Document of The World Bank

FOR OFFICIAL USE ONLY Public Disclosure Authorized Report No. 36553- KH

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT FOR A PROPOSED GRANT Public Disclosure Authorized

IN THE AMOUNT OF SDR9.8 MILLION US$15 MILLION EQUIVALENT

TO

CAMBODIA

FOR A

POVERTY REDUCTION AND GROWTH OPERATION Public Disclosure Authorized June 18,2007

Poverty Reduction and Economic Management Unit Southeast Asia Unit East Asia and Pacific Region

Public Disclosure Authorized This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. GOVERNMENTFISCAL YEAR January 1 - December 3 1

CURRENCY EQUIVALENTS (Exchange Rate Effective as ofMay 11,2007)

Currency Unit = Cambodian Riel (CR) US$ 1.00 - CR 3,977

Weights and Measures Metric System

ABBREVIATION AND ACRONYMS

AAA Analytical and Advisory Assistance ADB Asian Development Bank ASYCUDA Automated System for Customs Data CAP Consolidated Action Plan CAR Council for Administrative Reform CAS Country Assistance Strategy CDC Council for the Development of Cambodia CDHS Cambodia Demographic Health Survey CED Customs and Excise Department CEFP Committee for Economic and Financial Policies CFAA Country Financial Accountability Assessment CG Consultative Group CIB Cambodia Investment Board CLP Council for Land Policy CMDG Cambodia Millennium Development Goal CNPA Cambodia National Petroleum Authority COM Council of Ministers CPI Corruption Perceptions Index CPIA Country Policy and Institutional Assessment CSES Cambodian Socio-Economic Survey c SP Country Strategy Paper D&D Decentralization and Deconcentration DFID Department for International Department EITI Extractives Industries Transparency Initiative ELC Economic Land Concessions EU European Union FDI Foreign Direct Investment FIAS Foreign Investment Advisory Service FMIS Financial Management Information System FSAL Financial Sector Adjustment Loan GDCC Government Donor Coordination Committee GDP Gross Domestic Product GNP Gross National Product HIPC Heavily Indebted Poor Countries FOR OFFICIAL USE ONLY

IBRD International Bank for Reconstruction and Development IDA International Development Association IF Integrated Framework IFAF'ER Integrated Fiduciary Assessment and Public Expenditure Review IFC International Finance Corporation IMC International Maritime Committee IMF International Monetary Fund INT Department of Institutional Integrity IPA Independent Procurement Agent IRITWG Infrastructure and Regional Integration Technical Working Group JBIC Japan Bank for International Cooperation JMI Joint Monitoring Indicator JSAN Joint Staff Advisory Note LASED Land Allocation for Social and Economic Development LDP Letter of Development Policy LICUS Low Income Country Under Stress LJR Legal and Judicial Reform LMAP Land Mapping and Administration Project LNRM Land and Natural Resources Management M&E Monitoring and Evaluation MAFF Ministry of Agriculture, Forestry and Fisheries MBPI Merit-Based Pay Initiative MDGs Millennium Development Goals MDRI Multilateral Debt Relief Initiative MEF Ministry of Economy and Finance MIME Ministry of Industry Mines and Energy MLMUPC Ministry of Land Management, Urban Planning and Construction MMR Maternal Morality Rate MONASRI Ministry of National Assembly and Senate Relations and Inspection MOC Ministry of Commerce MOE Ministry of Environment MOEYS Ministry of Education, Youth and Sport MOH Ministry of Health MOJ Ministry of Justice MOP Ministry of Planning MOU Memorandum of Understanding MOWA Ministry of Women Affairs MOWRAM Ministry of Water Resources and Meteorology MPTC Ministry of Post and Telecommunications MPWT Ministry of Public Works and Transport MTEF Medium Term Expenditure Framework NAA National Audit Authority NARLD National Authority for the Resolution of Land Disputes

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. NBC National Bank of Cambodia NCCS National Cadastral Committee Secretariat NCDM National Committee for Disaster Management NIP National Indicator Program NRM Natural Resources Management NSDP National Strategic Development Plan NT National Treasury oss One Stop Service owos One Window Offices PAP Priority Action Program PER Public Expenditure Review PFM Public Financial Management PFMRP Public Financial Management Reform Program PHRD Japan Policy and Human Resources Development Trust Fund PMG Priority Mission Group PMO Prime Ministerial Order PPI Private Participation in Infrastructure PRGF Poverty Reduction and Growth Facility PRGO Poverty Reduction and Growth Operation PSD Private Sector Development PSIA Poverty and Social Impact Analysis RGC Royal Government of Cambodia ROSC Report on the Observance of Standards and Codes RS Rectangular Strategy SAC Structural Adjustment Credit SAD Single Administration Document SDR Special Drawing Rights SEZ Special Economic Zone SME Small and Medium Enterprise SOE Statement of Expenditures TB Tuberculosis TD Tax Department TFCP Trade Facilitation and Competitiveness Project TI Transparency International TIFA Trade and Investment Framework Agreement TWG Technical Working Group UNDP United Nations Development Program WTO World Trade Organization

Vice President: James W. Adams Country Director: Ian C. Porter Acting Sector Director: Deepak Bhattasali Country Manager: Nisha Agrawal Sector Manager: Indermit Gill Lead Economist: Kazi Mahbub-A1 Matin Task Team Leader: Robert R. Taliercio CAMBODIA

CAMBODIA POVERTY REDUCTION AND GROWTH OPERATION

TABLE OF CONTENTS

GRANT AND PROGRAM SUMMARY ...... 1 I. INTRODUCTION ...... 2 I1. COUNTRY CONTEXT ...... 3 GOVERNANCE: REFORM AND CHALLENGES ...... 3 RECENT ECONOMIC DEVELOPMENTS AND MACROECONOMIC OUTLOOK ...... 5 I11. THE GOVERNMENT’S PROGRAM: THE NATIONAL STRATEGIC DEVELOPMENT PLAN AND THE JOINT MONITORING INDICATORS ...... 13 IV. ALIGNMENT OF DEVELOPMENT PARTNER AND BANK SUPPORT ...... 15 V . THE PROPOSED CAMBODIA POVERTY REDUCTION AND GROWTH OPERATION.... 18 OPERATION DESCRIPTION...... 18 VI. OPERATION IMPLEMENTATION ...... 49 FIDUCIARY ASPECTS ...... 49 IMPLEMENTATION, MONITORING AND EVALUATION...... 50 RISKS AND RISK MITIGATION ...... 51

ANNEXES

ANNEX 1: LETTER OF DEVELOPMENT POLICY ...... 54 ANNEX 2 . GOVERNMENT’S PRIORITY REFORM MEASURES ...... 62 ANNEX 3 : OPERATION POLICY MATRIX ...... 75 ANNEX 4: FUND RELATIONS NOTE ...... 83 ANNEX 5: CAMBODIA AT A GLANCE ...... 87

MAP # IBRD 33381

The operation was prepared by an IDA team consisting of Ahsan Ali. Keith Bell. Mudita Chamroeun. Huot Chea. Tim Conway. Gloria Elmore. Mia Hyun. Peter Jipp. Sophorn Kith. Andrew Laing. Roch Levesque. Kazi Matin. Peter Murphy. Steven Schonberger. Eric Sidgwick. Robert Taliercio. Jennifer Thomson. and Albert Zeufack .

GRANT AND PROGRAM SUMMARY

CAMBODIA

CAMBODIA POVERTY REDUCTION AND GROWTH OPERATION

Borrower Royal Government of Cambodia

Implementing Agency Ministry of Economy and Finance

Amount US$ 15 million

Terms Grant

Tranching Single tranche

Description The purpose of the Poverty Reduction and Growth Operation (PRGO) program (2007-2009) is to provide support for the implementation of the “good governance” reform program laid out in the Royal Government of Cambodia’s (RGC) National Strategic Development Plan (NSDP), 2006-20 10. The Country Assistance Strategy for Cambodia, endorsed by the Board in May 2005, follows Government’s strategy by recognizing governance issues as the primary obstacle to growth, poverty reduction, and aid effectiveness. Benefits The PRGO program (2007-2009) has three expected benefits: (1) higher rates of growth and poverty reduction based on an improving investment climate, higher agricultural productivity, and more effective public service delivery; (2) a reform dialogue with Government more focused on results; and, (3) improved harmonization and alignment of development partner (DP) policy positions and financial support. Risks While there is strong ownership of the reform program at the MEF, there appears to be less commitment in some other agencies. Elections in 2008 raise the risk of a reform slowdown. Implementation of the reform program could also be delayed because of weak capacity of public institutions, especially at the sub-national level, which could impede the implementation of proposed reforms. Corruption in Cambodia, also a critical constraint, has exerted a negative impact on the implementation of the reform program. In a weak governance environment there is also a reputational risk of providing budnet sumort. Operation ID Number PO7 1103

1 INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED POVERTY REDUCTION AND GROWTH OPERATION TO CAMBODIA

I. INTRODUCTION

1. The principal purpose of the proposed Poverty Reduction and Growth Operation (PRGO) program (2007-2009)is to provide support for the implementation of the “good governance” reform program laid out in the Royal Government of Cambodia’s (RGC) National Strategic Development Plan (NSDP), 2006-2010. The NSDP is intended to operationalize the “Rectangular Strategy for Growth, Equity and Efficiency,” which was adopted by the new Government in July 2004. The Rectangular Strategy placed “Good Governance” squarely at the heart of the reform agenda. The CAS for Cambodia, endorsed by the Board in May 2005, follows the Strategy by recognizing governance issues as the primary obstacle to growth, poverty reduction, and aid effectiveness in Cambodia.

2. The PRGO program (2007-2009) has three objectives: a. To support a program of ‘second generation’ growth and poverty reduction based on an improving investment climate, higher agricultural productivity, and more effective public service delivery. Since the early 1990s Cambodia has enjoyed over a decade of high average economic growth-8.4 percent from 1994-2006-which drove significant poverty reduction: 35 percent of Cambodians lived below the poverty line in 2004, down from an estimated 47 percent a decade earlier. The primary objective of the PRGO is to support the next phase of policy and institutional reform required to maintain growth and accelerate poverty reduction by facilitating trade and diversifying exports, guaranteeing land tenure and increasing access to land for the rural poor, and making the budget a credible management tool while reducing fiduciary risk to public funds. b. To provide support for the reform agenda by focusing the policy dialogue on results and undergirding momentum where political opportunity exists. The PRGO program provides an opening to deepen and accelerate the reform agenda, especially as it pertains to challenging issues of governance in Cambodia, and offers some insurance against back- tracking on governance-related reform. The PRGO program is also necessary to support successful project implementation in key areas. The RGC looks to the PRGOs to showcase its reform program by demonstrating its resolve to improve outcomes for the average Cambodian. The PRGO also ties aid more closely to Government’s performance on the reform agenda, which is increasingly important to Cambodia’s development partners.

C. To harmonize and align development partner (DP) policy positions and financial support through the CG process. The prior actions in PRGO-1 are drawn from the Joint Monitoring Indicators (JMIs) agreed by Government and its partners at the Consultative Group (CG) Meeting in March 2006. Progress on meeting the operation’s prior actions is discussed in sectoral Technical Working Groups (TWGs), where triggers for future operations are also jointly agreed. Moreover, the PRGO reinforces the use of agreed

2 monitoring frameworks at the sectoral level, reducing transaction costs for Government by engaging partners around the same performance indicators.

11. COUNTRY CONTEXT

3. Cambodia is a post-conflict country, and though the Paris Peace Accords formally established a truce in 1991, politico-military violence continued until 1997. Many important institutions of governance and public sector management, destroyed during the Khmer Rouge period, are only just starting to be rebuilt according to democratic and meritocratic norms. The conflict has contributed to weak governance, high levels of corruption, and a fragile political discourse. Poor governance is thus the primary constraint on development in general and on the World Bank Group’s program in particular. This section reviews those governance challenges in the context of Cambodia’s economic growth and poverty reduction record, and concludes with the rationale for the proposed operation.

GOVERNANCE: REFORM AND CHALLENGES 4. Cambodia’s devastating conflict-many important institutions of governance were destroyed during the Khmer Rouge period and are only just starting to be rebuilt-has resulted in weak governance and high levels of corruption. The Transparency International (TI) Corruption Perceptions Index (CPI) shows that the level of corruption in Cambodia is perceived to be high, though comparable to those of other Low Income Countries under Stress

(LICUS) *

5. Improvements in policy, moreover, continue to be undermined by serious institutional weaknesses, resulting in difficulties translating good intentions into good outcomes for Cambodian citizens. Though public sector performance has slowly improved in some sectors, serious problems remain (World BanWAsian Development Bank, 2003). Overall, however, the RGC continues to be dogged by low levels of capacity, resources, and accountability. The bureaucracy remains largely inefficient and ineffective in meeting the needs of its citizens, and particularly that third of its citizens who live below the poverty line (World BanWAsian Development Bank, 2003). In order to implement its development agenda, the RGC recognizes that it will have to make much more progress.

6. Institutional weaknesses, including the lack of effective sanctions for malfeasance, have also undermined the delivery of project-based ODA. The World Bank Department of Institutional Integrity’s (INT) investigations of 63 contracts financed by seven projects resulted in declarations of misprocurement in six projects on 42 contracts (and a declaration of non-eligible expenditures on one contract) valued at US$ 12.1 million. Disbursement on three projects was partially suspended pending the execution of actions plans, which were communicated to the RGC in July 2006. Progress has been made on the action plans and, as a result, all the suspensions were lifted in February 2007. In addition, the RGC and the Bank have agreed to hire an Independent Procurement Agent (IPA) to carry out the procurement activities for the entire portfolio, and it is expected that the IPA will be operational by August 2007.

7. Recent signs, however, are encouraging, as the RGC has begun to implement reform programs-in private sector development, public financial management, and natural resources management-focusing on improving the capacity of the public sector to deliver growth and poverty reduction:

Private sector development-Significant progress has been made in improving the regulatory framework for sustained private sector development in Cambodia despite the slow pace and some reversals in trade facilitation reform. The RGC has taken proactive steps to streamline import-export procedures, which has led to improvements noted by the Doing Business 2007 report. While Cambodia ranked 143 out of 175, the study noted good progress in the areas of dealing with licenses (specifically on mandating a statutory time limit for issuing a license) and trading across borders. Procedures relative to issuance of certificates of origin and certificates of processing have been simplified. In addition, MIME, MOC, CED, and CamControl have agreed to joint inspection of factories that results in the issuance of certificates without further inspections required. The findings of the Performance Measurement System (PMS), introduced as part of the Trade Facilitation and Competitiveness Project (TFCP), suggest that these efforts have led to reductions in businesses’ processing times and costs since 2003. Looking forward, full deployment of the customs automation program (ASYCUDA), implementation of the Single Administrative Document (SAD), the creation of One Stop Services (OSS) in Special Economic Zones (SEZs), and the Trade Information Gateway (TIG) will facilitate trade, improve transparency of trade-related procedures, and lead to a further reduction in transaction costs for the private sector over the period of the proposed operation.

Public financial management-The Ministry of Economy and Finance (MEF), together with its development partners, has established a best practice performance management framework for the Public Financial Management Reform Program, which is yielding major achievements in its first two years of implementation. Major reforms measures commenced implementation in January 2007, including: a significant streamlining of budget execution procedures, the introduction of program budgeting, and adoption of a new chart of accounts. These follow on significant reforms in 2005: the amount of customs revenue collected through the banking system increased (from zero in 2004 to nearly 1/3 in 2006); more than % of all Tax Department revenue is now collected through the banking system; about % of Treasury payments to suppliers in Phnom Penh and Sihanoukville are now made by check instead of cash; the stock of old expenditure arrears has been reduced by over 40 percent; the procurement process has been streamlined, tightened, and made more competitive with the passing of a new sub-decree in late 2006; the Government has set up internal audit departments in a dozen line ministries, and, for the first time in Cambodia, a pilot program has been launched to pay civil servants through commercial banks instead of by cash.

Natural resource management-Some progress is being made in this area but substantial challenges remain. The Ministry of Land Management, Urban Planning and Construction (MLMUPC), working closely with its development partners, has considerably improved the pace of systematic land titling such that 25,000 title certificates per month are now being distributed, primarily in rural areas. The Prime Minister has announced the RGC’s objective to increase the rate of systematic titling to 50,000 per month. In December 2005 the RGC adopted a Sub-decree on Economic Land Concessions (ELCs), which includes provisions for resolution of issues of prior

4 occupancyhe of lands with local communities and requires formal classification and registration of land to exclude forests and protected areas. While the overall size of individual concessions has been kept below the 10,000 ha. limit established by the new sub-decree, the number and total area of ELCs increased significantly in 2006. Though public reporting on the status of ELCs is now established, approval for areas up to 1,000 ha. has been delegated to the provincial level, and areas subject to provincial approval have not yet been included. Legal requirements for prior state land registration and environmental and social assessments have yet to be completed and provisions for transparent bidding on ELC contracts are being circumvented through a loop hole in the sub-decree that allows for no-bid approvals in “exceptional” cases. Of great concern is the fact that land grabbing continues unabated, while there has been no progress on the implementation of Article 18 of the Land Law 2001, which deals with recovery of illegally grabbed state land.

8. As a result of progress in these areas and others, for the first time in many years, Cambodia’s Country Policy and Institutional Assessment (CPIA) ratings showed consistent improvement in 2005 and 2006, with the overall rating increasing from 3.0 to 3.2. In comparison to 2004, the 2006 assessment found that economic management remained strong (at 3.5); the structural policy cluster rating increased from 2.8 to 3.2; the rating for policies for social inclusion and equity increased from 3.0 to 3.3; and public sector management and institutions cluster rating increased from 2.5 to 2.7. Other improvements that did not lead to increases in the ratings were also noted across the board. Cambodia’s CPIA rating, at 3.2, is now just under the IDA average of 3.3, which is a major achievement given Cambodia’s recent history.

RECENT ECONOMIC DEVELOPMENTS AND MACROECONOMIC OUTLOOK 9. Cambodia’s real GDP grew by about 10.8 percent in 2006, following an unprecedented 13.5 percent growth rate in 2005, marking the third consecutive year of double digit growth. The stellar performance was driven by solid garment exports, strong tourism receipts, significant growth in FDI, the continuing construction boom, and robust crop growth in agriculture. Agriculture continued to be a crucial sector for the economy, accounting for some 60 percent of total employment and growing by 5.5 percent in 2006.

10. A sound macroeconomic framework has helped underpin success in recent years, with Cambodia’s GDP growth averaging 8.4 percent over the period 1994-2006. However, Cambodia’s narrow growth base remains a concern. Recent and ongoing work- including the National Export Strategy, 2007-2010, the Small and Medium Enterprise Development Framework, 2005-20 10, and the second phase of the Integrated Framework (IF) for trade-aim to tackle this challenge.

11. External developments were also positive in 2006. Despite pressure from high world oil prices, the balance of payments improved as the current account deficit (excluding transfers) declined to 7.2 percent in 2006 (from 9.4 percent in 2005) and gross international reserves expanded by 20 percent to US$ 1.1 billion. FDI continued its upward trend reaching a record high of US$ 475 million. Consumer price inflation declined to 2.8 percent (from 5.9 percent in 2005)’ due to an easing of oil prices and a significant drop of price index of food and clothing. The consumer price index is expected to remain low (below 5 percent) for 2007

5 and the riel is expected to remain stable both in terms of dollars and other partner country currencies.

12. The fiscal front saw some improvement in 2006 as the ratio of tax revenue to GDP grew modestly from 7.6 percent in 2005 to an estimated 8.0 percent in 2006. As a share of GDP non-tax revenue remained constant at 2.3 percent. In nominal terms, however, year on year growth was very high: tax revenue is estimated to have grown by nearly 22 percent in 2006. Non-tax revenue is estimated to have grown by nearly 18 percent, but is starting from a very low base. Expenditure is estimated to have remained steady at 13.5 percent of GDP in 2006 but greater emphasis continued to be put on the social sectors with an increase in nominal spending. Total capital spending is estimated to have increased modestly to 5.6 percent of GDP. In 2007 the overall budget balance is anticipated to be stable at around -3.2 percent of GDP (excluding grants).

13. Similarly, the financial sector saw some improvement in 2006, though some management vulnerabilities remained. Combined deposits (deposits in riel and foreign currency) of banks operating in Cambodia rose by 43 percent and the lending-to-deposit ratio has continued to trend upward, reaching 68 percent in 2006 (from 64 percent in 2005), reflecting growing business activities in 2006 (business registration grew by nearly 50 percent over 2005, for example). There are now 20 banks operating in Cambodia, an increase from 18 banks at the end of 2005. Cambodia also remains a highly dollarized economy with nearly 75 percent of broad money and 97 percent of the banking deposits made in US dollars. The commercial interest rate is still high at around 16.3 percent per annum.

14. Financial sector reform, guided by the ten-year sector blueprint adopted in 2001, has also progressed. The Government continued to pursue financial sector reform designed to increase competitiveness, including privatization of the state-owned Foreign Trade Bank and adoption of the Law on Negotiable Instruments and Payment Transactions, which aims to improve payment transactions, eliminates legal uncertainties, and reduce payment system risks. A Credit Information Sharing System has been introduced, providing commercial banks with credit-related information on prospective customers, thus lowering delinquency rates and loan defaults. The development of a national payment system and a comprehensive information technology system for banking functions has become a pressing sectoral challenge.

15. International and domestic conditions bode well for continued favorable economic prospects in 2007. The four growth pillars-garments, tourism, construction, and agriculture-are expected to continue to thrive in 2007 with real GDP growth estimated at about 9.0 percent. Overall growth is also expected to remain strong in the medium terms. Increasing FDI is expected to be sustained and the discovery of offshore oil and gas reserves will likely bring about even higher growth. However, the garments sector is now facing stiffer competition from Vietnam’s accession to the WTO and the possibility of greater competition from China in 2008. At the same time agricultural growth in Cambodia has been particularly volatile over the past several years, and is therefore somewhat unpredictable. The emerging oil sector will also pose additional challenges to macroeconomic and fiscal management. Strong macroeconomic performance, underpinned by prudent fiscal and monetary policies, is thus expected to persist, though new opportunities and risks will shape medium term prospects.

6 16. The Cambodian economy is expected to grow at a somewhat lower rate of about 7.5 percent per annum over the next several years, but growth will likely accelerate again thereafter when oil production commences in 2010 or 2011. A non-trivial portion of growth over the past decade was due to the post-conflict ‘catch up’ phenomenon, which will likely level off over the next few years. As Cambodia confronts stiffer competition from globalization (e.g., Vietnam’s entry into WTO), the high cost of doing business- characterized principally by high corruption-related informal fees and high energy and transport costs-will also become binding constraints. As a result of these effects, growth in the driving sectors will likely become less buoyant. The economy will likely continue to be led by tourism, the garment industry, and construction, with agriculture providing periodic but volatile growth spurts. Beyond the near term, however, Cambodia will need to diversify its sources of growth to sustain 7.0 percent or higher annual non-oil growth rates. As private sector development reforms take root, non-garment sectors should increasingly contribute to growth. Agriculture is also expected to improve its performance when reforms, including those pertaining to land management, are implemented and when investment in infrastructure increases. The external current account deficit is projected to decline in the medium term. Inflation is targeted to fall to about 3 percent in the medium term program.

