Inclusive Financial Sector Development Program, Subprogram 2 (RRP CAM 44263–015)

PROGRAM IMPACT ASSESSMENT

1. Executive Summary

1. Only a few policy actions have been selected to estimate costs and benefits in this assessment. Transfers between agents within the economy are excluded, as far as is practicable, although direct transfers to the poor are incorporated. Benefits are attributed to two channels: reduced borrowing costs and increased access to . Reduced borrowing costs are achieved by having a better regulatory framework that reduces risks to lenders and increases confidence among borrowers; this deepens the thus making it more flexible and responsive to consumer needs. Improved access to finance is achieved by improving financial literacy of borrowers, enabling more efficient microfinance and increasing the number of ATMs and branches. Improved financial inclusion also helps to alleviate poverty and reduce income inequality, in addition to measures that specifically target the poor, rural people and women. In summary, the program produces benefits to the economy with a present value of between $341 million and $672 million, with the most likely scenario yielding $507 million in benefits. Benefits are split evenly between reduced borrowing costs and financial inclusion. Estimated costs range between $113 and $282 million and arise primarily from staffing and regulatory costs, as well as the establishment of a deposit protection scheme. 2. Macroeconomic context

2. The Cambodian economy has grown above 7% per annum from 2011 to 2016 with a slight decrease to just below 7% in 2017 and 2018. This growth is broadly in line with Association of Southeast Asian Nations (ASEAN) countries in a similar stage of economic development such as Laos, Myanmar and Vietnam. However, from a welfare perspective, GDP per capita has grown at a rate of around 5% per annum and more than 70% of Cambodians live on less than $3 a day. The new Rectangular Strategy (Phase IV) acknowledges that maintaining a 7% broad-based rate will require structural adjustments, which includes development of the financial sector to make it more inclusive and to deepen and diversify it.

3. Development problem and constraints

3. The finance sector is shallow and lacks diversity. dominate the Cambodian financial sector for 84% of total financial sector assets and representing 142% of GDP, which is higher than comparable ASEAN countries.1 Microfinance institutions account for about 15% of the sector and the remaining 1% consists of financial products relating to , leasing, capital markets and pension funds. Cambodia has yet to develop a local currency government market, although local currency corporate bonds were issued for the first time in Cambodia in October 2018, an initiative supported by the Securities and Exchange Commission of Cambodia (SECC). bureau penetration is low, with only 144 reporting institutions out of 2,951 (including 2,476 money changers) in the system.

1 https://www.theglobaleconomy.com/rankings/bank_assets_GDP/ accessed on 26 February 2019.

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4. Low level of financial inclusion.2 Cambodia ranks 155 out of 176 countries. This is mainly due to low financial literacy, where it ranks 135 out of 144 countries;3 lack of consumer protection from unfair business practices; financial market unresponsive to consumer needs due to inadequate regulatory framework; and limited availability of financial sources for SMEs, small farmers and the agriculture sector. Despite rapid credit growth, lending is fragmented with credit readily available in urban areas, but rural areas remain underserved. A financial inclusion study in 2015,4 highlighted a major problem of financial exclusion in the Cambodia, estimating that only 59% of the adult population had access to formal financial services (68% in urban areas and only 55% in rural), 12% use informal services and 29% were completely excluded having no access to formal and informal financial services.

5. Weak financial sector stability framework due to a lack of coordination among National Bank of Cambodia (NBC), Ministry of Economy and Finance (MEF) and the SECC; absence of a deposit protection scheme (DPS); and the lack of a local currency government .

6. Underdeveloped financial infrastructure due to outdated payment systems; lack of a legal framework to enable e-commerce and related financial products; and weak anti-money laundering and counter-terrorist financing mechanisms.

4. Policy interventions to overcome constraints

7. The program consists of measures to support financial inclusion, financial stability and financial infrastructure. These build on the achievements of subprogram 1.

4.1 Measures to enhance financial inclusion

8. Under subprogram 2, the government finalized the National Strategy for Financial Inclusion (NSFI). NSFI seeks to provide a framework to broaden the access to financial services for individuals including specific targets for women and micro, small and medium enterprises (MSMEs); and to deepen the provision of financial services making them responsive to consumer demand. Under subprogram 3, the government will launch and implement the NSFI, implement the Consumer Protection Law and establish its enforcement agency, pilot financial literacy programs in schools and license microinsurance operators.

