ancl Pacific Region

Document of the World Bank

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CUJRRENCY EVALtJATIONS

Currency Unit = Cambodian Riel

AVERAGE VALUE OF USS1.00IN

1994 1995 1996 late -May 1997

2,543 2,462 2,624 2,740

WEIGHTS AND MEASURESMetric System

GOVERNMENT'S FISCAL YEARJanuary I - December 31

ABBREVIATIONS AND ACRONYMS

ADB - Asian Development BankAFTA - ASEAN Free Trade AreaASEAN - Association of South-East Asian NationsAusAID - Australian Agency for International DevelopmentBOT - Build-Operate-TransferCDC - Council for Development of CambodiaCEPT - Common Effective Preferential TariffCG - Consultative GroupCMAC - Cambodian Mine Action CenterCOCMA - Central Company for Agricultural MaterialsCVAP - Cambodia Veterans Assistance ProgramEAC - Electricity Authority of CambodiaEDC - Electricite du CambodgeESAF - Enhanced Structural Adjustment FacilityEU - European UnionFAO - Food and Agriculture Organization of the United NationsFDI - Foreign Direct InvestmentFIAS - Foreign Investment Advisory ServiceFTB - Foreign Trade BankGDP - Gross Domestic ProductGSP - General System of PreferencesICRC - International Commission for the Red CrossICSID - Intemational Convention for the Settlement of Investment DisputesIDA - International Development AssociationIMF - International Monetary FundIPP - Independent Power ProducersMEF - Ministry of Economy and FinanceMFN - Most Favored NationMIGA - Multilateral Investment Guarantee AgencyMOH - Ministry of HealthMPWT - Ministry of Public Works and TransportNBC - National Bank of CambodiaNGO - Non-Governmental OrganizationO & M - Operations and MaintenancePFP - Policy Framework PaperPIP - Public Investment ProgramPPWSA - Phnom Penh Water Supply AuthorityRCAF - Royal Cambodian Armed ForcesSOE - State-Owned EnterprisetlNDP - United Nations Development ProgrammetlNTAC - United Nations Transitional Authority in CambodiaVAT - Valued Added TaxWFP - World Food ProgrammeWTO - World Trade Organization

Vice President: Jean-Michel Severino, EAPDirector: Javad Khalilzadeh-Shirazi, EAIActing Division Chief: Sanjay Dhar, EAICOTask Manager: Su-Yong Song, EAICO

TABLE OF CONTENTS

EXECUTIVE SUMMARY ..................................................... i

I. INTRODUCTION .1

II. RECENT ECONOMIC DEVELOPMENTS. 3

A. Overview .3B. Real Sector Developments. 3C. Fiscal Developments and Policies. 5D. Monetary Policy, Inflation, Exchange Rates, and Financial Sector

Reform.7E. External Sector Developments and Policies. 9

III. CHALLENGES FOR THE TRANSITION TOWARDSUSTAINABLE DEVELOPMENT .11

A. Enhancing Public Resource Mobilization ............................................. 11B. Improving the Efficiency of Public Expenditure .................. ................ 19C. Strengthening Institutional Capacity ..................................................... 25

IV. MEDIUM-TERM PROSPECTS, EXTERNAL FINANCINGREQUIREMENTS, AND RISKS ..................................................... 28

Appendix I: Assessment of Public Investment ......................................... 33

LIST OF TABLES. FIGURES AND BOXESTables

1. Key Macroeconomic Indicators. 42. Comparison of Revenue Efforts .123. Cambodia's Tax Revenue Structure in 1996 Compared with Selected

Country Groups .134. Current Expenditure by Sector .205. Budgetary Expenditures by Functional and Sectoral Allocations 216. Projection of Main Macroeconomic Indicators .297. External Financing Requirements .318. Required Commitments of Offtcial Development Assistance 32

Al. PIP 1997-1999: Programmed Level Sector Allocation ...... ....... 42

Figures1. GDP Growth by Sector ......................................... 5............ ..... 52. Budgetary Development ......................................... 6........... ..... 63. 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 visitedCambodia in March 1997. The report was prepared by Su-Yong Song (task manager),based on the contributions of Kyle Peters (policy issues), William Magrath (forestryissues), David Steedman (administrative reform), Nat Colletta (military demobilization),Mostafa El-Erian (legal reform), Christopher Redfem (agriculture and ruraldevelopment), Christopher Chamberlin (health), Peter Moock (education), EnriqueCrousillat (energy), Koji Kuroda (transport), Vijay Jagannathan (water supply) and KyTran (statistics). Contributions were also made by Michel Cardona, Luca Papi, andR. Natarajan. The peer reviewers were Tamar Manuelyan Atinc and Luis Serven. It wasprepared under the guidance of William McCleary, Lead Economist of the East AsiaCountry Department I and Shahid Yusuf, Acting Lead Economist. The Director wasJavad Khalilzadeh-Shirazi. The manuscript was edited by Emily Evershed and typed andformatted by Lily Tsang. The mission would like to express its gratitude to variousministries and agencies that assisted in the preparation of this report. The report wasdiscussed with the Government of Cambodia in May 1997 and revised on the basis ofthese discussions.

EXECUTIVE SUMMARY

(i) Following two decades of conflict, Cambodia has made significant progress in stabilizing theeconomy, in restoring economic growth, and also in undertaking policy reforms to transform theeconomy into a market-oriented one. Progress has been especially rapid since the formation of theRoyal Government in 1993. Macroeconomic developments have been impressive: GDP expanded at anaverage annual of about 6 percent during 1991-95; inflation which averaged about 140 percent perannum in 1990-92 was reduced to 3.5 percent in 1995; and budgetary revenue as a share of GDPdoubled (albeit from a low base) during 1991-95. Fiscal discipline has been instrumental in achievingmacroeconomic stability. On policy reform, prices were freed up; a major customs reform and new taxmeasures were introduced; a two-tier banking system has been initiated; most non-tariff barriers havebeen eliminated and tariffs have been reduced and streamlined; and the exchange rate has beenliberalized. These recent achievements have been supported by a high level of foreign aiddisbursements. Nevertheless, they are remarkable when compared with the experiences of otherpost-conflict countries such as Angola or Mozambique.

(ii) Even with these recent improvements in the economy's performance, Cambodia remains one ofthe poorest countries in Asia, with a per capita income estimated at US$300 in 1996. It is alsoestimated that 39 percent of the total population falls below the poverty line. Cambodia's socialindicators compare unfavorably with other low-income countries: population growth rate (3 percent ayear) is much higher than the average of 1.7 percent, the infant mortality rate at 110 per thousand istwice as high, life expectancy at 52 years is 10 years lower, and primary enrollment rate is 50 pointslower.

A. Recent Economic Developments

(iii) Macroeconomic performance in 1996 continued to be largely favorable. Despite the adverseimpact of floods, GDP growth is estimated at 6.5 percent. However, the floods did put pressure onfood prices, which raised the annual inflation rate to 9 percent. The exchange rate remained broadlystable, and foreign investment flows continued to increase. Fiscal discipline continued to be the anchorfor sustaining macroeconomic stability. Nevertheless, fiscal developments in 1996 repeated the patternof the past two years: namely, civilian operating expenditures were compressed significantly to sustainmacroeconomic stability because of a revenue shortfall compared with the budget target and an overrunin defense and security outlays. During the first four months of 1997, whereas defense and securityoutlays were contained well within the target, the pattern of a revenue shortfall and a compression ofcivilian non-wage operating outlays continued.

(iv) Important progress also has been made in implementing policy reforms. The Governmentpromulgated the Central Bank Law and the Public Enterprise Law. More recently, along with anambitious 1997 budget, the Law on Taxation, which includes new revenue-enhancing measures as wellas 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 discretionarytax exemptions and key features of the Law on Taxation have yet to be fully implemented. Regardingadministrative reform, the implementation of civil service reform has been set back due to the lack of acomprehensive strategy and new hiring. There have also been delays in the enactment of several criticaleconomic and financial laws, in particular the Financial Institutions Law and the Commercial Code.

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The implementing regulations for the Investment Law, which are critical to eliminating ad hoc taxexemptions, have also been long delayed.

(vi) Recent achievements have also been threatened by insufficient accountability and transparency insome areas of economic management. In particular, the lack of action in implementing a sustainableand transparent forestry management policy and in channeling forestry revenues into the budget hasposed serious concern on the prospects for sustainable development. The Government recently hastaken certain positive actions in forestry management and public resource mobilization, and preparedthe 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 importantelements of the Khmer Rouge defected to the Royal Government, political tensions between the twomain coalition partners have recently escalated. Recent political developments have, in turn,contributed to delays in implementing necessary policy reforms, and sometimes to insufficienttransparency and accountability in economic management. Preparations for the two elections--localelections 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 ofmacroeconomic stability and economic liberalization. Cambodia is now at the crossroads. It must makea transition toward sustainable development as these initial gains will soon be exhausted. In order toreduce poverty significantly and enhance economic and social well-being, Cambodia must sustain rapidand broad-based economic growth over the long term. Three of the main challenges confronting thecountry in making the transition are a weak revenue effort, inefficient expenditure allocation, and weakinstitutional capacity. Enhancing public resource mobilization will be of utmost importance formaintaining macroeconomic stability and increasing domestic contributions to developmentexpenditures for economic and social infrastructure. Improving the efficiency of public expenditureswill be critical to re-directing expenditures toward the social sectors and rural development, and alsoenhancing the effectiveness of public investment. Strengthening institutional capacity will be key toeffectively implementing economic reforms and development programs. Confronting these issues willbe essential especially in that, while economic development will be largely private sector driven overthe longer term, the public sector must play a catalytic role in providing enabling environment forprivate sector development for some years to come. Whether the country will be able to make asuccessful transition will depend on the political will and the Government's determined efforts inimplementing the necessary reforms.

1. Enhancing Public Resource Mobilization

(ix) Taxation. Government revenues as a share of GDP have doubled during the past 5 years, albeitfrom 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 amodern tax system and improving revenue performance with the adoption of the new Law on Taxationin February 1997. The Law on Taxation includes some important revenue-enhancing measures: levyingturnover tax on the first sale after importation; broadening the coverage of excise duties; introducingtaxes on interest and dividends; extending the coverage of the tax on salaries and reducing the currentexemption threshold; introducing the withholding of taxes; and introducing a value-added tax for thelargest 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

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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 exemptionsgranted under the Law on Investment as well as ad hoc exemptions; (ii) strengthening the capacity tocollect 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 comefrom the liberal exemptions granted under the Law on Investment. The Council of Ministers iscurrently reviewing the long-delayed implementing regulations for the Law on Investment, which willhelp limit the scope for ad hoc exemptions. The immediate challenge for the authorities is to ensurethat the implementing regulations are adopted as proposed and strictly implemented, and that no new adhoc exemptions are granted. Over the medium term, the authorities will need to review the overallinvestment incentive scheme, including the possibility of revising the Law on Investment, which hasgenerous provisions compared to other countries. Ad hoc exemptions were granted for rubber exportsand 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, additionalexemptions have been granted, such as for forestry exports. Such ad hoc exemptions not only erode thetax base, but also raise concerns regarding transparency in economic management.

(xi) Tax Administration. Although improvements have been made especially in on-site tax auditsof 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 ofthe tax authorities to enforce compliance with the tax laws. For the medium term, strong efforts areneeded in the following areas: (i) training tax officials in accounting, assessment, auditing, disputeresolution, and the VAT; (ii) strengthening the systematic exchange of taxpayer information among theCustoms Department, the Tax Department, and the CDC; and (iii) establishing a computerized database for medium-size enterprises and extending the requirement of declaration based on simplifiedactual accounting to medium-size enterprises.

(xii) Non-tax Revenue. While improvements have been made, the budgetary coverage of non-taxrevenues remains incomplete, with some line ministries and other government entities continuing tocollect revenues without control and supervision by the Ministry of Economy and Finance. To bringextrabudgetary revenues under budgetary control, the Government intends, as stated in the PolicyFramework Paper, to issue an Order, giving the Minister of Economy and Finance control over allnegotiations involving the national patrimony and requiring the Minister of Economy and Finance'ssignature on all such contracts. It is critical to swiftly issue such an Order. Over the medium term, itwould also be essential to: (i) engage international audit firms for valuation; (ii) apply transparent andcompetitive procedures in awarding concessions for natural resource exploitation; and (iii) ensure thetimely transfer of associated revenue to the budget.

(xiii) Forestry Resource Management. Forests are Cambodia's most developmentally significantnatural resources. The implementation of economically and environmentally sound forestry policiescould generate some US$100 million a year in government revenue, equivalent to over one-third ofbudget revenue or over 3 percent of GDP in 1996. As discussed in the World Bank/UNDP/FAO ForestPolicy Assessment Report, the mismanagement of forestry resources, however, has caused concerns:uncontrolled logging has led to rapid degradation that severely threatens Cambodia's forests; largeconcessions have been awarded, with unsustainably high harvesting intensity and royalties that accountfor about one-fifth of their economic value; and only a part of revenues from logging activities havebeen transferred to the national budget. In 1996, US$10.5 million (or one-tenth of potential revenueunder economically and environmentally sound forestry policies) was collected from forestry

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exploitation. After some delays, the Government has taken initial actions to regain control over loggingactivities and has reconfirmed its intention to pursue medium-term measures for a' sustainableexploitation of forestry resources. Progress in implementation of the necessary policy actions to datehas, however, been mixed. The immediate necessary steps are: (i) to tighten supervision of bordercrossing points and ports; (ii) to proceed swiftly with the four technical assistance studies recommendedby the World Bank/UNDP/FAO report; (iii) to secure adequate budget resources for the recentlyestablished Secretariat of the National Committee for Forest Policy; and (iv) to cease granting newconcessions, harvesting licenses, and collection agreements until a transparent and competitive processis put in place.

2. Improving the Efficiency of Public Expenditure

(xiv) Quality of Expenditure Policies. The Government has made significant progress inexpenditure management since the adoption of the Budget Law in 1993, and has succeeded incontaining current expenditures despite revenue shortfalls and overruns in defense and securityexpenditures, mainly through the compression in civilian non-wage O&M expenditures. This pattern ofspending has not adversely affected economic growth significantly, as the nature of the recent growthwas largely a recovery from the past. Over the longer term, however, it will be detrimental to economicgrowth and poverty reduction. Thus, while continued fiscal discipline is essential, the composition ofspending needs to be changed to support development priorities. As indicated in the Policy FrameworkPaper, Government expenditures need to be redirected toward priority social sectors and economicinfrastructure. The composition of O&M expenditures also needs to be shifted away from salariestoward materials and supplies. To achieve these objectives, the Government needs to: (i) strengthen thecapacity to monitor and control budgetary expenditures through full implementation of the recentlyintroduced measures such as the assignment of financial controllers, direct payment systems, andcompetitive bidding procedures; (ii) contain the military wage bill in spite of the need for theintegration of former Khmer Rouge soldiers, limit non-wage operating outlays for defense and securitythrough strengthened audits, and implement military demobilization; (iii) re-establish control overrecruitment into the civil service and implement civil service reform; and (iv) carry out a PublicExpenditure Review, with a view to providing a firmer basis for sectoral allocations and the adequacyof non-wage O&M allocations in the budget.

