Cambodia Outlook and Risks

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PHNOM PENH March 15, 2014 (Khmer Times) The IMF has stated that Cambodia’s economic activity remains strong driven by robust exports, with garment exports, helped by preferential access to European Union (EU), and tourism with more diversified destinations. 
Real estate and construction also expanded rapidly supported by fast credit growth. Foreign direct investment (FDI) remained strong partly driven by factories relocating from China and Vietnam. 
Despite these indicators, growth is expected to stay at 7 percent in 2013 due to the sluggish global recovery, recent floods, and a slowdown in activity during the election period. 
Growth is projected to pick up to 7¼ percent in 2014 in line with the global recovery and to 7½ percent in the medium term with improvements in infrastructure, competitiveness, and investment climate.
Inflation is projected to stay around 3–4 percent during 2013–14 owing to projected stable commodity prices, once the impact of the recent floods on food prices subsides. 
Private sector credit has been growing by about 30 percent (y/y) on average in the last three years nearly doubling credit-to-GDP ratio to over 40 percent. 
While part of this is due to new banks entering the market, which increased bank flows from abroad, heightened competition in the system also contributed to rapid credit growth. In the process, lending rates and interest rate spreads have declined.
Despite robust exports and tourism, the current account deficit including official transfers is expected to stay flat at around 8½ percent of GDP in 2013 due to strong but moderating imports, and remains fully financed by FDI and official loan flows. 
The deficit is projected to decline to 5½ percent of GDP over the medium term with improved competitiveness and diversification of exports, and lower imports after the completion of large power projects.
Gross official reserves stood at US$3.6 billion in November, about 3½ months of prospective imports. Although this reserve coverage appears to be adequate considering the long term nature of Cambodia’s external debt, the high degree of dollarization (foreign currency deposits are more than 1½ times of gross official reserves) suggests that a higher level of reserves—than that suggested by the reserve adequacy estimates—may be warranted. 
Consistent with this stable external position, the real effective exchange rate has remained broadly flat since 2008 and in line with fundamentals, suggesting little evidence of a fundamental misalignment.
The outlook is subject to downside risks. Slow European growth could affect garment exports, although the impact is likely to be limited as reallocating factories from the region, such as China and Vietnam, brought their supply contracts to benefit from Cambodia’s lower production costs and preferential access to the EU market. 
Cambodia’s direct exposure to international capital markets remains limited, but U.S. tapering as well as slower growth in China may have significant spillovers to the region, and affect Cambodia’s FDI and tourism. 
The potential increase in dollar funding costs in the post-tapering period could also lead to a stop in foreign bank financing from the region.
In light of the fragile confidence in the banking sector following large deposit withdrawals during the election, renewed pressure on deposits could undermine financial stability. 
On the domestic front, further extreme weather conditions could affect the rural poor especially hard, and dent exports and tourism, while prolonged labor disputes could disrupt garment production. 
On the positive side, improving power and rural infrastructure as well as more diversified FDI and a renewed reform momentum after the elections could provide a boost to exports and growth.
Should downside risks materialize, the policy space to support growth is limited as fiscal consolidation has been slower than expected since 2010.
In case of adverse shocks, this limited room for additional spending should be allocated to high impact expenditures on development priorities in education, health, and infrastructure. 
At the same time, high dollarization limits effectiveness of monetary policy and the declining reserve coverage in terms of foreign currency deposits highlights the limitations on the National Bank of Cambodia’s (NBC) lender of last resort capacity to respond to shocks. 
This limited policy space underscores the need for vigilance in containing financial sector risks before they materialize. 
However, should risks to the financial sector materialize NBC should use its available lender of last resort capacity, while expediting the implementation of the crisis management framework, including by enhancing bank resolution powers. 
The authorities broadly agreed with staff views on the exchange rate assessment, outlook, risks and the limited policy space. However, they remained cautiously optimistic that the floods’ impact would be less than projected and expected GDP growth to exceed 7 percent in 2013.
High Medium Exit from unconventional monetary policy could trigger capital outflows from emerging markets.
The potential increase in dollar funding costs could lead to a stop in foreign bank financing.
The direct impact is limited because of Cambodia’s small exposure to the international capital markets, and most capital inflows to Cambodia are FDI-related. 
However, should the volatility affect the countries in the region, tourism and FDI could be affected.
Continued geopolitical events in the Middle East could raise global fuel prices. With no fuel subsidy, any increase in world oil prices would create domestic inflationary pressure.
Slow growth in Europe could reduce Cambodia’s garment exports. The impact would be mitigated by continued utilization of preferential trade access to the E.U. market.
Continued incidences of labor strikes could disrupt garment production. Labor market instability could create a drag on exports and growth, and if prolonged, could weaken Cambodia’s competitiveness.
Extreme weather conditions (drought or flood) could lower agricultural production. Extreme weather shocks would adversely affect growth and have serious welfare implications on farmers and rural population.
Slow progress in fiscal reforms could hamper fiscal consolidation. Limited progress in mobilizing revenue and pressures to increase spending would hamper the efforts to rebuild fiscal space and jeopardize fiscal sustainability.
Continued rapid credit growth and proliferation of real estate financing could jeopardize macroeconomic and financial stability.
Excessive risk taking by banks to compete for market share amid a growing role of foreign financing could result in a deterioration of asset quality, increase in financial sector vulnerabilities and liquidity risks, and a decline in confidence during a downturn. 
High degree of dollarization limits the lender-of-last resort capacity of the central bank. 

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