Cambodia

Seizing the Global Opportunity : Investment Climate

Assessment & Reform Strategy

August 2004

This report is prepared for the Royal Cambodian Government by the World Bank Group

Executive Summary

The Challenge of Private Sector Development

        The growth of the private sector in Cambodia over the past decade has been remarkable in light of the destruction wrought by years of conflict and has proven that private investment can create jobs at wage levels that can reduce poverty. In the period 1997-2001, industrial employment grew by an average of over 43 percent per year, compared with less than 2 percent growth of both agricultural and service employment. This growth was driven by the export performance of the garment sector, which has grown from $28 million in 1995 to over $1.35 billion in 2002.

       The employment impact of this growth, however, has been narrow and has failed to reach the majority of the population. In terms of a share of its total exports, Cambodia has the second highest degree of specialization in the garment sector in the world – other sectors have simply failed to match the performance of garments. Moreover, with the garment sector increasingly subject to international competition, the engine of growth and poverty reduction is at risk. Overall, the manufacturing sector still employs less than 9 percent of the workforce, compared with over 70 percent of employment in agriculture, forestry, and fisheries.

       Manufacturing jobs can have a dramatic impact on poverty. Private sector development has proven to be an effective strategy to reduce poverty in Cambodia . Households headed by those with industrial employment had only 4 percent poverty incidence, while 80 percent of families in which the head of household was employed in agriculture were poor.

       As a small country competing in a globally-integrated, dynamic, and fast growing region, Cambodia 's private sector-led growth strategy must be anchored in trade. Cambodia borders on Thailand and Vietnam – each growing rapidly with distinct factor advantages. Cambodia itself has a small domestic market, due to its small population base, its poverty, and the fact that this population is only 18 percent urban. In light of this, the country's leadership has wisely chosen the route of globalization. To the Cambodian authorities, WTO represents an opportunity to reap gains from integration with the global economy and broaden its industrial base, particularly in light of its small domestic market. The Royal Government's commitment to private sector-led growth has been clearly demonstrated by the range of reforms being pursued as a package by a cross-ministerial team led by Commerce. Accession to WTO will afford Cambodia market access to member country markets on a most-favored nation basis, but will also intensify competition. Unless steps are taken to remove impediments to domestic enterprises, it is unlikely that many of Cambodia 's entrepreneurs will benefit in the short-run from market access.

        Recent history destroyed institutions that support productive economic exchange, and human and financial resources in the public sector are overstretched. Any private sector development strategy must address this gap. Cambodia's challenge is compounded by the legacy of internal conflict that not only depleted the country's reserves of human talent on which entrepreneurship is based, but also disrupted the continuity of social institutions and formal and informal rules that provide the framework for trade and investment. The economic landscape reflects this lack of key institutions, most notably the rule of law. It also reflects an attempt by the Government to fill the institutional vacuum through administrative measures that have largely not worked, and created opportunities for corruption. Beyond human and social capital, physical infrastructure is lacking. Basic public services are absent for much of the population.

       The decade from its first elections in 1993 has been spent consolidating peace and taking important steps toward a market-based economy , including dismantling much of the central planning and state-trading infrastructure, selling state-owned enterprises, establishing macroeconomic stability, liberalizing trade, freeing prices, and passing basic laws that enable private investment. The right to private property was enshrined in the constitution. FDI responded very well in the early years of liberalization, but gains from the first generation of reforms appear now to have peaked prior to the combination of political instability and regional economic crisis in 1997-1998. The perception of entrepreneurs inside and outside of Cambodia is that corruption is widespread, the rules of the game are not fair or do not exist, and that the country is prone to instability. Consequently, foreign direct investment has fallen consistently since 1999.

