Information about Asia and the Pacific Asia y el Pacífico

Chapter 5. What Can Go Wrong? Shifting Vulnerabilities as Asia Rebalances

Olaf Unteroberdoerster
Published Date:
February 2014
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Information about Asia and the Pacific Asia y el Pacífico
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Faisal Ahmed, Jung Yeon Kim and Nujin Suphaphiphat 

At the current juncture, Cambodia is displaying some hybrid economic features—still mostly those of a low-income country but including some aspects of an emerging market economy. It best exemplifies this duality in the concentrated production structure of a low-income country and the capital account openness of an emerging market economy. This chapter provides an overview of Cambodia’s economic vulnerabilities, given its ongoing economic transformation and taking into consideration the country’s unique features and economic structure. We show that external shocks can explain more than half of Cambodia’s growth variation, a trend that is expected to accelerate in the years ahead as its integration with the global economy, and with emerging Asia in particular, expands and deepens. In this context, we explore the likely evolution of vulnerabilities by sector—external, financial, and fiscal—and their interactions over time. We conclude by advocating a virtuous cycle of vulnerability-mitigating policies to make growth more resilient.

Cambodia: Vulnerability Analysis in the Context of Low-Income Countries

Before delving into Cambodia-specific discussion, some stylized facts about low-income countries and their vulnerabilities are in order.

When compared to middle- and high-income countries, low-income countries tend to have greater output, consumption, and investment volatility (Table 5.1), reflecting an interplay of structural and external shocks.1

Table 5.1Output, Consumption, and Investment Volatility, 1970–2004(median)
Source: Tabova (2009).

σ[y], σ[c], and σ[i] represent standard deviation of agregate output, consumption, and investment, respectively.

Source: Tabova (2009).

σ[y], σ[c], and σ[i] represent standard deviation of agregate output, consumption, and investment, respectively.

Recent empirical work finds that low-income countries and, in some cases, emerging market economies face a higher probability of financial sector (e.g., banking and currency) and terms of trade shocks (Table 5.2). In low-income countries in the past decade external shocks have also been of growing importance as a source of macroeconomic volatility (IMF, 2010, 2011a).

Table 5.2Frequency of Shocks Across Country Groups 1970–2007
Frequency of Shocks
Low-income countriesEmerging marketsAdvanced economies
Total numberProbability (In percent of country years)Total numberProbability (In percent of country years)Total numberProbability (In percent of country years)
Financial and Macro-economic Shocks
Banking crisis511.9533.2131.1
Currency crisis993.8694.1131.1
Debt crisis281.1281.700
Reversal of capital flows40515.41418.5463.9
Country-specific external shocks Terms of trade shock45317.21609.6453.8
Natural disaster722.8352.1171.4
Source: IMF (2011a).
Source: IMF (2011a).

In Cambodia, as in many other low-income countries, growing trade and financial linkages with the rest of the world can confer important benefits through investment and growth, but such linkages can also increase an economy’s exposure to spillovers from abroad. Furthermore, Cambodia’s underlying vulnerabilities can amplify the impact of external shocks. For example, because the economy depends on a few sectors and concentrated exports, global price shocks can easily translate into relatively large terms of trade shocks and thus embody higher financial stability risks.2 Cambodia’s underlying vulnerabilities can be usefully illustrated schematically as the interaction between macroeconomic and structural vulnerabilities (IMF, 2011a), as in Figure 5.1.

Figure 5.1

We will first underscore the features of the Cambodian economy that give rise to these structural and macroeconomic vulnerabilities and then stress their sectoral implications. We will also explore how the economic risks are likely to evolve amid ongoing trade and financial integration against the backdrop of Asia’s economic rebalancing.

Sources of Vulnerability: Structural and Macroeconomic

This section highlights the key sources of vulnerabilities for Cambodia and groups them into structural and macroeconomic factors. It should be noted that these two groups of factors are often interlinked and therefore jointly determine the overall vulnerabilities.

