Efforts to de-dollarise the economy has been ongoing, slowed down only by the pandemic. Heng Chivoan
Experts weigh in on the effect of a potential interest rate expansion by the US Federal Reserve on a highly dollarised Cambodia
Anticipation of the US Federal Reserve’s interest rate hike in March is putting developing economies on edge, a recent blog post by the International Monetary Fund (IMF) stated.
Experts are predicting between two and four rate increases to quell an overheating US economy, aside from the central bank’s known plan to reduce the pace of purchase for treasury and mortgage-backed securities.
These monetary policies that the US Federal Reserve is implementing are aimed at keeping the US employment and inflation rate at two per cent in the long run, which was why it set the target range of the interest rate between zero and 0.25 per cent.
But inflation has “exceeded two per cent for some time”, it said last December.
In a note on January 9, Wall Street chief economist Jan Hatzius, who was quoted by CNBC, wrote that the US Federal Reserve could be looking to a full increase of “100 basis points” by the end of 2022.
His view alluded that there could be four hikes of 0.25 per cent each time.
Against this backdrop, the US dollar has been gaining strength, rising 5.1 per cent in a year on the DXY index (which measures the US dollar against a basket of major currencies), at the time of writing.
For a highly dollarised Cambodian economy, this does not augur well for growth, but it is not all bad news either, experts believe.
In its recent macroeconomic and banking sector outlook, National Bank of Cambodia (NBC) made a note of the “high level of dollarisation” which caused depreciation pressures on the Khmer riel, as public expenditures rose.
It also mentioned that the drop in the value of the Khmer riel was compounded by a “weaker demand”.
Although efforts to de-dollarise the economy are ongoing, present situations are slowing that process, as dollar deposits surged amid high dependence on gold as saving assets.
It was evidenced by the ten-fold increase year-on-year in gold imports totalling $4.08 billion in the first nine months in 2021 – which contributed to the widening of the trade deficit, said the World Bank, adding that it reflected a “hedge against price volatility and inflation”.
As the riel is based on a floating exchange rate regime, the NBC conducts open market operations from time to time to peg the value based on demand and supply, which is comparable to the US dollar.
Last year, the NBC “continuously intervened in the foreign exchange market” to maintain stability of the riel and preserve the purchasing power of the people, owing to the drop in external demands.
It said up to $500 million was injected to maintain the value of the riel at around 4,099 to the dollar, which was a slight depreciation of about one per cent in relation to that in 2019.
“Exchange rate stability and sound management of money supply in the economy have contributed significantly to price stability, with a low inflation rate of 2.9 per cent,” NBC said.
The central bank said inflation in 2021 was contributed by the “rebound in the price of oil-related items while food price and core inflation decelerated”.
This year, it expects the consumer price index or the headline inflation to ease to 2.6 per cent, mainly underpinned by “subdued food prices due to improved supply condition” while the riel stabilises around 4,075 per US dollar.
Source: Economy and Monetary Statistics, August 2021 (National Bank of Cambodia)
However, it cautioned that global economic recovery and rising inflationary trend in major developed economies might push it to normalise the monetary policy.
It inadvertently could trigger capital outflows from emerging economies and cause gradual revaluation of the US dollar.
“This trend will put pressure on the riel exchange rate against US dollar and reduce the competitiveness of Cambodian exports due to high dollarisation,” the bank statement read.
In the meantime, the World Bank said there is also the risk of “importing inflation”, where Cambodia’s main import partners experience price pressures.
For instance, a surge in inflation in US could impact domestic price pressures.
Given Cambodia’s high dollarisation and the riel pegged to the dollar, rising inflation in the US could lead to “rising domestic price pressures, which often results in imported inflation”, it said in its latest economic update.
Source: Cambodia Economic Update, Dec 2021 (World Bank)
US, an exception
This year, NBC projects the economy to expand by five per cent as its opens up the economy, with renewed external demand, following a subdued three per cent growth in 2021.
Singapore-based economists Bernard Aw and Eve Barre of Euronext Paris-listed Coface SA, a French global credit insurer, believed that while a robust greenback would impact Cambodia’s competitiveness in key export markets, such as EU, China, Japan and ASEAN with 54 per cent dominance in export destination, the “US market, which makes up for 30 per cent of total exports, would be an exception”.
“That said, garment exports, around 42 per cent of total exports in 2020, would also benefit from the gradual recovery of the global economy in 2022, and the continued normalisation of the retail sector,” they said.
In the midst, there would be pressures on the riel exchange rate, but they are of the opinion that NBC would continue intervening in the market to maintain its local currency stability.
Similarly, Moody’s Analytics Inc associate economist Dave Chia remarked that the potential outflow of capital will likely be “tamed” by NBC’s intervention to stabilise the riel if outflow pressure intensified.
This, he said, has been ongoing before and during the pandemic, which resulted in the reduced exchange rate volatility.
Meanwhile, Chia felt that the US dollar denominated term deposits in Cambodia would remain an “attractive option” to foreign investors as banks paid competitive interest rates.
He also forecast that the Omicron variant in the US is likely to have a temporary effect on the March GDP growth.
The underlying fundamentals of the US economy are strong, he said, noting that Moody’s Analytics’ baseline assumed that the Federal funds rate would begin rising from May.
“As the NBC is expected to continue stabilising the riel against the US dollar, a material impact on the competitiveness of Cambodian exports is not expected, particularly given that the US is Cambodia’s largest exporter,” he asserted.
‘Be prepared’
But experts will keep a cautious outlook.