       Cambodia now faces an historic opportunity to change its growth path. The Royal Government of Cambodia enters its second decade having held relatively stable elections, and in the broader context of a growing, stable, and integrating East Asian region. This provides a good context to undertake a second generation of reform not focused on establishment of a market economy, but on enabling broad-based growth. The process of accession to the World Trade Organization has been accompanied by a wide range of legal and trade-policy reforms and proposals that define the broad outlines of a new growth platform. Specific reforms that enable the private sector would constitute an important part of this platform.

       Stimulating growth and employment will require development of a policy reform package that rebuilds the confidence of the private sector. Much of the current status of the private sector, particularly the garment sector, responded to the first wave of policy reforms – from 1993 to 1997. The impact of this package was cut short both by political violence and the regional crisis. A new package is now needed to reinvigorate investment and job growth. Such a package must address the real business costs and issues that reduce productivity and profitability for the private sector (to encourage growth) and also address the issues that are perceived as serious risks that impact the confidence of the private sector (to encourage new investment).

       Because of the magnitude of the issues, reforms required, and limited resources, private sector development implies strategic choice. The process of setting priorities, making choices, and undertaking reforms is what is referred to as private sector development strategy. It is hoped that this document serves as an input to this process.

Source: The World Bank, PICS for each respective country

 1. The Productivity Challenge

       The first challenge of private sector development is to address the productivity gap with countries where key competitors in international markets are located. Cambodian firms and workers are less productive than China, India, Pakistan, and Bangladesh . Total factor productivity is some 18 percentage points below India , 24 points below China , while roughly even with Bangladesh . Because of its scarcity, the productivity of capital is high. However, TFP is brought down by labor productivity , which is roughly 65 percent behind India , 62 percent behind China , and about 10 percentage points below Bangladesh . Labor costs are low, but do not compensate for low productivity levels. The ratio of labor costs to value added is actually higher than China , India , and Pakistan .

       The message from the survey is one of weak rule of law, bureaucratic costs, and corruption. Cambodia firms identify corruption as their leading constraint.

  •  Four-fifths of the private sector sampled acknowledges the necessity of paying bribes, and 71% of large firms report that these payments are frequent. The private sector estimates that unofficial payments cost firms an average of 5.2% of total sales revenue.

  •  Business's view of agency integrity is alarmingly negative, with the Judiciary and Customs viewed the most negatively.

  •  Comparing these ratings to results from a related 1999/2000 survey, perceptions of corruption have not improved. Unfair and informal competition and the functioning of the judiciary are now rated as more constraining than before.

Royal Government of Cambodia , National Poverty Reduction Strategy , February 2003. p. iv.

      The formal private sector faces myriad transaction costs and barriers to establishment and operation. It takes 94 days to start a business in Cambodia – 30 days longer to start than in Vietnam and 52 days longer than in Thailand . Staying in the informal sector appears to be a rational response to the investment climate, because informal firms face lower taxes and bribes. They benefit little from formality.

        Trade facilitation practices in Cambodia stand out in having high official and unofficial costs, delays, uncertainty, and discretion – a critical problem for a country that must rely on exports for growth. In contrast to the public perception of the Cambodian economy as largely free of red tape, Cambodian firms are subject to an unusually high number of inspections, averaging 16 per year, second only to Pakistan and more than China among comparators. There is a high “time tax” associated with government inspections, and in this regard, Cambodia is second only to China .

       The corruption problem is so acute that it crowds out the poor functioning of factor inputs – finance, skills, and infrastructure – as constraints identified by managers, but this is more likely a result of a lack of competition rather than adequate supply of these important factors

As the private sector grows in size and sophistication of transactions, it will quickly confront the weaknesses in finance, human capital, and infrastructure as constraints. Given that these factors take time to develop, impediments in the markets for these factors need to be understood and addressed.