Structural Sources of Vulnerability

Production structure. Cambodia’s economic base remains narrow. For example, its merchandise production base is still concentrated and exposed to external shocks, as evidenced by the sharp growth slowdown in 2009 following the onset of the global financial crisis.3

Export structure. Exports remain heavily concentrated, with garments and footwear accounting for more than 80 percent of merchandise exports (Figure 5.2). Early signs of export diversification through commodities—rice, rubber, and a few other agricultural commodities—and non-textile manufacturing (e.g., recent Japanese investments in light manufacturing such as automotive supplies) are slowly emerging, though from a very low base.

Figure 5.2Concentrated Export Structure

Source: Data provided by the Cambodian authorities.

Export market. Export market diversification is under way, beginning with the recent headway that Cambodian textiles have made into European (catalyzed by preferential access) and other markets, such as Japan, reducing the country’s exclusive reliance on the U.S. market for export growth. But, as illustrated by Figure 5.3, market diversification is taking place only gradually.

Figure 5.3Market Diversification

Source: Data provided by the Cambodian authorities.

Dollarization. Cambodia has one of the highest levels of dollarization relative to its peers, including within the region (Figure 5.4). Empirical evidence suggests that dollarization can increase the vulnerability of a country’s financial system by increasing its solvency and liquidity risks (Gulde and others, 2004). Cross-country estimates of the impact of dollarization on some key indicators of financial soundness, while controlling for changes in underlying macroeconomic volatilities, are consistent with the hypothesis that a rise in dollarization may increase financial vulnerability. In particular, the variance of deposit growth is positively correlated with the degree of dollarization, suggesting that highly dollarized financial systems may be more exposed to credit cycles and liquidity risk, given their limited control over monetary policy and liquidity management tools.

Figure 5.4Cross-Country Comparison of Dollarization

Shallow or missing financial market and safety net. A confluence of factors hampers risk management in the financial system and, in turn, accentuates financial fragilities in Cambodia. The main factors include (i) a lack of government securities, resulting in the absence of any lower-risk instruments in the system to support interbank market activity; and (ii) a shallow and informal foreign exchange market.4 The lack of a well-developed interagency crisis management framework and a deposit insurance system could accentuate a banking crisis.

Banking system structure. Cambodia’s banking system is highly liberalized and dollarized. In addition, foreign banks have a large presence, representing more than two-thirds of all banks and accounting for half of total deposits. As discussed in Chapter 4 of this volume, the banking system appears to be overbanked, populated by a large cluster of small banks.5 At the same time, it is relatively concentrated, with the five largest banks directly controlling about 60 percent of banking system assets at end-2012. The proliferation of banks could weaken financial stability, including by encouraging excessive risk taking, limiting the scope for product diversification, and overburdening supervisory capacity as the system relies more on foreign funding. In addition, cross-country evidence actually suggests a negative correlation between the number of banks and the degree of competition between them (Claessens and Laeven, 2004).

Quasi-banking activities. Microfinance institutions are growing rapidly in Cambodia and increasing their presence in banking services, with their total assets at 10 percent of GDP at end-2012. Their capital structure makes them particularly exposed to funding shocks, with about three-fourths of their funding sourced from abroad, so shocks could cause spillover into the banking system given their increasing interconnectedness.6

Macroeconomic Sources of Vulnerability

Shifting sources of external demand. Cambodia’s growth has exhibited strong and increasing co-movements with the United States, the European Union, and emerging Asia.7 The degree of correlation between Cambodia and other countries and regions has increased substantially during the last decade (Figure 5.5). Reflecting ongoing trade and financial integration, Cambodia’s growth in recent years has been increasingly driven by external factors, including from Asia.

Figure 5.5Cambodia’s Growing Economic Integration by Region

Source: IMF, World Economic Outlook (WEO) database (October 2012); and IMF staff calculations.