(xv) Public Investment Program. Securing an adequate level of public investment, and, equallyimportant, enhancing the efficiency of public investment are critical to Cambodia's long-term sustaineddevelopment. While public investment has contributed significantly to the rehabilitation of Cambodia'sdevastated physical and social infrastructure, it has too often been donor-driven and sometimes lackingadequate provision for the associated recurrent expenditure needs. The Government has made someimportant progress toward improving public investment management, in particular, initiating theNational Public Investment Management System and preparing a three-year rolling Public InvestmentProgram (PIP) for 1996-98 and for 1997-99, to assist in determining both the appropriate priorities forpublic investments and recurrent expenditure requirements. The second PIP (1997-99) has madesignificant improvements over the first one, but there remain a number of weaknesses. To enhance theefficiency of the PIP, the Government needs to: (i) strengthen the capacity at the Ministry of Planningand line ministries in monitoring and implementing the program, especially through more effective useof TA; (ii) formulate the next PIP on the basis of the findings of the first two PIP implementation and aPublic Expenditure Review; (iii) enhance coordination among various agencies, in particular, betweenthe Ministry of Planning and the Ministry of Economy and Finance in estimating and allocatingrecurrent 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 toimplement its economic reforms and development programs. Without a strengthening of theGovernment's institutional capacity, its ability to deliver and manage the rural development and socialsector programs necessary to reduce poverty and achieve broad-based growth will be limited. Inaddition to strengthening the human resource base, administrative and legal reform are key to buildingthe institutional capacity necessary for achieving long-term development. This issue is closely linked tothe two issues discussed above. For example, progress in civil service reform and militarydemobilization will have significant bearing on the allocation of government expenditures.

(xvii) Administrative Reform. The Government has launched a broad and ambitious program ofadministrative reform. While progress has been made in certain elements of reform, the civil servicerenewal 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 alack of a political consensus within the Government. The Government has recently restated in thePolicy Framework Paper its intention to exercise strict controls over the size of the civil service and toaccelerate preparation for the reform. The Government aims to carry out the following measures, forwhich decisive and timely implementation will be critical to accelerating reform: (i) containing thenumber of civil servants at the present level or below by removing the already-identified list from thecivil service rolls, by updating its data base to eliminate ghost workers and personnel with irregularstatus, and by strictly limiting new recruitments; (ii) presenting a prioritized program for civil servicereform which reflects government objectives and implementation capacity; (iii) carrying out a civilservice 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 technicalcapacity.

(xviii) Military Demobilization. The Government prepared a comprehensive military downsizing andrehabilitation program--the Cambodia Veterans Assistance Program (CVAP)--to be carried out in fourphases over the medium term. A training program to build capacity for management, organization andprogram development, monitoring and evaluation, and financial management, and also preparation for afull registration of the RCAF are under way. The completion of the registration and the issuance ofidentity cards are now priority tasks as a basis for establishing the actual size of the Armed Forcesand 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 keyconstraints facing the program are political will within the Government and the creation of sustainableemployment 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 itslegal and regulatory framework in the economic and financial areas, by adopting such laws as theBudget Law, the Law on Investment, the Central Bank Law, and the Law on Taxation. However, manycritical business, economic, and financial laws, which are key elements of the enabling environment forprivate sector development, are still absent, and those that have been recently enacted have yet to beadequately enforced, which often creates security and governance problems. The medium-termobjective of legal reform is twofold: re-establishment of the rule of law; and progressive developmentof a legal framework that facilitates commercial transactions, promotes private sector development, andstimulates national and foreign investment. Toward these objectives, in addition to rapidly adopting thelong-delayed laws and regulations, in particular, the Financial Institutions Law, the remaining six lawsof the complete Commercial Code, and the implementing regulations for the Law on Investment, the

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Government will need to adopt the necessary implementing regulations, for example, for theCommercial Code. In parallel, the Government will need to develop the mechanisms, institutions, andhuman resources necessary to implement all manners of laws. Otherwise, the enactment of laws andregulations to support private sector development would have limited impact on Cambodia's economicdevelopment.

C. Medium-term Prospects, External Financing Requirements, and Risks

(xx) High Growth Scenario. The Cambodian economy will need to achieve high and sustainableeconomic growth if it is to significantly reduce poverty and enhance economic and social well-being, asenvisaged 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 inSection 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 anacceleration of economic reforms and the strengthening of institutional capacity. In turn, such policieswould engender a high level of donor support, through official grants in the next several years andconcessional loans. The continuation of economic reforms would also lead to continuing foreigninvestment. Under these assumptions, GDP would grow at 7-8 percent per annum, which is comparableto the growth rates achieved by several East Asian countries since the 1970s. Private sector would playa leading role in achieving this growth, with the public sector playing a supporting catalytic role byproviding an improved enabling environment for private sector development.

(xxi) External Financing Requirements. Under this scenario, even with an increase in privatecapital flows, disbursements of official assistance--grants and concessional loans--would need to bemaintained at the 1996 level for 1997-99. This would require commitments of official assistance ofabout US$455 million per year during 1997-99, of which about US$60 million would be balance ofpayments/budget support. Official assistance would need to cover some recurrent expenditures(especially for civil service reform and military demobilization), domestic counterpart funds, and theforeign exchange costs of the public investment program. In the near term, there remains a need forsome fast-disbursing assistance to help meet the costs of special programs and to close the balance ofpayments gap until the volume of project disbursements increases.

(xxii) Downside Risks. Cambodia faces a number of risks and uncertainties. In the near term, theprimary risk would be either a loss of fiscal discipline, due to an inadequate revenue effort, or delays inimplementation of necessary economic reforms, especially in the period preceding the nationalelections. Over the medium term, the primary risk would stem from inadequate pace and depth ofeconomic reforms necessary to place the economy on a sustainable growth path. Under this scenario, aloss of macroeconomic stability combined with little structural reform could lead to inflationarypressures resulting from domestic financing of the budget deficit, which would lead to price rises andbalance of payments pressures. Moreover, inadequate investments in human capital because ofcontinued weak revenue performance could pose a threat to future growth, once the gains fromliberalization and relative stability have been exhausted. Such a situation could jeopardize thesustainability 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 inthe transparency of economic management. In particular, Cambodia's natural resources would beexploited in an unsustainable manner with inadequate resources accruing to the state. Should thispersist for an extended period, a major source of growth for the Cambodian economy would besquandered 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 theeconomy, in restoring economic growth, and also in undertaking policy reforms to transform theeconomy into a market-oriented one. Progress has been especially rapid since the formation of theRoyal Government in 1993. Macroeconomic developments have been impressive: GDP expanded at anaverage annual of about 6 percent during 1991-95; inflation which averaged about 140 percent perannum in 1990-92 was reduced to 3.5 percent in 1995; and budgetary revenue as a share of GDPdoubled (albeit from a low base) during 1991-95. Fiscal discipline has been instrumental in achievingmacroeconomic stability. On policy reform, prices were freed up; a major customs reform and new taxmeasures were introduced; a two-tier banking system has been initiated; most non-tariff barriers havebeen eliminated and tariffs have been reduced and streamlined; and the exchange rate has beenliberalized. These recent achievements have been supported by a high level of foreign aiddisbursements. 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 ofthe poorest countries in Asia, with a per capita income estimated at US$300 in 1996. It is alsoestimated that 39 percent of the total population falls below the poverty line. Cambodia's socialindicators compare unfavorably with other low-income countries: population growth rate (3 percent ayear) is much higher than the average of 1.7 percent, the infant mortality rate at 110 per thousand istwice as high, life expectancy at 52 years is 10 years lower, and primary enrollment rate at present is 50points lower.

3. In 1996, macroeconomic performance continued to be largely favorable, with 6.5 percent GDPgrowth and 9 percent inflation (see Section 11). Progress also has been made in implementing policyreforms. The Government promulgated the Central Bank Law and the Public Enterprise Law. Morerecently, 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 alsolegislated.

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 discretionarytax exemptions and key features of the Law on Taxation have yet to be fully implemented. Regardingadministrative reform, the implementation of civil service reform has been set back due to the lack of acomprehensive strategy and new hiring. There have also been delays in the enactment of several criticaleconomic 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 taxexemptions, have also been long delayed.

5. Recent achievements have also been threatened by insufficient accountability and transparencyin some areas of economic management. In particular, the lack of action in implementing a sustainableand transparent forestry management policy and in channeling forestry revenues into the budget hasposed serious concern on the prospects for sustainable development. After delays, the Governmentrecently has taken initial actions to regain control over logging activities and to pursue medium-termmeasures for a sustainable exploitation of forestry resources.

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6. On the political front, while there was a significant positive development in that some importantelements of the Khmer Rouge defected to the Royal Government, political tensions between the twomain coalition partners--the Funcinpec and the CPP--have recently escalated. Tensions started toescalate as both parties sought political allegiance from the defecting forces and they formed coalitionswith 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 policyreforms, 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 November1998--are underway.

7. Recent economic growth largely reflected a recovery from the past, and also, the benefits ofmacroeconomic stability and economic liberalization. Cambodia is now at the crossroads. It must makea transition toward sustainable development as these initial gains will soon be exhausted. In order toreduce poverty significantly and enhance economic and social well-being, Cambodia must sustain rapidand broad-based economic growth over the long term. Three of the main challenges confronting thecountry in making the transition are a weak revenue effort, inefficient expenditure allocation, and weakinstitutional capacity. Enhancing public resource mobilization will be of utmost importance formaintaining maceoeconomic stability and increasing domestic contributions to developmentexpenditures for economic and social infrastructure. Improving the efficiency of public expenditureswill be critical to re-directing expenditures toward the social sectors and rural development, and alsoenhancing the effectiveness of public investment. Strengthening institutional capacity will be key toeffectively implementing economic reforms and development programs. Meeting these challenges willbe essential especially in that, while economic development will be largely private sector driven overthe longer term, the public sector must play a catalytic role in providing enabling environment forprivate sector development for some years to come.

8. Whether the country will be able to make a successful transition will depend on the politicalwill and the Government's determined efforts in implementing the necessary reforms. Recently, theGovernment has taken certain positive actions in this direction, such as the initial actions to improveforestry management and strengthen public resource mobilization. In addition, the Government hasprepared 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 timelyfashion 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 theenterprise and agriculture sectors; and identified an agenda for sustainable and broad-baseddevelopment. The present report, which updates the 1996 report, assesses recent progress inmacroeconomic and policy reform; analyzes the challenges that lie ahead to maintain macroeconomicstability and deepen the reform program; and sheds light on the prospects for the transition tosustainable development. Section II summarizes recent economic developments and discusses relevantpolicy issues. Section III evaluates progress made in policy reform and assesses the scope for furtherreform, as well as the constraints and prospects. It focuses on three of the main challenges for thetransition toward sustainable development: (i) enhancing public resource mobilizatioft; (ii) improvingpublic expenditure management; and (iii) strengthening institutional capacity. Section IV provides anmacroeconomic outlook and associated external financing requirements.

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II. RECENT ECONOMIC DEVELOPMENTS

A. Overview

10. Macroeconomic outcome in 1996 was broadly favorable (see Table 1). Despite the adverseimpact of the floods, GDP growth for 1996 is estimated at 6.5 percent. The temporary upward pressureon food prices--as a result of the floods in September/October--raised the annual inflation rate to 9percent. The exchange rate remained broadly stable, and foreign investment flows continued toincrease. Fiscal discipline continued to be the anchor for sustaining macroeconomic stability, albeitthrough continued compression in civilian non-wage operating expenditures.

11. Economic developments during 1996 and early 1997 are discussed in depth below. Section Boutlines developments in the real sector. Next, fiscal developments and the 1997 budget are discussedin Section C. This is followed by a discussion of monetary policy and developments in inflation and theexchange rate, as well as financial sector reform (Section D). It concludes in Section E with adiscussion 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 developmentsin the real sector in Cambodia. Moreover, the large role of agriculture in the economy (almost a half ofGDP) 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 in1996 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 ofthe growth has been driven by services and construction, concentrated in urban areas, especially inPhnom Penh. Growth in agriculture has been slower, and as a result, the gains in the living standards ofrural populace--85 percent of the total population-- have been smaller. In 1996, agricultural growth wasestimated at 1.8 percent, reflecting the estimated negative growth in rice output.' The slow growth inagriculture was offset by strong growth in industry (13.1 percent), especially in construction andgarment manufacturing. Services also continued to expand at a robust rate of 8.8 percent, owing mainlyto buoyant tourism.

13. Poverty Situation. According to a recent Bank report based on the Socio-Economic Survey, 39percent of the total population in Cambodia live below the poverty line The main findings of thereport are as follows. First, the highest incidence of poverty is found in the rural areas, with 43 percentestimated 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 onrural areas. Second, the highest poverty rate--46 percent--is found among people living in householdsheaded 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, 2percent above the record harvest of the 1995/96 season and 35 percent higher than the average for the previousfive 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 systemicassessment of poverty on a national basis.

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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 6.5CPI (final quarter basis) 150.4 112.5 41.0 17.9 3.5 9.0Domestic Liquidity 28.6 209.0 40.0 29.4 44.3 40.4Net Credits to Government 22.9 141.8 5.6 -7.9 1.1 -3.1Velocity 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 298Import of Goods (US$, retained import) 113 160 305 499 673 749Gross 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 9.1Tax 2.3 4.4 4.3 5.9 6.2 6.5Non-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 16.4Current expenditure 7.4 9.5 6.9 11.0 9.6 9.9Capital 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 -0.8Overall 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 20.7Government Investment 0.4 0.3 4.3 5.5 7.1 6.5Non-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 20.7National 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 -0.8Non-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 8,200Official exchange rate (Riels/US$) 703 1,253 2,470 2,543 2,462 2,624

Source: Cambodian authorities.

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Figure 1: GDP Growth by Sector

168.0

o.410.0---

-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 atreducing poverty through enhancing income generating capacities should be targeted toward theagricultural sector. Third, Cambodians living in households with uneducated head are more likely to bepoor, with a poverty rate of 47 percent. The prevalence of poverty among households in which the headhad completed secondary education falls to around 30 percent. Raising educational attainment isclearly a high priority in order to improve living standards and reduce poverty. Fourth, It does notappear to be the case that female-headed households are generally more vulnerable to poverty thanthose 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 byhousehold headship are similar to those observed in other East Asian countries such as Vietnam andIndonesia. 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, takingIndonesia as an example (24 percent). However, it must be borne in mind that rural poverty inCambodia may have been underestimated by the exclusion of significant portions of the countrysidefrom the survey. On the other hand, urban poverty appears to be slightly higher in Cambodia (24percent) than its Indochina neighbors--Vietnam (20 percent) or Lao PDR (24 percent)--and much higherthan Indonesia (10 percent).

