Based on an interview with Radio Free Asia in January 1998 that was broadcast February 3, 1998 the following article represents the author's own views and should not be attributed to CICP.

The CICP Newsletter, Issue No. 23, January-February 1998

by Sophal Ear*

 In an increasingly globalized world, countries are much more vulnerable to external shocks. Country size and openness are the paramount factors--namely how much impact the country will have on world prices (i.e., if it is large, it may be able to change prices, but if it is small it won't) and to what extent international trade and finance comes into the picture. The Asian crisis has had an impact and will continue to have an impact on all countries which have economic relations with the countries undergoing turmoil.

Of particular importance is how a currency and financial shock abroad can be transmitted at home not just in the form of contagion, but via reduced competitiveness and withdrawal of foreign direct investment.

a. The countries which have devalued their currency invest heavily in Cambodia. Thailand, Malaysia, Indonesia, and South Korea all have sizeable commitments. Malaysia is the number one investor in Cambodia, with nearly $1.4 billion committed in 1994 alone. Total committed investments in Cambodia were recently reported at $750 million for 1997, but were estimated at less than 1/3 that amount ($200 million or less) in actuality. Cambodia is now much less of a bargain relative to other countries which have devalued.

b. The countries in turmoil also trade with Cambodia, and their industries compete with domestic industries. The crisis has forced them to adjust their exchange to an extent so dramatic that it would be like needing three or more times the number of Riels now required in terms of their currency to get one dollar. This has put severe pressure on domestic producers stymied by out of control smuggling. First PM Hun Sen recently complained of an instance when a oil tanker was caught trying to unload without paying customs duties. Particularly affected and vociferously complaining are the cement, oil, and soft-drinks producers. The latter reported sales down 90% over the previous year, as well as competing import prices from Thailand that were below production cost. Low import prices are putting domestic producers out of business. If these businesses (like cement manufacturers) employ Cambodians, there will be layoffs. At the same time, one should not forget that other producers (like Construction companies) in the economy will benefit tremendously and the cost of construction will be reduced. In that case, the employment of laborers will increase on construction sites as that non-tradable factor will be cheaper relative to say the price of the cement used (a tradable)

That angle of the crisis, i.e., the positive benefit of lower import prices for a country like Cambodia, should not be ignored.

Thirdly, as Malaysia, Korea, and Thailand are countries which had high financial credibility and credit-worthiness, poorer neighbors like Cambodia and Laos are likely to be seen as even less attractive or riskier bets. Investors may see one, two, or three rotten apples in Southeast Asia and throw away the whole basket--thus plunging the economies of countries that are financially sound into turmoil. Cambodia isn't a likely candidate now or in the near term future to be considered investment grade, but Thailand, and in particular South Korea, have lost their good credit-rating just like that and it will make it all the more difficult to convince the rest of the world that Cambodia isn't another "Thailand."

Although the crisis started as a disease of the rich, and while Finance Ministers and senior officials from the VLC countries were confident the effects would be very limited, saying that they were immune, the crisis has hit home.

2- What is your analysis regarding that implication?

The implications of the Asian crisis are far-reaching.

First, they teach us that the banking system needs to be supervised and regulated. Furthermore, that sound financial policy by governments should be employed. What do I mean by this?

Economic policies must be consistent--governments should not peg their currency if they intend to allow inflation to run amuck. Investor expectations will magnify the inconsistency and stopping speculators will do nothing to rectify the root of the problem--which only the government can prevent. It is as if the choice were between doing the devaluation, i.e., sustaining a market-based, competitive exchange rate now or later, doing it voluntarily and calmly or doing it forcibly and in a frenzy.

Second, countries like Cambodia can and should try to avoid facing problems similar to those of Thailand, South Korea and Indonesia in the future. Borrowing heavily in the short-term and pegging your currency is a dangerous combination already. Mix-in economic slow-down in the form of reduced exports or worse a sinking real estate market and the outcome is explosive.

3- Is Cambodia in the same situation as Laos?

Cambodia faces issues similar to Laos, but generally "no," the situation is fundamentally different in other ways.

4- If not, why?

Cambodia is different in one very important respect from Laos and virtually all other countries in Southeast Asia. Cambodians overwhelmingly use the dollar, and this is known as dollarization.

There is a bright side and a not so bright side to Cambodia's heavy dollarization and what its impact will have on the country. The exchange rate in Cambodia is virtually unaffected, because the Riel is not circulated nor is it traded on the international market. This means that things that were sold in terms of dollars will not change in price--and that's good for price stability. However, it also means that the country is made considerably less competitive relative to Thailand, S. Korea, and Indonesia--countries which devalued. By their act, everyone else is pressured to competitively devalue their currency as well--yet Cambodia doesn't have that ability because of dollarization. Although a tough pill to swallow by the NBC, Cambodia's central bank, people don't yet trust the Riel for really big transactions and even smaller ones (like going to restaurants after the Japanese Friendship bridge). In terms of labor costs especially, Cambodia is looking less attractive. If everything is half price in Thailand, why go to Cambodia? Domestic producers in Cambodia are also feeling the pinch, their goods aren't selling because they've become much more expensive and cannot compete.

Furthermore, Cambodia has sizeable investment projects which may never be delivered because of the crisis due to this same problem of dollarization and lack of competitiveness in devaluation. The $750 million announced recently can melt into air--just as the $1.3 billion casino on Snake Island off Kampong Som has yet to see the light of day, there will be more broken promises ahead. All three countries Thailand, South Korea and Indonesia are big investors in Cambodia, there'll be a lot of rethinking ahead for them.

5- What Cambodian economic policy would minimize the impact of the crisis?

a. The policy solution is not to seek protection, but to exploit Cambodia's comparative advantage in trade. The reason is this, Cambodia is a small and relatively open country already, its market power is minimal and the optimal tariff would be zero. What can we do better than others, at a lower relative price?

In any event, protection begets protection. Rent-seeking interests would fight for their continuation in a never ending struggle to continue special privileges and market power acquired through government protection.

b. Additionally, the Government could take this opportunity to collect more in tariff revenues, but smuggling is such a problem that it's already virtually impossible to fight. Increasing tariffs (theoretically suboptimal) would exacerbate the smuggling problem.

c. Take advantage of the crisis, buy cheap while you can! Although it's true your industries hurt, they hurt for a reason: they can't compete anymore. That's reality--now find something else to do. For instance, the country would amass sizable foreign exchange were it to promote tourism. However, that is unlikely for two reasons: (1) continued conflagration and instability and (2) the fact that Cambodia is now relatively more expensive compared to other destinations in Southeast Asia which have devalued.

d. Cracking down on speculative investments is only a problem when somebody gets hurt--the recently introduced policy of putting up a 1.5 to two percent deposit is good, but let's not start making things too difficult for investors or else they might just go elsewhere in an already credit-starved market.

e. Reduce dollarization. However, this is a long term proposition that only true political stability and peace can help achieve.

Other things to do in the future, when it comes time to do them:

a. Keep your banking system supervised and regulated.

b. Don't adopt inconsistent monetary, fiscal, and exchange rate policies!

c. Don't borrow short-term assets and convert them to your domestic currency, and then turn around and lend this out. This is a formula for disaster when devaluations come. You multiply your liability by the same factor as the devaluation, essentially doubling, tripling, even quadrupling what your liability in terms of your own currency.

* Sophal Ear is a research fellow with CICP and a development consultant based in Washington, DC.