Sectorally, the intensifying integration with Asia has taken place through trade and tourism. Among the most notable trends in Cambodia, imports from emerging Asia are the highest of all the regions and continue to rise steadily, while imports from the United States and the European Union have changed marginally, a development that goes beyond textiles and holds even after controlling for exports to China. Even though exports to emerging Asia are still relatively modest, that region’s share has more than tripled during the past 10 years, while during the same period the share of tourist arrivals from emerging Asia has almost doubled, reaching 55 percent in 2012 (Figure 5.6).

Figure 5.6Evolving Sources of External Demand in Cambodia

Sources: CEIC Asia database (bottom panels); and IMF, Direction of Trade Statistics database (top panels).

Growth spillovers. Box 5.1 highlights the empirical finding that external shocks are playing an increasingly large role in explaining growth volatility in Cambodia, with Asia becoming the source of an increasing share of spillovers. Econometric analysis also confirms the rising importance of emerging Asia in recent years (Box 5.2). Although historical spillover estimates for the euro area remain modest, such spillovers in Cambodia are likely to increase in the years ahead, given increasing trade flows and preferential tariff agreements, especially in the garment exporting sector.

Limited fiscal space. With a tax-to-GDP ratio at around 12 percent, Cambodia’s revenue performance remains weak by the standards of both its region and other peer economies, mainly reflecting administrative weaknesses (see Chapters 6 and 7). After stalling for some time, revenue performance improved in 2012 owing to economic buoyancy and strengthened administration. Contingent liabilities from the financial sector and government guarantees to hydropower projects also constrain fiscal space.

Box 5.1Decomposing Cambodia’s Growth Volatility

Variance decomposition analysis captures how much of the variation in economic activity can be explained by external shocks. External shocks contributed to 40 percent of the variation in Cambodia’s economic activity between 1994 and 2012 and to 60 percent of it during the last decade. The United States remains the single most important external source of business cycle variation (or economic swings) in Cambodia, accounting for 20 percent of the economic variation explained by external shocks during the whole sample period (1994–2012), and doubling its contribution during the past decade. Similarly, emerging Asia, which was responsible for 14 percent of economic variation over the whole sample period, is an increasing source of variation, accounting for 20 percent of Cambodia’s economic swings over the past decade.

Figure 5.1.1

Sources: IMF, International Financial Statistics, 2012; and IMF staff calculations.

Low level of government deposits. In the aftermath of the global financial crisis, the stock of government deposits, the only readily available fiscal buffer for Cambodia, declined to about 4 percent of GDP in 2012 from 8 percent of GDP (precrisis). These deposits serve as an important policy buffer in the absence of government domestic debt, with their reconstitution requiring fiscal consolidation.

Box 5.2Growth Spillover Analysis for Cambodia

To evaluate growth spillovers from external shocks, a vector autoregressive (VAR) model is used. The analysis focuses on the impact of shocks to real GDP growth in the United States, the European Union, and emerging Asia on Cambodia’s real GDP growth during 1994:Q1–2012:Q2, with the sources of spillovers measured and ranked by a Cholesky ordering as follows: the United States, the European Union, and emerging Asia. Changes in ordering did not yield significantly different results.

The main results are as follows:

  • The United States remains the main source of growth spillover for Cambodia: a one percentage point deviation of the U.S. GDP growth rate from its mean leads to a one percentage point deviation in Cambodia’s growth.

  • Growth spillover from emerging Asia has a significant and growing impact on Cambodia. A one percentage point deviation in emerging Asia’s growth from its mean leads to a 0.9 percentage point deviation in Cambodia’s growth.

  • The impact of emerging Asia’s growth spillover has also increased in the past decade (2003–12). A one percentage point deviation in that region’s growth from its mean causes a 1.4 percentage point deviation in Cambodia’s growth.

Figure 5.2.1Impulse Response Function: One Percent Shock from Selected Economies

(Percentage change in mean deviation)

Source: IMF staff calculations.

