Limit of Cambodia Monetary Policy under Dollarization

I. Introduction

a. Background

Dollarization in Cambodia resulted from a series of shocks, experiences, and events that eroded public

confidence in the capacity of the authorities to maintain the value of the riel national currency.

There were already some amounts of the US dollars circulating in Cambodia during the period of

Khmer Republic (1970-1975); however, riel was the main currency used normally in domestic

transactions. The shock occurred from 1975-1979 when all financial infrastructures such as markets,

money, trade and banking were destroyed.

After the end of Pol Pol Regime, commercial transactions were conducted mainly in a form of barter or

using rice and gold and later also Vietnamese dong.

In 1980, the Central bank was re-established under the name of People’s Bank of Kampuchea and the

riel was again the country’s legal currency. It provided a multitude of services, including acting as the

monetary authority, the cashier of the government, and the only institution providing banking services

such as deposits, loans, and payment instruments(Tal Nay Im, 2007).

Cambodia has made a lot of progress after the support of United Nations for first election in 1993. In

1998, Cambodia has achieved its full peace that underpinned macroeconomic and political stability.

Real GDP rose 7.4 percent a year on average during 1990s and moved to 9.7 percent a year during

2000s. The rapid growth has helped to increase the income per capita to more than triple since 1990s to

760 USD in 2010and to reduce the poverty rate from 47 percent in 1993-1994 to 21 percent in

2008(World Bank, 2011).

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Cambodia has become partially dollarize owning to the flood of 1.7 billion of US dollar as a result of

UNTAC support for the election. The foreign currency deposits increased from around 44 million of

U.S. dollar in 1993 to 3,058 million of U.S. dollar in 2009(Siphat, 2011). The Cambodia economic

growth in 2000s was partly possible through major reconstruction efforts following decades of civil

war and the Khmer Rouge Regime and significant dollar inflows through garment sector exports,

tourism receipts, foreign direct investment, and aid(Duma, 2011). However, in 2008 Cambodia as well

as other countries in the world faced global financial crisis where the world real GDP growth had

dropped from 3.4 percent in 2008 to 0.5 percent in 2009(Cham Prasidh, 2009).Similarly Cambodia real

GDP growth has dropped from 6.7 percent in 2008 to minus (-1.5) percent in 2009(Economic

Intelligence Unit, 2011).

b. Statement of the problem

Dollarization limits the prudent degree of exchange rate flexibility. Limited

exchange rate flexibility in turn limits monetary policy to achieve any objectives

other than price stability(Kraft, 2003). Dollarization may be burden of the

Cambodian government with national strategic plan of poverty alleviation. It also

worsens distributional problems between the poor and the non-poor through the

depreciation and instability of exchange rate. The poor people typically have to

pay for some goods and services in the U.S. dollar while their earnings are in riel

currency. These people are facing the problem of losing the purchasing power

with a higher risk of exchange rate fluctuations(Sok Heng Lay, 2012).

Duma also argued that the dollarization in Cambodia has benefitted the dollar-

based urban economy rather than the riel base rural economy where the poverty

issue is more intense (Duma, 2011).

c. Research Question

1. How dollarization hinders the NBC to achieve its monetary objectives?

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2. What monetary instruments had the National Bank of Cambodia conducted

under dollarization?

3. What are the strategies of the National Bank of Cambodia as well as the

Royal Government of Cambodia to promote official riel currency?

d. Objectives of the research

The main objectives of are to study of the effect of dollarization on Cambodia

monetary policy. It will look the history of history of dollar inflow to Cambodia and

how the National Bank of Cambodia takes action in response to a huge amount of

dollar inflow.

e. Limitations and Scope of the research

The study will look at the huge present of the dollar in Cambodia in 2000 to 2010 affect the application

of monetary policy of Cambodia. Also international experience related to reducing dollarization and/ or

de-dollarization in the context of Cambodia would be proposed.

f. Significance of the research:

The finding of this research would help students to have in-depth knowledge of the monetary

application of the National Bank of Cambodia in a dollarized economy with the analysis of advantages

and disadvantages of dollarization. The expected result of the study would benefit the

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Chapter I: Literature Review:

1. Monetary Policy

1.1. Monetary Policy Definition: Monetary policy the set of procedures and measures taken by

monetary authorities to manage money supply, interest and exchange rates and to influence

credit conditions to achieve certain economic objectives(Mansfied, 1988).

1.2. Goals of monetary policy: There is worldwide agreement that the ultimate goals of monetary

policy at present in both the developed and developing countries are price stability and high

employment rates, enhancing economic growth rates and controlling imbalances in external

payments, including the protection of the external purchasing power of the currency through

maintaining relatively stable levels of exchange rates.