14. The central goal of the Government's development program is the eventual eradication ofCambodia's widespread poverty. However, there is a lack of the necessary information to identifyprograms and policies to target the poor more effectively. Therefore, the Government is carrying out amultipurpose household survey designed to measure living standards at regular intervals. Informationobtained 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 sustainingmacroeconomic stability. The Government contained the budget deficit and prevented bank financing

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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 macroeconomicstability because of a revenue shortfall compared with the budget target and an overrun in defense andsecurity operating outlays.

16. On the revenue side, despite the implementation of new tax measures introduced in October1995, as well as the initiation of pre-shipment import inspections, total budget revenue amounted to 9.1percent 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 taxcollection capacity. Tax exemptions granted to foreign investors under the Law on Investment, haveeroded the tax base. Furthermore, additional ad hoc exemptions--granted on rubber and processed woodexports and on luxury automobile imports--exacerbated the situation. Although some progress has beenmade in strengthening tax collection capacity, tax collection capacity remains weak, exemplified by thefact that a recent tax audit of the largest enterprises identified substantial tax arrears, few of which havebeen collected to date. There were also shortfalls in collections of non-tax revenue, in part because theMinistry of Economy and Finance does not have sole responsibility for and control over contractsrelating to the use of state assets. In particular, while log exports took place despite the ban imposed inApril 1995, few revenues were transferred to the national budget. (For forestry revenue issues, see paras55-60 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 andsecurity (by 0.4 percent of GDP compared with the budget allocation), budgetary expenditures havebeen contained almost exclusively through a compression of civilian non-wage expenditures. Outlays inpriority social sectors have been hit particularly hard. Moreover, the redeployment of the budget awayfrom 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 currencycounterpart for externally financed projects also continued to be used as a balancing item to contain thetotal level of expenditure.

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19. Prospects for 1997. In the Policy Framework Paper, the Government recognizes that recentbudgetary developments demonstrate the need for a significant and sustained improvement in revenuemobilization and also in the quality of fiscal adjustment. (Issues on public resource mobilization andpublic expenditure management are discussed in detail in Section III.) The 1997 budget represents anambitious and bold attempt to meet these fiscal challenges. It aims to increase revenue by 0.6 percentof GDP; to reduce outlays for defense and security by 0.8 percent; to re-orient outlays toward socialexpenditures; and to achieve a small current budget surplus.

20. Achieving the envisaged targets will be challenging and will request decisive implementation ofthe new Law on Taxation, improved tax administration, and expenditure discipline. On the revenueside, while the Government adopted the Law on Taxation, which includes new revenue-enhancingmeasures as well as measures to strengthen tax enforcement laws and procedures, the enforcement ofthe Law is being delayed owing partly to the preparation of the associated regulations. Furthermore, theadoption of the long-delayed implementing regulations for the Law on Investment--which would help toeliminate the scope for ad hoc tax exemptions--is also delayed. On the expenditure side, costs related toprovincial elections, relief for flood victims, the impact of further Khmer Rouge integrations into theRoyal Cambodian Armed Forces (RCAF), and possible incorporation of political appointees hired in1996 into the civil service payroll are not reflected in the budget, but they would need to be paid. (Fordetails 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 overinto the next fiscal year.3

21. Budgetary developments during the first four months indicate that improving the revenueperformance will be essential to maintaining macroeconomic stability and achieving budgetarypriorities. While there may be some seasonality factors, total revenue collection amounted to 29percent of yearly target (compared with the norm of 33 percent) due mainly to shortfalls in customsrevenue. Whereas defense and security outlays were contained well within the target, non-wageoperating outlays for civil administration have been squeezed to the bare minimum (7 percent of thebudgetary 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 ischaracterized by a high degree of dollarization and cash transactions, limiting significantly theGovernment's scope for running an active and effective monetary policy. The use of the riel isconfined to small transactions and wage payments by the Government. Most financial intermediation isconducted largely in foreign currency. The National Bank of Cambodia (NBC) is not using directmonetary instruments: interest rates are completely liberalized and there are no quantitative restrictionson bank lending. The development of indirect tools of monetary policy is at an early stage as reserverequirements and refinancing facilities were only recently introduced. Open market operations do notyet exist, but during 1997, the authorities are planning to issue Treasury bills in order to develop suchtools, and create incentives for the market to invest in domestically denominated securities. Given thelack of instruments, the monetary authority has used foreign exchange interventions to regulate rielliquidity and to smoothen fluctuations in the exchange rate. Limitations on monetary financing of thebudget 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 carriedover into 1997.

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23. Broad money continued to grow at an accelerated pace in 1996, about 40 percent, only a slightdrop from 44 percent in 1995.4 This rapid growth was mainly due to a continued sharp increase (57percent) in foreign currency deposits, as a result of the establishment of new commercial banks, steadyinflows of foreign direct investment, and a continued portfolio shift away from foreign currency incirculation. 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 introductionof larger denominations of riel notes in March 1995. The continued high growth rate in measured M2did not, however, lead to a spur in inflation (see Figure 3). As prudent fiscal policy limited the needfor the direct financing of the budget deficit, inflation was contained at 9 percent in 1996, despite theeffect 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 ontight financial policies to ensure stability in the foreign exchange market. Interventions in the foreignexchange market have been geared towards raising the level of international reserves and smootheningout fluctuations in the exchange rate. The exchange rate has been fairly stable and largely in line during1996: the spread with parallel market rate has been maintained within 2 percent; and the depreciationagainst the dollar was 7.2 percent in nominal terms.

25. Financial Sector Reform. The financial sector in Cambodia essentially consists of the bankingsector. In 1990, the NBC was created from the monobank and responsibility for public accounting wasassumed 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-tierbanking system, e. g. the Governor of NBC is the Chief executive of the FTB. Moreover, NBC stillholds minority shares in three joint-venture banks. Finally, 20 NBC branches continue to grantcommercial credit. Besides the two public banks and three joint venture banks, there are seven foreignbank branches and 19 locally incorporated banks active in Cambodia. The banking sector is alsocharacterized 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 outstandingloans) and a wide variation among the banks in the scale of activity (some of the smaller banksessentially extend no credit). The banks hold large amounts of foreign assets that are mostly placedwith correspondent banks. The level of financial intermediation is low: total loans outstandingamounted 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 inestablishing a modern legal framework for the financial system by giving the NBC the primary mandateof maintaining price stability and providing a number of monetary policy instruments. An immediatepriority 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 urgentas FDI inflows are increasing sharply. While the NBC made some progress in the strengthening ofbank supervision with the reorganization of the department and the addition of new staff, the adoptionof new reporting forms for commercial banks' off-site supervision and the initiation of on-siteinspections, the proliferation of banks has placed a strain on scarce and generally weak banksupervision capacity. The NBC needs to ensure that its commitment to strengthening supervisioncapacity especially through conducting on-site inspections of eight commercial banks by end-1997 isrealized.

27. In addition to the weak bank supervision, most of the prudential regulatory framework is notcommensurate with the high risk environment in which banks in Cambodia operate and the accountingsystem 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-delayedFinancial Institutions Law, which will clarify the legal framework of the banking system and improvethe framework for bank supervision, adequate prudential regulations need to be put in place over themedium term.

28. The Government also needs to complete the establishment of a two-tier system. The NBC hasannounced its intention to divest its interest in the three joint venture banks in the near term, and theGovernment is currently reviewing plans to separate the FTB from the NBC and to divest it. A fullaudit and a review of this bank which accounts for 19 percent of the banking system assets will becompleted in 1997. The authorities are also considering steps to divest the remaining assets ofMunicipal Bank.

E. External Sector Developments and Policies

29. Balance of Payments. Cambodia's balance of payments performance needs to be interpretedwith caution in view of, among other factors, the estimated unrecorded (illegal) exports of log and sawntimber and rubber; the estimated imports destined for re-exports and tariff-exempt imports; and theestimated 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 1995to US$102 million in 1996), associated mostly with garments. Cambodia has obtained GSP status from26 countries (with tariff free access to its counterparts, with markets in annual quotas) on selected

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manufactured goods, particularly garments.5 While retained imports increased by 11 percent, duelargely to imports under the Law on Investment, imports for re-exports declined sharply because of asharp 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 loaninflows remained at the 1995 level. In contrast, FDI continued to increase rapidly, from US$80 millionin 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 quantitativerestrictions on imports, and export bans apply only to unprocessed timber and sawn logs (but notprocessed wood products). The import tariff schedule has four dominant rates--7, 15, 35, and 50percent--which covers some 93 percent of tariff lines. The unweighted average tariff rate was estimatedat 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 andrubber.

32. Cambodia is an observer in ASEAN and will become a full member in July 1997. As a memberof ASEAN, Cambodia would participate in the ASEAN Free Trade Area (AFTA) and the CommonEffective Preferential Tariff (CEPT). Cambodia currently holds an observer status in the World TradeOrganization (WTO) and plans to apply for full membership in the near future. While the authoritiesare examining the possible effects of tariff changes, the potential effects of joining these twoinstitutions--AFTA/CEPT and the Uruguay Round--have not been fully studied. In particular, theauthorities urgently need to assess the implications of the CEPT in terms of budgetary, balance ofpayments, 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, Cambodiareceived highly concessional terms ("Naples terms") on its official convertible currency debt to ParisClub 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 alsodid 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 Rubledebt is rescheduled.

The arrangement with the European Union (EU), however, has been jeopardized by foreign products bearingcounterfeit 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.

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III. CHALLENGES FOR THE TRANSITION TOWARDSUSTAINABLE 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 comparedwith other low-income countries. Cambodia needs to achieve high, sustainable, and broad-basedeconomic growth over the long run if it is to reduce poverty significantly and enhance economic andsocial welfare. Cambodia faces a number of challenges that cloud its prospects for sustainabledevelopment, among others:

* A Weak Revenue Effort. Although tax revenues, as a share of GDP, tripled during 1991-1996, theyremain among the lowest in the world. Moreover, the Government has yet to manage forestresources in a transparent, economically sound, and environmentally sustainable manner and totransfer associated revenues fully to the budget. The result is that the domestic contribution tofinancing development expenditures remains weak.

* Inefficient Expenditure Allocation. Although the Govemment continues to contain currentexpenditures incorporating revenue shortfalls, the current fiscal situation is not sustainable over themedium term. A high level of defense and security expenditures, and a significant portion ofsalaries within civilian expenditures, are squeezing non-wage operations and maintenanceexpenditures for key economic and social sectors, as well as the local currency counterpart forexternally financed investment projects, to the bare minimum. Combined with the donor-drivennature of many investment projects, this also often leads to inefficiency in the implementation ofpublic investment.

* Weak Institutional Capacity. While improving, as a legacy of years of civil conflict, institutionalcapacity remains weak. The Government's administrative capacity to formulate policy andimplement development programs is constrained. An open, transparent, and consistent legalframework 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 toreduce poverty and improve the livelihood of the Cambodian people, especially in that while economicdevelopment will be largely private sector driven over the longer term, the public sector must play acatalytic 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 resourcemobilization (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 lowbase. Through such measures as a major customs reform, the introduction of a hotel tax and a salarytax, increases in turnover tax rates, and the application of excise taxes to a range of goods, tax revenueshave risen from 2.3 percent of GDP in 1991 to 6.5 percent in 1996. Non-tax revenues have beenlimited to 2-3 percent of GDP owing partly to failure to collect full economic values for forestryrevenues.

37. Cambodia's budget revenue-to-GDP ratio (at 9.1 percent in 1996) is very low by internationalstandards. The current tax effort (at 6.5 percent of GDP) is roughly half of the average for low-income

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countries. It compares unfavorably not only with Indochina neighbors but also with sub-SaharanAfrican countries (see Table 2 and Table 3). Total budget revenues have not covered currentexpenditures. The current budget deficit and almost all capital expenditures have been financed byexternal 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, maintainingmacroeconomic stability and raising the domestic contribution to the financing of the public investmentprogram--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 9.8Lao PDR 1995/96 10.8 2.5 13.3Vietnam 1996 19.6 3.4 23.0Ethiopia 1995/96 12.2 5.4 17.6Uganda 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 goodsand services and on income (see Table 3). Accordingly, trade taxes account for more than 60 percentof total tax revenue, which will not be sustainable in view of an expected decline stemming frommembership in ASEAN/AFTA and from re-exports, as tariff differentials with neighboring countriesdecline and their trade regimes become more open.

40. Recognizing the urgency of significantly enhancing revenue mobilization, the Governmentprepared a comprehensive medium-term tax reform strategy. Based on this strategy, along with the1997 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 personwho is not a large taxpayer, is exempt from profits tax; (ii) dividends paid to domestic and foreign shareholdersare subject to a final withholding tax; (iii) medical services, public transportation, primary financial and insuranceservices, and public interest non-profit activities are exempt from VAT; and (iv) luxury automobiles are taxed atthe 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 TaxesTax Services . Property Other

Revenue Turnover, Taxes TaxesTotal 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.

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* Broadening the coverage of excise duties to automobiles, international air travel, and internationaltelecommunications service;

* Introducing taxes on interest and dividends;

* Strengthening the application of the (already existing) minimum tax to the enterprises, includingthose granted tax holidays under the Law on Investment; applying a 30 percent profit tax rate for oiland 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, andemployees of NGOs; reducing the current exemption threshold; introducing taxation of fringebenefits;

* Introducing the withholding of taxes; and

* Replacing taxes on turnover and consumption with a value-added tax (VAT) for the 600 largesttaxpayers, by January 1, 1998, and extending it gradually.

41. Among the above measures, eliminating the exemption of turnover tax on the first sale after theimportation would have the biggest revenue-boosting effect, estimated roughly at 30 billion riels on anannual basis (or 0.3 percent of GDP). While it introduces cascading, this provision would eliminate thecurrent implicit subsidy to imports at the expense of domestic or potential domestic production. Itwould also remove the current incentive to vertical integration. Effective tax rates paid by theconsumers 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 domesticallyproduced goods. Imposition of the turnover tax on the first sale after importation would level theeffective rates between 7.5 percent and 11.5 percent which would help prepare for the introduction of aIO percent VAT.