Constrained exchange rate and monetary policy framework. High dollarization constrains both monetary and foreign exchange policy (see Chapter 3). One of the side effects has been the stunted development of a formal foreign exchange market. Although dollarization in the wake of the post-conflict reconstruction phase imposed some policy discipline, the cost has been the lack of an independent monetary policy and use of the exchange rate to facilitate adjustment.

Sectoral Vulnerabilities

This section provides an aggregate view of the interaction of sectoral vulnerabilities—external, financial, and fiscal—with the structural and macroeconomic vulnerabilities described above. Given Cambodia’s concentrated production structure, limited fiscal space, and high dollarization, sectoral vulnerabilities are quite interlinked. For example, a credit boom amid high dollarization and limited exchange rate flexibility can increase both financial and external sector vulnerabilities. In fact, rapid credit growth and the accompanying domestic demand boom in a stabilized or fixed exchange rate regime can lead to larger current account deficits and raise external sustainability risks. Additionally, external shocks, such as a reversal of capital flows, can worsen financial stability risks given the openness of the banking system and capital account.

External Sector

Traditional (and often backward-looking) indicators suggest that Cambodia’s vulnerability to the external sector is relatively benign. The import coverage of its reserves was around 4½ months at end-2012; its short-term external debt is low; and Bank for International Settlements (BIS) data show that cross-border banking sector exposure is limited (see Figure 5.7).8 But, as noted above, external vulnerability is closely linked to financial sector vulnerability. As a result, the rapidly transforming financial sector and sharp changes in Cambodia’s debt (both public and private) profile could have a bearing on medium-term external vulnerability.

Figure 5.7Cross-Border Banking Sector Exposure to Cambodia

Sources: Bank for International Settlements; and IMF, World Economic Outlook database (April 2012).

The lessons for Cambodia from emerging Europe are instructive in this regard. Emerging Europe experienced rapid foreign-currency-denominated credit growth, a large presence of foreign banks, a credit-fueled domestic demand boom, and large current account deficits, but ultimately faced external crises when the cycle reversed. As discussed in Chapter 4, Cambodia remains structurally poised to face similar types of vulnerability, since some of the ingredients for external vulnerabilities are in place or could emerge quickly. For example, recent credit growth in Cambodia has been accompanied by increasing bank flows from abroad. It is important to note that many of these risks are often underestimated during an economic upswing.

Financial Sector

Credit growth is one of the most significant predictors of financial vulnerabilities and subsequent crises (Dell’Ariccia and others, 2012). Cambodia now has one of the highest rates of credit growth in Asia (Figure 5.8), primarily in foreign currency and from a modest base (Box 5.3). With a credit-to-GDP ratio at over 35 percent, the size of the banking system, as a share of GDP, is already bigger than in some emerging Asian economies, such as Indonesia and the Philippines (Figure 5.9).9

Figure 5.8Cross-Country Comparison of Credit Growth

(In precent, year-over-year, 2012:Q1)

Source: IMF staff calculations.

Figure 5.9Comparing Cambodia’s Financial Depth and Credit Growth

(Financial Depth of Regional Peers at Economic Takeoff and Credit Growth During the Boom Years)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

To provide a regional and historical perspective, Cambodia’s credit growth, at over 30–35 percent, is far higher than that of its regional peers when they experienced comparable rapid growth (Figure 5.9). Moreover, the size of Cambodia’s banking system relative to GDP is already larger than in other Asian economies during their economic takeoffs in the 1970s and 1980s. Going beyond individual country comparisons, Cambodia’s credit-to-GDP ratio now is far above the median for low-income countries and, at the current pace of growth, will soon exceed the median among emerging market economies as well. This too highlights the need for regulatory vigilance (Box 5.3). As noted earlier, high dollarization significantly limits the central bank’s ability to curb credit growth and minimize financial stability risks. Therefore, large external shocks and consequent macroeconomic vulnerability can easily translate into financial sector vulnerability and further amplify negative feedback loops between these two sectors.

