Reduced earnings and shrinking concessional loans amid the pandemic suggest that it is time to revamp the financing model as the Kingdom moves closer to graduating from LDC status

The pandemic has exposed some vulnerabilities in Cambodia’s financing model, indicating an urgency to reevaluate its strategies to raise revenue and secure funds as the process for migration out of Least Developed Country (LDC) status beckons.

Following the collapse of the tourism sector and a major slowdown in the garment manufacturing and real estate and construction sectors, the stress on the government coffers has been daunting, particularly with severe shortfalls in revenue collection and grants.

Cambodia’s main revenue, in terms of direct and indirect (value-added tax and excise duties) as well as international trade revenue, is from the export and construction sectors while domestic revenue boosted savings, which stood at 20.2 per cent of gross domestic product (GDP) in 2019.

The austere landscape has been further compounded by the economic fallout in the past year, and even more so in the last five months of the third wave where more than $300 million in business activities has been wiped out, economist Dr Chheng Kimlong estimated in March.

In the near term, the impact from Covid-19 would mean that financing to support development is likely to more than double to $23.4 billion, accounting for 69.8 per cent of GDP by 2025, UN Development Programme (UNDP)’s latest Development Finance Assessment showed.

Aside from that, development financing as a whole might have retreated by $3.6 billion or 19.8 per cent in 2020 compared to a scenario without the pandemic.

This loss is made up of domestic revenues at $1.5 billion, foreign direct investment ($1.3 billion), domestic private investment ($410 million), and remittances ($330.9 million).

“Of all the financing flows, FDI might suffer the sharpest drop followed by domestic revenue, remittances and private investment, declining by 31 percent, 23.6 percent, 20.2 percent and 16.3 percent, respectively,” UNDP resident representative Nick Beresford said.

Using a multiple linear regression technique, which employs several explanatory variables to gauge the result of the subject matter, the report showed that net FDI fell back by $2.9 billion in 2020 while domestic revenue dropped 28 per cent year-on-year to $4.2 billion in 2020.

The fall in FDI is expected because of Cambodia’s heavy reliance on investment in global value chain-intensive industries, which have been severely hit, and because it cannot afford to adopt the same economic support measures as developed economies.

Mainland China continues to account for the majority of foreign investments as well as public debt, where it represents 35 per cent of overall external borrowing in Cambodia.

With the ongoing deployment of fiscal stimulus to support the economy and protect vulnerable groups, UNDP expects deficit to rise.

Measures were taken to protect the banking system by easing bank and microfinance institution reserve requirements and relaxing the few monetary policy measures available to the National Bank of Cambodia (NBC), which strengthened liquidity buffers.

However, a slowdown in China and an overextended financial sector pose further downside risks to Cambodia’s growth prospects given its heavy reliance on capital inflows from China.

“There are impacts on a variety of other flows ranging from remittances to official development assistance (ODA) loans. The government’s fiscal position is anticipated to come under further pressure,” the report warned.

Dramatic fall in ODA

By virtue of the Kingdom’s economic profile since independence, grants and concessional loans, classified as ODA have financed development projects such as health, transportation, energy as well as supported budget and trade deficits.

To date, the Council for the Development of Cambodia (CDC) data showed that 3,517 out of 3,830 ODA projects are recorded as grants, meaning that repayment is not required whereas the remainder are concessional loans, albeit with a 25 per cent grant element.

In order to reach medium-term growth targets, around $15 billion has been budgeted under the current National Strategic Development Plan for capital investment by 2023.

So far, the government has been successful in mobilising significant development cooperation resources to support socioeconomic development, reaching levels over $1 billion per year since 2008, UNDP said.

But having reached lower-middle income status, Cambodia’s development financing needs would change with the available sources of finance.

“Some forms of finance, such as grant-funded ODA, have fallen dramatically. Other flows, such as domestic resources, remittances and FDI, are expected to continue to increase,” it said, barring recovery from the pandemic.

Beresford told The Post that the decline in relative term for ODAs is something to be expected, as the size of the Cambodian economy is growing.

“This trend can also be observed in many developing countries, particularly Cambodia’s neighbouring countries, including Vietnam and Laos,” he said, noting that ODA is not the only development financing source available to support investment in Cambodia.

Domestic financing sources, including public domestic revenue, private domestic investment and remittances, have been growing quickly over the past 20 years whereas remittances alone are as significant as loans from ODA. For example, remittances grew some 28 per cent to $1.5 billion in 2019 from 2015.