42. The introduction of a VAT at a single rate of 10 percent would be, in principle, revenueenhancing, as a significant amount of the current turnover tax is collected at the border in the form of aconsumption tax (currently at a standard rate of 4 percent). The introduction of a VAT initially for thelarge taxpayers (legal person, import/export firms, and investment enterprises) registered at the LargeTaxpayer Unit (BGGE) is considered feasible as the BGGE is the most efficient office in the TaxDepartment, all these firms are covered by one office, and these firms would account for 80-90 percentof the VAT take. This approach is also consistent with best practice which suggests that it is better toexclude firms from coverage on the basis of their size (as in Malawi) rather than on the basis of theirplace in the production and distribution chain.9 The cascading effect on the small firms outside theVAT system would be minimized by reducing the turnover tax rate to 2 percent from the current 4percent.

43. While foreign experts have been working to design an appropriate VAT and to ensure that itcan be properly administered, international experience shows that preparation for the properimplementation of a VAT would require 12-18 months and implementation could further strain the

Lessons of Tax Reforn, World Bank, 1991.

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weak administration capacity. Therefore, the extent of such enhancement would critically depend onprogress made in strengthening the tax administration capacity.

44. Over the medium term, the Government's objective is to increase the revenue ratio from thecurrent 9 percent of GDP to 13-14 percent by the year 2000. Tax revenue is envisaged to reach 9-10percent, of which 60 percent would be from domestic taxes compared with the current contribution of40 percent. In the near term, strengthened tax administration and strictly limited tax exemptions wouldplay the major role in enhancing revenue. In the later years, the contribution of the new tax measureswould 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 arebeing put in place. The challenge for the Government will be its implementation in view of the weaktax administration. Over the medium term, the Government will need to add the remaining elements--inparticular land and property taxation and a proper duty drawback system to replace the current ad hocre-export scheme, and do away with some of the tax measures--such as the minimum tax andprepayment 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 comefrom the liberal exemptions granted under the Law on Investment. Customs revenue losses resultingfrom 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 theexemptions for rubber and luxury automobiles were discontinued in 1997, additional exemptions havebeen granted, such as for forestry exports. Such ad hoc exemptions not only erode the tax base, but alsoraise concerns regarding transparency in economic management. Customs revenue losses in 1996 fromad hoc duty exemptions were estimated at US$23 million (or 0.7 percent of GDP). In total, customsrevenue 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 implementingregulations for the Law on Investment to eliminate significantly the scope for these exemptions. TheCouncil of Ministers is currently reviewing these long-delayed implementing regulations. To beeffective in eliminating unnecessary and ad-hoc tax exemptions, the Government needs to adopt theimplementing regulations (as proposed) which include the following main provisions: (i) clarifying thatexemptions apply to profit tax and customs duties, and not to other taxes such as the tax on salary, theturnover tax, or the VAT, which have been major areas of contention between investors and the TaxDepartment; (ii) strictly limiting the scope of the investment activities eligible for the generous taxincentives 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 rateas 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 revenuecollected, than those for trade and excise taxes, ranging from I to 3 percent. (World Development Report, WorldBank,1988)

These transitional measures would not be necessary under a well administered tax system. The minimum taxcould be viewed as a proxy for a wealth tax usually in the form of an assets tax which is applied regardless of thelevel of taxable income. Prepayment of tax on profits is necessary in view of low tax compliance.

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enterprises granted an exemption from the profit tax; (v) requiring that enterprises are grantedinvestment incentives to pay import duties on all imports, which will be rebated once the appropriateuse of the goods has been established; and (vi) requiring all enterprises that are granted investmentincentives 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 theauthorities is to ensure that: the implementing regulations contain these provisions; they are strictlyimplemented; and no new ad hoc exemptions are granted. 12

48. Even with the adoption of the implementing regulations, the tax incentives offered by the Lawon Investment would still be generous by international standards. The experience of other countriesindicates that tax incentives rank low as determinants of investment flows. Moreover, tax policyaffecting multilateral corporations in the majority of countries allows for some credit for tax paidabroad, so that tax holidays in Cambodia only serve to shift tax revenue to foreign governments. Overthe medium term, the authorities should review the overall investment incentive scheme--including thepossibility of revising of the Law on Investment--based on an in-depth analysis. A recent FIAS studywill provide an input into this review.13

3. Tax Administration

49. The Government has also committed to strengthen tax administration, which will be essentialfor broadening the tax base and achieving the envisaged revenue enhancement. Althoughimprovements have been made, the current tax and customs administrative capacity is still weak. Ondomestic 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 beingtracked) 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 andidentified CR 23.6 billion in unpaid taxes, of which only CR 600 million have been collected. The TaxDepartment aims to conduct on-site tax audits of additional 225 enterprises by end- 1997. On customsadministration, the Government has instituted a system of pre-shipment inspections in order to reducerevenue 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, duemainly to the lack of clear legal provisions.

50. The legal framework for tax administration is being improved. The Law on Taxationstrengthens the tax rules and procedures, in particular the power of the tax administration authorities toenforce the tax code, including provisions for confiscation, the freezing of bank accounts, the stoppingof export-import operations, and the nullifying of permits and licenses. The Law on Taxation, alongwith the implementing regulations for the Law on Investment, should strengthen the capacity of the taxauthorities to enforce compliance with the tax laws.

51. For the medium term, strong efforts will be needed in the following areas: (i) training taxofficials in accounting, assessment, auditing, dispute resolution, and the VAT; (ii) strengthening thesystematic 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, additionalad 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 therequirement 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 areroyalty payments from forestry, fees and commissions paid in connection with government jointventures 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, especiallyfrom forestry.

53. The budgetary coverage of non-tax revenues remains incomplete, with some line ministries andother government entities continuing to collect revenues without control and supervision by theMinistry of Economy and Finance. Extrabudgetary revenues need to be brought under budgetarycontrol. The Government aims to issue an Order, giving the Minister of Economy and Finance controlover all negotiations involving the sale, transfer, or use of the national patrimony and requiring theMinister of Economy and Finance's signature on all such contracts. The Order would bring themanagement of all financial aspects of existing contracts under the control of the Ministry of Economyand Finance. With the enactment of the Order, the commercial activities of the line ministries wouldeffectively 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 forvaluation; (ii) apply transparent and competitive procedures in awarding concessions for naturalresource exploitation such as forestry, oil and gas, land, and gem extraction; and (iii) ensure the timelytransfer of associated revenue to the budget. The same procedures should be applied to any revenueresulting from the privatization of SOEs, rubber plantations in particular.

55. Forestry Resource Management. Raising revenue from forestry is one major element of theGovernment's reform efforts to establish an export-oriented, market-based system for the sustainableexploitation of resources. Forests are Cambodia's most developmentally significant natural resources.The implementation of economically and environmentally sound forestry policies could generate someUS$100 million a year in government revenue, equivalent to over one-third of budget revenue or over 3percent 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; largeconcessions have been awarded, with unsustainably high harvesting intensity and royalties that accountfor about one- fifth of their economic value (US$14 per cubic meter compared with an averagestumpage value of US$70); and only a part of revenues from logging activities have been transferred tothe national budget. In 1996, US$10.5 million (or one-tenth of potential revenue under economicallyand environmentally sound forestry policies) was collected from forestry exploitation.

56. Actions taken by the Government during 1996 raised questions about its commitment tosustainable forestry management. Most significant was the decision to allow the export of up to onemillion 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 ratherthan open auctions, and the sales procedures, which were developed well after the initiation ofnegotiations, 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.

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authorized amount of exports was finally reduced to 125,000 cubic meters, based on the verificationthat the logs in question were indeed felled before April 1995.

57. After some delays, the Government has taken initial actions to regain control over loggingactivities and has reconfirmed its intention to pursue medium-term measures for a sustainableexploitation of forestry resources. The Government issued a Declaration that includes: reimposing acomplete ban on all exports of logs and sawn timber effective January 1, 1997; allowing only forestconcession 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 studiesproposed 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 ofcontrols on illegal logging and of a credible log export ban. While not entirely successful, theGovernment's efforts, which include improved cooperation among government agencies including themilitary (a regiment of 1,900 soldiers has been assigned to the enforcement of the log export ban andthe control of illegal logging), seizures of illegally felled logs and logging equipment, and diplomaticinitiatives with neighboring countries, have led to a decline in illegal logging. In some borderprovinces, however, illegal log exports with the help of foreign traders continued. Second, someprogress has been made on the technical assistance studies and, with a concerted effort, the four studiesrecommended by the World Bank/UNDP/FAO report could commence by July 1997. These studiesshould provide a specific and monitorable agenda for further actions in forestry, as well as interimrecommendation 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 andconsisting of representatives of nine agencies most directly involved in forest development has beenestablished as has the Committee's Secretariat.

59. On the other hand, three recent developments call into question the Government's commitmentto sustainable forestry management. First, forestry revenue collection has not been satisfactory as theGovernment has granted export tax exemptions to 8 forestry companies. Second, the Government hasnot yet allocated sufficient budgetary resources to the Secretariat of the National Committee for ForestPolicy. Third and perhaps most troubling has been continued granting of forest concessions, annualharvesting licenses and authorizations for collection of logs outside of concession area that are notmarket-based, transparent, nor based on satisfactory environmental assessments. The recent granting ofa large concession of about 459,000 hectares and other award of land and harvesting permits areinconsistent with the commitment of the Government to the fundamental need for forestry policyreform. In addition, the Government has issued annual harvesting licenses, albeit at higher royaltyrates, without adequate planning, supervision, or local consultation. Other ad hoc arrangementsproviding private firms access to public resources, such as permission to one firm for the collection of80,000 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 andports; (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 beenreports of smuggling to Vietnam.

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Bank/UNDP/FAO report; (iii) to secure adequate budget resources for the recently establishedSecretariat 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 inplace. Over the medium term, based on best practice of other countries, three principles should guideforestry policy: effective rent capture; environmental sustainability; and transparent and accountablegovernance. In particular, the experience of many other countries shows that the use of low coststumpage to promote rapid development is unlikely to be sustainable or economically viable. Methodsto improve rent capture include revised royalty schedules, controlled deregulation of restrictions on logexports, and competitive bidding for the allocation of concessions and cutting rights. Guaranteeingsustainable timber extraction is likely to require a cautious approach to the use of natural forests and thecontinuation and expansion of forest inventory work (now under way with the assistance of FAO andUNDP). Improved transparency and governance await pending legislation which will ensure concessionand 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 adoptionof the Budget Law in 1993. The Law established the authority of the central Treasury over all revenueof government institutions, and ensures ex ante as well as ex post review of expenditures by theTreasury. Progress has since been made in establishing audit and inspection, Treasury cashmanagement, and accounting. More recent progress includes: assigning financial controllers to eachministry, establishing a system of direct payments by the Treasury for procurement over a specifiedamount, establishing competitive bidding procedures through the Public Procurement Department, andadopting a public accounting sub-decree to avoid having unpaid pay orders carry over into the nextfiscal year.

62. Quality of Expenditure Policies. The Government, through these steps and measures and astrong policy commitment to macroeconomic stability, has succeeded in containing currentexpenditures at around 10 percent of GDP. However, the very high level of defense and securityexpenditures (while declining to 50 percent of total current expenditure in 1996) has resulted in a verylimited scope for civilian expenditures (see Table 4). Furthermore, as salaries are the predominant itemof 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 higherdevelopment-oriented expenditures in the initial budget allocations during 1994-95, actual defense andsecurity outturns have significantly overrun the budgetary targets, often through ad hoc non-transparentprocesses. This, combined with lower revenue outturns compared with budgetary targets, has meantthat the allocations for social sectors and local currency counterparts have often been reduced tominimum levels from the budgetary targets. In 1996, however, the Government succeeded in containingdefense and security expenditures largely within the initial budget allocations, but a revenue shortfallstill constrained non-defense expenditures.

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Table 4: Current Expenditure by Sector 1/

1994 1 1995 1996 r 1997Budget Outcome Budget IOutcome Budget I Outcome Budget

(in billion of riels)

Defense and Security 283.2 391.5 299.0 421.2 392.3 400.7 383.5Education 63.8 61.0 73.4 72.4 83.8 80.5 87.9Health 42.4 30.0 36.2 26.1 60.4 44.0 60.7Agriculture & 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 44.1Education 10.9 9.2 11.3 9.9 11.2 10.1 10.1Health 7.2 4.5 5.5 3.6 8.0 5.5 7.0Agriculture & 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 averageof 5 percent of GDP for low-income countries. In contrast, Cambodia's level of expenditures fordefense and security is two to three times higher. This pattern of spending has not adversely affectedeconomic 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 tosupport development priorities: government expenditures need to be significantly redirected towardpriority social sectors and economic infrastructure, and the composition of 0 & M expenditures needsto 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 hascommitted to achieve this re-orientation in the PFP. The objective is to increase expenditures for healthand education to 5 percent of GDP from the current 2 percent by the year 2000, and reduce defense andsecurity 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 tomonitor and control budgetary expenditures through full implementation of the recently introducedmeasures such as the assignment of financial controllers, direct payment systems, and competitivebidding procedures. Second, the Government should make strong efforts to contain the military wagebill in spite of the need for the integration of former Khmer Rouge soldiers. Non-wage operatingoutlays 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 becritical (see paras 80-84 in Section III). Third, the Government will need to re-establish control overrecruitment 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-jSalary 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 88.6 113.0Public 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 86.6Industry 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 91.0Health 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 92.7 153.5Education 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 78.4 100.0Public 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 90.4 100.0Industry 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 93.1 100.0Health 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 60.4 100.0Education 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.

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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-termsustained development. Since 1993, public investment has been almost entirely financed by externalsources. A substantial part of the foreign-funded projects, especially from NGOs, has been operatedoutside of Government agencies. The Government's provision of a local currency counterpart forforeign-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'sdevastated physical and social infrastructure, it has often been donor-driven, concentrating on thebuilding of new infrastructure--roads, hospitals, and schools--and sometimes lacking adequate provisionfor the associated recurrent expenditure needs. The lack of adequate O&M expenditures has oftenundermined 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 againbecoming impassable because of inadequate maintenance). Reflecting needs that are of an emergencyrehabilitation 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 (11percent), and social development (9 percent).

68. The Government has made some important progress toward improving public investmentmanagement, in particular, initiating the National Public Investment Management System and preparingthe 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 andthe recurrent expenditure requirements. The second PIP (1997-99) made significant improvements overthe 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 betterlinked to macroeconomic and sectoral strategies and policies; and (iv) coordination among variousagencies, the Ministry of Planning, the CDC, the Ministry of Economy and Finance, and line ministrieswas improved.