1.3. Monetary Policy Instrument: The set of instruments available to monetary authorities may

differ from one country to another, according to differences in political systems, economic

structures, statutory and institutional procedures, development of money and capital markets

and other considerations. In most advanced capitalist countries, monetary authorities use one or

more of the following key instruments: changes in the legal reserve ratio, changes in the

discount rate or the official key bank rate, exchange rates and open market operations(Central

Bank of Kuwait)

2. Monetary Policy of the National Bank of Cambodia

2.1. Aim of the policy:

The monetary policy of the National Bank of Cambodia aims at maintaining price stability

through conducting a managed floating exchange rate regime, accumulating more international

reserves and strengthening the confidence of the public.

2.2. Monetary Policy instruments

2.2.1. Exchange Rate Regime and Foreign Exchange Intervention in Cambodia

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2.2.1.1. Foreign Exchange Regime: The exchange rate regime in Cambodia is

characterized as an official and parallel exchange rate.

2.2.1.1.1. The Official Exchange Rate: is determined by the National Bank of

Cambodia (NBC) for transactions between the NBC, government and the public

sector.

2.2.1.1.2. The parallel market rate is a freely floating exchange rate and determined by

market. It is used for all the private sector transactions. (Bonnang, 2009)

2.2.1.2. Foreign Exchange Intervention: When market sentiments and psychological factors

caused disorder in the foreign exchange markets and the foreign exchange fluctuate

sharply, the National Bank of Cambodia intervenes in the market to smooth foreign

exchange movements through foreign exchange auctions, and to defend against

speculative attack. The system of Foreign Exchange Auction was introduced in

September 1993. Thus US dollar auctions were the most frequent instruments to be used

to maintain the foreign exchange stability to promote price stability.

2.2.2. Reserve Requirement System: National Bank of Cambodia uses the reserve requirement

system as a monetary policy tool. It should be noted that when the credit to private sector and

money growth M2 grew by 80 and 57 percent during the period from August 2007 to April

2008, the National Bank of Cambodia increased the required reserve ratio on foreign currency

deposit from 8 to 16 percent in April 2008. The reserve requirement was decreased to 12

percent in January 2009 when money growth M2 and the growth of credit to private sector

were 4.8 and 55 percent in December 2008.

2.2.3. Standing facilities

2.2.3.1. Fixed Deposits: The NBC operates fixed deposit facilities in both USD and Riel.

Maturities of three, six and twelve months are offered. For most banks the NBC fixed

deposit facility is an avenue for managing liquidity. This is because there is no interbank

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market and banks are restricted in making placements with offshore correspondent

banks.

2.2.3.2. Overdraft facility The NBC overdraft was introduced by Prakas (regulations) issued

January 2009. The stated purpose of the facility is to help eligible institutions to

overcome temporary or short-term liquidity shortages. The Prakas emphasizes the need

for institutions to establish both prudent liquidity management policies and contingency

funding plans to mitigate the risks arising from liquidity shocks.

2.2.3.3. Refinancing Window: The NBC provides a swap window to banks and other

financial institutions to facilitate microfinance lending to specified sectors. The NBC

provides Riels in exchange for US dollar deposits. This is a currency swap. Institutions

accessing this window must provide full details to the NBC of the purpose of the moneys

on-lent; generally the purpose is for agriculture loans in the rural sector.

3. Causes of dollarization

3.1. Large macroeconomic imbalances and hyperinflation: Chile,

Colombia, and Peru, for example, became dollarized following periods of

macroeconomic instability and high inflation that resulted in the

substitution of the domestic currency for U.S. dollars.

3.2. Financial repression and capital controls: Nigeria, Republican

Bolivariana de Venezuela, and many sub-saharan African countries became

dollarized following the introduction of policies that repressed financial

transactions and imposed capital controls.

3.3. The appeal of the U.S. dollar as an anchor of macroeconomic

stability: Argentina and Ecuador, for example, adopted the U.S. dollar as a

legal tender in order to help deal with a long history of problems with

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monetary and exchange rate policy; and following a deep economic and

political crisis, respectively.

3.4. Demand for foreign currency assets. There are two motives for the

demand of currency assets which are currency substitution and assets

substitution.

3.4.1. Currency substitution is the use of foreign assets as means of

payment and unit of account. Currency substitution tends to follow

periods of hyperinflation, prompting the public to seek alternative

currencies to use as money.

3.5. Asset substitution: It is result from the risk and return considerations between domestic and

foreign assets. Price instability and prolonged depressions have prompted the

use of foreign-denominated assets as a store of value.

3.6. Dollarization causes exchange rate instability. Sok Heng Lay, Makoto Kakinaka and Koji

Kotani found out in their research study that dollarization induces the depreciation of the

Cambodian riel as well as intensifies exchange rate variety. It is consistent with the argument

Mckinnon that dollarization is one of the crucial cause of exchange rate instability.