17. Cambodia’s current account deficit for 2007 is estimated at US$592 million, a large share of which would be financed by official transfers. However, the financing gap after official transfers is estimated to be around US$ 29 million and is anticipated to be closed by the PRGO, including DP co-financing (see Table 1). The financing gap over 2008-2010 is estimated at about US$30 to 40 million per annum.

Table 1. Cambodia: External Financingv and Sources 2001-2009 (US$. millions) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Est. Projection

Current account (excl. official transfers) -348 -358 -497 -436 -591 -525 -592 -794 -806 -728 Current account (incl. official transfers) -45 -47 -170 -118 -265 -146 -174 -352 -434 -408 Official transfers (net) 303 312 326 318 326 379 417 442 372 320

Capital and financial account 90 106 177 168 330 339 420 517 571 560 Medium and LT Loans 63 133 126 163 138 121 161 175 179 135 Disbursement 98 167 162 182 158 148 185 205 212 175 Amortization -35 -34 -36 -19 -21 -27 -24 -30 -33 -30 Foreign Direct Investment 142 139 74 121 375 475 557 619 492 525 ST Flows and errors and omissions -115 -166 -23 -116 -183 -333 -298 -278 -100 -100

Overall Balance 45 59 7 49 65 193 246 165 137 152

Total financing requirements -45 -59 -7 -49 -65 -193 -246 -165 -137 -152 Change in gross official reserves -64 -115 -45 -60 -77 -138 -295 -216 -177 -195 Use of Fund Credit 9 9 -2 -10 -9 -82 0 0 0 0 Debt restructuring -1 6 0 0 0 0 6 0 0 0 0 Accumulation of arrears 26 47 40 21 22 21 20 21 0 0

Financing Gap .. -29 -30 -40 -43

Sources: NIS, IMF June 2007 Article IV Consultation--Cambodia, and Bank Staff Estimates.

18. External debt-of which 35 percent is owed to the United States and the Russian Federation-constitutes nearly 95 percent of Cambodia’s total public debt. At end-2006, Cambodia’s total external public debt was $2% billion (31 percent of GDP; 22 percent of

7 GDP in NPV terms), while domestic debt amounted to 2.0 percent of GDP, one third of which was denominated in foreign currency.’ It should be noted that Cambodia’s relatively high debt stock is largely due to the historical legacy of borrowing from the US and USSR. The recent debt policy of the Royal Government has been prudent, though an increasing volume of concessional borrowing from China, and possibly other non-traditional DPs, is being monitored. The RGC is currently negotiating debt rescheduling agreements with the United States and the Russian Federation. However, discussions have stalled and may not resume in earnest for some time. In December 2005 Cambodia met the Fund’s criteria for the Multilateral Debt Relief Initiative, which resulted in debt relief of US$ 82 million, based on Cambodia’s satisfactory performance on macroeconomic performance, implementation of a poverty reduction policy, and progress on public expenditure management reforms.

19. The joint IMF/WB debt sustainability analysis (DSA) comes to the conclusion that Cambodia’s debt is on a sustainable path and that the risk of debt distress is moderate. In the baseline scenario none of the five debt sustainability indicators’ thresholds are breached over the medium term. The NPV of public debt-to-GDP, which declines steadily from 22 percent in the baseline scenario over the projection period (as compared to the 30 percent threshold) and the NPV of public debt-to-revenue, which stands at 185 percent in 2007 in the baseline and declines steadily over the projection period (as compared to the 200 percent threshold) are only breached for a few years in the most extreme stress tests. The macroeconomic framework is, however, vulnerable to the weak revenue base in the short to medium term. Significant oil revenue, however, would considerably strengthen the revenue base and further diminish the risk of debt distress. At the same time the influx of official assistance from China, which recently committed about US$ 600 million over a multi-year period, could alter the debt dynamics if it continues at the same pace. Chinese aid is provided on concessional terms and is reflected in the current DSA. In order to ensure that Cambodia is maximizing value for money from Chinese assistance (as well as other DP assistance), however, it should be subject to rigorous investment appraisal analysis, to ensure that the increasing debt burden isjustified in economic and financial terms.