4.2 Measures to strengthen financial stability

9. Under subprogram 2, the government has taken measures to increase coordination among finance regulators, enhance the effectiveness of credit insurance and facilitate the establishment of a bond market in Cambodia. It established a joint financial stability technical group comprising NBC, MEF and SECC to facilitate a coordinated response for crisis management. The government also selected the Paybox Plus DPS model in which the deposit insurer provides additional resolution functions. To establish a basis for a domestic bond market, the government revised its debt strategy to incorporate provisions to authorize the eventual issuance of , which establishes a yield curve and provides a meaningful

2 Park and Mercado Jr, Financial Inclusion, Poverty, and Income Inequality in Developing Asia, ADB Economic Working Paper Series, No 426, January 2015. 3 Atlas. Global financial literacy ranking. https://www.theatlas.com/charts/VJDhtA8Xe (accessed 29 January 2019). 4 United Nations Capital Development Fund. 2015. FinScope Consumer Survey 2015. Phnom Penh.

3 benchmark for capital markets. Under subprogram 3, the government will establish a fully-fledged national financial stability committee, implement the Paybox Plus DPS, and formalize a roadmap for government debt securities.

4.3 Measures to upgrade financial infrastructure

10. Under subprogram 2, the government will launch a Central Shared Switch System for ATMs and point-of-sale terminals to allow all bank cards to be used at all participating merchants; increase coverage of the national credit bureau’s database to include corporate borrowers; and set up a steering committee to formalize an action plan to address evaluation findings of the Asia Pacific Group. Also, significant progress has been made in addressing the lack of an enabling legal framework for modern financial products and services. The Trust Law, which governs the establishment, registration, supervision and termination of trusts thus paving the way for the development of investment vehicles, has been submitted to the National Assembly for approval; and the e-Commerce Law, which provides a framework for domestic and international e- commerce, was also submitted to the National Assembly for approval. Under subprogram 3, the government will establish a Real Time Gross Settlements system, achieving a pre-agreed number of “compliant” or “largely compliant” ratings on FATF Recommendations, establish new financial products under the trust scheme and establish payment system infrastructure to facilitate the introduction of e-Commerce.

5. Benefits and costs of policy intervention

5.1 Policy interventions and impacts

11. Only a few policy measures were selected for estimating the costs and benefits of subprogram 2. Costs calculated and benefits estimated are not exhaustive; hence these are for illustrative purposes only. The three output measures are very much interlinked; therefore, it is difficult to directly link costs to specific benefits. For example, measures to strengthen financial stability will reduce borrowing costs (due to reduced risks), deepen finance (due to more finance providers entering the market and providing more responsive financial products to satisfy borrowers) and enhance financial inclusion (due to small being protected). Similarly measures to increase financial inclusion and measures to upgrade financial infrastructure will result in benefits across sectors, all resulting from increased confidence of large- and small-scale investors.

Table 1: Summary of measures

Policy measure Summary of impact

Financial inclusion (4.1) Increased access to finance and associated benefits. Costs are mainly due to staff and administration set up. - A formal process to develop the country’s first comprehensive financial inclusion strategy, to encourage wider and more inclusive participation in the financial sector.

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Policy measure Summary of impact

Financial stability (4.2) Reduction in borrowing costs due to decreased risk (borrowing multiplied by decrease in interest rates). Cost - Coordination among regulators of Paybox Plus DPS and staff and administrative costs. - Deposit insurance. Paybox Plus DPS

- Establishment of bond market

Financial infrastructure upgrade (4.3) • Benefits of financial inclusion - financial infrastructure upgrades enhance financial inclusion and result in - Central Shared Switch System economic benefits. For example, CSSS expands (CSSS) for Point-of-Sale terminals access of those who live in rural areas to ATMs. and ATMs • Software for CSSS - Expansion of credit bureau database coverage • Software development costs

- Implementation of Trust law and e- • Administrative costs for data base administrators Commerce law

Summary of benefits (common to all measures)

• Increase in banking and microfinance and reduction in associated interest margins. Increase in utilization due to expanded insurance.