 2.The Diversification Challenge

       The second challenge of private sector development is to broaden the base of economic opportunity and jobs. The private sector is exceptionally narrowly-based. The garment sector contributed nearly four-fifths of Cambodia 's total official exports of $1.44 billion. Yet, employment and the great majority of enterprises numerically are concentrated in agriculture and agro-industry, which does not export much and has a labor productivity less than half that of the garment sector. For reasons of equity, risk, and poverty reduction, the country needs a broader base of firms and sectors that operate at higher productivity levels. From a cost and resources standpoint, Cambodia has a comparative advantage in agro-industry. If value added can be raised, agro-industry can contribute to diversifying the economy by shifting more rural employment to manufacturing. The key question is why value added remains so low, when other sectors, particularly garments, have been able to raise value added. To illustrate the policy and institutional issues involved, the report uses PICS data to compare the urban, large scale, formal sector, represented by the garment industry; with agro-industry which has remained largely small-scale and informal.

       Diversification appears constrained by fragmented markets which limit competition and productivity gains. Integrating markets depends on institutions that support a transition from local, personal exchange to arm's length transactions over a wide geographical area. The increased market scope enabled by formal trade is the basis for competition , which in turn creates specialization and productivity gains . The key factors affecting this transition are the extent to which institutions exist to reduce the risk and cost of exchange, including quality, price, and contractual risks, and the cost of coordinating production, finding partners, and executing transactions. We compare the institutional environment for garments and agro-industry.

        The garment sector has proven its ability to export and grow, but it now faces the prospect of lower prices and therefore the need to increase its efficiency. Like garment exporters throughout the world, Cambodian firms must contend with the liberalization of garment trade at the end of 2004. Cambodia 's garment sector has grown in an environment of preferential access to the US and EU markets. Through the WTO Agreement on Textiles and Clothing, the US has given Cambodia a quota in its protected market, the volume of which depends on labor practices. Such agreements will be replaced by competition in 2005. There is a possibility that corporate social responsibility practices will become a source of competitive advantage, but Cambodia competes in high-volume segments where demand is likely to be cost-sensitive. The evolution of price behavior in Cambodia 's non-quota exports to the US suggest declining margins. As the global industry consolidates to reap economies of scale, Cambodia 's industry is at risk. Therefore, the focus is on reducing excessive and overlapping bureaucratic processes and high associated costs – particularly in trade facilitation.

       There is a substantial gap in the scope of trade-supporting institutions in the two sectors (see Table 3.5 in Chapter 3 for full table). Trade in the garment sector is supported by well-developed institutions that provide confidence and trust in Cambodia 's exporters, even in absence of the formal rule of law. These institutions authenticate country of origin, manage quota allocation, verify compliance with labor standards, verify fulfillment of quotas both on the Cambodian side and in the export destination, verify compliance with duty exemptions, and manage quality. Disputes are resolved overseas. Unions exist to organize and express the needs of labor, and the voice of the Garment Manufacturer's Association of Cambodia has clearly influenced policies that support the needs of the sector.

        Since the scope of trade in agro-industry has not yet reached levels that demand a competitive response, demand for more efficient factors of production is low. Extremely low levels of educational attainment and high levels of functional illiteracy characterize the working population in rural areas. Firms in the food sector provide little training to their employees. Firms do not report that infrastructure is a constraint, yet it takes rural firms 2.6 hours to reach their most important market, 3.6 hours to reach the supplier of their main input, and 3.6 hours to get to a financial institution. Commercial funding is almost absent for the agro-industrial sector – only 3 percent of working capital is met from commercial sources.

        To support diversification, the focus is on integrating agro-industry and other rural firms into urban, and ultimately, international markets. This will require (a) removing impediments in such areas as trade facilitation, inspections, and exclusive licensing and (b) building trade-supporting institutions including dispute resolution, product quality and standardization, and market information systems. The rule of law – particularly the enactment and enforcement of contract law embedded in the civil and commercial code – will be required, along with efforts to raise awareness among entrepreneurs of their legal rights and obligations. Because most industries outside of textiles/garments and tourism are at a formative stage, the role of both the private sector in organizing itself and of institutional learning are essential. Given weaknesses in public administration, the report suggests a focus on the development of effective non-state institutions, including business and trade associations.