20. The major opportunity and threat to Cambodia’s medium to long term growth is the discovery of significant amounts of offshore oil. The RGC has demarcated six offshore blocks for licensing. To date, contracts are known to have been awarded for two blocks (A and B). According to the Cambodia National Petroleum Agency (CNPA), the precise amounts of oil and natural gas in block A are not known. Exploration by Chevron is ongoing and new estimates may be available shortly. CNPA estimates that oil production could start in 2009 and gas production in 201 1. The most recent estimates show that oil revenue could exceed all current revenue sources: 500 million barrels of recoverable oil at current world oil prices would yield, for example, an annual peak revenue stream to the government of more than $700 million (the revenue stream peaks four years after the start of production), equal to over 11 percent of GDP in 2005. This estimate does not include government revenue from natural gas production and sale. Whether oil and gas revenues translate into greater economic diversification and poverty reduction-or macroeconomic and fiscal imbalances-is the most salient issue in Cambodia’s medium term outlook.

~~~ I This analysis, drawn from the June 2007 DSA, assumes that the Russian debt stock is treated according to the standard Convertible Ruble exchange rate and the seventy percent up front discount. 8 21. Both the staffs of the Bank and the Fund have concluded that Cambodia’s macroeconomic policy framework is appropriate and sustainable. The Fund’s 2007 Article IV mission strongly supported the RGC’s macroeconomic and structural reform agenda. Moreover, Cambodia has earned consistently high macroeconomic management ratings on the CPIA (4.0 from 2005-2006). Despite the soundness of the macroeconomic framework and good progress on the structural reform agenda, the proposed PRGF has been delayed due to a lack of resolution of the US and Russian debt negotiations. However, in the short to medium term, the delay of the PRGF will not likely jeopardize macroeconomic stability or the attainment of the economic development objectives of the proposed program (see the Fund Relations Note in Annex 4). Moreover, Fund staff intends to agree a monitoring framework similar to that which would be used for monitoring PRGF quantitative and structural conditionality.

POVERTY TRENDS AND HUMAN DEVELOPMENT

22. Economic growth over the last decade has raised living standards and reduced poverty headcounts. Analysis of trends in consumption and poverty in Cambodia is made complex by the limitations of the data. However, when comparing living standards within the same geographical frame in 2004 and 1993/4, average per capita household consumption is found to have risen 32% in real terms (to 2,932 riels per day in 2004). In Phnom Penh and other urban centers the rise has been considerably more dramatic.

23. The decline in poverty has been significant and widespread. As average per capita consumption has risen, many more households now have per capita consumption values above the poverty line, resulting in falling poverty headcounts (Figure 1). It is difficult to measure the fall in poverty in the country as a whole with precision given the lack of an all- Cambodia baseline in 1993/4 (when the survey was only able to cover around two-thirds of the rural population). Within the geographical sampling frame of the first survey, the headcount fell from 39 to 28 percent. Backward projection on the basis of this observed trend suggests that the national poverty rate fell by 10-15 percentage points over the last decade (from a projected 45-50 percent in 1993/4 to a measured 35 percent in 2004). Moreover, though actual data are unavailable, poverty is very likely to have fallen further in 2005 and 2006 due to the exceptionally high growth rates of those years, especially in agriculture. Projections put the poverty rate at about 32.5 percent in 2006.

9 Figure 1 Poverty has fallen in rural as well as urban areas - albeit much faster in urban areas

&- 50 - 40

30 c r" 20 H 10 0 Cambodia A Cambodia B Rural Urban (excluding Phnom Pen entire country 199314 Phnom Penh) (NB 199314 sampling estim ate based tram e on backward projection)

Source: CSES 199314 and 2004; WB 2006.

24. Although the rate of improvement has varied considerably between groups and locations, poverty reduction has clearly been widespread. The poverty headcount fell in rural areas (by a fifth) as well as in urban areas (falling by a half in the capital Phnom Penh); and in all but one of the five broad agro-ecological regions of the country. Broadly speaking, women as well as men have benefited from economic expansion and rising average consumption, as significant numbers of young rural women have found employment in the new garment industry and improvements in primary education have started to close the gender gap in literacy within younger age groups.

25. Rising levels of consumption have not only lifted many households out of poverty, they have also lifted households that remain in poverty closer to the poverty line. The poverty gap-the average distance by which the consumption of poor households falls below the consumption poverty line-has declined throughout the country, signifying that those who remain below the line experienced less severe poverty in 2004 than was the case in 1993/4.

26. The picture of improving living standards suggested by rising per capita consumption is corroborated by other indicators. The food share of total household expenditure has fallen significantly across all consumption quintiles; conversely, the quality of housing and ownership of key assets have risen.

27. Rising incomes and gradual improvements in service delivery have started to result in improved human development indicators. In many areas Cambodia's human development indicators are lagging other countries in the region. However, the health and education ministries have progressed further than most in developing sector-wide strategies; aligning policy, planning, budgeting and M&E processes toward these strategies; and gradually reorienting priorities in a pro-poor direction. These fundamental improvements in core systems are starting to result in improved outcomes.

28. Starting from a low base, the Cambodian education system has made some impressive gains. Estimated net enrolment rates at the primary level are up significantly from 65% in 2000 to 76% in 2004 (CSES). Lower Secondary (grades 7-9) net enrollment has more than doubled since 1997, increasing from 7.6% to 16.4%. Advances in important indicators

10 such as literacy, repetition rates and years of schooling for younger age cohorts are further positive signs that the rebuilding of the national education system is taking root. Progress has also tended to be pro-poor. While socioeconomic, rural and gender gaps in educational attainment exist, these gaps have generally been reduced significantly in recent years, particularly at the primary level.

29. Recently released data suggests progress on a number of health indicators, reflecting rising average levels of consumption and falling poverty rates recorded last year from the household living standards survey. Preliminary findings from the 2005 Cambodia Demographic and Health Survey (CDHS) suggest significant progress on a number of output and outcome measures relative to the previous (2000) CDHS. Health service delivery has improved in a number of critical respects (notably rates of childhood immunization and the percentage of births attended by a trained professional). Health practices are also changing, with a dramatic rise in exclusive breastfeeding of children aged under six months. These improvements in service delivery and utilization are feeding through into a number of health outcomes, with falling fertility rates, better (though still extremely poor) childhood nutrition, and significant improvements in childhood survival (with infant mortality rates falling from 95 to 65 per 100,000 live births, and under-five mortality falling from 124 to 83). Maternal mortality (per 100,000 live births) has also decreased, from over 437 in 2000 to 343 in 2005. While births at home are slowly giving ways to births at a facility (up from 32% to 44%), progress is starting from an extremely low base, and there is a long way to go. Although Cambodia has still the highest prevalence of HIV/AIDS in the region, it has been successful in arresting and reversing the growth of epidemic (the estimated prevalence rate for the percentage of adults aged 15-49 years fell from 3.0 in 1997 to 1.9 in 2003). Similarly, the TB epidemic has shown a declining trend.

30. At the same time, the Government will need to monitor inequality, which increased over the last decade, due mainly to widening inequality within rural areas. (Inequality in urban areas, while higher than in rural areas, has remained largely stable.) On the basis of the data available, the report Cambodia: Shaving Growth (World Bank, 2007) concluded that consumption inequality rose primarily in the early stages of Cambodia’s transition to the market (between 1993/4 and 1997), but remained stable between 1997 and 2004. If consumption inequality remains at 2004 levels, it need not create any structural impediments to continued growth and poverty reduction. Alongside this broadly optimistic conclusion, the report notes some caveats regarding the adequacy of consumption as a measure, and household surveys as a tool, when analyzing inequality. Data from the 2007 survey will provide an opportunity for updated analysis of poverty and inequality trends in early- to mid- 2008.

THE REFORM AGENDA GOING FORWARD

31. As the previous sections show, Cambodia has established a commendable record of strong economic growth and moderate poverty reduction by relying on ‘first generation’ reforms and taking advantage of favorable external conditions. Cambodia has moved from an isolated, low-growth, state-managed, and subsistence-oriented economy to a market- based economy that is open to international flows of capital, goods, and labor. Since the early 1990s Cambodia has implemented ‘first generation’ economic reforms: deregulation of prices and markets, privatization of state-owned enterprises, and liberalization of trade and

11 investment flows. Macroeconomic management, including a managed float of the exchange rate, fiscal policy, and debt policy are all prudent and in these areas Cambodia does as well or better than its low income country peers.

32. These factors, plus the reorientation of expenditure policy, have resulted in moderate poverty reduction. The RGC has since 1998 significantly improved the alignment of resources with its developmental objectives by increasing allocations for priority sectors, notably education and health. As a share of total budgetary spending, the percentage dedicated to health, education, and social protection increased from 19.5 percent in 1996 to 31.7 percent in 2004, while the share for defensehecurity fell from 45 percent to 20 percent over the same period. In the past couple of years the RGC has turned its attention to increasing spending on the economic sectors, especially rural infrastructure.

33. Cambodia’s high growth and moderate poverty reduction over the past decade could belie the thesis that governance matters for development. However, growth has been narrowly based. The garment sector has benefited from the Multi Fiber Arrangement and the protection imposed by the US and EU against Chinese imports. Tourism is based largely on Cambodia’s Angkor Wat heritage and also benefits from strong demand throughout Asia. Though agriculture has contributed to high growth rates in selected years, it has also contributed negatively to growth in off years, and is a highly volatile sector. Construction is largely a post-conflict phenomenon. At the same time, Cambodia is not on track to meet the CMDGs, and though there has been good progress on human development indicators, some are among the worst in the region. Inequality is also high. Thus, though recent progress has been noteworthy, it is possible that growth would have been higher and more diversified, and poverty reduction greater, had there been better governance, including less corruption.

34. This is to say that the set of first generation reforms that served Cambodia well- by removing the binding constraints to growth and poverty reduction at that time-is now in need of a successor reform program. New binding constraints have clearly emerged. On the one hand economic growth is likely to slow over the medium term unless the investment climate, particularly in terms of trade facilitation, is improved and the agricultural sector is revitalized. On the other hand delivery of public services in the priority sectors is seriously hampered by weak public financial management and an impaired civil service.

35. A second generation of reforms has begun to coalesce into an overall program that promises to revitalize growth and accelerate poverty reduction. A raft of private sector development reforms is needed to facilitate trade, improve the business regulatory environment, and attract new investment, all in the context of fulfilling the commitment to WTO membership. The potential of the agricultural sector needs to be unlocked by measures that raise its productivity by addressing land tenure insecurity and landlessness. Further PFM reform is needed to remove the constraints to improving service delivery at the frontlines of poverty reduction in order to move further on key human development indicators as well as to reduce the fiduciary risk to public funds. The purpose of the proposed operation is to bring together these reforms into a coherent medium term package that will provide the cornerstone for the second generation of policy and institutional reforms needed to diversify and amplify growth while broadening the bases of poverty reduction.

12 111. THE GOVERNMENT’S PROGRAM: THE NATIONAL STRATEGIC DEVELOPMENT PLAN AND THE JOINT MONITORING INDICATORS

36. The National Strategic Development Plan (NSDP) 2006-2010, approved by the National Assembly in May 2006, constitutes Cambodia’s medium-term development strategy. The NSDP provides an over-arching set of development goals and priorities with a results focus derived from the targets established as the Cambodian Millennium Development Goals (CMDGs: see Box 1). For the Bank and the Fund, the NSDP serves as the Government’s second PRSP, following on the National Poverty Reduction Strategy (NPRS) for 2003-2005 (see Joint Staff Assessment Note, WB/IMF, July 2006). I Box 1. The Cambodian Millennium Development Goals (CMDGs) I The CMDGs were derived from the global MDGs in a process led by the Ministry of Planning with support from the UNDP. The CMDGs consist of 9 Goals, 25 overall targets, and 106 specific targets covering: (1) extreme poverty and hunger; (2) universal nine-year basic education, (3) gender equality and women’s empowerment, (4) child mortality; (5) maternal health; (6) HIV/AIDS, malaria and other diseases; (7) environmental sustainability, (8) partnerships for development, and (9) de-mining. In 2005 a review of progress made towards the 2015 targets suggested a mixed record, with achievements (including a significant fall in poverty; expansion of primary education; reduction in child and under-five mortality; and improved immunization and breastfeeding rates) alongside areas of concern (e.g. continuing high rates of rural poverty and low enrolments in post-primary education; persistent high levels of domestic violence and maternal mortality; and degradation of forest and water resources).

I Source: Ministry of Planning, 2005.

37. The PRGO will support progress towards the MDG-based goals of the NSDP in a number of ways. The livelihoods of the rural poor-and progress toward the poverty reduction targets-will be enhanced directly, through the policies and programs for the redistribution of non-functioning concessions to poor farmers and the protection of smallholder property rights; and indirectly, through the creation of a more supportive private sector environment for small and medium enterprises and for trade-driven growth and diversification. Positive trends toward the human development CMDGs will be reinforced by reform of the PFM system: the inability of the current system to align resources to priority goals, or to adjust spending targets and modalities on the basis of results, now constitutes the primary bottleneck to improved delivery of basic services.

38. Cambodia’s NSDP adheres to an internationally recognized set of core poverty reduction strategy principles (see Box 2) and provides the strategic framework under which sectoral and sub-national plans are elaborated. The NSDP and corresponding sector strategies should serve as the basis for future three-year rolling investment plans and annual budgets, and for aligning ODA to Government priorities. The NSDP includes a projection for budget allocation by sector, with a breakdown for rural and urban areas intended to help target poverty in rural areas.

39. The Government is in the process of implementing key reforms from the NSDP, and these are jointly agreed and monitored by the collective DP community. The Joint Monitoring Indicators (JMIs) represent the highest priorities for the RGC and their

13 implementation is closely monitored (see Annex 3 for the 2006 JMIs as well as the draft 2007 JMIs). The JMIs encompass key reforms ranging across all sectors and issues, including anti- corruption, legal and judicial reform, public administration, decentralization, public financial management, private sector development, agriculture, infrastructure, gender equality, and natural resource management. Overall, Cambodia’s development partners have recognized good progress in a number of areas, including decentralization, public financial management, infrastructure, gender equality, private sector development, and some aspects of natural resources management.

40. Cambodia’s progress was recognized by all development partners at the 2006 CG Meeting, at which DPs were encouraged by the recent progress that Cambodia had made, and recognized it by pledging $601 million in aid, a 20 percent increase as compared with pledges made in December 2004. This was in sharp contrast to the 2004 CG Meeting where the overall aid pledged had fallen as the World Bank and the ADB both cut back due to Cambodia’s poor performance on governance indicators. The reduction in aid by both multilateral development banks had a significant impact on the RGC and brought home the message that in the future, aid would be closely linked to Cambodia’s performance, especially on governance issues.

41. At the same time, however, development partners agree that reforms needed to be accelerated in a number of areas, most notably anti-corruption, legal and judicial reform, and natural resources management, especially forestry. The anti-corruption law has been drafted, though concerns remain about whether the draft meets international best practice and though pending since 2004, it is not clear when the law will be sent to the National Assembly. With support from the Bank, the Government adopted a Legal and Judicial Reform (LJR) Strategy in June 2003. Priority actions with regard to LJR were agreed at the consultative group (CG) meeting in December 2004. These focused on the passing of eight key laws (Criminal Code, Criminal Procedure, Civil Code, Civil Procedure, Law on Anti-Corruption, Law on the Supreme Council of the Magistracy, Law on the Organization and Functioning of the Courts, and Law on the Status of Judges and Prosecutors). The past year has seen some progress on the drafting of these laws, and the civil procedure code was passed by the National Assembly in June 2006. Issues related to the forestry sector also remain problematic-the recent Inspection Panel report highlights the problems that the Bank has faced in this sector and given the apparent inability of the Government to successfully fight forest crime, a consensus has yet to emerge on a clear way forward. Progress in public administration has also been minimal, as reflected in the low CPIA rating for public sector management and institutions.

14 Box 2. National Plans as Poverty Reduction Strategies: Core Principles in East Asia

A regional Forum on National Plans as Poverty Reduction Strategies in East Asia was held in Vientiane on April 4-6, 2006. This was the third in a series of conferences on poverty reduction strategies and, like the first two, was organized jointly by the World Bank, IMF, ADB, and UNDP. The main objectives of the Forum were: (1) to exchange experiences with formulating and implementing national plans and poverty reduction strategies among the six countries of the region that have participated in the PRSP initiative-Cambodia, Indonesia, Lao PDR, Mongolia, Timor- Leste, and Vietnam-as well as the experiences in formulating national plans in China and Thailand; and, (2) to agree on core principles for continuing these efforts and discuss next steps by governments and development agencies.

It was agreed that the five-year experience with PRSPs has helped in identifying the core principles of a successful poverty reduction strategy: Broad participation: consultation and transparency in formulating development strategies; Poverty focus: a greater poverty focus in the policies and programs that comprise these development strategies; Results orientation: better monitoring of the results expected from implementing these policies, better evaluation systems, and a tighter feedback to policymaking; and DP harmonization: alignment of assistance with country priorities and synchronization of aid cycles and reporting mechanisms with country processes.

Source: http://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/EASTASIAPACIFICEXT/O,,contentMD K:208624 16-menuPK:2098868-uagePK:64002643-~iPK:640026 19-theSitePK:226301 ,OO.html

IV. ALIGNMENT OF DEVELOPMENT PARTNER AND BANK SUPPORT

COUNTRY ASSISTANCE STRATEGY

42. The CAS, which covers the period FY05-08, complements the NSDP’s focus on strengthening governance and reducing poverty. The PRGO is designed to support the implementation of the CAS objectives, which are directed at tackling the governance constraints to inclusive, sustainable growth and pro-poor service delivery through support to PSD, PFM, NRM and decentralization and deconcentration (D&D), which includes mechanisms for establishing social accountability. For both PSD and PFM the government has well-developed sector strategies and programs in place and has begun implementation, thus the CAS and the PRGO objectives with respect to PSD and PFM are mainly to support implementation of the Government’s programs. For the remaining two objectives: NRM, which includes land, and D&D, the Government’s strategies and programs are at much earlier stages of development.

COLLABORATION WITH IMF AND OTHER DEVELOPMENT PARTNERS

43. Bank-Fund collaboration involves two levels of dialogue, through the policy based lending program and AAA. Bank-Fund collaboration, as well as collaboration with other DPs, occurs overall at the level of the National Strategic Development Plan. In addition, close coordination occurs at the level of the Technical Working Groups in PFM, PSD, Land Management, and Forestry and Environment.

44. The Bank and Fund staffs have coordinated closely on the proposed PRGF and PRGO programs and have worked under streamlined conditionality arrangements. The

15 Bank and Fund have ensured that proposed conditionalities (and structural policy aims in the Article IV consultations) are complementary and mutually reinforcing. The Fund’s PRGF, which was originally scheduled to be presented to its Executive Board in October 2005, has been delayed due to ongoing discussions between Cambodia’s bilateral discussions with both the United States and Russia regarding concessional debt rescheduling scenarios. It is uncertain when the PRGF may be presented to the Fund’s Board, though presentation in 2007 is highly unlikely.

45. Discussions with other DPs on co-financing the operation are at an advanced stage. DFID has indicated that it would like to provide up to S1.5 million of budget support to the RGC in 2007, rising to E2 million in 2008 depending on satisfactory performance. DFID will seek approval from Ministers after the PRGO has been approved by the World Bank’s board. JBIC supports the PRGO framework and actions agreed between the RGC and DPs as a potential financial partner of the RGC subject to the approval of the Japanese Government. JBIC also welcomes the progress of policy reforms agreed upon by the RGC and DPs. The European Commission (EC), in line with its international commitments on harmonization and alignment and in response to the RGC’s request to increase program-based budgetary aid, has confirmed its intention to support the implementation of the NSDP via the provision of a multi-annual Direct Budget Support operation anchored to the WB-led PRGO. The Commission is planning to provide 35% of its Multi Annual Indicative Programme (approved in March 2007 and equal to a total of Euro 77 million for the period 2007-2010) as budgetary support pending the approval of the EU Member States and the European Parliament, with a view to obtaining a Commission Financing Decision in October 2007. The first annual disbursement will relate to the successful achievement of all the PRGO-1 triggers and should be disbursed by the end of the year. CIDA is developing a Country Strategy for Cambodia that is aligned with the NSDP and harmonized with the programs of other DPs. CIDA supports in principle the PRGO approach linking multi-donor budget support to the key reforms agreed by the RGC in the policy matrix. The CIDA team is presently seeking approval for a contribution to the PRGO covering all three operations. CIDA would likely request its funding be provided through a World Bank trust fund. If the proposal to support the PRGO is approved, CIDA would likely be able to make a first contribution in the calendar year 2007.

46. The CAS also recognized a need to improve DP coordination and partnerships. Poor governance has encouraged DPs to adopt short-term approaches to development effectiveness (e.g., stand-alone projects often managed by foreign consultants) and allowed for uncoordinated aid. Conversely, poor DP coordination and inadequate outreach to civil society have accentuated the problems of weak governance (by imposing high transaction costs for all stakeholders; providing conflicting messages to the Government and undermining the evolution of a government-owned vision of development; and closing off opportunities for learning, scaling up or building effective constituencies to tackle the most challenging reforms). Much progress has been made over the past three years.

ANALYTICAL UNDERPINNINGS AND RELATIONSHIP TO OTHER BANK OPERATIONS

47. A catalytic program of AAA work has been carried out in each of the three PRGO areas. In PSD the Investment Climate Assessment (2004) served as a key input to Cambodia’s private sector development strategy and the Bank’s subsequent investment project. The

16 report’s recommendations focused on improving trade facilitation practices, integrating markets through institutions such as private value chains, and injecting competition and transparency in private participation in infrastructure. In PFM the Zntegrated Fiduciary Assessment and Public Expenditure Review (2003), which was followed by the Country Procurement Assessment Report (2004) and a Public Expenditure Tracking Survey in Education (2005), served as the key input to the RGC’s PFM Reform Program. The IFAPER yielded four principal findings: (1) resource mobilization must be improved to ensure fiscal sustainability; (2) weaknesses in the public financial management system create unacceptably high levels of fiduciary risk to public funds; (3) in order to meet poverty reduction targets the Government will need to improve the effectiveness of public spending by more tightly linking it with priority outcomes and by reallocating resources away from lower priority sectors and functions; and (4) given the serious problems afflicting the civil service-low pay, low skills, and thus low capacity-strategic civil service reform will have to be initiated in the short term. In NRM a Poverty and Social Impact Analysis (2004) was carried out in support of plans to implement a program of social land concessions, and a Rural Sector Strategy Note (2005) establishes a broad framework to explore options for Cambodia’s future directions for rural development. The objective of the PSIA was to assess the likely poverty and social impacts of implementation of RGC’s Sub-decree on Social Land Concessions, including the implementation challenges and determinants of successful performance.

48. In order to make progress it is necessary that the Bank and other DPs assist the RGC with all available instruments-including investment projects, and PRGOs- especially given weak implementation capacity. In each of the three PRGO areas the Bank has on-going and future projects planned. The PRGO is an important complement to the investment projects, which are focusing on capacity development and implementation of reform measures. The PRGO addresses high level policy change and cross-sectoral issues. Both development policy and investment operations are needed in the Cambodian context, given the institutional and political challenges in place:

Trade Facilitation and Competitiveness Project (2005, US$ 10 million): The project’s objective is to support the Government’s strategy to promote economic growth by reducing transaction costs associated with trade and investment, introducing transparency in investment processes, and facilitating access of enterprises to export markets. The project focuses on trade facilitation, export promotion, fostering private participation in infrastructure, and legal transparency. Public Financial Management and Accountability Proiect (2006, US$ 14 million): In order to set the stage for improved service delivery and reduced corruption, the objective of the project is to improve public financial management by strengthening: (1) the mobilization of public resources, (2) the management of public resources, (3) the management of human resources, and (4) external audit capacity. The project focuses on revenue management, budget formulation and execution, capacity development, and external audit. The project is co-financed by a US$ 17 million Multi-Donor PFM Trust Fund (2005), managed by the Bank, and supported by AusAID, DFID, EC, and Sida. Land Management and Administration Proiect (2002, US$ 24 million): The goals of the project are to reduce poverty, promote social stability, and stimulate economic development. The specific objectives of the project are to improve land tenure security

17 and promote the development of efficient land markets. These objectives will be achieved through: (1) development of national policies, the regulatory framework, and institutions for land administration; (2) issuance and registration of titles in urban and rural areas; and (3) establishment of an efficient and transparent land administration system. A proposed Land for Social and Economic Development Project (FY08) is under preparation.

V. THE PROPOSED CAMBODIA POVERTY REDUCTION AND GROWTH OPERATION

OPERATION DESCRIPTION 49. PRGO-1, the first in a series of three proposed annual operations, would selectively focus on the key reform areas of private sector development (PSD), public financial management (PFM), and natural resource management (including land). Of these areas public financial management and private sector development are the most advanced in terms of agreement on reform measures. These areas would provide the prior actions for PRGO-1 and the triggers for PRGO-2 and PRGO-3. To help reduce the burden of multiple conditionalities, all of these prior actions are derived from either actions agreed at the 2006 CG meeting, or from sectoral strategy commitments agreed by the relevant technical working groups (see Box 3).

Box 3. Good Practice Principles on Conditionality Principle 1: Reinforce Ownership The operation is anchored in the overall framework of the National Strategic Development Plan adopted in 2006 by the National Assembly. The prior actions for PRGO-1 are drawn from the Joint Monitoring Indicators (JMIs) of the Cambodia Development Cooperation Forum. The JMIs are regularly discussed, including by civil society organizations and in the press. The Government has developed a track record of policy and institutional reform over the past fifteen years. Going forward, the Bank’s support strategically focuses on policy areas where there are Government counterparts who want to progress the reform agenda. The Bank’s analytical work program has been instrumental in assisting the government to design reform programs. Principle 2: Agree up front with the government and other financial partners on a coordinated accountability framework The Bank’s support is summarized in a brief, focused joint policy matrix. The matrix has been developed in full coordination with the relevant government agencies and has relied to a very large extent on the actions already agreed in the joint Government-Development Partner Technical Working Groups (TWG). The matrix is routinely discussed in the relevant TWGs both in terms of progress on the prior actions and on thinking about future triggers. Other development partners planning budget support are using the same joint matrix for their operations. Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The timing of the first operation is not ideally aligned with the budget cycle, due to the need to pace reforms in a “step by step” manner. At present the Bank is prioritizing a feasible, sustainable pace of reform over the timing of the operation. However, the cycle of operations will be better aligned with the budget cycle in subsequent operations. There is evidence that that the actions and triggers genuinely reflect the Government’s policy priorities; most of the actions are drawn directly from :xisting sectoral reform programs, such as the Public Financial Management Reform Program, the

