CAMBODIA ECONOMIC UPDATE 2050 High Income $12,056 2030 Upper Middle Income $3,896 2017 $1,230 RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? OCTOBER 2018 CAMBODIA ECONOMIC UPDATE OCTOBER 2018 Recent economic developments and outlook TABLE OF CONTENTS ACKNOWLEDGEMENTS ���������������������������������������������������������������������������������������������������������� 1 ABBREVIATIONS������������������������������������������������������������������������������������������������������������������������� 2 EXECUTIVE SUMMARY�������������������������������������������������������������������������������������������������������������� 3 SECTION 1 – Recent Economic Developments and Outlook������������������������������������������������������� 9 Recent economic developments������������������������������������������������������������������������������������������������������������������������� 9 Growth has remained strong in Cambodia�������������������������������������������������������������������������������������������������� 9 There has been a surge in FDI inflows������������������������������������������������������������������������������������������������������ 12 The recent FDI inflows also favored investment in the manufacturing industries, especially garments���������������������������������������������������������������������������������������������������������������������������������������� 12 A thriving tourism industry, as visitor arrivals grew to 3.0 million or 13.6 percent (y/y) by mid-2018������13 Nevertheless, Cambodia remains far behind Thailand and Vietnam in attracting foreign tourists�� 14 Only 5 percent tourists visiting Vietnam and 13.5 percent of tourists coming to Thailand extended their visits to Cambodia �������������������������������������������������������������������������������������������������������������� 14 Agricultural diversification, including quality differentiation, will help the sector respond to changing domestic and external demand��������������������������������������������������������������������������������������������������� 15 Access to safe water for rural households, however, remains a challenge ������������������������������������������� 16 Rising domestic demand has been met by a surge in imports���������������������������������������������������������������� 17 Cambodia has been quite successful in attracting FDI inflows, thanks to its liberal trade and investment policy ������������������������������������������������������������������������������������������������������������������������������������������ 21 Confidence in the banking system continued to underpin foreign currency deposits������������������������ 22 As a share of GDP, Cambodia’s bank credit has already overtaken that of Indonesia and the Philippines���������������������������������������������������������������������������������������������������������������������������������������� 25 Fiscal expansion fueled domestic demand, consumption, and imports������������������������������������������������ 27 This year’s revenue performance continues to be strong and is projected to meet or exceed the 2018 budget target����������������������������������������������������������������������������������������������������������������������������������� 27 China is by far the largest creditor, accounting for almost half of Cambodia’s outstanding debt��� 29 Against a backdrop of better-than-expected export performance, rising consumption, and upbeat investor sentiment, the growth outlook has been revised up��������������������������������������������� 29 Risks are growing as domestic credit continues to substantially go to the construction and real estate sector������������������������������������������������������������������������������������������������������������������������������������� 30 Potential spill-over effects of U.S.-China trade disputes on the economy�������������������������������������������� 31 Safeguarding the health of the financial sector is a top priority ����������������������������������������������������������� 31 Cambodia requires a substantial boost in its investment to achieve its higher-income economy targets��������������������������������������������������������������������������������������������������������������������������������������������� 32 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050?���������������������������������������������������������������� 35 I. Introduction������������������������������������������������������������������������������������������������������������������������������������������������� 35 II. Structural transformation ������������������������������������������������������������������������������������������������������������������������� 36 III. Assessing Cambodia’s long-term growth potential ������������������������������������������������������������������������������� 38 IV. Policy options���������������������������������������������������������������������������������������������������������������������������������������������� 49 Annex: A description of the Long-Term Growth Model�������������������������������������������������������������� 52 CAMBODIA: KEY INDICATORS����������������������������������������������������������������������������������������������� 54 References�������������������������������������������������������������������������������������������������������������������������������������� 55 ACKNOWLEDGEMENTS ACKNOWLEDGEMENTS The preparation of the 2018 October Cambodia Economic Update (CEU) was led by Sodeth Ly, with contributions from Miguel Eduardo Sánchez Martín. The selected issue “Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050?” was prepared by Steven Michael Pennings, with contributions from Jorge Luis Guzman Correa and Norman V. Loayza, and comments from Sodeth Ly and Runsinarith Phim. Linna Ky served as research assistant. Inputs for the poverty section were provided by Kimsun Tong. Saroeun Bou helped with the press release, web display, and dissemination events. The team worked under the overall guidance of Deepak Mishra, Practice Manager, Macroeconomics, Trade, and Investment Global Practice. The team is grateful for the advice and comments provided by Ellen Goldstein, Country Director for Myanmar, Cambodia and Lao PDR and Inguna Dobraja, Country Manager for Cambodia. Several World Bank colleagues provided comments on the draft version including Bronwyn Grieve, Ekaterine Vashakmadze, Ergys Islamaj, Francesca de Nicola, Lan Van Nguyen, Phyrum Kov, Ratchada Anantavrasilpa, Sinem Celik, Sudhir Shetty and Ulla Heher. The team is grateful to the Cambodian authorities, particularly the Ministry of Economy and Finance and the National Bank of Cambodia for their cooperation and support. The report also benefited from the advice, comments and views of various stakeholders in Cambodia, including its enthusiastic readers and critics. The CEU, produced biannually, provides up-to-date information on macroeconomic developments in Cambodia. It is distributed and discussed widely including among Cambodian authorities, development partners, the private sector, think tanks, civil society organizations and academia. For information about the World Bank and its activities in Cambodia, please visit our website at www.worldbank.org/cambodia. To be included in the email distribution list of the CEU and related publications, please contact Socheat Ath (sath@worldbank.org). For questions on the content of this publication, please contact Saroeun Bou (sbou@worldbank.org). 1 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 ABBREVIATIONS ABBREVIATIONS ABSD Additional Buyer’s Stamp Duty LTGM Long-Term Growth Model AFTA ASEAN Free Trade Agreement LTV loan-to-valuation ASEAN Association of Southeast Asian MA moving average Nations MAFF Ministry of Agriculture, Forestry and bbl barrel Fisheries BOT Bank of Thailand MDI microfinance deposit-taking institution CDC Council for the Development of MEF Ministry of Economy and Finance Cambodia MFI microfinance institution CEU Cambodia Economic Update MOEYS Ministry of Education, Youth and CR Cambodian riel Sport DECMG Development Economics and Chief MOP Ministry of Planning Economist: Macroeconomics & MPK marginal product of capital Growth NCD negotiable certificate of deposit DP Development Partner NIS National Institute of Statistics EAP East Asia and Pacific NPL nonperforming loan EBA Everything But Arms NSDP National Strategic Development Plan EMDEs emerging markets and developing PC per capita economies PDR People’s Democratic Republic EOP end of period PFM public financial management EU European Union ppts percentage points FCD foreign currency deposit RGC Royal Government of Cambodia FDI foreign direct investment RMS Revenue Mobilization Strategy GDCE General Department of Customs and RS Rectangular Strategy Excises SDR Special Drawing Rights GDP gross domestic product SEA Southeast Asia GDPPC gross domestic product per capita SME small and medium-sized enterprise GMAC Garment Manufacturers’ Association in Cambodia TVET Technical and Vocational Education and Training GNI gross national income UMI upper middle-income GNIPC gross national income per capita US$ United States dollar GTAP Global Trade Analysis Project VAT value-added tax GVC global value chain WBG World Bank Group ICOR incremental capital-to-output ratio YTD year-to-date IDP Industrial Development Policy y/y or yoy year-on-year IMF International Monetary Fund LPCO Liquidity-Providing Collateralized Operation CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 2 EXECUTIVE SUMMARY EXECUTIVE SUMMARY Recent developments and footwear industries, and to agroprocessing. Vibrant construction activity continues to be Economic growth remains strong, driven financed by rising FDI inflows and domestic credit. primarily by robust expansion in consumption FDI is estimated to have increased by 14.3 percent and exports. Domestic demand has been boosted (y/y) during the first six months of 2018. About by higher wage growth and larger public investments, 90 percent of the inflows (excluding those to the with fiscal expansion serving as stimulus. Public financial sector) have originated from China and outlays were budgeted to increase to 24.6 percent are directed toward the construction and real estate, of GDP in 2018 from 23.1 percent in 2017. At the agriculture and agroprocessing, and garment sectors. same time, strong external demand has boosted A growing proportion of FDI is now invested in the exports of garment and footwear products, which productive sectors, namely the manufacturing and increased 16.1 percent (y/y) during the first half of agriculture sectors, albeit its share remains relatively 2018—a two year high—from 8.3 percent at the end small at about 20 percent of total inflows. of 2017. Tourist arrivals reached 3 million during Rising disposable income remains the main the first six months of 2018, a 13.6 percent increase driver of domestic demand, fueling economic (y/y), compared with 11.8 percent in 2017, driven activity. Rapidly rising wages in the private and by a surge in tourist arrivals by air from China. public sector have underpinned strong domestic Capital inflows, mainly comprising foreign demand, which is being largely met by a surge in direct investment (FDI) continue to increase, imports. Motor vehicles and steel imports, which underpinning Cambodia’s stable external gauge domestic consumption and construction position. Official data showed rising FDI to the demand, skyrocketed, rising by 81.4 percent and manufacturing sector, especially the textile, apparel, 50.0 percent respectively, in June 2018. Therefore, 3 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 EXECUTIVE SUMMARY the current account deficit slightly widened in the the next two years. The favorable longer-term first half of 2018 but continued to be entirely outlook is boosted largely by rising FDI inflows to financed by FDI inflows. manufacturing and agriculture, and improved supply chain linkages between FDI and Cambodian firms. While easing, credit growth remains elevated. Authorities have introduced several new initiatives Though credit growth continues to moderate, bank to promote small- and medium-sized enterprises, (and microfinance) credit-to-GDP rose to an all- including strengthening their linkages with the time high of 73 percent (and 20 percent) at the end FDI sector (see box 2). Strong economic growth is of June 2018, up from 31.4 percent (and 3.8 percent) expected to result in continued poverty reduction. in 2010. Confidence in the banking system has so far remained strong and private sector deposits, largely Risks in the financial sector continue to grow, in U.S. dollars, grew at 22.4 percent (y/y) in June with large exposure to the construction and real 2018. Gross international reserves rose to US$9.0 estate sector. The growth of domestic credit in billion or about six months of prospective imports. Cambodia has been faster than any other country The Cambodian riel (CR) which is pegged to the in East Asia– increasing nine-fold in 12 years. As U.S. dollar due to Cambodia’s highly dollarized construction and real estate typically are more economy, has slightly depreciated, reaching CR prone to boom and bust cycles, rising domestic 4,082 per U.S. dollar at the end of September 2018, credit financing the construction sector increases compared to CR 4,037 at the end of December the financial sector’s vulnerability. In addition, the 2017. Rising prices of food items (and utilities) have construction sector has experienced a lengthy boom pushed up inflation, which rose to 2.9 percent (y/y) since the end of the 2008–09 global financial crisis. in June 2018, from 2.2 percent in December 2017. External risks are rising as well, with the Consequently, the real exchange rate continued its potential temporary withdrawal of Everything appreciating trend. But Arms (EBA) preferences for Cambodia, Rapid fiscal expansion has underpinned ongoing trade frictions between the two largest consumption and growth. The overall fiscal trading nations, and continued appreciation of deficit (including grants) is expected to widen the U.S. dollar against most global currencies. significantly to 4.2 percent in 2018, up from 1.6 The European Union market accounts for more percent in 2017. Cambodia’s debt distress level, than a third of Cambodia’s key exports, which however, remained low as per the 2018 World Bank/ are garment and footwear products. Therefore, IMF Debt Sustainability Analysis, given the fact losing EBA preferences, which currently provide that the authorities only contract external debt on Cambodia full duty-free and quota-free access to the concessional terms. In addition, after years of fiscal EU for all their exports with the exception of arms consolidation and strong revenue performance, the and armaments, will likely slow Cambodia’s export authorities have built up the fiscal buffer in the form growth, and negatively impact its labor market of government deposits, accounting for about 13 in the short term. Trade disputes among major percent of GDP by mid-2018. economies, especially the United States and China, will negatively impact global trade and disrupt Outlooks and risks regional and global value chains, with uncertain impact on Cambodia. Given Cambodia’s increased With the impact of the fiscal stimulus wearing dependency on China for its FDI, tourism, and off after 2018, Cambodia’s growth is expected official development assistance, a sharp downturn to return to its long-term potential. Cambodia’s in the Chinese economy will diminish Cambodia’s growth, which was trending downward since 2013, is growth outlook in the short and medium term. expected to continue to marginally expand, reaching The hardening of global monetary conditions and 7.1 percent in 2018, driven by strong domestic and appreciation of the U.S. dollar could erode the external demands. Given that the recent cyclical competitiveness of exports, given Cambodia’s high acceleration in growth has been driven in part by level of dollarization. substantial fiscal expansion, the growth outlook is projected to ease slightly to 6.8 percent over CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 4 EXECUTIVE SUMMARY Key messages and policy options trade expansion, connectivity such as transportation and logistics upgrade is being identified with the Given the lengthy construction boom, a high preparation of the National Logistics Masterplan priority for the authorities would be to safeguard and the introduction of the National Logistics the health of the financial sector in the near Council. In terms of logistics capabilities, Cambodia term. Lately, the real estate sector has shifted ranked 98th out of 160 countries on the 2018 toward more speculative activity in which there is Logistic Performance Index (LPI), declining from a growing trend of land sales and purchases with 73rd place in 2016. On average, successful exporters less obvious or justifiable investment returns in the of electronics, such as Thailand and Malaysia, rank foreseeable future. The recent surge in FDI inflows in the top 40. has masked the financial sector’s vulnerability caused Mobilizing domestic savings to boost by prolonged rapid credit growth. It is therefore investment in the medium term is paramount. necessary to develop macroprudential policies, As discussed in the selected issue section, “Can including both financial and fiscal measures to Cambodia become an upper middle-income reduce the scope for speculative activities financed economy by 2030 and a high-income country by by the banking and microfinance sectors. It is crucial 2050?” Cambodia’s gross domestic savings, at under to adopt lending guidelines including value-to-loan 20 percent of GDP, is among the lowest in the ratio limits, while considering imposing additional region. The county is therefore heavily dependent taxes on sales and purchases of property, especially on foreign savings in the form of FDI, which is land, for investment (speculative) purposes. It is not only volatile but also unsustainable in the long equally important to revisit the nonperforming term. It is therefore necessary to start generating loan to classifications. In addition, other prudential additional domestic resources to finance productive measures such as loan-to-income ratio, increased investment as Cambodia endeavors to become a down payment and other factors could be high-income country within the next four decades. considered. Pro-saving policies similar to those provided by To absorb rising FDI inflows in manufacturing regional countries (see box S2), are therefore needed and agroprocessing, further bridging of the to encourage households to save and to reward infrastructure deficit is warranted. While businesses to reinvest. Enhancing the regulatory improving, further investment to upgrade and and supervisory framework, improving the financial expand physical infrastructure needs to be a reporting system, developing good corporate priority to enable Cambodia to better integrate governance practices, and establishing a financial into regional (and global) value chains. To facilitate protection system will help further promote savings. 5 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 EXECUTIVE SUMMARY FIGURE ES. 1: CAMBODIA’S ECONOMY AT A GLANCE Real growth is improving… … as key exports accelerated Real growth (percent) Garment exports (y/y, percent change) 7�4 7�4 35 35 7�3 7�3 7�4 7�4 35 35 7�1 7�3 7�4 7�3 35 7�1 7�3 7�1 7�1 7�0 30 7�1 7�1 7�4 7�1 7�0 7�1 7�0 7�0 30 7�1 35 7�1 7�3 7�1 7�0 7�0 6�9 6�9 7�0 7�07�1 30 30 7�0 7�0 7�1 30 7�1 7�1 7�1 6�9 6�9 6�9 7�1 25 7�0 7�0 25 30 6�9 7�1 25 25 25 6�1 6�1 20 2520 6�1 6�1 20 20 20 6�1 15 2015 6�1 15 15 15 10 1510 10 10 10 5 10 5 5 5 5 2010 2011 2012 2013 2014 2015 2016 2017 2018/p 2010 2011 2012 2013 2014 2015 2016 2017 2018/p 0 50 2010 2011 2010 2012 2011 2013 2012 2014 2013 2015 2014 2016 2015 2017 2016 2017 2018/p 2018/p 0 0 D-10 2010 2011 2012 2013 2014 2015 2016 2017 2018/p 0 D-10 D-12 D-12 D-11 D-11 D-13 D-13 D-15 D-15 D-14 D-14 D-17 D-17 D-16 D-16 J-18 J-18 D-10 D-11 D-11 D-11 D-10 D-12 D-12 D-12 D-13 D-13 D-13 D-14 D-14 D-14 D-15 D-15 D-15 D-16 D-16 D-16 D-17 D-17 D-17 J-18 J-18 J-18 2010 2011 2012 2013 2014 2015 2016 2017 2018/p D-10 0 D-10 D-11 D-12 D-13 D-14 D-15 D-16 D-17 J-18 … agriculture recovered… …underpinned by rising FDI inflows Annual wet season rice production increase (approved FDI fixed assets, percent of GDP) (in million metric tons) 14 14 14 14 14 0�6 0�6 0�6 0�6 0�6 12 12 14 0�5 0�5 12 12 12 0�5 0�6 0�5 0�5 10 10 12 0�4 0�4 10 10 0�4 0�5 0�4 10 0�4 0�3 0�3 8 8 10 0�3 0�4 0�3 8 8 0�3 8 0�2 0�2 6 8 0�2 0�3 0�2 6 0�2 6 6 6 0�1 0�1 0�1 0�2 0�1 4 6 0�1 4 0 0 4 4 4 0 0�10 0 2 2 4 -0�1 -0�1 2 2 -0�1 0 -0�1 2 -0�1 -0�2 -0�2 0 20 -0�2 -0�1 -0�2 0 0 -0�2 0 2013 2013 2014 2014 2015 2015 2016 2016 2017 2017 6m-2018 6m-2018 -0�2 2013 2013 2013 0 2014 2015 2015 2015 2014 2014 2017 2017 2017 2016 2016 2016 6m-2018 6m-2018 6m-2018 2013 2014 2015 2016 2017 6m-2018 Credit growth has eased, but lending to the Fiscal expansion fueled construction sector has risen domestic demand Contribution of lending to the construction and real General government expenditures estate sector to credit growth (percentage points) 25 25 (percent of GDP) 10% 10% 25 25 25 10% 10% 10% 24 24 24 25 24 10% 8% 24 8% 23 23 8% 8% 8% 23 24 23 23 6% 8% 6% 22 22 22 23 22 6% 6% 6% 22 21 21 6% 4% 21 22 21 4% 21 4% 4% 4% 20 20 20 21 20 2% 4% 2% 20 2% 2% 19 19 2% 19 20 19 19 0% 2% 0% 18 18 18 19 18 0% 0% 0% 18 17 17 -2% 0% -2% 17 18 17 -2% -2% 17 -2% 16 16 16 17 16 -4% -2% -4% 16 -4% -4% 15 15 -4% 16 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Dec-14 Dec-15 Jun-16 Dec-16 Jun-17 Jun-14 Jun-15 Dec-17 15 15 Jun-16 Jun-17 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Dec-16 Dec-17 15 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016 2017 2018e 2018e 2017 Jun-16 Jun-17 Jun-16 Jun-17 Dec-09 Jun-10 Dec-10 Dec-09 Jun-11 Jun-10 Dec-11 Dec-10 Jun-12 Jun-11 Dec-12 Dec-11 Jun-13 Jun-12 Dec-13 Dec-12 Jun-14 Jun-13 Dec-14 Dec-13 Jun-15 Jun-14 Dec-15 Dec-14 Jun-15 Dec-16 Dec-15 Dec-17 Dec-16 Dec-17 -4% Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Jun-16 Jun-17 Dec-09 Jun-10 Dec-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Dec-16 Dec-17 2010 2010 15 2010 2011 2011 2012 2011 2012 2012 2013 2013 2013 2014 2014 2015 2014 2015 2015 2016 2016 2016 2017 2017 2017 2018e 2018e 2018e Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Dec-14 Jun-16 Jun-17 Jun-14 Jun-15 Dec-15 Dec-16 Dec-17 2010 2011 2012 2013 2014 2015 2016 2017 2018e Sources: Cambodian authorities and World Bank staff estimates and projections. Note: pre = preliminary; p = projection; RHS = right-hand side. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 6 SECTION 1 Recent Economic Developments and Outlook SECTION 1 – Recent Economic Developments and Outlook SECTION 1 – Recent Economic Developments and Outlook Recent economic developments strength in domestic demand, especially investment. The Euro Area economy grew 2.4 percent in Growth has remained strong in Cambodia 2017, its fastest increase since the financial crisis, reflecting strong consumption, investment, and Overall, economic activity has continued exports. Advanced economy growth is projected to remain strong, driven by domestic at 2.2 percent for 2018—a slight deceleration from consumption and exports. Against a backdrop last year (as additional fiscal stimulus in the United of rising consumption, better-than-expected export States is offset by moderating growth in other major performance, and upbeat investor sentiment, economies), while consumer confidence is still high growth outlook has been revised up modestly in and new jobs are being created at a solid pace (see the short and medium term. Cambodia’s growth is box 1 for the global and regional economic outlook). expected to reach 7.1 percent in 2018 (compared to Following a gradual recovery in the second half a newly revised official number of 7 percent growth of 2017, Cambodia’s exports surged, supported in 2017) (figure 1). largely by strong demand in the United States Cambodia is among the few countries in the East and the European Union (EU). The overall Asia and Pacific (EAP) region that are expected textile, apparel, and footwear product exports, to experience marginal improvements in growth. accounting for 74 percent of Cambodia’s total Growth in advanced economies remained above merchandise exports, recorded double-digit growth potential despite signs of softening.1 In the United of 16.1 percent during the first six months of 2018, States, significant fiscal stimulus will boost near- up from 8.3 percent at the end of 2017 (figure 2). term activity. Growth in the United States reached 2.3 percent in 2017, supported by broad-based FIGURE 1:  Contribution to real growth FIGURE 2: Garment and footwear export (percentage point) performance improved (US$ billion, YTD) Agriculture Indus-garment & footwear Garment exports growth rate (RHS) Indus-construction Indus-others Serv-hotels & rests Serv-others Taxes less subsidies GDP growth 8 7�4 8,000 35 7�1 7�0 7�1 6�9 7�0 7 7,000 30 6 6,000 25 5 5,000 20 4 4,000 15 3 3,000 10 2,000 2 1,000 5 1 0 0 0 2013 2014 2015 2016 2017 2018/p 0 1 2 3 4 5 6 7 8 -1 -1 -1 -1 -1 -1 -1 -1 -1 ec ec ec ec ec ec ec ec n Ju D D D D D D D D Source: Cambodian authorities. Sources: Cambodian authorities. Note: pre = preliminary; p = projection. Note: RHS = Right-hand side. 1  Global Economic Prospects, June 2018, the World Bank Group, Washington, DC. 9 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook Box 1 Global and Regional Economic Outlook1 Global growth is moderating, as the recovery in trade fallen by an average of around 11 percent. Cumulative and manufacturing activity loses steam. It is projected portfolio outflows from EMDEs have surpassed those to slow from 3 percent in 2018 to 2.9 percent in 2019, as seen after the Taper Tantrum in 2013, reflecting a broad- economic slack dissipates, major central banks continue based selloff in both equity and bond funds. While to remove policy accommodations, and global trade and financial market stress was most pronounced in Turkey and investment growth weaken further (figure B1.1).2Growth Argentina, many other EMDEs have also suffered from in advanced economies is projected to ease slightly from increased risk aversion. Countries with sizable external 2.2 percent in 2018 to 2 percent in 2019, and gradually financing needs and policy uncertainties were most severely decelerate toward potential, reaching 1.6 percent in 2020, as impacted, pointing to heightened investor focus on external capacity constraints become binding. vulnerabilities and growth prospects. External financing conditions are expected to continue to deteriorate in 2019, External conditions, which have deteriorated in 2018, are as monetary policy accommodation in advanced economies expected to become even less supportive of emerging ends, and even reverses. markets and developing economies (EMDEs) during the forecast horizon. This reflects moderating advanced- Growth in the East Asia and Pacific region is expected economy growth, softening global trade and investment, to gradually moderate from 6.3 percent in 2018 to 6 tightening financing conditions, and rising trade tensions. percent in 2019 and 2020 (figure B1.2). The slowdown in EMDE growth, which stalled at an estimated 4.2 percent in regional growth reflects the structural slowdown and weaker 2018, as a number of countries suffered financial pressures, exports amid rising trade tensions between China and the is expected to increase only slightly in 2019, to 4.3 percent. United States. Activity in the rest of the region is expected Global trade, which accelerated sharply in 2017, benefiting to remain steady, around its potential rate in 2019, but from a cyclical upturn in global manufacturing, is expected downside risks to the outlook have increased. The potential to slow faster than expected in 2018 and will moderate growth for the region appears to have declined. This reflects further in 2019–20. Trade policy uncertainty has increased, increasingly adverse demographic patterns and the projected weighing on the outlook for global investment and trade. slowing pace of capital accumulation, needed to rein in Borrowing costs have generally tightened in EMDEs credit growth. Tightening global financing conditions, following a broad-based appreciation of the U.S. dollar, higher borrowing costs, moderating capital flows, and bouts of investor risk aversion, and increased focus on lingering policy uncertainty may hamper investment growth country-specific vulnerabilities. Since the U.S. dollar started in the coming years, further constraining potential growth. strengthening again in April 2018, EMDE currencies have FIGURE B1.1: Real GDP growth FIGURE B1.2: Real GDP growth (percent) (percent) 6 Emerging Markets & 2017 2018 2019 5 Developing Economies 7 4 6 3 World 5 2 Advanced 4 1 economies 0 3 2012 2013 2014 2015 2016 2017 2018f 2019f 2020f Lao PDR China Cambodia Mongolia Vietnam Malaysia Thailand Myanmar Source: Global Development Finance, January 2019 (forthcoming). Source: Global Development Finance, January 2019 (forthcoming). 1 Prepared by Ekaterine T. Vashakmadze, Senior Country Economist, World Bank. 2  These are working assumptions, which will be finalized and published in the World Bank’s January 2019 Global Economic Prospects. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 10 SECTION 1 – Recent Economic Developments and Outlook Commodity prices have diverged over the last six vulnerabilities in many countries. The probability of months. While oil prices have risen since mid-2018, most escalating trade restrictions continues to increase, which other commodity prices have weakened amid growing trade could have broad-based consequences in the presence of tensions (figure B1.3). After a notable increase in the first global value chains. In addition, policy uncertainty and half of last year, metal prices fell sharply in the second geopolitical risks remain elevated and could negatively half following the imposition of broad-based tariffs by the impact confidence and investment both in the affected United States on Chinese imports and market concerns countries and globally. about a global trade slowdown. Oil prices are expected to Risks to the regional outlook are also tilted to the average US$73/barrel (bbl) in 2019, before softening to downside and have intensified. Increased protectionist US$71/bbl in 2020—a rise of US$4/bbl and US$2/bbl, tendencies continue to create uncertainty about the future respectively, relative to June forecasts. (Metals prices are of established trading relationships. The imposition expected to weaken in 2019 and 2020 amid muted demand.) of trade restrictions by advanced economies would Agricultural prices are projected to remain stable in 2019 disproportionately affect the more open economies in the and 2020 on ample supply. region. The EAP region is characterized by deep regional The balance of risk to the global outlook is firmly on and global integration, which makes it vulnerable to trade the downside. Disorderly financial market developments shocks. It relies significantly on foreign income from could spread through EMDEs, amplified by elevated exports and other foreign sources (World Bank October 2018 East Asia and Pacific Economic Update). In addition, FIGURE B1.3: World commodity prices forecast a faster-than-expected tightening of global financing (nominal U.S. dollars, 2010 = 100) conditions and associated financing stress—triggered, for 130 Energy instance, by changes in market expectations of advanced- Metals and minerals economy monetary policy or a rise in risk aversion—could 110 Agriculture further reduce capital inflows, heighten financial market volatility, and place pressure on regional exchange rates 90 and asset prices. Rising borrowing costs could substantially 70 increase the burden of debt servicing, which has been contained in recent years by low global interest rates and 50 risk premiums. If a combination of downside risks were to materialize, it could trigger an even sharper-than-expected 30 slowdown in regional growth. Domestic vulnerabilities— elevated domestic debt and large external financing needs 10 in some countries—would amplify the impact of external 1980 1985 1990 1995 2000 2005 2010 2015 2020 shocks and dampen growth, especially where policy buffers Source: Global Development Finance, January 2019 (forthcoming). are limited. 11 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook This represents a two-and half-year high. Notably, FDI inflows and foreign investors arriving in the exports to the EU (excluding the United Cambodia are on the rise. International visitors Kingdom), with a 34.0 percent market share (figure who have reported coming to Cambodia to conduct 3), and to the United States, with a 26.0 percent business rose to almost 9 percent in 2018, compared market share, rapidly expanded, climbing at 15.5 to 4.4 percent in 2013. Approved FDI (fixed assets) percent and 26.3 percent, respectively. While these amounts increased quickly, rising at 38.4 percent, two markets did well, the rest of Cambodia’s export reaching US$2.4 billion during the first six months of markets, namely the UK, Japan, and other markets, 2018 (figure 4).3 Recently, FDI inflows have largely were flat. Consistent with the surge in textile and originated from China. As a share of approved apparel exports, fabric imports, largely used as FDI project value, Chinese FDI accounted for 60 inputs for garment production, climbed sharply, percent of total FDI-funded projects (excluding growing at 37.1 percent during the first six months FDI invested in the financial sector) in 2017. In of 2018, reaching a three-year high. 2018, the share rose further, reaching 90 percent during the first six months. Official data show that investment in the textile, apparel, bag, and footwear industries rose, with The recent FDI inflows also favored a rising number of factories opening during the first half of 2018.2 In contrast to a net decline of investment in the manufacturing 48 factories due to factory closures in 2017, 44 new industries, especially garments factories started operating (31 of which are in the textile and apparel industries) during the first half of Unlike previous years when the share of 2018, totaling 1,075 factories. Other manufacturing FDI going to the garment sector shrank, industries such as chemical, rubber, plastic, electrical the recent inflows favored investment in the appliances, and auto parts also received additional manufacturing industries, especially garments investment, with a net increase of 17 factories. and agroprocessing. During the first half of In addition, several factories witnessed expanded 2018, the manufacturing industry received US$120 operation in the first half of 2018. A total of 33,000 million or a 90 percent (y/y) increase. Similarly, new jobs have reportedly been created, resulting in a FDI inflows to the agriculture sector, including total of 1.015 million jobs or a 3.4 percent increase. agroprocessing also increased, reaching US$167 million during the first six months of 2018 or a There has been a surge in FDI inflows 26.5 percent increase. However, FDI continues to predominantly go to physical infrastructure projects, FIGURE 3: Textile, apparel, and footwear exports by FIGURE 4: Rising foreign direct investment main destination (percent share) 2014 2018 Approved FDI (US$ million) 40% Chinese FDI (% of approved FDI, RHS) 34% 3000 Chinese FDI (% of FDI projects, RHS) 1 33% 0�9 2500 26% 0�8 22% 0�7 2000 20% 0�6 1500 0�5 0�4 10% 9% 1000 0�3 6% 0�2 500 0�1 0 0 US EU UK Japan Others 2013 2014 2015 2016 2017 6m-2018 Source: Cambodian authorities. Source: Cambodian authorities. Note: The EU market in 2014 included the UK. Note: RHS = Right hand side 2 Data from the Ministry of Industry and Handicraft. 3 Data from the Council for the Development of Cambodia. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 12 SECTION 1 – Recent Economic Developments and Outlook including commercial and residential real estate An abrupt slowdown in FDI from China due development projects which have helped sustain to a change in Chinese investor confidence vibrant construction activity. therefore poses a risk. This can negatively affect investment and growth. Challenges in doing business Newly emerging hot spots of the current continue as Cambodia is currently ranked 138th out construction boom have spread to seaside cities of 190 countries in Doing Business ranking in 2019, and border towns. Sihanoukville received US$126 declining from 135th in 2018 and 131st in 2017. million in approved FDI in June 2018 alone. Total While the country is ahead of Lao PDR (154th), approved development projects for residential and it is far behind many regional countries such as commercial purposes accounted for about 1,600 Indonesia (73rd), Vietnam (69th) and Thailand projects, amounting to US$2.1 billion during the first (27th).4 In the latest Investment Climate Assessment six months of 2018, indicating a continued strong (see box 2), while acknowledging the significant investment appetite. However, the per-square-meter progress made, the assessment concludes that the value of approved investment in construction current investment climate hampers improvements has declined, pointing to a shift toward lower-end in productivity, diversification, and the development development projects, targeting less affluent market of a dynamic local private sector. segments. This is consistent with the expansion of more affordable housing projects on the outskirts A thriving tourism industry, as visitor of the capital city of Phnom Penh and in other urban areas. arrivals grew to 3.0 million or 13.6 percent (y/y) by mid-2018 Those newly developed projects seem to partly respond to a thriving tourism industry as visitor Efforts by the authorities to attract Chinese arrivals grew to 3.0 million, or a 13.6 percent tourists have paid off. Chinese tourists are ranked (y/y) increase in mid-2018, compared with an first (followed by Vietnamese, Lao, and Republic 11.8 percent increase at the end of 2017 (figure 5). of Korea visitors) and their number skyrocketed, Expansion of construction activity in coastal cities, growing by 80 percent y/y, accounting for 30 especially Sihanoukville, may have responded to percent of total arrivals (higher than in Thailand, the rising demand of tourism activity there. With where 27 percent of foreign visitors are Chinese). the rising popularity of coastal zones, their share Travel by air now accounts for almost 70 percent of tourists rose to 13.6 percent of total destination of total arrival numbers, increasing from just 50 arrivals in 2018, compared to only 5.5 percent in 2010. FIGURE 5: Tourist arrivals to Cambodia, Thailand, and FIGURE 6: Tourist arrivals by air to Cambodia, Thailand, Vietnam (y/y, percent change) and Vietnam (percent of total arrivals) Thailand Cambodia Vietnam Cambodia Vietnam Thailand 35 90 30 85 25 80 20 75 15 70 10 65 5 60 0 55 -5 50 -10 45 -15 40 9 0 1 2 3 4 5 6 7 18 D-05 D-06 D-07 D-08 D-09 D-10 D-11 D-12 D-13 D-14 D-15 D-16 D-17 -0 -1 -1 -1 -1 -1 -1 -1 -1 n- ec ec ec ec ec ec ec ec ec Ju D D D D D D D D D Source: Cambodian authorities;Thailand’s Ministry of Tourism and Sport; Source: Cambodian authorities; Thailand’s Ministry of Tourism and Sport; and Vietnam’s Ministry of Culture, Sport and Tourism. and Vietnam’s Ministry of Culture, Sport and Tourism. 4 http://www.doingbusiness.org/content/dam/doingBusiness/country/c/  cambodia/KHM.pdf. 13 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook percent a few years ago (figure 6). While Siem Reap Only 5 percent tourists visiting Vietnam International Airport continues to attract the largest and 13.5 percent of tourists coming to share, capturing 51 percent of all travel by air, arrivals via Phnom Penh International Airport have Thailand extended their visits to Cambodia6 surged, expanding at 40 percent y/y by mid-2018 In this regard, it is important to have a policy and accounting for 45 percent of total arrivals by air. to make inroads into this growing market Nevertheless, Cambodia remains far located at Cambodia’s doorstep. The policy may involve looking at the demand segments beyond behind Thailand and Vietnam in attracting what are being offered in Thailand and Vietnam. foreign tourists Potential market segments may include ecotourism, especially wildlife adventure parks and trekking, given In 2017, Cambodia attracted only 5.6 million Cambodia’s relatively large share of the land area that foreign visitors, whereas Thailand and Vietnam is covered by national parks and reserves with high received 35.4 million and 12.9 million visitors, biodiversity. Cambodia could then develop a strategy respectively. Looking at the combined tourism to meet those segments, while establishing linkages markets in its two large neighbors, Cambodia with major attraction sites in Thailand and Vietnam.7 obtains only a small (and declining) fraction. As a share, Cambodia captures only 10 percent of the Favorable weather conditions have contributed combined tourist arrivals to Thailand and Vietnam to improved production of the agriculture sector in 2017, down from 12 percent in 2014. This reflects this year. In 2017, rice production rose to 10.4 substantial untapped potential as the country has million metric tons, a 4.4 percent y/y increase (figure not been very successful in luring tourists who visit 7). The contribution by land (as the rice harvested its neighbors to come to the country. area increased) and by yield to production increase is 230,000 and 180,000 metric tons, respectively. With More than 80 percent of foreign tourists to rising rice surplus and exports, Cambodia jasmine, Cambodia are first-time visitors. Due to limited which is the country’s famous fragrant rice, is gaining tourist destinations and product diversification, only in popularity. The rice once again won the World’s Best 16.5 percent of foreign tourists coming to Cambodia Rice Award in 2018 in the World’s Best Rice Contest are returning tourists, compared with more than 50 organized annually by The Rice Trader.8 Since 2009, percent in Thailand. One study indicated that repeat Cambodian Jasmine rice has been competing globally, visits can be due to several factors. These include especially against Thai Jasmin rice, for the annual title satisfaction with accommodations, shopping, of World’s Best Rice. So far, Cambodia has won four restaurant and food, and attitude of local people that awards, in 2012, 2013, 2014, and 2018, while Thai generate relaxation and recreation.5 Lessons learned rice received five awards. U.S. rice and Myanmar rice from Vietnam may be applicable to Cambodia. received one award each. Vietnam has done exceptionally well as, since 2016, foreign tourist arrivals there have grown by almost The gradual recovery of agriculture commodity 30 percent y/y. Key issues such as far-reaching prices has helped underpin increased reform including implementation of a tourism agricultural production. However, agricultural law, preferential policies encouraging investment growth during 2016–17 remains much lower than in tourism, prioritizing capital for tourism human during the period before 2013 (figure 8), because land resources, and enhancing tourism promotion work expansion, which had been the main driver of strong are among key policy measures that have helped agricultural performance, may have reached its limit. propel Vietnam’s tourism sector. Raising the yield of agricultural production requires improvements in land and labor productivity, while diversification, intensification, and better seeds will 6  34.7 percent and 31.2 percent of foreign tourists come to Cambodia via Thailand and Vietnam, respectively, according to the 20017 Annual Report of the Ministry of Tourism. 7  See the selected issue section entitled “Cambodia Calling: Maximizing Tourism Potential,” October 2017 “Cambodia Economic Update” for an in-depth 5  “Factors Influencing International Visitors to Revisit Bangkok, Thailand,” analysis of the tourism sector. by Tun Thiumsak and Athapol Ruangkanjanase; http://www.joebm.com/ 8  https://thericetrader.com/conferences/2018-WRC-Hanoi/worlds-best- vol4/394-E00008.pdf. rice/. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 14 SECTION 1 – Recent Economic Developments and Outlook promote land productivity. As Cambodia is located particularly regarding its consumption of within the neighborhood of commodity giants, animal products. This is also true for exports as namely Thailand and Vietnam, it is strategically the Asian middle class, especially in China, expands. important to work toward quality differentiation However, during the last decade or so, diversification (rice, pepper), sustainability premiums (“green”), toward production of animal products and fisheries and improved food safety (“clean”), while advancing remains less successful despite rising demand and agroprocessing (cashews, starch). prices (figure 9). Agricultural diversification, including Therefore, a national strategy to promote agricultural diversification could play a crucial quality differentiation, will help the role. As in the case of the rice sector, the Policy sector respond to changing domestic and on Paddy Rice Production and Promotion of external demand Milled Rice Export introduced in 2010 has a lot to do with boosting private and public investment Domestically, rising income and urbanization and underpinning the trade and export regulatory with a rapid expansion of the tourism sector environment favorable to the expansion of milled is changing household food consumption, rice production and exports (figure 10). FIGURE 7: Contribution to annual wet season rice FIGURE 8: Growth of agriculture GDP recovers but production increase (in million metric tons) remains well below pre-2003 levels Due to land expansion Agriculture GDP growth (percent, RHS) Due to yield improvements Rice Thai 5%, real index (2010=100) Total gains Casava real price index (2010=100) 0�6 140 7 0�5 120 6 0�4 0�3 100 5 0�2 80 4 0�1 0 60 3 -0�1 40 2 -0�2 20 1 -0�3 -0�4 0 0 2010 2011 2012 2013 2014 2015 2016 2017 06 07 08 09 10 11 12 13 14 15 16 17 Source: Cambodian authorities. Source: Cambodian authorities and the World Bank Group. FIGURE 9: There have been rising fish and seafood FIGURE 10: Rice policy in 2010 helped boost the prices, but diversification toward production of share of milled rice exports and domestic credit to fisheries remains unrealized the agriculture sector (percent) Fisheries (% of agriculture GDP) Milled rice exports (% of total rice surplus) Fish & seafood CPI (eop, 2006=100) Credit going to agriculture (% of total, RHS) 35 250 20 12 Introduction of 30 Rice Policy 10 200 25 15 8 20 150 10 6 15 100 10 4 50 5 5 2 0 0 0 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Cambodian authorities. Note: RHS = Right hand side Source: Cambodian authorities. 15 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook The recovery in agricultural production and unimproved rainwater collection). Access has promoted agriculture-related jobs and to improved sanitation facilities has expanded businesses, although jobs in primary agriculture significantly but remained relatively low, accounting continue to decline. The recovery in agricultural for 67 percent of rural households, up from 29 production in 2016 and 2017, coupled with percent in 2010.10 improving economic prospects in the rural areas, is Structural transformation continues, while the believed to have contributed to the return of some labor market is tightening. The agriculture sector migrants, especially from Thailand, as proxied by a shed 344,000 jobs in 2016 (figure 12), although recent fall in remittances (figure 11). In this regard, its performance improved. However, almost half poverty reduction is likely to continue in the rural a million jobs were created by the services sector, areas. more than offsetting the decline in agriculture Consistent with the decline in poverty, access to jobs, resulting in net job creation of a quarter of a housing and shelter has also improved. Nearly million (higher than 116,000 jobs created in 2015). 95 percent of all households in Cambodia owned This net job creation may have helped fully absorb dwellings in 2016, compared with 93 percent in Cambodia’s growing working-age population (age 2010. 9In the rural areas, as much as 96 percent of 15–64) with 164,000 new entrants into the labor households own dwellings (averaging 50 square force each year. meters each), although the quality of their homes is Rising FDI inflows will continue to demand inferior to those of their urban counterparts (82.7 more labor, especially skilled labor. In this percent with soft and temporary material flooring regard, it appears that local skilled workers are and 65 percent with one room only). not sufficient, and therefore for some industries Access to safe water for rural households, including construction, employing foreign skilled workers is necessary. The constraints caused by however, remains a challenge Cambodia’s inadequately educated workforce have As many as 47 percent of rural households been found to be the second-most-severe obstacle (declining from 64 percent in 2010) continue to for the operation of manufacturing enterprises, consume from unimproved water sources (such according to the 2016 World Bank Group Enterprise as unprotected dug wells, ponds, rivers, streams, Survey. FIGURE 11: Trends in rubber and rice prices, FIGURE 12: Contribution to job creation and remittances (’000 jobs) Rice (2003=100) Rubber (2003=100) Agriculture Industry Remittances, % of GDP 800 Services New jobs 500 3�5 600 Rice (Thai) & Rubber (SGP) price, 450 3 Remittances, % of GDP 400 400 350 2�5 200 2003=100 300 2 250 0 200 1�5 150 -200 1 100 -400 0�5 50 0 0 -600 2000 2002 2004 2006 2008 2010 2012 2014 2016 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Cambodian authorities. Source: Cambodian authorities. Note: RHS = Right hand side 9  According to the 2010 and 2016 Cambodia socioeconomic surveys, the 10  2010 and 2016 Cambodia Socio-Economic Surveys, National Institute of National Institute of Statistics. Statistics. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 16 SECTION 1 – Recent Economic Developments and Outlook Driven largely by external demand, merchandise which include largely passenger vehicles and exports have quickly accelerated this year. In motorcycles, skyrocketed, accelerating at 81.4 addition to the expansion of textile, apparel, and percent during the first six months of 2018 (figure footwear product exports discussed above, initial 13). Bustling construction activity has required diversification success has resulted in emerging rising construction material imports as strong manufactured product exports. Underpinned by investor confidence continues. The imports of key the EU’s Everything But Arms (EBA) arrangement, construction materials, which include steel, cement, Cambodia is now the biggest bicycle supplier to the and cooling equipment, grew at 50.9 percent, 21.1 EU market. It overtook Taiwan, China, which had percent, and 86.7 percent, respectively (figure 14). been the largest bicycle exporter to the EU for over Imports of foodstuff, beverages (soft drinks), and 20 years.11 In 2017, Cambodia exported more than medicines, combined accounting for about US$700 1.4 million conventional bicycles, or about a 9 percent million, also rose by 31.1 percent y/y during the first y/y increase, to the EU market, followed by Taiwan, six months of 2018. China (1.3 million bicycles) and the Philippines (0.8 Cambodia’s external position, however, million bicycles). Cambodia’s total bicycle export remains stable as healthy exports partly offset value was US$335 million in 2017. And during the the surge in import demand and the current first six months of 2018, Cambodia’s bicycle export account deficit is fully financed by FDI inflows. grew by 16.7 percent. Other emerging exported While slightly widening, the current account deficit products include vehicle and electrical parts, with a is expected to remain fairly stable in 2018 at around combined export value of about US$400 million. 10.3 percent of GDP and entirely financed by FDI Rising domestic demand has been met by inflows. However, the fact that a disproportionate share of FDI is increasingly originating from one a surge in imports country can be a matter of concern. In addition, Cambodia recently experienced a surge in the surge in import demand has slowed the pace imports, reflecting rising consumer confidence. of gross international reserves accumulation, which Motor vehicles and steel imports, which gauge grew at 15 percent year-on-year in June 2018, down domestic consumption and construction demands, from 30 percent in December 2017 — the fastest accelerated quickly. The imports of motor vehicles, accumulation rate during the post-global financial FIGURE 13: Motor vehicle imports accelerated FIGURE 14: Construction materials and steel imports (YTD y/y, percent change) (y/y, percent change) 100 Other materials Steel imports Cement imports Cooling equipment 100 80 80 60 60 40 40 20 20 0 0 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 -20 -20 -40 -40 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Jun-18 Source: Cambodian authorities. Source: Cambodian authorities. 11  https://www.bike-eu.com/sales-trends/nieuws/2018/06/cambodia-now- eus-leading-bicycle-supplier-10134013?vakmedianet-approve-cookies=1&_ ga=2.250830918.1923186902.1532411510-374096326.1532411510. 17 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook Box 2 Cambodia Investment Climate Review – lessons for future competitiveness1 Cambodia experienced more than two decades of strong hampers improvements in productivity, diversification, and economic growth and graduated to lower middle-income the development of a dynamic local private sector, for the status in 2017. These results are commendable and have following reasons. pushed many Cambodians over the poverty line.2 To First, the current cost of doing business in Cambodia identify lessons for the future, we take a closer look at how does not encourage sufficient domestic investment and this exceptional growth was achieved. entrepreneurship. The “missing middle”6 phenomenon in This growth was mainly driven by export-oriented FDI the size distribution of firms is much more pronounced in and tourism. In the last decade, Cambodia ranked among Cambodia than in low-income-country averages. In fact, the countries that attracted the most FDI in relation to its there is also a scarcity of small-sized formally registered size worldwide.3 Its garment sector produces 84 percent of enterprises in Cambodia. The annual business entry density all value added in manufactured exports, and the boom in rate is less than a third of the average for lower middle- tourism brought foreigners’ cash to the country. In addition, income countries (figure B2.1). official development assistance has supported progress in many public services such as infrastructure, health, FIGURE B2.1: Enterprise Entry Density across and education. Overall, the growth was largely driven by income groups in Cambodia attracting foreign financial resources in various ways, which should not diminish its impact. 5 4�2 What senior policy makers should consider, however, 4 is that these foreign resources were attracted based on 3 a low-cost, low-value model, while real achievements in 2�4 productivity and competitiveness remain limited.4 Foreign 2 investors continuously confirm that low labor cost, high 1 0�8 tax incentives and tariff preferences, and preferential 0�3 0�23 access to export markets are the key reasons for their 0 investment in Cambodia. With prosperity, wages are rising High Upper Lower Lower Cambodia since the workforce has more opportunities. As a lower Income Middle Middle Income Income Income middle-income economy, Cambodia is likely to experience a progressive erosion in trade preferences and a decline in concessional financing over the next decade. The rise of Myanmar and other low-cost production destinations will Cambodia is one of the most difficult places in the world test Cambodia’s ability to retain and continue to attract high to register a business. Doing Business 2018 reported that levels of FDI inflows to sustain robust economic growth starting a business in Phnom Penh requires nine procedures and job creation. These are the consequences of progress— that take 99 days on average, costing 51.3 percent of not bad developments—but they will impact the pathway to Cambodia’s income per capita. Paid-in minimum capital of future growth. 82.5 percent of income per capita is also required. Thus, Cambodia ranks 183rd out of 190 economies globally on A recent World Bank Group assessment5 looked at the ease of starting a business and last out of 25 economies most important aspects of the investment climate affecting in the East Asia and Pacific region. Consequently, many the benefits FDI, trade, and SME development can have entrepreneurs do not register their business and avoid for future growth. An enabling investment climate creates paying taxes. Informality, by default, makes participating opportunities and incentives for private enterprises, both in trade or linking to FDI firms more difficult, which has foreign and domestic, to invest, create jobs, and expand severe consequences for business’ prospects—and for the which strengthens the Cambodian industrial base and competitiveness of the economy. the competitiveness of firms in international markets. While acknowledging the significant progress made, the assessment concludes that the current investment climate 1 Prepared by Ulla Heher, Private Sector Specialist, Macroeconomics, Trade and Investment GP. 2  According to official estimates, the poverty rate in 2014 was 13.5 percent compared to 47.8 percent in 2007. 3 Average FDI inflow of 7.8 percent of GDP between 2000 and 2016. 4  The World Economic Forum Global Competitiveness Index ranked Cambodia 110th out of 125 countries in 2006 and 94th out of 137 nations in 2017. This is below all its neighbors and significantly below the East Asia and Pacific average. 5 The full report will be published in the first half of 2019. 6  Cambodia has a significantly lower density of firms in the small-to-medium-sized segment than comparable economies. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 18 SECTION 1 – Recent Economic Developments and Outlook Second, trade costs weigh heavily on Cambodia’s export for improved GVC integration in every dimension, for structure and exporting firms’ performance. For a small final and intermediate GVC product manufacturing. While country like Cambodia, the global marketplace is an trade-related capabilities are relatively stronger (figure important source for growth and development. Trade B2.3a), they remain below the requirements for integration costs make up a significant portion of the total operating into more sophisticated activities. Indeed, indicators on costs for Cambodia’s importers and exporters, particularly trade facilitation costs reveal that Cambodia lags regional for FDI, as most is export oriented. The contribution of comparators in monetary and time terms, which also have transport and logistics to the total exported value added increased in relative terms (figure B2.3b). from Cambodia reached 14 percent.7 This is double the Fourth, the current quality and intensity of supply chain contribution of these sectors in Thailand and 3.5 times linkages between FDI and Cambodian firms is low. Given that of Malaysia or Vietnam.8 Reducing trade costs will not its large FDI stock, enhancing the local embeddedness of only enhance the cost competitiveness of existing exporters international firms to capture knowledge spillovers has been but will also help attract more sophisticated FDI into the a long-standing policy goal of the Royal Government of country. This is particularly important, since exporters and Cambodia (RGC). Such linkages are an important channel foreign companies in Cambodia are 25 to 40 percent more through which foreign firms transfer technology, know- productive than non-exporters and domestic companies.9 how, and management practices, and improve supplier Third, the sophistication of Cambodia’s economy and productivity. Especially when linked to exporters, linkages trade costs determine its ability to participate in regional are often an important conduit for suppliers to access and global value chains (GVCs). Currently, Cambodia is international markets and value chains. However, FDI inserted in the least demanding GVC in the least demanding mostly uses Cambodia as an export platform for low-cost, form—garments as a buyer — and is specialized in low- low-productivity activities that have limited potential for quality, low-sophistication, and highly substitutable transferring capital and knowledge. FDI manufacturing segments. Cambodia falls short of required capabilities firms import about 95 percent of production inputs, by far FIGURE B2.3a: Revealed capability intensities FIGURE B2.3b: Cambodia’s Trading Across of GVC products and Cambodia’s endowments Borders indicators relative to the regional average (Standard deviations in world averages) (Above 1 indicates Cambodia has higher trade costs than the regional average) Cambodia's endowment Final GVC products 2�5 requirement 2009 2018 Intermediate GVC products 2�14 requirement 2�0 1�0 0�5 1�72 0�4 0�2 0�2 0�5 0�0 0�10�2 0�1 0�1 0�0 1�5 -0�5 -0�1 0�0 -0�1 1�21 1�26 -0�1 1�16 -1�0 -0�4 -0�5 1�11 -1�5 -0�9 1�0 -1�3 -1�1 0�82 0�70 Proximity to markets Physical capital Institutional capital Market access Human capital Logistics/Connectivity 0�5 0�0 Time to export Time to Export costs Import Costs import Sources: Authors’ calculations based on the Centre d’Études Prosproctives et d’Informations Internationales (CEPII), The Changing Wealth of Sources: Trading Across Borders, Doing Business, World Bank. Nations database, Barro and Lee Education database, Penn World Tables 9.0, World Bank Governance Indicators, World Bank Logistics Performance Index, and Farole and Pathikonda (2016). 7  This includes direct contributions and those through other sectors (forward linkages). 8  These differences result from a combination of the sectoral composition of exports of each country, as transport and logistics matter more given Cambodia’s export basket, plus the cost differences that countries face in the provision of these sectors. 9  Measured through comparison of TFP, size and wage premia for firms in all countries, in lower middle-income countries, for EAP and Cambodian only. 19 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook the largest among peer countries. The import share increased to success will depend on the details determining focus, further compared to 2013, indicating that very little of the conditions, and implementation of these initiatives. Two new demand created through recent FDI arrivals was met points are important to learn from international experience. by local firms, and most of the value was captured abroad First, finance by itself is usually not effective. Support (figure B2.4a). Linkages in services are more prevalent. needs to include enabling legal and policy frameworks as well as promotion services in the form of enterprise FIGURE B2.4a: Share of foreign inputs in capacity building, human resource development, and manufacturing operations market information. Second, local content rules―especially in highly tradable and substitutable sectors―usually do not Domestic Foreign work, because they fail to address the underlying issues Bangladesh 2013 and might exacerbate the problem at the cost of long- Philippines 2014-26 term competitiveness. When applied to only one group of Lao PDR 2016 investors, such rules distort competition. Vietnam 2015 The review of the investment climate highlights that the Indonesia 2015 whole economy is currently geared to support the low-cost, Thailand 2015-16 low-value growth model, some of the characteristics of Cambodia 2013 which have enabled Cambodia to reach its current income Cambodia 2016 level. Given past successes, Cambodia needs to adapt this model toward one that fosters productivity growth as the 0 20 40 60 80 100 main driver of future growth and prosperity. This is also Foreign inputs (% of total) essential to better accommodate social and environmental Sources: WBG Enterprise Survey 2016. considerations and to avoid the middle-income trap that Cambodia runs the risk of entering at a low level. First, global connections via trade, FDI, participation in GVCs, The current investment climate in Cambodia has not and the international mobility of skilled labor need to be addressed the market failures and constraints that prevent its fostered. Second, investment in education and skills is private sector from profiting from linkages gains. FDI firms crucial to ensure that workers have the capacity to learn new report10 that the lack of competitive local firms active in skills to make the most of new opportunities and to adapt FDI-dominant sectors is by far the biggest constraint. Next to changing technologies and working conditions. Third, on the list of barriers are the high search costs to identify investment in entrepreneurship and innovation is essential suitable suppliers, the inability of suppliers to meet quality to enable the economy to absorb, adapt, and reap the full and cost requirements and the lack of basic certification,11 benefits of international exposure and new technologies. the cumbersome process to claim VAT refunds, and Committing to reforms in the investment climate will be informality. Likewise, Cambodian suppliers cite the gap in inevitable in this transformation. productivity and workforce skills as their main constraint As Nobel Laureate in economics Paul Krugman once said, in linking to FDI. Due to the lengthy time lags in supply “Productivity isn’t everything, but, in the long run, it is chain financing and high investment needs for upgrading almost everything.” Certainly, if Cambodia wants to achieve production capacity, access-to-finance issues are also more the ambitious goals set forth in the recently published pronounced for Cambodian suppliers when linking to FDI. fourth Rectangular Strategy12 of becoming an upper Until now, there was hardly any business support middle-income country in 2030 with a vision to achieve infrastructure available for the domestic private sector to tap high-income status by 2050, the country needs to rethink into. Recent RGC initiatives to establish a fund to enhance its growth model. A crucial determinant for success will be entrepreneurship, an SME bank, and a tax incentive to whether policy makers in Cambodia succeed in adopting a support SMEs in priority sectors are first steps. The route longer-term perspective. The World Bank Group conducted a survey of FDI and supply firms in 10  2017. The findings are based on survey results. Only 5 percent of Cambodian firms have internationally recognized quality 11  12  http://cnv.org.kh/wp-content/uploads/2012/10/Rectangular-Strategy- certification compared to the 12 percent average for the East Asia and Pacific Phase-IV-of-the-Royal-Government-of-Cambodia-of-the-Sixth-Legislature- region. of-the-National-Assembly-2018-2023.pdf. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 20 SECTION 1 – Recent Economic Developments and Outlook crisis period (see more discussion on the impact Strong consumer confidence with rising wages of the surge in import demand on the exchange has pushed up inflation, which edged up to 2.9 rate in the monetary sector section below). Gross percent (y/y) in June 2018, up from 2.2 percent international reserves reached US$9.08 billion by in December 2017 (figure 16). Driven largely by June 2018, or six months of prospective imports. rising prices of animal products, especially beef, fish, and seafood, the food component (subindex), Cambodia has been quite successful in which captures a 43 percent weight of the inflation attracting FDI inflows, thanks to its liberal basket, contributed 1.7 percentage points to the trade and investment policy increase in the Consumer Price Index. To a lesser extent, the transport component contributed Over the last 10 years, Cambodia has received 0.4 percentage points to the increase. Note that a relatively large amount of net FDI inflows, improved weather conditions have supported the averaging about 10 percent of GDP. The country expansion of agricultural production, which in turn is among the top 20 in the world in terms of net FDI helped contain retail prices of some food items, inflows as percent of GDP (figure 15). According to especially rice, vegetables, and fruits. This has helped the annual study by fDi Intelligence, which looked at subdue overall inflationary pressures. inbound greenfield investment in 2017 relative to the In addition, to stabilize the retail prices of size of each country’s economy, Cambodia is the leading petroleum products against the gradual rise in Asian country, and ranks third overall. Singapore and international oil prices, the authorities earlier Vietnam rank second and third, respectively.12 introduced a reduction in a special tax levied To promote export diversification, supply chain on imported petroleum products. In July 2018, linkages are an important channel through a special tax (one of four taxes) levied on imported which FDI firms transfer technology, know- petroleum products was reduced. The special tax on how, and management practices. Improving the gasoline was cut to 15 percent (from 35 percent), investment climate to promote small and medium- on diesel to 5.5 percent (from 15 percent), and sized enterprises and businesses to grow and to on kerosene to 5 percent (from 15 percent).13 The capture FDI spillovers, that is, the productivity reported revenue forgone is US$30 million a year. gains that result from the diffusion of knowledge As Cambodia imports all petroleum products and technology from foreign investors to the for domestic consumption, there is a full “pass- local economy, is especially crucial for a small and through” from international oil prices to domestic concentrated economy such as Cambodia (see box 2). retail prices. FIGURE 15: Cambodia is among top 20 countries FIGURE 16: Contributions to 12-month inflation receiving largest net inflows of FDI as percent of (percent) GDP (2017) Others Cyprus Luxemb… Transport sub-index Netherla… 8 Food sub-index Malta Congo,… 7 Housing & utilities sub-index Liberia 6 Y/Y Singapore Mozamb… 5 Guinea 4 Ireland Mongolia 3 Turkme… 2 Georgia Mauritania 1 Palau 0 Montene… Cambodia -1 Maldives -2 Panama Djibouti -3 Dec-17 Mar-18 Jun-18 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Sep-14 Dec-14 Mar-15 Jun-15 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Jun-11 Sep-11 Dec-11 0 10 20 30 40 50 Source: World Development Indicators. Note: 2017 or latest available years. Source: Cambodian authorities. 12  https://www.fdiintelligence.com/Locations/Asia-Pacific/Mozambique-tops- 2017-Greenfield-FDI-Performance-Index?utm_campaign=August+2018+e- news+2&utm_source=emailCampaign&utm_medium=email&utm_content. 13 http://cnv.org.kh/petroleum-price-decrease-0-03-first-july/. 21 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook Inflation across the East Asia and Pacific region Accumulation of gross foreign reserves is also edging up, especially in Myanmar, the continued but at a slower pace as FCD growth Philippines, and Vietnam, where elevated decelerated. The central bank’s gross foreign consumer prices have already prompted policy reserves reached US$9.08 billion or six months of responses.14 Both consumer and producer prices prospective imports coverage in June 2018. Similarly, are expected to rise due to four key factors: (a) riel in circulation continued to increase but at a slower continued firm economic growth, which is closing pace, decelerating to 18.2 percent (y/y) in June 2018, output gaps; (b) nominal depreciation, which is down from 28.2 percent in December 2017 (figure 18) pushing up import prices; (c) pass-through from as the local currency was under increased pressures higher global oil and food prices; and (d) rising because of rising demand for imports. wages. Rising production costs indicate that price As a result, the riel versus the U.S. dollar pressures may start to emerge, although consumer exchange rate depreciated, reaching CR 4,082 per prices generally remain within regional central U.S. dollar at the end of September 2018, compared banks’ target bands. to CR 4,037 at the end of December 2017. The riel Confidence in the banking system continued also slightly depreciated against the Thai baht but appreciated against the Vietnamese dong. Against the to underpin foreign currency deposits currencies of its main export markets (besides the Broad money growth, however, slightly United States), the riel recently appreciated against decelerated to 21.6 percent in June 2018, down the euro, the Canadian dollar, and the British pound. from 23.8 percent in December 2017. This slight However, given that the economy continues to deceleration was due largely to slower growth of be highly dollarized, the exchange rate does not foreign currency deposits (FCDs) of 18.8 percentage fully perform its roles. For example, the exchange points (as imports rose) and local currency in rate may not affect prices in international trade. The circulation of 2.0 percentage points, down from share of U.S. dollar deposits in total deposits is as 19.6 percentage points and 3.2 percentage points, much as 95 percent, or 68 percent of GDP. Large respectively (figure 17). transactions and private sector wages, especially for those working for the garment and footwear industry, the largest export sector in Cambodia, are denominated in U.S. dollars. As the development- partner-funded component has shrunk, the majority FIGURE 17: Contribution to broad money growth FIGURE 18: Riel in circulation (percentage points) (y/y, percent change) Riel in circulation Riel deposits 30 35 Foreign currency deposits 30 25 25 20 20 15 15 10 10 5 5 0 0 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-16 Jul-17 Nov-16 Nov-17 Mar-16 Mar-18 Mar-17 Sep-16 Sep-17 May-16 May-17 May-18 Jan-16 Jan-17 Jan-18 Source: Cambodian authorities. Source: Cambodian authorities. 14 World Bank October 2018 East Asia and Pacific Economic Update. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 22 SECTION 1 – Recent Economic Developments and Outlook of public expenditures (including civil servants’ of riel lending rate. The LPCO facility, which wages) is denominated in local currency. With rising requires negotiable certificates of deposit (NCDs) public spending as a percent of GDP, the use of as collateral to obtain the local currency (together local currency expands. Efforts by the central bank with the requirement to increase riel-denominated to promote the use of the local currency continue. loans to at least 10 percent of the total loan portfolio by the end of 2019) has allowed the central bank to Lending rates continue to gradually decline inject local currency while maintaining a relatively (figure 19). The weighted average of the U.S. dollar stable riel-U.S. dollar exchange rate.17 As a result, the lending rate dropped to 11.4 percent per year in riel lending rate has now converged with that of the June 2018, down from 11.7 percent per year in U.S. dollar. December 2017. However, the average lending rate of microfinance institutions is substantially Deposit interest rates, however, remain largely higher than that of banks. Cambodia’s high cost unchanged as banks and MDIs compete to of borrowing may have prompted the central bank mobilize funds. The weighted average of the U.S. to impose an interest cap at 18 percent in April dollar deposit interest rate (12-month maturity) 2017, targeting all microfinance institutions (MFIs), stayed at 4.42 percent per year in June 2018. Rapid microfinance deposit-taking institutions (MDIs), expansion of the banking and microfinance sector and rural credit operators under its supervision. The is likely to continue, given that the spread between average interest rate charged by banks in Cambodia lending and deposit rates remains large, especially at remain high compared to that of other countries in MFIs and MDIs (with the average lending rate of the region and the world (figure 20). In Thailand, 17.15 percent and the deposit rate of 4.85 percent the average minimum loan rate, the interest rate for June 2018). This also indicates that there is still charged by commercial banks, is only 8 percent.15 In considerable room to improve the efficiency of Vietnam, lending interest rates for production and the financial sector. Note that while lending rates business were commonly 6.8 percent to 9 percent at MFIs and MDIs are declining, they were as high per year for short-term loans.16 as 25.7 percent before the interest rate cap was imposed in April 2017. The success of the Liquidity-Providing Collateralized Operation (LPCO) introduced By mid-2018, total outstanding loans financed last year to establish a benchmark rate of local by the banking and microfinance sector currency borrowing has led to a reduction reached 93 percent of GDP, or 92 trillion riels FIGURE 19: Bank’s short-term U.S. dollar interest FIGURE 20: Cambodia’s lending rate, while rates have declined declining, remains high (percent per year) (percent per year) Lending rate Deposit rate (RHS) 20 7 18 18 16 6 14 16 12 6 10 14 8 5 12 6 5 4 10 2 8 4 0 ate ds I nd m a re n k D in n pa po na n Mar-09 Mar-12 Mar-15 Mar-18 Jun-08 Jun-11 Jun-14 Jun-17 Ba a Sep-07 Sep-10 Sep-13 Sep-16 Dec-06 Dec-09 Dec-12 Dec-15 eR /M Ch fu ail Ja et ga a- Th Vi im al FI n er Si di M Pr d bo Fe a- S m U di S Ca U bo m Source: Cambodian authorities. Ca Source: Cambodian authorities and regional countries’ central banks/ statistical offices. 15  Bank of Thailand; https://www.bot.or.th. 16  Social and economic situation in the first quarter of 2018, General Statistics Office of Vietnam; https://www.gso.gov.vn/default_ 17  See “Cambodia Economic Update”, April 2018, for a detailed discussion on en.aspx?tabid=622&ItemID=18799. the introduction of the LPCO under the monetary sector. 23 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook (US$22.6 billion). While easing, credit growth million borrowers and 1.8 million depositors. Given remains elevated. Though credit growth continues its small market share and larger borrowers, average to moderate, bank (and microfinance) credit-to- loan size of the microfinance sector was only 9.4 GDP rose to an all-time high of 73 percent (and million riels (or US$2,372), or about 10 percent of 20 percent) at the end of June 2018, up from that of the banking sector. 31.4 percent (and 3.8 percent) in 2010 (figure 21). Access to finance provided by the microfinance The banking sector provided 80 percent of total sector was curtailed because the sector’s domestic credit, while the remaining 20 percent was average loan size rapidly increased, growing at supplied by the microfinance sector. This, however, 43 percent in 2017, up from 11.8 percent in 2016. excludes credit provided by the informal sector (and While credit growth of the MFI/MDI sector was shadow banking activity). Domestic credit supplied 36.1 percent in 2017, up from 34.0 percent in 2016, by the banking and microfinance sector grew at 20.8 borrowers (of which 70 percent are female) from the percent y/y by mid-2018, slightly lower than 21.8 microfinance sector declined to 1.8 million in 2017, percent at the end of 2017. down from 1.88 million in 2016. Access to finance Reported nonperforming loan (NPL) ratios provided by the banking sector barely expanded in for both the banking and microfinance sectors 2017. The number of borrowers from the banking deteriorated. Reported NPL ratios for the banking sector marginally increased, growing at only 1.1 sector rose to 3.1 percent in June 2018, compared percent in 2017, rising to 775,107 borrowers, up with 2.4 percent at the end of 2017.18 Similarly, slightly from 746,930 borrowers in 2016 (when the reported NPLs for the microfinance sector rose, sector experienced 45.7 percent growth in number reaching 5.0 percent in June 2018, compared with of borrowers, partly due to reclassification of an 2.1 percent at the end of 2017. Still, the reported MDI to a commercial bank). As a result, the banking NPL ratios need to be carefully interpreted as sector also experienced an increase in the average there are inconsistencies in loan classifications and loan size, growing at 17.2 percent, in contrast to its a continuous rolling over and refinancing of loans good performance in terms of access to finance in that may disguise deeper problems. 2016 (when its average loan size declined by 15.6 percent). The banking sector served 755,000 borrowers, while there were 3.48 million bank depositors in While it is clear that the interest cap has reduced 2017. The microfinance sector captured about 1.8 interest rates charged by the microfinance FIGURE 21: Domestic credit growth decelerated but TABLE 1: Rising average loan sizes of the banking remains elevated sector and microfinanace sector while access to (percent of GDP) finance curtailed MFI credit (% of GDP) The microfinance Bank credit (% of GDP) The banking sector y/y percent change, RHS sector 100 80 70 Average 80 Average Number 60 loan Number of 50 loan sizes of 60 sizes borrowers 40 (US$) borrowers 40 30 (US$) 20 20 2015 22,196.66 512,582 1,483.84 2,037,424 10 0 0 2016 18,723.75 746,930 1,659.46 1,889.914 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Jun-18 2017 21,953.59 755,107 2,372.01 1,800,00 Source: Cambodian authorities. Sources: Cambodian Authorities. 18  2018 Mid-year report and 2017 Banking supervision report, the National Bank of Cambodia. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 24 SECTION 1 – Recent Economic Developments and Outlook sector, its implication for access to finance needs nascent banking sector (figure 22). The rapid further analysis. For the microfinance sector, a acceleration of bank credit growth that occurred reduction in the number of borrowers began a during the post-global financial crisis period is year before the introduction of the cap (table 1), largely associated with the construction and real although a structural issue involving reclassification estate boom. As depicted in figure 23, while overall of an MDI to a commercial bank in 2016 may bank credit growth eased, starting in mid-2016, rapid partly explain this. Adjusting for the reclassification credit growth financing the construction and real reveals that the number of borrowers of the estate sector has continued. Figure 23 also indicates microfinance sector declined by 1.8 percent and that bank credit going to tradeable sectors such as 4.8 percent in 2016 and 2017, respectively. During the wholesale, retail, and manufacturing sectors has the same period, the number of borrowers of the been substantially curtailed since. banking sector increased by 22 percent and 0.7 Lately, the real estate sector has shifted toward percent.19 So, the interest rate cap may have largely more speculative activity with a new wave of impacted access to finance for the microfinance land plot sales and purchases with increasingly sector. Nonetheless, given its much smaller loan less obvious or justifiable investment returns. size and deep penetration in rural and remote Recently, the government issued a prakas areas, access to finance by the microfinance sector (regulation) on land development aimed at ensuring is crucial for supporting productive activity, leading sustainable land management and urbanization.20 to poverty reduction. The microfinance sector has The prakas may be an attempt to better manage, been credited in large part for its contribution to and in particular to contain, the unregulated promoting access to finance by the poor and those proliferation of land developments into land plots previously negatively affected by informal lending for sales and purchases. (For measures taken by practices often associated with loansharking. neighboring countries to cool the property market, As a share of GDP, Cambodia’s bank see box 3 on Singapore’s efforts.) Importantly, the recent surge in FDI inflows may have helped sustain credit has already overtaken that of the construction boom further, while masking the Indonesia and the Philippines financial sector’s vulnerability after several years of rapid credit growth. Regional comparisons show that Cambodia’s bank credit growth is rapid, given the country’s FIGURE 22: Cambodia’s bank credit growth is FIGURE 23: Contribution to domestic credit growth among the highest (domestic credit, percent of GDP) (percentage points) China (RHS) Indonesia Malaysia (RHS) Philippines 60% Agriculture Others Thailand (RHS) Cambodia Hotels and Restaurants Wholesale & retail 100 Vietnam (RHS) 160 Manufacturing Construction, estate & mortg Total 140 40% 80 120 60 20% 100 40 80 0% 20 60 -20% Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan-18 0 40 06 08 10 12 14 16 18 Source: October 2018 East Asia and Pacific Economic Update, World Source: Cambodian authorities. Bank. 19  Based on Sathapana Bank’s 2017 annual report, there were 113,000, 121,500, 20  Prakas on Land Development, May 11, 2018, Ministry of Land Management, and 125,200 borrowers in 2015, 2016 and 2017, respectively. Urbanization and Construction. 25 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook Box 3 Singapore has imposed new cooling measures on properties1 Effective July 6, 2018, the Government of Singapore Tightening of loan-to-valuation (LTV): Singapore’s imposed new property cooling measures to moderate the banks are only allowed to give a housing loan based on LTV investment demand for residential and industries properties. limits. The LTV is the maximum percentage of the property’s This is the latest in a series of cooling measures, which purchase price or valuation price that can be borrowed from include increasing the Buyer’s Stamp Duty and tightening the Bank. After July 6, 2018, these rates were reduced by 5 the loan-to-valuation limits. percent of a property’s value for those who do not have an existing loan (see figure B3.2). Increase Buyer’s Stamp Duty: The Buyer’s Stamp Duty (BSD) is levied on all purchases of properties. The Additional As a result, home sales dropped by 49 percent while home Buyer’s Stamp Duty (ABSD), first introduced in 2012, aims prices increased by 0.1 percent, following the latest cooling to ensure that the residential property remains affordable for measures. These prudent measures make Singaporeans less Singaporeans and to stabilize the property market. The ABSD enthusiastic about buying new homes and help prevent rate was recently raised by 5 percent for all groups of individuals property prices from rapidly increasing. and by 10 percent for entities except Singapore citizens and Singapore permanent residents who are purchasing their first home (see figure B3.1). FIGURE B3.1: Revised ABSD rates Before 5 July 2018 After 6 July 2018 SCs buying first residential property 0% 0% (no change) SCs buying second residential property 7% 12% SCs buying third and subsequent resident property 10% 15 % SPRs buying first residential property 5% 5% (no change) SPRs buying second and subsequent residential property 10% 15% Foreigners buying any residential property 15% 20% 25% + 5% Entities buying any residential property 15% (new, non-remittable) Source: Inland Revenue Authority of Singapore. Note: SCs = Singapore citizens; SPRs = Singapore permanent residents. FIGURE B3.2: Revised LTV limits Before 5 July 2018 After 6 July 2018 LTV limit for first home 80% 75% LTV limit for second home 50% 45% LTV limit for third home onward 40% 35% Minimum cash down payment 5% 5% (No change) Remaining down payment (cash/Central Provident Fund) 15% 20% Source: Inland Revenue Authority of Singapore. 1 Prepared by Linna Ky, Consultant, World Bank. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 26 SECTION 1 – Recent Economic Developments and Outlook Fiscal expansion fueled domestic demand, constrained by the tax holiday, the country will consumption, and imports continue to rely on indirect taxes for some time. Non-tax revenue is gradually improving due largely Fiscal expansion introduced this year has helped to an improved collection system and administration serve as a stimulus, fueling domestic demand, with the implementation of interministerial prakases consumption, and imports. Driven by both wages and a standardized receipting system. Trade tax is on and public investment, public outlay is budgeted to the decline due to Cambodia’s commitment under increase significantly, reaching 24.6 percent of GDP the ASEAN Free Trade Agreement (AFTA). in 2018, up from 23.1 percent in 2017. During the last several years, solid revenue performance has been remarkable and may This year’s revenue performance continues not be repeated in the next five years or so to be strong and is projected to meet or unless a new strategy is introduced. A new exceed the 2018 budget target revenue mobilization strategy for the next five years, scheduled to be introduced soon, is expected to However, given the exceptional revenue further improve revenue administration and address collection recorded last year, this year’s current structural weaknesses of the current revenue collection is anticipated to be more moderate system, including broadening of the revenue base. (figure 24). Based on the performance during the first six months of 2018, this year’s general This year’s fiscal expansion also boosts general government domestic revenue is expected to grow government expenditures to finance rising civil at about 10 percent, projected to reach about 19 servant wages and initial scale-up of public percent of GDP. investment. The public sector wage bill increases to 8.4 percent of GDP in 2018 (figure 25) to meet Domestic revenue continues to be mainly the minimum civil servants’ wage target of at least provided by indirect taxes, contributing about 1 million riels a month by 2018. This represents a half of the total collection this year, of which tripling of civil servants’ minimum wage, compared the VAT and excise taxes (on imports) account for to the level in 2013. In addition, for the first time 90 percent. Contribution by direct taxes is second, in several years, a significant boost is provided to accounting for about 20 percent of total collection. domestically financed capital investment. The The rest is covered by non-tax revenue, the trade relatively large fiscal expansion lifts domestically tax, and other taxes. Direct tax collection is also financed capital spending to 3.2 percent of GDP, improving, with better administration. Given the up from 2.3 percent in 2017. fact that Cambodia has not introduced a personal income tax, while corporate income tax remains FIGURE 24: General government revenue: Main FIGURE 25: General government expenditures: Main components components (percent of GDP) (percent of GDP) Non-wage Wage Direct taxes Indirect taxes Gov't-financed capital External fin capital Trade taxes Non-tax and others NSDP (required capital) 25 25 20 20 8�3 7�7 7�7 7�8 15 7�2 6�9 6�7 7�3 15 10 4�6 5�0 8�4 8�4 9�7 5�7 6�5 7�2 7�9 8�8 9�5 8�8 10 8�1 8�6 2�1 2�1 6�8 6�8 1��� 2�5 5 2�5 2�2 3�2 3�2 5 3�6 4�2 3�9 3�9 7�0 7�0 6�3 2�3 2�5 2�9 3�4 5�0 4�8 4�7 4�6 4�6 - 0 2012 2013 2014 2015 2016 2017 2018e 2018b 2012 2013 2014 2015 2016 2017 2018e 2018b Source: Cambodian authorities. Source: Cambodian authorities. Note: e = estimates and b = budget. Note: e = estimates and b = budget. 27 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook TABLE 2: Cambodia’s wage bill as a share of expenses TABLE 3: Cambodia’s wage bill as a share of revenue rose and is among the highest in Southeast Asia rose and is among the highest in Southeast Asia Wage (% of Wage (% of 2008 2013 2017* 2008 2013 2017* revenue) expense) Cambodia 38.9 37.8 40.4 Lao PDR 37.8 60.5 50.0 Philippines 34.3 36.6 35.6 Cambodia 26.6 32.6 34.6 Malaysia 27.2 29.1 34.9 Malaysia 25.7 28.6 34.4 Lao PDR 47.4 56.3 34.8 Philippines 31.9 34 32.9 Thailand 35.3 28.9 28.5 Thailand 32.0 26.9 27.1 Singapore 27.2 29.6 26.6 Singapore 19.3 21.3 20.8 Indonesia 12.4 15.1 16.4 Indonesia 11.5 15.5 19.5 Sources: World Development Indicators, Cambodian authorities, and 2018 Sources: World Development Indicators, Cambodian authorities, and 2018 IMF Article IV staff report. IMF Article IV staff report. Note: *Data are for 2016 except for Cambodia and Lao PDR. Note: *Data are for 2016 except for Cambodia and Lao PDR. Scaling up domestically financed public The public sector wage bill has grown quickly investment may reflect an effort by the authorities during the last five years. Regional comparison to compensate for the gradual decline (in percent shows that Cambodia’s public sector wage spending of GDP) in the development-partner-funded as a share of public expenditures and domestic capital budget, as Cambodia has now become a revenue is on the high side (tables 2 and 3). So, there lower middle-income economy. Total (domestically is limited room for further expansion of the wage and externally financed) capital spending already bill in a sustainable way. More importantly, there reaches the level recommended in the 2014–18 is a need to accelerate the critical tasks on public National Strategic Development Plan. The Ministry administration reforms, focusing human resources of Education, Youth and Sports (MoEYS) receives management to bring about an improvement the largest boost to its 2018 capital investment budget in public service delivery. Given that the public to meet the demand for building additional provincial sector is a major service provider and facilitator, schools, with its capital investment budget of CR 420 it is crucial to link the public sector’s significant trillion (or 0.5 percent of GDP), up from a mere CR wage increases to improvements in service delivery. 90 trillion in 2017. Raising public sector productivity underpins private sector development in driving growth and reducing poverty. FIGURE 26: The general government fiscal deficit FIGURE 27: Government deposits in the banking widened in 2018, thanks to fiscal expansion system (percent of GDP) (percent of GDP) Total revenue (and grants) Total expenditure Overall balance 14 25 12 20 10 15 8 10 6 5 4 0 2 -5 0 -10 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09 Jun-10 Mar-11 Dec-11 Sep-12 Jun-13 Mar-14 Dec-14 Sep-15 Jun-16 Mar-17 Dec-17 2012 2013 2014 2015 2016 2017 2018e 2018b Source: Cambodian authorities. Note: e = estimates and b = budget. Source: Cambodian authorities. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 28 SECTION 1 – Recent Economic Developments and Outlook The overall fiscal deficit is targeted to increase to debts (under negotiations) account for 9.1 percent. 4.2 percent of GDP in the 2018 budget, up from Cambodia’s debt distress level remained low as per 1.6 percent in 2017 (figure 26). External finance is the 2018 World Bank/IMF Debt Sustainability budgeted to cover 3.7 percent of GDP of the 4.2 Analysis. percent of GDP fiscal deficit, while the remaining 0.5 percent of GDP is budgeted to be financed by Against a backdrop of better-than- domestic funds—mostly from the drawdown of expected export performance, rising government deposits at the central bank. However, consumption, and upbeat investor the authorities’ fiscal buffer remains substantial, accounting for about 13 percent of GDP by mid- sentiment, the growth outlook has been 2018 (figure 27). During the past six months of revised up 2018, government deposits at the banking system continued to increase, thanks partly to strong Underpinned by exports and government revenue performance.21 spending, Cambodia’s growth is expected to accelerate to 7.1 percent in 2018, (compared to a In 2017, Cambodia contracted US$977.63 million newly revised official number of 7.0 percent growth of public debt in the form of concessional loans in 2017). Given that this year’s growth is boosted in with development partners (DPs) (equivalent part by substantial fiscal expansion, growth outlook to Special Drawing Rights [SDR] 684.71 million), is projected to ease slightly in the next two years accounting for 97.82 percent of the debt ceiling of but remains at a healthy rate of 6.8 percent until SDR 700 million,22 of which 82.3 percent was signed 2020. The longer-term growth outlook is favorable, with bilateral DPs and the rest with multilateral DPs. thanks largely to rising FDI inflows going to the The purpose of the borrowing was to finance public productive sectors, namely manufacturing and investment projects which, for 2017, covered 100 agriculture, including agroprocessing. Several new percent of total borrowing. Overall, the borrowing initiatives have been introduced by the authorities remained highly concessional, with an average to promote small and medium-sized enterprises grant element of 54.9 percent. From 1993 to the and businesses, while promoting their linkages with end of 2017, the authorities signed US$9.6 billion the FDI sector (see box 2). Poverty reduction is in concessional loan agreements with DPs (87.8 expected to continue with expansion of the services percent for infrastructure projects and 12.2 percent and manufacturing sectors. for other priority sectors). The recent surge in FDI inflows going to the At the end of 2017, the public debt outstanding manufacturing sector including agroprocessing was US$6.67 billion (30.2 percent of GDP), of has been encouraging. In this regard, Cambodia’s which 0.04 percent (or US$2.77 million) was public growth trajectory is expected to improve, especially domestic debt. in the short- and medium-term outlook, compared to previous projections (table 4). The authorities’ China is by far the largest creditor, efforts to improve access to and quality of basic accounting for almost half of Cambodia’s education including the introduction of a new outstanding debt generation of school initiatives may result in improved learning outcomes and better labor force Cambodia’s external debt owed to China quality in the medium to long term. Initiatives accounts for 48.4 percent of the total under the public financial management and public outstanding debt as of the first half of 2018. The administration reforms are designed primarily to second- and third-largest creditors are multilateral, improve value for money and public service delivery, namely the Asian Development Bank and the World facilitating private sector growth. Bank, covering for 19.3 percent and 8.0 percent of total outstanding debt, respectively, while old 21 As of June 2018, 31 percent of government deposits at the National Bank  of Cambodia is in U.S. dollars. 22  “Cambodia Public Debt Statistical Bulletin,” Volume 5, March 2018; and Volume 6, September 2018, Ministry of Economy and Finance. 29 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook TABLE 4: Improved macro outlook in the short Malaysia—to reach both the upper middle-income and medium term 2035 and high-income 2050 goals. Percent of GDP 2018 2019 2020 It is important to be prepared for eventual unless specified otherwise graduation from least developing country status GDP growth (%) 7.1 6.8 6.8 and the loss of preferential trade treatment and more restricted access to concessional loans Domestic demand 9.4 9.7 10.1 in the next decade or so. Currently, Cambodia (% change y/y) is benefiting from EBA with full duty-free and quota-free access to the EU for all their exports, Inflation 3.2 3.3 3.0 (% change, average) with the exception of arms and armaments, and from the U.S. Generalized System of Preferences Overall fiscal balance -4.2 -4.2 -4.3 (GSP), which removed U.S. customs tariffs on Cambodian-made travel products such as luggage, Government debt 36 37 38 backpacks, handbags, and wallets. Once Cambodia loses preferential trade access to the EU and U.S. Export growth 14.9 13.6 12.7 markets in the next decade or so, the country will (% change) likely become less attractive for FDI inflows, and Import growth 14.6 12.0 10.3 its access to concessional borrowing will also be (% change) curtailed. In that regard, authorities need to start Current account -10.3 -10.2 -9.9 taking action now to comply with the requirements and conventions needed to keep accessing the EU FDI 10.9 10.6 10.4 market under the GSP+ scheme (with better terms than under no agreement). Gross international 5.9 6.0 6.0 reserves (months of Risks are growing as domestic credit imports) continues to substantially go to the Source: World Bank staff estimates and projections. construction and real estate sector This, together with Cambodia’s low domestic While rising FDI inflows have so far helped savings rate, increases exposure of the financial boost investment, sustaining high investment sector. Lately, the expansion of real estate sector rates in the long term are only practicably activity has encompassed increased speculative possible with high domestic savings rates. activity, with growing purchases and sales of land Feldstein and Horioka found that international located on the city outskirts or in nearby provinces, differences in domestic savings rates among major with increasingly less obvious or justifiable industrial countries have resulted in almost equal investment returns. The recent surge in FDI corresponding differences in domestic investment inflows has, however, masked the financial sector’s rates.23 As Cambodia endeavors to become high vulnerability caused by lengthy rapid credit growth. income within the next four decades or so, the country will need to sustain a higher investment rate Externally, risks are associated with the potential than it currently achieves. Given Cambodia’s very temporary withdrawal of EBA preferences for low savings rate—and existing heavy reliance of Cambodia. The EU market accounts for more foreign savings through FDI—a larger increase in than a third of Cambodia’s key exports, which are investment rates might not be possible. A simulation garment and footwear products. Therefore, losing presented in the selected issue section shows that EBA preferences will likely shrink Cambodia’s Cambodia will need to increase the investment rate export market share there and negatively impact real to 28.5 percent of GDP (from the current rate of 20 growth, if the temporary EBA withdrawal becomes percent of GDP) by 2030—similar to the path of effective within the next 12 months.24 There is 23  Domestic Saving and International Capital Flows by Feldstein and Horioka, 24  Media Release, October 7, 2018, European Union, Delegation to the NBER Working Paper 310 January 1979. Kingdom of Cambodia. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 30 SECTION 1 – Recent Economic Developments and Outlook no recent study on the impact of the temporary Safeguarding the health of the financial withdrawal. Without EBA, most of Cambodia’s sector is a top priority exports to the EU market will face 12 percent customs. Given the lengthy construction boom, a high priority for the authorities would be to safeguard Potential spill-over effects of U.S.-China the health of the financial sector in the near trade disputes on the economy term. Lately, the real estate sector has shifted toward more speculative activity in which there is A spill-over of U.S-China trade disputes could a growing trend of land sales and purchases with be positive and negative for other countries less obvious or justifiable investment returns in the including Cambodia. On the plus side, higher foreseeable future. The recent surge in FDI inflows tariffs on bilateral U.S.-China trade could create an has masked the financial sector’s vulnerability caused opportunity for other countries to increase exports by prolonged rapid credit growth. It is therefore to U.S. markets. Countries most able to increase necessary to develop macroprudential policies, their export shares to the United States are those including both financial and fiscal measures to that already compete with Chinese exports in the reduce the scope for speculative activities financed United States and can leverage their knowledge of by the banking and microfinance sectors (see box trade processes and existing U.S.-based business 3). It is crucial to adopt lending guidelines including relationships. value-to-loan ratio limits, while considering There are signs that the trade disputes may imposing additional taxes on sales and purchases have resulted in relocations of companies out of property, especially land, for investment of China, and Cambodia has witnessed rising (speculative) purposes. It is equally important to inward Chinese FDI to the garment, footwear, revisit the nonperforming loan to classifications. In and travel goods sectors. The negative impacts of addition, other prudential measures such as loan- the U.S.-China trade disputes would pass through to-income ratio, increased down payment and other to other economies via regional supply chains. factors could be considered. Further U.S. tariffs would push up the final prices Further addressing the infrastructure deficit of Chinese goods in the United States, reducing the is necessary to absorb rising FDI inflows in quantity demanded. This effect would reverberate manufacturing and agroprocessing. While through regional value chains, weakening demand improving, further investment to upgrade and expand for developing country exports that are inputs for physical infrastructure continues to be a priority to Chinese exports to the United States. However, enable Cambodia to better integrate into regional Cambodia seems little affected by this tension since (and global) value chains. This is to take advantage the country’s exports to China, which consist of of Cambodia’s strategic location at the heart of both final and intermediate goods, account for a ASEAN, facilitating and further fostering investment mere 9 percent of its total export to the world.25 for export diversification (see box 2). To facilitate Large possible negative spill-over effects trade expansion, connectivity such as transportation may instead occur through trade in services, and logistics upgrade is being identified with the especially in the tourism sector, and financial preparation of the National Logistics Masterplan and flows mainly in the form of FDI. Tourism, the introduction of the National Logistics Council. especially tourist revenue from Chinese tourists, has In terms of logistics capabilities, Cambodia ranked been one of the main sources of Cambodia’s foreign 98th out of 160 countries on the 2018 Logistic exchanges. Excluding the rising share of Chinese Performance Index (LPI), declining from 73rd tourists, tourist arrivals to Cambodia have recently place in 2016. On average, successful exporters of declined. Similarly, excluding the rising share of electronics, such as Thailand and Malaysia, rank in the inward Chinese FDI, FDI inflows have shrunk. top 40. In addition, upskilling the labor force in the short and medium term will be important.26 25 https://www.adb.org/publications/key-indicators-asia-and-pacific-2018. 26  For a detailed analysis, see selected issue, “Summary Findings of Future Jobs in Cambodia,” April 2018 “Cambodia Economic Update.” 31 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook Cambodia requires a substantial boost in to finance productive investment as Cambodia its investment to achieve its higher-income endeavors to become high income within the next four decades or so. Boosting investment is necessary economy targets to propel the economy toward higher-income status, as envisaged. In this regard, mobilization of savings Mobilizing domestic savings is necessary to is a prerequisite, and developing capital markets, boost investment in the medium to long term. including pension fund systems, will be fundamental. As discussed in the selected issue section, “Can Pro-saving policy measures are therefore needed Cambodia become an upper middle-income economy to encourage households to save and to reward by 2030 and a high-income country by 2050?” below, businesses for reinvesting (see box S2). Developing Cambodia’s gross domestic savings of below 20 the financial ecosystem in order to build trust in the percent of GDP is among the lowest in the region. financial sector, including an enhanced regulatory The country is heavily dependent on foreign savings and supervisory framework, an improved financial in the form of FDI, which is not only volatile but also reporting system, good corporate governance unsustainable in the long term. It is therefore necessary practices, and establishing a financial protection to start generating additional domestic resources system, will help further promote savings. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 32 SECTION 1 – Recent Economic Developments and Outlook 33 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 1 – Recent Economic Developments and Outlook SECTION 2 Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 34 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050?27 I. Introduction After more than two decades of sustained rapid promising opportunities for international companies economic growth, Cambodia attained lower to invest in.30 middle-income status in 2015. With its current Together with Myanmar and Lao PDR, population of 16.1 million, Cambodia’s gross Cambodia is classified among the “Southeast national income (GNI) per capita is estimated to Asian frontier markets” in a report by the have reached US$1,230 in 2017. Official estimates Swedish Trade and Investment Council.31 show that the percentage of Cambodians living “Frontier markets,” also known as pre-emerging under the national poverty line fell from 47.8 percent markets, are developing countries with high potential in 2007 to 13.5 percent in 2014. Real GDP growth for investment, presenting significant opportunities– is projected to grow at 7.1 percent in 2018 and is high growth, low labor costs, and growing consumer expected to expand robustly in the medium term. markets–but requiring long-term work and enormous Unlike many aging regional countries in the infrastructure and construction development, and EAP region, Cambodia is benefiting from a posing challenges in doing business. demographic dividend. Cambodia’s working- Cambodia has set itself a target to become an age population (age 15–64) is growing faster than upper middle-income country by 2030 and a its population—2.3 percent compared to 1.56 high-income economy by 2050.32 This selected percent during 2007–15—freeing up resources for issue is prepared using the World Bank’s Long-Term investment and family income growth.28 Given the Growth Model (LTGM) to shed light on Cambodia’s existing population dynamics, the country has a potential growth during the next 33 years (Loayza window of opportunity for rapid economic growth and Pennings 2018).33 It discusses opportunities during the next 30 years, until its working-age and challenges, if Cambodia is to become an population starts to decline. upper middle-income country in 2030 and a high- Cambodia’s strategic location at the heart of income economy in 2050, including what needs to ASEAN, together with its liberal trade and be improved and what needs to happen. Regional investment policy, has attracted rising inflows of comparisons will be provided to assess the pace of foreign investment. Net FDI inflows into the country gross national income (GNI) per capita growth that account for over 10 percent of GDP on average during Cambodia can reasonably accomplish. the last decade, ranked among the top 20 countries in the This selected issue section is organized as follows. world. Cambodia is the leading Asian country (ahead Section II provides background information on the of Singapore and Vietnam, which ranked second and economy, focusing on structural transformation. third, respectively), and ranked third overall on the Section III uses the LTGM to simulate Cambodia’s 2017 Greenfield FDI Performance Index.29 Cambodia attainment in GNI per capita (Atlas method). Section has been positioned by Euromonitor International’s IV provides key policy options. data as part of the 20 Markets of the Future, providing 27 This Note was prepared by Steven Pennings and Jorge Guzman with inputs from Sodeth Ly and Runsinarith Phim. 28 World Bank staff ’s calculation based on WDI data. 29 https://www.fdiintelligence.com. 30  http://www.euromonitor.com/markets-of-the-future-in-cambodia/report; https://www.fundhive.com/Invest_in_Cambodia_ebook.pdf. 31  https://www.business-sweden.se/contentassets/4ecbc372953f4ed4be227d97c758cd73/frontier-sea-markets-pov---final-report.pdf. 32 See Fourth Rectangular Strategy, Royal Government of Cambodia, September 2018, p. 44. 