Economic recoveries around the globe, especially Cambodia’s major trading partners and migrant destination countries, have accelerated export and will absorb the migrant labour force from Cambodia.

“This, in turn, will help improve investment domestic revenue and remittance flows,” Beresford said.

In addition, the government can look at restoring the level of FDI and private domestic investment via credit guarantees to firms, especially small and medium enterprises, and by examining the use of tax concession to boost FDI and domestic investment.

Post-graduation effect

This year, Cambodia “finally” met the criteria for graduating from LDC status, although it still fell short on the economic and environmental vulnerability components, said Dr Jayant Menon, visiting senior fellow at Singapore-based Institute of Southeast Asian Studies (ISEAS-Yusof Ishak Institute).

While Cambodia should start preparing for the consequences of graduation now, the major impacts are unlikely to be felt for some years yet.

“Even after graduating from LDC status, which will not be for several years still, Cambodia will [remain] eligible for concessional and grant financing for some years after that, as long as it remains a lower middle income developing country,” he told The Post via email.

The immediate impact of graduation is usually felt on the trade front, impacting preferential market access and the implementation of World Trade Organization rules and disciplines, but Cambodia has already had to deal with that.

“Therefore, it is unlikely that graduation from LDC status in a few years’ time will have a very large impact but will require some adjustment, and preparations for that should start sooner rather than later,” he opined.

In 2015, Cambodia was declared a lower-middle income nation. It hopes to reach upper-middle income status by 2030 and developed status by 2050.

According to Beresford, the graduation is not automatic as the UN Committee for Development Policy (CDP) also considers a set of supplementary indicators and other information on the sustainability of a country’s development progress.

Its per-capita gross national income (GNI) of $1,377 (based on the 2017-2019 average) was “well above” the graduation threshold of $1,222 while its performance on the Human Assets Index, which is a set of health and education indicators, stood at 74.8, also above the graduation threshold of 66.

However, Cambodia’s score on the Economic and Environmental Vulnerability Index in 2021, as Menon indicated earlier, was 30.6, marginally below the graduation threshold of 32.

Beresford said 2021 was the first triennial review at which Cambodia met the overall graduation threshold and if it continues to do so in 2024, CDP will consider whether to recommend it for graduation.

The recommendation would need the endorsement of the Economic and Social Council (ECOSOC) and the UN General Assembly, following which Cambodia would enter a minimum three-year preparatory period.

“[It] could still enjoy the LDC-specific trade preferences and derogations until at least 2027, with some LDC-specific measures offering extended transition periods beyond that date,” he said.

In any case, Cambodia has been a recipient of other official flows (OOFs), particularly from China, said Dr Sophal Ear, associate professor of Diplomacy and World Affairs at Occidental College in the US, adding that OOFs are “far less” concessional in nature and do not qualify as ODA at all.

“Whether or not Cambodia is ready, the country will graduate sooner or later from LDC status and must ready itself for the reality that grants will be replaced by loans.

“Yes, the process will be slowed down due to the pandemic, but it will be inevitable. Everything for Cambodia is likely to become less concessional, period,” he said via a social media platform.

Revving up domestic revenue

This circles back to Cambodia’s financing management model, as the government dips further into the coffers to support fiscal stimulus programmes and capital expenditure of public infrastructure projects.

Cambodia’s domestic revenue is dominated by tax revenue at around 80 per cent. Had Covid-19 not occurred, UNDP said the revenue would be 23.6 per cent higher at $6.5 billion in 2020 compared to 2019.

In the near term, the pandemic has had a profound impact on Cambodia’s overall financing position where resource flows except ODA are negatively affected with public sector resources especially challenged.

“The situation is serious enough to merit an emergency response to public financing and rapid policy changes for private sector flows to support businesses and protect value chains,” UNDP said.

Sophal agreed that urgent response was sensible to protect value chains which he said were difficult to establish and could be easily destroyed.

“[However] Cambodia is not a poor country … just look at the Bugatti Chiron and Bentleys on the streets. Why is that money in private hands only and not being used for the benefit of the nation? There is so much more scope for public financing, only if there is political will,” he remarked.

Earlier this year, the government submitted its application for the first round of concessional loans of $2.1 billion, making it the largest-ever borrowing on record.