Box 5.3When Is Credit Growth Too Fast? (And How to Deal With It)

Cambodia’s financial system appears to be shifting from a normal deepening to excessive credit growth. Cambodia’s financial system is expanding rapidly. With private credit growing by more than 30 percent during 2012–13, the credit-to-GDP ratio has reached 37 percent, well above the median for low-income countries. If credit growth were to continue at the current pace, by end-2013 the ratio would exceed even the median for more advanced emerging market economies. These benchmarks suggest that the size of Cambodia’s financial system has already outstripped the level that can be justified by normal financial deepening.1

Figure 5.3.1.

Sources: Cambodian authorities; and IMF staff estimates and projections.

Note: EM = emerging market; LIC = low-income country.

Cambodia’s past trend of credit-to-GDP ratio is another simple proxy for the normal pace of financial deepening. To the extent that the actual credit-to-GDP ratio deviates significantly from its trend, one might interpret it as a sign of overheating in the credit market. This “credit gap” measure has indeed been empirically shown to be a good predictor of financial stress.2 At 30 percent credit growth, the gap measure would widen rapidly and by end-2013 surpass a level last seen in 2008 at the height of Cambodia’s real estate boom, which ended in a bust. Projecting this expansion further shows that Cambodia’s credit trajectory is clearly breaking away from the country’s own long-term pace of financial deepening.

Macroprudential measures may be needed. In addition to raising the reserve requirement, currently the only tool at the disposal of the National Bank of Cambodia, consideration should be given to other macroprudential measures. At its current level, the reserve requirement is not binding on most Cambodian banks, since they still possess considerable excess liquidity. As a result, a number of them have lowered interest rate spreads in recent years to compete for market share. Some are also increasingly relying on cheaper external funding from foreign banks, with commercial banks’ other foreign liabilities tripling in 2012 and nonresident deposits increasing fivefold since 2009 (albeit from a low base).

Figure 5.3.2.

Sources: Cambodian authorities; and IMF staff estimates and projections.

What measures and trade-offs? In considering macroprudential measures, the National Bank of Cambodia must strike a balance in choosing an instrument that is not only simple to implement but also effective in slowing credit growth and causes the least distortions to the credit market. For example, adopting a capital surcharge would be relatively simple and create few distortions, but it might be less effective in an already booming credit market, where capital has been boosted by profitability. Also, the capital-to-asset ratio of 29 percent reported by Cambodian banks is already much higher than the regional average. On the other hand, a tightening of the loan-to-value cap, while potentially effective, could be complicated by challenges in asset valuations. Capping the loan-to-deposit ratio, which rose to 89 percent in 2012 from 82 percent at end-2010, could also be effective, but it would have a disproportionate impact on foreign bank branches that rely less on their deposit base, potentially causing distortions to competition.

1 The benchmarks are taken from IMF (2012a), based on global samples of 35 low-income countries and 108 emerging market economies.2 See Borio and Drehmann, 2009.

Fiscal Vulnerabilities

Fiscal vulnerabilities stem from both structural and macroeconomic factors: (i) low-revenue; (ii) risks from contingent liabilities (e.g., government guarantees); and (iii) the role of fiscal policy as the main policy lever in case of large shocks. The low level of government deposits, the key fiscal buffer in the absence of a government securities market, further constrains the potency of fiscal policy to respond to adverse shocks.

The Impact of Asia’s Rebalancing

Asia’s rebalancing—the ongoing shift in the region from export-led to domestic demand-led growth, in part spurred by the slow recovery in advanced economies—will in the years ahead deeply transform many facets of regional economic relations. As a result of the 2008–09 global financial crisis, many advanced economies will have to save more as they deleverage and repair their private and public balance sheets. Increasingly, the growth in the counterpart economies that relied on exports and financed advanced economies (e.g., current account surplus economies in Asia such as China) will have to be increasingly driven by domestic demand, resulting in higher imports. These cross-currents—slower growth in traditional export destinations in advanced economies but stronger final demand from emerging Asia, especially China (Box 5.4)—will not only open up new opportunities for frontier economies such as Cambodia but also will likely alter the sources and magnitude of risks.