18 Private Sector Development Strategy, and the Land Policy Statement. The framework includes some sensitive policy reform issues, but only those which are supported by high level officials. Principle 4: Choose only actions critical for achieving results as conditions of disbursement The Bank’s policy matrix uses only a limited set of conditions (10 in total per year) and highlights only a maximum of 20 benchmarks per year. Conditionality is focused on critical issues, including the adoption of laws by parliament. Principle 5: Conduct transparent progress reviews conducive to predictable and performance- based financial support There is a regular cycle of performance reviews embedded in the operation through the regular monitoring of the TWGs and the Government-Donor Coordination Committee, which meets quarterly at the ministerial/head of agency level to review progress and challenges. Individual TWGs also produce regular progress reports. The operation only undertakes additional assessment when existing reports and mechanisms are lacking. The process is increasingly promoting a focus on results. The policy matrix also contains jointly agreed performance indicators drawn from sectoral reform plans and TWGs.

50. The operation’s development objective is to support ‘second generation’ growth and poverty reduction based on an improving business climate, higher agricultural productivity, and more effective public service delivery. The PRGO will support the next phase of policy and institutional reform required to maintain growth and accelerate poverty reduction by facilitating trade and diversifying exports, guaranteeing land tenure and increasing access to land for the rural poor, and making the budget a credible management tool and reducing fiduciary risk to public funds. The PRGO program would support outcomes that are driven by policy measures and expenditure policy, both of which are supported by the DP community as necessary for underpinning medium term growth and accelerating poverty reduction. PRGO- 1 features 10 prior actions across private sector development, public financial management, and land and natural resource management (Table 2):

Table 2. Summary of Progress on PRGO-1Prior Actions I PRGO-1 Prior Actions I Status I

Issuance of Prime Ministerial Order requiring all Achieved: The PMO has been issued, and the relevant agencies to define their critical data SAD was prepared and its technical needs for the adoption of a single administrative configuration and layout have been completed. document (SAD) The effective use of the SAD is expected to happen in the third quarter of 2007. Issue a sub-decree and implementing regulations On track: The sub-decree was issued. The risk on trade facilitation through a risk management management strategy is expected to be jointly approach to inspections and clearance of imports implemented with ASYCUDA by end-2007. and exports of goods 3. Adopt sub-decrees establishing Special Achieved: The sub-decrees were issued and an Economic Zones (SEZs) and an SEZ Board in SEZ Board established. CDC

4. Fortify decentralized procurement by Achieved: The Prakas on the Implementation strengthening the 1995 procurement sub-decree of Deconcentrated Public Procurement was and the 1998 implementing regulations to issued on January 3,2005 and an amended promote economy, efficiency, and transparency 1995 Sub-decree on Public Procurement was issued on October 28, 2006 (the corresponding

19 revised 1998 implementing rules and regulations were issued on January 23,2007)

5. Develop and implement first phase of new Achieved: The first phase of streamlined transaction processes from budget release to execution procedures was adopted by MEF via commitment in order to streamline budget a circular and a prakas, and became effective execution January 2007.

6. Increase reliance on the banking system for tax Achieved: The prakas mandating that all and customs payments, and for RGC payments customs and excise duties be paid by check at to creditors and civil servants via transfer andor the NBC in Phnom Penh and Sihanoukville check was adopted in December 2004 (and complemented by a clarifying instruction in March 2007).

Achieved: The order for Treasury to pay all suppliers by check or transfer in Phnom Penh and Sihanoukville took effect September 1, 2006 (for all payments).

Achieved: The pilot program to pay civil servants by transfer to private commercial bank accounts began in August 2006 for nearly 300 staff in MEF and MOH. 7. Introduce an official merit-based pay and Achieved: The MEF MBPI was introduced in employment reform pilot in MEF in support of August 2005. the PFMRP Land and Natural Resources Management 8. COM adopts Sub-decree on State Land Achieved: Sub-decree adopted in 2005 and Management including participation of local prakas in 2006. communities in mapping and land use planning, as well as open public access at provincial level to register of state land use information and issues implementing regulations

9. COM adopts Sub-decree on Economic Land Achieved: Sub-decree adopted and the ELC Concessions that includes provisions for Technical Secretariat was established in June resolution with local communities of issues of 2006 (there are concerns about the quality of prior occupancyluse of lands and classification implementing regulations with respect to of land to exclude forests and protected areas transparency issues, but a time-bound concession review process associated with public information provision has been triggered). 10. Establish a mechanism and periodically Achieved: Mechanism to disseminate disseminate information on Economic Land information on ELCs has been established and Concessions updated httr,://maff.eov.kh/elc/.

51. The proposed triggers for PRGO-2 (Table 3) deepen the reforms undertaken in the context of PRGO-1, and also extend the scope of the reform program. There is agreement on all of these proposed triggers for PRGO-2, reflecting, in particular the depth of the dialogue in PFM. All of the PFM triggers are drawn from the Government’s PFM Reform Program, with the exception of endorsing the Extractive Industries Transparency Initiative (EITI), reflecting the recent confirmed discovery of oil reserves.

20 Table 3. PRGO-2 Triggers Private Sector Development Use of SAD mandatory and applied throughout Cambodia based on prakas Review implementation of risk management and act accordingly to reduce inspection rate to 50 percent (total of inspections by any agency as a share of declarations) Publication of regulations, procedures, fee schedules, penalties, and necessary forms on websites of all trade-related ministries and agencies and 10 of the Ministry of Commerce’s provincial

IPublic Financial Management Develop an overarching resource mobilization policy including tax, non tax, and debt sources Inter-ministerial EITI working group under PFMRP makes a recommendation to RGC on the endorsement of EITI, and the RGC and World Bank sign an MOUon EITI design and implementation Implement FMIS pilot of core purchase, payables, and general ledger modules in MEF and in two line ministries and two provinces Civil Service Reform Design and implement MBPIs in the Ministries of Health and Commerce Land and Natural Resources Management Implement interim protective measures to safeguard indigenous community lands Establish and make public log book of ELCs, including those issued at provincial level, and review a minimum of 5 economic land concessions over 10,000 hectares, taking appropriate action consistent with Chapter 6 of the Sub-Decree on ELCs Clearly define operational procedures for forest boundary demarcation that are fully consistent with state land management and demarcation sub-decrees

POLICY AREA: PRIVATE SECTOR DEVELOPMENT

52. The proposed operation seeks to support the implementation of key elements of the RGC’s private sector development strategy, and reduce well-identified vulnerabilities to sustaining growth and reducing poverty. Against the backdrop of the phasing out of the MFA quota system for garments, the need to raise competitiveness in light of WTO accession, and increasing rates of unemployment among the new entrants to the labor market (especially in Phnom Penh), the proposed operation would directly support the implementation of the RGC’s policy by: (a) facilitating trade and investment, including through streamlining and automation of procedures in trade-related agencies, and implementation of a merit-based pay system; (b) improving the investment climate for domestic and foreign firms and fostering greater private participation in infrastructure (PPI); and (c) more firmly entrenching the rule of law, especially as it relates to encouraging and protecting commercial business activities.

21 Table 4. Private Sector Development: Focus on Improved Outcomes

Government Strategy CAS Outcomes PRGO Outcomes Objectives Achieve higher Governance-related constraints to productivity and Facilitate trade, productivity levels growth are substantially reduced and improve among private firms, Both the level of unofficial payments and the time transparency and allowing more growth required to import and export products are accountability of and employment substantially reduced, as measured by follow-up all trade-related Investment Climate Assessments procedures Cambodia succeeds in establishing its reputation as a country that protects Core Labor Standards Encourage more Institutions that integrate new firms into international Increase volume diversified, broad- value chains established of exports and based and inclusive * Procedures for foreign direct investment are diversify export private sector, streamlined base integrating smaller, Modern standards and technologies introduced in a rural and informal range of sectors through IFC-funded investment firms Provincial investment climate streamlined Voice of private sector amplified through PS Forum and stronger business associations Improve private Private investment in infrastructure increased under a Increase domestic sector delivery of fair, competitive, regulated regime and foreign public services Regulatory environments for private provision of private through more water, education, telecom, and electricity investment, transparent and established including in accountable private Transparent, competitive processes for public infrastructure participation in concessions enshrined in law and implemented infrastructure (PPI)

53. The proposed operation would support core policy and institutional reforms in each of the three sub-areas targeted by the RGC as key policy reform priorities; namely, trade facilitation, investment promotion, and strengthening the rule of law to better support business activities. The following section presents prior actions and milestones for PRGO- 1, triggers and milestones for PRGO-2 and PRGO-3, and performance indicators and baseline measurements for each of the three outcomes.

PSD Outcome 1 End of PRGO Program Performance Indicators Facilitate trade, and improve > 80% of declarations are processed online through ASYCUDA transparency and accountability > Reduce the number of documentary requirements to clear of all trade-related procedures imports to 3 > Reduce the time required to clear imports to 2 days P Reduce the number of documentary requirements to clear exports to 3 > Reduce the time required to clear exports to 1 day > Automatic issuance of statistics and revenue reports in all Customs offices automated P Inspection rate reduced to below 25% (total of inspections by any agency as a share of declarations)

54. Prior Action: Issuance of a Prime Ministerial Order (PMO) requiring: (a) all government agencies involved in trade facilitation to define their critical informational and data needs in the development and adoption of an ASYCUDA-based Single Administrative Document (SAD), including in the Special Economic Zones (SEZs); and (b) the preparation of a detailed

22 action plan by March 2006 to implement an electronic Single Window, including; a pilot in the Port Authority of Sihanoukville (PAS) by December 2006.

55. A Prime Ministerial Order (PM0/90) was issued on December 6, 2005 mandating: (a) development of a single administrative document (SAD) by March 2006; (b) preparation of a detailed action plan for implementing the Single Window, including a pilot in the Port Authority of Sihanoukville (PAS), by March 2006; (c) development of a risk management strategy to manage and control the clearance of imported and exported goods by December 2005, and submission to the Council of Ministers (COM) for approval by January 2006; and (d) implementation of inter-agency administrative agreements spelling out the relative roles and responsibilities of all trade facilitation agencies, including CamControl, by March 2006.

56. The Single Administrative Document (SAD) was prepared and adopted in March 2006. The technical configuration and layout of the SAD and explanatory notes for its 54 boxes have been completed and approved by the steering committee on December 18, 2006. The translation of the SAD and its attached explanatory notes is ongoing and extensive training for the Customs and Excise Department (CED) and traders in using the SAD will soon be conducted by the UNCTAD-led ASYCUDA team. Implementation of SAD nationwide will take place first on a paper form by the third quarter of 2007. The electronic usage of the SAD together with implementation of the harmonized system will be done in conjunction with the ASYCUDA pilot in Sihanoukville by end-2007. The mandatory use of the SAD, applied throughout Cambodia in the third quarter of 2007, will constitute a trigger for PRGO-2.

57. The dialogue, however, on the electronic Single Window reached an impasse due to the lack of agreement on its operational modalities. The design and implementation of an electronic Single Window would have allowed traders to submit their required importlexport documentation through one electronic gateway and do so only once instead of several times to different agencies. The RGC’s position, expressed by the Prime Minister, is that the Single Window will be based on ASYCUDA and managed exclusively by CED by 2012. In January 2007, the World Bank and the Government agreed to restructure the TFCP and to redirect the funds allocated to the Single Window to alternatives with potential to improving transparency in trade-related processes.

58. The RGC has agreed to establish a Trade Information Gateway. The Trade Information Gateway (TIG), which will be implemented as part of the restructured TFCP, envisages the publication of trade related information on individual ministry and agency websites and the establishment of a virtual link of this content. In its second stage of development the TIG will allow electronic submission of trade-related requests. The Ministry of Commerce has decided to move expeditiously toward full electronic submission of permits and licenses by the trading community. This will ensure Cambodia’s ability to comply with changes to GATT Article X as currently being discussed as part of the WTO Trade Facilitation negotiations. Implementation of the TIG will lead to the strengthening of capacity of MOC’s provincial offices to deliver services to the local business community including electronic company registration. The TIG will increase transparency of trade-related processes and accountability of civil servants in trade-related functions and therefore help in achieving the TFCP’s development objectives. Publication of regulations, procedures, fee schedules, penalties, and necessary forms on the websites of all trade-related ministries and agencies and

23 10 of MOC’s provincial offices, and electronic submission of 75% of permits and licenses required by MOC, will be triggers for PRGO-2 and PRGO-3, respectively.

59. Prior Action: Issue a sub-decree on trade facilitation through a risk management approach to inspections and clearance of imports and exports of goods, specifying the Customs and Excise Department (CED) as the sole lead agency for all types of inspections [documentary. physical, and electronic); and adopt and publish the inter-agency administrative agreements among all the relevant agencies on procedures and widelines for the inspection and clearance of imported and exported goods.

60. The Sub-decree on Risk Management was issued on March 1,2006, along with the accompanying guidelines and explanatory notes. The sub-decree identifies the respective roles and responsibilities of all trade facilitation-related agencies (CED, CamControl, MAFF, MOC, MOH, MIME), and ensures that there is no overlap of responsibilities or duplication of activities. In particular, while CED is to exercise overall responsibility for administering general controls over international trade, the other above mentioned agencies are responsible for particular commodities or products, and for providing CED with detailed guidelines for it to act on their behalf at specified control points. The adoption of a risk management approach has codified a policy of selective trade-related inspections based on risk. The risk element is based on a statistical evaluation of the risk of false declaration of the content of the consignment, and supported by a post-clearance audit process.

6 1. Progress in implementing the risk management strategy has been uneven, however. While the Minister of Economy and Finance signed Prakas No. 607 on August 7, 2006, establishing a Risk Management and Post Clearance Office in the CED, the office is still to be staffed, contributing to delays in ASYCUDA implementation. MEF has issued Prakas No. 1015 on October 24, 2006, establishing the Inter-agency Coordination Group on Trade Facilitation through Risk Management. The Group includes members from trade-related agencies. In addition, a 15-member Steering Group on Risk Management led by CED has been set up and is meeting once a month, and has received assistance including training from JICA and AUSAID. However, progress, including in creating the master list of prohibited and restricted goods and the development of Standard Operating Procedures (SOP) between agencies, has been slow due to poor inter-agency collaboration. While Inter-Agency Agreements have been drafted and attached to Sub-decree No. 21 in March 2006, they are still pending signature by respective institutions. Development partners including AUSAID, EC, JICA, and the World Bank are all willing to provide support to the RGC in this area. The Risk Management strategy is expected to be jointly implemented with ASYCUDA by end-2007. Implementation performance of the strategy will provide the triggers for PRGO-2 and -3. The RGC will review implementation of risk management and act accordingly to reduce the inspection rate to 50 percent (total of inspections by any agency as a share of declarations) for PRGO-2 and to 25 percent for PRGO-3. Signing and implementing service-level agreements between trade-related agencies will be a critical milestone.

62. A very important milestone in the private sector development reform agenda is the full implementation of ASYCUDA and its use in the Port of Sihanoukville by end-2007. Implementation of the World Bank-funded ASYCUDA-World package started in April 2006. ASYCUDA-World (Automated System for Custom DAta) is the most up to date version of the UNCTAD-designed information technology package for customs automation and

24 modernization. In April 2006 the ASYCUDA Project Management Unit and a national Project Team were established in CED. The national team has been trained and is fully operational, and about two-thirds of codification/automation of the current legislative framework has been completed and endorsed by the Steering Committee.

63. ASYCUDA implementation is on-track. A prototype of ASYCUDA-World is expected to be deployed in CED headquarters by end-April 2007 and the pilot project functional in the port of Sihanoukville by the end of 2007. Next steps include preparation, endorsement, and implementation of reformed procedures by CED, endorsement of proposed reports to be generated by ASYCUDA, validation of the prototype, and preparation for a parallel run at the pilot site (Sihanoukville), inclusive of training, equipment purchase, and validation of the pilot site. The deployment and usage of ASYCUDA in the five CED offices is expected to take place by mid-2008 and is a trigger for PRGO-3.

64. Discussions are ongoing with the Government to support the full rollout of the ASYCUDA system throughout Cambodia. Under the current arrangement, ASYCUDA will cover most land and sea checkpoints, including the port of Sihanoukville, CED headquarters, the Phnom Penh airport, and the Phnom Penh river port. Also, under the restructured TFCP, the World Bank will fund the establishment of service bureaus to support direct trader input for SMEs and other traders to input their import and export declarations electronically.

65. Other important milestones supporting trade facilitation have also seen recent progress. The draft Law on Customs was submitted to the National Assembly, and all associated implementing rules and regulations have been prepared. The law is currently under consideration by the Second Commission of the National Assembly, which has committed to adopting the law before July 2007. The World Bank has provided technical assistance to the National Assembly’s Second Commission to review the draft Customs Law. To further facilitate trade, the RGC has also committed, as part of its 12-point action plan, to introduce a WTO-compatible Flat Fee for Services. This action will constitute one of the milestones of the proposed program.

PSD Outcome 2 End of PRGO Program Performance Indicators Increase volume of exports and k Growth of 5% per annum in exports excluding garments and oil diversify export base > 80% of transactions of the One Stop Service (OSS) in SEZs are processed electronically k All company registrations at MOC provincial offices completed electronically within 4 days

66. Diversifying the industrial export base in the context of the anticipated natural resource (oil) boom will be a daunting challenge. In order to avoid the natural resource curse, often characterized by a contraction of activities in non-oil industrial sectors, the RGC needs to further improve the investment climate and infrastructure to attract investment in non-garment related manufacturing activities. Promotion of Special Economic Zones (SEZs) to attract FDI, and strengthening the capacity of MOC provincial offices to deliver electronic services, including company registration, to the local business community-a trigger for PRGO-3-would help achieving this objective. In addition, implementation of the Duty Suspension Scheme would further facilitate export procedures for existing investors and allow them to diversify in other activities. With the assistance of FIAS, the authorities have been working on the adoption of an export duty suspension scheme. The scheme will be

25 administered by the CIB, with selected audits to be undertaken by CED, and the software will be fully integrated with ASYCUDA. A final report prepared by FIAS detailing the operational steps required for implementation was submitted in late April 2006. Discussions are ongoing between FIAS, GMAC, and the RGC to finalize preparations for implementation.

67. Prior Action: Adoption of enabling legislation regulating Special Economic Zones (SEZs). A sub-decree on the establishment and management of SEZs was issued on December 29, 2005. The sub-decree incorporates many of the valuable lessons learned from the global experience with such zones over many years. In particular, it calls for public-private partnerships in SEZ development, establishes rules for the provision of infrastructure, utilities, and municipal services, and incorporates the concept of a one-stop service to streamline business regulations and procedures. Incentives are in line with the Law on Investment and its associated sub-decree, and important social considerations are addressed, including labor regulations and vocational training. The RGC recognizes that the enabling legislation could be further improved by incorporating more "best practice" provisions, including in the area of local administration of the zones, land use provisions, and extending backward linkages to surrounding rural areas, and it has recently requested technical assistance from the World Bank group in that regard. An accompanying sub-decree was also issued on December 29, 2005, detailing the new organization and functioning of the Council for the Development of Cambodia (CDC), including the creation of a Cambodian SEZ Board under the direct supervision of a Secretary-General.

68. A milestone in the implementation of SEZs regulations is the adoption and operationalization of the "one-stop service'' (OSS) in all established SEZs. The One Stop Service (OSS) is now operational in the Bavet SEZ with five agencies represented in a single room (CDC, CED, Camcontrol, MOC, and Ministry of Labor). This constitutes a step in the right direction, although efforts are still needed to reduce the number of institutions at the table. The RGC has confirmed that an OSS will be established whenever a new SEZ becomes operational. Automating OSSs in SEZs, in line with ASYCUDA and risk management principles, and reviewing the implementation experience of the sub-decree on SEZs by end- 2008 with a view to submit a law on SEZs to the NA, or issue revisions to the sub-decree by April 2009, will constitute other important steps.

PSD Outcome 3 End of PRGO Program Performance Indicators Increase domestic and foreign 9 Response time of CIB to investor enquiries is reduced by 25 percent private investment, including in P Issuance of at least two judgments by a recognized arbitration infrastructure. center

69. Increasing domestic and foreign private investment in Cambodia will require further reform of the regulatory framework. Such measures should aim at reducing uncertainty over investment procedures and approval processes, enhancing confidence in Cambodia as a destination for FDI, and encouraging greater private participation in infrastructure (PPI) through fair, transparent, and competitive procedures. Adopting a PPI governance framework to effectively manage, deliver, and implement PPI transactions conducted fairly, transparently, competitively, and in the public interest, would be highly useful.

26 70. As part of its strategy to increase private investment, the Government has issued a Sub-decree on the Law on Investment. The Law on Investment, which was amended in 2003, creates a transparent 28-day process for investment approvals. The associated sub- decree giving the law effect and containing the implementing rules and regulations, was approved on September 5, 2005. Importantly, the sub-decree: (a) defines so-called “special nature” projects, which would not be subject to the standard automatic approval process, as “large infrastructure and natural resource activities;” (b) provides an explanation of the RGC’s underlying policies in relation to the listed activities ineligible for investment incentives, including those below a specified threshold; and (c) redefines the role of the Cambodian Investment Board (CIB) as an investment facilitation and promotion. The implementing regulations for the Law on Investment are being effected to the full satisfaction of clients. Examples of improved procedures are noted: approval by CDC of ‘routine’ investment project proposals (e.g. those relating to shoes or garments factories in regular locations) within seven working days instead of the earlier 45 days, while approvals of ‘more complex’ projects (involving e.g. a potential threat to national security, environment, culture, etc.) now take about 28 working days, whereas earlier these could have taken up to three months. Progress in CIB reform toward an investment facilitation and promotion agency will be a milestone in the proposed operation.

71. An important measure, which is a trigger for PRGO-3, is that all concessions are issued in accordance with the Law on Concessions. The Law on Concessions was endorsed by the Council of Ministers on July 15, 2005, and forwarded to the National Assembly on September 18, 2005. The draft law defines a clear process for planning, approving, negotiating, awarding, and managing private participation in infrastructure (PPI) investment in a fair, transparent, and competitive manner. However, despite the RGC’s affirmation of the great importance it attaches to the Law, its enactment is still pending. The RGC is committed to working with the National Assembly to place the draft law on the agenda of its plenary session in the near future.

72. Adoption of the Law on Concession by the National Assembly will enact the much needed revised process for private participation in infrastructure (PPI), a milestone for the proposed operation. The National Assembly’s Second Commission has committed to adopting the law within the timeframe of PRGO-2. In the meantime, preparations are underway on the associated implementing rules and regulations, and these are expected to be issued in the form of a sub-decree. As evidence that the revised process is fully functioning, two concessions have been completed using the new framework since the draft was endorsed by the COM. It will be crucial that the legal provisions in the draft Law are applied to the process and implementation of all concessions as soon as it is made law.

73. The assurance of the impartiality of commercial arbitration in Cambodia is an important indicator of an improved business climate. An important milestone in this arena is the submission of a draft Law on Commercial Arbitration to the National Assembly. The Law on Commercial Arbitration, which will facilitate prompt and fair resolution of commercial disputes, was passed by the National Assembly and subsequently promulgated on May 5, 2006. However, the implementation of the law has not seen much progress thus far. As per the law, MOC is planning to establish a National Arbitration Center during 2007.

27 74. Under the WTO accession agreement, the authorities have also committed to establishing a Commercial Court, which would permit plaintiffs to pursue their grievances in the event of dissatisfaction with commercial arbitration. A draft Commercial Court Law is now under review and is expected to be delivered to the National Assembly in 2007. Judges to be trained in commercial law have been selected and a course is being developed at the Royal Academy for Judicial Professions. DPs are providing assistance to the RGC in this area. The issuance of at least two judgments by a recognized arbitration center is therefore a robust performance indicator.

75. Improved coordination among donors active in PSD in Cambodia as well as improved DP-RGC coordination will be crucial to the success of the operation. Donors active in PSD have recently agreed to step up their efforts to ensure increased aid effectiveness, and are considering the possibility of increasing financial support to the Enhanced Integrated Framework. The restructuring of MOC, as well as the adoption of service-level agreements and the interagency agreement on risk management, are expected to provide greater clarity for the private sector about the division of responsibilities among government agencies. Provision by all relevant agencies of complete information on trade procedures through the internet and increasing automation of trade procedures will increase transparency and efficiency, and limit possibilities for rent-seeking. The MOC is in the process of implementing a Sector-Wide Approach (SWAP). The SWAP will be based on existing analytical work, including the updated Diagnostic Trade Integration Study (DTIS) that is being supported by a number of DPs including the EC, UNCTAD, UNDP, and the World Bank. Thematic areas that will form the basis for the RGC’s reform program in PSD include trade facilitation and the legal and regulatory framework for commercial transactions. The legal framework for commercial transactions is based in part on the schedule of commitments that Cambodia has adopted upon its accession to the World Trade Organization.

76. Although important progress has been made in establishing the required legal framework for commercial transactions, important impediments to traders and investors remain in the absence of an effective framework for combating corruption and upholding the rule of law. It will be vital to continue to focus on implementing integrity programs, transparency provisions, automation of procedures, and merit-based pay reform.

Impact on Growth and Poverty Reduction

77. Trade facilitation and investment climate improvements are likely to spur growth primarily in Cambodia’s urban areas. The actions supported under the PRGO program will likely lead to increased private investment and higher and more diversified exports. As investment and exports expand, formal sector jobs will increase, especially in the traded sectors (e.g., through trade facilitation the reduction in informal fees would be passed on to labor in greater employment and higher wages). These reforms are needed to push Cambodia’s medium term growth above the projected 7 percent level.