• Increase in GDP due to more financial inclusion, as availability of credit to lower income groups improves their access to financial services, which in turn enables them to undertake productive activities.

• Second-round effects: increased investment resulting from lower cost of capital and leading to increased productivity and employment.

12. There are also benefits that have not been quantified. For example, financial inclusion is likely to decrease income inequality. Furthermore, there are significant second-round effects resulting from lower cost of finance such as increased investment, higher employment and reduction in poverty especially among the rural population.

13. There are risks in implementation. Unintended consequences are a scourge of any regulation. More specifically, macro-economic instability can delay reforms, reforms may be pursued in an ad-hoc manner resulting in smaller benefits, and reforms are less likely to effective when public financial management is weak due to lack of transparency and accountability.

5.2 Methodology and assumptions

14. Only a few policy actions have been selected to estimate costs and benefits in this assessment. Continuing costs and benefits, which do not have a termination date, are assumed to be perpetual and are present-valued using the ADB’s preferred social discount rate of 9%. One- off costs and benefits take their face value. Ongoing costs are discounted using a rate of 9% over the period in which the costs are expected to be incurred and benefits gained. 5

15. The analysis focuses on genuine improvements in efficiency as a source of benefits. Transfers between agents within the economy are excluded, as far as is practicable, although direct transfers to the poor are incorporated. Efficiency is broadly interpreted to include lower debt servicing costs resulting from increased creditworthiness, technological improvements and a more responsive financial market.

16. Costs relate mainly to staff and information technology infrastructure. Additional employees are necessary to develop regulations (including laws), and to implement and enforce them. Staff are also required to run additional bank branches and computer systems. In addition, physical assets such as ATMs and related infrastructure must be procured to achieve improvements. Calculation of these costs are described in paragraphs 26–30.

17. The impact of the policy measures is to reduce borrowing costs and to improve access to finance. Reduced borrowing costs are achieved by having a better regulatory framework that reduces risks to lenders and increases confidence among borrowers; this deepens the financial market thus making it more flexible and responsive to consumer needs. Improved access to finance is achieved by improving financial literacy of borrowers, enabling more efficient microfinance and increasing the number of ATMs and bank branches. Improved financial inclusion also helps to alleviate poverty and reduce income inequality, in addition to measures that specifically target the poor, rural people and women.

5.3 Estimation of benefits and costs

18. Benefits and costs of selected measures are explained in the following paragraphs, which are cross-referenced. Details of calculations are in attachment 1–4. These are for illustrative purposes, due to the limitations outlined in paragraphs 11–13.

Benefits

19. Countries which have banking systems with rigorous prudential requirements have lower risks which result in lower interest rates. This is explicitly recognised in the modelling approaches of international ratings agencies. Hence, a very modest reduction of 5 basis points has been chosen in the PIA, based on experience of similar countries such as Indonesia. Such reduction has been applied to bank loans in 2019 to estimate the reduction of debt service costs (impact of lower on microfinance loans has been excluded, as it is possible that they may be captured under the benefits of financial inclusion, to avoid double counting). PV was calculated using ADB’s discount rate of 9% applied to the debt reduction costs in perpetuity. The following table provides a sensitivity analysis of benefits for varying reductions in basis points, to give a feel for the impact.

Table 2: PV of benefits for reduction in basis points (USD millions) Basis point reduction (bp) 3 5 7 PV of benefits (USD millions) 158 263 368 (see attachment 2 and paragraphs 19, 20 and 23)

20. SECC supported the first ever issuance of corporate bonds prepared under the ASEAN+3 multi-currency bond issuance framework, in October 2018. However, when government bonds are eventually issued (a medium-term goal of the government), they will decrease the banks’ vulnerability to dollarization providing the government with more effective and independent tools to manage financial system risks; and contribute to the development of capital market and institutional base. Government bonds will establish a yield curve and 6 provide a meaningful benchmark for capital markets. However, as these were the first issuance of bonds, it is too early to make a realistic estimate of costs and benefits, even though the benefits are likely to far outweigh the costs.

