The CICP Newsletter, Issues No. 15 & 16, June-July 1996

by Sophal Ear*

In traditional international macro-economic analysis, dollarization poses both a problem and a solution. For Cambodia, this is no exception. Dollarization is a term used to describe the use of the dollar, along with, and sometimes without the domestic currency, in market transactions. Usually, it is a problem of central bankers because it virtually eliminates the ability of the National Bank of Cambodia (NBC) to set monetary policy independent of the American Federal Reserve if it wishes maintain currency stability.

What does it mean for a country to experience monetary independence? Monetary independence means that the country's central bank, in our case, the NBC, can move the money supply to target a certain level of unemployment deemed to be the natural rate of unemployment for macro-stability. In addition, a particular interest rate, or an optimal inflation rate can also be targeted. The targeting which takes place in other countries is impossible here, because of dollarization. Monetary independence, however, is not something always desirable. With a relatively small country that is open, in terms of traded goods, capital and labor, the power of the central bank to affect these variables is quite minimal. An example of such a country-colony is Hong Kong, where the HK$ is pegged to the US$. Why does dollarization take place? When people lose faith in the domestic currency, they turn, quite rationally, to currencies which have established records of stability. The dollar, arguably, is one of these currencies. What problem is dollarization trying to solve? When the exchange rate for the riel is volatile, volatile to an extent unbearable for those who do business, the use of other currencies with proven stability is not unexpected. What does exchange rate volatility produce? Price instability, and more often than not, inflation. Inflation, which is really a tax on money holdings, can, when it is high and unpredictable, lead to low economic growth.

Therefore, dollarization is really the rational individual's solution to keeping prices stable, and business moving. At the same time, it prevents the use of policy instruments like monetary expansion and contraction to steer the economy. In the U.S., the main instrument for macroeconomics policy has increasingly become monetary policy, because the federal budget is constrained by entitlements and the payment of interest on the national debt. Fiscal policy has lost influence and flexibility relative monetary policy. For Cambodia, the NBC needs to establish its own credibility as an independent central bank with the will required to keep inflation low.

On 31/05/96, at the Phnom Penh Central Market, an American dollar sold for 2640 Riels while it was bought for 2660 Riels. For those who are interested, the transaction cost of only 20 riel is about .76%, a very small spread which suggests healthy competition. This competition is reflected in the large number of sellers, but also in the large number of buyers. This is similar to the cost of "moto-doob" transportation in Cambodia which, to the savvy residents, costs only 500 to 600 Riels.

For Cambodia, there is, to be sure, more underemployment or disguised unemployment in Phnom Penh than unemployment per se. People are working, but often times, three or four are doing the job of one person (especially in services like waitressing). This is a problem that Cambodia seriously faces. One plausible way it can be alleviated is by increasing the level of investment in human capital, namely, education and health care, to increase marginal product of labor for all individuals, and thus their respective wage.

* Sophal Ear is a master's degree candidate, concentrating in economics and public policy, at the Woodrow Wilson School of Public and International Affairs, Princeton University. The article here is based on his recent observation in Cambodia.