33  Developed by Steven Pennings, Leonardo Garrido, and Jorge Luis Guzman. See http://www.worldbank.org/LTGM. The LTGM builds on earlier work by Hevia and Loayza (2012). 35 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? II. Structural transformation Cambodia’s gross fixed capital formation as a percentage of GDP averaged less than 20 1. Strong growth, driven by the agriculture, percent of GDP over the last two decades. This is lower than comparator countries and much lower garment, tourism, and more recently, than Vietnam and Thailand during their boom years construction sectors is driving rapid (figure S3). While total investment in Cambodia has economic structural transformation been rising in recent years, it has mostly gone into construction, and not machinery and equipment. Cambodia ranked sixth in the world in economic Cambodia’s low gross fixed capital formation may growth during 1994–2015, with an average be explained by its low national savings rate. As growth rate of 7.6 percent, and is experiencing depicted in figure S4, because the national savings rapid structural transformation. GNI per capita ratio has been low, most of the investment has been grew at an average rate of 5.4 percent between 1996 financed by foreign savings—private investment by and 2015, the year in which Cambodia became a foreign investors and public investment by official lower middle-income economy. This period was development partners. It is estimated that about 10 marked by significant structural transformation to 11 percent of GDP in terms of capital formation in the economy. The share of agricultural GDP is financed by FDI and about half is financed by dropped from 45.3 percent in 1993 to 23.4 percent domestic investment. The rest is public investment, in 2017 (figure S1). Agriculture employment in largely financed by development partners. While total employment declined to 36.4 percent in 2016, capital formation has increased in recent years, down from 58.3 percent in 2004. The decline the allocation of this investment appears to in agriculture jobs continued to be offset by the have become less efficient, as manifested in the increase of employment in the industry and services falling rate of return on investment.34 Equipment sectors, resulting in net employment creation and investment is found to generate more growth absorption of new entrants into the labor force as than building investment, and countries with high population grew (figure S2). equipment investment had higher growth (Summers and DeLong 1991, 1992). 2. Gross capital formulation remains low, The country’s low national savings rate can be with limited ability to mobilize domestic traced to Cambodia’s tragic history, including savings the spillovers of the Vietnam War and a mass FIGURE S1: Structural transformation, 1995–2017 FIGURE S2: Agriculture jobs declined Rapidly declining agriculture GDP (percent share) Contribution to job creation (’000 jobs) Agriculture Industry Agriculture Industry Services 800 Services New jobs 100% 600 90% 80% 400 70% 60% 200 50% 40% 0 30% -200 20% 10% -400 0% -600 95 97 99 01 03 05 07 09 11 13 20 15 /p 2008 2009 2010 2011 2012 2013 2014 2015 2016 19 19 19 20 20 20 20 20 20 20 20 17 Sources: Official sources and World Bank staff estimates. Source: Cambodia socioeconomic surveys. 34  “2017 Cambodia – Sustaining Strong Growth for the Benefit of All: A Systematic Country Diagnostic,” World Bank, Washington, DC, 2017. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 36 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? genocide. During these periods, Cambodia 3. Human capital is accumulating rapidly but experienced persistent hyperinflation. The worst from a low base, while the growing labor happened during the Khmer Rouge regime when the country’s currency was completely abolished force remains inadequately trained and virtually replaced by a barter system for more The most recent enterprise survey revealed than three years. During the 1980s, after the that a significant percent of firms found an Khmer Rouge regime was toppled, the banking inadequately educated workforce to be among sector did not fully function due to instability and the top three obstacles (figure S5). The constraint the continuation of civil war in many parts of of an unskilled workforce is reflected in the World the country. Even after peace was largely restored Economic Forum’s Executive Opinion Survey in the 1990s, confidence in the banking system in which a similar share of firms signaled it as a only slowly improved, and confidence in the local significant impediment to conducting business. currency lagged behind. Cambodia’s persistent high The potential for economic diversification may dollarization is a reflection of its unstable past. be constrained by limited human capital and the Cambodia’s financial sector remains nascent, relatively high costs in terms of informal fees limiting the country’s ability to raise capital and electricity.35 A rapidly rising minimum wage is to finance investment. There is as yet no well- another challenge. functioning capital market or a domestic debt market The accumulation of human capital is crucial in Cambodia, so there is no facility to raise long-term for facilitating economic diversification and funds, while providing opportunity for the public to job creation. Human capital is expected to be invest their long-term savings. Opportunities for increasingly critical as Cambodia endeavors to different institutions such as commercial banks, move up the value chain and diversify beyond mutual funds, or investment trusts in which to low-end garment product exports. While a high invest savings remain limited. Rising FDI inflows degree of openness in terms of regulation helps that Cambodia has experienced during the past increase Cambodia’s ability, relative to its neighbors, decade are associated with the country’s widening to diversify services, the country’s low education savings-investment gap that makes it increasingly attainment is a constraint for moving toward higher- difficult to sustain strong growth in the long run. value-added and more sophisticated sectors and More importantly, with its persistently large current industries (figure S6). account deficit, the economy is increasingly exposed to external shocks. FIGURE S3: Capital formation remains low FIGURE S4: Cambodia’s savings-investment gap Foreign Direct Investment Current Account Balance Gross fixed capital formation (period average, % of GDP) 25 Investment Savings 40 20 35 15 30 25 10 20 5 15 0 10 -5 5 -10 0 China Korea Thailand Vietnam Cambodia -15 (1978-17) (1977-2000) (1977-98) (1994-2011) (2000-17) 95 93 97 99 01 03 05 07 09 11 13 15 17 19 19 19 19 20 20 20 20 20 20 20 20 20 Source: World Development Indicators. Source: World Development Indicators. Note: Savings is defined as a residual equal to the investment rate plus the current account balance. 35  “2017 Cambodia – Sustaining Strong Growth for the Benefit of All: A Systematic Country Diagnostic,” World Bank, Washington, DC, 2017. 37 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? FIGURE S5: Inadequately skilled labor force SMEs FIGURE S6: Low education attainment include “inadequately skilled LF” among their top 3 Education attainment, at least completed lower secondary constraints, ranks lower for large firms (percent of firms) (pop. 25+, total (%), cumulative) 22�9 Singapore 17�6 Philippines 15�7 16 14�2 Malaysia 10�1 10�8 9�6 Vietnam 8�1 Indonesia Thailand Bangladesh 6) 1) 5) 5) c ) 6) Cambodia 01 15 cifi 01 3) ) 01 01 16 01 (2 01 0 (2 (2 Pa (2 (2 20 (2 R (2 ka s am a( sia PD & ar ne h an nm 0�0 20�0 40�0 60�0 80�0 100�0 di es ne ia etn pi iL bo o As lad ilip do ya La Vi Sr m ng M In st Ph Ca Ea Ba Source: Enterprise Survey 2016. Source: WDI and CSES 2016. Note: The data are 2016 or most recent available years. The section below discusses opportunities per capita growth at 9.3 percent over 2018-30 to and challenges for Cambodia in pursuing an reach the 2030 upper middle-income goal, and 7.2 upper middle-income target in 2030 and a high- percent over 2018-50 to reach the 2050 high-income income target in 2050 as set forth in the fourth target. In contrast, over the last five years, GNI per Rectangular Strategy.36 To that end, the section capita has grown at around 5.2 percent (figure S7), specifically simulates Cambodia’s GNI per capita so the 2050 goal requires increasing growth by 2 attainments during the next 33 years by employing percentage points (ppts), whereas the upper middle- the World Bank’s Long-Term Growth Model- income goal requires almost doubling GDP per (Loayza and Pennings 2018). capita growth. Note that GDP per capita and GNI per capita grow at roughly similar rates, and we will III. Assessing Cambodia’s use the terms interchangeably.38 long-term growth potential Growth targets FIGURE S7: GDP per capita and GNI per capita Cambodia is endeavoring to become an upper growth at roughly similar rates (percent) middle-income country by 2030 and a high- income economy by 2050; however, achieving 12% Real GDP PC growth these targets requires rapid and sustained 10% Real GNIPC Growth economic growth. As classified by the World Bank 8% Group, upper middle-income economies are those with a gross national income per capita (GNIPC) 6% (Atlas method)37 of at least US$3,896, and high- 4% income economies are those with a GNI per capita 2% of at least US$12,056. In 2017, Cambodia had a GNI per capita of US$1,230, which means the gross 0% national income per capita must more than triple in 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 -2% 13 years to reach the 2030 upper middle-income target, and be almost 10 times larger in 33 years. In Source: World Development Indicators. other words, these targets require sustaining GNI Fourth Rectangular Strategy, Royal Government of Cambodia, September 2018. 36  https://datahelpdesk.worldbank.org/knowledgebase/articles/378832-the-world-bank-atlas-method-detailed-methodology. 37  The upper middle-income and high-income targets are defined in nominal U.S. dollar terms at market exchange rates averaged over several years (the Altas method). The 38  World Bank revises the cutoffs annually, usually upward to reflect inflation, so what the actual cutoffs will be in 2030 and 2050 are impossible to know. Instead, we make two simplifying assumptions: (a) the cutoffs stay constant in real terms (they increase with U.S. dollar inflation), and (b) GNI and GDP grow at the same rate. Historically, during 1996–2017, (c) is approximately true: the average growth rate of GNI was only 0.25 ppts slower than GDP growth. Over the period to 2030, a 0.25 ppt annual gap accumulates to 3 ppts, and over the period to 2050, 7 ppts. However, these are almost rounding errors relative to a three-fold or 10-fold increase in GDP per capita over the same period. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 38 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? Looking at development paths of rapidly saving around 35 percent of GDP in 1994, Cambodia growing Asian countries from when they were has never saved much more than 15 percent of at Cambodia’s level of income (figure S8), all GDP, as depicted in figure S4, above. Increasing except China missed the upper middle-income savings and investment rates may be possible over (2030) target, and all except the Republic of the long term (discussed further below), but they are Korea missed the high-income (2050) target. generally difficult to increase quickly. Malaysia was at Cambodia’s GNI per capita around Malaysia’s and Korea’s experience of slowly 1958 and Thailand in 1975. Despite high growth increasing investment rates are a better guide: rates in both countries, they substantially missed the a similar initial investment rate as Cambodia, goal of tripling gross national income per capita in increasing to around 30 percent of GDP after 13 years, or increasing it 10-fold in 33 years. Vietnam 15 years (figure S10). Investment rates in Malaysia was in Cambodia’s position much more recently and Korea were originally quite low as a share of (2006), but seems to follow similar growth paths as GDP, and in fact sometimes lower than Cambodian Thailand and Malaysia. Korea was at Cambodia’s investment rates today. But both countries managed level of development around 1963, but despite to increase them by around 10 ppts of GDP during spectacular growth as an “Asian tiger” economy, it the 1960s and early 1970s, to achieve investment rates also missed the upper middle-income target, though of 28 to 33 ppts. We consider this a more achievable it managed to reach the high-income target.39 path for Cambodia, and a guide for “investing like China’s recent experience is not a good guide Korea or Malaysia” simulations below. for Cambodia because of its very high initial rates of investment and savings. When China Simulating Cambodia’s growth prospects was at Cambodia’s level of development (around under business-as-usual scenario reveals that 1994), it was already investing around 35 percent of the country will miss both the upper middle- GDP, which hit 45 percent of GDP 15 years later (figure S9). In contrast, Cambodia currently invests income and high-income growth targets 22 percent of GDP and until recently invested less The World Bank Long-Term Growth Model than 20 percent. In practice, high investment rates (LTGM) is an Excel-based tool building on the are only practically possible with high savings rates, celebrated Solow-Swan growth model, and is even for countries with open capital accounts (the used for simulating Cambodia’s growth path Feldstein-Horioka Puzzle). Whereas China was under several scenarios. The LTGM includes FIGURE S8: Most fast-growing comparison countries FIGURE S9: China’s investment rate was extremely missed the upper middle-income target high, even when at Cambodia’s level of development Growth path of comparison countries from when they were at level of development 16 50 50 Korea 1963=0 Thailand 1975=0 GNI PC Magnitude Increase (multiple of Vietnam 2006=0 China 1994=0 HI2050: 45 45 $12,056 Malaysia 1958=0 Thresholds 40 40 8 35 35 UMI 2030: 30 30 4 $3,896 US$1230) 25 25 GNIPC20:17 20 20 $1,230 2 15 15 10 China 1994=0 Thailand 1975=0 10 1 5 Vietnam 2006=0 5 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 0 0 Years from when country was at Cambodia's development level 0 5 10 15 20 25 30 35 40 (US$1230) 0�5 Years from when country was at Cambodia’s development level (U$$1230) Source: World Development Indicators. Source: World Development Indicators. Note: $1,230 GNIPC (current Atlas dollars) in Cambodia is $1,062 in 2010 U.S. dollars. Calculations are based on when countries’ GNIPC was at that level (in 2010 U.S. dollars). Real GDPPC growth rates from PWT9 or WDI used to backfill series when real GNI is missing. 39  We also considered Singapore and Japan, but GNI per capita was above that investment, total factor productivity, human capital, of Cambodia when annual data started in 1950. 39 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? demographics, and other growth drivers that are differences. First, the default baseline assumes a important for developing and emerging economies. higher investment rate of 22 percent of GDP, as in (See Annex and www.worldbank.org/LTGM for 2017 and IMF forecasts, whereas the conservative a description of the LTGM, or to download the baseline assumes an investment-to-GDP (I/Y) model spreadsheet.) ratio of 20 percent, like the most recent 5- or 10- year average. Second, the default baseline assumes There are two business-as-usual baselines: a lower labor share (40 percent) based on Global a default baseline, which delivers 7 percent Trade Analysis Project (GTAP) data, which boosts headline GDP growth initially (similar to 2013– the effectiveness of investment for economic 17), or a more conservative baseline, which growth. Often, the GTAP labor share is too low, delivers 6.1 percent growth (similar to 2008–17). as the informal sector income is counted as capital Growth in each baseline is fairly stable (figure S12), income. So, the conservative baseline assumes 50 increasing by around 0.5 ppts over the period to percent instead, which is closer to the cross-country 2045, before slowing (mostly due to demographics, lower middle-income median of 53 percent (Barrot as discussed below). As can be seen from figure S11, 2016). Other features of the baselines are common headline growth (not per capita) has been stable at (see table S1): (a) a capital-to-output ratio of 2—a around 7 percent since 2011, which is targeted by low-to-medium value, which results from high the default baseline, though if one includes the growth and modest investment; (b) a fairly rapid financial crisis, growth is almost a percentage point human capital growth rate of 1.5 percent, based on slower (targeted by the conservative baseline). Penn World Tables v9 data averaged over the last The different growth rates of the default decade,40 and (c) a high total factor productivity and conservative baseline stem from two growth rate of 2 percent—a residual stemming from high growth rates but relatively low investment.41 FIGURE S10: Korea and Malaysia were able to FIGURE S11: Cambodia’s historical growth has increase investment rates, starting from Cambodia’s been rapid but stable at around 7 percent since 2011 level (percent) Comparative Investment-to-GDP ratio (percent) 45 45 14 40 13-32 yr average = 33% 40 12 35 35 10 30 30 25 25 8 20 20 6 13-32 yr 15 average = 15 28% 4 10 10 Korea 1963=0 Malaysia 1958=0 5 5 2 Korea 1963=0 Malaysia 1958=0 0 0 0 0 5 10 15 20 25 30 1996 2001 2006 2011 2016 Years from when country was at Cambodia's development level (US$1230) GDP Growth Rates 5 yr avg 10 yr avg 15 yr avg 20 yr avg Source: World Development Indicators (solid lines), Penn World Tables v9 Source: World Development Indicators. (dashed lines) Human capital is defined as the productivity of a worker with average years of schooling, relative to the productivity of a worker with no schooling. Productivity estimates 40  are based on how wages increase with schooling, as in a Mincer regression. The years of schooling are not quality adjusted. In 2014, the average years of schooling were 4.6, yielding a human capital measure of 1.8. This human capital growth rate is the same as in Korea during 1960–2014, and so is already quite high. The TFP growth rate is higher than Korea’s in every decade except 41  the 1980s (Jeong 2017). As a result, there is little room for material increases in the rate of total factor productivity or human capital growth, which is why they are not considered as ways to boost growth further in this section. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 40 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? TABLE S1: Summary of Key Parameters and Assumptions Variable Conservative Default Source/Comments Panel A: Universal Parameters/Assumptions Capital-to-Output 2.0 PWT 8.1 for 2010: 2.07, PWT 9 for 2014: 2.03. Ratio Human Capital Growth 1.5% Similar to PWT 9 5- to 10-year average TFP Growth 2% PWT TFP growth is missing. 2% is between the 2.2% for the 20-year average, and 1.3% for 10-year average (by own calculations) and around 95th percentile for the 20-year average, across countries Depreciation Rate 4.7% 2011 for the PWT 8.1 Population Growth 1.54%...0.54% UN Population projections (via World Bank and 2017…2050 Hunan Development Network) GNI PC Level (2017) US$1,230 Panel B: Business-as-usual baselines (other parameters as in Panel A) Investment-to-GDP 20% 22% Conservative: Close to the 5–10-year average. ratio Default: Equal to the 2017 value Similar to the IMF Article IV estimates for the near future 2018-2023 Labor Share of Income 50% 40% Default: GTAP (38%) (PWT data is missing) Conservative: Cross-country median (50%)* Implied headline GDP 6.1% 7.0% The 7% GDP headline growth rate is consistent Growth in 2018 with the IMF Article IV estimates Panel C: Scenarios with higher investment to reach the growth target (other parameters as in Panel A or B) Investment-to-GDP 28% 33% Default: Korea investment rate (1978–95 ave, ratio by 2030–50 WDI) Cons: Malaysia’s investment rate (1971–90 ave, WDI) Note: *GTAP labor share may be biased downward as informal sector business income is counted as profits rather than labor. GTAP = Global Trade Analysis Project; PWT = Penn World Table; TFP = total factor productivity. 