78. There is robust evidence from newly available data to suggest that poverty has fallen in the decade since Cambodia opened up to international trade and investment. Employment in the high growth sectors has created some poverty-reducing spillovers. As most of the approximately 300,000 jobs in garment manufacturing have been for young women, growth in this sector has had a positive effect on the gender equality of earnings, and

28 arguably has helped to empower women to some degree. However, the economy remains undiversified and heavily dependent upon a small number of sectors; and backward and forward linkages from these sectors into others have not been as strong as they might (for example, most of the food supplied to the tourist industry is imported, and garment manufacturing has not resulted in the development of a domestic textile production sector)

79. Private sector development is thus crucial both for maintaining existing sources of growth as well as generating new ones, to ensure more rapid and sustainable poverty reduction. The challenge is now to sustain the high growth rates seen in the last decade, improve productivity, and diversify the economy into other sectors. The PRGO policy measures would result in an expansion of trade in existing sub-sectors and facilitate the growth of new sectors. Each change would also help to increase the poverty elasticity of growth, by removing some of the barriers that hold back business start-up and growth in a broader range of goods and services.

80. The PSD policy reforms anticipated in the PRGO would benefit poorer groups in Cambodian society both directly and indirectly. Reducing the regulatory burden on business would likely have a direct impact by encouraging small-scale, household-based enterprises to expand (a decision that many small informal producers and traders currently defer because the regulatory burden and the unofficial levies that come with growth and formalization combine to offset any gains). The greater impact, however, is likely to be indirect, but can be expected to be significant. Increased and more diversified investment and growth would create opportunities for waged, salaried, and self-employment, raise incomes, and so allow for the accumulation of household assets and investments in household human capital. This is not to suggest that weak governance is the primary constraint on diversification, but that it is likely an important one. Critically, economic diversification would promote more balanced economic development, helping to ensure that national growth does not merely proceed at a good rate but also without the periodic setbacks that are more likely in an undiversified economy.

POLICY AREA: PUBLIC FINANCIAL MANAGEMENT

81. The RGC has placed public financial management reform squarely on its development and poverty reduction agendas. It is well known that weaknesses in the public expenditure and financial management system not only have high costs in terms of allocative and operational efficiency but also create unacceptably high levels of fiduciary risk to public funds. The critical test of a public expenditure management system is its ability to deliver a predictable and timely flow of funds to the spending agencies, allowing flexibility in the application of resources while ensuring adequate control at a sectoral and aggregate level. Cambodia’s system does not currently meet this test. The cash-based payments system has emerged as a major constraint. Budget execution has suffered from delays and an unpredictable release of funds, due to cash constraints, undermining operational planning, and leading to the build-up of arrears. The system is plagued by gate-keeping and deficient accounting and reporting systems, thus leading to a weak control environment and increasing opportunities for corruption. Indeed, in comparative perspective, Cambodia’s PFM system ranks below average with respect to other low income countries.

29 82. When funds release is unpredictable, the budget ceases to be a useful planning tool, seriously undermining agency performance and expenditure control. Delays in the approval of commitments and the release of funds prevent timely implementation of agency work plans, undermining the effectiveness of spending in education, where school materials should be available at the beginning of the school year, or road maintenance, where funds should be available after the rainy season. Recourse to unauthorized commitments to by-pass these problems creates another series of perverse incentives, not least of which is the tying of agencies to suppliers with whom they have credit arrangements, thereby hindering attempts to introduce a transparent procurement process. Agencies have incentives to withhold and underreport revenues, since this generates cash that can easily be used to finance expenditures.

83. Beyond public financial management, one of the other major reasons for low quality public services is the absence of an effective system of incentives and accountability mechanisms in the Cambodian civil service. Weak merit-based civil service management, low pay and pervasive corruption are the leading causes of Cambodia’s relatively poor standing on public sector performance. The Country Policy and Institutional Assessment (CPIA) ranks Cambodia in the fourth lowest quintile among fellow low income countries on issues pertaining to public sector management and institutions, indicating the need for significant improvement. Given these serious problems, a strategically sequenced civil service reform will need to be initiated in the short term and carried out over the medium term if the Government’s vision of poverty reduction is to become reality. The reform program will need to take a broad approach to strengthening civil service management, by introducing a merit-based system that guarantees that human resource expenditures are subject to controls (viz., on hiring and promotion) and fully integrated with the budget formulation process; improving civil service pay, to attract and retain slulled staff, especially for high level management and priority sector staff; and rationalizing civil service employment, to ensure that human resources are wisely deployed in high priority sectors. Indeed, one of the principal risks to the government’s poverty reduction strategy is the capacity of the civil service to deliver.

84. In response to these challenge, the Government has formulated a ten-year Public Financial Management Reform Program (PFMRP), launched by the Prime Minister in December 2004, which focuses on four development objectives: (1) Ensuring the budget is realistic and implemented as intended in a predictable manner; (2) Implementing the policy agenda through a comprehensive, orderly and transparent budget process; (3) Improving accountability and internal control systems to strengthen compliance and transparency in the mobilization and use of public resources; and (4) Motivating civil servants by an effective incentive system managed according to meritocratic principles and procedures.2

85. The first cycle of PRGOs will focus on achieving four outcomes: (1) the annual budget is realistic and implemented as intended in a predictable manner; (2) the policy agenda is implemented through a comprehensive, orderly and transparent budget process, including better control of the civil service establishment; (3) improved accountability and systems result in strengthened compliance and transparency in mobilization and use of public resources; and (4) an increase in the number of priority ministries with civil servants who are

Note that the CG JMI for PFM was: “Implement RGC’s PFM reform agenda: first 12 months of platform 1.” As such, no specific actions are highlighted here as JMIs.

30 motivated by adequate pay and credible sanctions for malfeasance (Table 5 relates these to the NPRS and CAS).

Tab1 5. Public Financial Management R sults Focus Government CAS Outcomes PRGO Outcomes Strategy Objectives Accelerate Strengthened mobilization and 1. Annual budget is realistic improvements in management of public finance (setting and implemented as intended in service delivery the stage for improved service delivery a predictable manner through increasingly and reduced corruption): efficient and effective increases in tax and non-tax revenues 2. Policy agenda implemented public financial and accountable stewardship of oil through a comprehensive, management revenue orderly and transparent budget more credible budget implementation process, including better reduced fiduciary risk through greater control of the civil service control and internal audit establishment strengthened external audit 3. Improved accountability and systems result in strengthened compliance and transparency in mobilization and use of public resources

86. The following sections start with each outcome and performance indicators, then describe the relevant prior actions and milestones for PRGO-1, and triggers for PRGO-2 and PRGO-3.

PFM Outcome 1 End of PRGO Program Performance Indicators The annual budget is realistic and P Quarterly cumulative expenditure commitment profile: implemented as intended in a Q1 15%, 42 45%, 43 67%, 44 96% predictable manner > Execution rate to budget: salaries 98%, goods/services 95%, capital 80% > Payments to creditors made by check: 85% by 2008 > Payments to civil servants made through the banking system: 20% by 2009

87. Prior action: Increase reliance on the banking system for tax and customs payments, and for RGC payments to creditors and civil servants via transfer andor check (PFMRP CAP 7.5, 7.7, 7.15, and 7.16).3 This action encompasses several sub-actions: (i)salary payment via commercial banks to civil servants; (ii)payment of customs and excise duties at the NBC by checwtransfer; and (iii)government payments to creditors via checwtransfer.

88. The pilot for paying civil servants via bank transfers commenced in MEF and MOH at the director level (and above), and including MBPI participants, in Phnom Penh initially, in August 2006. ANZ has been selected through a competitive process to provide the service, and the MOU was signed with Government. NT has committed to rolling out the pilot further during the second quarter of 2007 to all ministry staff in Phnom Penh earning more than CR 400,00O/month and to all ministry staff in Siem Reap and Sihanoukville earning more than CR 200,00O/month.

Numbers in parenthesis refer to the PFMRP Consolidated Action Program Activities and “FR” to recommendations from the joint Bank-RGC Fiduciary Review.

31 89. On the payment of CED obligations at the National Bank of Cambodia (NBC), progress has also been made. MEF issued a prakas (#636, December 31, 2004) mandating that payment of taxes and duties collected by CED be paid at NBC by check (or cash for payments less than US$ 1,000). Initial implementation of the prakas had been uneven. However, some progress has been made as a result of the measure. In 2005, 33 percent of obligations were liquidated by check. In 2006, 29 percent of CED obligations were liquidated by check, but only 25 percent by cash (fully 46 percent were liquidated as offsetting transactions). As a result, MEF issued a new instruction in March 2007 to rectify the situation. As of April 2007, all payments made in Phnom Penh and Sihanoukville above US$ 1,000 are required to be made by check at NBC (with the exception of payments made on public holidays and by exemption from MEF). The new instruction should reduce the total amount of cash payments to less than 20 percent in 2007. This measure will be further rolled out to other provinces as triggers for PRGO-2 and PRGO-3, as banking conditions permit. A further measure will be the publication of the prakas in the press and a more active engagement with private sector working groups, to inform them of their obligations.

90. The National Treasury (NT) has also issued an order to require payment of creditors by check as of September 2006 for all payments made in Phnom Penh (central NT and the municipal treasury) and Sihanoukville. As a result of this measure, for the period October through December 2006, the percentages of payments made by check at the central NT, Phnom Penh Treasury, and Sihanoukville Treasury were 63, 78, and 30 percent, respectively. Before the measure, only about 20 percent of payments to suppliers were made by check in these locales. No cash payments in these locales, however, were made to suppliers after September 2006 (the remaining share of payments in these three treasuries were made by offsetting transactions to the accounts of suppliers held at the NT). As a result of this measure, 41 percent of total NT payments to suppliers were made by check (from September to December 2006). Further roll out is planned to other provinces as triggers in PRGO-2 and PRGO-3, so that the use of cash would nearly be eliminated for supplier payments by 2008.

91. Prior action: Develop and implement new transaction processes from budget release to commitment to payment in order to streamline ability of budget holders to spend in line with the budget (PFMRP CAP 6.1 to 6.14). MEF prepared detailed mappings of the budget execution process in all major departments, and followed with technical assistance to help MEF design new streamlined processes. A new budget execution manual, based on a new circular and prakas, was prepared to streamline execution procedures and to introduce program budgeting starting in January 2007. The key features of the first phase reform include: (a) simplification of salary approval in the seven priority line ministries (in which financial controllers were given approval authority); (b) streamlining of execution for non- procurement items (utilities, rental fees, mission fees, workshops, etc.), including enhanced use of petty cash for program budget spending (with special arrangements for schools and health operating districts), and revamped commitment and payment processes in MEF’s Financial Affairs Department, which reduced processing time from an average of 16 days to an estimated 8 days; and (c) redesigned commitment processes for procurement items for program budget expenditures, such that commitment is only required twice per year (50% for each commitment request) for each line item and such that 50% commitment authority is available in November of the previous year for the priority line ministries.

32 92. Additional budget streamlining measures will be rolled out in a second phase for the 2008 budget, in light of the need to further reduce processing times, especially for procurement items, and to reengineer processes before the installation of the Financial Management Information System. Estimates of average processing times for procurement items put the commitment process at 23 working days (13 for FAD approval and 10 for MEF senior management approval) and the payment order process at 23 days (12 for FAD approval and 11 for MEF senior management approval), totaling 46 working days for completion of the process (not including processing time in line ministries). The number of steps and the time required for key authorizations for procurement items should be significantly reduced as part of the second phase of the reform.

93. The RGC is focusing on procurement reform as a policy action to make the budget credible. MEF’s output for PRGO-1 would be to issue new procurement regulations, provide oversight, and expedite payment. Several prior actions, milestones, and triggers are programmed.

94. Prior action: Fortify decentralized procurement by strengthening the 1995 procurement sub-decree and the 1998 implementing regulations to promote economy, efficiency, and transparency (PFMRP CAP 13 and FR). To fill the gaps in the 1995 procurement sub-decree and the 1998 Implementing Rules and Regulations (IRR), and to update them in line with good public procurement practices, DPP undertook preparation of an amended sub-decree and IRRs. DPP accelerated the amendment of the 1995 procurement sub-decree and on October 18, 2006, the Prime Minister signed a new sub-decree, representing a very important accomplishment for MEF. The new sub-decree sets out the broad principles and parameters for the public procurement system, providing an improved framework for implementation of public procurement in Cambodia. In January 2007, MEF also issued a prakas adopting the new IRRs, including standard bidding documents, to support implementation of the new sub- decree. The new IRRs provide detailed procurement procedures and greater clarity of roles and responsibilities in the management of the procurement function for further increasing economy, efficiency, and transparency in the procurement process. Both the issuance of the new sub-decree and the new IRRs were originally expected to be prior actions for PRGO-2. The early completion of these actions under PRGO-1 is an indication of the government’s commitment to procurement reform.

95. Milestone: Issue prakas to initiate deconcentration of procurement in ministries, provinces, and SOEs. This action was completed in early 2005 with the issuance of the prakas deconcentrating procurement authority to the line ministries. New thresholds, below with MEF has only a post-review function, were enacted in the December 3 1, 2005 prakas. The old threshold of CR 50 million has been increased to: CR 200 million for provincial spending, CR 300 million for provincial own-resources (Salakhet), and CR 500 million for most line ministries, with the exception of CR 1,000 million for MOHand MOEYS. It is estimated that ?4 of spending falls below the new thresholds, implying an urgent need to reorient the work of the Department of Public Procurement (DPP) from prior review to post review. In addition, MEF issued a circular in June 2006 limiting the use of non-competitive procurement methods to safeguard against fraud and abuse by deconcentrated procurement entities. For PRGO-3 the Government will submit the draft procurement law to the National Assembly, completing the strengthening of the legal framework for public procurement.

33 96. Additional milestones include: (1) strengthening MEF capacity to monitor public procurement outcomes, including through use of performance measurement tools; and (2) establishing an e-procurement website for advertising bidding opportunities and publication of contract award information, procurement policies, and standard documents. Concerted capacity development efforts are now needed to strengthen the capacity of the DPP, line ministries, and provinces/municipalities in implementing the new procurement system. This will include training programs on the new procurement sub-decree, IRRs, standard procurement documents, and good public procurement practices. An assessment of the overall public procurement system, using the OECD-DAC Baseline Indicator System (BIS) framework, should be conducted and a procurement performance measurement tool should be developed to benchmark and monitor procurement performance and outcomes, forming the basis for establishment of a national procurement monitoring system.

97. The program also supports some actions on the revenue side, in coordination with the Fund. The RGC is committing to increases revenue, both from new policy measures as well as from increases in the revenue yield of the tax base and in the regulation and oversight of non-tax resources. The trigger for PRGO-2 on revenue is the development of an overarching resource mobilization policy including tax, non tax, and debt sources. There is currently little capacity to support the development of a tax and non-tax revenue policy function, and an organizational home for this function was only recently established in the EPFPD. The overarching policy will specify target collection goals for each category of revenue and will indicate the needed policy measures to achieve those goals.

98. An important milestone is improved tax administration through a functional reorganization of the Tax Department (3.21).4 The prakas (#248, May 26, 2005) establishing the legal basis to implement the Tax Department’s (TD) new functional organizational structure has been promulgated. TD needs, however, technical assistance in implementing the new model. The Bank and Fund will jointly provide TA in this area.

99. The discovery of oil, with revenue expected to flow in 2009-2010, necessitates planning for the flow of funds, and safeguarding of transparency and accountability in this important sector. Cambodia’s development partners (DPs) see Extractive Industries Transparency Initiative (EITI) endorsement as critically important for improving the likelihood of sound oil revenue management in Cambodia and for sending the right signal to the global community about Cambodia’s commitment to a favorable investment climate. The RGC formally initiated consideration of EITI endorsement in August 2006 through technical workshops for MEF, the Cambodia National Petroleum Authority (CNPA), and the Ministry of Mines, Industry, and Energy, as well as for the National Assembly and Senate through the offices of the Assembly’s Second Commission. In addition, the Senior Minister, HE Keat Chhon, attended the EITI conference in Oslo in October 2006. The Chairman, HE Cheam Yeap, and the former Vice-Chairman of the Second Commission, both of the National Assembly, have called for EITI endorsement. The Prime Minister has indicated the need for further in-depth study in order to consider EITI endorsement and to manage EITI under the PFMRP. The RGC and DPs have thus agreed the following triggers for PRGO-2 and PRGO- 3, respectively: “Inter-ministerial EITI working group under PFMRP makes a recommendation to RGC on the endorsement of EITI, and the RGC and World Bank sign an

This measure was a prior action in the proposed PRGF program.

34 MOU on EITI design and implementation in the context of PFMRP" and "RGC begins implementation of EITI as per the MOUbetween the RGC and the World Bank." It is hoped that the RGC will develop a clear consensus position over the coming year on the importance of endorsing EITI.

PFM Outcome 2 End of PRGO Program Performance Indicators Policy agenda implemented through a 9 Number of ministries using program budgets: 7 in 2007 comprehensive, orderly and transparent and 12 in 2009 budget process, including better control of the civil service establishment

101. On strengthening the link between policy and the budget, MEF intends to provide the following key output actions: provide line ministries with a framework for program budgeting that strengthens links between spending and results, and improving civil service establishment control in coordination with the Council for Administrative Reform (CAR). Only triggers for PRGO-2 and PRGO-3 are supported in this area.

102. Milestone: Develop and implement pilot establishment control arrangements in MEF to improve budget comprehensiveness. An important measure in this area is developing and implementing pilot establishment control arrangements in MEF to improve budget comprehensiveness (PFMRP CAP 2.5 and 2.6; MBPI MOU).

103. Milestone: Develop and implement program budget (PB) pilots in priority line ministries, including MOEYS, MOH, MOJ, and MOWA (PFMRP CAP 26.1-26.3). Together with the introduction of a new chart of accounts, the new budget classification structure, and the new streamlined execution procedures, MEF has also piloted program budgets in the seven priority ministries as of January. The Budget Department regards the introduction of program budgeting as essential for introducing a stronger focus on results in public service provision, and has stressed the importance of monitoring performance indicators in the context of program budgets. Refinement and expansion of the pilot will take place in 2008 and 2009.

PFM Outcome 3 End of PRGO Program Performance Indicators Improved accountability and 9 Account classification and reporting allows comparison to systems result in strengthened budget of expenditure at both commitment and payment stages compliance and transparency in 9 FMIS-generated budget execution reports prepared quarterly mobilization and use of public and issued within 1 week of the end of quarter by 2009 resources 9 Internal audit reports issued regularly by at least 10 IADsto the management of the ministry, with copies to the MEF and the NAA by 2009

104. To support the outcome of improved accountability and control systems, MEF will introduce measures to automate and improve data management, as well as accounting data formats and sources. In 2006 the RGC took the first steps toward procurement of an

35 FMIS (PFMRP CAP 2 1). Following stakeholder consultations an FMIS specification and Request for Proposals (RFP) for the software have been developed (milestone for PRGO-1). The procurement process is currently underway. Arrangements for acquisition of the ICT infrastructure component, which will be procured separately, are also being progressed. Based on the agreed initial FMIS design and the user requirement specification, MEF has issued the request for proposals, which were due in March (first stage) and are being evaluated. The formal process has now commenced and it will be important to keep it on track.

105. For PRGO-2 the trigger is piloting FMIS implementation beginning with core modules in 2008 (based on testing in mid to late 2007). Based on the current progress and the estimated time to complete the procurement, MEF will implement on a pilot basis initially the core General Ledger Module and then roll out other source modules (Purchase Order, Accounts Payable, Accounts Receivable, Cash Management, Budget, Assets Management, Inventory, etc.) thereafter in a phased manner. The initial pilot is proposed to cover MEF, three line ministries, and four provinces. The milestone for PRGO-3 is to continue rollout of core FMIS modules to ministries and provinces and commence implementation of budget module.

106. The operation also supports three key milestones on the development of the internal audit function. PRGO-1 supports the establishment of Internal Audit Departments (IADs) in line ministries and agencies. In 2006 the RGC created nineteen Internal Audit Departments (IAD) in line ministries, including a coordinating IAD in MEF. Of these nineteen IADs, seven are now operational; however their individual capacity and staffing vary significantly, depending on the scale of RCG operations and DP support. IAD-MEF, as part of its intended coordination/oversight role, has been working on developing and implementing the overall legal and institutional framework including necessary capacity building for effective IAD operation across government. With DP support, some IADs have undertaken some internal audit activity. However all IADs have identified the need for further substantive support, specifically to enable internal audit skills development, guidance on internal audit methodologies, and acquisition of sufficient resources to facilitate effective operation.

107. The challenge now is to strengthen MEF’s capacity to manage and oversee these internal audit departments. During 2007 the RCG proposes to focus on: (a) further evolving the overall framework for internal audit across government; (b) capacity building; and (c) activities targeted at specific risk areas. These activities will aim to recognize the lessons learned from ongoing internal audit developments at the line ministry level and, where appropriate, seek opportunities for shared capacity building. The RGC proposes therefore to develop and secure approval of an overall strategic plan for internal audit. The plan will, based on legislative, regulatory, and best practice requirements, articulate the roles and responsibilities of MEF and ministry IADs, relationships with General Inspections Department and the National Audit Authority. MEF will also develop training and resource inputs necessary to implement an effective government wide internal audit function, and prepare a training needs analysis (management, professional, and ICT). MEF will also plan and implement an integrated program of capacity building designed to strengthen internal audit coordination, risk analysis, planning, and reporting. The milestones for PRGO-2 and PRGO-3, respectively, are: (a) MEF develops a strategic plan for internal audit encompassing roles and responsibilities, coordination with GIDNAA, development of IA methodologies,

36 and a code of conduct; and (b) Ministry IADs produce annual risk assessments, internal audit plans, and quarterly audit reports for review and discussion by MEF.

108. The operation also encompasses the objective of civil service reform (CSR) (Table 6). The end program outcome sought is that civil servants are motivated by an effective incentive system and are managed according to meritocratic principles and procedures. In order to attain this objective CAR and MEF will provide adequate policy options to strengthen positive and negative incentives for civil servants.

Table 6. Civil Service Reform Results Focus Government CAS Outcomes PRGO Outcomes Strategy Objectives Improve public sector Meritocratic civil service management 4. Increase in the number of governance by and incentives tied to performance priority ministries with civil uprooting causes of and (setting the stage for reduced servants who are motivated by opportunities for corruption and better service delivery): adequate pay and credible corruption merit-based pay and organizational sanctions for malfeasance reform piloted salaries increased and decompressed in key ministries strengthened performance management system implemented DP salary supplement practices rationalized

CSR Outcome End of PRGO Program Performance Indicators Civil servants are motivated by an effective P 1,500 civil servants in 4 ministries incorporated incentive system and are managed according to into the MBPI by 2009 meritocratic principles and procedures:

1. Civil service remuneration is increasingly adequate to attract and retain the requisite skills

2. Civil servants are increasingly managed according to merit- and performance-based criteria

109. Prior Action: Introduce an official merit-based pay and employment reform pilot in MEF in support of the PFMRP (31.1-31.5). After nearly one year of design work and tripartite negotiations between CAR, MEF, and DPs, a memorandum of understanding (MOU), including the operations manual, on the PFM MBPI was signed in May 2005. On August 5, 2005, the Prime Minister issued Sub-decree 98 on the “Implementation of the Merit-based Pay Supplement Incentive,” which established the official legal foundation for the MBPI. MEF has completed the selection process (262 staff were selected of a possible 300 maximum). MBPI payments commenced in late 2005.

110. Progress on rolling out of the MBPI to other ministries-a trigger for future operations-had been less successful. Discussions with MOC are on-going, and the Minister of Commerce requested that the Bank work with him to develop an MBPI for MOC in 2007.

37 Discussions with MOH are more advanced, and a deal in principle has now been reached between MOH, CAR, and the health DPs.

111. The trigger on CSR for PRGO-3 is that the COM approves a phased medium-term civil service remuneration plan to improve civil service pay selectively to appropriate levels (PAR JMI 2 and NPAR priorities section 2.1.1, 2.1.3 and 5.1). The trigger for the RGC to develop and approve a new pay policy is an agreed JMI from the Public Administration Reform (PAR) TWG. Development partners regard civil service pay reform as a key priority for the effective implementation of the NSDP, and recognize that progress to date has been limited, though the issue requires urgent attention. The trigger was originally agreed for completion by end-2006. As this has been delayed, and given the upcoming elections, this measure has been converted to a trigger for PRGO-3.

112. Though not currently in the PFM pillar of the matrix, which is based on the PFMRP, the operation has been closely coordinated with the National Audit Authority (NAA). It is important that future PRGO operations include milestones, and potential actions and triggers, on external audit. The NAA has made progress in improving the timeliness of audits. However, institutional bottlenecks seem to have prevented the finalization and publication of the annual audit reports, none of which have yet been published. The preparation and publication of timely and comprehensive audit reports is a critical element of a sound public financial system and also are important for the PRGO DPs. Based on agreement reached during the last mission, the NAA reaffirmed its commitment to publish the audit report for the 2003 financial year, which was submitted to the National Assembly in 2006. The Bank is providing assistance to NAA to prepare the 2003 report for publication as soon as possible and to prepare guidelines for publication of all future audit reports.

113. The NAA has developed a draft strategy for 2007-11 and an activity plan for its IDF grant on capacity development. In addition, the PFMAP features a component dedicated to the external audit function. Based on these plans and subject to confirmation by the NAA, possible actions include:

PRGO-2: Issue implementing guidelines and decree on the procedures and reporting framework between the National Audit Authority and the parliamentary commissions together with guidelines on the practical aspects of how and when audit reports are made public; and issue publicly the annual financial audit reports that have been submitted to the National Assembly.

PRGO-3: Summary of semi-annual and annual activity and financial reports, including the recommendations and responses from audited entities and the NAA’s forthcoming activities, sent to the National Assembly.

Impact on Growth and Poverty Reduction

