Update March 31, 2007 Dollarization in Cambodia by Tal Nay Im and Michel Dabadie Executive Summary Dollarization emerged spontaneously in Cambodia, because public confidence in the riel eroded, following a series of shocks that ranged from the destruction of all infrastructures by the Khmers Rouges, to the subsequent mismanagement of the economy. The lack of public confidence in institutions and in the banking system remains high and dollarization is still in progress, in spite of recent improvements in macroeconomic stability and of measures taken by the authorities to restore confidence. If this trend continues, the country may eventually become fully dollarized. No harsh action should certainly be taken against the use of dollar. However, there is a need to build up a consensus on how to promote the use of the national currency. This paper is one step in that direction. Summary Part I – Dollarization did not result from policy decision, but emerged spontaneously, because confidence of the public was eroded. 1. History of Dollarization 2. Current Situation 3. Trends of dollarization Part II- Immediate or forced de-dollarization could jeopardize macroeconomic stability; however it is possible to promote the use of the national currency. 1. Advantages of dollarization 2. Disadvantages of dollarization 3. International Experience 4. What to do in Cambodia? 5. How to Promote the Use of Riel? Conclusion References Part I – Dollarization Did Not Result from Policy Decision, but Emerged Spontaneously, Because Public Confidence Eroded. 1. History of Dollarization Dollarization in Cambodia resulted from a series of shocks, experiences and events that eroded public confidence in the capacity of the authorities to maintain the value of the national currency, the Riel. There were already some amounts of US dollars circulating in Cambodia during the period of the Khmer Republic (1970-1975). However the Riel remained the currency used normally in domestic transactions. The first shock occurred from 1975 to 1979, when all financial infrastructures in Cambodia (markets, trade, money, and banking) were systematically destroyed. There was no place for a financial system under the Khmer Rouge1. Immediately after they conquered the capital city, the National Bank of 2 Cambodia’s headquarters was bombed to the ground . This picture of the National Bank of Cambodia’s headquarters was taken in January 1979 after the defeat of the Khmer Rouge. After the end of the Pol Pot regime, in 1979, commercial transactions were conducted mainly in the form of barter, or using rice and gold and later also Vietnamese dong. In 1980 the Central Bank was re-established, under the name of the People’s Bank of Kampuchea and the Riel was again the country’s legal currency. During the 1980s, the People’s Bank of Kampuchea 1 Initially, the Khmer Rouge leadership had every intention of issuing its own currency and establishing a banking system of its own. In January 1975, new banknotes, printed in China, were brought down the Ho Chi Minh Trail. In May 1975, it was decided that Riels should be put progressively into circulation. Nong Suan was appointed National Bank Chairman; in August he was replaced by Pich Chheang. Supplies of notes were sent to provinces in August 1975, and the new currency was effectively circulated in the Northern Zone, north-west of Kompong Cham. But the Central Committee and Pol Pot himself considered that the question of whether or not to use money concerned the essence of the Khmer Rouge state. On September 19, 1975, the Central Committee of the Communist Party of Kampuchea (CPK) resolved not to issue the new currency, a decision confirmed at the CPK’s Fourth Congress four months later (Pol Pot, the History of a Nightmare, Philip SHORT, John Murray 2005). 2 More than a deliberate decision of the regime, the destruction of the National Bank of Cambodia headquarters appears to be due to pillage by men from Easter Zone’s headquarters: perpetrators allegedly made off with 200 kilos of gold and then blew up the building to make the theft appear to be the work of gangsters profiting from the confusion (ibid). 2 provided a multitude of services, including acting as the monetary authority, the cashier of the Government, and the only institution providing banking services, such as deposits, loans, and payment instruments. The use of US dollar (USD) and Thai baht (THB) was restricted by the centrally planned economy. However, confidence in the Riel remained low, given the political structure and the security situation, with the consequence that dollar and baht and above all gold were largely considered as a refuge by Cambodians. Dollar Flows and the Start of Dollarization of the Economy Cambodia was transformed from a planned economy to a market economy in the late 1980s, when its borders started to open to trade and when economic and political relations with western countries resumed. In 1991-1992, the United Nations Transitional Authority in Cambodia (UNTAC) was one of the largest and most expensive operations in UN history, at a cost of USD 1.7 billion. US dollars flooded the economy, creating a new shock against the national currency, which the NBC was not prepared to cope with. Subsequently, the central bank and the unique commercial bank (namely Cambodian Commercial Bank, established in 1991 as a joint venture with Siam Commercial Bank), handled all the UNTAC operations and received growing foreign currency deposits. This was the start of huge inflows of capital in the Cambodian economy (see chart 1). Chart 1-Evolution of Foreign Direct Investment (FDI), and Private and Official Flows Subsequently, the dollar started to be used as medium of exchange and unit of accounts, and eventually also to store value alongside with the local currency. 