21. Low level of financial inclusion has been recognised as a significant constraint, hence the subprogram includes the adoption of a national financial inclusion strategy (NSFI). Four main constraints have been recognised: low financial literacy, lack of consumer protection laws, regulatory framework that has resulted in paucity of financial instruments that are responsive to consumer needs, and limited financing of SMEs, small farmers and agriculture sector. Financial inclusion is often considered a critical element that makes growth inclusive as access to finance can enable economic agents to make longer-term consumption and investment decisions, participate in productive activities, and cope with unexpected short-term shocks.5

22. Cambodians have low financial literacy and have been ranked as 135 out of 144 countries,6 perhaps due to lack of financial modules in school curriculums, government public outreach programs and information programs led by the banking industry. To improve this, the program aims to incorporate financial literacy in the Cambodian education system covering value of money, types of financial products, savings and investments.

23. Subprogram 2 builds on the efforts of subprogram 1. The Trust, Consumer Protection and e-Commerce laws were submitted to the National Assembly for approval. These laws increase access to finance by increasing the confidence of the people, especially the poor and those living in rural areas, and by developing financial products that are suitable for their needs. The laws also reduce risks for financial market participants and help to deepen financial markets thereby contributing to the reduction in margins stated in paragraph 12.

24. The benefits of financial inclusion are substantial. An ADB report prepared by Oliver Wyman in 20177 estimated that the potential boost to GDP is as high as 32% in Cambodia. The report claims that only 13% of adults have bank accounts and fewer than 4% save with a formal financial institution. However, such a large increase in GDP is only possible with ‘closing the gap’ in financial inclusion, of which this program will only achieve a part. Yet, even a small part will result in substantial benefits. This PIA assumes GDP growth of 0.32% (one hundredth of the 32% forecast by Oliver Wyman). The effects of the intervention is assumed to last 3 years, and in 2019 prices the GDP increase over that period as shown below. The current GDP of 2019 is estimated at $25.37 billion (based on the annual 7% GDP growth trend).

Table 3: GDP increase due to financial inclusion (USD millions) GDP increase (in constant prices) 0.24% 0.32% 0.4% Total GDP increase for 3 years from 2019 183 244 304 (see attachment 1 and paragraphs 21-25)

25. There are also substantial welfare benefits of financial inclusion, ranging from reducing poverty to increasing incomes and promoting economic growth, which have been widely cited. For example, a 2015 publication by the ADB8 studied the importance of financial inclusion in reducing poverty and lowering income inequality in developing Asia. The report found a significant correlation between higher financial inclusion and lower poverty and income equality.

5 Park and Mercado Jr, Financial Inclusion, poverty and income inequality in developing Asia, ADB Economics Working paper Series, No 26, January 2015. 6 Atlas. Global financial literacy ranking. https://www.theatlas.com/charts/VJDhtA8Xe. (accessed 29 January 2019). 7 Oliver Wyman, Accelerating Financial Inclusion in South-East Asia with Digital Finance, ADB 2017. 8 ADB (2015): No.426 “Financial inclusion, poverty, and income equality in developing Asia”. 7

Costs

26. Cost of ATMs: The PIA estimates that the installation of ATMs will continue to increase for the next 10 years (at the 5-year moving average rate during 2013-17), by which time the growth will taper due to saturation and technology (e.g. phone banking and Electronic Funds Transfer (EFT) replacing ATMs).9 PV of installing ATMs over 10 years was calculated. Also, each year some machines will have to be replaced. It was assumed that about 200 ATMs will be replaced each year in the future. The PV of replacement was calculated $3 million and added to the PV of installing new machines $2 million. These additional ATMs will contribute to increase access to finance, especially to the rural population and poor, thereby contributing to better financial inclusion.

27. Cost of additional staff: Banks and MFIs. Number of employees in banks and MFIs are forecast to increase over the next 10 years, at the same average increase over the five years from 2013 (16,221) to 2017 (29,863).10 After 10 years the numbers will cease to increase, like ATMs, due to saturation and technology and automation replacing workers. Estimates of average salaries11 were used to calculate wage costs (increase in staff x average wage). The PV for 10 years was calculated as $80 million for bank staff and $23 million for MFI staff. This staff increase, especially in the MFI sector, will facilitate financial inclusion by making banking more accessible. It should be noted that in the past, number of branches and employees in banks have increased, whereas MFI branches have decreased while their employees have increased. This suggests structural changes in MFIs and a possible impact of technology.