114. The PFM reform program is intended to mobilize higher resource levels and improve the management of public resources, both of which should result in a higher quantity and quality of pro-growth, pro-poor service delivery. Greater revenue will allow higher levels of expenditure in both the neglected economic sectors-transportation, agriculture, irrigation, and energy-as well as in the social sectors, which have benefited from

38 significant increases in funding over the past years (Table 7). Improvements in PFM systems will also allow for more efficient and effective spending, generating higher rates of return on investment projects and greater impact in terms of the efficiency of service delivery.

Table 7. Government and Externally Financed Expenditure by Summary Function, 1996-2003 (% GDP) Summary Function 1996 1997 1998 1999 2000 2001 2002 2003 Core Government 9.5 9.2 9.4 6.8 8.0 7.6 7.8 6.6 Economic Services 6.4 4.7 4.5 4.5 4.9 5.2 5.6 4.3 Agriculture 2.3 0.8 0.6 1.0 1.6 1.5 1.4 1.3 Transport 2.2 1.6 1.7 1.3 2.0 2.6 2.9 2.1 Other Economic Services 1.8 2.1 2.1 2.1 1.2 1.0 0.9 0.8 Environmental Protection 0.1 0.2 0.1 0.1 0.1 0.1 0.4 0.1 Rural Development 2.5 2.2 2.1 1.9 2.1 2.0 1.7 1.7 Social Services 5.2 5.4 6.8 6.9 7.2 8.9 8.6 7.2 Health 1.9 1.6 2.5 3.1 2.8 2.9 2.8 2.3 Education 2.1 2.5 2.8 2.4 2.5 3.0 3.5 2.6 Community & Social Services 1.3 1.2 1.6 1.3 2.0 3.0 2.4 1.9 Humanitarian Aid & Relief 0.4 0.5 0.3 1.4 2.0 1.2 0.4 0.5 Other 0.7 0.1 0.2 0.4 0.3 0.3 1.0 1.8 Total 24.8 22.2 23.4 21.9 24.6 25.3 25.1 22.0 Of which Treasury Executed 10.8 10.2 9.3 10.6 11.8 12.8 13.5 13.4

115. The RGC has indicated its intention to direct the PRGO proceeds toward expenditure in the following priority areas: roads, irrigation, agriculture productivity, education, and health. Although the grant proceeds will not be tied to any specific purchases, the proceeds will be made available in the middle of the 2007 fiscal year, thus creating additional fiscal space and resulting in the need for programming of additional (i.e., unbudgeted) spending. The RGC will indicate to the Bank the allocation of the funds and the additional spending resulting from the use of the grant funds in the high priority sectors at the end of the fiscal year.

116. Revenue is projected to increase gradually from 10.5 percent of GDP in 2005, opening up fiscal space for higher expenditures in agriculture, irrigation, roads, and energy, as well as growth in social sector spending. The Government has indicated its intention to significantly increase spending on rural infrastructure, and is beginning by allocating a large share of MDRI funds (US$33 million) to fund small rural irrigation projects in eastern provinces from 2006-2008. In addition the RGC is considering scaling up maintenance expenditures on its road network. Maintenance spending has been quite low compared to needs, resulting in a deterioration of the capital stock beyond normal depreciation. The RGC has also stressed the need to continue to expand funding for health and education, and would allocate PRGO funds toward those sectors.

117. Increases in social spending in recent years seem to have resulted in positive trends in education and health outcomes. Development of sector strategies and matching systems for planning, budgeting and M&E have provided a framework within which investments in physical infrastructure (schools and clinics) and increasing numbers and to some degree quality of front-line service delivery staff (teachers, doctors and nurses) have started to shift a

39 number of human development indicators upward. Primary enrollment has increased significantly. Net primary enrollment rates improved and net lower secondary enrollment rates also increased. Similarly in health, there has been remarkable success in controlling and then reducing the spread of HIV and apparent significant decline in infant and under-five mortality rates.

118. The fundamental underlying impediments to further improvement in service delivery and outcomes are inadequate systems for managing public finances and public sector human resources. In PFM, budget allocations fail to reflect priority goals and actual disbursements often fail to reflect the budget (generally to the further disadvantage of spending in key poverty-reducing sectors, both social and productive). Though the recent public expenditure tracking survey in education (World Bank, 2005) found that allocated funds were reaching primary schools through the Priority Action Program, the results in health were less positive. Sub-provincial budgets were ill-defined and a very large share of spending went to indirect costs, including administrative overhead, in the health sector. Mechanisms to feed results back into policy review and reformulation are weak and accountability for the efficient and effective management of resources is limited.

119. The second fundamental and related cross-cutting weakness that holds back improvements in service delivery is public sector human resource management, and particularly the inadequate level of remuneration for civil servants. The salary of public sector employees at all levels-including those (such as teachers and health center staff) who are directly responsible for the delivery of basic services to the population-is not enough to live on, resulting in absenteeism, the levying of additional, informal fees which bias against the poor, and low job motivation. Pilot merit-based pay initiatives will help to identify approaches to systematically raise salaries in such a way as to reward ability and job performance.

POLICY AREA: LANDAND NATURAL RESOURCES MANAGEMENT

120. The RGC has clearly indicated that stewardship of natural resources and secure access to land are of vital importance to Cambodia's rural majority, yet major governance constraints-rooted in non-transparent state processes and a lack of public accountability-undermine the use of natural resources for pro-poor growth and poverty reduction. Government has recognized the importance of improved management of land resources, vital for unlocking Cambodia's productive potential and invigorating the agricultural sector, in its Statement on Land Policy approved by the Council of Ministers in May 2001. The Statement identifies three objectives for a pro-poor, pro-growth land policy: (1) to strengthen land tenure security and land markets, and prevent or resolve land disputes; (2) to manage natural resources in an equitable, sustainable, and efficient manner; (3) to promote land distribution with equity. The RGC has acknowledged past and current abuses of natural resources management, but has also recognized that reforms will take time, given the challenges of competing interests within and outside government. Given this context, RGC has focused on completing the legal framework, establishing delivery systems for key services required to establish a more transparent and participatory approach to land and natural resources management and, where necessary, piloting implementation of the delivery systems to build implementation capacity and to improve the regulatory framework.

40 121. The Land Policy objectives respond to the need to increase agricultural productivity by addressing landlessness and tenure insecurity. The proportion of rural households laclung land for cultivation has trended upward, from 13 percent in 1997 to 20 percent in 2004. While the major causes of landlessness are population growth and low agricultural productivity, widespread legal and illegal transfer of state lands (including those occupied by the poor) to powerful interests is worsening the situation. At the same time the lack of secure tenure-about 80 percent of rural households that owned land were without title in 2004 (World Bank, 2006)-is undermining the agriculture sector’s ability to underpin broad-based growth and poverty reduction. In fact, the 2004 Cambodian Socio-Economic Survey (CSES) indicates that the most important factor affecting agricultural productivity is land tenure. It is also the case in Cambodia that smaller farms are more efficient than larger farms (World Bank, 2006), a finding that supports the RGC’s smallholder titling objectives. Thus, the Government’s land resources management initiatives are vital for increasing agricultural productivity, which lags in Cambodia in regional comparison, and reducing social conflict.

122. In order to implement the policy statement, the RGC has enacted a new Land Law, established the Council for Land Policy, and mobilized development partner financing. The new Land Law was passed in October 2001 following an extensive consultation process. The Council for Land Policy (CLP) was established to coordinate Government agencies involved in land resources management. The Bank has a strong track record of partnership with the RGC in the design and implementation of the land resource management reform agenda, however recently identified weaknesses in Bank-financed operations in Cambodia (including the ongoing Land Management and Administration Project) have raised concerns and prompted a detailed discussion about strengthening governance and ensuring adequate financial controls.

123. Despite numerous obstacles the Government has taken proactive steps in recent months and has: (1) passed a sub-decree on privatization of state land requiring that all property be registered in the state property inventory at MEF prior to sale or lease; (2) prepared a draft law on expropriation of private property setting out clear procedures for public appropriation of privately owned land (including limitations on the instances in which land can be expropriated and frameworks for deciding on compensation); and (3) supported an independent review of the functioning of the Cadastral Commission (completed in 2006) providing a sound basis for setting up continuous monitoring of its performance. Importantly, the Government has completed its first mapping and registration of state lands-a key element of improving overall state land management-in the context of allocation of land to the poor through social land concessions.

124. The proposed operation would build on these recent steps and support the implementation of key elements of the RGC’s land policy strategic framework which are required to improve the utilization of land resources in support of sustainable growth and poverty reduction. The actions proposed are also supportive of the Strategic Framework for Natural Resources Management (NRM) being developed with RGC, and other development partners. The draft NRM framework emphasizes increased transparency, decentralization and local empowerment, and partnership as the basis for moving from a situation of high conflict and minimal public benefits to one which increases both local and national public benefits and increases collaboration amongst state actors and state and private

41 entities in the protection and use of natural resources. The areas of focus-titling and dispute resolution, decentralized state land management, increased transparency of state land utilization and land distribution, expanding use of participatory approaches to natural resources management, and demarcation of production and protection forests-represent the basis for implementing a substantial shift in the governance of land and natural resources in favor of local communities and the poor as well as increasing public accountability (Table 8).

Table 8. Improved Land and Natural Resources Management for Sustainable Growth and Poverty Reduction Government CAS Results PRGO Outcomes Strategy Objective Create a favorable [ncreased number of poor Cambodians able to benefit Accelerate the distribution environment in land kom formal mechanisms for access to and secure of land and the issuance of resource Jwnership of private lands: secure land titles by: management Increased number of plots under 5 ha. registered conducive to private with title Extension of tenure securitj sector enterprise Increased proportion of land disputes involving by plot registration and powerful state/private interests evaluated as land titling decided fairly by civil society through cadastral commissions. Resolution of land disputes Proportion of state land allocated to social quickly and transparently concessions relative to economic land concessions increases each year by 10% Implementation of social land concessions RGC will review idle [ncreased public access to information regarding status Legal framework defining and vacant state and use of state lands and local participation in state procedures for mapping, lands, as well as land use decisions: allocating and managing state lands illegally Publicly accessible state land database state lands in place occupied by private Provincial land use classification and allocation entities maps completed by Provincial State Land Greater public access to Management Committees information on location and use of state lands RGC will develop Strengthened systems for management of forest Improved forest and implement a *esourcesbased on working with local communities management through National Forest Development of sustainable and equitable forest increased transparency, Program focusing on policies and improved frameworks for resolution of participatory demarcation strengthening conflicts/disputes over implementation and of forest boundaries, Forestry managemenl regulation of forest management systems strengthened protected and conservation 100% increase each year in forest area under local areas management, and and increasing benefit sharing management improved/expanded Yorestry Five protected areas have completed management community forestry zontributions to plans reflecting principles of the New PA Law such socio-economic as boundary demarcation based on participatory jevelopment and processes, and co-management areas poverty reduction

125. To improve land tenure security, the Government is focusing on a program of accelerated registration of private land plots, including distribution of titles; extension of tenure security to those not covered by individual titles; more efficient and equitable mechanisms for resolving land disputes; and implementation of a program of social land concessions.

42 LNRM Outcome 1 End of PRGO Program Performance Indicators Accelerate the distribution of land > Cumulative total of 1 million titles surveyed and adjudicated; of and the issuance of secure land titles

126. The RGC will expand implementation of a transparent and participatory process of systematic registration and title issuance consistent with the procedures agreed in the context of LMAP. In order to increase the likelihood of registration of subsequent transactions, revisions will be made to reduce the cost and increase the transparency of official fees. The following prior actions, milestones, and triggers are necessary for attaining the objective in this area:

127. The number of titles issued each year was a prior action for PRGO-1 and will also serve as a milestone for subsequent operations. Issuance of land title certificates during PRGO-2 and PRGO-3 is expected to continue at the rate of approximately 20,000 titles per month leading to an end of series total of approximately 1 million titles issued and adjudicated with 800,000 titles issued and 95% of issued titles delivered to beneficiaries. The RGC expects to increase productivity of the registration teams through improved personnel management based on experience in the first years of registration.

128. Another important milestone will be the expanded delegation of signature authority for cadastral maps to governors in 3 additional provinces in PRGO-3. In order to reduce central level delays, prakas have been issued by the MLMUPC authorizing provincial governors to sign off on cadastral maps as the basis for title issuance.

129. In order to extend the basis for tenure security to those not covered by individual titles, the RGC will develop the legal and technical basis for communal titling, particularly for indigenous communities. As a milestone RGC began implementing three communal titling pilots and initiated public consultation on communal land registration and titling with indigenous communities in Ratanakiri and Mondulkiri Provinces. A draft Policy on Registration and Right to Use of Indigenous Communal Land in Cambodia has been prepared and released for public comment, but finalization of the policy and regulations to enable full implementation of the communal titling provisions of the Land Law in indigenous communities is likely to require another one to two years. In the interim, senior RGC officials have publicly supported the idea of implementing interim protective measures (pilot identification, mapping, classification, and provisional endorsement of indigenous land within the framework of provincial level state land management committees and district working groups as per Sub-Decree #118) to avoid further land losses by indigenous communities. Consistent with the Law on Communities and Articles 23 to 28 of Land Law, the legal status of indigenous communities needs to be established by the Ministry of Interior. Implementation

43 PRGO-2, and adoption of RGC’s policy and supporting sub-decree on registration of IP communal land rights is a trigger under PRGO-3. 130. The RGC will continue implementation of locally initiated social land concessions to gain practical implementation experience as the basis for improving its approach as well as attracting additional development partner support. The RGC has initiated implementation of social land concession guidelines and the state land management sub- decree, and identified land for social land concessions in two provinces. The provinces of Kampong Cham and Kratie have indicated land areas they consider suitable for social land concessions. Officials from both provinces were trained at the provincial, district, and commune levels to carry out the procedures for land use planning and state land registration to confirm areas suitable and available for social land concessions prior to initiating process of selecting land recipients and designing supporting sub-projects. During the PRGO series the RGC proposes to settle 2,000 eligible households on social land concessions, with livelihood support provided and identify an additional 10,000 hectares of land, including from cancelled or reduced ELCs, through the established bottom-up commune land use planning process. 131. As a milestone the RGC supported the establishment of cadastral commissions for alternative land dispute resolution. The legal framework for the establishment of Cadastral Commissions (CCs) at district, provincial, and national levels was completed in 2003. Cadastral Commissions are now operational in all provinces and municipalities, and all districts that have a district office of the MLMUPC (more than 90%). In addition, a new body, the National Authority for the Resolution of Land Disputes (NARLD), was established in early 2006. This represents an important advance as the appeals process is expected to contribute to more rapid and equitable resolution of land use disputes however coordination mechanisms and respective roles of NARLD and the cadastral commissions are still being worked out. Statistics provided by the National Cadastral Commission Secretariat (NCCS) show that, as of the end of April 2006, the CCs had received 4,254 cases. Of these, 1,246 (29%) had been successfully resolved and 950 (22%) dismissedwithdrawn; 2,196 (5 1%) cases were pending. According to the NCCS, the majority of successfully resolved cases involved small numbers of families. To date the CC has resolved few of the more complicated cases involving powerful people or numerous parties. 132. In order to implement a sustainable and efficient approach to state land management, the Government will strengthen the legal framework defining the procedures for mapping, allocating, and managing state lands, as well as implementing provisions for participatory management of natural resources and improving public access to information on the use of state lands. LNRM Outcome 2 End of PRGO Program Performance Indicators Management of state lands 9 Five state land maps and databases established through transparent, k Review of all ELCs greater than 10,000 has. completed, participatory mechanisms, including any cancellations or reductions required by law, and including review and check on results reported to public every 6 months commercial contracts and k Technical Secretariat for ELCs reports publicly and regularly concession agreements on natural on outcomes of concession review process resources and state assets 9 100% of communities managing forest areas have approved Community Forest Agreements and 25% have approved Community Forest Management Plans 9 Information on PASand forests is available to the public and updated on a regular basis

44 133. The following prior actions, milestones, and triggers contribute to the RGC’s objective:

134. Prior action: Council of Ministers adopts Sub-decree and implementing prakas on State Land Management. The Sub-decree was adopted by the Council of Ministers on September 30, 2005 and contains the basis for increased public participation and transparency in management of state lands, reflecting some comments received during public consultation process. The prakas was issued in March 2006, though criteria for classification of state public and private lands have been delegated to provincial state land management committees under broad and somewhat vague guidelines. In March 2007, Cambodia completed its first registration of state land following the decentralized and participatory process outlined by the sub-decree in the context of allocating land for the social land concession pilot in Kratie Province. As a milestone for PRGO-2 state land mapping; will be conducted in five districts and the results placed in a publicly accessible state land database.

135. The RGC is attempting to improve the performance of economic land concessions by ensuring that they are based on effective land assessment, local consultation, formal registration of land boundaries, and competitive bidding procedures. Prior action: The Council of Ministers adopts the Sub-decree on Economic Land Concessions (ELCs) and establishes a technical secretariat. The Sub-decree was adopted by the Council of Ministers in December 2005. While the sub-decree contains several important provisions regarding public disclosure and local participation in review of existing ELCs, similar provisions for the process of granting new concessions are not well-specified. The RGC established the ELC Technical Secretariat required under the sub-decree in June 2006 to address this shortcoming in the implementation prakas and to commence the time-bound concession review process. a prior action the RGC established a mechanism to periodically but regularly disseminate information on ELCs in accordance with the notice issued by the Prime Minister in June 2005. In February 2006, MAFF placed a significant amount of information on its website. In response to concerns about the completeness of the information and quality of map coordinates, MAFF committed to update and further improve the information disclosure. The provision of information from agencies other than MAFF is still pending. The related triEEer for PRGO-2 will be to complete this process of information disclosure, prepare a log book with information on all concessions established, complete a review of at least five concessions in excess of 10,000 hectares, register all concessions in the state property inventory (consistent with the recently issued sub-decree) and issue six-monthly reports on the status of the review process, all issued as oublic documents.

136. In order to reach a common understanding on the way forward in management of natural resources, a dialogue with the Government and other stakeholders on forestry and rural development options is underway and drawing, where appropriate, on recent analytical work undertaken by the Bank and others. During the proposed PRGO series this dialogue will be deepened and will proceed with the explicit aim of exploring both the short-term imperative to address concerns related to access to natural resources by the rural poor, illegal logging and forest land encroachment, and continuing forest loss, as well as the longer-term options for sustainable management of forest resources, attempting to balance the competing objectives of biodiversity conservation and expanding opportunities for economic growth. At present the focus is on the gradual expansion of community-based approaches to natural resources management and building on progress with biodiversity conservation in Ratanaluri under the Biodiversity and Protected Areas Management Project (BPAMP). &

45 trigger under PRGO-2 the RGC will define operational procedures for forest boundarv demarcation that are fully consistent with both the state land management- and forest demarcation sub-decrees and under PRGO-3 forest boundary demarcation will be carried out in five provinces following the agreed procedures.

Impact on Growth and Poverty Reduction

137. The PRGO program would support growth in rural areas through more secure property rights, provision of social land concessions to small-holders, and crop diversification. Agriculture remains central to the livelihoods of the great majority of Cambodians, and particularly poor Cambodians. In 2004, 91% of the poor lived in rural areas; 63% of poor households (and 51% of all households) reported agriculture as the occupation of the head of household. In the interests of poverty reduction it is thus critical that land, as the key productive asset in agricultural production, is managed equitably. Improved land resource management can be expected to exercise a strong positive influence on growth and the reduction of poverty via: (1) enhanced agricultural productivity arising from increased security of land tenure; (2) increased attention to public interest and developmental goals (equity, rural livelihoods, state revenue generation and environmental sustainability) in the management of state land assets; and (3) direct improvements in the welfare of poor households which are the beneficiary of equitable and efficiently-managed land distribution.

138. Analyses find that secure land tenure, in the form of certificates or application receipts, significantly raises crop yields, value of land, and household consumption (WB, 2006). Secure land tenure, i.e., formal land title in the form of a certificate, increases rental value by 57 percent; sale value by 38 percent; crop yields by 65 percent; and household consumption by 24 percent. The main reason is that well-defined property right improves private appropriability of returns. Owners with secure land titles are more willing to invest in higher-risk and potentially higher-payoff activities, such as planting perennial trees and diversifying into vegetable and cash crops.

139. Moreover, reallocating idle “economic” concession land to smallholders through “social” concessions has a clear rationale in terms of improved productive efficiency. As in other countries, it appears that rural households in Cambodia are small but efficient agricultural producers, particularly when they have access to improved technology and inputs through public programs or contract farming arrangements. According to analyses from the CSES 2004, small farms are more efficient than large farms, whether measured by crop income, crop yields, profit or output value per hectare. Increased land utilization compared to the existing economic concessions will boost aggregate economic activity.

140. If managed in a manner consistent with poverty reduction objectives, state- managed lands represent an important potential asset for helping the poor move out of poverty. Currently, state management of land and forests has had very limited or even adverse impacts on the poor. Allocations to large business interests and unsustainable resource exploitation have reduced access to land for the poor; the revenues generated through these allocations, which could be utilized to support public service provision, has been very poor. The PRGO will support implementation of the existing legal framework for land distribution to the poor through better management of state lands consistent with RGC’s poverty reduction and growth objectives through the agreed prior actions and triggers.

46 141. The PRGO will also support distribution of state lands to the landless and land- poor. While the landless only represent about 12 to 15 percent of the poor, their ability to move out of poverty in rural areas is dependent in large part on their ability to access productive land and support services. The PRGO will support the development of guidelines for implementation of social land concessions, as well as the provision of land and supporting services for land recipients.

142. The PRGO will contribute to expediting state land mapping through development and implementation of forest boundary demarcation procedures. Forest demarcation will help strengthen forest law enforcement by clarifying jurisdiction and facilitating prosecution of forest encroachment cases in the courts. Clearly defined procedures will also help expedite the process of state land mapping and foster improved inter-ministerial coordination once competing sub-decrees on forest demarcation and state land management are fully reconciled at the operational level.

ENVIRONMENTAL ASSESSMENT AND SAFEGUARDS

143. The proposed PRGO has been screened under the applicable policy (OP/BP 8.60) to assess its potential to cause significant effects on the Cambodia’s environment and natural resources. The PRGO is not expected to have significant negative effects on Cambodia’s environment and may have positive effects, particularly on Cambodia’s forest and land resources as tenure security improves and government capacity to implement existing rules and regulations is strengthened.

144. The Cambodia Environment Monitor (World Bank, 2003) identified the exploitation and degradation of natural resources, air pollution, water scarcity and pollution, solid and hazardous waste disposal, land use and biodiversity conservation as the most urgent challenges. A country safeguards implementation review, completed in 2006, also highlighted weaknesses in RGC environmental monitoring and enforcement capacities. To successfully address these challenges requires environmental management at all levels.

145. To gain a fuller understanding of potential impacts of the PRGO series on the environment and to further develop the analytical basis for identifying and monitoring appropriate indicators, analytical work will be undertaken through the Environment Monitor and other instruments in FY08. In addition the Bank is currently preparing a concept note in response to a request from the RGC to support strengthening environmental management in Cambodia, including increasing the capacity of the Ministry of Environment to prepare Environmental Impact Assessments in conformity with the existing legislation.

OTHER CAS AREAS

Deconcentration and Decentralization (D&D)

146. The D&D reforms embodied in the organic laws that are currently being drafted and discussed within RCG, have the potential to be among the most profound and complex constitutional development in Cambodia since the adoption of the Constitution. Such reforms, if fully implemented, would redirect accountability of the state to its citizens, as

47 well as affect all sectors and levels of government by redistributing political and administrative authority, functions, financial resources and personnel.

147. As the D&D reforms would be far reaching and complex to design and implement, it is envisaged the reforms would be undertaken in a phased approach:

Preparatory Phase (2007), during which the organic laws are being drafted, consultation on the drafts undertaken, and the laws finalized and submitted for approval. An Implementation Strategy will also be drafted.

Initial Phase (2007-2009), during which the reform process will begin implementation, including: (a) establishment of the Implementation Authority; (b) design of modified sub- national structures and systems; (c) functional assignments, structural changes, transfer of personnel; (d) inter-governmental fiscal arrangements for transfer of resources.

Transition Phase (2010-2012), during which the progress on the reform process would be reviewed and appropriate adjustments made.

148. PRGO-2 could draw from the D&D Reform Implementation Strategy, once finalized, to adopt an appropriate set of triggers and milestones. As the D&D Reform Implementation Strategy is currently under discussion and is contingent on approval of the organic laws, it is not possible to identify the specific actions on D&D to be included at this time.

Human Development

149. The Royal Government of Cambodia has espoused an ambitious reform agenda in health and education and has made some important progress in recent years. Salient priorities within the NSDP 2006-20 10, which could be incorporated into future PRGOs, include: (1) removing barriers to access, expanding coverage and addressing problems of affordability; (2) improving the quality and efficiency of service delivery; (3) strengthening sectoral expenditure management and improving the efficiency of spending; (4) promoting civil service reform to address the low pay for teachers and health care providers, a critical determinant of poor service quality, through salary increases and incentive programs such as the Merit Based Pay Initiative (MBPI); and (5) developing institutions and building capacity-not only at the central level, but also at the provincial and community levels.

Infrastructure