69. Notwithstanding these significant improvements, there remain a number of weaknesses in thesecond PIP. First, some projects are still omitted as a large number of projects funded by bilateral andmultilateral donors as well as most NGO projects continue to operate outside the national budgetdespite 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 coordinationwith donors (especially with NGOs), the coverage is better (e.g., health). The coverage appears to beweak for sectors such as education and agriculture. Second, the second PIP has not yet fully connectedproposed allocations to past progress in implementation, as the monitoring mechanism is currentlylacking--owing partly to the fact that a significant part of the donor-financed projects is outside of theauthority of ministries. Third, while this is inevitable to some extent, a number of projects continue tobe 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 withprojects. In preparing the 1997 budget, considerations for recurrent expenditure allocations forinvestment projects in the PIP were not completely incorporated as the PIP was only completed andapproved 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 specialprograms such as administrative reform and military demobilization. For the US$1.2 billion, theallocation 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 (13.5percent), energy (12.7 percent), agriculture (12.5 percent.), and water supply and sanitation (9.5percent) (Table A.1 in the Appendix I). The proposed allocation shows greater investment thancurrently in health and non-transport economic infrastructure and less investment in transportinfrastructure. This reflects appropriately a gradual transition from emergency rehabilitation andrecovery toward more long-term development.

71. To enhance the efficiency of the public investment program, the Government needs toundertake the following. First, capacity at the Ministry of Planning and line ministries in monitoringand implementing the program needs to be developed. Second, the Government needs to formulate thenext PIP on the basis of the findings of the first two PIP implementation as well as a Public ExpenditureReview. Third, coordination among various agencies needs to be strengthened. In particular, closercollaboration is needed between the Ministry of Planning and the Ministry of Economy and Finance inestimating and allocating the appropriate amounts for recurrent expenditures. Fourth, coordination withdonors needs to be strengthened to ensure that the available financing is in fact allocated to theGovernment's priority program and to improving the coordination of the various technical assistanceprograms. This could be achieved through donor coordination meetings on selected sectors, such as theone 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 coveredare agriculture and rural development, health, education, energy, transport, and water supply andsanitation. For each sector, there is an assessment of the current situation and an assessment of the PIPfor 1997-99. The summary of the main findings are as follows. First, government involvement in thepublic investment projects is generally justified, with the exception of agriculture, e.g., agriculturalinputs distribution, rice trading, and rubber marketing. Greater private participation should be activelysought out, as only in the power sector are there important private initiatives. Second, while it isdifficult to judge the appropriateness of the investment level, as a significant part of donor-financedprojects operate outside of Government agencies, the level of donor-financed investment could beconsidered reasonable with respect to absorptive capacity. The budgetary contribution, however, isinadequate in providing non-wage O&M expenditures--most severely in education, transport, andagriculture 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 allministries (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 sectoraldescription 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 committedprojects. Rank 3 was assigned to pipeline-high priority projects that are at an advanced stage of receiving fundingcommitment or are of high national priority.

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PIP could be strengthened. The supply-driven nature of some projects is a problem in this regard. Inparticular, in contrast to the emphasis given to rural development in view of its importance forpromoting broad-based economic development and poverty reduction, not enough projects thatspecifically 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 tostrengthen 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 managethe rural development and social sector programs necessary to reduce poverty and achieve broad-basedgrowth will be limited. This is especially important as the Government needs to provide enablingenvironment 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 achievinglong-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 theallocation of government expenditures.

1. Administrative Reform

74. As a legacy of years of civil strife, while improving, the Government's capacity to formulatepolicy and implement development programs is still severely constrained. The current Governmentinherited a civil service that was poorly remunerated, lacking in the skills and knowledge necessary tomanage a technical bureaucracy in a market economy, and suffering from a distorted demographicprofile. There are relatively few staff in the 30 to 40 age group and younger staff are poorly equippedto perform. Older staff, while better trained, are poorly motivated and their skills are unsuited to amarket economy. Absenteeism is rampant because wages are well below the poverty line. The bulk ofthe work is done by expatriate Khmers and other foreign experts paid by donors or by local staff whoreceive salary supplements to work on donor-aided projects. This approach has yielded fairly goodresults 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 wasintended as an interim solution threatens to become of longer duration because of slow progress inadministrative 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 strategyfor institutional strengthening should be an integral part of the development effort. The first stageshould consist of putting the essential building blocks in place: (i) a reorganized public sector reflectingprivatization of public enterprises and a smaller, professional military; and (ii) a reconstituted civilservice management system and the initial phase of civil service reform. Once this initial stage hasbeen achieved and stability established within the civil service, the prerequisites will be in place for amajor capacity-building effort whereby retrained civil servants and new recruits could gradually takeover the duties of expatriates, and ad hoc administrative arrangements funded by donors could bereplaced by fully functioning line ministries. This transition would take 5 to 10 years to be fullyimplemented.

76. Recognizing the importance of administrative reform, in the fall of 1994 the Governmentlaunched a broad and ambitious program of administrative reform in five main areas: (i) re-establishing

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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 provincialadministration. With substantial technical assistance from UNDP, the European Union, France, and theBank, the Government has produced studies and plans on: reducing the size and renewing the skillsprofile and composition of the civil service; creating the management tools and systems necessary forsustaining performance; installing a data base and a personnel and payroll management system;devising a new remuneration policy; reforming recruitment and personnel management; andreorganizing the ministries. This work has been complemented by the analysis and modeling of variousoptions for the reduction and renewal of the civil service.

77. While progress has been made in certain aspects of public sector reform, the civil servicerenewal program has made little headway. Despite significant background work, civil service reformefforts have suffered from a lack of clear rationale, objectives, and targets and a lack of a politicalconsensus within the Government. Of particular concern is the failure to control the size of the civilservice, which crowds out useful government expenditures and makes impossible the improvement inremuneration that is necessary to attract better qualified and skilled persons. Whereas the target for thesize of the civil service at end-1996 was set at 130,000, the year began with 145,000 and about 18,000political recruitments were added, bringing the number of individuals with the right to claim civilservice status to 163,000. The political appointees have been integrated based on the Paris PeaceAccord, 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 ofthe civil service and to accelerate preparation for the reform. The Government aims to carry out thefollowing measures, for which decisive and timely implementation will be critical to acceleratingreform: (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 andpersonnel with irregular status, and by strictly limiting new recruitments through consistent applicationof new circular governing recruitment; (ii) presenting a prioritized program for civil service reformwhich reflects government objectives and implementation capacity to the CG meeting in July 1997 witha 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 civilservice, and completing the census by April 1998; and (iv) creating a Superior Council for the Reformof the State Apparatus to be chaired by the two Co-Prime Ministers, and a Steering Committee forAdministrative Reform to implement the reform process, under the guidance of the Superior Council, toincrease political commitment to the civil service reform process and enhance technical capacity.

79. Best practice of other countries--for example, Malaysia or Uganda--demonstrates theimportance of defining goals, ensuring sustained commitment from the highest levels over the longhaul, and devising a strategic plan and setting up appropriate institutional arrangements. Prospects forsuccessful implementation will, therefore, critically depend on the Government's political will as wellas the strengthening of the implementation capacity with continued technical assistance from variousdonors.

2. Military Demobilization

80. The high levels of expenditures on defense are crowding out essential government expendituresin the productive and social sectors. The Government recognizes this problem and intends to carry outmilitary downsizing, or the demobilization and reintegration of combatants into a productive civilian

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life, as an integral part of its overall development strategy. RCAF is estimated at 127,000 includingseveral thousand recently registered Khmer Rouge defectors, which could increase to 130,000 withfurther defections. Given the likelihood of ghost soldiers, part-time irregular soldiers, and payments towidows of deceased soldiers, there is a serious need to conduct a full census on the registration of theRCAF to determine the actual universe from which a demobilization program would draw candidatesfor dowAisizing.

81. To guide the downsizing, the Government has established a National Commission forDemobilization and Reintegration, chaired by the two Co-Prime Ministers with cross-ministerialrepresentation, an Executive Secretariat to handle the day-to-day implementation, and prepared acomprehensive military downsizing and reintegration program--the Cambodia Veterans AssistanceProgram (CVAP). The program design has benefited from the best practice established in similardownsizing exercises in countries like Uganda and Mozambique.

82. The Government is currently targeting 43,000, although the total could rise as high as 50,000depending 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 1,500soldiers involving those close to retirement and most vulnerable. A second phase targeting the mostvulnerable and involving 10,000 soldiers would take place in mid-1998 depending on the results of thepilot and on the security conditions in the country. The third and fourth phases, involving groups ofabout 1 1,000 and 17,000 regular soldiers, would take place at intervals of three to six months dependingon the implementation capacity and performance of the previous phases. The total cost of the programis estimated at about US$72 million (of which about 60 percent for departure allowances) over three tofour years.

83. A training program is under way to build capacity for management, organization and programdevelopment, monitoring and evaluation, and financial management. Preparation for a full registrationof the RCAF is also under way. This is currently being financed with funds from IDA's TechnicalAssistance Credit and the Australian Trust Funds. The German Government has pledged funding toassist in registration and pilot development. Registration is expected to begin by August 1, 1997. Thecompletion of the registration and the issuance of identity cards are now priority tasks as a basis forestablishing the actual size of the Army and creating a transparent, monitorable system for identifyingbeneficiaries and accounting for benefits. The further public education or promotion of the programawareness within and outside government, the strengthening of capacity, particularly in the keyimplementing agencies, and the pilot testing of the program in one or two selected provinces are thecontingent next steps.

84. In addition to finding sources of financing, the key constraints or problems facing the programare political will within the Government and the creation of sustainable employment in the ruraleconomy, to which the majority of the demobilized are likely to return. By moving step-by-step andtransparently on program implementation, first by confirming the beneficiary group through atransparent registration process, and second by piloting the program in one or two provinces, theGovernment can build a consensus and the political will to move forward quickly with fullimplementation after the election. The creation of employment will depend largely on theGovernment'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 salariesalone.

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and to ensure property rights and access to arable land in the rural areas for those soldiers who chooseto 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 enablingenvironment for private sector development, are still absent, and those that have been recently enactedhave yet to be adequately enforced, which often creates security and governance problems. TheGovernment has been reforming the legal framework with a view to establishing greater certainty andclarity in law, regulations, and procedures. The legal and regulatory framework is being re-establishedfrom those systems that existed under previous regimes. Consequently, there are number of gaps andinconsistencies and in areas where the law is not clear or where implementing regulations do not yetexist (e.g., land) procedures are negotiated on a case-by-case basis. Moreover, capacity to implementthe law is not solidly established.

86. Cambodia has made steady progress during the past few years in developing its legal andregulatory framework in the economic and financial areas. Since the 1993 elections, fundamental piecesol .z,gislation, such as the Budget Law, the Law on Investment, and the Central Bank Law, have beenprepared. More recently, several important pieces of legislation have been adopted--Public EnterpriseLaw, Law on Commercial Regulations and Registration, Law on the Chambers of Commerce, and thenew Law on Taxation. However, other key laws and regulations have been delayed, in particular theFinancial Institutions Law, implementing regulations for the Law on Investment, and the remaining sixlaws 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 ruleof 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 beachieved through adoption of additional basic commercial laws and implementing regulations,strengthening key judicial institutions, promoting transparent and consistent enforcement of laws, andenhancing 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 theproper training of law officials and practitioners, as well as adequate institutional mechanisms to assurethe constitutionality of laws and the smooth functioning of constitutional processes. This twofoldobjective would be accomplished also through the creation of procedural structures that are likely toproduce the most effective legal reform in the medium term. Toward these objectives, in addition torapidly adopting the laws and regulations mentioned above, to enhance the effectiveness ofimplementation the Government will need to adopt the necessary implementing regulations--forexample, 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, theenactment of laws and regulations to support private sector development would have limited impact onCambodia's economic development.

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IV. MEDIUM-TERM PROSPECTS, EXTERNAL FINANCINGREQUIREMENTS, AND RISKS

88. The improvement in Cambodia's performance over the last few years reflects an encouragingresponse to the Government's initial program of liberalization, stabilization, and market reforms.However, recent delays in implementing policy reforms as well as insufficient accountability andtransparency in economic management pose concerns for the medium term. The successful transitiontoward sustainable development will hinge critically on the Government's political will and its efforts toimplement the necessary economic reforms--the three areas discussed in Section III in particular--aswell 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 sustainableeconomic growth if it is to significantly reduce poverty and enhance economic and social well-being, asenvisaged 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 outlinedin Section III as well as in the recent PFP, sustained high growth could be achieved. Under thisscenario, there would be continued progress in consolidating macroeconomic stability, combined withan acceleration of economic reforms and the strengthening of institutional capacity. In turn, suchpolicies would engender a high level of donor support, through official grants in the next several yearsand concessional loans. The continuation of economic reforms would also lead to continuing foreigninvestment. Under these assumptions, GDP would grow at 7-8 percent per annum (see Table 6). Thisgrowth 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 asupporting catalytic role by providing an improved enabling environment for private sectordevelopment (see Box 1).

90. Agriculture would grow by 4.5 percent per year over the next five years (assuming normalweather conditions), and by 5 percent per year over the following five years. While this is high growthfor agriculture, it should be noted that much of this represents a recovery that would be made possibleby higher public outlays on rural and agricultural development and improvement in the securitysituation. Strong supply response would be expected in rice production as a result of enhancedproductivity. In the later years, robust growth would be expected for rubber, with more private sectorparticipation, and also for forestry, with the establishment of an export-oriented, market-based systemfor the sustainable exploitation of forestry. Industry would grow by 9-10 percent a year. Reforms in theenabling environment would translate into higher industrial growth, albeit from a small base, led bylabor-intensive manufacturing and stimulated by foreign investment. Garment production would be theleading sector, but basic consumer goods for the domestic market can also be expected to expandrapidly in response to rising incomes. Services would also grow rapidly, 8-9 percent a year, spurred bytourism, for which Cambodia has great potential.

91. Attaining economic growth in the range of 7-8 percent a year would entail a substantial increasein domestic savings and investment. National saving would more than double from the present lowlevel of 5 percent of GDP to 12 percent by the year 2001. Government savings would improvesignificantly as a result of enhanced tax efforts (13 percent of GDP by the year 2006) and increasednon-tax revenue, especially from forestry, as sustainable management practices take hold. The extentof improvement in government savings, however, would be limited up to the year 2001, as theimplementation of civil service and military reform would require additional expenditures.

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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 inthe period of its rapid economic growth in the 1970s and the 1980s. Private savings would increasesteadily as macroeconomic stability is maintained, as disposable incomes increase, and as financialinstitutions are developed. Private investment would also increase steadily, reflecting both higherdomestic savings and expanded foreign direct investment. While the government investment wouldremain at around 7 percent of GDP, the part coming from government savings would expand relative tothe part that is externally financed.