3.7. Dollarization causes loss of seigniorage?: Kang (2005) estimates the loss in seigniorage to be

$682 million at the end of 2004, with an additional $61 million lost annually. the increase in

dollarization could in fact have been associated with an increase in social welfare provided,

which would otherwise not have been realized if dollarization had not taken place. Chang

(2002) further argues that purely considering computed seigniorage loss can only be

unambiguously interpreted as ”real losses” to the economy if policy credibility problems are

assumed away. There are benefits to dollarization, which have been evident in the stability of

the Cambodian macroeconomy and containment of inflation.

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3.8. Two parallel world in Cambodia: As mentioned by (Duma, 2011) Cambodia has two parallel

worlds which are the urban economy and the rural economy. The urban economy is mostly

dollar based and has benefited a lot from the buoyant garment sector, tourism, foreign direct

investment and aid. Rural economy is largely agriculture and riel based. The contribution of

the garment and tourism sectors has surpassed that of the agricultural sector as shown in figure

1. Significant inflows of aid, foreign direct investment, tourism receipts, and growth of the

garment export sector that transacts in dollars contribute to a large amount of dollars.

Figure 1: Cambodia: Source of growth and financing flow

3.9. Persistence of dollarization: (Menon, 2008) mentioned that there are two factors that explain

the persistence of dollarization in Cambodia. The first one is the degree of reform themselves

and the second one is hysteresis.

3.9.1. The degree of reform themselves: Even though Cambodia has achieved to reduce

political uncertainty and growth has been spectacular, Cambodia has remained a low

income country with significant inequality and poverty and some degree of political

uncertainty remains. The great constraint relates to the levels of development of financial,

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banking, and monetary system as well as the continued absence of riel dominated interest-

bearing assets. Cambodia continues to wrestle with the challenge of developing a viable

banking system with emphasis on a solid legal and supervisory framework.

3.9.2. Hysteresis: political and economic uncertainties in the 1990s have kept the level of

dollarization at high levels. The magnitude and duration dollarization have combined to

create significant inertia and path dependence in the system. It will take just as much and

just as long, if not more of both, before any reversal is likely.

Chapter II: Research Methodology

The research will mainly rely on the secondary data which is taken from ADB website, World Bank

website, National Bank of Cambodia, PUC Library textbook, and E-library. Descriptive statistics will

be used to interpret the result.

Chapter III: Data Presentation, Data Analysis and Discussion

1. Limit of the monetary policy due to the large flow of US dollars.

The degree of dollarization which is measured by the ratio of foreign currency deposits to broad money

(M2) has been steadily increasing since the late 1990s. The dollarization index has surged from around

60 percent in 2010 to around 80 percent in 2010 base on figure 2.

Figure2: Cambodia: Foreign Currency Deposits to Broad Money, 2000–2010

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Sources: Data provided by the authorities; and IMF staff estimates.

Foreign currency deposits increase from around 44 million US dollars in 1993 to 3,058 million US

dollar in 2009.The conduct of monetary policy by the monetary authority is weak

because the amount of cash US dollar circulation outside the bank is not known

and the National Bank of Cambodia has limits ability to influence interest rate in

the market. The interest rate is determined by the market mechanism (the

borrowing and the deposit rate in USD dollar on average are 16.13% and 4.67 %

respectively (Siphat, 2011)

Lender as a last resort cannot be carried out by the National Bank of Cambodia which limits the

ability of central bank to influence interest rate in the market. The interest rate is determined by market

mechanism (the borrowing and deposit rate in USD on average are 16.13% and 4.67% respectively)

Due to high level of dollarization, exchange rate becomes the only tool for managing monetary policy

in order to stabilize the price level since National Bank of Cambodia does not have any other effective

tools to manage its monetary policy (Siphat, 2011).

The Cambodia’s monetary system is characterized by a de facto dollarization resulting in an unofficial

multimonetary system. The dollar is widely used by residents but it is not a legal tender. In urban areas,

prices for goods and services are mostly quoted in dollars and transactions are predominantly settled in

dollars. In rural areas, far from the borders, the riel remains main means of payment, and serves also as

a store of value, along with gold (Sa, 2002).

Figure 3 illustrates that macroeconomic variables in Cambodia respond significantly to changes in the

US monetary policy.

For example, during late 2007 and early 2008, Cambodia experienced an increase in inflation pressures

as commodity prices and foreign inflows rose. Coincidentally, U.S. monetary policy had become loose

following the Federal Reserve’s attempt to increase liquidity as the subprime crises hit. The federal 10

funds rate had declined from about 5.26 percent in July 2007 to 1.98 percent by May 2008.(Duma,

2011)The fact that about 60 percent of Cambodia’s garments exports go to the United States indicates

strong real linkages between the Cambodian economy and the U.S. economy in addition to the

financial linkages caused by dollarization.