For Cambodia, the broader rebalancing trend in Asia is best captured through the prism of China’s rebalancing, which has three facets: (i) as a source of regional final demand, (ii) as a supply chain hub, and (iii) as a competitor. Cambodia’s medium-term productive capacity will likely continue to consist of commodity production and labor-intensive manufacturing, making the first two facets of China’s rebalancing more relevant. With this rebalancing taking place against the backdrop of an industrial upgrading and rising regional wages, Cambodia’s attractiveness as an investment destination has the potential to improve (IMF, 2012b).

The transmission channels of spillover from China’s rebalancing would include, among other things, (i) trade, (ii) foreign direct investment, and (iii) capital flows—both portfolio flows (debt and equity) and other flows (e.g., bank flows). The capital flow channel, although currently modest, has the potential to increase sharply over the medium term as capital markets deepen and banks in Cambodia seek additional low-cost funding from abroad, including from their parent banks, some of which are located in Asian economies with liquidity surpluses. Finally, official loans from China constitute the single largest source of external public donor financing in Cambodia (Box 5.4).

Box 5.4Cambodia’s Scope for Regional Integration as Asia, Especially China, Rebalances

Asia’s rebalancing will affect both the direction and strength of Cambodia’s economic integration with the region and the global economy. By some measures, Cambodia is already well integrated with Asia: 67 percent of foreign direct investment and about 70 percent of imports come from emerging Asia. But Asia’s rebalancing will likely significantly increase exports to emerging Asia, now at only 20 percent of total, and capital flows. The creation of the ASEAN Economic Community will further accentuate that trend since Cambodia, as a hub, would attract investment to tap into the ASEAN market of 600 million people.

Going forward, consumption-led domestic demand in China is expected to witness a secular increase, underpinned by rising household income. In fact, even as the global financial crisis was unfolding, Chinese household consumption increased by 48 percent between 2008 and 2011—by 52 percent in urban areas and 35 percent in rural areas, in part supported by a government policy of increasing basic pensions, social transfers, and unemployment benefits.

China, with its ample liquidity, is already the largest provider of financial support and foreign direct investment to Cambodia, accounting for over two-thirds of bilateral loans and over 40 percent of foreign direct investment during 2006–12. Most of these loans were concessional and associated with development projects.

Figure 5.4.1.

Source: Ministry of Economy and Finance, Cambodia.

Given Camobodia’s limited access to global capital markets, these loans are an important source for the country’s much needed infrastructure development.

At the industry level, higher wages (three to four times higher) in China are already catalyzing opportunities for Cambodia to expand its industrial base, initially in garments, but now increasingly in other labor-intensive manufacturing. More than 50 percent of the garment factories in Cambodia are from China and Taiwan Province of China.

A growing number of factories are now targeting the domestic market in China instead of the traditional advanced economies. Similar trends are emerging with respect to Japanese investments in Cambodia, which are catering to final demand in Japan (e.g., garments and commodities) and intermediate products for Japanese supply chains in other countries (e.g., Vietnam and Thailand). The upside potential of the Chinese domestic market for Cambodia is highlighted by the pickup in exports to China, including manufactured products. Moreover, with continued urbanization and the rise of middle-income households in China and in other emerging Asian economies, the demand for agricultural products will increase, providing an opportunity for land-rich Cambodia to expand agro-processing industries. Similarly, the tourism sector is successfully pivoting toward the Asian market, with the share of tourist arrivals from emerging Asia almost doubling between 2003 and 2012, helping the industry to cope with the fallout from the recent financial crisis in the United States and the euro area.

Figure 5.4.2.

Source: National Bureau of Statistics of China.

Figure 5.4.3.

Source: National Bureau of Statistics of China.