Table 6: Projection of Main Macroeconomic Indicators I/(In Percent)

1995 1996 1997 1998 Average Average1999-2001 2002-2006

Actual Prel. Projection

GDP Growth 7.6 6.5 6.5 6.5 7.1 7.6Inflation 3.5 9.0 5.0 5.0 5.0 5.0

Revenue/GDP 8.9 9.1 9.7 11.1 13.7 16.9Current Expenditure/GDP 2/ 9.6 9.9 9.4 10.5 12.2 13.1Govemment Savings/GDP -0.6 -0.8 0.3 0.6 1.5 3.7Government 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 18.2Private 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 -8.8Debt/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 peryear over the long term, led by strong growth in non traditional, labor-intensive light manufacturingproducts--garments, in particular. The increase in these exports (at about 13 percent per annum) wouldbe spurred by foreign direct investment inflows. Rubber, rice, and other agricultural products wouldalso contribute to export growth, especially in later years. Log exports would gradually increase aftersustainable forestry management mechanisms have been put in place. Retained imports (i.e., excludingimports for re-exports) would grow by slightly less than GDP.

93. External Financing Requirements. Although the current account deficit would narrow as apercentage of GDP to about 13 percent by the year 2000, it would rise in dollar terms from US$488million in 1996 to US$580 million (Table 7). An increasing proportion of Cambodia's externalfinancing requirements, which also reflect reserve accumulation and debt amortization, would be metby foreign direct investment inflows. FDI would steadily increase to US$300 million by the year 2000.

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Even with this increase in private capital flows, a substantial need for the disbursement of officialassistance would remain. Disbursements of official assistance--grants and concessional loans--wouldneed 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 agrowth rate in the 7-8 percent range comparable to what several other East Asian countries have achieved since the 1970s. Asidefrom attention to the macroeconomic fundamentals and investment in human resources, such performance will depend upon theinitiative and dynamism of the private sector. As with the other East Asian economies, Cambodia's ability to realize its fulleconomic 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 investmentmainly in the urban areas. Construction, light manufacturing and service activities are on the rise and its is these that have beenlargely responsible for Cambodia's respectable growth rate during the first half of the 1 990s. A substantial flow of FDI has usefullyaugmented 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 benecessary to satisfy the expectations that have been generated and move to the next stage. This will help to sharpen incentives andmarket competition still further.

(ii) Governance. To strengthen private investors' belief in the govemment's commitment to reform and the irreversibilityof the liberalization measures already taken, improvements in governance are highly desirable. These should be designed so as toincrease accountability of public agencies, minimize political interference in policy enforcement, reduce red tape, promotetransparency and build trust between the government and the business community. Better governance will lessen the perceived riskand 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 effortto build an autonomous, impartial and effective legal system that is able not just to pass laws but to enforce them as well. Suchinstitution building is a lengthy process, which is all the more reason to give it early attention. It will require the accumulation ofspecialized skills, putting in place a substantial infrastructure of courts and enforcement mechanisms and embedding a number ofsubstantive and procedural rules. Development of the legal system will buttress the progress made in adopting fundamental pieces oflegislation, such as the Law on Investment and the Law on Commercial Regulations and Registration. However, other legislationhas been delayed because of insufficient technical capacity or sometimes insufficient political commitment. In some cases, such asthe Financial Institutions Law, the Government needs to act with speed so as to clarify the legal framework for the ownership, capitalstructure, management and prudential supervision of banks. Furthermore, implementing regulations for the Law on Investment willclarify the scope of investment incentives.

(iv) Public Utilities. A serious bottleneck to private sector development is the inadequate supply and poor quality of basicservices. This has been repeatedly singled out as one of the principal factors that sharply increases the costs of doing business inCambodia. As an initial step, the Government should undertake the organizational changes and the investment needed to augmentthe supplies of power, water and communication services. But the medium run strategy should be to divest public utilities, wherethis is feasible, and to encourage the entry of the private sector into these activities. To ensure competition and efficient servicesdelivery by private suppliers, the Government will also have to build its regulatory capacity, drawing where possible on theexperience of other countries that have taken the privatization route.

(v) Administration. An enabling environment in which transaction costs for private participants are low requires anefficient administration. Currently, Cambodia's administrative capabilities are inadequate even though the level of civil serviceemployment has been rising. There are three main problems: first is the acute shortage of skilled and experienced personnel; secondcivil service pay scales are low and provide few incentives; third the organization of ministries and the information systems at theirdisposal are still weak. All of these deserve urgent attention because delay will only worsen the situation and administrativeshortcomings will slow progress in other areas needed to create the desired enabling environment.

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94. During 1992-95, the international community pledged significant official assistance (aboutUS$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 ofabout US$455 million per year during 1997-99, of which about US$60 million would be balance ofpayments/budget support (see Table 8). Until the Government significantly increases domesticrevenues, official assistance would need to cover some recurrent expenditures (especially for civilservice reform and military demobilization), domestic counterpart funds, and the foreign exchange costsof 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 PublicInvestment 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 580Reserve Accumulation of NBC 52 56 20 33 41Medium & Long-term Debt Amortization 16 7 15 17 17

Total 557 599 597 620 639

Financing Resources

Official Grants 299 274 257 246 200Medium & Long-term Borrowing 75 85 117 125 149IMF (net) 0 40 -1 -4 -10Foreign Direct Investment 241 252 269 288 300Other 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.

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Table 8: Required Commitments of Official Development Assistance(US$ millions)

ExistingComistment Projected Commitment

Commitment

CG 1996 1997 1998 1999

BOP/Budget Support 97 65 65 55Project 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, theprimary risk would be either a loss of fiscal discipline, due to an inadequate revenue effort, or delays inimplementation of necessary economic reforms, especially in the period preceding the nationalelections. Over the medium term, the primary risk would stem from inadequate pace and depth ofeconomic reforms necessary to place the economy on a sustainable growth path. Under this scenario, aloss of macroeconomic stability combined with little structural reform could lead to inflationarypressures resulting from domestic financing of the budget deficit, which would lead to price rises andbalance of payments pressures. Moreover, inadequate investments in human capital because ofcontinued weak revenue performance could pose a threat to future growth, once the gains fromliberalization and relative stability have been exhausted. Such a situation could jeopardize thesustainability 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 inthe transparency of economic management. In particular, Cambodia's natural resources would beexploited in an unsustainable manner with inadequate resources accruing to the state. Should this persistfor an extended period, a major source of growth for the Cambodian economy would be squandered andthe economy's future prospects would be adversely affected.

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Appendix IPage 1 of 10

Appendix I: Assessment of Public Investment

1. A brief assessment of public investment by sector is given below. The sectors covered areagriculture 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 ofthe country and whether there is an appropriate division of labor between the public and privatesectors; also discussed is whether the balance is appropriate between current and capitalexpenditures, and between wage and non-wage O&M expenditures;

* The current policy environment (pricing policy, cost recovery, autonomy of SOEs, etc.) andimplementation 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 alegitimate 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 onthe following issues:

* Is the PIP consistent with the Government's stated overall development strategy as well as itssectoral 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 notableexception is the agriculture sector, e.g., agricultural inputs distribution, rice trading, and rubbermarketing. The Government has committed to privatize these activities in the PFP. Greater privateparticipation should be actively sought out, as only in the power sector are there important privateinitiatives to address power supply in provincial towns. In health, spontaneous private investmenthas only focused on the sale of drugs or disease treatment and on private medical consultations. Ineducation, private sector involvement is restricted to vocational education and higher education. Intransport, proposed BOT operations have yet to attract private investors. In water supply, privateparticipation has been only in the form of outsourcing goods and services.

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Appendix IPage 2 of 10

* While it is difficult to judge the appropriateness of the investment level, as a significant part ofdonor-financed projects operate outside of Government agencies (in agriculture and ruraldevelopment, for example), the level of donor-financed investment could be considered reasonablewith respect to absorptive capacity. The budgetary contribution, however, is inadequate in providingnon-wage O&M expenditures-- most severely in education, transport, and agriculture and ruraldevelopment (see Table 5 in the main text).

* The policy environment has improved toward a more market-oriented strategy, but much still needsto be done, especially in the area of cost recovery. In power, the current tariff levels do not permitcost recovery because of EDC's poor collection records. In water supply, the Government hasrecently agreed to a revamped water tariff structure for Phnom Penh city, but it is not clear whetherthe autonomous PPWSA has authority to raise tariff rates. In health, there exists a de facto policyof cost recovery, with practitioners and specialists charging patients informally for services inpublic facilities. In education, despite non-existent cost recovery policies, even for highereducation, household spending is perhaps three to eight times that of government expenditures atthe different levels of education. In transport, despite increased traffic volumes and heavier axleloads, there are no adequate road user charges.

* Implementation capacity and the effectiveness of expenditure, although improving, are weak in allministries (with the possible exception of health). In education, weak implementation capacity isdue primarily to the absence of managerial capacity among the sector's 74,000 employees. Thecost-effectiveness of expenditure is hampered by excessive numbers of non-teaching staff. Inagriculture, capacity is limited also, especially in research and extension. While continuedtechnical assistance is required, more effective use will be critical to improving implementationcapacity.

* While the sectoral description in the PIP document is adequate, the linkage between the statedstrategy and the proposed PIP could be strengthened. The supply-driven nature of some projects isa problem in this regard. In particular, in contrast to the emphasis given to rural development inview 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 actualimplementation, some projects in particular would require a rigorous feasibility and sustainabilitystudy. Examples are: in agriculture, small irrigation systems; in health, national hospitalrehabilitation and mental development programs; and in power, the Kirirom electricity stationrehabilitation project. The viability of some other projects also would need to be re-examined basedon more details of those projects or the completion of the sector master plan. Examples are: inagriculture, canal rehabilitation and an animal production center; in health, pharmaceutical reform;in power, the KamChay hydropower project and the Sambor hydropower study; and in watersupply, Chinese-assisted rural water supply.

* Some issues require fuller treatment in the PIP. In rural development, projects specifically aimed atthis 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 ruralcredit services, are missing. In health, the continuation of the blood transfusion program is in doubtas ICRC begins to withdraw from its large program of support and no other donors are lined up tofill the gap. In education, secondary education, which will become increasingly important toprovide further opportunities for those who complete primary education and as the base for

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Appendix IPage 3 of 10

strengthening the quality of tertiary education, is largely neglected. In transport, although asustainable maintenance system has to be developed to ensure that investments will continue todeliver the expected benefits after rehabilitation road works, little funding is provided for themaintenance of recently rehabilitated roads.

B. Agriculture and Rural Development

4. Assessment of the Current Situation. Public investment expenditures through the Ministriesof Agriculture and Rural Development were US$11.8 million in 1995, and US$32.1 million (budget) in1997, rising from 5.6 percent to 14.2 percent of the total. How much additional public investment inthe sector takes place through wholly foreign-funded projects not reflected in the national budget is notknown, but it is possible that part of the increase in budgeted expenditure for investment in agriculturesimply 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 1994World Bank Economic Report, indicated that an annual amount of expenditure on agriculture and ruraldevelopment of about US$90 million should be maintained, with a decreasing proportion going to foodaid, 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 spentby NGOs, and most of the rest was provided and managed by international organizations and otherdonors. A progressive shift to Government execution, and recording in the national budget, wasexpected. The data provided on the 1995 and 1997 capital budget expenditures suggest that this shift istaking place, but without a more detailed study, it is not possible to tell what is happening to donor andIO/NGO financing trends. While there are no estimates, the rate of change in private investment inagricultural sector could be considerably higher than public investment growth as rural households andentrepreneurs 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 thelate 1980s, there still remain areas to be further liberalized. The Government should have a major rolein organizing the provision and maintenance of public infrastructure for agriculture, including theprovision of roads, water, research and extension, animal health and crop protection services, and themanagement of common property resources such as public lands, forests, and water and fisheries. TheGovernment's policy should be to avoid direct intervention in the economy and to promote thedevelopment of competitive markets for agricultural inputs and products, intervening only for theregulation of standards, the protection of public health and the environment, and the management ofemergency situations such as floods and epidemics. In accordance with this strategy, the Governmentneeds to wind up its involvement in agricultural inputs distribution (through COCMA), rice trading, andrubber marketing (through KAMPEXIM or other SOEs). The implementation capacity of the Ministryof 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 theimplementation capacity of the ministries. Within the sector, the PIP allocates about half of the total tocrop production, followed by de-mining, research and extension, and livestock. This sector allocationwithin the sector is broadly consistent with the Government's sectoral strategy and the Bank's policydialogue with the Government. A notable exception is the lack of projects that specifically target ruraldevelopment, such as rural roads and rural water supply.

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Appendix Page 4 of 10

7. The feasibility of the some of the larger items included in the "high-priority" list would need tobe carefully reviewed before actual implementation. Some examples are canal rehabilitation, "smallirrigation systems", and the animal production center. In contrast, the omission of other importantprojects whose priority has been urged in numerous donor reports would need to be addressed--such asinvestment in rural roads (which would probably require at least US$10 million per year added toongoing 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 forany of the programs under the Ministry of Rural Development.

8. The Ministries of Agriculture and Rural Development approved capital expenditure budgets for1997, exceeding their current budgets by a factor of about 4:1 in each case. Given the pervading lack offunds for salaries and non-wage operating expenses, and the low level of motivation and outputresulting from this, it would be difficult--without an increase in its current budget for 0 & M, assuredcounterpart budgets, and increased technical assistance for capacity building--to satisfactorilyaccomplish all of those development projects for which funding is either committed or proposed. Inparticular, care needs to be given to ensuring feasibility of any large investments for water controlprojects before firm funding commitments are made.

C. Health

9. Assessment of the Current Situation. The Government's health budget expenditure has grownrapidly but is still well below that of other poor countries and well below the minimum expenditurerequired for the delivery of basic health services. The Ministry of Health (MOH), with its very lowbudgets of recent years has spent most of its budget on salaries, running costs, and drugs. The Ministryof Health's budgets for non-wage O&M have been substantial compared to salaries, but the ability toexpend those resources has lagged behind salary expenditures. Donor direct financed programs havefunded the construction and equipping of many facilities in Cambodia, but not through the budget of theMOH. With the recent funding from the Bank and the ADB directly flowing through the Governmentsystem, the MOH will build the basic service delivery capacity that the many disparate donor and NGOprograms 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, thecoverage and cure rate of the tuberculosis program, and the proportion of doctors working outsidePhnom Penh show improving cost effectiveness. The MOH is one of the more capable and efficientministries. At the policy and strategy level, the MOH has made impressive strides, but the capacity formore detailed implementation activities in the area of expenditure planning, accounting anddisbursement, and procurement is needed.

11. The priorities of the MOH are to control communicable and preventable diseases and torehabilitate and extend access to basic health services. The private sector is not constrained fromentering these areas of health services and in fact will be contracted to provide special services in HIVcontrol and malaria prevention. On an experimental basis, the MOH will contract out some basicservice facilities to the private sector in order to compare costs, quality, and impact with publiclymanaged services. Spontaneous private investment has focused where private returns are morelucrative, namely on the sale of drugs for disease treatment and private medical consultations. Nosubstantial investments in private hospitals have yet emerged. The network of public health facilities inCambodia has long pursued a de facto policy of cost recovery, with practitioners and specialists

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Appendix IPage 5 of 10

charging patients informally for services in public facilities. In 1996 the MOH produced a statement ofprinciple 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 collectedwould support service improvement.

