Key messages:

  • Cambodia is a great development success story, building on the return of peace, a dynamic neighbourhood, its economic openness, and its unorthodox but pragmatically successful macroeconomic management.
  • The major short-term challenge is to navigate the ‘perfect storm’ of a series of turbulent economic and geostrategic shocks in 2022.
  • So far, Cambodia appears to be managing these shocks quite well, thanks in part to its minor economic relationships with Russia and its relatively low public debt. But if China’s economic slowdown persists, this will pose a major challenge for Cambodia.
  • The medium-longer term challenges will be to forge a development strategy that achieves rapid, durable, inclusive and environmentally sustainable growth.
  • I see five sets of factors that are likely to be central to achieving this overarching objective:
  • First, allowing the unorthodox monetary policy settings to continue to evolve, while intensifying resource mobilization efforts as the country graduates from ODA.
  • Second, maintaining economic openness, as before emphasizing unilateral and multilateral initiatives, with regional initiatives that are primarily ASEAN-centred, and supplemented by measures to enhance supply-side competitiveness, a phasing out of the ‘dual’ commercial incentives regime, and reform of the fiscal incentives framework.
  • Third, greater attention to equity goals, including a stronger focus on the provision of high-quality primary and secondary education and public health to all socio-economic classes, progressivity in the tax and transfer systems, and the construction of at least a rudimentary social welfare net.
  • Fourth, institutional reform consistent with the aspiration to be an upper-middle income country within a decade, including responsive governance catering to the needs of all strata of society, a commercial environment where competitiveness rather than political patronage is the primary arbiter of business success, and the development of arms-length, transparent checks on public sector malfeasance.
  • Fifth, particular attention to Cambodia’s environmental fragilities, including equitable access to the Mekong, the management of the Tonle Sap ecosystem, and improved urban amenities.

Cambodia is undoubtedly one of the world’s great development success stories. After decades of debilitating conflict it has now recorded the better part of 30 years of rapid economic development and improved living standards. While researching its economy some years ago with Jay Menon, I came to the conclusion that this rapid economic development could be broadly explained by the peace accords, Cambodia’s economic openness, its unorthodox but pragmatically successful macroeconomic policy regime, and a very supportive global and regional environment. The latter included the original multilateral economic/strategic interventions, very large amounts of international development assistance, and an open, dynamic regional economic environment.

The development challenges that today’s middle-income Cambodia faces, aspiring to reach upper-middle income status within a decade, are altogether different from those at the time the 1991 Paris Peace Accords were signed. To think through these issues, I find it helpful to distinguish between short term and medium-longer term challenges.

The short-term challenge is to navigate the perfect economic storm that the world is currently experiencing, and which many poorer countries are feeling acutely. At the beginning of 2022 the world was anticipating a vigorous recovery from the Covid pandemic and a return to normal civic, social and economic life. However, a series of adverse, largely unanticipated, but interrelated global shocks has tempered the earlier optimism:

  • the Ukraine War, and the attendant spike in energy and food prices;
  • rapidly rising inflation, triggering aggressive tightening of monetary policy, especially in the advanced economies; \
  • in turn having at least two negative consequences – sharply slowing global economic growth and the rising probability of a global recession in 2023, and increasing debt distress, potential or actual, in many developing countries (at least 50 according to the IMF);
  • a sharp deceleration in China’s growth with its pursuit of a zero-Covid strategy, thus removing the world’s principal economic locomotive in recent years;
  • ongoing disruptions to global supply chains from multiple sources – catchup from the Covid era, inflamed geostrategic conflicts (especially superpower rivalries), and high energy prices.

These are in addition to the escalating risks posed by climate change, and the global community’s continued ambivalence on how to rapidly achieve a coordinated, effective and equitable response to it.

How does Cambodia look in this very worrying outlook? The priors suggest a mixed picture: Russia is a very minor trading partner, but China is huge. Cambodia is a very open economy (trade of goods and services is the equivalent of more than 120% of GDP), and one that is highly dependent on tourism, suggesting a mixed outlook – increased international travel is good for its tourism sector, but any disruptions to international trade (policy or logistics) will be harmful. Cambodia is net energy importer but a net food (rice) exporter, so the recent trends in its terms of trade effects may be ambiguous. In fact, they are likely negative because, unlike wheat, international rice prices have remained fairly stable in 2022, thanks to good harvests in most of the major rice producing countries. Cambodia is a net external debtor, and so rising interest rates may be of some concern; in fact, its public debt is comparatively modest (although private debt is worryingly high).