41 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? The per capita growth rate (figure S13)—which 0.5 ppts over 2043–48, as depicted in figure S14.43 is what is relevant for the upper middle-income If Cambodia continues to grow at current and high-income targets—is initially around 1.5 rates—at the business-as-usual baselines— ppts slower than the headline GDP growth rate the country will miss both the upper middle- (figure S12), though the gap narrows in the outyears income and high-income growth targets (figure as population growth slows. Current population S15). Cambodia needs to grow at 9.3 percent in growth in Cambodia is around 1.5 percent but per capita terms to reach the upper middle-income is expected to fall to 0.5 percent by 2050 (figure target by 2030, yet only averages 6 percent per capita S14) according to UN projections. The declining growth in the default baseline, and 5 percent in the population growth increases GDP per capita growth more conservative baseline over that period, as by around 0.3 ppts by 2050 in the default baseline depicted in figure S13—resulting in a sizable miss but reduces headline growth by around 0.7 ppts.42 where gross national income per capita is less than There is a small demographic dividend from an two-thirds of the target. The high-income target by increasing share of the population of working age, 2050 requires 7.2 percent per capita growth, which which boosts growth by around 0.1 to 0.2 percent is still above the 5.4 to 6.4 percent average per capita for 2023–43. After 2043, the demographic dividend growth of the baselines over this period, resulting in becomes a cost as the population ages, which is what gross national income per capita that is only three- causes the decline in per capita growth of around fourths of the target. FIGURE S12: Cambodia Real GDP Growth Rate FIGURE S13: Cambodia GDP Per Capita Growth Rate 9�0% 8�0% 8�0% 7�0% 7�0% 6�0% 6�0% 5�0% 5�0% 4�0% 4�0% 3�0% 3�0% 2�0% 2�0% 1�0% 1�0% 0�0% 0�0% 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 Default Conservative Default Conservative Source: World Bank Group’s LTGM. Source: World Bank Group’s LTGM. FIGURE S14: Cambodia Demographics FIGURE S15: Cambodia GNI PC Level (US$) 2�0% 16000 HI 2050: $12,056 1�5% 1�0% UMI 2030: $3,896 0�5% 4000 0�0% 2017 2020 2023 2026 2029 2032 2035 2038 2041 2047 2050 2044 -0�5% -1�0% 1000 -1�5% 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2042 2044 2046 2048 2050 2040 Population Growth Default Conservative Working age-to-total popul growth Growth Targets Source: World Bank Group’s LTGM. Source: World Bank Group’s LTGM. 42  In the conservative baseline, declining population growth increases GDP per 43  In Korea, changes in the working-age population ratio and labor force capita growth by 0.2 ppts and decreases headline GDP per capita growth by participation added around 0.5 ppts each to growth during 1960–2014 (Jeong 0.8 ppts. 2017). CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 42 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? Cambodia may achieve [some] relevant, given they did manage to achieve high- income status around 33 years after they were at growth targets through higher Cambodia’s development level. Specifically, our investment first simulation starts at the default baseline, and increases investment rates to Korea’s 33 percent of a) With an “investing like Korea” simulation, GDP by 2030. Our second simulation starts with the Cambodia reaches the high-income 2050 conservative baseline and increases investment rates target, but misses the 2030 upper middle- to Malaysia’s rate of 28 percent of GDP by 2030. income target With a rapid increase in investment and default parameters, Cambodia reaches the high-income To accelerate growth, Cambodia might like 2050 target, but misses the 2030 upper middle- to follow the path of Malaysia or Korea by income target (figure S17). Figure 16 displays the increasing investment rates to 28 to 33 percent simulated increase in investment rates in our first by 2030. As indicated in figure S10, both Korea and “investing like Korea” simulation, where investment Malaysia started with investment rates similar to that increases 11 ppts of GDP (from 22 percent to 33 of Cambodia currently, but then increased them to percent) over 2018–30. The extra investment boosts around 28 to 33 percent of GDP (respectively) over growth by almost 2.5 ppts by 2031, which results in per around 15 years. Korea’s experience is particularly capita growth of 8.8 percent (figure S18) and boosts FIGURE S16: Cambodia Investment to GDP Ratio FIGURE S17: Cambodia GNI PC Level (with Korean investment rates from 2030) 35% 16000 HI 2050: $12,056 30% 25% UMI 2030: $3,896 20% 4000 15% 10% 5% 0% 1000 2018 2020 2022 2024 2026 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2028 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 2049 Default Default Default + I/Y 33% by 2030 (like Korea) Default + I/Y 33% by 2030 (like Korea) Growth Targets Source: World Bank Group’s LTGM. Source: World Bank Group’s LTGM. FIGURE S18: Cambodia GDP Per Capita Growth FIGURE S19: Cambodia Real GDP Growth Rate Rate 10�0% 10�0% 8�0% 8�0% 6�0% 6�0% 4�0% 4�0% 2�0% 2�0% 0�0% 0�0% 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 Default Default Default + I/Y 33% by 2030 (like Korea) Default + I/Y 33% by 2030 (like Korea) Source: World Bank Group’s LTGM. Source: World Bank Group’s LTGM. 43 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? headline growth to almost 10 percent (figure S19). Therefore, with more conservative (and perhaps However, the level of GNI per capita still falls about realistic) assumptions regarding investment and 20 percent short of the 2030 upper middle-income the capital share, both growth targets are missed. target as depicted in figure S17, in part because of the Figure S20 displays the increase in investment rates ambition of that goal, and in part because the increase in our “investing like Malaysia” simulation, where in investment rates are phased in over a period of investment increases 8 ppts of GDP (from 20 percent more than a decade (like in Korea). On the plus side, to 28 percent) during 2018–30, with a capital share Cambodia does reach the high-income target. In fact, of 50 percent. Given Cambodia’s very low savings the 2050 target is exceeded; Cambodia only needs an rate—and existing heavy reliance of foreign savings investment-to-GDP ratio of 28.3 percent from 2030 through FDI—a larger increase in investment rates to reach that target. might not be possible. The extra investment boosts growth by almost 1.5 ppts by 2031, which results in b) If investment follows the path of Malaysia per capita growth of 7 percent (not reported) and and more conservative (and perhaps realistic) headline growth of almost 8 percent (figure S22). assumptions for the capital share, Cambodia Unfortunately, all targets are missed: the upper middle-income target is still missed (though with a will likely miss both growth targets wider margin), and Cambodia now misses the 2050 high-income target by 25 percent, as depicted in figure S21. FIGURE S20: Cambodia Investment to GDP Ratio FIGURE S21: Cambodia GNI PC level [conservative] (with Malaysian Inv/Y from 2030) 30% 16000 HI 2050: $12,056 25% 20% UMI 2030: $3,896 15% 4000 10% 5% 0% 1000 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 2049 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 Conservative Baseline Conservative Baseline Conservative + I/Y 28% by 2030 (like Malaysia) Conservative + I/Y 28% by 2030 (like Malaysia) Growth Targets Source: World Bank Group’s LTGM. Source: World Bank Group’s LTGM. FIGURE S22: Cambodia Real GDP Growth Rate FIGURE S23: [Marginal] Incremental Capital Output Ratio (ICOR) 10�0% 5�0 9�0% 4�5 8�0% 7�0% 4�0 6�0% 3�5 5�0% 4�0% 3�0 3�0% 2�0% 2�5 1�0% 2�0 0�0% 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2018 2020 2022 2024 2028 2030 2032 2034 2036 2038 2040 2042 2044 2048 2050 2026 2046 Conservative Baseline Conservative Baseline Conservative with higher Inv/Y Conservative + I/Y 28% by 2030 (like Malaysia) Default Baseline Default with higher Inv/Y Source: World Bank Group’s LTGM. Source: World Bank Group’s LTGM. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 44 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? Cambodia fails to hit its growth targets with the c) Implications for required savings second conservative simulation in part because of the lower rate of investment, but also because The current account deficit is likely to shrink the effect of investment on growth is lower. The in the long term from its current elevated level. effectiveness of investment in boosting growth Around 9 ppts of the 22 percent investment rate are can be measured in the LTGM by the marginal funded by foreign savings in the terms of a current incremental capital-to-output ratio (ICOR), which account deficit. The current account balance of is the size of the increase in investment required to comparator countries, Malaysia and Korea, averaged generate an extra 1 ppt of growth (the inverse of the around -2 percent of GDP in the 20+ years from marginal product of capital).44 The marginal ICOR when data begin to the Asian financial crisis (figure is calculated as the capital-to-output ratio (initially S24), though the current account balance was 2 in all simulations) divided by the capital share of very volatile during that time. In the 20 years to income (1- the labor share). The capital share is 0.6 2012, the Cambodian current account balance was in the default baseline, but 0.5 in the conservative relatively stable at -5 percent of GDP, which is often baseline. This yields marginal ICORs of 3.3 (default) considered a rule-of-thumb threshold for a possibly compared to 4 (conservative), which means an extra unsustainable deficit. Although Cambodia’s current unit of growth requires 20 percent more investment account deficit is driven by FDI, it is likely to close with the conservative parametrization (figure S23). somewhat during the simulation period. Based on Cambodia’s own history, we assume that the current High rates of investment also become less account balance converges to -5 percent of GDP by effective over time in boosting growth. Dynamically, 2030 (figure S25). investment-driven growth leads to a faster increase in the capital stock than GDP, results in an increase in To maintain current investment rates—or the capital-to-output ratio and the marginal ICOR, and increase investment to reach the growth target— hence a fall in investment effectiveness. This is the reason Cambodia will have to increase savings rates the boost to growth falls after 2031 in all the simulations dramatically (figure S25). Given the assumed paths with higher investment (figures S18, S19, and S22). For for investment and the current account balance, example, in 2050 with the conservative parametrization, required savings rates as a share of GDP can be an extra unit of growth requires 30 percent more calculated simply as the sum of the investment rate investment with the higher investment (marginal ICOR and the current account balance (both as shares of = 4.7), than in the baseline (marginal ICOR = 3.65). GDP). FIGURE S24: Malaysia and Korea: Savings and FIGURE S25: Cambodia Savings and CAB Current Account Balance (percent of GDP) (percent of GDP) 20+years pre-Asian Financial Crisis* Korea: Current Account Balance 30% Malaysia: Current Account Balance Malaysia: Savings Korea: Savings 40 20% 30 1997 Asian Financial Crisis 10% Required Savings: Default Baseline 20 10 0% 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 2049 0 -10 -10% -20 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 -20% Source: World Development Indicators. Source: World Development Indicators. Note: *In 1998, the current account balance moved into a surplus of more than 10 percent of GDP 44  The traditional ICOR is measured as the ratio investment to growth and is commonly used as a rule of thumb for investment effectiveness. The marginal ICOR is its analogue in the LTGM, which allows for the fact that growth is also affected by other non-investment factors. 45 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? Cambodia currently saves around 13 percent of they also maintained those growth rates over long GDP, so to maintain current rates of investment it horizons. This is particularly relevant for the goal will have to increase savings to 17 percent of GDP of becoming a high-income country by 2050, which by 2030—a 4-ppt GDP increase. If Cambodia requires maintaining growth for more than 30 years. increases investment rates to those of Korea (33 As the quote from Jones and Olken (2008) above percent of GDP by 2030), savings rates will have suggests, periods of fast growth are common among to increase to 28 percent of GDP—a 15-ppt GDP developing countries. But the difficulty is that they increase. Savings rates in Malaysia and Korea are not maintained, and instead per capita incomes averaged around 30 percent of GDP around 15+ stagnate or decline. Cambodia’s own experience bears years after they were at Cambodia’s current level this out: although growth has been fairly stable since of development, with a strong upward trend as the mid-1980s, political instability before that resulted depicted in figure S24. Box S1 provides additional in rapidly falling per capita incomes (figure S27). information on comparison countries, and box S2 suggests ways that policy can help support higher Cambodian policy makers might like to savings rates in Cambodia. consider policies to extend their growth spells in addition to policies to accelerate growth. Berg, The challenge of sustaining Ostry, and Zettelmeyer (2012) list policies that are growth: cross-country evidence associated with longer periods of expansion. First, they find that countries that are growing faster tend “[V]irtually all [developing] countries to have less durable expansions, which is consistent with the fact that overheating economies are more experience both growth miracles and failures likely to fall into recession.45 Second, they find over substantial periods [10–15– year time countries that are more equal, have more democratic scales]…but sustaining growth is difficult and institutions, greater export orientation, and greater may pose a very different set of challenges macroeconomic stability are likely to have more durable growth. Cambodia already scores well on than starting it” (Jones and Olken 2008). many of these, such as economic equality (with a The key to long-term development is often more low Gini coefficient of around 0.31), strong export about maintaining growth than accelerating orientation (high FDI and strong export growth), growth. The world’s richest large country, the United and a stable macroeconomic environment. Political States, never grew extremely fast. Rather, it maintained variables are also important. Specifically, Berg, a steady rate of 2 percent per capita growth for more Ostry, and Zettelmeyer (2012) find that constraints than a century (figure S26, taken from Jones [2016]). on executive power and political competition seem Although other Asian countries, such as Singapore, to be associated with more durable growth, and Malaysia, and Korea, achieved fast growth rates, autocracy is associated with less durable growth. FIGURE S26: United States: Real GDP per capita FIGURE S27: Cambodia level of GDPPC Log scale, chained 2009 dollars 64,000 8 Log Real GDP per capita 32,000 7�5 16,000 2�0% per year 8000 7 4000 6�5 2000 1880 1900 1920 1940 1960 1980 2000 1970 1980 1990 2000 2010 Year Year Source: Jones (2016). Source: PWT9. 45  Higher current account balances and savings rates are also sometimes related to a more durable expansion. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 46 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? Box S1 Regional experience1 FIGURE SB1: Government spending on education (percent of GDP) Malaysia, Indonesia, and Thailand are three among the eight countries in East Asia the economies of 6 1960 1990 2016 which grew so rapidly during 1960–1990 that their 5 growth has been referred as the “East Asian miracle.” 4 High rates of investment, in particular unusually 3 high rates of private investment, combined with 2 1 high and rising endowments of human capital due 0 to universal primary and secondary education, tell a Malaysia Thailand Indonesia Cambodia large part of their growth successes. Governments of Source: WDI and ADB. these countries have focused education spending on the lower grades first by providing universal primary education, and later by increasing the availability of the export processing zones, primarily from foreign- secondary education. More than three-quarters of owned firms. the education budget was allocated to primary and In the 1970s, Thailand followed import substitution secondary education. Rapid demographic transitions strategies favored by many other developing facilitated these efforts. Declining fertility and rapid economies by raising tariffs on consumer goods economic growth meant that, even when education to a range of 30 to 55 percent. Capital and investment as a share of GDP remained constant, intermediate goods entered with low duty rates. more resources were available per child. They Textiles, pharmaceuticals, and automobile assembly limited public funding of postsecondary education, were particularly favored. At times, vehicles imports which primarily focused on technical skills. were banned. Domestic content requirements and Malaysia and Thailand adopted import substitution parts raised production costs in the assembly sector and a wide variety of export incentives, while while subsidizing the producers of inputs. The shifting from resource-based to manufactured second oil shock exposed weaknesses in the Thai export. Exchange rate policies were liberalized and economy tainted with import substitution policies currencies frequently devalued to support export of the 1970s. In 1981, Thailand’s trade policy shifted growth. Overall, these policies exposed much of explicitly in the direction of export promotion. the industrial sector to international competition Automatic and concessionary credit was another and resulted in domestic relative prices that were major element in the export promotion strategy. closer to international prices than in most other The Bank of Thailand had traditionally extended developing economies. Under Malaysia’s New refinancing facilities, through the commercial banks, Economic Policy launched in 1971, major export to key economic sectors. As part of the export incentives included taxable income deductions incentives package, Bank of Thailand revised its linked to export performance and domestic rediscount rules to focus more explicitly on small, input content, tax allowances for export-related nontraditional exporters and on other productive promotional expenses, and accelerated depreciation activities. for firms exporting more than 20 percent of their The outcome of these policy changes was dramatic. output. Credit policies promoted exports through By 1986, light manufactures represented 30.6 guarantees and automatic rediscounting of export percent of a growing volume of Thai exports. financing at low interest rates. Export processing Leading sectors include clothing, footwear, artificial zones, free trade zones, and licensed manufacturing flowers, jewellery, and integrated circuits. Foreign warehouses that permitted duty-free import of direct investment played a major role in the export materials to be assembled or processed for export boom, as firms from the more developed economies were crucial to the successful combination of import in Asia moved more labor-intensive manufacturing substitution and export promotion. By 1980, about processes offshore. 70 percent of manufactured exports originated in 1 Prepared by Runsinarith Phim, Consultant, World Bank. 47 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? Box S2 Promoting Savings1 Malaysia, Indonesia, and Thailand increased savings could be one of the important policy objectives to and investment with a combination of fundamental discourage speculative lending, which has become and interventionist policies. Two fundamental the main source of financial disruption in Thailand, policy areas provided a foundation for high and as it was in other East Asian economies during the rising saving rates. First, by avoiding inflation, they 1980s. avoided volatility of real interest rates on deposits and ensured that rates were largely positive. As a Thailand also followed other East Asian peers by result, they have generally offered higher real interest imposing a mandatory savings scheme after the rates on deposits in the financial system than other 1997 Asian financial crisis. The scheme has three developing economies. Second, they ensure the pillars. Pillar 1, for private sector employees, and security of banks and made them more convenient pillar 2, for government officials, are complemented to small and rural savers. by the provident funds (pillar III). Provident funds Malaysia promoted national saving by creating are offered by corporations and state enterprises postal saving systems. These systems attracted to their employees. Under pillar III, employee’s multitudes of small savers by giving them security contributions must be at least 3 percent of wages but and convenient access. The Malaysian government must not exceed 15 percent. Employer contributions also used compulsory pension plans to boost must not be less than employee contributions. The domestic savings.2 Two rationales are given for such employees receive lump sum proceeds when they plans. First, most developing countries lack private resign or retire. Funds are generally placed in the annuity markets, and the few that exist are barely custody of major financial institutions licensed by functional. Indexed annuities, for example, are rarely the Ministry of Finance. In addition to the provident available, and nonindexed annuities are often priced funds, Thailand has retirement mutual funds that are unattractively because of large transaction costs and problems of adverse selection. Second, even when similar to U.S. individual retirement accounts (IRAs). annuities are available, people may not save enough An individual can set up a personal account with any for their old age, and governments end up assisting authorized financial institution. Contributions are elderly people who are unable to support themselves. tax deductible up to the stipulated limit. Retirement To avoid this free-rider problem, government may mutual funds were introduced in Thailand in March require citizens to have at least a minimum level of 2001 to provide a means of voluntary retirement savings for retirement. savings for employees not in the provident fund or Thailand established the Government Saving Bank wanting to make additional contributions. Investors (GSB) in 1913 with the mandate of promoting are given broad freedom in fund asset allocation. saving among the Thai population, with a special However, withdrawal is not permitted until age 55. focus on kids and students. To enhance people’s trust TABLE S2.1. Public and private savings (% of GDP) in the GSB, the Royal Thai Government explicitly guarantees GSB’s saving accounts. With this targeted Economy Public Savings Private Savings mandate, the GSB has initiated several saving Malaysia options with a lot of saving campaigns. The GSB 1961–80 3.2 18.7 is partly contributing to the strong domestic saving 1981–90 10.3 19.1 habits. The Royal Thai Government imposed several Thailand regulations to enhance the solvency of financial 1980–85 14.3 4.7 institutions, which improved both the savings rate 1986–87 8.6 14.6 and the efficiency of resource allocation. Thailand introduced prudential regulations in the 1980s in the Indonesia forms of capital adequacy requirements, collateral 1981–88 7.7 14.0 requirements and lending restrictions, and central Source: “East Asia’s Miracle,” World Bank. bank’s direct supervision. Lending restrictions 1 Prepared by Runsinarith Phim, Consultant, World Bank. 2  “Financial Markets, Public Policy, and the East Asian Miracle,” Joseph Stiglitz and Marilou Uy, World Bank, Washington, DC, 1996. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 48 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? IV. Policy options greater borrowing might lead to excessive credit growth and a banking crisis. Combinations of these The results of the Long-Term Growth Model have affected Cambodia’s peers in the past, with indicate that Cambodia will likely miss the upper disastrous consequences. On the microeconomic middle-income target by 2030, even with higher side, the quality of investment can suffer as investment. However, there is an opportunity that investment projects are approved with the goal of Cambodia may be able to reach the high-income increasing growth rather than generating a market- target by 2050 with a large boost to investment. based return. What can Cambodian policy makers do? Second, Cambodia should seek to maintain First, Cambodia should consider delaying the strong rates of human capital and total factor 2030 upper middle-income (UMI) target to 2035 productivity growth. In the background of all the (figure S28) as the 2030 target is unlikely to be simulations above is rapid growth in human capital met, given other Asian tiger economies would per worker and total factor productivity (TFP), have missed such a goal when they were at which have supported rapid growth at around 7 Cambodia’s development level.46 The simulations percent in recent years. Growth in human capital above have shown that even with rapid total factor and TFP is important to retain competitiveness as productivity and human capital growth, as well as a (a) wage growth reduces Cambodia’s comparative massive increase in investment similar to the level advantage as a low-wage economy, and (b) rising of Republic of Korea rates, Cambodia will still miss income means Cambodia will no longer be eligible the 2030 UMI target. This is neither surprising nor for trade preferential treatment, which is accorded a cause for concern: even fast-growing Korea and to least developed countries. Malaysia would have missed that target. Per capita Maintaining the same rate of growth requires growth would have to average 9.3 percent over 13 further reforms, as the easy gains have already years, a feat almost no other country has achieved. been made. In addition, as discussed, global In contrast, a UMI target by 2035 is achievable: conditions are expected to become less supportive it would require average per capita growth of 6.6 for EMDE growth (see Box 1: Global and Regional percent. Given that per capita growth over the last Economic Outlook) and Cambodia is no exception. five years was 5.2 percent, this is still an ambitious Cambodia’s fast rates of human capital and TFP goal and one that will be missed under “business- growth over the last decade are impressive, but they as-usual.” However, it is achievable if Cambodia were able to increase investment rates (figure S28), FIGURE S28: Cambodia GNI PC Level as discussed further below. (with 28.5 percent investment rates from 2030) Trying to grow too rapidly can lead to 16000 imbalances that can threaten the sustainability HI 2050: $12,056 of growth.47 Another reason to postpone the UMI target UMI 2030 target to 2035 is to make sure that the UMI 2030: $3,896 moved to 2035 4000 economy does not overheat in the pursuit of that goal. Trying to achieve an overly ambitious growth target might lead to policies that boost short-term growth but threaten long-term growth. On the 1000 macroeconomic side is the possibility of excessive 2018 2020 2022 2026 2028 2030 2032 2034 2036 2040 2042 2044 2046 2048 2050 2024 2038 current account deficits and a sudden stop in capital Default flows, driven by excessive investment. Alternatively, Default + I/Y 28�5% by 2030 Growth Targets policies designed to increase firm investment via Source: World Bank Group’s LTGM. This recommendation is based on the current level of GNI per capita. Many 46  developing countries have improved the methodology to calculate GDP and GNI, which has resulted in those values being revised upward. In that case, the UMI 2030 target might be more achievable. Imbalances that Cambodia may face, if it tries to grow too fast, include 47  unsustainable fiscal deficit and external debt, financial sector instability, and runaway inflation. 49 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? are off a low base from where gains are easily made. upside potential to improve Cambodia’s business For example, moving workers from rice farming to environment. Cambodia is currently ranked 138th garment manufacturing leads to a large increase in out of 190 countries in Doing Business ranking in productivity. But these are a one-off: increasing the 2019, declining from 135th in 2018 and 131st in 2017. productivity of current garment manufacturers is While the country is ahead of Lao PDR (154th), it is more difficult. The same applies to human capital: far behind many regional countries such as Indonesia providing a basic education can provide large gains (73rd), Vietnam (69th) and Thailand (27).50 In the off a low base, but future advances are more difficult. latest Investment Climate Assessment (see box 2), while acknowledging the significant progress made, In the short to medium term, enhancing the assessment concludes that the current investment human capital by improving access and climate hampers improvements in productivity, quality education, especially at the primary diversification, and the development of a dynamic and secondary levels, is necessary. The recent local private sector. gains from achieving universal primary education are undermined by poor learning outcomes in Third, Cambodia will need to increase primary education.48 It is necessary to address poor investment rates. Figure S28 suggests that an learning outcomes attributed to a combination of increase in investment to 28.5 percent of GDP by fewer and poor-quality teachers compared to peers, 2030–similar to the path of Malaysia–is needed to fewer learning hours, and delayed engagement reach both the upper middle-income 2035 and high- of children in schools due to low early childhood income 2050 goals. The simulations in figure S28 education enrollment. In addition, lower secondary are similar to those above using the default baseline completion rates, at 47.4 percent in 2016, are the (not the conservative basline, in which investment lowest in the region. Stronger human capital is less effective for growth). However, this time (a) we crucial not only for enabling people to take up calculate the increase in investment by 2030 required better job opportunities in the non-farm sector, but to just achieve the growth targets (rather than also for facilitating economic diversification and job following the experience of other countries), and creation (see box S1 for regional experience). (b) the upper middle-income 2035 target is easier to reach. Starting at 22 percent of GDP investment Maintaining TFP growth will involve today, it involves an increase in the investment rate continued structural transformation, as well as by 6.5 ppts. To put this in context, investment rates further reforms to increase the quality of the also increased by around 6.5 ppts from the mid-to- business environment.49 In addition to structural late 1990s to the early-mid 2000s, suggesting this an transformation across sectors (moving labor from achievable increase (figure S4). It is also a path taken agriculture to manufacturing and services), TFP by comparator countries like Malaysia (figure S10). growth in developing countries is driven by a Reforms to the investment and business climate reallocation of capital and labor toward more efficient can encourage firms to invest more. In addition to firms within sectors. Politically driven access to credit, boosting efficiency, a better business climate will also inefficient regulations, and costly enforcement of attract more investment. Firms will invest more if contracts can result in misallocation. For example, they feel secure that their contracts will be honored, Hsieh and Klenow (2009) found that reducing there is a predictable policy environment, and the misallocation in China and India to U.S. levels would macroeconomy is stable. Greater competition can increase manufacturing TFP 30 to 50 percent in China also boost investment by new firms (see box 2). and 40 to 60 percent in India. There is a substantial “2017 Cambodia – Sustaining Strong Growth for the Benefit of All: A 48  Systematic Country Diagnostic,” World Bank, Washington, DC, 2017. An increase in the quality and quantity of public infrastructure investment 49  can also increase TFP growth. Public investment currently is about 7.5 percent of GDP, which is relatively high for a lower middle-income country, though typical for a low-income country (Devadas and Pennings 2018). Given that, Cambodia might instead like to focus on improving the quality of public infrastructure, by improving road quality, reducing power transmission losses, and reducing water leaks. The Infrastructure Efficiency Index in Devadas and Pennings (2018) of 0.67 suggests substantial room for 50  http://www.doingbusiness.org/content/dam/doingBusiness/country/c/ improvement. cambodia/KHM.pdf. CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 50 SECTION 2 – SELECTED ISSUE: Can Cambodia become an upper middle-income economy by 2030 and a high-income country by 2050? Finally, Cambodia will need to increase savings to maintain the share of GDP, which international rates by around 10 ppts of GDP to fund the investors might not want to provide. increased investment required to achieve the Cambodia can rely on the experience of peer growth goals and reduce dependence on foreign countries in finding ways to increase savings. savings.51 The increase in required savings is smaller Several countries in the region have successfully than that above in figure S25, where we assumed mobilized their savings through different means (see that Cambodia followed Korea’s investment path, box S2 and figure S24). Digitalization for financial but is still substantial. Around 6 ppts of this is due inclusion, and developing capital markets and a to the expansion of investment required to meet the domestic debt market while introducing incentives growth goals. Around 4 ppts of GDP extra savings to deposit and save in local currency would also is needed to reduce reliance on foreign savings and support both higher investment and progressive shrink the current account balance of its long-term de-dollarization. Currently, the willingness of average of around -5 percent of GDP (as discussed households and firms to deposit in the domestic above). Cambodia might have no choice in this. banking sector is also sensitive to its perceived As incomes increase, it likely will lose preferential riskiness. Therefore, introducing enhanced access to markets that are the motivation for regulation and deposit insurance can increase much of the inbound FDI in the garment sector confidence.52 For instance, Malaysia promoted (it will also become less competitive as wages rise national savings by, as mentioned above, creating with development). Finally, modest amounts of a postal saving system, while Thailand introduced inbound FDI in dollar terms appear large as a share the Government Saving Bank and imposed several of GDP because GDP is currently low. As GDP regulations to enhance the solvency of financial increases 10-fold over the next 32 years (according institutions, which improved both the savings rate to simulations), the real dollar value of capital and the efficiency of resource allocation. inflows would also have to increase 10-fold simply 51  “2017 Cambodia – Sustaining Strong Growth for the Benefit of All: A Systematic Country Diagnostic,” World Bank, Washington, DC, 2017. 52  This would ultimately help attain greater exchange rate flexibility and regain monetary policy independence. In the medium term, market measures aimed at fostering the use of the Cambodian riel, coupled with the progressive development of capital and bond markets, could help provide sources of long-term funding for the corporate sector and establish alternatives to investment in construction and real estate. 51 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 Annex: A description of the Long-Term Growth Model ANNEX: A DESCRIPTION OF THE LONG-TERM GROWTH MODEL The Long-Term Growth Model (LTGM) is an Excel-based tool building based on the celebrated Solow- Swan growth model but adapted for growth analysis in developing countries.53 (The Excel-based tool and documentation are freely downloadable from www.worldbank.org/LTGM.) Investment, savings, and productivity are key growth drivers, but the model includes other factors important for developing and emerging countries, like human capital, demographics, and labor market participation (especially for women). Recently, the baseline LTGM has been extended to allow for an analysis of the effects of growth (and inequality) on poverty, based on a log-normal approximation of the income distribution. There are two important common results in the LTGM. First, investment-led growth is unsustainable in the long run, as the capital stock grows faster than output, which increases the capital-to-output ratio and reduces the effectiveness of investment for growth. Enhancing other growth drivers, like total factor productivity, human capital, and labor force participation, helps contain the capital-to-output ratio by boosting output, and hence makes growth more sustainable. Second, high rates of investment need to be financed by either domestic or foreign savings. As foreign savings can be fickle, high rates of investment in the long run usually require high rates of domestic savings. The LTGM economy consists of a single sector that produces GDP using physical capital ( ) and effective labor ( ). denotes total factor productivity, which determines the aggregate efficiency of the economy. (1) where β is the aggregate labor share of income and effective labor is decomposed into human capital per worker ( ) and the number of workers ( ). The total number of workers can be written as: (2) where is the participation rate, is the ratio of working-age population to total population, and is the total population. Physical capital next period ( ) is formed by undepreciated capital and new investment : (3) Investment is funded by either domestic savings or foreign savings via a current account deficit ( ): (4) 53 The LTGM builds on earlier work by Hevia and Loayza (2012). CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 52 Annex: A description of the Long-Term Growth Model Changes in foreign savings can be further decomposed into inbound foreign direct investment, and changes in total external debt ( ): (5) By combining these, the model can calculate growth resulting from an investment constraint (Model 1), or a savings constraint (Model 3), or it can calculate required investment to meet a growth target (Model 2). It also calculates changes in the poverty rate, as growth in GDP per capita shifts the income distribution to the right. (6) . Headline GDP growth ( ) can be decomposed using a log-linear approximation into different growth fundamentals (Equation 6). Here is the growth rate of factor x from t to t+1. Equation (7) is the equivalent formulation for per capita GDP growth, , with the key difference being that population growth adds to headline GDP growth, but subtracts from GDP per capita growth. (7) is the marginal product of capital (MPK), or the inverse of the marginal ICOR (mICOR), which determines the effectiveness of investment in boosting growth. An increase in , for example, from excessive investment, will decrease the marginal product of capital (MPK) and increase the mICOR. 53 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 CAMBODIA: KEY INDICATORS CAMBODIA: KEY INDICATORS 2015 2016 2017 2018e 2019f 2020f Output and Economic Growth Real GDP (% change, yoy) 7.0 6.9 7.0 7.1 6.8 6.8 Domestic demand (% change, yoy) 8.0 9.9 7.8 11.2 9.7 8.5 GDP per capita (US$, nominal) 1,171.0 1,264.9 1,372.6 1,451.6 1,563.9 1,701.0 Money and Prices Inflation, consumer prices (annual %, period average) 1.7 3.5 3.1 3.2 3.3 3.0 M2 (% of GDP) 66.6 70.9 79.6 87.0 94.0 101.0 Domestic Credit to the Private Sector (% of GDP) 62.7 69.5 74.7 82.7 86.8 89.9 Nominal Exchange Rate (local currency per US$) 4,025 4,058 4,062 4,067 4,087 4,063 Real Exchange Rate Index (2010 = 100) 103.6 105.1 103.7 103.7 103.9 103.9 Short-term interest rate (% p.a.) 11.6 11.8 11.4 11.4 11.7 11.8 Fiscal Revenue (% of GDP) 19.5 20.7 21.5 20.4 19.8 19.4 Expenditure (% of GDP) 21.3 22.1 23.1 24.6 23.9 23.7 Overall Fiscal Balance (% of GDP) -1.9 -1.4 -1.6 -4.2 -4.1 -4.3 Primary Fiscal Balance (% of GDP) -1.6 -1.0 -1.2 -3.8 -3.7 -3.9 General Government Debt (% of GDP) 31.3 32.4 33.9 36.2 37.0 37.5 External Accounts Export growth, f.o.b. (nominal US$, annual %) 7.5 9.0 9.4 14.7 13.0 13.3 Import growth, c.i.f. (nominal US$, annual %) 7.6 9.0 7.8 14.5 11.4 10.9 Merchandise exports (% of GDP) 45.4 45.5 45.3 48.4 50.0 50.9 Merchandise imports (% of GDP) 57.3 56.9 55.7 59.8 61.2 61.3 Services, net (% of GDP) 7.5 7.0 7.0 7.9 8.6 9.3 Current account balance (current US$ millions)1/ -2,007.0 -2,041.4 -2,160.6 -2,432.2 -2,637.6 -2,813.6 Current account balance (% of GDP) -11.0 -10.2 -9.8 -10.3 -10.2 -9.9 Foreign direct investment (Net, current US$ millions) 1,668.8 2,164.4 2,381.0 2,582.0 2,739.3 2,964.9 Foreign direct investment, net inflows (% of GDP) 9.1 10.8 10.8 10.9 10.6 10.4 Gross international reserves (current US$ millions) 5,672.1 6,730.8 8,757.9 9,081.9 9,536.0 10,012.8 (prospective months of imports of g&s) 5.2 5.7 6.8 6.6 6.3 5.9 Memo: Nominal GDP (current US$ millions) 18,241.7 20,020.2 22,059.2 23,680.3 25,883.3 28,550.3 Sources: Cambodian authorities, IMF and World Bank staff estimates and projections. Note: e = estimates; f = forecast; g&s = goods and service; p = projection. 1/ Excluding transfers.           CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 54 References References Barrot, D. 2016. “Long-Term Growth Model (LTGM): Reference Note on Data Issues.” Internal Note. World Bank, Washington, DC. Berg, A., J. Ostry, and J. Zettelmeyer. 2012. “What makes growth sustained?” Journal of Development Economics (29) 149–166. Devadas, S., and S. Pennings. 2018. “Assessing the Effect of Public Capital on Growth: An Extension of the World Bank Long-Term Growth Model.” Policy Research Working Paper 8604, World Bank, Washington, DC. Hevia, C., and N. Loayza. 2012. “Savings and Growth in Egypt.” Middle East Development Journal 4 (1). Hsieh, Chang-Tai, and P. Klenow. “Misallocation and Manufacturing TFP in China and India.” The Quarterly Journal of Economics 124 (4): 1403–1448. Jeong, H. 2017. “Korea’s Growth Experience and the Long-Term Growth Model.” Policy Research Working Paper 8240, World Bank, Washington, DC. Jones, B., and B. Olken. 2008. “The Anatomy of Start-stop Growth.” Review of Economic and Statistics 90 (3): 582–587. Jones, C. 2016. “The Facts of Economic Growth.” Handbook of Macroeconomics Vol. 2A, Chapter 1: 3–69. Stiglitz, Joseph, and Marilou Uy. 1996. “Financial Markets, Public Policy, and the East Asian Miracle.” World Bank, Washington, DC. Thiumsak, Tun, and Athapol Ruangkanjanases. 2016. “Factors Influencing International Visitors to Revisit Bangkok, Thailand.” Journal of Economics, Business and Management 4 (3): March. http://www.joebm. com/vol4/394-E00008.pdf. World Bank. 2017. “2017 Cambodia – Sustaining Strong Growth for the Benefit of All: A Systematic Country Diagnostic.” World Bank, Washington, DC. World Bank. 2018. East Asia Pacific Economic Update, October 2018: Navigating Uncertainty. Washington, DC: World Bank. 55 CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 References Additional References Annual Reports (2013–17), Ministry of Agriculture, Forestry and Fisheries Annual Reports (2016–17), National Bank of Cambodia Balance of Payment Statistics (2018), National Bank of Cambodia Banking Supervision Reports (2016–17), National Bank of Cambodia Budget Law (2018), Royal Government of Cambodia Cambodia Doing Business Ranking (2018), World Bank Cambodia Enterprise Survey (2016), World Bank Cambodia Future Jobs (2018), the World Bank Cambodia Industrial Development Policy (2015–25), Royal Government of Cambodia Cambodia Investment Climate Assessment (2018), World Bank Cambodia Public Debt Statistical Bulletin, Volume 5, March 2018, Ministry of Economy and Finance Cambodia Public Expenditure Review (2018), World Bank Cambodia Socioeconomic Surveys (2004–16), National Institute of Statistics, Ministry of Planning Cambodia Systematic Country Diagnostic (2017), World Bank Cambodia Tourism Statistics (2017–18), Ministry of Tourism Cambodian National Accounts Statistics (2017), National Institute of Statistics, Ministry of Planning East Asia and Pacific Economic Update (October 2018), World Bank Global Economic Prospects (2018), World Bank IMF Article IV Staff Report (2017), International Monetary Fund Logistic Performance Index (2016), World Bank Mid-year report, June 2018, National Bank of Cambodia Monetary Statistic Bulletin (2018), National Bank of Cambodia National Strategic Development Plan (2014–18), Ministry of Planning Rectangular Strategy, Royal Government of Cambodia, September 2018 World Development Report 2019: The Changing Nature of Work, World Bank CAMBODIA ECONOMIC UPDATE | OCTOBER 2018 56 The World Bank Cambodia Country Office Exchange Square Building Floor 10th IBRD and 11th IFC Streets 51-61 and Streets 102 -106 Sangkat Wat Phnom, Khan Daun Penh Phnom Penh, Cambodia Website: www.worldbank.org/cambodia