28. Experts are required to administer trust and consumer protection laws, and the PIA estimates that 20 of them are required. Information technology staff are required to service computer systems that integrate ATMs and manage DPS systems. The DPS will be managed and supported by NBC at the onset and medium-term but transition into an independent scheme in the long-term. As such, except for IT-related costs, no significant additional staff costs will be associated with DPS whilst incorporated within NBC. It is estimated that 10 staff are required and each employee, on average earns a salary of $15,000 per annum. The resulting flow of $450,000, discounted for perpetuity is calculated as $4.8 million.

29. To prepare for an SME credit guarantee scheme, the government addressed the structural and infrastructure constraints in the rice sector by providing a total of $73 million for working capital and investment funds to purchase paddy rice and build drying, storage and milling facilities. The portion of expenses used to build the infrastructure was used in the cost calculations.

30. The government supports several financial infrastructure upgrades, building on its efforts in subprogram 1. For example, it launched a Central Shared Switch System for ATMs and point- of-sale terminals which allows consumers to use their bank cards at all participating merchants and increased the coverage of the national credit bureau’s database to include corporate borrowers. The ongoing staff costs for these has been captured under staff costs, and the set-up and hardware costs are assumed to be $12 million, a lower estimate reflecting the Cambodian

9 Over the indicated period, ATMs increased at a rate of 181 per year. 10 National bank of Cambodia. 2018. Annual Supervision Report. Phnom Penh. 11 50% and 25% increases on Cambodia’s 2016 annual household income per capita were applied to banking and MFI staff salaries respectively. https://www.ceicdata.com/en/indicator/cambodia/annual-household-income-per-capita. Legal and IT staff salary estimates were derived from https://www.averagesalarysurvey.com/cambodia.

8 economy and size compared with costs ranging from $50 to $300 million typically associated with building IT infrastructure in financial institutions in developed countries.12

Table 4: PV of costs (USD millions)13 Ref para

Installation of ATM machines 5 26

Staffing costs: banks, MFIs, legal/regulatory and IT 108 27 & 28

SME credit guarantee scheme 44 29

IT infrastructure (e.g. cost of Paybox Plus DPS, shared ATMs etc) 12 30

Total 169 ADB’s discount rate of 9% was used to calculate PVs.

Table 5: Range of costs (USD millions) PV of costs (refer Table 4) under varying assumptions High PIA Low

Cost of ATM, staffing, SME credit guarantee scheme and IT 282 169 113 infrastructure

31. It is important to note that the PIA is based on very conservative assumptions. For example, only a 5-basis points reduction (2–7 range) is assumed. Even more prudently, GDP growth due to financial inclusion is estimated to be 0.32% (0.24%–0.4% range), whereas the ADB-Wyman Report considers that potential gains can be as high as 32%. Also, the PIA does not monetize several other benefits due to practical difficulties in making assumptions to translate qualitative indicators to robust dollar values. For example, benefits arising from dynamic efficiencies in the job market, reduction of poverty, decrease in income inequality and benefits arising from insurance have not been included. These are briefly discussed in the following paragraphs.

32. More employment leads to movement in the job market and efficiencies are often achieved due to better match of skills to jobs. An efficiency dividend of 1% can result in a PV of benefit of over $20 million. Also, increased number of ATMs and branches result in less time spent on financial transactions. A rough value of such time savings also exceeds $100 million.

33. The insurance industry in Cambodia has been growing, suggesting a healthy net benefit arising from the industry. Over 2013–2017 gross insurance premiums grew by 28% on average and the gross premium receipts from all insurance products was $151 million in 2017. However, in a strict financial sense, insurance transactions result in negative value, as premiums exceed payouts (to cover overheads, etc). Moral hazard and adverse selection associated with insurance transactions further decrease the value. However, there is utility in insurance which is difficult to value and has not been considered in this PIA. Insurance, especially microinsurance, can benefit the poor by enabling them to undertake activities that they otherwise would not without insurance cover.

12 https://www.mckinsey.com/business-functions/digital-mckinsey/our-insights/overhauling-banks-it-systems. 13 Total may not reconcile due to rounding. 9

34. Welfare effects of poverty alleviation and inequality reduction are well known. The financial inclusion component of the program attempts to address these. These benefits also have not been monetized in the PIA.