In fact, these priors explain a good deal of Cambodia’s recent economic developments and immediate outlook. Pre-Covid the economy was growing very strongly, averaging 7.1% 2015-19. It suffered a relatively mild decline in 2020, of 3.1%, and recovered to 3% in 2021, both thanks in part to the country’s effective management of Covid and the vaccine rollout. Owing to its low public debt, the government was able run sizeable fiscal deficits (7.1% of GDP in 2021). Its public debt is still equivalent to less than 40% of GDP, though it will have to watch this ratio as it continues to graduate from sources of concessional finance. Tourism will likely recover strongly in 2023, assuming that China loosens its outward travel restrictions. Merchandise exports have been recovering quite strongly, a trend that should continue, although Cambodia will need to address the challenge of losing preferential EU market access for its garments and footwear industry. (The country’s dependence on these two sectors has been declining over time, but they still account for almost half of total merchandise exports.)

For all these reasons, and bearing in mind my imperfect knowledge of the country, there is every prospect that, barring some catastrophic event, the country’s economic recovery should continue apace.

What of the medium and longer-term outlook? The principal challenge will be to return to the earlier high growth, while ensuring that the benefits of this growth are distributed more broadly and in an environmentally sustainable manner, again assuming an open and supportive international environment. The fact that Cambodia has achieved very rapid growth in most years since the early 1990s must be grounds for cautious optimism. I suggest that the following five factors are likely to be key determinants of the country’s development trajectory. It’s obviously not an exhaustive list.

1. The macroeconomic policy framework

Cambodia’s quasi-dollarized economy is unorthodox but it has served the country well for three decades. It might be – in fact is in certain quarters – an affront to nationalist sensitivities. It does involve some (minor) loss of seigniorage. And it has the consequence that the government has one less economic policy tool at its disposal. But in a world where misguided macroeconomic policy has severe developmental consequences, the system is functional. It should therefore be allowed to evolve at its own pace. That will likely involve the increased adoption of the Riel, though it needs to be noted that it is not uncommon for smaller economies surrounded by much larger ones to be dollarized, formally or defacto.

The principal fiscal policy challenge will be domestic resource mobilization as the country graduates from international development assistance. A particular challenge will be government-guaranteed mega infrastructure projects, which call for high-quality, arms-length project evaluation. There are political economy implications here too, for in small open economies infrastructure projects (and land) are very often the major sources of political patronage. Also, as Cambodia progresses towards upper-middle income status, social policy objectives are likely to be elevated, beyond the immediate provision of basic education and health services. Cambodia’s tax and transfer system lacks progressivity and the public social welfare net is minimal.

2. Staying open

Cambodia’s open economy is fundamental to its post-conflict economic success. The economic openness has transformed the labour market and been a major driver of declining poverty. The signal that Cambodia is ‘open for business’ has registered in regional and global production and service networks. Initially heavily reliant on just garments and tourism, the export base has progressively broadened, to footwear, electronics and other manufactures. In addition there has been upgrading within these industries, for example in garments from simple sewing operations to manufacture of various accessories. Cambodia’s openness has also created opportunities when investors and buyers seek market diversification, including ‘China + 1’ strategies, and also ‘Thailand +1’ after that country’s crippling 2010 floods.

This industrial evolution can be expected to continue, providing attention is paid to key demand and supply-side variables. Cambodia has the great fortune of being able to closely observe, and learn from, neighbouring Vietnam, the stellar manufacturing export success story of ASEAN in the 21st century.

A ‘staying open’ strategy has several dimensions. First, the main policy game will always be unilateral and multilateral reform. Non-ASEAN bilateral and regional trade agreements are unlikely to deliver much, and can be hugely distracting of bureaucratic resources, unless they are open and large-scale agreements. (Arguably, with reservations, RCEP and the CPTTP, meet the latter criteria; Cambodia is a member of the former but not (yet) the latter.) The danger with most other PTA’s (preferential trading agreements), especially for a still-poor country like Cambodia, is that the concessions they deliver are invariably less than anticipated and they distract policy makers from the more important unilateral reforms.