 3. The Service Delivery Challenge

       The third challenge of private sector development is to play a role in improving access to efficient and affordable water, electricity, transport, and telecommunication services. This can have major impacts on Cambodian living standards and on the investment climate . Efficient infrastructure is essential to sustain economic growth and industrial competitiveness. Cambodia has one of the lowest electrification rates outside sub-Saharan Africa ; it has no power transmission system and has no large generation capacity. Where electricity is available, firms and individual consumers face some of the highest energy costs in the world. Cambodia has the least developed road network in the region with the smallest percentage of paved roads.

       It is difficult to see how Cambodia can address these backlogs in a short period of time using internal resources alone. Inadequate domestic revenue mobilization and skewed public expenditure allocations have kept Cambodia heavily dependent on foreign aid for financing the provision of basic goods and services. A 2002 study revealed that 65 percent of the costs of all infrastructure projects to be undertaken between 1999 and 2001 had no identified source of funding. Further, government resources are able to cover less than one-third of the total annual cost of rehabilitation and maintenance.

       There is significant scope for the private sector to bridge the financing gap, but mobilizing private capital is not the most important role for the private sector to play in infrastructure provision. Internationally, there is a growing recognition that the private provision of infrastructure, within an appropriate contractual and regulatory framework, offers a number of additional “efficiency” advantages over public service delivery, including faster implementation, reduced whole life costs, better risk allocation, better incentives to perform, improved quality of service, enhanced public management, and sometimes even opportunities for the generation of additional revenues. The need for efficiency in service delivery is a key driver for change and creates an opportunity for growth. A number of international firms have already made substantial investments in power, telecom, transport, and airports. Moreover, the local private sector is entrepreneurial and willing to contribute their own equity.

       However, the existing practices associated with PPI prevents many of the benefits frequently associated with PPI from being secured:

The consequences of these problems include unbankable projects, higher than necessary prices, unavailability of information on the value-for-money from infrastructure projects and limited protection of the public interest. The deficiencies in the wider legal framework are reinforced by problems at various stages of a typical PPI project cycle:

       The RGC will need to making immediate and fundamental changes to the current regulatory and institutional environment for PPI – focusing on transparency, predictability, competition, and accountability. It will need to r einforce government performance risk by using political risk guarantee instruments to protect foreign investors and lenders not only against war, currency transfer, and expropriation, but also against government breach of contract risks . It will need to make a transition from subsidized tariffs to full cost recovering tariffs and connection subsidies to connect some of the poorest households, employing private partners to ensure effective delivery of subsidies and recognizing that at least some of the investment to achieve build-out targets will need to be kick-started by public finance.

Guiding Principles for Reform

        Ease the burden on business: a shift from a culture of control to a culture of facilitation. Streamline institutional overlaps, particularly in trade facilitation, and reduce the large number of inspections and licensing requirements, particularly those related to ensuring quality.

       Empower markets and competition. The healthy development of the private sector depends on removing policy distortions that prevent market signals from reaching the private sector and helping shape economic decisions. This includes elimination of exclusive dealing arrangements.

       Do not go beyond the limited capacity of public institutions. Given capacity constraints, it is necessary to focus on the role of non-governmental institutions and to streamline the role of the public sector. The strategy should reposition the state to provide effective governance, accountability to the public, and a focus wherever possible on enabling private service delivery.

       Focus on reforms that are empirically shown to relate to improving competitiveness and productivity. There is a range of institutions and reforms that can help the private sector, but in consideration of the survey and value chain analysis, a few that impact productivity. Increasing labor productivity is the most sustainable way to increase job growth.

       Use private institutions to integrate rural and informal sectors. Integration means removing policy-related impediments, both formal and informal, that raise the cost of doing business for firms that are now limited to either informal or small-scale, local trade. This will be achieved by (1) reducing policy-based impediments, particularly in such areas as trade facilitation and business inspections and (2) reducing entry barriers, such as unnecessary licenses and the high cost of registering businesses.