3 De Facto Currency and Asset Substitution Dollarization did not result from a policy decision. It emerged because confidence of the public in the national currency and in the government policy was eroded. In the early 1990s, while tax revenues were very limited due to inactive economy, low profile of the fiscal policy and lack of international support, the budget was mainly financing by central bank, which caused banks’ net claims on government be multiplied by four between 1990 and 1993. The money supply (M2) swelled by 241% in 1990, 29% in 1991, and above 200% in 1992 (see chart 2). This resulted in a sharp devaluation of the riel and in a three-digit hyperinflation which created an additional shock for potential users of the riel. Chart 2-Evolution of Net Claims on the Government (NCG) and Broad Money Supply (M2) Cambodia has known hyperinflation until 1992. Subsequently, Cambodians suffered from a rapid loss of purchasing power of the riel (see the following chart). Chart 3-Evolution of Inflation and Exchange Rate The fiscal performance went also out of control, which resulted in the monetization of fiscal deficit (see the following chart). 4 Chart 4-Evolution of Fiscal Deficit and Broad Money Supply (M2) All these factors contributed to encourage an extensive use of US dollars. Dollarization became a pervasive phenomenon in Cambodia, like elsewhere in the world, in places where high and variable inflation rates have persisted. With hyperinflation, a large proportion of domestic transactions preferably used hard currency, rather than local currency. People also reacted by partially shifting their asset holdings into foreign currency, which was not subject to the same degree of inflation, in order to protect the value of their assets. The conversion of domestic currency into foreign currency put pressure on the exchange rate, which tended to depreciate. Episode of the Asian Crisis in 1997-1998 When the Asian crisis erupted, the Cambodian economy was already largely dollarized, whereas holdings of foreign currency were unrestricted. Finally, the effects of the Asian crisis were reduced in Cambodia. However, again, net credit to the government by banks rose by 300% in 1998, which resulted in another shock, with a high pressure on the exchange rate, which plunged by 29%. Finally, partial dollarization has imposed some discipline on fiscal operations, but not totally. 2. Current Situation Cambodia is a highly, but not fully dollarized economy: it is a multiple currency zone, where the Vietnamese dong (VND) coexists with the riel near the border with Vietnam, the Thai baht (THB) circulates in Western provinces, while the dollar of the United States (USD) commands the greatest share in domestic use. 5 Only 4% of the deposits in banks, and 5% of bank loans, are denominated in riel, as indicated in the following table. Billion riels In Riels In Foreign Currency Total Percentage of riel End-2006 Loans 101 3 371 3 472 2,9% Deposits 186 5 501 5 687 3,3% Table 1- Loans and Deposits in Banks as of end-2006 In addition to the large amount of dollar denominated assets captured by official statistics, an unknown volume of dollars is widely circulating alongside the riel. Be careful with statistics! In fact, the actual amount of dollars and other foreign currency denominated bills circulating in Cambodia is unknown. Therefore, we ignore the real figure of the money supply (M2). Statistics published by the Central Bank include only deposits in banks (denominated in both riels and foreign currencies) and bills in circulation (in riels only). Assuming that bills in riels represent only ten percent of the bills in circulation, the money supply is assessed at some USD 4 billion in 2005, instead of USD 1.2 billion, and USD 5.3 billion in 2006, instead of USD 1.7 billion, as indicated in the following table. billion KHR million USD Money Supply 2005 2006 2005 2006 Currency outside banks (bills in riels) 1282 1600 313 394 Foreign currency deposits 3589 5196 875 1280 Riel deposits 153 147 37 36 M2 (official statistics) 5024 6943 1225 1711 Rough guess of bills in foreign currency (90% of total bills) 11538 14400 2814 3549 Adjusted M2 (rough guess) 16562 21343 4040 5259 Table 2- Adjusted Money Supply There is no evidence that the above assumption is realistic and that bills denominated in dollars, baths and dongs actually represent 90 percent of the bills in circulation.