This upside potential from China’s rebalancing is subject to risks. Non-labor costs—such as electricity and transportation—are higher in Cambodia than in its regional peers. Despite significant progress in promoting growth over the past decade and improvements in the business climate, there is significant room for enhancing Cambodia’s competitiveness relative to the region (see Table 5.4.1). The urgency of continued reform is highlighted by the fact that the potential labor supply for manufacturing is much smaller than in larger frontier economies such as Bangladesh and Myanmar. Furthermore, given the high level of dollarization in Cambodia, the prospects of a stronger dollar relative to other major currencies for the next few years increases the risks.

Table 5.4.1Cambodia: Global Competitive Indices
UN, Human Development Index2012138/186
Heritage Foundation, Economic Freedom Index201295/177
Transparency International, Corruption Perception Index2012157/176
World Bank, Ease of Doing Business Index2012133/185
World Economic Forum, Global Competitiveness Index2012–1385/144

In terms of vulnerabilities, therefore, a rotation of trade and finance toward emerging Asia, and China in particular, has the following implications for Cambodia.

Macroeconomic vulnerabilities. Structurally, the growing integration with emerging Asia could imply some diversification benefits as Cambodia broadens its economic base. However, these benefits in terms of vulnerability management will likely be limited to the extent that new trading partners and product groups are subject to similar shocks.

Financial sector vulnerabilities. The potential for risk buildup through capital flows is amplified as Cambodia further integrates with regional financial markets during Asia’s rebalancing. In fact, some emerging market economies, such as China, are undergoing substantial financial sector reforms. The potential therefore remains high for financial risk spillovers (e.g., reversal of capital inflows) from unintended distortions created during the reform process. These spillover risks for Cambodia are compounded by the shallow capital and foreign exchange markets and the fact that the absolute size of its financial system is small compared to the size of the capital-exporting economies in the region.

Competitiveness. Cambodia will face increasing pressure to upgrade its infrastructure, human capital, and business environment as larger developing economies (e.g., Bangladesh and Myanmar) also compete for the same realm of export to emerging Asia.

Risks Ahead: Steps Toward a Mitigation Strategy

Cambodia is entering a new phase in transitioning from a low-income to an emerging-market economy. It is not only diversifying its economic base, but also adding new sources of risks to its existing structural vulnerabilities, as commonly experienced by regional emerging market economies during their economic takeoff. In this context, although Asia’s rebalancing offers an exciting opportunity to improve the quality and increase the duration of that takeoff, the scope for vulnerability mitigation through diversification may be limited. Cambodia’s economic vulnerabilities therefore need to be managed through a comprehensive approach, since its sectoral vulnerabilities can easily transmit from one sector to another (e.g., from the external to the financial sector). Asia’s rebalancing might complicate the cross-sectoral transmission channel through similar shocks until financial markets deepen sufficiently and the economy becomes sufficiently diversified, highlighting the urgent need to build policy buffers in Cambodia.

Given that policy buffers are limited and can be built only gradually, a multipronged and forward-looking approach will be critical. The speed at which different buffers can be ramped up will also need to guide reform priorities. For example, since reducing structural vulnerabilities such as dollarization or diversifying the production base will take time, the burden of vulnerability mitigation will fall on stronger revenue efforts to build fiscal buffers and on better supervision to minimize financial stability risks. More specifically:

  • Financial deepening. Financial deepening needs to be closely synchronized with market development (e.g., interbank and foreign exchange). Given the shifting funding structure of the banking system, moderating credit growth and closely monitoring risk buildup will need to be major components of the strategy to mitigate vulnerabilities.

  • External buffers. External buffers, including the buildup of foreign exchange reserves and prudent external borrowing practices, need to be stepped up. Asia’s rebalancing will likely accelerate Cambodia’s integration with the global economy as an important growth driver, but it could also expose its economy to more external shocks.

  • Fiscal buffers. Fiscal buffers need to be augmented by increasing revenue, replenishing government deposits, and minimizing contingent liabilities. These buffers also need to be commensurate with the elevated financial sector risks as Cambodia matures into a full-fledged emerging market economy.