6. Transmission Mechanism

35. Table 6 summarizes, the reforms, impacts (qualitative and quantitative where possible), transmission mechanism and provides estimates of costs and benefits for selected reforms.

Table 6: Impact of reforms and transmission mechanism Reforms Transmission mechanisms Expected benefits Access to formal financial services to • Additional ATMs, bank • GDP growth of 0.32%. the poor expanded (reform area 1) branches and staff, and MFI • Increased access to i. National strategy for staff deposits, loans and financial inclusion with • Introduction of withdrawals specific targets to support microinsurance products and • Increased access and women licensing of microinsurance inclusion to ii. RDB restructured as a policy operators microinsurance bank products iii. Gender-responsive financial • Poverty alleviation, literacy campaign for low- reduced inequality and income youth improved economic iv. Consumer Protection Law conditions for women enacted and literacy for (female) v. Consumer complaint children functions and consumer outreach programs established by NBC, MEF and SECC. vi. Preparation for an SME credit guarantee scheme vii. Implementing policies for microinsurance. Financial sector stability enhanced • Better prudential controls • Benefit of low interest: (reform area 2) result in lower risks (low PV $263 million (reform i. Joint Financial Stability interest rates) areas 2 and 3) Technical Group • Consumer deposit • Better resilience to established protection and cross-sector financial crises and ii. DPS model finalized supervision systemic losses iii. Strategy for government • Introduction of government • Deepening of capital bond issuance. securities which provide a market yield curve and meaningful benchmark for corporate bonds and other securities

Financial sector infrastructure • Regional and international • Increased financial upgraded (reform area 3) interconnectivity inclusion i. Central shared switch • Trust and investment • Deepening of capital system for ATMs and products market and creation of point-of-sale terminals, • Regulated e-Commerce investor base enabling interconnected activities • Increased local and electronic transactions • Improved corporate international trade regardless of customer borrower data • Improved corporate bank credit risk assessment 10

Reforms Transmission mechanisms Expected benefits ii. Corporate borrowers and scoring included in credit information database iii. Action plan to address the 2016 APG evaluation findings established iv. Enactment of Trust Law v. Enactment of e-Commerce Law Triggers in bold.

7. Risks

36. The Cambodian economy is likely to experience significant headwinds if the EU or US removed preferential trade access for Cambodia’s exports. In February 2019, the EU announced14 that it would begin the process of suspending the Everything but Arms (EBA) trade scheme. The EBA trade scheme allows Cambodia to export products other than weapons to the EU duty-free and quota-free. In 2017, Cambodia exported approximately $5.8 billion worth of goods to the EU, accounting for 40% of Cambodia’s exports. Over 99% of Cambodian exports to the EU, Cambodia’s largest export market, were eligible for EBA preferential duties, which included textiles, footwear, and agricultural products such as rice. Since joining the trade scheme in 2001, the textile industry in Cambodia has experienced tremendous growth and today employs around 700,000 workers.15 Also, in January 2019, two US Senators introduced the Cambodian Trade Act of 2019, which would require the administration to review the preferential trade treatment Cambodia receives under the General System of Preferences.16 The US is Cambodia’s second biggest export country accounting for over a quarter of its exports.

8. Conclusion

37. The benefits of subprogram 2 arising from lower interest margins and financial inclusion, estimated under very conservative assumptions, are likely to be substantial. The scope of the analysis is limited in nature and several welfare enhancing measures such as poverty alleviation have not been monetized and incorporated in the calculations. Although the quantification of the expected benefits is for illustrative purposes, it highlights the importance of reforms and corroborates the discussion that ADB’s collaboration with the Government of Cambodia by offering budgetary support will encourage the government to implement the reforms that would result in financial sector inclusiveness, stability and infrastructure improvement.

14 http://europa.eu/rapid/press-release_IP-19-882_en.htm accessed on 14 March 2019. 15 https://thediplomat.com/2019/02/cambodias-democracy-and-eu-trade-privileges-taking-a-long-term-view/ accessed on 14 March 2019. 16 https://www.business-humanrights.org/en/cambodia-two-us-senators-introduce-the-cambodian-trade-act-of-2019- after-witnessing-deteriorating-human-rights-and-labour-rights-situations-in-cambodia accessed on 14 March 2019.