12. Assessment of the PIP. The PIP summarizes well the policy priorities of the MOH. Theinvestment program targets public goods and basic services, all of which are disproportionatelyconsumed by the poor. The Blood Transfusion Program is entering a period of uncertainty as the ICRCbegins to withdraw from its large program of support for the Cambodia blood supply system. Thereare, as yet, no donors ready to fill the gap. The Blood Transfusion Service is considered a high qualityprogram 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 heavybudgetary burden on the MOH and a regressive feature of the MOH 's spending pattern. In the CorePIP Tables, a funding gap of US$3 million is identified for national hospital rehabilitation. This issuewould require a detailed analysis of the cost-effectiveness and poverty targeting of such investmentsand more attention to issues of donor coordination. The "Mental Development Program" would alsoneed to be scrutinized before the large funding gap is met with donor or Government of Cambodiaresources; 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 wouldneed to be scrutinized. If the funding gap of US$4.2 million for 1997 includes the additional cost ofrehabilitating 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 judgedacceptable in terms of their recurrent cost burden. Many of the other programs listed are countingrecurrent-type costs as part of the PIP (for example, the tuberculosis and malaria programs andtraining). Most of the programs listed therefore do not involve heavy recurrent cost implications. ThePIP includes a program of financial pilot projects to assess the fiscal and health impacts of differentmixes of private and public sector production of health services. Over the next few years, these pilotswill be useful for long-term planning for the sector and, in particular, for deciding how to release orreduce the Government's responsibility for hospital recurrent costs.

D. Education

15. Assessment of the Current Situation. Total education investment requirements for the nextfive years is estimated at approximately US$300 million. Despite significant support from theinternational 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 rehabilitationand 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 teachersprovide 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 ofrecurrent spending on education by the provinces, which are responsible for basic education and mostsecondary education, and the present trends indicate that this share is rising. There is currently verylittle private sector investment in education other than in vocational training (for example, language andcommercial courses) and in a few higher education programs.

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Appendix IPage 6 of 10

16. The education sector's implementation capacity is weak, owing primarily to the lack ofmanagerial capacity among the sector's 74,000 employees. The Ministry lacks qualified trainedplanners and managers throughout the system, and especially in the area of financial management. Thecost-effectiveness of expenditure on education is hampered by excessive numbers of non-teachingstaff. Of the 38,200 employees in primary education, 7,800 are estimated to be out-of-classroomadministrative staff, and approximately 4,000 of this number are qualified teachers. The EducationMinistry planned to redeploy 1,000 qualified staff from support positions to active teaching positionsfor the beginning of the 1996-97 school year, and it proposes to extend this redeployment on the samescale 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 loweradministrative costs, and share resources among several small-scale schools, thereby increasingefficiency.

17. Although education in Cambodia is, in principle, free of charge to all students, unofficial feesare charged at most levels of the education system. Despite the lack of a transparent pricing policy andcost recovery system for the education sector, household spending on education is perhaps three to eighttimes that of government expenditures at different levels of education. Cost recovery policies arecurrently non-existent, even at the higher education level, but the forthcoming Higher EducationNational Action Plan identifies the need for cost recovery in higher education and calls for a feasibilitystudy. Private sector involvement in education is restricted primarily to vocational education andtraining and to higher education.

18. Assessment of the PIP. Priority in investment is being given to basic education, followed byhigher 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 furtheropportunities for those completing primary education and as the base for strengthening the quality oftertiary education. The PIP would need to be adjusted to increase the relative level of investment inboth lower secondary and upper secondary education. Another critical investment area is the financialmanagement and administrative procedures necessary for running the education system at both primaryand secondary levels.

19. The PIP does not, in and of itself, impose unsustainable additional recurrent costs in educationon the budget. However, the PIP does not adequately address the ongoing problems of currentexpenditures in education--namely, the high salary costs relative to non-salary expenditures, whichundermine quality, and also the low level of individual salaries, which undermines motivation, andensures 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 theeducation and training system. The first step would be to increase levels of cost recovery withinexisting management and financial arrangements, and the second to encourage a more commercialapproach, especially in technical and vocational education and higher education initially, withinstitutions being allowed to raise and keep additional incomes.

E. Energy

21. Assessment of the Current Situation. The Government's priority program focuses mainly onthe power sub-sector, since the highly deregulated hydrocarbon sector is driven by market forces. The

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Appendix IPage 7 of 10

power supply constraint in Phnom Penh is about to be resolved as multilateral and bilateral support ingeneration and distribution is being complemented by private independent power producers. Inaddition, there are important private initiatives to address power supply in provincial towns. In thisrespect, the level of investment in recent years has been adequate both in absolute terms and in itsprivate-public mix. Although Cambodia's energy needs largely exceed the current supply, a largerlevel of investment would have been constrained by limited implementing capability. TheGovernment's strategy addresses short-term investment needs as well as medium- to long-term issuesassociated with institutional strengthening and sector reform, including the commercialization of thestate-owned power utility, Electricite du Cambodge (EDC).

22. The government's efforts to re-establish an adequate power supply and to reform the sector areconstrained 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 inthe 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 inthe high price of Independent Power Producers (IPP).

23. The current tariff levels do not permit cost recovery because of EDC's poor collectionsrecord (around 60 percent--a problem caused mostly by Government customers). Therefore, there is anurgent need to agree with the Ministry of Economy and Finance on the implementation of an actionplan to address EDC's accounts receivables. It is also urgent to secure funding for EDC's InstitutionalSupport. EDC's financial situation is weak and its short-term commercial performance will rely heavilyon 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 andaddresses Cambodia's most important energy sector needs. However, the proposed PIP is somewhatunbalanced and appears to be supply driven (i.e., only those projects supported by multilateral orbilateral donors are included). This could introduce a bias toward projects of specific commercialinterest (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 insufficientcoordination among donors.

25. There is no project addressing rural electrification needs, inconsistent with the Government'soverall strategy and the extremely low level of electrification in rural areas. The PIP includes theKirirom power station rehabilitation project: the economic merit of this investment would need to befully examined given its high capital cost and relatively small capacity. Its status would need to bereviewed once the ongoing Master Plan for Transmission and Rural Electrification (AusAid-funded/World Bank-executed) is completed. KamChay hydropower is misclassified as an ongoingproject, as it is still at an early stage of study, and its priority would need to be re-examined uponcompletion of the Master Plan. The high-priority character of the Sambor hydropower study wouldalso 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 priorityinvestment program for 1994-96 at US$217 million, mainly aiming at emergency repairs of transportfacilities, especially roads. A sizable amount of donor financing has been mobilized, but the envisaged

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AppendixIPage 8 of 10

budgetary contribution for complementing listed projects such as rural roads projects, as well asrecurrent maintenance activities, has not materialized. While capital investment funded by externalsources largely achieved the initial objective of emergency repairs to transport infrastructure it was notsufficient to keep up with the continued deterioration of the road network. The Ministry of PublicWorks and Transport (MPWT) is suffering from budget shortage and has no financing instruments forroutine maintenance activities for transport infrastructure. Thus, maintenance has been deferred evenfor the recently rehabilitated facilities. A sustainable maintenance system has to be developed in orderto 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 roaduser charges. Port charges and tariff setting are in their infancy. The Government has been processingthe 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 beused for road maintenance. Although there is discussion of a BOT operation for toll road operationsbetween the international airport and downtown Phnom Penh, the MPWT has yet to attract privateinvestors. Prospects for BOT operations for ports and railways are not promising at this stage, asprivate investors are requesting Government support for fixed infrastructure costs.

28. Studies are needed to develop a resource mobilization strategy for transport investments. Thisstrategy would need to cover such issues as road pricing, user charges, duties, and taxation. On the otherhand, a strategy would also need to be established for improving the operations of transport publicenterprises, privatizing transport services, and facilitating private sector participation in the financing ofthe transport sector. In the process of establishing strategies, in the short term, the operations ofGovernment institutions including state-owned transport enterprises would need to be improved byobtaining technical assistance focusing on management in operations and equipment maintenance.

29. Assessment of the PIP. While sector strategy in the PIP document properly addresses theneeds, constraints, and challenges, the PIP only lists possible donor-financed projects and consequentlythe 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 Route5, which the ADB has been discussing with MPWT under the next road project. This rehabilitation isof high priority as, once it is completed, it would reduce the transportation operation costs for thecommodity flow between Thailand and Cambodia and would contribute to reducing the gap in thecommodity prices between the two countries. Within Route 6, which is included in the PIP, the sectionbetween Siem Reap and Kampong Thum would need to be given priority, as it would provide anothertransport mode in addition to air transport between Phnom Penh and Siem Reap, the tourism area. Itwould 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 highlyinadequate in terms of needs, it has been reasonable with respect to the resource absorption capacity. Asubstantial part of external assistance has been directed at the repair and rehabilitation of existingfacilities, making the distinction between current and capital expenditure unclear. Adequate data arelacking on the wage/non-wage mix in public expenditure in water utilities, but the Phnom Penh Water

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Appendix IPage 9 of 10

Supply Authority (PPWSA) has a fairly good record in this respect, with wages expected to account forunder 20 percent of total operational expenditure.

32. The Government is committed to the principle of cost recovery for water and sanitation servicesand has agreed recently to a revamped water tariff structure for Phnom Penh city. The Government'srecent legislation conferring a degree of autonomy on PPWSA under the new Public Enterprise Lawhas increased managerial autonomy and is expected to generate incentives for improving operationalefficiency. It is not clear, however, whether this autonomy extends to empowering PPWSA to raisetariff rates. The Government's long-term objective for provincial towns is to develop autonomousutilities on the model of PPWSA, although this is unlikely to be achieved in the PIP period for 1997-99except in the port town of Sihanoukville.

33. The sector suffers from weak regulatory structures, along with inadequate institutional andimplementation capacity. Skilled manpower in engineering, accountancy, administration andprocurement, and even semi-skilled manpower for tasks such as meter-reading, and leak repairing, is inshort supply, especially outside of PPWSA. A crucial weakness in the existing sectoral environment isin the policymaking process itself. Responsibility for water and sanitation is fragmented among at leastseven 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. TheGovernment has encouraged the private sector to participate in both rural and urban water andsanitation provision. In the absence of adequate regulatory and institutional framework, private sectorparticipation 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'sstated development strategy. Investments in expanding water supply in Phnom Penh make good senseas a growth promotion strategy as well as a strategy to improve public health. The former would beaccomplished by the creation of a facilitative industrial and commercial environment, and the latter bythe mitigation of the existing adverse health impacts of the unsatisfactory water supply and sanitationservices 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 pipelinefor rural water or sanitation. A feasible option, once initial improvements in Phnom Penh arecompleted, is for an increased share of public investment to be directed to secondary cities and ruralareas of the country.

36. The data in the PIP do not enable an assessment to be made of whether recurrent costs havebeen provided for. However, in respect of the Phnom Penh water supply investments, this is not asignificant issue, as the PPWSA appears to be capable of managing the incremental recurrent costswithout recourse to the budget. The PIP is generally consistent with the appropriate public-private mixin the country's present conditions.

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Appendix IPage 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 12.5 100.0Crop production 72234 48.3De-mining 24275 16.2Fisheries 2280 1.5Forestry 11210 7.5Livestock 18652 12.5Research and extension 21017 14.0

Transport 210125 17.5 100.0Aviation 18067 8.6Ports and Waterways 2579 1.2Rail 3000 1.4Roads 186479 88.7

Communications 56400 4.7 100.0Information 21600 38.3Telecommunications 34800 61.7

Trade and Industry 12856 1.1 100.0Manufacturing 9856 76.7Mining 3000 23.3

Education 162400 13.5 100.0Basic Education 95800 59.0Higher Education 29700 18.3Technical & Vocational 20000 12.3Upper Secondary Education 10400 6.4Youth and Sports 6500 4.0

Energy (Electricity) 152342 12.7Religion and Culture 30731 2.6Administration 11781 1.0Water Supply & Sanitation 113988 9.5Health 233811 19.5Environment & Conservation 23365 1.9Social & Community Services 39824 3.3Tourism 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.

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Statistical Appendix

List of Tables

Table No.

1 Population by Age Group and Sex, 19932 Income and Social Indicators3. Gross Domestic Product by Industrial Origin at 1989 Constant Prices4. Growth Rates of GDP By Industrial Origin at 1989 Constant Prices5. Shares of GDP by Industrial Origin, at 1989 Constant Prices6. Major Export Products, 1991-19967. Customs Imports, 1993-19958 Balance of Payments, 1991-19969. Summary of Budget Operations, 1991-199710. Structure of Revenue, 1994-199711 Budgetary Expenditure by Economic Classification, 1994-199712. External Debt, 1991-199513. Consumer Price Index and Exchange Rates14. Monetary Survey, 1991-199615. 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.

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Table 2: Income and Social Indicators

Unit of Latest Single YearIndicators Measure 1970-75 1980-85 1990-96

PopulationPopulation (mnid-year) millions 7.1 7.6 10.0Population growth rate annual % 0.5 3.4 3.0Total fertility rate births per woman 5.5 5.1 5.1

PovertyNational poverty lineTotal Riels per day

Phnom Penh .. .. 1578Other urban " . .. 1264Rural .. .. 1117

National Headcount IndexTotal % of population .. .. 39.0

Phnom Penh .. .. 11.4Other urban .. .. 36.6Rural .. .. 43.1

Income

GNP per capita US$ 280Consumer price index Dec. 1989 = 100 .. .. 1817

Social IndicatorsPublic expenditure on basic socialservices % share of GDP .. 1.8Gross primary enrollment rate

Total % of school age 42 .. 47Male " 48 .. 48Female 35 .. 46

Access to safe waterTotal % of population 45

Urban 97 .. 20Rural 38 .. 12

Immunization rateMeasles % under 12 months .. .. 38DPT .. .. 38

Under-five malnutrition rate % age group .. 20Life expectancy at birth years 40 46 52Infant mortality rate per 1,000 livebirths 181 160 110Under-five mortality rate per 1,000 live births .. .. 177Maternal mortality ratio per 100,000 live births .. 500 900

Sources: Social Indicators of Development, 1996; Cambodia-Poverty Profile, 1993/94; and Bank staff estimates.

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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 82.9Rice 47.6 46.7 48.2 38.6 47.9 47.3Other 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 43.8Fishery 13.5 12.7 12.0 11.8 12.2 12.1Forestry 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 4.6Manufacturing 18.4 19.0 20.5 22.1 24.3 27.5Electricity and Water 0.5 0.6 0.7 0.7 0.8 0.9Construction 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 12.2Wholesale and Retail Trade 34.4 39.9 42.3 44.8 48.8 54.6Hotels and Restaurants 1.0 1.3 1.4 1.7 1.8 2.2Govt. Admin., Education & Health 11.0 11.0 11.5 12.5 12.9 12.7Home Ownership 16.3 17.4 18.8 20.3 21.8 23.0Other 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 ItemsNominal 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.