It shows that financial sector variables (including domestic interest rates) and real economy variables

(including trade) respond greatly to changes in the federal funds rate within the first few months. A

standard deviation shock to the federal funds rate (an increase of about 0.3 percent) results in an

increase in the lending rates of about 0.4 percent and a 0.46 percent increase in deposit rates as local

banks attempt to minimize the spread between domestic and foreign interest rates. This illustrates the

extent to which monetary conditions are beyond the control of the Cambodian monetary authorities.

Figure3: Residual

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Figure 4 illustrates the nominal and real exchange rates against the US dollar. The policy of NBC is the

exchange market intervention to maintain the purchasing power of the riel and to control inflation and

exchange rate policy now is partially through foreign exchange auctions.

Figure 3: Nominal and Real Exchange rate

Source: Sok Heng Lay, Exchange rate movement in a dollarized economy: the case of Cambodia

2. Is de-dollarized good for Cambodia currently?

Several countries have been identified as having successfully de-dollarized:

Reinhart, Rogoff, and Savastano (2003) separate countries into two categories:

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First, those that de-dollarized their local issued foreign currency obligation

(examples are Mexico and Argentina) and those that reduce the share of foreign

currency deposits to broad money (examples are Israel, Poland, Mexico, and

Pakistan). The latter category is more relevant for Cambodia, given that the

country has a high share of foreign currency deposits in broad money, and that

there are currency no locally issued government securities in foreign currency.

3. International Experience related to de-dollarization:

3.1. Gradual and market-driven policies have been more

successful. Countries where supportive policies aimed at lowering inflation

and deepening financial markets helped reduce dollarization include Israel,

Poland, Chile, and Egypt. In these cases, a combination of policies were

implemented including: (i) creating markets for local currency denominated

bonds; (ii) introducing differential remuneration rates on reserve

requirements on foreign currency deposits to introduce a wedge in bank

intermediation spreads; and (iii) active bank supervision to ensure that

banks fully covered their foreign currency loans positions (Erasmus,

Leichter, and Menkulasi, (2009). Further, in the cases of Israel and Chile,

indexation was also used successfully to promote local currencies.

3.2. Forced de-dollarization has had macroeconomic costs. Forced conversion of dollar

deposits into domestic currency was imposed in 1982 and 1998 in Mexico

and Pakistan, respectively. Conversion was done using an exchange rate

that was substantially lower than the prevailing market rate (Reinhart,

Rogoff, and Savastano, 2003). While Mexico and Pakistan successfully de-

dollarized, there were costs. In the case of Mexico, there was substantial

capital flight and private sector bank credit almost halved in two years. 13

Growth suffered significantly and inflation shot up (Reinhart, Rogoff, and

Savastano, 2003). In the case of Bolivia and Peru, forced conversion of

dollar deposits was subsequently followed by macroeconomic instability

that resulted in hyperinflation and led these countries to later allow foreign

currency deposits (Reinhart, Rogoff, and Savastano, 2003). A similar

restriction was introduced in Israel; however, this was gradual and market

oriented. In the case of Israel, a mandatory one-year holding period for all

foreign currency deposits was introduced in 1985, which made those

deposits less attractive than other indexed financial instruments.

3.3. Reversing dollarization is not easy and is mainly a gradual process. According to

Baliño, Bennett, and Borensztein (1999), de-dollarization tends to be

difficult, since it depends on institutional changes and occurs when

significant benefits can be gained by switching currencies. De-dollarization

requires persistence in reducing inflation and stabilizing macroeconomic

policy (Erasmus, Leichter, and Menkulasi, 2009). Establishing the credibility

of macroeconomic policy is essential.

A strategy to reduce dollarization should be aligned with an appropriate exchange rate policy. Once dollarization has taken hold, maintaining an independent monetary policy isdifficult and therefore exchange rate stabilization becomes a viable option. The NBC hasmaintained a relatively fixed exchange rate vis-à-vis the U.S. dollar, which has been theeffective nominal anchor for three decades in the absence of a formal monetary framework.However, the achievement of low inflation has not halted or reversed the trend increase in:

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The dollar circulation outside the banks increased from 2.10 billion USD in 1995 to 12.10 billion USD in 2009, but the level of currency substitution is stable.

While the NBC uses from time to time the dollar reserve requirement ratio (RRR) as a monetary policy

tool to control liquidity, its effectiveness has proven limited. At the end of November 2010, the

required reserve ratio on foreign currency is 12 percent, while that on riel is 8 percent.

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