150. The Government’s Rectangular Strategy places great importance on the rehabilitation of the country’s existing infrastructure and the construction of new infrastructure assets to meet the demand of its growing economy. The road sector continues to be a high priority and is also an area where the Bank has been engaged. After years of repair and rehabilitation, the time is now ripe for Cambodia to introduce the concept and practices of road asset management to ensure the maximum benefits of road investments. The Bank is keen to support a Government Road Asset Management Program, preferably through co-financing with ADB and other DPs. On this basis, the DP support should aim to help build institutional capacity for road asset management, fill the funding gaps for routine

48 and periodic maintenance before the domestic funding sources reach the sustainable level, and finance the restoration of badly deteriorated roads to the maintainable condition. The Government, ADB, and Bank are currently discussing investment options and complementary policy measures; the road sector could thus be integrated into the PRGO program starting with the second operation. In addition, with the recent announcements about the discovery of oil and gas in offshore Block A, work in the oil and gas sector is being ramped up. While public finance issues are already addressed under the PFMRP, there is new work being undertaken on sectoral oil and gas issues, including the legal framework for and regulation of the sector. These issues could also be incorporated into future PRGOs.

VI. OPERATION IMPLEMENTATION

FIDUCIARY ASPECTS 15 1. The 2003 IFAPER, which incorporated a Country Financial Accountability Assessment (CFAA) and which was followed by a Country Procurement Assessment Report (CPAR) in 2004, concluded that the overall level of fiduciary risk in Cambodia is high. High fiduciary risk is a result of weak control over public expenditure execution, which derives from unreliable systems and procedures. As a consequence the PFM system cannot provide assurance that public funds are used for authorized purposes. The Government fully accepted the diagnosis and recommendations of the IFAPER and the CPAR, and has developed and endorsed a Public Financial Management Reform Program (PFMRP) that fully incorporates the analytical foundations of both.

152. Since 2005 implementation of the Government’s PFMRP has been addressing-and therefore reducing-the fiduciary issues identified in the IFAPER and the CPAR. The first two platforms of the PFMRP are designed to tackle the underlying fiduciary weaknesses inherent in the system. Platform 1 will make the budget more credible in delivering resources in a timely and predictable manner to spending ministries, and has been under implementation since February 2005. It is expected that Platform 1, which is improving budget comprehensiveness, Treasury operations, and procurement procedures, will be completed before the end of 2007. The overarching objective of Platform 2 is to improve financial accountability, and this will be accomplished by strengthening accounting systems, automating budget reporting and analysis, and building internal audit procedures and controls. Detailed development of Platform 2 is currently underway and it is expected that implementation will commence before the end of 2007.

153. The principal means of addressing fiduciary risk is therefore through vigorous support for the PFMRP. The Bank has led the PFM Development Partner Committee (DPC) since 2003 in supplying both analytical and implementation support to the RGC. It is the view of the Bank, as well as the DPC, that the Government has demonstrated credible commitment to the PFMRP, as indicated by its largely successful track record of implementation from 2005-2007. The PFMRP will take a decade to complete, but significant impact is already being noted.

154. In addition to addressing fiduciary risk through the PFMRP, the Bank will complement standard fiduciary arrangements with additional safeguard measures. According to standard procedures, grant proceeds will be disbursed in accordance with the Bank’s procedures for development policy lending as set out in OP 8.60 and against

49 satisfactory implementation of the PRGO-1 program. Once the grant is approved by the Board and becomes effective, the proceeds will be disbursed in a single tranche. The borrower will open and maintain a dedicated foreign currency deposit account in US dollars at the National Bank of Cambodia (NBC), and the grant proceeds will be deposited by the Bank into that account. Within thirty days, an equivalent amount will be converted into Riel and credited to the National Treasury (NT) in order to finance budget expenditure. The NBC has been subject to a full IMF Safeguard Assessment with respect to a possible successor PRGF arrangement (though the assessment is now somewhat dated). The assessment, completed in March 2004, addressed four broad areas and made specific recommendations to strengthen: external audit, legal structures and independence, financial reporting, and internal audit and control.

155. Additional safeguard measures will also be utilized. These include the establishment of a dedicated NT budget account (to be used exclusively for PRGO funds) to receive the funds from the dedicated foreign currency account; and a mandatory audit of both the foreign currency deposit account and the NT budget account (including the balances and transactions of both accounts). MEF will report to IDA on: the amount received into the NBC’s foreign currency deposit account, and the amount withdrawn from the foreign currency deposit account and the equivalent amount in Riel deposited into the dedicated NT account for budgeted expenditure (the information provided is to include the date and namehumber of the NT account into which the local currency amount has been deposited). The dedicated accounts and related funds flows to and from these accounts will be audited by independent auditors and in accordance with terms of reference to be agreed with IDA.

156. The RGC will also ensure that the grant proceeds are not used for ineligible purposes or items (Le., to finance goods or services on IDA’S ‘negative list’) as agreed during negotiations and defined in the Financing Agreement. If the proceeds of the grant or any part of the grant proceeds are used for purposes other than the agreed expenditures as specified in the Financing Agreement, the Bank will require the RGC to either return the amount to the Deposit Account or the NT Account to be used for eligible purposes, or to refund the amount directly to IDA for cancellation.

IMPLEMENTATION, MONITORING AND EVALUATION 157. The beneficiary is the Royal Government of Cambodia (RGC). PRGO-1 is a single tranche grant that will be disbursed upon effectiveness after the opening of a dedicated foreign currency account at the NBC. It is envisaged that there will be two further single-tranche PRGOs in the series on a twelve to eighteen month basis, depending on the speed of the reform program.

158. The RGC will be responsible for the overall implementation of the PRGO program. MEF coordinates with other ministries through the multi-ministerial Committee for Economic and Financial Policies (CEFP), and through bilateral meetings. MEF also prepares a regular report on PRGO progress. Bank supervision will focus on regular verification processes that monitor implementation of the policies being supported by the PRGO and the PFMRP. The Bank’s monitoring will be aligned with the government’s monitoring and evaluation of the NSDP, which will occur through the TWGs. The PSD, PFM, and Land TWGs are chaired by the Bank on behalf of the partner community, which allows for close supervision of PRGO actions and triggers.

50 RISKS AND RISK MITIGATION 159. An innovative pilot stakeholder analysis was carried out in 2005-2006 to analyze the risks at the level of specific prior actions. Using a modified expected utility model, the positions, salience, and resources of key stakeholders were analyzed. The results of the analysis were used to assess the feasibility of consensus on individual prior actions. The detailed results have been reported ~eparately.~

160. The general risks concerning the PRGO and its implementation can be grouped into the following categories: (i)political risks and ownership; (ii)weak capacity of public institutions; (iii)weak governance and accountability environment, including corruption.

Political risks and ownership

161. The Government’s ownership of the reform program is indeed the key to its successful implementation. While there is strong ownership in MEF, there appears to be less commitment in some of the other agencies involved. There is a risk of a narrowing of the coverage of the operation, as opposed to the typical broadening of coverage that takes place over time in many countries. Further, despite the Government’s experience with the Bank’s policy lending operations (through the Structural Adjustment Credit), it did not establish a clear track record of reform through the SAC, as implementation of policies agreed was uneven.

162. National elections in 2008 raise a serious risk of a slowdown in the reform program. Upcoming elections could be used as a pretext to retard and/or delay reform. If this is the case, the second operation of the series would likely be delayed until well after the election. The reform program could also be stymied if there are perceived threats or perceived encroachment on their territories by powerful vested interests.

163. There is also a risk that the World Bank and other ‘traditional’ DPs could lose influence. The flow of oil revenue in a few years’ time could alter the rules dramatically. This could mean that the leverage of the PRGO would derive principally from technical assistance in the form of analytical and advisory services from the Bank. There is also a risk that oil revenue could be poorly and non-transparently managed, which could put macroeconomic stability at risk.

A few preliminary points are noted on three key PFM prior actions: (1) Treasury payments to suppliers by check: A consensus formed around a policy measure such that approximately 1/3 of total payments to suppliers are now made by checks; (2) Customs payments made by check to the NBC: The negotiations around this issue eventually produced a consensus, though resolution was delayed due to the somewhat difficult nature of the discussions (in the sense of important stakeholders having high salience on the issue, but also having different positions). A more incremental prior action position yielded greater consensus but less progress on the desired outcome; (3) Expansion of MBPI to three other ministries: Negotiations are proceeding on this issue, and it appears that support for the prior action is growing. Many stakeholders will likely support the MBPI expansion to three other ministries, while many other stakeholders would prefer to see an expansion to four. In either case there is robust support for this prior action at the level of MEF and the line ministries, though not necessarily in CAR.

51 164. These risks, however, should also be reduced slightly by the connection between the PRGO and the March 2006 CG Meeting, which linked the Government’s implementation of reforms and DPs’ contributions by rewarding Cambodia with higher ODA (just as the 2004 CG saw both the Asian Development Bank and the World Bank reducing their pledges because of poor performance on governance). Moreover, the operation is now firmly embedded in the CG process, including in the joint Government-DP discussions in the Technical Working Groups, where regular updates on the operation are provided. In sum, the Government has realized that it must move from announcements in these three areas to actual implementation if it is to continue to receive DP support. The PRGO process is designed to strengthen this linkage between results and DP assistance.

165. The Government has set up a monitoring mechanism in the form of a Government Donor Coordination Committee (GDCC) that meets on a quarterly basis and monitors the entire reform program with a special focus on identifying lagging areas. Many of the actions agreed to at the CG Meeting are cross-sectoral in nature and this monitoring mechanism brings an internal cohesion to the reform program that had been lacking. The PRGO’s prior actions and triggers are based on the JMIs agreed at the CG Meeting, so that the reform program remains government-owned and led and supported by the entire DP community collectively.

166. However, any wavering commitment could result in a possible risk that the reform program would take place in a piecemeal basis; reform actions taken could be diluted by subsequent measures; and worse yet, these could be subject to reversals-as was reflected in the past pattern of reform in Cambodia. The Bank, through its active dialogue with Government counterparts, could provide some external support to preserve the momentum of reform among the senior decision-makers, while serving as an ally, through the PRGO instrument, to the Government and especially the MEF to help maintain and sustain the government strategy for and its commitments to the reform program. Still, despite the PRGO, powerful pockets of resistance within Government to some of these reforms are likely to remain.

167. One of the major concerns here is that governance reforms not directly supported by this operation could soon become the binding constraints to growth and poverty reduction. In this scenario, though reforms in PFM, PSD, and LNRM proceed, the lack of reform in the legal and judicial and civil service arenas would block further sectoral reform from having much impact. The lack of progress on civil service reform is particularly worrisome and has the potential to undermine the entirety of the PRGO reform program. The operation is attempting to tackle civil service reform on a ministry by ministry basis, but even this modest approach is proving difficult.

Weak capacity of public institutions

168. Even with the government’s full commitment, implementation of the reform program could be delayed because of weak capacity of public institutions, especially at the sub-national levels which could impede the implementation of proposed reforms. The Bank aims to mitigate this risk by: proposing and formulating a clear phased strategy in policy actions and ensuring that in all the key areas of PRGO implementation, institutional capacity is built up through well designed and targeted capacity development support, which

52 would ideally encompass mechanisms such as the MBPI to address civil servants weak incentives for performance. A related risk concerns the piloting of reform and the possibility that pilots are not rolled out into more systematic reform efforts. Piloting is occurring in all three sectors and is an accepted way of working in Cambodia. The threat, however, is that pilots proceed without ever having system-wide impact, due either to weak capacity or lack of political will.

Weak governance and limited accountability

169. Corruption in Cambodia is a critical constraint-with economic and social advancement often driven by nepotism and graft instead of productivity, integrity, and entrepreneurship. All these have exerted a negative impact on the implementation of the reform program. The Bank’s ability to mitigate these political risks is limited, except through promotion of activities that foster greater participation of civil society and greater transparency.

170. In a weak governance environment there is also a reputational risk of providing budget support. Following the declaration of misprocurement in the Bank’s portfolio with a development policy operation is likely to generate criticism from some quarters. For this reason the task team is proposing enhanced fiduciary arrangements, while vigorously supporting Government’s efforts to improve the PFM system.

Exogenous shocks

171. Given the fragile and fledging economic base of the country, Cambodia is prone to exogenous shocks including adverse terms of trade, lower exports, increasing regional insecurity and global economic slowdown, ill effects of health-related problems such as avian flu or SARS, and natural disasters. All these could cause a widening of the external financial gap and disrupt macroeconomic stability as Cambodia depends heavily on exports.

Collaboration with DPs and civil society

172. To strengthen the country’s commitment, enhance sustainability of reforms, and mitigate any adverse impact on would-be losers, the Bank has been closely coordinating with other DPs, NGOs, and the private sector. Strong partnerships with other DPs in helping the implementation of the reform program are highlighted in the TA matrix. In particular, under the NSDP framework, the PRGO program has been closely coordinated with the IMF. Close coordination among DPs would mitigate the burden imposed on the government, minimize overlapping DP demands, and insure consistency of the reform program across all areas.

53 ANNEX 1: LETTER OF DEVELOPMENT POLICY

*. ._ .*

S*...,...... 2071...... WEFl ......

Phnom Penh, 25 April ,2007

H.E. Paul D. Wolfowib President ' The World Bank Washington, D.C.

Excellency,

On behalf of the Royal Government of Cambodia, I am writing to thank the World Bank for providing Cambodian with Poverty Reduction and Growth Operation (PRGO), which will play a crucial role in supporting and driving further structural reforms in key sectors, The Royal Government has clearly understood that the proposed reform measures will lead to poverty reduction .and prosperity for all Cambodian people.

This letter is intended to briefly outline the recent progress in Cambodia, to reiterate once again the Royal Government Cambodia's commitment to reform and to seek the International Development Association's support on these reforms and the implementation of our government political platform, the Rectangular Strategy (RS), as well as the National Strategic Development Plan (NSDP) through the implementation of the PRGO.

Recent Progress in Cambodia

Cambodia has gone through sweeping change not only in political and security, but also in its economic and social landscape. While peace, territorial unity and political stability have been achieved, this stable, safe, and secure environment is an essential precondition to Cambodia realizing its economic and social potential as a peaceful and prosperous nation. Poli'tical stability has opened up a window of tremendous opportunities for social and economic development for Cambodians from all walks of life.

During the past decade, prudent and sound macroeconomic management. particularly in the area of fiscal policy has helped the economy to achieve remarkable progress. The recent economic performance of Cambodia has been noteworthy. During 1999-2006, annual average GDP growth reached around 9.7 percent. In 2005 and 2006, the real GDP growth reached an all time peak of 13.4 percent and 10.5 percent respectively. Growth in 2005 and 2006 was largely driven by continued high export growth: increased tourism receipts, robust construction activity, and especially, strong agriculture production bolstered by massive investment in irrigation facilities and well conceived government policies.

Per capita income has almost doubled from US$247 in 1994 to US$ 506 in 2006. Inflation averaged 3 percent from 1994-2006. The exchange rate has been broadly stable. The country's international reserves increased by 10 times from a low level of US$lOO million in 1994 to M gmtl ~ILIrdpiipi i%;smy ntm@rnq np giro3 : GrjM-Igrn-ribCI 3aG yml : Gdd-Im-GGd fl8d Phune, aSSZ.L714 664 Val ' WSS-23417798 # $.92. Sangksl HI81 Phiilrn, Khm nun Pmh. Phnom Pmh. CAMBbIllA. [email protected] m.m.r.g'*.Lh 54 more than US$ I billion in 2006. The high economic growth has resulted in rapid poverty reduction, which declined from an estimated 47 per cent in 1994 to 34.5 per cent in 2004, i.e. we have managed to reduce poverty by 1 percent per annum.

The strong economic growth and massive investments in infrastructure, especially rural infrastructure, have also led to significant improvement in social sector such as health and education. During the last decade, we have increased education spending by more than fivefold from 102 billion of Riels in 1998 to 546 billion of Riels or US$134 million in 2007. Net enrolment rates at the primary level are up significantly from 65 percent in 2000 to 76 percent in 2004. The lower secondary net enrollment has more than doubled since 1997, increasing from 7.6 percent to 16.4 percent. Advances in important indicators such as literacy, repetition rates and years of schooling for younger age cohorts are further positive signs that the rebuilding of the national education system is taking root.

At the same time, substantial progress has been achieved in the public health sector. During the last decade, we have increased health spending by more than sevenfold from 44 .billion of Riels in 1998 to 337 billion of Riels or US$83 million in 2007. The mortality rate of children below five decreased from 124 in 2000 to only 83 per thousand births, which means 30% reduction. Moreover, the malnutrition of children below five went down from 15% to 7%, which means reduction by more than half.

In general, undoubted progress has been made on all fronts and positive and progressive changes are clearly manifest. Major highlights are:

Restoration of, and vast improvements in, internal peace and security. Territorial unity and political stability have been achieved. Democracy taking roots, both at the national and sub-national levels. Major advances in rule of law and improvements in maintenance of law and social order. Vast enhancement in personal freedoms and freedom of expression. Better and steadily improving fiscal discipline and management. Accelerating integration of Cambodia with the region and the rest of the world, Measurable improvements in other social indicators such as: significant reduction in communicable diseases, spectacular in HIVIAIDS; improved urban access to safe water, and rural access to sanitation; and, reduction in gender disparity in many fields.

Rectangular Strategy (RS)

To keep the momentum of this progress and to make sure the government will be able to achieve the CMDGs by 2015, the Royal Government in the third term of the National Assembly has laid out the Rectangular Strategy which clearly stated the importance of "Promoting Economic Growth" "Generating Employment for Workers" "Promoting Social Equity" as well as "Strengthening the Public Sector's Capacity".

The Rectangular Strategy for Growth, Employment, Equity and Efficiency (RS) was launched by Samdech Prime Minister HUN SEN on 16 July 2004 during the first Cabinet Meeting of the Third Mandate Royal Government of Cambodia. This Strategy represents the RGC's political platform which constitutes the common national vision and mission statement to guide the implementation of the economic policy agenda of the Government during its term in office. The RS, which can be visualized as a series of interlocking rectangles, has good governance at its core. The other rectangles focus on the desired environment to implement the strategy, and on promoting economic growth through agriculture development, rehabilitation and construction of physical infrastructure, private sector development, and capacity building and human resource development.

First, the core of the RS is Good Governance, focused at four reform areas: (1) anti- conuption, (2) legal and judicial reform, (3) public administration, and (4) reform of the armed forces, especially demobilization;

Second, the environment for the implementation of the RS consists of four elements: (1) peace, political stability and social order; (2) partnership in development with all stakeholders, including the private sector, donor community and civil society; (3) favorable macroeconomic environment; and (4) regional and international integration.

Third, the four strategic “growth rectangles” are: (1) agriculture enhancement; (2) private sector development and employment generation; (3) continued rehabilitation and construction ofphysical infrastructure, and (4) capacity building and human resource development.

Fourth, each strategic “growth rectangle” has four sides:

Rectangle I: Enhancement of Agricultural Sector which covers: (1) improved productivity and diversification of agriculture; (2) land reform and clearing of mines; (3) fisheries reform; and (4) forestry reform. Rectangle 2: Further Rehabilitation and Construction of Physical Inftastructure, involving: (1) further restoration and construction transport infrastructure (inland, marine and air transport); (2) management of water resources and irrigation; (3) development of energy and power grids, and (4) development of information and communication technology. Rectangle 3: Private Sector Development and Employment Generation covers (1) strengthened private sector and attraction of investments; (2) promotion of SMEs; (3) creation of jobs and ensuring improved working conditions; and (4) establishment of social safety nets for civil servants, employees and workers; and Rectangle 4: Capacity Building und Human Resource Development, including: (1) enhanced quality of education; (2) improvement of health services; (3) fostering gender equity, and (4) implementation of population policy.

National Strategic Development Plan (2006-2010)

The National Strategic Development Plan (2006-201O), has been formulated using the comprehensive Rectangular Strategy of the Royal Government of Cambodia and synthesizes various policy documents (Cambodia Millennium Development Goals, National Poverty Reduction Strategy, National Population Policy, etc.) and through extensive consultations were also held among all stakeholders. It provides the framework and compass for growth, employment, equity, and efficiency to reach CMDGs and well-focused and directed future equitable development, pro-poor and pro-rural. It will take the country on an assured growth path, at once sustainable. It lays out the vision, goals, strategies and priority actions for the next five years. It makes balanced, realistic and feasible allocations to various sectors on a priority basis. Its implementation will be closely and regularly monitored to make annual adjustments. With peace and internal stability taking strong hold, improvements in social order, and robust economic growth in the past few years, Cambodia is at a critical threshold for faster future progress. The next ten years represent a decade ofopportunity to realize ambitious CMDGs and uplift the poor and vulnerable.

The National Strategic Development Plan (NSDP), 2006-1 0, contained in this document should therefore be considered an operational and guiding tool to achieve the said objectives, goals and targets. It is a document "for and by the whole of Cambodia". It is not a mere academic exercise. It is a practical document to achieve realistic, specific high priority national targets by 2010 to move towards longer-term goals, using the framework of the Rectangular Strategy. Emphasis is on results (outputs, outcomes) to be achieved, not merely on inputs, activities and processes. The NSDP is also a compact and concise document. It highlights the most essential overarching goals, strategies, targets and actions and leaves more details to be developed and spelt out in sectoral and sub-national plans based on national priorities contained in the NSDP.

The NSDP is therefore a practical, result-oriented implementing tool with the clear purpose Of:

Rapidly improving the lives ofall Cambodians. More specifically, bringing about meaningful and measurable reduction in poverty levels especially in the rural areas where these are high.

In Cambodia, greatest and quickest gains in poverty alleviation will be possible in rural areas where most of the poor live. The NSDP will, therefore, direct over 60% of resources to rural areas, with increased attention to productive activities like agriculture, rural development and to health and education to increase and enhance human capital and better contribute to overall development.

Successful and timely implementation of NSDP strategies and achievement of NSDP targets would need substantial and well-directed additional investments and their focused and effective use. Such investments need to be made both in the public and private sector, but only the public sector aspect is considered here.

Based on projected macro-economic growth and needed investments in the public sector, and taking into account the absorptive capacity of the public sector apparatus, it is estimated that Cambodian Riel (CR) 15,225 billion equivalent to US$ 3,500 million will be needed for the public sector during 2006-2010 to achieve the goals and targets set forth in the NSDP. Within this envelope, priority attention is needed to some major sectors. To ensure a rural focus for poverty alleviation, allocations have to be more for activities which will benefit rural areas directly.

The resources to be available for the NSDP will come from: (a) surpluses in current account in the annual national budgets; (b) grant aid from external development partners; (c) concessional loans from multilateral financial institutions (MFIs); (c) resources from non traditional partners including semi-concessional loans from MFIs; and (d) funds made available from possible past debt relief. A high priority is to direct resources in a meaningful way to "real investments", including through significant reductions in technical assistance projects, and to persuade EDPs to fully align their assistance to NSDP. RGC is confident and optimistic that a small gap of about CR 980 billion or US$ 225 million in resources could be covered by increases in internal revenues and external support. Finally, the NSDP recognizes that critical to its success is regular, timely and clear monitoring and evaluation of results being achieved as implementation progresses so that needed corrections could be made from time to time. It is therefore to be considered a dynamic, live, evolving and flexible document to be regularly monitored and evaluated against progress, and to be revised, adapted and adjusted to reflect new data and to realign actions on an annual basis. An annual review of progress, shortfalls and corrective actions will be produced for dissemination and consultations.

Macroeconomic Management

The last decade fantastic macroeconomic performance has further strengthened the Royal Government of Cambodia's commitment in maintaining this stability in years to come. The Royal Government of Cambodia understands that the macroeconomic stability is vital in promoting growth and reducing poverty. Without low and stable inflation, careful control of public finances, manageable public debt and sustainable level of government spending, we would not expect or hope for a strong and sustainable growth and a reduction in poverty.

The government will manage the fiscal policy prudentially and to maintain the budget deficit at the lowest possible level. At the same time, the Royal Government will ensure that the government's expenditure will be consistent with macroeconomic stability a well as making the expenditure program as a part of a systemic reform package aimed at promoting domestic saving, productive investment, and efficient resource allocation. Moreover, as the country is now peaceful, the government will channel more resources into the social and economic sectors in order to improve the well-being of the people and to fight against poverty.

Though, macroeconomic stability is a necessary condition for growth, it is not sufficient by itself. To be truly effective, reforms must extend right across the policy spectrum. To be effective, the Government places a great deal of emphasis on improving governance as a necessary condition for promoting private investment. Indeed governance reform is a cornerstone of the Rectangular Strategy. The reforms underway include Judicial Reforms and Civil Administration Reforms. The Government ,is working on an anti-corruption law. Structural adjustment in the key sectors of the economy is proceeding smoothly. The main objective is to promote private sector led growth supported by proactive public policy. The role of the Government is envisaged as efficient provision of infrastructure and helping the private sector to improve competitiveness. We have also created a Steering Committee on Private Sector Development with the aim to improve the investment climate, business environment and trade facilitation. To further strengthen financial sector development, the Royal Government of Cambodia adopted in 2006 the updated Financial Sector Development Plan for 2006-2015.

At the same time, to promote macroeconomic stability, the government will promote the economic diversification by promoting the agriculture sector, agro-industry and small and medium enterprises through the implementation of a number of the following reform programs:

1. Continue to prudentially implement macroeconomic policy as a base for high economic growth and sustainability with low inflation. 2, Continue to implement the Public Financial Management Reform Program, especially to achieve the goal of the first platform, which is a more credible budget through reducing expenditure procedures, maintaining and sustaining revenue, strengthening cash management in order to improve efficiency in providing services, introducing measures to reduce arrears to private suppliers, starting to implement the new Chart of Accounts and Budget Classification and testing the implementation of program budgeting, which is the base for the second and third platforms. 3. Continue restructuring in order to strengthen a favorable environment for the development of the private sector, especially promoting agriculture sector, agro- industry and small and medium enterprises as well as enhancing trade facilitation through the Single Window and promoting the participation fiom the private sector in the infrastructure construction. 4. Continue to implement land management reform in order to support the agricultural sector in accordance with the Land Law in order to transform this sector to be a strong base for economic growth and poverty reduction. 5. Continue to strengthen the banking system, insurance sector and financial sector in order to mobilize capital for financing the projects in the private sector. 6. Implement the Judicial Reform, the strengthening of rule of law, building and strengthening the implementation of law and other legal document, which is the necessary factor to build confidence of investment. 7. Continue to implement the public administrative reform, especially strengthening the implementation of Priority Mission Group, merit base payment initiative, and functional analysis in order to improve civil service productivity and efficiency.