       Focus on institutions that reduce risk and transaction costs. Reduce the cost of measurement of quality and quantity by building standards and, where feasible, sustainable alternatives to state or donor-funded measurement systems.

       Focus on institutional learning, given the early stage of private sector development. Explore the role of local business organizations, scaling up pilot work with rice millers and rural electricity enterprises (REEs).

       Introducing greater accountability in policy formulation and performance. No strategy or economic policy can have impact unless it is monitored and there are consequences for objectives and milestones that are not achieved. In Cambodia , donors currently provide a monitoring role. This is inconsistent with a program designed to achieve sustainability. The strategy should strengthen private sector and citizen monitoring of public performance (including corruption) and capability to participate in policy dialogue – both to support Government-Private Sector Forum and rural areas.

Reform Initiatives

       The analysis suggests a number of reforms that are clearly linked to restoring confidence and raising productivity. Private sector development is an evolving process, and a successful reform can only emerge from a continual effort to improve the investment climate. Based on the analyses conducted to date, the following eight reforms emerge as initial priorities that (a) address some of the key problems raised in the analysis that are closely associated with costs, and (b) address what the private sector perceives as the key problems, and (c) support the WTO accession and the related legislative package.

       1. Trade Facilitation. Any trade-led private sector development strategy depends on efficient trade facilitation. As described in the value chain analysis, Cambodia 's trade facilitation practices are markedly inefficient, both in cost and time terms, due to a combination of administrative overlap, inefficient processes, a lack of automation, and high unofficial and official costs.

       •  Process streamlining and automation. CED's current streamlining program – which is already defined – should eliminate a number of non-value adding steps. Following this, comprehensive automation should be introduced, including documentation related to documentation, export licensing, certificates of origin, and risk management. Inspections should be conducted on each container, but only on those that clearly fall within risk parameters, which can be automated.

       2. Removing Impediments to Diversification. A set of administrative requirements, including some parts of the business registration process, licensing, and inspections, should be eliminated as they are frequently ignored, and as currently designed, contribute to informality and are associated with bribe payments.

       3. Strengthen the Rule of Law. Contract law, as embedded in the Civil and Commercial Code, is of critical importance to a trade-led private sector development strategy.

       4. Leveraging Private Sector Value Chains. This recommendation focuses on the use of supplier development programs and value chain incentives to create linkages, rather than relying extensively on public institutions. This involves facilitating FDI in retailing, logistics, and agribusiness.

       5. Review the role of CamControl. CamControl serves several functions, including regulating quality and public safety. Some of these mandates are vital for public safety, but the way it currently executes its mandate needs to be modernized. It should base the import inspection activities on a risk management approach and it should strengthen the efficiency of its knowledge-providing role, with its laboratories used more on a voluntary basis to facilitate product testing and trade. The review should consider the possibility of merger with Customs, retaining as is, or establishing a new Food and Drug authority.

       6. Strengthen Governance for Increased Private Participation in Infrastructure. A reform plan would rationalize institutional overlap and clarify processes at each stage of the project life cycle: primary and secondary approvals, responsibility for granting contracts, contract management and monitoring, and capacity building.

       7. Strengthen Institutional Learning through Business Associations.

Particularly at the early phases of organizing the private sector's response to increased market opportunity, it will be important for the private sector to coordinate and share the cost of learning. Business Associations can increase access to market information. Over time, it is important that the private sector develop its own capacity to monitor development of policy and to advocate sectoral interests within a fair political process.

       8. Accelerate leasing. While access to capital did not appear as a high priority to many firms, it is clear that it will constrain firms that compete. Leasing is potentially viable as a form of finance that depends least on a fully-functioning legal system, since title typically does not change hands during the transaction.

Prioritizing Reforms

       During stakeholder workshops in December and February, the reforms were discussed in terms of their impact, urgency, degree of further analysis needed, and their ease of implementation. The outcome of the workshops suggested that trade facilitation and removing of impediments to diversification such as licenses would be the most immediate and actionable areas, despite significant political will required.