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Table 4: Growth Rates of GDP By Industrial Originat 1989 Constant Prices

(in percent)

1991 1992 1993 1994 1995 1996

Agriculture 6.7 1.9 -1.0 0.0 6.4 1.8Crop & Rubber 7.2 -0.4 -2.3 -8.2 15.9 0.9Rice -4.0 -1.9 3.2 -19.9 24.1 -1.3Other 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 6.6Fishery 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 13.3Mining and Quarrying 7.1 6.7 6.3 8.8 8.1 15.0Manufacturing 7.0 3.3 7.9 7.8 10.0 13.2Electricity and Water 0.0 20.0 16.7 0.0 14.3 12.5Construction 11.4 30.1 18.3 7.4 10.0 13.1

Services 8.5 11.2 7.0 7.5 7.8 8.8Transport and Conunwnication 9.4 15.7 9.9 9.0 10.3 14.0Wholesale and Retail Trade 12.8 16.0 6.0 5.8 9.1 11.9Hotels and Restaurants 42.9 30.0 7.7 21.4 5.9 22.2Govt. Admin., Education & Health 0.0 0.0 4.5 8.3 3.6 -1.6Home Ownership 2.5 6.7 8.0 8.0 7.4 5.5Other 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.

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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 42.7Crop & 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 19.9Mining 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 37.4Transport 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.

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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.

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Table 7: Customs Imports, 1993-1995(in millions of US dollars)

1993 1994 1995

Gold 28.0 78.4 305.0Cigarettes 60.0 95.9 192.5Petrol 17.7 29.0 58.3Motorcycles 13.3 29.0 36.0Diesel oil 18.4 30.4 51.0Vehicles 18.5 12.0 22.0Construction material 24.2 20.8 19.2Clothing 20.7 11.9 17.2Food Products 2.7 11.6 17.8Beer 10.0 14.7 14.7VCRs 15.8 23.1 14.9TVs 10.3 21.2 17.3Fabric 69.5 36.2 12.6Cement 0.0 12.3 12.3Radio cassettes 4.7 4.3 4.0Vehicle parts 4.3 3.2 6.8Fuel oil 2.7 3.2 6.4Nonalcoholic drinks 3.8 5.9 4.3Alcohol 0.7 7.7 6.9Refrigerators 1.1 1.3 1.8Generators 4.1 2.6 2.5Sugar 0.0 13.8 6.4Lubricants 0.0 3.0 4.5Monosodium 0.0 6.1 9.6Steel 0.0 7.8 4.3Cooking oil 0.0 0.5 1.7Silver 0.0 0.8 1.1Other 30.8 66.4 78.8

Total 361.3 553.1 929.9

Source: Data provided by Cambodian authorities.

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Table 8: Balance of Payments, 1991-1996(in millions US$)

1993 1994 1995 1996

Trade Balance -203.0 -275.4 405.0 -451.0Total Exports 219.0 461.7 809.0 659.0

Domestic Exports 102.0 233.7 269.0 298.0Re- Exports 117.0 228.0 540.0 361.0

Total Imports 422.0 737.1 1213.0 1110.0O.w. Retained Imports 1/ 305.0 499.0 673.0 749.0

Services Balance 10.0 -74.6 -92.0 -60.0Receipts 66.0 59.7 121.0 172.0Payments 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 75.0 136.0 171.0 241.0Official medium-and long-term loans(net) 5.0 54.0 71.0 59.0

Disbursements 5.0 61.0 75.0 75.0Amortization 2/ 0.0 7.0 4.0 16.0

Foreign Direct Investment 0.0 80.0 151.0 240.0Short-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 -52.0Change in gross official reserves 41.0 -72.0 -82.0 -52.0Debt rescheduling 0.0 0.0 239.0 0.0Arrears reduction 0.0 10.0 -239.0 0.0I1 6.0 21.0 42.0 0.0

Purchase/disbursement 6.0 21.0 42.0 0.0Repurchase/repayment 0.0 0.0 0.0 0.0

Memorandum Items:Current Account Balance/GDP (excluding official transfers) -8.4 -14.1 -16.2 -15.6Current Account Balance/GDP (including official transfers) -1.8 -4.1 -4.5 -6.0Gross Official Reserves 3/In Millions Of US Dollars 71 100 182 234In 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.

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Table 9: Summary of Budget Operations, 1991-1997 I/

1991 1992 1993 1994 1995 1996 1997Budget

(In Billions of Riels)

Revenue 58.8 156.1 290.1 590.4 642.9 749.1 896.4Tax 31.1 109.7 234.1 364.6 445.4 534.3 673.3

O/w Customs Duties 22.0 79.3 159.5 280.9 320.8 344.1 437.8Non-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 55.3O/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 1480.8Current Expenditure 98.9 238.6 373.2 673.8 689.6 812.9 870.0

Defense & Security 46.8 118.6 219.4 398.2 398.2 399.9 390.8O/w Salaries 22.5 56.9 105.3 192.1 214.8 220.6 232.5

Civilian 52.2 119.9 153.8 275.6 291.4 413.0 479.2O/w Salaries 25.1 57.6 73.8 101.4 110.9 130.2 132.2

Capital Expenditure 5.2 7.1 235.2 335.3 511.1 529.9 610.8O/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 26.4Overall Deficit -45.3 -89.6 -318.3 -418.7 -557.7 -593.7 -584.4

Financing 45.3 89.6 318.3 418.7 557.7 593.7 584.4Foreign Financing 6.1 1.5 239.1 432.1 559.3 575.6 597.5

Project Aid 6.1 1.5 230.2 256.8 454.2 467.1 488.0Budget 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 7.3O/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 2.4Expenditures 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 9.4Defense & Security 3.5 4.7 4.1 6.5 5.5 4.9 4.2Civilian 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 6.6Current Deficit -3.0 -3.3 -1.5 -1.4 -0.6 -0.8 0.3Overall Deficit -3.4 -3.6 -5.9 -6.8 -7.7 -7.2 -6.3Financing 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 6.5Domestic 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.

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Table 10: Cambodia: Structure of Revenue, 1994-1997(In billions of riels)

1994 1995 1996 1997Prov. 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 40.3Wage tax 0.0 1.1 2.7 3.5Profit tax 6.3 17.8 18.5 32.8Property tax 0.9 1.2 2.1 3.0Others 1.5 0.8 3.1 1.0

Indirect taxes 75.0 103.8 163.7 195.2Turnover tax 8.2 17.1 27.4 35.0Consumption tax 46.9 60.0 70.4 79.3Excise taxes 2.9 9.0 56.6 65.0Tax on illegally imported cars 11.0 8.3 0.4 0.2Others 6.0 9.2 8.9 15.7

Taxes on international trade 280.9 320.8 344.1 437.8Taxes 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 16.9Others 5.1 2.7 1.2 3.8

Nontax receipts 225.8 197.5 214.8 223.1

Receipts on publicproperty 148.6 128.2 131.9 121.3Fisheries 4.8 9.1 7.1 10.0Forests 86.0 52.8 27.5 25.8

Receipts from public enterprises, of which 42.7 26.7 34.8 55.3Factory leases 4.8 5.9 10.1 22.0Civil aviation 8.2 10.8 17.1 16.5

Royalties and concessions 4.2 17.0 6.2 6.5Privatization proceeds 0.0 0.0 21.6 0.0Others 10.9 22.4 29.6 23.7

Othernontaxreceipts, of which 77.2 69.3 98.5 101.8Posts and telecommunication 61.0 54.4 80.0 81.2

Source: Data provided by the Cambodian authorities.

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Table 11: Budgetary Expenditure by Economic Classification, 1994-1997 1/

1994 1995 1996 1997Budget

(In billions of riels)

Salaries 293.4 325.7 350.8 364.7Operating costs 324.3 284.4 344.9 362.2Social transfers 41.3 44.8 63.9 80.7Economic transfers 4.7 14.5 16.1 10.2Capital 335.3 511.1 529.9 610.8Other 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 24.6Operating costs 32.1 23.7 25.7 24.5Social transfers 4.1 3.7 4.8 5.4Economic transfers 0.5 1.2 1.2 0.7Capital 33.2 42.6 39.5 41.2Other 2/ 1.0 1.7 2.8 3.5Total 100.0 100.0 100.0 100.0

(In percent of GDP)

Salaries 4.8 4.5 4.3 3.9Operating costs 5.3 4.0 4.2 3.9Social transfers 0.7 0.6 0.8 0.9Economic transfers 0.1 0.2 0.2 0.1Capital 5.5 7.1 6.5 6.6Other 2/ 0.2 0.3 0.5 0.6Total 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.

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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 (°/O) 834.6 594.5 653.4 378.8 225.2

Debt/GNP (%/6) 99.7 93.6 92.5 82.1 71.3

Debt Service/Exports (%/6) 7.1 4.1 12.1 0.4 2.7

1/ The official exchange rate of US$ 0.554 rubles is used in converting ruble debt into US dollars.This valuation method does not constitute an endorsement of its appropriateness.

Source: World Debt Tables, 1996; Cambodia CAS 1997.

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Table 13: Consumer Price Index and Exchange Rates

Consumer Price Inflation Parallel Official Official RateIndex(CPI) Rate 1/ Market Exchange /Parallel

(March 1988=100) (%) Exchange Rate Rate 2/ Rate(%)

1990

March 293.2 128.5 380 345 9.2June 378.7 143.2 480 380 20.8September 558.9 150.5 675 510 24.4December 604.5 152.3 613 600 2.1

1991March 925.0 224.7 691 600 13.2June 1137.4 200.3 905 800 11.6September 1767.8 216.3 1125 1000 11.1December 1135.6 87.9 550 250 5.5

1992March 1360.6 42.9 935 800 14.4June 1971.1 73.3 1275 1000 21.6September 3224.3 82.4 2142 2000 6.6December 3143.0 176.8 2310 2000 13.4

1993March 6003.8 341.3 4200 3800 9.5June 5651.2 186.7 2950 2700 8.5September 4832.4 49.9 2700 2617 3.1December 4117.0 31.0 2470 2390 3.2

1994March 4299.0 -28.4 2535 2480 2.2June 4588.0 -18.8 2540 2515 1.0September 5064.0 4.8 2615 2605 0.4December 5192.0 26.1 2593 2575 0.7

1995March 4794.0 11.5 2387 2521 -5.3June 5030.0 9.6 2371 2322 2.1September 5463.0 7.9 2530 2498 1.3December 5197.0 0.1 2560 2526 1.3

1996 3/March ... 6.0 2591 2558 1.3June ... 6.9 2667 2619 1.8September ... 5.6 2724 2687 1.4December ... 10.5 2728 2713 0.6

1/ Inflation rate is the percentage change in the CPI from the same month of the previous year.2/ End-period buying rate.3/ From 1996, National Institute of Statistics! CPI was used.

Sources: National Bank of Cambodia, National Institute of Statistics.

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Table 14: Monetary Survey, 1991-1996(in billions of riels)

1991 1992 1993 1994 1995 1996

Net Foreign Assets -1.7 24.2 101.9 390.8 550.0 881.0

Foreign Assets 16.1 203.2 298.5 631.5 897.0 1,230.0

Foreign Liabilities 17.8 179.0 196.6 240.7 347.0 350.0

Net Domestic Assets 80.7 223.9 224.9 59.2 99.0 31.0

Domestic Credit 87.6 267.3 355.3 386.3 446.0 567.0

Net Claims on Govemment 55.6 156.8 187.5 143.2 148.0 128.0

Claims on Government 55.6 170.0 218.5 215.0 217.0 214.0

Deposits of Government 13.2 31.0 71.8 69.0 86.0

State Enterprises 22.1 11.7 6.2 6.0 5.0 5.0

Private Sector 9.9 98.8 161.6 237.1 293.0 435.0

OtherItems (Net) -6.9 -43.4 -130.4 -327.1 -347.0 -536.0

Total Liquidity 79.0 248.1 326.8 449.0 649.0 912.0

Narrow Money 77.6 171.8 203.8 199.0 279.1 329.0

Currency outside Banks 64.8 158.7 189.7 176.0 251.1 300.0

Demand Deposits 12.8 13.1 14.1 23.0 28.0 29.0

Quasi-Money 1.4 76.3 123.1 250.0 371.0 583.0

Time and Savings Deposits 0.7 11.0 8.5 18.0 5.0 8.0

Foreign Currency Deposits 0.7 65.3 114.6 233.0 366.0 575.0

Source: National Bank of Cambodia.

- 58 -

Table 15: Agriculture, Livestock, Fishery,and Forestry Production, 1985-1996

Unit ('000) 1985 1990 1991 1992 1993 1994 1995 1996

Crops 1/

Rice Tons 1,812 2,500 2,400 2,221 2,117 2,223 2,745 3,300

Corn Tons 42 88 60 60 54 45 55 64

Cassava Tons 17 60 56 150 66 65 82 68

Sweetpotato Tons 15 31 39 60 55 36 39 37

Vegetables Tons 143 170 249 210 200 197 193 141

Mungbean Tons 21 12 13 14 12 17 20 16

Groundnut Tons 5 4 4 4 4 5 6 7

Soybean Tons 13 22 35 40 39 23 17 28

Sesame Tons 6 5 8 6 5 4 4 5

Sugar cane Tons 169 258 145 142 140 219 202 178

Tobacco Tons 6 8 9 9 10 12 11 5

Jute Tons 3 2 1 2 2 2 1 0

Rubber Tons 18 35 35 30 22 27 35 34

Livestock

Cows Heads 1,560 2,181 2,257 2,468 2,542 2,621 2,777 na

Butfalo Heads 613 736 755 804 824 810 764 na

Pigs Heads 1,203 1,515 1,550 2,043 2,123 2,024 2,038 na

Poultry Heads 6,398 8,163 8,816 9,901 10,692 10,027 10,066 na

Draught oxen Heads 780 1,018 1,042 1,050 1,184 1,161 1,320 na

Draught buffalo Heads 425 478 502 482 520 473 444 na

Fish

Fresh fish Tons 71 111 118 103 94 65 40 na

Dried fish Tons 3 3 2 2 2 30 3 na

Salted preserved fish Tons 4 6 6 4 5 8 7 na

Forestry

Round logs m3 97 257 309 105 83 14,260 na na

Sawn wood m3 13 16 16 29 29 45 na na

Fire wood Steres 84 105 62 103 58 9 na na

Charcoal Tons 53 7 0.4 na na na na na

Bamboo 000 409 - - - na na na na

I/ Harvest year for crops.

Source: Ministry of Agriculture, Forestry and Fishery.

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