Other elements of the trade architecture are also important. Global production networks are driving much of intra-ASEAN and intra-East Asian trade, and to participate in these membership of the WTO-ITA (World Trade Organisation Information Technology Agreement) II agreement is essential. As noted also, EU market access for garments and other exports is a key challenge. And perhaps most important of all, Cambodia needs to do everything it can to avoid being dragged into China-US trade and geostrategic conflict. Here, too, ASEAN membership is central (and especially Vietnam’s record of adroit diplomatic management).

The domestic commercial incentives framework will also need to evolve. In the early stages, it made sense for Cambodia to introduce special economic zones, as a signal to investors, and to ensure the smooth movement of goods and the efficient provision of infrastructure. Cambodia reportedly now has 54 SEZ’s. But this arrangement should be best seen as a transitional strategy on the way to economy-wide liberalization. In this respect, Cambodia can do no better than look to Singapore on how to manage this transition. The evolution needs to proceed to avoid the country becoming an unintegrated dual economy. The very generous fiscal incentives will also need to be reformed, as they undermine the government’s fiscal effort and are no longer as important as they once were.

3. Ensuring broad-based improvements in living standards

Forty years ago Cambodia probably had the highest poverty incidence in the world. The dramatic reduction in poverty incidence since the early 1990s is surely one of the most remarkable achievements in recent human history. Rapid economic growth was the primary determinant of this success, facilitated by rising education and health facilities, the labour market transformation and investments in rural infrastructure. In this respect, Cambodia’s growth-poverty elasticities appear to be similar to those of other high-growth East Asian economies, although Vietnam’s may be somewhat higher (that is poverty is even more responsive to growth).

As Cambodia graduates to higher income status it can afford to place more emphasis on the ‘growth plus’ factors that ensure broad-based improvements in living standards. As I read the inequality literature on Cambodia (see for example the recent IMF working paper, WP/19/187), the evidence on inequality is ambiguous. Cambodia commenced its rapid growth phase with very low levels of inequality, as a predominantly smallholder rice economy. Some increase in inequality was therefore inevitable and, with high economic growth, it did not significantly detract from the rapid poverty reduction. Now that the historical legacies of low levels of education and health provision have been largely overcome, the challenge will be to develop more egalitarian systems that equip all children for life in an upper-middle income economy. For example, Cambodia’s infant mortality rates are still relatively high compared to its richer ASEAN neighbours, as are its school dropout rates. There are very large inter-regional differences in living standards for a geographically compact nation, especially the gap between Phnom Penh and rural areas. Gender differences in educational achievements appear to be relatively moderate, more so than is reportedly the case in the labour market and the political system. As noted also, the tax and transfer system is not yet pro-poor.

4. Institutional development

Among all of Cambodia’s future challenges, this is probably the most complex, overlaid as it is with the ongoing transition from a post-conflict society presided over by one of the most long-lived regimes in the world. Here at least Cambodia can learn from its successful neighbours. Several of the successful developmental states of East and Southeast Asia have developed models where limited direct political accountability can co-exist with responsive and representative governance.

The key is to develop institutions that are independent of political pressures and interference. Several examples are evident in the field of economic governance: professional and well managed central banks, and in some cases competition commissions that ensure a reasonably level playing field. Anti-corruption commissions are another example, although maintaining genuine political independence for these institutions is more problematic. Cambodia will be able to prosper the more that business efficiency rather than political connections is the primary arbiter of commercial success. The country’s high international orientation is a positive factor in this regard, since export success requires business to be internationally competitive. International governance indicators are arbitrary, subjective and contentious, but Cambodia’s ranking in Transparency International’s Corruption Perceptions Index (157 out of 180 countries) is sending an unwanted message to international investors and traders. Justice with respect to land titling and access is reportedly still a major issue, another illustration of post-conflict legacies (as it is, for similar reasons, in nearby Timor Leste).

5. Managing the environment

Cambodia is a net food exporter, and its agricultural resilience (not to mention its tourism industry) will continue to be challenged by climate change. It also faces two major water issues which are significantly beyond its control and therefore require high-level international cooperation. One is the state of the Tonle Sap Lake system, which is a huge source of livelihood and nutrition for so many rural Cambodians. For various reasons, the health of this vital eco system is reportedly under threat. The other challenge is the state of the Mekong River, and Cambodia’s imperilled access to it as a result of climatic factors and irrigation/hydro activities upstream. Clearly Cambodia does not have the luxury of waiting for the ‘environmental Kuznets curve’ to take effect.