Government Actions and Commitments

       The Bank team presented the findings of the Investment Climate Assessment to the Government in February 2004. The Senior Minister of Economy and Finance, the Minister of Commerce, with the support of the Prime Minister, called for a Government-wide discussion which took place in a series of government discussions in March. In one such the discussion, the findings of the report were presented to a meeting of approximately 90 senior Government officials. From these discussions, the Prime Minister issued Decision No 12/2004 on March 22, 2004 , creating a Special Inter-ministerial Task Force (SITF) for Improving the Investment Climate and Trade Facilitation. This task force has the task of proposing immediate measures to reduce trade facilitation costs, reduce duplication and simplify processes, reduce the time required, and increase official Government revenue.

       The Bank team met with the SITF on March 25, 2004 and agreed in principle to focus on (a) reducing product inspection burden, (b) implementing a single window, (c) developing a performance measurement system, and (d) restructuring human resources management. The Government, via the task force, decided to take several short-term reform measures in these areas as a response to the findings of the ICA as discussed below. The Bank and Government mutually agreed on a two month period to develop these reforms.

       Following the two-month period, the Bank met with the Special Inter-Ministerial Task Force (SITF) again on 7 June 2004 . During this second meeting, the Government committed to a number of critical reforms to be undertaken over an eighteen-month period from June 2004 to December 2005. A cross-agency reform team was identified to lead this effort, including all key agencies involved in investment climate and trade facilitation issues: Ministries of Economy and Finance, Commerce, Agriculture, Labor and Social Welfare, Interior, Industry, the CDC, and the Port Authority of Sihanoukville. The reform team will report to the Special Inter-Ministerial Task Force Chaired by the Minister of Economy and Finance, will work closely with the Bank, and interact with the private sector.

       The Special Inter-ministerial Task Force (SITF) committed to developing a transparent performance measurement system, measuring the steps, time and cost to import and export product, including all relevant agencies. The private sector will play a role in the monitoring system. SITF agreed to replace the current frequent and discretionary inspections with a risk management approach, in which inspections will be selective, based on the risk profile of the shipment only. The SITF will lead a process of simplifying and streamlining the process, including removing redundant steps, and replacing all current documents with a Single Administrative Document to be filled out once by the private sector. Rather than have the private sector meet with each agency involved in trade facilitation separately, a Single Window process will be established and the roles of various agencies will be rationalized. The SITF also agreed to simplifying licensing and registration processes, and automation of the trade facilitation process.

       On 26 July, 2004, the Prime Minister's Decision 44/2004 end the mandate of the Inter-ministerial Special Task Force for Investment Climate Improvement and Trade Facilitation and formed a Steering Committee for Private Sector Development, which will serve as the Government's focal point in determining, leading, implementing, and monitoring the implementation of the Rectangular Strategy on Private Sector Development, including improving the investment climate, trade facilitation, SME promotion, and PPI.

       Implementing the reform program will require the engagement of all stakeholders. To help ensure that the private sector contributes to a new investment climate characterized by better governance, the Government will encourage, through the Government-Private Sector Forum, the development of codes of ethics in the private sector, and the creation of a national award for good corporate governance and citizenship. The Government has also encouraged the donor community to develop a Sector-Wide Approach (SWAp) to align its support, which is currently fragmented, to an agreed set of policy priorities. This report has been discussed with donors, and there is broad agreement on its relevance as a policy platform that donors can support. Other important efforts to be integrated in a potential SWAp include those of UNDP, Asian Development Bank, JICA, the European Union, AusAID, GTZ, and Danida. On the Government's request, the Bank will review options for financing the reform program.

       Details on all of these areas and on actions agreed by the Task Force and the Bank can be found in Chapter Six. Chapter Six also includes previous reforms undertaken by the Government in related areas.[Back to main]