To be sure, the public debt stock remains comparatively low, at 28.2 percent of GDP as of 2019, which is beneath the Debt Sustainability Analysis threshold of 55 percent.

Regardless of the economic contraction due to the pandemic, experts say there is growth opportunity in domestic revenue.

Noting three key recommendations to review the funding structure, UNDP urged the government to consider the implementation of sin taxes to gambling, tobacco and alcohol, and other taxes with social and environmental positive externalities.

“[The taxes] not only increase revenue collection but also avoid future public expenditures such as provision of health services,” it said.

Anthony Galliano, CEO of Cambodian Investment Management Co Ltd, a financial services firm, said a recovery plan should focus on growing and diversifying the financing pillars – domestic revenue, FDI and private domestic investment, given the impact on financing flows.

While he commended the General Department of Taxation for improving tax collection and expanding the tax base, he said implementing capital gains tax and sin taxes would provide a new avenue of tax revenue and boost the national treasury.

“[The capital gains tax] would lessen the dependency on corporate taxpayers who are pulling all the weight,” he said, adding that individuals investing and speculating in property have “long enjoyed freedom” from capital gains tax.

“Given the more urgent need to improve the country’s finances post Covid-19, the capital gains tax should finally be implemented, and more importantly, taxation on individuals broadened and enforced.

“There is room for refining the proposed capital gains tax to make it more palatable, such as exemption on capital gains tax on sale of main home up to certain limits, long-term and short-term rate differentials, and a tiered tax to alleviate the burden on the less wealthy,” he said.

Having been a long advocate for the increase of sin taxes in all sectors, Galliano opined that Cambodia’s cigarette tax is among the lowest in ASEAN.

He said the increase in sin taxes has multiple benefits not only financially, as in raising government revenues, but it would also reduce harmful consumption and contribute to population health.

Other form of taxes that can help the coffers include property taxes which currently only represent one per cent of GDP, well below a normal range of two to three per cent of GDP.

“Progressive increases and stronger enforcement [prompting increases in limited and comprehensive audits] would be low hanging fruit for an increase in tax revenues,” he said, however cautioning that in the long-term, enforcement on the same parties could be counterproductive as it could shrink the taxpayer base.

“There remains a very large pool of unregistered businesses operating in the Kingdom, a focus on reining in those recalcitrant businesses, [which] was successful in 2016. [This] will yield substantial gains,” he told The Post.

Separately, Beresford said the government should look into blended financial models to raise efforts of delivering governance on increasingly varied capital resource flows, particularly to boost private investment.

These models involve pooling finance from public and private investors as well as from ODA and other players, he cited, adding that green and climate change bonds can equally expand financing sources where issuers are committed at investing proceeds to generate environmental-friendly goals.

However, all these boils down to accountability and transparency where Cambodia lacks results-based budgeting. So far, implementations are only limited to government office supplies but not for programmes, ministries or national development goals, UNDP said.

“When a billion or more dollars is literally controlled from the Prime Minister’s office, there is obviously a problem of inadequate transparency in usage of public resources,” Sophal commented.

He felt that the government treasury should never “be a slush fund of this size or proportion”, although it has been that for “many years”.

“Why can’t a budget handbook and open budgets be part of the process of graduation from LDC status? We need to open the books. Accountability will follow,” he said.

Beresford explained that results-based budgeting are aimed at improving the efficiency and effectiveness of public expenditure by linking the funding of public sector organisations to the results they deliver, making systematic use of performance information.

“[Although] Cambodia has already engaged in results-based budgeting, its reach remains limited. Work still needs to be done to improve capacities within the government to work according to results-based management principles and to further apply this to budgeting,” he contended.

Loans over grants

While near term outlook seems grim, UNDP’s medium term forecast on financing flows is no better, suggesting that trends might take a minimum of two to three years to re-establish themselves, depending on the progress to end the pandemic.

It said ODA would continue declining in relative terms, but its absolute value, especially through concessional lending, would remain significant, having grown in real terms in recent years.

“Its composition has and will continue to evolve, however, favouring loans over grants. The level of loan concessionality will decline as Cambodia progressively exits preferential terms. Public sector domestic revenues will recover slowly as the crisis abates, although solid growth is expected to return.

In time, recurrent revenues will reach ceilings as a proportion of GDP, and then record GDP equivalent growth.

“Given this, and the decline in ODA, it is vital that the government establish mechanisms for long-term sovereign borrowing in domestic currency,” it said.