Poverty Reduction and Growth Operation (PRCO-1)

The PRGO has been implemented in order to enhance reforms in core sectors. In this program, the Royal Government agreed to select three prioritized areas, the Public Financial Management Reform Program, Land Management Reform Program and Private Sector -Development. The PRGO is a good instrument to improve coordination between donors and government, alignment of donor priority with government reform priorities and more effective govemment-development partner dialogue on cross cutting issues. Moreover, the PRGO also provides a number of opportunities to strengthen the strategic linkages between the Rectangular Strategy and the National Strategic Development Plan.

The selection of these three sectors in the first PRGO reflects the Royal Government of Cambodia's prioritized reform programs both in the Rectangular Strategy and National Strategic Development Plan 2006-20 10. These are cross-cutting areas that will have potent impacts, or positive externalities, on other reform programs by contributing both poverty reduction and growth.

The progress in these three sectors will contribute tremendously to the improvement of the private sector by reducing transaction costs associated with trade and investment, introducing transparency in investment processes, facilitating access of enterprises to export markets; improving public financial management by reducing corruption and improving transparency in the public spending; and providing a secure and proper property rights to all the people. The PRGO-1 has been divided into three different components with detailed agreed actions and clear output.

Components and PRGO-1 Prior Actions:

The first component in the PRGO-I focused on Private Sector Development (PSD). Even though the government had a pro-poor trade strategy, the Private Sector Forum, WTO membership, and reforms of the foreign investment regime, it was acknowledged that further work was needed to develop a clear strategy on private sector development. The objective of' the PSD initiative was the establishment of a single entry point, or 'ASYCUDA-based Single Window,' that would allow all parties involved in trade to fulfill the documentary and

53 payment requirements for import or export in a single transaction. Prior actions for PRGO-I include: 1. Issuance of Prime Ministerial Order requiring all relevant agencies to define their critical data needs for the adoption of a single administrative document (SAD)

2. Issue a sub-decree and implementing regulations on trade facilitation through a risk management approach to inspections and clearance of imports and exports of goods

3. Adopt sub-decrees establishing Special Economic Zones (SEZs) and an SEZ Board in CDC

Component 2 focused on the strengthening public financial management by improving the quality of publicly provided social services and increasing the amount and effectiveness of public resources, which would enable the government to deliver poverty-reducing services in health, education and other important social sectors. The transparent and effective public expenditure and financial management system will definitely enhance allocative and operational efficiency and reduce the level of fiduciary risk to public funds. Component 2 of the prior actions for PRGO-1 are:

4. Fortify decentralized procurement by strengthening the 1995 procurement sub-decree and the 1998 implementing regulations to promote economy, efficiency, and transparency

5. Develop and implement first phase of new transaction processes from budget release to commitment in order to streamline budget execution

6. Increase reliance on the banking system for tax and customs payments, and for RGC payments to creditors and civil servants via transfer and/or check

7. Introduce an official merit-based pay and employment reform pilot in MEF in support of the PFMRP

Finally, the component 3 focused on Land and Natural Resources Management Reform. The Royal Government of Cambodia is redoubling its efforts to reduce poverty by providing all Cambodian people with more secure property rights and access to land. Improving land management has the potential to directly reduce rural poverty by enabling people to make greater use of the nation productive assets. The secured land title will definitely contribute to the improvement of the productivity, rebuilding the agricultural sector and contributing to the poverty reduction. Component 3 prior actions for PRGO-1 are:

8. COM adopts Sub-decree on State Land Management including participation of local communities in mapping and land use planning, as well as open public access at provincial level to register of state land use information and issues implementing regulations

9. COM adopts Sub-decree on Economic Land Concessions that includes provisions for resolution with local communities of issues of prior occupancyhse of lands and classification of land to exclude forests and protected areas

10. Establish a mechanism and periodically disseminate information on Economic Land Concessions PRGO-2 Triggers

Realizing that the selected three reform programs in PRGO-I are potent to the poverty reduction and economic development and have not been completed yet, the Royal Government of Cambodia will continue to focus on these three reforms programs in the PRGO-2. The Royal Government of Cambodia has engaged actively with the World Bank to set the triggers under these three reform programs,

Moreover, the recent confirmed discovery of oil reserves has sparked debate over the management of oil revenue. The Royal Government understands that the proper and transparent management and accountability of oil revenue will be crucial in serving the development purpose and avoiding the resource curse. Oil revenue will provide additional resources for financing development projects in Cambodia and present opportunity to bolster Cambodia's medium to long term growth, promote greater economic diversification and poverty reduction.

In this regard, the Royal Government of Cambodia is considering the endorsement of the Extractive Industries Transparency Initiative (EITI) in order to define the proper policies for efficient management of oil revenues. The Prime Minister has indicated that all oil revenues will go directly to the budget and will be managed under the PFM Reform Program.

Conclusion

The good performance in the last decade and the rapid poverty reduction show that Cambodia has been on the right path of development. This progress would have never happened without the reforms initiated by the Royal Government of Cambodia and help from all development partners. However, the road ahead is still long. With CMDGs as the goal, the Royal Government of Cambodia once again reiterates its stand and commitment to stay on the course of reform and would like to request all necessary assistances from the International Development Association, so that those reforms will be successfully implemented and prosperity will avail for all Cambodian people. Your Excellent1 1, the assurances of my highest consideration. F- --I

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0 0 n n n v) v) v) v) v) a a a a a W 0 P n v) 0 Joint Monitoring Indicators for 1st CDCF Meeting (19-20 June 2007) To be implemented and monitored in the period between the first and second meetings of the CDCF

NSDPI Approve final MPSP as a strategic document to be implemented with coordinated EDP support. UN Bring together the NSDP APR and the alignment section o IEF 3 be B the CDC AER to document and assess progress on key etermined yhers NSDP indicators and resources committedJaligned to DC NSDP priorities. Strengthening Ownership, Managing for Results and RDBICDC P+H TWG Mutual Accountability. Development partners: (i) report to CDC on details of all new and on-going support; (ii) provide up-dated information in the CDC Database; and (iii) hold periodic consultations with CDC to validate data and to assess progress in implementing H-A-R priority actions; RDBJCDC All TWGs Promoting Harmonisation and Alignment. Progress in ully JICA implementing the H-A-R Action Plan and TWG Guideline is ?sourced MDSP reported by TWGs and consolidated as a background document for each GDCC meeting; :L- RDBJCDC P+H TWG Managing for Results. The H-A-R Action Plan is augmented with a set of indicators, the Aid Effectiveness Report assesses progress in H-A-R Action Plan implementation and is presented to CDCF. I INSDP Social Sector Prioi ?S Improvedopportunities MOEYS WG :' 1. Increase the net enrolment in primary school (total, and or primary by sex). Education 2. Increase the sulvival rate from grades 1 to 6. I I . Increase the proportion MoH 4f deliveries attended by 1. Recruitment and deployment of at least 68 midwives for 68 health centres that do not yet have any midwife by the Okilled health personnel in end of 2007 the public sector to 45% by December 2007 (38% in 2. Provide salary incentives to midwives - an incentive based December 2006) on the number of deliveries was adopted under the Inter- Ministerial Prakas of the MEF and the MoH No 268, April 2 2007 and the adapted midwife salary scales and compensation payments for professional related health risks as proposed by MoH are to be endorsed at a full session of the Cabinet of Ministers. 5. Enhanced national NAA&NACD TWG Increase coverage of effective drug & HIVIAIDS response to HIVIAIDS prevention, comprehensive care and support, and effective pandemic mitigations interventions. 6. Food security and TWG-FSN Under RGC leadership, a Strategic Framework to nutrition integrated into MOP mainstream food security and nutrition is developed by relevant sector CARD TWG-FSN and endorsed by relevant ministries. NSDP Economic Sector Priorities I

71 Implement and monitor 1. Progressive implementation of the Strategy for AgricLltun WG-AW . IAFF partnership-based and Water, as required by the NSDP: IOWRAM pproach to agriculture an1 later sector priorities. a) Reaching agreement by the end of June 2007 on a Statement of Principles to guide donors and Government agencies working the in agriculture and water sectors b) Obtaining approval by MAFF, MOWRAM and donors or the terms of reference for the design of the 5 National Programs under the SAW, by July 2007 c) Completing the design of two National Programs by the end of December 2007, and d) Completing design of all 5 National Programs by the end of July 2008. 2. Improved donor and government coordination a) Ensure relevant stakeholders have up to date information on activities by posting twice each year (a end June and end December) on the TWGAW website an updated project database listing the donor and government activities in the agriculture and water sectors. . Implement the legal 1. To adopt RGCs Policy on Registration and Use Rights of ILMUPC WG-Land ,amework established by Indigenous Communal Land and pilot interim protective le Land Law measures (identification, mapping, classification and provisional endorsement of indigenous land legal claims) to safeguard the indigenous community's land in two provinces within the framework of provincial level state land management committees and district working group: as per Sub-Decree #118). L To improve the livelihoods of the rural poor, i.e. 500 eligible households are settled on social land concessions with livelihood support and at least 10,000 hectares of suitable land confirmed as available for social land concessions

I With the aim of stoppin! 1. Implement all provisions of the sub-decree on ELCs, 1AFF WG-F&E le loss including establishing and making public log book of ELCs, WG-L f Cambodia's forest including those issued at provincial level, and review a ?sources, the legal minimum of 5 economic land concessions over 10,000 .ameworks established by hectares, taking appropriate action consistent with le Forestry Law and in Chapter 6 of the Sub-Decree on ELCs. articular the Sub-Decree ?. Rapid implementation across Cambodia of forest n Economic Land demarcation in accordance with the sub-decree No. 53, oncessions must be fully dated 1 April 2005. nplemented at all levels o iovernment agencies. 0. Take appropriate actio1 1. Cambodian Code of Conduct for Responsible Fisheries IAFF WG- reflect the priorities of (Camcode) drafted by the end of 2007 isheries ie Fisheries sector to ?, Work with the government agencies/ revenue authorities nprove the livelihoods of and donors to ensure the FiA is adequately funded iral communities in including the revenue from the sector to carry out its mmune, district and mandate with reference to Article 14 of the Fisheries Law rovincial development lans as well as donor 3. Donors in fisheries use the planning, accounting and inding levels. monitoring systems of the Fisheries Administration to be in line with MTEF and MBPI by the end of 2007. 1. Further reduction of 7C L. Ensure the implementation, monitoring and evaluation of MAA WG-MA 0 landmines/ERW existing mine action/ERW policy, strategy, and action ssualties and a decrease plans. -10% of contaminated !. Ensure timely disbursement of RGC and development iine/ERW land partner funds. 1. Improve mechanism to monitor the use of resources and their impact in a transparent, efficient and effective manner.

72 Relevant agencies (Le. MOC, MoH, MAFF, MIME and MEF) MOC, MoH, WG-PSD to sign and implement the Service Level Agreements, MAFF, MIME attaching agreed - upon lists of prohibited goods betweenand MEF trade related agencies. Review implementation of risk management and act MOC ll accordingly to reduce the inspection rate to fifty percent including in SEZ's. Review to be conducted under the purview of the Sub-steering Committee on Trade Development. IIME Make specific recommendations on 20 priority licenses impacting on SMEs to ensure relevancy, efficiency, and cost effectiveness I

MPWT WG-I Develop Action Plans for the Establishment of the Road National and Rural Road MRD Network Maintenance Management Systems by June Network 2008. Preserve Road Assets by (i) piloting and review of out- sourcing of 3 periodic road maintenance contracts (June 2008); and (ii) improving and developing Overload Control Programs (June 2008). 14 Increase use of Develop and adopt a rural water supply and sanitation improved sanitation, orking (RWSS) strategy and budget that is based on the official hygiene and drinking watei roup is to RWSS policy and aligned to the NSDP supply, especially in rural areas stablished under a relevant G to be

NSDP Governance and ;s-Sectoral Priorities 15. Further develop the Implement the approved "Joint Government-Donor AR WG-PAR Public Administration to Strategy for Phasing Out Salary Supplementation Practice serve people better and to in Cambodia" by: become an effective a. implementing approved sectoral action plans; and b. establishing Priority Mission Groups (PMGs), and PMG/Merit Based Pay Initiatives (PMG/MBPIs) in MOH, and at least one other ministry/agency. Improve pay and employment conditions in the civil i service by developing and implementing: a. a medium term strategy and action plan to enhance remuneration; and b. a redeployment policy and action plan. Design and implement an HRM policy and action plan to improve merit and performance management by introducing an HRM Guide and further developing the Human Resource Management Information System (HRMIS) for the Civil Service. Enhance service delivery though developing a One Window Offices (OWOs) policy, legal framework and implementation plan, including establishment of at least 5 OWOs across Cambodia. URS Strategic Objective 2. Complete the drafting and 03 IR-TWG unctioning, transparent approval of the remaining fundamental Laws (Penal nd accountable legal and Procedure Code, Penal Code, Civil Code, Law on the 'udicial system that protect Statute of the Judges, Law on Court Organization and individual rights as defined Functioning, Law on the Amendment of the Law on the in the Constitution Organization and Functioning of the Supreme Council of the Magistracy). URS Strategic Objectives 2 & 7. Review and finalise guidelines for the legislative drafting process that draws

I 73 on lessons from past experience. Guidelines should seek to inform externally mobilised TA, with an emphasis on building the capacity and ownership of the relevant Ministry's legal unit. . URS Strategic Objectives 7 & 4. Ongoing training and transparent selection of judicial professionals to improve the supply of judicial services and the functioning of the courts. . Finalize and approve Anti-Corruption Law, based on best 10NASRI international practices. :OM . Prepare an implementation plan to enforce and manage the implementation of the Anti-Corruption Law. . Disseminate information on reported cases on corruption and conviction on semi-annual basis.

I Develop a clear policy framework on Access to Information.

18. Preparation made for I Continue preparation and initiate broad stakeholder CDD full implementation of the consultations on the organic laws on democratic RGC's Strategic Framework development at sub-national level during 44 of 2007. fro Decentralisation and Deconcentration (D&D) . National programme design process and modalities CDD reforms. developed, agreed, and resourced for implementation to begin in 2nd quarter of 2008. CDD . RGC and development partners design the principles of engagement in support of D&D reform in Cambodia. 19. A more credible budget IEF Continue implementing the PFMRP by: and more effective financial accountability a) sustaining actions already implemented and completing the remaining key actions necessary for Platform 1; b) preparing the consolidated action plan for implementation of Stage Z/Platform 2), including to make recommendations on the endorsement of Em; and c) continue monitoring impact through the agreed PFM Performance Indicators. 20. Adopt laws and sub- . Sub-decree on the administrative decision on domestic decrees and relevant legal violence adopted. loJ lo1 documents, and implement Law on suppression of human trafficking and sexual plans against all forms of . IOWA exploitation adopted, and in compliance with the UN IOLvr violence and exploitation Protocol on trafficking and UN convention on transnationa against women and organized crime, and the Cambodian draft penal code. children, according to international standards . National Action plan to combat violence against women implemented. The specific target for 2007 is to establish a working group in MoI/DOLA for training materials on the Sub-decree. . Policy and legislation on migration reviewed. Specific targets for 2007 include: Adopt comprehensive Strategy Paper on Migration that links Migration with Trafficking, Smuggling and the Labour Law Reform and closes existinc legal gaps to enhance legal protection of migrants.

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ANNEX 4: FUND RELATIONS NOTE

Cambodia: Assessment Letter for World Bank PRGO June 18,2007 Contact person: Mr. Jeremy Carter A. Recent Economic Developments and Outlook' 1. Recent macroeconomic performance has been very strong, underpinned by cautious fiscal policy, significant aid, and increasing foreign direct investment. Growth in 2006 is currently estimated to have been 10% percent. Inflation has stabilized in the low single digits while continued strong performance in the garments and tourism sectors led to a narrowing of the external current account deficit in 2006. Financing from aid and increased FDI allowed further reserve accumulation. Financial intermediation continues to expand rapidly (40 percent annually) but the level remains very low-credit represents about 12 percent ofGDP. The exchange rate has been broadly stable.

2. Rapid growth is expected to continue in the coming years. Continued high levels of FDI will support activity in export-oriented sectors while agriculture is well-placed to expand steadily. Nevertheless, risks do remain. In particular, the accession ofVietnam to the WTO will challenge Cambodia's competitiveness in the garments sector and the soundness ofthe banking sector remains a key concern. Improving governance remains crucial to sustainable economic and social development-a weak rule of law and widespread corruption continue to place a drag on economic activity, investment, and government revenue.

3. For the longer term, oil production could have a significant impact on activity and the budget position. There is still considerable uncertainty as to scale and timing ofoil production, Chevron, the only active operator, has yet to announce the results oftheir latest exploration drilling. As a result, the Fund staffs principal current medium-term macroeconomic framework does not include estimates ofthe potential impact.

4. With grants and concessional lending more than financing the fiscal deficit, public debt is sustainable with only moderate risk of distress. The DSA shows public external debt declining fiom 33 percent of GDP in 2006 to 9 percent in 2027 and debt service at very,low levels. Cambodia remains in arrears on debts to the United States and the Russian Federation, dating from the 1970s and 1980s and totaling $800 million. Nevertheless, caution needs to be exercised in borrowing based on the recently-acquired sovereign credit rating. Stress tests that illustrate the effect of large-scale (1 0 percent ofGDP) borrowing on commercial terms yield significant fiscal costs, though do not materially change the findings ofthe DSA.

' This assessment is based on Article IV policy discussions in May-June 2007. The 2007 consultation is expected to be concluded by the IMF Executive Board in early August. The 2006 Article IV was concluded on July 7,2006.

83 B. Fiscal policy 5. Fiscal policy is prudent but weak administration impedes the effectiveness of the tax system and the quality of expenditure. Whereas moderate primary deficits are more than financed with aid, revenue is very low and excessively dependent on taxes on international trade. It is important that with trade liberalization reducing external tariffs, medium-term revenue policies focus on steps to broaden the base and improve the efficiency and equity of the domestic tax system (including incorporating the nascent oil sector). Successful implementation of the authorities’ Public Financial Management Reform Program will also enable gains in budget management needed for sustained increases in poverty-reducing expenditure. An important part of that strategy will be civil service reform.

6. The 2007 budget reflects the government’s cautious approach in recent years of setting very low revenue targets, while constraining spending. Taking account of the enhanced economic outlook and continued strong collections, revenue should be expected to exceed budget projections significantly. Reflecting the additional resources available-even after the recent within-year wage increase, which added less than 0.1 percent of GDP to the 2007 wage bill-the government could then ensure that budgetary allocations to priority sectors are fully executed, allow additional growth in poverty-reducing expenditure, or further reduce domestic payment arrears.

C. Monetary and financial sector 7. In the staff‘s view, dollarization has been, and will continue to be a valuable foundation for Cambodia’s macroeconomic stability and financial sector growth. Recent strong growth in money demand is to be expected at this stage of Cambodia’s development and is consistent with low inflation over the medium term. Active monetary policy is precluded by the high level of dollarization. The National Bank of Cambodia (NBC)’s passive monetary approach of supplying riel through foreign exchange purchases in response to demand while . avoiding fiscal financing is appropriate. Staff continues to support the policy of a stable nominal exchange rate against the US dollar, which has been part of a successful policy of reserve accumulation, strong export performance and low inflation. ..

8. The rapidly expanding banking sector remains vulnerable and the central bank needs to be strengthened. Reported system-wide non-performing loans are low (around 10 percent), but there are concerns as to the quality of asset classification and the level of exposure to the booming real estate market. Information on both is limited. Enforcement of prudential regulations remains patchy. Rapid credit expansion reinforces the importance of effective bank supervision and stronger enforcement of prudential regulations. In particular, decisive measures to address weaknesses in the two largest, jointly owned, banksxanadia and FTB-are important.

84 D. Relations with the Fund 9. A proposed PRGF arrangement remains stalled as negotiations on outstanding bilateral debt obligations continue. A Fund arrangement cannot be put in place while arrears exist to official creditors unless agreement is reached to reschedule, within the context of the Paris Club. An in-principle agreement has been reached with the United States but is still to be finalized. However, agreement is yet to be reached on the rescheduling of Russian debt. At the authorities’ request, staff has agreed to maintain an intensive policy dialogue until a formal program can be presented to the Board. The monitoring will address progress against the authorities’ macroeconomic targets and structural reform priorities. The Fund continues to provide extensive technical assistance, particularly to the central bank and in public financial management (working closely with the World Bank) and revenue administration.

85 Table 1. Cambodia: Selected Economic Indicators, 2004-08 Nominal GDP (2006): $7254 million GDP per capita (2006): $513 Population (2006): 14 2 million Fund Quota. SDR87.5 million 2004 2005 2006 2007 2008 Est. Proj. Proj. Real economy (annual growth rates, in percent) Real GDP 10.0 13.5 10.6 9.1 7.9 Real GDP excluding agriculture 15.2 0.7 17.0 11.3 9.5 Real agricultural output -0.9 15.7 5.5 3.4 3.4 GDP deflator 4.8 6.1 4.7 4.0 3.9 CPI Inflation (end of period) 5.6 6.7 2.8 3.8 3.8 (in percent of GDP) Domestic investment 17.7 20.1 21.5 21.5 23.7 Government investment 6.0 5.4 5.6 5.3 5.6 Non-budgetary grant-financed investment 4.3 3.1 2.7 3.1 3.3 Nongovernment investment 7.4 11.6 13.2 13.0 14.8 National saving 15 5 15.8 19.5 19.4 19.9 Government saving 1.4 1.8 2.3 2.1 2.1 Nongovernment saving 14.2 14.1 17.2 17.3 17.8

Money and credit (annual growth rates in percent, unless othelwise indicated) Broad money 30 4 16 1 36 2 42 9 27.0 Net credit to the government 1/ -2 4 -49 -10 6 -0 6 -0.1 Private sector credit 35 9 31 8 51 6 44 7 35.0 Velocity of money 21 54 54 49 40 3.4

Government operations (in percent of GDP) Revenue 3/ 10.3 10.3 11.5 10.7 11.2 Of which : Tax revenue 7.7 7.6 8.0 8.2 6.5 Expenditure 14.9 13.5 13.5 13.9 14.4 Current expenditure 8.9 8.1 8.0 8.5 8.8 Capital expenditure 41 6.0 5.4 5.6 5.3 5.6 Overall budget balance -4.6 -3.2 -2.0 -3.2 -3.2 Overall budget balance (ind. grants) -2 9 -1.0 0.5 -1.3 -1.8 Foreign financing, net 4.7 4.7 4.5 3.9 3.3 Domestic financing 51 -0.2 -1.5 -2.5 -0.7 -0.1 Balance of payments (in millions of dollars, unless otherwise indicated) Exports 2,589 2,910 3,693 4,270 4,726 Imports -3,269 -3.928 -4.749 -5,489 -6,176 Current account (exd. official transfers) -436 -591 -525 -592 -794 (in percent of GDP) -8.2 -9.4 -7.2 -7.1 -8.5 Current account (ind. official transfers) -118 -265 -146 -174 -352 (in percent of GDP) -2.2 -4.2 -2.0 -2.1 -3.8 Overall balance 49 65 193 246 165 Gross official reserves 809 915 1,097 1,400 1,609 (in months of imports of goods and non-factor services) 2.6 2.4 2.4 2.6 2.6 (in percent of uncovered dollar deposits in banks) 61 179 146 113 90 78 Public external debt 71 8/ 2,043 2,107 2,235 2,440 2,641 (in percent of GDP) 38.5 33.6 30.8 29.2 28.2 Public debt service (cash basis) 28 29 28 28 36 (in percent of exports of goods and services) 0.8 0.7 0.6 0.5 0.6 Memorandum items: Nominal GDP (in billions of riels) 21,343 25,693 29,809 33,822 37,905 (in millions of US. dollars) 5.306 6,271 7,254 Exchange rate (riels per dollar: end of period) 4,031 4,116 4,046 ... Sources: Data provided by the Cambodian authorities: and Fund staff estimates and projections. 1/ Contribution to broad money growth. 2/ Ratio of nominal GDP to average stock of broad money. 31 In 2006, includes transfer of MDRI proceeds as capital revenue transfer. 41 Includes repayment of arrears in 2004 and 2005. 51 Includes funds in transit and payment orders in excess of cash released. 6/ Dollar deposits in commercial banks net of their unrestricted reserves at NBC. 71 From January 2006 includes the impact of debt forgiveness from the IMF under the MDRI. 8/ Russian Federation debt Is valued at 0.6 USSR Roubles per US$ with the standard 70 percent discount.

86 ANNEX 5. CAMBODIA AT A GLANCE

Cambodia at a glance 411 7/07

East POVERTY and SOCIAL Asia & Low- Development diamond’ Cambodia Pacific Income 2005 Population, mid-year (millions) 14.1 1,885 2,353 GNI per capita (Atlas method, US$) 430 1,627 580 Life expectancy GNI (Atlas method, US$ billions) 6.1 3,067 1,364 - Average annual growth, 1999-05 Population (%) 2.0 0.9 1.9 Labor force (%) 3.1 1.3 2.3 GNI Gross per primarb Most recent estimate (latest year available, 1999-05) capita enrollmenl Poverty (“A of population below national pover?y line) 35 Urban population (% of total population) 20 42 31 Life expectancy at birth (years) 57 70 59 1 Infant mortality (per 1,000 live births) 97 29 80 Child malnutrition (% of children under5) 45 15 39 Access to improved water source Access to an improved water source (“A ofpopulation) 41 79 75 Literacy (% ofpopulation age 15+) 91 62 Gross primary enrollment (99 of school-age population) 137 115 104 -Cambodia Male 142 116 110 Low-income oroup Female 131 114 99

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1985 1995 2004 2005 ~ Economic ratios’ GDP (US$ billions) 3.4 5.3 6.2 Gross capital formationlGDP 14.4 17.5 19.7 Exports of goods and servicesIGDP 31.2 64.5 65.1 I Trade Gross domestic savingsiGDP -1 .o 10.1 10.9 Gross national savingsiGDP 5.4 14.0 14.4 Current account balanceIGDP -5.4 -2.3 -4.3 Domestic Capital Interest paymentsiGDP 0.1 0.2 0.2 savings formation Total debffGDP 66.3 65.4 56.8 Total debt serviceleworts 0.7 0.8 0.8 Present value of debffGDP 54.5 Present value of debffexports 83.5 I Indebtedness 1985-95 1995-05 2004 2005 2005-09 (average annual growth) GDP 8.2 10.0 13.4 8.5 -Cambodia GDP per capita .. 5.9 7.8 11.2 6.4 Low-income group Exports of goods and services .. 19.3 28.4 16.7

STRUCTURE of the ECONOMY lQB5lgQ5 2004 2005 1 Growth of capltal and GDP (Oh) PA of GDP) Agriculture .. 49.6 32.7 34.2 80 T I Industry .. 14.8 27.7 26.7 60 40 Manufacturing 9.5 20.3 19.1 20 Services .. 35.5 39.6 39.1 0 Household final consumption expenditure .. 95.2 85.3 85.0 -20

General goVt final consumption expenditure 58 45 41 ~ I -GCF -0-GDP Imports of goods and services 46 6 71 9 739 I I

1985-95 995-05 (average annual growth) Agriculture .. 3.8 Industry .. 15.9 Manufacturing .. 18.2 Services .. 8.2 11.7 12.1 Household final consumption expenditure 8.4 11.8 12.2 General poVt final ConSumDtion exoenditure 6.8 Gross capital formation .. 12.2 -10.6 29.0 FEworts -O’lmpolts

87 Cambodia

PRICES and GOVERNMENT FINANCE 1985 1995 2004 2005 Dornesfic prices (% chanqe) Consumer prices 11 5.6 6.7 Implicit GDP deflator 11 7 5.3 5.7 Government finance (% of GDP, includes current grants) Current revenue 75 10.4 10 0 Current budqet balance -0 6 1.3 1.6 Overall surolusideficit -6 6 -4.7 -3 2

TRADE 1985 1995 2004 7-- 2005 ,Export and import levels (US$ mill.) (US$ millions) Total exports (fob) 855 2,589 2,910 15,000 - Rubber 41 115 118 !I‘4 000 + Logs and sawn timber 185 18 19 Manufactures 27 1,963 2,171 Total imports (cif) 1,167 3,270 3,928 Food 62 42 45 Fuel and energy 105 575 788 Capital qoods 961 1,030

~ 99 00 01 02 03 04 05 Export price index (ZOOO=lOO) 59 Import price index (2000=100) I XIEworts Tp Imports Terms of trade (ZOOO=lOO)

BALANCE of PAYMENTS 1985 1995 2004 2005 Current account balance to GDP (%) /US$ miilionsj Exports of qoods and services 969 3,394 4,028 Imports of qoods and services 1,375 3,784 4,575 Resource balance -406 -390 -547 Net income -57 -221 -254 Net current transfers 277 428 440 Current account balance -1 86 -122 -268 Financinq items (net) 198 40 1 Chanqes in net reserves -76 -133 1 Memo: Reserves includinq gold (US$ millions) 110 884 1,050 Conversion rate (DEC, local/US$) 2 450 8 4,019.0 4,097.0

EXTERNAL DEBT and RESOURCE FLOWS 1985 1995 2004 2005 :omposition debt mill.) (US$ millions) of 2004 (USS Total debt outstandinq and disbursed 7 2,284 3,439 3,515 IBRD IDA 65 467 462 8: 467 Total debt service 7 28 31 IBRD IDA 5 6 Composition of net resource flows Official grants 5 312 174 210 Official creditors 63 163 160 Private creditors Foreign direct investment (net inflows) 151 131 379 Portfolio equity (net inflows) World Bank program Commitments i - IBRD E - Bil; Disbursements 3 - IDA D - Other muitilateral F - Pm Principal repayments ;- IMF G - ShC Net flows Interest payments Net transfers

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