The recent literature points toward a virtuous cycle from the cross-sectoral synergy in a comprehensive strategy of vulnerability mitigation. First, policy buffers can reduce economic volatility. Second, reduced economic vulnerabilities support investment and economic growth and diversification. Third, export diversification also contributes to an acceleration of growth. Finally, prudent fiscal management and sound financial sector policies can reduce the cost of and increase access to funds for growth-friendly investment (e.g., in education and infrastructure) (Hesse, 2008; IMF, 2010).

Sustained and more resilient growth, in turn, will make it easier to build and safeguard policy buffers. A sound macro-financial environment, through the policies outlined above, can reduce macroeconomic and structural vulnerabilities and give rise to a self-sustaining vulnerability mitigation dynamic. Part II of this book takes a closer look at the package of policy measures—fiscal, monetary, and financial—that are important components of an overall risk management strategy in Cambodia’s new phase of growth amid Asia’s rebalancing and an ever changing global economic environment.


Cambodia’s structural vulnerabilities stem from its concentrated production and export structure, its high degree of dollarization, and the limited development of its financial system, all against the backdrop of a deliberate strategy of maintaining an open economy. The key points that emerged from the analysis in this chapter may be summarized as follows.

  • Cambodia’s macroeconomic vulnerabilities reflect its structural vulnerabilities and initial conditions: a rapidly growing and increasingly interconnected financial system, limited monetary policy tools and exchange rate flexibility, and narrow fiscal space.

  • Risk buildup from the interaction of structural and macroeconomic vulnerabilities during economic takeoff from a low-income to an emerging market economy can be rapid.

  • To simultaneously address Cambodia’s existing structural and macroeconomic vulnerabilities and additional vulnerabilities that may arise from their interaction, a comprehensive cross-sectoral approach to policy formulation will be needed. For example, safeguarding financial stability at the current juncture would not only require moderating credit growth, but also require further strengthening financial sector supervision, building more financial market infrastructure, and increasing policy buffers.

  • Asia’s rebalancing could offer some diversification benefits as Cambodia broadens its economic base, but in terms of managing vulnerabilities these benefits will likely be limited to the extent that new trading partners and product groups are subject to similar shocks.


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Macroeconomic volatility and growth tend to be negatively correlated through various types of uncertainty (e.g., economic, political, and policy-related) and through binding constraints on investment, such as low saving and limited financial development (Loayza and others, 2007).

Beyond the real economy, financial shocks from capital flows appear to be the most pertinent risk for Cambodia. Since many banks in Cambodia can easily source funding from liquidity-rich Asian economies, as evidenced in recent quarters, the potential for surges in bank flows and associated risks remains high. Although dollarization and low debt may partly mitigate the risks of a currency and/or debt crisis, financial stability risks could still stem from a credit boom induced by bank flows, the most volatile of all capital flows (IMF, 2011b).

Among the 64 low-income countries surveyed by the IMF (2010), the decline in average growth between 2007 and 2009 was 2.8 percentage points (from 6.0 percent to 3.2 percent). Cambodia exerienced the second largest growth collapse, behind only Georgia.

The shallow foreign exchange market can come under pressure (in either direction) from sizable transactions, as partly foreshadowed when the first listed stock started trading in the Cambodian Stock Exchange in 2012.

A few specialized banks are restricted from taking domestic deposits.

It should be noted that in recent years microfinance institutions have increasingly been shifting their funding strategy toward domestic deposits.

Emerging Asia refers to China, Hong Kong SAR, India, Indonesia, the Republic of Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam.

BIS cross-border exposure statistics do not include banks from Cambodia’s neighbors such as China and Vietnam, which have recently become more active.

It is important to point out that other indicators, for example the size and activity of capital markets—equity and debt—are still very rudimentary or nonexistent (debt), pointing to a still maturing financial system.

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