Among them, NBC economist Oudom Cheng, who spoke in a personal capacity said the increase in the US policy rate could lead to higher interest rate in the global financial market, explained.
“Historically, capitals in emerging market and developing economies tend to find its way back to the US and advanced economies where yields are expected to improve and credit ratings are overall better,” he said.
As such, some capital, especially in the short-term, would be the first to return back but long-term capital inflows in emerging and developing economies such as FDI would remain for “quite a while” because of the “pull factors” the markets possess.
“Nonetheless, with less availability of capital, cost would increase for the banking sector in emerging markets and developing countries, including Cambodia,” he said.
In addition, Cambodia is a net importer of capital, which includes borrowings from abroad, particularly by the banking sector.
“This can pose a challenge for banking institutions in terms of rolling-over sources of funds from abroad to supply domestic credit at higher rates, [which] could translate into more expensive cost of borrowings and interest rates for Cambodia in the coming months.
“Another factor is that higher US dollar means [that] banking institutions face a challenge of holding a more expensive US dollar debt than their previously issued loans,” Cheng pointed out.
Given the looming interest rate, it might be only progressive as the US monetary policy normalisation would only be sequential and dependent on the exposure of Cambodia to the US, and how it could indirectly impact Cambodia through other economies.
Therefore, it would not be a shock to emerging markets and developing economies, including Cambodia, he said, adding that the scenario could mean that Cambodia can sometimes buy in the short-term.
However, he warned, Cambodia should be prepared as “vulnerabilities have also been accumulating”.
On the financial sector front, banking institutions are dealing with new challenges such as loans restructuring and expected higher non-performing loans, subdued growth, along with more exposure to unproductive sectors.
“Meanwhile, they also have to deal with old challenges regarding reliance on foreign borrowings, which is now subject to the change in global financial condition,” Cheng said.
On the economic front, the faster pace of US dollar strengthening can obstruct Cambodia’s economic recovery progress.
It should be noted that Cambodia remains a highly dollarised economy where the dollar is being used in almost all economic and financial transactions, especially import-export invoicing.
“Appreciation of the US dollar can reduce Cambodia’s competitiveness and thus lower exports,” he said.
But, a few factors could lessen this impact, as the pace of the strengthening of the US dollar would not be rapid.
Cheng said Cambodia’s major exports are “not very elastic” to its many trading partners, which means its exports would only gradually slowdown.
“In contrast, improvements in the US economic condition and probably other Cambodia’s trading partners could strengthen foreign demand for Cambodia’s exports, which could somewhat offset the impact of higher US dollar,” he added.
Another channel that can impact Cambodia’s economic recovery progress is the transmission of the effect of higher US dollar and rising global interest rate to higher cost of funding in Cambodia.
Higher borrowing cost means higher investment cost which then can reduce the pace of investment growth in Cambodia.
“In this period, policy setting for Cambodia has to take into account three factors [which include] reducing existing macro-financial vulnerabilities, preparing to tackle the impact from the shift in global financial condition, and sustaining domestic economic recovery,” he shared.
Hot money outflow?
The likely increase in borrowing costs can be an issue, said Coface economists Aw and Barre, although these costs have “decreased noticeably” in recent years due to an improved efficiency in the local banking and microfinance sectors.
Source: Cambodia Economic Update, Dec 2021 (World Bank)
They claim that it could raise the debt repayment burden of households and companies, and in turn, weigh on private consumption and investments.
“The Cambodian economy is heavily reliant on private consumption, which contributes 70 per cent of gross domestic product [GDP], while fixed investment is also sizable at 22 per cent,” they told The Post.
Dave Chia of Moody’s Analytics said the exposure of high borrowing cost on consumers is “plausible”.
But, because boosting of private consumption and investments are key objectives to the NBC in the present recovery period, it will likely “mitigate such effects and improve financial liquidity with similar measures adopted during the pandemic”.
This includes loan restructuring and reduction of interest rates on Negotiable Certificate of Deposits in riel and US dollar, he cited.
Separately, he reiterated that outflow of investments or hot money capital was “not likely”, on the expectation that the riel “will largely remain stable against the US dollar due to central bank intervention”.
Although for long-term investment, a stronger USD would imply a higher cost to foreign investors in a highly dollarised Cambodian economy, the “superior” return on foreign investment on a developing economy such as Cambodia could outweigh the higher costs.
“[As such], the impact on FDI also hinges on other economic factors such as how quickly the Cambodian economy could reopen relatively to neighboring countries and the operating environment for foreign firms,” he said.
Riel confidence
Because of Cambodia’s high dollarisation level, NBC has limited space to implement policies, particularly in the short term where only a few policy instruments are available to influence monetary aggregates.
On a longer term, Aw and Barre said efforts to gradually de-dollarise the economy should present the country with a greater degree of policy space to mitigate the undesirable effects of a rising dollar.
In the meantime, they note, NBC has already implemented some measures to encourage greater use of riel, such as setting higher banks’ reserve requirement on foreign currency.
“Other possible measures include having differentiated levels of provisions required on US dollar loans, or a gradual removal of dollar notes in circulation would also help,” they said.
Moody’s Analystics’ Chia also offered that monetary measures such as foreign exchange intervention and reduction of reserve requirements and liquidity coverage ratio should continue, as well as with loan restructuring which remains an important tool to stabilise the financial sector.
“It is important to create confidence in the riel by reducing its volatility as the country seeks to gradually adopt it as the main currency,” he said, stressing that progress in financial innovation such as digital currency is crucial in order to stay competitive and be able to improve efficiency in trade and investment.
